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ABT | 2 | 2,024 | 2024-07-18 09:00:00 | Operator: Good morning and thank you for standing by. Welcome to Abbott’s second quarter 2024 earnings conference call. All participants will be able to listen only until the question and answer portion of this call. During the question and answer session, you will be able to ask your question by pressing the star-one-one keys on your touchtone phone. This call is being recorded by Abbott. With the exception of any participants’ questions asked during the question and answer session, the entire call including the question and answer session is material copyrighted by Abbott. It cannot be recorded or rebroadcast with Abbott’s express written permission. I would now like to introduce Mr. Mike Comilla, Vice President, Investor Relations.
Mike Comilla: Good morning and thank you for joining us. With me today are Robert Ford, Chairman and Chief Executive Officer, and Phil Boudreau, Executive Vice President, Finance and Chief Financial Officer. Robert and Phil will provide opening remarks. Following their comments, we’ll take your questions. Before we get started, some statements made today may be forward-looking for purposes of the Private Securities Litigation Reform Act of 1995, including the expected financial results for 2024. Abbott cautions that these forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those indicated in the forward-looking statements. Economic, competitive, governmental, technological, and other factors that may affect Abbott’s operations are discussed in Item Ia, Risk Factors to our annual report on Form 10-K for the year ended December 31, 2023. Abbott undertakes no obligation to release publicly any revisions to forward-looking statements as a result of subsequent events or developments, except as required by law. On today’s conference call, as in the past, non-GAAP financial measures will be used to help investors understand Abbott’s ongoing business performance. These non-GAAP financial measures are reconciled with comparable GAAP financial measures in our earnings news release and regulatory filings from today, which are available on our website at abbott.com. Note that Abbott has not provided the GAAP financial measure for organic sales growth on a forward-looking basis because the company is unable to predict future changes in foreign exchange rate, which could impact reported sales growth. Unless otherwise noted, our commentary on sales growth refers to organic sales growth, which is defined in the press release issued earlier today. With that, I will now turn the call over to Robert.
Robert Ford: Thanks Mike. Good morning everyone and thank you for joining us. Today we reported organic sales growth of more than 9%, excluding COVID testing sales. We also reported adjusted earnings per share of $1.14, which exceeded analyst consensus estimates and represents a 16% sequential increase from the first quarter. Based on our performance in the quarter and confidence in our outlook for the remainder of the year, we raised our guidance and now forecast full year organic sales growth, excluding COVID testing sales, to be 9.5% to 10% and adjusted earnings per share in a range of $4.61 to $4.71. Our performance continues to be driven by broad-based growth across the portfolio with growth this quarter led by double-digit growth in medical devices and high single-digit growth in established pharmaceuticals and nutrition. In addition to benefiting from outperforming expectations on the top line, we are also seeing positive contribution from gross margin expansion coming from continued execution from our supply chain teams, lower commodity costs, and favorable sales mix. I’ll now summarize our second quarter results in more detail before turning the call over to Phil, and I’ll start with nutrition, where sales increased 7.5% in the quarter. Strong quarter in the quarter was led by double-digit growth in international adult nutrition and U.S. pediatric nutrition. International adult nutrition continues to perform at a very high level. The five-year compound annual growth rate of this business is more than 10%, which in addition to our market-leading position and commercial execution reflects the impact from positive demographic trends that drive increasing demand for our Ensure and Glucerna brands. Through the investments we’ve made to expand capacity, we are well positioned to continue to capitalize on these secular demand trends. On the topic of litigation, regarding pre-term infant formula and human milk fortifier, Abbott stands by our products and the information provided to the neonatologist specialists who have used them for decades. Necrotizing enterocolitis, or NEC, is a terrible gastrointestinal disease that primarily affects premature infants, and it is devastating to families; however, plaintiff lawyers are advancing a theory that is without merit or scientific support. These products, which are sold for hospital use, are incorporated into a feeding regimen along with human milk by experienced specialists and are an important part of the standard of care for the majority of preterm infants. Their use is supported by medical associations in the United States and other countries around the world. The products and their ingredients have been reviewed and are deemed safe for use by regulators, who have also reviewed their labels. There has been no increase in the rate of NEC, meaning these cases have not emerged in response to a trend or any new information, yet we’re seeing plaintiffs’ lawyers investing millions of dollars in misleading TV advertising in an attempt to move physician decisions from the hospital to the courtroom. Total revenues for these products are about $9 million annually, and have remained at that level for the past several years. If these products were no longer available, physicians would be deprived of the vital food that is needed in the NICU. This would create a public health crisis affecting every state across this country. We believe it’s important for all who have an interest in health of preterm infants, who recognize the need for these products and to take action accordingly. Moving to diagnostics, where sales increased 6% excluding COVID testing sales, growth in the quarter was driven by high single-digit growth in core laboratory diagnostics and double-digit growth in point-of-care diagnostics. In core lab diagnostics, we continued to drive growth through increased adoption and utilization of our market-leading systems and global demand for our extensive testing menus across the areas of immunoassay, clinical chemistry, hematology, and blood screening. While our Alinity family of diagnostic systems first launched more than six years ago, given the long contract cycles common in the diagnostics industry, we continued to see a benefit in our contract renewal and competitive win rates with several recent large account wins expected to increasingly contribute to growth in the second half of the year. Turning to EPD, where sales increased 8% in the quarter, EPD continues to deliver at a high level as this business executes its unique branded generic strategy in emerging markets, where growth is supported by favorable demographic trends, including increasing populations, growing middle classes, and increasing focus on expanding access to healthcare. As you recall, we identified biosimilars as a new strategic growth pillar for this business. With our extensive presence in emerging markets, we have a unique opportunity to scale a licensing model that is capital efficient and can bring access to these life-changing medicines to millions of people in emerging markets. We began implementing this strategy last year when we announced an agreement to commercialize several biosimilars in the areas of oncology and women’s health, with the first of these expected to launch in 2025. We recently completed additional agreements that provide Abbott access to biosimilar versions of market-leading autoimmune disease and GLP1 medications. Biosimilars represent the highest growth segment in the branded generic pharmaceutical market, and we look forward to continuing to build one of the most complete portfolios in the industry. I’ll wrap up with medical devices, where sales grew 12%, in diabetes care, Freestyle Libre sales were $1.6 billion in the quarter and grew 20%. We announced in June that we received FDA approval for two new over-the-counter continuous glucose monitoring systems called Lingo and Libre Rio, which are based on Libre’s glucose technology that is now used by more than 6 million people around the world. While over-the-counter availability is a new option in the United States, we’ve been selling over-the-counter in international markets since Libre launched 10 years ago. Given our clear leadership position in these markets, we have demonstrated our ability to tailor solutions, approach and communication for the various types of users who compose the CGM customer base. Lingo is designed for consumers who are willing to improve their overall health and wellness. The Lingo wearable sensor and app will track glucose, provide personalized data, insights and coaching to help create and maintain healthy habits. Libre Rio is designed for adults with Type 2 diabetes who do not use insulin and typically manage their diabetes through lifestyle modifications. In electro-physiology, growth of 17% was driven by double-digit growth in all major geographic regions, including 17% growth in the U.S., which represents an acceleration compared to the growth in the first quarter. Growth was broad-based across the portfolio and included 20% growth in ablation catheters. In structural heart, growth of more than 15% reflects an acceleration in growth compared to the first quarter and was led by several recently launched products that are driving new adoption and share capture in attractive high growth areas, including TAVR, LAA, and tricuspid repair. This quarter, we launched our tricuspid repair device, TriClip in the United States and continued our trend of capturing market share in the global TAVR market. In rhythm management, growth of 6% was led by Aveir, our highly innovative leadless pacemaker, and in June we announced that we received CE mark in Europe for Aveir to be used in dual chamber pacing procedures, which is the largest segment of the pacing market. In heart failure, growth of 9% was driven by our market-leading portfolio of heart-assist devices that offer treatment for both chronic and temporary conditions. In neuromodulation, growth of 8% was driven by strong demand in international markets for our Eterna rechargeable spinal cord stimulation device, which obtained CE mark in Europe last year. In vascular, we received FDA approval in late April for our Esprit dissolvable stent, a breakthrough innovation for people who suffer from blocked arteries located below the knee. Esprit is designed to keep the arteries open, deliver a drug to support vessel healing prior to completely dissolving over time. New products like Esprit combined with the investments that we made in our vascular business, both organically and inorganically, have expanded our presence in faster growing areas and increased the future growth outlook for this business. In summary, we exceeded expectations both the top and bottom lines and, as a result, we raised our financial outlook for the year. We continue to make good progress on our gross margin initiatives and, more importantly, our pipeline continues to be highly productive, and thus we’re well positioned to deliver strong results for the remainder of the year. I’ll now turn over the call to Phil.
Phil Boudreau: Thanks Robert. As Mike mentioned earlier, please note that all references to sales growth rates, unless otherwise noted, are on an organic basis. Turning to our second quarter results, sales increased 7.4% on an organic basis and increased 9.3% when excluding COVID testing sales. Foreign exchange had an unfavorable year-over-year impact of 3.5% on second quarter sales. During the quarter, we saw the U.S. dollar strengthen versus several currencies, which resulted in more unfavorable impact on sales compared to exchange rates at the time of our earnings call in April. Regarding other aspects of the P&L, the adjusted gross margin ratio was 56% of sales. Adjusted R&D was 6.3% of sales, and adjusted SG&A was 27.7% of sales in the second quarter. Lastly, our second quarter adjusted tax rate was 15%. Turning to our outlook for the full year, we now forecast full-year adjusted earnings per share of $4.61 to $4.71, which represents an increase compared to the guidance range we provided in April. We also raised the midpoint of our guidance for organic sales growth. We now forecast organic sales growth excluding COVID testing sales to be in the range of 9.5% to 10%. Based on current rates, we expect exchange to have an unfavorable impact of more than 2.5% on full-year reported sales, which includes an expected unfavorable impact of approximately 3% on third quarter reported sales. Lastly, for the third quarter we forecast adjusted earnings per share of $1.18 to $1.22. With that, we’ll now open the call for questions.
Operator: Thank you. At this time, we will conduct a question and answer session. [Operator instructions] Our first question will come from Larry Biegelsen from Wells Fargo. Your line is now open.
Larry Biegelsen: Good morning. Thanks for taking the question, and Robert, congratulations on a nice quarter. Thanks for your comments on the NEC litigation. I’m wondering if you have anything to add on that, Robert, and then I have one follow-up question.
Robert Ford: No Larry, I think I said everything I said during my prepared comments. I guess the only add here is I think this is way overblown in terms of its impact, and we are--we’re working to obviously defend our position and--you know, working with all the different stakeholders so that they are aware of the situation, the gravity of the situation as it progresses. But I said all I had to say right now in my prepared comments, and if there’s a need to kind of give further updates, we will.
Larry Biegelsen: All right, thanks. Separately, Robert, your EPD business grew nicely in the second quarter, 17% in both the U.S. and international. What drove that, what are you seeing with PFA in the different geographies, and how are you thinking about the sustainability of that growth before bolt [ph] launches? Thank you.
Robert Ford: Sure, well I’m seeing what I thought I was going to see. It might be a little different from what some of you thought you were going to see, but what we’ve been seeing is obviously an increase in the market, so right now the market has accelerated, seems to be growing above 20%, so when you look at our 17%, it’s lower than the market but it’s actually growing faster than what it was growing pre-pandemic, or just after we had done the acquisition. We’ll see if the--I mean, that growth is obviously in value. We’ll see if the growth in procedures actually translates. We are actually in more procedures than what we were in the past, given our mapping and our teams, but I think it’s a little bit too early to say if the actual number of procedures is going to significantly increase. The market has accelerated, but it’s predominantly, I think, price right now with the introduction of this new product. It’s predominantly being used in de novo procedures, atrial procedures, right, and we think that’s about a third of all ablation procedures, Larry. The other two-thirds, we continue to see, whether it’s re-dos, VT, SVT, ablations, in that case we continue to see RF really being viewed as the better option for those procedures. We’ll see how that’s going to translate over time, but OUS, the penetration is around 10%, 15%. It’s been pretty stable. From the point of view of mapping, I think we haven’t seen a real big change of what we saw during those first couple of months of launch and in the last call, so over 90% of cases here in the U.S. are still being used as mapping. We’ve got a 50 share of those mapping cases. I don’t try and look at different types of denominators to get to that market share, so I make sure my team just basically has the best access and, from what we’re seeing, it’s about 50%. RF catheters, similar to what we saw in the last call, still being used in about 20% of the PFA cases, so we continue to see that. I think the net effect of all of this is the market’s growing, it’s accelerating. We’ve got a strong position. Everything that we’ve talked about in the past, about our opportunity with the mapping and all of the other consumables is there. RF still plays a role, it’s still an important role, and our business has actually grown faster than what it was growing before. If you look at ’19, we were about 12%, ’18 was about 14%, so we’re actually doing better now. I think that is positive for the market, which is why we’ve invested heavily in our PFA portfolio, which will--you will start to see hit the market in the--I’d say next year, I’m not going to try and time the quarter here, but definitely next year. I think this is good and the teams have done an incredible job at executing the strategy that we laid out, so kudos to them.
Larry Biegelsen: Thanks so much. Thanks for the comprehensive answer.
Operator: Thank you. Our next question will come from Travis Steed from BofA Securities. Your line is open.
Travis Steed: Hey, congrats on the good quarter. I wanted to ask about structural heart - really stood out this quarter, accelerated from last quarter. Just curious how much of that is on MitraClip recovery, you got TriClip approved early, how much you’re seeing from the TriClip side and how much is coming in from some of the other newer products, like Amulet and Navitor.
Robert Ford: Sure. Obviously TriClip was an important launch and helped to accelerate the growth rate, Travis, but I think it’s pretty broad-based here. I mean, if you look at TriClip, we were ready to go because we had certain built-in advantages in this area, right - we had the scale, we had the sales force, the manufacturing capacity, so we were ready to go. I think from our estimates here, even though we launched a quarter after our competitor with their system, I think the repair device is already in twice as many accounts as the replacement system, so we had a natural kind of built-in advantage here as we went to the market, and the cases are doing very well. The feedback has been very positive. But I think it’s really broad-based here. Navitor has done very well, both in international markets and in the U.S., and the value proposition is starting to gain more traction - you know, great clinical profile, excellent hemodynamics, and that’s driving a lot of opportunity for us in international and U.S. markets. We shared some data from our registry, from our Japan registry, and great safety also, so that’s doing very well. Amulet, we saw really nice growth in the U.S. for Amulet this quarter - it was about 45%, so that product is doing very well and we’re focusing here on continued, what I would call penetration in same store sales, so we’re about close to 20% in the accounts that we’re in. We’re in about half of the market here in the U.S., so our opportunity here is to continue to expand the sales force and go to newer accounts, so that’s done very well, too. MitraClip, I think we continue to see some continued growth internationally. In the U.S. with competitive activity, that’s kind of slowed down a little bit of the growth, but I think with TriClip now coming into the market and gaining traction, we’ll be able to provide a value proposition across both repair systems and drive there. So structural heart, the growth rate has accelerated from Q1, doing very well, and I’d say it’s really across a full portfolio approach versus just really trying to single out one product or one technology. There’s work we have to do in MitraClip - that’s clear, in the U.S., internationally it’s done very well; but all the other products that I’ve talked about are doing very well and gaining market share, and gaining adoption, so that’s why you saw structural heart’s growth rate actually accelerate, and I continue to see that that’s going to be definitely for the rest of this year and going into next year.
Travis Steed: That’s super helpful. Then on your sensor business, how are you thinking about segmenting the market with Lingo versus Rio, and how do you think those markets are going to develop over time? When you look at your core Libre business, anything to call out, any changes in U.S. versus international market dynamics?
Robert Ford: Well, you’re trying to cover a lot of ground there with that question. You could probably spend a whole call going through all of that. I think at its highest level, Libre continues to do very well. There’s still a lot of growth opportunity. Obviously the basal opportunity is the biggest one, and we’re doing--having great progress over there, but even in the MDI segment, there’s still a lot of penetration to occur in the MDI segment. I think in the U.S., there’s still about a third of multiple daily injectors that aren’t using CGM, and international developed markets, it’s around 50%, so there’s plenty of growth in Libre. Our strategy here with Lingo and Libre Rio is just really to have a full portfolio and look at this as a platform where we can expand the use of the sensor technology across different types of diabetes populations, but also what is probably the larger market, which is people that don’t have diabetes, right? I think if you--if you take--right now, I would say we’re doing to launch it here in the U.S. and we’re going to start expanding globally, and we’ll see how it looks like and what it takes to win there. But what I do know, based on the U.K. experience, is that it takes some time to educate and communicate with a patient population that, while excited about having new tools to drive healthier habits, they do need some time to understand its use. But I think it’s a pretty big opportunity for us and one that we’ve disproportionately invested to be able to get into this position. I think if you take Lingo and you look at U.S. and Western Europe, the adult population there, you’ve got about 400 million people in those markets. If you take a single-digit penetration rate, a few sensors a year, you’re looking at a multi-billion opportunity there, and we’re not there yet. I think once we’ve got better understanding of how this is going to work, we’ll be better at forecasting it; but just at a high level and looking at it from a total adult population and relatively, I’d say, modest penetration rate, it’s a pretty big opportunity. Like I said in my comments, we’ve done this for a while since we’ve launched internationally, and we’ve learned a lot and we’re going to bring that learning and experience here to the U.S., so it’s an exciting opportunity for us.
Travis Steed: Great, thanks Robert.
Operator: Thank you. Our next question will come from Robbie Marcus from JP Morgan. Your line is open.
Robbie Marcus: Oh great, thanks. I’ll add my congratulations on a good quarter. Two for me, two product questions. Maybe just to follow up on the diabetes Libre question, Robert, how are you thinking about a holistic drive of advertising and word of mouth for these new products, especially as we move into the OTC, versus generating data, and how much will be necessary? I think back five years ago, and where we are today was probably not in most people’s forecasts, and with the amount of data we have showing in non-diabetics how beneficial CGM is, how are you thinking about data versus not data, insurance coverage versus not insurance coverage, and how do the markets look one way or the other?
Robert Ford: Yeah, I don’t think--so from an insurance coverage perspective, if you’re referring to Lingo specifically for non-diabetes, I think it’s going to be--you know, I don’t think that that’s going to be something that we’re building a forecast assuming reimbursement coverage over it, even though I agree with you - you know, there is nice data that shows that people that don’t have diabetes can benefit from this, Robbie, and it helps sustain behavior modification. Ultimately this is what it is, right - it’s using data to be able to kind of help people that want to stay healthy, give them more information, and ensure that they can refine their habits or change habits. I think that that is at the core there - it’s really communicating directly with consumers. If you think about the diabetes space and how CGM uptake, you needed both a communication with the patient and you needed obviously a communication with the physician. I think that that’s still important for the non-diabetes. I think that some people will want to have some sort of recognition from the healthcare professional that this might be a good investment to do in, right, and the key thing here is just the utilization. I don’t think you’re going to see people that don’t have diabetes use this, you know, a sensor 365 days a year, but like I said, if they’re using a couple times a year, there’s still a benefit, and we’ll be generating data on this over time. I think it’s going to be important to generate data, even if it’s not to communicate to payors to get reimbursement, but even if it’s to communicate to physicians, the primary care and the direct consumers, that there’s a value here of doing that. I think the key thing here is personalization and how do you personalize information and the data and the coaching, so the strategy here is, yes, you’re doing to have to use TV to be able to communicate, but I don’t think it’s--I don’t think given our experience here that you could just go on TV and blast TV advertising and you’ll get this big uptake. You’re going to have to do some on-the-ground kind of gorilla marketing - let’s call it like that, together with TV advertising to really be able to open up the market and then sustain it, right, and sustain its use. That’s how we’re thinking about it, and that’s why we have a separate team completely removed from the Libre and the diabetes team, that they’re focusing on how to execute this strategy. I think it’s more of an S-curve growth versus an out-of-the-gate. I know that everybody is focused on what the sales are in the second half, whether it’s me or the competitor. I think the bigger picture here is, hey, there’s a really big opportunity here and if we do it right, it’s an opportunity that will be more than a flash in the frying pan. It will sustain itself and it could become standard, so.
Robbie Marcus: Great color. One more from me - Aveir and the leadless pacing, particularly the dual chamber now with coverage, I think is an underappreciated opportunity. Maybe if you don’t mind, spend a minute there, how you see this market evolving, and what’s the early feedback on the launch so far? Thanks.
Robert Ford: Yes, I mean, ultimately I think this whole leadless is going to change the growth trajectory of our CRM business. If you look at CRM, it grew 7% last year, it’s grown 7% the first half of this year - it was previously a flat business, and we’ve been doing that, I would say, with good success on dual, but I wouldn’t say that it’s at full cycle yet, because one of the things that we’re working on is ensuring that we’re doing the training and we’re getting physicians comfortable with the procedure, right? It’s a completely different procedure versus what the entire industry has been accustomed to. We’re using mapping, we’re going into the groin versus doing pockets above the chest, so it is a little different and we’re focusing on that. That being said, we’ve been able to accelerate the growth rate just with a single chamber. I think right now after two years, we’ve probably captured about 50 share, but to your point, the bigger opportunity is in dual, and the procedures are going great. Once physicians get several under their--you know, experience with several of them, they’re talking about okay, how do we accelerate this and an opportunity to drive more patients into it, but we want to make sure we’ve got a pretty large base of well-trained, great outcomes physicians across the United States. Listen, this is a $3 billion global segment and there really hasn’t been much innovation in it, and here you have something that’s truly unique and differentiated, and I’d say once we feel that we’ve gotten to a point where we feel good about the capabilities and training and the amount of physician coverage that exists, this is definitely a product that I can see going a little bit more mainstream, having more direct consumer communications because of the value proposition it affords them, so I think this is a great opportunity for us. It might be under-appreciated with the market, but it is definitely appreciated amongst me and the device team and the CRM team, and we’re working hard to get to that point where you can really let it go strong.
Robbie Marcus: Great, thank you very much.
Operator: Thank you. Our next question will come from Josh Jennings from TD Cowen. Your line is now open.
Josh Jennings: Good morning, thanks for taking the questions. Robert, I wanted to just start asking about just this multi-year trajectory for Abbott. You’ve been delivering top tier organic revenue growth performance over the last two years and potentially have a two-year double-digit stacked comp next year, but I think the team has been publicly stating that potentially the business could outpace pre-pandemic levels, which were in that 7% to 8% range. I think during this call, you’ve put forward a lot that supports that type of trajectory, but maybe just to reiterate your confidence level there, and is this kind of outpacing your pre-pandemic levels over the medium term dependent on M&A, or is this the core business with internal development programs that’s really going to drive this top tier growth out over the next couple of years?
Robert Ford: Was that an attempt to get to the 2025 kind of question? I’d say, listen - we’ve been saying that we made investments during COVID to accelerate the company, make it stronger, build our portfolio so we could accelerate the growth, right? If you look at the last six quarters, we’ve been delivering top tier, high single digit, double digit growth, and this is on a company that’s doing $40 billion-plus of revenues, so I think that’s pretty impressive. If you look at our med tech portfolio, it was the fastest growing med tech portfolio last year, fastest growing in the first quarter of this year. We’ll see what happens this second quarter, but we’ve positioned the company to be able to deliver this, and do I think that we can continue to deliver this top tier performance throughout this year and into next year? Yes, I absolutely do, because of, one, what we’ve built, and then just the evidence and the proof points that we’ve been able to reliably and sustainably deliver that. So yes, we feel good about our ability. The markets that we’re participating in are attractive, so they are markets that we lead, and when those markets grow, our leadership benefits. There are markets that are attractive that we’re entering, and there’s plenty of opportunity for market share gain; and there are markets that are attractive that we’re building, and there’s no real clinical opportunity--or there’s a clinical opportunity for our products that we’re developing to come in there, so as we build those markets, they become attractive and our position gets solidified. I think that framework applies to all four of our business units have opportunities across those three frameworks. On the M&A front, yes, if we’re able to find an asset that makes sense strategically to us, makes sense financially that could add even further to that growth, then we’ve got the balance sheet to be able to do that; but it’s not dependent--as I’ve told you, it’s really focused on the organic side to be able to deliver this top tier growth.
Josh Jennings: Understood, and thanks for that answer. Another kind of high level question you probably receive regularly, but just wanted--it’s our understanding as well that your team, the Board ever year at least once a year, maybe multiple times a year, is just considering the strategic fit of the four major business units for Abbott, and maybe just if we could get an update on your thoughts on the business combinations and the potential for spins down the line. Thanks a lot.
Robert Ford: Well, we look at our portfolio on an ongoing basis. I don’t think there’s this one moment in the year that we do it - we’re doing it on an ongoing basis, and the company has a history of ensuring that the portfolio that is assembled is not only delivering value to patients and governments and healthcare systems, but it’s also delivering value to our shareholders. We historically haven’t shied away from asking ourselves the questions and answering those questions, and if there’s an opportunity to create value through addition or through subtraction, then the company has shown that it’s ready to do that. I think the two fundamental questions about that is, is there an opportunity to create value for shareholders, and is there somebody that could do better with our businesses? Right now, you look at what we’re doing with our businesses, we’re performing at the highest level across all of the four segments. We’ll see what happens during this earnings season here, but I feel very good about the team and what they’re doing. Obviously there are areas that we could always do better, and we focus on that; but at the highest level, all four of our sectors have been delivering outstanding growth, market-leading growth, and quite frankly innovating and fulfilling our purpose and our mission, which is to help people live healthier lives. I like the diversity. The diversity provides both defense and offense capabilities, and as long as you’re managing them within each one of their segments, allocating capital that is proportionate to their growth and their industry, and we spend a lot of time managing all four segments, then I think we’re doing a good job at running them.
Josh Jennings: Great, thanks a lot.
Operator: Thank you. Our next question will come from David Roman from Goldman Sachs. Your line is open.
David Roman: Thank you and good morning everybody. I was hoping to ask one question on the P&L side and one on the capital allocation side. Maybe I’ll start with the P&L here. As I kind of look at the guidance here for the back half of the year, our math implies it’s something like 100 basis points-plus of year-over-year operating margin expansion, and about 9% EPS growth at the midpoint of the range. Can you maybe talk through some of the drivers that underpin that margin expansion on a year-over-year basis? Obviously we saw a turn here in Q2 versus what we saw in Q1, but maybe walk us through some of the drivers that get to that improved margin and earnings growth performance in the back half of the year.
Robert Ford: Sure, I’ll let Phil take that.
Phil Boudreau: Yes, good morning David. Robert touched a little bit in his opening comments here on some of that expansion already this year, and we’re in a pretty unique position relative to some of our peers in terms of our op margin profile, that we’re already back to pre-pandemic levels, and we did that strategically through managing spend through the ups and downs of COVID testing. As we talked earlier this year, Q1 was really the last big comp on COVID testing impacts on sales and profiles. With respect to margin expansion and gross margin in particular, the guidance for the year is around 75 basis points as you highlight some progress here, and more to go, but the trajectory is there. We’re focused on the things that we can control and execute on, and in particular some of this great portfolio contribution from our sales top line performance, particularly in accretive businesses, is a contributor here, and one that we anticipate will continue to expand here throughout the year. We have dedicated teams in each one of our businesses focused solely on gross margin improvement, productivity yield improvements, cost reductions, innovation that brings accretion to the portfolio. All of those elements are contributors here quarter in and quarter out and continue to contribute through the rest of the year. Then we also have elements--we’ve talked about some of the cycles that we go through, be it in commodities markets and the like, some of the inflation the last few years, that are starting to sort of stabilize and normalize We’re seeing freight and distribution profiles normalize and start to be more a tailwind as opposed to headwind, and we’re also seen in commodity markets as well things not only stabilizing, but coming down and also contributing to tailwinds to gross margin, and anticipate that to persist here as well. The combination of all of those contributes to the confidence here and continuing to drive the top tier sales performance, but also expand margins throughout the year.
David Roman: Super helpful, thank you. Then maybe just on the capital allocation side, maybe thinking about the other side of Josh’s question, if you look across the sector here, we’ve seen M&A pick up a little bit in the second quarter - I think there were two billion dollar-plus transactions announced with transaction multiples starting to trend toward the lower end of historical levels. But could you maybe give us your latest perspective on the M&A environment and how you’re thinking about capital allocation as your cash balance continues to build nicely here?
Robert Ford: Well, on the capital allocation more broadly, listen - I’ve been pretty clear every call about we have a balanced approach, right? I know you guys cover a lot of companies that have different approaches. Our approach is balanced, and we believe that that balanced approach benefits the long term shareholder. One of the metrics that I believe, David, is a good measure of evaluating capital deployment effectiveness is ROIC, and if you look at ROIC over the last three years, we’ve averaged around high teens, and that’s on the higher end of the med tech peers that we often get compared to, so. We believe that ROIC is a good measure of how effectively we’re deploying the capital, and we look at a balanced approach, so are there internal capital investments that drive future growth. We’ve been talking about all these great opportunities we have, and we’re funding them and they have great returns. Debt pay down - we don’t have much this year, but we took care of some towers last year because we didn’t want--we obviously didn’t want to refinance them. Dividend and buybacks are--you know, the dividend is definitely core to our investment identity, and we intend to continue to grow our dividend, so that is a balanced approach. Even with all of that, we also, as you’ve probably seen, we have opportunity from a balance sheet perspective to deploy that from an M&A perspective, and we’ve been spending time talking about our strong top line and the pipeline that we’ve developed, and that allows us to be a little bit more selective. You look at other transactions that happened and you have to ask, okay, what’s the strategy behind that, and a lot of the time you can see you’re having to sustain your growth rate, right? If you’re in the business of driving top line through acquisitions, then you’ve got to--you know, that’s part of your model, you’re going to have to keep doing that, whether the valuations are right or wrong, or not right. But we look at these strategic fit, can they generate an attractive return, can we make the business better that we’re acquiring. We don’t want to be just a holding, and I think that we’ve shown that when we do, do our acquisitions, that’s the framework, you know - fits in strategically, generates nice return, and we tend to operate them or add value to them than when they were a standalone, so.
David Roman: Appreciate all the perspective, and thanks for taking the question.
Operator: Thank you. Our next question will come from Danielle Antalffy from UBS. Your line is open.
Danielle Antalffy: Hey, good morning guys, thanks so much for taking the question. Congrats on a really good quarter here. Robert, one of the things that struck me when we spoke--I have two product-specific questions, when we last spoke is how you’re looking at the sustainability of historically slower growing businesses and areas exposed to historically slower growing markets, so obviously I’m thinking CRM. Can you talk a little bit about the strategy there - obviously Aveir is a big part of that, and just leadless pacing in general, and how sustainable--I mean, it’s been, like, multiple quarters now of organic growth in the mid-plus single digit range, and then just one follow-up, another product question.
Robert Ford: Yes, well that was part of our strategy as we looked at our med tech portfolio - you’ve obviously got high growth drivers there with EDP, structural heart, diabetes care, neuro, heart failure, and we looked at CRM and vascular, and those are more flat businesses, so the combination of all that is you had a med tech portfolio that was growing 7%, 8%, maybe 9% a quarter there. To get to double digits, we needed those two businesses to get at least to mid single digits, right, and I’d say on the CRM side, our strategy there was to really focus on Aveir leadless pacemakers. You know, there’s a pipeline of products there - I don’t want to tilt my hand here, but we didn’t do Aveir DR and stop there. The team’s gotten R&D programs to continue to advance those and even to look at the ICD market also and what are the opportunities that we can do to innovate. But there is space to innovate in that market, and that for me is important, is the diabetes market, you know, 15 years ago, people would say, gee, that’s a slow growth market - well, now look at it, right? If you focus on innovation on meeting needs, unmet needs, you can turn a market around. From a vascular perspective, as I said in my comments, we’re trying to--we’ve been repositioning the portfolio to more higher growth areas, peripheral areas, endovascular areas, but we started that a little bit later than what we did in CRM, so I expect to start to see our vascular business start to also contribute to a higher growth rate, the same way that CRM is, and that just kind of bolsters our entire med tech portfolio and gets us into that 12%, 13% growth rate, at least that’s our target.
Danielle Antalffy: Okay, that’s helpful. Then the follow-up question is on the structural heart side of things, and I know Amulet has been on the market for a little bit here, but my impression is that now it’s kind of like Abbott is no longer fighting with one hand tied behind their back. Can you talk a little bit about that, and your 45% growth, I think you said in the quarter, where to from here for Amulet? Thanks so much for taking the questions.
Robert Ford: Yes, so it was a great quarter. I think the team’s kind of hitting its stride right now. As I’ve said, our focus here was really to kind of drive adoption in the centers that we were at, versus expansion. The competitor has expanded the market - there is probably about 800 centers that are doing these implants, and we’re probably in about half of it. Now, that’s good, right - that provides a market expansion dynamic here in the U.S., but-. I mean, I’m really encouraged by some of the data that I’m seeing, and I think it starts with the data, right? You know, we had patient registry data come out where we showed that 95% closure rates were achieved post implant and sustained after 45 days, 90% of closure success rate using Amulet, for patients that actually fail to achieve proper closure rate with a competitive product, so I think that there’s an opportunity here for our value proposition, and then we’ve got to continue to invest. We are already investing on our next-generation Amulet, focusing on ease of use, focusing--and we’ll maintain our superiority here that we believe we have regarding the ceiling of LEA. We’re investing in clinical trials, obviously we’ve been public about Catalyst, which is a trial that will compare Amulet to NOAC and to ablation treatment, so this is an exciting market for us and we will continue to invest in it, and ultimately it comes down to really looking at surrounding the electrophysiologist with the most comprehensive portfolio, whether it’s on pacemakers and ICDs, structural heart interventions with stroke preventions, and then obviously ablations and AF treatment. At its highest level, that’s the important side here, is Amulet fits an important role even though we report it as structural heart. It’s really playing a role here to surround the physician, the EP with the tools they need to advance care.
Danielle Antalffy: Thank you.
Mike Comilla: Operator, we’ll take one more question, please.
Operator: Thank you. Our final question will come from Vijay Kumar from Evercore ISI. Your line is open.
Vijay Kumar: Hi Robert. Thanks for taking my question, and congrats on a nice sprint here. I wanted to touch on biosimilars - you know, you brought this up on the call. Can you elaborate on your strategy there? Are you planning to manufacture these products? Is Abbott going to be a CDMO in that space or do you plan to launch your own biosimilars, or is this more of Abbott being a distributor and taking advantage of your brand presence in emerging markets? What is Abbott’s role in that place, and how do you size that market opportunity for Abbott? When should that start contributing to Abbott?
Robert Ford: Sure. You know, this is one where I’d say there’s a couple phases to the strategy. The core premise of this, Vijay, is if you look at the emerging markets and the disease prevalence that exists in these emerging markets, they’re no different than the disease prevalence in the U.S or Europe. You could look at some of them are higher, etc., but in general there’s an opportunity to bring these biologics into the emerging market. For a variety of reasons, those markets have not been a priority for the originators. Their main focus has obviously been in the international developed markets - U.S., Western Europe, Japan, Canada, Australia, etc., so this provides just a patient need opportunity that we want to size up. What we’ve seen through some of our--you know, we have done some more regional biosimilar deals that we’ve launched, and what we’ve seen is that the growth of the molecule grows significantly once a biosimilar enters in terms of penetration into a patient population. It’s a different dynamic in developed markets, as we know, but in emerging markets the category really expands, so what we wanted to do is to say, okay, before we start to think about manufacturing, before we start to think about that, we want to be able to understand what is the uptake of these products once you go ahead and put a concerted effort to developing these types of products in emerging markets. It fits right into our wheelhouse, where we’ve got relationships with governments, we have relationships with physicians, and we’ve got relationships with the distribution area. The question is how can you do it in--how can you execute that strategy that’s capital efficient and doesn’t erode gross margin of that business, and I give a lot of kudos to the team because they’ve really been able to position our presence in these markets as an advantage to these players that really aren’t focusing on emerging markets, they’re focusing more on the opportunity that exists in developed markets, and now they can partner with one single company, reputable company to be able to use that capacity in other markets. I’d say we’re in the phase right now of, okay, is there sustainability to this, so the deals that we’ve done give us access, our gross margin is not dilutive, and we’re going to see how it goes. As you think about the ramp-up of what we’ve got in the pipeline, we’ll start launching in 2025, but you look at some of the big molecules that will come up for us ’26,’27, that’s I think when some of these very large oncology opportunities that we have will play a huge role for us and accelerate the growth there.
Vijay Kumar: That’s helpful. Maybe one last one on capital deployment. I know it’s been asked - I’m curious on share repurchases. You guys have done phenomenal growth. The street doesn’t seem to be giving credit. Why not? You didn’t see any share repurchase in the first half. Why is Abbott being conservative on share repurchases?
Robert Ford: Yes, well we’ve done a lot of share repurchases over the last couple of years, say catching up a little bit, to maybe not doing as much repurchasing after the two acquisitions we did in 2017 and 2018. If you look at our repurchases and dividends, it’s been about $20 billion that we’ve returned over the last four years, Vijay - $20 billion in dividends and buybacks, and that accounts for a good amount of our free cash flow over the last couple of years to our shareholders. We’re not--the year’s not over, and again we’ll see opportunities. We’ve got plenty of opportunities to be able to do that, so I’d say I think we’ve done a pretty good here at returning cash back to our shareholders over the last couple of years, and that commitment we’ll maintain, so.
Robert Ford: I’ll just close here. This was a great quarter for us and, quite frankly, a great quarter in connection with five quarters before that, where we’ve delivered above-market growth. I’m really pleased with our continued strong performance. We’ve raised our sales outlook, our EPS ranges for the second time this year. The toughest COVID test comps are now behind us, so I look forward to not having to--you know, we’ll obviously report our COVID testing sales, but you’ll start to see those comps start to dwindle away now, which means then that our EPS is back to growth. I think one of the questions there about showing our EPS exiting the year in high single digits, double-digit kind of range and getting back to our formula, that’s what we’re interested in, and we’ve got a lot of positive momentum here heading into the second half of the year. With that, we’ll wrap up, and thank you for joining us.
Mike Comilla: Thank you Operator, and thank you all for your questions. This now concludes Abbott’s conference call. A webcast replay of this call will be available after 11:00 am Central time today on Abbott’s Investor Relations website at abbottinvestor.com. Thank you for joining us today.
Operator: Thank you. This concludes today’s conference call. Thank you for your participation. You may now disconnect. Everyone have a wonderful day. | [
{
"speaker": "Operator",
"text": "Good morning and thank you for standing by. Welcome to Abbott’s second quarter 2024 earnings conference call. All participants will be able to listen only until the question and answer portion of this call. During the question and answer session, you will be able to ask your question by pressing the star-one-one keys on your touchtone phone. This call is being recorded by Abbott. With the exception of any participants’ questions asked during the question and answer session, the entire call including the question and answer session is material copyrighted by Abbott. It cannot be recorded or rebroadcast with Abbott’s express written permission. I would now like to introduce Mr. Mike Comilla, Vice President, Investor Relations."
},
{
"speaker": "Mike Comilla",
"text": "Good morning and thank you for joining us. With me today are Robert Ford, Chairman and Chief Executive Officer, and Phil Boudreau, Executive Vice President, Finance and Chief Financial Officer. Robert and Phil will provide opening remarks. Following their comments, we’ll take your questions. Before we get started, some statements made today may be forward-looking for purposes of the Private Securities Litigation Reform Act of 1995, including the expected financial results for 2024. Abbott cautions that these forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those indicated in the forward-looking statements. Economic, competitive, governmental, technological, and other factors that may affect Abbott’s operations are discussed in Item Ia, Risk Factors to our annual report on Form 10-K for the year ended December 31, 2023. Abbott undertakes no obligation to release publicly any revisions to forward-looking statements as a result of subsequent events or developments, except as required by law. On today’s conference call, as in the past, non-GAAP financial measures will be used to help investors understand Abbott’s ongoing business performance. These non-GAAP financial measures are reconciled with comparable GAAP financial measures in our earnings news release and regulatory filings from today, which are available on our website at abbott.com. Note that Abbott has not provided the GAAP financial measure for organic sales growth on a forward-looking basis because the company is unable to predict future changes in foreign exchange rate, which could impact reported sales growth. Unless otherwise noted, our commentary on sales growth refers to organic sales growth, which is defined in the press release issued earlier today. With that, I will now turn the call over to Robert."
},
{
"speaker": "Robert Ford",
"text": "Thanks Mike. Good morning everyone and thank you for joining us. Today we reported organic sales growth of more than 9%, excluding COVID testing sales. We also reported adjusted earnings per share of $1.14, which exceeded analyst consensus estimates and represents a 16% sequential increase from the first quarter. Based on our performance in the quarter and confidence in our outlook for the remainder of the year, we raised our guidance and now forecast full year organic sales growth, excluding COVID testing sales, to be 9.5% to 10% and adjusted earnings per share in a range of $4.61 to $4.71. Our performance continues to be driven by broad-based growth across the portfolio with growth this quarter led by double-digit growth in medical devices and high single-digit growth in established pharmaceuticals and nutrition. In addition to benefiting from outperforming expectations on the top line, we are also seeing positive contribution from gross margin expansion coming from continued execution from our supply chain teams, lower commodity costs, and favorable sales mix. I’ll now summarize our second quarter results in more detail before turning the call over to Phil, and I’ll start with nutrition, where sales increased 7.5% in the quarter. Strong quarter in the quarter was led by double-digit growth in international adult nutrition and U.S. pediatric nutrition. International adult nutrition continues to perform at a very high level. The five-year compound annual growth rate of this business is more than 10%, which in addition to our market-leading position and commercial execution reflects the impact from positive demographic trends that drive increasing demand for our Ensure and Glucerna brands. Through the investments we’ve made to expand capacity, we are well positioned to continue to capitalize on these secular demand trends. On the topic of litigation, regarding pre-term infant formula and human milk fortifier, Abbott stands by our products and the information provided to the neonatologist specialists who have used them for decades. Necrotizing enterocolitis, or NEC, is a terrible gastrointestinal disease that primarily affects premature infants, and it is devastating to families; however, plaintiff lawyers are advancing a theory that is without merit or scientific support. These products, which are sold for hospital use, are incorporated into a feeding regimen along with human milk by experienced specialists and are an important part of the standard of care for the majority of preterm infants. Their use is supported by medical associations in the United States and other countries around the world. The products and their ingredients have been reviewed and are deemed safe for use by regulators, who have also reviewed their labels. There has been no increase in the rate of NEC, meaning these cases have not emerged in response to a trend or any new information, yet we’re seeing plaintiffs’ lawyers investing millions of dollars in misleading TV advertising in an attempt to move physician decisions from the hospital to the courtroom. Total revenues for these products are about $9 million annually, and have remained at that level for the past several years. If these products were no longer available, physicians would be deprived of the vital food that is needed in the NICU. This would create a public health crisis affecting every state across this country. We believe it’s important for all who have an interest in health of preterm infants, who recognize the need for these products and to take action accordingly. Moving to diagnostics, where sales increased 6% excluding COVID testing sales, growth in the quarter was driven by high single-digit growth in core laboratory diagnostics and double-digit growth in point-of-care diagnostics. In core lab diagnostics, we continued to drive growth through increased adoption and utilization of our market-leading systems and global demand for our extensive testing menus across the areas of immunoassay, clinical chemistry, hematology, and blood screening. While our Alinity family of diagnostic systems first launched more than six years ago, given the long contract cycles common in the diagnostics industry, we continued to see a benefit in our contract renewal and competitive win rates with several recent large account wins expected to increasingly contribute to growth in the second half of the year. Turning to EPD, where sales increased 8% in the quarter, EPD continues to deliver at a high level as this business executes its unique branded generic strategy in emerging markets, where growth is supported by favorable demographic trends, including increasing populations, growing middle classes, and increasing focus on expanding access to healthcare. As you recall, we identified biosimilars as a new strategic growth pillar for this business. With our extensive presence in emerging markets, we have a unique opportunity to scale a licensing model that is capital efficient and can bring access to these life-changing medicines to millions of people in emerging markets. We began implementing this strategy last year when we announced an agreement to commercialize several biosimilars in the areas of oncology and women’s health, with the first of these expected to launch in 2025. We recently completed additional agreements that provide Abbott access to biosimilar versions of market-leading autoimmune disease and GLP1 medications. Biosimilars represent the highest growth segment in the branded generic pharmaceutical market, and we look forward to continuing to build one of the most complete portfolios in the industry. I’ll wrap up with medical devices, where sales grew 12%, in diabetes care, Freestyle Libre sales were $1.6 billion in the quarter and grew 20%. We announced in June that we received FDA approval for two new over-the-counter continuous glucose monitoring systems called Lingo and Libre Rio, which are based on Libre’s glucose technology that is now used by more than 6 million people around the world. While over-the-counter availability is a new option in the United States, we’ve been selling over-the-counter in international markets since Libre launched 10 years ago. Given our clear leadership position in these markets, we have demonstrated our ability to tailor solutions, approach and communication for the various types of users who compose the CGM customer base. Lingo is designed for consumers who are willing to improve their overall health and wellness. The Lingo wearable sensor and app will track glucose, provide personalized data, insights and coaching to help create and maintain healthy habits. Libre Rio is designed for adults with Type 2 diabetes who do not use insulin and typically manage their diabetes through lifestyle modifications. In electro-physiology, growth of 17% was driven by double-digit growth in all major geographic regions, including 17% growth in the U.S., which represents an acceleration compared to the growth in the first quarter. Growth was broad-based across the portfolio and included 20% growth in ablation catheters. In structural heart, growth of more than 15% reflects an acceleration in growth compared to the first quarter and was led by several recently launched products that are driving new adoption and share capture in attractive high growth areas, including TAVR, LAA, and tricuspid repair. This quarter, we launched our tricuspid repair device, TriClip in the United States and continued our trend of capturing market share in the global TAVR market. In rhythm management, growth of 6% was led by Aveir, our highly innovative leadless pacemaker, and in June we announced that we received CE mark in Europe for Aveir to be used in dual chamber pacing procedures, which is the largest segment of the pacing market. In heart failure, growth of 9% was driven by our market-leading portfolio of heart-assist devices that offer treatment for both chronic and temporary conditions. In neuromodulation, growth of 8% was driven by strong demand in international markets for our Eterna rechargeable spinal cord stimulation device, which obtained CE mark in Europe last year. In vascular, we received FDA approval in late April for our Esprit dissolvable stent, a breakthrough innovation for people who suffer from blocked arteries located below the knee. Esprit is designed to keep the arteries open, deliver a drug to support vessel healing prior to completely dissolving over time. New products like Esprit combined with the investments that we made in our vascular business, both organically and inorganically, have expanded our presence in faster growing areas and increased the future growth outlook for this business. In summary, we exceeded expectations both the top and bottom lines and, as a result, we raised our financial outlook for the year. We continue to make good progress on our gross margin initiatives and, more importantly, our pipeline continues to be highly productive, and thus we’re well positioned to deliver strong results for the remainder of the year. I’ll now turn over the call to Phil."
},
{
"speaker": "Phil Boudreau",
"text": "Thanks Robert. As Mike mentioned earlier, please note that all references to sales growth rates, unless otherwise noted, are on an organic basis. Turning to our second quarter results, sales increased 7.4% on an organic basis and increased 9.3% when excluding COVID testing sales. Foreign exchange had an unfavorable year-over-year impact of 3.5% on second quarter sales. During the quarter, we saw the U.S. dollar strengthen versus several currencies, which resulted in more unfavorable impact on sales compared to exchange rates at the time of our earnings call in April. Regarding other aspects of the P&L, the adjusted gross margin ratio was 56% of sales. Adjusted R&D was 6.3% of sales, and adjusted SG&A was 27.7% of sales in the second quarter. Lastly, our second quarter adjusted tax rate was 15%. Turning to our outlook for the full year, we now forecast full-year adjusted earnings per share of $4.61 to $4.71, which represents an increase compared to the guidance range we provided in April. We also raised the midpoint of our guidance for organic sales growth. We now forecast organic sales growth excluding COVID testing sales to be in the range of 9.5% to 10%. Based on current rates, we expect exchange to have an unfavorable impact of more than 2.5% on full-year reported sales, which includes an expected unfavorable impact of approximately 3% on third quarter reported sales. Lastly, for the third quarter we forecast adjusted earnings per share of $1.18 to $1.22. With that, we’ll now open the call for questions."
},
{
"speaker": "Operator",
"text": "Thank you. At this time, we will conduct a question and answer session. [Operator instructions] Our first question will come from Larry Biegelsen from Wells Fargo. Your line is now open."
},
{
"speaker": "Larry Biegelsen",
"text": "Good morning. Thanks for taking the question, and Robert, congratulations on a nice quarter. Thanks for your comments on the NEC litigation. I’m wondering if you have anything to add on that, Robert, and then I have one follow-up question."
},
{
"speaker": "Robert Ford",
"text": "No Larry, I think I said everything I said during my prepared comments. I guess the only add here is I think this is way overblown in terms of its impact, and we are--we’re working to obviously defend our position and--you know, working with all the different stakeholders so that they are aware of the situation, the gravity of the situation as it progresses. But I said all I had to say right now in my prepared comments, and if there’s a need to kind of give further updates, we will."
},
{
"speaker": "Larry Biegelsen",
"text": "All right, thanks. Separately, Robert, your EPD business grew nicely in the second quarter, 17% in both the U.S. and international. What drove that, what are you seeing with PFA in the different geographies, and how are you thinking about the sustainability of that growth before bolt [ph] launches? Thank you."
},
{
"speaker": "Robert Ford",
"text": "Sure, well I’m seeing what I thought I was going to see. It might be a little different from what some of you thought you were going to see, but what we’ve been seeing is obviously an increase in the market, so right now the market has accelerated, seems to be growing above 20%, so when you look at our 17%, it’s lower than the market but it’s actually growing faster than what it was growing pre-pandemic, or just after we had done the acquisition. We’ll see if the--I mean, that growth is obviously in value. We’ll see if the growth in procedures actually translates. We are actually in more procedures than what we were in the past, given our mapping and our teams, but I think it’s a little bit too early to say if the actual number of procedures is going to significantly increase. The market has accelerated, but it’s predominantly, I think, price right now with the introduction of this new product. It’s predominantly being used in de novo procedures, atrial procedures, right, and we think that’s about a third of all ablation procedures, Larry. The other two-thirds, we continue to see, whether it’s re-dos, VT, SVT, ablations, in that case we continue to see RF really being viewed as the better option for those procedures. We’ll see how that’s going to translate over time, but OUS, the penetration is around 10%, 15%. It’s been pretty stable. From the point of view of mapping, I think we haven’t seen a real big change of what we saw during those first couple of months of launch and in the last call, so over 90% of cases here in the U.S. are still being used as mapping. We’ve got a 50 share of those mapping cases. I don’t try and look at different types of denominators to get to that market share, so I make sure my team just basically has the best access and, from what we’re seeing, it’s about 50%. RF catheters, similar to what we saw in the last call, still being used in about 20% of the PFA cases, so we continue to see that. I think the net effect of all of this is the market’s growing, it’s accelerating. We’ve got a strong position. Everything that we’ve talked about in the past, about our opportunity with the mapping and all of the other consumables is there. RF still plays a role, it’s still an important role, and our business has actually grown faster than what it was growing before. If you look at ’19, we were about 12%, ’18 was about 14%, so we’re actually doing better now. I think that is positive for the market, which is why we’ve invested heavily in our PFA portfolio, which will--you will start to see hit the market in the--I’d say next year, I’m not going to try and time the quarter here, but definitely next year. I think this is good and the teams have done an incredible job at executing the strategy that we laid out, so kudos to them."
},
{
"speaker": "Larry Biegelsen",
"text": "Thanks so much. Thanks for the comprehensive answer."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from Travis Steed from BofA Securities. Your line is open."
},
{
"speaker": "Travis Steed",
"text": "Hey, congrats on the good quarter. I wanted to ask about structural heart - really stood out this quarter, accelerated from last quarter. Just curious how much of that is on MitraClip recovery, you got TriClip approved early, how much you’re seeing from the TriClip side and how much is coming in from some of the other newer products, like Amulet and Navitor."
},
{
"speaker": "Robert Ford",
"text": "Sure. Obviously TriClip was an important launch and helped to accelerate the growth rate, Travis, but I think it’s pretty broad-based here. I mean, if you look at TriClip, we were ready to go because we had certain built-in advantages in this area, right - we had the scale, we had the sales force, the manufacturing capacity, so we were ready to go. I think from our estimates here, even though we launched a quarter after our competitor with their system, I think the repair device is already in twice as many accounts as the replacement system, so we had a natural kind of built-in advantage here as we went to the market, and the cases are doing very well. The feedback has been very positive. But I think it’s really broad-based here. Navitor has done very well, both in international markets and in the U.S., and the value proposition is starting to gain more traction - you know, great clinical profile, excellent hemodynamics, and that’s driving a lot of opportunity for us in international and U.S. markets. We shared some data from our registry, from our Japan registry, and great safety also, so that’s doing very well. Amulet, we saw really nice growth in the U.S. for Amulet this quarter - it was about 45%, so that product is doing very well and we’re focusing here on continued, what I would call penetration in same store sales, so we’re about close to 20% in the accounts that we’re in. We’re in about half of the market here in the U.S., so our opportunity here is to continue to expand the sales force and go to newer accounts, so that’s done very well, too. MitraClip, I think we continue to see some continued growth internationally. In the U.S. with competitive activity, that’s kind of slowed down a little bit of the growth, but I think with TriClip now coming into the market and gaining traction, we’ll be able to provide a value proposition across both repair systems and drive there. So structural heart, the growth rate has accelerated from Q1, doing very well, and I’d say it’s really across a full portfolio approach versus just really trying to single out one product or one technology. There’s work we have to do in MitraClip - that’s clear, in the U.S., internationally it’s done very well; but all the other products that I’ve talked about are doing very well and gaining market share, and gaining adoption, so that’s why you saw structural heart’s growth rate actually accelerate, and I continue to see that that’s going to be definitely for the rest of this year and going into next year."
},
{
"speaker": "Travis Steed",
"text": "That’s super helpful. Then on your sensor business, how are you thinking about segmenting the market with Lingo versus Rio, and how do you think those markets are going to develop over time? When you look at your core Libre business, anything to call out, any changes in U.S. versus international market dynamics?"
},
{
"speaker": "Robert Ford",
"text": "Well, you’re trying to cover a lot of ground there with that question. You could probably spend a whole call going through all of that. I think at its highest level, Libre continues to do very well. There’s still a lot of growth opportunity. Obviously the basal opportunity is the biggest one, and we’re doing--having great progress over there, but even in the MDI segment, there’s still a lot of penetration to occur in the MDI segment. I think in the U.S., there’s still about a third of multiple daily injectors that aren’t using CGM, and international developed markets, it’s around 50%, so there’s plenty of growth in Libre. Our strategy here with Lingo and Libre Rio is just really to have a full portfolio and look at this as a platform where we can expand the use of the sensor technology across different types of diabetes populations, but also what is probably the larger market, which is people that don’t have diabetes, right? I think if you--if you take--right now, I would say we’re doing to launch it here in the U.S. and we’re going to start expanding globally, and we’ll see how it looks like and what it takes to win there. But what I do know, based on the U.K. experience, is that it takes some time to educate and communicate with a patient population that, while excited about having new tools to drive healthier habits, they do need some time to understand its use. But I think it’s a pretty big opportunity for us and one that we’ve disproportionately invested to be able to get into this position. I think if you take Lingo and you look at U.S. and Western Europe, the adult population there, you’ve got about 400 million people in those markets. If you take a single-digit penetration rate, a few sensors a year, you’re looking at a multi-billion opportunity there, and we’re not there yet. I think once we’ve got better understanding of how this is going to work, we’ll be better at forecasting it; but just at a high level and looking at it from a total adult population and relatively, I’d say, modest penetration rate, it’s a pretty big opportunity. Like I said in my comments, we’ve done this for a while since we’ve launched internationally, and we’ve learned a lot and we’re going to bring that learning and experience here to the U.S., so it’s an exciting opportunity for us."
},
{
"speaker": "Travis Steed",
"text": "Great, thanks Robert."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from Robbie Marcus from JP Morgan. Your line is open."
},
{
"speaker": "Robbie Marcus",
"text": "Oh great, thanks. I’ll add my congratulations on a good quarter. Two for me, two product questions. Maybe just to follow up on the diabetes Libre question, Robert, how are you thinking about a holistic drive of advertising and word of mouth for these new products, especially as we move into the OTC, versus generating data, and how much will be necessary? I think back five years ago, and where we are today was probably not in most people’s forecasts, and with the amount of data we have showing in non-diabetics how beneficial CGM is, how are you thinking about data versus not data, insurance coverage versus not insurance coverage, and how do the markets look one way or the other?"
},
{
"speaker": "Robert Ford",
"text": "Yeah, I don’t think--so from an insurance coverage perspective, if you’re referring to Lingo specifically for non-diabetes, I think it’s going to be--you know, I don’t think that that’s going to be something that we’re building a forecast assuming reimbursement coverage over it, even though I agree with you - you know, there is nice data that shows that people that don’t have diabetes can benefit from this, Robbie, and it helps sustain behavior modification. Ultimately this is what it is, right - it’s using data to be able to kind of help people that want to stay healthy, give them more information, and ensure that they can refine their habits or change habits. I think that that is at the core there - it’s really communicating directly with consumers. If you think about the diabetes space and how CGM uptake, you needed both a communication with the patient and you needed obviously a communication with the physician. I think that that’s still important for the non-diabetes. I think that some people will want to have some sort of recognition from the healthcare professional that this might be a good investment to do in, right, and the key thing here is just the utilization. I don’t think you’re going to see people that don’t have diabetes use this, you know, a sensor 365 days a year, but like I said, if they’re using a couple times a year, there’s still a benefit, and we’ll be generating data on this over time. I think it’s going to be important to generate data, even if it’s not to communicate to payors to get reimbursement, but even if it’s to communicate to physicians, the primary care and the direct consumers, that there’s a value here of doing that. I think the key thing here is personalization and how do you personalize information and the data and the coaching, so the strategy here is, yes, you’re doing to have to use TV to be able to communicate, but I don’t think it’s--I don’t think given our experience here that you could just go on TV and blast TV advertising and you’ll get this big uptake. You’re going to have to do some on-the-ground kind of gorilla marketing - let’s call it like that, together with TV advertising to really be able to open up the market and then sustain it, right, and sustain its use. That’s how we’re thinking about it, and that’s why we have a separate team completely removed from the Libre and the diabetes team, that they’re focusing on how to execute this strategy. I think it’s more of an S-curve growth versus an out-of-the-gate. I know that everybody is focused on what the sales are in the second half, whether it’s me or the competitor. I think the bigger picture here is, hey, there’s a really big opportunity here and if we do it right, it’s an opportunity that will be more than a flash in the frying pan. It will sustain itself and it could become standard, so."
},
{
"speaker": "Robbie Marcus",
"text": "Great color. One more from me - Aveir and the leadless pacing, particularly the dual chamber now with coverage, I think is an underappreciated opportunity. Maybe if you don’t mind, spend a minute there, how you see this market evolving, and what’s the early feedback on the launch so far? Thanks."
},
{
"speaker": "Robert Ford",
"text": "Yes, I mean, ultimately I think this whole leadless is going to change the growth trajectory of our CRM business. If you look at CRM, it grew 7% last year, it’s grown 7% the first half of this year - it was previously a flat business, and we’ve been doing that, I would say, with good success on dual, but I wouldn’t say that it’s at full cycle yet, because one of the things that we’re working on is ensuring that we’re doing the training and we’re getting physicians comfortable with the procedure, right? It’s a completely different procedure versus what the entire industry has been accustomed to. We’re using mapping, we’re going into the groin versus doing pockets above the chest, so it is a little different and we’re focusing on that. That being said, we’ve been able to accelerate the growth rate just with a single chamber. I think right now after two years, we’ve probably captured about 50 share, but to your point, the bigger opportunity is in dual, and the procedures are going great. Once physicians get several under their--you know, experience with several of them, they’re talking about okay, how do we accelerate this and an opportunity to drive more patients into it, but we want to make sure we’ve got a pretty large base of well-trained, great outcomes physicians across the United States. Listen, this is a $3 billion global segment and there really hasn’t been much innovation in it, and here you have something that’s truly unique and differentiated, and I’d say once we feel that we’ve gotten to a point where we feel good about the capabilities and training and the amount of physician coverage that exists, this is definitely a product that I can see going a little bit more mainstream, having more direct consumer communications because of the value proposition it affords them, so I think this is a great opportunity for us. It might be under-appreciated with the market, but it is definitely appreciated amongst me and the device team and the CRM team, and we’re working hard to get to that point where you can really let it go strong."
},
{
"speaker": "Robbie Marcus",
"text": "Great, thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from Josh Jennings from TD Cowen. Your line is now open."
},
{
"speaker": "Josh Jennings",
"text": "Good morning, thanks for taking the questions. Robert, I wanted to just start asking about just this multi-year trajectory for Abbott. You’ve been delivering top tier organic revenue growth performance over the last two years and potentially have a two-year double-digit stacked comp next year, but I think the team has been publicly stating that potentially the business could outpace pre-pandemic levels, which were in that 7% to 8% range. I think during this call, you’ve put forward a lot that supports that type of trajectory, but maybe just to reiterate your confidence level there, and is this kind of outpacing your pre-pandemic levels over the medium term dependent on M&A, or is this the core business with internal development programs that’s really going to drive this top tier growth out over the next couple of years?"
},
{
"speaker": "Robert Ford",
"text": "Was that an attempt to get to the 2025 kind of question? I’d say, listen - we’ve been saying that we made investments during COVID to accelerate the company, make it stronger, build our portfolio so we could accelerate the growth, right? If you look at the last six quarters, we’ve been delivering top tier, high single digit, double digit growth, and this is on a company that’s doing $40 billion-plus of revenues, so I think that’s pretty impressive. If you look at our med tech portfolio, it was the fastest growing med tech portfolio last year, fastest growing in the first quarter of this year. We’ll see what happens this second quarter, but we’ve positioned the company to be able to deliver this, and do I think that we can continue to deliver this top tier performance throughout this year and into next year? Yes, I absolutely do, because of, one, what we’ve built, and then just the evidence and the proof points that we’ve been able to reliably and sustainably deliver that. So yes, we feel good about our ability. The markets that we’re participating in are attractive, so they are markets that we lead, and when those markets grow, our leadership benefits. There are markets that are attractive that we’re entering, and there’s plenty of opportunity for market share gain; and there are markets that are attractive that we’re building, and there’s no real clinical opportunity--or there’s a clinical opportunity for our products that we’re developing to come in there, so as we build those markets, they become attractive and our position gets solidified. I think that framework applies to all four of our business units have opportunities across those three frameworks. On the M&A front, yes, if we’re able to find an asset that makes sense strategically to us, makes sense financially that could add even further to that growth, then we’ve got the balance sheet to be able to do that; but it’s not dependent--as I’ve told you, it’s really focused on the organic side to be able to deliver this top tier growth."
},
{
"speaker": "Josh Jennings",
"text": "Understood, and thanks for that answer. Another kind of high level question you probably receive regularly, but just wanted--it’s our understanding as well that your team, the Board ever year at least once a year, maybe multiple times a year, is just considering the strategic fit of the four major business units for Abbott, and maybe just if we could get an update on your thoughts on the business combinations and the potential for spins down the line. Thanks a lot."
},
{
"speaker": "Robert Ford",
"text": "Well, we look at our portfolio on an ongoing basis. I don’t think there’s this one moment in the year that we do it - we’re doing it on an ongoing basis, and the company has a history of ensuring that the portfolio that is assembled is not only delivering value to patients and governments and healthcare systems, but it’s also delivering value to our shareholders. We historically haven’t shied away from asking ourselves the questions and answering those questions, and if there’s an opportunity to create value through addition or through subtraction, then the company has shown that it’s ready to do that. I think the two fundamental questions about that is, is there an opportunity to create value for shareholders, and is there somebody that could do better with our businesses? Right now, you look at what we’re doing with our businesses, we’re performing at the highest level across all of the four segments. We’ll see what happens during this earnings season here, but I feel very good about the team and what they’re doing. Obviously there are areas that we could always do better, and we focus on that; but at the highest level, all four of our sectors have been delivering outstanding growth, market-leading growth, and quite frankly innovating and fulfilling our purpose and our mission, which is to help people live healthier lives. I like the diversity. The diversity provides both defense and offense capabilities, and as long as you’re managing them within each one of their segments, allocating capital that is proportionate to their growth and their industry, and we spend a lot of time managing all four segments, then I think we’re doing a good job at running them."
},
{
"speaker": "Josh Jennings",
"text": "Great, thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from David Roman from Goldman Sachs. Your line is open."
},
{
"speaker": "David Roman",
"text": "Thank you and good morning everybody. I was hoping to ask one question on the P&L side and one on the capital allocation side. Maybe I’ll start with the P&L here. As I kind of look at the guidance here for the back half of the year, our math implies it’s something like 100 basis points-plus of year-over-year operating margin expansion, and about 9% EPS growth at the midpoint of the range. Can you maybe talk through some of the drivers that underpin that margin expansion on a year-over-year basis? Obviously we saw a turn here in Q2 versus what we saw in Q1, but maybe walk us through some of the drivers that get to that improved margin and earnings growth performance in the back half of the year."
},
{
"speaker": "Robert Ford",
"text": "Sure, I’ll let Phil take that."
},
{
"speaker": "Phil Boudreau",
"text": "Yes, good morning David. Robert touched a little bit in his opening comments here on some of that expansion already this year, and we’re in a pretty unique position relative to some of our peers in terms of our op margin profile, that we’re already back to pre-pandemic levels, and we did that strategically through managing spend through the ups and downs of COVID testing. As we talked earlier this year, Q1 was really the last big comp on COVID testing impacts on sales and profiles. With respect to margin expansion and gross margin in particular, the guidance for the year is around 75 basis points as you highlight some progress here, and more to go, but the trajectory is there. We’re focused on the things that we can control and execute on, and in particular some of this great portfolio contribution from our sales top line performance, particularly in accretive businesses, is a contributor here, and one that we anticipate will continue to expand here throughout the year. We have dedicated teams in each one of our businesses focused solely on gross margin improvement, productivity yield improvements, cost reductions, innovation that brings accretion to the portfolio. All of those elements are contributors here quarter in and quarter out and continue to contribute through the rest of the year. Then we also have elements--we’ve talked about some of the cycles that we go through, be it in commodities markets and the like, some of the inflation the last few years, that are starting to sort of stabilize and normalize We’re seeing freight and distribution profiles normalize and start to be more a tailwind as opposed to headwind, and we’re also seen in commodity markets as well things not only stabilizing, but coming down and also contributing to tailwinds to gross margin, and anticipate that to persist here as well. The combination of all of those contributes to the confidence here and continuing to drive the top tier sales performance, but also expand margins throughout the year."
},
{
"speaker": "David Roman",
"text": "Super helpful, thank you. Then maybe just on the capital allocation side, maybe thinking about the other side of Josh’s question, if you look across the sector here, we’ve seen M&A pick up a little bit in the second quarter - I think there were two billion dollar-plus transactions announced with transaction multiples starting to trend toward the lower end of historical levels. But could you maybe give us your latest perspective on the M&A environment and how you’re thinking about capital allocation as your cash balance continues to build nicely here?"
},
{
"speaker": "Robert Ford",
"text": "Well, on the capital allocation more broadly, listen - I’ve been pretty clear every call about we have a balanced approach, right? I know you guys cover a lot of companies that have different approaches. Our approach is balanced, and we believe that that balanced approach benefits the long term shareholder. One of the metrics that I believe, David, is a good measure of evaluating capital deployment effectiveness is ROIC, and if you look at ROIC over the last three years, we’ve averaged around high teens, and that’s on the higher end of the med tech peers that we often get compared to, so. We believe that ROIC is a good measure of how effectively we’re deploying the capital, and we look at a balanced approach, so are there internal capital investments that drive future growth. We’ve been talking about all these great opportunities we have, and we’re funding them and they have great returns. Debt pay down - we don’t have much this year, but we took care of some towers last year because we didn’t want--we obviously didn’t want to refinance them. Dividend and buybacks are--you know, the dividend is definitely core to our investment identity, and we intend to continue to grow our dividend, so that is a balanced approach. Even with all of that, we also, as you’ve probably seen, we have opportunity from a balance sheet perspective to deploy that from an M&A perspective, and we’ve been spending time talking about our strong top line and the pipeline that we’ve developed, and that allows us to be a little bit more selective. You look at other transactions that happened and you have to ask, okay, what’s the strategy behind that, and a lot of the time you can see you’re having to sustain your growth rate, right? If you’re in the business of driving top line through acquisitions, then you’ve got to--you know, that’s part of your model, you’re going to have to keep doing that, whether the valuations are right or wrong, or not right. But we look at these strategic fit, can they generate an attractive return, can we make the business better that we’re acquiring. We don’t want to be just a holding, and I think that we’ve shown that when we do, do our acquisitions, that’s the framework, you know - fits in strategically, generates nice return, and we tend to operate them or add value to them than when they were a standalone, so."
},
{
"speaker": "David Roman",
"text": "Appreciate all the perspective, and thanks for taking the question."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from Danielle Antalffy from UBS. Your line is open."
},
{
"speaker": "Danielle Antalffy",
"text": "Hey, good morning guys, thanks so much for taking the question. Congrats on a really good quarter here. Robert, one of the things that struck me when we spoke--I have two product-specific questions, when we last spoke is how you’re looking at the sustainability of historically slower growing businesses and areas exposed to historically slower growing markets, so obviously I’m thinking CRM. Can you talk a little bit about the strategy there - obviously Aveir is a big part of that, and just leadless pacing in general, and how sustainable--I mean, it’s been, like, multiple quarters now of organic growth in the mid-plus single digit range, and then just one follow-up, another product question."
},
{
"speaker": "Robert Ford",
"text": "Yes, well that was part of our strategy as we looked at our med tech portfolio - you’ve obviously got high growth drivers there with EDP, structural heart, diabetes care, neuro, heart failure, and we looked at CRM and vascular, and those are more flat businesses, so the combination of all that is you had a med tech portfolio that was growing 7%, 8%, maybe 9% a quarter there. To get to double digits, we needed those two businesses to get at least to mid single digits, right, and I’d say on the CRM side, our strategy there was to really focus on Aveir leadless pacemakers. You know, there’s a pipeline of products there - I don’t want to tilt my hand here, but we didn’t do Aveir DR and stop there. The team’s gotten R&D programs to continue to advance those and even to look at the ICD market also and what are the opportunities that we can do to innovate. But there is space to innovate in that market, and that for me is important, is the diabetes market, you know, 15 years ago, people would say, gee, that’s a slow growth market - well, now look at it, right? If you focus on innovation on meeting needs, unmet needs, you can turn a market around. From a vascular perspective, as I said in my comments, we’re trying to--we’ve been repositioning the portfolio to more higher growth areas, peripheral areas, endovascular areas, but we started that a little bit later than what we did in CRM, so I expect to start to see our vascular business start to also contribute to a higher growth rate, the same way that CRM is, and that just kind of bolsters our entire med tech portfolio and gets us into that 12%, 13% growth rate, at least that’s our target."
},
{
"speaker": "Danielle Antalffy",
"text": "Okay, that’s helpful. Then the follow-up question is on the structural heart side of things, and I know Amulet has been on the market for a little bit here, but my impression is that now it’s kind of like Abbott is no longer fighting with one hand tied behind their back. Can you talk a little bit about that, and your 45% growth, I think you said in the quarter, where to from here for Amulet? Thanks so much for taking the questions."
},
{
"speaker": "Robert Ford",
"text": "Yes, so it was a great quarter. I think the team’s kind of hitting its stride right now. As I’ve said, our focus here was really to kind of drive adoption in the centers that we were at, versus expansion. The competitor has expanded the market - there is probably about 800 centers that are doing these implants, and we’re probably in about half of it. Now, that’s good, right - that provides a market expansion dynamic here in the U.S., but-. I mean, I’m really encouraged by some of the data that I’m seeing, and I think it starts with the data, right? You know, we had patient registry data come out where we showed that 95% closure rates were achieved post implant and sustained after 45 days, 90% of closure success rate using Amulet, for patients that actually fail to achieve proper closure rate with a competitive product, so I think that there’s an opportunity here for our value proposition, and then we’ve got to continue to invest. We are already investing on our next-generation Amulet, focusing on ease of use, focusing--and we’ll maintain our superiority here that we believe we have regarding the ceiling of LEA. We’re investing in clinical trials, obviously we’ve been public about Catalyst, which is a trial that will compare Amulet to NOAC and to ablation treatment, so this is an exciting market for us and we will continue to invest in it, and ultimately it comes down to really looking at surrounding the electrophysiologist with the most comprehensive portfolio, whether it’s on pacemakers and ICDs, structural heart interventions with stroke preventions, and then obviously ablations and AF treatment. At its highest level, that’s the important side here, is Amulet fits an important role even though we report it as structural heart. It’s really playing a role here to surround the physician, the EP with the tools they need to advance care."
},
{
"speaker": "Danielle Antalffy",
"text": "Thank you."
},
{
"speaker": "Mike Comilla",
"text": "Operator, we’ll take one more question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our final question will come from Vijay Kumar from Evercore ISI. Your line is open."
},
{
"speaker": "Vijay Kumar",
"text": "Hi Robert. Thanks for taking my question, and congrats on a nice sprint here. I wanted to touch on biosimilars - you know, you brought this up on the call. Can you elaborate on your strategy there? Are you planning to manufacture these products? Is Abbott going to be a CDMO in that space or do you plan to launch your own biosimilars, or is this more of Abbott being a distributor and taking advantage of your brand presence in emerging markets? What is Abbott’s role in that place, and how do you size that market opportunity for Abbott? When should that start contributing to Abbott?"
},
{
"speaker": "Robert Ford",
"text": "Sure. You know, this is one where I’d say there’s a couple phases to the strategy. The core premise of this, Vijay, is if you look at the emerging markets and the disease prevalence that exists in these emerging markets, they’re no different than the disease prevalence in the U.S or Europe. You could look at some of them are higher, etc., but in general there’s an opportunity to bring these biologics into the emerging market. For a variety of reasons, those markets have not been a priority for the originators. Their main focus has obviously been in the international developed markets - U.S., Western Europe, Japan, Canada, Australia, etc., so this provides just a patient need opportunity that we want to size up. What we’ve seen through some of our--you know, we have done some more regional biosimilar deals that we’ve launched, and what we’ve seen is that the growth of the molecule grows significantly once a biosimilar enters in terms of penetration into a patient population. It’s a different dynamic in developed markets, as we know, but in emerging markets the category really expands, so what we wanted to do is to say, okay, before we start to think about manufacturing, before we start to think about that, we want to be able to understand what is the uptake of these products once you go ahead and put a concerted effort to developing these types of products in emerging markets. It fits right into our wheelhouse, where we’ve got relationships with governments, we have relationships with physicians, and we’ve got relationships with the distribution area. The question is how can you do it in--how can you execute that strategy that’s capital efficient and doesn’t erode gross margin of that business, and I give a lot of kudos to the team because they’ve really been able to position our presence in these markets as an advantage to these players that really aren’t focusing on emerging markets, they’re focusing more on the opportunity that exists in developed markets, and now they can partner with one single company, reputable company to be able to use that capacity in other markets. I’d say we’re in the phase right now of, okay, is there sustainability to this, so the deals that we’ve done give us access, our gross margin is not dilutive, and we’re going to see how it goes. As you think about the ramp-up of what we’ve got in the pipeline, we’ll start launching in 2025, but you look at some of the big molecules that will come up for us ’26,’27, that’s I think when some of these very large oncology opportunities that we have will play a huge role for us and accelerate the growth there."
},
{
"speaker": "Vijay Kumar",
"text": "That’s helpful. Maybe one last one on capital deployment. I know it’s been asked - I’m curious on share repurchases. You guys have done phenomenal growth. The street doesn’t seem to be giving credit. Why not? You didn’t see any share repurchase in the first half. Why is Abbott being conservative on share repurchases?"
},
{
"speaker": "Robert Ford",
"text": "Yes, well we’ve done a lot of share repurchases over the last couple of years, say catching up a little bit, to maybe not doing as much repurchasing after the two acquisitions we did in 2017 and 2018. If you look at our repurchases and dividends, it’s been about $20 billion that we’ve returned over the last four years, Vijay - $20 billion in dividends and buybacks, and that accounts for a good amount of our free cash flow over the last couple of years to our shareholders. We’re not--the year’s not over, and again we’ll see opportunities. We’ve got plenty of opportunities to be able to do that, so I’d say I think we’ve done a pretty good here at returning cash back to our shareholders over the last couple of years, and that commitment we’ll maintain, so."
},
{
"speaker": "Robert Ford",
"text": "I’ll just close here. This was a great quarter for us and, quite frankly, a great quarter in connection with five quarters before that, where we’ve delivered above-market growth. I’m really pleased with our continued strong performance. We’ve raised our sales outlook, our EPS ranges for the second time this year. The toughest COVID test comps are now behind us, so I look forward to not having to--you know, we’ll obviously report our COVID testing sales, but you’ll start to see those comps start to dwindle away now, which means then that our EPS is back to growth. I think one of the questions there about showing our EPS exiting the year in high single digits, double-digit kind of range and getting back to our formula, that’s what we’re interested in, and we’ve got a lot of positive momentum here heading into the second half of the year. With that, we’ll wrap up, and thank you for joining us."
},
{
"speaker": "Mike Comilla",
"text": "Thank you Operator, and thank you all for your questions. This now concludes Abbott’s conference call. A webcast replay of this call will be available after 11:00 am Central time today on Abbott’s Investor Relations website at abbottinvestor.com. Thank you for joining us today."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today’s conference call. Thank you for your participation. You may now disconnect. Everyone have a wonderful day."
}
] | Abbott Laboratories | 247,483 |
ABT | 1 | 2,024 | 2024-04-17 09:00:00 | Robert Ford - Chairman and Chief Executive Officer:
Phil Boudreau - Senior Vice President, Finance and Chief Financial Officer:
Bob Funck - Executive Vice President, Finance:
Operator: Good morning, and thank you for standing by. Welcome to Abbott's First Quarter 2024 Earnings Conference Call. All participants will be able to listen-only until the question-and-answer portion of this call. [Operator Instructions] This call is being recorded by Abbott. With the exception of any participants’ questions asked during the question-and-answer session, the entire call, including the question-and-answer session is material copyrighted by Abbott. It cannot be recorded or rebroadcast without Abbott's expressed written permission. I would now like to introduce Mr. Mike Comilla, Vice President, Investor Relations.
Mike Comilla: Good morning, and thank you for joining us. With me today are Robert Ford, Chairman and Chief Executive Officer; Bob Funck, Executive Vice President, Finance; and Phil Boudreau, Senior Vice President, Finance and Chief Financial Officer. Robert and Phil will provide opening remarks. Following their comments, we'll take your questions. Before we get started, some statements made today may be forward-looking for purposes of the Private Securities Litigation Reform Act of 1995, including the expected financial results for 2024. Abbott cautions that these forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those indicated in the forward-looking statements. Economic, competitive, governmental, technological, and other factors that may affect Abbott's operations are discussed in Item 1A, Risk Factors, to our annual report on Form 10-K for the year ended December 31, 2023. Abbott undertakes no obligation to release publicly any revisions to forward-looking statements as a result of subsequent events or developments, except as required by law. On today's conference call, as in the past, non-GAAP financial measures will be used to help investors understand Abbott's ongoing business performance. These non-GAAP financial measures are reconciled with the comparable GAAP financial measures in our earnings news release and regulatory filings from today, which are available on our website at abbott.com. Note, that Abbott has not provided the GAAP financial measure for organic sales growth on a forward-looking basis because the Company is unable to predict future changes in foreign exchange rates, which could impact reported sales growth. Unless otherwise noted, our commentary on sales growth refers to organic sales growth, which is defined in the press release issued earlier today. With that, I will now turn the call over to Robert.
Robert Ford : Thanks, Mike. Good morning everyone, and thank you for joining us. Today, we reported first quarter adjusted earnings per share of $0.98, which was above analyst consensus estimates. We also raised the midpoint of our guidance ranges for both earnings per share and sales growth. We now forecast full year adjusted earnings per share of $4.55 to $4.70 and organic sales growth, excluded COVID testing related sales of 8.5% to 10%. Organic sales growth, excluding COVID testing related sales was 10.8% in the quarter, which represents the fifth consecutive quarter of double-digit growth. The strong start to the year was driven by broad base growth across a portfolio, including growth of 14% in medical devices and established pharmaceuticals. In addition to exceeding expectations of both top and bottom lines this quarter, we accomplished a number of objectives across the pipeline, including obtaining several new product approvals and achieving important clinical trial related milestones. I'll now summarize our first quarter results in more detail before turning the coal over to Phil, and I'll start with nutrition, where sales increased 8% in the quarter. Strong growth in the quarter was led by double-digit growth in pediatric nutrition, driven by continued market share gains in the U.S. infant formula business and growth across our international portfolio of infant formula, toddler and adult nutrition brands. In January, we launched a new nutrition shake called PROTALITY, which provides nutritional support for adults pursuing weight loss. As people eat less and lose weight from taking GLP-1 medications, undergoing a weight loss surgery, or following a calorie restricted diet. A portion of what is lost is lean muscle mass, which plays an important role in overall health. Combination of high protein and essential vitamins and minerals that totality offers can help people preserve muscle while pursuing their personal weight loss goals. Turning to EPD or sales increased 14% in the quarter. This quarter was a continuation of EPDs impressive trend of strong performance, including double-digit growth in four of the last five quarters. In addition to a strong track record of top line growth, this business has delivered equally impressive gains on the bottom line with an operating margin profile last year that reflected more than 350 basis points of improvement compared to 2019. Moving to diagnostics, where sales increased more than 5%, excluding COVID testing sales. Growth in diagnostics continues to be led by the adoption of our market leading systems and demand for testing that takes place in a variety of settings, including hospitals, laboratories, urgent care centers, physician offices, retail pharmacies, and blood screening facilities. Our development efforts and diagnostics focus on developing new systems and creating new tests that play an important role in making healthcare decisions, expand the accessibility of testing and deliver a result as fast as possible. In April, we received FDA approval for a point of care diagnostic test that could help determine if someone suffered a mild traumatic brain injury or concussion in just 15 minutes. The test is run on our portable i-STAT Alinity instrument, which allows concussion testing to move beyond the traditional hospital setting and into urgent care centers, physician offices, and other locations that are closer to the patient, with nearly 5 million people in the U.S. going to the emergency room to be checked for suspected concussion each year. We believe this test has the potential to transform the standard of care for concussion testing, and I will wrap up with medical devices, where sales grew 14% in diabetes care. FreeStyle Libre sales were $1.5 billion in the quarter and grew 23%. As I previously mentioned, that Libre has several new growth opportunities that will help continue to fuel the strong sales trajectory we have forecasted. One of those growth opportunities relates to the continued expansion of reimbursement coverage for Libre, for individuals who use basal insulin therapy to manage their diabetes. Last year, we announced that Libre became the first and only continuous glucose monitoring system to be nationally reimbursed in France to include all people, who use basal insulin as part of their diabetes management. During this first quarter, Libre obtained reimbursement from a select number of institutional payers in Germany for basal insulin users who also use oral diabetes medication to manage their condition. These select public and private payers cover a limited number of the approximately 1 million basal insulin users in Germany, but this is an encouraging sign of the potential for further coverage expansion not only in Germany but across other European markets. In cardiovascular devices, sales grew 10.5% overall in the quarter, led by double-digits growth in electrophysiology, structural heart and continued acceleration in our cardiac Rhythm Management and Vascular portfolios. In electrophysiology, sales grew 18%, driven by double-digits growth in all major geographic regions and across all major product categories, including double-digits growth in ablation catheters and cardiac mapping related products. We continue to make great progress toward bringing our innovative PFA catheter, Volt to market. In March, we completed enrollment in our CE Mark clinical study, putting us on-track to file for international approval before the end of the year. We also recently began enrolling patients in our U.S. clinical trial called VOLT-AF, which will generate the data needed to support an FDA approval filing. In structural heart, growth of 13% was led by strong performance in several high-growth areas, including TAVR, LAA, mitral and tricuspid repair. Structural heart is an area that we have invested in over the past years in order to create a diversified portfolio that can sustainably deliver double-digits growth. In the past, we relied almost exclusively on MitraClip to drive the growth, but today the portfolio and growth are more balanced and reflect increasing contributions from newer products like Navitor, Amulet and TriClip. In April, we received FDA approval for TriClip, a first of its kind heart valve repair device designed for the treatment of tricuspid regurgitation or a leaky tricuspid valve. Data from the clinical trial supporting this approval demonstrated that, patients who receive TriClip experienced a significant improvement in the severity of their symptoms and quality of life. We are excited to now offer this life-changing treatment option to people in the United States that suffer from this condition. In Rhythm Management, growth of 7.5% was led by AVEIR, our recently launched leadless pacemaker. AVEIR has rapidly captured market share in the single chamber pacing segment of the market and is now being used for dual chamber pacing, which is the largest segment of the pacing market. This revolutionary technology is helping to deliver growth rates in our Rhythm Management business that significantly exceed the overall growth in this market. And lastly, in neuromodulation, sales grew 17%, driven by Eterna, a rechargeable neurostimulation device for pain management. In January, we announced the launch of Liberta, the world's smallest rechargeable deep brain stimulation device, which is used to treat movement disorders such as Parkinson's disease. In summary, we're off to a very good start to the year, exceeding expectations on both top and bottom lines. And as a result, we have raised the midpoint of our sales and EPS guidance ranges. We continue to make good progress on our gross margin expansion initiatives and we're seeing strong returns from the investments we are making across our growth platforms. Our pipeline has continued to be highly productive, delivering several recently new product approvals and we're very well-positioned to continue to deliver strong results for the remainder of the year, and I'll turn over the call to Phil.
Phil Boudreau: Thanks, Robert. As Mike mentioned earlier, please note that all references to sales growth rates unless otherwise noted, are on an organic basis. Turning to our first quarter results, sales increased 4.7% on an organic basis, which as expected includes the impact of year-over-year decline in COVID testing related sales. Excluding COVID testing sales underlying base business, organic sales growth was 10.8% in the quarter. Foreign exchange had an unfavorable year-over-year impact of 2.9% on first quarter sales. During the quarter, we saw the U.S. dollar strengthen versus several currencies, which resulted in exchange having a more unfavorable impact on sales compared to exchange rates at the time of our earnings call in January. Regarding other aspects of the P&L, the adjusted gross margin ratio was 55.7% of sales, adjusted R&D was 6.7% of sales and adjusted SG&A was 29.4% of sales in the first quarter. Lastly, our first quarter adjusted tax rate was 15%. Turning to our outlook for the full year, we now forecast full year adjusted earnings per share of $4.55 to $4.70, which represents an increase at the midpoint of the range compared to the guidance range we provided in January. We also raised the midpoint of our guidance for organic sales growth. We now forecast organic sales growth, excluding COVID testing to be in the range of 8.5% to 10%. Based on current rates, we expect exchange to have an unfavorable impact of approximately 2.5% on full year reported sales, which includes an expected unfavorable impact of approximately 3% on second quarter reported sales. Lastly, for the second quarter, we forecast adjusted earnings per share of $1.08 to $1.12. With that, we'll now open the call for questions.
Operator: [Operator Instructions] And our first question will come from Robbie Marcus from JPMorgan.
Robbie Marcus : Two for me. I'll just ask them both up front. First, Robert, we almost never see Abbott raise guidance particularly on the top line in the first quarter. Looking back over the past, I don't know, 5, 10 years, it's very rare. First part is what gave you the confidence to raise the midpoint of the guidance this early on in the year? And then second, obviously, there's been a lot of concern during the quarter with competitor’s loss in a case for NEC as it relates to infant nutrition. I was hoping you could address that what's your stance on the ongoing litigation? I think there's about a thousand cases that have been filed and any upcoming data points or timelines we should be looking for.
Robert Ford : Let's go first to your question on the guidance, yeah, you're right. I guess I had to go back and take a look at that. I think the last time we did raise in Q1 was in 2016. I would say the framework here, Rob, is we've always done is, we set a guidance at the beginning of the year, which we believe is top tier, and then throughout the year, we want to beat that guidance, and we consider top tier to be high single-digit double-digit EPS growth. And that's obviously excluding the COVID testing portion, which is what investors are really more focused on. So that was the guidance that we set a couple months ago, back in January. We will target always have that top tier guidance and find the appropriate balance between, the opportunities. And obviously the challenge is that bracket that range. If you remember in January, I said I thought that there was more opportunities than risks. I think that some of the risks that we saw in January, I still think they haven't gone away. They are still there, whether it's geopolitics or whether it's FX, those are still there. But clearly the performance of the business continues to be very, very strong. And some of our businesses, a lot of our businesses actually accelerating our in performance. As I said in my comments, five consecutive quarters of double-digit growth here. You look at each of the businesses, EPD consecutive, three consecutive of double-digit growth, great margin expansion, and the teams are now working to be able to introduce biosimilars in all the markets that we are participating in. Nutrition has done an incredible job at recovering share and growing our adult business. We have grown adult over $1 billion versus 2019. Diagnostics continues to have a great track record here, outperforming the market. We have got some great large account wins both in the U.S. and internationally that we're rolling out into this year. And medical devices, I mean, what can I tell you? It is just been a real strong performer. The team's done an incredible job there. Last year, we were the fastest growing MedTech Company, at least from what I have seen from our guidance and from the other guidance’s in the market. That's what it seems to be again this year. So you put all that together, plus the pipeline that's been contributing to an accelerated level, great new product approvals. I put all that together and I just feel that this type of performance that we deliver just gives us the confidence for the remainder of the outlook of the year. We felt comfortable raising the guidance again, in the first quarter, which is as you pointed out something that we don't usually do. I continue to believe going into the second quarter, as we move through that there's probably more opportunities than risks here, as we move forward. I guess that's the framework of raising our guidance in the first quarter, which is something that we usually don't do. Just great performance and great momentum. And then your other question was regarding the net cases. I would say from a date, we have some court cases that will happen in July. So that's maybe a milestone that we want to look at. But if you are asking me about kind of our framework of how we look at this. I'd say, for decades, we've provided specialized nutrition products that help doctors. And I think that's a key thing here. It helps doctors to provide the lifesaving nutrition to the premature infants. How you feed a premature infant, it's a medical decision, Robbie. Health care providers, they're going to use a range of options to meet the unique needs of each baby. That includes mother's milk, that includes pasteurized donor's milk, but that also includes preterm infant formula, because where mother's milk is not available, there is not a sufficient supply of donor milk to satisfy the nutritional needs of all of these premature infants that are born in the U.S. And quite frankly, even when they're available for some premature infants, human milk may lack some of the calories, the proteins, the vitamins et cetera that are necessary to support the nutritional needs of the premature infants. That mother's milk needs to be fortified in order to boost the nutritional output. The medical community, they consider these products to be critical part of the standard-of-care for feeding premature infants. Most of the societies when you read their positions, it is a standard-of-care to use these products. The doctors who work in the NICUs, they've used our products for decades and they continue to do so today. Countless babies, Robbie, have benefited from these products, lifesaving experiences over many, many years and there are clinical studies that have repeatedly established that, these products are safe. These litigation cases, they're really seeking to advance a theory promoted by plenty of lawyers that distorts the science and it distorts everything that we know and it's not supported by the medical community. We are preparing for our cases to be able to kind of lay out the facts, the science and the data and we stand behind our products.
Robbie Marcus: Appreciate it, Robert. Thanks a lot.
Operator: Our next question will come from Larry Biegelsen from Wells Fargo.
Larry Biegelsen: Good morning. I'll echo, Robbie's, congratulations on the strong start to the year here. Robert, I just wanted to focus on EP. A multipart question here, but just one. The EP business grew nicely in the first quarter in the U.S. and outside the U.S. Can you talk about what drove that? What you're seeing with PFA in the different geographies? Your expectations for your EP business going forward before the Volt launch? Just lastly, it sounds like we should expect the Volt approval in Europe sometime next year based on the filing date. Just want to confirm that.
Robert Ford: Sure. Like I said in my opening comments, we completed the trial. There's a six month follow-up, Larry. That means that, we will be on target here to file for CE mark by the end of this year. Then, it's just going to depend on that process. I think that's probably our anchor point here is getting the filing in before the end of the year. Yes, I mean, I'm not surprised by our EP growth. I know many on the call might be, but I'm not surprised. First of all, it's an important therapy. It's an underpenetrated disease. We know there's plenty of growth in this segment, and as a result of that, it's highly competitive. But we haven't been surprised by the growth. If you look at PFA, it's been in Europe for three years. If you average our growth rate over those last three years in Europe, we've been growing mid-teens, and the growth, it remains broad base. It was broad based in Europe, again, this quarter where we saw double-digit growth in ablation catheters. Not just on the mapping side, on the ablation catheter side also but then also great growth on the mapping side, and this technology has now come to the U.S. I think we probably had maybe two months of seeing the technology be rolled out here in the U.S. I think the competitors have been very aggressive here in terms of bringing the technology to the accounts in the U.S., and I can say, we've mapped a lot of those cases, Larry. I'm not going to say we've been in every single case, but I'd say, a vast majority of the cases we've been in there. And there are some similarities to Europe, but there are some differences to Europe. I think one of the things that we saw in Europe was that there was this inclination to use the technology starting off as kind of a one shot. So that had an impact more on the CRYO business than I would say on the RF side. And that's what we saw in our mapping cases. We saw here, at least in the first couple of months, that's where a large portion of those cases occurred, at least the ones that we mapped were in places where they were traditionally used in CRYO. I think the difference that we saw a little bit in Europe is that at least 90% of the cases that we were part of direct or indirectly were using mapping that that number was lower in Europe. So that's probably a little bit of the difference I saw here in the U.S., and that bodes well for us. Our end site system, our mapping system, our mapping catheters are widely viewed as an excellent option here for mapping these PFA cases. We have a large install base. Customers are familiar with it. Don't need a make room, don't need a fight for capital. We've got best in class clinical support. And the architecture here is open, as I've said in previous calls. So it integrates well with these PFA catheters. We actually recently released a software upgrade last month that provides even better visualization to these catheters and potential for faster procedures and less floor time. I think this is a perfect combination, quite frankly, in a time where there's going to be market transition, There's a lot of new products, there's a lot of choices. And when you have a situation like that, I think flexibility is key, and that's what we heard from our customers. One data point that I thought was also interesting to your question of what helped drive that in the cases that we were part of, and we saw, we also observed that an RF catheter was pulled in about a quarter of the cases that we saw. So on top of the PFA catheter, an RF catheter was pulled to do touchups, et cetera. I'd say right now, everything that we've seen in Europe on the positive side is happening. And then I think there's some interesting dynamics here in the U.S. that could be favorable for us also, but it's still very early. If I look at March, we had probably one of our most, we look at cases per day. That was probably one of our highest months. So far so good. And we're excited about the technology, we're excited about our program. We released data on our program and some recent medical meetings that occurred. And the feedback, from those that have been used in our product are very positive. And the integration with EnSite in including like the tissue contact force algorithm and the visualization, all of that is seen as a real promise and a differentiator versus what's being used today.
Operator: Our next question will come from Josh Jennings from Cowen.
Josh Jennings : Great to see the strong start here, the Q1 results. Robert, I was hoping to just ask first on Libre and just internationally, any other payment or coverage decisions that we should have on our radar in various countries. Sounds like you have made sense, some nice progress already in Germany, and then in the U.S. I was hoping you could just help or share your thoughts on the share gain opportunity in integrated pump segment of CGM market versus the share loss risk in the Type 2 non-insulin cash pace segment with a competitive launch share early in 2024. I just have one follow up.
Robert Ford : On your international question, I mean, it's always difficult to forecast exactly by month a quarter coverage kind of payment decisions. I can tell you though that the team has a full global map of all the work that's being done regarding clinical information and negotiations, et cetera. It's difficult to kind of forecast it, but what I have said is on previous calls and on some of my prepared remarks that I think you're going to see this just this build that will be occurring globally in the market as the data proves and shows the clinical medical and health economic benefit by reimbursing for this patient population. And I think we're well positioned there. Internationally, I think we got some pretty large markets already. Canada, Japan, France, Italy, Germany, those are markets that are either fully reimbursed or starting their process. And like I said, I think you will see as the year progresses, whether it's in medical events or just as the year progresses, I think you'll see more coverage decisions. Maybe they don't get splashy, big PR news, but we are seeing continuous increasing there on that. On the U.S. side, I guess I disagree with your premise that I'm going to be trading share gains on the pump side for share losses on the non-insulin side. I mean, I'm just, right now I'm looking at the data, third party audited data, 7 out of every 10 new prescriptions for this basal population, which is primarily served by the primary care channel, 7 out of 10 are going to Libre. I think our product's going to get even more competitive and compelling, I think this is a great opportunity and our objective here is to maintain kind of our shared dominance and our share leadership as it results in this patient segment. But we do have an opportunity here to participate a little bit more actively in what is a little bit more of a smaller segment of the population, but nonetheless a very important one, which is the AID and the market system. There's 150,000 to 200,000 new starts a year. There's an opportunity for share gain also of existing users. I think that, the opportunity to bring a dual analyte sensor with ketones. We showed some data at ATTD this year, that showed the safety benefit or the value proposition of a dual analyte sensor for AID system. I think that's going to be a compelling value proposition. We are working with all the pump companies here and I think as the year progresses, we'll see connectivity occur whether it's with Libre 2 Plus our streaming product or whether it's with Libre 3. This is an area that we are focusing on and it's a new segment for us to compete in. But I don't think that, we are going to be taking our eye off the ball as it relates to the basal opportunity that exists.
Josh Jennings: Understood. Thanks. And then just wanted to ask on the transcatheter tricuspid market, congratulations on the TriClip approval, but there's been some questions around the patient opportunity breakdown between TIER, TriClip and replacement with EVOQUE. Maybe just any internal team thoughts on that patient opportunity breakdown and then maybe you could share on the pricing strategy for TriClip in the setting of competitor pricing its replacement device at a significant premium? Thanks for taking the questions.
Robert Ford: I'm not going to comment on our pricing strategy for competitive reasons. It is a differentiated and novel technology. There is an opportunity, but we'll have to see how this all plays out. You got NTAP submissions and all this stuff going on right now. What we are focused on here is, launching the product and getting cases ramped up and that's what's happening. I got some feedback yesterday from the team after a couple of weeks, real nice cadence of growth. We are obviously focusing on our initial cases on most of the account that were part of our pivotal trial, but just but just real nice cadence growth there and great feedback from physicians and patients post-surgery. I mean, if you're trying to poke at, what's the breakdown going to be about replace and repair, listen, I think it's good to have options. I guess my view here is that, I believe that, probably safety is a key driver here, just to start off with. I think TriClip has shown a very strong excellent safety record, both in clinical trials and real world use. I think that's going to play a key role here in determining repair versus replace. I expect repair or TriClip at least to be the preferred option unless the valves are too damaged and then obviously replacement is the only option. But there is a large pool of patients here. You got 5 million people globally, 2 million people here in the U.S. and it's going to be an opportunity here that we will be generating more data, expand the indication of the product. I think this is easily a $1 billion opportunity for us here as we build the capabilities and as we build more clinical data.
Operator: Our next question will come from Travis Steed from BofA Securities.
Travis Steed: Maybe just while we're on the pipeline, talk a little bit about AVEIR it sounds like that that product's going really well. And then I had a question on gross margins as well. Trying to think about is this the right pace to kind of get back to pre-COVID levels and still the opportunity kind of longer term for gross margins?
Robert Ford : I think if AVEIR's done very well, I mean, we all know the advantages it has over the competitive system, whether it's single and dual chamber, the longer lasting battery, the ability for replacement, retrievability, upgradeability. It's done very well. From a single chamber perspective, I think we are now at about 50 share of the US market. So that's been doing very well. It's performed, we started doing our dual chamber procedures towards the end of last year. Seeing a nice kind of ramp up over this first quarter here. Focus here really is a really about, it's a completely different procedure, right? If you think about how these devices have been implanted, this is probably the first time in like 30 years that you have like a real meaningful change on how this is done. Our focus here is really getting great clinical results real thoughtful approach here about opening new sensors and training. And that's been working very well for us. And you could see the impact on our growth rate. I mean, historically our CRM business has been relatively flat with some platforms going up, some platforms going down. Our goal here with this program was to get our CRM portfolio to at least be contributor to growth mid-single digits, 6%, 7%. These last couple of quarters we've done seven and a half percent, and so AVEIR's been doing well, and it's going to continue to get better as more and more physicians get trained and we increase the amount of accounts. So I really like the cadence of how we're forecasting this business and the impact that it's going to have on our CRM portfolio. What was your other question?
Travis Steed : Just on gross margins, kind of thinking about the path back to pre COVID levels over the long term and is this the right kind of cadence that you're -- this year's cadence, the right way to think about that?
Robert Ford: I think that's a good cadence. I think we're forecasting here about 70 basis points of improvement this year. Feel good about that. I've talked about this not being a question of if, just a question of when, so I think that's not a bad cadence. And we're going to focus on the things that we can control and the things that we can control are obviously our cost and our cost teams and the teams that are working on improving gross margin, they're delivering great results here, while at the same time maintaining high service levels not running to back orders, et cetera. But probably the biggest the biggest opportunity we have here Travis, is just to expand the gross margin through portfolio mix. When you have our medical device businesses growing at mid-teens consistently over the last, whatever, four or five quarters, that has a real strong impact on our gross margin. So a lot of focus on what we control our gross margin, the cadence. That's what we are targeting. It's not really a question of if it's just a question of when.
Operator: Our next question will come from Vijay Kumar from Evercore, ISI.
Vijay Kumar : Robert, I had a two forward question. A lot of questions on pipeline, but I'm curious when people ask us on sustainability of growth, if you could elaborate on pipeline, what else is there? When you look at the future, that gives us the confidence of sustaining its premium growth within the med tech industry. My second part was on the financial modeling side, looks like FX headwinds came in a little bit higher. Prior guidance that is $0.20 headwind to EPS from FX. Did that increase? I'm just curious on because some questions on why the high end of the guidance was not raised. I suspect the FX headwind increase.
Robert Ford : As I said, there are certain challenges that still remain with us from January and FX is one of them. I'll let Phil answer that one. On your question on pipeline, listen, I could spend a whole hour on this just going through the pipeline, but I guess I would bucket them into like three categories, Vijay. I would say you got your current contributors and Libre and Alinity, they still operate like pipeline projects and products. We still got multiple innovations going through them. MitraClip, great familiarity, AVEIR, Navitor, TriClip, Amulet, PROTALITY or our concussion tests, I think got great opportunity and CardioMEMS, I mean, these are all products that I would still characterize them as early innings. Yes, they're established, but they're still early innings and they got a lot of growth rate there. The second group of products I would call, probably near-term future contributors, so think about it in the next 12 to 18 months, these products coming to market and starting to kind of generate revenue there. Our lingo product, I'm very excited about that and bringing that to the U.S. and expanding that globally. Our dual analyte sensor, our Volt system Esprit, which is our drug eluding bioabsorbable stent for below the knee. It will be the first of its kind. We are developing a whole new Alinity system that will target a segment of the market that we currently don't participate in. And there'll be more to come on that. And then just the great opportunity we have with biosimilars into the emerging markets and doing it in a very capital efficient way. And bringing that and leveraging our position there. That's our next 12 to 18 month kind of catalyst there. Then thinking about beyond 2026, I mean, we are working on a PFA, RF catheter. You got leadless, another kind of leadless pacing system that would be launching. We have a second generation Amulet, excited about entry into the IVL market sometime in 2027, coronary DCB, we're working on kind of new TAVR systems also that allow us to branch out into other segments. We've got a whole plethora of new analytes in our bio wearables market that will start to come out and have different applications in 2026. And then on top of that, all the clinical work that we're doing to expand indications, expand market, whether it's in TAVR, whether it's in LAA, whether it's in mitral. So we've got, I'd say a real nice cadence here of products and pipeline beyond, I'd say, the next 12, 18 months. We're looking at this '26, '27, '28 and I feel really excited about that. There's obviously more that we need to do and add, but I think the base here looks really good in terms of the pipeline. And then I think your question on FX, Phil, you want to take that?
Phil Boudreau: Yes. I mentioned at the onset here, Vijay, in Q1, we saw about a 2.9% headwind on sales growth and we kind of the current rates anticipate something similar here in Q2. From a full year perspective at the current rates, it's about a 2.5% headwind on the top-line. That said, kind of the earnings guide that we have here is in line with the organic sales performance and drop through to earnings on the increased midpoint on EPS guidance.
Operator: Our next question will come from Joanne Wuensch from Citi.
Joanne Wuensch: Good morning. May I add my compliments and congratulations to the quarter? I have two questions put them right up front. The first one is on concussion testing. I'd love to understand the go-to-market strategy for that, how you think about the financial benefit impact and all that kind of good stuff? But I think my second question is a little bit more big picture. As you step back in a post-pandemic environment a couple of years into the CEO seat, how do you think about taking Abbott sort of to the next level? I mean, we all sit here and take a look at an incredibly strong balance sheet. How do you put that cash to work? Are these segments, divisions, ones you want to keep? Or how do you think about adding to it?
Robert Ford: Sure. On the point of care concussion test, I guess I'd summarize the opportunity here in twofold. I think there's a market conversion component to this, Joanne. I mentioned there are 5 million ER visits to diagnose a concussion. The number one method there to use that is on a CT scan. I think there's an opportunity here to transform that and allow one to get a faster response in that emergency kind of emergency room visit, which is where the -- and the point of care team already have a good position with some of our other blood gas and other assays that we provide to that segment. I think this will slide right into that team. The value proposition here is going to be, okay, what's the cost of the system and can we bend that cost curve. I think we've shown a little bit how we think about things Joanne, if you look at Libre, if you look at Binax, if you look at how we think about pricing our products, when it comes to market conversion and the opportunities that we have there? We'll be able to do it at a nice return for our shareholders. I think that's an important part. The market expansion opportunity that we have, I think is going to still require some work on the product. Right now the product is approved whole blood, but it's a venous draw. We're going to be working on a capillary draw and if you can then run this assay, taking a sample from a finger prick, then you can look at bringing that technology even closer to where the need for a rapid concussion test would be. You could just look at how many universities exist in this country, how many high schools exist in this country? You can do some multiplications there and say, this is a great market creation, market expansion opportunity. I think that that's how we're thinking about it commercially, conversion and creation slash expansion. There's some more work to be done in terms of the product and the claims and the trials there. This will be a multi-year kind of program over here where we'll start to see kind of nice growth in that segment. And then your other question was about the portfolio and balance sheet. And do we like the four segments? The answer to that is yes, we like all the four segments. We feel that it gives us a real unique view into the healthcare system as a whole starting with nutrition that's obviously the bedrock of good health. But then, things happen and you need to get a diagnosis. And we've got a great diagnostic portfolio that we've been expanding on and building on to make sure that we can capitalize on all the different types of modalities and locations where people can get tested. And then, once a physician knows what the problem is, then they got to run through treatment, right? And we do that either through a medicines business or through a medical device business. I think all four segments are super well aligned to the global demographics and trends in healthcare. And so we like that there's always opportunities to add, and we've shown that if there are areas that we feel that we can bring value in a combination then as you mentioned we've got a strong balance sheet and strategic flexibility to do that. As long as we feel that we can add value to that asset. We felt like that about CSI, we felt like that about St. Jude. We felt like that about Alere. And those deals, they obviously help kind of reshape the company and accelerate our growth rates. But I think that's predicated on us really believing that we can kind of bring value and we're not trying to fill some top line gap or some issues. ROIC for us matters, profitability matters. We've got opportunities and we could be a little bit more selective to be able to add, but I like the four segments that we're in. And they've been well to shareholders, especially the long-term shareholders.
Operator: Our next question will come from Matt Miksic from Barclays.
Matt Miksic : Congrats on the really strong quarter, particularly med devices. I had one follow-up on the -- sorry, here, background. One question on structural heart. Robert, you talked a little bit about the portfolio and the combination of the leading peer device and MitraClip of being a little bit more mature in the category of structural heart, but being kind of augmented by some of these new products like most recently, obviously TriClip. And if you could talk a little bit about sort of the momentum in the portfolio as well as how much of the build out of this portfolio is still coming organically or under review kind of strategically, I appreciate it.
Robert Ford : Sure. I mean I didn't want my comments on mitral to be construed like that 1 there is slowing down, and we're relying on others to drive the growth. I mean, that wasn't the intent. If you look at MitraClip this quarter, it's high single digits. And if you look at the last 5 quarters, that's what it's been doing between high single-digits, low double-digits. And that's good. But we always had a view here that this is an attractive area of growth, an attractive area of medical need. And we wanted to be a leader here. So yes, MitraClip, I guess we can call MitraClip, the founding father of our structural heart portfolio. But I think the team here has done an incredible job at bringing organic innovation into the portfolio. So if you look at our structural heart, I mean, we grew 13% today. MitraClip grew high single digits. But it accounted for 3% of that growth. The rest -- the other 10% came from all the rest of the portfolio that's being built. So I think that you'll continue to see that. We'll continue to make investments in this business, continue to make investments in the pipeline. I'd say right now, most of it is organic, whether it's innovating on LAA, innovating on our TAVR side and all the clinical trial that we're doing there. If there's an opportunity inorganically, I just put that in the same bucket that I think I answered kind of Joanne's question here if it makes sense. And we can add it. We've got the flexibility to do it. But the whole strategy here was to say, listen, we're going to build a multibillion-dollar structural heart business that can sustainably grow double digits. And the way to do that is you can't be a division of only 1 product. And I think the teams over the last 4 or 5 years, have done a really good job at building that and there's more opportunity. I'd say probably the one that we're looking at and is very exciting for us is mitral replacement. We've launched our Pendine product, which was more a transapical system. Our Cephea system is the transfemoral transseptal and feedback that we've seen from early implanters, early first in man is that this is a great, great valve. So there's an opportunity there also. So I'd say most organic, but we got the capacity for inorganic if it makes sense.
Mike Comilla: Operator, we'll take one more question, please.
Operator: And our final question will come from Danielle Antalffy from UBS.
Danielle Joy Antalffy : And yes, congrats on a strong start to the year. Robert, we spent a lot of time talking about the durability of growth in the med tech business. So I don't want to get too greedy, but just following up on Joanne's question regarding you guys do have a strong balance sheet. Are there any areas -- I guess sort of how do you feel about the state of the med tech business today? And do you feel there are growth areas within med tech that maybe Abbott isn't participating in today that Abbott could or should participate in today? And where are you looking beyond your current markets, if at all? I'll just leave it to one.
Robert Ford : Sure. I get the attempt for triangulation here in the multiple different ways, and I guess I'll sign a little bit boring here in terms of how I talk about this. I've been public that, yes, we are interested. We look at areas that we can add value to. I'd say, probably the ones that have jumped out more at us in terms of a study and looking at are probably more in the medical device side and on the diagnostic side. We did look at a strategy for biosimilars for our medicines business and that was a pretty capital efficient way to do it. Yes, we're looking. We continue to study, but I'm not going to sit here and telegraph exactly it's this, it's that. I think the key thing here is just, I mean, look at our medtech business did this quarter, look what it did previous four quarters and that allows me to be a little bit more selective. Over the last couple of months we've seen some fairly large transactions in the medtech space. Those seem to be attractive growth areas. I talked about us getting access to some early IVL technology with the CSI acquisition. That's an important area for us to focus on. But I don't feel that, with our strong organic growth that we need to go out and not pay attention to like other key financial metrics that for us are important in terms of ROICs and those, because we've got that strong growth rate in medtech. You won't get me telegraphing here exactly, Danielle, what specific segments we are looking at. What I can tell you is, we have an active team. They study a lot. We look a lot. We follow a lot. If there's a moment that makes sense for us and those segments continue to be interesting, we've got the balance sheet and the track record to show that, we can drive value out of these acquisitions. I'll just leave it like that. Yes, we've got flexibility, that doesn't mean that we don't pay attention to other key financial returns as we're looking at it. I feel that I can do that because we've got such a strong top-line growth and great pipeline and prospects. With that, I'll leave it like that. I'll just close by saying that, we're very pleased with a very strong start to the year. We delivered another quarter of double-digits organic sales growth on the base business. The investments that we've made during all those years of COVID are generating real strong returns. The pipeline continues to be highly productive, as I've outlined. We've got clear visibility to a pipeline all the way out to '27, '28. Obtained several new product approvals that are going to help us accelerate our growth in certain areas. Typically don't raise guidance in the first quarter, but given the strong performance and the outlook and the remainder of the year, we felt comfortable doing that and we're very well positioned to continue to sustainably deliver top tier results. With that, I'll wrap up and thank all of you for joining us today.
Mike Comilla: Thank you, operator, and thank you all for your questions. This now concludes Abbott's conference call. A webcast replay of this call will be available after 11:00 am Central Time today on Abbott's Investor Relations website at abbotinvestor.com. Thank you for joining us today.
Operator: Thank you. This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day. | [
{
"speaker": "Robert Ford - Chairman and Chief Executive Officer",
"text": ""
},
{
"speaker": "Phil Boudreau - Senior Vice President, Finance and Chief Financial Officer",
"text": ""
},
{
"speaker": "Bob Funck - Executive Vice President, Finance",
"text": ""
},
{
"speaker": "Operator",
"text": "Good morning, and thank you for standing by. Welcome to Abbott's First Quarter 2024 Earnings Conference Call. All participants will be able to listen-only until the question-and-answer portion of this call. [Operator Instructions] This call is being recorded by Abbott. With the exception of any participants’ questions asked during the question-and-answer session, the entire call, including the question-and-answer session is material copyrighted by Abbott. It cannot be recorded or rebroadcast without Abbott's expressed written permission. I would now like to introduce Mr. Mike Comilla, Vice President, Investor Relations."
},
{
"speaker": "Mike Comilla",
"text": "Good morning, and thank you for joining us. With me today are Robert Ford, Chairman and Chief Executive Officer; Bob Funck, Executive Vice President, Finance; and Phil Boudreau, Senior Vice President, Finance and Chief Financial Officer. Robert and Phil will provide opening remarks. Following their comments, we'll take your questions. Before we get started, some statements made today may be forward-looking for purposes of the Private Securities Litigation Reform Act of 1995, including the expected financial results for 2024. Abbott cautions that these forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those indicated in the forward-looking statements. Economic, competitive, governmental, technological, and other factors that may affect Abbott's operations are discussed in Item 1A, Risk Factors, to our annual report on Form 10-K for the year ended December 31, 2023. Abbott undertakes no obligation to release publicly any revisions to forward-looking statements as a result of subsequent events or developments, except as required by law. On today's conference call, as in the past, non-GAAP financial measures will be used to help investors understand Abbott's ongoing business performance. These non-GAAP financial measures are reconciled with the comparable GAAP financial measures in our earnings news release and regulatory filings from today, which are available on our website at abbott.com. Note, that Abbott has not provided the GAAP financial measure for organic sales growth on a forward-looking basis because the Company is unable to predict future changes in foreign exchange rates, which could impact reported sales growth. Unless otherwise noted, our commentary on sales growth refers to organic sales growth, which is defined in the press release issued earlier today. With that, I will now turn the call over to Robert."
},
{
"speaker": "Robert Ford",
"text": "Thanks, Mike. Good morning everyone, and thank you for joining us. Today, we reported first quarter adjusted earnings per share of $0.98, which was above analyst consensus estimates. We also raised the midpoint of our guidance ranges for both earnings per share and sales growth. We now forecast full year adjusted earnings per share of $4.55 to $4.70 and organic sales growth, excluded COVID testing related sales of 8.5% to 10%. Organic sales growth, excluding COVID testing related sales was 10.8% in the quarter, which represents the fifth consecutive quarter of double-digit growth. The strong start to the year was driven by broad base growth across a portfolio, including growth of 14% in medical devices and established pharmaceuticals. In addition to exceeding expectations of both top and bottom lines this quarter, we accomplished a number of objectives across the pipeline, including obtaining several new product approvals and achieving important clinical trial related milestones. I'll now summarize our first quarter results in more detail before turning the coal over to Phil, and I'll start with nutrition, where sales increased 8% in the quarter. Strong growth in the quarter was led by double-digit growth in pediatric nutrition, driven by continued market share gains in the U.S. infant formula business and growth across our international portfolio of infant formula, toddler and adult nutrition brands. In January, we launched a new nutrition shake called PROTALITY, which provides nutritional support for adults pursuing weight loss. As people eat less and lose weight from taking GLP-1 medications, undergoing a weight loss surgery, or following a calorie restricted diet. A portion of what is lost is lean muscle mass, which plays an important role in overall health. Combination of high protein and essential vitamins and minerals that totality offers can help people preserve muscle while pursuing their personal weight loss goals. Turning to EPD or sales increased 14% in the quarter. This quarter was a continuation of EPDs impressive trend of strong performance, including double-digit growth in four of the last five quarters. In addition to a strong track record of top line growth, this business has delivered equally impressive gains on the bottom line with an operating margin profile last year that reflected more than 350 basis points of improvement compared to 2019. Moving to diagnostics, where sales increased more than 5%, excluding COVID testing sales. Growth in diagnostics continues to be led by the adoption of our market leading systems and demand for testing that takes place in a variety of settings, including hospitals, laboratories, urgent care centers, physician offices, retail pharmacies, and blood screening facilities. Our development efforts and diagnostics focus on developing new systems and creating new tests that play an important role in making healthcare decisions, expand the accessibility of testing and deliver a result as fast as possible. In April, we received FDA approval for a point of care diagnostic test that could help determine if someone suffered a mild traumatic brain injury or concussion in just 15 minutes. The test is run on our portable i-STAT Alinity instrument, which allows concussion testing to move beyond the traditional hospital setting and into urgent care centers, physician offices, and other locations that are closer to the patient, with nearly 5 million people in the U.S. going to the emergency room to be checked for suspected concussion each year. We believe this test has the potential to transform the standard of care for concussion testing, and I will wrap up with medical devices, where sales grew 14% in diabetes care. FreeStyle Libre sales were $1.5 billion in the quarter and grew 23%. As I previously mentioned, that Libre has several new growth opportunities that will help continue to fuel the strong sales trajectory we have forecasted. One of those growth opportunities relates to the continued expansion of reimbursement coverage for Libre, for individuals who use basal insulin therapy to manage their diabetes. Last year, we announced that Libre became the first and only continuous glucose monitoring system to be nationally reimbursed in France to include all people, who use basal insulin as part of their diabetes management. During this first quarter, Libre obtained reimbursement from a select number of institutional payers in Germany for basal insulin users who also use oral diabetes medication to manage their condition. These select public and private payers cover a limited number of the approximately 1 million basal insulin users in Germany, but this is an encouraging sign of the potential for further coverage expansion not only in Germany but across other European markets. In cardiovascular devices, sales grew 10.5% overall in the quarter, led by double-digits growth in electrophysiology, structural heart and continued acceleration in our cardiac Rhythm Management and Vascular portfolios. In electrophysiology, sales grew 18%, driven by double-digits growth in all major geographic regions and across all major product categories, including double-digits growth in ablation catheters and cardiac mapping related products. We continue to make great progress toward bringing our innovative PFA catheter, Volt to market. In March, we completed enrollment in our CE Mark clinical study, putting us on-track to file for international approval before the end of the year. We also recently began enrolling patients in our U.S. clinical trial called VOLT-AF, which will generate the data needed to support an FDA approval filing. In structural heart, growth of 13% was led by strong performance in several high-growth areas, including TAVR, LAA, mitral and tricuspid repair. Structural heart is an area that we have invested in over the past years in order to create a diversified portfolio that can sustainably deliver double-digits growth. In the past, we relied almost exclusively on MitraClip to drive the growth, but today the portfolio and growth are more balanced and reflect increasing contributions from newer products like Navitor, Amulet and TriClip. In April, we received FDA approval for TriClip, a first of its kind heart valve repair device designed for the treatment of tricuspid regurgitation or a leaky tricuspid valve. Data from the clinical trial supporting this approval demonstrated that, patients who receive TriClip experienced a significant improvement in the severity of their symptoms and quality of life. We are excited to now offer this life-changing treatment option to people in the United States that suffer from this condition. In Rhythm Management, growth of 7.5% was led by AVEIR, our recently launched leadless pacemaker. AVEIR has rapidly captured market share in the single chamber pacing segment of the market and is now being used for dual chamber pacing, which is the largest segment of the pacing market. This revolutionary technology is helping to deliver growth rates in our Rhythm Management business that significantly exceed the overall growth in this market. And lastly, in neuromodulation, sales grew 17%, driven by Eterna, a rechargeable neurostimulation device for pain management. In January, we announced the launch of Liberta, the world's smallest rechargeable deep brain stimulation device, which is used to treat movement disorders such as Parkinson's disease. In summary, we're off to a very good start to the year, exceeding expectations on both top and bottom lines. And as a result, we have raised the midpoint of our sales and EPS guidance ranges. We continue to make good progress on our gross margin expansion initiatives and we're seeing strong returns from the investments we are making across our growth platforms. Our pipeline has continued to be highly productive, delivering several recently new product approvals and we're very well-positioned to continue to deliver strong results for the remainder of the year, and I'll turn over the call to Phil."
},
{
"speaker": "Phil Boudreau",
"text": "Thanks, Robert. As Mike mentioned earlier, please note that all references to sales growth rates unless otherwise noted, are on an organic basis. Turning to our first quarter results, sales increased 4.7% on an organic basis, which as expected includes the impact of year-over-year decline in COVID testing related sales. Excluding COVID testing sales underlying base business, organic sales growth was 10.8% in the quarter. Foreign exchange had an unfavorable year-over-year impact of 2.9% on first quarter sales. During the quarter, we saw the U.S. dollar strengthen versus several currencies, which resulted in exchange having a more unfavorable impact on sales compared to exchange rates at the time of our earnings call in January. Regarding other aspects of the P&L, the adjusted gross margin ratio was 55.7% of sales, adjusted R&D was 6.7% of sales and adjusted SG&A was 29.4% of sales in the first quarter. Lastly, our first quarter adjusted tax rate was 15%. Turning to our outlook for the full year, we now forecast full year adjusted earnings per share of $4.55 to $4.70, which represents an increase at the midpoint of the range compared to the guidance range we provided in January. We also raised the midpoint of our guidance for organic sales growth. We now forecast organic sales growth, excluding COVID testing to be in the range of 8.5% to 10%. Based on current rates, we expect exchange to have an unfavorable impact of approximately 2.5% on full year reported sales, which includes an expected unfavorable impact of approximately 3% on second quarter reported sales. Lastly, for the second quarter, we forecast adjusted earnings per share of $1.08 to $1.12. With that, we'll now open the call for questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question will come from Robbie Marcus from JPMorgan."
},
{
"speaker": "Robbie Marcus",
"text": "Two for me. I'll just ask them both up front. First, Robert, we almost never see Abbott raise guidance particularly on the top line in the first quarter. Looking back over the past, I don't know, 5, 10 years, it's very rare. First part is what gave you the confidence to raise the midpoint of the guidance this early on in the year? And then second, obviously, there's been a lot of concern during the quarter with competitor’s loss in a case for NEC as it relates to infant nutrition. I was hoping you could address that what's your stance on the ongoing litigation? I think there's about a thousand cases that have been filed and any upcoming data points or timelines we should be looking for."
},
{
"speaker": "Robert Ford",
"text": "Let's go first to your question on the guidance, yeah, you're right. I guess I had to go back and take a look at that. I think the last time we did raise in Q1 was in 2016. I would say the framework here, Rob, is we've always done is, we set a guidance at the beginning of the year, which we believe is top tier, and then throughout the year, we want to beat that guidance, and we consider top tier to be high single-digit double-digit EPS growth. And that's obviously excluding the COVID testing portion, which is what investors are really more focused on. So that was the guidance that we set a couple months ago, back in January. We will target always have that top tier guidance and find the appropriate balance between, the opportunities. And obviously the challenge is that bracket that range. If you remember in January, I said I thought that there was more opportunities than risks. I think that some of the risks that we saw in January, I still think they haven't gone away. They are still there, whether it's geopolitics or whether it's FX, those are still there. But clearly the performance of the business continues to be very, very strong. And some of our businesses, a lot of our businesses actually accelerating our in performance. As I said in my comments, five consecutive quarters of double-digit growth here. You look at each of the businesses, EPD consecutive, three consecutive of double-digit growth, great margin expansion, and the teams are now working to be able to introduce biosimilars in all the markets that we are participating in. Nutrition has done an incredible job at recovering share and growing our adult business. We have grown adult over $1 billion versus 2019. Diagnostics continues to have a great track record here, outperforming the market. We have got some great large account wins both in the U.S. and internationally that we're rolling out into this year. And medical devices, I mean, what can I tell you? It is just been a real strong performer. The team's done an incredible job there. Last year, we were the fastest growing MedTech Company, at least from what I have seen from our guidance and from the other guidance’s in the market. That's what it seems to be again this year. So you put all that together, plus the pipeline that's been contributing to an accelerated level, great new product approvals. I put all that together and I just feel that this type of performance that we deliver just gives us the confidence for the remainder of the outlook of the year. We felt comfortable raising the guidance again, in the first quarter, which is as you pointed out something that we don't usually do. I continue to believe going into the second quarter, as we move through that there's probably more opportunities than risks here, as we move forward. I guess that's the framework of raising our guidance in the first quarter, which is something that we usually don't do. Just great performance and great momentum. And then your other question was regarding the net cases. I would say from a date, we have some court cases that will happen in July. So that's maybe a milestone that we want to look at. But if you are asking me about kind of our framework of how we look at this. I'd say, for decades, we've provided specialized nutrition products that help doctors. And I think that's a key thing here. It helps doctors to provide the lifesaving nutrition to the premature infants. How you feed a premature infant, it's a medical decision, Robbie. Health care providers, they're going to use a range of options to meet the unique needs of each baby. That includes mother's milk, that includes pasteurized donor's milk, but that also includes preterm infant formula, because where mother's milk is not available, there is not a sufficient supply of donor milk to satisfy the nutritional needs of all of these premature infants that are born in the U.S. And quite frankly, even when they're available for some premature infants, human milk may lack some of the calories, the proteins, the vitamins et cetera that are necessary to support the nutritional needs of the premature infants. That mother's milk needs to be fortified in order to boost the nutritional output. The medical community, they consider these products to be critical part of the standard-of-care for feeding premature infants. Most of the societies when you read their positions, it is a standard-of-care to use these products. The doctors who work in the NICUs, they've used our products for decades and they continue to do so today. Countless babies, Robbie, have benefited from these products, lifesaving experiences over many, many years and there are clinical studies that have repeatedly established that, these products are safe. These litigation cases, they're really seeking to advance a theory promoted by plenty of lawyers that distorts the science and it distorts everything that we know and it's not supported by the medical community. We are preparing for our cases to be able to kind of lay out the facts, the science and the data and we stand behind our products."
},
{
"speaker": "Robbie Marcus",
"text": "Appreciate it, Robert. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Our next question will come from Larry Biegelsen from Wells Fargo."
},
{
"speaker": "Larry Biegelsen",
"text": "Good morning. I'll echo, Robbie's, congratulations on the strong start to the year here. Robert, I just wanted to focus on EP. A multipart question here, but just one. The EP business grew nicely in the first quarter in the U.S. and outside the U.S. Can you talk about what drove that? What you're seeing with PFA in the different geographies? Your expectations for your EP business going forward before the Volt launch? Just lastly, it sounds like we should expect the Volt approval in Europe sometime next year based on the filing date. Just want to confirm that."
},
{
"speaker": "Robert Ford",
"text": "Sure. Like I said in my opening comments, we completed the trial. There's a six month follow-up, Larry. That means that, we will be on target here to file for CE mark by the end of this year. Then, it's just going to depend on that process. I think that's probably our anchor point here is getting the filing in before the end of the year. Yes, I mean, I'm not surprised by our EP growth. I know many on the call might be, but I'm not surprised. First of all, it's an important therapy. It's an underpenetrated disease. We know there's plenty of growth in this segment, and as a result of that, it's highly competitive. But we haven't been surprised by the growth. If you look at PFA, it's been in Europe for three years. If you average our growth rate over those last three years in Europe, we've been growing mid-teens, and the growth, it remains broad base. It was broad based in Europe, again, this quarter where we saw double-digit growth in ablation catheters. Not just on the mapping side, on the ablation catheter side also but then also great growth on the mapping side, and this technology has now come to the U.S. I think we probably had maybe two months of seeing the technology be rolled out here in the U.S. I think the competitors have been very aggressive here in terms of bringing the technology to the accounts in the U.S., and I can say, we've mapped a lot of those cases, Larry. I'm not going to say we've been in every single case, but I'd say, a vast majority of the cases we've been in there. And there are some similarities to Europe, but there are some differences to Europe. I think one of the things that we saw in Europe was that there was this inclination to use the technology starting off as kind of a one shot. So that had an impact more on the CRYO business than I would say on the RF side. And that's what we saw in our mapping cases. We saw here, at least in the first couple of months, that's where a large portion of those cases occurred, at least the ones that we mapped were in places where they were traditionally used in CRYO. I think the difference that we saw a little bit in Europe is that at least 90% of the cases that we were part of direct or indirectly were using mapping that that number was lower in Europe. So that's probably a little bit of the difference I saw here in the U.S., and that bodes well for us. Our end site system, our mapping system, our mapping catheters are widely viewed as an excellent option here for mapping these PFA cases. We have a large install base. Customers are familiar with it. Don't need a make room, don't need a fight for capital. We've got best in class clinical support. And the architecture here is open, as I've said in previous calls. So it integrates well with these PFA catheters. We actually recently released a software upgrade last month that provides even better visualization to these catheters and potential for faster procedures and less floor time. I think this is a perfect combination, quite frankly, in a time where there's going to be market transition, There's a lot of new products, there's a lot of choices. And when you have a situation like that, I think flexibility is key, and that's what we heard from our customers. One data point that I thought was also interesting to your question of what helped drive that in the cases that we were part of, and we saw, we also observed that an RF catheter was pulled in about a quarter of the cases that we saw. So on top of the PFA catheter, an RF catheter was pulled to do touchups, et cetera. I'd say right now, everything that we've seen in Europe on the positive side is happening. And then I think there's some interesting dynamics here in the U.S. that could be favorable for us also, but it's still very early. If I look at March, we had probably one of our most, we look at cases per day. That was probably one of our highest months. So far so good. And we're excited about the technology, we're excited about our program. We released data on our program and some recent medical meetings that occurred. And the feedback, from those that have been used in our product are very positive. And the integration with EnSite in including like the tissue contact force algorithm and the visualization, all of that is seen as a real promise and a differentiator versus what's being used today."
},
{
"speaker": "Operator",
"text": "Our next question will come from Josh Jennings from Cowen."
},
{
"speaker": "Josh Jennings",
"text": "Great to see the strong start here, the Q1 results. Robert, I was hoping to just ask first on Libre and just internationally, any other payment or coverage decisions that we should have on our radar in various countries. Sounds like you have made sense, some nice progress already in Germany, and then in the U.S. I was hoping you could just help or share your thoughts on the share gain opportunity in integrated pump segment of CGM market versus the share loss risk in the Type 2 non-insulin cash pace segment with a competitive launch share early in 2024. I just have one follow up."
},
{
"speaker": "Robert Ford",
"text": "On your international question, I mean, it's always difficult to forecast exactly by month a quarter coverage kind of payment decisions. I can tell you though that the team has a full global map of all the work that's being done regarding clinical information and negotiations, et cetera. It's difficult to kind of forecast it, but what I have said is on previous calls and on some of my prepared remarks that I think you're going to see this just this build that will be occurring globally in the market as the data proves and shows the clinical medical and health economic benefit by reimbursing for this patient population. And I think we're well positioned there. Internationally, I think we got some pretty large markets already. Canada, Japan, France, Italy, Germany, those are markets that are either fully reimbursed or starting their process. And like I said, I think you will see as the year progresses, whether it's in medical events or just as the year progresses, I think you'll see more coverage decisions. Maybe they don't get splashy, big PR news, but we are seeing continuous increasing there on that. On the U.S. side, I guess I disagree with your premise that I'm going to be trading share gains on the pump side for share losses on the non-insulin side. I mean, I'm just, right now I'm looking at the data, third party audited data, 7 out of every 10 new prescriptions for this basal population, which is primarily served by the primary care channel, 7 out of 10 are going to Libre. I think our product's going to get even more competitive and compelling, I think this is a great opportunity and our objective here is to maintain kind of our shared dominance and our share leadership as it results in this patient segment. But we do have an opportunity here to participate a little bit more actively in what is a little bit more of a smaller segment of the population, but nonetheless a very important one, which is the AID and the market system. There's 150,000 to 200,000 new starts a year. There's an opportunity for share gain also of existing users. I think that, the opportunity to bring a dual analyte sensor with ketones. We showed some data at ATTD this year, that showed the safety benefit or the value proposition of a dual analyte sensor for AID system. I think that's going to be a compelling value proposition. We are working with all the pump companies here and I think as the year progresses, we'll see connectivity occur whether it's with Libre 2 Plus our streaming product or whether it's with Libre 3. This is an area that we are focusing on and it's a new segment for us to compete in. But I don't think that, we are going to be taking our eye off the ball as it relates to the basal opportunity that exists."
},
{
"speaker": "Josh Jennings",
"text": "Understood. Thanks. And then just wanted to ask on the transcatheter tricuspid market, congratulations on the TriClip approval, but there's been some questions around the patient opportunity breakdown between TIER, TriClip and replacement with EVOQUE. Maybe just any internal team thoughts on that patient opportunity breakdown and then maybe you could share on the pricing strategy for TriClip in the setting of competitor pricing its replacement device at a significant premium? Thanks for taking the questions."
},
{
"speaker": "Robert Ford",
"text": "I'm not going to comment on our pricing strategy for competitive reasons. It is a differentiated and novel technology. There is an opportunity, but we'll have to see how this all plays out. You got NTAP submissions and all this stuff going on right now. What we are focused on here is, launching the product and getting cases ramped up and that's what's happening. I got some feedback yesterday from the team after a couple of weeks, real nice cadence of growth. We are obviously focusing on our initial cases on most of the account that were part of our pivotal trial, but just but just real nice cadence growth there and great feedback from physicians and patients post-surgery. I mean, if you're trying to poke at, what's the breakdown going to be about replace and repair, listen, I think it's good to have options. I guess my view here is that, I believe that, probably safety is a key driver here, just to start off with. I think TriClip has shown a very strong excellent safety record, both in clinical trials and real world use. I think that's going to play a key role here in determining repair versus replace. I expect repair or TriClip at least to be the preferred option unless the valves are too damaged and then obviously replacement is the only option. But there is a large pool of patients here. You got 5 million people globally, 2 million people here in the U.S. and it's going to be an opportunity here that we will be generating more data, expand the indication of the product. I think this is easily a $1 billion opportunity for us here as we build the capabilities and as we build more clinical data."
},
{
"speaker": "Operator",
"text": "Our next question will come from Travis Steed from BofA Securities."
},
{
"speaker": "Travis Steed",
"text": "Maybe just while we're on the pipeline, talk a little bit about AVEIR it sounds like that that product's going really well. And then I had a question on gross margins as well. Trying to think about is this the right pace to kind of get back to pre-COVID levels and still the opportunity kind of longer term for gross margins?"
},
{
"speaker": "Robert Ford",
"text": "I think if AVEIR's done very well, I mean, we all know the advantages it has over the competitive system, whether it's single and dual chamber, the longer lasting battery, the ability for replacement, retrievability, upgradeability. It's done very well. From a single chamber perspective, I think we are now at about 50 share of the US market. So that's been doing very well. It's performed, we started doing our dual chamber procedures towards the end of last year. Seeing a nice kind of ramp up over this first quarter here. Focus here really is a really about, it's a completely different procedure, right? If you think about how these devices have been implanted, this is probably the first time in like 30 years that you have like a real meaningful change on how this is done. Our focus here is really getting great clinical results real thoughtful approach here about opening new sensors and training. And that's been working very well for us. And you could see the impact on our growth rate. I mean, historically our CRM business has been relatively flat with some platforms going up, some platforms going down. Our goal here with this program was to get our CRM portfolio to at least be contributor to growth mid-single digits, 6%, 7%. These last couple of quarters we've done seven and a half percent, and so AVEIR's been doing well, and it's going to continue to get better as more and more physicians get trained and we increase the amount of accounts. So I really like the cadence of how we're forecasting this business and the impact that it's going to have on our CRM portfolio. What was your other question?"
},
{
"speaker": "Travis Steed",
"text": "Just on gross margins, kind of thinking about the path back to pre COVID levels over the long term and is this the right kind of cadence that you're -- this year's cadence, the right way to think about that?"
},
{
"speaker": "Robert Ford",
"text": "I think that's a good cadence. I think we're forecasting here about 70 basis points of improvement this year. Feel good about that. I've talked about this not being a question of if, just a question of when, so I think that's not a bad cadence. And we're going to focus on the things that we can control and the things that we can control are obviously our cost and our cost teams and the teams that are working on improving gross margin, they're delivering great results here, while at the same time maintaining high service levels not running to back orders, et cetera. But probably the biggest the biggest opportunity we have here Travis, is just to expand the gross margin through portfolio mix. When you have our medical device businesses growing at mid-teens consistently over the last, whatever, four or five quarters, that has a real strong impact on our gross margin. So a lot of focus on what we control our gross margin, the cadence. That's what we are targeting. It's not really a question of if it's just a question of when."
},
{
"speaker": "Operator",
"text": "Our next question will come from Vijay Kumar from Evercore, ISI."
},
{
"speaker": "Vijay Kumar",
"text": "Robert, I had a two forward question. A lot of questions on pipeline, but I'm curious when people ask us on sustainability of growth, if you could elaborate on pipeline, what else is there? When you look at the future, that gives us the confidence of sustaining its premium growth within the med tech industry. My second part was on the financial modeling side, looks like FX headwinds came in a little bit higher. Prior guidance that is $0.20 headwind to EPS from FX. Did that increase? I'm just curious on because some questions on why the high end of the guidance was not raised. I suspect the FX headwind increase."
},
{
"speaker": "Robert Ford",
"text": "As I said, there are certain challenges that still remain with us from January and FX is one of them. I'll let Phil answer that one. On your question on pipeline, listen, I could spend a whole hour on this just going through the pipeline, but I guess I would bucket them into like three categories, Vijay. I would say you got your current contributors and Libre and Alinity, they still operate like pipeline projects and products. We still got multiple innovations going through them. MitraClip, great familiarity, AVEIR, Navitor, TriClip, Amulet, PROTALITY or our concussion tests, I think got great opportunity and CardioMEMS, I mean, these are all products that I would still characterize them as early innings. Yes, they're established, but they're still early innings and they got a lot of growth rate there. The second group of products I would call, probably near-term future contributors, so think about it in the next 12 to 18 months, these products coming to market and starting to kind of generate revenue there. Our lingo product, I'm very excited about that and bringing that to the U.S. and expanding that globally. Our dual analyte sensor, our Volt system Esprit, which is our drug eluding bioabsorbable stent for below the knee. It will be the first of its kind. We are developing a whole new Alinity system that will target a segment of the market that we currently don't participate in. And there'll be more to come on that. And then just the great opportunity we have with biosimilars into the emerging markets and doing it in a very capital efficient way. And bringing that and leveraging our position there. That's our next 12 to 18 month kind of catalyst there. Then thinking about beyond 2026, I mean, we are working on a PFA, RF catheter. You got leadless, another kind of leadless pacing system that would be launching. We have a second generation Amulet, excited about entry into the IVL market sometime in 2027, coronary DCB, we're working on kind of new TAVR systems also that allow us to branch out into other segments. We've got a whole plethora of new analytes in our bio wearables market that will start to come out and have different applications in 2026. And then on top of that, all the clinical work that we're doing to expand indications, expand market, whether it's in TAVR, whether it's in LAA, whether it's in mitral. So we've got, I'd say a real nice cadence here of products and pipeline beyond, I'd say, the next 12, 18 months. We're looking at this '26, '27, '28 and I feel really excited about that. There's obviously more that we need to do and add, but I think the base here looks really good in terms of the pipeline. And then I think your question on FX, Phil, you want to take that?"
},
{
"speaker": "Phil Boudreau",
"text": "Yes. I mentioned at the onset here, Vijay, in Q1, we saw about a 2.9% headwind on sales growth and we kind of the current rates anticipate something similar here in Q2. From a full year perspective at the current rates, it's about a 2.5% headwind on the top-line. That said, kind of the earnings guide that we have here is in line with the organic sales performance and drop through to earnings on the increased midpoint on EPS guidance."
},
{
"speaker": "Operator",
"text": "Our next question will come from Joanne Wuensch from Citi."
},
{
"speaker": "Joanne Wuensch",
"text": "Good morning. May I add my compliments and congratulations to the quarter? I have two questions put them right up front. The first one is on concussion testing. I'd love to understand the go-to-market strategy for that, how you think about the financial benefit impact and all that kind of good stuff? But I think my second question is a little bit more big picture. As you step back in a post-pandemic environment a couple of years into the CEO seat, how do you think about taking Abbott sort of to the next level? I mean, we all sit here and take a look at an incredibly strong balance sheet. How do you put that cash to work? Are these segments, divisions, ones you want to keep? Or how do you think about adding to it?"
},
{
"speaker": "Robert Ford",
"text": "Sure. On the point of care concussion test, I guess I'd summarize the opportunity here in twofold. I think there's a market conversion component to this, Joanne. I mentioned there are 5 million ER visits to diagnose a concussion. The number one method there to use that is on a CT scan. I think there's an opportunity here to transform that and allow one to get a faster response in that emergency kind of emergency room visit, which is where the -- and the point of care team already have a good position with some of our other blood gas and other assays that we provide to that segment. I think this will slide right into that team. The value proposition here is going to be, okay, what's the cost of the system and can we bend that cost curve. I think we've shown a little bit how we think about things Joanne, if you look at Libre, if you look at Binax, if you look at how we think about pricing our products, when it comes to market conversion and the opportunities that we have there? We'll be able to do it at a nice return for our shareholders. I think that's an important part. The market expansion opportunity that we have, I think is going to still require some work on the product. Right now the product is approved whole blood, but it's a venous draw. We're going to be working on a capillary draw and if you can then run this assay, taking a sample from a finger prick, then you can look at bringing that technology even closer to where the need for a rapid concussion test would be. You could just look at how many universities exist in this country, how many high schools exist in this country? You can do some multiplications there and say, this is a great market creation, market expansion opportunity. I think that that's how we're thinking about it commercially, conversion and creation slash expansion. There's some more work to be done in terms of the product and the claims and the trials there. This will be a multi-year kind of program over here where we'll start to see kind of nice growth in that segment. And then your other question was about the portfolio and balance sheet. And do we like the four segments? The answer to that is yes, we like all the four segments. We feel that it gives us a real unique view into the healthcare system as a whole starting with nutrition that's obviously the bedrock of good health. But then, things happen and you need to get a diagnosis. And we've got a great diagnostic portfolio that we've been expanding on and building on to make sure that we can capitalize on all the different types of modalities and locations where people can get tested. And then, once a physician knows what the problem is, then they got to run through treatment, right? And we do that either through a medicines business or through a medical device business. I think all four segments are super well aligned to the global demographics and trends in healthcare. And so we like that there's always opportunities to add, and we've shown that if there are areas that we feel that we can bring value in a combination then as you mentioned we've got a strong balance sheet and strategic flexibility to do that. As long as we feel that we can add value to that asset. We felt like that about CSI, we felt like that about St. Jude. We felt like that about Alere. And those deals, they obviously help kind of reshape the company and accelerate our growth rates. But I think that's predicated on us really believing that we can kind of bring value and we're not trying to fill some top line gap or some issues. ROIC for us matters, profitability matters. We've got opportunities and we could be a little bit more selective to be able to add, but I like the four segments that we're in. And they've been well to shareholders, especially the long-term shareholders."
},
{
"speaker": "Operator",
"text": "Our next question will come from Matt Miksic from Barclays."
},
{
"speaker": "Matt Miksic",
"text": "Congrats on the really strong quarter, particularly med devices. I had one follow-up on the -- sorry, here, background. One question on structural heart. Robert, you talked a little bit about the portfolio and the combination of the leading peer device and MitraClip of being a little bit more mature in the category of structural heart, but being kind of augmented by some of these new products like most recently, obviously TriClip. And if you could talk a little bit about sort of the momentum in the portfolio as well as how much of the build out of this portfolio is still coming organically or under review kind of strategically, I appreciate it."
},
{
"speaker": "Robert Ford",
"text": "Sure. I mean I didn't want my comments on mitral to be construed like that 1 there is slowing down, and we're relying on others to drive the growth. I mean, that wasn't the intent. If you look at MitraClip this quarter, it's high single digits. And if you look at the last 5 quarters, that's what it's been doing between high single-digits, low double-digits. And that's good. But we always had a view here that this is an attractive area of growth, an attractive area of medical need. And we wanted to be a leader here. So yes, MitraClip, I guess we can call MitraClip, the founding father of our structural heart portfolio. But I think the team here has done an incredible job at bringing organic innovation into the portfolio. So if you look at our structural heart, I mean, we grew 13% today. MitraClip grew high single digits. But it accounted for 3% of that growth. The rest -- the other 10% came from all the rest of the portfolio that's being built. So I think that you'll continue to see that. We'll continue to make investments in this business, continue to make investments in the pipeline. I'd say right now, most of it is organic, whether it's innovating on LAA, innovating on our TAVR side and all the clinical trial that we're doing there. If there's an opportunity inorganically, I just put that in the same bucket that I think I answered kind of Joanne's question here if it makes sense. And we can add it. We've got the flexibility to do it. But the whole strategy here was to say, listen, we're going to build a multibillion-dollar structural heart business that can sustainably grow double digits. And the way to do that is you can't be a division of only 1 product. And I think the teams over the last 4 or 5 years, have done a really good job at building that and there's more opportunity. I'd say probably the one that we're looking at and is very exciting for us is mitral replacement. We've launched our Pendine product, which was more a transapical system. Our Cephea system is the transfemoral transseptal and feedback that we've seen from early implanters, early first in man is that this is a great, great valve. So there's an opportunity there also. So I'd say most organic, but we got the capacity for inorganic if it makes sense."
},
{
"speaker": "Mike Comilla",
"text": "Operator, we'll take one more question, please."
},
{
"speaker": "Operator",
"text": "And our final question will come from Danielle Antalffy from UBS."
},
{
"speaker": "Danielle Joy Antalffy",
"text": "And yes, congrats on a strong start to the year. Robert, we spent a lot of time talking about the durability of growth in the med tech business. So I don't want to get too greedy, but just following up on Joanne's question regarding you guys do have a strong balance sheet. Are there any areas -- I guess sort of how do you feel about the state of the med tech business today? And do you feel there are growth areas within med tech that maybe Abbott isn't participating in today that Abbott could or should participate in today? And where are you looking beyond your current markets, if at all? I'll just leave it to one."
},
{
"speaker": "Robert Ford",
"text": "Sure. I get the attempt for triangulation here in the multiple different ways, and I guess I'll sign a little bit boring here in terms of how I talk about this. I've been public that, yes, we are interested. We look at areas that we can add value to. I'd say, probably the ones that have jumped out more at us in terms of a study and looking at are probably more in the medical device side and on the diagnostic side. We did look at a strategy for biosimilars for our medicines business and that was a pretty capital efficient way to do it. Yes, we're looking. We continue to study, but I'm not going to sit here and telegraph exactly it's this, it's that. I think the key thing here is just, I mean, look at our medtech business did this quarter, look what it did previous four quarters and that allows me to be a little bit more selective. Over the last couple of months we've seen some fairly large transactions in the medtech space. Those seem to be attractive growth areas. I talked about us getting access to some early IVL technology with the CSI acquisition. That's an important area for us to focus on. But I don't feel that, with our strong organic growth that we need to go out and not pay attention to like other key financial metrics that for us are important in terms of ROICs and those, because we've got that strong growth rate in medtech. You won't get me telegraphing here exactly, Danielle, what specific segments we are looking at. What I can tell you is, we have an active team. They study a lot. We look a lot. We follow a lot. If there's a moment that makes sense for us and those segments continue to be interesting, we've got the balance sheet and the track record to show that, we can drive value out of these acquisitions. I'll just leave it like that. Yes, we've got flexibility, that doesn't mean that we don't pay attention to other key financial returns as we're looking at it. I feel that I can do that because we've got such a strong top-line growth and great pipeline and prospects. With that, I'll leave it like that. I'll just close by saying that, we're very pleased with a very strong start to the year. We delivered another quarter of double-digits organic sales growth on the base business. The investments that we've made during all those years of COVID are generating real strong returns. The pipeline continues to be highly productive, as I've outlined. We've got clear visibility to a pipeline all the way out to '27, '28. Obtained several new product approvals that are going to help us accelerate our growth in certain areas. Typically don't raise guidance in the first quarter, but given the strong performance and the outlook and the remainder of the year, we felt comfortable doing that and we're very well positioned to continue to sustainably deliver top tier results. With that, I'll wrap up and thank all of you for joining us today."
},
{
"speaker": "Mike Comilla",
"text": "Thank you, operator, and thank you all for your questions. This now concludes Abbott's conference call. A webcast replay of this call will be available after 11:00 am Central Time today on Abbott's Investor Relations website at abbotinvestor.com. Thank you for joining us today."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day."
}
] | Abbott Laboratories | 247,483 |
ABT | 1 | 2,025 | 2025-04-16 09:00:00 | Operator: Good morning, and thank you for standing by. Welcome to Abbott Laboratories' First Quarter 2025 Earnings Conference Call. Participants will be able to listen only until the question and answer portion of this call. During the question and answer session, you will be able to ask your question by pressing the star one one keys on your touch-tone phone. This call is being recorded by Abbott Laboratories. With the exception of any participants' questions asked during the question and answer session, the entire call, including the question and answer session, is material copyrighted by Abbott Laboratories. It cannot be recorded or rebroadcast without Abbott Laboratories' expressed written permission. I would now like to introduce Mr. Mike Comilla, Vice President, Investor Relations.
Mike Comilla: Good morning, everyone, and thank you for joining us. With me today are Robert Ford, Chairman and Chief Executive Officer, and Phil Boudreau, Executive Vice President, Finance, and Chief Financial Officer. Robert and Phil will provide opening remarks. Following their comments, we'll take your questions. Before we get started, some statements made today may be forward-looking for purposes of the Private Securities Litigation Reform Act of 1995, including the expected financial results for 2025. Abbott Laboratories cautions that these forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those indicated in the forward-looking statements. Economic, competitive, governmental, technological, and other factors may affect Abbott Laboratories' operations as discussed in item 1A, risk factors to our annual report on form 10-K for the year ended December 31, 2024. Abbott Laboratories undertakes no obligation to release publicly any revisions to forward-looking statements as a result of subsequent events or developments except as required by law. Today's conference call, as in the past, non-GAAP financial measures will be used to help investors understand Abbott Laboratories' ongoing business performance. These non-GAAP financial measures are reconciled with comparable GAAP financial measures in our earnings news release and regulatory filings from today, which are available on our website at abbott.com. Note that Abbott Laboratories has not provided the related GAAP financial measures on a forward-looking basis for the non-GAAP financial measures for which it is providing guidance, because the company is unable to predict with reasonable certainty and without unreasonable effort the timing and impact of certain items, which could significantly impact Abbott Laboratories' results in accordance with GAAP. Unless otherwise noted, our commentary on sales growth refers to organic sales growth, which is defined in the press release issued earlier today. With that, I will now turn the call over to Robert.
Robert Ford: Good morning, everyone, and thank you for joining us. As we progress through 2025, it is clear we are operating in an increasingly dynamic environment. Abbott Laboratories was built not just to operate, but to succeed and rapidly evolve in environments like this. We have consistently demonstrated our ability to navigate complexities arising from a range of global circumstances, including the repercussions of a global pandemic, global financial crisis, numerous geopolitical events, just to name a few. And the current evolving economic environment influenced by new tariff policies represents another global development that we are prepared to adeptly manage. The proven benefits of our diversified business model are evident now as a result of the strategic framework that drives our global manufacturing and supply chain operations. While tariffs will have a financial impact, with ninety manufacturing sites around the world and decades of experience executing our global network strategy, we're well-positioned to implement mitigations to help manage the impact of the tariffs. I'll now shift our focus to discussing our results for the quarter. Overall, we achieved our target growth objective, delivering high single-digit sales growth and double-digit earnings per share growth. First quarter sales grew 7% or more than 8% excluding COVID testing sales. First quarter adjusted earnings per share of $1.09 grew 11% versus the prior year and finished at the high end of our guidance range. I'll now summarize our first quarter results in more detail before turning the call over to Phil, and I'll start with nutrition. Year sales increased 7% in the quarter. Growth in the quarter was driven by high single-digit growth in adult nutrition and double-digit growth in US pediatric nutrition. In pediatric nutrition, our relentless focus on research, innovation, and product quality continues to make our Similac family of products the number one choice for parents in the United States. In adult nutrition, growth of 8.5% was driven by growing demand for Abbott Laboratories' Entra family of products, which serve as a source of complete and balanced nutrition for people with a wide range of nutritional needs. Moving to diagnostics, sales declined 5% in the quarter due to the year-over-year decline in COVID-19 testing sales resulting from a much weaker COVID season, which primarily impacted growth in our rapid diagnostics business. In core laboratory diagnostics, low single-digit growth in the quarter reflects the impact of volume-based procurement programs in China. Excluding China, core laboratory sales grew 6.5%.
Robert Ford: And wrapping up in diagnostics, we remain on track to go live by the end of the year with two new manufacturing and R&D investments in Illinois and Texas, totaling half a billion dollars related to expanding our US transfusion diagnostic business. Our transfusion business is responsible for screening the US blood supply. Our current blood screening system, Validity S, runs diagnostic tests to identify if there are antibodies and antigens that may be present in donated blood. We have developed a new system called Alinity N that will allow Abbott Laboratories to enter the molecular nucleic acid testing segment of the blood screening market. This advanced technology is capable of detecting DNA and RNA of several diseases that could potentially contaminate blood donations. The nucleic acid testing market opportunity is estimated to be around a billion dollars and represents an attractive new growth opportunity for our business. Turning to EPD, where sales increased 8% in the quarter. Growth was broad-based across the markets we serve, led by double-digit growth in more than half of our key fifteen markets. We continue to make great progress on building a best-in-class portfolio of biosimilars that spans across several large and attractive therapeutic areas. In January, we entered into an agreement that provides Abbott Laboratories commercialization rights to four additional biosimilars across emerging markets in Asia, Latin America, the Middle East, and Africa. Through the various collaboration agreements we have executed, we have now added a total of fifteen biosimilar products projected to contribute to sales over the next three years. And I'll wrap up with medical devices, where sales grew 12.5%. In diabetes care, sales of continuous glucose monitors were $1.7 billion in the quarter and grew more than 20%, including growth of 30% in the United States. In electrophysiology, sales grew 10%, which included double-digit growth in the US and high single-digit growth in international markets. In March, we announced that Abbott Laboratories obtained CE Mark earlier than expected for our Volt PFA system to help treat patients battling atrial fibrillation. We have already initiated the launch of Volt and will further expand the rollout across European markets over the course of the year. In structural heart, growth of 15% was driven by strong performance across our market-leading portfolio of surgical valves, structural interventions, and transcatheter repair and replacement products. Growth in the quarter was led by continued share gains in TAVR and growing adoption of TriClip. In March, new two-year data from the Trilumet clinical trial was presented at the American College of Cardiology Conference. The data showed that patients receiving TriClip had a statistically significant reduction in the occurrence of heart failure-related hospitalizations along with sustained reductions in tricuspid regurgitation and life-changing improvements in quality of life. In Rhythm Management, growth of 6% was led by consistent and sustained market penetration of Aveir, our innovative leadless pacemaker, and Assert, our newest implantable cardiac monitor. In heart failure, growth of 12% was driven by our market-leading portfolio of heart assist devices, which offer treatment for chronic and temporary conditions. In January, CMS issued a national coverage decision to cover CardioMEMS, a small implantable sensor that provides early warning indications to help doctors treat heart failure. This expanded coverage will broaden access to CardioMEMS for those with Medicare Advantage plans and help further expand coverage to those with commercial insurance plans. In vascular, growth of 6% was led by double-digit growth in vascular imaging and vessel closure products, and growth from Esprit, our below-the-knee resorbable stent. In March, we announced the start of our US pivotal trial to evaluate our coronary intravascular lithotripsy system in treating severe calcification in the coronary arteries prior to implanting stents. We expect to complete enrollment in this trial next year and file for FDA approval shortly thereafter. We look forward to entering this large and fast-growing segment of the coronary intervention market and expect this to become a meaningful growth driver for our vascular business. And lastly, neuromodulation. We began treating patients in our TRANSCEND clinical trial, a first-of-its-kind trial designed to evaluate using deep brain stimulation to address treatment-resistant depression, which represents a market opportunity exceeding a billion dollars. So in summary, we delivered another quarter of top-tier performance. Sales grew high single digits, and earnings per share grew double digits. We expanded gross margin by 140 basis points and operating margin by 130 basis points compared to the prior year. Our pipeline continues to provide a steady cadence of new growth opportunities, with more than 25 key new products forecasted to launch over the next three years. We are on track to deliver on the financial commitments we set at the beginning of the year. I'll now turn the call to Phil.
Phil Boudreau: Thanks, Robert. As Mike mentioned earlier, please note that all references to sales growth rates, unless otherwise noted, are on an organic basis. Turning to our first quarter results, sales increased 6.9% or 8.3% when excluding COVID testing-related sales. Adjusted earnings per share of $1.09 increased 11% compared to the prior year and finished at the high end of our guidance range and above the consensus estimate. Foreign exchange had an unfavorable year-over-year impact of 2.8% on the first quarter sales. During the quarter, we saw the US dollar weaken, which resulted in a favorable impact on sales compared to exchange rates at the time of our earnings call in January. Regarding other aspects of the P&L, the adjusted gross margin profile was 57.1% of sales, which increased 140 basis points compared to the prior year. This increase was driven by delivering on the underlying organic margin expansion we forecasted and also included an added benefit of more favorable fall-through from foreign exchange. Gross margin expansion has always been a significant element of company culture. At any point in time, a substantial number of margin improvement initiatives are underway that span across our businesses as well as our functional areas, including supply chain, marketing, and other administrative groups. I'd like to take a moment to acknowledge the valuable contributions from our Abbott Laboratories employees around the world who are driving these exceptional margin expansion results.
Phil Boudreau: Turning our focus back to the first quarter results, adjusted R&D was 6.7% of sales, and adjusted SG&A was 29.5% of sales in the first quarter. Adjusted operating margin was 21% of sales, which reflects an increase of 130 basis points compared to the prior year. Based on current rates, we now expect exchange to have an unfavorable impact of around 1% on the full-year reported sales, which includes an expected unfavorable impact of around half of a percent on the second quarter reported sales. Lastly, for the second quarter, we forecast adjusted earnings per share to be in the range of $1.23 to $1.27. With that, we'll now open the call for questions.
Operator: Thank you. At this time, we will conduct a question and answer session. As a reminder, to ask a question, you will need to press star one one on your telephone. You will then hear an automated message advising you that your hand is raised. To withdraw your question, please press star one one again. Please use your speakerphone when asking your question. And our first question will come from Robbie Marcus from JPMorgan. Your line is open.
Robbie Marcus: Oh, great. Good morning. Congrats on a good quarter and thanks for taking the questions. Robert, I'll just ask them both together since they're sort of related. First, on the full-year guidance update, it looks like it moves a little lower when you back out the or it stays the same when you back out COVID tests but moves a little lower including that. But you were able to hold EPS for the full year even including the recently announced tariffs. And I guess that's the elephant in the room is tariffs. So maybe you could walk us through the impact of that, how it hits the balance sheet and P&L timing. You know, we're all trying to figure out what does it look like on a full year. So maybe some of the offsets you talked about, the flexibility in the manufacturing footprint, how you're using that to your advantage. And I'll leave it there. Thanks a lot.
Robert Ford: Sure, Robbie. I mean, listen, I think the maintaining of our guidance range, you know, we've had a great first quarter here and achieved what we wanted to achieve from, you know, a target growth perspective. You know, high single-digit sales growth, double-digit EPS growth. We talked about getting back to that formula and, you know, excluding COVID testing sales, which I could tell you right now are our lowest gross margin product, you know, we grew over 8%. So I think on the top line, everything that we've kind of put in place we feel very good about as evidenced in our first quarter. Gross margin expansion is a key element of our plan to get back to double-digit EPS. To your question on tariffs, it's going to be an important muscle to exercise here in really strong performance here. I think we guided 70 basis points of improvement, then we saw about 140 in the first quarter. So really strong performance for the team there. And then the pipeline to kind of sustain the growth, Robbie, I think you saw a lot of activity this first quarter, whether it's the Volt CE mark, beginning of our IVL trial, the NCD for CardioMEMS, the new data on TriClip. So there's a lot of great activity there when you think about kind of how we guided in the beginning of the year, everything is pretty certain for us in terms of how we're executing and the expectations we have from the products. I guess the only aspect there of maybe some uncertainty that you raised is the tariff piece. And, you know, I'd say prior to tariffs, prior to the whole tariffs, we were even considering given the momentum that we were seeing in the base business, you know, we're even considering raising our EPS guidance. But, you know, tariffs are here, so we felt reaffirming our guidance is already, I think, a pretty strong statement. We've completed a pretty strong assessment of every possible different type of scenario. Not just in what it could how it could impact us, but more importantly, Robbie, how what are the different scenarios to be able to mitigate it? So the team has been working, call it, very diligently. I think we only took a break over the weekend to watch the playoff hole, and then we went right back to it. I can tell you, we feel very comfortable right now with the information that we've got and obviously looking at potential scenarios that could arise down the road that we can cover an impact of tariff, which I'd say really two geographies, the United States and China. So right now, we estimate the tariff impact in 2025 to be a few hundred million dollars. That's a half-year impact because I don't see any impact in Q2. And then we start to kind of see the impact happening in Q3. But there are other items here that I'd say are variables related to the tariffs that help offset. I could tell you there's not a lot of R&D slowing down or SG&A slowing down in those mitigation plans. But there are other variables to consider here. FX, we could see what's going on with the dollar as this discussion of tariff is ongoing. Interest rates, tax, there are a lot of, let's call it, levers that, you know, we've got at our disposal, put it this way, to be able to mitigate. Our job here is to manage this in the aggregate and contemplate and contemplate here, you know, trade-offs of the decisions. You know, we're working on I think the key thing here that as we're going through it over the last ten days is there are definitely short-term things that can be done to mitigate and close the gap. And we will be looking at those and delivering on those. But I think more importantly, Robbie, is how can you actually look at these on an ongoing basis? You know, one thing we have learned from tariffs is they don't go away. So whatever comes, it stays and stays for a while. Look at the tariffs that went in place in 2017. They're still there. So we need to think about how do you mitigate this more in a long-term sustainable way. So, yeah, you can use a balance sheet and you can build some inventory, and we'll probably do some of that. But if your entire strategy is building inventory, guess what's going to happen in 2026 or whenever that inventory runs out? So we're really looking at the manufacturing network and optimizing it. As I said in my comments, prepared comments, we've got ninety manufacturing sites across the world. We have the manufacturing strategy and framework that's been in place for decades, Robbie. And, you know, they weren't it's a framework that hasn't been put in place because of tariffs. But it's going to serve us well that same framework when we think about more long-term planning for tariffs. So, hey, I understand the temptation that many of you will have just to, you know, take this number that I've given or a few hundred million dollars and then just double it as an annualized impact, I think it's a little bit too early to do that. Like I said, our manufacturing network has got the ability on a more long-term basis to communicate this considerably. And you just got to have intent. You got to have a balance sheet, obviously, to be able to make the CapEx investments. Some of them take longer. Some of them you can do pretty fast. I mean, think about what we did during COVID, where we built three ISO-certified GMP clean remediators manufacturing. We did it in, you know, three months. So, you know, there is opportunity to do that also. But I think the key thing here is, you know, how do you balance the short-term, the medium-term, and the long-term? And we're not putting everything in a short-term even though we are going to leverage, you know, some of those variables that I talked about, FX, interest, tax, etcetera. But we're really focusing on how to mitigate this going forward. So thanks a lot.
Operator: Thank you. And our next question will come from Larry Biegelsen from Wells Fargo. Your line is open.
Larry Biegelsen: Good morning. Thanks for taking the question. Hey, Robert. Just wanted to focus on the EP franchise. You know, we're headed into the Heart Rhythm Society meeting next week. You just got approval for Volt in Europe. You put up a nice balanced quarter here. So maybe just kind of give us a kind of a state of the union and your, you know, how you're feeling about that business in 2025 and beyond, and just remind us of kind of the US approval timeline for Volt. Thanks for taking the question.
Robert Ford: Sure. Well, listen. I've always felt bullish about our strategy. I think many of you in your reports a couple of years ago probably wouldn't have anticipated that, you know, last year with all the PSA that we would have been the second fastest-growing competitor. And that's basically the strategy that the team delivered, but more importantly, the execution of it. So I think we had great success, and you saw that success continue into Q1, you know, without Volt. So I think the announcement of Volt was a little earlier than we expected, and that's a good thing, obviously. And, you know, the initial feedback that my team has shared with me has been very, very positive. Obviously, we're going to start with a rollout where we'll focus a little bit on the users that were part of our clinical trial, and then we'll start to ramp up that as we go into the second half of the year. I think the data that presented at the European part of the meeting was very strong. It stacked up very well against the other products. Obviously, it's always difficult to compare, you know, trial to trial. There's different, you know, patients. There's different kind of protocols. But I think in general, the data that presented was very strong. And then I think the integration here is key. I think we continue to be the market leader in the mapping of PFA cases. At least that's what we saw in Q1. And so we've got a built-in scale and capability here to drive, you know, to drive the adoption. I think that, you know, some of the advantages that I think our product has, we talked about not just the integration, but I think the balloon feature is perfect for PBI. A lot of stability, optimizes contact. As I think we've said, not only in conferences, but I also said, I think we think contact matters and visualization of contact matters. I think there's less muscle contraction, especially with lower anesthesia or the use of just sedation. So anyways, I think the product's going to do really well. I think it's going to do what we intended it to do. Related to timelines here in the US, you know, we'll be reporting data out and, you know, we'll be submitting it this year and, you know, I'm very optimistic that, you know, we should see an approval, you know, as I'm cautious here, Larry, because I hate giving predictions. But, you know, I'd say right now, our timeline is, you know, probably beginning of next year. Might be surprised on that, but I think that's a good kind of base case to have. And then the investments in the business are going very well too. I think the teams have done a really good job, not only with the mapping and the infrastructure we have out in the field, but also the R&D focus there. We've completed enrollment of our FocalFlex trial for CE Mark, and, you know, that's combining the RF and the PSA on the TacticFlex catheter. So I feel good. I feel good about where we are. I feel good about what the team's doing. You know, and as we accelerate the launch of Volt into international markets in the second half of the year, I think I said in the beginning of this year, I think the second half of the year will be better than the first half.
Larry Biegelsen: Alright. Thanks so much.
Operator: Thank you. Our next question will come from Travis Steed from B of A Securities. Your line is open.
Travis Steed: Hey. Thanks for taking the question. Just a few follow-ups on the tariff side. For the few hundred million half-year impact, just want to make sure that assumes kind of current rates as they are today and, you know, curious if assume China is probably the bigger portion of that. I don't know if there's any color you could kind of give on how you got to that impact. But it sounds like you really don't want us kind of to run rate down into 2026 yet because you think there's a lot of offsets. And when you think about the offsets, curious, you know, is network protocol included in that? Do you think kind of the diabetes business fits under that protocol? You know, how much of this can you offset with pricing? But you think a lot of the offsets are really going to be around moving around manufacturing and changing around the supply chain.
Robert Ford: Yeah. Sure. I think a question on FX rates, yeah, we're making an assumption that on that mitigation as rates are as of today, you know, there you can make an argument. Some of them have kind of gotten even the dollar has gotten even weaker versus some of them. So, yeah, we're making that assumption. Regarding US and China, you know, I'd say right now on that initial forecast, I'd say there's I'd say that's pretty evenly split. But I think as we think about mitigations more long-term, I think we've got opportunities across both of them. I think one thing that is important to keep in mind is we've always had a view with our manufacturing framework. And, like I said, this has been in place for decades. Two key tenets here, Travis. One, align the manufacturing as close as possible to the customer and then have an appropriate amount of redundancy. So, you know, the advantages of being close to your customer, I mean, you can get efficiencies and a lot of cost advantages there. It allows you to tap into local talent. But more importantly for us, it's always when you match your against FX. So it doesn't do much for it to protect the top line, but it definitely helps protect the EPS. And so a very large percent of our sales here in the US are sourced from US products. And then we try and mitigate risk by spreading that manufacturing network out. So a good example of that is Libre, for example, where we've got six manufacturing sites for Libre, a total of six. And of those six, two are in the United States. And obviously, those manufacturing in the United States serve the US demand. And then the other sites outside of the United States service OUS demand. We did that with COVID too. Binax was made in the US for the US, and Panbio was made outside the US for international markets. So that's going to allow us to kind of mitigate a lot of this. You know, if we had put all of our manufacturing in Southeast Asia or put all of our manufacturing in Europe, then that might be a little bit more complicated. But we've always had a view of kind of being able to spread it out and mitigate the risk that way. You know, tariff wasn't on the list of risks, but, you know, it provides a lot of maneuverability on this. So, yeah, I think you mentioned, you know, different opportunities to be able to, you know, offset impacts. Yeah. You mentioned one, but there are lots of other opportunities to do that. And, you know, we're looking at all of those. Those, you know, those help. Those help to be more sustainable, but, you know, somebody could decide to not want to be part of those agreements. So we've got to really leverage the manufacturing network that we have if you really want to make it sustainable. And I think those are the two areas that we're going to be looking at. And focusing on those two markets.
Travis Steed: Great. Thanks a lot.
Operator: Thank you. Our next question will come from David Roman from Goldman Sachs. Your line is open.
David Roman: Good morning. Thank you for all the color here on tariffs. Obviously, a topic we're watching very closely. Maybe you could switch over to some of the business performance metrics here. And could you maybe talk to us a little bit about the broader diagnostic strategy here, certainly understanding the unique dynamics of VBP influencing the business in China. If you think about where you're positioned and how you accelerate this business back toward end market growth, what are the key products that can help you do that? And are you thinking about M&A in this category to support a turn in the growth rate?
Robert Ford: Yeah. Sure. Listen. Yeah. A little disappointing on the diagnostic side. Yeah. Part of it was COVID, but, you know, we've also got some improvements to be made here. I'd say specifically in China, David, your point, I mean, we're seeing growth in our business. In our diagnostic business everywhere except China. Outside of China this quarter, we grew around 7%, which has been in line with our Core Lab overall growth rate. US grew 7%, and if you remove kind of the capital piece and just focus on the consumables, it was over 8%. EMEA grew 7%, Latin America grew mid-teens. Our transfusion business grew 7%. So I think we're seeing good performance here. It's really been a challenge here, as I mentioned, as you mentioned, which is China. And it's really price-driven. On VDPs. I think if you look at what's happened in other VDPs, at least the ones that we've been part of, when you bid on those businesses, yeah, you have a price hit, but you have an offset because you're part of a smaller group of competitors who are picking up volume. This one here was very different in that everybody, all manufacturers, stayed on the market, maintained their contracts, but we took these price hits. So we're really here faced with the price hit and no volume offset. So the team is doing a good job right now. Let's say, at navigating this. We're going to have to do better in some of the other geographies, and I know the teams are looking at how to accelerate even more our growth rate in the other markets. It's a delicate balance. You place a lot more capital, and that's going to hit your gross margin. So we've kind of looked at this being a kind of a, you know, between a 7% to 9% growth where we can grow above the market and still expand margins. So the team is looking carefully at how to do that, but offset some of that challenge coming out of China. We're just going to have to go through this. And still an important market. It's still got good profitability, but you're just going through the cycle here. Of VBP that is a little bit different from what we've seen in the past where you don't have the volume offset. Your question on M&A, yeah, this is a, you know, we believe diagnostics is critical to health care. Seventy percent of health care decisions involve a diagnostic test. Which is why we've been investing in this business. Talking about expanding our portfolio in the blood bank business with the nucleic acid testing system. I think that's going to be a great opportunity for our business. We're excited about, you know, showing the product to our customers this year and start working on really composing an offering here that you can have both serology and nucleic acid testing, you know, with Abbott Laboratories. Combined with all the automation and all the other digital services we provide, we think it's a real strong offering there. Other opportunities in diagnostics. Yeah. Sure. There are. I've been public about areas that we would be looking at in the M&A world being medical devices and diagnostics. But, you know, we've got opportunities to do that, but we've also got opportunities to do it organically.
David Roman: And maybe just a related follow-up on that last point. I think on the last call, it sounded like M&A might become a more important part of your capital allocation strategy. Maybe just update us on how you're thinking about that and any comments on how NEC might be influencing capital deployment priorities?
Robert Ford: Absolutely no impact whatsoever on capital allocation priorities and update on commentary on M&A. I mean, David, there is no update in the sense that the mindset hasn't shifted. Right? Which is yes, we're looking at opportunities in devices and diagnostics. Yes. We have opportunities to add to our business. We've got a strong balance sheet to be able to do that. We're going to look at things strategically. We're going to look at things also from a financial lens. We can be selective in the sense that we feel that we've got a growth model here that allows us to sustain this organic growth rate, this high single-digit organic growth rate. So it allows us to ensure that we're not only being strategic about it, but we're also being disciplined about how we're thinking about it. As I said, ROIC matters to us. Profitability matters for us. I think even more important in today's environment. Protecting your EPS, protecting your profitability, I think, is important. At least for us, it's going to be important. So regarding an update on M&A thoughts, there's no update on our thinking, on our framework.
David Roman: Great. Thanks so much.
Operator: Our next question will come from Vijay Kumar from Evercore ISI. Your line is open.
Vijay Kumar: Hey, guys. Congrats on a nice print here and thanks for taking my question. Robert, just on maybe the top line here. The 7.5% to 8.5% organic, which is that's pretty impressive considering the macro. What drives the back half acceleration rate when we look at Q1 starting point of 7%? Are we looking at, you know, Volt is, you know, stepping up or is this China, which is, you know, assuming China improves in the back half? Maybe walk us through it from Q1.
Robert Ford: Yeah. I mean, I think it's when we guided back in January, Vijay, we kind of guided to this, you know, second half better than the first half. And there's a couple of things there. First of all, I think you've got the impact of new kind of product launches kind of ramping up. And that obviously contributes to the growth rate in the second half. You mentioned one product, that's one. But as you're familiar with our pipeline, we've got a lot of recently launched products that as you go scaling up, you know, that scale goes building, and then it goes accelerating. So I think that's a key driver. And then the second part, I'd say is comps. If you remember, you know, the VBP really started to really impact us, you know, kind of last year, you know, Q3, Q4. So I expect that, you know, lapping some of those VBP components and diagnostics will be a contributor. And then if you remember also last year in Q3, we had some challenges on our nutrition business. Just some commercial execution challenges that we had a pretty big significant kind of drop in our nutrition, in our international churn of, you know, regaining the share in some of those markets. And so that's the other component I would say is, like, you know, these are two pretty big comps. If you look at Q3, you know, that was a pretty kind of low point, I'd say, for our nutrition business in the year. So that's kind of high level how the math works.
Vijay Kumar: Understood. And maybe one on the gross margins here. I think the prior guide is perhaps 60 to 80 basis points step up. Is the, I guess, the tariff, is that hitting gross margin? Is that a COGS impact? How should we think about gross margins here for the back half?
Phil Boudreau: Yeah, Vijay. It's Phil. And, yes, exactly, you highlighted here. We guided a strong gross margin into the year after nice sequential growth each quarter last year and very pleased with Q1. Delivering on that actually being a little bit better than what we had modeled or forecasted here, along with the benefit of the FX movement. Here. So those help serve as some of the offsets to the tariffs, which would largely be felt in the gross margin.
Vijay Kumar: Got it. Thank you, guys.
Operator: Thank you. And our next question will come from Joanne Wuensch from Citi. Your line is open.
Joanne Wuensch: Good morning, and thanks for taking the question and all of the information. I'd like to pivot a little bit to some of the products and particularly the IVL product, which you announced you've begun clinical trials for. And on a second question, some of your structural heart products, this is another quarter of double-digit revenue growth in that segment. That would be great. Thank you so much.
Robert Ford: Sure. It's great to talk about products a little bit, Joanne. So thanks about that. Yeah. So your first question on IVL. Listen, we're excited to enter this category. This is a billion-dollar opportunity right now. We think we see there's a lot of growth. If you remember, this asset came to us through the CSI acquisition that we did a few years ago. So, you know, we saw this as a, like, a really interesting asset that was in there that we could kind of add value. The team's been working on it, and it's great to see that we started to enroll patients in the trial. It's too early to think about kind of timelines here. Like, precise timelines from a quarterly perspective, but I expect to complete enrollment of this trial next year and file for approval next year. I think the catheter that's been that we put into the trial is being viewed as very easy to deliver. And seems like a great tool here to treat severe calcification. So, I've gotten, like, early data on kind of the first cases. They seem to all go very well. You know, praise from the interventionists on the deliverability of it, and I think that's always an important part given our experience in the world of stents. Deliverability is super important. So that's it seems like it's hitting the mark there. And then we also know that there's, you know, obviously, a peripheral market for this. If you think about our portfolio in our vascular business, this would complement it also very well. So I know the team's working on a peripheral program there too, and we'll provide updates on that as we progress. But, yeah, excited about the opportunity. I think it's going to be a meaningful growth driver here for our vascular business, which we've already started to see an improvement on the growth rate. And this will obviously help sustain it. Yeah. On your question on structural heart, yes, 15% growth. We've always talked about, Joanne, this being like moving away from being a single product company and MicroClip to be a full portfolio product. And the investments that we made in R&D during those years post-integration of St. Jude and really kind of building a best-in-class portfolio here, I think is going to pay off. It's paying off now, and I think it's going to pay off long-term also. Navitor is doing really well. We've talked about, you know, the opportunities that we have in TAVR, good share gains in Europe and looking forward to see this investment that we've been making in the US in terms of building our commercial presence, expanding it, looking forward to see that team be able to start to really gain momentum as we progress throughout the year. Keep in mind, we're only in 25% of the cases. It's 5% of the implanting hospitals here in the US. So I think there's a great opportunity for us there. And then, TriClip is another one that has been doing very well. The launch continues to go super. In terms of market share, I think TriClip here is now clearly the preferred option. Safety plays a major role in deciding what to choose and, you know, the safety record here is pretty excellent, not just in the clinical trials, but also in the real world. So I expect this to annualize at around a quarter of a billion dollars but really gaining a lot of momentum as we exit the year for a couple of things. One, we were launching a next generation of TriClip, and it's going to further enhance the ease of use. It simplifies all of the prep work. I've been to a couple of cases, and it's not a pain point, but it's just a nice thing to have to be able to reduce some of that device prep work before. So I think the team's done a really good job there. We also saw the CMS publish their end. I expect that to hit midyear, and that's another great opportunity. But the two-year data, I think, was pretty significant at ACC and really showed, you know, I know there's a lot of question marks about, you know, the endpoint a year ago, but, you know, that really was empowered for one year. You know, and you're starting to see now the benefits on that hard data come out. I think that plays a huge role when you got the safety and you got the hard endpoint. So all in all, I think the structural heart business is going to continue to be in these teen growth rates. And we got opportunities for international expansion too. So and then plus all the R&D work that's ongoing, whether it's balloon expandable, you know, next generation MitraClip, next generation TriClip, next generation Angulet. I mean, it's just really stacked up, and the team's doing a good job. So looking forward for that business to continue to be a contributor in the next few years.
Joanne Wuensch: Excellent. Thank you so much.
Operator: Thank you. Our next question comes from Josh Jennings from TD Cowen. Your line is open.
Josh Jennings: Hi, good morning. Thanks for taking the questions. Robert, I was hoping to maybe a little bit early for this, but was hoping you could share either what Abbott Laboratories is doing individually or plans to do along with conjunction with AdvaMed and industry to potentially seek exemptions in the US, China, Europe. And should investors hold out hope that exemptions for the medical devices industry specifically could be secured.
Robert Ford: Hey, Josh. I mean, you know, Abbott Laboratories, hope is not a strategy for us. So I would stick away from that. But are we talking with industry association sharing data, sharing information? I think the key thing here is always just getting some of the facts and the data is always important. And I think that's obviously an opportunity that exists to at least make sure that everybody who's making decisions is aware of the facts and data and the implications. So are we actively involved with AdvaMed? Yes. We are. But I also think that, you know, we have to the med tech industry, and you guys know this, is, whatever, six fifty million dollars, seven hundred billion dollars kind of industry, US companies, you know, have a very high share of that global industry around at least over 50%. So I think it is in the interest of the US to make sure that we protect the innovation, that we protect the investment in R&D. And a lot of the manufacturing in med tech is done, I would say, mostly in the US already. So yes, there's opportunities to have conversations, and that's part of our strategy. But hope is not one of them. So we're, you know, we're working through weekends and thinking about how we're going to do this on a long-term basis.
Josh Jennings: Understood. Thanks for that. And then just one follow-up. You know, I know the macro conditions are evolving rapidly. There have been some events Abbott Laboratories specifically with the NEC litigation over the past twelve months. Just was hoping for an update on how you and your team are thinking about the diversified model at Abbott Laboratories. It served the company well for decades. But any updates just on the potential to unlock value, a number of other competitors have been either divesting or spinning out business units. I was hoping to get your thoughts here in early 2025.
Robert Ford: Sure. I mean, you threw a couple of things in there. You know, the fact that we had this ongoing litigation on NEC doesn't necessarily kind of lead us down a path of, you know, whether businesses are here to drive value or not. So I'm going to move the litigation piece aside here, to be quite honest with you. Listen, we've always looked at the value of our diversified model. As long as you're in the right places, it provides a lot of shots on goal. And then it allows us to manage through moments of uncertainty, you know, in the global market. And I made reference to that in my opening statements. And we've shown plenty of examples of how that model has actually helped us. The key thing here is, you know, are these businesses operating at the highest level? And are we driving the value through them? I mean, you guys can do some of the parts. I think that we're pretty fairly valued, I guess, if you were to kind of do that analysis. You know, there's always going to be a little bit of a disconnect there. But I think we're operating as businesses each at the highest level. And, you know, I think they provide us with a strategic advantage that very few health care companies have. We have a unique perch where we get to see the entire spectrum of health care through nutrition, through diagnostics, through pharmaceuticals, through medical technologies, and we think that's a competitive advantage. But we look at our portfolio always on an ongoing basis. We continue to evaluate whether there's an opportunity to create value. I talked about these questions we ask ourselves. Is there an opportunity to create value? And is there somebody else that could, you know, be a better owner of our business? And for me right now, those two questions are no. They're not. And we just got to keep driving and executing, and I think you've seen, you know, you've seen us as a company. You know, we've engaged in these probably long before. These were, you know, these were the portfolio moves to juror, I'd say, that we're seeing right now. I got to get to ask yourself some of these moves, have they created value to shareholders? So I think that's always a fundamental question.
Josh Jennings: Thanks a lot, Robert.
Mike Comilla: Operator, we'll take one more question, please.
Operator: Thank you. And our last question will come from Marie Thibault from BTIG. Your line is open.
Marie Thibault: Good morning. Thanks for squeezing me in. I wanted to ask a question here on Rhythm Management. I think this is the second or third quarter that we've seen really strong results, particularly in the US. And I assume some of this is because of Aveir. Can you catch us up to date on where we are in terms of the rollout? Some of the new data we might be seeing at HRS on left bundle branch. Some of the other opportunities we should be seeing there in Aveir. Thanks.
Robert Ford: Yeah. Thanks, Marie. Yeah. I listen. I think Aveir remains one of the probably one of the most underappreciated opportunities here in our portfolio. I think rarely do you have an opportunity to completely change the standard of care. And I predict that we're going to see that standard of care change in the at least in the pacing market. You know, next five years. I think that the majority of the market is going to be leadless. And I'd say that the key thing for us was to think about, okay, if we think that this is going to be a complete change and change in paradigm and standard of care, we got to make sure that we build a strong enough foundation for that to happen. It is a different implant technique that have been accustomed, have been trained for, you know, decades. So as I've said, we were going to go, I guess you could say we're going to go a little slower to go fast. If you couldn't argue what we've been doing. I mean, I think this will probably exit the year at about half a billion dollars. So I think the teams have done a really good job at establishing that foundation. We've seen an increase in accounts. So we've increased our accounts by about 50%. The amount of physicians that have been trained have been increased by 50%. We've more than doubled the amount of implants per day we're doing. Now, that's not just the expansion of new accounts, but we've actually seen a 30% increase in the monthly implants of the early adopters. So not only are we increasing the penetration to new accounts, but we're also seeing deeper penetration and usage in the accounts that we've already opened. So that gives me confidence that, you know, on the statement that I made that I think this is going to be a complete change in category. And so much so that we've been obviously investing from an R&D perspective on next-generation leadless products. We're going to have a next-generation version come out we're working on that's going to increase the battery life by about 25%. So that's going to be good and important as we think about more increased penetration, you know, younger implants, younger population implants. And then we also talked about developing a leadless conduction system pacing product. This has got a breakthrough designation by the FDA. I'm not going to get too ahead of me in terms of HRS, what you'll see, but our goal is to start the pivotal trial for this product in 2026. So the point here is we believe this is going to fundamentally change. We've made the investments to prepare the market, train the market, condition the market, and we're also making investments in the pipeline also because we believe that's where the standard is going to go. So I think if you looked at our CRM business, you're seeing the impact of that strategy, which is, okay, this has been a business that historically has been flat from our perspective in a single-digit kind of growth market. Over the last couple of years. Thank you for pointing that out. We've been growing around 7%, and I think it's really part of the strategy. So we look forward to HRS. We look forward to, you know, what we're going to be presenting across the entire EP portfolio, not just on the CRM side. On the structural side and also on the ablation side. So I think we're going to have a real good HRS and good data there too. So listen, I'll just I get that there's a lot of questions on tariffs. We've been doing a lot of work, a lot of modeling, but more important, a lot of ways to think about how to mitigate the impacts. Part of my push to the team and push to myself, quite frankly, is we need to figure out how to do this in a way that's sustainable and not just using gap closes, which we will use for sure, but how do we make this more sustainable? I found it interesting. We did not get a single Libre question. So you guys are very concerned on tariffs and macro, but all good there. We've had a good start to the year, and I anticipate that that momentum is going to continue. Gross margin and the operating margin expansion is very important, and I think it's even more important now with the dynamics that we're in. But we're not doing that at the expense of the pipeline. The pipeline continues to provide great new growth opportunities. And, like I said, I think the diversified model here, I think that Josh's question, I think it serves us very well. There's a lot of moving pieces. Maybe it's to Robbie's point, but our job here is to make all that complexity and all those moving pieces into sustained and reliable growth and performance. Which is what we've been doing and what we're going to continue to do. So which is why we've reaffirmed our guidance here, and so we look forward to updating you guys as we go through the year. So with that, I'll wrap up, and thank you for joining us.
Mike Comilla: Thank you, operator, and thank you all for your questions. This now concludes Abbott Laboratories' conference call. A webcast replay of this call will be available after 11 AM Central Time today on Abbott Laboratories' Investor Relations website at abbottinvestor.com. Thank you for joining us today.
Operator: Thank you. This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day. | [
{
"speaker": "Operator",
"text": "Good morning, and thank you for standing by. Welcome to Abbott Laboratories' First Quarter 2025 Earnings Conference Call. Participants will be able to listen only until the question and answer portion of this call. During the question and answer session, you will be able to ask your question by pressing the star one one keys on your touch-tone phone. This call is being recorded by Abbott Laboratories. With the exception of any participants' questions asked during the question and answer session, the entire call, including the question and answer session, is material copyrighted by Abbott Laboratories. It cannot be recorded or rebroadcast without Abbott Laboratories' expressed written permission. I would now like to introduce Mr. Mike Comilla, Vice President, Investor Relations."
},
{
"speaker": "Mike Comilla",
"text": "Good morning, everyone, and thank you for joining us. With me today are Robert Ford, Chairman and Chief Executive Officer, and Phil Boudreau, Executive Vice President, Finance, and Chief Financial Officer. Robert and Phil will provide opening remarks. Following their comments, we'll take your questions. Before we get started, some statements made today may be forward-looking for purposes of the Private Securities Litigation Reform Act of 1995, including the expected financial results for 2025. Abbott Laboratories cautions that these forward-looking statements are subject to risks and uncertainties that may cause actual results to differ materially from those indicated in the forward-looking statements. Economic, competitive, governmental, technological, and other factors may affect Abbott Laboratories' operations as discussed in item 1A, risk factors to our annual report on form 10-K for the year ended December 31, 2024. Abbott Laboratories undertakes no obligation to release publicly any revisions to forward-looking statements as a result of subsequent events or developments except as required by law. Today's conference call, as in the past, non-GAAP financial measures will be used to help investors understand Abbott Laboratories' ongoing business performance. These non-GAAP financial measures are reconciled with comparable GAAP financial measures in our earnings news release and regulatory filings from today, which are available on our website at abbott.com. Note that Abbott Laboratories has not provided the related GAAP financial measures on a forward-looking basis for the non-GAAP financial measures for which it is providing guidance, because the company is unable to predict with reasonable certainty and without unreasonable effort the timing and impact of certain items, which could significantly impact Abbott Laboratories' results in accordance with GAAP. Unless otherwise noted, our commentary on sales growth refers to organic sales growth, which is defined in the press release issued earlier today. With that, I will now turn the call over to Robert."
},
{
"speaker": "Robert Ford",
"text": "Good morning, everyone, and thank you for joining us. As we progress through 2025, it is clear we are operating in an increasingly dynamic environment. Abbott Laboratories was built not just to operate, but to succeed and rapidly evolve in environments like this. We have consistently demonstrated our ability to navigate complexities arising from a range of global circumstances, including the repercussions of a global pandemic, global financial crisis, numerous geopolitical events, just to name a few. And the current evolving economic environment influenced by new tariff policies represents another global development that we are prepared to adeptly manage. The proven benefits of our diversified business model are evident now as a result of the strategic framework that drives our global manufacturing and supply chain operations. While tariffs will have a financial impact, with ninety manufacturing sites around the world and decades of experience executing our global network strategy, we're well-positioned to implement mitigations to help manage the impact of the tariffs. I'll now shift our focus to discussing our results for the quarter. Overall, we achieved our target growth objective, delivering high single-digit sales growth and double-digit earnings per share growth. First quarter sales grew 7% or more than 8% excluding COVID testing sales. First quarter adjusted earnings per share of $1.09 grew 11% versus the prior year and finished at the high end of our guidance range. I'll now summarize our first quarter results in more detail before turning the call over to Phil, and I'll start with nutrition. Year sales increased 7% in the quarter. Growth in the quarter was driven by high single-digit growth in adult nutrition and double-digit growth in US pediatric nutrition. In pediatric nutrition, our relentless focus on research, innovation, and product quality continues to make our Similac family of products the number one choice for parents in the United States. In adult nutrition, growth of 8.5% was driven by growing demand for Abbott Laboratories' Entra family of products, which serve as a source of complete and balanced nutrition for people with a wide range of nutritional needs. Moving to diagnostics, sales declined 5% in the quarter due to the year-over-year decline in COVID-19 testing sales resulting from a much weaker COVID season, which primarily impacted growth in our rapid diagnostics business. In core laboratory diagnostics, low single-digit growth in the quarter reflects the impact of volume-based procurement programs in China. Excluding China, core laboratory sales grew 6.5%."
},
{
"speaker": "Robert Ford",
"text": "And wrapping up in diagnostics, we remain on track to go live by the end of the year with two new manufacturing and R&D investments in Illinois and Texas, totaling half a billion dollars related to expanding our US transfusion diagnostic business. Our transfusion business is responsible for screening the US blood supply. Our current blood screening system, Validity S, runs diagnostic tests to identify if there are antibodies and antigens that may be present in donated blood. We have developed a new system called Alinity N that will allow Abbott Laboratories to enter the molecular nucleic acid testing segment of the blood screening market. This advanced technology is capable of detecting DNA and RNA of several diseases that could potentially contaminate blood donations. The nucleic acid testing market opportunity is estimated to be around a billion dollars and represents an attractive new growth opportunity for our business. Turning to EPD, where sales increased 8% in the quarter. Growth was broad-based across the markets we serve, led by double-digit growth in more than half of our key fifteen markets. We continue to make great progress on building a best-in-class portfolio of biosimilars that spans across several large and attractive therapeutic areas. In January, we entered into an agreement that provides Abbott Laboratories commercialization rights to four additional biosimilars across emerging markets in Asia, Latin America, the Middle East, and Africa. Through the various collaboration agreements we have executed, we have now added a total of fifteen biosimilar products projected to contribute to sales over the next three years. And I'll wrap up with medical devices, where sales grew 12.5%. In diabetes care, sales of continuous glucose monitors were $1.7 billion in the quarter and grew more than 20%, including growth of 30% in the United States. In electrophysiology, sales grew 10%, which included double-digit growth in the US and high single-digit growth in international markets. In March, we announced that Abbott Laboratories obtained CE Mark earlier than expected for our Volt PFA system to help treat patients battling atrial fibrillation. We have already initiated the launch of Volt and will further expand the rollout across European markets over the course of the year. In structural heart, growth of 15% was driven by strong performance across our market-leading portfolio of surgical valves, structural interventions, and transcatheter repair and replacement products. Growth in the quarter was led by continued share gains in TAVR and growing adoption of TriClip. In March, new two-year data from the Trilumet clinical trial was presented at the American College of Cardiology Conference. The data showed that patients receiving TriClip had a statistically significant reduction in the occurrence of heart failure-related hospitalizations along with sustained reductions in tricuspid regurgitation and life-changing improvements in quality of life. In Rhythm Management, growth of 6% was led by consistent and sustained market penetration of Aveir, our innovative leadless pacemaker, and Assert, our newest implantable cardiac monitor. In heart failure, growth of 12% was driven by our market-leading portfolio of heart assist devices, which offer treatment for chronic and temporary conditions. In January, CMS issued a national coverage decision to cover CardioMEMS, a small implantable sensor that provides early warning indications to help doctors treat heart failure. This expanded coverage will broaden access to CardioMEMS for those with Medicare Advantage plans and help further expand coverage to those with commercial insurance plans. In vascular, growth of 6% was led by double-digit growth in vascular imaging and vessel closure products, and growth from Esprit, our below-the-knee resorbable stent. In March, we announced the start of our US pivotal trial to evaluate our coronary intravascular lithotripsy system in treating severe calcification in the coronary arteries prior to implanting stents. We expect to complete enrollment in this trial next year and file for FDA approval shortly thereafter. We look forward to entering this large and fast-growing segment of the coronary intervention market and expect this to become a meaningful growth driver for our vascular business. And lastly, neuromodulation. We began treating patients in our TRANSCEND clinical trial, a first-of-its-kind trial designed to evaluate using deep brain stimulation to address treatment-resistant depression, which represents a market opportunity exceeding a billion dollars. So in summary, we delivered another quarter of top-tier performance. Sales grew high single digits, and earnings per share grew double digits. We expanded gross margin by 140 basis points and operating margin by 130 basis points compared to the prior year. Our pipeline continues to provide a steady cadence of new growth opportunities, with more than 25 key new products forecasted to launch over the next three years. We are on track to deliver on the financial commitments we set at the beginning of the year. I'll now turn the call to Phil."
},
{
"speaker": "Phil Boudreau",
"text": "Thanks, Robert. As Mike mentioned earlier, please note that all references to sales growth rates, unless otherwise noted, are on an organic basis. Turning to our first quarter results, sales increased 6.9% or 8.3% when excluding COVID testing-related sales. Adjusted earnings per share of $1.09 increased 11% compared to the prior year and finished at the high end of our guidance range and above the consensus estimate. Foreign exchange had an unfavorable year-over-year impact of 2.8% on the first quarter sales. During the quarter, we saw the US dollar weaken, which resulted in a favorable impact on sales compared to exchange rates at the time of our earnings call in January. Regarding other aspects of the P&L, the adjusted gross margin profile was 57.1% of sales, which increased 140 basis points compared to the prior year. This increase was driven by delivering on the underlying organic margin expansion we forecasted and also included an added benefit of more favorable fall-through from foreign exchange. Gross margin expansion has always been a significant element of company culture. At any point in time, a substantial number of margin improvement initiatives are underway that span across our businesses as well as our functional areas, including supply chain, marketing, and other administrative groups. I'd like to take a moment to acknowledge the valuable contributions from our Abbott Laboratories employees around the world who are driving these exceptional margin expansion results."
},
{
"speaker": "Phil Boudreau",
"text": "Turning our focus back to the first quarter results, adjusted R&D was 6.7% of sales, and adjusted SG&A was 29.5% of sales in the first quarter. Adjusted operating margin was 21% of sales, which reflects an increase of 130 basis points compared to the prior year. Based on current rates, we now expect exchange to have an unfavorable impact of around 1% on the full-year reported sales, which includes an expected unfavorable impact of around half of a percent on the second quarter reported sales. Lastly, for the second quarter, we forecast adjusted earnings per share to be in the range of $1.23 to $1.27. With that, we'll now open the call for questions."
},
{
"speaker": "Operator",
"text": "Thank you. At this time, we will conduct a question and answer session. As a reminder, to ask a question, you will need to press star one one on your telephone. You will then hear an automated message advising you that your hand is raised. To withdraw your question, please press star one one again. Please use your speakerphone when asking your question. And our first question will come from Robbie Marcus from JPMorgan. Your line is open."
},
{
"speaker": "Robbie Marcus",
"text": "Oh, great. Good morning. Congrats on a good quarter and thanks for taking the questions. Robert, I'll just ask them both together since they're sort of related. First, on the full-year guidance update, it looks like it moves a little lower when you back out the or it stays the same when you back out COVID tests but moves a little lower including that. But you were able to hold EPS for the full year even including the recently announced tariffs. And I guess that's the elephant in the room is tariffs. So maybe you could walk us through the impact of that, how it hits the balance sheet and P&L timing. You know, we're all trying to figure out what does it look like on a full year. So maybe some of the offsets you talked about, the flexibility in the manufacturing footprint, how you're using that to your advantage. And I'll leave it there. Thanks a lot."
},
{
"speaker": "Robert Ford",
"text": "Sure, Robbie. I mean, listen, I think the maintaining of our guidance range, you know, we've had a great first quarter here and achieved what we wanted to achieve from, you know, a target growth perspective. You know, high single-digit sales growth, double-digit EPS growth. We talked about getting back to that formula and, you know, excluding COVID testing sales, which I could tell you right now are our lowest gross margin product, you know, we grew over 8%. So I think on the top line, everything that we've kind of put in place we feel very good about as evidenced in our first quarter. Gross margin expansion is a key element of our plan to get back to double-digit EPS. To your question on tariffs, it's going to be an important muscle to exercise here in really strong performance here. I think we guided 70 basis points of improvement, then we saw about 140 in the first quarter. So really strong performance for the team there. And then the pipeline to kind of sustain the growth, Robbie, I think you saw a lot of activity this first quarter, whether it's the Volt CE mark, beginning of our IVL trial, the NCD for CardioMEMS, the new data on TriClip. So there's a lot of great activity there when you think about kind of how we guided in the beginning of the year, everything is pretty certain for us in terms of how we're executing and the expectations we have from the products. I guess the only aspect there of maybe some uncertainty that you raised is the tariff piece. And, you know, I'd say prior to tariffs, prior to the whole tariffs, we were even considering given the momentum that we were seeing in the base business, you know, we're even considering raising our EPS guidance. But, you know, tariffs are here, so we felt reaffirming our guidance is already, I think, a pretty strong statement. We've completed a pretty strong assessment of every possible different type of scenario. Not just in what it could how it could impact us, but more importantly, Robbie, how what are the different scenarios to be able to mitigate it? So the team has been working, call it, very diligently. I think we only took a break over the weekend to watch the playoff hole, and then we went right back to it. I can tell you, we feel very comfortable right now with the information that we've got and obviously looking at potential scenarios that could arise down the road that we can cover an impact of tariff, which I'd say really two geographies, the United States and China. So right now, we estimate the tariff impact in 2025 to be a few hundred million dollars. That's a half-year impact because I don't see any impact in Q2. And then we start to kind of see the impact happening in Q3. But there are other items here that I'd say are variables related to the tariffs that help offset. I could tell you there's not a lot of R&D slowing down or SG&A slowing down in those mitigation plans. But there are other variables to consider here. FX, we could see what's going on with the dollar as this discussion of tariff is ongoing. Interest rates, tax, there are a lot of, let's call it, levers that, you know, we've got at our disposal, put it this way, to be able to mitigate. Our job here is to manage this in the aggregate and contemplate and contemplate here, you know, trade-offs of the decisions. You know, we're working on I think the key thing here that as we're going through it over the last ten days is there are definitely short-term things that can be done to mitigate and close the gap. And we will be looking at those and delivering on those. But I think more importantly, Robbie, is how can you actually look at these on an ongoing basis? You know, one thing we have learned from tariffs is they don't go away. So whatever comes, it stays and stays for a while. Look at the tariffs that went in place in 2017. They're still there. So we need to think about how do you mitigate this more in a long-term sustainable way. So, yeah, you can use a balance sheet and you can build some inventory, and we'll probably do some of that. But if your entire strategy is building inventory, guess what's going to happen in 2026 or whenever that inventory runs out? So we're really looking at the manufacturing network and optimizing it. As I said in my comments, prepared comments, we've got ninety manufacturing sites across the world. We have the manufacturing strategy and framework that's been in place for decades, Robbie. And, you know, they weren't it's a framework that hasn't been put in place because of tariffs. But it's going to serve us well that same framework when we think about more long-term planning for tariffs. So, hey, I understand the temptation that many of you will have just to, you know, take this number that I've given or a few hundred million dollars and then just double it as an annualized impact, I think it's a little bit too early to do that. Like I said, our manufacturing network has got the ability on a more long-term basis to communicate this considerably. And you just got to have intent. You got to have a balance sheet, obviously, to be able to make the CapEx investments. Some of them take longer. Some of them you can do pretty fast. I mean, think about what we did during COVID, where we built three ISO-certified GMP clean remediators manufacturing. We did it in, you know, three months. So, you know, there is opportunity to do that also. But I think the key thing here is, you know, how do you balance the short-term, the medium-term, and the long-term? And we're not putting everything in a short-term even though we are going to leverage, you know, some of those variables that I talked about, FX, interest, tax, etcetera. But we're really focusing on how to mitigate this going forward. So thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question will come from Larry Biegelsen from Wells Fargo. Your line is open."
},
{
"speaker": "Larry Biegelsen",
"text": "Good morning. Thanks for taking the question. Hey, Robert. Just wanted to focus on the EP franchise. You know, we're headed into the Heart Rhythm Society meeting next week. You just got approval for Volt in Europe. You put up a nice balanced quarter here. So maybe just kind of give us a kind of a state of the union and your, you know, how you're feeling about that business in 2025 and beyond, and just remind us of kind of the US approval timeline for Volt. Thanks for taking the question."
},
{
"speaker": "Robert Ford",
"text": "Sure. Well, listen. I've always felt bullish about our strategy. I think many of you in your reports a couple of years ago probably wouldn't have anticipated that, you know, last year with all the PSA that we would have been the second fastest-growing competitor. And that's basically the strategy that the team delivered, but more importantly, the execution of it. So I think we had great success, and you saw that success continue into Q1, you know, without Volt. So I think the announcement of Volt was a little earlier than we expected, and that's a good thing, obviously. And, you know, the initial feedback that my team has shared with me has been very, very positive. Obviously, we're going to start with a rollout where we'll focus a little bit on the users that were part of our clinical trial, and then we'll start to ramp up that as we go into the second half of the year. I think the data that presented at the European part of the meeting was very strong. It stacked up very well against the other products. Obviously, it's always difficult to compare, you know, trial to trial. There's different, you know, patients. There's different kind of protocols. But I think in general, the data that presented was very strong. And then I think the integration here is key. I think we continue to be the market leader in the mapping of PFA cases. At least that's what we saw in Q1. And so we've got a built-in scale and capability here to drive, you know, to drive the adoption. I think that, you know, some of the advantages that I think our product has, we talked about not just the integration, but I think the balloon feature is perfect for PBI. A lot of stability, optimizes contact. As I think we've said, not only in conferences, but I also said, I think we think contact matters and visualization of contact matters. I think there's less muscle contraction, especially with lower anesthesia or the use of just sedation. So anyways, I think the product's going to do really well. I think it's going to do what we intended it to do. Related to timelines here in the US, you know, we'll be reporting data out and, you know, we'll be submitting it this year and, you know, I'm very optimistic that, you know, we should see an approval, you know, as I'm cautious here, Larry, because I hate giving predictions. But, you know, I'd say right now, our timeline is, you know, probably beginning of next year. Might be surprised on that, but I think that's a good kind of base case to have. And then the investments in the business are going very well too. I think the teams have done a really good job, not only with the mapping and the infrastructure we have out in the field, but also the R&D focus there. We've completed enrollment of our FocalFlex trial for CE Mark, and, you know, that's combining the RF and the PSA on the TacticFlex catheter. So I feel good. I feel good about where we are. I feel good about what the team's doing. You know, and as we accelerate the launch of Volt into international markets in the second half of the year, I think I said in the beginning of this year, I think the second half of the year will be better than the first half."
},
{
"speaker": "Larry Biegelsen",
"text": "Alright. Thanks so much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from Travis Steed from B of A Securities. Your line is open."
},
{
"speaker": "Travis Steed",
"text": "Hey. Thanks for taking the question. Just a few follow-ups on the tariff side. For the few hundred million half-year impact, just want to make sure that assumes kind of current rates as they are today and, you know, curious if assume China is probably the bigger portion of that. I don't know if there's any color you could kind of give on how you got to that impact. But it sounds like you really don't want us kind of to run rate down into 2026 yet because you think there's a lot of offsets. And when you think about the offsets, curious, you know, is network protocol included in that? Do you think kind of the diabetes business fits under that protocol? You know, how much of this can you offset with pricing? But you think a lot of the offsets are really going to be around moving around manufacturing and changing around the supply chain."
},
{
"speaker": "Robert Ford",
"text": "Yeah. Sure. I think a question on FX rates, yeah, we're making an assumption that on that mitigation as rates are as of today, you know, there you can make an argument. Some of them have kind of gotten even the dollar has gotten even weaker versus some of them. So, yeah, we're making that assumption. Regarding US and China, you know, I'd say right now on that initial forecast, I'd say there's I'd say that's pretty evenly split. But I think as we think about mitigations more long-term, I think we've got opportunities across both of them. I think one thing that is important to keep in mind is we've always had a view with our manufacturing framework. And, like I said, this has been in place for decades. Two key tenets here, Travis. One, align the manufacturing as close as possible to the customer and then have an appropriate amount of redundancy. So, you know, the advantages of being close to your customer, I mean, you can get efficiencies and a lot of cost advantages there. It allows you to tap into local talent. But more importantly for us, it's always when you match your against FX. So it doesn't do much for it to protect the top line, but it definitely helps protect the EPS. And so a very large percent of our sales here in the US are sourced from US products. And then we try and mitigate risk by spreading that manufacturing network out. So a good example of that is Libre, for example, where we've got six manufacturing sites for Libre, a total of six. And of those six, two are in the United States. And obviously, those manufacturing in the United States serve the US demand. And then the other sites outside of the United States service OUS demand. We did that with COVID too. Binax was made in the US for the US, and Panbio was made outside the US for international markets. So that's going to allow us to kind of mitigate a lot of this. You know, if we had put all of our manufacturing in Southeast Asia or put all of our manufacturing in Europe, then that might be a little bit more complicated. But we've always had a view of kind of being able to spread it out and mitigate the risk that way. You know, tariff wasn't on the list of risks, but, you know, it provides a lot of maneuverability on this. So, yeah, I think you mentioned, you know, different opportunities to be able to, you know, offset impacts. Yeah. You mentioned one, but there are lots of other opportunities to do that. And, you know, we're looking at all of those. Those, you know, those help. Those help to be more sustainable, but, you know, somebody could decide to not want to be part of those agreements. So we've got to really leverage the manufacturing network that we have if you really want to make it sustainable. And I think those are the two areas that we're going to be looking at. And focusing on those two markets."
},
{
"speaker": "Travis Steed",
"text": "Great. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from David Roman from Goldman Sachs. Your line is open."
},
{
"speaker": "David Roman",
"text": "Good morning. Thank you for all the color here on tariffs. Obviously, a topic we're watching very closely. Maybe you could switch over to some of the business performance metrics here. And could you maybe talk to us a little bit about the broader diagnostic strategy here, certainly understanding the unique dynamics of VBP influencing the business in China. If you think about where you're positioned and how you accelerate this business back toward end market growth, what are the key products that can help you do that? And are you thinking about M&A in this category to support a turn in the growth rate?"
},
{
"speaker": "Robert Ford",
"text": "Yeah. Sure. Listen. Yeah. A little disappointing on the diagnostic side. Yeah. Part of it was COVID, but, you know, we've also got some improvements to be made here. I'd say specifically in China, David, your point, I mean, we're seeing growth in our business. In our diagnostic business everywhere except China. Outside of China this quarter, we grew around 7%, which has been in line with our Core Lab overall growth rate. US grew 7%, and if you remove kind of the capital piece and just focus on the consumables, it was over 8%. EMEA grew 7%, Latin America grew mid-teens. Our transfusion business grew 7%. So I think we're seeing good performance here. It's really been a challenge here, as I mentioned, as you mentioned, which is China. And it's really price-driven. On VDPs. I think if you look at what's happened in other VDPs, at least the ones that we've been part of, when you bid on those businesses, yeah, you have a price hit, but you have an offset because you're part of a smaller group of competitors who are picking up volume. This one here was very different in that everybody, all manufacturers, stayed on the market, maintained their contracts, but we took these price hits. So we're really here faced with the price hit and no volume offset. So the team is doing a good job right now. Let's say, at navigating this. We're going to have to do better in some of the other geographies, and I know the teams are looking at how to accelerate even more our growth rate in the other markets. It's a delicate balance. You place a lot more capital, and that's going to hit your gross margin. So we've kind of looked at this being a kind of a, you know, between a 7% to 9% growth where we can grow above the market and still expand margins. So the team is looking carefully at how to do that, but offset some of that challenge coming out of China. We're just going to have to go through this. And still an important market. It's still got good profitability, but you're just going through the cycle here. Of VBP that is a little bit different from what we've seen in the past where you don't have the volume offset. Your question on M&A, yeah, this is a, you know, we believe diagnostics is critical to health care. Seventy percent of health care decisions involve a diagnostic test. Which is why we've been investing in this business. Talking about expanding our portfolio in the blood bank business with the nucleic acid testing system. I think that's going to be a great opportunity for our business. We're excited about, you know, showing the product to our customers this year and start working on really composing an offering here that you can have both serology and nucleic acid testing, you know, with Abbott Laboratories. Combined with all the automation and all the other digital services we provide, we think it's a real strong offering there. Other opportunities in diagnostics. Yeah. Sure. There are. I've been public about areas that we would be looking at in the M&A world being medical devices and diagnostics. But, you know, we've got opportunities to do that, but we've also got opportunities to do it organically."
},
{
"speaker": "David Roman",
"text": "And maybe just a related follow-up on that last point. I think on the last call, it sounded like M&A might become a more important part of your capital allocation strategy. Maybe just update us on how you're thinking about that and any comments on how NEC might be influencing capital deployment priorities?"
},
{
"speaker": "Robert Ford",
"text": "Absolutely no impact whatsoever on capital allocation priorities and update on commentary on M&A. I mean, David, there is no update in the sense that the mindset hasn't shifted. Right? Which is yes, we're looking at opportunities in devices and diagnostics. Yes. We have opportunities to add to our business. We've got a strong balance sheet to be able to do that. We're going to look at things strategically. We're going to look at things also from a financial lens. We can be selective in the sense that we feel that we've got a growth model here that allows us to sustain this organic growth rate, this high single-digit organic growth rate. So it allows us to ensure that we're not only being strategic about it, but we're also being disciplined about how we're thinking about it. As I said, ROIC matters to us. Profitability matters for us. I think even more important in today's environment. Protecting your EPS, protecting your profitability, I think, is important. At least for us, it's going to be important. So regarding an update on M&A thoughts, there's no update on our thinking, on our framework."
},
{
"speaker": "David Roman",
"text": "Great. Thanks so much."
},
{
"speaker": "Operator",
"text": "Our next question will come from Vijay Kumar from Evercore ISI. Your line is open."
},
{
"speaker": "Vijay Kumar",
"text": "Hey, guys. Congrats on a nice print here and thanks for taking my question. Robert, just on maybe the top line here. The 7.5% to 8.5% organic, which is that's pretty impressive considering the macro. What drives the back half acceleration rate when we look at Q1 starting point of 7%? Are we looking at, you know, Volt is, you know, stepping up or is this China, which is, you know, assuming China improves in the back half? Maybe walk us through it from Q1."
},
{
"speaker": "Robert Ford",
"text": "Yeah. I mean, I think it's when we guided back in January, Vijay, we kind of guided to this, you know, second half better than the first half. And there's a couple of things there. First of all, I think you've got the impact of new kind of product launches kind of ramping up. And that obviously contributes to the growth rate in the second half. You mentioned one product, that's one. But as you're familiar with our pipeline, we've got a lot of recently launched products that as you go scaling up, you know, that scale goes building, and then it goes accelerating. So I think that's a key driver. And then the second part, I'd say is comps. If you remember, you know, the VBP really started to really impact us, you know, kind of last year, you know, Q3, Q4. So I expect that, you know, lapping some of those VBP components and diagnostics will be a contributor. And then if you remember also last year in Q3, we had some challenges on our nutrition business. Just some commercial execution challenges that we had a pretty big significant kind of drop in our nutrition, in our international churn of, you know, regaining the share in some of those markets. And so that's the other component I would say is, like, you know, these are two pretty big comps. If you look at Q3, you know, that was a pretty kind of low point, I'd say, for our nutrition business in the year. So that's kind of high level how the math works."
},
{
"speaker": "Vijay Kumar",
"text": "Understood. And maybe one on the gross margins here. I think the prior guide is perhaps 60 to 80 basis points step up. Is the, I guess, the tariff, is that hitting gross margin? Is that a COGS impact? How should we think about gross margins here for the back half?"
},
{
"speaker": "Phil Boudreau",
"text": "Yeah, Vijay. It's Phil. And, yes, exactly, you highlighted here. We guided a strong gross margin into the year after nice sequential growth each quarter last year and very pleased with Q1. Delivering on that actually being a little bit better than what we had modeled or forecasted here, along with the benefit of the FX movement. Here. So those help serve as some of the offsets to the tariffs, which would largely be felt in the gross margin."
},
{
"speaker": "Vijay Kumar",
"text": "Got it. Thank you, guys."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question will come from Joanne Wuensch from Citi. Your line is open."
},
{
"speaker": "Joanne Wuensch",
"text": "Good morning, and thanks for taking the question and all of the information. I'd like to pivot a little bit to some of the products and particularly the IVL product, which you announced you've begun clinical trials for. And on a second question, some of your structural heart products, this is another quarter of double-digit revenue growth in that segment. That would be great. Thank you so much."
},
{
"speaker": "Robert Ford",
"text": "Sure. It's great to talk about products a little bit, Joanne. So thanks about that. Yeah. So your first question on IVL. Listen, we're excited to enter this category. This is a billion-dollar opportunity right now. We think we see there's a lot of growth. If you remember, this asset came to us through the CSI acquisition that we did a few years ago. So, you know, we saw this as a, like, a really interesting asset that was in there that we could kind of add value. The team's been working on it, and it's great to see that we started to enroll patients in the trial. It's too early to think about kind of timelines here. Like, precise timelines from a quarterly perspective, but I expect to complete enrollment of this trial next year and file for approval next year. I think the catheter that's been that we put into the trial is being viewed as very easy to deliver. And seems like a great tool here to treat severe calcification. So, I've gotten, like, early data on kind of the first cases. They seem to all go very well. You know, praise from the interventionists on the deliverability of it, and I think that's always an important part given our experience in the world of stents. Deliverability is super important. So that's it seems like it's hitting the mark there. And then we also know that there's, you know, obviously, a peripheral market for this. If you think about our portfolio in our vascular business, this would complement it also very well. So I know the team's working on a peripheral program there too, and we'll provide updates on that as we progress. But, yeah, excited about the opportunity. I think it's going to be a meaningful growth driver here for our vascular business, which we've already started to see an improvement on the growth rate. And this will obviously help sustain it. Yeah. On your question on structural heart, yes, 15% growth. We've always talked about, Joanne, this being like moving away from being a single product company and MicroClip to be a full portfolio product. And the investments that we made in R&D during those years post-integration of St. Jude and really kind of building a best-in-class portfolio here, I think is going to pay off. It's paying off now, and I think it's going to pay off long-term also. Navitor is doing really well. We've talked about, you know, the opportunities that we have in TAVR, good share gains in Europe and looking forward to see this investment that we've been making in the US in terms of building our commercial presence, expanding it, looking forward to see that team be able to start to really gain momentum as we progress throughout the year. Keep in mind, we're only in 25% of the cases. It's 5% of the implanting hospitals here in the US. So I think there's a great opportunity for us there. And then, TriClip is another one that has been doing very well. The launch continues to go super. In terms of market share, I think TriClip here is now clearly the preferred option. Safety plays a major role in deciding what to choose and, you know, the safety record here is pretty excellent, not just in the clinical trials, but also in the real world. So I expect this to annualize at around a quarter of a billion dollars but really gaining a lot of momentum as we exit the year for a couple of things. One, we were launching a next generation of TriClip, and it's going to further enhance the ease of use. It simplifies all of the prep work. I've been to a couple of cases, and it's not a pain point, but it's just a nice thing to have to be able to reduce some of that device prep work before. So I think the team's done a really good job there. We also saw the CMS publish their end. I expect that to hit midyear, and that's another great opportunity. But the two-year data, I think, was pretty significant at ACC and really showed, you know, I know there's a lot of question marks about, you know, the endpoint a year ago, but, you know, that really was empowered for one year. You know, and you're starting to see now the benefits on that hard data come out. I think that plays a huge role when you got the safety and you got the hard endpoint. So all in all, I think the structural heart business is going to continue to be in these teen growth rates. And we got opportunities for international expansion too. So and then plus all the R&D work that's ongoing, whether it's balloon expandable, you know, next generation MitraClip, next generation TriClip, next generation Angulet. I mean, it's just really stacked up, and the team's doing a good job. So looking forward for that business to continue to be a contributor in the next few years."
},
{
"speaker": "Joanne Wuensch",
"text": "Excellent. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Josh Jennings from TD Cowen. Your line is open."
},
{
"speaker": "Josh Jennings",
"text": "Hi, good morning. Thanks for taking the questions. Robert, I was hoping to maybe a little bit early for this, but was hoping you could share either what Abbott Laboratories is doing individually or plans to do along with conjunction with AdvaMed and industry to potentially seek exemptions in the US, China, Europe. And should investors hold out hope that exemptions for the medical devices industry specifically could be secured."
},
{
"speaker": "Robert Ford",
"text": "Hey, Josh. I mean, you know, Abbott Laboratories, hope is not a strategy for us. So I would stick away from that. But are we talking with industry association sharing data, sharing information? I think the key thing here is always just getting some of the facts and the data is always important. And I think that's obviously an opportunity that exists to at least make sure that everybody who's making decisions is aware of the facts and data and the implications. So are we actively involved with AdvaMed? Yes. We are. But I also think that, you know, we have to the med tech industry, and you guys know this, is, whatever, six fifty million dollars, seven hundred billion dollars kind of industry, US companies, you know, have a very high share of that global industry around at least over 50%. So I think it is in the interest of the US to make sure that we protect the innovation, that we protect the investment in R&D. And a lot of the manufacturing in med tech is done, I would say, mostly in the US already. So yes, there's opportunities to have conversations, and that's part of our strategy. But hope is not one of them. So we're, you know, we're working through weekends and thinking about how we're going to do this on a long-term basis."
},
{
"speaker": "Josh Jennings",
"text": "Understood. Thanks for that. And then just one follow-up. You know, I know the macro conditions are evolving rapidly. There have been some events Abbott Laboratories specifically with the NEC litigation over the past twelve months. Just was hoping for an update on how you and your team are thinking about the diversified model at Abbott Laboratories. It served the company well for decades. But any updates just on the potential to unlock value, a number of other competitors have been either divesting or spinning out business units. I was hoping to get your thoughts here in early 2025."
},
{
"speaker": "Robert Ford",
"text": "Sure. I mean, you threw a couple of things in there. You know, the fact that we had this ongoing litigation on NEC doesn't necessarily kind of lead us down a path of, you know, whether businesses are here to drive value or not. So I'm going to move the litigation piece aside here, to be quite honest with you. Listen, we've always looked at the value of our diversified model. As long as you're in the right places, it provides a lot of shots on goal. And then it allows us to manage through moments of uncertainty, you know, in the global market. And I made reference to that in my opening statements. And we've shown plenty of examples of how that model has actually helped us. The key thing here is, you know, are these businesses operating at the highest level? And are we driving the value through them? I mean, you guys can do some of the parts. I think that we're pretty fairly valued, I guess, if you were to kind of do that analysis. You know, there's always going to be a little bit of a disconnect there. But I think we're operating as businesses each at the highest level. And, you know, I think they provide us with a strategic advantage that very few health care companies have. We have a unique perch where we get to see the entire spectrum of health care through nutrition, through diagnostics, through pharmaceuticals, through medical technologies, and we think that's a competitive advantage. But we look at our portfolio always on an ongoing basis. We continue to evaluate whether there's an opportunity to create value. I talked about these questions we ask ourselves. Is there an opportunity to create value? And is there somebody else that could, you know, be a better owner of our business? And for me right now, those two questions are no. They're not. And we just got to keep driving and executing, and I think you've seen, you know, you've seen us as a company. You know, we've engaged in these probably long before. These were, you know, these were the portfolio moves to juror, I'd say, that we're seeing right now. I got to get to ask yourself some of these moves, have they created value to shareholders? So I think that's always a fundamental question."
},
{
"speaker": "Josh Jennings",
"text": "Thanks a lot, Robert."
},
{
"speaker": "Mike Comilla",
"text": "Operator, we'll take one more question, please."
},
{
"speaker": "Operator",
"text": "Thank you. And our last question will come from Marie Thibault from BTIG. Your line is open."
},
{
"speaker": "Marie Thibault",
"text": "Good morning. Thanks for squeezing me in. I wanted to ask a question here on Rhythm Management. I think this is the second or third quarter that we've seen really strong results, particularly in the US. And I assume some of this is because of Aveir. Can you catch us up to date on where we are in terms of the rollout? Some of the new data we might be seeing at HRS on left bundle branch. Some of the other opportunities we should be seeing there in Aveir. Thanks."
},
{
"speaker": "Robert Ford",
"text": "Yeah. Thanks, Marie. Yeah. I listen. I think Aveir remains one of the probably one of the most underappreciated opportunities here in our portfolio. I think rarely do you have an opportunity to completely change the standard of care. And I predict that we're going to see that standard of care change in the at least in the pacing market. You know, next five years. I think that the majority of the market is going to be leadless. And I'd say that the key thing for us was to think about, okay, if we think that this is going to be a complete change and change in paradigm and standard of care, we got to make sure that we build a strong enough foundation for that to happen. It is a different implant technique that have been accustomed, have been trained for, you know, decades. So as I've said, we were going to go, I guess you could say we're going to go a little slower to go fast. If you couldn't argue what we've been doing. I mean, I think this will probably exit the year at about half a billion dollars. So I think the teams have done a really good job at establishing that foundation. We've seen an increase in accounts. So we've increased our accounts by about 50%. The amount of physicians that have been trained have been increased by 50%. We've more than doubled the amount of implants per day we're doing. Now, that's not just the expansion of new accounts, but we've actually seen a 30% increase in the monthly implants of the early adopters. So not only are we increasing the penetration to new accounts, but we're also seeing deeper penetration and usage in the accounts that we've already opened. So that gives me confidence that, you know, on the statement that I made that I think this is going to be a complete change in category. And so much so that we've been obviously investing from an R&D perspective on next-generation leadless products. We're going to have a next-generation version come out we're working on that's going to increase the battery life by about 25%. So that's going to be good and important as we think about more increased penetration, you know, younger implants, younger population implants. And then we also talked about developing a leadless conduction system pacing product. This has got a breakthrough designation by the FDA. I'm not going to get too ahead of me in terms of HRS, what you'll see, but our goal is to start the pivotal trial for this product in 2026. So the point here is we believe this is going to fundamentally change. We've made the investments to prepare the market, train the market, condition the market, and we're also making investments in the pipeline also because we believe that's where the standard is going to go. So I think if you looked at our CRM business, you're seeing the impact of that strategy, which is, okay, this has been a business that historically has been flat from our perspective in a single-digit kind of growth market. Over the last couple of years. Thank you for pointing that out. We've been growing around 7%, and I think it's really part of the strategy. So we look forward to HRS. We look forward to, you know, what we're going to be presenting across the entire EP portfolio, not just on the CRM side. On the structural side and also on the ablation side. So I think we're going to have a real good HRS and good data there too. So listen, I'll just I get that there's a lot of questions on tariffs. We've been doing a lot of work, a lot of modeling, but more important, a lot of ways to think about how to mitigate the impacts. Part of my push to the team and push to myself, quite frankly, is we need to figure out how to do this in a way that's sustainable and not just using gap closes, which we will use for sure, but how do we make this more sustainable? I found it interesting. We did not get a single Libre question. So you guys are very concerned on tariffs and macro, but all good there. We've had a good start to the year, and I anticipate that that momentum is going to continue. Gross margin and the operating margin expansion is very important, and I think it's even more important now with the dynamics that we're in. But we're not doing that at the expense of the pipeline. The pipeline continues to provide great new growth opportunities. And, like I said, I think the diversified model here, I think that Josh's question, I think it serves us very well. There's a lot of moving pieces. Maybe it's to Robbie's point, but our job here is to make all that complexity and all those moving pieces into sustained and reliable growth and performance. Which is what we've been doing and what we're going to continue to do. So which is why we've reaffirmed our guidance here, and so we look forward to updating you guys as we go through the year. So with that, I'll wrap up, and thank you for joining us."
},
{
"speaker": "Mike Comilla",
"text": "Thank you, operator, and thank you all for your questions. This now concludes Abbott Laboratories' conference call. A webcast replay of this call will be available after 11 AM Central Time today on Abbott Laboratories' Investor Relations website at abbottinvestor.com. Thank you for joining us today."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day."
}
] | Abbott Laboratories | 247,483 |
ACGL | 4 | 2,020 | 2021-02-11 08:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2020 Arch Capital Group Earnings Call. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's Web site. I would now like to introduce your hosts for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sir, you may begin.
Marc Grandisson: Good morning, Liz. Good Morning and welcome to our fourth quarter earnings call. Overall, we are pleased with the current market conditions and the opportunities available to Arch as we close out 2020 and spring into 2021. One of our fundamental principles is that achieving growth and book value per share above the cost of capital over the long run is the best way to create and sustain shareholder value. We believe we delivered on that front in 2020. Our disciplined underwriting and diversified business model enabled Arch to grow its year-end book value per share by 5.4% over the third quarter and by 14.7% for the last 12 months. We've responded to broadly hardening market conditions and as a result, all three of our segments grew their premium writings in the quarter. In particular, the hardening markets allowed for significant growth within our P&C units, increasing our net premium written for the P&C by 32% for the full year. On the whole for 2020 we achieved an operating profit of $557 million and grew book value to $30.31 per share. Now, as most of you know, cycle management is core to who we are. Arch lean strongly into improving markets because history has shown that times like these are when superior risk adjusted returns gradually compound and accelerate book value growth and Arch is positioned to significantly expand as others derisk, rethink their underwriting strategies or even retrench. As we look at the opportunities ahead for Arch. I'm reminded of a situation in hockey that is exciting for any fan. In hockey, you get a one player advantage, if the other team takes a penalty. It's called a power play. When that happens, a few things need to be kept in mind as you deploy your specialty power play unit to try and improve the odds of scoring. You need to have a clear five on four strategy you need to be defensively savvy enough to not forget to protect your own zone and you need to have a sense of urgency because the clock will stick done and you will soon be back to even strength. These are the few moments that make a difference in a hockey game. The advantages position we find ourselves in is similar to that hockey power play where the odds are in our favor. I'm proud of how our team performed last year during the challenges of 2020. Now after spending a good portion of their last several years in a defensive position, we're embracing a more offensive mindset. Here's what that looked like in the fourth quarter. Let's begin with our insurance segment. Across our worldwide Insurance Group, renewal rate change has increased approximately 12% up to 200 bps from the prior quarters rate changes. Our fourth quarter growth occurred in many lines, with D&O, property, energy and marine all exhibiting strong advances. E&S casualty and our alternative markets business also grew this quarter. We believe that rate momentum in these lines is healthy and we also see it building in other lines albeit at a slower pace. Increasing margins helped improve our insurance accident year x cat loss ratio which decreased by 4.6 percentage points in the fourth quarter. As you may know, the full effects of increased rate levels can take approximately five quarters to become 40 reflected in underwriting margins. So today, we are earning the higher rates from the past year. In addition, our operating expense ratio has benefited from rising production this past year. We are pleased with the continuing progress achieved by our Insurance Group in the last two years. Turning next to our reinsurance segment, underwriting results were significantly better than the fourth quarter of 2019 despite the impact of $94 million worth of cap losses, while market conditions are not uniformly strong in the reinsurance sector, dislocation from other carriers that are reducing their positions is creating pockets with heartening rates that Arch is well positioned to capitalize on. Reinsurance also benefits from the underlying insurance market rate increases through its clients. For 2020, we grew reinsurance net written premium by 53% with the two main areas of growth being non-cap property and specialty. At the January 2021 renewals, we saw continued rate increases in most areas. However, we agree with the market consensus that property cap pricing moves were more subdued than expected or hoped, as capacity for that risk still remains strong. Accordingly, we maintain a cautious approach to this business. Our mortgage segment delivered good returns in both the fourth quarter and for the entire year despite the economic headwinds. We are confident in the continued earnings strength of this segment and frankly, the uncertainty we were facing during the early stages of COVID has been largely mitigated. Both premium rates and the credit quality of the new insurance written improved in 2020 and accordingly, the return on capital for our new U.S. MI business is essentially back to 2018 level, which was a strong year. Here's why MI is unwell this past year. First, housing markets have remained strong despite the difficult economic conditions. Second, the government forbearance program achieved largely what it was intended to do, which was to provide financial respite to many homeowners; and third credit criteria in the mortgage sector tightened in 2020 and as you know, credit quality is a critical factor in determining underwriting profitability. On a side note, just yesterday, the FHFA announced that a forbearance program has been extended an additional three months, which should help further mitigate the risk in our delinquency inventory. The delinquency rate of our portfolio decreased by 50 bps sequentially in the fourth quarter and year-end roughly two-thirds of our delinquent loans were in the government sponsored forbearance program. We currently estimate that 89% of delinquent borrowers in our portfolio at year end have at least 10% equity in their homes and as we have discussed on prior calls, the amount of equity in a home is a single most important factor in determining MI losses, as it plays a significant role in mitigating claim activity. We are cautiously optimistic that delinquencies will continue to cure as vaccines enable the economies to reopen. Importantly, record home purchases in the U.S. in 2020, supported a 5% price appreciation nationwide, while historically low interest rates, accelerated housing and refinance demand. This enabled Arch U.S. to report record NIW of 38 billion in the fourth quarter of 2020, up nearly 60% from the same period in 2019. Our outlook for continued growth in 2021 remains positive. Turning back to the current fate of the P&C cycle, there are three conditions that we believe will persist and help sustain the improved underwriting environment. One, social inflation and reserving problems and are starting to apply pressure for companies that haven't been prudent enough; two, anemic investment yields require a sharper focus on underwriting profit; and three, a return to a post-COVID world should accelerate economic activity and increase the demand for insurance. Each of these conditions will put pressure on results for the industry. Our conservative approach to reserving over the past several years means that we are well positioned to drive results in P&C going forward since we expect, our future returns to better reflect current and forward pricing. Finally, with better visibility into the overall economic conditions and with more clarity on the mortgage and P&C prospects, along with our strong capital generation, we see a compelling opportunity to invest in our shares at very attractive returns, François will talk to it in a moment. This recent share repurchase is a testament to our capital strategy and designed to enhance shareholder value over the long-term. We still have ample resources to deploy towards new growth and feel confident in our team's ability to be creative in order to capitalize on the opportunities before us. This is a time in the game where our cycle management strategy allows us to play offense and deploy capital dynamically to generate above average returns. And now I'll turn the game commentary over to François.
François Morin: Thank you, Marc, and good morning to all. We at Arch hope that you are in good health and that 2021 is off to a good start. On to the fourth quarter results, as a reminder and consistent with prior practice, the following comments are on a core basis which corresponds to Arch's financial results excluding the other segment, i.e., the operations of Watford Holdings Limited, in our filings the term consolidated includes Watford. After tax operating income for the quarter was $230.4 million which translates to an annualized 7.7% operating return on average common equity and $0.56 per share. For the year, our operating return on average common equity stood at 4.8%, while the return on average common equity stood at 11.8%. Book value per share increased to $30.31 at December 31, up 5.4% from last quarter and 14.7% from one year ago, again, an excellent result despite the strong headwinds from catastrophe losses this year, which is a testament to the resilience of our operations and our superior diversification strategy. Losses from 2020 catastrophic events in the quarter including COVID-19 net of reinsurance recoverables and reinstatement premiums stood at $156.4 million, or 9.4 combined ratio points, compared to 2.2 combined ratio points in the fourth quarter of 2019. The losses impacted both our insurance and reinsurance segments, primarily as a result of a series of natural catastrophes in the quarter, including Hurricanes Delta and Zeta and other smaller events, as well as adjustments to our estimates for events that occurred earlier in 2020. Our best estimate of ultimate losses for COVID-19, for occurrences through December 31, remained essentially unchanged from prior estimates. As of December 31, the vast majority of our COVID-19 claims are yet to be settled or paid, with approximately two-thirds of the inception to-date incurred loss amount recorded as incurred, but not reported IBNR reserves or as additional case reserves within our insurance and reinsurance segments. As regards to the potential impact of COVID-19 on our mortgage segment, as Marc alluded to, the delinquency rate at the end of the quarter was 4.19%, down from 4.69% at September 30. We are encouraged with a downward trend and delinquency rates over the last few quarters, which continue to come in significantly better than our earlier forecasts. Our latest assessment of the situation assumes a progressively improving economy in 2021, which should bode well for the housing sector and the performance of our book as we move forward. In the insurance segment, net written premium grew 21.6% over the same quarter one year ago, 29.6% if we exclude the impact of the pandemic on our travel, accident and health unit. The insurance segment's accident in the quarter combined ratio excluding cats was 93.6%, lower by 800 basis points over the same period one year ago. Approximately 360 basis points of the difference is due to our lower expense ratio, primarily from the growth in the premium base from one year ago and continued lower levels of travel and entertainment expenses. The lower ex-cat accident quarter loss ratio reflects the benefits of rate increases achieved over the last 12 months and changes in our mix of business, prior period net loss reserve development net of related adjustments was favorable at 1.2 million. As for our reinsurance operations, we had strong growth of 44.9% in net written premiums on a year-over-year basis, which was observed across most of our lines and includes a combination of new business opportunities, rate increases and the integration of the Barbican reinsurance business. The segment's accident quarter combined ratio excluding cats stood at 82.1% compared to 92.3% on the same basis 1 year ago. The year-over-year movement is primarily driven by rate change activity over the last 12 months, in a more normal level of large attritional losses compared to a year ago. Most of the remaining difference is explained by operating expense ratio improvements, primarily resulting from the growth and earned premium. Favorable prior period net losses reserve development, net of related adjustments was $40.5 million, or 6.9 combined ratio points, compared to 4.9 combined ratio points in the fourth quarter of 2019. The development was mostly in short-tail lines. The mortgage industry had a second consecutive record breaking quarter in terms of mortgage originations, which allowed Arch MI to produce 38 billion of NIW in the fourth quarter, a full 15.9% higher than our prior high watermark. With refinance activity leveling off from prior peaks, we saw our insurance in force increase by 2.5% across the mortgage segment. The combined ratio was 45.1% reflecting the lower level of new delinquencies reporting during the quarter. The expense ratio was slightly lower over the same quarter over one year ago and prior period net loss reserve development was favorable at 8.2 million this quarter, mostly from our second lien runoff portfolios. Improving investor sentiment enabled Arch to issue two Bellemeade transactions during the fourth quarter at terms that are getting closer to pre-pandemic levels. You will recall that we discussed our 2020-3 transaction on the last call and on the run deal covering our production from June through August of 2020. Our latest transaction Bellemeade 2020-4 provides additional protection on mortgages we insured in the second half of 2019 and already covered by our 2020-1 Bellemeade transaction by effectively reducing the original retention from 7.5% to 1.85% of the risk in force. At the year end, the Bellemeade structure has provided approximately $4 billion of aggregate reinsurance coverage. Total investment return for the quarter was positive 246 basis points on a U.S. dollar basis. And we ended the year with our investment portfolio producing a 7.77% total return. While our fixed income portfolio generated an excellent return of 188 bps in the quarter, contributions from our equity and alternative investments were also significant and represented approximately 40% of the total return for the quarter. The duration of our investment portfolio would decrease modestly to 3.01 years at year end, reflecting our ongoing positioning of the portfolio towards shorter term maturities. The effective tax rate on pre-tax operating income was 6.8% in the quarter, reflecting changes in the full year estimated tax rate, the geographic mix of our pre-tax income and a benefit from discrete tax items in the quarter. We currently estimate the full year tax rate to be in the 10% to 12% range for 2021. Turning briefly to risk management, our natural cat PML on a net basis decreased slightly to 860 million as of January 1 which at approximately 7.4% of tangible common equity remains well below our internal limits at the single event 1-in-250 year return level. The decrease in our Peak Zone PML this quarter is mostly attributable to our E&S property unit within the insurance segment where we reduced property aggregates in the Florida, Tri-County Peak Zone and made selective additions to our reinsurance purchases. Our balance sheet remains strong and our debt plus preferred leverage ratio stood at 22.1% at year end well within a reasonable range. Finally, on the capital front, we repurchased approximately 251,000 shares at an aggregate cost of $8 million in the fourth quarter of 2020. It is worth noting that we have since repurchased an additional 2.6 million shares at an aggregate cost of 83.6 million in the first quarter of 2021 under a rule 10b5 plan that we implemented during this quarter's close window period. Our remaining share authorization currently stands at 833 million. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions] Your first question comes from Elyse Greenspan, Wells Fargo.
Elyse Greenspan: My first question is related to your returns, Marc, I think in the prepared remarks you associated with mortgage business going back to return on capital levels from 2018. And I'm hoping since for all three businesses insurance, reinsurance, mortgage, can you give us a sense of the return profile, the business you're writing today versus, what you would have said, if I'd asked the same question 12 months ago?
Marc Grandisson: I think the high level of 2018, sort of long-term expected return on MI was roughly in the mid teens. So we're not going back to that level, which is really a good place for us to be. On the insurance, I think that we had a bit of a decrease in expected returns, even though the combined ratio did not, get that much better for the industry. But right now, if you factor in all the rate changes and everything, we think we're in the double-digit in insurance return. And we think that reinsurance is a little bit in between those two. So we have a really, really different, risk adjusted return profile in our portfolio that has improved and largerly as a result of the price increase, not as a result of the investment return as you know Elyse.
Elyse Greenspan: And then my second question on, I think you alluded to this a little bit in your prepared remarks, Marc, when you were mentioning a few issues that would help from the pricing momentum side, like persisting from here. A big question, that I get is, does this momentum persist through 2021 and perhaps beyond and can you obviously, different dynamics in the insurance and reinsurance P&C markets. But, can you just give us a sense, based off of what you know, today, do you think that the pricing momentum can persist through 2021 in insurance and also reinsurance.
Marc Grandisson: We expect it to be the case, Elyse, because of all the factors I mentioned, the social inflation, there's a lot of uncertainty in terms of loss ratio picks, for years, specifically 2015, through '19, as we all know. It sort of makes for correcting some of the ongoing pricing so that's definitely sustainable, we do not have as much, protection from the investment returns so that puts a lot of pressure on the returns for the industry. And uncertainty and lack of people coverage and we also had a fair amount of cat losses in the last three or four years. So, there's a lot going on, a lot more risk out there. So I think, overall, collectively as an industry, we all collectively think and know and believe that we need to get better rate and better pricing, because the risk is not being rewarded accordingly. As in every hardening market, what the length is like, how long is the piece of string, but I think that our hardening market does not only last four or five quarters, I think as you have this initial stages of the initial reaction of rate increases, then you get momentum building in the underwriters mentality, the brokers are sort of accepting as being sort of a new way to deal and do the business. And eventually that builds upon itself, I would fully expect to be lasting to 2021 and into 2022. This is what we believe at this point in time.
Elyse Greenspan: Okay. One last numbers question. You guys mentioned the PML going up a little bit but in terms of your cat load, I think in the past aren't used to talk to like 40 million of quarterly cats, obviously, we've seen growth in cat reinsurance and other property related lines like you mentioned, how should we think about the cat load from here?
Marc Grandisson: Yes. I mean, no question that we've written a lot more property premium in the last, I want to say four to six quarters we've really ramped up our property exposures. I mean, there's a lot of -- in different areas, as you know, different lines of business, U.S. International, et cetera. Yes, so the cat load, I think on a quarterly basis has definitely gone up from what we were -- in the old days, thinking about, like, 40 million a quarter. It's still evolving, but I'd say it's probably more than $60 million to $70 million range right now.
Operator: Our next question comes from Mike Zaremski with Credit Suisse.
Mike Zaremski: Follow up on mortgage insurance and Elyse's question. If you're talking about, you're encouraged about the downward delinquency rates and assuming the economy progressively improves and you think you mentioned mortgage biz can throw off return some of 2018 levels? So are you saying kind of directionally, we should be thinking about a combined ratio that continues to move south that kind of towards 2018 levels or the capital assumptions changed since then?
Marc Grandisson: No, Mike. Talking about combined ratio, capital is a different story, because it's a bit of a lagging indicator based on the delinquencies we have. But if you look at the combined ratio, yes, we think that we're tending to go towards more -- so the run rate that we had in 2018, we're just caveat that there was some prior development -- favorable development in 2018. So that will probably adjust for that. But certainly the long-term range of 35 to 45 is not something that is out of the realm of no real possibility if you look at 2018. And I think, depending on what, how the economy recovers that could be in the lower end of that and it's a couple things still develop in a different direction, it might be a bit on the higher side, but you're right, it should be getting closer to where we were in 2018, in terms of combined ratio.
Mike Zaremski: Switching gears to the -- the non-MI insurance segments, the expense ratio has been better than expected for a number of quarters and you guys have called out some items, maybe you can kind of remind us and talk to kind of watch what you think is kind of cyclical. And what's kind of structural in terms of the expense ratio improvements?
Marc Grandisson: Yes. I think this is more structural, I would say, Mike, because right now, you have to factor in the fact that our platform grew both sides, both in the sense of growing the top-line for organic lines of business. And we also had the acquisition in London and really pushed to be much more relevant, much more bigger in London. So our international operations also gained scale. So if you now look at the overall structure or the way the company is laid out in terms of top-line and the way the expenses is constructed between the unit, I think it's much more of a structural change. I would say that it's probably 50:50. But the growth is certainly something that's really important in terms of helping that grow. So that could also get, presumably a bit better over time. But I would also tell you that the growth in our operating expense on the insurance side has lagged the growth in our top-line, which is what we should expect because a lot of the increase if not more work, even though we are writing more business, a lot of the increase in premium is just rate in and of itself. So I think that the company is flexing itself in terms of top-line growth and expense, deployment very, very nicely so a bit more structural than I would have told you probably two years ago.
Operator: Our next question comes from Yaron Kinar with Goldman Sachs.
Yaron Kinar: I guess my first question revolves around MI. Do you have any comments or thoughts around potential changes to FHA fees and its potential -- their potential impact on MI business?
François Morin: Yes. Listen it's still early on. It is a new administration change, couple of things going on all over the place, Washington, I'm sure they're very busy right now trying to changing things. We hear the same things that you guys hear about 25 bps, potential price cut that FHA could put in there. And as a reminder for everyone if you take a step back, the FHA was a large market share provider of MI insurance and all in the years where the PMI, private mortgage insurance were not in great of a shape. And, frankly, that was needed to fill the gap and fill the void if you will, of the need for the homeowners and mortgage providers. So this has changed, I think that the FHA, also ultimate role and core role is to provide, mortgage insurance for the ones those are probably could be perceived as this more risky for the private sector. And so we've done the analysis, which means that if you look at our portfolio on, we're high FICO, very high quality, most of the borrowers that we have on our portfolio do not really need to consider FHA. So, from our perspective, we'll react obviously to whatever's out there. But we, we believe that this if it comes to fruition at 25 bps rate cut in FHA will help to lower FICO and high LTV borrower, which is really not the ones affecting and the ones that we're currently having success with, because our pricing is actually better, if you compare our pricing versus the FHA in that sector, our pricing is better and execution is cheaper for the borrower, so we're not losing sleep over that.
Yaron Kinar: And then, my second question, you previously talked, I think about shifting capital deployment from MI more into P&C, I think last call you used more of a basketball analogy that was easier for me to follow. Thank you for explaining. But I guess as market conditions, your views on market conditions change a bit, seems like reinsurance may be a little less exciting then maybe a quarter or two, the outlook was a quarter two ago and MI maybe a little better than the outlook was a quarter or two ago? Does your appetite for capital deployment between the three segments, has that shifted, or will it shift into 2021?
Marc Grandisson: I wouldn't say it shifts in any major way. I think we see all three segments with very good opportunities in front of them. And maybe, we'd argue somewhere overdue, especially on the P&C side. So we're bullish there. Mortgage has always been and basketball, 7.6 guy down low and ready for dunks and that hasn't really changed in our view. So yeah, I mean, we got certainly have more visibility into what the ultimate or what the current market conditions are -- especially in mortgage, given what we -- the second half of the year how things progress. And that's good. I mean, that's something that we take -- I think it works in our favor. So, but in a big picture, we don't see major changes in how we deploy capital. And Yaron, one thing I wouldn't mention to you that it's always -- it's hard for people not to see us being in Bermuda as being a property cat writer on the reinsurance side, but I would argue that, yes, on property cat side is not as good and you've heard it from other people. And we certainly agree with that. But we're still growing in areas that are non-property cat right exposed. So we're seeing a lot of other lines to be honest, between United are actually better now or the prospects for '21 better than they were in 2020. We're not growing necessarily in the one that get a better headline, if you will, from your perspective, but by and large, I think that our prospects is very, very good on the reinsurance side, very much so.
Operator: Our next question comes from Jammi Bhullar with JPMorgan.
Jammi Bhullar: I had a couple of questions. First, if you could just talk about your sort of comfort level with the RBI reserves given that the developments in the U.S. seem to be favoring the industry for the most part. So do you feel like you're overly conservative on your reserves? And obviously, internationally, things haven't gone as well. And then I have another one as well.
Marc Grandisson: We never would say that we're overly conservative. We want to be prudent and conservative for sure in how we set reserves. I'd say starting again with international which maybe has gotten a bit more a headlight -- made the headlines a bit more. Our position hasn't changed in the U.K., again, the book we have as a small regional book. We're well protected by reinsurance protection. So we feel that the reserves we have there, even after the call it slightly adverse rulings from the courts in the U.K. are going to affect our bottom-line, so no changes from our point of view there. And in the U.S., for the most part, as you said, all the rulings have kind of been in favor of the industry, a couple of places where there is maybe some that didn't go as expected, but on those items, our view is that the policies that were being challenged were manuscript policy. So not the standard ISO form that we typically use without necessarily the strong wording around virus exclusions and property damage, the trigger coverage. So on both those fronts, we get, as we said, before, vast majority of our policies well north of 90%, across the book that has these -- both of these call it protections. So we're very confident that our results -- our reserves at this point won't develop adversely and we will keep looking at it but we're in a good spot.
Jammi Bhullar: And I think you said about two thirds or three fourths were IBNR as of last quarter, what's that number now?
Marc Grandisson: Two-thirds, went down a little bit. So roughly from 75 to 67, roughly and it hasn't changed much. And some of that is around as you can expect mostly on the reinsurance side, right, a lot of our reserves are still on the reinsurance side with significant IBNR and ACRS on that book.
Jammi Bhullar: And then on buybacks, you did a decent amount in, you've done a lot of this year. So what's driving your sort of action there? Is it the stock price, is it I'm assuming there's decent opportunity to deploy capital in your businesses given pricing? But what drove the big up tick in buybacks versus what you've done in the last few quarters?
Marc Grandisson: Yes, certainly more visibility. I think that we said that from the start, at the end of the first quarter of last year, we said, listen, we're going to take a little bit of a pause, because we need to know where things are going to play out and mortgage being a major driver in that performance. You've seen the results. So we were a lot more confident where the economy is going, vaccines are rolling out. So there's a lot of things that yes, we'll take some time. But, as we look forward, I think that gives us a lot more comfort that the worst is behind us and that gives us a more clarity on how do we deploy capital, we're still in an online world, we are fully capable of doing both, we want to grow the book and also buy back shares. There's no reason why they have to be exclusive. We think our growth is still very strong, we expect to keep growing in '21 and across the book. But we also see a good opportunity at the current level, pricing levels for the stock to buy back at this point.
Marc Grandisson: So before we get to the next one, I think I have to stop the broadcast, I think I believe we have a breaking news just hit the wire. So I think we have to go to François for some commentary that he wants to share with us.
François Morin: Long overdue Marc, but just wanted to take advantage of the opportunity to fill everybody on the call on the latest developments with our proposed acquisition of a 29.5% ownership stake in Coface, the global trade credit insurer. To confirm what some of you may have seen across the business wire over the last few minutes, if they weren't paying attention to what we were saying but we closed on this transaction within Texas earlier today. And the reason for the timing is that we have to wait for their markets to close which they have so the consideration paid by Arch was €9.95 per share for an aggregate 453 million euros in aggregate including related fees. In connection with our minority stake in the company Arch now has four representatives on the Coface Board of Directors. As we stated before, we continue to view this transaction as an investment and we currently do not intend to increase our ownership position in Coface. From a financial reporting perspective, you should all expect us to include our proportionate share of Coface's results in our financials starting next quarter. We intend to report the contribution in a new separate line titled equity method earnings from operating affiliates, which will be included in our definition of operating earnings. This line will also include the contributions from other non-consolidated affiliates, such as premier holdings. So that's the breaking news, Marc.
Marc Grandisson: Thank you, François for the update. And Liz, if we can go back to Mr. Dunn who is waiting in line I believe.
Operator: Geoff Dunn with Dowling & Partners.
Q - Geoff Dunn: Couple of questions on MI. First of all, what was the incidence assumption for the current period provision as well as the average severity factor this quarter.
A - Marc Grandisson: So 9.4% for the new annuities in the quarter and the average reserve for the Q was a little bit over 5000, pretty much in line with the third quarter, Geoff, because the risk that came in were a little bit less coverage in this quarter. So that would explain the average thing a bit lower, or bit more in line.
Q - Geoff Dunn: Okay. And so as you think about '20, or the first part of '21, there, to my knowledge, they extended the forbearance period of 15 months, but you can't enter new forbearance activity. So what did your provision for non-forbearance loans? Are your incidence assumption for non-forbearance loans look like in the fourth quarter?
A - Marc Grandisson: Yes. I don't think we did not -- the way we reserve it, we sort of tried to make an overall all encompassing assessment and put that in that number. So I think that's what you might have said, might have thought in the past, our number could have been a bit higher. So we think that we have enough in the reserving in totality, based on the number of factors we've used.
Q - Geoff Dunn: Okay, but with forbearance options going away fair to assume that instance assumption will probably climb in the first half?
A - Marc Grandisson: Yes, Geoff, we might, but we'll have to evaluate when we get there. I think you're right. I mean, so you have to till February 28, to actually ask for this -- be under the forbearance program. So we'll see how that develops. We have a surge in a couple of weeks of people asking for forbearance that might help. Again, more, we'll have to readjust Geoff, as we see the end of the quarter, we'll have another month of non-forbearance, effective new, not new forbearance. So we'll have to reevaluate when we get there.
Q - Geoff Dunn: Okay. And then, within the PML, can you talk a little bit about what drove the pretty notable sequential drop in earned premium, as well as some of the movement on both the expense lines? Was there any reallocation on the expense stuff?
A - Marc Grandisson: Specific to any segments or I mean…
Q - Geoff Dunn: Premium line was down 15 million sequentially. And then you had some just -- looks like a little bit of abnormal movement, particularly in the acquisition expense line fell to the third quarter, but just a little bit more volatility than what we tend to see.
A - Marc Grandisson: Yes. The first one, I'd say, a) was a -- I call it an accounting catch up or true up on our Australian business, how we on the written side. So that I'd say that's more of a one-off kind of blip that we had to adjust for, or was actually was present last quarter and more than this quarter. So that's how that explains that movement. On the acquisition, there's -- we entered into a quota share agreement, starting last, at the middle of the year, covering our U.S. MI book and that actually gives us, a benefit in terms of the acquisition, it's a reduction towards the acquisition during the seeding commission. So that is what is starting to flow through in our numbers.
Operator: Our next question comes from Philip Stefano with Deutsche Bank.
Q - Philip Stefano: So you had mentioned that roughly two thirds of the defaults are in forbearance, I was hoping you could give us a flavor for how many people are nearing the end of their forbearance window and how many people in forbearance does it feel like are apparent on their mortgages?
A - Marc Grandisson: Yes. The numbers we report to you are that are in forbearance and who have skipped two payments at least. So we have a few more, as you could appreciate, that are in forbearance and are still current. The data is coming in very, very haphazardly. So it's very -- I wish that we are constantly asking and prodding for that kind of information. I think that most of the forbearance that are still there are lower in the year, most of the forbearance that were declared early in April, May June, the vast majority of them have cured by now. So it seems to be the pattern of getting to forbearance and sort of thing in there for four, five months, and then eventually things get back to normalcy. So that's what we would expect it to be the case going forward.
Q - Philip Stefano: I think the one question that we're trying to get to and I get a lot of questions about is, you had mentioned 89% of the delinquents have at least 10% in equity in the home. And you had talked about the visibility allowing you to repurchase shares. I mean, what point do we get visibility that maybe the MI reserves are a little more redundant and we can start to see a release there? How do we think about what you are looking for in the visibility to adjust that.
A - Marc Grandisson: So from your lips to God's ear, I hope you're right, that it's going to be redundant, we'll see, only time will tell for us. I think the way we look at reserve, Phil is very simple, it's just -- we have to wait to get the data that we feel confident that we're going to get there. And as you know, you've seen us do the reserving on MI and P&C for a long time. You tell me when a forbearance program is done, and when the unemployment rate goes down to three or four and the economy picks up again, then I'll have a better sense for what it is. So we hope -- having said all this, I hope that by the summer after the vaccines have been rolled out that we'll have much, much better visibility as to what, if any, the reserve needs to be released or is not necessary to pick links.
Q - Philip Stefano: Understood. Okay and switching gears on the reinsurance business, I appreciate the remarks you made in response to an earlier question. Is there any way you can help frame for us what the opportunity is for premium volume? So maybe, how their one one's go versus last year? Or how should we thinking about the growth potential in 2021?
A - Marc Grandisson: I think the growth in 2021 should be more in line at least, what we have seen last year. I think the opportunities on the reinsurance side -- I think the reinsurance opportunities are still very, very solid, very strong. They're not necessary as I mentioned earlier, in a traditional property cat arena, but we're definitely looking at a lot of transactions and a lot of them will have to do with what you would expect a reinsurance company to be providing, which is capital, as we get into harder market, a lot of people -- some of our clients are looking for capital at least looking for validation of their plan going forward and want to make sure that they -- they reunderwrite and repurpose their book of business that we're there to help them. And we're able in that case to help them get through that transition period. So the opportunity in reinsurance was great last year and I think it's actually very, very good again, as we go this year. One interesting fact for everyone that one of the key leading indicator to us, to me, at least personally, based on my history, as to what is a leading indicator of the treaty reinsurance conditions are, the facultative industry is still really, really strong. And you typically have a hard market or hardening market for as long as the fact market goes, you'll have a treaty market, no staying strong, well beyond that a year to two years beyond that. So we expect that to be yet again, a strong leading indicator and we are facultative team is telling us that it's a really good market for them at this point in time, which is encouraging.
Operator: Our next question comes from Meyer Shields with KB W.
Q - Meyer Shields: Great, thanks. So two questions on the P&C side. First, Arch's confidence in the pricing cycle is clearly borne itself out. But is it safe to say that maybe this is as good as it gets on the property cat side because there is this level of capital available? So that cycle will play out along historical lines?
A - Marc Grandisson: Yes. I will tell you Meyer is my experience, we did a lot of property cat writing in 01 in 02 and if you remember, at Arch, we were not heavily focused on property cat XL at the time, we were more on the liability side and the market was going down in 04 and well in 05. And we thought we had seen the last of the hard market for a little while and Katrina Rita and Wilma happened it change the whole thing. So my answer to you is, I don't know. I don't know is the short answer. I think that there's clearly a lot of capital that, again, found its way over the last four or five years. And once capital found its way to a niche, it gets sticky, it wants to stay there for a while and we will sort of justify itself for a while longer, perhaps than it should. But I think we're always hopefully it doesn't happen but we could be one major event away from changing the perception of risk in that area. And that I think will mean actually probably a much harder market you would expect Meyer because the volatility and the knee jerk reaction would be like an elastic like when this happens. I think you'll have a -- you may have a massive excessive capital out of the door. And that might create more opportunities for us. I'm not saying it will happen Meyer but I could see a scenario where your premise does not actually hold true. So there's always a chance.
Q - Meyer Shields: Okay. No, I just want to understand what you're thinking about. Second, you talk, I think on the insurance segment about market dislocation. And I think maybe the sense is out there that that has been a major factor or was a major factor in 2020. But now most companies are kind of settling down and are comfortable with their books of business. Are you still seeing like today, that level of market dislocation?
A - Marc Grandisson: Dislocation is, you're right, there's some realignment, there is a couple of people, going back to the market, this is truly happening. But it's not across the board. And there are still, we believe bad news that needs to come find their way through the system. And that might make somewhat of a difference as we go forward. But again, if you had a 20% rate increase on one transaction on the insurance side this year and you had, this is on top of a 10% last year, if you get rate on, rate on rate perhaps three times it's not a bad place to be and plus, I think what we hear Meyer for what it's worth, and it's actually not insignificant, we're hearing terms and conditions funny changing and moving in the right direction. So rates will move first and terms and conditions sort of follow right behind them, we're hearing that this is what's happening in marketplace. So even though we may not have a headline, going as high in terms of reaching it as much as it was over last two, three years. I think underlying conditions in their policies, could actually help improve it way beyond the number that we see on -- as the headline number.
Operator: Our next question comes from Brian Meredith with UBS.
Q - Brian Meredith: Couple of them for you here. The first one, Marc, first, I wonder if you could just confirm it used to be that your determination on whether you buy back your stock or not is that if you could actually recoup the premium you paid relative to book value over a three year period? Is that still the case? And if it is, does that basically mean that you could just continue to be pretty aggressive with your share buyback given where your stocks trading right now?
A - Marc Grandisson: Yes. I think that rule of thumb is still in place. I mean, obviously, it's not a black and white. I mean, there's always factors we consider around deploying, whether there's business opportunities and et cetera. But, yes, we still think in those terms of the buyback, the premium we bake and we want to earn it back over -- no more than three years. And you're right, I mean, I think the fact that the stock price is not as, is below that level, suggest that maybe we'll be up there buying more stock as we go through the year. Well, we'll assess, obviously, as we every day, every quarter, we will look at what's in front of us but for the time being, I think we're certainly something we're considering and we probably will do more of.
Q - Brian Meredith: And then just on that topic. So just maybe a little bit on uses of capital or cash kind of here going forward in the next 12 months, it sounds like you've got 453 million that's going out here, we've got Watford that I think is yet to get the close, is that it's all going to be constraining to your ability to actually buy back stock, given you also capital you need to fund your growth in your business and particularly as Marc just said on the reinsurance business is going to be very capital kind of generated type transactions.
A - François Morin: No, because we I mean, we raised a billion dollars of capital as you know last summer, we didn't deploy fully until, there was all part of that kind of on1/1 looking ahead as to what the 1/1 we were doing all these transactions, we're on the horizon. And we have a lot of faith in our ability to generate earnings moving forward on our own, I mean, self-funding the growth. I think is something that is part of the plan. And we don't really have, a whole lot of constraints other than that.
A - Marc Grandisson: And Brian, both of these acquisitions, as you mentioned will actually be accretive and grow book value for us. So they're capital positive for us.
Q - Brian Meredith: And then last question, I guess, now that is closed Coface, maybe you can give us a little bit of color and what the title insurance market looks like in Europe kind of return profile. What should we expect here?
A - François Morin: It's been about what, 20 minutes that we announced this, so you're going to have to give me a couple of more quarters.
Q - Brian Meredith: [Is that] [ph] challenging?
A - François Morin: No. We have it but listen we got -- we have to think it through, we are going to have a directors on there to -- are going to be working very closely hand in hand with Coface and we're very excited as you know, Brian. I think there's more than meets the eye in this one. I think strategically, it's going to be a very, very valuable thing for us, way beyond just know the initial investment. I think it's a formidable, established company across so many countries with so many client contacts where we're really excited about that.
End of Q&A:
Operator: I'm not showing any further questions. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thank you very much, everyone. Have a nice several months ahead. We're heading for the first quarter returns. It is an exciting time to be at Arch and we're very pleased that you are there with us to enjoy. Thank you.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Fourth Quarter 2020 Arch Capital Group Earnings Call. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's Web site. I would now like to introduce your hosts for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sir, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Good morning, Liz. Good Morning and welcome to our fourth quarter earnings call. Overall, we are pleased with the current market conditions and the opportunities available to Arch as we close out 2020 and spring into 2021. One of our fundamental principles is that achieving growth and book value per share above the cost of capital over the long run is the best way to create and sustain shareholder value. We believe we delivered on that front in 2020. Our disciplined underwriting and diversified business model enabled Arch to grow its year-end book value per share by 5.4% over the third quarter and by 14.7% for the last 12 months. We've responded to broadly hardening market conditions and as a result, all three of our segments grew their premium writings in the quarter. In particular, the hardening markets allowed for significant growth within our P&C units, increasing our net premium written for the P&C by 32% for the full year. On the whole for 2020 we achieved an operating profit of $557 million and grew book value to $30.31 per share. Now, as most of you know, cycle management is core to who we are. Arch lean strongly into improving markets because history has shown that times like these are when superior risk adjusted returns gradually compound and accelerate book value growth and Arch is positioned to significantly expand as others derisk, rethink their underwriting strategies or even retrench. As we look at the opportunities ahead for Arch. I'm reminded of a situation in hockey that is exciting for any fan. In hockey, you get a one player advantage, if the other team takes a penalty. It's called a power play. When that happens, a few things need to be kept in mind as you deploy your specialty power play unit to try and improve the odds of scoring. You need to have a clear five on four strategy you need to be defensively savvy enough to not forget to protect your own zone and you need to have a sense of urgency because the clock will stick done and you will soon be back to even strength. These are the few moments that make a difference in a hockey game. The advantages position we find ourselves in is similar to that hockey power play where the odds are in our favor. I'm proud of how our team performed last year during the challenges of 2020. Now after spending a good portion of their last several years in a defensive position, we're embracing a more offensive mindset. Here's what that looked like in the fourth quarter. Let's begin with our insurance segment. Across our worldwide Insurance Group, renewal rate change has increased approximately 12% up to 200 bps from the prior quarters rate changes. Our fourth quarter growth occurred in many lines, with D&O, property, energy and marine all exhibiting strong advances. E&S casualty and our alternative markets business also grew this quarter. We believe that rate momentum in these lines is healthy and we also see it building in other lines albeit at a slower pace. Increasing margins helped improve our insurance accident year x cat loss ratio which decreased by 4.6 percentage points in the fourth quarter. As you may know, the full effects of increased rate levels can take approximately five quarters to become 40 reflected in underwriting margins. So today, we are earning the higher rates from the past year. In addition, our operating expense ratio has benefited from rising production this past year. We are pleased with the continuing progress achieved by our Insurance Group in the last two years. Turning next to our reinsurance segment, underwriting results were significantly better than the fourth quarter of 2019 despite the impact of $94 million worth of cap losses, while market conditions are not uniformly strong in the reinsurance sector, dislocation from other carriers that are reducing their positions is creating pockets with heartening rates that Arch is well positioned to capitalize on. Reinsurance also benefits from the underlying insurance market rate increases through its clients. For 2020, we grew reinsurance net written premium by 53% with the two main areas of growth being non-cap property and specialty. At the January 2021 renewals, we saw continued rate increases in most areas. However, we agree with the market consensus that property cap pricing moves were more subdued than expected or hoped, as capacity for that risk still remains strong. Accordingly, we maintain a cautious approach to this business. Our mortgage segment delivered good returns in both the fourth quarter and for the entire year despite the economic headwinds. We are confident in the continued earnings strength of this segment and frankly, the uncertainty we were facing during the early stages of COVID has been largely mitigated. Both premium rates and the credit quality of the new insurance written improved in 2020 and accordingly, the return on capital for our new U.S. MI business is essentially back to 2018 level, which was a strong year. Here's why MI is unwell this past year. First, housing markets have remained strong despite the difficult economic conditions. Second, the government forbearance program achieved largely what it was intended to do, which was to provide financial respite to many homeowners; and third credit criteria in the mortgage sector tightened in 2020 and as you know, credit quality is a critical factor in determining underwriting profitability. On a side note, just yesterday, the FHFA announced that a forbearance program has been extended an additional three months, which should help further mitigate the risk in our delinquency inventory. The delinquency rate of our portfolio decreased by 50 bps sequentially in the fourth quarter and year-end roughly two-thirds of our delinquent loans were in the government sponsored forbearance program. We currently estimate that 89% of delinquent borrowers in our portfolio at year end have at least 10% equity in their homes and as we have discussed on prior calls, the amount of equity in a home is a single most important factor in determining MI losses, as it plays a significant role in mitigating claim activity. We are cautiously optimistic that delinquencies will continue to cure as vaccines enable the economies to reopen. Importantly, record home purchases in the U.S. in 2020, supported a 5% price appreciation nationwide, while historically low interest rates, accelerated housing and refinance demand. This enabled Arch U.S. to report record NIW of 38 billion in the fourth quarter of 2020, up nearly 60% from the same period in 2019. Our outlook for continued growth in 2021 remains positive. Turning back to the current fate of the P&C cycle, there are three conditions that we believe will persist and help sustain the improved underwriting environment. One, social inflation and reserving problems and are starting to apply pressure for companies that haven't been prudent enough; two, anemic investment yields require a sharper focus on underwriting profit; and three, a return to a post-COVID world should accelerate economic activity and increase the demand for insurance. Each of these conditions will put pressure on results for the industry. Our conservative approach to reserving over the past several years means that we are well positioned to drive results in P&C going forward since we expect, our future returns to better reflect current and forward pricing. Finally, with better visibility into the overall economic conditions and with more clarity on the mortgage and P&C prospects, along with our strong capital generation, we see a compelling opportunity to invest in our shares at very attractive returns, François will talk to it in a moment. This recent share repurchase is a testament to our capital strategy and designed to enhance shareholder value over the long-term. We still have ample resources to deploy towards new growth and feel confident in our team's ability to be creative in order to capitalize on the opportunities before us. This is a time in the game where our cycle management strategy allows us to play offense and deploy capital dynamically to generate above average returns. And now I'll turn the game commentary over to François."
},
{
"speaker": "François Morin",
"text": "Thank you, Marc, and good morning to all. We at Arch hope that you are in good health and that 2021 is off to a good start. On to the fourth quarter results, as a reminder and consistent with prior practice, the following comments are on a core basis which corresponds to Arch's financial results excluding the other segment, i.e., the operations of Watford Holdings Limited, in our filings the term consolidated includes Watford. After tax operating income for the quarter was $230.4 million which translates to an annualized 7.7% operating return on average common equity and $0.56 per share. For the year, our operating return on average common equity stood at 4.8%, while the return on average common equity stood at 11.8%. Book value per share increased to $30.31 at December 31, up 5.4% from last quarter and 14.7% from one year ago, again, an excellent result despite the strong headwinds from catastrophe losses this year, which is a testament to the resilience of our operations and our superior diversification strategy. Losses from 2020 catastrophic events in the quarter including COVID-19 net of reinsurance recoverables and reinstatement premiums stood at $156.4 million, or 9.4 combined ratio points, compared to 2.2 combined ratio points in the fourth quarter of 2019. The losses impacted both our insurance and reinsurance segments, primarily as a result of a series of natural catastrophes in the quarter, including Hurricanes Delta and Zeta and other smaller events, as well as adjustments to our estimates for events that occurred earlier in 2020. Our best estimate of ultimate losses for COVID-19, for occurrences through December 31, remained essentially unchanged from prior estimates. As of December 31, the vast majority of our COVID-19 claims are yet to be settled or paid, with approximately two-thirds of the inception to-date incurred loss amount recorded as incurred, but not reported IBNR reserves or as additional case reserves within our insurance and reinsurance segments. As regards to the potential impact of COVID-19 on our mortgage segment, as Marc alluded to, the delinquency rate at the end of the quarter was 4.19%, down from 4.69% at September 30. We are encouraged with a downward trend and delinquency rates over the last few quarters, which continue to come in significantly better than our earlier forecasts. Our latest assessment of the situation assumes a progressively improving economy in 2021, which should bode well for the housing sector and the performance of our book as we move forward. In the insurance segment, net written premium grew 21.6% over the same quarter one year ago, 29.6% if we exclude the impact of the pandemic on our travel, accident and health unit. The insurance segment's accident in the quarter combined ratio excluding cats was 93.6%, lower by 800 basis points over the same period one year ago. Approximately 360 basis points of the difference is due to our lower expense ratio, primarily from the growth in the premium base from one year ago and continued lower levels of travel and entertainment expenses. The lower ex-cat accident quarter loss ratio reflects the benefits of rate increases achieved over the last 12 months and changes in our mix of business, prior period net loss reserve development net of related adjustments was favorable at 1.2 million. As for our reinsurance operations, we had strong growth of 44.9% in net written premiums on a year-over-year basis, which was observed across most of our lines and includes a combination of new business opportunities, rate increases and the integration of the Barbican reinsurance business. The segment's accident quarter combined ratio excluding cats stood at 82.1% compared to 92.3% on the same basis 1 year ago. The year-over-year movement is primarily driven by rate change activity over the last 12 months, in a more normal level of large attritional losses compared to a year ago. Most of the remaining difference is explained by operating expense ratio improvements, primarily resulting from the growth and earned premium. Favorable prior period net losses reserve development, net of related adjustments was $40.5 million, or 6.9 combined ratio points, compared to 4.9 combined ratio points in the fourth quarter of 2019. The development was mostly in short-tail lines. The mortgage industry had a second consecutive record breaking quarter in terms of mortgage originations, which allowed Arch MI to produce 38 billion of NIW in the fourth quarter, a full 15.9% higher than our prior high watermark. With refinance activity leveling off from prior peaks, we saw our insurance in force increase by 2.5% across the mortgage segment. The combined ratio was 45.1% reflecting the lower level of new delinquencies reporting during the quarter. The expense ratio was slightly lower over the same quarter over one year ago and prior period net loss reserve development was favorable at 8.2 million this quarter, mostly from our second lien runoff portfolios. Improving investor sentiment enabled Arch to issue two Bellemeade transactions during the fourth quarter at terms that are getting closer to pre-pandemic levels. You will recall that we discussed our 2020-3 transaction on the last call and on the run deal covering our production from June through August of 2020. Our latest transaction Bellemeade 2020-4 provides additional protection on mortgages we insured in the second half of 2019 and already covered by our 2020-1 Bellemeade transaction by effectively reducing the original retention from 7.5% to 1.85% of the risk in force. At the year end, the Bellemeade structure has provided approximately $4 billion of aggregate reinsurance coverage. Total investment return for the quarter was positive 246 basis points on a U.S. dollar basis. And we ended the year with our investment portfolio producing a 7.77% total return. While our fixed income portfolio generated an excellent return of 188 bps in the quarter, contributions from our equity and alternative investments were also significant and represented approximately 40% of the total return for the quarter. The duration of our investment portfolio would decrease modestly to 3.01 years at year end, reflecting our ongoing positioning of the portfolio towards shorter term maturities. The effective tax rate on pre-tax operating income was 6.8% in the quarter, reflecting changes in the full year estimated tax rate, the geographic mix of our pre-tax income and a benefit from discrete tax items in the quarter. We currently estimate the full year tax rate to be in the 10% to 12% range for 2021. Turning briefly to risk management, our natural cat PML on a net basis decreased slightly to 860 million as of January 1 which at approximately 7.4% of tangible common equity remains well below our internal limits at the single event 1-in-250 year return level. The decrease in our Peak Zone PML this quarter is mostly attributable to our E&S property unit within the insurance segment where we reduced property aggregates in the Florida, Tri-County Peak Zone and made selective additions to our reinsurance purchases. Our balance sheet remains strong and our debt plus preferred leverage ratio stood at 22.1% at year end well within a reasonable range. Finally, on the capital front, we repurchased approximately 251,000 shares at an aggregate cost of $8 million in the fourth quarter of 2020. It is worth noting that we have since repurchased an additional 2.6 million shares at an aggregate cost of 83.6 million in the first quarter of 2021 under a rule 10b5 plan that we implemented during this quarter's close window period. Our remaining share authorization currently stands at 833 million. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Your first question comes from Elyse Greenspan, Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question is related to your returns, Marc, I think in the prepared remarks you associated with mortgage business going back to return on capital levels from 2018. And I'm hoping since for all three businesses insurance, reinsurance, mortgage, can you give us a sense of the return profile, the business you're writing today versus, what you would have said, if I'd asked the same question 12 months ago?"
},
{
"speaker": "Marc Grandisson",
"text": "I think the high level of 2018, sort of long-term expected return on MI was roughly in the mid teens. So we're not going back to that level, which is really a good place for us to be. On the insurance, I think that we had a bit of a decrease in expected returns, even though the combined ratio did not, get that much better for the industry. But right now, if you factor in all the rate changes and everything, we think we're in the double-digit in insurance return. And we think that reinsurance is a little bit in between those two. So we have a really, really different, risk adjusted return profile in our portfolio that has improved and largerly as a result of the price increase, not as a result of the investment return as you know Elyse."
},
{
"speaker": "Elyse Greenspan",
"text": "And then my second question on, I think you alluded to this a little bit in your prepared remarks, Marc, when you were mentioning a few issues that would help from the pricing momentum side, like persisting from here. A big question, that I get is, does this momentum persist through 2021 and perhaps beyond and can you obviously, different dynamics in the insurance and reinsurance P&C markets. But, can you just give us a sense, based off of what you know, today, do you think that the pricing momentum can persist through 2021 in insurance and also reinsurance."
},
{
"speaker": "Marc Grandisson",
"text": "We expect it to be the case, Elyse, because of all the factors I mentioned, the social inflation, there's a lot of uncertainty in terms of loss ratio picks, for years, specifically 2015, through '19, as we all know. It sort of makes for correcting some of the ongoing pricing so that's definitely sustainable, we do not have as much, protection from the investment returns so that puts a lot of pressure on the returns for the industry. And uncertainty and lack of people coverage and we also had a fair amount of cat losses in the last three or four years. So, there's a lot going on, a lot more risk out there. So I think, overall, collectively as an industry, we all collectively think and know and believe that we need to get better rate and better pricing, because the risk is not being rewarded accordingly. As in every hardening market, what the length is like, how long is the piece of string, but I think that our hardening market does not only last four or five quarters, I think as you have this initial stages of the initial reaction of rate increases, then you get momentum building in the underwriters mentality, the brokers are sort of accepting as being sort of a new way to deal and do the business. And eventually that builds upon itself, I would fully expect to be lasting to 2021 and into 2022. This is what we believe at this point in time."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. One last numbers question. You guys mentioned the PML going up a little bit but in terms of your cat load, I think in the past aren't used to talk to like 40 million of quarterly cats, obviously, we've seen growth in cat reinsurance and other property related lines like you mentioned, how should we think about the cat load from here?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I mean, no question that we've written a lot more property premium in the last, I want to say four to six quarters we've really ramped up our property exposures. I mean, there's a lot of -- in different areas, as you know, different lines of business, U.S. International, et cetera. Yes, so the cat load, I think on a quarterly basis has definitely gone up from what we were -- in the old days, thinking about, like, 40 million a quarter. It's still evolving, but I'd say it's probably more than $60 million to $70 million range right now."
},
{
"speaker": "Operator",
"text": "Our next question comes from Mike Zaremski with Credit Suisse."
},
{
"speaker": "Mike Zaremski",
"text": "Follow up on mortgage insurance and Elyse's question. If you're talking about, you're encouraged about the downward delinquency rates and assuming the economy progressively improves and you think you mentioned mortgage biz can throw off return some of 2018 levels? So are you saying kind of directionally, we should be thinking about a combined ratio that continues to move south that kind of towards 2018 levels or the capital assumptions changed since then?"
},
{
"speaker": "Marc Grandisson",
"text": "No, Mike. Talking about combined ratio, capital is a different story, because it's a bit of a lagging indicator based on the delinquencies we have. But if you look at the combined ratio, yes, we think that we're tending to go towards more -- so the run rate that we had in 2018, we're just caveat that there was some prior development -- favorable development in 2018. So that will probably adjust for that. But certainly the long-term range of 35 to 45 is not something that is out of the realm of no real possibility if you look at 2018. And I think, depending on what, how the economy recovers that could be in the lower end of that and it's a couple things still develop in a different direction, it might be a bit on the higher side, but you're right, it should be getting closer to where we were in 2018, in terms of combined ratio."
},
{
"speaker": "Mike Zaremski",
"text": "Switching gears to the -- the non-MI insurance segments, the expense ratio has been better than expected for a number of quarters and you guys have called out some items, maybe you can kind of remind us and talk to kind of watch what you think is kind of cyclical. And what's kind of structural in terms of the expense ratio improvements?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think this is more structural, I would say, Mike, because right now, you have to factor in the fact that our platform grew both sides, both in the sense of growing the top-line for organic lines of business. And we also had the acquisition in London and really pushed to be much more relevant, much more bigger in London. So our international operations also gained scale. So if you now look at the overall structure or the way the company is laid out in terms of top-line and the way the expenses is constructed between the unit, I think it's much more of a structural change. I would say that it's probably 50:50. But the growth is certainly something that's really important in terms of helping that grow. So that could also get, presumably a bit better over time. But I would also tell you that the growth in our operating expense on the insurance side has lagged the growth in our top-line, which is what we should expect because a lot of the increase if not more work, even though we are writing more business, a lot of the increase in premium is just rate in and of itself. So I think that the company is flexing itself in terms of top-line growth and expense, deployment very, very nicely so a bit more structural than I would have told you probably two years ago."
},
{
"speaker": "Operator",
"text": "Our next question comes from Yaron Kinar with Goldman Sachs."
},
{
"speaker": "Yaron Kinar",
"text": "I guess my first question revolves around MI. Do you have any comments or thoughts around potential changes to FHA fees and its potential -- their potential impact on MI business?"
},
{
"speaker": "François Morin",
"text": "Yes. Listen it's still early on. It is a new administration change, couple of things going on all over the place, Washington, I'm sure they're very busy right now trying to changing things. We hear the same things that you guys hear about 25 bps, potential price cut that FHA could put in there. And as a reminder for everyone if you take a step back, the FHA was a large market share provider of MI insurance and all in the years where the PMI, private mortgage insurance were not in great of a shape. And, frankly, that was needed to fill the gap and fill the void if you will, of the need for the homeowners and mortgage providers. So this has changed, I think that the FHA, also ultimate role and core role is to provide, mortgage insurance for the ones those are probably could be perceived as this more risky for the private sector. And so we've done the analysis, which means that if you look at our portfolio on, we're high FICO, very high quality, most of the borrowers that we have on our portfolio do not really need to consider FHA. So, from our perspective, we'll react obviously to whatever's out there. But we, we believe that this if it comes to fruition at 25 bps rate cut in FHA will help to lower FICO and high LTV borrower, which is really not the ones affecting and the ones that we're currently having success with, because our pricing is actually better, if you compare our pricing versus the FHA in that sector, our pricing is better and execution is cheaper for the borrower, so we're not losing sleep over that."
},
{
"speaker": "Yaron Kinar",
"text": "And then, my second question, you previously talked, I think about shifting capital deployment from MI more into P&C, I think last call you used more of a basketball analogy that was easier for me to follow. Thank you for explaining. But I guess as market conditions, your views on market conditions change a bit, seems like reinsurance may be a little less exciting then maybe a quarter or two, the outlook was a quarter two ago and MI maybe a little better than the outlook was a quarter or two ago? Does your appetite for capital deployment between the three segments, has that shifted, or will it shift into 2021?"
},
{
"speaker": "Marc Grandisson",
"text": "I wouldn't say it shifts in any major way. I think we see all three segments with very good opportunities in front of them. And maybe, we'd argue somewhere overdue, especially on the P&C side. So we're bullish there. Mortgage has always been and basketball, 7.6 guy down low and ready for dunks and that hasn't really changed in our view. So yeah, I mean, we got certainly have more visibility into what the ultimate or what the current market conditions are -- especially in mortgage, given what we -- the second half of the year how things progress. And that's good. I mean, that's something that we take -- I think it works in our favor. So, but in a big picture, we don't see major changes in how we deploy capital. And Yaron, one thing I wouldn't mention to you that it's always -- it's hard for people not to see us being in Bermuda as being a property cat writer on the reinsurance side, but I would argue that, yes, on property cat side is not as good and you've heard it from other people. And we certainly agree with that. But we're still growing in areas that are non-property cat right exposed. So we're seeing a lot of other lines to be honest, between United are actually better now or the prospects for '21 better than they were in 2020. We're not growing necessarily in the one that get a better headline, if you will, from your perspective, but by and large, I think that our prospects is very, very good on the reinsurance side, very much so."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jammi Bhullar with JPMorgan."
},
{
"speaker": "Jammi Bhullar",
"text": "I had a couple of questions. First, if you could just talk about your sort of comfort level with the RBI reserves given that the developments in the U.S. seem to be favoring the industry for the most part. So do you feel like you're overly conservative on your reserves? And obviously, internationally, things haven't gone as well. And then I have another one as well."
},
{
"speaker": "Marc Grandisson",
"text": "We never would say that we're overly conservative. We want to be prudent and conservative for sure in how we set reserves. I'd say starting again with international which maybe has gotten a bit more a headlight -- made the headlines a bit more. Our position hasn't changed in the U.K., again, the book we have as a small regional book. We're well protected by reinsurance protection. So we feel that the reserves we have there, even after the call it slightly adverse rulings from the courts in the U.K. are going to affect our bottom-line, so no changes from our point of view there. And in the U.S., for the most part, as you said, all the rulings have kind of been in favor of the industry, a couple of places where there is maybe some that didn't go as expected, but on those items, our view is that the policies that were being challenged were manuscript policy. So not the standard ISO form that we typically use without necessarily the strong wording around virus exclusions and property damage, the trigger coverage. So on both those fronts, we get, as we said, before, vast majority of our policies well north of 90%, across the book that has these -- both of these call it protections. So we're very confident that our results -- our reserves at this point won't develop adversely and we will keep looking at it but we're in a good spot."
},
{
"speaker": "Jammi Bhullar",
"text": "And I think you said about two thirds or three fourths were IBNR as of last quarter, what's that number now?"
},
{
"speaker": "Marc Grandisson",
"text": "Two-thirds, went down a little bit. So roughly from 75 to 67, roughly and it hasn't changed much. And some of that is around as you can expect mostly on the reinsurance side, right, a lot of our reserves are still on the reinsurance side with significant IBNR and ACRS on that book."
},
{
"speaker": "Jammi Bhullar",
"text": "And then on buybacks, you did a decent amount in, you've done a lot of this year. So what's driving your sort of action there? Is it the stock price, is it I'm assuming there's decent opportunity to deploy capital in your businesses given pricing? But what drove the big up tick in buybacks versus what you've done in the last few quarters?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, certainly more visibility. I think that we said that from the start, at the end of the first quarter of last year, we said, listen, we're going to take a little bit of a pause, because we need to know where things are going to play out and mortgage being a major driver in that performance. You've seen the results. So we were a lot more confident where the economy is going, vaccines are rolling out. So there's a lot of things that yes, we'll take some time. But, as we look forward, I think that gives us a lot more comfort that the worst is behind us and that gives us a more clarity on how do we deploy capital, we're still in an online world, we are fully capable of doing both, we want to grow the book and also buy back shares. There's no reason why they have to be exclusive. We think our growth is still very strong, we expect to keep growing in '21 and across the book. But we also see a good opportunity at the current level, pricing levels for the stock to buy back at this point."
},
{
"speaker": "Marc Grandisson",
"text": "So before we get to the next one, I think I have to stop the broadcast, I think I believe we have a breaking news just hit the wire. So I think we have to go to François for some commentary that he wants to share with us."
},
{
"speaker": "François Morin",
"text": "Long overdue Marc, but just wanted to take advantage of the opportunity to fill everybody on the call on the latest developments with our proposed acquisition of a 29.5% ownership stake in Coface, the global trade credit insurer. To confirm what some of you may have seen across the business wire over the last few minutes, if they weren't paying attention to what we were saying but we closed on this transaction within Texas earlier today. And the reason for the timing is that we have to wait for their markets to close which they have so the consideration paid by Arch was €9.95 per share for an aggregate 453 million euros in aggregate including related fees. In connection with our minority stake in the company Arch now has four representatives on the Coface Board of Directors. As we stated before, we continue to view this transaction as an investment and we currently do not intend to increase our ownership position in Coface. From a financial reporting perspective, you should all expect us to include our proportionate share of Coface's results in our financials starting next quarter. We intend to report the contribution in a new separate line titled equity method earnings from operating affiliates, which will be included in our definition of operating earnings. This line will also include the contributions from other non-consolidated affiliates, such as premier holdings. So that's the breaking news, Marc."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, François for the update. And Liz, if we can go back to Mr. Dunn who is waiting in line I believe."
},
{
"speaker": "Operator",
"text": "Geoff Dunn with Dowling & Partners."
},
{
"speaker": "Q - Geoff Dunn",
"text": "Couple of questions on MI. First of all, what was the incidence assumption for the current period provision as well as the average severity factor this quarter."
},
{
"speaker": "A - Marc Grandisson",
"text": "So 9.4% for the new annuities in the quarter and the average reserve for the Q was a little bit over 5000, pretty much in line with the third quarter, Geoff, because the risk that came in were a little bit less coverage in this quarter. So that would explain the average thing a bit lower, or bit more in line."
},
{
"speaker": "Q - Geoff Dunn",
"text": "Okay. And so as you think about '20, or the first part of '21, there, to my knowledge, they extended the forbearance period of 15 months, but you can't enter new forbearance activity. So what did your provision for non-forbearance loans? Are your incidence assumption for non-forbearance loans look like in the fourth quarter?"
},
{
"speaker": "A - Marc Grandisson",
"text": "Yes. I don't think we did not -- the way we reserve it, we sort of tried to make an overall all encompassing assessment and put that in that number. So I think that's what you might have said, might have thought in the past, our number could have been a bit higher. So we think that we have enough in the reserving in totality, based on the number of factors we've used."
},
{
"speaker": "Q - Geoff Dunn",
"text": "Okay, but with forbearance options going away fair to assume that instance assumption will probably climb in the first half?"
},
{
"speaker": "A - Marc Grandisson",
"text": "Yes, Geoff, we might, but we'll have to evaluate when we get there. I think you're right. I mean, so you have to till February 28, to actually ask for this -- be under the forbearance program. So we'll see how that develops. We have a surge in a couple of weeks of people asking for forbearance that might help. Again, more, we'll have to readjust Geoff, as we see the end of the quarter, we'll have another month of non-forbearance, effective new, not new forbearance. So we'll have to reevaluate when we get there."
},
{
"speaker": "Q - Geoff Dunn",
"text": "Okay. And then, within the PML, can you talk a little bit about what drove the pretty notable sequential drop in earned premium, as well as some of the movement on both the expense lines? Was there any reallocation on the expense stuff?"
},
{
"speaker": "A - Marc Grandisson",
"text": "Specific to any segments or I mean…"
},
{
"speaker": "Q - Geoff Dunn",
"text": "Premium line was down 15 million sequentially. And then you had some just -- looks like a little bit of abnormal movement, particularly in the acquisition expense line fell to the third quarter, but just a little bit more volatility than what we tend to see."
},
{
"speaker": "A - Marc Grandisson",
"text": "Yes. The first one, I'd say, a) was a -- I call it an accounting catch up or true up on our Australian business, how we on the written side. So that I'd say that's more of a one-off kind of blip that we had to adjust for, or was actually was present last quarter and more than this quarter. So that's how that explains that movement. On the acquisition, there's -- we entered into a quota share agreement, starting last, at the middle of the year, covering our U.S. MI book and that actually gives us, a benefit in terms of the acquisition, it's a reduction towards the acquisition during the seeding commission. So that is what is starting to flow through in our numbers."
},
{
"speaker": "Operator",
"text": "Our next question comes from Philip Stefano with Deutsche Bank."
},
{
"speaker": "Q - Philip Stefano",
"text": "So you had mentioned that roughly two thirds of the defaults are in forbearance, I was hoping you could give us a flavor for how many people are nearing the end of their forbearance window and how many people in forbearance does it feel like are apparent on their mortgages?"
},
{
"speaker": "A - Marc Grandisson",
"text": "Yes. The numbers we report to you are that are in forbearance and who have skipped two payments at least. So we have a few more, as you could appreciate, that are in forbearance and are still current. The data is coming in very, very haphazardly. So it's very -- I wish that we are constantly asking and prodding for that kind of information. I think that most of the forbearance that are still there are lower in the year, most of the forbearance that were declared early in April, May June, the vast majority of them have cured by now. So it seems to be the pattern of getting to forbearance and sort of thing in there for four, five months, and then eventually things get back to normalcy. So that's what we would expect it to be the case going forward."
},
{
"speaker": "Q - Philip Stefano",
"text": "I think the one question that we're trying to get to and I get a lot of questions about is, you had mentioned 89% of the delinquents have at least 10% in equity in the home. And you had talked about the visibility allowing you to repurchase shares. I mean, what point do we get visibility that maybe the MI reserves are a little more redundant and we can start to see a release there? How do we think about what you are looking for in the visibility to adjust that."
},
{
"speaker": "A - Marc Grandisson",
"text": "So from your lips to God's ear, I hope you're right, that it's going to be redundant, we'll see, only time will tell for us. I think the way we look at reserve, Phil is very simple, it's just -- we have to wait to get the data that we feel confident that we're going to get there. And as you know, you've seen us do the reserving on MI and P&C for a long time. You tell me when a forbearance program is done, and when the unemployment rate goes down to three or four and the economy picks up again, then I'll have a better sense for what it is. So we hope -- having said all this, I hope that by the summer after the vaccines have been rolled out that we'll have much, much better visibility as to what, if any, the reserve needs to be released or is not necessary to pick links."
},
{
"speaker": "Q - Philip Stefano",
"text": "Understood. Okay and switching gears on the reinsurance business, I appreciate the remarks you made in response to an earlier question. Is there any way you can help frame for us what the opportunity is for premium volume? So maybe, how their one one's go versus last year? Or how should we thinking about the growth potential in 2021?"
},
{
"speaker": "A - Marc Grandisson",
"text": "I think the growth in 2021 should be more in line at least, what we have seen last year. I think the opportunities on the reinsurance side -- I think the reinsurance opportunities are still very, very solid, very strong. They're not necessary as I mentioned earlier, in a traditional property cat arena, but we're definitely looking at a lot of transactions and a lot of them will have to do with what you would expect a reinsurance company to be providing, which is capital, as we get into harder market, a lot of people -- some of our clients are looking for capital at least looking for validation of their plan going forward and want to make sure that they -- they reunderwrite and repurpose their book of business that we're there to help them. And we're able in that case to help them get through that transition period. So the opportunity in reinsurance was great last year and I think it's actually very, very good again, as we go this year. One interesting fact for everyone that one of the key leading indicator to us, to me, at least personally, based on my history, as to what is a leading indicator of the treaty reinsurance conditions are, the facultative industry is still really, really strong. And you typically have a hard market or hardening market for as long as the fact market goes, you'll have a treaty market, no staying strong, well beyond that a year to two years beyond that. So we expect that to be yet again, a strong leading indicator and we are facultative team is telling us that it's a really good market for them at this point in time, which is encouraging."
},
{
"speaker": "Operator",
"text": "Our next question comes from Meyer Shields with KB W."
},
{
"speaker": "Q - Meyer Shields",
"text": "Great, thanks. So two questions on the P&C side. First, Arch's confidence in the pricing cycle is clearly borne itself out. But is it safe to say that maybe this is as good as it gets on the property cat side because there is this level of capital available? So that cycle will play out along historical lines?"
},
{
"speaker": "A - Marc Grandisson",
"text": "Yes. I will tell you Meyer is my experience, we did a lot of property cat writing in 01 in 02 and if you remember, at Arch, we were not heavily focused on property cat XL at the time, we were more on the liability side and the market was going down in 04 and well in 05. And we thought we had seen the last of the hard market for a little while and Katrina Rita and Wilma happened it change the whole thing. So my answer to you is, I don't know. I don't know is the short answer. I think that there's clearly a lot of capital that, again, found its way over the last four or five years. And once capital found its way to a niche, it gets sticky, it wants to stay there for a while and we will sort of justify itself for a while longer, perhaps than it should. But I think we're always hopefully it doesn't happen but we could be one major event away from changing the perception of risk in that area. And that I think will mean actually probably a much harder market you would expect Meyer because the volatility and the knee jerk reaction would be like an elastic like when this happens. I think you'll have a -- you may have a massive excessive capital out of the door. And that might create more opportunities for us. I'm not saying it will happen Meyer but I could see a scenario where your premise does not actually hold true. So there's always a chance."
},
{
"speaker": "Q - Meyer Shields",
"text": "Okay. No, I just want to understand what you're thinking about. Second, you talk, I think on the insurance segment about market dislocation. And I think maybe the sense is out there that that has been a major factor or was a major factor in 2020. But now most companies are kind of settling down and are comfortable with their books of business. Are you still seeing like today, that level of market dislocation?"
},
{
"speaker": "A - Marc Grandisson",
"text": "Dislocation is, you're right, there's some realignment, there is a couple of people, going back to the market, this is truly happening. But it's not across the board. And there are still, we believe bad news that needs to come find their way through the system. And that might make somewhat of a difference as we go forward. But again, if you had a 20% rate increase on one transaction on the insurance side this year and you had, this is on top of a 10% last year, if you get rate on, rate on rate perhaps three times it's not a bad place to be and plus, I think what we hear Meyer for what it's worth, and it's actually not insignificant, we're hearing terms and conditions funny changing and moving in the right direction. So rates will move first and terms and conditions sort of follow right behind them, we're hearing that this is what's happening in marketplace. So even though we may not have a headline, going as high in terms of reaching it as much as it was over last two, three years. I think underlying conditions in their policies, could actually help improve it way beyond the number that we see on -- as the headline number."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Meredith with UBS."
},
{
"speaker": "Q - Brian Meredith",
"text": "Couple of them for you here. The first one, Marc, first, I wonder if you could just confirm it used to be that your determination on whether you buy back your stock or not is that if you could actually recoup the premium you paid relative to book value over a three year period? Is that still the case? And if it is, does that basically mean that you could just continue to be pretty aggressive with your share buyback given where your stocks trading right now?"
},
{
"speaker": "A - Marc Grandisson",
"text": "Yes. I think that rule of thumb is still in place. I mean, obviously, it's not a black and white. I mean, there's always factors we consider around deploying, whether there's business opportunities and et cetera. But, yes, we still think in those terms of the buyback, the premium we bake and we want to earn it back over -- no more than three years. And you're right, I mean, I think the fact that the stock price is not as, is below that level, suggest that maybe we'll be up there buying more stock as we go through the year. Well, we'll assess, obviously, as we every day, every quarter, we will look at what's in front of us but for the time being, I think we're certainly something we're considering and we probably will do more of."
},
{
"speaker": "Q - Brian Meredith",
"text": "And then just on that topic. So just maybe a little bit on uses of capital or cash kind of here going forward in the next 12 months, it sounds like you've got 453 million that's going out here, we've got Watford that I think is yet to get the close, is that it's all going to be constraining to your ability to actually buy back stock, given you also capital you need to fund your growth in your business and particularly as Marc just said on the reinsurance business is going to be very capital kind of generated type transactions."
},
{
"speaker": "A - François Morin",
"text": "No, because we I mean, we raised a billion dollars of capital as you know last summer, we didn't deploy fully until, there was all part of that kind of on1/1 looking ahead as to what the 1/1 we were doing all these transactions, we're on the horizon. And we have a lot of faith in our ability to generate earnings moving forward on our own, I mean, self-funding the growth. I think is something that is part of the plan. And we don't really have, a whole lot of constraints other than that."
},
{
"speaker": "A - Marc Grandisson",
"text": "And Brian, both of these acquisitions, as you mentioned will actually be accretive and grow book value for us. So they're capital positive for us."
},
{
"speaker": "Q - Brian Meredith",
"text": "And then last question, I guess, now that is closed Coface, maybe you can give us a little bit of color and what the title insurance market looks like in Europe kind of return profile. What should we expect here?"
},
{
"speaker": "A - François Morin",
"text": "It's been about what, 20 minutes that we announced this, so you're going to have to give me a couple of more quarters."
},
{
"speaker": "Q - Brian Meredith",
"text": "[Is that] [ph] challenging?"
},
{
"speaker": "A - François Morin",
"text": "No. We have it but listen we got -- we have to think it through, we are going to have a directors on there to -- are going to be working very closely hand in hand with Coface and we're very excited as you know, Brian. I think there's more than meets the eye in this one. I think strategically, it's going to be a very, very valuable thing for us, way beyond just know the initial investment. I think it's a formidable, established company across so many countries with so many client contacts where we're really excited about that."
},
{
"speaker": "End of Q&A",
"text": ""
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you very much, everyone. Have a nice several months ahead. We're heading for the first quarter returns. It is an exciting time to be at Arch and we're very pleased that you are there with us to enjoy. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 3 | 2,020 | 2020-10-30 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Third Quarter 2020 Arch Capital Group Earnings Call. [Operator Instructions]. Before the company gets started with its update, management wants to remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your hosts for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sir, you may begin.
Marc Grandisson: Good morning, Liz. And welcome to our third quarter earnings call on Halloween Eve. You are in for a treat. In our results, you can see tangible evidence of the advantages of the Arch model. By protecting our capital during the soft market years, we are well positioned as each of our segments leans into improving market conditions. Our underwriters are making the most of the hardening property and casualty market, while our mortgage insure segment is benefiting from record mortgage origination activity this quarter. This year, for the first time in nearly a decade, we've been able to grow significantly and deploy more capital in our P&C businesses that provides acceptable expected returns. And due to our strong financial position, we have accomplished this while maintaining a strong presence in MI, which continues to deliver meaningful returns. Our ability to continually rebalance capital amongst our diverse businesses enhances our total underwriting returns. It also should decrease earnings volatility over time. Since our inception, we have believed in cycle management, and this strategy brings an added margin safety to our collective underwriting activity. Allow me to elaborate on our third quarter results by touching on 3 key themes: one, growth; two, margin improvement; and three, capital allocation. First, let's talk about growth. In this quarter, net written premiums in our P&C units grew 25% in total, 17% in insurance and 38% in reinsurance over the same period a year ago. This growth was driven by rate improvements, but also reflects our ability to increase our participations where clients needed additional capacity. In the insurance segment, we continued to obtain strong rate increases in areas like property, D&O and casualty. Group-wide, our rate increase for the third quarter averaged over 11%, and we believe this trend of increasing rates should continue through 2021. At Arch, we have always followed a simple rule: our participation in the business should follow the direction of premium rates. As rates improve, we write more business. When rate decrease, as they did over the past several years, we write less. This strategy takes courage. It will often appear an outlier to the market, but being intellectually honest, disciplined and applying our cycle management techniques is what we're all about at Arch. Obviously, the P&C market is broad, and all opportunities are not created equal. There are areas such as workers' comp where premium rate or conditions are not improving to the levels we believe are needed for an adequate return, and in those instances we manage our appetite accordingly. Despite headwinds from the pandemic, our growth in insurance lines are E&S property, casualty and professional lines are a great example of our platform's ability to flex into improved underwriting conditions. Our reinsurance unit has been able to lean into this hardening market both earlier and with more vigor than our primary operations. There are two main reasons for this. First, when the market transitions, needed rate increases compound up the insurance supply chain. Reinsurance is often a leading indicator of what's to come more broadly. Second, reinsurance can provide capacity quicker and in larger amounts, since it can put capital to work through clients' platforms. Of course, share growth is only one part of the equation of growing returns. Let's turn now to margin improvement. We all know that mathematically, rate increases in excess of loss trends lead to margin improvement. The marketplace seems to be supporting the momentum of continued rate increases. We are in the early stages of seeing the benefit of rate-on-rate increases in our operating results. Simply stated, adding the 2 parts, growth and margin will lead to better returns. Many factors are driving today's P&C markets. These include elevated natural cat loss activity in each of the past 4 years, weakened reserve positions from soft market years, lower investment yield and a rising claim inflation. Add in a global pandemic that is still ongoing, it's not surprising that market conditions are changing. Now pivoting to MI. Our $33 billion of NIW in the U.S. in the quarter was a record for Arch. Low interest rates are producing huge refinance activity and unsurprisingly, some churn in our in-force business. However, MI premium rates remain above pre-COVID levels, and the continued high credit quality of borrowers is generally better than it was pre-pandemic. We continue to face uncertainties such as the economy's health and how the pandemic may ultimately affect individual borrowers. However, we are optimistic that, among other positive factors, recent trends in the U.S. housing market will mitigate the effects of the pandemic. Finally, Arch's ability and willingness to allocate and manage capital remains a key competitive advantage. We always think about balancing our capital deployment over 5 pillars: into the insurance, reinsurance, MI, into our investment portfolio, and lastly into our stock repurchase. Our job is to optimize risk-adjusted returns through capital allocation across these pillars. We see managing the 5 pillars being similar to coaching a basketball team. We're constantly looking at how we can distribute the ball, i.e., our capital to the right players. For the past several years, we've been able to feed the big 7'7" MI guy down low and rely on him to get easy dunks. Now as a playing field, i.e., the market changes, we've adjusted our tactics slightly and are increasingly relying on our two hot shooters, reinsurance and insurance. MI will still score its fair share of points, but the P&C players are getting more open 3-point looks and layups. In short, our game is becoming more complete and diversified. Our ability to adapt the new conditions is what makes us stronger as a team. The market dynamics take me back in time. We have talked about Paul Ingrey's underwriting clock that helps track and measure the phases of the insurance cycle. It's been central to our management philosophy since the beginning and is a helpful reference to understand the underwriting life cycle and assist us in gauging our risk appetite. I recently asked our underwriting teams where we were on the Ingrey clock, and the most common response was around 8:00. If you take a look at the clock in our most recent annual report, you'll see that it's a very nice time to be at Arch. There's a buzz among our underwriters because we've become the first call for so many of our clients, that we have the capacity, the expertise and the desire to serve them. Now I'll turn the coach's whistle over to François, as he goes into more detail on our quarterly results. And I look forward to responding to your questions afterwards. François?
François Morin: Thank you, Marc, and good morning to all. We at Arch hope that you are in good health. On to the third quarter results. As a reminder and consistent with prior practice, the following comments are on a core basis, which corresponds to Arch's financial results excluding the other segment, i.e. the operations of Watford Holdings Limited. In our filings, the term Consolidated includes Watford. After-tax operating income for the quarter was $120.3 million, which translates to an annualized 4.2% operating return on average common equity and $0.29 per share. Book value per share increased to $28.75 at September 30, up 4.1% from last quarter and 12.2% from 1 year ago. The increase in the quarter was yield by the continued strong performance of our investment portfolio and good underwriting results, taking into consideration the elevated catastrophe activity in the quarter and the uncertainty surrounding the current pandemic. Our property casualty teams continued on their path of solid growth and improved performance as we continue to see strong positive pricing momentum in their markets. Losses from 2020 catastrophic events in the quarter including COVID-19, net of reinsurance recoverables and reinstatement premiums, stood at $203.3 million or 12.5 combined ratio points compared to 5.2 combined ratio points in the third quarter of 2019. The losses impacted both our insurance and reinsurance segments and include $191.4 million from a series of natural catastrophes in the quarter including Hurricanes Isaias, Laura and Sally, the Midwestern Tornado, California wildfires and other smaller events, as well as $11.9 million for losses related to the COVID-19 pandemic. The COVID-19 losses we recorded in the quarter were small, reflecting additional information that became available during the quarter and represent our current assessment and best estimate of the ultimate losses for occurrences through September 30 based on policy terms and conditions including limits, sub-limits and deductibles. As of September 30, the vast majority of our COVID-19 claims are yet to be settled or paid, with close to 80% of the inception-to-date incurred loss amount recorded as incurred but not reported, i.e. IBNR reserves, or as additional case reserves within our insurance and reinsurance segments. As regards the potential impact of COVID-19 on our mortgage segment, we note that the delinquency rate at the end of the quarter was 4.69%, down from 5.14% at June 30. Our current expectation is that the delinquency rate should be in the 5% to 5.5% range at year-end 2020. While we have seen many positive signs over the last few months that point us to a more favorable view of the ultimate performance of the U.S. MI book, many of the uncertainties we identified on our last call remain, in particular, the potential impact from a second wave of infections, potential lockdowns and the lack of an additional fiscal stimulus package or risk factors that we continue to monitor and evaluate on an ongoing basis. For these reasons, and consistent with our corporate reserving philosophy, we believe it is prudent to take a cautious approach in setting loss reserves across our MI book. In the insurance segment, net written premium grew 17.1% over the same quarter 1 year ago, a strong result demonstrating our ability to achieve profitable growth in this environment. Adjusting for the net written premium decrease observed in our travel, accident and health unit, the year-over-year growth in net written premium would have been 26.5%. The insurance segment's accident quarter combined ratio excluding cats was 94.1%, lower by 620 basis points from the same period 1 year ago. Approximately 300 basis points of the difference is due to a lower expense ratio, primarily from the growth in the premium base from 1 year ago and reduced levels of travel and entertainment expenses this quarter. The lower ex-cat accident quarter loss ratio reflects mix change and the benefits of rate increases achieved over the last 12 months. Prior period net loss reserve development net of related adjustments was favorable at $1.1 million, generally consistent with the level recorded in the third quarter of 2019. As for our reinsurance operations, we had strong growth of 38.4% in net written premiums on a year-over-year basis, which was observed across most of our lines and includes a combination of new business opportunities rate increases and the integration of the Barbican reinsurance business. The segment's accident quarter combined ratio excluding cats stood at 83.1% and compared to 92.8% on the same basis 1 year ago. The year-over-year movement is primarily driven by a more normal level of large attritional losses compared to a year ago and rate change activity over the last 12 months. Most of the remaining difference is explained by operating expense ratio improvements, primarily resulting from the growth in earned premium. Favorable prior period net loss reserve development, net of related adjustments, was $40.8 million or 7.4 combined ratio points compared to 4.0 combined ratio points in the third quarter of 2019. The development was mostly in short-tail lines. The mortgage industry had a record-breaking quarter in terms of NIW, and we certainly followed suit with this quarter's NIW of 38 -- $32.8 billion, a full 30% higher than our prior high-water mark. Offsetting this record level of production was the high level of refinancing activity across our portfolio, with the net result being a slight reduction in our insurance in force. The combined ratio was 64.2%, reflecting the lower delinquency rate observed during the quarter. The trends we saw this quarter were favorable relative to last quarter, but the game is far from over. The expense ratio was slightly lower over the same quarter 1 year ago. And prior period net loss reserve development was favorable at $4.5 million this quarter. Total investment return for the quarter was positive 230 basis points on a U.S. dollar basis as the strong recovery in the capital market produced healthy returns across our entire portfolio. Returns in our equity and alternative investments contributed approximately 40% of the total return for the quarter. The duration of our investment portfolio remained basically unchanged from the prior quarter at 3.21 years. The effective tax rate on pretax operating income was 4.8% in the quarter, reflecting a change in the full year estimated tax rate, the geographic mix of our pretax income, and a 10 basis point benefit from discrete tax items in the quarter. As always, the effective tax rate could vary depending on the level and location of income or loss and varying tax rates in each jurisdiction. We currently estimate the full year tax rate to be in the 8% to 10% range for 2020. Turning briefly to risk management. Our natural cat P&L on a net basis increased to $918 million as of October 1 which, at approximately 8.4% of tangible common equity, remains well below our internal limits at the single event 1-in-250-year return level. The growth in the P&L this quarter is attributable to our E&S property unit within the insurance segment, which increased its writings in an improving marketplace. On the capital front, the increase in interest expense this quarter was mainly the result of the issuance of the $1 billion senior notes we issued in June 2020. So far, we have been able to fund our recent growth with our existing capital base. And our balance sheet remains strong, with a debt plus preferred leverage ratio of 23.1% that remains well within a reasonable range. As for our U.S. MI operations, the mortgage insurance-linked notes market has recovered to a great extent from the lows we saw at the onset of the pandemic. Earlier this week, we priced our third Bellemeade transaction of the year at terms that are getting closer to what we saw in 2019, both in structure and price. Our latest transaction will provide 6.5% of coverage in excess of a 2.5% attachment point, both expressed as a percentage of the risk in force. Including this transaction, the Bellemeade structures currently provide approximately $3.9 billion of aggregate reinsurance coverage -- coverage. The fact that this market has recovered as extensively as it has in just over 7 months, with investors more and more comfortable with the exposure they are assuming, is quite telling and provide support to our current assessment of the health of the using the U.S. housing market. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions]. First question comes from Elyse Greenspan with Wells Fargo.
Elyse Greenspan: My first question is on the capital allocation, so what you laid out, 5 pillars. I just want to confirm, I guess, based off of how you were talking. It sounds like share repurchase is left kind of on the chain right now. And I guess because it seems like you have such good growth opportunities that you could put your capital to use just basically to incrementally add to your insurance and reinsurance writings? Am I understanding that correct?
Marc Grandisson: So yes. I didn't mean to put them in ranking order. I think that they are probably all very equally attractive at this point in time. I think that we're investigating, as you know, on a quarterly basis as to what the opportunities are in various signs of business. I didn't mean to name stock purchase as the last one as a rank ordering mechanism. I think that is also part and parcel of the discussion. I think that for the first time in a while, I would argue that the 5 players actually are actively making the point for receiving ball, the ball and play and be part of the game. So I would definitely say that. And we're evaluating. But certainly, our game number one, our focus number one is to allocate capital to the underwriting units. If the returns are there. And that certainly is a relatively easier place to deploy and easier what you see at this point in time. But everything is up, everything is -- every guy -- everybody is playing on the field, on the court.
Elyse Greenspan: Okay. That's helpful. And then my second question on your insurance underlying margin, 94% in the quarter. Arch had targeted to get to kind of a mid-90s. Yet you guys are kind of there, but there's more -- you mentioned a lot of rate, I think, 11% that you're getting in your book of business, which means you haven't even earned that in yet. So as we think about the earning in of the rate you're getting today, plus what seems like incremental rate you could get into 2021, do you have a new target for that business? Or is there a way that we can think about the margin profile there, especially since you've kind of hit that target that you laid out for the Street?
Marc Grandisson: Yes. So let me go back to the 95% combined, which I mentioned, I think, 3 years ago now. I think that was meant to be there as an aspirational target and to shoot for at that point in time, based on the mix of business and the opportunities that we had in the marketplace. I think this has changed, right? I think that now that we're obviously going in that direction and very nicely, and the market is certainly helping us, I think we still look very heavily into line by line and ROE by line of business. And I would argue, Elyse, that some lines of business would be less than a 95% combined and some might be still okay at above 95%. But certainly, what I would tell you is the combined ratio was aspirational. We have to keep in mind that there's still -- COVID-19 is still ongoing. And secondly, interest rates have also been decreased -- have decreased significantly since 3 years ago. So rate increases might be needed beyond the combined ratio, just to make the returns equivalent to what they should be, or would have been at the 95% historically. So it's really an ongoing process of reflecting current investment yield. So there are no targets on the combined ratio. But certainly target on a return basis. And I would agree with the 140 to 150 -- 150 bps decrease in interest rate, that the combined ratio would presumably mathematically need to go down to make an equivalent return.
Elyse Greenspan: Okay. That's helpful. And then last question, you mentioned taking a cautious approach to reserving within your mortgage book. And then I think you also laid out that default rate to get to 5% to 5.5 by the end of the year. And so I'm just trying to understand like as the default rate, I guess, your expectation is it will go up a little bit from where it sits today. And I'm assuming that you'll continue with the same conservative approach that we saw in the third quarter. So how should we think about kind of the combined ratio? You've been giving some metrics for how that business could trend. And you've obviously come in better than expected in the second and the third quarter. Do you have an expectation for how that could ultimately trend into Q4? And I imagine if you want to provide initial color on 2021.
François Morin: Yes. I'll take that, Elyse. I mean just to be pretty clear, I think I -- as you guys all know, I'll take the blame. I did a pretty poor job of forecasting combined ratios or delinquency rates over the last 2 calls. So I think we're trying to minimize the kind of bad forecasts. But listen, there's -- as we know, there's a lot of uncertainty out there. Yes, we're extremely pleased that the delinquency rates have come down, right? We had talked about even just last quarter, we had said like somewhere around 8% by the end of the year. It doesn't look like we're going to -- it's going to be as bad as that, based on what we know today. Still a few months to go, but definitely saw some encouraging signs this quarter. So that's all well and good. Does it translate to -- what kind of combined ratio does it translate to? I mean it's hard to know because again what we're facing is really -- we just don't know how long this pandemic is going to last. The fact that the forbearance programs are at this point scheduled to end, but who knows if they get extended or not? And how do people convert from forbearance to a regular delinquency? There's a lot of unknowns at this point that we feel are extremely hard to predict and estimate. So listen, we're taking it one quarter at a time. We're happy with where things are at right now. Again, it's reassuring, but we're not -- as I said, we're -- the game's far from over. And who knows, maybe hopefully even my 5% to 5.5% forecast or expectation for delinquency ends up being a bit high. But we'll find out in a few months, and we'll reassess at that point.
Operator: Our next question comes from Jimmy Bhullar with JPMorgan.
Jamminder Bhullar: First, I just had a question on how you're thinking about pricing, reinsurance pricing as a buyer of reinsurance? And how should we think about your sort of overall exposure, especially to cats as you're entering 2021? Are you, given better pricing, you can hold more exposure? Or maybe should we assume that you'll keep your retention sort of similar and be a buyer of record regardless of prices?
François Morin: Short answer is we don't know yet, right? I think we'll have to see what the 1 1 brings to our reinsurance folks on the inward side and certainly on our E&S property. We'll have to evaluate and assess what kind of exposure and what kind of margins we're getting there, and then look back and say, okay now, what is the -- because buying reinsurance, as you know, is like raising, it's like using capital. It's like we have to pay for that. So we're going to go through a very straightforward analysis of capital usage and what we pay for it. And we take a very, very first economic view of the whole world, and specifically as it relates to the insurance exposure we take on a property cat exposure specifically. But having said all this, we also have -- balancing it or adding to that information process is that we also are careful and not overstretching the capital. So we'll always be buying reinsurance to some extent. The question is what level and how much and at what price. But clearly we are -- we like stability, and we're always trading stability for sometimes lesser margin, and that's going to be part of the mix. But clearly both markets where we can be on the advantage, we can gain both sides, but we can actually get rate increases on the insurance side, find a way to buy reinsurance in a good way. And on the assumed basis, we actually are benefiting from the improvement in the market there as well. So it's really a holistic view of the cat exposure. Too early to tell what exactly is going to transpire, but everything is always up for discussion.
Jamminder Bhullar: Okay. And then on Watford, you raised the price. There's pressure on yield to raise it again. And at what point does the deal become sort of uneconomic? And -- or are you already there? Or any comments on how you're thinking about that situation?
Marc Grandisson: Well, I mean we didn't -- we did not raise the price, right? We have an agreement, we have a signed agreement with Watford that we're starting the process to get regulatory approvals, et cetera. But yes, I mean there's another party that has come in that Watford feels they have to look into their potential offer and what it means to them. But at this point, what's been announced is what is still valid. Depending on what they end up deciding, we may choose to do something different. But at this point, we can't really say much more than that.
Operator: Our next question comes from Mike Zaremski with Crédit Suisse.
Michael Zaremski: Yes. Focusing on the reinsurance segment, robust growth. Thanks for the commentary, bullish commentary. If we look at the underlying accident year loss ratio, I mean actually expense ratio too, so just a lot of improvement. Anything we should be thinking about? Anything to call out? Or are this just market conditions and operating leverage that you're benefiting from?
Marc Grandisson: Yes. So then the reinsurance group has grown tremendously. So the expense ratio going down, or what it did certainly is explained by that in large part. I think in terms of the loss ratio, what I would like -- and we said it on prior calls as well is we tend to look at reinsurance performance on a 12- to 18-month basis. There's a lot more volatility in that segment, in that sector. There's also a lot of shift in the mix over time. Our reinsurance folks do not tend to have a -- they have stable relationships obviously, but there's a lot of things moving on in terms of taking cede and the opportunities in the marketplace. So what I would look at the loss ratio is more like this is -- some quarters is much better than others. And it's really due to the volatility in the reinsurance results, I would say.
Michael Zaremski: Okay. Okay. Got it. So the expense ratio, some of that's going to roll in. Okay. A follow-up on the mortgage side, I think I heard you say earlier that ILN pricing kind of had improved a lot. I guess I'm looking at -- we're trying to -- we've been trying to track overall ILN pricing. And maybe kind of still double what it was pre-pandemic, but maybe I'm just looking. Maybe Arch's pricing is better, or maybe I'm just incorrect?
François Morin: Yes. I mean there's two parts there, right? Is the structure, meaning in particular attachment points, and then the pricing. So right, so this is our third one, our first one of the year. Really, we were the first ones out of the gate after the pandemic. The reality at that point is appetite from the investors was not as good as it was in the past when our attachment point was much higher. Second one, attachment point came down with slightly better pricing. With this new latest one, we're effectively back to the same -- the 2.5% attachment point that we had seen pre-COVID. So that's certainly by design. Pricing, if you risk adjust for everything, it's still up, no question. It's not the same level that it was pre-COVID, but it's not double for sure. So it's much better than that, much lower than that [indiscernible] quality of the book is better. So how does that get factored in? And so there's a couple of other things. It's hard to make it perfectly apples-to-apples. But directionally and on an absolute basis as well, we're very happy with where things are going.
Michael Zaremski: Okay. Got it. That's helpful because I think you're describing it better than what we thought. Okay. And lastly, sticking on mortgage, hopefully -- you said you -- the delinquency rate doesn't pick up as much as you thought. But are you -- it's almost November. Have you seen, over the last 2 weeks, the delinquency rate tick up?
François Morin: So last few weeks, it's been actually keeping in the same general direction that we saw in the third quarter. So it hasn't picked up. Flattish, I'd call it. We got a couple of months to go. We'll see how things play out, but that's kind of what we're seeing.
Operator: Our next question comes from Josh Shanker with Bank of America.
Joshua Shanker: Two questions, one just to understand accounting and the other one is about Watford. On the accounting, you had a decline in delinquencies due to cures of 6,000 approximately, but you took up reserves. I know you can't really reserve for loss that hasn't happened yet, but it looks like you're reserving for these new claims at about $12,000, $13,000 per claim compared to a historical average of $4,000 to $5,000 per claim. Am I doing the math correctly? And can you explain sort of how you think about that in the books? I think in the first quarter, you also took up reserves more than typical because you can only take them up when you have claims. But can you walk through that a little bit?
François Morin: Yes. No question that we bumped up reserves this quarter on effectively the delinquencies that we saw in the second quarter. So your math is correct. I mean that's -- I mean the reserves per delinquency, you did the math, right? But what you need to adjust for, I would say, is call it a reserve-strengthening exercise that we went through just to reassess where we were -- took a hard -- every quarter, we take a hard look. And our view is that might as well not -- be cautious, knowing what we know and knowing what we don't know. So think of about a $45 million adjustment on reserves in the third quarter for effectively Q2 delinquencies. So once you adjust for that, I think you get back to claim levels or severities that you would be -- would be more in line with what maybe you would have expected.
Joshua Shanker: So along those lines, is there a reason to believe that the severity of the losses are going to be different than historical severities? I can understand because there's not frequencies and you can't really take frequencies until you get a claim. But is there reason to be more cautious surrounding severity in this pandemic?
François Morin: We don't see it. The only adjustment obviously that what we're reporting in our supplement in terms of paid severities is lower than what we're seeing from the new delinquencies, right? New delinquencies, we mentioned it last quarter at about a $65,000 or so or per NOD. This quarter, it's right around $60,000. So I mean it's certainly higher because it's more recent loans that are going delinquent versus what the loans we paid on in the quarter. So that's the only adjustment. But in terms of percentage of the insured value or the insurance in force or the risk in force, we don't at this point, don't have a reason to think that it's going to be materially different than what it's been in the past.
Joshua Shanker: Okay. And then on Watford, we don't know how it's going to turn out. But your own stock trades around book value. The offers for Watford are around 0.8x book. I'm not sure, and maybe you've some thoughts on whether Watford is a better investment at 0.8x book than Arch is that 1x book. But if you don't buy in Watford, it would suggest that you have a chunk of excess capital that you were already allocating towards financial uses. Can we expect that your interest in buying business you already know is attractive, even given the market opportunities here?
Marc Grandisson: I think we made the point clear by putting our offer up there, and that's pretty much what we'll leave it as, Josh. I think we're we still think that Watford is a good platform, a valuable platform. And we--
Joshua Shanker: But clearly Arch is a more valuable platform than Watford. If you're willing to buy in Watford stock, shouldn't you be willing to buy in Arch stock as well?
Marc Grandisson: I think the answer is always yes. We're always looking at the possibility of buying our stock. And certainly like I said before, 5 players on the court, I think that the share repurchase is really -- is attractive, as you would expect me to say as the CEO of the company.
Joshua Shanker: All right. We'll keep watching.
Operator: Our next question comes from Yaron Kinar with Goldman Sachs.
Yaron Kinar: I do want to start by thanking you for giving a basketball analogy, so I can actually understand what's going on. I was worried you'd give a hockey analogy. And my first question goes to the slight increase in COVID losses in the quarter. Can you maybe talk about what drove that specifically? I guess specifically, what I want to get at is does it have anything to do with the FCA court cases over in the U.K. and how you're thinking about your overseas business interruption exposures?
François Morin: Yes. I mean it's really in two parts. I think in the -- on the insurance side, it's very much -- it's all basically related to our travel book in the U.S. So no connection to the FCA ruling. And the little bit we added in the reinsurance side is around property exposures, mostly out of Europe. So it's a little bit of a BI angle to it, but that's pretty much it. So I mean it's -- I mean I call it a bit of just new information coming in, nothing -- no, nothing kind of -- no material new information that came through that would have caused us to revisit our picks. And the FCA, as we said, we didn't change it. And the ruling where it stands, it's -- we're still very much -- we had fully reserved for it. And there's -- again, the ruling doesn't change our position on that.
Marc Grandisson: The rest of the portfolio, Yaron, for what it's worth, and we mentioned that on prior calls, is that we have the vast majority, almost totality of our parties have the exclusions that would protect us somewhat from a deviation. So this is nothing in there to really think about.
Yaron Kinar: Okay. That's very helpful. And then my second question, when you talked about the improvement in the ACI loss ratio for insurance, you didn't talk about total frequency. So is it because you didn't see that? Or is it because you didn't book that?
François Morin: It's a little bit of both actually. We saw some of it -- some improvement on the frequency of claims possibly in the second quarter. That was definitely a difference. But if you neutralize for the obvious lines of business where claims would actually naturally go down, such has travel for instance where we have the a lot less exposure or go up. Then if you neutralize all of this, we didn't see a discernible change through the 9 months of this year. It's hard to see what the natural rate would be, but we don't see a discernible change in the frequency to speak of. And really, we put our reserve pick and our loss pick based on long-term trend -- long-term averages. We're not looking at specifically one quarter at a time and one year, accident year at a time. We do get in the mix of multiple years and project out much more longer term expected. So it will take a little while before we would recognize any significant improvement in frequency of claims, if at all.
Yaron Kinar: Got it. And then maybe one final very quick one on Watford, if the deal does go through, I just want to confirm that the company wouldn't lose the fee income if Watford is consolidated, right?
François Morin: Correct.
Operator: Our next question comes from Ryan Tunis with Autonomous Research.
Ryan Tunis: The one I had was just on NII and thinking about low rate headwinds. It looks like you guys have almost 30% of your assets in essentially government bonds. Looks your portfolio yield is sub 2. We just heard another Bermuda competitor today say that their new money yield is 2%. It would seem to me, given how you're allocated, given your current portfolio yield, that there actually wouldn't be that much incremental yield headwind moving forward actually. Arguably if you're going to move out of some of the govies and take some credit risk will actually seem that maybe you could expand your portfolio yield? It doesn't sound like that's right, given your commentary. But I'm just kind of trying to understand like why does Arch continue to be incrementally exposed to this low rate environment, given the fact that you guys have already really take it on the trend in terms of where your yields are now.
François Morin: Yes. I mean we -- no question, we've been defensive on credit. So yes, we have a bit more on the treasury side that you're right, I mean -- unless rate going down, but they seem to have stabilized, I guess, for the time being. Our play in the last few quarters has been trying to, as many others I'm sure have done the same, is try to find other opportunities that are more in the alternative space that provide us still some level of investment income without taking on too much risk. So something we keep looking at, but it's a bit of a challenge. There's not a ton of opportunities out there. We're not -- we're worried a little bit. We're defensive on credit still, and that's something that we look at carefully. We don't want to over-source ourselves there yet.
Ryan Tunis: Do you guys have a new money investment yield you'd call out handy that you did in the third quarter.
François Morin: Well, the last, call it in the last month, we've been, call it putting our money to work. It's just above 2%. So that's kind of where the latest informational gap that we get from our investment guys.
Operator: Our next question comes from Geoff Dunn with Dowling & Partners.
Geoffrey Dunn: First question, and I appreciate the added color around the MI reserving. If we make the adjustment, is the math correct that you changed your incidence assumption up to about 9%?
François Morin: Close enough. 8% to 9%, yes. Yes. And our view on that is that we feel like that the more recent NODs are -- may be prone to a bit more stress. So the fact that these people took a bit longer to go into delinquency may tell us that there may be again subject to more stress, but again time will tell.
Geoffrey Dunn: And is that 9%, is that a -- just an overall number? Or is it a blend of just as an example, 6% on forbearance and 13% on non-forbearance notices? Do you delineate between the 2? Or is it just more of a holistic approach?
François Morin: It's more of an aggregate approach that we take. Yes. We don't separate the 2 as cleanly as you're suggesting, yes.
Marc Grandisson: We do look at all...
François Morin: Geoff, I want to make sure you understand that we also do look at prior events, prior cat events, prior programs of the sort. So -- but it's -- as you could appreciate, it's probably more art than science at this point in time.
Geoffrey Dunn: Right. With the new ILN, a little confusing in the documentation. It looks like it applies for policies after Jan 19, but it looks primarily more recent loans over the last 3, 4 months. What is it designed to do? Is it really the last quarter or so?
François Morin: Yes.
Geoffrey Dunn: Or is it part of the design to come underneath the 20-1?
François Morin: No. It's the latest, the 20-3 is very much -- the vast majority is covering June, July and August, so that's 3 months of production. There's a little bit of kind of spillage of the 20-2 that -- and also some 2019 loans that had kind of been late being processed, whatever. It's just -- we're a little bit of a catch-up on a few small things, but think of it as really June, July, August production.
Operator: Our next question comes from Meyer Shields with KBW.
Meyer Shields: Marc, I'm a little confused by something that you said. You were talking about the five capital deployment opportunities. And you cited the investment portfolio. And I guess I would have thought that if you're going to be writing more P&C or mortgage insurance, then the supporting capital will be in the investment portfolio anyway?
Marc Grandisson: Yes. So you're saying that we should -- just repeat the question, Meyer, please.
Meyer Shields: So I'm trying to figure out how capital deployment in the investment portfolio is distinct from capital deployment to either P&C mortgage.
Marc Grandisson: Okay. No I see what you mean. So the way we look at the underwriting returns is we attribute to the units the treasury return or the risk-free return. And we try and separate church and state is what we call it internally. We actually credit the float on the insurance on the underwriting piece at the treasury rate level. And then we allocate the capital for the excess over that to the investment portfolio. So this is how we separate the capital usage between those -- between the underwriting units and the investment unit.
Meyer Shields: Okay. That makes sense. Got it.
Marc Grandisson: Yes.
Meyer Shields: I'm trying to get a general sense of how you see either profitability in property casualty in metro? Or your view as to whether the vendor catastrophe models are conservative enough, based on recent years' cat activity and the underlying trends?
Marc Grandisson: Yes, it's a good question, Meyer. I think that our position on this, we have weather scientists upstairs and --who have a lot of lengthy experience and information to look at. Listen, we actually augment and modify the vendor models as we see fit. So the vendor model represents to us a solid starting point. From where we can -- there's definitely had a lot of science into this one. So we've been historically using them as a starting point and augmenting it and modifying it with our own view of the world. But I would caution everyone by saying that, yes, we do have a view of various perils and various exposure around the world. And we also try to factor in shorter term versus longer term, possibly modification of what could happen out there. But it's hard to predict those things. So what we tend to do is to hold ourselves to a higher return for those risks that are inherent in the way we underwrite the business. That also helps explain why where we've taken possibly somewhat of a more conservative approach to property cat exposure over the last 4, 5 years as you've seen our numbers. So I think -- and it's a year-on-year analysis, so we would look at it. And we'll evaluate, I think, in some of our discussion with El Nino, La Nina and all these various discussions happening all the time. And we're not the largest rider property cat, but we do have a very solid team looking into this. But I think we make it up -- try to make it up with holding ourselves up to a higher level of returns.
Operator: Our next question comes from Phil Stefano with Deutsche Bank.
Philip Stefano: Just one -- most have been asked and answered. One follow-up on the MI piece and thinking about the increase in the default rate. I guess in my mind, there are 3 mechanisms to get there. It's either new defaults are increasing, cures are slowing down, or the denominator policies in force is shrinking. I'm just curious how you're contemplating which of those levers is contributing to the increase in the default rate. I think it helps us think about does this come through as losses or premiums or maybe development if the cures are right.
François Morin: Okay. So Phil, let me try and take this. There's a lot of -- it's a big question, a lot of parts. So first and foremost, the denominator is not changing a whole lot, right? It's about a [indiscernible] what it is in terms of policy. The DQ rate has decreased this quarter, right? It went from 5.1 to about 4.7 this quarter. So this is like what's the number of policies at the numerator that are in default. And you divide by a similar number. So it did go down. I think what we're saying in terms of reserving, you reserve for the new notices that you received in the quarter, right? We received 58,000 in the second quarter. We received 20,000 this quarter. And what we're telling you is we take that, the book of these 20,000 new notices. The cures are the cure. They go away from the overall balance, if you will, that we just mentioned, which is the 4.7. But the new notices, we reserve for those in the quarter. So we have to reserve in the quarter on those that were newly notified. This is what typically you would do on reserving. What we did in addition to this is we modified our view of what we should have booked for the second quarter for the new notices in that quarter. So I'm not sure -- I'm trying to help give you a picture a whole -- bigger picture hopefully that helps you understand how we did all this.
Philip Stefano: No, I understand -- that makes sense from the reserving side. But the default rate is loans in default, that population over policies in force.
François Morin: Right.
Philip Stefano: And if the policies in force isn't changing and the default rate is going up, then presumably there's an expectation that new default is going to increase this quarter. And I guess I just wanted to make sure that I was thinking about it correctly because I -- to get to 4.7 to 5, 5.5, there must be an acceleration in new default, or cures is slowing down. I don't know. That's kind of the question.
François Morin: I mean that's -- listen, it's a big -- I mean kind of top-down view. It's hard to know. We don't have -- we can't predict. We don't have the crystal ball on whether cures are going to accelerate or not or slow down. And same thing with new notices. Again, we're trying to, I think, just provide a bit of color that we think the -- obviously or knock on wood, we're not going to be at 8% delinquency rate by the end of the year. We're certainly well below 5%. Does it go back to above 5% by the end of the year? That's what we think could happen, but again we don't know. So I think if everything stays the same, the odds are probably that it won't be at 5%. But we -- that's...
Marc Grandisson: But Phil, you're right. You're right on your assessment. If we go from 4.7, and we tell you it's going to be 5.5 in the end, that we'll have to have an increase in NODs or lesser cure. I'm not sure we have made enough assessment as to which is which. I would argue that we have tended to -- since May, we have tended to -- at least the last two quarters, we've overstated the amount, the number of new NODs that we received. And that probably is what would drive the potential. We just still don't know. François has said that we haven't been as good as we would have liked to be predicting. So I think the new NODs would be more the place to look at. Having said this, Phil, you also know that we had 2 things going on, less new NODs and higher cure rate. So they both actually helped to manage on. And they helped accelerate and actually go -- no, help explain why we had a projection of about 10% earlier in the year to much less right now. They are two moving parts.
Philip Stefano: Yes. No, understood. I guess in my mind, this default rate might continue to come down. But as you said...
Marc Grandisson: Yes, it very well could do. Yes.
Philip Stefano: The crystal ball is very cloudy at this point.
Operator: Our next question comes from Brian Meredith with UBS.
Brian Meredith: I have a couple for you just quickly. So just curious, given that you're getting 2% new money yields and your book yield is below that, should we just expect that your book yield on your investment portfolio fixed income to kind of be stable here going forward?
François Morin: I think in the short term, I think it's reasonable, yes.
Brian Meredith: Okay. Good. That's helpful. Second question on the reinsurance business, I'm just curious. Your property mix is definitely increasing as a percentage of your overall book. How much of the underlying combined ratio improvement that you're seeing there is actually driven by that mix shift versus just better loss specs?
François Morin: Well, boy, I don't think we parse out this way. It's still early in the game to see what it's going to look like. I would say that it's probably more mixed at this point in time because our growth is largely in property other than cat, cat XL. So we have a lot of play in that sector right now. It's more and more mix, I would say, Brian.
Brian Meredith: Yes. So it's not so much the rate activity that we're seeing, it's the mix shift that's driving it?
François Morin: Well, the way we are, you know us, Brian, for all these years is we'll tend to go where the rates are the better -- we have a better increase in margin. So that sort of goes hand in hand.
Brian Meredith: Got you. That makes sense. Another one just quickly on Watford, I'm just curious. Is it your guys' intentions to significantly increase your ownership in that ultimately? Or are you going to buy the whole thing in? Just because the volatility of the investment portfolio is kind of just a different strategy.
Marc Grandisson: Well, what we said publicly is that we are certainly talking to other parties to bring into the fold to support us in this vehicle, if it moves forward, if we close on the acquisition. So the answer is we would most likely increase our participation, but not to 100%, and be much less than that. So increase little bit, but recognize that we -- it's a different model that we -- others would want to participate on with us as well.
Brian Meredith: Got you. So the net capital outlay for the transaction wouldn't be this big as it could? Okay. That makes sense.
Marc Grandisson: Correct. Correct.
Brian Meredith: Got you. And then last question, I'm just curious. Any updates with respect to the Coface investment, where that stands? Are regulators going to ultimately make a decision on this?
Marc Grandisson: Yes. I think it's in process. We're going through the regular process. It's in -- It's on track. We're hopeful that we could get something done potentially in the first quarter, second quarter of next year. It takes a while, as you know, in this COVID environment. Government and regulators take a little while longer than otherwise. But yes, it's on track. And they produced, as you know, their results I believe earlier this week or early or late last week. So it's also looking much better for them, which is good for us.
Operator: Our next question comes from Jimmy Bhullar with JPMorgan.
Jamminder Bhullar: I just wanted to clarify your comments on not losing the fee income on Watford. Is that just because of the 5 years remaining on the contract, and so there's sort of finite life to it? Or was there something else that was behind that comment?
François Morin: Well, I mean the question was asked, if we buy the vehicle, do we still retain the fees? The answer is yes.
Jamminder Bhullar: Yes, it's an internal allocation then. But in case it goes to somebody else, then that fee arrangement stays intact through the [indiscernible], which is [indiscernible]
François Morin: Yes. Correct.
Jamminder Bhullar: Okay. And then does your approach to underwriting overall and how much sort of capacity you have and take on [indiscernible] change if you own Watford versus maybe if it does end up being bought by a third party at a higher offer?
François Morin: I think in a third-party environment, Jim, I think it's pretty clear that we need to take care of our brethren as well as we could take of ourselves. So our view is always to do the similar underwriting. Watford had a different investment profile, which allowed us to do slightly different things. But at a high level, the underwriting is very, very similar. And I would remind everyone that whatever we do on Watford, we take 15% of it on a quarter share basis in the back. We also are participating on the capital. We had like we're up about 13%, I believe, in our shareholding. So we collectively own 20% of the underwriting. So we do eat our own cooking there as well, and it's really important to us.
Operator: I'm not showing any further questions. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thank you, everyone. Looking forward to the last remaining couple of months in the year, and I hope you have a good one.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Third Quarter 2020 Arch Capital Group Earnings Call. [Operator Instructions]. Before the company gets started with its update, management wants to remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your hosts for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sir, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Good morning, Liz. And welcome to our third quarter earnings call on Halloween Eve. You are in for a treat. In our results, you can see tangible evidence of the advantages of the Arch model. By protecting our capital during the soft market years, we are well positioned as each of our segments leans into improving market conditions. Our underwriters are making the most of the hardening property and casualty market, while our mortgage insure segment is benefiting from record mortgage origination activity this quarter. This year, for the first time in nearly a decade, we've been able to grow significantly and deploy more capital in our P&C businesses that provides acceptable expected returns. And due to our strong financial position, we have accomplished this while maintaining a strong presence in MI, which continues to deliver meaningful returns. Our ability to continually rebalance capital amongst our diverse businesses enhances our total underwriting returns. It also should decrease earnings volatility over time. Since our inception, we have believed in cycle management, and this strategy brings an added margin safety to our collective underwriting activity. Allow me to elaborate on our third quarter results by touching on 3 key themes: one, growth; two, margin improvement; and three, capital allocation. First, let's talk about growth. In this quarter, net written premiums in our P&C units grew 25% in total, 17% in insurance and 38% in reinsurance over the same period a year ago. This growth was driven by rate improvements, but also reflects our ability to increase our participations where clients needed additional capacity. In the insurance segment, we continued to obtain strong rate increases in areas like property, D&O and casualty. Group-wide, our rate increase for the third quarter averaged over 11%, and we believe this trend of increasing rates should continue through 2021. At Arch, we have always followed a simple rule: our participation in the business should follow the direction of premium rates. As rates improve, we write more business. When rate decrease, as they did over the past several years, we write less. This strategy takes courage. It will often appear an outlier to the market, but being intellectually honest, disciplined and applying our cycle management techniques is what we're all about at Arch. Obviously, the P&C market is broad, and all opportunities are not created equal. There are areas such as workers' comp where premium rate or conditions are not improving to the levels we believe are needed for an adequate return, and in those instances we manage our appetite accordingly. Despite headwinds from the pandemic, our growth in insurance lines are E&S property, casualty and professional lines are a great example of our platform's ability to flex into improved underwriting conditions. Our reinsurance unit has been able to lean into this hardening market both earlier and with more vigor than our primary operations. There are two main reasons for this. First, when the market transitions, needed rate increases compound up the insurance supply chain. Reinsurance is often a leading indicator of what's to come more broadly. Second, reinsurance can provide capacity quicker and in larger amounts, since it can put capital to work through clients' platforms. Of course, share growth is only one part of the equation of growing returns. Let's turn now to margin improvement. We all know that mathematically, rate increases in excess of loss trends lead to margin improvement. The marketplace seems to be supporting the momentum of continued rate increases. We are in the early stages of seeing the benefit of rate-on-rate increases in our operating results. Simply stated, adding the 2 parts, growth and margin will lead to better returns. Many factors are driving today's P&C markets. These include elevated natural cat loss activity in each of the past 4 years, weakened reserve positions from soft market years, lower investment yield and a rising claim inflation. Add in a global pandemic that is still ongoing, it's not surprising that market conditions are changing. Now pivoting to MI. Our $33 billion of NIW in the U.S. in the quarter was a record for Arch. Low interest rates are producing huge refinance activity and unsurprisingly, some churn in our in-force business. However, MI premium rates remain above pre-COVID levels, and the continued high credit quality of borrowers is generally better than it was pre-pandemic. We continue to face uncertainties such as the economy's health and how the pandemic may ultimately affect individual borrowers. However, we are optimistic that, among other positive factors, recent trends in the U.S. housing market will mitigate the effects of the pandemic. Finally, Arch's ability and willingness to allocate and manage capital remains a key competitive advantage. We always think about balancing our capital deployment over 5 pillars: into the insurance, reinsurance, MI, into our investment portfolio, and lastly into our stock repurchase. Our job is to optimize risk-adjusted returns through capital allocation across these pillars. We see managing the 5 pillars being similar to coaching a basketball team. We're constantly looking at how we can distribute the ball, i.e., our capital to the right players. For the past several years, we've been able to feed the big 7'7\" MI guy down low and rely on him to get easy dunks. Now as a playing field, i.e., the market changes, we've adjusted our tactics slightly and are increasingly relying on our two hot shooters, reinsurance and insurance. MI will still score its fair share of points, but the P&C players are getting more open 3-point looks and layups. In short, our game is becoming more complete and diversified. Our ability to adapt the new conditions is what makes us stronger as a team. The market dynamics take me back in time. We have talked about Paul Ingrey's underwriting clock that helps track and measure the phases of the insurance cycle. It's been central to our management philosophy since the beginning and is a helpful reference to understand the underwriting life cycle and assist us in gauging our risk appetite. I recently asked our underwriting teams where we were on the Ingrey clock, and the most common response was around 8:00. If you take a look at the clock in our most recent annual report, you'll see that it's a very nice time to be at Arch. There's a buzz among our underwriters because we've become the first call for so many of our clients, that we have the capacity, the expertise and the desire to serve them. Now I'll turn the coach's whistle over to François, as he goes into more detail on our quarterly results. And I look forward to responding to your questions afterwards. François?"
},
{
"speaker": "François Morin",
"text": "Thank you, Marc, and good morning to all. We at Arch hope that you are in good health. On to the third quarter results. As a reminder and consistent with prior practice, the following comments are on a core basis, which corresponds to Arch's financial results excluding the other segment, i.e. the operations of Watford Holdings Limited. In our filings, the term Consolidated includes Watford. After-tax operating income for the quarter was $120.3 million, which translates to an annualized 4.2% operating return on average common equity and $0.29 per share. Book value per share increased to $28.75 at September 30, up 4.1% from last quarter and 12.2% from 1 year ago. The increase in the quarter was yield by the continued strong performance of our investment portfolio and good underwriting results, taking into consideration the elevated catastrophe activity in the quarter and the uncertainty surrounding the current pandemic. Our property casualty teams continued on their path of solid growth and improved performance as we continue to see strong positive pricing momentum in their markets. Losses from 2020 catastrophic events in the quarter including COVID-19, net of reinsurance recoverables and reinstatement premiums, stood at $203.3 million or 12.5 combined ratio points compared to 5.2 combined ratio points in the third quarter of 2019. The losses impacted both our insurance and reinsurance segments and include $191.4 million from a series of natural catastrophes in the quarter including Hurricanes Isaias, Laura and Sally, the Midwestern Tornado, California wildfires and other smaller events, as well as $11.9 million for losses related to the COVID-19 pandemic. The COVID-19 losses we recorded in the quarter were small, reflecting additional information that became available during the quarter and represent our current assessment and best estimate of the ultimate losses for occurrences through September 30 based on policy terms and conditions including limits, sub-limits and deductibles. As of September 30, the vast majority of our COVID-19 claims are yet to be settled or paid, with close to 80% of the inception-to-date incurred loss amount recorded as incurred but not reported, i.e. IBNR reserves, or as additional case reserves within our insurance and reinsurance segments. As regards the potential impact of COVID-19 on our mortgage segment, we note that the delinquency rate at the end of the quarter was 4.69%, down from 5.14% at June 30. Our current expectation is that the delinquency rate should be in the 5% to 5.5% range at year-end 2020. While we have seen many positive signs over the last few months that point us to a more favorable view of the ultimate performance of the U.S. MI book, many of the uncertainties we identified on our last call remain, in particular, the potential impact from a second wave of infections, potential lockdowns and the lack of an additional fiscal stimulus package or risk factors that we continue to monitor and evaluate on an ongoing basis. For these reasons, and consistent with our corporate reserving philosophy, we believe it is prudent to take a cautious approach in setting loss reserves across our MI book. In the insurance segment, net written premium grew 17.1% over the same quarter 1 year ago, a strong result demonstrating our ability to achieve profitable growth in this environment. Adjusting for the net written premium decrease observed in our travel, accident and health unit, the year-over-year growth in net written premium would have been 26.5%. The insurance segment's accident quarter combined ratio excluding cats was 94.1%, lower by 620 basis points from the same period 1 year ago. Approximately 300 basis points of the difference is due to a lower expense ratio, primarily from the growth in the premium base from 1 year ago and reduced levels of travel and entertainment expenses this quarter. The lower ex-cat accident quarter loss ratio reflects mix change and the benefits of rate increases achieved over the last 12 months. Prior period net loss reserve development net of related adjustments was favorable at $1.1 million, generally consistent with the level recorded in the third quarter of 2019. As for our reinsurance operations, we had strong growth of 38.4% in net written premiums on a year-over-year basis, which was observed across most of our lines and includes a combination of new business opportunities rate increases and the integration of the Barbican reinsurance business. The segment's accident quarter combined ratio excluding cats stood at 83.1% and compared to 92.8% on the same basis 1 year ago. The year-over-year movement is primarily driven by a more normal level of large attritional losses compared to a year ago and rate change activity over the last 12 months. Most of the remaining difference is explained by operating expense ratio improvements, primarily resulting from the growth in earned premium. Favorable prior period net loss reserve development, net of related adjustments, was $40.8 million or 7.4 combined ratio points compared to 4.0 combined ratio points in the third quarter of 2019. The development was mostly in short-tail lines. The mortgage industry had a record-breaking quarter in terms of NIW, and we certainly followed suit with this quarter's NIW of 38 -- $32.8 billion, a full 30% higher than our prior high-water mark. Offsetting this record level of production was the high level of refinancing activity across our portfolio, with the net result being a slight reduction in our insurance in force. The combined ratio was 64.2%, reflecting the lower delinquency rate observed during the quarter. The trends we saw this quarter were favorable relative to last quarter, but the game is far from over. The expense ratio was slightly lower over the same quarter 1 year ago. And prior period net loss reserve development was favorable at $4.5 million this quarter. Total investment return for the quarter was positive 230 basis points on a U.S. dollar basis as the strong recovery in the capital market produced healthy returns across our entire portfolio. Returns in our equity and alternative investments contributed approximately 40% of the total return for the quarter. The duration of our investment portfolio remained basically unchanged from the prior quarter at 3.21 years. The effective tax rate on pretax operating income was 4.8% in the quarter, reflecting a change in the full year estimated tax rate, the geographic mix of our pretax income, and a 10 basis point benefit from discrete tax items in the quarter. As always, the effective tax rate could vary depending on the level and location of income or loss and varying tax rates in each jurisdiction. We currently estimate the full year tax rate to be in the 8% to 10% range for 2020. Turning briefly to risk management. Our natural cat P&L on a net basis increased to $918 million as of October 1 which, at approximately 8.4% of tangible common equity, remains well below our internal limits at the single event 1-in-250-year return level. The growth in the P&L this quarter is attributable to our E&S property unit within the insurance segment, which increased its writings in an improving marketplace. On the capital front, the increase in interest expense this quarter was mainly the result of the issuance of the $1 billion senior notes we issued in June 2020. So far, we have been able to fund our recent growth with our existing capital base. And our balance sheet remains strong, with a debt plus preferred leverage ratio of 23.1% that remains well within a reasonable range. As for our U.S. MI operations, the mortgage insurance-linked notes market has recovered to a great extent from the lows we saw at the onset of the pandemic. Earlier this week, we priced our third Bellemeade transaction of the year at terms that are getting closer to what we saw in 2019, both in structure and price. Our latest transaction will provide 6.5% of coverage in excess of a 2.5% attachment point, both expressed as a percentage of the risk in force. Including this transaction, the Bellemeade structures currently provide approximately $3.9 billion of aggregate reinsurance coverage -- coverage. The fact that this market has recovered as extensively as it has in just over 7 months, with investors more and more comfortable with the exposure they are assuming, is quite telling and provide support to our current assessment of the health of the using the U.S. housing market. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. First question comes from Elyse Greenspan with Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question is on the capital allocation, so what you laid out, 5 pillars. I just want to confirm, I guess, based off of how you were talking. It sounds like share repurchase is left kind of on the chain right now. And I guess because it seems like you have such good growth opportunities that you could put your capital to use just basically to incrementally add to your insurance and reinsurance writings? Am I understanding that correct?"
},
{
"speaker": "Marc Grandisson",
"text": "So yes. I didn't mean to put them in ranking order. I think that they are probably all very equally attractive at this point in time. I think that we're investigating, as you know, on a quarterly basis as to what the opportunities are in various signs of business. I didn't mean to name stock purchase as the last one as a rank ordering mechanism. I think that is also part and parcel of the discussion. I think that for the first time in a while, I would argue that the 5 players actually are actively making the point for receiving ball, the ball and play and be part of the game. So I would definitely say that. And we're evaluating. But certainly, our game number one, our focus number one is to allocate capital to the underwriting units. If the returns are there. And that certainly is a relatively easier place to deploy and easier what you see at this point in time. But everything is up, everything is -- every guy -- everybody is playing on the field, on the court."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. That's helpful. And then my second question on your insurance underlying margin, 94% in the quarter. Arch had targeted to get to kind of a mid-90s. Yet you guys are kind of there, but there's more -- you mentioned a lot of rate, I think, 11% that you're getting in your book of business, which means you haven't even earned that in yet. So as we think about the earning in of the rate you're getting today, plus what seems like incremental rate you could get into 2021, do you have a new target for that business? Or is there a way that we can think about the margin profile there, especially since you've kind of hit that target that you laid out for the Street?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So let me go back to the 95% combined, which I mentioned, I think, 3 years ago now. I think that was meant to be there as an aspirational target and to shoot for at that point in time, based on the mix of business and the opportunities that we had in the marketplace. I think this has changed, right? I think that now that we're obviously going in that direction and very nicely, and the market is certainly helping us, I think we still look very heavily into line by line and ROE by line of business. And I would argue, Elyse, that some lines of business would be less than a 95% combined and some might be still okay at above 95%. But certainly, what I would tell you is the combined ratio was aspirational. We have to keep in mind that there's still -- COVID-19 is still ongoing. And secondly, interest rates have also been decreased -- have decreased significantly since 3 years ago. So rate increases might be needed beyond the combined ratio, just to make the returns equivalent to what they should be, or would have been at the 95% historically. So it's really an ongoing process of reflecting current investment yield. So there are no targets on the combined ratio. But certainly target on a return basis. And I would agree with the 140 to 150 -- 150 bps decrease in interest rate, that the combined ratio would presumably mathematically need to go down to make an equivalent return."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. That's helpful. And then last question, you mentioned taking a cautious approach to reserving within your mortgage book. And then I think you also laid out that default rate to get to 5% to 5.5 by the end of the year. And so I'm just trying to understand like as the default rate, I guess, your expectation is it will go up a little bit from where it sits today. And I'm assuming that you'll continue with the same conservative approach that we saw in the third quarter. So how should we think about kind of the combined ratio? You've been giving some metrics for how that business could trend. And you've obviously come in better than expected in the second and the third quarter. Do you have an expectation for how that could ultimately trend into Q4? And I imagine if you want to provide initial color on 2021."
},
{
"speaker": "François Morin",
"text": "Yes. I'll take that, Elyse. I mean just to be pretty clear, I think I -- as you guys all know, I'll take the blame. I did a pretty poor job of forecasting combined ratios or delinquency rates over the last 2 calls. So I think we're trying to minimize the kind of bad forecasts. But listen, there's -- as we know, there's a lot of uncertainty out there. Yes, we're extremely pleased that the delinquency rates have come down, right? We had talked about even just last quarter, we had said like somewhere around 8% by the end of the year. It doesn't look like we're going to -- it's going to be as bad as that, based on what we know today. Still a few months to go, but definitely saw some encouraging signs this quarter. So that's all well and good. Does it translate to -- what kind of combined ratio does it translate to? I mean it's hard to know because again what we're facing is really -- we just don't know how long this pandemic is going to last. The fact that the forbearance programs are at this point scheduled to end, but who knows if they get extended or not? And how do people convert from forbearance to a regular delinquency? There's a lot of unknowns at this point that we feel are extremely hard to predict and estimate. So listen, we're taking it one quarter at a time. We're happy with where things are at right now. Again, it's reassuring, but we're not -- as I said, we're -- the game's far from over. And who knows, maybe hopefully even my 5% to 5.5% forecast or expectation for delinquency ends up being a bit high. But we'll find out in a few months, and we'll reassess at that point."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jimmy Bhullar with JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"text": "First, I just had a question on how you're thinking about pricing, reinsurance pricing as a buyer of reinsurance? And how should we think about your sort of overall exposure, especially to cats as you're entering 2021? Are you, given better pricing, you can hold more exposure? Or maybe should we assume that you'll keep your retention sort of similar and be a buyer of record regardless of prices?"
},
{
"speaker": "François Morin",
"text": "Short answer is we don't know yet, right? I think we'll have to see what the 1 1 brings to our reinsurance folks on the inward side and certainly on our E&S property. We'll have to evaluate and assess what kind of exposure and what kind of margins we're getting there, and then look back and say, okay now, what is the -- because buying reinsurance, as you know, is like raising, it's like using capital. It's like we have to pay for that. So we're going to go through a very straightforward analysis of capital usage and what we pay for it. And we take a very, very first economic view of the whole world, and specifically as it relates to the insurance exposure we take on a property cat exposure specifically. But having said all this, we also have -- balancing it or adding to that information process is that we also are careful and not overstretching the capital. So we'll always be buying reinsurance to some extent. The question is what level and how much and at what price. But clearly we are -- we like stability, and we're always trading stability for sometimes lesser margin, and that's going to be part of the mix. But clearly both markets where we can be on the advantage, we can gain both sides, but we can actually get rate increases on the insurance side, find a way to buy reinsurance in a good way. And on the assumed basis, we actually are benefiting from the improvement in the market there as well. So it's really a holistic view of the cat exposure. Too early to tell what exactly is going to transpire, but everything is always up for discussion."
},
{
"speaker": "Jamminder Bhullar",
"text": "Okay. And then on Watford, you raised the price. There's pressure on yield to raise it again. And at what point does the deal become sort of uneconomic? And -- or are you already there? Or any comments on how you're thinking about that situation?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, I mean we didn't -- we did not raise the price, right? We have an agreement, we have a signed agreement with Watford that we're starting the process to get regulatory approvals, et cetera. But yes, I mean there's another party that has come in that Watford feels they have to look into their potential offer and what it means to them. But at this point, what's been announced is what is still valid. Depending on what they end up deciding, we may choose to do something different. But at this point, we can't really say much more than that."
},
{
"speaker": "Operator",
"text": "Our next question comes from Mike Zaremski with Crédit Suisse."
},
{
"speaker": "Michael Zaremski",
"text": "Yes. Focusing on the reinsurance segment, robust growth. Thanks for the commentary, bullish commentary. If we look at the underlying accident year loss ratio, I mean actually expense ratio too, so just a lot of improvement. Anything we should be thinking about? Anything to call out? Or are this just market conditions and operating leverage that you're benefiting from?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So then the reinsurance group has grown tremendously. So the expense ratio going down, or what it did certainly is explained by that in large part. I think in terms of the loss ratio, what I would like -- and we said it on prior calls as well is we tend to look at reinsurance performance on a 12- to 18-month basis. There's a lot more volatility in that segment, in that sector. There's also a lot of shift in the mix over time. Our reinsurance folks do not tend to have a -- they have stable relationships obviously, but there's a lot of things moving on in terms of taking cede and the opportunities in the marketplace. So what I would look at the loss ratio is more like this is -- some quarters is much better than others. And it's really due to the volatility in the reinsurance results, I would say."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. Okay. Got it. So the expense ratio, some of that's going to roll in. Okay. A follow-up on the mortgage side, I think I heard you say earlier that ILN pricing kind of had improved a lot. I guess I'm looking at -- we're trying to -- we've been trying to track overall ILN pricing. And maybe kind of still double what it was pre-pandemic, but maybe I'm just looking. Maybe Arch's pricing is better, or maybe I'm just incorrect?"
},
{
"speaker": "François Morin",
"text": "Yes. I mean there's two parts there, right? Is the structure, meaning in particular attachment points, and then the pricing. So right, so this is our third one, our first one of the year. Really, we were the first ones out of the gate after the pandemic. The reality at that point is appetite from the investors was not as good as it was in the past when our attachment point was much higher. Second one, attachment point came down with slightly better pricing. With this new latest one, we're effectively back to the same -- the 2.5% attachment point that we had seen pre-COVID. So that's certainly by design. Pricing, if you risk adjust for everything, it's still up, no question. It's not the same level that it was pre-COVID, but it's not double for sure. So it's much better than that, much lower than that [indiscernible] quality of the book is better. So how does that get factored in? And so there's a couple of other things. It's hard to make it perfectly apples-to-apples. But directionally and on an absolute basis as well, we're very happy with where things are going."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. Got it. That's helpful because I think you're describing it better than what we thought. Okay. And lastly, sticking on mortgage, hopefully -- you said you -- the delinquency rate doesn't pick up as much as you thought. But are you -- it's almost November. Have you seen, over the last 2 weeks, the delinquency rate tick up?"
},
{
"speaker": "François Morin",
"text": "So last few weeks, it's been actually keeping in the same general direction that we saw in the third quarter. So it hasn't picked up. Flattish, I'd call it. We got a couple of months to go. We'll see how things play out, but that's kind of what we're seeing."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Shanker with Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "Two questions, one just to understand accounting and the other one is about Watford. On the accounting, you had a decline in delinquencies due to cures of 6,000 approximately, but you took up reserves. I know you can't really reserve for loss that hasn't happened yet, but it looks like you're reserving for these new claims at about $12,000, $13,000 per claim compared to a historical average of $4,000 to $5,000 per claim. Am I doing the math correctly? And can you explain sort of how you think about that in the books? I think in the first quarter, you also took up reserves more than typical because you can only take them up when you have claims. But can you walk through that a little bit?"
},
{
"speaker": "François Morin",
"text": "Yes. No question that we bumped up reserves this quarter on effectively the delinquencies that we saw in the second quarter. So your math is correct. I mean that's -- I mean the reserves per delinquency, you did the math, right? But what you need to adjust for, I would say, is call it a reserve-strengthening exercise that we went through just to reassess where we were -- took a hard -- every quarter, we take a hard look. And our view is that might as well not -- be cautious, knowing what we know and knowing what we don't know. So think of about a $45 million adjustment on reserves in the third quarter for effectively Q2 delinquencies. So once you adjust for that, I think you get back to claim levels or severities that you would be -- would be more in line with what maybe you would have expected."
},
{
"speaker": "Joshua Shanker",
"text": "So along those lines, is there a reason to believe that the severity of the losses are going to be different than historical severities? I can understand because there's not frequencies and you can't really take frequencies until you get a claim. But is there reason to be more cautious surrounding severity in this pandemic?"
},
{
"speaker": "François Morin",
"text": "We don't see it. The only adjustment obviously that what we're reporting in our supplement in terms of paid severities is lower than what we're seeing from the new delinquencies, right? New delinquencies, we mentioned it last quarter at about a $65,000 or so or per NOD. This quarter, it's right around $60,000. So I mean it's certainly higher because it's more recent loans that are going delinquent versus what the loans we paid on in the quarter. So that's the only adjustment. But in terms of percentage of the insured value or the insurance in force or the risk in force, we don't at this point, don't have a reason to think that it's going to be materially different than what it's been in the past."
},
{
"speaker": "Joshua Shanker",
"text": "Okay. And then on Watford, we don't know how it's going to turn out. But your own stock trades around book value. The offers for Watford are around 0.8x book. I'm not sure, and maybe you've some thoughts on whether Watford is a better investment at 0.8x book than Arch is that 1x book. But if you don't buy in Watford, it would suggest that you have a chunk of excess capital that you were already allocating towards financial uses. Can we expect that your interest in buying business you already know is attractive, even given the market opportunities here?"
},
{
"speaker": "Marc Grandisson",
"text": "I think we made the point clear by putting our offer up there, and that's pretty much what we'll leave it as, Josh. I think we're we still think that Watford is a good platform, a valuable platform. And we--"
},
{
"speaker": "Joshua Shanker",
"text": "But clearly Arch is a more valuable platform than Watford. If you're willing to buy in Watford stock, shouldn't you be willing to buy in Arch stock as well?"
},
{
"speaker": "Marc Grandisson",
"text": "I think the answer is always yes. We're always looking at the possibility of buying our stock. And certainly like I said before, 5 players on the court, I think that the share repurchase is really -- is attractive, as you would expect me to say as the CEO of the company."
},
{
"speaker": "Joshua Shanker",
"text": "All right. We'll keep watching."
},
{
"speaker": "Operator",
"text": "Our next question comes from Yaron Kinar with Goldman Sachs."
},
{
"speaker": "Yaron Kinar",
"text": "I do want to start by thanking you for giving a basketball analogy, so I can actually understand what's going on. I was worried you'd give a hockey analogy. And my first question goes to the slight increase in COVID losses in the quarter. Can you maybe talk about what drove that specifically? I guess specifically, what I want to get at is does it have anything to do with the FCA court cases over in the U.K. and how you're thinking about your overseas business interruption exposures?"
},
{
"speaker": "François Morin",
"text": "Yes. I mean it's really in two parts. I think in the -- on the insurance side, it's very much -- it's all basically related to our travel book in the U.S. So no connection to the FCA ruling. And the little bit we added in the reinsurance side is around property exposures, mostly out of Europe. So it's a little bit of a BI angle to it, but that's pretty much it. So I mean it's -- I mean I call it a bit of just new information coming in, nothing -- no, nothing kind of -- no material new information that came through that would have caused us to revisit our picks. And the FCA, as we said, we didn't change it. And the ruling where it stands, it's -- we're still very much -- we had fully reserved for it. And there's -- again, the ruling doesn't change our position on that."
},
{
"speaker": "Marc Grandisson",
"text": "The rest of the portfolio, Yaron, for what it's worth, and we mentioned that on prior calls, is that we have the vast majority, almost totality of our parties have the exclusions that would protect us somewhat from a deviation. So this is nothing in there to really think about."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. That's very helpful. And then my second question, when you talked about the improvement in the ACI loss ratio for insurance, you didn't talk about total frequency. So is it because you didn't see that? Or is it because you didn't book that?"
},
{
"speaker": "François Morin",
"text": "It's a little bit of both actually. We saw some of it -- some improvement on the frequency of claims possibly in the second quarter. That was definitely a difference. But if you neutralize for the obvious lines of business where claims would actually naturally go down, such has travel for instance where we have the a lot less exposure or go up. Then if you neutralize all of this, we didn't see a discernible change through the 9 months of this year. It's hard to see what the natural rate would be, but we don't see a discernible change in the frequency to speak of. And really, we put our reserve pick and our loss pick based on long-term trend -- long-term averages. We're not looking at specifically one quarter at a time and one year, accident year at a time. We do get in the mix of multiple years and project out much more longer term expected. So it will take a little while before we would recognize any significant improvement in frequency of claims, if at all."
},
{
"speaker": "Yaron Kinar",
"text": "Got it. And then maybe one final very quick one on Watford, if the deal does go through, I just want to confirm that the company wouldn't lose the fee income if Watford is consolidated, right?"
},
{
"speaker": "François Morin",
"text": "Correct."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ryan Tunis with Autonomous Research."
},
{
"speaker": "Ryan Tunis",
"text": "The one I had was just on NII and thinking about low rate headwinds. It looks like you guys have almost 30% of your assets in essentially government bonds. Looks your portfolio yield is sub 2. We just heard another Bermuda competitor today say that their new money yield is 2%. It would seem to me, given how you're allocated, given your current portfolio yield, that there actually wouldn't be that much incremental yield headwind moving forward actually. Arguably if you're going to move out of some of the govies and take some credit risk will actually seem that maybe you could expand your portfolio yield? It doesn't sound like that's right, given your commentary. But I'm just kind of trying to understand like why does Arch continue to be incrementally exposed to this low rate environment, given the fact that you guys have already really take it on the trend in terms of where your yields are now."
},
{
"speaker": "François Morin",
"text": "Yes. I mean we -- no question, we've been defensive on credit. So yes, we have a bit more on the treasury side that you're right, I mean -- unless rate going down, but they seem to have stabilized, I guess, for the time being. Our play in the last few quarters has been trying to, as many others I'm sure have done the same, is try to find other opportunities that are more in the alternative space that provide us still some level of investment income without taking on too much risk. So something we keep looking at, but it's a bit of a challenge. There's not a ton of opportunities out there. We're not -- we're worried a little bit. We're defensive on credit still, and that's something that we look at carefully. We don't want to over-source ourselves there yet."
},
{
"speaker": "Ryan Tunis",
"text": "Do you guys have a new money investment yield you'd call out handy that you did in the third quarter."
},
{
"speaker": "François Morin",
"text": "Well, the last, call it in the last month, we've been, call it putting our money to work. It's just above 2%. So that's kind of where the latest informational gap that we get from our investment guys."
},
{
"speaker": "Operator",
"text": "Our next question comes from Geoff Dunn with Dowling & Partners."
},
{
"speaker": "Geoffrey Dunn",
"text": "First question, and I appreciate the added color around the MI reserving. If we make the adjustment, is the math correct that you changed your incidence assumption up to about 9%?"
},
{
"speaker": "François Morin",
"text": "Close enough. 8% to 9%, yes. Yes. And our view on that is that we feel like that the more recent NODs are -- may be prone to a bit more stress. So the fact that these people took a bit longer to go into delinquency may tell us that there may be again subject to more stress, but again time will tell."
},
{
"speaker": "Geoffrey Dunn",
"text": "And is that 9%, is that a -- just an overall number? Or is it a blend of just as an example, 6% on forbearance and 13% on non-forbearance notices? Do you delineate between the 2? Or is it just more of a holistic approach?"
},
{
"speaker": "François Morin",
"text": "It's more of an aggregate approach that we take. Yes. We don't separate the 2 as cleanly as you're suggesting, yes."
},
{
"speaker": "Marc Grandisson",
"text": "We do look at all..."
},
{
"speaker": "François Morin",
"text": "Geoff, I want to make sure you understand that we also do look at prior events, prior cat events, prior programs of the sort. So -- but it's -- as you could appreciate, it's probably more art than science at this point in time."
},
{
"speaker": "Geoffrey Dunn",
"text": "Right. With the new ILN, a little confusing in the documentation. It looks like it applies for policies after Jan 19, but it looks primarily more recent loans over the last 3, 4 months. What is it designed to do? Is it really the last quarter or so?"
},
{
"speaker": "François Morin",
"text": "Yes."
},
{
"speaker": "Geoffrey Dunn",
"text": "Or is it part of the design to come underneath the 20-1?"
},
{
"speaker": "François Morin",
"text": "No. It's the latest, the 20-3 is very much -- the vast majority is covering June, July and August, so that's 3 months of production. There's a little bit of kind of spillage of the 20-2 that -- and also some 2019 loans that had kind of been late being processed, whatever. It's just -- we're a little bit of a catch-up on a few small things, but think of it as really June, July, August production."
},
{
"speaker": "Operator",
"text": "Our next question comes from Meyer Shields with KBW."
},
{
"speaker": "Meyer Shields",
"text": "Marc, I'm a little confused by something that you said. You were talking about the five capital deployment opportunities. And you cited the investment portfolio. And I guess I would have thought that if you're going to be writing more P&C or mortgage insurance, then the supporting capital will be in the investment portfolio anyway?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So you're saying that we should -- just repeat the question, Meyer, please."
},
{
"speaker": "Meyer Shields",
"text": "So I'm trying to figure out how capital deployment in the investment portfolio is distinct from capital deployment to either P&C mortgage."
},
{
"speaker": "Marc Grandisson",
"text": "Okay. No I see what you mean. So the way we look at the underwriting returns is we attribute to the units the treasury return or the risk-free return. And we try and separate church and state is what we call it internally. We actually credit the float on the insurance on the underwriting piece at the treasury rate level. And then we allocate the capital for the excess over that to the investment portfolio. So this is how we separate the capital usage between those -- between the underwriting units and the investment unit."
},
{
"speaker": "Meyer Shields",
"text": "Okay. That makes sense. Got it."
},
{
"speaker": "Marc Grandisson",
"text": "Yes."
},
{
"speaker": "Meyer Shields",
"text": "I'm trying to get a general sense of how you see either profitability in property casualty in metro? Or your view as to whether the vendor catastrophe models are conservative enough, based on recent years' cat activity and the underlying trends?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, it's a good question, Meyer. I think that our position on this, we have weather scientists upstairs and --who have a lot of lengthy experience and information to look at. Listen, we actually augment and modify the vendor models as we see fit. So the vendor model represents to us a solid starting point. From where we can -- there's definitely had a lot of science into this one. So we've been historically using them as a starting point and augmenting it and modifying it with our own view of the world. But I would caution everyone by saying that, yes, we do have a view of various perils and various exposure around the world. And we also try to factor in shorter term versus longer term, possibly modification of what could happen out there. But it's hard to predict those things. So what we tend to do is to hold ourselves to a higher return for those risks that are inherent in the way we underwrite the business. That also helps explain why where we've taken possibly somewhat of a more conservative approach to property cat exposure over the last 4, 5 years as you've seen our numbers. So I think -- and it's a year-on-year analysis, so we would look at it. And we'll evaluate, I think, in some of our discussion with El Nino, La Nina and all these various discussions happening all the time. And we're not the largest rider property cat, but we do have a very solid team looking into this. But I think we make it up -- try to make it up with holding ourselves up to a higher level of returns."
},
{
"speaker": "Operator",
"text": "Our next question comes from Phil Stefano with Deutsche Bank."
},
{
"speaker": "Philip Stefano",
"text": "Just one -- most have been asked and answered. One follow-up on the MI piece and thinking about the increase in the default rate. I guess in my mind, there are 3 mechanisms to get there. It's either new defaults are increasing, cures are slowing down, or the denominator policies in force is shrinking. I'm just curious how you're contemplating which of those levers is contributing to the increase in the default rate. I think it helps us think about does this come through as losses or premiums or maybe development if the cures are right."
},
{
"speaker": "François Morin",
"text": "Okay. So Phil, let me try and take this. There's a lot of -- it's a big question, a lot of parts. So first and foremost, the denominator is not changing a whole lot, right? It's about a [indiscernible] what it is in terms of policy. The DQ rate has decreased this quarter, right? It went from 5.1 to about 4.7 this quarter. So this is like what's the number of policies at the numerator that are in default. And you divide by a similar number. So it did go down. I think what we're saying in terms of reserving, you reserve for the new notices that you received in the quarter, right? We received 58,000 in the second quarter. We received 20,000 this quarter. And what we're telling you is we take that, the book of these 20,000 new notices. The cures are the cure. They go away from the overall balance, if you will, that we just mentioned, which is the 4.7. But the new notices, we reserve for those in the quarter. So we have to reserve in the quarter on those that were newly notified. This is what typically you would do on reserving. What we did in addition to this is we modified our view of what we should have booked for the second quarter for the new notices in that quarter. So I'm not sure -- I'm trying to help give you a picture a whole -- bigger picture hopefully that helps you understand how we did all this."
},
{
"speaker": "Philip Stefano",
"text": "No, I understand -- that makes sense from the reserving side. But the default rate is loans in default, that population over policies in force."
},
{
"speaker": "François Morin",
"text": "Right."
},
{
"speaker": "Philip Stefano",
"text": "And if the policies in force isn't changing and the default rate is going up, then presumably there's an expectation that new default is going to increase this quarter. And I guess I just wanted to make sure that I was thinking about it correctly because I -- to get to 4.7 to 5, 5.5, there must be an acceleration in new default, or cures is slowing down. I don't know. That's kind of the question."
},
{
"speaker": "François Morin",
"text": "I mean that's -- listen, it's a big -- I mean kind of top-down view. It's hard to know. We don't have -- we can't predict. We don't have the crystal ball on whether cures are going to accelerate or not or slow down. And same thing with new notices. Again, we're trying to, I think, just provide a bit of color that we think the -- obviously or knock on wood, we're not going to be at 8% delinquency rate by the end of the year. We're certainly well below 5%. Does it go back to above 5% by the end of the year? That's what we think could happen, but again we don't know. So I think if everything stays the same, the odds are probably that it won't be at 5%. But we -- that's..."
},
{
"speaker": "Marc Grandisson",
"text": "But Phil, you're right. You're right on your assessment. If we go from 4.7, and we tell you it's going to be 5.5 in the end, that we'll have to have an increase in NODs or lesser cure. I'm not sure we have made enough assessment as to which is which. I would argue that we have tended to -- since May, we have tended to -- at least the last two quarters, we've overstated the amount, the number of new NODs that we received. And that probably is what would drive the potential. We just still don't know. François has said that we haven't been as good as we would have liked to be predicting. So I think the new NODs would be more the place to look at. Having said this, Phil, you also know that we had 2 things going on, less new NODs and higher cure rate. So they both actually helped to manage on. And they helped accelerate and actually go -- no, help explain why we had a projection of about 10% earlier in the year to much less right now. They are two moving parts."
},
{
"speaker": "Philip Stefano",
"text": "Yes. No, understood. I guess in my mind, this default rate might continue to come down. But as you said..."
},
{
"speaker": "Marc Grandisson",
"text": "Yes, it very well could do. Yes."
},
{
"speaker": "Philip Stefano",
"text": "The crystal ball is very cloudy at this point."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Meredith with UBS."
},
{
"speaker": "Brian Meredith",
"text": "I have a couple for you just quickly. So just curious, given that you're getting 2% new money yields and your book yield is below that, should we just expect that your book yield on your investment portfolio fixed income to kind of be stable here going forward?"
},
{
"speaker": "François Morin",
"text": "I think in the short term, I think it's reasonable, yes."
},
{
"speaker": "Brian Meredith",
"text": "Okay. Good. That's helpful. Second question on the reinsurance business, I'm just curious. Your property mix is definitely increasing as a percentage of your overall book. How much of the underlying combined ratio improvement that you're seeing there is actually driven by that mix shift versus just better loss specs?"
},
{
"speaker": "François Morin",
"text": "Well, boy, I don't think we parse out this way. It's still early in the game to see what it's going to look like. I would say that it's probably more mixed at this point in time because our growth is largely in property other than cat, cat XL. So we have a lot of play in that sector right now. It's more and more mix, I would say, Brian."
},
{
"speaker": "Brian Meredith",
"text": "Yes. So it's not so much the rate activity that we're seeing, it's the mix shift that's driving it?"
},
{
"speaker": "François Morin",
"text": "Well, the way we are, you know us, Brian, for all these years is we'll tend to go where the rates are the better -- we have a better increase in margin. So that sort of goes hand in hand."
},
{
"speaker": "Brian Meredith",
"text": "Got you. That makes sense. Another one just quickly on Watford, I'm just curious. Is it your guys' intentions to significantly increase your ownership in that ultimately? Or are you going to buy the whole thing in? Just because the volatility of the investment portfolio is kind of just a different strategy."
},
{
"speaker": "Marc Grandisson",
"text": "Well, what we said publicly is that we are certainly talking to other parties to bring into the fold to support us in this vehicle, if it moves forward, if we close on the acquisition. So the answer is we would most likely increase our participation, but not to 100%, and be much less than that. So increase little bit, but recognize that we -- it's a different model that we -- others would want to participate on with us as well."
},
{
"speaker": "Brian Meredith",
"text": "Got you. So the net capital outlay for the transaction wouldn't be this big as it could? Okay. That makes sense."
},
{
"speaker": "Marc Grandisson",
"text": "Correct. Correct."
},
{
"speaker": "Brian Meredith",
"text": "Got you. And then last question, I'm just curious. Any updates with respect to the Coface investment, where that stands? Are regulators going to ultimately make a decision on this?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think it's in process. We're going through the regular process. It's in -- It's on track. We're hopeful that we could get something done potentially in the first quarter, second quarter of next year. It takes a while, as you know, in this COVID environment. Government and regulators take a little while longer than otherwise. But yes, it's on track. And they produced, as you know, their results I believe earlier this week or early or late last week. So it's also looking much better for them, which is good for us."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jimmy Bhullar with JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"text": "I just wanted to clarify your comments on not losing the fee income on Watford. Is that just because of the 5 years remaining on the contract, and so there's sort of finite life to it? Or was there something else that was behind that comment?"
},
{
"speaker": "François Morin",
"text": "Well, I mean the question was asked, if we buy the vehicle, do we still retain the fees? The answer is yes."
},
{
"speaker": "Jamminder Bhullar",
"text": "Yes, it's an internal allocation then. But in case it goes to somebody else, then that fee arrangement stays intact through the [indiscernible], which is [indiscernible]"
},
{
"speaker": "François Morin",
"text": "Yes. Correct."
},
{
"speaker": "Jamminder Bhullar",
"text": "Okay. And then does your approach to underwriting overall and how much sort of capacity you have and take on [indiscernible] change if you own Watford versus maybe if it does end up being bought by a third party at a higher offer?"
},
{
"speaker": "François Morin",
"text": "I think in a third-party environment, Jim, I think it's pretty clear that we need to take care of our brethren as well as we could take of ourselves. So our view is always to do the similar underwriting. Watford had a different investment profile, which allowed us to do slightly different things. But at a high level, the underwriting is very, very similar. And I would remind everyone that whatever we do on Watford, we take 15% of it on a quarter share basis in the back. We also are participating on the capital. We had like we're up about 13%, I believe, in our shareholding. So we collectively own 20% of the underwriting. So we do eat our own cooking there as well, and it's really important to us."
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, everyone. Looking forward to the last remaining couple of months in the year, and I hope you have a good one."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 2 | 2,020 | 2020-08-02 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Second Quarter 2020 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sirs you may begin.
Marc Grandisson: Thanks, Liz. Good morning and welcome to our second quarter earnings call. On a reported basis, Arch had an acceptable quarter despite COVID-19 related economic disruptions. Our operating results were good from the underlying accident year ex-cat combined ratio perspective as each segment that benefited from the recent rate improvements. All three segments are poised to see the opportunities to grow based on the underwriting returns outlook. Consequently this quarter, rate improvements continue to enable us to expand our writings in our property casualty units as we increasingly achieve acceptable risk-adjusted returns. We know from experience that this environment is an appropriate time to raise additional capital so that we can more significantly take advantage of this hardening P&C market. As we have discussed in previous earnings calls, we continuously rank order our capital allocation opportunities among and within the units. And today P&C insurance and reinsurance prospects have moved up the scale even as MI returns improved at the same time. To be sure, we are experiencing unprecedented times across our world and the insurance industry. There is still much uncertainty from the pandemic and its ultimate impact. The P&C industry faces emerging claims trends the possibility of long-lasting lower investment returns and a strain from on-model cat losses and chronic underpricing from the soft market years. This new reality points to the need for further premium rate increases for the foreseeable future. While not all lines are fully attractive on an absolute basis, the positive momentum is evident and has accelerated through the second quarter. Turning to our operating segments, I'd like to begin with the mortgage insurance segment. Reported delinquencies were 5.1% at June 30, 2020 and came in better than our expectation last quarter, which was at the early onset of the COVID-19 pandemic. As you may recall from our call last quarter given the uncertainty surrounding COVID-19, we were forecasting more pressure on the housing market and a more pessimistic view of the economy that is -- than is indicated by the latest delinquency data. As we stand today, we believe that the U.S. MI industry has been benefiting from a combination of solid credit quality of the post-2008 crisis originations; two, favorable supply and demand imbalance in housing inventory as well as; three, strong and swift government intervention to help homeowners. As a result we're seeing better than expected delinquency rates emerging this quarter even as rates are at elevated levels reflecting the recessionary environment. Our current incurred loss view equates to a claim rate slightly above 5% on newly reported delinquencies. While this claim rate is significantly higher than what we have seen from claim rates on the previous hurricane forbearance programs, it is also significantly lower than what the industry experienced in the GFC and reflects the better underlying conditions I mentioned earlier. Because of the current economic conditions, the credit quality of our new insurance written business as measured by average FICO scores and loan to value is stronger than a year ago. Mortgage lenders have tightened underwriting standards and a higher quality of loans originated is a direct benefit to us. We saw record mortgage originations fueled by the historically low mortgage rate and that has created surges in both refinancing and purchase activity. This favorable financing environment is supporting home prices. We see prices rising around 5% on an annual basis across the U.S. Despite the weakened economy, we estimate that the mark-to-market homeowners' equity and the vast majority of our policies is in excess of 10%. The level of equity as a reminder has proven to be a strong indicator of a borrower's propensity to default, i.e. the higher the equity, the less likely a default will happen and turn into a claim. Turning now to our P&C businesses. First let's talk about COVID-19, which is affecting many lines at the same time and developing much more slowly than a natural catastrophe. Adding to the uncertainty is the fact that many coverage issues have yet to be resolved all of this informed how we approached our reserving for COVID-19 within our P&C segment based on a bottom-up approach to develop our view of ultimate losses. François will cover this in more detail in a few minutes. Moving on to the P&C business environment starting with insurance. We see a growing number of opportunities as net premium written grew 7% in the quarter for the unit despite the fact that our travel premiums decreased materially due to the pandemic. Excluding travel, our insurance NPW growth would have been approximately 17%. Most of our growth was generated in the E&S casualty, E&S property, professional lines and the specialty lines written out of London, about two-thirds of that increase came from exposure growth and the balance from rate. Our overall insurance renewal rate change was plus 8.5%. up significantly from plus 5.5% in the first quarter. Earned premium that we wrote at higher rate levels over the last several quarters helped lower our quarterly accident year combined ratio ex-cat to 96.1% from 99.4% for the same quarter in 2019. In summary, our insurance group's main mission right now is to grow in those lines where conditions improve enough to allow for an appropriate risk-adjusted return and the market is allowing this ever more. Over to the reinsurance segment now. We had very strong premiums growth at plus 50%, reflecting ongoing dislocations and improvements in the marketplace. Growth opportunities presented themselves across a vast majority of our business lines. Property cat NPW was up 153%, other properties was up 70% and casualty was up 35%. Partially offsetting this growth were declines in our motor quota share net premium written due to the impacts of COVID-19 exposure decreases. Generally, our reinsurance segment is able to seize on opportunities earlier than our insurance segment. We're also incrementally increasing our capital allocation to our property cat sector. However, our PML usage is still substantially below what we could deploy if return expectations were to get to the levels we saw in 2006. Our reinsurance accident quarter combined ratio ex-cat improved to 87.5% from 92.2% over the same period in 2019. This partly reflects our opportunistic underwriting strategy and capital allocation over the last two years, but also is a reflection of the benign attritional loss experience relative to the prior year's quarter. To summarize, for our P&C operations after several years of cycle managing our portfolio, we are well positioned to deploy more capital at attractive returns. With respect to our investment returns, our outlook remains cautious as we believe the economic recovery could be slow and take several quarters to develop. Accordingly, underwriting performance should be the driver of earnings for the industry in the near term, which we believe should help sustain the momentum of increasing premium rates. From a capital standpoint, we are in a strong position and we have room to grow with our clients after many years of playing defense. In other words, our core principle again of active cycle management exercised by our team has positioned us to move much more aggressively into a growing number of improving lines. Last, but not least we want our shareholders to know that our employees' hard work and our clients' strong relationships over the last three months were critical in getting us through these tough times. And for that, a huge thanks to all of them. With that, François will take you through the financials.
François Morin: Thank you, Mark and good morning to all. We at Arch hope that you are in good health. On to the second quarter results. As a reminder and consistent with prior practice, the following comments are on a core basis, which corresponds to Arch's financial results excluding the other segment i.e. the operations of Watford Holdings Ltd. In our filings the term consolidated includes Watford. After-tax operating income for the quarter was $16.6 million which translates to an annualized 0.6% operating return on average common equity and $0.04 per share. Book value per share increased to $27.62 at June 30, up 5.8% from last quarter and 12.1% from one year ago. The increase in the quarter was fueled by the strong recovery in the capital markets. Outside of the losses related to the COVID-19 pandemic, our underwriting groups continued on their path of solid growth and improving results, as we benefited from the generally improving property casualty markets. Losses from 2020 catastrophic events in the quarter including COVID-19, net of reinsurance recoverables and reinstatement premiums stood at $207.2 million or 13.5 combined ratio points compared to 0.5 combined ratio points in the second quarter of 2019. The losses impacted both our insurance and reinsurance segments and include $173.1 million from the COVID-19 pandemic as well as $34.1 million for other catastrophic events, including losses related to civil unrest claims across the U.S. The losses we recorded in the quarter for COVID-19 across our P&C operations were split 45% insurance and 55% reinsurance. These loss estimates incorporate additional information that became available during the quarter and represent our current assessment and best estimate of the ultimate losses for occurrences through June 30, based on policy terms and conditions including limits, sublimits and deductibles. We are confident that the approach we took to develop these estimates is conservative and are comfortable with our estimates as they currently stand, but needless to say, we continue to monitor the pandemic in its effects as they play out and we will adjust our estimates as necessary in the coming quarters. As of June 30, the vast majority of our COVID-19 claims are yet to be settled or paid, as approximately 90% of the incurred loss amount has been recorded as IBNR incurred, but not reported reserves or as additional case reserves within our insurance and reinsurance segments. In the insurance segment, the loss reserves we recorded this quarter for the pandemic were primarily attributable to exposures in our North American unit across the national accounts, programs and travel lines of business. In the reinsurance segment, the majority of the losses came from the property catastrophe, accident and health and trade credit lines of business. As regards the potential impact of COVID-19 on our mortgage segment, it is important to mention that our estimates for our U.S. primary mortgage insurance book are based only on reported delinquencies as of June 30, 2020 as mandated by GAAP. As we discussed on the last call, our expectation at the end of the first quarter was for the delinquency rate to progressively increase throughout the remainder of the year with a resulting expectation that underwriting income for the overall segment would be minimal for the remainder of 2020. While we did see such an increase in reported delinquencies in the second quarter, the current delinquency rate of 5.14% is approximately 30% to 40% lower than what we expected it would be when we developed our forecast at the end of the first quarter. While that is a positive sign for the ultimate performance of the book, we are also aware that many uncertainties remain, including the rate of conversion from delinquency to cure or claim, which we expect to be different than under more normal conditions. In addition, it is extremely difficult to predict how reported delinquencies and forbearance which represent approximately two-thirds of total current delinquencies will behave over time, given the lack of historical data that is directly applicable to the current economic reality, which includes elevated unemployment rates, historically low interest rates, solid home price levels and unprecedented government intervention. As we look towards the remainder of 2020 for our U.S. MI business, in light of the developments we have observed during the second quarter, our current expectation is that pretax underwriting income for the remainder of 2020 for the entire mortgage segment will remain positive with a combined ratio in the 70% to 80% range, slightly better than the result we reported this quarter. In summary, while we are still faced with significant economic uncertainty, our expectations for the mortgage segment are definitely more positive than what we thought only a few weeks back. In the insurance segment, net written premium grew 7.1% over the same quarter one year ago, a strong result given the material impact COVID-19 has had on some of our businesses, such as our travel and accident unit. As Mark said, if we exclude this line the year-over-year growth in net written premium would have been 16.9%. The insurance segment's accident quarter combined ratio excluding cat's was 96.1%, lower by 330 basis points from the same period one year ago. Approximately 90 basis points of the difference is due to our lower expense ratio, primarily from the growth in the premium base from one year ago and reduced levels of travel and entertainment expenses this quarter. The lower ex-cat accident quarter loss ratio primarily reflects the benefits of rate increases achieved over the last 12 months. Prior period net loss reserve development, net of related adjustments was favorable at $2.1 million, generally consistent with the level recorded in the second quarter of 2019. As for our reinsurance operations, we had strong growth of 50.3% in net written premiums on a year-over-year basis, which was observed across most of our lines and includes a combination of new business opportunities, rate increases and the integration of the Barbican reinsurance business. The segment's accident quarter combined ratio excluding cats stood at 87.5% compared to 92.2% on the same basis one year ago, a 470 basis point reduction. The year-over-year movement is primarily driven by a more normal level of large attritional losses compared to a year ago, which explains approximately 330 basis points of the difference and the impact of the non-renewal of a large transaction from a year ago, which contributed approximately 50 basis points. Most of the remaining difference is explained by operating expense ratio improvements resulting from the growth in earned premium. Favorable prior period net loss reserve development, net of related adjustments was strong at $28.9 million or six combined ratio points compared to 3.1 combined ratio points in the second quarter of 2019. The benefit was mostly in short-tail lines. The mortgage segment's combined ratio was 80.9%, reflecting the increased level of reported delinquencies in the quarter as mentioned earlier. The loss ratio in the quarter is based on an assumed claim rate of – on newly reported delinquencies for our U.S. MI book of slightly above 5%, combined with an average expected future claim value for severity that is approximately 50% higher than claims we settled and paid in the quarter. This difference is explained by the fact that the distribution of the newly reported delinquencies carry a higher average outstanding loan balance as a higher proportion is for mortgages from the more recent origination years and from states that have higher loan values such as California, Florida and New York. The expense ratio was lower by 100 basis points over the same quarter one year ago reflecting lower operating costs including reduced levels of travel and entertainment expenses. Prior period net loss reserve development was minimal this quarter at $0.2 million favorable. Total investment return for the quarter was positive 372 basis points on a U.S. dollar basis, as the strong recovery in the capital markets produced healthy returns across our entire portfolio. The duration of our investment portfolio remained basically unchanged from the prior quarter at 3.18 years. The effective tax rate on pre-tax operating income resulted in a benefit of 0.9% in the quarter, reflecting a change in the full year estimated tax rate the geographic mix of our pretax income and 110 basis point expense from discrete tax items in the quarter. As always, the effective tax rate could vary depending on the level and location of income or loss and varying tax rates in each jurisdiction. We currently estimate the full year tax rate to be in the 9% to 12% range for 2020. Turning briefly to risk management. Our natural cat PML on a net basis increased to $832 million as of July 1, which had approximately 8% of tangible common equity remains well below our internal limits at the single event 1-in-250-year return level. The growth in the PML this quarter is attributable to both E&S property within our insurance segment and property lines within the reinsurance segment, reflecting our ability to deploy more capacity to opportunities that safely exceeded our return thresholds, some of which were slightly tempered by additional reinsurance purchases. As you know, we issued $1 billion of 30-year senior notes at the end of the second quarter, enhancing our capital base and furthering our objective of maintaining a strong and liquid balance sheet. Our debt plus preferred leverage ratio of 23.8% remains within a reasonable range. As discussed on the prior call, we paused our share repurchase activity since the start of the pandemic and we do not expect to repurchase shares for the remainder of 2020. At USMI, our capital position remains strong with our PMIERs sufficiency ratio at 161% at the end of June, which reflects the coverage afforded by our Bellemeade mortgage insurance-linked notes. In late June, we were able to obtain $528 million of coverage on our in-force book for the second half of 2019. Our ability to execute this transaction highlights the credit quality of our in-force book and further protects our balance sheet should an extreme tail event materialize. The Bellemeade structures provide approximately $3.1 billion of aggregate reinsurance coverage at June 30, 2020. With these introductory comments, we are now prepared to take your questions.
Operator: Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo.
Elyse Greenspan: Hi, thanks. Good morning. My first question on the property casualty side, you guys seem pretty optimistic and started to see – saw a continuation of pretty good growth in the quarter. And so you guys don't disclose the capital supporting, your property casualty versus the mortgage business, but if we're sitting outside the company and we just want to get a sense of the opportunity at hand and the capital that you have given the recent debt raise could you potentially if it really is a strong market double the size of your insurance book of business on your current capital base?
Marc Grandisson: I think it's a fair assessment. I think in general you could think of capital allocation on premium from the P&C as a 1:1 that sort of, gives you a range for capital usage but certainly the ability is there. And I would say that is also informed by how you develop it right? Elyse if you -- property care is a different and capital requirements and then other lines of business such as quota share, let's say, on the reinsurance side on liability. So there's a lot -- there's plenty of room for us to grow.
Elyse Greenspan: Great. And then on the mortgage side of things, you guys see some pretty helpful color that the current delinquency rate is about 30% to 40% lower than where you thought it would have been. So as you set the new guide for the outlook for the underwriting -- positive underwriting mortgage income for the rest of the year in that 70% to 80% combined ratio can you give us a sense of where you expect delinquency rates to trend in the third and the fourth quarter?
François Morin: Well we don't really -- we had -- the quarterly movements are a bit harder to predict. But I mean we had forecasted last quarter somewhere around a 10% or so delinquency rate by the end of the year. We think -- right now we're thinking that it will be more like around 8%. So obviously, we're monitoring weekly and we get data that comes in from all our servicers et cetera, but that's kind of where we're at. There's about 8% delinquency rate by the end of the year.
Marc Grandisson: Yes. I think to add to this Elyse. I would -- just to add to this Elyse, I would say that this is it's a one quarter data point so it will take us we still take a longer-term view and are not fully all reflecting the decrease or the lesser delinquency that we had. We had reported versus what we expected where you get 30% to 40% and then François told you a 20% increase. That tells you sort of a level where we're thoughtful and measured in the way we want to recognize any immediate improvement.
Elyse Greenspan: That's helpful. And then my last question. You guys have pointed to the severity per claim. I believe you said it was about 50% higher than some of the claims you settled in the quarter just given the higher housing values, I believe. If I look in your supplement on the mortgage page, the average case reserve per default went down to 6,900 in the quarter and it has been 14,400. Why would that number have gone down if you're actually setting up more for the current claims? I'm just trying to reconcile those numbers.
François Morin: Yes. The average is very much a function of the percentage of the delinquencies that are effectively in early stages of delinquency. So if you think of all these newly reported delinquencies in the quarter they carry again effectively a 5-or-so percent claim rate versus the older-stage delinquencies and the percentages go up as the more mature the later-stage mature delinquencies we have. So it's really -- there's no changes in assumptions. I'd say it's really just the way the mix of the portfolio or the mix of the delinquencies that we currently have changes over time. And this was really as you know the first quarter where we had a large surge of delinquencies coming from the pandemic.
Elyse Greenspan: Okay. Thanks. I appreciate all the color.
François Morin: Thanks, Elyse.
Marc Grandisson: You’re welcome.
Operator: Our next question comes from Mike Zaremski with Crédit Suisse.
Mike Zaremski: Hey, good morning. I guess sticking with MI so clearly there -- feels like there's some conservatism kind of built in that you expect the delinquency rate to continue moving north. Is the government stimulus kind of a big x factor in terms of like the -- how the $600 weekly unemployment insurance subsidy whether that continues or not? Just trying to think about -- or I mean you can just should we just probably be looking at unemployment levels as well? Just trying to think about how to gauge because clearly results have been good so far much better than expected which is great.
Marc Grandisson: So Mike, I think, the easy question is unemployment matters it is a contributing factor that would precipitate if you will in delinquency and in claims ultimately. The number one, the leading indicators as I said in my notes that will tell you whether there's a heightened increased risk of delinquencies is really the house price in there. So to the extent that the house prices are stable or keep on going up or that there is -- which is another way to say as long as there's reasonable amount of equity in the house, we have found that borrowers do not tend to walk away from their obligation to mortgages. I know. So if you saw the great financial crisis what happened is we had a combination of house price decreases and unemployment so it sort of contributed to the acceleration and a more of an acute delinquency rate that we saw in the great financial crisis which we are not seeing right now. So what we're focusing on -- of course we look at what the government is doing that's going to be helpful. And I think we'll see more of this impact at the end of the forbearance period. But for now the house price index is extremely encouraging to us and really is a leading indicator on the propensity for homeowners to default.
Mike Zaremski: Okay. That makes sense and that's helpful. Then in terms of -- we get a number of questions about the court cases in the United Kingdom the FCA has kind of been writing about that. Is that contemplated in your COVID IBNR whether those court cases go for or against the industry?
Marc Grandisson: Yes. We've taken a conservative approach and we actually had reserves for it as the end of March. So we have reserved for it appropriately with fairly good level of reinsurance against it so we're pretty much reserved there. If things -- it could presumably could be good news going forward for us there.
Mike Zaremski: Okay. And just lastly quickly I'm sure other people will ask about kind of the segments. Any thoughts on new capital entering the broader insurance and reinsurance marketplaces? Do you feel that capital will continue then or is it having an impact on your ability to play offense at this point or is it still just a drop in the bucket? Any color would be helpful. Thanks.
Marc Grandisson: So Mike, it's a little bit of everything you mentioned. I would say that the capital needs that are out there that we see in terms of client trying to find solutions and towers of coverage is meaning a place, a new place, a new home. We would need a significant amount of capital to neutralize that impact if you will. So we're seeing actually acceleration even though there are -- there's more capital being raised and new entrants as we speak thinking about coming in. We're not seeing any ebbing of the rate pressure that we see right now. And I think the demand for capital are pretty high. There's a couple of large players that were really providing a lot of capacity acute capacity in very, very high capacity mongers in the industry have pulled out significantly, so that means that there's a lot of other capital that needs to find its way around to support it. So I would say that, we are not seeing -- we hear what's out there, what's happening. We're encouraged by -- we raised some more capital and there's other folks such as ourselves who have access to the business, access to the clients and relationships. We're able to raise capital. It bodes well for the health of those companies. But any new entrants, it will take them a while to get ramped up and I don't think it's impossible. I think it's totally doable, but it's certainly not something that we're losing sleep over.
Mike Zaremski: Thank you.
Operator: Our next question comes from Yaron Kinar with Goldman Sachs.
Yaron Kinar: Hi, everybody. First question on MI and then a couple on the COVID losses. So in MI, I haven't really seen any significant pullback from that market. So I guess should I take that to mean that even with all the COVID economic uncertainty you still view it as a pretty attractive business?
Marc Grandisson: Yes, it is still very attractive. I would even argue on that the production in the second quarter and as we speak is actually better than it was six months or a year ago where the rates that's -- rate pressures and also quality of underwriting quality of the originations is a lot better than it was even a year ago. So yes there is a lot more activity. The activity Yaron to be fair is also driven by the refinancing market which was not there and by -- dropping the mortgage rate below 3% that does create more business back into the market. As a result of that there's a lot of prepay, right? There's a higher level of the lower level of persistency which means that there's more churn, if you will in the portfolio of business. So I think it's just a reflection of people coming out of their current -- they're coming out of their higher mortgage rate and it's just refinancing at a low level which still makes economic sense. Now we're on the receiving end to grow. That's what we have such we believe much higher NIWs than otherwise would have been in a more stable marketplace.
Yaron Kinar: Got it. That's helpful. And then with regards to the COVID losses maybe a couple of questions there. One when you talk about IBNR, do you include only events or losses from events that have already occurred or do you also include events in the future that are probable very probable to occur?
François Morin: Well I mean that's a -- I mean a good question which as you know people are -- I think companies are may be answering that, I don't want to say, differently. But I think the words - we have to be careful with how we use the words, right? So I'd say, no question that we can only reserve for incidents or occurrences that have happened before June 30. I mean that's under GAAP. And anybody that tells you they're reserving for occurrences that are going to happen in the third or fourth quarter, I just don't know how you can do that. What we have done is, set again a high level I think a prudent level of IBNR on both insurance and reinsurance on things that we know happened or think have happened right? I mean the whole concept of IBNR. So we have certain claims that have been reported. We don't know. And certainly when you get into structures or when you're in an excess position, you're somewhat making a judgment on whether the claim will attach in your layer etcetera and that's where there's a bit more -- there's a bit of art that goes on and not necessarily tons of data or science around it. So I think the answer to us is, we've reserved for everything through June 30 and we would say there's an ultimate right? So the truly our best estimate of what we think the exposure is and that's where we are. I mean we can't really do more than that at this point given the accounting rules and guidelines.
Yaron Kinar: Got it. And then final question also with regards to COVID, between first quarter and second quarter the increase in loss and COVID losses is some of that coming from IBNRs that you had already set up in 1Q, but then took a second look and realized they need to be higher or is that from really new lines of business and new areas that had not been not previously reserved for?
François Morin: Well I'd say it's a bit of both. I mean I would say on the insurance side for example at Q1 we had reserved primarily in set IBNR primarily in our international book because again back to the in the U.K. in particular property book or regional property book there we were of the opinion that there was exposure there. We took action and we booked IBNR on that. I'd say in the second quarter for example we booked and I mentioned it on national accounts that's where we have workers' comp exposure. Again if you want to be very technical at one point, I mean the deaths or the occurrences hadn't happened at the end of March they started to take place especially with health care workers as an example in April and May. So that's when we -- that's what we reserved for in the second quarter. I'd say on the reinsurance side, it's a bit murkier. It's not -- we're somewhat at the mercy or have to have discussions with our scenes and on the property cat book for example. We had booked a little bit of IBNR at the end of Q1. But through additional discussions and investigations and file reviews in the second quarter we booked a bit more on that front and the same is true in trade credit. So hopefully that answers, it but it's a bit of both I'd say.
Yaron Kinar: That is helpful. And maybe one other one if I could sneak it in. On the BI front in reinsurance, the increases in COVID losses that you're reserving for today are those coming more from international accounts or more from the U.S.?
François Morin: Correct more international. Absolutely. As you know we have exposure. I mean -- Continental Europe in particular there's France here there's certain countries where the BI coverage is more implicit and provided by the primary policies so those are some of the examples that we -- or policies that we -- or treaties that we're reserving for at this point.
Yaron Kinar: Thank you very much.
Operator: Our next question comes from Josh Shanker with Bank of America.
Josh Shanker: Can we talk a little bit about July and how it compared with -- noticing for mortgage defaults?
Marc Grandisson: Can you repeat the question please Josh?
Josh Shanker: Yes. Can we talk about -- compare May June July -- of you receiving notices for forbearance and defaults?
Marc Grandisson: Yes. I think we -- I think the one place the one thing that we could say I mean it's -- the data is probably lagging a little bit from our perspective. But the good one to look at is the -- there's information back now I think and the MBA is providing information as to what is their estimate surveying the market and their clients as to who -- what's the forbearance percentage. I think it was pretty much plateauing as we got into May -- towards the end of May into June and through the second - first or second week of July and it's gotten down since then. So we're about 6.1% based on that metric in percent of forbearance from the GSE portfolio from the industry data and now it's at 5.49% as of July 13, I believe this last week. So we've seen a decrease right now Josh. Whether it continues that way or goes back up again. As you know a lot of people pay on the first of the month, but we'll probably have more information and a better clear picture as to what August look -- July looks like in the middle of August.
Josh Shanker: Okay. Thank you. And do you have any evidence one way or the other what RateStar has had any discernible difference in claim behavior -- I should say, claim-noticing behavior compared to how a lot of your competitors were pricing risk prior to your -- to adopting your methods?
Marc Grandisson : Yes, I think, it does. It has had an impact. I think when we talk about cycle management. We also were doing it possibly a little bit more under the radar screen and MI. I think that our RateStar approach with all the parameters actually took us away from a higher than 95 LTV, higher DTIs in certain geographical areas. So yes, we do believe if we adjust for all the variation. I mean, it's not a huge differential, but there is a slight improvement or a slight difference going to our advantage in terms of our delinquencies based on our portfolio and the risk that we underwrote for the last four, five years.
Josh Shanker: All right. And one last one. I think you mentioned the change in AML. I don't think you mentioned the RDS change or maybe I missed it. Where is RDS as a percent of -- directly as of the end of the quarter?
François Morin: Still right at 8% pretty flat. We've -- a couple of movements across the kind of contributions, but yes 8% of tangible book.
Josh Shanker: Thank you for all the answers.
François Morin: You’re welcome.
Marc Grandisson : Thanks, Josh.
Operator: Our next question comes from Ryan Tunis with Autonomous Research.
Ryan Tunis: Hey, Thanks. Appreciate the MI guidance, I realize all this is like literally impossible to nail down, but I'll go ahead and I'll push on it a little bit more, because it is interesting. So when you think about the full year delinquency rate in your mind what are you thinking the percentage of forbearances are going to be of I think you said what was it 8%? How much of that is forbearance versus what you think of as like a real delinquency?
Marc Grandisson: Well, the forbearance that we will declare -- that we will report that we're reporting to you are delinquencies by definition, right? So it's very hard to see I know what you're asking. And I think the one thing that we will tell you about projecting forbearance rates and delinquency rates in this forbearance world is that data is very, very hard to get and it's lagging a fair amount, so very difficult for us to tell you.
Ryan Tunis: And, I guess, my follow-up too is, how are you planning on treating these delinquencies as they age? Like you're obviously using a pretty conservative incidence rate of 5%. I mean, as those move into the -- as those age to six months or whatever like are you going to keep it at 5% or are you going to assume something bigger than that?
Marc Grandisson: I think it's -- there are two moving parts of that 5% Ryan. One is the -- it comes up really as our pre-COVID NODs to ultimate, which was 7.9% and we gave a discount about 33% haircut by virtue of being a forbearance. So as we move forward that 7.9%, which is a claim that's aged three months versus a claim that's aged two years or nine months even though it's a forbearance, we might have to increase those rates. But at the same time if the forbearance programs are getting better we might give a bit more discount or less discount. So it's a really, really -- and you're right you just pointed at the beginning of your comments. I think I should have probably let you answer your own question, which is it's pretty much impossible to answer at this point in time. But right -- and we have -- all we have is a 7.9% pre-COVID ultimate NODs, which was starting point getting some discount, recognizing that the regular forbearance program on hurricanes, which it is not right now -- is as low as 2%. So we're try to find our way around that environment, also recognizing that the delinquencies out of this crisis this COVID-19 will be longer to resolve, because the forbearance program as we all know will last for 12 months. So it's going to be -- it's going to take us a while to really understand the underlying fundamental characteristics of those risks. And to add all this -- to all of this if that wasn't enough, we'll have remediation programs put in place by the GSEs, which presumably should help a tremendous amount. But again, it remains very early to see -- to say.
Ryan Tunis: Understood. And then lastly, Mark, this is purely hypothetical, but if you had $1 of capital for the next year or two years and you can only allocate it to reinsurance or primary insurance, is there a clear preference for which one you allocate it to?
Marc Grandisson: How many years?
Ryan Tunis: Two years.
Marc Grandisson: Man, so to me you're asking me to choose among my kids. I got three kids, I love dearly.
Ryan Tunis: I would split it in three -- three ways or I mean, which way I would like to know…
Marc Grandisson: I mean, to me it's not an all or nothing. But I do believe right now at this point in time, which is I think what you're getting into, which I mentioned in my comments the returns on the reinsurance are quicker to a high level get quicker. But in terms of value creation over the longer time insurance will get there and get traction. It just takes a longer time to accumulate business at a higher level so -- but the problem with the reinsurance it's great for a couple of years but then you might lose that business. So it's not an all or nothing kind of situation. I wouldn't want to go, let's say, all-in in reinsurance even though they have higher ROEs sooner at the cost of losing long-term value creation from the insurance unit.
Ryan Tunis: Thanks for the color. Appreciate it.
Marc Grandisson: Yes.
Operator: Our next question comes from Meyer Shields with KBW.
Meyer Shields: Thank you. I wanted to follow-up on that question, but in a different direction. You talked about reinsurance maybe recovering faster than insurance. How is the current hardening cycle playing out in terms of speed relative to past cycles? Is there any observable difference?
Marc Grandisson: Not really. I would say that we -- Meyer we may have that discussion before. A hard market never happens overnight. It takes five signal – two, three quarters. Losses have to develop. Management team have to figure out what they want to do and put pressure on their underwriting team. So it's no -- it's not unlike others that we've seen before. I would say that we were going to a strengthening of the market conditions even before COVID-19, I think that COVID is probably accelerating the reaction and the willingness and the boldness that we see in the underwriting teams around the industry. But there are still pockets Meyer where people seem to be a little bit aloof in what's going around. And these are the areas we're not growing as much as we should. But I know every cycle turn is different, but I'm not seeing significant difference. It does take-up -- and well one last thing, I will tell you. The one thing about this one is that, we have yet to see is the 1/1 renewal on reinsurance is a really important renewal date, so we'll have a lot more sense as to how quickly and how reactive the market will be as we head into this one.
Meyer Shields: Okay. No. That's very helpful. Thank you. In the past, we've been, I guess, targeting improvements within insurance that would get to a 95% combined. And when we look to the lens of current pricing, is there an update in terms of what that 95% can become?
Marc Grandisson: I hope it's lower. But all kidding aside Meyer, I think that the 95% was put in place as an aspirational number two, three years ago. Now, two years ago now in an interest environment that was different. So, I think right now what we're processing it through -- this was sort of an aspirational as a guiding sort of target for our insurance group. I think right now what we're seeing is we're going through every different line of business and business units and attributing capital and return on investment and we're pitching everything to get to the right level. So, 95% is an over-simplistic way of looking at this. But all things being equal I think I would expect it to be lower right for the industry and that's also why you'll probably see a bit more pressure on the pricing around us in the industry.
Meyer Shields: Okay, perfect. And then final question if I can just in terms of whether you've had to take into account whether it's COVID or something like that that's so remote or other pressures whether you've dialed up your overall last year numbers in insurance or reinsurance?
François Morin: Not in a meaningful way. I think -- I mean we've been pretty cautious. And I think I've been I'd say realistic about what the loss trends have been and what we expect them to be going forward. As you know we haven't relied exclusively on kind of the last five or 10 years of data. We superimposed our own views on what a more normalized view of loss trends is or should be. And I think we're still very comfortable with where we were at and recognizing that yes COVID is a bit of an outlier. But at this point, haven't really factored in any material changes in our loss trends in how we price the business.
Meyer Shields: Okay, fantastic. Thank you so much.
Operator: Our next question comes from Brian Meredith with UBS.
Brian Meredith: Yes, thanks. A couple here for you. First one, I don't think you mentioned it, but was there any benefit at all in the quarter from just lower frequency of economic activity kind of from a claims perspective in any lines of business?
François Morin: I mean there are some indications that in some places yes, there's lower economic activity which will translate to lower losses or claims. We really haven't reflected that yet. I mean we want to take a cautious approach on that, so I'd like to think that maybe there's some to come down the road but for now we haven't factored that in anywhere in our numbers.
Brian Meredith: Great. And then second question I'm just curious Marc as you look at I guess the HEALS Act here there's a component into it of kind of liability call it indemnification. As you think about it if that doesn't go through is that a potential issue here for you and the insurance industry? And how do you kind of think about it from an underwriting perspective here going forward?
Marc Grandisson: I missed the word you said Brian. Could you repeat the early part of your question?
Brian Meredith: Well, it's -- basically curious about protection or what you think about as far as the economy reopening here and potential liability associated with kind of COVID-19. The current I think it's called the HEALS Act or the CARES 2 Act has got some language in there trying to grant businesses and immunity for it right? I'm just curious of your thoughts around that. And if you're interested for insurance?
Marc Grandisson: Well, it's not good. They're going to allocate more liability to us or presumption to us is not good. But I think in this sense these laws are always there. There's always things that are happening. We're going to have to react to what we see when we see it. That's all I can tell you Brian. It's very hard to sit here and go through what impact it is. If we were to react and do this full drill about everything that goes and a bill that's proposed it would take a lot of our time. So, we'll react to it when we'll react to it, right?
Brian Meredith: Yes. And Marc I think you get it wrong. I think you mistake my question. My question more is from your insurance policies perspective as you look going forward as the economy reopens up there's clearly EPLI exposures or GL exposures all sorts of exposures to potentially present themselves as benefits. How do you -- how are you thinking about that from an underwriting perspective?
Marc Grandisson: Well, we have written policies that have EPLI exposure, we have GL exposures but we are not a large risk writer. We don't write the large insurers so that's certainly something that would be helpful to us. We would argue that a lot of the larger claims a lot of the focus from the low risk plaintiff bar would be focused on the larger deeper pocket insurer, so that's one thing we have for us. We also have a fairly amount -- a good healthy amount of reinsurance, so we're not overly concerned with the sideways change.
Brian Meredith: Yes. Got you. Okay. And then another just quick one here. Your travel insurance I'm just curious how big of a book is that? And obviously we're probably going to see some continued pressures there for the rest of the year.
Marc Grandisson: Yes, it was originally about a couple of hundred million dollars of premium and now it's down -- I mean you could see the numbers you can multiply by four. I don't need to -- 250 actually for the year. So that's -- it's been -- it's taken a big dent and that also explains why the growth was more tested this quarter than otherwise could have been.
Brian Meredith: Great. And then one other just quick one here for you. I know you guys launched the sidecar guesses in the first quarter. Any thoughts about additional kind of alternative capacity here to potentially capture some of the good attractive opportunities in reinsurance?
Marc Grandisson: It's a good question Brian. You're trying to get us to say something we don't want to say we can't say and we won't say. We don't mention about we certainly are always on the lookout to raise capital to deploy it with third party a lot of discussions are happening all over. We'll have probably more update as we see it happen and we'll be communicating to you to the extent it's appropriate but how much more it is clearly -- yes.
Brian Meredith: Great. Great. Great. And last one just quickly any updates on Coface?
Marc Grandisson: Coface strategically is still something we really very much think is valuable for the shareholders. There's a lot going on. We're still going through the process of approval process and we're keeping a keen eye on what's happening. I think they reported results yesterday which were better than The Street expected. So, hopefully if that goes. It's also there as well a developing situation with them.
Brian Meredith: Great. Thank you.
Operator: Our next question comes from Phil Stefano with Deutsche Bank.
Phil Stefano: Yes, thanks. Just a quick one on the Bellemeade transaction. I'm thinking about the potential for these moving forward. I guess it seems like the Bellemeade deal that was done in the past quarter just given its attachment was probably more for S&P capital credit than PMIERs. When we saw an MI pure play come out with their own ILN transaction which is in my mind more of a traditional attachment point in the low single digits but the spreads on that and the pricing was significantly higher. How are you thinking about the managing of tail risk that Bellemeade provides versus just the capital credit that could be from playing I would think something that could be considered well above the working layers for the MI reinsurance coverage and the capital relief that something like that might provide?
Marc Grandisson: Yes, it's a good question. I think it's always something we evaluate when and if we place or look at options that are in front of us. You're correct this one attaches -- the last one attaches above the PMIERs credit, but we're still very much in -- we have a healthy PMIERs ratio so that didn't really concern us too much. At this point not to say that next time or down the road, we may not go back to a lower attachment point. But yes, the focus was really -- yes it's an available source of capital. From a rating agency point of view, S&P you're correct it covers that. It provides us coverage there. And also we felt as being the first one out of the gate even before the GSEs to go back and access the capital markets was we thought a very strong message demonstrated. Again ,I touched on it the quality the book and the investor base is still very has a lot of interest and appetite for the product, so I think we were happy with the placement. No question it's always too expensive. We'd like to see the price to come down. We hope they do down the road. But for the time being given the economics in front of us we were -- I think it was a good move on our part.
Phil Stefano: Got it. And to the extent that you guys have a disclosure wish list that you keep in the background, I think it might be helpful to see the USMI disaggregated from the international and the mortgage reinsurance book just been the significant differences in how those businesses are reserved for? Thanks for appreciating.
François Morin : See you, back. Thank you.
Operator: Our next question comes from Geoffrey Dunn with Dowling & Partners.
Geoffrey Dunn : Thanks. Good morning. I guess first just a quick number question. Can you quantify the impact of the accelerated singles in the quarter?
Marc Grandisson: Did we do that? I think it's about $50 million.
Geoffrey Dunn : $50 million, okay. And then let's think forward past the end of new forbearance so early next year, so given what you know about the economy now obviously very different from a couple of months ago. How would you think about claim rates on new notices without forbearance? Because again you pointed out it's very different with home prices remains to be seen if we're going into a recession or not. And I think Marc last quarter you suggested, we might be looking at 13%, 14% given what you knew then. So what do you think about that type of number as you get into early 2021 based on what you know today?
Marc Grandisson : I think the 5% is probably -- this is like on NODs or you're talking about ultimate claims rate for the portfolio?
Geoffrey Dunn : On NODs. So new notices coming in forbearance goes away.
Marc Grandisson : NODs, yes. Right. I think we were at 7.9% pre-COVID. I think that the forbearance should be pretty helpful and to bring it up -- not bring up to the 13%, 14% you just mentioned, I mentioned first quarter. That's probably -- my gut would tell me a slight increase for a little while until we see things shake out and things came back to more normalcy. And I think reverting back to some kind of level. I think the forbearance program were to play out to the way it should play out. It's still very uncertain as you know Geoff. I think that we should get back to -- it might stay elevated for a while maybe 12%, 13% for a little while but it should go back down at some point for next year I would say.
Geoffrey Dunn : Okay. Alright. So you do think given what you know about the economy and built-up equity that you could still see 12% type of incidence assumption?
Marc Grandisson : Yes. Yes on NODs, right? On new NODs for regular piece not for the forbearance piece? The forbearance piece we gave -- we did give a discount, right? There's a discount to that. So yes then just got it from – right. Congrats, yes.
Geoffrey Dunn : All right. Thank you.
François Morin : Quick, I mean before you go on to the next one, Geoff quick update for you. The actual impact of the singles was $27 million in the quarter. Just correction to Marc $50 million.
Geoffrey Dunn : Thanks, again.
Marc Grandisson : Okay. Go with $51 million.
François Morin : You’re welcome.
Operator: Our next question comes from Jimmy Bhullar with JPMorgan.
Jimmy Bhullar : Hi. I just had a question on pricing and just how you think about the interplay between the decline in exposures if the economy remains weak and how that could affect demand and pricing? And relatedly what else is out there that you think could potentially derail the momentum that you've seen in pricing both in insurance and reinsurance?
Marc Grandisson : I mean it's hard to predict the future. As you know -- my God! I think if everything resolves, I mean even if things resolved for the better, I think the momentum that we've seen in the first quarter, late 2019, early 2020 I think we would still see some momentum. I think it would be just a matter of degree how much higher the rates could go. But I do believe the momentum was there for a turnover market way before pre-COVID-19. COVID-19 like I said before exacerbated the need for rate and accelerate the need for rate.
Jimmy Bhullar : And then there's been a lot of talk about sort of ILS and trapped capacity and what do you think about when either some of the capacity gets relieved or potentially gets absorbed? And once there's clarity on that do you think by this time next year like a lot of the trapped capital would actually be out?
Marc Grandisson : It's a possibility. I mean that's also assuming there's no more cat occurring this year. But this is a long-lasting cat event so it's not as clear as having a quake let's say in March. And I guess in a year out it's still developing but you have a better sense for wanting to or would be willing to release capital. This one will take a bit longer to process through, right? For instance, you could have arguments in courts and new ways and new push back on the insurance industry to pay claims in a property cycle. And that would take -- that could take another 1.5 years or two years to resolve. So, there's a lot more uncertainty in terms of timing finding resolution of the ultimate prices. So, it's a lot less certain that it will take only a year to get through it.
Jimmy Bhullar: Thank you.
Marc Grandisson: Sure.
Operator: Our next question comes from Jamie Inglis with Philo Smith.
James Inglis: Hi. Good afternoon. I wanted to follow-up on the conversation we've been having about forbearance programs and to what extent delinquencies get cured get claims -- turn into claims sort of, et cetera. And I appreciate that we don't know what's going to happen going forward, but I'm wondering if you could speak to what you learned in previous forbearance programs and how that affects your thinking about your current book? And if -- and what you learned in there? Was it -- did you learn anything about LTVs geographies sort of, et cetera? And how does that apply to your existing book today?
Marc Grandisson: I think we have done reserving in the past, considering all the dimensions you just talked about, I think that we had the -- the beautiful thing about the prior hurricanes or the beautiful thing in a way is that we have prior hurricanes and prior events that we can go back to and look at the experience. This definitely help us put I guess, boundaries around what could happen, but this one is very unusual in the length of the forbearance program and the breadth and how widely spread it is. And I think we also have to throw in there the $600 per week unemployment benefits and the distribution that we talked about. Some regions are more heavily affected than others. So I think everything gets in the mix Jimmy -- Jamie. It's not just one dimension. And I think what we've learned is that, we sort of can use the historical forbearance experience as sort of as a range of possible outcome. But, we actually are digging heavily, heavily into developing a much more refined view of a forbearance-specific programs, such as the one we're facing right now. And we may never use it again, but at least we're in the process of readjusting our development claims model called ARMOR that we have internally. So, we're -- it's still very much developing and we're learning on the fly.
François Morin: Yeah. Two things I'll add quickly to that. As Mark mentioned, the historically forbearance delinquencies most of them cure. I mean -- and we made comment that the 2% kind of claim rate. So that's obviously a very positive sign, but that's again more localized and it's a short-term issue. So, I mean understandable that these delinquencies most of them would cure. So that would be one extreme that would be a very good result in this situation. Maybe a little counter to that, as you may know, many of the claims or the mortgages or loans and forbearance up to 40% were actually still current, up until recently. So, in the early days of the second quarter, many loans had accessed the forbearance programs, but remained current and made their mortgage payments. The data now suggests that that percentage has come down. So the reality is, now we'll get a few more loans that have turned delinquent that were historically current or had been current in forbearance, but now have turned delinquent. So, that's a bit of a data point that we're monitoring, but that kind of gives us a bit of -- not necessarily concerned, but we have to understand better so that we can refine our estimates as we move forward, because the 2% ultimate claim rate may not be achievable or probably won't be what we end up with in this current situation.
James Inglis: Okay. Thank you. Appreciate it. Good luck in future.
François Morin: Thank you, Jamie.
Operator: I'm not showing any further questions. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thanks for joining us this quarter. Please stay safe. Have a nice rest of the summer, and we'll talk to you in the fall again. Thank you.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Second Quarter 2020 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sirs you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks, Liz. Good morning and welcome to our second quarter earnings call. On a reported basis, Arch had an acceptable quarter despite COVID-19 related economic disruptions. Our operating results were good from the underlying accident year ex-cat combined ratio perspective as each segment that benefited from the recent rate improvements. All three segments are poised to see the opportunities to grow based on the underwriting returns outlook. Consequently this quarter, rate improvements continue to enable us to expand our writings in our property casualty units as we increasingly achieve acceptable risk-adjusted returns. We know from experience that this environment is an appropriate time to raise additional capital so that we can more significantly take advantage of this hardening P&C market. As we have discussed in previous earnings calls, we continuously rank order our capital allocation opportunities among and within the units. And today P&C insurance and reinsurance prospects have moved up the scale even as MI returns improved at the same time. To be sure, we are experiencing unprecedented times across our world and the insurance industry. There is still much uncertainty from the pandemic and its ultimate impact. The P&C industry faces emerging claims trends the possibility of long-lasting lower investment returns and a strain from on-model cat losses and chronic underpricing from the soft market years. This new reality points to the need for further premium rate increases for the foreseeable future. While not all lines are fully attractive on an absolute basis, the positive momentum is evident and has accelerated through the second quarter. Turning to our operating segments, I'd like to begin with the mortgage insurance segment. Reported delinquencies were 5.1% at June 30, 2020 and came in better than our expectation last quarter, which was at the early onset of the COVID-19 pandemic. As you may recall from our call last quarter given the uncertainty surrounding COVID-19, we were forecasting more pressure on the housing market and a more pessimistic view of the economy that is -- than is indicated by the latest delinquency data. As we stand today, we believe that the U.S. MI industry has been benefiting from a combination of solid credit quality of the post-2008 crisis originations; two, favorable supply and demand imbalance in housing inventory as well as; three, strong and swift government intervention to help homeowners. As a result we're seeing better than expected delinquency rates emerging this quarter even as rates are at elevated levels reflecting the recessionary environment. Our current incurred loss view equates to a claim rate slightly above 5% on newly reported delinquencies. While this claim rate is significantly higher than what we have seen from claim rates on the previous hurricane forbearance programs, it is also significantly lower than what the industry experienced in the GFC and reflects the better underlying conditions I mentioned earlier. Because of the current economic conditions, the credit quality of our new insurance written business as measured by average FICO scores and loan to value is stronger than a year ago. Mortgage lenders have tightened underwriting standards and a higher quality of loans originated is a direct benefit to us. We saw record mortgage originations fueled by the historically low mortgage rate and that has created surges in both refinancing and purchase activity. This favorable financing environment is supporting home prices. We see prices rising around 5% on an annual basis across the U.S. Despite the weakened economy, we estimate that the mark-to-market homeowners' equity and the vast majority of our policies is in excess of 10%. The level of equity as a reminder has proven to be a strong indicator of a borrower's propensity to default, i.e. the higher the equity, the less likely a default will happen and turn into a claim. Turning now to our P&C businesses. First let's talk about COVID-19, which is affecting many lines at the same time and developing much more slowly than a natural catastrophe. Adding to the uncertainty is the fact that many coverage issues have yet to be resolved all of this informed how we approached our reserving for COVID-19 within our P&C segment based on a bottom-up approach to develop our view of ultimate losses. François will cover this in more detail in a few minutes. Moving on to the P&C business environment starting with insurance. We see a growing number of opportunities as net premium written grew 7% in the quarter for the unit despite the fact that our travel premiums decreased materially due to the pandemic. Excluding travel, our insurance NPW growth would have been approximately 17%. Most of our growth was generated in the E&S casualty, E&S property, professional lines and the specialty lines written out of London, about two-thirds of that increase came from exposure growth and the balance from rate. Our overall insurance renewal rate change was plus 8.5%. up significantly from plus 5.5% in the first quarter. Earned premium that we wrote at higher rate levels over the last several quarters helped lower our quarterly accident year combined ratio ex-cat to 96.1% from 99.4% for the same quarter in 2019. In summary, our insurance group's main mission right now is to grow in those lines where conditions improve enough to allow for an appropriate risk-adjusted return and the market is allowing this ever more. Over to the reinsurance segment now. We had very strong premiums growth at plus 50%, reflecting ongoing dislocations and improvements in the marketplace. Growth opportunities presented themselves across a vast majority of our business lines. Property cat NPW was up 153%, other properties was up 70% and casualty was up 35%. Partially offsetting this growth were declines in our motor quota share net premium written due to the impacts of COVID-19 exposure decreases. Generally, our reinsurance segment is able to seize on opportunities earlier than our insurance segment. We're also incrementally increasing our capital allocation to our property cat sector. However, our PML usage is still substantially below what we could deploy if return expectations were to get to the levels we saw in 2006. Our reinsurance accident quarter combined ratio ex-cat improved to 87.5% from 92.2% over the same period in 2019. This partly reflects our opportunistic underwriting strategy and capital allocation over the last two years, but also is a reflection of the benign attritional loss experience relative to the prior year's quarter. To summarize, for our P&C operations after several years of cycle managing our portfolio, we are well positioned to deploy more capital at attractive returns. With respect to our investment returns, our outlook remains cautious as we believe the economic recovery could be slow and take several quarters to develop. Accordingly, underwriting performance should be the driver of earnings for the industry in the near term, which we believe should help sustain the momentum of increasing premium rates. From a capital standpoint, we are in a strong position and we have room to grow with our clients after many years of playing defense. In other words, our core principle again of active cycle management exercised by our team has positioned us to move much more aggressively into a growing number of improving lines. Last, but not least we want our shareholders to know that our employees' hard work and our clients' strong relationships over the last three months were critical in getting us through these tough times. And for that, a huge thanks to all of them. With that, François will take you through the financials."
},
{
"speaker": "François Morin",
"text": "Thank you, Mark and good morning to all. We at Arch hope that you are in good health. On to the second quarter results. As a reminder and consistent with prior practice, the following comments are on a core basis, which corresponds to Arch's financial results excluding the other segment i.e. the operations of Watford Holdings Ltd. In our filings the term consolidated includes Watford. After-tax operating income for the quarter was $16.6 million which translates to an annualized 0.6% operating return on average common equity and $0.04 per share. Book value per share increased to $27.62 at June 30, up 5.8% from last quarter and 12.1% from one year ago. The increase in the quarter was fueled by the strong recovery in the capital markets. Outside of the losses related to the COVID-19 pandemic, our underwriting groups continued on their path of solid growth and improving results, as we benefited from the generally improving property casualty markets. Losses from 2020 catastrophic events in the quarter including COVID-19, net of reinsurance recoverables and reinstatement premiums stood at $207.2 million or 13.5 combined ratio points compared to 0.5 combined ratio points in the second quarter of 2019. The losses impacted both our insurance and reinsurance segments and include $173.1 million from the COVID-19 pandemic as well as $34.1 million for other catastrophic events, including losses related to civil unrest claims across the U.S. The losses we recorded in the quarter for COVID-19 across our P&C operations were split 45% insurance and 55% reinsurance. These loss estimates incorporate additional information that became available during the quarter and represent our current assessment and best estimate of the ultimate losses for occurrences through June 30, based on policy terms and conditions including limits, sublimits and deductibles. We are confident that the approach we took to develop these estimates is conservative and are comfortable with our estimates as they currently stand, but needless to say, we continue to monitor the pandemic in its effects as they play out and we will adjust our estimates as necessary in the coming quarters. As of June 30, the vast majority of our COVID-19 claims are yet to be settled or paid, as approximately 90% of the incurred loss amount has been recorded as IBNR incurred, but not reported reserves or as additional case reserves within our insurance and reinsurance segments. In the insurance segment, the loss reserves we recorded this quarter for the pandemic were primarily attributable to exposures in our North American unit across the national accounts, programs and travel lines of business. In the reinsurance segment, the majority of the losses came from the property catastrophe, accident and health and trade credit lines of business. As regards the potential impact of COVID-19 on our mortgage segment, it is important to mention that our estimates for our U.S. primary mortgage insurance book are based only on reported delinquencies as of June 30, 2020 as mandated by GAAP. As we discussed on the last call, our expectation at the end of the first quarter was for the delinquency rate to progressively increase throughout the remainder of the year with a resulting expectation that underwriting income for the overall segment would be minimal for the remainder of 2020. While we did see such an increase in reported delinquencies in the second quarter, the current delinquency rate of 5.14% is approximately 30% to 40% lower than what we expected it would be when we developed our forecast at the end of the first quarter. While that is a positive sign for the ultimate performance of the book, we are also aware that many uncertainties remain, including the rate of conversion from delinquency to cure or claim, which we expect to be different than under more normal conditions. In addition, it is extremely difficult to predict how reported delinquencies and forbearance which represent approximately two-thirds of total current delinquencies will behave over time, given the lack of historical data that is directly applicable to the current economic reality, which includes elevated unemployment rates, historically low interest rates, solid home price levels and unprecedented government intervention. As we look towards the remainder of 2020 for our U.S. MI business, in light of the developments we have observed during the second quarter, our current expectation is that pretax underwriting income for the remainder of 2020 for the entire mortgage segment will remain positive with a combined ratio in the 70% to 80% range, slightly better than the result we reported this quarter. In summary, while we are still faced with significant economic uncertainty, our expectations for the mortgage segment are definitely more positive than what we thought only a few weeks back. In the insurance segment, net written premium grew 7.1% over the same quarter one year ago, a strong result given the material impact COVID-19 has had on some of our businesses, such as our travel and accident unit. As Mark said, if we exclude this line the year-over-year growth in net written premium would have been 16.9%. The insurance segment's accident quarter combined ratio excluding cat's was 96.1%, lower by 330 basis points from the same period one year ago. Approximately 90 basis points of the difference is due to our lower expense ratio, primarily from the growth in the premium base from one year ago and reduced levels of travel and entertainment expenses this quarter. The lower ex-cat accident quarter loss ratio primarily reflects the benefits of rate increases achieved over the last 12 months. Prior period net loss reserve development, net of related adjustments was favorable at $2.1 million, generally consistent with the level recorded in the second quarter of 2019. As for our reinsurance operations, we had strong growth of 50.3% in net written premiums on a year-over-year basis, which was observed across most of our lines and includes a combination of new business opportunities, rate increases and the integration of the Barbican reinsurance business. The segment's accident quarter combined ratio excluding cats stood at 87.5% compared to 92.2% on the same basis one year ago, a 470 basis point reduction. The year-over-year movement is primarily driven by a more normal level of large attritional losses compared to a year ago, which explains approximately 330 basis points of the difference and the impact of the non-renewal of a large transaction from a year ago, which contributed approximately 50 basis points. Most of the remaining difference is explained by operating expense ratio improvements resulting from the growth in earned premium. Favorable prior period net loss reserve development, net of related adjustments was strong at $28.9 million or six combined ratio points compared to 3.1 combined ratio points in the second quarter of 2019. The benefit was mostly in short-tail lines. The mortgage segment's combined ratio was 80.9%, reflecting the increased level of reported delinquencies in the quarter as mentioned earlier. The loss ratio in the quarter is based on an assumed claim rate of – on newly reported delinquencies for our U.S. MI book of slightly above 5%, combined with an average expected future claim value for severity that is approximately 50% higher than claims we settled and paid in the quarter. This difference is explained by the fact that the distribution of the newly reported delinquencies carry a higher average outstanding loan balance as a higher proportion is for mortgages from the more recent origination years and from states that have higher loan values such as California, Florida and New York. The expense ratio was lower by 100 basis points over the same quarter one year ago reflecting lower operating costs including reduced levels of travel and entertainment expenses. Prior period net loss reserve development was minimal this quarter at $0.2 million favorable. Total investment return for the quarter was positive 372 basis points on a U.S. dollar basis, as the strong recovery in the capital markets produced healthy returns across our entire portfolio. The duration of our investment portfolio remained basically unchanged from the prior quarter at 3.18 years. The effective tax rate on pre-tax operating income resulted in a benefit of 0.9% in the quarter, reflecting a change in the full year estimated tax rate the geographic mix of our pretax income and 110 basis point expense from discrete tax items in the quarter. As always, the effective tax rate could vary depending on the level and location of income or loss and varying tax rates in each jurisdiction. We currently estimate the full year tax rate to be in the 9% to 12% range for 2020. Turning briefly to risk management. Our natural cat PML on a net basis increased to $832 million as of July 1, which had approximately 8% of tangible common equity remains well below our internal limits at the single event 1-in-250-year return level. The growth in the PML this quarter is attributable to both E&S property within our insurance segment and property lines within the reinsurance segment, reflecting our ability to deploy more capacity to opportunities that safely exceeded our return thresholds, some of which were slightly tempered by additional reinsurance purchases. As you know, we issued $1 billion of 30-year senior notes at the end of the second quarter, enhancing our capital base and furthering our objective of maintaining a strong and liquid balance sheet. Our debt plus preferred leverage ratio of 23.8% remains within a reasonable range. As discussed on the prior call, we paused our share repurchase activity since the start of the pandemic and we do not expect to repurchase shares for the remainder of 2020. At USMI, our capital position remains strong with our PMIERs sufficiency ratio at 161% at the end of June, which reflects the coverage afforded by our Bellemeade mortgage insurance-linked notes. In late June, we were able to obtain $528 million of coverage on our in-force book for the second half of 2019. Our ability to execute this transaction highlights the credit quality of our in-force book and further protects our balance sheet should an extreme tail event materialize. The Bellemeade structures provide approximately $3.1 billion of aggregate reinsurance coverage at June 30, 2020. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi, thanks. Good morning. My first question on the property casualty side, you guys seem pretty optimistic and started to see – saw a continuation of pretty good growth in the quarter. And so you guys don't disclose the capital supporting, your property casualty versus the mortgage business, but if we're sitting outside the company and we just want to get a sense of the opportunity at hand and the capital that you have given the recent debt raise could you potentially if it really is a strong market double the size of your insurance book of business on your current capital base?"
},
{
"speaker": "Marc Grandisson",
"text": "I think it's a fair assessment. I think in general you could think of capital allocation on premium from the P&C as a 1:1 that sort of, gives you a range for capital usage but certainly the ability is there. And I would say that is also informed by how you develop it right? Elyse if you -- property care is a different and capital requirements and then other lines of business such as quota share, let's say, on the reinsurance side on liability. So there's a lot -- there's plenty of room for us to grow."
},
{
"speaker": "Elyse Greenspan",
"text": "Great. And then on the mortgage side of things, you guys see some pretty helpful color that the current delinquency rate is about 30% to 40% lower than where you thought it would have been. So as you set the new guide for the outlook for the underwriting -- positive underwriting mortgage income for the rest of the year in that 70% to 80% combined ratio can you give us a sense of where you expect delinquency rates to trend in the third and the fourth quarter?"
},
{
"speaker": "François Morin",
"text": "Well we don't really -- we had -- the quarterly movements are a bit harder to predict. But I mean we had forecasted last quarter somewhere around a 10% or so delinquency rate by the end of the year. We think -- right now we're thinking that it will be more like around 8%. So obviously, we're monitoring weekly and we get data that comes in from all our servicers et cetera, but that's kind of where we're at. There's about 8% delinquency rate by the end of the year."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think to add to this Elyse. I would -- just to add to this Elyse, I would say that this is it's a one quarter data point so it will take us we still take a longer-term view and are not fully all reflecting the decrease or the lesser delinquency that we had. We had reported versus what we expected where you get 30% to 40% and then François told you a 20% increase. That tells you sort of a level where we're thoughtful and measured in the way we want to recognize any immediate improvement."
},
{
"speaker": "Elyse Greenspan",
"text": "That's helpful. And then my last question. You guys have pointed to the severity per claim. I believe you said it was about 50% higher than some of the claims you settled in the quarter just given the higher housing values, I believe. If I look in your supplement on the mortgage page, the average case reserve per default went down to 6,900 in the quarter and it has been 14,400. Why would that number have gone down if you're actually setting up more for the current claims? I'm just trying to reconcile those numbers."
},
{
"speaker": "François Morin",
"text": "Yes. The average is very much a function of the percentage of the delinquencies that are effectively in early stages of delinquency. So if you think of all these newly reported delinquencies in the quarter they carry again effectively a 5-or-so percent claim rate versus the older-stage delinquencies and the percentages go up as the more mature the later-stage mature delinquencies we have. So it's really -- there's no changes in assumptions. I'd say it's really just the way the mix of the portfolio or the mix of the delinquencies that we currently have changes over time. And this was really as you know the first quarter where we had a large surge of delinquencies coming from the pandemic."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. Thanks. I appreciate all the color."
},
{
"speaker": "François Morin",
"text": "Thanks, Elyse."
},
{
"speaker": "Marc Grandisson",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from Mike Zaremski with Crédit Suisse."
},
{
"speaker": "Mike Zaremski",
"text": "Hey, good morning. I guess sticking with MI so clearly there -- feels like there's some conservatism kind of built in that you expect the delinquency rate to continue moving north. Is the government stimulus kind of a big x factor in terms of like the -- how the $600 weekly unemployment insurance subsidy whether that continues or not? Just trying to think about -- or I mean you can just should we just probably be looking at unemployment levels as well? Just trying to think about how to gauge because clearly results have been good so far much better than expected which is great."
},
{
"speaker": "Marc Grandisson",
"text": "So Mike, I think, the easy question is unemployment matters it is a contributing factor that would precipitate if you will in delinquency and in claims ultimately. The number one, the leading indicators as I said in my notes that will tell you whether there's a heightened increased risk of delinquencies is really the house price in there. So to the extent that the house prices are stable or keep on going up or that there is -- which is another way to say as long as there's reasonable amount of equity in the house, we have found that borrowers do not tend to walk away from their obligation to mortgages. I know. So if you saw the great financial crisis what happened is we had a combination of house price decreases and unemployment so it sort of contributed to the acceleration and a more of an acute delinquency rate that we saw in the great financial crisis which we are not seeing right now. So what we're focusing on -- of course we look at what the government is doing that's going to be helpful. And I think we'll see more of this impact at the end of the forbearance period. But for now the house price index is extremely encouraging to us and really is a leading indicator on the propensity for homeowners to default."
},
{
"speaker": "Mike Zaremski",
"text": "Okay. That makes sense and that's helpful. Then in terms of -- we get a number of questions about the court cases in the United Kingdom the FCA has kind of been writing about that. Is that contemplated in your COVID IBNR whether those court cases go for or against the industry?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. We've taken a conservative approach and we actually had reserves for it as the end of March. So we have reserved for it appropriately with fairly good level of reinsurance against it so we're pretty much reserved there. If things -- it could presumably could be good news going forward for us there."
},
{
"speaker": "Mike Zaremski",
"text": "Okay. And just lastly quickly I'm sure other people will ask about kind of the segments. Any thoughts on new capital entering the broader insurance and reinsurance marketplaces? Do you feel that capital will continue then or is it having an impact on your ability to play offense at this point or is it still just a drop in the bucket? Any color would be helpful. Thanks."
},
{
"speaker": "Marc Grandisson",
"text": "So Mike, it's a little bit of everything you mentioned. I would say that the capital needs that are out there that we see in terms of client trying to find solutions and towers of coverage is meaning a place, a new place, a new home. We would need a significant amount of capital to neutralize that impact if you will. So we're seeing actually acceleration even though there are -- there's more capital being raised and new entrants as we speak thinking about coming in. We're not seeing any ebbing of the rate pressure that we see right now. And I think the demand for capital are pretty high. There's a couple of large players that were really providing a lot of capacity acute capacity in very, very high capacity mongers in the industry have pulled out significantly, so that means that there's a lot of other capital that needs to find its way around to support it. So I would say that, we are not seeing -- we hear what's out there, what's happening. We're encouraged by -- we raised some more capital and there's other folks such as ourselves who have access to the business, access to the clients and relationships. We're able to raise capital. It bodes well for the health of those companies. But any new entrants, it will take them a while to get ramped up and I don't think it's impossible. I think it's totally doable, but it's certainly not something that we're losing sleep over."
},
{
"speaker": "Mike Zaremski",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Yaron Kinar with Goldman Sachs."
},
{
"speaker": "Yaron Kinar",
"text": "Hi, everybody. First question on MI and then a couple on the COVID losses. So in MI, I haven't really seen any significant pullback from that market. So I guess should I take that to mean that even with all the COVID economic uncertainty you still view it as a pretty attractive business?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, it is still very attractive. I would even argue on that the production in the second quarter and as we speak is actually better than it was six months or a year ago where the rates that's -- rate pressures and also quality of underwriting quality of the originations is a lot better than it was even a year ago. So yes there is a lot more activity. The activity Yaron to be fair is also driven by the refinancing market which was not there and by -- dropping the mortgage rate below 3% that does create more business back into the market. As a result of that there's a lot of prepay, right? There's a higher level of the lower level of persistency which means that there's more churn, if you will in the portfolio of business. So I think it's just a reflection of people coming out of their current -- they're coming out of their higher mortgage rate and it's just refinancing at a low level which still makes economic sense. Now we're on the receiving end to grow. That's what we have such we believe much higher NIWs than otherwise would have been in a more stable marketplace."
},
{
"speaker": "Yaron Kinar",
"text": "Got it. That's helpful. And then with regards to the COVID losses maybe a couple of questions there. One when you talk about IBNR, do you include only events or losses from events that have already occurred or do you also include events in the future that are probable very probable to occur?"
},
{
"speaker": "François Morin",
"text": "Well I mean that's a -- I mean a good question which as you know people are -- I think companies are may be answering that, I don't want to say, differently. But I think the words - we have to be careful with how we use the words, right? So I'd say, no question that we can only reserve for incidents or occurrences that have happened before June 30. I mean that's under GAAP. And anybody that tells you they're reserving for occurrences that are going to happen in the third or fourth quarter, I just don't know how you can do that. What we have done is, set again a high level I think a prudent level of IBNR on both insurance and reinsurance on things that we know happened or think have happened right? I mean the whole concept of IBNR. So we have certain claims that have been reported. We don't know. And certainly when you get into structures or when you're in an excess position, you're somewhat making a judgment on whether the claim will attach in your layer etcetera and that's where there's a bit more -- there's a bit of art that goes on and not necessarily tons of data or science around it. So I think the answer to us is, we've reserved for everything through June 30 and we would say there's an ultimate right? So the truly our best estimate of what we think the exposure is and that's where we are. I mean we can't really do more than that at this point given the accounting rules and guidelines."
},
{
"speaker": "Yaron Kinar",
"text": "Got it. And then final question also with regards to COVID, between first quarter and second quarter the increase in loss and COVID losses is some of that coming from IBNRs that you had already set up in 1Q, but then took a second look and realized they need to be higher or is that from really new lines of business and new areas that had not been not previously reserved for?"
},
{
"speaker": "François Morin",
"text": "Well I'd say it's a bit of both. I mean I would say on the insurance side for example at Q1 we had reserved primarily in set IBNR primarily in our international book because again back to the in the U.K. in particular property book or regional property book there we were of the opinion that there was exposure there. We took action and we booked IBNR on that. I'd say in the second quarter for example we booked and I mentioned it on national accounts that's where we have workers' comp exposure. Again if you want to be very technical at one point, I mean the deaths or the occurrences hadn't happened at the end of March they started to take place especially with health care workers as an example in April and May. So that's when we -- that's what we reserved for in the second quarter. I'd say on the reinsurance side, it's a bit murkier. It's not -- we're somewhat at the mercy or have to have discussions with our scenes and on the property cat book for example. We had booked a little bit of IBNR at the end of Q1. But through additional discussions and investigations and file reviews in the second quarter we booked a bit more on that front and the same is true in trade credit. So hopefully that answers, it but it's a bit of both I'd say."
},
{
"speaker": "Yaron Kinar",
"text": "That is helpful. And maybe one other one if I could sneak it in. On the BI front in reinsurance, the increases in COVID losses that you're reserving for today are those coming more from international accounts or more from the U.S.?"
},
{
"speaker": "François Morin",
"text": "Correct more international. Absolutely. As you know we have exposure. I mean -- Continental Europe in particular there's France here there's certain countries where the BI coverage is more implicit and provided by the primary policies so those are some of the examples that we -- or policies that we -- or treaties that we're reserving for at this point."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Shanker with Bank of America."
},
{
"speaker": "Josh Shanker",
"text": "Can we talk a little bit about July and how it compared with -- noticing for mortgage defaults?"
},
{
"speaker": "Marc Grandisson",
"text": "Can you repeat the question please Josh?"
},
{
"speaker": "Josh Shanker",
"text": "Yes. Can we talk about -- compare May June July -- of you receiving notices for forbearance and defaults?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think we -- I think the one place the one thing that we could say I mean it's -- the data is probably lagging a little bit from our perspective. But the good one to look at is the -- there's information back now I think and the MBA is providing information as to what is their estimate surveying the market and their clients as to who -- what's the forbearance percentage. I think it was pretty much plateauing as we got into May -- towards the end of May into June and through the second - first or second week of July and it's gotten down since then. So we're about 6.1% based on that metric in percent of forbearance from the GSE portfolio from the industry data and now it's at 5.49% as of July 13, I believe this last week. So we've seen a decrease right now Josh. Whether it continues that way or goes back up again. As you know a lot of people pay on the first of the month, but we'll probably have more information and a better clear picture as to what August look -- July looks like in the middle of August."
},
{
"speaker": "Josh Shanker",
"text": "Okay. Thank you. And do you have any evidence one way or the other what RateStar has had any discernible difference in claim behavior -- I should say, claim-noticing behavior compared to how a lot of your competitors were pricing risk prior to your -- to adopting your methods?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, I think, it does. It has had an impact. I think when we talk about cycle management. We also were doing it possibly a little bit more under the radar screen and MI. I think that our RateStar approach with all the parameters actually took us away from a higher than 95 LTV, higher DTIs in certain geographical areas. So yes, we do believe if we adjust for all the variation. I mean, it's not a huge differential, but there is a slight improvement or a slight difference going to our advantage in terms of our delinquencies based on our portfolio and the risk that we underwrote for the last four, five years."
},
{
"speaker": "Josh Shanker",
"text": "All right. And one last one. I think you mentioned the change in AML. I don't think you mentioned the RDS change or maybe I missed it. Where is RDS as a percent of -- directly as of the end of the quarter?"
},
{
"speaker": "François Morin",
"text": "Still right at 8% pretty flat. We've -- a couple of movements across the kind of contributions, but yes 8% of tangible book."
},
{
"speaker": "Josh Shanker",
"text": "Thank you for all the answers."
},
{
"speaker": "François Morin",
"text": "You’re welcome."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks, Josh."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ryan Tunis with Autonomous Research."
},
{
"speaker": "Ryan Tunis",
"text": "Hey, Thanks. Appreciate the MI guidance, I realize all this is like literally impossible to nail down, but I'll go ahead and I'll push on it a little bit more, because it is interesting. So when you think about the full year delinquency rate in your mind what are you thinking the percentage of forbearances are going to be of I think you said what was it 8%? How much of that is forbearance versus what you think of as like a real delinquency?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, the forbearance that we will declare -- that we will report that we're reporting to you are delinquencies by definition, right? So it's very hard to see I know what you're asking. And I think the one thing that we will tell you about projecting forbearance rates and delinquency rates in this forbearance world is that data is very, very hard to get and it's lagging a fair amount, so very difficult for us to tell you."
},
{
"speaker": "Ryan Tunis",
"text": "And, I guess, my follow-up too is, how are you planning on treating these delinquencies as they age? Like you're obviously using a pretty conservative incidence rate of 5%. I mean, as those move into the -- as those age to six months or whatever like are you going to keep it at 5% or are you going to assume something bigger than that?"
},
{
"speaker": "Marc Grandisson",
"text": "I think it's -- there are two moving parts of that 5% Ryan. One is the -- it comes up really as our pre-COVID NODs to ultimate, which was 7.9% and we gave a discount about 33% haircut by virtue of being a forbearance. So as we move forward that 7.9%, which is a claim that's aged three months versus a claim that's aged two years or nine months even though it's a forbearance, we might have to increase those rates. But at the same time if the forbearance programs are getting better we might give a bit more discount or less discount. So it's a really, really -- and you're right you just pointed at the beginning of your comments. I think I should have probably let you answer your own question, which is it's pretty much impossible to answer at this point in time. But right -- and we have -- all we have is a 7.9% pre-COVID ultimate NODs, which was starting point getting some discount, recognizing that the regular forbearance program on hurricanes, which it is not right now -- is as low as 2%. So we're try to find our way around that environment, also recognizing that the delinquencies out of this crisis this COVID-19 will be longer to resolve, because the forbearance program as we all know will last for 12 months. So it's going to be -- it's going to take us a while to really understand the underlying fundamental characteristics of those risks. And to add all this -- to all of this if that wasn't enough, we'll have remediation programs put in place by the GSEs, which presumably should help a tremendous amount. But again, it remains very early to see -- to say."
},
{
"speaker": "Ryan Tunis",
"text": "Understood. And then lastly, Mark, this is purely hypothetical, but if you had $1 of capital for the next year or two years and you can only allocate it to reinsurance or primary insurance, is there a clear preference for which one you allocate it to?"
},
{
"speaker": "Marc Grandisson",
"text": "How many years?"
},
{
"speaker": "Ryan Tunis",
"text": "Two years."
},
{
"speaker": "Marc Grandisson",
"text": "Man, so to me you're asking me to choose among my kids. I got three kids, I love dearly."
},
{
"speaker": "Ryan Tunis",
"text": "I would split it in three -- three ways or I mean, which way I would like to know…"
},
{
"speaker": "Marc Grandisson",
"text": "I mean, to me it's not an all or nothing. But I do believe right now at this point in time, which is I think what you're getting into, which I mentioned in my comments the returns on the reinsurance are quicker to a high level get quicker. But in terms of value creation over the longer time insurance will get there and get traction. It just takes a longer time to accumulate business at a higher level so -- but the problem with the reinsurance it's great for a couple of years but then you might lose that business. So it's not an all or nothing kind of situation. I wouldn't want to go, let's say, all-in in reinsurance even though they have higher ROEs sooner at the cost of losing long-term value creation from the insurance unit."
},
{
"speaker": "Ryan Tunis",
"text": "Thanks for the color. Appreciate it."
},
{
"speaker": "Marc Grandisson",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "Our next question comes from Meyer Shields with KBW."
},
{
"speaker": "Meyer Shields",
"text": "Thank you. I wanted to follow-up on that question, but in a different direction. You talked about reinsurance maybe recovering faster than insurance. How is the current hardening cycle playing out in terms of speed relative to past cycles? Is there any observable difference?"
},
{
"speaker": "Marc Grandisson",
"text": "Not really. I would say that we -- Meyer we may have that discussion before. A hard market never happens overnight. It takes five signal – two, three quarters. Losses have to develop. Management team have to figure out what they want to do and put pressure on their underwriting team. So it's no -- it's not unlike others that we've seen before. I would say that we were going to a strengthening of the market conditions even before COVID-19, I think that COVID is probably accelerating the reaction and the willingness and the boldness that we see in the underwriting teams around the industry. But there are still pockets Meyer where people seem to be a little bit aloof in what's going around. And these are the areas we're not growing as much as we should. But I know every cycle turn is different, but I'm not seeing significant difference. It does take-up -- and well one last thing, I will tell you. The one thing about this one is that, we have yet to see is the 1/1 renewal on reinsurance is a really important renewal date, so we'll have a lot more sense as to how quickly and how reactive the market will be as we head into this one."
},
{
"speaker": "Meyer Shields",
"text": "Okay. No. That's very helpful. Thank you. In the past, we've been, I guess, targeting improvements within insurance that would get to a 95% combined. And when we look to the lens of current pricing, is there an update in terms of what that 95% can become?"
},
{
"speaker": "Marc Grandisson",
"text": "I hope it's lower. But all kidding aside Meyer, I think that the 95% was put in place as an aspirational number two, three years ago. Now, two years ago now in an interest environment that was different. So, I think right now what we're processing it through -- this was sort of an aspirational as a guiding sort of target for our insurance group. I think right now what we're seeing is we're going through every different line of business and business units and attributing capital and return on investment and we're pitching everything to get to the right level. So, 95% is an over-simplistic way of looking at this. But all things being equal I think I would expect it to be lower right for the industry and that's also why you'll probably see a bit more pressure on the pricing around us in the industry."
},
{
"speaker": "Meyer Shields",
"text": "Okay, perfect. And then final question if I can just in terms of whether you've had to take into account whether it's COVID or something like that that's so remote or other pressures whether you've dialed up your overall last year numbers in insurance or reinsurance?"
},
{
"speaker": "François Morin",
"text": "Not in a meaningful way. I think -- I mean we've been pretty cautious. And I think I've been I'd say realistic about what the loss trends have been and what we expect them to be going forward. As you know we haven't relied exclusively on kind of the last five or 10 years of data. We superimposed our own views on what a more normalized view of loss trends is or should be. And I think we're still very comfortable with where we were at and recognizing that yes COVID is a bit of an outlier. But at this point, haven't really factored in any material changes in our loss trends in how we price the business."
},
{
"speaker": "Meyer Shields",
"text": "Okay, fantastic. Thank you so much."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Meredith with UBS."
},
{
"speaker": "Brian Meredith",
"text": "Yes, thanks. A couple here for you. First one, I don't think you mentioned it, but was there any benefit at all in the quarter from just lower frequency of economic activity kind of from a claims perspective in any lines of business?"
},
{
"speaker": "François Morin",
"text": "I mean there are some indications that in some places yes, there's lower economic activity which will translate to lower losses or claims. We really haven't reflected that yet. I mean we want to take a cautious approach on that, so I'd like to think that maybe there's some to come down the road but for now we haven't factored that in anywhere in our numbers."
},
{
"speaker": "Brian Meredith",
"text": "Great. And then second question I'm just curious Marc as you look at I guess the HEALS Act here there's a component into it of kind of liability call it indemnification. As you think about it if that doesn't go through is that a potential issue here for you and the insurance industry? And how do you kind of think about it from an underwriting perspective here going forward?"
},
{
"speaker": "Marc Grandisson",
"text": "I missed the word you said Brian. Could you repeat the early part of your question?"
},
{
"speaker": "Brian Meredith",
"text": "Well, it's -- basically curious about protection or what you think about as far as the economy reopening here and potential liability associated with kind of COVID-19. The current I think it's called the HEALS Act or the CARES 2 Act has got some language in there trying to grant businesses and immunity for it right? I'm just curious of your thoughts around that. And if you're interested for insurance?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, it's not good. They're going to allocate more liability to us or presumption to us is not good. But I think in this sense these laws are always there. There's always things that are happening. We're going to have to react to what we see when we see it. That's all I can tell you Brian. It's very hard to sit here and go through what impact it is. If we were to react and do this full drill about everything that goes and a bill that's proposed it would take a lot of our time. So, we'll react to it when we'll react to it, right?"
},
{
"speaker": "Brian Meredith",
"text": "Yes. And Marc I think you get it wrong. I think you mistake my question. My question more is from your insurance policies perspective as you look going forward as the economy reopens up there's clearly EPLI exposures or GL exposures all sorts of exposures to potentially present themselves as benefits. How do you -- how are you thinking about that from an underwriting perspective?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, we have written policies that have EPLI exposure, we have GL exposures but we are not a large risk writer. We don't write the large insurers so that's certainly something that would be helpful to us. We would argue that a lot of the larger claims a lot of the focus from the low risk plaintiff bar would be focused on the larger deeper pocket insurer, so that's one thing we have for us. We also have a fairly amount -- a good healthy amount of reinsurance, so we're not overly concerned with the sideways change."
},
{
"speaker": "Brian Meredith",
"text": "Yes. Got you. Okay. And then another just quick one here. Your travel insurance I'm just curious how big of a book is that? And obviously we're probably going to see some continued pressures there for the rest of the year."
},
{
"speaker": "Marc Grandisson",
"text": "Yes, it was originally about a couple of hundred million dollars of premium and now it's down -- I mean you could see the numbers you can multiply by four. I don't need to -- 250 actually for the year. So that's -- it's been -- it's taken a big dent and that also explains why the growth was more tested this quarter than otherwise could have been."
},
{
"speaker": "Brian Meredith",
"text": "Great. And then one other just quick one here for you. I know you guys launched the sidecar guesses in the first quarter. Any thoughts about additional kind of alternative capacity here to potentially capture some of the good attractive opportunities in reinsurance?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a good question Brian. You're trying to get us to say something we don't want to say we can't say and we won't say. We don't mention about we certainly are always on the lookout to raise capital to deploy it with third party a lot of discussions are happening all over. We'll have probably more update as we see it happen and we'll be communicating to you to the extent it's appropriate but how much more it is clearly -- yes."
},
{
"speaker": "Brian Meredith",
"text": "Great. Great. Great. And last one just quickly any updates on Coface?"
},
{
"speaker": "Marc Grandisson",
"text": "Coface strategically is still something we really very much think is valuable for the shareholders. There's a lot going on. We're still going through the process of approval process and we're keeping a keen eye on what's happening. I think they reported results yesterday which were better than The Street expected. So, hopefully if that goes. It's also there as well a developing situation with them."
},
{
"speaker": "Brian Meredith",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Phil Stefano with Deutsche Bank."
},
{
"speaker": "Phil Stefano",
"text": "Yes, thanks. Just a quick one on the Bellemeade transaction. I'm thinking about the potential for these moving forward. I guess it seems like the Bellemeade deal that was done in the past quarter just given its attachment was probably more for S&P capital credit than PMIERs. When we saw an MI pure play come out with their own ILN transaction which is in my mind more of a traditional attachment point in the low single digits but the spreads on that and the pricing was significantly higher. How are you thinking about the managing of tail risk that Bellemeade provides versus just the capital credit that could be from playing I would think something that could be considered well above the working layers for the MI reinsurance coverage and the capital relief that something like that might provide?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, it's a good question. I think it's always something we evaluate when and if we place or look at options that are in front of us. You're correct this one attaches -- the last one attaches above the PMIERs credit, but we're still very much in -- we have a healthy PMIERs ratio so that didn't really concern us too much. At this point not to say that next time or down the road, we may not go back to a lower attachment point. But yes, the focus was really -- yes it's an available source of capital. From a rating agency point of view, S&P you're correct it covers that. It provides us coverage there. And also we felt as being the first one out of the gate even before the GSEs to go back and access the capital markets was we thought a very strong message demonstrated. Again ,I touched on it the quality the book and the investor base is still very has a lot of interest and appetite for the product, so I think we were happy with the placement. No question it's always too expensive. We'd like to see the price to come down. We hope they do down the road. But for the time being given the economics in front of us we were -- I think it was a good move on our part."
},
{
"speaker": "Phil Stefano",
"text": "Got it. And to the extent that you guys have a disclosure wish list that you keep in the background, I think it might be helpful to see the USMI disaggregated from the international and the mortgage reinsurance book just been the significant differences in how those businesses are reserved for? Thanks for appreciating."
},
{
"speaker": "François Morin",
"text": "See you, back. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Geoffrey Dunn with Dowling & Partners."
},
{
"speaker": "Geoffrey Dunn",
"text": "Thanks. Good morning. I guess first just a quick number question. Can you quantify the impact of the accelerated singles in the quarter?"
},
{
"speaker": "Marc Grandisson",
"text": "Did we do that? I think it's about $50 million."
},
{
"speaker": "Geoffrey Dunn",
"text": "$50 million, okay. And then let's think forward past the end of new forbearance so early next year, so given what you know about the economy now obviously very different from a couple of months ago. How would you think about claim rates on new notices without forbearance? Because again you pointed out it's very different with home prices remains to be seen if we're going into a recession or not. And I think Marc last quarter you suggested, we might be looking at 13%, 14% given what you knew then. So what do you think about that type of number as you get into early 2021 based on what you know today?"
},
{
"speaker": "Marc Grandisson",
"text": "I think the 5% is probably -- this is like on NODs or you're talking about ultimate claims rate for the portfolio?"
},
{
"speaker": "Geoffrey Dunn",
"text": "On NODs. So new notices coming in forbearance goes away."
},
{
"speaker": "Marc Grandisson",
"text": "NODs, yes. Right. I think we were at 7.9% pre-COVID. I think that the forbearance should be pretty helpful and to bring it up -- not bring up to the 13%, 14% you just mentioned, I mentioned first quarter. That's probably -- my gut would tell me a slight increase for a little while until we see things shake out and things came back to more normalcy. And I think reverting back to some kind of level. I think the forbearance program were to play out to the way it should play out. It's still very uncertain as you know Geoff. I think that we should get back to -- it might stay elevated for a while maybe 12%, 13% for a little while but it should go back down at some point for next year I would say."
},
{
"speaker": "Geoffrey Dunn",
"text": "Okay. Alright. So you do think given what you know about the economy and built-up equity that you could still see 12% type of incidence assumption?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. Yes on NODs, right? On new NODs for regular piece not for the forbearance piece? The forbearance piece we gave -- we did give a discount, right? There's a discount to that. So yes then just got it from – right. Congrats, yes."
},
{
"speaker": "Geoffrey Dunn",
"text": "All right. Thank you."
},
{
"speaker": "François Morin",
"text": "Quick, I mean before you go on to the next one, Geoff quick update for you. The actual impact of the singles was $27 million in the quarter. Just correction to Marc $50 million."
},
{
"speaker": "Geoffrey Dunn",
"text": "Thanks, again."
},
{
"speaker": "Marc Grandisson",
"text": "Okay. Go with $51 million."
},
{
"speaker": "François Morin",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jimmy Bhullar with JPMorgan."
},
{
"speaker": "Jimmy Bhullar",
"text": "Hi. I just had a question on pricing and just how you think about the interplay between the decline in exposures if the economy remains weak and how that could affect demand and pricing? And relatedly what else is out there that you think could potentially derail the momentum that you've seen in pricing both in insurance and reinsurance?"
},
{
"speaker": "Marc Grandisson",
"text": "I mean it's hard to predict the future. As you know -- my God! I think if everything resolves, I mean even if things resolved for the better, I think the momentum that we've seen in the first quarter, late 2019, early 2020 I think we would still see some momentum. I think it would be just a matter of degree how much higher the rates could go. But I do believe the momentum was there for a turnover market way before pre-COVID-19. COVID-19 like I said before exacerbated the need for rate and accelerate the need for rate."
},
{
"speaker": "Jimmy Bhullar",
"text": "And then there's been a lot of talk about sort of ILS and trapped capacity and what do you think about when either some of the capacity gets relieved or potentially gets absorbed? And once there's clarity on that do you think by this time next year like a lot of the trapped capital would actually be out?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a possibility. I mean that's also assuming there's no more cat occurring this year. But this is a long-lasting cat event so it's not as clear as having a quake let's say in March. And I guess in a year out it's still developing but you have a better sense for wanting to or would be willing to release capital. This one will take a bit longer to process through, right? For instance, you could have arguments in courts and new ways and new push back on the insurance industry to pay claims in a property cycle. And that would take -- that could take another 1.5 years or two years to resolve. So, there's a lot more uncertainty in terms of timing finding resolution of the ultimate prices. So, it's a lot less certain that it will take only a year to get through it."
},
{
"speaker": "Jimmy Bhullar",
"text": "Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Sure."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jamie Inglis with Philo Smith."
},
{
"speaker": "James Inglis",
"text": "Hi. Good afternoon. I wanted to follow-up on the conversation we've been having about forbearance programs and to what extent delinquencies get cured get claims -- turn into claims sort of, et cetera. And I appreciate that we don't know what's going to happen going forward, but I'm wondering if you could speak to what you learned in previous forbearance programs and how that affects your thinking about your current book? And if -- and what you learned in there? Was it -- did you learn anything about LTVs geographies sort of, et cetera? And how does that apply to your existing book today?"
},
{
"speaker": "Marc Grandisson",
"text": "I think we have done reserving in the past, considering all the dimensions you just talked about, I think that we had the -- the beautiful thing about the prior hurricanes or the beautiful thing in a way is that we have prior hurricanes and prior events that we can go back to and look at the experience. This definitely help us put I guess, boundaries around what could happen, but this one is very unusual in the length of the forbearance program and the breadth and how widely spread it is. And I think we also have to throw in there the $600 per week unemployment benefits and the distribution that we talked about. Some regions are more heavily affected than others. So I think everything gets in the mix Jimmy -- Jamie. It's not just one dimension. And I think what we've learned is that, we sort of can use the historical forbearance experience as sort of as a range of possible outcome. But, we actually are digging heavily, heavily into developing a much more refined view of a forbearance-specific programs, such as the one we're facing right now. And we may never use it again, but at least we're in the process of readjusting our development claims model called ARMOR that we have internally. So, we're -- it's still very much developing and we're learning on the fly."
},
{
"speaker": "François Morin",
"text": "Yeah. Two things I'll add quickly to that. As Mark mentioned, the historically forbearance delinquencies most of them cure. I mean -- and we made comment that the 2% kind of claim rate. So that's obviously a very positive sign, but that's again more localized and it's a short-term issue. So, I mean understandable that these delinquencies most of them would cure. So that would be one extreme that would be a very good result in this situation. Maybe a little counter to that, as you may know, many of the claims or the mortgages or loans and forbearance up to 40% were actually still current, up until recently. So, in the early days of the second quarter, many loans had accessed the forbearance programs, but remained current and made their mortgage payments. The data now suggests that that percentage has come down. So the reality is, now we'll get a few more loans that have turned delinquent that were historically current or had been current in forbearance, but now have turned delinquent. So, that's a bit of a data point that we're monitoring, but that kind of gives us a bit of -- not necessarily concerned, but we have to understand better so that we can refine our estimates as we move forward, because the 2% ultimate claim rate may not be achievable or probably won't be what we end up with in this current situation."
},
{
"speaker": "James Inglis",
"text": "Okay. Thank you. Appreciate it. Good luck in future."
},
{
"speaker": "François Morin",
"text": "Thank you, Jamie."
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks for joining us this quarter. Please stay safe. Have a nice rest of the summer, and we'll talk to you in the fall again. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 1 | 2,020 | 2020-05-05 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Arch Capital Group First Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference Mr. Marc Grandisson and Mr. François Morin. Sirs you may begin.
Marc Grandisson: Thank you, Shannon, and good morning to you. It would not be an understatement to say that, the coronavirus has changed the world since our last call with you just three months ago. Fortunately, at Arch we are entering this period with the investments we have made in our P&C business beginning to pay off, while our mortgage group navigates through the current turbulence. If you work long enough in the insurance business, like I have, you are bound to experience the industry cycle its highs and its lows. As management, we have to keep our eye on the goal which for Arch is generating sustainable growth in book value per share. The current stress in the financial and insurance markets reminds us of changes that can occur to which we need to adapt. While we are still early in the assessment of our direct and indirect claims exposure to the coronavirus, it is clear that this event will be a significant industry loss and will result in profound changes. However, dislocation often leads to opportunity. As you know, one of Arch's strategic principles from inception has been cycle management. We are embarking in this new market environment, with both a strong financial foundation and the creative ability of our more than 4,200 employees that position us for the opportunities that will emerge. Turning to the quarter. We saw improving conditions in our P&C businesses, while our mortgage operations continued to produce good results. Strengthening P&C market conditions remain evident, even as the economy contracts. We have seen a rise in our submission activity along with accelerating rate increases, across multiple lines of business in Q1 and it is continuing here in Q2. Our belief in the continuing hardening of the P&C market is due to the need our industry has to address the accumulation of risk factors over the last five years of soft market conditions. These risk elements are; one, future claims and covered litigation related to COVID-19; two, a heightened perception of risk in general; three, economic uncertainty; four, a continuation of low interest rates and the dampening effect on investment returns; five, a potential for shortfalls in casualty reserves; and six, reduced availability of retro and alternative capital in general. These risk elements are all in play today and are likely to lead insurance companies to be more cautious in allocating capital to risk. In our insurance group, our strategy remains to be selective and pick our spots in this improving market. The rising rates environment and dislocation in the markets have allowed us to grow profitably in the past two years in many sectors, such as, E&S property, D&O and E&S casualty. On a reported basis, we saw our margins improve this current quarter as our accident combined ratio ex-cat of COVID and PYD improved to 97%. In our reinsurance business, pricing is also improving and we continue to observe tightening of terms and conditions in many lines. The value of reinsurance as a capital protection tool has been enhanced by the recent events. The hallmark of our reinsurance group remains the dynamic allocation of capital to contracts that will provide appropriate risk-adjusted returns, while helping clients with solutions that are tailored to their needs and was a large factor in our growth this quarter. Switching now to our mortgage insurance segment, the industry is facing its first significant test, since the fundamental reforms and product improvements that were adopted following the global financial crisis or GFC. As you know, Arch MI is a data and analytics-driven company and our investment in the sector was predicated on a new and better MI operating model than the industry employed prior to 2008. Now, pricing is more precise, products and documentation are better and the MI industry buys protection against downside. In addition, another change in the industry can be; seen in the aggressive government actions taken in the early stages of the pandemic directed at helping borrowers stay in their homes. The GSE's forbearance program and the unemployment benefits programs provide unprecedented support that should enable borrowers to cure delinquent – delinquencies as the economy improves and will result in fewer losses. As noted in our quarterly HaMMR report, the MI industry is far better positioned for a recession than they were in 2008. At that time, mortgage insurance portfolios were facing a housing market that was significantly overbuilt, risky mortgage products and less creditworthy borrowers. More than two-thirds of mortgage insurance written in 2007 would have been uninsurable during the last 10 years. And finally, there was a speculative bubble in home prices. Mortgages filed under the FHFA's forbearance programs, were estimated at 5.85% of the GSE mortgages as of April 26. This program allows homeowners to suspend mortgage payment for six months, which can then be extended for up to another six months. While initially recorded as delinquencies under GAAP, our data on forbearance programs utilized in recent natural catastrophes indicates that almost all of these loans cure by providing borrowers time to return to work. Over the next few quarters, rising delinquency rates under GAAP, should lead to elevated loss ratios in the MI segment. Furthermore, once the forbearance programs expire, the GSEs have instituted a sturdy list of remedial solutions that once again will enable loans to be back-performing. We realize that this pandemic-led recession will be different than a GFC. But based on what we can see today, our view is this is an earnings not a capital event for Arch. It is worth noting again, that even if this recession is worse than we currently expect, we hold significant reinsurance protection on our risk in force that would moderate our net losses even in a more severe recession. While some of our reinsurers' quota share attaches at first-dollar loss that index-linked know that from our Bellemeade securitization, we’ll provide up to an additional $3 billion of excess and loss protection, if this becomes a recession worse than what the industry experienced in a GFC. Lastly, turning to our investment operations. We believe that interest rates are likely to stay at historically low levels for the foreseeable future and that will over time require insurers to improve their underwriting margins through price increases. In our investment strategy, as in our underwriting approach, we have maintained our focus on risk-adjusted total return while enabled us -- which enabled us to avoid much of the negative impact of the pandemic on our investments this quarter. As perception of risk increases, so does the cost of capital and underwriting discipline becomes important. Again, recent world events reminds us that risk is always present, that insurance premiums must include an adequate margin of safety and that reinsurance plays an important role in protecting capital and returns. In summary, through to Arch's cycle and risk management principles and fortified by our conservative balance sheet, Arch is prepared for this crisis and is well-positioned to continue to build on its track record of book value growth. In closing, I want to thank all of our employees around the world, as they are responsible for the success of Arch, and are working tirelessly throughout the world to meet the needs of our insurers. Thank you. With that, I'll turn the call over to François.
François Morin: Thank you, Marc, and good morning to all. We, at Arch, hope that you are in good health in these difficult and uncertain times. This quarter, in anticipation of some of the questions you may have, I will try to elaborate in more detail on some notable items in addition to the regular discussion of financial items. I recognize this may take a bit longer than usual, so please bear with me. Now on to the first quarter results. As a reminder and consistent with prior practice, the following comments are on a core basis which corresponds to Arch's financial results, excluding the other segment i.e. the operations of Watford Holdings Ltd. In our filings, the term consolidated includes Watford. After-tax operating income for the quarter was $189.8 million, which translates to an annualized 7.1% operating return on average common equity and $0.46 per share. Book value per share decreased to $26.10 at March 31, a slight reduction of 1.2% from last quarter and a 12.9% increase from one year ago. The defensive posture of our investment portfolio ahead of the COVID-19 crisis served us extremely well in preserving our capital base relatively intact during the stressed economic environment of recent months. I will elaborate on this in more detail later on. Outside of the losses related to the COVID-19 pandemic, which impacted on our first quarter results, our underwriting groups fared very well this quarter with strong growth and generally improving underwriting results through our property casualty insurance and reinsurance operations. Given the unusual circumstances and breadth of the pandemic, we have classified COVID-19 losses as a catastrophe. However, as you saw in the financial supplement, we have also provided the segment level detail of our current estimates to assist with the analysis of the underlying performance of our book of business. We expect to follow this approach until the end of 2020 at a minimum. Losses from 2020 catastrophic events in the quarter, not including COVID-19, net of reinsurance recoverables and reinstatement premiums stood at $31.8 million or 2.0 combined ratio points compared to 0.6 combined ratio points in the first quarter of 2019. The losses impacted both our insurance and reinsurance segments and were primarily due to various U.S. severe convective storms, U.K. storms and floods, and Australian bushfires. We recorded approximately $87 million of COVID-19 losses across our P&C operations, split 41% to insurance and 59% to reinsurance. While it is still very early and we have extremely limited information to accurately quantify our potential exposure to the pandemic, we believe that it was prudent to establish a certain level of IBNR reserves for occurrences through March 31, based on policy terms and conditions including limits, sublimits and deductibles. These reserves were recorded across a limited number of lines of business, such as property, where we have a very small number of policies that do not contain a specific pandemic exclusion and/or explicitly afford business interruption coverage under a pandemic and trade credit. As regards the potential impact of COVID-19 on our mortgage segment and our estimation process at this time we believe it's important to make a distinction between our U.S. primary mortgage insurance unit which we refer to as USMI and the rest of this segment which includes our international book and our portfolio of GSE credit risk transfer policies. For USMI pursuant to GAAP our estimates are based only on reported delinquencies as of March 31 2020. However, given the potential effect of the pandemic, we elected to book reserves at a higher level of confidence within our range of reserve estimates for such known delinquencies. The financial impact of this increased level of conservatism was approximately 5.2 loss ratio points across the segment. For the rest of this segment the loss-reserving approach we use is more consistent with traditional property casualty techniques where loss ratio picks are set at the policy level and are able to consider future delinquencies on business already earned. This quarter in response to the potential impact from the pandemic across our portfolio, we adjusted our loss-ratio picks for some policies, which resulted in an increase of 6.8 loss-ratio points to the overall segment results. Based on the information known to date and economic forecast, we believe the adjustment across the non-USMI book is prudent and consistent with a moderately severe stress level. As we look towards the remainder of 2020 for our USMI unit, we are expecting the delinquency rate to increase progressively from the current level as more borrowers request forbearance on their mortgage loans under the CARES Act. As mandated by GAAP, we expect to record loss reserves on these delinquencies which will most likely translate into an increase in our levels of incurred losses over the coming quarters. Over time, we would expect many of these delinquencies to cure and revert back to performing loans as the economy returns to a more normal state. At this time, we do not have enough visibility to predictably forecast the rate at which forbearance delinquencies will be reported to us. Cure are ultimately turned into claims on an annual let alone a quarterly basis. That said, based on our current analysis which tells us that the pandemic will represent an earnings event for our mortgage segment and not a capital event, our current expectation is that our pretax underwriting income for the entire mortgage segment will be minimal for the remainder of 2020, i.e. from the second through the fourth quarter of 2020. However, there is likely to be variability in underwriting income between quarters based on the timing of receipt of notice of defaults. Turning to prior period net loss reserve development, we recognized $17.8 million of favorable development in the first quarter net of related adjustments or 1.1 combined ratio points compared to three combined ratio points in the first quarter of 2019. All three of our segments experienced favorable development at $0.8 million $11 million and $6.1 million for the insurance, reinsurance, and mortgage segments respectively. We had excellent net written premium growth in the insurance segment of 33.4% over the same quarter one year ago. The insurance segment's accident quarter combined ratio excluding cats which as a reminder include COVID-19 losses was 97.1% lower by 310 basis points from the same period one year ago. Approximately 190 basis points of the difference is due to a lower expense ratio, primarily from the growth in the premium base over one year ago. The lower ex-cat accident quarter loss ratio primarily reflects the benefits of rate increases achieved throughout most of 2019 and the first quarter of 2020. As for our reinsurance operations, we had a significant transaction in the quarter which affected the comparability of our underwriting results an $88 million loss portfolio transfer written and fully earned in the period in the other specialty line of business. Absent this transaction, net premiums written would have been 57.2% higher than the same quarter one year ago. This net written premium growth was observed around -- sorry across most of our lines and includes a combination of new business opportunities, rate increases, and the integration of the Barbican reinsurance business. While the loss portfolio transfer had a minimal impact on the overall combined ratio for this segment, a decrease of approximately 50 basis points, its impact on each of the loss and expense ratio components was more observable with a resulting increase of 400 basis points to the loss ratio and a decrease of 450 basis points to the expense ratio. Overall, the growth and underlying performance of our reinsurance segment was very good this quarter. The mortgage segment's combined ratio was at 44.1% including the 12-point loss ratio -- loss ratio impact resulting from the increased level of conservatism in our overall segment reserve estimates discussed earlier. The expense ratio was higher by 240 basis points over the same quarter one year ago reflecting reductions in profit commissions on ceded business and higher compensation costs and employee benefits. Total investment return for the quarter was negative 80 basis points on a U.S. dollar basis as the defensive positioning of our portfolio served us extremely well in this difficult period. Given some of our fund investments are reported on a lag typically three months, their first quarter performance will be included in our second quarter financials. The duration of our investment portfolio was slightly lower than last quarter at 3.19 years compared to 3.40 years at December 31st, but remain overweight relative to our target allocation by approximately 0.35 years. Most financial markets had a positive return in April which should help reverse some of the results we're -- we observed in the first quarter. The effective tax rate in the quarter on pretax operating income was 10.5% and reflects the geographic mix of our pretax income and a 110 basis point benefit from discrete tax items in the quarter. As always, the effective tax rate could vary depending on the level and location of income or loss and varying tax rates in each jurisdiction. Turning briefly to risk management. Our natural cat PML on a net basis increased to $680 million as of April 1, which had approximately 7% of tangible common equity remains well below our internal limits at the single event 1-in-250-year return level. With respect to capital management, we remain committed to maintaining a strong and liquid balance sheet. During the quarter, we repurchased approximately 2.6 million shares at an aggregate cost of $75.5 million. While we have a meaningful remaining share authorization under our current program, we do not expect to repurchase shares for the remainder of 2020. At USMI, our capital position remained strong with our PMIERs sufficiency ratio at 165% at the end of March 31, 2020, which reflects the coverage afforded by a Bellemeade mortgage insurance link notes. These structures provide approximately $3.1 billion of aggregate reinsurance coverage as of March 31, 2020. Finally, to echo Marc's comments, I'd like to give a special shout out to our more than 4,000 colleagues around the world that have demonstrated a tremendous amount of creativity, patience, resilience and compassion with clients and business partners, the communities they live in, their families and loved ones and each other over the last seven-plus weeks. They are the essence of what Arch is all about and I couldn't be prouder to be part of such a great team of individuals. Thank you. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo. Your line is open.
Elyse Greenspan: Thanks. Good morning. My first question is on the mortgage segment. So, I heard you guys say that kind of still difficulty -- difficult to put your hands around what the total loss could be within MI. But you did say that you expect no underwriting income for the next three quarters. So, if I look at what you guys might have been expecting, it seems like -- and look at what you've generated right in the back few quarters of 2019 and that translates maybe into about an $800 million of vicinity loss. Now the reason why I go there is your RDS that you guys disclosed at the end of last year for that business was around 8% of your tangible equity. So the numbers seem within the same ballpark of each other. So, am I triangulating correct that you're assuming that this loss could be equivalent to your RDS, or am I missing something in putting those thoughts together?
Marc Grandisson: Yes. I think -- thanks Elyse for the question. I think that the two numbers appear to be the same level, but they're actually coming from a different source. The $800 million that you referred to that could be let's say, it's a great number for the next three quarters will be incurred losses. And against that you have to put premium. And if you look at our RDS scenario, we actually look at the rollout of all the claims paid in the future and we offset it by all the premiums that we would receive and this is what constitutes the PML. So they're very different. One is a net P&L impact. The other one is the incurred loss of the $800 million you mentioned the first time around.
Elyse Greenspan: So the $800 million is the losses that you expect over the balance of the next three quarters not the -- I thought you had said it wouldn't generate any underwriting income?
François Morin: Yes. I mean just to clarify I think, it's really a difference between the next nine months versus the full runoff of the in-force portfolio. As we think of the remainder of 2020 what -- the comment I made was really underwriting income meaning premiums minus losses minus expenses. And we're saying, we don't expect a whole lot of underwriting income for the remainder of 2020. When we think about the RDS, fundamentally to get to a similar let's say an $800 million number that you quote of RDS. What that would mean was really -- would be a much larger incurred loss because we expect to have material premium flows or premium income coming to us in future calendar years which may be five, seven, 10 years. So, it's just -- the RDS is really a full comprehensive premium and gain/loss -- underwriting income across the full runoff of the in-force portfolio.
Elyse Greenspan: Okay. And then within the RDS, can you remind us what are the assumptions for delinquency rates as well as like housing price depreciation and how we think about you guys coming to that 8% loss figure?
Marc Grandisson: Yes. There are many assumptions, but at a high level decrease in-house price 25% below fundamental, so 25% from now going down and staying there for two to three years. Interest rates shooting up 7% or 8% that these are major -- the two major ones that unemployment of course lasting longer. The length of time that our RDS is stressing our portfolio when we go through it is a much longer period than even the 2007 crisis would have generated. To the delinquency equivalent, it's something more like 9% ultimate claims rate. It's hard for me to parse out what is delinquency versus conversion to claims. So, at a high level we prefer to think in terms of claims rate. So, the portfolio as it stands right now, if you run it off and 9% of it were to default that will be equivalent to the RDS net that we have which is significantly above what we expect right now just to -- just for your benefit which is significantly above what we expect to happen for the next 12 months.
Elyse Greenspan: And then one last one on the guide for the lack of underwriting income for the year-end mortgage, does -- and you -- do you guys -- are you guys assuming that you're going to have to use some of your ILS the Bellemeade securities, or at this point you do not think you might attach into any of those covers?
François Morin: Well, two things that just for -- I think good points of clarification for you guys. First of all, the Bellemeade protections as you probably do know amortize over time. But there's a trigger on them that basically once you exceed a certain level of delinquencies, they stop amortizing. And that we think we expect will happen most likely sometime in 2020, and maybe in the second quarter maybe in the third quarter maybe later. And that will basically freeze at least for some period the amount of covereds that is available to us, and would remain most likely for the duration of each of those structures. But to answer I think more directly to your question, we do not expect under most scenarios that we would trigger the coverage of the provided by the Bellemeade protection. So the $3 billion of excess of loss cover that we talk about, we know is available, we know it's there. But at this time under most scenarios, we don't expect to pierce the attachment that we would -- where we would actually fully -- well, we'd start to receive coverage or cede some of our exposures.
Elyse Greenspan: Okay. Thank you for all the color.
François Morin: You’re welcome.
Marc Grandisson: Welcome.
Operator: Thank you. Our next question comes from Jimmy Bhullar with JPMorgan. Your line is open.
Jimmy Bhullar: Thanks. Good morning. So just first a question on the MI business. Your assumption of no underwriting income for the rest of the year, does that reflect primarily you having to reserve at the level that reflects sort of delinquencies given GAAP rules, or does it also -- and not -- and you -- from your comments, it seems like you think ultimate defaults will be lower than that given that people are taking advantage of forbearance and stuff and then the cure rates will be higher. But it's more because of just you having to reserve at a higher -- at the level that reflects delinquencies, or is it also a reflection of your views on ultimate defaults?
François Morin: Yes. It's certainly more of the former. So right we do expect the reality given the forbearance programs that have been in place we expect a higher than normal flow of delinquencies to be reported to us. Some people are just taking advantage of the programs just to be safe and they'd rather just play safe and not take the risk of falling behind on their mortgage payments. So what we expect will happen, we haven't seen much of it yet but we do expect -- I mean, that will pick up in Q2 and Q3 is that we will have to -- we will receive these delinquencies. When we come to the end of Q2, we'll have to assess what kind of reserves, we'll set on those delinquencies. We'll make determinations on the probability that those will actually cure based on the information, we'll have in front of us at that time. It's too early today to tell you what that will look like. But certainly based on the fact that we expect just an elevated number of delinquencies to be reported to us that will just by nature trigger us. We will reserve for those delinquencies and we'll incur some losses. Whether those will translate into claims paid ultimately, we don't know. Time will tell, but that's really just how we think that the accounting will work at least in the year -- I mean, certainly for the next few quarters.
Jimmy Bhullar: And then on business interruption you mentioned provisions in most of your contracts that actually exclude losses, because of pandemics or viruses. I'm assuming you're talking about primary contracts. On the reinsurance side, should we assume that if your clients are paying either, because there wasn't a provision or because they lose a case and then -- and a lawsuit then you would have to be on the hook to the extent you provided coverage as well?
Marc Grandisson: Yes. I think – yes, the comment had to do with insurance, which as you can appreciate the vast majority or more than the vast majority of what we do has an exclusion for viral -- it is a virus exclusion. On the reinsurance, it's still early, right? We still have to figure out what the BI losses are going to be if they come to fruition for our clients. And then they'll have to go through and say, whether there's protection on the risk or quota share or for that matter excess of loss on a cat basis. So this is going to play out over the next several quarters. A lot of contracts have hours clause for those kinds of events. There'll be a lot of discussions back and forth as to when do we start counting, how do we count them. So there's a lot more uncertainty and some other folks in the industry, I've echoed the same comments that it's going to be a little bit longer to figure out what it means, because in general, the contracts are not written to cater for those kinds of event. There's not a specific virus protection. It's really meant primarily to be a property coverage by and large from -- I'm talking from cat-excessive loss perspective. So people will have to sift through the language and see what it means to each and every one of them.
Jimmy Bhullar: Okay. And then just lastly on the acceleration of growth in your insurance and reinsurance premiums, how much of this is pricing versus you potentially gaining share or just increased demand for some of the lines that you're in?
Marc Grandisson: Yes. At a high level about 15%, 1-5 of the increase in premium came through acquisition. Barbican is definitely one of them. We also had acquired a team on credit and surety from Aspen towards the second half of last year. That's about 1-5, 15%. 25% is due to rate. The rate increase this quarter across our P&C was between 5% and 10%. So it's actually better than the fourth quarter of 2019, and the rest 60% is truly growth in exposure new business one-offs or unique situations or opportunities one of which François mentioned in his comments.
Jimmy Bhullar: Okay. Thank you.
Marc Grandisson: Sure. You’re welcome.
Operator: Thank you. Our next question comes from Mike Zaremski with Credit Suisse. Your line is open.
Mike Zaremski: Hey, good afternoon. Sticking moving back to MI. Can we talk about capital requirements? Capital charges for loans and non-payment are usually materially higher than for performing loans. I know I saw it in the prepared remarks, you said that the PMIERs efficiency ratio is well in excess of 100%. Is the FEMA designation kicked in? It means that it will allow Arch and other MIs to potentially hold less capital, or just kind of how should we as investors think about the capital requirements and how that could play out over the next three to 12 months as nonperforming loan levels or deferred loan levels increase?
François Morin: Yes. I mean to answer your question, the answer is yes the -- it's actually in the wording in PMIERs that when there's a FEMA-designated zone, the capital requirements of -- for delinquencies are reduced by 70%. So -- and given that all 50 states have actually declared -- have been declared a FEMA disaster zone. Currently, we are adjusting at the end -- starting at the end of March and going forward, we're adjusting the PMIERs capital requirements to reflect that haircut I'd say on the capital charges for delinquent loans. There's a bit of a discussion going on with FHFA around how long that will be available. I think the industry and FHFA are working together on that and the GSEs to come up to clarify everything. I think there's a bit of some technicalities and maybe it wasn't I'd say perfectly considered or awarded in the wording of the PMIERs, but still we think that they'll -- we expect that the call it the haircut on the capital charges will remain in place until we're -- we have a bit more visibility on how some of those loans will cure and go back to performing.
Mike Zaremski: And just the final part François that you mentioned in terms of the clarification on how long, does that play into why Arch has decided to most likely not repurchase stock for the remaining of the year? I guess maybe this is a broader question. I -- it feels like prior to COVID, you guys were playing kind of more I'd call it offense than most carriers. Does COVID change the playbook? I know this is a broader question. And is the lack of MI earnings and maybe some of the clarification of capital kind of why you're not purchasing stock, when it's trading below book value?
François Morin: Yes. Well I'd flip it a little bit on you. I'd like to think we played a fair amount of offense in Q1 on the P&C side. So I think our view is that we -- again we said it before we like optionality. And the fact that we have a strong balance sheet, we want to keep it that way. We want to be able to take advantage of opportunities that may surface. So does COVID change the playbook? Not per se, but we think there will be probably a fair amount of disruption that's going to emerge in -- through the end of 2020 and maybe beyond. So that's really -- that's the Arch playbook and Marc can chime in, but that's really how we think about having the opportunity or the ability to execute on those opportunities.
Marc Grandisson: Yes. Clearly, we had played the MI market. We still are in the market very involved. We were by and large a lot more allocation of capital to the MI always with the lookout as you guys know us, but it's something were to develop and get better on the other side and more the very important piece of what we do every day the P&C that we would shift and allocate more capital there. And I think as we look through the first quarter and the perspectives, we have business reviews with everyone and understanding and hearing even after COVID-19. Even though there might be a little bit of a dip in premium in the second and third quarter, it's clear that opportunities are there. And our first mission as François mentioned is to deploy capital. This is what I believe our shareholders want us to do is to deploy capital towards insurance underwriting. And I think we have an increased level of opportunities that wasn't there six months or nine months ago. So capital. And as I said, capital becomes very important as we go through the next year or so. So we'll be able to deploy it and make hopefully great returns for our shareholders.
Mike Zaremski: So I guess Marc what you would then -- we should continue to expect the non-MI operations to continue playing offense and growing at a fairly fast pace?
Marc Grandisson: Well right now based on what we see in terms and conditions and opportunities, the answer is, yes, we should expect that to happen. Absent as I said, the market getting a bit softer in terms of GDP, because of exposure stagnating for a while. But yes by and large, our focus is to play more offense on the P&C side both insurance and reinsurance.
Mike Zaremski: Thank you.
Operator: Thank you. Our next question comes from Yaron Kinar with Goldman Sachs. Your line is open. Yaron, your line is open. Please shut the mute button. Our next question from Ron Bobman with Capital Returns. Your line is open.
Ron Bobman: Don't worry Yaron they will circle you back in I am sure. Thanks to hear you. And I hope everyone's well of course. I had a couple of questions. The mortgage business and the reinsurance purchases and in particular the Bellemeade notes. I'm wondering prospectively, do you think that the capacity will be there to sort of continue to be put in place? And is the game plan to sort of continue to as best you can buy sort of like-sized and like-structured protections for the mortgage book and in effect put that through into primary pricing on the mortgage book?
Marc Grandisson: So the first question is, I don't know when it's going to come back. We expect this to come back. I think there was a healthy market, a healthy level of interest before COVID-19. So we would expect that to come back when things gone back to some more normalcy of sort. But time is ahead of us. We don't know when that's going to happen. And if it were to come back, I guess the question will be an economic decision, right? If it does fit within our return and risk profile, we would continue doing those transactions the way we did. We might do more, we might do a bit less. So it will be depending on our view of the pricing and what kind of recovery we get from this. I do believe as a general rule that our risk management mantra is still important. We like to have some downside protection. And I think this proves very useful in these events of late that they would come in and play a big part in supporting us if things were to go a little bit worse than we would expect them to do so. So I would argue that there's definitely a price, at which things or conditions, at which things are a bit difficult to do but I would expect us to still do them within reason for this reason I just mentioned.
Ron Bobman: Thanks. I have a cat reinsurance, sort of, market question. Are there going to be a lot of instances -- in the context of COVID and losses and ceded losses, are there going to be a lot of instances where primaries have cat towers and cat protections that are peril-defined as being natural catastrophes, or is this a narrow peril listings in the reinsurance treaties that -- because the pandemic isn't I guess deemed or classified as a natural cat there would not be stated coverage in a reinsurance treaty?
Marc Grandisson: Yeah. I mean, just sorting the case. What I would add to this though Ron is you have followed the fortunes in many contracts on a quota share and risk excess. So -- and on natural perils, I don't think it's a majority of the coverage that are purchased right now. I think it's a little bit different. I think the -- it's also different in the U.S. versus international. But I think that we'll expect a lot of discussions, because I'm not sure it's as natural peril specific as you think it could be. It was a softer reinsurance market for a while. So when that happens, conditions tend to be a bit broader than one would expect.
Ron Bobman: Okay. Thanks a lot. Good luck, gentlemen. All the best.
Marc Grandisson: Thank you.
Operator: Thank you. Our next question is from Yaron Kinar with Goldman Sachs. Your line is open.
Yaron Kinar: Thank you. Hopefully, you can hear me now?
Marc Grandisson: Yes, we can.
François Morin : Yes.
Yaron Kinar: Great. Good morning everybody. First question on MI. Have you been able to book the U.S. MI using a consistent methodology that was used by the rest of the MI book? What would the loss ratio look like this quarter?
François Morin: Well, I mean roughly speaking if we -- I mean if we extrapolate for the year for the -- we're saying the remainder of the year is going to be call it 100 combined ratio just to be on the safe. So if you annualize the minus 25% expense ratio ballpark, it gets you a 75% loss ratio plus or minus.
Yaron Kinar: Okay. And maybe that also answers my next question, which was -- would the GAAP accounting basically make the results in the MI business progressively worse quarter-over-quarter, or do you expect it to be flattish in the breakeven range through the rest of the year?
François Morin: Very hard to know. I mean we -- I mean, it depends on how quickly the delinquencies are going to show up. If all the delinquencies show up in Q2 when they start right -- you could see a scenario where people missed their first mortgage payment on April 1. They missed their second payment on May 1. And along the way they told their servicer that they want to take advantage of the forbearance program, we could expect a significant amount of delinquencies to show up in Q2 not as much as Q3. It might be a flip-flop. People might try to keep making payments and call their servicer in July. I don't know. So it's very much a function of how quickly we think the delinquencies are going to show up that will dictate a bit more the volatility from quarter-to-quarter in 2020 on how the call it the calendar quarter loss ratios are going to look like.
Yaron Kinar: Okay, okay. And if I turn to insurance, can you maybe talk about the programs business how you'd expect that to perform both from top line and margin perspective in the face of COVID?
Marc Grandisson: Well, yeah, that's a good question. It's not really workers comp exposed. So that piece we can take off. It doesn't really have maturity of credit lines. The lines that we could think it's -- it would be exposed to is property. And almost the totality of all the policies exclude -- have a viral -- virus exclusion. So that should not be a significant contributor to the loss experience on the programs business.
Yaron Kinar: Okay. Thank you very much.
Marc Grandisson: Welcome.
Operator: Thank you. Our next question comes from Phil Stefano with Deutsche Bank. Your line is open.
Phil Stefano: Yes. I was hoping you could give some commentary on your thoughts around the flow of new business for MI this year. How does this feel like purchase originations versus refi originations are going to shake out? And maybe within that you can embed a commentary around what you see with pricing. I guess in my mind the risk-based pricing and rates are -- would react in real time to the extent that there were changes in the economic environment. And this might be one of those instances where you could actually flex pricing up. Does it feel like we're starting to see that come through as the flow of business…
Marc Grandisson: Three questions in there. That's pretty cool. I'm trying to keep it up, so you tell me if I'm wrong on this one. The number one had to do with the origination going forward, right? So the -- what we can tell you is the industry, we don't know, but the industry consensus seems to be 20% less production this year. What that means for us and the market I mean we follow along. We have about one-third -- if you look at the MBA, 35% penetration of mortgage insurance, 45% private MI so you can follow through, so about 18% to 20% decrease, so if all else being equal, we should expect lesser production from that perspective. And you're right, I think we are still continuing -- we're continuing to see a lot of refinancing, although there's a glut and there's a lot of movement and a lot of things that are blocked actually at the origination of the mortgage originators, because there's so much demand for that, due to the historically very low mortgage rates. But we do actually see some purchasing happening. But I think it's going to be -- it's going to be probably more along the lines of the last -- rolling rate over the last three quarters. I think is what we should expect. So again, it's hard to tell if the purchase market is going to come back, in wild fashion. But certainly there is a lot of pent-up demand out there, which also helps the house price index. We believe the house prices are going to go down, not as much as you might think maybe in a single-digit percentage over this year because of all the pent-up demand, so, which talks to the purchasing market being still there, its not gone altogether. I think the article this morning in Wall Street Journal, that there's a lot of -- there's a good pricing sustained, as a result of higher demand for housing. That's the second part. The third part which was about the pricing, of course right we look at -- I mean, the things have changed. We look at things in a different light with the risk -- different risk characteristics. We went through more than once through our portfolio, on our risk-based pricing and our various assumptions and parameters. And we're making adjustments, as we see it appropriate, across the industry. I do want to think that the MI industry sees it as a, hey! There's a bit more risk. There's a bit more losses. So maybe we should do something about it. And I do expect them to follow suit in general. We do have indication that people are -- have increased their expected loss in their pricing.
Phil Stefano: When we think about the expected returns that you're seeing in MI, have they changed materially? And maybe insurance is a better place or a better lever to be exercising at this point to put capital to use, can you just -- any thoughts around that?
Marc Grandisson: No. It's very, very well put. I think this is exactly -- I mean, I think, two years ago, I would have said to you that, except for a few spots on the -- on P&C insurance and reinsurance that, the MI provided by far superior return. So when we rank order things, François and I go through it. And our executive team go through it. We rank order the three businesses, the investment, in repurchasing shares MI was up there. And it has been there for quite a while. And I think, it's -- our loss expectation is probably not as low. It's probably modified somewhat. So, depending on the pricing going forward, we'll see how that falls out. But clearly, the returns from the P&C unit has been inflating and then, putting them higher in the positioning -- the relative positioning for capital allocation, without a doubt.
Phil Stefano: Got it. Thank you. And be well.
Marc Grandisson: Thank you.
François Morin: You too, thanks, Phil.
Operator: Thank you. Our next question is from Meyer Shields with KBW. Your line is open.
Meyer Shields: Great thanks. I do feel like I'm beating a dead horse here. But does your first quarter COVID reserve, in P&C, does that assume that FDA policy requires direct physical damage but doesn't have a virus occlusion? Does that assume that, that's an absolute Defense?
François Morin: Well, I'll start. And I'm sure Marc will chime in. As you know it's – again, we said it's very early, but where we have taken some books and reserves on -- particularly I mean on property right is there are certainly a very small subset of our policies that, don't have an exclusion. So, for those we felt it's prudent to -- we expect losses to come through and we booked the ID&R to go against those policies. And those are generally outside of the U.S. I mean they are outside of the U.S. So, it's in the U.K., it's in Canada, on the insurance side. And we also have a small amount in some property fact deals that may specifically cover pandemic. And we expect that some of these -- some of the certificates will have to respond. So, it's a bit -- mostly in insurance a little bit in reinsurance. But that's where we -- that's kind of how we thought about booking the reserves on BI. Yes, I mean in the U.S. no question that you need property damage to have the BI respond. That's a fact. Yeah. There’s a proposal out there that people want to make it retroactive and challenge that. We'll see how far -- how that goes, but for the time being we don't have reserves on those. We don't think it's correct. We want to think, its right. So we've relied on the policy wording to make our assessments of reserves on those policies.
Marc Grandisson: And the other piece I would add to this, François is that, there are other lines of business Meyer we have these three data that we can point to and say this is what we think we would expect this to develop to. And one example is trade credit. We have a small portfolio but we did actually do proactively, reflect the fact that we might -- we're expecting an increased level of claims for the -- based on what we write this year. So that's something that we pick our loss ratio, specifically. So most of them on the property side I agree absolutely, what François said we did more granularly at a level the claims level the portfolio level. And I think we've taken a loss ratio approach to the other lines of business where we've seen historically losses emerge as a result of events, such as this one.
Meyer Shields: Okay. That's very helpful. The second related question, I'm just trying getting my arms around, what sort of events would constitute second quarter COVID-related P&C losses.
François Morin: I think the development of BI losses will – firstly, we have to go through the insurance business, the insurance companies telling their losses evaluating every claim. I mean this is not an easy thing to do from a 30,000 feet position. Meyer you have to go through the claims process evaluates things talk to clients’ brokers and whatnot. So, it's going to take a while before things get sorted out. A couple of things on presumption of workers comp, coverage that's also part of that. I think -- it was lot of things developing. So, I'm not even sure second quarter, we're going to have the ultimate picture. That's for sure. It's going to take a bit longer to go through all these losses, how they accumulate. And also in line with the question I just had earlier, in how it -- if it does, and how and if it does accumulate towards a reinsurance recovery. So that also might happen towards the end of this year. So this is going to take a little while to sort out. And that's not even talking about potential litigation and whatever else could happen out there. So it's going to be a while.
Marc Grandisson: This is going to be a slow developing cat loss.
Meyer Shields: Absolutely. Thank you so much guys. That’s very helpful.
Marc Grandisson: Thanks, Meyer.
Operator: Thank you. Our next question comes from Brian Meredith with UBS. Your line is open.
Brian Meredith: Yes. Thanks. So one or two quick questions here. First, Marc, can you tell us, what is the status of the Coface investment? And if indeed, the transaction goes through, should we anticipate some type of impairment charge on close, given where Coface stock is relative to your agreed investment?
Marc Grandisson: So, everything is a lot too early at this point in time, right? They themselves are going through evaluating and looking at this and our -- as you know, we made that investment with a long-term strategic vision. We also know that they are -- they have been proactive in many things. And we also know that the credit -- that the credit quality of what they had underwritten through the end of last year was -- is also different as well than what it was in 2008. So we're trying to triangulate all these things. We still have a lot of process to go through from a regulatory perspective. We expect to receive this towards the end of the year. So that's all I'm going to say about Coface, is we are sort of monitoring staying close to it and see what we're going to do about it if we do anything about it.
Brian Meredith: Got you. And then my second one, just going back to the MI. If I think about the lawsuits you guys are seeing, potentially for the rest of this year that you're going to have. What does that mean for 2021, as far as the MI results? How far are we into the deductible on the Bellemeade transactions? How much additional could there potentially be in 2021?
François Morin: Well, again, it's very premature. I think the answer to that question, again, will very much depend on the level of delinquencies and how quickly they get -- come to us. And now we see the economy going back, opening up a little bit. So the people will go back to work. And by fourth quarter of 2020, we see already some people carrying -- going back to having current loans, et cetera. But, yes, I would think that a reasonable expectation for 2021 is that, yes, we should do better than 2020. The loss ratio should be coming down. I don't think to the level it was in 2019, but as -- because let's -- we would think that no question that some people will -- there'll be some jobs lost and there may be some actual claims that actually convert to actually -- or delinquencies that convert to real claims and pay claims, that may be late in 2021, as you know, with a 12-month forbearance program and then the time to really go through all the process, to go to -- to paying the claim will take quite some time. So, I would -- at a high level, I would think that, the 2021 loss ratio would be better or lower than 2020, but not at the same level as low as it has been in -- as it was in 2019, for sure.
Brian Meredith: Got you. That makes sense. And so I think what I'm trying to do is, just scale this like, how much additional loss could we potentially have here in the MI book before you hit the Bellemeade deductibles, right? Just what's kind of a worst-case there?
François Morin: Well, let me try this and maybe Marc will chime in. We've looked at a bunch of -- a variety of economic scenarios. Some are based on our own internal analysis, like the RDS stress test that we run through our portfolio. Some are based on external economic scenarios, such as the Moody's -- what's published by Moody's, the severe -- the S3 and S4 economic scenario. And under most scenarios, again, we don't expect to -- we get close, but we don't expect to attach with the Bellemeade transactions. And those are in particular like the S4, where we get very close. We might start attaching a few years down the road, but it's -- those are severe stresses. So, how we think about it is, does it even impact 2021? The answer is probably not. It probably starts to really -- we really start to recover a few years down the road. And, I mean, to us, it's a -- I don't want to say necessarily sleep-at-night insurance or coverage, but it's really, there to say, we think we've run some very severe stresses. They don't seem to attach with the Bellemeade, but we're often -- they get to be worse -- a little bit worse than what we're thinking, what the scenarios could look like. We tell ourselves, well, we got $3 billion of coverage that is available to us, if things get much worse.
Marc Grandisson: At a very high level, Brian, if you think of the Bellemeade retention and we talk about this amongst ourselves is that, we have about $1.5 billion to $1.6 billion of retention. So that sort of gives you a sense for how many -- how much losses we would need to go through to start to get some recovery. So that -- I think, that should give you $1 billion a year premium earned. So that gives you some kind of benchmark. I think we're trying to figure a way -- we'll talk to Don, obviously, and François. We'll try to find a way to make it a bit more clear to everyone, because it's not an easy thing to explain. But, I think, at a high level, what we just said to you is true, that the level of retention is high enough that we don't expect it in the next couple of years. Yes.
Brian Meredith: Great. Thank you.
Marc Grandisson: Sure. Thanks.
Operator: Thank you. Our next question comes from Mark Dwelle with RBC Capital Markets. Your line is open.
Mark Dwelle: Yes. Good morning. Just to continue with the MI discussion. As you're contemplating within the guidance of no earnings for the balance of the year, are you assuming a case average per reserve similar to what you've been reserving at, or something more similar to the -- like, after hurricanes or something of that nature?
Marc Grandisson: We're just assuming -- we apply a forbearance rate and then we apply conversion from forbearance to claims that we would do. And the severity is pretty close to 100% on most of those cases. So it's really more binary than you might think it is. So there's not much -- I mean the two big variables are really the forbearance and our view of the conversion from forbearance to claim, ultimately, which is very uncertain at that point in time.
Mark Dwelle: Within that, then, are these being evaluated on literally a case-by-case basis, or is it the -- or are you applying just, sort of, a formula to all of the losses that whatever some particular bank presents you over some period of time?
François Morin: Well, I think, it's a bit early to know exactly how everything is going to play out. I mean no question that -- as I said earlier we're -- we expect more delinquencies to come through. No question that we would expect a higher cure rate on those than we would see from a typical delinquency in a call it normal economic environment. So -- but we don't know yet how we're going to book our reserves at the end of the second quarter and let alone third and fourth quarter. So the answer is yes, probably I mean if you compare a regular delinquency to what we're -- we expect the delinquencies we get through forbearance programs there's no question that there's a higher cure rate. And then associated with that the severity et cetera. So I mean it's the product of those gives you the total incurred loss in the quarter. But it's – if we will look at them a bit differently for sure than we would otherwise in a call it a regular quarter.
Marc Grandisson: But -- Mark just to make sure it's clear to you because you did ask specifically how do we develop our scenario. And we have -- we do go at the individual loan level with the risk characteristics and applying assumptions and shock on the unemployment and whatever else you have around house price index. And we go through the lifetime of that loan and see what's going to result. You can think of it as the ladders series -- series of ladders going forward decision tree of sort. And then at the end we come up with the ultimate projection of the claims based on the assumption that we had. So that was a bottom-up approach we did. And we verified this at least try to get some perspective from a top-down approach which François mentioned the Moody's S3 and S4. So -- and those seem to converge very nicely and by coincidence I would add to a similar number for ultimate claims.
Mark Dwelle: And then just the last question and again this is another, sort of process question. But I mean, suppose I'm an individual and I default beginning in April and May as François described before. And then I get recorded as a delinquency in forbearance, let's say, sometime in June. And I take advantage of the 6 month requirement. You'll put up some type of reserve for me in probably the second quarter. Will you be able to release that reserve back then as quickly as, let's say, October which would be the end of the 6 months, which would then provide offset against any additional adds that you would otherwise be taking in say the fourth quarter for people who are newly delinquent or further delinquent?
François Morin: Correct. I mean, if the borrower cures and I think there's a little bit of work that has to be done exactly on how borrowers are going to exit the program. I mean, initially there's I wouldn't say confusion, but people thought well they have to make a balloon payment, do I just defer my payments et cetera. I think the government is stepping in to make sure that there is no -- I mean the expectations are clear on both sides. But correct if somebody after six months in October or November December they -- everybody's back. I mean for that particular borrower, they're back to work and they go back to current and they strike a -- they reach an agreement with their borrower to just effectively, let's say, they missed four or five payments and they agreed to just add those on at the end of their mortgage period they would -- whatever reserves we had put up on that particular loan would get eliminated reduced to zero and they would be available if we think there's new coming in that we -- yes so it's a reduction…
Mark Dwelle: Just to clarify second and third quarter, you would think of kind of as reserve accumulation and then beginning in perhaps the fourth quarter, you would start to see offsets develop assuming people follow that type of a pattern.
François Morin: Assuming – yes, but again what we don't know yet is everybody or is the vast majority of people are going to use the forbearance programs in Q2 or are they going to try to make a couple of payments and then -- maybe there'll be more in Q2 and -- Q3 and Q4. I mean the timing of it is uncertain. But assuming -- I think which is what -- I mean, assuming, I think what you were assuming is for somebody who starts on the forbearance program earlier and then let's say it's just temporary where they do go back to work and they go back to current. They cure their delinquency in the fourth quarter, correct. I mean there would be -- we would be see -- potentially see a reversal of the accumulation of reserves that we saw in Q2 and Q3.
Marc Grandisson: Yes. So Mark, I would add to this to be cautious -- to be very cautious when we compare the development of the GSEs versus now again having more of a front-loading of reported delinquencies that could -- from there to your point go plus or minus, but a lot more front-loading of delinquencies recognized at the beginning than it was in 2007 and 2008 where it took a while for the claim -- took like two, three years for real delinquencies to really pick up and peak. So it takes a while to get there. I don't think we're going to see that this time around. I think we should expect more of a front-loading, which means a little bit more activity from a loss perspective in the first -- in the next couple of quarters.
Mark Dwelle: Understood. Thank you. Very helpful
Marc Grandisson: Yeah, sure.
Operator: Thank you. Our next question comes from Geoff Dunn with Dowling & Partners. Your line is open.
Geoff Dunn: Thanks. Good morning.
Marc Grandisson: Good morning, Geoff.
Geoff Dunn: First a technical question on PMIERs. Are forbearance loans treated the same way from an aging standpoint meaning that you'll get that asset charge progression as well, or is it just that initial point in time asset charge? It seems there's kind of confusing interpretations out there on that front.
François Morin: Sorry, Geoff I -- we couldn't quite hear. I mean you're not coming through very loudly so.
Geoff Dunn: Is that any better?
François Morin: A little bit.
Marc Grandisson: Little bit.
Geoff Dunn: What I was asking is are forbearance loans subject to the aging asset charges on the PMIERs or are they just held at a point in time that initial charge? It seems like some of the language out there has been confusing and up to interpretation.
Marc Grandisson: Yes true. I think that it's unchartered territories as well for the GSEs. I think there are a lot of discussions between the MIs and the GSEs and the FHFA to try to figure out. So I don't have an answer to this one Geoff.
Geoff Dunn: Okay. And then I'm still trying to piece together your underwriting outlook for the remainder of the year. It sounds clear that incidents assumptions will be below a normalized level because of the potential for cure activity. And it seems like the implication is that your forbearance expectation is a lot higher than the near 6% number we've seen from April 26. It's not maybe two or three times that if I'm looking at the math right. So obviously, you have a cumulative loss expectation for the year maybe not all the pieces that generated. But what are some of the higher level assumptions that get you to that kind of level of loss activity whether it be unemployment home – what are some of your macro assumptions that support the cumulative loss outlook for the remainder of the year?
Marc Grandisson: Yes I think – yes that's a good question. I think you were right on the forbearance comment. I don't think – we don't think it's going to 5% or 6%. I think if you ask us we're – our modeling is pretty much like 15%. That's sort of what we would expect forbearance to peak at. And then the question remains to your point about the conversion which is the one that is so hard as you know to pin down. But we can use something between one in seven to one in 10. There's no real reason to that other than it seems to be in the ballpark of what we would expect. If we look at the current annuities or the current delinquencies as you know Geoff, the ultimate claims rate that we ascribed as an industry is closer to 7% or 8%. So to go to a 14% or 15% does not seem too crazy right now. The biggest one – so we – the sort of what we use I think if you look at the S3 that's sort of where our assumption sort of would converge to, if you will. You all know that model. So this is pretty much where we are. I think the biggest thing that we'll have to debate for the next several quarters is how do we convert from forbearance to claim. That's going to be as you know the biggest question mark that we'll have to go through.
Geoff Dunn: I'm sorry. And are you suggesting the – you said 14% or 15%, are you suggesting that the incident assumption will be higher than normal or lower than normal?
Marc Grandisson: I'm sorry I can't hear you. Can you repeat it please, Geoff?
Geoff Dunn: Are you suggesting that the incident assumption will be higher than normal or lower than normal? You're saying 14%...
Marc Grandisson: Higher, higher than normal. If normal is 7% of one in 14, right now one in 13 on new delinquencies, I would expect it to be one in seven or one in six, one in eight. That's what sort of what the model implies. I'm not saying this is what's going to happen but you're asking about the parameters of the deal and this is what – of the modeling.
Geoff Dunn: Okay. Well, all right. And then my last question has to do with your reinsurance strategy. Obviously, the ILN market is hot right now. Does that create any interest with the company of looking at a traditional QSR to supplement your ILN strategy longer term?
Marc Grandisson: We haven't really looked at it.
François Morin: I mean we have – I mean everything is on the table, right? I mean, it's all based on the economics. No question that in the last couple of years to us the Bellemeade transactions were very efficient, provide a lot of capital relief and we thought it was a good protection to get for a variety of reasons. Again we expect them to come back but assuming that they're not back for let's say the end of the – until the end of the year or maybe beyond, no question that we will probably think of other ways to protect the portfolio. And a traditional reinsurance agreement is something that would be on the table for sure.
Geoff Dunn: Okay. Thank you.
Marc Grandisson: Geoff, I think you've asked about MSRs as well. So I think we're starting to evaluate all these things. Nothing is -- but everything again is on the table. We're looking at everything.
François Morin: Goeff, said QSR, right?
Marc Grandisson: I mean is that correct, Geoff? I mean I heard QSR. Did we answer your question Geoff? I just want to make sure we answered it correctly.
Geoff Dunn: You did. Thank you.
Marc Grandisson: Okay, great.
François Morin: Good luck.
Operator: Thank you. Our next question comes from Ryan Tunis with Autonomous Research. Your line is open.
Ryan Tunis: Hey, thanks. So yeah, I guess I'm trying to unpack that the answer to the last question on the forbearance to claims rate being higher than -- if I heard that correctly, your modeling that gets to breakeven is assuming that that's actually higher than, say, a random notice that you have received in December.
François Morin: Yes. That's true.
Marc Grandisson: This is the model. You're stress testing it while you stress -- you're pushing for the scenarios, because it's so uncertain. But who knows, right? It's an opinion.
Ryan Tunis: Right. It's certainly not quite how I think most people are thinking about it. But yeah, that does sound somewhat conservative. And I guess in terms of thinking about the rest of the year, like one thing I noticed that gave you [Indiscernible] is you've got these three buckets like -- I think, it's like three or four months delinquent and it's I think five to 11 months and 12 plus. Is there expected pressure as these delinquencies age? Like is there -- like do you kind of recondition what the expected loss might be? Is that potentially a source of pressure later on in the year?
Marc Grandisson: Well, it's not a high number of claims, so that's not a massive amount. We have about $250 million of reserves or something like this. And François will correct me, if I'm wrong on this one. But I do believe that there is -- a lot of them also are older vintage so have been in and out of delinquency. Some of them are coming back in and out of cure. So, we're -- if there is pressure going forward, typically it will impact not only the more recent bookings. It will -- it would impact all prior book years that you have. And specifically, those are currently in delinquency, because it does -- they may not be the ones that can avail themselves of the forbearance program. They may have been in default before that event occurred. And they might be in a worse position than most borrowers, if they're currently -- they were delinquent at the end of 2019. So, yes, it would tend to ascribe a higher possible incidents to those claims.
Ryan Tunis: Understood. And then, I guess the last one is kind of housekeeping. But on the premium yield number, first of all, how much was that helped this quarter by any of the single premium stuff? And then, has the outlook for that changed at all just given the -- I guess elevated refinancing activity? I'm not sure the composition of book changes.
Marc Grandisson: It felt about 10% to 15% of premium for the quarter, because of the refinancing.
Ryan Tunis: Okay. Thank you.
Marc Grandisson: Welcome.
François Morin: You’re welcome.
Operator: Thank you. I'm not showing any further questions at this time. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thank you very much everyone. Stay safe out there. We're looking forward to have more to report and talk about at the second quarter. In the meantime be good. Thank you.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Arch Capital Group First Quarter 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference Mr. Marc Grandisson and Mr. François Morin. Sirs you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, Shannon, and good morning to you. It would not be an understatement to say that, the coronavirus has changed the world since our last call with you just three months ago. Fortunately, at Arch we are entering this period with the investments we have made in our P&C business beginning to pay off, while our mortgage group navigates through the current turbulence. If you work long enough in the insurance business, like I have, you are bound to experience the industry cycle its highs and its lows. As management, we have to keep our eye on the goal which for Arch is generating sustainable growth in book value per share. The current stress in the financial and insurance markets reminds us of changes that can occur to which we need to adapt. While we are still early in the assessment of our direct and indirect claims exposure to the coronavirus, it is clear that this event will be a significant industry loss and will result in profound changes. However, dislocation often leads to opportunity. As you know, one of Arch's strategic principles from inception has been cycle management. We are embarking in this new market environment, with both a strong financial foundation and the creative ability of our more than 4,200 employees that position us for the opportunities that will emerge. Turning to the quarter. We saw improving conditions in our P&C businesses, while our mortgage operations continued to produce good results. Strengthening P&C market conditions remain evident, even as the economy contracts. We have seen a rise in our submission activity along with accelerating rate increases, across multiple lines of business in Q1 and it is continuing here in Q2. Our belief in the continuing hardening of the P&C market is due to the need our industry has to address the accumulation of risk factors over the last five years of soft market conditions. These risk elements are; one, future claims and covered litigation related to COVID-19; two, a heightened perception of risk in general; three, economic uncertainty; four, a continuation of low interest rates and the dampening effect on investment returns; five, a potential for shortfalls in casualty reserves; and six, reduced availability of retro and alternative capital in general. These risk elements are all in play today and are likely to lead insurance companies to be more cautious in allocating capital to risk. In our insurance group, our strategy remains to be selective and pick our spots in this improving market. The rising rates environment and dislocation in the markets have allowed us to grow profitably in the past two years in many sectors, such as, E&S property, D&O and E&S casualty. On a reported basis, we saw our margins improve this current quarter as our accident combined ratio ex-cat of COVID and PYD improved to 97%. In our reinsurance business, pricing is also improving and we continue to observe tightening of terms and conditions in many lines. The value of reinsurance as a capital protection tool has been enhanced by the recent events. The hallmark of our reinsurance group remains the dynamic allocation of capital to contracts that will provide appropriate risk-adjusted returns, while helping clients with solutions that are tailored to their needs and was a large factor in our growth this quarter. Switching now to our mortgage insurance segment, the industry is facing its first significant test, since the fundamental reforms and product improvements that were adopted following the global financial crisis or GFC. As you know, Arch MI is a data and analytics-driven company and our investment in the sector was predicated on a new and better MI operating model than the industry employed prior to 2008. Now, pricing is more precise, products and documentation are better and the MI industry buys protection against downside. In addition, another change in the industry can be; seen in the aggressive government actions taken in the early stages of the pandemic directed at helping borrowers stay in their homes. The GSE's forbearance program and the unemployment benefits programs provide unprecedented support that should enable borrowers to cure delinquent – delinquencies as the economy improves and will result in fewer losses. As noted in our quarterly HaMMR report, the MI industry is far better positioned for a recession than they were in 2008. At that time, mortgage insurance portfolios were facing a housing market that was significantly overbuilt, risky mortgage products and less creditworthy borrowers. More than two-thirds of mortgage insurance written in 2007 would have been uninsurable during the last 10 years. And finally, there was a speculative bubble in home prices. Mortgages filed under the FHFA's forbearance programs, were estimated at 5.85% of the GSE mortgages as of April 26. This program allows homeowners to suspend mortgage payment for six months, which can then be extended for up to another six months. While initially recorded as delinquencies under GAAP, our data on forbearance programs utilized in recent natural catastrophes indicates that almost all of these loans cure by providing borrowers time to return to work. Over the next few quarters, rising delinquency rates under GAAP, should lead to elevated loss ratios in the MI segment. Furthermore, once the forbearance programs expire, the GSEs have instituted a sturdy list of remedial solutions that once again will enable loans to be back-performing. We realize that this pandemic-led recession will be different than a GFC. But based on what we can see today, our view is this is an earnings not a capital event for Arch. It is worth noting again, that even if this recession is worse than we currently expect, we hold significant reinsurance protection on our risk in force that would moderate our net losses even in a more severe recession. While some of our reinsurers' quota share attaches at first-dollar loss that index-linked know that from our Bellemeade securitization, we’ll provide up to an additional $3 billion of excess and loss protection, if this becomes a recession worse than what the industry experienced in a GFC. Lastly, turning to our investment operations. We believe that interest rates are likely to stay at historically low levels for the foreseeable future and that will over time require insurers to improve their underwriting margins through price increases. In our investment strategy, as in our underwriting approach, we have maintained our focus on risk-adjusted total return while enabled us -- which enabled us to avoid much of the negative impact of the pandemic on our investments this quarter. As perception of risk increases, so does the cost of capital and underwriting discipline becomes important. Again, recent world events reminds us that risk is always present, that insurance premiums must include an adequate margin of safety and that reinsurance plays an important role in protecting capital and returns. In summary, through to Arch's cycle and risk management principles and fortified by our conservative balance sheet, Arch is prepared for this crisis and is well-positioned to continue to build on its track record of book value growth. In closing, I want to thank all of our employees around the world, as they are responsible for the success of Arch, and are working tirelessly throughout the world to meet the needs of our insurers. Thank you. With that, I'll turn the call over to François."
},
{
"speaker": "François Morin",
"text": "Thank you, Marc, and good morning to all. We, at Arch, hope that you are in good health in these difficult and uncertain times. This quarter, in anticipation of some of the questions you may have, I will try to elaborate in more detail on some notable items in addition to the regular discussion of financial items. I recognize this may take a bit longer than usual, so please bear with me. Now on to the first quarter results. As a reminder and consistent with prior practice, the following comments are on a core basis which corresponds to Arch's financial results, excluding the other segment i.e. the operations of Watford Holdings Ltd. In our filings, the term consolidated includes Watford. After-tax operating income for the quarter was $189.8 million, which translates to an annualized 7.1% operating return on average common equity and $0.46 per share. Book value per share decreased to $26.10 at March 31, a slight reduction of 1.2% from last quarter and a 12.9% increase from one year ago. The defensive posture of our investment portfolio ahead of the COVID-19 crisis served us extremely well in preserving our capital base relatively intact during the stressed economic environment of recent months. I will elaborate on this in more detail later on. Outside of the losses related to the COVID-19 pandemic, which impacted on our first quarter results, our underwriting groups fared very well this quarter with strong growth and generally improving underwriting results through our property casualty insurance and reinsurance operations. Given the unusual circumstances and breadth of the pandemic, we have classified COVID-19 losses as a catastrophe. However, as you saw in the financial supplement, we have also provided the segment level detail of our current estimates to assist with the analysis of the underlying performance of our book of business. We expect to follow this approach until the end of 2020 at a minimum. Losses from 2020 catastrophic events in the quarter, not including COVID-19, net of reinsurance recoverables and reinstatement premiums stood at $31.8 million or 2.0 combined ratio points compared to 0.6 combined ratio points in the first quarter of 2019. The losses impacted both our insurance and reinsurance segments and were primarily due to various U.S. severe convective storms, U.K. storms and floods, and Australian bushfires. We recorded approximately $87 million of COVID-19 losses across our P&C operations, split 41% to insurance and 59% to reinsurance. While it is still very early and we have extremely limited information to accurately quantify our potential exposure to the pandemic, we believe that it was prudent to establish a certain level of IBNR reserves for occurrences through March 31, based on policy terms and conditions including limits, sublimits and deductibles. These reserves were recorded across a limited number of lines of business, such as property, where we have a very small number of policies that do not contain a specific pandemic exclusion and/or explicitly afford business interruption coverage under a pandemic and trade credit. As regards the potential impact of COVID-19 on our mortgage segment and our estimation process at this time we believe it's important to make a distinction between our U.S. primary mortgage insurance unit which we refer to as USMI and the rest of this segment which includes our international book and our portfolio of GSE credit risk transfer policies. For USMI pursuant to GAAP our estimates are based only on reported delinquencies as of March 31 2020. However, given the potential effect of the pandemic, we elected to book reserves at a higher level of confidence within our range of reserve estimates for such known delinquencies. The financial impact of this increased level of conservatism was approximately 5.2 loss ratio points across the segment. For the rest of this segment the loss-reserving approach we use is more consistent with traditional property casualty techniques where loss ratio picks are set at the policy level and are able to consider future delinquencies on business already earned. This quarter in response to the potential impact from the pandemic across our portfolio, we adjusted our loss-ratio picks for some policies, which resulted in an increase of 6.8 loss-ratio points to the overall segment results. Based on the information known to date and economic forecast, we believe the adjustment across the non-USMI book is prudent and consistent with a moderately severe stress level. As we look towards the remainder of 2020 for our USMI unit, we are expecting the delinquency rate to increase progressively from the current level as more borrowers request forbearance on their mortgage loans under the CARES Act. As mandated by GAAP, we expect to record loss reserves on these delinquencies which will most likely translate into an increase in our levels of incurred losses over the coming quarters. Over time, we would expect many of these delinquencies to cure and revert back to performing loans as the economy returns to a more normal state. At this time, we do not have enough visibility to predictably forecast the rate at which forbearance delinquencies will be reported to us. Cure are ultimately turned into claims on an annual let alone a quarterly basis. That said, based on our current analysis which tells us that the pandemic will represent an earnings event for our mortgage segment and not a capital event, our current expectation is that our pretax underwriting income for the entire mortgage segment will be minimal for the remainder of 2020, i.e. from the second through the fourth quarter of 2020. However, there is likely to be variability in underwriting income between quarters based on the timing of receipt of notice of defaults. Turning to prior period net loss reserve development, we recognized $17.8 million of favorable development in the first quarter net of related adjustments or 1.1 combined ratio points compared to three combined ratio points in the first quarter of 2019. All three of our segments experienced favorable development at $0.8 million $11 million and $6.1 million for the insurance, reinsurance, and mortgage segments respectively. We had excellent net written premium growth in the insurance segment of 33.4% over the same quarter one year ago. The insurance segment's accident quarter combined ratio excluding cats which as a reminder include COVID-19 losses was 97.1% lower by 310 basis points from the same period one year ago. Approximately 190 basis points of the difference is due to a lower expense ratio, primarily from the growth in the premium base over one year ago. The lower ex-cat accident quarter loss ratio primarily reflects the benefits of rate increases achieved throughout most of 2019 and the first quarter of 2020. As for our reinsurance operations, we had a significant transaction in the quarter which affected the comparability of our underwriting results an $88 million loss portfolio transfer written and fully earned in the period in the other specialty line of business. Absent this transaction, net premiums written would have been 57.2% higher than the same quarter one year ago. This net written premium growth was observed around -- sorry across most of our lines and includes a combination of new business opportunities, rate increases, and the integration of the Barbican reinsurance business. While the loss portfolio transfer had a minimal impact on the overall combined ratio for this segment, a decrease of approximately 50 basis points, its impact on each of the loss and expense ratio components was more observable with a resulting increase of 400 basis points to the loss ratio and a decrease of 450 basis points to the expense ratio. Overall, the growth and underlying performance of our reinsurance segment was very good this quarter. The mortgage segment's combined ratio was at 44.1% including the 12-point loss ratio -- loss ratio impact resulting from the increased level of conservatism in our overall segment reserve estimates discussed earlier. The expense ratio was higher by 240 basis points over the same quarter one year ago reflecting reductions in profit commissions on ceded business and higher compensation costs and employee benefits. Total investment return for the quarter was negative 80 basis points on a U.S. dollar basis as the defensive positioning of our portfolio served us extremely well in this difficult period. Given some of our fund investments are reported on a lag typically three months, their first quarter performance will be included in our second quarter financials. The duration of our investment portfolio was slightly lower than last quarter at 3.19 years compared to 3.40 years at December 31st, but remain overweight relative to our target allocation by approximately 0.35 years. Most financial markets had a positive return in April which should help reverse some of the results we're -- we observed in the first quarter. The effective tax rate in the quarter on pretax operating income was 10.5% and reflects the geographic mix of our pretax income and a 110 basis point benefit from discrete tax items in the quarter. As always, the effective tax rate could vary depending on the level and location of income or loss and varying tax rates in each jurisdiction. Turning briefly to risk management. Our natural cat PML on a net basis increased to $680 million as of April 1, which had approximately 7% of tangible common equity remains well below our internal limits at the single event 1-in-250-year return level. With respect to capital management, we remain committed to maintaining a strong and liquid balance sheet. During the quarter, we repurchased approximately 2.6 million shares at an aggregate cost of $75.5 million. While we have a meaningful remaining share authorization under our current program, we do not expect to repurchase shares for the remainder of 2020. At USMI, our capital position remained strong with our PMIERs sufficiency ratio at 165% at the end of March 31, 2020, which reflects the coverage afforded by a Bellemeade mortgage insurance link notes. These structures provide approximately $3.1 billion of aggregate reinsurance coverage as of March 31, 2020. Finally, to echo Marc's comments, I'd like to give a special shout out to our more than 4,000 colleagues around the world that have demonstrated a tremendous amount of creativity, patience, resilience and compassion with clients and business partners, the communities they live in, their families and loved ones and each other over the last seven-plus weeks. They are the essence of what Arch is all about and I couldn't be prouder to be part of such a great team of individuals. Thank you. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo. Your line is open."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks. Good morning. My first question is on the mortgage segment. So, I heard you guys say that kind of still difficulty -- difficult to put your hands around what the total loss could be within MI. But you did say that you expect no underwriting income for the next three quarters. So, if I look at what you guys might have been expecting, it seems like -- and look at what you've generated right in the back few quarters of 2019 and that translates maybe into about an $800 million of vicinity loss. Now the reason why I go there is your RDS that you guys disclosed at the end of last year for that business was around 8% of your tangible equity. So the numbers seem within the same ballpark of each other. So, am I triangulating correct that you're assuming that this loss could be equivalent to your RDS, or am I missing something in putting those thoughts together?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think -- thanks Elyse for the question. I think that the two numbers appear to be the same level, but they're actually coming from a different source. The $800 million that you referred to that could be let's say, it's a great number for the next three quarters will be incurred losses. And against that you have to put premium. And if you look at our RDS scenario, we actually look at the rollout of all the claims paid in the future and we offset it by all the premiums that we would receive and this is what constitutes the PML. So they're very different. One is a net P&L impact. The other one is the incurred loss of the $800 million you mentioned the first time around."
},
{
"speaker": "Elyse Greenspan",
"text": "So the $800 million is the losses that you expect over the balance of the next three quarters not the -- I thought you had said it wouldn't generate any underwriting income?"
},
{
"speaker": "François Morin",
"text": "Yes. I mean just to clarify I think, it's really a difference between the next nine months versus the full runoff of the in-force portfolio. As we think of the remainder of 2020 what -- the comment I made was really underwriting income meaning premiums minus losses minus expenses. And we're saying, we don't expect a whole lot of underwriting income for the remainder of 2020. When we think about the RDS, fundamentally to get to a similar let's say an $800 million number that you quote of RDS. What that would mean was really -- would be a much larger incurred loss because we expect to have material premium flows or premium income coming to us in future calendar years which may be five, seven, 10 years. So, it's just -- the RDS is really a full comprehensive premium and gain/loss -- underwriting income across the full runoff of the in-force portfolio."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. And then within the RDS, can you remind us what are the assumptions for delinquency rates as well as like housing price depreciation and how we think about you guys coming to that 8% loss figure?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. There are many assumptions, but at a high level decrease in-house price 25% below fundamental, so 25% from now going down and staying there for two to three years. Interest rates shooting up 7% or 8% that these are major -- the two major ones that unemployment of course lasting longer. The length of time that our RDS is stressing our portfolio when we go through it is a much longer period than even the 2007 crisis would have generated. To the delinquency equivalent, it's something more like 9% ultimate claims rate. It's hard for me to parse out what is delinquency versus conversion to claims. So, at a high level we prefer to think in terms of claims rate. So, the portfolio as it stands right now, if you run it off and 9% of it were to default that will be equivalent to the RDS net that we have which is significantly above what we expect right now just to -- just for your benefit which is significantly above what we expect to happen for the next 12 months."
},
{
"speaker": "Elyse Greenspan",
"text": "And then one last one on the guide for the lack of underwriting income for the year-end mortgage, does -- and you -- do you guys -- are you guys assuming that you're going to have to use some of your ILS the Bellemeade securities, or at this point you do not think you might attach into any of those covers?"
},
{
"speaker": "François Morin",
"text": "Well, two things that just for -- I think good points of clarification for you guys. First of all, the Bellemeade protections as you probably do know amortize over time. But there's a trigger on them that basically once you exceed a certain level of delinquencies, they stop amortizing. And that we think we expect will happen most likely sometime in 2020, and maybe in the second quarter maybe in the third quarter maybe later. And that will basically freeze at least for some period the amount of covereds that is available to us, and would remain most likely for the duration of each of those structures. But to answer I think more directly to your question, we do not expect under most scenarios that we would trigger the coverage of the provided by the Bellemeade protection. So the $3 billion of excess of loss cover that we talk about, we know is available, we know it's there. But at this time under most scenarios, we don't expect to pierce the attachment that we would -- where we would actually fully -- well, we'd start to receive coverage or cede some of our exposures."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. Thank you for all the color."
},
{
"speaker": "François Morin",
"text": "You’re welcome."
},
{
"speaker": "Marc Grandisson",
"text": "Welcome."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jimmy Bhullar with JPMorgan. Your line is open."
},
{
"speaker": "Jimmy Bhullar",
"text": "Thanks. Good morning. So just first a question on the MI business. Your assumption of no underwriting income for the rest of the year, does that reflect primarily you having to reserve at the level that reflects sort of delinquencies given GAAP rules, or does it also -- and not -- and you -- from your comments, it seems like you think ultimate defaults will be lower than that given that people are taking advantage of forbearance and stuff and then the cure rates will be higher. But it's more because of just you having to reserve at a higher -- at the level that reflects delinquencies, or is it also a reflection of your views on ultimate defaults?"
},
{
"speaker": "François Morin",
"text": "Yes. It's certainly more of the former. So right we do expect the reality given the forbearance programs that have been in place we expect a higher than normal flow of delinquencies to be reported to us. Some people are just taking advantage of the programs just to be safe and they'd rather just play safe and not take the risk of falling behind on their mortgage payments. So what we expect will happen, we haven't seen much of it yet but we do expect -- I mean, that will pick up in Q2 and Q3 is that we will have to -- we will receive these delinquencies. When we come to the end of Q2, we'll have to assess what kind of reserves, we'll set on those delinquencies. We'll make determinations on the probability that those will actually cure based on the information, we'll have in front of us at that time. It's too early today to tell you what that will look like. But certainly based on the fact that we expect just an elevated number of delinquencies to be reported to us that will just by nature trigger us. We will reserve for those delinquencies and we'll incur some losses. Whether those will translate into claims paid ultimately, we don't know. Time will tell, but that's really just how we think that the accounting will work at least in the year -- I mean, certainly for the next few quarters."
},
{
"speaker": "Jimmy Bhullar",
"text": "And then on business interruption you mentioned provisions in most of your contracts that actually exclude losses, because of pandemics or viruses. I'm assuming you're talking about primary contracts. On the reinsurance side, should we assume that if your clients are paying either, because there wasn't a provision or because they lose a case and then -- and a lawsuit then you would have to be on the hook to the extent you provided coverage as well?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think – yes, the comment had to do with insurance, which as you can appreciate the vast majority or more than the vast majority of what we do has an exclusion for viral -- it is a virus exclusion. On the reinsurance, it's still early, right? We still have to figure out what the BI losses are going to be if they come to fruition for our clients. And then they'll have to go through and say, whether there's protection on the risk or quota share or for that matter excess of loss on a cat basis. So this is going to play out over the next several quarters. A lot of contracts have hours clause for those kinds of events. There'll be a lot of discussions back and forth as to when do we start counting, how do we count them. So there's a lot more uncertainty and some other folks in the industry, I've echoed the same comments that it's going to be a little bit longer to figure out what it means, because in general, the contracts are not written to cater for those kinds of event. There's not a specific virus protection. It's really meant primarily to be a property coverage by and large from -- I'm talking from cat-excessive loss perspective. So people will have to sift through the language and see what it means to each and every one of them."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. And then just lastly on the acceleration of growth in your insurance and reinsurance premiums, how much of this is pricing versus you potentially gaining share or just increased demand for some of the lines that you're in?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. At a high level about 15%, 1-5 of the increase in premium came through acquisition. Barbican is definitely one of them. We also had acquired a team on credit and surety from Aspen towards the second half of last year. That's about 1-5, 15%. 25% is due to rate. The rate increase this quarter across our P&C was between 5% and 10%. So it's actually better than the fourth quarter of 2019, and the rest 60% is truly growth in exposure new business one-offs or unique situations or opportunities one of which François mentioned in his comments."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Sure. You’re welcome."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mike Zaremski with Credit Suisse. Your line is open."
},
{
"speaker": "Mike Zaremski",
"text": "Hey, good afternoon. Sticking moving back to MI. Can we talk about capital requirements? Capital charges for loans and non-payment are usually materially higher than for performing loans. I know I saw it in the prepared remarks, you said that the PMIERs efficiency ratio is well in excess of 100%. Is the FEMA designation kicked in? It means that it will allow Arch and other MIs to potentially hold less capital, or just kind of how should we as investors think about the capital requirements and how that could play out over the next three to 12 months as nonperforming loan levels or deferred loan levels increase?"
},
{
"speaker": "François Morin",
"text": "Yes. I mean to answer your question, the answer is yes the -- it's actually in the wording in PMIERs that when there's a FEMA-designated zone, the capital requirements of -- for delinquencies are reduced by 70%. So -- and given that all 50 states have actually declared -- have been declared a FEMA disaster zone. Currently, we are adjusting at the end -- starting at the end of March and going forward, we're adjusting the PMIERs capital requirements to reflect that haircut I'd say on the capital charges for delinquent loans. There's a bit of a discussion going on with FHFA around how long that will be available. I think the industry and FHFA are working together on that and the GSEs to come up to clarify everything. I think there's a bit of some technicalities and maybe it wasn't I'd say perfectly considered or awarded in the wording of the PMIERs, but still we think that they'll -- we expect that the call it the haircut on the capital charges will remain in place until we're -- we have a bit more visibility on how some of those loans will cure and go back to performing."
},
{
"speaker": "Mike Zaremski",
"text": "And just the final part François that you mentioned in terms of the clarification on how long, does that play into why Arch has decided to most likely not repurchase stock for the remaining of the year? I guess maybe this is a broader question. I -- it feels like prior to COVID, you guys were playing kind of more I'd call it offense than most carriers. Does COVID change the playbook? I know this is a broader question. And is the lack of MI earnings and maybe some of the clarification of capital kind of why you're not purchasing stock, when it's trading below book value?"
},
{
"speaker": "François Morin",
"text": "Yes. Well I'd flip it a little bit on you. I'd like to think we played a fair amount of offense in Q1 on the P&C side. So I think our view is that we -- again we said it before we like optionality. And the fact that we have a strong balance sheet, we want to keep it that way. We want to be able to take advantage of opportunities that may surface. So does COVID change the playbook? Not per se, but we think there will be probably a fair amount of disruption that's going to emerge in -- through the end of 2020 and maybe beyond. So that's really -- that's the Arch playbook and Marc can chime in, but that's really how we think about having the opportunity or the ability to execute on those opportunities."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. Clearly, we had played the MI market. We still are in the market very involved. We were by and large a lot more allocation of capital to the MI always with the lookout as you guys know us, but it's something were to develop and get better on the other side and more the very important piece of what we do every day the P&C that we would shift and allocate more capital there. And I think as we look through the first quarter and the perspectives, we have business reviews with everyone and understanding and hearing even after COVID-19. Even though there might be a little bit of a dip in premium in the second and third quarter, it's clear that opportunities are there. And our first mission as François mentioned is to deploy capital. This is what I believe our shareholders want us to do is to deploy capital towards insurance underwriting. And I think we have an increased level of opportunities that wasn't there six months or nine months ago. So capital. And as I said, capital becomes very important as we go through the next year or so. So we'll be able to deploy it and make hopefully great returns for our shareholders."
},
{
"speaker": "Mike Zaremski",
"text": "So I guess Marc what you would then -- we should continue to expect the non-MI operations to continue playing offense and growing at a fairly fast pace?"
},
{
"speaker": "Marc Grandisson",
"text": "Well right now based on what we see in terms and conditions and opportunities, the answer is, yes, we should expect that to happen. Absent as I said, the market getting a bit softer in terms of GDP, because of exposure stagnating for a while. But yes by and large, our focus is to play more offense on the P&C side both insurance and reinsurance."
},
{
"speaker": "Mike Zaremski",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Yaron Kinar with Goldman Sachs. Your line is open. Yaron, your line is open. Please shut the mute button. Our next question from Ron Bobman with Capital Returns. Your line is open."
},
{
"speaker": "Ron Bobman",
"text": "Don't worry Yaron they will circle you back in I am sure. Thanks to hear you. And I hope everyone's well of course. I had a couple of questions. The mortgage business and the reinsurance purchases and in particular the Bellemeade notes. I'm wondering prospectively, do you think that the capacity will be there to sort of continue to be put in place? And is the game plan to sort of continue to as best you can buy sort of like-sized and like-structured protections for the mortgage book and in effect put that through into primary pricing on the mortgage book?"
},
{
"speaker": "Marc Grandisson",
"text": "So the first question is, I don't know when it's going to come back. We expect this to come back. I think there was a healthy market, a healthy level of interest before COVID-19. So we would expect that to come back when things gone back to some more normalcy of sort. But time is ahead of us. We don't know when that's going to happen. And if it were to come back, I guess the question will be an economic decision, right? If it does fit within our return and risk profile, we would continue doing those transactions the way we did. We might do more, we might do a bit less. So it will be depending on our view of the pricing and what kind of recovery we get from this. I do believe as a general rule that our risk management mantra is still important. We like to have some downside protection. And I think this proves very useful in these events of late that they would come in and play a big part in supporting us if things were to go a little bit worse than we would expect them to do so. So I would argue that there's definitely a price, at which things or conditions, at which things are a bit difficult to do but I would expect us to still do them within reason for this reason I just mentioned."
},
{
"speaker": "Ron Bobman",
"text": "Thanks. I have a cat reinsurance, sort of, market question. Are there going to be a lot of instances -- in the context of COVID and losses and ceded losses, are there going to be a lot of instances where primaries have cat towers and cat protections that are peril-defined as being natural catastrophes, or is this a narrow peril listings in the reinsurance treaties that -- because the pandemic isn't I guess deemed or classified as a natural cat there would not be stated coverage in a reinsurance treaty?"
},
{
"speaker": "Marc Grandisson",
"text": "Yeah. I mean, just sorting the case. What I would add to this though Ron is you have followed the fortunes in many contracts on a quota share and risk excess. So -- and on natural perils, I don't think it's a majority of the coverage that are purchased right now. I think it's a little bit different. I think the -- it's also different in the U.S. versus international. But I think that we'll expect a lot of discussions, because I'm not sure it's as natural peril specific as you think it could be. It was a softer reinsurance market for a while. So when that happens, conditions tend to be a bit broader than one would expect."
},
{
"speaker": "Ron Bobman",
"text": "Okay. Thanks a lot. Good luck, gentlemen. All the best."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question is from Yaron Kinar with Goldman Sachs. Your line is open."
},
{
"speaker": "Yaron Kinar",
"text": "Thank you. Hopefully, you can hear me now?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, we can."
},
{
"speaker": "François Morin",
"text": "Yes."
},
{
"speaker": "Yaron Kinar",
"text": "Great. Good morning everybody. First question on MI. Have you been able to book the U.S. MI using a consistent methodology that was used by the rest of the MI book? What would the loss ratio look like this quarter?"
},
{
"speaker": "François Morin",
"text": "Well, I mean roughly speaking if we -- I mean if we extrapolate for the year for the -- we're saying the remainder of the year is going to be call it 100 combined ratio just to be on the safe. So if you annualize the minus 25% expense ratio ballpark, it gets you a 75% loss ratio plus or minus."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. And maybe that also answers my next question, which was -- would the GAAP accounting basically make the results in the MI business progressively worse quarter-over-quarter, or do you expect it to be flattish in the breakeven range through the rest of the year?"
},
{
"speaker": "François Morin",
"text": "Very hard to know. I mean we -- I mean, it depends on how quickly the delinquencies are going to show up. If all the delinquencies show up in Q2 when they start right -- you could see a scenario where people missed their first mortgage payment on April 1. They missed their second payment on May 1. And along the way they told their servicer that they want to take advantage of the forbearance program, we could expect a significant amount of delinquencies to show up in Q2 not as much as Q3. It might be a flip-flop. People might try to keep making payments and call their servicer in July. I don't know. So it's very much a function of how quickly we think the delinquencies are going to show up that will dictate a bit more the volatility from quarter-to-quarter in 2020 on how the call it the calendar quarter loss ratios are going to look like."
},
{
"speaker": "Yaron Kinar",
"text": "Okay, okay. And if I turn to insurance, can you maybe talk about the programs business how you'd expect that to perform both from top line and margin perspective in the face of COVID?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, yeah, that's a good question. It's not really workers comp exposed. So that piece we can take off. It doesn't really have maturity of credit lines. The lines that we could think it's -- it would be exposed to is property. And almost the totality of all the policies exclude -- have a viral -- virus exclusion. So that should not be a significant contributor to the loss experience on the programs business."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. Thank you very much."
},
{
"speaker": "Marc Grandisson",
"text": "Welcome."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Phil Stefano with Deutsche Bank. Your line is open."
},
{
"speaker": "Phil Stefano",
"text": "Yes. I was hoping you could give some commentary on your thoughts around the flow of new business for MI this year. How does this feel like purchase originations versus refi originations are going to shake out? And maybe within that you can embed a commentary around what you see with pricing. I guess in my mind the risk-based pricing and rates are -- would react in real time to the extent that there were changes in the economic environment. And this might be one of those instances where you could actually flex pricing up. Does it feel like we're starting to see that come through as the flow of business…"
},
{
"speaker": "Marc Grandisson",
"text": "Three questions in there. That's pretty cool. I'm trying to keep it up, so you tell me if I'm wrong on this one. The number one had to do with the origination going forward, right? So the -- what we can tell you is the industry, we don't know, but the industry consensus seems to be 20% less production this year. What that means for us and the market I mean we follow along. We have about one-third -- if you look at the MBA, 35% penetration of mortgage insurance, 45% private MI so you can follow through, so about 18% to 20% decrease, so if all else being equal, we should expect lesser production from that perspective. And you're right, I think we are still continuing -- we're continuing to see a lot of refinancing, although there's a glut and there's a lot of movement and a lot of things that are blocked actually at the origination of the mortgage originators, because there's so much demand for that, due to the historically very low mortgage rates. But we do actually see some purchasing happening. But I think it's going to be -- it's going to be probably more along the lines of the last -- rolling rate over the last three quarters. I think is what we should expect. So again, it's hard to tell if the purchase market is going to come back, in wild fashion. But certainly there is a lot of pent-up demand out there, which also helps the house price index. We believe the house prices are going to go down, not as much as you might think maybe in a single-digit percentage over this year because of all the pent-up demand, so, which talks to the purchasing market being still there, its not gone altogether. I think the article this morning in Wall Street Journal, that there's a lot of -- there's a good pricing sustained, as a result of higher demand for housing. That's the second part. The third part which was about the pricing, of course right we look at -- I mean, the things have changed. We look at things in a different light with the risk -- different risk characteristics. We went through more than once through our portfolio, on our risk-based pricing and our various assumptions and parameters. And we're making adjustments, as we see it appropriate, across the industry. I do want to think that the MI industry sees it as a, hey! There's a bit more risk. There's a bit more losses. So maybe we should do something about it. And I do expect them to follow suit in general. We do have indication that people are -- have increased their expected loss in their pricing."
},
{
"speaker": "Phil Stefano",
"text": "When we think about the expected returns that you're seeing in MI, have they changed materially? And maybe insurance is a better place or a better lever to be exercising at this point to put capital to use, can you just -- any thoughts around that?"
},
{
"speaker": "Marc Grandisson",
"text": "No. It's very, very well put. I think this is exactly -- I mean, I think, two years ago, I would have said to you that, except for a few spots on the -- on P&C insurance and reinsurance that, the MI provided by far superior return. So when we rank order things, François and I go through it. And our executive team go through it. We rank order the three businesses, the investment, in repurchasing shares MI was up there. And it has been there for quite a while. And I think, it's -- our loss expectation is probably not as low. It's probably modified somewhat. So, depending on the pricing going forward, we'll see how that falls out. But clearly, the returns from the P&C unit has been inflating and then, putting them higher in the positioning -- the relative positioning for capital allocation, without a doubt."
},
{
"speaker": "Phil Stefano",
"text": "Got it. Thank you. And be well."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you."
},
{
"speaker": "François Morin",
"text": "You too, thanks, Phil."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question is from Meyer Shields with KBW. Your line is open."
},
{
"speaker": "Meyer Shields",
"text": "Great thanks. I do feel like I'm beating a dead horse here. But does your first quarter COVID reserve, in P&C, does that assume that FDA policy requires direct physical damage but doesn't have a virus occlusion? Does that assume that, that's an absolute Defense?"
},
{
"speaker": "François Morin",
"text": "Well, I'll start. And I'm sure Marc will chime in. As you know it's – again, we said it's very early, but where we have taken some books and reserves on -- particularly I mean on property right is there are certainly a very small subset of our policies that, don't have an exclusion. So, for those we felt it's prudent to -- we expect losses to come through and we booked the ID&R to go against those policies. And those are generally outside of the U.S. I mean they are outside of the U.S. So, it's in the U.K., it's in Canada, on the insurance side. And we also have a small amount in some property fact deals that may specifically cover pandemic. And we expect that some of these -- some of the certificates will have to respond. So, it's a bit -- mostly in insurance a little bit in reinsurance. But that's where we -- that's kind of how we thought about booking the reserves on BI. Yes, I mean in the U.S. no question that you need property damage to have the BI respond. That's a fact. Yeah. There’s a proposal out there that people want to make it retroactive and challenge that. We'll see how far -- how that goes, but for the time being we don't have reserves on those. We don't think it's correct. We want to think, its right. So we've relied on the policy wording to make our assessments of reserves on those policies."
},
{
"speaker": "Marc Grandisson",
"text": "And the other piece I would add to this, François is that, there are other lines of business Meyer we have these three data that we can point to and say this is what we think we would expect this to develop to. And one example is trade credit. We have a small portfolio but we did actually do proactively, reflect the fact that we might -- we're expecting an increased level of claims for the -- based on what we write this year. So that's something that we pick our loss ratio, specifically. So most of them on the property side I agree absolutely, what François said we did more granularly at a level the claims level the portfolio level. And I think we've taken a loss ratio approach to the other lines of business where we've seen historically losses emerge as a result of events, such as this one."
},
{
"speaker": "Meyer Shields",
"text": "Okay. That's very helpful. The second related question, I'm just trying getting my arms around, what sort of events would constitute second quarter COVID-related P&C losses."
},
{
"speaker": "François Morin",
"text": "I think the development of BI losses will – firstly, we have to go through the insurance business, the insurance companies telling their losses evaluating every claim. I mean this is not an easy thing to do from a 30,000 feet position. Meyer you have to go through the claims process evaluates things talk to clients’ brokers and whatnot. So, it's going to take a while before things get sorted out. A couple of things on presumption of workers comp, coverage that's also part of that. I think -- it was lot of things developing. So, I'm not even sure second quarter, we're going to have the ultimate picture. That's for sure. It's going to take a bit longer to go through all these losses, how they accumulate. And also in line with the question I just had earlier, in how it -- if it does, and how and if it does accumulate towards a reinsurance recovery. So that also might happen towards the end of this year. So this is going to take a little while to sort out. And that's not even talking about potential litigation and whatever else could happen out there. So it's going to be a while."
},
{
"speaker": "Marc Grandisson",
"text": "This is going to be a slow developing cat loss."
},
{
"speaker": "Meyer Shields",
"text": "Absolutely. Thank you so much guys. That’s very helpful."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks, Meyer."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Brian Meredith with UBS. Your line is open."
},
{
"speaker": "Brian Meredith",
"text": "Yes. Thanks. So one or two quick questions here. First, Marc, can you tell us, what is the status of the Coface investment? And if indeed, the transaction goes through, should we anticipate some type of impairment charge on close, given where Coface stock is relative to your agreed investment?"
},
{
"speaker": "Marc Grandisson",
"text": "So, everything is a lot too early at this point in time, right? They themselves are going through evaluating and looking at this and our -- as you know, we made that investment with a long-term strategic vision. We also know that they are -- they have been proactive in many things. And we also know that the credit -- that the credit quality of what they had underwritten through the end of last year was -- is also different as well than what it was in 2008. So we're trying to triangulate all these things. We still have a lot of process to go through from a regulatory perspective. We expect to receive this towards the end of the year. So that's all I'm going to say about Coface, is we are sort of monitoring staying close to it and see what we're going to do about it if we do anything about it."
},
{
"speaker": "Brian Meredith",
"text": "Got you. And then my second one, just going back to the MI. If I think about the lawsuits you guys are seeing, potentially for the rest of this year that you're going to have. What does that mean for 2021, as far as the MI results? How far are we into the deductible on the Bellemeade transactions? How much additional could there potentially be in 2021?"
},
{
"speaker": "François Morin",
"text": "Well, again, it's very premature. I think the answer to that question, again, will very much depend on the level of delinquencies and how quickly they get -- come to us. And now we see the economy going back, opening up a little bit. So the people will go back to work. And by fourth quarter of 2020, we see already some people carrying -- going back to having current loans, et cetera. But, yes, I would think that a reasonable expectation for 2021 is that, yes, we should do better than 2020. The loss ratio should be coming down. I don't think to the level it was in 2019, but as -- because let's -- we would think that no question that some people will -- there'll be some jobs lost and there may be some actual claims that actually convert to actually -- or delinquencies that convert to real claims and pay claims, that may be late in 2021, as you know, with a 12-month forbearance program and then the time to really go through all the process, to go to -- to paying the claim will take quite some time. So, I would -- at a high level, I would think that, the 2021 loss ratio would be better or lower than 2020, but not at the same level as low as it has been in -- as it was in 2019, for sure."
},
{
"speaker": "Brian Meredith",
"text": "Got you. That makes sense. And so I think what I'm trying to do is, just scale this like, how much additional loss could we potentially have here in the MI book before you hit the Bellemeade deductibles, right? Just what's kind of a worst-case there?"
},
{
"speaker": "François Morin",
"text": "Well, let me try this and maybe Marc will chime in. We've looked at a bunch of -- a variety of economic scenarios. Some are based on our own internal analysis, like the RDS stress test that we run through our portfolio. Some are based on external economic scenarios, such as the Moody's -- what's published by Moody's, the severe -- the S3 and S4 economic scenario. And under most scenarios, again, we don't expect to -- we get close, but we don't expect to attach with the Bellemeade transactions. And those are in particular like the S4, where we get very close. We might start attaching a few years down the road, but it's -- those are severe stresses. So, how we think about it is, does it even impact 2021? The answer is probably not. It probably starts to really -- we really start to recover a few years down the road. And, I mean, to us, it's a -- I don't want to say necessarily sleep-at-night insurance or coverage, but it's really, there to say, we think we've run some very severe stresses. They don't seem to attach with the Bellemeade, but we're often -- they get to be worse -- a little bit worse than what we're thinking, what the scenarios could look like. We tell ourselves, well, we got $3 billion of coverage that is available to us, if things get much worse."
},
{
"speaker": "Marc Grandisson",
"text": "At a very high level, Brian, if you think of the Bellemeade retention and we talk about this amongst ourselves is that, we have about $1.5 billion to $1.6 billion of retention. So that sort of gives you a sense for how many -- how much losses we would need to go through to start to get some recovery. So that -- I think, that should give you $1 billion a year premium earned. So that gives you some kind of benchmark. I think we're trying to figure a way -- we'll talk to Don, obviously, and François. We'll try to find a way to make it a bit more clear to everyone, because it's not an easy thing to explain. But, I think, at a high level, what we just said to you is true, that the level of retention is high enough that we don't expect it in the next couple of years. Yes."
},
{
"speaker": "Brian Meredith",
"text": "Great. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Sure. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mark Dwelle with RBC Capital Markets. Your line is open."
},
{
"speaker": "Mark Dwelle",
"text": "Yes. Good morning. Just to continue with the MI discussion. As you're contemplating within the guidance of no earnings for the balance of the year, are you assuming a case average per reserve similar to what you've been reserving at, or something more similar to the -- like, after hurricanes or something of that nature?"
},
{
"speaker": "Marc Grandisson",
"text": "We're just assuming -- we apply a forbearance rate and then we apply conversion from forbearance to claims that we would do. And the severity is pretty close to 100% on most of those cases. So it's really more binary than you might think it is. So there's not much -- I mean the two big variables are really the forbearance and our view of the conversion from forbearance to claim, ultimately, which is very uncertain at that point in time."
},
{
"speaker": "Mark Dwelle",
"text": "Within that, then, are these being evaluated on literally a case-by-case basis, or is it the -- or are you applying just, sort of, a formula to all of the losses that whatever some particular bank presents you over some period of time?"
},
{
"speaker": "François Morin",
"text": "Well, I think, it's a bit early to know exactly how everything is going to play out. I mean no question that -- as I said earlier we're -- we expect more delinquencies to come through. No question that we would expect a higher cure rate on those than we would see from a typical delinquency in a call it normal economic environment. So -- but we don't know yet how we're going to book our reserves at the end of the second quarter and let alone third and fourth quarter. So the answer is yes, probably I mean if you compare a regular delinquency to what we're -- we expect the delinquencies we get through forbearance programs there's no question that there's a higher cure rate. And then associated with that the severity et cetera. So I mean it's the product of those gives you the total incurred loss in the quarter. But it's – if we will look at them a bit differently for sure than we would otherwise in a call it a regular quarter."
},
{
"speaker": "Marc Grandisson",
"text": "But -- Mark just to make sure it's clear to you because you did ask specifically how do we develop our scenario. And we have -- we do go at the individual loan level with the risk characteristics and applying assumptions and shock on the unemployment and whatever else you have around house price index. And we go through the lifetime of that loan and see what's going to result. You can think of it as the ladders series -- series of ladders going forward decision tree of sort. And then at the end we come up with the ultimate projection of the claims based on the assumption that we had. So that was a bottom-up approach we did. And we verified this at least try to get some perspective from a top-down approach which François mentioned the Moody's S3 and S4. So -- and those seem to converge very nicely and by coincidence I would add to a similar number for ultimate claims."
},
{
"speaker": "Mark Dwelle",
"text": "And then just the last question and again this is another, sort of process question. But I mean, suppose I'm an individual and I default beginning in April and May as François described before. And then I get recorded as a delinquency in forbearance, let's say, sometime in June. And I take advantage of the 6 month requirement. You'll put up some type of reserve for me in probably the second quarter. Will you be able to release that reserve back then as quickly as, let's say, October which would be the end of the 6 months, which would then provide offset against any additional adds that you would otherwise be taking in say the fourth quarter for people who are newly delinquent or further delinquent?"
},
{
"speaker": "François Morin",
"text": "Correct. I mean, if the borrower cures and I think there's a little bit of work that has to be done exactly on how borrowers are going to exit the program. I mean, initially there's I wouldn't say confusion, but people thought well they have to make a balloon payment, do I just defer my payments et cetera. I think the government is stepping in to make sure that there is no -- I mean the expectations are clear on both sides. But correct if somebody after six months in October or November December they -- everybody's back. I mean for that particular borrower, they're back to work and they go back to current and they strike a -- they reach an agreement with their borrower to just effectively, let's say, they missed four or five payments and they agreed to just add those on at the end of their mortgage period they would -- whatever reserves we had put up on that particular loan would get eliminated reduced to zero and they would be available if we think there's new coming in that we -- yes so it's a reduction…"
},
{
"speaker": "Mark Dwelle",
"text": "Just to clarify second and third quarter, you would think of kind of as reserve accumulation and then beginning in perhaps the fourth quarter, you would start to see offsets develop assuming people follow that type of a pattern."
},
{
"speaker": "François Morin",
"text": "Assuming – yes, but again what we don't know yet is everybody or is the vast majority of people are going to use the forbearance programs in Q2 or are they going to try to make a couple of payments and then -- maybe there'll be more in Q2 and -- Q3 and Q4. I mean the timing of it is uncertain. But assuming -- I think which is what -- I mean, assuming, I think what you were assuming is for somebody who starts on the forbearance program earlier and then let's say it's just temporary where they do go back to work and they go back to current. They cure their delinquency in the fourth quarter, correct. I mean there would be -- we would be see -- potentially see a reversal of the accumulation of reserves that we saw in Q2 and Q3."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So Mark, I would add to this to be cautious -- to be very cautious when we compare the development of the GSEs versus now again having more of a front-loading of reported delinquencies that could -- from there to your point go plus or minus, but a lot more front-loading of delinquencies recognized at the beginning than it was in 2007 and 2008 where it took a while for the claim -- took like two, three years for real delinquencies to really pick up and peak. So it takes a while to get there. I don't think we're going to see that this time around. I think we should expect more of a front-loading, which means a little bit more activity from a loss perspective in the first -- in the next couple of quarters."
},
{
"speaker": "Mark Dwelle",
"text": "Understood. Thank you. Very helpful"
},
{
"speaker": "Marc Grandisson",
"text": "Yeah, sure."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Geoff Dunn with Dowling & Partners. Your line is open."
},
{
"speaker": "Geoff Dunn",
"text": "Thanks. Good morning."
},
{
"speaker": "Marc Grandisson",
"text": "Good morning, Geoff."
},
{
"speaker": "Geoff Dunn",
"text": "First a technical question on PMIERs. Are forbearance loans treated the same way from an aging standpoint meaning that you'll get that asset charge progression as well, or is it just that initial point in time asset charge? It seems there's kind of confusing interpretations out there on that front."
},
{
"speaker": "François Morin",
"text": "Sorry, Geoff I -- we couldn't quite hear. I mean you're not coming through very loudly so."
},
{
"speaker": "Geoff Dunn",
"text": "Is that any better?"
},
{
"speaker": "François Morin",
"text": "A little bit."
},
{
"speaker": "Marc Grandisson",
"text": "Little bit."
},
{
"speaker": "Geoff Dunn",
"text": "What I was asking is are forbearance loans subject to the aging asset charges on the PMIERs or are they just held at a point in time that initial charge? It seems like some of the language out there has been confusing and up to interpretation."
},
{
"speaker": "Marc Grandisson",
"text": "Yes true. I think that it's unchartered territories as well for the GSEs. I think there are a lot of discussions between the MIs and the GSEs and the FHFA to try to figure out. So I don't have an answer to this one Geoff."
},
{
"speaker": "Geoff Dunn",
"text": "Okay. And then I'm still trying to piece together your underwriting outlook for the remainder of the year. It sounds clear that incidents assumptions will be below a normalized level because of the potential for cure activity. And it seems like the implication is that your forbearance expectation is a lot higher than the near 6% number we've seen from April 26. It's not maybe two or three times that if I'm looking at the math right. So obviously, you have a cumulative loss expectation for the year maybe not all the pieces that generated. But what are some of the higher level assumptions that get you to that kind of level of loss activity whether it be unemployment home – what are some of your macro assumptions that support the cumulative loss outlook for the remainder of the year?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes I think – yes that's a good question. I think you were right on the forbearance comment. I don't think – we don't think it's going to 5% or 6%. I think if you ask us we're – our modeling is pretty much like 15%. That's sort of what we would expect forbearance to peak at. And then the question remains to your point about the conversion which is the one that is so hard as you know to pin down. But we can use something between one in seven to one in 10. There's no real reason to that other than it seems to be in the ballpark of what we would expect. If we look at the current annuities or the current delinquencies as you know Geoff, the ultimate claims rate that we ascribed as an industry is closer to 7% or 8%. So to go to a 14% or 15% does not seem too crazy right now. The biggest one – so we – the sort of what we use I think if you look at the S3 that's sort of where our assumption sort of would converge to, if you will. You all know that model. So this is pretty much where we are. I think the biggest thing that we'll have to debate for the next several quarters is how do we convert from forbearance to claim. That's going to be as you know the biggest question mark that we'll have to go through."
},
{
"speaker": "Geoff Dunn",
"text": "I'm sorry. And are you suggesting the – you said 14% or 15%, are you suggesting that the incident assumption will be higher than normal or lower than normal?"
},
{
"speaker": "Marc Grandisson",
"text": "I'm sorry I can't hear you. Can you repeat it please, Geoff?"
},
{
"speaker": "Geoff Dunn",
"text": "Are you suggesting that the incident assumption will be higher than normal or lower than normal? You're saying 14%..."
},
{
"speaker": "Marc Grandisson",
"text": "Higher, higher than normal. If normal is 7% of one in 14, right now one in 13 on new delinquencies, I would expect it to be one in seven or one in six, one in eight. That's what sort of what the model implies. I'm not saying this is what's going to happen but you're asking about the parameters of the deal and this is what – of the modeling."
},
{
"speaker": "Geoff Dunn",
"text": "Okay. Well, all right. And then my last question has to do with your reinsurance strategy. Obviously, the ILN market is hot right now. Does that create any interest with the company of looking at a traditional QSR to supplement your ILN strategy longer term?"
},
{
"speaker": "Marc Grandisson",
"text": "We haven't really looked at it."
},
{
"speaker": "François Morin",
"text": "I mean we have – I mean everything is on the table, right? I mean, it's all based on the economics. No question that in the last couple of years to us the Bellemeade transactions were very efficient, provide a lot of capital relief and we thought it was a good protection to get for a variety of reasons. Again we expect them to come back but assuming that they're not back for let's say the end of the – until the end of the year or maybe beyond, no question that we will probably think of other ways to protect the portfolio. And a traditional reinsurance agreement is something that would be on the table for sure."
},
{
"speaker": "Geoff Dunn",
"text": "Okay. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Geoff, I think you've asked about MSRs as well. So I think we're starting to evaluate all these things. Nothing is -- but everything again is on the table. We're looking at everything."
},
{
"speaker": "François Morin",
"text": "Goeff, said QSR, right?"
},
{
"speaker": "Marc Grandisson",
"text": "I mean is that correct, Geoff? I mean I heard QSR. Did we answer your question Geoff? I just want to make sure we answered it correctly."
},
{
"speaker": "Geoff Dunn",
"text": "You did. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Okay, great."
},
{
"speaker": "François Morin",
"text": "Good luck."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Ryan Tunis with Autonomous Research. Your line is open."
},
{
"speaker": "Ryan Tunis",
"text": "Hey, thanks. So yeah, I guess I'm trying to unpack that the answer to the last question on the forbearance to claims rate being higher than -- if I heard that correctly, your modeling that gets to breakeven is assuming that that's actually higher than, say, a random notice that you have received in December."
},
{
"speaker": "François Morin",
"text": "Yes. That's true."
},
{
"speaker": "Marc Grandisson",
"text": "This is the model. You're stress testing it while you stress -- you're pushing for the scenarios, because it's so uncertain. But who knows, right? It's an opinion."
},
{
"speaker": "Ryan Tunis",
"text": "Right. It's certainly not quite how I think most people are thinking about it. But yeah, that does sound somewhat conservative. And I guess in terms of thinking about the rest of the year, like one thing I noticed that gave you [Indiscernible] is you've got these three buckets like -- I think, it's like three or four months delinquent and it's I think five to 11 months and 12 plus. Is there expected pressure as these delinquencies age? Like is there -- like do you kind of recondition what the expected loss might be? Is that potentially a source of pressure later on in the year?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, it's not a high number of claims, so that's not a massive amount. We have about $250 million of reserves or something like this. And François will correct me, if I'm wrong on this one. But I do believe that there is -- a lot of them also are older vintage so have been in and out of delinquency. Some of them are coming back in and out of cure. So, we're -- if there is pressure going forward, typically it will impact not only the more recent bookings. It will -- it would impact all prior book years that you have. And specifically, those are currently in delinquency, because it does -- they may not be the ones that can avail themselves of the forbearance program. They may have been in default before that event occurred. And they might be in a worse position than most borrowers, if they're currently -- they were delinquent at the end of 2019. So, yes, it would tend to ascribe a higher possible incidents to those claims."
},
{
"speaker": "Ryan Tunis",
"text": "Understood. And then, I guess the last one is kind of housekeeping. But on the premium yield number, first of all, how much was that helped this quarter by any of the single premium stuff? And then, has the outlook for that changed at all just given the -- I guess elevated refinancing activity? I'm not sure the composition of book changes."
},
{
"speaker": "Marc Grandisson",
"text": "It felt about 10% to 15% of premium for the quarter, because of the refinancing."
},
{
"speaker": "Ryan Tunis",
"text": "Okay. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Welcome."
},
{
"speaker": "François Morin",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Thank you. I'm not showing any further questions at this time. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you very much everyone. Stay safe out there. We're looking forward to have more to report and talk about at the second quarter. In the meantime be good. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 4 | 2,021 | 2022-02-10 11:00:00 | Operator: Good day ladies and gentlemen, and welcome to Arch Capital Group's Fourth Quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. Later we'll conduct a question-and-answer session and instructions will follow at that time. If anyone should require assistance during the conference, please [Operator Instruction] on your touchtone telephone. As a reminder, this conference call is being recorded. Before the company get started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call, may constitute forward-looking statements under the federal securities. So federal securities laws, these statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical fact, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also, will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished by the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference. Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin.
Marc Grandisson: Thanks. Atif. Good morning and welcome to our fourth quarter earnings call. We ended a good year. Here with a great quarter on the year Arch generated a return on net income of 16.7%. And importantly, book value per common share grew by 10.7% with net earnings per share of $5.23. We accomplished these results despite elevated CAT activity, and a short-term effect, that substantial share repurchases had on our book value per share. Our ability to effectively allocate capital also contributed to our 2021 results. Whether opportunistically investing more resources into the most profitable pockets of our business or buying back $1.2 billion worth of our common shares fully, 7.7% of the shares outstanding at the start of the year. We remain committed to a capital management strategy that creates value for shareholders. I'd like to begin by sharing some highlights from our operating units. In our P&C insurance segment, net written premium grew 24% and earned premium grew 34% over the fourth quarter of 2020 as we earned in the rate increases of the past several quarters. Growth occurred across many lines with profession lines and travel exhibiting the strongest advances. Overall submission activity and rate momentum remained healthy and rate increases were above loss trend. A change in business mix led to a slightly higher acquisition expense in the quarter. However, we believe that this increase belies the underlying return potential of the segment. More accurately, it is a reflection of the insurance group's outstanding job or positioning itself to act on the better opportunities available in today's market. Turning now to reinsurance, our shareholders continue to benefit from the extraordinary talents of this group, which grew gross written premium by 88% and net written premium by nearly 45% from a year-ago. On haul, the reinsurance group grew in nearly every line, a reflection of our diversified specialty mix of business and our larger participation in quota share reinsurance, which allows us to participate in the improved premium rates of [Indiscernible] more directly. Briefly on renewals at January 1st, while property cut raise were up broadly, the increases were not enough for us to deploy more capital into our peak zones. However, we found many opportunities to grow in the other 93% of our reinsurance business, that its specialty in nature, including property ex-cat. Finally, onto the mortgage segment, which again delivered excellent underwriting results, even as written premiums declined in the quarter. Seasonally, the fourth quarter, as you know, it's lower for mortgage originations and rising interest rates further depressed refinance activity reducing new insurance rhythm. However, our insurance in fourth, the ultimate driver of earnings, still grew modestly in the quarter mainly due to the lower refinancing activity. Credit conditions remain excellent in the U.S. with a strong housing market and demand for housing continuing to exceed supply. As most of you already know, home price appreciation remains robust across most of the country. This is a net positive for mortgage insurers as increasing borrower equity ultimately leads to a lower risk of default. Competition in this sector remains robust but stable, and we believe that the better credit quality of our recent originations compensates for marginally lower premium yields. We continue to focus on a more stable returns available in higher credit quality business, instead of broadly chasing top-line growth, a luxury afforded to us by our diversified model. Turning to the fourth leg of our stool, investment income contributions were up materially for the year, primarily due to alternative investments accounted under the equity method. These investments are primarily fixed income in nature, but because of the structure of our investments, their contributions are excluded from net investment income and our definition of operating income. Notwithstanding, these investments contributed $366 million or $0.92 per share for the full year. Over the past five-years below the line investment returns have added between 75 to 125 bps to our net ROE. But taking a step back to get more of a big picture view, we like the way our businesses are currently positioned. Within our P&C segments, we believe that P&C pricing and returns have more room to grow in this part of the cycle, and in the mortgage segment, insurance in force is benefiting from both solid credit conditions and good house price appreciation. Underwriting income for our P&C insurance and reinsurance segments expanded significantly in the fourth quarter. It's worth noting that if we were to include components of investment income that relate to the flow-generation farm underwriting. P&C [Indiscernible] contribution to arches earnings were roughly in balance. We believe that this balance improves the risk adjusted returns for our shareholders. Our corporate culture of being patient in soft markets while maintaining an agile mindset is a key to our success and allows us to seize opportunity when the odds for success are more in our favor because different sectors have their own cycles, our disciplined, defensive underwriting during the softer parts of the cycles is what has enabled us to grow faster than many of our peers in the current environment. We have begun to read the benefits of the strong defensive posture we maintained from 2016 through 2019. The Winter Olympics are underway, and I found an analogy to our business in a somewhat unexpected place. The most exquisite and exciting game of Curling. You may or may not be aware that Curling has been dubbed, chess on ice. And like insurance, it's much more strategic than the uninformed may realize. Curling is played over ten long ENS or rounds. A defensive strategy is most common, patiently waiting for an opening to pivot to offense. Unfortunately, defending is not exciting. It's about minimizing your opponent scoring opportunities and avoiding mistakes. But like insurance, patience is often handsomely rewarded because when her opponent makes an error, the SKIP knows that now is the time to pounce and all of a sudden, patient is out-the-door and action is in. Most games are won in that one crucial reversal of fortune. That's how we play the insurance cycle. One year at a time, patiently waiting for the market to give us that opening. And once we see it, we're all-in, just like the last 2.5 years and counting. Don't ever let anyone tell you that curling or insurance are not exciting. For 20 years, we've been committed to taking the long-term view of the insurance cycle being thoughtful and balanced with our capital management strategy and differentiating ourselves by being committed to a specialty model, all with the aim of enhancing shareholder value over the long term. Although every year is different and markets aren't always predictable, we've demonstrated that we can succeed in any market. So we're looking forward to what 2022 has in store for us. Francois?
Francois Morin: Thank you Marc. And good morning to all. Thanks for joining us today. As Marc shared earlier, our after-tax operating income for the quarter was $493.3 million or $1.27 per share, resulting in an annualized 15.6% operating return on average, common equity. Book value per share increase to $33.56 at December 31 up 3.5% in the quarter. For the year, our operating return on equity stood at 11.5% while our net return on equity was 16.7%, excellent results in deed. In the insurance segment, net written premium grew 23.7% over the same quarter one year ago. And the accident quarter combined ratio excluding [Indiscernible] was 91.2%, lower by approximately 240 basis points from the same period one year ago. The growth was particularly strong in North America, where a combination of new business opportunities and rate increases supported this profitable growth. One item to note this quarter for the insurance segment relates to the acquisition expense ratio, which was higher than in both the prior quarter and the same quarter one year ago. As we mentioned in the earnings release, some of this increase is related to premium growth in lines of business with higher acquisition costs such as travel. But it also reflects increased contingent commission accruals on profitable business, as well as lower ceded premiums in lines with higher ceding commission offsets. As we have said before, our focus remains on the returns we are able to generate from all our businesses, and we remain positive on the current pricing environment and the opportunities that should be available to us in 2022. For the reinsurance segment, growth in net written premium remain strong at 44.5% on a quarter-over-quarter basis. The gross [Indiscernible] the growth was driven by increases in our casualty property other than property catastrophe and other specialty lines where new business opportunities, strong rate increases, and growth in new accounts helped increase the top line. For the full 2021 year, the ex-cat accident year combined ratio was 84.4%, improving by approximately 160 basis points over the 2020 year, a reflection of the underwriting conditions we have seen in most of the lines we write. Losses from 2021 catastrophic events in the quarter, net of reinsurance recoverables and reinstatement premiums stood at $72.3 million or 3.5 combined ratio points compared to 9.4 combined ratio points in the fourth quarter of 2020. The losses came from a combination of fourth-quarter events including the December U.S. tornadoes, and other minor global events, as well as some development on events that occurred earlier in the year. Our estimate of our ultimate exposure to COVID related claims decreased by approximately $3 million during the quarter. We currently hold approximately $195 million in reserves for this exposure. Two-thirds of which are recorded either as ACRS are IBNR. Our mortgage segment had an excellent quarter with combined ratio of 11.7%, due in part to favorable prior-year development of $72.9 million. The decrease in net premiums earned on a sequential basis was attributable to a combination of higher levels of premium ceded, a lower level of earnings from single premium policy terminations, and lower U.S. primary mortgage insurance monthly premiums, due to lower premium yields from recent originations, which were of excellent credit quality. While approximately two-thirds of the favorable clean development came from [Indiscernible], related to better than expected cure activity and recoveries on second lien loans. We also saw favorable prior year development across our other mortgage units includes our CRT portfolio and our international MI operations. Consistent with historical practice, we maintain a prudent approach and setting loss reserves, especially in light of the uncertainty we are facing with borrowers exiting forbearance programs and moratoriums on foreclosures. The delinquency rate for our US MI book came in at 2.36% at the end of the quarter, more than 50% lower than the peak we observed at the end of the second quarter of 2020. Production levels were down from last quarter, certainly a typical outcome given the seasonality in new purchases, and also partially, as a result of the lower level of refinance activity due to higher interest rates. Offsetting lower origination activity in the quarter is the improving persistency rate now at 62.4%. We expect persistency to keep improving throughout 2022 on the heels of lower refinance activity. This goes well for our insurance in force portfolio. And accordingly, the returns we can generate on our mortgage business. Income from operating affiliates stood at 40.6 million. Again, an excellent result primarily as a result of contributions from Coface and summer's reef. We are pleased with the returns these investments have generated for us so far. Total investment return for our investment portfolio was 39 basis points on a US dollar basis for the quarter. And net investment income was $90.5 million this quarter up slightly, in part due to slightly higher dividends on equity investments. The duration of our portfolio remains low at 2.7 years at the end of the quarter, basically unchanged from last quarter and reflecting our internal view of the risk and return trade-offs in the fixed income markets. Alternative investments representing just under 15% of our total portfolio performed well this year, returning 12.6%. The portfolio we have constructed has a slightly heavier bent towards debt strategies and should produce we believe, returns that are relatively less volatile over time given the level of diversification across sectors and geographies. Amortization of intangibles was $33.1 million up sequentially as a result of the acquisition of Westpac LMI and Somerset Bridge Group Limited which were completed in the third quarter. For your modeling purposes, we are currently forecasting an amortization expense of $110 million for the full 2022 year which is expected to be recognized evenly throughout the year. The effective tax rate on pre -tax operating income was 4.7% in the quarter, reflecting the geography mix of our pre -tax income and a 2% benefit from discrete tax items in the quarter. That discrete tax items in the quarter primarily relate to a partial release in evaluation allowance on certain international deferred tax assets. For 2022, we would expect our tax rate on pre -tax operating income to be in the 8% to 10% range based on current tax laws. Turning briefly to risk management, our natural account PML on a net basis stood at $748 million as of January 1 or 5.9% of tangible common equity which remains well below our internal limit at the single event 1250 year return level. Our peak zone PML is currently in the Northeast U.S. On the capital front, we repurchased approximately 8.7 million common shares at an aggregate cost of $362.1 million in the fourth quarter. And as Mark mentioned, we repurchased almost 31.5 million shares at an average price of $39.20 in 2021. Our remaining share repurchase authorization currently stands at $1.18 billion. Finally, I wanted to take a quick moment to thank over our over 5,000 colleagues around the globe in what has certainly been a challenging period. Without their ongoing commitment to Arch and its constituents, we certainly won't have been able to generate and report record earnings today as we closed the books on our 20th year. Your efforts and dedication are truly appreciated. With these introductory comments, we are now prepared to take your questions.
Operator: Thank you if you have a question at this time, [Operator instructions]. Our first question comes from the line of Elyse Greenspan of Wells Fargo. Your line is open.
Elyse Greenspan: Thanks. Good morning. My first question follows up on just some of Francois concluding comments going to capital management. Recognizing where your stock is today, can we just get some updated thoughts at how you guys think about share repurchase at these levels? And if at some point the valuation continues to expand, would you consider the use of a dividend to return capital to shareholders?
Marc Grandisson: Well, as you know, the top of mine and top priority for us, is to put the capital to work in the business. And we're seeing plenty of opportunities to continue in our growth trajectory, so I'd say that remains the key focus. But as you saw last year, you had no question that we've accumulated a bit of capital that we didn't have the options to deploy and put to work, so yeah, we did return a fair amount to shareholders last year. What ends up happening in 2022 is a bit of an unknown. We'll keep looking at our opportunities. Certainly, if you have the 1.3 times book multiple is something that we've looked at, and we talked about a three-year payback and how we look at share repurchases. But the business is doing very well, so I'd say that the current prices are maybe a little bit above where the three-year payback might come into play. But there's also other things, all other factors we consider and I'd say, that to your final question, like, would we think about a dividend, that's something we discuss with the Board regularly. And right now, as you know, we haven't declared a dividend, but things could change down the road.
Elyse Greenspan: And then Mark, I think you said that the earnings mix to allocate investment income between the segments is around [Indiscernible] was around 50-50. Sorry. If you think about them, that can for 2022. Would that sway more in the direction of P&C or mortgage? Or how do you see that earnings mix playing out over the coming year?
Marc Grandisson: Yes, I think it will slightly go towards P&C. I mean, absent cats and everything else, obviously at least, as you know. But overall I would expect to be seen at 50. Maybe a bit more towards the P&C as we go forward. Okay. And then one last one at the [Indiscernible] the process of rolling out some capital changes. And I know we're in the middle of the comment per year, but I wasn't sure if you guys can just share with us just some high level thoughts just on what they put out there at how could potentially impact our Arch. Thank you
Elyse Greenspan: Sure.
Marc Grandisson: Yeah. Listen, it's comprehensive. We obviously are studying it pretty deeply. We've got a large team internally that's focused on [Indiscernible] because it touches everything, right? It touches mortgage, it touches cat losses, and it touches reserve risk, so all the risk charges investments. There's a lot of things that are being suggested by S&B as to how they want to move forward and we'll be ready and we'll certainly most likely respond to their RFC in the coming weeks. And we'll see how that plays out. But big picture, I'd say its [Indiscernible] there's pluses and minuses as you'd expect. There are things that we think are [Indiscernible] we've been working with them over the last few years and trying to address, and looks like there are some changes coming through potentially, and some that we, I'd say didn't expect and maybe a bit more punitive and we'll adjust as time goes on. But still a bit of a ways to go before we have finality, and have the clear picture on what this all will mean for everybody.
Elyse Greenspan: Thank you.
Marc Grandisson: You are welcome.
Operator: Thank you. Our next question comes from Josh Shanker of Bank of America. Please go ahead.
Josh Shanker: Thank you. I was hoping you might help us think about other going forward. We have summers, we have Coface. What's sort of thoughts can you give us about the run rate goals for that unusual line and even the P&L and what sort of volatility should we expect from it?
Marc Grandisson: Well, certainly I'd say, that this quarter maybe the first [Indiscernible] it is the first quarter where we, let's say, there's no I call it noise, right? It's more recurring business as usual for both of them and also premier and all the other smaller investments that we haven't had operating affiliates. We as you know, in the balance sheet, we've got over call it a billion dollars of investments or equity in those vehicles. There's a reason why we made the investments, we think they can generate good returns for us. And that's how I would think about it. On your side, I'd say what kind of ROE should I expect from those businesses over the last [Indiscernible] over the 2022 period, given there's a billion dollars invested? I will let you can make your decisions on that are model it out, but that's how we would suggest maybe you think about it, as an ROE basis given there's a billion dollars or so [Indiscernible].
Francois Morin: And Josh you actually have one that's coming from Coface, obviously, was a public company that's helpful to you guys and also in the rear. So you had a good sense of where we're going the next quarter. On the summers, which is the old walk through it I think, it's fair to say that it would track a P&C return. It would tend to stand at this looking like a P&C insurance company. So I will describe those return just to help you give you a sense of the magnitude and the relative magnitude between the two.
Josh Shanker: And then in a little bit of shrinkage on the mortgage side of things, if you can talk about your rankings, mortgage reinsurance, insurance, share buyback. They're all attractive I know, where are the best returns right now?
Marc Grandisson: I think from a cut-down I would say that mortgage is still just currency, right? Because longer-term they might have different, that's also why I'd explained a couple of quarters back that you maybe positioning yourself in areas where the returns maybe not as high comparatively but there's a longer-term reason for this. For the high level right now, Josh, mortgage is number one, number two, I would say is reinsurance and three is insurance but [Indiscernible] and the investment income potentials in the future improving will again bring up the insurance and reinsurance. But they're not very much different from one another. I mean, there used to be a lot wider difference between them three or four years ago as you know, but now the market the hardening market on the P&C side has made them all very, very favorable and very attractive. On the share repurchase you heard Francois say so, where [Indiscernible] what we bought it at, and what we think of it. So it's still always a possibility and I would say on the capital management, as Francois mentioned, [Indiscernible] only returns specific in [Indiscernible] in terms of returning it, if we don't [Indiscernible] if we can't find anything more interesting to work with, a higher return. But I think right now we have a lot of opportunity.
Josh Shanker: Thank you very much.
Marc Grandisson: You're welcome.
Operator: Our next question comes from Tracy Benguigui with Barclays. Your line is open.
Tracy Benguigui: I would like to touch on the expense ratio. Francois, you mentioned increased contingent commission accruals on profitable business. And I'm assuming you mean with MGU maybe you could just walk us through how that structure works. I think there's a multiyear look-back period and where I'm going with it is essential, if there's a lot of in calculating that profit sharing component, should we expect this profit sharing components sticking around for a while to catch up with all the good work you've done on underwriting profitability?
Francois Morin: Well, as you can imagine, there is lots of different types of agreements with all our producers, U.S. international. And so going into the specifics would take a lot of time, but I'd say at a high level, no question that if we book a lower loss ratio on business in some situations that does trigger a higher contingent commission and that has to go hand-in-hand and how we accrue it, how we book it in the quarter. As long as the business is performing well and then yes, it gets [Indiscernible] the settlements take place over a period of time with true-ups, etc. But at a higher level, no question that, as long as the business performs well and the loss ratio has remained half the level they are at right now, we would expect commensurate levels of contingent commission to be there in place over time.
Tracy Benguigui: Got it. And then, on the same topic. I mean, basically, I'm just curious, what are you writing that cost you more besides maybe travel business? So I was looking at the changes in our business mix, basically something that pops up, maybe it's professional lines in insurance and (Re)insurance, it bounces around more quarter-to-quarter. So if you could just provide more context about the business mix changes that we're really driving at, as well as the direction of ceding commissions.
Marc Grandisson: Yeah, absolutely. It's a very good question. I think that if you look at the structure on [Indiscernible] starting with the insurance group, it's [Indiscernible] similar phenomenon but different reasons on the reinsurance side. On the insurance side, programs is also something that we are growing, we also smolder risk. In the professional lines, we do a lot of private DNO and not-for-profit DNO, for instance, that comes with a much higher expense ratio than you would have normally with a larger commercial enterprises, so that's one example. We also are increasing our footprint in the UK, which also carries a higher acquisition cost. So I would tend to think on the insurance side is a size of risks, the fact that we trapped absent travel. There is risk that we write some cyber as well, primarily small risks that's also carrying [Indiscernible] because it's primary and small accounts will have a higher acquisition expense ratio. So the size of the risk is what makes it on the insurance on the insurance side, accident, travel, which is also a small risk to be fair. On the reinsurance side, Tracy, as you know, it's a lot, a quota share is a big, big difference. You could have an expense ratio and acquisition ratio on the excess of loss, which is 10 to 15. It could be 30, 33 on the quota share basis. So that really will [Indiscernible] we've been growing both on the insurance side for the small risks and on the reinsurance side on our quarter share participation. So that is just the price of getting access to the business that we have to pay for.
Tracy Benguigui: So we're on the [Indiscernible] commission?
Marc Grandisson: Say it again?
Tracy Benguigui: And if you could comment on the ceding commission.
Marc Grandisson: The ceding commissions are [Indiscernible] have been stable to slightly up on the reinsurance but not significantly. They are a bit more stable for the last year and a half than they have been in other harder markets, that's one thing that's really intriguing, but I guess it makes sense in terms of the economic returns in the pricing that's coming through on the primary side. But the increase itself in ceding commission is not what's driving the acquisition expense ratio, it's truly the type of business in the mix that we are writing.
Tracy Benguigui: Thank you.
Marc Grandisson: Thank you
Operator: Our next question comes from Mike Zaremski of Wolfe Research. Please go ahead.
Mike Zaremski: Hey, great. Thanks. A follow-up on the maybe I'm reading too much into this, but on the increase in the expense ratio specifically, I believe probably the acquisition expense ratio, but maybe also the other portion of the expense ratio in the primary insurance segment. So I believe you said some of it was due to increased profitability or contingent commissions, but I guess if I'm looking at the overall combined ratio for that segment for the year, it was 96 and changed. And for the quarter was 93, I thought we were shooting for overall profitably being better than that in other years, or maybe even this year. So I didn't think profitability was much better than expected. Any thoughts there?
Marc Grandisson: Well, obviously, you got a slice it down by the lines and by line of business. So the agreements, they're not on the overall profitability. So sometimes we have [Indiscernible] we do have some books of business that are doing extremely well and commissions go up with that. The other thing that I mentioned and I think is not insignificant, is the fact that we are retaining a bit more in some lines of business, and that moves the economics, I'd say, right? So you're going to get a bit less sitting commissions that are maybe higher in some places. And you retain more net than that at a better loss ratio going forward. So that's something to [Indiscernible] that also impacts the overall acquisition. I'd say at a high level, there's no question that there's a bit of noise this quarter, but it's not something that has us extremely worried at this point. I think it's very much a quarterly kind of a bit of noise. There's a bit of again, recovery from COVID like last year, quarter-over-quarter, we are still in the [Indiscernible] very deep into the COVID crisis with no travel, etc. So there's other reasons that impact all the our expense ratio in total, I'd say at a high level, we think it's a bit elevated this quarter, but not really a costs are concerned. And like you're quoting numbers that include cat events like actual cat events. If you do it ex-cat, which is probably a better reflection on the unloading margins, it's really going down from 95 to 91 for the year. So we are getting improved margin. One could argue whether it's will be more or less, but it's pretty much an improvement that we saw the last 12 months. So it's [Indiscernible] your numbers was cute somewhat with a cat events, I believe.
Mike Zaremski: No. You're right. I probably should have quoted maybe ex-cat too, but although the cats matter, but and also good point on the [Indiscernible] your net to gross is keeping.
Marc Grandisson: Yeah.
Mike Zaremski: Okay. And that's helpful. And maybe just switching gears to capital and inorganic growth, I guess one of the MIs hit the tape that they are potentially exploring a sale. If another MI buys another mortgage insurer is one plus one still less than two, or have come dynamics you think maybe changed over recent years?
Marc Grandisson: It's a good question because our understanding was that the GSEs and it's really [Indiscernible] you know, we have to talk to the people in Washington and Virginia to understand what they think about this, was that there was a preference to have more [Indiscernible] no, not lesser amount that they might provide us more diversification, so we'll see what happens. There's not much gain and benefit and scale in combining two MI companies, I mean, you still [Indiscernible] all the capital models and whatnot are linear. So there's not really a saving of capital. I think there will probably be some net loss on a market share. I think we saw ourselves some of it from the [Indiscernible] when we acquired UG. So it's not one plus one is not equal to 1.5, but it was a little bit of a loss on the market share. So that's probably not 1 plus 1 equals 2 or plus. So I don't know what's going to happen. I don't know what people have in mind. I think to me, our core principle about MI and the way we've operated stays which is it's always better in a multi-line diversified platform, and that's not going away. I would say that some of the S&P new modeling is appreciating and recognizing that. So that's my view, at least. I think the more sensible thing would be for these MI to find another home somewhere else outside of the MI arena. But I'm not a predictor of this, Mike.
Mike Zaremski: So that's helping. So you mentioned the S&P capital model will the diversification get an increased benefits? So [Indiscernible]
Marc Grandisson: In general only MI, in general there's better diversity and credit, the more diversified you are, which again speaks to our model, which makes sense to us.
Mike Zaremski: Thank you.
Marc Grandisson: Thanks.
Operator: Thank you. Our next question comes from Mark Dwelle of RBC. Your line is open.
Mark Dwelle: Yeah. Good morning. Couple of questions related to MI. First in the quarter, it looked like the average paid claim [Indiscernible] average paid cost per claim was around 51,000, it's been lying more in the 30s. Is there anything in particular that accounts for the uptick, maybe some large claims or something. It's a one-off really, it's a settlement with a servicer that took place this quarter that was for pre -crisis claims. So definitely a one-off here. And then a second question related to MI, just really a clarification. The reserve releases that you did in the quarter are we don't understand that those related to the reserves set up when COVID began, or maybe where these reserves related to other time periods or other classes of reserve?
Marc Grandisson: We made the point in the past that we have a hard time to some extent isolating COVID from non-COVID claims, but still more than half is for reserves that we had set up before COVID. So I mean, the vast majority or the majority is if you want to go and just appear as a when they were set up is pre first-quarter 2020.
Mark Dwelle: Okay thank you. And the last question I had was really more of a general market kind of question. Maybe for Mark. Are you seeing any signs in the insurance or Reinsurance businesses of competitors taking more aggressive pricing stances? I mean, basically getting at is the insurance clock getting towards 12 o'clock or are we still firmly at 11 o'clock?
Marc Grandisson: Probably like the longest 11 o'clock that we'll see in our lifetime. I think that if you look at the risks that are ahead of us, you still have climate to deal with, you still have inflation concerns, which I guess leads to reserve, potential reserve questioning or analysis, cyber risk, and COVID reopening. There's a lot of stuff going on right now that sort of leads the whole market to be a lot more careful and thoughtful. So the market is always competitive, right? There's always competition out there. But right now what we are, it's a very disciplined market and we're not seeing anything. We haven't seen anything and we're not seeing anything percolating that would indicate that this would change for 2022.
Mark Dwelle: Thank you. That's all my questions.
Operator: Your next question comes from Meyer Shields of KBW. Your line is open.
Meyer Shields: Thanks. If I go back to the contingent commission question, I guess it's clear that underlying profitability is getting better? So we expect that smoother recognition of contingent commission accruals in 2022?
Marc Grandisson: Not necessarily, because Meyer, the release of profit commission or contingent commissions is dependent on loss fix, so we tend to take our beautiful time to make sure we have all the data available to make those contingent commission so can be spotty. But we can make a decision to look at two or three underwriting years and have that adjustment made. And we accrue for some of it, but we don't always accrue to the full extent of the ultimate. The losses actually drive these contingent commissions. So this is [Indiscernible] so it's really spotty, it's very hard to predict.
Meyer Shields: Okay. So that's fair. I just want to understand the process. Second question, I think Francois had talked about maybe reducing the sessions on some quota share contracts in insurance, so less of an offset. Does that outpace or trail the loss ratio improvements that you should anticipate from keeping that business?
Marc Grandisson: Let me [Indiscernible] I make sure, so, are you saying that? Repeat your question differently, I'm not sure I got exactly where you want to get to Meyer. I apologize.
Meyer Shields: Okay. Let me try again. So [Indiscernible] is going up because you're ceding less business that has high ceding commissions.
Marc Grandisson: Yeah.
Meyer Shields: Just hoping that you can frame that relative to the last ratio improvements that we should expect because you're keeping more profitable business.
Marc Grandisson: Yes. So if we're keeping more profitable business, the loss ratio would [Indiscernible] everything else being equal go down.
Meyer Shields: Right. By more than the increase in acquisition expense.
Marc Grandisson: Possibly. It's hard to say right [Indiscernible]
Meyer Shields: Okay.
Marc Grandisson: [Indiscernible] from the get-go. I think we made these economic decisions, it's kind of a hard one to pin down. Sometimes the [Indiscernible] what you see that's capital, capital with return, that's different than the pure combined ratio. So there's a lot of things going on. It's more [Indiscernible] it's not only about the pure combined ratio. The return is improving, that's what matters to us.
Francois Morin: Directionally, I think we're [Indiscernible] we don't disagree with what you're saying. I think the precision or the timing at which everything happens is less [Indiscernible] it's not precise, I would say [Indiscernible] I would assume. Directionally, I think its right, yeah.
Marc Grandisson: Better return.
Meyer Shields: Okay. I completely understand. And one big picture question if I can. Anything [Indiscernible] everything that you're saying Mark about the cycle lasting longer. Because of concerns on the loss trend side. I guess why rates are going up. Why do you think rates are still going up more than loss trends?
Marc Grandisson: Well, that's definitely question Meyer. That's one that we should probably have the BARDA corn and all kidding aside, I think that it's probably a recognition that this uncertainty is what creates the need for more margin safety. I think that when you're faced with uncertain pick-up in inflation, I mean, we had a 7% roughly inflation print this morning. When you have a high number that comes like this, it comes as the shocker. So I think that people are being preempting, preempting in making sure that they cover as much of the base as they can. I think the insurance industry for what it's worth has been very disciplined and is acting in a very profitable way and I think over the last 2 years, it recognizes that the risk is building up and need to price better, price higher because there's more risk of sliding a bit slide sideways. So I think it's an appropriate and very welcome change. A very [Indiscernible] if this is in the market is pretty good from that perspective.
Meyer Shields: Thanks [Indiscernible].
Marc Grandisson: Sure.
Operator: Thank you. Our next question comes from Brian Meredith of UBS. Please go ahead.
Brian Meredith: Yes. Thanks. I got two questions for you guys. First one, I'm just curious, I know there was a block of stock of [Indiscernible] to trade and you all didn't bite. Was there any regulatory reasons you couldn't do it? Or is that just a capital allocation decision that, you don't want to own the whole thing?
Francois Morin: Well, not at all. I think the existing shareholder wanted to sell and very much [Indiscernible] very [Indiscernible] much easier for them to do it the way they did it. Then, to come to us and at which point, yes, we would've had to go to the regulators and that would take them weeks if not months. And the whole approval process would have maybe dragged on. So I think they wanted speed over maybe better execution and that's what they got deal in doing it the way they did.
Brian Meredith: So is that profit state less strategic for you than going forward?
Francois Morin: Not at all. To be candid, I mean, they even come to us offering it up to, I mean, they just went ahead on their own instead of coming to us and saying, would you be interested in buying the 10% or 12% we want to get rid of or we don't want anymore. They just went through their own process because again, they knew that we trip the requirements that we'd have to do a tender and all of that, which would have taken again longer. So that was their decision and we respect it. But going forward strategically, I mean, we still look at profiles and it's been very good to us so far, and we keep thinking about how we, if and when, or how we do things differently going forward.
Brian Meredith: Great. And then, first of all, let me just clarify one comment you made earlier in talking about kind of repurchasing your stock and I understand that you want that 3 year payback period, which is the other considerations and I understand that. But does that mean that with your stock trading just a little over one for book value right now, that you would not be buying back stock right now? It's your return profile doesn't fit that.
Francois Morin: Well. It's never black and white but I'd say that the forward-looking returns that we see for how we think about the business and better profitability over three years, it's higher than 10%, right? So you could kind of stretch it a bit more than 1.3 times book. And so it's [Indiscernible] I'll stop here. I'd say we could consider going above 1.3 times book, very much as a function of how we think about the business and what kind of profitability we see coming our way.
Marc Grandisson: I think Brian, I would say, you know this as well, right. I mean, there are a couple of things happening for instance, on the MI side that might change that what we perceive to be the real book value of the company. So these are also considerations that could be way outside of the return possibility going forward. That's one exemplary.
Brian Meredith: Got you. Thank you.
Marc Grandisson: Thank you.
Operator: I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Well, thank you everyone want to thank our employees, as Francois mentioned as well, and sometimes they run the corners so make sure you take care of your loved one this weekend. On to the next quarter.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day ladies and gentlemen, and welcome to Arch Capital Group's Fourth Quarter 2021 earnings conference call. At this time, all participants are in a listen-only mode. Later we'll conduct a question-and-answer session and instructions will follow at that time. If anyone should require assistance during the conference, please [Operator Instruction] on your touchtone telephone. As a reminder, this conference call is being recorded. Before the company get started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call, may constitute forward-looking statements under the federal securities. So federal securities laws, these statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical fact, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also, will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished by the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference. Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks. Atif. Good morning and welcome to our fourth quarter earnings call. We ended a good year. Here with a great quarter on the year Arch generated a return on net income of 16.7%. And importantly, book value per common share grew by 10.7% with net earnings per share of $5.23. We accomplished these results despite elevated CAT activity, and a short-term effect, that substantial share repurchases had on our book value per share. Our ability to effectively allocate capital also contributed to our 2021 results. Whether opportunistically investing more resources into the most profitable pockets of our business or buying back $1.2 billion worth of our common shares fully, 7.7% of the shares outstanding at the start of the year. We remain committed to a capital management strategy that creates value for shareholders. I'd like to begin by sharing some highlights from our operating units. In our P&C insurance segment, net written premium grew 24% and earned premium grew 34% over the fourth quarter of 2020 as we earned in the rate increases of the past several quarters. Growth occurred across many lines with profession lines and travel exhibiting the strongest advances. Overall submission activity and rate momentum remained healthy and rate increases were above loss trend. A change in business mix led to a slightly higher acquisition expense in the quarter. However, we believe that this increase belies the underlying return potential of the segment. More accurately, it is a reflection of the insurance group's outstanding job or positioning itself to act on the better opportunities available in today's market. Turning now to reinsurance, our shareholders continue to benefit from the extraordinary talents of this group, which grew gross written premium by 88% and net written premium by nearly 45% from a year-ago. On haul, the reinsurance group grew in nearly every line, a reflection of our diversified specialty mix of business and our larger participation in quota share reinsurance, which allows us to participate in the improved premium rates of [Indiscernible] more directly. Briefly on renewals at January 1st, while property cut raise were up broadly, the increases were not enough for us to deploy more capital into our peak zones. However, we found many opportunities to grow in the other 93% of our reinsurance business, that its specialty in nature, including property ex-cat. Finally, onto the mortgage segment, which again delivered excellent underwriting results, even as written premiums declined in the quarter. Seasonally, the fourth quarter, as you know, it's lower for mortgage originations and rising interest rates further depressed refinance activity reducing new insurance rhythm. However, our insurance in fourth, the ultimate driver of earnings, still grew modestly in the quarter mainly due to the lower refinancing activity. Credit conditions remain excellent in the U.S. with a strong housing market and demand for housing continuing to exceed supply. As most of you already know, home price appreciation remains robust across most of the country. This is a net positive for mortgage insurers as increasing borrower equity ultimately leads to a lower risk of default. Competition in this sector remains robust but stable, and we believe that the better credit quality of our recent originations compensates for marginally lower premium yields. We continue to focus on a more stable returns available in higher credit quality business, instead of broadly chasing top-line growth, a luxury afforded to us by our diversified model. Turning to the fourth leg of our stool, investment income contributions were up materially for the year, primarily due to alternative investments accounted under the equity method. These investments are primarily fixed income in nature, but because of the structure of our investments, their contributions are excluded from net investment income and our definition of operating income. Notwithstanding, these investments contributed $366 million or $0.92 per share for the full year. Over the past five-years below the line investment returns have added between 75 to 125 bps to our net ROE. But taking a step back to get more of a big picture view, we like the way our businesses are currently positioned. Within our P&C segments, we believe that P&C pricing and returns have more room to grow in this part of the cycle, and in the mortgage segment, insurance in force is benefiting from both solid credit conditions and good house price appreciation. Underwriting income for our P&C insurance and reinsurance segments expanded significantly in the fourth quarter. It's worth noting that if we were to include components of investment income that relate to the flow-generation farm underwriting. P&C [Indiscernible] contribution to arches earnings were roughly in balance. We believe that this balance improves the risk adjusted returns for our shareholders. Our corporate culture of being patient in soft markets while maintaining an agile mindset is a key to our success and allows us to seize opportunity when the odds for success are more in our favor because different sectors have their own cycles, our disciplined, defensive underwriting during the softer parts of the cycles is what has enabled us to grow faster than many of our peers in the current environment. We have begun to read the benefits of the strong defensive posture we maintained from 2016 through 2019. The Winter Olympics are underway, and I found an analogy to our business in a somewhat unexpected place. The most exquisite and exciting game of Curling. You may or may not be aware that Curling has been dubbed, chess on ice. And like insurance, it's much more strategic than the uninformed may realize. Curling is played over ten long ENS or rounds. A defensive strategy is most common, patiently waiting for an opening to pivot to offense. Unfortunately, defending is not exciting. It's about minimizing your opponent scoring opportunities and avoiding mistakes. But like insurance, patience is often handsomely rewarded because when her opponent makes an error, the SKIP knows that now is the time to pounce and all of a sudden, patient is out-the-door and action is in. Most games are won in that one crucial reversal of fortune. That's how we play the insurance cycle. One year at a time, patiently waiting for the market to give us that opening. And once we see it, we're all-in, just like the last 2.5 years and counting. Don't ever let anyone tell you that curling or insurance are not exciting. For 20 years, we've been committed to taking the long-term view of the insurance cycle being thoughtful and balanced with our capital management strategy and differentiating ourselves by being committed to a specialty model, all with the aim of enhancing shareholder value over the long term. Although every year is different and markets aren't always predictable, we've demonstrated that we can succeed in any market. So we're looking forward to what 2022 has in store for us. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Thank you Marc. And good morning to all. Thanks for joining us today. As Marc shared earlier, our after-tax operating income for the quarter was $493.3 million or $1.27 per share, resulting in an annualized 15.6% operating return on average, common equity. Book value per share increase to $33.56 at December 31 up 3.5% in the quarter. For the year, our operating return on equity stood at 11.5% while our net return on equity was 16.7%, excellent results in deed. In the insurance segment, net written premium grew 23.7% over the same quarter one year ago. And the accident quarter combined ratio excluding [Indiscernible] was 91.2%, lower by approximately 240 basis points from the same period one year ago. The growth was particularly strong in North America, where a combination of new business opportunities and rate increases supported this profitable growth. One item to note this quarter for the insurance segment relates to the acquisition expense ratio, which was higher than in both the prior quarter and the same quarter one year ago. As we mentioned in the earnings release, some of this increase is related to premium growth in lines of business with higher acquisition costs such as travel. But it also reflects increased contingent commission accruals on profitable business, as well as lower ceded premiums in lines with higher ceding commission offsets. As we have said before, our focus remains on the returns we are able to generate from all our businesses, and we remain positive on the current pricing environment and the opportunities that should be available to us in 2022. For the reinsurance segment, growth in net written premium remain strong at 44.5% on a quarter-over-quarter basis. The gross [Indiscernible] the growth was driven by increases in our casualty property other than property catastrophe and other specialty lines where new business opportunities, strong rate increases, and growth in new accounts helped increase the top line. For the full 2021 year, the ex-cat accident year combined ratio was 84.4%, improving by approximately 160 basis points over the 2020 year, a reflection of the underwriting conditions we have seen in most of the lines we write. Losses from 2021 catastrophic events in the quarter, net of reinsurance recoverables and reinstatement premiums stood at $72.3 million or 3.5 combined ratio points compared to 9.4 combined ratio points in the fourth quarter of 2020. The losses came from a combination of fourth-quarter events including the December U.S. tornadoes, and other minor global events, as well as some development on events that occurred earlier in the year. Our estimate of our ultimate exposure to COVID related claims decreased by approximately $3 million during the quarter. We currently hold approximately $195 million in reserves for this exposure. Two-thirds of which are recorded either as ACRS are IBNR. Our mortgage segment had an excellent quarter with combined ratio of 11.7%, due in part to favorable prior-year development of $72.9 million. The decrease in net premiums earned on a sequential basis was attributable to a combination of higher levels of premium ceded, a lower level of earnings from single premium policy terminations, and lower U.S. primary mortgage insurance monthly premiums, due to lower premium yields from recent originations, which were of excellent credit quality. While approximately two-thirds of the favorable clean development came from [Indiscernible], related to better than expected cure activity and recoveries on second lien loans. We also saw favorable prior year development across our other mortgage units includes our CRT portfolio and our international MI operations. Consistent with historical practice, we maintain a prudent approach and setting loss reserves, especially in light of the uncertainty we are facing with borrowers exiting forbearance programs and moratoriums on foreclosures. The delinquency rate for our US MI book came in at 2.36% at the end of the quarter, more than 50% lower than the peak we observed at the end of the second quarter of 2020. Production levels were down from last quarter, certainly a typical outcome given the seasonality in new purchases, and also partially, as a result of the lower level of refinance activity due to higher interest rates. Offsetting lower origination activity in the quarter is the improving persistency rate now at 62.4%. We expect persistency to keep improving throughout 2022 on the heels of lower refinance activity. This goes well for our insurance in force portfolio. And accordingly, the returns we can generate on our mortgage business. Income from operating affiliates stood at 40.6 million. Again, an excellent result primarily as a result of contributions from Coface and summer's reef. We are pleased with the returns these investments have generated for us so far. Total investment return for our investment portfolio was 39 basis points on a US dollar basis for the quarter. And net investment income was $90.5 million this quarter up slightly, in part due to slightly higher dividends on equity investments. The duration of our portfolio remains low at 2.7 years at the end of the quarter, basically unchanged from last quarter and reflecting our internal view of the risk and return trade-offs in the fixed income markets. Alternative investments representing just under 15% of our total portfolio performed well this year, returning 12.6%. The portfolio we have constructed has a slightly heavier bent towards debt strategies and should produce we believe, returns that are relatively less volatile over time given the level of diversification across sectors and geographies. Amortization of intangibles was $33.1 million up sequentially as a result of the acquisition of Westpac LMI and Somerset Bridge Group Limited which were completed in the third quarter. For your modeling purposes, we are currently forecasting an amortization expense of $110 million for the full 2022 year which is expected to be recognized evenly throughout the year. The effective tax rate on pre -tax operating income was 4.7% in the quarter, reflecting the geography mix of our pre -tax income and a 2% benefit from discrete tax items in the quarter. That discrete tax items in the quarter primarily relate to a partial release in evaluation allowance on certain international deferred tax assets. For 2022, we would expect our tax rate on pre -tax operating income to be in the 8% to 10% range based on current tax laws. Turning briefly to risk management, our natural account PML on a net basis stood at $748 million as of January 1 or 5.9% of tangible common equity which remains well below our internal limit at the single event 1250 year return level. Our peak zone PML is currently in the Northeast U.S. On the capital front, we repurchased approximately 8.7 million common shares at an aggregate cost of $362.1 million in the fourth quarter. And as Mark mentioned, we repurchased almost 31.5 million shares at an average price of $39.20 in 2021. Our remaining share repurchase authorization currently stands at $1.18 billion. Finally, I wanted to take a quick moment to thank over our over 5,000 colleagues around the globe in what has certainly been a challenging period. Without their ongoing commitment to Arch and its constituents, we certainly won't have been able to generate and report record earnings today as we closed the books on our 20th year. Your efforts and dedication are truly appreciated. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you if you have a question at this time, [Operator instructions]. Our first question comes from the line of Elyse Greenspan of Wells Fargo. Your line is open."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks. Good morning. My first question follows up on just some of Francois concluding comments going to capital management. Recognizing where your stock is today, can we just get some updated thoughts at how you guys think about share repurchase at these levels? And if at some point the valuation continues to expand, would you consider the use of a dividend to return capital to shareholders?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, as you know, the top of mine and top priority for us, is to put the capital to work in the business. And we're seeing plenty of opportunities to continue in our growth trajectory, so I'd say that remains the key focus. But as you saw last year, you had no question that we've accumulated a bit of capital that we didn't have the options to deploy and put to work, so yeah, we did return a fair amount to shareholders last year. What ends up happening in 2022 is a bit of an unknown. We'll keep looking at our opportunities. Certainly, if you have the 1.3 times book multiple is something that we've looked at, and we talked about a three-year payback and how we look at share repurchases. But the business is doing very well, so I'd say that the current prices are maybe a little bit above where the three-year payback might come into play. But there's also other things, all other factors we consider and I'd say, that to your final question, like, would we think about a dividend, that's something we discuss with the Board regularly. And right now, as you know, we haven't declared a dividend, but things could change down the road."
},
{
"speaker": "Elyse Greenspan",
"text": "And then Mark, I think you said that the earnings mix to allocate investment income between the segments is around [Indiscernible] was around 50-50. Sorry. If you think about them, that can for 2022. Would that sway more in the direction of P&C or mortgage? Or how do you see that earnings mix playing out over the coming year?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, I think it will slightly go towards P&C. I mean, absent cats and everything else, obviously at least, as you know. But overall I would expect to be seen at 50. Maybe a bit more towards the P&C as we go forward. Okay. And then one last one at the [Indiscernible] the process of rolling out some capital changes. And I know we're in the middle of the comment per year, but I wasn't sure if you guys can just share with us just some high level thoughts just on what they put out there at how could potentially impact our Arch. Thank you"
},
{
"speaker": "Elyse Greenspan",
"text": "Sure."
},
{
"speaker": "Marc Grandisson",
"text": "Yeah. Listen, it's comprehensive. We obviously are studying it pretty deeply. We've got a large team internally that's focused on [Indiscernible] because it touches everything, right? It touches mortgage, it touches cat losses, and it touches reserve risk, so all the risk charges investments. There's a lot of things that are being suggested by S&B as to how they want to move forward and we'll be ready and we'll certainly most likely respond to their RFC in the coming weeks. And we'll see how that plays out. But big picture, I'd say its [Indiscernible] there's pluses and minuses as you'd expect. There are things that we think are [Indiscernible] we've been working with them over the last few years and trying to address, and looks like there are some changes coming through potentially, and some that we, I'd say didn't expect and maybe a bit more punitive and we'll adjust as time goes on. But still a bit of a ways to go before we have finality, and have the clear picture on what this all will mean for everybody."
},
{
"speaker": "Elyse Greenspan",
"text": "Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "You are welcome."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Josh Shanker of Bank of America. Please go ahead."
},
{
"speaker": "Josh Shanker",
"text": "Thank you. I was hoping you might help us think about other going forward. We have summers, we have Coface. What's sort of thoughts can you give us about the run rate goals for that unusual line and even the P&L and what sort of volatility should we expect from it?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, certainly I'd say, that this quarter maybe the first [Indiscernible] it is the first quarter where we, let's say, there's no I call it noise, right? It's more recurring business as usual for both of them and also premier and all the other smaller investments that we haven't had operating affiliates. We as you know, in the balance sheet, we've got over call it a billion dollars of investments or equity in those vehicles. There's a reason why we made the investments, we think they can generate good returns for us. And that's how I would think about it. On your side, I'd say what kind of ROE should I expect from those businesses over the last [Indiscernible] over the 2022 period, given there's a billion dollars invested? I will let you can make your decisions on that are model it out, but that's how we would suggest maybe you think about it, as an ROE basis given there's a billion dollars or so [Indiscernible]."
},
{
"speaker": "Francois Morin",
"text": "And Josh you actually have one that's coming from Coface, obviously, was a public company that's helpful to you guys and also in the rear. So you had a good sense of where we're going the next quarter. On the summers, which is the old walk through it I think, it's fair to say that it would track a P&C return. It would tend to stand at this looking like a P&C insurance company. So I will describe those return just to help you give you a sense of the magnitude and the relative magnitude between the two."
},
{
"speaker": "Josh Shanker",
"text": "And then in a little bit of shrinkage on the mortgage side of things, if you can talk about your rankings, mortgage reinsurance, insurance, share buyback. They're all attractive I know, where are the best returns right now?"
},
{
"speaker": "Marc Grandisson",
"text": "I think from a cut-down I would say that mortgage is still just currency, right? Because longer-term they might have different, that's also why I'd explained a couple of quarters back that you maybe positioning yourself in areas where the returns maybe not as high comparatively but there's a longer-term reason for this. For the high level right now, Josh, mortgage is number one, number two, I would say is reinsurance and three is insurance but [Indiscernible] and the investment income potentials in the future improving will again bring up the insurance and reinsurance. But they're not very much different from one another. I mean, there used to be a lot wider difference between them three or four years ago as you know, but now the market the hardening market on the P&C side has made them all very, very favorable and very attractive. On the share repurchase you heard Francois say so, where [Indiscernible] what we bought it at, and what we think of it. So it's still always a possibility and I would say on the capital management, as Francois mentioned, [Indiscernible] only returns specific in [Indiscernible] in terms of returning it, if we don't [Indiscernible] if we can't find anything more interesting to work with, a higher return. But I think right now we have a lot of opportunity."
},
{
"speaker": "Josh Shanker",
"text": "Thank you very much."
},
{
"speaker": "Marc Grandisson",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tracy Benguigui with Barclays. Your line is open."
},
{
"speaker": "Tracy Benguigui",
"text": "I would like to touch on the expense ratio. Francois, you mentioned increased contingent commission accruals on profitable business. And I'm assuming you mean with MGU maybe you could just walk us through how that structure works. I think there's a multiyear look-back period and where I'm going with it is essential, if there's a lot of in calculating that profit sharing component, should we expect this profit sharing components sticking around for a while to catch up with all the good work you've done on underwriting profitability?"
},
{
"speaker": "Francois Morin",
"text": "Well, as you can imagine, there is lots of different types of agreements with all our producers, U.S. international. And so going into the specifics would take a lot of time, but I'd say at a high level, no question that if we book a lower loss ratio on business in some situations that does trigger a higher contingent commission and that has to go hand-in-hand and how we accrue it, how we book it in the quarter. As long as the business is performing well and then yes, it gets [Indiscernible] the settlements take place over a period of time with true-ups, etc. But at a higher level, no question that, as long as the business performs well and the loss ratio has remained half the level they are at right now, we would expect commensurate levels of contingent commission to be there in place over time."
},
{
"speaker": "Tracy Benguigui",
"text": "Got it. And then, on the same topic. I mean, basically, I'm just curious, what are you writing that cost you more besides maybe travel business? So I was looking at the changes in our business mix, basically something that pops up, maybe it's professional lines in insurance and (Re)insurance, it bounces around more quarter-to-quarter. So if you could just provide more context about the business mix changes that we're really driving at, as well as the direction of ceding commissions."
},
{
"speaker": "Marc Grandisson",
"text": "Yeah, absolutely. It's a very good question. I think that if you look at the structure on [Indiscernible] starting with the insurance group, it's [Indiscernible] similar phenomenon but different reasons on the reinsurance side. On the insurance side, programs is also something that we are growing, we also smolder risk. In the professional lines, we do a lot of private DNO and not-for-profit DNO, for instance, that comes with a much higher expense ratio than you would have normally with a larger commercial enterprises, so that's one example. We also are increasing our footprint in the UK, which also carries a higher acquisition cost. So I would tend to think on the insurance side is a size of risks, the fact that we trapped absent travel. There is risk that we write some cyber as well, primarily small risks that's also carrying [Indiscernible] because it's primary and small accounts will have a higher acquisition expense ratio. So the size of the risk is what makes it on the insurance on the insurance side, accident, travel, which is also a small risk to be fair. On the reinsurance side, Tracy, as you know, it's a lot, a quota share is a big, big difference. You could have an expense ratio and acquisition ratio on the excess of loss, which is 10 to 15. It could be 30, 33 on the quota share basis. So that really will [Indiscernible] we've been growing both on the insurance side for the small risks and on the reinsurance side on our quarter share participation. So that is just the price of getting access to the business that we have to pay for."
},
{
"speaker": "Tracy Benguigui",
"text": "So we're on the [Indiscernible] commission?"
},
{
"speaker": "Marc Grandisson",
"text": "Say it again?"
},
{
"speaker": "Tracy Benguigui",
"text": "And if you could comment on the ceding commission."
},
{
"speaker": "Marc Grandisson",
"text": "The ceding commissions are [Indiscernible] have been stable to slightly up on the reinsurance but not significantly. They are a bit more stable for the last year and a half than they have been in other harder markets, that's one thing that's really intriguing, but I guess it makes sense in terms of the economic returns in the pricing that's coming through on the primary side. But the increase itself in ceding commission is not what's driving the acquisition expense ratio, it's truly the type of business in the mix that we are writing."
},
{
"speaker": "Tracy Benguigui",
"text": "Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you"
},
{
"speaker": "Operator",
"text": "Our next question comes from Mike Zaremski of Wolfe Research. Please go ahead."
},
{
"speaker": "Mike Zaremski",
"text": "Hey, great. Thanks. A follow-up on the maybe I'm reading too much into this, but on the increase in the expense ratio specifically, I believe probably the acquisition expense ratio, but maybe also the other portion of the expense ratio in the primary insurance segment. So I believe you said some of it was due to increased profitability or contingent commissions, but I guess if I'm looking at the overall combined ratio for that segment for the year, it was 96 and changed. And for the quarter was 93, I thought we were shooting for overall profitably being better than that in other years, or maybe even this year. So I didn't think profitability was much better than expected. Any thoughts there?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, obviously, you got a slice it down by the lines and by line of business. So the agreements, they're not on the overall profitability. So sometimes we have [Indiscernible] we do have some books of business that are doing extremely well and commissions go up with that. The other thing that I mentioned and I think is not insignificant, is the fact that we are retaining a bit more in some lines of business, and that moves the economics, I'd say, right? So you're going to get a bit less sitting commissions that are maybe higher in some places. And you retain more net than that at a better loss ratio going forward. So that's something to [Indiscernible] that also impacts the overall acquisition. I'd say at a high level, there's no question that there's a bit of noise this quarter, but it's not something that has us extremely worried at this point. I think it's very much a quarterly kind of a bit of noise. There's a bit of again, recovery from COVID like last year, quarter-over-quarter, we are still in the [Indiscernible] very deep into the COVID crisis with no travel, etc. So there's other reasons that impact all the our expense ratio in total, I'd say at a high level, we think it's a bit elevated this quarter, but not really a costs are concerned. And like you're quoting numbers that include cat events like actual cat events. If you do it ex-cat, which is probably a better reflection on the unloading margins, it's really going down from 95 to 91 for the year. So we are getting improved margin. One could argue whether it's will be more or less, but it's pretty much an improvement that we saw the last 12 months. So it's [Indiscernible] your numbers was cute somewhat with a cat events, I believe."
},
{
"speaker": "Mike Zaremski",
"text": "No. You're right. I probably should have quoted maybe ex-cat too, but although the cats matter, but and also good point on the [Indiscernible] your net to gross is keeping."
},
{
"speaker": "Marc Grandisson",
"text": "Yeah."
},
{
"speaker": "Mike Zaremski",
"text": "Okay. And that's helpful. And maybe just switching gears to capital and inorganic growth, I guess one of the MIs hit the tape that they are potentially exploring a sale. If another MI buys another mortgage insurer is one plus one still less than two, or have come dynamics you think maybe changed over recent years?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a good question because our understanding was that the GSEs and it's really [Indiscernible] you know, we have to talk to the people in Washington and Virginia to understand what they think about this, was that there was a preference to have more [Indiscernible] no, not lesser amount that they might provide us more diversification, so we'll see what happens. There's not much gain and benefit and scale in combining two MI companies, I mean, you still [Indiscernible] all the capital models and whatnot are linear. So there's not really a saving of capital. I think there will probably be some net loss on a market share. I think we saw ourselves some of it from the [Indiscernible] when we acquired UG. So it's not one plus one is not equal to 1.5, but it was a little bit of a loss on the market share. So that's probably not 1 plus 1 equals 2 or plus. So I don't know what's going to happen. I don't know what people have in mind. I think to me, our core principle about MI and the way we've operated stays which is it's always better in a multi-line diversified platform, and that's not going away. I would say that some of the S&P new modeling is appreciating and recognizing that. So that's my view, at least. I think the more sensible thing would be for these MI to find another home somewhere else outside of the MI arena. But I'm not a predictor of this, Mike."
},
{
"speaker": "Mike Zaremski",
"text": "So that's helping. So you mentioned the S&P capital model will the diversification get an increased benefits? So [Indiscernible]"
},
{
"speaker": "Marc Grandisson",
"text": "In general only MI, in general there's better diversity and credit, the more diversified you are, which again speaks to our model, which makes sense to us."
},
{
"speaker": "Mike Zaremski",
"text": "Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Mark Dwelle of RBC. Your line is open."
},
{
"speaker": "Mark Dwelle",
"text": "Yeah. Good morning. Couple of questions related to MI. First in the quarter, it looked like the average paid claim [Indiscernible] average paid cost per claim was around 51,000, it's been lying more in the 30s. Is there anything in particular that accounts for the uptick, maybe some large claims or something. It's a one-off really, it's a settlement with a servicer that took place this quarter that was for pre -crisis claims. So definitely a one-off here. And then a second question related to MI, just really a clarification. The reserve releases that you did in the quarter are we don't understand that those related to the reserves set up when COVID began, or maybe where these reserves related to other time periods or other classes of reserve?"
},
{
"speaker": "Marc Grandisson",
"text": "We made the point in the past that we have a hard time to some extent isolating COVID from non-COVID claims, but still more than half is for reserves that we had set up before COVID. So I mean, the vast majority or the majority is if you want to go and just appear as a when they were set up is pre first-quarter 2020."
},
{
"speaker": "Mark Dwelle",
"text": "Okay thank you. And the last question I had was really more of a general market kind of question. Maybe for Mark. Are you seeing any signs in the insurance or Reinsurance businesses of competitors taking more aggressive pricing stances? I mean, basically getting at is the insurance clock getting towards 12 o'clock or are we still firmly at 11 o'clock?"
},
{
"speaker": "Marc Grandisson",
"text": "Probably like the longest 11 o'clock that we'll see in our lifetime. I think that if you look at the risks that are ahead of us, you still have climate to deal with, you still have inflation concerns, which I guess leads to reserve, potential reserve questioning or analysis, cyber risk, and COVID reopening. There's a lot of stuff going on right now that sort of leads the whole market to be a lot more careful and thoughtful. So the market is always competitive, right? There's always competition out there. But right now what we are, it's a very disciplined market and we're not seeing anything. We haven't seen anything and we're not seeing anything percolating that would indicate that this would change for 2022."
},
{
"speaker": "Mark Dwelle",
"text": "Thank you. That's all my questions."
},
{
"speaker": "Operator",
"text": "Your next question comes from Meyer Shields of KBW. Your line is open."
},
{
"speaker": "Meyer Shields",
"text": "Thanks. If I go back to the contingent commission question, I guess it's clear that underlying profitability is getting better? So we expect that smoother recognition of contingent commission accruals in 2022?"
},
{
"speaker": "Marc Grandisson",
"text": "Not necessarily, because Meyer, the release of profit commission or contingent commissions is dependent on loss fix, so we tend to take our beautiful time to make sure we have all the data available to make those contingent commission so can be spotty. But we can make a decision to look at two or three underwriting years and have that adjustment made. And we accrue for some of it, but we don't always accrue to the full extent of the ultimate. The losses actually drive these contingent commissions. So this is [Indiscernible] so it's really spotty, it's very hard to predict."
},
{
"speaker": "Meyer Shields",
"text": "Okay. So that's fair. I just want to understand the process. Second question, I think Francois had talked about maybe reducing the sessions on some quota share contracts in insurance, so less of an offset. Does that outpace or trail the loss ratio improvements that you should anticipate from keeping that business?"
},
{
"speaker": "Marc Grandisson",
"text": "Let me [Indiscernible] I make sure, so, are you saying that? Repeat your question differently, I'm not sure I got exactly where you want to get to Meyer. I apologize."
},
{
"speaker": "Meyer Shields",
"text": "Okay. Let me try again. So [Indiscernible] is going up because you're ceding less business that has high ceding commissions."
},
{
"speaker": "Marc Grandisson",
"text": "Yeah."
},
{
"speaker": "Meyer Shields",
"text": "Just hoping that you can frame that relative to the last ratio improvements that we should expect because you're keeping more profitable business."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So if we're keeping more profitable business, the loss ratio would [Indiscernible] everything else being equal go down."
},
{
"speaker": "Meyer Shields",
"text": "Right. By more than the increase in acquisition expense."
},
{
"speaker": "Marc Grandisson",
"text": "Possibly. It's hard to say right [Indiscernible]"
},
{
"speaker": "Meyer Shields",
"text": "Okay."
},
{
"speaker": "Marc Grandisson",
"text": "[Indiscernible] from the get-go. I think we made these economic decisions, it's kind of a hard one to pin down. Sometimes the [Indiscernible] what you see that's capital, capital with return, that's different than the pure combined ratio. So there's a lot of things going on. It's more [Indiscernible] it's not only about the pure combined ratio. The return is improving, that's what matters to us."
},
{
"speaker": "Francois Morin",
"text": "Directionally, I think we're [Indiscernible] we don't disagree with what you're saying. I think the precision or the timing at which everything happens is less [Indiscernible] it's not precise, I would say [Indiscernible] I would assume. Directionally, I think its right, yeah."
},
{
"speaker": "Marc Grandisson",
"text": "Better return."
},
{
"speaker": "Meyer Shields",
"text": "Okay. I completely understand. And one big picture question if I can. Anything [Indiscernible] everything that you're saying Mark about the cycle lasting longer. Because of concerns on the loss trend side. I guess why rates are going up. Why do you think rates are still going up more than loss trends?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, that's definitely question Meyer. That's one that we should probably have the BARDA corn and all kidding aside, I think that it's probably a recognition that this uncertainty is what creates the need for more margin safety. I think that when you're faced with uncertain pick-up in inflation, I mean, we had a 7% roughly inflation print this morning. When you have a high number that comes like this, it comes as the shocker. So I think that people are being preempting, preempting in making sure that they cover as much of the base as they can. I think the insurance industry for what it's worth has been very disciplined and is acting in a very profitable way and I think over the last 2 years, it recognizes that the risk is building up and need to price better, price higher because there's more risk of sliding a bit slide sideways. So I think it's an appropriate and very welcome change. A very [Indiscernible] if this is in the market is pretty good from that perspective."
},
{
"speaker": "Meyer Shields",
"text": "Thanks [Indiscernible]."
},
{
"speaker": "Marc Grandisson",
"text": "Sure."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Brian Meredith of UBS. Please go ahead."
},
{
"speaker": "Brian Meredith",
"text": "Yes. Thanks. I got two questions for you guys. First one, I'm just curious, I know there was a block of stock of [Indiscernible] to trade and you all didn't bite. Was there any regulatory reasons you couldn't do it? Or is that just a capital allocation decision that, you don't want to own the whole thing?"
},
{
"speaker": "Francois Morin",
"text": "Well, not at all. I think the existing shareholder wanted to sell and very much [Indiscernible] very [Indiscernible] much easier for them to do it the way they did it. Then, to come to us and at which point, yes, we would've had to go to the regulators and that would take them weeks if not months. And the whole approval process would have maybe dragged on. So I think they wanted speed over maybe better execution and that's what they got deal in doing it the way they did."
},
{
"speaker": "Brian Meredith",
"text": "So is that profit state less strategic for you than going forward?"
},
{
"speaker": "Francois Morin",
"text": "Not at all. To be candid, I mean, they even come to us offering it up to, I mean, they just went ahead on their own instead of coming to us and saying, would you be interested in buying the 10% or 12% we want to get rid of or we don't want anymore. They just went through their own process because again, they knew that we trip the requirements that we'd have to do a tender and all of that, which would have taken again longer. So that was their decision and we respect it. But going forward strategically, I mean, we still look at profiles and it's been very good to us so far, and we keep thinking about how we, if and when, or how we do things differently going forward."
},
{
"speaker": "Brian Meredith",
"text": "Great. And then, first of all, let me just clarify one comment you made earlier in talking about kind of repurchasing your stock and I understand that you want that 3 year payback period, which is the other considerations and I understand that. But does that mean that with your stock trading just a little over one for book value right now, that you would not be buying back stock right now? It's your return profile doesn't fit that."
},
{
"speaker": "Francois Morin",
"text": "Well. It's never black and white but I'd say that the forward-looking returns that we see for how we think about the business and better profitability over three years, it's higher than 10%, right? So you could kind of stretch it a bit more than 1.3 times book. And so it's [Indiscernible] I'll stop here. I'd say we could consider going above 1.3 times book, very much as a function of how we think about the business and what kind of profitability we see coming our way."
},
{
"speaker": "Marc Grandisson",
"text": "I think Brian, I would say, you know this as well, right. I mean, there are a couple of things happening for instance, on the MI side that might change that what we perceive to be the real book value of the company. So these are also considerations that could be way outside of the return possibility going forward. That's one exemplary."
},
{
"speaker": "Brian Meredith",
"text": "Got you. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Well, thank you everyone want to thank our employees, as Francois mentioned as well, and sometimes they run the corners so make sure you take care of your loved one this weekend. On to the next quarter."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 3 | 2,021 | 2021-10-28 11:00:00 | Operator: Good day ladies and gentlemen, and welcome to the third quarter 2021 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we’ll conduct a question-and-answer session and instruction will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today’s press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management’s current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also, will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company’s current report on Form 8-K furnished to the SEC yesterday, which contains the company’s earnings press release and is available on the company’s website. I would now like to introduce your host for today’s conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin.
Marc Grandisson: Thank you, Liz. Good morning and welcome to our third quarter earnings call. We are pleased to have delivered solid results this quarter as our operating units generated a 9.3% annualized operating return on equity and a 12.5% annualized net income ROE despite an active catastrophic quarter. Premium writings and rate growth remains strong in our P&C unit, driving solid fundamental earnings while our mortgage insurance unit again produced excellent results. The current market condition allow us to demonstrate the value of our diversified platform and underwriting strength as they provide us with plenty of opportunities to deploy capital and generate an expected return on equity in the mid teens. In the broader P&C arena, we continue to see the market hardening along with ample evidence that our industry is addressing the adequacy of pricing across most sectors. The trajectory and market acceptance of rate increases reinforce why we remain optimistic that improved economics in the P&C market will be sustainable for some time. As you know, the P&C industry is facing many degrees of uncertainty; heightened care activity in four of the last five years, rising inflation, COVID ongoing influence on a global economy and enduring low interest rates. When faced with escalating risk, underwriters need both rate increases and conservative loss estimates in order to build adequate margins of safety into premium levels. With our agile underwriting, established teams and strong capital position, we are well equipped to grow into this improving market. Turning now to our operating units. We’ll begin with insurance, where our early focus on strengthening our underwriting capabilities and seizing recent market opportunities is working. Gross written premiums continued to grow substantially up 32% over the same quarter in 2020 and our accident year combined ratio ex-cats improved to 90.5%. This is another indication of the progress we have made in our specialty insurance business. We have been leaning into this hardening market for two years now as rate increases remain well above the long term loss cost trends and have spread to more lines than last year. Overall 2021 rates are up around 10% compared to 2020 and we expect that the benefit of higher premium levels will be realized well into 2023 enhancing our expected returns for that period. This quarter had many bright spots including positive rate increases have accelerated and lower limits account. These lines have previously lagged the increases in larger accounts that is no longer the case. Two, our early focus on Lloyds and business in the UK has improved our scale and our economics in this market. Three, some of our business lines that were most impacted by COVID, like travel are recapturing some of the lost volume, as both business and consumer travel increases. In summary, our specialty insurance group is making the most of the current opportunities. Pivoting now to our reinsurance group. It delivered strong growth in the quarter with gross written premiums up nearly 25% over the same period in 2020. On a net basis reported growth was only a modest 3% versus the same quarter in 2020 due to a catch up in sessions to Watford following the purchase of the company with our partners at July 1. Francois will provide more detail during his comments. But absent this one-off transaction, reinsurance net return premium growth was still very strong at 30% and our outlook remains favorable as similar to instruments, we’re experiencing broad rate increases in our specialty and casualty reinsurance lines. In the quarter our reinsurance segments reported a combined ratio of 106%, reflecting the effects of the third quarter caps, primarily Ida and the Central European floods. But reinsurance accident year combined ratio ex-cat is excellent at 83.2%. There are signs that property market rates could adjust higher due to cat fatigue, as you’ve likely heard on other calls this quarter. The recent five year period of elevated losses from catastrophes proves an important insurance adage. Losses don’t know the level of the premium. There are also early indications that retro sessional and aggregate excess of loss protections are becoming increasingly hard to come by and we believe that this will be reflected in higher property rates broadly. As you know, we were and remain judicious in the deployment of our cat PML, which was effectively flat in the third quarter. At less than 6% of our tangible equity, we remained under weighed in net property cat exposure and we will deploy more capital to the line as expected returns improve above our target. It’s too early to make a call on a January 1 renewal process, but pricing in this sector is heavily influenced at the margins and if ILS or other capacity phase, there is a possibility for significant rate corrections and increased engagement on our part. In the meantime, our reinsurance teams are demonstrating their agility and like insurance are leaning hard into the markets where returns are most attractive. Thirdly, our mortgage group continues to deliver exceptional returns. It generated $234 million of underwriting profit in the third quarter and continues its impressive rebound from last concerns associated with the pandemic. At September 30, insurance in force of $457 billion for the segment was up modestly. Further good news is that notices of default have declined to pre-pandemic levels at September 30, which is a good indicator of improved conditions. Additionally, loans in forbearance continue to decline as federal programs conclude and we remain cautiously optimistic that most of these loans will ultimately cure. Rising home prices have broadly increased homeowner equity and you will recall our position that equity levels are the best indication of whether a delinquency will ultimately result in a loss. We estimate that 98% of our loans in forbearance today have at least 10% equity, providing significant protection against potential losses. Overall, the MI market remains competitive but rational and our business continues to generate returns on capital in the mid teens. Mortgage originations continue to pay similar to last year’s record origination volume and credit quality remains excellent. As you know in all of our operations, we actively manage capital to enhance shareholder returns. The strong result in our mortgage segments have enabled us to optimize our capital structure via increased reinsurance sessions through our Bellemeade mortgage insurance-linked notes as well as traditional reinsurance. Additional reinsurance purchases enable us to reallocate capital towards faster growing areas and specialty property and casualty lines while enhancing our return profile and MI by reducing required capital. MI remains a very attractive business for us. Now a point of pride and interest to us and perhaps to you all is that last Saturday, October 23 Arch celebrated its 20 year anniversary. So I want to say to our investors, thank you for believing in us and to our employees past and present, thank you for your contributions to Arch for last 20 years and our client for showing support and conviction in our capacity to provide products to you. Finally, the PGA Tour is in Bermuda this weekend, so golf is top of mind. A golf tournament is interesting in that it takes place over several days and therefore consistency is critical. You have to be sure to pick your spot and lower your score. But if you want to make the cut, you have to limit the bogeys early so that you can play more aggressively in the stretch. And then once you get to the weekend, you can play with a bit more freedom and really try for the birdies and eagles. At this point in the cycle, we feel we’ve made the cut and now we focus on really taking advantage of our positioning to make sure we end up at the top of the leader board. Francois?
Francois Morin: Thank you, Marc. And good morning to you all on this first day of the Butterfield Bermuda championship here in Bermuda. Thanks for joining us today. Before providing more color on our solid third quarter results, you will have observed that while our earnings release still makes a distinction between core and consolidated for purposes of comparison to prior periods, there is no difference between the two presentations this quarter. As we discussed on the last call the closing of the Watford transaction on July 1 gave rise to a reconsideration event and as a result of our updated VIE analysis, we no longer consolidate the results of Watford in our financial results. Our 40% share of Watford results is now reported in the income from operating affiliates line and there is no longer a need to make a distinction between core and consolidated results in our financials. As Marc shared earlier, our after tax operating income for the quarter was $294.7 million or $0.74 per share, resulting in an annualized 9.3% operating return on average common equity and book value per share increase to $32.43 at September 30, up 1.3% in the quarter, a very solid result in light of the catastrophe activity that was much higher than the long term average for this quarter, which we estimate that over $45 billion uninsured losses for the P&C industry approximately three times the average third quarter cat losses observed over the last 10 years. This quarter, I wanted to first give you some additional detail on the results of our reinsurance operations which were impacted by the Watford acquisition especially on the top line. As part of the agreement signed at the beginning of the year with our co-investors in Watford we committed to ceding varying percentages of the premium written by our Bermuda and U.S. treaty reinsurance operations to Watford effectively enhancing the existing business model to also serve as a sidecar for Arch. While their retrocession agreements were effective as of the start of the year, their signing was contingent on the transaction closing which delayed their recognition in our income statement until this quarter. As a result, the third quarter ceded written premium reflects a catch up of approximately 161.2 million from the first half of the year. The impact of the premium catch up adjustment on underwriting income for the reinsurance segment was minimal. Growth in gross written premium remained strong at 24.6% on a quarter-over-quarter basis, and growth in net written premium would have come in at 29.5% adjusting for the Watford catch up. The growth was observed across most of our lines but especially in our casualty, other specialty and property other than property catastrophe lines or strong rate increases and growth in new accounts helped increase the top line. The segment’s accident quarter combined ratio excluding cats stood at 83.2% compared to 83.1% on the same basis one year ago. On a year-to-date basis, the ex-cat accident year combined ratio has improved by approximately 250 basis points over the same period last year reflecting the improving underwriting results and most of the lines in which we write. In the insurance segment, net written premium grew 40% over the same quarter one year ago and the segments accident quarter combined ratio excluding cats was 90.5% lower by approximately 360 basis points from the same period one year ago; excellent results across the board, which demonstrate the progress or insurance segment has made over the last three plus years and improving its performance and provide us with optimism on the underlying quality of our franchise going forward. Losses from 2021 catastrophic events in the quarter net of reinsurance recoverable and reinstatement premiums stood at $335.9 million, or 17.4 combined ratio points compared to 12.5 combined ratio points in the third quarter of 2020. As noted in our pre-release, our P&C operations were impacted by Hurricane Ida, the European flooding events of July as well as a series of other events across the globe. Our mortgage segment had an excellent quarter with a combined ratio of 26.2% reflecting favorable prior development of $48.4 million about half of which came from U.S. MI from better than expected cure activity in pre-pandemic delinquencies and recoveries on second lien loans. And the other half from our CRT portfolio and international MI. The decrease in net premiums on a sequential basis was primarily attributable to lower levels of single premium terminations in the quarter for U.S. MI business and to a lower level of call to CRT transaction than what was observed in the second quarter. Recall the second quarter benefited from higher earned premiums due to an unusually high number of CRT transactions being called which we highlighted as effectively being a non-recurring event. The delinquency rate for U.S. MI book came in at 2.67% at the end of the quarter, a material reduction from the peak we observed at the end of the second quarter one year ago. We had another solid quarter in terms of production, mostly from the purchase market and with refinance activity coming down from prior levels the insurance in force for our U.S. MI book grew slightly. The increase from last quarter in the insurance in force of our international mortgage unit is mostly the result of the acquisition of Westpac Lenders Mortgage Insurance Limited in early August. Although income from operating affiliates grew significantly to $124.1 million it is worth noting that approximately $95.7 million of the total is attributable to a one time operating gains resulting from the acquisition of a 40% stake in Watford which was offset in part by a realized loss upon deconsolidation with a resulting net income gain of $62.5 million. The remainder of the operating income from affiliates represents our share of the net income generated this quarter by our operating affiliates, which consists primarily of Watford, Coface and Premia. Total investment return for our investment portfolio was de-minimis on a U.S. dollar basis for the quarter. Net investment income was $88.2 million during the quarter down by $1.2 million on a sequential basis, driven by lower coupons on fixed maturities and lower income on consolidated funds. The duration of our portfolio remains low at 2.68 years at the end of the quarter, reflecting our internal view of the risk and return tradeoffs in the fixed income markets. Equity and net income of investment funds accounted for using the equity method produced $105.4 million during the quarter, more than half of the total income generated by our investment portfolio and a key contributor to the growth in our book value. As we discussed on prior calls, we have increased our allocation to alternative investments in the last few years and these funds now represent approximately 12% of our total portfolio at the end of the quarter. We are also very pleased with their performance so far this year which stands at 13% year-to-date. Of note, had we included income from funds using the equity method in our definition of operating income, our reported operating ROE would have increased by 3.2% on a year-to-date basis to 13.3%. While these funds returns are potentially more volatile than core fixed income strategies, we believe the incremental returns they provide more than compensate for the liquidity constraints and volatility that are usually associated with them. The effective tax rate on pre-tax operating income was a benefit of 0.7% in the quarter reflecting changes in the full year estimated tax rate, the geography mix of our pre-tax income and an 8.2% benefit from discrete tax items in the quarter. The discrete tax items in the quarter primarily relate to partial release in the valuation allowance on certain U.K. deferred tax assets. Now a quick comment on the two acquisitions that we closed on this quarter, Westpac and Somerset Bridge. You will have seen that in accordance with purchase gap we established approximately 337.4 million of intangibles and goodwill this quarter most of which will be amortized through our income statement going forward. To help with your modeling efforts, we now expect our amortization expense to be approximately $25 million in the fourth quarter of this year and $21 million quarterly throughout 2022. On the capital front we redeemed all of our outstanding series e-non cumulative preferred shares for $450 million on September 30. Separately we repurchased approximately 9.7 million common shares at an aggregate cost of $386.9 million in the third quarter. If we include the additional common shares we have purchased in the fourth quarter the year-to-date totals are now approximately 24 million shares or 5.9% of the common shares outstanding at the beginning of the year for $917.7 million. Some of the additional share repurchases in the fourth quarter were effectuated under the new share repurchase authorization of 1.5 billion approved by our Board of Directors earlier this month. As we have said since our formation 20 years ago, our core operating principles are anchored in active cycle and capital management. We believe this quarter results demonstrates our ability to execute on this philosophy and leads us to invest in opportunities where we believe the returns are most attractive. At recent prices and with the prospect of improving returns, we believe buying back our shares continues to represent another compelling value proposition for our shareholders without compromising or capital flexibility nor lessening the quality and strength of our balance sheet. With these introductory comments, we are now prepared to take your questions.
Operator: Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo.
Elyse Greenspan: My first question Marc, you’re talking about the mortgage business you talked about buying more reinsurance. So there was more capital for growth on the P&C side, which I found interesting. In the past you spoken about mortgage running at around a 15 plus return and P&C kind of 10 to 12. Has the dynamics changed that that caused you to buy some more reinsurance to pursue more growth on the property casualty side?
Marc Grandisson: Yes, I think all opportunities on the P&C side just have improved right over the last couple of years and I think we’re even more convinced of the length and that has legs for the foreseeable future. So that makes us be more proactive to balance, if you will, the capital allocation between more than one year. I mean, we did rely heavily on a capital deployed in MI for quite a while because the returns in P&C as release weren’t as attractive. But now that we have a new attractive and increase and improve returns in the P&C, it behooves us to balance the risk profile in the portfolio. That’s one of the reasons why we would do some more reinsurance and again, the reinsurance also helps our return on the net basis as well which is also another benefit.
Elyse Greenspan: But are the returned numbers I gave still kind of where you see the three businesses. So 50% plus and then 10 to 12.
Marc Grandisson: Yes. I would say on the P&C side, at least I would say it’s getting up is north of that now. I think we have our prospects closing, the gap is closing between MI and P&C if you will.
Elyse Greenspan: So north of a higher than 12%.
Marc Grandisson: I would agree. Yes, I would think it’s the case, yes.
Elyse Greenspan: And then, in terms of capital, you guys put in place a 1.5 billion authorization. It sounds like you’ve bought back a little bit under that so far this quarter going through the end of next year. I know obviously, what you buyback depends upon the market also for your shares and the trading over the course of the next year. But when you put that in place was that designed to set a mark of what you will buyback, or either just other factors that could cause you to either fully buyback that level, or maybe come in lower, just help us kind of think through that as we think about capital return through 2022?
Marc Grandisson: Well, I mean, two things. I mean, we bought, we’re close to a billion dollars this year. So we don’t want to go back to the Board every three months and ask for more. So we thought, okay, what may we need, could we need by the end of 2022, over the next 15 months effectively, 1.5 billion that’s just a number that nice round number, nothing special about it. But are we committed to that number? The answer is absolutely not. If the market keeps improving and we have the ability to deploy your capital, all the capital and then some in the business, we may not end up buying anything back. So it’s really, again, a function of the market conditions and vice versa. If the market doesn’t really generate give us a lot of opportunities to grow, we might be in a position where we buyback more than not. So it’s really, again, it’ll be a function of what we see in front of us over the next 15 months. And if we end up going through the billion and a half sooner than next year, then we’ll do something else. So again, it’s very dynamic, very real time I’d say and we’ll see where things take us.
Elyse Greenspan: Thanks for the color.
Operator: Our next question comes from Jimmy Bhullar with JPMorgan.
Jimmy Bhullar: So first, I’ve question on just what you’re seeing in terms of pricing both on the insurance and reinsurance side. And to what extent do you think price increases are going to hold versus may be especially on the reinsurance market? Seems like things have been getting a little bit softer over through the course of the year. But how do recently high catastrophes affect your view of what one knows?
Marc Grandisson: Right Jimmy. If we bifurcate the market into property cat you agree, I would tend to agree with you that the property cat raise did not increase as much as we had hoped collectively as an industry I would say not only at Arch, it’s not a single Arch phenomenon. Therefore, that’s why you saw us right less property cat over the last nine months as a reaction to those rate levels. It’s still early, like I said in my commentary, but I think we should have a re-pricing, definitely re-pricing in Europe and in the U.S. even for the layers that have been impacted, that’s for sure. And I think it would start to spill out even on to those that have not sustained a loss because I think there’s a recognition of heightened cat activity. And I think that the market is sort of bracing for that as we go forward. It’s going to be a matter of degree. On the rest of the marketplace I think that overall since if you look at the liability lines in general, overall you can think of in terms of a quarter share if you’ve got quarter share of casualty or liability lines you’re benefiting from the rate increases in the business and I think the ceding commissions which were held high through 2020 are starting to come down a little bit. So there’s a recognition that so there’s a bit of an improvement from that perspective and a quarter share on the excess of loss in general for liability, the ratio is stable to somewhat and is more stable, but again, you apply those rate against a base that is increasing in premium level. So they are also getting some price uplift. And I think that big as soon I mean, the reinsurance market, Jimmy feeds off of the insurance market, right in a positive way, I want to make sure it’s a positive message. We actually, we on the receiving end of a portion of what the insurance market writes and to the extent that interest market writes premium at a higher level, we are benefiting from those rate increases.
Jimmy Bhullar: And then can you quantify how much you’ve got in terms of COVID reserves, especially for business interruption and I’m assuming they’re mostly still IBNR as you’d been quantifying last year and just discuss what the process would be and the timeline would be for releasing these given that for the most part, it seems like the courts have been siding with the insurance companies at least thus far in the U.S.?
Marc Grandisson: Yes, I would say, I mean, we’re still very much, a lot of IBNR and our COVID reserves more than half, 60% or so I’d say, call it COVID reserves on the P&C side are still IBNR. So and how quickly do we, well, we know or not know whether we’ll need those reserves time will tell. I think it’s where we said yes I don’t disagree that so far there have been a couple of positive developments from the cores, but it's going to take a while. I truly think this is a very complicated and issue that will take years to resolve. So I wouldn't expect us to really take dramatic action on the level of COVID reserves on the P&C side for some time.
Francois Morin: And Jimmy in our industry and insurance you could win 95 lawsuits and lose 96 and it changes everything. So there's a lot of uncertainty in our space, even though we've been a good streak one change could change everything.
Jimmy Bhullar: And what is the rough number of or rough dollar amount of reserves?
Francois Morin: That's a good question. I don't have it in front of me. We can circle back with you. I know we booked a few 100 million dollars last year and we paid some of that. I don't have the current figure, but we can give you that.
Marc Grandisson: We haven't changed ultimate Jimmy over the last three quarters.
Jimmy Bhullar: But it's not something like that's more maybe 2023/ 24 as opposed to 22 in terms of potential releases on these?
Marc Grandisson: There are releases. I will say yes it will probably take another year, year and a half and we might hold a little bit more longer for the reasons I just mentioned in terms of the court decisions.
Operator: Our next question comes from Mike Zaremski with Wolf Research.
Mike Zaremski: Great morning, afternoon. I guess some of the prepared remarks, when you guys were talking about the primary insurance segment, talked about kind of seeing rate acceleration actually in the lower limits kind of the smaller commercial space. Any theories on why that's happening? Is it due to loss cost trend increasing, because we're kind of you're seeing a fading of rate a little bit or deceleration in the large account space. So kind of curious if, if you guys have any views, maybe broadly to, on kind of loss cost trend given all the uncertainty during the pandemic on the primary insurance side?
Marc Grandisson: Well, the loss cost trend as we observe it, and it might change is still roughly 3% to 5% it depends on lines of business. But we have already changed our view on this at this point. And we had a loss reserve review, I believe, a couple of months ago. So then it's not changing, although we are putting in a loss ratio pick an extra level of margin of safety to make sure we wouldn't be missing because it could be higher as you know inflation is certainly another concern that we all have collectively as underwriters. In terms of my theory about why the smaller accounts get those rates right now, it's just, the market is a human psychology market. And pricing gets more acutely needed in a larger capacity play. This is where the market starts focusing its first efforts as the market hardens. And this is not unusual. This is a very, very normal phenomenon and hardening markets. You'll tend to try and fix those are more important, meaning you can put a 10 million to 15 million to 25 million limit, these are the ones you're going to try to fix right away, because presumably those will have caused you a bit more pain over the last two to three years, you were expecting more pains coming from that portfolio. And it's just a matter of time before people start looking sideways as to what other lines of business need rate. And then you start dipping down into your overall portfolio and seeing where the liability trends for instance, might also be impacted. And this is sort of a second round sort of a rippling effect from the main capacity providing players into the ones who have lower players and at the same time, to be fair, and to be I mean, to be truthful, you also have development ongoing happening on the smaller account at the same time. It's just not as acute and as glaring and as obvious early as a larger capacity play. That's why.
Mike Zaremski: That's interesting. It's helpful. Let me switching gears to mortgage segment. Just curious I know the forbearance levels continue to decrease. If you could remind us I believe there's some extensions to the forbearance program or maybe even new kind of enhanced programs where the P&I could be reduced if the payment can be reduced by up to 25%. Is that correct? And if so, are you seeing your borrowers utilize those options?
Marc Grandisson: Yes. So right now the program is done expires at 930, expired at 930 in terms of foreclosure but, the forbearance I'm sorry. The foreclosure, it's still unclear because they could also come back and extend it further if things were to change and the CFPB is also involved with the FHFA saying that we don't want to have any more, there's a moratorium on the foreclosure process as well. So I think both federal entities are trying to push to go back to your last point of the question, push the mortgage loan or the mortgage originator and provider of providing solutions to the borrowers who are still in forbearance or not current on their payments. And to your point a lot of it is going to be continuous same payment, most of it is going to be continuing the same payment as prior to the COVID forbearance program and is attaching towards the end the lack of what wasn't paid, or what was accrued as unpaid at the end of the loan. So this is roughly what it's going to look like. But it's going to be another three quarters before we have more visibility because even though the forbearance programs stopped in 930, and people should come now to the banks, and to the mortgage originator and trying to remediate their position from a forbearance perspective, it's still going to take another six to nine months, and I think the agencies are watching carefully. So everything is heading towards a happy resolution, if you will, of the overall forbearance programs like everybody is focusing on this as of this point in time.
Mike Zaremski: And one last one sticking to mortgage and I could take this offline with, but just to want to the increased premium ceded as percentage of gross, is that due to Bellemeade and I guess if it is, can you guys continue to upsize the reinsurance usage in the segment, if you thought opportunistically you wanted to ship more growth towards other lines of business?
Francois Morin: Yes. That's very much in that vein, I think Marc made the point earlier. We're always looking to optimize the portfolio and certainly a lot of that is focused on capital deployment. We I think, made the point, last call that we had increased our quarter share percentages on the U.S. MI book at 71. So that's starting to play through basically and that is reflected. We are still very active in the Bellemeade space. So we're purchasing quite a lot there as well and I'd say those two things combined really explained why we have more ceded premium starting this quarter.
Mike Zaremski: Got it and there is more appetite, if you decided to do more, either quota or Bellemeade or both in the future? Are you kind of reaching kind of a max?
Marc Grandisson: I mean I'd say we certainly do a lot of Bellemeade as it is. So I don't want to say we wouldn't do more, but it's I mean, we already are very active in that space and made big placements. So I wouldn't expect us to necessarily increase that vehicle, that mechanism to transfer risk a whole lot. And on the quota share, yes we see more we could, but then it's a risk return trade off and whether the economics work are reasonable or work in our favor, too. So right now we're happy where we're at. But if things change in the market gives us better opportunities we could conceivably see a bit more. Yes.
Operator: Our next question comes from Josh Shanker with Bank of America.
Josh Shanker: Yes, good morning, everyone. This may not be the best math, but it's rough. I think you guys had the inventory of COVID era Moore's claims, about 120,000, you had about 90,000 cures. I'm estimating that you guys have about $20,000 up or notice right now in the portfolio, may not be exact. Historically, you've had about an average of $5,000 up for notice. It seems like the reserves are stuffed particularly if you tell us that 90%, 98% of the claims have at least $10,000 in equity. So, I mean, I'm trying to rectify all this like, can you explain to me I feel so I've asked this question before I just don't understand what's going on there?
Marc Grandisson: Yes. I think the answer is going to be very similar. So very good question. Hope you are -- by the police in back here. If you look at the average case reserved for annuities it's exactly 23,500 I believe it's in the supplement, you can look into it. And you're right. It was it went up from last year. The run rate pre-COVID was roughly 10,000, 11,000, 12,000, so it did increase. And was about 110,000 for claims that we got as well a COVID in the forbearance and about 78% of them have cured so far, so we’ve about 20,500. So [Indiscernible] we have about 31,770, I think is a number in terms of an NOD outstanding. When you multiply by 23, you’re right it would look on the high side, a couple things I will say here, number one is the average severity of the policies that are facing the COVID-19 are starting from 1819, we'd have a higher phase than the one we had as an NOD back in 2019. Those in 2019, were largely pre-2008. So you have to adjust for the level of coverage that has increased over the last 10-12 years. So that explains one why the 23 would be higher than 1113 historically. The second part of your question, which was where should it go, and this is where it's more art than science. Josh. We hear you. We are cautiously optimistic that it may not come to pass in terms of needing the reserves, and hopefully some of it will cure better than we anticipated. But I just want to remind everyone on call and as we remind ourselves all the time, it's that this is a political positioning. Things could change very quickly from the FHFA, the GSEs, or the housing department. So we need to be really careful and we've never been through that kind of event. So we are Arch as you know, and we will take a cautious, prudent approach to reserving. And if we happen not to need those reserves, as we do, typically, we'll be taking them by the hand from the liability side down to the capital side. We're not going to have let them stranded for a long time. But again, so much so many uncertainties Josh. We understand your puzzling. This is a very unusual situation for the industry. Therefore we have to and that's what we appear probably to be a little bit unusual in that we're reserving it.
Josh Shanker: And my second question unrelated. Can you talk about the differential, I guess the new business penalty, between a new business you're putting on the book, and legacy customers who you have a deep sense of their risk factors on those accounts? Is there a gap? Is the business that you're renewing, at better margins at least the way you're booking it to new business, given that more about the business you already have?
Marc Grandisson: I believe Josh, you're talking about P&C right.
Josh Shanker: Yes. This is totally primary P&C not more.
Marc Grandisson: Right. That makes sense to me. So it's a really very astute question Josh because we're keeping track of the renewal rate versus a new business rate level. And symptomatic or as a representation of the hardening market, the pricing of the new business is coming higher than the renewal business and that's sort of speaks to the fact that they need a new home and they need to be re-priced, and people sort of get tired of that relationship and that goes back through them back into either the ENS or the mid market. So right now, we're still seeing, on average, the new business price better than renewal business.
Operator: Our next question comes from Tracy Benguigui with Barclays.
Tracy Benguigui: Thank you. Just a big picture question. I’ve seen this quarter with you and your closer peer group is that the insurance growth is outpacing the more primary market focus players without reinsurance arm. Are you seeing a lot of market dislocation where you feel like you just do a better job assuming displaced risks that still meet your risk adjusted return hurdle?
Marc Grandisson: I would like to think we're better than the average guy out there. But the truth I think, overall, the dislocation was much larger in 2020. I think you're still seeing some dislocation right now. It's certainly not, there is still some repositioning of limits provided the market by a lot of players still as we speak. And I think what explains our ability to grow is, first we have a really well established presence and we were very underweight Tracy, historically. We are really, really a good market for people that want a good security for products such as DNO for instance, right. We're really good home for someone to take on new as an insurer, and we're sort of better we're definitely benefiting from that as an incumbent with a good quality, good reputation as we do. And also, I think the other thing that I want to mention, we had said that last year, we were suffering a little bit from, from a travel, lack of traveling that impacted our travel portfolio. That certainly helps right Tracy, the fact that economy is reopening and people traveling a bit more. That also helps explain why we're able to grow a bit more than probably meet the average than the average would. Lastly, I would say that beyond just new business funding new homes I think they are programs were also going in programs, as you see this is very specialty, smaller risk. I think that again another example of programs, finding a new home going away from the existing incumbent, possibly because of our results in finding a new home and we're definitely on the receiving end of that relationship.
Francois Morin: Yes. And one thing I'll add quickly, I think, both depending on the mix of business of what you call the more established and the traditional insurers I mean workers comp and commercial auto typically will make up bigger shares of their portfolio. Auto is moving up nicely, but I would say that certainly comp is and had a really good period of excellent results. So rate increases on the comp side have been pretty flattish. So again that's probably worth adjusting for comp because it's such a big line for some of these carriers.
Tracy Benguigui: And I'm wondering how much of that is structural in nature like, are others raising attachment points, and you're lowering attachment points or offering lower deductible?
Marc Grandisson: No. We don't do that. No, we don't play that game. I think we would just be replacing most of our play typically on specialty lines Tracy is mid access versus second access is sort of what we play a lot of times and high access, of course, in certain our areas. So for the record Tracy we're not seeing any of the deductible being played out in the marketplace. And that's been fact, there are deductible increases, if anything else. We just see a lot of shortening of limit toward in the stacking. We saw that in 2020. It's ongoing as we speak, instead of adding stretch of 25. I'm talking about a larger placements. You'll have stretches of 10 or 5 or 5 or 10, really in 15, perhaps till saying but there's a lot more players needed to fill up the towers. That's definitely happening more so. It's still continuing to some extent less sort of in 2020.
Tracy Benguigui: And then just shifting to reinsurance where are you seeing your favorable reserve development coming from?
Marc Grandisson: Yes, I mean, the vast majority, and we'll talk to it obviously in the Q1 the vast majority is in short tail lines, I mean, I'd say probably 80% in short tail lines. Mostly property other than cat where we've grown a lot in the last couple of years, and while the tail is always a bit longer than we think it should be, it's still we have a pretty good idea to three years out after writing the policy or the account and we're seeing a lot of that coming through in this quarter, a bit of favorable development on prior year cats as well. And a bit on trade credit and surety from a few years ago where we had some reserves that proved out to be a bit more required. So we released those this quarter.
Operator: Our next question comes from Meyer Shields with KBW.
Meyer Shields: Thanks. This is a cycle management question, I guess for Marc. When if ever do we decide that there's never going to be an appropriate hard market and property patent just get out of the line?
Marc Grandisson: I think that by virtue of well, first, I'm an optimist. I've always been an optimist. I've heard so many times over the last 27 years from some of our own underwriters that there will never be a hard market again. And when I hear this it's music to my ears because that means we're cruising for bruises. So I think that things will get better and get at some point. It may not be this quarter, but might at some point. Numbers speak for themselves. If you lose money every year people just get disenchanted and just walk away from. It's happened early storms in Europe, 92 Andrews earthquake in California 94, terrorist attack Katrina, Rita and Wilma. I mean there's always changes and it's not I rattled by five or six of them. And you got to believe that the world is a dangerous place Meyer. So I think something will happen and again losses don't necessarily change the market pricing, but perception of risk will and would. So maybe we're on this place where people say, you know what, why bother? And if that's the case, then that's in the demand for cat as protection is inelastic. So if supply shrinks then the demand will stay as is and pricing will therefore increase. So I'm an optimist. I'm not sure when it's going to happen, but I believe it will happen at some point.
Meyer Shields: No, I understand. That's exactly what I'm looking for. Thank you.
Operator: Our next question comes from Brian Meredith with UBS.
Brian Meredith: Yes, thanks. A couple quick questions here for you. First, just want to follow up on the comment about new business pricing better than renewal pricing. And I've heard that from other carriers. I'm just curious, when you actually go to book the margin on that new piece of business are you booking a better margin than perhaps that renewal piece of business? Or do you have to build in some level of cushion because it is new?
Marc Grandisson: Well, it's that's a very good. I think the latter part is what we would do. But even we would also take a higher level of cushion margin of safety, if you will now reserving even in our renewal business. I think that we're reserving wise and loss ratio pick wise at Arch we tend to be more conservative and hope for the best. And hopefully, good news come down later. We're trying to figure out a way to have as much cushion as we can early on so that we're not surprised down the road. That's not changing. We say the same approach renewal or new business, right? Not much of a change.
Brian Meredith: Not much of a change. Got you. Second, just quick question here. Are we still seeing admitted market shed business to the ENS market? Or is that slowed?
Marc Grandisson: That's slowed down a little bit, but it's still happening. We're not seeing a return back to the market quite yet. It's going to take a little bit longer, we think.
Brian Meredith: Got you. And then one kind of bigger, I guess, philosophical question for you. I think with MI business clearly you've demonstrated that it is not a big of a volatility businesses maybe some perceived just given the results we've seen through this recent crisis. If that is indeed the case, in the amount of cash that business throws off, because it's not a growth business I guess I see you guys using share buyback as your means of capital management, and I completely get that where your stocks trading now. But what about a dividend? In the end, maybe remind us about your philosophy with respect to a dividend?
Francois Morin: Well, I mean, I'll take that, Brian, I think it's something we talked about with a board and between ourselves all the time. We had a pretty long discussion at our last board meeting on that. It's always on the table. I'd say right now I mean I think it's, I mean, the share buybacks that we went through this quarter were very attractive towards economics. We were very much I think they're easy to justify, justify sorry. But could we ever introduced a dividend? Certainly that's on the table. Not saying it's imminent, but it's something that we evaluate pretty much definitely regularity. And we'll keep looking at it.
Operator: Our next question comes from Elyse Greenspan with Wells Fargo.
Elyse Greenspan: Hi, thanks. Just one additional question. You guys spend time highlighting that session to Watford in the quarter, given that that transaction close. So my sense is, they're going to become more arched like in terms of the business that you're receiving to them versus prior to this transaction. So as we think about your 40% stake, can you just help us think about the earning stream there? Because I would think that as we go through next year that that could become a meaningful contributor to your earnings as the underwriting income of Watford pick up from what we're used to?
Marc Grandisson: Yes. I think the 40% share would grow at an average sort of reinsurance market results. Why? Because we are writing business on the balance sheet of Watford. So you would expect that. I think that what you would also see is our collecting fees or for our efforts, a compensation for our efforts for Watford's that would be for the 100%. So I think that the overall return would be slightly better even though at least as you can appreciate with the accounting rules it might not show us such but I think that our results will be as good I would hope for if not better than our overall results. So it's definitely an a creative return generator for reinsurance platform. It's going to be hard to see.
Elyse Greenspan: And that should pick up within that other income line as we move through next year?
Marc Grandisson: Yes, so a couple yes so 40%. Correct. The other income line is well, the fees are picked up by the reinsurance sector because it's for the underwriting services they provide to Watford. But you're correct in saying that the net equity picked up of the 40% that we own in Watford if you're modeling and what kind of combined ratio is it going to operate at, what kind of premium are you going to see in terms in the volume I would you're right. I mean, it's probably more and more over time, it's going to look more and more like archery, the reinsurance segment. The percentages we seed to Watford are not uniform across all our divisions, but directionally, I think that's a good way to think about it. And the other thing, too, which has somewhat been an issue with Watford is the performance of the investments. And that has, that's being a little bit as being addressed as we speak. I think there's a process underway to reduce the volatility from the investment portfolio of investment strategy at Watford. So think of it more as that, yes, a more less volatile stream of income with more reliance on underwriting income and less on investment income. And hopefully that gets you in a good place to start modeling out how Watford is going to play out for us or the 40% for Arch going forward.
Elyse Greenspan: And then maybe I'll squeeze one last and I'm not sure if you provided an updated tax guidance. And so I missed it, if you can just let us know that. And then we've heard about some potential tax changes whether in the U.S. and also abroad in relation to Bermuda, any kind of prospective tax loss and just some of what we're hearing in the market and how that could impact Arch?
Marc Grandisson: Yes. I'd say first of all that question your fourth quarter, we're still in the 9% to 11% kind of tax rate for Arch in the fourth quarter. For 2022 and beyond and Marc will chime in its way too early. Unfortunately, we track it we look at all developments very carefully we're on top of things. And the reality is they change daily. So it's very hard for us at this point, to give you any kind of guidance or any expectations and what we think 2022 is going to look like. We will be more than happy to have a good discussion on the next call. But for now, it's we feel it's just premature to because we really don't know.
Francois Morin: At least just to make the point about daily, literally last night our tax director, or this morning just sent us like there's a new proposal on the Hill that brings back shield and then corrects other things and then dispenses of other areas of the tax proposal in [OECD]. So, again, a moving target. It's politics. We will react to it when we do, when we see it.
Operator: Our next question comes from Matthew Carletti with JMP Securities.
Matthew Carletti: Thanks. Good morning. I just wanted to circle back on the discussion about kind of pandemic reserves and Marc, you're pretty clear on the P&C side in terms of get 95 good outcomes, but the 96 can change everything. How about MI? I mean it kind of follow up to Josh's line of questioning, like things look pretty conservative there. Can you help us with a little bit the timeline by which things can kind of continue to unfold well the timing by which we might see things unwind?
Francois Morin: Well, let me start, I'd say we may see a little in the fourth quarter, but that will be, I don't think everything will be resolved. But I truly think that the first half of 22 is when you'll see most of the movement or the corrections and our assumptions and the link cure rates and mediation so I'd say we're going to start seeing some data as early as this month internally and the number of cures and people moving out of forbearance, but the way it's going to flow through our numbers, again, given some of the uncertainties that Marc talked about, I think will be first half of 22. And the reason also Matt has to be said and understood that they had 18 months of forbearance worth when you get into forbearance earlier in 2020. And some of them went into forbearance, came out of forbearance and went back in again, but they still get to get to do to benefit from 18 months was forbearance. That's why some of them will coming out of there 18 months in fourth quarter, and many of them in the first and second quarter next. So it seems like some of them were able to get back current for four or five months and went back to forbearance program. That's what we have this lengthy adjustment period.
Matthew Carletti: Alright. Thank you. That's very helpful. Thanks.
Operator: I'm not showing any further questions. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thank you so much for being here. We're going to be, going from watching some golf, Francois and I and happy 20 years and have a good weekend everyone. Thank you.
Operator: Ladies and gentlemen thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day ladies and gentlemen, and welcome to the third quarter 2021 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we’ll conduct a question-and-answer session and instruction will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today’s press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management’s current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also, will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company’s current report on Form 8-K furnished to the SEC yesterday, which contains the company’s earnings press release and is available on the company’s website. I would now like to introduce your host for today’s conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, Liz. Good morning and welcome to our third quarter earnings call. We are pleased to have delivered solid results this quarter as our operating units generated a 9.3% annualized operating return on equity and a 12.5% annualized net income ROE despite an active catastrophic quarter. Premium writings and rate growth remains strong in our P&C unit, driving solid fundamental earnings while our mortgage insurance unit again produced excellent results. The current market condition allow us to demonstrate the value of our diversified platform and underwriting strength as they provide us with plenty of opportunities to deploy capital and generate an expected return on equity in the mid teens. In the broader P&C arena, we continue to see the market hardening along with ample evidence that our industry is addressing the adequacy of pricing across most sectors. The trajectory and market acceptance of rate increases reinforce why we remain optimistic that improved economics in the P&C market will be sustainable for some time. As you know, the P&C industry is facing many degrees of uncertainty; heightened care activity in four of the last five years, rising inflation, COVID ongoing influence on a global economy and enduring low interest rates. When faced with escalating risk, underwriters need both rate increases and conservative loss estimates in order to build adequate margins of safety into premium levels. With our agile underwriting, established teams and strong capital position, we are well equipped to grow into this improving market. Turning now to our operating units. We’ll begin with insurance, where our early focus on strengthening our underwriting capabilities and seizing recent market opportunities is working. Gross written premiums continued to grow substantially up 32% over the same quarter in 2020 and our accident year combined ratio ex-cats improved to 90.5%. This is another indication of the progress we have made in our specialty insurance business. We have been leaning into this hardening market for two years now as rate increases remain well above the long term loss cost trends and have spread to more lines than last year. Overall 2021 rates are up around 10% compared to 2020 and we expect that the benefit of higher premium levels will be realized well into 2023 enhancing our expected returns for that period. This quarter had many bright spots including positive rate increases have accelerated and lower limits account. These lines have previously lagged the increases in larger accounts that is no longer the case. Two, our early focus on Lloyds and business in the UK has improved our scale and our economics in this market. Three, some of our business lines that were most impacted by COVID, like travel are recapturing some of the lost volume, as both business and consumer travel increases. In summary, our specialty insurance group is making the most of the current opportunities. Pivoting now to our reinsurance group. It delivered strong growth in the quarter with gross written premiums up nearly 25% over the same period in 2020. On a net basis reported growth was only a modest 3% versus the same quarter in 2020 due to a catch up in sessions to Watford following the purchase of the company with our partners at July 1. Francois will provide more detail during his comments. But absent this one-off transaction, reinsurance net return premium growth was still very strong at 30% and our outlook remains favorable as similar to instruments, we’re experiencing broad rate increases in our specialty and casualty reinsurance lines. In the quarter our reinsurance segments reported a combined ratio of 106%, reflecting the effects of the third quarter caps, primarily Ida and the Central European floods. But reinsurance accident year combined ratio ex-cat is excellent at 83.2%. There are signs that property market rates could adjust higher due to cat fatigue, as you’ve likely heard on other calls this quarter. The recent five year period of elevated losses from catastrophes proves an important insurance adage. Losses don’t know the level of the premium. There are also early indications that retro sessional and aggregate excess of loss protections are becoming increasingly hard to come by and we believe that this will be reflected in higher property rates broadly. As you know, we were and remain judicious in the deployment of our cat PML, which was effectively flat in the third quarter. At less than 6% of our tangible equity, we remained under weighed in net property cat exposure and we will deploy more capital to the line as expected returns improve above our target. It’s too early to make a call on a January 1 renewal process, but pricing in this sector is heavily influenced at the margins and if ILS or other capacity phase, there is a possibility for significant rate corrections and increased engagement on our part. In the meantime, our reinsurance teams are demonstrating their agility and like insurance are leaning hard into the markets where returns are most attractive. Thirdly, our mortgage group continues to deliver exceptional returns. It generated $234 million of underwriting profit in the third quarter and continues its impressive rebound from last concerns associated with the pandemic. At September 30, insurance in force of $457 billion for the segment was up modestly. Further good news is that notices of default have declined to pre-pandemic levels at September 30, which is a good indicator of improved conditions. Additionally, loans in forbearance continue to decline as federal programs conclude and we remain cautiously optimistic that most of these loans will ultimately cure. Rising home prices have broadly increased homeowner equity and you will recall our position that equity levels are the best indication of whether a delinquency will ultimately result in a loss. We estimate that 98% of our loans in forbearance today have at least 10% equity, providing significant protection against potential losses. Overall, the MI market remains competitive but rational and our business continues to generate returns on capital in the mid teens. Mortgage originations continue to pay similar to last year’s record origination volume and credit quality remains excellent. As you know in all of our operations, we actively manage capital to enhance shareholder returns. The strong result in our mortgage segments have enabled us to optimize our capital structure via increased reinsurance sessions through our Bellemeade mortgage insurance-linked notes as well as traditional reinsurance. Additional reinsurance purchases enable us to reallocate capital towards faster growing areas and specialty property and casualty lines while enhancing our return profile and MI by reducing required capital. MI remains a very attractive business for us. Now a point of pride and interest to us and perhaps to you all is that last Saturday, October 23 Arch celebrated its 20 year anniversary. So I want to say to our investors, thank you for believing in us and to our employees past and present, thank you for your contributions to Arch for last 20 years and our client for showing support and conviction in our capacity to provide products to you. Finally, the PGA Tour is in Bermuda this weekend, so golf is top of mind. A golf tournament is interesting in that it takes place over several days and therefore consistency is critical. You have to be sure to pick your spot and lower your score. But if you want to make the cut, you have to limit the bogeys early so that you can play more aggressively in the stretch. And then once you get to the weekend, you can play with a bit more freedom and really try for the birdies and eagles. At this point in the cycle, we feel we’ve made the cut and now we focus on really taking advantage of our positioning to make sure we end up at the top of the leader board. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Thank you, Marc. And good morning to you all on this first day of the Butterfield Bermuda championship here in Bermuda. Thanks for joining us today. Before providing more color on our solid third quarter results, you will have observed that while our earnings release still makes a distinction between core and consolidated for purposes of comparison to prior periods, there is no difference between the two presentations this quarter. As we discussed on the last call the closing of the Watford transaction on July 1 gave rise to a reconsideration event and as a result of our updated VIE analysis, we no longer consolidate the results of Watford in our financial results. Our 40% share of Watford results is now reported in the income from operating affiliates line and there is no longer a need to make a distinction between core and consolidated results in our financials. As Marc shared earlier, our after tax operating income for the quarter was $294.7 million or $0.74 per share, resulting in an annualized 9.3% operating return on average common equity and book value per share increase to $32.43 at September 30, up 1.3% in the quarter, a very solid result in light of the catastrophe activity that was much higher than the long term average for this quarter, which we estimate that over $45 billion uninsured losses for the P&C industry approximately three times the average third quarter cat losses observed over the last 10 years. This quarter, I wanted to first give you some additional detail on the results of our reinsurance operations which were impacted by the Watford acquisition especially on the top line. As part of the agreement signed at the beginning of the year with our co-investors in Watford we committed to ceding varying percentages of the premium written by our Bermuda and U.S. treaty reinsurance operations to Watford effectively enhancing the existing business model to also serve as a sidecar for Arch. While their retrocession agreements were effective as of the start of the year, their signing was contingent on the transaction closing which delayed their recognition in our income statement until this quarter. As a result, the third quarter ceded written premium reflects a catch up of approximately 161.2 million from the first half of the year. The impact of the premium catch up adjustment on underwriting income for the reinsurance segment was minimal. Growth in gross written premium remained strong at 24.6% on a quarter-over-quarter basis, and growth in net written premium would have come in at 29.5% adjusting for the Watford catch up. The growth was observed across most of our lines but especially in our casualty, other specialty and property other than property catastrophe lines or strong rate increases and growth in new accounts helped increase the top line. The segment’s accident quarter combined ratio excluding cats stood at 83.2% compared to 83.1% on the same basis one year ago. On a year-to-date basis, the ex-cat accident year combined ratio has improved by approximately 250 basis points over the same period last year reflecting the improving underwriting results and most of the lines in which we write. In the insurance segment, net written premium grew 40% over the same quarter one year ago and the segments accident quarter combined ratio excluding cats was 90.5% lower by approximately 360 basis points from the same period one year ago; excellent results across the board, which demonstrate the progress or insurance segment has made over the last three plus years and improving its performance and provide us with optimism on the underlying quality of our franchise going forward. Losses from 2021 catastrophic events in the quarter net of reinsurance recoverable and reinstatement premiums stood at $335.9 million, or 17.4 combined ratio points compared to 12.5 combined ratio points in the third quarter of 2020. As noted in our pre-release, our P&C operations were impacted by Hurricane Ida, the European flooding events of July as well as a series of other events across the globe. Our mortgage segment had an excellent quarter with a combined ratio of 26.2% reflecting favorable prior development of $48.4 million about half of which came from U.S. MI from better than expected cure activity in pre-pandemic delinquencies and recoveries on second lien loans. And the other half from our CRT portfolio and international MI. The decrease in net premiums on a sequential basis was primarily attributable to lower levels of single premium terminations in the quarter for U.S. MI business and to a lower level of call to CRT transaction than what was observed in the second quarter. Recall the second quarter benefited from higher earned premiums due to an unusually high number of CRT transactions being called which we highlighted as effectively being a non-recurring event. The delinquency rate for U.S. MI book came in at 2.67% at the end of the quarter, a material reduction from the peak we observed at the end of the second quarter one year ago. We had another solid quarter in terms of production, mostly from the purchase market and with refinance activity coming down from prior levels the insurance in force for our U.S. MI book grew slightly. The increase from last quarter in the insurance in force of our international mortgage unit is mostly the result of the acquisition of Westpac Lenders Mortgage Insurance Limited in early August. Although income from operating affiliates grew significantly to $124.1 million it is worth noting that approximately $95.7 million of the total is attributable to a one time operating gains resulting from the acquisition of a 40% stake in Watford which was offset in part by a realized loss upon deconsolidation with a resulting net income gain of $62.5 million. The remainder of the operating income from affiliates represents our share of the net income generated this quarter by our operating affiliates, which consists primarily of Watford, Coface and Premia. Total investment return for our investment portfolio was de-minimis on a U.S. dollar basis for the quarter. Net investment income was $88.2 million during the quarter down by $1.2 million on a sequential basis, driven by lower coupons on fixed maturities and lower income on consolidated funds. The duration of our portfolio remains low at 2.68 years at the end of the quarter, reflecting our internal view of the risk and return tradeoffs in the fixed income markets. Equity and net income of investment funds accounted for using the equity method produced $105.4 million during the quarter, more than half of the total income generated by our investment portfolio and a key contributor to the growth in our book value. As we discussed on prior calls, we have increased our allocation to alternative investments in the last few years and these funds now represent approximately 12% of our total portfolio at the end of the quarter. We are also very pleased with their performance so far this year which stands at 13% year-to-date. Of note, had we included income from funds using the equity method in our definition of operating income, our reported operating ROE would have increased by 3.2% on a year-to-date basis to 13.3%. While these funds returns are potentially more volatile than core fixed income strategies, we believe the incremental returns they provide more than compensate for the liquidity constraints and volatility that are usually associated with them. The effective tax rate on pre-tax operating income was a benefit of 0.7% in the quarter reflecting changes in the full year estimated tax rate, the geography mix of our pre-tax income and an 8.2% benefit from discrete tax items in the quarter. The discrete tax items in the quarter primarily relate to partial release in the valuation allowance on certain U.K. deferred tax assets. Now a quick comment on the two acquisitions that we closed on this quarter, Westpac and Somerset Bridge. You will have seen that in accordance with purchase gap we established approximately 337.4 million of intangibles and goodwill this quarter most of which will be amortized through our income statement going forward. To help with your modeling efforts, we now expect our amortization expense to be approximately $25 million in the fourth quarter of this year and $21 million quarterly throughout 2022. On the capital front we redeemed all of our outstanding series e-non cumulative preferred shares for $450 million on September 30. Separately we repurchased approximately 9.7 million common shares at an aggregate cost of $386.9 million in the third quarter. If we include the additional common shares we have purchased in the fourth quarter the year-to-date totals are now approximately 24 million shares or 5.9% of the common shares outstanding at the beginning of the year for $917.7 million. Some of the additional share repurchases in the fourth quarter were effectuated under the new share repurchase authorization of 1.5 billion approved by our Board of Directors earlier this month. As we have said since our formation 20 years ago, our core operating principles are anchored in active cycle and capital management. We believe this quarter results demonstrates our ability to execute on this philosophy and leads us to invest in opportunities where we believe the returns are most attractive. At recent prices and with the prospect of improving returns, we believe buying back our shares continues to represent another compelling value proposition for our shareholders without compromising or capital flexibility nor lessening the quality and strength of our balance sheet. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question Marc, you’re talking about the mortgage business you talked about buying more reinsurance. So there was more capital for growth on the P&C side, which I found interesting. In the past you spoken about mortgage running at around a 15 plus return and P&C kind of 10 to 12. Has the dynamics changed that that caused you to buy some more reinsurance to pursue more growth on the property casualty side?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, I think all opportunities on the P&C side just have improved right over the last couple of years and I think we’re even more convinced of the length and that has legs for the foreseeable future. So that makes us be more proactive to balance, if you will, the capital allocation between more than one year. I mean, we did rely heavily on a capital deployed in MI for quite a while because the returns in P&C as release weren’t as attractive. But now that we have a new attractive and increase and improve returns in the P&C, it behooves us to balance the risk profile in the portfolio. That’s one of the reasons why we would do some more reinsurance and again, the reinsurance also helps our return on the net basis as well which is also another benefit."
},
{
"speaker": "Elyse Greenspan",
"text": "But are the returned numbers I gave still kind of where you see the three businesses. So 50% plus and then 10 to 12."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I would say on the P&C side, at least I would say it’s getting up is north of that now. I think we have our prospects closing, the gap is closing between MI and P&C if you will."
},
{
"speaker": "Elyse Greenspan",
"text": "So north of a higher than 12%."
},
{
"speaker": "Marc Grandisson",
"text": "I would agree. Yes, I would think it’s the case, yes."
},
{
"speaker": "Elyse Greenspan",
"text": "And then, in terms of capital, you guys put in place a 1.5 billion authorization. It sounds like you’ve bought back a little bit under that so far this quarter going through the end of next year. I know obviously, what you buyback depends upon the market also for your shares and the trading over the course of the next year. But when you put that in place was that designed to set a mark of what you will buyback, or either just other factors that could cause you to either fully buyback that level, or maybe come in lower, just help us kind of think through that as we think about capital return through 2022?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, I mean, two things. I mean, we bought, we’re close to a billion dollars this year. So we don’t want to go back to the Board every three months and ask for more. So we thought, okay, what may we need, could we need by the end of 2022, over the next 15 months effectively, 1.5 billion that’s just a number that nice round number, nothing special about it. But are we committed to that number? The answer is absolutely not. If the market keeps improving and we have the ability to deploy your capital, all the capital and then some in the business, we may not end up buying anything back. So it’s really, again, a function of the market conditions and vice versa. If the market doesn’t really generate give us a lot of opportunities to grow, we might be in a position where we buyback more than not. So it’s really, again, it’ll be a function of what we see in front of us over the next 15 months. And if we end up going through the billion and a half sooner than next year, then we’ll do something else. So again, it’s very dynamic, very real time I’d say and we’ll see where things take us."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks for the color."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jimmy Bhullar with JPMorgan."
},
{
"speaker": "Jimmy Bhullar",
"text": "So first, I’ve question on just what you’re seeing in terms of pricing both on the insurance and reinsurance side. And to what extent do you think price increases are going to hold versus may be especially on the reinsurance market? Seems like things have been getting a little bit softer over through the course of the year. But how do recently high catastrophes affect your view of what one knows?"
},
{
"speaker": "Marc Grandisson",
"text": "Right Jimmy. If we bifurcate the market into property cat you agree, I would tend to agree with you that the property cat raise did not increase as much as we had hoped collectively as an industry I would say not only at Arch, it’s not a single Arch phenomenon. Therefore, that’s why you saw us right less property cat over the last nine months as a reaction to those rate levels. It’s still early, like I said in my commentary, but I think we should have a re-pricing, definitely re-pricing in Europe and in the U.S. even for the layers that have been impacted, that’s for sure. And I think it would start to spill out even on to those that have not sustained a loss because I think there’s a recognition of heightened cat activity. And I think that the market is sort of bracing for that as we go forward. It’s going to be a matter of degree. On the rest of the marketplace I think that overall since if you look at the liability lines in general, overall you can think of in terms of a quarter share if you’ve got quarter share of casualty or liability lines you’re benefiting from the rate increases in the business and I think the ceding commissions which were held high through 2020 are starting to come down a little bit. So there’s a recognition that so there’s a bit of an improvement from that perspective and a quarter share on the excess of loss in general for liability, the ratio is stable to somewhat and is more stable, but again, you apply those rate against a base that is increasing in premium level. So they are also getting some price uplift. And I think that big as soon I mean, the reinsurance market, Jimmy feeds off of the insurance market, right in a positive way, I want to make sure it’s a positive message. We actually, we on the receiving end of a portion of what the insurance market writes and to the extent that interest market writes premium at a higher level, we are benefiting from those rate increases."
},
{
"speaker": "Jimmy Bhullar",
"text": "And then can you quantify how much you’ve got in terms of COVID reserves, especially for business interruption and I’m assuming they’re mostly still IBNR as you’d been quantifying last year and just discuss what the process would be and the timeline would be for releasing these given that for the most part, it seems like the courts have been siding with the insurance companies at least thus far in the U.S.?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, I would say, I mean, we’re still very much, a lot of IBNR and our COVID reserves more than half, 60% or so I’d say, call it COVID reserves on the P&C side are still IBNR. So and how quickly do we, well, we know or not know whether we’ll need those reserves time will tell. I think it’s where we said yes I don’t disagree that so far there have been a couple of positive developments from the cores, but it's going to take a while. I truly think this is a very complicated and issue that will take years to resolve. So I wouldn't expect us to really take dramatic action on the level of COVID reserves on the P&C side for some time."
},
{
"speaker": "Francois Morin",
"text": "And Jimmy in our industry and insurance you could win 95 lawsuits and lose 96 and it changes everything. So there's a lot of uncertainty in our space, even though we've been a good streak one change could change everything."
},
{
"speaker": "Jimmy Bhullar",
"text": "And what is the rough number of or rough dollar amount of reserves?"
},
{
"speaker": "Francois Morin",
"text": "That's a good question. I don't have it in front of me. We can circle back with you. I know we booked a few 100 million dollars last year and we paid some of that. I don't have the current figure, but we can give you that."
},
{
"speaker": "Marc Grandisson",
"text": "We haven't changed ultimate Jimmy over the last three quarters."
},
{
"speaker": "Jimmy Bhullar",
"text": "But it's not something like that's more maybe 2023/ 24 as opposed to 22 in terms of potential releases on these?"
},
{
"speaker": "Marc Grandisson",
"text": "There are releases. I will say yes it will probably take another year, year and a half and we might hold a little bit more longer for the reasons I just mentioned in terms of the court decisions."
},
{
"speaker": "Operator",
"text": "Our next question comes from Mike Zaremski with Wolf Research."
},
{
"speaker": "Mike Zaremski",
"text": "Great morning, afternoon. I guess some of the prepared remarks, when you guys were talking about the primary insurance segment, talked about kind of seeing rate acceleration actually in the lower limits kind of the smaller commercial space. Any theories on why that's happening? Is it due to loss cost trend increasing, because we're kind of you're seeing a fading of rate a little bit or deceleration in the large account space. So kind of curious if, if you guys have any views, maybe broadly to, on kind of loss cost trend given all the uncertainty during the pandemic on the primary insurance side?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, the loss cost trend as we observe it, and it might change is still roughly 3% to 5% it depends on lines of business. But we have already changed our view on this at this point. And we had a loss reserve review, I believe, a couple of months ago. So then it's not changing, although we are putting in a loss ratio pick an extra level of margin of safety to make sure we wouldn't be missing because it could be higher as you know inflation is certainly another concern that we all have collectively as underwriters. In terms of my theory about why the smaller accounts get those rates right now, it's just, the market is a human psychology market. And pricing gets more acutely needed in a larger capacity play. This is where the market starts focusing its first efforts as the market hardens. And this is not unusual. This is a very, very normal phenomenon and hardening markets. You'll tend to try and fix those are more important, meaning you can put a 10 million to 15 million to 25 million limit, these are the ones you're going to try to fix right away, because presumably those will have caused you a bit more pain over the last two to three years, you were expecting more pains coming from that portfolio. And it's just a matter of time before people start looking sideways as to what other lines of business need rate. And then you start dipping down into your overall portfolio and seeing where the liability trends for instance, might also be impacted. And this is sort of a second round sort of a rippling effect from the main capacity providing players into the ones who have lower players and at the same time, to be fair, and to be I mean, to be truthful, you also have development ongoing happening on the smaller account at the same time. It's just not as acute and as glaring and as obvious early as a larger capacity play. That's why."
},
{
"speaker": "Mike Zaremski",
"text": "That's interesting. It's helpful. Let me switching gears to mortgage segment. Just curious I know the forbearance levels continue to decrease. If you could remind us I believe there's some extensions to the forbearance program or maybe even new kind of enhanced programs where the P&I could be reduced if the payment can be reduced by up to 25%. Is that correct? And if so, are you seeing your borrowers utilize those options?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So right now the program is done expires at 930, expired at 930 in terms of foreclosure but, the forbearance I'm sorry. The foreclosure, it's still unclear because they could also come back and extend it further if things were to change and the CFPB is also involved with the FHFA saying that we don't want to have any more, there's a moratorium on the foreclosure process as well. So I think both federal entities are trying to push to go back to your last point of the question, push the mortgage loan or the mortgage originator and provider of providing solutions to the borrowers who are still in forbearance or not current on their payments. And to your point a lot of it is going to be continuous same payment, most of it is going to be continuing the same payment as prior to the COVID forbearance program and is attaching towards the end the lack of what wasn't paid, or what was accrued as unpaid at the end of the loan. So this is roughly what it's going to look like. But it's going to be another three quarters before we have more visibility because even though the forbearance programs stopped in 930, and people should come now to the banks, and to the mortgage originator and trying to remediate their position from a forbearance perspective, it's still going to take another six to nine months, and I think the agencies are watching carefully. So everything is heading towards a happy resolution, if you will, of the overall forbearance programs like everybody is focusing on this as of this point in time."
},
{
"speaker": "Mike Zaremski",
"text": "And one last one sticking to mortgage and I could take this offline with, but just to want to the increased premium ceded as percentage of gross, is that due to Bellemeade and I guess if it is, can you guys continue to upsize the reinsurance usage in the segment, if you thought opportunistically you wanted to ship more growth towards other lines of business?"
},
{
"speaker": "Francois Morin",
"text": "Yes. That's very much in that vein, I think Marc made the point earlier. We're always looking to optimize the portfolio and certainly a lot of that is focused on capital deployment. We I think, made the point, last call that we had increased our quarter share percentages on the U.S. MI book at 71. So that's starting to play through basically and that is reflected. We are still very active in the Bellemeade space. So we're purchasing quite a lot there as well and I'd say those two things combined really explained why we have more ceded premium starting this quarter."
},
{
"speaker": "Mike Zaremski",
"text": "Got it and there is more appetite, if you decided to do more, either quota or Bellemeade or both in the future? Are you kind of reaching kind of a max?"
},
{
"speaker": "Marc Grandisson",
"text": "I mean I'd say we certainly do a lot of Bellemeade as it is. So I don't want to say we wouldn't do more, but it's I mean, we already are very active in that space and made big placements. So I wouldn't expect us to necessarily increase that vehicle, that mechanism to transfer risk a whole lot. And on the quota share, yes we see more we could, but then it's a risk return trade off and whether the economics work are reasonable or work in our favor, too. So right now we're happy where we're at. But if things change in the market gives us better opportunities we could conceivably see a bit more. Yes."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Shanker with Bank of America."
},
{
"speaker": "Josh Shanker",
"text": "Yes, good morning, everyone. This may not be the best math, but it's rough. I think you guys had the inventory of COVID era Moore's claims, about 120,000, you had about 90,000 cures. I'm estimating that you guys have about $20,000 up or notice right now in the portfolio, may not be exact. Historically, you've had about an average of $5,000 up for notice. It seems like the reserves are stuffed particularly if you tell us that 90%, 98% of the claims have at least $10,000 in equity. So, I mean, I'm trying to rectify all this like, can you explain to me I feel so I've asked this question before I just don't understand what's going on there?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think the answer is going to be very similar. So very good question. Hope you are -- by the police in back here. If you look at the average case reserved for annuities it's exactly 23,500 I believe it's in the supplement, you can look into it. And you're right. It was it went up from last year. The run rate pre-COVID was roughly 10,000, 11,000, 12,000, so it did increase. And was about 110,000 for claims that we got as well a COVID in the forbearance and about 78% of them have cured so far, so we’ve about 20,500. So [Indiscernible] we have about 31,770, I think is a number in terms of an NOD outstanding. When you multiply by 23, you’re right it would look on the high side, a couple things I will say here, number one is the average severity of the policies that are facing the COVID-19 are starting from 1819, we'd have a higher phase than the one we had as an NOD back in 2019. Those in 2019, were largely pre-2008. So you have to adjust for the level of coverage that has increased over the last 10-12 years. So that explains one why the 23 would be higher than 1113 historically. The second part of your question, which was where should it go, and this is where it's more art than science. Josh. We hear you. We are cautiously optimistic that it may not come to pass in terms of needing the reserves, and hopefully some of it will cure better than we anticipated. But I just want to remind everyone on call and as we remind ourselves all the time, it's that this is a political positioning. Things could change very quickly from the FHFA, the GSEs, or the housing department. So we need to be really careful and we've never been through that kind of event. So we are Arch as you know, and we will take a cautious, prudent approach to reserving. And if we happen not to need those reserves, as we do, typically, we'll be taking them by the hand from the liability side down to the capital side. We're not going to have let them stranded for a long time. But again, so much so many uncertainties Josh. We understand your puzzling. This is a very unusual situation for the industry. Therefore we have to and that's what we appear probably to be a little bit unusual in that we're reserving it."
},
{
"speaker": "Josh Shanker",
"text": "And my second question unrelated. Can you talk about the differential, I guess the new business penalty, between a new business you're putting on the book, and legacy customers who you have a deep sense of their risk factors on those accounts? Is there a gap? Is the business that you're renewing, at better margins at least the way you're booking it to new business, given that more about the business you already have?"
},
{
"speaker": "Marc Grandisson",
"text": "I believe Josh, you're talking about P&C right."
},
{
"speaker": "Josh Shanker",
"text": "Yes. This is totally primary P&C not more."
},
{
"speaker": "Marc Grandisson",
"text": "Right. That makes sense to me. So it's a really very astute question Josh because we're keeping track of the renewal rate versus a new business rate level. And symptomatic or as a representation of the hardening market, the pricing of the new business is coming higher than the renewal business and that's sort of speaks to the fact that they need a new home and they need to be re-priced, and people sort of get tired of that relationship and that goes back through them back into either the ENS or the mid market. So right now, we're still seeing, on average, the new business price better than renewal business."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tracy Benguigui with Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "Thank you. Just a big picture question. I’ve seen this quarter with you and your closer peer group is that the insurance growth is outpacing the more primary market focus players without reinsurance arm. Are you seeing a lot of market dislocation where you feel like you just do a better job assuming displaced risks that still meet your risk adjusted return hurdle?"
},
{
"speaker": "Marc Grandisson",
"text": "I would like to think we're better than the average guy out there. But the truth I think, overall, the dislocation was much larger in 2020. I think you're still seeing some dislocation right now. It's certainly not, there is still some repositioning of limits provided the market by a lot of players still as we speak. And I think what explains our ability to grow is, first we have a really well established presence and we were very underweight Tracy, historically. We are really, really a good market for people that want a good security for products such as DNO for instance, right. We're really good home for someone to take on new as an insurer, and we're sort of better we're definitely benefiting from that as an incumbent with a good quality, good reputation as we do. And also, I think the other thing that I want to mention, we had said that last year, we were suffering a little bit from, from a travel, lack of traveling that impacted our travel portfolio. That certainly helps right Tracy, the fact that economy is reopening and people traveling a bit more. That also helps explain why we're able to grow a bit more than probably meet the average than the average would. Lastly, I would say that beyond just new business funding new homes I think they are programs were also going in programs, as you see this is very specialty, smaller risk. I think that again another example of programs, finding a new home going away from the existing incumbent, possibly because of our results in finding a new home and we're definitely on the receiving end of that relationship."
},
{
"speaker": "Francois Morin",
"text": "Yes. And one thing I'll add quickly, I think, both depending on the mix of business of what you call the more established and the traditional insurers I mean workers comp and commercial auto typically will make up bigger shares of their portfolio. Auto is moving up nicely, but I would say that certainly comp is and had a really good period of excellent results. So rate increases on the comp side have been pretty flattish. So again that's probably worth adjusting for comp because it's such a big line for some of these carriers."
},
{
"speaker": "Tracy Benguigui",
"text": "And I'm wondering how much of that is structural in nature like, are others raising attachment points, and you're lowering attachment points or offering lower deductible?"
},
{
"speaker": "Marc Grandisson",
"text": "No. We don't do that. No, we don't play that game. I think we would just be replacing most of our play typically on specialty lines Tracy is mid access versus second access is sort of what we play a lot of times and high access, of course, in certain our areas. So for the record Tracy we're not seeing any of the deductible being played out in the marketplace. And that's been fact, there are deductible increases, if anything else. We just see a lot of shortening of limit toward in the stacking. We saw that in 2020. It's ongoing as we speak, instead of adding stretch of 25. I'm talking about a larger placements. You'll have stretches of 10 or 5 or 5 or 10, really in 15, perhaps till saying but there's a lot more players needed to fill up the towers. That's definitely happening more so. It's still continuing to some extent less sort of in 2020."
},
{
"speaker": "Tracy Benguigui",
"text": "And then just shifting to reinsurance where are you seeing your favorable reserve development coming from?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, I mean, the vast majority, and we'll talk to it obviously in the Q1 the vast majority is in short tail lines, I mean, I'd say probably 80% in short tail lines. Mostly property other than cat where we've grown a lot in the last couple of years, and while the tail is always a bit longer than we think it should be, it's still we have a pretty good idea to three years out after writing the policy or the account and we're seeing a lot of that coming through in this quarter, a bit of favorable development on prior year cats as well. And a bit on trade credit and surety from a few years ago where we had some reserves that proved out to be a bit more required. So we released those this quarter."
},
{
"speaker": "Operator",
"text": "Our next question comes from Meyer Shields with KBW."
},
{
"speaker": "Meyer Shields",
"text": "Thanks. This is a cycle management question, I guess for Marc. When if ever do we decide that there's never going to be an appropriate hard market and property patent just get out of the line?"
},
{
"speaker": "Marc Grandisson",
"text": "I think that by virtue of well, first, I'm an optimist. I've always been an optimist. I've heard so many times over the last 27 years from some of our own underwriters that there will never be a hard market again. And when I hear this it's music to my ears because that means we're cruising for bruises. So I think that things will get better and get at some point. It may not be this quarter, but might at some point. Numbers speak for themselves. If you lose money every year people just get disenchanted and just walk away from. It's happened early storms in Europe, 92 Andrews earthquake in California 94, terrorist attack Katrina, Rita and Wilma. I mean there's always changes and it's not I rattled by five or six of them. And you got to believe that the world is a dangerous place Meyer. So I think something will happen and again losses don't necessarily change the market pricing, but perception of risk will and would. So maybe we're on this place where people say, you know what, why bother? And if that's the case, then that's in the demand for cat as protection is inelastic. So if supply shrinks then the demand will stay as is and pricing will therefore increase. So I'm an optimist. I'm not sure when it's going to happen, but I believe it will happen at some point."
},
{
"speaker": "Meyer Shields",
"text": "No, I understand. That's exactly what I'm looking for. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Meredith with UBS."
},
{
"speaker": "Brian Meredith",
"text": "Yes, thanks. A couple quick questions here for you. First, just want to follow up on the comment about new business pricing better than renewal pricing. And I've heard that from other carriers. I'm just curious, when you actually go to book the margin on that new piece of business are you booking a better margin than perhaps that renewal piece of business? Or do you have to build in some level of cushion because it is new?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, it's that's a very good. I think the latter part is what we would do. But even we would also take a higher level of cushion margin of safety, if you will now reserving even in our renewal business. I think that we're reserving wise and loss ratio pick wise at Arch we tend to be more conservative and hope for the best. And hopefully, good news come down later. We're trying to figure out a way to have as much cushion as we can early on so that we're not surprised down the road. That's not changing. We say the same approach renewal or new business, right? Not much of a change."
},
{
"speaker": "Brian Meredith",
"text": "Not much of a change. Got you. Second, just quick question here. Are we still seeing admitted market shed business to the ENS market? Or is that slowed?"
},
{
"speaker": "Marc Grandisson",
"text": "That's slowed down a little bit, but it's still happening. We're not seeing a return back to the market quite yet. It's going to take a little bit longer, we think."
},
{
"speaker": "Brian Meredith",
"text": "Got you. And then one kind of bigger, I guess, philosophical question for you. I think with MI business clearly you've demonstrated that it is not a big of a volatility businesses maybe some perceived just given the results we've seen through this recent crisis. If that is indeed the case, in the amount of cash that business throws off, because it's not a growth business I guess I see you guys using share buyback as your means of capital management, and I completely get that where your stocks trading now. But what about a dividend? In the end, maybe remind us about your philosophy with respect to a dividend?"
},
{
"speaker": "Francois Morin",
"text": "Well, I mean, I'll take that, Brian, I think it's something we talked about with a board and between ourselves all the time. We had a pretty long discussion at our last board meeting on that. It's always on the table. I'd say right now I mean I think it's, I mean, the share buybacks that we went through this quarter were very attractive towards economics. We were very much I think they're easy to justify, justify sorry. But could we ever introduced a dividend? Certainly that's on the table. Not saying it's imminent, but it's something that we evaluate pretty much definitely regularity. And we'll keep looking at it."
},
{
"speaker": "Operator",
"text": "Our next question comes from Elyse Greenspan with Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi, thanks. Just one additional question. You guys spend time highlighting that session to Watford in the quarter, given that that transaction close. So my sense is, they're going to become more arched like in terms of the business that you're receiving to them versus prior to this transaction. So as we think about your 40% stake, can you just help us think about the earning stream there? Because I would think that as we go through next year that that could become a meaningful contributor to your earnings as the underwriting income of Watford pick up from what we're used to?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think the 40% share would grow at an average sort of reinsurance market results. Why? Because we are writing business on the balance sheet of Watford. So you would expect that. I think that what you would also see is our collecting fees or for our efforts, a compensation for our efforts for Watford's that would be for the 100%. So I think that the overall return would be slightly better even though at least as you can appreciate with the accounting rules it might not show us such but I think that our results will be as good I would hope for if not better than our overall results. So it's definitely an a creative return generator for reinsurance platform. It's going to be hard to see."
},
{
"speaker": "Elyse Greenspan",
"text": "And that should pick up within that other income line as we move through next year?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, so a couple yes so 40%. Correct. The other income line is well, the fees are picked up by the reinsurance sector because it's for the underwriting services they provide to Watford. But you're correct in saying that the net equity picked up of the 40% that we own in Watford if you're modeling and what kind of combined ratio is it going to operate at, what kind of premium are you going to see in terms in the volume I would you're right. I mean, it's probably more and more over time, it's going to look more and more like archery, the reinsurance segment. The percentages we seed to Watford are not uniform across all our divisions, but directionally, I think that's a good way to think about it. And the other thing, too, which has somewhat been an issue with Watford is the performance of the investments. And that has, that's being a little bit as being addressed as we speak. I think there's a process underway to reduce the volatility from the investment portfolio of investment strategy at Watford. So think of it more as that, yes, a more less volatile stream of income with more reliance on underwriting income and less on investment income. And hopefully that gets you in a good place to start modeling out how Watford is going to play out for us or the 40% for Arch going forward."
},
{
"speaker": "Elyse Greenspan",
"text": "And then maybe I'll squeeze one last and I'm not sure if you provided an updated tax guidance. And so I missed it, if you can just let us know that. And then we've heard about some potential tax changes whether in the U.S. and also abroad in relation to Bermuda, any kind of prospective tax loss and just some of what we're hearing in the market and how that could impact Arch?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I'd say first of all that question your fourth quarter, we're still in the 9% to 11% kind of tax rate for Arch in the fourth quarter. For 2022 and beyond and Marc will chime in its way too early. Unfortunately, we track it we look at all developments very carefully we're on top of things. And the reality is they change daily. So it's very hard for us at this point, to give you any kind of guidance or any expectations and what we think 2022 is going to look like. We will be more than happy to have a good discussion on the next call. But for now, it's we feel it's just premature to because we really don't know."
},
{
"speaker": "Francois Morin",
"text": "At least just to make the point about daily, literally last night our tax director, or this morning just sent us like there's a new proposal on the Hill that brings back shield and then corrects other things and then dispenses of other areas of the tax proposal in [OECD]. So, again, a moving target. It's politics. We will react to it when we do, when we see it."
},
{
"speaker": "Operator",
"text": "Our next question comes from Matthew Carletti with JMP Securities."
},
{
"speaker": "Matthew Carletti",
"text": "Thanks. Good morning. I just wanted to circle back on the discussion about kind of pandemic reserves and Marc, you're pretty clear on the P&C side in terms of get 95 good outcomes, but the 96 can change everything. How about MI? I mean it kind of follow up to Josh's line of questioning, like things look pretty conservative there. Can you help us with a little bit the timeline by which things can kind of continue to unfold well the timing by which we might see things unwind?"
},
{
"speaker": "Francois Morin",
"text": "Well, let me start, I'd say we may see a little in the fourth quarter, but that will be, I don't think everything will be resolved. But I truly think that the first half of 22 is when you'll see most of the movement or the corrections and our assumptions and the link cure rates and mediation so I'd say we're going to start seeing some data as early as this month internally and the number of cures and people moving out of forbearance, but the way it's going to flow through our numbers, again, given some of the uncertainties that Marc talked about, I think will be first half of 22. And the reason also Matt has to be said and understood that they had 18 months of forbearance worth when you get into forbearance earlier in 2020. And some of them went into forbearance, came out of forbearance and went back in again, but they still get to get to do to benefit from 18 months was forbearance. That's why some of them will coming out of there 18 months in fourth quarter, and many of them in the first and second quarter next. So it seems like some of them were able to get back current for four or five months and went back to forbearance program. That's what we have this lengthy adjustment period."
},
{
"speaker": "Matthew Carletti",
"text": "Alright. Thank you. That's very helpful. Thanks."
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you so much for being here. We're going to be, going from watching some golf, Francois and I and happy 20 years and have a good weekend everyone. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 2 | 2,021 | 2021-08-01 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the second quarter 2021 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we’ll conduct a question-and-answer session and instruction will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also, will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin.
Marc Grandisson: Thanks, Liz. Good morning, and thank you for joining our second quarter 2021 earnings call. At Arch our playbook remains simple yet effective. We protect our capital through soft markets and unleash our underwriters during hard market. We believe that this time tested strategy gives us the best chance to generate superior risk-adjusted returns over time. You should expect then from us at this stage of the cycle comes straight from that playbook. As long as rate increases support returns above our threshold, we will continue to grow our writings. We have seen this video before in the hard market of 2002 through 2005, when P&C results generated a sustainable stream of earnings for several years after market prices peaked and were fully earned. And so again this quarter, the power of Arch's diversified platform is evident in the strong underlying earnings in each of our operating segments. We delivered a 13% annualized operating ROE and aided by good investment returns, an annualized net income ROE of 21% this quarter. One item that stands out this quarter was our strong P&C underwriting activity. Our P&C insurance results demonstrate significant improvement in underwriting performance. Better market conditions allowed our teams to expand their overall positioning and grow net written premiums substantially over the same quarter last year. We are now in the sixth consecutive quarter of rate increases at plus 10% this quarter comfortably in excess of loss cost trend estimates. The higher level of premium earned from the post 2019 policy years is a primary driver of our improving underlying accident year combined ratio. About two-third of the combined ratio improvement was due to lower loss ratios, attributable to rate increases and underwriting actions, we have taken over the past several years. The balance of the improvement was driven by a lower expense ratio. Production increased across most lines of business and geography areas as pricing improvements spread. While rate increases have tapered off from previous highs in some lines, we're seeing increases in lines that had been immune to meaningful change. And in lines where price increases have eased, we're still getting rate on rate increases on an improving margins. We estimate that approximately 30% of our insurance premium growth reflects rate increases. About 15% is from higher net retention level and the remaining growth comes from new business and exposure growth with existing clients. Both our international and US insurance platforms continue to excel in the current market with substantial growth in professional lines, programs, property and travel and A&H writings. Our reinsurance group also had a quarter of strong growth while producing strong underwriting results. A large portion of this growth results from our ability to leverage our expertise and historical experience as a writer of quota share business. When markets dislocate our clients need capacity and capital as they seek to reshape their portfolio. That's why since 2019, we have been increasing our participation in side-by-side quota share arrangements. This has always been part of our reinsurance playbook and based on historical patterns, we believe a good place to deploy our capital for the next few years. As you may have heard, this market is notable as rate increases in traditional XOL reinsurance lag the insurance rate increases. So our current preference is to be closer to the primary rate increases through quota share with our clients. Property cat XL is one of the few areas where we have reduced premium writings. They are down 26%, as we are not finding enough opportunities that meet our return expectations. However, as you can see in our supplement, premium writings grew substantially in property other than cat and specialty segments. Casualty and marine also produced excellent levels of growth. As with insurance, we expect the ongoing rate improvements to be reflected in our underwriting results over the next several quarters. The Arch reinsurance story is one of providing creative capital solutions during hard markets that enables us to leverage our growth faster than in our primary insurance markets. We have considered this a core capability throughout our history. Our reaction to this market is no exception. All in all, it was a very satisfactory job of seizing hard market opportunities by our team. Carpe diem as they say. From a strategic standpoint, it's worth noting that we, along with our business partners successfully completed the purchase of Watford at the beginning of the third quarter and are focused on working to build a sustainable reinsurance franchise. Allow me now to switch to inflation fears which continues to be a hot topic for our industry. I want to reiterate our perspective on how we view inflation at Arch. As underwriters, we study inflation on a line-by-line basis to price the business and establish reserves. In some lines like workers' comp inflation remains low at this stage, I'd say 0% to 1%. However in other lines like high excess general liability, we're estimating inflation to be in the 8% to 12% range. As a point of comparison, loss cost inflation from the ground-up has been in a 3% to 5% range for around five years, broadly across our portfolio. It's important to consider line of business specifics when we discuss claims inflation. Second, it's worth noting that in every line of business the inflation rate increases as you move up attachment points. The key in pricing or reserving for an excess policy is to start with the proper ground-up trend and then apply the best curve to select a range for the trend in the upper layers. As is often the case in insurance, we are estimating and there is a lot of uncertainty around the correct number. Our philosophy is to keep this methodology consistent, through the cycle. Third, we also supplement our analysis with some subjectivity. In the current environment and in certain lines, we had to try and account for the increased uncertainty, including the possibility of the so-called social inflation. We are typically more willing to adjust the trend above our indications, than we are to reduce it, all with creating a margin of safety in mind. This is not a new concept at Arch, but a time-tested philosophy that has allowed us to navigate both, soft and hard markets, through our opportunistic cycle management approach. Let's turn now to our mortgage group, which continues to operate as a well-oiled machine, generating $250 million of operating earnings in the quarter. Our insurance in force remained steady at roughly $278 billion for US primary MI. Refinance activity has slowed and we expect improving persistency throughout the remainder of the year and into 2022. Delinquency rates are decreasing across our portfolio and we still expect a large portion of delinquencies to cure, based on many factors, including the strong equity position of our current inventory where more than 95% of delinquent policies have over 10% of equity. New notices of default, continues to decline and at 7,400 in the second quarter are better than pre-COVID levels. Outside of the US, we increased our writings in Australia as the housing market remains strong. We like the long-term opportunity in Australia as demonstrated by our announcement to acquire Westpac's LMI business, which we now expect to close later this quarter. Pricing remains competitive, but rational across the MI industry has rated our back to 2019 levels. However, the credit quality of borrowers remains strong, similar to 2016, supporting our confidence in the continued earnings from our mortgage insurance portfolio. As I close my prepared remarks, this quarter I'll borrow from cricket, which is top of mind because, this weekend marks Cup Match here in Bermuda, when the entire island goes cricket crazy for a four-day holiday weekend. I think of the current P&C market like being the first team to bat during a cricket test match. Test cricket is one of the few sports that isn't governed by a clock. Unlike games that must be completed in 60 or 90 minutes, test cricket is about scoring as any runs as possible, as long as you are getting favorable balls or pitches for baseball fans, and for as long as it takes for all of your batsmen to be out. The details are not critical, but the idea is that similar to this market, we're waiting for the right ball and scoring as many runs as possible, while we can. Rather than swinging aimlessly, we'll do what we always do, play defensively when we have to, but become aggressive and score as many runs as possible, when the opportunity arises. We're not worried about the clock running out. We'll just keep scoring runs. Now, I'll ball it over to Francois to run through the financials.
Francois Morin: Thank you, Marc and good morning to all on this first day of the Bermuda Cup Match Classic. Thanks for joining us today. Before I provide more color on our excellent second quarter results, I should remind you that, consistent with prior practice, the following comments are on a core basis, which corresponds to Arch's financial results, excluding the other segment, i.e. the operations of Watford Holdings Ltd. In our filings, the term consolidated includes Watford. As you know, we closed earlier this month on the transaction we announced late last year to acquire Watford in partnership with Warburg, Pincus and Kelso. Concurrent with the closing, we will be making changes going forward in how we report our equity interest in Watford results, which I will share with you in a few minutes. As Marc shared earlier, we had an excellent quarter with each of the three legs of our stool performing very well and our investment portfolio also producing solid results. After-tax operating income for the quarter was $407.2 million or $1 per share, resulting in an annualized 13% operating return on average common equity. Book value per share increased to $32.02 at June 30, up 4.8% in the quarter. In the insurance segment, net written premium grew 43.3% over the same quarter one year ago, 38.5% if we exclude the growth due to the COVID-related recovery in our travel, accident and health unit from the same quarter one year ago. The insured segment's accident quarter combined ratio excluding cats was 91.4%, lower by 470 basis points from the same period one year ago. The improvement in the ex-cat accident quarter loss ratio reflects the benefits of rate increases achieved over the last 12 months and changes in our mix of business. In addition, the expense ratio was lower by approximately 180 basis points since the same quarter one year ago, primarily due to the growth in the premium base. As for our reinsurance operations, we had strong growth of 63.6% in net written premiums on a year-over-year basis. The growth was observed across most of our lines, but especially in our casualty and other specialty lines, where strong rate increases and growth in new accounts helped increase the topline. The segment's accident quarter combined ratio excluding cats, stood at 87.1% compared to 87.5% on the same basis one year ago. As we have discussed in the past, we believe the underlying performance of our reinsurance segment is better analyzed on a rolling 12-month basis, which typically smooths out the impact of certain large transactions and/or claims that can have an impact on quarterly results. On that basis, the ex-cat accident year combined ratio stood at 84.3% over the last 12 months, lower by 660 basis points from the prior 12 months, where the improvement almost entirely reflected on the loss side, as a result of the rate increases we have observed over the last six-plus quarters. Losses from 2021 catastrophic events in the quarter, net of reinsurance recoverables and reinstatement premiums, stood at $46.5 million or 2.4 combined ratio points, compared to 13.5 combined ratio points in the second quarter of 2020. The activity in the quarter was the result of a series of small events across the globe and some late reported claim activity from the North American winter storms Uri and Viola in February. Following up on the trends we have seen in the last few quarters, the ultimate impact of COVID-19 on our mortgage segment remains very manageable. In particular, the delinquency rate, which came in at 3.11% at the end of the quarter, is now close to 40% lower than it was when it reached its peak during the pandemic at the end of the second quarter one year ago. We had another solid quarter in terms of production. And with refinance activity coming down from prior levels, we saw the insurance in force for our U.S. MI book remained relatively stable. Of note, this quarter was the exercise of call features by the GSEs on certain vintage credit risk transfer contracts, reducing the insurance in force for our non-U.S. MI portfolio. The overall impact of these calls was an approximate one-time $31 million benefit to our underwriting income, approximately two-thirds of which came from the release of prior year loss reserves and the rest from the call premiums received. The combined ratio for this segment was 26.5%, reflecting the lower level of new delinquencies reported during the quarter. Income from operating affiliates was strong at $24.5 million, mostly driven by an excellent first quarter at Coface. As a reminder, we report our ownership interest in Coface's results on a quarter lag into our financial statements. As regards to Watford, the closing of the transaction on July 1 gave rise to a reconsideration event. And as a result, we revisited our VIE analysis. Based on the new governing documents of the entity, we have concluded that while we will attain significant influence, we will not control the entity going forward. Accordingly, we will no longer consolidate the results of Watford in our financial results, starting with our third quarter financials. And our 40% share of Watford's results will be reported in the income from operating affiliates line, along with our proportionate share of other operating affiliates, such as Coface and Premia. As a result of the closing of the transaction, we also expect to report a one-time nonrecurring gain of approximately $65 million in the third quarter. Total investment return for our investment portfolio was positive 150 basis points on a U.S. dollar basis for the quarter. Net investment income was $89.4 million during the quarter, up $10.7 million on a sequential basis, driven by lower investment expenses and interest received on funds withheld transactions. The duration of our portfolio remains at one of its lowest levels in our history, 2.31 years at the end of the quarter, reflecting our internal view of the risk and return trade-offs in the fixed income markets. Equity and net income of investment funds accounting for using the equity method returned approximately $122 million during the quarter, a key contributor to the growth in our book value. The effective tax rate on pretax operating income was 7.6% in the quarter, reflecting changes in the full year estimated tax rate, the geographic mix of our pretax income and a benefit from discrete tax items in the quarter. Turning briefly to risk management. Our natural cat PML on a net basis decreased to $676 million as of July 1 for the Northeast peak zone down to approximately 5.6% of tangible common equity and well below our internal limits at the single event 1-in-250-year return level. On the capital front, we issued $500 million of 4.55% perpetual fixed rate preferred shares in June. We expect to use the proceeds to redeem all or a portion of our outstanding Series E non-cumulative preferred shares in September 2021 and to use any remaining amounts for general corporate purposes. Separately, we repurchased approximately 7.8 million shares at an aggregate cost of $306 million in the second quarter, bringing our year-to-date share repurchases to over $485 million, or approximately 45% of our year-to-date net income, all while growing our book value and top line. As we have said since our formation 20 years ago, we are strong proponents of active cycle and capital management. We believe this quarter's results demonstrates our ability to execute on this philosophy and leads us to invest in opportunities where we believe the returns are most attractive. At current prices and with the prospect of improving returns we believe buying back our shares represent another compelling value proposition for our shareholders without compromising our capital flexibility. With these introductory comments, we are now prepared to take your questions.
Operator: Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo.
Elyse Greenspan: Hi. Thanks. Good morning. My first question was on capital. Do you guys -- Francois, you just said, right, you bought back less than half of your earnings to start this year. And I believe going into the year you guys thought you had more than enough capital to support your growth -- the growth that you thought you would see. So should we think about a pickup in potentially capital return if that statement is true in the back half of the year? And can you just update us? Would you be willing to be active buying back your stock during wind season, just given that it seems like you have a good level of excess capital?
Francois Morin: Sure. On the second question, Elyse, yes. We're -- while in our early days and I'd say pre-mortgage years, we were somewhat more careful with share buybacks during the wind season. We're not -- we're now, as you know, a lot more diversified. So I think that constraint or that reality is maybe less applicable than it used to be. But, yes, certainly, as we think about share repurchases or capital deployment throughout the second half of the year, we certainly think that we could be buying back more shares. I mean our top priority is still to invest in the business and grow the business as best we can. But as you saw this quarter, I mean, we were able to do both and then some and like to think that, if things stay where they are or within reason, we'd be doing the same in the second half of the year.
Elyse Greenspan: Okay. And then, in terms of your insurance segment, so you guys still seem pretty positive, right? 30% of the growth came from rate increases in the quarter, positive on pricing, a little bit concern of that inflation, which we've heard throughout the industry. So, broadly, as you guys are thinking about the pricing environment as well as, just what's going on with inflation, do you have a sense of for how long you think pricing should continue to exceed loss trend, just broadly across insurance recognizing, obviously, its many different lines that comes together?
Marc Grandisson: There's a question that will lead all of us, if you get the right answer to riches, Elyse. But I think it's fair to say that the market momentum is clearly there. I think you heard on other calls that, that push for rate and increase in the rate adequacy and getting to a better level getting to a better level is shared among most in the industry. I think there's recognition between some of the losses that have occurred in the past and cat losses included some uncertainty in such inflation cyber risk as well as no property cat events. Obviously, that have occurred, I think there's a -- and the interest rates being lower, I think there's a recognition that the prices need to go up. I think I will just give you a quick anecdote. Some of our folks are doing file audits, on the reinsurance side, that is with some of our clients, who are competitors of ours as well. And the common thread or theme that seems to come through the audit is that the underwriting community is recognizing that more needs to be done. And you can see this evidenced in the discussion that they have with brokers. So we're very secure. I think there's going to be quite a bit more run way to this pricing improvement.
Elyse Greenspan: And then one last one on the reinsurance side, it sounds like, Francois from your comments that the deterioration in the quarter was more just kind of one-off. I guess, as we think about going forward, my question more is, as we've seen the shift to more, longer tail lines within that book and away from property, would you expect the underlying loss ratio to deteriorate, or was it just that there was just some one-off factors in the quarter, we could still see improvement in that on a go-forward basis?
Francois Morin: Yeah. If you're -- in terms of modeling I think it's going to go up and down, right? And I would say, the numbers we quoted in terms of the rolling 12 months is probably as good a -- it's a good starting point. The business mix, yeah, there'll be some fluctuations here and there. But -- yeah, we wrote more casualty but we wrote also a lot more other specialty which is -- maybe combined ratios there a bit better. So it's hard to pinpoint exactly, where everything -- I mean, what's going to happen obviously in the next few quarters. But I'd steer you to the kind of the rolling 12-month number that I quoted to be -- that should be a good starting point.
Marc Grandisson: Elyse, if I may add to that point. I mean, also bear in mind, at Arch, we tend to be prudent in reflecting all the margin improvement early on. So we'll have to wait and see where the data takes us. I just want to make sure we keep that in mind, as we go forward.
Elyse Greenspan: Okay. That's helpful. Thanks for the color.
Marc Grandisson: Thank you.
Francois Morin: Thank you.
Operator: Our next question comes from Jimmy Bhullar with JPMorgan.
Jimmy Bhullar: Hi. Good morning. So first just had a question …
Francois Morin: Good morning.
Jimmy Bhullar: …on pricing and -- obviously your comments are pretty positive. But can you sort of compare and contrast what you're seeing on the primary side versus what you're seeing in reinsurance broadly?
Marc Grandisson: Yeah. So on the insurance side, there's a lot more activity, more price pickup on the insurance side. And that's why on a quota share basis, even though the seeding commissions have not decreased as much as they would have, otherwise in other hard markets. I think that if you're on a quota share basis, you've essentially taken -- you're participating alongside your clients in terms of rate increases. So whatever rate increase I would have included in my remarks on the insurance you could ascribe, to the quota share reinsurance participation. On the excess of loss, it tends to always lag a little bit behind. There's some benefit from the underlying rate, because the excess of loss pricing typically is a percentage of the underlying portfolio. So to the extent that, some rate increase at the primary level, the excess of loss would get presumably a bigger percentage. But I think that, it would be safe to say, that the softer markets probably gave a little bit less adequacy or probably more of a need for price pickup in the excess of loss, in general. And we're probably expecting this to start to happen soon. I think there will be some recognition that is sort of a second derivative of typically of a hardening market. I hope that helps.
Jimmy Bhullar: And are you equally optimistic, or are there signs because you mentioned, property cat may be slowing down a little bit? But are you equally optimistic about the sustainability of the trend on pricing in both reinsurance and in insurance?
Marc Grandisson: Yes on the excess of loss. Because like I said, if I go back to 2002, 2005 market, I think that, the excess of loss market got probably a lot better. It took to like 2004 to get there. So you need a couple of years of primary rate increases to start to find its way or their way onto the reinsurance excess pricing. It's a very normal hardening market. So I'm very encouraged actually.
Jimmy Bhullar: Okay. And then just lastly you mentioned, credit quality on the MI side being strong. How are you, -- and obviously the labor market is very good as well. But how are you thinking about high property prices and just inflated values for homes? And how that factors into your view of the business that you're writing now?
Marc Grandisson: If you were in an equilibrium in terms of supply and demand or the supply was plentiful, we'd be worried. That would take us back to the 2006 and 2007 period. But the supply and demand on the housing is such that, it should help maintain the pricing for quite a while. We have 1.5 million to two million homes missing in the marketplace. It takes a while to find their way to the market. There's also under built, as you know as we all read in the press. So, from our perspective, the house price appreciation is there. We look at over or undervaluation. We also have these metrics from our economist. And we're not seeing significant national overvaluations. So that's not another -- yet another -- not a concern. And the interest rates are still pretty low at 3% -- the mortgage rate that is at 3%. So the affordability is still pretty high, compared to historical metrics. So all of these, put together, it's never one dimension, right? And Jimmy, I mean, if you look at, I think overall if you across everything it tends in a positive direction.
Jimmy Bhullar: Okay. Thank you.
Marc Grandisson: You're welcome.
Operator: Our next question comes from Josh Shanker with Bank of America.
Josh Shanker: So I think I've asked the same question like from the last two conference calls. I'm going to ask it again. I look at the reserve releases in mortgage. And I look at the reserves per new case, in the 2Q 2021 numbers. And you're reserving more than ever for new defaults or delinquencies, as you're releasing the reserves. Yet the housing prices are appreciating. I'm trying to figure out, what the math is, about why the potential claim per loss keeps getting worse?
Francois Morin: Well, you're asking a very good question, Josh. I think big picture, as you know, we're still -- there's still a lot that has to happen before we have more visibility until - in how the forbearance loans are going to pan out? How they're going to -- whether they're going to cure or whether they're going to turn to claim? And as you know, those are -- I mean, that's an 18-month process. So we -- if we look at the peak months of April and May of last year, their 18-month period will expire -- unless things change should expire in the fourth quarter this year. So that's when we'll certainly have again more visibility. And have a more definitive view on how to -- I mean whether reserves were too high or not. And so that's where we sit on that at this point. We're reacting a little bit to the data. But again we still feel there's quite a need -- a lot that needs to be settled before we take I'd say action on the current reserve levels. In terms of the new delinquencies, there's always tweaks that happen every quarter. You look at the average, the incidence rate and how severities and frequency assumptions that we put on the new delinquencies that get reported this quarter Again it's a smaller inventory of new delinquencies. So I wouldn't -- there's a bit more leverage in how those numbers play out. But big picture, I think we're still very comfortable with our reserve levels. Yes, I think you're implying maybe that we got too much. That's a possibility. But again we'll know more in the second half of the year.
Josh Shanker: So when I look at the reserves, I guess the $55 million in reserves for current accident year period put up in the fourth quarter, is that a strengthening of average claim for the entire portfolio, or is that a new -- we think the new claims being put on 2Q, 2021 have the potential to be worse in terms of severity than the average claim currently on the book?
Francois Morin: Yeah. I think it's the latter. We didn't really make any adjustments in terms of prior notices, so notices that were on the books before the quarter started. The thinking on the new notices is that the fact that they became delinquent this late in the game I'd say given that forbearance programs have been available for some time over a year, we think that there's a possibility that they could turn out worse than the ones that we got earlier. So there's a bit of a mindset or a philosophy that and time will tell. But given that they might have gone through all their savings and they might have tried a lot of things and now they finally turned delinquent. So that's a little bit of the -- I think the rationale behind these numbers.
Josh Shanker: Okay. Thank you very much for the update.
Operator: Our next question comes from Ryan Tunis with Autonomous Research.
Ryan Tunis: Hey, thanks. Good afternoon guys. Marc, I guess my first question. Can you hear me?
Francois Morin: Yes we can. Go ahead.
Ryan Tunis: Sorry about that. So I had a cycle management question in with property cat. And I'm not being critical. I'm just curious. So a year ago, it looks like you wrote $118 million of premium. And this year you wrote $88 million. So you wrote less. I get the property cat is not the best place to be, but it feels like the rate environment was incrementally a little bit better. So I'm just I guess a little bit curious like what goes into the decision to as conditions improve actually decide that 2Q of 2021, we don't want to write as much as we did in 2Q of 2020?
Marc Grandisson: It's a really, really good question. So I think a couple of things happen, right? Number one, we probably like everyone else have a different perception on the riskiness of the cat book, right? There's a -- we just had a wind storm in January. So that will definitely make you take a different look at the non-model losses, right? There's a lot of non-model losses that seem to have percolated way more than we expected over the last two, three years. So there's an element of loss cost expectancy and also as a result of that needing a higher margin of safety for your return. That's clearly the number one consideration. And as a second one that is not to be forgotten is also -- it's an allocation of capital. They're saying well where is a better use of capital? Is a risk-adjusted of X in cat worth as much as a Y in other property for instance or in casualty? And those decisions are made on a quarterly basis, I would almost say almost daily. So as you get a broader range of opportunities on the reinsurance side specifically, you're able to manage your portfolio and reoptimize the portfolio as you go at least maybe in a quarter or two quarters ahead. So that's sort of a thinking beyond the stock management with a view of optimizing your return, not necessarily betting all out, right? I mean, that's a one thing that Paul [ph] told me way back when is that you don't want to be unlucky. Property cat, if you have all these great opportunities and not excluding out of the cat realm, it probably be who is your manager to taper it down a little bit also provided because it's not as juicy perhaps as the other lines are appearing at this point in time. So it's a bit of a window we think.
Ryan Tunis: Yeah, that makes sense. That's interesting. And then I guess just in mortgage insurance, seeing the attritional loss ratio, I mean yeah pretty much at pre-pandemic levels. I guess I was a little bit surprising just given there are some new notices and I felt like back in 2019 they're almost none. So is this sustainable, kind of, the 15% to 20% attritional, or is it something this quarter that was an unusual tailwind?
Francois Morin: Well, I mean attritional excluding PYD that's how we think about it. Again I think I mentioned it in prior quarters where a 20% loss ratio is plus or minus that should be what you should get over the cycle. And there's a bit of noise with the CRT transaction. So I mean, there's moving parts within that. But yes 20% is absolutely sustainable.
Ryan Tunis: Got it. And then just lastly just out of curiosity, I was wondering if you guys would be willing to share like an internal view of what your excess capital position is?
Francois Morin: Well, that's not something we've made public in the past. And I think we're -- because it's a daily a moving target right? I mean there's -- we don't know what the market is going to give us. So we could give you a number, but then next tomorrow will be different. So it's just -- we rather want to keep the flexibility there. And that's…
Ryan Tunis: I hear you. I thought I'd try.
Francois Morin: Yeah.
Ryan Tunis: Okay. Thanks guys.
Operator: Our next question comes from Meyer Shields with KBW.
Meyer Shields: Thank you. Two I think basic questions. First, I know there's a lot of commentary at Arch and elsewhere about if that was like prudent reserves, because of current uncertainties with regard to inflation. Is that -- let me phrase it differently. Are you releasing reserves more slowly now than you would have in the past because of that issue, or is that a current accident year issue?
Marc Grandisson: I think, Meyer you're an actuary as I am. So you know that inflation impacts current accident year and prior accident year, right? So clearly we are -- it's part of the recipe if you will of establishing reserves. So we're trying to peg the historical trend as you know in a triangle is the best we can to the extent it's not captured within a loss development factors. So I think it's on both sides. Does that mean that we are releasing? Yes, I think that probably means that we historically have been a bit more careful in establishing our loss pick. If you look back at our history of combined ratio in the insurance group specifically, you'll see that we were much higher than what most people were in the industry. So I think that tells you that we were reserving at that point with a view of loss inflation that was more in the 3% to 5%, and we haven't changed our view really at this point in time except for, like I said in my comments certain lines, where it's probably appropriate to do a bit more.
Meyer Shields : Okay. No I think that's the right call and it makes a lot of sense. Second question, in reinsurance. How should we think about the catastrophe exposure in the non-property cat, property book?
Marc Grandisson: Well, it's part of the $676 million that Francois, mentioned. We're accounting for that but it's definitely less of a cat exposure. There is some in there but it's definitely not the driver of the exposure at all. So it depends on what kind of business you look at. The cat load on these premium, is anywhere from 5% to 10% sometimes a bit higher depending on the quota share you're writing. But in a lot of our other specialty quota share you had some but again much, much smaller. So I would say that, still the larger contributor to our PML is through the cat XL portfolio.
Meyer Shields : Okay. Thanks, Marc. Thank you so much
Marc Grandisson: You’re welcome, Meyer. Thank you.
Operator: Our next question comes from Phil Stefano with Deutsche Bank.
Phil Stefano: Yes. Thanks and good morning.
Marc Grandisson: Good morning.
Phil Stefano: One or two focused on the MI business. So of the $44 million in favorable development it seems like just shy of half of that was due to the GSEs and the cancellation of the CRT deal. The other $24 million give or take can you give us a sense of the vintage years associated with that, or what's driving that development?
Francois Morin: Well, I'll be -- yes I'll give you a bit more specifics. So yes you're right just about half of the -- under half -- just slightly under half of the total was from the GSE call deals. And about a third I'd say is little tweaks again in call it COVID assumptions that we've kind of brought down a little bit. And that's across -- it's across all our books. So it's like a US -- primary US MI. It's across some CRT deal that are still around that we've made some adjustments on those reserves and also on the international book. So that gives you a perspective. And then there's just -- call it just under 20% of favorable development on runoff businesses or second lien and student loan businesses that have been in runoff for quite some time. So hopefully, that gives you the split Phil, and answers your question.
Phil Stefano: Yes, that's great. That's great. Thanks. And I think, the PMIER's efficiency ratio -- sorry go ahead.
Francois Morin: No, you go.
Marc Grandisson: No. We're good.
Phil Stefano: Yes. So the PMIER's efficiency ratio is pushing up near 200%. Maybe, you could talk to us about the ability to upstream capital? When the GSEs might let you do that, or do you go to the state regulators and contemplate getting permission for a special of some sort?
Francois Morin: Yes. That -- as we discussed last quarter that's in the works. Second half of the year we are -- we've begun the process already to upstream. As you mentioned the dividend from our regulated entities to the holding company in the US It's -- some of it will have to be extraordinary and some of it is ordinary dividends. So there's -- we'll have to have some discussions with the regulators on that. I'd like to think that we can get them comfortable that with our current levels of total capital and some of it as you know a lot of it being trapped in within the contingency reserves I think they'll -- I think we'll be able to get them comfortable that the levels of dividend that we're talking about will be -- will meet their needs and ours. So stay tuned but I'd like to think that we'll be able to extract some dividends in the second half of the year.
Marc Grandisson: If I can address for one second fill the GSE. The GSEs are allowing you to do a dividend without any approval at 150% or above right now PMIER. So at the end of the year it's going to go down to 115%. So we think we have flexibility even from that perspective even if you consider them as another gatekeeper of that dividend payout.
Phil Stefano: Okay, Marc. Thank you.
Marc Grandisson: Sure.
Operator: Our next question comes from Brian Meredith with UBS.
Brian Meredith: Yes, thanks. A couple of quick questions here. First, the decline you saw in your property cat reinsurance I'm assuming that was just reduction in Florida exposure. And I guess, on that question what does your Southeastern kind of Gulf exposure look like today versus last year?
Marc Grandisson: It's down versus last year. But the first question on Florida we had some decrease in flow. But if you look at premium it's not as -- it's not a one-to-one thing Brian. I think that the reduction was also as a result of buying a few things to if you will round of the portfolio. So it's not necessarily all like, because if we get into this market trying to get our net exposure to a different level because of returns we use also some reinsurance buying to take care. So it's not only Florida decrease.
Brian Meredith: Got you. Got you. And then my second question, is now that the Watford deal is closed. It is in some private hands no longer a public company. Any material or any meaningful changes in strategy here that you're anticipating with Watford here going forward different types of business they could write et cetera et cetera?
Francois Morin: Yes, I'd say at a high level I mean still early days but at a high level I think you should think more of Watford, as a closer clone to Arch Re business or underwriting than what Watford was. Watford was -- didn't necessarily do all the same classes of business was very much focused more on the longer-tail stuff because of the additional pick up the assumptions that were in terms of investment returns that we're going to get. So, the call it the 2.0 business model of Watford makes it more similar to what the Arch Re portfolio or book looks like.
Brian Meredith: Got you. So, results should actually trend towards ultimately trend towards what Arch Re looks like?
Francois Morin: Much more so correct. Yes.
Brian Meredith: Got you. And then I'm just curious on Watford, is there ability or any contemplation of maybe kicking on some of your mortgage insurance exposure going forward?
Marc Grandisson: We actually write some mortgage on Watford. Yes there is some already existing. It's actually been one of the things they've done for quite a while. That's also something that the Watford shareholders were very pleased with giving them the opportunity to participate.
Francois Morin: The only -- I mean that's an issue with ratings too like Brian. So, that's something that the ratings do matter for in terms of getting GSE and regulators comfortable. So, that's something that they're going to look into as well.
Brian Meredith: Great. Thank you.
Marc Grandisson: Thank you.
Operator: I'm not showing any further questions. I'd now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thanks for everyone to be here and listen to our call and we're off to Cup Match and we'll talk to you next quarter. Thank you.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the second quarter 2021 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we’ll conduct a question-and-answer session and instruction will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also, will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks, Liz. Good morning, and thank you for joining our second quarter 2021 earnings call. At Arch our playbook remains simple yet effective. We protect our capital through soft markets and unleash our underwriters during hard market. We believe that this time tested strategy gives us the best chance to generate superior risk-adjusted returns over time. You should expect then from us at this stage of the cycle comes straight from that playbook. As long as rate increases support returns above our threshold, we will continue to grow our writings. We have seen this video before in the hard market of 2002 through 2005, when P&C results generated a sustainable stream of earnings for several years after market prices peaked and were fully earned. And so again this quarter, the power of Arch's diversified platform is evident in the strong underlying earnings in each of our operating segments. We delivered a 13% annualized operating ROE and aided by good investment returns, an annualized net income ROE of 21% this quarter. One item that stands out this quarter was our strong P&C underwriting activity. Our P&C insurance results demonstrate significant improvement in underwriting performance. Better market conditions allowed our teams to expand their overall positioning and grow net written premiums substantially over the same quarter last year. We are now in the sixth consecutive quarter of rate increases at plus 10% this quarter comfortably in excess of loss cost trend estimates. The higher level of premium earned from the post 2019 policy years is a primary driver of our improving underlying accident year combined ratio. About two-third of the combined ratio improvement was due to lower loss ratios, attributable to rate increases and underwriting actions, we have taken over the past several years. The balance of the improvement was driven by a lower expense ratio. Production increased across most lines of business and geography areas as pricing improvements spread. While rate increases have tapered off from previous highs in some lines, we're seeing increases in lines that had been immune to meaningful change. And in lines where price increases have eased, we're still getting rate on rate increases on an improving margins. We estimate that approximately 30% of our insurance premium growth reflects rate increases. About 15% is from higher net retention level and the remaining growth comes from new business and exposure growth with existing clients. Both our international and US insurance platforms continue to excel in the current market with substantial growth in professional lines, programs, property and travel and A&H writings. Our reinsurance group also had a quarter of strong growth while producing strong underwriting results. A large portion of this growth results from our ability to leverage our expertise and historical experience as a writer of quota share business. When markets dislocate our clients need capacity and capital as they seek to reshape their portfolio. That's why since 2019, we have been increasing our participation in side-by-side quota share arrangements. This has always been part of our reinsurance playbook and based on historical patterns, we believe a good place to deploy our capital for the next few years. As you may have heard, this market is notable as rate increases in traditional XOL reinsurance lag the insurance rate increases. So our current preference is to be closer to the primary rate increases through quota share with our clients. Property cat XL is one of the few areas where we have reduced premium writings. They are down 26%, as we are not finding enough opportunities that meet our return expectations. However, as you can see in our supplement, premium writings grew substantially in property other than cat and specialty segments. Casualty and marine also produced excellent levels of growth. As with insurance, we expect the ongoing rate improvements to be reflected in our underwriting results over the next several quarters. The Arch reinsurance story is one of providing creative capital solutions during hard markets that enables us to leverage our growth faster than in our primary insurance markets. We have considered this a core capability throughout our history. Our reaction to this market is no exception. All in all, it was a very satisfactory job of seizing hard market opportunities by our team. Carpe diem as they say. From a strategic standpoint, it's worth noting that we, along with our business partners successfully completed the purchase of Watford at the beginning of the third quarter and are focused on working to build a sustainable reinsurance franchise. Allow me now to switch to inflation fears which continues to be a hot topic for our industry. I want to reiterate our perspective on how we view inflation at Arch. As underwriters, we study inflation on a line-by-line basis to price the business and establish reserves. In some lines like workers' comp inflation remains low at this stage, I'd say 0% to 1%. However in other lines like high excess general liability, we're estimating inflation to be in the 8% to 12% range. As a point of comparison, loss cost inflation from the ground-up has been in a 3% to 5% range for around five years, broadly across our portfolio. It's important to consider line of business specifics when we discuss claims inflation. Second, it's worth noting that in every line of business the inflation rate increases as you move up attachment points. The key in pricing or reserving for an excess policy is to start with the proper ground-up trend and then apply the best curve to select a range for the trend in the upper layers. As is often the case in insurance, we are estimating and there is a lot of uncertainty around the correct number. Our philosophy is to keep this methodology consistent, through the cycle. Third, we also supplement our analysis with some subjectivity. In the current environment and in certain lines, we had to try and account for the increased uncertainty, including the possibility of the so-called social inflation. We are typically more willing to adjust the trend above our indications, than we are to reduce it, all with creating a margin of safety in mind. This is not a new concept at Arch, but a time-tested philosophy that has allowed us to navigate both, soft and hard markets, through our opportunistic cycle management approach. Let's turn now to our mortgage group, which continues to operate as a well-oiled machine, generating $250 million of operating earnings in the quarter. Our insurance in force remained steady at roughly $278 billion for US primary MI. Refinance activity has slowed and we expect improving persistency throughout the remainder of the year and into 2022. Delinquency rates are decreasing across our portfolio and we still expect a large portion of delinquencies to cure, based on many factors, including the strong equity position of our current inventory where more than 95% of delinquent policies have over 10% of equity. New notices of default, continues to decline and at 7,400 in the second quarter are better than pre-COVID levels. Outside of the US, we increased our writings in Australia as the housing market remains strong. We like the long-term opportunity in Australia as demonstrated by our announcement to acquire Westpac's LMI business, which we now expect to close later this quarter. Pricing remains competitive, but rational across the MI industry has rated our back to 2019 levels. However, the credit quality of borrowers remains strong, similar to 2016, supporting our confidence in the continued earnings from our mortgage insurance portfolio. As I close my prepared remarks, this quarter I'll borrow from cricket, which is top of mind because, this weekend marks Cup Match here in Bermuda, when the entire island goes cricket crazy for a four-day holiday weekend. I think of the current P&C market like being the first team to bat during a cricket test match. Test cricket is one of the few sports that isn't governed by a clock. Unlike games that must be completed in 60 or 90 minutes, test cricket is about scoring as any runs as possible, as long as you are getting favorable balls or pitches for baseball fans, and for as long as it takes for all of your batsmen to be out. The details are not critical, but the idea is that similar to this market, we're waiting for the right ball and scoring as many runs as possible, while we can. Rather than swinging aimlessly, we'll do what we always do, play defensively when we have to, but become aggressive and score as many runs as possible, when the opportunity arises. We're not worried about the clock running out. We'll just keep scoring runs. Now, I'll ball it over to Francois to run through the financials."
},
{
"speaker": "Francois Morin",
"text": "Thank you, Marc and good morning to all on this first day of the Bermuda Cup Match Classic. Thanks for joining us today. Before I provide more color on our excellent second quarter results, I should remind you that, consistent with prior practice, the following comments are on a core basis, which corresponds to Arch's financial results, excluding the other segment, i.e. the operations of Watford Holdings Ltd. In our filings, the term consolidated includes Watford. As you know, we closed earlier this month on the transaction we announced late last year to acquire Watford in partnership with Warburg, Pincus and Kelso. Concurrent with the closing, we will be making changes going forward in how we report our equity interest in Watford results, which I will share with you in a few minutes. As Marc shared earlier, we had an excellent quarter with each of the three legs of our stool performing very well and our investment portfolio also producing solid results. After-tax operating income for the quarter was $407.2 million or $1 per share, resulting in an annualized 13% operating return on average common equity. Book value per share increased to $32.02 at June 30, up 4.8% in the quarter. In the insurance segment, net written premium grew 43.3% over the same quarter one year ago, 38.5% if we exclude the growth due to the COVID-related recovery in our travel, accident and health unit from the same quarter one year ago. The insured segment's accident quarter combined ratio excluding cats was 91.4%, lower by 470 basis points from the same period one year ago. The improvement in the ex-cat accident quarter loss ratio reflects the benefits of rate increases achieved over the last 12 months and changes in our mix of business. In addition, the expense ratio was lower by approximately 180 basis points since the same quarter one year ago, primarily due to the growth in the premium base. As for our reinsurance operations, we had strong growth of 63.6% in net written premiums on a year-over-year basis. The growth was observed across most of our lines, but especially in our casualty and other specialty lines, where strong rate increases and growth in new accounts helped increase the topline. The segment's accident quarter combined ratio excluding cats, stood at 87.1% compared to 87.5% on the same basis one year ago. As we have discussed in the past, we believe the underlying performance of our reinsurance segment is better analyzed on a rolling 12-month basis, which typically smooths out the impact of certain large transactions and/or claims that can have an impact on quarterly results. On that basis, the ex-cat accident year combined ratio stood at 84.3% over the last 12 months, lower by 660 basis points from the prior 12 months, where the improvement almost entirely reflected on the loss side, as a result of the rate increases we have observed over the last six-plus quarters. Losses from 2021 catastrophic events in the quarter, net of reinsurance recoverables and reinstatement premiums, stood at $46.5 million or 2.4 combined ratio points, compared to 13.5 combined ratio points in the second quarter of 2020. The activity in the quarter was the result of a series of small events across the globe and some late reported claim activity from the North American winter storms Uri and Viola in February. Following up on the trends we have seen in the last few quarters, the ultimate impact of COVID-19 on our mortgage segment remains very manageable. In particular, the delinquency rate, which came in at 3.11% at the end of the quarter, is now close to 40% lower than it was when it reached its peak during the pandemic at the end of the second quarter one year ago. We had another solid quarter in terms of production. And with refinance activity coming down from prior levels, we saw the insurance in force for our U.S. MI book remained relatively stable. Of note, this quarter was the exercise of call features by the GSEs on certain vintage credit risk transfer contracts, reducing the insurance in force for our non-U.S. MI portfolio. The overall impact of these calls was an approximate one-time $31 million benefit to our underwriting income, approximately two-thirds of which came from the release of prior year loss reserves and the rest from the call premiums received. The combined ratio for this segment was 26.5%, reflecting the lower level of new delinquencies reported during the quarter. Income from operating affiliates was strong at $24.5 million, mostly driven by an excellent first quarter at Coface. As a reminder, we report our ownership interest in Coface's results on a quarter lag into our financial statements. As regards to Watford, the closing of the transaction on July 1 gave rise to a reconsideration event. And as a result, we revisited our VIE analysis. Based on the new governing documents of the entity, we have concluded that while we will attain significant influence, we will not control the entity going forward. Accordingly, we will no longer consolidate the results of Watford in our financial results, starting with our third quarter financials. And our 40% share of Watford's results will be reported in the income from operating affiliates line, along with our proportionate share of other operating affiliates, such as Coface and Premia. As a result of the closing of the transaction, we also expect to report a one-time nonrecurring gain of approximately $65 million in the third quarter. Total investment return for our investment portfolio was positive 150 basis points on a U.S. dollar basis for the quarter. Net investment income was $89.4 million during the quarter, up $10.7 million on a sequential basis, driven by lower investment expenses and interest received on funds withheld transactions. The duration of our portfolio remains at one of its lowest levels in our history, 2.31 years at the end of the quarter, reflecting our internal view of the risk and return trade-offs in the fixed income markets. Equity and net income of investment funds accounting for using the equity method returned approximately $122 million during the quarter, a key contributor to the growth in our book value. The effective tax rate on pretax operating income was 7.6% in the quarter, reflecting changes in the full year estimated tax rate, the geographic mix of our pretax income and a benefit from discrete tax items in the quarter. Turning briefly to risk management. Our natural cat PML on a net basis decreased to $676 million as of July 1 for the Northeast peak zone down to approximately 5.6% of tangible common equity and well below our internal limits at the single event 1-in-250-year return level. On the capital front, we issued $500 million of 4.55% perpetual fixed rate preferred shares in June. We expect to use the proceeds to redeem all or a portion of our outstanding Series E non-cumulative preferred shares in September 2021 and to use any remaining amounts for general corporate purposes. Separately, we repurchased approximately 7.8 million shares at an aggregate cost of $306 million in the second quarter, bringing our year-to-date share repurchases to over $485 million, or approximately 45% of our year-to-date net income, all while growing our book value and top line. As we have said since our formation 20 years ago, we are strong proponents of active cycle and capital management. We believe this quarter's results demonstrates our ability to execute on this philosophy and leads us to invest in opportunities where we believe the returns are most attractive. At current prices and with the prospect of improving returns we believe buying back our shares represent another compelling value proposition for our shareholders without compromising our capital flexibility. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi. Thanks. Good morning. My first question was on capital. Do you guys -- Francois, you just said, right, you bought back less than half of your earnings to start this year. And I believe going into the year you guys thought you had more than enough capital to support your growth -- the growth that you thought you would see. So should we think about a pickup in potentially capital return if that statement is true in the back half of the year? And can you just update us? Would you be willing to be active buying back your stock during wind season, just given that it seems like you have a good level of excess capital?"
},
{
"speaker": "Francois Morin",
"text": "Sure. On the second question, Elyse, yes. We're -- while in our early days and I'd say pre-mortgage years, we were somewhat more careful with share buybacks during the wind season. We're not -- we're now, as you know, a lot more diversified. So I think that constraint or that reality is maybe less applicable than it used to be. But, yes, certainly, as we think about share repurchases or capital deployment throughout the second half of the year, we certainly think that we could be buying back more shares. I mean our top priority is still to invest in the business and grow the business as best we can. But as you saw this quarter, I mean, we were able to do both and then some and like to think that, if things stay where they are or within reason, we'd be doing the same in the second half of the year."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. And then, in terms of your insurance segment, so you guys still seem pretty positive, right? 30% of the growth came from rate increases in the quarter, positive on pricing, a little bit concern of that inflation, which we've heard throughout the industry. So, broadly, as you guys are thinking about the pricing environment as well as, just what's going on with inflation, do you have a sense of for how long you think pricing should continue to exceed loss trend, just broadly across insurance recognizing, obviously, its many different lines that comes together?"
},
{
"speaker": "Marc Grandisson",
"text": "There's a question that will lead all of us, if you get the right answer to riches, Elyse. But I think it's fair to say that the market momentum is clearly there. I think you heard on other calls that, that push for rate and increase in the rate adequacy and getting to a better level getting to a better level is shared among most in the industry. I think there's recognition between some of the losses that have occurred in the past and cat losses included some uncertainty in such inflation cyber risk as well as no property cat events. Obviously, that have occurred, I think there's a -- and the interest rates being lower, I think there's a recognition that the prices need to go up. I think I will just give you a quick anecdote. Some of our folks are doing file audits, on the reinsurance side, that is with some of our clients, who are competitors of ours as well. And the common thread or theme that seems to come through the audit is that the underwriting community is recognizing that more needs to be done. And you can see this evidenced in the discussion that they have with brokers. So we're very secure. I think there's going to be quite a bit more run way to this pricing improvement."
},
{
"speaker": "Elyse Greenspan",
"text": "And then one last one on the reinsurance side, it sounds like, Francois from your comments that the deterioration in the quarter was more just kind of one-off. I guess, as we think about going forward, my question more is, as we've seen the shift to more, longer tail lines within that book and away from property, would you expect the underlying loss ratio to deteriorate, or was it just that there was just some one-off factors in the quarter, we could still see improvement in that on a go-forward basis?"
},
{
"speaker": "Francois Morin",
"text": "Yeah. If you're -- in terms of modeling I think it's going to go up and down, right? And I would say, the numbers we quoted in terms of the rolling 12 months is probably as good a -- it's a good starting point. The business mix, yeah, there'll be some fluctuations here and there. But -- yeah, we wrote more casualty but we wrote also a lot more other specialty which is -- maybe combined ratios there a bit better. So it's hard to pinpoint exactly, where everything -- I mean, what's going to happen obviously in the next few quarters. But I'd steer you to the kind of the rolling 12-month number that I quoted to be -- that should be a good starting point."
},
{
"speaker": "Marc Grandisson",
"text": "Elyse, if I may add to that point. I mean, also bear in mind, at Arch, we tend to be prudent in reflecting all the margin improvement early on. So we'll have to wait and see where the data takes us. I just want to make sure we keep that in mind, as we go forward."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. That's helpful. Thanks for the color."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you."
},
{
"speaker": "Francois Morin",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jimmy Bhullar with JPMorgan."
},
{
"speaker": "Jimmy Bhullar",
"text": "Hi. Good morning. So first just had a question …"
},
{
"speaker": "Francois Morin",
"text": "Good morning."
},
{
"speaker": "Jimmy Bhullar",
"text": "…on pricing and -- obviously your comments are pretty positive. But can you sort of compare and contrast what you're seeing on the primary side versus what you're seeing in reinsurance broadly?"
},
{
"speaker": "Marc Grandisson",
"text": "Yeah. So on the insurance side, there's a lot more activity, more price pickup on the insurance side. And that's why on a quota share basis, even though the seeding commissions have not decreased as much as they would have, otherwise in other hard markets. I think that if you're on a quota share basis, you've essentially taken -- you're participating alongside your clients in terms of rate increases. So whatever rate increase I would have included in my remarks on the insurance you could ascribe, to the quota share reinsurance participation. On the excess of loss, it tends to always lag a little bit behind. There's some benefit from the underlying rate, because the excess of loss pricing typically is a percentage of the underlying portfolio. So to the extent that, some rate increase at the primary level, the excess of loss would get presumably a bigger percentage. But I think that, it would be safe to say, that the softer markets probably gave a little bit less adequacy or probably more of a need for price pickup in the excess of loss, in general. And we're probably expecting this to start to happen soon. I think there will be some recognition that is sort of a second derivative of typically of a hardening market. I hope that helps."
},
{
"speaker": "Jimmy Bhullar",
"text": "And are you equally optimistic, or are there signs because you mentioned, property cat may be slowing down a little bit? But are you equally optimistic about the sustainability of the trend on pricing in both reinsurance and in insurance?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes on the excess of loss. Because like I said, if I go back to 2002, 2005 market, I think that, the excess of loss market got probably a lot better. It took to like 2004 to get there. So you need a couple of years of primary rate increases to start to find its way or their way onto the reinsurance excess pricing. It's a very normal hardening market. So I'm very encouraged actually."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. And then just lastly you mentioned, credit quality on the MI side being strong. How are you, -- and obviously the labor market is very good as well. But how are you thinking about high property prices and just inflated values for homes? And how that factors into your view of the business that you're writing now?"
},
{
"speaker": "Marc Grandisson",
"text": "If you were in an equilibrium in terms of supply and demand or the supply was plentiful, we'd be worried. That would take us back to the 2006 and 2007 period. But the supply and demand on the housing is such that, it should help maintain the pricing for quite a while. We have 1.5 million to two million homes missing in the marketplace. It takes a while to find their way to the market. There's also under built, as you know as we all read in the press. So, from our perspective, the house price appreciation is there. We look at over or undervaluation. We also have these metrics from our economist. And we're not seeing significant national overvaluations. So that's not another -- yet another -- not a concern. And the interest rates are still pretty low at 3% -- the mortgage rate that is at 3%. So the affordability is still pretty high, compared to historical metrics. So all of these, put together, it's never one dimension, right? And Jimmy, I mean, if you look at, I think overall if you across everything it tends in a positive direction."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Shanker with Bank of America."
},
{
"speaker": "Josh Shanker",
"text": "So I think I've asked the same question like from the last two conference calls. I'm going to ask it again. I look at the reserve releases in mortgage. And I look at the reserves per new case, in the 2Q 2021 numbers. And you're reserving more than ever for new defaults or delinquencies, as you're releasing the reserves. Yet the housing prices are appreciating. I'm trying to figure out, what the math is, about why the potential claim per loss keeps getting worse?"
},
{
"speaker": "Francois Morin",
"text": "Well, you're asking a very good question, Josh. I think big picture, as you know, we're still -- there's still a lot that has to happen before we have more visibility until - in how the forbearance loans are going to pan out? How they're going to -- whether they're going to cure or whether they're going to turn to claim? And as you know, those are -- I mean, that's an 18-month process. So we -- if we look at the peak months of April and May of last year, their 18-month period will expire -- unless things change should expire in the fourth quarter this year. So that's when we'll certainly have again more visibility. And have a more definitive view on how to -- I mean whether reserves were too high or not. And so that's where we sit on that at this point. We're reacting a little bit to the data. But again we still feel there's quite a need -- a lot that needs to be settled before we take I'd say action on the current reserve levels. In terms of the new delinquencies, there's always tweaks that happen every quarter. You look at the average, the incidence rate and how severities and frequency assumptions that we put on the new delinquencies that get reported this quarter Again it's a smaller inventory of new delinquencies. So I wouldn't -- there's a bit more leverage in how those numbers play out. But big picture, I think we're still very comfortable with our reserve levels. Yes, I think you're implying maybe that we got too much. That's a possibility. But again we'll know more in the second half of the year."
},
{
"speaker": "Josh Shanker",
"text": "So when I look at the reserves, I guess the $55 million in reserves for current accident year period put up in the fourth quarter, is that a strengthening of average claim for the entire portfolio, or is that a new -- we think the new claims being put on 2Q, 2021 have the potential to be worse in terms of severity than the average claim currently on the book?"
},
{
"speaker": "Francois Morin",
"text": "Yeah. I think it's the latter. We didn't really make any adjustments in terms of prior notices, so notices that were on the books before the quarter started. The thinking on the new notices is that the fact that they became delinquent this late in the game I'd say given that forbearance programs have been available for some time over a year, we think that there's a possibility that they could turn out worse than the ones that we got earlier. So there's a bit of a mindset or a philosophy that and time will tell. But given that they might have gone through all their savings and they might have tried a lot of things and now they finally turned delinquent. So that's a little bit of the -- I think the rationale behind these numbers."
},
{
"speaker": "Josh Shanker",
"text": "Okay. Thank you very much for the update."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ryan Tunis with Autonomous Research."
},
{
"speaker": "Ryan Tunis",
"text": "Hey, thanks. Good afternoon guys. Marc, I guess my first question. Can you hear me?"
},
{
"speaker": "Francois Morin",
"text": "Yes we can. Go ahead."
},
{
"speaker": "Ryan Tunis",
"text": "Sorry about that. So I had a cycle management question in with property cat. And I'm not being critical. I'm just curious. So a year ago, it looks like you wrote $118 million of premium. And this year you wrote $88 million. So you wrote less. I get the property cat is not the best place to be, but it feels like the rate environment was incrementally a little bit better. So I'm just I guess a little bit curious like what goes into the decision to as conditions improve actually decide that 2Q of 2021, we don't want to write as much as we did in 2Q of 2020?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a really, really good question. So I think a couple of things happen, right? Number one, we probably like everyone else have a different perception on the riskiness of the cat book, right? There's a -- we just had a wind storm in January. So that will definitely make you take a different look at the non-model losses, right? There's a lot of non-model losses that seem to have percolated way more than we expected over the last two, three years. So there's an element of loss cost expectancy and also as a result of that needing a higher margin of safety for your return. That's clearly the number one consideration. And as a second one that is not to be forgotten is also -- it's an allocation of capital. They're saying well where is a better use of capital? Is a risk-adjusted of X in cat worth as much as a Y in other property for instance or in casualty? And those decisions are made on a quarterly basis, I would almost say almost daily. So as you get a broader range of opportunities on the reinsurance side specifically, you're able to manage your portfolio and reoptimize the portfolio as you go at least maybe in a quarter or two quarters ahead. So that's sort of a thinking beyond the stock management with a view of optimizing your return, not necessarily betting all out, right? I mean, that's a one thing that Paul [ph] told me way back when is that you don't want to be unlucky. Property cat, if you have all these great opportunities and not excluding out of the cat realm, it probably be who is your manager to taper it down a little bit also provided because it's not as juicy perhaps as the other lines are appearing at this point in time. So it's a bit of a window we think."
},
{
"speaker": "Ryan Tunis",
"text": "Yeah, that makes sense. That's interesting. And then I guess just in mortgage insurance, seeing the attritional loss ratio, I mean yeah pretty much at pre-pandemic levels. I guess I was a little bit surprising just given there are some new notices and I felt like back in 2019 they're almost none. So is this sustainable, kind of, the 15% to 20% attritional, or is it something this quarter that was an unusual tailwind?"
},
{
"speaker": "Francois Morin",
"text": "Well, I mean attritional excluding PYD that's how we think about it. Again I think I mentioned it in prior quarters where a 20% loss ratio is plus or minus that should be what you should get over the cycle. And there's a bit of noise with the CRT transaction. So I mean, there's moving parts within that. But yes 20% is absolutely sustainable."
},
{
"speaker": "Ryan Tunis",
"text": "Got it. And then just lastly just out of curiosity, I was wondering if you guys would be willing to share like an internal view of what your excess capital position is?"
},
{
"speaker": "Francois Morin",
"text": "Well, that's not something we've made public in the past. And I think we're -- because it's a daily a moving target right? I mean there's -- we don't know what the market is going to give us. So we could give you a number, but then next tomorrow will be different. So it's just -- we rather want to keep the flexibility there. And that's…"
},
{
"speaker": "Ryan Tunis",
"text": "I hear you. I thought I'd try."
},
{
"speaker": "Francois Morin",
"text": "Yeah."
},
{
"speaker": "Ryan Tunis",
"text": "Okay. Thanks guys."
},
{
"speaker": "Operator",
"text": "Our next question comes from Meyer Shields with KBW."
},
{
"speaker": "Meyer Shields",
"text": "Thank you. Two I think basic questions. First, I know there's a lot of commentary at Arch and elsewhere about if that was like prudent reserves, because of current uncertainties with regard to inflation. Is that -- let me phrase it differently. Are you releasing reserves more slowly now than you would have in the past because of that issue, or is that a current accident year issue?"
},
{
"speaker": "Marc Grandisson",
"text": "I think, Meyer you're an actuary as I am. So you know that inflation impacts current accident year and prior accident year, right? So clearly we are -- it's part of the recipe if you will of establishing reserves. So we're trying to peg the historical trend as you know in a triangle is the best we can to the extent it's not captured within a loss development factors. So I think it's on both sides. Does that mean that we are releasing? Yes, I think that probably means that we historically have been a bit more careful in establishing our loss pick. If you look back at our history of combined ratio in the insurance group specifically, you'll see that we were much higher than what most people were in the industry. So I think that tells you that we were reserving at that point with a view of loss inflation that was more in the 3% to 5%, and we haven't changed our view really at this point in time except for, like I said in my comments certain lines, where it's probably appropriate to do a bit more."
},
{
"speaker": "Meyer Shields",
"text": "Okay. No I think that's the right call and it makes a lot of sense. Second question, in reinsurance. How should we think about the catastrophe exposure in the non-property cat, property book?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, it's part of the $676 million that Francois, mentioned. We're accounting for that but it's definitely less of a cat exposure. There is some in there but it's definitely not the driver of the exposure at all. So it depends on what kind of business you look at. The cat load on these premium, is anywhere from 5% to 10% sometimes a bit higher depending on the quota share you're writing. But in a lot of our other specialty quota share you had some but again much, much smaller. So I would say that, still the larger contributor to our PML is through the cat XL portfolio."
},
{
"speaker": "Meyer Shields",
"text": "Okay. Thanks, Marc. Thank you so much"
},
{
"speaker": "Marc Grandisson",
"text": "You’re welcome, Meyer. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Phil Stefano with Deutsche Bank."
},
{
"speaker": "Phil Stefano",
"text": "Yes. Thanks and good morning."
},
{
"speaker": "Marc Grandisson",
"text": "Good morning."
},
{
"speaker": "Phil Stefano",
"text": "One or two focused on the MI business. So of the $44 million in favorable development it seems like just shy of half of that was due to the GSEs and the cancellation of the CRT deal. The other $24 million give or take can you give us a sense of the vintage years associated with that, or what's driving that development?"
},
{
"speaker": "Francois Morin",
"text": "Well, I'll be -- yes I'll give you a bit more specifics. So yes you're right just about half of the -- under half -- just slightly under half of the total was from the GSE call deals. And about a third I'd say is little tweaks again in call it COVID assumptions that we've kind of brought down a little bit. And that's across -- it's across all our books. So it's like a US -- primary US MI. It's across some CRT deal that are still around that we've made some adjustments on those reserves and also on the international book. So that gives you a perspective. And then there's just -- call it just under 20% of favorable development on runoff businesses or second lien and student loan businesses that have been in runoff for quite some time. So hopefully, that gives you the split Phil, and answers your question."
},
{
"speaker": "Phil Stefano",
"text": "Yes, that's great. That's great. Thanks. And I think, the PMIER's efficiency ratio -- sorry go ahead."
},
{
"speaker": "Francois Morin",
"text": "No, you go."
},
{
"speaker": "Marc Grandisson",
"text": "No. We're good."
},
{
"speaker": "Phil Stefano",
"text": "Yes. So the PMIER's efficiency ratio is pushing up near 200%. Maybe, you could talk to us about the ability to upstream capital? When the GSEs might let you do that, or do you go to the state regulators and contemplate getting permission for a special of some sort?"
},
{
"speaker": "Francois Morin",
"text": "Yes. That -- as we discussed last quarter that's in the works. Second half of the year we are -- we've begun the process already to upstream. As you mentioned the dividend from our regulated entities to the holding company in the US It's -- some of it will have to be extraordinary and some of it is ordinary dividends. So there's -- we'll have to have some discussions with the regulators on that. I'd like to think that we can get them comfortable that with our current levels of total capital and some of it as you know a lot of it being trapped in within the contingency reserves I think they'll -- I think we'll be able to get them comfortable that the levels of dividend that we're talking about will be -- will meet their needs and ours. So stay tuned but I'd like to think that we'll be able to extract some dividends in the second half of the year."
},
{
"speaker": "Marc Grandisson",
"text": "If I can address for one second fill the GSE. The GSEs are allowing you to do a dividend without any approval at 150% or above right now PMIER. So at the end of the year it's going to go down to 115%. So we think we have flexibility even from that perspective even if you consider them as another gatekeeper of that dividend payout."
},
{
"speaker": "Phil Stefano",
"text": "Okay, Marc. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Sure."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Meredith with UBS."
},
{
"speaker": "Brian Meredith",
"text": "Yes, thanks. A couple of quick questions here. First, the decline you saw in your property cat reinsurance I'm assuming that was just reduction in Florida exposure. And I guess, on that question what does your Southeastern kind of Gulf exposure look like today versus last year?"
},
{
"speaker": "Marc Grandisson",
"text": "It's down versus last year. But the first question on Florida we had some decrease in flow. But if you look at premium it's not as -- it's not a one-to-one thing Brian. I think that the reduction was also as a result of buying a few things to if you will round of the portfolio. So it's not necessarily all like, because if we get into this market trying to get our net exposure to a different level because of returns we use also some reinsurance buying to take care. So it's not only Florida decrease."
},
{
"speaker": "Brian Meredith",
"text": "Got you. Got you. And then my second question, is now that the Watford deal is closed. It is in some private hands no longer a public company. Any material or any meaningful changes in strategy here that you're anticipating with Watford here going forward different types of business they could write et cetera et cetera?"
},
{
"speaker": "Francois Morin",
"text": "Yes, I'd say at a high level I mean still early days but at a high level I think you should think more of Watford, as a closer clone to Arch Re business or underwriting than what Watford was. Watford was -- didn't necessarily do all the same classes of business was very much focused more on the longer-tail stuff because of the additional pick up the assumptions that were in terms of investment returns that we're going to get. So, the call it the 2.0 business model of Watford makes it more similar to what the Arch Re portfolio or book looks like."
},
{
"speaker": "Brian Meredith",
"text": "Got you. So, results should actually trend towards ultimately trend towards what Arch Re looks like?"
},
{
"speaker": "Francois Morin",
"text": "Much more so correct. Yes."
},
{
"speaker": "Brian Meredith",
"text": "Got you. And then I'm just curious on Watford, is there ability or any contemplation of maybe kicking on some of your mortgage insurance exposure going forward?"
},
{
"speaker": "Marc Grandisson",
"text": "We actually write some mortgage on Watford. Yes there is some already existing. It's actually been one of the things they've done for quite a while. That's also something that the Watford shareholders were very pleased with giving them the opportunity to participate."
},
{
"speaker": "Francois Morin",
"text": "The only -- I mean that's an issue with ratings too like Brian. So, that's something that the ratings do matter for in terms of getting GSE and regulators comfortable. So, that's something that they're going to look into as well."
},
{
"speaker": "Brian Meredith",
"text": "Great. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions. I'd now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks for everyone to be here and listen to our call and we're off to Cup Match and we'll talk to you next quarter. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 1 | 2,021 | 2021-04-28 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the first quarter 2021 Arch Capital Group Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also, will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin.
Marc Grandisson: Thanks, Liz. Good morning, and thank you for joining our earnings call for the first quarter of 2021. The power of Arch's diversified strategy is evident again this quarter as we have strong underlying earnings across our 3 operating divisions and a 7.8% operating ROE despite the cat events. Pricing is attractive in almost all of our insurance markets and more than meets our cost of capital thresholds. As a result, we expect the next several quarters to continue to show improved underwriting margins, partially due to the compounding of rate-on-rate increases and the rebalancing of our mix. Importantly, the market is showing discipline in maintaining its momentum and the recent cat losses are likely to keep upward pressure on rates. Our 3 primary areas of focus for 2021 are: one, continuing our growth in the sectors where rates allow for returns that are substantially more than our cost of capital; two, optimize our MI mortgage insurance book as it transitions from forbearance to recovery on its way back to normalcy in the next few quarters, our notices of default are leveling and the quality of recent production is excellent; three, actively managing our investments and capital to enhance our returns over the longer run. The past quarter, P&C premium renewal rates increased across a broader spectrum of lines, including several that did not show movement as recently as the third quarter of 2020. We also expect to see exposure growth as the economy recovers more fully, which, in turn, should further spur increased revenues and profit. On the MI front, housing has emerged as one of the stronger economic sectors due to a combination of positive house price appreciation with good affordability for homeowners. Although mortgage interest rates have increased modestly, they remain low compared to historic levels and continue to fuel strong demand for the purchase market. Finally, it's worth noting, and Francois will cover in more detail, that there's also some good news on the investment side as yields have increased slightly in 2021. For Arch, every 25 basis points increase in yield should've result in about a 50 basis point increase in our return on equity. Now let's dive into the businesses a bit more. Turning first to P&C insurance. We are very optimistic about the prospects across our specialty insurance group for 2021. This past quarter, the higher level of premium earned from the post-2019 written period is one of the main reasons why our underlying combined ratio continued to improve. About 2/3 of the improvement was due to lower loss ratios as a result of the impact of rate increases as well as to underwriting actions we have taken over the past several years. The other 1/3 of the improvement was driven by a lower expense ratio. In Q1, we observed a plus 11% rate increase on a global basis, solidifying the momentum for improving margins in P&C. We are now in the fifth consecutive quarter of rate increase in excess of loss cost as evidenced by our current underlying combined ratio of 93.3% versus 97.1% in the same quarter last year. Adding to the rate improvement already mentioned, we've seen lower claims activity over the last 4 quarters. Nevertheless, we continue to be prudent by maintaining what we believe to be an appropriate safety margin in our reserving approach. One of our key principles is that we are cautious when recognizing favorable news but react quickly to adverse signs in the data. Next, on to our reinsurance segment. We had another quarter of improving profitability fundamentals. Our trailing 12-month accident year combined ratio ex cat has improved significantly from a year ago. We again had a meaningful increase in net premium written of 25%. In the first quarter, we estimate that our effective rate change or rate over trend was roughly plus 8%. As with insurance, we expect these rate improvements to continue to be reflected in our underwriting results for the next several quarters. As you can see from our total premium growth in property over the last year, we continue to believe that risk-adjusted returns are more favorable in a non-cat XL property arena. Our reinsurance group incurred $146 million of cat losses in the quarter, which was within our expectations given the type of event and where we have historically positioned our property cat exposures. Let me explain a bit more. Strategically, we allocate more catastrophe capital towards homeowners and smaller commercial portfolios because we believe, one, they have homogeneous risk characteristics; two, the data used to model their exposure is of better quality; and three, policy language tends to have less variability than with larger commercial exposures. We believe that there is less uncertainty in the expected cat load of homeowners and smaller commercial portfolios. As a consequence of this portfolio construction bias, on a medium-sized storm such as Uri, at between $14 billion and $16 billion in losses that affects personal lines more markedly, we would expect our market share to be around 1%. And last, but certainly not least, mortgage. Overall, our mortgage group is very well positioned to produce good earnings as a reinvigorated U.S. housing market is promising in 2021 and beyond. In the first quarter, Arch MI U.S. new insurance written was $27 billion, around 60% above the same period last year and new loan originations are tracking towards another very strong year. As you know, last year saw a refinancing boom, which meant significant turnover in our insurance in force. Our first quarter annualized persistency was up from the 54% we experienced over the last 12 months as interest rates rose earlier this year. If mortgage rates continue to rise, we would expect persistency to gradually return to the longer-term range of 75%, which will be a net positive as we would hold more of the recent higher credit quality, higher risk-adjusted return portfolio on our books for longer. Looking next at our delinquency inventory, we still expect a large portion to cure based on many factors, including the strong equity position of our current DQ inventory. 94% of delinquent policies have over 20% of equity. We also had good news in March as the run rate for new notices of default was nearly back to 2019 levels at about 10,000 new annuities per quarter. Outside of the U.S., we increased our writings in Australia as the housing market remains strong there. We like the long-term opportunity in Australia as demonstrated by our announcement to acquire Westpac's LMI business in March. The agreement allows us to free up capital even as we build our Australian presence and diversify our earning streams at attractive risk-adjusted returns. To borrow a sports analogy for this quarter, with a nod to our friends at Coface, this market feels a little like the last legs of the Tour de France. We just went through the muteness section, came out among the leaders and a lot of writers struggle to keep pace. Now as we roll towards Paris, we can continue to build on our lead while remaining mindful of protecting our position and energy. We can go all out and be reckless at several stages as several stages of the race remain. However, our team is in great shape. We have many great writers working together to ensure we're ultimately smiling in that beautiful yellow jersey on the [indiscernible]. As usual, our focus is on finishing the race with grace and winning for our sponsors, our shareholders. Now I'll turn it over to Francois.
Francois Morin: Thank you, Marc, and good morning to all. Thanks for joining us today. On to the first quarter results. As a reminder, and consistent with prior practice, the following comments are on a core basis, which corresponds to Arch's financial results, excluding the other segment, i.e., the operations of Watford Holdings Limited. In our filings, the term consolidated includes Watford. On the transaction, we announced late last year to acquire Watford in partnership with Warburg Pincus and Kelso. To use Marc's cycling analogy, our team has been peddling hard in anticipation of the closing, and we are down to the last few kilometers before we reach our final destination. I will provide a bit more color on its status in a few minutes. As you will have seen by now, we had a very solid quarter despite the severe winter storms with after-tax operating income for the quarter of $239.8 million, or $0.59 per share, and an annualized 7.8% operating return on average common equity. Book value per share increased to $30.54 at March 31, up 0.8% from last quarter. In the insurance segment, net written premium grew 20% over the same quarter 1 year ago, 28.4% if we exclude the impact of the pandemic on our travel, accident and health units. The insurance segment's accident quarter combined ratio, excluding cats, was 93.3%, lower by 380 basis points from the same period 1 year ago. The improvement in the ex cat accident quarter loss ratio reflects the benefits of rate increases achieved over the last 12 months and changes in our mix of business. In Addition, the expense ratio was lower by approximately 80 basis points since the same quarter 1 year ago, primarily due to the growth in the premium base. As for our reinsurance operations, we also had strong growth of 25.3% in net written premium over -- on a year-over-year basis, 40.8% if we adjust for an $88 million loss portfolio transfer that was recorded in the first quarter of 2020. The growth was observed across most of our lines, but especially in our property, other than property catastrophe line, where strong rate increases and a few new accounts helped increase the top line by 84.3%. The segment's accident quarter combined ratio, excluding cats, stood at 84% compared to 91.3% on the same basis 1 year ago. Once we normalize for the onetime impact of the loss portfolio transfer, the improvement in the ex cat accident year combined ratio was 590 basis points, which is almost entirely attributable to a corresponding improvement in the loss ratio. The overall expense ratio remained relatively unchanged, again after adjusting for the LPT. Losses from 2021 catastrophic events in the quarter, net of reinsurance recoverables and reinstatement premiums stood at $188.3 million, or 10.5 combined ratio points, compared to 7.4 combined ratio points in the first quarter of 2020. These were primarily as a result of the North American winter storms Uri and Viola in February and consistent with our earnings pre-announcement 2 weeks ago, close to 80% of the losses came from our reinsurance segment with the rest attributable to the insurance segment. We remain comfortable with our level of loss reserves for COVID-19 claims, which remained essentially unchanged from prior estimates. Approximately 65% of the inception-to-date incurring loss amount sits within our incurred but not reported IBNR reserves or as additional case reserves within our insurance and reinsurance segments. The key performance indicators we track to help us assess the ultimate impact of COVID-19 on our mortgage segment keep trending in a favorable direction. Chief, of course, being the delinquency rate, which came in at 3.86% at the end of the quarter. Arch MI had another excellent quarter in terms of production. And with refinance activity leveling off from prior peaks, we saw our insurance inform remain relatively stable with an increase from our international book, offset by a small decrease in our U.S. MI book. The combined ratio for this segment was 42.4%, reflecting the lower level of new delinquencies reported during the quarter. Both the loss and expense ratio were slightly lower than the pre-pandemic levels experienced in the same quarter 1 year ago. As a reminder, I wanted to remind everyone of the seasonality that exists in the reporting of operating expenses across our underwriting segments, investment expenses and at the corporate level. Given all incentive compensation decisions, including share-based awards get approved by our Board of Directors in February of each year, the first quarter has generally been the quarter with the highest level of operating expenses, and we do expect the current year to follow this pattern. Overall, with the underlying improvements in both of our P&C segments, and mortgage segment fundamentals returning to pre-pandemic levels, we are excited by the prospects for each of the 3 legs of our stool. Our objective to deliver a well-balanced return to our shareholders with meaningful contributions from each of our underwriting segments should become more and more apparent as we move forward. I've kept my segment-level comments a bit shorter than usual in order to give a bit more color on the performance of our investment portfolio this quarter and on the new line in our income statement titled, income loss From operating affiliates. As regards to the investment portfolio, total investment return for the quarter was a negative 18 basis points on a U.S. dollar basis. Our defensive positioning with a short duration and limited credit exposure relative to our benchmark helped us withstand headwinds we experienced on the heels of an 80 basis point increase in the 10-year treasury rate during the quarter, which was a main factor in the negative 56 basis point price return on our portfolio during the quarter. Net investment income was $78.7 million during the quarter, down 9.3% on a sequential basis. This decrease, while certainly affected by lower available interest rates and higher investment expenses due to incentive compensation payments and investment management fees, is also very much the result of deliberate portfolio actions taken over the last few quarters. Specifically, we continue to maintain a short duration on our portfolio, 2.71 years at the end of the quarter, based on our internal view of the risk and return trade-offs in the fixed income markets. We also continue to deploy additional capital to an alternative investments, the returns from which are generally not reflected in investment income. Finally, we also transformed some short-term investments this quarter into our 29.5% equity ownership in Coface as well as an investment in corporate-owned life insurance policies. Again, both items whose returns are included in operating income, but are not reflected in net investment income. Equity and net income of investment funds using the -- accounted for using the equity method, and realized gains from nonfixed income investments returned approximately $154 million during the quarter and were key contributors to the growth in our book value. Now on to income from operating affiliates, which we are including in our definition of operating income. This quarter, in addition to our share of the quarterly results of investments we have made in operating affiliates, being primarily those from Premia Holdings at this time, we also benefited from an initial nonrecurring gain we made at closing of our acquisition of a 29.5% ownership stake in Coface for approximately $74.5 million. Consistent with our accounting policy under equity method accounting, we will report our investment in Coface on a quarter lag. As regards to Watford transaction, shareholder approval was obtained in late March, and we are awaiting a few final regulatory approvals before we can close the transaction, hopefully, over the next few weeks. As we disclosed earlier, we expect our ownership of Watford to increase to 40% at closing. The effective tax rate on pretax operating income was 10.6% in the quarter, reflecting changes in the full year estimated tax rate, the geographic mix of our pretax income, and a benefit from discrete tax items in the quarter. We currently estimate the full year tax rate to be in the 10% to 12% range for 2021. Turning briefly to risk management. Our natural cat PML on a net basis decreased to $778 million as of April 1, which had approximately 6.7% of tangible common equity remains well below our internal limits at the single event 1-in-250-year return level. Our peak zone across the group changed from the Florida tri-county area to the northeast, reflecting our view of better opportunities given the current rate environment. Our balance sheet remains strong. And our debt plus preferred leverage stood at 22.1% at quarter end, well within the reasonable range. On the capital front, we repurchased approximately 5.3 million shares at an aggregate cost of $179.3 million in the first quarter. Our remaining share repurchase authorization currently stands at $737.3 million. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions] Our first question comes from Phil Stefano, Deutsche Bank.
Phil Stefano: So the idea of rate adequacy is something that's gotten a lot of airtime with people focusing on the second derivative of the pricing move. I was hoping you could just talk about how you see rate adequacy from your perspective. Primarily, it's an insurance question, but reinsurance would be appreciated as well. In my mind, it feels like the messaging is that exposure growth will help to carry the baton, I don't know how to put that into a biking analogy. But move to the front from the tailwinds of pricing that we've seen and push forward to the next leg.
Marc Grandisson: Yes. It's a good question. I'll try not to steer away from the cycling analogy myself. I think very -- at a very high level, the rates keep on being really, really healthy. 11% is above the loss cost trend, as we mentioned earlier. We started seeing this last year in the first quarter. So we're in the second round, if you will, of round of rate increases. While we had some rate increases last year and those policies that are currently being renewed and whirring in the first quarter, had another set of rate increases. So I think where we are right now, the market is really -- psychologically, the market is in rate increases minded and being careful in the way to deploy capital. And I think if you look back at where we came out 18, 19 years, where combined ratio was in the way it's been developing and trending for the last 6 quarters, I think, the story tells itself. The fact that we are indeed getting rate-above-loss cost trend, and that also finds its way into our combined ratio on a quarterly basis. There's more to go. We put our first quarter prime last year. There's another -- the first coat of paint this year. We'd be surprised that we have another coat to paint given over the next several quarters. It remains to be seen how much more it will be. But certainly, anything we have at this point in time is -- helps improving the margins.
Phil Stefano: Okay. And switching gears a bit to look at mortgage. The incident rate assumptions were high single digits, something like 8%, 9%, as we talked through the second half 2020 results. Can you just let us know where about you're looking at booking that now? And maybe weave in some of the -- some additional color commentary around what exactly it means optimizing our MI book as we kind of migrate from the forbearance world to a more traditional operating environment.
Marc Grandisson: Absolutely. I think we have -- first, on the optimizing, we have a very substantial market share in the U.S., and we'll very soon have a very decent one in Australia as well. I think it's early to go towards the area where the better returns are. As we -- and we grew a little bit in the last half of 2020. We see the opportunity. The market is coming back to some more normalcy. So I think our game plan will be to -- as we were doing in 2019, as we were heading into 2020, to be -- rely on our best base pricing to make sure we pick the best area of the marketplace to make sure we are enhancing the returns as we go forward. In terms of NODs, our roll rate for the new NODs this quarter -- if you remember, last quarter, it was 9.4%. This quarter, we booked it for the U.S. MI at 9.1%. So it's slightly better than the last quarter. We did not -- we are sort of out of the predicting business of where it's going to end up at the end of the year in terms of the delinquency rate. But you see it going to 3.86% this quarter, which is way, way, way better than we would have anticipated sitting here a year ago.
Phil Stefano: Okay. Hopefully, a quick follow-up on the MI. Is there any clarity on the GSE limitations on dividends out of the operating entities? Any sense on when this will be lifted?
Francois Morin: Well, great question, Phil. There is a moratorium that's in place till the end of June. We are certainly hopeful that the moratorium will expire and not be extended. Nothing definitive. There's discussions going on, but the -- certainly, from our side, the hope is that in the second half of the year, we would be able to start dividending some of the capital from our U.S. MI operation.
Operator: Our next question comes from Elyse Greenspan with Wells Fargo.
Elyse Greenspan: My first question, on last quarter's call, you guys had alluded to, I believe, your property casualty businesses generating returns in the double digits and mortgage kind of getting back to the 15% level. Obviously, some noise in the quarter with cats and some of the investment items -- investment income items you pointed to. But do you guys broadly see your businesses generating returns on -- in the double digits and mortgage kind of around that 15% level?
Marc Grandisson: Yes. Our view has not changed in terms of expectations of what we've written from what we said last quarter, at least, very much in line.
Elyse Greenspan: Okay. That's helpful. And then on the underlying side, in your prepared remarks, right, you alluded to continuing to get underlying margin improvement. I mean you guys have done a really good job over the past few years of rejiggering the business mix, and we're seeing that come through in both insurance and reinsurance. So would that comment imply that the back 3 quarters of the year from an underlying basis would be better relative to the Q1? Was it a year-over-year comment? Just directionally, how should we think about the margins in insurance and reinsurance?
Marc Grandisson: Yes. It's all relating to the price increase that the market will push through, right, over the next several quarters. But certainly, the earnings that we are seeing currently in the first quarter, right, Elyse, some of it was at lower pricing last year. I know in the first half of the year and in the third quarter, and that kept on getting better as we went towards the end of 2020 and into 2021. So we should all, everything else being equal, expect -- and expect the margins to be expanding. And if there is more rate increases, then we should hopefully see this and -- well, nothing will -- we'll see them in the numbers right away. But certainly, the feeling and the momentum is building to get more margin improvements, yes.
Elyse Greenspan: And then in terms of mortgage, right, you guys had pointed to kind of getting back to the 35% to 45% combined ratio, 42%, [44%] in the quarter, right? So currently, within that range, based off of what you know today and the fact that you mentioned, right, the level of new notices is slowing, would you expect that the combined ratio for that business would continue to trend better during the next 3 quarters relative to what you reported in the Q1?
Francois Morin: Well, a couple of points on that. I think just to clarify the comment that I think I made was the, call it, the 35% to 45% range was meant to be more of a, call it, over the cycle, kind of a steady state, not in a stress environment kind of reasonable combined ratio. Do we feel we're kind of in that environment? Yes. Delinquencies, new notices, Marc touched on it. They're back to being roughly 10,000 orders. So that's a good sign. Could the combined ratio in the last 3 quarters of the year be lower than it was in first quarter? It could. We were not -- we don't know. I think some of it would certainly be a function of reserve releases, if there's any. We just -- again, that's -- we'll have more clarity on that once forbearance programs expire or get people come out of that. So I think at a high level, we're -- we -- the range that we put out there is -- we're still very comfortable with. Could we beat that or could we come in a bit lower? I guess we'll see when the data shows up. But certainly, yes, it's not inconceivable.
Elyse Greenspan: Okay. And then one last one on the FHFA this morning announced on new refi options for low-income families. Could you just help us think about how that could impact your -- the back book within your mortgage insurance portfolio?
Marc Grandisson: Yes. I think the -- to me, all the questions about the FHA, the FHFA and all the various government policy that could be put out there. I think we're only receiving it and react to it. And what we have at heart is a -- our risk-based pricing is really making sure that we're allocating capital and supporting the policies that meet our threshold, return thresholds. I think that we still believe that the -- even though there are some push to become -- get more affordable housing available to folks, which we're encouraging, there's still a very healthy level of appreciation for the risk in Washington. So we're not overly concerned with that. And most of the targeted markets that are towards -- that these policies are geared towards would be the lower FICO and most likely the higher LTVs, which is not typically where we are more -- most competitive and most focused on at this point in time. So we're not losing sleep over this, Elyse.
Operator: Our next question comes from Jimmy Bhullar with JPMorgan.
Jimmy Bhullar: I had a couple of questions. First, on the MI business. I think my speaker's on, let me see if I could turn it off. So first on the MI business. Can you talk about -- delinquencies, obviously, have improved a little bit, but they're still fairly elevated. And it seems like a lot of this has to do with this government forbearance programs versus actual hardship on the part of the borrower. But if you could just talk about what your view is, and you addressed a little bit of that in your comments about equity and homes and stuff. And then secondly, on your COVID-related reserves. I think last quarter, you gave a number that around 70% or so were still in IBNR, and you haven't had much in the way of additional losses recently. So just wondering what the likelihood is that, that number might be overly conservative now given the economy is opening up and the chances of reserve release is related to those.
Marc Grandisson: Yes. On the forbearance, clearly, well, I would have a different spin on you than you would have, obviously, on the delinquency rate. At 3.86%, I think, it's a pretty good place to be. We're not still out of the COVID, so the potential issues that could develop. Now it's looking very, very good, obviously, but we're still not out of it completely. Of the 3.86%, right, 2/3 of our delinquencies are actually in the forbearance program. And of those who are in those forbearance programs delinquency, 90% -- 94% of them actually have more than 10% of equity. So yes, there is -- this counts, the delinquency count staying in the inventory. We still have an extension of the forbearance moratorium until the end of June extended to -- for -- potentially could be extended. And that's all with the idea that the GSEs and sort of the government agencies want the homeowners to get back on their feet. So it's helping. It's maintaining a little bit higher level of uncertainty because the forbearance is still there. You still don't know 100% how they're going to turn out. But we still have many cures that had -- that occurred out of the forbearances that were put in there back in April or May of last year, right? 2/3 of them or fewer are now back into current being current. So on one hand, yes, it shows as a higher number in terms of delinquency. But when you look at being 2/3 forbearance program, which is very helpful for the homeowners on the heels of a high level of equity, this is, all things considered, a very reasonable place for us to be. And we think it's going to get -- most likely get better throughout the end of the year and go back to way we saw core delinquency, which is at 1.4% or 1.35%, which is more like what we have historically seen, at least, as of late as of the end of 2019. I'll ask Francois to answer the COVID question.
Francois Morin: Yes. And Jimmy, on the COVID, yes, I mentioned it quickly, I think, we're still at 65% in IBNR and ACRs through the end of the quarter. Are we redundant? I mean, again, it's early for us to have a view. I mean whether that mean what we accrued on our reserves is going to hold up. I think we're -- again, we're very comfortable that we've got a prudent provision for COVID-related claims, but it's going to take a while for everything to settle out. And from that point of view, I would think that a lot of our reserves will probably stay in IBNR for quite some time, and we'll see from there.
Operator: Our next question comes from Josh Shanker with Bank of America.
Josh Shanker: A quickie and a longer one. The quickie is, so I understand that the expenses are elevated in the first quarter. But first quarter '20 didn't have the same elevated expenses. Can you talk about what was exceptional in that quarter? And why maybe, I'm thinking going forward, we should -- how we should think about 1Q expenses?
Francois Morin: Well, two things I'd say. One is, I encourage everyone to compare the first quarter 2020 expense ratio and operating expenses compared to the last 3 quarters of 2020. And there's a quite -- there's a good differential there. So that, I think, is -- that's what I was trying to refer to and recognize that there's -- what we saw in Q1 is -- '21, we don't expect is going to reoccur or is going to be the going forward rate. This quarter, a little bit more -- I mean, I don't want to get too much in the weeds, but there's a couple of things that, I think, impacted this quarter's results. One is, call it, short-term bonus-related compensation where we have a process where we accrue bonuses throughout the year and what we think is going to happen and when they get finalized in February, the following year, then there's a true up. And last year, based on where we were in the first -- certainly the first 6 to 9 months of the year, we slowed down our accruals a little bit because we didn't think that the performance would be there, and it turned out to be actually not as bad as we had thought at the time. So there's -- effectively, this quarter, there's a bit of a catch-up on the, call it, the bonus accrual that came through. So I call that a bit -- a one-off. And second, there's -- on the equity side, there's -- and performance shares that were introduced 3 years ago. Last year was the first time that -- or this year their first time they actually vested. And there's a final calculation that came through this quarter. And while we accrued for it, it's never quite perfect and we do our best. But it's a bit of a catch-up going on this quarter as well here. So I'd say those are the kind of two things I'd point you to. I think it's OpEx, we manage those. We track them very carefully. And unfortunately, there's a bit of noise from quarter-to-quarter. But as we look forward for the rest of the year, I think, we're very confident that they're going to trend down from the current level.
Josh Shanker: Okay. Great. And that's -- the second question is -- this is the back of the envelope calculation. Maybe I'm not exactly right. But it looks to me that you're carrying right now about $20,000 worth of reserves per mortgage default -- mortgage and default. And if I look back before the pandemic, you were like a little bit higher, maybe '21, but kind of your back to the same reserve per notice that you were before the pandemic. When I think about the pool of mortgage and default that you have right now, my thoughts would be that a higher probability of those are going to cure than in run rate conditions when people go into default. Am I wrong to think that? Do you think that when you think of the pool that the percentage that are going to cure is normal to history? Or do you think a higher percent will cure or higher will go into claim given the amount you're carrying for reserves? I guess there's a lot in there, but maybe give us some thoughts.
Marc Grandisson: Yes. I think, Josh, I think, to that probably a shorter answer than you might expect, actually. The fact is that it's very uncertain, and we took -- we did take -- we believe we've taken conservative, at least prudent numbers to put the reserve because of -- due to the tremendous uncertainty surrounding what was going to happen, however long the forbearance would take place, what would be in place, what would the economy turn around? How long would COVID last? And frankly, we're still -- again, like we said to you, Josh, we're still not out of the wood. So we have taken -- not only us, I think, as an industry, people have taken a somewhat prudent approach to reserving. You're right. We should expect, everything else being equal, and forbearance programs in the past have showed us that when you had an 8% ultimate claims rate on a regular delinquency. When you compare to the forbearance through a cat event, for instance, that is -- that would be sort of a 1% to 2% ultimate claims rate, but we decided to be a bit more careful and prudent in establishing reserve. And I would say that we haven't really changed our mind quite yet. I think we've also put a moratorium on our revising our prior reserves, and we'll see where the data takes us for the next several quarters. And I hope that your assumption on the back of the envelope is right. And I hope that we prove to ourselves that it was, yes, indeed, a regular -- a more of a regular forbearance phenomenon in terms of curing than more of a regular DQ phenomenon.
Josh Shanker: Is there a time line for when that moratorium ends? Or is that a subjective item?
Marc Grandisson: On our reserving, we -- I think -- I actually looked at the CFO, I think, they're pretty difficult. And I think we just have to take several more quarters. I don't think we're quite ready yet for that. I would expect, Josh, over the next 2, 3 quarters, it's certainly inflecting a lot quicker than we would have anticipated back in third quarter of 2020. So we're like you seeing things well, at some point, we'll need to be as we are, typically, well, when we have solid data to back it, we'll take action at that point in time. And I'm hoping that it's over the next 3 to 4 quarters.
Operator: Our next question comes from John Collins with Dowling & Partners.
Geoff Dunn: It's actually Geoff Dunn. Two questions. One, just back on the provision this quarter from MI. Can you share the average severity assumption that went along with the 9/1 incidents? I think it was about $54,000 last quarter.
Marc Grandisson: $4,800.
Geoff Dunn: What was the total severity factor?
Marc Grandisson: 9.1%? Is that the one you're looking at?
Geoff Dunn: I'm sorry. So $4,800 was the actual vision and then [indiscernible]
Marc Grandisson: Have a reserve for annually. Yes. Yes.
Geoff Dunn: Okay. Perfect. And then secondly, Francois, you mentioned looking for dividends in the back half of the year from MI. How do you think about the capacity there, given that the surplus levels at both the primaries are down to about $200 million at year-end?
Francois Morin: Well, we've got room. That's for sure. The one thing that is a factor for us, and I'm sure many of the peers is contingency reserves. So there is a -- right? So it's not purely, I'd say, PMIs driven. There is an EIC constraints around the amount of dividends that we can declare based on contingency reserves and the 10-year time of that. So while -- on the face of it, you might say, "Oh, 190% PMI ratio, there's tons of capacity." We have some, and we're happy with it. But no question that we'll have to go through a bit more modeling and figure out how much we could move out. And then there's other sources for the -- for those funds. But ballpark, a couple of hundred million, I think, is easily -- assuming we get the approval from both the FHFA, the GSEs and the right -- the state regulators. And then if we can get more, we'll certainly try and do so.
Geoff Dunn: So when you say a couple of hundred million, does that assume that you can convince the regulators to let you release contingencies earlier? Or do you think you can bleed surplus down below $100 million at each of the operating companies?
Francois Morin: Well, no, we think, we -- it's -- we would be within -- we wouldn't do anything, any special dividends from the regulators. It'd be very much within what's allowed from the regulatory point of view.
Operator: Our next question comes from Brian Meredith with UBS.
Brian Meredith: A couple of questions here for you. First, Marc, I'm just curious, now that Watford is going to be -- I guess, you own 40% of it. If you look at kind of the model there, it's a little different in the model you typically deploy in your traditional business. Combined ratio is well above 100%. Is there any thoughts to maybe changing the strategy there a little bit? Or are you going to keep the same one? And then as you book those numbers, are you going to assume those realized gains are kind of going through your operating results?
Marc Grandisson: Yes. I'll let the second question to Francois. But the first part, Brian, is, I think, that, first, we have 40%, so we're not majority, so there's a Board of Directors. But I do believe that at heart, this is a harder market. This is a good market on the underwriting side. And I think that collectively, we believe that there is an opportunity to maybe focus more the risk or the effort of the capital towards the underwriting as opposed to the investment side of things, but this will have to take place over time, right? We'll have to also talk to our -- to the partners that are currently in Watford and see what expectations they have in the return. So this is an ongoing discussion. But at a high level, right, I think, that we should expect Watford to become a little bit more strategic from an opportunistic positioning right now at this point in the cycle based on the opportunities that we have right now. I think that the reliance on investment income was probably more in favor back in 2014, 2015.
Francois Morin: And quickly on part 2 of your question, Brian. The -- listen, with the acquisition, it opens up, I call it, a little window for us to take a harder look at accounting policies. And what you mentioned around realized gains is something that we'll look at as well in the -- at closing. I mean we were already looking at it. I mean it's just a matter of -- we got a few documents and agreements that need to get finalized. But we'll be -- we'll make sure we communicate to you exactly how -- if things are going to change, how they're going to impact our financials.
Brian Meredith: Great. And then, Marc, my second question is, some of the, I guess, calls we've heard so far from the insurance brokers this quarter, have highlighted the fact that new business has gotten competitive. Renewals, companies still try to raise prices, but new business is getting much more competitive. I'm just curious, are you seeing that. And what does that potentially mean for the kind of length and duration of the cycle? Are we getting towards the end when that happens?
Marc Grandisson: No, I don't think so. I think that the -- some comments were made as well, Brian, about the E&S market, so they've been vibrant, which is a good sign of not dislocation, but really a renewed or a new underwriting appetite by the Main Street writers. That's not going away. In new business, it's normal to be expected, right? I think we went through the first year from underwriting, shuffling and readjusting to the new underwriting policy to now, well, let's say, what do we have and what do we want to focus on in terms of new business and maybe seek and grow that. And frankly, all of us here, right, Brian, talk about how the good the market is. So I think it probably makes them a little bit more willing to take on those policies. But I think it's a hardening market. I will add that new business could be more competitive, but the rates are not going down. I mean it's not like somebody is coming to undercut, which is really the important factor here. I do believe that the new business, typically -- we were once, way, way, way back when a new player in the marketplace. And I do believe that we had pretty lofty expectation in terms of pricing, we would need to get on that piece of business. And I'm expecting -- and that's what we're saying. We're not seeing a softening from that positioning from the external world. And frankly, Brian, I mean, the existing players are not growing so significantly that it's creating a lot of competition necessary, right? The new business is probably -- probably needs to find a new home with new players. So that's not that surprising. So I wouldn't lose -- I'm not losing sleep over this. Hard market does not last forever as you can appreciate. But we're already in the second round of this. I wouldn't be surprised we have another round to go. And even after that, Brian, it takes a bit longer for things to get softer yet again to the point of not getting the returns. So we have win our sales for a little while here.
Brian Meredith: Great. And then one just last quick one here. I noticed your construction and national accounts business finally started to grow, again, in the first quarter. Is there anything unusual there? Or is that something that we should see picking up growth as the economy improves?
Marc Grandisson: I think a couple of things. I think seeking quality accounts. There's still some shuffling of accounts around. Some people are debating what to do, stay with clients. We're able -- we have a very good product offering both on these instances. And this is -- these are 2 areas actually where -- I referred to in my comments where that didn't seem to be moving a whole lot. And then we're seeing, finally, for the first time and on rates moving in the right direction. As you can appreciate, right, a lot of it is work is comp-driven, but it's still -- we can still see clients working with us as we evidence the lack of interest in investment income, some COVID exposure. So I think we're seeing some good traction there and still offering good product. But we have to be careful obviously. We're here of the long haul. This is a franchise positioning for us. It's a little bit of everything. It's a really good story for us, and I'm glad you picked that up, Brian.
Operator: Our next question comes from Derek Han with KBW.
Derek Han: So my first question is, you talked about strong pricing and new accounts driving growth in the property business line within reinsurance. How are you thinking about the loss trends in that line of business, both in reinsurance and insurance?
Marc Grandisson: Yes. So very much with the same way we would the other lines of business, Derek, where we would look at the history of the loss cost and modeling out in terms of specifically talking about cat loss specifically. Just looking at the cat history of these accounts that are similar. If it's a reinsurance portfolio then it's the experience on the portfolio. And build in some modeling magic, I would call it, based on our own expectations of demand surge or maybe some on-model perspective. And we just price it this way to make sure we have a healthy level of margin. And it's really nothing new from what we've had historically. I think on property, the one beautiful thing about property is the feedback loop is a lot quicker as opposed to a GL portfolio where it may take you 4, 5, 6, 10 years sometimes to really figure out whether you did the right thing and you price your goods at the right level, property allows us to do a lot of repricing. And right now, our ability to grow in that lines of business is because we're also willing and able to go anywhere on the reinsurance side for that matter in terms of core share or risk access where some of the other players out there could be a little bit more reluctant to go. And just one thing you have to keep in mind when you price for business and property, you can't just take the last data point and say, this is going to be the recurring one. You have to take a small -- a longer-term period with the proper caveat on the margin for safety to price. So I'm trying to give you a 25-year knowledge base in 5 minutes, I'm not sure I'll be doing that great. But I think, hopefully, it gives you a good flavor for it.
Francois Morin: Yes. And -- but the only thing I'd add to that, I think, there's certainly been a lot of press in the last few weeks and months around building materials, costs going through the roof in some areas. So that's certainly something that our underwriters are fully aware of and fully engaged in adjusting their view of price as they trend. And so that's part of the underwriting decision when you're in some parts of the country where cost of materials, whether through shortage or just a lot of significant demand, I think, that is impacting the trends or the pricing that we're trying to get on the product. So I'd say that's maybe a bit more on the insurance side, more direct, but I think it's a bit of a something that is more top of mind currently.
Derek Han: That's really helpful. And then I have a quick second question. There was a sequential increase in the MI G&A ratio. Was that all incentive comp?
Francois Morin: Well, there's a couple of things. I mean, sequential, there's always -- Q1 is, yes, there's current, but there's also -- and it gets very granular around payroll taxes. And there's other things that we're just -- we pick up more of those expenses in the first quarter, and they do decrease over time throughout the year. So I'd say, yes, for the most part, is -- incentive comp is a big part of it, but there's also a few other things that just enhance that or make it stand out a bit more. But again, from our point of view or your point of view, you should fully expect a return back to a lower level and starting in the second quarter.
Operator: I'm not showing any further questions. I'd now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thank you for joining us this morning, and we're looking forward for better news, hopefully, in the second quarter.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the first quarter 2021 Arch Capital Group Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also, will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks, Liz. Good morning, and thank you for joining our earnings call for the first quarter of 2021. The power of Arch's diversified strategy is evident again this quarter as we have strong underlying earnings across our 3 operating divisions and a 7.8% operating ROE despite the cat events. Pricing is attractive in almost all of our insurance markets and more than meets our cost of capital thresholds. As a result, we expect the next several quarters to continue to show improved underwriting margins, partially due to the compounding of rate-on-rate increases and the rebalancing of our mix. Importantly, the market is showing discipline in maintaining its momentum and the recent cat losses are likely to keep upward pressure on rates. Our 3 primary areas of focus for 2021 are: one, continuing our growth in the sectors where rates allow for returns that are substantially more than our cost of capital; two, optimize our MI mortgage insurance book as it transitions from forbearance to recovery on its way back to normalcy in the next few quarters, our notices of default are leveling and the quality of recent production is excellent; three, actively managing our investments and capital to enhance our returns over the longer run. The past quarter, P&C premium renewal rates increased across a broader spectrum of lines, including several that did not show movement as recently as the third quarter of 2020. We also expect to see exposure growth as the economy recovers more fully, which, in turn, should further spur increased revenues and profit. On the MI front, housing has emerged as one of the stronger economic sectors due to a combination of positive house price appreciation with good affordability for homeowners. Although mortgage interest rates have increased modestly, they remain low compared to historic levels and continue to fuel strong demand for the purchase market. Finally, it's worth noting, and Francois will cover in more detail, that there's also some good news on the investment side as yields have increased slightly in 2021. For Arch, every 25 basis points increase in yield should've result in about a 50 basis point increase in our return on equity. Now let's dive into the businesses a bit more. Turning first to P&C insurance. We are very optimistic about the prospects across our specialty insurance group for 2021. This past quarter, the higher level of premium earned from the post-2019 written period is one of the main reasons why our underlying combined ratio continued to improve. About 2/3 of the improvement was due to lower loss ratios as a result of the impact of rate increases as well as to underwriting actions we have taken over the past several years. The other 1/3 of the improvement was driven by a lower expense ratio. In Q1, we observed a plus 11% rate increase on a global basis, solidifying the momentum for improving margins in P&C. We are now in the fifth consecutive quarter of rate increase in excess of loss cost as evidenced by our current underlying combined ratio of 93.3% versus 97.1% in the same quarter last year. Adding to the rate improvement already mentioned, we've seen lower claims activity over the last 4 quarters. Nevertheless, we continue to be prudent by maintaining what we believe to be an appropriate safety margin in our reserving approach. One of our key principles is that we are cautious when recognizing favorable news but react quickly to adverse signs in the data. Next, on to our reinsurance segment. We had another quarter of improving profitability fundamentals. Our trailing 12-month accident year combined ratio ex cat has improved significantly from a year ago. We again had a meaningful increase in net premium written of 25%. In the first quarter, we estimate that our effective rate change or rate over trend was roughly plus 8%. As with insurance, we expect these rate improvements to continue to be reflected in our underwriting results for the next several quarters. As you can see from our total premium growth in property over the last year, we continue to believe that risk-adjusted returns are more favorable in a non-cat XL property arena. Our reinsurance group incurred $146 million of cat losses in the quarter, which was within our expectations given the type of event and where we have historically positioned our property cat exposures. Let me explain a bit more. Strategically, we allocate more catastrophe capital towards homeowners and smaller commercial portfolios because we believe, one, they have homogeneous risk characteristics; two, the data used to model their exposure is of better quality; and three, policy language tends to have less variability than with larger commercial exposures. We believe that there is less uncertainty in the expected cat load of homeowners and smaller commercial portfolios. As a consequence of this portfolio construction bias, on a medium-sized storm such as Uri, at between $14 billion and $16 billion in losses that affects personal lines more markedly, we would expect our market share to be around 1%. And last, but certainly not least, mortgage. Overall, our mortgage group is very well positioned to produce good earnings as a reinvigorated U.S. housing market is promising in 2021 and beyond. In the first quarter, Arch MI U.S. new insurance written was $27 billion, around 60% above the same period last year and new loan originations are tracking towards another very strong year. As you know, last year saw a refinancing boom, which meant significant turnover in our insurance in force. Our first quarter annualized persistency was up from the 54% we experienced over the last 12 months as interest rates rose earlier this year. If mortgage rates continue to rise, we would expect persistency to gradually return to the longer-term range of 75%, which will be a net positive as we would hold more of the recent higher credit quality, higher risk-adjusted return portfolio on our books for longer. Looking next at our delinquency inventory, we still expect a large portion to cure based on many factors, including the strong equity position of our current DQ inventory. 94% of delinquent policies have over 20% of equity. We also had good news in March as the run rate for new notices of default was nearly back to 2019 levels at about 10,000 new annuities per quarter. Outside of the U.S., we increased our writings in Australia as the housing market remains strong there. We like the long-term opportunity in Australia as demonstrated by our announcement to acquire Westpac's LMI business in March. The agreement allows us to free up capital even as we build our Australian presence and diversify our earning streams at attractive risk-adjusted returns. To borrow a sports analogy for this quarter, with a nod to our friends at Coface, this market feels a little like the last legs of the Tour de France. We just went through the muteness section, came out among the leaders and a lot of writers struggle to keep pace. Now as we roll towards Paris, we can continue to build on our lead while remaining mindful of protecting our position and energy. We can go all out and be reckless at several stages as several stages of the race remain. However, our team is in great shape. We have many great writers working together to ensure we're ultimately smiling in that beautiful yellow jersey on the [indiscernible]. As usual, our focus is on finishing the race with grace and winning for our sponsors, our shareholders. Now I'll turn it over to Francois."
},
{
"speaker": "Francois Morin",
"text": "Thank you, Marc, and good morning to all. Thanks for joining us today. On to the first quarter results. As a reminder, and consistent with prior practice, the following comments are on a core basis, which corresponds to Arch's financial results, excluding the other segment, i.e., the operations of Watford Holdings Limited. In our filings, the term consolidated includes Watford. On the transaction, we announced late last year to acquire Watford in partnership with Warburg Pincus and Kelso. To use Marc's cycling analogy, our team has been peddling hard in anticipation of the closing, and we are down to the last few kilometers before we reach our final destination. I will provide a bit more color on its status in a few minutes. As you will have seen by now, we had a very solid quarter despite the severe winter storms with after-tax operating income for the quarter of $239.8 million, or $0.59 per share, and an annualized 7.8% operating return on average common equity. Book value per share increased to $30.54 at March 31, up 0.8% from last quarter. In the insurance segment, net written premium grew 20% over the same quarter 1 year ago, 28.4% if we exclude the impact of the pandemic on our travel, accident and health units. The insurance segment's accident quarter combined ratio, excluding cats, was 93.3%, lower by 380 basis points from the same period 1 year ago. The improvement in the ex cat accident quarter loss ratio reflects the benefits of rate increases achieved over the last 12 months and changes in our mix of business. In Addition, the expense ratio was lower by approximately 80 basis points since the same quarter 1 year ago, primarily due to the growth in the premium base. As for our reinsurance operations, we also had strong growth of 25.3% in net written premium over -- on a year-over-year basis, 40.8% if we adjust for an $88 million loss portfolio transfer that was recorded in the first quarter of 2020. The growth was observed across most of our lines, but especially in our property, other than property catastrophe line, where strong rate increases and a few new accounts helped increase the top line by 84.3%. The segment's accident quarter combined ratio, excluding cats, stood at 84% compared to 91.3% on the same basis 1 year ago. Once we normalize for the onetime impact of the loss portfolio transfer, the improvement in the ex cat accident year combined ratio was 590 basis points, which is almost entirely attributable to a corresponding improvement in the loss ratio. The overall expense ratio remained relatively unchanged, again after adjusting for the LPT. Losses from 2021 catastrophic events in the quarter, net of reinsurance recoverables and reinstatement premiums stood at $188.3 million, or 10.5 combined ratio points, compared to 7.4 combined ratio points in the first quarter of 2020. These were primarily as a result of the North American winter storms Uri and Viola in February and consistent with our earnings pre-announcement 2 weeks ago, close to 80% of the losses came from our reinsurance segment with the rest attributable to the insurance segment. We remain comfortable with our level of loss reserves for COVID-19 claims, which remained essentially unchanged from prior estimates. Approximately 65% of the inception-to-date incurring loss amount sits within our incurred but not reported IBNR reserves or as additional case reserves within our insurance and reinsurance segments. The key performance indicators we track to help us assess the ultimate impact of COVID-19 on our mortgage segment keep trending in a favorable direction. Chief, of course, being the delinquency rate, which came in at 3.86% at the end of the quarter. Arch MI had another excellent quarter in terms of production. And with refinance activity leveling off from prior peaks, we saw our insurance inform remain relatively stable with an increase from our international book, offset by a small decrease in our U.S. MI book. The combined ratio for this segment was 42.4%, reflecting the lower level of new delinquencies reported during the quarter. Both the loss and expense ratio were slightly lower than the pre-pandemic levels experienced in the same quarter 1 year ago. As a reminder, I wanted to remind everyone of the seasonality that exists in the reporting of operating expenses across our underwriting segments, investment expenses and at the corporate level. Given all incentive compensation decisions, including share-based awards get approved by our Board of Directors in February of each year, the first quarter has generally been the quarter with the highest level of operating expenses, and we do expect the current year to follow this pattern. Overall, with the underlying improvements in both of our P&C segments, and mortgage segment fundamentals returning to pre-pandemic levels, we are excited by the prospects for each of the 3 legs of our stool. Our objective to deliver a well-balanced return to our shareholders with meaningful contributions from each of our underwriting segments should become more and more apparent as we move forward. I've kept my segment-level comments a bit shorter than usual in order to give a bit more color on the performance of our investment portfolio this quarter and on the new line in our income statement titled, income loss From operating affiliates. As regards to the investment portfolio, total investment return for the quarter was a negative 18 basis points on a U.S. dollar basis. Our defensive positioning with a short duration and limited credit exposure relative to our benchmark helped us withstand headwinds we experienced on the heels of an 80 basis point increase in the 10-year treasury rate during the quarter, which was a main factor in the negative 56 basis point price return on our portfolio during the quarter. Net investment income was $78.7 million during the quarter, down 9.3% on a sequential basis. This decrease, while certainly affected by lower available interest rates and higher investment expenses due to incentive compensation payments and investment management fees, is also very much the result of deliberate portfolio actions taken over the last few quarters. Specifically, we continue to maintain a short duration on our portfolio, 2.71 years at the end of the quarter, based on our internal view of the risk and return trade-offs in the fixed income markets. We also continue to deploy additional capital to an alternative investments, the returns from which are generally not reflected in investment income. Finally, we also transformed some short-term investments this quarter into our 29.5% equity ownership in Coface as well as an investment in corporate-owned life insurance policies. Again, both items whose returns are included in operating income, but are not reflected in net investment income. Equity and net income of investment funds using the -- accounted for using the equity method, and realized gains from nonfixed income investments returned approximately $154 million during the quarter and were key contributors to the growth in our book value. Now on to income from operating affiliates, which we are including in our definition of operating income. This quarter, in addition to our share of the quarterly results of investments we have made in operating affiliates, being primarily those from Premia Holdings at this time, we also benefited from an initial nonrecurring gain we made at closing of our acquisition of a 29.5% ownership stake in Coface for approximately $74.5 million. Consistent with our accounting policy under equity method accounting, we will report our investment in Coface on a quarter lag. As regards to Watford transaction, shareholder approval was obtained in late March, and we are awaiting a few final regulatory approvals before we can close the transaction, hopefully, over the next few weeks. As we disclosed earlier, we expect our ownership of Watford to increase to 40% at closing. The effective tax rate on pretax operating income was 10.6% in the quarter, reflecting changes in the full year estimated tax rate, the geographic mix of our pretax income, and a benefit from discrete tax items in the quarter. We currently estimate the full year tax rate to be in the 10% to 12% range for 2021. Turning briefly to risk management. Our natural cat PML on a net basis decreased to $778 million as of April 1, which had approximately 6.7% of tangible common equity remains well below our internal limits at the single event 1-in-250-year return level. Our peak zone across the group changed from the Florida tri-county area to the northeast, reflecting our view of better opportunities given the current rate environment. Our balance sheet remains strong. And our debt plus preferred leverage stood at 22.1% at quarter end, well within the reasonable range. On the capital front, we repurchased approximately 5.3 million shares at an aggregate cost of $179.3 million in the first quarter. Our remaining share repurchase authorization currently stands at $737.3 million. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Phil Stefano, Deutsche Bank."
},
{
"speaker": "Phil Stefano",
"text": "So the idea of rate adequacy is something that's gotten a lot of airtime with people focusing on the second derivative of the pricing move. I was hoping you could just talk about how you see rate adequacy from your perspective. Primarily, it's an insurance question, but reinsurance would be appreciated as well. In my mind, it feels like the messaging is that exposure growth will help to carry the baton, I don't know how to put that into a biking analogy. But move to the front from the tailwinds of pricing that we've seen and push forward to the next leg."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. It's a good question. I'll try not to steer away from the cycling analogy myself. I think very -- at a very high level, the rates keep on being really, really healthy. 11% is above the loss cost trend, as we mentioned earlier. We started seeing this last year in the first quarter. So we're in the second round, if you will, of round of rate increases. While we had some rate increases last year and those policies that are currently being renewed and whirring in the first quarter, had another set of rate increases. So I think where we are right now, the market is really -- psychologically, the market is in rate increases minded and being careful in the way to deploy capital. And I think if you look back at where we came out 18, 19 years, where combined ratio was in the way it's been developing and trending for the last 6 quarters, I think, the story tells itself. The fact that we are indeed getting rate-above-loss cost trend, and that also finds its way into our combined ratio on a quarterly basis. There's more to go. We put our first quarter prime last year. There's another -- the first coat of paint this year. We'd be surprised that we have another coat to paint given over the next several quarters. It remains to be seen how much more it will be. But certainly, anything we have at this point in time is -- helps improving the margins."
},
{
"speaker": "Phil Stefano",
"text": "Okay. And switching gears a bit to look at mortgage. The incident rate assumptions were high single digits, something like 8%, 9%, as we talked through the second half 2020 results. Can you just let us know where about you're looking at booking that now? And maybe weave in some of the -- some additional color commentary around what exactly it means optimizing our MI book as we kind of migrate from the forbearance world to a more traditional operating environment."
},
{
"speaker": "Marc Grandisson",
"text": "Absolutely. I think we have -- first, on the optimizing, we have a very substantial market share in the U.S., and we'll very soon have a very decent one in Australia as well. I think it's early to go towards the area where the better returns are. As we -- and we grew a little bit in the last half of 2020. We see the opportunity. The market is coming back to some more normalcy. So I think our game plan will be to -- as we were doing in 2019, as we were heading into 2020, to be -- rely on our best base pricing to make sure we pick the best area of the marketplace to make sure we are enhancing the returns as we go forward. In terms of NODs, our roll rate for the new NODs this quarter -- if you remember, last quarter, it was 9.4%. This quarter, we booked it for the U.S. MI at 9.1%. So it's slightly better than the last quarter. We did not -- we are sort of out of the predicting business of where it's going to end up at the end of the year in terms of the delinquency rate. But you see it going to 3.86% this quarter, which is way, way, way better than we would have anticipated sitting here a year ago."
},
{
"speaker": "Phil Stefano",
"text": "Okay. Hopefully, a quick follow-up on the MI. Is there any clarity on the GSE limitations on dividends out of the operating entities? Any sense on when this will be lifted?"
},
{
"speaker": "Francois Morin",
"text": "Well, great question, Phil. There is a moratorium that's in place till the end of June. We are certainly hopeful that the moratorium will expire and not be extended. Nothing definitive. There's discussions going on, but the -- certainly, from our side, the hope is that in the second half of the year, we would be able to start dividending some of the capital from our U.S. MI operation."
},
{
"speaker": "Operator",
"text": "Our next question comes from Elyse Greenspan with Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question, on last quarter's call, you guys had alluded to, I believe, your property casualty businesses generating returns in the double digits and mortgage kind of getting back to the 15% level. Obviously, some noise in the quarter with cats and some of the investment items -- investment income items you pointed to. But do you guys broadly see your businesses generating returns on -- in the double digits and mortgage kind of around that 15% level?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. Our view has not changed in terms of expectations of what we've written from what we said last quarter, at least, very much in line."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. That's helpful. And then on the underlying side, in your prepared remarks, right, you alluded to continuing to get underlying margin improvement. I mean you guys have done a really good job over the past few years of rejiggering the business mix, and we're seeing that come through in both insurance and reinsurance. So would that comment imply that the back 3 quarters of the year from an underlying basis would be better relative to the Q1? Was it a year-over-year comment? Just directionally, how should we think about the margins in insurance and reinsurance?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. It's all relating to the price increase that the market will push through, right, over the next several quarters. But certainly, the earnings that we are seeing currently in the first quarter, right, Elyse, some of it was at lower pricing last year. I know in the first half of the year and in the third quarter, and that kept on getting better as we went towards the end of 2020 and into 2021. So we should all, everything else being equal, expect -- and expect the margins to be expanding. And if there is more rate increases, then we should hopefully see this and -- well, nothing will -- we'll see them in the numbers right away. But certainly, the feeling and the momentum is building to get more margin improvements, yes."
},
{
"speaker": "Elyse Greenspan",
"text": "And then in terms of mortgage, right, you guys had pointed to kind of getting back to the 35% to 45% combined ratio, 42%, [44%] in the quarter, right? So currently, within that range, based off of what you know today and the fact that you mentioned, right, the level of new notices is slowing, would you expect that the combined ratio for that business would continue to trend better during the next 3 quarters relative to what you reported in the Q1?"
},
{
"speaker": "Francois Morin",
"text": "Well, a couple of points on that. I think just to clarify the comment that I think I made was the, call it, the 35% to 45% range was meant to be more of a, call it, over the cycle, kind of a steady state, not in a stress environment kind of reasonable combined ratio. Do we feel we're kind of in that environment? Yes. Delinquencies, new notices, Marc touched on it. They're back to being roughly 10,000 orders. So that's a good sign. Could the combined ratio in the last 3 quarters of the year be lower than it was in first quarter? It could. We were not -- we don't know. I think some of it would certainly be a function of reserve releases, if there's any. We just -- again, that's -- we'll have more clarity on that once forbearance programs expire or get people come out of that. So I think at a high level, we're -- we -- the range that we put out there is -- we're still very comfortable with. Could we beat that or could we come in a bit lower? I guess we'll see when the data shows up. But certainly, yes, it's not inconceivable."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. And then one last one on the FHFA this morning announced on new refi options for low-income families. Could you just help us think about how that could impact your -- the back book within your mortgage insurance portfolio?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think the -- to me, all the questions about the FHA, the FHFA and all the various government policy that could be put out there. I think we're only receiving it and react to it. And what we have at heart is a -- our risk-based pricing is really making sure that we're allocating capital and supporting the policies that meet our threshold, return thresholds. I think that we still believe that the -- even though there are some push to become -- get more affordable housing available to folks, which we're encouraging, there's still a very healthy level of appreciation for the risk in Washington. So we're not overly concerned with that. And most of the targeted markets that are towards -- that these policies are geared towards would be the lower FICO and most likely the higher LTVs, which is not typically where we are more -- most competitive and most focused on at this point in time. So we're not losing sleep over this, Elyse."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jimmy Bhullar with JPMorgan."
},
{
"speaker": "Jimmy Bhullar",
"text": "I had a couple of questions. First, on the MI business. I think my speaker's on, let me see if I could turn it off. So first on the MI business. Can you talk about -- delinquencies, obviously, have improved a little bit, but they're still fairly elevated. And it seems like a lot of this has to do with this government forbearance programs versus actual hardship on the part of the borrower. But if you could just talk about what your view is, and you addressed a little bit of that in your comments about equity and homes and stuff. And then secondly, on your COVID-related reserves. I think last quarter, you gave a number that around 70% or so were still in IBNR, and you haven't had much in the way of additional losses recently. So just wondering what the likelihood is that, that number might be overly conservative now given the economy is opening up and the chances of reserve release is related to those."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. On the forbearance, clearly, well, I would have a different spin on you than you would have, obviously, on the delinquency rate. At 3.86%, I think, it's a pretty good place to be. We're not still out of the COVID, so the potential issues that could develop. Now it's looking very, very good, obviously, but we're still not out of it completely. Of the 3.86%, right, 2/3 of our delinquencies are actually in the forbearance program. And of those who are in those forbearance programs delinquency, 90% -- 94% of them actually have more than 10% of equity. So yes, there is -- this counts, the delinquency count staying in the inventory. We still have an extension of the forbearance moratorium until the end of June extended to -- for -- potentially could be extended. And that's all with the idea that the GSEs and sort of the government agencies want the homeowners to get back on their feet. So it's helping. It's maintaining a little bit higher level of uncertainty because the forbearance is still there. You still don't know 100% how they're going to turn out. But we still have many cures that had -- that occurred out of the forbearances that were put in there back in April or May of last year, right? 2/3 of them or fewer are now back into current being current. So on one hand, yes, it shows as a higher number in terms of delinquency. But when you look at being 2/3 forbearance program, which is very helpful for the homeowners on the heels of a high level of equity, this is, all things considered, a very reasonable place for us to be. And we think it's going to get -- most likely get better throughout the end of the year and go back to way we saw core delinquency, which is at 1.4% or 1.35%, which is more like what we have historically seen, at least, as of late as of the end of 2019. I'll ask Francois to answer the COVID question."
},
{
"speaker": "Francois Morin",
"text": "Yes. And Jimmy, on the COVID, yes, I mentioned it quickly, I think, we're still at 65% in IBNR and ACRs through the end of the quarter. Are we redundant? I mean, again, it's early for us to have a view. I mean whether that mean what we accrued on our reserves is going to hold up. I think we're -- again, we're very comfortable that we've got a prudent provision for COVID-related claims, but it's going to take a while for everything to settle out. And from that point of view, I would think that a lot of our reserves will probably stay in IBNR for quite some time, and we'll see from there."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Shanker with Bank of America."
},
{
"speaker": "Josh Shanker",
"text": "A quickie and a longer one. The quickie is, so I understand that the expenses are elevated in the first quarter. But first quarter '20 didn't have the same elevated expenses. Can you talk about what was exceptional in that quarter? And why maybe, I'm thinking going forward, we should -- how we should think about 1Q expenses?"
},
{
"speaker": "Francois Morin",
"text": "Well, two things I'd say. One is, I encourage everyone to compare the first quarter 2020 expense ratio and operating expenses compared to the last 3 quarters of 2020. And there's a quite -- there's a good differential there. So that, I think, is -- that's what I was trying to refer to and recognize that there's -- what we saw in Q1 is -- '21, we don't expect is going to reoccur or is going to be the going forward rate. This quarter, a little bit more -- I mean, I don't want to get too much in the weeds, but there's a couple of things that, I think, impacted this quarter's results. One is, call it, short-term bonus-related compensation where we have a process where we accrue bonuses throughout the year and what we think is going to happen and when they get finalized in February, the following year, then there's a true up. And last year, based on where we were in the first -- certainly the first 6 to 9 months of the year, we slowed down our accruals a little bit because we didn't think that the performance would be there, and it turned out to be actually not as bad as we had thought at the time. So there's -- effectively, this quarter, there's a bit of a catch-up on the, call it, the bonus accrual that came through. So I call that a bit -- a one-off. And second, there's -- on the equity side, there's -- and performance shares that were introduced 3 years ago. Last year was the first time that -- or this year their first time they actually vested. And there's a final calculation that came through this quarter. And while we accrued for it, it's never quite perfect and we do our best. But it's a bit of a catch-up going on this quarter as well here. So I'd say those are the kind of two things I'd point you to. I think it's OpEx, we manage those. We track them very carefully. And unfortunately, there's a bit of noise from quarter-to-quarter. But as we look forward for the rest of the year, I think, we're very confident that they're going to trend down from the current level."
},
{
"speaker": "Josh Shanker",
"text": "Okay. Great. And that's -- the second question is -- this is the back of the envelope calculation. Maybe I'm not exactly right. But it looks to me that you're carrying right now about $20,000 worth of reserves per mortgage default -- mortgage and default. And if I look back before the pandemic, you were like a little bit higher, maybe '21, but kind of your back to the same reserve per notice that you were before the pandemic. When I think about the pool of mortgage and default that you have right now, my thoughts would be that a higher probability of those are going to cure than in run rate conditions when people go into default. Am I wrong to think that? Do you think that when you think of the pool that the percentage that are going to cure is normal to history? Or do you think a higher percent will cure or higher will go into claim given the amount you're carrying for reserves? I guess there's a lot in there, but maybe give us some thoughts."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think, Josh, I think, to that probably a shorter answer than you might expect, actually. The fact is that it's very uncertain, and we took -- we did take -- we believe we've taken conservative, at least prudent numbers to put the reserve because of -- due to the tremendous uncertainty surrounding what was going to happen, however long the forbearance would take place, what would be in place, what would the economy turn around? How long would COVID last? And frankly, we're still -- again, like we said to you, Josh, we're still not out of the wood. So we have taken -- not only us, I think, as an industry, people have taken a somewhat prudent approach to reserving. You're right. We should expect, everything else being equal, and forbearance programs in the past have showed us that when you had an 8% ultimate claims rate on a regular delinquency. When you compare to the forbearance through a cat event, for instance, that is -- that would be sort of a 1% to 2% ultimate claims rate, but we decided to be a bit more careful and prudent in establishing reserve. And I would say that we haven't really changed our mind quite yet. I think we've also put a moratorium on our revising our prior reserves, and we'll see where the data takes us for the next several quarters. And I hope that your assumption on the back of the envelope is right. And I hope that we prove to ourselves that it was, yes, indeed, a regular -- a more of a regular forbearance phenomenon in terms of curing than more of a regular DQ phenomenon."
},
{
"speaker": "Josh Shanker",
"text": "Is there a time line for when that moratorium ends? Or is that a subjective item?"
},
{
"speaker": "Marc Grandisson",
"text": "On our reserving, we -- I think -- I actually looked at the CFO, I think, they're pretty difficult. And I think we just have to take several more quarters. I don't think we're quite ready yet for that. I would expect, Josh, over the next 2, 3 quarters, it's certainly inflecting a lot quicker than we would have anticipated back in third quarter of 2020. So we're like you seeing things well, at some point, we'll need to be as we are, typically, well, when we have solid data to back it, we'll take action at that point in time. And I'm hoping that it's over the next 3 to 4 quarters."
},
{
"speaker": "Operator",
"text": "Our next question comes from John Collins with Dowling & Partners."
},
{
"speaker": "Geoff Dunn",
"text": "It's actually Geoff Dunn. Two questions. One, just back on the provision this quarter from MI. Can you share the average severity assumption that went along with the 9/1 incidents? I think it was about $54,000 last quarter."
},
{
"speaker": "Marc Grandisson",
"text": "$4,800."
},
{
"speaker": "Geoff Dunn",
"text": "What was the total severity factor?"
},
{
"speaker": "Marc Grandisson",
"text": "9.1%? Is that the one you're looking at?"
},
{
"speaker": "Geoff Dunn",
"text": "I'm sorry. So $4,800 was the actual vision and then [indiscernible]"
},
{
"speaker": "Marc Grandisson",
"text": "Have a reserve for annually. Yes. Yes."
},
{
"speaker": "Geoff Dunn",
"text": "Okay. Perfect. And then secondly, Francois, you mentioned looking for dividends in the back half of the year from MI. How do you think about the capacity there, given that the surplus levels at both the primaries are down to about $200 million at year-end?"
},
{
"speaker": "Francois Morin",
"text": "Well, we've got room. That's for sure. The one thing that is a factor for us, and I'm sure many of the peers is contingency reserves. So there is a -- right? So it's not purely, I'd say, PMIs driven. There is an EIC constraints around the amount of dividends that we can declare based on contingency reserves and the 10-year time of that. So while -- on the face of it, you might say, \"Oh, 190% PMI ratio, there's tons of capacity.\" We have some, and we're happy with it. But no question that we'll have to go through a bit more modeling and figure out how much we could move out. And then there's other sources for the -- for those funds. But ballpark, a couple of hundred million, I think, is easily -- assuming we get the approval from both the FHFA, the GSEs and the right -- the state regulators. And then if we can get more, we'll certainly try and do so."
},
{
"speaker": "Geoff Dunn",
"text": "So when you say a couple of hundred million, does that assume that you can convince the regulators to let you release contingencies earlier? Or do you think you can bleed surplus down below $100 million at each of the operating companies?"
},
{
"speaker": "Francois Morin",
"text": "Well, no, we think, we -- it's -- we would be within -- we wouldn't do anything, any special dividends from the regulators. It'd be very much within what's allowed from the regulatory point of view."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Meredith with UBS."
},
{
"speaker": "Brian Meredith",
"text": "A couple of questions here for you. First, Marc, I'm just curious, now that Watford is going to be -- I guess, you own 40% of it. If you look at kind of the model there, it's a little different in the model you typically deploy in your traditional business. Combined ratio is well above 100%. Is there any thoughts to maybe changing the strategy there a little bit? Or are you going to keep the same one? And then as you book those numbers, are you going to assume those realized gains are kind of going through your operating results?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I'll let the second question to Francois. But the first part, Brian, is, I think, that, first, we have 40%, so we're not majority, so there's a Board of Directors. But I do believe that at heart, this is a harder market. This is a good market on the underwriting side. And I think that collectively, we believe that there is an opportunity to maybe focus more the risk or the effort of the capital towards the underwriting as opposed to the investment side of things, but this will have to take place over time, right? We'll have to also talk to our -- to the partners that are currently in Watford and see what expectations they have in the return. So this is an ongoing discussion. But at a high level, right, I think, that we should expect Watford to become a little bit more strategic from an opportunistic positioning right now at this point in the cycle based on the opportunities that we have right now. I think that the reliance on investment income was probably more in favor back in 2014, 2015."
},
{
"speaker": "Francois Morin",
"text": "And quickly on part 2 of your question, Brian. The -- listen, with the acquisition, it opens up, I call it, a little window for us to take a harder look at accounting policies. And what you mentioned around realized gains is something that we'll look at as well in the -- at closing. I mean we were already looking at it. I mean it's just a matter of -- we got a few documents and agreements that need to get finalized. But we'll be -- we'll make sure we communicate to you exactly how -- if things are going to change, how they're going to impact our financials."
},
{
"speaker": "Brian Meredith",
"text": "Great. And then, Marc, my second question is, some of the, I guess, calls we've heard so far from the insurance brokers this quarter, have highlighted the fact that new business has gotten competitive. Renewals, companies still try to raise prices, but new business is getting much more competitive. I'm just curious, are you seeing that. And what does that potentially mean for the kind of length and duration of the cycle? Are we getting towards the end when that happens?"
},
{
"speaker": "Marc Grandisson",
"text": "No, I don't think so. I think that the -- some comments were made as well, Brian, about the E&S market, so they've been vibrant, which is a good sign of not dislocation, but really a renewed or a new underwriting appetite by the Main Street writers. That's not going away. In new business, it's normal to be expected, right? I think we went through the first year from underwriting, shuffling and readjusting to the new underwriting policy to now, well, let's say, what do we have and what do we want to focus on in terms of new business and maybe seek and grow that. And frankly, all of us here, right, Brian, talk about how the good the market is. So I think it probably makes them a little bit more willing to take on those policies. But I think it's a hardening market. I will add that new business could be more competitive, but the rates are not going down. I mean it's not like somebody is coming to undercut, which is really the important factor here. I do believe that the new business, typically -- we were once, way, way, way back when a new player in the marketplace. And I do believe that we had pretty lofty expectation in terms of pricing, we would need to get on that piece of business. And I'm expecting -- and that's what we're saying. We're not seeing a softening from that positioning from the external world. And frankly, Brian, I mean, the existing players are not growing so significantly that it's creating a lot of competition necessary, right? The new business is probably -- probably needs to find a new home with new players. So that's not that surprising. So I wouldn't lose -- I'm not losing sleep over this. Hard market does not last forever as you can appreciate. But we're already in the second round of this. I wouldn't be surprised we have another round to go. And even after that, Brian, it takes a bit longer for things to get softer yet again to the point of not getting the returns. So we have win our sales for a little while here."
},
{
"speaker": "Brian Meredith",
"text": "Great. And then one just last quick one here. I noticed your construction and national accounts business finally started to grow, again, in the first quarter. Is there anything unusual there? Or is that something that we should see picking up growth as the economy improves?"
},
{
"speaker": "Marc Grandisson",
"text": "I think a couple of things. I think seeking quality accounts. There's still some shuffling of accounts around. Some people are debating what to do, stay with clients. We're able -- we have a very good product offering both on these instances. And this is -- these are 2 areas actually where -- I referred to in my comments where that didn't seem to be moving a whole lot. And then we're seeing, finally, for the first time and on rates moving in the right direction. As you can appreciate, right, a lot of it is work is comp-driven, but it's still -- we can still see clients working with us as we evidence the lack of interest in investment income, some COVID exposure. So I think we're seeing some good traction there and still offering good product. But we have to be careful obviously. We're here of the long haul. This is a franchise positioning for us. It's a little bit of everything. It's a really good story for us, and I'm glad you picked that up, Brian."
},
{
"speaker": "Operator",
"text": "Our next question comes from Derek Han with KBW."
},
{
"speaker": "Derek Han",
"text": "So my first question is, you talked about strong pricing and new accounts driving growth in the property business line within reinsurance. How are you thinking about the loss trends in that line of business, both in reinsurance and insurance?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So very much with the same way we would the other lines of business, Derek, where we would look at the history of the loss cost and modeling out in terms of specifically talking about cat loss specifically. Just looking at the cat history of these accounts that are similar. If it's a reinsurance portfolio then it's the experience on the portfolio. And build in some modeling magic, I would call it, based on our own expectations of demand surge or maybe some on-model perspective. And we just price it this way to make sure we have a healthy level of margin. And it's really nothing new from what we've had historically. I think on property, the one beautiful thing about property is the feedback loop is a lot quicker as opposed to a GL portfolio where it may take you 4, 5, 6, 10 years sometimes to really figure out whether you did the right thing and you price your goods at the right level, property allows us to do a lot of repricing. And right now, our ability to grow in that lines of business is because we're also willing and able to go anywhere on the reinsurance side for that matter in terms of core share or risk access where some of the other players out there could be a little bit more reluctant to go. And just one thing you have to keep in mind when you price for business and property, you can't just take the last data point and say, this is going to be the recurring one. You have to take a small -- a longer-term period with the proper caveat on the margin for safety to price. So I'm trying to give you a 25-year knowledge base in 5 minutes, I'm not sure I'll be doing that great. But I think, hopefully, it gives you a good flavor for it."
},
{
"speaker": "Francois Morin",
"text": "Yes. And -- but the only thing I'd add to that, I think, there's certainly been a lot of press in the last few weeks and months around building materials, costs going through the roof in some areas. So that's certainly something that our underwriters are fully aware of and fully engaged in adjusting their view of price as they trend. And so that's part of the underwriting decision when you're in some parts of the country where cost of materials, whether through shortage or just a lot of significant demand, I think, that is impacting the trends or the pricing that we're trying to get on the product. So I'd say that's maybe a bit more on the insurance side, more direct, but I think it's a bit of a something that is more top of mind currently."
},
{
"speaker": "Derek Han",
"text": "That's really helpful. And then I have a quick second question. There was a sequential increase in the MI G&A ratio. Was that all incentive comp?"
},
{
"speaker": "Francois Morin",
"text": "Well, there's a couple of things. I mean, sequential, there's always -- Q1 is, yes, there's current, but there's also -- and it gets very granular around payroll taxes. And there's other things that we're just -- we pick up more of those expenses in the first quarter, and they do decrease over time throughout the year. So I'd say, yes, for the most part, is -- incentive comp is a big part of it, but there's also a few other things that just enhance that or make it stand out a bit more. But again, from our point of view or your point of view, you should fully expect a return back to a lower level and starting in the second quarter."
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions. I'd now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you for joining us this morning, and we're looking forward for better news, hopefully, in the second quarter."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 4 | 2,022 | 2023-02-14 11:00:00 | Operator: Good day, ladies and gentlemen. And welcome to Arch Capital Group Fourth Quarter 2022 Earnings Call. At this time, all participants are in a listen only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed in the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in this call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report or Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's Web site. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sir, you may begin.
Marc Grandisson: Thank you, Towanda. Good morning, and welcome to the fourth quarter earnings call for Arch Capital Group. Happy Valentine's Day to all. I'm pleased to share that for the fourth quarter of 2022, each of our three underwriting segments produced exceptional results. Our quarter's results were buoyed by a lower than average cat loss experience, a significant favorable development in mortgage reserves and a higher level of profitable earned premiums from our recent growth. This quarter demonstrates the power of our strategy, namely our management of the underwriting cycle across the diversified specialty portfolio with a prudent reserving and underwriting stance. Our P&C insurance underwriting teams continued to lean into hard market conditions and our mortgage team delivered record underwriting income, which is again a direct result of our years as the established market leader there. For the full year of 2022, Arch generated over $1.8 billion of operating income with an operating return on equity of 14.8%. 2022 was our third consecutive year of sustained premium and revenue growth, supporting stronger and more stable earnings power for the near term. The net premium written growth from our P&C unit was exceptional. Reinsurance segment NPW grew 51% for 2022 as the team seized on market dislocations, while our insurance segment grew a robust 21% on the year. We continue to see a broad array of opportunities to allocate capital where rates and terms and conditions allow for growth and attractive returns. Taking stock of where we are in the current market cycle, it's important to note that we have recorded premium growth significantly above the long term industry average. Over the last four years, we've grown property and casualty net premium written threefold to nearly $10 billion from less than $3.6 billion in 2018, while overall rates increased cumulatively by over 40%. As we have stated previously, our cycle management strategy dictates that we maximize premium volume when rates are rising, which is precisely what we've done. While we expect to continue to allocate more capital to the P&C segments for the next several years, I wish to remind our shareholders that we capitalize on the attractive return opportunities in our MI segment to the tune of $5.4 billion of underwriting income since 2017. These profits allowed us to redeploy capital into more accretive uses, including $2 billion worth of share repurchases since 2018 and the substantial growth in profitable P&C premium. MI has been vital to our ability to propel our P&C underwriting growth. Underwriting cycle management is core to our culture, and I want to take a brief detour into how we think about the underwriting cycle here at Arch. Here within simplification of falling grade insurance clock split into four stages. Stage one, at the onset of the hard market, we see rates increase dramatically and capacity withdrawn. Results on the previous soft market results only begin to show up in claims activity. Stage two. This is the beginning of the restoration phase, which is indicated by second and sometimes third round of rate increases along with some improvements for the insurers in the terms and conditions as the industry adjusts its appetite and underwriting policies. Much of the focus during this stage is also geared to filling guests in and replenishing reserve shortfalls from the soft years while showing rapid improvements. Stage 3. That next period is where rates gradually decrease often as a result of overreaction in Stage 2. Underwriting profits from the hard market years gradually show up in the results. This period can be lengthy and it usually allows for still profitable growth, especially for the disciplined underwriters. And finally, Stage 4. Famous Stage 4 is where the industry foresakes underwriting discipline and overly focuses on topline growth even as rate decreases accelerate. This is where Arch's culture of underwriting discipline is most apparent as we cut exposure and prepare for the return of Stage 1. Right now, we are at Stage two in most lines. Some, for instance property, are back to Stage one since the fourth quarter. Understanding where you are at each point of the cycle for every product line and the nuances within each stage is critical to the timely allocation of capital to the areas of greatest opportunity. One of Arch's key sustainable advantages is the breadth of its capabilities across many specialty insurance lines, enhancing greatly our cycle management capabilities. A core strategic tenant of Arch is that underwriting acumen and discipline through the cycle drive superior risk adjusted returns. Now I'd like to share some highlights from our underwriting units. We'll kick it off with reinsurance. For the fourth quarter, net premium written in the reinsurance segment was $1.5 billion, that's more than double the same quarter one year ago. Francois will cover the details. But much of this growth is because we were well positioned to capitalize on broad market opportunities as well as several one off opportunities resulting from market dislocations emerging in the fourth quarter. It is worth noting that the fourth quarter growth does not include the January 1 property and property cat renewals, which will be reflected in our next quarter's results. As you've heard, pricing for the January 1 renewals were strong. Cat pricing and terms both improved, leading to effective rate changes in the plus 30% to plus 50% range. We anticipate these trends will continue as the midyear property cat renewal and should translate to strong property cat premium growth in 2023 for Arch. Moving now to our Insurance segment. where we continue to reap the benefits of the investments we've made in enhancing our specialty businesses in the UK and in the US. On the year, we wrote over $5 billion of NPW, net premium written, compared to $4.1 billion in '21, with growth coming from a diverse mix of business. Underwriting performance continues to be excellent with an ex-cat accident year commodity ratio of 89.6%. Rate increases with a few exceptions remain above loss cost trend and we expect this strong momentum to continue for 2023. The insurance market remains rational and disciplined. We expect also continued opportunities due to the ongoing global uncertainties and remain optimistic that this disciplined behavior that we saw in the P&C industry for the last three years will persist as we move through Stage two of the cycles. Next, our mortgage team, again, had an acceptable quarter, capping off an excellent year. As we benefited from earnings from our embedded book as well as from favorable reserve development as cures on delinquencies exceeded our expectations. The mortgage segment delivered $374 million of underwriting income in the quarter and $1.3 billion for the year, an excellent contribution in a year where higher mortgage interest rates slowed new originations. Our insurance in force, the earnings foundation of the mortgage segment, grew to $513 billion at year end '22 as persistency increased due to higher mortgage rates. As expected, higher mortgage rates led to reduced [NRW] as mortgage rates touched 7%, the highest rates in 20 years. Looking broadly at the MI industry's health, we have borrower credit quality which is outstanding and excess housing demand above supply, the US unemployment rate is near historic lows and the borrowers' equity in their homes remain at very healthy levels. One thing worthy of mention is that the MI industry is acting in a disciplined and responsible manner. In the face of these economic uncertainties, premium rates are increasing while underwriting quality remains strong. Finally, the interest rate increases we've seen in the last 12 plus months should help fuel our net investment income through 2023. We are poised to benefit from higher reinvestment rates coupled with the growth in invested assets. I've got auto racing on my mind lately, and when I look at our industry, I can't help but think that Arch is one of the best cars on the track. We know that winning the raise comes down to more than having a great driver or the fastest car. There is much preparation, analysis and looking at the conditions on the track as well as monitoring the other drivers. By recognizing the soft market conditions in '17 and '18, we avoided the mistakes others made early in the race when they might have burned tires or overheated their engines. The pricing began to improve in 2019, we're able to take advantage of some of our competition basket stuff and engine problems, and we took the opportunity to take more of a lead on the track by increasing substantially our writings. And then once we saw some clear track ahead of us, we were able to accelerate even faster. Today, we're firing on all cylinders and I know we've got the right crew to bring in home. Let's hand the wheel over to Francois before coming back to and answer your questions. Francois?
Francois Morin: Thank you, Marc, and good morning to all. Thanks for joining us today. I'm very pleased to share that once again, Arch had an excellent quarter on virtually every front. The year concluded with fourth quarter aftertax operating income of $2.14 per share for an annualized operating return on average common equity of 28%. Book value per share was up 9.9% in the quarter to $32.62 and down only 2.8% on the year, a great result considering the impact raising interest rates had on our fixed income portfolio with a difficult year in equity markets and the elevated catastrophe activity we experienced this year. Turning to the operating segments. Net premium written by our reinsurance segment grew by an exceptional 118% over same quarter last year. Although this quarter, we had a few large one off transactions that impacted our results and contributed $407 million to our net written premium. Adjusting for these transactions, our net premium written growth was still elevated at 61% for the quarter. These transactions are yet another example of the dislocated state of the uninsurance market where our strong balance sheet provides a significant advantage as we look to deploy meaningful capital to support ceding companies at terms that meet our target return expectations. More importantly, the underlying performance of the segment this quarter was very good with an ex-cat accident year combined ratio of 82.9% and a de minimis impact from current accident year capacity losses. Reflecting ongoing hard market conditions, the insurance segment also closed the year on a very good note with fourth quarter net premium written growth of 17.4% over the same quarter one year ago in an accident quarter combined ratio, excluding caps of 89.6%. Most of our lines of business still benefit from excellent market conditions, both in the US and internationally, and our expectations for the coming year remain very positive. Our mortgage segment continued its run of quarters with results better than long term averages as claim activity for the business remain low. While production volumes were down due to the lower level of originations in the market, we remain positive on the return prospects for this business. Net premiums earned were up slightly on a sequential basis as the persistency of our in-force insurance at 79.5% at the end of the quarter continued to increase. The combined ratio, excluding prior year development, was 45% for the quarter and reflects our prudent approach to loss reserving, one of our key operating principles. Our underwriting income reflected $270 million of favorable prior year development on a pretax basis across all segments this quarter, which represents approximately $0.66 per share after tax. While most of this favorable prior year development, $211 million, came from the mortgage segment, mostly on claim reserves set up for COVID related delinquencies in the 2020 and 2021 accident years at US MI, it is worth pointing out that our P&C reserves also contributed to the overall results. Of note, both our insurance and reinsurance segments had another quarter of favorable reserve development, and the 2022 calendar year phase two incurred ratio for our P&C operations was 58.7%, its lowest level in more than five years. Both these metrics provide some insight into the adequacy of our loss reserves, which constitute an important element in the quality of our balance sheet. Quarterly income from operating affiliates stood at $36 million and was generated from good results [indiscernible] in summers. Pretax net investment income was $0.48 per share, up 41% from the third quarter of 2022. Cash flow from operations, over $3.8 billion for the year, was strong and when combined with the proceeds from maturities and sales of securities in a rapidly rising yield environment, and hence, the underlying contribution from our investment portfolio. Going forward, with new money rates in our fixed income portfolio in the 4.5% to 5% range and a growing base of invested assets, we are well positioned to deliver an increasing level of investment income to help fuel our bottom line. Total return for our investment portfolio was 2.6% on a US dollar basis for the quarter with all of our strategies delivering positive returns. The contribution to the overall result was primarily led by our fixed income portfolio, which benefited from relatively stable interest rates and tightening credit spreads. The overall position of our investment portfolio remains relatively unchanged as we remain cautious relative to duration, credit and equity risk. Turning to risk management. Our natural cat PML on a net basis stood at $970 million as of January 1 or 8% of tangible shareholders' equity. Again, well below our internal limits at the single event one in 250 year return level. Our peak zone PML remains at Florida Tri-County region. And as Marc mentioned, the PMLs we report represent a point in time estimate of the exposure from our in-force portfolio and the premium associated with the January 1 renewals will get reported in our financials starting next quarter. On the capital front, we did not repurchase any shares this quarter as our assessment of the market opportunity in 2023 remains very positive, one where we should be able to deploy meaningful capital into our business at attractive returns for the benefit of our shareholders. Finally, as Marc mentioned in his remarks, the results we enjoyed this year across our operations were achieved through a thoughtful and deliberate execution of our cycle management strategy and a strong culture of allocating capital to the most profitable markets and opportunities. These results, which were an important contributor to us joining the S&P 500, were only made possible by the ongoing hard work and dedication of our over 5,000 employees across the globe. They deserve a tremendous amount of credit for making us who we are today, an industry leader with a stellar 20 plus year track record that is ready for the opportunities and challenges ahead of us. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions] Our first question comes from the line of Tracy Benguigui with Barclays.
Tracy Benguigui: Your one in 250 PML to tangible equity of 8% as of 1/1 wasn't too dissimilar to your 7.7% as of September 30th. So I'm wondering what made you pause to incrementally take more exposure? Did that have anything to do with less retro capacity or your view of ROEs based on pricing for that incremental cat exposure?
Marc Grandisson: I think this number -- interesting, this number is one region, one area, one sub zone. What is not seen in the numbers, and we'll have a more thorough discussion at the Q1 call is that we've increased cat exposure across a wider range of sub zones, and that doesn't really come across through that Tri-County. And I remind you, Tracy that the Tri-County renewal is going to be more important and more apparent at the June 1 renewal. So it's also one first step into it. So we have grown a European exposure because the race course look pretty good there. Significantly, it would not show up into that one single number, right? This is sort of a -- it relies sort of the true increase in allocated capital to catastrophe. If you look at the aggregate number, which is a better reflection there is [indiscernible] increase, that will be commensurate, it actually would -- you'll see the premium increase and the cap allocation increase are -- it will make sense to you.
Tracy Benguigui: So as you look through the year, even though 25% is your maximum threshold, where do you think you could realistically land based on your risk appetite?
Marc Grandisson: Tracy, our typical answer is, you tell me what the rate levels are like, and we'll tell you what we think we can do. We have a plan based on certain various levels of rate changes in terms of condition changes by zone by region. And our team, as you can appreciate, is willing and able to operate on that basis. If you take a step back, I think the overall capital position of the company is, we have plenty of opportunities to deploy, it's hard for us right now to see going all the way to '25. But certainly, we have room to grow and we have the capital and the relationships to do so.
Tracy Benguigui: And also really quickly on the reinsurance side, in recent times, you focused more on quota share over XOL. So with hard pricing, where do you see the best opportunities? I'm thinking about lower ceding commissions on quota shares and the higher rate online on the XOL side?
Marc Grandisson: So I think it's across the board. You just mentioned that we have improved economics both on the quota share in excess of loss. I think that the numbers you see in Q4, a lot of it has to do with our recent growth in the quota share that we've written. I think by virtue of the cat XL, as we just talked about a few months ago, increasing, I think that we would be in a position to increase our excess of loss contribution to the bottom line. But when the hard market is around, which we still see on the reinsurance side and the insurance and the P&C side, we have a tendency to migrate towards a quota share. There's a few reasons for that. Number one, one of the big reasons that we like to talk about is, you inherit some diversification within that portfolio that you otherwise would not necessarily get from a net excess of loss perspective. And we really, really like this and we like to be closer to the rate change, right? When you're on a quota share basis, you’re side by side with a client as opposed to in excess of loss, you need to be relying on your sole pricing to make it work. So over time when the market gets harder, I think you will expect us and as part of the cycle management to underwrite more quota share versus excess of loss. This year, they're both pretty good.
Operator: Our next question comes from the line of Michael Zaremski with BMO.
Michael Zaremski: I'll stick with the primary insurance segment, given I feel like most of the questions will probably be on reinsurance. The growth has been decelerating there a bit. Marc, we heard your prepared remarks, sounds like you're still excited, but maybe you can kind of talk about what's driving the deceleration, what are you guys seeing? I don't know if it's worth bifurcating between kind of E&S excess surplus lines versus non-E&S. I'm just curious if the discipline there is dissipating a bit more versus reinsurance?
Marc Grandisson: I think we're just experiencing, in the fourth quarter, that will probably change in '23, I think opportunities are going to resurface more broadly than we even had in the fourth quarter, right? I think it took a little bit to the market to digest in and to what it means for the overall market. I think another market, it's clearly in the camp up making -- doing what it needs to do to improve the return on the pricing on the property, which I think also you heard in other calls, I think will impact broader set of line business beyond the property exposure. But if we’re to go back, so if you look at the 70% growth, I mean 70% growth over, premium is about 3 times the size three, four years ago, we did have a lot of growth in the beginning of our market. So as you get into the late stages, I think 70% could be equivalent to another 50% increase in 2021 or 2020, when we started to lean into the market. So I think this is a natural phenomenon that after a while, you have -- now that you mined everything, but you really have pushed as hard as you could, and we're still pushing hard. Even 70% to me is about 3 times the average growth in the premium in the industry, that tells me that we're still seeing a lot of opportunities. But again, like I said, we're later in the stage of the [indiscernible]. And I think that we'll see a rejuvenation, if you will, of that growth possibly because the insurance companies are going to have to increase, as we all know, their pricing. One is the property cap and the higher retention why they have more risk retaining. And we're participating like the other guys on the insurance market, so we expect market to sort of getting a second bite of the apple, if you will, of a hardening market.
Michael Zaremski: And as a follow-up, sticking with the primary insurance segment. So it sounds like the opportunities might fall within the property space, if I'm interpreting your comments correctly. And when we're thinking about the segment's combined ratio, I feel like looking at my older notes, it was kind of mid-90s. Was the goal -- is that still what you're thinking, or as time has been so good in terms of the market cycle that we should be thinking lower 90s is the more near term goal?
Marc Grandisson: I think we said a few things about the combined ratio. The 95% was meant as a target back in '16, '17 when interest rates were quite a bit lower, and it went down further. As you know, that meant that we needed to have a lower combined ratio targets, which we targeted over last two, three years, that's where you see the impact to us. I think from our perspective, low 90s is still what -- or high 80s is sort of what we're still pushing for because within the interest rates, they may revert back and come down after a while in a year, year and half from now. So you don't want to be rushing to recognize all the various interest rates, although we are currently -- we are pricing into our business, but we tend to take a longer view like we do on the trend on our inflation. And we're thinking the rates might come back down. So I think we would still target a lower 90s to high 80s to get the returns that we think we deserve.
Operator: Our next question comes from the line of Jamminder Bhullar with JPMorgan.
Jamminder Bhullar: First, I had a question on the reinsurance business. If you look at your premium growth, even excluding the sort of large transactions, onetime transactions, you mentioned the number is extremely strong and obviously, doesn't have the impact of 1/1 renewals in it. So what's really driving that and do you expect some of those factors that drove the strong growth to continue into '23 as well?
Marc Grandisson: I mean the one thing that right from the get go, I think, you need to appreciate the quota share business is something that we might have written a deal in January 1 of '22, and the premium gets written over the four quarters. So we're benefiting from that, that's showing up in each of the four quarters. If the underlying rate increases also from the ceding companies are higher than what we might have expected at the start that gets adjusted throughout the year. So a couple of factors were, basically, we're just following effectively the fortunes of the companies. But still, I think our teams deserve a lot of credit for going after these opportunities, being responsive to the client needs, being -- providing good capacity with good ratings. Does that continue on in '23? We think so. We think the market is there and the [Technical Difficulty] growth was not only in [Technical Difficulty] business, it's pretty much in [Technical Difficulty] business. And property and properties [Technical Difficulty] a lot of attention in the last few weeks, but still, I mean all lines of business, other specialty, casualty, marine, aviation, remain -- I think all lines are, I think, in a position to really keep growing at a good cliff in ‘23.
Jamminder Bhullar: And then just shifting on to MI. Your loss ratio is obviously very good, but I think the loss pick did pick up a little bit in the fourth quarter. So is that more sort of national driven or is it more regional to where you're starting to see some maybe softening in the market in certain regions or states?
Francois Morin: Well, we've navigated through the regional differences in our pricing. So I think we have constructed our portfolio that we're very happy with, stayed away from what we perceive to be the more dangerous areas and underpriced areas. So I think that's kind of showing up in our performance over time. In terms of reserving, I'd say, two things. One, the delinquency rates are still very low. So it's not like we're really seeing pressure at this point in terms of the higher level of delinquencies being reported, and the loss ratio pick is really more a function of us being a bit more prudent. I think there's a little bit of uncertainty with -- whole prices, are they about to come down, does that create some potential pressure? We think we're very aware of that, whether there's a recession, et cetera. But we're still very, very positive on the segments. It's just a realization that this is maybe a likely riskier environment than we were in like a year or two years ago, and our reserves are going to reflect that.
Operator: Our next question comes from the line of Brian Meredith with UBS.
Brian Meredith: A couple of them here for me. First, Marc, Francois, you guys typically provide in your 10-Qs the one in 250 for the other regions well, Northeast and Gulf of Mexico, UK. I'm wondering if you could give -- have those statistics so we can get a better sense of what type of growth you're going to see at 1/1 renewals? And maybe focus also on Europe, because I know Europe was -- you got a good operation there and a lot of opportunities there.
Francois Morin: I mean the ones we reported really a couple more regions. We don't have -- I don't have those handy. I think the most of my -- to Marc's point, I think a lot of the growth that we saw, at least at 1/1, will come through in regions that were, I'd say, we were probably a little bit underweight in the past. So that's going to show up in Q1 premium and for the rest of the year, but in terms of P&L, it really doesn't have an impact.
Brian Meredith: And then second question. I'm just curious, Marc, if I take a look back -- and I'm going to date myself a little bit here. If I look back at which your underlying kind of combined ratios looks like back in 2003, 2004 after the last hard market, you're getting pretty close there in the reinsurance business. Are we getting to the point where we're kind of seeing max margins in that business, maybe you get a little bit more in 2023, but how much more do you think you really get here?
Marc Grandisson: I don't know the answer to that. I like the comparison to ‘02 or ‘03. I would actually like to compare probably more like a combination of ‘02, ‘03, maybe ‘04 in liability and maybe ‘06 or ‘07 on the property side. So I don't know what that means. We haven't blended growing the combined ratio that we had in this year, but that probably would be close to what we can do. I mean, look, there's a lot of things that are different this time around. The interest rates are lower than they were before internationally. More specifically, we're an international diversified reinsurance company. Hard to tell, but it's certainly going in a way of getting above our long term ROE targets that's for sure, and that's really what, in the end, what really drives us, as you know.
Operator: Our next question comes from the line of Yaron Kinar with Jefferies.
Yaron Kinar: My first question, just looking at the ROE profile of the company, clearly, there's upwards momentum here. Can you maybe talk about, A, what the target would be and B, if you'd see it coming more from -- or the expansion from here on coming more from NII or more from underwriting?
Francois Morin: I'd like to think we got room to grow. But you're right, I think the biggest probably opportunity is NII, just with the leverage and the correction or the increase in interest rates we saw last year. I think that's going to take still a little bit of time to show up in the numbers. But as we look forward over the next 12 to 24 months, I'd like to think that, that will -- there's leverage there that we can show up in the numbers. In terms of the segment’s results, I think they can all -- mortgages, again, the reported results, I mean significant reserve releases, which certainly helped the bottom line and the ROEs that are reported. But we think the segments, the fundamentals underlying each of the three segments are still very good and they can actually still deliver very healthy results.
Yaron Kinar: And then my second question, just looking at the insurance business, it sounds like you think that there maybe some inflection to accelerating growth again in '23. Can you maybe help us think about the impact of the reinsurance market, kind of available capacity, cost of reinsurance, how that plays into the potential growth that you see for net premiums written in '23 in insurance?
Marc Grandisson: Great question, Yaron, because I think what we're going to see through '23 is a recognition. I mean it's already there but it's probably really coming home and the rules for us as a saving company right on the insurance line and our clients and ceding companies that more needs to be charged to the insurers that they can in turn pay the reinsurer they need to buy. Even if they went there, right, we heard that a lot of increasing retention, there’s still more volatility that's absorbed by those insurance carriers, which should lead to, again, needing a higher rate, everything else being equal. So I think what we're seeing is -- what we'll see is gradually -- and again, on the reinsurance sectors, Yaron, you can just renew business 1/1 and everything changes on a dime, right, on one stroke of the pen. On the insurance side, it take 12 month period to transition and transform and then reprice the whole business. So that's what I think we're going to be seeing, that's why I'm also fairly optimistic is because we're going to have that repricing occurring throughout 2023 and beyond. And alongside with those, between all of us here, the terms and conditions are also going to be on the table, right, on the docket for companies to present to find a way to not curtail but find a way to have a better risk sharing with their insurers when it comes down to other policy. So I guess for that reason that's what underlies is that sticker shock, not sticker shock, but good increase in reinsurance at the beginning of the year that we'll have to filter through all the plans and budgeting for all the insurance companies, including ourselves as we go forward in '23. So it's going to be a slow motion but it's going to happen, that's why I'm optimistic.
Yaron Kinar: And I apologize, I'm going to try and sneak one more in here. A clarification, when you talked about kind of targeting low 90s, high 80s combined ratio, was that a reported combined ratio in the insurance segment?
Marc Grandisson: That's policy year target effective [Technical Difficulty] it’s just expected, right, plus or minus, as you know, in our space, is volatility around the expected numbers, but this is long term expected.
Yaron Kinar: Because I think you've been running at kind of mid-90s. So where is that improvement coming from, is it mostly just better rates and in risk selection?
Marc Grandisson: Well, we're running -- we're running about 90 now, and I think that we still continue to see improvement in pricing. So that should help us get there somehow.
Operator: Our next question comes from the line of Ryan Tunis with Autonomous.
Ryan Tunis: First question, I guess following up on Tracy. Could you give us some indication of, I guess, how you're viewing your overall cat budget this year relative to '21 based on what you saw with 1/1 renewals? Should we expect to kind of the expected cat ratio to be higher?
Francois Morin: The cat ratio or cat? I mean, in terms of…
Marc Grandisson: Cat load.
Francois Morin: Dollars of cap, yes, we think will go up. No question. We've been targeting, we’re targeting -- I mean our cat load in '22 was, call it, $80 million a quarter. Now it's probably between $100 million and $120 million for the first quarter of '23 based on what we wrote, right? And we'll see how that develops for the rest of the year. I mean, depending on how the 41, 61, 71 renewals, how those kind of materialize, there is, I'd say, a good probability that it will keep going up throughout the year. But based on the in-force portfolio that we have currently for the first quarter, I mean, that's kind of how we see the exposure to cat losses.
Ryan Tunis: And then I’d one for Marc, I guess, on the man-made cat side, which isn't something we've talked about too much. But I would think that's one of the better markets right now on the reinsurance side. And I guess just trying to size that, whether or not maybe some of the rate increases post Ukraine, if that can move the needle relative to property capital, just looking at your marine and aviation premium, it's actually pretty chunky relative to property cat. So if you could just give us some indication of can that move the needle, is that something that we should be paying more attention to in terms of the markets you're seeing that are getting incremental firming that could help Arch?
Marc Grandisson: I think the one thing with an event such as Ukraine, which is a war event, there's actually a specific market for those kinds of risks. So it's not like it's included part of the overall coverages for cat or whatever else out there. There was some -- there definitely is a result of that event in attempt to exclude a lot of these war events and bring them back into the proper -- aviation war, on marine war market, for instance. So yes, there is a lot of -- obviously, a lot of activity there, a lot of rate increases there. We're participating in there, but those markets are to begin with pretty small. So that's why I think you'll see some improvement, but it may not be necessarily enough to move the needle for the industry, even though it's a very, very healthy proposition that rates have gone through the roof as you can appreciate for the right reasons in those types of business.
Ryan Tunis: And then just lastly, the acquisition expense ratio has been kind of hard to pin down at Arch over the past few years, but it's gone up. Obviously, it sounds like there were some changes in terms of ceding commission structures, things like that at 1/1. Is there anything directional you can say about maybe how the acquisition expense ratios could move in '23 versus '22, or do we just kind of expect something relatively similar?
Francois Morin: I don't think it's going to move a whole lot from where it's been. I think there's been a lot of shifts in the mix of business over the years, right, as particularly as our insurance book in the UK has grown, that's a bit higher acquisition ratio, different kind of that reinsurance purchasing decision. So there's a long list of reasons or explanations as to why it is where it is now. And obviously, what we focus about -- what we're focused on is the bottom line returns whether -- if we're going to pay a bit more acquisition, we certainly think we're going to get a lower loss ratio and that has been the case. But for your modeling, we kind of, I think, exercise. I assume something pretty similar to '22 as a starting point, and we'll keep you updated as the year goes on.
Operator: Our next question comes from the line of Elyse Greenspan with Wells Fargo.
Elyse Greenspan: My first question, I guess, is going back to the reinsurance margin discussion that came up earlier. So you guys have a flat PML and you guys are seeing 30% to 50% rate increases in cat. Wouldn't that triangulate into margin improvement coming through in the reinsurance book in 2023?
Marc Grandisson: Well, if I could just isolate. First, we wonder where you were, so good to see you there. Second, I think if you look at the property characters, I think the returns have dramatically improved. But as you know, for us, it's going to be incrementally, of course, accretive to our bottom line, but we're not -- it's not the biggest line of business for us. So that's what allows us, we believe, the opportunity and room to grow the way we think we could grow in 2023. So it's hard to say how much more, but the property cat itself, the market itself, has significant margin improvement.
Elyse Greenspan: Would you say, building on that, Marc, would you say that of all your business lines as you sit here today, the line with the best expected return in '23 would be catastrophe reinsurance?
Marc Grandisson: It's up there, but there are others that we don't advertise too much that are really, really healthy and getting better, as we speak. And as big, if not has been -- probably, some of them are as big as a property cat -- property cat writing. So we have quite a few who are giving us pretty high returns, but it is up there, you heard on the call, this is a good time to write property cat excel, a really good time.
Elyse Greenspan: And then you said, on the PML discussion, you had mentioned, right, that we need to kind of see how things come together at June 1 that, that could also be a good opportunity. What could derail this, is it just alternative capital and more capital coming into the reinsurance space as you think leading up to June 1? And even when we think beyond that, what are you guys concerned about that could derail the uplift that we've seen in the catastrophe reinsurance market?
Marc Grandisson: I mean it's hard to imagine, Elyse. I think the third party capital you mentioned, there’s still -- we're in a wait and see attitude. The US renewal, as we all know, is a small portion of the overall cat writing in the year, so more has to happen and as we all know. And in line with what -- our Tri-County was up, Florida exposure -- Florida is the biggest exposure. So it's hard to tell what could derail it. I'm trying to think out loud, the third-party coming in, I don't see it being a case. No cat in the first half of the year. While we better have no -- it would be great for an industry to take advantage of the less cat activity. No, it's hard to see anything at least, because I think that the psychology of the market is quarry of the kind of remediating what needs to be remediated in a property cat space at all levels. And from the C-suite all the way down to the underwriting system desk, I think it's clearly a recognition that we need more. I think the only thing I could say is, the one thing that I could say just to help you out here, I think that will make sense to you that we may have a bit less than perhaps some people have budgeted or maybe a bit more than budgeted price increase when we have a delta around what we see. But in terms of core capital needs and supply and demand, I don't see a major shift. I mean that was a long question, because I was thinking out loud here, but there you go.
Operator: Our next question comes from the line of Meyer Shields with KBW.
Meyer Shields: I hope this one covered. I missed about a minute of the call. But I was hoping it would be dig into the nonrecurring transactions in reinsurance, I'm assuming this was a retroactive reinsurance. And I was hoping you could talk about specifically the sort of risks or the lines of business that you're assuming, and maybe give us an update on what that market looks like now?
Francois Morin: I mean to keep it at a fairly high level, those are general -- I mean, I consider them to be kind of capital relief, capital support transactions for a variety of reasons. Companies that have grown a lot under some rating agency pressures, aiming capital relief, companies trying to put some exposures behind them, et cetera. But just to clarify those are not retroactive so they're all insurance accounted transactions, insurance or reinsurance accounting, so that flows through our premium. They are across -- you saw it in our line of business, they did hit multiple of our lines of business. Some were other specialties, some were casualty, some are a little bit of property. So it's a spread. But it's all in a vibrant market. I mean there's a lot of pain that some companies are experiencing right now, and they're working for solutions. And again, we think we have strong balance sheet and capital to support them. So I think -- we don't know if they're going to happen again, those are lumpy. But if and when they are presented to us, we're happy to consider them and once in a while, we end up writing a few of them.
Meyer Shields: Second question on mortgage insurance, and I don't even know how to phrase this, but you put up very conservative reserves for mortgage insurance over the course of COVID. And I'm wondering how much of that unusual reserve is still there because clearly, speaking at least for myself, we haven't done a great job of forecasting reserve releases in that unit.
Francois Morin: Well, it's a great question, which is becoming harder and harder to answer, because in the early days, no question that we had adjusted our -- because so many loan, the delinquencies that were in our inventory were in forbearance and trying to make the distinction between kind of forbearance and non-forbearance delinquencies and how much of that worth was -- a new concept or new kind of reality we were basing. Over time, I mean it's been three years now. I think the reality is like the inventory is somewhat kind of commingled. So we don't really think of loans and forbearance kind of that differently than we look at the other loans, even though we know there's still a few of them in the inventory. So I mean long story to say that it's not something we tend to quantify directly every quarter anymore, but we still perceive that there's a bit of risk with COVID related reserves, and that's why we've been holding on to the reserves up to the point where we think we just don't need them. And right now, this quarter was an example where I think the data kind of suggested that we were -- it is the right time to really that there are no other reserves that were set up in those years.
Marc Grandisson: And Meyer, quickly, I think what Francois is saying is true for all lines of business and historically, while we'll try to take a prudent stance on reserve to ensure we have enough and will let data speak for itself. And this one is very unusual, Meyer, right, the dynamic [indiscernible] something unlike anything else. It's when we have another one, we'll have a better playbook to use, but we just didn't know. And we still don't know, it’s still not over [indiscernible] are forbearance. So it's still coming back in the -- it's not totally gone yet. So that's what leads us to be that much more. From the outside it looks like we're conservative, but we think we’re being prudent and the data speak for itself. And mostly, if it happens that we don't need it then we'll adjust it based on the data we see.
Operator: We have a follow-up question from the line of Tracy Benguigui with Barclays.
Tracy Benguigui: I'm wondering what your outlook is on professional lines within your insurance segment? And particularly, what stage you would classify that business in when you went through your stages?
Marc Grandisson: Tracy, would you -- do you include D&O there, or you just wanted the ex-D&O, which lines specifically -- professional lines is a really broad market…
Tracy Benguigui: So my focus is more on D&O.
Marc Grandisson: D&O, okay. So D&O, we expect similar trends that we saw in the last fourth quarter, it may change a little bit as a result of the overall thing that's happening in the marketplace. But the trend in the large commercial, for instance, have been neutral to negative, actually, for the last three, four years. So I would say that even though we may hear -- you hear, I know rate decreases on our D&O for large commercial, there's rationality behind it. So we expect rationality specific to this. It’s not -- there's a lot of data that points to -- that validates what kind of price points we're seeing on the D&O side. On the smaller D&O side, which we do a fair amount of -- to remind you, we do fair amount of D&O. We still see a very, very stable, very good marketplace. But again, the smaller D&Os are not the big ticket items that you would expect, but a lot of them are going to be not for profit small policy. So minimum premium is really -- a lot of times what happens and that 5% increase might be $50, right? So these are the kind of things that we do [indiscernible] and we have grown dramatically over the last four or five years, it's becoming a big section of what we do. That market is healthy from a [change] perspective, right, to go back where it said about the large commercial, the SCAs are down 25%, 30% over the last four years. So it's a pretty good market to be there. The IPO market has stabilized. It was pretty hot for a while, pricing got crazy. We took advantage of a lot of opportunity that's not crazy, but it was a very acute needing capacity. We expect this to sort of renormalize again. So I think I would say, D&O is normalizing for the large commercial, sort of a Stage four. I meant Stage 3 we’re recognizing some of the overreaction, but the smaller D&O is probably early stage or Stage 3, which is still very profitable and a little bit of decrease here and there or a slight increase.
Operator: I'm not showing any further questions in the queue. I would now like to turn the conference back over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Well, spend a good day with your loved ones, and we will see you in the next quarter. Thanks for listening, guys.
Operator: Ladies and gentlemen, that concludes today's conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen. And welcome to Arch Capital Group Fourth Quarter 2022 Earnings Call. At this time, all participants are in a listen only mode. Later we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed in the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in this call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report or Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's Web site. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sir, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, Towanda. Good morning, and welcome to the fourth quarter earnings call for Arch Capital Group. Happy Valentine's Day to all. I'm pleased to share that for the fourth quarter of 2022, each of our three underwriting segments produced exceptional results. Our quarter's results were buoyed by a lower than average cat loss experience, a significant favorable development in mortgage reserves and a higher level of profitable earned premiums from our recent growth. This quarter demonstrates the power of our strategy, namely our management of the underwriting cycle across the diversified specialty portfolio with a prudent reserving and underwriting stance. Our P&C insurance underwriting teams continued to lean into hard market conditions and our mortgage team delivered record underwriting income, which is again a direct result of our years as the established market leader there. For the full year of 2022, Arch generated over $1.8 billion of operating income with an operating return on equity of 14.8%. 2022 was our third consecutive year of sustained premium and revenue growth, supporting stronger and more stable earnings power for the near term. The net premium written growth from our P&C unit was exceptional. Reinsurance segment NPW grew 51% for 2022 as the team seized on market dislocations, while our insurance segment grew a robust 21% on the year. We continue to see a broad array of opportunities to allocate capital where rates and terms and conditions allow for growth and attractive returns. Taking stock of where we are in the current market cycle, it's important to note that we have recorded premium growth significantly above the long term industry average. Over the last four years, we've grown property and casualty net premium written threefold to nearly $10 billion from less than $3.6 billion in 2018, while overall rates increased cumulatively by over 40%. As we have stated previously, our cycle management strategy dictates that we maximize premium volume when rates are rising, which is precisely what we've done. While we expect to continue to allocate more capital to the P&C segments for the next several years, I wish to remind our shareholders that we capitalize on the attractive return opportunities in our MI segment to the tune of $5.4 billion of underwriting income since 2017. These profits allowed us to redeploy capital into more accretive uses, including $2 billion worth of share repurchases since 2018 and the substantial growth in profitable P&C premium. MI has been vital to our ability to propel our P&C underwriting growth. Underwriting cycle management is core to our culture, and I want to take a brief detour into how we think about the underwriting cycle here at Arch. Here within simplification of falling grade insurance clock split into four stages. Stage one, at the onset of the hard market, we see rates increase dramatically and capacity withdrawn. Results on the previous soft market results only begin to show up in claims activity. Stage two. This is the beginning of the restoration phase, which is indicated by second and sometimes third round of rate increases along with some improvements for the insurers in the terms and conditions as the industry adjusts its appetite and underwriting policies. Much of the focus during this stage is also geared to filling guests in and replenishing reserve shortfalls from the soft years while showing rapid improvements. Stage 3. That next period is where rates gradually decrease often as a result of overreaction in Stage 2. Underwriting profits from the hard market years gradually show up in the results. This period can be lengthy and it usually allows for still profitable growth, especially for the disciplined underwriters. And finally, Stage 4. Famous Stage 4 is where the industry foresakes underwriting discipline and overly focuses on topline growth even as rate decreases accelerate. This is where Arch's culture of underwriting discipline is most apparent as we cut exposure and prepare for the return of Stage 1. Right now, we are at Stage two in most lines. Some, for instance property, are back to Stage one since the fourth quarter. Understanding where you are at each point of the cycle for every product line and the nuances within each stage is critical to the timely allocation of capital to the areas of greatest opportunity. One of Arch's key sustainable advantages is the breadth of its capabilities across many specialty insurance lines, enhancing greatly our cycle management capabilities. A core strategic tenant of Arch is that underwriting acumen and discipline through the cycle drive superior risk adjusted returns. Now I'd like to share some highlights from our underwriting units. We'll kick it off with reinsurance. For the fourth quarter, net premium written in the reinsurance segment was $1.5 billion, that's more than double the same quarter one year ago. Francois will cover the details. But much of this growth is because we were well positioned to capitalize on broad market opportunities as well as several one off opportunities resulting from market dislocations emerging in the fourth quarter. It is worth noting that the fourth quarter growth does not include the January 1 property and property cat renewals, which will be reflected in our next quarter's results. As you've heard, pricing for the January 1 renewals were strong. Cat pricing and terms both improved, leading to effective rate changes in the plus 30% to plus 50% range. We anticipate these trends will continue as the midyear property cat renewal and should translate to strong property cat premium growth in 2023 for Arch. Moving now to our Insurance segment. where we continue to reap the benefits of the investments we've made in enhancing our specialty businesses in the UK and in the US. On the year, we wrote over $5 billion of NPW, net premium written, compared to $4.1 billion in '21, with growth coming from a diverse mix of business. Underwriting performance continues to be excellent with an ex-cat accident year commodity ratio of 89.6%. Rate increases with a few exceptions remain above loss cost trend and we expect this strong momentum to continue for 2023. The insurance market remains rational and disciplined. We expect also continued opportunities due to the ongoing global uncertainties and remain optimistic that this disciplined behavior that we saw in the P&C industry for the last three years will persist as we move through Stage two of the cycles. Next, our mortgage team, again, had an acceptable quarter, capping off an excellent year. As we benefited from earnings from our embedded book as well as from favorable reserve development as cures on delinquencies exceeded our expectations. The mortgage segment delivered $374 million of underwriting income in the quarter and $1.3 billion for the year, an excellent contribution in a year where higher mortgage interest rates slowed new originations. Our insurance in force, the earnings foundation of the mortgage segment, grew to $513 billion at year end '22 as persistency increased due to higher mortgage rates. As expected, higher mortgage rates led to reduced [NRW] as mortgage rates touched 7%, the highest rates in 20 years. Looking broadly at the MI industry's health, we have borrower credit quality which is outstanding and excess housing demand above supply, the US unemployment rate is near historic lows and the borrowers' equity in their homes remain at very healthy levels. One thing worthy of mention is that the MI industry is acting in a disciplined and responsible manner. In the face of these economic uncertainties, premium rates are increasing while underwriting quality remains strong. Finally, the interest rate increases we've seen in the last 12 plus months should help fuel our net investment income through 2023. We are poised to benefit from higher reinvestment rates coupled with the growth in invested assets. I've got auto racing on my mind lately, and when I look at our industry, I can't help but think that Arch is one of the best cars on the track. We know that winning the raise comes down to more than having a great driver or the fastest car. There is much preparation, analysis and looking at the conditions on the track as well as monitoring the other drivers. By recognizing the soft market conditions in '17 and '18, we avoided the mistakes others made early in the race when they might have burned tires or overheated their engines. The pricing began to improve in 2019, we're able to take advantage of some of our competition basket stuff and engine problems, and we took the opportunity to take more of a lead on the track by increasing substantially our writings. And then once we saw some clear track ahead of us, we were able to accelerate even faster. Today, we're firing on all cylinders and I know we've got the right crew to bring in home. Let's hand the wheel over to Francois before coming back to and answer your questions. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Thank you, Marc, and good morning to all. Thanks for joining us today. I'm very pleased to share that once again, Arch had an excellent quarter on virtually every front. The year concluded with fourth quarter aftertax operating income of $2.14 per share for an annualized operating return on average common equity of 28%. Book value per share was up 9.9% in the quarter to $32.62 and down only 2.8% on the year, a great result considering the impact raising interest rates had on our fixed income portfolio with a difficult year in equity markets and the elevated catastrophe activity we experienced this year. Turning to the operating segments. Net premium written by our reinsurance segment grew by an exceptional 118% over same quarter last year. Although this quarter, we had a few large one off transactions that impacted our results and contributed $407 million to our net written premium. Adjusting for these transactions, our net premium written growth was still elevated at 61% for the quarter. These transactions are yet another example of the dislocated state of the uninsurance market where our strong balance sheet provides a significant advantage as we look to deploy meaningful capital to support ceding companies at terms that meet our target return expectations. More importantly, the underlying performance of the segment this quarter was very good with an ex-cat accident year combined ratio of 82.9% and a de minimis impact from current accident year capacity losses. Reflecting ongoing hard market conditions, the insurance segment also closed the year on a very good note with fourth quarter net premium written growth of 17.4% over the same quarter one year ago in an accident quarter combined ratio, excluding caps of 89.6%. Most of our lines of business still benefit from excellent market conditions, both in the US and internationally, and our expectations for the coming year remain very positive. Our mortgage segment continued its run of quarters with results better than long term averages as claim activity for the business remain low. While production volumes were down due to the lower level of originations in the market, we remain positive on the return prospects for this business. Net premiums earned were up slightly on a sequential basis as the persistency of our in-force insurance at 79.5% at the end of the quarter continued to increase. The combined ratio, excluding prior year development, was 45% for the quarter and reflects our prudent approach to loss reserving, one of our key operating principles. Our underwriting income reflected $270 million of favorable prior year development on a pretax basis across all segments this quarter, which represents approximately $0.66 per share after tax. While most of this favorable prior year development, $211 million, came from the mortgage segment, mostly on claim reserves set up for COVID related delinquencies in the 2020 and 2021 accident years at US MI, it is worth pointing out that our P&C reserves also contributed to the overall results. Of note, both our insurance and reinsurance segments had another quarter of favorable reserve development, and the 2022 calendar year phase two incurred ratio for our P&C operations was 58.7%, its lowest level in more than five years. Both these metrics provide some insight into the adequacy of our loss reserves, which constitute an important element in the quality of our balance sheet. Quarterly income from operating affiliates stood at $36 million and was generated from good results [indiscernible] in summers. Pretax net investment income was $0.48 per share, up 41% from the third quarter of 2022. Cash flow from operations, over $3.8 billion for the year, was strong and when combined with the proceeds from maturities and sales of securities in a rapidly rising yield environment, and hence, the underlying contribution from our investment portfolio. Going forward, with new money rates in our fixed income portfolio in the 4.5% to 5% range and a growing base of invested assets, we are well positioned to deliver an increasing level of investment income to help fuel our bottom line. Total return for our investment portfolio was 2.6% on a US dollar basis for the quarter with all of our strategies delivering positive returns. The contribution to the overall result was primarily led by our fixed income portfolio, which benefited from relatively stable interest rates and tightening credit spreads. The overall position of our investment portfolio remains relatively unchanged as we remain cautious relative to duration, credit and equity risk. Turning to risk management. Our natural cat PML on a net basis stood at $970 million as of January 1 or 8% of tangible shareholders' equity. Again, well below our internal limits at the single event one in 250 year return level. Our peak zone PML remains at Florida Tri-County region. And as Marc mentioned, the PMLs we report represent a point in time estimate of the exposure from our in-force portfolio and the premium associated with the January 1 renewals will get reported in our financials starting next quarter. On the capital front, we did not repurchase any shares this quarter as our assessment of the market opportunity in 2023 remains very positive, one where we should be able to deploy meaningful capital into our business at attractive returns for the benefit of our shareholders. Finally, as Marc mentioned in his remarks, the results we enjoyed this year across our operations were achieved through a thoughtful and deliberate execution of our cycle management strategy and a strong culture of allocating capital to the most profitable markets and opportunities. These results, which were an important contributor to us joining the S&P 500, were only made possible by the ongoing hard work and dedication of our over 5,000 employees across the globe. They deserve a tremendous amount of credit for making us who we are today, an industry leader with a stellar 20 plus year track record that is ready for the opportunities and challenges ahead of us. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Tracy Benguigui with Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "Your one in 250 PML to tangible equity of 8% as of 1/1 wasn't too dissimilar to your 7.7% as of September 30th. So I'm wondering what made you pause to incrementally take more exposure? Did that have anything to do with less retro capacity or your view of ROEs based on pricing for that incremental cat exposure?"
},
{
"speaker": "Marc Grandisson",
"text": "I think this number -- interesting, this number is one region, one area, one sub zone. What is not seen in the numbers, and we'll have a more thorough discussion at the Q1 call is that we've increased cat exposure across a wider range of sub zones, and that doesn't really come across through that Tri-County. And I remind you, Tracy that the Tri-County renewal is going to be more important and more apparent at the June 1 renewal. So it's also one first step into it. So we have grown a European exposure because the race course look pretty good there. Significantly, it would not show up into that one single number, right? This is sort of a -- it relies sort of the true increase in allocated capital to catastrophe. If you look at the aggregate number, which is a better reflection there is [indiscernible] increase, that will be commensurate, it actually would -- you'll see the premium increase and the cap allocation increase are -- it will make sense to you."
},
{
"speaker": "Tracy Benguigui",
"text": "So as you look through the year, even though 25% is your maximum threshold, where do you think you could realistically land based on your risk appetite?"
},
{
"speaker": "Marc Grandisson",
"text": "Tracy, our typical answer is, you tell me what the rate levels are like, and we'll tell you what we think we can do. We have a plan based on certain various levels of rate changes in terms of condition changes by zone by region. And our team, as you can appreciate, is willing and able to operate on that basis. If you take a step back, I think the overall capital position of the company is, we have plenty of opportunities to deploy, it's hard for us right now to see going all the way to '25. But certainly, we have room to grow and we have the capital and the relationships to do so."
},
{
"speaker": "Tracy Benguigui",
"text": "And also really quickly on the reinsurance side, in recent times, you focused more on quota share over XOL. So with hard pricing, where do you see the best opportunities? I'm thinking about lower ceding commissions on quota shares and the higher rate online on the XOL side?"
},
{
"speaker": "Marc Grandisson",
"text": "So I think it's across the board. You just mentioned that we have improved economics both on the quota share in excess of loss. I think that the numbers you see in Q4, a lot of it has to do with our recent growth in the quota share that we've written. I think by virtue of the cat XL, as we just talked about a few months ago, increasing, I think that we would be in a position to increase our excess of loss contribution to the bottom line. But when the hard market is around, which we still see on the reinsurance side and the insurance and the P&C side, we have a tendency to migrate towards a quota share. There's a few reasons for that. Number one, one of the big reasons that we like to talk about is, you inherit some diversification within that portfolio that you otherwise would not necessarily get from a net excess of loss perspective. And we really, really like this and we like to be closer to the rate change, right? When you're on a quota share basis, you’re side by side with a client as opposed to in excess of loss, you need to be relying on your sole pricing to make it work. So over time when the market gets harder, I think you will expect us and as part of the cycle management to underwrite more quota share versus excess of loss. This year, they're both pretty good."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Michael Zaremski with BMO."
},
{
"speaker": "Michael Zaremski",
"text": "I'll stick with the primary insurance segment, given I feel like most of the questions will probably be on reinsurance. The growth has been decelerating there a bit. Marc, we heard your prepared remarks, sounds like you're still excited, but maybe you can kind of talk about what's driving the deceleration, what are you guys seeing? I don't know if it's worth bifurcating between kind of E&S excess surplus lines versus non-E&S. I'm just curious if the discipline there is dissipating a bit more versus reinsurance?"
},
{
"speaker": "Marc Grandisson",
"text": "I think we're just experiencing, in the fourth quarter, that will probably change in '23, I think opportunities are going to resurface more broadly than we even had in the fourth quarter, right? I think it took a little bit to the market to digest in and to what it means for the overall market. I think another market, it's clearly in the camp up making -- doing what it needs to do to improve the return on the pricing on the property, which I think also you heard in other calls, I think will impact broader set of line business beyond the property exposure. But if we’re to go back, so if you look at the 70% growth, I mean 70% growth over, premium is about 3 times the size three, four years ago, we did have a lot of growth in the beginning of our market. So as you get into the late stages, I think 70% could be equivalent to another 50% increase in 2021 or 2020, when we started to lean into the market. So I think this is a natural phenomenon that after a while, you have -- now that you mined everything, but you really have pushed as hard as you could, and we're still pushing hard. Even 70% to me is about 3 times the average growth in the premium in the industry, that tells me that we're still seeing a lot of opportunities. But again, like I said, we're later in the stage of the [indiscernible]. And I think that we'll see a rejuvenation, if you will, of that growth possibly because the insurance companies are going to have to increase, as we all know, their pricing. One is the property cap and the higher retention why they have more risk retaining. And we're participating like the other guys on the insurance market, so we expect market to sort of getting a second bite of the apple, if you will, of a hardening market."
},
{
"speaker": "Michael Zaremski",
"text": "And as a follow-up, sticking with the primary insurance segment. So it sounds like the opportunities might fall within the property space, if I'm interpreting your comments correctly. And when we're thinking about the segment's combined ratio, I feel like looking at my older notes, it was kind of mid-90s. Was the goal -- is that still what you're thinking, or as time has been so good in terms of the market cycle that we should be thinking lower 90s is the more near term goal?"
},
{
"speaker": "Marc Grandisson",
"text": "I think we said a few things about the combined ratio. The 95% was meant as a target back in '16, '17 when interest rates were quite a bit lower, and it went down further. As you know, that meant that we needed to have a lower combined ratio targets, which we targeted over last two, three years, that's where you see the impact to us. I think from our perspective, low 90s is still what -- or high 80s is sort of what we're still pushing for because within the interest rates, they may revert back and come down after a while in a year, year and half from now. So you don't want to be rushing to recognize all the various interest rates, although we are currently -- we are pricing into our business, but we tend to take a longer view like we do on the trend on our inflation. And we're thinking the rates might come back down. So I think we would still target a lower 90s to high 80s to get the returns that we think we deserve."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jamminder Bhullar with JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"text": "First, I had a question on the reinsurance business. If you look at your premium growth, even excluding the sort of large transactions, onetime transactions, you mentioned the number is extremely strong and obviously, doesn't have the impact of 1/1 renewals in it. So what's really driving that and do you expect some of those factors that drove the strong growth to continue into '23 as well?"
},
{
"speaker": "Marc Grandisson",
"text": "I mean the one thing that right from the get go, I think, you need to appreciate the quota share business is something that we might have written a deal in January 1 of '22, and the premium gets written over the four quarters. So we're benefiting from that, that's showing up in each of the four quarters. If the underlying rate increases also from the ceding companies are higher than what we might have expected at the start that gets adjusted throughout the year. So a couple of factors were, basically, we're just following effectively the fortunes of the companies. But still, I think our teams deserve a lot of credit for going after these opportunities, being responsive to the client needs, being -- providing good capacity with good ratings. Does that continue on in '23? We think so. We think the market is there and the [Technical Difficulty] growth was not only in [Technical Difficulty] business, it's pretty much in [Technical Difficulty] business. And property and properties [Technical Difficulty] a lot of attention in the last few weeks, but still, I mean all lines of business, other specialty, casualty, marine, aviation, remain -- I think all lines are, I think, in a position to really keep growing at a good cliff in ‘23."
},
{
"speaker": "Jamminder Bhullar",
"text": "And then just shifting on to MI. Your loss ratio is obviously very good, but I think the loss pick did pick up a little bit in the fourth quarter. So is that more sort of national driven or is it more regional to where you're starting to see some maybe softening in the market in certain regions or states?"
},
{
"speaker": "Francois Morin",
"text": "Well, we've navigated through the regional differences in our pricing. So I think we have constructed our portfolio that we're very happy with, stayed away from what we perceive to be the more dangerous areas and underpriced areas. So I think that's kind of showing up in our performance over time. In terms of reserving, I'd say, two things. One, the delinquency rates are still very low. So it's not like we're really seeing pressure at this point in terms of the higher level of delinquencies being reported, and the loss ratio pick is really more a function of us being a bit more prudent. I think there's a little bit of uncertainty with -- whole prices, are they about to come down, does that create some potential pressure? We think we're very aware of that, whether there's a recession, et cetera. But we're still very, very positive on the segments. It's just a realization that this is maybe a likely riskier environment than we were in like a year or two years ago, and our reserves are going to reflect that."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Brian Meredith with UBS."
},
{
"speaker": "Brian Meredith",
"text": "A couple of them here for me. First, Marc, Francois, you guys typically provide in your 10-Qs the one in 250 for the other regions well, Northeast and Gulf of Mexico, UK. I'm wondering if you could give -- have those statistics so we can get a better sense of what type of growth you're going to see at 1/1 renewals? And maybe focus also on Europe, because I know Europe was -- you got a good operation there and a lot of opportunities there."
},
{
"speaker": "Francois Morin",
"text": "I mean the ones we reported really a couple more regions. We don't have -- I don't have those handy. I think the most of my -- to Marc's point, I think a lot of the growth that we saw, at least at 1/1, will come through in regions that were, I'd say, we were probably a little bit underweight in the past. So that's going to show up in Q1 premium and for the rest of the year, but in terms of P&L, it really doesn't have an impact."
},
{
"speaker": "Brian Meredith",
"text": "And then second question. I'm just curious, Marc, if I take a look back -- and I'm going to date myself a little bit here. If I look back at which your underlying kind of combined ratios looks like back in 2003, 2004 after the last hard market, you're getting pretty close there in the reinsurance business. Are we getting to the point where we're kind of seeing max margins in that business, maybe you get a little bit more in 2023, but how much more do you think you really get here?"
},
{
"speaker": "Marc Grandisson",
"text": "I don't know the answer to that. I like the comparison to ‘02 or ‘03. I would actually like to compare probably more like a combination of ‘02, ‘03, maybe ‘04 in liability and maybe ‘06 or ‘07 on the property side. So I don't know what that means. We haven't blended growing the combined ratio that we had in this year, but that probably would be close to what we can do. I mean, look, there's a lot of things that are different this time around. The interest rates are lower than they were before internationally. More specifically, we're an international diversified reinsurance company. Hard to tell, but it's certainly going in a way of getting above our long term ROE targets that's for sure, and that's really what, in the end, what really drives us, as you know."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Yaron Kinar with Jefferies."
},
{
"speaker": "Yaron Kinar",
"text": "My first question, just looking at the ROE profile of the company, clearly, there's upwards momentum here. Can you maybe talk about, A, what the target would be and B, if you'd see it coming more from -- or the expansion from here on coming more from NII or more from underwriting?"
},
{
"speaker": "Francois Morin",
"text": "I'd like to think we got room to grow. But you're right, I think the biggest probably opportunity is NII, just with the leverage and the correction or the increase in interest rates we saw last year. I think that's going to take still a little bit of time to show up in the numbers. But as we look forward over the next 12 to 24 months, I'd like to think that, that will -- there's leverage there that we can show up in the numbers. In terms of the segment’s results, I think they can all -- mortgages, again, the reported results, I mean significant reserve releases, which certainly helped the bottom line and the ROEs that are reported. But we think the segments, the fundamentals underlying each of the three segments are still very good and they can actually still deliver very healthy results."
},
{
"speaker": "Yaron Kinar",
"text": "And then my second question, just looking at the insurance business, it sounds like you think that there maybe some inflection to accelerating growth again in '23. Can you maybe help us think about the impact of the reinsurance market, kind of available capacity, cost of reinsurance, how that plays into the potential growth that you see for net premiums written in '23 in insurance?"
},
{
"speaker": "Marc Grandisson",
"text": "Great question, Yaron, because I think what we're going to see through '23 is a recognition. I mean it's already there but it's probably really coming home and the rules for us as a saving company right on the insurance line and our clients and ceding companies that more needs to be charged to the insurers that they can in turn pay the reinsurer they need to buy. Even if they went there, right, we heard that a lot of increasing retention, there’s still more volatility that's absorbed by those insurance carriers, which should lead to, again, needing a higher rate, everything else being equal. So I think what we're seeing is -- what we'll see is gradually -- and again, on the reinsurance sectors, Yaron, you can just renew business 1/1 and everything changes on a dime, right, on one stroke of the pen. On the insurance side, it take 12 month period to transition and transform and then reprice the whole business. So that's what I think we're going to be seeing, that's why I'm also fairly optimistic is because we're going to have that repricing occurring throughout 2023 and beyond. And alongside with those, between all of us here, the terms and conditions are also going to be on the table, right, on the docket for companies to present to find a way to not curtail but find a way to have a better risk sharing with their insurers when it comes down to other policy. So I guess for that reason that's what underlies is that sticker shock, not sticker shock, but good increase in reinsurance at the beginning of the year that we'll have to filter through all the plans and budgeting for all the insurance companies, including ourselves as we go forward in '23. So it's going to be a slow motion but it's going to happen, that's why I'm optimistic."
},
{
"speaker": "Yaron Kinar",
"text": "And I apologize, I'm going to try and sneak one more in here. A clarification, when you talked about kind of targeting low 90s, high 80s combined ratio, was that a reported combined ratio in the insurance segment?"
},
{
"speaker": "Marc Grandisson",
"text": "That's policy year target effective [Technical Difficulty] it’s just expected, right, plus or minus, as you know, in our space, is volatility around the expected numbers, but this is long term expected."
},
{
"speaker": "Yaron Kinar",
"text": "Because I think you've been running at kind of mid-90s. So where is that improvement coming from, is it mostly just better rates and in risk selection?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, we're running -- we're running about 90 now, and I think that we still continue to see improvement in pricing. So that should help us get there somehow."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Ryan Tunis with Autonomous."
},
{
"speaker": "Ryan Tunis",
"text": "First question, I guess following up on Tracy. Could you give us some indication of, I guess, how you're viewing your overall cat budget this year relative to '21 based on what you saw with 1/1 renewals? Should we expect to kind of the expected cat ratio to be higher?"
},
{
"speaker": "Francois Morin",
"text": "The cat ratio or cat? I mean, in terms of…"
},
{
"speaker": "Marc Grandisson",
"text": "Cat load."
},
{
"speaker": "Francois Morin",
"text": "Dollars of cap, yes, we think will go up. No question. We've been targeting, we’re targeting -- I mean our cat load in '22 was, call it, $80 million a quarter. Now it's probably between $100 million and $120 million for the first quarter of '23 based on what we wrote, right? And we'll see how that develops for the rest of the year. I mean, depending on how the 41, 61, 71 renewals, how those kind of materialize, there is, I'd say, a good probability that it will keep going up throughout the year. But based on the in-force portfolio that we have currently for the first quarter, I mean, that's kind of how we see the exposure to cat losses."
},
{
"speaker": "Ryan Tunis",
"text": "And then I’d one for Marc, I guess, on the man-made cat side, which isn't something we've talked about too much. But I would think that's one of the better markets right now on the reinsurance side. And I guess just trying to size that, whether or not maybe some of the rate increases post Ukraine, if that can move the needle relative to property capital, just looking at your marine and aviation premium, it's actually pretty chunky relative to property cat. So if you could just give us some indication of can that move the needle, is that something that we should be paying more attention to in terms of the markets you're seeing that are getting incremental firming that could help Arch?"
},
{
"speaker": "Marc Grandisson",
"text": "I think the one thing with an event such as Ukraine, which is a war event, there's actually a specific market for those kinds of risks. So it's not like it's included part of the overall coverages for cat or whatever else out there. There was some -- there definitely is a result of that event in attempt to exclude a lot of these war events and bring them back into the proper -- aviation war, on marine war market, for instance. So yes, there is a lot of -- obviously, a lot of activity there, a lot of rate increases there. We're participating in there, but those markets are to begin with pretty small. So that's why I think you'll see some improvement, but it may not be necessarily enough to move the needle for the industry, even though it's a very, very healthy proposition that rates have gone through the roof as you can appreciate for the right reasons in those types of business."
},
{
"speaker": "Ryan Tunis",
"text": "And then just lastly, the acquisition expense ratio has been kind of hard to pin down at Arch over the past few years, but it's gone up. Obviously, it sounds like there were some changes in terms of ceding commission structures, things like that at 1/1. Is there anything directional you can say about maybe how the acquisition expense ratios could move in '23 versus '22, or do we just kind of expect something relatively similar?"
},
{
"speaker": "Francois Morin",
"text": "I don't think it's going to move a whole lot from where it's been. I think there's been a lot of shifts in the mix of business over the years, right, as particularly as our insurance book in the UK has grown, that's a bit higher acquisition ratio, different kind of that reinsurance purchasing decision. So there's a long list of reasons or explanations as to why it is where it is now. And obviously, what we focus about -- what we're focused on is the bottom line returns whether -- if we're going to pay a bit more acquisition, we certainly think we're going to get a lower loss ratio and that has been the case. But for your modeling, we kind of, I think, exercise. I assume something pretty similar to '22 as a starting point, and we'll keep you updated as the year goes on."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Elyse Greenspan with Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question, I guess, is going back to the reinsurance margin discussion that came up earlier. So you guys have a flat PML and you guys are seeing 30% to 50% rate increases in cat. Wouldn't that triangulate into margin improvement coming through in the reinsurance book in 2023?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, if I could just isolate. First, we wonder where you were, so good to see you there. Second, I think if you look at the property characters, I think the returns have dramatically improved. But as you know, for us, it's going to be incrementally, of course, accretive to our bottom line, but we're not -- it's not the biggest line of business for us. So that's what allows us, we believe, the opportunity and room to grow the way we think we could grow in 2023. So it's hard to say how much more, but the property cat itself, the market itself, has significant margin improvement."
},
{
"speaker": "Elyse Greenspan",
"text": "Would you say, building on that, Marc, would you say that of all your business lines as you sit here today, the line with the best expected return in '23 would be catastrophe reinsurance?"
},
{
"speaker": "Marc Grandisson",
"text": "It's up there, but there are others that we don't advertise too much that are really, really healthy and getting better, as we speak. And as big, if not has been -- probably, some of them are as big as a property cat -- property cat writing. So we have quite a few who are giving us pretty high returns, but it is up there, you heard on the call, this is a good time to write property cat excel, a really good time."
},
{
"speaker": "Elyse Greenspan",
"text": "And then you said, on the PML discussion, you had mentioned, right, that we need to kind of see how things come together at June 1 that, that could also be a good opportunity. What could derail this, is it just alternative capital and more capital coming into the reinsurance space as you think leading up to June 1? And even when we think beyond that, what are you guys concerned about that could derail the uplift that we've seen in the catastrophe reinsurance market?"
},
{
"speaker": "Marc Grandisson",
"text": "I mean it's hard to imagine, Elyse. I think the third party capital you mentioned, there’s still -- we're in a wait and see attitude. The US renewal, as we all know, is a small portion of the overall cat writing in the year, so more has to happen and as we all know. And in line with what -- our Tri-County was up, Florida exposure -- Florida is the biggest exposure. So it's hard to tell what could derail it. I'm trying to think out loud, the third-party coming in, I don't see it being a case. No cat in the first half of the year. While we better have no -- it would be great for an industry to take advantage of the less cat activity. No, it's hard to see anything at least, because I think that the psychology of the market is quarry of the kind of remediating what needs to be remediated in a property cat space at all levels. And from the C-suite all the way down to the underwriting system desk, I think it's clearly a recognition that we need more. I think the only thing I could say is, the one thing that I could say just to help you out here, I think that will make sense to you that we may have a bit less than perhaps some people have budgeted or maybe a bit more than budgeted price increase when we have a delta around what we see. But in terms of core capital needs and supply and demand, I don't see a major shift. I mean that was a long question, because I was thinking out loud here, but there you go."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Meyer Shields with KBW."
},
{
"speaker": "Meyer Shields",
"text": "I hope this one covered. I missed about a minute of the call. But I was hoping it would be dig into the nonrecurring transactions in reinsurance, I'm assuming this was a retroactive reinsurance. And I was hoping you could talk about specifically the sort of risks or the lines of business that you're assuming, and maybe give us an update on what that market looks like now?"
},
{
"speaker": "Francois Morin",
"text": "I mean to keep it at a fairly high level, those are general -- I mean, I consider them to be kind of capital relief, capital support transactions for a variety of reasons. Companies that have grown a lot under some rating agency pressures, aiming capital relief, companies trying to put some exposures behind them, et cetera. But just to clarify those are not retroactive so they're all insurance accounted transactions, insurance or reinsurance accounting, so that flows through our premium. They are across -- you saw it in our line of business, they did hit multiple of our lines of business. Some were other specialties, some were casualty, some are a little bit of property. So it's a spread. But it's all in a vibrant market. I mean there's a lot of pain that some companies are experiencing right now, and they're working for solutions. And again, we think we have strong balance sheet and capital to support them. So I think -- we don't know if they're going to happen again, those are lumpy. But if and when they are presented to us, we're happy to consider them and once in a while, we end up writing a few of them."
},
{
"speaker": "Meyer Shields",
"text": "Second question on mortgage insurance, and I don't even know how to phrase this, but you put up very conservative reserves for mortgage insurance over the course of COVID. And I'm wondering how much of that unusual reserve is still there because clearly, speaking at least for myself, we haven't done a great job of forecasting reserve releases in that unit."
},
{
"speaker": "Francois Morin",
"text": "Well, it's a great question, which is becoming harder and harder to answer, because in the early days, no question that we had adjusted our -- because so many loan, the delinquencies that were in our inventory were in forbearance and trying to make the distinction between kind of forbearance and non-forbearance delinquencies and how much of that worth was -- a new concept or new kind of reality we were basing. Over time, I mean it's been three years now. I think the reality is like the inventory is somewhat kind of commingled. So we don't really think of loans and forbearance kind of that differently than we look at the other loans, even though we know there's still a few of them in the inventory. So I mean long story to say that it's not something we tend to quantify directly every quarter anymore, but we still perceive that there's a bit of risk with COVID related reserves, and that's why we've been holding on to the reserves up to the point where we think we just don't need them. And right now, this quarter was an example where I think the data kind of suggested that we were -- it is the right time to really that there are no other reserves that were set up in those years."
},
{
"speaker": "Marc Grandisson",
"text": "And Meyer, quickly, I think what Francois is saying is true for all lines of business and historically, while we'll try to take a prudent stance on reserve to ensure we have enough and will let data speak for itself. And this one is very unusual, Meyer, right, the dynamic [indiscernible] something unlike anything else. It's when we have another one, we'll have a better playbook to use, but we just didn't know. And we still don't know, it’s still not over [indiscernible] are forbearance. So it's still coming back in the -- it's not totally gone yet. So that's what leads us to be that much more. From the outside it looks like we're conservative, but we think we’re being prudent and the data speak for itself. And mostly, if it happens that we don't need it then we'll adjust it based on the data we see."
},
{
"speaker": "Operator",
"text": "We have a follow-up question from the line of Tracy Benguigui with Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "I'm wondering what your outlook is on professional lines within your insurance segment? And particularly, what stage you would classify that business in when you went through your stages?"
},
{
"speaker": "Marc Grandisson",
"text": "Tracy, would you -- do you include D&O there, or you just wanted the ex-D&O, which lines specifically -- professional lines is a really broad market…"
},
{
"speaker": "Tracy Benguigui",
"text": "So my focus is more on D&O."
},
{
"speaker": "Marc Grandisson",
"text": "D&O, okay. So D&O, we expect similar trends that we saw in the last fourth quarter, it may change a little bit as a result of the overall thing that's happening in the marketplace. But the trend in the large commercial, for instance, have been neutral to negative, actually, for the last three, four years. So I would say that even though we may hear -- you hear, I know rate decreases on our D&O for large commercial, there's rationality behind it. So we expect rationality specific to this. It’s not -- there's a lot of data that points to -- that validates what kind of price points we're seeing on the D&O side. On the smaller D&O side, which we do a fair amount of -- to remind you, we do fair amount of D&O. We still see a very, very stable, very good marketplace. But again, the smaller D&Os are not the big ticket items that you would expect, but a lot of them are going to be not for profit small policy. So minimum premium is really -- a lot of times what happens and that 5% increase might be $50, right? So these are the kind of things that we do [indiscernible] and we have grown dramatically over the last four or five years, it's becoming a big section of what we do. That market is healthy from a [change] perspective, right, to go back where it said about the large commercial, the SCAs are down 25%, 30% over the last four years. So it's a pretty good market to be there. The IPO market has stabilized. It was pretty hot for a while, pricing got crazy. We took advantage of a lot of opportunity that's not crazy, but it was a very acute needing capacity. We expect this to sort of renormalize again. So I think I would say, D&O is normalizing for the large commercial, sort of a Stage four. I meant Stage 3 we’re recognizing some of the overreaction, but the smaller D&O is probably early stage or Stage 3, which is still very profitable and a little bit of decrease here and there or a slight increase."
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions in the queue. I would now like to turn the conference back over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Well, spend a good day with your loved ones, and we will see you in the next quarter. Thanks for listening, guys."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 3 | 2,022 | 2022-10-27 11:00:00 | Operator: Good day, ladies and gentlemen. And welcome to the Third Quarter 2022 Arch Soft Capital Group Earnings Conference Call. At this time, all participants are in listen-only mode. Later we will conduct the question-and-answer session. And instructions will be given at that time. As a reminder, this call may be recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sir, you may begin.
Marc Grandisson: Thank you, Michelle. Good morning, and welcome to Arch's third quarter earnings call. Our investors know that with Arch, you're getting a diversified time-tested active capital allocator. Are we on now?
Operator: Yes.
Marc Grandisson: Okay. Let me start again, guys. Sorry about this. Our investors know that with Arch, you're getting a diversified, time-tested active capital allocator that understands that how you navigate cycles is crucial for long-term success. Hurricane Ian gave us a stark reminder of the importance of insurance. And our hearts go first to all those lives or property. As we turn to 2023, our agility is never more important. As an insurer, we provide protection for our clients during times of uncertainty. The reality for our industry is that big events like Ian almost always result in opportunities for the company that actively manage their capital and have the ability and the decisiveness to act when markets need their capacity. Arch is one of those companies. The current environment presents Arch with the opportunity to enhance its relationships with clients as they seek out insurance and reinsurance solutions in these uncertain times. The cat activity in the third quarter has significantly increased pressure on property cat market, which could have ripple effects across all property and as we approach the 2023 renewals. Over the last several years, we've maintained that property cat rates have been inadequate. Now the market recognizes this as well. The events of the past 18 months significant interest rate hikes, repricing of investments, ongoing general inflation concerns and the increasing cost of capital, all point to the need for a higher margin safety in the premium with property being the poster job. We're pleased that the underwriting discipline of our insurance and reinsurance segments limited Ian's impact to a quarterly earnings event. As we have said before, our proactive approach to cycle management enables us to protect our capital over the long term. From Arch standpoint, as other insurers are reducing their overall participation, we have an opportunity to showcase our outstanding team, strong balance sheet, underwriting acumen and creative things. Our positioning should reward our shareholders with superior risk adjusted return in. I want to take a few minutes to call your attention to areas in each operating segment where we continue to make positive strides. In the third quarter, our insurance and reinsurance segments continued to grow premium and delivered solid current accident year ex cat combined ratios. 89.5 for insurance and 85.5 for reinsurance. In our insurance operations, we continue to see strong net premium written growth in the third quarter, up approximately 19% in the same period in 2021. Some of the most significant growth came from professional liability, including cyber as well as a strong increase in travel lines. Our excess and surplus lines business, both property and casualty, also continued to achieve rate increases of trend, and we are optimistic about the opportunity for further growth in 2023. Competition in P&C is robust, but rational, and the markets are taking a more technical approach to pricing and a project suits Arch's underwriting commodity. Cyber insurance has become increasingly important to our insurers globally, and we have substantially increased our support because quite simply, we believe that today's cyber market has changed for the better. The most important development over the past several quarters is that the alignment between clients and insurance companies have significantly improved as insurers have become more vigilant in their efforts to mitigate cyber risk. Additionally, insurance terms and conditions have sufficiently tightened, retentions have increased and rates have reached a level where we believe we have an opportunity to earn an appropriate return for the assumption of risk. Next, our reinsurance segment once again delivered excellent top line growth of the specialty businesses, including property, property cat and other specialty lines. Since inception, a hallmark of our reinsurance group has been its ability to quickly adapt to changing market and reallocate capital to earn better risk-adjusted returns. Excellent market conditions and the likelihood of capacity constraints were to likely create an eventful January 1 renewal period, and our teams are actively planning to meet the demands of our clients. Now to the mortgage group or, as I call it, our beautiful business. They once again provided proof of their sustainable earnings model by delivering $299 million of underwriting income that is essentially uncorrelated with our P&C operations. Although higher interest rates affected new origination volume, they also improve the persistency of our portfolio, which rose 4% in the quarter to 75.4% and allowed us to grow our U.S. primary mortgage insurance imports to nearly $295 million. Our embedded book is in great shape. Credit quality remains excellent. Unemployment is still at the historical low and the average borrower had a superior FICO score of 748. Homeowners equity, a key factor in protecting against claims is very high with 90% of policies having at least 15% equity in the home. In addition, the MI market is being proactive, increasing rates to adjust to the evolving environment. We continue to be thoughtful in how we manage our mortgage portfolio and because of our diversified model, we have the ability to take a measured view of the business as just one component of our diversified enterprise. In the near term, better returns will most likely come from our property and casual segment and we would expect that our capital allocation will bear this out. Although investment returns were challenged again in the third quarter, it's important to note that rising investment yields even after adjusting for claims inflation should help boost our return on equity. Obviously, with the Fed attempting to inflation, when we continue to see negative investment markdowns, a significant amount of which we would expect to recover as our fixed income securities mature over the next several years. Ultimately, the relatively high quality and short duration of our portfolio, combined with strong cash flows provide an opportunity for us to reinvest in new money yields that are substantially higher than our current book yields. In conclusion, outperforming in the P&C insurance market is always a challenge and the most recent paradigm where the property cat market was supported by cheaper alternative capital had increased the level of difficulty. However, many of the investors in ILS funds have recently seen their becomes underperformed and are beginning to leave the market. Without an obvious source of cheaper capital, our industry is nearing an inflection point. There appears to be a shortage of players with the capacity and willingness to participate, creating possible supply shortfall. Fortunately, for our shareholders, we have both the capacity and the willingness to deploy more capital in that space for as long as the reward justifies the risk. We're optimistic with regards to the opportunities ahead of us in the fourth quarter and into 2022. We talk about our principles of set cycle management and capital allocation at almost every opportunity because they're truly part of our DNA. We have remained disciplined over time and kept our focus on fundamentals when it came to underwriting. The market needs companies like us to rise to meet their needs. And as I like to say to our team, Arch is open for business. With that said, I'll turn it over to Francois to go through some of our financial details before returning to answer your questions. Francois?
Francois Morin: Thank you, Marc, and good morning to all. Thanks for joining us today. As we communicated in our release earlier last week, our third quarter results were adversely impacted by the effects of Hurricane Ian and other global catastrophe events. in spite of the severe nature of Ian, which we believe will end up being the largest single loss in our history, we reported after-tax operating income of $0.28 per share resulting in an annualized operating return on average common equity of 3.8%. Year-to-date, our annualized operating ROE is 11.6%. This result demonstrates once again the value and the resilience of our diversified platform. Now on to catastrophe and losses, where we wanted to provide a bit more color on our assessment of Hurricane Ian. We all know it's still very early in the claim adjusting process, and the final determination of our ultimate loss exposure will likely not be known for quite some time. Our initial estimate of the ultimate losses is based on an industry loss of $50 billion to $60 billion. We believe this range is appropriate at this time given the unknown impacts of inflationary trends, potential supply and demand imbalances and labor and material costs. The newly introduced Florida Property Insurance Reforms and the extent to which storm search claims may end up being covered by insurers, among others. Overall, we believe our estimated market share of the event will be comparable to prior or large events of a similar nature. In the insurance segment, net written premium grew 18.6% over the same quarter one year ago as our underwriting teams continue to find new business that meets our return expectations. Overall, underwriting performance was excellent with an excellent year combined ratio excluding cat of 89.5%, a 100 basis point improvement over the third quarter of 2021. In line with the last few quarters commentary, an ongoing shift in our business mix and structure of our reinsurance programs resulted in a slightly different split between the loss and expense ratios compared to the same quarter one year ago. In the reinsurance segment, net written premium grew by 73.6% over the same quarter last year. It's worth pointing out that in the third quarter of 2021, we had a cat up in seeded premium the Somers REIT, significantly reducing our net written premium. Absent this impact, the year-over-year increase in net written premium would have been 37.9% and much like the insurance group reflects an environment where we are better able to write business that meets our return thresholds. The segment produced a next cat accident year combined ratio of 85.5%, 230 basis points higher than the same quarter one year ago as a result of an elevated number of large attritional claims in our property other than property catastrophe book and also an increase in our expense ratio due to an ongoing shift from excess allowance to more proportional business. We believe this movement in the loss ratio is well within our expectations of the inherent variability of the underlying claims activity in our book of business. Our mortgage segment had an other excellent quarter with a combined ratio excluding prior year development of 39.9%. Net premiums earned decreased on a sequential basis as we continue to see the effects of higher recessions on our U.S. MI book and lower levels of single premium policy terminations. Persistency of our in-force insurance now stands at 75.4% at the end of the quarter. It has continued to increase due to the rising mortgage rates which considerably reduces the attractiveness of mortgage refinancing for most borrowers. We recognized $126 million of favorable prior year development across the mortgage segment this quarter as delinquencies continue to cure at a higher rate than expected. Over 80% of the favorable claim development came from our first lien insured portfolio at U.S. MI mostly related to the 2020 and 2021 accident years. The remainder of the favorable development came from recoveries on second lien loans and better-than-expected claim development in our Australian operations and our CRT portfolio. Income from operating affiliates stood at $8.5 million and was generated from consistent results of offset in part by underwriting losses at Somers Hurricane Ian. Net investment income was $0.34 per share, up 21% from the second quarter of 2022 and 55% from the third quarter of 2021 on a per share basis. The strong positive cash flow from operations over $2.8 billion year-to-date, combined with the proceeds from maturities and sales of securities, deployed in a rapidly rising yield environment underpinned this improving results. Going forward, with new money rates above 5% and a growing base of invested assets, we should have a good opportunity to further enhance our operating income through solid investment income results. Total investment return for the investment portfolio was negative 3.01% on a U.S. dollar basis for the quarter in a challenging environment of rising interest rates and weak equity markets. We remain cautious relative to our duration, credit and equity risk with our investment portfolio, and this defensive strategy helped minimize the mark-to-market hit to book value. Our investment duration remains relatively unchanged compared to one year ago and is slightly underway relative to our liability duration. Turning to risk management. Our natural cat PML on a net basis stood at $851 million as of October 1 or 7.7% of tangible shareholders' equity, again, well below our internal limits at the single event 1-in-250-year return level. Our peak zone PML is currently the Florida Tri-County region. On the capital front, we repurchased a minimal amount of share this quarter, approximately 236,000 common shares at an aggregate cost of $10.1 million. As our prospects of seeing meaningful opportunities in the business remain very good for the remainder of the year and into 2022. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions] Our first question comes from Jamminder Bhullar with JPMorgan. Your line is open.
Jamminder Bhullar : Hey. Good morning. So first, I just had a question on -- obviously, on pricing in the reinsurance market. Obviously, cat pricing hardening a lot with after Ian, how do you think it will affect pricing in non-cat lines? And where do you see the best opportunities for growth for Arch?
Marc Grandisson : So thanks for the question. I think it's still early. I think the Ian is one part of the equation. This is what I think we should probably see an impact on other lines of business because aside from Ian, we also have the markdowns and inflation concerns and whatever else is out there. So it would be reasonable to expect dripping effect through the other lines of business. I also want to remind everyone that the market has gone through a hardening outside of cat for the last three to four years. So I'm not sure we would see a similar or furthering or hardening the same level that we saw. But we're at a really, really good level right now. So anything that is incremental above that is hugely accretive to us on an industry certainly in Arch.
Jamminder Bhullar : And then how do you think about capital? Because a lot of companies, total equity has come down a lot because it marks on AOCI. And I noticed you bought back very little stock this quarter. Not sure if that has anything to do with capital or just preserving capital ahead of cat season. But how do you think about capital overall for the industry as well as for you guys and specifically, how that's affected by declining total book values?
Marc Grandisson : Yeah, I'll start with the overall industry, and I'll turn to Francois for specifics for Arch. I think that the capital going out in the industry is a big deal. We are an industry that rights against the surplus. And unlike 2008, when the markdown has recovered pretty quickly. We don't seem to be right now at this point in time, at least in a position where it will recover soon. So there's pressure on the capital in terms of how you write the business and how much you're allowed to write or the rating agencies or the regulatory agencies. So I think we'll refresh that pressure is not going to be short term. We think it's going to last for a while. And as an underwriter, capital is one of the main ingredients you have to create underwriting decisions and provide service to your clients. So it's a big deal. And we're talking some companies using 20% to 30%, 35% except these are big changes. And I would add, as you know, Jammie, that in initiatives, we have an environment where there are a lot of uncertainties, inflation, recession and whatever else is out there. So -- and I think we're all collectively bracing for interesting several quarters ahead of us. Francois?
Francois Morin : Yeah. The one thing, Jimmy, I'll add to specific to our Trey, and that's really part of our history. We've always operated with the principle that we wanted to have a strong and conservative balance sheet, right? And why have we done that? Why are we thinking that route? It was always with a mindset that we wanted to have optionality. We wanted to be able to take advantage of improving market conditions when and if they come around, right? . And what I mean consistent and strong and conservative balance sheet, it's, a, the investment portfolio, you saw that in our markdowns, we got some like everybody else, but I think we're probably more on the low side. And also in terms of leverage, we don't have a very levered balance sheet. Even today at 9/30, we're below 25% the right at 25% on a just-to-capital basis. So those are the reasons why we feel like that's -- again, that's been our strategy. And this may be a moment in our history that tells us that and we'll be able to enjoy the benefits or reap the rewards of maintaining such a strategy. So I think we're in a really, really good position. We're positive. We're optimistic about the market going forward. We're still not there yet, and we'll see what happens at one to one, but at least from the balance sheet point of view, we're in a really good position.
Jamminder Bhullar : And any color on the sort of minimal buybacks this quarter?
Francois Morin : Well, again, it's twofold. I'd say, a, we typically don't do a whole lot in the third quarter ahead of the hurricane season. So that's very consistent with our history. There's always -- the stock price matters, always, as you know, in the short and stock buybacks. So going into the quarter, we just wanted to see how things played out. And also with the expectation that we would -- the hard market, even before Ian, we still thought that the hard market would be -- go well into 2023. And that was one of the reasons why we felt maintaining the capital base that give us the ability to write on that business in '23 was critical to us.
Jamminder Bhullar : Thank you.
Operator: Our next question comes from Elyse Greenspan with Wells Fargo. Your line is open.
Elyse Greenspan : Yeah, thanks. Given your expectations for pretty strong price increases at January 1. Obviously, we have some time right until Florida and other business renews later next year. But where would you think -- based on the growth you think you could see in reinsurance? What do you think your PML will shake out next year?
Marc Grandisson : At a really good question, Elyse. And I think it's obviously dependent on the risk-adjusted return that we would see in there. Like I just want to remind everyone that we're underweight at 7.7%. So we have room to grow if we see the opportunity. We did grow a little bit in 2022, seeing opportunities. We would do the same thing if we were to be presented with the same situation. I think we have the capital, the appetite and the expertise to really participate in the upcoming market hardening. I think at least the -- if it continues to shape up the way it's designing itself, we're going to be part of a solution. We're going to be part of creating new solutions and providing meaningful capacity to our clients. What I like about what we are is we have a diversified platform. As you know, it is a lot of flexibility and as Francois Morin mentioned, we're in a very good position. What I could say is, if you tell me what the returns were, I would tell you how much we would be willing to take. But you would expect to hear from Arch that the way we think about building up the risk in the tower is incrementally as we would go up on the PML, we would the expected return to increasingly improve over that period. So it will be really, really highly depend on how much the rates go. And you might -- I think it's too early to tell. What it's going to be, right now, what we think it could change, but it should be significant.
Elyse Greenspan : So based on what you think could transpire and you think about putting your capital to use next year, insurance, reinsurance, mortgage, I mean it sounds like more will be on the P&C side. And then do you see more going to reinsurance versus insurance, because it sounds like you guys are still seeing some good opportunities on the insurance side as well.
Marc Grandisson : Yes. Well, I'll tell you, Elyse, if you look at this is the beauty of our platform, right? When you had a reinsurance company and an insurance company, was to participate in the upswing of the market that is reinsurance is a really, really quick and proactive way to do. So we think in the early stages of this hard market gets there, that we would be deploying more capital more quickly into our reinsurance unit because it's also what I think most of the need is going to do, right, on the insurance portfolio, at least as you know, fiscal year to turn over our portfolio, whereas a reinsurance portfolio could be done much quicker. So I think it's going to be in steps like it always has been. It's the same in 2002 when we were formed. We were really, really reactive and very quick to market on the reinsurance side as we saw our insurance business building up and getting traction and take via a hard market. So I think over time, we then where does it land in 2024 and beyond if we have this opportunity, again, as I mentioned, then it will be relative returns. It will depends who gets a better risk-adjusted return. They will have to go in front of Francois and I and argue their case. These are our prospective units. And this is what we're going to go through. We go through this on a quarterly basis to make sure we're keeping all the returns in the same -- the most optimal as possible.
Elyse Greenspan : And then 1 number is one. Francois, you pointed 230 basis points in the reinsurance segment, I think from elevated property claims. So if we're thinking about that kind of the run rate, I'm assuming we should ex out that $230 million and then assume as the business shifts more towards property and property cat that there would be underlying loss ratio improvement driven off of mix and rate in that business?
Francois Morin : Yeah. I think that's the third way to think about it. I mean, we've said before, I think looking at loss ratios on a quarterly basis is not something. It's not how we think about it. We like to take more rolling 12 months or even maybe longer periods to have a view of the long-term performance of the book. Again, I was just making a point that just to let everybody know that we're not worried about this little blip in our quarter, very much part of the normal volatility of our business. But going forward, if the market ends up being very constructive, let's say, on the short-term lines. Specifically, yes, the loss ratio presumably could come down a little bit.
Elyse Greenspan : Thank you.
Operator: Our next question comes from Michael Zaremski with BMO. Your line is open.
Michael Zaremski : Good morning. I guess just sticking with capital. Is the -- I know we don't -- I don't want to spend too much time about this S&P capital model. But I remember checking my notes from the spring when they were all using them as a punching bag or at least I was. And they were supposed to release a new version soon before year end, I thought. And there was always the issue of kind of the Bermuda senior debt, maybe not getting credits. I don't know. Any thoughts? Is that something you guys are thinking about? Or does that issue kind of not a tail risk we should -- or anything we should be thinking about?
Francois Morin : Yes. I mean I think we -- many of us thought we haven't answered all those questions by now. The model proposals that they perform were substantial and broad. So I think it impacted most -- I mean most types of companies, Europeans, North Americans, life B&T, et cetera. They did get a lot of feedback. So the current thinking and what they just let the world know recently that there -- call it, their second version of their proposal will be out in the first quarter. So there's a little bit of uncertainty there as to what changes they may make to what they suggested initially. We've had discussions with them. Many others have as well, specifically in the Bermuda debt issue. We'd like to think that's going to get resolved reasonably well. We don't have finality on that. But we're somewhat positive that we'll get a good resolution there. So from that point of view, I'd say our capital base is strong, and we don't see a need to make any changes to it at this point.
Marc Grandisson : If I may add, Mike, one of our key things on capital and we allocate capital on an economic basis, S&P is definitely an important piece of the puzzle, but it's not the only thing that drives us. So we're carefully paying attention to it. And we'll see what happens.
Michael Zaremski : Okay. Understood. Appreciate it. Maybe switching to your primary insurance operations, which I know are diversified among a number of businesses. But I guess a lot of good commentary in the prepared remarks. Could you give us an update on kind of where pricing has been trending? And maybe just a broad question on the primary insurance marketplace and maybe it's just -- maybe it's tough to put a paint with a broad brush. But if we thought about the angry insurance life cycle clock. Just kind of curious where you -- what time you think it is?
Marc Grandisson : It's a great question. I look at the clock many times a year and looked at it last week, we're about 12 noon, 11:30, 12 known on the P&C side, I would say. And probably 8:00-ish on the property cat space. But the clock can be turned back. So I'm not sure that 11:30 is going to stick. So that will be my comment and sort of alludes to the first question -- the first question I answered. I think that overall, most lines are getting rate over trend. We're still seeing plant. The fact that this is a broad statement, right, you're rightfully point that were specialty product company were many different products and every one, every one of these products has different characteristics, different exposure base, different attachment points, different geographies. Broadly speaking, most lines are clearing rate over trend. I think some others have said that in other calls this week. But I think that as an every hard market, this is what we're sort of observing in a few areas. We've -- there's been a lot of -- they have been for the last 3 years, almost over correction in some certain pockets. And I think that appropriately and rationally, people are looking at the history and the experience and they're seeing the difference is much improved. One example is [indiscernible]. I think it's a line of two here and there that have smaller rate increase or smaller rate decreases. The thing is it gets recorded broadly, gets a lot of headlines in the papers, but it's just not really a true reflection of the wider market. I think that by virtue, if you look at the way we operate on the insurance and reinsurance on the P&C and mortgage for that matter, we're really focused on risk-adjusted returns. And if we -- if you see us grow, it's because the risk-adjusted return is and the profit is there. So I think overall, the market is still very, very -- is presenting us with a lot of opportunity, both on insurance, P&C and reinsurance.
Michael Zaremski : And maybe -- I think you brought up the excess in surplus lines marketplace. Any maybe you can remind us how large of a business that is for you all? And is that -- is that -- are the dynamics different in that marketplace versus kind of the picture you painted in terms of the primary insurance marketplace clock?
Marc Grandisson : No, I think that -- no, actually not. It's actually an area that is still very, very active and very interesting for us. A lot of our growth actually comes from those E&S property and business. But to be selective, not all one line and all one monolithic subline as you can appreciate,. But certainly, we're participating in the ones where we like the risk return. Our E&S premium right now in the U.S. because it's hard to decipher what's in London. But in the U. S., it's about 28% of our premium that we write at E&S is almost double from what it was three or four years ago. So we have really leaned heavily into that marketplace and continue to do so. I think that what's happening with Ian and the acute need for capacity, specific kind of property should mean more E& S property opportunity and potentially some E&S casualty opportunities as well. I want to remind everyone this is a beautiful business to have as a specialty insurance company because you have a little bit more freedom of form, freedom of great -- and I think this is where really our underwriting acumen and underwriting expertise could showcase itself.
Michael Zaremski : Thank you. Best of luck.
Operator: Our next question comes from Yaron Kinar with Jefferies. Your line is open.
Yaron Kinar: Good morning. My first question is with regards to the changing reinsurance market. do you see that leading to changing retention rates in both insurance and reinsurance? And if so, what impact do you see that having not only on the top line but also on potentially lowering the attritional loss ratio and increasing the acquisition costs?
Marc Grandisson : That's a broad question, Yaron. It's a great question. And I think we're all incurring intently observing. I think -- maybe the best way to -- if I could allow me for 1 second to sort of draw a parallel with Katrina and the way it evolved back in. It's not exactly the , but let's go there for 12th and we'll back and come again turning back the insurance level. The insurance company took a long time, took 1.5 years to really repurpose and re-underwrite and reform, reshape their insurance portfolio to make sure that it was better. So risk -- not risk off, but readjusting the risk that issuance companies are taking is something that I believe they will be doing for the next 12 to 18 months. But as I said before, it takes a long time to do so. In the meantime, you still have the exposure. So typically, what happens is the reinsurance companies come in, say, well, we're going to need more returns for the capital capacity that we're providing to you the portfolio hasn't changed last two months is going to take a little while. We want to see what impact, what you're going to do in the portfolio. That was '05, right? So -- and then what happened, as you get into the New Year, as a buyer, of where our interest group is no exception, you still need to buy reinsurance and cat reinsurance. It's still a volatility that it's appropriate and prudent to purchase. So the purchasing still occurs. There might be some push and pull on the retention. Presumably, your retention would have to go up somewhat, maybe constraints and have a constraint on what limit is available. So I think if you put it all back together, there'll be shifting and changes in the reinsurance side, more likely at 1/1, as I mentioned. And as we go towards the Florida renewal of the year, the insurance portfolio will sort of be reacting to what the reinsurance market is telling them, that it's more costly from a cat perspective. So might take a long time to develop. I mean, it's not like a one renewal and done.
Yaron Kinar: Right, but do you think, I guess if we focus on the entrance segment for a second, so ultimately, I would think with maybe lower or higher retentions maybe you actually see some improvement in the attritional loss ratio, but at the same time, some headed to the acquisition ratio.
Marc Grandisson : Sorry, that's your question apologize. So there the answer is the second viewpoint. As you see the reinsure side gets more expensive, it's a change so perhaps you can buy reinsurance. The insurance team now know that they need to charge more to make up for what they lost or to get the protection because the reinsurance market is also telling them something very, very, very informative as to what is the price of cat chart and you need to chart for cat with. So you are right. So overall, we'll have pricing increase on the primary insurance portfolios, which to your point will lead to -- should lead to a lower attrition or loss ratio, because it's the same kind of losses from an attritional perspective with our agreement. So yes, that is a fair assessment for verifications.
Yaron Kinar: Okay. And then a follow-up statement you made earlier on the marks, I had always thought of rating agencies as largely looking through interest rate related marks, maybe with some exception with S&P. And I also thought that stat accounting doesn't really account for interest part. So why would that led or become an industry capital issue?
Marc Grandisson : Well, I think it's -- there's the official pronouncement or what -- the official view of how people look at certain things. But let's be honest here. I don't think anybody totally puts it to the side and doesn't consider it at all. There's companies that have lost, 20% plus of their capital base so far this year. If rates go up another 100, or 200 basis points over the next 12 plus months, at some point, there's -- you can't write a diversified book of P&C business at three or four or five to one. I mean, that's just -- people are going to push back and you got to have a plan to either remediate or have a view on when those markets are going to revert back. So rating agencies are, I think, in that camp. I think they'll give us and others some latitude, but it's not infinite. It's not like they don't consider it at all. So that's really our point here is that, it like it or not, some capital has evaporated, not permanently, but for the time being. It's something we need to work through.
Yaron Kinar: Got it? Thank you.
Operator: Our next question comes from Tracy Benguigui with Barclays. Your line is open.
Tracy Benguigui : Thank you. I have follow-up questions on your ability to grow prop cat risk and capitalization. So I feel like your 25% target of 1 and 250 PML at tangible equity is an easy way to communicate your appetite to the Street. But I realized a large consideration is allocating capital on a risk-adjusted basis. So can you remind us, how do you view diversification credit or covariance between MI and catastrophes? Or said another way, does your risk adjusted capital consumption from MI restrict your ability to take on prop cat risks even if there is diversification credit?
Marc Grandisson : Also Tracy. Very good question. But we won't divulge what I already know what economic model is. But if you look at an economic model, there is a large amount of lack of correlation between MI and P&C doesn't mean that they can go back and there's not really some non-correlation between the two. There's also a lot of correlation benefits that we derive from the multitude of stuff going on around the world. So we have a very, very diversified portfolio. I think the way that we look about this is, you know, the way you look at the curve, your economic curve, you know, again, we have to be careful, it's a mathematical exercise. We're not beholden to only mathematics. But if you look at the way you flex the P&L, if you put the pressure on an increase in currency and see what could happen if, do what if scenarios, and -- but you always have the eye on the maximum downside that you're going to take, combining both of these, or two or three of these really like 45 curves that we have. That's -- I'm going to leave it at that for now. I think that this is an exercise that we do all the time. We're going through it right now, and it's ever changing because pricing is moving. And it's one thing that is, I want to remind everyone is that we all only look at the loss itself. If you look at what premium you charge for the risk, and what really is working, the combined ratio and the profit level is very, very important. And every time you have a line of business that provides more profits, when margins improve or increase, it helps the overall balance sheet, the overall portfolio that you have on the reinsurance. Having said all this, with having a proper hard stop on the downside potential, we don't want to get a suspension of the balance sheet because we still want to be able to take advantage of the next market, if and when it does present itself. On the mortgage side, I will remind everyone that we buy a fair amount of quota shares that sort of protects a lot of downside. It's also part of our considerations. We buy quota share, we also buy excess of lots. So we have some protection. That's also a good example of how we manage the risk even if we like, we still very much like the MI risk, but we also are very prudent. And making sure some of the downside is somewhat protected, again, for the same reasons that as I mentioned earlier on the call. Thank you.
Tracy Benguigui : Yes, thank you for reviewing the process. I was just trying to get at, do you think that gives you an advantage to grow property CAT risk given the diversification credits?
Marc Grandisson : Absolutely. There's no doubt in my mind. But it's not -- again, it's not the worst application this diversity. We always are conscious, as I mentioned to make sure the process is improving. And I guess on the property cat the one thing that should be clear, I mean we it's reviewed. So now the charges, that's what we talked about, having an higher need -- higher charge need to take a commensurate or similar risk that we would take let's say in [indiscernible]. We need to be cognizant of those things. And I think yes, it is. It is really a fact that, in addition, our earnings power to your point, I mean, that's what you are sort of alluding to the fact that we have earnings coming from MI, definitely help us as we redeploy capital into the other opportunities that we see ahead of us.
Tracy Benguigui : Okay, and also want to go back to the conversation on negative mark and capital in a way, why does it matter? I know, S&P would penalize you for that. But don't you have access of up to $1.3 billion line of credit, so you shouldn't actually crystallize any unrealized losses by being a forced seller? Is that fair? I'm just wondering if investors should pay more attention to liquidity.
Marc Grandisson : Well, I mean, it's a fair point. We again, we're not constrained. I think that's the most important thing. Leverage ratio is down, but we also have access to other forms of capital or line of credit is one that you mentioned. There are others. So if the opportunity is there for an additional growth in our P&C lines, and maybe mortgage, whatever we'll see them as we move forward, I think, my view is that it's hard to write on, on call it, you know, capital, that's just not on the balance sheet. Right. So it's got to be in the balance sheet somehow. And our view is, yes, we see recovery in the unwinding of that mark to market hit so far. But the capital base, has to show that it's real and solid to get credit, and write on it.
Francois Morin: And Tracy, the argument, that you're pushing us, I mean, you could take it to the extreme, right, because the way they handled was up by 80%. But at some point, it starts to matter. It's not as important as 5% or 10%. It's more important at 30% and becomes progressively more important, because in the end we have to pay our policyholders. And then once we're out of reserves did a cat loss, we need to take care of our capital. And it does matter in the big world. So I think it's --I'm not saying it shouldn't matter 100% now, because at some mark and it's still capital available. But it has to make a difference somehow over time, because the argument would fall, right, at what point do you think it starts to matter, 50, 60, 80? I think it's matters just a different degree through the capital stack.
Tracy Benguigui : Okay, just one last one really quickly, given the higher reinvestment rates. How long will it take Arches market to creep back to book value?
Marc Grandisson : Well, I mean, there's -- we've done some rough math. I mean, you can kind of look at it like portfolio, turning over in the following two years on average. So let's call it eight quarters. And you can do get a rough now by that. But the reality is, we're going to also I think we're going to get -- we do have plenty of free cash flow coming through. And that's going to be reinvested at pretty significant levels. So we think that overall, the book value should start growing pretty quickly beyond just the recovery of the markets.
Tracy Benguigui : Thank you.
Marc Grandisson : You are welcome.
Operator: Our next question comes from Josh Shanker with Bank of America. Your line is open.
Josh Shanker: Yes, thank you. I wonder if you can give a little outlook on the mortgage insurance sector? Are we at the bottom of the issuance cycle here for opportunities? Does this last for a little while? Are there even fewer mortgages that are going to be purchasing insurance over the next year? Where do we stand right now?
Marc Grandisson : Sorry, Josh. In what sense -- on the primary side of MI or are you…?
Josh Shanker: Yes, primary, MI. I'm clearly like new home sales are down. And so obviously, we're going to expect less flow. Is it going to continue to decline from here? Or is this kind of what a -- I guess a holiday from mortgage issuance looks like for the MI business?
Francois Morin: Well, we've said it before. I think, and it still holds. I mean, the in-force book is where we're going to generate most of our underwriting income for the foreseeable future, right for the next two to three years. Doesn't matter really materially whether production is stable, declining increases, increasing the in-force books, is going to drive the underwriting income for the next three years or so. And we are very comfortable with the level the performance of that book right now, because as we know, and as we've said before, depreciation is a big part of that, refinancing refinance activities coming down. And so persistency is up, etc. So there's a lot of things pointing us in the direction of saying yes. That in-force book is doing well and will keep doing well, we think. Over time, no question that if new production kind of keeps declining to levels, very low levels for an extended period, then a maybe starts to show on the numbers, but we don't think that's anytime soon.
Marc Grandisson : And on the INW, which Francois just mentioned about new production, if you look at the NBA numbers, the purchase market, which is by far the most important one, for the MI business, is a lot more stable, there's not as much of a decrease. So we're still fairly positive, that we're still going to get some nice production from our team over the next several quarters. And again, I remind everyone that as you know mortgages is up north of 7%. So it does make it a bit hard to get into a home. But fact is, there's still pent up demand for housing if the purchase market should stay pretty active for the next several quarters, which bodes well for our INW, just forward-looking.
Josh Shanker: And if premium yield declines on insurance in force. I mean, is there a bottom that we should be expecting? Or does it continue to tick down in the coming years?
Francois Morin: Yeah, I think I just mentioned it in my comments, the industry always like everyone else here on the call talking about what's happening around the world, some uncertainties, discussions, whatever else. The potential thing that could happen and the industry is raising rates is right, is raising premium rate as we speak on the mortgage, the mortgage sector, which is good news, which speaks I believe, volume for the new environment, that we have in MI, an industry that, is a lot more disciplined and deliberate in what it's doing. It's something we would have expected, but it's good to see it happen in life, in real life case like that we are seeing right now.
Josh Shanker: Pending what happens at 1/1 is mortgage insurance still the highest ROIC of your opportunity?
Francois Morin: Right now we have a lot of discussions about this. Right now. We believe that our P&C operations are slightly gaining and getting ahead of it, don't tell our MI group that. But it seems that the ENC units are squarely taking the lead.
Josh Shanker: Thank you very much.
Francois Morin: You are welcome.
Operator: Our next question comes from Michael Phillips with Morgan Stanley. Your line is open.
Michael Phillips : Thanks, good morning, everybody. Just looking -- the questions on the no discount in the current times we're in with property, cat and massive hurricane on the heels of what's going on with interest rate environment and everything else and mark to markets. But and even lots of movements around property cat pricing, obviously. But to what extent do you think we're in a period, very early innings of more respect for property cat, and this will continue actually, over the long term, which clearly has not happened in a very long time?
Marc Grandisson : Well, the answer is we don't know, right? I mean, this is protecting the future. I mean, there's a lot of modeling out there that is trying to address it. We certainly are on the cutting edge ourselves with neurologists and everyone else we have on staff to make sure we're on top of it. But again, it's like everything else it's a prediction. And we try to put as much cushion or a little bit of extra level of conservativeness, to make sure that you're on the right side of the equation. And if things keep on going, and you're getting worse, getting better than you adjust and you're fighting the last data point into your next year's expectation. I think that if you take a step back, I talked about it on my comment, what is also -- what's also going on is that we sort of disregarded the true expected cat -- expected cat losses, if you were to just allocate without putting a lot of weight or a lot of increase into some of the factors that that go with cat pricing, we as an industry should have priced more, for which we are charged more for the cat risk and we didn't. And I'm always reminded of the law of large numbers which says, over the long run, you get what you deserve, in results. So it's not far from my mind to think that perhaps, just perhaps not a necessarily a change, a climate change but that could be the case but it could also be just by virtue of not charging enough over time that you sort of get -- you reap the reward of that mispricing.
Michael Phillips : Yeah, that's kind of what I was alluding to. But okay, perfect. Thank you. That's all I had.
Marc Grandisson : Thank you.
Operator: Our next question comes from Yaron Kinar with Jefferies. Your line is open.
Yaron Kinar: Thanks. Yeah, I thought I'd take this opportunity to follow-up on something you mentioned in the script, cyber. So maybe two questions there. First, on the attritional side, my understanding is that it's really about active management. So not just the annual questionnaire at the time of renewal, but really identifying and managing wheel time vulnerabilities. As a traditional insurer, what capabilities do you have on that front from a tech angle? Are you partnering with third party vendors to achieve this?
Marc Grandisson : Yeah, so the answer the great question, yeah, I think number one is we're partnering up with guys who are cutting edge really, on top of the latest technology, and latest forensic work for our clients. And that's a really good place to be. We also have a team. But funny enough, a lot of our teams were on the tech side for cyber risk are not part of the underwriting team. So we have a lot of people within the underwriting units who are actually more IT people than cyber specialists, and they themselves also contract with other third party vendors as well to make sure that we're on top of it. In addition to other third party vendor that we have ourselves within the company, so we also want to look out and understand it more and more. It's a big investment.
Yaron Kinar: Got it? And then the other question I had on cyber. Actually one of your competitors was talking about this today as well, the need to get more comfortable with the tail, before really pursuing more significant growth in this line. So how are you thinking about the tail? And how are you --are there actions you're taking in order to manage it and allow yourself to pick up the comfort to grow?
Marc Grandisson : That's a very good question. This is harder to manage at a technical level as you can appreciate, right? Because it's really the cloud and other systems. I think what we do right now is listen, instead of in lieu of adding this technical structure infrastructure, which we think at some point, should come [indiscernible], is that's the shortfall I'm realistic about what a worst case downside scenario can be. And we have various scenarios that we run every quarter to make sure that we're on top of it. And again, there's the downside to everything we do in life. But again, we're weighing it with the returns that we're seeing. And we think the risk reward is fairly in our favor. We like the odds of that business.
Francois Morin: And one thing I'll add to that Yaron is to us, we think of it as an earnings event, not a capital event. So we -- some of these kind of, we think pretty severe, widespread events would not hurt our capital base.
Yaron Kinar: That's probably also because the book is still relatively small and the overall portfolio if it does grow tech could become a capital unless you have proper exclusions or risk protection, and so on.
Marc Grandisson : Yeah, we'll also have reinsurance that we buy and other things that we can do there as well. So yes.
Yaron Kinar: Okay. Okay. Thank you. Best of luck.
Marc Grandisson : Yes, thank you.
Operator: I'm not showing any further questions. I'd like turn the call back over to Marc Grandisson for closing remarks.
Marc Grandisson : Thank you very much for your listening to our call. Looking forward to talk to you again in the New Year with perhaps more exciting news. We'll see what the market gives us. Thank you very much.
Operator: In today's conference, this concludes the program. You may now all disconnect. Everyone have a great day. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen. And welcome to the Third Quarter 2022 Arch Soft Capital Group Earnings Conference Call. At this time, all participants are in listen-only mode. Later we will conduct the question-and-answer session. And instructions will be given at that time. As a reminder, this call may be recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sir, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, Michelle. Good morning, and welcome to Arch's third quarter earnings call. Our investors know that with Arch, you're getting a diversified time-tested active capital allocator. Are we on now?"
},
{
"speaker": "Operator",
"text": "Yes."
},
{
"speaker": "Marc Grandisson",
"text": "Okay. Let me start again, guys. Sorry about this. Our investors know that with Arch, you're getting a diversified, time-tested active capital allocator that understands that how you navigate cycles is crucial for long-term success. Hurricane Ian gave us a stark reminder of the importance of insurance. And our hearts go first to all those lives or property. As we turn to 2023, our agility is never more important. As an insurer, we provide protection for our clients during times of uncertainty. The reality for our industry is that big events like Ian almost always result in opportunities for the company that actively manage their capital and have the ability and the decisiveness to act when markets need their capacity. Arch is one of those companies. The current environment presents Arch with the opportunity to enhance its relationships with clients as they seek out insurance and reinsurance solutions in these uncertain times. The cat activity in the third quarter has significantly increased pressure on property cat market, which could have ripple effects across all property and as we approach the 2023 renewals. Over the last several years, we've maintained that property cat rates have been inadequate. Now the market recognizes this as well. The events of the past 18 months significant interest rate hikes, repricing of investments, ongoing general inflation concerns and the increasing cost of capital, all point to the need for a higher margin safety in the premium with property being the poster job. We're pleased that the underwriting discipline of our insurance and reinsurance segments limited Ian's impact to a quarterly earnings event. As we have said before, our proactive approach to cycle management enables us to protect our capital over the long term. From Arch standpoint, as other insurers are reducing their overall participation, we have an opportunity to showcase our outstanding team, strong balance sheet, underwriting acumen and creative things. Our positioning should reward our shareholders with superior risk adjusted return in. I want to take a few minutes to call your attention to areas in each operating segment where we continue to make positive strides. In the third quarter, our insurance and reinsurance segments continued to grow premium and delivered solid current accident year ex cat combined ratios. 89.5 for insurance and 85.5 for reinsurance. In our insurance operations, we continue to see strong net premium written growth in the third quarter, up approximately 19% in the same period in 2021. Some of the most significant growth came from professional liability, including cyber as well as a strong increase in travel lines. Our excess and surplus lines business, both property and casualty, also continued to achieve rate increases of trend, and we are optimistic about the opportunity for further growth in 2023. Competition in P&C is robust, but rational, and the markets are taking a more technical approach to pricing and a project suits Arch's underwriting commodity. Cyber insurance has become increasingly important to our insurers globally, and we have substantially increased our support because quite simply, we believe that today's cyber market has changed for the better. The most important development over the past several quarters is that the alignment between clients and insurance companies have significantly improved as insurers have become more vigilant in their efforts to mitigate cyber risk. Additionally, insurance terms and conditions have sufficiently tightened, retentions have increased and rates have reached a level where we believe we have an opportunity to earn an appropriate return for the assumption of risk. Next, our reinsurance segment once again delivered excellent top line growth of the specialty businesses, including property, property cat and other specialty lines. Since inception, a hallmark of our reinsurance group has been its ability to quickly adapt to changing market and reallocate capital to earn better risk-adjusted returns. Excellent market conditions and the likelihood of capacity constraints were to likely create an eventful January 1 renewal period, and our teams are actively planning to meet the demands of our clients. Now to the mortgage group or, as I call it, our beautiful business. They once again provided proof of their sustainable earnings model by delivering $299 million of underwriting income that is essentially uncorrelated with our P&C operations. Although higher interest rates affected new origination volume, they also improve the persistency of our portfolio, which rose 4% in the quarter to 75.4% and allowed us to grow our U.S. primary mortgage insurance imports to nearly $295 million. Our embedded book is in great shape. Credit quality remains excellent. Unemployment is still at the historical low and the average borrower had a superior FICO score of 748. Homeowners equity, a key factor in protecting against claims is very high with 90% of policies having at least 15% equity in the home. In addition, the MI market is being proactive, increasing rates to adjust to the evolving environment. We continue to be thoughtful in how we manage our mortgage portfolio and because of our diversified model, we have the ability to take a measured view of the business as just one component of our diversified enterprise. In the near term, better returns will most likely come from our property and casual segment and we would expect that our capital allocation will bear this out. Although investment returns were challenged again in the third quarter, it's important to note that rising investment yields even after adjusting for claims inflation should help boost our return on equity. Obviously, with the Fed attempting to inflation, when we continue to see negative investment markdowns, a significant amount of which we would expect to recover as our fixed income securities mature over the next several years. Ultimately, the relatively high quality and short duration of our portfolio, combined with strong cash flows provide an opportunity for us to reinvest in new money yields that are substantially higher than our current book yields. In conclusion, outperforming in the P&C insurance market is always a challenge and the most recent paradigm where the property cat market was supported by cheaper alternative capital had increased the level of difficulty. However, many of the investors in ILS funds have recently seen their becomes underperformed and are beginning to leave the market. Without an obvious source of cheaper capital, our industry is nearing an inflection point. There appears to be a shortage of players with the capacity and willingness to participate, creating possible supply shortfall. Fortunately, for our shareholders, we have both the capacity and the willingness to deploy more capital in that space for as long as the reward justifies the risk. We're optimistic with regards to the opportunities ahead of us in the fourth quarter and into 2022. We talk about our principles of set cycle management and capital allocation at almost every opportunity because they're truly part of our DNA. We have remained disciplined over time and kept our focus on fundamentals when it came to underwriting. The market needs companies like us to rise to meet their needs. And as I like to say to our team, Arch is open for business. With that said, I'll turn it over to Francois to go through some of our financial details before returning to answer your questions. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Thank you, Marc, and good morning to all. Thanks for joining us today. As we communicated in our release earlier last week, our third quarter results were adversely impacted by the effects of Hurricane Ian and other global catastrophe events. in spite of the severe nature of Ian, which we believe will end up being the largest single loss in our history, we reported after-tax operating income of $0.28 per share resulting in an annualized operating return on average common equity of 3.8%. Year-to-date, our annualized operating ROE is 11.6%. This result demonstrates once again the value and the resilience of our diversified platform. Now on to catastrophe and losses, where we wanted to provide a bit more color on our assessment of Hurricane Ian. We all know it's still very early in the claim adjusting process, and the final determination of our ultimate loss exposure will likely not be known for quite some time. Our initial estimate of the ultimate losses is based on an industry loss of $50 billion to $60 billion. We believe this range is appropriate at this time given the unknown impacts of inflationary trends, potential supply and demand imbalances and labor and material costs. The newly introduced Florida Property Insurance Reforms and the extent to which storm search claims may end up being covered by insurers, among others. Overall, we believe our estimated market share of the event will be comparable to prior or large events of a similar nature. In the insurance segment, net written premium grew 18.6% over the same quarter one year ago as our underwriting teams continue to find new business that meets our return expectations. Overall, underwriting performance was excellent with an excellent year combined ratio excluding cat of 89.5%, a 100 basis point improvement over the third quarter of 2021. In line with the last few quarters commentary, an ongoing shift in our business mix and structure of our reinsurance programs resulted in a slightly different split between the loss and expense ratios compared to the same quarter one year ago. In the reinsurance segment, net written premium grew by 73.6% over the same quarter last year. It's worth pointing out that in the third quarter of 2021, we had a cat up in seeded premium the Somers REIT, significantly reducing our net written premium. Absent this impact, the year-over-year increase in net written premium would have been 37.9% and much like the insurance group reflects an environment where we are better able to write business that meets our return thresholds. The segment produced a next cat accident year combined ratio of 85.5%, 230 basis points higher than the same quarter one year ago as a result of an elevated number of large attritional claims in our property other than property catastrophe book and also an increase in our expense ratio due to an ongoing shift from excess allowance to more proportional business. We believe this movement in the loss ratio is well within our expectations of the inherent variability of the underlying claims activity in our book of business. Our mortgage segment had an other excellent quarter with a combined ratio excluding prior year development of 39.9%. Net premiums earned decreased on a sequential basis as we continue to see the effects of higher recessions on our U.S. MI book and lower levels of single premium policy terminations. Persistency of our in-force insurance now stands at 75.4% at the end of the quarter. It has continued to increase due to the rising mortgage rates which considerably reduces the attractiveness of mortgage refinancing for most borrowers. We recognized $126 million of favorable prior year development across the mortgage segment this quarter as delinquencies continue to cure at a higher rate than expected. Over 80% of the favorable claim development came from our first lien insured portfolio at U.S. MI mostly related to the 2020 and 2021 accident years. The remainder of the favorable development came from recoveries on second lien loans and better-than-expected claim development in our Australian operations and our CRT portfolio. Income from operating affiliates stood at $8.5 million and was generated from consistent results of offset in part by underwriting losses at Somers Hurricane Ian. Net investment income was $0.34 per share, up 21% from the second quarter of 2022 and 55% from the third quarter of 2021 on a per share basis. The strong positive cash flow from operations over $2.8 billion year-to-date, combined with the proceeds from maturities and sales of securities, deployed in a rapidly rising yield environment underpinned this improving results. Going forward, with new money rates above 5% and a growing base of invested assets, we should have a good opportunity to further enhance our operating income through solid investment income results. Total investment return for the investment portfolio was negative 3.01% on a U.S. dollar basis for the quarter in a challenging environment of rising interest rates and weak equity markets. We remain cautious relative to our duration, credit and equity risk with our investment portfolio, and this defensive strategy helped minimize the mark-to-market hit to book value. Our investment duration remains relatively unchanged compared to one year ago and is slightly underway relative to our liability duration. Turning to risk management. Our natural cat PML on a net basis stood at $851 million as of October 1 or 7.7% of tangible shareholders' equity, again, well below our internal limits at the single event 1-in-250-year return level. Our peak zone PML is currently the Florida Tri-County region. On the capital front, we repurchased a minimal amount of share this quarter, approximately 236,000 common shares at an aggregate cost of $10.1 million. As our prospects of seeing meaningful opportunities in the business remain very good for the remainder of the year and into 2022. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Jamminder Bhullar with JPMorgan. Your line is open."
},
{
"speaker": "Jamminder Bhullar",
"text": "Hey. Good morning. So first, I just had a question on -- obviously, on pricing in the reinsurance market. Obviously, cat pricing hardening a lot with after Ian, how do you think it will affect pricing in non-cat lines? And where do you see the best opportunities for growth for Arch?"
},
{
"speaker": "Marc Grandisson",
"text": "So thanks for the question. I think it's still early. I think the Ian is one part of the equation. This is what I think we should probably see an impact on other lines of business because aside from Ian, we also have the markdowns and inflation concerns and whatever else is out there. So it would be reasonable to expect dripping effect through the other lines of business. I also want to remind everyone that the market has gone through a hardening outside of cat for the last three to four years. So I'm not sure we would see a similar or furthering or hardening the same level that we saw. But we're at a really, really good level right now. So anything that is incremental above that is hugely accretive to us on an industry certainly in Arch."
},
{
"speaker": "Jamminder Bhullar",
"text": "And then how do you think about capital? Because a lot of companies, total equity has come down a lot because it marks on AOCI. And I noticed you bought back very little stock this quarter. Not sure if that has anything to do with capital or just preserving capital ahead of cat season. But how do you think about capital overall for the industry as well as for you guys and specifically, how that's affected by declining total book values?"
},
{
"speaker": "Marc Grandisson",
"text": "Yeah, I'll start with the overall industry, and I'll turn to Francois for specifics for Arch. I think that the capital going out in the industry is a big deal. We are an industry that rights against the surplus. And unlike 2008, when the markdown has recovered pretty quickly. We don't seem to be right now at this point in time, at least in a position where it will recover soon. So there's pressure on the capital in terms of how you write the business and how much you're allowed to write or the rating agencies or the regulatory agencies. So I think we'll refresh that pressure is not going to be short term. We think it's going to last for a while. And as an underwriter, capital is one of the main ingredients you have to create underwriting decisions and provide service to your clients. So it's a big deal. And we're talking some companies using 20% to 30%, 35% except these are big changes. And I would add, as you know, Jammie, that in initiatives, we have an environment where there are a lot of uncertainties, inflation, recession and whatever else is out there. So -- and I think we're all collectively bracing for interesting several quarters ahead of us. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Yeah. The one thing, Jimmy, I'll add to specific to our Trey, and that's really part of our history. We've always operated with the principle that we wanted to have a strong and conservative balance sheet, right? And why have we done that? Why are we thinking that route? It was always with a mindset that we wanted to have optionality. We wanted to be able to take advantage of improving market conditions when and if they come around, right? . And what I mean consistent and strong and conservative balance sheet, it's, a, the investment portfolio, you saw that in our markdowns, we got some like everybody else, but I think we're probably more on the low side. And also in terms of leverage, we don't have a very levered balance sheet. Even today at 9/30, we're below 25% the right at 25% on a just-to-capital basis. So those are the reasons why we feel like that's -- again, that's been our strategy. And this may be a moment in our history that tells us that and we'll be able to enjoy the benefits or reap the rewards of maintaining such a strategy. So I think we're in a really, really good position. We're positive. We're optimistic about the market going forward. We're still not there yet, and we'll see what happens at one to one, but at least from the balance sheet point of view, we're in a really good position."
},
{
"speaker": "Jamminder Bhullar",
"text": "And any color on the sort of minimal buybacks this quarter?"
},
{
"speaker": "Francois Morin",
"text": "Well, again, it's twofold. I'd say, a, we typically don't do a whole lot in the third quarter ahead of the hurricane season. So that's very consistent with our history. There's always -- the stock price matters, always, as you know, in the short and stock buybacks. So going into the quarter, we just wanted to see how things played out. And also with the expectation that we would -- the hard market, even before Ian, we still thought that the hard market would be -- go well into 2023. And that was one of the reasons why we felt maintaining the capital base that give us the ability to write on that business in '23 was critical to us."
},
{
"speaker": "Jamminder Bhullar",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Elyse Greenspan with Wells Fargo. Your line is open."
},
{
"speaker": "Elyse Greenspan",
"text": "Yeah, thanks. Given your expectations for pretty strong price increases at January 1. Obviously, we have some time right until Florida and other business renews later next year. But where would you think -- based on the growth you think you could see in reinsurance? What do you think your PML will shake out next year?"
},
{
"speaker": "Marc Grandisson",
"text": "At a really good question, Elyse. And I think it's obviously dependent on the risk-adjusted return that we would see in there. Like I just want to remind everyone that we're underweight at 7.7%. So we have room to grow if we see the opportunity. We did grow a little bit in 2022, seeing opportunities. We would do the same thing if we were to be presented with the same situation. I think we have the capital, the appetite and the expertise to really participate in the upcoming market hardening. I think at least the -- if it continues to shape up the way it's designing itself, we're going to be part of a solution. We're going to be part of creating new solutions and providing meaningful capacity to our clients. What I like about what we are is we have a diversified platform. As you know, it is a lot of flexibility and as Francois Morin mentioned, we're in a very good position. What I could say is, if you tell me what the returns were, I would tell you how much we would be willing to take. But you would expect to hear from Arch that the way we think about building up the risk in the tower is incrementally as we would go up on the PML, we would the expected return to increasingly improve over that period. So it will be really, really highly depend on how much the rates go. And you might -- I think it's too early to tell. What it's going to be, right now, what we think it could change, but it should be significant."
},
{
"speaker": "Elyse Greenspan",
"text": "So based on what you think could transpire and you think about putting your capital to use next year, insurance, reinsurance, mortgage, I mean it sounds like more will be on the P&C side. And then do you see more going to reinsurance versus insurance, because it sounds like you guys are still seeing some good opportunities on the insurance side as well."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. Well, I'll tell you, Elyse, if you look at this is the beauty of our platform, right? When you had a reinsurance company and an insurance company, was to participate in the upswing of the market that is reinsurance is a really, really quick and proactive way to do. So we think in the early stages of this hard market gets there, that we would be deploying more capital more quickly into our reinsurance unit because it's also what I think most of the need is going to do, right, on the insurance portfolio, at least as you know, fiscal year to turn over our portfolio, whereas a reinsurance portfolio could be done much quicker. So I think it's going to be in steps like it always has been. It's the same in 2002 when we were formed. We were really, really reactive and very quick to market on the reinsurance side as we saw our insurance business building up and getting traction and take via a hard market. So I think over time, we then where does it land in 2024 and beyond if we have this opportunity, again, as I mentioned, then it will be relative returns. It will depends who gets a better risk-adjusted return. They will have to go in front of Francois and I and argue their case. These are our prospective units. And this is what we're going to go through. We go through this on a quarterly basis to make sure we're keeping all the returns in the same -- the most optimal as possible."
},
{
"speaker": "Elyse Greenspan",
"text": "And then 1 number is one. Francois, you pointed 230 basis points in the reinsurance segment, I think from elevated property claims. So if we're thinking about that kind of the run rate, I'm assuming we should ex out that $230 million and then assume as the business shifts more towards property and property cat that there would be underlying loss ratio improvement driven off of mix and rate in that business?"
},
{
"speaker": "Francois Morin",
"text": "Yeah. I think that's the third way to think about it. I mean, we've said before, I think looking at loss ratios on a quarterly basis is not something. It's not how we think about it. We like to take more rolling 12 months or even maybe longer periods to have a view of the long-term performance of the book. Again, I was just making a point that just to let everybody know that we're not worried about this little blip in our quarter, very much part of the normal volatility of our business. But going forward, if the market ends up being very constructive, let's say, on the short-term lines. Specifically, yes, the loss ratio presumably could come down a little bit."
},
{
"speaker": "Elyse Greenspan",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Zaremski with BMO. Your line is open."
},
{
"speaker": "Michael Zaremski",
"text": "Good morning. I guess just sticking with capital. Is the -- I know we don't -- I don't want to spend too much time about this S&P capital model. But I remember checking my notes from the spring when they were all using them as a punching bag or at least I was. And they were supposed to release a new version soon before year end, I thought. And there was always the issue of kind of the Bermuda senior debt, maybe not getting credits. I don't know. Any thoughts? Is that something you guys are thinking about? Or does that issue kind of not a tail risk we should -- or anything we should be thinking about?"
},
{
"speaker": "Francois Morin",
"text": "Yes. I mean I think we -- many of us thought we haven't answered all those questions by now. The model proposals that they perform were substantial and broad. So I think it impacted most -- I mean most types of companies, Europeans, North Americans, life B&T, et cetera. They did get a lot of feedback. So the current thinking and what they just let the world know recently that there -- call it, their second version of their proposal will be out in the first quarter. So there's a little bit of uncertainty there as to what changes they may make to what they suggested initially. We've had discussions with them. Many others have as well, specifically in the Bermuda debt issue. We'd like to think that's going to get resolved reasonably well. We don't have finality on that. But we're somewhat positive that we'll get a good resolution there. So from that point of view, I'd say our capital base is strong, and we don't see a need to make any changes to it at this point."
},
{
"speaker": "Marc Grandisson",
"text": "If I may add, Mike, one of our key things on capital and we allocate capital on an economic basis, S&P is definitely an important piece of the puzzle, but it's not the only thing that drives us. So we're carefully paying attention to it. And we'll see what happens."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. Understood. Appreciate it. Maybe switching to your primary insurance operations, which I know are diversified among a number of businesses. But I guess a lot of good commentary in the prepared remarks. Could you give us an update on kind of where pricing has been trending? And maybe just a broad question on the primary insurance marketplace and maybe it's just -- maybe it's tough to put a paint with a broad brush. But if we thought about the angry insurance life cycle clock. Just kind of curious where you -- what time you think it is?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a great question. I look at the clock many times a year and looked at it last week, we're about 12 noon, 11:30, 12 known on the P&C side, I would say. And probably 8:00-ish on the property cat space. But the clock can be turned back. So I'm not sure that 11:30 is going to stick. So that will be my comment and sort of alludes to the first question -- the first question I answered. I think that overall, most lines are getting rate over trend. We're still seeing plant. The fact that this is a broad statement, right, you're rightfully point that were specialty product company were many different products and every one, every one of these products has different characteristics, different exposure base, different attachment points, different geographies. Broadly speaking, most lines are clearing rate over trend. I think some others have said that in other calls this week. But I think that as an every hard market, this is what we're sort of observing in a few areas. We've -- there's been a lot of -- they have been for the last 3 years, almost over correction in some certain pockets. And I think that appropriately and rationally, people are looking at the history and the experience and they're seeing the difference is much improved. One example is [indiscernible]. I think it's a line of two here and there that have smaller rate increase or smaller rate decreases. The thing is it gets recorded broadly, gets a lot of headlines in the papers, but it's just not really a true reflection of the wider market. I think that by virtue, if you look at the way we operate on the insurance and reinsurance on the P&C and mortgage for that matter, we're really focused on risk-adjusted returns. And if we -- if you see us grow, it's because the risk-adjusted return is and the profit is there. So I think overall, the market is still very, very -- is presenting us with a lot of opportunity, both on insurance, P&C and reinsurance."
},
{
"speaker": "Michael Zaremski",
"text": "And maybe -- I think you brought up the excess in surplus lines marketplace. Any maybe you can remind us how large of a business that is for you all? And is that -- is that -- are the dynamics different in that marketplace versus kind of the picture you painted in terms of the primary insurance marketplace clock?"
},
{
"speaker": "Marc Grandisson",
"text": "No, I think that -- no, actually not. It's actually an area that is still very, very active and very interesting for us. A lot of our growth actually comes from those E&S property and business. But to be selective, not all one line and all one monolithic subline as you can appreciate,. But certainly, we're participating in the ones where we like the risk return. Our E&S premium right now in the U.S. because it's hard to decipher what's in London. But in the U. S., it's about 28% of our premium that we write at E&S is almost double from what it was three or four years ago. So we have really leaned heavily into that marketplace and continue to do so. I think that what's happening with Ian and the acute need for capacity, specific kind of property should mean more E& S property opportunity and potentially some E&S casualty opportunities as well. I want to remind everyone this is a beautiful business to have as a specialty insurance company because you have a little bit more freedom of form, freedom of great -- and I think this is where really our underwriting acumen and underwriting expertise could showcase itself."
},
{
"speaker": "Michael Zaremski",
"text": "Thank you. Best of luck."
},
{
"speaker": "Operator",
"text": "Our next question comes from Yaron Kinar with Jefferies. Your line is open."
},
{
"speaker": "Yaron Kinar",
"text": "Good morning. My first question is with regards to the changing reinsurance market. do you see that leading to changing retention rates in both insurance and reinsurance? And if so, what impact do you see that having not only on the top line but also on potentially lowering the attritional loss ratio and increasing the acquisition costs?"
},
{
"speaker": "Marc Grandisson",
"text": "That's a broad question, Yaron. It's a great question. And I think we're all incurring intently observing. I think -- maybe the best way to -- if I could allow me for 1 second to sort of draw a parallel with Katrina and the way it evolved back in. It's not exactly the , but let's go there for 12th and we'll back and come again turning back the insurance level. The insurance company took a long time, took 1.5 years to really repurpose and re-underwrite and reform, reshape their insurance portfolio to make sure that it was better. So risk -- not risk off, but readjusting the risk that issuance companies are taking is something that I believe they will be doing for the next 12 to 18 months. But as I said before, it takes a long time to do so. In the meantime, you still have the exposure. So typically, what happens is the reinsurance companies come in, say, well, we're going to need more returns for the capital capacity that we're providing to you the portfolio hasn't changed last two months is going to take a little while. We want to see what impact, what you're going to do in the portfolio. That was '05, right? So -- and then what happened, as you get into the New Year, as a buyer, of where our interest group is no exception, you still need to buy reinsurance and cat reinsurance. It's still a volatility that it's appropriate and prudent to purchase. So the purchasing still occurs. There might be some push and pull on the retention. Presumably, your retention would have to go up somewhat, maybe constraints and have a constraint on what limit is available. So I think if you put it all back together, there'll be shifting and changes in the reinsurance side, more likely at 1/1, as I mentioned. And as we go towards the Florida renewal of the year, the insurance portfolio will sort of be reacting to what the reinsurance market is telling them, that it's more costly from a cat perspective. So might take a long time to develop. I mean, it's not like a one renewal and done."
},
{
"speaker": "Yaron Kinar",
"text": "Right, but do you think, I guess if we focus on the entrance segment for a second, so ultimately, I would think with maybe lower or higher retentions maybe you actually see some improvement in the attritional loss ratio, but at the same time, some headed to the acquisition ratio."
},
{
"speaker": "Marc Grandisson",
"text": "Sorry, that's your question apologize. So there the answer is the second viewpoint. As you see the reinsure side gets more expensive, it's a change so perhaps you can buy reinsurance. The insurance team now know that they need to charge more to make up for what they lost or to get the protection because the reinsurance market is also telling them something very, very, very informative as to what is the price of cat chart and you need to chart for cat with. So you are right. So overall, we'll have pricing increase on the primary insurance portfolios, which to your point will lead to -- should lead to a lower attrition or loss ratio, because it's the same kind of losses from an attritional perspective with our agreement. So yes, that is a fair assessment for verifications."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. And then a follow-up statement you made earlier on the marks, I had always thought of rating agencies as largely looking through interest rate related marks, maybe with some exception with S&P. And I also thought that stat accounting doesn't really account for interest part. So why would that led or become an industry capital issue?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, I think it's -- there's the official pronouncement or what -- the official view of how people look at certain things. But let's be honest here. I don't think anybody totally puts it to the side and doesn't consider it at all. There's companies that have lost, 20% plus of their capital base so far this year. If rates go up another 100, or 200 basis points over the next 12 plus months, at some point, there's -- you can't write a diversified book of P&C business at three or four or five to one. I mean, that's just -- people are going to push back and you got to have a plan to either remediate or have a view on when those markets are going to revert back. So rating agencies are, I think, in that camp. I think they'll give us and others some latitude, but it's not infinite. It's not like they don't consider it at all. So that's really our point here is that, it like it or not, some capital has evaporated, not permanently, but for the time being. It's something we need to work through."
},
{
"speaker": "Yaron Kinar",
"text": "Got it? Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tracy Benguigui with Barclays. Your line is open."
},
{
"speaker": "Tracy Benguigui",
"text": "Thank you. I have follow-up questions on your ability to grow prop cat risk and capitalization. So I feel like your 25% target of 1 and 250 PML at tangible equity is an easy way to communicate your appetite to the Street. But I realized a large consideration is allocating capital on a risk-adjusted basis. So can you remind us, how do you view diversification credit or covariance between MI and catastrophes? Or said another way, does your risk adjusted capital consumption from MI restrict your ability to take on prop cat risks even if there is diversification credit?"
},
{
"speaker": "Marc Grandisson",
"text": "Also Tracy. Very good question. But we won't divulge what I already know what economic model is. But if you look at an economic model, there is a large amount of lack of correlation between MI and P&C doesn't mean that they can go back and there's not really some non-correlation between the two. There's also a lot of correlation benefits that we derive from the multitude of stuff going on around the world. So we have a very, very diversified portfolio. I think the way that we look about this is, you know, the way you look at the curve, your economic curve, you know, again, we have to be careful, it's a mathematical exercise. We're not beholden to only mathematics. But if you look at the way you flex the P&L, if you put the pressure on an increase in currency and see what could happen if, do what if scenarios, and -- but you always have the eye on the maximum downside that you're going to take, combining both of these, or two or three of these really like 45 curves that we have. That's -- I'm going to leave it at that for now. I think that this is an exercise that we do all the time. We're going through it right now, and it's ever changing because pricing is moving. And it's one thing that is, I want to remind everyone is that we all only look at the loss itself. If you look at what premium you charge for the risk, and what really is working, the combined ratio and the profit level is very, very important. And every time you have a line of business that provides more profits, when margins improve or increase, it helps the overall balance sheet, the overall portfolio that you have on the reinsurance. Having said all this, with having a proper hard stop on the downside potential, we don't want to get a suspension of the balance sheet because we still want to be able to take advantage of the next market, if and when it does present itself. On the mortgage side, I will remind everyone that we buy a fair amount of quota shares that sort of protects a lot of downside. It's also part of our considerations. We buy quota share, we also buy excess of lots. So we have some protection. That's also a good example of how we manage the risk even if we like, we still very much like the MI risk, but we also are very prudent. And making sure some of the downside is somewhat protected, again, for the same reasons that as I mentioned earlier on the call. Thank you."
},
{
"speaker": "Tracy Benguigui",
"text": "Yes, thank you for reviewing the process. I was just trying to get at, do you think that gives you an advantage to grow property CAT risk given the diversification credits?"
},
{
"speaker": "Marc Grandisson",
"text": "Absolutely. There's no doubt in my mind. But it's not -- again, it's not the worst application this diversity. We always are conscious, as I mentioned to make sure the process is improving. And I guess on the property cat the one thing that should be clear, I mean we it's reviewed. So now the charges, that's what we talked about, having an higher need -- higher charge need to take a commensurate or similar risk that we would take let's say in [indiscernible]. We need to be cognizant of those things. And I think yes, it is. It is really a fact that, in addition, our earnings power to your point, I mean, that's what you are sort of alluding to the fact that we have earnings coming from MI, definitely help us as we redeploy capital into the other opportunities that we see ahead of us."
},
{
"speaker": "Tracy Benguigui",
"text": "Okay, and also want to go back to the conversation on negative mark and capital in a way, why does it matter? I know, S&P would penalize you for that. But don't you have access of up to $1.3 billion line of credit, so you shouldn't actually crystallize any unrealized losses by being a forced seller? Is that fair? I'm just wondering if investors should pay more attention to liquidity."
},
{
"speaker": "Marc Grandisson",
"text": "Well, I mean, it's a fair point. We again, we're not constrained. I think that's the most important thing. Leverage ratio is down, but we also have access to other forms of capital or line of credit is one that you mentioned. There are others. So if the opportunity is there for an additional growth in our P&C lines, and maybe mortgage, whatever we'll see them as we move forward, I think, my view is that it's hard to write on, on call it, you know, capital, that's just not on the balance sheet. Right. So it's got to be in the balance sheet somehow. And our view is, yes, we see recovery in the unwinding of that mark to market hit so far. But the capital base, has to show that it's real and solid to get credit, and write on it."
},
{
"speaker": "Francois Morin",
"text": "And Tracy, the argument, that you're pushing us, I mean, you could take it to the extreme, right, because the way they handled was up by 80%. But at some point, it starts to matter. It's not as important as 5% or 10%. It's more important at 30% and becomes progressively more important, because in the end we have to pay our policyholders. And then once we're out of reserves did a cat loss, we need to take care of our capital. And it does matter in the big world. So I think it's --I'm not saying it shouldn't matter 100% now, because at some mark and it's still capital available. But it has to make a difference somehow over time, because the argument would fall, right, at what point do you think it starts to matter, 50, 60, 80? I think it's matters just a different degree through the capital stack."
},
{
"speaker": "Tracy Benguigui",
"text": "Okay, just one last one really quickly, given the higher reinvestment rates. How long will it take Arches market to creep back to book value?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, I mean, there's -- we've done some rough math. I mean, you can kind of look at it like portfolio, turning over in the following two years on average. So let's call it eight quarters. And you can do get a rough now by that. But the reality is, we're going to also I think we're going to get -- we do have plenty of free cash flow coming through. And that's going to be reinvested at pretty significant levels. So we think that overall, the book value should start growing pretty quickly beyond just the recovery of the markets."
},
{
"speaker": "Tracy Benguigui",
"text": "Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "You are welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Shanker with Bank of America. Your line is open."
},
{
"speaker": "Josh Shanker",
"text": "Yes, thank you. I wonder if you can give a little outlook on the mortgage insurance sector? Are we at the bottom of the issuance cycle here for opportunities? Does this last for a little while? Are there even fewer mortgages that are going to be purchasing insurance over the next year? Where do we stand right now?"
},
{
"speaker": "Marc Grandisson",
"text": "Sorry, Josh. In what sense -- on the primary side of MI or are you…?"
},
{
"speaker": "Josh Shanker",
"text": "Yes, primary, MI. I'm clearly like new home sales are down. And so obviously, we're going to expect less flow. Is it going to continue to decline from here? Or is this kind of what a -- I guess a holiday from mortgage issuance looks like for the MI business?"
},
{
"speaker": "Francois Morin",
"text": "Well, we've said it before. I think, and it still holds. I mean, the in-force book is where we're going to generate most of our underwriting income for the foreseeable future, right for the next two to three years. Doesn't matter really materially whether production is stable, declining increases, increasing the in-force books, is going to drive the underwriting income for the next three years or so. And we are very comfortable with the level the performance of that book right now, because as we know, and as we've said before, depreciation is a big part of that, refinancing refinance activities coming down. And so persistency is up, etc. So there's a lot of things pointing us in the direction of saying yes. That in-force book is doing well and will keep doing well, we think. Over time, no question that if new production kind of keeps declining to levels, very low levels for an extended period, then a maybe starts to show on the numbers, but we don't think that's anytime soon."
},
{
"speaker": "Marc Grandisson",
"text": "And on the INW, which Francois just mentioned about new production, if you look at the NBA numbers, the purchase market, which is by far the most important one, for the MI business, is a lot more stable, there's not as much of a decrease. So we're still fairly positive, that we're still going to get some nice production from our team over the next several quarters. And again, I remind everyone that as you know mortgages is up north of 7%. So it does make it a bit hard to get into a home. But fact is, there's still pent up demand for housing if the purchase market should stay pretty active for the next several quarters, which bodes well for our INW, just forward-looking."
},
{
"speaker": "Josh Shanker",
"text": "And if premium yield declines on insurance in force. I mean, is there a bottom that we should be expecting? Or does it continue to tick down in the coming years?"
},
{
"speaker": "Francois Morin",
"text": "Yeah, I think I just mentioned it in my comments, the industry always like everyone else here on the call talking about what's happening around the world, some uncertainties, discussions, whatever else. The potential thing that could happen and the industry is raising rates is right, is raising premium rate as we speak on the mortgage, the mortgage sector, which is good news, which speaks I believe, volume for the new environment, that we have in MI, an industry that, is a lot more disciplined and deliberate in what it's doing. It's something we would have expected, but it's good to see it happen in life, in real life case like that we are seeing right now."
},
{
"speaker": "Josh Shanker",
"text": "Pending what happens at 1/1 is mortgage insurance still the highest ROIC of your opportunity?"
},
{
"speaker": "Francois Morin",
"text": "Right now we have a lot of discussions about this. Right now. We believe that our P&C operations are slightly gaining and getting ahead of it, don't tell our MI group that. But it seems that the ENC units are squarely taking the lead."
},
{
"speaker": "Josh Shanker",
"text": "Thank you very much."
},
{
"speaker": "Francois Morin",
"text": "You are welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Phillips with Morgan Stanley. Your line is open."
},
{
"speaker": "Michael Phillips",
"text": "Thanks, good morning, everybody. Just looking -- the questions on the no discount in the current times we're in with property, cat and massive hurricane on the heels of what's going on with interest rate environment and everything else and mark to markets. But and even lots of movements around property cat pricing, obviously. But to what extent do you think we're in a period, very early innings of more respect for property cat, and this will continue actually, over the long term, which clearly has not happened in a very long time?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, the answer is we don't know, right? I mean, this is protecting the future. I mean, there's a lot of modeling out there that is trying to address it. We certainly are on the cutting edge ourselves with neurologists and everyone else we have on staff to make sure we're on top of it. But again, it's like everything else it's a prediction. And we try to put as much cushion or a little bit of extra level of conservativeness, to make sure that you're on the right side of the equation. And if things keep on going, and you're getting worse, getting better than you adjust and you're fighting the last data point into your next year's expectation. I think that if you take a step back, I talked about it on my comment, what is also -- what's also going on is that we sort of disregarded the true expected cat -- expected cat losses, if you were to just allocate without putting a lot of weight or a lot of increase into some of the factors that that go with cat pricing, we as an industry should have priced more, for which we are charged more for the cat risk and we didn't. And I'm always reminded of the law of large numbers which says, over the long run, you get what you deserve, in results. So it's not far from my mind to think that perhaps, just perhaps not a necessarily a change, a climate change but that could be the case but it could also be just by virtue of not charging enough over time that you sort of get -- you reap the reward of that mispricing."
},
{
"speaker": "Michael Phillips",
"text": "Yeah, that's kind of what I was alluding to. But okay, perfect. Thank you. That's all I had."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Yaron Kinar with Jefferies. Your line is open."
},
{
"speaker": "Yaron Kinar",
"text": "Thanks. Yeah, I thought I'd take this opportunity to follow-up on something you mentioned in the script, cyber. So maybe two questions there. First, on the attritional side, my understanding is that it's really about active management. So not just the annual questionnaire at the time of renewal, but really identifying and managing wheel time vulnerabilities. As a traditional insurer, what capabilities do you have on that front from a tech angle? Are you partnering with third party vendors to achieve this?"
},
{
"speaker": "Marc Grandisson",
"text": "Yeah, so the answer the great question, yeah, I think number one is we're partnering up with guys who are cutting edge really, on top of the latest technology, and latest forensic work for our clients. And that's a really good place to be. We also have a team. But funny enough, a lot of our teams were on the tech side for cyber risk are not part of the underwriting team. So we have a lot of people within the underwriting units who are actually more IT people than cyber specialists, and they themselves also contract with other third party vendors as well to make sure that we're on top of it. In addition to other third party vendor that we have ourselves within the company, so we also want to look out and understand it more and more. It's a big investment."
},
{
"speaker": "Yaron Kinar",
"text": "Got it? And then the other question I had on cyber. Actually one of your competitors was talking about this today as well, the need to get more comfortable with the tail, before really pursuing more significant growth in this line. So how are you thinking about the tail? And how are you --are there actions you're taking in order to manage it and allow yourself to pick up the comfort to grow?"
},
{
"speaker": "Marc Grandisson",
"text": "That's a very good question. This is harder to manage at a technical level as you can appreciate, right? Because it's really the cloud and other systems. I think what we do right now is listen, instead of in lieu of adding this technical structure infrastructure, which we think at some point, should come [indiscernible], is that's the shortfall I'm realistic about what a worst case downside scenario can be. And we have various scenarios that we run every quarter to make sure that we're on top of it. And again, there's the downside to everything we do in life. But again, we're weighing it with the returns that we're seeing. And we think the risk reward is fairly in our favor. We like the odds of that business."
},
{
"speaker": "Francois Morin",
"text": "And one thing I'll add to that Yaron is to us, we think of it as an earnings event, not a capital event. So we -- some of these kind of, we think pretty severe, widespread events would not hurt our capital base."
},
{
"speaker": "Yaron Kinar",
"text": "That's probably also because the book is still relatively small and the overall portfolio if it does grow tech could become a capital unless you have proper exclusions or risk protection, and so on."
},
{
"speaker": "Marc Grandisson",
"text": "Yeah, we'll also have reinsurance that we buy and other things that we can do there as well. So yes."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. Okay. Thank you. Best of luck."
},
{
"speaker": "Marc Grandisson",
"text": "Yes, thank you."
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions. I'd like turn the call back over to Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you very much for your listening to our call. Looking forward to talk to you again in the New Year with perhaps more exciting news. We'll see what the market gives us. Thank you very much."
},
{
"speaker": "Operator",
"text": "In today's conference, this concludes the program. You may now all disconnect. Everyone have a great day."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 2 | 2,022 | 2022-07-28 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Second Quarter 2022 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found on the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin.
Marc Grandisson: Thanks Elizabeth. Good morning, and welcome to our earnings call. Arch delivered strong results this quarter headlined by an operating return on equity of 17%. Our results were driven by excellent underwriting performance across all three operating segments as we continued our focus on growth opportunities during this hard market, as demonstrated by the 27% increase in P&C net premium written over the same quarter one year ago. These results demonstrate how our company is positioned to capitalize on market opportunities across the many lines that we underwrite. We've said it before, but it bears repeating. We are committed to agile cycle management predicated by a focus on risk adjusted returns. And it has enabled us to accelerate our growth through the deployment of meaningful capacity to our clients. Because we invested in capabilities and reserved capital during the soft market years, we are in the enviable position of being able to maximize to these opportunity. Increasingly Arch is seen as a provider of choice by our distribution partners and clients, which allows us to take on leadership positions, some in the industry retrench. P&C rate hardening continues in many lines. It's important to keep in mind that for the vast majority of the P&C lines, we've been able to achieve compounded rate increases meaningfully above last cost trends for the last two or three annual renewals and as such healthy margins of safety have been created. We believe this attractive level of expected returns should remain in place for the next few years. I will now offer a few highlights on our business units. In the quarter, our insurance and reinsurance segments both had excellent operating results, largely because of how we leaned hard into the improving market early on. We also have invested in improving our data analytics while broadening our market presence. In our North American insurance operations, premium growth was broad based with net premium written up 29% from the same period in 2021. Some of the most significant growth came from our E&S lines, both property and casualty, professional lines, including cyber and a resurgent travel and accident sector. All our lines of business where we believe risk adjusted returns are most attractive. Our specialty international insurance business, which includes our Lloyds and UK regional businesses, also delivered strong growth in the quarter with net premium written up 23% from the same period last year driven primarily by specialty, casualty and property. Our investment in building the UK regional small business is gaining traction as well. When looking at the improved results of our insurance business, it's apparent that the work of our teams over the past several years is paying off. We have developed a platform that responds swiftly to opportunities presented by the hard markets while at the same time building more sustainable positions in lines that are less cyclical. We have the capital, the people and the desire to lead in today's environment, as long as attractive opportunities are available, Arch will be there to write them. Our reinsurance segment continued to deliver excellent top line growth and bottom line earnings this quarter because of the diversified and specialty focus of our reinsurance business. The strong growth reflects our increased writings of quarter share treaties which allow us to participate in the rate increases experienced by our [indiscernible]. The 61 and 71 renewals showed a property [cap] market in transition and while I hesitate to make predictions, we are cautiously optimistic that this momentum will continue in January 1, 2023. The general psychology of the market appears to have shifted to requiring substantial rate increases to accept cat exposure. As an example, in Florida, where capacity remains constrained, property cap rates were up in excess of 30% and our P&L in a one and a 250 year events increased as we selectively expanded our writings. Rate pressure was evident also beyond Florida. However, we will need a few more quarters to confirm we are facing a hard property cap marketplace. Turning to our mortgage segment. The group continues to deliver the consistent underwriting results we projected when we began building our EMI business a decade ago. Our embedded book of high credit quality risks as well as continued on price increases have been key elements to our exceptional return this quarter. All the rising mortgage interest rates have slowed the volume of new originations, the purchase market remains strong, as housing demand continues to outstrip new supply. Rising rates also mean that persistency is increasing which allowed Arch to grow its U.S. primary mortgage insurance in force to $292 billion and all time high. The forbearance programs continue to roll off and cures have brought our delinquency rate down to 1.77%, which is consistent with what we experienced before COVID. Last and perhaps most important, the credit quality of homebuyers remains excellent. And we believe our portfolio is well-positioned for a variety of economic scenarios. We will continue to be deliberate in managing our mortgage portfolio, benefiting from a diversified business model that gives us the flexibility to focus on credit quality and profitability, not on volume. Briefly on investments, where rising interest rates and market volatility are setting the stage for additional investment income contributions over the next several quarters. We're seeing the benefits of not chasing yield during the past several years as well as the work done to reposition our portfolio in response to the changing interest rate environment. Earlier this year our investment team reduced our equity exposure in our fixed income portfolios shorter duration has allowed us to quickly move our investments into higher rate securities that provides further cushion against potential inflation impacts. This year surge of inflation has been a call to arms to underwriting teams across the industry. And by and large the industry has proactively incorporated higher trends into its models. We believe that the uncertainty surrounding future inflation should keep upward pressure on rates. At Arch, we manage inflation by business segments as we said before. We believe inflation is a net benefit to our MIS portfolios performance while our P&C exposure to inflation is mitigated by many tools available to us. Overall, we're very pleased with our underwriting results and returns in a quarter. And we are optimistic about the rest of '22 and into '23. As always, our objective remains to generate profitable growth and deliver long term value for our shareholders and this quarter's results are another example of our ability to do just that. I want to thank the Arch team for everything they've done this past quarter and over the last several years. Our people have made Arch into an employer and insurer of choice and have us well-positioned to sustain our growth trajectory into '23 and beyond. Francois?
Francois Morin: Thank you, Marc. And good morning to all. Thanks for joining us today. As you will have seen by now we had a very strong quarter and with very few unusual items to discuss or highlight to you. I have kept my prepared remarks relatively brief to allow for more time for the Q&A session. So here we go. For the quarter we reported after tax operating income of $1.34 per share, resulting in an annualized operating return on average common equity of 17.1%, two excellent results. In the insurance segment net written premium growth of 27.5% over the same quarter one year ago, combined with excellent underwriting performance resulted in an excellent year combined ratio exploiting cats of 90% a 140 basis point improvement over the same quarter one year ago. Like last quarter, a change in our business mix resulted in a slightly different split between the loss and expense ratios, compared to the same quarter one year ago. In the reinsurance segment, net written premium grew by 25.7% over the same quarter one year ago. The segment produced ex-cat accident year combined ratio of 82.8%, 430 basis points lower than the same quarter one year ago. Here also a reduction in the accident year ex-cat loss ratio was partially offset by a slight increase in the expense ratio due to growth in areas with slightly higher acquisition expenses, and targeted personnel expansion to support our growth. Losses from 2022 catastrophic events net of reinsurance recoverable and reinstatement premiums stood at $82.4 million, or 3.5 combined ratio points compared to 2.4 combined ratio points in the second quarter of 2021. The losses were split approximately 80% to reinsurance and 20% to our insurance segment. It's worth noting that approximately two thirds of the estimated losses came from events outside the U.S. including Australian floods, South African floods, a directional storm in Canada, and other miscellaneous natural catastrophe events. Our mortgage segment had an excellent quarter with a combined ratio excluding prior development of 39.2%. Net premiums earned increased on sequential basis due to increased persistency of our enforce insurance, which now stands at 71.3% at the end of the quarter, and growth in our CRT portfolio. Production levels also increased from last quarter consistent with the seasonality of the business. We recognized $118.1 million of favorable prior year development across a segment this quarter. A meaningful benefit to our bottom line, as delinquencies cured at a higher rate than expected. Close to 80% of the favorable claim development came from our first lien insured portfolio at USMI mostly related to the 2020 accident year. The remainder of the favorable development came from recoveries on second lien loans, and better than expected claim development in our CRT portfolio in our international MI operations. In all our segments, we maintain a prudent approach and setting loss reserves considering the uncertainty we face in a variety of factors, such as macroeconomic conditions, inflation, both monetary and social, and lags and settling longer tail liabilities as COVID related delays get worked through the legal systems. Income from operating affiliates stood at $4.6 million. It was generated from good results at Coface mostly offset by the negative mark to market impacts on the summer's portfolio for those securities that are accounted under the fair value option method. Gross investment income before investment expenses increased 20% from the first quarter of 2022 to $123.6 million driven by the reinvestment that higher yields of proceeds from the maturities and sales of investments and securities and the presence of floating rates investment floating rate investments in our portfolio. Total investment return for our investment portfolio was a negative 3.02% on a U.S. dollar basis for the quarter hurt by mark-to-market losses due to rising interest rates and weak equity markets. As you know, it is worth remembering that while mark-to-market impacts are fully reflected in our financials, a significant portion of this decrease hasn't been crystallized through the selling of securities and has the potential to reverse itself over time, in particular for our fixed maturity investments as they mature. As we discussed on the first quarter call that defensive investment strategy we have employed for a number of quarters with high quality investments and a short portfolio duration has helped minimize the impact of rising interest rates and the mark to market hit to book value. Our investment duration remains slightly below three years at the end of the quarter and slightly underweight and relative to our liability duration target. The performance of our alternative investments remained very solid this quarter, as we benefited from the returns generated by a number of funds that outperformed broad market indices. Turning briefly to risk management. Our natural cap P&L on a net basis stood at $888 million as of July one, or 7.7% of tangible shareholders equity. Again, well below our internal limits at the single event one and 250 year return level. Our peak zone P&L is currently the Florida Tri county region. On the capital front, we repurchased approximately 7.1 million common shares at an aggregate cost of 320.7 million in the second quarter. Our remaining share authorization currently stands at $600.6 million. With these introductory comments, we are now prepared to take your questions.
Operator: Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo. Your line is now open.
Elyse Greenspan: Hi, my first question is on the rate versus trend discussion which we've had a lot so far this earnings season. Marc, you started off your conversation by saying you continue to see hardening and many lines. Where would you place when you think about your insurance business where you place price and loss trend? And how do you think that could go from here as we think about higher inflation levels?
Marc Grandisson: Yes, I think the pricing, nice hearing from you Elyse, I think the pricing in the market is definitely clearing the last round. You've heard us on some of the calls that we would concur with that conclusion.
Elyse Greenspan: And you think as you're thinking out the next year, do you think that remain as especially right to your comments when we've heard about weight on top of weight on top of rate. Or do you see dynamics? They will keep talking about that for the next year or so?
Marc Grandisson: I see what you mean. So I think I would answer by saying the perceived risk in the marketplace has actually increased. So there's all this on the property categories. I mentioned briefly, my comments. And also on the liability side as well. I think that the uncertainty about the social inflation, and what it could mean and also geopolitical risks, just a lot of stuff going on in the world, I would expect this to continue well into 2023. But I've been wrong before. So I have to be careful the way I tell you this.
Elyse Greenspan: And then on the investment side, where are you putting new fixed income money to work in terms of rates and then how much of the portfolio is turning over the next 12 months?
Francois Morin: Good question. I think we don't plan specifically how much of it we're going to turn over. But we've been less than that. Our investment team has been pretty active trying to make sure that a first of all, we did take a lot of investments. So offer risk in the first half of the year. And then it'll all be about how much of what kind of opportunities we see as with the environment we're in, but we certainly with a short duration that we're at three years, you could certainly think that a meaningful amount of it, there's going to turn over the next 12 months.
Elyse Greenspan: And then what's the new rate today?
Marc Grandisson: Well, new rate want to be a little bit careful here. Certainly corporates you've heard it we're calling for approaching 4.5% in some places and the corporates investments on and corporate securities that we made in the month of July. With the Fed announcement yesterday, I mean, the risk for you the treasuries I think everything is going to move up a little bit from there. So that's kind of where what we're seeing today, it's going to evolve as we move forward. And that compares to an embedded book yield of 2.2% or so at the end of the quarter. So it's meaningfully higher than what we're the portfolio has been at.
Elyse Greenspan: Okay, thanks for the color.
Marc Grandisson: Yes.
Operator: Thank you. Our next question comes from Jimmy Bhullar with J.P. Morgan. Your line is now open.
Jimmy Bhullarn: Hi, good morning. So first just had a question on the mortgage insurance business. How are you, what's your view on the operating environment in the business, but just as the threat of a potential recession and then its impact on margins, and then just with the higher interest rates, and how that's going to affect top line growth in the business?
Marc Grandisson: Yes, and I think it's quite answered a bit more specifically, I think that as I mentioned in my comments that we mentioned more than once on the calls, you're going to hear some of the other I believe, competitors is that the credit quality of the borrowers that we see right now is exceptional. By and large, the credit quality has actually improved through the pandemic. So we're very, very pleased with this. And I'm saying this, because the biggest driver of default in distress is a credit quality of the borrower. It's by far and it overwhelms the risk possibility. We also are in position where we have substantial equity buildup in the housing stock. So that's also helpful. So we're very comfortable with the way the portfolio is position. And I think it's, we're not recession proof. But I think we have a lot going for us if there were to be a recession. Now, the top line, as you know, if there's less production, there's some indication that the third quarter might be a bit slower than usual, then that would mean no production that's less than positive for the industry in that quarter. But the impact on your premium will take a little bit longer to be felt because as you know, monthly premiums are written through a longer period of time and most of what we write and earn at this point in time comes from prior underwriting years 2020, 2021 and 2019. So we're not going to see a huge impact immediate impact. It's not like a property casualty portfolio. So, again, it's a somewhat of a tempered impact on top line, we believe.
Jimmy Bhullarn: Okay. And then on share buybacks, you've spent, I think it was $321 million this quarter, $255 million last quarter. And if I look over the past year and a half, they've averaged almost $300 million a quarter. Do you expect to be at the same pace going forward? Or should we assume a slowdown?
Marc Grandisson: That's a good question. I think, yes, we've been active. I think we, it's part of our evaluation of all the alternatives in front of us when we buy back stock compared to how we deploy the capital in the business. The one thing that I want to make sure as you're aware, I mean, realizes and we're bullish on the market, right, we think the market that we see today is strong and has some potential for even getting better. Time will tell. We certainly need to put odds on that. But the reality is, if it gets better, and we have the ability to deploy more capital in the business at one-one, will certainly want to do that. So the -- we'll reevaluate that daily and weekly, like we always do, but I could see a scenario where we have to pull back a little bit on the share buybacks really just to have the capital base that we need to fully execute on deploying the capital in the business and the three segments which are, as you see all humming and growing at a very good clip, make sure that we can execute on that opportunity in '23 and beyond.
Jimmy Bhullarn: Okay. Thank you.
Marc Grandisson: You're welcome.
Operator: Thank you. Our next question comes from Tracy Benguigui with Barclays. Your line is now open.
Tracy Benguigui: Good morning. I also had a loss turn question. Marc you've said in the past that your view of last trends, your book is roughly 250 basis points above CPI. And for access layers, it could be even higher. Can you just share your latest take on that? Because I think when you talked about these levels, CPI was below 2%?
Francois Morin: Yes, I think it's on a long term basis, right. These surge and inflation may create distortion in that spread over this but over the long haul. I still maintain this and seen another statistics recently that concurs with that sort of analysis. I think that the CPI we've fitting it right now in the shorter lines of business, shorter pay lines of business and property specifically, as you know, we've had all collectively a lot of labor and cost material that went through hire, very significantly. I think in some lines of business, we're not seeing evidence of yet of trend above the CPI significantly above the CPI. So I think our position has been to maintain, as we said before, Tracy, a longer term view of the loss trend. And when we had indication, perhaps zero to 1% in certain years, we probably have higher from a longer term perspective. So that helps on a cumulative basis when you buy the business not having to do as much catch up. It keeps you a little bit more balanced through to changes in inflation sometimes we see right now.
Tracy Benguigui: Okay, so it's more of a view, not what you're seeing today.
Marc Grandisson: Correct.
Tracy Benguigui: Okay. Also started a conversation yesterday on the intersection of investment yields and combined ratio targets typically combined ratio targets we share with underwriters is informed by ROE. And I believe you guys, when you come up with these targets, you're actually looking at new money yields on a risk free duration match basis. So not your portfolio yield. Are those the right clicks and takes of your pricing model? I guess, ultimately, could hire new money yield risk free in your case change your indicated rate need?
Marc Grandisson: Yes, it's a great question Tracy. And I like the way we've built our compensation scheme for our underwriting team. It's actually self correcting and self adjusting as we go forward. Number one, when the prize the business, this is our underwriting underwriters. They actually look, they used to look in the Wall Street Journal at a three to five year equivalent treasury rate. And that's what they would ascribe to the cash flow in terms of investment income, that he could earn on the premium that we could earn on the premium. So it's really a treasury return. This is what you get credit for their compensation plan. So as interest rates go up their interest yield go up on their on the floor that they create, or help generate for Arch from the insurance perspective, but as a counterpart to that our targets is also in flux and actually moves in lockstep with that treasury equivalent. We have actually set a target that 950 bips above treasury for the target. So while at the same time they're getting more investment income, you can see a higher margin, they're going to have a higher threshold on the target that they're that they're looking at. And we do this continuously. I know our reinsurance folks, because it's portfolio based, it's almost a daily occurrence, they actually look it up every day, on their own insurance, on the insurance basis, we actually look at it through a portfolio on a quarterly basis. Unless there's a big change that we just saw, then they'll be like immediate changes made to the pricing model. So everything is linked together. So interest rates go up. Yes, you get more investment income, but hey, guess what, we need to have a higher return.
Tracy Benguigui: Okay, that was excellent color. If I could just speak and this was really quick. What is your new insurance rate in MI go up this quarter sequentially?
Marc Grandisson: Can you repeat the question again please?
Tracy Benguigui: Sequentially, yes, sequentially what is your new insurance written for mortgage insurance went up?
Marc Grandisson: Yes. Okay. Yes. [indiscernible] it's $23.5 billion versus $20 billion in the first quarter. And largely, as you know, Tracy, it's a very seasonal marketplace. A lot more origination takes place in the second quarter. The school year finishes, people move, the size of summer gets around. That's why there's other people moving and buying houses and refinancing even, not so much these days, but certainly purchasing houses in the second quarter. So historically, the first and fourth quarter are about the same. They're lower than the middle two quarters. So that's sort of a, it's just a by virtue of the market origination. There's nothing in our pricing or appetite has changed in the border.
Tracy Benguigui: Thank you.
Marc Grandisson: Okay.
Operator: Thank you. Our next question comes from Brian Meredith with UBS. Your line is now open.
Brian Meredith: Yes, thanks. A couple of them here for you. First Marc just curious. Big growth in Florida property cat. How do you get comfortable reinsuring some of the less credit worthy companies down in Florida?
Marc Grandisson: Yes, we have a very good question, Brian. I think probably like other competitors of ours. We have a very, very extensive list of clients and we've done auditing of all of them even if they're not our clients throughout the years. Two aspects that we will look at the claims paying ability how good they are adjusting claims because as you can appreciate, Brian is very important. And secondly, we're looking at the financial situation. So we have rank order them in two or three buckets. And we actually tend to focus our limit in the ones that are healthier, and the ones that we believe have better claims adjustment processes and teams and expertise. So but having said this does mean that we won't do a business with someone who's a bit more fragile from a financial perspective, but you probably heard it already that there are conditions that put in a contract such as prepaying reinstatement premium to make sure that we don't have to run after two credit risk. So there's a lot of things you can bells and whistles. So we treat, different clients different way based on our assessment of claims, paying ability, and then expertise and credit worthiness.
Brian Meredith: Got you. Thanks. And then second question, just curious, professional liability premium insurance still really strong growth. That's the one area we've actually been hearing some concern from some companies may not concern to the right word for it, but are you seeing some competitive pressures in the public market DNO area? Maybe talk a little bit about what's in that professional liability line for you all and are you seeing the same type of trends?
Marc Grandisson: Yes, the excess DNO I think is a little bit more stable, more sideways, some go down, some go up, but it's clearly not as -- as heated as it was three or four years ago. But one thing I want to mention, Brian, that people forget, race and excess DNO are two, three, four times what they were three or four years ago. So it's extremely, still a very, very healthy marketplace. I think we would argue that capacity is stable. There's not much -- no longer any dislocations. I just think that for the right company, for the ride experience, no claims or very good quality, there's a tendency that there's a willingness on the marketplace to give more credit to those companies, which is sort of normal. And given where we are in the market after four years of extreme rate pressure. I think on the second question, with our growth a lot of our growth isn't a cyber products. We actually have put cyber in a professional line. And that's one area which we said before, we're very keen to develop and grow as we're seeing really great opportunities there as well. And much needed. Capacity is much needed in that in that marketplace actually.
Brian Meredith: Makes sense. Thank you.
Marc Grandisson: Sure.
Operator: Thank you. Our next question comes from Josh Shanker with Bank of America. Your line is now open.
Josh Shanker: Thank you. I'm understanding your answer to Tracy correctly, you have a long term view of inflation and the changes in inflation wouldn't cause you to change your the inflationary outlook embedded in your in your reserves. Now, if that's correct, does that mean some years you're going to run a little hot because inflation will be higher than you expect? And in some years lower. And would you need would you or any other insurer need to take a charge in order to shore up higher inflation for an extended period?
Marc Grandisson: No. I think that what I say is when there's lower interest rates, lower inflation rates loss trend, we tend to take a longer term view. And as you know, Josh, we had multiple years of, I would argue depress loss cost trend, which was great for the industry, but we still maintain a healthy skepticism as to how we can last and over the long haul. So that makes us maintain a pricing actually higher, during times of, I would argue softer times. What I think it means is that our bright line as to where we think we can make a great return or a good return is doesn't move as much around as we go forward. Right. Because we have a property, we believe we want to have a healthier or more conservative, if you will view of the loss cost trend as we price the business going forward.
Josh Shanker: So your loss cross trend assumptions are already higher and inflation [indiscernible] has been meeting the loss trends you already assumed?
Francois Morin: Yes. I think that's fair. Let me add a bit more on your question. I think Josh, specifically on reserves, I mean that's where the feedback loop comes into play where we do start with more long term assumptions around trend. And as Marc said, we've been through a period where inflation has been pretty benign. So we effectively over time, because we've been pretty, I guess we're slow to react. The good news has been that that's been an Arch kind of philosophy for a number of years forever, really. We effectively end up building a little bit of a cushion that may come in handy if things do pick up again. If there's a bit of a spike in inflation, which depending on the lines of business and some lines of business property, short tail, no question that we're seeing a little bit of higher inflation on labor and goods and materials. In some other lines of business, we're just not seeing it. So it doesn't mean it's not there, it doesn't mean that it won't happen. But for the time being, we have built up this again, buffer that we would call or a little bit of cushion in the reserve base, which would prevent us or what actually, we use up first before ever having to take a charge which in our 20 year history, we've never had to take charges. And we certainly hope to keep it that way.
Josh Shanker: That makes sense. I'm trying to understand mechanics. So you have a high, I don't mean to repair it, but you have you have a high assumption going in, nothing has changed that assumption. If something were to happen, that would change the assumption, by definition, it would mean you need to carry more reserves. But you have a buffer in there. And so you don't need to?
Marc Grandisson: On the old years. On the new years, we right. So the new business that we priced today, we will increase, we have increased. And again, it varies by line. But in some lines of business, no question that we've raised our assumptions, our pricing assumptions and loss cost trends so implicitly that when we reserve those new business, those new years '22 and moving forward they will start at a higher level reflecting the inflation assumptions that we put in place today. When we worry about reserves on the older, [in force] the old years, right '21 and prior, the fact that we priced them with more conservative assumptions on loss cost trends gives us that buffer that we think will be a mechanism to absorb some of the volatility.
Josh Shanker: And in terms of buffers, could you update us on your IBNR reserve for COVID?
Marc Grandisson: Our total reserves for COVID are still at $160 million, 75% of which are either IBNR or ACR within a reinsurance segment.
Josh Shanker: That's very complete. Thank you.
Marc Grandisson: You're welcome.
Operator: Thank you. Our next question comes from Ryan Tunis with Autonomous Research. Your line is now open.
Ryan Tuniss: Hey, good afternoon. Just one question from me. Can you talk a little bit about the impact that global minimum tax would have on the MI tax rate?
Marc Grandisson: It's pretty mature Ryan to analyze all this. There are so many moving parts of these global minimum tax right now whether it's going to take place, whether it's going to happen, which country is going to enact it? So way too premature. I mean, of course, our tax folks are working always every week, there's a new notion, something new coming from all the various governments and agencies and treasuries around the world. But right now, it's still a moving target. Too early, too premature to say what it would mean for us.
Ryan Tuniss: Understood. Thank you.
Marc Grandisson: Thanks.
Operator: Thank you. Our next question comes from Meyer Shields with KBW.
Meyer Shields: Good. Thanks. First, I want to follow up on Brian's questions if I can. Nothing much in terms of the quality companies in Florida. But given the sort of bizarre litigation environment there, how do you get comfortable that even the good companies are with reinsurance?
Marc Grandisson: It's a very good question. I think that in general, that's why we actually ask and want a higher margin of safety in Florida. So I think if you look at our expected pricing in Florida reflects all of these. And we need a healthier margin and you will find that the margin in Florida is higher than most other jurisdictions around and I think we've increased a little bit in Florida. We know we didn't go as Francois mentioned the P&L went up slightly in the Florida Tricounty area. But these prices, the prices that we saw as well Myers at some point, they're not necessarily sort of settled market, they might be sort of harder to place or a layer that needs to be fun finalized. So the pricing will be quite a bit better than you would expect than the average market would be. Again, Meyer there is no guarantee in this slide specifically an insurance as you know. I think we tend to think about having a higher margin of safety in Florida and several deals gave us that opportunity this year.
Meyer Shields: Okay, no, that makes perfect sense. Second question, if I can look over your shoulder on the reinsurance side. You talked a little bit about the industry recognizing faster rates of inflation. How much does that vary when you look at potential feedings?
Marc Grandisson: Wildly, it varies wildly. I think now we probably have more consensus building in the industry. But it does vary wildly, because to be fair to our clients, they have different books of business, they have different lines, they have different focus geographically or line size. So it does vary a lot. But there's clearly among our clients that we can see and sense that there is development coming, there is some of that inflation taking up a little bit, which they have, by and large, already understood and appreciated would come. But I think like, it's, I would say it's varies by [sitting] company, the level but I think the general direction of pricing for more and recognizing more is there than [sitting] company clearly. They've been very, very proactive, most of them if not all of them.
Meyer Shields: Okay, no, excellent. Thank you very much.
Operator: I am not showing any further questions. I'd now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thank you very much, everyone. We're looking forward for the second half of this year and there we'll talk to you soon.
Operator: Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Second Quarter 2022 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found on the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks Elizabeth. Good morning, and welcome to our earnings call. Arch delivered strong results this quarter headlined by an operating return on equity of 17%. Our results were driven by excellent underwriting performance across all three operating segments as we continued our focus on growth opportunities during this hard market, as demonstrated by the 27% increase in P&C net premium written over the same quarter one year ago. These results demonstrate how our company is positioned to capitalize on market opportunities across the many lines that we underwrite. We've said it before, but it bears repeating. We are committed to agile cycle management predicated by a focus on risk adjusted returns. And it has enabled us to accelerate our growth through the deployment of meaningful capacity to our clients. Because we invested in capabilities and reserved capital during the soft market years, we are in the enviable position of being able to maximize to these opportunity. Increasingly Arch is seen as a provider of choice by our distribution partners and clients, which allows us to take on leadership positions, some in the industry retrench. P&C rate hardening continues in many lines. It's important to keep in mind that for the vast majority of the P&C lines, we've been able to achieve compounded rate increases meaningfully above last cost trends for the last two or three annual renewals and as such healthy margins of safety have been created. We believe this attractive level of expected returns should remain in place for the next few years. I will now offer a few highlights on our business units. In the quarter, our insurance and reinsurance segments both had excellent operating results, largely because of how we leaned hard into the improving market early on. We also have invested in improving our data analytics while broadening our market presence. In our North American insurance operations, premium growth was broad based with net premium written up 29% from the same period in 2021. Some of the most significant growth came from our E&S lines, both property and casualty, professional lines, including cyber and a resurgent travel and accident sector. All our lines of business where we believe risk adjusted returns are most attractive. Our specialty international insurance business, which includes our Lloyds and UK regional businesses, also delivered strong growth in the quarter with net premium written up 23% from the same period last year driven primarily by specialty, casualty and property. Our investment in building the UK regional small business is gaining traction as well. When looking at the improved results of our insurance business, it's apparent that the work of our teams over the past several years is paying off. We have developed a platform that responds swiftly to opportunities presented by the hard markets while at the same time building more sustainable positions in lines that are less cyclical. We have the capital, the people and the desire to lead in today's environment, as long as attractive opportunities are available, Arch will be there to write them. Our reinsurance segment continued to deliver excellent top line growth and bottom line earnings this quarter because of the diversified and specialty focus of our reinsurance business. The strong growth reflects our increased writings of quarter share treaties which allow us to participate in the rate increases experienced by our [indiscernible]. The 61 and 71 renewals showed a property [cap] market in transition and while I hesitate to make predictions, we are cautiously optimistic that this momentum will continue in January 1, 2023. The general psychology of the market appears to have shifted to requiring substantial rate increases to accept cat exposure. As an example, in Florida, where capacity remains constrained, property cap rates were up in excess of 30% and our P&L in a one and a 250 year events increased as we selectively expanded our writings. Rate pressure was evident also beyond Florida. However, we will need a few more quarters to confirm we are facing a hard property cap marketplace. Turning to our mortgage segment. The group continues to deliver the consistent underwriting results we projected when we began building our EMI business a decade ago. Our embedded book of high credit quality risks as well as continued on price increases have been key elements to our exceptional return this quarter. All the rising mortgage interest rates have slowed the volume of new originations, the purchase market remains strong, as housing demand continues to outstrip new supply. Rising rates also mean that persistency is increasing which allowed Arch to grow its U.S. primary mortgage insurance in force to $292 billion and all time high. The forbearance programs continue to roll off and cures have brought our delinquency rate down to 1.77%, which is consistent with what we experienced before COVID. Last and perhaps most important, the credit quality of homebuyers remains excellent. And we believe our portfolio is well-positioned for a variety of economic scenarios. We will continue to be deliberate in managing our mortgage portfolio, benefiting from a diversified business model that gives us the flexibility to focus on credit quality and profitability, not on volume. Briefly on investments, where rising interest rates and market volatility are setting the stage for additional investment income contributions over the next several quarters. We're seeing the benefits of not chasing yield during the past several years as well as the work done to reposition our portfolio in response to the changing interest rate environment. Earlier this year our investment team reduced our equity exposure in our fixed income portfolios shorter duration has allowed us to quickly move our investments into higher rate securities that provides further cushion against potential inflation impacts. This year surge of inflation has been a call to arms to underwriting teams across the industry. And by and large the industry has proactively incorporated higher trends into its models. We believe that the uncertainty surrounding future inflation should keep upward pressure on rates. At Arch, we manage inflation by business segments as we said before. We believe inflation is a net benefit to our MIS portfolios performance while our P&C exposure to inflation is mitigated by many tools available to us. Overall, we're very pleased with our underwriting results and returns in a quarter. And we are optimistic about the rest of '22 and into '23. As always, our objective remains to generate profitable growth and deliver long term value for our shareholders and this quarter's results are another example of our ability to do just that. I want to thank the Arch team for everything they've done this past quarter and over the last several years. Our people have made Arch into an employer and insurer of choice and have us well-positioned to sustain our growth trajectory into '23 and beyond. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Thank you, Marc. And good morning to all. Thanks for joining us today. As you will have seen by now we had a very strong quarter and with very few unusual items to discuss or highlight to you. I have kept my prepared remarks relatively brief to allow for more time for the Q&A session. So here we go. For the quarter we reported after tax operating income of $1.34 per share, resulting in an annualized operating return on average common equity of 17.1%, two excellent results. In the insurance segment net written premium growth of 27.5% over the same quarter one year ago, combined with excellent underwriting performance resulted in an excellent year combined ratio exploiting cats of 90% a 140 basis point improvement over the same quarter one year ago. Like last quarter, a change in our business mix resulted in a slightly different split between the loss and expense ratios, compared to the same quarter one year ago. In the reinsurance segment, net written premium grew by 25.7% over the same quarter one year ago. The segment produced ex-cat accident year combined ratio of 82.8%, 430 basis points lower than the same quarter one year ago. Here also a reduction in the accident year ex-cat loss ratio was partially offset by a slight increase in the expense ratio due to growth in areas with slightly higher acquisition expenses, and targeted personnel expansion to support our growth. Losses from 2022 catastrophic events net of reinsurance recoverable and reinstatement premiums stood at $82.4 million, or 3.5 combined ratio points compared to 2.4 combined ratio points in the second quarter of 2021. The losses were split approximately 80% to reinsurance and 20% to our insurance segment. It's worth noting that approximately two thirds of the estimated losses came from events outside the U.S. including Australian floods, South African floods, a directional storm in Canada, and other miscellaneous natural catastrophe events. Our mortgage segment had an excellent quarter with a combined ratio excluding prior development of 39.2%. Net premiums earned increased on sequential basis due to increased persistency of our enforce insurance, which now stands at 71.3% at the end of the quarter, and growth in our CRT portfolio. Production levels also increased from last quarter consistent with the seasonality of the business. We recognized $118.1 million of favorable prior year development across a segment this quarter. A meaningful benefit to our bottom line, as delinquencies cured at a higher rate than expected. Close to 80% of the favorable claim development came from our first lien insured portfolio at USMI mostly related to the 2020 accident year. The remainder of the favorable development came from recoveries on second lien loans, and better than expected claim development in our CRT portfolio in our international MI operations. In all our segments, we maintain a prudent approach and setting loss reserves considering the uncertainty we face in a variety of factors, such as macroeconomic conditions, inflation, both monetary and social, and lags and settling longer tail liabilities as COVID related delays get worked through the legal systems. Income from operating affiliates stood at $4.6 million. It was generated from good results at Coface mostly offset by the negative mark to market impacts on the summer's portfolio for those securities that are accounted under the fair value option method. Gross investment income before investment expenses increased 20% from the first quarter of 2022 to $123.6 million driven by the reinvestment that higher yields of proceeds from the maturities and sales of investments and securities and the presence of floating rates investment floating rate investments in our portfolio. Total investment return for our investment portfolio was a negative 3.02% on a U.S. dollar basis for the quarter hurt by mark-to-market losses due to rising interest rates and weak equity markets. As you know, it is worth remembering that while mark-to-market impacts are fully reflected in our financials, a significant portion of this decrease hasn't been crystallized through the selling of securities and has the potential to reverse itself over time, in particular for our fixed maturity investments as they mature. As we discussed on the first quarter call that defensive investment strategy we have employed for a number of quarters with high quality investments and a short portfolio duration has helped minimize the impact of rising interest rates and the mark to market hit to book value. Our investment duration remains slightly below three years at the end of the quarter and slightly underweight and relative to our liability duration target. The performance of our alternative investments remained very solid this quarter, as we benefited from the returns generated by a number of funds that outperformed broad market indices. Turning briefly to risk management. Our natural cap P&L on a net basis stood at $888 million as of July one, or 7.7% of tangible shareholders equity. Again, well below our internal limits at the single event one and 250 year return level. Our peak zone P&L is currently the Florida Tri county region. On the capital front, we repurchased approximately 7.1 million common shares at an aggregate cost of 320.7 million in the second quarter. Our remaining share authorization currently stands at $600.6 million. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan with Wells Fargo. Your line is now open."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi, my first question is on the rate versus trend discussion which we've had a lot so far this earnings season. Marc, you started off your conversation by saying you continue to see hardening and many lines. Where would you place when you think about your insurance business where you place price and loss trend? And how do you think that could go from here as we think about higher inflation levels?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, I think the pricing, nice hearing from you Elyse, I think the pricing in the market is definitely clearing the last round. You've heard us on some of the calls that we would concur with that conclusion."
},
{
"speaker": "Elyse Greenspan",
"text": "And you think as you're thinking out the next year, do you think that remain as especially right to your comments when we've heard about weight on top of weight on top of rate. Or do you see dynamics? They will keep talking about that for the next year or so?"
},
{
"speaker": "Marc Grandisson",
"text": "I see what you mean. So I think I would answer by saying the perceived risk in the marketplace has actually increased. So there's all this on the property categories. I mentioned briefly, my comments. And also on the liability side as well. I think that the uncertainty about the social inflation, and what it could mean and also geopolitical risks, just a lot of stuff going on in the world, I would expect this to continue well into 2023. But I've been wrong before. So I have to be careful the way I tell you this."
},
{
"speaker": "Elyse Greenspan",
"text": "And then on the investment side, where are you putting new fixed income money to work in terms of rates and then how much of the portfolio is turning over the next 12 months?"
},
{
"speaker": "Francois Morin",
"text": "Good question. I think we don't plan specifically how much of it we're going to turn over. But we've been less than that. Our investment team has been pretty active trying to make sure that a first of all, we did take a lot of investments. So offer risk in the first half of the year. And then it'll all be about how much of what kind of opportunities we see as with the environment we're in, but we certainly with a short duration that we're at three years, you could certainly think that a meaningful amount of it, there's going to turn over the next 12 months."
},
{
"speaker": "Elyse Greenspan",
"text": "And then what's the new rate today?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, new rate want to be a little bit careful here. Certainly corporates you've heard it we're calling for approaching 4.5% in some places and the corporates investments on and corporate securities that we made in the month of July. With the Fed announcement yesterday, I mean, the risk for you the treasuries I think everything is going to move up a little bit from there. So that's kind of where what we're seeing today, it's going to evolve as we move forward. And that compares to an embedded book yield of 2.2% or so at the end of the quarter. So it's meaningfully higher than what we're the portfolio has been at."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay, thanks for the color."
},
{
"speaker": "Marc Grandisson",
"text": "Yes."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Jimmy Bhullar with J.P. Morgan. Your line is now open."
},
{
"speaker": "Jimmy Bhullarn",
"text": "Hi, good morning. So first just had a question on the mortgage insurance business. How are you, what's your view on the operating environment in the business, but just as the threat of a potential recession and then its impact on margins, and then just with the higher interest rates, and how that's going to affect top line growth in the business?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, and I think it's quite answered a bit more specifically, I think that as I mentioned in my comments that we mentioned more than once on the calls, you're going to hear some of the other I believe, competitors is that the credit quality of the borrowers that we see right now is exceptional. By and large, the credit quality has actually improved through the pandemic. So we're very, very pleased with this. And I'm saying this, because the biggest driver of default in distress is a credit quality of the borrower. It's by far and it overwhelms the risk possibility. We also are in position where we have substantial equity buildup in the housing stock. So that's also helpful. So we're very comfortable with the way the portfolio is position. And I think it's, we're not recession proof. But I think we have a lot going for us if there were to be a recession. Now, the top line, as you know, if there's less production, there's some indication that the third quarter might be a bit slower than usual, then that would mean no production that's less than positive for the industry in that quarter. But the impact on your premium will take a little bit longer to be felt because as you know, monthly premiums are written through a longer period of time and most of what we write and earn at this point in time comes from prior underwriting years 2020, 2021 and 2019. So we're not going to see a huge impact immediate impact. It's not like a property casualty portfolio. So, again, it's a somewhat of a tempered impact on top line, we believe."
},
{
"speaker": "Jimmy Bhullarn",
"text": "Okay. And then on share buybacks, you've spent, I think it was $321 million this quarter, $255 million last quarter. And if I look over the past year and a half, they've averaged almost $300 million a quarter. Do you expect to be at the same pace going forward? Or should we assume a slowdown?"
},
{
"speaker": "Marc Grandisson",
"text": "That's a good question. I think, yes, we've been active. I think we, it's part of our evaluation of all the alternatives in front of us when we buy back stock compared to how we deploy the capital in the business. The one thing that I want to make sure as you're aware, I mean, realizes and we're bullish on the market, right, we think the market that we see today is strong and has some potential for even getting better. Time will tell. We certainly need to put odds on that. But the reality is, if it gets better, and we have the ability to deploy more capital in the business at one-one, will certainly want to do that. So the -- we'll reevaluate that daily and weekly, like we always do, but I could see a scenario where we have to pull back a little bit on the share buybacks really just to have the capital base that we need to fully execute on deploying the capital in the business and the three segments which are, as you see all humming and growing at a very good clip, make sure that we can execute on that opportunity in '23 and beyond."
},
{
"speaker": "Jimmy Bhullarn",
"text": "Okay. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Tracy Benguigui with Barclays. Your line is now open."
},
{
"speaker": "Tracy Benguigui",
"text": "Good morning. I also had a loss turn question. Marc you've said in the past that your view of last trends, your book is roughly 250 basis points above CPI. And for access layers, it could be even higher. Can you just share your latest take on that? Because I think when you talked about these levels, CPI was below 2%?"
},
{
"speaker": "Francois Morin",
"text": "Yes, I think it's on a long term basis, right. These surge and inflation may create distortion in that spread over this but over the long haul. I still maintain this and seen another statistics recently that concurs with that sort of analysis. I think that the CPI we've fitting it right now in the shorter lines of business, shorter pay lines of business and property specifically, as you know, we've had all collectively a lot of labor and cost material that went through hire, very significantly. I think in some lines of business, we're not seeing evidence of yet of trend above the CPI significantly above the CPI. So I think our position has been to maintain, as we said before, Tracy, a longer term view of the loss trend. And when we had indication, perhaps zero to 1% in certain years, we probably have higher from a longer term perspective. So that helps on a cumulative basis when you buy the business not having to do as much catch up. It keeps you a little bit more balanced through to changes in inflation sometimes we see right now."
},
{
"speaker": "Tracy Benguigui",
"text": "Okay, so it's more of a view, not what you're seeing today."
},
{
"speaker": "Marc Grandisson",
"text": "Correct."
},
{
"speaker": "Tracy Benguigui",
"text": "Okay. Also started a conversation yesterday on the intersection of investment yields and combined ratio targets typically combined ratio targets we share with underwriters is informed by ROE. And I believe you guys, when you come up with these targets, you're actually looking at new money yields on a risk free duration match basis. So not your portfolio yield. Are those the right clicks and takes of your pricing model? I guess, ultimately, could hire new money yield risk free in your case change your indicated rate need?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, it's a great question Tracy. And I like the way we've built our compensation scheme for our underwriting team. It's actually self correcting and self adjusting as we go forward. Number one, when the prize the business, this is our underwriting underwriters. They actually look, they used to look in the Wall Street Journal at a three to five year equivalent treasury rate. And that's what they would ascribe to the cash flow in terms of investment income, that he could earn on the premium that we could earn on the premium. So it's really a treasury return. This is what you get credit for their compensation plan. So as interest rates go up their interest yield go up on their on the floor that they create, or help generate for Arch from the insurance perspective, but as a counterpart to that our targets is also in flux and actually moves in lockstep with that treasury equivalent. We have actually set a target that 950 bips above treasury for the target. So while at the same time they're getting more investment income, you can see a higher margin, they're going to have a higher threshold on the target that they're that they're looking at. And we do this continuously. I know our reinsurance folks, because it's portfolio based, it's almost a daily occurrence, they actually look it up every day, on their own insurance, on the insurance basis, we actually look at it through a portfolio on a quarterly basis. Unless there's a big change that we just saw, then they'll be like immediate changes made to the pricing model. So everything is linked together. So interest rates go up. Yes, you get more investment income, but hey, guess what, we need to have a higher return."
},
{
"speaker": "Tracy Benguigui",
"text": "Okay, that was excellent color. If I could just speak and this was really quick. What is your new insurance rate in MI go up this quarter sequentially?"
},
{
"speaker": "Marc Grandisson",
"text": "Can you repeat the question again please?"
},
{
"speaker": "Tracy Benguigui",
"text": "Sequentially, yes, sequentially what is your new insurance written for mortgage insurance went up?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. Okay. Yes. [indiscernible] it's $23.5 billion versus $20 billion in the first quarter. And largely, as you know, Tracy, it's a very seasonal marketplace. A lot more origination takes place in the second quarter. The school year finishes, people move, the size of summer gets around. That's why there's other people moving and buying houses and refinancing even, not so much these days, but certainly purchasing houses in the second quarter. So historically, the first and fourth quarter are about the same. They're lower than the middle two quarters. So that's sort of a, it's just a by virtue of the market origination. There's nothing in our pricing or appetite has changed in the border."
},
{
"speaker": "Tracy Benguigui",
"text": "Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Okay."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Brian Meredith with UBS. Your line is now open."
},
{
"speaker": "Brian Meredith",
"text": "Yes, thanks. A couple of them here for you. First Marc just curious. Big growth in Florida property cat. How do you get comfortable reinsuring some of the less credit worthy companies down in Florida?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, we have a very good question, Brian. I think probably like other competitors of ours. We have a very, very extensive list of clients and we've done auditing of all of them even if they're not our clients throughout the years. Two aspects that we will look at the claims paying ability how good they are adjusting claims because as you can appreciate, Brian is very important. And secondly, we're looking at the financial situation. So we have rank order them in two or three buckets. And we actually tend to focus our limit in the ones that are healthier, and the ones that we believe have better claims adjustment processes and teams and expertise. So but having said this does mean that we won't do a business with someone who's a bit more fragile from a financial perspective, but you probably heard it already that there are conditions that put in a contract such as prepaying reinstatement premium to make sure that we don't have to run after two credit risk. So there's a lot of things you can bells and whistles. So we treat, different clients different way based on our assessment of claims, paying ability, and then expertise and credit worthiness."
},
{
"speaker": "Brian Meredith",
"text": "Got you. Thanks. And then second question, just curious, professional liability premium insurance still really strong growth. That's the one area we've actually been hearing some concern from some companies may not concern to the right word for it, but are you seeing some competitive pressures in the public market DNO area? Maybe talk a little bit about what's in that professional liability line for you all and are you seeing the same type of trends?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, the excess DNO I think is a little bit more stable, more sideways, some go down, some go up, but it's clearly not as -- as heated as it was three or four years ago. But one thing I want to mention, Brian, that people forget, race and excess DNO are two, three, four times what they were three or four years ago. So it's extremely, still a very, very healthy marketplace. I think we would argue that capacity is stable. There's not much -- no longer any dislocations. I just think that for the right company, for the ride experience, no claims or very good quality, there's a tendency that there's a willingness on the marketplace to give more credit to those companies, which is sort of normal. And given where we are in the market after four years of extreme rate pressure. I think on the second question, with our growth a lot of our growth isn't a cyber products. We actually have put cyber in a professional line. And that's one area which we said before, we're very keen to develop and grow as we're seeing really great opportunities there as well. And much needed. Capacity is much needed in that in that marketplace actually."
},
{
"speaker": "Brian Meredith",
"text": "Makes sense. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Sure."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Josh Shanker with Bank of America. Your line is now open."
},
{
"speaker": "Josh Shanker",
"text": "Thank you. I'm understanding your answer to Tracy correctly, you have a long term view of inflation and the changes in inflation wouldn't cause you to change your the inflationary outlook embedded in your in your reserves. Now, if that's correct, does that mean some years you're going to run a little hot because inflation will be higher than you expect? And in some years lower. And would you need would you or any other insurer need to take a charge in order to shore up higher inflation for an extended period?"
},
{
"speaker": "Marc Grandisson",
"text": "No. I think that what I say is when there's lower interest rates, lower inflation rates loss trend, we tend to take a longer term view. And as you know, Josh, we had multiple years of, I would argue depress loss cost trend, which was great for the industry, but we still maintain a healthy skepticism as to how we can last and over the long haul. So that makes us maintain a pricing actually higher, during times of, I would argue softer times. What I think it means is that our bright line as to where we think we can make a great return or a good return is doesn't move as much around as we go forward. Right. Because we have a property, we believe we want to have a healthier or more conservative, if you will view of the loss cost trend as we price the business going forward."
},
{
"speaker": "Josh Shanker",
"text": "So your loss cross trend assumptions are already higher and inflation [indiscernible] has been meeting the loss trends you already assumed?"
},
{
"speaker": "Francois Morin",
"text": "Yes. I think that's fair. Let me add a bit more on your question. I think Josh, specifically on reserves, I mean that's where the feedback loop comes into play where we do start with more long term assumptions around trend. And as Marc said, we've been through a period where inflation has been pretty benign. So we effectively over time, because we've been pretty, I guess we're slow to react. The good news has been that that's been an Arch kind of philosophy for a number of years forever, really. We effectively end up building a little bit of a cushion that may come in handy if things do pick up again. If there's a bit of a spike in inflation, which depending on the lines of business and some lines of business property, short tail, no question that we're seeing a little bit of higher inflation on labor and goods and materials. In some other lines of business, we're just not seeing it. So it doesn't mean it's not there, it doesn't mean that it won't happen. But for the time being, we have built up this again, buffer that we would call or a little bit of cushion in the reserve base, which would prevent us or what actually, we use up first before ever having to take a charge which in our 20 year history, we've never had to take charges. And we certainly hope to keep it that way."
},
{
"speaker": "Josh Shanker",
"text": "That makes sense. I'm trying to understand mechanics. So you have a high, I don't mean to repair it, but you have you have a high assumption going in, nothing has changed that assumption. If something were to happen, that would change the assumption, by definition, it would mean you need to carry more reserves. But you have a buffer in there. And so you don't need to?"
},
{
"speaker": "Marc Grandisson",
"text": "On the old years. On the new years, we right. So the new business that we priced today, we will increase, we have increased. And again, it varies by line. But in some lines of business, no question that we've raised our assumptions, our pricing assumptions and loss cost trends so implicitly that when we reserve those new business, those new years '22 and moving forward they will start at a higher level reflecting the inflation assumptions that we put in place today. When we worry about reserves on the older, [in force] the old years, right '21 and prior, the fact that we priced them with more conservative assumptions on loss cost trends gives us that buffer that we think will be a mechanism to absorb some of the volatility."
},
{
"speaker": "Josh Shanker",
"text": "And in terms of buffers, could you update us on your IBNR reserve for COVID?"
},
{
"speaker": "Marc Grandisson",
"text": "Our total reserves for COVID are still at $160 million, 75% of which are either IBNR or ACR within a reinsurance segment."
},
{
"speaker": "Josh Shanker",
"text": "That's very complete. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Ryan Tunis with Autonomous Research. Your line is now open."
},
{
"speaker": "Ryan Tuniss",
"text": "Hey, good afternoon. Just one question from me. Can you talk a little bit about the impact that global minimum tax would have on the MI tax rate?"
},
{
"speaker": "Marc Grandisson",
"text": "It's pretty mature Ryan to analyze all this. There are so many moving parts of these global minimum tax right now whether it's going to take place, whether it's going to happen, which country is going to enact it? So way too premature. I mean, of course, our tax folks are working always every week, there's a new notion, something new coming from all the various governments and agencies and treasuries around the world. But right now, it's still a moving target. Too early, too premature to say what it would mean for us."
},
{
"speaker": "Ryan Tuniss",
"text": "Understood. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Meyer Shields with KBW."
},
{
"speaker": "Meyer Shields",
"text": "Good. Thanks. First, I want to follow up on Brian's questions if I can. Nothing much in terms of the quality companies in Florida. But given the sort of bizarre litigation environment there, how do you get comfortable that even the good companies are with reinsurance?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a very good question. I think that in general, that's why we actually ask and want a higher margin of safety in Florida. So I think if you look at our expected pricing in Florida reflects all of these. And we need a healthier margin and you will find that the margin in Florida is higher than most other jurisdictions around and I think we've increased a little bit in Florida. We know we didn't go as Francois mentioned the P&L went up slightly in the Florida Tricounty area. But these prices, the prices that we saw as well Myers at some point, they're not necessarily sort of settled market, they might be sort of harder to place or a layer that needs to be fun finalized. So the pricing will be quite a bit better than you would expect than the average market would be. Again, Meyer there is no guarantee in this slide specifically an insurance as you know. I think we tend to think about having a higher margin of safety in Florida and several deals gave us that opportunity this year."
},
{
"speaker": "Meyer Shields",
"text": "Okay, no, that makes perfect sense. Second question, if I can look over your shoulder on the reinsurance side. You talked a little bit about the industry recognizing faster rates of inflation. How much does that vary when you look at potential feedings?"
},
{
"speaker": "Marc Grandisson",
"text": "Wildly, it varies wildly. I think now we probably have more consensus building in the industry. But it does vary wildly, because to be fair to our clients, they have different books of business, they have different lines, they have different focus geographically or line size. So it does vary a lot. But there's clearly among our clients that we can see and sense that there is development coming, there is some of that inflation taking up a little bit, which they have, by and large, already understood and appreciated would come. But I think like, it's, I would say it's varies by [sitting] company, the level but I think the general direction of pricing for more and recognizing more is there than [sitting] company clearly. They've been very, very proactive, most of them if not all of them."
},
{
"speaker": "Meyer Shields",
"text": "Okay, no, excellent. Thank you very much."
},
{
"speaker": "Operator",
"text": "I am not showing any further questions. I'd now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you very much, everyone. We're looking forward for the second half of this year and there we'll talk to you soon."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 1 | 2,022 | 2022-04-28 11:00:00 | Disclaimer*: This transcript is designed to be used alongside the freely available audio recording on this page. Timestamps within the transcript are designed to help you navigate the audio should the corresponding text be unclear. The machine-assisted output provided is partly edited and is designed as a guide.:
Operator: 00:04 Good day, ladies and gentlemen, and welcome to the First Quarter 2022 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. 00:29 Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. 01:03 Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. 01:19 Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. 01:37 I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin.
Marc Grandisson: 01:45 Thank you very much. Good morning, and welcome to Arch's earnings call for the first quarter of 2022. Arch delivered a strong first quarter, as our dynamic capital allocation and cycle management strategy combined with strong underwriting skills delivered a 13.6% annualized operating ROE. This past quarter provided yet another reminder that we live in a world of uncertainty. The war in Ukraine has affected countless lives and initiated a humanitarian crisis that is still unfolding and the pandemic continues now into year three. 02:23 In addition to the war in Ukraine, global inflation and supply chain issues pushed interest rates up, which in turn led to investment markdowns in the quarter. In spite of these headwinds for our industry, we demonstrated the effectiveness of our diversified platform as: one, we grew premium above market average again. Two, repurchased 5.6 million shares; and three, generated a strong operating ROE. Our objective remains as always to deliver long-term value for our shareholders using all the levers available to us. 03:06 The underlying fundamentals of our businesses continue to improve as we benefit from better market conditions in the P&C industry and execute our cycle management strategy where we actively allocate capital to the most attractive sectors of our business. Our P&C operations generated $2.3 billion of net written premium in the quarter, which represents an increase of 18% from the same quarter in 2021 and speaks to our confidence in the improving underwriting conditions in our P&C operations. 03:44 Mortgage insurance contributed substantial underwriting profit in the quarter and insurance in force grew modestly again highlighting that mortgage remains a positive differentiator of our business model. Now, inflation is top of mind for everyone in the P&C industry, which to its credit has historically been adequately respond to inflation trends. Inflation is not a new phenomenon and in fact it permeates discussions in evaluating claims all the time in an insurance company. 04:21 As such, our focus is always on proactively incorporating new data into our reserving and pricing. We believe that this focus in addition to increased future investment returns and reserving prudently will help mitigate inflation's impact. As far as our mortgage business is concerned, inflation mainly has a positive effect, as it increases homeowner equity, which again mitigates potential losses. 04:51 I'll now share a few highlights from our segments. Across most lines our P&C units remained in a growth phase of the underwriting cycle according to falling rates insurance clock. In the quarter, our P&C net premiums earned grew by 25% over the first quarter of 2021, as we continue to earn in the rate increases of the past 24-months. Our data indicates that we are still experiencing average rate increases in excess of expected loss cost. 05:25 In Specialty Insurance, underwriting conditions remain very good, as pricing discipline, terms and conditions and limits management are stable across most markets. This stability combined with the uncertainties, I mentioned at the beginning of this call should help keep the market discipline and sustain rate increases. 05:46 Our specialty business in Lloyds and our UK regional business delivered strong growth in the quarter as our European insurance operations now represent 30% of Arch insurances total net written premium, up from 20% pre-pandemic. We are pleased to see the positive results of the investments we made into this platform prior to 2020. 06:11 We also created meaningful growth across our U.S. operations in the quarter, primarily in professional liability, including cyber, as well as travel where we believe relative returns are attractive. On the reinsurance side of our business, the emphasis remains on quarter share treaties over excess of loss reinsurance. This allows Arch to participate in the rate increases on primary insurance, while improving the balance between the risk and the return. 06:42 Overall in our Reinsurance Group, growth opportunities remains strong. Since it's been a talking point on prior calls, it’s worth noting that although property cat rates have improved in response to elevated loss activity in the past few years, we have remained disciplined and have not allocated material additional capital to this line as we maintain our view that other lines of business have better risk-adjusted returns. 07:10 Turning now to the mortgage segment, which once again delivered excellent underwriting results as we continue to benefit from strong housing demand and excellent credit conditions. Delinquency rates on our MI portfolio continue to trend to a historically low levels and cures on delinquent mortgages in our portfolio resulted in favorable prior development in the quarter. 07:35 The increase in mortgage interest rates currently at 5% for 30-year fixed-rate mortgages is a steeper rise, then we have seen in decades. These higher rates have dramatically curtailed refinancing. However, our MI business is far more geared to the purchase market, which continues to benefit from strong demand and limited housing supply. Of note, the decline in refinancing activity improves persistency which in turn should improve returns on our in-force portfolio. 08:07 While the rise in mortgage rates may ultimately cool demand and slow the rapid home price appreciation of the last year. So far, we have yet to see demand weaken and we expect home prices to continue to rise, albeit at a slower pace. Again, as mentioned earlier, rising home prices increase equity for homeowners, which ultimately reduces the risk of claim in mortgage insurance. So our perspective is that this expected future equity buildup and the strong credit profiles of borrowers should strengthen the resilience of our in-force mortgage portfolio. 08:44 Moving forward, our diversified platform and cycle management philosophy, will enable our MI team to continue to make measured responsible decisions with our capital. Our MI Group has the flexibility to grow or moderate the business they choose to right based on their view of market conditions. 09:02 A few brief notes on investments, were net investment income was down from last quarter, as we reduced risk positions primarily equities given increasing market volatility. Rising interest rates also caused mark-to-market losses in the quarter. However, the relatively short duration of our investment portfolio, as well as our healthy cash flow will naturally allow us to reinvest at higher interest rates, which should be reflected in future quarters. 09:30 In closing even with current uncertainties, opportunities exist. In the quarter, Arch was able to deliver strong results with positive growth across its businesses and we're well-positioned to sustain our growth trajectory in this favorable P&C market. We've consistently demonstrated our ability to allocate capital effectively to the areas of our business with the most attractive returns. As you know, with Arch, we are constantly looking for and seizing the opportunities that offer the best returns for our shareholders. Francois?
Francois Morin: 10:06 Thank you, Marc, and good morning to all. Thanks for joining us today. As Marc shared earlier our P&C units remained on their path of underlying margin improvement, while the Mortgage Group delivered another quarter of strong underlying performance, which was supplemented by solid cure activity in their insured loan portfolio. Overall our results translated into an after-tax operating income of $1.10 per share for the quarter and an annualized operating return on average common equity of 13.6%. 10:42 In the insurance segment net written premium grew 21.3% over the same quarter one year ago. Growth was particularly strong within our professional liability and travel business units and was achieved both in North America and internationally. Underwriting performance was excellent with an accident quarter combined ratio, excluding cats of 90.8%, a 250 basis point improvement over the same quarter one year ago. 11:12 Similar to last quarter, a change in our business mix as a result of more pronounced growth in lines of business with lower loss ratios helps explain some of the 470 basis point improvement we observed in our underlying loss ratio. This benefit was slightly offset by a higher acquisition expense ratio. Increased contingent commission accruals on profitable business and lower levels of ceded business for lines with higher ceding commission offsets also slightly increased the expense ratio. 11:46 As we have said before, our focus remains on improving our expected returns through a variety of levers. And we are encouraged to see that our efforts are paying off for our shareholders. In the reinsurance segment, it's worth mentioning that reinsurance agreements that were put in place at the time of the closing of the Somers acquisition in the third quarter of last year made comparisons from the current to prior periods imperfect. For example, while our reported growth in net written premium remained solid at 14% on a quarter-over-quarter basis, it would have been 26.6% after adjusting for the Somers session. The growth came primarily in our casualty and other specialty lines where rate increases, new business opportunities and growth in existing accounts help increase the top line. 12:40 The segment produced an ex-cat accident year combined ratio of 82.7%, an excellent result, as we continue to enjoy healthy underwriting conditions in most of the lines we write. Losses from first quarter catastrophic events, net of reinsurance to recoverables and reinstatement premiums stood at $85.8 million or 4.0 combined ratio points, compared to 10.5 combined ratio points in the first quarter of 2021. Approximately two-thirds of the estimated losses came from the Russia invasion of Ukraine with the rest coming from other global natural catastrophe events including the Australian floods. 13:26 Our mortgage segment had an excellent quarter with a combined ratio of 3.1%, due in large part to favorable prior year development of $105.6 million. In line with last quarter's results net premiums earned decreased on a sequential basis, due to a combination of higher levels of ceded premiums a lower level of earnings from single premium policy terminations and reduced US primary mortgage insurance monthly premiums, primarily from recent originations, which remain of excellent credit quality. 14:04 Production levels were down slightly from last quarter, but certainly in line with seasonal trends and new purchases and diminishing refinancing opportunities for borrowers. As we have discussed on prior calls, one of the benefits of higher interest rates as an improving persistency rate, which now stands at 66.9% and should continue to increase throughout 2022. Ultimately, higher persistency benefits our insurance in-force and should result in a stable base of premium income to help drive underwriting income for the rest of the year and beyond. 14:40 With respect to claim activity, approximately three quarters of the favorable claims development came from our first lien insured portfolio at USMI as we benefited from better than expected cure activity mostly related to the 2020 accident year. The remainder of the favorable development came from recoveries on second lien loans and better-than-expected claim development in our CRT portfolio in our International MI operations. 15:08 We maintain a prudent approach in setting loss reserves in light of the uncertainty we are facing with borrowers exiting forbearance programs and moratoriums on foreclosures. Income from operating affiliates stood at $24.5 million and was generated from good results across our various investments, including Coface, Somers Re and Premium. 15:32 Total investment return for our investment portfolio was a negative 3.07% on a U.S. dollar basis for the quarter, which explains the decrease in our book value per share to $32.18 at March 31st down 4.1% in the quarter. The decrease was primarily due to the mark-to-market impact for our available for sale fixed maturities portfolio, resulting in a $1.55 hit to our book value per share. 16:02 This quarter, the meaningful increase in interest rates and negative returns in the equity markets contributed to the negative total return. As you know, we are maintaining a relatively short duration in our investment portfolio for some time and this strategy help temper the mark-to-market hit to book value in the first quarter. While still relatively short, we have extended our duration slightly to 2.93 years at the end of the quarter in order to get closer to our duration target. 16:31 The change in net investment income this quarter on a sequential basis was mostly due to a lower level of dividends as we shifted out of some equity positions and higher investment expenses related to incentive compensation payments as is normal for us in the first quarter of the year. 16:49 Going forward, we would expect net investment income to increase over the next few quarters as our portfolio gets reinvested at higher yields. At the end of the quarter, new money yields were approximately 145 basis points higher than the embedded book yield in our fixed income portfolio. Alternative investments representing approximately 15% of our total portfolio return to 1.4% in the quarter. The performance of our alternative investments is generally reported on a one quarter lag. 17:24 I wanted to spend a brief moment on corporate expenses and what you should expect for the rest of the year. As you know, the first quarter is always elevated relative to the other quarters due to the timing of incentive compensation accruals. This year you should also expect a slightly higher amount in the second quarter, again due to our accounting policy for non-cash compensation for retirement eligible employees. As a result, we expect corporate expenses to be approximately $25 million in the second quarter before coming down to a level closer to the 2021 amounts for the third and fourth quarters. 18:04 Turning briefly to risk management, our natural cat PML on a net basis stood at $768 million as of April 1 or 6.4% of tangible shareholders' equity. Again well below our internal limits at the single event, one in 250 year return level. Our peak zone PML is currently the Florida Tri-County region. 18:27 On the capital front, we repurchased approximately 5.6 million common shares at an aggregate cost of $255 million in the first quarter. Our remaining share repurchase authorization, currently stands at $927.2 million. With these introductory comments, we are now prepared to take your questions.
Operator: 18:49 Thank you. [Operator Instructions] Our first question comes from Jimmy Bhullar with J.P. Morgan.
Jimmy Bhullar: 19:14 Hey, good morning. So I had a question first just on the expense ratio. And I guess if you could discuss a little bit more how much of it is just, because of a mix shift in the business where some of the lines that entail a higher loss ratio or lower loss ratio, but higher expense ratios are growing faster versus incentive comp or other expenses that might sustain through the rest of the year.
Francois Morin: 19:39 Well, I think to me, it's -- the way to think about it is to -- I mean, if you want to focus on operating expenses is where all the incentive comp payments or expenses will come through. So that, that you can easily see that our track record the last 12-months where you see in Q1, there is higher and then it levels off of the second through the fourth quarters. So that should give you a good idea of how to project that out. The rest, I would say, I'd like to think of it in combination. In loss and acquisition to me or -- we can't think of them separately. They have -- they go together, there's offsets, they -- we think about it when we write the business. So ultimately, the way we certainly think about the whole kind of underwriting performance is the combined ratio. And that's how I suggest you maybe think about it.
Marc Grandisson: 20:34 I think from a perspective of acquisition expense, I think that the mix has shifted over the last couple of years. So I think I would probably look at the last one quarter or two quarters as an indication for the future, because our mix is shifting in that direction. So it's clearly -- and as a result of that, you see the loss ratio expectations actually coming down, which makes sense based on what Francois mentioned.
Jimmy Bhullar: 20:57 And then on your cat losses, I think you mentioned that the majority of the cat losses that were booked this quarter were Russia-related, and I'm assuming most of those are IBNR. But if you could give some color on that? And then relatedly you've in the past indicated what you had in terms of COVID reserves, and I think most of those were IBNR as well. But if you can talk about what you would need to see to be able to start releasing some of those reserves related to COVID?
Francois Morin: 21:28 Yes. I'll start with Ukraine. I think Ukraine, again, very early to me. It's somewhat similar to COVID two-years ago when -- it's still ongoing, right? So we took a fairly -- we think, a prudent approach at this point based on what we know. We think we're going to have some losses, but it's all IBNR, right? So the question really, we don't have any claims yet that our certain or we have to set up case reserves for. It's highly preliminary at this point, and it's based on kind of some assessment of what we think the overall exposure might be. So we think we're in a good place right now, but we're going to have to monitor it and see how it goes in future quarters.
Marc Grandisson: 22:13 And I believe our COVID losses, we're about 70% IBNR at this point in time. So it's still not finalized by any means.
Jimmy Bhullar: 22:20 And what's the magnitude?
Francois Morin: 22:24 Well. Our numbers haven't changed, so total reserves, right? So with total reserves for COVID is about $160 million and 70% of that is COVID. Sorry, not COVID.
Marc Grandisson: 22:34 IBNR.
Francois Morin: 22:35 IBNR.
Jimmy Bhullar: 22:36 Thank you.
Francois Morin: 22:37 You’re welcome.
Operator: 22:40 Our next question comes from Tracy Benguigui with Barclays.
Tracy Benguigui: 22:45 Hello, everyone. I recognize that the 10-year anniversary for mortgage insurers setting up their contingency reserves is approaching where these reserves will be released on a first-in first-out basis into unassigned statutory funds. And I believe Arch has about $3.1 billion of such contingency MI reserves. I'm just wondering, if this anniversary is of any significance for Arch, like does this orderly reserve relief improve your ordinary statutory dividend capacity or improve your view of capital allocation in any way?
Francois Morin: 23:23 First of all, I mean, the fact -- the contingency reserves, no question or a statutory requirement. They're part of our overall way of operating, but I would say they haven't really been a constraint in the sense of how we deploy capital, where we deploy it, their ability to come in and out of market. So I think it's certainly something we watch and are aware of, but I wanted to make sure that everybody understood that it's not -- it hasn't been really -- it caused a major issue for us at this point. 23:55 You're correct. The 10-years, though we're going to start getting closer to our ability to release contiguity reserves. And yes, no question that, that effectively shifts the money from contingent reserves that available surplus to -- and it gives us more ability to declare dividends upstream from the MI companies. That said, we are always looking -- and it’s -- and we've been able to do a little bit of that with the regulators in the last few years though -- on an exception basis and have kind of submitted some plans to them to make it so that we can actually access some of those funds maybe a bit earlier than would have been, I guess, officially the case with the contingency reserves, but we're still -- something that we're constantly working on.
Tracy Benguigui: 24:48 Got it. I'd also like to touch on the negative marks in your investment portfolio. So I noticed in your proxy, your key KPIs like growth in book value per share or ROE, these are metrics that Arch doesn't adjust for unrealized gains or losses will from your peers do. So my question basically is do these negative marks change review deployable capital in any way?
Marc Grandisson: 25:12 No, not really. I think that the operating income -- the way we look at the operating ROE, it's more of like a run rate as to how our business is performing. Fully recognizing that a lot of the mark-to-markets will eventually recover, so it's really the way we've chosen way back in our history to get a better reflection for and how we're performing from a core business perspective, letting the bigger of the market volatility find their way over time. That's really our way to be a bit more forward thinking and looking at how we present our returns and our performance.
Tracy Benguigui: 25:47 Got it. Thank you.
Marc Grandisson: 25:49 Thanks.
Francois Morin: 25:50 Welcome.
Operator: 25:51 Our next question comes from Josh Shanker with Bank of America.
Josh Shanker: 25:57 Yes. Thank you. If I go back in time about nine months ago, when I asked you about opportunities you have to deploy capital, we look at it as mortgage insurance, reinsurance, share buybacks, acquisitions. The mortgage issuing pace was hot, and reinsurance is attractive. It still is, but ceding commissions are up now and maybe with where rates are going, mortgage issuance is going to be declining? Does that make insurance and buybacks more attractive on the relative slate of things you can do right now? And what's changed about the ROI in mortgage and reinsurance over the last six months?
Marc Grandisson: 26:42 Yes. I think over the last year, Josh, good question. In terms of the rank ordering our opportunities right now, I think you’ve -- that the growth in premium speaks for itself. It's really an indication of where we think the value proposition is for our shareholders. I think that clearly, reinsurance and insurance are close to one another. Our reinsurance team would argue that they have a better return perspective. We'd like to have these discussions internally, but certainly, the P&C has moved up in the rank in terms of top return. 27:13 I think MI is a close second and as you saw on the share repurchase, I mean, it's clearly another way for us to deploy capital that's very attractive for our shareholders. So we have a lot of levers that we can deploy at that point in time. But having said this, our focus right now is really to grow the business, because we have so many good opportunities ahead of us.
Josh Shanker: 27:34 And the Ukraine crisis has caused a skepticism about the value of trade credit, which has hurt the valuation of Coface in terms of your view of the attractiveness of that asset post Ukraine and whether the diminished pricing opportunity. Do you have any thoughts there?
Marc Grandisson: 27:57 Well. I think, first, the Ukraine and Russia area is not a big portion of what companies such as Coface, would be playing into. So that certainly is a smaller footprint. And a lot of the losses that could have emerged or are emerging, they'll be short tail by and large, right? It's definitely a shorter term, even though we're not out of the woods yet in terms of developing losses broadly, I think on trade credit, I'm confident that our Coface team has a good handle as to what their exposure is. 28:26 And I think if I take COVID as an example for how resilient they are, even absence on the government scheme, I think that we like the resilience and the diversification even within Coface themselves, what they provided to the shareholders. So let's just say we're not overly concerned. I mean, I think the numbers are going to come today or very recently. I think they'll have way more and more insight into this. But at this point in time, our expectation is that it's -- it will have an impact on their result, but not the extent that, as always, it seems that the market expects way more downside than actually meets the eye. Because it's a line of business that I believe is largely misunderstood. And the way that Xavier and his team has developed and deployed risk management is underappreciated. I think Coface, they do a very, very good job in risk managing the portfolio.
Josh Shanker: 29:17 And if I can sneak one more in. You said that 75% of COVID reserves are still in IBNR. Is COVID a long tail or a short tail risk? And what would you be waiting for to get better comfort on the use or lack of the IBNR reserves?
Marc Grandisson: 29:39 I think on a short and long tail, I would say, yes. So it's both, right? I mean, there's a lot of things going on. And I think we certainly saw some of the BI losses, right, Josh, last year or even early, in middle of 2020. I think some of them are being resolved as we speak. I think we're of the mind that this is a big event, things have happened, people are still trying to figure out as they recover into this new market, this new environment. And it's still being thrown into it some inflation and more -- it seems more dislocation. So I think that we may have things coming through potentially on the liability side of things, eventually. It's hard to know what it's going to look like. But it's clearly, clearly, a lot that we've never faced before. So that's why we will tend to be more prudent at Arch, as you know us. There's a lot more uncertainty than the average loss that we've seen so far in our history.
Francois Morin: 30:31 And even the short tail that you would think a short tail coverage’s are going to be litigated, then that will take time to resolve itself. So I mean, we're keeping an eye on it, but we think it's going to be with us for quite a bit longer.
Josh Shanker: 30:47 Thank you for all the answers.
Marc Grandisson: 30:48 Thanks, Josh.
Operator: 30:51 Our next question comes from Ryan Tunis with Autonomous.
Ryan Tunis: 30:57 Hey, thanks. Good afternoon --
Marc Grandisson: 31:01 Ryan. Are you still there, Ryan? We can't hear you.
Operator: 31:12 Ryan, you may be on mute.
Marc Grandisson: 31:14 Yes. Yes, I think Ryan just came out somehow.
Ryan Tunis: 31:23 Can you hear me?
Marc Grandisson: 31:25 Ryan?
Ryan Tunis: 31:26 Yes. Yes guys got me?
Marc Grandisson: 31:28 Yes, we got you now. Great, we got to you, we got you and we got you.
Ryan Tunis: 31:31 Really Sorry about that. So yes, I had a MI reserve question. It's not as deep MI as the last one, I don't think. But -- what I was curious about is just like trying to get a feel for how 2020 that year has developed. Obviously, you guys released a lot of reserves from that year this quarter, and maybe it's something I can calculate myself. But yes, what have been the total number of reserve releases on the 20-years since you initially booked it?
Marc Grandisson: 32:01 But I don't have that number handy with me. It's most of it -- well, on the ones we just did, there will be most of it. Because most of the delinquencies and there was the largest cohort in April and May of 2020 second quarter. And those are the ones that are obviously coming out of delinquencies and being settled, so most of it is from the 2020 year.
Ryan Tunis: 32:26 But do you have a sense, I guess, Marc, for like -- I mean if we were to compare what that ultimate is now relative to kind of the years headed into 2020? Are we getting to a point where on a fully developed basis that year looks like -- some of the years? I'm just trying to understand like how much more reserve potential there could be?
Marc Grandisson: 32:49 Yes. Well, I have to be careful the way I answer it. I think I would say to you that 2020, '21 may turn out to be more like an average year. There's a good possibility for that to happen. It's still uncertain, because we're still going through the forbearance exiting as we speak. It's accelerating really as we speak literally. So I think 2020, 2021 will turn out to be much more of average years than we had maybe feared when we talked about it in the second quarter of 2020.
Ryan Tunis: 33:22 Got it. And then on the P&C side, I guess, I might be wrong on this. But I don't remember there being quite this much volatility with the acquisition cost. It just seems like something that is kind of ramping, like as you said in the past two, three quarters. Could you just give us like maybe a little bit of a better understanding of why are we seeing more of that now? Is it because of the amount of loss ratio improvement that's going through the business? Is it the way you've structured reinsurance. I'm just kind of trying to kind of lately understand what might have changed.
Marc Grandisson: 33:56 It's a good question, and I would just welcome you to Arch's way of cycle management, which is moving and pivoting to where the opportunities are. So it will be probably surprising to you as Francois and I don't really know what kind of acquisition expense we'll have in one quarter, because our team just make the best evaluation possible as to what's ahead of them. And I think on the reinsurance side, right, we mentioned in our commentary, is that quota share focus, definitely over time, will increase the acquisition expense ratio. 34:26 And on the insurance side, the travel, for instance, right, was really went down in premium written as you remember, Ryan, in 2020. It's coming back up and that has historically a high expense ratio. We also have some programs, new programs that we've entertained on the insurance side. And those will naturally come up with higher acquisitions. So I think that it's a really dynamic market. I don't think we've seen that kind of market where we can shuffle around and really pivot and make capital allocation or decision to write more of one or the other. I think you had more of a -- to your point about not having more volatility this quarter than ever before is because we had a very stable, frankly, doll market for about five or six years, we were defensive. There was really no need for us to shift and we're sort of across the board shifting down our involvement on the P&C side. Now I think its way more dynamic, and that's why you have this shift around. 35:22 So -- but to your question about the loss ratio, the loss ratio itself will find its way naturally, whether we write quota share or excess of loss. So the higher the expense ratio, frankly, the lower you should expect the loss ratio to be. Because it's really a combined ratio gain, as we said before. So I understand that it's not easy to pin down, we understand. But it's really due to the cycle management and where we are in this marketplace.
Ryan Tunis: 35:50 Understood, that makes sense. Thanks guys.
Marc Grandisson: 35:52 Thanks.
Operator: 35:54 Our next question comes from Meyer Shields with KBW.
Meyer Shields: 35:59 Thanks. I want to start with one underwriting question, and maybe it pertains to what you were just talking about, Marc. We've seen year-over-year written premiums and programs actually go down after some very solid growth in the first three quarters of 2021. And I was hoping you could talk us through what's going on there?
Francois Morin: 36:18 Yes. [Matt] (ph), there's a bit of noise. I think it's really related to the timing of a renewal of a program and when we onboard one. So I wouldn't kind of read too much into that, Meyer. I think it's very -- it's a one-off.
Marc Grandisson: 36:33 I think the earned premium is a better indicator of the trajectory of where we're going here.
Meyer Shields: 36:38 Okay, perfect. That's very helpful. The second question, I'm sorry.
Marc Grandisson: 36:43 Go ahead, Meyer.
Meyer Shields: 36:44 Okay, so you talked a lot and very helpful in terms of the guidance for corporate expenses. Is there the same sort of accrual trend in the individual segments, because I'm asking because of the year-over-year growth in other operating expenses?
Francois Morin: 37:02 Well, I mean it's the same general -- I mean the timing is the same. It's just that, obviously, the corporate -- in the corporate segment or what you see in corporate expenses, it's -- I mean, it's a very -- I mean it's, A, there is, some more non-cash comp that comes into play, right? And that is, again, more tilted to the first quarter. And it's just -- that's basically all it is. I mean, for the most part, it's just comp and benefits versus the OpEx in the segments has a lot more to it, right? There's systems, there's IT, there's a lot more things that -- so you'll never have that much impact or more -- as much volatility in the segment. 37:49 But the rules are the same though. I mean, when we have people that become retirement age eligible, it triggers that different kind of accounting or immediate expensing of the non-cash comp, and that's part of it. Related, I think, just the growth in the OpEx dollars, no question that went up. We stay -- I mean, and we look at that. We certainly -- I want to make sure that premium is growing faster. So I think the ratio, as you saw in all the segments, certainly, insurance arrangements went down. 38:26 And I think the important message here is that we've been performing well, and we need to pay our people. And our people is basically all we have, we need to retain that talent and that came through in Q1 as we kind of made incentive comp decisions.
Marc Grandisson: 38:44 Meyer, what I would add to this is you can look at that line item either as an expense or as an investment item. So I think from our perspective, we also are investing in our people, as you heard from Francois. And investing in other things, right, that will improve the results over time. And that's -- this is a good time to invest. We have -- it's a growing platform, money is coming in. So it's a good time to invest. So we're really also spending some money to make it more sustainable as a platform.
Meyer Shields: 39:12 Okay, perfect. Thank you so much.
Marc Grandisson: 39:14 Welcome.
Operator: 39:17 Our next question comes from Mark Dwelle with RBC Capital Markets.
Mark Dwelle: 39:22 Hey, good morning. Just a couple of questions, you've already covered a lot of ground. On the Russia-Ukraine losses, what lines of business or products were impacted there? Was it your own trade credit or war or marine whatever?
Marc Grandisson: 39:40 Yes. It's the traditional lines you would expect. I think that most of our losses come from our exposure at Lloyd's, either through from the insurance platform, the reinsurance platform. And that's what you would expect, right, because this is where the specialty lines have been underwritten. So either through the Lloyd's of the London really operations. So this is where we're expecting it from. One the trade credit is part of the considerations. Again, like I said, so it's also part of that as well. So we look across our lines of business. But I would think London, Lloyd's, aviation, marine war, the classic Lloyd's exposure.
Mark Dwelle: 40:17 Okay. And then building on that, you -- I'm just trying to make sure I understand it correctly. To the extent that Coface incurs losses, you're picking those up effectively on a one quarter lag basis. So whatever they have, you'll get your proportional share of how those run through in the second quarter and so on going forward, correct?
Francois Morin: 40:42 100% correct, yes.
Mark Dwelle: 40:45 Okay. And then the last question, I just wanted to clarify, you made a number of comments related to the investment portfolio. Am I understanding correctly, so you're both extending the duration and getting a higher new money yield on both the reinvestment, as well as, I guess, any new money that you're generating?
Francois Morin: 41:08 Yes. New on yield, no question. I mean I mentioned the 145 basis points. That is comparing your embedded book yield on the portfolio at the end of the quarter or two what we're currently seeing in the market. And we extend the duration is really a bit more of a strategic thing. I mean we were short -- I mean, relative to our benchmark, we got a bit closer to the benchmark, just being a bit more of a defensive move, we want to make sure we weren't too far off from the target.
Mark Dwelle: 41:39 In terms of thinking forward, which will have the greater impact on rising investment income, it will be the -- I would assume it would probably be the higher new money rate more so than the duration extension.
Francois Morin: 41:52 Totally. Yes, we -- listen, we don't know how quickly the portfolio will turn over. But certainly, as Marc mentioned, the free cash flow coming in and also how quickly the portfolio will churn or either mature and/or will trade in and out of certain securities, we'll be able to reinvest that. So it will take certainly a few quarters. But as I mentioned, I think we'll start seeing some benefits starting next quarter and by the end of the year, it should be hopefully somewhat measurable and meaningful.
Mark Dwelle: 42:28 Okay, thank you. I appreciate the thoughts.
Francois Morin: 42:30 Sure, welcome.
Operator: 42:33 Our next question comes from Yaron Kinar with Jefferies.
Yaron Kinar: 42:37 Hey, good morning everybody. My first question, and maybe it's more of just me rephrasing and making sure I'm thinking about it correctly. Am I to understand that really your focus or your myopic focus is on getting the loss ratio better, and you're kind of agnostic as to whether the expense ratio goes up or down as long as the combined ratio comes down because the loss ratio improves more?
Marc Grandisson: 43:04 Yes, I think you're right. I think the combined ratio, which leads to return on equity is what we're focusing on. Yes.
Yaron Kinar: 43:10 Okay. And I should probably be careful with how I phrase this, we talk industry here. At some stage, you expect -- in the cycle, you expect to see some adverse reserve development and then probably followed by some favorable development. I guess where do you see the industry at today? And maybe at what point do you start seeing the reported combined ratio improve and coming more from favorable development as opposed to the accident year loss ratio improving?
Marc Grandisson: 43:42 Yes. I can't speak really to the level of reserve in the industry. I mean everybody -- it's like beauty is in the eye of the beholder, right? It's kind of difficult for me to opine on this. I think in terms of earnings versus pricing cycles, I think it's true that the pricing cycle peaks and then the earnings cycle peaks probably a couple two to three years after. So I think that, that historically has been the case. So I would expect earnings to -- if pricing is -- I don't -- I'm not saying it's peaking, but once it peaked, we should probably have earnings still getting better for a couple of years after that. So we're still very much in the margin improvement still in the market. So it's a tough question to ask as opposed to what right, Yaron, where it's going to come from, prior development or current accident years. So that's a different -- it's probably different also for every company.
Yaron Kinar: 44:35 Fair. I'd be happy for you to opine on Arch specifically, if you want.
Marc Grandisson: 44:40 We're doing pretty good.
Yaron Kinar: 44:42 Okay. If I could sneak one last one in. So two-thirds of cat losses are related to Russia. Is that true for both the insurance and reinsurance segments?
Francois Morin: 44:56 It's a good question. It's -- I mean, directionally, it's about that. Yes, I mean we might have had a bit more -- the non-Ukraine cat losses were mostly reinsurance, so Australian floods is where we can -- that we picked that up a bit more from the reinsurance side. But it's -- directionally, it's about -- not a big difference.
Yaron Kinar: 45:17 Got it. Thanks so much.
Francois Morin: 45:18 Thanks.
Operator: 45:21 Our next question comes from Brian Meredith with UBS.
Brian Meredith: 45:26 Hey, thanks. A couple of one’s here for you. First, Marc, can you talk a little bit about what you think about the opportunities maybe in Florida with the renewal season, a lot of turmoil and stuff going on down there.
Marc Grandisson: 45:37 Yes, I can only tell you right now what we hear from our team. And what we hear from our teams, and including our colleagues and brokers and friendly brokers out there, is this is going to be a tough renewal. There's a lot of question marks, a lot of decision that needs to be made. It's too early, Brian, to call what it's going to look like. But people are expecting, I think you may have heard this on other call, a difficult renewal. There's a lot of things that need to be fixed between the recognition of the litigation that hasn't really stopped as much as we would have wanted. Some of the companies are struggling to even survive, do you get paid your reinstatement. And I understand that the state is also trying to find solution. We probably have an impending discussion from the Department of Insurance as to what they want to do or the direction, what they want to do in Florida. So we're like you, Brian, we're in a wait and see kind of mode. We have -- the one thing I would tell you, which all our shareholders should hear is if there's an opportunity, we have capital to deploy there. We're very bullish.
Brian Meredith: 46:38 That's what I wanted to know. So you've got the company. And then, Marc, another one, so a couple of stories out last night and this morning about companies looking potentially sell themselves. I'm just curious what your thoughts are on M&A, kind of Arch's view with respect to the M&A environment? Is the organic growth opportunity is just too good right now to distract yourself from potential M&A opportunities?
Marc Grandisson: 47:03 Listen, we're a broadly equal opportunity kind of company, right? We'll look at what can be done and what should be done and what makes sense for the shareholders. We're not looking for transactions necessarily. But our history show that when a transaction come that's accretive to our shareholders, we'll entertain and look at it. We certainly have look at what's out there, what has been discussed, as you would expect, Brian. So I think we have probably the best position possible, which is we don't have to do anything. We have plenty of opportunity. And we are in a seat where we can just like wait for the pitch to come to us. So I feel very, very fortunate to be where we are at Arch Capital Group. So we'll look at it. We'll look at it, pitch, if we like it, we'll swing, if not we'll just go back.
Brian Meredith: 47:47 Great, thank you.
Marc Grandisson: 47:48 Yes, sure.
Operator: 47:52 Our next question comes from Elyse Greenspan with Wells Fargo.
Elyse Greenspan: 47:57 Hi, thanks. My first question, if I look at your insurance segment, it's been six quarters in a row where you guys have grown by more than 20%. It seems from your comments you guys are still pretty bullish about opportunities there, even with perhaps a little bit less price. So Marc, does this feel like an environment where you can continue to see pretty robust levels of growth within your insurance segment for this year and beyond?
Marc Grandisson: 48:26 The answer is yes, Elyse. I wonder where you were for the call. The answer is yes. Broadly, it was probably more of a broad market opportunity probably two years ago. Now it's refining itself and turn more certain lines of business. As we mentioned before, some of the programs, we're seeing a better pickup in pricing and property as we speak right now, it's getting hard again on the heels of failing to get the value right as an industry. So listen, I think that it's a bit more of an opportunistic. I think we still have the ability and the willingness to lean in hard if we see opportunities, and we are seeing opportunities, so yes. It's just not as broadly based perhaps as it would have been two years ago.
Elyse Greenspan: 49:08 And then as we think about some stuff that's come up throughout the call, right, we're dealing with higher inflation, also higher interest rates that you guys mentioned could be a tailwind on the investment income side. So where would you put the ROE within the P&C business? Where do you think that's running at today when you think about how 2022 could come in? I know you've talked about, right, kind of targeting the -digits in the past. Where do you think things are now?
Marc Grandisson: 49:38 I think we can speak for our book of business. I think we expect our ROE on a policy year basis, but we write currently to be close to the mid-teens. I mean, we're really getting there inching every -- possibly every quarter since the end of 2019. So yes, this is sort of where we are, Elyse. Yes, pretty much. Was there another part of your question? I want to make sure I think you had something else. No?
Elyse Greenspan: 50:04 No. That was the event. And then another one just on buybacks and I think this came up a little bit earlier when you guys were talking about ROEs in general. I know in the past, we've used some rule of thumbs with book value, right? But you guys, it seems like bought back your stock, right within range of one-fourth of book in the Q1. I know the shares are a little bit higher today, right. Partially, that's a function of the mark-to-market in the quarter. So obviously, would -- buybacks would depend upon the growth opportunities, but it seems like you guys would still be willing to buy back your stock given the valuation today?
Francois Morin: 50:44 I think that's fair. I think -- listen, I mean, again, the multiple is not something we focus when we look at it. But again, I think on the heels of Marc's answer to your earlier question, I think we like our prospects. I mean we think the forward-looking ROEs that we have in front of us are very attractive. We think the stock is priced relatively attractively for us. And depending on what opportunities come our way and how we can deploy the capital, share buybacks are always part of the solution or part of the -- how we deploy our capital.
Elyse Greenspan: 51:19 Thanks for the color.
Marc Grandisson: 51:21 Thanks.
Operator: 51:23 Our next question comes from Tracy Benguigui with Barclays.
Tracy Benguigui: 51:29 Thank you so much for it takes me on again, I noticed that you increased your reinsurance prop cat writings by 10% this quarter, and I recognize you're underweight on PMLs relative to peers. But still, can you break down how meaningful -- is this growth driven by exposure increases versus rate increases? And if you could just comment about your overall risk appetite or prop cat risk, you are balancing pricing inflation and your exposure management.
Francois Morin: 51:56 Yes. In terms of -- I mean, appetite, we've been relatively neutral for the recent last few quarters. I mean we haven't grown. I mean this -- again, this is a bit of a slight one-off in terms of the -- you saw the growth in the premium, just the timing of a renewal. We have like a 14-month premium that program that fell in different quarters. So again, I wouldn't read too much into the dollars of growth in the quarter. But we still -- we're still players in the space. We still say and believe that we need to get a bit more to really put the pedal to the metal. And we'll see where it goes.
Marc Grandisson: 52:35 Yes. On the cat exposure, Tracy, I think that we look at how we deploy it, right? We could deploy it through cat Excel or you could do it through [indiscernible] quota shares or some marine. It's coming from many lines of business. And I think that for the last 18-months or 24-months, because of the significant increases in TMC changes, improvements on the property, in large property segment in general, that our deployment of capital from the cat perspective has been more towards quota share reinsurance. And I think the cat Excel has been lagging, frankly, in terms of pricing. And we've said that more than one. So I think that -- and again, that's another one that -- the similar answer to the program that I answered to Meyer earlier, which is the earned premium is probably a better indicator of our relative growth or non-growth, in this case, in the property cat space.
Tracy Benguigui: 53:28 Okay. Great. And just one real quick follow-up on actually Elyse's question. I felt like last quarter, you kind of alluded that you could buybacks talk above the 1.3 times, just given your view of intrinsic value of your MI business. I don't know if those comments were fully appreciated. I don't know if it's possible, you could flesh out your view of what you think the intrinsic value of your MI book is and how that plays in.
Francois Morin: 53:54 Well, it's part of the -- I mean, forward-looking ROE. So no question that we -- there is significant embedded value that's built into the MI book, and we have good visibility on that. We're very bullish on it, and that gives us even more comfort that there's significant value in the stock. So as we think about buybacks, I mean, no question that from our side, it's fully factored in.
Tracy Benguigui: 54:19 Thank you.
Marc Grandisson: 54:20 Thanks Tracy.
Operator: 54:23 Our next question comes from Michael Phillips with Morgan Stanley.
Michael Phillips: 54:29 Hey, thanks. Just one follow-up for me, and it's back to MI for a second. Trying to marry your earlier comments on the rank order of capital allocation, and you put MI second behind P&C, which obviously makes sense given the fundamentals in the P&C book right now. But if we take that and then look at earlier comments and opening comments, which were pretty positive on the MI space. I'm trying to figure out how to think about -- any help you can give us on thinking about, I guess, growth for the MI business, given what we saw this quarter growth over the next year.
Marc Grandisson: 55:01 Well, I think we -- I mean, it's hard to see from the way we report, but I think the growth, we have a fair amount of growth through the CRT. We also have a very healthy CRT, which is the credit risk transfer program from the GSEs. We also have, as you know, taken on the mortgage -- the mortgage company that was owned by Westpac in Australia, so that's also seeing some growth. In the U.S., I mean, we expect -- I mean we have to remember the production was record for 2020 and 2021. 55:32 So it's kind of hard to grow from there significantly. So the market itself probably will -- might be decreasing a little bit, so we'll see where it shakes up. Definitely, the refinancing is very, very much, you know, pretty much behind us, because of the mortgage rate increases for the that six months. So I wouldn't say that new production is -- because by virtue of the size of the market, on the U.S. MI sort of shrinking somewhat from the refinancing perspective, but what is happening, because of this mortgage rates increasing, the premium written will be much more stable and actually could increase because of the lack of refinancing precisely, which means the insurance in force will increase, which will give some lift into our ongoing written premium. So even though we may not have a similar production from an NIW perspective, I think that the existing portfolio, I would expect the written premium to go up on a gross basis, definitely at some point, starting probably in the second half of the year, Francois, possibly, yes.
Michael Phillips: 56:39 Okay, well thank you, Marc, thanks for the color.
Marc Grandisson: 56:42 Thank, Mike.
Operator: 56:46 I'm not showing any further questions. I'd now like to turn the conference back over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: 56:53 Yes, thanks everyone for being here today. Great questions and we look forward to see and talk to you again in July. Thank you.
Operator: 57:02 Ladies and gentlemen, thank you for participating in today's conference, this concludes the program. You may all disconnect. | [
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{
"speaker": "Operator",
"text": "00:04 Good day, ladies and gentlemen, and welcome to the First Quarter 2022 Arch Capital Group Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. [Operator Instructions] As a reminder, this conference call is being recorded. 00:29 Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time-to-time. 01:03 Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. 01:19 Management also will make reference to some non-GAAP measures of financial performance. The reconciliation to GAAP and definition of operating income can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website. 01:37 I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "01:45 Thank you very much. Good morning, and welcome to Arch's earnings call for the first quarter of 2022. Arch delivered a strong first quarter, as our dynamic capital allocation and cycle management strategy combined with strong underwriting skills delivered a 13.6% annualized operating ROE. This past quarter provided yet another reminder that we live in a world of uncertainty. The war in Ukraine has affected countless lives and initiated a humanitarian crisis that is still unfolding and the pandemic continues now into year three. 02:23 In addition to the war in Ukraine, global inflation and supply chain issues pushed interest rates up, which in turn led to investment markdowns in the quarter. In spite of these headwinds for our industry, we demonstrated the effectiveness of our diversified platform as: one, we grew premium above market average again. Two, repurchased 5.6 million shares; and three, generated a strong operating ROE. Our objective remains as always to deliver long-term value for our shareholders using all the levers available to us. 03:06 The underlying fundamentals of our businesses continue to improve as we benefit from better market conditions in the P&C industry and execute our cycle management strategy where we actively allocate capital to the most attractive sectors of our business. Our P&C operations generated $2.3 billion of net written premium in the quarter, which represents an increase of 18% from the same quarter in 2021 and speaks to our confidence in the improving underwriting conditions in our P&C operations. 03:44 Mortgage insurance contributed substantial underwriting profit in the quarter and insurance in force grew modestly again highlighting that mortgage remains a positive differentiator of our business model. Now, inflation is top of mind for everyone in the P&C industry, which to its credit has historically been adequately respond to inflation trends. Inflation is not a new phenomenon and in fact it permeates discussions in evaluating claims all the time in an insurance company. 04:21 As such, our focus is always on proactively incorporating new data into our reserving and pricing. We believe that this focus in addition to increased future investment returns and reserving prudently will help mitigate inflation's impact. As far as our mortgage business is concerned, inflation mainly has a positive effect, as it increases homeowner equity, which again mitigates potential losses. 04:51 I'll now share a few highlights from our segments. Across most lines our P&C units remained in a growth phase of the underwriting cycle according to falling rates insurance clock. In the quarter, our P&C net premiums earned grew by 25% over the first quarter of 2021, as we continue to earn in the rate increases of the past 24-months. Our data indicates that we are still experiencing average rate increases in excess of expected loss cost. 05:25 In Specialty Insurance, underwriting conditions remain very good, as pricing discipline, terms and conditions and limits management are stable across most markets. This stability combined with the uncertainties, I mentioned at the beginning of this call should help keep the market discipline and sustain rate increases. 05:46 Our specialty business in Lloyds and our UK regional business delivered strong growth in the quarter as our European insurance operations now represent 30% of Arch insurances total net written premium, up from 20% pre-pandemic. We are pleased to see the positive results of the investments we made into this platform prior to 2020. 06:11 We also created meaningful growth across our U.S. operations in the quarter, primarily in professional liability, including cyber, as well as travel where we believe relative returns are attractive. On the reinsurance side of our business, the emphasis remains on quarter share treaties over excess of loss reinsurance. This allows Arch to participate in the rate increases on primary insurance, while improving the balance between the risk and the return. 06:42 Overall in our Reinsurance Group, growth opportunities remains strong. Since it's been a talking point on prior calls, it’s worth noting that although property cat rates have improved in response to elevated loss activity in the past few years, we have remained disciplined and have not allocated material additional capital to this line as we maintain our view that other lines of business have better risk-adjusted returns. 07:10 Turning now to the mortgage segment, which once again delivered excellent underwriting results as we continue to benefit from strong housing demand and excellent credit conditions. Delinquency rates on our MI portfolio continue to trend to a historically low levels and cures on delinquent mortgages in our portfolio resulted in favorable prior development in the quarter. 07:35 The increase in mortgage interest rates currently at 5% for 30-year fixed-rate mortgages is a steeper rise, then we have seen in decades. These higher rates have dramatically curtailed refinancing. However, our MI business is far more geared to the purchase market, which continues to benefit from strong demand and limited housing supply. Of note, the decline in refinancing activity improves persistency which in turn should improve returns on our in-force portfolio. 08:07 While the rise in mortgage rates may ultimately cool demand and slow the rapid home price appreciation of the last year. So far, we have yet to see demand weaken and we expect home prices to continue to rise, albeit at a slower pace. Again, as mentioned earlier, rising home prices increase equity for homeowners, which ultimately reduces the risk of claim in mortgage insurance. So our perspective is that this expected future equity buildup and the strong credit profiles of borrowers should strengthen the resilience of our in-force mortgage portfolio. 08:44 Moving forward, our diversified platform and cycle management philosophy, will enable our MI team to continue to make measured responsible decisions with our capital. Our MI Group has the flexibility to grow or moderate the business they choose to right based on their view of market conditions. 09:02 A few brief notes on investments, were net investment income was down from last quarter, as we reduced risk positions primarily equities given increasing market volatility. Rising interest rates also caused mark-to-market losses in the quarter. However, the relatively short duration of our investment portfolio, as well as our healthy cash flow will naturally allow us to reinvest at higher interest rates, which should be reflected in future quarters. 09:30 In closing even with current uncertainties, opportunities exist. In the quarter, Arch was able to deliver strong results with positive growth across its businesses and we're well-positioned to sustain our growth trajectory in this favorable P&C market. We've consistently demonstrated our ability to allocate capital effectively to the areas of our business with the most attractive returns. As you know, with Arch, we are constantly looking for and seizing the opportunities that offer the best returns for our shareholders. Francois?"
},
{
"speaker": "Francois Morin",
"text": "10:06 Thank you, Marc, and good morning to all. Thanks for joining us today. As Marc shared earlier our P&C units remained on their path of underlying margin improvement, while the Mortgage Group delivered another quarter of strong underlying performance, which was supplemented by solid cure activity in their insured loan portfolio. Overall our results translated into an after-tax operating income of $1.10 per share for the quarter and an annualized operating return on average common equity of 13.6%. 10:42 In the insurance segment net written premium grew 21.3% over the same quarter one year ago. Growth was particularly strong within our professional liability and travel business units and was achieved both in North America and internationally. Underwriting performance was excellent with an accident quarter combined ratio, excluding cats of 90.8%, a 250 basis point improvement over the same quarter one year ago. 11:12 Similar to last quarter, a change in our business mix as a result of more pronounced growth in lines of business with lower loss ratios helps explain some of the 470 basis point improvement we observed in our underlying loss ratio. This benefit was slightly offset by a higher acquisition expense ratio. Increased contingent commission accruals on profitable business and lower levels of ceded business for lines with higher ceding commission offsets also slightly increased the expense ratio. 11:46 As we have said before, our focus remains on improving our expected returns through a variety of levers. And we are encouraged to see that our efforts are paying off for our shareholders. In the reinsurance segment, it's worth mentioning that reinsurance agreements that were put in place at the time of the closing of the Somers acquisition in the third quarter of last year made comparisons from the current to prior periods imperfect. For example, while our reported growth in net written premium remained solid at 14% on a quarter-over-quarter basis, it would have been 26.6% after adjusting for the Somers session. The growth came primarily in our casualty and other specialty lines where rate increases, new business opportunities and growth in existing accounts help increase the top line. 12:40 The segment produced an ex-cat accident year combined ratio of 82.7%, an excellent result, as we continue to enjoy healthy underwriting conditions in most of the lines we write. Losses from first quarter catastrophic events, net of reinsurance to recoverables and reinstatement premiums stood at $85.8 million or 4.0 combined ratio points, compared to 10.5 combined ratio points in the first quarter of 2021. Approximately two-thirds of the estimated losses came from the Russia invasion of Ukraine with the rest coming from other global natural catastrophe events including the Australian floods. 13:26 Our mortgage segment had an excellent quarter with a combined ratio of 3.1%, due in large part to favorable prior year development of $105.6 million. In line with last quarter's results net premiums earned decreased on a sequential basis, due to a combination of higher levels of ceded premiums a lower level of earnings from single premium policy terminations and reduced US primary mortgage insurance monthly premiums, primarily from recent originations, which remain of excellent credit quality. 14:04 Production levels were down slightly from last quarter, but certainly in line with seasonal trends and new purchases and diminishing refinancing opportunities for borrowers. As we have discussed on prior calls, one of the benefits of higher interest rates as an improving persistency rate, which now stands at 66.9% and should continue to increase throughout 2022. Ultimately, higher persistency benefits our insurance in-force and should result in a stable base of premium income to help drive underwriting income for the rest of the year and beyond. 14:40 With respect to claim activity, approximately three quarters of the favorable claims development came from our first lien insured portfolio at USMI as we benefited from better than expected cure activity mostly related to the 2020 accident year. The remainder of the favorable development came from recoveries on second lien loans and better-than-expected claim development in our CRT portfolio in our International MI operations. 15:08 We maintain a prudent approach in setting loss reserves in light of the uncertainty we are facing with borrowers exiting forbearance programs and moratoriums on foreclosures. Income from operating affiliates stood at $24.5 million and was generated from good results across our various investments, including Coface, Somers Re and Premium. 15:32 Total investment return for our investment portfolio was a negative 3.07% on a U.S. dollar basis for the quarter, which explains the decrease in our book value per share to $32.18 at March 31st down 4.1% in the quarter. The decrease was primarily due to the mark-to-market impact for our available for sale fixed maturities portfolio, resulting in a $1.55 hit to our book value per share. 16:02 This quarter, the meaningful increase in interest rates and negative returns in the equity markets contributed to the negative total return. As you know, we are maintaining a relatively short duration in our investment portfolio for some time and this strategy help temper the mark-to-market hit to book value in the first quarter. While still relatively short, we have extended our duration slightly to 2.93 years at the end of the quarter in order to get closer to our duration target. 16:31 The change in net investment income this quarter on a sequential basis was mostly due to a lower level of dividends as we shifted out of some equity positions and higher investment expenses related to incentive compensation payments as is normal for us in the first quarter of the year. 16:49 Going forward, we would expect net investment income to increase over the next few quarters as our portfolio gets reinvested at higher yields. At the end of the quarter, new money yields were approximately 145 basis points higher than the embedded book yield in our fixed income portfolio. Alternative investments representing approximately 15% of our total portfolio return to 1.4% in the quarter. The performance of our alternative investments is generally reported on a one quarter lag. 17:24 I wanted to spend a brief moment on corporate expenses and what you should expect for the rest of the year. As you know, the first quarter is always elevated relative to the other quarters due to the timing of incentive compensation accruals. This year you should also expect a slightly higher amount in the second quarter, again due to our accounting policy for non-cash compensation for retirement eligible employees. As a result, we expect corporate expenses to be approximately $25 million in the second quarter before coming down to a level closer to the 2021 amounts for the third and fourth quarters. 18:04 Turning briefly to risk management, our natural cat PML on a net basis stood at $768 million as of April 1 or 6.4% of tangible shareholders' equity. Again well below our internal limits at the single event, one in 250 year return level. Our peak zone PML is currently the Florida Tri-County region. 18:27 On the capital front, we repurchased approximately 5.6 million common shares at an aggregate cost of $255 million in the first quarter. Our remaining share repurchase authorization, currently stands at $927.2 million. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "18:49 Thank you. [Operator Instructions] Our first question comes from Jimmy Bhullar with J.P. Morgan."
},
{
"speaker": "Jimmy Bhullar",
"text": "19:14 Hey, good morning. So I had a question first just on the expense ratio. And I guess if you could discuss a little bit more how much of it is just, because of a mix shift in the business where some of the lines that entail a higher loss ratio or lower loss ratio, but higher expense ratios are growing faster versus incentive comp or other expenses that might sustain through the rest of the year."
},
{
"speaker": "Francois Morin",
"text": "19:39 Well, I think to me, it's -- the way to think about it is to -- I mean, if you want to focus on operating expenses is where all the incentive comp payments or expenses will come through. So that, that you can easily see that our track record the last 12-months where you see in Q1, there is higher and then it levels off of the second through the fourth quarters. So that should give you a good idea of how to project that out. The rest, I would say, I'd like to think of it in combination. In loss and acquisition to me or -- we can't think of them separately. They have -- they go together, there's offsets, they -- we think about it when we write the business. So ultimately, the way we certainly think about the whole kind of underwriting performance is the combined ratio. And that's how I suggest you maybe think about it."
},
{
"speaker": "Marc Grandisson",
"text": "20:34 I think from a perspective of acquisition expense, I think that the mix has shifted over the last couple of years. So I think I would probably look at the last one quarter or two quarters as an indication for the future, because our mix is shifting in that direction. So it's clearly -- and as a result of that, you see the loss ratio expectations actually coming down, which makes sense based on what Francois mentioned."
},
{
"speaker": "Jimmy Bhullar",
"text": "20:57 And then on your cat losses, I think you mentioned that the majority of the cat losses that were booked this quarter were Russia-related, and I'm assuming most of those are IBNR. But if you could give some color on that? And then relatedly you've in the past indicated what you had in terms of COVID reserves, and I think most of those were IBNR as well. But if you can talk about what you would need to see to be able to start releasing some of those reserves related to COVID?"
},
{
"speaker": "Francois Morin",
"text": "21:28 Yes. I'll start with Ukraine. I think Ukraine, again, very early to me. It's somewhat similar to COVID two-years ago when -- it's still ongoing, right? So we took a fairly -- we think, a prudent approach at this point based on what we know. We think we're going to have some losses, but it's all IBNR, right? So the question really, we don't have any claims yet that our certain or we have to set up case reserves for. It's highly preliminary at this point, and it's based on kind of some assessment of what we think the overall exposure might be. So we think we're in a good place right now, but we're going to have to monitor it and see how it goes in future quarters."
},
{
"speaker": "Marc Grandisson",
"text": "22:13 And I believe our COVID losses, we're about 70% IBNR at this point in time. So it's still not finalized by any means."
},
{
"speaker": "Jimmy Bhullar",
"text": "22:20 And what's the magnitude?"
},
{
"speaker": "Francois Morin",
"text": "22:24 Well. Our numbers haven't changed, so total reserves, right? So with total reserves for COVID is about $160 million and 70% of that is COVID. Sorry, not COVID."
},
{
"speaker": "Marc Grandisson",
"text": "22:34 IBNR."
},
{
"speaker": "Francois Morin",
"text": "22:35 IBNR."
},
{
"speaker": "Jimmy Bhullar",
"text": "22:36 Thank you."
},
{
"speaker": "Francois Morin",
"text": "22:37 You’re welcome."
},
{
"speaker": "Operator",
"text": "22:40 Our next question comes from Tracy Benguigui with Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "22:45 Hello, everyone. I recognize that the 10-year anniversary for mortgage insurers setting up their contingency reserves is approaching where these reserves will be released on a first-in first-out basis into unassigned statutory funds. And I believe Arch has about $3.1 billion of such contingency MI reserves. I'm just wondering, if this anniversary is of any significance for Arch, like does this orderly reserve relief improve your ordinary statutory dividend capacity or improve your view of capital allocation in any way?"
},
{
"speaker": "Francois Morin",
"text": "23:23 First of all, I mean, the fact -- the contingency reserves, no question or a statutory requirement. They're part of our overall way of operating, but I would say they haven't really been a constraint in the sense of how we deploy capital, where we deploy it, their ability to come in and out of market. So I think it's certainly something we watch and are aware of, but I wanted to make sure that everybody understood that it's not -- it hasn't been really -- it caused a major issue for us at this point. 23:55 You're correct. The 10-years, though we're going to start getting closer to our ability to release contiguity reserves. And yes, no question that, that effectively shifts the money from contingent reserves that available surplus to -- and it gives us more ability to declare dividends upstream from the MI companies. That said, we are always looking -- and it’s -- and we've been able to do a little bit of that with the regulators in the last few years though -- on an exception basis and have kind of submitted some plans to them to make it so that we can actually access some of those funds maybe a bit earlier than would have been, I guess, officially the case with the contingency reserves, but we're still -- something that we're constantly working on."
},
{
"speaker": "Tracy Benguigui",
"text": "24:48 Got it. I'd also like to touch on the negative marks in your investment portfolio. So I noticed in your proxy, your key KPIs like growth in book value per share or ROE, these are metrics that Arch doesn't adjust for unrealized gains or losses will from your peers do. So my question basically is do these negative marks change review deployable capital in any way?"
},
{
"speaker": "Marc Grandisson",
"text": "25:12 No, not really. I think that the operating income -- the way we look at the operating ROE, it's more of like a run rate as to how our business is performing. Fully recognizing that a lot of the mark-to-markets will eventually recover, so it's really the way we've chosen way back in our history to get a better reflection for and how we're performing from a core business perspective, letting the bigger of the market volatility find their way over time. That's really our way to be a bit more forward thinking and looking at how we present our returns and our performance."
},
{
"speaker": "Tracy Benguigui",
"text": "25:47 Got it. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "25:49 Thanks."
},
{
"speaker": "Francois Morin",
"text": "25:50 Welcome."
},
{
"speaker": "Operator",
"text": "25:51 Our next question comes from Josh Shanker with Bank of America."
},
{
"speaker": "Josh Shanker",
"text": "25:57 Yes. Thank you. If I go back in time about nine months ago, when I asked you about opportunities you have to deploy capital, we look at it as mortgage insurance, reinsurance, share buybacks, acquisitions. The mortgage issuing pace was hot, and reinsurance is attractive. It still is, but ceding commissions are up now and maybe with where rates are going, mortgage issuance is going to be declining? Does that make insurance and buybacks more attractive on the relative slate of things you can do right now? And what's changed about the ROI in mortgage and reinsurance over the last six months?"
},
{
"speaker": "Marc Grandisson",
"text": "26:42 Yes. I think over the last year, Josh, good question. In terms of the rank ordering our opportunities right now, I think you’ve -- that the growth in premium speaks for itself. It's really an indication of where we think the value proposition is for our shareholders. I think that clearly, reinsurance and insurance are close to one another. Our reinsurance team would argue that they have a better return perspective. We'd like to have these discussions internally, but certainly, the P&C has moved up in the rank in terms of top return. 27:13 I think MI is a close second and as you saw on the share repurchase, I mean, it's clearly another way for us to deploy capital that's very attractive for our shareholders. So we have a lot of levers that we can deploy at that point in time. But having said this, our focus right now is really to grow the business, because we have so many good opportunities ahead of us."
},
{
"speaker": "Josh Shanker",
"text": "27:34 And the Ukraine crisis has caused a skepticism about the value of trade credit, which has hurt the valuation of Coface in terms of your view of the attractiveness of that asset post Ukraine and whether the diminished pricing opportunity. Do you have any thoughts there?"
},
{
"speaker": "Marc Grandisson",
"text": "27:57 Well. I think, first, the Ukraine and Russia area is not a big portion of what companies such as Coface, would be playing into. So that certainly is a smaller footprint. And a lot of the losses that could have emerged or are emerging, they'll be short tail by and large, right? It's definitely a shorter term, even though we're not out of the woods yet in terms of developing losses broadly, I think on trade credit, I'm confident that our Coface team has a good handle as to what their exposure is. 28:26 And I think if I take COVID as an example for how resilient they are, even absence on the government scheme, I think that we like the resilience and the diversification even within Coface themselves, what they provided to the shareholders. So let's just say we're not overly concerned. I mean, I think the numbers are going to come today or very recently. I think they'll have way more and more insight into this. But at this point in time, our expectation is that it's -- it will have an impact on their result, but not the extent that, as always, it seems that the market expects way more downside than actually meets the eye. Because it's a line of business that I believe is largely misunderstood. And the way that Xavier and his team has developed and deployed risk management is underappreciated. I think Coface, they do a very, very good job in risk managing the portfolio."
},
{
"speaker": "Josh Shanker",
"text": "29:17 And if I can sneak one more in. You said that 75% of COVID reserves are still in IBNR. Is COVID a long tail or a short tail risk? And what would you be waiting for to get better comfort on the use or lack of the IBNR reserves?"
},
{
"speaker": "Marc Grandisson",
"text": "29:39 I think on a short and long tail, I would say, yes. So it's both, right? I mean, there's a lot of things going on. And I think we certainly saw some of the BI losses, right, Josh, last year or even early, in middle of 2020. I think some of them are being resolved as we speak. I think we're of the mind that this is a big event, things have happened, people are still trying to figure out as they recover into this new market, this new environment. And it's still being thrown into it some inflation and more -- it seems more dislocation. So I think that we may have things coming through potentially on the liability side of things, eventually. It's hard to know what it's going to look like. But it's clearly, clearly, a lot that we've never faced before. So that's why we will tend to be more prudent at Arch, as you know us. There's a lot more uncertainty than the average loss that we've seen so far in our history."
},
{
"speaker": "Francois Morin",
"text": "30:31 And even the short tail that you would think a short tail coverage’s are going to be litigated, then that will take time to resolve itself. So I mean, we're keeping an eye on it, but we think it's going to be with us for quite a bit longer."
},
{
"speaker": "Josh Shanker",
"text": "30:47 Thank you for all the answers."
},
{
"speaker": "Marc Grandisson",
"text": "30:48 Thanks, Josh."
},
{
"speaker": "Operator",
"text": "30:51 Our next question comes from Ryan Tunis with Autonomous."
},
{
"speaker": "Ryan Tunis",
"text": "30:57 Hey, thanks. Good afternoon --"
},
{
"speaker": "Marc Grandisson",
"text": "31:01 Ryan. Are you still there, Ryan? We can't hear you."
},
{
"speaker": "Operator",
"text": "31:12 Ryan, you may be on mute."
},
{
"speaker": "Marc Grandisson",
"text": "31:14 Yes. Yes, I think Ryan just came out somehow."
},
{
"speaker": "Ryan Tunis",
"text": "31:23 Can you hear me?"
},
{
"speaker": "Marc Grandisson",
"text": "31:25 Ryan?"
},
{
"speaker": "Ryan Tunis",
"text": "31:26 Yes. Yes guys got me?"
},
{
"speaker": "Marc Grandisson",
"text": "31:28 Yes, we got you now. Great, we got to you, we got you and we got you."
},
{
"speaker": "Ryan Tunis",
"text": "31:31 Really Sorry about that. So yes, I had a MI reserve question. It's not as deep MI as the last one, I don't think. But -- what I was curious about is just like trying to get a feel for how 2020 that year has developed. Obviously, you guys released a lot of reserves from that year this quarter, and maybe it's something I can calculate myself. But yes, what have been the total number of reserve releases on the 20-years since you initially booked it?"
},
{
"speaker": "Marc Grandisson",
"text": "32:01 But I don't have that number handy with me. It's most of it -- well, on the ones we just did, there will be most of it. Because most of the delinquencies and there was the largest cohort in April and May of 2020 second quarter. And those are the ones that are obviously coming out of delinquencies and being settled, so most of it is from the 2020 year."
},
{
"speaker": "Ryan Tunis",
"text": "32:26 But do you have a sense, I guess, Marc, for like -- I mean if we were to compare what that ultimate is now relative to kind of the years headed into 2020? Are we getting to a point where on a fully developed basis that year looks like -- some of the years? I'm just trying to understand like how much more reserve potential there could be?"
},
{
"speaker": "Marc Grandisson",
"text": "32:49 Yes. Well, I have to be careful the way I answer it. I think I would say to you that 2020, '21 may turn out to be more like an average year. There's a good possibility for that to happen. It's still uncertain, because we're still going through the forbearance exiting as we speak. It's accelerating really as we speak literally. So I think 2020, 2021 will turn out to be much more of average years than we had maybe feared when we talked about it in the second quarter of 2020."
},
{
"speaker": "Ryan Tunis",
"text": "33:22 Got it. And then on the P&C side, I guess, I might be wrong on this. But I don't remember there being quite this much volatility with the acquisition cost. It just seems like something that is kind of ramping, like as you said in the past two, three quarters. Could you just give us like maybe a little bit of a better understanding of why are we seeing more of that now? Is it because of the amount of loss ratio improvement that's going through the business? Is it the way you've structured reinsurance. I'm just kind of trying to kind of lately understand what might have changed."
},
{
"speaker": "Marc Grandisson",
"text": "33:56 It's a good question, and I would just welcome you to Arch's way of cycle management, which is moving and pivoting to where the opportunities are. So it will be probably surprising to you as Francois and I don't really know what kind of acquisition expense we'll have in one quarter, because our team just make the best evaluation possible as to what's ahead of them. And I think on the reinsurance side, right, we mentioned in our commentary, is that quota share focus, definitely over time, will increase the acquisition expense ratio. 34:26 And on the insurance side, the travel, for instance, right, was really went down in premium written as you remember, Ryan, in 2020. It's coming back up and that has historically a high expense ratio. We also have some programs, new programs that we've entertained on the insurance side. And those will naturally come up with higher acquisitions. So I think that it's a really dynamic market. I don't think we've seen that kind of market where we can shuffle around and really pivot and make capital allocation or decision to write more of one or the other. I think you had more of a -- to your point about not having more volatility this quarter than ever before is because we had a very stable, frankly, doll market for about five or six years, we were defensive. There was really no need for us to shift and we're sort of across the board shifting down our involvement on the P&C side. Now I think its way more dynamic, and that's why you have this shift around. 35:22 So -- but to your question about the loss ratio, the loss ratio itself will find its way naturally, whether we write quota share or excess of loss. So the higher the expense ratio, frankly, the lower you should expect the loss ratio to be. Because it's really a combined ratio gain, as we said before. So I understand that it's not easy to pin down, we understand. But it's really due to the cycle management and where we are in this marketplace."
},
{
"speaker": "Ryan Tunis",
"text": "35:50 Understood, that makes sense. Thanks guys."
},
{
"speaker": "Marc Grandisson",
"text": "35:52 Thanks."
},
{
"speaker": "Operator",
"text": "35:54 Our next question comes from Meyer Shields with KBW."
},
{
"speaker": "Meyer Shields",
"text": "35:59 Thanks. I want to start with one underwriting question, and maybe it pertains to what you were just talking about, Marc. We've seen year-over-year written premiums and programs actually go down after some very solid growth in the first three quarters of 2021. And I was hoping you could talk us through what's going on there?"
},
{
"speaker": "Francois Morin",
"text": "36:18 Yes. [Matt] (ph), there's a bit of noise. I think it's really related to the timing of a renewal of a program and when we onboard one. So I wouldn't kind of read too much into that, Meyer. I think it's very -- it's a one-off."
},
{
"speaker": "Marc Grandisson",
"text": "36:33 I think the earned premium is a better indicator of the trajectory of where we're going here."
},
{
"speaker": "Meyer Shields",
"text": "36:38 Okay, perfect. That's very helpful. The second question, I'm sorry."
},
{
"speaker": "Marc Grandisson",
"text": "36:43 Go ahead, Meyer."
},
{
"speaker": "Meyer Shields",
"text": "36:44 Okay, so you talked a lot and very helpful in terms of the guidance for corporate expenses. Is there the same sort of accrual trend in the individual segments, because I'm asking because of the year-over-year growth in other operating expenses?"
},
{
"speaker": "Francois Morin",
"text": "37:02 Well, I mean it's the same general -- I mean the timing is the same. It's just that, obviously, the corporate -- in the corporate segment or what you see in corporate expenses, it's -- I mean, it's a very -- I mean it's, A, there is, some more non-cash comp that comes into play, right? And that is, again, more tilted to the first quarter. And it's just -- that's basically all it is. I mean, for the most part, it's just comp and benefits versus the OpEx in the segments has a lot more to it, right? There's systems, there's IT, there's a lot more things that -- so you'll never have that much impact or more -- as much volatility in the segment. 37:49 But the rules are the same though. I mean, when we have people that become retirement age eligible, it triggers that different kind of accounting or immediate expensing of the non-cash comp, and that's part of it. Related, I think, just the growth in the OpEx dollars, no question that went up. We stay -- I mean, and we look at that. We certainly -- I want to make sure that premium is growing faster. So I think the ratio, as you saw in all the segments, certainly, insurance arrangements went down. 38:26 And I think the important message here is that we've been performing well, and we need to pay our people. And our people is basically all we have, we need to retain that talent and that came through in Q1 as we kind of made incentive comp decisions."
},
{
"speaker": "Marc Grandisson",
"text": "38:44 Meyer, what I would add to this is you can look at that line item either as an expense or as an investment item. So I think from our perspective, we also are investing in our people, as you heard from Francois. And investing in other things, right, that will improve the results over time. And that's -- this is a good time to invest. We have -- it's a growing platform, money is coming in. So it's a good time to invest. So we're really also spending some money to make it more sustainable as a platform."
},
{
"speaker": "Meyer Shields",
"text": "39:12 Okay, perfect. Thank you so much."
},
{
"speaker": "Marc Grandisson",
"text": "39:14 Welcome."
},
{
"speaker": "Operator",
"text": "39:17 Our next question comes from Mark Dwelle with RBC Capital Markets."
},
{
"speaker": "Mark Dwelle",
"text": "39:22 Hey, good morning. Just a couple of questions, you've already covered a lot of ground. On the Russia-Ukraine losses, what lines of business or products were impacted there? Was it your own trade credit or war or marine whatever?"
},
{
"speaker": "Marc Grandisson",
"text": "39:40 Yes. It's the traditional lines you would expect. I think that most of our losses come from our exposure at Lloyd's, either through from the insurance platform, the reinsurance platform. And that's what you would expect, right, because this is where the specialty lines have been underwritten. So either through the Lloyd's of the London really operations. So this is where we're expecting it from. One the trade credit is part of the considerations. Again, like I said, so it's also part of that as well. So we look across our lines of business. But I would think London, Lloyd's, aviation, marine war, the classic Lloyd's exposure."
},
{
"speaker": "Mark Dwelle",
"text": "40:17 Okay. And then building on that, you -- I'm just trying to make sure I understand it correctly. To the extent that Coface incurs losses, you're picking those up effectively on a one quarter lag basis. So whatever they have, you'll get your proportional share of how those run through in the second quarter and so on going forward, correct?"
},
{
"speaker": "Francois Morin",
"text": "40:42 100% correct, yes."
},
{
"speaker": "Mark Dwelle",
"text": "40:45 Okay. And then the last question, I just wanted to clarify, you made a number of comments related to the investment portfolio. Am I understanding correctly, so you're both extending the duration and getting a higher new money yield on both the reinvestment, as well as, I guess, any new money that you're generating?"
},
{
"speaker": "Francois Morin",
"text": "41:08 Yes. New on yield, no question. I mean I mentioned the 145 basis points. That is comparing your embedded book yield on the portfolio at the end of the quarter or two what we're currently seeing in the market. And we extend the duration is really a bit more of a strategic thing. I mean we were short -- I mean, relative to our benchmark, we got a bit closer to the benchmark, just being a bit more of a defensive move, we want to make sure we weren't too far off from the target."
},
{
"speaker": "Mark Dwelle",
"text": "41:39 In terms of thinking forward, which will have the greater impact on rising investment income, it will be the -- I would assume it would probably be the higher new money rate more so than the duration extension."
},
{
"speaker": "Francois Morin",
"text": "41:52 Totally. Yes, we -- listen, we don't know how quickly the portfolio will turn over. But certainly, as Marc mentioned, the free cash flow coming in and also how quickly the portfolio will churn or either mature and/or will trade in and out of certain securities, we'll be able to reinvest that. So it will take certainly a few quarters. But as I mentioned, I think we'll start seeing some benefits starting next quarter and by the end of the year, it should be hopefully somewhat measurable and meaningful."
},
{
"speaker": "Mark Dwelle",
"text": "42:28 Okay, thank you. I appreciate the thoughts."
},
{
"speaker": "Francois Morin",
"text": "42:30 Sure, welcome."
},
{
"speaker": "Operator",
"text": "42:33 Our next question comes from Yaron Kinar with Jefferies."
},
{
"speaker": "Yaron Kinar",
"text": "42:37 Hey, good morning everybody. My first question, and maybe it's more of just me rephrasing and making sure I'm thinking about it correctly. Am I to understand that really your focus or your myopic focus is on getting the loss ratio better, and you're kind of agnostic as to whether the expense ratio goes up or down as long as the combined ratio comes down because the loss ratio improves more?"
},
{
"speaker": "Marc Grandisson",
"text": "43:04 Yes, I think you're right. I think the combined ratio, which leads to return on equity is what we're focusing on. Yes."
},
{
"speaker": "Yaron Kinar",
"text": "43:10 Okay. And I should probably be careful with how I phrase this, we talk industry here. At some stage, you expect -- in the cycle, you expect to see some adverse reserve development and then probably followed by some favorable development. I guess where do you see the industry at today? And maybe at what point do you start seeing the reported combined ratio improve and coming more from favorable development as opposed to the accident year loss ratio improving?"
},
{
"speaker": "Marc Grandisson",
"text": "43:42 Yes. I can't speak really to the level of reserve in the industry. I mean everybody -- it's like beauty is in the eye of the beholder, right? It's kind of difficult for me to opine on this. I think in terms of earnings versus pricing cycles, I think it's true that the pricing cycle peaks and then the earnings cycle peaks probably a couple two to three years after. So I think that, that historically has been the case. So I would expect earnings to -- if pricing is -- I don't -- I'm not saying it's peaking, but once it peaked, we should probably have earnings still getting better for a couple of years after that. So we're still very much in the margin improvement still in the market. So it's a tough question to ask as opposed to what right, Yaron, where it's going to come from, prior development or current accident years. So that's a different -- it's probably different also for every company."
},
{
"speaker": "Yaron Kinar",
"text": "44:35 Fair. I'd be happy for you to opine on Arch specifically, if you want."
},
{
"speaker": "Marc Grandisson",
"text": "44:40 We're doing pretty good."
},
{
"speaker": "Yaron Kinar",
"text": "44:42 Okay. If I could sneak one last one in. So two-thirds of cat losses are related to Russia. Is that true for both the insurance and reinsurance segments?"
},
{
"speaker": "Francois Morin",
"text": "44:56 It's a good question. It's -- I mean, directionally, it's about that. Yes, I mean we might have had a bit more -- the non-Ukraine cat losses were mostly reinsurance, so Australian floods is where we can -- that we picked that up a bit more from the reinsurance side. But it's -- directionally, it's about -- not a big difference."
},
{
"speaker": "Yaron Kinar",
"text": "45:17 Got it. Thanks so much."
},
{
"speaker": "Francois Morin",
"text": "45:18 Thanks."
},
{
"speaker": "Operator",
"text": "45:21 Our next question comes from Brian Meredith with UBS."
},
{
"speaker": "Brian Meredith",
"text": "45:26 Hey, thanks. A couple of one’s here for you. First, Marc, can you talk a little bit about what you think about the opportunities maybe in Florida with the renewal season, a lot of turmoil and stuff going on down there."
},
{
"speaker": "Marc Grandisson",
"text": "45:37 Yes, I can only tell you right now what we hear from our team. And what we hear from our teams, and including our colleagues and brokers and friendly brokers out there, is this is going to be a tough renewal. There's a lot of question marks, a lot of decision that needs to be made. It's too early, Brian, to call what it's going to look like. But people are expecting, I think you may have heard this on other call, a difficult renewal. There's a lot of things that need to be fixed between the recognition of the litigation that hasn't really stopped as much as we would have wanted. Some of the companies are struggling to even survive, do you get paid your reinstatement. And I understand that the state is also trying to find solution. We probably have an impending discussion from the Department of Insurance as to what they want to do or the direction, what they want to do in Florida. So we're like you, Brian, we're in a wait and see kind of mode. We have -- the one thing I would tell you, which all our shareholders should hear is if there's an opportunity, we have capital to deploy there. We're very bullish."
},
{
"speaker": "Brian Meredith",
"text": "46:38 That's what I wanted to know. So you've got the company. And then, Marc, another one, so a couple of stories out last night and this morning about companies looking potentially sell themselves. I'm just curious what your thoughts are on M&A, kind of Arch's view with respect to the M&A environment? Is the organic growth opportunity is just too good right now to distract yourself from potential M&A opportunities?"
},
{
"speaker": "Marc Grandisson",
"text": "47:03 Listen, we're a broadly equal opportunity kind of company, right? We'll look at what can be done and what should be done and what makes sense for the shareholders. We're not looking for transactions necessarily. But our history show that when a transaction come that's accretive to our shareholders, we'll entertain and look at it. We certainly have look at what's out there, what has been discussed, as you would expect, Brian. So I think we have probably the best position possible, which is we don't have to do anything. We have plenty of opportunity. And we are in a seat where we can just like wait for the pitch to come to us. So I feel very, very fortunate to be where we are at Arch Capital Group. So we'll look at it. We'll look at it, pitch, if we like it, we'll swing, if not we'll just go back."
},
{
"speaker": "Brian Meredith",
"text": "47:47 Great, thank you."
},
{
"speaker": "Marc Grandisson",
"text": "47:48 Yes, sure."
},
{
"speaker": "Operator",
"text": "47:52 Our next question comes from Elyse Greenspan with Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "47:57 Hi, thanks. My first question, if I look at your insurance segment, it's been six quarters in a row where you guys have grown by more than 20%. It seems from your comments you guys are still pretty bullish about opportunities there, even with perhaps a little bit less price. So Marc, does this feel like an environment where you can continue to see pretty robust levels of growth within your insurance segment for this year and beyond?"
},
{
"speaker": "Marc Grandisson",
"text": "48:26 The answer is yes, Elyse. I wonder where you were for the call. The answer is yes. Broadly, it was probably more of a broad market opportunity probably two years ago. Now it's refining itself and turn more certain lines of business. As we mentioned before, some of the programs, we're seeing a better pickup in pricing and property as we speak right now, it's getting hard again on the heels of failing to get the value right as an industry. So listen, I think that it's a bit more of an opportunistic. I think we still have the ability and the willingness to lean in hard if we see opportunities, and we are seeing opportunities, so yes. It's just not as broadly based perhaps as it would have been two years ago."
},
{
"speaker": "Elyse Greenspan",
"text": "49:08 And then as we think about some stuff that's come up throughout the call, right, we're dealing with higher inflation, also higher interest rates that you guys mentioned could be a tailwind on the investment income side. So where would you put the ROE within the P&C business? Where do you think that's running at today when you think about how 2022 could come in? I know you've talked about, right, kind of targeting the -digits in the past. Where do you think things are now?"
},
{
"speaker": "Marc Grandisson",
"text": "49:38 I think we can speak for our book of business. I think we expect our ROE on a policy year basis, but we write currently to be close to the mid-teens. I mean, we're really getting there inching every -- possibly every quarter since the end of 2019. So yes, this is sort of where we are, Elyse. Yes, pretty much. Was there another part of your question? I want to make sure I think you had something else. No?"
},
{
"speaker": "Elyse Greenspan",
"text": "50:04 No. That was the event. And then another one just on buybacks and I think this came up a little bit earlier when you guys were talking about ROEs in general. I know in the past, we've used some rule of thumbs with book value, right? But you guys, it seems like bought back your stock, right within range of one-fourth of book in the Q1. I know the shares are a little bit higher today, right. Partially, that's a function of the mark-to-market in the quarter. So obviously, would -- buybacks would depend upon the growth opportunities, but it seems like you guys would still be willing to buy back your stock given the valuation today?"
},
{
"speaker": "Francois Morin",
"text": "50:44 I think that's fair. I think -- listen, I mean, again, the multiple is not something we focus when we look at it. But again, I think on the heels of Marc's answer to your earlier question, I think we like our prospects. I mean we think the forward-looking ROEs that we have in front of us are very attractive. We think the stock is priced relatively attractively for us. And depending on what opportunities come our way and how we can deploy the capital, share buybacks are always part of the solution or part of the -- how we deploy our capital."
},
{
"speaker": "Elyse Greenspan",
"text": "51:19 Thanks for the color."
},
{
"speaker": "Marc Grandisson",
"text": "51:21 Thanks."
},
{
"speaker": "Operator",
"text": "51:23 Our next question comes from Tracy Benguigui with Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "51:29 Thank you so much for it takes me on again, I noticed that you increased your reinsurance prop cat writings by 10% this quarter, and I recognize you're underweight on PMLs relative to peers. But still, can you break down how meaningful -- is this growth driven by exposure increases versus rate increases? And if you could just comment about your overall risk appetite or prop cat risk, you are balancing pricing inflation and your exposure management."
},
{
"speaker": "Francois Morin",
"text": "51:56 Yes. In terms of -- I mean, appetite, we've been relatively neutral for the recent last few quarters. I mean we haven't grown. I mean this -- again, this is a bit of a slight one-off in terms of the -- you saw the growth in the premium, just the timing of a renewal. We have like a 14-month premium that program that fell in different quarters. So again, I wouldn't read too much into the dollars of growth in the quarter. But we still -- we're still players in the space. We still say and believe that we need to get a bit more to really put the pedal to the metal. And we'll see where it goes."
},
{
"speaker": "Marc Grandisson",
"text": "52:35 Yes. On the cat exposure, Tracy, I think that we look at how we deploy it, right? We could deploy it through cat Excel or you could do it through [indiscernible] quota shares or some marine. It's coming from many lines of business. And I think that for the last 18-months or 24-months, because of the significant increases in TMC changes, improvements on the property, in large property segment in general, that our deployment of capital from the cat perspective has been more towards quota share reinsurance. And I think the cat Excel has been lagging, frankly, in terms of pricing. And we've said that more than one. So I think that -- and again, that's another one that -- the similar answer to the program that I answered to Meyer earlier, which is the earned premium is probably a better indicator of our relative growth or non-growth, in this case, in the property cat space."
},
{
"speaker": "Tracy Benguigui",
"text": "53:28 Okay. Great. And just one real quick follow-up on actually Elyse's question. I felt like last quarter, you kind of alluded that you could buybacks talk above the 1.3 times, just given your view of intrinsic value of your MI business. I don't know if those comments were fully appreciated. I don't know if it's possible, you could flesh out your view of what you think the intrinsic value of your MI book is and how that plays in."
},
{
"speaker": "Francois Morin",
"text": "53:54 Well, it's part of the -- I mean, forward-looking ROE. So no question that we -- there is significant embedded value that's built into the MI book, and we have good visibility on that. We're very bullish on it, and that gives us even more comfort that there's significant value in the stock. So as we think about buybacks, I mean, no question that from our side, it's fully factored in."
},
{
"speaker": "Tracy Benguigui",
"text": "54:19 Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "54:20 Thanks Tracy."
},
{
"speaker": "Operator",
"text": "54:23 Our next question comes from Michael Phillips with Morgan Stanley."
},
{
"speaker": "Michael Phillips",
"text": "54:29 Hey, thanks. Just one follow-up for me, and it's back to MI for a second. Trying to marry your earlier comments on the rank order of capital allocation, and you put MI second behind P&C, which obviously makes sense given the fundamentals in the P&C book right now. But if we take that and then look at earlier comments and opening comments, which were pretty positive on the MI space. I'm trying to figure out how to think about -- any help you can give us on thinking about, I guess, growth for the MI business, given what we saw this quarter growth over the next year."
},
{
"speaker": "Marc Grandisson",
"text": "55:01 Well, I think we -- I mean, it's hard to see from the way we report, but I think the growth, we have a fair amount of growth through the CRT. We also have a very healthy CRT, which is the credit risk transfer program from the GSEs. We also have, as you know, taken on the mortgage -- the mortgage company that was owned by Westpac in Australia, so that's also seeing some growth. In the U.S., I mean, we expect -- I mean we have to remember the production was record for 2020 and 2021. 55:32 So it's kind of hard to grow from there significantly. So the market itself probably will -- might be decreasing a little bit, so we'll see where it shakes up. Definitely, the refinancing is very, very much, you know, pretty much behind us, because of the mortgage rate increases for the that six months. So I wouldn't say that new production is -- because by virtue of the size of the market, on the U.S. MI sort of shrinking somewhat from the refinancing perspective, but what is happening, because of this mortgage rates increasing, the premium written will be much more stable and actually could increase because of the lack of refinancing precisely, which means the insurance in force will increase, which will give some lift into our ongoing written premium. So even though we may not have a similar production from an NIW perspective, I think that the existing portfolio, I would expect the written premium to go up on a gross basis, definitely at some point, starting probably in the second half of the year, Francois, possibly, yes."
},
{
"speaker": "Michael Phillips",
"text": "56:39 Okay, well thank you, Marc, thanks for the color."
},
{
"speaker": "Marc Grandisson",
"text": "56:42 Thank, Mike."
},
{
"speaker": "Operator",
"text": "56:46 I'm not showing any further questions. I'd now like to turn the conference back over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "56:53 Yes, thanks everyone for being here today. Great questions and we look forward to see and talk to you again in July. Thank you."
},
{
"speaker": "Operator",
"text": "57:02 Ladies and gentlemen, thank you for participating in today's conference, this concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 4 | 2,023 | 2024-02-15 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Q4 2023 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with this update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filled by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management will also make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the Company's current report on Form 8-K furnished to the SEC yesterday, which contains the Company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sirs, you may begin.
Marc Grandisson: Thank you, Gigi. Good morning and thank you for joining our earnings call. Our fourth quarter results conclude another record year as we continued to lean into broadly favorable underwriting conditions in the property and casualty sectors. Our full year financial performance was excellent with an annual operating return on average common equity of 21.6% and an exceptional 43.9% increase in book value per share, which remains an impressive 34.2% if we exclude the one-time benefit from the deferred tax asset we booked in the fourth quarter. The $3.2 billion of operating income reported in 2023 made it Arch's most profitable year-to-date. Growth was strong all year as we allocated capital to our property and casualty teams, we short over $17 billion of gross premium and over $12.4 billion of net premium. And while most current growth opportunities are in the P&C sector, it's important to recognize the steady quality underwriting performance of our mortgage group. Although, mortgage market conditions meant fewer opportunities for top-line MI growth, the business unit continued to generate significant profits totaling nearly $1.1 billion of underwriting income for the year. As we have mentioned on previous calls, those earnings have helped fund growth opportunities in the segments with the best risk adjusted returns, demonstrating that the disciplined underwriting approach and active capital allocation are essential throughout the cycle. Our ability to deploy capital early in the hard market cycle is paying dividends as we own the renewals, a phrase I learned from Paul Ingrey, a personal mentor and foundational leader of Arch. What Paul meant was quite simple. When markets turn hard, you should aggressively write business early in the cycle. This puts your underwriters in a strong position to fully capitalize on the market opportunity. By making decisive early moves, you won become an [indiscernible] then want to do more business with you. In some ways, the growth becomes self-sustaining, which explains part of our success throughout this hard market. At Arch, our primary focus has always been on rate adequacy, regardless of market conditions. Our underwriting culture dictates that we include a meaningful margin of safety in our pricing, especially in softer conditions. And we also take a longer view of inflation and rates. For these reasons, Arch was underweight in casualty premium from 2016 to 2019, when cumulative rates were cut by as much as 50%. I thought I'd borrow a soccer analogy to help explain the current casualty market. In soccer, players who commit a deliberate foul are often given a yellow card. Two yellow cards mean the player is ejected from the remainder of the match and their team continues with a one player disadvantage. Today's casualty market feels as though some market participants took to the field with a yellow card from a prior game. They're playing in match but cautiously, not wanting to make an error that will put their entire team at a disadvantage. So whilst Arch sometimes plays aggressively, we've remained disciplined and avoided drawing a yellow card. At a high level, we must remember that casualty lines take longer to remediate than property. So if insurers are being cautious and adding to their margin of safety, we could experience profitable underwriting opportunities in an improving casualty market for the next several years. Now, I'll provide some additional color about the performance of our operating units, starting with reinsurance. The performance of our reinsurance segment last year was nothing short of stellar. For the year, reinsurance net premium written were $6.6 billion, an increase of over $1.6 billion from 2022. Underwriting income of nearly $1.1 billion is a record for this segment and a significant improvement from the cat heavy 2022. Reinsurance underwriting results remain excellent as we ended the year with an 81.4% combined ratio overall in a 77.4% combined ratio ex-cat and prior year development both significant improvements over 2022. Turning now to our insurance segment, which continued its growth trajectory by writing nearly $5.9 billion of net premium in 2023, a 17% increase from the prior year. While the business model for primary insurance means that shifts may not appear as dramatic as our reinsurance groups, a look at where we've allocated capital year-over-year provides meaningful insight into our view of the market opportunities. In 2023, the most notable gains came in from property, marine, construction, and national accounts. The $450 million of underwriting income generated by the insurance segment in 2023 doubled our 2022 output as we continue to earn in premium from our deliberate growth during the early years of this hard market. Underwriting results remained solid on the year as the insurance segment delivered a combined ratio of 91.7% and a healthy 89.6% excluding cat and prior year development. Now on to mortgage, our industry-leading mortgage segment continued to deliver profitable results, despite a significant industry-wide reduction in mortgage originations last year. The high persistency of our insurance in-force portfolio, which carries its own unique version of owning the renewals, enables a segment to consistently serve as an earnings engine for our shareholders. The credit profile of our U.S. primary MI portfolio remains excellent and the overall MI market continues to be disciplined and returned focus. These conditions should help to ensure that our mortgage segment remains a valuable source of earnings diversification for Arch. Onto investments, net investment income grew to over $1 billion for the year due to rising interest rates that enhanced earnings from the float generated by our increasing cash flows from underwriting. The significant increases to our asset base provide a tailwind for our creative investment group to further increase its contributions to Arch's earnings. Over the past several years, Arch has leaned into both the hard market and our role as a market leader in the specialty insurance space. We have successfully deployed capital into our diversified operating segments to fuel growth, while also making substantial operational enhancements to our platform, including entering new lines, expanding into new geographies and making investments into new underwriting teams, technology and data analytics. Finally, as we bid adieu to 2023, I want to take a moment to thank our more than 6,500 employees around the world who help deliver so much value to our customers and shareholders. Our people are our competitive advantage and without their creativity, dedication and integrity, none of this would be possible. So thank you to team Arch. François?
François Morin: Thank you, Marc, and good morning to all. Thanks for joining us today. As Marc mentioned, we closed the year on a high note with after-tax operating income of $2.49 per share for the quarter for an annualized operating return on average common equity of 23.7%. Book value per share was $46.94 as of December 31, up 21.5% for the quarter and 43.9% for the year aided by the establishment of a net deferred tax asset related to the recently introduced Bermuda Corporate Income Tax, which I will expand on in a moment. Our excellent performance resulted from an outstanding quarter across our three business segments highlighted by $715 million in underwriting income. We delivered strong net premium written growth across our insurance and reinsurance segments, a 22% increase over the fourth quarter of 2022 after adjusting for large non-recurring reinsurance transactions we discussed last year, and an excellent combined ratio of 78.9% for the Group. Our underwriting income reflected $135 million of favorable prior year development on a pretax basis or 4.1 points on the combined ratio across our three segments. We observed favorable development across many units, but primarily in short day lines in our property and casualty segments and in mortgage due to strong cure activity. While there were no major catastrophe industry events this quarter, a series of smaller events that occurred across the globe throughout the year resulted in current accident year catastrophe losses of $137 million for the Group in the quarter. Overall, the catastrophe losses we recognize were below our expected catastrophe load. As of January 1, our peak zone natural cat PML for a single event, one in 250-year return level on a net basis increased 11% from October 1 but has declined relative to our capital and now stands at 9.2% of tangible shareholders equity, well below our internal limits. On the investment front, we earned $415 million combined from net investment income and income from funds accounted using the equity method, up 27% from last quarter. This amount represents $1.09 per share. With an investable asset base approaching $35 billion, supported by a record $5.7 billion of cash flow from operating activities in 2023 and new money rates near 5%, we should see continued positive momentum in our investment returns. Our capital base grew to $21.1 billion with a low leverage ratio of 16.9%, represented as debt plus preferred shares to total capital. Overall, our balance sheet remains extremely strong and we retain significant financial flexibility to pursue any opportunities that arise. Moving to the recently introduced corporate -- Bermuda Corporate Income Tax. As mentioned in our earnings release and in connection with the law change, we recognized a net deferred tax asset of $1.18 billion this quarter, which we have excluded from operating income due to its non-recurring nature. This asset will amortize mostly over a 10-year period in our financials, reducing our cash tax payments in those years. All things equal, we expect our effective tax rate to be in the 9% to 11% range for 2024, with a higher expected rate starting in 2025. As regards our income from operating affiliates, it's worth mentioning that approximately 40% of this quarter's income is attributable to non-recurring items such as Coface adoption of IFRS 17 and the establishment of a deferred tax asset at summers in connection with the Bermuda Corporate Income Tax. With these introductory comments, we are now prepared to take your questions.
Operator: Thank you. [Operator Instructions] Our first question comes from the line of Elyse Greenspan from Wells Fargo.
Elyse Greenspan: Thanks. Marc, my first question, I wanted to expand on some of your introductory comments just on the casualty side, right? We've started to see some reserve additions this quarter, and I think you alluded to that last quarter as being what was going to drive the market turn. So how do you see it playing out from here? I know you said it should play out over the next several years. Could you just give us a little bit of a roadmap in how you think about this opportunity emerging for Arch?
Marc Grandisson: Yes. Great question. I think that we're observing our own book of business. We also look at all the information around; I think from an actuaries perspective both François and I have maybe dusting off our actuarial diplomas. You rely on data that's historically stable, or at least has some kind of predictability. I think what we've seen over the last two, three years, as a result of the pandemic, largely in the courts being closed and everything else in between all the uncertainty and then the bout of inflation, there's a lot of data that's really hard to pin down and get comfortable with to make your prediction for what you should be pricing the business. As we all know, reserving leads to the pricing, right, by virtue of reserving and having the right number for the reserving, you then feed that into your pricing. So we're in a situation where people have lesser visibility or about what the reserving will ultimately develop to. So I can totally understand our clients and our competitors having to adjust on the fly, or having to adjust a little bit progressively and cumulatively. The issue with casualty, at least as you know, is even if you have that information and you make some correction of corrective actions, it still takes a while to evaluate whether what you did was enough or whether what you needed to do. So I think right now, we have -- we already had a couple of rate increases in casualty starting in 2020. But I think that now we're realizing that maybe it's a little bit worse collectively as an industry than we thought. And there's a lot more uncertainty, a lot more inflation, certainly, as we all know, is a big factor. So what I would expect right now is people will start refining their book of business. They will try to re-underwrite away from the social inflation impact lines. They'll probably push for rates. Some of them might kick some business to E&S until such time as we have more stability in the reserving now the loss emerges as it relates to what your initial pricing assumptions was. And in casualty, that's why it takes several years and its history is any indication. If you look back at the -- even the [indiscernible] market and then the yo tutors the 90s -- 1999 or 2000 to 2003, it took three to four years from the start of that, even in the middle of it, to really get clarity. And the market got much harder, in fact, in 2004 or 2005 than it was in 2002. Just because you have to do the action and see what the actions did, what you thought. And I think that's what we're going to collectively as an industry are going through and we're seeing it with our clients and that's really what's happening.
Elyse Greenspan: Thanks. And then, my second question, second quarter in a row, right, we've seen the underlying loss ratio within your reinsurance business come in sub-50, and you guys are obviously earning in like cat business written at strong rates last year. How should we think about the sustainability of a sub-50 underlying loss ratio within your reinsurance book?
François Morin: Well, sustainability is a great question. I think you're absolutely right that we have more property premium that is more short tail and should have a lower loss ratio ex cat than not, right, compared to other lines. It's a good market. So obviously profitability embedded in the business should be strong. But we send you back to kind of quarterly volatility, where you are -- sometimes we have a better than, call it normal quarter, even as a function of the book and sometimes not. There's going to volatility. We said it before; we said again the 12-month kind of rolling average is to us a better way to look at it and that's how we see it. But certainly we like the profitability in the book and it should be -- it should remain strong. One thing I will tell you Elyse, by heard on the other calls is that the markets -- reinsurance market is continuing to improve somewhat into the one, one renewal. So it is still a very good marketplace. So what it means for the loss ratio, I don't know. But certainly, we're seeing improvement.
Elyse Greenspan: And then, just one last one on capital, right? I believe on there was some pushes and pulls from the S&P capital changes on your capital but should be positive relative to your mortgage business. Can you just help us think through your capital position and relative to just organic growth opportunities you see at hand over the next year.
François Morin: Well, certainly, I mean S&P is one thing that we look at. We look at many different way -- I mean, we have different looks at capital adequacy. We have our own internal view which drives really how we make our decisions. Rating agencies are an important factor but I think more importantly is how we think about it. But you're right. I mean no question that from the S&P point of view, I mean the change of their model was a net benefit and that's reduced kind, you know give us, I say a bit more excess capital. But we -- and we look at it very carefully. We want to make sure that we're able to seize the opportunities that will be in front of us and we see plenty for 2024. So right now our very -- our main focus is growing the business and kind of deploying that capital into what's in front of us and then we'll see how the rest of the year plays out.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Andrew Kligerman from TD Cowen.
Andrew Kligerman: First question -- good morning. First question would be around M&A, we've seen a lot in the media about other specialty players that could be acquired. Arch has been mentioned along with other companies. And I know you can't comment on specific transactions and that you've talked a lot about 15% return on capital over time. But when you do transactions, could you give us a little color on what the parameters might be, what's really important to Arch when you do deals?
Marc Grandisson: Yes. On the M&A front, we're very prudent and careful when we do -- if we do anything. And I think historically, our historical track record is probably the best way to look at this. We'll look for something where our opportunities to earn a return is with a proper margin of safety is fairly healthy. We're not -- there's no desire to grow for growth sake in this company. It really has to do with the return on capital. And as François mentioned, the fact that we have opportunities to above 15% opportunities in this marketplace certainly makes it a little more harder. Having said all this, we might make not exceptions, but there might be some other considerations as it relates to maybe a strategic, maybe a different kind of product, maybe a geography, or maybe -- and we prefer that, maybe a new team that can really bring the expertise on an underwriting basis. So it's a very, very disciplined approach to M&A that we take. And we have the luxury because we have plenty of organic growth available to us. So something has to be very compelling for us to engage in those and also other risks, as you all know, that we don't want to take on necessarily the number one is the culture. Now we're very, very adamant about keeping top culture the way it is, and that's really something. And that quite oftentimes the thing that makes the most, and then -- probably the one that makes the most difference in whether or not we'll entertain an M&A or not.
Andrew Kligerman: That makes a lot of sense. You mentioned on the favorable developments that short tail property was a big driver. So looking at insurance at $21 million favorable, reinsurance at seven favorable. Just trying to understand, were there any large casualty offsets that might have played in and if so, what would they be?
François Morin: Yes, well, there's no, I'd say offsets. I mean, we look at each line on its own. There's always going to be pluses and minuses on that every single quarter. We look at the data, we react to the data. I think, as you can imagine, or I mean, very much a function of the type of business that we've written the last few years we -- in reinsurance in particular, we've grown a lot in property. We've taken our usual -- used our same methodology, same approach to reserve, and that generated a little bit of redundancies or releases this quarter on the short tail side. There's always a little bit of noise on any line of business. Yes. Did we have a couple of sublines or kind of sales in casualty where we had a little bit of adverse? Absolutely, but it's not -- I wouldn't call it an offset. I mean, we booked every single line on its own. We reacted to data, and then when numbers come up is what we end up with.
Marc Grandisson: One thing I would add to this, our reserving approach at a high level is to typically recognize bad news quickly and good news over time. So again, our philosophy hasn't changed at all in all those years.
Andrew Kligerman: Maybe if I could sneak one quick one in. You mentioned during the call that one of the growth areas in insurance was national accounts. What type of limits do you write on national accounts?
Marc Grandisson: Well, it's statutory, right? So -- and it's on an excessive loss basis. And these are loss. There's a lot of sharing of experience, plus or minus business with clients. They tend to be larger clients. The national account is 95% plus workers comp. It's really a self-insured sort of structure that of sort, we provide the paper and actually the document to allow people to operate in their state because you need the required thing to be able to demonstrate the workers comp insurance as a protection. This is statutory, so it's unlimited by definition. We have some reinsurance that protect some of the capping. That's really what it is.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Jimmy Bhullar from JPMorgan.
Jimmy Bhullar: Hey, good morning. So, first, just a question on the casualty business. We've seen significant growth in your property exposures with the hard -- since the hardening of the market, or significant hardening the market since early last year. What are your views on just overall market trends on the casualty side, and are you comfortable enough with pricing in terms to increase volumes in that area?
Marc Grandisson: Yes, I think our comfort -- great question. Our comfort on the casualty, on liability in general, more general liability, right, if you exclude professional lines, I think we're -- the market is turning or has more pressure on the primary side. So I think that our focus right now is really on the primary, as you can see on our reinsurance, what we did in reinsurance for the last year, we think the reinsurance market is a little bit delayed in reacting to what happened, as in some of the development that we see and some of the increase in inflation. And of course, for your point that we mentioned. So I think that we'll probably see first an insurance market that really takes it to hard, like I mentioned, all the remediation that they need to do. And I think the reinsurance market will probably follow suit with their own -- possibly their own way to look at this, if the prior hard markets are any indication. On the reinsurance side, one thing that's a little bit beneficial at this point in time, and there's a reason why reinsurers are not reacting possibly as abruptly as they probably should as in regards to city and commission is that we collectively understand as an industry that our clients are trying to make those changes, so we're trying to go along with them and help them, support them in their efforts. We'll see whether that's enough. Our team is a little bit waiting to see whether that develops, but I do expect this to also come around and also provide another opportunity for us to grow.
Jimmy Bhullar: And then on mortgage insurance, I would have assumed that reserve releases would moderate over time, and they've actually become even more favorable. And I think there's a shift in what's driving that. It used to be COVID reserves last year, and now it's stuff written post-COVID. As you think about, just want to get an idea on what are you assuming in your reserves that you're putting on the book right now? Are you assuming experience commensurate with what you're seeing in the market or is it reasonable to assume that if the environment stays the way it is, there's more room to go in terms of reserve releases?
Marc Grandisson: Great question. I say reserve releases this year in general were somewhat driven by our -- the views we had on the housing market at the start of the year, right? So if you rolled back the tape a year, we were more concerned about home prices dropping fairly rapidly, recession, no soft landing, et cetera. So those reserves we set, call it a year ago were very much a function of those assumptions, and they just didn't materialize throughout the year. So throughout the year, we saw very strong or very well performing housing market. People are hearing their delinquencies much higher than we'd actually forecasted. Home prices are holding up. Unemployment remains relatively low. So you put it all together, I mean it's really, what transpired in 2023 is very much a function of the reserve releases reflect kind of how things -- how much better they played out relative to what we thought a year ago. Where we are today at the start of 2024 is certainly a bit more, I wouldn't call it optimistic in the sense that we see good home prices and a solid housing market for 2024. So on a relative basis, the reserves that we're holding today are not as high as they were a year ago. So if you extrapolate from that, is there room for as much in reserve releases going forward? Probably not, but we just don't know. I mean, the data will again play out as it does and we'll react to it, but hopefully that helps you kind of compare and understand how, where we sit today versus a year ago.
Jimmy Bhullar: Okay. Thanks. And just lastly, your comfort with the reserves in your casualty book, despite all the industry-wide issues, does that apply to the business that came over from Watford as well? Because that company obviously had a decent amount of exposure to casualty.
Marc Grandisson: That's an easy one. Watford, really the underwriting is managed by our team here. So the reserving and approach [Technical Difficulty] okay.
Jimmy Bhullar: Thanks.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Michael Zaremski from BMO.
Michael Zaremski: Hey, good morning. First question for François on capital in regards to mortgage specifically. So my understanding of the mortgage reserving rules is that after a decade or so, you can start releasing a material amount of reserves. And mortgage obviously isn't growing now, so -- but you also have a Bermuda, I think some captives there too. So just curious, is there a material amount of capital coming or expected to come from releasing from the legacy mortgage or old mortgage business?
François Morin: Well, I'd say the short answer is yes, in the sense that the contingency reserves. You're right, we will start releasing a bit more progressively, starting in 2024 and 2025. That will be -- and we already had some of that in the fourth quarter this year. So if you look at our PMI's ratio, why it dropped in the quarter, the fourth quarter was very much a function of a dividend that we were able to extract from our regulated USMI Company to the Group. So that we think, well, should the plan and is scheduled to keep, we should keep having dividends in 2024 and beyond. But the one point I want to touch on is, and we touched on it in the past is while on a regulatory basis, yes, it's released, we would argue that capital is already somewhat being deployed in the business. So it's not -- that it's just sitting there not being deployed in the business. It's already been used to other sources because the regulators and the rating agencies look at the aggregate Arch Cap Group kind of level of capital. So yes, on the statutory basis, the goal here is to put the capital in the better location. But overall, it's somewhat not as big an impact as you might imagine.
Michael Zaremski: Okay. That's helpful. And sticking with capital, when Elyse asked about you mentioned the S&P Capital model, but I don't think you actually gave any quantitative or answers on the benefit, because when we -- on paper we see that Arch appears to be one of if not the most diversified. Any help there on how much of a benefit or how to think about how much of a benefit the model offers Arch?
François Morin: Yes, you're right. I didn't put a number, and we're not going to start putting a number, but it's a net positive. No question that, yes, mortgage charges, diversification benefit were reductions in capital requirements, but we also -- the final rulings on debt was not as favorable, right? So S&P and their new rules, they no longer treat $1.75 billion of our debt as being capital. So that's a significant offset. But all things considered, all in, it's a positive. But again, what I want to remind everyone is it's not the only thing we look at, it's just one thing among many and other rating agencies matter. And more importantly, again, is how we think about the capital we need to run the business.
Michael Zaremski: Okay. And lastly, since everyone else is sneaking in a lot more questions, based on the remarks you've made it, unless I'm understanding it incorrectly, it sounds like the growth might be you're more excited about the primary insurance segment. Can primary insurance potentially grow just as much in 2024 as it did in 2023?
Marc Grandisson: It's a great question. I mean, again, the way we talk, we don't provide guidance because I don't know, we don't know what the market conditions will be this year. But in terms of capabilities and capital and talent and everything else in between, absolutely, we have -- we could do more. Yes, we could. If the opportunities are there, we'll do more, both on insurance or reinsurance for that matter.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Josh Shanker from Bank of America.
Josh Shanker: Hey, everyone, I think there might be a problem with the phones. We heard Jimmy and Mike just fine, but we couldn't hear your answers to the questions. I don't know. So -- and I hear you. I don't know if anyone can hear me. Let me ask my team. Can you guys hear me on the phone? They hear me. So somehow it's been corrected. Okay, so I don't know what --
Marc Grandisson: Yes, Josh, we can hear you. So hopefully, it's been recorded. I don't know if it's been recorded.
Josh Shanker: Okay, very good.
Marc Grandisson: Yes.
Josh Shanker: So yes, I’ve got a couple of quick ones. So it's the lowest quarter of new insurance written in the mortgage insurance business since acquiring UGC. And yet it looks like the capital utilization went up, at least the risk to capital, and the premiers capital ratio went up. Can you sort of talk about the moving pieces that are driving that?
Marc Grandisson: Well, our PMIers, -- well, very much a function of a Bellemeade transactions that we called Josh, I think there's significant amounts of capital protection that we exercised on and no longer give us capital credit.
Josh Shanker: Yes, that's obviously what it is. Yes, definitely that makes sense.
Marc Grandisson: Yes.
Josh Shanker: And another easy one, it looks to me from quarter end 2000, September 30 to year-end, Coface stock was about flat, although it round tripped through the quarter. And yet you had very strong other income in the quarter. There's some summers in that. There's other things in there. Can you talk about the moving pieces?
François Morin: Well, Coface, I mean, the stock price is one thing, but obviously for us, we booked the income, right. And they declared pretty much. I don't know the exact numbers, but their dividend, their annual dividend has been close to their full net income, 100% kind of payout ratio. So that ends up being what we book in our financials. So yes, the stock price is going to move up and down over the year, but it doesn't directly, I'd say factor in or end up in their financials.
Josh Shanker: Okay. And just so I'm getting a lot of inbound call volume or e-mails from people right now. Nobody can hear these answers that you're giving me. It may be being recorded. They hear me, but they don't hear you.
Marc Grandisson: Hold on a second, Josh. Are we being recorded? Let's work a little bit through this quickly. Maybe we can fix it.
François Morin: What's happening now?
Marc Grandisson: Yes.
Josh Shanker: Okay. So just so that I don't know. Anyway, they're addressing it. People can't hear the Arch team. But for people who are emailing you right now saying they can't hear the Arch team, they're working on addressing it.
Operator: Thank you. One moment for our next question. Please note everyone that this call has been recorded and it will be available after the call is over. Our next question comes from the line of Yaron Kinar from Jefferies.
Yaron Kinar: Hey, good morning, everybody. Should I ask the questions or should we wait till this issue is fixed?
Marc Grandisson: I think we should continue on. Just ask your question. It's recorded. Hopefully people can --
François Morin: There will be a replay.
Marc Grandisson: Yes, it'll be a replay for everyone, hopefully. We apologize for this, but we'll try to figure it out afterwards. Let's go for it in line, yes.
Yaron Kinar: Yes. No problem. So I guess first question, when you set loss fix into a year, do you update those other than for bad news or frequency? And what I'm trying to get at here is when we look at the reinsurance loss ratios, are they already incorporating the step change in the reinsurance market that we saw in 2023, or were those losses or the loss ratio essentially a reflection of your expectations heading into 2023 and we should therefore see another step up in margins over the course of 2024?
Marc Grandisson: Yes, I think our tendency when we do loss ratio of fixed; you're on, especially on the long tail line. Remember François mentioned that earlier, we're much more of a short tail player than we were in proportion, right? So property is a bit easier to understand, right? It is what it is. You get the loss, you don't get the loss. So you do pick the loss ratio at the end of the year for what you think the attritional will be and there's no cap, then you can't really book the cap, right? There's a couple of things you need to address. On the liability and then we'll see over the next 12 months how it develops. And there are cadences of releasing or decreasing the IDNR on property, that's a bit shorter tail as you can appreciate. On the liability side, our tendency as an insurance or reinsurer on both sides of the equation of the aisle is to actually pick a loss ratio that has a little bit of a margin of safety at the beginning, not 100%, recognizing all potential benefits that we've seen, and we let it season for a while before we go in and make a change to them. And what we look at is obviously how the emergence, which I mentioned about, you may not have heard this one, but I mentioned about the emergence of the losses, how they are emerging versus what we expected. And you do this throughout the lifecycle of the deal, but that's a longer-term phenomenon.
Yaron Kinar: Got it. And then my second question Marc, I think in your prepared comments you'd said that casualty may be collectively worse than expected for the industry. And I'm curious that comment, is that really referencing kind of the soft market years of 2013 through 2018 or 2019? Or do you think there could also be some of that emerging for the more recent accident years, where market conditions were clearly good, but maybe the expectations of inflationary trends were still a bit lower than what they ended up being?
Marc Grandisson: It's a really good question, Yaron. My -- our -- we look at the actual as expected and we see it much more in the softer years, to be honest with you. The recent ones, it's here or there, plus or minuses as François mentioned, but it's all well, as far as we can tell, our portfolio is well within a range of reasonable expectations. It's nothing really that's surprising because your honestly, remember starting 2019, there were improvements in the marketplace, there were price increases already. So I think that those years are not as soft, clearly not as soft as 2016 to 2019 were.
Yaron Kinar: Right. But I guess the question would be, even if they weren't as soft and you were getting a lot of piece, the industry was getting a lot of rate at that point, if the expectation was for a inflationary trend of five and it ended up being seven, you could still see some deterioration of very profitable years nonetheless.
Marc Grandisson: You could, but we do reserving with the rate level in mind. So when we were writing the bids in 2021, we tend to look at a longer-term loss ratio and not the more recent years that before the stock market, for instance. So when you factor it all that in, we will tend to take higher loss ratio pick initial loss ratio, pick ourselves on the liability side. So you don't have a similar. One of the things that happened in 2016, 2019, and it was mentioned before is that people probably were more aggressive than they should have been on the loss ratio pick that they did in those years. I think by the time we get to 2021, I think already there was recognition and we saw through the rate increases that the market was trying to get to. I think the loss ratios lifted up a little bit, and I don't think we have a similar kind of deviation from initial loss ratio in those years.
Yaron Kinar: Got it. I'll just end by saying I think you disappointed a lot of swifty fans, including my daughter, by referencing rest of world football instead of U.S. football this quarter.
Marc Grandisson: We'll do better its looks like.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Bob Jian Huang from Morgan Stanley.
Bob Jian Huang: Hey, good morning. Just two quick ones. First, I think two quarters ago on the earnings call, you said when we look at the insurance underwriting cycle, we were at about 11 o'clock. That’s kind of where we were implying improved rates and also lost trend stabilization. Just curious, in your view, what time is it right now? Is it 11:30 or is it 11:59, 2:00 p.m.? Just kind of curious is it where you think.
Marc Grandisson: It’s the longest 11 o'clock I’ve ever seen in my life is what I’m going to tell you. So I think we’re still roughly around the 11 o'clock , which again, that clock is never like a one year after the other, right? You can stay 11:00. Unfortunately, you can stay into the 3 o'clock and 4 o'clock or where that you would want. So I think that it’s still roughly around that level the 11 o'clock , 11:30, perhaps in some cases, but, yes, roughly in that range.
Bob Jian Huang: Okay. That’s helpful. 11:00 to 11:30, that's very helpful. Thank you.
Marc Grandisson: Yes.
Bob Jian Huang: My second question regarding MGA and capacity in general, there has been some concern that MGAs have been increasingly aggressive. Is this something you're seeing? Is this concern rightfully placed? Does it have any impact on how you think about your underwriting cycle management? Are you becoming more cautious, especially within your reinsurance? Not sure if you answered that before, so apologies.
Marc Grandisson: That's a great question. I think I mean the MGAs emerge, as we all know, when there’s a dislocation where there's need for capacity. And I think we see it more acutely in the professional lines and some of them in property. But again, between the supply and demand on the professional lines, I think now that the capacity is probably more plentiful than. It's not more probably, it is more plentiful than it was. So I think it has some impact at the margin. Of course it does. I think the answer to your second part of the question, which is, how do we react? Well, we do it, the same way we always do it, which is if the pricing is going down and the returns are not as good. We will tend to deemphasize or pick or select the better clients that we have in our portfolio and still react the same way we would do in cycle management. On the property side, we also have similar MGAs and MGUs, right? But I think these guys, there’s an acute need for property coverage and capacity. And I think it sort of feels that we need all the capacity we can get our hands on a property at this point in time. So we're not seeing that much of as much of an impact. The property market is still very strong.
Bob Jian Huang: Okay. So property side, not enough capacity, professional line, plentiful capacity. That's the way we should think about it. Thank you.
Marc Grandisson: Yes, that's right.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Meyer Shields from Keefe, Bruyette & Woods.
Meyer Shields: Hi, I think we're in the same situation where people can only hear the answers to their specific questions. So I'm hoping that comes through here as well. Similar question to Bob, we've seen, obviously, a number of companies report some reserve problems in the fourth quarter. And I'm wondering, when you look at the book of sedans that you have within reinsurance, is what we're seeing in the public companies a good representation of overall trends, or is it something different in the non-public world?
Marc Grandisson: Well, I think when you price -- Meyer, good question. But for the record, this will be recorded, right? So we'll be able to -- so this will be recorded. So we'll be able to share, you’ll be able to hear the other questions and the other answers. Sorry, is that okay?
Meyer Shields: Yes, that's perfect. Thank you.
Marc Grandisson: So I think the issue with casualty reserving, and you’re an actuary as well as I am, the actual number is in the high of whoever is doing the work. So I think it's like everything else. Our teams may have different views about the loss ratio pick for some of the things that we’re looking at than they would have themselves. So I wouldn't say that it's a one to one. Some of them will not renew, or some of them we may not be able to participate on because we have a different view of the ultimate loss ratio. So I think it's really each individual underwriter and each individual company or sitting company come up with their own number and you have to make your own decision and your own opinion as to where it is.
Meyer Shields: Okay. I'm sorry, go ahead.
Marc Grandisson: No, no, go ahead. I was wondering whether you were still there, so carry on, please.
Meyer Shields: Yes, no, I'm still here. Similar question, I guess, obviously what we've seen here is a lot of domestic concerns over liability lines on the international casualty side, is that concern worsening as well, or should we think of that as just a domestic concern?
Marc Grandisson: It's a similar issue. It's not to the same acuteness in some kind of level, but the world has similarly closed down in a courts. It's not as litigious internationally as you would expect, but we're still seeing some hardening in international casualty as well. We saw this for the last two, three years. So it’s a very similar hardening of the market, may not be as acute in terms of reserving potential issues. And I'm not talking now to the globals that are internationally underwriting internationally, that's a different story, right? If they write in the U.S., they will have similar issue, but there is similar issues all around, but it's not to the same level internationally we’d see in the U.S.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Elyse Greenspan from Wells Fargo.
Elyse Greenspan: Hi, thanks for taking the follow-up. I will say I think you have a lot of folks wondering who's writing the coverage for your conference call provider. But my follow-up is on casualty insurance. Can you give us a sense of the loss trend that you're booking your casualty insurance book to and what rate you're getting in casualty insurance as well?
Marc Grandisson: Well, it depends on line of business, Elyse, but I think the numbers you hear around 7, 8, 9, 10, sometimes it's 5. It depends on line of business, depends on the attachment point, it depends on the limit that you provide, depends on the size of risk. But the numbers you hear -- the numbers that are heard around the marketplaces, we see the similar phenomenon. I think we've said it historically, it's coming -- it's happening as we speak, that the insurance trend in liability generally will out pay the CPI increase. And we're seeing this coming back, so with 200, 300 basis points above. So we’re largely consistent with those kinds of pick.
Elyse Greenspan: So loss trends, you said 7, 8, 9, 10, but can vary by line and sometimes be 5%. Where would you put the price increase?
Marc Grandisson: Oh, again, depending on line of business, but we're low to mid-teens, I would say right now.
Elyse Greenspan: Okay. Low to mid-teens. I'm just also repeating. So folks listening?
Marc Grandisson: Yes, I appreciate. I appreciate, Elyse. Thank you. Yes.
Elyse Greenspan: Can't hear the answer. So low to mid-teens. Yes, I think that's one, I guess on your, one last one, your cat, you said your PML went a little bit higher, right? But the percent of equity is lower, given the equity rise in the quarter, where would you put your cat load at the start of 2024?
François Morin: Well, certainly up from 2023, right. I'd say for the year, we’re looking at somewhere loss ratio points, right? Call it 7% or so of like 6% to 8% of like our premium would be kind of like the cat load.
Elyse Greenspan: Okay. 6% to 8% cat load. Thank you for taking the follow-up.
Marc Grandisson: Thanks, Elyse.
François Morin: You're welcome.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Cave Montazeri from Deutsche Bank.
Cave Montazeri: Good morning, guys, it's Cave.
Marc Grandisson: Good morning.
Cave Montazeri: Hey, I have a question on reinsurance terms and conditions and attachment points. Does feel like overall the industry probably took on more high frequency, low severity risk than they should have over the past couple of years. And now maybe on aggregate reinsures are probably more willing to negotiate on price than on attachment points or terms and conditions. Just tell me what your view is on that topic.
François Morin: Are you talking about property?
Cave Montazeri: Yes, property.
François Morin: Yes. I think -- well, I think what we’ve seen is we continue to see is that a lot of lower layers historically for the last four or five years turn out to be just swapping money, trading dollars back and forth. And there was a lot more activity, perhaps of frequency, as you mentioned, and the reinsurance market was willing to take on. So there was a natural tendency to try to increase a premium at those level but then at some point it breaks down in a sense that the client is buying the reinsurance protection, is paying more for things than they actually realize they should be retaining. That's why you've seen retention go up. Now in a sense, by virtue of having a higher retention, then they have to turn on and then that's what we've seen, they’re turning onto their own portfolio and try to manage and make it better and improving the aggregate loss that they have there. I'm sorry about this. I think that what we're seeing on the cat excessive loss right now is that people are buying more on top because they also are appreciating and evaluating the total level of exposure capacity needed in PML. So I think what people -- what we're seeing is people trading away the bottom layers and buying more on top. And I think we're going to see that a bit more as we go into 2024, which totally makes sense.
Cave Montazeri: Okay. My follow-up question is on mortgage insurance. Now you had been kind of pulling back even before activity came to a halt. But if the fed rate cuts, if they do come lead to a pickup in the U.S. activity in the housing market, would you be happy to grow in line with the market or should we expect you to kind of grow maybe less stuff in the market?
Marc Grandisson: Yes, mortgage, absolutely, we would be. I think that -- yes, the answer is we would be more than happy. We have capacity, capital to be able to deploy and I think we would be very, very pleased to do more. Absolutely.
François Morin: And as you know it's been a very good market, very rationale market. So obviously, the rates were able to charge for the risk will matter and where we -- how we position the book. But in terms of our ability to grow, when we get originations go up, we're absolutely capable and willing to do that.
Operator: Thank you. One more for our next question. Our next question comes from the line of David Motemaden from Evercore.
David Motemaden: Hi, thanks. Good morning, and apologies, I haven't been hearing the answers, so not sure if you've answered any of these already. But just Marc, you spoke a little bit at the beginning of the call about the need or the strategy to lean in at the early part of a hard market. I guess how do you manage that with potential false starts? It sounds like casualty market on the reinsurance side hasn't hardened as quickly as you've expected. But how do you manage that just internally between writing business that might be hardening, but not totally to where you think it should go and the potential for false starts?
Marc Grandisson: It's a very, very good question. And I think this is where the Arch comes into play; right, in experience and knowing some of the markings of a hardening market, a lot of it also has to do with things you won't hear, right, is our underwriting team sitting down with clients, potential clients, and try to understand, how do you think about the risk? I've talked about reinsurance now specifically, and we also have a very healthy database like everyone else, but we also have our own, and we have our own view of claims and how it develops. And we have, again, experience over 20 years of data and information. And this is what we use to hopefully get the compass in the right order. But if I can't be sitting here and tell you and pretend that we're going to get everything right 100%, it's a little bit more art and science. And I would think that as I'm getting older, the psychology of the market is becoming way more important, feels to me, than even the numbers. And that's probably what compelled me or what made me ask the team to lean into 2019. And you don't know for a fact until it's done, but there are markings or signs in the overall market that help you and support your decision to lean into it heavily. That's all I can tell you, because it's really not a one for one. There’s no like one number one spreadsheet I can point to that will tell you the answer.
François Morin: And the one thing I'll add quickly, David, is the reverse is true as well. When the market goes soft, sometimes you pull back and you might go back too early. But that's the game we play. That's the business we're in, and we do our best. Again, we're never going to time it perfectly, but what matters more is the direction of it. And then over the cycle, we think we should come out ahead.
David Motemaden: Yes, no, understood. That makes sense. And then Marc, you had mentioned that at 1/1 the property market continued to improve, property cat reinsurance market. I guess as we sit here today and sort of looking forward at the sustainability of that as we move through 2024, what's your view now on that and the growth opportunities in property cat?
Marc Grandisson: First, we have no growth constraints per se. We can grow. As you know, François mentioned, the value of our PML is 9.2%, so we have room to grow there. I think the question about where it's going to go is so difficult to answer because it's dependent on what happens and what kind of activity we see this year. But if I would probably point to you to the 2006 turn of the market in 2007, that's probably a better way to think about it. 2006, or 2007, 2007 was a better year than 2006. And 2008, 2009, and 2010 were really, really good years in property because the market, as we all know, goes up really, really quickly but does not go down in one fell swoop. You've got a lot of sustainability in the returns for a little while. It takes a while before things get too close to the line or below the line of what we want to adjust. So we have some runway in front of us.
David Motemaden: Got it. Understood. And I know in the past you've said alternative capital, or ILS can -- has the ability to swing the market one way or the other. What exactly are you seeing there?
Marc Grandisson: What we hear is there’s still a very high demand for returns which prevents or high demand for returns and also still some level of skepticism that might change, but we'll see where that goes. But clearly, right now, at the margin, some increases, but it's not the wave that we saw probably in 2014, 2015, 2016, nowhere near that.
Operator: Thank you. Arch Capital Group answers have been captured and will be available in the replay. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: First of all, I want to apologize thoroughly for the call quality and the dropping in and out. There will be a recording available for replay, and you know, our two esteemed colleagues, Don and Vinay will be available to follow-up obviously. I want to thank you for listening to our call and I'm looking forward to speak to you again in April. Thank you very much.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Q4 2023 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with this update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filled by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management will also make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the Company's current report on Form 8-K furnished to the SEC yesterday, which contains the Company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sirs, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, Gigi. Good morning and thank you for joining our earnings call. Our fourth quarter results conclude another record year as we continued to lean into broadly favorable underwriting conditions in the property and casualty sectors. Our full year financial performance was excellent with an annual operating return on average common equity of 21.6% and an exceptional 43.9% increase in book value per share, which remains an impressive 34.2% if we exclude the one-time benefit from the deferred tax asset we booked in the fourth quarter. The $3.2 billion of operating income reported in 2023 made it Arch's most profitable year-to-date. Growth was strong all year as we allocated capital to our property and casualty teams, we short over $17 billion of gross premium and over $12.4 billion of net premium. And while most current growth opportunities are in the P&C sector, it's important to recognize the steady quality underwriting performance of our mortgage group. Although, mortgage market conditions meant fewer opportunities for top-line MI growth, the business unit continued to generate significant profits totaling nearly $1.1 billion of underwriting income for the year. As we have mentioned on previous calls, those earnings have helped fund growth opportunities in the segments with the best risk adjusted returns, demonstrating that the disciplined underwriting approach and active capital allocation are essential throughout the cycle. Our ability to deploy capital early in the hard market cycle is paying dividends as we own the renewals, a phrase I learned from Paul Ingrey, a personal mentor and foundational leader of Arch. What Paul meant was quite simple. When markets turn hard, you should aggressively write business early in the cycle. This puts your underwriters in a strong position to fully capitalize on the market opportunity. By making decisive early moves, you won become an [indiscernible] then want to do more business with you. In some ways, the growth becomes self-sustaining, which explains part of our success throughout this hard market. At Arch, our primary focus has always been on rate adequacy, regardless of market conditions. Our underwriting culture dictates that we include a meaningful margin of safety in our pricing, especially in softer conditions. And we also take a longer view of inflation and rates. For these reasons, Arch was underweight in casualty premium from 2016 to 2019, when cumulative rates were cut by as much as 50%. I thought I'd borrow a soccer analogy to help explain the current casualty market. In soccer, players who commit a deliberate foul are often given a yellow card. Two yellow cards mean the player is ejected from the remainder of the match and their team continues with a one player disadvantage. Today's casualty market feels as though some market participants took to the field with a yellow card from a prior game. They're playing in match but cautiously, not wanting to make an error that will put their entire team at a disadvantage. So whilst Arch sometimes plays aggressively, we've remained disciplined and avoided drawing a yellow card. At a high level, we must remember that casualty lines take longer to remediate than property. So if insurers are being cautious and adding to their margin of safety, we could experience profitable underwriting opportunities in an improving casualty market for the next several years. Now, I'll provide some additional color about the performance of our operating units, starting with reinsurance. The performance of our reinsurance segment last year was nothing short of stellar. For the year, reinsurance net premium written were $6.6 billion, an increase of over $1.6 billion from 2022. Underwriting income of nearly $1.1 billion is a record for this segment and a significant improvement from the cat heavy 2022. Reinsurance underwriting results remain excellent as we ended the year with an 81.4% combined ratio overall in a 77.4% combined ratio ex-cat and prior year development both significant improvements over 2022. Turning now to our insurance segment, which continued its growth trajectory by writing nearly $5.9 billion of net premium in 2023, a 17% increase from the prior year. While the business model for primary insurance means that shifts may not appear as dramatic as our reinsurance groups, a look at where we've allocated capital year-over-year provides meaningful insight into our view of the market opportunities. In 2023, the most notable gains came in from property, marine, construction, and national accounts. The $450 million of underwriting income generated by the insurance segment in 2023 doubled our 2022 output as we continue to earn in premium from our deliberate growth during the early years of this hard market. Underwriting results remained solid on the year as the insurance segment delivered a combined ratio of 91.7% and a healthy 89.6% excluding cat and prior year development. Now on to mortgage, our industry-leading mortgage segment continued to deliver profitable results, despite a significant industry-wide reduction in mortgage originations last year. The high persistency of our insurance in-force portfolio, which carries its own unique version of owning the renewals, enables a segment to consistently serve as an earnings engine for our shareholders. The credit profile of our U.S. primary MI portfolio remains excellent and the overall MI market continues to be disciplined and returned focus. These conditions should help to ensure that our mortgage segment remains a valuable source of earnings diversification for Arch. Onto investments, net investment income grew to over $1 billion for the year due to rising interest rates that enhanced earnings from the float generated by our increasing cash flows from underwriting. The significant increases to our asset base provide a tailwind for our creative investment group to further increase its contributions to Arch's earnings. Over the past several years, Arch has leaned into both the hard market and our role as a market leader in the specialty insurance space. We have successfully deployed capital into our diversified operating segments to fuel growth, while also making substantial operational enhancements to our platform, including entering new lines, expanding into new geographies and making investments into new underwriting teams, technology and data analytics. Finally, as we bid adieu to 2023, I want to take a moment to thank our more than 6,500 employees around the world who help deliver so much value to our customers and shareholders. Our people are our competitive advantage and without their creativity, dedication and integrity, none of this would be possible. So thank you to team Arch. François?"
},
{
"speaker": "François Morin",
"text": "Thank you, Marc, and good morning to all. Thanks for joining us today. As Marc mentioned, we closed the year on a high note with after-tax operating income of $2.49 per share for the quarter for an annualized operating return on average common equity of 23.7%. Book value per share was $46.94 as of December 31, up 21.5% for the quarter and 43.9% for the year aided by the establishment of a net deferred tax asset related to the recently introduced Bermuda Corporate Income Tax, which I will expand on in a moment. Our excellent performance resulted from an outstanding quarter across our three business segments highlighted by $715 million in underwriting income. We delivered strong net premium written growth across our insurance and reinsurance segments, a 22% increase over the fourth quarter of 2022 after adjusting for large non-recurring reinsurance transactions we discussed last year, and an excellent combined ratio of 78.9% for the Group. Our underwriting income reflected $135 million of favorable prior year development on a pretax basis or 4.1 points on the combined ratio across our three segments. We observed favorable development across many units, but primarily in short day lines in our property and casualty segments and in mortgage due to strong cure activity. While there were no major catastrophe industry events this quarter, a series of smaller events that occurred across the globe throughout the year resulted in current accident year catastrophe losses of $137 million for the Group in the quarter. Overall, the catastrophe losses we recognize were below our expected catastrophe load. As of January 1, our peak zone natural cat PML for a single event, one in 250-year return level on a net basis increased 11% from October 1 but has declined relative to our capital and now stands at 9.2% of tangible shareholders equity, well below our internal limits. On the investment front, we earned $415 million combined from net investment income and income from funds accounted using the equity method, up 27% from last quarter. This amount represents $1.09 per share. With an investable asset base approaching $35 billion, supported by a record $5.7 billion of cash flow from operating activities in 2023 and new money rates near 5%, we should see continued positive momentum in our investment returns. Our capital base grew to $21.1 billion with a low leverage ratio of 16.9%, represented as debt plus preferred shares to total capital. Overall, our balance sheet remains extremely strong and we retain significant financial flexibility to pursue any opportunities that arise. Moving to the recently introduced corporate -- Bermuda Corporate Income Tax. As mentioned in our earnings release and in connection with the law change, we recognized a net deferred tax asset of $1.18 billion this quarter, which we have excluded from operating income due to its non-recurring nature. This asset will amortize mostly over a 10-year period in our financials, reducing our cash tax payments in those years. All things equal, we expect our effective tax rate to be in the 9% to 11% range for 2024, with a higher expected rate starting in 2025. As regards our income from operating affiliates, it's worth mentioning that approximately 40% of this quarter's income is attributable to non-recurring items such as Coface adoption of IFRS 17 and the establishment of a deferred tax asset at summers in connection with the Bermuda Corporate Income Tax. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from the line of Elyse Greenspan from Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks. Marc, my first question, I wanted to expand on some of your introductory comments just on the casualty side, right? We've started to see some reserve additions this quarter, and I think you alluded to that last quarter as being what was going to drive the market turn. So how do you see it playing out from here? I know you said it should play out over the next several years. Could you just give us a little bit of a roadmap in how you think about this opportunity emerging for Arch?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. Great question. I think that we're observing our own book of business. We also look at all the information around; I think from an actuaries perspective both François and I have maybe dusting off our actuarial diplomas. You rely on data that's historically stable, or at least has some kind of predictability. I think what we've seen over the last two, three years, as a result of the pandemic, largely in the courts being closed and everything else in between all the uncertainty and then the bout of inflation, there's a lot of data that's really hard to pin down and get comfortable with to make your prediction for what you should be pricing the business. As we all know, reserving leads to the pricing, right, by virtue of reserving and having the right number for the reserving, you then feed that into your pricing. So we're in a situation where people have lesser visibility or about what the reserving will ultimately develop to. So I can totally understand our clients and our competitors having to adjust on the fly, or having to adjust a little bit progressively and cumulatively. The issue with casualty, at least as you know, is even if you have that information and you make some correction of corrective actions, it still takes a while to evaluate whether what you did was enough or whether what you needed to do. So I think right now, we have -- we already had a couple of rate increases in casualty starting in 2020. But I think that now we're realizing that maybe it's a little bit worse collectively as an industry than we thought. And there's a lot more uncertainty, a lot more inflation, certainly, as we all know, is a big factor. So what I would expect right now is people will start refining their book of business. They will try to re-underwrite away from the social inflation impact lines. They'll probably push for rates. Some of them might kick some business to E&S until such time as we have more stability in the reserving now the loss emerges as it relates to what your initial pricing assumptions was. And in casualty, that's why it takes several years and its history is any indication. If you look back at the -- even the [indiscernible] market and then the yo tutors the 90s -- 1999 or 2000 to 2003, it took three to four years from the start of that, even in the middle of it, to really get clarity. And the market got much harder, in fact, in 2004 or 2005 than it was in 2002. Just because you have to do the action and see what the actions did, what you thought. And I think that's what we're going to collectively as an industry are going through and we're seeing it with our clients and that's really what's happening."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks. And then, my second question, second quarter in a row, right, we've seen the underlying loss ratio within your reinsurance business come in sub-50, and you guys are obviously earning in like cat business written at strong rates last year. How should we think about the sustainability of a sub-50 underlying loss ratio within your reinsurance book?"
},
{
"speaker": "François Morin",
"text": "Well, sustainability is a great question. I think you're absolutely right that we have more property premium that is more short tail and should have a lower loss ratio ex cat than not, right, compared to other lines. It's a good market. So obviously profitability embedded in the business should be strong. But we send you back to kind of quarterly volatility, where you are -- sometimes we have a better than, call it normal quarter, even as a function of the book and sometimes not. There's going to volatility. We said it before; we said again the 12-month kind of rolling average is to us a better way to look at it and that's how we see it. But certainly we like the profitability in the book and it should be -- it should remain strong. One thing I will tell you Elyse, by heard on the other calls is that the markets -- reinsurance market is continuing to improve somewhat into the one, one renewal. So it is still a very good marketplace. So what it means for the loss ratio, I don't know. But certainly, we're seeing improvement."
},
{
"speaker": "Elyse Greenspan",
"text": "And then, just one last one on capital, right? I believe on there was some pushes and pulls from the S&P capital changes on your capital but should be positive relative to your mortgage business. Can you just help us think through your capital position and relative to just organic growth opportunities you see at hand over the next year."
},
{
"speaker": "François Morin",
"text": "Well, certainly, I mean S&P is one thing that we look at. We look at many different way -- I mean, we have different looks at capital adequacy. We have our own internal view which drives really how we make our decisions. Rating agencies are an important factor but I think more importantly is how we think about it. But you're right. I mean no question that from the S&P point of view, I mean the change of their model was a net benefit and that's reduced kind, you know give us, I say a bit more excess capital. But we -- and we look at it very carefully. We want to make sure that we're able to seize the opportunities that will be in front of us and we see plenty for 2024. So right now our very -- our main focus is growing the business and kind of deploying that capital into what's in front of us and then we'll see how the rest of the year plays out."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Andrew Kligerman from TD Cowen."
},
{
"speaker": "Andrew Kligerman",
"text": "First question -- good morning. First question would be around M&A, we've seen a lot in the media about other specialty players that could be acquired. Arch has been mentioned along with other companies. And I know you can't comment on specific transactions and that you've talked a lot about 15% return on capital over time. But when you do transactions, could you give us a little color on what the parameters might be, what's really important to Arch when you do deals?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. On the M&A front, we're very prudent and careful when we do -- if we do anything. And I think historically, our historical track record is probably the best way to look at this. We'll look for something where our opportunities to earn a return is with a proper margin of safety is fairly healthy. We're not -- there's no desire to grow for growth sake in this company. It really has to do with the return on capital. And as François mentioned, the fact that we have opportunities to above 15% opportunities in this marketplace certainly makes it a little more harder. Having said all this, we might make not exceptions, but there might be some other considerations as it relates to maybe a strategic, maybe a different kind of product, maybe a geography, or maybe -- and we prefer that, maybe a new team that can really bring the expertise on an underwriting basis. So it's a very, very disciplined approach to M&A that we take. And we have the luxury because we have plenty of organic growth available to us. So something has to be very compelling for us to engage in those and also other risks, as you all know, that we don't want to take on necessarily the number one is the culture. Now we're very, very adamant about keeping top culture the way it is, and that's really something. And that quite oftentimes the thing that makes the most, and then -- probably the one that makes the most difference in whether or not we'll entertain an M&A or not."
},
{
"speaker": "Andrew Kligerman",
"text": "That makes a lot of sense. You mentioned on the favorable developments that short tail property was a big driver. So looking at insurance at $21 million favorable, reinsurance at seven favorable. Just trying to understand, were there any large casualty offsets that might have played in and if so, what would they be?"
},
{
"speaker": "François Morin",
"text": "Yes, well, there's no, I'd say offsets. I mean, we look at each line on its own. There's always going to be pluses and minuses on that every single quarter. We look at the data, we react to the data. I think, as you can imagine, or I mean, very much a function of the type of business that we've written the last few years we -- in reinsurance in particular, we've grown a lot in property. We've taken our usual -- used our same methodology, same approach to reserve, and that generated a little bit of redundancies or releases this quarter on the short tail side. There's always a little bit of noise on any line of business. Yes. Did we have a couple of sublines or kind of sales in casualty where we had a little bit of adverse? Absolutely, but it's not -- I wouldn't call it an offset. I mean, we booked every single line on its own. We reacted to data, and then when numbers come up is what we end up with."
},
{
"speaker": "Marc Grandisson",
"text": "One thing I would add to this, our reserving approach at a high level is to typically recognize bad news quickly and good news over time. So again, our philosophy hasn't changed at all in all those years."
},
{
"speaker": "Andrew Kligerman",
"text": "Maybe if I could sneak one quick one in. You mentioned during the call that one of the growth areas in insurance was national accounts. What type of limits do you write on national accounts?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, it's statutory, right? So -- and it's on an excessive loss basis. And these are loss. There's a lot of sharing of experience, plus or minus business with clients. They tend to be larger clients. The national account is 95% plus workers comp. It's really a self-insured sort of structure that of sort, we provide the paper and actually the document to allow people to operate in their state because you need the required thing to be able to demonstrate the workers comp insurance as a protection. This is statutory, so it's unlimited by definition. We have some reinsurance that protect some of the capping. That's really what it is."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Jimmy Bhullar from JPMorgan."
},
{
"speaker": "Jimmy Bhullar",
"text": "Hey, good morning. So, first, just a question on the casualty business. We've seen significant growth in your property exposures with the hard -- since the hardening of the market, or significant hardening the market since early last year. What are your views on just overall market trends on the casualty side, and are you comfortable enough with pricing in terms to increase volumes in that area?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, I think our comfort -- great question. Our comfort on the casualty, on liability in general, more general liability, right, if you exclude professional lines, I think we're -- the market is turning or has more pressure on the primary side. So I think that our focus right now is really on the primary, as you can see on our reinsurance, what we did in reinsurance for the last year, we think the reinsurance market is a little bit delayed in reacting to what happened, as in some of the development that we see and some of the increase in inflation. And of course, for your point that we mentioned. So I think that we'll probably see first an insurance market that really takes it to hard, like I mentioned, all the remediation that they need to do. And I think the reinsurance market will probably follow suit with their own -- possibly their own way to look at this, if the prior hard markets are any indication. On the reinsurance side, one thing that's a little bit beneficial at this point in time, and there's a reason why reinsurers are not reacting possibly as abruptly as they probably should as in regards to city and commission is that we collectively understand as an industry that our clients are trying to make those changes, so we're trying to go along with them and help them, support them in their efforts. We'll see whether that's enough. Our team is a little bit waiting to see whether that develops, but I do expect this to also come around and also provide another opportunity for us to grow."
},
{
"speaker": "Jimmy Bhullar",
"text": "And then on mortgage insurance, I would have assumed that reserve releases would moderate over time, and they've actually become even more favorable. And I think there's a shift in what's driving that. It used to be COVID reserves last year, and now it's stuff written post-COVID. As you think about, just want to get an idea on what are you assuming in your reserves that you're putting on the book right now? Are you assuming experience commensurate with what you're seeing in the market or is it reasonable to assume that if the environment stays the way it is, there's more room to go in terms of reserve releases?"
},
{
"speaker": "Marc Grandisson",
"text": "Great question. I say reserve releases this year in general were somewhat driven by our -- the views we had on the housing market at the start of the year, right? So if you rolled back the tape a year, we were more concerned about home prices dropping fairly rapidly, recession, no soft landing, et cetera. So those reserves we set, call it a year ago were very much a function of those assumptions, and they just didn't materialize throughout the year. So throughout the year, we saw very strong or very well performing housing market. People are hearing their delinquencies much higher than we'd actually forecasted. Home prices are holding up. Unemployment remains relatively low. So you put it all together, I mean it's really, what transpired in 2023 is very much a function of the reserve releases reflect kind of how things -- how much better they played out relative to what we thought a year ago. Where we are today at the start of 2024 is certainly a bit more, I wouldn't call it optimistic in the sense that we see good home prices and a solid housing market for 2024. So on a relative basis, the reserves that we're holding today are not as high as they were a year ago. So if you extrapolate from that, is there room for as much in reserve releases going forward? Probably not, but we just don't know. I mean, the data will again play out as it does and we'll react to it, but hopefully that helps you kind of compare and understand how, where we sit today versus a year ago."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. Thanks. And just lastly, your comfort with the reserves in your casualty book, despite all the industry-wide issues, does that apply to the business that came over from Watford as well? Because that company obviously had a decent amount of exposure to casualty."
},
{
"speaker": "Marc Grandisson",
"text": "That's an easy one. Watford, really the underwriting is managed by our team here. So the reserving and approach [Technical Difficulty] okay."
},
{
"speaker": "Jimmy Bhullar",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Michael Zaremski from BMO."
},
{
"speaker": "Michael Zaremski",
"text": "Hey, good morning. First question for François on capital in regards to mortgage specifically. So my understanding of the mortgage reserving rules is that after a decade or so, you can start releasing a material amount of reserves. And mortgage obviously isn't growing now, so -- but you also have a Bermuda, I think some captives there too. So just curious, is there a material amount of capital coming or expected to come from releasing from the legacy mortgage or old mortgage business?"
},
{
"speaker": "François Morin",
"text": "Well, I'd say the short answer is yes, in the sense that the contingency reserves. You're right, we will start releasing a bit more progressively, starting in 2024 and 2025. That will be -- and we already had some of that in the fourth quarter this year. So if you look at our PMI's ratio, why it dropped in the quarter, the fourth quarter was very much a function of a dividend that we were able to extract from our regulated USMI Company to the Group. So that we think, well, should the plan and is scheduled to keep, we should keep having dividends in 2024 and beyond. But the one point I want to touch on is, and we touched on it in the past is while on a regulatory basis, yes, it's released, we would argue that capital is already somewhat being deployed in the business. So it's not -- that it's just sitting there not being deployed in the business. It's already been used to other sources because the regulators and the rating agencies look at the aggregate Arch Cap Group kind of level of capital. So yes, on the statutory basis, the goal here is to put the capital in the better location. But overall, it's somewhat not as big an impact as you might imagine."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. That's helpful. And sticking with capital, when Elyse asked about you mentioned the S&P Capital model, but I don't think you actually gave any quantitative or answers on the benefit, because when we -- on paper we see that Arch appears to be one of if not the most diversified. Any help there on how much of a benefit or how to think about how much of a benefit the model offers Arch?"
},
{
"speaker": "François Morin",
"text": "Yes, you're right. I didn't put a number, and we're not going to start putting a number, but it's a net positive. No question that, yes, mortgage charges, diversification benefit were reductions in capital requirements, but we also -- the final rulings on debt was not as favorable, right? So S&P and their new rules, they no longer treat $1.75 billion of our debt as being capital. So that's a significant offset. But all things considered, all in, it's a positive. But again, what I want to remind everyone is it's not the only thing we look at, it's just one thing among many and other rating agencies matter. And more importantly, again, is how we think about the capital we need to run the business."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. And lastly, since everyone else is sneaking in a lot more questions, based on the remarks you've made it, unless I'm understanding it incorrectly, it sounds like the growth might be you're more excited about the primary insurance segment. Can primary insurance potentially grow just as much in 2024 as it did in 2023?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a great question. I mean, again, the way we talk, we don't provide guidance because I don't know, we don't know what the market conditions will be this year. But in terms of capabilities and capital and talent and everything else in between, absolutely, we have -- we could do more. Yes, we could. If the opportunities are there, we'll do more, both on insurance or reinsurance for that matter."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Josh Shanker from Bank of America."
},
{
"speaker": "Josh Shanker",
"text": "Hey, everyone, I think there might be a problem with the phones. We heard Jimmy and Mike just fine, but we couldn't hear your answers to the questions. I don't know. So -- and I hear you. I don't know if anyone can hear me. Let me ask my team. Can you guys hear me on the phone? They hear me. So somehow it's been corrected. Okay, so I don't know what --"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, Josh, we can hear you. So hopefully, it's been recorded. I don't know if it's been recorded."
},
{
"speaker": "Josh Shanker",
"text": "Okay, very good."
},
{
"speaker": "Marc Grandisson",
"text": "Yes."
},
{
"speaker": "Josh Shanker",
"text": "So yes, I’ve got a couple of quick ones. So it's the lowest quarter of new insurance written in the mortgage insurance business since acquiring UGC. And yet it looks like the capital utilization went up, at least the risk to capital, and the premiers capital ratio went up. Can you sort of talk about the moving pieces that are driving that?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, our PMIers, -- well, very much a function of a Bellemeade transactions that we called Josh, I think there's significant amounts of capital protection that we exercised on and no longer give us capital credit."
},
{
"speaker": "Josh Shanker",
"text": "Yes, that's obviously what it is. Yes, definitely that makes sense."
},
{
"speaker": "Marc Grandisson",
"text": "Yes."
},
{
"speaker": "Josh Shanker",
"text": "And another easy one, it looks to me from quarter end 2000, September 30 to year-end, Coface stock was about flat, although it round tripped through the quarter. And yet you had very strong other income in the quarter. There's some summers in that. There's other things in there. Can you talk about the moving pieces?"
},
{
"speaker": "François Morin",
"text": "Well, Coface, I mean, the stock price is one thing, but obviously for us, we booked the income, right. And they declared pretty much. I don't know the exact numbers, but their dividend, their annual dividend has been close to their full net income, 100% kind of payout ratio. So that ends up being what we book in our financials. So yes, the stock price is going to move up and down over the year, but it doesn't directly, I'd say factor in or end up in their financials."
},
{
"speaker": "Josh Shanker",
"text": "Okay. And just so I'm getting a lot of inbound call volume or e-mails from people right now. Nobody can hear these answers that you're giving me. It may be being recorded. They hear me, but they don't hear you."
},
{
"speaker": "Marc Grandisson",
"text": "Hold on a second, Josh. Are we being recorded? Let's work a little bit through this quickly. Maybe we can fix it."
},
{
"speaker": "François Morin",
"text": "What's happening now?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes."
},
{
"speaker": "Josh Shanker",
"text": "Okay. So just so that I don't know. Anyway, they're addressing it. People can't hear the Arch team. But for people who are emailing you right now saying they can't hear the Arch team, they're working on addressing it."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Please note everyone that this call has been recorded and it will be available after the call is over. Our next question comes from the line of Yaron Kinar from Jefferies."
},
{
"speaker": "Yaron Kinar",
"text": "Hey, good morning, everybody. Should I ask the questions or should we wait till this issue is fixed?"
},
{
"speaker": "Marc Grandisson",
"text": "I think we should continue on. Just ask your question. It's recorded. Hopefully people can --"
},
{
"speaker": "François Morin",
"text": "There will be a replay."
},
{
"speaker": "Marc Grandisson",
"text": "Yes, it'll be a replay for everyone, hopefully. We apologize for this, but we'll try to figure it out afterwards. Let's go for it in line, yes."
},
{
"speaker": "Yaron Kinar",
"text": "Yes. No problem. So I guess first question, when you set loss fix into a year, do you update those other than for bad news or frequency? And what I'm trying to get at here is when we look at the reinsurance loss ratios, are they already incorporating the step change in the reinsurance market that we saw in 2023, or were those losses or the loss ratio essentially a reflection of your expectations heading into 2023 and we should therefore see another step up in margins over the course of 2024?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, I think our tendency when we do loss ratio of fixed; you're on, especially on the long tail line. Remember François mentioned that earlier, we're much more of a short tail player than we were in proportion, right? So property is a bit easier to understand, right? It is what it is. You get the loss, you don't get the loss. So you do pick the loss ratio at the end of the year for what you think the attritional will be and there's no cap, then you can't really book the cap, right? There's a couple of things you need to address. On the liability and then we'll see over the next 12 months how it develops. And there are cadences of releasing or decreasing the IDNR on property, that's a bit shorter tail as you can appreciate. On the liability side, our tendency as an insurance or reinsurer on both sides of the equation of the aisle is to actually pick a loss ratio that has a little bit of a margin of safety at the beginning, not 100%, recognizing all potential benefits that we've seen, and we let it season for a while before we go in and make a change to them. And what we look at is obviously how the emergence, which I mentioned about, you may not have heard this one, but I mentioned about the emergence of the losses, how they are emerging versus what we expected. And you do this throughout the lifecycle of the deal, but that's a longer-term phenomenon."
},
{
"speaker": "Yaron Kinar",
"text": "Got it. And then my second question Marc, I think in your prepared comments you'd said that casualty may be collectively worse than expected for the industry. And I'm curious that comment, is that really referencing kind of the soft market years of 2013 through 2018 or 2019? Or do you think there could also be some of that emerging for the more recent accident years, where market conditions were clearly good, but maybe the expectations of inflationary trends were still a bit lower than what they ended up being?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a really good question, Yaron. My -- our -- we look at the actual as expected and we see it much more in the softer years, to be honest with you. The recent ones, it's here or there, plus or minuses as François mentioned, but it's all well, as far as we can tell, our portfolio is well within a range of reasonable expectations. It's nothing really that's surprising because your honestly, remember starting 2019, there were improvements in the marketplace, there were price increases already. So I think that those years are not as soft, clearly not as soft as 2016 to 2019 were."
},
{
"speaker": "Yaron Kinar",
"text": "Right. But I guess the question would be, even if they weren't as soft and you were getting a lot of piece, the industry was getting a lot of rate at that point, if the expectation was for a inflationary trend of five and it ended up being seven, you could still see some deterioration of very profitable years nonetheless."
},
{
"speaker": "Marc Grandisson",
"text": "You could, but we do reserving with the rate level in mind. So when we were writing the bids in 2021, we tend to look at a longer-term loss ratio and not the more recent years that before the stock market, for instance. So when you factor it all that in, we will tend to take higher loss ratio pick initial loss ratio, pick ourselves on the liability side. So you don't have a similar. One of the things that happened in 2016, 2019, and it was mentioned before is that people probably were more aggressive than they should have been on the loss ratio pick that they did in those years. I think by the time we get to 2021, I think already there was recognition and we saw through the rate increases that the market was trying to get to. I think the loss ratios lifted up a little bit, and I don't think we have a similar kind of deviation from initial loss ratio in those years."
},
{
"speaker": "Yaron Kinar",
"text": "Got it. I'll just end by saying I think you disappointed a lot of swifty fans, including my daughter, by referencing rest of world football instead of U.S. football this quarter."
},
{
"speaker": "Marc Grandisson",
"text": "We'll do better its looks like."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Bob Jian Huang from Morgan Stanley."
},
{
"speaker": "Bob Jian Huang",
"text": "Hey, good morning. Just two quick ones. First, I think two quarters ago on the earnings call, you said when we look at the insurance underwriting cycle, we were at about 11 o'clock. That’s kind of where we were implying improved rates and also lost trend stabilization. Just curious, in your view, what time is it right now? Is it 11:30 or is it 11:59, 2:00 p.m.? Just kind of curious is it where you think."
},
{
"speaker": "Marc Grandisson",
"text": "It’s the longest 11 o'clock I’ve ever seen in my life is what I’m going to tell you. So I think we’re still roughly around the 11 o'clock , which again, that clock is never like a one year after the other, right? You can stay 11:00. Unfortunately, you can stay into the 3 o'clock and 4 o'clock or where that you would want. So I think that it’s still roughly around that level the 11 o'clock , 11:30, perhaps in some cases, but, yes, roughly in that range."
},
{
"speaker": "Bob Jian Huang",
"text": "Okay. That’s helpful. 11:00 to 11:30, that's very helpful. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Yes."
},
{
"speaker": "Bob Jian Huang",
"text": "My second question regarding MGA and capacity in general, there has been some concern that MGAs have been increasingly aggressive. Is this something you're seeing? Is this concern rightfully placed? Does it have any impact on how you think about your underwriting cycle management? Are you becoming more cautious, especially within your reinsurance? Not sure if you answered that before, so apologies."
},
{
"speaker": "Marc Grandisson",
"text": "That's a great question. I think I mean the MGAs emerge, as we all know, when there’s a dislocation where there's need for capacity. And I think we see it more acutely in the professional lines and some of them in property. But again, between the supply and demand on the professional lines, I think now that the capacity is probably more plentiful than. It's not more probably, it is more plentiful than it was. So I think it has some impact at the margin. Of course it does. I think the answer to your second part of the question, which is, how do we react? Well, we do it, the same way we always do it, which is if the pricing is going down and the returns are not as good. We will tend to deemphasize or pick or select the better clients that we have in our portfolio and still react the same way we would do in cycle management. On the property side, we also have similar MGAs and MGUs, right? But I think these guys, there’s an acute need for property coverage and capacity. And I think it sort of feels that we need all the capacity we can get our hands on a property at this point in time. So we're not seeing that much of as much of an impact. The property market is still very strong."
},
{
"speaker": "Bob Jian Huang",
"text": "Okay. So property side, not enough capacity, professional line, plentiful capacity. That's the way we should think about it. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Yes, that's right."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Meyer Shields from Keefe, Bruyette & Woods."
},
{
"speaker": "Meyer Shields",
"text": "Hi, I think we're in the same situation where people can only hear the answers to their specific questions. So I'm hoping that comes through here as well. Similar question to Bob, we've seen, obviously, a number of companies report some reserve problems in the fourth quarter. And I'm wondering, when you look at the book of sedans that you have within reinsurance, is what we're seeing in the public companies a good representation of overall trends, or is it something different in the non-public world?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, I think when you price -- Meyer, good question. But for the record, this will be recorded, right? So we'll be able to -- so this will be recorded. So we'll be able to share, you’ll be able to hear the other questions and the other answers. Sorry, is that okay?"
},
{
"speaker": "Meyer Shields",
"text": "Yes, that's perfect. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "So I think the issue with casualty reserving, and you’re an actuary as well as I am, the actual number is in the high of whoever is doing the work. So I think it's like everything else. Our teams may have different views about the loss ratio pick for some of the things that we’re looking at than they would have themselves. So I wouldn't say that it's a one to one. Some of them will not renew, or some of them we may not be able to participate on because we have a different view of the ultimate loss ratio. So I think it's really each individual underwriter and each individual company or sitting company come up with their own number and you have to make your own decision and your own opinion as to where it is."
},
{
"speaker": "Meyer Shields",
"text": "Okay. I'm sorry, go ahead."
},
{
"speaker": "Marc Grandisson",
"text": "No, no, go ahead. I was wondering whether you were still there, so carry on, please."
},
{
"speaker": "Meyer Shields",
"text": "Yes, no, I'm still here. Similar question, I guess, obviously what we've seen here is a lot of domestic concerns over liability lines on the international casualty side, is that concern worsening as well, or should we think of that as just a domestic concern?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a similar issue. It's not to the same acuteness in some kind of level, but the world has similarly closed down in a courts. It's not as litigious internationally as you would expect, but we're still seeing some hardening in international casualty as well. We saw this for the last two, three years. So it’s a very similar hardening of the market, may not be as acute in terms of reserving potential issues. And I'm not talking now to the globals that are internationally underwriting internationally, that's a different story, right? If they write in the U.S., they will have similar issue, but there is similar issues all around, but it's not to the same level internationally we’d see in the U.S."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Elyse Greenspan from Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi, thanks for taking the follow-up. I will say I think you have a lot of folks wondering who's writing the coverage for your conference call provider. But my follow-up is on casualty insurance. Can you give us a sense of the loss trend that you're booking your casualty insurance book to and what rate you're getting in casualty insurance as well?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, it depends on line of business, Elyse, but I think the numbers you hear around 7, 8, 9, 10, sometimes it's 5. It depends on line of business, depends on the attachment point, it depends on the limit that you provide, depends on the size of risk. But the numbers you hear -- the numbers that are heard around the marketplaces, we see the similar phenomenon. I think we've said it historically, it's coming -- it's happening as we speak, that the insurance trend in liability generally will out pay the CPI increase. And we're seeing this coming back, so with 200, 300 basis points above. So we’re largely consistent with those kinds of pick."
},
{
"speaker": "Elyse Greenspan",
"text": "So loss trends, you said 7, 8, 9, 10, but can vary by line and sometimes be 5%. Where would you put the price increase?"
},
{
"speaker": "Marc Grandisson",
"text": "Oh, again, depending on line of business, but we're low to mid-teens, I would say right now."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. Low to mid-teens. I'm just also repeating. So folks listening?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, I appreciate. I appreciate, Elyse. Thank you. Yes."
},
{
"speaker": "Elyse Greenspan",
"text": "Can't hear the answer. So low to mid-teens. Yes, I think that's one, I guess on your, one last one, your cat, you said your PML went a little bit higher, right? But the percent of equity is lower, given the equity rise in the quarter, where would you put your cat load at the start of 2024?"
},
{
"speaker": "François Morin",
"text": "Well, certainly up from 2023, right. I'd say for the year, we’re looking at somewhere loss ratio points, right? Call it 7% or so of like 6% to 8% of like our premium would be kind of like the cat load."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. 6% to 8% cat load. Thank you for taking the follow-up."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks, Elyse."
},
{
"speaker": "François Morin",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Cave Montazeri from Deutsche Bank."
},
{
"speaker": "Cave Montazeri",
"text": "Good morning, guys, it's Cave."
},
{
"speaker": "Marc Grandisson",
"text": "Good morning."
},
{
"speaker": "Cave Montazeri",
"text": "Hey, I have a question on reinsurance terms and conditions and attachment points. Does feel like overall the industry probably took on more high frequency, low severity risk than they should have over the past couple of years. And now maybe on aggregate reinsures are probably more willing to negotiate on price than on attachment points or terms and conditions. Just tell me what your view is on that topic."
},
{
"speaker": "François Morin",
"text": "Are you talking about property?"
},
{
"speaker": "Cave Montazeri",
"text": "Yes, property."
},
{
"speaker": "François Morin",
"text": "Yes. I think -- well, I think what we’ve seen is we continue to see is that a lot of lower layers historically for the last four or five years turn out to be just swapping money, trading dollars back and forth. And there was a lot more activity, perhaps of frequency, as you mentioned, and the reinsurance market was willing to take on. So there was a natural tendency to try to increase a premium at those level but then at some point it breaks down in a sense that the client is buying the reinsurance protection, is paying more for things than they actually realize they should be retaining. That's why you've seen retention go up. Now in a sense, by virtue of having a higher retention, then they have to turn on and then that's what we've seen, they’re turning onto their own portfolio and try to manage and make it better and improving the aggregate loss that they have there. I'm sorry about this. I think that what we're seeing on the cat excessive loss right now is that people are buying more on top because they also are appreciating and evaluating the total level of exposure capacity needed in PML. So I think what people -- what we're seeing is people trading away the bottom layers and buying more on top. And I think we're going to see that a bit more as we go into 2024, which totally makes sense."
},
{
"speaker": "Cave Montazeri",
"text": "Okay. My follow-up question is on mortgage insurance. Now you had been kind of pulling back even before activity came to a halt. But if the fed rate cuts, if they do come lead to a pickup in the U.S. activity in the housing market, would you be happy to grow in line with the market or should we expect you to kind of grow maybe less stuff in the market?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, mortgage, absolutely, we would be. I think that -- yes, the answer is we would be more than happy. We have capacity, capital to be able to deploy and I think we would be very, very pleased to do more. Absolutely."
},
{
"speaker": "François Morin",
"text": "And as you know it's been a very good market, very rationale market. So obviously, the rates were able to charge for the risk will matter and where we -- how we position the book. But in terms of our ability to grow, when we get originations go up, we're absolutely capable and willing to do that."
},
{
"speaker": "Operator",
"text": "Thank you. One more for our next question. Our next question comes from the line of David Motemaden from Evercore."
},
{
"speaker": "David Motemaden",
"text": "Hi, thanks. Good morning, and apologies, I haven't been hearing the answers, so not sure if you've answered any of these already. But just Marc, you spoke a little bit at the beginning of the call about the need or the strategy to lean in at the early part of a hard market. I guess how do you manage that with potential false starts? It sounds like casualty market on the reinsurance side hasn't hardened as quickly as you've expected. But how do you manage that just internally between writing business that might be hardening, but not totally to where you think it should go and the potential for false starts?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a very, very good question. And I think this is where the Arch comes into play; right, in experience and knowing some of the markings of a hardening market, a lot of it also has to do with things you won't hear, right, is our underwriting team sitting down with clients, potential clients, and try to understand, how do you think about the risk? I've talked about reinsurance now specifically, and we also have a very healthy database like everyone else, but we also have our own, and we have our own view of claims and how it develops. And we have, again, experience over 20 years of data and information. And this is what we use to hopefully get the compass in the right order. But if I can't be sitting here and tell you and pretend that we're going to get everything right 100%, it's a little bit more art and science. And I would think that as I'm getting older, the psychology of the market is becoming way more important, feels to me, than even the numbers. And that's probably what compelled me or what made me ask the team to lean into 2019. And you don't know for a fact until it's done, but there are markings or signs in the overall market that help you and support your decision to lean into it heavily. That's all I can tell you, because it's really not a one for one. There’s no like one number one spreadsheet I can point to that will tell you the answer."
},
{
"speaker": "François Morin",
"text": "And the one thing I'll add quickly, David, is the reverse is true as well. When the market goes soft, sometimes you pull back and you might go back too early. But that's the game we play. That's the business we're in, and we do our best. Again, we're never going to time it perfectly, but what matters more is the direction of it. And then over the cycle, we think we should come out ahead."
},
{
"speaker": "David Motemaden",
"text": "Yes, no, understood. That makes sense. And then Marc, you had mentioned that at 1/1 the property market continued to improve, property cat reinsurance market. I guess as we sit here today and sort of looking forward at the sustainability of that as we move through 2024, what's your view now on that and the growth opportunities in property cat?"
},
{
"speaker": "Marc Grandisson",
"text": "First, we have no growth constraints per se. We can grow. As you know, François mentioned, the value of our PML is 9.2%, so we have room to grow there. I think the question about where it's going to go is so difficult to answer because it's dependent on what happens and what kind of activity we see this year. But if I would probably point to you to the 2006 turn of the market in 2007, that's probably a better way to think about it. 2006, or 2007, 2007 was a better year than 2006. And 2008, 2009, and 2010 were really, really good years in property because the market, as we all know, goes up really, really quickly but does not go down in one fell swoop. You've got a lot of sustainability in the returns for a little while. It takes a while before things get too close to the line or below the line of what we want to adjust. So we have some runway in front of us."
},
{
"speaker": "David Motemaden",
"text": "Got it. Understood. And I know in the past you've said alternative capital, or ILS can -- has the ability to swing the market one way or the other. What exactly are you seeing there?"
},
{
"speaker": "Marc Grandisson",
"text": "What we hear is there’s still a very high demand for returns which prevents or high demand for returns and also still some level of skepticism that might change, but we'll see where that goes. But clearly, right now, at the margin, some increases, but it's not the wave that we saw probably in 2014, 2015, 2016, nowhere near that."
},
{
"speaker": "Operator",
"text": "Thank you. Arch Capital Group answers have been captured and will be available in the replay. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "First of all, I want to apologize thoroughly for the call quality and the dropping in and out. There will be a recording available for replay, and you know, our two esteemed colleagues, Don and Vinay will be available to follow-up obviously. I want to thank you for listening to our call and I'm looking forward to speak to you again in April. Thank you very much."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 3 | 2,023 | 2023-10-31 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Q3 2023 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the Company gets started with this update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These states are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filled by the Company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the Company's current report on Form 8-K furnished to the SEC yesterday, which contains the Company's earnings press release and is available on the Company's website and on the SEC's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sirs, you may begin.
Marc Grandisson: Thank you, Gigi. Good morning, and thank you for joining our third quarter earnings call. I hope everybody is safe and well. Yesterday, we reported another excellent quarter, highlighted by strong performances from each of our three operating segments that resulted in an annualized operating return of 25% and a 4% increase in book value per share. Overall, our teams capitalized on good underwriting conditions and relatively light catastrophe losses to produce an outstanding $721 million of underwriting income in the quarter. Our property and casualty teams continued to lean into favorable market conditions to drive $3 billion of net premium, up 26% from one year ago. Mortgage insurance once again delivered impressive high-quality underwriting earnings that we redeployed into our P&C segments where opportunities abound. Broadly, we continue to achieve rate increases above loss trend in most sectors of the P&C market. Although rate increases are slowing in some lines, they are reaccelerating, which is a good reminder that there is not a single insurance cycle with May. As always, Arch is well positioned to navigate across these many cycles by reallocating capital to the segment with the best risk-adjusted returns. One of our core differentiating principle is that our underwriters are aligned with our shareholders through our unique compensation structure. Our underwriting teams are always seeking to maximize opportunities as long as they need our shareholders' targets. As we near the end of 2023 and look ahead to 2024, I believe that although the dynamics may shift, this hard market will continue to support profitable growth. Let's take a moment to recap the current state of the market and where we are likely headed. I see it as a play in three acts. The first act, the current hard market started in primary liability insurance in 2019 and then has a unique circumstance of a two-year pause in claims activity due to a global pandemic. The second act introduced Hurricane Ian as a main character where property reinsurers had to adjust both their pricing and risk appetite. In addition, capital got more expensive and the industry has to respond to meet new expectations from investors. While property has been the most recent driver of this market as we move into act three. We are faced with increasing evidence at casualty rates widely underpriced and oversold during the last submarket need to increase. We expect this third act of the extended hard market already one of the longest in memory to persist until the industry's reserving issues are resolved and until capital rates generate positive results. Arch is well positioned to capitalize on this operating environment. As new hard market underwriting opportunities arise, our incredibly nimble reinsurance group allows us to grow more quickly and significantly than in our insurance group and is therefore where we are most likely to deploy capital first. Today, market trends point to a reinsurance-driven GL hard market, and we stand ready to act. The third act has very started, but things are very promising for Arch. Now some color on our operating segments. Our reinsurance group has once again driven our growth with third quarter net premium written of $1.6 billion, up 45% from the same quarter in 2022 and 60% over the last 12 months. Underwriting performance in the reinsurance group was excellent with a combined ratio of 80% for the quarter. Our expectation is that we will continue to see hard property market conditions to next year's renewal cycle as uncertainty and loss activity remains elevated. As noted above, we expect increased opportunities in liability as well. Our insurance group also remains in growth mode in both our North American and international units, while net premium written in the Insurance segment, up 16% over the last -- over the past 12 months, are more modest than in reinsurance, they are more broad-based because of our focus on small- and medium-sized specialty accounts. Underwriting income continues to build with increased earned premium and a strong combined ratio of 90.9%. Today, there are still plenty of opportunities to grow profitably in insurance. Property and short-dated lines pricing in terms and conditions remained very strong with rate increases in excess of 15%. The then casualty pricing is increasing in response to overall casualty trends in the market and our programs unit continues to achieve rate increases above trend. Professional liability rates softened in the quarter, with net premiums written down 9% in the third quarter of '22. We share the marketplace sentiment about the D&O segment where both IPO and M&A activity decreased, at the same time as rig pressures from competition and security class action activity increased. However, returns in that segment are still strong. In the same vein, we maintained a positive outlook on cyber pricing on an absolute basis despite rate decreases in the 15% range. Our outstanding mortgage group continues to deliver quality earnings for our shareholders anda higher persistency of our in-force portfolio helped offset the slight decrease in NIW which has been affected by lower mortgage originations. Although we tend to focus our comments on the U.S. primary MI market, it is worth noting that nearly 40% of our mortgage segment underwriting profit this quarter came from non-U.S. operations compared to just over 10% in 2017. International business represents a significant growth opportunity for the mortgage group at Arch and our strategic decision to diversify our mortgage operations is yielding positive results that further differentiate Arch from our competitors. We are currently in a positive cycle on the investment side of our business, where increasing cash flows from growth are being invested into today's higher yield environment. New money rates are well in excess of our book yield which should continue to boost our investment income over time and provide us with an additional ongoing tailwind. In late October, which for baseball fans, mean it's fine for the world series, baseball is somewhat unique in that it's one of the few team sports that isn't limited to a specific length of time. You can score as many runs as possible until the other team gets three outs. To me, the current hard market feels like a baseball game. We know there's only nine innings to be placed, but we have no idea how long those innings will take. We've got a great lineup, we're happy to keep paying our singles, doubles and occasional home runs until the beginning is over. At Arch, we remain committed to being good stewards that are capital entrusted to us. We do that by following a tried and true data-driven approach that maximizes the capability of our diversified platform, diligently adheres to a cycle management philosophy and is centered around superior risk selection and prudent reserving. All the while, our underwriters are fully aligned with our shareholders. This principles are foundational to our playbook and underscore our long-term commitment to superior value creation. As we close out 2023, we have significant momentum in all three of our businesses and a reliable and high-quality earnings engine in our mortgage group that are helping fuel our growing investment base. All the pieces are fitting together nicely, and we're well positioned for the future. Now I'll call François up on an on-deck circle, and we'll return to answer your questions shortly. François?
François Morin: Thank you, Marc, and good morning to all. Thanks for joining us today. To add to the baseball team, I would also emphasize that while this long winning streak has certainly been fueled by a timely and dynamic offense, we're also very much aware that team defense has played an important role in our success. We've been working hard not to waste any offensive production with careless errors and by executing well actively and on the field. We produced exceptional third quarter results from high-quality earnings across all our lines. The highlights of this team effort are numerous and include after-tax operating income of $2.31 per share for an annualized operating return on average common equity of 24.8% and a book value per share of $38.62 as of September 30, up 4.3% in the quarter and 18.4% on a year-to-date basis. Similar to the quarterly results, our reinsurance segment grew net written premium by 45% over the same quarter last year, led by the property other than catastrophe line which was 73% higher than the same quarter one year ago. As for our property catastrophe business, it's worth mentioning that the net written premium in the third quarter one year ago included approximately $34 million of reinstatement premiums, mostly as a result of Hurricane Ian. If we adjust for the impact of reinstatement premiums, our growth in net written premium for this line would have been approximately 64% year-over-year. The quarterly bottom line for the segment was excellent with a combined ratio of 80%, 73.5% on an accident year ex cat basis, producing an underwriting profit of $310 million. The Insurance segment had another very strong quarter, with third quarter net premium roving growth of 11% over the same quarter one year ago. Similar to last quarter's results, we experienced good growth in most lines of business with the main exception being professional lines where the market remains competitive, particularly in public directors and officers liability. If we exclude professional lines, net written premium would have been 20% higher this quarter compared to the same quarter one year ago. Overall, market conditions for our insurance and reinsurance segment remained attractive and we expect the returns on the business underwritten this year to exceed our long-term targets by a solid margin for some business units. Profitable growth during periods of favorable market conditions is one of the hallmarks of our cycle management strategy and the current hard market is definitely giving us the opportunity to deploy meaningful capital in many areas. Our Mortgage segment's banning average has consistently been a league leader, and this quarter was no different with a 4.7% combined ratio. Net premiums earned were in line with the past few quarters across each of our lines of business. Included in our results was approximately $98 million of favorable prior year reserve development in the quarter, net of acquisition expenses with over 75% of that amount coming from U.S. MI and the rest from other underwriting units. Our delinquency rate at U.S. MI remains low based on historical averages and close to 85% of our net reserves at U.S. MI are from post-COVID accident periods at the end of the quarter. Across our three segments, our underwriting income reflected $152 million of favorable prior year development on a pretax basis or 4.7 points on the combined ratio was observed across all three segments, driven by short cat lines. Current accident year catastrophe losses across the group were $180 million, approximately half of which are related to U.S. severe convective storms with the rest coming from the Lahaina wildfire, Hurricane Idaliaand other global events. Pretax net investment income was $0.71 per share, up 11% from last quarter as our pretax investment income yield was up by approximately 18 basis points since last quarter. Total return for our investment portfolio was a negative 40 bps on a U.S. dollar basis for the quarter as our fixed income portfolio was impacted by the increase in interest rates during the quarter and most other asset classes and negative returns in line with broader financial market indices, such as the S&P 500, which was approximately 3.7% in the quarter. Net cash flow from operating activities has been very strong so far this year in excess of $4 billion, which has helped grow our invested asset base by approximately 20% in the last 12 months with new money rates in our fixed income portfolio comfortably above 5%, we should see continued meaningful tailwinds in our net investment income. Turning to risk management. As of October 1, on a net basis, our peak zone natural cat PML for a single event 1- to 250-year return level remain basically unchanged on a dollar basis from July 1 and now stands at 10.1% of tangible shareholders' equity well below our internal earnings. Our capital base grew and got stronger during the quarter and now stands at $18 billion. Our leverage ratio represented as debt plus preferred shares to total capital is currently under 20%, which provides us with significant flexibility as we look to deploy capital as opportunities arise. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions] Our first question comes from the line of Elyse Greenspan from Wells Fargo.
Elyse Greenspan: My first question was, hoping to get some thoughts on the January 1 property cat renewals on the reinsurance side. So where do you think rates end up next year on a risk-adjusted basis?
Marc Grandisson: Well, I think the -- it's still early. We have a lot of movement in the marketplace and capital and people are, as you can appreciate, positioning at all the conferences. But our general consensus in the team when we talk to underwriters is that we'll still have improvements in 1/1/24, not as big as 1/1/23, we're still going to get some slight improvement on the reinsurance side of things. What is also -- I mentioned before, this is not really fully reflecting what we believe has been the re-underwriting and reallocating of capacity by our clients, and that remains to be seen how it's going to be reflected and it will depend on the clients frankly. But overall, we still expect a very healthy, very robust 1/1/24 renewal on property.
Elyse Greenspan: And then on your casualty comments, Marc, right, you alluded to that being the third act and really leaning in there on the reinsurance side. I was hoping you could just give us a sense of timing on how that will play out. And if that's a '24 event, do you see the reinsurance book shifting more to casualty? Or do you think it's an environment where they both on property and casualty offer good growth opportunities for the Company?
Marc Grandisson: It's a great question. I think the -- we have a big play in property, as you saw between the property cat on the region side that is and the property other than have core shares and thing in between. So I think we're still very much keen on that line of the business. Liability is a bit harder to evaluate right now because I think the first order is going to have to be looking at our plan for 2024, looking at the reserve or development of the area, the just talking about our clients. So it's going to take a little bit more time for people to figure out what it is they have and what they want to do with it going forward '24. So we'll have probably some of us think that we may have a renewal that is a bit more not as stable as it once was. So I think we'll probably see the early innings to go back to my baseball analogy of that liability possibly at 1/1. The one beautiful thing about GL or the one bad thing depending on the cyber market you're in, it's a longer-term development on a softening and on the hardening the GL can -- it will take a little bit longer to get to where it needs to get to because it takes time for you to get the losses, reflect them in the reserving, and we have a good sense of where the ultimate results are from the prior year to adjust and help inform the pricing you're going to have over there. So this is going to be a lot -- much more protracted third act than the second net was.
Operator: Our next question comes from the line of Jimmy Bhullar from JPMorgan.
Jimmy Bhullar: So first, just staying on casualty, there's been a lot of concern about reserves. And obviously, casualty is a fairly broad market category, but what are your thoughts on overall industry reserves in casualty, your reserves? And then maybe any color on the lines within casualty where you think there might be inadequacies and sort of the drivers of that or what's driven the reserve issues?
François Morin: That's a great question, Jimmy. I think there's -- as you said, it's a broad market. Certainly, we've seen some pressure in our own results. I think we see -- so you see both on insurance and reinsurance. On the reinsurance side, we see some of our clients recognizing adverse and the latency of some clients being reported to us, I think is coming through. We like to think we've been proactive in addressing those issues, but you never quite know for sure until everything comes through. But some of the subsets, definitely umbrella is an area that it's something that we're watching carefully. The good thing, I think, with our book is, again, we are big players in that space in the soft market years. So we're seeing some pain but not to the same level we think that may be other as well. And -- but it's a hot topic, and we're going to keep looking at it.
Marc Grandisson: The one thing I would add, Jimmy, to what François just mentioned, is that we are you're hearing from the call that it's going to be more acute, more of a pressure point on the larger accounts than the smaller accounts. I think that the limits deployed there and the uncertainty and the combination of all these years developing is a little bit more probably more a bit more of an urgency in that sector. So we expect the larger accounts, which we don't do a lot of on the insurance side to be the first one to really feel the pressure.
Jimmy Bhullar: Okay. And then on mortgage insurance, I would have thought, and I think most investors thought that at some point, you would see sort of a step down in your results, still strong earnings, but maybe not as strong as they had been the years following COVID because of the release of COVID related reserves. Just wondering how we can sort of get an idea on how much of the COVID-related reserves are still on your books and could be released versus maybe an ongoing benefit from that in the next few quarters?
François Morin: Well, I made the comment close to 85% of our reserves as U.S. MI are from post-COVID years. So that would mean '20 and after. But let's remember that when we were coming out of COVID, we saw just a lot of changes in home prices, home price appreciation and potential over valuation, right? So when we were sending reserves in the last few years, '21, '22, even up until early '23, that was a concern of ours. So we were somewhat -- as you would expect us to do somewhat more prudent I'd say in setting our reserves. how that plays out when delinquencies cure, we don't know. Could there be further favorable development maybe. But I'd say, for the most part, what's really been happening in the last couple of years is just I'd say very much again a function of the housing market, which has been just exploded and then created a different set of kind of data points that we're trying to analyze, and that's how -- what we based our reserves on. So hopefully, that gives you a bit of color on the question.
Marc Grandisson: I'll just add one thing to me on the industry. The industry is extremely disciplined again, a very nice thing to see around us. So from an ongoing perspective, putting the reserve for one second, if I can talk to the -- our expectations. And we think that there's still risk on the horizon, but the credit quality of our portfolio the housing supply imbalance that you hear fromFrançois and the fact that we have a lot of healthy equity into a policies in force is it looks really, really good. And when we say that our mortgage growth is also doing very well, and that's what we mean. It's in a really good place.
Operator: Our next question comes from the line of Tracy Benguigui from Barclays.
Tracy Benguigui: While you posted double-digit insurance premium growth this quarter, the pace has decelerated a bit over the last two years. It looks like peak insurance premium growth was in mid-'21, and that might be a tough benchmark given you've grown a ton and professional ability and you are shrinking error, as you pointed out. Could we expect insurance premium growth at double digits to be sustainable going forward? Or should we see it fall to high single digits because of the professional lines headwind? And I'm just wondering if it's fair to assume that you prefer deploying capital into reinsurance now, all else being equal?
Marc Grandisson: Yes. In terms of return expectations, I think your instinct is right on. I think reinsurance is providing right now very, very healthy returns. We expect this to continue into '24 and '25, to be honest. But the insurance group, I think it's one quarter, there's couple of moving parts due to some accounting thing, timing and stuff here and there sometimes. But as François mentioned, the growth in the line that we like to see growth into I'm very pleased to see because this is where I would expect the team to grow it but the market conditions are great there. And I would expect even some of those nonprofessional lines to actually maybe carry the day bit more going forward. I wouldn't be surprised that we could go back above 10% next quarter and into 2024. So I'm not -- I don't see one quarter of the trend, to be honest.
Tracy Benguigui: Right very helpful. You slightly shortened the duration of your asset portfolio in September to 2-point, nine, seven years from 3.03 years in June. It feels like you're taking durational asset mismatch because the MI liabilities are much longer dated. Given the shape of the yield curve is beginning to show signs of steepening, I mean to tad bit less inverted. Going forward, would you consider lengthening your asset duration? Or you feel comfortable with the sub-3-year duration level?
François Morin: Good point. I think the duration is probably the lower it's been in a long, long time, and that's just our investment professionals here again make the decisions, and there's obviously a little bit of tax expats involved and kind of where they want to play at a certain point in time. But for sure, absolutely. If interest rates, we think the longer the curve ends up being a bit more attractive. I mean, we certainly consider extending the duration a little bit. And we've got a bit of room there anyway just to match with the liabilities to make sure that we're not mismatch there. So that's certainly something that we'll look at in the coming months and quarters, yes.
Operator: Our next question comes from the line of Yaron Kinar from Jefferies.
Yaron Kinar: First question, it sounds like you are pretty constructive looking into 1/24. Can you maybe talk about your prioritization of capital? And maybe give us a way to think about maybe potential available capital you have to deploy into the insurance and reinsurance markets?
François Morin: Well, yes, we are constructive on 1/1. I think we -- Marc and I said it, I think it's a really good market in totality. There's some pockets that are certainly better than others. We think that the internal capital generation, we've been able to generate in the last few quarters gives us the ability to really grow and take advantage of the opportunities that we think have a good chance of being there. Again, we don't make the market. We participate in the market. So if the market is as positive as we think it can be, then we'll be happy to step in and take a bigger share of it. But I think the fact that we've got capital flexibility has always been one of the -- and on a onetime things and our strategy all along is we want to make sure that we have plenty of capital to deploy when the market is right. And so far, we've been able to do that.
Marc Grandisson: So Yaron, if I look at the high level, the way we think about -- we think about it, it's different perhaps than even our underwriting units, meaning that they don't really, they were doubting how much capital is allocated to them at the beginning of the period. I want to remind everyone that people write the business or underwriting fee write the business. And then we -- after that, charge them with the capital they've been using. And based on the planning and all the expectations that we have, our message there has been -- there is no capital constraint or issue concerns that, that pertains to you guys. If you see the market being a better and even get better than we saw, feel free to deploy more capital if you wish to do so. So there's definitely there's all hands on deck go forward if we can invite the business. That's one thing that's really nice and we'll then attribute the capital after we have written the business. That's what we do every year. On the property cat side, which is probably a more interesting one for is worth to you, we're about 85% allocated to the reinsurance group in terms of PML thatFrançois mentioned. And I think it's because the returns there are a little bit more favorable on the reinsurance side. And then we had the discussion at the group level. That's one exception. So when we have an acute or a specific area of the capital, we'll sit down with the Insurance Group and Reinsurance Group with Nicolas facilitating the whole discussion, and we'll sort of decide to roughly broadly where we want to allocate capital.
Yaron Kinar: I appreciate that. And then certainly, I think the capital availability and the appetite to deploy is a very important part of the or story. And I guess from that perspective, is there anything you can offer us in terms of an attempt to quantify the available capacity? Or is that something that we'll just have to watch and see?
François Morin: Yes. I mean, we -- certainly, we have some capital -- we have plenty of capital available. We just don't know what the market will look like at 1/01. So that's why I'd say you're right, probably have to -- what you see a little bit, see how 1/1 play out and then we'll have the ability to do something with the excess capital in.
Yaron Kinar: Okay. And then my other question, just on public D&O and cyber, where we're clearly seeing a little bit of pressure and competitive pressure there. Do you still view rates as adequate there? And are they clearing the loss cost trends?
Marc Grandisson: Yes, our return expectation on both these lines, cyber and D&O, is still very, very healthy.
Operator: Our next question comes from the line of Joshua Shanker from Bank of America.
Joshua Shanker: Yes. With the high retentions, this quarter in terms of premium ceded. Can you go maybe line by line or dig in a little bit about which lines of business you're retaining more? And is that a signal that you've gotten to the point where you have enough information that you love the profitability more and want to keep it yourself? Or is your you're looking at your capital thing, we have the capital deployed. So let's eat a bigger plates the pie. How did that all come together?
Marc Grandisson: I think you answered the question beautifully. I mean by asking a question to give the answer, I think that all those things you said are true. I'll get to the lines in a second. But to your point is exactly right. We're going to this hard market and we make -- we still value reinsurance. You cannot go without a reinterest. You still need for various reasons, limits management, risk management and also information, right? Reinsurers are providing us on the insurance side with valuable information about what the market is and the state of the market. So we don't want to be an outlier out there. So it's always good to have this as an additional value proposition from the reinsurance companies. In terms of what we decided to do over three years, you're quite right, we have been building, asFrançois mentioned, a significant amount of capital through our mortgage earnings. So that's certainly something that was helpful and available to deploy in other areas, and that also helps being able to maintain and retain more net. I think if you at a high level, I think that the patterns of buying, we're buying a fair amount of less on the liability lines, specifically those that went through the first act and really had a lot of good uplift. So we definitely saw that happening on the property, even though the property is very hard, as we all know, since last year, this is a much more volatile line of business, so we still maintain our loss on the cat side and still by a quota share, a significant quota share on that business as well. So I think overall, it's meant to be the balancing act between providing relief or volatility protection to some extent and information. But you're quite right, having more capital definitely helped us take more net on our balance sheet.
Joshua Shanker: And switching gears a little bit. When you have a 25% ROE quarter, you're making a lot of money and you have a large team that has contributed to that result. I assume they'd like to be paid for their good work. How should we think -- we've not seen a quarter like this in a long time in a year like this. How should we think about the pattern and the cost of discretionary comp where it hits the P&L and how it should compare with prior years?
François Morin: Great question, sorry. We -- just again, in terms of timing, right, our incentive compensation decisions are made in the first quarter will be made in February of next year. But no question that throughout the year, we accrue expected bonuses based on what we think that our performance might look like, and there's effectively a true-up that takes place in the first quarter when the final amounts are determined. Something we're keeping an eye on. So I don't know if there'll be an early adjustment in the fourth quarter or not something we'll be looking at carefully, so that we don't go to distort too much the first quarter next year. Obviously, the Board has final say in how much money will be available to pay our troop. So that's -- it's a little bit of -- we don't want to front run it. We want to be reasonable and not introduce too much volatility in the numbers on the OpEx side. But that's certainly something that we'll take a look at in the fourth quarter to make sure we're not missing anything here.
Operator: Our next question comes from the line of Alex Scott from Goldman Sachs.
Alex Scott: First one I had is on the attritional loss ratio in the reinsurance segment. I was just thinking if you could give us a little more color around just what's driving this year, favorable performance year-over-year? And if there's anything new as we should be thinking about or if it's just the pricing environment being as strong as it is?
François Morin: Two quick things there. One is -- and we said it before, and it goes both ways. We think of reinsurance as a line of business or a segment that we think is better analyzed on a trailing 12 month basis. We think looking at a quarterly there'll be some good, it will be some bad. And we've said in past quarters where we have elevated the traditional claim activity. We said don't panic, don't overthink it in the same way here, I think. So we would certainly encourage everybody here to look at a trailing 12-month basis to have a better view of the long-term kind of prospects of the segment. The other thing I'd say is also, obviously, we've grown a bit more in property than relative to get align. So by nature, right, our ex cat combined ratio should probably come down and it has as a result of, again, the growth -- the significant growth we've had both in property cat and property other than cat.
Alex Scott: Got it. Very helpful. I wanted to ask a follow-up on the comments you made on casualty reinsurance. And I'm just interested in what is changing that's causing more of this commentary to sort of bubble to the surface? I mean, we've heard it from some of the European reinsurers as well. Is it I mean, is it truly just that they're starting to see reserves develop in a poor way for some companies? Or is there something that's changed about the social inflation environment? I mean what do you think is the underlying driver or drivers?
Marc Grandisson: Yes. I think the industry is -- there's a couple of things going on at the same time, and they unfortunately don't go in the right direction for both for all our industry if you have written casualty. First, we have -- as I mentioned in my comments, we had a bit of a slowdown in activity including core activity, settlement activity. And we also have, as we all know, there's a lot of litigation funding, it's a bit more aggressive is coming from the platelet bar, and that's certainly something that you could describe to be social inflation, but that's not really something new. But there was sort of a lull in this market. It was sort of a spike, if you will, between 2020, '21 to really middle of this year, early this year. So, I think right now, we have sort of a refresh reupdating all the information about the losses of where we are and what could happen with the demand being updated and made more current. At the same time, we have price that business as an industry in 1,519 with inflation at 2%. Now inflation is north of 5, 6, 7, depending on where you look at. So at the same time, of course, we open things are being adjudicated reanalyzed, you have to account for a higher inflation number. And that is a classic case of having a couple of things going against you, nothing that the industry did on its own. It's just the economy and the environment and the risk in it and the environment. So I think that we're facing all collectively as an industry, that phenomenon. And what I like about the industry's capability is, it's reacting and that's what you hear. That's something that we should be very, very happy for collective as an industry. The other calls that you heard this quarter recognize it, and once you recognize an issue and a problem, people are very good and very adept at addressing it. And I think that's what's going on there are couple combination coming in very, very short order because of the surrounding environment. I think this is what largely drives what's going on right now.
Operator: Our next question comes from the line of Michael Zaremski from BMO Capital Markets.
Michael Zaremski: Switching gears to the to the investment portfolio. So the net realized losses were somewhat outsized again this quarter. I know they run below the line, but any color -- are those -- are you actually crystalizing to take advantage of the higher rates? Or is there noise in there from unrealized stuff or maybe the LPT transactions in the past?
François Morin: Yes. I mean it's mostly around kind of crystallizing some losses. I think it's a process we go through for each security on the fixed income side, where we make the determination. Is it appropriate to sell some of those and redeploy the proceeds and higher yields and our investment team does that. So yes, there are going to be some realized losses coming through the fixed income. Obviously, the equity portfolio, which is not huge, but still there's FBO securities like fair value option securities, including equities that are effectively mark to market, and that comes through the realized gains of losses line in the income statement. So those are the two big items. There's a little bit of other stuff going on that is a little bit of the wheat. So, I wouldn't want to go there, but that's directionally hopefully that's just normal course of action.
Michael Zaremski: Okay. And lastly, on -- is my understanding for me to put out there a second comment letter, maybe it's different, they call something else. But on the potential tax changes that will take place. Are -- any way you could offer us some color on what's -- how things are going to play out base case over the coming year two or? Or does the step-up -- if everything goes as planned, does the step-up in tax rate happen in '24? Or is it a '25 event or both?
François Morin: Yes. It's, again, very early. So too early, unfortunately, to give clear or kind of views on what we think could happen or because they're still developing the laws and we expect more progress on that before the end of the year. But at a high level, it doesn't start at one start if it goes through until 2025. So, there's no impact for 2024 and we will be evaluating the and may publish some target tax rate that they will try to get to. But again, more to come, I think we'll do our best to keep you apprised of how we think about it probably on the next call. But until we have work to now any more clarity on where it's going to land, I think it's a bit premature to give you too much do any details here.
Operator: Our next question comes from the line of Meyer Shields from Keefe, Bruyette & Woods.
Meyer Shields: First question on, I guess, casualty reinsurance. This year, like January 2023, we saw not only significant increases in property capital. We saw changes in program structures with higher attachment points. Is there anything analogous to that, that we should see on the casualty reside in 2024? Or is it just going to be a great story?
Marc Grandisson: Probably more of a great story. The buying pattern on GL is mostly on a quota share. There's a lot of quota share being purchased in that segment. That's also certainly something we prefer to focus our capacity on those of you who followed us for years, this is where we prefer to focus on capacity. On the excess of loss, my people don't really buy a lot. People don't put out is like $60 million, $80 million, $100 million limit. So, we don't have a similar kind of risk -- the risk vertical is not as big. And in terms of events, like a cat portfolio, you could see where things are accumulating can generate hundreds and hundreds million dollars of exposure. In the liability side, it's not the same. You already have a necessarily one or two events that could really impact such a wide area of your GL. So, I think we'll see a lot more filters more on a quota share basis and some of the excess of look here and there. It's not very similar -- it's not at all similar to the property market.
Meyer Shields: Okay. That's very helpful. And second question, and hopefully, I can ask this in a way that makes sense. When we talk about reserve problems from older accident years, ultimately driving casualty rate increases to accelerate. Is that the industry can over earn in 2024 and backfill? Or is it because the recalculated full year's losses mean that current rates are actually not as adequate as we thought?
Marc Grandisson: I think it's the latter. I mean it's a bit of the former, to be honest with you, people have to recognize those losses if they have them. I do believe -- as we talk about Meyer, you know that as well as we do, you're going to enter yourself, the reserving process feeds the pricing process. And clearly, if we have a reserving that's a bit higher than you would have expected, it will help inform your loss ratio historically. You have to put a trend on them, to the on-level analysis that helps get you to the price increase that you're looking at. So the past as it's developing, will inevitably lead you to having to charge more. And the reason we'll do a whole lot of large GL for that matter is precisely because of your second point, which has been historically a little bit wanting on the rate level and the rate level side.
Meyer Shields: Okay. That's worrisome about recent years for the industry, but that's very helpful.
Operator: Our next question comes from the line of Bob Huang from Morgan Stanley.
Bob Huang: Congratulations on the quarter. Just a quick question on your insurance segment's loss ratio year-on-year loss ratio improved for about 30 bps. But just given just the strong E&S pricing environment, shouldn't we expect a little bit better improvement in loss ratio. Is there anything in the loss trends that probably differed from how you thought about your loss picks in the past, just see if there are any comments around that?
François Morin: Maybe -- I mean I think the answer is really around like us being proof and initial loss picks. We don't want to get into the game of being overly optimistic. There's still a lot of risk out there. There's still a lot of uncertainty when we price the business, whether, again, we just been talking about casualty loss trends in particular, that's an area that we're watching carefully. So, we'd rather -- and it's been our model for many, many years is pick a realistic kind of a bit more conservative initial loss pick on -- when we book the business and then react to the data when it comes in. So, we're hopeful there could be good news down the road. But for the time being, we're very happy with our loss picks.
Bob Huang: Okay. My second question is a follow-up on the reinsurance core combined ratio. Obviously, it was very strong and I think you mentioned that a lot of it is due to business mix shift, right, shifting towards property and then because of that and then you naturally have an improving combined rate -- loss ratio there. Just curious if we were to think about going forward, the run rate combined ratio for your reinsurance segment, based on the comments so far, is it fair to sort of assume that it's going to be closer to what you printed over the last two quarters and probably better than the prior quarters. Is that a fair way to think about it just from a modeling perspective?
François Morin: Again, I mentioned like the thinking around trailing 12 months, which is where I would start -- to help you kind of with assumptions, I would -- if you're going to -- we think about it in totality around the combined ratio, but if you're breaking down the loss and the expense ratio, yes, maybe there's a -- given the growth, maybe there's potentially the latest quarter of OpEx is probably more sustainable given we've been able to generate that premium, that growth with the same level of resources. But on the loss ratio side, I think it's just -- I would be careful not to over I mean give too much weight to the latest quarter.
Operator: Our next question comes from the line of Brian Meredith from UBS.
Brian Meredith: A couple of questions here, first on the MI segment. I know there's clearly some market pressures, but NIW definitely down year-over-year. And it looks like just looking at some of the stats you all have been losing some market share in the MI segment. Is that intentional? Are you any concerns about the outlook here on the MI as far as delinquencies? Or is it more related to perhaps just better use of capital elsewhere?
Marc Grandisson: It's more the latter than the former. I would actually say tell you, right, that the market is better this year than it was in last year. So, I would argue that we might change the way we intent the market over the next 12 to 24 months. But certainly, at heart, we have been saying that to you historically it hasn't changed last quarter, which in terms of relative returns based on the three segments on the underwriting segments. MI is a third one, but a very strong one, I would say, at this point in time. But again, it's more a reflection of the relative opportunity between the units than anything else. In the market, Brian, I'll tell you the market is very, very disciplined. We're very impressed by the industry or the MI industry.
Brian Meredith: Good to hear. And then I guess my second question, Marc, as I think about if this next leg is coming through the third act on the casualty reinsurance side. I guess that probably comes through a lot on the ceding commission side, if you get you get better ceding commissions, should we continue to see kind of the acquisition kind of expense ratios on the reinsurance side kind of moving down here as we head through 2024, given was going on with the casualty reinsurance part, particularly since you play quota share?
Marc Grandisson: Well, yes, I think the ceding commissions about store three right now we'll see what that ends up. There might be a slight change or we'll see how -- it's also going to be dependent on how the underlying market is improving as a reinsurance player. But I think what's our acquisition comes right now reinsurance is mid-low, low 20s. So, I think if you have more of a portfolio even if that's argued, it's a 30% ceding commission. So you might see actually, the acquisition going up a little bit. But again, as Franco mentioned, all the time talk about when we have these questions about the expense ratio and loss ration but not restarted the return and whether the combined ratio lends ourselves to return when it comes from losses of expenses we have already losing sleep here. So, I think this is…
Brian Meredith: And I was going to say that I guess maybe the right way to think about it is that if you're leaning more into the GL, the underlying combined ratios may actually move up some here as you look forward because we have a different return profile.
Operator: Our next question comes from the line of Scott Heleniak from RBC Capital Markets.
Scott Heleniak: Just on the MI. I wondering if you could expand on the growth opportunity internationally, you referenced in your commentary. I know Australia is a big market for you, but we're also are you focused outside of the U.S.? Or is it mostly just Australia you're referring to?
Marc Grandisson: Great question. I think in non-U.S. base is also the CRT, which is granted exposed to the U.S. MI, the excess of loss program that the GSEs have developed over that and we have developed over the last 11, 12 years. Internationally -- so that's a piece of it, you see it in our financial supplement. Internationally, we have Australia. As you know, we have a good size, great relationship and a great presence there. We're very pleased with it. We're also getting a little bit more market share there even though the mortgage origination is a slowdown there as well. The other is really in development is the international with European specifically, SRT, which are 90% mortgage-backed credit risk transfer, they look a lot like the CRT business that we have in the U.S. Most of it is done because banks need to release capital that Basel III led the transactions. And we've been doing it for a little while, and we've partnered up, we actually with another European company who's very steep in that area. So that's a growing area right now because I think the -- there's a lot more need for capital. As you know, Scott, not only in the U.S. [indiscernible] has a similar consideration. So, it helps us be there for them to provide more capital relief and it's certainly something that we're focusing more efforts on.
Scott Heleniak: Okay. That's helpful. And then the -- just the risk profile and the credit quality and the default ratios on those, I would assume those are very favorable. But how does that all compare to outside of the U.S. and internationally versus the U.S. book?
Marc Grandisson: I don't want to say too much because you're going to get more competition in the segment. High level of comparable and sometimes better than the CRT we see, but we still a little bit more work to be done there, those who are trying to get in the business. I think you should talk to us, first of all, help you hit in the business.
Operator: Thank you. At this time, I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thank you so much, everyone, for listening to our commentary this quarter. Looking forward to the end of the year. Happy Halloween. See you next time.
Operator: Ladies and gentlemen, thank you for your participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Q3 2023 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the Company gets started with this update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These states are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filled by the Company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the Company's current report on Form 8-K furnished to the SEC yesterday, which contains the Company's earnings press release and is available on the Company's website and on the SEC's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. François Morin. Sirs, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, Gigi. Good morning, and thank you for joining our third quarter earnings call. I hope everybody is safe and well. Yesterday, we reported another excellent quarter, highlighted by strong performances from each of our three operating segments that resulted in an annualized operating return of 25% and a 4% increase in book value per share. Overall, our teams capitalized on good underwriting conditions and relatively light catastrophe losses to produce an outstanding $721 million of underwriting income in the quarter. Our property and casualty teams continued to lean into favorable market conditions to drive $3 billion of net premium, up 26% from one year ago. Mortgage insurance once again delivered impressive high-quality underwriting earnings that we redeployed into our P&C segments where opportunities abound. Broadly, we continue to achieve rate increases above loss trend in most sectors of the P&C market. Although rate increases are slowing in some lines, they are reaccelerating, which is a good reminder that there is not a single insurance cycle with May. As always, Arch is well positioned to navigate across these many cycles by reallocating capital to the segment with the best risk-adjusted returns. One of our core differentiating principle is that our underwriters are aligned with our shareholders through our unique compensation structure. Our underwriting teams are always seeking to maximize opportunities as long as they need our shareholders' targets. As we near the end of 2023 and look ahead to 2024, I believe that although the dynamics may shift, this hard market will continue to support profitable growth. Let's take a moment to recap the current state of the market and where we are likely headed. I see it as a play in three acts. The first act, the current hard market started in primary liability insurance in 2019 and then has a unique circumstance of a two-year pause in claims activity due to a global pandemic. The second act introduced Hurricane Ian as a main character where property reinsurers had to adjust both their pricing and risk appetite. In addition, capital got more expensive and the industry has to respond to meet new expectations from investors. While property has been the most recent driver of this market as we move into act three. We are faced with increasing evidence at casualty rates widely underpriced and oversold during the last submarket need to increase. We expect this third act of the extended hard market already one of the longest in memory to persist until the industry's reserving issues are resolved and until capital rates generate positive results. Arch is well positioned to capitalize on this operating environment. As new hard market underwriting opportunities arise, our incredibly nimble reinsurance group allows us to grow more quickly and significantly than in our insurance group and is therefore where we are most likely to deploy capital first. Today, market trends point to a reinsurance-driven GL hard market, and we stand ready to act. The third act has very started, but things are very promising for Arch. Now some color on our operating segments. Our reinsurance group has once again driven our growth with third quarter net premium written of $1.6 billion, up 45% from the same quarter in 2022 and 60% over the last 12 months. Underwriting performance in the reinsurance group was excellent with a combined ratio of 80% for the quarter. Our expectation is that we will continue to see hard property market conditions to next year's renewal cycle as uncertainty and loss activity remains elevated. As noted above, we expect increased opportunities in liability as well. Our insurance group also remains in growth mode in both our North American and international units, while net premium written in the Insurance segment, up 16% over the last -- over the past 12 months, are more modest than in reinsurance, they are more broad-based because of our focus on small- and medium-sized specialty accounts. Underwriting income continues to build with increased earned premium and a strong combined ratio of 90.9%. Today, there are still plenty of opportunities to grow profitably in insurance. Property and short-dated lines pricing in terms and conditions remained very strong with rate increases in excess of 15%. The then casualty pricing is increasing in response to overall casualty trends in the market and our programs unit continues to achieve rate increases above trend. Professional liability rates softened in the quarter, with net premiums written down 9% in the third quarter of '22. We share the marketplace sentiment about the D&O segment where both IPO and M&A activity decreased, at the same time as rig pressures from competition and security class action activity increased. However, returns in that segment are still strong. In the same vein, we maintained a positive outlook on cyber pricing on an absolute basis despite rate decreases in the 15% range. Our outstanding mortgage group continues to deliver quality earnings for our shareholders anda higher persistency of our in-force portfolio helped offset the slight decrease in NIW which has been affected by lower mortgage originations. Although we tend to focus our comments on the U.S. primary MI market, it is worth noting that nearly 40% of our mortgage segment underwriting profit this quarter came from non-U.S. operations compared to just over 10% in 2017. International business represents a significant growth opportunity for the mortgage group at Arch and our strategic decision to diversify our mortgage operations is yielding positive results that further differentiate Arch from our competitors. We are currently in a positive cycle on the investment side of our business, where increasing cash flows from growth are being invested into today's higher yield environment. New money rates are well in excess of our book yield which should continue to boost our investment income over time and provide us with an additional ongoing tailwind. In late October, which for baseball fans, mean it's fine for the world series, baseball is somewhat unique in that it's one of the few team sports that isn't limited to a specific length of time. You can score as many runs as possible until the other team gets three outs. To me, the current hard market feels like a baseball game. We know there's only nine innings to be placed, but we have no idea how long those innings will take. We've got a great lineup, we're happy to keep paying our singles, doubles and occasional home runs until the beginning is over. At Arch, we remain committed to being good stewards that are capital entrusted to us. We do that by following a tried and true data-driven approach that maximizes the capability of our diversified platform, diligently adheres to a cycle management philosophy and is centered around superior risk selection and prudent reserving. All the while, our underwriters are fully aligned with our shareholders. This principles are foundational to our playbook and underscore our long-term commitment to superior value creation. As we close out 2023, we have significant momentum in all three of our businesses and a reliable and high-quality earnings engine in our mortgage group that are helping fuel our growing investment base. All the pieces are fitting together nicely, and we're well positioned for the future. Now I'll call François up on an on-deck circle, and we'll return to answer your questions shortly. François?"
},
{
"speaker": "François Morin",
"text": "Thank you, Marc, and good morning to all. Thanks for joining us today. To add to the baseball team, I would also emphasize that while this long winning streak has certainly been fueled by a timely and dynamic offense, we're also very much aware that team defense has played an important role in our success. We've been working hard not to waste any offensive production with careless errors and by executing well actively and on the field. We produced exceptional third quarter results from high-quality earnings across all our lines. The highlights of this team effort are numerous and include after-tax operating income of $2.31 per share for an annualized operating return on average common equity of 24.8% and a book value per share of $38.62 as of September 30, up 4.3% in the quarter and 18.4% on a year-to-date basis. Similar to the quarterly results, our reinsurance segment grew net written premium by 45% over the same quarter last year, led by the property other than catastrophe line which was 73% higher than the same quarter one year ago. As for our property catastrophe business, it's worth mentioning that the net written premium in the third quarter one year ago included approximately $34 million of reinstatement premiums, mostly as a result of Hurricane Ian. If we adjust for the impact of reinstatement premiums, our growth in net written premium for this line would have been approximately 64% year-over-year. The quarterly bottom line for the segment was excellent with a combined ratio of 80%, 73.5% on an accident year ex cat basis, producing an underwriting profit of $310 million. The Insurance segment had another very strong quarter, with third quarter net premium roving growth of 11% over the same quarter one year ago. Similar to last quarter's results, we experienced good growth in most lines of business with the main exception being professional lines where the market remains competitive, particularly in public directors and officers liability. If we exclude professional lines, net written premium would have been 20% higher this quarter compared to the same quarter one year ago. Overall, market conditions for our insurance and reinsurance segment remained attractive and we expect the returns on the business underwritten this year to exceed our long-term targets by a solid margin for some business units. Profitable growth during periods of favorable market conditions is one of the hallmarks of our cycle management strategy and the current hard market is definitely giving us the opportunity to deploy meaningful capital in many areas. Our Mortgage segment's banning average has consistently been a league leader, and this quarter was no different with a 4.7% combined ratio. Net premiums earned were in line with the past few quarters across each of our lines of business. Included in our results was approximately $98 million of favorable prior year reserve development in the quarter, net of acquisition expenses with over 75% of that amount coming from U.S. MI and the rest from other underwriting units. Our delinquency rate at U.S. MI remains low based on historical averages and close to 85% of our net reserves at U.S. MI are from post-COVID accident periods at the end of the quarter. Across our three segments, our underwriting income reflected $152 million of favorable prior year development on a pretax basis or 4.7 points on the combined ratio was observed across all three segments, driven by short cat lines. Current accident year catastrophe losses across the group were $180 million, approximately half of which are related to U.S. severe convective storms with the rest coming from the Lahaina wildfire, Hurricane Idaliaand other global events. Pretax net investment income was $0.71 per share, up 11% from last quarter as our pretax investment income yield was up by approximately 18 basis points since last quarter. Total return for our investment portfolio was a negative 40 bps on a U.S. dollar basis for the quarter as our fixed income portfolio was impacted by the increase in interest rates during the quarter and most other asset classes and negative returns in line with broader financial market indices, such as the S&P 500, which was approximately 3.7% in the quarter. Net cash flow from operating activities has been very strong so far this year in excess of $4 billion, which has helped grow our invested asset base by approximately 20% in the last 12 months with new money rates in our fixed income portfolio comfortably above 5%, we should see continued meaningful tailwinds in our net investment income. Turning to risk management. As of October 1, on a net basis, our peak zone natural cat PML for a single event 1- to 250-year return level remain basically unchanged on a dollar basis from July 1 and now stands at 10.1% of tangible shareholders' equity well below our internal earnings. Our capital base grew and got stronger during the quarter and now stands at $18 billion. Our leverage ratio represented as debt plus preferred shares to total capital is currently under 20%, which provides us with significant flexibility as we look to deploy capital as opportunities arise. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Elyse Greenspan from Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question was, hoping to get some thoughts on the January 1 property cat renewals on the reinsurance side. So where do you think rates end up next year on a risk-adjusted basis?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, I think the -- it's still early. We have a lot of movement in the marketplace and capital and people are, as you can appreciate, positioning at all the conferences. But our general consensus in the team when we talk to underwriters is that we'll still have improvements in 1/1/24, not as big as 1/1/23, we're still going to get some slight improvement on the reinsurance side of things. What is also -- I mentioned before, this is not really fully reflecting what we believe has been the re-underwriting and reallocating of capacity by our clients, and that remains to be seen how it's going to be reflected and it will depend on the clients frankly. But overall, we still expect a very healthy, very robust 1/1/24 renewal on property."
},
{
"speaker": "Elyse Greenspan",
"text": "And then on your casualty comments, Marc, right, you alluded to that being the third act and really leaning in there on the reinsurance side. I was hoping you could just give us a sense of timing on how that will play out. And if that's a '24 event, do you see the reinsurance book shifting more to casualty? Or do you think it's an environment where they both on property and casualty offer good growth opportunities for the Company?"
},
{
"speaker": "Marc Grandisson",
"text": "It's a great question. I think the -- we have a big play in property, as you saw between the property cat on the region side that is and the property other than have core shares and thing in between. So I think we're still very much keen on that line of the business. Liability is a bit harder to evaluate right now because I think the first order is going to have to be looking at our plan for 2024, looking at the reserve or development of the area, the just talking about our clients. So it's going to take a little bit more time for people to figure out what it is they have and what they want to do with it going forward '24. So we'll have probably some of us think that we may have a renewal that is a bit more not as stable as it once was. So I think we'll probably see the early innings to go back to my baseball analogy of that liability possibly at 1/1. The one beautiful thing about GL or the one bad thing depending on the cyber market you're in, it's a longer-term development on a softening and on the hardening the GL can -- it will take a little bit longer to get to where it needs to get to because it takes time for you to get the losses, reflect them in the reserving, and we have a good sense of where the ultimate results are from the prior year to adjust and help inform the pricing you're going to have over there. So this is going to be a lot -- much more protracted third act than the second net was."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jimmy Bhullar from JPMorgan."
},
{
"speaker": "Jimmy Bhullar",
"text": "So first, just staying on casualty, there's been a lot of concern about reserves. And obviously, casualty is a fairly broad market category, but what are your thoughts on overall industry reserves in casualty, your reserves? And then maybe any color on the lines within casualty where you think there might be inadequacies and sort of the drivers of that or what's driven the reserve issues?"
},
{
"speaker": "François Morin",
"text": "That's a great question, Jimmy. I think there's -- as you said, it's a broad market. Certainly, we've seen some pressure in our own results. I think we see -- so you see both on insurance and reinsurance. On the reinsurance side, we see some of our clients recognizing adverse and the latency of some clients being reported to us, I think is coming through. We like to think we've been proactive in addressing those issues, but you never quite know for sure until everything comes through. But some of the subsets, definitely umbrella is an area that it's something that we're watching carefully. The good thing, I think, with our book is, again, we are big players in that space in the soft market years. So we're seeing some pain but not to the same level we think that may be other as well. And -- but it's a hot topic, and we're going to keep looking at it."
},
{
"speaker": "Marc Grandisson",
"text": "The one thing I would add, Jimmy, to what François just mentioned, is that we are you're hearing from the call that it's going to be more acute, more of a pressure point on the larger accounts than the smaller accounts. I think that the limits deployed there and the uncertainty and the combination of all these years developing is a little bit more probably more a bit more of an urgency in that sector. So we expect the larger accounts, which we don't do a lot of on the insurance side to be the first one to really feel the pressure."
},
{
"speaker": "Jimmy Bhullar",
"text": "Okay. And then on mortgage insurance, I would have thought, and I think most investors thought that at some point, you would see sort of a step down in your results, still strong earnings, but maybe not as strong as they had been the years following COVID because of the release of COVID related reserves. Just wondering how we can sort of get an idea on how much of the COVID-related reserves are still on your books and could be released versus maybe an ongoing benefit from that in the next few quarters?"
},
{
"speaker": "François Morin",
"text": "Well, I made the comment close to 85% of our reserves as U.S. MI are from post-COVID years. So that would mean '20 and after. But let's remember that when we were coming out of COVID, we saw just a lot of changes in home prices, home price appreciation and potential over valuation, right? So when we were sending reserves in the last few years, '21, '22, even up until early '23, that was a concern of ours. So we were somewhat -- as you would expect us to do somewhat more prudent I'd say in setting our reserves. how that plays out when delinquencies cure, we don't know. Could there be further favorable development maybe. But I'd say, for the most part, what's really been happening in the last couple of years is just I'd say very much again a function of the housing market, which has been just exploded and then created a different set of kind of data points that we're trying to analyze, and that's how -- what we based our reserves on. So hopefully, that gives you a bit of color on the question."
},
{
"speaker": "Marc Grandisson",
"text": "I'll just add one thing to me on the industry. The industry is extremely disciplined again, a very nice thing to see around us. So from an ongoing perspective, putting the reserve for one second, if I can talk to the -- our expectations. And we think that there's still risk on the horizon, but the credit quality of our portfolio the housing supply imbalance that you hear fromFrançois and the fact that we have a lot of healthy equity into a policies in force is it looks really, really good. And when we say that our mortgage growth is also doing very well, and that's what we mean. It's in a really good place."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Tracy Benguigui from Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "While you posted double-digit insurance premium growth this quarter, the pace has decelerated a bit over the last two years. It looks like peak insurance premium growth was in mid-'21, and that might be a tough benchmark given you've grown a ton and professional ability and you are shrinking error, as you pointed out. Could we expect insurance premium growth at double digits to be sustainable going forward? Or should we see it fall to high single digits because of the professional lines headwind? And I'm just wondering if it's fair to assume that you prefer deploying capital into reinsurance now, all else being equal?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. In terms of return expectations, I think your instinct is right on. I think reinsurance is providing right now very, very healthy returns. We expect this to continue into '24 and '25, to be honest. But the insurance group, I think it's one quarter, there's couple of moving parts due to some accounting thing, timing and stuff here and there sometimes. But as François mentioned, the growth in the line that we like to see growth into I'm very pleased to see because this is where I would expect the team to grow it but the market conditions are great there. And I would expect even some of those nonprofessional lines to actually maybe carry the day bit more going forward. I wouldn't be surprised that we could go back above 10% next quarter and into 2024. So I'm not -- I don't see one quarter of the trend, to be honest."
},
{
"speaker": "Tracy Benguigui",
"text": "Right very helpful. You slightly shortened the duration of your asset portfolio in September to 2-point, nine, seven years from 3.03 years in June. It feels like you're taking durational asset mismatch because the MI liabilities are much longer dated. Given the shape of the yield curve is beginning to show signs of steepening, I mean to tad bit less inverted. Going forward, would you consider lengthening your asset duration? Or you feel comfortable with the sub-3-year duration level?"
},
{
"speaker": "François Morin",
"text": "Good point. I think the duration is probably the lower it's been in a long, long time, and that's just our investment professionals here again make the decisions, and there's obviously a little bit of tax expats involved and kind of where they want to play at a certain point in time. But for sure, absolutely. If interest rates, we think the longer the curve ends up being a bit more attractive. I mean, we certainly consider extending the duration a little bit. And we've got a bit of room there anyway just to match with the liabilities to make sure that we're not mismatch there. So that's certainly something that we'll look at in the coming months and quarters, yes."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Yaron Kinar from Jefferies."
},
{
"speaker": "Yaron Kinar",
"text": "First question, it sounds like you are pretty constructive looking into 1/24. Can you maybe talk about your prioritization of capital? And maybe give us a way to think about maybe potential available capital you have to deploy into the insurance and reinsurance markets?"
},
{
"speaker": "François Morin",
"text": "Well, yes, we are constructive on 1/1. I think we -- Marc and I said it, I think it's a really good market in totality. There's some pockets that are certainly better than others. We think that the internal capital generation, we've been able to generate in the last few quarters gives us the ability to really grow and take advantage of the opportunities that we think have a good chance of being there. Again, we don't make the market. We participate in the market. So if the market is as positive as we think it can be, then we'll be happy to step in and take a bigger share of it. But I think the fact that we've got capital flexibility has always been one of the -- and on a onetime things and our strategy all along is we want to make sure that we have plenty of capital to deploy when the market is right. And so far, we've been able to do that."
},
{
"speaker": "Marc Grandisson",
"text": "So Yaron, if I look at the high level, the way we think about -- we think about it, it's different perhaps than even our underwriting units, meaning that they don't really, they were doubting how much capital is allocated to them at the beginning of the period. I want to remind everyone that people write the business or underwriting fee write the business. And then we -- after that, charge them with the capital they've been using. And based on the planning and all the expectations that we have, our message there has been -- there is no capital constraint or issue concerns that, that pertains to you guys. If you see the market being a better and even get better than we saw, feel free to deploy more capital if you wish to do so. So there's definitely there's all hands on deck go forward if we can invite the business. That's one thing that's really nice and we'll then attribute the capital after we have written the business. That's what we do every year. On the property cat side, which is probably a more interesting one for is worth to you, we're about 85% allocated to the reinsurance group in terms of PML thatFrançois mentioned. And I think it's because the returns there are a little bit more favorable on the reinsurance side. And then we had the discussion at the group level. That's one exception. So when we have an acute or a specific area of the capital, we'll sit down with the Insurance Group and Reinsurance Group with Nicolas facilitating the whole discussion, and we'll sort of decide to roughly broadly where we want to allocate capital."
},
{
"speaker": "Yaron Kinar",
"text": "I appreciate that. And then certainly, I think the capital availability and the appetite to deploy is a very important part of the or story. And I guess from that perspective, is there anything you can offer us in terms of an attempt to quantify the available capacity? Or is that something that we'll just have to watch and see?"
},
{
"speaker": "François Morin",
"text": "Yes. I mean, we -- certainly, we have some capital -- we have plenty of capital available. We just don't know what the market will look like at 1/01. So that's why I'd say you're right, probably have to -- what you see a little bit, see how 1/1 play out and then we'll have the ability to do something with the excess capital in."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. And then my other question, just on public D&O and cyber, where we're clearly seeing a little bit of pressure and competitive pressure there. Do you still view rates as adequate there? And are they clearing the loss cost trends?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, our return expectation on both these lines, cyber and D&O, is still very, very healthy."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Joshua Shanker from Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "Yes. With the high retentions, this quarter in terms of premium ceded. Can you go maybe line by line or dig in a little bit about which lines of business you're retaining more? And is that a signal that you've gotten to the point where you have enough information that you love the profitability more and want to keep it yourself? Or is your you're looking at your capital thing, we have the capital deployed. So let's eat a bigger plates the pie. How did that all come together?"
},
{
"speaker": "Marc Grandisson",
"text": "I think you answered the question beautifully. I mean by asking a question to give the answer, I think that all those things you said are true. I'll get to the lines in a second. But to your point is exactly right. We're going to this hard market and we make -- we still value reinsurance. You cannot go without a reinterest. You still need for various reasons, limits management, risk management and also information, right? Reinsurers are providing us on the insurance side with valuable information about what the market is and the state of the market. So we don't want to be an outlier out there. So it's always good to have this as an additional value proposition from the reinsurance companies. In terms of what we decided to do over three years, you're quite right, we have been building, asFrançois mentioned, a significant amount of capital through our mortgage earnings. So that's certainly something that was helpful and available to deploy in other areas, and that also helps being able to maintain and retain more net. I think if you at a high level, I think that the patterns of buying, we're buying a fair amount of less on the liability lines, specifically those that went through the first act and really had a lot of good uplift. So we definitely saw that happening on the property, even though the property is very hard, as we all know, since last year, this is a much more volatile line of business, so we still maintain our loss on the cat side and still by a quota share, a significant quota share on that business as well. So I think overall, it's meant to be the balancing act between providing relief or volatility protection to some extent and information. But you're quite right, having more capital definitely helped us take more net on our balance sheet."
},
{
"speaker": "Joshua Shanker",
"text": "And switching gears a little bit. When you have a 25% ROE quarter, you're making a lot of money and you have a large team that has contributed to that result. I assume they'd like to be paid for their good work. How should we think -- we've not seen a quarter like this in a long time in a year like this. How should we think about the pattern and the cost of discretionary comp where it hits the P&L and how it should compare with prior years?"
},
{
"speaker": "François Morin",
"text": "Great question, sorry. We -- just again, in terms of timing, right, our incentive compensation decisions are made in the first quarter will be made in February of next year. But no question that throughout the year, we accrue expected bonuses based on what we think that our performance might look like, and there's effectively a true-up that takes place in the first quarter when the final amounts are determined. Something we're keeping an eye on. So I don't know if there'll be an early adjustment in the fourth quarter or not something we'll be looking at carefully, so that we don't go to distort too much the first quarter next year. Obviously, the Board has final say in how much money will be available to pay our troop. So that's -- it's a little bit of -- we don't want to front run it. We want to be reasonable and not introduce too much volatility in the numbers on the OpEx side. But that's certainly something that we'll take a look at in the fourth quarter to make sure we're not missing anything here."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Alex Scott from Goldman Sachs."
},
{
"speaker": "Alex Scott",
"text": "First one I had is on the attritional loss ratio in the reinsurance segment. I was just thinking if you could give us a little more color around just what's driving this year, favorable performance year-over-year? And if there's anything new as we should be thinking about or if it's just the pricing environment being as strong as it is?"
},
{
"speaker": "François Morin",
"text": "Two quick things there. One is -- and we said it before, and it goes both ways. We think of reinsurance as a line of business or a segment that we think is better analyzed on a trailing 12 month basis. We think looking at a quarterly there'll be some good, it will be some bad. And we've said in past quarters where we have elevated the traditional claim activity. We said don't panic, don't overthink it in the same way here, I think. So we would certainly encourage everybody here to look at a trailing 12-month basis to have a better view of the long-term kind of prospects of the segment. The other thing I'd say is also, obviously, we've grown a bit more in property than relative to get align. So by nature, right, our ex cat combined ratio should probably come down and it has as a result of, again, the growth -- the significant growth we've had both in property cat and property other than cat."
},
{
"speaker": "Alex Scott",
"text": "Got it. Very helpful. I wanted to ask a follow-up on the comments you made on casualty reinsurance. And I'm just interested in what is changing that's causing more of this commentary to sort of bubble to the surface? I mean, we've heard it from some of the European reinsurers as well. Is it I mean, is it truly just that they're starting to see reserves develop in a poor way for some companies? Or is there something that's changed about the social inflation environment? I mean what do you think is the underlying driver or drivers?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think the industry is -- there's a couple of things going on at the same time, and they unfortunately don't go in the right direction for both for all our industry if you have written casualty. First, we have -- as I mentioned in my comments, we had a bit of a slowdown in activity including core activity, settlement activity. And we also have, as we all know, there's a lot of litigation funding, it's a bit more aggressive is coming from the platelet bar, and that's certainly something that you could describe to be social inflation, but that's not really something new. But there was sort of a lull in this market. It was sort of a spike, if you will, between 2020, '21 to really middle of this year, early this year. So, I think right now, we have sort of a refresh reupdating all the information about the losses of where we are and what could happen with the demand being updated and made more current. At the same time, we have price that business as an industry in 1,519 with inflation at 2%. Now inflation is north of 5, 6, 7, depending on where you look at. So at the same time, of course, we open things are being adjudicated reanalyzed, you have to account for a higher inflation number. And that is a classic case of having a couple of things going against you, nothing that the industry did on its own. It's just the economy and the environment and the risk in it and the environment. So I think that we're facing all collectively as an industry, that phenomenon. And what I like about the industry's capability is, it's reacting and that's what you hear. That's something that we should be very, very happy for collective as an industry. The other calls that you heard this quarter recognize it, and once you recognize an issue and a problem, people are very good and very adept at addressing it. And I think that's what's going on there are couple combination coming in very, very short order because of the surrounding environment. I think this is what largely drives what's going on right now."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Michael Zaremski from BMO Capital Markets."
},
{
"speaker": "Michael Zaremski",
"text": "Switching gears to the to the investment portfolio. So the net realized losses were somewhat outsized again this quarter. I know they run below the line, but any color -- are those -- are you actually crystalizing to take advantage of the higher rates? Or is there noise in there from unrealized stuff or maybe the LPT transactions in the past?"
},
{
"speaker": "François Morin",
"text": "Yes. I mean it's mostly around kind of crystallizing some losses. I think it's a process we go through for each security on the fixed income side, where we make the determination. Is it appropriate to sell some of those and redeploy the proceeds and higher yields and our investment team does that. So yes, there are going to be some realized losses coming through the fixed income. Obviously, the equity portfolio, which is not huge, but still there's FBO securities like fair value option securities, including equities that are effectively mark to market, and that comes through the realized gains of losses line in the income statement. So those are the two big items. There's a little bit of other stuff going on that is a little bit of the wheat. So, I wouldn't want to go there, but that's directionally hopefully that's just normal course of action."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. And lastly, on -- is my understanding for me to put out there a second comment letter, maybe it's different, they call something else. But on the potential tax changes that will take place. Are -- any way you could offer us some color on what's -- how things are going to play out base case over the coming year two or? Or does the step-up -- if everything goes as planned, does the step-up in tax rate happen in '24? Or is it a '25 event or both?"
},
{
"speaker": "François Morin",
"text": "Yes. It's, again, very early. So too early, unfortunately, to give clear or kind of views on what we think could happen or because they're still developing the laws and we expect more progress on that before the end of the year. But at a high level, it doesn't start at one start if it goes through until 2025. So, there's no impact for 2024 and we will be evaluating the and may publish some target tax rate that they will try to get to. But again, more to come, I think we'll do our best to keep you apprised of how we think about it probably on the next call. But until we have work to now any more clarity on where it's going to land, I think it's a bit premature to give you too much do any details here."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Meyer Shields from Keefe, Bruyette & Woods."
},
{
"speaker": "Meyer Shields",
"text": "First question on, I guess, casualty reinsurance. This year, like January 2023, we saw not only significant increases in property capital. We saw changes in program structures with higher attachment points. Is there anything analogous to that, that we should see on the casualty reside in 2024? Or is it just going to be a great story?"
},
{
"speaker": "Marc Grandisson",
"text": "Probably more of a great story. The buying pattern on GL is mostly on a quota share. There's a lot of quota share being purchased in that segment. That's also certainly something we prefer to focus our capacity on those of you who followed us for years, this is where we prefer to focus on capacity. On the excess of loss, my people don't really buy a lot. People don't put out is like $60 million, $80 million, $100 million limit. So, we don't have a similar kind of risk -- the risk vertical is not as big. And in terms of events, like a cat portfolio, you could see where things are accumulating can generate hundreds and hundreds million dollars of exposure. In the liability side, it's not the same. You already have a necessarily one or two events that could really impact such a wide area of your GL. So, I think we'll see a lot more filters more on a quota share basis and some of the excess of look here and there. It's not very similar -- it's not at all similar to the property market."
},
{
"speaker": "Meyer Shields",
"text": "Okay. That's very helpful. And second question, and hopefully, I can ask this in a way that makes sense. When we talk about reserve problems from older accident years, ultimately driving casualty rate increases to accelerate. Is that the industry can over earn in 2024 and backfill? Or is it because the recalculated full year's losses mean that current rates are actually not as adequate as we thought?"
},
{
"speaker": "Marc Grandisson",
"text": "I think it's the latter. I mean it's a bit of the former, to be honest with you, people have to recognize those losses if they have them. I do believe -- as we talk about Meyer, you know that as well as we do, you're going to enter yourself, the reserving process feeds the pricing process. And clearly, if we have a reserving that's a bit higher than you would have expected, it will help inform your loss ratio historically. You have to put a trend on them, to the on-level analysis that helps get you to the price increase that you're looking at. So the past as it's developing, will inevitably lead you to having to charge more. And the reason we'll do a whole lot of large GL for that matter is precisely because of your second point, which has been historically a little bit wanting on the rate level and the rate level side."
},
{
"speaker": "Meyer Shields",
"text": "Okay. That's worrisome about recent years for the industry, but that's very helpful."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Bob Huang from Morgan Stanley."
},
{
"speaker": "Bob Huang",
"text": "Congratulations on the quarter. Just a quick question on your insurance segment's loss ratio year-on-year loss ratio improved for about 30 bps. But just given just the strong E&S pricing environment, shouldn't we expect a little bit better improvement in loss ratio. Is there anything in the loss trends that probably differed from how you thought about your loss picks in the past, just see if there are any comments around that?"
},
{
"speaker": "François Morin",
"text": "Maybe -- I mean I think the answer is really around like us being proof and initial loss picks. We don't want to get into the game of being overly optimistic. There's still a lot of risk out there. There's still a lot of uncertainty when we price the business, whether, again, we just been talking about casualty loss trends in particular, that's an area that we're watching carefully. So, we'd rather -- and it's been our model for many, many years is pick a realistic kind of a bit more conservative initial loss pick on -- when we book the business and then react to the data when it comes in. So, we're hopeful there could be good news down the road. But for the time being, we're very happy with our loss picks."
},
{
"speaker": "Bob Huang",
"text": "Okay. My second question is a follow-up on the reinsurance core combined ratio. Obviously, it was very strong and I think you mentioned that a lot of it is due to business mix shift, right, shifting towards property and then because of that and then you naturally have an improving combined rate -- loss ratio there. Just curious if we were to think about going forward, the run rate combined ratio for your reinsurance segment, based on the comments so far, is it fair to sort of assume that it's going to be closer to what you printed over the last two quarters and probably better than the prior quarters. Is that a fair way to think about it just from a modeling perspective?"
},
{
"speaker": "François Morin",
"text": "Again, I mentioned like the thinking around trailing 12 months, which is where I would start -- to help you kind of with assumptions, I would -- if you're going to -- we think about it in totality around the combined ratio, but if you're breaking down the loss and the expense ratio, yes, maybe there's a -- given the growth, maybe there's potentially the latest quarter of OpEx is probably more sustainable given we've been able to generate that premium, that growth with the same level of resources. But on the loss ratio side, I think it's just -- I would be careful not to over I mean give too much weight to the latest quarter."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Brian Meredith from UBS."
},
{
"speaker": "Brian Meredith",
"text": "A couple of questions here, first on the MI segment. I know there's clearly some market pressures, but NIW definitely down year-over-year. And it looks like just looking at some of the stats you all have been losing some market share in the MI segment. Is that intentional? Are you any concerns about the outlook here on the MI as far as delinquencies? Or is it more related to perhaps just better use of capital elsewhere?"
},
{
"speaker": "Marc Grandisson",
"text": "It's more the latter than the former. I would actually say tell you, right, that the market is better this year than it was in last year. So, I would argue that we might change the way we intent the market over the next 12 to 24 months. But certainly, at heart, we have been saying that to you historically it hasn't changed last quarter, which in terms of relative returns based on the three segments on the underwriting segments. MI is a third one, but a very strong one, I would say, at this point in time. But again, it's more a reflection of the relative opportunity between the units than anything else. In the market, Brian, I'll tell you the market is very, very disciplined. We're very impressed by the industry or the MI industry."
},
{
"speaker": "Brian Meredith",
"text": "Good to hear. And then I guess my second question, Marc, as I think about if this next leg is coming through the third act on the casualty reinsurance side. I guess that probably comes through a lot on the ceding commission side, if you get you get better ceding commissions, should we continue to see kind of the acquisition kind of expense ratios on the reinsurance side kind of moving down here as we head through 2024, given was going on with the casualty reinsurance part, particularly since you play quota share?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, yes, I think the ceding commissions about store three right now we'll see what that ends up. There might be a slight change or we'll see how -- it's also going to be dependent on how the underlying market is improving as a reinsurance player. But I think what's our acquisition comes right now reinsurance is mid-low, low 20s. So, I think if you have more of a portfolio even if that's argued, it's a 30% ceding commission. So you might see actually, the acquisition going up a little bit. But again, as Franco mentioned, all the time talk about when we have these questions about the expense ratio and loss ration but not restarted the return and whether the combined ratio lends ourselves to return when it comes from losses of expenses we have already losing sleep here. So, I think this is…"
},
{
"speaker": "Brian Meredith",
"text": "And I was going to say that I guess maybe the right way to think about it is that if you're leaning more into the GL, the underlying combined ratios may actually move up some here as you look forward because we have a different return profile."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Scott Heleniak from RBC Capital Markets."
},
{
"speaker": "Scott Heleniak",
"text": "Just on the MI. I wondering if you could expand on the growth opportunity internationally, you referenced in your commentary. I know Australia is a big market for you, but we're also are you focused outside of the U.S.? Or is it mostly just Australia you're referring to?"
},
{
"speaker": "Marc Grandisson",
"text": "Great question. I think in non-U.S. base is also the CRT, which is granted exposed to the U.S. MI, the excess of loss program that the GSEs have developed over that and we have developed over the last 11, 12 years. Internationally -- so that's a piece of it, you see it in our financial supplement. Internationally, we have Australia. As you know, we have a good size, great relationship and a great presence there. We're very pleased with it. We're also getting a little bit more market share there even though the mortgage origination is a slowdown there as well. The other is really in development is the international with European specifically, SRT, which are 90% mortgage-backed credit risk transfer, they look a lot like the CRT business that we have in the U.S. Most of it is done because banks need to release capital that Basel III led the transactions. And we've been doing it for a little while, and we've partnered up, we actually with another European company who's very steep in that area. So that's a growing area right now because I think the -- there's a lot more need for capital. As you know, Scott, not only in the U.S. [indiscernible] has a similar consideration. So, it helps us be there for them to provide more capital relief and it's certainly something that we're focusing more efforts on."
},
{
"speaker": "Scott Heleniak",
"text": "Okay. That's helpful. And then the -- just the risk profile and the credit quality and the default ratios on those, I would assume those are very favorable. But how does that all compare to outside of the U.S. and internationally versus the U.S. book?"
},
{
"speaker": "Marc Grandisson",
"text": "I don't want to say too much because you're going to get more competition in the segment. High level of comparable and sometimes better than the CRT we see, but we still a little bit more work to be done there, those who are trying to get in the business. I think you should talk to us, first of all, help you hit in the business."
},
{
"speaker": "Operator",
"text": "Thank you. At this time, I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you so much, everyone, for listening to our commentary this quarter. Looking forward to the end of the year. Happy Halloween. See you next time."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for your participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 2 | 2,023 | 2023-07-27 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Q2 2023 Arch Capital Earnings Conference Call. [Operator Instructions]. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends to be forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website and on the SEC's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sir, you may begin.
Marc Grandisson: Thank you, Josh. Good morning, and welcome to our second quarter earnings call. We're more than half way through 2023 and through our commitment to underwriting acumen, prudent reserving and cycle focused capital allocation, we were able to deliver another quarter of profitable growth. In the second quarter, our results were primarily driven by our willingness and ability to deploy capital into lines with superior risk-adjusted returns. Our operating results in the quarter were stellar with an annualized operating return on average common equity of 21.5% that drove a 4.8% increase in Arch's book value of common share for the quarter. As you know, book value per share growth is our primary focus on our road to creating long-term value for our shareholders. Each segment generated over $100 million of underwriting income in the quarter. These outstanding returns reflect our ability to effectively execute in each segment. We're really operating in our sweet spot. I also want to commend our employees for the continued exceptional growth they've delivered in the quarter, most notably a 32% increase in property and casualty net premium written compared to the same quarter a year ago. This hard P&C market is proving to be one of the longest we've experienced and we are in an enviable position as we look to 2024 and beyond. We often refer to the insurance clock developed by to help illustrate the insurance cycle. You can find the clock on the download cap for this webcast or on our corporate website. If you can't do the clock right now, just picture a traditional clock dial. For some time, we've been hovering at 11:00, which is one we expect most companies in the market to show good results as rate adequacy improves and loss trends stabilize. Last year, a popular topic on earnings calls was whether rate increases were slowing or what the rates were even decreasing. These are classic signs of the clock hitting 12 when returns are still very good, but conditions begin to soften. Yet here we are in mid-2023 and conditions in most markets remain at 11:00. We've even checked the batteries in the clock and they're just fine. The clock isn't broken. It's just that the current environment dictates an extended period of rate hardening. So what's sustaining this hard market? Well, I believe it's a relatively simple combination. Heightened uncertainty is driving an imbalance of supply and demand for insurance coverage. Since this hard market inception in 2019, we've had COVID to war in Ukraine, increased cat activity and rising inflation, all of which create significant economic uncertainty. Underwriters have had to account for more unknowns. Beyond those macro factors, industry dynamics also play a role in sustaining the hard market. Generally, in adequate pricing and overly optimistic loss trend assumptions during the soft market years of 2016 through 2019 have led to inadequate returns for the industry. The impact of these factors should cause insurers to raise rates and purchase more reinsurance in a capacity-constrained market with limited new capital formation. Put it all together, and it may be a while before the clock strikes 12 and we begin to move beyond this hard market. I'll now share a few highlights from our segments. First, P&C. In the second quarter, the reinsurance group was successful again at seizing growth opportunities. In particular, the media property and property cat renewals saw a significant improvement in rate adequacy and our underwriters are already willing and able to provide valuable capacity to our clients. Our PML or exposure to a single event in a 1-in-250-year return period went up in the quarter while our premium income grew substantially. At July 1, our peak zone exposure rose to 10.5% of tangible equity. Overall exposure to property cat risk remain well within our threshold and because of our diversified portfolio and broad set of opportunities, we retain the flexibility to pursue the most attractive returns across lines and geographies. Although there are lines where pricing has declined, large public comes to mind. P&C markets continue to see rate changes above loss trends. Even with those fee lines with weakening rates, the compounded rate increases over the past several years continue to be earned and are generating attractive returns. Overall, we like the range of opportunities in front of us, and we continue to lean into the current market. Next is mortgage, which keeps generating meaningful underwriting income and risk-adjusted returns. Housing and credit conditions remain favorable, although high mortgage interest rates tempered demand for mortgage originations and limit refinancing options. The lack of refinancing has led to a historically high persistency rate of 83%. High persistency stabilizes our insurance in force, which, as many of you know, drives mortgage insurance earnings. Our disciplined underwriting process and risk-based pricing model have helped us to build a healthy risk-reward profile for the business we write. The composition of the overall book with high FICO scores and low loan-to-value and debt-to-income ratios remains one of the best risk profiles in the industry. International growth, along with our GSE credit risk transfer of business, enabled us to profitably manage risk better than more online U.S.-only companies, a key differentiator of our MI global platform. Mortgage insurance plays a valuable role in our diversified business model and continues to generate capital that is and can be deployed into the most attractive opportunities across the enterprise. Moving on to investments now. Since our second quarter on the call last year, the Federal Reserve has increased, as we all know, the rates 8x for a total of 375 basis points. Given our short duration portfolio, these hikes have positively affected our net investment income, which is up approximately 22% over the first quarter of '23. New money rates exceed our book yield, which, along with our strong cash flow, sets the stage for further growth and book value creation. Have a on the brain after watching the incredible Wimbledon final couple of weeks ago, it was an epic match-up 20-year-old sensation, Carlos Alcaraz, taking on all-time Novak Djokovic, was a back and forth match that lasted nearly 5 hours before Alcaraz emerged victorious. There was one pivotal moment that will be remembered for years. In the third set, a single game, something that usually takes about 3 to 5 minutes, instead lasted 26 minutes. The game included 13 deuces and 7 breakpoints. It was an incredible display of tenacity and athleticism. Not to mention the mental strength required to remain focused. It was insane. But what really struck with me was that kind of like this hard market, the game simply refused to end where many times where a single winning shot would have ended the game, but it just kept going. About 15 minutes in, it became clear that we just needed to enjoy what we were watching and not focus on the end point. So that's what we're doing with this hard market, returning what the market serves us with gusto. As always, our goal remains to generate strong risk-adjusted returns in order to create long-term value for our shareholders at lower volatility. The exceptional profitable growth over the last several years has fortified our market presence and helped us achieve one of the most profitable quarters in our company's history. This is a type of well around the quarter we've always envisioned. The sweet spot, if you will, and we look forward to building on this momentum in upcoming quarters. I'll the court now to Francois, and then we'll return to answer your questions.
Francois Morin: Thank you, Marc, and good morning to all. Thanks for joining us today on this gorgeous day in Bermuda. As Marc highlighted, our underwriting and investment teams delivered excellent results across their respective areas in the second quarter, which resulted in a performance that exceeded that from our very strong first quarter. For the quarter, we reported after-tax operating income of $1.92 per share for an annualized operating return on average common equity of 21.5%. Book value per share was $37.04 as of June 30, up 4.8% in the quarter and 13.5% on a year-to-date basis. Turning to the operating segments. Net premium written by our Reinsurance segment grew by 47% over the same quarter last year, and this growth was observed in most lines of business. Growth was particularly strong in the property catastrophe and property other than catastrophe lines with net written premium being 205% and 53% higher, respectively, than the same quarter 1 year ago, a reflection of the fact that market conditions in these lines remain very attractive. As a result, the quarterly bottom line for the segment was excellent, with a combined ratio of 81.9%, producing an underwriting profit of $245 million. The accident year ex cat combined ratio was 77.4%. The Insurance segment also performed well, with second quarter net premium written growth of 18% over the same quarter 1 year ago and an accident quarter combined ratio, excluding cats of 89.8%. Except for professional lines, which saw a slight decrease in net written premium in our public directors and officers business due to a more competitive market, all our underwriting units in insurance, both in the U.S. and internationally, saw good growth in the quarter as market conditions remain excellent. Our Mortgage segment had another excellent quarter with strong performance across all units, leading to a combined ratio of 15%. Net premiums earned were in line with the past few quarters, reflecting a high level of persistency in our insurance in force during the quarter at U.S. MI, partially offset by lower levels of terminations in Australia and higher levels of premium. Benefitting results was approximately $84 million in favorable prior year reserve development in the quarter, net of acquisition expenses, with over 75% of that amount coming from U.S. MI and the rest spread across our other underwriting units. [Indiscernible] activity at U.S. MI was again very strong this quarter, and our delinquency rate stood at 1.61%, its lowest level since the onset of the COVID pandemic. At the end of the quarter, over 80% of our net reserves at U.S. MI are from post-COVID accident periods. Overall, our underwriting income reflected $116 million of favorable prior year development on a pretax basis or 3.9 points on the combined ratio and was observed across all 3 segments mainly in short-term lines. Current accident year catastrophe losses across the group were $119 million, over half of which are related to U.S. severe convective storms that have occurred so far this year. Pretax net investment income was $0.64 per share, up 21% from the first quarter of 2023 as our pretax investment income yield was almost up 50 basis points since last quarter. Total return for our investment portfolio was 0.56% on a U.S. dollar basis for the quarter with most of our strategies delivering positive returns. Our interest rate positioning with a slightly shorter duration helped minimize the impact of the increase in interest rates during the quarter. We remain comfortable with our commercial real estate and bank exposure, which is a high quality and short duration. Net cash flow from operating activities was strong in excess of $1.1 billion this quarter and continues to provide our investment team with additional resources to deploy into the higher interest rate environment. With new money rates in our fixed income portfolio is still in the 4.5% to 5% range, we should see further improvement in our net investment income in the coming quarters, arising primarily from positive cash flows and the rollover of maturing lower-yielding assets. Turning to risk management. Our natural cat PML on a net basis of the single event 1-in-250-year return level stood at $1.46 billion as of July 1 or 10.5% of tangible shareholders' equity, again, well below our internal limits. In light of the improved market conditions in the property market, we were able to deploy more capacity, which resulted in a significant premium growth for property lines in both our Insurance and Reinsurance segments. This growth was well diversified across multiple zones. Our view is that the current in-force portfolio with a broader spread of risk across many zones is well positioned to deliver attractive returns. Our capital base remains very strong with $17.4 billion in capital and a debt plus preferred to capital ratio of 20.5%. Even though the results of the past quarter set the high watermark for us on many fronts. We believe the continued hard work and dedication from our teams, serving the needs of our clients every single day, along with our steadfast commitment as disciplined and dynamic capital allocators, sets us up very well for future success. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions]. Our first question comes from Elyse Greenspan with Wells Fargo..
Elyse Greenspan: My first question, Marc, can you quantify the supply-demand imbalance that you're seeing within the reinsurance market? And how much of that do you think could transpire from an additional pickup in demand potentially at 1/1 2024?
Marc Grandisson: Good question, Elyse. I think the numbers we've seen for around $50 billion to $70 billion is not a crazy number. So I think that where we still have this imbalance occurring. I think that market has found a way to do the reinsurance transaction and buy coverage. But indeed, there was also a -- there could have been more to be had from a reinsurance perspective. But we believe and you heard on the call that insurance companies also had to -- a shock at sort into evaluate what they can buy and how much they could afford based on where the pricing level was. So I think that just in balance right there of reinsurance. There's also, I believe, we also believe it's in balance in the terms and conditions in the overall broad industry that needs to be more of a function. On one hand, you could create capacity for cat exposure through third-party capital or reinsurance protection. But at the same time, we could also do it through improve in terms of condition on the insurance level. And I think that's also something that will help bridge a gap. And we believe that's going to be more of the key element as well for the next 18 to 24 months.
Elyse Greenspan: And then the , Francois, the accident year underlying combined ratio within reinsurance. Is that a good run rate level or maybe you could get better as we think about some rate earning into the . Is there anything one-off in that number in the quarter?
Francois Morin: Well, I wouldn't say there's anything one-off. It is certainly a very good quarter. I think our view, as we said in the past, when we had some quarters where there's a little bit more activity as we think it's better to look at it on a on a 12-month kind of forward-looking view. So is this quarter going to repeat in the future? Maybe, we just don't know. I mean, but I'll say it's certainly good. There's room for further improvement. But again, recognizing that there's going to be volatility in the reinsurance segment from quarter-to-quarter, I'd say it's -- I'll let you make your pick from there.
Elyse Greenspan: And then, Marc, one more for you. I mean your stock has done really well. So you have a problem, a good problem that any CEO would want in that you have an extremely valuable currency. We sit here with the hard market. You guys obviously have a lot of organic growth opportunities. What would you need to see from an M&A perspective to consider using your stock as currency to enter into any type of transaction?
Marc Grandisson: Well, many things are needed. Obviously, you need -- it takes the time goes -- is going to appreciate in this world. But I think at a high level, at least we're not focused on M&A at this point in time. We're really focusing on growing the book organically. We're also maintaining pretty well EMI as well as other nonproperty exposure. So we do -- we are seeing a lot of opportunities broadly. And this is where -- what our shareholders are paying us to do and this is what we're doing. And this is -- this represents really a once in a little while opportunity to really deploy and really get access to the market in a bigger way to provide more capacity to our clients. And we don't want to miss that. I mean an M&A would have to strategically fit for us beyond the money I think right now, our efforts and time is better focused on organic growth, though at this point in time. And this is where -- I think we have plenty of opportunities on our own.
Operator: Our next question comes from Tracy Benguigui with Barclays.
Tracy Benguigui: You mentioned that your 1-in-250 PML intangible equity was 10.5% at 7/1 which was up from 8.1% at 4/1 and I recognize your upper tolerance of 25%, it almost feels to me like you have a supplement below the 25%. Is it fair to assume that getting closer to 25% requires an even higher ROE hurdle rate or pricing? Like could we just be theoretical, what would you need to see in order to get more comfortable taking on more volatility in your book where you can get closer over time to that 25%?
Marc Grandisson: Well, I think the -- we're -- first, the one thing about the PML, which is so interesting to us is that we're in the early innings of where it's going to go. So we have to be careful that when we talk about this even internally ourselves, these are the early innings of our market getting much better. And as I mentioned, terms and conditions, we believe, also improving and really helping to manage cat and the cat-related risk better as an industry. So we'll see how that develops over time, Tracy. I think that we're also a different animal than we were way back when. We've grown up our capital faster than the growth in exposure and needed. So the 25% before is probably a lesser number. I think you're quite right. And we also have to balance the overall portfolio risk profile. But having said all this, there's plenty of room to go from 10.5% to wherever we're going to end up. We don't know where that's going to be, assuming conditions say as they are or even improve further, it certainly will mean more PML growth. I think that it would have to be substantially better. We actually have a very, very solid construct within our overall capital allocation that will dictate what kind of market share we would have of the market. And all I would say is there's always a place to go to the numbers you talk about, but we'll see if we get there. And I will also remind everyone that it's not a bad to start the index of one of the major brokers, as you all know, it shows us that the pricing for the cat is the highest it's ever been since 1990, even before Andrew. There's a lot of room, and we're excited to see where that takes us. And one final thing I will take is if you look back at the '05, '06, '07, '08, if you go back on this, if you have enough of a memory or a good document retention policy or a bad one in your company, you'll see that our PML grew in '06, '07, '08, '09. So we kept on accumulating and growing the PML. So it's just a start.
Francois Morin: I'll add on that. Just going back to Marc's earlier point about supply and demand and balance. In is obviously a big market. It was a big renewal in 6/1. And the reality is, even if we wanted to deploy more capital, I think, or more capacity, I mean, the buyers or the companies just don't have the resources or the money to buy the coverage that we think they should be buying. So there's a little bit of wait and see whether it will take -- it will be a full year before the they reprice their product and then it gives them more money potentially to spend on resource protection, which we, again, assuming the pricing stays at the current levels, we would deploy more capital. But certainly, the demand is a big factor in our ability to grow PML.
Tracy Benguigui: Got it. I would say that if you do change your threshold and I get it's very fluid and the demand equation is also different, that you would provide an update to the market on that. Real quick, do you have a house view on how this year's hurricane season will shape up. There was talk about average hurricane season and now people are talking about above average. How do you see that playing out this year?
Marc Grandisson: Well, we don't have a view on the view. What we have a view with [indiscernible], we have a mineralogists who evaluate the sea surface temperature, which I'm sure everybody is in those numbers. We expect average, maybe slightly above average last time you gave us a presentation. But as you know, Tracy, it moves week to weeks, and we'll see when we get there. We're a little bit almost starting this season, so we'll see how that develops. But we tend to take a longer-term view, Tracy, of the frequency and the severity of the hurricane season. So we believe that the pricing as it is right now accounts for a lot of deviation from the long-term expected that even if you had a little bit above average, I think that the market will be in a really, really good place. Not only us as a part in the market is on the reinsurance side has priced the business with that long-term expected, which has, as we all know, a little bit of that increased frequency in of late. So that is reflected in the marketing that all companies are using.
Operator: Our next question comes from Jimmy Bhullar with JPMorgan.
Jamminder Bhullar: First, just a question on your comments on supply/demand. And besides the absolute price, obviously, terms and conditions have improved as well. And where we can see the data, it seems like most of the primary insurers are absorbing more of the first dollar loss. But obviously, we don't see the data from all of them. But how broad-based is this and do you think there's sort of been a little bit of a transfer of risk, cat risk from the reinsurers to the primary companies given changes in terms and conditions.
Marc Grandisson: I think the last part is a true statement. I think the Q2 numbers you saw for some of the other -- some of our clients actually and competitors demonstrate that that's a little bit more retained. And these are the kind of question. I mean if you get quite a coverage, you have to retain it yourself. The terms and conditions change, this is what fastening for this market, it is not only a property cat terms and condition change. It is a very broad-based property terms and conditions and price improvement that is sought by a lot of companies. I think the market globally has the like I said last quarter's scoring the camp, but having to mend and optimize and reshape and re-underwrite the portfolio. And one of the key things that we see that evidence is that, is that a facultative team in our property have an increased amount of submission this first half of the year. And what's interesting, the E&S property on the insurance obviously has some kind of exposure, a fair amount of it, but it's not only that. Our [indiscernible] data book of business is not necessarily. It's actually not cat-heavy portfolio, which is an indication as fact that it is typically in any market is a good indication for where the market psychology is. So beyond the cat when they provide fire protection, the pricing and the conditions are improving there as well. In very much a broad base and in the early stages. And I will say and remind everyone, and we have to remind ourselves of this is that this is a second or third year of property rates in terms of consumer loan approval. So it's not the first shot at it. It's an ongoing process. And I think that it just got -- we position in top of mind to and certainly in the second quarter. This year, we believe will help maintain a bit of that going forward.
Jamminder Bhullar: And then on the MI business, you've had obviously very sizable reserve releases over the past couple of years. How much of the forbearance related reserves that you put up. Are those mostly released? Or is there more room to go there?
Francois Morin: I mean they're mostly gone. I think we've released a fair amount of the reserves that we put up in the early, in 2020, effectively during the early days of the pandemic. As I mentioned, like a lot of the cures that we're seeing now are from '21 and '22. So that's good news. And as you know, the reserve base has shrunk quite substantially from the peak of 2020 or late 2020. So we were still very prudent. We still look at the data every single month as the new delinquencies come in and how quickly we cure and all of that, but we're so very comfortable with our reserve position there.
Jamminder Bhullar: And if I could just ask one more on -- in the past, when the market has been really good, we've seen some companies go out and raise equity, try to take advantage of that. And a couple of your peers have done that as well, obviously, not to a very large extent. But what do you think about your sort of desire to do that if the demand really picks up and your business continues to grow?
Francois Morin: Well, it will be a function of the market. I mean it's -- we've been able to grow quite substantially in the last few years without raising any additional capital. As I've told many people over the last few months, we have the luxury of having a mortgage unit that provides a source of capital that we have been able to redeploy in the P&C space. So assuming similar conditions where P&C start stays very hard and mortgage still does very well, but isn't growing substantially, we still think there'll be -- we'll be able to generate capital internally. But again, hard to have the crystal ball on what 2024 will look like. So we're -- as I mentioned, we got plenty of capacity. We have low leverage, so that we got a lot of tools in the toolbox, and we'll react to the market as it presents itself.
Operator: Our next question comes from Michael Zaremski with BMO.
Michael Zaremski: Great. Maybe just wanted to learn more about market conditions in the primary insurance segments. I definitely heard your comments about rate change both loss trend and pieces of where overall we are in the underwriting lifestyle clock. But just curious, we're seeing kind of different data points from companies on pricing power levels. Some are showing flattish pricing power, some are showing deceleration. I know you guys operate in a lot of different pockets. But would you say overall pricing in the primary insurance segment is accelerating? Or maybe it's worth bifurcating between casualty versus property as well?
Marc Grandisson: Yes, you have to bifurcate the market to your question. I think the overall statement, I will say is that from our perspective, we look at our portfolio, as you just mentioned, by all the specialty lines and most of them still getting rate increases that actually get a bit more pickup in rate increase on the last quarter or 2, which was a good thing to see and the right thing to see, obviously. But I think the workers' comp is a good example for rates not going up still, and there's a reason for it. It's been historically well performing, performing better than all the initial picks from all the folks out there. So I can see why there is some validity or at least reason behind that. This is what I would tell you the word we use for the industry right now in the U.S. specifically is rationality. It's a very rational market. That's a reason for things to happen. The reason for example, are economically based and not grow the market share or making it flash or marketing driven. Companies are really doing the best they can to underwrite the best and being appropriate, like in getting price increase a certain degree to line that needed more than others. I think the market is fairly rationalize for future.
Michael Zaremski: Okay. Switching gears a bit to the reinsurance side of the marketplace. Would you say there's been a lot of terms and conditions changes and just even changes too, especially in Florida. Would you say that if there is a major event, should we be looking at historical market shares that the reinsurers in Arch have had and then care cutting it? Would that be like the right exercise to do given we're or kind of in hurricane season?
Marc Grandisson: I think we've grown our portfolio, right? I mean, you can see that the exposure of growth. I think the proxy for market share is probably better to use the delta and the PML, even though that's only one zone. But as Francois mentioned in his remarks, we do have -- we have an increased participation in a much more wider set of property cat exposure that we used than before. But the market share that we said anywhere from historically from 0.5 to 0.8 is going up a little bit. And I think I will use the PML as a proxy. That's the best thing to tell you right now. [indiscernible] zone.
Operator: Our next question comes from Josh Shanker with Bank of America.
Joshua Shanker: I've read the reinsurance clock, but it doesn't really relate to something that [indiscernible] knew about, which I don't, which is having make money in the late 1970s in the insurance industry. Given where you see loss trends are and given that pricing is going up over a extended period of time, is there an element that we just don't know really what the loss cost trend is and we need an extra padding in there compared with our historical appraisals? And is it possible to put a supplemental ambiguous loss trend on top of what you think the loss trends currently and still get new business attractively?
Marc Grandisson: Yes. So a very good question. I think this may break it in parts. I think that, yes, we do, as you know, as a reserving practice, we're very keen on the reserving being prudent. We do reserve to a higher level of trend that is embedded in the pricing or what we even observed in the data to make sure that we're accounting for this. I think as a result of that uncertainty and the need to get a bit more cushion and the uncertainty that it generates. I mean, you heard us on the other call, I think it does generate that need to get higher price for that reason. But there's a -- there's a recognition in the industry that we need to be a little bit on this side of the decimal, create some kind of margin of safety. So I do believe that companies are pricing for a higher inflation ratio going forward and also adding a little bit, and that's what helps and sustain the hard market as we speak.
Joshua Shanker: Is Arch padding more now than it has as a company standard practice in the past?
Marc Grandisson: Not really. I think we've -- like we talked about this, Josh on calls for the last 2, 3 years. I think we've been consistent. We -- it is a little bit of art , it's not only science, not as granular as you might think it is. You do the reserving process, you do the reserving process and then you look at what your expectations are versus what the actual is emerging and you adjust your loss ratio. These 2 things are right now has a tendency to sort of take a higher loss ratio than otherwise will be indicated because we have to still see through that underwriting year developed, and it's been very consistent. And if you look at our IBNR ratios and that we book the business on our insurance portfolio, it's been consistent for the last 3 years. So we tend to want to make sure that we still emerge that allows us to reduce some of that before we do. So we have not changed a whole lot. And it's not -- so it's quite a bit a way above you expected there will be actual emergent or losses. But inflation developed in the future. So it's an appropriate thing to do. I think, at the early stages, Francois?
Francois Morin: Yes. I'd add like COVID certainly through a wrench in the whole process, right? I'd say it's -- the way we think about the business today, the way that the environment is today is different than it was 5 years ago, it was different than it was 10 years ago. So great question, Josh. But it's -- no 2 periods are alike. And right now, back to Marc's point, I'd say the reaction or how do we think about court closing and courts reopening and coverages and everything that came with COVID, I think, I mean we're still kind of working through that. So that's why I think it would suggest that we're -- we like to be prudent and maybe even more so in this environment.
Joshua Shanker: And then on Tracy's PML question, you kind of ripped into Francois down on this a little bit. But the corporate charter says you're willing to put 25% of the company's equity capital at risk for a 1-in-250-year event. You're nowhere near that, and I don't really expect there's any market where Arch at this point, given how big it is, would really put 25% of its equity capital at risk for a 1-in-250-year event. How -- what's the reasonable feeling on how much cat risk you'd be willing to take in the best cat market ever?
Francois Morin: I'd say -- I mean, we think we're in a good market. We know we're in a good market, but we don't know what tomorrow holds. So I mean rates could go up again by a factor of quite substantially next year. Again, I don't want to speculate, but there could be some markets kind of pulling back. And then I think -- I agree that in what we know today, it's unlikely that we would hit 25%, but we just don't know what the future holds. So I think we're cognizant that there could be better opportunities at some point down the road.
Operator: Our next question comes from Ryan Tunis with Autonomous Research.
Ryan Tunis: I guess my first question is in MI. It's kind of a follow-up on Jimmy's but on Page 21 of the supplement, it looks like you guys give reserves, loss reserves like by vintage year. And the dollar amount of reserves in '21, '22 looks pretty similar to what it was at the end of last year. Instead, you continue to release quite a few, over $100 million. So I guess I was just trying to square that a bit, like where exactly have these release has been coming from?
Francois Morin: Well, just to clarify, I'd say, Ryan, that the reserves, we don't disclose the reserves by year. We show the risk in force. We give you the total dollar amount of reserves as of -- $403 million at the end of the quarter and the same at the end of the year, but there are some shifts between what was at year-end versus now. I will say that most of the reserves that we've -- the releases in the first 6 months of the year, have been coming primarily from the '21 to '22 years, I mean, and a little bit of '20 as well.
Marc Grandisson: In mind what you're saying also recognition by the MI group, there were more uncertainties and potential recession figures of things going on. So the assumptions when you do reserving in the long term at that time, you'll tend to increase because of the increased level of risk. So I think that also could explain why well after 2, 3 quarters, we don't need them well is because things are also wise we now changing for the better as we speak on the MI. So that could explain a little bit why it's a bit higher this quarter.
Ryan Tunis: Got it. And maybe just some perspective on kind of where the ultimate loss ratios on those years are now trending at?
Francois Morin: Well, they are -- I mean, they turned out to be really, really good. I mean the reality is with -- even with COVID and kind of what transpired after that and the forbearance, et cetera, I'd say, again, we've talked historically about, call it, a long-term average loss ratio in the 20% to 25% range, we're certainly going to be below that. Still a little bit more than -- yes. But I mean there still has to be -- we need more clarity on how the remaining delinquencies are going to settle or whether they're going to cure or not. But where we're at today, I'd say we're going to be below the long-term average.
Ryan Tunis: Got it. And then just a follow-up -- go ahead, sorry.
Marc Grandisson: Just to let you know, in terms of loss emergence in MI, it takes a little while, right? It takes 2 or 3 years for losses to start emerging. So it takes a little while to get to know what the ultimate is going to be. So I just want to make sure you know it's not like a one and done. It's -- you generate an underwriting year, takes 2 or 3 years for losses starting to emerge, right? Situations, situation, economic situation and the borrowers evolve over time. So I just want to make sure you know that it's not -- just because nothing has happened.
Ryan Tunis: Yes. I'm still trying to figure this business out, so I appreciate it. A follow-up, I guess, for Marc, just on P&C. I'm not sure there's ever been a cycle where like when rates started to decelerate, they reaccelerated? Why hasn't that happened before in your...
Marc Grandisson: It's happened before. From '99 to 2001, we had 2002, 2003, 2004, actually, we had a hardening market and liability side in the U.S. We have new lines of business such as and aviation going through the ringer. So we have that going. And I remember a period of time when Arch was underweight cat for the first 2, 3 years of its existence, and we were sold the going against the grain. Most people were shying away from casualty and doing more property. And then we ran into and then we had a hard market as well in property. And I think it helped maintain even the business on the liability line is a bit longer. If you look back the year '06, '07, '08 were still very, very good and the price decrease were not as probably as high as they could have been otherwise. I think the one factor with these kinds of hard market and properties had is us competing is competition for capital. And I think it also helps buffer or paying down the rate decrease that would have otherwise have happened. And that's an important or rate stabilizing more than just going out for. So we've had this before. We've had this before.
Ryan Tunis: And then so after Katrina, correct me if I'm wrong, there was like 1 year of really good rate. There's quite a bit of supply that came in, and now it's kind of [indiscernible]. I'm just kind of trying to contrast from a reinsurance standpoint, how the supply-demand balance looks today sort of a year after in versus how it did a year after Katrina.
Marc Grandisson: It hasn't changed the hold up. We hear from our third-party capital team and in the market. I mean, you hear from other markets, I think that there's a general more leveling off of capacity that's been deployed than we would have expected from the existing incumbent, which helps explain a lot of the price increase that we've seen in our ability to flex in incidents. We're not seeing or hearing supply increasing for a while. I think that there's still a very much -- the money that was there before that Brazil was requiring lower returns has not returned back to the table. And even if they were to come back to the table, what we hear is their return expectations, like ours have increased dramatically. So we'll see what that ends up.
Ryan Tunis: What are you paying the purest attention to thinking like looking forward into 1/1, kind of what might drive pricing when you get to the end of the year?
Marc Grandisson: Well, activity, cat activity, of course, and demand increasing, demand people, like we said before, needing to buy more or having to buy the bullet and do the right thing at the same time as they are improving on insurance portfolio. That's a big tell for us.
Operator: Our next question comes from Brian Meredith with UBS.
Brian Meredith: A couple of questions here for you. First, just on your PML, what is your peak zone right now? Is it still Northeast?
Francois Morin: [Indiscernible], Florida.
Brian Meredith: Where is it, pardon me?
Francois Morin: Florida. Miami Day.
Brian Meredith: Okay. And then on the PML question, I'm just curious, you gave us 1-in-250 but how is your kind of 1-in-50 and 1-in-100 kind of increased over -- since, call at the beginning of the year? Is it -- as they increased more or less about the same amount? I'm just trying to get a sense of where you're playing in programs.
Marc Grandisson: Yes. So from a big zone perspective, it's gone up similarly in terms of percentage. It's a very similar increase.
Brian Meredith: Got you. That's helpful. And then Marc, I'm just curious, I know there was a lot of one-off type transactions, top-up programs that happened in the second quarter. Can you give maybe some perspective on how much of that contributed to your growth here in the second quarter? And how much is kind of continuing here going forward, just so we can get a sense of how is this growth sustainable here for the remainder of the year, maybe in the '24.
Marc Grandisson: We've had a couple of -- we've had a couple of programs, for instance, in the Asia that we won, and we've had a couple of big but I don't think this quarter is necessarily a large transaction quarter right to where you make it sound. I think it was more regular growth. A couple of transactions here and there, but nothing to the extent that when we talk on the call as Francois mentioned in his remarks, that it has to highlight it specifically before. I don't think there's nothing really to highlight in this quarter, actually.
Brian Meredith: Good. And then I guess last one, just quickly here. One of your competitors talked about reducing market share in the MI business because there's some concerns about recession or going forward. Maybe give us your kind of perspective on what you're seeing right now in your MI and kind of outlook and potential for some higher loss ratios there if we do go into recession or look in the '24?
Marc Grandisson: Yes. I think pricing has improved over the last 2 years and credit quality stays really beautiful. And it's why among the best, I think we go back to 2013, 2012 in terms of quality of origination. So it's -- as you know, credit is not readily available. The availability of credit is still pretty tight out there. So from a credit quality perspective, Brian, it's as good. It's a really, really solid marketplace. I think the market share question, which we never -- we don't lose sleep with this, as you know, Brian. I think -- I'll -- couple of things in the market share that we're trying to do in terms of shaping the portfolio in the MI is trying to get the higher quality, like I mentioned in my remarks, lower FICO -- higher FICO, lower LTV and also geographically go to the places where there's less perceived inflation or overvaluation and also, there's some different programs that have different returns, meaning they are less than we would have hoped for them to be and they just don't [indiscernible] threshold and especially, Brian, if you overlay the opportunity set that we have on the property side, it just makes for our fellow folks and MI willing to take the earnings that they generate and give it to us on the P&C side to generate even better returns. So really good return business, Brian, it's just also for us a matter of comparative ROEs as well as absolute.
Operator: Our next question comes from Meyer Shields with Keefe, Bruyette & Wood.
Meyer Shields: A quick question to start. The level of reserve releases in reinsurance was lower than it's been in recent quarters. I was hoping you can give us some color. Is that because you're assuming higher loss trends? Or are there other factors that may have played into the quarter's results?
Francois Morin: No, I'd say it's -- I mean we will look at the data, right? So I think some quarters, there's evidence that we can release a bit more this quarter, maybe not as much. It's a process that we go through every quarter. So I think our underwriters and our actuaries kind of sit down and take a look at the respective treaties and come up with a point of view on whether there's enough evidence to release reserves. So I wouldn't read too much into it right now. I think it's a -- just another quarter still, we think, healthy reserves, healthy reserve releases, but not as much as you said in prior quarters.
Meyer Shields: Okay. No, that's fair. Second question, and I'm really not sure how to ask this, but there's a lot of chaos right now in U.S. personal lines and [indiscernible] always been really opportunistic. I was wondering if there's a way that in a line of business that's so dominated by major players, but you do have this level of instability. Is there an opportunity for Arch?
Marc Grandisson: I think it's a hard one, Meyer. I think that our shareholders -- I mean, we could always see what we could do there. But from our perspective, I think we're more of a B2B and more of a commercial provider of insurance and specialty provider of insurance. Certainly, on the reinsurance side, we're helpful. Our companies -- a lot of companies are homeowners, homeowners are writers, and we do -- we do provide significant capacity for them, be it on a quarter share basis or excess of loss and also be on property. So I think our game plan on homeowners is more to support the clients that we have because I think on a long-term basis, it has a set of characteristics, as we all know, and focus that is not necessarily core to what we do every day, great filing and everything else in between. It's a bit of a different animal for us.
Operator: Our next question comes from Yaron Kinar with Jefferies.
Yaron Kinar: With most of my questions already asked and answered, I figured I'd maybe focus on a couple of more items. So first, on ad covers, can you maybe talk about how much you're still writing in '23 versus '22?
Marc Grandisson: We've cut our ad book significantly over the last 12 months. You see even in 2022, we started cut already as we saw this. And again, it's a matter of opportunity, right? I mean we do some but we've cut the book heavily because of the better -- frankly, better opportunities on the excess of loss occurrence, much better, yes.
Yaron Kinar: And is the client base there? Has that changed at all? Can you maybe talk about the mix between large global, smaller regionals?
Marc Grandisson: We -- well, we had a -- when we grew at in Florida was, as you know, is a different kind of animal because of all the [indiscernible] small companies out there. But in general, I would say that our portfolio will opportunistically grow into the larger global companies. We tend to think that relatively not as the transparency of visibility into what they write. So our tendency is to be more of a super regional businesses and more ones that have a lesser footprint in terms of stake. We think we can better allocate capital. This is sort of a high-level philosophy that we've had for years. That hasn't really changed our one. I think that we prefer to grow with these clients over time. But having that all this opportunistically, being on a core share basis of excess of if it's a large corporate, we definitely were able to provide more capacity, but they needed. As we speak and the price, we believe, reflected the higher level of risk that they have. So I think I would say same as before, we're a little bit opportunistically on larger companies.
Yaron Kinar: Got it. And then if I put this together then and we look at the very large cat activity that has really been incurred much more by the primaries here. With the changes in terms of conditions and maybe tighter, more limited cover per peril. Ultimately, how does that impact ad covers later in the year, if, let's say, the primaries had a lot of cat losses on perils, secondary perils that are now no longer covered by reinsurers at least not per event, ultimately, does that also flow into the ad covers that will not be breached on a reinsurance level because of that?
Marc Grandisson: Yes. So I think that excess of loss is very similar to the current, if you do change terms and positions and cut the coverage at the underlying portfolio level, it will have a leverage impact into your aggregate excess or occurrence, meaning it will definitely cut down the loss expectations heavily into these layers. But what I would tell you on is we're not there yet, right? This is the early innings like I mentioned to you before on the call is that we're going to have -- the phenomenon just talked about will have a much better perspective and view on this and the impact it's going to have on the losses next year and through '25. I think right now, we still have a portfolio that hasn't gone through quite 100%, right, of all these [indiscernible] that you and I expect to happen, I think, in the marketplace. So the aggregate of losses for that reason, probably still bad bet in 2023, right? So we probably need to see this underlying change in terms of conditions on the insurance portfolio before we can see this being a potential viable product.
Operator: Thank you. And I'm not showing any further questions at this time. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: So from Pembroke, Bermuda, I want to wish everybody a good month of August, and we'll see you in the fall. Thanks for your support.
Operator: Thank you. Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Q2 2023 Arch Capital Earnings Conference Call. [Operator Instructions]. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends to be forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website and on the SEC's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sir, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, Josh. Good morning, and welcome to our second quarter earnings call. We're more than half way through 2023 and through our commitment to underwriting acumen, prudent reserving and cycle focused capital allocation, we were able to deliver another quarter of profitable growth. In the second quarter, our results were primarily driven by our willingness and ability to deploy capital into lines with superior risk-adjusted returns. Our operating results in the quarter were stellar with an annualized operating return on average common equity of 21.5% that drove a 4.8% increase in Arch's book value of common share for the quarter. As you know, book value per share growth is our primary focus on our road to creating long-term value for our shareholders. Each segment generated over $100 million of underwriting income in the quarter. These outstanding returns reflect our ability to effectively execute in each segment. We're really operating in our sweet spot. I also want to commend our employees for the continued exceptional growth they've delivered in the quarter, most notably a 32% increase in property and casualty net premium written compared to the same quarter a year ago. This hard P&C market is proving to be one of the longest we've experienced and we are in an enviable position as we look to 2024 and beyond. We often refer to the insurance clock developed by to help illustrate the insurance cycle. You can find the clock on the download cap for this webcast or on our corporate website. If you can't do the clock right now, just picture a traditional clock dial. For some time, we've been hovering at 11:00, which is one we expect most companies in the market to show good results as rate adequacy improves and loss trends stabilize. Last year, a popular topic on earnings calls was whether rate increases were slowing or what the rates were even decreasing. These are classic signs of the clock hitting 12 when returns are still very good, but conditions begin to soften. Yet here we are in mid-2023 and conditions in most markets remain at 11:00. We've even checked the batteries in the clock and they're just fine. The clock isn't broken. It's just that the current environment dictates an extended period of rate hardening. So what's sustaining this hard market? Well, I believe it's a relatively simple combination. Heightened uncertainty is driving an imbalance of supply and demand for insurance coverage. Since this hard market inception in 2019, we've had COVID to war in Ukraine, increased cat activity and rising inflation, all of which create significant economic uncertainty. Underwriters have had to account for more unknowns. Beyond those macro factors, industry dynamics also play a role in sustaining the hard market. Generally, in adequate pricing and overly optimistic loss trend assumptions during the soft market years of 2016 through 2019 have led to inadequate returns for the industry. The impact of these factors should cause insurers to raise rates and purchase more reinsurance in a capacity-constrained market with limited new capital formation. Put it all together, and it may be a while before the clock strikes 12 and we begin to move beyond this hard market. I'll now share a few highlights from our segments. First, P&C. In the second quarter, the reinsurance group was successful again at seizing growth opportunities. In particular, the media property and property cat renewals saw a significant improvement in rate adequacy and our underwriters are already willing and able to provide valuable capacity to our clients. Our PML or exposure to a single event in a 1-in-250-year return period went up in the quarter while our premium income grew substantially. At July 1, our peak zone exposure rose to 10.5% of tangible equity. Overall exposure to property cat risk remain well within our threshold and because of our diversified portfolio and broad set of opportunities, we retain the flexibility to pursue the most attractive returns across lines and geographies. Although there are lines where pricing has declined, large public comes to mind. P&C markets continue to see rate changes above loss trends. Even with those fee lines with weakening rates, the compounded rate increases over the past several years continue to be earned and are generating attractive returns. Overall, we like the range of opportunities in front of us, and we continue to lean into the current market. Next is mortgage, which keeps generating meaningful underwriting income and risk-adjusted returns. Housing and credit conditions remain favorable, although high mortgage interest rates tempered demand for mortgage originations and limit refinancing options. The lack of refinancing has led to a historically high persistency rate of 83%. High persistency stabilizes our insurance in force, which, as many of you know, drives mortgage insurance earnings. Our disciplined underwriting process and risk-based pricing model have helped us to build a healthy risk-reward profile for the business we write. The composition of the overall book with high FICO scores and low loan-to-value and debt-to-income ratios remains one of the best risk profiles in the industry. International growth, along with our GSE credit risk transfer of business, enabled us to profitably manage risk better than more online U.S.-only companies, a key differentiator of our MI global platform. Mortgage insurance plays a valuable role in our diversified business model and continues to generate capital that is and can be deployed into the most attractive opportunities across the enterprise. Moving on to investments now. Since our second quarter on the call last year, the Federal Reserve has increased, as we all know, the rates 8x for a total of 375 basis points. Given our short duration portfolio, these hikes have positively affected our net investment income, which is up approximately 22% over the first quarter of '23. New money rates exceed our book yield, which, along with our strong cash flow, sets the stage for further growth and book value creation. Have a on the brain after watching the incredible Wimbledon final couple of weeks ago, it was an epic match-up 20-year-old sensation, Carlos Alcaraz, taking on all-time Novak Djokovic, was a back and forth match that lasted nearly 5 hours before Alcaraz emerged victorious. There was one pivotal moment that will be remembered for years. In the third set, a single game, something that usually takes about 3 to 5 minutes, instead lasted 26 minutes. The game included 13 deuces and 7 breakpoints. It was an incredible display of tenacity and athleticism. Not to mention the mental strength required to remain focused. It was insane. But what really struck with me was that kind of like this hard market, the game simply refused to end where many times where a single winning shot would have ended the game, but it just kept going. About 15 minutes in, it became clear that we just needed to enjoy what we were watching and not focus on the end point. So that's what we're doing with this hard market, returning what the market serves us with gusto. As always, our goal remains to generate strong risk-adjusted returns in order to create long-term value for our shareholders at lower volatility. The exceptional profitable growth over the last several years has fortified our market presence and helped us achieve one of the most profitable quarters in our company's history. This is a type of well around the quarter we've always envisioned. The sweet spot, if you will, and we look forward to building on this momentum in upcoming quarters. I'll the court now to Francois, and then we'll return to answer your questions."
},
{
"speaker": "Francois Morin",
"text": "Thank you, Marc, and good morning to all. Thanks for joining us today on this gorgeous day in Bermuda. As Marc highlighted, our underwriting and investment teams delivered excellent results across their respective areas in the second quarter, which resulted in a performance that exceeded that from our very strong first quarter. For the quarter, we reported after-tax operating income of $1.92 per share for an annualized operating return on average common equity of 21.5%. Book value per share was $37.04 as of June 30, up 4.8% in the quarter and 13.5% on a year-to-date basis. Turning to the operating segments. Net premium written by our Reinsurance segment grew by 47% over the same quarter last year, and this growth was observed in most lines of business. Growth was particularly strong in the property catastrophe and property other than catastrophe lines with net written premium being 205% and 53% higher, respectively, than the same quarter 1 year ago, a reflection of the fact that market conditions in these lines remain very attractive. As a result, the quarterly bottom line for the segment was excellent, with a combined ratio of 81.9%, producing an underwriting profit of $245 million. The accident year ex cat combined ratio was 77.4%. The Insurance segment also performed well, with second quarter net premium written growth of 18% over the same quarter 1 year ago and an accident quarter combined ratio, excluding cats of 89.8%. Except for professional lines, which saw a slight decrease in net written premium in our public directors and officers business due to a more competitive market, all our underwriting units in insurance, both in the U.S. and internationally, saw good growth in the quarter as market conditions remain excellent. Our Mortgage segment had another excellent quarter with strong performance across all units, leading to a combined ratio of 15%. Net premiums earned were in line with the past few quarters, reflecting a high level of persistency in our insurance in force during the quarter at U.S. MI, partially offset by lower levels of terminations in Australia and higher levels of premium. Benefitting results was approximately $84 million in favorable prior year reserve development in the quarter, net of acquisition expenses, with over 75% of that amount coming from U.S. MI and the rest spread across our other underwriting units. [Indiscernible] activity at U.S. MI was again very strong this quarter, and our delinquency rate stood at 1.61%, its lowest level since the onset of the COVID pandemic. At the end of the quarter, over 80% of our net reserves at U.S. MI are from post-COVID accident periods. Overall, our underwriting income reflected $116 million of favorable prior year development on a pretax basis or 3.9 points on the combined ratio and was observed across all 3 segments mainly in short-term lines. Current accident year catastrophe losses across the group were $119 million, over half of which are related to U.S. severe convective storms that have occurred so far this year. Pretax net investment income was $0.64 per share, up 21% from the first quarter of 2023 as our pretax investment income yield was almost up 50 basis points since last quarter. Total return for our investment portfolio was 0.56% on a U.S. dollar basis for the quarter with most of our strategies delivering positive returns. Our interest rate positioning with a slightly shorter duration helped minimize the impact of the increase in interest rates during the quarter. We remain comfortable with our commercial real estate and bank exposure, which is a high quality and short duration. Net cash flow from operating activities was strong in excess of $1.1 billion this quarter and continues to provide our investment team with additional resources to deploy into the higher interest rate environment. With new money rates in our fixed income portfolio is still in the 4.5% to 5% range, we should see further improvement in our net investment income in the coming quarters, arising primarily from positive cash flows and the rollover of maturing lower-yielding assets. Turning to risk management. Our natural cat PML on a net basis of the single event 1-in-250-year return level stood at $1.46 billion as of July 1 or 10.5% of tangible shareholders' equity, again, well below our internal limits. In light of the improved market conditions in the property market, we were able to deploy more capacity, which resulted in a significant premium growth for property lines in both our Insurance and Reinsurance segments. This growth was well diversified across multiple zones. Our view is that the current in-force portfolio with a broader spread of risk across many zones is well positioned to deliver attractive returns. Our capital base remains very strong with $17.4 billion in capital and a debt plus preferred to capital ratio of 20.5%. Even though the results of the past quarter set the high watermark for us on many fronts. We believe the continued hard work and dedication from our teams, serving the needs of our clients every single day, along with our steadfast commitment as disciplined and dynamic capital allocators, sets us up very well for future success. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our first question comes from Elyse Greenspan with Wells Fargo.."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question, Marc, can you quantify the supply-demand imbalance that you're seeing within the reinsurance market? And how much of that do you think could transpire from an additional pickup in demand potentially at 1/1 2024?"
},
{
"speaker": "Marc Grandisson",
"text": "Good question, Elyse. I think the numbers we've seen for around $50 billion to $70 billion is not a crazy number. So I think that where we still have this imbalance occurring. I think that market has found a way to do the reinsurance transaction and buy coverage. But indeed, there was also a -- there could have been more to be had from a reinsurance perspective. But we believe and you heard on the call that insurance companies also had to -- a shock at sort into evaluate what they can buy and how much they could afford based on where the pricing level was. So I think that just in balance right there of reinsurance. There's also, I believe, we also believe it's in balance in the terms and conditions in the overall broad industry that needs to be more of a function. On one hand, you could create capacity for cat exposure through third-party capital or reinsurance protection. But at the same time, we could also do it through improve in terms of condition on the insurance level. And I think that's also something that will help bridge a gap. And we believe that's going to be more of the key element as well for the next 18 to 24 months."
},
{
"speaker": "Elyse Greenspan",
"text": "And then the , Francois, the accident year underlying combined ratio within reinsurance. Is that a good run rate level or maybe you could get better as we think about some rate earning into the . Is there anything one-off in that number in the quarter?"
},
{
"speaker": "Francois Morin",
"text": "Well, I wouldn't say there's anything one-off. It is certainly a very good quarter. I think our view, as we said in the past, when we had some quarters where there's a little bit more activity as we think it's better to look at it on a on a 12-month kind of forward-looking view. So is this quarter going to repeat in the future? Maybe, we just don't know. I mean, but I'll say it's certainly good. There's room for further improvement. But again, recognizing that there's going to be volatility in the reinsurance segment from quarter-to-quarter, I'd say it's -- I'll let you make your pick from there."
},
{
"speaker": "Elyse Greenspan",
"text": "And then, Marc, one more for you. I mean your stock has done really well. So you have a problem, a good problem that any CEO would want in that you have an extremely valuable currency. We sit here with the hard market. You guys obviously have a lot of organic growth opportunities. What would you need to see from an M&A perspective to consider using your stock as currency to enter into any type of transaction?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, many things are needed. Obviously, you need -- it takes the time goes -- is going to appreciate in this world. But I think at a high level, at least we're not focused on M&A at this point in time. We're really focusing on growing the book organically. We're also maintaining pretty well EMI as well as other nonproperty exposure. So we do -- we are seeing a lot of opportunities broadly. And this is where -- what our shareholders are paying us to do and this is what we're doing. And this is -- this represents really a once in a little while opportunity to really deploy and really get access to the market in a bigger way to provide more capacity to our clients. And we don't want to miss that. I mean an M&A would have to strategically fit for us beyond the money I think right now, our efforts and time is better focused on organic growth, though at this point in time. And this is where -- I think we have plenty of opportunities on our own."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tracy Benguigui with Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "You mentioned that your 1-in-250 PML intangible equity was 10.5% at 7/1 which was up from 8.1% at 4/1 and I recognize your upper tolerance of 25%, it almost feels to me like you have a supplement below the 25%. Is it fair to assume that getting closer to 25% requires an even higher ROE hurdle rate or pricing? Like could we just be theoretical, what would you need to see in order to get more comfortable taking on more volatility in your book where you can get closer over time to that 25%?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, I think the -- we're -- first, the one thing about the PML, which is so interesting to us is that we're in the early innings of where it's going to go. So we have to be careful that when we talk about this even internally ourselves, these are the early innings of our market getting much better. And as I mentioned, terms and conditions, we believe, also improving and really helping to manage cat and the cat-related risk better as an industry. So we'll see how that develops over time, Tracy. I think that we're also a different animal than we were way back when. We've grown up our capital faster than the growth in exposure and needed. So the 25% before is probably a lesser number. I think you're quite right. And we also have to balance the overall portfolio risk profile. But having said all this, there's plenty of room to go from 10.5% to wherever we're going to end up. We don't know where that's going to be, assuming conditions say as they are or even improve further, it certainly will mean more PML growth. I think that it would have to be substantially better. We actually have a very, very solid construct within our overall capital allocation that will dictate what kind of market share we would have of the market. And all I would say is there's always a place to go to the numbers you talk about, but we'll see if we get there. And I will also remind everyone that it's not a bad to start the index of one of the major brokers, as you all know, it shows us that the pricing for the cat is the highest it's ever been since 1990, even before Andrew. There's a lot of room, and we're excited to see where that takes us. And one final thing I will take is if you look back at the '05, '06, '07, '08, if you go back on this, if you have enough of a memory or a good document retention policy or a bad one in your company, you'll see that our PML grew in '06, '07, '08, '09. So we kept on accumulating and growing the PML. So it's just a start."
},
{
"speaker": "Francois Morin",
"text": "I'll add on that. Just going back to Marc's earlier point about supply and demand and balance. In is obviously a big market. It was a big renewal in 6/1. And the reality is, even if we wanted to deploy more capital, I think, or more capacity, I mean, the buyers or the companies just don't have the resources or the money to buy the coverage that we think they should be buying. So there's a little bit of wait and see whether it will take -- it will be a full year before the they reprice their product and then it gives them more money potentially to spend on resource protection, which we, again, assuming the pricing stays at the current levels, we would deploy more capital. But certainly, the demand is a big factor in our ability to grow PML."
},
{
"speaker": "Tracy Benguigui",
"text": "Got it. I would say that if you do change your threshold and I get it's very fluid and the demand equation is also different, that you would provide an update to the market on that. Real quick, do you have a house view on how this year's hurricane season will shape up. There was talk about average hurricane season and now people are talking about above average. How do you see that playing out this year?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, we don't have a view on the view. What we have a view with [indiscernible], we have a mineralogists who evaluate the sea surface temperature, which I'm sure everybody is in those numbers. We expect average, maybe slightly above average last time you gave us a presentation. But as you know, Tracy, it moves week to weeks, and we'll see when we get there. We're a little bit almost starting this season, so we'll see how that develops. But we tend to take a longer-term view, Tracy, of the frequency and the severity of the hurricane season. So we believe that the pricing as it is right now accounts for a lot of deviation from the long-term expected that even if you had a little bit above average, I think that the market will be in a really, really good place. Not only us as a part in the market is on the reinsurance side has priced the business with that long-term expected, which has, as we all know, a little bit of that increased frequency in of late. So that is reflected in the marketing that all companies are using."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jimmy Bhullar with JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"text": "First, just a question on your comments on supply/demand. And besides the absolute price, obviously, terms and conditions have improved as well. And where we can see the data, it seems like most of the primary insurers are absorbing more of the first dollar loss. But obviously, we don't see the data from all of them. But how broad-based is this and do you think there's sort of been a little bit of a transfer of risk, cat risk from the reinsurers to the primary companies given changes in terms and conditions."
},
{
"speaker": "Marc Grandisson",
"text": "I think the last part is a true statement. I think the Q2 numbers you saw for some of the other -- some of our clients actually and competitors demonstrate that that's a little bit more retained. And these are the kind of question. I mean if you get quite a coverage, you have to retain it yourself. The terms and conditions change, this is what fastening for this market, it is not only a property cat terms and condition change. It is a very broad-based property terms and conditions and price improvement that is sought by a lot of companies. I think the market globally has the like I said last quarter's scoring the camp, but having to mend and optimize and reshape and re-underwrite the portfolio. And one of the key things that we see that evidence is that, is that a facultative team in our property have an increased amount of submission this first half of the year. And what's interesting, the E&S property on the insurance obviously has some kind of exposure, a fair amount of it, but it's not only that. Our [indiscernible] data book of business is not necessarily. It's actually not cat-heavy portfolio, which is an indication as fact that it is typically in any market is a good indication for where the market psychology is. So beyond the cat when they provide fire protection, the pricing and the conditions are improving there as well. In very much a broad base and in the early stages. And I will say and remind everyone, and we have to remind ourselves of this is that this is a second or third year of property rates in terms of consumer loan approval. So it's not the first shot at it. It's an ongoing process. And I think that it just got -- we position in top of mind to and certainly in the second quarter. This year, we believe will help maintain a bit of that going forward."
},
{
"speaker": "Jamminder Bhullar",
"text": "And then on the MI business, you've had obviously very sizable reserve releases over the past couple of years. How much of the forbearance related reserves that you put up. Are those mostly released? Or is there more room to go there?"
},
{
"speaker": "Francois Morin",
"text": "I mean they're mostly gone. I think we've released a fair amount of the reserves that we put up in the early, in 2020, effectively during the early days of the pandemic. As I mentioned, like a lot of the cures that we're seeing now are from '21 and '22. So that's good news. And as you know, the reserve base has shrunk quite substantially from the peak of 2020 or late 2020. So we were still very prudent. We still look at the data every single month as the new delinquencies come in and how quickly we cure and all of that, but we're so very comfortable with our reserve position there."
},
{
"speaker": "Jamminder Bhullar",
"text": "And if I could just ask one more on -- in the past, when the market has been really good, we've seen some companies go out and raise equity, try to take advantage of that. And a couple of your peers have done that as well, obviously, not to a very large extent. But what do you think about your sort of desire to do that if the demand really picks up and your business continues to grow?"
},
{
"speaker": "Francois Morin",
"text": "Well, it will be a function of the market. I mean it's -- we've been able to grow quite substantially in the last few years without raising any additional capital. As I've told many people over the last few months, we have the luxury of having a mortgage unit that provides a source of capital that we have been able to redeploy in the P&C space. So assuming similar conditions where P&C start stays very hard and mortgage still does very well, but isn't growing substantially, we still think there'll be -- we'll be able to generate capital internally. But again, hard to have the crystal ball on what 2024 will look like. So we're -- as I mentioned, we got plenty of capacity. We have low leverage, so that we got a lot of tools in the toolbox, and we'll react to the market as it presents itself."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Zaremski with BMO."
},
{
"speaker": "Michael Zaremski",
"text": "Great. Maybe just wanted to learn more about market conditions in the primary insurance segments. I definitely heard your comments about rate change both loss trend and pieces of where overall we are in the underwriting lifestyle clock. But just curious, we're seeing kind of different data points from companies on pricing power levels. Some are showing flattish pricing power, some are showing deceleration. I know you guys operate in a lot of different pockets. But would you say overall pricing in the primary insurance segment is accelerating? Or maybe it's worth bifurcating between casualty versus property as well?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, you have to bifurcate the market to your question. I think the overall statement, I will say is that from our perspective, we look at our portfolio, as you just mentioned, by all the specialty lines and most of them still getting rate increases that actually get a bit more pickup in rate increase on the last quarter or 2, which was a good thing to see and the right thing to see, obviously. But I think the workers' comp is a good example for rates not going up still, and there's a reason for it. It's been historically well performing, performing better than all the initial picks from all the folks out there. So I can see why there is some validity or at least reason behind that. This is what I would tell you the word we use for the industry right now in the U.S. specifically is rationality. It's a very rational market. That's a reason for things to happen. The reason for example, are economically based and not grow the market share or making it flash or marketing driven. Companies are really doing the best they can to underwrite the best and being appropriate, like in getting price increase a certain degree to line that needed more than others. I think the market is fairly rationalize for future."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. Switching gears a bit to the reinsurance side of the marketplace. Would you say there's been a lot of terms and conditions changes and just even changes too, especially in Florida. Would you say that if there is a major event, should we be looking at historical market shares that the reinsurers in Arch have had and then care cutting it? Would that be like the right exercise to do given we're or kind of in hurricane season?"
},
{
"speaker": "Marc Grandisson",
"text": "I think we've grown our portfolio, right? I mean, you can see that the exposure of growth. I think the proxy for market share is probably better to use the delta and the PML, even though that's only one zone. But as Francois mentioned in his remarks, we do have -- we have an increased participation in a much more wider set of property cat exposure that we used than before. But the market share that we said anywhere from historically from 0.5 to 0.8 is going up a little bit. And I think I will use the PML as a proxy. That's the best thing to tell you right now. [indiscernible] zone."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Shanker with Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "I've read the reinsurance clock, but it doesn't really relate to something that [indiscernible] knew about, which I don't, which is having make money in the late 1970s in the insurance industry. Given where you see loss trends are and given that pricing is going up over a extended period of time, is there an element that we just don't know really what the loss cost trend is and we need an extra padding in there compared with our historical appraisals? And is it possible to put a supplemental ambiguous loss trend on top of what you think the loss trends currently and still get new business attractively?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So a very good question. I think this may break it in parts. I think that, yes, we do, as you know, as a reserving practice, we're very keen on the reserving being prudent. We do reserve to a higher level of trend that is embedded in the pricing or what we even observed in the data to make sure that we're accounting for this. I think as a result of that uncertainty and the need to get a bit more cushion and the uncertainty that it generates. I mean, you heard us on the other call, I think it does generate that need to get higher price for that reason. But there's a -- there's a recognition in the industry that we need to be a little bit on this side of the decimal, create some kind of margin of safety. So I do believe that companies are pricing for a higher inflation ratio going forward and also adding a little bit, and that's what helps and sustain the hard market as we speak."
},
{
"speaker": "Joshua Shanker",
"text": "Is Arch padding more now than it has as a company standard practice in the past?"
},
{
"speaker": "Marc Grandisson",
"text": "Not really. I think we've -- like we talked about this, Josh on calls for the last 2, 3 years. I think we've been consistent. We -- it is a little bit of art , it's not only science, not as granular as you might think it is. You do the reserving process, you do the reserving process and then you look at what your expectations are versus what the actual is emerging and you adjust your loss ratio. These 2 things are right now has a tendency to sort of take a higher loss ratio than otherwise will be indicated because we have to still see through that underwriting year developed, and it's been very consistent. And if you look at our IBNR ratios and that we book the business on our insurance portfolio, it's been consistent for the last 3 years. So we tend to want to make sure that we still emerge that allows us to reduce some of that before we do. So we have not changed a whole lot. And it's not -- so it's quite a bit a way above you expected there will be actual emergent or losses. But inflation developed in the future. So it's an appropriate thing to do. I think, at the early stages, Francois?"
},
{
"speaker": "Francois Morin",
"text": "Yes. I'd add like COVID certainly through a wrench in the whole process, right? I'd say it's -- the way we think about the business today, the way that the environment is today is different than it was 5 years ago, it was different than it was 10 years ago. So great question, Josh. But it's -- no 2 periods are alike. And right now, back to Marc's point, I'd say the reaction or how do we think about court closing and courts reopening and coverages and everything that came with COVID, I think, I mean we're still kind of working through that. So that's why I think it would suggest that we're -- we like to be prudent and maybe even more so in this environment."
},
{
"speaker": "Joshua Shanker",
"text": "And then on Tracy's PML question, you kind of ripped into Francois down on this a little bit. But the corporate charter says you're willing to put 25% of the company's equity capital at risk for a 1-in-250-year event. You're nowhere near that, and I don't really expect there's any market where Arch at this point, given how big it is, would really put 25% of its equity capital at risk for a 1-in-250-year event. How -- what's the reasonable feeling on how much cat risk you'd be willing to take in the best cat market ever?"
},
{
"speaker": "Francois Morin",
"text": "I'd say -- I mean, we think we're in a good market. We know we're in a good market, but we don't know what tomorrow holds. So I mean rates could go up again by a factor of quite substantially next year. Again, I don't want to speculate, but there could be some markets kind of pulling back. And then I think -- I agree that in what we know today, it's unlikely that we would hit 25%, but we just don't know what the future holds. So I think we're cognizant that there could be better opportunities at some point down the road."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ryan Tunis with Autonomous Research."
},
{
"speaker": "Ryan Tunis",
"text": "I guess my first question is in MI. It's kind of a follow-up on Jimmy's but on Page 21 of the supplement, it looks like you guys give reserves, loss reserves like by vintage year. And the dollar amount of reserves in '21, '22 looks pretty similar to what it was at the end of last year. Instead, you continue to release quite a few, over $100 million. So I guess I was just trying to square that a bit, like where exactly have these release has been coming from?"
},
{
"speaker": "Francois Morin",
"text": "Well, just to clarify, I'd say, Ryan, that the reserves, we don't disclose the reserves by year. We show the risk in force. We give you the total dollar amount of reserves as of -- $403 million at the end of the quarter and the same at the end of the year, but there are some shifts between what was at year-end versus now. I will say that most of the reserves that we've -- the releases in the first 6 months of the year, have been coming primarily from the '21 to '22 years, I mean, and a little bit of '20 as well."
},
{
"speaker": "Marc Grandisson",
"text": "In mind what you're saying also recognition by the MI group, there were more uncertainties and potential recession figures of things going on. So the assumptions when you do reserving in the long term at that time, you'll tend to increase because of the increased level of risk. So I think that also could explain why well after 2, 3 quarters, we don't need them well is because things are also wise we now changing for the better as we speak on the MI. So that could explain a little bit why it's a bit higher this quarter."
},
{
"speaker": "Ryan Tunis",
"text": "Got it. And maybe just some perspective on kind of where the ultimate loss ratios on those years are now trending at?"
},
{
"speaker": "Francois Morin",
"text": "Well, they are -- I mean, they turned out to be really, really good. I mean the reality is with -- even with COVID and kind of what transpired after that and the forbearance, et cetera, I'd say, again, we've talked historically about, call it, a long-term average loss ratio in the 20% to 25% range, we're certainly going to be below that. Still a little bit more than -- yes. But I mean there still has to be -- we need more clarity on how the remaining delinquencies are going to settle or whether they're going to cure or not. But where we're at today, I'd say we're going to be below the long-term average."
},
{
"speaker": "Ryan Tunis",
"text": "Got it. And then just a follow-up -- go ahead, sorry."
},
{
"speaker": "Marc Grandisson",
"text": "Just to let you know, in terms of loss emergence in MI, it takes a little while, right? It takes 2 or 3 years for losses to start emerging. So it takes a little while to get to know what the ultimate is going to be. So I just want to make sure you know it's not like a one and done. It's -- you generate an underwriting year, takes 2 or 3 years for losses starting to emerge, right? Situations, situation, economic situation and the borrowers evolve over time. So I just want to make sure you know that it's not -- just because nothing has happened."
},
{
"speaker": "Ryan Tunis",
"text": "Yes. I'm still trying to figure this business out, so I appreciate it. A follow-up, I guess, for Marc, just on P&C. I'm not sure there's ever been a cycle where like when rates started to decelerate, they reaccelerated? Why hasn't that happened before in your..."
},
{
"speaker": "Marc Grandisson",
"text": "It's happened before. From '99 to 2001, we had 2002, 2003, 2004, actually, we had a hardening market and liability side in the U.S. We have new lines of business such as and aviation going through the ringer. So we have that going. And I remember a period of time when Arch was underweight cat for the first 2, 3 years of its existence, and we were sold the going against the grain. Most people were shying away from casualty and doing more property. And then we ran into and then we had a hard market as well in property. And I think it helped maintain even the business on the liability line is a bit longer. If you look back the year '06, '07, '08 were still very, very good and the price decrease were not as probably as high as they could have been otherwise. I think the one factor with these kinds of hard market and properties had is us competing is competition for capital. And I think it also helps buffer or paying down the rate decrease that would have otherwise have happened. And that's an important or rate stabilizing more than just going out for. So we've had this before. We've had this before."
},
{
"speaker": "Ryan Tunis",
"text": "And then so after Katrina, correct me if I'm wrong, there was like 1 year of really good rate. There's quite a bit of supply that came in, and now it's kind of [indiscernible]. I'm just kind of trying to contrast from a reinsurance standpoint, how the supply-demand balance looks today sort of a year after in versus how it did a year after Katrina."
},
{
"speaker": "Marc Grandisson",
"text": "It hasn't changed the hold up. We hear from our third-party capital team and in the market. I mean, you hear from other markets, I think that there's a general more leveling off of capacity that's been deployed than we would have expected from the existing incumbent, which helps explain a lot of the price increase that we've seen in our ability to flex in incidents. We're not seeing or hearing supply increasing for a while. I think that there's still a very much -- the money that was there before that Brazil was requiring lower returns has not returned back to the table. And even if they were to come back to the table, what we hear is their return expectations, like ours have increased dramatically. So we'll see what that ends up."
},
{
"speaker": "Ryan Tunis",
"text": "What are you paying the purest attention to thinking like looking forward into 1/1, kind of what might drive pricing when you get to the end of the year?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, activity, cat activity, of course, and demand increasing, demand people, like we said before, needing to buy more or having to buy the bullet and do the right thing at the same time as they are improving on insurance portfolio. That's a big tell for us."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Meredith with UBS."
},
{
"speaker": "Brian Meredith",
"text": "A couple of questions here for you. First, just on your PML, what is your peak zone right now? Is it still Northeast?"
},
{
"speaker": "Francois Morin",
"text": "[Indiscernible], Florida."
},
{
"speaker": "Brian Meredith",
"text": "Where is it, pardon me?"
},
{
"speaker": "Francois Morin",
"text": "Florida. Miami Day."
},
{
"speaker": "Brian Meredith",
"text": "Okay. And then on the PML question, I'm just curious, you gave us 1-in-250 but how is your kind of 1-in-50 and 1-in-100 kind of increased over -- since, call at the beginning of the year? Is it -- as they increased more or less about the same amount? I'm just trying to get a sense of where you're playing in programs."
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So from a big zone perspective, it's gone up similarly in terms of percentage. It's a very similar increase."
},
{
"speaker": "Brian Meredith",
"text": "Got you. That's helpful. And then Marc, I'm just curious, I know there was a lot of one-off type transactions, top-up programs that happened in the second quarter. Can you give maybe some perspective on how much of that contributed to your growth here in the second quarter? And how much is kind of continuing here going forward, just so we can get a sense of how is this growth sustainable here for the remainder of the year, maybe in the '24."
},
{
"speaker": "Marc Grandisson",
"text": "We've had a couple of -- we've had a couple of programs, for instance, in the Asia that we won, and we've had a couple of big but I don't think this quarter is necessarily a large transaction quarter right to where you make it sound. I think it was more regular growth. A couple of transactions here and there, but nothing to the extent that when we talk on the call as Francois mentioned in his remarks, that it has to highlight it specifically before. I don't think there's nothing really to highlight in this quarter, actually."
},
{
"speaker": "Brian Meredith",
"text": "Good. And then I guess last one, just quickly here. One of your competitors talked about reducing market share in the MI business because there's some concerns about recession or going forward. Maybe give us your kind of perspective on what you're seeing right now in your MI and kind of outlook and potential for some higher loss ratios there if we do go into recession or look in the '24?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think pricing has improved over the last 2 years and credit quality stays really beautiful. And it's why among the best, I think we go back to 2013, 2012 in terms of quality of origination. So it's -- as you know, credit is not readily available. The availability of credit is still pretty tight out there. So from a credit quality perspective, Brian, it's as good. It's a really, really solid marketplace. I think the market share question, which we never -- we don't lose sleep with this, as you know, Brian. I think -- I'll -- couple of things in the market share that we're trying to do in terms of shaping the portfolio in the MI is trying to get the higher quality, like I mentioned in my remarks, lower FICO -- higher FICO, lower LTV and also geographically go to the places where there's less perceived inflation or overvaluation and also, there's some different programs that have different returns, meaning they are less than we would have hoped for them to be and they just don't [indiscernible] threshold and especially, Brian, if you overlay the opportunity set that we have on the property side, it just makes for our fellow folks and MI willing to take the earnings that they generate and give it to us on the P&C side to generate even better returns. So really good return business, Brian, it's just also for us a matter of comparative ROEs as well as absolute."
},
{
"speaker": "Operator",
"text": "Our next question comes from Meyer Shields with Keefe, Bruyette & Wood."
},
{
"speaker": "Meyer Shields",
"text": "A quick question to start. The level of reserve releases in reinsurance was lower than it's been in recent quarters. I was hoping you can give us some color. Is that because you're assuming higher loss trends? Or are there other factors that may have played into the quarter's results?"
},
{
"speaker": "Francois Morin",
"text": "No, I'd say it's -- I mean we will look at the data, right? So I think some quarters, there's evidence that we can release a bit more this quarter, maybe not as much. It's a process that we go through every quarter. So I think our underwriters and our actuaries kind of sit down and take a look at the respective treaties and come up with a point of view on whether there's enough evidence to release reserves. So I wouldn't read too much into it right now. I think it's a -- just another quarter still, we think, healthy reserves, healthy reserve releases, but not as much as you said in prior quarters."
},
{
"speaker": "Meyer Shields",
"text": "Okay. No, that's fair. Second question, and I'm really not sure how to ask this, but there's a lot of chaos right now in U.S. personal lines and [indiscernible] always been really opportunistic. I was wondering if there's a way that in a line of business that's so dominated by major players, but you do have this level of instability. Is there an opportunity for Arch?"
},
{
"speaker": "Marc Grandisson",
"text": "I think it's a hard one, Meyer. I think that our shareholders -- I mean, we could always see what we could do there. But from our perspective, I think we're more of a B2B and more of a commercial provider of insurance and specialty provider of insurance. Certainly, on the reinsurance side, we're helpful. Our companies -- a lot of companies are homeowners, homeowners are writers, and we do -- we do provide significant capacity for them, be it on a quarter share basis or excess of loss and also be on property. So I think our game plan on homeowners is more to support the clients that we have because I think on a long-term basis, it has a set of characteristics, as we all know, and focus that is not necessarily core to what we do every day, great filing and everything else in between. It's a bit of a different animal for us."
},
{
"speaker": "Operator",
"text": "Our next question comes from Yaron Kinar with Jefferies."
},
{
"speaker": "Yaron Kinar",
"text": "With most of my questions already asked and answered, I figured I'd maybe focus on a couple of more items. So first, on ad covers, can you maybe talk about how much you're still writing in '23 versus '22?"
},
{
"speaker": "Marc Grandisson",
"text": "We've cut our ad book significantly over the last 12 months. You see even in 2022, we started cut already as we saw this. And again, it's a matter of opportunity, right? I mean we do some but we've cut the book heavily because of the better -- frankly, better opportunities on the excess of loss occurrence, much better, yes."
},
{
"speaker": "Yaron Kinar",
"text": "And is the client base there? Has that changed at all? Can you maybe talk about the mix between large global, smaller regionals?"
},
{
"speaker": "Marc Grandisson",
"text": "We -- well, we had a -- when we grew at in Florida was, as you know, is a different kind of animal because of all the [indiscernible] small companies out there. But in general, I would say that our portfolio will opportunistically grow into the larger global companies. We tend to think that relatively not as the transparency of visibility into what they write. So our tendency is to be more of a super regional businesses and more ones that have a lesser footprint in terms of stake. We think we can better allocate capital. This is sort of a high-level philosophy that we've had for years. That hasn't really changed our one. I think that we prefer to grow with these clients over time. But having that all this opportunistically, being on a core share basis of excess of if it's a large corporate, we definitely were able to provide more capacity, but they needed. As we speak and the price, we believe, reflected the higher level of risk that they have. So I think I would say same as before, we're a little bit opportunistically on larger companies."
},
{
"speaker": "Yaron Kinar",
"text": "Got it. And then if I put this together then and we look at the very large cat activity that has really been incurred much more by the primaries here. With the changes in terms of conditions and maybe tighter, more limited cover per peril. Ultimately, how does that impact ad covers later in the year, if, let's say, the primaries had a lot of cat losses on perils, secondary perils that are now no longer covered by reinsurers at least not per event, ultimately, does that also flow into the ad covers that will not be breached on a reinsurance level because of that?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So I think that excess of loss is very similar to the current, if you do change terms and positions and cut the coverage at the underlying portfolio level, it will have a leverage impact into your aggregate excess or occurrence, meaning it will definitely cut down the loss expectations heavily into these layers. But what I would tell you on is we're not there yet, right? This is the early innings like I mentioned to you before on the call is that we're going to have -- the phenomenon just talked about will have a much better perspective and view on this and the impact it's going to have on the losses next year and through '25. I think right now, we still have a portfolio that hasn't gone through quite 100%, right, of all these [indiscernible] that you and I expect to happen, I think, in the marketplace. So the aggregate of losses for that reason, probably still bad bet in 2023, right? So we probably need to see this underlying change in terms of conditions on the insurance portfolio before we can see this being a potential viable product."
},
{
"speaker": "Operator",
"text": "Thank you. And I'm not showing any further questions at this time. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "So from Pembroke, Bermuda, I want to wish everybody a good month of August, and we'll see you in the fall. Thanks for your support."
},
{
"speaker": "Operator",
"text": "Thank you. Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 1 | 2,023 | 2023-04-27 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Q1 2023 Arch Capital Group Earnings Conference Call. [Operator Instructions]. Before the company gets started with this update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed on the company -- excuse me, filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also may make reference to certain non-GAAP measures of financial performance. The reconciliation to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished on the SEC yesterday, which contains the company's earnings press release and is available on the company's website and on the SEC's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin.
Marc Grandisson: Thank you, Lisa. Good morning, and welcome to Arch's earnings call for the first quarter of 2023. I'm pleased to report that as a direct result of our premium growth momentum from the past few hard market years, we reported an excellent start to the year. Financial highlights include book value per share growth of 8.4% in the quarter and an annualized operating ROE of 20.7%. Our P&C underwriting teams continue to lean into attractive market conditions were excellent risk-adjusted returns remain available, growing net premiums written by 35% over the same period last year. A key element of cycle management is to respond aggressively when you see conditions change. Since 2019, we have seen the market psychology pivot to underwriting discipline and our underwriting teams were prepared to become a more willing provider of capacity. The current property cat dislocation has resulted in us targeting growth in property lines and this should further improve our returns as we continue to benefit on the cumulative effect of improved rates, terms and conditions. The $327 million of underwriting income generated from our 2 P&C segments this quarter is a testament to our commitment in the improved market. Our mortgage segment operates on a different cycle than the P&C, but it remains a significant contributor to earnings, generating a healthy $243 million of underwriting income in the quarter as our high-quality insurance in force portfolio remained stable at $513 million. And in our P&C growth, I want to emphasize that Arch is first and foremost, an underwriting company. Being an effective underwriting cycle manager means that our underwriters know that they have degrees of freedom in choosing to deploy capital across our diversified specialty focused platform. Because we have a wider range of choices to allocate underwriting capital at any time, we can generate more consistent and stable underwriting income over the long run. Our growth in this hard market would not exist without our unwavering underwriting integrity. Our focus on underwriting leads through profit stability and better reserving visibility. And over time, these more stable results lead to greater balance sheet strength which in turn enables us to more aggressively deploy capital when we see market conditions change in our favor. At Arch, we're deeply committed to the art and science of underwriting because we know that underwriting integrity over time solidified our conviction and agility to proactively respond to changing market positions. I'll now share a few highlights from our segments. First with P&C. Overall, the P&C environment continues to offer plenty of opportunities as evidenced by our growth. As you see in our premium numbers, the reinsurance market, in particular, is very attractive right now. Reinsurance typically react more quickly to the changing environment and primary insurance, and we are witnessing this phenomenon in these early stages of improvement in the property market. In our insurance segment, we continue to take advantage of favorable market conditions. For the past few quarters, property has seen significant rate escalation, which supported our 37% net premium written growth in that line of business during the first quarter of '23. The property market is still broadly dislocated, and we believe it will take further rate improvement before it finds equilibrium. Elsewhere, general liability rates have pick up again and large account D&O is on a very few P&C lines that has decelerating rates. Overall, the market remains disciplined in its behavior, and we continue to obtain rate above trend. On our last earnings call, we noted property cat reinsurance dislocation at the 1/1 renewals, which led to significant effective rate increases. For the first quarter, reinsurance cat net premiums written roughly doubled over the last -- over the same period in '22. From our perspective, the improved conditions at 1/1 are a positive leading indicator as we prepare for the midyear renewals, where peak zone capacity remains tight. We are well positioned to take advantage of this opportunity. Arch is an increasingly prominent provider of choice in the property and casualty space. This is to be expected over time because of our differentiated cycle management strategy. To execute our strategy, we continuously invest in improving our capabilities. We hire and retain tough tier talent and teams, and we seek to enhance our tools and technology with the aim of becoming a more intelligent, stable and able provider of insurance products for our clients. Finally, our compensation structure rewards underwriting performance first and foremost. This is a powerful glue that aligns strategy with execution. Now let me move to mortgage. Our mortgage segment continued to generate solid underwriting income and risk-adjusted returns, largely because our portfolio was shaped with a focus on credit quality and data-driven risk selection. Credit quality in our mortgage portfolio is excellent, as demonstrated by our 1.65% delinquency rate, the lowest since March of 2020. Our disciplined underwriting approach has produced a portfolio with a more favorable risk profile, including higher fiber scores and both lower loan-to-value and debt-to-income ratios than our peers in the sector. Typical seasonality and tempered demand for housing in the first quarter affected new insurance written. However, production was in line with our expectations given the healthy market conditions. We're seeing pricing discipline across the MI industry as rates have increased over the past year. The MI industry's underwriting discipline is encouraging and allows us to maintain our focus on risk selection to achieve adequate risk-adjusted return. The MI industry is competitive, but faced with the current risk factors in the broader economy is acting rationally. As a result, our MI team continues to have opportunities to deploy capital. It isn't a football season yet, but with the NFL draft beginning tonight, football was on my mind. Back in the 1960s, a football team from a small Wisconsin town dominated the sport winning 5 championships in a decade. The team, as you all know, was the Green Bay Packers and their coach was Vince Lombardi, widely regarded as one of the greatest coach of all time in any sport. One thing that made Lombardi a great leader was his obsession with excellence and execution. During their dominance, a key part of their offense was a very simple play called the Power Sweep. The quarter back would hand the ball to the running back, we ran the ball to one side of the offensive line and then defensive line acted at blockers, allowing the running back to [indiscernible] it. No frills, no surprises. Opponents knew what was coming, but [indiscernible] and nobody could sell it. We talk a lot about cycle management and underwriting discipline on these calls and for good reason. It's hardwired into how we operate the company. They are not novel concepts. They're actually quite simplistic. The key, like with Lombardi Green Bay Packers is conviction and execution excellence. So day after day and year after year, we line up and essentially run the same play, write a lot of business when rates are high and a lot less when rates are well. Francois?
Francois Morin: Thank you, Marc, and good morning to all, and thanks for joining us today. As Marc highlighted, we kicked off 2023 with excellent underwriting results across all the segments, and our investment income continued its upward path, benefiting from a higher interest rate environment and strong operating cash flows. For the quarter, we reported after-tax operating income of $1.73 per share for an annualized operating return on average common equity of 20.7%. Book value per share was up 8.4% in the quarter to $35.35, reflecting not only our strong results, but also the unwinding of approximately $350 million of unrealized losses on our fixed income portfolio net of taxes. Turning to the operating segments. Net premium written by our reinsurance segment remained on its strong trajectory and grew by 51.5% over the same quarter last year. This growth occurred across most of our lines of business with a particular emphasis on property lines, marine and aviation and other specialties. The overall bottom line of the segment will also very good with a combined ratio of 84.3% and a relatively small impact of $59 million from current accident year capacity lawsuits. It's worth mentioning that our top line reflects the impact of some larger transactions which are not uncommon during periods of significant market dislocation. We cannot tell whether the frequency and size of these transactions will recur in future periods, but we are optimistic that market conditions will remain attractive for this foreseeable future. The Insurance segment also performed well with first quarter net premium revenue growth of 19.1% over the same quarter 1 year ago and an [indiscernible] quarter combined ratio, excluding cat of 89.8%. There were a handful of items affecting our top line marked significantly this quarter, such as a large transaction in the lenders and the warranty line of business and very strong market conditions in the property, energy and marine lines business, both positives, which were partially offset by the headwinds of weaker foreign currencies against the U.S. dollar compared to a year ago. We estimate that on a constant dollar basis, our net written premium growth would have been approximately 230 basis points higher than reported in our financials. Most of our lines of business still benefit from excellent market conditions both in the U.S. and internationally, and we remain positive about our ability to grow and write business at expected returns that meet our [indiscernible] as we approach the second half of the year. Our Mortgage segment had another excellent quarter with a combined ratio of 20% from strong performance across all our units. Net premiums earned were up slightly on a sequential basis reflecting the increased persistency of our insurance in force during the quarter at U.S. MI and good growth in our units outside of U.S. MI. We recorded approximately $73 million of favorable prior reserve development in the quarter, with approximately 2/3 coming from U.S. MI and the rest spread across our other units. [indiscernible] activity this quarter in U.S. MI was particularly strong as we benefited from the highest first quarter cure rate we have seen in the past 6 years, excluding 2020. At the end of the quarter, over 80% of our net reserves at U.S. MI are from post-COVID accident periods. Overall, our underwriting income reflected $126 million of favorable prior year reserve development on a pretax basis or 4.3 points on the combined ratio and was observed across all 3 segments. Quarterly income from operating affiliates stood at $39 million and was generated from good results at Coface, Somers and Premia. As you may already know, Coface recently declared a dividend of EUR 1.52 per share, which should result in a EUR 68 million dividend to Arch and link May, subject to Coface shareholder approval. Although this amount will not benefit our income statement next quarter, we believe it reflects very well on Coface's results and prospects for the periods ahead. Pretax net investment income was $0.53 per share, up 10% from the fourth quarter of 2022 as our pretax investment income yield exceeded 3% for the first quarter since 2011. With new money rates in our fixed income portfolio holding relatively flat in the 4.5% to 5% range, we should see further improvement in our net investment income returns in the coming quarters. Total return for our investment portfolio was 2.54% on a U.S. dollar basis for the quarter with all our strategies delivering positive returns. The contribution to the overall result was primarily led by our fixed income portfolio, which benefited from slight downward pressure on interest rates during the quarter. While fixed income market volatility was elevated intra-quarter because of the stress in the U.S. and Swiss banking systems and the implications for monetary policies of central banks, spreads at quarter end were generally consistent with those at year-end 2022. The overall position of our investment portfolio remains neutral relative to our target allocation and we are well positioned to capitalize should there be further dislocation in the capital markets. Of interest, our commercial real estate exposure is distributed across a variety of strategies. Accounts are only 6% of Arch's investment portfolio is highly rated as a low loan-to-value ratio and is more concentrated in multifamily housing investments with minimal positions in the office properties. [indiscernible] the acquisitions are concentrated with large money central banks with no significant exposure to U.S. regional banks. Turning to risk management. Our natural cat PML on a net basis stood at $1.69 billion as of April 1 or 8.1% of tangible shareholders' equity, again, well below our internal limits at the single event 1 in 250-year return level. Our peak zone PML is currently the U.S. Northeast and reflects some pockets of increased capacity we deployed at April 1 in response to good market opportunities ahead of the more active renewal period at June 1 and July 1. In summary, we remain very positive on the current market and the opportunities ahead of us across all the segments. As the current expected returns, we believe deploying meaningful capacity in our businesses currently represents our best option to maximize returns for the benefit of our shareholders. Our commitment to being active yet disciplined capital allocators, remain a core principle of ours that should lead to long-term value creation and success. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions]. The first question comes from Elyse Greenspan of Wells Fargo.
Elyse Greenspan: My first question, Marc, in your introductory comments, you said that we're in the early stages of improvement in the property market, right? We've seen strong rates at January 1 that have persisted into April 1. And my sense is could persist through the midyear. So could you just comment on what you mean by early stages and how you could see this playing out in -- during the rest of 2023 and into 2024.
Marc Grandisson: Very good question, Elyse. I think the -- when we have a dislocation such as the one we sort of realized and experienced after Ian in the fourth quarter of last year, the renewals took place on the reinsurance place at much higher rates by 30%, 50%, 60% price and the rate increases. Obviously, you have heard that on other calls. We had the same experience. The reason [indiscernible] the first to move reacting to deploying capacity and they should because they have to commit the capital for a 12-month period. Now we have a lot of portfolio from the insurance side. This is what I think is going to be leading the market and continue to underscore and support the market is the insurance portfolios hours included at the interest level, they're going through a reoptimization, realigning of capacity, realigning our pricing terms and positions, and this is widely spread across the industry. But an insurance product does not get all renewed at 1/1, right? The renewal takes place over a 12-month deal. So what we're seeing and hearing right now is the market psychology is squarely in the camp of getting improved terms and positions on the primary side. Which will then lead to obviously further improvement from the distance as a reinsurer. Now this will take 12 to 18 months to really take hold, and we believe, which is actually a little bit positive from our perspective. We should see that improvement carrying on and staying around for more than this year. We expect the underlying property improvements to be there for 2, maybe 2.5, maybe 3 years, which is a great, great leading position to be on insurance. So first, the reinsurance react. The interest is reacting, it takes a longer time to modify and correct itself as momentum being built and creating a better equilibrium on the insurance level the region will get renewed again at . We most likely have more things to improve on the portfolio. I think this is how hard market takes place over time, how it developed and unfolds over time. what we mean. We think that we have a little bit quite some nice runway ahead of us because of that reason.
Elyse Greenspan: That's helpful. Then could you give us a sense if in your margins in both insurance and reinsurance, did social inflation or financial inflation that impact on how you booked the current accident year in both insurance and reinsurance?
Marc Grandisson: Yes. So the way we operate and the way we put our reserving or loss ratio you won't be surprised to hear from us is we tend to take a prudent stance. That's the first step that you need to understand and we could all realize, and I know we saw that historically is one of the key things that we need to -- that we work on. Our game plan is to look at the trend and look at the rate level on a quarterly basis, modified if we have a good reason to modify it. And book it to a [indiscernible] 60th percentile confidence interval, not playing too close to the average because we want to have some protections because who knows what the future will hold. So if you look at the reserving overall in our company, we look line by line, we look at inflation in financial, social, bilayer by attachment point by region, and we correspondingly loss ratio for the overall portfolio. And what you see in our results in our numbers is a sum total of the aggregation of all of these very decisions within our insurance or reinsurance units. And I think that -- and then at the end of the day, as when I look at it to make sure that we have -- we feel more comfortable than possibly the average bear out there, and we make sure that it's on a trajectory that is responsible and prudent as well. So our tendency will not depict all the good news right away. We will probably wait and see and we've grown as well, at least, as you know. So it means that we have to be [indiscernible] careful and thoughtful in the way the [indiscernible], which we would recognize some of these improvements.
Elyse Greenspan: And maybe just one more, sticking there, Marc, right? In the reinsurance segment, right, the -- the growth, exceptional really strong, but the underlying loss ratio, right, was did tick up from last year. And I think part of that, there's always noise in each quarter, and it does take time to earn in this business for January 1. But can you help us kind of put that all together and just give us a sense of the margin profile of the reinsurance business over the balance of the year.
Francois Morin: Yes. I'll take that one, Elyse. I think a lot of interest people obviously look at the quarterly numbers. Our view is we -- we look at it, but we don't lose sleep over it. I think we look at long-term trends. We look at the quality of the business and how it prices and what the expected returns are. And when we find the deals. But specific to this quarter, as I mentioned, didn't give you really a whole lot specifics, but there's 2 transactions that really distorted a little bit our ratios with basically higher loss ratios and lower acquisition. So yes, you saw a little bit of movement on both the loss ratio and the combined ratio impact on the ex cat accident year loss ratio was 2.2 points. So it's -- if there -- we know it's there. We don't -- again, I wouldn't make that a trend. I mean it's just the reality of the business we've had this quarter. That's why I mentioned that we these are nonrecurring items. But in this market, we know there could be more in the coming quarters. So that's kind of how we -- that's the result of the business we have this quarter.
Operator: And the next question is coming from Jimmy Bhullar of JPMorgan.
Jamminder Bhullar: So first, I had a question on your comments on pricing, obviously very positive, both in reinsurance and insurance. But can you distinguish between pricing in both reinsurance and insurance on property and more of the cat-exposed business versus the casualty lines?
Marc Grandisson: Yes. So the last numbers we heard is a good question. Last number we heard on the primary side, we're looking at pricing depending on the cat exposed, obviously, is more acute, but rate increases 40% to 50% plus, definitely, and a little bit less if you're intercoastal, if you win in land, it's many 10% to 15% increase. But it's clearly, clearly a push for rate increase. But what's not really fully reflected and you should hear there are other things going on underneath the terms and conditions, deductibles are going up. That's also a really important factor also helps if you're a reinsurer of this portfolio. There's a statement of value, which pretty much states that any company now providing coverage needs to have an up-to-date valuation of the property you're trying to ensure. And that is a big deal because the industry has been frankly lacked in updating these numbers. And once you have the right exposure, it actually makes the pricing that much more effective and accurate. So this is the whole market is moving in that direction. And thirdly, I think that's also important, which creates more dislocation there is a shrinking of capacity at the individual players. So when people were putting $25 million, $30 million worth of capacity on even a cat exposed. So these are [indiscernible] going down $2.5 million to -- $2.5 million, maybe $10 million on an exceptional basis. So I think that the -- so the insurance portfolio, the rates are going up for a lot of reflection, echo back to questions about an inflation on the property side that is reflected the statement of value. So we're definitely clearing that one. So depending on where you are in working , lesser get exposed to , cat exposed. On the reinsurance side, it's a little bit similar, although it's a bit more of a monolithic marketplace. The rates are going in a more slower narrow range. It's almost like more commoditized, if you will. It's a little bit between to 50 pretty much broadly across. Of course, there will be differences. We'll see what the doing reserve for us. But the more acute the cat need, the more acute in the key zones of capacity demand the higher the pricing. But the general -- the overall general pricing is in sync. The insurance one will be able to grab those increased rates and improve time on condition over the next 12 months. The reinsurance or were able to get there quicker.
Jamminder Bhullar: And then just on the MI business. You had very high cues. I'm assuming most of these are just on reserves you put on around COVID when there were forbearance programs. And if that is the case, how much more of these such reserves do you have that will most likely I'm assuming it will be released over the course of this year?
Francois Morin: Well, we still have -- we definitely do have still some delinquencies that are in forbearance programs. I quote 80% of our loss reserves are from post COVID periods. We don't have all the detail around how much or by year, et cetera. But just hopefully, that gives you a flavor of like what maybe could potentially be down coming down the pike in terms of more releases if able to secure. I think the fact that unemployment levels are still performing very well. I think that's a good sign, right? I mean that's there's some pressure on home prices, et cetera. But for the in-force book, we think, again, the credit quality has been excellent, and we think there is performing well. And when we go to cure those delinquencies over time, hopefully, that should help the bottom line.
Operator: The next question is coming from Tracy Benguigui of Barclays.
Tracy Benguigui: I'm trying to understand mechanically why an LPT type of transaction could add noise to your underlying loss ratio on the reinsurance side. Is it that you're not imposing a loss corridor and you're assuming losses would attach at inception? Or is it accounting on the premium recognition? If you could explain the mechanics, that would be helpful.
Francois Morin: Sure. I mean at a high level what these transactions typically look like is the limited. So in terms of, a, the acquisition expenses is hero, if not very, very small. So if you think in a traditional quota share deal where the -- I assume the acquisition ratio could be 30%, well, that goes away. And then you're effectively just picking up losses and the investment income on the float is effectively part of the overall return of the transaction. So it changes the dynamic, and that's what we're trying to convey here is that -- on the underwriting side, it's usually book closer to 100% combined within that kind of range. But the investment income that you pick up is significant. So that impacts the overall bottom line return on the business.
Tracy Benguigui: Okay. Also, and maybe a little bit early, but can you discuss how June 1 and July 1 renewals are shaping up at this point? Like how would you compare pricing to what you saw in January?
Marc Grandisson: We heard from our team, we've been talking to them quite a bit of late, and the -- I can talk about all specifics, but at a high level, the continuation of the hard market that we saw at 1/1. We're seeing continuing partnering or continuing on the same level as 1/1 if not that better. But I want treatment to tell you, 6/1 and 7/1 are not done yet, like people are still very actively for ended. But is the momentum is there, clearly.
Tracy Benguigui: So how would that compare and you see momentum the same or better since January?
Marc Grandisson: It's early. I think it's early right now. I don't want to venture because also rather we all want to collect the veto keep in mind is 7/1 of '22 was also pretty good renewal floor, for instance, right? So it may not need as much of a pricing because we believe we're specifically in Europe, that we're -- we believe, not as well priced as ought to be based on the risk that you're taking. So it's still going to be return-wise, better, most likely better return than possibility, most likely the 1/1 that we sell because it such peaks up if everybody source of capital or use of capital.
Operator: The next question is coming from Yaron Kinar of Jefferies.
Yaron Kinar: I want to go back to the margins in reinsurance, the underlying margins. And I think that even with the LPTs, the accident year loss ratio ex cats, still deteriorated a bit. And I just want to understand kind of the context of why that would be if we are seeing business mix shifting more to kind of inherently lower loss ratio lines on an underlying basis and with the rate environment?
Francois Morin: Yes, 3 things I'd say, a, is I mean we focus on return. And while the obviously, what's in front of you is just the underwriting part of it. We focus on overall returns, which is the first thing. Second thing I'd say is you've got to give us a little bit of a chance to earn the premium. I mean, the market was solid in '22 and get better at 1/1/23. We're a quarter into the year. I think there's more benefit or more improvements that come, but it doesn't all sell up initially. And third thing, as Marc said earlier, I think we'll be proven. I mean, the math may suggest that, a, if you did this on that, that the combined ratio of losses should be yes. But we are proven in how we look at things. And when the data tells us that maybe we were a bit high, we'll be more than happy to release those reserves. But we're not going to declare victory quite yet.
Yaron Kinar: Okay. And then a second question just on cat. Can you maybe offer some color on the distribution between the various sources, whether it's Turkey or New Zealand floods, the European stores and so on in both reinsurance and insurance?
Francois Morin: Yes. I mean it's small ticket items. I think the biggest one for us was we had $25 million loss in Turkey, which is kind of what we do. It's not a huge deal, but that was the biggest item. Yes, we had some kind of participations in New Zealand with the cyclone and also some floods. And in the U.S., kind of the normal[indiscernible] tornados, [indiscernible] storms that hit -- that was mostly insurance, but a little bit of noise there as well in reinsurance so it's -- call it a hunch punch of small things, but the biggest one was -- for us this quarter was a Turkey.
Yaron Kinar: And was Turkey and New Zealand were those mostly reinsurance?
Francois Morin: Yes. Yes. Turkey was only reinsurance. Yes. Okay. And so -- I mean both of them are only reinsurances..
Operator: Next question will be coming from Josh Shanker of Bank of America.
Joshua Shanker: Yes. I was looking at the investment return. I mean, there's a lot of ways to measure yield. Let me just take the investment income divided by the float. I'm getting about 2.76% for the quarter, which makes Arch the lowest burner on its float in your peer group. I know you guys have a more conservative portfolio that's also allowed you to redeploy pretty quickly, but with new money yields maybe in the 5% range without taking any equity risk or whatnot, you have an opportunity to increase that yield of are you still seeing some powder drive? You still think it's time to be fairly conservative in seeking yield less points?
Francois Morin: I think it's something we obviously realized that there's -- new money yields are higher. And for us, it becomes a question of like crystallizing losses, there's implications around statutory versus GAAP accounting, we have restrictions in some places. So I think for us, we do the analysis very carefully in trying to make sure that we're doing what's best for the -- ultimately the shareholders. Sometimes we're better off kind of holding some investments to majority until and not kind of taking on the loss and reinvesting the money faster. But in terms of opportunities, whether we see more or want to think on more risk, it's something that we are thinking about. And we have grown our presence in alternative in the last few years, and that's something that -- and for us alternatives is, call it, more right structure kind of investments, and that's where we see the better opportunity and we've been pretty aggressive in growing the money there. But obviously, the returns there don't show up in investment income. They show up in equity method funds for the most part and that's where we expect to see a little bit of pickup as well going forward.
Marc Grandisson: We're also just thinking about the overall risk, right, about the enterprise, right? So we have a lot of underwriting push and growth. So that's also factored in our risk -- now that we're -- sorry, but just it's all one of the other part of the equation that we have to factor in as well.
Joshua Shanker: And what's the new money yield right now for you?
Francois Morin: We're to.
Joshua Shanker: Okay. And then, look, I know that you do listen to your competitors' conference calls and think about what they're saying. It looks like the pricing environment is pretty attractive. I think that's universally viewed few of your competitors have said as much. And then when we look at their premium growth in the quarter, it's kind of tepid, especially on the insurance side. You guys are growing your net premium in about 20% right now. It's been going that way for a little while. Is business hard to capture? Is it hard to get the business you want, and you've been silly successful outmaneuvering your competitors? I guess there's 2 things. One is, why are you so successful growing when others have not been able to do so. And two, can you give comfort on the fact that maybe some question, maybe the market is not as good as we think it is, and maybe there should be more concerned. So how can you give a comment with the rate adequacy? And why are you successful where others have failed?
Marc Grandisson: So from a rate acuity perspective, I mean, this is sort of a system that's well establishing our company. I don't know how many kind of reverify the assumptions and projections beat the individual underwriter level, group level in segment level corporate between the holding company, including the Board. I mean there's a lot of vetting going on comparing to and triangulating. So we're pretty confident. We wouldn't be growing that level if we didn't think that the returns were in our favor. Does that mean that we're going to get all the returns that we expect precisely to the decimal, most likely enough, Josh, we're in uncertain world, and we're making a bet on the longer term expected and that's the best thing that we can do right now. We are a fans of thinking about the rate as being by far the most important place to start to make sure that you have enough -- you put the odds in your favor and the rates going up, a lot of lines -- rates go up 60%, 80%, 70%, even some of them went to 2x and even if there's some of it decrease goes to 1.9x. While we also look at the history of the industry and the industry was printing 5 or 6 years ago, 60%, 65% loss ratio, even if they were on a reserving level grows to 80% and you put all the factor in the trend and you put a cumulative rate impact, I think that there's no certainty, but there's certainly a level of margin safety that you build within the price and that's what makes us feel that much more comfortable. Now in terms of our reduction in the marketplace, how we're able to lean in and see that business. First, we were early in the 2019 to really lean into it. A lot of people were pulling back, and that creates void and vacuum for our clients. And we were the ones the beacon in the storm, if you will, able to give them capacity. And that goodwill for lack of a better word, really builds upon itself. So it really creates more relationship build relationships that, frankly, has been a little bit less strong because of our defensive mode prior to 2019, but we rebuilt it very, very nicely. We're always there, but we rebuild, we kindle them in a much major way because I talk to our producers, they'll tell you that we're a great partner of theirs, and that makes a big difference. So when the next piece of business comes in, you look at the people who could write that business, and we've heard this from insurance group. Well, we can look at kind of markets. The market that wants the business right now was on 4 years ago, they'll probably not have the first bit at it. We probably has to first look at it because we were there for 4 or 5 years. Also, I would add that we're an E&S player. And as you heard, the E&S market is growing. So the market is also going towards the tailwind going from our perspective on that note. And we're pretty good security, Josh. We're a pretty good company. People want to deal with us, we're good for their money. We have a good expertise and good teams that really can't buy the client. I think we spent a lot of time not only providing coverage and policies but finding clients and being a good market leader right now. And certainly, that growth for the last 3 or 4 years have created its own momentum and inertia. So the gravity, if you will, that it's increasing has been pretty nice. It helps. It helps grow further even in that marketplace. And even the market gets a bit more competitive. I would argue that we'll be able to hold on to a lot of good business that we've written for the last 4, 5 years.
Joshua Shanker: Well, thank for the fulsome answers. And congratulations to everyone on graduating from rounding to the nearest thousand surrounding to the nearest million from bunch of new people.
Operator: Next question is coming from Brian Meredith of UBS.
Brian Meredith: A couple with me for you. Just quickly. Francois, you gave us loss ratio impact of the LPT. Can you give us what the combined ratio, maybe the premium impact just for modeling reason purposes?
Francois Morin: Combined ratio was 1.1 point. 2.2 in the loss ratio and all that cap, and the premium was $118 million.
Brian Meredith: Brilliant. Second question, Marc, looking at the 6/1 renewals, Florida, I guess, one, what is the impact of the legislation that was recently enacted having, you think, on that marketplace? Will it have an impact on renewals, pricing capacity coming into the market? And then, how do you typically think about Florida from a reinsurance perspective. Is it a market you'd like to play cat? Do you like to play quota share? How do you kind of think about it when you look at the Florida market?
Marc Grandisson: But the second part -- Brian, the second part of your question is easier. I think we're much more of a excess of loss in the library floor. We believe it's a better play for us at this point in time. And that seems to be sort of well also where the market is slowly migrating towards at least from the first indication. The second part -- the first part of your question which is the most interesting one is we're in Florida, we might well be in Missouri. You did show me state, but we stole to see and as evidence that those to reform will take hold. It's going to take a while. As we all know, we've got through a claims when before the 1st of April, 1st of May [indiscernible] of claims to make sure that we -- that they take advantage of the last resonance of the weaker toward area there. But that's going to take a while to work through. It also might mean that some of the losses from prior years are developing adversely, which is not necessarily useful and helpful for those who try to renew for on an ongoing basis, why if you have more losses from that on the prior years, the acceleration of losses you may have to make up for a lot of that or some of that, it's not a lot of it is pure value of reinsurance. So I think overall, I think the market will take sort of a view that it's not there at 100% and they'll probably sort of factor in who is more -- is more or less exposed to those, but they get credit those more or less exposed. But you're not going to get -- like everything else, we'll need to see it through to get full credit. I think the market will get some credit, but not the full extent of it. There's no way at least not at this time. Maybe in 2 years or next year or 2 years time, but don't take a while because we need to show and see what's happening for.
Operator: And the next question comes from Meyer Shields of KBW.
Meyer Shields: I have one, I guess, a technical question on the LPT side of things. Is it fair to assume that this is 100% combined ratio business as you write it? Or does the fact that it pertains to -- well, let me stop there.
Francois Morin: Well, that's typically where we book it. I mean plus or minus those types of transactions, that's kind of where they -- yes, that's where the combined ratio is on those.
Marc Grandisson: Because the contribution to profit and margin is square a lot more on the investment income side than it is on the pure rating income side.
Meyer Shields: Okay. And then speaking -- I don't know if you want to talk about the transactions or the demand that you're seeing. You talked about that, I guess, understand that we being a function of distress in the marketplace. Is this -- is the market right now focusing on the, let's say, 2019 and earlier accident years where pricing was soft or to say and/or is there interest in even more recent years because of loss trends?
Marc Grandisson: Yes. I think the market is focusing on it because I think that -- and also if you add on top of it the reopening of the court post-COVID, there's a lot of uncertainty. We've heard about inflation, financial inflation and social inflation. So there's a lot of scrutiny. And the rates were much lower then. So there is definitely less banked for those years to get the right number, the right loss ratio pick. So yes, definitely, people are looking as we are as well and where we -- on the reinsurance side, if you're treated we can see not anything or some companies have development that adverse in those periods. Some of them don't. But yes, it's definitely a point of discussion, which I think [indiscernible] helps explain why we had the -- we continue to have this price increase in the GL, for instance. I do believe that people are realizing it and understanding that for their recasting, right, the long-term trend and long-term loss ratio projection on a level basis how that works. So I think really that people are reflecting. And that's also why we have this. We don't have massive combined ratio above across the industry. We do have still a healthy level of price increase because of that [indiscernible].
Meyer Shields: Okay. That's helpful. And if I can just pick up on that because in your prepared comments also you talked about GL rate increases ticking up a little bit. I haven't heard a lot of that. We've heard a lot on the property side. I was hoping to get a little more color.
Marc Grandisson: Yes, the liability lines are -- of course, a lot of it has been historically led by auto, specifically on the umbrella. But the GL is clearly picking up again and it's late it's also international. And we have a low book of business as well as our insurance portfolio in the U.S. I think that there's also a dislocation going on the GL side, people are reevaluating the lines of business, the areas and the industry that they're providing coverage for. So this is happening probably a bit more -- it sort of slowed down a little bit towards the second half of 2022. And I think that's reoptimizing or re-underwriting or refocus on the underwriting and price for the GL and it also led, as you can appreciate, might some increase in trend, specifically in the excess layers because it's levered. So I think that's what we're seeing some of that prior year coming through. We're having to recast the pricing, which you wouldn't have had or would have seen necessarily in 2020, '21 because those years '16 to '19 were probably too young to really get the development coming out. So you probably can see that the duration of development of GL coming through and people reacting to it.
Operator: Next question comes from Mike Zaremski of BMO.
Michael Zaremski: Maybe a question or 2 on the catastrophe levels this quarter. I mean, Marc, you brought up terms and conditions changes. I think it probably blows certain people's minds that the valuations on property are just getting up to date and it seems kind of antiquated, but that's just, I guess, the way that the reinsurance maybe -- or sorry, the overall marketplace works. But just curious to the piece, yes, cat loss levels for the industry in the U.S. were way above a normal 1Q. I know you guys aren't right? That's not the best guy for Arch. But it looks like Arch's cat levels were normal-ish, but you can correct me if I'm wrong. Any read-throughs on the terms and conditions changes that have taken place that are -- is there any read through there that there are some good things coming through?
Marc Grandisson: I think on our results, I don't think you would describe the improvement in terms of conditions. I think it's probably just a function of how we book -- where our exposures are, right? We didn't have as much exposure in the areas where the losses occurred. That's -- I guess I would say the miss that could happen, that happens sometimes. That's really all we can see right now. We haven't seen the impact of the things I mentioned already because they're starting to pay holding. So it's going to take a lot of them to see. So that loss of these losses next year would presumably be because of all the conditions in terms that I told you are changing. It would be reasonable to expect that the losses will be less than they are right now, but we have yet to see whether the portfolios go through these changes. So nothing other than our exposure was not where the losses occurred.
Michael Zaremski: And as a follow-up, when we're hearing about the substantial rate increases, especially in property, does that take into account the terms and condition changes? Or is that -- are these kind of risk-adjusted rate increases that you're speaking to on some industry participants are speaking to?
Marc Grandisson: Yes. They're not fully risk adjusted, -- it's a really good question because it's a factor of a harder market or a softer market that when you see a rate -- the things that you can measure, you all incorporate into your calculation, but there are things that you cannot calculate or specifically isolate for input in your formula, right? So there's some core insurance wallets in there that are finally going to be put back in the marketplace. But really prevent some of the collections and that could otherwise happen. That's not factored in the pricing. There's -- adding the venue for litigation or mitigation of the losses to be in a different environment, one that's, for instance, more than its 2 or 1 that's left at it, that's not unable to factor that in the pricing. So I would say to the extent that you factor in the deductibles, the sub-living and you can run the cat losses based on the layers where you attach, if you attach higher. I think that is reflected in the pricing that we mentioned. The other things that are also going in the same direction, that's the trademark of a hard market, that is not fully reflected the extra backup that takes a brave that we don't see that we know collectively is there. So it also helps us feel a bit more -- we have more conviction on running more of that business.
Michael Zaremski: Got it. And maybe lastly, switching gears a bit. I believe Arch write a decent amount of professional lines. That's one marketplace that we've seen some stats pointing it to being more of a softer marketplace. Maybe you can comment if that's the case for Arch as well. And I don't know if you gave commentary also just on overall kind of rate increases on your primary insurance book this quarter.
Marc Grandisson: No. So thank you. Good question. So on the first part, for the D&O, we -- our portfolio has been going down a bit further than the rate increase that we saw the professional lines that we have on our financial supplement includes more than this, obviously. But suffice it to say that we're, like everybody else, are seeing a little bit more aggressiveness in that segment. But the one thing that we're -- that makes us being still want to be in there and not declare that this is over by any [indiscernible] is that the trends have been favorable to the OSC claims were down for the last 2 years. And a lot of clients got more broadbrushed rate increase -- rate increase and personally did not fully deserve it. So there's a lot of pushback on this as we speak right now. So again, talk about underwriting and risk selection. There are ways and there are areas where you'll keep getting a 10% rate. There are the areas where you're not okay getting a plus 5%. So I think our team is extremely experienced. I've been doing this for almost 30 years. So there, they're pretty good at picking and choosing their spot in that basis. The overall rate change on that -- we don't record it because the overall rate change is not a good indicator, especially when you have so many varied line of business going up and down. I think that the delta between the rate and -- but you heard with other people and also our book of business, the average is not really a good indicator. But I think the pickup between the trend and the rate is anywhere between to depending on the line of business. So we're still getting some pickup. And those that we may not be getting pickup in margin, at least from the appearance the jury is not as to whether the losses -- the loss trend is truly positive. So it's still not certain where these lines will to be specific D&O.
Operator: We have a follow-up question from Jimmy.
Jamminder Bhullar: On your PMLs, they've obviously gone up because you've written a lot more business and you're retaining a lot more. The 8.1% number that you mentioned, it's still lower than peers. Where would you feel comfortable taking it if the market environment remains favorable?
Francois Morin: Well, we think -- yes, just a quick reminder, I think zones for us right now, we're kind of Northeast [indiscernible], we also have like Florida Tri-County, which is kind of at the same level. The 1/1 renewals were more international, more national. So national accounts, not really Southeast specific where we expect to see more activity at 6/1 and 7/1. So no question that we think it will go up. I mean if the market stays as it is right now, could it go up 10%, 12%, we think so, and I think it's a reasonable scenario. But obviously, we'll have to wait and see and figure out and see how the renewals -- how everything gets lined up, but then directionally, I think that's kind of where we think we might be at July 1.
Operator: I'm not seeing any further questions. Would you like to have closing remarks?
Marc Grandisson: Thank you, everyone, for listening to our story. It's a great one, and we are looking forward to get even more good news in the July call. So thank you for everything then.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Q1 2023 Arch Capital Group Earnings Conference Call. [Operator Instructions]. Before the company gets started with this update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed on the company -- excuse me, filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management also may make reference to certain non-GAAP measures of financial performance. The reconciliation to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished on the SEC yesterday, which contains the company's earnings press release and is available on the company's website and on the SEC's website. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, Lisa. Good morning, and welcome to Arch's earnings call for the first quarter of 2023. I'm pleased to report that as a direct result of our premium growth momentum from the past few hard market years, we reported an excellent start to the year. Financial highlights include book value per share growth of 8.4% in the quarter and an annualized operating ROE of 20.7%. Our P&C underwriting teams continue to lean into attractive market conditions were excellent risk-adjusted returns remain available, growing net premiums written by 35% over the same period last year. A key element of cycle management is to respond aggressively when you see conditions change. Since 2019, we have seen the market psychology pivot to underwriting discipline and our underwriting teams were prepared to become a more willing provider of capacity. The current property cat dislocation has resulted in us targeting growth in property lines and this should further improve our returns as we continue to benefit on the cumulative effect of improved rates, terms and conditions. The $327 million of underwriting income generated from our 2 P&C segments this quarter is a testament to our commitment in the improved market. Our mortgage segment operates on a different cycle than the P&C, but it remains a significant contributor to earnings, generating a healthy $243 million of underwriting income in the quarter as our high-quality insurance in force portfolio remained stable at $513 million. And in our P&C growth, I want to emphasize that Arch is first and foremost, an underwriting company. Being an effective underwriting cycle manager means that our underwriters know that they have degrees of freedom in choosing to deploy capital across our diversified specialty focused platform. Because we have a wider range of choices to allocate underwriting capital at any time, we can generate more consistent and stable underwriting income over the long run. Our growth in this hard market would not exist without our unwavering underwriting integrity. Our focus on underwriting leads through profit stability and better reserving visibility. And over time, these more stable results lead to greater balance sheet strength which in turn enables us to more aggressively deploy capital when we see market conditions change in our favor. At Arch, we're deeply committed to the art and science of underwriting because we know that underwriting integrity over time solidified our conviction and agility to proactively respond to changing market positions. I'll now share a few highlights from our segments. First with P&C. Overall, the P&C environment continues to offer plenty of opportunities as evidenced by our growth. As you see in our premium numbers, the reinsurance market, in particular, is very attractive right now. Reinsurance typically react more quickly to the changing environment and primary insurance, and we are witnessing this phenomenon in these early stages of improvement in the property market. In our insurance segment, we continue to take advantage of favorable market conditions. For the past few quarters, property has seen significant rate escalation, which supported our 37% net premium written growth in that line of business during the first quarter of '23. The property market is still broadly dislocated, and we believe it will take further rate improvement before it finds equilibrium. Elsewhere, general liability rates have pick up again and large account D&O is on a very few P&C lines that has decelerating rates. Overall, the market remains disciplined in its behavior, and we continue to obtain rate above trend. On our last earnings call, we noted property cat reinsurance dislocation at the 1/1 renewals, which led to significant effective rate increases. For the first quarter, reinsurance cat net premiums written roughly doubled over the last -- over the same period in '22. From our perspective, the improved conditions at 1/1 are a positive leading indicator as we prepare for the midyear renewals, where peak zone capacity remains tight. We are well positioned to take advantage of this opportunity. Arch is an increasingly prominent provider of choice in the property and casualty space. This is to be expected over time because of our differentiated cycle management strategy. To execute our strategy, we continuously invest in improving our capabilities. We hire and retain tough tier talent and teams, and we seek to enhance our tools and technology with the aim of becoming a more intelligent, stable and able provider of insurance products for our clients. Finally, our compensation structure rewards underwriting performance first and foremost. This is a powerful glue that aligns strategy with execution. Now let me move to mortgage. Our mortgage segment continued to generate solid underwriting income and risk-adjusted returns, largely because our portfolio was shaped with a focus on credit quality and data-driven risk selection. Credit quality in our mortgage portfolio is excellent, as demonstrated by our 1.65% delinquency rate, the lowest since March of 2020. Our disciplined underwriting approach has produced a portfolio with a more favorable risk profile, including higher fiber scores and both lower loan-to-value and debt-to-income ratios than our peers in the sector. Typical seasonality and tempered demand for housing in the first quarter affected new insurance written. However, production was in line with our expectations given the healthy market conditions. We're seeing pricing discipline across the MI industry as rates have increased over the past year. The MI industry's underwriting discipline is encouraging and allows us to maintain our focus on risk selection to achieve adequate risk-adjusted return. The MI industry is competitive, but faced with the current risk factors in the broader economy is acting rationally. As a result, our MI team continues to have opportunities to deploy capital. It isn't a football season yet, but with the NFL draft beginning tonight, football was on my mind. Back in the 1960s, a football team from a small Wisconsin town dominated the sport winning 5 championships in a decade. The team, as you all know, was the Green Bay Packers and their coach was Vince Lombardi, widely regarded as one of the greatest coach of all time in any sport. One thing that made Lombardi a great leader was his obsession with excellence and execution. During their dominance, a key part of their offense was a very simple play called the Power Sweep. The quarter back would hand the ball to the running back, we ran the ball to one side of the offensive line and then defensive line acted at blockers, allowing the running back to [indiscernible] it. No frills, no surprises. Opponents knew what was coming, but [indiscernible] and nobody could sell it. We talk a lot about cycle management and underwriting discipline on these calls and for good reason. It's hardwired into how we operate the company. They are not novel concepts. They're actually quite simplistic. The key, like with Lombardi Green Bay Packers is conviction and execution excellence. So day after day and year after year, we line up and essentially run the same play, write a lot of business when rates are high and a lot less when rates are well. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Thank you, Marc, and good morning to all, and thanks for joining us today. As Marc highlighted, we kicked off 2023 with excellent underwriting results across all the segments, and our investment income continued its upward path, benefiting from a higher interest rate environment and strong operating cash flows. For the quarter, we reported after-tax operating income of $1.73 per share for an annualized operating return on average common equity of 20.7%. Book value per share was up 8.4% in the quarter to $35.35, reflecting not only our strong results, but also the unwinding of approximately $350 million of unrealized losses on our fixed income portfolio net of taxes. Turning to the operating segments. Net premium written by our reinsurance segment remained on its strong trajectory and grew by 51.5% over the same quarter last year. This growth occurred across most of our lines of business with a particular emphasis on property lines, marine and aviation and other specialties. The overall bottom line of the segment will also very good with a combined ratio of 84.3% and a relatively small impact of $59 million from current accident year capacity lawsuits. It's worth mentioning that our top line reflects the impact of some larger transactions which are not uncommon during periods of significant market dislocation. We cannot tell whether the frequency and size of these transactions will recur in future periods, but we are optimistic that market conditions will remain attractive for this foreseeable future. The Insurance segment also performed well with first quarter net premium revenue growth of 19.1% over the same quarter 1 year ago and an [indiscernible] quarter combined ratio, excluding cat of 89.8%. There were a handful of items affecting our top line marked significantly this quarter, such as a large transaction in the lenders and the warranty line of business and very strong market conditions in the property, energy and marine lines business, both positives, which were partially offset by the headwinds of weaker foreign currencies against the U.S. dollar compared to a year ago. We estimate that on a constant dollar basis, our net written premium growth would have been approximately 230 basis points higher than reported in our financials. Most of our lines of business still benefit from excellent market conditions both in the U.S. and internationally, and we remain positive about our ability to grow and write business at expected returns that meet our [indiscernible] as we approach the second half of the year. Our Mortgage segment had another excellent quarter with a combined ratio of 20% from strong performance across all our units. Net premiums earned were up slightly on a sequential basis reflecting the increased persistency of our insurance in force during the quarter at U.S. MI and good growth in our units outside of U.S. MI. We recorded approximately $73 million of favorable prior reserve development in the quarter, with approximately 2/3 coming from U.S. MI and the rest spread across our other units. [indiscernible] activity this quarter in U.S. MI was particularly strong as we benefited from the highest first quarter cure rate we have seen in the past 6 years, excluding 2020. At the end of the quarter, over 80% of our net reserves at U.S. MI are from post-COVID accident periods. Overall, our underwriting income reflected $126 million of favorable prior year reserve development on a pretax basis or 4.3 points on the combined ratio and was observed across all 3 segments. Quarterly income from operating affiliates stood at $39 million and was generated from good results at Coface, Somers and Premia. As you may already know, Coface recently declared a dividend of EUR 1.52 per share, which should result in a EUR 68 million dividend to Arch and link May, subject to Coface shareholder approval. Although this amount will not benefit our income statement next quarter, we believe it reflects very well on Coface's results and prospects for the periods ahead. Pretax net investment income was $0.53 per share, up 10% from the fourth quarter of 2022 as our pretax investment income yield exceeded 3% for the first quarter since 2011. With new money rates in our fixed income portfolio holding relatively flat in the 4.5% to 5% range, we should see further improvement in our net investment income returns in the coming quarters. Total return for our investment portfolio was 2.54% on a U.S. dollar basis for the quarter with all our strategies delivering positive returns. The contribution to the overall result was primarily led by our fixed income portfolio, which benefited from slight downward pressure on interest rates during the quarter. While fixed income market volatility was elevated intra-quarter because of the stress in the U.S. and Swiss banking systems and the implications for monetary policies of central banks, spreads at quarter end were generally consistent with those at year-end 2022. The overall position of our investment portfolio remains neutral relative to our target allocation and we are well positioned to capitalize should there be further dislocation in the capital markets. Of interest, our commercial real estate exposure is distributed across a variety of strategies. Accounts are only 6% of Arch's investment portfolio is highly rated as a low loan-to-value ratio and is more concentrated in multifamily housing investments with minimal positions in the office properties. [indiscernible] the acquisitions are concentrated with large money central banks with no significant exposure to U.S. regional banks. Turning to risk management. Our natural cat PML on a net basis stood at $1.69 billion as of April 1 or 8.1% of tangible shareholders' equity, again, well below our internal limits at the single event 1 in 250-year return level. Our peak zone PML is currently the U.S. Northeast and reflects some pockets of increased capacity we deployed at April 1 in response to good market opportunities ahead of the more active renewal period at June 1 and July 1. In summary, we remain very positive on the current market and the opportunities ahead of us across all the segments. As the current expected returns, we believe deploying meaningful capacity in our businesses currently represents our best option to maximize returns for the benefit of our shareholders. Our commitment to being active yet disciplined capital allocators, remain a core principle of ours that should lead to long-term value creation and success. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. The first question comes from Elyse Greenspan of Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first question, Marc, in your introductory comments, you said that we're in the early stages of improvement in the property market, right? We've seen strong rates at January 1 that have persisted into April 1. And my sense is could persist through the midyear. So could you just comment on what you mean by early stages and how you could see this playing out in -- during the rest of 2023 and into 2024."
},
{
"speaker": "Marc Grandisson",
"text": "Very good question, Elyse. I think the -- when we have a dislocation such as the one we sort of realized and experienced after Ian in the fourth quarter of last year, the renewals took place on the reinsurance place at much higher rates by 30%, 50%, 60% price and the rate increases. Obviously, you have heard that on other calls. We had the same experience. The reason [indiscernible] the first to move reacting to deploying capacity and they should because they have to commit the capital for a 12-month period. Now we have a lot of portfolio from the insurance side. This is what I think is going to be leading the market and continue to underscore and support the market is the insurance portfolios hours included at the interest level, they're going through a reoptimization, realigning of capacity, realigning our pricing terms and positions, and this is widely spread across the industry. But an insurance product does not get all renewed at 1/1, right? The renewal takes place over a 12-month deal. So what we're seeing and hearing right now is the market psychology is squarely in the camp of getting improved terms and positions on the primary side. Which will then lead to obviously further improvement from the distance as a reinsurer. Now this will take 12 to 18 months to really take hold, and we believe, which is actually a little bit positive from our perspective. We should see that improvement carrying on and staying around for more than this year. We expect the underlying property improvements to be there for 2, maybe 2.5, maybe 3 years, which is a great, great leading position to be on insurance. So first, the reinsurance react. The interest is reacting, it takes a longer time to modify and correct itself as momentum being built and creating a better equilibrium on the insurance level the region will get renewed again at . We most likely have more things to improve on the portfolio. I think this is how hard market takes place over time, how it developed and unfolds over time. what we mean. We think that we have a little bit quite some nice runway ahead of us because of that reason."
},
{
"speaker": "Elyse Greenspan",
"text": "That's helpful. Then could you give us a sense if in your margins in both insurance and reinsurance, did social inflation or financial inflation that impact on how you booked the current accident year in both insurance and reinsurance?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So the way we operate and the way we put our reserving or loss ratio you won't be surprised to hear from us is we tend to take a prudent stance. That's the first step that you need to understand and we could all realize, and I know we saw that historically is one of the key things that we need to -- that we work on. Our game plan is to look at the trend and look at the rate level on a quarterly basis, modified if we have a good reason to modify it. And book it to a [indiscernible] 60th percentile confidence interval, not playing too close to the average because we want to have some protections because who knows what the future will hold. So if you look at the reserving overall in our company, we look line by line, we look at inflation in financial, social, bilayer by attachment point by region, and we correspondingly loss ratio for the overall portfolio. And what you see in our results in our numbers is a sum total of the aggregation of all of these very decisions within our insurance or reinsurance units. And I think that -- and then at the end of the day, as when I look at it to make sure that we have -- we feel more comfortable than possibly the average bear out there, and we make sure that it's on a trajectory that is responsible and prudent as well. So our tendency will not depict all the good news right away. We will probably wait and see and we've grown as well, at least, as you know. So it means that we have to be [indiscernible] careful and thoughtful in the way the [indiscernible], which we would recognize some of these improvements."
},
{
"speaker": "Elyse Greenspan",
"text": "And maybe just one more, sticking there, Marc, right? In the reinsurance segment, right, the -- the growth, exceptional really strong, but the underlying loss ratio, right, was did tick up from last year. And I think part of that, there's always noise in each quarter, and it does take time to earn in this business for January 1. But can you help us kind of put that all together and just give us a sense of the margin profile of the reinsurance business over the balance of the year."
},
{
"speaker": "Francois Morin",
"text": "Yes. I'll take that one, Elyse. I think a lot of interest people obviously look at the quarterly numbers. Our view is we -- we look at it, but we don't lose sleep over it. I think we look at long-term trends. We look at the quality of the business and how it prices and what the expected returns are. And when we find the deals. But specific to this quarter, as I mentioned, didn't give you really a whole lot specifics, but there's 2 transactions that really distorted a little bit our ratios with basically higher loss ratios and lower acquisition. So yes, you saw a little bit of movement on both the loss ratio and the combined ratio impact on the ex cat accident year loss ratio was 2.2 points. So it's -- if there -- we know it's there. We don't -- again, I wouldn't make that a trend. I mean it's just the reality of the business we've had this quarter. That's why I mentioned that we these are nonrecurring items. But in this market, we know there could be more in the coming quarters. So that's kind of how we -- that's the result of the business we have this quarter."
},
{
"speaker": "Operator",
"text": "And the next question is coming from Jimmy Bhullar of JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"text": "So first, I had a question on your comments on pricing, obviously very positive, both in reinsurance and insurance. But can you distinguish between pricing in both reinsurance and insurance on property and more of the cat-exposed business versus the casualty lines?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So the last numbers we heard is a good question. Last number we heard on the primary side, we're looking at pricing depending on the cat exposed, obviously, is more acute, but rate increases 40% to 50% plus, definitely, and a little bit less if you're intercoastal, if you win in land, it's many 10% to 15% increase. But it's clearly, clearly a push for rate increase. But what's not really fully reflected and you should hear there are other things going on underneath the terms and conditions, deductibles are going up. That's also a really important factor also helps if you're a reinsurer of this portfolio. There's a statement of value, which pretty much states that any company now providing coverage needs to have an up-to-date valuation of the property you're trying to ensure. And that is a big deal because the industry has been frankly lacked in updating these numbers. And once you have the right exposure, it actually makes the pricing that much more effective and accurate. So this is the whole market is moving in that direction. And thirdly, I think that's also important, which creates more dislocation there is a shrinking of capacity at the individual players. So when people were putting $25 million, $30 million worth of capacity on even a cat exposed. So these are [indiscernible] going down $2.5 million to -- $2.5 million, maybe $10 million on an exceptional basis. So I think that the -- so the insurance portfolio, the rates are going up for a lot of reflection, echo back to questions about an inflation on the property side that is reflected the statement of value. So we're definitely clearing that one. So depending on where you are in working , lesser get exposed to , cat exposed. On the reinsurance side, it's a little bit similar, although it's a bit more of a monolithic marketplace. The rates are going in a more slower narrow range. It's almost like more commoditized, if you will. It's a little bit between to 50 pretty much broadly across. Of course, there will be differences. We'll see what the doing reserve for us. But the more acute the cat need, the more acute in the key zones of capacity demand the higher the pricing. But the general -- the overall general pricing is in sync. The insurance one will be able to grab those increased rates and improve time on condition over the next 12 months. The reinsurance or were able to get there quicker."
},
{
"speaker": "Jamminder Bhullar",
"text": "And then just on the MI business. You had very high cues. I'm assuming most of these are just on reserves you put on around COVID when there were forbearance programs. And if that is the case, how much more of these such reserves do you have that will most likely I'm assuming it will be released over the course of this year?"
},
{
"speaker": "Francois Morin",
"text": "Well, we still have -- we definitely do have still some delinquencies that are in forbearance programs. I quote 80% of our loss reserves are from post COVID periods. We don't have all the detail around how much or by year, et cetera. But just hopefully, that gives you a flavor of like what maybe could potentially be down coming down the pike in terms of more releases if able to secure. I think the fact that unemployment levels are still performing very well. I think that's a good sign, right? I mean that's there's some pressure on home prices, et cetera. But for the in-force book, we think, again, the credit quality has been excellent, and we think there is performing well. And when we go to cure those delinquencies over time, hopefully, that should help the bottom line."
},
{
"speaker": "Operator",
"text": "The next question is coming from Tracy Benguigui of Barclays."
},
{
"speaker": "Tracy Benguigui",
"text": "I'm trying to understand mechanically why an LPT type of transaction could add noise to your underlying loss ratio on the reinsurance side. Is it that you're not imposing a loss corridor and you're assuming losses would attach at inception? Or is it accounting on the premium recognition? If you could explain the mechanics, that would be helpful."
},
{
"speaker": "Francois Morin",
"text": "Sure. I mean at a high level what these transactions typically look like is the limited. So in terms of, a, the acquisition expenses is hero, if not very, very small. So if you think in a traditional quota share deal where the -- I assume the acquisition ratio could be 30%, well, that goes away. And then you're effectively just picking up losses and the investment income on the float is effectively part of the overall return of the transaction. So it changes the dynamic, and that's what we're trying to convey here is that -- on the underwriting side, it's usually book closer to 100% combined within that kind of range. But the investment income that you pick up is significant. So that impacts the overall bottom line return on the business."
},
{
"speaker": "Tracy Benguigui",
"text": "Okay. Also, and maybe a little bit early, but can you discuss how June 1 and July 1 renewals are shaping up at this point? Like how would you compare pricing to what you saw in January?"
},
{
"speaker": "Marc Grandisson",
"text": "We heard from our team, we've been talking to them quite a bit of late, and the -- I can talk about all specifics, but at a high level, the continuation of the hard market that we saw at 1/1. We're seeing continuing partnering or continuing on the same level as 1/1 if not that better. But I want treatment to tell you, 6/1 and 7/1 are not done yet, like people are still very actively for ended. But is the momentum is there, clearly."
},
{
"speaker": "Tracy Benguigui",
"text": "So how would that compare and you see momentum the same or better since January?"
},
{
"speaker": "Marc Grandisson",
"text": "It's early. I think it's early right now. I don't want to venture because also rather we all want to collect the veto keep in mind is 7/1 of '22 was also pretty good renewal floor, for instance, right? So it may not need as much of a pricing because we believe we're specifically in Europe, that we're -- we believe, not as well priced as ought to be based on the risk that you're taking. So it's still going to be return-wise, better, most likely better return than possibility, most likely the 1/1 that we sell because it such peaks up if everybody source of capital or use of capital."
},
{
"speaker": "Operator",
"text": "The next question is coming from Yaron Kinar of Jefferies."
},
{
"speaker": "Yaron Kinar",
"text": "I want to go back to the margins in reinsurance, the underlying margins. And I think that even with the LPTs, the accident year loss ratio ex cats, still deteriorated a bit. And I just want to understand kind of the context of why that would be if we are seeing business mix shifting more to kind of inherently lower loss ratio lines on an underlying basis and with the rate environment?"
},
{
"speaker": "Francois Morin",
"text": "Yes, 3 things I'd say, a, is I mean we focus on return. And while the obviously, what's in front of you is just the underwriting part of it. We focus on overall returns, which is the first thing. Second thing I'd say is you've got to give us a little bit of a chance to earn the premium. I mean, the market was solid in '22 and get better at 1/1/23. We're a quarter into the year. I think there's more benefit or more improvements that come, but it doesn't all sell up initially. And third thing, as Marc said earlier, I think we'll be proven. I mean, the math may suggest that, a, if you did this on that, that the combined ratio of losses should be yes. But we are proven in how we look at things. And when the data tells us that maybe we were a bit high, we'll be more than happy to release those reserves. But we're not going to declare victory quite yet."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. And then a second question just on cat. Can you maybe offer some color on the distribution between the various sources, whether it's Turkey or New Zealand floods, the European stores and so on in both reinsurance and insurance?"
},
{
"speaker": "Francois Morin",
"text": "Yes. I mean it's small ticket items. I think the biggest one for us was we had $25 million loss in Turkey, which is kind of what we do. It's not a huge deal, but that was the biggest item. Yes, we had some kind of participations in New Zealand with the cyclone and also some floods. And in the U.S., kind of the normal[indiscernible] tornados, [indiscernible] storms that hit -- that was mostly insurance, but a little bit of noise there as well in reinsurance so it's -- call it a hunch punch of small things, but the biggest one was -- for us this quarter was a Turkey."
},
{
"speaker": "Yaron Kinar",
"text": "And was Turkey and New Zealand were those mostly reinsurance?"
},
{
"speaker": "Francois Morin",
"text": "Yes. Yes. Turkey was only reinsurance. Yes. Okay. And so -- I mean both of them are only reinsurances.."
},
{
"speaker": "Operator",
"text": "Next question will be coming from Josh Shanker of Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "Yes. I was looking at the investment return. I mean, there's a lot of ways to measure yield. Let me just take the investment income divided by the float. I'm getting about 2.76% for the quarter, which makes Arch the lowest burner on its float in your peer group. I know you guys have a more conservative portfolio that's also allowed you to redeploy pretty quickly, but with new money yields maybe in the 5% range without taking any equity risk or whatnot, you have an opportunity to increase that yield of are you still seeing some powder drive? You still think it's time to be fairly conservative in seeking yield less points?"
},
{
"speaker": "Francois Morin",
"text": "I think it's something we obviously realized that there's -- new money yields are higher. And for us, it becomes a question of like crystallizing losses, there's implications around statutory versus GAAP accounting, we have restrictions in some places. So I think for us, we do the analysis very carefully in trying to make sure that we're doing what's best for the -- ultimately the shareholders. Sometimes we're better off kind of holding some investments to majority until and not kind of taking on the loss and reinvesting the money faster. But in terms of opportunities, whether we see more or want to think on more risk, it's something that we are thinking about. And we have grown our presence in alternative in the last few years, and that's something that -- and for us alternatives is, call it, more right structure kind of investments, and that's where we see the better opportunity and we've been pretty aggressive in growing the money there. But obviously, the returns there don't show up in investment income. They show up in equity method funds for the most part and that's where we expect to see a little bit of pickup as well going forward."
},
{
"speaker": "Marc Grandisson",
"text": "We're also just thinking about the overall risk, right, about the enterprise, right? So we have a lot of underwriting push and growth. So that's also factored in our risk -- now that we're -- sorry, but just it's all one of the other part of the equation that we have to factor in as well."
},
{
"speaker": "Joshua Shanker",
"text": "And what's the new money yield right now for you?"
},
{
"speaker": "Francois Morin",
"text": "We're to."
},
{
"speaker": "Joshua Shanker",
"text": "Okay. And then, look, I know that you do listen to your competitors' conference calls and think about what they're saying. It looks like the pricing environment is pretty attractive. I think that's universally viewed few of your competitors have said as much. And then when we look at their premium growth in the quarter, it's kind of tepid, especially on the insurance side. You guys are growing your net premium in about 20% right now. It's been going that way for a little while. Is business hard to capture? Is it hard to get the business you want, and you've been silly successful outmaneuvering your competitors? I guess there's 2 things. One is, why are you so successful growing when others have not been able to do so. And two, can you give comfort on the fact that maybe some question, maybe the market is not as good as we think it is, and maybe there should be more concerned. So how can you give a comment with the rate adequacy? And why are you successful where others have failed?"
},
{
"speaker": "Marc Grandisson",
"text": "So from a rate acuity perspective, I mean, this is sort of a system that's well establishing our company. I don't know how many kind of reverify the assumptions and projections beat the individual underwriter level, group level in segment level corporate between the holding company, including the Board. I mean there's a lot of vetting going on comparing to and triangulating. So we're pretty confident. We wouldn't be growing that level if we didn't think that the returns were in our favor. Does that mean that we're going to get all the returns that we expect precisely to the decimal, most likely enough, Josh, we're in uncertain world, and we're making a bet on the longer term expected and that's the best thing that we can do right now. We are a fans of thinking about the rate as being by far the most important place to start to make sure that you have enough -- you put the odds in your favor and the rates going up, a lot of lines -- rates go up 60%, 80%, 70%, even some of them went to 2x and even if there's some of it decrease goes to 1.9x. While we also look at the history of the industry and the industry was printing 5 or 6 years ago, 60%, 65% loss ratio, even if they were on a reserving level grows to 80% and you put all the factor in the trend and you put a cumulative rate impact, I think that there's no certainty, but there's certainly a level of margin safety that you build within the price and that's what makes us feel that much more comfortable. Now in terms of our reduction in the marketplace, how we're able to lean in and see that business. First, we were early in the 2019 to really lean into it. A lot of people were pulling back, and that creates void and vacuum for our clients. And we were the ones the beacon in the storm, if you will, able to give them capacity. And that goodwill for lack of a better word, really builds upon itself. So it really creates more relationship build relationships that, frankly, has been a little bit less strong because of our defensive mode prior to 2019, but we rebuilt it very, very nicely. We're always there, but we rebuild, we kindle them in a much major way because I talk to our producers, they'll tell you that we're a great partner of theirs, and that makes a big difference. So when the next piece of business comes in, you look at the people who could write that business, and we've heard this from insurance group. Well, we can look at kind of markets. The market that wants the business right now was on 4 years ago, they'll probably not have the first bit at it. We probably has to first look at it because we were there for 4 or 5 years. Also, I would add that we're an E&S player. And as you heard, the E&S market is growing. So the market is also going towards the tailwind going from our perspective on that note. And we're pretty good security, Josh. We're a pretty good company. People want to deal with us, we're good for their money. We have a good expertise and good teams that really can't buy the client. I think we spent a lot of time not only providing coverage and policies but finding clients and being a good market leader right now. And certainly, that growth for the last 3 or 4 years have created its own momentum and inertia. So the gravity, if you will, that it's increasing has been pretty nice. It helps. It helps grow further even in that marketplace. And even the market gets a bit more competitive. I would argue that we'll be able to hold on to a lot of good business that we've written for the last 4, 5 years."
},
{
"speaker": "Joshua Shanker",
"text": "Well, thank for the fulsome answers. And congratulations to everyone on graduating from rounding to the nearest thousand surrounding to the nearest million from bunch of new people."
},
{
"speaker": "Operator",
"text": "Next question is coming from Brian Meredith of UBS."
},
{
"speaker": "Brian Meredith",
"text": "A couple with me for you. Just quickly. Francois, you gave us loss ratio impact of the LPT. Can you give us what the combined ratio, maybe the premium impact just for modeling reason purposes?"
},
{
"speaker": "Francois Morin",
"text": "Combined ratio was 1.1 point. 2.2 in the loss ratio and all that cap, and the premium was $118 million."
},
{
"speaker": "Brian Meredith",
"text": "Brilliant. Second question, Marc, looking at the 6/1 renewals, Florida, I guess, one, what is the impact of the legislation that was recently enacted having, you think, on that marketplace? Will it have an impact on renewals, pricing capacity coming into the market? And then, how do you typically think about Florida from a reinsurance perspective. Is it a market you'd like to play cat? Do you like to play quota share? How do you kind of think about it when you look at the Florida market?"
},
{
"speaker": "Marc Grandisson",
"text": "But the second part -- Brian, the second part of your question is easier. I think we're much more of a excess of loss in the library floor. We believe it's a better play for us at this point in time. And that seems to be sort of well also where the market is slowly migrating towards at least from the first indication. The second part -- the first part of your question which is the most interesting one is we're in Florida, we might well be in Missouri. You did show me state, but we stole to see and as evidence that those to reform will take hold. It's going to take a while. As we all know, we've got through a claims when before the 1st of April, 1st of May [indiscernible] of claims to make sure that we -- that they take advantage of the last resonance of the weaker toward area there. But that's going to take a while to work through. It also might mean that some of the losses from prior years are developing adversely, which is not necessarily useful and helpful for those who try to renew for on an ongoing basis, why if you have more losses from that on the prior years, the acceleration of losses you may have to make up for a lot of that or some of that, it's not a lot of it is pure value of reinsurance. So I think overall, I think the market will take sort of a view that it's not there at 100% and they'll probably sort of factor in who is more -- is more or less exposed to those, but they get credit those more or less exposed. But you're not going to get -- like everything else, we'll need to see it through to get full credit. I think the market will get some credit, but not the full extent of it. There's no way at least not at this time. Maybe in 2 years or next year or 2 years time, but don't take a while because we need to show and see what's happening for."
},
{
"speaker": "Operator",
"text": "And the next question comes from Meyer Shields of KBW."
},
{
"speaker": "Meyer Shields",
"text": "I have one, I guess, a technical question on the LPT side of things. Is it fair to assume that this is 100% combined ratio business as you write it? Or does the fact that it pertains to -- well, let me stop there."
},
{
"speaker": "Francois Morin",
"text": "Well, that's typically where we book it. I mean plus or minus those types of transactions, that's kind of where they -- yes, that's where the combined ratio is on those."
},
{
"speaker": "Marc Grandisson",
"text": "Because the contribution to profit and margin is square a lot more on the investment income side than it is on the pure rating income side."
},
{
"speaker": "Meyer Shields",
"text": "Okay. And then speaking -- I don't know if you want to talk about the transactions or the demand that you're seeing. You talked about that, I guess, understand that we being a function of distress in the marketplace. Is this -- is the market right now focusing on the, let's say, 2019 and earlier accident years where pricing was soft or to say and/or is there interest in even more recent years because of loss trends?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think the market is focusing on it because I think that -- and also if you add on top of it the reopening of the court post-COVID, there's a lot of uncertainty. We've heard about inflation, financial inflation and social inflation. So there's a lot of scrutiny. And the rates were much lower then. So there is definitely less banked for those years to get the right number, the right loss ratio pick. So yes, definitely, people are looking as we are as well and where we -- on the reinsurance side, if you're treated we can see not anything or some companies have development that adverse in those periods. Some of them don't. But yes, it's definitely a point of discussion, which I think [indiscernible] helps explain why we had the -- we continue to have this price increase in the GL, for instance. I do believe that people are realizing it and understanding that for their recasting, right, the long-term trend and long-term loss ratio projection on a level basis how that works. So I think really that people are reflecting. And that's also why we have this. We don't have massive combined ratio above across the industry. We do have still a healthy level of price increase because of that [indiscernible]."
},
{
"speaker": "Meyer Shields",
"text": "Okay. That's helpful. And if I can just pick up on that because in your prepared comments also you talked about GL rate increases ticking up a little bit. I haven't heard a lot of that. We've heard a lot on the property side. I was hoping to get a little more color."
},
{
"speaker": "Marc Grandisson",
"text": "Yes, the liability lines are -- of course, a lot of it has been historically led by auto, specifically on the umbrella. But the GL is clearly picking up again and it's late it's also international. And we have a low book of business as well as our insurance portfolio in the U.S. I think that there's also a dislocation going on the GL side, people are reevaluating the lines of business, the areas and the industry that they're providing coverage for. So this is happening probably a bit more -- it sort of slowed down a little bit towards the second half of 2022. And I think that's reoptimizing or re-underwriting or refocus on the underwriting and price for the GL and it also led, as you can appreciate, might some increase in trend, specifically in the excess layers because it's levered. So I think that's what we're seeing some of that prior year coming through. We're having to recast the pricing, which you wouldn't have had or would have seen necessarily in 2020, '21 because those years '16 to '19 were probably too young to really get the development coming out. So you probably can see that the duration of development of GL coming through and people reacting to it."
},
{
"speaker": "Operator",
"text": "Next question comes from Mike Zaremski of BMO."
},
{
"speaker": "Michael Zaremski",
"text": "Maybe a question or 2 on the catastrophe levels this quarter. I mean, Marc, you brought up terms and conditions changes. I think it probably blows certain people's minds that the valuations on property are just getting up to date and it seems kind of antiquated, but that's just, I guess, the way that the reinsurance maybe -- or sorry, the overall marketplace works. But just curious to the piece, yes, cat loss levels for the industry in the U.S. were way above a normal 1Q. I know you guys aren't right? That's not the best guy for Arch. But it looks like Arch's cat levels were normal-ish, but you can correct me if I'm wrong. Any read-throughs on the terms and conditions changes that have taken place that are -- is there any read through there that there are some good things coming through?"
},
{
"speaker": "Marc Grandisson",
"text": "I think on our results, I don't think you would describe the improvement in terms of conditions. I think it's probably just a function of how we book -- where our exposures are, right? We didn't have as much exposure in the areas where the losses occurred. That's -- I guess I would say the miss that could happen, that happens sometimes. That's really all we can see right now. We haven't seen the impact of the things I mentioned already because they're starting to pay holding. So it's going to take a lot of them to see. So that loss of these losses next year would presumably be because of all the conditions in terms that I told you are changing. It would be reasonable to expect that the losses will be less than they are right now, but we have yet to see whether the portfolios go through these changes. So nothing other than our exposure was not where the losses occurred."
},
{
"speaker": "Michael Zaremski",
"text": "And as a follow-up, when we're hearing about the substantial rate increases, especially in property, does that take into account the terms and condition changes? Or is that -- are these kind of risk-adjusted rate increases that you're speaking to on some industry participants are speaking to?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. They're not fully risk adjusted, -- it's a really good question because it's a factor of a harder market or a softer market that when you see a rate -- the things that you can measure, you all incorporate into your calculation, but there are things that you cannot calculate or specifically isolate for input in your formula, right? So there's some core insurance wallets in there that are finally going to be put back in the marketplace. But really prevent some of the collections and that could otherwise happen. That's not factored in the pricing. There's -- adding the venue for litigation or mitigation of the losses to be in a different environment, one that's, for instance, more than its 2 or 1 that's left at it, that's not unable to factor that in the pricing. So I would say to the extent that you factor in the deductibles, the sub-living and you can run the cat losses based on the layers where you attach, if you attach higher. I think that is reflected in the pricing that we mentioned. The other things that are also going in the same direction, that's the trademark of a hard market, that is not fully reflected the extra backup that takes a brave that we don't see that we know collectively is there. So it also helps us feel a bit more -- we have more conviction on running more of that business."
},
{
"speaker": "Michael Zaremski",
"text": "Got it. And maybe lastly, switching gears a bit. I believe Arch write a decent amount of professional lines. That's one marketplace that we've seen some stats pointing it to being more of a softer marketplace. Maybe you can comment if that's the case for Arch as well. And I don't know if you gave commentary also just on overall kind of rate increases on your primary insurance book this quarter."
},
{
"speaker": "Marc Grandisson",
"text": "No. So thank you. Good question. So on the first part, for the D&O, we -- our portfolio has been going down a bit further than the rate increase that we saw the professional lines that we have on our financial supplement includes more than this, obviously. But suffice it to say that we're, like everybody else, are seeing a little bit more aggressiveness in that segment. But the one thing that we're -- that makes us being still want to be in there and not declare that this is over by any [indiscernible] is that the trends have been favorable to the OSC claims were down for the last 2 years. And a lot of clients got more broadbrushed rate increase -- rate increase and personally did not fully deserve it. So there's a lot of pushback on this as we speak right now. So again, talk about underwriting and risk selection. There are ways and there are areas where you'll keep getting a 10% rate. There are the areas where you're not okay getting a plus 5%. So I think our team is extremely experienced. I've been doing this for almost 30 years. So there, they're pretty good at picking and choosing their spot in that basis. The overall rate change on that -- we don't record it because the overall rate change is not a good indicator, especially when you have so many varied line of business going up and down. I think that the delta between the rate and -- but you heard with other people and also our book of business, the average is not really a good indicator. But I think the pickup between the trend and the rate is anywhere between to depending on the line of business. So we're still getting some pickup. And those that we may not be getting pickup in margin, at least from the appearance the jury is not as to whether the losses -- the loss trend is truly positive. So it's still not certain where these lines will to be specific D&O."
},
{
"speaker": "Operator",
"text": "We have a follow-up question from Jimmy."
},
{
"speaker": "Jamminder Bhullar",
"text": "On your PMLs, they've obviously gone up because you've written a lot more business and you're retaining a lot more. The 8.1% number that you mentioned, it's still lower than peers. Where would you feel comfortable taking it if the market environment remains favorable?"
},
{
"speaker": "Francois Morin",
"text": "Well, we think -- yes, just a quick reminder, I think zones for us right now, we're kind of Northeast [indiscernible], we also have like Florida Tri-County, which is kind of at the same level. The 1/1 renewals were more international, more national. So national accounts, not really Southeast specific where we expect to see more activity at 6/1 and 7/1. So no question that we think it will go up. I mean if the market stays as it is right now, could it go up 10%, 12%, we think so, and I think it's a reasonable scenario. But obviously, we'll have to wait and see and figure out and see how the renewals -- how everything gets lined up, but then directionally, I think that's kind of where we think we might be at July 1."
},
{
"speaker": "Operator",
"text": "I'm not seeing any further questions. Would you like to have closing remarks?"
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, everyone, for listening to our story. It's a great one, and we are looking forward to get even more good news in the July call. So thank you for everything then."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 4 | 2,024 | 2025-02-11 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Q4 2024 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time, including our annual report on Form 10-K for the 2023 fiscal year. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make a reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. And now I would like to introduce your host for today's conference, Mr. Nicolas Papadopoulo and Mr. Francois Morin. Please go ahead.
Nicolas Papadopoulo: Good morning, and welcome to our fourth quarter earnings call. I'll begin by offering our thoughts and sympathies to all of those affected by the California wildfires. This is a terrible event that will require the effort of many, including insurance companies, to help the affected communities recover and rebuild. At last, we will, of course, fulfill our role in these efforts. As noted in yesterday's press release, we expect the wildfires to result in a net loss between $450 million and $550 million based on an industry loss estimate of $35 billion to $45 billion. Turning now to our results, Arch had a solid top quarter writing $3.8 billion of net premium, which is a 17% increase over the same quarter last year. The $625 million of underwriting income in the quarter is down 13% from last year, primarily due to losses related to cat activities in the second half of 2024. Our full-year results were excellent, with $3.5 billion of after-tax operating income and an operating return on average common equity of 18.9%. Despite an increased level of natural catastrophes, book value per share, a preferred measure of value creation, ended 2024 at $53.11, representing a 13% increase for the year and nearly 24% increase after adjusting for the impact of the $5 per share special dividend we paid in December. The decision to pay a special dividend was the result of Arch's strong financial performance and excellent capital position and represented an effective means of returning excess capital to our shareholders. We also repurchased shares worth $24 million in the fourth quarter. Both the dividend and the share repurchase reflect our ongoing commitment to effective and active capital management. Market conditions within our segments remain favorable with a number of select growth opportunities ahead of us. As you may have heard from our peers this quarter, rate and loss trends vary by line of business. Broadly offset each other. All hands do not point to the same underwriting clock. For example, we are selectively deploying capital to the areas producing attractive risk-adjusted returns such as insurance and reinsurance liability lines, specialty business at Lloyds, and property charter insurance. Alternatively, lines of business where competitive pressures have eroded margins to levels below adequate, our underwriting teams are focused on improving our business mix within each of those lines to ensure our minimum profitability targets are met. Effective cycle management, the key to our strategy, requires empowering underwriters to execute on both sourcing and retaining attractive business without the constraint of production targets. In classes and subclasses where returns do not meet our minimum threshold, we have the agility and the incentives to reallocate capital to more profitable opportunities across our diversified portfolio. And as we have demonstrated throughout our history, we will not hesitate to return excess capital to our shareholders when appropriate. Now I will offer a few highlights about the performance of our underwriting segments starting with reinsurance, which finished the year with a strong fourth quarter delivering $328 million of underwriting income. The full-year results for the reinsurance group were excellent. The segment delivered a record $1.2 billion of underwriting income while writing over $7.7 billion of net premium. At the January first renewal, we grew the reinsurance business by selectively increasing our writings in property liability and specialty lines. Arch's status as a leading global reinsurer is a result of its focus on addressing broker and clients' needs, combined with its underwriting vigilance and high degree of scrutiny on the performance of its business. Throughout the whole market, Arch has had the conviction to increase its support and relevance with brokers and clients, making Arch a more valuable collaborative partner when other reinsurers wavered and in some cases, even withdrew capacity. Now moving to insurance, which also sees some strong growth opportunities in 2024. Overall, Arch and Helene and Milton limited fourth quarter underwriting income to $30 million. For the full year, the insurance group wrote $6.9 billion of net premium, a 17% increase from 2023, and delivered $345 million of underwriting income. Growth was enhanced by the acquisition of the US Midcorp and Entertainment business. Although it's still early, the performance and integration of the Midcorp and Entertainment business are consistent with our expectations and objectives. Organic growth in North America came from our casualty business unit, which more than offset premium decreases in professional lines. International insurance remained a bright spot, writing over $2 billion of net premium in 2024, primarily in specialty lines out of our large platform. Overall, rate increases remained slightly above loss trends, keeping return margins relatively flat in the fourth quarter. The outlook for both North America and international insurance growth is favorable for 2025. Looking ahead, we expect primary market conditions to remain competitive given the attractive underlying margins. However, we have experienced a slowdown in new business volumes as competition for premium volumes has increased. The mortgage segment contributed $267 million of underwriting income in the fourth quarter, resulting in the first consecutive years of delivering over $1 billion in underwriting income. Fundamentals remained positive, including strong persistency of our $500 billion-plus insurance in force portfolio, while the overall credit quality of the book remains excellent. The delinquency rate in our US MI business increased modestly to just over 2% at the end of December but remained near historic lows. Increased delinquency can be attributed to expected defaults in areas hit by natural catastrophes and the seasoning of the insurance in force. Overall, the US mortgage insurance industry remained disciplined despite suppressed mortgage origination due to low housing supply and high mortgage rates. Finally, to the investment group, which delivered nearly $1.5 billion of annual net investment income from an asset base that increased to over $40 billion after accounting for the special dividend. Rising investment yields and the growth of our investable assets from strong operating cash flows provide additional tailwinds for our earnings and book value growth. Overall, 2024 was another excellent year for Arch. Looking ahead, our primary goal is to maintain attractive margins despite expected heightened competition. Our strong underwriting culture, proven track record of cycle management, dynamic capital management capabilities, and progress to date in becoming a data-driven enterprise give me confidence in our ability to navigate ever-changing market dynamics with a clear objective of maximizing shareholder return over the long term. As we officially turn the page to 2025, I want to recognize the hard work and dedication of Arch's nearly 7,000 employees who share in our entrepreneurial culture that demands and rewards excellence to the benefit of our clients and stakeholders. Now I will turn it to Francois to provide more detail on the financials before returning to answer your questions. Francois?
Francois Morin: Thank you, Nicolas, and good morning to all. As you know by now, we closed 2024 with fourth-quarter after-tax operating income of $2.26 per share, for an annualized operating return on average common equity of 16.4%. For the year, our net income return on average common equity was an excellent 22.8%. Once again, our three business segments delivered a combined ratio of 78.6% for the year. Current accident year catastrophe losses were $393 million for the group in the quarter, split roughly 60% and 40% between the reinsurance and insurance segments respectively. Most of our catastrophe losses this quarter are due to Hurricane Milton, a fourth-quarter event, with an additional contribution from Hurricane Helene, where we saw some delayed emergence of claims given the late occurrence date in the third quarter. As of January 1, our peak zone natural catastrophe probable maximum loss for a single event at a one-in-250-year return level on a net basis increased slightly and now stands at 9.2% of tangible shareholders' equity. Our PML remains well below our internal limits. As we look forward to 2025, with the recent addition of the Midcorp and Entertainment business, and current market conditions in property, we expect our cat load to represent approximately 7% to 8% of our full-year group-wide net earned premium. Our underwriting income in the quarter included $146 million of favorable prior development on a pre-tax basis, or 3.5 points on the combined ratio across our three segments. We recognized favorable development across many lines of business but primarily in short-tail lines in our reinsurance segment, and in mortgage due to strong cure activity. As we discussed last quarter, the acquisition of the mid-corporate entertainment insurance businesses has impacted some key performance metrics for our insurance segment. First, the net written premium coming from the acquired businesses was $393 million for the quarter, contributing 27.1 points to the reported quarter-over-quarter premium growth for our insurance segment. Second, the acquired business lowered the insurance segment's accident year ex-cat combined ratio by 1.6 points this quarter. This result was due to the current quarter's acquisition expense ratio that was lowered by 2.1 points due to the write-off of deferred acquisition costs for the acquired business at closing under purchase GAAP, and an operating expense ratio that was lowered by 0.8 points as our Midcorp operations aren't fully ramped up yet. Partially offsetting these benefits was an increase in the accident year cat loss ratio of 1.2 points, reflecting the underlying results of the acquired business. On a related note, we expensed $99 million this quarter through intangible amortization, more than 75% of which was for the mid-corporate entertainment acquisition. This expense was in line with our expectations as we communicated last quarter. On the investment front, we earned a combined $548 million pre-tax from net investment income and income from funds accounted for using the equity method, or $1.43 per share. Our net investment income this quarter was partially impacted by a $1.9 billion dividend paid in December, which entailed that we liquidate a portion of our investment portfolio. Cash flow from operations remained strong. It was approximately $6.7 billion for the full year, up 16% from 2023. Our effective tax rate on pre-tax operating income was an expense of 6.7% for the quarter and 8.2% for the full year. As we look ahead, we would expect our annualized effective tax rate to be in the 16% to 18% range for the full year 2025, reflecting the introduction of a 15% corporate income tax in Bermuda. On a cash basis, we will start recognizing this with the establishment of the $1.2 billion deferred tax asset at the end of 2023. As you may have heard on other calls, the recent OECD guidance may partially impact the realizable value of the DTA. We will keep you apprised as additional information becomes available. In closing, our balance sheet remains extremely strong with common shareholders' equity of $20 billion after recognition of the $1.9 billion common dividend that was paid in December. Our debt plus preferred to capital ratio remains low at 15.1%. With these introductory comments, we are now prepared to take your questions. Sylvie?
Operator: Thank you, Mr. Morin. If you would like to ask a question, please press *1 on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. And your first question will be from Elyse Greenspan at Wells Fargo. Please go ahead.
Elyse Greenspan: Hi. Thanks. Good morning. My first question is on the insurance underlying loss ratio. I mean, I recognize, right, Francois, you highlighted, you know, some of the impact right, from the Allianz deal coming in right a little bit over one point calculated kind of Arch standalone, running at just under fifty seven, which is close to the Q3. Is it right way to think about it that that's about where Arch is and then kind of blend in, write this a little bit over one point from Midcorp so that insurance underlying is somewhere in the range of fifty eight on an ongoing basis, something like that.
Francois Morin: Yeah. That's about right. I think the yeah, the the impact of MC is, call it, know, on the loss ratio, about one point. So whatever the assumption you have around the, you know, pre-MC kinda run rate loss ratio, which is pretty stable has been pretty stable. There's some movements up and down from quarter to quarter, but generally speaking, it's been it's been stable. And introducing the MC maybe adds about a one one point to to that.
Elyse Greenspan: And then my second question is on reinsurance. Right? You guys you know, pulled back a little bit at midyear twenty four. Now the PML went back up, right, but it's flat. You know, one one twenty five with one one twenty four. Did you see conditions get incrementally better at January one. I'm just trying to understand the thought process around, you know, bringing the PMLs back up a little bit.
Nicolas Papadopoulo: No. I think I think what's happening is that we we like the business. So I think, you know, absent the the competitive nature and other people liking the business too, I think we we're looking to write more of this business. We think the the the returns are quite attractive. And I think at one one, we we had we had some opportunity to do so based on our positioning. So I think we we were pleased by that, I think.
Elyse Greenspan: And then I guess the the follow-up to that is, right, the California fire is pretty big loss. Do you see that know, being able to impact other cat renewal seasons in twenty five. Some of it, I guess, might bleed one one twenty six. How do you see the market impact from the California fires? And is this something, you know, where you guys would expect your PML and and cat ridings to go up during the year?
Nicolas Papadopoulo: So I think, you know, the as I mentioned in my remarks, I mean, this is a significant loss for the market. I mean, we pitch it between thirty thirty five and and forty five billion. We believe that a significant part of that losses will go to the reinsurance market. I think it will I think most reinsurer, including ourselves, we we start the year with a loss ratio. You know, in the twenties or the thirties or depending of your luck, maybe higher than that. So I think it would it should, you know, dump all the enthusiasm of you know, many market trying to be heroes and and and and and writing the business. So I would I would think that it it will have a an effect on on on on on the rates at at you know, for the rest of the year. So Thank you. And that's Thank you.
Operator: Next question will be from Michael Zaremski at BMO. Please go ahead.
Michael Zaremski: Hey. Thanks. I guess, first question, I'll just go back to the the catastrophe load guidance. Seven to eight it Probably just obvious, but that so that includes right. It's higher than the historical six day mostly because of the the one q California losses is that correct?
Francois Morin: A little bit, but also the MCU acquisition adds, you know, on a relative basis, kind of adds a little bit of you know, of load to, you know, to the, you know, to to increase the cat load. Because it's it's it's a heavier property book than people in this know, realize it. It didn't really Impact or PMLs because it's in different zones, it's more distributed. But when we think about you know, the contribution to the to the cat load throughout the year. It it has a meaningful impact.
Michael Zaremski: Okay. I would have actually plugging in the Cali losses. I actually would have thought to lower would have been a little bit higher, but but okay. Good good color. Switching gears just to the I guess one of the elephants in the rooms for for lots of insurers is going back to the kind of the casualty GL umbrella environment. In some of the prepared remarks, was, you know, said that overall rate increases remain slightly above loss trend. I think that was the primary insurance marketplace. Any comments on whether you know, what you're seeing And you're GL book. I know that, you know, you guys are one of the more honest ones. In my humble opinion. And at the investor day, you know, you said you'd probably be adding small amounts to your your GL reserves, but, you know, nothing that that's really too out of out of trend line with what you've you've been doing for a while now and better than the industry. But any updated commentary on what you're seeing there?
Francois Morin: Yeah. And so I think I'll answer in two parts. One on the position, we didn't add to our reserves. We're very comfortable with the reserve position both both in insurance and reinsurance. You know, our actual versus expected analysis or year end analysis all are supporting that that view that our reserves for prior accident years are are very adequate. So no no concern there. But as we look at, you know, second half of twenty four and into twenty five, you know, yes, we are seeing rate changes keeping up with loss trends, so we're not and even exceeding in some places. So we're comfortable with the the environment there. But we also recognize that there's a lot of uncertainty there. So we are being cautious, prudent. We are in some specific very targeted areas increased our initial loss picks. But it's not I think I wanna make it clear here. It's not as a reflect it's not a reflection of adverse development or, you know, signals or data telling us that we missed a mark on the old years, It's very much a function of the current rate environment and how we perceive the risk around our initial loss picks. And for that reason, we're choosing to be a bit more prudent.
Michael Zaremski: Okay. Got it. And just lastly, real quick. Thanks for the tax rate guidance. Is the DTA that was established is I think some of some peers have said that they're could be tweaks to to the DTA due to guidance from from Bermuda. Is that something that's influx or any way you could kind of a a handicap whether, you know, if it if a DTA was influx, would it change materially or just a little bit?
Francois Morin: Yeah. I mean, the guidance right now and that's an important thing, it's it's guidance that's not the law, which you know, we do follow, obviously, Bermuda law, which allows us or instruct us really to carry the DTA. The recent guidance from the OECD suggests that you know, we may only be able to realize up to twenty percent of that amount. That is still again, that that's the light of guidance. I mean, things change pretty quick in this when we start talking about taxes, but if know, I I'd say you know, from your perspective, maybe worst case, that's kinda what may happen is that we end up only realizing twenty percent of this amount and the rest we might have to write off at some point you know, in twenty six or late twenty six or twenty seven, But for the time being, Bermuda law has not changed, and that, you know, that's what we're following.
Michael Zaremski: Appreciate the color.
Operator: Thank you. Next question will be from Jimmy Bhullar at JPMorgan. Please go ahead.
Jimmy Bhullar: Hey. Good morning. So just had a question. A different topic. On MI reserve releases, can you go through the details on what's driving those and how much of that is from the last one to two years versus maybe a few years back? And just your overall expectations for margins in that business?
Francois Morin: Yeah. I mean, the reserve release has come, you know, from both I mean, from all three of our segments. Right? There there's a meaning again, that's a little bit of of the same story that we've we've been talking about the last few quarters where you know, we based on conditions at the time, I wanna say twenty two and twenty three, we had set up initial reserves on the delinquencies that were reported at the time and turns out that people have been curing and and severity has not been to the level that we thought. So that's just a normal, I'd say, kinda You know, process that the reserving, you know, we go through with our reserves at USMI at say for the other pieces, a little bit of the same, I say, in the CRT business where you know, it's a slightly different methodology, but we have initial loss picks on that business and that has proven out to be a little bit kinda in excess of what we need today. So there's been some releases there, and finally, the international book, a little bit of the same too where you know, there there's different methodologies in place, but the the the long story or the, you know, the short of it maybe is that you know, all three books or all three pieces of our mortgage segments are performing really, really well. So we like the margins. We think the margins are are healthy. We don't see any deterioration in how we think about, you know, the business and the returns we're writing today. So if we're very very excited about it.
Jimmy Bhullar: And then on share buybacks, I'm assuming part of the reason you did a little bit of buybacks this quarter versus none before was just the decline in the stock price. So assuming the stock's stays around here, Reasonable to assume that you'd be active throughout twenty five as well?
Francois Morin: For sure. I mean, it's something we look at, you know, regularly. I mean, every time all the time. No. I mean, in this particular situation, yes, there's old kinda, you know, opportunity in late in the fourth quarter. But, you know, our capital position remains strong even with, you know, the California California wildfires. I mean, that's part of the volatility we may see from time to time, but, you know, whether again, we we will not sit on a level of excess capital that we don't think we can deploy in the business. So if the if we don't you know, we stink we still think we can grow. We we are bullish about twenty twenty five. The market conditions are still really good.
Jimmy Bhullar: But
Francois Morin: You know, can we deploy all the capital we have or that we generate, maybe not? And at that point, we'll return it then if the price is right, we think share buybacks are a great way to do that.
Nicolas Papadopoulo: Yeah. I think the the order of play is that we want to look at where we can deploy capital attractively in the business. I think that we do that all the time, I think. And, yeah, after a while, when, you know, periodically, when we assess our capital position. And if we see that know, the opportunities may not be there to deploy all the excess capital. That's when we consider the the most effective way, I would say, at the time to to return capital to our shareholders. So
Jimmy Bhullar: Thank you.
Nicolas Papadopoulo: Thank you.
Operator: Next question will be from Wes Carmichael at Autonomous. Please go ahead.
Wes Carmichael: Hey. Good morning. Thank you. A question on favorable development quarter, particularly in reinsurance. Can you just give us a little bit of color on what drove most of that release and maybe if you had any strengthening. I think you mentioned short tail lines in prepared remarks, but any more color will Okay.
Francois Morin: Yeah. The vast, vast majority is on property cat and property other than cat. So that's what we consider to be short line a short tail. We were flat on casualty. So across the reinsurance segment, so no no development on casualty and, you know, a couple of moves up and down marine, other small lines, other small items, but that's the that's the bulk of it. It's really property. Some is, you know, I'd say prior caps, meaning kinda large events that we had reserved for that are developing a bit favorably. Some of it is just you know, the IBNR we hold for, you know, miscellaneous kinda traditional losses that has proven out to be in excess of what we needed. So that's kinda how we we recognize it this quarter through through those lines of business.
Wes Carmichael: Got it. Thanks. In in prepared remarks, I think maybe a broader comment, but you mentioned some competitive pressure where that's eroded margins in certain lines of business. Can you just talk a little bit about where that might be more pronounced?
Nicolas Papadopoulo: Yeah. So I think was thinking this question was gonna come up. So so I think, you know, it's it's mainly in in two areas. I would say the most feasible one is you know, I would say public public DNO where, you know, I think we we've seen significant decrease in the last in the last two years. In double digits. That seems to be tempering, but the the you know, it's richer level that you you really have to ask yourself you know, account by account. You know? Is is the overall line, you know, still profitable? And second area that we we are watching is in the is the cyber area where, you know, also on the excess side, we've seen, you know, double digit rate decreases and and and the supply of capacity in both know, public DNO and cyber that that don't seem to be wanting to to to to reduce. I think
Operator: Did you have any further questions, Mr. McCarmichael?
Nicolas Papadopoulo: Yeah. I guess, I'll I'll follow-up with one more. But just on on MI and the delinquency pickup, I I think you mentioned that can be impacted by cat exposed areas and you obviously had a couple sizable storms last year, but just hoping you could unpack a little bit with what you saw in the tick up there.
Francois Morin: Yeah. I mean, it's very much part of the natural process. As you'd expect, some people were affected by these events. And, you know, once they, you know, missed two consecutive mortgage payments, they they turned delinquent and, you know, that's what we fully expected would happen in the fourth quarter. About half of the increase in the delinquency rate is is directly attributable to these cap affected areas. I mean, it's it's, you know, that that's our best estimate at this point. The historical cure rate on these types of delinquencies driven by natural events is extremely high. So that's why we think the the financial impact ultimately will be minimal but currently that's, you know, that's how the the process works. They show up in the delinquency rate, and we reserve for those. But Typically, those to get resolved or cured at a high level. Over time.
Wes Carmichael: Thank you.
Francois Morin: And and just quickly, I'll add I mean, just I'll add quickly on the California wildfires, slightly different different type of exposures we expect minimal again, very early, too early to know, but get given the the the types of mortgages that exist in these areas, we would not expect to be impacted at all or very mean, certainly not significantly at all in In the due to the California wildfires.
Wes Carmichael: Understood. Thank you. Yep.
Operator: Thank you. Next question will be from David Motemaden at Evercore. Please go ahead.
David Motemaden: Hey. Thanks. Good morning. I had a question, and I saw the solid casualty reinsurance growth in the fourth quarter as well as twenty twenty four, and it sounded like that continued at one one twenty five. Yeah. I guess I'm wondering if you could just talk a little bit about the rate adequacy specifically within the casualty reinsurance line. I know it it's a it's a broad line, Right. Little surprising to see you guys lean in there. It sounds like others have been more critical on just the rate adequacy there. So I wonder if you could elaborate a little bit on that.
Nicolas Papadopoulo: Yes. I I think, you know, the we started from a position that we were really, I think, underweight on the on the casualty treaty or insurance. And I think our view and it's true, by the way, on the insurance side is that we You know, we we've tried over the years to You know, to to get to get into program that are more, I would say, specialty, casualty. If you think of it as more with an ENS flavor. So Similar to what we would be riding, you know, growing on the on the insurance side, I think it's it's been it's been a while, but I think based on the you know, the the additional cloud that's you know, the value of the brand on the reinsurance side, I think we've been and and and our ceiling companies, you know, forecasting some wavering from the from from maybe some of the reinsurance or less appetite for the casualty, I think we've been able finally get onto probe you know, programs or insurance programs that we we think are backing the the the right people to take advantage of the of the opportunity. So that has been really the the engine behind behind the growth. It's not you know, we're not underwriting the market. We're just underwriting selective underwriters that we think have the the know how and the and the expertise to to be able to to to deliver attractive return for for us. So
David Motemaden: Great. Yep. Understood. I yep. Definitely, you guys are are underway there, so that makes sense. And and so maybe just switching gears to the insurance segment. And just wanted to get a little bit more color on the current accident year loss pick increases that you noted. It sounded like it was minor. But wanted to just get a little bit more detail on what lines it was And it didn't sound like that had any impact on the prior year reserve. Any prior year reserve impact. I just wanted to understand, how that's how that happened.
Francois Morin: Yeah. I mean, again, I you know, roughly, if we we break it down, call it a third of the increase is is due to the mid mid corporate entertainment inclusion or addition to the segment. There may another third I'd say it's lines of business where we just you know, reacting to the rate environment and example of that would be professional lines like both cyber and d and o where you know, you guys have seen it, we've seen it, you've heard it. Mean, rates have been coming down over the last couple of years pretty significantly and that's a big part of our book. So naturally, I think you'd expect us and we are booking a higher loss ratio this year than we did a year ago, and that's just a function of the rate environment. So that's an example. Another example is some of our auto warranty product, our gap product, where you know, due to, you know, the, you know, different market conditions, different economic realities with the the value of used cars and and what we insure and what we cover, know, loss ratio inched up a little bit there. So nothing that was surprising to us, but, again, we're reflecting or reacting to the data And, you know, that that's and, you know, obviously, there's always mix a little bit at the end, but those I'd say are some examples of kinda minor, kinda small adjustments that contributed to the overall increase.
David Motemaden: Got it. Okay. That is yeah. So it doesn't sound like that was any GL or umbrella related pick increases. It was it was more in other lines.
Francois Morin: Correct.
David Motemaden: Great. You.
Francois Morin: You're welcome.
Operator: Next question will be from Andrew Kligerman at TD Securities. Please go ahead.
Andrew Kligerman: Hey. Thanks a lot. First question, maybe you could drill down a little more into the casualty lines the E and S areas of casualty. Where you'd like to grow or where you are growing in both insurance and reinsurance, respectively. And then with that, could you give us a sense of the rate changes in those areas in both reinsurance and insurance, respectively.
Nicolas Papadopoulo: Yes. So those are, I would say, for the large part, similar book of business. So it's really e E and S what we call ENS liability, and it's it's more middle to, you know, high excess layers where we've seen the market know, reacting to the propensity of larger losses in the last last few years. So what's happening in that market is people used to have on the retail side, first, you know, big limits. So once once the once the once the admitted market know, decide that You know, they're not gonna be able to offer those limits anymore. You know, by definition, if you had a two hundred million dollar program with Maybe five or or seven players. You know, now that, you know, the admitted players decide to reduce their limit to ten million, you're gonna need twenty people to And so the the way the market work is and that has been going on for a while, a lot of that business now is getting repriced into the ENS market, not only on the pricing side, but also on the terms and condition. You're able to get exclusion that you will not be able to get on the on the on the on the admitted retail side. So we We like, you know, that that business. We've been riding that business. We've been underway that business for years. You know? And we we have experience We've been riding the business for over twenty years, and we have you know, really specific line of business. I'm not gonna go over it over the the the call, but that we actually have experience in it. We have you know, we know the venues where to ride it. We know, you know, the the the type of severity of claims. We we know we know the exposure to, you know, cover order that's embedded in those in those risk. And so we we're able to selectively And good good companies do that. Effectively pick a subset of the market and we're still getting, you know, very decent rate increases. I think double digits. You know? And I think it has been the weight increase have been going on for a while. They were know, in the twenties, they were in the double digit, then they went to the single digit, then we're back in the double digits of late. And so we we think we're getting rates of a trend. I think we think the business underwritten properly with the right limit think, could be very attractive. But You have to pick and choose. You know, it's it's it's not it's not, again, the the cost of the ball that we make.
Andrew Kligerman: You know, that's very, very helpful answers. I I I guess as I think about it, you know, a lot of your competitors are running scared. On on on the high layer excess of loss casualty just just given the inflationary environment. So so maybe just a little color on and and and you kinda gave some of it just in terms of your experience in the market, but but maybe a little color why you don't fear that that that could get out of hand and, you know, we could wake up one day and just see Arch Arch get hit with with a lot of these things. You know, kind of jumping into the high layers, you know,
Nicolas Papadopoulo: So this is this is not this is this is what market do. When when you when you have a lot of severity losses, whether it's property or whether it's it's, you know, liability, reaction of the market is to cut limit. So I think if you think think of it. If you have a let's say, fifty million dollar limit. You're writing a hundred million dollar portfolio two short loss, and your loss ratio is a hundred percent. I think what we've seen is people cutting their limit dramatically to fives and tens. So now you know, when we get the full tower losses, the contribution to your portfolio is five or ten million. So it makes you know, the the beauty of diversification, it makes it makes the the your loss ratio a lot more stable. And I think when this happens, because I what what I said earlier, before to do, like, a two hundred million dollar tower, for a program, you needed five seven market because now you need twenty. You know, by definition, it costs a lot more. And so the the the the price adequacy is is is a lot better. So that's what we're seeing.
Andrew Kligerman: Got it. Thanks a lot.
Operator: Thank you. Next question will be from Cave Montazeri at Deutsche Bank. Please go ahead.
Cave Montazeri: Thank you. Another question on cash proceeds, that's why you see good growth opportunities. Seeing good rate increases on the primary side. Because she's also helping quota share of reinsurance. But the city and commissions didn't change much at one one. Despite the adverse development. Carriers continue to face, My question is, what's the incremental supply of casualty reinsurance at one one? Higher than what you would have expected? I know you're writing both, and, yes, we do found the specific line. But it is currently more attractive to write new casualty business on the primary side rather than on the reinsurance side.
Nicolas Papadopoulo: Yes. So, you know, as as soon as I'll answer the first question, I think the supply casualty, treasury reinsurance, I think we're hearing bubbles of people on on the call saying that they don't think it's effective. So hopefully hopefully, they withdraw. But right now, I think it's there's plenty of people willing to to ride the business. So I think it's you know, it's a lot of the supplies and demand. I mean, Sydney commission will go down the day where people are putting their food on the ground and on the and say, listen. I'm not gonna ride it unless the commission is down two or three percent. So we haven't seen that. Even on the business that we place, we are you know, ourselves, that we we haven't seen that. So I think that so for sure, I think the you know, the math for the reinsurer you know, they get the rate increase. They get a lower commission. It helps you know, justifying why you would write those those those business. So but I think for us, I think we yeah. We are I think we are more bullish on the primary side today on the ENS side because I think that we have a true expertise there. We underwrite the business one by one. And I think we have we that that would say that's I put it on the list. I would say that goes number one. Being able to you know, there there is good companies out of ours before we we admire or we hire on the right of from I mean, being able to To to support those people on the through our reinsurance team, I think next sense to me. So I think, yeah, I think the the commission may be a little high, but I think if you you pick people that can outperform on on the loss ratio, you you you you may still be alright.
Cave Montazeri: Good. And then my second question is still on growth on the primary side this time. Early days, but can you give us an update on how the integration of Medcorp is going? And if the growth prospects how that's evolving versus your expectations prior to the deal?
Nicolas Papadopoulo: Yes. So I think you know, I think we're pretty much on plan, to be honest. I think the integration is is it's it's it's a it's a big lift, but I think we we are pretty comfortable so far that things are pretty much on plan. In term of the business itself, it's it's already too bad, but, you know, the the business is pretty much what we expected. I don't think it's Okay. It's better or or worse. I think it's pretty much what what what we had planned for. So Just And I think on the the good news for us on the mid cop aspect is that you know, we're seeing some double digit trade increases on the property side. And And is and it's and also the liability side. So I think on the property side, it's really driven by the secondary periods that have you know, that that you know, not only for us, but for others on the on the market side that have been a problem in the past. So people are you know, we're underwriting around it, but also getting rate increase. And we're seeing the same you know, some of the same rate increase on the total liability in the GL.
Cave Montazeri: Thanks.
Operator: Thank you. Next question will be from Alex Scott at Barclays. Please go ahead.
Alex Scott: Hi. Good morning. First one I have is on the PMLs. And I just wanted to understand, you know, to what degree you all have exposure to aggregate reinsurance treaties and and just when we think about it pro forma for some of the wildfire losses, would that you know, cause any upward pressure of note to the PMLs as we, you know, think about heading into when season.
Nicolas Papadopoulo: So we we we we do some, but we have very little exposure to aggregate aggregate release. I think it's as a as a general Undividing philosophy. It's hard enough to price the severity. You know, the frequency is is is really, really hard to to price. So I think we we do it but, you know, when we we really feel that we have because of the line of business and the exposure, a good we could have a good grab on the on the frequency or, you know, the the the we get enough away from the from the frequency that, you know, maybe providing and I gotta get cover makes sense.
Francois Morin: So we have very limited exposure to aggregate covers.
Nicolas Papadopoulo: Terms of the the PML, can you repeat the same question? I'm I'm I'm I just forgot.
Alex Scott: Well, I it it was long the same. I was just trying to understand it. If you had you know, exposure to aggregate treaties, then to what extent would it potentially increase your PMLs? Just thinking through, like, You know, for example, a you know, a primary this morning announced a wildfire number that know, when you look at their baseline cap budget, I think it would know, potentially cause them to to pierce the aggregate.
Francois Morin: Yeah. My guess is immaterial for us.
Alex Scott: Got it. Okay. And then just as a separate follow-up, on on Midcorp, I just wanted to to probe there. Now that you have Look, it sounds like things are going to plan, but could you could you talk about, like, what portion of those premiums that you've gotten in are going through the heavier remediation and and just how we should think about the trajectory of premiums considering that, you know, there's still some remediation work going on in the background.
Nicolas Papadopoulo: I think it's mainly around I would say, the program book of business. When we when we bought Miccoop, memory, again, I think there was a five hundred million dollar book of programs, and this is not what we bought mid corp, and I think we have ourself a significant, I think, I mean, something like you know, in the book of business. I think that's where we try to integrate their teams with our teams and have a very defined risk appetite for, you know, the the the type of under IT manager that we do business with, the the the type of back office integration that we require to get the information very quickly. So I think we we are going through the their book of business to make sure which which one qualify and which one which one doesn't. So
Francois Morin: Yeah. To add to that, I mean, we have already kinda taken action on a number of programs, but, you know, given the the period to to notice, I mean, it it will start to show more in the second half of twenty twenty five. The impact of those actions. On the top line at least. And certainly we think the bottom line, you know, the loss ratios will follow as well.
Alex Scott: Got you. Okay. Thank you.
Francois Morin: You're welcome.
Operator: Next question will be from Andrew Anderson at Jefferies. Please go ahead.
Andrew Anderson: Hey. Good morning. You'd mentioned deploying capital into London specialty markets. I would have thought that scenario where perhaps a bit more competition has come in and maybe rate is decelerating, but perhaps you'll add a inadequate level. Could you just maybe talk about the growth environment there?
Nicolas Papadopoulo: No. So I think we, you know, we I'm personally and we I think we are bullish in the in the lender market. I think the thing that yeah. There is more competition. I think rates have You know, have flattened in in certain of our certain of our business, but I think the the thing that help us in the London market is that we've grown from being a substandard sub scale business to business today that's right close to, you know, in the London market, probably a a billion five or more of of premium. So we are one of the and the market is consolidating around a fewer number of carriers. So we are we are one of the beneficiary of that consolidation. We're not the only one, but I think we're beneficiary, and we we build the team has done an amazing job building leading capabilities in a in a in a number of lines of business, and that makes a huge difference. So I think you know, we get to pick first, which, you know, business is is a huge advantage.
Andrew Anderson: Thank you. And then maybe just within reinsurance, it sounds like still kinda positive on PropCat. The the other specialty line, I realize there's probably a number of different businesses in here, but it declined in the quarter. Can you maybe just touch on the drivers of the the decrease year over year?
Nicolas Papadopoulo: Yeah. So I think I think, you know, the first first is the fourth quarter is really smaller so smaller of the fourth quarter. So and, you know, we the thing I want people to to understand on reinsurance, it's true in the insurance as well. It's that we are extremely dynamic, you know, We don't you know, if something, you know, doesn't fit or a city company decide to If I sense happened if a senior company decide to change from proportional to to excess, Premium in itself is never our target. We're not trying to replace the premium. We're actually looking for profitable premiums. Those are two different concepts. So I think, you know, in the fourth quarter, what happened is I think we you know, we're starting to have a negative bias on on cyber be honest. I think we we are a big provider of quota share in the cyber side. So a couple of our contracts you know, we either the Citi company retain more, I think is more or we may have cut back on on on the number one based on the the new terms and condition. That explained most of it. So Thank you.
Operator: Thank you. Next question will be from Meyer Shields at KBW. Please go ahead.
Meyer Shields: Great. Thank you very much. I guess one question for twenty twenty five on the insurance segment. You talk about how reinsurance purchase is your reinsurance outward reinsurance. Has I don't know whether that's a market question or a mid score question or both.
Nicolas Papadopoulo: Sure.
Meyer Shields: I I think, you know, the may may maybe I understand this, how did it change? Or what what's the outcome? I think the the the one change The one change that we had to do is we had to you know Allianz was buying our insurance to to cover the mid core portfolio, a lot of it being properties, some of it being casualty. So so I think we at one one, I think we on the property side, I think we had to and and and they buy they bought large limit. You know, limits of up to seven hundred or eight hundred million dollars. So I think we had to that was one thing we bought. I mean, so we had to transfer that reinsurance onto, you know, onto an arch you know, managed framework. So outside of the the Allianz CID CID department. So and and within the RCD department. So that happened at one one. I think the team did a You did a great job, you know. And we we kept the capacity, which is a huge part of the the value proposition that the mid corp offer. You know? It's like to be able to compete in the in the middle market, you need large capacity you know, up to seven up to a billion dollars on anyone, you know, account or or or location. So I think we by by being able to do that, I think we secured, you know, a lot of the a lot of the brand or a lot of the value that we we bought I think that was a very satisfactory outcome for us.
Meyer Shields: Okay. Great. Thank you. And then, Francois, you mentioned that there's a lot of property and therefore cat risk within the empty portfolio. Right now, obviously, the underlying loss ratio is elevated. Once all of that is done, should Etsy have a lower attritional loss ratio than the legacy arch side of things because of that cat exposure?
Nicolas Papadopoulo: So I think the yeah. The the the cat exposure of the mid core business is more around the secondary period than it is around the primary period of hurricane and and so I think we that was something attractive for us because he was very complementary to to to the footprint that we that that we that that we had. So I think you know, The going forward, I think, you know, those secondary barriers you know, attritional catalyst ratio, they they remain. That part of the I mean, we we we we oh, we underwrite, you know, we underwrite the flood. We underwrite the the tornadoes, we underwrite the but, ultimately, the so I don't I I really don't expect you know, the attritional loss ratio coming from the mid corp to to a really churns going forward.
Francois Morin: Yeah. That's yeah. I have yeah. Exactly that. I mean, I think pre and post and see after call it, we we fully integrated the business. You know, I would not expect a significant change to you know, the the ex cat loss ratio.
Meyer Shields: Okay. Perfect. That's what I needed done.
Operator: Thank you. Next question will be from Brian Meredith at UBS. Please go ahead.
Brian Meredith: Yeah. Thanks. First, Nicolas DeFranco. I'm just curious. How are you thinking about the potential impact of tariffs on your business?
Francois Morin: Nothing significant for us at this point. You know, as you know I mean, the businesses are transacted locally, you know, between local carriers and each of the Jurisdictions in which we operate and You know, so so from that point of view, that that's that's don't think there's an issue there or any concern. Does it you know, does it slow down trade in in the broader sense? Maybe. I think that's you know, I could see a potential impact on a, you know, our coal fast investment, for example. I mean, you could see some some reductions in in world trade and and that how that might have an impact. But I think too early to tell would be our answer. But, you know, that's something, obviously, we're we're We're watching.
Brian Meredith: Great. Thanks. And then second question, think you've kinda answered this around that way, but what are you assuming right now in your reserving and pricing with respect to GL, call it, loss trend?
Francois Morin: I mean, it varies by sell, but, you know, certainly, it's for the excess business, it's double digits. It's like twelve percent to fourteen percent on the primary E and kinda low limit casualties probably around five.
Brian Meredith: That's
Francois Morin: Five zero six. Yep.
Brian Meredith: Five zero six Mullen County. And then one other one and then quickly switch within here. Y'all have typically done a reasonable amount of structured in your reinsurance. You're you're good at that surplus fleet, that kind of stuff. Are you seeing how much opportunity here in twenty five and twenty six on that?
Nicolas Papadopoulo: We don't you know, we we We don't think so. I think there there there has been a few. Again, it's it's really you know, we are in that business. You know, we need the the margin to make sense for us to write it and I think for a while, we were successful because it seems that some of the traditional players were you know, pulling back. So we got a couple of opportunities to participate at our terms in in a couple of transactions. It looks like the maybe some capacity is coming back, so it's it's it's hard to tell. So it's not Something we we we target, I think, is we we are, you know, we are in that business, and we when when something fits, we do it. And if it doesn't, we just don't.
Francois Morin: Yeah. We're a a not not a typical arch thing, but a little bit more reactive on that type of business. We we don't drive the the demand for it. Sometimes you have a company that may be into may have some capital issues because of cats or any other some other you know, kinda result or could be reserve development. Who knows? So that's where the you know, it's hard to predict whether the demand will be there these products, but we're we're open for business.
Nicolas Papadopoulo: Think we benefit there, Yan, of the the the support we offer to some of our precedents. I think we today, especially in the in the US, we have we are multilingual insurer. So we just don't do the CAT. We do the CAT. We do the risk. We do the quarter share. So know, right now, the the the opportunity that we got one one one of those silly companies, the other problem, they think of us as one of the partners. So they so that's how, you know, some of those opportunities opportunities came to us. It's more like because of all the all the things we were doing for them, they're like, listen, we have this problem in March. Could you help us doing this? And then, you know, the the the they looked at it together. So I think that that that probably puts a bit more tailwind in our ability to do this, but, again, they asked to be the right structure or it has to be the right price.
Francois Morin: Great. Appreciate it. Thank you.
Operator: You're welcome. Next question will be from Elyse Greenspan at Wells Fargo. Please go ahead.
Elyse Greenspan: Hi. Thanks. Just a couple follow ups. First one, Francois, was on the the seven to eight point cat load. I just wanna understand that correctly. That does include the fire. So then would would that also be the cat load for twenty six, or are you assuming in that that the fires kinda take the place of another large loss that you might have seen this year.
Francois Morin: Yeah. With that x it it it it does not include the buyers in a a direct way in the January first. This is what we thought the cat losses or cat load was for the year. Now if it turns out that you know, the wildfires, which so far may end up being higher than what our cat load specifically for wildfires for the year would have been, then yeah, there's a chance that we exceed, you know, the total that that total of load, but by the same token, hurricanes end up could end up being lower. So that's truly a a start of the year without any kinda additional knowledge, you know, reflected in that number.
Elyse Greenspan: Okay. And then the my second question, on Midcorp, right, when you guys announced the transaction, you said post integration, right, it would run at a low nineties combined ratio. It sounds like from everything you were saying, it's running in track with Plan? So that would still be the target. If you guys said when Like, you know, when when we might see that loan IDs number, like, what year would be considered post integration.
Nicolas Papadopoulo: You didn't say when? It's gonna take some time. You know, I think, you know, those things take always longer. I think, you know, the the goal, I think from what we know today, we I think I'm I'm still very comfortable that we get there Again, we have to finish the integration. There's you know, we we for people, we still operating the the business on Allianz systems. So you can see that there's limit to what we can do you know, in terms of insight. And so we we we're preparing for, you know, a lift over ops that we should happen sometime next year. So I think it's gonna take a bit of time.
Elyse Greenspan: And then just one follow-up, Francois. I think someone asked a question. Anyone I bet Midcorp would maybe one at the same loss ratio once integrated with Meaning, run at the same loss ratio as legacy arch. Is that what you were saying there?
Francois Morin: Yeah. I mean I mean, I haven't done the math recently, but my my expectation would be that, you know, the, you know, again, the ex cap, accident year loss ratio pre MCE, your legacy arch, and, you know, that same metric once you include MCE after the integration's completed, meaning a little bit of remediation on some of the business we acquired, I don't think would be that different. So I think those would be pretty much in line.
Elyse Greenspan: Okay. It. Thank you.
Francois Morin: You're welcome.
Operator: Thank you. I'm not showing any further questions. I would like to turn the conference over to Mr. Nicolas Papadopoulo for closing remarks.
Nicolas Papadopoulo: So thank you for your time today, and I yes. We'll see you next quarter. Thank you.
Operator: Thank you, sir. Ladies and gentlemen, this does indeed conclude your conference call for today. We once again, thank you for attending. At this time, we do ask that you please disconnect your lines. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Q4 2024 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time, including our annual report on Form 10-K for the 2023 fiscal year. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends forward-looking statements in the call to be subject to the safe harbor created thereby. Management also will make a reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. And now I would like to introduce your host for today's conference, Mr. Nicolas Papadopoulo and Mr. Francois Morin. Please go ahead."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Good morning, and welcome to our fourth quarter earnings call. I'll begin by offering our thoughts and sympathies to all of those affected by the California wildfires. This is a terrible event that will require the effort of many, including insurance companies, to help the affected communities recover and rebuild. At last, we will, of course, fulfill our role in these efforts. As noted in yesterday's press release, we expect the wildfires to result in a net loss between $450 million and $550 million based on an industry loss estimate of $35 billion to $45 billion. Turning now to our results, Arch had a solid top quarter writing $3.8 billion of net premium, which is a 17% increase over the same quarter last year. The $625 million of underwriting income in the quarter is down 13% from last year, primarily due to losses related to cat activities in the second half of 2024. Our full-year results were excellent, with $3.5 billion of after-tax operating income and an operating return on average common equity of 18.9%. Despite an increased level of natural catastrophes, book value per share, a preferred measure of value creation, ended 2024 at $53.11, representing a 13% increase for the year and nearly 24% increase after adjusting for the impact of the $5 per share special dividend we paid in December. The decision to pay a special dividend was the result of Arch's strong financial performance and excellent capital position and represented an effective means of returning excess capital to our shareholders. We also repurchased shares worth $24 million in the fourth quarter. Both the dividend and the share repurchase reflect our ongoing commitment to effective and active capital management. Market conditions within our segments remain favorable with a number of select growth opportunities ahead of us. As you may have heard from our peers this quarter, rate and loss trends vary by line of business. Broadly offset each other. All hands do not point to the same underwriting clock. For example, we are selectively deploying capital to the areas producing attractive risk-adjusted returns such as insurance and reinsurance liability lines, specialty business at Lloyds, and property charter insurance. Alternatively, lines of business where competitive pressures have eroded margins to levels below adequate, our underwriting teams are focused on improving our business mix within each of those lines to ensure our minimum profitability targets are met. Effective cycle management, the key to our strategy, requires empowering underwriters to execute on both sourcing and retaining attractive business without the constraint of production targets. In classes and subclasses where returns do not meet our minimum threshold, we have the agility and the incentives to reallocate capital to more profitable opportunities across our diversified portfolio. And as we have demonstrated throughout our history, we will not hesitate to return excess capital to our shareholders when appropriate. Now I will offer a few highlights about the performance of our underwriting segments starting with reinsurance, which finished the year with a strong fourth quarter delivering $328 million of underwriting income. The full-year results for the reinsurance group were excellent. The segment delivered a record $1.2 billion of underwriting income while writing over $7.7 billion of net premium. At the January first renewal, we grew the reinsurance business by selectively increasing our writings in property liability and specialty lines. Arch's status as a leading global reinsurer is a result of its focus on addressing broker and clients' needs, combined with its underwriting vigilance and high degree of scrutiny on the performance of its business. Throughout the whole market, Arch has had the conviction to increase its support and relevance with brokers and clients, making Arch a more valuable collaborative partner when other reinsurers wavered and in some cases, even withdrew capacity. Now moving to insurance, which also sees some strong growth opportunities in 2024. Overall, Arch and Helene and Milton limited fourth quarter underwriting income to $30 million. For the full year, the insurance group wrote $6.9 billion of net premium, a 17% increase from 2023, and delivered $345 million of underwriting income. Growth was enhanced by the acquisition of the US Midcorp and Entertainment business. Although it's still early, the performance and integration of the Midcorp and Entertainment business are consistent with our expectations and objectives. Organic growth in North America came from our casualty business unit, which more than offset premium decreases in professional lines. International insurance remained a bright spot, writing over $2 billion of net premium in 2024, primarily in specialty lines out of our large platform. Overall, rate increases remained slightly above loss trends, keeping return margins relatively flat in the fourth quarter. The outlook for both North America and international insurance growth is favorable for 2025. Looking ahead, we expect primary market conditions to remain competitive given the attractive underlying margins. However, we have experienced a slowdown in new business volumes as competition for premium volumes has increased. The mortgage segment contributed $267 million of underwriting income in the fourth quarter, resulting in the first consecutive years of delivering over $1 billion in underwriting income. Fundamentals remained positive, including strong persistency of our $500 billion-plus insurance in force portfolio, while the overall credit quality of the book remains excellent. The delinquency rate in our US MI business increased modestly to just over 2% at the end of December but remained near historic lows. Increased delinquency can be attributed to expected defaults in areas hit by natural catastrophes and the seasoning of the insurance in force. Overall, the US mortgage insurance industry remained disciplined despite suppressed mortgage origination due to low housing supply and high mortgage rates. Finally, to the investment group, which delivered nearly $1.5 billion of annual net investment income from an asset base that increased to over $40 billion after accounting for the special dividend. Rising investment yields and the growth of our investable assets from strong operating cash flows provide additional tailwinds for our earnings and book value growth. Overall, 2024 was another excellent year for Arch. Looking ahead, our primary goal is to maintain attractive margins despite expected heightened competition. Our strong underwriting culture, proven track record of cycle management, dynamic capital management capabilities, and progress to date in becoming a data-driven enterprise give me confidence in our ability to navigate ever-changing market dynamics with a clear objective of maximizing shareholder return over the long term. As we officially turn the page to 2025, I want to recognize the hard work and dedication of Arch's nearly 7,000 employees who share in our entrepreneurial culture that demands and rewards excellence to the benefit of our clients and stakeholders. Now I will turn it to Francois to provide more detail on the financials before returning to answer your questions. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Thank you, Nicolas, and good morning to all. As you know by now, we closed 2024 with fourth-quarter after-tax operating income of $2.26 per share, for an annualized operating return on average common equity of 16.4%. For the year, our net income return on average common equity was an excellent 22.8%. Once again, our three business segments delivered a combined ratio of 78.6% for the year. Current accident year catastrophe losses were $393 million for the group in the quarter, split roughly 60% and 40% between the reinsurance and insurance segments respectively. Most of our catastrophe losses this quarter are due to Hurricane Milton, a fourth-quarter event, with an additional contribution from Hurricane Helene, where we saw some delayed emergence of claims given the late occurrence date in the third quarter. As of January 1, our peak zone natural catastrophe probable maximum loss for a single event at a one-in-250-year return level on a net basis increased slightly and now stands at 9.2% of tangible shareholders' equity. Our PML remains well below our internal limits. As we look forward to 2025, with the recent addition of the Midcorp and Entertainment business, and current market conditions in property, we expect our cat load to represent approximately 7% to 8% of our full-year group-wide net earned premium. Our underwriting income in the quarter included $146 million of favorable prior development on a pre-tax basis, or 3.5 points on the combined ratio across our three segments. We recognized favorable development across many lines of business but primarily in short-tail lines in our reinsurance segment, and in mortgage due to strong cure activity. As we discussed last quarter, the acquisition of the mid-corporate entertainment insurance businesses has impacted some key performance metrics for our insurance segment. First, the net written premium coming from the acquired businesses was $393 million for the quarter, contributing 27.1 points to the reported quarter-over-quarter premium growth for our insurance segment. Second, the acquired business lowered the insurance segment's accident year ex-cat combined ratio by 1.6 points this quarter. This result was due to the current quarter's acquisition expense ratio that was lowered by 2.1 points due to the write-off of deferred acquisition costs for the acquired business at closing under purchase GAAP, and an operating expense ratio that was lowered by 0.8 points as our Midcorp operations aren't fully ramped up yet. Partially offsetting these benefits was an increase in the accident year cat loss ratio of 1.2 points, reflecting the underlying results of the acquired business. On a related note, we expensed $99 million this quarter through intangible amortization, more than 75% of which was for the mid-corporate entertainment acquisition. This expense was in line with our expectations as we communicated last quarter. On the investment front, we earned a combined $548 million pre-tax from net investment income and income from funds accounted for using the equity method, or $1.43 per share. Our net investment income this quarter was partially impacted by a $1.9 billion dividend paid in December, which entailed that we liquidate a portion of our investment portfolio. Cash flow from operations remained strong. It was approximately $6.7 billion for the full year, up 16% from 2023. Our effective tax rate on pre-tax operating income was an expense of 6.7% for the quarter and 8.2% for the full year. As we look ahead, we would expect our annualized effective tax rate to be in the 16% to 18% range for the full year 2025, reflecting the introduction of a 15% corporate income tax in Bermuda. On a cash basis, we will start recognizing this with the establishment of the $1.2 billion deferred tax asset at the end of 2023. As you may have heard on other calls, the recent OECD guidance may partially impact the realizable value of the DTA. We will keep you apprised as additional information becomes available. In closing, our balance sheet remains extremely strong with common shareholders' equity of $20 billion after recognition of the $1.9 billion common dividend that was paid in December. Our debt plus preferred to capital ratio remains low at 15.1%. With these introductory comments, we are now prepared to take your questions. Sylvie?"
},
{
"speaker": "Operator",
"text": "Thank you, Mr. Morin. If you would like to ask a question, please press *1 on your telephone keypad. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. And your first question will be from Elyse Greenspan at Wells Fargo. Please go ahead."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi. Thanks. Good morning. My first question is on the insurance underlying loss ratio. I mean, I recognize, right, Francois, you highlighted, you know, some of the impact right, from the Allianz deal coming in right a little bit over one point calculated kind of Arch standalone, running at just under fifty seven, which is close to the Q3. Is it right way to think about it that that's about where Arch is and then kind of blend in, write this a little bit over one point from Midcorp so that insurance underlying is somewhere in the range of fifty eight on an ongoing basis, something like that."
},
{
"speaker": "Francois Morin",
"text": "Yeah. That's about right. I think the yeah, the the impact of MC is, call it, know, on the loss ratio, about one point. So whatever the assumption you have around the, you know, pre-MC kinda run rate loss ratio, which is pretty stable has been pretty stable. There's some movements up and down from quarter to quarter, but generally speaking, it's been it's been stable. And introducing the MC maybe adds about a one one point to to that."
},
{
"speaker": "Elyse Greenspan",
"text": "And then my second question is on reinsurance. Right? You guys you know, pulled back a little bit at midyear twenty four. Now the PML went back up, right, but it's flat. You know, one one twenty five with one one twenty four. Did you see conditions get incrementally better at January one. I'm just trying to understand the thought process around, you know, bringing the PMLs back up a little bit."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "No. I think I think what's happening is that we we like the business. So I think, you know, absent the the competitive nature and other people liking the business too, I think we we're looking to write more of this business. We think the the the returns are quite attractive. And I think at one one, we we had we had some opportunity to do so based on our positioning. So I think we we were pleased by that, I think."
},
{
"speaker": "Elyse Greenspan",
"text": "And then I guess the the follow-up to that is, right, the California fire is pretty big loss. Do you see that know, being able to impact other cat renewal seasons in twenty five. Some of it, I guess, might bleed one one twenty six. How do you see the market impact from the California fires? And is this something, you know, where you guys would expect your PML and and cat ridings to go up during the year?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So I think, you know, the as I mentioned in my remarks, I mean, this is a significant loss for the market. I mean, we pitch it between thirty thirty five and and forty five billion. We believe that a significant part of that losses will go to the reinsurance market. I think it will I think most reinsurer, including ourselves, we we start the year with a loss ratio. You know, in the twenties or the thirties or depending of your luck, maybe higher than that. So I think it would it should, you know, dump all the enthusiasm of you know, many market trying to be heroes and and and and and writing the business. So I would I would think that it it will have a an effect on on on on on the rates at at you know, for the rest of the year. So Thank you. And that's Thank you."
},
{
"speaker": "Operator",
"text": "Next question will be from Michael Zaremski at BMO. Please go ahead."
},
{
"speaker": "Michael Zaremski",
"text": "Hey. Thanks. I guess, first question, I'll just go back to the the catastrophe load guidance. Seven to eight it Probably just obvious, but that so that includes right. It's higher than the historical six day mostly because of the the one q California losses is that correct?"
},
{
"speaker": "Francois Morin",
"text": "A little bit, but also the MCU acquisition adds, you know, on a relative basis, kind of adds a little bit of you know, of load to, you know, to the, you know, to to increase the cat load. Because it's it's it's a heavier property book than people in this know, realize it. It didn't really Impact or PMLs because it's in different zones, it's more distributed. But when we think about you know, the contribution to the to the cat load throughout the year. It it has a meaningful impact."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. I would have actually plugging in the Cali losses. I actually would have thought to lower would have been a little bit higher, but but okay. Good good color. Switching gears just to the I guess one of the elephants in the rooms for for lots of insurers is going back to the kind of the casualty GL umbrella environment. In some of the prepared remarks, was, you know, said that overall rate increases remain slightly above loss trend. I think that was the primary insurance marketplace. Any comments on whether you know, what you're seeing And you're GL book. I know that, you know, you guys are one of the more honest ones. In my humble opinion. And at the investor day, you know, you said you'd probably be adding small amounts to your your GL reserves, but, you know, nothing that that's really too out of out of trend line with what you've you've been doing for a while now and better than the industry. But any updated commentary on what you're seeing there?"
},
{
"speaker": "Francois Morin",
"text": "Yeah. And so I think I'll answer in two parts. One on the position, we didn't add to our reserves. We're very comfortable with the reserve position both both in insurance and reinsurance. You know, our actual versus expected analysis or year end analysis all are supporting that that view that our reserves for prior accident years are are very adequate. So no no concern there. But as we look at, you know, second half of twenty four and into twenty five, you know, yes, we are seeing rate changes keeping up with loss trends, so we're not and even exceeding in some places. So we're comfortable with the the environment there. But we also recognize that there's a lot of uncertainty there. So we are being cautious, prudent. We are in some specific very targeted areas increased our initial loss picks. But it's not I think I wanna make it clear here. It's not as a reflect it's not a reflection of adverse development or, you know, signals or data telling us that we missed a mark on the old years, It's very much a function of the current rate environment and how we perceive the risk around our initial loss picks. And for that reason, we're choosing to be a bit more prudent."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. Got it. And just lastly, real quick. Thanks for the tax rate guidance. Is the DTA that was established is I think some of some peers have said that they're could be tweaks to to the DTA due to guidance from from Bermuda. Is that something that's influx or any way you could kind of a a handicap whether, you know, if it if a DTA was influx, would it change materially or just a little bit?"
},
{
"speaker": "Francois Morin",
"text": "Yeah. I mean, the guidance right now and that's an important thing, it's it's guidance that's not the law, which you know, we do follow, obviously, Bermuda law, which allows us or instruct us really to carry the DTA. The recent guidance from the OECD suggests that you know, we may only be able to realize up to twenty percent of that amount. That is still again, that that's the light of guidance. I mean, things change pretty quick in this when we start talking about taxes, but if know, I I'd say you know, from your perspective, maybe worst case, that's kinda what may happen is that we end up only realizing twenty percent of this amount and the rest we might have to write off at some point you know, in twenty six or late twenty six or twenty seven, But for the time being, Bermuda law has not changed, and that, you know, that's what we're following."
},
{
"speaker": "Michael Zaremski",
"text": "Appreciate the color."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Jimmy Bhullar at JPMorgan. Please go ahead."
},
{
"speaker": "Jimmy Bhullar",
"text": "Hey. Good morning. So just had a question. A different topic. On MI reserve releases, can you go through the details on what's driving those and how much of that is from the last one to two years versus maybe a few years back? And just your overall expectations for margins in that business?"
},
{
"speaker": "Francois Morin",
"text": "Yeah. I mean, the reserve release has come, you know, from both I mean, from all three of our segments. Right? There there's a meaning again, that's a little bit of of the same story that we've we've been talking about the last few quarters where you know, we based on conditions at the time, I wanna say twenty two and twenty three, we had set up initial reserves on the delinquencies that were reported at the time and turns out that people have been curing and and severity has not been to the level that we thought. So that's just a normal, I'd say, kinda You know, process that the reserving, you know, we go through with our reserves at USMI at say for the other pieces, a little bit of the same, I say, in the CRT business where you know, it's a slightly different methodology, but we have initial loss picks on that business and that has proven out to be a little bit kinda in excess of what we need today. So there's been some releases there, and finally, the international book, a little bit of the same too where you know, there there's different methodologies in place, but the the the long story or the, you know, the short of it maybe is that you know, all three books or all three pieces of our mortgage segments are performing really, really well. So we like the margins. We think the margins are are healthy. We don't see any deterioration in how we think about, you know, the business and the returns we're writing today. So if we're very very excited about it."
},
{
"speaker": "Jimmy Bhullar",
"text": "And then on share buybacks, I'm assuming part of the reason you did a little bit of buybacks this quarter versus none before was just the decline in the stock price. So assuming the stock's stays around here, Reasonable to assume that you'd be active throughout twenty five as well?"
},
{
"speaker": "Francois Morin",
"text": "For sure. I mean, it's something we look at, you know, regularly. I mean, every time all the time. No. I mean, in this particular situation, yes, there's old kinda, you know, opportunity in late in the fourth quarter. But, you know, our capital position remains strong even with, you know, the California California wildfires. I mean, that's part of the volatility we may see from time to time, but, you know, whether again, we we will not sit on a level of excess capital that we don't think we can deploy in the business. So if the if we don't you know, we stink we still think we can grow. We we are bullish about twenty twenty five. The market conditions are still really good."
},
{
"speaker": "Jimmy Bhullar",
"text": "But"
},
{
"speaker": "Francois Morin",
"text": "You know, can we deploy all the capital we have or that we generate, maybe not? And at that point, we'll return it then if the price is right, we think share buybacks are a great way to do that."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yeah. I think the the order of play is that we want to look at where we can deploy capital attractively in the business. I think that we do that all the time, I think. And, yeah, after a while, when, you know, periodically, when we assess our capital position. And if we see that know, the opportunities may not be there to deploy all the excess capital. That's when we consider the the most effective way, I would say, at the time to to return capital to our shareholders. So"
},
{
"speaker": "Jimmy Bhullar",
"text": "Thank you."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Next question will be from Wes Carmichael at Autonomous. Please go ahead."
},
{
"speaker": "Wes Carmichael",
"text": "Hey. Good morning. Thank you. A question on favorable development quarter, particularly in reinsurance. Can you just give us a little bit of color on what drove most of that release and maybe if you had any strengthening. I think you mentioned short tail lines in prepared remarks, but any more color will Okay."
},
{
"speaker": "Francois Morin",
"text": "Yeah. The vast, vast majority is on property cat and property other than cat. So that's what we consider to be short line a short tail. We were flat on casualty. So across the reinsurance segment, so no no development on casualty and, you know, a couple of moves up and down marine, other small lines, other small items, but that's the that's the bulk of it. It's really property. Some is, you know, I'd say prior caps, meaning kinda large events that we had reserved for that are developing a bit favorably. Some of it is just you know, the IBNR we hold for, you know, miscellaneous kinda traditional losses that has proven out to be in excess of what we needed. So that's kinda how we we recognize it this quarter through through those lines of business."
},
{
"speaker": "Wes Carmichael",
"text": "Got it. Thanks. In in prepared remarks, I think maybe a broader comment, but you mentioned some competitive pressure where that's eroded margins in certain lines of business. Can you just talk a little bit about where that might be more pronounced?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yeah. So I think was thinking this question was gonna come up. So so I think, you know, it's it's mainly in in two areas. I would say the most feasible one is you know, I would say public public DNO where, you know, I think we we've seen significant decrease in the last in the last two years. In double digits. That seems to be tempering, but the the you know, it's richer level that you you really have to ask yourself you know, account by account. You know? Is is the overall line, you know, still profitable? And second area that we we are watching is in the is the cyber area where, you know, also on the excess side, we've seen, you know, double digit rate decreases and and and the supply of capacity in both know, public DNO and cyber that that don't seem to be wanting to to to to reduce. I think"
},
{
"speaker": "Operator",
"text": "Did you have any further questions, Mr. McCarmichael?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yeah. I guess, I'll I'll follow-up with one more. But just on on MI and the delinquency pickup, I I think you mentioned that can be impacted by cat exposed areas and you obviously had a couple sizable storms last year, but just hoping you could unpack a little bit with what you saw in the tick up there."
},
{
"speaker": "Francois Morin",
"text": "Yeah. I mean, it's very much part of the natural process. As you'd expect, some people were affected by these events. And, you know, once they, you know, missed two consecutive mortgage payments, they they turned delinquent and, you know, that's what we fully expected would happen in the fourth quarter. About half of the increase in the delinquency rate is is directly attributable to these cap affected areas. I mean, it's it's, you know, that that's our best estimate at this point. The historical cure rate on these types of delinquencies driven by natural events is extremely high. So that's why we think the the financial impact ultimately will be minimal but currently that's, you know, that's how the the process works. They show up in the delinquency rate, and we reserve for those. But Typically, those to get resolved or cured at a high level. Over time."
},
{
"speaker": "Wes Carmichael",
"text": "Thank you."
},
{
"speaker": "Francois Morin",
"text": "And and just quickly, I'll add I mean, just I'll add quickly on the California wildfires, slightly different different type of exposures we expect minimal again, very early, too early to know, but get given the the the types of mortgages that exist in these areas, we would not expect to be impacted at all or very mean, certainly not significantly at all in In the due to the California wildfires."
},
{
"speaker": "Wes Carmichael",
"text": "Understood. Thank you. Yep."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from David Motemaden at Evercore. Please go ahead."
},
{
"speaker": "David Motemaden",
"text": "Hey. Thanks. Good morning. I had a question, and I saw the solid casualty reinsurance growth in the fourth quarter as well as twenty twenty four, and it sounded like that continued at one one twenty five. Yeah. I guess I'm wondering if you could just talk a little bit about the rate adequacy specifically within the casualty reinsurance line. I know it it's a it's a broad line, Right. Little surprising to see you guys lean in there. It sounds like others have been more critical on just the rate adequacy there. So I wonder if you could elaborate a little bit on that."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. I I think, you know, the we started from a position that we were really, I think, underweight on the on the casualty treaty or insurance. And I think our view and it's true, by the way, on the insurance side is that we You know, we we've tried over the years to You know, to to get to get into program that are more, I would say, specialty, casualty. If you think of it as more with an ENS flavor. So Similar to what we would be riding, you know, growing on the on the insurance side, I think it's it's been it's been a while, but I think based on the you know, the the additional cloud that's you know, the value of the brand on the reinsurance side, I think we've been and and and our ceiling companies, you know, forecasting some wavering from the from from maybe some of the reinsurance or less appetite for the casualty, I think we've been able finally get onto probe you know, programs or insurance programs that we we think are backing the the the right people to take advantage of the of the opportunity. So that has been really the the engine behind behind the growth. It's not you know, we're not underwriting the market. We're just underwriting selective underwriters that we think have the the know how and the and the expertise to to be able to to to deliver attractive return for for us. So"
},
{
"speaker": "David Motemaden",
"text": "Great. Yep. Understood. I yep. Definitely, you guys are are underway there, so that makes sense. And and so maybe just switching gears to the insurance segment. And just wanted to get a little bit more color on the current accident year loss pick increases that you noted. It sounded like it was minor. But wanted to just get a little bit more detail on what lines it was And it didn't sound like that had any impact on the prior year reserve. Any prior year reserve impact. I just wanted to understand, how that's how that happened."
},
{
"speaker": "Francois Morin",
"text": "Yeah. I mean, again, I you know, roughly, if we we break it down, call it a third of the increase is is due to the mid mid corporate entertainment inclusion or addition to the segment. There may another third I'd say it's lines of business where we just you know, reacting to the rate environment and example of that would be professional lines like both cyber and d and o where you know, you guys have seen it, we've seen it, you've heard it. Mean, rates have been coming down over the last couple of years pretty significantly and that's a big part of our book. So naturally, I think you'd expect us and we are booking a higher loss ratio this year than we did a year ago, and that's just a function of the rate environment. So that's an example. Another example is some of our auto warranty product, our gap product, where you know, due to, you know, the, you know, different market conditions, different economic realities with the the value of used cars and and what we insure and what we cover, know, loss ratio inched up a little bit there. So nothing that was surprising to us, but, again, we're reflecting or reacting to the data And, you know, that that's and, you know, obviously, there's always mix a little bit at the end, but those I'd say are some examples of kinda minor, kinda small adjustments that contributed to the overall increase."
},
{
"speaker": "David Motemaden",
"text": "Got it. Okay. That is yeah. So it doesn't sound like that was any GL or umbrella related pick increases. It was it was more in other lines."
},
{
"speaker": "Francois Morin",
"text": "Correct."
},
{
"speaker": "David Motemaden",
"text": "Great. You."
},
{
"speaker": "Francois Morin",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Next question will be from Andrew Kligerman at TD Securities. Please go ahead."
},
{
"speaker": "Andrew Kligerman",
"text": "Hey. Thanks a lot. First question, maybe you could drill down a little more into the casualty lines the E and S areas of casualty. Where you'd like to grow or where you are growing in both insurance and reinsurance, respectively. And then with that, could you give us a sense of the rate changes in those areas in both reinsurance and insurance, respectively."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. So those are, I would say, for the large part, similar book of business. So it's really e E and S what we call ENS liability, and it's it's more middle to, you know, high excess layers where we've seen the market know, reacting to the propensity of larger losses in the last last few years. So what's happening in that market is people used to have on the retail side, first, you know, big limits. So once once the once the once the admitted market know, decide that You know, they're not gonna be able to offer those limits anymore. You know, by definition, if you had a two hundred million dollar program with Maybe five or or seven players. You know, now that, you know, the admitted players decide to reduce their limit to ten million, you're gonna need twenty people to And so the the way the market work is and that has been going on for a while, a lot of that business now is getting repriced into the ENS market, not only on the pricing side, but also on the terms and condition. You're able to get exclusion that you will not be able to get on the on the on the on the admitted retail side. So we We like, you know, that that business. We've been riding that business. We've been underway that business for years. You know? And we we have experience We've been riding the business for over twenty years, and we have you know, really specific line of business. I'm not gonna go over it over the the the call, but that we actually have experience in it. We have you know, we know the venues where to ride it. We know, you know, the the the type of severity of claims. We we know we know the exposure to, you know, cover order that's embedded in those in those risk. And so we we're able to selectively And good good companies do that. Effectively pick a subset of the market and we're still getting, you know, very decent rate increases. I think double digits. You know? And I think it has been the weight increase have been going on for a while. They were know, in the twenties, they were in the double digit, then they went to the single digit, then we're back in the double digits of late. And so we we think we're getting rates of a trend. I think we think the business underwritten properly with the right limit think, could be very attractive. But You have to pick and choose. You know, it's it's it's not it's not, again, the the cost of the ball that we make."
},
{
"speaker": "Andrew Kligerman",
"text": "You know, that's very, very helpful answers. I I I guess as I think about it, you know, a lot of your competitors are running scared. On on on the high layer excess of loss casualty just just given the inflationary environment. So so maybe just a little color on and and and you kinda gave some of it just in terms of your experience in the market, but but maybe a little color why you don't fear that that that could get out of hand and, you know, we could wake up one day and just see Arch Arch get hit with with a lot of these things. You know, kind of jumping into the high layers, you know,"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So this is this is not this is this is what market do. When when you when you have a lot of severity losses, whether it's property or whether it's it's, you know, liability, reaction of the market is to cut limit. So I think if you think think of it. If you have a let's say, fifty million dollar limit. You're writing a hundred million dollar portfolio two short loss, and your loss ratio is a hundred percent. I think what we've seen is people cutting their limit dramatically to fives and tens. So now you know, when we get the full tower losses, the contribution to your portfolio is five or ten million. So it makes you know, the the beauty of diversification, it makes it makes the the your loss ratio a lot more stable. And I think when this happens, because I what what I said earlier, before to do, like, a two hundred million dollar tower, for a program, you needed five seven market because now you need twenty. You know, by definition, it costs a lot more. And so the the the the price adequacy is is is a lot better. So that's what we're seeing."
},
{
"speaker": "Andrew Kligerman",
"text": "Got it. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Cave Montazeri at Deutsche Bank. Please go ahead."
},
{
"speaker": "Cave Montazeri",
"text": "Thank you. Another question on cash proceeds, that's why you see good growth opportunities. Seeing good rate increases on the primary side. Because she's also helping quota share of reinsurance. But the city and commissions didn't change much at one one. Despite the adverse development. Carriers continue to face, My question is, what's the incremental supply of casualty reinsurance at one one? Higher than what you would have expected? I know you're writing both, and, yes, we do found the specific line. But it is currently more attractive to write new casualty business on the primary side rather than on the reinsurance side."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. So, you know, as as soon as I'll answer the first question, I think the supply casualty, treasury reinsurance, I think we're hearing bubbles of people on on the call saying that they don't think it's effective. So hopefully hopefully, they withdraw. But right now, I think it's there's plenty of people willing to to ride the business. So I think it's you know, it's a lot of the supplies and demand. I mean, Sydney commission will go down the day where people are putting their food on the ground and on the and say, listen. I'm not gonna ride it unless the commission is down two or three percent. So we haven't seen that. Even on the business that we place, we are you know, ourselves, that we we haven't seen that. So I think that so for sure, I think the you know, the math for the reinsurer you know, they get the rate increase. They get a lower commission. It helps you know, justifying why you would write those those those business. So but I think for us, I think we yeah. We are I think we are more bullish on the primary side today on the ENS side because I think that we have a true expertise there. We underwrite the business one by one. And I think we have we that that would say that's I put it on the list. I would say that goes number one. Being able to you know, there there is good companies out of ours before we we admire or we hire on the right of from I mean, being able to To to support those people on the through our reinsurance team, I think next sense to me. So I think, yeah, I think the the commission may be a little high, but I think if you you pick people that can outperform on on the loss ratio, you you you you may still be alright."
},
{
"speaker": "Cave Montazeri",
"text": "Good. And then my second question is still on growth on the primary side this time. Early days, but can you give us an update on how the integration of Medcorp is going? And if the growth prospects how that's evolving versus your expectations prior to the deal?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. So I think you know, I think we're pretty much on plan, to be honest. I think the integration is is it's it's it's a it's a big lift, but I think we we are pretty comfortable so far that things are pretty much on plan. In term of the business itself, it's it's already too bad, but, you know, the the business is pretty much what we expected. I don't think it's Okay. It's better or or worse. I think it's pretty much what what what we had planned for. So Just And I think on the the good news for us on the mid cop aspect is that you know, we're seeing some double digit trade increases on the property side. And And is and it's and also the liability side. So I think on the property side, it's really driven by the secondary periods that have you know, that that you know, not only for us, but for others on the on the market side that have been a problem in the past. So people are you know, we're underwriting around it, but also getting rate increase. And we're seeing the same you know, some of the same rate increase on the total liability in the GL."
},
{
"speaker": "Cave Montazeri",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Alex Scott at Barclays. Please go ahead."
},
{
"speaker": "Alex Scott",
"text": "Hi. Good morning. First one I have is on the PMLs. And I just wanted to understand, you know, to what degree you all have exposure to aggregate reinsurance treaties and and just when we think about it pro forma for some of the wildfire losses, would that you know, cause any upward pressure of note to the PMLs as we, you know, think about heading into when season."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So we we we we do some, but we have very little exposure to aggregate aggregate release. I think it's as a as a general Undividing philosophy. It's hard enough to price the severity. You know, the frequency is is is really, really hard to to price. So I think we we do it but, you know, when we we really feel that we have because of the line of business and the exposure, a good we could have a good grab on the on the frequency or, you know, the the the we get enough away from the from the frequency that, you know, maybe providing and I gotta get cover makes sense."
},
{
"speaker": "Francois Morin",
"text": "So we have very limited exposure to aggregate covers."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Terms of the the PML, can you repeat the same question? I'm I'm I'm I just forgot."
},
{
"speaker": "Alex Scott",
"text": "Well, I it it was long the same. I was just trying to understand it. If you had you know, exposure to aggregate treaties, then to what extent would it potentially increase your PMLs? Just thinking through, like, You know, for example, a you know, a primary this morning announced a wildfire number that know, when you look at their baseline cap budget, I think it would know, potentially cause them to to pierce the aggregate."
},
{
"speaker": "Francois Morin",
"text": "Yeah. My guess is immaterial for us."
},
{
"speaker": "Alex Scott",
"text": "Got it. Okay. And then just as a separate follow-up, on on Midcorp, I just wanted to to probe there. Now that you have Look, it sounds like things are going to plan, but could you could you talk about, like, what portion of those premiums that you've gotten in are going through the heavier remediation and and just how we should think about the trajectory of premiums considering that, you know, there's still some remediation work going on in the background."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "I think it's mainly around I would say, the program book of business. When we when we bought Miccoop, memory, again, I think there was a five hundred million dollar book of programs, and this is not what we bought mid corp, and I think we have ourself a significant, I think, I mean, something like you know, in the book of business. I think that's where we try to integrate their teams with our teams and have a very defined risk appetite for, you know, the the the type of under IT manager that we do business with, the the the type of back office integration that we require to get the information very quickly. So I think we we are going through the their book of business to make sure which which one qualify and which one which one doesn't. So"
},
{
"speaker": "Francois Morin",
"text": "Yeah. To add to that, I mean, we have already kinda taken action on a number of programs, but, you know, given the the period to to notice, I mean, it it will start to show more in the second half of twenty twenty five. The impact of those actions. On the top line at least. And certainly we think the bottom line, you know, the loss ratios will follow as well."
},
{
"speaker": "Alex Scott",
"text": "Got you. Okay. Thank you."
},
{
"speaker": "Francois Morin",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Next question will be from Andrew Anderson at Jefferies. Please go ahead."
},
{
"speaker": "Andrew Anderson",
"text": "Hey. Good morning. You'd mentioned deploying capital into London specialty markets. I would have thought that scenario where perhaps a bit more competition has come in and maybe rate is decelerating, but perhaps you'll add a inadequate level. Could you just maybe talk about the growth environment there?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "No. So I think we, you know, we I'm personally and we I think we are bullish in the in the lender market. I think the thing that yeah. There is more competition. I think rates have You know, have flattened in in certain of our certain of our business, but I think the the thing that help us in the London market is that we've grown from being a substandard sub scale business to business today that's right close to, you know, in the London market, probably a a billion five or more of of premium. So we are one of the and the market is consolidating around a fewer number of carriers. So we are we are one of the beneficiary of that consolidation. We're not the only one, but I think we're beneficiary, and we we build the team has done an amazing job building leading capabilities in a in a in a number of lines of business, and that makes a huge difference. So I think you know, we get to pick first, which, you know, business is is a huge advantage."
},
{
"speaker": "Andrew Anderson",
"text": "Thank you. And then maybe just within reinsurance, it sounds like still kinda positive on PropCat. The the other specialty line, I realize there's probably a number of different businesses in here, but it declined in the quarter. Can you maybe just touch on the drivers of the the decrease year over year?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yeah. So I think I think, you know, the first first is the fourth quarter is really smaller so smaller of the fourth quarter. So and, you know, we the thing I want people to to understand on reinsurance, it's true in the insurance as well. It's that we are extremely dynamic, you know, We don't you know, if something, you know, doesn't fit or a city company decide to If I sense happened if a senior company decide to change from proportional to to excess, Premium in itself is never our target. We're not trying to replace the premium. We're actually looking for profitable premiums. Those are two different concepts. So I think, you know, in the fourth quarter, what happened is I think we you know, we're starting to have a negative bias on on cyber be honest. I think we we are a big provider of quota share in the cyber side. So a couple of our contracts you know, we either the Citi company retain more, I think is more or we may have cut back on on on the number one based on the the new terms and condition. That explained most of it. So Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Meyer Shields at KBW. Please go ahead."
},
{
"speaker": "Meyer Shields",
"text": "Great. Thank you very much. I guess one question for twenty twenty five on the insurance segment. You talk about how reinsurance purchase is your reinsurance outward reinsurance. Has I don't know whether that's a market question or a mid score question or both."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Sure."
},
{
"speaker": "Meyer Shields",
"text": "I I think, you know, the may may maybe I understand this, how did it change? Or what what's the outcome? I think the the the one change The one change that we had to do is we had to you know Allianz was buying our insurance to to cover the mid core portfolio, a lot of it being properties, some of it being casualty. So so I think we at one one, I think we on the property side, I think we had to and and and they buy they bought large limit. You know, limits of up to seven hundred or eight hundred million dollars. So I think we had to that was one thing we bought. I mean, so we had to transfer that reinsurance onto, you know, onto an arch you know, managed framework. So outside of the the Allianz CID CID department. So and and within the RCD department. So that happened at one one. I think the team did a You did a great job, you know. And we we kept the capacity, which is a huge part of the the value proposition that the mid corp offer. You know? It's like to be able to compete in the in the middle market, you need large capacity you know, up to seven up to a billion dollars on anyone, you know, account or or or location. So I think we by by being able to do that, I think we secured, you know, a lot of the a lot of the brand or a lot of the value that we we bought I think that was a very satisfactory outcome for us."
},
{
"speaker": "Meyer Shields",
"text": "Okay. Great. Thank you. And then, Francois, you mentioned that there's a lot of property and therefore cat risk within the empty portfolio. Right now, obviously, the underlying loss ratio is elevated. Once all of that is done, should Etsy have a lower attritional loss ratio than the legacy arch side of things because of that cat exposure?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So I think the yeah. The the the cat exposure of the mid core business is more around the secondary period than it is around the primary period of hurricane and and so I think we that was something attractive for us because he was very complementary to to to the footprint that we that that we that that we had. So I think you know, The going forward, I think, you know, those secondary barriers you know, attritional catalyst ratio, they they remain. That part of the I mean, we we we we oh, we underwrite, you know, we underwrite the flood. We underwrite the the tornadoes, we underwrite the but, ultimately, the so I don't I I really don't expect you know, the attritional loss ratio coming from the mid corp to to a really churns going forward."
},
{
"speaker": "Francois Morin",
"text": "Yeah. That's yeah. I have yeah. Exactly that. I mean, I think pre and post and see after call it, we we fully integrated the business. You know, I would not expect a significant change to you know, the the ex cat loss ratio."
},
{
"speaker": "Meyer Shields",
"text": "Okay. Perfect. That's what I needed done."
},
{
"speaker": "Operator",
"text": "Thank you. Next question will be from Brian Meredith at UBS. Please go ahead."
},
{
"speaker": "Brian Meredith",
"text": "Yeah. Thanks. First, Nicolas DeFranco. I'm just curious. How are you thinking about the potential impact of tariffs on your business?"
},
{
"speaker": "Francois Morin",
"text": "Nothing significant for us at this point. You know, as you know I mean, the businesses are transacted locally, you know, between local carriers and each of the Jurisdictions in which we operate and You know, so so from that point of view, that that's that's don't think there's an issue there or any concern. Does it you know, does it slow down trade in in the broader sense? Maybe. I think that's you know, I could see a potential impact on a, you know, our coal fast investment, for example. I mean, you could see some some reductions in in world trade and and that how that might have an impact. But I think too early to tell would be our answer. But, you know, that's something, obviously, we're we're We're watching."
},
{
"speaker": "Brian Meredith",
"text": "Great. Thanks. And then second question, think you've kinda answered this around that way, but what are you assuming right now in your reserving and pricing with respect to GL, call it, loss trend?"
},
{
"speaker": "Francois Morin",
"text": "I mean, it varies by sell, but, you know, certainly, it's for the excess business, it's double digits. It's like twelve percent to fourteen percent on the primary E and kinda low limit casualties probably around five."
},
{
"speaker": "Brian Meredith",
"text": "That's"
},
{
"speaker": "Francois Morin",
"text": "Five zero six. Yep."
},
{
"speaker": "Brian Meredith",
"text": "Five zero six Mullen County. And then one other one and then quickly switch within here. Y'all have typically done a reasonable amount of structured in your reinsurance. You're you're good at that surplus fleet, that kind of stuff. Are you seeing how much opportunity here in twenty five and twenty six on that?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "We don't you know, we we We don't think so. I think there there there has been a few. Again, it's it's really you know, we are in that business. You know, we need the the margin to make sense for us to write it and I think for a while, we were successful because it seems that some of the traditional players were you know, pulling back. So we got a couple of opportunities to participate at our terms in in a couple of transactions. It looks like the maybe some capacity is coming back, so it's it's it's hard to tell. So it's not Something we we we target, I think, is we we are, you know, we are in that business, and we when when something fits, we do it. And if it doesn't, we just don't."
},
{
"speaker": "Francois Morin",
"text": "Yeah. We're a a not not a typical arch thing, but a little bit more reactive on that type of business. We we don't drive the the demand for it. Sometimes you have a company that may be into may have some capital issues because of cats or any other some other you know, kinda result or could be reserve development. Who knows? So that's where the you know, it's hard to predict whether the demand will be there these products, but we're we're open for business."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Think we benefit there, Yan, of the the the support we offer to some of our precedents. I think we today, especially in the in the US, we have we are multilingual insurer. So we just don't do the CAT. We do the CAT. We do the risk. We do the quarter share. So know, right now, the the the opportunity that we got one one one of those silly companies, the other problem, they think of us as one of the partners. So they so that's how, you know, some of those opportunities opportunities came to us. It's more like because of all the all the things we were doing for them, they're like, listen, we have this problem in March. Could you help us doing this? And then, you know, the the the they looked at it together. So I think that that that probably puts a bit more tailwind in our ability to do this, but, again, they asked to be the right structure or it has to be the right price."
},
{
"speaker": "Francois Morin",
"text": "Great. Appreciate it. Thank you."
},
{
"speaker": "Operator",
"text": "You're welcome. Next question will be from Elyse Greenspan at Wells Fargo. Please go ahead."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi. Thanks. Just a couple follow ups. First one, Francois, was on the the seven to eight point cat load. I just wanna understand that correctly. That does include the fire. So then would would that also be the cat load for twenty six, or are you assuming in that that the fires kinda take the place of another large loss that you might have seen this year."
},
{
"speaker": "Francois Morin",
"text": "Yeah. With that x it it it it does not include the buyers in a a direct way in the January first. This is what we thought the cat losses or cat load was for the year. Now if it turns out that you know, the wildfires, which so far may end up being higher than what our cat load specifically for wildfires for the year would have been, then yeah, there's a chance that we exceed, you know, the total that that total of load, but by the same token, hurricanes end up could end up being lower. So that's truly a a start of the year without any kinda additional knowledge, you know, reflected in that number."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. And then the my second question, on Midcorp, right, when you guys announced the transaction, you said post integration, right, it would run at a low nineties combined ratio. It sounds like from everything you were saying, it's running in track with Plan? So that would still be the target. If you guys said when Like, you know, when when we might see that loan IDs number, like, what year would be considered post integration."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "You didn't say when? It's gonna take some time. You know, I think, you know, those things take always longer. I think, you know, the the goal, I think from what we know today, we I think I'm I'm still very comfortable that we get there Again, we have to finish the integration. There's you know, we we for people, we still operating the the business on Allianz systems. So you can see that there's limit to what we can do you know, in terms of insight. And so we we we're preparing for, you know, a lift over ops that we should happen sometime next year. So I think it's gonna take a bit of time."
},
{
"speaker": "Elyse Greenspan",
"text": "And then just one follow-up, Francois. I think someone asked a question. Anyone I bet Midcorp would maybe one at the same loss ratio once integrated with Meaning, run at the same loss ratio as legacy arch. Is that what you were saying there?"
},
{
"speaker": "Francois Morin",
"text": "Yeah. I mean I mean, I haven't done the math recently, but my my expectation would be that, you know, the, you know, again, the ex cap, accident year loss ratio pre MCE, your legacy arch, and, you know, that same metric once you include MCE after the integration's completed, meaning a little bit of remediation on some of the business we acquired, I don't think would be that different. So I think those would be pretty much in line."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. It. Thank you."
},
{
"speaker": "Francois Morin",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Thank you. I'm not showing any further questions. I would like to turn the conference over to Mr. Nicolas Papadopoulo for closing remarks."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So thank you for your time today, and I yes. We'll see you next quarter. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you, sir. Ladies and gentlemen, this does indeed conclude your conference call for today. We once again, thank you for attending. At this time, we do ask that you please disconnect your lines."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 3 | 2,024 | 2024-10-31 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Q3 2024 Arch Capital Earnings Conference Call. [Operator Instructions]. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review the periodic reports that are filed by the company with the SEC from time to time, including our annual report on Form 10-K for the 2023 fiscal year. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management will also make references to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Nicolas Papadopoulo, and Mr. Francois Morin. Sirs, you may begin.
Nicolas Papadopoulo: Good morning, and welcome to our third quarter earnings call. I'd like to begin by wishing the best to my friend and my business partners of 23 years, Marc Grandisson, who retired earlier this month, after the fantastic road under Marc's leadership. While we will miss him, I'm very excited about the opportunities before us. My message to our shareholders, employees, brokers, clients and business partners is that it is business as usual at Arch. Our core objective remains unchanged to be the best-in-class specialty lines insurer in the market. We will continue to execute on the key pillars of our strategy, which are build a diversified mix of businesses, actively manage the underwriting cycle, remain prudent stewards of capital be dynamic managers of a data-driven enterprise and foster a culture that attracts best-in-class talent. Back to the quarter, where Arch generated strong top and bottom line results with an annualized operating return on equity of 14.8% and an 8.1% increase in book value per share. Our third quarter results included $450 million of cat losses across multiple levers, including Hurricane Evan. It's worth noting that this cat loss is within our third quarter seasonally adjusted cap load. Overall, the P&C environment remains very favorable despite increasing competition in many lines of business, making underwriting and risk mitigation increasingly important. Underwriting strategies empower our businesses to respond quickly to their trading environment. This has been and remains a competitive advantage as we pursue those opportunities with the best risk-adjusted return. Industry cat losses have once again exceeded $100 billion for the third quarter. We should continue to support increasing demand for property insurance and reinsurance. Even with this increased cat activity, we believe the property market remains attractive and one in which disciplined underwriters can produce attractive return on capital. [indiscernible] rates continue to outpace trend which is consistent with our hypothesis of a hardening casualty market. We have selectively increased our casualty riding in both insurance and reinsurance as the markets respond to claim inflation and uncertainty around loss trend with higher prices. Turning now to underwriting segments. Our insurance segment was $1.8 billion of net premium and delivered $120 million of underwriting income in the third quarter. Acquisition of the MidCorp and entertainment business from Valiance in August help drive a 20% growth over the same quarter a year ago. We are confident that the mid-core team will be an important part of our growth story as we further enhance our capabilities in the middle market. Excluding MidCorp insurance growth was mid-single digits as we continue to find attractive growth opportunity in casualty programs and our London market specialty business. premiums competitive in E&S property and professional lines. Reinsurance had another excellent growth quarter with net premium return up more than 24% to over $1.9 billion, along with underwriting income of $149 million as our team continued to benefit from a more robust relationship with our brokers and cedents. Growth was driven by property ex cat, including facultative business, casualty and other specialty. Our industry-leading mortgage segment again contributed significantly to our earnings with $269 million of underwriting income for the quarter. Underlying fundamentals remain excellent for the mortgage insurance industry, including strong credit conditions and continued favorable house price appreciation. Mortgage origination activities remains light that new insurance return of $13.5 billion was in line with our expectation as relatively high mortgage rates and continued house price acquisition have kept most buyers on the side mines. Finally, the contribution from our investment portfolio were substantial. In the quarter, Arch Investment Management generated $399 million of net investment income. Significant operating cash flows from our underwriting units should support continued growth of our assets under management, setting us up for strong investment contribution in the years to come. Looking ahead, we like our position and the market opportunities. This is true as we enter a responsible growth part of the P&C cycle where disciplined underwriting and thoughtful rate collection are essential to success. A few final comments in closing. Arch has proven to be an exceptional company defined by a culture of underwriting excellence, underpinned by our core strategies of cycle management and thoughtful capital allocation. That was true yesterday, it is true today and it will be true tomorrow. I'm very excited and proud to lead this company and work with our leadership team as we continue to strive to deliver the greatest value to our clients and shareholders over the long term. I'll now turn it over to Francois to provide some more color on our financial results in the quarter. and then we will return to take your questions. Francois?
Francois Morin : Thank you, Nicolas, and good morning to all. As you know by now, we reported third quarter after-tax operating income of $1.99 per share for annualized operating return on average common equity of 14.8%. Book value per share was $57 as of September 30 of 8.1% for the quarter and 21.4% on a year-to-date basis. Once again, our three business segments delivered excellent underlying results highlighted by $538 million in underwriting income and an 86.6% combined ratio, which was slightly elevated from an active catastrophe quarter. Our combined ratio was 78.3% on an underlying ex-cat accident year basis. Overall, current accident year catastrophe losses were $450 million for the group in the quarter, split roughly 80%, 20% between the reinsurance and insurance segments. Approximately 45% of our catastrophe losses this quarter are due to Hurricane Helene with the rest coming from a series of events, including Canadian events, smaller named hurricanes, U.S. severe convective storms, flooding in Europe and other events across the globe. As of October 1, our peak zone natural cap probable maximum loss for a single event 1-in-200-year return level on a net basis increased slightly and now stands at 8.1% of tangible shareholders' equity as we incorporated exposures from the MidCorp acquisition on August 1. Our PML remains well below our internal limits. Our underwriting income included $119 million of favorable prior year development on a pretax basis in the quarter, or three points on the combined ratio across our three segments. We recognize favorable development across many lines of business, but primarily in short tail lines in our Property and Casualty segments and in mortgage, due to strong cure activity. As you know, we closed on our purchase of the U.S. MidCorp and entertainment insurance businesses from Allianz on August 1, and I would like to expand on a few items that impacted our financials this quarter. First, the net written premium coming from the acquired businesses was $209 million for the 2-month period, contributing to the reported year-over-year premium growth for our Insurance segment. Second, in accordance with U.S. GAAP, the fair value of the acquired balance sheet does not include an asset for deferred acquisition costs. Therefore, since there is no amortization of deferred acquisition costs associated with the in-force business at the time of the acquisition, the current quarter's acquisition expense ratio is lower than in the third quarter of 2023. This item resulted in a benefit this quarter of approximately 1.9 points in the Insurance segment's acquisition expense ratio. Although we would expect this benefit to become less significant over the next three quarters to four quarters as a larger proportion of our earned premium relates to premium written after the closing date. Operating expenses in the new business were also somewhat lower than ultimately expected as we ramp up operations contributing to a 60-basis point benefit in the quarter. Third, as is required with business combinations, we recorded goodwill and intangibles in connection with the transaction, primarily from the value of the business acquired, distribution relationships, and the present value adjustment related to the reserves for losses and loss adjustment expenses. This quarter, we incurred an expense for the amortization of intangibles of $88 million, $63 million of which was for the MidCorp and entertainment acquisition. We expect our overall amortization expense across the group to be approximately $100 million in the fourth quarter of this year and $195 million in 2025, spread evenly throughout the four quarters. While still early, the mid-core business is performing as expected or even maybe slightly better, and we are satisfied with the progress we are making in our integration activities. Turning to our reinsurance group. The team delivered a very solid 92.3% combined ratio in an active catastrophe quarter. Of note, the reported net written premium growth of 24.5% in the quarter was augmented by reinstatement premiums. Adjusting for this item, the growth rate would have been approximately 22.4%. The mortgage segment reported an excellent 14.8% combined ratio as cure activity on delinquent mortgages is strong and the underlying credit quality of the book remains very high. the reported delinquency rate that USMI inched up slightly this quarter and was impacted primarily by seasonal factors. On the investment front, we earned a combined $570 million pretax from net investment income and income from funds accounted using the equity or $1.49 per share. Our investment income reflects approximately $20 million earned during the 2-month period from the assets we've received in connection with the MidCorp acquisition. Total return for the portfolio came in at 3.97% for the quarter, as there was significant price appreciation on our fixed-income portfolio due to lower interest rates. The appreciation of our available-for-sale investment portfolio resulted in a book value increase of $1.56 per share net of tax. Cash flow from operations remained strong and exceeds $5 billion on a year-to-date basis. Our effective tax rate on a pretax operating income was an expense of 8% for the third quarter in our annualized effective tax rate remains in the 9% to 11% range for the full year 2024. In closing, our balance sheet is strong with common shareholders' equity of $21.4 billion and a debt plus preferred to capital ratio of 14.2%. This level of financial resources gives us flexibility to deploy capital as needed. And continue delivering outstanding results for the benefit of our shareholders. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions]. Our first question comes from the line of Elyse Greenspan with Wells Fargo. Please go ahead.
Elyse Greenspan: Thanks. Good morning. I guess my first question is on the Allianz deal. You gave us some good color on the expenses. But anyway, could you give us a sense of just the impact on the underlying loss ratio within the insurance segment in the quarter?
Francois Morin : Yes, sure. I mean, just to give you a bit more details on that, the -- call it, the normalized meaning ex cat accident year loss ratio for the segment was $57.6 million. right? And the stand-alone for the mid-core business was 62% in the quarter. So that's how came up. So effectively, kind of increased, call it by 70 basis points and increased the reported loss ratio for the ex-cat loss ratio.
Elyse Greenspan: Okay. And then in reinsurance, the margin sometimes does fluctuate quarter-to-quarter but the underlying loss ratio did trend up in the Q3. Was there anything business mix in there that might have impacted that in the quarter?
Francois Morin : Nothing specific. Again, we will -- we'll go back to our trailing 12 months way of looking at things. I mean I took another look this morning and there's nothing unusual in the quarter. I mean the trends are very consistent. Trailing 12 months are doing very well. So, the answer is nothing to report. I mean there's just kind of some claims happen, some don't. And over the last 12 months, we're very comfortable with the loss picks and how things are behaving.
Elyse Greenspan: And then my last question is on capital, right? You guys have left the Doral ban, just given your excess capital position to doing something to return to shareholders, be that right a quarterly dividend, a special or even a return to repurchase. So, what's the timing there? I thought maybe it was post the end of wind season. Does that still apply? And how are you thinking about how you might look to return capital to shareholders?
Francois Morin : I mean you hit all the good points. I think it's very much a conversation and it's not a new conversation. It's a conversation we have all the time. And yes, we had certainly mentioned that we wanted to wait till the end of the wind season, which is coming close to an end. And as we get ready for 2025, certainly part of the outlook for 2025 growth opportunities, how -- where we may be able to deploy the capital is something we'll consider as well. But Yes, no question that this is an area that we're focused on. And I'll say you should -- we're not sleeping on it, and we'll report back when there's more to say on that.
Elyse Greenspan: Okay. Thank you.
Operator: Our next question comes from the line of Andrew Kligerman with TD Cowen.
Andrew Kligerman: Good morning. Maybe following up on the insurance division and MidCorp. And I think France Swap, I heard correctly the MidCorp impact on the underlying loss ratio was about 60 basis points to 70 basis points, and if that's the case, it kind of moved up a fair amount, like 250 bps year-over-year. So, I'm trying to get a sense of should we be thinking that this is kind of a good run rate underlying number for the loss ratio? How should we think about it going forward?
Francois Morin : Well, I mean, we indicated that we thought initially, I mean, we have to get, call it, under the hood, we have to understand the business. But we certainly have said that in the first year, we thought this business was going to be breakeven for us. So yes, we should expect a little increase in the loss ratio and the combined ratio for the segment. No question. In terms of run rate, I'd be a little bit hesitant to commit to anything beyond, call it, the first year. I think we're already making adjustments, taking underwriting actions in terms of we like, what we don't like as much. I think there is good traction, good opportunities in terms of the casualty business that they write. The rates right environment is very strong. So that will help, we think, -- so that's -- again, the short-term answer is yes. I think the combined ratio will probably inch up a little bit, but we have very -- definitive ideas and plans on how to bring that down as we move forward.
Nicolas Papadopoulo : Yes. And I think -- it's dynamic. I mean, again, we I mean if you look at the insurance group overall, it's heavy non-property lines, so the property line attract lower loss ratio. So, we were growing in the property line in the last couple of years and the market now it makes it more difficult. And we have a large component of professional lines where rates have been challenging, so that probably incur Carlos ratio. And then we have casualty where I think we think there is opportunities potentially to grow more with higher margin, but it may come also with a higher switcher than property. So that's a playbook that we are facing.
Andrew Kligerman: Interesting. And maybe breaking down some of the lines of business in insurance what kind of rate are you seeing? And is this rate exceeding loss costs? I suspect it's not in property, but maybe you could talk a little bit about some of the key lines in insurance?
Nicolas Papadopoulo : So, I mean let's talk about casualty, which is talk of the time. I think in casualty, we're definitely seeing rates on the trend -- but there are really good reasons for that. I think the market is going through some pain. And so, I think we are underweight in casualty. We historically underwrite casualty. So now I think based on our own analysis of the pocket of casualty business that we like. We are selectively growing both from the insurance and the reinsurance side. So there, I expect margin to expand. I think if you mention property, if you talk about reinsurance versus insurance, we're mostly focusing on insurance. On E&S property, we think the profitability is actually very attractive. I think over the last few years and post the Hurricane Helene, I think the business has reacted with a lot of rate increase and a lot of change in terms and conditions, which make the business really attractive. So there, I think after year without losses, people have really short. We see a lot more competition coming from Lloyd's, coming from NGS, coming from new entrants that want to have a piece of that business. So, I think we -- our rates are pretty flat, but I think we'd expect that margin on the business will be depend on the reaction to the catastrophes that just happened. So, I think with Milton and Eli, we price expectation with things would stabilize, but ultimate the supply and the demand, there's more supply. We think there's more demand. I think the demand has been constrained by the high price and high deductibles and high retention on the reinsurance side. So, I think we're close to an equitable year -- I think the business will remain attractive for a while.
Operator: Our next question comes from the line of Mike Zaremski with BMO Capital Markets.
Michael Zaremski : First question is on catastrophes. So, I don't know if you disclosed what you're assuming for Hurricane Helene. I know you're I think the cats were a bit higher than the consensus, but you guys have done a good job of giving us disclosure that you've been taking more risk in Florida specifically and just overall? And then also, should we be thinking about Milton as well. I think there's some conflicting numbers out there on open sure PCS is only a $5 billion so far, but there's some much bigger numbers out there?
Francois Morin : Yes, sure. On Helene, our view is that it's going to be the type of event that probably will have a bit more leakage than you would otherwise expect. I mean it's just multiple states, and it's a lot of flooding. So, we are currently assuming, call it, a $12 billion to $14 billion industry loss. Which is maybe higher than others? And -- but that's how we see it today. I mean things could change, but that hopefully informs how we thought about the event initially and is reflected in our third quarter numbers. As it relates to Milton, we need to do a bit more work, but we will certainly give you our initial thoughts on that, I think, in the coming weeks in terms of what a loss -- what a range of estimates could be for us. But no question that what we -- what people thought might have been a really scary and large events doesn't seem to have materialized. I think industry estimates are coming down as we speak. So, call it the $30 billion plus or minus market loss seems to be about right, given what we know today. And in terms of our own loss related to that, I mean, again, more to come, but you shouldn't expect anything unusual from us. I think from what we can tell at this point, it should be in a relatively consistent kind of market share for us for an event of that size.
Michael Zaremski : Okay. That's helpful. And -- my last question for Nicolas. Is there any context or color you can add to the -- what -- why the CEO change took place at the number 1 question I'm sure you all have received, and we have two people wondering if it's performance related versus just some other events or anything else? Any color you'd be able to add?
Nicolas Papadopoulo : I didn't understand the deal?
Francois Morin : The CEO Marc's departure.
Nicolas Papadopoulo : Should know that. No. I mean, again, it was a personal decision that is, I think as I said, Marc and I were a good trend. It's a bit bittersweet for me, but based on this decision, I'm actually very excited about the opportunity in front of us. I think Marc is, I think Arch is bigger than any one of us, and I think we have a lot to do, and we have not an exciting thing to continue to do in the coming years. And I think we have a really good management team. We have 7,000 employees that are really engaged. And as I said, I think Arch is an exceptional company, and I'm really looking forward to continue this journey and, certainly, I think Marc departure is not performance related that the guy under his leadership, and I said the company has performed amazingly well.
Michael Zaremski : And I guess, Nicolas is helpful. Obviously, you put your own stamp on the company over time and you're a different type of leader and we're all excited to -- about your position. But I'm just curious, is there now that you are at the Boss, are there certain things we should kind of stay tuned for that have kind of been on your wish list that you'll be able to kind of push through? Or do you kind of expect just more of the same directionally?
Nicolas Papadopoulo : No, not a message to -- it's really business as usual. I think I've been with the company for 23 years, have worked very closely with Marc in the last 5 years or 6 years in setting up strategies, looking at operation changes, looking at culture. So, I think we -- him and I were extremely aligned. So, I think I would not expect any changes in the way we operate.
Operator: Our next question comes from the line of Jimmy Bhullar with JPMorgan.
Jamminder Bhullar : Good morning. So first, I just had a question on your views on 1/1 renewal and what do you think about the sort of supply-demand imbalance? And has that sort of shifted given losses from Milton -- or is your view consistent with how you would have thought before?
Nicolas Papadopoulo : So, is the question on property cat I assume?
Jamminder Bhullar : Yes, yes.
Nicolas Papadopoulo : Yes. So, I think on property cat, I think, as you've seen, we've grown the book quite a bit in the last 2 years or 3 years. So, we think the returns are really attractive. The Yes. I think the we have vet of midterm and Helene in my view, what we hear is that you stabilize the market. And I think there was a lot some supply, as I said earlier, is there from nodes or from MGAs or from our competitors. After 1 year without losses really wanting to get back in the business and realizing that they may have missed out on a profitable line of business. So, what I would expect, and we see it on the insurance side that things have stabilized. And I think my guess is at this stage is that we will do the same on the cat reinsurance side.
Jamminder Bhullar : And more specifically, are you expecting pricing to be down, flat or -- and to whatever extent you're able to qualify quantify would be helpful?
Nicolas Papadopoulo : Yes. I don't have a crystal ball. I would say, again, it's always the same with programs that are being impacted by losses. I would expect prices to go up. in regions that had no losses, you could see in the bottom of the programs, I think people are still really scared about frequency. So, I'd expect the bottom to middle side of the program to perform well. The upper layers where people seem to be more comfortable to play where competition is coming because you are away from the midsize also, it could be a little bit of weakness, but not really have a strong conviction in a way. But I think mostly stable.
Jamminder Bhullar : And then on casualty reserves, a lot of companies have had adverse development, some on recent years, some money even some on peak over the years as well. Can you talk about your own comfort with your casualty reserves on your legacy book as well as the Watford business?
Francois Morin : Sure. I mean, reserves is something we looked at. We look at regularly, quarterly, right? So, it's nothing new here. I think we're -- to answer your question, we're very comfortable with our reserve levels. I think from couple of reasons. One is we were -- as Nicolas said, we have been underweighting casualty for a number of years. So as much as, yes, we do feel and see some of the impacts of social inflation and pressures on loss trends on casualty business in general. I mean the fact that we're underweight in those lines has been very helpful. So yes, we are monitoring casualty reserves. There, we have experienced some adverse development, but it's been overall very manageable. And that explains, in our mind, is a big reason as to why rates are moving up because the industry is seeing the pressure and a way to correct for those results is really by getting more rate.
Operator: Our next question comes from the line of Cave Montazeri with Deutsche Bank.
Cave Montazeri : First question is on growth. I guess, Francois, you've already explained the growth in primary insurance I guess, underlying once you exclude MidCorp, is about 5%. In reinsurance, you also mentioned the impact of reinstatement premium. I think you said it was still 22% growth even adjusting for that, still a big number. Could you give us a bit more color on like what drove that in terms of how much of that was pricing? How much of those like unit growth? How much of that was maybe writing more casualty business. Any type of color on that would be quite helpful, please.
Nicolas Papadopoulo : Yes. I think for the quarter, I think the driver of the growth was a bit of casualty return mostly our U.S. company, where I think we selectively are trying to -- are getting on programs that we haven't been as rates get better, we think there's opportunities for us to write attractive casualty business. And on the other side of the business that grew is the specialty business, the return. And that's more of business that we wrote 1/1 that is coming in on quarter shares, and some of it is we have a decent size book of business that support Lloyd's [indiscernible] where called Ponat where we get quarter share of what they write net of their protection. So that business is growing. Lloyd's is growing, and we think it's a profitable business. So, we benefit from that. And the second aspect is we have a decent size book of motor United Kingdom motor and that business is really dislocated, it's been dislocated, and we've been playing in that field for a while. And as rates are continuing to go up, and I think they added a 1/1 additional relationship be benefiting of this in the quarter. But it's not any action that we actually took during this specific quarter. So -- the last piece is our facultative operation that has an amazing track record and is one of the leading accusative operation, property operation in North America and -- they also have shown some excellent growth.
Cave Montazeri : Perfect. My follow-up is on the mortgage insurance business. I guess two parts to that question. The first one is the growth in the quarter, was that primarily driven by the Fed cuts that just boosted demand. And I guess linked to that is the pickup in delinquency in mortgage insurance, is that also just linked to more activity? I know you mentioned some seasonal factors. I don't know what those were. If there's any details we can have on that, please?
Francois Morin : Yes. I'll start with that. I think the delinquency, again, yes, itself, but it's absolutely very much within our expectations. The one thing maybe for people to remember or appreciate is given we've refinanced a significant part of the book in 2020 and 2021. We're now entering call it, the prime years of when delinquencies get recorded. So that's very much part of the -- again, within our expectations, right? So as new loans get on the books. Usually, it takes 3 years, 4 years for them to show a bit of, just call it, really predictable and normal delinquencies. So that explains why in aggregate or delinquency rate is trending up a little bit. And more specifically on the seasonal aspect, I mean, every year, there's fairly predictable behaviors that we see from the borrowers, whether they get their tax refunds and in the first quarter and then they catch up on their mortgages and whether they borrow more to buy holiday presence. So that happens. And then the third quarter is typically expected and seen as we -- I mean, we've seen that in the recent history that the delinquency rate just goes up in the third quarter without any more just seasonal. So again, we're very comfortable with the overall rate. And again, there's a little bit -- the same differential that I mentioned last quarter related to the -- RMIC acquisition is still there. So, it's a pre-financial crisis book that is -- has its own set of characteristics. So, we're, again, overall, very happy, very comfortable with the delinquency rate -- and in terms of the premium, your first part of the question, there's a couple of accounting differences or nuances this quarter. So, I wouldn't read too much, I think, in the growth that we saw this quarter. There's a little bit of a catch-up on premium that was related to old -- or related to Bellemeade transactions on the seed aside. So generally speaking, I'd say the mortgage segment is relatively flat in terms of growth opportunities.
Operator: Our next question comes from the line of David Motemaden with Evercore ISI.
David Motemaden : Thanks Francois, thanks. So much for all the detail you gave on the insurance underlying loss ratio, both including and excluding the mid-corp acquisition. So, I guess just sort of running through those numbers there, it looks like if I take out mid-corp, it was about a 57% underlying loss ratio for the sort of core Arch insurance business. And so that picked up a little over 100 basis points versus last quarter and also on a year-over-year basis. So, I'm just wondering if you could help me think through some of the drivers of that increase?
Francois Morin : Yes. I'd say, again, it's -- Nicolas touched on it, it's growth related in mix, right, in the sense that where you saw us grow this quarter. And I don't think if you have the time to look at in the supplement, how we report the lines of business, which is we have changed this quarter relative to the past, more growth in casualty and other liability lines of business, both -- I mean, primarily on an occurrence basis, claims made, which is more professional lines book and cyber or that has come down. But that business typically carries a higher accident year loss ratio than property business once we remove the cat load. So that is really the big driver of the pickup is really mix as we have grown in the last little while more in casualty and remain relatively flat on property.
David Motemaden : Got it. Okay. That's helpful. I appreciate that. And then maybe a follow-up on the reserves just within insurance and reinsurance. I was wondering if there's any way you could size those moving pieces for us between the short tail and the long tail development?
Francois Morin : Well, I mean, we -- in total, I mean -- and that will be in the queue, but yes, we definitely very favorable on short tail lines of business, a little bit of adverse on long tail lines. So that's consistent with recent trends. I mean, as I mentioned earlier, we are -- we're seeing a little bit of pressure on casualty, longer-tail lines of business. There's been some favorable in workers' comp, as you've seen, I'm sure, with many of our competitors. I think that's been a consistent story for quite some time. But again, the bottom line in aggregate is we're able to -- we're observing kind of favorable development, lower actual than expected, and that is coming through in our numbers.
David Motemaden: Understood. Thank you.
Operator: Our next question comes from the line of Yaron Kinar with Jefferies.
Francois Morin : I think he might have dropped. We're not hearing anything.
Operator: Our next question comes from the line of Meyer Shields with KBW.
Meyer Shields : Great. I think we've talked about this in the past, but I wanted to get Nicolas' thoughts on cycle management. Specifically, I guess, with retail distribution and in particular, the mid-core business, is that less amenable to cycle management?
Nicolas Papadopoulo : So, I mean, my view is it's a different type of cycle management. I mean the -- what's attractive with the mid-core business is it's more stable. So, which means that the cycle are more muted. You don't see the same price going up and down like excess D&O public excess D&O. You got 40 and you make up 20 or 10. So, I think in the middle market business, I think you have more -- it's going up slower, and it's going down much lower. So, I think that that provide -- I think we like that provides a much balance to our insurance book that has a large component of larger corporate risk that are more subject to large situations in rates. And the thing that's attractive to us is the value proposition of a carrier in the MidCorp segment is better because usually the distribution partner, the broker rely on the carrier to provide more than one kind of business like -- so you're more important to him. The interaction with the carrier is more valued. So, you create the stickiness that really help -- you're not competing solely on price, where when you deal with a large account and a risk manager price is an important component of the value proposition. But here, I think -- so it's less subject to in my view price competition, which make it more stable and more attractive. And I think the thing that's interesting to us with the MidCorp aquisition is that the timing is pretty good because we've seen price increases on the property side because this book is more exposed to secondary period and the liability component of the book is subject to the discussion that we talked about before. So, I think we -- our timing is really good. I think the book looks to be performing well enough. And so, we're pretty excited to be able to find like a decent chunk of that business and to be at scale and being able to expand our footprint in what we think is a very attractive part of the market.
Meyer Shields : Okay. That's very helpful. And then if I can switch gears a little bit I know it's early on the January 1 discussions for property cat. Is there anything you can share with regard to expectations for seating commission trends in casualty reinsurance?
Nicolas Papadopoulo : So, I'm going to be the wise person here. I think as we insure and including ourselves in see more bad news coming from the past. I think the -- there will be pressure on seating commission. You would expect that -- the question is the supply. I mean the pressure on the seating commission will be muted by the supplier, because if there's more people wanting the business and there's a limited amount of business being placed I think the brokers is going to -- is going to play a big role in minimizing I mean, the directions of where the seating commission are going to be. So, it's going to be some sort of conflict between what the reinsurance wants and what the seating companies are willing to do. And -- but the driver would be the supply versus the demand. And I think -- and what I'm hearing is that there is ample supply in the marketplace.
Operator: Our next question comes from the line of Yaron Kinar with Jefferies.
Yaron Kinar : Good morning. I apologize for dropping earlier. I wanted to dive a little bit deeper into the other liability occurrence growth in insurance. How much of that came from MC versus just organic or legacy growth?
Francois Morin : It's a good question. There was a fair amount of E&S casualty business on our kind of like is just organic, right? So that is an area of maybe the most exciting area for us. I mean, where rates are well into the double digits in terms of rate increases. So that is a very, very attractive area the MC book is split. There's some commercial multi-peril -- there's some occurrence of the liability occurrence, so it's a mixed bag. But I'd say I don't have the exact numbers in front of me, but I think you should -- the takeaway is that the rate environment in that particular line of business is very, very good right now.
Yaron Kinar : Okay. And what is it about the third quarter where the environment it seems to have accelerated significantly or at least the opportunity set in other liability occurrence accelerated significantly?
Nicolas Papadopoulo : I think it's just a function of people realizing that the way they were looking at the reserves in the last few years is not exactly playing out. I think COVID for a while muted the claims. So, people kind of in my view, sitting out there to make sure they were not making their own reason. And since COVID, I think we -- we've seen some severity larger world, planted jewelry world, and we've seen -- and we've seen more places where those jewelry awards are taking place larger Europe. So, I think you have like social inflation that's driving much more severity and you have -- so frequency of places used to be County, self-test mixing border, but now you have Georgia, you have some place in Nevada, where certain juries actually, if you get code in one of these journeys, you're going to get a significantly larger work. So, I think it's a combination of frequency and severity and people realizing that they have to -- they have to stay ahead of those. And the normal reaction, which I think is the right reaction for the market has been to cut limits because if you're caught up in one of those difficult juries, you want to have small limits. And typically, when you had, I don't know, $200 million placement with 10 players and suddenly, you have 40 players to complete the placement, some of those layers going to the NS market, you're starting to see some taste increases. And that's what we're witnessing right now.
Yaron Kinar : But if I could maybe flesh this out a little more. What you're describing is not new. I mean, if we go back to previous management meetings, conferences, calls. We have been hearing management talk about this for several quarters, if not years, even in some cases. So, what's happened in this third quarter that seems to have triggered some significant change?
Nicolas Papadopoulo : I think it's just the accumulation in that people took actions, but when actuaries or management look at the chance for the business they're writing today to be profitable, they ask themselves, they need more safety margin. I think it's I think there was some rate increase double-digit trade increases 2 years or 3 years ago. Then we -- for a little while, we went to single digit, and suddenly, we are back in double digit. It tells you that there is paying in the back years of people that have written that business in the early years and in the last few years. And usually, the reaction -- it's not unusual that the reactions are more broad because at some point, management lose faith in the story they've being told, so they require more drastic actions. That's the usual playbook of how market happens.
Operator: Our next question comes from the line of Brian Meredith with UBS Financial.
Brian Meredith : Nicolas, I want to follow up on that a little, just a little bit. So, I understand what you're saying about your opportunities for growth here in some of the casualty lines. But maybe I can get your perspective a little bit more on what do you think casualty trend is? And where is it going, just because you must be pretty confident in kind of having good grasp on where casualty trend is, given that you're growing and some other are shrinking?
Nicolas Papadopoulo : Yes. So, I think, I mean, yes, it's a tale of several stories. I think -- at the bottom of the program, I think people can have a pretty good idea what your casualty trend is, whether it's mid-single digit. The issue is when you go excess. If you go in excess of $50 million, if you got excess of $100 million, that's where the trend get to multiply OpEx. And you are certainly in double digits. I think ourselves, in a way, we were lucky we didn't have a huge footprint on the casualty business, but we have enough footprint to be able to do our own analysis. And again, it’s selective. The thing to treat different class of business, different you have to be able to do really selective price increases, analysis to get comfortable that in certain jurisdictions, with certain parts of business, you think the business based on your own actual experience, the business makes sense to be returned. So, it's not -- I would not say it's a sea change that suddenly any pieces of business that come across your desk is going to be profitable. You have to be you have to be selective and have a thoughtful approach to what you want to underwrite. That's a market we are in.
Brian Meredith : Got you. And the same question, I guess, for reinsurance, right? Reinsurance you're kind of relying on the seeds?
Nicolas Papadopoulo : Yes. So again, I mean, the job of the reinsurer is still back the right companies. So, I think we are -- for a while, I think we've been really underweight on the casualty U.S. quota shares and excess of loss. And I think this dislocation in the marketplace has allowed us to get on program that we wanted to get on 2 years or 3 years ago because we like the underwriting. We like the limit discipline. We like the class of business they're right, but we couldn't get on because nobody was exceeding. So, I think we -- and I think there is some sort of a flight into quality of who is here for the long term and who is not. And I think we're benefiting from that.
Brian Meredith : Makes sense. And then, Francois, one quick one here for you on the investment portfolio. I guess, one, where are we looking at new money yields versus current book yields? And where are you deploying the assets you got out of MidCorp. Is there some more potential book yield to come out going forward?
Francois Morin : Yes. I mean, part of the transaction was certainly some of the -- a good chunk of the assets came in cash. So, our investment team has been very disciplined and thoughtful on where to put that money to work and -- but the good thing is just on money market or cash, we're still getting a decent yield. But yes, I'd say, call it, 4.5% on new money yield, I mean, as you see, the book yield and the new money yields are kind of pretty close to each other right now. We're still very short duration, very high-quality fixed income book, so that's not changing. But yes, there's certainly been, call it, the $2 billion in assets that we got we are putting that to work and trying to fit that into the portfolio as best we can.
Operator: Our next question comes from the line of Joshua Shanker with Bank of America.
Joshua Shanker : So, I get it, there's less meaty sports talk than ever. But I was wondering, in the past, we've talked about the ROIC on the different legs of the Arch stool reinsurance, insurance mortgage. Could you review right now sort of state of the union on what the return on new capital is for the various businesses?
Francois Morin : We like all our businesses. That has not changed. The one thing that I'd say right now is -- I mean, fourth quarter, we're a little bit kind of dependent on where the market goes at 1/1. So that is Certainly, reinsurance has been just a really, really good environment for 2024, how does it play out in '25. It's still a little bit early to know for sure. We think it's going to be still a very good market. Is it going to get better to the point where we have the ability to deploy that much more capital in reinsurance, we don't know quite yet. So -- that's kind of the answer. I mean, there were a little bit wait-and-see approach in terms of how the market plays out. But again, what we talked about this morning, the growth opportunities in casualty, in particular, I think are exciting to us. So, both insurance and reinsurance, I think we're ready to play. And mortgage is -- don't want to forget about mortgage. I mean this has been a terrific engine for us. No question that the origination market is not as large as we'd like it to be, but that's okay. I mean we've got terrific earnings coming from the in-force book and we're finding other opportunities outside of primary MI in the U.S., and we're deploying the capital in the right way. So, we're very comfortable with the mix right now.
Joshua Shanker : Would it be wrong to paraphrase that reinsurance is better than insurance and mortgage, but that's pending what happens on 1/1?
Francois Morin : It's not wrong. I think it's a fair statement. It's better right now. We like to think it's going to stay better, but just don't know quite yet.
Nicolas Papadopoulo : It's a higher component -- reinsurance is a higher component of property business. So, you have to think on the half of the business is property. So, you -- it's high risk, high reward. So, I think we have -- we get better high the high return, but it's also high risk as we saw this quarter. I think the insurance work is much more heavily geared towards casualty and professional lines. So, I think it's an environment that is [indiscernible] but it's a different set of return. I think you have to balance those two. So -- and sometimes, the E in the ROE doesn't do enough of that, I think.
Joshua Shanker : And Francois, you made the comment of the origination market in mortgage isn't quite as strong as you'd like it to be. but also, Arch has lowered its market share of new business compared to where it was 3 years ago or so. If Arch wanted to ramp it up -- is there a possibility of growing that business without improvements in the origination market? Or would that cause pricing and margins to weaken in that business?
Francois Morin : Yes. It's becoming a more kind of homogeneous market, right? So, I think the risk of trying to grow market share is just as you said, I think you have to cut prices I think we've built a very resilient, very high-quality book through picking different types of loans to ensure different geographies. I think we -- I mean, we are very comfortable with what we've done. But for us to move from the, call it, 16%, 17% market share and say we want to be at 18%, 19%, 20%. Right now, we just don't see that happening because the market, I think, will just react with us, and it will just push prices down. So, I think right now, I mean, I just be surprising for us to grow our market share that significantly in the near term.
Nicolas Papadopoulo : Yes, we've asked this question all the time. And the answer is that we ended up in the worst place. I think status quo, the current status quo based on the Remember, we're dealing with monoline business. That's all what they have. So, I think, ultimately, they're going to defend their book and we'll end up in a worse place. That has been the analysis that we carried.
Joshua Shanker : Well, thank you very much for all the answers, and I'll let you go to lunch.
Operator: Our next question comes from Elyse Greenspan with Wells Fargo?
Elyse Greenspan: I'll just shove a few more in before lunch. But my first question is on Hurricane Helene, right? I think you guys said it was 45% of cats. So, I calculate that at just over $200 million, so that's like 1.5% to 1.7% market share, given your 12 to 14 -- is that about what you would expect, I guess, for these large type events? And does that share a good frame of reference when thinking about Milton?
Francois Morin : I mean, your math is about right, but the Helene is a bit unusual for us. I mean it's a little bit on the elevated side in terms of market share based on some of the accounts we wrote Again, Milton is different because it's Florida only. So, it's -- we have a different mix of business there, a different type of accounts we write. So, I would not draw a correlation or an analogy from the lean, call it, implied market share to what Milton could look like.
Elyse Greenspan: Okay. That's helpful. And then my second one, I guess, is a follow-up on reserves, right? We had another company this morning that kind of flagged they're kind of going to take an in-depth review and there might be some movement with their fourth quarter review. It sounds like from earlier questions that you guys really haven't seen like change in loss trends or actual versus expected in the third quarter versus later in the year. But is there anything, I guess, that you're concerned about or anything that's come up with the quarterly reviews that you guys are paying particular attention to will be going to the end of your review?
Francois Morin : There's nothing unusual. I mean it's something we look at all the time. The trends are relatively stable. I mean we have views going way back that the loss trends that we were seeing in the market were a bit optimistic. So, we've always taken a longer-term view of trends and we review those annually at a minimum, sometimes some twice a year. But yes, really nothing that stands out, that's, I'd say, unusual or that we're overly concerned with. I mean that's the standard kind of themes that we've been talking about for quite some time.
Elyse Greenspan: And then I might just shove one last one in there. You guys have an upcoming Investor Day in a couple of weeks. Is this -- are you going to expecting to use this to lay out bigger strategy, financial targets something on capital, I guess. Can you just give us a little bit of a preview of what you expect to talk to us about in a few weeks?
Francois Morin : We're just missing you guys in person. So that's why we schedule this. But no, I wouldn't expect anything really unusual from the upcoming Investor Day. We you've known this for a while, the strategy remains the same. Nicolas will obviously be focal point. So, we'll make sure everybody gets to hear a bit more from how we want to shape the company going forward, but I would not message or think that there's anything unusual or kind of a new regulation that you should expect to hear from us in a couple of weeks.
Operator: I would now like to turn the conference over to Mr. Nicolas Papadopoulo, for closing remarks.
Nicolas Papadopoulo : Yes. So, there's not any more questions. So, this will conclude our presentation today. And thank you for your questions, and we see you next quarter.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Q3 2024 Arch Capital Earnings Conference Call. [Operator Instructions]. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review the periodic reports that are filed by the company with the SEC from time to time, including our annual report on Form 10-K for the 2023 fiscal year. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the safe harbor created thereby. Management will also make references to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Nicolas Papadopoulo, and Mr. Francois Morin. Sirs, you may begin."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Good morning, and welcome to our third quarter earnings call. I'd like to begin by wishing the best to my friend and my business partners of 23 years, Marc Grandisson, who retired earlier this month, after the fantastic road under Marc's leadership. While we will miss him, I'm very excited about the opportunities before us. My message to our shareholders, employees, brokers, clients and business partners is that it is business as usual at Arch. Our core objective remains unchanged to be the best-in-class specialty lines insurer in the market. We will continue to execute on the key pillars of our strategy, which are build a diversified mix of businesses, actively manage the underwriting cycle, remain prudent stewards of capital be dynamic managers of a data-driven enterprise and foster a culture that attracts best-in-class talent. Back to the quarter, where Arch generated strong top and bottom line results with an annualized operating return on equity of 14.8% and an 8.1% increase in book value per share. Our third quarter results included $450 million of cat losses across multiple levers, including Hurricane Evan. It's worth noting that this cat loss is within our third quarter seasonally adjusted cap load. Overall, the P&C environment remains very favorable despite increasing competition in many lines of business, making underwriting and risk mitigation increasingly important. Underwriting strategies empower our businesses to respond quickly to their trading environment. This has been and remains a competitive advantage as we pursue those opportunities with the best risk-adjusted return. Industry cat losses have once again exceeded $100 billion for the third quarter. We should continue to support increasing demand for property insurance and reinsurance. Even with this increased cat activity, we believe the property market remains attractive and one in which disciplined underwriters can produce attractive return on capital. [indiscernible] rates continue to outpace trend which is consistent with our hypothesis of a hardening casualty market. We have selectively increased our casualty riding in both insurance and reinsurance as the markets respond to claim inflation and uncertainty around loss trend with higher prices. Turning now to underwriting segments. Our insurance segment was $1.8 billion of net premium and delivered $120 million of underwriting income in the third quarter. Acquisition of the MidCorp and entertainment business from Valiance in August help drive a 20% growth over the same quarter a year ago. We are confident that the mid-core team will be an important part of our growth story as we further enhance our capabilities in the middle market. Excluding MidCorp insurance growth was mid-single digits as we continue to find attractive growth opportunity in casualty programs and our London market specialty business. premiums competitive in E&S property and professional lines. Reinsurance had another excellent growth quarter with net premium return up more than 24% to over $1.9 billion, along with underwriting income of $149 million as our team continued to benefit from a more robust relationship with our brokers and cedents. Growth was driven by property ex cat, including facultative business, casualty and other specialty. Our industry-leading mortgage segment again contributed significantly to our earnings with $269 million of underwriting income for the quarter. Underlying fundamentals remain excellent for the mortgage insurance industry, including strong credit conditions and continued favorable house price appreciation. Mortgage origination activities remains light that new insurance return of $13.5 billion was in line with our expectation as relatively high mortgage rates and continued house price acquisition have kept most buyers on the side mines. Finally, the contribution from our investment portfolio were substantial. In the quarter, Arch Investment Management generated $399 million of net investment income. Significant operating cash flows from our underwriting units should support continued growth of our assets under management, setting us up for strong investment contribution in the years to come. Looking ahead, we like our position and the market opportunities. This is true as we enter a responsible growth part of the P&C cycle where disciplined underwriting and thoughtful rate collection are essential to success. A few final comments in closing. Arch has proven to be an exceptional company defined by a culture of underwriting excellence, underpinned by our core strategies of cycle management and thoughtful capital allocation. That was true yesterday, it is true today and it will be true tomorrow. I'm very excited and proud to lead this company and work with our leadership team as we continue to strive to deliver the greatest value to our clients and shareholders over the long term. I'll now turn it over to Francois to provide some more color on our financial results in the quarter. and then we will return to take your questions. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Thank you, Nicolas, and good morning to all. As you know by now, we reported third quarter after-tax operating income of $1.99 per share for annualized operating return on average common equity of 14.8%. Book value per share was $57 as of September 30 of 8.1% for the quarter and 21.4% on a year-to-date basis. Once again, our three business segments delivered excellent underlying results highlighted by $538 million in underwriting income and an 86.6% combined ratio, which was slightly elevated from an active catastrophe quarter. Our combined ratio was 78.3% on an underlying ex-cat accident year basis. Overall, current accident year catastrophe losses were $450 million for the group in the quarter, split roughly 80%, 20% between the reinsurance and insurance segments. Approximately 45% of our catastrophe losses this quarter are due to Hurricane Helene with the rest coming from a series of events, including Canadian events, smaller named hurricanes, U.S. severe convective storms, flooding in Europe and other events across the globe. As of October 1, our peak zone natural cap probable maximum loss for a single event 1-in-200-year return level on a net basis increased slightly and now stands at 8.1% of tangible shareholders' equity as we incorporated exposures from the MidCorp acquisition on August 1. Our PML remains well below our internal limits. Our underwriting income included $119 million of favorable prior year development on a pretax basis in the quarter, or three points on the combined ratio across our three segments. We recognize favorable development across many lines of business, but primarily in short tail lines in our Property and Casualty segments and in mortgage, due to strong cure activity. As you know, we closed on our purchase of the U.S. MidCorp and entertainment insurance businesses from Allianz on August 1, and I would like to expand on a few items that impacted our financials this quarter. First, the net written premium coming from the acquired businesses was $209 million for the 2-month period, contributing to the reported year-over-year premium growth for our Insurance segment. Second, in accordance with U.S. GAAP, the fair value of the acquired balance sheet does not include an asset for deferred acquisition costs. Therefore, since there is no amortization of deferred acquisition costs associated with the in-force business at the time of the acquisition, the current quarter's acquisition expense ratio is lower than in the third quarter of 2023. This item resulted in a benefit this quarter of approximately 1.9 points in the Insurance segment's acquisition expense ratio. Although we would expect this benefit to become less significant over the next three quarters to four quarters as a larger proportion of our earned premium relates to premium written after the closing date. Operating expenses in the new business were also somewhat lower than ultimately expected as we ramp up operations contributing to a 60-basis point benefit in the quarter. Third, as is required with business combinations, we recorded goodwill and intangibles in connection with the transaction, primarily from the value of the business acquired, distribution relationships, and the present value adjustment related to the reserves for losses and loss adjustment expenses. This quarter, we incurred an expense for the amortization of intangibles of $88 million, $63 million of which was for the MidCorp and entertainment acquisition. We expect our overall amortization expense across the group to be approximately $100 million in the fourth quarter of this year and $195 million in 2025, spread evenly throughout the four quarters. While still early, the mid-core business is performing as expected or even maybe slightly better, and we are satisfied with the progress we are making in our integration activities. Turning to our reinsurance group. The team delivered a very solid 92.3% combined ratio in an active catastrophe quarter. Of note, the reported net written premium growth of 24.5% in the quarter was augmented by reinstatement premiums. Adjusting for this item, the growth rate would have been approximately 22.4%. The mortgage segment reported an excellent 14.8% combined ratio as cure activity on delinquent mortgages is strong and the underlying credit quality of the book remains very high. the reported delinquency rate that USMI inched up slightly this quarter and was impacted primarily by seasonal factors. On the investment front, we earned a combined $570 million pretax from net investment income and income from funds accounted using the equity or $1.49 per share. Our investment income reflects approximately $20 million earned during the 2-month period from the assets we've received in connection with the MidCorp acquisition. Total return for the portfolio came in at 3.97% for the quarter, as there was significant price appreciation on our fixed-income portfolio due to lower interest rates. The appreciation of our available-for-sale investment portfolio resulted in a book value increase of $1.56 per share net of tax. Cash flow from operations remained strong and exceeds $5 billion on a year-to-date basis. Our effective tax rate on a pretax operating income was an expense of 8% for the third quarter in our annualized effective tax rate remains in the 9% to 11% range for the full year 2024. In closing, our balance sheet is strong with common shareholders' equity of $21.4 billion and a debt plus preferred to capital ratio of 14.2%. This level of financial resources gives us flexibility to deploy capital as needed. And continue delivering outstanding results for the benefit of our shareholders. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our first question comes from the line of Elyse Greenspan with Wells Fargo. Please go ahead."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks. Good morning. I guess my first question is on the Allianz deal. You gave us some good color on the expenses. But anyway, could you give us a sense of just the impact on the underlying loss ratio within the insurance segment in the quarter?"
},
{
"speaker": "Francois Morin",
"text": "Yes, sure. I mean, just to give you a bit more details on that, the -- call it, the normalized meaning ex cat accident year loss ratio for the segment was $57.6 million. right? And the stand-alone for the mid-core business was 62% in the quarter. So that's how came up. So effectively, kind of increased, call it by 70 basis points and increased the reported loss ratio for the ex-cat loss ratio."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. And then in reinsurance, the margin sometimes does fluctuate quarter-to-quarter but the underlying loss ratio did trend up in the Q3. Was there anything business mix in there that might have impacted that in the quarter?"
},
{
"speaker": "Francois Morin",
"text": "Nothing specific. Again, we will -- we'll go back to our trailing 12 months way of looking at things. I mean I took another look this morning and there's nothing unusual in the quarter. I mean the trends are very consistent. Trailing 12 months are doing very well. So, the answer is nothing to report. I mean there's just kind of some claims happen, some don't. And over the last 12 months, we're very comfortable with the loss picks and how things are behaving."
},
{
"speaker": "Elyse Greenspan",
"text": "And then my last question is on capital, right? You guys have left the Doral ban, just given your excess capital position to doing something to return to shareholders, be that right a quarterly dividend, a special or even a return to repurchase. So, what's the timing there? I thought maybe it was post the end of wind season. Does that still apply? And how are you thinking about how you might look to return capital to shareholders?"
},
{
"speaker": "Francois Morin",
"text": "I mean you hit all the good points. I think it's very much a conversation and it's not a new conversation. It's a conversation we have all the time. And yes, we had certainly mentioned that we wanted to wait till the end of the wind season, which is coming close to an end. And as we get ready for 2025, certainly part of the outlook for 2025 growth opportunities, how -- where we may be able to deploy the capital is something we'll consider as well. But Yes, no question that this is an area that we're focused on. And I'll say you should -- we're not sleeping on it, and we'll report back when there's more to say on that."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Andrew Kligerman with TD Cowen."
},
{
"speaker": "Andrew Kligerman",
"text": "Good morning. Maybe following up on the insurance division and MidCorp. And I think France Swap, I heard correctly the MidCorp impact on the underlying loss ratio was about 60 basis points to 70 basis points, and if that's the case, it kind of moved up a fair amount, like 250 bps year-over-year. So, I'm trying to get a sense of should we be thinking that this is kind of a good run rate underlying number for the loss ratio? How should we think about it going forward?"
},
{
"speaker": "Francois Morin",
"text": "Well, I mean, we indicated that we thought initially, I mean, we have to get, call it, under the hood, we have to understand the business. But we certainly have said that in the first year, we thought this business was going to be breakeven for us. So yes, we should expect a little increase in the loss ratio and the combined ratio for the segment. No question. In terms of run rate, I'd be a little bit hesitant to commit to anything beyond, call it, the first year. I think we're already making adjustments, taking underwriting actions in terms of we like, what we don't like as much. I think there is good traction, good opportunities in terms of the casualty business that they write. The rates right environment is very strong. So that will help, we think, -- so that's -- again, the short-term answer is yes. I think the combined ratio will probably inch up a little bit, but we have very -- definitive ideas and plans on how to bring that down as we move forward."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. And I think -- it's dynamic. I mean, again, we I mean if you look at the insurance group overall, it's heavy non-property lines, so the property line attract lower loss ratio. So, we were growing in the property line in the last couple of years and the market now it makes it more difficult. And we have a large component of professional lines where rates have been challenging, so that probably incur Carlos ratio. And then we have casualty where I think we think there is opportunities potentially to grow more with higher margin, but it may come also with a higher switcher than property. So that's a playbook that we are facing."
},
{
"speaker": "Andrew Kligerman",
"text": "Interesting. And maybe breaking down some of the lines of business in insurance what kind of rate are you seeing? And is this rate exceeding loss costs? I suspect it's not in property, but maybe you could talk a little bit about some of the key lines in insurance?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So, I mean let's talk about casualty, which is talk of the time. I think in casualty, we're definitely seeing rates on the trend -- but there are really good reasons for that. I think the market is going through some pain. And so, I think we are underweight in casualty. We historically underwrite casualty. So now I think based on our own analysis of the pocket of casualty business that we like. We are selectively growing both from the insurance and the reinsurance side. So there, I expect margin to expand. I think if you mention property, if you talk about reinsurance versus insurance, we're mostly focusing on insurance. On E&S property, we think the profitability is actually very attractive. I think over the last few years and post the Hurricane Helene, I think the business has reacted with a lot of rate increase and a lot of change in terms and conditions, which make the business really attractive. So there, I think after year without losses, people have really short. We see a lot more competition coming from Lloyd's, coming from NGS, coming from new entrants that want to have a piece of that business. So, I think we -- our rates are pretty flat, but I think we'd expect that margin on the business will be depend on the reaction to the catastrophes that just happened. So, I think with Milton and Eli, we price expectation with things would stabilize, but ultimate the supply and the demand, there's more supply. We think there's more demand. I think the demand has been constrained by the high price and high deductibles and high retention on the reinsurance side. So, I think we're close to an equitable year -- I think the business will remain attractive for a while."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Mike Zaremski with BMO Capital Markets."
},
{
"speaker": "Michael Zaremski",
"text": "First question is on catastrophes. So, I don't know if you disclosed what you're assuming for Hurricane Helene. I know you're I think the cats were a bit higher than the consensus, but you guys have done a good job of giving us disclosure that you've been taking more risk in Florida specifically and just overall? And then also, should we be thinking about Milton as well. I think there's some conflicting numbers out there on open sure PCS is only a $5 billion so far, but there's some much bigger numbers out there?"
},
{
"speaker": "Francois Morin",
"text": "Yes, sure. On Helene, our view is that it's going to be the type of event that probably will have a bit more leakage than you would otherwise expect. I mean it's just multiple states, and it's a lot of flooding. So, we are currently assuming, call it, a $12 billion to $14 billion industry loss. Which is maybe higher than others? And -- but that's how we see it today. I mean things could change, but that hopefully informs how we thought about the event initially and is reflected in our third quarter numbers. As it relates to Milton, we need to do a bit more work, but we will certainly give you our initial thoughts on that, I think, in the coming weeks in terms of what a loss -- what a range of estimates could be for us. But no question that what we -- what people thought might have been a really scary and large events doesn't seem to have materialized. I think industry estimates are coming down as we speak. So, call it the $30 billion plus or minus market loss seems to be about right, given what we know today. And in terms of our own loss related to that, I mean, again, more to come, but you shouldn't expect anything unusual from us. I think from what we can tell at this point, it should be in a relatively consistent kind of market share for us for an event of that size."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. That's helpful. And -- my last question for Nicolas. Is there any context or color you can add to the -- what -- why the CEO change took place at the number 1 question I'm sure you all have received, and we have two people wondering if it's performance related versus just some other events or anything else? Any color you'd be able to add?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "I didn't understand the deal?"
},
{
"speaker": "Francois Morin",
"text": "The CEO Marc's departure."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Should know that. No. I mean, again, it was a personal decision that is, I think as I said, Marc and I were a good trend. It's a bit bittersweet for me, but based on this decision, I'm actually very excited about the opportunity in front of us. I think Marc is, I think Arch is bigger than any one of us, and I think we have a lot to do, and we have not an exciting thing to continue to do in the coming years. And I think we have a really good management team. We have 7,000 employees that are really engaged. And as I said, I think Arch is an exceptional company, and I'm really looking forward to continue this journey and, certainly, I think Marc departure is not performance related that the guy under his leadership, and I said the company has performed amazingly well."
},
{
"speaker": "Michael Zaremski",
"text": "And I guess, Nicolas is helpful. Obviously, you put your own stamp on the company over time and you're a different type of leader and we're all excited to -- about your position. But I'm just curious, is there now that you are at the Boss, are there certain things we should kind of stay tuned for that have kind of been on your wish list that you'll be able to kind of push through? Or do you kind of expect just more of the same directionally?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "No, not a message to -- it's really business as usual. I think I've been with the company for 23 years, have worked very closely with Marc in the last 5 years or 6 years in setting up strategies, looking at operation changes, looking at culture. So, I think we -- him and I were extremely aligned. So, I think I would not expect any changes in the way we operate."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jimmy Bhullar with JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"text": "Good morning. So first, I just had a question on your views on 1/1 renewal and what do you think about the sort of supply-demand imbalance? And has that sort of shifted given losses from Milton -- or is your view consistent with how you would have thought before?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So, is the question on property cat I assume?"
},
{
"speaker": "Jamminder Bhullar",
"text": "Yes, yes."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. So, I think on property cat, I think, as you've seen, we've grown the book quite a bit in the last 2 years or 3 years. So, we think the returns are really attractive. The Yes. I think the we have vet of midterm and Helene in my view, what we hear is that you stabilize the market. And I think there was a lot some supply, as I said earlier, is there from nodes or from MGAs or from our competitors. After 1 year without losses really wanting to get back in the business and realizing that they may have missed out on a profitable line of business. So, what I would expect, and we see it on the insurance side that things have stabilized. And I think my guess is at this stage is that we will do the same on the cat reinsurance side."
},
{
"speaker": "Jamminder Bhullar",
"text": "And more specifically, are you expecting pricing to be down, flat or -- and to whatever extent you're able to qualify quantify would be helpful?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. I don't have a crystal ball. I would say, again, it's always the same with programs that are being impacted by losses. I would expect prices to go up. in regions that had no losses, you could see in the bottom of the programs, I think people are still really scared about frequency. So, I'd expect the bottom to middle side of the program to perform well. The upper layers where people seem to be more comfortable to play where competition is coming because you are away from the midsize also, it could be a little bit of weakness, but not really have a strong conviction in a way. But I think mostly stable."
},
{
"speaker": "Jamminder Bhullar",
"text": "And then on casualty reserves, a lot of companies have had adverse development, some on recent years, some money even some on peak over the years as well. Can you talk about your own comfort with your casualty reserves on your legacy book as well as the Watford business?"
},
{
"speaker": "Francois Morin",
"text": "Sure. I mean, reserves is something we looked at. We look at regularly, quarterly, right? So, it's nothing new here. I think we're -- to answer your question, we're very comfortable with our reserve levels. I think from couple of reasons. One is we were -- as Nicolas said, we have been underweighting casualty for a number of years. So as much as, yes, we do feel and see some of the impacts of social inflation and pressures on loss trends on casualty business in general. I mean the fact that we're underweight in those lines has been very helpful. So yes, we are monitoring casualty reserves. There, we have experienced some adverse development, but it's been overall very manageable. And that explains, in our mind, is a big reason as to why rates are moving up because the industry is seeing the pressure and a way to correct for those results is really by getting more rate."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Cave Montazeri with Deutsche Bank."
},
{
"speaker": "Cave Montazeri",
"text": "First question is on growth. I guess, Francois, you've already explained the growth in primary insurance I guess, underlying once you exclude MidCorp, is about 5%. In reinsurance, you also mentioned the impact of reinstatement premium. I think you said it was still 22% growth even adjusting for that, still a big number. Could you give us a bit more color on like what drove that in terms of how much of that was pricing? How much of those like unit growth? How much of that was maybe writing more casualty business. Any type of color on that would be quite helpful, please."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. I think for the quarter, I think the driver of the growth was a bit of casualty return mostly our U.S. company, where I think we selectively are trying to -- are getting on programs that we haven't been as rates get better, we think there's opportunities for us to write attractive casualty business. And on the other side of the business that grew is the specialty business, the return. And that's more of business that we wrote 1/1 that is coming in on quarter shares, and some of it is we have a decent size book of business that support Lloyd's [indiscernible] where called Ponat where we get quarter share of what they write net of their protection. So that business is growing. Lloyd's is growing, and we think it's a profitable business. So, we benefit from that. And the second aspect is we have a decent size book of motor United Kingdom motor and that business is really dislocated, it's been dislocated, and we've been playing in that field for a while. And as rates are continuing to go up, and I think they added a 1/1 additional relationship be benefiting of this in the quarter. But it's not any action that we actually took during this specific quarter. So -- the last piece is our facultative operation that has an amazing track record and is one of the leading accusative operation, property operation in North America and -- they also have shown some excellent growth."
},
{
"speaker": "Cave Montazeri",
"text": "Perfect. My follow-up is on the mortgage insurance business. I guess two parts to that question. The first one is the growth in the quarter, was that primarily driven by the Fed cuts that just boosted demand. And I guess linked to that is the pickup in delinquency in mortgage insurance, is that also just linked to more activity? I know you mentioned some seasonal factors. I don't know what those were. If there's any details we can have on that, please?"
},
{
"speaker": "Francois Morin",
"text": "Yes. I'll start with that. I think the delinquency, again, yes, itself, but it's absolutely very much within our expectations. The one thing maybe for people to remember or appreciate is given we've refinanced a significant part of the book in 2020 and 2021. We're now entering call it, the prime years of when delinquencies get recorded. So that's very much part of the -- again, within our expectations, right? So as new loans get on the books. Usually, it takes 3 years, 4 years for them to show a bit of, just call it, really predictable and normal delinquencies. So that explains why in aggregate or delinquency rate is trending up a little bit. And more specifically on the seasonal aspect, I mean, every year, there's fairly predictable behaviors that we see from the borrowers, whether they get their tax refunds and in the first quarter and then they catch up on their mortgages and whether they borrow more to buy holiday presence. So that happens. And then the third quarter is typically expected and seen as we -- I mean, we've seen that in the recent history that the delinquency rate just goes up in the third quarter without any more just seasonal. So again, we're very comfortable with the overall rate. And again, there's a little bit -- the same differential that I mentioned last quarter related to the -- RMIC acquisition is still there. So, it's a pre-financial crisis book that is -- has its own set of characteristics. So, we're, again, overall, very happy, very comfortable with the delinquency rate -- and in terms of the premium, your first part of the question, there's a couple of accounting differences or nuances this quarter. So, I wouldn't read too much, I think, in the growth that we saw this quarter. There's a little bit of a catch-up on premium that was related to old -- or related to Bellemeade transactions on the seed aside. So generally speaking, I'd say the mortgage segment is relatively flat in terms of growth opportunities."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Motemaden with Evercore ISI."
},
{
"speaker": "David Motemaden",
"text": "Thanks Francois, thanks. So much for all the detail you gave on the insurance underlying loss ratio, both including and excluding the mid-corp acquisition. So, I guess just sort of running through those numbers there, it looks like if I take out mid-corp, it was about a 57% underlying loss ratio for the sort of core Arch insurance business. And so that picked up a little over 100 basis points versus last quarter and also on a year-over-year basis. So, I'm just wondering if you could help me think through some of the drivers of that increase?"
},
{
"speaker": "Francois Morin",
"text": "Yes. I'd say, again, it's -- Nicolas touched on it, it's growth related in mix, right, in the sense that where you saw us grow this quarter. And I don't think if you have the time to look at in the supplement, how we report the lines of business, which is we have changed this quarter relative to the past, more growth in casualty and other liability lines of business, both -- I mean, primarily on an occurrence basis, claims made, which is more professional lines book and cyber or that has come down. But that business typically carries a higher accident year loss ratio than property business once we remove the cat load. So that is really the big driver of the pickup is really mix as we have grown in the last little while more in casualty and remain relatively flat on property."
},
{
"speaker": "David Motemaden",
"text": "Got it. Okay. That's helpful. I appreciate that. And then maybe a follow-up on the reserves just within insurance and reinsurance. I was wondering if there's any way you could size those moving pieces for us between the short tail and the long tail development?"
},
{
"speaker": "Francois Morin",
"text": "Well, I mean, we -- in total, I mean -- and that will be in the queue, but yes, we definitely very favorable on short tail lines of business, a little bit of adverse on long tail lines. So that's consistent with recent trends. I mean, as I mentioned earlier, we are -- we're seeing a little bit of pressure on casualty, longer-tail lines of business. There's been some favorable in workers' comp, as you've seen, I'm sure, with many of our competitors. I think that's been a consistent story for quite some time. But again, the bottom line in aggregate is we're able to -- we're observing kind of favorable development, lower actual than expected, and that is coming through in our numbers."
},
{
"speaker": "David Motemaden",
"text": "Understood. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Yaron Kinar with Jefferies."
},
{
"speaker": "Francois Morin",
"text": "I think he might have dropped. We're not hearing anything."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Meyer Shields with KBW."
},
{
"speaker": "Meyer Shields",
"text": "Great. I think we've talked about this in the past, but I wanted to get Nicolas' thoughts on cycle management. Specifically, I guess, with retail distribution and in particular, the mid-core business, is that less amenable to cycle management?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So, I mean, my view is it's a different type of cycle management. I mean the -- what's attractive with the mid-core business is it's more stable. So, which means that the cycle are more muted. You don't see the same price going up and down like excess D&O public excess D&O. You got 40 and you make up 20 or 10. So, I think in the middle market business, I think you have more -- it's going up slower, and it's going down much lower. So, I think that that provide -- I think we like that provides a much balance to our insurance book that has a large component of larger corporate risk that are more subject to large situations in rates. And the thing that's attractive to us is the value proposition of a carrier in the MidCorp segment is better because usually the distribution partner, the broker rely on the carrier to provide more than one kind of business like -- so you're more important to him. The interaction with the carrier is more valued. So, you create the stickiness that really help -- you're not competing solely on price, where when you deal with a large account and a risk manager price is an important component of the value proposition. But here, I think -- so it's less subject to in my view price competition, which make it more stable and more attractive. And I think the thing that's interesting to us with the MidCorp aquisition is that the timing is pretty good because we've seen price increases on the property side because this book is more exposed to secondary period and the liability component of the book is subject to the discussion that we talked about before. So, I think we -- our timing is really good. I think the book looks to be performing well enough. And so, we're pretty excited to be able to find like a decent chunk of that business and to be at scale and being able to expand our footprint in what we think is a very attractive part of the market."
},
{
"speaker": "Meyer Shields",
"text": "Okay. That's very helpful. And then if I can switch gears a little bit I know it's early on the January 1 discussions for property cat. Is there anything you can share with regard to expectations for seating commission trends in casualty reinsurance?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So, I'm going to be the wise person here. I think as we insure and including ourselves in see more bad news coming from the past. I think the -- there will be pressure on seating commission. You would expect that -- the question is the supply. I mean the pressure on the seating commission will be muted by the supplier, because if there's more people wanting the business and there's a limited amount of business being placed I think the brokers is going to -- is going to play a big role in minimizing I mean, the directions of where the seating commission are going to be. So, it's going to be some sort of conflict between what the reinsurance wants and what the seating companies are willing to do. And -- but the driver would be the supply versus the demand. And I think -- and what I'm hearing is that there is ample supply in the marketplace."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Yaron Kinar with Jefferies."
},
{
"speaker": "Yaron Kinar",
"text": "Good morning. I apologize for dropping earlier. I wanted to dive a little bit deeper into the other liability occurrence growth in insurance. How much of that came from MC versus just organic or legacy growth?"
},
{
"speaker": "Francois Morin",
"text": "It's a good question. There was a fair amount of E&S casualty business on our kind of like is just organic, right? So that is an area of maybe the most exciting area for us. I mean, where rates are well into the double digits in terms of rate increases. So that is a very, very attractive area the MC book is split. There's some commercial multi-peril -- there's some occurrence of the liability occurrence, so it's a mixed bag. But I'd say I don't have the exact numbers in front of me, but I think you should -- the takeaway is that the rate environment in that particular line of business is very, very good right now."
},
{
"speaker": "Yaron Kinar",
"text": "Okay. And what is it about the third quarter where the environment it seems to have accelerated significantly or at least the opportunity set in other liability occurrence accelerated significantly?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "I think it's just a function of people realizing that the way they were looking at the reserves in the last few years is not exactly playing out. I think COVID for a while muted the claims. So, people kind of in my view, sitting out there to make sure they were not making their own reason. And since COVID, I think we -- we've seen some severity larger world, planted jewelry world, and we've seen -- and we've seen more places where those jewelry awards are taking place larger Europe. So, I think you have like social inflation that's driving much more severity and you have -- so frequency of places used to be County, self-test mixing border, but now you have Georgia, you have some place in Nevada, where certain juries actually, if you get code in one of these journeys, you're going to get a significantly larger work. So, I think it's a combination of frequency and severity and people realizing that they have to -- they have to stay ahead of those. And the normal reaction, which I think is the right reaction for the market has been to cut limits because if you're caught up in one of those difficult juries, you want to have small limits. And typically, when you had, I don't know, $200 million placement with 10 players and suddenly, you have 40 players to complete the placement, some of those layers going to the NS market, you're starting to see some taste increases. And that's what we're witnessing right now."
},
{
"speaker": "Yaron Kinar",
"text": "But if I could maybe flesh this out a little more. What you're describing is not new. I mean, if we go back to previous management meetings, conferences, calls. We have been hearing management talk about this for several quarters, if not years, even in some cases. So, what's happened in this third quarter that seems to have triggered some significant change?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "I think it's just the accumulation in that people took actions, but when actuaries or management look at the chance for the business they're writing today to be profitable, they ask themselves, they need more safety margin. I think it's I think there was some rate increase double-digit trade increases 2 years or 3 years ago. Then we -- for a little while, we went to single digit, and suddenly, we are back in double digit. It tells you that there is paying in the back years of people that have written that business in the early years and in the last few years. And usually, the reaction -- it's not unusual that the reactions are more broad because at some point, management lose faith in the story they've being told, so they require more drastic actions. That's the usual playbook of how market happens."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Brian Meredith with UBS Financial."
},
{
"speaker": "Brian Meredith",
"text": "Nicolas, I want to follow up on that a little, just a little bit. So, I understand what you're saying about your opportunities for growth here in some of the casualty lines. But maybe I can get your perspective a little bit more on what do you think casualty trend is? And where is it going, just because you must be pretty confident in kind of having good grasp on where casualty trend is, given that you're growing and some other are shrinking?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. So, I think, I mean, yes, it's a tale of several stories. I think -- at the bottom of the program, I think people can have a pretty good idea what your casualty trend is, whether it's mid-single digit. The issue is when you go excess. If you go in excess of $50 million, if you got excess of $100 million, that's where the trend get to multiply OpEx. And you are certainly in double digits. I think ourselves, in a way, we were lucky we didn't have a huge footprint on the casualty business, but we have enough footprint to be able to do our own analysis. And again, it’s selective. The thing to treat different class of business, different you have to be able to do really selective price increases, analysis to get comfortable that in certain jurisdictions, with certain parts of business, you think the business based on your own actual experience, the business makes sense to be returned. So, it's not -- I would not say it's a sea change that suddenly any pieces of business that come across your desk is going to be profitable. You have to be you have to be selective and have a thoughtful approach to what you want to underwrite. That's a market we are in."
},
{
"speaker": "Brian Meredith",
"text": "Got you. And the same question, I guess, for reinsurance, right? Reinsurance you're kind of relying on the seeds?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. So again, I mean, the job of the reinsurer is still back the right companies. So, I think we are -- for a while, I think we've been really underweight on the casualty U.S. quota shares and excess of loss. And I think this dislocation in the marketplace has allowed us to get on program that we wanted to get on 2 years or 3 years ago because we like the underwriting. We like the limit discipline. We like the class of business they're right, but we couldn't get on because nobody was exceeding. So, I think we -- and I think there is some sort of a flight into quality of who is here for the long term and who is not. And I think we're benefiting from that."
},
{
"speaker": "Brian Meredith",
"text": "Makes sense. And then, Francois, one quick one here for you on the investment portfolio. I guess, one, where are we looking at new money yields versus current book yields? And where are you deploying the assets you got out of MidCorp. Is there some more potential book yield to come out going forward?"
},
{
"speaker": "Francois Morin",
"text": "Yes. I mean, part of the transaction was certainly some of the -- a good chunk of the assets came in cash. So, our investment team has been very disciplined and thoughtful on where to put that money to work and -- but the good thing is just on money market or cash, we're still getting a decent yield. But yes, I'd say, call it, 4.5% on new money yield, I mean, as you see, the book yield and the new money yields are kind of pretty close to each other right now. We're still very short duration, very high-quality fixed income book, so that's not changing. But yes, there's certainly been, call it, the $2 billion in assets that we got we are putting that to work and trying to fit that into the portfolio as best we can."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Joshua Shanker with Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "So, I get it, there's less meaty sports talk than ever. But I was wondering, in the past, we've talked about the ROIC on the different legs of the Arch stool reinsurance, insurance mortgage. Could you review right now sort of state of the union on what the return on new capital is for the various businesses?"
},
{
"speaker": "Francois Morin",
"text": "We like all our businesses. That has not changed. The one thing that I'd say right now is -- I mean, fourth quarter, we're a little bit kind of dependent on where the market goes at 1/1. So that is Certainly, reinsurance has been just a really, really good environment for 2024, how does it play out in '25. It's still a little bit early to know for sure. We think it's going to be still a very good market. Is it going to get better to the point where we have the ability to deploy that much more capital in reinsurance, we don't know quite yet. So -- that's kind of the answer. I mean, there were a little bit wait-and-see approach in terms of how the market plays out. But again, what we talked about this morning, the growth opportunities in casualty, in particular, I think are exciting to us. So, both insurance and reinsurance, I think we're ready to play. And mortgage is -- don't want to forget about mortgage. I mean this has been a terrific engine for us. No question that the origination market is not as large as we'd like it to be, but that's okay. I mean we've got terrific earnings coming from the in-force book and we're finding other opportunities outside of primary MI in the U.S., and we're deploying the capital in the right way. So, we're very comfortable with the mix right now."
},
{
"speaker": "Joshua Shanker",
"text": "Would it be wrong to paraphrase that reinsurance is better than insurance and mortgage, but that's pending what happens on 1/1?"
},
{
"speaker": "Francois Morin",
"text": "It's not wrong. I think it's a fair statement. It's better right now. We like to think it's going to stay better, but just don't know quite yet."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "It's a higher component -- reinsurance is a higher component of property business. So, you have to think on the half of the business is property. So, you -- it's high risk, high reward. So, I think we have -- we get better high the high return, but it's also high risk as we saw this quarter. I think the insurance work is much more heavily geared towards casualty and professional lines. So, I think it's an environment that is [indiscernible] but it's a different set of return. I think you have to balance those two. So -- and sometimes, the E in the ROE doesn't do enough of that, I think."
},
{
"speaker": "Joshua Shanker",
"text": "And Francois, you made the comment of the origination market in mortgage isn't quite as strong as you'd like it to be. but also, Arch has lowered its market share of new business compared to where it was 3 years ago or so. If Arch wanted to ramp it up -- is there a possibility of growing that business without improvements in the origination market? Or would that cause pricing and margins to weaken in that business?"
},
{
"speaker": "Francois Morin",
"text": "Yes. It's becoming a more kind of homogeneous market, right? So, I think the risk of trying to grow market share is just as you said, I think you have to cut prices I think we've built a very resilient, very high-quality book through picking different types of loans to ensure different geographies. I think we -- I mean, we are very comfortable with what we've done. But for us to move from the, call it, 16%, 17% market share and say we want to be at 18%, 19%, 20%. Right now, we just don't see that happening because the market, I think, will just react with us, and it will just push prices down. So, I think right now, I mean, I just be surprising for us to grow our market share that significantly in the near term."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes, we've asked this question all the time. And the answer is that we ended up in the worst place. I think status quo, the current status quo based on the Remember, we're dealing with monoline business. That's all what they have. So, I think, ultimately, they're going to defend their book and we'll end up in a worse place. That has been the analysis that we carried."
},
{
"speaker": "Joshua Shanker",
"text": "Well, thank you very much for all the answers, and I'll let you go to lunch."
},
{
"speaker": "Operator",
"text": "Our next question comes from Elyse Greenspan with Wells Fargo?"
},
{
"speaker": "Elyse Greenspan",
"text": "I'll just shove a few more in before lunch. But my first question is on Hurricane Helene, right? I think you guys said it was 45% of cats. So, I calculate that at just over $200 million, so that's like 1.5% to 1.7% market share, given your 12 to 14 -- is that about what you would expect, I guess, for these large type events? And does that share a good frame of reference when thinking about Milton?"
},
{
"speaker": "Francois Morin",
"text": "I mean, your math is about right, but the Helene is a bit unusual for us. I mean it's a little bit on the elevated side in terms of market share based on some of the accounts we wrote Again, Milton is different because it's Florida only. So, it's -- we have a different mix of business there, a different type of accounts we write. So, I would not draw a correlation or an analogy from the lean, call it, implied market share to what Milton could look like."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. That's helpful. And then my second one, I guess, is a follow-up on reserves, right? We had another company this morning that kind of flagged they're kind of going to take an in-depth review and there might be some movement with their fourth quarter review. It sounds like from earlier questions that you guys really haven't seen like change in loss trends or actual versus expected in the third quarter versus later in the year. But is there anything, I guess, that you're concerned about or anything that's come up with the quarterly reviews that you guys are paying particular attention to will be going to the end of your review?"
},
{
"speaker": "Francois Morin",
"text": "There's nothing unusual. I mean it's something we look at all the time. The trends are relatively stable. I mean we have views going way back that the loss trends that we were seeing in the market were a bit optimistic. So, we've always taken a longer-term view of trends and we review those annually at a minimum, sometimes some twice a year. But yes, really nothing that stands out, that's, I'd say, unusual or that we're overly concerned with. I mean that's the standard kind of themes that we've been talking about for quite some time."
},
{
"speaker": "Elyse Greenspan",
"text": "And then I might just shove one last one in there. You guys have an upcoming Investor Day in a couple of weeks. Is this -- are you going to expecting to use this to lay out bigger strategy, financial targets something on capital, I guess. Can you just give us a little bit of a preview of what you expect to talk to us about in a few weeks?"
},
{
"speaker": "Francois Morin",
"text": "We're just missing you guys in person. So that's why we schedule this. But no, I wouldn't expect anything really unusual from the upcoming Investor Day. We you've known this for a while, the strategy remains the same. Nicolas will obviously be focal point. So, we'll make sure everybody gets to hear a bit more from how we want to shape the company going forward, but I would not message or think that there's anything unusual or kind of a new regulation that you should expect to hear from us in a couple of weeks."
},
{
"speaker": "Operator",
"text": "I would now like to turn the conference over to Mr. Nicolas Papadopoulo, for closing remarks."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. So, there's not any more questions. So, this will conclude our presentation today. And thank you for your questions, and we see you next quarter."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 2 | 2,024 | 2024-07-31 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Q2 2024 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the Company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the Company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the Company's current report on Form 8-K, furnished to the SEC yesterday, which contains the Company's earnings press release and is available on the Company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may now begin.
Marc Grandisson: Thank you, Jericho. Good morning, and welcome to Arch's second quarter earnings call. We are pleased to report another highly profitable quarter due to significant contributions from all three underwriting segments and strong investment results. Our ability to successfully deploy capital into this extended hard market has fueled excellent risk-adjusted returns. Coupling our cycle management strategy with an emphasis on returns and consistent disciplined execution throughout the enterprise resulted in a record $762 million of underwriting income and an annualized operating ROE of 20.5%. Our results are thanks to our teams that work diligently with deep capability and a long track record of experience to earn these results. Broadly speaking, the P&C environment remains excellent, and opportunities for attractive returns are plentiful even as competition normalizes. The duration and breadth of the current hard market over the last several years has been exceptional, and while rate increases are broadly above trend, disciplined underwriting requires that we keep our eye on the primary goal, shareholder returns. An overly aggressive appetite for growth could come at a cost of eroding underwriting margins. The art of underwriting in this part of the cycle rests on one's ability to know how hard to push and when to pull back. At Arch, we strive to be an active yet disciplined market participant, practicing restraint and patience. We believe that capital allocation is one of our most powerful differentiators. Our priority is to deploy capital into our underwriting units first, where we have the knowledge and experience to better price risk. However, we are always assessing other value-creating opportunities. One example is our previously announced intent to acquire Allianz's U.S. MidCorp and Entertainment businesses. With regulatory approval on MidCorp secured, I'm able to share a few thoughts about the strategic acquisition. The addition of the talented team and their client relationships gives us a greater presence in the U.S. primary middle market while expanding our cycle management toolkit. We will have more to say about the opportunities in the middle market as we integrate our teams. I'll now take a few moments to highlight the performance of our underwriting units this past quarter. Second quarter results from our Property and Casualty segments demonstrate the benefits of our strong leadership throughout the ongoing hard market. The Reinsurance and Insurance segments combined to deliver $475 million of underwriting income and just over $5 billion of gross premium. Reinsurance generated $366 million of underwriting income, despite higher frequency of catastrophic events from secondary perils, both in the U.S. and internationally. Higher premium rates in our diversified book of business enabled us to report excellent underwriting results for the segment, which has built a resilient, stable platform. Due to our view of heightened overall storm risk this year, we chose not to grow our property cat writings at the midyear renewal. We've grown property cat meaningfully over the last few years. But as we learned during the 2002 to 2005 hard market, when there are so many good things happening across the underwriting platform, [why chase] returns and cat exposure at the risk of being unlucky. Property in general is very well priced. We just want to have the right balance across our portfolio. As you have heard from others, casualty lines remain an area of interest that we will continue to monitor as we observe rate increases and ongoing reserve strengthening taking place across the industry. Our Insurance segment contributed $109 million of underwriting income in the quarter. Net written premium growth was 7% this quarter compared to the second quarter a year ago. We meaningfully grew premiums in our programs business and in E&S casualty where rates are improving. In a more competitive market, it's important to be able to quickly reallocate capital to the best relative return opportunities as we have done in the past and remain well equipped to do in future quarters. Our international insurance unit continues to benefit from its position as a lead underwriter at Lloyd's, where a disciplined market is providing attractive growth opportunities in specialty lines. Moving on to P&C and into our Mortgage business. At the risk of repeating myself, the consistently excellent underwriting income delivered by our Mortgage segment quarter-over-quarter provides significant value for our shareholders by producing a solid base of sustained earnings. MI underwriting has been solid across the industry since 2009, and the current environment is one that rewards the MI companies underwriting the risk. This quarter, the Mortgage segment generated $287 million of underwriting income while increasing new insurance written at the U.S. by 12% from the same quarter a year ago. The delinquency rate at U.S. MI remains low compared to historical norms and the credit quality of our portfolio remains high with policyholders and strong equity positions. We are pleased to have successfully closed our acquisition of RMIC in the second quarter. Although no new business comes with this run-up block is emblematic of our ongoing pursuit of finding profitable opportunities in which we can deploy capital. Primarily due to strong cash flows generated by our underwriting operations, our investments portfolio increased to $37.8 billion, generating $364 million of net investment income in the quarter as higher yields continue to move through our portfolio. The eyes of the world are focused on Paris this week as the Olympics get into full swing. One of the toughest events in the decathlon and all around athletic tests featuring 10 events over a range of disciplines, spread over two days. The decathlon is an incredible physical and mental test that requires maximum performance in every event. At the end of the two days, points for all 10 events are totaled up and the individual with the most points is the winner. Similar to a decathlon, in the dynamic insurance market, the ability to perform at a consistently high level across the enterprise is crucial for long-term success, and Arch is built to excel across a multi-disciplined market. Our capital allocation helps ensure that we can focus on the lines that give us the best chance to score points. The first event in the decathlon is 100-meter sprint, and our ability to get out of the gates quickly at the beginning of this hard market position us to score early. Since then, our P&C and Mortgage teams have been racking up lots of points, adding our investments team clearing the bar in the pole vault, and we have an all-around performance that puts us in serious contention for the gold medal, as you would expect from a world-class leadership team. Before I hand it over to Francois, I need to mention the passing of our friend, Dinos, this past June. Dinos was not only an industry legend, he was also a mentor and tremendous leader who steered this company for over 15 years. Dinos led these earnings calls with his keen insights, principle beliefs and trademark humor. He was truly one of a kind. So tonight, please raise a glass, be it Ouzo or Retsina or anything of your choosing to Dinos. You are missed my friend. Francois?
Francois Morin: Thank you, Marc, and good morning to all. As you know by now, we reported excellent second quarter results last night with after-tax operating income of $2.57 per share, up 34% from the second quarter of 2023 for an annualized operating return on average common equity of 20.5%. Book value per share was $52.75 as of June 30, up 6.9% for the quarter and 12.4% on a year-to-date basis. Once again, our three business segments delivered outstanding results, highlighted by $762 million in underwriting income and a 78.7% combined ratio, 76.7% on an underlying ex cat accident year basis. We continue to benefit from strong market conditions across our businesses as the pricing environment remains disciplined, giving us confidence in our ability to generate solid returns over the coming quarters. Our underwriting income reflected $124 million of favorable prior development on a pretax basis or 3.5 points on the combined ratio across our three segments. We recognize favorable development across many lines of business, but primarily in short tail lines in our Property and Casualty segments and in Mortgage due to strong cure activity. Catastrophe loss activity was in line with our expectations as we were impacted by a series of events across the globe, generating current accident year catastrophe losses of $196 million for the group in the quarter. Approximately 70% of our catastrophe losses this quarter are related to U.S. secondary perils with the rest coming from a series of international events. As of July 1, our peak zone natural cat PML for a single event one-in-250-year return level on a net basis declined slightly and now stands at 7.9% of tangible shareholders' equity, well below our internal limits. For the Mortgage segment, since this is the first quarter end since we acquired RMIC Companies, Inc. and the subsidiaries that together comprised a runoff mortgage insurance business of Old Republic, there are certain items that I'd like to highlight. First, the acquired book of business represented $3.6 billion or a 1.2% increase to our U.S. primary mortgage insurance in force at the end of the quarter. Second, given the risk and forces from older vintages and has been in runoff since 2011, its makeup resulted in an incremental 19 basis points to our reported delinquency rate at U.S. MI. Absent this transaction, our reported delinquency rate would have improved slightly since last quarter. On the investment front, we earned a combined $531 million pretax from net investment income and income from funds accounted using the equity method or $1.39 per share. Total return for the portfolio came in at 1.33% for the quarter. Cash flow from operations remained strong. And a $3.1 billion on a year-to-date basis, we have seen material growth in our investable asset base, which should result in an increasing level of investment income. Our effective tax rate on a pretax operating income was an expense of 9.5% for the second quarter, with our current expected range of 9% to 11% for the full-year 2024. As disclosed last week, we now expect an August 1 close of the transaction to acquire the U.S. MidCorp and Entertainment insurance businesses from Allianz. At this time, we do not have new information to share on the estimated financial impact of the transaction beyond what we provided in early April. Starting next quarter, we expect to update this information to help in developing a forward-looking view of the insurance segment's results, including this new business. All in, our balance sheet is in excellent health with our common shareholders' equity approaching $20 billion, a net debt plus preferred to capital ratio was slightly above 15%. We are well positioned to take advantage of opportunities that may arise as we move forward. Before I conclude my remarks, I also wanted to take a moment to build on Marc's comments and share a word of sincere appreciation for the impact Dinos had on Arch, its employees and many others across the industry. While he will certainly be remembered for his energetic personality and his ability to captivate an audience, we are truly grateful for his guidance, vision and leadership during his career at Arch. Thank you, Dinos. Marc?
Marc Grandisson: Now, so we don't keep anyone from their lunch, which we know is very important to Dinos. Onto your questions.
Operator: Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan from Wells Fargo.
Elyse Greenspan: Hi, thanks. Good morning. My first question, I guess, is on the insurance side, right? Marc, I think it's been since probably late October of last year with Q3 earnings, you were kind of leading the industry in terms of talking about this casualty market turn. And it's been slow to evolve, maybe it's in line with your expectations, but it just seems it's been slow to get price through those lines. How do you see that transpiring from here relative to price increases in casualty lines?
Marc Grandisson: Well, like I said – well, good morning, Elyse. I think the point we made last quarter, the quarter before is that the casualty turn and realizing actually how much well or bad you're doing in casualty line takes a while. It has a tail to it. It could take five or six years. So I think we're seeing the – we start to see the early signs of more recent years being a bit more impacted by the inflation that we saw of late. And I think that it will take a while. People are trying to adjust. We're trying to look at the numbers in the triangles that are actually not as good as they used to be. So there's a lot of uncertainty in the space. And I think it will take us several quarters to come to a more stable or a better view of the industry. So the last hard market in casualty started to turn in 2000. And it took until about 2004 to really see the impact and sort of running out of – having to price and rate increase after that point. So it takes several years. Unlike the property cat right at least 2022 something happened at the bottom in the fall, will right away that people are adjusting because the cost of goods sold or losses are known. So this is not surprising to me. I'm expecting a bit more – we're expecting a bit more. We're seeing it through our reinsurance emissions. I think people are slowly, but surely recognizing some of these bad years, but it takes a while.
Elyse Greenspan: And then in terms of just on the insurance side, as you think the underlying, I guess, margin, right, kind of low 90s in the quarter, given your views about price and loss trend, does that feel like kind of the run rate level from here?
Marc Grandisson: Well, as you know, Elyse, we report the numbers as we see it based on the data that we see. That sort of seems to be the emerging sort of rough average over the last couple of years. There's also a mix going on, Elyse. So things are shifting, as you know, from time to time. So it's hard to compare combined ratio. But right now, based on where we are, it's well within the expectation of getting the returns. And our returns on insurance, we believe are in excess of our long-term target.
Elyse Greenspan: And then the mortgage releases have held steady, Q2 was above the Q1 level. Can you just provide, Francois, maybe a little bit more color on what's going on there and how we could kind of think about run rate level of potential releases within the MI book?
Francois Morin: Great question. I think – I mean, I and many others have been wrong about taking a forward-looking view of releases on – or favorable development on mortgage in general. I think, right, stepping back, I'd say that early in 2020 – late 2022, early 2023, we are more cautious about the state of the economy and took a view about new notices and average reserves that we are attaching to these notices that was a bit more that didn't turn out to be the case, right? They turnout to be better than what we had expected at that time. The fact that we just had another quarter of more – better cure activity. I don't think a lot of these cures this quarter were related to the 2023 accident year. So we're more positive, I think, I'd say in general about the housing market. So the level of reserving that we're attaching to the new delinquencies is a bit lower than it was a year ago. So maybe directionally, we would not expect to have the same level of reserve releases going forward. But again, not knowing for sure how quickly people are going to cure unemployment, et cetera, I mean, that will be – that will have an impact on the level of reserve releases.
Elyse Greenspan: Thanks for the color.
Francois Morin: Welcome.
Operator: Our next question comes from the line of Jimmy Bhullar from JPMorgan.
Jamminder Bhullar: Hi. So first, just a question on reserves. You had favorable development overall, and so did many of your peers. But a lot of the competitors had adverse development in casualty for both older and recent years. It doesn't seem like you had that, but maybe you could go into detail a little bit on the development in the second quarter. And then also, why do you feel that you're not as susceptible as some of the competitors do all the casualty issues, either in your book or maybe in the Watford block that you inherited?
Francois Morin: Yes. Let me take a stab on that. I'm sure Marc will have something to add. I'd say on the part two your question, Jimmy, I'd say the book of business that we have is – I wouldn't call it a standard commercial general liability book of business that some other competitors have. We don't write a whole lot of commercial auto, for example. So that's another line of business that's been a difficult line to get a good handle on the trends and how inflation has picked up in there. So the books that we have in general liability, a, I think, are smaller. Certainly, we think, underweight in those lines of business. Roughly speaking, our insurance book is like, call it, less than 15% what we consider to be of our overall premium, what we consider to be traditional casualty in the GL lines of business. So the mix matters. Certainly, the areas where we write, the business matters. I mean we have an international book within that. So it's not only U.S. where I think we've seen more pain. And then in terms of the favorable – the movements in the quarter, I think, yes, in aggregate, we were favorable, mostly in the short-tail lines. On the longer tail lines, which is primarily GL, I think we were pretty flat. I think it's something we look at carefully. Some noise here and there. But collectively, in aggregate, we're very comfortable with the level of reserves. And so far, our numbers are holding up pretty well.
Marc Grandisson: And what I would add to what Francois just said, and as you know, Jimmy, we're a cycle manager. We also didn't write as much in even the year that we believe are now still very soft year. So that also prevents you from having to – to having outsized no surprise.
Jamminder Bhullar: Okay. And then on a different topic, your capital is building up pretty nicely, and I'm assuming it's enough to fund your growth. And you have done a couple of acquisitions. But how do you think about buybacks or potentially instituting a dividend, given the capital levels that you have?
Francois Morin: Yes. I mean that – the philosophy has not changed, right? I'd say, certainly, we are on track to close the Allianz acquisition tomorrow, so that will certainly be a draw on that capital base that we have. We are also entering the active wind season, so we'll want to take a look at what – how that develops. But absolutely, going forward, the fact that we historically have been very – I think, very good stewards of capital, we like to deploy it in the business where we can. But if there are no opportunities beyond what we – what's in front of us, in the coming months, we'll do what we've always done is return that capital, and it could be in the form of share buybacks or dividends or any other method.
Jamminder Bhullar: Thank you.
Operator: Our next question comes from Josh Shanker from Bank of America.
Joshua Shanker: Yes, thank you very much. So Marc, sometime in the past, I think one thing you said to me was that the big surprise was from the hard market of 2024 that pricing stayed good for a lot longer than we thought it would, and we pulled back too early. I mean, clearly, you're not pulling back here, but the growth has decelerated a great deal. Given that you have that 2020 hindsight, how are you looking at this market opportunity and how long it might last compared with what you know from the past?
Marc Grandisson: Yes. Well, first, Josh, is I'd probably raised my memory what we did wrong in 2004 and 2005, but thanks for reminding me. What I would tell you, Josh, is we talk about this at underwriting meetings. Our underwriters and our underwriting executives are acutely aware of that phenomenon. We also have to remind ourselves that pricing is going up as we talked about, specifically non-casualty, which seems to be the more acute area. I think it will take a longer time to go down or it takes longer to take down, right. It goes up in an elevator and goes on an escalator. So that's probably why we would expect the market to be. I think we're aware of this. Now we have more data, we have more experience, we have an existing platform, underwriters. Many of them have been there through those years. So very confident that we will be more judicious, if you will, in terms of holding the line when the market gets a little bit softer. In terms of growth, we still have like close to 11% growth in P&C, which is a big feat. It's still – it's a very, very good growth. But as I said in my comments, and you probably heard already, Josh, the market is a little bit more reaching equilibrium in terms of supply and demand for the risk. So the question that we have to ask ourselves all the time is, if we push too hard, we might dilute the broader margin and return expectations in the marketplace. So we take this. And not only us, by the way, I think the market is broadly very, very widely behaving the same way. People want to make sure that they get it right and nobody wants to be the first one running out and doing something that will probably jeopardize or not jeopardize, but maybe take down the returns expectations. So it's just that kind of the market, Josh. The equilibrium on the supply and demand for capacity is just coming back more to a more normal level. It's still on the side of the underwriters, but it's clearly moving in a more equilibrium state.
Joshua Shanker: And then continuing on the thought [indiscernible] Jimmy asked. I have a very crude capital model, and I wouldn't recommend anyone else use it. But it does seem like at the pace that the premium is decelerating, you're going to be sitting on some sizable excess capital in a fairly short order. Can you – I guess, talk a little bit about how the Allianz transaction uses capital that might be incorrect? My assumption that it may be – that may be a source that's really causing capital plug there. Or additionally, am I correct that you have at the kind of trajectory, a real capital buildup that's going to need to be utilized in short order?
Francois Morin: Well, I mean, first, on the Allianz transaction, we disclosed that we were – the rough numbers of capital that we were going to deploy in that transaction is $1.8 billion, which is the premium we're paying to acquire the asset and also the capital that we need to deploy to support the LPT that's coming our way immediately and then the ramp-up of the new business or the renewals that will end up on our balance sheet. So sizable number. And that is so far – I mean, as far as we know, I mean, there's – things are on track to be kind of at that level. To your point, yes, we – I mean, returns have been excellent, and we're very – we're proud of that. But we're not going to accumulate capital just that we can't deploy forever. So the reality is if you give us another couple of quarters maybe, but I mean, we'll definitely have a better view of where things stand by later this year. And then Marc has been talking about the casualty can pick up potentially. So if that accelerates in the third and fourth quarters and early next year, then we want to have the capital ready to deploy there. So that's certainly how we think about a big picture, but it's an ongoing discussion we have here.
Joshua Shanker: All right. Thank you for the answers. Have a good day.
Marc Grandisson: Thanks, you too.
Operator: Our next question comes from Michael Zaremski from BMO.
Michael Zaremski: Thanks. I'll keep with the theme on casualty and social inflation, especially since we do value your thoughts on this. I guess, can you remind us, two part, I believe you've said in the past that Arch's casualty reserve reviews are more geared towards the summer months. And related, now that you've been studying your book and the industry a little bit more. I recall last year, not just – and Marc, you had said, but others have said too that they thought that the casualty pressures would be more large accounts kind of than small accounts. But the data we see so far appears to be that the small account players have really added to the reserves more so. So I don't know if there's any thoughts there? Thanks.
Marc Grandisson: I'll start with the second part of your question. You're exactly right. I think that I said that the large accounts, there are at the ground zero for pressure points on the losses because they're deeper pockets, right? They are larger limits, bigger enterprises, more complex cases and more attractive to the plaintiff lawyers. But you're right, we've seen, as well as everyone else, pressure building commercial auto as well, even of all sizes also going through a similar process. And it impacts, obviously, the umbrella portfolio. But you're quite right. We're sort of a second round sort of the rippling effect starting in ground zero, which is always a larger account, and it's sort of slowly, but surely ripples through the market, and we're starting to see this impact on the smaller packages as well. Smaller policies as well have lower limits. So it's probably easier – well, it seems to be currently in the space, you heard this too, I'm sure, the $1 million limit is what it used to be. So there's probably more of a pressure to pay the full limit as opposed to before maybe the industry was more willing to fight or push back. But again, the $1 million because of all the inflation has changed. In terms of reserve review, I'll say it, but we do a quarterly review of our reserving of every line of business that we do. Our actuaries review it every single time. And we have a change of loss ratio that we get reported on every line of business and sub-line quarterly for all the units that we look at. The one thing that we have as an added benefit at Arch is we have also – we have the insurance group and the reinsurance company, so we're able to compare at the high level of the holding company, Francois and I, as to what the trends are developing and what they're looking like. So it's a constant – I think what we used – what we may have said to you is we used to do an annual trend analysis. Now it's becoming a twice-a-year analysis, and it might accelerate as well. And I would assume that most people are using the same frequency because as we talk about all the time, reserving feed into pricing.
Francois Morin: Yes. The one quick thing just to add on reserving, we monitor actual versus expected experience quarterly. That's a big part of the process. And not only do we do it against our own expectations but we monitor against our external actuaries expectations. So we got two views of how independent groups of actuaries think business or the reserves should develop over time. And that certainly informs the action we take every quarter. And to Marc's point, that's done in all the business units regularly.
Michael Zaremski: Okay. That's helpful. Understood. And just last quickly on catastrophe levels. I think you guys are more open than others on "normal." The Reinsurance segment cat ratio – the load ratio this quarter, is that kind of normal-ish since you guys have grown into property over the years?
Marc Grandisson: I think – yes. No, I think – no, again, repeating what we said before, and it's always hard to appreciate from your perspective, I'm sure, is that the Reinsurance has more volatility into it. So we tend to look at this on a longer-term average. So sometimes, we have a quarter – I remind everyone here, sometimes we have a quarter where the combined – the current accident year, ex-cap combined ratio and reinsurance goes up a little bit and people say it's a trend, but it's very hard to see this in Reinsurance. Sometimes it's above, sometimes it's below. I think this quarter, frankly, we had no lower attritional losses across the Reinsurance portfolio. And this is what – this what explains that. But if you look on a 12-month basis, it's not as drastic of a move.
Francois Morin: Yes. I'd add to that also, the cat load that we reported or we kind of quoted earlier this year, I mean, we have a view on seasonality when these losses may or may not hit. I mean it's imprecise. Does it happen second quarter? Does it happen third quarter? It's a little bit of a – there's historical data to support that. But big picture, again, what we experienced this quarter was not unexpected. Was not – it was very much within what we thought was reasonable given the growth in the size of the book, the fact that it's broader, it's not only U.S., a lot of international and the different types of exposures that we reinsure primarily, yes.
Michael Zaremski: Okay. That's helpful. And I'll sneak one last quickly on Mortgage just on a macro perspective. Would – if home price appreciation continues at a healthy pace or I guess, resumes at healthy pace with that, is that any factor in kind of the reserve release as maybe it was unexpected? Is there anything there from a very high level we can think about?
Marc Grandisson: Yes, it would, right? Because by virtue of having house price appreciation, you therefore increase your equity in your home. And the equity in the home is by far the lag thereof is a leading indicator as to whether you're going to have a foreclosure or a loss in your policy. And most of the policies, even if you had another 3% to 4%, whatever we're expecting, next year maybe 4.5% of HPA appreciation, the equity were built. And what happens – and it's very simple, right? The reason why equity matters is because, well, if you're running into trouble, the divorce, you're losing your job, you don't want to lose the equity in the home, you can just turn around and sell it to somebody else and then recapture at least a portion, if not all of the equity that you've built into it that something that people will do in and that the healthy market supply and demand market is such that you'll be able to sell your home with – and capture that equity even after some expenses. So that's what happens on HPA. If it goes too wild like it did in 2007, 2008, but it got into trouble for different reasons altogether. I think the credit space and the weighted mortgages have been originated over the last several years. HPA going up right now would be helpful. It's definitely helpful for us as an MI provider.
Michael Zaremski: Thank you.
Marc Grandisson: Sure.
Operator: Our next question comes from David Motemaden from Evercore.
David Motemaden: Good morning. I had a question on the underlying loss ratio in the insurance business. It was up a little bit year-over-year. That's despite having a higher mix of short tail business within the earned premium mix. Could you maybe talk about what was driving the loss ratio up year-on-year? And was that conservatism you guys are baking in on the casualty lines? Or a little bit of color there would be helpful?
Marc Grandisson: Yes. It's a pretty small increase. And this is – we don't want to ascribe any more precision to those numbers. They're judgment call quite often times. I think it's just a reflection of the mix and perhaps one on the business, the actuaries may take a little bit more of a conservative or a prudent stance and put a bit more – increase the loss ratio for a certain year or certain line of business or product line. That's really all there is to it. I think the variability around this even on an insurance level, we're a specialty writer. So there's a lot of things going on all at once in our portfolio. It's not very – it's not as predictive, I guess, as we wish we could be. But this is also why we believe we can attract higher returns because there's a lot more uncertainty in selecting the loss ratio pick. I would just attribute it to noise that happens from time to time as well as mix. Francois, anything to add?
Francois Morin: Good. Yes.
David Motemaden: Great. Thanks. And then Francois, you had mentioned the actual to expected. Wondering if we could just get a little bit more color on that for the quarter? And then if you guys have changed your view of expected losses, just given it appears like claims payment patterns have been extending. So I'm wondering if that's been reflected as well in your expected – expectations?
Francois Morin: Yes. I think the A versus C work, it's done by line, by year. So yes, there's pockets where – I mean, it's puts and takes, right. There's some that we run favorable, some that there could be a year for when claim shows up and it's going to show adverse. But both quarter-to-date and year-to-date, in aggregate, both by segment, we are running ahead of expectations, which we didn't take the full credit for that. Some of that favorable experience is showing up in their actually favorable prior year development. But the indications are giving us a lot of comfort that our reserve base and our reserve levels are adequate to pay the claims. Absolutely, your question on patterns, that is – I mean, there's a good attempt – good-faith attempt to adjust the patterns with the experience that we have. Again, both internally and the advice or the opinions we get from external actuaries. So that's factored into the expectations that claims may be – may take longer to develop. And we understand that it's an evolving situation. I mean that seems that the patterns are changing over time, but that is fully kind of considered in those numbers.
David Motemaden: Great. Thank you.
Marc Grandisson: Welcome.
Operator: Our next question comes from Charlie Lederer with Citigroup.
Charles Lederer: Hey. Thanks. Good morning. Definitely, I heard Marc's comments on the reasons for the flattening out of property cat growth. Would you say the weather forecast had an impact on that? And could you – could we see you reverse course and reaccelerate if pricing is still good in 1/1 and you have a better view of how much of the MidCorp business you're keeping?
Marc Grandisson: I'm going to say this is one of the easiest answer, yes and yes to both of your questions, yes and yes. Yes, yes, we believe we took a conviction that there was a heightened – higher likelihood of frequency of events. And you're right, and it could change. This will be a short-term perspective, and this will help inform whatever new vision or new projection and new belief we have will help us make a decision as we get into 1/1 2025 after the wind season is over. Mind you, the business is still very good even with our increased frequency. So it's still a very, very good book of business. We just wanted to have the right balance.
Charles Lederer: Got it. Thank you. And then, I guess, I'm wondering if you guys have your arms wrapped around the CrowdStrike cyber event yet. And if you can help us frame what the losses might be? And if you see any impact on the cyber pricing environment coming out of it?
Marc Grandisson: Yes, well, on the CrowdStrike, I mean we're still gathering information on our units, want to figure out what's out there and it's not only the – necessarily the cyber, but there might be some other lines of business. So we're just going through it as we speak. It's still kind of hard to disentangle. I mean some people are claiming some losses. They're not insured. So there's a lot of things going on. I think we tend to agree broadly with the market view that $500 million, $600 million to $1.2 billion. That's sort of – it's still a wide range at this point in time. It's going to take a while to know how it develops. I think I would want to – I mean it's not a big number in terms of loss ratio points for all the premium worldwide for cyber, but it's certainly a reminder that there's risk in the portfolio. And it's early now, we haven't seen them any renewals, but I would expect rates could still go down a little bit, but probably not as fast as they were going down. And people are going to probably take a bit of a more of a pause, if you will, to evaluate what it looks like. It can go either way, right? If CrowdStrike does not create a big loss, that might reinforce to believe that it's not as risky. Although, having that event, which was not malicious, happened out of nowhere, and we were all like out of – unable to work for a day, I think it's a good reminder of people that there's still uncertainty and there's some loss potential there.
Charles Lederer: Thank you.
Marc Grandisson: Welcome.
Operator: Our next question comes from Andrew Kligerman from TD Securities.
Andrew Kligerman: Hey. Thank you. Good morning.
Marc Grandisson: Good morning.
Andrew Kligerman: So I was interested in the net written premium there in professional lines. It looked like you were pretty much flattish this quarter year-over-year at $345 million. Could you share some of the puts and takes? Was public D&O awful lot? Did you see a pickup or a decrease in cyber? What were some of the big lines? And how do they move?
Marc Grandisson: Yes, there's a lot of things in the professional lines. It's kind of hard to disentangle from your perspective. But at a high level, D&O, we're reacting to what's out there. We're still maintaining our positioning. Cyber, we're still making exposure. Rates still go down, so that would go the other way. Health care, we like a lot. So we've grown that book of business. This is within the professional lines. And there's been some re-underwriting of some areas, if you will, at a high level that were not performing as well. So there's a lot of things going on all at once. I think what you're seeing, it was not the 300 – the flattish number is really a sum total of many decisions that were independent from one another. That's really what you can read into this.
Andrew Kligerman: Got it. And along the same lines in reinsurance, property ex catastrophe, it was up quite a bit at $585 million versus $457 million last year. What did you like in the property area in reinsurance?
Marc Grandisson: Well, it's – in there, there's a lot of different lines, but there's a lot of quota share, some risk excess. We also have a facultative book in there as well. And all these units are taking advantage of the hard market still to this day and picking their spots. And we think the return expectations is not as cat exposed within – there is some cat exposure there, obviously. But we believe the returns are just very, very accretive and very, very favorable. Some of them are opportunistic by nature, right? We might be doing a specific deal in some specific payroll because we think the market is hard as we speak. So some of that was also factored in our writing. So it's a really broad line of business. As you can see, we love that line. We love the opportunities there. It's a little bit more complicated, I would say, to underwrite than a property cat – pure property cat book of business, but we've had the expertise and the knowledge and the willingness to do this for a long time, and we're – we really like to – we'd like to be exposed and do more of that line of business in that current return expectations.
Francois Morin: Yes. And I'll add to that quickly. Just on the accounting side, it's important to remember that the property cat line of business is mostly on an XOL basis where we write all the premium on day one versus this property other than property cat line where the component that is on a quota share basis, the premium is written evenly throughout the exposure period. So they could very well be – there's accounts that we wrote at 1/1, for example, that the ramp-up of that premium is taking place over the four quarters of 2024 as we write the premium. So a little bit of a different kind of accounting policy on those types of reinsurance agreements, and that certainly has an impact on how it shows up in the quarterly numbers.
Andrew Kligerman: Got it. And if I could just sneak one quick one in on the insurance line, the expense ratio picked up by 70 basis points. Should we be thinking about the expense ratio being slightly more elevated as you take on the Allianz book and invest there?
Francois Morin: Well, the investments that we made through this quarter are not related to that, right? So they are other opportunities, other efforts that we have underway that were predictive analytics, some tech companies that we've invested in. So we feel it's the right time for us to make those investments given how strong the returns are. And we'll see how those develop over time, maybe they slow down the road. But for now, we're very comfortable with the level of investments we're making. In terms of Allianz, just we'll give you more information as we move forward, but there will certainly be some integration expenses that will come through in the insurance segment, specifically going forward. Some of those expenses that will be kind of onetime, and we'll probably report those as part of a transaction cost and others. So that will clarify that for everybody once we close and after we have a time to – some time to digest it. But yes, the investments so far this quarter are for other initiatives.
Andrew Kligerman: Got it. Thank you.
Marc Grandisson: Welcome.
Operator: Our next question comes from Brian Meredith from UBS.
Brian Meredith: Yes. Thanks. A couple of them for you guys. The first, I'm just curious, do you all still stand by the three-year payback period for share buyback when it comes to book value dilution?
Francois Morin: That has been our practice. It's not a hard and fast rule. I think it's been the practice historically. But again, that's part of the framework of how we evaluate kind of various alternatives. Could we think about extending the payback at some point? And the answer is maybe.
Brian Meredith: Got you. That's helpful. Thank you. And then, I guess, my next question, thinking about M&A here, it looks like you probably have the financial capacity to still do a reasonable amount of M&A. But do you have the kind of, call it, management and strategic – or call it, management capacity at this point as you're integrating the Allianz business or Fireman's Fund business over the next, call it, six to 12 months to do anything? You're going to kind of take a pause here for a while?
Marc Grandisson: Well, I think, Brian, it's also dependent on the opportunity that we have ahead of us, and we can certainly attract people to help us do any other integration. We have a team between us leading the effort on Allianz also were instrumental in integrating guaranteed way back in 2017, 2018. So we have already some good experience there. So I think we have enough bandwidth for what we're doing now quickly. And if something were to happen right, Francois, was really accretive and interesting, we would find a way to do this. I think that we're not there to work at the time. If something is very favorable to us, we'll expand the effort and the work that needs to get this done.
Francois Morin: I mean these opportunities were – I mean, actually geography-specific and segment specific. So the Allianz acquisition is purely insurance North America. So that absolutely has taken center stage. But if we were to do some other M&A in other parts of the world in the reinsurance segment, that could be a different team most likely that would contribute.
Brian Meredith: Makes sense. And then one other just quick one. I know you don't give us some numbers on the Allianz thing. But is there any color you can give us with respect to how does it add to your PMLs as we think about it going forward? Just looking at the map you provided us, it looks like there's a decent amount of business in kind of cat-exposed areas?
Francois Morin: Not materially because it's not as much in our peak zone. The book is more diversified, more Midwest, more California, less Florida, which is our peak zone. So in terms of the 1-in-250, marginal impact.
Brian Meredith: Great. Thank you. Appreciate it.
Operator: Our next question comes from Meyer Shields from KBW.
Meyer Shields: Great. Thanks so much. Two quick questions. First, Marc, I think you and Francois both mentioned the elevated frequency predictions for not growing cat premium. Was there any reshaping of the portfolio to move further away from frequency events?
Marc Grandisson: No, I think that if you look at a high level, I think our exposure was – is more stable. It may have grown a little bit even on a gross basis, but what happened is we just shaped it through retrocession purchases. That's really what we did. And that's how we got back to a more reasonable and more acceptable level of PML.
Meyer Shields: Okay. That's helpful. And second, just sort of for the most recent or up-to-date events, as we've seen more capital markets activity comes back – come back and we've seen that being blamed for pressure on public D&O pricing. Are you seeing any inflection that coincides with recovering activity?
Marc Grandisson: Not really. I mean the third-party capital that we hear – again, even those third parties, there's a healthy level of rationality in the behavior. So we haven't seen, like I said before, crazy players or mavericks in the marketplace. It's a pretty well-behaved marketplace.
Meyer Shields: Okay. Thank you very much.
Marc Grandisson: Sure, Meyer.
Operator: I'm not showing any further questions. Would you like to proceed with any further remarks?
Marc Grandisson: Thank you very much, everyone. We'll talk to you again in October.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Q2 2024 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the Company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the Company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The Company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the Company's current report on Form 8-K, furnished to the SEC yesterday, which contains the Company's earnings press release and is available on the Company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may now begin."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you, Jericho. Good morning, and welcome to Arch's second quarter earnings call. We are pleased to report another highly profitable quarter due to significant contributions from all three underwriting segments and strong investment results. Our ability to successfully deploy capital into this extended hard market has fueled excellent risk-adjusted returns. Coupling our cycle management strategy with an emphasis on returns and consistent disciplined execution throughout the enterprise resulted in a record $762 million of underwriting income and an annualized operating ROE of 20.5%. Our results are thanks to our teams that work diligently with deep capability and a long track record of experience to earn these results. Broadly speaking, the P&C environment remains excellent, and opportunities for attractive returns are plentiful even as competition normalizes. The duration and breadth of the current hard market over the last several years has been exceptional, and while rate increases are broadly above trend, disciplined underwriting requires that we keep our eye on the primary goal, shareholder returns. An overly aggressive appetite for growth could come at a cost of eroding underwriting margins. The art of underwriting in this part of the cycle rests on one's ability to know how hard to push and when to pull back. At Arch, we strive to be an active yet disciplined market participant, practicing restraint and patience. We believe that capital allocation is one of our most powerful differentiators. Our priority is to deploy capital into our underwriting units first, where we have the knowledge and experience to better price risk. However, we are always assessing other value-creating opportunities. One example is our previously announced intent to acquire Allianz's U.S. MidCorp and Entertainment businesses. With regulatory approval on MidCorp secured, I'm able to share a few thoughts about the strategic acquisition. The addition of the talented team and their client relationships gives us a greater presence in the U.S. primary middle market while expanding our cycle management toolkit. We will have more to say about the opportunities in the middle market as we integrate our teams. I'll now take a few moments to highlight the performance of our underwriting units this past quarter. Second quarter results from our Property and Casualty segments demonstrate the benefits of our strong leadership throughout the ongoing hard market. The Reinsurance and Insurance segments combined to deliver $475 million of underwriting income and just over $5 billion of gross premium. Reinsurance generated $366 million of underwriting income, despite higher frequency of catastrophic events from secondary perils, both in the U.S. and internationally. Higher premium rates in our diversified book of business enabled us to report excellent underwriting results for the segment, which has built a resilient, stable platform. Due to our view of heightened overall storm risk this year, we chose not to grow our property cat writings at the midyear renewal. We've grown property cat meaningfully over the last few years. But as we learned during the 2002 to 2005 hard market, when there are so many good things happening across the underwriting platform, [why chase] returns and cat exposure at the risk of being unlucky. Property in general is very well priced. We just want to have the right balance across our portfolio. As you have heard from others, casualty lines remain an area of interest that we will continue to monitor as we observe rate increases and ongoing reserve strengthening taking place across the industry. Our Insurance segment contributed $109 million of underwriting income in the quarter. Net written premium growth was 7% this quarter compared to the second quarter a year ago. We meaningfully grew premiums in our programs business and in E&S casualty where rates are improving. In a more competitive market, it's important to be able to quickly reallocate capital to the best relative return opportunities as we have done in the past and remain well equipped to do in future quarters. Our international insurance unit continues to benefit from its position as a lead underwriter at Lloyd's, where a disciplined market is providing attractive growth opportunities in specialty lines. Moving on to P&C and into our Mortgage business. At the risk of repeating myself, the consistently excellent underwriting income delivered by our Mortgage segment quarter-over-quarter provides significant value for our shareholders by producing a solid base of sustained earnings. MI underwriting has been solid across the industry since 2009, and the current environment is one that rewards the MI companies underwriting the risk. This quarter, the Mortgage segment generated $287 million of underwriting income while increasing new insurance written at the U.S. by 12% from the same quarter a year ago. The delinquency rate at U.S. MI remains low compared to historical norms and the credit quality of our portfolio remains high with policyholders and strong equity positions. We are pleased to have successfully closed our acquisition of RMIC in the second quarter. Although no new business comes with this run-up block is emblematic of our ongoing pursuit of finding profitable opportunities in which we can deploy capital. Primarily due to strong cash flows generated by our underwriting operations, our investments portfolio increased to $37.8 billion, generating $364 million of net investment income in the quarter as higher yields continue to move through our portfolio. The eyes of the world are focused on Paris this week as the Olympics get into full swing. One of the toughest events in the decathlon and all around athletic tests featuring 10 events over a range of disciplines, spread over two days. The decathlon is an incredible physical and mental test that requires maximum performance in every event. At the end of the two days, points for all 10 events are totaled up and the individual with the most points is the winner. Similar to a decathlon, in the dynamic insurance market, the ability to perform at a consistently high level across the enterprise is crucial for long-term success, and Arch is built to excel across a multi-disciplined market. Our capital allocation helps ensure that we can focus on the lines that give us the best chance to score points. The first event in the decathlon is 100-meter sprint, and our ability to get out of the gates quickly at the beginning of this hard market position us to score early. Since then, our P&C and Mortgage teams have been racking up lots of points, adding our investments team clearing the bar in the pole vault, and we have an all-around performance that puts us in serious contention for the gold medal, as you would expect from a world-class leadership team. Before I hand it over to Francois, I need to mention the passing of our friend, Dinos, this past June. Dinos was not only an industry legend, he was also a mentor and tremendous leader who steered this company for over 15 years. Dinos led these earnings calls with his keen insights, principle beliefs and trademark humor. He was truly one of a kind. So tonight, please raise a glass, be it Ouzo or Retsina or anything of your choosing to Dinos. You are missed my friend. Francois?"
},
{
"speaker": "Francois Morin",
"text": "Thank you, Marc, and good morning to all. As you know by now, we reported excellent second quarter results last night with after-tax operating income of $2.57 per share, up 34% from the second quarter of 2023 for an annualized operating return on average common equity of 20.5%. Book value per share was $52.75 as of June 30, up 6.9% for the quarter and 12.4% on a year-to-date basis. Once again, our three business segments delivered outstanding results, highlighted by $762 million in underwriting income and a 78.7% combined ratio, 76.7% on an underlying ex cat accident year basis. We continue to benefit from strong market conditions across our businesses as the pricing environment remains disciplined, giving us confidence in our ability to generate solid returns over the coming quarters. Our underwriting income reflected $124 million of favorable prior development on a pretax basis or 3.5 points on the combined ratio across our three segments. We recognize favorable development across many lines of business, but primarily in short tail lines in our Property and Casualty segments and in Mortgage due to strong cure activity. Catastrophe loss activity was in line with our expectations as we were impacted by a series of events across the globe, generating current accident year catastrophe losses of $196 million for the group in the quarter. Approximately 70% of our catastrophe losses this quarter are related to U.S. secondary perils with the rest coming from a series of international events. As of July 1, our peak zone natural cat PML for a single event one-in-250-year return level on a net basis declined slightly and now stands at 7.9% of tangible shareholders' equity, well below our internal limits. For the Mortgage segment, since this is the first quarter end since we acquired RMIC Companies, Inc. and the subsidiaries that together comprised a runoff mortgage insurance business of Old Republic, there are certain items that I'd like to highlight. First, the acquired book of business represented $3.6 billion or a 1.2% increase to our U.S. primary mortgage insurance in force at the end of the quarter. Second, given the risk and forces from older vintages and has been in runoff since 2011, its makeup resulted in an incremental 19 basis points to our reported delinquency rate at U.S. MI. Absent this transaction, our reported delinquency rate would have improved slightly since last quarter. On the investment front, we earned a combined $531 million pretax from net investment income and income from funds accounted using the equity method or $1.39 per share. Total return for the portfolio came in at 1.33% for the quarter. Cash flow from operations remained strong. And a $3.1 billion on a year-to-date basis, we have seen material growth in our investable asset base, which should result in an increasing level of investment income. Our effective tax rate on a pretax operating income was an expense of 9.5% for the second quarter, with our current expected range of 9% to 11% for the full-year 2024. As disclosed last week, we now expect an August 1 close of the transaction to acquire the U.S. MidCorp and Entertainment insurance businesses from Allianz. At this time, we do not have new information to share on the estimated financial impact of the transaction beyond what we provided in early April. Starting next quarter, we expect to update this information to help in developing a forward-looking view of the insurance segment's results, including this new business. All in, our balance sheet is in excellent health with our common shareholders' equity approaching $20 billion, a net debt plus preferred to capital ratio was slightly above 15%. We are well positioned to take advantage of opportunities that may arise as we move forward. Before I conclude my remarks, I also wanted to take a moment to build on Marc's comments and share a word of sincere appreciation for the impact Dinos had on Arch, its employees and many others across the industry. While he will certainly be remembered for his energetic personality and his ability to captivate an audience, we are truly grateful for his guidance, vision and leadership during his career at Arch. Thank you, Dinos. Marc?"
},
{
"speaker": "Marc Grandisson",
"text": "Now, so we don't keep anyone from their lunch, which we know is very important to Dinos. Onto your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from Elyse Greenspan from Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi, thanks. Good morning. My first question, I guess, is on the insurance side, right? Marc, I think it's been since probably late October of last year with Q3 earnings, you were kind of leading the industry in terms of talking about this casualty market turn. And it's been slow to evolve, maybe it's in line with your expectations, but it just seems it's been slow to get price through those lines. How do you see that transpiring from here relative to price increases in casualty lines?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, like I said – well, good morning, Elyse. I think the point we made last quarter, the quarter before is that the casualty turn and realizing actually how much well or bad you're doing in casualty line takes a while. It has a tail to it. It could take five or six years. So I think we're seeing the – we start to see the early signs of more recent years being a bit more impacted by the inflation that we saw of late. And I think that it will take a while. People are trying to adjust. We're trying to look at the numbers in the triangles that are actually not as good as they used to be. So there's a lot of uncertainty in the space. And I think it will take us several quarters to come to a more stable or a better view of the industry. So the last hard market in casualty started to turn in 2000. And it took until about 2004 to really see the impact and sort of running out of – having to price and rate increase after that point. So it takes several years. Unlike the property cat right at least 2022 something happened at the bottom in the fall, will right away that people are adjusting because the cost of goods sold or losses are known. So this is not surprising to me. I'm expecting a bit more – we're expecting a bit more. We're seeing it through our reinsurance emissions. I think people are slowly, but surely recognizing some of these bad years, but it takes a while."
},
{
"speaker": "Elyse Greenspan",
"text": "And then in terms of just on the insurance side, as you think the underlying, I guess, margin, right, kind of low 90s in the quarter, given your views about price and loss trend, does that feel like kind of the run rate level from here?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, as you know, Elyse, we report the numbers as we see it based on the data that we see. That sort of seems to be the emerging sort of rough average over the last couple of years. There's also a mix going on, Elyse. So things are shifting, as you know, from time to time. So it's hard to compare combined ratio. But right now, based on where we are, it's well within the expectation of getting the returns. And our returns on insurance, we believe are in excess of our long-term target."
},
{
"speaker": "Elyse Greenspan",
"text": "And then the mortgage releases have held steady, Q2 was above the Q1 level. Can you just provide, Francois, maybe a little bit more color on what's going on there and how we could kind of think about run rate level of potential releases within the MI book?"
},
{
"speaker": "Francois Morin",
"text": "Great question. I think – I mean, I and many others have been wrong about taking a forward-looking view of releases on – or favorable development on mortgage in general. I think, right, stepping back, I'd say that early in 2020 – late 2022, early 2023, we are more cautious about the state of the economy and took a view about new notices and average reserves that we are attaching to these notices that was a bit more that didn't turn out to be the case, right? They turnout to be better than what we had expected at that time. The fact that we just had another quarter of more – better cure activity. I don't think a lot of these cures this quarter were related to the 2023 accident year. So we're more positive, I think, I'd say in general about the housing market. So the level of reserving that we're attaching to the new delinquencies is a bit lower than it was a year ago. So maybe directionally, we would not expect to have the same level of reserve releases going forward. But again, not knowing for sure how quickly people are going to cure unemployment, et cetera, I mean, that will be – that will have an impact on the level of reserve releases."
},
{
"speaker": "Elyse Greenspan",
"text": "Thanks for the color."
},
{
"speaker": "Francois Morin",
"text": "Welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jimmy Bhullar from JPMorgan."
},
{
"speaker": "Jamminder Bhullar",
"text": "Hi. So first, just a question on reserves. You had favorable development overall, and so did many of your peers. But a lot of the competitors had adverse development in casualty for both older and recent years. It doesn't seem like you had that, but maybe you could go into detail a little bit on the development in the second quarter. And then also, why do you feel that you're not as susceptible as some of the competitors do all the casualty issues, either in your book or maybe in the Watford block that you inherited?"
},
{
"speaker": "Francois Morin",
"text": "Yes. Let me take a stab on that. I'm sure Marc will have something to add. I'd say on the part two your question, Jimmy, I'd say the book of business that we have is – I wouldn't call it a standard commercial general liability book of business that some other competitors have. We don't write a whole lot of commercial auto, for example. So that's another line of business that's been a difficult line to get a good handle on the trends and how inflation has picked up in there. So the books that we have in general liability, a, I think, are smaller. Certainly, we think, underweight in those lines of business. Roughly speaking, our insurance book is like, call it, less than 15% what we consider to be of our overall premium, what we consider to be traditional casualty in the GL lines of business. So the mix matters. Certainly, the areas where we write, the business matters. I mean we have an international book within that. So it's not only U.S. where I think we've seen more pain. And then in terms of the favorable – the movements in the quarter, I think, yes, in aggregate, we were favorable, mostly in the short-tail lines. On the longer tail lines, which is primarily GL, I think we were pretty flat. I think it's something we look at carefully. Some noise here and there. But collectively, in aggregate, we're very comfortable with the level of reserves. And so far, our numbers are holding up pretty well."
},
{
"speaker": "Marc Grandisson",
"text": "And what I would add to what Francois just said, and as you know, Jimmy, we're a cycle manager. We also didn't write as much in even the year that we believe are now still very soft year. So that also prevents you from having to – to having outsized no surprise."
},
{
"speaker": "Jamminder Bhullar",
"text": "Okay. And then on a different topic, your capital is building up pretty nicely, and I'm assuming it's enough to fund your growth. And you have done a couple of acquisitions. But how do you think about buybacks or potentially instituting a dividend, given the capital levels that you have?"
},
{
"speaker": "Francois Morin",
"text": "Yes. I mean that – the philosophy has not changed, right? I'd say, certainly, we are on track to close the Allianz acquisition tomorrow, so that will certainly be a draw on that capital base that we have. We are also entering the active wind season, so we'll want to take a look at what – how that develops. But absolutely, going forward, the fact that we historically have been very – I think, very good stewards of capital, we like to deploy it in the business where we can. But if there are no opportunities beyond what we – what's in front of us, in the coming months, we'll do what we've always done is return that capital, and it could be in the form of share buybacks or dividends or any other method."
},
{
"speaker": "Jamminder Bhullar",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Josh Shanker from Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "Yes, thank you very much. So Marc, sometime in the past, I think one thing you said to me was that the big surprise was from the hard market of 2024 that pricing stayed good for a lot longer than we thought it would, and we pulled back too early. I mean, clearly, you're not pulling back here, but the growth has decelerated a great deal. Given that you have that 2020 hindsight, how are you looking at this market opportunity and how long it might last compared with what you know from the past?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. Well, first, Josh, is I'd probably raised my memory what we did wrong in 2004 and 2005, but thanks for reminding me. What I would tell you, Josh, is we talk about this at underwriting meetings. Our underwriters and our underwriting executives are acutely aware of that phenomenon. We also have to remind ourselves that pricing is going up as we talked about, specifically non-casualty, which seems to be the more acute area. I think it will take a longer time to go down or it takes longer to take down, right. It goes up in an elevator and goes on an escalator. So that's probably why we would expect the market to be. I think we're aware of this. Now we have more data, we have more experience, we have an existing platform, underwriters. Many of them have been there through those years. So very confident that we will be more judicious, if you will, in terms of holding the line when the market gets a little bit softer. In terms of growth, we still have like close to 11% growth in P&C, which is a big feat. It's still – it's a very, very good growth. But as I said in my comments, and you probably heard already, Josh, the market is a little bit more reaching equilibrium in terms of supply and demand for the risk. So the question that we have to ask ourselves all the time is, if we push too hard, we might dilute the broader margin and return expectations in the marketplace. So we take this. And not only us, by the way, I think the market is broadly very, very widely behaving the same way. People want to make sure that they get it right and nobody wants to be the first one running out and doing something that will probably jeopardize or not jeopardize, but maybe take down the returns expectations. So it's just that kind of the market, Josh. The equilibrium on the supply and demand for capacity is just coming back more to a more normal level. It's still on the side of the underwriters, but it's clearly moving in a more equilibrium state."
},
{
"speaker": "Joshua Shanker",
"text": "And then continuing on the thought [indiscernible] Jimmy asked. I have a very crude capital model, and I wouldn't recommend anyone else use it. But it does seem like at the pace that the premium is decelerating, you're going to be sitting on some sizable excess capital in a fairly short order. Can you – I guess, talk a little bit about how the Allianz transaction uses capital that might be incorrect? My assumption that it may be – that may be a source that's really causing capital plug there. Or additionally, am I correct that you have at the kind of trajectory, a real capital buildup that's going to need to be utilized in short order?"
},
{
"speaker": "Francois Morin",
"text": "Well, I mean, first, on the Allianz transaction, we disclosed that we were – the rough numbers of capital that we were going to deploy in that transaction is $1.8 billion, which is the premium we're paying to acquire the asset and also the capital that we need to deploy to support the LPT that's coming our way immediately and then the ramp-up of the new business or the renewals that will end up on our balance sheet. So sizable number. And that is so far – I mean, as far as we know, I mean, there's – things are on track to be kind of at that level. To your point, yes, we – I mean, returns have been excellent, and we're very – we're proud of that. But we're not going to accumulate capital just that we can't deploy forever. So the reality is if you give us another couple of quarters maybe, but I mean, we'll definitely have a better view of where things stand by later this year. And then Marc has been talking about the casualty can pick up potentially. So if that accelerates in the third and fourth quarters and early next year, then we want to have the capital ready to deploy there. So that's certainly how we think about a big picture, but it's an ongoing discussion we have here."
},
{
"speaker": "Joshua Shanker",
"text": "All right. Thank you for the answers. Have a good day."
},
{
"speaker": "Marc Grandisson",
"text": "Thanks, you too."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Zaremski from BMO."
},
{
"speaker": "Michael Zaremski",
"text": "Thanks. I'll keep with the theme on casualty and social inflation, especially since we do value your thoughts on this. I guess, can you remind us, two part, I believe you've said in the past that Arch's casualty reserve reviews are more geared towards the summer months. And related, now that you've been studying your book and the industry a little bit more. I recall last year, not just – and Marc, you had said, but others have said too that they thought that the casualty pressures would be more large accounts kind of than small accounts. But the data we see so far appears to be that the small account players have really added to the reserves more so. So I don't know if there's any thoughts there? Thanks."
},
{
"speaker": "Marc Grandisson",
"text": "I'll start with the second part of your question. You're exactly right. I think that I said that the large accounts, there are at the ground zero for pressure points on the losses because they're deeper pockets, right? They are larger limits, bigger enterprises, more complex cases and more attractive to the plaintiff lawyers. But you're right, we've seen, as well as everyone else, pressure building commercial auto as well, even of all sizes also going through a similar process. And it impacts, obviously, the umbrella portfolio. But you're quite right. We're sort of a second round sort of the rippling effect starting in ground zero, which is always a larger account, and it's sort of slowly, but surely ripples through the market, and we're starting to see this impact on the smaller packages as well. Smaller policies as well have lower limits. So it's probably easier – well, it seems to be currently in the space, you heard this too, I'm sure, the $1 million limit is what it used to be. So there's probably more of a pressure to pay the full limit as opposed to before maybe the industry was more willing to fight or push back. But again, the $1 million because of all the inflation has changed. In terms of reserve review, I'll say it, but we do a quarterly review of our reserving of every line of business that we do. Our actuaries review it every single time. And we have a change of loss ratio that we get reported on every line of business and sub-line quarterly for all the units that we look at. The one thing that we have as an added benefit at Arch is we have also – we have the insurance group and the reinsurance company, so we're able to compare at the high level of the holding company, Francois and I, as to what the trends are developing and what they're looking like. So it's a constant – I think what we used – what we may have said to you is we used to do an annual trend analysis. Now it's becoming a twice-a-year analysis, and it might accelerate as well. And I would assume that most people are using the same frequency because as we talk about all the time, reserving feed into pricing."
},
{
"speaker": "Francois Morin",
"text": "Yes. The one quick thing just to add on reserving, we monitor actual versus expected experience quarterly. That's a big part of the process. And not only do we do it against our own expectations but we monitor against our external actuaries expectations. So we got two views of how independent groups of actuaries think business or the reserves should develop over time. And that certainly informs the action we take every quarter. And to Marc's point, that's done in all the business units regularly."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. That's helpful. Understood. And just last quickly on catastrophe levels. I think you guys are more open than others on \"normal.\" The Reinsurance segment cat ratio – the load ratio this quarter, is that kind of normal-ish since you guys have grown into property over the years?"
},
{
"speaker": "Marc Grandisson",
"text": "I think – yes. No, I think – no, again, repeating what we said before, and it's always hard to appreciate from your perspective, I'm sure, is that the Reinsurance has more volatility into it. So we tend to look at this on a longer-term average. So sometimes, we have a quarter – I remind everyone here, sometimes we have a quarter where the combined – the current accident year, ex-cap combined ratio and reinsurance goes up a little bit and people say it's a trend, but it's very hard to see this in Reinsurance. Sometimes it's above, sometimes it's below. I think this quarter, frankly, we had no lower attritional losses across the Reinsurance portfolio. And this is what – this what explains that. But if you look on a 12-month basis, it's not as drastic of a move."
},
{
"speaker": "Francois Morin",
"text": "Yes. I'd add to that also, the cat load that we reported or we kind of quoted earlier this year, I mean, we have a view on seasonality when these losses may or may not hit. I mean it's imprecise. Does it happen second quarter? Does it happen third quarter? It's a little bit of a – there's historical data to support that. But big picture, again, what we experienced this quarter was not unexpected. Was not – it was very much within what we thought was reasonable given the growth in the size of the book, the fact that it's broader, it's not only U.S., a lot of international and the different types of exposures that we reinsure primarily, yes."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. That's helpful. And I'll sneak one last quickly on Mortgage just on a macro perspective. Would – if home price appreciation continues at a healthy pace or I guess, resumes at healthy pace with that, is that any factor in kind of the reserve release as maybe it was unexpected? Is there anything there from a very high level we can think about?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, it would, right? Because by virtue of having house price appreciation, you therefore increase your equity in your home. And the equity in the home is by far the lag thereof is a leading indicator as to whether you're going to have a foreclosure or a loss in your policy. And most of the policies, even if you had another 3% to 4%, whatever we're expecting, next year maybe 4.5% of HPA appreciation, the equity were built. And what happens – and it's very simple, right? The reason why equity matters is because, well, if you're running into trouble, the divorce, you're losing your job, you don't want to lose the equity in the home, you can just turn around and sell it to somebody else and then recapture at least a portion, if not all of the equity that you've built into it that something that people will do in and that the healthy market supply and demand market is such that you'll be able to sell your home with – and capture that equity even after some expenses. So that's what happens on HPA. If it goes too wild like it did in 2007, 2008, but it got into trouble for different reasons altogether. I think the credit space and the weighted mortgages have been originated over the last several years. HPA going up right now would be helpful. It's definitely helpful for us as an MI provider."
},
{
"speaker": "Michael Zaremski",
"text": "Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Sure."
},
{
"speaker": "Operator",
"text": "Our next question comes from David Motemaden from Evercore."
},
{
"speaker": "David Motemaden",
"text": "Good morning. I had a question on the underlying loss ratio in the insurance business. It was up a little bit year-over-year. That's despite having a higher mix of short tail business within the earned premium mix. Could you maybe talk about what was driving the loss ratio up year-on-year? And was that conservatism you guys are baking in on the casualty lines? Or a little bit of color there would be helpful?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. It's a pretty small increase. And this is – we don't want to ascribe any more precision to those numbers. They're judgment call quite often times. I think it's just a reflection of the mix and perhaps one on the business, the actuaries may take a little bit more of a conservative or a prudent stance and put a bit more – increase the loss ratio for a certain year or certain line of business or product line. That's really all there is to it. I think the variability around this even on an insurance level, we're a specialty writer. So there's a lot of things going on all at once in our portfolio. It's not very – it's not as predictive, I guess, as we wish we could be. But this is also why we believe we can attract higher returns because there's a lot more uncertainty in selecting the loss ratio pick. I would just attribute it to noise that happens from time to time as well as mix. Francois, anything to add?"
},
{
"speaker": "Francois Morin",
"text": "Good. Yes."
},
{
"speaker": "David Motemaden",
"text": "Great. Thanks. And then Francois, you had mentioned the actual to expected. Wondering if we could just get a little bit more color on that for the quarter? And then if you guys have changed your view of expected losses, just given it appears like claims payment patterns have been extending. So I'm wondering if that's been reflected as well in your expected – expectations?"
},
{
"speaker": "Francois Morin",
"text": "Yes. I think the A versus C work, it's done by line, by year. So yes, there's pockets where – I mean, it's puts and takes, right. There's some that we run favorable, some that there could be a year for when claim shows up and it's going to show adverse. But both quarter-to-date and year-to-date, in aggregate, both by segment, we are running ahead of expectations, which we didn't take the full credit for that. Some of that favorable experience is showing up in their actually favorable prior year development. But the indications are giving us a lot of comfort that our reserve base and our reserve levels are adequate to pay the claims. Absolutely, your question on patterns, that is – I mean, there's a good attempt – good-faith attempt to adjust the patterns with the experience that we have. Again, both internally and the advice or the opinions we get from external actuaries. So that's factored into the expectations that claims may be – may take longer to develop. And we understand that it's an evolving situation. I mean that seems that the patterns are changing over time, but that is fully kind of considered in those numbers."
},
{
"speaker": "David Motemaden",
"text": "Great. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from Charlie Lederer with Citigroup."
},
{
"speaker": "Charles Lederer",
"text": "Hey. Thanks. Good morning. Definitely, I heard Marc's comments on the reasons for the flattening out of property cat growth. Would you say the weather forecast had an impact on that? And could you – could we see you reverse course and reaccelerate if pricing is still good in 1/1 and you have a better view of how much of the MidCorp business you're keeping?"
},
{
"speaker": "Marc Grandisson",
"text": "I'm going to say this is one of the easiest answer, yes and yes to both of your questions, yes and yes. Yes, yes, we believe we took a conviction that there was a heightened – higher likelihood of frequency of events. And you're right, and it could change. This will be a short-term perspective, and this will help inform whatever new vision or new projection and new belief we have will help us make a decision as we get into 1/1 2025 after the wind season is over. Mind you, the business is still very good even with our increased frequency. So it's still a very, very good book of business. We just wanted to have the right balance."
},
{
"speaker": "Charles Lederer",
"text": "Got it. Thank you. And then, I guess, I'm wondering if you guys have your arms wrapped around the CrowdStrike cyber event yet. And if you can help us frame what the losses might be? And if you see any impact on the cyber pricing environment coming out of it?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, well, on the CrowdStrike, I mean we're still gathering information on our units, want to figure out what's out there and it's not only the – necessarily the cyber, but there might be some other lines of business. So we're just going through it as we speak. It's still kind of hard to disentangle. I mean some people are claiming some losses. They're not insured. So there's a lot of things going on. I think we tend to agree broadly with the market view that $500 million, $600 million to $1.2 billion. That's sort of – it's still a wide range at this point in time. It's going to take a while to know how it develops. I think I would want to – I mean it's not a big number in terms of loss ratio points for all the premium worldwide for cyber, but it's certainly a reminder that there's risk in the portfolio. And it's early now, we haven't seen them any renewals, but I would expect rates could still go down a little bit, but probably not as fast as they were going down. And people are going to probably take a bit of a more of a pause, if you will, to evaluate what it looks like. It can go either way, right? If CrowdStrike does not create a big loss, that might reinforce to believe that it's not as risky. Although, having that event, which was not malicious, happened out of nowhere, and we were all like out of – unable to work for a day, I think it's a good reminder of people that there's still uncertainty and there's some loss potential there."
},
{
"speaker": "Charles Lederer",
"text": "Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from Andrew Kligerman from TD Securities."
},
{
"speaker": "Andrew Kligerman",
"text": "Hey. Thank you. Good morning."
},
{
"speaker": "Marc Grandisson",
"text": "Good morning."
},
{
"speaker": "Andrew Kligerman",
"text": "So I was interested in the net written premium there in professional lines. It looked like you were pretty much flattish this quarter year-over-year at $345 million. Could you share some of the puts and takes? Was public D&O awful lot? Did you see a pickup or a decrease in cyber? What were some of the big lines? And how do they move?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes, there's a lot of things in the professional lines. It's kind of hard to disentangle from your perspective. But at a high level, D&O, we're reacting to what's out there. We're still maintaining our positioning. Cyber, we're still making exposure. Rates still go down, so that would go the other way. Health care, we like a lot. So we've grown that book of business. This is within the professional lines. And there's been some re-underwriting of some areas, if you will, at a high level that were not performing as well. So there's a lot of things going on all at once. I think what you're seeing, it was not the 300 – the flattish number is really a sum total of many decisions that were independent from one another. That's really what you can read into this."
},
{
"speaker": "Andrew Kligerman",
"text": "Got it. And along the same lines in reinsurance, property ex catastrophe, it was up quite a bit at $585 million versus $457 million last year. What did you like in the property area in reinsurance?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, it's – in there, there's a lot of different lines, but there's a lot of quota share, some risk excess. We also have a facultative book in there as well. And all these units are taking advantage of the hard market still to this day and picking their spots. And we think the return expectations is not as cat exposed within – there is some cat exposure there, obviously. But we believe the returns are just very, very accretive and very, very favorable. Some of them are opportunistic by nature, right? We might be doing a specific deal in some specific payroll because we think the market is hard as we speak. So some of that was also factored in our writing. So it's a really broad line of business. As you can see, we love that line. We love the opportunities there. It's a little bit more complicated, I would say, to underwrite than a property cat – pure property cat book of business, but we've had the expertise and the knowledge and the willingness to do this for a long time, and we're – we really like to – we'd like to be exposed and do more of that line of business in that current return expectations."
},
{
"speaker": "Francois Morin",
"text": "Yes. And I'll add to that quickly. Just on the accounting side, it's important to remember that the property cat line of business is mostly on an XOL basis where we write all the premium on day one versus this property other than property cat line where the component that is on a quota share basis, the premium is written evenly throughout the exposure period. So they could very well be – there's accounts that we wrote at 1/1, for example, that the ramp-up of that premium is taking place over the four quarters of 2024 as we write the premium. So a little bit of a different kind of accounting policy on those types of reinsurance agreements, and that certainly has an impact on how it shows up in the quarterly numbers."
},
{
"speaker": "Andrew Kligerman",
"text": "Got it. And if I could just sneak one quick one in on the insurance line, the expense ratio picked up by 70 basis points. Should we be thinking about the expense ratio being slightly more elevated as you take on the Allianz book and invest there?"
},
{
"speaker": "Francois Morin",
"text": "Well, the investments that we made through this quarter are not related to that, right? So they are other opportunities, other efforts that we have underway that were predictive analytics, some tech companies that we've invested in. So we feel it's the right time for us to make those investments given how strong the returns are. And we'll see how those develop over time, maybe they slow down the road. But for now, we're very comfortable with the level of investments we're making. In terms of Allianz, just we'll give you more information as we move forward, but there will certainly be some integration expenses that will come through in the insurance segment, specifically going forward. Some of those expenses that will be kind of onetime, and we'll probably report those as part of a transaction cost and others. So that will clarify that for everybody once we close and after we have a time to – some time to digest it. But yes, the investments so far this quarter are for other initiatives."
},
{
"speaker": "Andrew Kligerman",
"text": "Got it. Thank you."
},
{
"speaker": "Marc Grandisson",
"text": "Welcome."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brian Meredith from UBS."
},
{
"speaker": "Brian Meredith",
"text": "Yes. Thanks. A couple of them for you guys. The first, I'm just curious, do you all still stand by the three-year payback period for share buyback when it comes to book value dilution?"
},
{
"speaker": "Francois Morin",
"text": "That has been our practice. It's not a hard and fast rule. I think it's been the practice historically. But again, that's part of the framework of how we evaluate kind of various alternatives. Could we think about extending the payback at some point? And the answer is maybe."
},
{
"speaker": "Brian Meredith",
"text": "Got you. That's helpful. Thank you. And then, I guess, my next question, thinking about M&A here, it looks like you probably have the financial capacity to still do a reasonable amount of M&A. But do you have the kind of, call it, management and strategic – or call it, management capacity at this point as you're integrating the Allianz business or Fireman's Fund business over the next, call it, six to 12 months to do anything? You're going to kind of take a pause here for a while?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, I think, Brian, it's also dependent on the opportunity that we have ahead of us, and we can certainly attract people to help us do any other integration. We have a team between us leading the effort on Allianz also were instrumental in integrating guaranteed way back in 2017, 2018. So we have already some good experience there. So I think we have enough bandwidth for what we're doing now quickly. And if something were to happen right, Francois, was really accretive and interesting, we would find a way to do this. I think that we're not there to work at the time. If something is very favorable to us, we'll expand the effort and the work that needs to get this done."
},
{
"speaker": "Francois Morin",
"text": "I mean these opportunities were – I mean, actually geography-specific and segment specific. So the Allianz acquisition is purely insurance North America. So that absolutely has taken center stage. But if we were to do some other M&A in other parts of the world in the reinsurance segment, that could be a different team most likely that would contribute."
},
{
"speaker": "Brian Meredith",
"text": "Makes sense. And then one other just quick one. I know you don't give us some numbers on the Allianz thing. But is there any color you can give us with respect to how does it add to your PMLs as we think about it going forward? Just looking at the map you provided us, it looks like there's a decent amount of business in kind of cat-exposed areas?"
},
{
"speaker": "Francois Morin",
"text": "Not materially because it's not as much in our peak zone. The book is more diversified, more Midwest, more California, less Florida, which is our peak zone. So in terms of the 1-in-250, marginal impact."
},
{
"speaker": "Brian Meredith",
"text": "Great. Thank you. Appreciate it."
},
{
"speaker": "Operator",
"text": "Our next question comes from Meyer Shields from KBW."
},
{
"speaker": "Meyer Shields",
"text": "Great. Thanks so much. Two quick questions. First, Marc, I think you and Francois both mentioned the elevated frequency predictions for not growing cat premium. Was there any reshaping of the portfolio to move further away from frequency events?"
},
{
"speaker": "Marc Grandisson",
"text": "No, I think that if you look at a high level, I think our exposure was – is more stable. It may have grown a little bit even on a gross basis, but what happened is we just shaped it through retrocession purchases. That's really what we did. And that's how we got back to a more reasonable and more acceptable level of PML."
},
{
"speaker": "Meyer Shields",
"text": "Okay. That's helpful. And second, just sort of for the most recent or up-to-date events, as we've seen more capital markets activity comes back – come back and we've seen that being blamed for pressure on public D&O pricing. Are you seeing any inflection that coincides with recovering activity?"
},
{
"speaker": "Marc Grandisson",
"text": "Not really. I mean the third-party capital that we hear – again, even those third parties, there's a healthy level of rationality in the behavior. So we haven't seen, like I said before, crazy players or mavericks in the marketplace. It's a pretty well-behaved marketplace."
},
{
"speaker": "Meyer Shields",
"text": "Okay. Thank you very much."
},
{
"speaker": "Marc Grandisson",
"text": "Sure, Meyer."
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions. Would you like to proceed with any further remarks?"
},
{
"speaker": "Marc Grandisson",
"text": "Thank you very much, everyone. We'll talk to you again in October."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 1 | 2,024 | 2024-04-30 11:00:00 | Operator: Good day, ladies and gentlemen, and welcome to the Q1 2024 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management will also make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K, furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin. Marc Grandisson Thank you. Good morning, and welcome to Arch's First Quarter Earnings Call. We are pleased to report a terrific start to the year. In the first quarter, we posted $736 million in underwriting income and a 5.2% increase in book value per share as we realized the benefits from several years of strong and profitable premium growth. Underwriters in our P&C units continued to lean into hard market conditions, writing $5.6 billion of gross premium in the quarter, a 26% increase from the same quarter last year. Overall, rate changes are exceeding loss trends, and absolute returns remain above our long-term targets, positive indicators in our continued efforts to deliver superior results to our shareholders. Broadly, we are seeing incremental signs of increased underwriting appetite in the market, but this is not surprising, given the favorable conditions that exist. It is still an underwriter's market where Arch can thrive. At the beginning of this hard market, as other providers pull back, Arch sought to establish itself as a key trading partner, aiming to solidify relationships and remain top of mind when it comes to addressing our clients' increased needs. Our success in establishing deeper client connections continues to pay dividends in this extended, yet increasingly competitive hard market. The first quarter served as a reminder of our risky world when an active catastrophe quarter concluded with a major industry loss, as the Dali cargo ship collided with the Francis Scott Key Bridge in Baltimore. Although we recognized a loss related to this event, the virtue of having multiple lines of business with improved and positive expected margins, made this event manageable for Arch. Incidents like this reinforce the importance of our core tenants. One, we practice disciplined underwriting that builds a meaningful margin of safety into our pricing. Two, we take a long-term view of risk and a conservative approach to reserving. And three, we operate a diversified global business that we believe maximizes our total return by mitigating volatility in any one line of business. Capital management has been a key differentiator for Arch and is integral to how we operate our company. Effective capital management requires that we allocate resources to the most profitable underwriting opportunities, while retaining the flexibility to invest in our platform when we find attractive opportunities. One of those prospects came to fruition earlier this month, when we announced our intent to acquire Allianz's US. middle market and entertainment businesses. We see this as a unique opportunity to quickly build scale in the $100 billion-plus US. middle market, a long-term strategic area of underwriting interest for us. Increasing our middle market presence will further diversify our North American insurance platform by adding stable businesses with recurring premiums that can generate attractive returns over the cycle. As a cycle manager, we like having many ponds to fish in, and this acquisition will significantly expand our opportunities in the middle market pond for years to come. I'll now share a few highlights from our segments. As you know, The Property and Casualty market cycle is evolving, but still offers attractive growth opportunities at good returns, particularly for our skilled specialty underwriters, who can use their expertise and experience to differentiate Arch. The first quarter results from our Reinsurance segment were outstanding. Underwriting income for the segment was $379 million, while gross premium written grew by 41% over the same quarter last year. While there is some developing competition, we're observing an increased flight to quality and fully expect to capitalize on that trend as the cycle ages. Our Reinsurance segment is in an enviable position. The in-force book constructed over the last several years is strong and allows us to exercise our underwriting acumen. When opportunities emerge, whether from dislocation in the casualty market or by offering value that others cannot, Arch is there to provide solutions and financial strength to its clients. In our Insurance segment, growth tapered from the highs of the past few years as rate increases slowed and some of the dislocations were met by additional capacity. Overall, conditions remained strong and the market is behaving rationally, two important factors that continue to support growth and strong profit. In the first quarter, we fund growth opportunities in several lines, including Property and Casualty E&S and other specialty lines. Across most of our specialty lines, pricing remains very healthy, and we are able to deploy capital in order to deliver attractive returns above our long-term target of 15%. Like Reinsurance, our Insurance segment has made strong efforts to establish itself as a first-choice provider for its clients, and that manifests in seeing more opportunities. In life, you have to play to win, and in insurance, if you don't see the business, you can't write it. And now let's pivot from P&C to Mortgage, which to borrow from a famous ad campaign just keeps on going and going and going. Our Mortgage segment continues to generate solid underwriting income and risk-adjusted returns from its high-quality portfolio. While Mortgage originations remain tempered by high mortgage interest rates, the persistency of our in-force book remains a healthy 83.6%, while the delinquency rate is near all-time lows. New insurance written is in line with our appetite given market conditions. When the mortgage market picks up again, we're prepared to increase our production. However, if the status quo persists, we're content with our current situation that has extended the duration over which we earn mortgage insurance premium. Competition within the MI industry remains disciplined, which means we are in a good place. Finally, our Investments portfolio grew to $35.9 billion, generating $327 million of net investment income in the quarter. The extraordinary premium growth from our P&C segments continues to increase our float, which provides a significant tailwind to our overall earnings through the next several quarters. In the US, the NFL conducted its annual draft this past weekend. Traditionally, the team that finished last season with the worst record gets the first pick, a chance to select the best college player, while the champions pick last. The player selected with the top picks are expected to be immediate difference makers, even though they are typically selected by a team with multiple deficiencies, making success far from guaranteed. If you're a talented quarterback has nobody to throw the ball to, it can ruin the player's confidence, and the pressure can quickly sabotage a career. Compare this with teams drafting at the end of the round coming off successful seasons with talented rosters in place. They often have the luxury of selecting an excellent player who doesn't need to contribute right away. Instead, these teams select players who can fill a specific short-term role and be given time to grow into a difference maker. Our acquisition of the Allianz MidCorp business is like adding a solid player to a winning team. We already have established all-stars, a winning talent-dense culture in a favorable schedule in the years ahead. Adding the MidCorp team to our diversified franchise makes us better today and tomorrow, and that's a winning proposition. I'll now turn it over to Francois to provide some more color on our financial results from the quarter, and then we'll return to take your questions. Francois?
François Morin: Thank you, Marc, and good morning to all. As you will have seen, we started out 2024 on a very strong note, with after-tax operating income of $2.45 per share for the quarter for an annualized operating return on average common equity of 20.7%. Book value per share was $49.36 as of March 31, up 5.2% for the quarter. Our excellent performance was again the result of outstanding results across our three business segments, highlighted by $736 million in underwriting income. We delivered exceptional net premium written growth across our Reinsurance segment, a 31% increase over the first quarter of 2023, driven by strong business flow in all our lines of business. Growth was also solid for our Insurance segment, 12% after adjusting for the impact of a large nonrecurring transaction we underwrote in the first quarter last year in our warranty and lenders business unit. Overall, the combined ratio from the group came in at an excellent 78.8%. Our underwriting income reflected $126 million of favorable prior year development on a pretax basis or 3.7 points on the combined ratio across our three segments. We observed favorable development across many units, but primarily in short-tail lines in our Property and Casualty segments and in Mortgage due to strong cure activity. The collapse of the Francis Scott Key Bridge in Baltimore last month, has the potential to become the largest insured marine event in history. Both our Insurance and Reinsurance segments were exposed to this disaster, and our current estimates represent an impact of 2.1 and 3.0 points, respectively, on the combined ratio in these segments results this quarter. We note that the losses for this event were reported as non-catastrophe losses in our ratios. Catastrophe loss activity was relatively subdued and below our expectations across our portfolio, with a series of smaller events generating current accident year catastrophe losses of $58 million for the group in the quarter. Overall, our underlying ex cat combined ratio remained excellent with the increase this quarter relative to the last few quarters, mostly due to the Baltimore Bridge collapse. Despite the impact of this event, our current quarter ex cat combined ratio still improved by 1.4 points from a year ago, as a result of earned rate changes above our loss trend in our P&C businesses and lower expense ratios mostly from the growth in our premium base. These benefits were slightly offset by investments we continue to make in people, data and analytics and technology to improve the quality and resilience of our platform going forward. From a modeling perspective, I'd also like to remind everyone that our operating expense ratios are typically at their highest in the first quarter of the year due to seasonality and compensation expenses, including equity-based grants for retirement eligible employees that were made in March. As of April 1, our peak zone natural cat PML for a single event, one in 250-year return level on a net basis remained basically flat from January 1, but declined relative to our capital to 9.0% of tangible shareholders' equity, well below our internal limits. On the Investment front, we earned a combined $426 million pretax from net Investment income and income from funds accounted using the equity method or $1.12 per share. Total return for the portfolio came in at 0.8% for the quarter, reflecting the unrealized losses on the company's fixed income securities, driven by higher interest rates. Our growing Investment portfolio keeps providing meaningful tailwinds to our bottom line and remains of high quality and short duration. We have grown our investable asset base significantly over the last few years, primarily to significant cash flow from operations. This positive result, combined with new money rates near 5%, should support further growth in our Investment income for the foreseeable future. Income from operating affiliates was strong at $55 million. Of note, approximately $14 million of this quarter's income is attributable to the true-up of the deferred tax asset at our operating affiliate Somers in connection with the Bermuda corporate income tax, a nonrecurring item. Our effective tax rate on pretax operating income was an expense of 8.5% for the 2024 first quarter, slightly below our current expected range of 9% to 11% for the full year, mostly as a result of the timing of tax benefits related to equity-based compensation. As regard to our announcement to acquire the US. MidCorp and Entertainment insurance businesses from Allianz, we are making progress in obtaining the necessary regulatory approvals and are targeting a third quarter close for the transaction. At a high level, the agreement is structured around two related contracts. A loss portfolio transfer of loss reserves for years 2016 to 2023 and a new business agreement for business written in 2024 and after. Overall, we expect to deploy approximately $1.4 billion in internal capital resources to support both contracts, in addition to the cash consideration of $450 million. The overall transaction is expected to be moderately accretive to earnings per share and return on equity, starting in 2025. It is important to note that even when reflecting the capital to be deployed for this transaction, our capital base remains strong with a leverage ratio in the mid-teen range. We maintain ample financial resources and remain committed in allocating our capital in the most optimal way for the long-term benefit of our shareholders. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions] Our first question comes from the line of Elyse Greenspan from Wells Fargo.
Elyse Greenspan: Hi, thanks. Good morning. My first question is on the reinsurance market. Marc, I think in your opening comments, you mentioned something about potential dislocation in the casualty market. Are you starting to see casualty market, just opportunities emerge there? I know you've highlighted this, I think, starting in the third quarter of last year. Or is this something that you still think might take a couple of quarters to kind of fully present an opportunity to Arch?
Marc Grandisson: Yes. The casualty market is going through, I wouldn't say repricing, but not re-underwriting as thorough because it has been already getting -- was hard, getting harder for the last several years. We may have some respite in terms of price increase middle of last year. But I think that the development of the prior year, as we all know, has created a little bit more uncertainties, and inflation is not ebbing. So right now, what we're seeing is people still being very, very careful and disciplined in how they underwrite the business, which leads Arch and gives us opportunity to lean into this even more so. We have grown our casualty book of business on the insurance side quite a bit. Our casualty book is E&S, as we all know, and very specialized in specialty. But sorry, I thought there was some technical difficulties here. Elyse, are you still there? I just want to make sure you can hear me.
Elyse Greenspan: Yes, we can hear you.
Marc Grandisson: Okay. Thank you, you. Thank you, you're a trooper. So the casualty market on the insurance side, we're growing, but I think now we're having more opportunities to grow. I think that there's some kind of -- not repricing, but definitely a focus on that line of business on the Insurance side. On the Reinsurance side, I think we're starting to see some of the renewals that came through and anecdotally it's creating a little bit more friction in terms of renewal of the casualty quota share, for instance. So what we expect right now is the early stages. We don't know how long it's going to last and where it's going to go, but there's clearly a psychological belief within the human system and the human interaction in the casualty that people need and know that we need to get more rate to make up for all the risks and potentially some of the misses that we had in the past.
Elyse Greenspan: And then you guys mentioned the middle market opportunity you saw with this Allianz deal. After this transaction, are there other things on the list like when you think about Insurance, Reinsurance, now middle market and Mortgage. Are there other things that you guys think that maybe down the road, you would need or want to potentially add to the platform?
Marc Grandisson: Yes. We have a long list of things we'd like to acquire or have part of our arsenal. We talk about Allianz as an acquisition, and that's an important one and a significant one and a very good one for us. We're very pleased with that one. But what we also would want to tell our shareholders is, as you know, Elyse, we've also added teams along the way. So acquisition, a pure acquisition of a company is not the only thing that we're able to do. We've acquired some teams to do contingency, some more terror and everything in between. So we're always on the lookout. Again, as a cycle manager, Elyse, what you want is as many areas to deploy your capital, depending on the market conditions, creates a much more stable enterprise, much less volatility to the bottom line. And again, the more -- the market cycles are not monolithic, they are in multi phases and multi places. So we also have a little bit of an inside baseball. We -- our executive team is always -- almost every other month -- we have a list, a wish list that I will not share with you on this call, but it's a wish list of things that we know for a fact would be accretive and additive to our diversification of our portfolio, and we're always on the lookout for those. Mid market was on the list. And this is what -- so opportunities met the willingness to do it, and this is where we are.
Operator: Our next question comes from the line of Jimmy Bhullar from JPMorgan Securities, LLC.
Jamminder Bhullar: Hi, good morning. So, just a question on the Baltimore bridge loss that you reported in Insurance and Reinsurance. And I recognize your results were pretty strong overall. But the number seems fairly high that you reported relative to what some of your peers have talked about and also what the industry losses seem to be? So I'm just wondering, I'm assuming most of this is IBNR, but just wondering sort of -- is this because of how much conservatism there was baked into the number? Or maybe the market is underestimating what the losses from the event are eventually going to end up being?
Marc Grandisson: Well, Jimmy, just at a high level, I'll let Francois talk about the reserving level. But we have been a participant in marine liability for quite a while. I used to underwrite the IGA in the Reinsurance group, way back in '02 or '03. This is nothing new to us. We also acquired Barbican in 2019. So we have -- and we have a stronger presence than we ever had in the London market, which, again, is another marine market positioning. So we do also, we do Insurance, Reinsurance and some retro actually. So it's nothing new to us. We like that business quite a bit, made money over the years. The rates and the returns were and are still acceptable. I mean but sometimes a loss occurs. I'm not sure about what the other ones are thinking about. But we definitely think that this is pretty much in line with what we would have expected the market share to be or what we think our presence in the marketplace would be. I'll let Francois talk about...
François Morin: Yes. I mean again, we can't speculate or comment on how others may or may not be reserving for this event. For us, it's not unusual. And I'd say that we've taken a very conservative view of the loss and still a lot to be determined, obviously, in terms of who's going to end up paying for it. But -- and the last point you asked last question is, yes, for us right now, it's all IBNR, I mean we don't really have all the specifics to establish case reserves. So we booked it as IBNR and we'll see how things develop.
Jamminder Bhullar: And then on casualty reserves, your overall development was favorable, but was there any pockets of unfavorable within the overall number? And then if you could talk specifically about how your casualty reserves trended for pre-COVID and post-COVID years?
François Morin: Well, part one of your question, there was really no material development on long-tail casualty lines of business across all years. So both pre-2015 to '19 years and '21 to '23. So we're very comfortable with that. I think our reserves are holding up nicely. And I know there's been some concerns around the more recent years where there's been some signs of adverse in the industry. We're not seeing that. Actually, our metrics or our actuaries are commenting that our actual development is coming in more favorable than expected. Again, very early to declare victory, but that's certainly for us a positive sign, and we'll keep monitoring and see how things develop for the rest of the year.
Operator: Our next question comes from the line of Andrew Kligerman from TD Cowen.
Andrew Kligerman: Hey, thank you and good morning. Marc, you mentioned that the MI market is going and going and going. How do you think about the favorable prior year developments? I mean last year in the first quarter, it was 25 points this year. In the first quarter, it's another 25 points. I mean does that still continue going forward as well?
Marc Grandisson: Well, I don't have a crystal ball for the future. But we're -- like everybody else, we're just on the receiving end of a market that's curing better. The borrower is in good conditions. There are programs on the GSEs that help the borrower staying in their homes. Most of those that even would have a delinquency, as we speak, would have a much lower mortgage rate. So they have a lot of incentive to stay in the home and not having to do anything with it, plus there's a lot of equity being built up in the home. So people have -- are sitting on because, as you know, there's been a significant increase in property valuation over three to 4 years. So everything is really indicating that we have a lot of the alignment between starting from the borrower, all the way to the mortgage insurer and the mortgage origination of the mortgage companies to make sure that the borrowers can make the payment, you can refinance, delay or attach it to a lot of things, a lot of tools and toolbox that weren't there, frankly, in '07 and '08 when the crisis happened. So -- but what does that mean in terms of development, we'll have to see what happens. But again, it's been more favorable than we would have said probably 2, three years ago, and we're just -- when we see the data, we just react to it.
Andrew Kligerman: Pretty amazing stuff. And then my follow-up question is around the Allianz acquisition. And I love your analogy about the NFL draft and picking the high-quality players. Some have criticized Allianz as maybe I'll say they weren't a first round draft choice. So with that, what will Arch be able to do to kind of turn them into a first round type player? I mean I know I've heard about data and analytics, but can that help overnight? So I'd like to know what you're going to do there to really enhance that operation?
Marc Grandisson: Well, there's a lot of things going on. There's a thorough and very complete plan by our unit to first integrate them, making part of our company and our culture. And we'll have to look at everything that we can do to help them out It's an okay, it's okay business, very decent business, but we'll have to make it more of an Arch business, but recognizing some of the cultural differences in the distribution, it's a little bit of a different business. Data analytics is certainly one of them. We also bring to bear. We believe Allianz is a big company and they did a lot of work on this, where we have a strong presence in the US. as well. We also already do some middle market business. So we already have experience in that space. And so we have a -- we have a couple of things, a couple of tricks up our sleeve, if you will, to make it better. I won't go into all the details, obviously, but I think we're pretty excited about what we can do with the asset. And I think like I say all the time, and this is not a comparison with Allianz or us, but truthfully, it adds to the same thing to the Mortgage through UG, they're relatively a bigger piece of our overall enterprise and perhaps they would be in some other company. So that makes it a little bit more exciting and a bit more -- and the willingness from our part, obviously, to invest, right? I'll remind everyone that some of the earnings that we make, we put aside to invest for the future. So we have a lot of things going on, and we're pretty excited.
Operator: Our next question comes from the line of Michael Zaremski from BMO.
Michael Zaremski: Hey, thanks. Good morning. On the Insurance segment, the underlying loss ratio of 57.5%, I know I'm probably just nitpicking. But I heard the commentary about the impact from the Baltimore bridge. But just curious, you've grown into property, which has a lower loss ratio, attritional loss ratio, I believe. So is there anything going on in the mix, that maybe you're putting in more conservatism on the casualty growth or anything we should be thinking about there?
François Morin: Mike, I'd say it's just the nature of the business we're in. I think there's going to be some ebbs and flows. There are going to be some -- I wouldn't call them unusual or unexpected developments. There could be 1 or two claims that surfaced in the quarter. We booked them, we recognized adverse or bad news early on and see how things play out. So there's really nothing to say that we want -- that needs to be highlighted. It's really part of the course. And yes, absolutely, this quarter, it turns out that the ex GAAP kind of underlying loss ratio was up, I'd say, 30 bps. And that's just the reality of the world we're in, and we think it's still an excellent result.
Michael Zaremski: Okay. Got it. Second question is probably a quick one, but you all are kind enough to give us guidance on the cat load in the last quarter. I think you said it was in the 6% to 7% range for -- I believe it's just the premiums ex Mortgage segment. Is that expected to change or maybe be towards the high end of that range on a base case scenario as you kind of continue to lean into the hard market conditions as we think about '24?
François Morin: Well, the comment I made last quarter was -- yes, for the full year on the overall ACGL premium, 6% to 8%. We don't see that changing at this point. I think that was based on our view of how the year had a chance to play out. That's why we gave you a range. We were very happy with the 1/1 renewals. 401s went pretty much as expected and 6/1 so far are holding up nicely. I mean still a little bit of time to go before that gets finalized. But big picture, again, that's the 6% to 8% range for the year in terms of cat load is holding up nicely.
Michael Zaremski: Sorry, is that 6% to 8% on all insurance premiums ex mortgage or just with total company...
François Morin: Total company-wide, ACGL total.
Operator: Our next question comes from the line of Dean Criscitiello from KBW.
Dean Criscitiello: My first question was on the net to gross ratio in reinsurance. I saw that it ticked down about 5 points year-over-year. I was wondering, is that a function of buying more reinsurance? Or is there anything else going on there?
Marc Grandisson: No. I think if you look at the -- it's a good question. If you look at the last 4 or 5 years in the first quarter, you'll see that our net to gross ratio hovers between 65% to 70%. Last quarter last year, it was 70% because we had a larger transaction that came through that was not seated. So it's really just a comparison that's not -- just 1 period comparison is not reflective of what's going on. If you look at the longer term, you look at the 65% to 70%, so nothing changed there.
Dean Criscitiello: Okay. And then the next thing, shifting back to the insurance business, I was a bit surprised to see solid growth within Professional lines given the rate environment there. So can you maybe talk about the market dynamics or the opportunities that you're seeing in that? And is that growth coming from D&O? Or is that within other professional lines?
Marc Grandisson: Yes. So the -- it's -- the thing -- our professional liability has many things into it. It's got a large company, large public company D&O, it's got some smaller private, also has cyber in it and some professional liability like agents and stuff like this, that's more E&O based. I think that the growth is largely attributed to the cyber. Our teams are leaning a little bit more into it, and we've also acquired a couple of more team or developing a team in Europe, there's a big need for what we realize as a need for cyber in Europe, and that's something that we're starting to grow and see more of. And the reason it's grown in cyber is because even though some of the rates, as we all heard, went down slightly, it's still a very, very favorable, we believe, very favorable proposition for us to underwrite. Also it helps us doing other lines of business because it creates value for our clients. It's still a little bit harder to get in terms of coverage. On the D&O, we would have decreases and increases depending on where the rates are or where we see the relative valuation or the profitability of our portfolio. On that note, the rates in D&O went down about 8% in this quarter, not as bad as it was 1.5 years ago. You heard the comments that the SEAs are down. So there's there's still -- we believe there's still a lot of favorable opportunities in that segment as well. We just have to be a little bit more circumspect when we do this.
Operator: Our next question comes from the line of David Motemaden from Evercore ISI.
David Motemaden: Marc, you mentioned in your prepared remarks that you're seeing increased underwriting appetite and developing competition, specifically within Reinsurance. Could you just talk about where you're seeing that, elaborate on that a little bit? And what specific lines you're seeing that in and how you guys are responding to that?
Marc Grandisson: Yes. I think right now, what we're seeing is more a higher appetite, cyber is one of them. That's for sure, Insurance and Reinsurance, that would also -- I mean, can run the gamut, there are many of them. Typically, right now, what we are the lines that are more short-tail in nature. You can see a little bit more willingness to take some more risk from the competition. And how we react to it is, we have many things we do. We typically will tend to first look at the overall [indiscernible] if the rates go down or if the rates stay as is, with the new conditions, you actually price the business as if it's a new piece of business and what kind of return it will get to you. And if it's a little bit not as much -- or not too close for comfort, we might just decrease our participation. And we also might just stay on the clients that we believe have a better chance to really maneuver through that a little bit sideways market, if you will. It's really an underwriters' market at this time.
David Motemaden: Got it. And just within Reinsurance, the underlying margins there were strong and even better, if I exclude the bridge loss. Can you talk about if there is anything in there that would flatter the results? Or is it more just sort of the earn-in of the property, more short-tail lines and these results are fairly sustainable? I guess how should I think about the sustainability of the results on the Reinsurance side?
François Morin: Yes. I mean it's a great market, right? And we've been saying that for a few quarters. I think and we've said it before, I think we encourage you all to look at results on a trailing 12-month basis. I think it's a bit more reliable, I think, less prone to volatility that is sometimes hard to predict. But yes. I mean, we -- and Marc said it. I think the quality of the book that's in force right now is excellent, and we're going to earn that in. But whether how -- was this quarter a little bit better than maybe the long-term run rate? Maybe, we don't know. But again, as you try to look ahead, I'd say more of a trailing 12 month, again, view is probably a bit more reliable.
Operator: Our next question comes from the line of Josh Shanker from Bank of America.
Joshua Shanker: On the other income which doesn't get enough attention, that's Somers and Coface. It was a weak quarter for Coface stock return in 4Q '23, yet the other was quite strong and maybe I'm misunderstanding how to model this, but I bring this up because Coface had an excellent quarter this past 1Q '24. And I'm wondering if that presages a very, very strong other income return for the company as we head into 2Q '24?
François Morin: Yes. So just to be -- make sure we're on the same page, there's a lag, right? So Coface is booked on a one lag -- one quarter lag basis. So what they just reported for Q1 will show up in our Q2 numbers. Somers is on a real-time basis. And as we know, Somers should follow relatively closely the performance of our Reinsurance book because it's effectively [indiscernible] there's some nuances to it. But big picture, that is booked on a real-time basis and should mirror fairly closely our Reinsurance book. But to your point, yes. I mean if Coface reported out a strong Q1, you should see the benefits of that to flow through in our second quarter.
Joshua Shanker: In theory, there should be -- I guess, if you're saying some correlation between Reinsurance segment underwriting income and Somers, which appears in that other line?
François Morin: Correct. Yes. It's not perfectly correlated because it's not the whole segment. It's mostly the Bermuda Reinsurance unit that we -- that they follow. Not the entire business, but big picture is still -- I mean, if the market conditions are good and Reinsurance, the Somers will benefit from that on a similar basis.
Joshua Shanker: And if one other numbers question post the S&P Model, the change from a few months ago, is there any way to think smartly about how much excess capital you think you're sitting on or the possibility if you find other interesting M&A items, the ability to quickly deploy?
François Morin: Yes. I mean that's always an evolving topic, right? I think we are always focused on putting the capital to work in the business where we can. I think we've done a fair amount of that, obviously, this quarter with the Reinsurance growth that we saw. The $1.8 billion that will support the Allianz transaction is another example. We will see how the year plays out. No question that, we're generating significant earnings so that goes to the bottom line. And we'll be patient with it until we can't really find other ways to deploy it. But for the time being, it's -- we're in a really good place in terms of capital and gives us a lot of flexibility.
Operator: Our next question comes from the line of Brian Meredith from UBS.
Brian Meredith: A couple of quick numbers and one big-picture question for you all. The first one, just quickly, on the Allianz deal, is it possible to give us how much cash you're expecting to come in from the, I guess, [indiscernible] net cash position you're expecting...
François Morin: Yes, big picture, it's a $2 billion [indiscernible] with dollar for dollar, right? So we get $2 billion in cash, and we were spending $450 million that goes out back to them for the cash consideration. So net-net, it's $1.5 billion of incremental cash that we will get. And the rest on the new business, then it's, call it, it's the premium flow with as we write that business, that's the overall -- over time, that will be the incremental investment income or invested assets that we will get.
Brian Meredith: That's helpful. Second quick question here. You referenced in your commentary higher contingent commissions on ceded business in your Reinsurance. What exactly is that?
François Morin: A lot of it is third-party capital, right? We -- last year was a very light or a good year for the performance of that book. So some of those agreements, many of them actually pay us a commission that is -- there's a base and then there's a variable aspect to it, then that was kind of a lot -- a large part of that. So that's effectively performance-based commissions on property cat or property business.
Brian Meredith: Makes sense. And then one bigger-picture question here. I'm just curious, on your Reinsurance business, Obviously, during the first quarter, you're getting a lot of [indiscernible] coming in from clients. What are you seeing with respect to reserve development at your clients, right? And how you kind of protect against that and not potentially seeing some of that adverse development that your clients are seeing on your cut of casualty quota share business?
Marc Grandisson: Yes. So I think the -- Francois mentioned the actual is expected, which is sort of consistent in both insurance and reinsurance on the more recent policy or accident year, which having the right starting point means that you don't really have to correct frequently. So I would say that we're not surprised on the Reinsurance about what we see. But as I said earlier, I think there is anecdotally and some heavy -- a lot of more friction, I would say, between Insurance and Reinsurance companies to make sure that people get an agreement as to what the ultimate book is going to be. So we're hearing this going in the marketplace. Of course, we participate in that, but we're not seeing this as being a big issue for us. And the other years that would have been pre-2020 and 2021, I want to remind everyone that we were very defensive. We do not have a whole lot of those premium and those harder-in-developing areas that people are talking about. So I will say that we see opportunities to write more of those, and we expect to see more opportunities to write more of those types of deals this year, but I wouldn't say that we are the most present in those worst years, if you will.
Operator: Our next question comes from the line of Cave Montazeri from Deutsche Bank.
Cave Montazeri: I only have one question today on the Florida market. The total reform implemented over a year ago seems to have had some positive impact on the primary carriers, and Reinsurance capital seems to be coming back. This is a market that you guys know very well. Do you have any color you can share with us on the state of the market in Florida?
Marc Grandisson: No, I think it's -- to your point, some of the adjustments are coming through, but inflation is also picking up. And there's also, as we all hear, there's potentially more activity in the Southeast of the US. in terms of activities and storms. So I think that people are trying to sort out what they will do at this point in time. I think we have already existing relationships that we think will get us a little bit ahead of the game in terms of participating and getting a participation in the marketplace. But bottom line is we expect the Florida market to be well priced and very good from a risk-adjusted basis. Nothing indicates anything else other than that. Even, of course, the -- everything that's been done to take care [indiscernible] and whatever else in between, I think, is helpful. But it's still the largest property cat exposure for everybody around the world. So even if you make some corrections and they have made some corrections, I think we still have a couple of years before we start thinking about having a heavy softening in the market. There might be some here and there, but we still believe the market will be healthy as a reinsurer.
Operator: Our next question comes from the line of Bob Huang from Morgan Stanley.
Bob Jian Huang: Quick question on M&A side. Obviously, you have historically generated very durable underwriting returns, mainly because of cycle management, in my view. Just curious as you move into M&A and diversify your business mix, does that impact your cycle management ability for retention levels when we think about M&A or potential M&A down the road?
Marc Grandisson: No, it doesn't change. I mean cycle management is a core principle of ours. And if anything, we'd like to be able to do -- it's going to be a matter of degree perhaps. Some lines of business have more acute cycle management because they're probably more heavily commoditized. I would expect the cycle management to be much softer in the Allianz and the US. MidCorp business. And that's also what's attractive about it, right, because it creates more stability for the portfolio.
Bob Jian Huang: Got it. No, that's very helpful. And then in that case, when we think about M&A or future M&A, is it the first preference to use the excess capital or excess cash you're generating from this business to do the M&A deals? Or is it more preferable to use some of the stocks given where the valuation is and things of that nature?
François Morin: I mean there's no one answer to that. I think there's always -- I mean, and we talk about M&A, but M&A doesn't happen that often. So there's a size that matters, how much could we need -- would we need to raise in terms of using our own stock? Certainly, in terms of dilution, it's always, we think better to kind of use our cash. But there's many considerations we look at, trying to optimize as best we can all the options. We've got plenty of capacity in raising debt too, if need be. So it's very much a function of each specific circumstance, each specific opportunity. We look at it on its own and go from there.
Bob Jian Huang: Sorry, if I can just have a little bit of clarification on it. Is it fair to say that in that case, cash and debt is more preferable and then equity may be a little bit less or I'm [indiscernible]? So sorry, just maybe a little bit clarification on that.
François Morin: I mean that's been the preference historically. But I mean, again, it's hard to speculate on what could be the next thing. So yes, historically, but things change over time, too.
Operator: Our next question comes from the line of Michael Zaremski from BMO.
Michael Zaremski: Just a quick follow-up. You mentioned fee income earlier. Arch has a lot of diversified sources of income. Is there a way you can update us on kind of what percentage of your earnings maybe last year was derived from these kind of fee income type arrangements at a high level?
François Morin: I mean it's grown over the years, for sure. I think that the difficulty or the reality we face is some of these fees are somewhat -- with the expense -- the revenue we get that has some expenses that go with it, and those are kind of co-mingled with our own internal expenses. So isolating, call it, the margin on those contracts is a little bit kind of cloudy. But yes, it's grown. It's part of what we do. It's part of the leveraging our platform, leveraging our underwriting capabilities, in all our segments, right? All three segments have some fee income that comes into the errors. Obviously, Somers is part of that as well. But yes, it's become a bit more sizable for us.
Operator: Thank you. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks.
Marc Grandisson: Thank you very much for hearing our earnings. Great start of the year. We look forward to seeing you all in July.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen, and welcome to the Q1 2024 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in today's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, investors should review periodic reports that are filed by the company with the SEC from time to time. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management will also make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K, furnished to the SEC yesterday, which contains the company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Marc Grandisson and Mr. Francois Morin. Sirs, you may begin. Marc Grandisson Thank you. Good morning, and welcome to Arch's First Quarter Earnings Call. We are pleased to report a terrific start to the year. In the first quarter, we posted $736 million in underwriting income and a 5.2% increase in book value per share as we realized the benefits from several years of strong and profitable premium growth. Underwriters in our P&C units continued to lean into hard market conditions, writing $5.6 billion of gross premium in the quarter, a 26% increase from the same quarter last year. Overall, rate changes are exceeding loss trends, and absolute returns remain above our long-term targets, positive indicators in our continued efforts to deliver superior results to our shareholders. Broadly, we are seeing incremental signs of increased underwriting appetite in the market, but this is not surprising, given the favorable conditions that exist. It is still an underwriter's market where Arch can thrive. At the beginning of this hard market, as other providers pull back, Arch sought to establish itself as a key trading partner, aiming to solidify relationships and remain top of mind when it comes to addressing our clients' increased needs. Our success in establishing deeper client connections continues to pay dividends in this extended, yet increasingly competitive hard market. The first quarter served as a reminder of our risky world when an active catastrophe quarter concluded with a major industry loss, as the Dali cargo ship collided with the Francis Scott Key Bridge in Baltimore. Although we recognized a loss related to this event, the virtue of having multiple lines of business with improved and positive expected margins, made this event manageable for Arch. Incidents like this reinforce the importance of our core tenants. One, we practice disciplined underwriting that builds a meaningful margin of safety into our pricing. Two, we take a long-term view of risk and a conservative approach to reserving. And three, we operate a diversified global business that we believe maximizes our total return by mitigating volatility in any one line of business. Capital management has been a key differentiator for Arch and is integral to how we operate our company. Effective capital management requires that we allocate resources to the most profitable underwriting opportunities, while retaining the flexibility to invest in our platform when we find attractive opportunities. One of those prospects came to fruition earlier this month, when we announced our intent to acquire Allianz's US. middle market and entertainment businesses. We see this as a unique opportunity to quickly build scale in the $100 billion-plus US. middle market, a long-term strategic area of underwriting interest for us. Increasing our middle market presence will further diversify our North American insurance platform by adding stable businesses with recurring premiums that can generate attractive returns over the cycle. As a cycle manager, we like having many ponds to fish in, and this acquisition will significantly expand our opportunities in the middle market pond for years to come. I'll now share a few highlights from our segments. As you know, The Property and Casualty market cycle is evolving, but still offers attractive growth opportunities at good returns, particularly for our skilled specialty underwriters, who can use their expertise and experience to differentiate Arch. The first quarter results from our Reinsurance segment were outstanding. Underwriting income for the segment was $379 million, while gross premium written grew by 41% over the same quarter last year. While there is some developing competition, we're observing an increased flight to quality and fully expect to capitalize on that trend as the cycle ages. Our Reinsurance segment is in an enviable position. The in-force book constructed over the last several years is strong and allows us to exercise our underwriting acumen. When opportunities emerge, whether from dislocation in the casualty market or by offering value that others cannot, Arch is there to provide solutions and financial strength to its clients. In our Insurance segment, growth tapered from the highs of the past few years as rate increases slowed and some of the dislocations were met by additional capacity. Overall, conditions remained strong and the market is behaving rationally, two important factors that continue to support growth and strong profit. In the first quarter, we fund growth opportunities in several lines, including Property and Casualty E&S and other specialty lines. Across most of our specialty lines, pricing remains very healthy, and we are able to deploy capital in order to deliver attractive returns above our long-term target of 15%. Like Reinsurance, our Insurance segment has made strong efforts to establish itself as a first-choice provider for its clients, and that manifests in seeing more opportunities. In life, you have to play to win, and in insurance, if you don't see the business, you can't write it. And now let's pivot from P&C to Mortgage, which to borrow from a famous ad campaign just keeps on going and going and going. Our Mortgage segment continues to generate solid underwriting income and risk-adjusted returns from its high-quality portfolio. While Mortgage originations remain tempered by high mortgage interest rates, the persistency of our in-force book remains a healthy 83.6%, while the delinquency rate is near all-time lows. New insurance written is in line with our appetite given market conditions. When the mortgage market picks up again, we're prepared to increase our production. However, if the status quo persists, we're content with our current situation that has extended the duration over which we earn mortgage insurance premium. Competition within the MI industry remains disciplined, which means we are in a good place. Finally, our Investments portfolio grew to $35.9 billion, generating $327 million of net investment income in the quarter. The extraordinary premium growth from our P&C segments continues to increase our float, which provides a significant tailwind to our overall earnings through the next several quarters. In the US, the NFL conducted its annual draft this past weekend. Traditionally, the team that finished last season with the worst record gets the first pick, a chance to select the best college player, while the champions pick last. The player selected with the top picks are expected to be immediate difference makers, even though they are typically selected by a team with multiple deficiencies, making success far from guaranteed. If you're a talented quarterback has nobody to throw the ball to, it can ruin the player's confidence, and the pressure can quickly sabotage a career. Compare this with teams drafting at the end of the round coming off successful seasons with talented rosters in place. They often have the luxury of selecting an excellent player who doesn't need to contribute right away. Instead, these teams select players who can fill a specific short-term role and be given time to grow into a difference maker. Our acquisition of the Allianz MidCorp business is like adding a solid player to a winning team. We already have established all-stars, a winning talent-dense culture in a favorable schedule in the years ahead. Adding the MidCorp team to our diversified franchise makes us better today and tomorrow, and that's a winning proposition. I'll now turn it over to Francois to provide some more color on our financial results from the quarter, and then we'll return to take your questions. Francois?"
},
{
"speaker": "François Morin",
"text": "Thank you, Marc, and good morning to all. As you will have seen, we started out 2024 on a very strong note, with after-tax operating income of $2.45 per share for the quarter for an annualized operating return on average common equity of 20.7%. Book value per share was $49.36 as of March 31, up 5.2% for the quarter. Our excellent performance was again the result of outstanding results across our three business segments, highlighted by $736 million in underwriting income. We delivered exceptional net premium written growth across our Reinsurance segment, a 31% increase over the first quarter of 2023, driven by strong business flow in all our lines of business. Growth was also solid for our Insurance segment, 12% after adjusting for the impact of a large nonrecurring transaction we underwrote in the first quarter last year in our warranty and lenders business unit. Overall, the combined ratio from the group came in at an excellent 78.8%. Our underwriting income reflected $126 million of favorable prior year development on a pretax basis or 3.7 points on the combined ratio across our three segments. We observed favorable development across many units, but primarily in short-tail lines in our Property and Casualty segments and in Mortgage due to strong cure activity. The collapse of the Francis Scott Key Bridge in Baltimore last month, has the potential to become the largest insured marine event in history. Both our Insurance and Reinsurance segments were exposed to this disaster, and our current estimates represent an impact of 2.1 and 3.0 points, respectively, on the combined ratio in these segments results this quarter. We note that the losses for this event were reported as non-catastrophe losses in our ratios. Catastrophe loss activity was relatively subdued and below our expectations across our portfolio, with a series of smaller events generating current accident year catastrophe losses of $58 million for the group in the quarter. Overall, our underlying ex cat combined ratio remained excellent with the increase this quarter relative to the last few quarters, mostly due to the Baltimore Bridge collapse. Despite the impact of this event, our current quarter ex cat combined ratio still improved by 1.4 points from a year ago, as a result of earned rate changes above our loss trend in our P&C businesses and lower expense ratios mostly from the growth in our premium base. These benefits were slightly offset by investments we continue to make in people, data and analytics and technology to improve the quality and resilience of our platform going forward. From a modeling perspective, I'd also like to remind everyone that our operating expense ratios are typically at their highest in the first quarter of the year due to seasonality and compensation expenses, including equity-based grants for retirement eligible employees that were made in March. As of April 1, our peak zone natural cat PML for a single event, one in 250-year return level on a net basis remained basically flat from January 1, but declined relative to our capital to 9.0% of tangible shareholders' equity, well below our internal limits. On the Investment front, we earned a combined $426 million pretax from net Investment income and income from funds accounted using the equity method or $1.12 per share. Total return for the portfolio came in at 0.8% for the quarter, reflecting the unrealized losses on the company's fixed income securities, driven by higher interest rates. Our growing Investment portfolio keeps providing meaningful tailwinds to our bottom line and remains of high quality and short duration. We have grown our investable asset base significantly over the last few years, primarily to significant cash flow from operations. This positive result, combined with new money rates near 5%, should support further growth in our Investment income for the foreseeable future. Income from operating affiliates was strong at $55 million. Of note, approximately $14 million of this quarter's income is attributable to the true-up of the deferred tax asset at our operating affiliate Somers in connection with the Bermuda corporate income tax, a nonrecurring item. Our effective tax rate on pretax operating income was an expense of 8.5% for the 2024 first quarter, slightly below our current expected range of 9% to 11% for the full year, mostly as a result of the timing of tax benefits related to equity-based compensation. As regard to our announcement to acquire the US. MidCorp and Entertainment insurance businesses from Allianz, we are making progress in obtaining the necessary regulatory approvals and are targeting a third quarter close for the transaction. At a high level, the agreement is structured around two related contracts. A loss portfolio transfer of loss reserves for years 2016 to 2023 and a new business agreement for business written in 2024 and after. Overall, we expect to deploy approximately $1.4 billion in internal capital resources to support both contracts, in addition to the cash consideration of $450 million. The overall transaction is expected to be moderately accretive to earnings per share and return on equity, starting in 2025. It is important to note that even when reflecting the capital to be deployed for this transaction, our capital base remains strong with a leverage ratio in the mid-teen range. We maintain ample financial resources and remain committed in allocating our capital in the most optimal way for the long-term benefit of our shareholders. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Elyse Greenspan from Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "Hi, thanks. Good morning. My first question is on the reinsurance market. Marc, I think in your opening comments, you mentioned something about potential dislocation in the casualty market. Are you starting to see casualty market, just opportunities emerge there? I know you've highlighted this, I think, starting in the third quarter of last year. Or is this something that you still think might take a couple of quarters to kind of fully present an opportunity to Arch?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. The casualty market is going through, I wouldn't say repricing, but not re-underwriting as thorough because it has been already getting -- was hard, getting harder for the last several years. We may have some respite in terms of price increase middle of last year. But I think that the development of the prior year, as we all know, has created a little bit more uncertainties, and inflation is not ebbing. So right now, what we're seeing is people still being very, very careful and disciplined in how they underwrite the business, which leads Arch and gives us opportunity to lean into this even more so. We have grown our casualty book of business on the insurance side quite a bit. Our casualty book is E&S, as we all know, and very specialized in specialty. But sorry, I thought there was some technical difficulties here. Elyse, are you still there? I just want to make sure you can hear me."
},
{
"speaker": "Elyse Greenspan",
"text": "Yes, we can hear you."
},
{
"speaker": "Marc Grandisson",
"text": "Okay. Thank you, you. Thank you, you're a trooper. So the casualty market on the insurance side, we're growing, but I think now we're having more opportunities to grow. I think that there's some kind of -- not repricing, but definitely a focus on that line of business on the Insurance side. On the Reinsurance side, I think we're starting to see some of the renewals that came through and anecdotally it's creating a little bit more friction in terms of renewal of the casualty quota share, for instance. So what we expect right now is the early stages. We don't know how long it's going to last and where it's going to go, but there's clearly a psychological belief within the human system and the human interaction in the casualty that people need and know that we need to get more rate to make up for all the risks and potentially some of the misses that we had in the past."
},
{
"speaker": "Elyse Greenspan",
"text": "And then you guys mentioned the middle market opportunity you saw with this Allianz deal. After this transaction, are there other things on the list like when you think about Insurance, Reinsurance, now middle market and Mortgage. Are there other things that you guys think that maybe down the road, you would need or want to potentially add to the platform?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. We have a long list of things we'd like to acquire or have part of our arsenal. We talk about Allianz as an acquisition, and that's an important one and a significant one and a very good one for us. We're very pleased with that one. But what we also would want to tell our shareholders is, as you know, Elyse, we've also added teams along the way. So acquisition, a pure acquisition of a company is not the only thing that we're able to do. We've acquired some teams to do contingency, some more terror and everything in between. So we're always on the lookout. Again, as a cycle manager, Elyse, what you want is as many areas to deploy your capital, depending on the market conditions, creates a much more stable enterprise, much less volatility to the bottom line. And again, the more -- the market cycles are not monolithic, they are in multi phases and multi places. So we also have a little bit of an inside baseball. We -- our executive team is always -- almost every other month -- we have a list, a wish list that I will not share with you on this call, but it's a wish list of things that we know for a fact would be accretive and additive to our diversification of our portfolio, and we're always on the lookout for those. Mid market was on the list. And this is what -- so opportunities met the willingness to do it, and this is where we are."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jimmy Bhullar from JPMorgan Securities, LLC."
},
{
"speaker": "Jamminder Bhullar",
"text": "Hi, good morning. So, just a question on the Baltimore bridge loss that you reported in Insurance and Reinsurance. And I recognize your results were pretty strong overall. But the number seems fairly high that you reported relative to what some of your peers have talked about and also what the industry losses seem to be? So I'm just wondering, I'm assuming most of this is IBNR, but just wondering sort of -- is this because of how much conservatism there was baked into the number? Or maybe the market is underestimating what the losses from the event are eventually going to end up being?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, Jimmy, just at a high level, I'll let Francois talk about the reserving level. But we have been a participant in marine liability for quite a while. I used to underwrite the IGA in the Reinsurance group, way back in '02 or '03. This is nothing new to us. We also acquired Barbican in 2019. So we have -- and we have a stronger presence than we ever had in the London market, which, again, is another marine market positioning. So we do also, we do Insurance, Reinsurance and some retro actually. So it's nothing new to us. We like that business quite a bit, made money over the years. The rates and the returns were and are still acceptable. I mean but sometimes a loss occurs. I'm not sure about what the other ones are thinking about. But we definitely think that this is pretty much in line with what we would have expected the market share to be or what we think our presence in the marketplace would be. I'll let Francois talk about..."
},
{
"speaker": "François Morin",
"text": "Yes. I mean again, we can't speculate or comment on how others may or may not be reserving for this event. For us, it's not unusual. And I'd say that we've taken a very conservative view of the loss and still a lot to be determined, obviously, in terms of who's going to end up paying for it. But -- and the last point you asked last question is, yes, for us right now, it's all IBNR, I mean we don't really have all the specifics to establish case reserves. So we booked it as IBNR and we'll see how things develop."
},
{
"speaker": "Jamminder Bhullar",
"text": "And then on casualty reserves, your overall development was favorable, but was there any pockets of unfavorable within the overall number? And then if you could talk specifically about how your casualty reserves trended for pre-COVID and post-COVID years?"
},
{
"speaker": "François Morin",
"text": "Well, part one of your question, there was really no material development on long-tail casualty lines of business across all years. So both pre-2015 to '19 years and '21 to '23. So we're very comfortable with that. I think our reserves are holding up nicely. And I know there's been some concerns around the more recent years where there's been some signs of adverse in the industry. We're not seeing that. Actually, our metrics or our actuaries are commenting that our actual development is coming in more favorable than expected. Again, very early to declare victory, but that's certainly for us a positive sign, and we'll keep monitoring and see how things develop for the rest of the year."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Andrew Kligerman from TD Cowen."
},
{
"speaker": "Andrew Kligerman",
"text": "Hey, thank you and good morning. Marc, you mentioned that the MI market is going and going and going. How do you think about the favorable prior year developments? I mean last year in the first quarter, it was 25 points this year. In the first quarter, it's another 25 points. I mean does that still continue going forward as well?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, I don't have a crystal ball for the future. But we're -- like everybody else, we're just on the receiving end of a market that's curing better. The borrower is in good conditions. There are programs on the GSEs that help the borrower staying in their homes. Most of those that even would have a delinquency, as we speak, would have a much lower mortgage rate. So they have a lot of incentive to stay in the home and not having to do anything with it, plus there's a lot of equity being built up in the home. So people have -- are sitting on because, as you know, there's been a significant increase in property valuation over three to 4 years. So everything is really indicating that we have a lot of the alignment between starting from the borrower, all the way to the mortgage insurer and the mortgage origination of the mortgage companies to make sure that the borrowers can make the payment, you can refinance, delay or attach it to a lot of things, a lot of tools and toolbox that weren't there, frankly, in '07 and '08 when the crisis happened. So -- but what does that mean in terms of development, we'll have to see what happens. But again, it's been more favorable than we would have said probably 2, three years ago, and we're just -- when we see the data, we just react to it."
},
{
"speaker": "Andrew Kligerman",
"text": "Pretty amazing stuff. And then my follow-up question is around the Allianz acquisition. And I love your analogy about the NFL draft and picking the high-quality players. Some have criticized Allianz as maybe I'll say they weren't a first round draft choice. So with that, what will Arch be able to do to kind of turn them into a first round type player? I mean I know I've heard about data and analytics, but can that help overnight? So I'd like to know what you're going to do there to really enhance that operation?"
},
{
"speaker": "Marc Grandisson",
"text": "Well, there's a lot of things going on. There's a thorough and very complete plan by our unit to first integrate them, making part of our company and our culture. And we'll have to look at everything that we can do to help them out It's an okay, it's okay business, very decent business, but we'll have to make it more of an Arch business, but recognizing some of the cultural differences in the distribution, it's a little bit of a different business. Data analytics is certainly one of them. We also bring to bear. We believe Allianz is a big company and they did a lot of work on this, where we have a strong presence in the US. as well. We also already do some middle market business. So we already have experience in that space. And so we have a -- we have a couple of things, a couple of tricks up our sleeve, if you will, to make it better. I won't go into all the details, obviously, but I think we're pretty excited about what we can do with the asset. And I think like I say all the time, and this is not a comparison with Allianz or us, but truthfully, it adds to the same thing to the Mortgage through UG, they're relatively a bigger piece of our overall enterprise and perhaps they would be in some other company. So that makes it a little bit more exciting and a bit more -- and the willingness from our part, obviously, to invest, right? I'll remind everyone that some of the earnings that we make, we put aside to invest for the future. So we have a lot of things going on, and we're pretty excited."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Michael Zaremski from BMO."
},
{
"speaker": "Michael Zaremski",
"text": "Hey, thanks. Good morning. On the Insurance segment, the underlying loss ratio of 57.5%, I know I'm probably just nitpicking. But I heard the commentary about the impact from the Baltimore bridge. But just curious, you've grown into property, which has a lower loss ratio, attritional loss ratio, I believe. So is there anything going on in the mix, that maybe you're putting in more conservatism on the casualty growth or anything we should be thinking about there?"
},
{
"speaker": "François Morin",
"text": "Mike, I'd say it's just the nature of the business we're in. I think there's going to be some ebbs and flows. There are going to be some -- I wouldn't call them unusual or unexpected developments. There could be 1 or two claims that surfaced in the quarter. We booked them, we recognized adverse or bad news early on and see how things play out. So there's really nothing to say that we want -- that needs to be highlighted. It's really part of the course. And yes, absolutely, this quarter, it turns out that the ex GAAP kind of underlying loss ratio was up, I'd say, 30 bps. And that's just the reality of the world we're in, and we think it's still an excellent result."
},
{
"speaker": "Michael Zaremski",
"text": "Okay. Got it. Second question is probably a quick one, but you all are kind enough to give us guidance on the cat load in the last quarter. I think you said it was in the 6% to 7% range for -- I believe it's just the premiums ex Mortgage segment. Is that expected to change or maybe be towards the high end of that range on a base case scenario as you kind of continue to lean into the hard market conditions as we think about '24?"
},
{
"speaker": "François Morin",
"text": "Well, the comment I made last quarter was -- yes, for the full year on the overall ACGL premium, 6% to 8%. We don't see that changing at this point. I think that was based on our view of how the year had a chance to play out. That's why we gave you a range. We were very happy with the 1/1 renewals. 401s went pretty much as expected and 6/1 so far are holding up nicely. I mean still a little bit of time to go before that gets finalized. But big picture, again, that's the 6% to 8% range for the year in terms of cat load is holding up nicely."
},
{
"speaker": "Michael Zaremski",
"text": "Sorry, is that 6% to 8% on all insurance premiums ex mortgage or just with total company..."
},
{
"speaker": "François Morin",
"text": "Total company-wide, ACGL total."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Dean Criscitiello from KBW."
},
{
"speaker": "Dean Criscitiello",
"text": "My first question was on the net to gross ratio in reinsurance. I saw that it ticked down about 5 points year-over-year. I was wondering, is that a function of buying more reinsurance? Or is there anything else going on there?"
},
{
"speaker": "Marc Grandisson",
"text": "No. I think if you look at the -- it's a good question. If you look at the last 4 or 5 years in the first quarter, you'll see that our net to gross ratio hovers between 65% to 70%. Last quarter last year, it was 70% because we had a larger transaction that came through that was not seated. So it's really just a comparison that's not -- just 1 period comparison is not reflective of what's going on. If you look at the longer term, you look at the 65% to 70%, so nothing changed there."
},
{
"speaker": "Dean Criscitiello",
"text": "Okay. And then the next thing, shifting back to the insurance business, I was a bit surprised to see solid growth within Professional lines given the rate environment there. So can you maybe talk about the market dynamics or the opportunities that you're seeing in that? And is that growth coming from D&O? Or is that within other professional lines?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So the -- it's -- the thing -- our professional liability has many things into it. It's got a large company, large public company D&O, it's got some smaller private, also has cyber in it and some professional liability like agents and stuff like this, that's more E&O based. I think that the growth is largely attributed to the cyber. Our teams are leaning a little bit more into it, and we've also acquired a couple of more team or developing a team in Europe, there's a big need for what we realize as a need for cyber in Europe, and that's something that we're starting to grow and see more of. And the reason it's grown in cyber is because even though some of the rates, as we all heard, went down slightly, it's still a very, very favorable, we believe, very favorable proposition for us to underwrite. Also it helps us doing other lines of business because it creates value for our clients. It's still a little bit harder to get in terms of coverage. On the D&O, we would have decreases and increases depending on where the rates are or where we see the relative valuation or the profitability of our portfolio. On that note, the rates in D&O went down about 8% in this quarter, not as bad as it was 1.5 years ago. You heard the comments that the SEAs are down. So there's there's still -- we believe there's still a lot of favorable opportunities in that segment as well. We just have to be a little bit more circumspect when we do this."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of David Motemaden from Evercore ISI."
},
{
"speaker": "David Motemaden",
"text": "Marc, you mentioned in your prepared remarks that you're seeing increased underwriting appetite and developing competition, specifically within Reinsurance. Could you just talk about where you're seeing that, elaborate on that a little bit? And what specific lines you're seeing that in and how you guys are responding to that?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. I think right now, what we're seeing is more a higher appetite, cyber is one of them. That's for sure, Insurance and Reinsurance, that would also -- I mean, can run the gamut, there are many of them. Typically, right now, what we are the lines that are more short-tail in nature. You can see a little bit more willingness to take some more risk from the competition. And how we react to it is, we have many things we do. We typically will tend to first look at the overall [indiscernible] if the rates go down or if the rates stay as is, with the new conditions, you actually price the business as if it's a new piece of business and what kind of return it will get to you. And if it's a little bit not as much -- or not too close for comfort, we might just decrease our participation. And we also might just stay on the clients that we believe have a better chance to really maneuver through that a little bit sideways market, if you will. It's really an underwriters' market at this time."
},
{
"speaker": "David Motemaden",
"text": "Got it. And just within Reinsurance, the underlying margins there were strong and even better, if I exclude the bridge loss. Can you talk about if there is anything in there that would flatter the results? Or is it more just sort of the earn-in of the property, more short-tail lines and these results are fairly sustainable? I guess how should I think about the sustainability of the results on the Reinsurance side?"
},
{
"speaker": "François Morin",
"text": "Yes. I mean it's a great market, right? And we've been saying that for a few quarters. I think and we've said it before, I think we encourage you all to look at results on a trailing 12-month basis. I think it's a bit more reliable, I think, less prone to volatility that is sometimes hard to predict. But yes. I mean, we -- and Marc said it. I think the quality of the book that's in force right now is excellent, and we're going to earn that in. But whether how -- was this quarter a little bit better than maybe the long-term run rate? Maybe, we don't know. But again, as you try to look ahead, I'd say more of a trailing 12 month, again, view is probably a bit more reliable."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Josh Shanker from Bank of America."
},
{
"speaker": "Joshua Shanker",
"text": "On the other income which doesn't get enough attention, that's Somers and Coface. It was a weak quarter for Coface stock return in 4Q '23, yet the other was quite strong and maybe I'm misunderstanding how to model this, but I bring this up because Coface had an excellent quarter this past 1Q '24. And I'm wondering if that presages a very, very strong other income return for the company as we head into 2Q '24?"
},
{
"speaker": "François Morin",
"text": "Yes. So just to be -- make sure we're on the same page, there's a lag, right? So Coface is booked on a one lag -- one quarter lag basis. So what they just reported for Q1 will show up in our Q2 numbers. Somers is on a real-time basis. And as we know, Somers should follow relatively closely the performance of our Reinsurance book because it's effectively [indiscernible] there's some nuances to it. But big picture, that is booked on a real-time basis and should mirror fairly closely our Reinsurance book. But to your point, yes. I mean if Coface reported out a strong Q1, you should see the benefits of that to flow through in our second quarter."
},
{
"speaker": "Joshua Shanker",
"text": "In theory, there should be -- I guess, if you're saying some correlation between Reinsurance segment underwriting income and Somers, which appears in that other line?"
},
{
"speaker": "François Morin",
"text": "Correct. Yes. It's not perfectly correlated because it's not the whole segment. It's mostly the Bermuda Reinsurance unit that we -- that they follow. Not the entire business, but big picture is still -- I mean, if the market conditions are good and Reinsurance, the Somers will benefit from that on a similar basis."
},
{
"speaker": "Joshua Shanker",
"text": "And if one other numbers question post the S&P Model, the change from a few months ago, is there any way to think smartly about how much excess capital you think you're sitting on or the possibility if you find other interesting M&A items, the ability to quickly deploy?"
},
{
"speaker": "François Morin",
"text": "Yes. I mean that's always an evolving topic, right? I think we are always focused on putting the capital to work in the business where we can. I think we've done a fair amount of that, obviously, this quarter with the Reinsurance growth that we saw. The $1.8 billion that will support the Allianz transaction is another example. We will see how the year plays out. No question that, we're generating significant earnings so that goes to the bottom line. And we'll be patient with it until we can't really find other ways to deploy it. But for the time being, it's -- we're in a really good place in terms of capital and gives us a lot of flexibility."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Brian Meredith from UBS."
},
{
"speaker": "Brian Meredith",
"text": "A couple of quick numbers and one big-picture question for you all. The first one, just quickly, on the Allianz deal, is it possible to give us how much cash you're expecting to come in from the, I guess, [indiscernible] net cash position you're expecting..."
},
{
"speaker": "François Morin",
"text": "Yes, big picture, it's a $2 billion [indiscernible] with dollar for dollar, right? So we get $2 billion in cash, and we were spending $450 million that goes out back to them for the cash consideration. So net-net, it's $1.5 billion of incremental cash that we will get. And the rest on the new business, then it's, call it, it's the premium flow with as we write that business, that's the overall -- over time, that will be the incremental investment income or invested assets that we will get."
},
{
"speaker": "Brian Meredith",
"text": "That's helpful. Second quick question here. You referenced in your commentary higher contingent commissions on ceded business in your Reinsurance. What exactly is that?"
},
{
"speaker": "François Morin",
"text": "A lot of it is third-party capital, right? We -- last year was a very light or a good year for the performance of that book. So some of those agreements, many of them actually pay us a commission that is -- there's a base and then there's a variable aspect to it, then that was kind of a lot -- a large part of that. So that's effectively performance-based commissions on property cat or property business."
},
{
"speaker": "Brian Meredith",
"text": "Makes sense. And then one bigger-picture question here. I'm just curious, on your Reinsurance business, Obviously, during the first quarter, you're getting a lot of [indiscernible] coming in from clients. What are you seeing with respect to reserve development at your clients, right? And how you kind of protect against that and not potentially seeing some of that adverse development that your clients are seeing on your cut of casualty quota share business?"
},
{
"speaker": "Marc Grandisson",
"text": "Yes. So I think the -- Francois mentioned the actual is expected, which is sort of consistent in both insurance and reinsurance on the more recent policy or accident year, which having the right starting point means that you don't really have to correct frequently. So I would say that we're not surprised on the Reinsurance about what we see. But as I said earlier, I think there is anecdotally and some heavy -- a lot of more friction, I would say, between Insurance and Reinsurance companies to make sure that people get an agreement as to what the ultimate book is going to be. So we're hearing this going in the marketplace. Of course, we participate in that, but we're not seeing this as being a big issue for us. And the other years that would have been pre-2020 and 2021, I want to remind everyone that we were very defensive. We do not have a whole lot of those premium and those harder-in-developing areas that people are talking about. So I will say that we see opportunities to write more of those, and we expect to see more opportunities to write more of those types of deals this year, but I wouldn't say that we are the most present in those worst years, if you will."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Cave Montazeri from Deutsche Bank."
},
{
"speaker": "Cave Montazeri",
"text": "I only have one question today on the Florida market. The total reform implemented over a year ago seems to have had some positive impact on the primary carriers, and Reinsurance capital seems to be coming back. This is a market that you guys know very well. Do you have any color you can share with us on the state of the market in Florida?"
},
{
"speaker": "Marc Grandisson",
"text": "No, I think it's -- to your point, some of the adjustments are coming through, but inflation is also picking up. And there's also, as we all hear, there's potentially more activity in the Southeast of the US. in terms of activities and storms. So I think that people are trying to sort out what they will do at this point in time. I think we have already existing relationships that we think will get us a little bit ahead of the game in terms of participating and getting a participation in the marketplace. But bottom line is we expect the Florida market to be well priced and very good from a risk-adjusted basis. Nothing indicates anything else other than that. Even, of course, the -- everything that's been done to take care [indiscernible] and whatever else in between, I think, is helpful. But it's still the largest property cat exposure for everybody around the world. So even if you make some corrections and they have made some corrections, I think we still have a couple of years before we start thinking about having a heavy softening in the market. There might be some here and there, but we still believe the market will be healthy as a reinsurer."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Bob Huang from Morgan Stanley."
},
{
"speaker": "Bob Jian Huang",
"text": "Quick question on M&A side. Obviously, you have historically generated very durable underwriting returns, mainly because of cycle management, in my view. Just curious as you move into M&A and diversify your business mix, does that impact your cycle management ability for retention levels when we think about M&A or potential M&A down the road?"
},
{
"speaker": "Marc Grandisson",
"text": "No, it doesn't change. I mean cycle management is a core principle of ours. And if anything, we'd like to be able to do -- it's going to be a matter of degree perhaps. Some lines of business have more acute cycle management because they're probably more heavily commoditized. I would expect the cycle management to be much softer in the Allianz and the US. MidCorp business. And that's also what's attractive about it, right, because it creates more stability for the portfolio."
},
{
"speaker": "Bob Jian Huang",
"text": "Got it. No, that's very helpful. And then in that case, when we think about M&A or future M&A, is it the first preference to use the excess capital or excess cash you're generating from this business to do the M&A deals? Or is it more preferable to use some of the stocks given where the valuation is and things of that nature?"
},
{
"speaker": "François Morin",
"text": "I mean there's no one answer to that. I think there's always -- I mean, and we talk about M&A, but M&A doesn't happen that often. So there's a size that matters, how much could we need -- would we need to raise in terms of using our own stock? Certainly, in terms of dilution, it's always, we think better to kind of use our cash. But there's many considerations we look at, trying to optimize as best we can all the options. We've got plenty of capacity in raising debt too, if need be. So it's very much a function of each specific circumstance, each specific opportunity. We look at it on its own and go from there."
},
{
"speaker": "Bob Jian Huang",
"text": "Sorry, if I can just have a little bit of clarification on it. Is it fair to say that in that case, cash and debt is more preferable and then equity may be a little bit less or I'm [indiscernible]? So sorry, just maybe a little bit clarification on that."
},
{
"speaker": "François Morin",
"text": "I mean that's been the preference historically. But I mean, again, it's hard to speculate on what could be the next thing. So yes, historically, but things change over time, too."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Michael Zaremski from BMO."
},
{
"speaker": "Michael Zaremski",
"text": "Just a quick follow-up. You mentioned fee income earlier. Arch has a lot of diversified sources of income. Is there a way you can update us on kind of what percentage of your earnings maybe last year was derived from these kind of fee income type arrangements at a high level?"
},
{
"speaker": "François Morin",
"text": "I mean it's grown over the years, for sure. I think that the difficulty or the reality we face is some of these fees are somewhat -- with the expense -- the revenue we get that has some expenses that go with it, and those are kind of co-mingled with our own internal expenses. So isolating, call it, the margin on those contracts is a little bit kind of cloudy. But yes, it's grown. It's part of what we do. It's part of the leveraging our platform, leveraging our underwriting capabilities, in all our segments, right? All three segments have some fee income that comes into the errors. Obviously, Somers is part of that as well. But yes, it's become a bit more sizable for us."
},
{
"speaker": "Operator",
"text": "Thank you. I would now like to turn the conference over to Mr. Marc Grandisson for closing remarks."
},
{
"speaker": "Marc Grandisson",
"text": "Thank you very much for hearing our earnings. Great start of the year. We look forward to seeing you all in July."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACGL | 1 | 2,025 | 2025-04-30 09:00:00 | Operator: Good day, ladies and gentlemen and welcome to the First Quarter 2025 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in yesterday's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, Investors should review periodic reports that are filed by the company with the SEC from time to time, including our annual report on Form 10-K for the 2024 fiscal year. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished to the SEC yesterday which contains the company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Nicolas Papadopoulo and Mr. François Morin. Sir, you may begin.
Nicolas Papadopoulo: Good morning and welcome to Arch's first quarter earnings call. I'm pleased to report solid results for the quarter with $587 million of after-tax operating income, $1.54 in operating earnings per share an annualized operating return on equity of 11.5%. These results were achieved despite $547 million of catastrophe losses affecting our Property and Casualty segment primarily from the California wildfire. The P&C market has become increasingly competitive. However, we remain optimistic about our prospects as we continue to achieve broadly attractive rates across the sectors where we compete. At Arch, we believe that prioritizing expected profitability of our market share by allocating capital to lines of business with attractive risk-adjusted returns gives us the best opportunity to outperform for the cycle. This is what we mean by cycle management and we stand by the historical results of this approach. While the market may be more competitive ample growth opportunities remain. This is true despite emerging macroeconomic concerns, including the potential impact of tariffs that increased uncertainty for many of our insured across the globe and raised inflationary risks for some of our businesses. During times such as these, risk selection is critical as a growing number of our previously attractive accounts no longer meet our return criteria. We believe the acumen of our underwriting teams, breadth of our platform, investment in data and analytics and depth of our financial resources have Arch well positioned to navigate the P&C cycle. Now we'll turn to our segments, starting with Reinsurance. Reinsurance results were solid despite substantial catastrophe losses in the quarter and 91.8 combined ratio, inclusive of 18 points of catastrophe losses demonstrates the strong underlying profitability of our diversified reinsurance portfolio. Growth in net premium written in the quarter was modest due to an increased level of competition more risk retention by ceding companies and reducing our participation for treaties where margin no longer meet are hurdles. In the first quarter, the reinsurance group deployed additional capacity into property catastrophe lines where opportunities remain attractive, particularly in loss-impacted accounts. Specialty premium rising declined primarily due to non-renewing a large structure transaction. Weaker margin in cyber and part of our international treaty business also led to reduced premium linings. Treaty casualty lines experienced growth in the quarter as Arch recapitalized on a handful of select opportunities. We are hopeful these lines will continue to achieve rate and the treaty casualty market terms and conditions will continue to improve. As we look towards major renewals, particularly wind coverage in Florida and the Gulf, we expect additional demand from existing and new clients. On the supply side, it is worth noting that for many reinsurers and ALS funds, this zone represents peak exposure. As a result, significant additional capacity may be harder to come by -- even if the market is more competitive on the margin. Moving to our insurance segment, where the California wildfires led to a small underwriting loss for the quarter due in part to commercial risk from the recently acquired middle market commercial and entertainment businesses. The additional premium generated from those businesses contributed to the insurance group, $1.9 billion of net premium return in the quarter, a 25% increase from the first quarter of 2024. The integration of the middle market business is progressing well and we remain excited about the increased capabilities this team brings to the Arch Insurance platform. As we've said before, there isn't one underwriting cycle but many. In today's market, it's possible to deliver double-digit growth in some lines, while experiencing similar declines in others. In the first quarter, we generated meaningful growth in casualty led sectors, including construction, national account and international casualty. At the same time, we experienced premium reduction in other lines of business due to rate decreases and our desire to maintain margin in lines such as E&S property and professional lines, including cyber. We have seen competition increasing in the London market specialty lines which has made profitable growth difficult. Looking ahead, we expect continued growth in casualty lines as well as the U.S. middle market where opportunities remain for both rate and premium growth. We are well positioned across the insurance group because of our market-leading capabilities and relevance with distribution partners that gives us first look at many opportunities. The Mortgage segment continued to provide a steady earnings stream contributing $252 million of underwriting income in the first quarter. Economic uncertainty, limited housing supply and high relative mortgage rates continue to create headwinds for new mortgage origination which resulted in modest new insurance returns in our U.S. and international Mortgage businesses. For U.S. MI, high mortgage interest rates and on price appreciation have kept persistency around 82% and insurance in force relatively stable. The delinquency rate of our in-force portfolio remains low ending the quarter below 2%. Our near-term outlook for the Mortgage industry is unlikely to change significantly. While recessionary trends resulting from tariffs and other economic policy could create headwinds, we still expect the Mortgage segment to continue generating attractive underwriting income given the high credit quality and embedded equity of our in-force portfolio. Turning to our Investment group, where invested assets increased by 4% from year-end to $43.1 billion, providing a large sustainable contributor to group earnings. Investment market volatility increased broadly leading us to reposition our portfolio to a more market-neutral position. To manage the cycle, it's important to understand that you cannot control the market but you can control how your underwriting teams respond to it. At Arch, we manage a different cycle across our many lines with the ability of our underwriters to access, analyze and ultimately select risk. Over time, our underwriting teams have built strong relationships with our distribution partners which gives us an access advantage as they look to place risk with fewer, more relevant carriers, including Arch. Risk analysis combines experience, expertise and deep analytical insight to understand and assess the underlying risk and match it with a technical price that reflects an adequate premium for that risk. Ultimately, risk selection is what separates the winners from the losers. If the return doesn't adequately account for the risk, you must be willing to let others take the business. The P&C market in transition is one where Arch can and has previously demonstrated its ability to find success. While premium growth may be more challenging than in recent years, plenty of profitable opportunities remain. For a company with a strong underwriting culture like Arch, this is a market where we can stand out and continue to maximize returns for our shareholders. François?
François Morin: Thank you, Nicolas and good morning to all. Last night, we reported our first quarter results with after-tax operating income of $1.54 per share resulting in an annualized operating return on average common equity of 11.5% and growth in book value per share of 3.8% for the quarter. At a high level, our three business segments delivered excellent underlying results with an overall ex-cat accident year combined ratio of 81%. And importantly, each of our segments showing an improvement for that metric over the same quarter 1 year ago. Our underwriting income included $167 million of favorable prior year development on a pre-tax basis in the quarter or 4 points on the overall combined ratio. We recognized favorable development across all three of our segments and in many of -- many of our lines of business but the effect was most notable in short tail lines in our Reinsurance segment and in Mortgage due to strong cure activity. The acquisition of the MidCorp and Entertainment Insurance Businesses continues to roll through our financial metrics within the Insurance segment. This quarter, the net premiums written coming from the acquired businesses was $373 million, contributing 24.2 points to the reported year-over-year premium growth for the segment and generally consistent with last quarter. Also, the inclusion of the acquired business in the segment's results lowered the current accident year ex-cat combined ratio by 1.1 points. This can be further broken down to include the current quarter acquisition expense ratio that was lowered by 0.9 points due to the write-off of deferred acquisition costs for the acquired business at closing under purchase GAAP. The other operating expense ratio that was lowered by 0.9 points and the accident year ex-cat loss ratio that ended up being 0.7 points higher, reflecting the underlying results of the acquired business. The quarter-over-quarter comparison of net premiums written for the reinsurance segment showing growth of 2.2% was also impacted by a few items. Of note, this quarter's net premiums written includes approximately $70 million of reinstatement premiums, mostly related to the California wildfires. Offsetting this benefit was the nonrenewal of large structured transactions in the specialty line of business which reduced our top line by $147 million in the quarter. There were also some timing differences in the recognition of certain treaty renewals which resulted in lower net premiums written in the quarter of approximately $103 million. Our mortgage segment delivered yet again another very strong quarter with underwriting income of $252 million. Even though the origination environment remains challenged, the underlying fundamentals of the business are excellent, as exhibited by most of our key metrics, including a very low delinquency rate for our U.S. MI business which currently stands at 1.96%. On the investment front, we earned a combined $431 million pre-tax from net investment income and income from funds accounting using the equity method or $1.13 per share pre-tax. The reduction in net investment income relative to last quarter is attributable to a few items, including the impact of paying a $1.9 billion special dividend in December the timing of incentive compensation expenses, slightly lower interest rates in the quarter and the repositioning of our portfolio to a lower risk posture in light of the current macroeconomic uncertainty. Income from operating affiliates was down this quarter, mostly due to a lower level of affiliate income at Somers Re in part as a result of California wildfires. Cash flow from operations remained strong it was approximately $1.5 billion for the quarter. Our effective tax rate on pre-tax operating income was an expense of 11.7% for the quarter and reflects a onetime discrete benefit of 4.6% related to differences in the expensing of noncash compensation. Also, it is worth mentioning that we started to amortize this quarter the deferred tax asset we established at the end of 2023 related to the introduction of the Bermuda corporate income tax. This benefit does not impact our operating or our net income effective tax rates in the period. But as we mentioned previously, will flow through our financials as a reduction to pay taxes. As of January 1, our peak zone natural cap probable maximum loss for a single event, 1 in 250-year return level on a net basis, increased slightly and now stands at 9% of tangible shareholders' equity. Our PML remains well below our internal limits. On the capital management front, we repurchased $196 million worth of our common shares in the first quarter and an additional $100 million in April demonstrating our ongoing disciplined approach to managing our capital to enhance shareholder returns. In closing, our balance sheet remains extremely strong with common shareholders' equity of $20.7 billion and a debt plus preferred to capital ratio remains low at 14.7%. With these introductory comments, we are now prepared to take your questions.
Operator: [Operator Instructions] The first question comes from Mike Zaremski at BMO.
Michael Zaremski: Thanks for all the insightful market commentary. On the Reinsurance group deploying additional capacity into catastrophe lines, you said that loss impacted accounts remain particularly attractive -- should we be -- I guess, we'll think through kind of the -- how to change our loss ratio a bit, if you kind of feel like you're going to continue leaning in. Any kind of updates to your cat load guide, I believe it was 7 to 8 points when you updated us last, should we expect that number to move up a bit?
François Morin: I don't think so. I think the number should be relatively stable. I mean full year cat load. Obviously, there's seasonality to it. As we look at market conditions, we certainly have thought that after the California wildfires, there might be a little bit of a I think a more -- some stabilization in that market which we think will happen, although as we touch on, I think Florida is its own different market, right? So a little bit early for us to know exactly how Florida is kind of ultimately perform or what opportunities we're going to see there. But big picture, I think what we saw at the start of the year seems to be holding up pretty well.
Nicolas Papadopoulo: I agree. I think the Florida outlook, as we see it is -- for the reason I described in my comments is pretty flattish. So I think we like the business. I think the -- if our teams -- again, we don't know but if our teams find opportunities to grow and we expect more demand in the marketplace for several reasons. I think the FHCF is raising the retention by $1.5 billion. And I think the -- we're seeing more cedents wanted to increase their limits, things that they haven't been able to do in the last few years because of the lack of capacity. So we think an opportunity to potentially do more if the rates hold up.
Michael Zaremski: Got it. Okay. Switching gears to market competition outside of Reinsurance. I think the common theme has been in recent quarters that large account property is well priced and we're seeing some more meaningful downward pressure. You mentioned in your prepared remarks, the London specialty market as well. Maybe can you kind of unpack what you mean by the London specialty market and maybe kind of help frame which lines in particular are -- the clock isn't where you'd want to grow as much?
Nicolas Papadopoulo: Yes. I think in London, what's happening, I mean it's twofold. First, I think we've seen after years of good results, more appetite for people to expand in lines like terror, marine and energy. The typical species, the typical lines of business that are returned historically out of Lloyd's. And also, I think what we are seeing is London is kind of the excess and surplus market of the rest of the world. And so we're seeing as companies in their local market become more comfortable with their risk, their appetite expand. And so there is a little bit less business coming from Australia, from Asia, from jurisdiction that historically relies on Lloyd's as the appetite of their local companies get diminished. So that's what we're seeing. We're seeing the combination of the two -- I mean the tailwinds for us and a few other markets is that the market is consolidating around leaders. And I think we will lead in many of our lines of business. So it's difficult to predict. So it's come out but we feel positive about how we are positioned to continue to take advantage of the market there.
Operator: The next question comes from Cave Montazeri at Deutsche Bank.
Cave Montazeri: My first question is going to be on net premium growth in Reinsurance. I think it's pretty clear that the days of 30%-plus growth in NPW are behind us now as you become more selective. I'm assuming also 2.2% growth, that's probably a little bit too low to expect going forward. So can you maybe unpack some of the key drivers of the deceleration you saw in the quarter? Maybe give us a bit more details on the impact of the structured yields. Just to give us -- help us understand maybe where -- how we should think about that going forward in terms of premium growth in Reinsurance?
François Morin: Yes. I mean I touched on it in my comments, right? There's a couple of items. If you adjust for what we mentioned, again, we're not trying to do the [indiscernible] and adjust for everything. But if you adjust for those two things, you still get to a call it, like 6%, 7% growth rate which may be more consistent with what we see in the near future. But beyond that, I'd say there's really a separation like there's -- we had good growth in property other than property cat and property cap [ph] and in casualty where we saw some decreases on the specialty line beyond the structured and the timing of accruals on written premium. And there, I'd say it's a function of some of the lines or some of the smaller specialty lines that we participate in, where there's been more competition. And cyber is a prime example of that. It's a combination of rates coming down a little and also of some of our ceding companies retaining more of the risk. So that's how I'd say, like midterm, yes, you're right, the 30% growth is probably behind us but for the near term at least. But hopefully, these couple of things help you kind of reconcile a little bit like from the 2.2% to a -- what you may perceive to be a more kind of realistic expected growth in -- for the rest of the year.
Nicolas Papadopoulo: Yes. I think in the specialty book, you have a mix of lines of business. I mean it goes from credit to a cyber to agriculture and a few others. So our team are really scouting the world to find opportunities. We had a great opportunity in Brazil last year on the agriculture side. And this year, the cedent is winning more of the business. So, I think you have to be opportunistic in those lines of business to make money. So yes, if we have a big book, the ups and downs offset each other in the last few years it grew together because it was what the hard market does. I think we should be prepared to see more ups and down quarter-by-quarter going forward in that particular book. That's what we want them to do.
Cave Montazeri: My second question is on casualty. Last year, a big theme was just the strengthening in the casualty reserves at the industry level. We haven't seen much of that so far in 2025. I think some people are thinking maybe we might be past the point of maximum fear with regard to social inflation. Just wondering like what your thoughts are? Do you agree with that? What do you think we're just in the eye of the storm and there's more pain to come in the second half of 2025?
Nicolas Papadopoulo: My prediction is I don't know when the pain will come but he will come. There's more pain. That would be my -- how people manage the pain and I can't tell but -- we think the casualty social inflation story has not fully played out. I think that's our view. And we're still -- we were getting definitely rate above trend on our casualty line and where we feel comfortable with the exposure, the jurisdiction, the type of the terms and condition that we get, I think we're willing to lean in but I don't think we are still at the case where it's a market that you can take a share of it and guarantee that you're going to make an adequate return. So I think there's more to come. That would be our general underwriting view.
Operator: The next question comes from Elyse Greenspan at Wells Fargo.
Elyse Greenspan: My first one, I think, is a quick one. François, the 7% adjusted growth in Reinsurance that you were talking about, in the quarter. Is that excluding reinstatements and the structured deals? I just want to make sure I understand what you're backing out.
François Morin: No, I'm just putting back in the two items I mentioned. That's all. So the -- I'm not backing out the reinstatements, I'm just handing back the non-renewed deals and the timing of the accruals on some business.
Elyse Greenspan: Okay. Got it. And then my second question is on the commentary around the midyear. It sounds like you're expecting perhaps some opportunity on the demand side, what about pricing? I guess, are you guys expecting that price is probably down but that -- there could be some growth opportunities just with demand. Can you help me think through those two pieces?
Nicolas Papadopoulo: So clearly, it is the data point at 4/1 where single-digit down, most places, maybe a bit more than that in Japan due to, I think, one of the players buying less which the market's crumble around that. But I think the dynamic in Florida is, as I said in my remarks, is a little different because it's a big zone for both markets. And you -- the dynamic is people like the top players but they're not that many top players and people didn't like the bottom of the program. There's not as much -- and what we've seen in the past and we're seeing still today is bottom of the programs which have been impacted by the last year, the hurricane last year, Milton, we'd expect those probably to see some price increase and would that be compensated by price decrease at the top of the market at the top of the problem, I don't know. But I think -- that's why I think our view is, if things play out the way they should which they never do. We would expect something more flattish for Florida. And at that point, we feel that based on our positioning and we should be able at least to keep our share of the programs that are buying more and therefore, we may have opportunity to deploy more capital.
Elyse Greenspan: Okay. And then one last one. In insurance, if I kind of ex out MidCorp, is that I think, around like a 56.7% underlying loss ratio that was slightly below the Q4. Is that about like run rate-ish, I guess, on core Arch, right? And then we think about bringing in MidCorp on top? Or anything else we need to think about just with pricing and loss trend and dynamics on the margin as we go through the year.
François Morin: Yes. Well, we -- I mean, call it for the legacy Arch book, I mean, it's -- at a high level, we'd say that our margins are holding up in terms of rate above trend kind of being kind of keeping us steady. The one thing, though, that you have to factor in somehow is the mix is changing, right? As we pivot a little bit more into casualty. You might see that underlying loss ratio go up a little bit as we see more competition on the property and we mentioned it like a lot of our growth was in the casualty led kind of lines of business or profit units for us. So that might be the only thing. But big picture, we still think the loss ratio that we're -- we had this quarter is seeing no reason why it can't hold up at that level.
Operator: The next question comes from Andrew Kligerman at TD Securities.
Andrew Kligerman: First question is around the reserving. It looked like you had some nice favorable developments, particularly in Reinsurance. But could you call out anything around commercial auto and other liability, net plus or minus in both Insurance and Reinsurance, how did that perform? And how do you feel about the reserving in those lines going forward?
François Morin: Great question. We -- our reserves are something we -- again, we mentioned before, we look at it every quarter. The actual versus expected that we monitor very carefully is looking good. But for us, it's a little bit early to call it victory. So we're monitoring everything, plus or minuses, yes, there's always going to be the finer -- if you slice that down to very fine levels. There are some pockets where we took a little bit of adverse which were offset by others where we had some good favorable coming through. But big picture, I'd say we're flattish. I mean everything on the casualty kind of long tail side auto and some of the more difficult lines, as you mentioned, umbrella, etcetera, where we're comfortable with what the reserve -- what the indications are.
Andrew Kligerman: Okay. So that's good to hear. And then maybe shifting this is sort of a two-part question. Being clearly the acclaimed cycle manager that you are, could you share a little color on -- and maybe -- I know Nicolas, you mentioned many different cycles but maybe very broadly two cycles, casualty and property, maybe we'll even skip professional or you could throw that in, if you want. But how do you see those cycles playing out as we sit here today? How much longer will we see property pricing come down? How much longer can casualty pricing hold up? I know it's a really tough question but be really interested in your response on that. And then the second part is just -- what are you seeing with MGAs today? Are they still proliferating? Are they still very competitive? And I'll stop there. That was a lot of questions. Sorry for that.
Nicolas Papadopoulo: The two are [indiscernible]. I'll start on the property side and I'll start on the -- I mean on the Reinsurance side, I think my view is that the market is more disciplined. So I think we've seen rate decrease. But from a peak of the market, I think the markets remain attractive. We haven't seen any really actors behaving in a totally irrational way. The new guys are coming but they're small. And so, I think really -- we remain very optimistic about the property cat and the way the industry behaves in general on that aspect. If you move to the cat the property in general and especially the E&S property and the North American net properties. I think you have -- there, you have a tale of two markets. I think you have the middle market, more, I would say, admitted retail where the convective storm and some of the recent cat element, I would say, will include the wildfire to a certain extent, keep putting pressure on the companies and they have to keep on getting rates to be make sure that they cover the cat load which has gone up in the last few years. And then you have the more the E&S cat, coastal and maybe earthquake driven risk, where that's where the MGAs play a bigger role. So I think the market has responded to my surprise, very quickly giving up double-digit rate increases we went through in and everybody was surprised, big limit was really something that people didn't like and took a ton of losses. So I think the market became in 2023, much more disciplined and cut limits which really pushed when people -- when the capacity withdraw that's where you see rates going up. So we got a huge upswing, re-underwriting, terms and conditions. And I think 1 year, 1.5 years later, I think we've seen MGAs which their capacity has been curtailed coming back with much bigger limits. And if you think of a typical risk, it's a $200 million risk where you need it probably 20 markets or more to complete. And let's say, Arch was doing the first 10 or doing the 10x10 [ph], and then the MGA come in and they do 40. It creates a complete run for the heel in terms of -- if you -- as I say, as was 10x10 [ph] and then MGA come in capacity and then -- and now they ask $40 million. So what do we do? We run for the hit and we're trying to reposition $10 million elsewhere in the program and that creates the huge pressure on the rates that we've seen. And I think capacity of MGAs have gone up this year. So I think they play a big role in my view, in quickly, the market turned to be much more competitive. That's what I see.
Andrew Kligerman: And same thing on casualty?
Nicolas Papadopoulo: On casualty, there's less MGAs. I think on casualty, I think what you've seen is -- and to go back into property, I think when you see markets like us, increasing capacity, maybe we increased capacity from 10 to 15. We don't go from 10 to 40. I think -- so if you go on the casualty side of the house, now whether it's E&S or -- you've seen the same thing. You've seen response to typical losses is reduction of limit. You want prices to be applied to multiple risk of business to create the diversification and the lower number works better. So I think that's what we've seen and the reduction of the capacity and the usual limit from 50s to 25s and to 15s have created this opportunity, especially on the excess side for rates to go up. I think we haven't seen a ton of people. In fact, we're seeing people still reducing limits. So this tells me that the runway to a more competitive marketplace is going to be longer.
Operator: The next question comes from David Motemaden at Evercore ISI.
David Motemaden: Good morning. I had a question on the $147 million of structured deals that were non-renewed. Just so I'm thinking about it correctly. Were there any other chunkier quarters in 2024 that we should think about where like there were chunky structured deals that might not renew as we go through the rest of 2025?
François Morin: There's always some chunky books or deals that we write throughout the year. I mean, what we don't know is whether they'll reappear or we'll -- they may renew at the same thing at the same level, same kind of structure for another year. So hard to know what the impact may or may not be for the rest of the year. Again, we're just trying to give you a bit of additional information on how the premium is, why it's going up or down. Sometimes, it works in our favor in the sense that, yes, we write new deals that are significant and improve or increase the growth or the reported growth but -- in this case, it was different. So these are, I'd say, though, they're on the larger side. I mean it's unusual that we -- we don't have that many deals that are -- that have that much premium associated with them.
David Motemaden: And then on the insurance underlying loss ratio, I think last quarter, you spoke about it running at around the 58% level going forward. It obviously came in nicely below that this quarter. I'm wondering was there anything that drove that? It sounded like you split it out between the legacy Arch and MCE was there more improvement on the MCE side? Is that something we can expect to continue? So maybe some color around that would be helpful.
François Morin: Yes, hard to say. I think -- I'd say, the quarterly numbers matter but we don't overly put too much weight on them. I'd say we want to make sure we have a longer-term view of what underlying profitability of the book is. So I would not factor in or expect any significant movements up or down, let's say, from -- for either the MCE or the legacy business. And as you know, I mean, last year, we had the Baltimore Bridge which impacted the loss ratio upward. We didn't have that this quarter. So there's always going to be the random element of a couple of large clients here and there that may -- that have an impact ultimately on the quarterly loss ratio. So, big picture -- we call it a fairly stable environment. And we always expect a little bit of volatility from quarter-to-quarter depending on what happens.
Operator: The next question comes from Alex Scott at Barclays.
Alex Scott: I thought I'd see if you could provide a little more commentary on what you're seeing in the property cat reinsurance market I guess, specifically, what's your view of the impact of ILS? Is the pricing pressure more at the top of the tower? Any commentary on sort of the way it's affecting these towers and where you play in them?
Nicolas Papadopoulo: Yes. So the -- what we've seen and what seems to continue to happen is what you described, more pressure at the top. We've seen the cat bond market being repriced to lower margin. So I think that put pressure also to the layer below the cat bond market and obviously, there hasn't been any losses on those layers where at the bottom of the program between the California wild fire, on the nationwide account and some of the storms that we've seen, we have a loss. So I think the more, I would say, the place where price decrease seems to be focusing is really at the top of the program. So I think we -- in Florida is going to be more complicated because I think, again, there's not that much supply in the marketplace. So I would expect it to maybe not be as strong as maybe in the Northeast region where you haven't had a loss in any of the top players or middle to top players for a long time and people see that. So, I think -- but yes, I think the -- what you described is we expect it to -- if something is going to happen, my view is that's what's going to happen. It's probably more pressure at the top of the program and maybe less moderate pressure on the bottom.
Alex Scott: Got it. That's helpful. Next one on capital management. I mean, you had very strong capitalization and growth slowing a little bit, just given the environment. How do you think about priorities there? And how quickly do I ramp up capital return if you don't get the opportunity to grow in the midyear.
François Morin: Yes. I mean it's something we look at constantly, it's part of the same framework. We've always had no question that if the growth moderates which is it's starting to and we still have solid earnings coming through. We'll probably be in a position where we accumulate a bit more excess capital and we'll probably be looking to return most of it back to our shareholders. So there could be some small M&A. There could be some other things that come our way. But at a high level, you could certainly -- I think it's reasonable for us to think that we'd be returning a significant amount of capital as we move forward. We had a special dividend late last year. We obviously like share buybacks a lot. And given the -- if the pricing and the metrics work for us, we're happy to do that.
Operator: The next question comes from Wes Carmichael at Autonomous Research.
Wes Carmichael: In Reinsurance, I think you mentioned a couple of times of primary companies retaining more risk. Just hoping you could provide a little more color on what you're seeing from primaries and maybe where that's most pronounced?
Nicolas Papadopoulo: I think it's most pronounced in the other property where we see it, some of the other line of business, like maybe energy and where results have been good, ceding commissions are good but companies feel more comfortable with their results. So that's a normal trend that you see as the -- as you go through the whole market and you go through the clock is that people tend to retain more of the risk. They bought the reinsurance because they either wanted the volatility and they were a portion of the business, they were unsure of the performance as they have re-underwritten their book it's not unusual for people to feel more comfortable. I know Arch insurance, that's what we do. And we are more comfortable with the risk. We definitely buy more insurance. So we move the reinsurance that we would buy to an excess of loss, where we retain more of the premium. So, I think we haven't seen a ton of quota share going through excessive loss but we've definitely seen companies as they feel more comfortable with the risk or feel better about their financial situation, retaining more of the risk. And certainly, on the structure, if you're related to the structure on the structure side, structured deals are usually capital relief deals. So I think those deals last as long as the company is -- needs the surplus relief. If you go in a situation where they don't need the surplus relief anymore, then the deal goes away. So...
Wes Carmichael: That's helpful. And I think in mortgage, prepared remarks touched on headwinds of origination. Can you maybe just talk about what behavior you're seeing in that business? And are you seeing any potential leading indicators of recessionary activity at this point?
François Morin: Too early. I mean, really too early. I mean we can speculate. We do the work. We certainly have a view that, yes, I mean, if recession, we have a severe recession and that impacts unemployment and home prices go down a little bit, that may have an impact on the performance of the book but we keep going back to the strong fundamentals, the high credit quality of the borrowers. Home prices are -- there's a lot of equity that's been built up by the homeowners in their home. So it's a vastly different situation than what we had back in 2008. So -- or not to say that we don't worry about it because we do but we're a lot more comfortable with our position. And for a stress scenario to generate or create significant hardship on Arch would take -- it would have to be very, very severe. So we're -- at this point, we're in a -- we think, in a very good place.
Operator: The next question comes from Josh Shanker of Bank of America.
Josh Shanker: Good morning, everybody. Back in the fourth quarter, you paid a big special dividend, you bought back a little stock. You bought back more stock this quarter. I tend to find it difficult to parse paying special dividends and buy back stock at the same time, either the return on the stock is attractive or you need to give money back to shareholders promptly because it's not so attractive A couple of things there. One, can you talk about, little about your philosophy which is about 3-year ahead book value. But I've done a little bit of the math. And if the 3-year ahead book value rule of thumb applies, the market is very much underestimating your earnings power for the next couple of years. Can you talk about the philosophy of buybacks versus dividends and what that means for this year and what you think about the attractiveness of the stock at this point?
François Morin: Well, we like the stock. That's for sure. But I mean the biggest obstacle, Josh, is truly the level of -- the speed at which you can execute share buybacks. We have limits on daily trading volume, etcetera. So the main reason, if you put aside even if the price was right and you say, well, it's really attractive to buy at a certain level, the advantage of a dividend is you can execute a much bigger return of capital I mean instantly versus over a long period of time. So for us to buy back $1.9 billion of stock at the rate at which we can actually do it because of the restrictions we have would take a long time, at which point we'd accumulate more excess capital and you never catch up. So that is, I think, important to realize that there's only so much we can do with share buybacks. When you get into what's the 3-year payback, yes, 3 years is a good metric for us that we follow. Do we have a different view of what the book value might be out in 3 years out than you do, maybe and we take a hard look at what we know about our business but we're still within that roughly that 3-year payback period and we still think there's a lot of good runway for us to keep growing book value at a good clip for the next little while. So that gives us a lot of comfort that buying back stock at this price has been -- is a good way to return capital to shareholders.
Josh Shanker: If you started now, do you think you could execute $2 billion in buybacks before year-end and preclude the need for a special dividend?
François Morin: It would be hard. It would be hard. I mean there's ways you can kind of create some programs but we like to retain the flexibility, we like to have optionality, so locking yourselves in and that's true in everything we do. So to lock yourselves into making it public that we're buying back a certain amount at a certain price is something we try not to do. We like to be opportunistic and it's something that we -- again, it's constantly something we look at and try to optimize as best we can.
Josh Shanker: Well, thanks for being transparent about the behind the curtain, how the sauce is made..
Operator: The next question comes from Andrew Anderson at Jefferies.
Andrew Andersen: Just on the income from operating affiliates, I think it was $17 million in the quarter. It was down a bit year-over-year. I think that Somers is in Coface. Can you maybe just talk about the moving pieces there and perhaps how you're thinking about full year?
François Morin: Yes. Coface has been very, very good. So it's been a great story for us. We're extremely happy with it. There could be some pressure with trade credit going forward but that's, again, something we're keeping an eye on. We don't have visibility or a ton of clarity on it. So really, the drop in operating -- income from operating affiliates was mostly -- almost exclusively due to the Somers and let's remember that Somers is effectively a side car to Arch Re. So you have wildfires this quarter, they impact us and they impacted Somers as well. There's a little bit of a kind of a one-off on the Bermuda tax that was reflected in the Somers financials Q1 of 2024 that maybe makes the drop more significant than you would think otherwise. But as you look for the run rate, I'd say this quarter is a bit lower than what we would normally think for the operating affiliates in general. And I think we're still looking -- when you think about our returns, we think plus or minus like where we're earning well into call it, 10% range on these investments, if not more and let's just say we have over $1 billion in assets there. So hopefully, you can do the math from there.
Andrew Andersen: That's helpful. And then just insurance expense ratio and there was improvement in OpEx but is full year '24 still a good way to think about the rest of the year for the OpEx? Or is there still some head count costs coming on?
François Morin: I mean, it's a good place. We are no question -- I mean as we think about our growth and how we need to manage our expense base, we are being very thoughtful and diligent about do we need to replace people that resign, do retirement, etcetera. So, we -- I think we're going to get some benefits from the MCE acquisition, like scale brings a little bit of a bit of leverage, a bit of kind of -- we can scale better. But no question that we're trying to hire still on the MCE side. We want to staff up with data scientists and we need a few more actuaries, etcetera. But big picture, I think we are watching our expenses and that's something that will be a focus as we move forward.
Operator: The next question comes from Meyer Shields at KBW.
Meyer Shields: I think I have the same question in two contexts. I think Nicolas started for comments talking about the preference of brokers to work with fewer bigger insurers. And I'm wondering if you could talk about the volume versus profitability implications of that to companies like Arch?
Nicolas Papadopoulo: Yes. So I don't think the two are necessarily linked. I think in my view, the best place to talk about this is probably the London market. In the London market, the brokers because the business come to London, the main three brokers control a lot of access to the business we write. So I think it's more of a supporting them where they need you to be supported and playing the role that you have to play where you can align with their own strategy. And I think if you think of the way they're organizing the market, having their own facilities, then they need leaders, without leaders, nothing works. Then they have some follow facilities and then ultimately, they have the open market that remains. I think you need to find a place, you can't service just one. I think if you service just one, you'd be -- so you have to be able to figure out your distribution strategy is a key component of our future success. That's what I'm saying. And I think we spent a ton of time thinking out how do we align better and where do we bring value to our distributors. And it varies for the bigger distributors it maybe one thing for a smaller distributor, mid-market distributor where they rely better on the expertise of art, it may be something different. So I think you have to really to be successful going forward, you really have to question the value you bring in the transaction. You can't just underwrite business. So the two components is that you have to do the underwriting cycle thoughtfully. And -- but you have also to figure out what your place in the food chain and what value you bring. So that's really the -- so we've done a lot of work and we're still thinking of this in a way that's less -- it's less about us but it's about ultimately the customers. Without customers, we don't exist. So we need to provide value to the ultimate customers. That's our -- and that dynamic is -- maybe is playing out in London, it's playing out in North America. You can't just be sitting at your box in Lloyds and waiting for the business to come to you and underwrite, because you're not even sure that the business you're going to see is the one you want to write. That's the issue. I think if there is five people in front of you that are picking up the good business, now you're picking up from a part that by definition, is not so good. So I think you have to work hard and size matters and relationship matters and being able you can see the business you're really targeting. And that's where distribution strategy matter.
Meyer Shields: Okay, perfect. That's very helpful. Second, on reinsurance, when you have cedents retaining more business, how do you deal with the risk of adverse selection when the cedent kind of decide -- a more educated cedent because of the experience decides what they're going to keep and what they're going to reinsure?
Nicolas Papadopoulo: So a lot of the business is about adverse selection. The question is I have insight into the business to understand why people are buying and does it make sense? And do you -- can you -- they have a need you have to -- we spend a lot of time and creating insight to figure out their needs that we are willing to insure or reinsure and there are things that we are unwilling to do because it's this -- I said before, I think we're looking for risk where we have upside that outweigh the downside. So that's the one way to look at it. When you have only downside usually don't want to do those risks. And so I think that there is always that risk. On the selection, it's a very dynamic market. And anti-selection is everywhere. So I think you have to factor that in, into your risk selection in my view. So I think it's -- yes, you can't -- if you're on the right risk, A lot of what we -- you get told as an underwriter is more like a fairytale used. So if you like to fairytale, you're not going to end up in a very successful underwriting shop. So I think you have to, that's part of the job. The job is to have the insight to be able to ask the right questions and get to the answer and build a relationship with the clients where they come to you to for legitimate concern that they have and where you can really provide value by either insuring or reinsuring them -- but you can't -- we have both sides of the house. I mean on the insurance side, those people that we try to tell our guys to do the right thing. If the risk is good, try to retain it to have conviction about -- so if you for a while, you're not sure, so you buy reinsurance on a quota share basis. And ultimately, you -- over time, you build conviction that your underwriting guidelines work, your pricing is okay. At that point, you don't need the insurance. So you retain it net. And that -- there's nothing wrong about that. My view is that we should -- that's a role the reinsurance play.
Operator: I'm not showing any further questions. Would you like to proceed with any further remarks?
Nicolas Papadopoulo: No. I think -- thank you. And I think another I think good quarter for us in a little more difficult or more competitive market but I think we remain bullish about I just said in my remarks to stand out. So I think we'll see you guys in next quarter.
Operator: Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect. | [
{
"speaker": "Operator",
"text": "Good day, ladies and gentlemen and welcome to the First Quarter 2025 Arch Capital Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session and instructions will follow at that time. As a reminder, this conference call is being recorded. Before the company gets started with its update, management wants to first remind everyone that certain statements in yesterday's press release and discussed on this call may constitute forward-looking statements under the federal securities laws. These statements are based upon management's current assessments and assumptions and are subject to a number of risks and uncertainties. Consequently, actual results may differ materially from those expressed or implied. For more information on the risks and other factors that may affect future performance, Investors should review periodic reports that are filed by the company with the SEC from time to time, including our annual report on Form 10-K for the 2024 fiscal year. Additionally, certain statements contained in the call that are not based on historical facts are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The company intends the forward-looking statements in the call to be subject to the Safe Harbor created thereby. Management also will make reference to certain non-GAAP measures of financial performance. The reconciliations to GAAP for each non-GAAP financial measure can be found in the company's current report on Form 8-K furnished to the SEC yesterday which contains the company's earnings press release and is available on the company's website at www.archgroup.com and on the SEC's website at www.sec.gov. I would now like to introduce your host for today's conference, Mr. Nicolas Papadopoulo and Mr. François Morin. Sir, you may begin."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Good morning and welcome to Arch's first quarter earnings call. I'm pleased to report solid results for the quarter with $587 million of after-tax operating income, $1.54 in operating earnings per share an annualized operating return on equity of 11.5%. These results were achieved despite $547 million of catastrophe losses affecting our Property and Casualty segment primarily from the California wildfire. The P&C market has become increasingly competitive. However, we remain optimistic about our prospects as we continue to achieve broadly attractive rates across the sectors where we compete. At Arch, we believe that prioritizing expected profitability of our market share by allocating capital to lines of business with attractive risk-adjusted returns gives us the best opportunity to outperform for the cycle. This is what we mean by cycle management and we stand by the historical results of this approach. While the market may be more competitive ample growth opportunities remain. This is true despite emerging macroeconomic concerns, including the potential impact of tariffs that increased uncertainty for many of our insured across the globe and raised inflationary risks for some of our businesses. During times such as these, risk selection is critical as a growing number of our previously attractive accounts no longer meet our return criteria. We believe the acumen of our underwriting teams, breadth of our platform, investment in data and analytics and depth of our financial resources have Arch well positioned to navigate the P&C cycle. Now we'll turn to our segments, starting with Reinsurance. Reinsurance results were solid despite substantial catastrophe losses in the quarter and 91.8 combined ratio, inclusive of 18 points of catastrophe losses demonstrates the strong underlying profitability of our diversified reinsurance portfolio. Growth in net premium written in the quarter was modest due to an increased level of competition more risk retention by ceding companies and reducing our participation for treaties where margin no longer meet are hurdles. In the first quarter, the reinsurance group deployed additional capacity into property catastrophe lines where opportunities remain attractive, particularly in loss-impacted accounts. Specialty premium rising declined primarily due to non-renewing a large structure transaction. Weaker margin in cyber and part of our international treaty business also led to reduced premium linings. Treaty casualty lines experienced growth in the quarter as Arch recapitalized on a handful of select opportunities. We are hopeful these lines will continue to achieve rate and the treaty casualty market terms and conditions will continue to improve. As we look towards major renewals, particularly wind coverage in Florida and the Gulf, we expect additional demand from existing and new clients. On the supply side, it is worth noting that for many reinsurers and ALS funds, this zone represents peak exposure. As a result, significant additional capacity may be harder to come by -- even if the market is more competitive on the margin. Moving to our insurance segment, where the California wildfires led to a small underwriting loss for the quarter due in part to commercial risk from the recently acquired middle market commercial and entertainment businesses. The additional premium generated from those businesses contributed to the insurance group, $1.9 billion of net premium return in the quarter, a 25% increase from the first quarter of 2024. The integration of the middle market business is progressing well and we remain excited about the increased capabilities this team brings to the Arch Insurance platform. As we've said before, there isn't one underwriting cycle but many. In today's market, it's possible to deliver double-digit growth in some lines, while experiencing similar declines in others. In the first quarter, we generated meaningful growth in casualty led sectors, including construction, national account and international casualty. At the same time, we experienced premium reduction in other lines of business due to rate decreases and our desire to maintain margin in lines such as E&S property and professional lines, including cyber. We have seen competition increasing in the London market specialty lines which has made profitable growth difficult. Looking ahead, we expect continued growth in casualty lines as well as the U.S. middle market where opportunities remain for both rate and premium growth. We are well positioned across the insurance group because of our market-leading capabilities and relevance with distribution partners that gives us first look at many opportunities. The Mortgage segment continued to provide a steady earnings stream contributing $252 million of underwriting income in the first quarter. Economic uncertainty, limited housing supply and high relative mortgage rates continue to create headwinds for new mortgage origination which resulted in modest new insurance returns in our U.S. and international Mortgage businesses. For U.S. MI, high mortgage interest rates and on price appreciation have kept persistency around 82% and insurance in force relatively stable. The delinquency rate of our in-force portfolio remains low ending the quarter below 2%. Our near-term outlook for the Mortgage industry is unlikely to change significantly. While recessionary trends resulting from tariffs and other economic policy could create headwinds, we still expect the Mortgage segment to continue generating attractive underwriting income given the high credit quality and embedded equity of our in-force portfolio. Turning to our Investment group, where invested assets increased by 4% from year-end to $43.1 billion, providing a large sustainable contributor to group earnings. Investment market volatility increased broadly leading us to reposition our portfolio to a more market-neutral position. To manage the cycle, it's important to understand that you cannot control the market but you can control how your underwriting teams respond to it. At Arch, we manage a different cycle across our many lines with the ability of our underwriters to access, analyze and ultimately select risk. Over time, our underwriting teams have built strong relationships with our distribution partners which gives us an access advantage as they look to place risk with fewer, more relevant carriers, including Arch. Risk analysis combines experience, expertise and deep analytical insight to understand and assess the underlying risk and match it with a technical price that reflects an adequate premium for that risk. Ultimately, risk selection is what separates the winners from the losers. If the return doesn't adequately account for the risk, you must be willing to let others take the business. The P&C market in transition is one where Arch can and has previously demonstrated its ability to find success. While premium growth may be more challenging than in recent years, plenty of profitable opportunities remain. For a company with a strong underwriting culture like Arch, this is a market where we can stand out and continue to maximize returns for our shareholders. François?"
},
{
"speaker": "François Morin",
"text": "Thank you, Nicolas and good morning to all. Last night, we reported our first quarter results with after-tax operating income of $1.54 per share resulting in an annualized operating return on average common equity of 11.5% and growth in book value per share of 3.8% for the quarter. At a high level, our three business segments delivered excellent underlying results with an overall ex-cat accident year combined ratio of 81%. And importantly, each of our segments showing an improvement for that metric over the same quarter 1 year ago. Our underwriting income included $167 million of favorable prior year development on a pre-tax basis in the quarter or 4 points on the overall combined ratio. We recognized favorable development across all three of our segments and in many of -- many of our lines of business but the effect was most notable in short tail lines in our Reinsurance segment and in Mortgage due to strong cure activity. The acquisition of the MidCorp and Entertainment Insurance Businesses continues to roll through our financial metrics within the Insurance segment. This quarter, the net premiums written coming from the acquired businesses was $373 million, contributing 24.2 points to the reported year-over-year premium growth for the segment and generally consistent with last quarter. Also, the inclusion of the acquired business in the segment's results lowered the current accident year ex-cat combined ratio by 1.1 points. This can be further broken down to include the current quarter acquisition expense ratio that was lowered by 0.9 points due to the write-off of deferred acquisition costs for the acquired business at closing under purchase GAAP. The other operating expense ratio that was lowered by 0.9 points and the accident year ex-cat loss ratio that ended up being 0.7 points higher, reflecting the underlying results of the acquired business. The quarter-over-quarter comparison of net premiums written for the reinsurance segment showing growth of 2.2% was also impacted by a few items. Of note, this quarter's net premiums written includes approximately $70 million of reinstatement premiums, mostly related to the California wildfires. Offsetting this benefit was the nonrenewal of large structured transactions in the specialty line of business which reduced our top line by $147 million in the quarter. There were also some timing differences in the recognition of certain treaty renewals which resulted in lower net premiums written in the quarter of approximately $103 million. Our mortgage segment delivered yet again another very strong quarter with underwriting income of $252 million. Even though the origination environment remains challenged, the underlying fundamentals of the business are excellent, as exhibited by most of our key metrics, including a very low delinquency rate for our U.S. MI business which currently stands at 1.96%. On the investment front, we earned a combined $431 million pre-tax from net investment income and income from funds accounting using the equity method or $1.13 per share pre-tax. The reduction in net investment income relative to last quarter is attributable to a few items, including the impact of paying a $1.9 billion special dividend in December the timing of incentive compensation expenses, slightly lower interest rates in the quarter and the repositioning of our portfolio to a lower risk posture in light of the current macroeconomic uncertainty. Income from operating affiliates was down this quarter, mostly due to a lower level of affiliate income at Somers Re in part as a result of California wildfires. Cash flow from operations remained strong it was approximately $1.5 billion for the quarter. Our effective tax rate on pre-tax operating income was an expense of 11.7% for the quarter and reflects a onetime discrete benefit of 4.6% related to differences in the expensing of noncash compensation. Also, it is worth mentioning that we started to amortize this quarter the deferred tax asset we established at the end of 2023 related to the introduction of the Bermuda corporate income tax. This benefit does not impact our operating or our net income effective tax rates in the period. But as we mentioned previously, will flow through our financials as a reduction to pay taxes. As of January 1, our peak zone natural cap probable maximum loss for a single event, 1 in 250-year return level on a net basis, increased slightly and now stands at 9% of tangible shareholders' equity. Our PML remains well below our internal limits. On the capital management front, we repurchased $196 million worth of our common shares in the first quarter and an additional $100 million in April demonstrating our ongoing disciplined approach to managing our capital to enhance shareholder returns. In closing, our balance sheet remains extremely strong with common shareholders' equity of $20.7 billion and a debt plus preferred to capital ratio remains low at 14.7%. With these introductory comments, we are now prepared to take your questions."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] The first question comes from Mike Zaremski at BMO."
},
{
"speaker": "Michael Zaremski",
"text": "Thanks for all the insightful market commentary. On the Reinsurance group deploying additional capacity into catastrophe lines, you said that loss impacted accounts remain particularly attractive -- should we be -- I guess, we'll think through kind of the -- how to change our loss ratio a bit, if you kind of feel like you're going to continue leaning in. Any kind of updates to your cat load guide, I believe it was 7 to 8 points when you updated us last, should we expect that number to move up a bit?"
},
{
"speaker": "François Morin",
"text": "I don't think so. I think the number should be relatively stable. I mean full year cat load. Obviously, there's seasonality to it. As we look at market conditions, we certainly have thought that after the California wildfires, there might be a little bit of a I think a more -- some stabilization in that market which we think will happen, although as we touch on, I think Florida is its own different market, right? So a little bit early for us to know exactly how Florida is kind of ultimately perform or what opportunities we're going to see there. But big picture, I think what we saw at the start of the year seems to be holding up pretty well."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "I agree. I think the Florida outlook, as we see it is -- for the reason I described in my comments is pretty flattish. So I think we like the business. I think the -- if our teams -- again, we don't know but if our teams find opportunities to grow and we expect more demand in the marketplace for several reasons. I think the FHCF is raising the retention by $1.5 billion. And I think the -- we're seeing more cedents wanted to increase their limits, things that they haven't been able to do in the last few years because of the lack of capacity. So we think an opportunity to potentially do more if the rates hold up."
},
{
"speaker": "Michael Zaremski",
"text": "Got it. Okay. Switching gears to market competition outside of Reinsurance. I think the common theme has been in recent quarters that large account property is well priced and we're seeing some more meaningful downward pressure. You mentioned in your prepared remarks, the London specialty market as well. Maybe can you kind of unpack what you mean by the London specialty market and maybe kind of help frame which lines in particular are -- the clock isn't where you'd want to grow as much?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. I think in London, what's happening, I mean it's twofold. First, I think we've seen after years of good results, more appetite for people to expand in lines like terror, marine and energy. The typical species, the typical lines of business that are returned historically out of Lloyd's. And also, I think what we are seeing is London is kind of the excess and surplus market of the rest of the world. And so we're seeing as companies in their local market become more comfortable with their risk, their appetite expand. And so there is a little bit less business coming from Australia, from Asia, from jurisdiction that historically relies on Lloyd's as the appetite of their local companies get diminished. So that's what we're seeing. We're seeing the combination of the two -- I mean the tailwinds for us and a few other markets is that the market is consolidating around leaders. And I think we will lead in many of our lines of business. So it's difficult to predict. So it's come out but we feel positive about how we are positioned to continue to take advantage of the market there."
},
{
"speaker": "Operator",
"text": "The next question comes from Cave Montazeri at Deutsche Bank."
},
{
"speaker": "Cave Montazeri",
"text": "My first question is going to be on net premium growth in Reinsurance. I think it's pretty clear that the days of 30%-plus growth in NPW are behind us now as you become more selective. I'm assuming also 2.2% growth, that's probably a little bit too low to expect going forward. So can you maybe unpack some of the key drivers of the deceleration you saw in the quarter? Maybe give us a bit more details on the impact of the structured yields. Just to give us -- help us understand maybe where -- how we should think about that going forward in terms of premium growth in Reinsurance?"
},
{
"speaker": "François Morin",
"text": "Yes. I mean I touched on it in my comments, right? There's a couple of items. If you adjust for what we mentioned, again, we're not trying to do the [indiscernible] and adjust for everything. But if you adjust for those two things, you still get to a call it, like 6%, 7% growth rate which may be more consistent with what we see in the near future. But beyond that, I'd say there's really a separation like there's -- we had good growth in property other than property cat and property cap [ph] and in casualty where we saw some decreases on the specialty line beyond the structured and the timing of accruals on written premium. And there, I'd say it's a function of some of the lines or some of the smaller specialty lines that we participate in, where there's been more competition. And cyber is a prime example of that. It's a combination of rates coming down a little and also of some of our ceding companies retaining more of the risk. So that's how I'd say, like midterm, yes, you're right, the 30% growth is probably behind us but for the near term at least. But hopefully, these couple of things help you kind of reconcile a little bit like from the 2.2% to a -- what you may perceive to be a more kind of realistic expected growth in -- for the rest of the year."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. I think in the specialty book, you have a mix of lines of business. I mean it goes from credit to a cyber to agriculture and a few others. So our team are really scouting the world to find opportunities. We had a great opportunity in Brazil last year on the agriculture side. And this year, the cedent is winning more of the business. So, I think you have to be opportunistic in those lines of business to make money. So yes, if we have a big book, the ups and downs offset each other in the last few years it grew together because it was what the hard market does. I think we should be prepared to see more ups and down quarter-by-quarter going forward in that particular book. That's what we want them to do."
},
{
"speaker": "Cave Montazeri",
"text": "My second question is on casualty. Last year, a big theme was just the strengthening in the casualty reserves at the industry level. We haven't seen much of that so far in 2025. I think some people are thinking maybe we might be past the point of maximum fear with regard to social inflation. Just wondering like what your thoughts are? Do you agree with that? What do you think we're just in the eye of the storm and there's more pain to come in the second half of 2025?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "My prediction is I don't know when the pain will come but he will come. There's more pain. That would be my -- how people manage the pain and I can't tell but -- we think the casualty social inflation story has not fully played out. I think that's our view. And we're still -- we were getting definitely rate above trend on our casualty line and where we feel comfortable with the exposure, the jurisdiction, the type of the terms and condition that we get, I think we're willing to lean in but I don't think we are still at the case where it's a market that you can take a share of it and guarantee that you're going to make an adequate return. So I think there's more to come. That would be our general underwriting view."
},
{
"speaker": "Operator",
"text": "The next question comes from Elyse Greenspan at Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"text": "My first one, I think, is a quick one. François, the 7% adjusted growth in Reinsurance that you were talking about, in the quarter. Is that excluding reinstatements and the structured deals? I just want to make sure I understand what you're backing out."
},
{
"speaker": "François Morin",
"text": "No, I'm just putting back in the two items I mentioned. That's all. So the -- I'm not backing out the reinstatements, I'm just handing back the non-renewed deals and the timing of the accruals on some business."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. Got it. And then my second question is on the commentary around the midyear. It sounds like you're expecting perhaps some opportunity on the demand side, what about pricing? I guess, are you guys expecting that price is probably down but that -- there could be some growth opportunities just with demand. Can you help me think through those two pieces?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So clearly, it is the data point at 4/1 where single-digit down, most places, maybe a bit more than that in Japan due to, I think, one of the players buying less which the market's crumble around that. But I think the dynamic in Florida is, as I said in my remarks, is a little different because it's a big zone for both markets. And you -- the dynamic is people like the top players but they're not that many top players and people didn't like the bottom of the program. There's not as much -- and what we've seen in the past and we're seeing still today is bottom of the programs which have been impacted by the last year, the hurricane last year, Milton, we'd expect those probably to see some price increase and would that be compensated by price decrease at the top of the market at the top of the problem, I don't know. But I think -- that's why I think our view is, if things play out the way they should which they never do. We would expect something more flattish for Florida. And at that point, we feel that based on our positioning and we should be able at least to keep our share of the programs that are buying more and therefore, we may have opportunity to deploy more capital."
},
{
"speaker": "Elyse Greenspan",
"text": "Okay. And then one last one. In insurance, if I kind of ex out MidCorp, is that I think, around like a 56.7% underlying loss ratio that was slightly below the Q4. Is that about like run rate-ish, I guess, on core Arch, right? And then we think about bringing in MidCorp on top? Or anything else we need to think about just with pricing and loss trend and dynamics on the margin as we go through the year."
},
{
"speaker": "François Morin",
"text": "Yes. Well, we -- I mean, call it for the legacy Arch book, I mean, it's -- at a high level, we'd say that our margins are holding up in terms of rate above trend kind of being kind of keeping us steady. The one thing, though, that you have to factor in somehow is the mix is changing, right? As we pivot a little bit more into casualty. You might see that underlying loss ratio go up a little bit as we see more competition on the property and we mentioned it like a lot of our growth was in the casualty led kind of lines of business or profit units for us. So that might be the only thing. But big picture, we still think the loss ratio that we're -- we had this quarter is seeing no reason why it can't hold up at that level."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Kligerman at TD Securities."
},
{
"speaker": "Andrew Kligerman",
"text": "First question is around the reserving. It looked like you had some nice favorable developments, particularly in Reinsurance. But could you call out anything around commercial auto and other liability, net plus or minus in both Insurance and Reinsurance, how did that perform? And how do you feel about the reserving in those lines going forward?"
},
{
"speaker": "François Morin",
"text": "Great question. We -- our reserves are something we -- again, we mentioned before, we look at it every quarter. The actual versus expected that we monitor very carefully is looking good. But for us, it's a little bit early to call it victory. So we're monitoring everything, plus or minuses, yes, there's always going to be the finer -- if you slice that down to very fine levels. There are some pockets where we took a little bit of adverse which were offset by others where we had some good favorable coming through. But big picture, I'd say we're flattish. I mean everything on the casualty kind of long tail side auto and some of the more difficult lines, as you mentioned, umbrella, etcetera, where we're comfortable with what the reserve -- what the indications are."
},
{
"speaker": "Andrew Kligerman",
"text": "Okay. So that's good to hear. And then maybe shifting this is sort of a two-part question. Being clearly the acclaimed cycle manager that you are, could you share a little color on -- and maybe -- I know Nicolas, you mentioned many different cycles but maybe very broadly two cycles, casualty and property, maybe we'll even skip professional or you could throw that in, if you want. But how do you see those cycles playing out as we sit here today? How much longer will we see property pricing come down? How much longer can casualty pricing hold up? I know it's a really tough question but be really interested in your response on that. And then the second part is just -- what are you seeing with MGAs today? Are they still proliferating? Are they still very competitive? And I'll stop there. That was a lot of questions. Sorry for that."
},
{
"speaker": "Nicolas Papadopoulo",
"text": "The two are [indiscernible]. I'll start on the property side and I'll start on the -- I mean on the Reinsurance side, I think my view is that the market is more disciplined. So I think we've seen rate decrease. But from a peak of the market, I think the markets remain attractive. We haven't seen any really actors behaving in a totally irrational way. The new guys are coming but they're small. And so, I think really -- we remain very optimistic about the property cat and the way the industry behaves in general on that aspect. If you move to the cat the property in general and especially the E&S property and the North American net properties. I think you have -- there, you have a tale of two markets. I think you have the middle market, more, I would say, admitted retail where the convective storm and some of the recent cat element, I would say, will include the wildfire to a certain extent, keep putting pressure on the companies and they have to keep on getting rates to be make sure that they cover the cat load which has gone up in the last few years. And then you have the more the E&S cat, coastal and maybe earthquake driven risk, where that's where the MGAs play a bigger role. So I think the market has responded to my surprise, very quickly giving up double-digit rate increases we went through in and everybody was surprised, big limit was really something that people didn't like and took a ton of losses. So I think the market became in 2023, much more disciplined and cut limits which really pushed when people -- when the capacity withdraw that's where you see rates going up. So we got a huge upswing, re-underwriting, terms and conditions. And I think 1 year, 1.5 years later, I think we've seen MGAs which their capacity has been curtailed coming back with much bigger limits. And if you think of a typical risk, it's a $200 million risk where you need it probably 20 markets or more to complete. And let's say, Arch was doing the first 10 or doing the 10x10 [ph], and then the MGA come in and they do 40. It creates a complete run for the heel in terms of -- if you -- as I say, as was 10x10 [ph] and then MGA come in capacity and then -- and now they ask $40 million. So what do we do? We run for the hit and we're trying to reposition $10 million elsewhere in the program and that creates the huge pressure on the rates that we've seen. And I think capacity of MGAs have gone up this year. So I think they play a big role in my view, in quickly, the market turned to be much more competitive. That's what I see."
},
{
"speaker": "Andrew Kligerman",
"text": "And same thing on casualty?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "On casualty, there's less MGAs. I think on casualty, I think what you've seen is -- and to go back into property, I think when you see markets like us, increasing capacity, maybe we increased capacity from 10 to 15. We don't go from 10 to 40. I think -- so if you go on the casualty side of the house, now whether it's E&S or -- you've seen the same thing. You've seen response to typical losses is reduction of limit. You want prices to be applied to multiple risk of business to create the diversification and the lower number works better. So I think that's what we've seen and the reduction of the capacity and the usual limit from 50s to 25s and to 15s have created this opportunity, especially on the excess side for rates to go up. I think we haven't seen a ton of people. In fact, we're seeing people still reducing limits. So this tells me that the runway to a more competitive marketplace is going to be longer."
},
{
"speaker": "Operator",
"text": "The next question comes from David Motemaden at Evercore ISI."
},
{
"speaker": "David Motemaden",
"text": "Good morning. I had a question on the $147 million of structured deals that were non-renewed. Just so I'm thinking about it correctly. Were there any other chunkier quarters in 2024 that we should think about where like there were chunky structured deals that might not renew as we go through the rest of 2025?"
},
{
"speaker": "François Morin",
"text": "There's always some chunky books or deals that we write throughout the year. I mean, what we don't know is whether they'll reappear or we'll -- they may renew at the same thing at the same level, same kind of structure for another year. So hard to know what the impact may or may not be for the rest of the year. Again, we're just trying to give you a bit of additional information on how the premium is, why it's going up or down. Sometimes, it works in our favor in the sense that, yes, we write new deals that are significant and improve or increase the growth or the reported growth but -- in this case, it was different. So these are, I'd say, though, they're on the larger side. I mean it's unusual that we -- we don't have that many deals that are -- that have that much premium associated with them."
},
{
"speaker": "David Motemaden",
"text": "And then on the insurance underlying loss ratio, I think last quarter, you spoke about it running at around the 58% level going forward. It obviously came in nicely below that this quarter. I'm wondering was there anything that drove that? It sounded like you split it out between the legacy Arch and MCE was there more improvement on the MCE side? Is that something we can expect to continue? So maybe some color around that would be helpful."
},
{
"speaker": "François Morin",
"text": "Yes, hard to say. I think -- I'd say, the quarterly numbers matter but we don't overly put too much weight on them. I'd say we want to make sure we have a longer-term view of what underlying profitability of the book is. So I would not factor in or expect any significant movements up or down, let's say, from -- for either the MCE or the legacy business. And as you know, I mean, last year, we had the Baltimore Bridge which impacted the loss ratio upward. We didn't have that this quarter. So there's always going to be the random element of a couple of large clients here and there that may -- that have an impact ultimately on the quarterly loss ratio. So, big picture -- we call it a fairly stable environment. And we always expect a little bit of volatility from quarter-to-quarter depending on what happens."
},
{
"speaker": "Operator",
"text": "The next question comes from Alex Scott at Barclays."
},
{
"speaker": "Alex Scott",
"text": "I thought I'd see if you could provide a little more commentary on what you're seeing in the property cat reinsurance market I guess, specifically, what's your view of the impact of ILS? Is the pricing pressure more at the top of the tower? Any commentary on sort of the way it's affecting these towers and where you play in them?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. So the -- what we've seen and what seems to continue to happen is what you described, more pressure at the top. We've seen the cat bond market being repriced to lower margin. So I think that put pressure also to the layer below the cat bond market and obviously, there hasn't been any losses on those layers where at the bottom of the program between the California wild fire, on the nationwide account and some of the storms that we've seen, we have a loss. So I think the more, I would say, the place where price decrease seems to be focusing is really at the top of the program. So I think we -- in Florida is going to be more complicated because I think, again, there's not that much supply in the marketplace. So I would expect it to maybe not be as strong as maybe in the Northeast region where you haven't had a loss in any of the top players or middle to top players for a long time and people see that. So, I think -- but yes, I think the -- what you described is we expect it to -- if something is going to happen, my view is that's what's going to happen. It's probably more pressure at the top of the program and maybe less moderate pressure on the bottom."
},
{
"speaker": "Alex Scott",
"text": "Got it. That's helpful. Next one on capital management. I mean, you had very strong capitalization and growth slowing a little bit, just given the environment. How do you think about priorities there? And how quickly do I ramp up capital return if you don't get the opportunity to grow in the midyear."
},
{
"speaker": "François Morin",
"text": "Yes. I mean it's something we look at constantly, it's part of the same framework. We've always had no question that if the growth moderates which is it's starting to and we still have solid earnings coming through. We'll probably be in a position where we accumulate a bit more excess capital and we'll probably be looking to return most of it back to our shareholders. So there could be some small M&A. There could be some other things that come our way. But at a high level, you could certainly -- I think it's reasonable for us to think that we'd be returning a significant amount of capital as we move forward. We had a special dividend late last year. We obviously like share buybacks a lot. And given the -- if the pricing and the metrics work for us, we're happy to do that."
},
{
"speaker": "Operator",
"text": "The next question comes from Wes Carmichael at Autonomous Research."
},
{
"speaker": "Wes Carmichael",
"text": "In Reinsurance, I think you mentioned a couple of times of primary companies retaining more risk. Just hoping you could provide a little more color on what you're seeing from primaries and maybe where that's most pronounced?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "I think it's most pronounced in the other property where we see it, some of the other line of business, like maybe energy and where results have been good, ceding commissions are good but companies feel more comfortable with their results. So that's a normal trend that you see as the -- as you go through the whole market and you go through the clock is that people tend to retain more of the risk. They bought the reinsurance because they either wanted the volatility and they were a portion of the business, they were unsure of the performance as they have re-underwritten their book it's not unusual for people to feel more comfortable. I know Arch insurance, that's what we do. And we are more comfortable with the risk. We definitely buy more insurance. So we move the reinsurance that we would buy to an excess of loss, where we retain more of the premium. So, I think we haven't seen a ton of quota share going through excessive loss but we've definitely seen companies as they feel more comfortable with the risk or feel better about their financial situation, retaining more of the risk. And certainly, on the structure, if you're related to the structure on the structure side, structured deals are usually capital relief deals. So I think those deals last as long as the company is -- needs the surplus relief. If you go in a situation where they don't need the surplus relief anymore, then the deal goes away. So..."
},
{
"speaker": "Wes Carmichael",
"text": "That's helpful. And I think in mortgage, prepared remarks touched on headwinds of origination. Can you maybe just talk about what behavior you're seeing in that business? And are you seeing any potential leading indicators of recessionary activity at this point?"
},
{
"speaker": "François Morin",
"text": "Too early. I mean, really too early. I mean we can speculate. We do the work. We certainly have a view that, yes, I mean, if recession, we have a severe recession and that impacts unemployment and home prices go down a little bit, that may have an impact on the performance of the book but we keep going back to the strong fundamentals, the high credit quality of the borrowers. Home prices are -- there's a lot of equity that's been built up by the homeowners in their home. So it's a vastly different situation than what we had back in 2008. So -- or not to say that we don't worry about it because we do but we're a lot more comfortable with our position. And for a stress scenario to generate or create significant hardship on Arch would take -- it would have to be very, very severe. So we're -- at this point, we're in a -- we think, in a very good place."
},
{
"speaker": "Operator",
"text": "The next question comes from Josh Shanker of Bank of America."
},
{
"speaker": "Josh Shanker",
"text": "Good morning, everybody. Back in the fourth quarter, you paid a big special dividend, you bought back a little stock. You bought back more stock this quarter. I tend to find it difficult to parse paying special dividends and buy back stock at the same time, either the return on the stock is attractive or you need to give money back to shareholders promptly because it's not so attractive A couple of things there. One, can you talk about, little about your philosophy which is about 3-year ahead book value. But I've done a little bit of the math. And if the 3-year ahead book value rule of thumb applies, the market is very much underestimating your earnings power for the next couple of years. Can you talk about the philosophy of buybacks versus dividends and what that means for this year and what you think about the attractiveness of the stock at this point?"
},
{
"speaker": "François Morin",
"text": "Well, we like the stock. That's for sure. But I mean the biggest obstacle, Josh, is truly the level of -- the speed at which you can execute share buybacks. We have limits on daily trading volume, etcetera. So the main reason, if you put aside even if the price was right and you say, well, it's really attractive to buy at a certain level, the advantage of a dividend is you can execute a much bigger return of capital I mean instantly versus over a long period of time. So for us to buy back $1.9 billion of stock at the rate at which we can actually do it because of the restrictions we have would take a long time, at which point we'd accumulate more excess capital and you never catch up. So that is, I think, important to realize that there's only so much we can do with share buybacks. When you get into what's the 3-year payback, yes, 3 years is a good metric for us that we follow. Do we have a different view of what the book value might be out in 3 years out than you do, maybe and we take a hard look at what we know about our business but we're still within that roughly that 3-year payback period and we still think there's a lot of good runway for us to keep growing book value at a good clip for the next little while. So that gives us a lot of comfort that buying back stock at this price has been -- is a good way to return capital to shareholders."
},
{
"speaker": "Josh Shanker",
"text": "If you started now, do you think you could execute $2 billion in buybacks before year-end and preclude the need for a special dividend?"
},
{
"speaker": "François Morin",
"text": "It would be hard. It would be hard. I mean there's ways you can kind of create some programs but we like to retain the flexibility, we like to have optionality, so locking yourselves in and that's true in everything we do. So to lock yourselves into making it public that we're buying back a certain amount at a certain price is something we try not to do. We like to be opportunistic and it's something that we -- again, it's constantly something we look at and try to optimize as best we can."
},
{
"speaker": "Josh Shanker",
"text": "Well, thanks for being transparent about the behind the curtain, how the sauce is made.."
},
{
"speaker": "Operator",
"text": "The next question comes from Andrew Anderson at Jefferies."
},
{
"speaker": "Andrew Andersen",
"text": "Just on the income from operating affiliates, I think it was $17 million in the quarter. It was down a bit year-over-year. I think that Somers is in Coface. Can you maybe just talk about the moving pieces there and perhaps how you're thinking about full year?"
},
{
"speaker": "François Morin",
"text": "Yes. Coface has been very, very good. So it's been a great story for us. We're extremely happy with it. There could be some pressure with trade credit going forward but that's, again, something we're keeping an eye on. We don't have visibility or a ton of clarity on it. So really, the drop in operating -- income from operating affiliates was mostly -- almost exclusively due to the Somers and let's remember that Somers is effectively a side car to Arch Re. So you have wildfires this quarter, they impact us and they impacted Somers as well. There's a little bit of a kind of a one-off on the Bermuda tax that was reflected in the Somers financials Q1 of 2024 that maybe makes the drop more significant than you would think otherwise. But as you look for the run rate, I'd say this quarter is a bit lower than what we would normally think for the operating affiliates in general. And I think we're still looking -- when you think about our returns, we think plus or minus like where we're earning well into call it, 10% range on these investments, if not more and let's just say we have over $1 billion in assets there. So hopefully, you can do the math from there."
},
{
"speaker": "Andrew Andersen",
"text": "That's helpful. And then just insurance expense ratio and there was improvement in OpEx but is full year '24 still a good way to think about the rest of the year for the OpEx? Or is there still some head count costs coming on?"
},
{
"speaker": "François Morin",
"text": "I mean, it's a good place. We are no question -- I mean as we think about our growth and how we need to manage our expense base, we are being very thoughtful and diligent about do we need to replace people that resign, do retirement, etcetera. So, we -- I think we're going to get some benefits from the MCE acquisition, like scale brings a little bit of a bit of leverage, a bit of kind of -- we can scale better. But no question that we're trying to hire still on the MCE side. We want to staff up with data scientists and we need a few more actuaries, etcetera. But big picture, I think we are watching our expenses and that's something that will be a focus as we move forward."
},
{
"speaker": "Operator",
"text": "The next question comes from Meyer Shields at KBW."
},
{
"speaker": "Meyer Shields",
"text": "I think I have the same question in two contexts. I think Nicolas started for comments talking about the preference of brokers to work with fewer bigger insurers. And I'm wondering if you could talk about the volume versus profitability implications of that to companies like Arch?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "Yes. So I don't think the two are necessarily linked. I think in my view, the best place to talk about this is probably the London market. In the London market, the brokers because the business come to London, the main three brokers control a lot of access to the business we write. So I think it's more of a supporting them where they need you to be supported and playing the role that you have to play where you can align with their own strategy. And I think if you think of the way they're organizing the market, having their own facilities, then they need leaders, without leaders, nothing works. Then they have some follow facilities and then ultimately, they have the open market that remains. I think you need to find a place, you can't service just one. I think if you service just one, you'd be -- so you have to be able to figure out your distribution strategy is a key component of our future success. That's what I'm saying. And I think we spent a ton of time thinking out how do we align better and where do we bring value to our distributors. And it varies for the bigger distributors it maybe one thing for a smaller distributor, mid-market distributor where they rely better on the expertise of art, it may be something different. So I think you have to really to be successful going forward, you really have to question the value you bring in the transaction. You can't just underwrite business. So the two components is that you have to do the underwriting cycle thoughtfully. And -- but you have also to figure out what your place in the food chain and what value you bring. So that's really the -- so we've done a lot of work and we're still thinking of this in a way that's less -- it's less about us but it's about ultimately the customers. Without customers, we don't exist. So we need to provide value to the ultimate customers. That's our -- and that dynamic is -- maybe is playing out in London, it's playing out in North America. You can't just be sitting at your box in Lloyds and waiting for the business to come to you and underwrite, because you're not even sure that the business you're going to see is the one you want to write. That's the issue. I think if there is five people in front of you that are picking up the good business, now you're picking up from a part that by definition, is not so good. So I think you have to work hard and size matters and relationship matters and being able you can see the business you're really targeting. And that's where distribution strategy matter."
},
{
"speaker": "Meyer Shields",
"text": "Okay, perfect. That's very helpful. Second, on reinsurance, when you have cedents retaining more business, how do you deal with the risk of adverse selection when the cedent kind of decide -- a more educated cedent because of the experience decides what they're going to keep and what they're going to reinsure?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "So a lot of the business is about adverse selection. The question is I have insight into the business to understand why people are buying and does it make sense? And do you -- can you -- they have a need you have to -- we spend a lot of time and creating insight to figure out their needs that we are willing to insure or reinsure and there are things that we are unwilling to do because it's this -- I said before, I think we're looking for risk where we have upside that outweigh the downside. So that's the one way to look at it. When you have only downside usually don't want to do those risks. And so I think that there is always that risk. On the selection, it's a very dynamic market. And anti-selection is everywhere. So I think you have to factor that in, into your risk selection in my view. So I think it's -- yes, you can't -- if you're on the right risk, A lot of what we -- you get told as an underwriter is more like a fairytale used. So if you like to fairytale, you're not going to end up in a very successful underwriting shop. So I think you have to, that's part of the job. The job is to have the insight to be able to ask the right questions and get to the answer and build a relationship with the clients where they come to you to for legitimate concern that they have and where you can really provide value by either insuring or reinsuring them -- but you can't -- we have both sides of the house. I mean on the insurance side, those people that we try to tell our guys to do the right thing. If the risk is good, try to retain it to have conviction about -- so if you for a while, you're not sure, so you buy reinsurance on a quota share basis. And ultimately, you -- over time, you build conviction that your underwriting guidelines work, your pricing is okay. At that point, you don't need the insurance. So you retain it net. And that -- there's nothing wrong about that. My view is that we should -- that's a role the reinsurance play."
},
{
"speaker": "Operator",
"text": "I'm not showing any further questions. Would you like to proceed with any further remarks?"
},
{
"speaker": "Nicolas Papadopoulo",
"text": "No. I think -- thank you. And I think another I think good quarter for us in a little more difficult or more competitive market but I think we remain bullish about I just said in my remarks to stand out. So I think we'll see you guys in next quarter."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for participating in today's conference. This concludes the program. You may all disconnect."
}
] | Arch Capital Group Ltd. | 346,919 |
ACN | 4 | 2,020 | 2020-09-24 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to Accenture's Fourth Quarter Fiscal 2020 Earnings Call. [Operator Instructions]. And I would now like to turn the conference over to your host, Angie Park, Managing Director, Head of Investor Relations. Please go ahead.
Angie Park: Thank you, operator, and thanks, everyone, for joining us today on our fourth quarter and full fiscal 2020 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and the balance sheet, along with some key operational metrics for both the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the first quarter and full fiscal year 2021. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie.
Julie Sweet: Thank you, Angie, and thank you, everyone, for joining us. Fiscal '20 results demonstrate the relevance of our growth strategy, the resilience of our business and our people, our operational rigor and discipline, the power of the relationships we have with the world's leading companies and ecosystem partners and our ability to pivot rapidly to meet the needs of our clients and new ways of operating. Fiscal year '20 also demonstrated the unique advantages of our long track record of focusing on being a responsible business, from our commitment to inclusion and diversity that has helped make us an innovation-led company, to our focus on investing in our people and their skills, to the way we live our core values, all of which help make us the trusted partner that our clients have turned to in the face of the ongoing global health, economic and social crisis. And if there was ever any doubt, we clearly demonstrated that scale matters. We are unique in our industry for the scale of our digital, cloud and security capabilities, and for our leadership in all the services critical to building a company's digital core, transforming its operations, and accelerating growth with our four services of strategy and consulting, interactive, technology and operations, as well as our deep industry experience and data and artificial intelligence capabilities, and we are also unique in the scale we have with large client relationships and across 13 industry groups with a global footprint. This scale has been core to our resilience in the second half of FY '20. Let me share a few highlights. We are now approximately 70% in "the New"- digital, cloud, and security, just when the need for these services, already high, accelerated dramatically as a result of COVID-19. In fact, in FY '21, we will no longer measure "the New" as "the New" is now our core. And as of March 1, with the new growth model, we have embedded digital everywhere. We will continue to share color on our growth drivers, including cloud and security as we continue to invest in these large, high-growth market opportunities. We ended FY '20 with 216 Diamond clients, which represent our largest client relationships, a net increase of 15 over the prior year. We transitioned seamlessly to our new growth model with a new global management committee to increase our agility in bringing together the power of our multiservice teams to our clients and to create greater opportunities for our people. And the new model and team successfully passed a challenging test, navigating the pandemic and emerging stronger. More on that later. We committed to stronger bookings in Q4, and we delivered with our second highest bookings ever in the fourth quarter, finishing the year with a record $50 billion of sales. In FY '20, we continued to increase our investments for the future at scale with $1.5 billion in acquisitions, $871 million in R&D in our assets, platforms and solutions, including growing our portfolio of patents and pending patents to over 7,900 and delivering a 6% increase in training hours for our 500,000 people, while reducing our training cost by 11% to $866 million due to our digital learning platforms. We are now 45% women, on track for our 2025 goal of a 50-50 gender balance. And this month, we announced ambitious new goals to increase our African-American and Black and Hispanic American and Latinx communities in the U.S. And despite the unprecedented uncertainty and volatility, with the pandemic declared only a few days before we had to give guidance for Q3, we called it like we saw it for each of Q3 and Q4 and delivered within our guidance. For the full year, we delivered either within or above our guided range and continued to deliver growth ahead of market modest margin expansion and record free cash flow. Our resilience begins with an exceptional leadership team and our incredibly talented and dedicated people. Before I turn over to KC, I want to thank each of them for what has truly been an exceptional year that we should all be proud of. KC, over to you.
Kathleen McClure: Thank you, Julie, and thanks to all of you for joining us on today's call. We were pleased with our overall results in the fourth quarter, which were within our guided range and aligned to our expectations. Our results reinforce our distinctive position in the marketplace and reflect the diversity of our business. Once again, these results illustrate Accenture's unique ability to run our business with discipline and deliver significant value for our shareholders in an uncertain environment. So, let me begin by summarizing a few of the highlights of the quarter. Revenues declined 1% in local currency, in line with our guided range. This includes a reduction of approximately 2 percentage points from a decline in revenues from reimbursable travel costs. Importantly, aligned with our growth imperatives, we continued to take significant market share for both the quarter and the year. The diversity of our business continues to serve us well. From an industry perspective, consistent with last quarter, approximately 50% of our revenues came from seven industries that were less impacted from the pandemic and, in aggregate, grew high-single digits with continued double-digit growth in Public Service, Software & Platforms, and Life Sciences. At the same time, as we expected, we saw continued pressure from clients in highly impacted industries, which include travel; retail; energy; high tech, including aerospace and defense; and industrial. While performance varied, this group collectively represents over 20% of our revenues and declined mid-teens. Operating margin was 14.3%, an increase of 10 basis points for the quarter and the full year. We continue to drive sustainable margin expansion while making significant investments in our business and our people to extend our market leadership. We continue to benefit from lower spend on travel, meetings, and events. And finally, we delivered free cash flow of $3 billion, which surpassed our expectations, driven by superior DSO management. Now let me turn to some of the details. New bookings were $14 billion for the quarter, our second highest on record and reflect 9% growth with a book-to-bill of 1.3. Consulting bookings were $6.5 billion with a book-to-bill of 1.1. Outsourcing bookings of $7.5 billion were a record with a book-to-bill of 1.5. Bookings continue to be dominated by strong demand for digital, cloud, and security-related services, which we estimate represented approximately 70% of our new bookings. We were very pleased that we delivered on our expectations of strong bookings this quarter, and they came in as we expected with strong bookings in technology and operations and lower bookings in strategy and consulting. Turning now to revenues. Revenues for the quarter were $10.8 billion, a 1% decline in local currency and 2% decline in U.S. dollars, including a reduction of approximately 2% from a decline in revenues from reimbursable travel costs. Consulting revenues for the quarter were $5.7 billion, a decline of 8% in both local currency and U.S. dollars, which includes a reduction of approximately 3% from a decline in revenues from reimbursable travel costs. Outsourcing revenues were $5.2 billion, up 7% in local currency and 6% in U.S. dollars. Digital, cloud, and security-related services grew low-single digits. Taking a closer look at our service dimensions. Operations grew high single digits. Technology services grew mid-single digits. And strategy and consulting services declined low teens. Before I give color on our markets, the industry dynamics that I have mentioned previously played out in a similar fashion across all 3. In North America, revenue growth was flat in local currency. In Europe, revenue declined 5% in local currency. We saw mid-single-digit growth in Italy, slight growth in Germany, with continued declines in the U.K. In the Growth Markets, we delivered 3% revenue growth in local currency, led by double-digit growth in Japan and high single-digit growth in Brazil. Moving down the income statement. Gross margin for the quarter was 31.8% compared with 31.1% for the same period last year. Sales and marketing expense for the quarter was 10.6%, consistent with the fourth quarter last year. General and administrative expenses was 6.8% compared to 6.2% for the same quarter last year. Operating income was $1.5 billion in the fourth quarter, reflecting a 14.3% operating margin, up 10 basis points compared with Q4 last year. Before I continue, I'd like to highlight an investment gain that impacted our tax rate and increased EPS by $0.29 for the fourth quarter and $0.43 for the full year. Of this $0.43 gain, $0.27 was factored into the full year EPS guidance provided in June, and a quarterly reconciliation can be found on our website. The following comparisons exclude this impact and reflect adjusted results. Our adjusted effective tax rate for the quarter was 28.4% compared with an effective tax rate of 26.6% for the fourth quarter last year. Adjusted diluted earnings per share were $1.70 compared to EPS of $1.74 in the fourth quarter last year. For the full fiscal year, adjusted earnings per share were $7.46, which was $0.03 above our adjusted guidance range for the year. Days service outstanding were 35 days compared to 41 days last quarter and 40 days in the fourth quarter of last year. Free cash flow for the quarter was $3 billion, resulting from cash generated by operating activities of $3.2 billion, net of property and equipment additions of $189 million. Our cash balance at August 31 was $8.4 billion compared with $6.1 billion at August 31 last year. With regards to our ongoing objective to return cash to shareholders, in the fourth quarter, we repurchased or redeemed 2.6 million shares for $590 million at an average price of $225.25 per share. Also in August, we paid our fourth quarterly cash dividend of $0.80 per share for a total of $509 million. And our Board of Directors declared a quarterly cash dividend of $0.88 per share to be paid on November 13, a 10% increase over last year, and approved $5 billion of additional share repurchase authority. Reflecting our results for the full year. We started with strong momentum in the first half and quickly adjusted and reset with the onset of the pandemic. We delivered approximately $50 billion in new bookings, reflecting a 10% increase over last year, setting 2 record highs this year. We continued to provide guidance on our business throughout the year and, importantly, delivered revenues within our guided range at 4%, significantly taking market share. We delivered on our commitment of margin expansion even with lower top line growth and fully continued all elements of our capital allocation, with $1.5 billion of investments in acquisitions, a record $7.6 billion of free cash flow and returned $5 billion of cash to shareholders, exceeding our outlook provided last September. In closing with fiscal year '20 behind us, we are proud of how we managed our business and delivered for our clients, our people, our shareholders, our partners and our communities in what was truly an unprecedented fiscal year. And we feel really good about our positioning for fiscal '21. Now let me turn it back to Julie.
Julie Sweet: Thank you, KC. From an overall demand perspective, the trends that we discussed last quarter are continuing. Companies need to accelerate their digital transformation across their enterprises and move to the cloud; address cost pressures, which vary by industry but are universal; build resilience; adjust their operations and customer engagement to a remote-everything environment; and find new sources of growth. Now I will give you a little more color on the depth and breadth of our ability to deliver value to our clients in this environment through the lens of some of our 17 clients with new bookings over $100 million in Q4. Then I will turn to fiscal year '21. Diebold Nixdorf, a global leader in services, software and hardware for the banking and retail industries, and Accenture have extended a strategic agreement to accelerate Diebold Nixdorf's multiyear digital and cloud transformation program, which includes streamlining its finance, human resource, IT and sales systems. The collaboration will unlock approximately $50 million of incremental savings through 2023, while improving business productivity, consolidating operations and enabling investment in innovation and growth opportunities. Prudential Financial, a financial wellness leader and premier active global investment manager, has entered into an agreement with Accenture to transform its group insurance operating model by redesigning its processes, operations and technology to create simple, intuitive interactions between brokers, customers and employees that enhance financial wellness. New digital solutions designed by Accenture Interactive and powered by artificial intelligence and analytics from our SynOps platform and our operations team will provide more data-driven, seamless and human-centered experiences in onboarding, billing and claims processes, enhancing user satisfaction and, ultimately, revenue growth. Halliburton, a leading global provider of products and services to the energy industry, Accenture and Microsoft entered into a 5-year strategic agreement to advance Halliburton's digital capabilities in Microsoft Azure. Halliburton will complete its move to cloud-based digital platforms, drive additional business agility, reduce capital expenditures and strengthen its customer offerings as well as achieve sustainability benefits by migrating all of its physical data centers to Azure. A leading global automotive company has selected Accenture to migrate 55% of its applications over 18 months to the cloud, working with its ecosystem partners for the public cloud, AWS and GCP, and HPE for its hybrid cloud. This work will address both cost pressures and the need to transform their IT infrastructure to address obsolescence and provide digital experiences. These examples are noteworthy for their diversity across industries, complexity requiring multiservice teams, strong ecosystem partnerships and using our assets, platforms and solutions. And many involve us delivering what we call 360-degree value, because we are creating agility, helping reskill our clients' employees or helping reduce their carbon footprint to the move to the cloud in addition to delivering clear financial value. And stepping back for a moment. Our clients were being impacted by unprecedented change before COVID-19. Then came COVID-19, giving a whole new meaning to unprecedented and requiring our clients to change virtually every aspect of their business faster than ever before, and they are turning to us to help embrace that need for change and become stronger. Turning to fiscal year '21. Our own formula for market leadership is enduring. We continually transform our business and embrace change to create more value for our clients with incredibly talented people. We view fiscal year '21 as turning a page. We are no longer navigating a crisis. We are facing a new reality, and we plan on returning to pre-COVID growth rates by the second half of this fiscal year, and we are ready. We are emerging from the second half of fiscal year '20 stronger than when we entered, which was our strategy. As a leadership team, we set five measures of what stronger means, and we have met each of them. First, did we grow market share faster than pre-COVID? Check. We grew at approximately 4x the market in H2 as compared to 2x the market in H1. And as a reminder, when we say market, we were referring to our basket of publicly traded companies. Second, did we execute on our big deal pipeline in H2 despite the crisis, which would be a proxy for enhancing our role as the trusted transformation partner? Check. In fact, we had 3 more clients with over $100 million of bookings in H2 compared to H1 of this year. Third, did we capture new growth opportunities? Check. We have had substantial new bookings in the health and public sector, such as the 10 states in the U.S. where we are doing contact tracing in remote collaboration services as well as cloud, security, supply chain and digital manufacturing, which helped offset a portion of the severe impact on some of our clients. Fourth, did we continue to invest in our business and our people? Check. Not only did we invest significantly in our business and increase our training hours, but we also created the capacity to pay our people meaningful bonuses for fiscal year '20 performance and are planning for a significant level of promotions in our upcoming December promotion cycle. And all of this, we believe, will distinguish us from our competitors. And finally, fifth, did we continue to deliver consistently on our shareholder commitments? Check. And we also reduced structural costs through our new growth model and took to accelerate our fiscal year '21 usual level of performance management-related exits of around 5% each fiscal year so that we are preserving our talented workforce for the future while positioning ourselves for modest margin expansion and continued investment in our business in fiscal year '21. Before KC gives you more details on our FY '21 outlook, I want to touch on Accenture Cloud first, which is an example of how we anticipate client needs and then act at speed and at scale. Last week, we announced the creation of Accenture Cloud First and a $3 billion investment over 3 years, which will be funded by prioritizing our expected investments across the business. Accenture Cloud First is a new multiservice group of 70,000 cloud professionals with more than 100,000 people providing cloud-related services, which brings together the full power and breadth of Accenture's industry and technology capabilities, ecosystem partnerships and deep commitment to upskilling clients' employees and to responsible business with the singular focus of enabling organizations to move to the cloud with greater speed and achieve greater value for all their stakeholders at this critical time. We have been building our cloud capabilities for the last decade and are a leader with approximately $12 billion in cloud revenue for FY '20, growing double digits, which includes our SaaS capabilities delivered through our Intelligent Platform Services business. This positioned us well to recognize that COVID-19 has created a new inflection point that requires every company to dramatically accelerate the move to the cloud as a foundation for digital transformation to build the resilience, new experience and products, trust, speed and structural cost reduction that the ongoing health, economic and societal crisis demands and that a better future for all requires. Post-COVID leadership requires that every business become a cloud-first business, quickly moving from today's approximately 20% in the cloud to 80%. This is a "once in a digital era" massive replatforming of global business. Accenture Cloud First works seamlessly with our Intelligent Platform Services, which focuses on our SaaS capabilities, which are an important part of replatforming global businesses. Recent wins include working with a leading consumer goods manufacturer on a global deployment of SAP S/4HANA, initially focusing on their central finance system and building a new digital backbone for the entire supply chain in China from purchasing to direct-to-consumer sales; working with the U.S. Air Force to establish a new cloud-based common infrastructure for its Oracle Enterprise Resources Planning program; working with a bank on the integration of their front office operations and enhancing customer relationships powered by Salesforce; and working with a top higher education research institution to implement Workday to transform their HR capabilities, to drive real-time data analytics and become a strategic partner across the organization. And ServiceNow is another digital platform that is critical. For example, for a public service agency, we collaborated with ServiceNow to rapidly implement a cloud-enabled workflow solution, enabling millions of citizens to access government services while complying with dynamic pandemic health safety guidelines. Now over to you, KC.
Kathleen McClure: Thanks, Julie. Before I get into our business outlook, as I did last quarter, I would like to remind you that given the coronavirus pandemic, there are a number of factors that we may not be able to accurately predict, including the duration and magnitude of the impact, the pace of recovery as well as those described in our most recent quarterly filings. With that said, let me now turn to our business outlook. For the first quarter of fiscal '21, we expect revenues to be in the range of $11.15 billion to $11.55 billion. This assumes the impact of FX will be about a positive 1.5% compared to the first quarter of fiscal '20. It also reflects an estimated negative 3% to flat growth in local currency and includes a reduction of approximately 2 percentage points from a decline in revenue from reimbursable travel costs. For the full fiscal year '21, based on how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results in U.S. dollars will be approximately positive 2% compared to fiscal '20. For the full fiscal '21, we expect our revenue to be in the range of 2% to 5% growth in local currency over fiscal '20, including approximately negative 1% from a decline in revenues from reimbursable travel based on a 2% reduction in the first half of the year and no material impact in the second half of the year. A couple of key points that are helpful to understand our guidance. We expect our growth will be lower in H1, with Q1 and Q2 ranges being similar, and we expect we will reconnect with higher growth in H2 in the range of high single digits to low double digits. For operating margin, we expect fiscal year '21 to be 14.8% to 15%, a 10 to 30 basis point expansion over fiscal '20 results. We expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.9% in fiscal '20. For earnings per share, we expect full year diluted EPS for fiscal '21 to be in the range of $7.80 to $8.10 and or 5% to 9% growth over adjusted fiscal '20 results. For the full fiscal '21, we expect operating cash flow to be in the range of $6.35 billion to $6.85 billion; property and equipment additions to be approximately $650 million; and free cash flow to be in the range of $5.7 billion to $6.2 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we expect to return at least $5.3 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so that we can take your questions. Angie?
Angie Park: Thanks, KC. [Operator Instructions]. Operator, would you provide instructions for those on the call?
Operator: [Operator Instructions]. Our first question today will come from the line of Tien-Tsin Huang of JPMorgan.
Tien-Tsin Huang: I wanted to -- you gave a lot of good information here. It sounds like strategy and consulting services saw the biggest rate of change exiting the year, a little bit more pressure. I know operations improved. So I'm curious on the visibility and the outlook for strategy and consulting in fiscal '21. I presume that's going to see probably a nice recovery in the second half, based on your comments there. And are you over-indexed at all in strategy and consulting to some of the industries impacted by the pandemic?
Kathleen McClure: Thanks, Tien-Tsin, for your question. So let me talk about what we see for growth in strategy and consulting, and then Julie can pass on some additional color. So first thing I would say is that when we look at strategy and consulting, we really do see that it's held up in this environment, because it really is critical to our differentiation in the places where our clients are continuing to invest. And if we look at the actual results, strategy and consulting, they came in really as we expected in Q4. And you're right, it does follow a very similar pattern from an industry perspective, Tien-Tsin, where we see pressure in strategy and consulting in the most highly impacted industries in the market. Now in terms of the dynamics for growth, we see the same dynamics in the first quarter essentially that we're seeing from an industry perspective in strategy and consulting growth in the first quarter as we saw in the fourth quarter, and that should play out pretty similar in the first half. But we do see recovery and reconnecting with growth in the back half of the year. Let me just hand it over to Julie for some more comments.
Julie Sweet: Yes. Tien-Tsin, I think what's important -- so in other words, we're not over-indexed in strategy and consulting versus the rest of our business and industries, and so how it's kind of worked with sort of 20% in severe industries, et cetera. As I talked about last quarter, right, when you think about strategy and consulting, it's a huge differentiator in sort of these transformational deals, and I'll talk about that in a minute. And then, as I said, the leading companies right now are very focused. So some of the smaller work that you would do to sort of incubate and to start doing things, companies are saying and we're telling companies, focus on the big rocks that you need to do, right. And so, what's playing out in the market isn't about sort of a weakness in strategy and consulting. It's a reflection of how our clients are thinking about their businesses and what they need. So, I'm actually quite pleased with how well strategy and consulting is holding up. And the thing that's the most important is that this is how we're delivering 17 clients with over $100 million bookings, because each of these big transformations, like require this deep understanding of industry and functions. And you see that in other places. For example, the Bank of England, we announced a deal there where we're helping them with their high-value payments infrastructure to support resilience and innovation, right. Digital payments and instant payments were huge before the crisis. As you know, it's changed dramatically. And because we understand the industry, we have cross-industry expertise in how digital payments are being used, right, as well as the understanding of data and the technology, those things come together to create this new system that improves resiliency, customer experience, access to data and end-to-end risk management. No one can do that, right, with all of those skills but [audio disturbance] anything? Maybe next question.
Angie Park: Next question is from Lisa.
Operator: Lisa Ellis of MoffettNathanson.
Lisa Ellis: Yes, following up a little bit on -- well, a related question to Tien-Tsin's question about consulting. Can you talk a little bit about -- just looking like, obviously, revenue is down in the quarter, but then bookings and consulting very strong. I guess a follow-up on that is what are you seeing clients kind of commit to in the current environment on the consulting side of things? Like meaning, what's their willingness to commit on these kind of new, more strategic projects in the current environment? I'll leave it there, and then I have a follow-up.
Julie Sweet: So Lisa, and again, and I know all of you guys think very much about strategy and consulting and then the technology and operations separately. But in fact, as I've said consistently, including pre-COVID, we really think about our services together. But let me just give you an example of one of the most severely impacted industries, energy. So last week, I'm with the CEO and the leadership team of one of our major clients, and the meeting goes like this: The first part of the meeting is, thank you very much, Accenture, for helping us save money in finance and accounting operations because we lowered what they needed to create some -- help them with their cost pressures. Then the next part of the meeting is all about the IT modernization that we signed during Q3, right, which includes strategy and consulting. It includes our application outsourcing, maintenance. And it includes other technology services, right. And that was about -- because they have to continue to build their digital core, they need -- it's helping them with cost, but it's also about moving to the cloud. It's about creating those capabilities. Then the third part of the meeting was around some pilots that we're trying to shape with them that include -- that are -- it's driven by strategy and consulting, where the criteria is we need to turn them faster. So there's small pilots all about innovation, right. But the criteria we're helping them say is, well what should we do that will get more return, right, because they've got to balance, right. So again, we think about this as what are the needs of the client and how do we bring these services to deal with their short term, their longer-term transformation and also thinking very quickly about how they can innovate to get nearer-term returns. Does that help kind of bring that together in terms of how they're thinking?
Lisa Ellis: Yes. Yes. And then my follow-up, this is a kind of broader industry question. But we're looking at -- we typically think of Accenture, given your scale, as sort of a bellwether for the industry, and we are looking at kind of historical times in history when we've seen this bifurcation between IT spending and GDP. And you're running kind of flattish on revenues, which is very impressive given that GDP is running down mid- to high-single digits. And those times in the history have always been when there's been like a really big disruption on the technology side: the Internet, personal computers, whatnot. Do you feel like -- and this is again a question because I know you're in client meetings all day every day. Do you feel like the shift to digital happening right now because of the pandemic is kind of similar to those situations and that we're seeing sort of that level of dislocation or change at the enterprise level in terms of their investments in technology?
Julie Sweet: Yes. And Lisa, that's exactly what's happening. Because remember, before crisis, there was exponential technology change, right. I mean, just in January, we were talking about the big inflection point. Remember, it was back in 2013 that we first said every business is a digital business. So that was happening pre-COVID. What COVID has done -- we thought it would take a decade. It's now shortened to what we think is more like five years. That's why we announced Accenture Cloud First last week, because we think this is right now the "once in a digital era" moment where we are rapidly moving to a complete replatforming of global business, right. It is hugely significant and that's why having invested since 2014 when we first created digital in these capabilities is what's helping us, as you say, do so well in this incredibly difficult challenging macro environment.
Angie Park: Great. Thank you, Lisa.
Operator: We'll go next to the line of Jason Kupferberg of Bank of America.
Jason Kupferberg: I just had kind of a two-part question, so maybe I'll ask it upfront. Just if we look at the growth in "the New" here in Q4, it was up low single digits, and it was less of a premium in the growth rate there relative to the overall corporate growth than we saw last quarter. So I just wanted to get a sense of whether or not that was in line with your expectations. And then can you just more broadly comment like across consulting and outsourcing, what you're seeing in terms of the pace of converting bookings to revenue? And how that's factoring into your thought process, especially for the outlook in the first half of fiscal '21.
Kathleen McClure: Yes. Let me cover the first question. In terms of the growth of "the New", so it did hold up very well, and it really came in as we had expected, right. So remember, "the New" now is 70% of our business. And when we talked about "the New" and you remember this well when we put this in, the point of it really was to make sure that we were resilient in the pace of change. And if you go through and look back at what we did in 2015, where it's 1/3 of the business, it's now 70% of our business. And that really has provided us with a position of strength in which we were able then to -- when we talked about our new growth model in March 1, that we embedded digital everywhere. So that's all now the core of our business. So we did come in where we expected it to be. And overall, we feel very good about our positioning in "the New." So on the second question around how are things kind of bleeding into -- I think your question is more, how are bookings bleeding into our revenue? So let me just cover that in terms of maybe, first, looking at our bookings in terms of the mix. So if you look at the mix of what we're selling, which was very strong in the fourth quarter, $14 billion of bookings, very strong in tech, very strong in operations and I mentioned lower bookings in strategy and consulting, which we expected. So given that the lower percentage of the mix of our bookings are strategy and consulting, and as you know, they tend to be shorter, the overall duration of our bookings are a little bit longer. So when you think about our revenue and when it's going to start coming into our bookings and when it's going to start coming into revenue, I think it's important to really take a look at what's been happening in our business since COVID hit. So when we talked about our business as really impacted, and we hit our lows in April and May. And we were very pleased that in Q4, we improved from those lows, right? And we came in at where we expected within our guidance range. We also, Jason, have that 2% headwind from reimbursable revenues. So that also has a 3% impact in consulting. So that's also very unique and unusual to the situation. And the third thing just to continue to remember is that dynamics that we saw, we talked in Q3, about the higher -- the more impacted industries being where we said, 20%, feeling a little bit more pressure on growth. That's going to play out very similar -- that played out very similar in Q4, and we see that playing out very similar in the beginning part of H1 in the year. But we will build back our business in Q1 to Q2 based on our guided range that we provided. So just again, to be very clear, the guided range for Q1 of negative 3% to 0% implies stability from the growth that we -- the build back that we had in Q4, stability at the bottom end, and improvement at -- anywhere else in the range. And we continue to see that build happening in Q2 through the first half of the year.
Operator: We'll go next to the line of Bryan Keane of Deutsche Bank.
Bryan Keane: I had kind of a similar question, and so let me ask it a different way. The dichotomy between strong bookings, up 9% in Q4, but revenue is dropping down 1% in constant currency, that gap is the biggest, I recall, in the company's history. Because bookings are so strong, but it doesn't quite translate to revenue. And other factors I'm thinking about is potentially pricing and was there any cancellations. And then maybe there's a high amount of renewals in there. Just thinking about for the quarter itself, the dichotomy, maybe you can comment on that.
Kathleen McClure: Yes. And let me just take, Bryan -- I'm going to just take your question, and I want to just talk about connecting the point of, okay, bookings and the top line revenue growth. So I talked a little bit about the duration when I was talking with Jason on his question. So let me round it out by just kind of stepping back and looking at how we see all of these bookings connecting to revenue growth. So I did touch on already what happened in Q3 and how we -- the build back from April and May in Q4. And I've touched quite a bit on H1, how we see that playing out, where we're going to continue to build back in our business. So you're going to see those bookings, Bryan, start coming back into Q1 and Q2. Although our growth rates are going to be in the similar range, we are building back our business. But let me just talk a little bit about the second half, because it's going to get a little bit more to probably your question on bookings. So we do see a different growth dynamic in the second half of fiscal '21, and we expect to reconnect with higher growth. And when we say higher growth, at the bottom end of our range, that's high single digits. At the top end, it's low double digits. And there are really 4 main drivers that we see for connecting with this higher-level growth in the back half. So the first assumption that we have is we do expect some improvement in the macroeconomic environment, which doesn't -- so we don't assume another macroeconomic shock. The second thing that we see, and this gets to your question is, we will see more of the benefit from the significant transformation deals that we sold over the last few quarters in the back half of the year. But then the third point is, at the same time, that's when we expect strategy in consulting to reconnect with growth. And I think Julie gave just terrific color on why it is that we see that coming back in the second half. And then the fourth point is that we will have in the back half of the year, as all of you know, the benefit of an easier compare. And with that, I just want to point out a couple of things. We're going to anniversary the reimbursable revenue headwind. So that's been 2% in the first half of the year. But not only will we anniversary that, but we have adjusted to this new reality of less travel as have our clients. So of course, we are meeting with clients, and, yes, we are returning to some client sites, but our H2 revenue assumption does not include a significant increase in travel. So along with a 2% inorganic contribution for the year, which aligns to about $1.7 billion acquisition spend, that gives you kind of the full picture of how we shaped our guidance, how the bookings are going to come in, when they're going to come in and drive our top line growth. And based on the current environment, while I want to continue to say for quarter one and for the full fiscal '21, that all of our ranges in play, we will connect with strong level of growth in H2. So you can consider that if you look at the impact of this, and Julie talked about turning the page, the pandemic, it was really an H2 of FY '20 impact on our business. We're building back up in H1 of fiscal year '21. And we're going to connect with growth that we believe is a strong level of growth, as characterized by at least high single digits in the second half of the year, which is implied in the low end of our guidance.
Operator: Our next question will come from the line of Ashwin Shirvaikar of Citi.
Ashwin Shirvaikar: So good results. Good results and comments, pretty directionally consistent with what we essentially said. And thank you for the clarification with regards to just the trajectory. I just want to put maybe a couple of finer points on it, if you don't mind. So you're essentially saying on one of those elements, the step-up in demand for "the New," you're already seeing in terms of conversations, bookings, pipeline building, all of that. The meat of it can potentially basically kick in when budgets are nailed down by your clients next calendar year, because it just takes time for large enterprises to move from a plan to do something over 5, 7 years to do it over 3 to 5 years, right and then the clarification on that is consultants traveling on projects with clients, you do not expect that to come back. Is that more of a fiscal '21 thing? Or is that just like the new reality?
Kathleen McClure: Yes. So let me take just the last question and a point on the first question, then hand it over to Julie. So maybe Ashwin, a point on your first question, so let me talk about how we see demand in terms of our pipeline and bookings in FY '21. So we have a strong pipeline coming into the year, even after doing the $14 billion of bookings in Q4. And just as we look at how that's going to play out over the year, we do see Q1 being a little bit lighter and building throughout the year, which is our typical pattern. And then on the last point, what I would say is, I just want to be clear on the assumption that I have made on what we have in revenue in the back half of the year. We've been talking about this revenue headwind from travel. So I just wanted to be really clear about the assumption that I'm making in revenue that we are not assuming an uplift in the back half of the year.
Julie Sweet: Yes, which means, of course, H1, we've still got the headwinds in terms of the compare. It's like the sunsets. But we're not saying, hey, but we're just going to get on. We're going to get an uplift.
Kathleen McClure: I'm not baking any uplift in.
Julie Sweet: It could be an upside, right, but just on the demand side, you do have it right, Ashwin, in that there's -- what's happening right now is you've got certain things we're doing immediately, and then you have these bigger conversations that we're doing. That's how you saw 17 clients last quarter. We're continuing to shape a lot of these bigger things. If you take like supply chain, for example, with one client, they needed immediate forecasting help because it's a pharma client that had to get PPE. So we worked quickly with SAP to put an integrated business planning, help forecasting, decrease critical shortages, while we're talking about a broader transformation of supply chain. Same thing for a leading health and personal care company. They needed a transportation management system, which we partnered with Blue Yonder to put in, to immediately address the issues about getting goods to different places. But we're talking about shaping an entire transformation of the supply chain to build in the resilience, get the data and the analytics, right. And that's what we're doing kind of everywhere, where we have the agility to quickly -- and by the way, the critical ecosystem partnerships to do that while at the same time we're shaping the larger conversations. That's happening in cloud as well, right. That's why we're doing Accenture Cloud First. We're oftentimes doing some immediate things, but we're shaping these bigger transformations, working with the public hyperscalers on the hybrid cloud, working with the hyperscalers as well as the HPE, VMware, Red Hat, Ciscos of the world, who are incredibly important partners as we shape this.
Ashwin Shirvaikar: Got it. And then the second question on cash flow. It's solid in the quarter, continues to be -- projections look pretty good for next year. And I know cash flow has always been a strong point for Accenture, but these levels of cash conversion are still quite impressive. So I had to ask, has something changed? Or is it perhaps related to single factors like lower variable comp? Is it sustainable at this level?
Kathleen McClure: Yes. So thanks for the question on free cash flow. You're right, I mean we had record free cash flow of $7.6 billion in the year, and it surpassed even our expectations for the year. And why is that? Really, it's due to just stellar billing and collections this year. So you know we have industry-leading DSO, right. You know us well. So we're usually either around 40 days, 41 days. We closed at 35 days, right, so -- which is we haven't seen those levels since fiscal 2015. And we did all that during liquidity crisis, during a pandemic, right. So I think it's just very impressive. And it just goes to the rigor and discipline that our team has and how we run the business. And that was a 1.5 free cash flow to net income ratio. So Ashwin, you're used to how we do guide free cash flow. You know how strong we perform. And it's typical for the bottom end of our range to be a decline. And what you see this year is that we have all of our ranges decline over what we did last year. And I just want to give you some just context in this. As you know, when we go back to what is still industry-leading DSO, we've added at least five days to get back into 40 days of DSO. The way free cash flow works is it's that change of five days, and that's almost $1 billion, it's like $800 million plus of a change in free cash flow, just getting ourselves back to that level. So there's nothing other than just stellar free cash flow this year and going back to what is still superior cash management next year.
Operator: We'll go next to the line of James Faucette of Morgan Stanley.
James Faucette: Just two quick questions from me. First, we've talked a lot about the engagement with customers and what they're looking for from Accenture. But wondering if you can provide any color as to what we're seeing in terms of decision cycles and times around those. If those are seeing any improvement, et cetera? And my second question is related to inorganic contribution. I think you mentioned that you're expecting some level of inorganic contribution is built into your guidance. Can you just once again clarify what that looks like? And I guess more importantly, as we think about all the change and the type of work you're doing for your clients, should we expect that level of inorganic contribution to persist into the future beyond fiscal year '21?
Kathleen McClure: So thanks for the question. So I'll just take the -- just clarify and confirm that for next year, we do have 2% inorganic revenue contribution factored into our guidance with up to $1.7 billion of spend. I'm not -- we won't -- don't guide into future years in terms of what we're going to do. But obviously, the D&A is a key part of our capital allocation. We have no planned changes at all to our capital allocation approach. And I'm going to hand it over to Julie to talk a little bit about any other color.
Julie Sweet: Yes. Look, on the decision-making, what's happening is what you'd expect to happen, right. Everyone had to make really fast decisions in how to navigate the crisis. So there are some things that are happening at lightning speed, right. When you have to figure out your supply chain or get up on Teams fast, you do that. We've seen some acceleration in the transformation deals, right, because they're like, we got to move faster to kind of get to that. And you have other places where they slowed down things, clients where we had three things teed up, and they're like, let's do this one and then let's wait and see on these others. And so I would just say it's very contextual right now and it varies also by industry. And of course, we're now going into kind of budgets for the end of the -- as you normally note, due in the fall season. So that will be -- and that will -- we'll see how that plays out as well.
Angie Park: Okay. Operator, we have time for one more question, and then Julie will wrap up the call.
Operator: And that will come from the line of Bryan Bergin of Cowen. .
Bryan Bergin: I just got one here for you. So on margin, how should we be thinking about your comfort level in your typical margin expansion range? And can you also comment how work-from-home implications may play into that?
Kathleen McClure: Yes. So thanks for the question. So obviously, one of our key financial imperatives is to expand -- give modest margin expansion while investing at scale in our business and in our people. And we did this, you saw, Bryan, even in fiscal year '20 with lower ranges of revenue growth. And so we feel comfortable that we can continue to create the flexibility and the investment, to do our investments in talent, to do the investments in the business. Julie talked quite a bit about how excited we are in Cloud First. So I would say it's the normal rigor and discipline that we need to bring to our business, to create that margin capacity, to invest back while keeping within our 10 to 30 basis points of expansion.
Julie Sweet: Yes. And on remote -- on the work from home, right, that's -- I talked about the new reality, and we're going to be working differently, but it's going to be constantly evolving. So for example, we've got about 1,400 clients worldwide, where our people are back at the clients. We're encouraging our people to come into the offices with respect to doing collaboration. We're back to approving travel. Now it's massively restricted because you're not going to go to a place where you're quarantining. We've got some people who have childcare issues, who've got health issues, and that is the reality, right. And so we're going to continue to navigate that. And this, of course, is where we already were so remote that we're really good at being able to navigate that. But that's all about the new reality.
Bryan Bergin: Okay. And KC, you said 2% inorganic for fiscal '21. Was that -- was it 1% or 2% in fiscal '20 as well?
Kathleen McClure: Yes. It was 2% in fiscal '20.
Julie Sweet: Great. So we're excited to turn the page and deliver for our clients, people, shareholders, ecosystem partners and communities in FY '21. We call this shared success, and it is a mindset we strive to live every day. Thank you to our people and leaders for how you come together to deliver on these commitments and shared success and a special thank you to our shareholders for your continued trust and support. Be well, everyone, and thank you for joining.
Operator: Thank you. And ladies and gentlemen, today's conference will be available for replay, available today after 10 a.m. Eastern Time, running through December 17 at midnight. You may access the replay system by dialing 1-866-207-1041 and entering the access code of 4996254. International participants may dial 402-970-0847. That does conclude our conference for today. Thank you for your participation and for using AT&T Teleconferencing Services. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to Accenture's Fourth Quarter Fiscal 2020 Earnings Call. [Operator Instructions]. And I would now like to turn the conference over to your host, Angie Park, Managing Director, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, operator, and thanks, everyone, for joining us today on our fourth quarter and full fiscal 2020 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and the balance sheet, along with some key operational metrics for both the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the first quarter and full fiscal year 2021. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie, and thank you, everyone, for joining us. Fiscal '20 results demonstrate the relevance of our growth strategy, the resilience of our business and our people, our operational rigor and discipline, the power of the relationships we have with the world's leading companies and ecosystem partners and our ability to pivot rapidly to meet the needs of our clients and new ways of operating. Fiscal year '20 also demonstrated the unique advantages of our long track record of focusing on being a responsible business, from our commitment to inclusion and diversity that has helped make us an innovation-led company, to our focus on investing in our people and their skills, to the way we live our core values, all of which help make us the trusted partner that our clients have turned to in the face of the ongoing global health, economic and social crisis. And if there was ever any doubt, we clearly demonstrated that scale matters. We are unique in our industry for the scale of our digital, cloud and security capabilities, and for our leadership in all the services critical to building a company's digital core, transforming its operations, and accelerating growth with our four services of strategy and consulting, interactive, technology and operations, as well as our deep industry experience and data and artificial intelligence capabilities, and we are also unique in the scale we have with large client relationships and across 13 industry groups with a global footprint. This scale has been core to our resilience in the second half of FY '20. Let me share a few highlights. We are now approximately 70% in \"the New\"- digital, cloud, and security, just when the need for these services, already high, accelerated dramatically as a result of COVID-19. In fact, in FY '21, we will no longer measure \"the New\" as \"the New\" is now our core. And as of March 1, with the new growth model, we have embedded digital everywhere. We will continue to share color on our growth drivers, including cloud and security as we continue to invest in these large, high-growth market opportunities. We ended FY '20 with 216 Diamond clients, which represent our largest client relationships, a net increase of 15 over the prior year. We transitioned seamlessly to our new growth model with a new global management committee to increase our agility in bringing together the power of our multiservice teams to our clients and to create greater opportunities for our people. And the new model and team successfully passed a challenging test, navigating the pandemic and emerging stronger. More on that later. We committed to stronger bookings in Q4, and we delivered with our second highest bookings ever in the fourth quarter, finishing the year with a record $50 billion of sales. In FY '20, we continued to increase our investments for the future at scale with $1.5 billion in acquisitions, $871 million in R&D in our assets, platforms and solutions, including growing our portfolio of patents and pending patents to over 7,900 and delivering a 6% increase in training hours for our 500,000 people, while reducing our training cost by 11% to $866 million due to our digital learning platforms. We are now 45% women, on track for our 2025 goal of a 50-50 gender balance. And this month, we announced ambitious new goals to increase our African-American and Black and Hispanic American and Latinx communities in the U.S. And despite the unprecedented uncertainty and volatility, with the pandemic declared only a few days before we had to give guidance for Q3, we called it like we saw it for each of Q3 and Q4 and delivered within our guidance. For the full year, we delivered either within or above our guided range and continued to deliver growth ahead of market modest margin expansion and record free cash flow. Our resilience begins with an exceptional leadership team and our incredibly talented and dedicated people. Before I turn over to KC, I want to thank each of them for what has truly been an exceptional year that we should all be proud of. KC, over to you."
},
{
"speaker": "Kathleen McClure",
"text": "Thank you, Julie, and thanks to all of you for joining us on today's call. We were pleased with our overall results in the fourth quarter, which were within our guided range and aligned to our expectations. Our results reinforce our distinctive position in the marketplace and reflect the diversity of our business. Once again, these results illustrate Accenture's unique ability to run our business with discipline and deliver significant value for our shareholders in an uncertain environment. So, let me begin by summarizing a few of the highlights of the quarter. Revenues declined 1% in local currency, in line with our guided range. This includes a reduction of approximately 2 percentage points from a decline in revenues from reimbursable travel costs. Importantly, aligned with our growth imperatives, we continued to take significant market share for both the quarter and the year. The diversity of our business continues to serve us well. From an industry perspective, consistent with last quarter, approximately 50% of our revenues came from seven industries that were less impacted from the pandemic and, in aggregate, grew high-single digits with continued double-digit growth in Public Service, Software & Platforms, and Life Sciences. At the same time, as we expected, we saw continued pressure from clients in highly impacted industries, which include travel; retail; energy; high tech, including aerospace and defense; and industrial. While performance varied, this group collectively represents over 20% of our revenues and declined mid-teens. Operating margin was 14.3%, an increase of 10 basis points for the quarter and the full year. We continue to drive sustainable margin expansion while making significant investments in our business and our people to extend our market leadership. We continue to benefit from lower spend on travel, meetings, and events. And finally, we delivered free cash flow of $3 billion, which surpassed our expectations, driven by superior DSO management. Now let me turn to some of the details. New bookings were $14 billion for the quarter, our second highest on record and reflect 9% growth with a book-to-bill of 1.3. Consulting bookings were $6.5 billion with a book-to-bill of 1.1. Outsourcing bookings of $7.5 billion were a record with a book-to-bill of 1.5. Bookings continue to be dominated by strong demand for digital, cloud, and security-related services, which we estimate represented approximately 70% of our new bookings. We were very pleased that we delivered on our expectations of strong bookings this quarter, and they came in as we expected with strong bookings in technology and operations and lower bookings in strategy and consulting. Turning now to revenues. Revenues for the quarter were $10.8 billion, a 1% decline in local currency and 2% decline in U.S. dollars, including a reduction of approximately 2% from a decline in revenues from reimbursable travel costs. Consulting revenues for the quarter were $5.7 billion, a decline of 8% in both local currency and U.S. dollars, which includes a reduction of approximately 3% from a decline in revenues from reimbursable travel costs. Outsourcing revenues were $5.2 billion, up 7% in local currency and 6% in U.S. dollars. Digital, cloud, and security-related services grew low-single digits. Taking a closer look at our service dimensions. Operations grew high single digits. Technology services grew mid-single digits. And strategy and consulting services declined low teens. Before I give color on our markets, the industry dynamics that I have mentioned previously played out in a similar fashion across all 3. In North America, revenue growth was flat in local currency. In Europe, revenue declined 5% in local currency. We saw mid-single-digit growth in Italy, slight growth in Germany, with continued declines in the U.K. In the Growth Markets, we delivered 3% revenue growth in local currency, led by double-digit growth in Japan and high single-digit growth in Brazil. Moving down the income statement. Gross margin for the quarter was 31.8% compared with 31.1% for the same period last year. Sales and marketing expense for the quarter was 10.6%, consistent with the fourth quarter last year. General and administrative expenses was 6.8% compared to 6.2% for the same quarter last year. Operating income was $1.5 billion in the fourth quarter, reflecting a 14.3% operating margin, up 10 basis points compared with Q4 last year. Before I continue, I'd like to highlight an investment gain that impacted our tax rate and increased EPS by $0.29 for the fourth quarter and $0.43 for the full year. Of this $0.43 gain, $0.27 was factored into the full year EPS guidance provided in June, and a quarterly reconciliation can be found on our website. The following comparisons exclude this impact and reflect adjusted results. Our adjusted effective tax rate for the quarter was 28.4% compared with an effective tax rate of 26.6% for the fourth quarter last year. Adjusted diluted earnings per share were $1.70 compared to EPS of $1.74 in the fourth quarter last year. For the full fiscal year, adjusted earnings per share were $7.46, which was $0.03 above our adjusted guidance range for the year. Days service outstanding were 35 days compared to 41 days last quarter and 40 days in the fourth quarter of last year. Free cash flow for the quarter was $3 billion, resulting from cash generated by operating activities of $3.2 billion, net of property and equipment additions of $189 million. Our cash balance at August 31 was $8.4 billion compared with $6.1 billion at August 31 last year. With regards to our ongoing objective to return cash to shareholders, in the fourth quarter, we repurchased or redeemed 2.6 million shares for $590 million at an average price of $225.25 per share. Also in August, we paid our fourth quarterly cash dividend of $0.80 per share for a total of $509 million. And our Board of Directors declared a quarterly cash dividend of $0.88 per share to be paid on November 13, a 10% increase over last year, and approved $5 billion of additional share repurchase authority. Reflecting our results for the full year. We started with strong momentum in the first half and quickly adjusted and reset with the onset of the pandemic. We delivered approximately $50 billion in new bookings, reflecting a 10% increase over last year, setting 2 record highs this year. We continued to provide guidance on our business throughout the year and, importantly, delivered revenues within our guided range at 4%, significantly taking market share. We delivered on our commitment of margin expansion even with lower top line growth and fully continued all elements of our capital allocation, with $1.5 billion of investments in acquisitions, a record $7.6 billion of free cash flow and returned $5 billion of cash to shareholders, exceeding our outlook provided last September. In closing with fiscal year '20 behind us, we are proud of how we managed our business and delivered for our clients, our people, our shareholders, our partners and our communities in what was truly an unprecedented fiscal year. And we feel really good about our positioning for fiscal '21. Now let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. From an overall demand perspective, the trends that we discussed last quarter are continuing. Companies need to accelerate their digital transformation across their enterprises and move to the cloud; address cost pressures, which vary by industry but are universal; build resilience; adjust their operations and customer engagement to a remote-everything environment; and find new sources of growth. Now I will give you a little more color on the depth and breadth of our ability to deliver value to our clients in this environment through the lens of some of our 17 clients with new bookings over $100 million in Q4. Then I will turn to fiscal year '21. Diebold Nixdorf, a global leader in services, software and hardware for the banking and retail industries, and Accenture have extended a strategic agreement to accelerate Diebold Nixdorf's multiyear digital and cloud transformation program, which includes streamlining its finance, human resource, IT and sales systems. The collaboration will unlock approximately $50 million of incremental savings through 2023, while improving business productivity, consolidating operations and enabling investment in innovation and growth opportunities. Prudential Financial, a financial wellness leader and premier active global investment manager, has entered into an agreement with Accenture to transform its group insurance operating model by redesigning its processes, operations and technology to create simple, intuitive interactions between brokers, customers and employees that enhance financial wellness. New digital solutions designed by Accenture Interactive and powered by artificial intelligence and analytics from our SynOps platform and our operations team will provide more data-driven, seamless and human-centered experiences in onboarding, billing and claims processes, enhancing user satisfaction and, ultimately, revenue growth. Halliburton, a leading global provider of products and services to the energy industry, Accenture and Microsoft entered into a 5-year strategic agreement to advance Halliburton's digital capabilities in Microsoft Azure. Halliburton will complete its move to cloud-based digital platforms, drive additional business agility, reduce capital expenditures and strengthen its customer offerings as well as achieve sustainability benefits by migrating all of its physical data centers to Azure. A leading global automotive company has selected Accenture to migrate 55% of its applications over 18 months to the cloud, working with its ecosystem partners for the public cloud, AWS and GCP, and HPE for its hybrid cloud. This work will address both cost pressures and the need to transform their IT infrastructure to address obsolescence and provide digital experiences. These examples are noteworthy for their diversity across industries, complexity requiring multiservice teams, strong ecosystem partnerships and using our assets, platforms and solutions. And many involve us delivering what we call 360-degree value, because we are creating agility, helping reskill our clients' employees or helping reduce their carbon footprint to the move to the cloud in addition to delivering clear financial value. And stepping back for a moment. Our clients were being impacted by unprecedented change before COVID-19. Then came COVID-19, giving a whole new meaning to unprecedented and requiring our clients to change virtually every aspect of their business faster than ever before, and they are turning to us to help embrace that need for change and become stronger. Turning to fiscal year '21. Our own formula for market leadership is enduring. We continually transform our business and embrace change to create more value for our clients with incredibly talented people. We view fiscal year '21 as turning a page. We are no longer navigating a crisis. We are facing a new reality, and we plan on returning to pre-COVID growth rates by the second half of this fiscal year, and we are ready. We are emerging from the second half of fiscal year '20 stronger than when we entered, which was our strategy. As a leadership team, we set five measures of what stronger means, and we have met each of them. First, did we grow market share faster than pre-COVID? Check. We grew at approximately 4x the market in H2 as compared to 2x the market in H1. And as a reminder, when we say market, we were referring to our basket of publicly traded companies. Second, did we execute on our big deal pipeline in H2 despite the crisis, which would be a proxy for enhancing our role as the trusted transformation partner? Check. In fact, we had 3 more clients with over $100 million of bookings in H2 compared to H1 of this year. Third, did we capture new growth opportunities? Check. We have had substantial new bookings in the health and public sector, such as the 10 states in the U.S. where we are doing contact tracing in remote collaboration services as well as cloud, security, supply chain and digital manufacturing, which helped offset a portion of the severe impact on some of our clients. Fourth, did we continue to invest in our business and our people? Check. Not only did we invest significantly in our business and increase our training hours, but we also created the capacity to pay our people meaningful bonuses for fiscal year '20 performance and are planning for a significant level of promotions in our upcoming December promotion cycle. And all of this, we believe, will distinguish us from our competitors. And finally, fifth, did we continue to deliver consistently on our shareholder commitments? Check. And we also reduced structural costs through our new growth model and took to accelerate our fiscal year '21 usual level of performance management-related exits of around 5% each fiscal year so that we are preserving our talented workforce for the future while positioning ourselves for modest margin expansion and continued investment in our business in fiscal year '21. Before KC gives you more details on our FY '21 outlook, I want to touch on Accenture Cloud first, which is an example of how we anticipate client needs and then act at speed and at scale. Last week, we announced the creation of Accenture Cloud First and a $3 billion investment over 3 years, which will be funded by prioritizing our expected investments across the business. Accenture Cloud First is a new multiservice group of 70,000 cloud professionals with more than 100,000 people providing cloud-related services, which brings together the full power and breadth of Accenture's industry and technology capabilities, ecosystem partnerships and deep commitment to upskilling clients' employees and to responsible business with the singular focus of enabling organizations to move to the cloud with greater speed and achieve greater value for all their stakeholders at this critical time. We have been building our cloud capabilities for the last decade and are a leader with approximately $12 billion in cloud revenue for FY '20, growing double digits, which includes our SaaS capabilities delivered through our Intelligent Platform Services business. This positioned us well to recognize that COVID-19 has created a new inflection point that requires every company to dramatically accelerate the move to the cloud as a foundation for digital transformation to build the resilience, new experience and products, trust, speed and structural cost reduction that the ongoing health, economic and societal crisis demands and that a better future for all requires. Post-COVID leadership requires that every business become a cloud-first business, quickly moving from today's approximately 20% in the cloud to 80%. This is a \"once in a digital era\" massive replatforming of global business. Accenture Cloud First works seamlessly with our Intelligent Platform Services, which focuses on our SaaS capabilities, which are an important part of replatforming global businesses. Recent wins include working with a leading consumer goods manufacturer on a global deployment of SAP S/4HANA, initially focusing on their central finance system and building a new digital backbone for the entire supply chain in China from purchasing to direct-to-consumer sales; working with the U.S. Air Force to establish a new cloud-based common infrastructure for its Oracle Enterprise Resources Planning program; working with a bank on the integration of their front office operations and enhancing customer relationships powered by Salesforce; and working with a top higher education research institution to implement Workday to transform their HR capabilities, to drive real-time data analytics and become a strategic partner across the organization. And ServiceNow is another digital platform that is critical. For example, for a public service agency, we collaborated with ServiceNow to rapidly implement a cloud-enabled workflow solution, enabling millions of citizens to access government services while complying with dynamic pandemic health safety guidelines. Now over to you, KC."
},
{
"speaker": "Kathleen McClure",
"text": "Thanks, Julie. Before I get into our business outlook, as I did last quarter, I would like to remind you that given the coronavirus pandemic, there are a number of factors that we may not be able to accurately predict, including the duration and magnitude of the impact, the pace of recovery as well as those described in our most recent quarterly filings. With that said, let me now turn to our business outlook. For the first quarter of fiscal '21, we expect revenues to be in the range of $11.15 billion to $11.55 billion. This assumes the impact of FX will be about a positive 1.5% compared to the first quarter of fiscal '20. It also reflects an estimated negative 3% to flat growth in local currency and includes a reduction of approximately 2 percentage points from a decline in revenue from reimbursable travel costs. For the full fiscal year '21, based on how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results in U.S. dollars will be approximately positive 2% compared to fiscal '20. For the full fiscal '21, we expect our revenue to be in the range of 2% to 5% growth in local currency over fiscal '20, including approximately negative 1% from a decline in revenues from reimbursable travel based on a 2% reduction in the first half of the year and no material impact in the second half of the year. A couple of key points that are helpful to understand our guidance. We expect our growth will be lower in H1, with Q1 and Q2 ranges being similar, and we expect we will reconnect with higher growth in H2 in the range of high single digits to low double digits. For operating margin, we expect fiscal year '21 to be 14.8% to 15%, a 10 to 30 basis point expansion over fiscal '20 results. We expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.9% in fiscal '20. For earnings per share, we expect full year diluted EPS for fiscal '21 to be in the range of $7.80 to $8.10 and or 5% to 9% growth over adjusted fiscal '20 results. For the full fiscal '21, we expect operating cash flow to be in the range of $6.35 billion to $6.85 billion; property and equipment additions to be approximately $650 million; and free cash flow to be in the range of $5.7 billion to $6.2 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we expect to return at least $5.3 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so that we can take your questions. Angie?"
},
{
"speaker": "Angie Park",
"text": "Thanks, KC. [Operator Instructions]. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Our first question today will come from the line of Tien-Tsin Huang of JPMorgan."
},
{
"speaker": "Tien-Tsin Huang",
"text": "I wanted to -- you gave a lot of good information here. It sounds like strategy and consulting services saw the biggest rate of change exiting the year, a little bit more pressure. I know operations improved. So I'm curious on the visibility and the outlook for strategy and consulting in fiscal '21. I presume that's going to see probably a nice recovery in the second half, based on your comments there. And are you over-indexed at all in strategy and consulting to some of the industries impacted by the pandemic?"
},
{
"speaker": "Kathleen McClure",
"text": "Thanks, Tien-Tsin, for your question. So let me talk about what we see for growth in strategy and consulting, and then Julie can pass on some additional color. So first thing I would say is that when we look at strategy and consulting, we really do see that it's held up in this environment, because it really is critical to our differentiation in the places where our clients are continuing to invest. And if we look at the actual results, strategy and consulting, they came in really as we expected in Q4. And you're right, it does follow a very similar pattern from an industry perspective, Tien-Tsin, where we see pressure in strategy and consulting in the most highly impacted industries in the market. Now in terms of the dynamics for growth, we see the same dynamics in the first quarter essentially that we're seeing from an industry perspective in strategy and consulting growth in the first quarter as we saw in the fourth quarter, and that should play out pretty similar in the first half. But we do see recovery and reconnecting with growth in the back half of the year. Let me just hand it over to Julie for some more comments."
},
{
"speaker": "Julie Sweet",
"text": "Yes. Tien-Tsin, I think what's important -- so in other words, we're not over-indexed in strategy and consulting versus the rest of our business and industries, and so how it's kind of worked with sort of 20% in severe industries, et cetera. As I talked about last quarter, right, when you think about strategy and consulting, it's a huge differentiator in sort of these transformational deals, and I'll talk about that in a minute. And then, as I said, the leading companies right now are very focused. So some of the smaller work that you would do to sort of incubate and to start doing things, companies are saying and we're telling companies, focus on the big rocks that you need to do, right. And so, what's playing out in the market isn't about sort of a weakness in strategy and consulting. It's a reflection of how our clients are thinking about their businesses and what they need. So, I'm actually quite pleased with how well strategy and consulting is holding up. And the thing that's the most important is that this is how we're delivering 17 clients with over $100 million bookings, because each of these big transformations, like require this deep understanding of industry and functions. And you see that in other places. For example, the Bank of England, we announced a deal there where we're helping them with their high-value payments infrastructure to support resilience and innovation, right. Digital payments and instant payments were huge before the crisis. As you know, it's changed dramatically. And because we understand the industry, we have cross-industry expertise in how digital payments are being used, right, as well as the understanding of data and the technology, those things come together to create this new system that improves resiliency, customer experience, access to data and end-to-end risk management. No one can do that, right, with all of those skills but [audio disturbance] anything? Maybe next question."
},
{
"speaker": "Angie Park",
"text": "Next question is from Lisa."
},
{
"speaker": "Operator",
"text": "Lisa Ellis of MoffettNathanson."
},
{
"speaker": "Lisa Ellis",
"text": "Yes, following up a little bit on -- well, a related question to Tien-Tsin's question about consulting. Can you talk a little bit about -- just looking like, obviously, revenue is down in the quarter, but then bookings and consulting very strong. I guess a follow-up on that is what are you seeing clients kind of commit to in the current environment on the consulting side of things? Like meaning, what's their willingness to commit on these kind of new, more strategic projects in the current environment? I'll leave it there, and then I have a follow-up."
},
{
"speaker": "Julie Sweet",
"text": "So Lisa, and again, and I know all of you guys think very much about strategy and consulting and then the technology and operations separately. But in fact, as I've said consistently, including pre-COVID, we really think about our services together. But let me just give you an example of one of the most severely impacted industries, energy. So last week, I'm with the CEO and the leadership team of one of our major clients, and the meeting goes like this: The first part of the meeting is, thank you very much, Accenture, for helping us save money in finance and accounting operations because we lowered what they needed to create some -- help them with their cost pressures. Then the next part of the meeting is all about the IT modernization that we signed during Q3, right, which includes strategy and consulting. It includes our application outsourcing, maintenance. And it includes other technology services, right. And that was about -- because they have to continue to build their digital core, they need -- it's helping them with cost, but it's also about moving to the cloud. It's about creating those capabilities. Then the third part of the meeting was around some pilots that we're trying to shape with them that include -- that are -- it's driven by strategy and consulting, where the criteria is we need to turn them faster. So there's small pilots all about innovation, right. But the criteria we're helping them say is, well what should we do that will get more return, right, because they've got to balance, right. So again, we think about this as what are the needs of the client and how do we bring these services to deal with their short term, their longer-term transformation and also thinking very quickly about how they can innovate to get nearer-term returns. Does that help kind of bring that together in terms of how they're thinking?"
},
{
"speaker": "Lisa Ellis",
"text": "Yes. Yes. And then my follow-up, this is a kind of broader industry question. But we're looking at -- we typically think of Accenture, given your scale, as sort of a bellwether for the industry, and we are looking at kind of historical times in history when we've seen this bifurcation between IT spending and GDP. And you're running kind of flattish on revenues, which is very impressive given that GDP is running down mid- to high-single digits. And those times in the history have always been when there's been like a really big disruption on the technology side: the Internet, personal computers, whatnot. Do you feel like -- and this is again a question because I know you're in client meetings all day every day. Do you feel like the shift to digital happening right now because of the pandemic is kind of similar to those situations and that we're seeing sort of that level of dislocation or change at the enterprise level in terms of their investments in technology?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. And Lisa, that's exactly what's happening. Because remember, before crisis, there was exponential technology change, right. I mean, just in January, we were talking about the big inflection point. Remember, it was back in 2013 that we first said every business is a digital business. So that was happening pre-COVID. What COVID has done -- we thought it would take a decade. It's now shortened to what we think is more like five years. That's why we announced Accenture Cloud First last week, because we think this is right now the \"once in a digital era\" moment where we are rapidly moving to a complete replatforming of global business, right. It is hugely significant and that's why having invested since 2014 when we first created digital in these capabilities is what's helping us, as you say, do so well in this incredibly difficult challenging macro environment."
},
{
"speaker": "Angie Park",
"text": "Great. Thank you, Lisa."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Jason Kupferberg of Bank of America."
},
{
"speaker": "Jason Kupferberg",
"text": "I just had kind of a two-part question, so maybe I'll ask it upfront. Just if we look at the growth in \"the New\" here in Q4, it was up low single digits, and it was less of a premium in the growth rate there relative to the overall corporate growth than we saw last quarter. So I just wanted to get a sense of whether or not that was in line with your expectations. And then can you just more broadly comment like across consulting and outsourcing, what you're seeing in terms of the pace of converting bookings to revenue? And how that's factoring into your thought process, especially for the outlook in the first half of fiscal '21."
},
{
"speaker": "Kathleen McClure",
"text": "Yes. Let me cover the first question. In terms of the growth of \"the New\", so it did hold up very well, and it really came in as we had expected, right. So remember, \"the New\" now is 70% of our business. And when we talked about \"the New\" and you remember this well when we put this in, the point of it really was to make sure that we were resilient in the pace of change. And if you go through and look back at what we did in 2015, where it's 1/3 of the business, it's now 70% of our business. And that really has provided us with a position of strength in which we were able then to -- when we talked about our new growth model in March 1, that we embedded digital everywhere. So that's all now the core of our business. So we did come in where we expected it to be. And overall, we feel very good about our positioning in \"the New.\" So on the second question around how are things kind of bleeding into -- I think your question is more, how are bookings bleeding into our revenue? So let me just cover that in terms of maybe, first, looking at our bookings in terms of the mix. So if you look at the mix of what we're selling, which was very strong in the fourth quarter, $14 billion of bookings, very strong in tech, very strong in operations and I mentioned lower bookings in strategy and consulting, which we expected. So given that the lower percentage of the mix of our bookings are strategy and consulting, and as you know, they tend to be shorter, the overall duration of our bookings are a little bit longer. So when you think about our revenue and when it's going to start coming into our bookings and when it's going to start coming into revenue, I think it's important to really take a look at what's been happening in our business since COVID hit. So when we talked about our business as really impacted, and we hit our lows in April and May. And we were very pleased that in Q4, we improved from those lows, right? And we came in at where we expected within our guidance range. We also, Jason, have that 2% headwind from reimbursable revenues. So that also has a 3% impact in consulting. So that's also very unique and unusual to the situation. And the third thing just to continue to remember is that dynamics that we saw, we talked in Q3, about the higher -- the more impacted industries being where we said, 20%, feeling a little bit more pressure on growth. That's going to play out very similar -- that played out very similar in Q4, and we see that playing out very similar in the beginning part of H1 in the year. But we will build back our business in Q1 to Q2 based on our guided range that we provided. So just again, to be very clear, the guided range for Q1 of negative 3% to 0% implies stability from the growth that we -- the build back that we had in Q4, stability at the bottom end, and improvement at -- anywhere else in the range. And we continue to see that build happening in Q2 through the first half of the year."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Bryan Keane of Deutsche Bank."
},
{
"speaker": "Bryan Keane",
"text": "I had kind of a similar question, and so let me ask it a different way. The dichotomy between strong bookings, up 9% in Q4, but revenue is dropping down 1% in constant currency, that gap is the biggest, I recall, in the company's history. Because bookings are so strong, but it doesn't quite translate to revenue. And other factors I'm thinking about is potentially pricing and was there any cancellations. And then maybe there's a high amount of renewals in there. Just thinking about for the quarter itself, the dichotomy, maybe you can comment on that."
},
{
"speaker": "Kathleen McClure",
"text": "Yes. And let me just take, Bryan -- I'm going to just take your question, and I want to just talk about connecting the point of, okay, bookings and the top line revenue growth. So I talked a little bit about the duration when I was talking with Jason on his question. So let me round it out by just kind of stepping back and looking at how we see all of these bookings connecting to revenue growth. So I did touch on already what happened in Q3 and how we -- the build back from April and May in Q4. And I've touched quite a bit on H1, how we see that playing out, where we're going to continue to build back in our business. So you're going to see those bookings, Bryan, start coming back into Q1 and Q2. Although our growth rates are going to be in the similar range, we are building back our business. But let me just talk a little bit about the second half, because it's going to get a little bit more to probably your question on bookings. So we do see a different growth dynamic in the second half of fiscal '21, and we expect to reconnect with higher growth. And when we say higher growth, at the bottom end of our range, that's high single digits. At the top end, it's low double digits. And there are really 4 main drivers that we see for connecting with this higher-level growth in the back half. So the first assumption that we have is we do expect some improvement in the macroeconomic environment, which doesn't -- so we don't assume another macroeconomic shock. The second thing that we see, and this gets to your question is, we will see more of the benefit from the significant transformation deals that we sold over the last few quarters in the back half of the year. But then the third point is, at the same time, that's when we expect strategy in consulting to reconnect with growth. And I think Julie gave just terrific color on why it is that we see that coming back in the second half. And then the fourth point is that we will have in the back half of the year, as all of you know, the benefit of an easier compare. And with that, I just want to point out a couple of things. We're going to anniversary the reimbursable revenue headwind. So that's been 2% in the first half of the year. But not only will we anniversary that, but we have adjusted to this new reality of less travel as have our clients. So of course, we are meeting with clients, and, yes, we are returning to some client sites, but our H2 revenue assumption does not include a significant increase in travel. So along with a 2% inorganic contribution for the year, which aligns to about $1.7 billion acquisition spend, that gives you kind of the full picture of how we shaped our guidance, how the bookings are going to come in, when they're going to come in and drive our top line growth. And based on the current environment, while I want to continue to say for quarter one and for the full fiscal '21, that all of our ranges in play, we will connect with strong level of growth in H2. So you can consider that if you look at the impact of this, and Julie talked about turning the page, the pandemic, it was really an H2 of FY '20 impact on our business. We're building back up in H1 of fiscal year '21. And we're going to connect with growth that we believe is a strong level of growth, as characterized by at least high single digits in the second half of the year, which is implied in the low end of our guidance."
},
{
"speaker": "Operator",
"text": "Our next question will come from the line of Ashwin Shirvaikar of Citi."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "So good results. Good results and comments, pretty directionally consistent with what we essentially said. And thank you for the clarification with regards to just the trajectory. I just want to put maybe a couple of finer points on it, if you don't mind. So you're essentially saying on one of those elements, the step-up in demand for \"the New,\" you're already seeing in terms of conversations, bookings, pipeline building, all of that. The meat of it can potentially basically kick in when budgets are nailed down by your clients next calendar year, because it just takes time for large enterprises to move from a plan to do something over 5, 7 years to do it over 3 to 5 years, right and then the clarification on that is consultants traveling on projects with clients, you do not expect that to come back. Is that more of a fiscal '21 thing? Or is that just like the new reality?"
},
{
"speaker": "Kathleen McClure",
"text": "Yes. So let me take just the last question and a point on the first question, then hand it over to Julie. So maybe Ashwin, a point on your first question, so let me talk about how we see demand in terms of our pipeline and bookings in FY '21. So we have a strong pipeline coming into the year, even after doing the $14 billion of bookings in Q4. And just as we look at how that's going to play out over the year, we do see Q1 being a little bit lighter and building throughout the year, which is our typical pattern. And then on the last point, what I would say is, I just want to be clear on the assumption that I have made on what we have in revenue in the back half of the year. We've been talking about this revenue headwind from travel. So I just wanted to be really clear about the assumption that I'm making in revenue that we are not assuming an uplift in the back half of the year."
},
{
"speaker": "Julie Sweet",
"text": "Yes, which means, of course, H1, we've still got the headwinds in terms of the compare. It's like the sunsets. But we're not saying, hey, but we're just going to get on. We're going to get an uplift."
},
{
"speaker": "Kathleen McClure",
"text": "I'm not baking any uplift in."
},
{
"speaker": "Julie Sweet",
"text": "It could be an upside, right, but just on the demand side, you do have it right, Ashwin, in that there's -- what's happening right now is you've got certain things we're doing immediately, and then you have these bigger conversations that we're doing. That's how you saw 17 clients last quarter. We're continuing to shape a lot of these bigger things. If you take like supply chain, for example, with one client, they needed immediate forecasting help because it's a pharma client that had to get PPE. So we worked quickly with SAP to put an integrated business planning, help forecasting, decrease critical shortages, while we're talking about a broader transformation of supply chain. Same thing for a leading health and personal care company. They needed a transportation management system, which we partnered with Blue Yonder to put in, to immediately address the issues about getting goods to different places. But we're talking about shaping an entire transformation of the supply chain to build in the resilience, get the data and the analytics, right. And that's what we're doing kind of everywhere, where we have the agility to quickly -- and by the way, the critical ecosystem partnerships to do that while at the same time we're shaping the larger conversations. That's happening in cloud as well, right. That's why we're doing Accenture Cloud First. We're oftentimes doing some immediate things, but we're shaping these bigger transformations, working with the public hyperscalers on the hybrid cloud, working with the hyperscalers as well as the HPE, VMware, Red Hat, Ciscos of the world, who are incredibly important partners as we shape this."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Got it. And then the second question on cash flow. It's solid in the quarter, continues to be -- projections look pretty good for next year. And I know cash flow has always been a strong point for Accenture, but these levels of cash conversion are still quite impressive. So I had to ask, has something changed? Or is it perhaps related to single factors like lower variable comp? Is it sustainable at this level?"
},
{
"speaker": "Kathleen McClure",
"text": "Yes. So thanks for the question on free cash flow. You're right, I mean we had record free cash flow of $7.6 billion in the year, and it surpassed even our expectations for the year. And why is that? Really, it's due to just stellar billing and collections this year. So you know we have industry-leading DSO, right. You know us well. So we're usually either around 40 days, 41 days. We closed at 35 days, right, so -- which is we haven't seen those levels since fiscal 2015. And we did all that during liquidity crisis, during a pandemic, right. So I think it's just very impressive. And it just goes to the rigor and discipline that our team has and how we run the business. And that was a 1.5 free cash flow to net income ratio. So Ashwin, you're used to how we do guide free cash flow. You know how strong we perform. And it's typical for the bottom end of our range to be a decline. And what you see this year is that we have all of our ranges decline over what we did last year. And I just want to give you some just context in this. As you know, when we go back to what is still industry-leading DSO, we've added at least five days to get back into 40 days of DSO. The way free cash flow works is it's that change of five days, and that's almost $1 billion, it's like $800 million plus of a change in free cash flow, just getting ourselves back to that level. So there's nothing other than just stellar free cash flow this year and going back to what is still superior cash management next year."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of James Faucette of Morgan Stanley."
},
{
"speaker": "James Faucette",
"text": "Just two quick questions from me. First, we've talked a lot about the engagement with customers and what they're looking for from Accenture. But wondering if you can provide any color as to what we're seeing in terms of decision cycles and times around those. If those are seeing any improvement, et cetera? And my second question is related to inorganic contribution. I think you mentioned that you're expecting some level of inorganic contribution is built into your guidance. Can you just once again clarify what that looks like? And I guess more importantly, as we think about all the change and the type of work you're doing for your clients, should we expect that level of inorganic contribution to persist into the future beyond fiscal year '21?"
},
{
"speaker": "Kathleen McClure",
"text": "So thanks for the question. So I'll just take the -- just clarify and confirm that for next year, we do have 2% inorganic revenue contribution factored into our guidance with up to $1.7 billion of spend. I'm not -- we won't -- don't guide into future years in terms of what we're going to do. But obviously, the D&A is a key part of our capital allocation. We have no planned changes at all to our capital allocation approach. And I'm going to hand it over to Julie to talk a little bit about any other color."
},
{
"speaker": "Julie Sweet",
"text": "Yes. Look, on the decision-making, what's happening is what you'd expect to happen, right. Everyone had to make really fast decisions in how to navigate the crisis. So there are some things that are happening at lightning speed, right. When you have to figure out your supply chain or get up on Teams fast, you do that. We've seen some acceleration in the transformation deals, right, because they're like, we got to move faster to kind of get to that. And you have other places where they slowed down things, clients where we had three things teed up, and they're like, let's do this one and then let's wait and see on these others. And so I would just say it's very contextual right now and it varies also by industry. And of course, we're now going into kind of budgets for the end of the -- as you normally note, due in the fall season. So that will be -- and that will -- we'll see how that plays out as well."
},
{
"speaker": "Angie Park",
"text": "Okay. Operator, we have time for one more question, and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "And that will come from the line of Bryan Bergin of Cowen. ."
},
{
"speaker": "Bryan Bergin",
"text": "I just got one here for you. So on margin, how should we be thinking about your comfort level in your typical margin expansion range? And can you also comment how work-from-home implications may play into that?"
},
{
"speaker": "Kathleen McClure",
"text": "Yes. So thanks for the question. So obviously, one of our key financial imperatives is to expand -- give modest margin expansion while investing at scale in our business and in our people. And we did this, you saw, Bryan, even in fiscal year '20 with lower ranges of revenue growth. And so we feel comfortable that we can continue to create the flexibility and the investment, to do our investments in talent, to do the investments in the business. Julie talked quite a bit about how excited we are in Cloud First. So I would say it's the normal rigor and discipline that we need to bring to our business, to create that margin capacity, to invest back while keeping within our 10 to 30 basis points of expansion."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And on remote -- on the work from home, right, that's -- I talked about the new reality, and we're going to be working differently, but it's going to be constantly evolving. So for example, we've got about 1,400 clients worldwide, where our people are back at the clients. We're encouraging our people to come into the offices with respect to doing collaboration. We're back to approving travel. Now it's massively restricted because you're not going to go to a place where you're quarantining. We've got some people who have childcare issues, who've got health issues, and that is the reality, right. And so we're going to continue to navigate that. And this, of course, is where we already were so remote that we're really good at being able to navigate that. But that's all about the new reality."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And KC, you said 2% inorganic for fiscal '21. Was that -- was it 1% or 2% in fiscal '20 as well?"
},
{
"speaker": "Kathleen McClure",
"text": "Yes. It was 2% in fiscal '20."
},
{
"speaker": "Julie Sweet",
"text": "Great. So we're excited to turn the page and deliver for our clients, people, shareholders, ecosystem partners and communities in FY '21. We call this shared success, and it is a mindset we strive to live every day. Thank you to our people and leaders for how you come together to deliver on these commitments and shared success and a special thank you to our shareholders for your continued trust and support. Be well, everyone, and thank you for joining."
},
{
"speaker": "Operator",
"text": "Thank you. And ladies and gentlemen, today's conference will be available for replay, available today after 10 a.m. Eastern Time, running through December 17 at midnight. You may access the replay system by dialing 1-866-207-1041 and entering the access code of 4996254. International participants may dial 402-970-0847. That does conclude our conference for today. Thank you for your participation and for using AT&T Teleconferencing Services. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 3 | 2,020 | 2020-06-25 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by. Welcome to Accenture’s Third Quarter Fiscal 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director and Head of Investor Relations, Angie Park. Please go ahead.
Angie Park: Thank you, Greg and thanks everyone for joining us today on our third quarter fiscal 2020 earnings announcement. As Greg just mentioned, I am Angie Park, Managing Director, Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you have had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the fourth quarter and full fiscal year 2020. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today’s news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Angie, and thank you everyone for joining us. Since our last earnings call, the world has continued to face unprecedented challenges; health, economic, and social, and throughout Q3 we saw rapidly deteriorating economic conditions globally. I am proud of and want to thank our people and our leaders around the world for coming together in Q3 to continue to deliver on our commitment to our shareholders, our clients, our people, and our communities in the face of this crisis. Before turning to our delivery on these commitments, let me provide a bit more color on the context. Within days of our earnings call on March 19, we continued to quickly mobilize our people to work from home, and during the quarter we had approximately 95% of our people enabled to work remotely. For all of April and May other than China, virtually every country in which we operate was in lockdown. In addition, as you may remember, in January we announced that as of March 1, we were implementing a new growth model and making leadership changes. We seamlessly implemented this new model demonstrating our agility at massive scale, which is a testament to the talent of our over 500,000 people and the strength of our leadership team. So, in terms of delivery on our commitments to our shareholders, we delivered Q3 revenues in line with the range we provided only eight days after the global pandemic was declared, and we hit a new milestone of approximately 70% in the “New,” which is digital, cloud, and security. We delivered $11 billion in new bookings, a 6% increase over Q3 last year, which demonstrates the relevance of our services and our ability to sell in a remote everything world. We continue to invest in our business for the long term, closing an additional $742 million in strategic acquisitions for a total of $1.3 billion year-to-date. We delivered operating margin expansion of 10 basis points, and we continued to strengthen our balance sheet closing the quarter with $6.4 billion in cash. In terms of delivering on our commitments to our clients, our clients rely on us for mission-critical work. 95 of our top 100 clients have been with us for over 10 years because we are a trusted partner. And during this time, we have deepened that trust yet again because of our ability to deliver seamlessly, including how we transitioned our people from the delivery centers in India and the Philippines to work from home without service interruption. For example, we closed the books on time for more than 70 public companies in operation, and we continued our pre-crisis track record in technology with around-the-clock go live on new releases every 15 minutes on average. In both technology and operations, we were able to execute entirely remote knowledge transfer with great success. In terms of delivering on our commitment to our people, we continue to invest in training and development and the continuous re-skilling of our people. We are on track to deliver the same training hours as last year while pivoting completely to a digital learning experience built on our platform Accenture Connected Learning. We continued to promote people midyear, although at a reduced level compared to last year to ensure that our very best talent continues to build a vibrant career and is recognized and rewarded. In terms of delivering on our commitment to our communities, we believe strongly in our responsibility to contribute to the well-being of our communities. In addition to our teams who have supported our health and public service clients with extraordinary COVID-19 related work, we also wanted to make a unique pro bono contribution that leveraged our strength. In addition to our many local activities, we are very proud that we are helping put people back to work around the world with the People + Work Connect platform that we created together with Lincoln Financial Group, ServiceNow, and Verizon. This platform is a global online employer-to-employer initiative to bring together at no cost companies that have laid off or furloughed people with organizations in urgent need of workers. Designed by CHROs including our own extraordinary CHRO, Ellyn Shook, Accenture built the platform in only 14 days. The response has been overwhelming as more than 1,300 organizations across approximately 80 countries have engaged with currently about 400,000 positions already on the platform which are balanced between open needs and availability. With that, over to you KC.
KC McClure: Thank you, Julie and thanks to all of you for taking the time to join us on today's call. We are pleased with our third quarter results which were in line with our expectations and reflect the diversity and durability of our growth model across geographies, industries, and services. Our results continue to reinforce the relevance of our offerings and capabilities in the market to deliver value for our clients. Importantly, these results illustrate Accenture's unique ability to manage our business and deliver significant value to our shareholders in a very uncertain environment. Before I get into the details, let me summarize the major headlines of our third quarter results, which reflect continued strong execution against our three financial imperatives. Revenue grew 1.3% in local currency at the top end of our guided range. This includes a reduction of approximately 2% from a decline in revenues from reimbursable travel costs. Taking a look at revenues through an industry lens, the diversity of our portfolio continues to serve us well. Approximately 50% of our revenues came from seven industries that were less impacted from the pandemic and in aggregate grew high-single digits with double-digit growth in software and platforms, life-sciences, and public service. At the same time as we expected, we saw pressure from clients in the highly impacted industries which include travel, retail, energy, high-tech including aerospace and defense and industrials. While performance varied, this group collectively represents over 20% of our revenues and declined high-single digits. Given this is the first quarter of results since the onset of the pandemic, let me share a bit more color on how it shaped our quarter. We had strong momentum coming into the quarter, which continued through March. We began to see the impacts on our business in April and May as a result of clients postponing work, reducing existing volumes, and deferring decisions on new work. These impacts were more pronounced in strategy and consulting. We did not, however, see an uptick in cancellations over typical levels. In addition, we experienced very little revenue impact from needing to shift to remote working as we continued to successfully deliver services to our clients. Operating margin was 15.6%, an increase of 10 basis points, both for the quarter and year-to-date as we continued to demonstrate our ability to drive sustainable margin expansion. This result continues to reflect the absorption of significant investments in our people and our business as we further strengthen our leadership position in the market. We are also benefiting from significant lower spend on non-billable travel, meetings, and events. And finally, we delivered very strong free cash flow of $2.6 billion in the quarter, while also continuing all elements of our capital allocation program, including returning roughly $1.1 billion to shareholders via dividends and share repurchases. We've made investments of $1.3 billion acquisitions, primarily attributed to 29 transactions year-to-date, and we continue to expect to invest up to $1.6 billion in acquisitions this fiscal year. With that, let me turn to some of the details starting with new bookings. New bookings were $11 billion for the quarter, reflecting growth of 6% in local currency and 4% in U.S. dollars. Consulting bookings were $6.2 billion, up 5% in local currency and 3% in U.S. dollars with a book-to-bill of 1. Outsourcing bookings were $4.8 billion, up 8% in local currency and 5% in U.S. dollars with a book-to-bill of 1. We were very pleased with our new bookings which continue to be dominated by high demand for digital, cloud, and security-related services, which we estimate represented approximately 70% of our new bookings in the quarter. Looking forward, we expect strong bookings in Q4. The fact that we delivered $11 billion of bookings in this environment with growth over last year with much of these sales closed virtually, while at the same time building a very strong pipeline, speaks to both our agility and the strength of our client relationships. Turning now to revenues. Revenues for the quarter were $11 billion, a 1% decrease in U.S. dollars and a 1.3% increase in local currency, reflecting a foreign exchange headwind of roughly 2.5% compared to the 1.5 estimated impact provided in our guidance for quarter. This result was at the top end of our FX adjusted range. Consulting revenues for the quarter were $6 billion down 4% in U.S. dollars and down 2% in local currency which includes a reduction of approximately 3 percentage points from a decline in revenues from reimbursable travels. Outsourcing revenues were $5 billion, up 3% in U.S. dollars and up 5% in local currency. Taking a closer look at our service dimensions. Technology services grew mid-single-digits, operations grew low single-digit, and strategy and consulting declined mid-single-digit. Additionally, digital, cloud and security-related services grew high-single-digits. Turning to our geographic markets, in North America we delivered 2% revenue growth in local currency driven by double-digit growth in public service, life-sciences and software and platforms and high single digit growth in banking and capital markets. Growth is offset by declines in chemicals and natural resources and high-tech. In Europe revenue declined 2% in local currency. We saw double-digit growth in four industries, including software and platforms, chemical and natural resources, health and life-sciences. Growth was offset by declines in consumer goods, retail and travel, high-tech, and banking and capital markets. Looking closer at the countries, Europe was driven by high single-digit growth in Italy and mid-single-digit growth in Germany, offset by continued declines in the UK as well as declines in Spain and France. In growth markets we delivered 5% revenue growth in local currency driven by double-digit growth in six industries with particular strength in software and platforms, public service, and chemicals and natural resources. Growth is offset by decline in consumer goods, retail and travel. From a country perspective, growth markets was led by Japan, which again had strong double-digit growth. Moving down the income statement, gross margin for the quarter was 32.1% compared with 31.8% for the same period last year. The sales and marketing expense for the quarter was 10.2% compared with 10.7% for the third quarter of last year. General and administrative expense was 6.3% compared to 5.6% for the same quarter last year. Operating income was $1.7 billion in the third quarter reflecting a 15.6% operating margin up 10 basis points compared with Q3 last year. Our effective tax rate for the quarter was 25.5% compared with an effective tax rate of 25.6% for the third quarter last year. Diluted earnings per share were $1.90 compared to EPS of $1.93 in the third quarter last year. Days service outstanding were 41 days compared to 39 days last quarter and 39 days in the third quarter of last year. Free cash flow for the quarter was $2.6 billion resulting from cash generated by operating activities of $2.7 billion net of property and equipment additions of $150 million. Our cash balance at May 31, was $6.4 billion compared with $6.1 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the third quarter we repurchased or redeemed 3.7 million shares for $627 million at an average price of $107.54 per share. As of May 31, we had approximately 1.9 billion of share repurchase authority remaining. Also in May we paid our third quarterly cash dividend of $0.80 per share for a total of $509 million. This represents a 10% increase of equivalent quarterly rate late last year. And our Board of Directors declared our fourth quarterly cash dividend of $0.80 per share to be paid on August 14, also 10% increase of the equivalent rate last year. So in summary, we delivered to the expectations we provided in March. Looking ahead, we remain laser focused on capturing growth opportunities in the market and delivering value for our clients. As you know and expect of us, we will operate with vigor and discipline, while continuing to invest in our business and our people for long-term market leadership. We entered the crisis in a position of strength and we are driving our business to emerge even stronger. We remain committed to delivering significant value to our clients, our people, and our shareholders, as we continue to navigate this very uncertain environment. Now let me turn it back to Julie.
Julie Sweet: Thank you, KC. As we look forward, we are starting to see the overall business environment improve with more engagement with many of our clients. However, the high level of uncertainty persists and it is too early to predict when the pandemic and economic conditions will improve. Now working from home is highly efficient and I am connecting personally with more clients around the world than ever before. I first want to share our perspective on the crisis and how demand is shaping up based on what I'm hearing from CEOs and then bring it to life. Crisis is unique in two ways, first it has created the largest ever change in human behavior, at scale, and almost instantaneously, requiring companies to fill new demand trends, change how they engage with customers and adapt quickly to volatile market conditions, all of which require a strong digital foundation just as they also face massive cost pressures. Second, the pandemic is happening during a period of exponential technology change, which was already driving entirely new ways of doing business. In our future systems research last year, we identified that the top 10% of companies in terms of tech adoption, depth and culture where the leaders are performing twice as well and is the bottom 25%. We believe COVID immediately widened that gap. We see the leaders doubling down on their investments while the laggards recognize the speed to accelerate the pace of their transformation. Companies are turning to Accenture as the trusted partner with the industry experience and the ability to help them create investment capacity and change at scale and to execute with multidisciplinary teams, spanning strategy and consulting to operations and trust matters more than ever, making our strong client relationships and reputation a critical advantage. This is reflected in our Q3 bookings, which include 11 clients over $100 million and importantly is reflected in our strong pipeline as we look ahead to Q4. Let me highlight some of the transformational deals in our Q3 bookings to bring to life what our clients need and how we're able to deliver. Leveraging our intelligent platform services for a major global beverage company seeking to drive growth, we will be implementing SAP S/4HANA to support business simplification and better engagement with customers and consumers through real-time data. We are also providing ongoing IT modernization and application maintenance leveraging our myWizard asset to lower costs and improved user experience. IT modernization overall continues to be an area of high demand. Leveraging our industry ex-capabilities, another area where we are seeing increased demand, we will be helping Airbus reduce costs by up to 15% and speed time-to-market by modernizing their legacy product lifestyle, lifecycle management system. We are implementing and enabling a digital platform built with that source [ph] systems a leader in 3D design to help the company reinvent how they design, build and support new aircraft, products and components. Leveraging operations, we extended our strategic partnership with Microsoft to provide them with credit and collection services, collecting over $120 billion in cash annually across the 170 countries in 30 languages. By combining the market-leading AI powered assets in our SynOps platform, like intelligent collections. With Microsoft's Azure and power platform technologies and by simplifying global processes and policies, we will drive significant day one savings and lower the marginal cost of growth. At the same time, we will deliver top-tier performance. This is an example of why we continue to be the market leader in business process services powered by our ecosystem relationships. Operations is an area where we are seeing a significant increase in demand. Each of these deals create tangible value in both cost efficiency and business outcomes, leveraging our mix of services in deep industry and functional expertise which Accenture is uniquely able to bring to our clients. I also want to touch on another area of demand where we are seeing even more significant growth post COVID across industries. Cloud migration and cloud-based data and innovative business models have quickly accelerated, Amazon Web Services, Microsoft Azure, and Google Cloud platform, as well as Alibaba Cloud in China, and Oracle Cloud Infrastructure or OCI. Companies are looking to more quickly reduce costs and capture the innovation of the cloud as well as provide the foundation for better access to data for new business outcomes and models. Examples from our Q3 sales include working with a global pharmaceutical company to consolidate multiple data sources on AWS to drive faster product development. Working with a major global insurance company to migrate over 30% of their business applications to Azure in just 18 months, working with a leading Asian bank to build digital banking services on GCP, working with one of the largest dairy companies in China to migrate and modernize their customer and omnichannel commerce systems using Alibaba Cloud, and working with a European telecommunications provider on a living systems IT modernization, which includes the migration of their Oracle state to OCI. With cloud our ability to bring industry and cross industry insights to our clients and world class change management for speed and value due to our strong strategy and consulting capability is a major competitive advantage. Given the events of the last weeks, I do you want to pause and take a moment to talk about a core part of who we are as a company. We have an unwavering commitment to inclusion and diversity and equality for all. We have zero tolerance for racism, bigotry and hate of any kind. We live this commitment every day because it is the right thing to do and because becoming the most inclusive and diverse company in the world has been critical to our strategy. Since 2014, when we doubled down on inclusion and diversity and created our digital business, we have delivered 9% compound annual revenue growth in local currency. We are a talent magnet, in part because the most talented people want to work at a company that not only creates value but also leads with values. We have made progress with respect to our people of color, but not enough. We are determined to use this moment in the U.S. as another moment of change for us. This month we announced our commitment to take our next set of actions, which includes setting external goals in the U.S. for increasing overall representation and managing directors for African-American, black and Hispanic American Latin communities, similar to how we have set public goals for gender globally. We also are adding new mandatory training that will help our people identify, speak up against and report racism, and we are committed to take similar actions globally. Now, I'll turn it over to KC to provide our updated business outlook. KC?
KC McClure: Thanks Julie. Before I get into our business outlook, as I did last quarter, I would like to remind you that given the coronavirus pandemic, there are a number of factors that we may not be able to accurately predict, including the duration and magnitude of the impact, the pace of recovery, as well as those described in the quarterly filing we made earlier today. Now with that said, let me turn to our business outlook. For the fourth quarter of fiscal 2020, we expect revenues to be in the range of $10.6 billion to $11.0 billion. This assumes the impact of FX will be approximately negative 1 compared to the fourth quarter of fiscal 2019 and reflects an estimated negative 3% to positive 1% growth in local currency and includes approximately negative 2% from the decline in revenues from reimbursable travel. For the full fiscal year 2020, based on how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in U.S. dollars will be approximately negative 1.5% compared to fiscal 2019. For the full fiscal 2020, we now expect revenue to be in the range of 3.5% to 4.5% growth in local currency over fiscal 2019. For operating margin, we now expect fiscal year 2020 to be 14.7%, a 10 basis point expansion over our fiscal 2019 results. We now expect our annual effective tax rate to be in the range of 23.5% to 24.5%. This compares to an effective tax rate of 22.5% in fiscal 2019. For earnings per share we now expect full-year diluted EPS for fiscal 2020 to be in the range of $7.57 to $7.70 or 3% to 5% growth over fiscal 2019 results. For the full fiscal 2020 we now expect operating cash flows to be in the range of $6.45 billion to $6.95 billion, property and equipment additions to be approximately $650 million, and free cash flow to be in the range of $5.8 billion to $6.3 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.2 to 1.3. Finally, we continue to expect to return at least $4.8 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open up so we can take your questions. Over to Angie.
Angie Park: Thanks KC. I would ask that you each keep to one question and a follow-up to allow as many people as possible to ask a question. Greg, would you provide instructions for those on the call?
Operator: Thank you. [Operator Instructions] Your first question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead.
Tien-tsin Huang: Hey, thanks so much Greg. Tien-tsin here. Just on the – I want to hone in on the strong bookings comment for the fourth quarter, can you maybe give us a little bit more on the type of work you are doing, consulting versus outsourcing, but also what is COVID-specific work versus transformational? And maybe also Julie, I think last quarter you mentioned or talked about clients adapting to a new normal. Has that happened or is Accenture really driving or just adapting to demand in this uncertain market, as you called it?
KC McClure: Yes, so maybe I’ll start and then Julie can weigh in on demand. So, Tien-tsin, thanks for your question. In terms of strong bookings, maybe I'll just talk a little bit about what, maybe if I could take this opportunity to talk about guidance overall, and I'll hit on the bookings point as well. So, in terms of what we’re talking - what we’re looking at for the fourth quarter in terms of both, you know, our revenue and our bookings, I want to put some context into our guidance. Obviously, it continues to be an uncertain environment; and in revenue, we always aim for the top portion of our guided range, but as we said last quarter, this quarter, the entire range is at play. And if I put the context of Q4 into what we experienced in Q3, you know, we have [indiscernible] momentum coming into the third quarter and that carried through in March, and we began to see the impacts of the pandemic on our business in April and May. And so, as we think about Q4, as it relates to what we saw in Q3, at the top end of our revenue guidance range, it implies an improved performance over what we saw in April and May, and at the bottom end of our revenue guidance for the fourth quarter, it means we’ve stabilized. And so, as it relates specifically to your question on bookings, we were able to grow very strong pipeline during the same time, and we do see that we have the potential for strong bookings in the fourth quarter. I’ll let Julie give you a little bit of view on that - on the color as it relates to what we’re seeing in demand in the market.
Julie Sweet: Sure, and as between kind of consulting and outsourcing, we saw sort of similar patterns in Q3 in this. We had lower sales in strategy and consulting in Q3, and we’re going to have some lower sales, you know, in Q4. We sort of expect that as we continue, but as we step it back, let’s just look at demand, right, because the whole set of demand that started in Q3 that will continue into Q4 in some areas around a few things. So, health and public sector, right. So, we saw a surge in need in health and public sector. For example, we became, we pioneered in the - before the Commonwealth of Massachusetts in the U.S. working with partners in health and Salesforce, diverse, you know, contracting, tracing applications and operation, which we've now taken to Phoenix; for example in the State of California where we’re working with Salesforce and AWS, that work will continue. You saw us working around the world doing things like using our industry and technology expertise to set up virtual agents like in India with MyGov and Microsoft in [indiscernible] we set up virtual agent. If you go to Brazil, we worked with Microsoft to set up telemedicine for a major hospital there. That work and the trends around telemedicine and the need to support citizens through the pandemic will continue, we believe. And what’s important there is, it is not simply - this isn’t about technology right? This is about taking all of our insights from the needs of – from health and public sector and supporting citizenry [ph] with technology, with the ecosystem partners, and quite honestly innovating remotely. Right? The work that we've been doing and that will continue. You also see the supply chain really being an area of big focus. So, we worked with Danone, a multinational food products company whose supply chain was immediately disrupted severely and leveraging analytics it became essential for them to give them a near real-time data around their supply chain to avoid disruption. So that kind of work supply chain is gowing, we’ve been doing it, it’s going to continue and of course clients are now moving from the immediate needs in leveraging the assets and tools and understanding that we have to thinking longer-term because of course what you have is completely different, trends and uncertainty, and so how do you really connect everything from understanding the customer all the way back to manufacturing, and that's why you start to see the demand in digital manufacturing, supply chain, and we expect on the customer side that to continue. Then finally the whole area of online, so we worked with a global retailer who’s been investing for years in omnichannel. We've been piloting curbside pickup before the crisis of a hundred stores, and in 48 hours we took them to 1,400 stores. And so we’re beginning to really talk about -- with the other retailers who were behind. Right? We talked about the laggards and the leaders to how are they going to be adjusting it. Now, if you take a step back, Tien-tsin on the big picture, we do three big things. We build digital core, and I talked about it in my script how cloud is accelerating, security is accelerating. We just bought Symantec's Managed Service business. We are now one of the largest and leading providers in the world. The threat landscape has expanded and we're seeing tons of demand in security, lots of demand in data and applied intelligence, as data is so necessary. But on the other hand, intelligent platform services, which as we've shared in the past is about 40% of our business and pre-crisis was growing double-digits, that moderated in Q3 and we'll see further moderation. In Q4, we expect, as clients have to take a step back, refocus, prioritize, we're helping them shape that, but the demand long term is absolutely there. And you saw that in our bookings that we talked about the S/4HANA implementation in Q3, where we are at - there we're doing so to drive growth as well as efficiencies. And so, while we continue to see that moderating, we really do see that is being very much affected by the industries that are most severely impacted. But also as clients frankly are taking a step back to figure out how they're going to accelerate and in what sequence their digital core building. In the area of optimizing operations, which is the second big thing we do, our operations business is seeing surge in demand. We talked about this last quarter, where we had double-digit growth for 25 consecutive quarters. Obviously, some crisis-related impacts in this quarter. But as the need for digital transformation has accelerated, the ability to use our digital platform SynOps to drive cost efficiencies and to get better data faster, right, is really taking - having that business have another new surge in demand as we look at our pipeline and then also the digital manufacturing as I've referred to. And then finally on the growth agenda side, Accenture Interactive, right, an incredible business. We hit $10 billion and it was having significant growth. It was significantly impacted in Q3 as companies focused more on shoring up what they had as opposed to thinking about the next generation of customer experience, et cetera. We're now seeing those conversations begin again. And what's really interesting there, is that the B2B companies like the industrials, who have their - have a traditional field sales model, were able to get connected with remote work, but they weren't online, right? And so, we think there's going to be a real surge over time and we're starting to have those conversations about how you move online. In general, to your question around kind of remote working, we've enabled lots of companies to work remotely, right, whether it was an aerospace and defense company on G Suite, 100,000 people to the NHS hospital system with teams over 1 million people, companies have really adapted, and where we have the advantage is because we've been so remote and because of the - we are a global company and have a strong tradition of working with our clients around the globe, we've just adapted very quickly and you see that in our strong bookings. You know it's higher than last year's Q3 and what we expect in Q4.
Tien-tsin Huang: Great, that's good stuff. Good color. I'll get back in the queue. Thank you.
Operator: Thanks. Your next question comes from the line of Lisa Ellis from MoffettNathanson. Please go ahead.
Lisa Ellis: Hi, good morning and good to hear your voices. Just a follow-on on Tien-tsin question. I mean, you obviously recorded solid revenue in 3Q, solid growth in bookings, have a strong pipeline again for 4Q. At the same time the WEO just downgraded its economic outlook to nearly a 5% decline for this year. So, which is pretty terrible. So I'm just trying to ask, can you provide color on how those two things and those two trends reconcile, meaning, are you seeing that businesses either a, have not made revisions yet to their overall IT budgets to reflect a weaker longer-term economic outlook or more optimistically, be they have, but they have actually reallocated more dollars into IT to drive the digital transformations or is it that you're picking up share? I mean, I guess maybe just some color on kind of how you reconciled those two dynamics? Thank you.
Julie Sweet: Yes, sure. You know, Lisa remember what we're guiding to is really a modest growth, it would reflect the economic conditions. Right? So what we're seeing in Q4 is we're seeing our business stabilize at what is a much lower level, right than pre-crisis with at the high end of the range, starting to tick up and improve. Right? So that is what's really, as you said like that's how you reconcile that. Right? And as I just went through with Tien-tsin, there are parts of our business that are accelerating like cloud and security and operations. But a big part of our business, our intelligent platform services business, which is 40% was growing double-digits moderated in Q3 and we expect a further moderation reflecting the economic conditions, clients sort of taking a step back and saying, how do I sequence and so, when you look at what's happening, the IT budgets, all the analysts are telling us and we're seeing it is too is that they are declining, but they are focusing on the digital transformation that's needed to navigate. So like the supply chain examples where you have to do this, this is why Lisa, our position is so important right now, because what we can uniquely do is provide cost savings while we transform. When we talk about IT modernization and managed services, we're doing managed services and we talked about this in prior quarters called Living Systems, where we're taking down the costs, but we're helping them have DevOps and Agile at scale to get their product releases faster. We are seeing deals like if you look at the one I highlighted on SAP, it has two components where they put the global beverage company. It was re-platforming, but it also had a managed service component that was modernizing and cutting their costs and so what we're seeing is this flight to Accenture for flight to quality, because we can deliver with the ability to increase investment capacity, decrease costs, but still modernize like what we do with operations. And so, of course we're going to be impacted, but we've got severely impacted is went through businesses that industries that of course we're good, we're feeling all of those effects, but we believe our results, we don't know, nobody else has come yet are taking share in this environment.
Lisa Ellis: Terrific, thank you. And then maybe my follow on is just on the talent side, can you provide, I mean, I know you're an environment where attrition just dropped to 11%. Not surprisingly, given the environment. Utilization is also down a little bit, but of course you're continuing as you said to maintain promotions, maintain higher, and can you just remind us of how you manage talent through this type of environment, so you emerge with a stronger bench on the other side? Thanks.
Julie Sweet: Sure. I mean, it's a great question and something we really focus on because our competitive advantage is phenomenal talent. And the underlying fundamentals of the market, the need to digitally transform and of our business remain strong. And so, we are very focused on preserving that great talent and our strategic capabilities because we have everything from Strategy and Consulting to operations and so that's been our principle. So we're pulling the usual levers of less hiring, except in specific areas of replacing subcontractors if we don't need it. We continue to promote, but we moderated the promotions. But it's important that we're delivering still on it. We've delayed some start dates, as you would do, as you would imagine. The second thing we're doing is, we did just put in this new growth model and we were able in a more simplified organization to identify efficiencies. So we're going after some cost structural decreases that are helping. And then as we move forward, we'll do things like we're in our annual performance process. And so, the pace of how we do our kind of business as usual, managing out of our lower performers is another lever that we can pull as we look forward, and what we're really focused on is making sure, like say for our intelligent platform services business, yes it's moderating, but we know it is an absolute critical part of our business. So we're doing a lot of upskilling. I mean, I think this - I'm going to give you a number that I think is so phenomenal. Since the beginning of March, when we hit COVID and we saw the shift in demand in technology we have reskilled 37,000 people in hot areas like cloud since the beginning of March. And these are in sort of 15 to - on average 15 to 20-hour modules of reskilling to pivot. We've taken our Strategy and Consulting people and pivoted to some of the needs for operations in the public sector, because again those are - also require those insights. And the resiliency of a business like ours because we're in multiple industries, multiple types of work and we're able to kind of seamlessly move people who are used to working in these multi-dimensional teams anyway. And by the way, our people love it, because they get great new opportunities. So we feel really good about how we're managing it. And to your point, Lisa, we think we're going to come out much stronger because of how we're delivering for our people.
Lisa Ellis: Terrific, great color, thank you. Thanks, guys.
Operator: Your next question comes from the line of Dave Koning from Baird. Please go ahead.
David Koning: Yes, hey, guys. Thank you and congrats. My question, The New really didn't decelerate that much and maybe that just is a function of exactly you're talking about some of these newer products doing well, while some of the older part decelerated more. As the economy comes back, eventually, do you think The New kind of just gets to just a higher level of growth and then the older services just stay at a lower level? I mean is that really what we're seeing now?
Julie Sweet: I mean, look, if you sort of look at it I would start with like we're in the big shock, right? I mean that how fast the economy went down, the need that every business is now a health business and so all of these. So, I don't read too much into a quarter's sort of response in terms of now new versus legacy other than the impact of what's happening to have to move to online everything and remote will absolutely require and is requiring and that's what we see in our pipeline, an acceleration of building the digital foundation which means, companies are going to have to make more choices. And this is why - we used to tell you, our theory was in a financial crisis that the rotation to The New would make us more resilient and that's what is absolutely the facts. So is that - we've seen what's happened. You have to be more digital and that's going to stay and that will no doubt have some effects on where you're spending the money, but it's part of what's driving what we're doing now with our managed services and helping modernize those for our clients in a more cost-effective way to get our clients to The New. And a lot of what we're doing now is taking all of our learning capabilities and building that in for our clients to help them rotate their talent, which they need to do as well.
David Koning: Great, thanks. And one quick numbers question. The new reporting on segments with the geos, the margins in the growth markets have been very high this year, and specifically in Q3 was very high, I think 21%. Is there something changing in the environment that allows those margins to be higher? Is that going to continue, or maybe it's just a short-term blip?
KC McClure: Yes, thanks for the question. This is the first time that we have provided operating income by market. And the way I would just say, to take a look at operating income across our markets, Dave, would be the very same way that you thought about it as it relates to the operating groups, like you're going to have - we have variations by markets just like we did throughout the years in operating groups. It's really going to be impacted by these services that we do in that market, the mix of industries that we have, any type of economic impacts that are happening in a specific market, as well as maybe investments that we're making particularly to that geography. So I think that's - the lens I would look at operating income would be the same as we've always historically done against operating groups and we manage obviously to overall Accenture operating income. As it relates specifically to the growth markets, we had very strong performance in our Japanese business, which is a major growth driver, and overall our contract performance and profitability is very strong in the growth markets.
David Koning: Great, thanks, guys.
Operator: Your next question comes from the line of Harshita Rawat from Bernstein. Please go ahead.
Harshita Rawat: Hi, good morning Julie, KC. My question is, we are seeing in this environment that many companies are starting to rethink work from home policies as a margin driver longer term, given the higher productivity we've seen in this remote working environment. Is this something you're seeing, looking at? And more broadly what have been some of the positive and negative surprises in this new working environment? Thank you.
KC McClure: Yes, I think I'll start and Julie can certainly weigh in. I think one of the things that's kind of - you asked about margin and unique in this environment is, what I would say that, and we're taking full advantage of this is the fact that we are really not traveling, particularly for non-billable events and meetings. And so we are using - we're taking full advantage of that and making sure that we continue then to use that extra capacity to invest in our business, to preserve our talent, while at the same time giving margin expansion. So I think for us, that's probably the bigger change within this environment. We have obviously moved - we've always been able to work from home to a great degree, and within our centers, we have been able to make that change as well this quarter. But that's not really going to be a significant increase or decrease in margin in and of itself.
Julie Sweet: And then if you look at it, as it relates to ourselves, it's complicated. Right? Looking at our operations business it's 24/7 and we run shifts and we get to have the advantage of sort of using assets over and over. So, I mean, it's a - it's not a straightforward sort of discussion around that, but maybe let's just take a step back, what are the realities, right? We're opened 30% of our offices now, but we're not putting a lot of people back in the office and neither are our clients around the globe because we're dealing with an ongoing health situation. And so, whether you like it or not, remote working is going to be here to stay at a pretty high level for some time. And so, we and our clients are focused on understanding where does that make sense. I was just talking to a technology company yesterday where what they've said is, look, everything is working pretty well except R&D, not because R&D needs to be in the office, but they're just struggling to collaborate as well. And so, company by company, are learning. I give a lot of advice to CEOs about this because there are some who've got really excited about, let's get rid of all our real estate. Back in the '90s, we pioneered remote working and we called it hoteling, and particularly in the U.S., we took out a lot of real estate because we said our people are at our client sites and they're - or they could be home. And what we found, in fact, over the last five years, when I was running North America, we started gradually to expand the footprint again because there is a benefit of bringing people together as well. Now, we've proved you can innovate remotely as I gave some of those examples, but I would say it's going to be cautious. As a respect to sort of driving our business, what it has helped CEOs really understand is some of the areas in some industries that have resisted say finance and accounting and certain areas saying no, no, no, we need to have the teams together is to recognize that they can really rethink like what should they do in-house? What can they rely on a partner like Accenture? How to get the right balance, both from an expertise and a cost perspective, but just as much this idea of leveraging others for digital transformation and you're going to see more of that thinking. I mean, when you move to the cloud, you're basically saying you have this important permanent third-party partners that are running your business, right? And so, how digital transformation happens at speed going forward is really going to be this weaving of partners together, which is why the fact that we're so trusted really helps us in this environment.
Harshita Rawat: Great, thank you very much.
Operator: Your next question comes from the line of Edward Caso from Wells Fargo. Please go ahead.
Edward Caso: Hi, good morning. Can you talk a little bit more about your Consulting bookings? How much of the sort of the solid quarter do you expect that you had in the quarter was related to the responding to the COVID crisis? And I'm not sure I heard it in response to Tien-tsin's question, but the strong awards outlook for Q4, how does that split out between Consulting and Outsourcing? Thank you.
KC McClure: Yes, hey, nice to talk to you. In terms of what we were guiding to in Q4, we see overall stronger bookings. I'll leave it at that in terms of, you know, we don't really give a sense or guide to the overall fourth quarter. And I think, just in terms of what was in our consulting bookings, Julie provided a lot of color, we had, as we talked about our overall bookings were 70% in The New which is digital to move to the cloud. Security was really important in this current environment, as well as other digital areas. So, I don't know, Julie, if there's anything else in addition you want to add on.
Julie Sweet: No, I mean as I said, our bookings were kind of sort of split between Outsourcing and Consulting sort of similar to that pattern overall.
KC McClure: No, change there, yes.
Julie Sweet: In the quarter.
KC McClure: Yes, in the quarter. That's right.
Edward Caso: And my other question is around utilization, it went down a few points here. Have you found bottom yet on utilization or we're sort of picking up information that you guys are doing some layoffs and so forth and wondering if you've been able to sort of stabilize the utilization yet?
KC McClure: Yes, maybe I'll just quickly on utilization, yes, we did do a tick down in Q3. It's nothing that we're concerned about. It's really a bit particularly in operations in our centers, as we moved during the time that we moved to work from home, as well as there were some elements - minor elements of work from home restrictions. But that said, it was within the zone that we expected, and we continue to deliver for our clients in their time of need.
Julie Sweet: Yes. And with respect to managing, as I've said before, we've identified some real areas of efficiencies and so that has obviously headcount implications to it, which may be what you're calling layoffs. We really see it is as focusing on our cost structure, and then otherwise managing our supply and demand as I went through before in a pretty ordinary course. We don't see some extraordinary workforce actions, and remember that Q4 guidance builds that in and that we think we're either stabilizing to slightly up in terms of our business environment, because if you look at our guidance, we're pretty pleased. I mean Q3 had a great strong March. We don't have that in Q4. And so we see - do see our business either stabilizing or slightly up.
KC McClure: Yes and then I just - another fact on that, as you saw from our - our headcount went up sequentially 1%. Right? So for the quarter, we're up over 6% for the year.
Edward Caso: Thank you.
Angie Park: Great, thanks, Ed. Greg, we have time for one more question, and then Julie will wrap up the call.
Operator: Okay. That question comes from the line of Bryan Bergin from Cowen. Please go ahead.
Bryan Bergin: Hi, good morning, thank you. I wanted to ask on bookings conversion. Can you comment on clients' willingness to ramp up some of these large projects in this environment? I'm curious, if you're seeing any extension of the period between signings and project startups and how that might impact near-term outlook?
Julie Sweet: Well, I mean, our outlook includes kind of what we're seeing and it's a little bit all over the map, right? You've got some clients who want to go faster, because they need the savings faster, you have other clients to maybe having a slower ramp-up. So I'd say it's mixed.
KC McClure: Yes. And I think maybe in terms of our outlook, maybe the way I'd answer it too is, if you look at our Q4 revenue guidance, I think there is really kind of what would put us at the top versus what would put us at the bottom is probably two swing factors. One would be really how the industries - that industry dynamic that we talked about, how that continues to play out and then how the Strategy & Consulting work evolves in the quarter.
Bryan Bergin: Okay. And then just on your comments on digital, can you give us a sense on how those underlying components performs interactive relative to cloud and security and any quantification there?
Julie Sweet: Well, we don't, we don't know about quantify. But as I told you earlier, right, we had Accenture Interactive pre-crisis have been significantly growing and it was significantly impacted in Q3 and that primarily around industries and kind of focus, so you've got that. And then, whereas we sort of look at cloud that really was up and security was up, and remember Intelligent Platform Services came down. So those are kind of the big components that we normally kind of give you a sense of.
KC McClure: Yes, I would say just - just to add on to what Julie said when we talked about the industry dynamics that I talked about earlier, that really plays out the same way with Accenture Interactive. There was growth in Accenture Interactive and the less impacted industries. Right? And they had also a similar dynamic on the areas that had more pressure - industries that had more pressure this quarter they have some declines.
Julie Sweet: Great. Well thank you, everyone. Before I wrap up, I did want to give a special shout out to Fabio Benasso, who leads our Italian business to his leadership team and all of our people in Italy. As you all saw, Italy was actually in lockdown in the entire three months of the quarter and it was an extraordinarily difficult time, and yet they delivered 8% revenue growth in local currency in Q3, because they stayed so close to our clients and to each other and I just thought it deserved a very special mention. As I wrap up, we really believe that Accenture is uniquely positioned today to help our clients succeed in the current environment, both because of what we do as well as how we do it. We are committed to shared success with our clients, people, shareholders and communities to living our core values and to being a trusted leader and responsible business. Thank you to our people and leaders for how you come together every day to deliver on our commitments, and a special thank you to our shareholders for your continued trust and support. Be well everyone, and thank you for joining.
Operator: Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T Teleconferencing. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to Accenture’s Third Quarter Fiscal 2020 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director and Head of Investor Relations, Angie Park. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, Greg and thanks everyone for joining us today on our third quarter fiscal 2020 earnings announcement. As Greg just mentioned, I am Angie Park, Managing Director, Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you have had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the fourth quarter and full fiscal year 2020. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today’s news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie, and thank you everyone for joining us. Since our last earnings call, the world has continued to face unprecedented challenges; health, economic, and social, and throughout Q3 we saw rapidly deteriorating economic conditions globally. I am proud of and want to thank our people and our leaders around the world for coming together in Q3 to continue to deliver on our commitment to our shareholders, our clients, our people, and our communities in the face of this crisis. Before turning to our delivery on these commitments, let me provide a bit more color on the context. Within days of our earnings call on March 19, we continued to quickly mobilize our people to work from home, and during the quarter we had approximately 95% of our people enabled to work remotely. For all of April and May other than China, virtually every country in which we operate was in lockdown. In addition, as you may remember, in January we announced that as of March 1, we were implementing a new growth model and making leadership changes. We seamlessly implemented this new model demonstrating our agility at massive scale, which is a testament to the talent of our over 500,000 people and the strength of our leadership team. So, in terms of delivery on our commitments to our shareholders, we delivered Q3 revenues in line with the range we provided only eight days after the global pandemic was declared, and we hit a new milestone of approximately 70% in the “New,” which is digital, cloud, and security. We delivered $11 billion in new bookings, a 6% increase over Q3 last year, which demonstrates the relevance of our services and our ability to sell in a remote everything world. We continue to invest in our business for the long term, closing an additional $742 million in strategic acquisitions for a total of $1.3 billion year-to-date. We delivered operating margin expansion of 10 basis points, and we continued to strengthen our balance sheet closing the quarter with $6.4 billion in cash. In terms of delivering on our commitments to our clients, our clients rely on us for mission-critical work. 95 of our top 100 clients have been with us for over 10 years because we are a trusted partner. And during this time, we have deepened that trust yet again because of our ability to deliver seamlessly, including how we transitioned our people from the delivery centers in India and the Philippines to work from home without service interruption. For example, we closed the books on time for more than 70 public companies in operation, and we continued our pre-crisis track record in technology with around-the-clock go live on new releases every 15 minutes on average. In both technology and operations, we were able to execute entirely remote knowledge transfer with great success. In terms of delivering on our commitment to our people, we continue to invest in training and development and the continuous re-skilling of our people. We are on track to deliver the same training hours as last year while pivoting completely to a digital learning experience built on our platform Accenture Connected Learning. We continued to promote people midyear, although at a reduced level compared to last year to ensure that our very best talent continues to build a vibrant career and is recognized and rewarded. In terms of delivering on our commitment to our communities, we believe strongly in our responsibility to contribute to the well-being of our communities. In addition to our teams who have supported our health and public service clients with extraordinary COVID-19 related work, we also wanted to make a unique pro bono contribution that leveraged our strength. In addition to our many local activities, we are very proud that we are helping put people back to work around the world with the People + Work Connect platform that we created together with Lincoln Financial Group, ServiceNow, and Verizon. This platform is a global online employer-to-employer initiative to bring together at no cost companies that have laid off or furloughed people with organizations in urgent need of workers. Designed by CHROs including our own extraordinary CHRO, Ellyn Shook, Accenture built the platform in only 14 days. The response has been overwhelming as more than 1,300 organizations across approximately 80 countries have engaged with currently about 400,000 positions already on the platform which are balanced between open needs and availability. With that, over to you KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie and thanks to all of you for taking the time to join us on today's call. We are pleased with our third quarter results which were in line with our expectations and reflect the diversity and durability of our growth model across geographies, industries, and services. Our results continue to reinforce the relevance of our offerings and capabilities in the market to deliver value for our clients. Importantly, these results illustrate Accenture's unique ability to manage our business and deliver significant value to our shareholders in a very uncertain environment. Before I get into the details, let me summarize the major headlines of our third quarter results, which reflect continued strong execution against our three financial imperatives. Revenue grew 1.3% in local currency at the top end of our guided range. This includes a reduction of approximately 2% from a decline in revenues from reimbursable travel costs. Taking a look at revenues through an industry lens, the diversity of our portfolio continues to serve us well. Approximately 50% of our revenues came from seven industries that were less impacted from the pandemic and in aggregate grew high-single digits with double-digit growth in software and platforms, life-sciences, and public service. At the same time as we expected, we saw pressure from clients in the highly impacted industries which include travel, retail, energy, high-tech including aerospace and defense and industrials. While performance varied, this group collectively represents over 20% of our revenues and declined high-single digits. Given this is the first quarter of results since the onset of the pandemic, let me share a bit more color on how it shaped our quarter. We had strong momentum coming into the quarter, which continued through March. We began to see the impacts on our business in April and May as a result of clients postponing work, reducing existing volumes, and deferring decisions on new work. These impacts were more pronounced in strategy and consulting. We did not, however, see an uptick in cancellations over typical levels. In addition, we experienced very little revenue impact from needing to shift to remote working as we continued to successfully deliver services to our clients. Operating margin was 15.6%, an increase of 10 basis points, both for the quarter and year-to-date as we continued to demonstrate our ability to drive sustainable margin expansion. This result continues to reflect the absorption of significant investments in our people and our business as we further strengthen our leadership position in the market. We are also benefiting from significant lower spend on non-billable travel, meetings, and events. And finally, we delivered very strong free cash flow of $2.6 billion in the quarter, while also continuing all elements of our capital allocation program, including returning roughly $1.1 billion to shareholders via dividends and share repurchases. We've made investments of $1.3 billion acquisitions, primarily attributed to 29 transactions year-to-date, and we continue to expect to invest up to $1.6 billion in acquisitions this fiscal year. With that, let me turn to some of the details starting with new bookings. New bookings were $11 billion for the quarter, reflecting growth of 6% in local currency and 4% in U.S. dollars. Consulting bookings were $6.2 billion, up 5% in local currency and 3% in U.S. dollars with a book-to-bill of 1. Outsourcing bookings were $4.8 billion, up 8% in local currency and 5% in U.S. dollars with a book-to-bill of 1. We were very pleased with our new bookings which continue to be dominated by high demand for digital, cloud, and security-related services, which we estimate represented approximately 70% of our new bookings in the quarter. Looking forward, we expect strong bookings in Q4. The fact that we delivered $11 billion of bookings in this environment with growth over last year with much of these sales closed virtually, while at the same time building a very strong pipeline, speaks to both our agility and the strength of our client relationships. Turning now to revenues. Revenues for the quarter were $11 billion, a 1% decrease in U.S. dollars and a 1.3% increase in local currency, reflecting a foreign exchange headwind of roughly 2.5% compared to the 1.5 estimated impact provided in our guidance for quarter. This result was at the top end of our FX adjusted range. Consulting revenues for the quarter were $6 billion down 4% in U.S. dollars and down 2% in local currency which includes a reduction of approximately 3 percentage points from a decline in revenues from reimbursable travels. Outsourcing revenues were $5 billion, up 3% in U.S. dollars and up 5% in local currency. Taking a closer look at our service dimensions. Technology services grew mid-single-digits, operations grew low single-digit, and strategy and consulting declined mid-single-digit. Additionally, digital, cloud and security-related services grew high-single-digits. Turning to our geographic markets, in North America we delivered 2% revenue growth in local currency driven by double-digit growth in public service, life-sciences and software and platforms and high single digit growth in banking and capital markets. Growth is offset by declines in chemicals and natural resources and high-tech. In Europe revenue declined 2% in local currency. We saw double-digit growth in four industries, including software and platforms, chemical and natural resources, health and life-sciences. Growth was offset by declines in consumer goods, retail and travel, high-tech, and banking and capital markets. Looking closer at the countries, Europe was driven by high single-digit growth in Italy and mid-single-digit growth in Germany, offset by continued declines in the UK as well as declines in Spain and France. In growth markets we delivered 5% revenue growth in local currency driven by double-digit growth in six industries with particular strength in software and platforms, public service, and chemicals and natural resources. Growth is offset by decline in consumer goods, retail and travel. From a country perspective, growth markets was led by Japan, which again had strong double-digit growth. Moving down the income statement, gross margin for the quarter was 32.1% compared with 31.8% for the same period last year. The sales and marketing expense for the quarter was 10.2% compared with 10.7% for the third quarter of last year. General and administrative expense was 6.3% compared to 5.6% for the same quarter last year. Operating income was $1.7 billion in the third quarter reflecting a 15.6% operating margin up 10 basis points compared with Q3 last year. Our effective tax rate for the quarter was 25.5% compared with an effective tax rate of 25.6% for the third quarter last year. Diluted earnings per share were $1.90 compared to EPS of $1.93 in the third quarter last year. Days service outstanding were 41 days compared to 39 days last quarter and 39 days in the third quarter of last year. Free cash flow for the quarter was $2.6 billion resulting from cash generated by operating activities of $2.7 billion net of property and equipment additions of $150 million. Our cash balance at May 31, was $6.4 billion compared with $6.1 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the third quarter we repurchased or redeemed 3.7 million shares for $627 million at an average price of $107.54 per share. As of May 31, we had approximately 1.9 billion of share repurchase authority remaining. Also in May we paid our third quarterly cash dividend of $0.80 per share for a total of $509 million. This represents a 10% increase of equivalent quarterly rate late last year. And our Board of Directors declared our fourth quarterly cash dividend of $0.80 per share to be paid on August 14, also 10% increase of the equivalent rate last year. So in summary, we delivered to the expectations we provided in March. Looking ahead, we remain laser focused on capturing growth opportunities in the market and delivering value for our clients. As you know and expect of us, we will operate with vigor and discipline, while continuing to invest in our business and our people for long-term market leadership. We entered the crisis in a position of strength and we are driving our business to emerge even stronger. We remain committed to delivering significant value to our clients, our people, and our shareholders, as we continue to navigate this very uncertain environment. Now let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. As we look forward, we are starting to see the overall business environment improve with more engagement with many of our clients. However, the high level of uncertainty persists and it is too early to predict when the pandemic and economic conditions will improve. Now working from home is highly efficient and I am connecting personally with more clients around the world than ever before. I first want to share our perspective on the crisis and how demand is shaping up based on what I'm hearing from CEOs and then bring it to life. Crisis is unique in two ways, first it has created the largest ever change in human behavior, at scale, and almost instantaneously, requiring companies to fill new demand trends, change how they engage with customers and adapt quickly to volatile market conditions, all of which require a strong digital foundation just as they also face massive cost pressures. Second, the pandemic is happening during a period of exponential technology change, which was already driving entirely new ways of doing business. In our future systems research last year, we identified that the top 10% of companies in terms of tech adoption, depth and culture where the leaders are performing twice as well and is the bottom 25%. We believe COVID immediately widened that gap. We see the leaders doubling down on their investments while the laggards recognize the speed to accelerate the pace of their transformation. Companies are turning to Accenture as the trusted partner with the industry experience and the ability to help them create investment capacity and change at scale and to execute with multidisciplinary teams, spanning strategy and consulting to operations and trust matters more than ever, making our strong client relationships and reputation a critical advantage. This is reflected in our Q3 bookings, which include 11 clients over $100 million and importantly is reflected in our strong pipeline as we look ahead to Q4. Let me highlight some of the transformational deals in our Q3 bookings to bring to life what our clients need and how we're able to deliver. Leveraging our intelligent platform services for a major global beverage company seeking to drive growth, we will be implementing SAP S/4HANA to support business simplification and better engagement with customers and consumers through real-time data. We are also providing ongoing IT modernization and application maintenance leveraging our myWizard asset to lower costs and improved user experience. IT modernization overall continues to be an area of high demand. Leveraging our industry ex-capabilities, another area where we are seeing increased demand, we will be helping Airbus reduce costs by up to 15% and speed time-to-market by modernizing their legacy product lifestyle, lifecycle management system. We are implementing and enabling a digital platform built with that source [ph] systems a leader in 3D design to help the company reinvent how they design, build and support new aircraft, products and components. Leveraging operations, we extended our strategic partnership with Microsoft to provide them with credit and collection services, collecting over $120 billion in cash annually across the 170 countries in 30 languages. By combining the market-leading AI powered assets in our SynOps platform, like intelligent collections. With Microsoft's Azure and power platform technologies and by simplifying global processes and policies, we will drive significant day one savings and lower the marginal cost of growth. At the same time, we will deliver top-tier performance. This is an example of why we continue to be the market leader in business process services powered by our ecosystem relationships. Operations is an area where we are seeing a significant increase in demand. Each of these deals create tangible value in both cost efficiency and business outcomes, leveraging our mix of services in deep industry and functional expertise which Accenture is uniquely able to bring to our clients. I also want to touch on another area of demand where we are seeing even more significant growth post COVID across industries. Cloud migration and cloud-based data and innovative business models have quickly accelerated, Amazon Web Services, Microsoft Azure, and Google Cloud platform, as well as Alibaba Cloud in China, and Oracle Cloud Infrastructure or OCI. Companies are looking to more quickly reduce costs and capture the innovation of the cloud as well as provide the foundation for better access to data for new business outcomes and models. Examples from our Q3 sales include working with a global pharmaceutical company to consolidate multiple data sources on AWS to drive faster product development. Working with a major global insurance company to migrate over 30% of their business applications to Azure in just 18 months, working with a leading Asian bank to build digital banking services on GCP, working with one of the largest dairy companies in China to migrate and modernize their customer and omnichannel commerce systems using Alibaba Cloud, and working with a European telecommunications provider on a living systems IT modernization, which includes the migration of their Oracle state to OCI. With cloud our ability to bring industry and cross industry insights to our clients and world class change management for speed and value due to our strong strategy and consulting capability is a major competitive advantage. Given the events of the last weeks, I do you want to pause and take a moment to talk about a core part of who we are as a company. We have an unwavering commitment to inclusion and diversity and equality for all. We have zero tolerance for racism, bigotry and hate of any kind. We live this commitment every day because it is the right thing to do and because becoming the most inclusive and diverse company in the world has been critical to our strategy. Since 2014, when we doubled down on inclusion and diversity and created our digital business, we have delivered 9% compound annual revenue growth in local currency. We are a talent magnet, in part because the most talented people want to work at a company that not only creates value but also leads with values. We have made progress with respect to our people of color, but not enough. We are determined to use this moment in the U.S. as another moment of change for us. This month we announced our commitment to take our next set of actions, which includes setting external goals in the U.S. for increasing overall representation and managing directors for African-American, black and Hispanic American Latin communities, similar to how we have set public goals for gender globally. We also are adding new mandatory training that will help our people identify, speak up against and report racism, and we are committed to take similar actions globally. Now, I'll turn it over to KC to provide our updated business outlook. KC?"
},
{
"speaker": "KC McClure",
"text": "Thanks Julie. Before I get into our business outlook, as I did last quarter, I would like to remind you that given the coronavirus pandemic, there are a number of factors that we may not be able to accurately predict, including the duration and magnitude of the impact, the pace of recovery, as well as those described in the quarterly filing we made earlier today. Now with that said, let me turn to our business outlook. For the fourth quarter of fiscal 2020, we expect revenues to be in the range of $10.6 billion to $11.0 billion. This assumes the impact of FX will be approximately negative 1 compared to the fourth quarter of fiscal 2019 and reflects an estimated negative 3% to positive 1% growth in local currency and includes approximately negative 2% from the decline in revenues from reimbursable travel. For the full fiscal year 2020, based on how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in U.S. dollars will be approximately negative 1.5% compared to fiscal 2019. For the full fiscal 2020, we now expect revenue to be in the range of 3.5% to 4.5% growth in local currency over fiscal 2019. For operating margin, we now expect fiscal year 2020 to be 14.7%, a 10 basis point expansion over our fiscal 2019 results. We now expect our annual effective tax rate to be in the range of 23.5% to 24.5%. This compares to an effective tax rate of 22.5% in fiscal 2019. For earnings per share we now expect full-year diluted EPS for fiscal 2020 to be in the range of $7.57 to $7.70 or 3% to 5% growth over fiscal 2019 results. For the full fiscal 2020 we now expect operating cash flows to be in the range of $6.45 billion to $6.95 billion, property and equipment additions to be approximately $650 million, and free cash flow to be in the range of $5.8 billion to $6.3 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.2 to 1.3. Finally, we continue to expect to return at least $4.8 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open up so we can take your questions. Over to Angie."
},
{
"speaker": "Angie Park",
"text": "Thanks KC. I would ask that you each keep to one question and a follow-up to allow as many people as possible to ask a question. Greg, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Your first question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-tsin Huang",
"text": "Hey, thanks so much Greg. Tien-tsin here. Just on the – I want to hone in on the strong bookings comment for the fourth quarter, can you maybe give us a little bit more on the type of work you are doing, consulting versus outsourcing, but also what is COVID-specific work versus transformational? And maybe also Julie, I think last quarter you mentioned or talked about clients adapting to a new normal. Has that happened or is Accenture really driving or just adapting to demand in this uncertain market, as you called it?"
},
{
"speaker": "KC McClure",
"text": "Yes, so maybe I’ll start and then Julie can weigh in on demand. So, Tien-tsin, thanks for your question. In terms of strong bookings, maybe I'll just talk a little bit about what, maybe if I could take this opportunity to talk about guidance overall, and I'll hit on the bookings point as well. So, in terms of what we’re talking - what we’re looking at for the fourth quarter in terms of both, you know, our revenue and our bookings, I want to put some context into our guidance. Obviously, it continues to be an uncertain environment; and in revenue, we always aim for the top portion of our guided range, but as we said last quarter, this quarter, the entire range is at play. And if I put the context of Q4 into what we experienced in Q3, you know, we have [indiscernible] momentum coming into the third quarter and that carried through in March, and we began to see the impacts of the pandemic on our business in April and May. And so, as we think about Q4, as it relates to what we saw in Q3, at the top end of our revenue guidance range, it implies an improved performance over what we saw in April and May, and at the bottom end of our revenue guidance for the fourth quarter, it means we’ve stabilized. And so, as it relates specifically to your question on bookings, we were able to grow very strong pipeline during the same time, and we do see that we have the potential for strong bookings in the fourth quarter. I’ll let Julie give you a little bit of view on that - on the color as it relates to what we’re seeing in demand in the market."
},
{
"speaker": "Julie Sweet",
"text": "Sure, and as between kind of consulting and outsourcing, we saw sort of similar patterns in Q3 in this. We had lower sales in strategy and consulting in Q3, and we’re going to have some lower sales, you know, in Q4. We sort of expect that as we continue, but as we step it back, let’s just look at demand, right, because the whole set of demand that started in Q3 that will continue into Q4 in some areas around a few things. So, health and public sector, right. So, we saw a surge in need in health and public sector. For example, we became, we pioneered in the - before the Commonwealth of Massachusetts in the U.S. working with partners in health and Salesforce, diverse, you know, contracting, tracing applications and operation, which we've now taken to Phoenix; for example in the State of California where we’re working with Salesforce and AWS, that work will continue. You saw us working around the world doing things like using our industry and technology expertise to set up virtual agents like in India with MyGov and Microsoft in [indiscernible] we set up virtual agent. If you go to Brazil, we worked with Microsoft to set up telemedicine for a major hospital there. That work and the trends around telemedicine and the need to support citizens through the pandemic will continue, we believe. And what’s important there is, it is not simply - this isn’t about technology right? This is about taking all of our insights from the needs of – from health and public sector and supporting citizenry [ph] with technology, with the ecosystem partners, and quite honestly innovating remotely. Right? The work that we've been doing and that will continue. You also see the supply chain really being an area of big focus. So, we worked with Danone, a multinational food products company whose supply chain was immediately disrupted severely and leveraging analytics it became essential for them to give them a near real-time data around their supply chain to avoid disruption. So that kind of work supply chain is gowing, we’ve been doing it, it’s going to continue and of course clients are now moving from the immediate needs in leveraging the assets and tools and understanding that we have to thinking longer-term because of course what you have is completely different, trends and uncertainty, and so how do you really connect everything from understanding the customer all the way back to manufacturing, and that's why you start to see the demand in digital manufacturing, supply chain, and we expect on the customer side that to continue. Then finally the whole area of online, so we worked with a global retailer who’s been investing for years in omnichannel. We've been piloting curbside pickup before the crisis of a hundred stores, and in 48 hours we took them to 1,400 stores. And so we’re beginning to really talk about -- with the other retailers who were behind. Right? We talked about the laggards and the leaders to how are they going to be adjusting it. Now, if you take a step back, Tien-tsin on the big picture, we do three big things. We build digital core, and I talked about it in my script how cloud is accelerating, security is accelerating. We just bought Symantec's Managed Service business. We are now one of the largest and leading providers in the world. The threat landscape has expanded and we're seeing tons of demand in security, lots of demand in data and applied intelligence, as data is so necessary. But on the other hand, intelligent platform services, which as we've shared in the past is about 40% of our business and pre-crisis was growing double-digits, that moderated in Q3 and we'll see further moderation. In Q4, we expect, as clients have to take a step back, refocus, prioritize, we're helping them shape that, but the demand long term is absolutely there. And you saw that in our bookings that we talked about the S/4HANA implementation in Q3, where we are at - there we're doing so to drive growth as well as efficiencies. And so, while we continue to see that moderating, we really do see that is being very much affected by the industries that are most severely impacted. But also as clients frankly are taking a step back to figure out how they're going to accelerate and in what sequence their digital core building. In the area of optimizing operations, which is the second big thing we do, our operations business is seeing surge in demand. We talked about this last quarter, where we had double-digit growth for 25 consecutive quarters. Obviously, some crisis-related impacts in this quarter. But as the need for digital transformation has accelerated, the ability to use our digital platform SynOps to drive cost efficiencies and to get better data faster, right, is really taking - having that business have another new surge in demand as we look at our pipeline and then also the digital manufacturing as I've referred to. And then finally on the growth agenda side, Accenture Interactive, right, an incredible business. We hit $10 billion and it was having significant growth. It was significantly impacted in Q3 as companies focused more on shoring up what they had as opposed to thinking about the next generation of customer experience, et cetera. We're now seeing those conversations begin again. And what's really interesting there, is that the B2B companies like the industrials, who have their - have a traditional field sales model, were able to get connected with remote work, but they weren't online, right? And so, we think there's going to be a real surge over time and we're starting to have those conversations about how you move online. In general, to your question around kind of remote working, we've enabled lots of companies to work remotely, right, whether it was an aerospace and defense company on G Suite, 100,000 people to the NHS hospital system with teams over 1 million people, companies have really adapted, and where we have the advantage is because we've been so remote and because of the - we are a global company and have a strong tradition of working with our clients around the globe, we've just adapted very quickly and you see that in our strong bookings. You know it's higher than last year's Q3 and what we expect in Q4."
},
{
"speaker": "Tien-tsin Huang",
"text": "Great, that's good stuff. Good color. I'll get back in the queue. Thank you."
},
{
"speaker": "Operator",
"text": "Thanks. Your next question comes from the line of Lisa Ellis from MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Hi, good morning and good to hear your voices. Just a follow-on on Tien-tsin question. I mean, you obviously recorded solid revenue in 3Q, solid growth in bookings, have a strong pipeline again for 4Q. At the same time the WEO just downgraded its economic outlook to nearly a 5% decline for this year. So, which is pretty terrible. So I'm just trying to ask, can you provide color on how those two things and those two trends reconcile, meaning, are you seeing that businesses either a, have not made revisions yet to their overall IT budgets to reflect a weaker longer-term economic outlook or more optimistically, be they have, but they have actually reallocated more dollars into IT to drive the digital transformations or is it that you're picking up share? I mean, I guess maybe just some color on kind of how you reconciled those two dynamics? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Yes, sure. You know, Lisa remember what we're guiding to is really a modest growth, it would reflect the economic conditions. Right? So what we're seeing in Q4 is we're seeing our business stabilize at what is a much lower level, right than pre-crisis with at the high end of the range, starting to tick up and improve. Right? So that is what's really, as you said like that's how you reconcile that. Right? And as I just went through with Tien-tsin, there are parts of our business that are accelerating like cloud and security and operations. But a big part of our business, our intelligent platform services business, which is 40% was growing double-digits moderated in Q3 and we expect a further moderation reflecting the economic conditions, clients sort of taking a step back and saying, how do I sequence and so, when you look at what's happening, the IT budgets, all the analysts are telling us and we're seeing it is too is that they are declining, but they are focusing on the digital transformation that's needed to navigate. So like the supply chain examples where you have to do this, this is why Lisa, our position is so important right now, because what we can uniquely do is provide cost savings while we transform. When we talk about IT modernization and managed services, we're doing managed services and we talked about this in prior quarters called Living Systems, where we're taking down the costs, but we're helping them have DevOps and Agile at scale to get their product releases faster. We are seeing deals like if you look at the one I highlighted on SAP, it has two components where they put the global beverage company. It was re-platforming, but it also had a managed service component that was modernizing and cutting their costs and so what we're seeing is this flight to Accenture for flight to quality, because we can deliver with the ability to increase investment capacity, decrease costs, but still modernize like what we do with operations. And so, of course we're going to be impacted, but we've got severely impacted is went through businesses that industries that of course we're good, we're feeling all of those effects, but we believe our results, we don't know, nobody else has come yet are taking share in this environment."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific, thank you. And then maybe my follow on is just on the talent side, can you provide, I mean, I know you're an environment where attrition just dropped to 11%. Not surprisingly, given the environment. Utilization is also down a little bit, but of course you're continuing as you said to maintain promotions, maintain higher, and can you just remind us of how you manage talent through this type of environment, so you emerge with a stronger bench on the other side? Thanks."
},
{
"speaker": "Julie Sweet",
"text": "Sure. I mean, it's a great question and something we really focus on because our competitive advantage is phenomenal talent. And the underlying fundamentals of the market, the need to digitally transform and of our business remain strong. And so, we are very focused on preserving that great talent and our strategic capabilities because we have everything from Strategy and Consulting to operations and so that's been our principle. So we're pulling the usual levers of less hiring, except in specific areas of replacing subcontractors if we don't need it. We continue to promote, but we moderated the promotions. But it's important that we're delivering still on it. We've delayed some start dates, as you would do, as you would imagine. The second thing we're doing is, we did just put in this new growth model and we were able in a more simplified organization to identify efficiencies. So we're going after some cost structural decreases that are helping. And then as we move forward, we'll do things like we're in our annual performance process. And so, the pace of how we do our kind of business as usual, managing out of our lower performers is another lever that we can pull as we look forward, and what we're really focused on is making sure, like say for our intelligent platform services business, yes it's moderating, but we know it is an absolute critical part of our business. So we're doing a lot of upskilling. I mean, I think this - I'm going to give you a number that I think is so phenomenal. Since the beginning of March, when we hit COVID and we saw the shift in demand in technology we have reskilled 37,000 people in hot areas like cloud since the beginning of March. And these are in sort of 15 to - on average 15 to 20-hour modules of reskilling to pivot. We've taken our Strategy and Consulting people and pivoted to some of the needs for operations in the public sector, because again those are - also require those insights. And the resiliency of a business like ours because we're in multiple industries, multiple types of work and we're able to kind of seamlessly move people who are used to working in these multi-dimensional teams anyway. And by the way, our people love it, because they get great new opportunities. So we feel really good about how we're managing it. And to your point, Lisa, we think we're going to come out much stronger because of how we're delivering for our people."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific, great color, thank you. Thanks, guys."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Dave Koning from Baird. Please go ahead."
},
{
"speaker": "David Koning",
"text": "Yes, hey, guys. Thank you and congrats. My question, The New really didn't decelerate that much and maybe that just is a function of exactly you're talking about some of these newer products doing well, while some of the older part decelerated more. As the economy comes back, eventually, do you think The New kind of just gets to just a higher level of growth and then the older services just stay at a lower level? I mean is that really what we're seeing now?"
},
{
"speaker": "Julie Sweet",
"text": "I mean, look, if you sort of look at it I would start with like we're in the big shock, right? I mean that how fast the economy went down, the need that every business is now a health business and so all of these. So, I don't read too much into a quarter's sort of response in terms of now new versus legacy other than the impact of what's happening to have to move to online everything and remote will absolutely require and is requiring and that's what we see in our pipeline, an acceleration of building the digital foundation which means, companies are going to have to make more choices. And this is why - we used to tell you, our theory was in a financial crisis that the rotation to The New would make us more resilient and that's what is absolutely the facts. So is that - we've seen what's happened. You have to be more digital and that's going to stay and that will no doubt have some effects on where you're spending the money, but it's part of what's driving what we're doing now with our managed services and helping modernize those for our clients in a more cost-effective way to get our clients to The New. And a lot of what we're doing now is taking all of our learning capabilities and building that in for our clients to help them rotate their talent, which they need to do as well."
},
{
"speaker": "David Koning",
"text": "Great, thanks. And one quick numbers question. The new reporting on segments with the geos, the margins in the growth markets have been very high this year, and specifically in Q3 was very high, I think 21%. Is there something changing in the environment that allows those margins to be higher? Is that going to continue, or maybe it's just a short-term blip?"
},
{
"speaker": "KC McClure",
"text": "Yes, thanks for the question. This is the first time that we have provided operating income by market. And the way I would just say, to take a look at operating income across our markets, Dave, would be the very same way that you thought about it as it relates to the operating groups, like you're going to have - we have variations by markets just like we did throughout the years in operating groups. It's really going to be impacted by these services that we do in that market, the mix of industries that we have, any type of economic impacts that are happening in a specific market, as well as maybe investments that we're making particularly to that geography. So I think that's - the lens I would look at operating income would be the same as we've always historically done against operating groups and we manage obviously to overall Accenture operating income. As it relates specifically to the growth markets, we had very strong performance in our Japanese business, which is a major growth driver, and overall our contract performance and profitability is very strong in the growth markets."
},
{
"speaker": "David Koning",
"text": "Great, thanks, guys."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Harshita Rawat from Bernstein. Please go ahead."
},
{
"speaker": "Harshita Rawat",
"text": "Hi, good morning Julie, KC. My question is, we are seeing in this environment that many companies are starting to rethink work from home policies as a margin driver longer term, given the higher productivity we've seen in this remote working environment. Is this something you're seeing, looking at? And more broadly what have been some of the positive and negative surprises in this new working environment? Thank you."
},
{
"speaker": "KC McClure",
"text": "Yes, I think I'll start and Julie can certainly weigh in. I think one of the things that's kind of - you asked about margin and unique in this environment is, what I would say that, and we're taking full advantage of this is the fact that we are really not traveling, particularly for non-billable events and meetings. And so we are using - we're taking full advantage of that and making sure that we continue then to use that extra capacity to invest in our business, to preserve our talent, while at the same time giving margin expansion. So I think for us, that's probably the bigger change within this environment. We have obviously moved - we've always been able to work from home to a great degree, and within our centers, we have been able to make that change as well this quarter. But that's not really going to be a significant increase or decrease in margin in and of itself."
},
{
"speaker": "Julie Sweet",
"text": "And then if you look at it, as it relates to ourselves, it's complicated. Right? Looking at our operations business it's 24/7 and we run shifts and we get to have the advantage of sort of using assets over and over. So, I mean, it's a - it's not a straightforward sort of discussion around that, but maybe let's just take a step back, what are the realities, right? We're opened 30% of our offices now, but we're not putting a lot of people back in the office and neither are our clients around the globe because we're dealing with an ongoing health situation. And so, whether you like it or not, remote working is going to be here to stay at a pretty high level for some time. And so, we and our clients are focused on understanding where does that make sense. I was just talking to a technology company yesterday where what they've said is, look, everything is working pretty well except R&D, not because R&D needs to be in the office, but they're just struggling to collaborate as well. And so, company by company, are learning. I give a lot of advice to CEOs about this because there are some who've got really excited about, let's get rid of all our real estate. Back in the '90s, we pioneered remote working and we called it hoteling, and particularly in the U.S., we took out a lot of real estate because we said our people are at our client sites and they're - or they could be home. And what we found, in fact, over the last five years, when I was running North America, we started gradually to expand the footprint again because there is a benefit of bringing people together as well. Now, we've proved you can innovate remotely as I gave some of those examples, but I would say it's going to be cautious. As a respect to sort of driving our business, what it has helped CEOs really understand is some of the areas in some industries that have resisted say finance and accounting and certain areas saying no, no, no, we need to have the teams together is to recognize that they can really rethink like what should they do in-house? What can they rely on a partner like Accenture? How to get the right balance, both from an expertise and a cost perspective, but just as much this idea of leveraging others for digital transformation and you're going to see more of that thinking. I mean, when you move to the cloud, you're basically saying you have this important permanent third-party partners that are running your business, right? And so, how digital transformation happens at speed going forward is really going to be this weaving of partners together, which is why the fact that we're so trusted really helps us in this environment."
},
{
"speaker": "Harshita Rawat",
"text": "Great, thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Edward Caso from Wells Fargo. Please go ahead."
},
{
"speaker": "Edward Caso",
"text": "Hi, good morning. Can you talk a little bit more about your Consulting bookings? How much of the sort of the solid quarter do you expect that you had in the quarter was related to the responding to the COVID crisis? And I'm not sure I heard it in response to Tien-tsin's question, but the strong awards outlook for Q4, how does that split out between Consulting and Outsourcing? Thank you."
},
{
"speaker": "KC McClure",
"text": "Yes, hey, nice to talk to you. In terms of what we were guiding to in Q4, we see overall stronger bookings. I'll leave it at that in terms of, you know, we don't really give a sense or guide to the overall fourth quarter. And I think, just in terms of what was in our consulting bookings, Julie provided a lot of color, we had, as we talked about our overall bookings were 70% in The New which is digital to move to the cloud. Security was really important in this current environment, as well as other digital areas. So, I don't know, Julie, if there's anything else in addition you want to add on."
},
{
"speaker": "Julie Sweet",
"text": "No, I mean as I said, our bookings were kind of sort of split between Outsourcing and Consulting sort of similar to that pattern overall."
},
{
"speaker": "KC McClure",
"text": "No, change there, yes."
},
{
"speaker": "Julie Sweet",
"text": "In the quarter."
},
{
"speaker": "KC McClure",
"text": "Yes, in the quarter. That's right."
},
{
"speaker": "Edward Caso",
"text": "And my other question is around utilization, it went down a few points here. Have you found bottom yet on utilization or we're sort of picking up information that you guys are doing some layoffs and so forth and wondering if you've been able to sort of stabilize the utilization yet?"
},
{
"speaker": "KC McClure",
"text": "Yes, maybe I'll just quickly on utilization, yes, we did do a tick down in Q3. It's nothing that we're concerned about. It's really a bit particularly in operations in our centers, as we moved during the time that we moved to work from home, as well as there were some elements - minor elements of work from home restrictions. But that said, it was within the zone that we expected, and we continue to deliver for our clients in their time of need."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And with respect to managing, as I've said before, we've identified some real areas of efficiencies and so that has obviously headcount implications to it, which may be what you're calling layoffs. We really see it is as focusing on our cost structure, and then otherwise managing our supply and demand as I went through before in a pretty ordinary course. We don't see some extraordinary workforce actions, and remember that Q4 guidance builds that in and that we think we're either stabilizing to slightly up in terms of our business environment, because if you look at our guidance, we're pretty pleased. I mean Q3 had a great strong March. We don't have that in Q4. And so we see - do see our business either stabilizing or slightly up."
},
{
"speaker": "KC McClure",
"text": "Yes and then I just - another fact on that, as you saw from our - our headcount went up sequentially 1%. Right? So for the quarter, we're up over 6% for the year."
},
{
"speaker": "Edward Caso",
"text": "Thank you."
},
{
"speaker": "Angie Park",
"text": "Great, thanks, Ed. Greg, we have time for one more question, and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Okay. That question comes from the line of Bryan Bergin from Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, good morning, thank you. I wanted to ask on bookings conversion. Can you comment on clients' willingness to ramp up some of these large projects in this environment? I'm curious, if you're seeing any extension of the period between signings and project startups and how that might impact near-term outlook?"
},
{
"speaker": "Julie Sweet",
"text": "Well, I mean, our outlook includes kind of what we're seeing and it's a little bit all over the map, right? You've got some clients who want to go faster, because they need the savings faster, you have other clients to maybe having a slower ramp-up. So I'd say it's mixed."
},
{
"speaker": "KC McClure",
"text": "Yes. And I think maybe in terms of our outlook, maybe the way I'd answer it too is, if you look at our Q4 revenue guidance, I think there is really kind of what would put us at the top versus what would put us at the bottom is probably two swing factors. One would be really how the industries - that industry dynamic that we talked about, how that continues to play out and then how the Strategy & Consulting work evolves in the quarter."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And then just on your comments on digital, can you give us a sense on how those underlying components performs interactive relative to cloud and security and any quantification there?"
},
{
"speaker": "Julie Sweet",
"text": "Well, we don't, we don't know about quantify. But as I told you earlier, right, we had Accenture Interactive pre-crisis have been significantly growing and it was significantly impacted in Q3 and that primarily around industries and kind of focus, so you've got that. And then, whereas we sort of look at cloud that really was up and security was up, and remember Intelligent Platform Services came down. So those are kind of the big components that we normally kind of give you a sense of."
},
{
"speaker": "KC McClure",
"text": "Yes, I would say just - just to add on to what Julie said when we talked about the industry dynamics that I talked about earlier, that really plays out the same way with Accenture Interactive. There was growth in Accenture Interactive and the less impacted industries. Right? And they had also a similar dynamic on the areas that had more pressure - industries that had more pressure this quarter they have some declines."
},
{
"speaker": "Julie Sweet",
"text": "Great. Well thank you, everyone. Before I wrap up, I did want to give a special shout out to Fabio Benasso, who leads our Italian business to his leadership team and all of our people in Italy. As you all saw, Italy was actually in lockdown in the entire three months of the quarter and it was an extraordinarily difficult time, and yet they delivered 8% revenue growth in local currency in Q3, because they stayed so close to our clients and to each other and I just thought it deserved a very special mention. As I wrap up, we really believe that Accenture is uniquely positioned today to help our clients succeed in the current environment, both because of what we do as well as how we do it. We are committed to shared success with our clients, people, shareholders and communities to living our core values and to being a trusted leader and responsible business. Thank you to our people and leaders for how you come together every day to deliver on our commitments, and a special thank you to our shareholders for your continued trust and support. Be well everyone, and thank you for joining."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T Teleconferencing. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 2 | 2,020 | 2020-03-19 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by and welcome to Accenture’s Second Quarter Fiscal 2020 Earnings Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] Now, I’d like to turn the conference over to your host, Angie Park, Managing Director and Head of Investor Relations. Please go ahead.
Angie Park: Thank you, operator and thanks everyone for joining us today on our second quarter fiscal 2020 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director, Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chief Executive Officer and KC McClure, our Chief Financial Officer. We hope you have had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the third quarter and full fiscal year 2020. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today’s news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call, we will reference certain non-GAAP financial measures which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Angie and thank you everyone for joining us. Today, we are very pleased to announce our outstanding financial results for the second quarter and first half of fiscal ‘20. I want to start by thanking our leadership team and all of our people for their dedication to our clients and to delivering on our commitments. And it is because of our leaders and people that I have absolute confidence in our ability to adapt and successfully navigate the unprecedented global health crisis the world is now facing. I am incredibly proud of how our leadership team and people have rallied in the face of this crisis and works 24/7 to ensure the safety and well-being of each other and to continue to serve our clients at this time of great need. KC and I know that you are keenly interested in understanding how the coronavirus is impacting Accenture and our people. First, we are going to cover our starting point, KC will take you through Q2 results and I will give you color on the strength of our business and our growth strategy as we exited H1. Then I will specifically address the current environment in light of the coronavirus and how we are managing the impacts. Finally, KC will give you our updated business outlook. KC, over to you to go through our strong Q2 results.
KC McClure: Thank you, Julie and thanks to all of you for taking the time to join us on today’s call. Let me start by saying that we were very pleased with our overall financial results in the second quarter, which were aligned with our expectations and completed a very strong first half of the year. Both our Q2 and H1 results demonstrate the power of our highly differentiated growth strategy. A key intent of our growth strategy is to create durability in our revenue range at a level that is consistently above the market taking share and strengthening our position as a leader. Against this objective, we have created a unique footprint that includes scale and leadership in the world’s largest and most critical geographic markets and industries. This footprint, along with our highly relevant offering, from strategy and consulting to operations, is key to being a market leader in helping our clients the world’s leading companies rotate to the new. Now, let me begin by summarizing a few of the highlights for the quarter. Revenue growth of 8% in local currency was at the top end of our guided range for the quarter and reflected growth in 12 of our 13 industry groups, with 5 growing double-digit. Revenue continued to be driven by strong double-digit growth in digital, cloud and security related services and broad-based growth across our business dimensions. We continue to expand our leadership position with growth we estimated to be more than 2x the market. Operating margin was 13.4%, an increase of 10 basis points for the quarter and 20 basis points year-to-date, reflecting strong underlying profitability as we continue to invest in our business and in our people to position us for long-term market leadership. We delivered very strong EPS of $1.91 which represents 10% growth compared to last year and includes a 1% FX headwind. And finally, we generated significant free cash flow of $1.4 billion in the quarter and $2.1 billion year-to-date. We continue to execute on our strategic capital allocation objectives with roughly $2.7 billion return to shareholders via dividends and share repurchases year-to-date. And we have made investments of $584 million in acquisitions primarily attributed to 17 transactions in the first half of the year. And we continue to expect to invest up to $1.6 billion in acquisitions this fiscal year. With that, let me turn to some of the details starting with new bookings. New bookings were a record at $14.2 billion for the quarter and surpassed our previous all-time high by $1.3 billion. We had very strong overall book-to-bill of 1.3 in the quarter and 1.1 year-to-date. Consulting bookings were $7.2 billion, a record high with a book-to-bill of 1.2. Outsourcing bookings were also a record at $7 billion with a book-to-bill of 1.4. We were very pleased with our new bookings which represent 22% growth in local currency and reflect our unique position in the market and continued strong demand for our services. Bookings continued to be dominated by high demand for digital, cloud and security related services which we estimate represented more than 65% of our new bookings in the quarter. Turning now to revenues, revenues for the quarter were $11.1 billion, a 7% increase in U.S. dollars and 8% in local currency. Consulting revenues for the quarter were $6.2 billion, up 7% in U.S. dollars and 8% in local currency. Outsourcing revenues were $5 billion, up 6% in U.S. dollars and 8% in local currency. Looking at the trends and estimated revenue growth across our dimensions: strategy and consulting services posted strong high single-digit growth; technology services grew mid single-digits; and operations continued its trend of double-digit growth. Taking a closer look at our operating groups. H&PS led all operating groups with 15% growth in local currency driven by double-digit growth in both health and public service. Double-digit growth in North America was driven by our U.S. federal business and we also had double-digit growth in the growth markets. Products grew 10%, reflecting continued strength in our largest operating group, with double-digit growth in life sciences, consumer goods and services as well as retail. We are very pleased with the double-digit growth in both North America and growth markets. Communications, Media and Technology delivered 5% growth, reflecting continued double-digit growth in software and platforms. We had strong growth overall in the growth markets and solid growth in both North America and Europe. Resources grew 5% in the quarter driven by double-digit growth in energy with double-digit growth in chemicals in Europe and in the growth markets. Overall, we saw double-digit growth in the growth markets and strong growth in Europe. Finally, Financial Services grew 3% this quarter with solid growth in insurance. We continued to see modest growth in banking and capital markets globally, with strong growth in North America and in the growth markets and continued declines in banking and capital markets in Europe. Overall, in Financial Services, we continued to see double-digit growth in the growth markets and strong growth in North America partially offset by contraction in Europe. Turning to the geographic dimensions of our business, in North America, we delivered 11% revenue growth in local currency driven by double-digit growth in the United States. In Europe, revenue grew 2% in local currency with double-digit growth in Germany, Italy and Ireland offset by a decline in the UK. And we delivered another very strong quarter in growth markets with 11% growth in local currency led by Japan, which again had very strong double-digit growth as well as double-digit growth in Brazil. Moving down the income statement, gross margin for the quarter was 30.2% compared with 29.2% for the same period last year. Sales and marketing expense for the quarter was 10.4% compared with 9.8% for the second quarter last year. General and administrative expense was 6.4% compared to 6.2% for the same quarter last year. Operating income was $1.5 billion in the second quarter, reflecting a 13.4% operating margin, up 10 basis points compared with Q2 last year. Our effective tax rate for the quarter was 17.1% consistent with the effective tax rate for the second quarter last year. Diluted earnings per share were $1.91, an increase of 10% from EPS of $1.73 in the second quarter last year. Days service outstanding were 39 days compared to 43 days last quarter and 40 days in the second quarter of last year. Free cash flow for the quarter was $1.4 billion, resulting from cash generated by operating activities of $1.5 billion, net of property and equipment additions of $165 million. Our cash balance at February 29 was $5.4 billion compared with $6.1 billion in August 31. With regards to our ongoing objectives to return cash to shareholders, in the second quarter, we repurchased or redeemed 4.7 million shares for $970 million at an average price of $206.73 per share. As of February 29, we had approximately $2.8 billion of share repurchased authority remaining. Also, in February, we paid our second quarterly cash dividend of $0.80 per share for a total of $511 million. This represented a 10% increase over the equivalent quarterly rate last year and our Board of Directors declared our third quarterly cash dividend of $0.80 per share to be paid on May 15, also a 10% increase over the equivalent quarterly rate last year. So, at the halfway point of fiscal ‘20, we have delivered very strong results. Even in the current environment, we remain extremely focused on achieving our longstanding financial objectives bring factors in market and taking share, generating modest margin expansion, while at the same time investing its scale for long-term market leadership, generating strong free cash flow and returning cash to shareholders. Now, let me turn it back to Julie.
Julie Sweet: Thank you, KC. So, as we reflect in where we are for the first half, we delivered record bookings of $24.5 billion, revenue growth of 8% in local currency, 20 basis points of operating margin expansion and 8% increase in earnings per share and $2.7 billion in cash return to our shareholders, which means we exceeded H1 in a clear position of strength delivering outstanding results, taking market share and continuing to successfully execute our growth strategy. In H1, we continue to see how our unique business model, which spans services from strategy and consulting to operations, resonates with our clients who seek speed to value and our unparalleled digital and technology capabilities, ecosystem partnerships, deep industry and functional expertise, and incredibly talented people are making the difference. Let me give you color on the demand we saw from our clients in Q2 and H1 overall. This quarter, we had 18 clients with new bookings over $100 million and operations hit a milestone of 25 consecutive quarters of double-digit growth. Let me double click on operations. First of all, congratulations to the entire operations team on this remarkable achievement. In operations where we continue to lead the market at nearly twice the size of our largest competitor, we have unparallel capabilities to create value for our clients by delivering tangible business outcomes at speed by leveraging our SynOps operating engine. This engine uses a truly unique approach combining data, applied intelligence and emerging technologies with human expertise to reinvent business processes and enable intelligent operations. It allows our clients to reduce costs and achieve technology enabled enterprise transformation faster by using our engine rather than investing to build their own. Our operations capabilities span the enterprise from finance, HR, marketing, procurement, supply chain and digital manufacturing to industry specific offerings, such as banking and insurance operations, health claims operations and trust and safety, which is doing the vital work of helping to keep the internet safe. And the power of our operation services also comes from our unique business model which allows us to bring multidisciplinary teams to create new value for our clients. For example, Accenture was recently named Agency of Record for Kimberly Clark’s Baby and Childcare segment, a huge win for Accenture Interactive and their Droga5 Creative team combining creative talent with our unparalleled operations capabilities was key to our success enabling us to deliver customized, local, market-driven experiences powered by data and technology. And we are so proud that Droga5 was just recently named by Fast Company as one of the world’s most innovative companies. Our industry expertise across our 13 diverse industry groups also continues to be a core competitive advantage allowing us to bring deep industry and cross industry knowledge coupled with our technology, including our ecosystem relationships and applied intelligence capabilities to help our clients tap into new opportunities for growth. For example, for KDDI, the Japanese telecom operator, we are leveraging our data and analytics capabilities, the AWS platform and knowledge of the industry to grow their core business by improving customer retention and expanding services for existing customers. At the same time, with our broad industry expertise, we are uniquely positioned to partner with KDDI to help transform their business by expanding beyond telecom into the banking, insurance, electricity and automotive sectors. Finally, as always, let me highlight how our continuous innovation approach is driving our business. Last year, we launched Living Systems, a new approach to IT and business transformation. Living Systems is an innovation multiplier that creates value for our clients through a series of transformations, including organizational, technological and talent in an agile way, while efficiently managing applications and infrastructure for our clients. It fundamentally shifts IT to be measured by business outcomes rather than traditional metrics. This offering continues to gain momentum in the marketplace across multiple industries. For example, we are partnering with Cortiva, the major global agroscience company to enhance its performance through our Living Systems approach. We leveraged Accenture’s myWizard platform and analytics to enable Cortiva’s innovative product-driven IT organizations, while activating savings that funded essential projects during its first year as a public company. Innovation is core to our growth strategy and is in the DNA of Accenture. We just released our Accenture Technology Vision for 2020 marking the 20th anniversary of this annual thought leadership piece on the most important technology trends for the next few years. This is where we first predicted in 2013 that every business would be a digital business and today, digital is everywhere. It is the core of our business and our client’s business. This year’s research explores how enterprises need to think differently and re-imagine their fundamental business and technology approaches in a responsible human-centered way in order to deliver on the full promise and value of digital. Finally, we are incredibly proud that Ethosphere recently recognized us as one of the world’s most ethical companies for the 13th consecutive year and Fortune included Accenture under list of Best Companies to Work For in the U.S. for the 12th consecutive year ranking us #41, up significantly from #61 last year. Let me now turn to the coronavirus. We currently have two priorities, the safety and well-being of our people and continuing to serve our clients at this time of critical need. In addition to our exceptional leaders and people and strong financial hand, we are well-positioned to address the impacts of the growing global health crisis due to five key factors. First, our global management committee already operates our business as a virtual team. We do not have a headquarters, our top leaders are spread across the globe and Accenture has operated this way as a management team for over three decades. And so mobilizing to address this situation has been seamless. Second, we have a standing crisis management committee, which is led by our Chief Operating Officer, Jo Deblaere, one of our most experienced leaders. As designed, we were able to quickly activate our protocols and a team of our most senior leaders, who under the leadership of Jo and with support from across Accenture has done what can only be called a truly remarkable job. We have had these protocols in place, which we have tested and we tested for years through real and simulated crisises and they are focused in our people, business continuity, facilities management and financial impact, among other things. While we have not planned for a global pandemic, the ability to trigger these protocols and then adapt for this unprecedented situation is allowing us to move rapidly. For example, we have restricted travel and asked people to work remotely from home where possible. As of today globally, we have already enabled a very significant percentage of our people to work from home, including 60% – approximately, 60% of our people in our centers in India and the Philippines. And to give you a bit more color on how our crisis management team is operating. Some of our work cannot be done from home given the nature of the work and some employees do not have the ability to work from home. And these cases we have reduced the density of the people in our offices and centers and instituted extra hygiene procedures and social distancing protocols. We are working closely with our clients every step of the way as they also adapt to remote working environment and to-date, have not experienced any material service interruptions. Third, we are deeply experienced in working virtually and already have deployed at scale in the normal course in our business collaboration technologies and infrastructure for remote working. For example, with the largest user of teens by Microsoft in the world and in the last few weeks as we rapidly ramped more people working remotely from home, team’s audio usage has almost doubled from our typical 16 million minutes per day to almost 30 million minutes per day. We are using our deep experience of working together virtually across Accenture and with our clients to help adapt how we work together from home. Fourth, our strong corporate functions and investments we have made to digitize Accenture have always been key to our attracting and retaining talent and operating Accenture with rigor and discipline. Our top notch professionals in finance, HR, operations, geographic services, marketing and communications and CIO enabled by these significant investments in our own digitization are making the critical difference in how we are responding agility to the crisis and we are deeply grateful for their dedication and hard work. Finally, as our record bookings in Q2 demonstrate, our services are highly relevant to our clients. Our rotation to the new over the last several years now at over 60% of our business, our deep clients’ relationships with the world’s leading companies and our unique business model will enable us to help our clients succeed in this uncertain period and continue to position us strongly for the long-term. With that, I will turn it over to KC to provide our updated business outlook. KC?
KC McClure: Thanks, Julie. Before I get into our business outlook, I would like to provide some context. The coronavirus crisis is rapidly evolving and has created a significant amount of uncertainty. Our third quarter and full year guidance reflects our assumptions as of today based on the best information we have regarding the potential effect of the coronavirus on our business. There are number of factors that we may not be able to accurately predict, including the duration and magnitude of the impact as well as those factors described in the quarterly filing we made earlier today. I would also like to point out that our guidance assumes a higher degree of impact to our financial results in Q3 with some improvement in the business environment in the fourth quarter either due to an improved situation or our clients having adjusted to operating in a new environment. With that said, let me now turn to our business outlook. For the third quarter of fiscal ‘20, we expect revenues to be in the range of $10.75 billion to $11.15 billion. This assumes the impact of FX will be about negative 1.5% compared to the third quarter of fiscal ‘19 and reflects an estimated negative 2% to positive 2% growth in local currency. For the full fiscal year ‘20, based on how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately negative 1.5% compared to fiscal ‘19. For the full fiscal ‘20, we now expect our revenues to be in the range of 3% to 6% growth in local currency over fiscal ‘19. For operating margin, we now expect fiscal year ‘20 to be a 14.7% to 14.8%, a 10 to 20 basis point expansion over fiscal ‘19 results. We continue to expect our annual effective tax rate to be in the range of 23.5% to 25.5%. This compares to an effective tax rate of 22.5% in fiscal ‘19. For earnings per share, we now expect full year diluted EPS for fiscal ‘20 to be in the range of $7.48 to $7.70 or 2% to 5% growth over fiscal ‘19 results. For the full fiscal ‘20, we now expect operating cash flow to be in the range of $6.15 billion to $6.65 billion, property and equipment additions to be approximately $650 million, and free cash flow to be in the range of $5.5 billion to $6 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $4.8 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let’s open it up so that we can take your questions. Angie?
Angie Park: Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask the questions. Operator, would you provide instructions for those on the call?
Operator: Yes, thank you. [Operator Instructions] Our first question is going to come from the line of Tien-tsin Huang. Please go ahead.
Tien-tsin Huang: Good. Thanks so much. I hope everyone is safe and healthy. I want to ask on the – let me ask on your commitment to protect earnings, if a recession is longer than expected, I am curious what levers or levers you have that might be different than the credit crisis in ‘08/09 to protect margins if demand comes in weaker than expected? Thanks.
Julie Sweet: Yes, thanks Tien-tsin and thanks for taking time to calling today. So we talk about margin expansion in earnings. You have heard me talk about in the context of a few levers. So let me talk about that as it relates to how we are running our business now and how we think about that as we go forward in this environment. So I will start with pricing. You have always heard me talk about how earnings expansion really starts with pricing. So if we look at where we were pre-crisis in the first half of the year, our pricing in Q2 was relatively stable. So in this environment, we are fortunate to have our client executives who have longstanding relationship with our clients and they know how to help our clients navigate this uncertainty, but they also know how to ensure that we are making the right arrangements for both them and for us. So we sill have a focus on pricing. The second thing that we have talked about in terms of margin expansion is how we are going to continually invest and Tien-tsin that continues to be with what I consider, we consider competitive advantage for us. So we will be able to continue to expand margins, while we invest in our business and you have heard me say today that we continue to expect to invest up to $1.6 billion in acquisitions this year. We have already committed $1.1 billion to-date. So we have the ability to invest another $500 million in acquisitions, should those opportunities arise. So we continue to invest, and we’re also going to continue to invest in our people. We’re going to make sure that we have the capabilities that our clients need, both today and in the future, and we are going to invest, so that people can develop the skills that they will need for today and for tomorrow. In terms of what is a specific margin lever, Tien-tsin, that we would have now, I’ll just point to the help that we will get from not traveling, right? So even in a virtual organization like ours, you’ve heard Julie talk about the status of how often and how much we use Teams. We still with 500,000 people have significant travel costs, and we do see that decreasing as a result of the current environment and that is something that is unique during this time period, that does help support our margin expansion.
Tien-tsin Huang: Got it. That makes sense on the travel point. Maybe just a quick follow-up really helpful comments around your business continuity. Just curious, does your guidance reflect any sort of – maybe inability to deliver against the bookings in your signed contracts? I’m just curious if there is any sort of plans there, anything specific that we should be aware of on the, on the continuity side, it sounds like not, but just wanted to make sure?
KC McClure: Yes, so let me maybe take a second just explain how we arrived at our guidance overall, and Julie will talk about a lot of the continuity question that you had, Tien-tsin. So I think first of all, it’s important to step back and take a look at our trajectory for our year prior to the coronavirus. As you heard Julie and I talk, we exited H1 with very strong momentum, and we were on a path to be at the top end of our previous annual guidance range of 6% to 8%. And at a minimum, we would have been reconfirming all of the other elements in our guidance. But obviously, things are different and let’s talk a little bit about how we arrived at our guidance, and it really reflects how we manage our business today. So we took a look at our business from an industry, geography and a type of work, specifically the various services that we offer, and then we analyze the potential impacts from these unprecedented circumstances, such as you know, working remotely at this scale for us and for our clients and the fact that there will be more impacts in various industries and others. And then based on these impacts, we reasonably estimated what we saw today, as being the impact in our business in the second half of the year. So as a result of that, we lowered the top end of our previous guidance range from 8% to 6% as you have seen, and given the uncertainty, Tien-tsin, we also, as you saw broadened to a 3 point range for the full year and also 4 point range for Q3. There is an important thing that’s on the other side of the travel discussion that we just talked about, as it relates to margin. The other context is, the impact of lower travel on our revenue, and that’s really important, as you look at our lowered guidance range for the year. So the importance of that on revenue is, to understand that we will have a significant decline in our travel reimbursement revenue. And for the full year, that could be a full percent. So really, it could be as much as 2% in the second half of the year. So that is really reflected in the guidance range, where we said, we are at sort of negative 2% to positive 2%. And also, it’s important to understand that that is disproportionately weighted to our consulting type of work, probably, as you would expect. And lastly, before I hand over the Julie, I do want to just mention, probably the most important thing is, we continue to be laser focused on our clients during this time. As Julie mentioned in her script, we are clearly the fabric of our clients’ business now, more than ever, doing mission critical work. We are an integral part of their operations and we’re partnering with them on what they need. We know that the fundamental drivers of our business will continue to create tremendous opportunity for us in the long term, and we’re very confident in our positioning in the market. So thanks for letting me take a little bit of time to maybe expand a bit on guidance, because I thought it was important given the environment. And I hand it over to Julie to talk about continuity.
Julie Sweet: Sure. Really, what I want to take you through, Tien-tsin and thanks for the question, because clearly, the way we’ve updated guidance, is we are expecting that our business is going to evolve differently for the next two quarters for a whole host of reasons. So I think maybe what might be most helpful, is to kind of give you some color on what’s really happening on the ground with our clients. And there is really three sets of activities right now, right? So the first is, our clients are focused, as a first priority of the safety of their people and adjusting to the need to have remote working, right which for many of our clients is very new and we’re helping many of our clients make that adjustment. So for example, we have a client who asked us literally to go – when we partnered with Microsoft to do this, to go from zero people using Teams, in five days it’ll be their entire 61,000 workforce, right? So in 5 days zero to 61,000 right. And so as we look at it, our clients are very much focused on how to adjust to remote working, and that’s easier or harder depending on the nature of the industry and the kind of work, and at the same time, is responding to the crisis you have. Our clients for example in the public sector, who are having to respond not only for their own work forces, but to what they need to do for the public. So for example, we’re working with some of our public sector clients, to deploy more virtual agents that are pre-configured with COVID-19 advice to continue to free up capacity, to add to the more critical questions in our call center. So, the first is, safety of their own people and adjusting to this new environment, where they have to have remote working and make decisions about that. The second activity is really focused on mission critical services. That of course varies by company, but if you look at the work that we’re doing with our clients, we’re working very closely to them on mission critical services like – we do the settlement of services of trades for major banks. We do payroll services. We support many different healthcare services. We’re doing trust and safety services, keeping the Internet safe. So there is a big focus in this first phase on mission critical services, working together with our clients, being able to do that in some cases remote, in some cases, continuing to go into the centers. And then the third thing that’s going on with our clients, in parallel, of course, is the assessment of the impact on both the global health crisis and the disruption in the economy and what’s been happening with the travel restrictions, the restrictions of people needing to stay at home, in some cases sheltering and place. Now, as you might imagine, that assessment occurs along two vectors. It comes at the intersection of industry, technology and geography, as well as the individual circumstances of the clients. And so to give you some sense of the variety, I have a client in the utility industry that is of course dealing with the macro environment. But in my discussions with the CEO just this week, the first question was, hey, how do you feel Accenture, about your COVID-19 arrangements, because you do a lot of work for us. And then we went right back to our usual touch point on the ERP system that we are putting together, which they consider to be mission critical for how they operate. On the other side of the spectrum, you have a client in the industry – in automotive industry, that has been hard hit. We are executing our strategy beautifully there, because we’re helping them with enterprise transformation right and they are making choices in this environment, given what they’re facing. So in that case for example, they said look our HR transformation is mission critical. We may need to and are likely to postpone the finance transformation, and they’re working with us and their other partners, as they make the essential choices you would expect in this environment. If you go to a consumer goods client, that has less expectation of significant impact, our conversations with them are, help us understand how you are going to adjust and can we move even faster, because we think there is a competitive advantage in putting in place the ERP system that we’re helping them do. And then of course you have something like travel where what is critical at this time is very-very significantly different than many of the other industries for the obvious reasons. So as you think about our guidance, we’re thinking about how the impact is varying, looking at industry, geography and understanding the work, and anchored of course in much of the work that we do for our clients, is mission critical or critical to their agendas.
Tien-tsin Huang: That’s great. Thanks. Thoughtful. Thank you.
Operator: Thank you. Our next question then is going to come from the line of Ashwin Shirvaikar from Citi. Please go ahead.
Ashwin Shirvaikar: Thank you. Hi, Julie. Hi, KC. Hi, Angie. Good morning and I hope you and the entire Accenture team are doing well in these kind of tough times. It seems based on and thanks for the very detailed answer to the previous question from Tien-tsin. It seems clients are beginning to respond, but still possibly quite considerably internally focused. So I am specifically interested in a couple of areas. For example, what would be the creative elements of Interactive that perhaps might not look so well with social distancing norms, how would something like that be affected? And then secondly, the conversion of bookings into revenues, it needs the knowledge transfer and things like that which might need travel, how wouldn’t that be impacting what are you looking at different pace of conversion?
Julie Sweet: Sure. It’s interesting because Accenture Interactive that has some of our creative minds, so probably best suited in fact in thinking very creatively about how to stay connected. Many of those as you may know – as you think about how they work, virtually often do work in studios and so they work virtually with our clients as well. At this point, we are really just focusing on how to adapt the virtual environment and keep them and keep people connected. And so from an Accenture perspective, we feel very confident in our workforce being able to adjust and then of course working with our clients to help them do so. With respect to knowledge transfer, that’s a great question. And as you might imagine, because we are so familiar with how to do virtual, what we have done is rapidly look at, I mean, it’s one of the first things we do, how do you do knowledge transfer remotely. Some of it is already there. And to be honest, we have had a lot of that and oftentimes our clients have wanted to do it onsite even though we said it could be done much more efficiently. And one of the things you should recognize is that this is really going to be helping accelerate also the digital transformation of our clients, right, because our clients, for example, some of whom who wouldn’t have allowed us to work from now who are giving us permission who don’t themselves work remotely who aren’t using collaboration technologies are now being forced to and the upside for them is really the opportunity to accelerate the cultural change and the digital transformation. So on knowledge transfer, to answer your specific question we have put in place new ways of doing that, but it’s based on thinking that in this case we have already done. Do you think about SAP, one of the first things we did, SAP, Oracle, any of our systems is that we have looked at all of our methodologies, obviously, our methodologies today do involve being onsite and so we are converting them and then pushing that out across our workforce and helping our clients understand it. We are rapidly doing testing of those methodologies. And so at some point of course there is limitations. You do need to be able to get together for some pieces of it. And of course just remember, today, we have people working in offices as do our clients for essential work. And so on balance right, we have rapidly moved to use all of our knowledge to be able to convert, to help our clients do that to change our methodologies and then as we continue forward depending on the duration and the magnitude, our expectation today is we will get into a rhythm that continues to allow the essential things to happen over time.
Ashwin Shirvaikar: Thank you for that. And then the second question is with regards to sort of the underlying assumptions for the new updated guidance? To what extent are you – and this might just too early, but to what extent are you able to sort of make assumptions about some of the secondary impact say for example, looking on a vertical basis, financial services companies might be – profitability might be affected because the rates are in resources there are number of examples of profitability being affected or supply chains being affected, how are you thinking through that?
Julie Sweet: I mean our guidance and KC can add anything she’d like. At this point, we are giving you the guidance we see over the next six months, based on the best information we have today. And as you said, it’s early to speculate how some of this may play out on the individual industries and it’s just – it’s quite early.
Ashwin Shirvaikar: Thank you.
Julie Sweet: Thank you very much.
Operator: Thank you. And our next question is going to come from the line of Lisa Ellis from MoffettNathanson. Please go ahead.
Lisa Ellis: Hey, thank you and thanks for the transparency in what you’re seeing on the ground. So of course its imperfect and it’s still very early, but the best reference point many investors have for understanding, kind of how Accenture’s business reacts to this sort of sudden shock, is looking back at the financial crisis. However, of course, you now have Accenture Interactive you now have Accenture Operations, big pieces of the business that are very different. Can you just kind of give your perspective, whether you like it or not, I guess that that comparison is probably being made? So how do you think about how this situation might be different or similar to what we saw 10 plus years ago? Thank you.
Julie Sweet: Sure. Well at a macro level, of course, there are some real differences and that several years ago, that was about an economic crisis and today, because of the global health crisis you’re dealing with circumstances that are quite different in terms of, you know globally, clients having to move to work from home and what that does in terms of just the adaptation that they’re making, the cessation of commerce and retail etcetera in many communities, and so what I would say is, you kind of start with – this isn’t just an economic crisis, which one would never have thought that they would say that, as they look back at the financial crisis. But you are really dealing with two things. So, as you think even about how we expect the situation to evolve and then I’ll come to how we are different, as we enter into this, but you’d expect – what we are expecting is that right now, as clients are very focused in adapting to, not just the economic disruption, but as I said in those three buckets of things having to adjust how they’re working. Right, that’s why our guidance assumes that there’ll be an improvement in the business environment in Q4, either because the situation is better or because simply clients and ourselves, are adjusting to working together. But I would say, as you think about today that is at very different circumstances than the financial crisis, but as we look at it, we can’t imagine a better positioned company to address it for all the reasons that we talk about. This thing though is the nature of our services today. As you saw with our results in H1, if you go back to what have we been focusing on? We’ve been focusing on building the digital core of our clients, which is moving to the cloud, having the right systems, all of which this current crisis actually points out to, are very critical, right. And then the first wave of that, you’re just seeing it in the demand for us to help them improve their infrastructure, deploy collaboration technologies and so on. The second thing we’ve been helping them with is optimize their operations and the ability to use technology, not only to reduce costs, but to be more productive. And what you are seeing even now we are already having inbound things about, can you help us achieve more savings through technology in the shorter term? So we have very relevant offerings and what’s really interesting, if you go back to the financial crisis and operations, that business is very different. It was much more around labor arbitrage with some analytics on top of it. Today, as I talked about earlier, our business in Operations, our business in Living systems start fundamentally with technology platforms that we have built, so that as our clients are making decisions, do they invest themselves to build something, or should they leverage here. The current crisis actually makes those investments we’ve been making for years, even more attractive and relevant, because clients will have less investment capacity, they will need to move fast, and they’ve got to address the challenges. And so the final area is around accelerating the growth agenda and this is where Accenture Interactive is critical. I mean just think about what’s happening right now. People are staying home and they’re getting online and they can’t go to stores. The opportunity over time to engage differently with your customers, to establish different relationships, are going to be very important and Accenture Interactive is at the core, right, of customer experience and very relevant. So we knew coming out of H1, you see the strength of that. But as you think about what’s actually happening, and of course it’s still early days, but we could see what’s going – our services, we believe will be even more relevant rate, as we get through this first period, where we need to, and I just want to be clear, at the end of the day, we have to serve our clients, and we need to help them adjust. We need to make sure their mission critical services are continuing, and then help them evaluate how to navigate, grow and address this, and that will be very different in different industries and companies and we are very – this is where our relationships matter so much. 95 of our top 100 clients, we have been there for over 10 years. So I feel very confident and I think we are in a very significant position of strength as we go into this chapter.
KC McClure: Yes. And maybe one thing I’d just add is – one thing that I would say that, we do expect that we saw coming out of the last crisis, that we also believe we’re well positioned this time again, is taking market share. So when we came out of the last financial crisis, we did take market share and that is our expectation that we are – as we look long term, that we will have tremendous opportunities for us over the long-term by staying close to our clients.
Lisa Ellis: Thank you. Then maybe my follow-up is on the talent side. I mean your 500,000 people are the most critical asset of Accenture. Can you just remind us, I mean it looks like headcount slowed a little bit in this last quarter, but it’s still running close to 7%. So, just as you think about this kind of sudden shock, can you just remind us how you manage rebalancing the types of skills and level of headcount you need in a very rapidly changing environment, what levers you’re pulling, just around slowing hiring etcetera? Thank you.
Julie Sweet: Sure. Thanks. It’s a great question. So first of all, just philosophically we are not ever going to be shortsighted here. And as you said, our people are really our competitive advantage and we are the envy of the industry. And so as we look at this, we do a couple of things. First of all, we’re obviously slowing recruiting, but we’re still recruiting, like for example, in Italy – and we all know the situation there. We’re still recruiting for security right now, because as our clients have been moving to home, they need greater health and security services. And just you know, a shout out to our HR team, we’ve rapidly turned our onboarding into entirely virtual, so that we can continue to recruit the critical services our clients need during this time, when obviously we cannot have people coming to the office. The second thing that we do, is we look at where we need skills and our ability to pivot people because of course, we are a great learning organization right, and so one of the first things we always do is, where is the demand and what can we do, and we’ve trained over 300,000 people in the last couple of years just on new IT. And so, part of what we will be doing – a significant part, is making sure that we also are able to adapt. For example, if you just look at the digital – the need for digital workplace; in this week alone, we took 600 people and spun them up and trained them on all the skills they need, to be deploying these technologies like Teams, because our clients rapidly needed that for the demand. And so in its first phase, our focus is of course, the slowing down on our recruiting, except where we need the critical skills and then deploying our people at the demand and we won’t be shortsighted.
Lisa Ellis: Wonderful. Thank you.
Operator: Thank you. Our next question then will come from the line of Bryan Keane from Deutsche Bank. Please go ahead. One moment please. And our next question from Bryan Keane. Please go ahead. Just another moment.
Angie Park: Why don’t we go to the next person in queue, please?
Bryan Keane: Can you guys hear me?
Angie Park: Sorry, Bryan.
Julie Sweet: Hey, Bryan.
Bryan Keane: Hey, guys. I am not sure what the issue is there, just wanted to ask about the guidance. Is the guidance about what the quarter looks like so far in March, and then straight-lining that forward, or is there an estimate on what kind of deterioration you’ll see? And then thinking you mentioned a little bit, I assume most of the guidance reduction is in consulting and not outsourcing? Thanks.
KC McClure: Yes. So let me start with the second part of your question first. So, as we look to what we think the back half of the year will be by type of work, we do think that consulting could be low-single digit positive or negative and remember, that also factors in – as they get a more disproportionate impact of the lower travel reimbursement revenue, Bryan. In the back half of the year, outsourcing will be low to mid single digit positive. Both types of work right now as you have seen are high single-digit growth. So at the end of the year, we do see consulting at low to mid single digit growth for the full year, and outsourcing at mid to high single digit. And what I would just give, in terms of other color on our guidance, just as an overall point. Is that we’ve done the risk profile, as you know, it’s higher than normal. We have provided our guidance in that context, based on what we see today. As a leadership team, we’re going to be as relevant as we can to our clients, and as we’ve always said, it’s our job to try to deliver as high as we can, the range. But I think it’s also important to note that in this environment, we believe it’s reasonably possible that we can land anywhere in this range. So our guidance does take into consideration what we see today, but Bryan, the environment remains fluid and evolve differently from our assumptions.
Bryan Keane: Okay. And then just a quick follow-up on staffing, thinking about staffing issues, is Accenture seeing any impact to the guidance due to – you’re not able to get on company sites. So just trying to think about the supply side issue of the guidance versus the demand issue?
Julie Sweet: Yes, I mean obviously we’ve got – its sort of client by client, and by the way our legal department is doing an amazing job right now because – as you might imagine, many of our contracts didn’t even contemplate ever working from home, right, and so they’ve been working client by client sort of 24/7 to evaluate that. But it’s just a mix and so I’d just tell you, our guidance is kind of taking into account, all of these different factors and that’s where we updated it to.
Bryan Keane: Okay. Stay safe. Thanks so much.
Angie Park: Thank you. Operator, we have time for one more question and then Julie will wrap up the call.
Operator: Thank you. Our next question then will come from the line of Bryan Bergin from Cowen. Please go ahead.
Julie Sweet: Hi, Bryan.
Bryan Bergin: Hi, good morning. Thank you. I wanted to just clarify some comments you made on the remote operations. I heard 60% in India and Philippines, curious, can you move that to a higher level or is that currently the max? And then just as far as the global mix of workforce, how are you thinking about the ability to deliver remotely on the total base of operations and what do you think that will go to ultimately?
Julie Sweet: Well, so, in the Philippines, we’re probably about where we are expect to be. In India, we’re still adding. But again, it really depends on the nature of the work, and so we wouldn’t expect it to be much higher than that, because some of the work – if you think about bandwidth, the need for power. What our employees can do in some – their conditions and then sort of be availability, the bandwidth on some of the things that take more bandwidth. So it’s going to go a little bit higher in India. But I think we’re in a pretty good position. Around the world, it varies. I mean, look at in Italy we are at 85% to 90%, in Spain, 90%. So globally, it’s actually much higher, right, because of the nature of the workforce. So you really have to look at nature of the work and country by country. But as my stat, at 16 million minutes a day to 30 million minutes a day, so we’ve mobilized very quickly.
Bryan Bergin: Okay. And then just as far as demand and the guidance, can you just discuss clients, what you are seeing in their spending priority, understanding it’s fluid, how are clients considering spend across those new areas versus traditional IT areas here – I mean, the crisis, and really just trying to understand what’s built into the guide across those two channels or whether you want to break it down by how you formulated the guide by industry verticals or regions? Just trying to understanding one layer of depth down on the guidance assumptions?
Julie Sweet: Why don’t you take that?
KC McClure: We did take a look, as I mentioned we – Bryan, we did take a look at different geographies, the lens of geography in our guidance. We also looked at the lens of industries. And we did take a look at which ones will be more severely impacted in our view, I’d put – as Julie talked about, we did mention, travel is a small part of Accenture’s business, it’s about 3% of our revenue and had already been in decline even before coming into this crisis. So that’s one industry, although it’s not a big part, we have important clients there, so not big part of our revenues, but travel is an industry. We talked last quarter about industrial being a little bit under pressure in North America and Europe. We do think – that’s about 7% of Accenture’s revenue and we do think that will be – continue to be affected, go forward. And I think within high tech, where we have our aerospace and defense business, that obviously will be – continue to be impacted as well. So maybe that gives just a little bit of color on some of our industries.
Bryan Bergin: Thank you.
Julie Sweet: Alright. Thank you again for joining us on today’s call. As we navigate the current environment, it is important to remember that we will continue to invest in our business and our people for the long-term. The fundamentals of our business are strong and we plan to emerge even stronger. I cannot emphasize enough my gratitude for the extraordinary efforts of our leaders and our people around the world, to both take care of each other and continue serving our clients, which they have done, even as they are concerned for their own health and health of their loved ones and communities. I also want to thank our clients for placing their trust in us, our investors for their continued confidence and our ecosystem partners for their shared commitment to our clients. Perhaps what is most unprecedented about the situation we face is how universal the tragedy is, that is unfolding around the world. It truly affects us all and I hope that each of you and your family and friends are healthy and continue to be well. Thank you.
Operator: Thank you. Ladies and gentlemen, this conference will be available for replay after 10.30 a.m. today through June 25, 2020. You may access the AT&T teleconference replay system at anytime by dialing 866-207-1041 and entering the access code of 2467991. International participants may dial 402-970-0847. Again, those numbers are 866-207-1041 and 402-970-0847 with an access code of 2467991. That does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by and welcome to Accenture’s Second Quarter Fiscal 2020 Earnings Call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] Now, I’d like to turn the conference over to your host, Angie Park, Managing Director and Head of Investor Relations. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, operator and thanks everyone for joining us today on our second quarter fiscal 2020 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director, Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chief Executive Officer and KC McClure, our Chief Financial Officer. We hope you have had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the third quarter and full fiscal year 2020. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today’s news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call, we will reference certain non-GAAP financial measures which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie and thank you everyone for joining us. Today, we are very pleased to announce our outstanding financial results for the second quarter and first half of fiscal ‘20. I want to start by thanking our leadership team and all of our people for their dedication to our clients and to delivering on our commitments. And it is because of our leaders and people that I have absolute confidence in our ability to adapt and successfully navigate the unprecedented global health crisis the world is now facing. I am incredibly proud of how our leadership team and people have rallied in the face of this crisis and works 24/7 to ensure the safety and well-being of each other and to continue to serve our clients at this time of great need. KC and I know that you are keenly interested in understanding how the coronavirus is impacting Accenture and our people. First, we are going to cover our starting point, KC will take you through Q2 results and I will give you color on the strength of our business and our growth strategy as we exited H1. Then I will specifically address the current environment in light of the coronavirus and how we are managing the impacts. Finally, KC will give you our updated business outlook. KC, over to you to go through our strong Q2 results."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie and thanks to all of you for taking the time to join us on today’s call. Let me start by saying that we were very pleased with our overall financial results in the second quarter, which were aligned with our expectations and completed a very strong first half of the year. Both our Q2 and H1 results demonstrate the power of our highly differentiated growth strategy. A key intent of our growth strategy is to create durability in our revenue range at a level that is consistently above the market taking share and strengthening our position as a leader. Against this objective, we have created a unique footprint that includes scale and leadership in the world’s largest and most critical geographic markets and industries. This footprint, along with our highly relevant offering, from strategy and consulting to operations, is key to being a market leader in helping our clients the world’s leading companies rotate to the new. Now, let me begin by summarizing a few of the highlights for the quarter. Revenue growth of 8% in local currency was at the top end of our guided range for the quarter and reflected growth in 12 of our 13 industry groups, with 5 growing double-digit. Revenue continued to be driven by strong double-digit growth in digital, cloud and security related services and broad-based growth across our business dimensions. We continue to expand our leadership position with growth we estimated to be more than 2x the market. Operating margin was 13.4%, an increase of 10 basis points for the quarter and 20 basis points year-to-date, reflecting strong underlying profitability as we continue to invest in our business and in our people to position us for long-term market leadership. We delivered very strong EPS of $1.91 which represents 10% growth compared to last year and includes a 1% FX headwind. And finally, we generated significant free cash flow of $1.4 billion in the quarter and $2.1 billion year-to-date. We continue to execute on our strategic capital allocation objectives with roughly $2.7 billion return to shareholders via dividends and share repurchases year-to-date. And we have made investments of $584 million in acquisitions primarily attributed to 17 transactions in the first half of the year. And we continue to expect to invest up to $1.6 billion in acquisitions this fiscal year. With that, let me turn to some of the details starting with new bookings. New bookings were a record at $14.2 billion for the quarter and surpassed our previous all-time high by $1.3 billion. We had very strong overall book-to-bill of 1.3 in the quarter and 1.1 year-to-date. Consulting bookings were $7.2 billion, a record high with a book-to-bill of 1.2. Outsourcing bookings were also a record at $7 billion with a book-to-bill of 1.4. We were very pleased with our new bookings which represent 22% growth in local currency and reflect our unique position in the market and continued strong demand for our services. Bookings continued to be dominated by high demand for digital, cloud and security related services which we estimate represented more than 65% of our new bookings in the quarter. Turning now to revenues, revenues for the quarter were $11.1 billion, a 7% increase in U.S. dollars and 8% in local currency. Consulting revenues for the quarter were $6.2 billion, up 7% in U.S. dollars and 8% in local currency. Outsourcing revenues were $5 billion, up 6% in U.S. dollars and 8% in local currency. Looking at the trends and estimated revenue growth across our dimensions: strategy and consulting services posted strong high single-digit growth; technology services grew mid single-digits; and operations continued its trend of double-digit growth. Taking a closer look at our operating groups. H&PS led all operating groups with 15% growth in local currency driven by double-digit growth in both health and public service. Double-digit growth in North America was driven by our U.S. federal business and we also had double-digit growth in the growth markets. Products grew 10%, reflecting continued strength in our largest operating group, with double-digit growth in life sciences, consumer goods and services as well as retail. We are very pleased with the double-digit growth in both North America and growth markets. Communications, Media and Technology delivered 5% growth, reflecting continued double-digit growth in software and platforms. We had strong growth overall in the growth markets and solid growth in both North America and Europe. Resources grew 5% in the quarter driven by double-digit growth in energy with double-digit growth in chemicals in Europe and in the growth markets. Overall, we saw double-digit growth in the growth markets and strong growth in Europe. Finally, Financial Services grew 3% this quarter with solid growth in insurance. We continued to see modest growth in banking and capital markets globally, with strong growth in North America and in the growth markets and continued declines in banking and capital markets in Europe. Overall, in Financial Services, we continued to see double-digit growth in the growth markets and strong growth in North America partially offset by contraction in Europe. Turning to the geographic dimensions of our business, in North America, we delivered 11% revenue growth in local currency driven by double-digit growth in the United States. In Europe, revenue grew 2% in local currency with double-digit growth in Germany, Italy and Ireland offset by a decline in the UK. And we delivered another very strong quarter in growth markets with 11% growth in local currency led by Japan, which again had very strong double-digit growth as well as double-digit growth in Brazil. Moving down the income statement, gross margin for the quarter was 30.2% compared with 29.2% for the same period last year. Sales and marketing expense for the quarter was 10.4% compared with 9.8% for the second quarter last year. General and administrative expense was 6.4% compared to 6.2% for the same quarter last year. Operating income was $1.5 billion in the second quarter, reflecting a 13.4% operating margin, up 10 basis points compared with Q2 last year. Our effective tax rate for the quarter was 17.1% consistent with the effective tax rate for the second quarter last year. Diluted earnings per share were $1.91, an increase of 10% from EPS of $1.73 in the second quarter last year. Days service outstanding were 39 days compared to 43 days last quarter and 40 days in the second quarter of last year. Free cash flow for the quarter was $1.4 billion, resulting from cash generated by operating activities of $1.5 billion, net of property and equipment additions of $165 million. Our cash balance at February 29 was $5.4 billion compared with $6.1 billion in August 31. With regards to our ongoing objectives to return cash to shareholders, in the second quarter, we repurchased or redeemed 4.7 million shares for $970 million at an average price of $206.73 per share. As of February 29, we had approximately $2.8 billion of share repurchased authority remaining. Also, in February, we paid our second quarterly cash dividend of $0.80 per share for a total of $511 million. This represented a 10% increase over the equivalent quarterly rate last year and our Board of Directors declared our third quarterly cash dividend of $0.80 per share to be paid on May 15, also a 10% increase over the equivalent quarterly rate last year. So, at the halfway point of fiscal ‘20, we have delivered very strong results. Even in the current environment, we remain extremely focused on achieving our longstanding financial objectives bring factors in market and taking share, generating modest margin expansion, while at the same time investing its scale for long-term market leadership, generating strong free cash flow and returning cash to shareholders. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. So, as we reflect in where we are for the first half, we delivered record bookings of $24.5 billion, revenue growth of 8% in local currency, 20 basis points of operating margin expansion and 8% increase in earnings per share and $2.7 billion in cash return to our shareholders, which means we exceeded H1 in a clear position of strength delivering outstanding results, taking market share and continuing to successfully execute our growth strategy. In H1, we continue to see how our unique business model, which spans services from strategy and consulting to operations, resonates with our clients who seek speed to value and our unparalleled digital and technology capabilities, ecosystem partnerships, deep industry and functional expertise, and incredibly talented people are making the difference. Let me give you color on the demand we saw from our clients in Q2 and H1 overall. This quarter, we had 18 clients with new bookings over $100 million and operations hit a milestone of 25 consecutive quarters of double-digit growth. Let me double click on operations. First of all, congratulations to the entire operations team on this remarkable achievement. In operations where we continue to lead the market at nearly twice the size of our largest competitor, we have unparallel capabilities to create value for our clients by delivering tangible business outcomes at speed by leveraging our SynOps operating engine. This engine uses a truly unique approach combining data, applied intelligence and emerging technologies with human expertise to reinvent business processes and enable intelligent operations. It allows our clients to reduce costs and achieve technology enabled enterprise transformation faster by using our engine rather than investing to build their own. Our operations capabilities span the enterprise from finance, HR, marketing, procurement, supply chain and digital manufacturing to industry specific offerings, such as banking and insurance operations, health claims operations and trust and safety, which is doing the vital work of helping to keep the internet safe. And the power of our operation services also comes from our unique business model which allows us to bring multidisciplinary teams to create new value for our clients. For example, Accenture was recently named Agency of Record for Kimberly Clark’s Baby and Childcare segment, a huge win for Accenture Interactive and their Droga5 Creative team combining creative talent with our unparalleled operations capabilities was key to our success enabling us to deliver customized, local, market-driven experiences powered by data and technology. And we are so proud that Droga5 was just recently named by Fast Company as one of the world’s most innovative companies. Our industry expertise across our 13 diverse industry groups also continues to be a core competitive advantage allowing us to bring deep industry and cross industry knowledge coupled with our technology, including our ecosystem relationships and applied intelligence capabilities to help our clients tap into new opportunities for growth. For example, for KDDI, the Japanese telecom operator, we are leveraging our data and analytics capabilities, the AWS platform and knowledge of the industry to grow their core business by improving customer retention and expanding services for existing customers. At the same time, with our broad industry expertise, we are uniquely positioned to partner with KDDI to help transform their business by expanding beyond telecom into the banking, insurance, electricity and automotive sectors. Finally, as always, let me highlight how our continuous innovation approach is driving our business. Last year, we launched Living Systems, a new approach to IT and business transformation. Living Systems is an innovation multiplier that creates value for our clients through a series of transformations, including organizational, technological and talent in an agile way, while efficiently managing applications and infrastructure for our clients. It fundamentally shifts IT to be measured by business outcomes rather than traditional metrics. This offering continues to gain momentum in the marketplace across multiple industries. For example, we are partnering with Cortiva, the major global agroscience company to enhance its performance through our Living Systems approach. We leveraged Accenture’s myWizard platform and analytics to enable Cortiva’s innovative product-driven IT organizations, while activating savings that funded essential projects during its first year as a public company. Innovation is core to our growth strategy and is in the DNA of Accenture. We just released our Accenture Technology Vision for 2020 marking the 20th anniversary of this annual thought leadership piece on the most important technology trends for the next few years. This is where we first predicted in 2013 that every business would be a digital business and today, digital is everywhere. It is the core of our business and our client’s business. This year’s research explores how enterprises need to think differently and re-imagine their fundamental business and technology approaches in a responsible human-centered way in order to deliver on the full promise and value of digital. Finally, we are incredibly proud that Ethosphere recently recognized us as one of the world’s most ethical companies for the 13th consecutive year and Fortune included Accenture under list of Best Companies to Work For in the U.S. for the 12th consecutive year ranking us #41, up significantly from #61 last year. Let me now turn to the coronavirus. We currently have two priorities, the safety and well-being of our people and continuing to serve our clients at this time of critical need. In addition to our exceptional leaders and people and strong financial hand, we are well-positioned to address the impacts of the growing global health crisis due to five key factors. First, our global management committee already operates our business as a virtual team. We do not have a headquarters, our top leaders are spread across the globe and Accenture has operated this way as a management team for over three decades. And so mobilizing to address this situation has been seamless. Second, we have a standing crisis management committee, which is led by our Chief Operating Officer, Jo Deblaere, one of our most experienced leaders. As designed, we were able to quickly activate our protocols and a team of our most senior leaders, who under the leadership of Jo and with support from across Accenture has done what can only be called a truly remarkable job. We have had these protocols in place, which we have tested and we tested for years through real and simulated crisises and they are focused in our people, business continuity, facilities management and financial impact, among other things. While we have not planned for a global pandemic, the ability to trigger these protocols and then adapt for this unprecedented situation is allowing us to move rapidly. For example, we have restricted travel and asked people to work remotely from home where possible. As of today globally, we have already enabled a very significant percentage of our people to work from home, including 60% – approximately, 60% of our people in our centers in India and the Philippines. And to give you a bit more color on how our crisis management team is operating. Some of our work cannot be done from home given the nature of the work and some employees do not have the ability to work from home. And these cases we have reduced the density of the people in our offices and centers and instituted extra hygiene procedures and social distancing protocols. We are working closely with our clients every step of the way as they also adapt to remote working environment and to-date, have not experienced any material service interruptions. Third, we are deeply experienced in working virtually and already have deployed at scale in the normal course in our business collaboration technologies and infrastructure for remote working. For example, with the largest user of teens by Microsoft in the world and in the last few weeks as we rapidly ramped more people working remotely from home, team’s audio usage has almost doubled from our typical 16 million minutes per day to almost 30 million minutes per day. We are using our deep experience of working together virtually across Accenture and with our clients to help adapt how we work together from home. Fourth, our strong corporate functions and investments we have made to digitize Accenture have always been key to our attracting and retaining talent and operating Accenture with rigor and discipline. Our top notch professionals in finance, HR, operations, geographic services, marketing and communications and CIO enabled by these significant investments in our own digitization are making the critical difference in how we are responding agility to the crisis and we are deeply grateful for their dedication and hard work. Finally, as our record bookings in Q2 demonstrate, our services are highly relevant to our clients. Our rotation to the new over the last several years now at over 60% of our business, our deep clients’ relationships with the world’s leading companies and our unique business model will enable us to help our clients succeed in this uncertain period and continue to position us strongly for the long-term. With that, I will turn it over to KC to provide our updated business outlook. KC?"
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Before I get into our business outlook, I would like to provide some context. The coronavirus crisis is rapidly evolving and has created a significant amount of uncertainty. Our third quarter and full year guidance reflects our assumptions as of today based on the best information we have regarding the potential effect of the coronavirus on our business. There are number of factors that we may not be able to accurately predict, including the duration and magnitude of the impact as well as those factors described in the quarterly filing we made earlier today. I would also like to point out that our guidance assumes a higher degree of impact to our financial results in Q3 with some improvement in the business environment in the fourth quarter either due to an improved situation or our clients having adjusted to operating in a new environment. With that said, let me now turn to our business outlook. For the third quarter of fiscal ‘20, we expect revenues to be in the range of $10.75 billion to $11.15 billion. This assumes the impact of FX will be about negative 1.5% compared to the third quarter of fiscal ‘19 and reflects an estimated negative 2% to positive 2% growth in local currency. For the full fiscal year ‘20, based on how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately negative 1.5% compared to fiscal ‘19. For the full fiscal ‘20, we now expect our revenues to be in the range of 3% to 6% growth in local currency over fiscal ‘19. For operating margin, we now expect fiscal year ‘20 to be a 14.7% to 14.8%, a 10 to 20 basis point expansion over fiscal ‘19 results. We continue to expect our annual effective tax rate to be in the range of 23.5% to 25.5%. This compares to an effective tax rate of 22.5% in fiscal ‘19. For earnings per share, we now expect full year diluted EPS for fiscal ‘20 to be in the range of $7.48 to $7.70 or 2% to 5% growth over fiscal ‘19 results. For the full fiscal ‘20, we now expect operating cash flow to be in the range of $6.15 billion to $6.65 billion, property and equipment additions to be approximately $650 million, and free cash flow to be in the range of $5.5 billion to $6 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $4.8 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let’s open it up so that we can take your questions. Angie?"
},
{
"speaker": "Angie Park",
"text": "Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask the questions. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Yes, thank you. [Operator Instructions] Our first question is going to come from the line of Tien-tsin Huang. Please go ahead."
},
{
"speaker": "Tien-tsin Huang",
"text": "Good. Thanks so much. I hope everyone is safe and healthy. I want to ask on the – let me ask on your commitment to protect earnings, if a recession is longer than expected, I am curious what levers or levers you have that might be different than the credit crisis in ‘08/09 to protect margins if demand comes in weaker than expected? Thanks."
},
{
"speaker": "Julie Sweet",
"text": "Yes, thanks Tien-tsin and thanks for taking time to calling today. So we talk about margin expansion in earnings. You have heard me talk about in the context of a few levers. So let me talk about that as it relates to how we are running our business now and how we think about that as we go forward in this environment. So I will start with pricing. You have always heard me talk about how earnings expansion really starts with pricing. So if we look at where we were pre-crisis in the first half of the year, our pricing in Q2 was relatively stable. So in this environment, we are fortunate to have our client executives who have longstanding relationship with our clients and they know how to help our clients navigate this uncertainty, but they also know how to ensure that we are making the right arrangements for both them and for us. So we sill have a focus on pricing. The second thing that we have talked about in terms of margin expansion is how we are going to continually invest and Tien-tsin that continues to be with what I consider, we consider competitive advantage for us. So we will be able to continue to expand margins, while we invest in our business and you have heard me say today that we continue to expect to invest up to $1.6 billion in acquisitions this year. We have already committed $1.1 billion to-date. So we have the ability to invest another $500 million in acquisitions, should those opportunities arise. So we continue to invest, and we’re also going to continue to invest in our people. We’re going to make sure that we have the capabilities that our clients need, both today and in the future, and we are going to invest, so that people can develop the skills that they will need for today and for tomorrow. In terms of what is a specific margin lever, Tien-tsin, that we would have now, I’ll just point to the help that we will get from not traveling, right? So even in a virtual organization like ours, you’ve heard Julie talk about the status of how often and how much we use Teams. We still with 500,000 people have significant travel costs, and we do see that decreasing as a result of the current environment and that is something that is unique during this time period, that does help support our margin expansion."
},
{
"speaker": "Tien-tsin Huang",
"text": "Got it. That makes sense on the travel point. Maybe just a quick follow-up really helpful comments around your business continuity. Just curious, does your guidance reflect any sort of – maybe inability to deliver against the bookings in your signed contracts? I’m just curious if there is any sort of plans there, anything specific that we should be aware of on the, on the continuity side, it sounds like not, but just wanted to make sure?"
},
{
"speaker": "KC McClure",
"text": "Yes, so let me maybe take a second just explain how we arrived at our guidance overall, and Julie will talk about a lot of the continuity question that you had, Tien-tsin. So I think first of all, it’s important to step back and take a look at our trajectory for our year prior to the coronavirus. As you heard Julie and I talk, we exited H1 with very strong momentum, and we were on a path to be at the top end of our previous annual guidance range of 6% to 8%. And at a minimum, we would have been reconfirming all of the other elements in our guidance. But obviously, things are different and let’s talk a little bit about how we arrived at our guidance, and it really reflects how we manage our business today. So we took a look at our business from an industry, geography and a type of work, specifically the various services that we offer, and then we analyze the potential impacts from these unprecedented circumstances, such as you know, working remotely at this scale for us and for our clients and the fact that there will be more impacts in various industries and others. And then based on these impacts, we reasonably estimated what we saw today, as being the impact in our business in the second half of the year. So as a result of that, we lowered the top end of our previous guidance range from 8% to 6% as you have seen, and given the uncertainty, Tien-tsin, we also, as you saw broadened to a 3 point range for the full year and also 4 point range for Q3. There is an important thing that’s on the other side of the travel discussion that we just talked about, as it relates to margin. The other context is, the impact of lower travel on our revenue, and that’s really important, as you look at our lowered guidance range for the year. So the importance of that on revenue is, to understand that we will have a significant decline in our travel reimbursement revenue. And for the full year, that could be a full percent. So really, it could be as much as 2% in the second half of the year. So that is really reflected in the guidance range, where we said, we are at sort of negative 2% to positive 2%. And also, it’s important to understand that that is disproportionately weighted to our consulting type of work, probably, as you would expect. And lastly, before I hand over the Julie, I do want to just mention, probably the most important thing is, we continue to be laser focused on our clients during this time. As Julie mentioned in her script, we are clearly the fabric of our clients’ business now, more than ever, doing mission critical work. We are an integral part of their operations and we’re partnering with them on what they need. We know that the fundamental drivers of our business will continue to create tremendous opportunity for us in the long term, and we’re very confident in our positioning in the market. So thanks for letting me take a little bit of time to maybe expand a bit on guidance, because I thought it was important given the environment. And I hand it over to Julie to talk about continuity."
},
{
"speaker": "Julie Sweet",
"text": "Sure. Really, what I want to take you through, Tien-tsin and thanks for the question, because clearly, the way we’ve updated guidance, is we are expecting that our business is going to evolve differently for the next two quarters for a whole host of reasons. So I think maybe what might be most helpful, is to kind of give you some color on what’s really happening on the ground with our clients. And there is really three sets of activities right now, right? So the first is, our clients are focused, as a first priority of the safety of their people and adjusting to the need to have remote working, right which for many of our clients is very new and we’re helping many of our clients make that adjustment. So for example, we have a client who asked us literally to go – when we partnered with Microsoft to do this, to go from zero people using Teams, in five days it’ll be their entire 61,000 workforce, right? So in 5 days zero to 61,000 right. And so as we look at it, our clients are very much focused on how to adjust to remote working, and that’s easier or harder depending on the nature of the industry and the kind of work, and at the same time, is responding to the crisis you have. Our clients for example in the public sector, who are having to respond not only for their own work forces, but to what they need to do for the public. So for example, we’re working with some of our public sector clients, to deploy more virtual agents that are pre-configured with COVID-19 advice to continue to free up capacity, to add to the more critical questions in our call center. So, the first is, safety of their own people and adjusting to this new environment, where they have to have remote working and make decisions about that. The second activity is really focused on mission critical services. That of course varies by company, but if you look at the work that we’re doing with our clients, we’re working very closely to them on mission critical services like – we do the settlement of services of trades for major banks. We do payroll services. We support many different healthcare services. We’re doing trust and safety services, keeping the Internet safe. So there is a big focus in this first phase on mission critical services, working together with our clients, being able to do that in some cases remote, in some cases, continuing to go into the centers. And then the third thing that’s going on with our clients, in parallel, of course, is the assessment of the impact on both the global health crisis and the disruption in the economy and what’s been happening with the travel restrictions, the restrictions of people needing to stay at home, in some cases sheltering and place. Now, as you might imagine, that assessment occurs along two vectors. It comes at the intersection of industry, technology and geography, as well as the individual circumstances of the clients. And so to give you some sense of the variety, I have a client in the utility industry that is of course dealing with the macro environment. But in my discussions with the CEO just this week, the first question was, hey, how do you feel Accenture, about your COVID-19 arrangements, because you do a lot of work for us. And then we went right back to our usual touch point on the ERP system that we are putting together, which they consider to be mission critical for how they operate. On the other side of the spectrum, you have a client in the industry – in automotive industry, that has been hard hit. We are executing our strategy beautifully there, because we’re helping them with enterprise transformation right and they are making choices in this environment, given what they’re facing. So in that case for example, they said look our HR transformation is mission critical. We may need to and are likely to postpone the finance transformation, and they’re working with us and their other partners, as they make the essential choices you would expect in this environment. If you go to a consumer goods client, that has less expectation of significant impact, our conversations with them are, help us understand how you are going to adjust and can we move even faster, because we think there is a competitive advantage in putting in place the ERP system that we’re helping them do. And then of course you have something like travel where what is critical at this time is very-very significantly different than many of the other industries for the obvious reasons. So as you think about our guidance, we’re thinking about how the impact is varying, looking at industry, geography and understanding the work, and anchored of course in much of the work that we do for our clients, is mission critical or critical to their agendas."
},
{
"speaker": "Tien-tsin Huang",
"text": "That’s great. Thanks. Thoughtful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question then is going to come from the line of Ashwin Shirvaikar from Citi. Please go ahead."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you. Hi, Julie. Hi, KC. Hi, Angie. Good morning and I hope you and the entire Accenture team are doing well in these kind of tough times. It seems based on and thanks for the very detailed answer to the previous question from Tien-tsin. It seems clients are beginning to respond, but still possibly quite considerably internally focused. So I am specifically interested in a couple of areas. For example, what would be the creative elements of Interactive that perhaps might not look so well with social distancing norms, how would something like that be affected? And then secondly, the conversion of bookings into revenues, it needs the knowledge transfer and things like that which might need travel, how wouldn’t that be impacting what are you looking at different pace of conversion?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. It’s interesting because Accenture Interactive that has some of our creative minds, so probably best suited in fact in thinking very creatively about how to stay connected. Many of those as you may know – as you think about how they work, virtually often do work in studios and so they work virtually with our clients as well. At this point, we are really just focusing on how to adapt the virtual environment and keep them and keep people connected. And so from an Accenture perspective, we feel very confident in our workforce being able to adjust and then of course working with our clients to help them do so. With respect to knowledge transfer, that’s a great question. And as you might imagine, because we are so familiar with how to do virtual, what we have done is rapidly look at, I mean, it’s one of the first things we do, how do you do knowledge transfer remotely. Some of it is already there. And to be honest, we have had a lot of that and oftentimes our clients have wanted to do it onsite even though we said it could be done much more efficiently. And one of the things you should recognize is that this is really going to be helping accelerate also the digital transformation of our clients, right, because our clients, for example, some of whom who wouldn’t have allowed us to work from now who are giving us permission who don’t themselves work remotely who aren’t using collaboration technologies are now being forced to and the upside for them is really the opportunity to accelerate the cultural change and the digital transformation. So on knowledge transfer, to answer your specific question we have put in place new ways of doing that, but it’s based on thinking that in this case we have already done. Do you think about SAP, one of the first things we did, SAP, Oracle, any of our systems is that we have looked at all of our methodologies, obviously, our methodologies today do involve being onsite and so we are converting them and then pushing that out across our workforce and helping our clients understand it. We are rapidly doing testing of those methodologies. And so at some point of course there is limitations. You do need to be able to get together for some pieces of it. And of course just remember, today, we have people working in offices as do our clients for essential work. And so on balance right, we have rapidly moved to use all of our knowledge to be able to convert, to help our clients do that to change our methodologies and then as we continue forward depending on the duration and the magnitude, our expectation today is we will get into a rhythm that continues to allow the essential things to happen over time."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you for that. And then the second question is with regards to sort of the underlying assumptions for the new updated guidance? To what extent are you – and this might just too early, but to what extent are you able to sort of make assumptions about some of the secondary impact say for example, looking on a vertical basis, financial services companies might be – profitability might be affected because the rates are in resources there are number of examples of profitability being affected or supply chains being affected, how are you thinking through that?"
},
{
"speaker": "Julie Sweet",
"text": "I mean our guidance and KC can add anything she’d like. At this point, we are giving you the guidance we see over the next six months, based on the best information we have today. And as you said, it’s early to speculate how some of this may play out on the individual industries and it’s just – it’s quite early."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question is going to come from the line of Lisa Ellis from MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Hey, thank you and thanks for the transparency in what you’re seeing on the ground. So of course its imperfect and it’s still very early, but the best reference point many investors have for understanding, kind of how Accenture’s business reacts to this sort of sudden shock, is looking back at the financial crisis. However, of course, you now have Accenture Interactive you now have Accenture Operations, big pieces of the business that are very different. Can you just kind of give your perspective, whether you like it or not, I guess that that comparison is probably being made? So how do you think about how this situation might be different or similar to what we saw 10 plus years ago? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure. Well at a macro level, of course, there are some real differences and that several years ago, that was about an economic crisis and today, because of the global health crisis you’re dealing with circumstances that are quite different in terms of, you know globally, clients having to move to work from home and what that does in terms of just the adaptation that they’re making, the cessation of commerce and retail etcetera in many communities, and so what I would say is, you kind of start with – this isn’t just an economic crisis, which one would never have thought that they would say that, as they look back at the financial crisis. But you are really dealing with two things. So, as you think even about how we expect the situation to evolve and then I’ll come to how we are different, as we enter into this, but you’d expect – what we are expecting is that right now, as clients are very focused in adapting to, not just the economic disruption, but as I said in those three buckets of things having to adjust how they’re working. Right, that’s why our guidance assumes that there’ll be an improvement in the business environment in Q4, either because the situation is better or because simply clients and ourselves, are adjusting to working together. But I would say, as you think about today that is at very different circumstances than the financial crisis, but as we look at it, we can’t imagine a better positioned company to address it for all the reasons that we talk about. This thing though is the nature of our services today. As you saw with our results in H1, if you go back to what have we been focusing on? We’ve been focusing on building the digital core of our clients, which is moving to the cloud, having the right systems, all of which this current crisis actually points out to, are very critical, right. And then the first wave of that, you’re just seeing it in the demand for us to help them improve their infrastructure, deploy collaboration technologies and so on. The second thing we’ve been helping them with is optimize their operations and the ability to use technology, not only to reduce costs, but to be more productive. And what you are seeing even now we are already having inbound things about, can you help us achieve more savings through technology in the shorter term? So we have very relevant offerings and what’s really interesting, if you go back to the financial crisis and operations, that business is very different. It was much more around labor arbitrage with some analytics on top of it. Today, as I talked about earlier, our business in Operations, our business in Living systems start fundamentally with technology platforms that we have built, so that as our clients are making decisions, do they invest themselves to build something, or should they leverage here. The current crisis actually makes those investments we’ve been making for years, even more attractive and relevant, because clients will have less investment capacity, they will need to move fast, and they’ve got to address the challenges. And so the final area is around accelerating the growth agenda and this is where Accenture Interactive is critical. I mean just think about what’s happening right now. People are staying home and they’re getting online and they can’t go to stores. The opportunity over time to engage differently with your customers, to establish different relationships, are going to be very important and Accenture Interactive is at the core, right, of customer experience and very relevant. So we knew coming out of H1, you see the strength of that. But as you think about what’s actually happening, and of course it’s still early days, but we could see what’s going – our services, we believe will be even more relevant rate, as we get through this first period, where we need to, and I just want to be clear, at the end of the day, we have to serve our clients, and we need to help them adjust. We need to make sure their mission critical services are continuing, and then help them evaluate how to navigate, grow and address this, and that will be very different in different industries and companies and we are very – this is where our relationships matter so much. 95 of our top 100 clients, we have been there for over 10 years. So I feel very confident and I think we are in a very significant position of strength as we go into this chapter."
},
{
"speaker": "KC McClure",
"text": "Yes. And maybe one thing I’d just add is – one thing that I would say that, we do expect that we saw coming out of the last crisis, that we also believe we’re well positioned this time again, is taking market share. So when we came out of the last financial crisis, we did take market share and that is our expectation that we are – as we look long term, that we will have tremendous opportunities for us over the long-term by staying close to our clients."
},
{
"speaker": "Lisa Ellis",
"text": "Thank you. Then maybe my follow-up is on the talent side. I mean your 500,000 people are the most critical asset of Accenture. Can you just remind us, I mean it looks like headcount slowed a little bit in this last quarter, but it’s still running close to 7%. So, just as you think about this kind of sudden shock, can you just remind us how you manage rebalancing the types of skills and level of headcount you need in a very rapidly changing environment, what levers you’re pulling, just around slowing hiring etcetera? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure. Thanks. It’s a great question. So first of all, just philosophically we are not ever going to be shortsighted here. And as you said, our people are really our competitive advantage and we are the envy of the industry. And so as we look at this, we do a couple of things. First of all, we’re obviously slowing recruiting, but we’re still recruiting, like for example, in Italy – and we all know the situation there. We’re still recruiting for security right now, because as our clients have been moving to home, they need greater health and security services. And just you know, a shout out to our HR team, we’ve rapidly turned our onboarding into entirely virtual, so that we can continue to recruit the critical services our clients need during this time, when obviously we cannot have people coming to the office. The second thing that we do, is we look at where we need skills and our ability to pivot people because of course, we are a great learning organization right, and so one of the first things we always do is, where is the demand and what can we do, and we’ve trained over 300,000 people in the last couple of years just on new IT. And so, part of what we will be doing – a significant part, is making sure that we also are able to adapt. For example, if you just look at the digital – the need for digital workplace; in this week alone, we took 600 people and spun them up and trained them on all the skills they need, to be deploying these technologies like Teams, because our clients rapidly needed that for the demand. And so in its first phase, our focus is of course, the slowing down on our recruiting, except where we need the critical skills and then deploying our people at the demand and we won’t be shortsighted."
},
{
"speaker": "Lisa Ellis",
"text": "Wonderful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question then will come from the line of Bryan Keane from Deutsche Bank. Please go ahead. One moment please. And our next question from Bryan Keane. Please go ahead. Just another moment."
},
{
"speaker": "Angie Park",
"text": "Why don’t we go to the next person in queue, please?"
},
{
"speaker": "Bryan Keane",
"text": "Can you guys hear me?"
},
{
"speaker": "Angie Park",
"text": "Sorry, Bryan."
},
{
"speaker": "Julie Sweet",
"text": "Hey, Bryan."
},
{
"speaker": "Bryan Keane",
"text": "Hey, guys. I am not sure what the issue is there, just wanted to ask about the guidance. Is the guidance about what the quarter looks like so far in March, and then straight-lining that forward, or is there an estimate on what kind of deterioration you’ll see? And then thinking you mentioned a little bit, I assume most of the guidance reduction is in consulting and not outsourcing? Thanks."
},
{
"speaker": "KC McClure",
"text": "Yes. So let me start with the second part of your question first. So, as we look to what we think the back half of the year will be by type of work, we do think that consulting could be low-single digit positive or negative and remember, that also factors in – as they get a more disproportionate impact of the lower travel reimbursement revenue, Bryan. In the back half of the year, outsourcing will be low to mid single digit positive. Both types of work right now as you have seen are high single-digit growth. So at the end of the year, we do see consulting at low to mid single digit growth for the full year, and outsourcing at mid to high single digit. And what I would just give, in terms of other color on our guidance, just as an overall point. Is that we’ve done the risk profile, as you know, it’s higher than normal. We have provided our guidance in that context, based on what we see today. As a leadership team, we’re going to be as relevant as we can to our clients, and as we’ve always said, it’s our job to try to deliver as high as we can, the range. But I think it’s also important to note that in this environment, we believe it’s reasonably possible that we can land anywhere in this range. So our guidance does take into consideration what we see today, but Bryan, the environment remains fluid and evolve differently from our assumptions."
},
{
"speaker": "Bryan Keane",
"text": "Okay. And then just a quick follow-up on staffing, thinking about staffing issues, is Accenture seeing any impact to the guidance due to – you’re not able to get on company sites. So just trying to think about the supply side issue of the guidance versus the demand issue?"
},
{
"speaker": "Julie Sweet",
"text": "Yes, I mean obviously we’ve got – its sort of client by client, and by the way our legal department is doing an amazing job right now because – as you might imagine, many of our contracts didn’t even contemplate ever working from home, right, and so they’ve been working client by client sort of 24/7 to evaluate that. But it’s just a mix and so I’d just tell you, our guidance is kind of taking into account, all of these different factors and that’s where we updated it to."
},
{
"speaker": "Bryan Keane",
"text": "Okay. Stay safe. Thanks so much."
},
{
"speaker": "Angie Park",
"text": "Thank you. Operator, we have time for one more question and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question then will come from the line of Bryan Bergin from Cowen. Please go ahead."
},
{
"speaker": "Julie Sweet",
"text": "Hi, Bryan."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, good morning. Thank you. I wanted to just clarify some comments you made on the remote operations. I heard 60% in India and Philippines, curious, can you move that to a higher level or is that currently the max? And then just as far as the global mix of workforce, how are you thinking about the ability to deliver remotely on the total base of operations and what do you think that will go to ultimately?"
},
{
"speaker": "Julie Sweet",
"text": "Well, so, in the Philippines, we’re probably about where we are expect to be. In India, we’re still adding. But again, it really depends on the nature of the work, and so we wouldn’t expect it to be much higher than that, because some of the work – if you think about bandwidth, the need for power. What our employees can do in some – their conditions and then sort of be availability, the bandwidth on some of the things that take more bandwidth. So it’s going to go a little bit higher in India. But I think we’re in a pretty good position. Around the world, it varies. I mean, look at in Italy we are at 85% to 90%, in Spain, 90%. So globally, it’s actually much higher, right, because of the nature of the workforce. So you really have to look at nature of the work and country by country. But as my stat, at 16 million minutes a day to 30 million minutes a day, so we’ve mobilized very quickly."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And then just as far as demand and the guidance, can you just discuss clients, what you are seeing in their spending priority, understanding it’s fluid, how are clients considering spend across those new areas versus traditional IT areas here – I mean, the crisis, and really just trying to understand what’s built into the guide across those two channels or whether you want to break it down by how you formulated the guide by industry verticals or regions? Just trying to understanding one layer of depth down on the guidance assumptions?"
},
{
"speaker": "Julie Sweet",
"text": "Why don’t you take that?"
},
{
"speaker": "KC McClure",
"text": "We did take a look, as I mentioned we – Bryan, we did take a look at different geographies, the lens of geography in our guidance. We also looked at the lens of industries. And we did take a look at which ones will be more severely impacted in our view, I’d put – as Julie talked about, we did mention, travel is a small part of Accenture’s business, it’s about 3% of our revenue and had already been in decline even before coming into this crisis. So that’s one industry, although it’s not a big part, we have important clients there, so not big part of our revenues, but travel is an industry. We talked last quarter about industrial being a little bit under pressure in North America and Europe. We do think – that’s about 7% of Accenture’s revenue and we do think that will be – continue to be affected, go forward. And I think within high tech, where we have our aerospace and defense business, that obviously will be – continue to be impacted as well. So maybe that gives just a little bit of color on some of our industries."
},
{
"speaker": "Bryan Bergin",
"text": "Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Alright. Thank you again for joining us on today’s call. As we navigate the current environment, it is important to remember that we will continue to invest in our business and our people for the long-term. The fundamentals of our business are strong and we plan to emerge even stronger. I cannot emphasize enough my gratitude for the extraordinary efforts of our leaders and our people around the world, to both take care of each other and continue serving our clients, which they have done, even as they are concerned for their own health and health of their loved ones and communities. I also want to thank our clients for placing their trust in us, our investors for their continued confidence and our ecosystem partners for their shared commitment to our clients. Perhaps what is most unprecedented about the situation we face is how universal the tragedy is, that is unfolding around the world. It truly affects us all and I hope that each of you and your family and friends are healthy and continue to be well. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Ladies and gentlemen, this conference will be available for replay after 10.30 a.m. today through June 25, 2020. You may access the AT&T teleconference replay system at anytime by dialing 866-207-1041 and entering the access code of 2467991. International participants may dial 402-970-0847. Again, those numbers are 866-207-1041 and 402-970-0847 with an access code of 2467991. That does conclude our conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 1 | 2,020 | 2019-12-19 08:00:00 | Company Representatives: Julie Sweet - Chief Executive Officer KC McClure - Chief Financial Officer Angie Park - Managing Director, Head of Investor Relations
Operator: Ladies and gentlemen, thank you for standing by. Welcome to Accenture's, First Quarter Fiscal 2020 Earnings Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session; instructions will be given at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Angie Park. Please go ahead.
Angie Park: Thank you operator, and thanks everyone for joining us today on our first quarter fiscal 2020 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chief Executive Officer, and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the second quarter and full fiscal year 2020. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today we will reference certain non-GAAP financial measures which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Angie, and thanks everyone for joining us. Today we are very pleased to announce strong financial results for the first quarter, continuing our momentum from fiscal year ‘19. We are especially pleased with our revenue growth of 9% in local currency, well ahead of the market, which is broad-based across all dimensions of our business. We also delivered strong profitability and again returned substantial cash to our shareholders. Our strong results across industries and geographic markets reflect the diversity and scale of Accenture's business around the world. We are very well-positioned to continue creating value for all our stakeholders. We're off to a great start in Q1 and we feel confident in our ability to deliver another strong year in fiscal ‘20. Now, let me hand it over to KC who will review the numbers in detail.
KC McClure : Thank you, Julie. Happy holidays to all of you, and thanks for taking the time to join us on today's call. We were very pleased with our Q1 results, which were strong across all dimensions of our business and position us well to achieve our full-year business outlook. Once again, the broad-based strength of our results demonstrates the durability of our business, the relevance of our services in the marketplace and our scale and leadership in the world’s largest and key geographic markets. Our results reflect very strong execution against our three financial imperatives for driving superior shareholder value. Revenue growth of 9% in local currency was well above the top end of our guided range for the quarter. Growth was broad based across all dimensions of our business, with the majority of industries growing at a high-single or double-digit rate. Results continue to be driven by strong double-digit growth in digital, cloud and security-related services, and our 9% growth represents continued market share gain as we extend our leadership position. Our operating margin was 15.6% for the quarter, an increase of 20 basis points. Importantly, we delivered this expansion while investing significantly in our people and in our business to position us for long-term market leadership. We delivered very strong EPS of $2.09, which represents 7% growth, which includes an FX headwind of about 2%. And finally, we delivered free cash flow of $692 million and returned $1.2 billion to shareholders through repurchases and dividends. We also invested $110 million in acquisitions in the quarter to bolster our skills and capabilities in strategic, high-growth areas of our business, and we expect to invest up to $1.6 billion in acquisitions this fiscal year. Now, let me turn to some details for the quarter. New bookings were $10.3 billion. Consulting bookings were $6 billion, with a book-to-bill of 0.9. Outsourcing bookings were $4.3 billion with a book-to-bill of 0.9. This quarter our bookings continue to be well-balanced across the dimensions of our business and continue to be dominated by high demand for digital, cloud and security-related services, which we estimate represented more than 65% of our new bookings. Overall Q1 bookings landed in the range that we expected, and followed our historical pattern of lower bookings in the first quarter. As you know, quarterly bookings can be lumpy, and looking forward we have a strong pipeline and expect strong bookings in Q2. Turning now to revenues. Revenues for the quarter were $11.4 billion, a 7% increase in U.S. dollars and nine percent in local currency. Consulting revenues for the quarter were $6.4 billion up 7% in U.S. dollars and 9% in local currency. Outsourcing revenues were $5.0 billion, up 7% in U.S. dollars and 9% in local currency. Looking at the trends and estimated revenue growth across our dimensions; technology Services and strategy and consulting services, both posted strong high single-digit growth and operations continued its trend of double-digit growth for the 24th consecutive quarter. Taking a closer look at our operating groups. H&PS grew 13% in local currency, driven by double-digit growth in both health and public service, including double-digit growth in North America and growth markets and strong growth in Europe. Products grew 12%, reflecting continued strength in our largest operating group, with double-digit growth in life sciences and consumer goods, retail and travel services. We continue to see strong demand for our services across all three geographies. Resources grew 7% in the quarter, with double-digit growth in energy and strong growth in utilities. Overall, we saw double-digit growth in both Europe and gross markets. Communications, Media and Technology delivered 7% growth, reflecting continued double-digit growth in software and platforms, with double-digit growth in Europe and strong growth in gross markets. Finally, Financial Services grew 6% this quarter. Insurance again grew double-digits and we saw continued improvement in banking and capital markets globally. Overall, Financial Services delivered double-digit growth in growth markets and strong growth in North America, partially offset by contraction in Europe. We expect to see continued challenges and banking capital markets in Europe and the near-term. Turning to the geographic dimension of our business. I am very pleased with the continued demand across all three of our geographic markets, which illustrates the diversity of our business which continues to serve us well. In North America we delivered 9% revenue growth in local currency, driven by double-digit growth in the United States. In Europe revenue grew 7% in local currency with double-digit growth in Italy, Germany and Ireland and high single-digit growth in France. And we delivered another very strong quarter in growth markets with 13% growth in local currency led by Japan, which again had very strong double-digit growth. We also had double-digit growth in Brazil and Singapore. Moving down the income statement. Gross margin for the quarter was 32.1% compared with 31.1% for the same period last year. Sales and marketing expense for the quarter was 10.5% compared to 10.1% for the first quarter last year. General and administrative expenses were 6.1% compared to 5.6% for the same quarter last year. Operating income was $1.8 billion for the first quarter, reflecting a 15.6% operating margin, up 20 basis points compared with quarter one last year. Our effective tax rate for the quarter was 23.6% compared with an effective tax rate of 19.8% for the first quarter last year. Diluted earnings per share were $2.09 compared with EPS of $1.96 in the first quarter last year. Days service outstanding were 43 days compared to 40 days last quarter and 42 days in the first quarter of last year. Free cash flow for the quarter was $692 million, resulting from cash generated by operating activities of $787 million, net of property and equipment additions of $95 million, and our cash balance at November 30th was $5.8 billion compared with $6.1 billion at August 31st. With regard to our ongoing objective to return cash to shareholders, in the first quarter we repurchased or redeemed 3.8 million shares for $729 million at an average price of $189.65 per share. At November 30 we had approximately 3 billion of share repurchase authority remaining. Also in November we paid our first quarterly cash dividend of $0.80 per share for a total of $508 million. This represents a 10% increase over the equivalent, quarterly rate last year and our Board of Directors declared our second quarterly cash dividend of $0.80 per share to be paid on February 14, also a 10% increase over the equivalent quarterly rate last year. So in summary, we were very pleased with our Q1 results and we are off to a good start in fiscal ‘20. Now, let me turn it back to Julie.
Julie Sweet: Thank you KC. Our first-quarter performance reflects continued strong demand for our services, as well as the disciplined execution of our growth strategy. Accenture is uniquely positioned to partner with our clients to successfully achieve transformation across the enterprise. We have unparalleled technology capabilities and ecosystem partnerships, deep industry and function expertise, a focus on continuous innovation, digital at scale and incredibly talented people. We create value for our clients from building out their digital core to helping them innovate across their growth agenda and realize significant value from optimizing their operations. ‘The New’ digital, cloud and security is now our core, accounting for about 65% of total revenues, and we are focused on continuous innovation across these services. In cloud for example, we have more than 300 patents and pending patent applications. We have 90,000 cloud professionals and are the leading global partner of Amazon Web Services, Google Cloud Platform and Microsoft Azure. And I am very pleased that we just launched MyNAP, a groundbreaking new platform to help clients accelerate their cloud transformation. Identifying the right cloud solutions can be complicated, so the key is stimulating and testing a scaled-up model to quantify value and build the business case, giving clients confidence in the potential benefits so they can move forward quickly. This is just another great example of our continuous innovation mindset and how we drive speed to value for our clients. Over the past few months, I have been spending time in many of our key geographic markets around the world, meeting with our clients, our people and our ecosystem partners. We have scale in every major market and we are the leader, number one in both North America and Europe and number three in growth markets where we continue to rapidly gain market share. As an example, we have reached scale in China with more than 17,000 people, and this is a key strategic market for us and our Global Clients. Let me double-click on our major markets. Our eight largest countries as we move around the world; the U.S., the U.K., Italy, Germany, France and Spain and Europe and Japan and Australia in the growth markets. These countries account for nearly 80% of our revenues and they all generate $1 billion or more in annual revenues. They also are home to more than 85% of our 200 diamond clients, our largest relationships with the world's leading companies. Our extensive global presence has always positioned us uniquely in the market to deliver best-in-class global programs for the largest multinational companies. And today it has created yet another competitive advantage, which is the ability to create value at speed and scale by leveraging our global expertise tailored to the local context. Leveraging our global network of more than 100 innovation hubs that we have built over the last few years, we can bring innovation from every corner of the world to our clients. And while the theme of transformation is common across the globe, it plays out at the intersection of industry technology and geography. We see growing and significant differences by country, while at the same time our global footprint gives us the opportunity to leverage our learnings and our talent from around the world to accelerate outcomes for our clients. Let me bring this to life with a few examples from our Resources business. The ways in which energy is produced, consumed and distributed are changing dramatically. But the shape and pace of the change and the opportunities for Accenture are different around the world. In Europe, we are working with clients in France and Italy to help them succeed in the transition to a low carbon economy. For Engie, the French Multinational Utility company, we are teaming with sales force and velocity, which we have a minority investment on a global unified CRM platform for more than 15,000 employees. The new platform gives Engie a common intelligent view of its customers across more than 70 countries and empowers employees to strengthen customer relationships and provide personalized recommendations to support Engie’s new zero-carbon transition strategy for the Fortune Global 500. In Italy we are collaborating with Snam, which operates the largest gas transmission network in Europe, to identify Internet-of-Things technologies on the Microsoft Azure platform, leveraging connected devices, as well as machine learning, artificial intelligence and advanced analytics to optimize the monitoring and maintenance of energy infrastructure to make it smarter and more sustainable, as well as more efficient. In the United States we are working with Southern Company, the gas and electric utilities, which is building the first new nuclear reactor in the U.S. in 30-years. Partnering with Southern Company, Accenture built the new cloud-based construction work management system on the Amazon GovCloud platform from scratch in just six months. This enabled Southern Company to expand and accelerate plant construction as it strives to bring this clean carbon-free energy production online for 500,000 homes and businesses. Let me pause for a moment and take a step back. Each of these examples demonstrates the power of our unique business model, which spans services from strategy to operations, with digital and technology at the core. This enables us to create the multidisciplinary teams that are needed to not just create a vision of transformation, but to execute and scale and give our clients the confidence that they will achieve real value. If you think about the environment our clients are navigating, unprecedented change, the need for speed and major investments to drive their enterprise transformation, our unique model and capabilities give us an incredible competitive advantage to be the partner of choice for the world's leading companies. Now, let me turn to Accenture’s greatest and undeniable strength, which is our people. During the first quarter the number of Accenture people surpassed 500,000, a significant milestone. I want to thank each and every one of them for their incredible commitment and dedication to serving our clients. As always, we continue to strengthen our leadership team, which now includes more than 8,000 Managing Directors. I was delighted that earlier this month we promoted 787 new Managing Directors and Senior Managing Directors, including a record 260 new women Managing Directors, accounting for 36% of the promotions to this level. And before I turn it back to KC, I just want to mention some of the great recognition we have recently received for our long-term success and cutting-edge capabilities. We are especially proud that Droga5, which joined Accenture Interactive last April was named Agency of the Decade by Adweek, which characterize Droga5 as a dominating creative force. Interbrand ranked Accenture number 31% on its list of top global brands, our highest ranking ever. Our brand value increased 14% for the second year in a row, and I want to recognize Amy Fuller, our Chief Marketing Officer, her team and all our people for this great work to continually strengthen the Accenture brands. With that, I will turn it over to KC to provide our updated fiscal ‘20 business outlook. KC?
KC McClure : Thanks Julie. Now let me turn to our business outlook. For the second quarter of fiscal ‘20 we expect revenues to be in the range of $10.85 billion to $11.15 billion. This assumes the impact of FX will be about negative 1% compared to the second-quarter fiscal ‘19 and reflects an estimated 5% to 8% growth in local currency. For the full fiscal year ’20, based on how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our result in U.S. dollars, will be approximately negative 1% compared to fiscal ‘19. But for the full fiscal ‘20 we now expect our revenue to be in the range of 6% to 8% growth in local currency over fiscal ‘19. For operating margin we continue to expect fiscal year ‘20 to be 14.7% to 14.9%, a 10 to 30 basis-point expansion over fiscal ‘19 results. We continue to expect our annual effective tax rate to be in the range of 23.5% to 25.5%. This compares to an effective tax rate of 22.5% in fiscal ‘19. For earnings per share, we now expect full-year diluted EPS for fiscal ‘20 to be in the range of $7.66 to $7.84 or 4% to 7% growth over fiscal ‘19 results. For fiscal ‘20 we continue to expect operating cash flow to be in the range of $6.35 billion to $6.75 billion; property and equipment additions to be approximately $650 million and free cash flow to be in the range of $5.7 billion to $6.1 billion. Finally, we continue to expect to return at least $4.8 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so we can take your questions. Angie?
Angie Park : Thanks KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask the question. Operator, would you provide instructions for those on the call?
Operator: Thank you. [Operator Instructions]. Your first question comes from the line of Lisa Ellis from Moffett Nathanson. Please go ahead.
Lisa Ellis: Hi, good morning guys and happy holidays! I just wanted to ask a question on acquisitions. I think KC you mentioned you are expecting to spend up to about $1.6 billion on acquisitions this year. Can you just give a little bit more color on the expected contribution to revenue growth this year from acquisitions and then also what you're, you know what your focus areas are for M&A? Thank you.
KC McClure: Yes, sure. So happy holidays to you to Lisa. In terms of our expected contribution to revenue in full fiscal year ‘20 from inorganic, we continue to expect it to be about 2%, which was in line of what we also had last year. And in terms of focus areas, I’m going to hand it over to Julie.
Julie Sweet: Great! Let me give you a color. So happy holiday to you too Lisa and thanks for joining us. So our acquisition strategy continues to be centered really around three focused sales – focus areas. The first is scaling in the hot skill areas where we see a big market opportunity. The second is continuing to add skills and capabilities in The New. And then the third is deepening our industry and functional expertise. And as you might imagine, acquisitions don't always fit exactly into one of those three; they often cross those. So let me just give you like a little bit of sense of just the three that we just announced in the last few months. So if you start in the U.S., we announced that we're buying, we're acquiring Clarity Insights, which is a leading provider of data science and applied intelligence capabilities. They are very focused on three industries; Healthcare and Financial – banking capital markets and insurance, which are priority areas for us globally and in particular in the U.S. And at the same time they bring with them accelerators that will help us bring more speed to value for our clients, and they are focused on one of our most important markets, so they are helping us scale where we already have scale, but it's a very hot area in Applied Intelligence, because it really crosses our services. Then if you move around the world and go to Europe, Silveo which we announced and expect to close actually just in a couple of days which is headquartered in London, they are a company that's focused on supply chain and manufacturing and particularly solutions on SAP and Dassault Systems which are both important partners. And so they are very much a part of our industry X.O strategy and at the same time providing scale and functional expertise in core areas for us; SAP, Dassault Systems and supply chain. And then if you move again around the world to China, where I was just there a few weeks ago, we're really excited about future move automotive. I actually spent a few hours there myself, really touching and feeling the work that they're doing and they are digital and mobility service provider for the automotive industry in China, incredibly advanced right, working with leading automakers there and what's so exciting is not only does this acquisition help us really partner with our clients in China, but they are advanced services and what they are doing with the connected car is something we’ll be able to leverage and bring as innovation all around the world, because we have important clients who are not only operating in China, but in the U.S. and Europe. And so that just sort of gives you a flavor and as you can probably tell, I'm so enthusiastic about what our team is delivering here, because it's very much targeted on making an impact close to clients in our markets around the world, but also bringing us skills that we can leverage around the world.
Lisa Ellis: Terrific! Thank you. And then maybe just for my follow-up, I know this is the time of year you are in a lot of discussions with clients around your 2020 programs with them. What are you seeing that's going to be different about 2020 in terms of the types of work you are doing with clients compared to 2019? Thanks.
Julie Sweet: It's very much more of the same in the sense of enterprise-wide transformation and then a focus on innovation, particularly around the growth agenda, and then continuing to optimize operations, and that really, that's been the theme and it continues to be the theme. In fact, I think since September 1 I've met with over 100 C-suite executives, and I'm very confident of – that we have a pulse on the demand and that we have the capabilities they need.
Operator: Your next question comes from the line of Joseph Foresi from Cantor Fitzgerald. Please go ahead.
Joseph Foresi: Hi! I wondered if we could talk about the cadence on bookings. I know that we’ve – and you said many times in the past that it can be lumpy. We saw it a little bit light ending I guess this quarter. So maybe you could talk about how you see the cadence and what we should expect from a seasonality perspective.
KC McClure: Yes sure. Hey Jos, thanks for joining. Yes, so you're right, you've heard us talk about – and you know us very well. You know that our history of bookings, you do see lumpiness. And I think really the most important thing and that's within that is that we're very pleased with the demand for our services in the marketplace, and if you think about that in the backdrop of bookings. So we're coming off a quarter, Q4, which was our records bookings quarter, and that was a record by more than $1 billion. We had strong bookings that came in the range that we expected in quarter one, right, and we talked about that last quarter. We tend to have it seasonally, lower quarter in one, so again this met our expectations, and that very importantly we have a strong pipeline and we see strong bookings in quarter two. And I think the other part of demand that's important, and you saw this in our results in the first quarter as well, is that we have broad-based demand in our revenue, right, and we far exceeded the upper end of our guidance by more than $160 million. So you would see that bookings demand – you see the demand in the market coming through our bookings, both in terms of what we've done last quarter, bookings coming in the range that we expected this quarter, a strong pipeline with strong bookings expected in quarter two, as well as broad-based, over-delivery of our expected range in the first quarter in revenue, which allowed us to increase our revenue range for the year.
Joseph Foresi: Got it. And then maybe you could talk a little bit about your expectations from a demand perspective across the verticals and the geographies. I’m particularly interested in Financial Services and what's going on with the European banks, but any color you know from a very high level across those geos and verticals would be very helpful? And happy holidays as well.
Julie Sweet: Hi Joe, this is Julie. Happy holidays! So maybe just kind of going across, let me just start with Financial Services, right. So on the Financial Services side, as you say Europe continues to be a challenging market in the industry and for us, and so we expect that we're going to continue to face challenges there, particularly in the UKI right. But overall our Financial Services business, if you look at North America and the growth markets, you know it remains robust, right. But we continue to expect challenges in Europe. If you just look at – take it up a little [ph] across the dimensions of our business and our industries, North America delivered very strong results. We are seeing continued momentum there. We have a very strong business in Europe, and so while we've got pockets of pressure in Financial Services and the other area I would call out in Europe is we have seen pressure in industry and automotive. But otherwise Europe remains a strong business, and in fact 12 out of 13 of our industries this quarter had positive growth. And then the growth markets keep being strong really across-the-board. The only other place of pressure that I would call out was in North America, we did also see not surprisingly some pressure in industry and automotive.
Operator: Your next question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead.
Tien-tsin Huang : Thanks, good morning. Good revenue acceleration here. I wanted to first ask on gross margin expansion. Actually it's one of the largest increases we've seen in some time looking at the model here. Would you attribute that large expansion to and then same thing on SG&A, that spend was up, can we assume that that's driving some prospecting and deal pursuit costs given your positive comments on bookings?
KC McClure: Yeah, so thanks for the question and hello Tien-tsin. In terms of how we look at our business as you all know, we first always start with looking at operating margin, and because the way our payroll costs works as you well know Tien-tsin, based on the activities that we have people doing from quarter-to-quarter and the demand that we see in the marketplace, you can see differences in the different segments of our income statement. So as it relates to the gross margin increase this quarter, it is tied to the sales and market, what's happening in sales and marketing, where we have more people out working our pipeline. So that will help our gross margin, and then you'll see the offsetting impact in sales and marketing. And you're right, that does tie in to the statements we've made of having – continuing to have a very strong pipeline.
Tien-tsin Huang : Okay. No, that’s helpful. KC, real quick if you don’t mind. Just on the consulting revenue growth, that has been improving here and I guess widening the gap to your consulting bookings growth or pattern. What explains the faster conversion? Thanks for the second question, I appreciate it.
A - KC McClure: Yes, so we really haven't seen any change in conversion Tien-tsin of our overall bookings, just overall to revenue. You know that can be within a range and that can vary. So as we look at what we've done in consulting bookings, we feel very good with our bookings for the quarter, as well as our pipeline, and see also strong bookings in quarter two as well in consulting. Then if you look at what our – production of our bookings in relation to revenue, you know we look at that over a prolonged period of time, and so we're still in the zone that we like, which is a book-to-bill ratio of about one point.
A - Julie Sweet: Yes, and Tien-Tsin hi. Hello! Nice to talk to you. And I would say, you know as we talked about last quarter, you know from the revenue side we are very pleased with mid-to-high single-digit growth and you're going to have some quarters here in mid, you have some quarters here in the high-growth, that's the zone we want to be in, because the context for our strategy and consulting business, you need to look at it in the context of our overall business. You know big drivers of growth are the fact that we can bring together these multi-disciplinary teams to drive enterprise-wide transformations, right. That is our huge competitive advantage. It's the demand that we see in the market, right, and it's our ability to actually go from strategy to operations, to feel these teams that really is what drives big growth in our business and of course that at the core we've got the digital and technology. So we look at our strategy and consulting business in the context of the needs we are trying to fulfill for our clients, which are very much around these multidisciplinary teams that span our services, which frankly nobody else can do, right, at our scale.
Operator: Your next question comes from the line of Darrin Peller from Wolfe Research. Please go ahead.
Darrin Peller : Thanks guys. You know it's amazing to see the headcount, where it is right now, and so if you could just quickly comment on you know your thoughts on talent management and going forward from this kind of a level, your ability to hire what you need, what you've always been obviously extremely strong at, and then maybe just comment on the linearity and the model now; maybe looking forward given where you are around the new and the type of revenue?
Julie Sweet: Sure. I mean maybe just to start with, you know our philosophy right around people and size, because you know every time we hit a milestone, it's always ‘can you keep doing it? Are you able to get the people?’ and so first of all our philosophy is that we can continue to grow in size as long as what our people are doing is the high-value work that drives our financial objectives, right, and so we're very focused on what our people are doing versus how many people we have, because the size part of it is about our ability to manage and we're really good at that, right. Like over the years we've made the adjustments, we've done the things we need to do to focus on our clients and our people, and so the big focus for us is on what our people are doing, which ties to the demand that we see in the market, right. We are early innings of digital transformation, enterprise-wide transformation. We are constantly seeing new emerging tech. You know for example, we're doing some great work with [Inaudible] Japan where we're putting in one of the most significant early examples of using block-chain to drive their business or creating a platform that allows their customers to access other financial products. That's very new cutting-edge, right, we're still at the beginning. So we see the demand for these new high-value services still quite early. Then you look at the model itself. We don't see the model today as being linear. I mean one of the things that people often talk about is well, you’re continuing to grow. But underneath that is we've been automating; we've been using people and their talents differently. I mean we often talk about the automation in our operations business where there, we actually didn't let people go. We automated and then up-skilled them to do the higher-value work, but not just in operations, but if you look at our other assets. So we are constantly – we don't have a linear model today, because we are constantly doing what we're doing for our clients, is leveraging technology to change the mixture of how we are using tech and our people to again continue to focus on the higher-value services, and so you know we are – and hopefully that gives you kind of the color for how we think about our model.
Darrin Peller : Yeah, no that is helpful. Just a quick follow-up is on pricing. I mean again, it seems like as you've trained your people to do the higher part of the food chain, you are able to pass that through. Any changes on that pattern or has pricing held up, just given competition has also picked up for digital. Thanks guys.
KC McClure: Yeah, so pricing – you know the environment for pricing remains competitive, right, and that's always the nature of the work that we do. Now within that, we are able to see pricing differentiation in areas where we're differentiated, where we've invested, and we do continue to see that we have pricing improvement in some areas of our business continuing in this quarter. It’s a constant focus for us and that really is the key part of – the key first lever to really driving our margin expansion pricing. So we are always – we always have been and will always continue to be focused on driving pricing that's the right value for the client and for Accenture.
Operator: Your next question comes from the line of Harshita Rawat from Bernstein. Please go ahead.
Harshita Rawat : Hi, good morning. Thank you for taking my question. I want to ask about industry X.O. It's a relatively new business for you and somewhat early innings, so can you talk about the journey in Interactive which was a new business for many, many years ago and now a huge revenue contributor. So can you talk about that journey, the lessons there and how you plan to go about scaling Industry X.O. Thank you.
A - Julie Sweet: Thanks Harshita, that's a great question, and we often you know internally talk about the analogies, because you'll remember with Accenture Interactive, that growth came from a mixture of both, inorganic and organic, and very much fueled though by the power of Accenture. So even as we were bringing in, as we've been bringing in skills and capabilities that we didn't have traditionally like a Droga5 and before them Monkeys and Kalorama [ph], these creative agencies, the value proposition for our clients is to take these other capabilities and pair them with the traditional strengths of Accenture for example on building digital platforms, and that is what has been able to drive the growth in Accenture Interactive. And as we look at Industry X.O, this is an opportunity for us to serve areas of the company that we serve today, but not as much at scale. Just like with Accenture Interactive we weren't as relevant to the CMO as we are today. Once we've built Accenture Interactive as well as you know new business creation and Industry X.O. Well, of course we have served and we have practiced, you know still significant practices in manufacturing and supply chain, Industry X.O is really about the digitization of manufacturing, the creation of connective products, and then also these digital platforms and engineering around the software. And while again we're in – just like Accenture Interactive when we began were in parts of these, what we're doing is we're adding the complementary skills that will allow us to take the power of Accenture and really scale and bring all of that to our clients who themselves are going through a whole change, because manufacturing is now being digitizing and it's the convergence of IT with operating technology, and we expect to grow Industry X.O as we have with Accenture Interactive through a combination of organic and inorganic. So you saw us last year buy companies like Mindtribe and Pillar in the U.S., which are all about connected products. We saw the future move acquisition I just mentioned in China, which is about automotive and Connected Services; Silveo in London, which is just the recent, and that's really about digitizing, manufacturing, leveraging our ecosystems. But at the same time we're building on the scaled digital and technology capabilities, which is what our clients need to do as we all go through, where we see this transformation to digitize these areas of the company that haven't been digitized in the same way that you have the customer front-end.
Harshita Rawat : Thank you very much.
Operator: Your next question comes from the line of David Koning from Baird. Please go ahead.
David Koning: Maybe my first question, just when we look back at some of the metrics you've given around The New you know in the percent of total revenue and we go back a couple of years, it looks like that was drilling 20% to 30% and some of the legacy was declining maybe low double. Today it looks like The New might be growing low-to-mid teens and legacy has actually kind of improved to maybe slightly declining. I’m just wondering that pace of change, you know what might be driving that and if that's even the right way to think about it.
KC McClure: Yeah, hi Dave. So in terms of looking at The New, I think really what you're touching on is the growth rates that we've had over the last few years and we continue to have very strong growth rates in The New. And as you look at that scale right of our business, I mean you would anticipate that even very strong growth rates would slow a bit, but again be very strong just based on scale. And if you look at the other portion of our business, let's call it the non-New or the core, we continue to see that that is stabilizing; it's been decreasing at about a mid-single digit rate and that's by design, that's our strategy, but it's been pretty consistent over the last few quarters.
David Koning: Great, thanks! And just one quick follow-up just on accounting. There was another income line in Q1 that was about $11 million positive this quarter. Last year that line was about $25 million to $35 million negative all through the year. Was there a one-time item in Q1 and does that more normalize the rest of the year.
KC McClure: Yeah, so we did have this quarter a small benefit below operating income where we had, we indeed do have non-operating income this quarter as opposed to what you saw in quarter one of last year, which was non-operating expense. So as a reminder last year, we adopted a new revenue - a new accounting standard that require that we marked our investments to fair market value, and while we don't have a large investment portfolio, what you will see Dave from time-to-time that may cause a little bit more variability in what we have a non-operating income and non-operating expense. In this quarter we did have a gain in non-operating income on some of our investments and that was offset by some FX losses as well, but it was a net gain this quarter in non-operating areas and it will fluctuate probably slightly more than it has in the past, really just because of that accounting change.
Operator: Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead.
Bryan Keane: Hi guys, good morning. Just wanted to ask about the beat and the upside surprise. For you guys was it in consulting in particular, because I know a lot of investors were concerned consulting was weakening and actually it strengthened. So just trying to figure out if that also surprised you guys or was there something else that created the upside.
KC McClure: Yeah, so we were really pleased overall with our revenue growth rate for this quarter Bryan, and obviously at 9% growth, which was as you mentioned a beat, $160 million higher than we expected. But the other thing that we were very pleased with is the fact that it was also a broad-based over-delivery. Now if I had to point out two areas in particular, I'd point to health and public service, particularly in North America, which was strong both in the health, industry, as well in the public sector industry and that's a statement overall for North America including our federal practice. And then also products that continue to have very good [ph] in life sciences, as well as consumer goods, retail and travel. And so what you'll see is that we do and we continue to expect Bryan that we will have for the full-year consulting in the mid-to-high single-digits growth and outsourcing also in the mid to high single growth rate.
Julie Sweet: Yes, and Bryan I would just add – this is Julie, that again as I talked about earlier, although obviously we look at strategy and consulting, tech services and operations separately and report on that, you know remember that our focus really has been because of the demand we see in the market, on our unique business model that brings these services together, and so it's not so much. You know you can't really – for us the way we manage our business, it's not that wait, there's a big surprise in strategy consulting, because KC's giving the answer around industries and clients because a lot of our work is actually bringing all of these services together to meet the needs we're seeing in the market. And so while we do report this to give you that insight into the types of work, when we are thinking about what's happening it's much more focused, it is only focused on clients, what are their needs, and how are we bringing these services together. And that really is the power of Accenture, is that we're able to bring these services together. And if you think about what our clients need right now, I mean as I said, I literally in the last four months, almost four months spent time with over a 100 C-Suite executives and top of mind for them is the importance of making sure they are going to get value. And that's why they want to partner with us, is because we're bringing the teams and we're able to really give them confidence in outcomes and we're able to point to the execution we've done with other clients and demonstrate the value, and that we're bringing that learning. And I think particularly as we see this inflection in the marketplace, moving from pilots and use cases to this enterprise-wide transformation, multiyear programs, it's more important than ever that we're able to bring these services together for our clients.
Bryan Keane: That's helpful and just as a follow-up on Europe, it was up 7% constant currency; I think that's up from four last quarter. Again a lot of investor concern around Europe, but you guys are showing an acceleration there. You talked about I think 12 of 13 industries showed improvement. So I guess I'm a little surprised to hear about that improvement. Can you just talk about broadly what's going on in Europe and why you are seeing that improvement?
KC McClure: Yeah, and I will maybe just reiterate a couple of the points, and some of that you also mentioned. So we were pleased with our business in Europe this quarter and we did have broad-based growth and it wasn't 12 of the 13 industries. And importantly it was high single to double-digit growth and nine out of that 13, and so that's really important to us, and that's something that we're very focused on and we're very proud of, the overall broad-based nature of our business in Europe and the diversity that we have. Then I think you'll see it has been and continues to provide some durability in that market. Now as we've mentioned, you know we do continue to have a focus on banking capital markets in Europe and that's particularly in the UK. So we do have some more work to do in that area, and as also as Julie mentioned, we do have some pressure in industrials and the automotive as well in Europe. But I just would point back to the double-digit growth that we Italy, Germany and Ireland as well. And so we're very focused on continuing in that market to drive the transformation that Julie was talking about, the she sees and talks with all the C-Suite about in her travels throughout the world.
Operator: Your next question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead.
Ashwin Shirvaikar: Julie you mentioned Droga5, I’m going to take you up on that one. Obviously Accenture spent many years growing the various parts of that business, steadily expanding from the technology part creative. Droga5 recently won The Kimberly-Clark Childcare account and based on our checks, you are increasingly going head on with the traditional agencies for what I'd call the whole shooting match. Can you speak to what you're seeing there specifically and whether you think your missing any pieces, so you could go when full accounts end-to-end what the traction you currently have there is?
Julie Sweet: Sure. Well, Kimberly-Clark is a great example of what we see is the demand in the market, which is for a company to bring together not only world-class creative, but the digital capabilities, as well as the advisory capabilities to truly transform the customer experience, right. And you’ll hear that term now a lot. We believe we're the only company today that actually has all of the capabilities that are needed in order to deliver a very different customer experience. And so while I know you think of it as going up straight against the agencies, what we think about it is what the clients are looking for is not just the creative agency and you see that in the industry as the industry, the broader creative industry is also expanding into these capabilities. The fact of the matter is very difficult to have creative, it's equally difficult to have depth and breadth in the digital and technology capabilities that our clients need, and so we believe that our competitive advantage here is to have such strong creative capabilities coupled with, like just unparalleled digital and technology capabilities at a huge scale in every major market. Because remember Accenture Interactive, we have built around the world, right, and we've got it – you know and I was in the studios in China, we have it in Australia, across Europe, as well as the U,S. So we're extremely proud of the work that Accenture Interactive under the leadership of Bryan Whipple, but his entire team have done, that its powered by the rest of Accenture, right, all of these skills and capabilities. That is very hard for anyone to replicate in our view.
Ashwin Shirvaikar: Got it, makes sense. The second question is, you mentioned the incremental elements of nonlinearity in the model in the prior question on headcount and revenue growth. What's the longer-term impact on margins and cash flow; if I can extend that question to those metrics?
KC McClure: So Ashwin, in terms of how we think about those two elements, right. In terms of margin, I think it's important to just point out that we always continue to look for modest margin expansion. But more importantly to us is that we're doing more than just the modest margin expansion as you well know that goes to our bottom line. We are doing more underlying margin expansion, so that we can invest at scale in our people and in our business for long-term market leadership, so that's a key part. And on free cash flow, you know that continues to be – you know there's no change there. I mean this year you’ll see that we managed that part of our business by looking at free cash flow to net income ratio, right, and this year again it's 1.1% to 1.2%. And as you think about that, while I won't guide for that long term, you know strong free cash flow will continue to be an anchor of how we run Accenture.
Angie Park : Okay, and operator we have time for one more question and then Julie will wrap up the call.
Operator: Okay. Your final question comes from the line of Bryan Bergin from Cowen. Please go ahead.
Bryan Bergin : Hi, good morning, thank you. I wanted to ask a question on how the mix of your client counterparts have changed. So if we think about enterprise budgets, can you give me a sense of how your revenue stream currently maps across an organization, whether it's CIO or the CMO budget or like board-level initiatives. And the reason I ask this, we’ve diversified the business so much over the last several years. I'm just really curious how this has evolved and how you really are mapping across the various budgets now today?
KC McClure: Well, I guess what I'd say is, if you think about what we're doing with respect to, you know for example Accenture Interactive, that work is almost always a combination of marketing plus-CIO, often plus the business units right, because the work is not – you know really is around customer experience and so where the budget sits really varies by company, and some companies you'll have budget sit with the Chief Digital Officer right. So what we – our focus is less on the specific budgets and more how are we serving the different needs of the enterprise. So if you just – and remember we go back to really – we think about it in three things; building the digital core, so 40% of our business growing double-digit today is in our intelligent platform services our five big platforms, because that's all about next-gen platforms right. Similarly our cloud business is there. Then we have the optimizing operations, so you've got a $6 billion scaled business growing high single-digit to double-digit, right, which is all about optimizing and making sure that within the functions, as well as industries they've got access to the best technologies in a most efficient way. And then on top of that you have the growth agenda like Accenture Interactive which is $10 billion. We announced last quarter with strong growth, as well as the new areas like connected products and services. And so we continue to focus – our big next focus area is Industry X.O, which is growing on our historic work and manufacturing and supply chain to the new and really going after that part of the enterprise along with the market, because that's not digitized as fast to say customer experience and that's really how we think about the business.
Bryan Bergin : Okay, that's helpful. And then just lastly, I heard your inorganic 2% you expect for fiscal ’20, was that close for that in 1Q as well? And happy holidays!
KC McClure: Yeah, Happy holidays to you too Bryan. I mean we look at that over a full year. So I would say you know 2% inorganic for the full-year is the number that I would continue to focus on.
Julie Sweet: Okay, thanks Bryan. So thanks everyone again for joining us on today's call. We are very pleased with our strong start in fiscal ‘20 as you've just heard and we are well-positioned to achieve our updated business outlook for the year. We will stay laser-focused on continuing our current momentum, capturing the opportunities in the marketplace and creating value for our clients and all of our stakeholders. I want to wish you all, our investors and analysts and everyone at Accenture and your families all the best for the New Year. And finally, I want to thank each of our people around the world, you are what makes Accenture unique and special. I will see everyone on the road.
Operator: Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect. | [
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"speaker": "Company Representatives",
"text": "Julie Sweet - Chief Executive Officer KC McClure - Chief Financial Officer Angie Park - Managing Director, Head of Investor Relations"
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"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to Accenture's, First Quarter Fiscal 2020 Earnings Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session; instructions will be given at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Angie Park. Please go ahead."
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"speaker": "Angie Park",
"text": "Thank you operator, and thanks everyone for joining us today on our first quarter fiscal 2020 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chief Executive Officer, and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the second quarter and full fiscal year 2020. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today we will reference certain non-GAAP financial measures which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
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"speaker": "Julie Sweet",
"text": "Thank you, Angie, and thanks everyone for joining us. Today we are very pleased to announce strong financial results for the first quarter, continuing our momentum from fiscal year ‘19. We are especially pleased with our revenue growth of 9% in local currency, well ahead of the market, which is broad-based across all dimensions of our business. We also delivered strong profitability and again returned substantial cash to our shareholders. Our strong results across industries and geographic markets reflect the diversity and scale of Accenture's business around the world. We are very well-positioned to continue creating value for all our stakeholders. We're off to a great start in Q1 and we feel confident in our ability to deliver another strong year in fiscal ‘20. Now, let me hand it over to KC who will review the numbers in detail."
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{
"speaker": "KC McClure",
"text": "Thank you, Julie. Happy holidays to all of you, and thanks for taking the time to join us on today's call. We were very pleased with our Q1 results, which were strong across all dimensions of our business and position us well to achieve our full-year business outlook. Once again, the broad-based strength of our results demonstrates the durability of our business, the relevance of our services in the marketplace and our scale and leadership in the world’s largest and key geographic markets. Our results reflect very strong execution against our three financial imperatives for driving superior shareholder value. Revenue growth of 9% in local currency was well above the top end of our guided range for the quarter. Growth was broad based across all dimensions of our business, with the majority of industries growing at a high-single or double-digit rate. Results continue to be driven by strong double-digit growth in digital, cloud and security-related services, and our 9% growth represents continued market share gain as we extend our leadership position. Our operating margin was 15.6% for the quarter, an increase of 20 basis points. Importantly, we delivered this expansion while investing significantly in our people and in our business to position us for long-term market leadership. We delivered very strong EPS of $2.09, which represents 7% growth, which includes an FX headwind of about 2%. And finally, we delivered free cash flow of $692 million and returned $1.2 billion to shareholders through repurchases and dividends. We also invested $110 million in acquisitions in the quarter to bolster our skills and capabilities in strategic, high-growth areas of our business, and we expect to invest up to $1.6 billion in acquisitions this fiscal year. Now, let me turn to some details for the quarter. New bookings were $10.3 billion. Consulting bookings were $6 billion, with a book-to-bill of 0.9. Outsourcing bookings were $4.3 billion with a book-to-bill of 0.9. This quarter our bookings continue to be well-balanced across the dimensions of our business and continue to be dominated by high demand for digital, cloud and security-related services, which we estimate represented more than 65% of our new bookings. Overall Q1 bookings landed in the range that we expected, and followed our historical pattern of lower bookings in the first quarter. As you know, quarterly bookings can be lumpy, and looking forward we have a strong pipeline and expect strong bookings in Q2. Turning now to revenues. Revenues for the quarter were $11.4 billion, a 7% increase in U.S. dollars and nine percent in local currency. Consulting revenues for the quarter were $6.4 billion up 7% in U.S. dollars and 9% in local currency. Outsourcing revenues were $5.0 billion, up 7% in U.S. dollars and 9% in local currency. Looking at the trends and estimated revenue growth across our dimensions; technology Services and strategy and consulting services, both posted strong high single-digit growth and operations continued its trend of double-digit growth for the 24th consecutive quarter. Taking a closer look at our operating groups. H&PS grew 13% in local currency, driven by double-digit growth in both health and public service, including double-digit growth in North America and growth markets and strong growth in Europe. Products grew 12%, reflecting continued strength in our largest operating group, with double-digit growth in life sciences and consumer goods, retail and travel services. We continue to see strong demand for our services across all three geographies. Resources grew 7% in the quarter, with double-digit growth in energy and strong growth in utilities. Overall, we saw double-digit growth in both Europe and gross markets. Communications, Media and Technology delivered 7% growth, reflecting continued double-digit growth in software and platforms, with double-digit growth in Europe and strong growth in gross markets. Finally, Financial Services grew 6% this quarter. Insurance again grew double-digits and we saw continued improvement in banking and capital markets globally. Overall, Financial Services delivered double-digit growth in growth markets and strong growth in North America, partially offset by contraction in Europe. We expect to see continued challenges and banking capital markets in Europe and the near-term. Turning to the geographic dimension of our business. I am very pleased with the continued demand across all three of our geographic markets, which illustrates the diversity of our business which continues to serve us well. In North America we delivered 9% revenue growth in local currency, driven by double-digit growth in the United States. In Europe revenue grew 7% in local currency with double-digit growth in Italy, Germany and Ireland and high single-digit growth in France. And we delivered another very strong quarter in growth markets with 13% growth in local currency led by Japan, which again had very strong double-digit growth. We also had double-digit growth in Brazil and Singapore. Moving down the income statement. Gross margin for the quarter was 32.1% compared with 31.1% for the same period last year. Sales and marketing expense for the quarter was 10.5% compared to 10.1% for the first quarter last year. General and administrative expenses were 6.1% compared to 5.6% for the same quarter last year. Operating income was $1.8 billion for the first quarter, reflecting a 15.6% operating margin, up 20 basis points compared with quarter one last year. Our effective tax rate for the quarter was 23.6% compared with an effective tax rate of 19.8% for the first quarter last year. Diluted earnings per share were $2.09 compared with EPS of $1.96 in the first quarter last year. Days service outstanding were 43 days compared to 40 days last quarter and 42 days in the first quarter of last year. Free cash flow for the quarter was $692 million, resulting from cash generated by operating activities of $787 million, net of property and equipment additions of $95 million, and our cash balance at November 30th was $5.8 billion compared with $6.1 billion at August 31st. With regard to our ongoing objective to return cash to shareholders, in the first quarter we repurchased or redeemed 3.8 million shares for $729 million at an average price of $189.65 per share. At November 30 we had approximately 3 billion of share repurchase authority remaining. Also in November we paid our first quarterly cash dividend of $0.80 per share for a total of $508 million. This represents a 10% increase over the equivalent, quarterly rate last year and our Board of Directors declared our second quarterly cash dividend of $0.80 per share to be paid on February 14, also a 10% increase over the equivalent quarterly rate last year. So in summary, we were very pleased with our Q1 results and we are off to a good start in fiscal ‘20. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you KC. Our first-quarter performance reflects continued strong demand for our services, as well as the disciplined execution of our growth strategy. Accenture is uniquely positioned to partner with our clients to successfully achieve transformation across the enterprise. We have unparalleled technology capabilities and ecosystem partnerships, deep industry and function expertise, a focus on continuous innovation, digital at scale and incredibly talented people. We create value for our clients from building out their digital core to helping them innovate across their growth agenda and realize significant value from optimizing their operations. ‘The New’ digital, cloud and security is now our core, accounting for about 65% of total revenues, and we are focused on continuous innovation across these services. In cloud for example, we have more than 300 patents and pending patent applications. We have 90,000 cloud professionals and are the leading global partner of Amazon Web Services, Google Cloud Platform and Microsoft Azure. And I am very pleased that we just launched MyNAP, a groundbreaking new platform to help clients accelerate their cloud transformation. Identifying the right cloud solutions can be complicated, so the key is stimulating and testing a scaled-up model to quantify value and build the business case, giving clients confidence in the potential benefits so they can move forward quickly. This is just another great example of our continuous innovation mindset and how we drive speed to value for our clients. Over the past few months, I have been spending time in many of our key geographic markets around the world, meeting with our clients, our people and our ecosystem partners. We have scale in every major market and we are the leader, number one in both North America and Europe and number three in growth markets where we continue to rapidly gain market share. As an example, we have reached scale in China with more than 17,000 people, and this is a key strategic market for us and our Global Clients. Let me double-click on our major markets. Our eight largest countries as we move around the world; the U.S., the U.K., Italy, Germany, France and Spain and Europe and Japan and Australia in the growth markets. These countries account for nearly 80% of our revenues and they all generate $1 billion or more in annual revenues. They also are home to more than 85% of our 200 diamond clients, our largest relationships with the world's leading companies. Our extensive global presence has always positioned us uniquely in the market to deliver best-in-class global programs for the largest multinational companies. And today it has created yet another competitive advantage, which is the ability to create value at speed and scale by leveraging our global expertise tailored to the local context. Leveraging our global network of more than 100 innovation hubs that we have built over the last few years, we can bring innovation from every corner of the world to our clients. And while the theme of transformation is common across the globe, it plays out at the intersection of industry technology and geography. We see growing and significant differences by country, while at the same time our global footprint gives us the opportunity to leverage our learnings and our talent from around the world to accelerate outcomes for our clients. Let me bring this to life with a few examples from our Resources business. The ways in which energy is produced, consumed and distributed are changing dramatically. But the shape and pace of the change and the opportunities for Accenture are different around the world. In Europe, we are working with clients in France and Italy to help them succeed in the transition to a low carbon economy. For Engie, the French Multinational Utility company, we are teaming with sales force and velocity, which we have a minority investment on a global unified CRM platform for more than 15,000 employees. The new platform gives Engie a common intelligent view of its customers across more than 70 countries and empowers employees to strengthen customer relationships and provide personalized recommendations to support Engie’s new zero-carbon transition strategy for the Fortune Global 500. In Italy we are collaborating with Snam, which operates the largest gas transmission network in Europe, to identify Internet-of-Things technologies on the Microsoft Azure platform, leveraging connected devices, as well as machine learning, artificial intelligence and advanced analytics to optimize the monitoring and maintenance of energy infrastructure to make it smarter and more sustainable, as well as more efficient. In the United States we are working with Southern Company, the gas and electric utilities, which is building the first new nuclear reactor in the U.S. in 30-years. Partnering with Southern Company, Accenture built the new cloud-based construction work management system on the Amazon GovCloud platform from scratch in just six months. This enabled Southern Company to expand and accelerate plant construction as it strives to bring this clean carbon-free energy production online for 500,000 homes and businesses. Let me pause for a moment and take a step back. Each of these examples demonstrates the power of our unique business model, which spans services from strategy to operations, with digital and technology at the core. This enables us to create the multidisciplinary teams that are needed to not just create a vision of transformation, but to execute and scale and give our clients the confidence that they will achieve real value. If you think about the environment our clients are navigating, unprecedented change, the need for speed and major investments to drive their enterprise transformation, our unique model and capabilities give us an incredible competitive advantage to be the partner of choice for the world's leading companies. Now, let me turn to Accenture’s greatest and undeniable strength, which is our people. During the first quarter the number of Accenture people surpassed 500,000, a significant milestone. I want to thank each and every one of them for their incredible commitment and dedication to serving our clients. As always, we continue to strengthen our leadership team, which now includes more than 8,000 Managing Directors. I was delighted that earlier this month we promoted 787 new Managing Directors and Senior Managing Directors, including a record 260 new women Managing Directors, accounting for 36% of the promotions to this level. And before I turn it back to KC, I just want to mention some of the great recognition we have recently received for our long-term success and cutting-edge capabilities. We are especially proud that Droga5, which joined Accenture Interactive last April was named Agency of the Decade by Adweek, which characterize Droga5 as a dominating creative force. Interbrand ranked Accenture number 31% on its list of top global brands, our highest ranking ever. Our brand value increased 14% for the second year in a row, and I want to recognize Amy Fuller, our Chief Marketing Officer, her team and all our people for this great work to continually strengthen the Accenture brands. With that, I will turn it over to KC to provide our updated fiscal ‘20 business outlook. KC?"
},
{
"speaker": "KC McClure",
"text": "Thanks Julie. Now let me turn to our business outlook. For the second quarter of fiscal ‘20 we expect revenues to be in the range of $10.85 billion to $11.15 billion. This assumes the impact of FX will be about negative 1% compared to the second-quarter fiscal ‘19 and reflects an estimated 5% to 8% growth in local currency. For the full fiscal year ’20, based on how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our result in U.S. dollars, will be approximately negative 1% compared to fiscal ‘19. But for the full fiscal ‘20 we now expect our revenue to be in the range of 6% to 8% growth in local currency over fiscal ‘19. For operating margin we continue to expect fiscal year ‘20 to be 14.7% to 14.9%, a 10 to 30 basis-point expansion over fiscal ‘19 results. We continue to expect our annual effective tax rate to be in the range of 23.5% to 25.5%. This compares to an effective tax rate of 22.5% in fiscal ‘19. For earnings per share, we now expect full-year diluted EPS for fiscal ‘20 to be in the range of $7.66 to $7.84 or 4% to 7% growth over fiscal ‘19 results. For fiscal ‘20 we continue to expect operating cash flow to be in the range of $6.35 billion to $6.75 billion; property and equipment additions to be approximately $650 million and free cash flow to be in the range of $5.7 billion to $6.1 billion. Finally, we continue to expect to return at least $4.8 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so we can take your questions. Angie?"
},
{
"speaker": "Angie Park",
"text": "Thanks KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask the question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions]. Your first question comes from the line of Lisa Ellis from Moffett Nathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Hi, good morning guys and happy holidays! I just wanted to ask a question on acquisitions. I think KC you mentioned you are expecting to spend up to about $1.6 billion on acquisitions this year. Can you just give a little bit more color on the expected contribution to revenue growth this year from acquisitions and then also what you're, you know what your focus areas are for M&A? Thank you."
},
{
"speaker": "KC McClure",
"text": "Yes, sure. So happy holidays to you to Lisa. In terms of our expected contribution to revenue in full fiscal year ‘20 from inorganic, we continue to expect it to be about 2%, which was in line of what we also had last year. And in terms of focus areas, I’m going to hand it over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Great! Let me give you a color. So happy holiday to you too Lisa and thanks for joining us. So our acquisition strategy continues to be centered really around three focused sales – focus areas. The first is scaling in the hot skill areas where we see a big market opportunity. The second is continuing to add skills and capabilities in The New. And then the third is deepening our industry and functional expertise. And as you might imagine, acquisitions don't always fit exactly into one of those three; they often cross those. So let me just give you like a little bit of sense of just the three that we just announced in the last few months. So if you start in the U.S., we announced that we're buying, we're acquiring Clarity Insights, which is a leading provider of data science and applied intelligence capabilities. They are very focused on three industries; Healthcare and Financial – banking capital markets and insurance, which are priority areas for us globally and in particular in the U.S. And at the same time they bring with them accelerators that will help us bring more speed to value for our clients, and they are focused on one of our most important markets, so they are helping us scale where we already have scale, but it's a very hot area in Applied Intelligence, because it really crosses our services. Then if you move around the world and go to Europe, Silveo which we announced and expect to close actually just in a couple of days which is headquartered in London, they are a company that's focused on supply chain and manufacturing and particularly solutions on SAP and Dassault Systems which are both important partners. And so they are very much a part of our industry X.O strategy and at the same time providing scale and functional expertise in core areas for us; SAP, Dassault Systems and supply chain. And then if you move again around the world to China, where I was just there a few weeks ago, we're really excited about future move automotive. I actually spent a few hours there myself, really touching and feeling the work that they're doing and they are digital and mobility service provider for the automotive industry in China, incredibly advanced right, working with leading automakers there and what's so exciting is not only does this acquisition help us really partner with our clients in China, but they are advanced services and what they are doing with the connected car is something we’ll be able to leverage and bring as innovation all around the world, because we have important clients who are not only operating in China, but in the U.S. and Europe. And so that just sort of gives you a flavor and as you can probably tell, I'm so enthusiastic about what our team is delivering here, because it's very much targeted on making an impact close to clients in our markets around the world, but also bringing us skills that we can leverage around the world."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific! Thank you. And then maybe just for my follow-up, I know this is the time of year you are in a lot of discussions with clients around your 2020 programs with them. What are you seeing that's going to be different about 2020 in terms of the types of work you are doing with clients compared to 2019? Thanks."
},
{
"speaker": "Julie Sweet",
"text": "It's very much more of the same in the sense of enterprise-wide transformation and then a focus on innovation, particularly around the growth agenda, and then continuing to optimize operations, and that really, that's been the theme and it continues to be the theme. In fact, I think since September 1 I've met with over 100 C-suite executives, and I'm very confident of – that we have a pulse on the demand and that we have the capabilities they need."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Joseph Foresi from Cantor Fitzgerald. Please go ahead."
},
{
"speaker": "Joseph Foresi",
"text": "Hi! I wondered if we could talk about the cadence on bookings. I know that we’ve – and you said many times in the past that it can be lumpy. We saw it a little bit light ending I guess this quarter. So maybe you could talk about how you see the cadence and what we should expect from a seasonality perspective."
},
{
"speaker": "KC McClure",
"text": "Yes sure. Hey Jos, thanks for joining. Yes, so you're right, you've heard us talk about – and you know us very well. You know that our history of bookings, you do see lumpiness. And I think really the most important thing and that's within that is that we're very pleased with the demand for our services in the marketplace, and if you think about that in the backdrop of bookings. So we're coming off a quarter, Q4, which was our records bookings quarter, and that was a record by more than $1 billion. We had strong bookings that came in the range that we expected in quarter one, right, and we talked about that last quarter. We tend to have it seasonally, lower quarter in one, so again this met our expectations, and that very importantly we have a strong pipeline and we see strong bookings in quarter two. And I think the other part of demand that's important, and you saw this in our results in the first quarter as well, is that we have broad-based demand in our revenue, right, and we far exceeded the upper end of our guidance by more than $160 million. So you would see that bookings demand – you see the demand in the market coming through our bookings, both in terms of what we've done last quarter, bookings coming in the range that we expected this quarter, a strong pipeline with strong bookings expected in quarter two, as well as broad-based, over-delivery of our expected range in the first quarter in revenue, which allowed us to increase our revenue range for the year."
},
{
"speaker": "Joseph Foresi",
"text": "Got it. And then maybe you could talk a little bit about your expectations from a demand perspective across the verticals and the geographies. I’m particularly interested in Financial Services and what's going on with the European banks, but any color you know from a very high level across those geos and verticals would be very helpful? And happy holidays as well."
},
{
"speaker": "Julie Sweet",
"text": "Hi Joe, this is Julie. Happy holidays! So maybe just kind of going across, let me just start with Financial Services, right. So on the Financial Services side, as you say Europe continues to be a challenging market in the industry and for us, and so we expect that we're going to continue to face challenges there, particularly in the UKI right. But overall our Financial Services business, if you look at North America and the growth markets, you know it remains robust, right. But we continue to expect challenges in Europe. If you just look at – take it up a little [ph] across the dimensions of our business and our industries, North America delivered very strong results. We are seeing continued momentum there. We have a very strong business in Europe, and so while we've got pockets of pressure in Financial Services and the other area I would call out in Europe is we have seen pressure in industry and automotive. But otherwise Europe remains a strong business, and in fact 12 out of 13 of our industries this quarter had positive growth. And then the growth markets keep being strong really across-the-board. The only other place of pressure that I would call out was in North America, we did also see not surprisingly some pressure in industry and automotive."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-tsin Huang",
"text": "Thanks, good morning. Good revenue acceleration here. I wanted to first ask on gross margin expansion. Actually it's one of the largest increases we've seen in some time looking at the model here. Would you attribute that large expansion to and then same thing on SG&A, that spend was up, can we assume that that's driving some prospecting and deal pursuit costs given your positive comments on bookings?"
},
{
"speaker": "KC McClure",
"text": "Yeah, so thanks for the question and hello Tien-tsin. In terms of how we look at our business as you all know, we first always start with looking at operating margin, and because the way our payroll costs works as you well know Tien-tsin, based on the activities that we have people doing from quarter-to-quarter and the demand that we see in the marketplace, you can see differences in the different segments of our income statement. So as it relates to the gross margin increase this quarter, it is tied to the sales and market, what's happening in sales and marketing, where we have more people out working our pipeline. So that will help our gross margin, and then you'll see the offsetting impact in sales and marketing. And you're right, that does tie in to the statements we've made of having – continuing to have a very strong pipeline."
},
{
"speaker": "Tien-tsin Huang",
"text": "Okay. No, that’s helpful. KC, real quick if you don’t mind. Just on the consulting revenue growth, that has been improving here and I guess widening the gap to your consulting bookings growth or pattern. What explains the faster conversion? Thanks for the second question, I appreciate it."
},
{
"speaker": "A - KC McClure",
"text": "Yes, so we really haven't seen any change in conversion Tien-tsin of our overall bookings, just overall to revenue. You know that can be within a range and that can vary. So as we look at what we've done in consulting bookings, we feel very good with our bookings for the quarter, as well as our pipeline, and see also strong bookings in quarter two as well in consulting. Then if you look at what our – production of our bookings in relation to revenue, you know we look at that over a prolonged period of time, and so we're still in the zone that we like, which is a book-to-bill ratio of about one point."
},
{
"speaker": "A - Julie Sweet",
"text": "Yes, and Tien-Tsin hi. Hello! Nice to talk to you. And I would say, you know as we talked about last quarter, you know from the revenue side we are very pleased with mid-to-high single-digit growth and you're going to have some quarters here in mid, you have some quarters here in the high-growth, that's the zone we want to be in, because the context for our strategy and consulting business, you need to look at it in the context of our overall business. You know big drivers of growth are the fact that we can bring together these multi-disciplinary teams to drive enterprise-wide transformations, right. That is our huge competitive advantage. It's the demand that we see in the market, right, and it's our ability to actually go from strategy to operations, to feel these teams that really is what drives big growth in our business and of course that at the core we've got the digital and technology. So we look at our strategy and consulting business in the context of the needs we are trying to fulfill for our clients, which are very much around these multidisciplinary teams that span our services, which frankly nobody else can do, right, at our scale."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Darrin Peller from Wolfe Research. Please go ahead."
},
{
"speaker": "Darrin Peller",
"text": "Thanks guys. You know it's amazing to see the headcount, where it is right now, and so if you could just quickly comment on you know your thoughts on talent management and going forward from this kind of a level, your ability to hire what you need, what you've always been obviously extremely strong at, and then maybe just comment on the linearity and the model now; maybe looking forward given where you are around the new and the type of revenue?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. I mean maybe just to start with, you know our philosophy right around people and size, because you know every time we hit a milestone, it's always ‘can you keep doing it? Are you able to get the people?’ and so first of all our philosophy is that we can continue to grow in size as long as what our people are doing is the high-value work that drives our financial objectives, right, and so we're very focused on what our people are doing versus how many people we have, because the size part of it is about our ability to manage and we're really good at that, right. Like over the years we've made the adjustments, we've done the things we need to do to focus on our clients and our people, and so the big focus for us is on what our people are doing, which ties to the demand that we see in the market, right. We are early innings of digital transformation, enterprise-wide transformation. We are constantly seeing new emerging tech. You know for example, we're doing some great work with [Inaudible] Japan where we're putting in one of the most significant early examples of using block-chain to drive their business or creating a platform that allows their customers to access other financial products. That's very new cutting-edge, right, we're still at the beginning. So we see the demand for these new high-value services still quite early. Then you look at the model itself. We don't see the model today as being linear. I mean one of the things that people often talk about is well, you’re continuing to grow. But underneath that is we've been automating; we've been using people and their talents differently. I mean we often talk about the automation in our operations business where there, we actually didn't let people go. We automated and then up-skilled them to do the higher-value work, but not just in operations, but if you look at our other assets. So we are constantly – we don't have a linear model today, because we are constantly doing what we're doing for our clients, is leveraging technology to change the mixture of how we are using tech and our people to again continue to focus on the higher-value services, and so you know we are – and hopefully that gives you kind of the color for how we think about our model."
},
{
"speaker": "Darrin Peller",
"text": "Yeah, no that is helpful. Just a quick follow-up is on pricing. I mean again, it seems like as you've trained your people to do the higher part of the food chain, you are able to pass that through. Any changes on that pattern or has pricing held up, just given competition has also picked up for digital. Thanks guys."
},
{
"speaker": "KC McClure",
"text": "Yeah, so pricing – you know the environment for pricing remains competitive, right, and that's always the nature of the work that we do. Now within that, we are able to see pricing differentiation in areas where we're differentiated, where we've invested, and we do continue to see that we have pricing improvement in some areas of our business continuing in this quarter. It’s a constant focus for us and that really is the key part of – the key first lever to really driving our margin expansion pricing. So we are always – we always have been and will always continue to be focused on driving pricing that's the right value for the client and for Accenture."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Harshita Rawat from Bernstein. Please go ahead."
},
{
"speaker": "Harshita Rawat",
"text": "Hi, good morning. Thank you for taking my question. I want to ask about industry X.O. It's a relatively new business for you and somewhat early innings, so can you talk about the journey in Interactive which was a new business for many, many years ago and now a huge revenue contributor. So can you talk about that journey, the lessons there and how you plan to go about scaling Industry X.O. Thank you."
},
{
"speaker": "A - Julie Sweet",
"text": "Thanks Harshita, that's a great question, and we often you know internally talk about the analogies, because you'll remember with Accenture Interactive, that growth came from a mixture of both, inorganic and organic, and very much fueled though by the power of Accenture. So even as we were bringing in, as we've been bringing in skills and capabilities that we didn't have traditionally like a Droga5 and before them Monkeys and Kalorama [ph], these creative agencies, the value proposition for our clients is to take these other capabilities and pair them with the traditional strengths of Accenture for example on building digital platforms, and that is what has been able to drive the growth in Accenture Interactive. And as we look at Industry X.O, this is an opportunity for us to serve areas of the company that we serve today, but not as much at scale. Just like with Accenture Interactive we weren't as relevant to the CMO as we are today. Once we've built Accenture Interactive as well as you know new business creation and Industry X.O. Well, of course we have served and we have practiced, you know still significant practices in manufacturing and supply chain, Industry X.O is really about the digitization of manufacturing, the creation of connective products, and then also these digital platforms and engineering around the software. And while again we're in – just like Accenture Interactive when we began were in parts of these, what we're doing is we're adding the complementary skills that will allow us to take the power of Accenture and really scale and bring all of that to our clients who themselves are going through a whole change, because manufacturing is now being digitizing and it's the convergence of IT with operating technology, and we expect to grow Industry X.O as we have with Accenture Interactive through a combination of organic and inorganic. So you saw us last year buy companies like Mindtribe and Pillar in the U.S., which are all about connected products. We saw the future move acquisition I just mentioned in China, which is about automotive and Connected Services; Silveo in London, which is just the recent, and that's really about digitizing, manufacturing, leveraging our ecosystems. But at the same time we're building on the scaled digital and technology capabilities, which is what our clients need to do as we all go through, where we see this transformation to digitize these areas of the company that haven't been digitized in the same way that you have the customer front-end."
},
{
"speaker": "Harshita Rawat",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David Koning from Baird. Please go ahead."
},
{
"speaker": "David Koning",
"text": "Maybe my first question, just when we look back at some of the metrics you've given around The New you know in the percent of total revenue and we go back a couple of years, it looks like that was drilling 20% to 30% and some of the legacy was declining maybe low double. Today it looks like The New might be growing low-to-mid teens and legacy has actually kind of improved to maybe slightly declining. I’m just wondering that pace of change, you know what might be driving that and if that's even the right way to think about it."
},
{
"speaker": "KC McClure",
"text": "Yeah, hi Dave. So in terms of looking at The New, I think really what you're touching on is the growth rates that we've had over the last few years and we continue to have very strong growth rates in The New. And as you look at that scale right of our business, I mean you would anticipate that even very strong growth rates would slow a bit, but again be very strong just based on scale. And if you look at the other portion of our business, let's call it the non-New or the core, we continue to see that that is stabilizing; it's been decreasing at about a mid-single digit rate and that's by design, that's our strategy, but it's been pretty consistent over the last few quarters."
},
{
"speaker": "David Koning",
"text": "Great, thanks! And just one quick follow-up just on accounting. There was another income line in Q1 that was about $11 million positive this quarter. Last year that line was about $25 million to $35 million negative all through the year. Was there a one-time item in Q1 and does that more normalize the rest of the year."
},
{
"speaker": "KC McClure",
"text": "Yeah, so we did have this quarter a small benefit below operating income where we had, we indeed do have non-operating income this quarter as opposed to what you saw in quarter one of last year, which was non-operating expense. So as a reminder last year, we adopted a new revenue - a new accounting standard that require that we marked our investments to fair market value, and while we don't have a large investment portfolio, what you will see Dave from time-to-time that may cause a little bit more variability in what we have a non-operating income and non-operating expense. In this quarter we did have a gain in non-operating income on some of our investments and that was offset by some FX losses as well, but it was a net gain this quarter in non-operating areas and it will fluctuate probably slightly more than it has in the past, really just because of that accounting change."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hi guys, good morning. Just wanted to ask about the beat and the upside surprise. For you guys was it in consulting in particular, because I know a lot of investors were concerned consulting was weakening and actually it strengthened. So just trying to figure out if that also surprised you guys or was there something else that created the upside."
},
{
"speaker": "KC McClure",
"text": "Yeah, so we were really pleased overall with our revenue growth rate for this quarter Bryan, and obviously at 9% growth, which was as you mentioned a beat, $160 million higher than we expected. But the other thing that we were very pleased with is the fact that it was also a broad-based over-delivery. Now if I had to point out two areas in particular, I'd point to health and public service, particularly in North America, which was strong both in the health, industry, as well in the public sector industry and that's a statement overall for North America including our federal practice. And then also products that continue to have very good [ph] in life sciences, as well as consumer goods, retail and travel. And so what you'll see is that we do and we continue to expect Bryan that we will have for the full-year consulting in the mid-to-high single-digits growth and outsourcing also in the mid to high single growth rate."
},
{
"speaker": "Julie Sweet",
"text": "Yes, and Bryan I would just add – this is Julie, that again as I talked about earlier, although obviously we look at strategy and consulting, tech services and operations separately and report on that, you know remember that our focus really has been because of the demand we see in the market, on our unique business model that brings these services together, and so it's not so much. You know you can't really – for us the way we manage our business, it's not that wait, there's a big surprise in strategy consulting, because KC's giving the answer around industries and clients because a lot of our work is actually bringing all of these services together to meet the needs we're seeing in the market. And so while we do report this to give you that insight into the types of work, when we are thinking about what's happening it's much more focused, it is only focused on clients, what are their needs, and how are we bringing these services together. And that really is the power of Accenture, is that we're able to bring these services together. And if you think about what our clients need right now, I mean as I said, I literally in the last four months, almost four months spent time with over a 100 C-Suite executives and top of mind for them is the importance of making sure they are going to get value. And that's why they want to partner with us, is because we're bringing the teams and we're able to really give them confidence in outcomes and we're able to point to the execution we've done with other clients and demonstrate the value, and that we're bringing that learning. And I think particularly as we see this inflection in the marketplace, moving from pilots and use cases to this enterprise-wide transformation, multiyear programs, it's more important than ever that we're able to bring these services together for our clients."
},
{
"speaker": "Bryan Keane",
"text": "That's helpful and just as a follow-up on Europe, it was up 7% constant currency; I think that's up from four last quarter. Again a lot of investor concern around Europe, but you guys are showing an acceleration there. You talked about I think 12 of 13 industries showed improvement. So I guess I'm a little surprised to hear about that improvement. Can you just talk about broadly what's going on in Europe and why you are seeing that improvement?"
},
{
"speaker": "KC McClure",
"text": "Yeah, and I will maybe just reiterate a couple of the points, and some of that you also mentioned. So we were pleased with our business in Europe this quarter and we did have broad-based growth and it wasn't 12 of the 13 industries. And importantly it was high single to double-digit growth and nine out of that 13, and so that's really important to us, and that's something that we're very focused on and we're very proud of, the overall broad-based nature of our business in Europe and the diversity that we have. Then I think you'll see it has been and continues to provide some durability in that market. Now as we've mentioned, you know we do continue to have a focus on banking capital markets in Europe and that's particularly in the UK. So we do have some more work to do in that area, and as also as Julie mentioned, we do have some pressure in industrials and the automotive as well in Europe. But I just would point back to the double-digit growth that we Italy, Germany and Ireland as well. And so we're very focused on continuing in that market to drive the transformation that Julie was talking about, the she sees and talks with all the C-Suite about in her travels throughout the world."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Julie you mentioned Droga5, I’m going to take you up on that one. Obviously Accenture spent many years growing the various parts of that business, steadily expanding from the technology part creative. Droga5 recently won The Kimberly-Clark Childcare account and based on our checks, you are increasingly going head on with the traditional agencies for what I'd call the whole shooting match. Can you speak to what you're seeing there specifically and whether you think your missing any pieces, so you could go when full accounts end-to-end what the traction you currently have there is?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. Well, Kimberly-Clark is a great example of what we see is the demand in the market, which is for a company to bring together not only world-class creative, but the digital capabilities, as well as the advisory capabilities to truly transform the customer experience, right. And you’ll hear that term now a lot. We believe we're the only company today that actually has all of the capabilities that are needed in order to deliver a very different customer experience. And so while I know you think of it as going up straight against the agencies, what we think about it is what the clients are looking for is not just the creative agency and you see that in the industry as the industry, the broader creative industry is also expanding into these capabilities. The fact of the matter is very difficult to have creative, it's equally difficult to have depth and breadth in the digital and technology capabilities that our clients need, and so we believe that our competitive advantage here is to have such strong creative capabilities coupled with, like just unparalleled digital and technology capabilities at a huge scale in every major market. Because remember Accenture Interactive, we have built around the world, right, and we've got it – you know and I was in the studios in China, we have it in Australia, across Europe, as well as the U,S. So we're extremely proud of the work that Accenture Interactive under the leadership of Bryan Whipple, but his entire team have done, that its powered by the rest of Accenture, right, all of these skills and capabilities. That is very hard for anyone to replicate in our view."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Got it, makes sense. The second question is, you mentioned the incremental elements of nonlinearity in the model in the prior question on headcount and revenue growth. What's the longer-term impact on margins and cash flow; if I can extend that question to those metrics?"
},
{
"speaker": "KC McClure",
"text": "So Ashwin, in terms of how we think about those two elements, right. In terms of margin, I think it's important to just point out that we always continue to look for modest margin expansion. But more importantly to us is that we're doing more than just the modest margin expansion as you well know that goes to our bottom line. We are doing more underlying margin expansion, so that we can invest at scale in our people and in our business for long-term market leadership, so that's a key part. And on free cash flow, you know that continues to be – you know there's no change there. I mean this year you’ll see that we managed that part of our business by looking at free cash flow to net income ratio, right, and this year again it's 1.1% to 1.2%. And as you think about that, while I won't guide for that long term, you know strong free cash flow will continue to be an anchor of how we run Accenture."
},
{
"speaker": "Angie Park",
"text": "Okay, and operator we have time for one more question and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Okay. Your final question comes from the line of Bryan Bergin from Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, good morning, thank you. I wanted to ask a question on how the mix of your client counterparts have changed. So if we think about enterprise budgets, can you give me a sense of how your revenue stream currently maps across an organization, whether it's CIO or the CMO budget or like board-level initiatives. And the reason I ask this, we’ve diversified the business so much over the last several years. I'm just really curious how this has evolved and how you really are mapping across the various budgets now today?"
},
{
"speaker": "KC McClure",
"text": "Well, I guess what I'd say is, if you think about what we're doing with respect to, you know for example Accenture Interactive, that work is almost always a combination of marketing plus-CIO, often plus the business units right, because the work is not – you know really is around customer experience and so where the budget sits really varies by company, and some companies you'll have budget sit with the Chief Digital Officer right. So what we – our focus is less on the specific budgets and more how are we serving the different needs of the enterprise. So if you just – and remember we go back to really – we think about it in three things; building the digital core, so 40% of our business growing double-digit today is in our intelligent platform services our five big platforms, because that's all about next-gen platforms right. Similarly our cloud business is there. Then we have the optimizing operations, so you've got a $6 billion scaled business growing high single-digit to double-digit, right, which is all about optimizing and making sure that within the functions, as well as industries they've got access to the best technologies in a most efficient way. And then on top of that you have the growth agenda like Accenture Interactive which is $10 billion. We announced last quarter with strong growth, as well as the new areas like connected products and services. And so we continue to focus – our big next focus area is Industry X.O, which is growing on our historic work and manufacturing and supply chain to the new and really going after that part of the enterprise along with the market, because that's not digitized as fast to say customer experience and that's really how we think about the business."
},
{
"speaker": "Bryan Bergin",
"text": "Okay, that's helpful. And then just lastly, I heard your inorganic 2% you expect for fiscal ’20, was that close for that in 1Q as well? And happy holidays!"
},
{
"speaker": "KC McClure",
"text": "Yeah, Happy holidays to you too Bryan. I mean we look at that over a full year. So I would say you know 2% inorganic for the full-year is the number that I would continue to focus on."
},
{
"speaker": "Julie Sweet",
"text": "Okay, thanks Bryan. So thanks everyone again for joining us on today's call. We are very pleased with our strong start in fiscal ‘20 as you've just heard and we are well-positioned to achieve our updated business outlook for the year. We will stay laser-focused on continuing our current momentum, capturing the opportunities in the marketplace and creating value for our clients and all of our stakeholders. I want to wish you all, our investors and analysts and everyone at Accenture and your families all the best for the New Year. And finally, I want to thank each of our people around the world, you are what makes Accenture unique and special. I will see everyone on the road."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T executive teleconference. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 4 | 2,021 | 2021-09-23 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to the Accenture Fourth Quarter Fiscal 2021 Earnings Conference Call. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] And as a reminder, today's call is being recorded. I would now like to turn the conference over to our host, Angie Park, Managing Director and Head of Investor Relations. Please go ahead.
Angie Park: Thank you, operator, and thanks, everyone, for joining us today on our fourth quarter and full fiscal 2021 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director and Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for both the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the first quarter and full fiscal year 2022. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today we will reference certain non-GAAP financial metrics, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our Web site at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Angie, and everyone, for joining us. Before diving into our results, thank you to our 624,000 incredibly talented people around the world, including over 8,500 managing directors. This past fiscal year, your hard work and dedication to creating value that matters for our clients was unwavering, despite the ongoing and sometimes quite extreme challenges of COVID. We've had a truly extraordinary year, as reflected in our outstanding financial results and in the 360 degree value we delivered beyond our financials. From the over 120,000 promotions and over 31 million training hours, an increase of 43% for our people, to increasing our workforce by approximately 118,000 people, creating significant employment opportunities in our communities, to achieving 46% women on our way to our goal of gender parity by 2025, to our top three ranking in the Refinitiv Global Diversity and Inclusion Index, for the fourth consecutive year. To the number one position with our largest ecosystem partners, to the exciting accomplishment of 50% renewable energy now powering our offices and centers globally, to the donation of $54 million in COVID surge relief. In December, we will publish our first ever annual 360 degree value report to more fully describe the FY'21 value we created in all directions and we’ll report against three additional key ESG frameworks: SASB, TCFD, and WEF/IBC. We believe that the trust we have from our clients and partners, our continuous innovation, and our ability to consistently attract the best people, including the 56,000 net new hires this past quarter, are directly linked to our commitment to measuring our success by how well we create this 360 degree value for all our stakeholders, clients, people, partners, shareholders, and communities, and on our culture of shared success. Here are some key financial highlights of the year, which position us strongly as we begin FY'22. FY'21 demonstrated our leadership in helping our clients achieve compressed transformation, with 72 clients with bookings greater than $100 million compared to 53 last year and 229 diamond clients, our largest client relationships compared to 216 last year. With a 20% increase in bookings to $59 billion, we have strong momentum across all dimensions of our business across geographic markets, industries, and services. Reaching revenues of $50.5 billion, a significant milestone, representing 11% growth, we added $6.2 billion in revenue this year, gaining significant market share with 40 basis points of operating margin expansion, demonstrating, yet again, our ability to grow profitably and at scale. We achieved this profitable growth while investing at a higher level than ever before, with $4.2 billion in acquisitions; $1.1 billion in R&D in assets, platforms, and industry solutions, including growing our portfolio of patents and pending patents to more than 8,200; and total training investment of $900 million. And according to BrandZ, our brand value increased 56% to over $64 billion, ranking us number 27 on the prestigious BrandZ's Top 100 Most Valuable Global Brands list. Finally, I want to highlight cloud and our ability to move with agility to serve our clients' needs and capture momentum in the market. At the beginning of FY'21, after investing in cloud for a decade, we saw that the pandemic would dramatically accelerate our clients' move to the cloud. More than technology, the move to the cloud would be about the adoption of a new operating system for future enterprise, a dynamic continuum of capabilities from public to edge to everything in between, opening up radically new ways for companies to work, compete, and drive value. Just over one year ago, we created Accenture Cloud First to capitalize on this momentum, bringing together all of our capabilities from migration to cloud-native development, data AI, industry talent, and change. Accenture Cloud First was the biggest driver of our overall cloud business growth from $12 billion to $18 billion, a 44% increase. KC, over to you.
KC McClure: Thank you, Julie, and thanks to all of you for joining us on today's call. We were very pleased with our results in the fourth quarter, which completes an outstanding year for Accenture and reflect broad-based momentum across all dimensions of our business. Once again, our results reflect our relentless focus to deliver across our three key imperatives for driving superior stakeholder value. So, let me begin by summarizing a few of the highlights of the quarter. Revenue growth of 21% in local currency, at the top end of our guided range, reflects double-digit growth across all markets, all industry groups, and all services. We also continue to extend our leadership position at an accelerated pace, with growth significantly above the market. Operating margin was 14.6%, an increase of 30 basis points for the quarter, reflecting 40 basis points of expansion for the full-year. We delivered this expansion while investing significantly in our business and in our people to position us for long-term market leadership. We delivered very strong EPS of $2.20, which represents 29% growth, compared to adjusted EPS last year. And finally, we delivered free cash flow of $2.2 billion, which was driven by continued strong growth and profitability. Now, let me turn to some of the details. New bookings were $15 billion for the quarter, with a book-to-bill of 1.1. Consulting bookings were $8 billion, with a book-to-bill of 1.1. Outsourcing bookings were $7.1 billion, with a book-to-bill of 1.2. We were very pleased with our new bookings, which represent 7% growth in U.S. dollars, with 18 clients with bookings over $100 million. We were also pleased with the strength of bookings across all services, with a book-to-bill of 1 in strategy and consulting, 1.2 in technology services, and 1.1 in operations. Turning now to revenues. Revenues for the quarter were $13.4 billion, a 24% increase in U.S. dollars and 21% in local currency, slightly above our FX-adjusted range as the FX tailwind was 3% compared to the 4% estimated last quarter. Consulting revenues for the quarter were $7.3 billion, up 29% in U.S. dollars and 25% in local currency. Outsourcing revenues were $6.1 billion, up 19% in U.S. dollars, and 16% in local currency. Taking a closer look at our service dimensions, strategy and consulting, technology services, and operations, all grew very strong double digits. Turning to our geographic markets, in North America, revenue was 22% in local currency, driven by double-digit growth in consumer goods, retail and travel services, software and platforms, and public service. In Europe, revenues grew 18% in local currency, led by double-digit growth in consumer goods retail and travel services, industrial, and banking and capital markets. Looking closer at the countries, Europe was driven by double-digit growth in the U.K., Germany, France, and Italy. In growth markets, we delivered 21% revenue growth in local currency, driven by double-digit growth in consumer goods, retail, and travel services, banking and capital markets, and high-tech. From a country perspective, growth markets was led by double-digit growth in Japan, Australia, and Brazil. Moving down the income statement, gross margin for the quarter was 33.3%, compared with 31.8% for the same period last year. Sales and marketing expense for the quarter was 11.3%, compared with 10.6% for the fourth quarter, last year. General administrative expense was 7.4%, compared to 6.8% for the same quarter last year. Our operating income was $2 billion in the fourth quarter, reflecting a 14.6% operating margin, up 30 basis points compared with Q4, last year. As a reminder, in Q4, last year, we recorded an investment gain that impacted our tax rate and increased EPS by $0.29 for the quarter. The following comparisons exclude this impact, and reflect adjusted results. Our effective tax rate for the quarter was 25%, compared with an adjusted effective tax rate of 28.4% for the fourth quarter last year. Diluted earnings per share were $2.20 compared with adjusted EPS of $1.70 in the fourth quarter last year. Days service outstanding were 38 days compared to 36 days last quarter and 35 days in the fourth quarter of last year. Free cash flow for the quarter was $2.2 billion, resulting from cash generated by operating activities of $2.4 billion net of property and equipment additions of $236 million. Our cash balance at August 31 was $8.2 billion, compared with $8.4 billion at August 31 last year with regards to our ongoing objective to return cash to shareholders. In the fourth quarter, we repurchased or redeemed 3 million shares for $915 million at an average price of $305.61 per share. Also in August, we paid our fourth quarterly cash dividends of $0.88 per share, for total of $558 million and our Board of Directors declared a quarterly cash dividend of $0.97 per share to be paid on November 15, a 10% increase over last year and approved $3 billion of additional share repurchase authority. Now, I would like to take a moment to summarize our outstanding year. We're extremely pleased with the performance of our business in fiscal year '21, greatly exceeding all aspects of our original outlook that we provided last September, we delivered $59 billion in new bookings, a 20% increase in U.S. dollars over last year, which positions us well as we begin fiscal year '22. Revenues increased a record $6.2 billion, hitting the $50 billion mark, reflecting growth of 11% in local currency for the full-year. This result which is more than double the revenue growth we anticipated at the beginning of the year showcases our agility and ability to quickly scale to deliver value and outcomes for our clients. Operating margin of 15.1% reflected a 40 basis point expansion over fiscal year '20 above the top-end of our original guided range, even after making continued significant investments in our business and our people. Adjusted earnings per share were $8.80, reflecting 80% growth over adjusted FY'20 EPS and was well above our revenue growth. As a reminder, we adjusted earnings in both years to exclude gains on an investment. Free cash flow of $8.4 billion was significantly above our original guided range, reflecting a free cash flow to net income ratio of 1.5 driven by strong profitability. And finally, we significantly exceeded our original guidance for capital allocation by returning $5.9 billion of cash to shareholders, while investing roughly $4.2 billion across 46 acquisitions to acquire critical skills and capabilities in strategic high growth areas of the market. So, again, FY'21 was truly an outstanding year. Momentum continues into fiscal '22 and we're laser focused on capturing the market opportunities, coupled with a disciplined execution that you and we expect of us. Now, let me turn it back to Julie.
Julie Sweet: Thanks, KC. Turning to the demand environment, compressed transformation underpinned by cloud and digital continues to drive strong double-digit growth across our business, including for Applied Intelligence, cloud, Industry X, Intelligent operations, Interactive, Intelligent platform services, security and transformational change management. Technology is the single biggest driver of change in companies today and the depth, breadth and scale of our technology capabilities across our services is unmatched. We see the demand environment shaping up for FY'22 to be more of the same while digital leaders seeking to widen their competitive advantage, and companies seeking to leapfrog their cloud and digital transformation are driving momentum in our business, the vast majority of companies are early in their transformation. And whether digital leader, leapfrogger, laggard or in between all face multi-year journeys ahead of them because the re-platforming in the cloud and use of new technologies across the enterprise is a once in a digital era profound transformation. Simultaneously, we have ongoing exponential technology change that is accelerating and will create new opportunities, disruptions and change for our clients. In addition, growth in parts of our business are by their very nature continuously evolving. For example, interactive, now a $12.5 billion business growing 15% continue to set a new standard for customer experience, connection, sales, and marketing at the intersection of data, creativity and technology, and is tied to the ever-changing needs and preferences of B2C and B2B customers. Similarly, security, now a $4.4 billion business growing 29% is driven by needs related to an ever expanding digital threat landscape. And with our managed services is providing much needed protection and talent to our clients. Our clients value the depth and breadth of our services for the entire enterprise across strategy and consulting, interactive technology and operations and industry and functional expertise across 13 industries. Plus the ability to deliver tangible outcomes as well as our strong track record of investing ahead of our clients to anticipate their needs and drive our next ways of growth such as our early moves in digital cloud and security. There remain entire parts of the enterprise. So, which digitization and the move to the cloud has only just begun. In particular, both the things companies make and the way they make things are being dramatically changed by technology. And that is the focus of our Industry X business, which we believe is the next big digital frontier. In fact, a 2021 Gartner survey, a Board of Directors indicates that 93% expect that the number one business priority that will see transformational improvement from digital technology is manufacturing, distribution, and supply chain. We have invested for nearly a decade in Industry X and are now at approximately $5 billion in revenue growing 36%. We look forward to welcoming the 4,200 industry leading engineers and consultants of Umlaut when the acquisition closes in October. Similarly, sustainability is a critical area for which technology is still evolving. We believe that every business must be a sustainable business, and yet companies are at very early stages of figuring out how to make this shift. Last year, building on years of investment and experience, we've launched our sustainability services under our new Chief Responsibility Officer and Global Sustainability Services Lead. We have continued to accelerate our focus in this expanding and changing market, and are proud of the work we are doing with leading partners like MasterCard, as we enhance its ability to track and analyze the carbon emissions of their suppliers and help de-carbonize the U.K. energy system with clients such as National Grid. We do see a shift in the nature of the demand for our managed services across IT, security and operations with these services emerging as one of our most strategic differentiators as companies simultaneously seek greater resilience, face a war for talent, the need to rapidly digitize and cost pressures, strategic managed services are increasingly a C-suite priority with Accenture as a trusted partner of choice, and increasingly integrated as part of their talent strategy. Table stakes from managed services are efficiency, resiliency, and reliability. We further differentiate in our managed services because they are uniquely informed by our strong strategy and consulting capabilities and deep industry and functional expertise. And they benefit from our strong level of investment for digital platforms like SynOps and myWizard and the seamless integration with our ecosystem partners, as well as due to the incredible pool of talented people our clients can access quickly when partnering with us. For example, we are partnering with Olympus, a leading manufacturer of optical and digital precision technology to help them drive their transformation to become a global medical technology company. As part of this partnership, we have acquired their Japanese IT subsidiary company, which we will transform to deliver significant IT cost savings to Olympus, as well as up-skill their people, combining their knowledge with our talent and technology to lead Olympus's digital transformation. And let me bring to life some more the demand we are seeing. All of these examples bring together the diverse capabilities across Accenture to create tangible value. We are a leader in cloud, because we're able to serve our clients across the cloud continuum and create business value. We are partnering with Kubota, a Japanese multi-national company, providing solutions leveraging a diverse range of products, technologies and services in the fields of food, water and the environment. To accelerate Kubota's digital transformation by creating solutions that will enhance the productivity and safety of food, promote circularity of water resources and waste and improve urban and living environments. We will help create innovative sustainability solutions and a platform applying leading edge digital technologies, including AI and IoT. Diverse data held across the group will be centralized for easy maintenance and use. We're also modernizing replacing our migrating legacy applications to the cloud and strengthening their global computer security incident response team. We are partnering with Jbal, a US-based global manufacturing services company to further enhance their IT infrastructure capabilities through providing infrastructure managed services for digital workplace, network, cloud and data center support. We're helping Senya a finish insurer offering casualty motor and health and accident services to implement a cloud-based policy administration system to improve customer service using data and automation to make sales, claims, payments and policy management processes more user friendly. This will allow the company to quickly respond to changing market and customer demands and meet its goal of providing the best customer experience in the industry. Compressed transformation is occurring across industries. We're partnering with Unilever, one of the world's largest consumer goods companies in their digital transformation. Together, we are setting a new industry standard by reinventing technology delivery with cutting edge automation, delivering cloud migration at scale, the largest ERP migration to the cloud and the industry and shifting to technology solutions that support their growth strategy. With McCormick a global leader in flavor in the food industry, where we're partnering on a strategic transformation program encompassing finance, supply chain logistics and plant maintenance. The new cloud-based platform an innovative data driven approach will help standardize processes, increase efficiencies, and support their goal of doubling in size quickly. We're helping a European financial institution, build the bank of the future and helping them become a next level innovator. One that is leveraging technology and sustainability to transform multiple parts of their business, drive hyper personalized customer experience, and create new lines of business like wealth management and insurance, which is expected to triple digital sales by 2023 and improve their already stellar cost to income ratio. At the same time, we're helping them deliver on their ESG initiatives, including inclusive financing, green software and carbon data free data centers. At Accenture, we're enabling new experience in growth and cost transformation across the enterprise and across industries. And a key enabler to these innovative scaled services is the power of our operations capabilities. We are helping Open Fiber an Italian telecommunications company design and orchestrate construction of an ultra-broadband network, which will deliver fiber to 20 million households across Italy. Digitization and automation will help the construction site to proceed faster and more efficiently. With Interactive, we're helping MediaMarktSaturn Retail Group, Europe's leading consumer electronics retailer transform their digital content capabilities with a state of the art marketing operations. Automation and data insights enabled by synapse will help deliver more engaging and personalized content, while driving millions and savings. Our industry expertise continues to be a core competitive advantage, allowing us to breathe deep industry and cross industry knowledge enterprise wide for our clients. I want to recognize in particular, our software and platform industry, which is approximately $4 billion in revenue. In Q4 this group celebrated 20 consecutive quarters of double-digit growth, serving as a leading partner to our clients in this hyper growth industry. KC, back to you.
KC McClure: Thanks, Julie. Now let me turn to our business outlook. For the first quarter fiscal '22, we expect revenues to be in the range of $13.9 billion to $14.35 billion. This assumes the impact of FX will be about positive 0.5%, compared to the first quarter of fiscal '21, and reflects an estimated 18% to 22% growth of currency. For the full fiscal year '22, based upon how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results, in U.S. dollars, will be approximately negative 0.5% compared to fiscal '21. For the full fiscal '22, we expect our revenue to be in the range of 12% to 15% growth in local currency over fiscal '21, which includes an inorganic contribution of about 5% as we continue to expect to invest about $4 billion in acquisitions. For operating margin, we expect fiscal year '22 to be 15.2% to 15.4%, a 10 to 30 basis point expansion over fiscal '21 results. We expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.1% in fiscal '21. For earnings per share, we expect full-year diluted EPS for fiscal '22 to be in the range of $9.90 to $10.18 or 13% to 16% growth over adjusted fiscal '21 results. For the full fiscal '22, we expect operating cash flow to be in the range of $8.2 billion to $8.7 billion, property and equipment additions to be approximately $700 million, and free cash flow to be in the range of $7.5 billion to $8 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we expect to return at last $6.3 billion through dividends and share repurchases, as we remain committed to returning a substantial portion of cash to our shareholders. With that, let's open it up so that we can take your questions. Angie.
Angie Park: Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you please provide instructions for those on the call?
Operator: Of course. [Operator Instructions] And today, let’s see our first question comes from the line of Keith Bachman of Bank of Montreal. Please go ahead.
Keith Bachman: Hi, many thanks for letting me the opportunity to ask a question. I had two, if I could. Outstanding set of results and guidance, first of all. I wanted to ask about the cash flow, if I could, guidance. And even at the high end of the range, the cash flow margin would be a pretty significant step down from fiscal '20 and fiscal '21. So, I just wondered, is there any puts and takes within the cash flow guidance that we should be aware of as we're doing our model? Thank you. And I have a quick follow-up to that.
KC McClure: Sure, it's great, thanks. Nice to hear from you, Keith. Yes, so our free cash flow of $7.5 billion to $8 billion, it reflects very strong free cash flow to net income ratio of 1.1 to 1.2. And so, we're really pleased with that. And it does have slightly higher CapEx expense of $700 million. So, that's one slight difference from over '21. We did have exceptionally strong free cash flow in fiscal year '21 at 1.5 free cash flow to net income ratio, and that is just exceptional performance. It's not unusual for us to have free cash flow guidance at the beginning of the year, that is a decrease over what we've done in the previous years. And then lastly, we do allow for a slight uptick in DSO in our guidance for next year, which would still be very industry-leading DSO performance.
Keith Bachman: Okay, excellent. And then Julie, maybe just for you, I think you mentioned, this year, you did 46 M&A deals. And you mentioned in the guidance comments that there's quite a bit of M&A, I think, $4 billion in M&A contemplated for this coming fiscal year. How do you think about the integration risk? Accenture has, I would argue, a very special culture. And you're brining in a lot of new people over the course of the last 12 months, and the forward next 12 months. How do you think about the risk of assimilation of these deals? And how do you manage this process? You have a very good track record over the last 10 years, but there is a lot of M&A on the table that you're bringing in the company. I’m just wondering if you could speak to how you think about the risk associated with that to make sure the business keeps moving forward?
Julie Sweet: Sure. So great question, and thanks, Keith. So, first of all, as you indicated, we've got a really strong track record. And so, this step up in acquisition comes based on years of experience, including and fine-tuning integration, so that's number one. Secondly, our acquisitions happen globally. And then as I've talked about this year, they're pretty evenly balanced. And why it is that important? When we switched to our model earlier this year of a geographic-focused model from a P&L perspective, one of the reasons is to allow us as well to be super close to our people. And most of these acquisitions are not global, right? Some are like an umlaut, but like for example, Project Novetta, in the federal business, very local. And the vast majority are in one or two markets. Like there -- and so, the integration, it's not like you have this enormous company that's trying to integrate lots of people all over the globe at the same time. We have senior leaders accountable for the acquisitions. And so, we really get the right balance. And we have our own -- and so, for example, when we look at this, we look at market-by-market how many acquisitions are we doing in this market, so how does that enable us to make sure that we can spend the time? So, this is a finely tuned approach for integration. And of course, we bring on people in acquisition or not all the time. And so, this focus on culture is just part of who we are.
Keith Bachman: Okay, excellent. Thank you, Julie.
Operator: And our next question comes from the line of Lisa Ellis with MoffettNathanson. Please go ahead.
Lisa Ellis: Hi, good morning. Thanks for taking my question. Thinking about the $50 billion revenue milestone, which is pretty amazing. Julie, as you're mapping out the path to $60 billion over the next few years, can you talk about where you see the major sources of incremental revenue looking out from here forward? Thank you.
Julie Sweet: Great. Well, thanks, Lisa, nice to talk to you. So, first of all, and I talked a little bit about this in the script. We are still very early in the transformation of companies in building just their digital core. So, for example, if you look at something like SAP, their stats that they could point out, you sort of have less than 20% of companies who've actually both bought and begun implementing S/4HANA, right? And we see the move to the cloud. You've got sort of maybe today, roughly 25% to 30% of workload. So, there's a lot of work, which is a multiyear journey in actually building the digital core, and then at the same time transforming the way they work. And there -- so, we've got multiyear ahead. And even when you look at who is doing compressed transformation, you have this core of leaders and leapfrogger. But the vast majority of companies are not yet engaged in compressed transformation. So, just from a multiyear outlook on the fundamentals of re-platforminig and moving to a true digital-enabled enterprise is still in early stages. Then you add on top of that, there are whole parts of the enterprise where even the technologies are really new. And so Industry X is a great example of that. We see that as the next digital frontier, and we're still very, very early. And so, that will be kind of its own wave as we look forward. And then areas like sustainability, again, technology is early. Every industry has to find its way on sustainability. And so, as we think about our own growth strategy, it starts with what our clients need. So, we continue to diversify the parts of the enterprise that we're serving. And that enables -- that's what our clients need, and that enables the next wave of growth for us. And we continue to innovate and anticipate, like in sustainability, what our clients need. And so, when you kind of take his, you see, both from serving the enterprise, the maturity of that. And then on add on top of that that there are areas that are evergreen, like interactive, it's all about client, the growth agenda, it's always going to change. Manufacturing will be the same. Security grows as the digital landscape grows. So, hopefully, that gives you a flavor of how we're thinking about, both our next ways of growth and just the resiliency of the diversity of what we do.
Lisa Ellis: Yes, terrific. My follow-up was actually on managed services, which you called out in the prepared remarks. Not really used to thinking about Accenture doing managed services. Can you just elaborate a bit on that? Is this primarily actually infrastructure-related managed services or apps or just maybe a little bit more detail on what exactly you're doing in Accenture's differentiation there? Thanks.
Julie Sweet: So just think if we have consulting and outsourcing, right, so managed services is just another term for outsourcing. And so, if you think about our operations business, which is now about $8 billion, right? So, all the managed services we provide, everything from finance and accounting to industry specific, like we called out in the script, the stuff we're doing in telecom, we're doing things in insurance, in both health and P&C, so we have industry specific, we have marketing services through that. Then of course, there's our powerful IT services, we've been doing outsourcing for years, right, term application outsourcing is an industry term. And then, we have our managed services and security, we bought Symantec last year. And so, this is a core part when you think about our revenue between consulting and outsourcing. And the point that's happening now is that we've already done this, but what we're seeing is, I just had a call with the CEO the other day, who's like he started a call with like, Julie, I'm really having a hard time hiring people in digital, right? And how are you seeing companies help and we talked about how, by strategically outsourcing like in security, in marketing, you can access the digital talent, and it becomes part of their own talent strategy to address the work for talent, while at the same time, digitizing faster, I have another client who said look, you had 50 things that my IT department was about to build in order for us to automate and transform and I get it through your SynOps platform, the same as to on the IT and infrastructure side. And, of course, infrastructure managed services in the cloud growing area as well from the move to the cloud. So, I think the shift we were calling out is just how strategic this is, at a time of compress transformation, because it's meeting the needs of the war on talent, and the need to digitize and the need to move fast at the same time.
Lisa Ellis: Great, thank you. Thanks a lot and congrats.
Julie Sweet: Thanks.
Operator: And our next question comes from the line of Bryan Bergin with Cowen. Please go ahead.
Bryan Bergin: Hi, good morning. Thank you. First, got a question on bookings, can you talk about the dynamic in 4Q, it looks like outsourcing did tick down for the first time in a while year-over-year. So, just anything to call up there, and then just generally, how do you see the pipeline developing as you think about fiscal '22 bookings levels?
KC McClure: Yes, thanks, Bryan. So, there's nothing really to point out in terms of Q4 bookings with outsourcing, they can just be a little bit lumpy. But it was very strong performance. But let me just maybe talk a little bit about overall bookings as we head into '22, we do feel really good about the momentum in our business. And as Julie went through, we had 72 clients with bookings over $100 million this year. And you can see that then helping us as we head into FY'22, Bryan with 18% to 22% that we have in Q1. And you also see that in our 12% to 15% revenue range that we have for fiscal '22. I think it's important to also note that, it does include about 5% in organic contribution, but it's at the top end of our revenue range, again driven by bookings, it's going to represent about 10% organic growth at the upper end. And while we do benefit from an easier compare in the first-half, it does continue to imply strong organic growth in the second-half. And if you look at why is that, when you peel back bookings, again pleased with the $15 billion that we had in Q4, strong book-to-bill is 1.1, it is $60 billion for the whole year with double-digit growth in consulting. And I think it's important also net consulting bookings, we had $8 billion for the last three quarters, which is terrific. In outsourcing, which for the entire year have had a very strong book-to-bill of 1.2 in all three markets and services. And when you peel it back, there's really three things again, just peeling back bookings for you, there's three things that I would also note, one is that yes, we did have a lot of larger bookings that help us for -- position us well for the future throughout FY'22, but we had a nice mix all the way through to the smaller deals which benefit near-term revenue. The second thing is that the bookings were very broad-based across all of our services, and that includes strategy and consulting, which is really good as well. And lastly, they're aligned as Julie talked quite a bit about our strategic priorities cloud, Industry X and security for example.
Bryan Bergin: Okay. Thank you. A follow-up here then on attrition, can you just give us a sense of what you're anticipating for attrition levels backward into '22, and any added measures you're taking to try and drive that 19% down?
KC McClure: Yes. So, let me just maybe talk a little bit about the numbers, and Julie can give some other color here, but our managed attrition 90% Bryan was really the fourth quarter was in the zone that we expected. And it's 14% for the year, and we've been at 19% before. It's obviously a very hot market right now, but when you peel it back, it continues to be more in the lower part of the pyramid, and it's largely concentrated in India where we really don't have any issues in hiring.
Julie Sweet: Yes. And I think that's important because you look at a headline number, and then you'd have to really kind of understand whereas the attrition, and at the same time, as you might imagine, we're always very focused on making sure that we're attractive. So, we're very pleased at our executive retention is going very well. I think we are very much focused on our employee value proposition. And when you think about the actions you've taken like a record number of 120,000 promotions, the training that we're providing people that's really valued. And then, frankly, things like the way that we have approached vaccines, right? So we've now vaccinated 85,000 of our people in their families directly in addition to what we're supporting through like in the U.S. through our carriers. And as I talked a little bit about in the script, what we find is people really care about the fact that they are working for a company that focuses on financials and all of the other -- what we call 360 degree values. So, what we're doing in sustainability, being a leader that we're going to be carbon emission by 2025 really matters. And so, we continue to look at how can we help our people be net better off succeed personally and professionally, and be proud of a company that not only creates value, but leads with values.
Bryan Bergin: Okay. Thank you.
Operator: And our next question comes from the line of James Faucette with Morgan Stanley. Please go ahead.
James Faucette: Thank you very much. Wanted to ask a couple of quick questions that are follow up on the hiring your pace of hiring and net has been quite stunning, at least over the last couple of quarters. Can you talk about a little more detail in terms of how you're finding the hiring environment, particularly for newer skill sets, and I guess, do you think you need to kind of sustain the recent pace of hiring going forward? And I guess my second question, I'll just throw it in at the same time as back to V&A, you talked about kind of the inorganic contribution and integration, but is this kind of the recent pace that we've seen? Is this also something that you expect to need to sustain and want to sustain on a go-forward basis on whether in terms of number of deals or amount that you're spending, et cetera? Thanks a lot.
Julie Sweet: Okay. Thanks. I will cover the head count. So, I would just first start with in this market with a war for talent, we're very pleased with the 56,000 net additional people that we hired in Q4, as we see strong momentum, really continuing in FY'22, and you see that again in our growth rates for the first quarter, we're off to a strong start at 18% to 22% in Q1, and the full-year at the top end at 15%. And we were able to accelerate some of our hiring, and we plan to continue to do so in quarter one, in order to have the talented people that we need to match demand in the market. And so, that's to your first question on hiring. To your second question on V&A, I won't guide longer term, and to the amount of spend that we're going to do past '22 in V&A. It remains an important part of our strategy on a go-forward basis.
KC McClure: Yes. And I think it's just to remember taking a step back, on two things. One is on the people side, we made a deliberate decision to accelerate hiring this quarter and next quarter, which given as you said, the environment and our ability to attract people we think makes sense so that we're not -- we're not worried about being constrained with respect to people. And we're able to do that. And I think that's a huge differentiator for us. And secondly, and we made a decision last year, and we've made a decision this year in V&A to really invest and take advantage of our ability to invest to serve our clients. And when I got clients, one of the things that we talk about is, and clients really value is that when they're partnering with us, they're partnering not just for the capabilities we have today, but because we have a track record of investing year in and year out and creating and anticipating their needs. And we point to the kinds of acquisitions like in Umlaut, like in Nevada, like Infinity Works in cloud, that we're doing it in markets all around the world to benefit them. And so, we believe this is really setting us up last year and this year, right for this next ways of growth. And it's truly differentiating in the eyes of our clients.
Operator: And our next question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead.
Ashwin Shirvaikar: Thank you. Hi, Julie. Hi, KC, Angie, congratulations on the results and outlook. First question is, it seems clear, we're in a very exciting time here for IT services. I've had this view for some time now that the acceleration of demand that you're seeing is sustainable for several years. And I don't mean to imply that getting revenue growth is easy. But if you have to worry less about revenue growth, given the investments you've already made. Do you have the opportunity to change your financial model as accelerated to get higher gross margins, better G&A leverage? Thoughts on moving to a more non-linear model with solutions may be especially important given the 620,000 people?
Julie Sweet: Yes, I'll start with that. I think, Ashwin, our financial model really remains the same in terms of three key imperatives that we have to go through each year, which is grow faster than the market take share, modest margin expansion while investing at scale and our business and our people. So, in the last part, maybe just talk about op margin. So, we are very proud of the 10% to 30%, that we have this year. That does imply obviously, that we will continue to get efficiencies in how we run our business, both in terms of how we deliver to our clients, as well as within the SG&A and how we run our own organization.
KC McClure: Yes, maybe just set a couple of points. I'm glad to acknowledge that revenue growth is not easy. So, thank you for that. But we're just taking a step back to just to make sure, because I think over the last decade you've seen a real shift in the professional services industry. The nature of the exponential technology change and the need to help clients move faster, and do so more efficiently has meant that you need to be able to invest significantly. So, as we think about moving forward, like the investments we've done to build, SynOps like to and continue to evolve it to build industry solutions as you mentioned, require us to continuously innovate, invest. You saw that in our IP patent portfolio. And so, what I would say is, it's not that you sort of say, here's the revenue, and then can you just fundamentally ship because there is significant cost. Having all aspects of our business grow like this is not simply, because there's demand. It's the solutions we're bringing them. And as I've talked about in prior earnings call, it isn't linear today even, because we've automated so much of what we do when you look at something like our operations business, you look at my wizard, and we continue to do so. And that's really part of the business now. And so, I think it's important to kind of understand what's helping drive the demand for our services. The way we're gaining market share is not simply because there's a lot of demand in the market, but the solutions we're bringing. And this is our big differentiator, because we can go all the way from strategy to operations right? All of the examples we're giving involve multiple assets or services and you can't just build that overnight either, right? So, the fact that we're becoming integrated in talent strategy in our outsourcing and we also call managed services is about being trusted. And the fact that we could deliver during the pandemic and be a trusted partner puts us in a very different place than others who might be trying to build these capabilities.
Ashwin Shirvaikar: Got it, got it. Thank you for that. And then the other question is over the last 18 months, your revenue growth has absorbed the negative impact of less P&E. Is that coming back, do you have updated thoughts on back to office, what's the assumption for that in your outlook?
Julie Sweet: So, I'll let KC answer specifically, but I will say that if any of us can actually predict, how we're going to go to the office, I'd like to meet that person. It is good to say, it's been a humbling experience, right? How many times have we all gotten ready to go back and I don't know about you, but like five different things that we're going to be in person the next two months, I've just turned back to Zoom or Teams. So, it's been an interesting time the new normal but KC, why don't you take us through just to see assumptions we're using?
KC McClure: Yes, so Ashwin, just I'll first start with revenue, our revenue guidance the 12 to 15, it does not include any specific up tick from reimbursable travel, and if that assumption changes will reflect that in our updated guidance. And as Julie said, just in terms of increases to travel assumed in our overall P&L for '22, it is difficult to predict, but we do have an increased build into particularly in the back half of the year for some travel costs.
Ashwin Shirvaikar: Got it. Thank you for that.
Operator: And our next question comes from the line of Jason Kupferberg with Bank of America. Please go ahead.
Jason Kupferberg: Thanks, guys. Good morning. I wanted to start just with the visibility question. The reason I asked is obviously your cost of currency revenue growth here in Q4 was quite robust. So, it wasn't really above the top end of your guidance, whereas in recent quarters, you had been handily exceeding the top end of your expectation. So, I'm just wondering, is this simply because your visibility has improved, so you've gotten more comfortable, you don't necessarily need to put extra cushion into the guidance or did some bookings not ramp as fast as expected in the quarter and then just a related question for fiscal '22 as you set the initial outlook for this year, any change in approach versus this time last year again perhaps because your visibility has improved? Thanks.
KC McClure: Yes, I will answer both questions in really the same way, which is for the fourth quarter, we were slightly above our FX adjusted guided range, but we always try to aim to be in the top quadrant, top part of our guided range. And really just this year, it's been a story of an unprecedented ramp. So, we're really pleased that we were able to kind of nail down where we thought we would end up the quarter. And it's the same thing really for '22, it's not any change in visibility, it's not any change in the way we're doing things. We always call it as we see it, these are our best estimates. And with the 12 and 15 all parts, all points are in possibility. That's why they're in the range, but we continue like we always do to aim for the top quadrant in top part of the range, no change.
Jason Kupferberg: Okay. Okay, good to know. And just a follow-up, what are your expectations for book-to-bill, in consulting and overall for the first quarter and for the full fiscal year? And then just what you're thinking about for consulting versus outsourcing revenue growth this year? Thanks, guys. Congrats.
KC McClure: Yes, thank you. Yes, so we feel good about our pipeline as we head into the fiscal year, I would say, I will just comment on Q1 bookings, we do feel really good about where we are, historically, we do see some seasonality in Q1 and large deals can make things lumpy, but we feel really good about our positioning for the first quarter. And in terms of revenue growth, I'll just say that for quarter one, we see consulting continuing in strong double-digits and outsourcing in the double-digit range.
Jason Kupferberg: Okay, got it.
Angie Park: Great, operator, we have time.
KC McClure: Yes, for the full-year, I mean consulting should continue to be strong double-digits and outsourcing depending on where we landed, the range will be high single to low double-digits.
Jason Kupferberg: Thank you.
Angie Park: Great, thanks. Operator, we have time for one more question and then Julie will wrap up the call.
Operator: Of course, and that last question comes from the line of Tien-tsin Huang with JPMorgan. Please go ahead.
Tien-tsin Huang: Thank you so much. Really impressive growth at scale here, I wanted to ask on Industry X, it was $5 billion in revenues, so it's up 36% I wrote down, so I think Julie said it's the next frontier here. Does this have potential to be as big as cloud? I'm just trying to think about the sizing of Industry X recognizing it's early, but also its importance?
Julie Sweet: Yes, I mean I think we're not really sizing that today. I mean, if we think about cloud as the entire enterprise, so sort of hard to sort of do that. What we'd say is, this will be I mean, we're already at $5 billion and we consider it the next digital frontier and it's super early, right, some technologies have just really been coming online in the last year or two that are cloud based. And when you look at like what we're doing for example, like Vivienne Westwood, one of the largest independent global fashion companies, we're doing a new PLM solution for them. We're doing so for Ahlstrom, Ahlstrom a ultimate global leader in transportation where you doing the same in a power company so that the range of what we're doing I mean is both broad based in terms of industry. And so, we do think of this as really a big growth driver for the future, but not sizing it today.
Tien-tsin Huang: Okay, no worries. Just thought it was interesting, because the scope of it can be quite large. Just my quick follow-up, I know you had you feel a lot of questions on acquisitions, already. Digital assets are being valued pretty highly here across the board. Looks like you're still implying a reasonable revenue multiple with your inorganic contribution, have you seen any changes on the valuation side? I know, you're still a destination for many companies, but just curious the valuations have changed in any way you're thinking?
Julie Sweet: KC, do you want to answer that?
KC McClure: You know, clearly, valuations, we participate in the overall market, you've seen what valuations have done in the overall market, but I would just say that, we have pretty high hurdle rates in terms of what we expect from our business cases. And we track that very closely, as you would expect of us. And we're very pleased with our ongoing performance of our portfolio against the hurdle rates that we put forth in this business cases.
Tien-tsin Huang: Yes, it's impressive. Thank you both.
KC McClure: Okay, thank you.
Julie Sweet: All right, well now it's time to wrap up. In closing, I want to thank all of our people and our Managing Directors for what you all do every day, our people at actions and results in FY'21 has really put us in a terrific position as we go into FY'22 to create even more value ahead. And I know I and the entire leadership team are super excited and confident about what's to come. And I'll simply end by thanking all of our shareholders for your continued trust and support. Be well everyone. Thanks.
Operator: And ladies and gentlemen, today's conference will be available for replay after 10 A.M. Eastern today through December 16. You may access AT&T Replay System at anytime by dialing 1-866-207-1041, entering the access code 6704907. International participants may dial 402-970-0847 and those numbers again are 1-866-207-1041 and 402-970-0847 again entering the access code 6704907. That does conclude your conference for today. Thank you for your participation and for using AT&T Conference Service. You may now disconnect. | [
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"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to the Accenture Fourth Quarter Fiscal 2021 Earnings Conference Call. At this time, all participants are in listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions] And as a reminder, today's call is being recorded. I would now like to turn the conference over to our host, Angie Park, Managing Director and Head of Investor Relations. Please go ahead."
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"speaker": "Angie Park",
"text": "Thank you, operator, and thanks, everyone, for joining us today on our fourth quarter and full fiscal 2021 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director and Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for both the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the first quarter and full fiscal year 2022. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today we will reference certain non-GAAP financial metrics, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our Web site at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
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{
"speaker": "Julie Sweet",
"text": "Thank you, Angie, and everyone, for joining us. Before diving into our results, thank you to our 624,000 incredibly talented people around the world, including over 8,500 managing directors. This past fiscal year, your hard work and dedication to creating value that matters for our clients was unwavering, despite the ongoing and sometimes quite extreme challenges of COVID. We've had a truly extraordinary year, as reflected in our outstanding financial results and in the 360 degree value we delivered beyond our financials. From the over 120,000 promotions and over 31 million training hours, an increase of 43% for our people, to increasing our workforce by approximately 118,000 people, creating significant employment opportunities in our communities, to achieving 46% women on our way to our goal of gender parity by 2025, to our top three ranking in the Refinitiv Global Diversity and Inclusion Index, for the fourth consecutive year. To the number one position with our largest ecosystem partners, to the exciting accomplishment of 50% renewable energy now powering our offices and centers globally, to the donation of $54 million in COVID surge relief. In December, we will publish our first ever annual 360 degree value report to more fully describe the FY'21 value we created in all directions and we’ll report against three additional key ESG frameworks: SASB, TCFD, and WEF/IBC. We believe that the trust we have from our clients and partners, our continuous innovation, and our ability to consistently attract the best people, including the 56,000 net new hires this past quarter, are directly linked to our commitment to measuring our success by how well we create this 360 degree value for all our stakeholders, clients, people, partners, shareholders, and communities, and on our culture of shared success. Here are some key financial highlights of the year, which position us strongly as we begin FY'22. FY'21 demonstrated our leadership in helping our clients achieve compressed transformation, with 72 clients with bookings greater than $100 million compared to 53 last year and 229 diamond clients, our largest client relationships compared to 216 last year. With a 20% increase in bookings to $59 billion, we have strong momentum across all dimensions of our business across geographic markets, industries, and services. Reaching revenues of $50.5 billion, a significant milestone, representing 11% growth, we added $6.2 billion in revenue this year, gaining significant market share with 40 basis points of operating margin expansion, demonstrating, yet again, our ability to grow profitably and at scale. We achieved this profitable growth while investing at a higher level than ever before, with $4.2 billion in acquisitions; $1.1 billion in R&D in assets, platforms, and industry solutions, including growing our portfolio of patents and pending patents to more than 8,200; and total training investment of $900 million. And according to BrandZ, our brand value increased 56% to over $64 billion, ranking us number 27 on the prestigious BrandZ's Top 100 Most Valuable Global Brands list. Finally, I want to highlight cloud and our ability to move with agility to serve our clients' needs and capture momentum in the market. At the beginning of FY'21, after investing in cloud for a decade, we saw that the pandemic would dramatically accelerate our clients' move to the cloud. More than technology, the move to the cloud would be about the adoption of a new operating system for future enterprise, a dynamic continuum of capabilities from public to edge to everything in between, opening up radically new ways for companies to work, compete, and drive value. Just over one year ago, we created Accenture Cloud First to capitalize on this momentum, bringing together all of our capabilities from migration to cloud-native development, data AI, industry talent, and change. Accenture Cloud First was the biggest driver of our overall cloud business growth from $12 billion to $18 billion, a 44% increase. KC, over to you."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie, and thanks to all of you for joining us on today's call. We were very pleased with our results in the fourth quarter, which completes an outstanding year for Accenture and reflect broad-based momentum across all dimensions of our business. Once again, our results reflect our relentless focus to deliver across our three key imperatives for driving superior stakeholder value. So, let me begin by summarizing a few of the highlights of the quarter. Revenue growth of 21% in local currency, at the top end of our guided range, reflects double-digit growth across all markets, all industry groups, and all services. We also continue to extend our leadership position at an accelerated pace, with growth significantly above the market. Operating margin was 14.6%, an increase of 30 basis points for the quarter, reflecting 40 basis points of expansion for the full-year. We delivered this expansion while investing significantly in our business and in our people to position us for long-term market leadership. We delivered very strong EPS of $2.20, which represents 29% growth, compared to adjusted EPS last year. And finally, we delivered free cash flow of $2.2 billion, which was driven by continued strong growth and profitability. Now, let me turn to some of the details. New bookings were $15 billion for the quarter, with a book-to-bill of 1.1. Consulting bookings were $8 billion, with a book-to-bill of 1.1. Outsourcing bookings were $7.1 billion, with a book-to-bill of 1.2. We were very pleased with our new bookings, which represent 7% growth in U.S. dollars, with 18 clients with bookings over $100 million. We were also pleased with the strength of bookings across all services, with a book-to-bill of 1 in strategy and consulting, 1.2 in technology services, and 1.1 in operations. Turning now to revenues. Revenues for the quarter were $13.4 billion, a 24% increase in U.S. dollars and 21% in local currency, slightly above our FX-adjusted range as the FX tailwind was 3% compared to the 4% estimated last quarter. Consulting revenues for the quarter were $7.3 billion, up 29% in U.S. dollars and 25% in local currency. Outsourcing revenues were $6.1 billion, up 19% in U.S. dollars, and 16% in local currency. Taking a closer look at our service dimensions, strategy and consulting, technology services, and operations, all grew very strong double digits. Turning to our geographic markets, in North America, revenue was 22% in local currency, driven by double-digit growth in consumer goods, retail and travel services, software and platforms, and public service. In Europe, revenues grew 18% in local currency, led by double-digit growth in consumer goods retail and travel services, industrial, and banking and capital markets. Looking closer at the countries, Europe was driven by double-digit growth in the U.K., Germany, France, and Italy. In growth markets, we delivered 21% revenue growth in local currency, driven by double-digit growth in consumer goods, retail, and travel services, banking and capital markets, and high-tech. From a country perspective, growth markets was led by double-digit growth in Japan, Australia, and Brazil. Moving down the income statement, gross margin for the quarter was 33.3%, compared with 31.8% for the same period last year. Sales and marketing expense for the quarter was 11.3%, compared with 10.6% for the fourth quarter, last year. General administrative expense was 7.4%, compared to 6.8% for the same quarter last year. Our operating income was $2 billion in the fourth quarter, reflecting a 14.6% operating margin, up 30 basis points compared with Q4, last year. As a reminder, in Q4, last year, we recorded an investment gain that impacted our tax rate and increased EPS by $0.29 for the quarter. The following comparisons exclude this impact, and reflect adjusted results. Our effective tax rate for the quarter was 25%, compared with an adjusted effective tax rate of 28.4% for the fourth quarter last year. Diluted earnings per share were $2.20 compared with adjusted EPS of $1.70 in the fourth quarter last year. Days service outstanding were 38 days compared to 36 days last quarter and 35 days in the fourth quarter of last year. Free cash flow for the quarter was $2.2 billion, resulting from cash generated by operating activities of $2.4 billion net of property and equipment additions of $236 million. Our cash balance at August 31 was $8.2 billion, compared with $8.4 billion at August 31 last year with regards to our ongoing objective to return cash to shareholders. In the fourth quarter, we repurchased or redeemed 3 million shares for $915 million at an average price of $305.61 per share. Also in August, we paid our fourth quarterly cash dividends of $0.88 per share, for total of $558 million and our Board of Directors declared a quarterly cash dividend of $0.97 per share to be paid on November 15, a 10% increase over last year and approved $3 billion of additional share repurchase authority. Now, I would like to take a moment to summarize our outstanding year. We're extremely pleased with the performance of our business in fiscal year '21, greatly exceeding all aspects of our original outlook that we provided last September, we delivered $59 billion in new bookings, a 20% increase in U.S. dollars over last year, which positions us well as we begin fiscal year '22. Revenues increased a record $6.2 billion, hitting the $50 billion mark, reflecting growth of 11% in local currency for the full-year. This result which is more than double the revenue growth we anticipated at the beginning of the year showcases our agility and ability to quickly scale to deliver value and outcomes for our clients. Operating margin of 15.1% reflected a 40 basis point expansion over fiscal year '20 above the top-end of our original guided range, even after making continued significant investments in our business and our people. Adjusted earnings per share were $8.80, reflecting 80% growth over adjusted FY'20 EPS and was well above our revenue growth. As a reminder, we adjusted earnings in both years to exclude gains on an investment. Free cash flow of $8.4 billion was significantly above our original guided range, reflecting a free cash flow to net income ratio of 1.5 driven by strong profitability. And finally, we significantly exceeded our original guidance for capital allocation by returning $5.9 billion of cash to shareholders, while investing roughly $4.2 billion across 46 acquisitions to acquire critical skills and capabilities in strategic high growth areas of the market. So, again, FY'21 was truly an outstanding year. Momentum continues into fiscal '22 and we're laser focused on capturing the market opportunities, coupled with a disciplined execution that you and we expect of us. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thanks, KC. Turning to the demand environment, compressed transformation underpinned by cloud and digital continues to drive strong double-digit growth across our business, including for Applied Intelligence, cloud, Industry X, Intelligent operations, Interactive, Intelligent platform services, security and transformational change management. Technology is the single biggest driver of change in companies today and the depth, breadth and scale of our technology capabilities across our services is unmatched. We see the demand environment shaping up for FY'22 to be more of the same while digital leaders seeking to widen their competitive advantage, and companies seeking to leapfrog their cloud and digital transformation are driving momentum in our business, the vast majority of companies are early in their transformation. And whether digital leader, leapfrogger, laggard or in between all face multi-year journeys ahead of them because the re-platforming in the cloud and use of new technologies across the enterprise is a once in a digital era profound transformation. Simultaneously, we have ongoing exponential technology change that is accelerating and will create new opportunities, disruptions and change for our clients. In addition, growth in parts of our business are by their very nature continuously evolving. For example, interactive, now a $12.5 billion business growing 15% continue to set a new standard for customer experience, connection, sales, and marketing at the intersection of data, creativity and technology, and is tied to the ever-changing needs and preferences of B2C and B2B customers. Similarly, security, now a $4.4 billion business growing 29% is driven by needs related to an ever expanding digital threat landscape. And with our managed services is providing much needed protection and talent to our clients. Our clients value the depth and breadth of our services for the entire enterprise across strategy and consulting, interactive technology and operations and industry and functional expertise across 13 industries. Plus the ability to deliver tangible outcomes as well as our strong track record of investing ahead of our clients to anticipate their needs and drive our next ways of growth such as our early moves in digital cloud and security. There remain entire parts of the enterprise. So, which digitization and the move to the cloud has only just begun. In particular, both the things companies make and the way they make things are being dramatically changed by technology. And that is the focus of our Industry X business, which we believe is the next big digital frontier. In fact, a 2021 Gartner survey, a Board of Directors indicates that 93% expect that the number one business priority that will see transformational improvement from digital technology is manufacturing, distribution, and supply chain. We have invested for nearly a decade in Industry X and are now at approximately $5 billion in revenue growing 36%. We look forward to welcoming the 4,200 industry leading engineers and consultants of Umlaut when the acquisition closes in October. Similarly, sustainability is a critical area for which technology is still evolving. We believe that every business must be a sustainable business, and yet companies are at very early stages of figuring out how to make this shift. Last year, building on years of investment and experience, we've launched our sustainability services under our new Chief Responsibility Officer and Global Sustainability Services Lead. We have continued to accelerate our focus in this expanding and changing market, and are proud of the work we are doing with leading partners like MasterCard, as we enhance its ability to track and analyze the carbon emissions of their suppliers and help de-carbonize the U.K. energy system with clients such as National Grid. We do see a shift in the nature of the demand for our managed services across IT, security and operations with these services emerging as one of our most strategic differentiators as companies simultaneously seek greater resilience, face a war for talent, the need to rapidly digitize and cost pressures, strategic managed services are increasingly a C-suite priority with Accenture as a trusted partner of choice, and increasingly integrated as part of their talent strategy. Table stakes from managed services are efficiency, resiliency, and reliability. We further differentiate in our managed services because they are uniquely informed by our strong strategy and consulting capabilities and deep industry and functional expertise. And they benefit from our strong level of investment for digital platforms like SynOps and myWizard and the seamless integration with our ecosystem partners, as well as due to the incredible pool of talented people our clients can access quickly when partnering with us. For example, we are partnering with Olympus, a leading manufacturer of optical and digital precision technology to help them drive their transformation to become a global medical technology company. As part of this partnership, we have acquired their Japanese IT subsidiary company, which we will transform to deliver significant IT cost savings to Olympus, as well as up-skill their people, combining their knowledge with our talent and technology to lead Olympus's digital transformation. And let me bring to life some more the demand we are seeing. All of these examples bring together the diverse capabilities across Accenture to create tangible value. We are a leader in cloud, because we're able to serve our clients across the cloud continuum and create business value. We are partnering with Kubota, a Japanese multi-national company, providing solutions leveraging a diverse range of products, technologies and services in the fields of food, water and the environment. To accelerate Kubota's digital transformation by creating solutions that will enhance the productivity and safety of food, promote circularity of water resources and waste and improve urban and living environments. We will help create innovative sustainability solutions and a platform applying leading edge digital technologies, including AI and IoT. Diverse data held across the group will be centralized for easy maintenance and use. We're also modernizing replacing our migrating legacy applications to the cloud and strengthening their global computer security incident response team. We are partnering with Jbal, a US-based global manufacturing services company to further enhance their IT infrastructure capabilities through providing infrastructure managed services for digital workplace, network, cloud and data center support. We're helping Senya a finish insurer offering casualty motor and health and accident services to implement a cloud-based policy administration system to improve customer service using data and automation to make sales, claims, payments and policy management processes more user friendly. This will allow the company to quickly respond to changing market and customer demands and meet its goal of providing the best customer experience in the industry. Compressed transformation is occurring across industries. We're partnering with Unilever, one of the world's largest consumer goods companies in their digital transformation. Together, we are setting a new industry standard by reinventing technology delivery with cutting edge automation, delivering cloud migration at scale, the largest ERP migration to the cloud and the industry and shifting to technology solutions that support their growth strategy. With McCormick a global leader in flavor in the food industry, where we're partnering on a strategic transformation program encompassing finance, supply chain logistics and plant maintenance. The new cloud-based platform an innovative data driven approach will help standardize processes, increase efficiencies, and support their goal of doubling in size quickly. We're helping a European financial institution, build the bank of the future and helping them become a next level innovator. One that is leveraging technology and sustainability to transform multiple parts of their business, drive hyper personalized customer experience, and create new lines of business like wealth management and insurance, which is expected to triple digital sales by 2023 and improve their already stellar cost to income ratio. At the same time, we're helping them deliver on their ESG initiatives, including inclusive financing, green software and carbon data free data centers. At Accenture, we're enabling new experience in growth and cost transformation across the enterprise and across industries. And a key enabler to these innovative scaled services is the power of our operations capabilities. We are helping Open Fiber an Italian telecommunications company design and orchestrate construction of an ultra-broadband network, which will deliver fiber to 20 million households across Italy. Digitization and automation will help the construction site to proceed faster and more efficiently. With Interactive, we're helping MediaMarktSaturn Retail Group, Europe's leading consumer electronics retailer transform their digital content capabilities with a state of the art marketing operations. Automation and data insights enabled by synapse will help deliver more engaging and personalized content, while driving millions and savings. Our industry expertise continues to be a core competitive advantage, allowing us to breathe deep industry and cross industry knowledge enterprise wide for our clients. I want to recognize in particular, our software and platform industry, which is approximately $4 billion in revenue. In Q4 this group celebrated 20 consecutive quarters of double-digit growth, serving as a leading partner to our clients in this hyper growth industry. KC, back to you."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Now let me turn to our business outlook. For the first quarter fiscal '22, we expect revenues to be in the range of $13.9 billion to $14.35 billion. This assumes the impact of FX will be about positive 0.5%, compared to the first quarter of fiscal '21, and reflects an estimated 18% to 22% growth of currency. For the full fiscal year '22, based upon how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results, in U.S. dollars, will be approximately negative 0.5% compared to fiscal '21. For the full fiscal '22, we expect our revenue to be in the range of 12% to 15% growth in local currency over fiscal '21, which includes an inorganic contribution of about 5% as we continue to expect to invest about $4 billion in acquisitions. For operating margin, we expect fiscal year '22 to be 15.2% to 15.4%, a 10 to 30 basis point expansion over fiscal '21 results. We expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.1% in fiscal '21. For earnings per share, we expect full-year diluted EPS for fiscal '22 to be in the range of $9.90 to $10.18 or 13% to 16% growth over adjusted fiscal '21 results. For the full fiscal '22, we expect operating cash flow to be in the range of $8.2 billion to $8.7 billion, property and equipment additions to be approximately $700 million, and free cash flow to be in the range of $7.5 billion to $8 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we expect to return at last $6.3 billion through dividends and share repurchases, as we remain committed to returning a substantial portion of cash to our shareholders. With that, let's open it up so that we can take your questions. Angie."
},
{
"speaker": "Angie Park",
"text": "Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you please provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Of course. [Operator Instructions] And today, let’s see our first question comes from the line of Keith Bachman of Bank of Montreal. Please go ahead."
},
{
"speaker": "Keith Bachman",
"text": "Hi, many thanks for letting me the opportunity to ask a question. I had two, if I could. Outstanding set of results and guidance, first of all. I wanted to ask about the cash flow, if I could, guidance. And even at the high end of the range, the cash flow margin would be a pretty significant step down from fiscal '20 and fiscal '21. So, I just wondered, is there any puts and takes within the cash flow guidance that we should be aware of as we're doing our model? Thank you. And I have a quick follow-up to that."
},
{
"speaker": "KC McClure",
"text": "Sure, it's great, thanks. Nice to hear from you, Keith. Yes, so our free cash flow of $7.5 billion to $8 billion, it reflects very strong free cash flow to net income ratio of 1.1 to 1.2. And so, we're really pleased with that. And it does have slightly higher CapEx expense of $700 million. So, that's one slight difference from over '21. We did have exceptionally strong free cash flow in fiscal year '21 at 1.5 free cash flow to net income ratio, and that is just exceptional performance. It's not unusual for us to have free cash flow guidance at the beginning of the year, that is a decrease over what we've done in the previous years. And then lastly, we do allow for a slight uptick in DSO in our guidance for next year, which would still be very industry-leading DSO performance."
},
{
"speaker": "Keith Bachman",
"text": "Okay, excellent. And then Julie, maybe just for you, I think you mentioned, this year, you did 46 M&A deals. And you mentioned in the guidance comments that there's quite a bit of M&A, I think, $4 billion in M&A contemplated for this coming fiscal year. How do you think about the integration risk? Accenture has, I would argue, a very special culture. And you're brining in a lot of new people over the course of the last 12 months, and the forward next 12 months. How do you think about the risk of assimilation of these deals? And how do you manage this process? You have a very good track record over the last 10 years, but there is a lot of M&A on the table that you're bringing in the company. I’m just wondering if you could speak to how you think about the risk associated with that to make sure the business keeps moving forward?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. So great question, and thanks, Keith. So, first of all, as you indicated, we've got a really strong track record. And so, this step up in acquisition comes based on years of experience, including and fine-tuning integration, so that's number one. Secondly, our acquisitions happen globally. And then as I've talked about this year, they're pretty evenly balanced. And why it is that important? When we switched to our model earlier this year of a geographic-focused model from a P&L perspective, one of the reasons is to allow us as well to be super close to our people. And most of these acquisitions are not global, right? Some are like an umlaut, but like for example, Project Novetta, in the federal business, very local. And the vast majority are in one or two markets. Like there -- and so, the integration, it's not like you have this enormous company that's trying to integrate lots of people all over the globe at the same time. We have senior leaders accountable for the acquisitions. And so, we really get the right balance. And we have our own -- and so, for example, when we look at this, we look at market-by-market how many acquisitions are we doing in this market, so how does that enable us to make sure that we can spend the time? So, this is a finely tuned approach for integration. And of course, we bring on people in acquisition or not all the time. And so, this focus on culture is just part of who we are."
},
{
"speaker": "Keith Bachman",
"text": "Okay, excellent. Thank you, Julie."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Lisa Ellis with MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Hi, good morning. Thanks for taking my question. Thinking about the $50 billion revenue milestone, which is pretty amazing. Julie, as you're mapping out the path to $60 billion over the next few years, can you talk about where you see the major sources of incremental revenue looking out from here forward? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Great. Well, thanks, Lisa, nice to talk to you. So, first of all, and I talked a little bit about this in the script. We are still very early in the transformation of companies in building just their digital core. So, for example, if you look at something like SAP, their stats that they could point out, you sort of have less than 20% of companies who've actually both bought and begun implementing S/4HANA, right? And we see the move to the cloud. You've got sort of maybe today, roughly 25% to 30% of workload. So, there's a lot of work, which is a multiyear journey in actually building the digital core, and then at the same time transforming the way they work. And there -- so, we've got multiyear ahead. And even when you look at who is doing compressed transformation, you have this core of leaders and leapfrogger. But the vast majority of companies are not yet engaged in compressed transformation. So, just from a multiyear outlook on the fundamentals of re-platforminig and moving to a true digital-enabled enterprise is still in early stages. Then you add on top of that, there are whole parts of the enterprise where even the technologies are really new. And so Industry X is a great example of that. We see that as the next digital frontier, and we're still very, very early. And so, that will be kind of its own wave as we look forward. And then areas like sustainability, again, technology is early. Every industry has to find its way on sustainability. And so, as we think about our own growth strategy, it starts with what our clients need. So, we continue to diversify the parts of the enterprise that we're serving. And that enables -- that's what our clients need, and that enables the next wave of growth for us. And we continue to innovate and anticipate, like in sustainability, what our clients need. And so, when you kind of take his, you see, both from serving the enterprise, the maturity of that. And then on add on top of that that there are areas that are evergreen, like interactive, it's all about client, the growth agenda, it's always going to change. Manufacturing will be the same. Security grows as the digital landscape grows. So, hopefully, that gives you a flavor of how we're thinking about, both our next ways of growth and just the resiliency of the diversity of what we do."
},
{
"speaker": "Lisa Ellis",
"text": "Yes, terrific. My follow-up was actually on managed services, which you called out in the prepared remarks. Not really used to thinking about Accenture doing managed services. Can you just elaborate a bit on that? Is this primarily actually infrastructure-related managed services or apps or just maybe a little bit more detail on what exactly you're doing in Accenture's differentiation there? Thanks."
},
{
"speaker": "Julie Sweet",
"text": "So just think if we have consulting and outsourcing, right, so managed services is just another term for outsourcing. And so, if you think about our operations business, which is now about $8 billion, right? So, all the managed services we provide, everything from finance and accounting to industry specific, like we called out in the script, the stuff we're doing in telecom, we're doing things in insurance, in both health and P&C, so we have industry specific, we have marketing services through that. Then of course, there's our powerful IT services, we've been doing outsourcing for years, right, term application outsourcing is an industry term. And then, we have our managed services and security, we bought Symantec last year. And so, this is a core part when you think about our revenue between consulting and outsourcing. And the point that's happening now is that we've already done this, but what we're seeing is, I just had a call with the CEO the other day, who's like he started a call with like, Julie, I'm really having a hard time hiring people in digital, right? And how are you seeing companies help and we talked about how, by strategically outsourcing like in security, in marketing, you can access the digital talent, and it becomes part of their own talent strategy to address the work for talent, while at the same time, digitizing faster, I have another client who said look, you had 50 things that my IT department was about to build in order for us to automate and transform and I get it through your SynOps platform, the same as to on the IT and infrastructure side. And, of course, infrastructure managed services in the cloud growing area as well from the move to the cloud. So, I think the shift we were calling out is just how strategic this is, at a time of compress transformation, because it's meeting the needs of the war on talent, and the need to digitize and the need to move fast at the same time."
},
{
"speaker": "Lisa Ellis",
"text": "Great, thank you. Thanks a lot and congrats."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Bryan Bergin with Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, good morning. Thank you. First, got a question on bookings, can you talk about the dynamic in 4Q, it looks like outsourcing did tick down for the first time in a while year-over-year. So, just anything to call up there, and then just generally, how do you see the pipeline developing as you think about fiscal '22 bookings levels?"
},
{
"speaker": "KC McClure",
"text": "Yes, thanks, Bryan. So, there's nothing really to point out in terms of Q4 bookings with outsourcing, they can just be a little bit lumpy. But it was very strong performance. But let me just maybe talk a little bit about overall bookings as we head into '22, we do feel really good about the momentum in our business. And as Julie went through, we had 72 clients with bookings over $100 million this year. And you can see that then helping us as we head into FY'22, Bryan with 18% to 22% that we have in Q1. And you also see that in our 12% to 15% revenue range that we have for fiscal '22. I think it's important to also note that, it does include about 5% in organic contribution, but it's at the top end of our revenue range, again driven by bookings, it's going to represent about 10% organic growth at the upper end. And while we do benefit from an easier compare in the first-half, it does continue to imply strong organic growth in the second-half. And if you look at why is that, when you peel back bookings, again pleased with the $15 billion that we had in Q4, strong book-to-bill is 1.1, it is $60 billion for the whole year with double-digit growth in consulting. And I think it's important also net consulting bookings, we had $8 billion for the last three quarters, which is terrific. In outsourcing, which for the entire year have had a very strong book-to-bill of 1.2 in all three markets and services. And when you peel it back, there's really three things again, just peeling back bookings for you, there's three things that I would also note, one is that yes, we did have a lot of larger bookings that help us for -- position us well for the future throughout FY'22, but we had a nice mix all the way through to the smaller deals which benefit near-term revenue. The second thing is that the bookings were very broad-based across all of our services, and that includes strategy and consulting, which is really good as well. And lastly, they're aligned as Julie talked quite a bit about our strategic priorities cloud, Industry X and security for example."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. Thank you. A follow-up here then on attrition, can you just give us a sense of what you're anticipating for attrition levels backward into '22, and any added measures you're taking to try and drive that 19% down?"
},
{
"speaker": "KC McClure",
"text": "Yes. So, let me just maybe talk a little bit about the numbers, and Julie can give some other color here, but our managed attrition 90% Bryan was really the fourth quarter was in the zone that we expected. And it's 14% for the year, and we've been at 19% before. It's obviously a very hot market right now, but when you peel it back, it continues to be more in the lower part of the pyramid, and it's largely concentrated in India where we really don't have any issues in hiring."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And I think that's important because you look at a headline number, and then you'd have to really kind of understand whereas the attrition, and at the same time, as you might imagine, we're always very focused on making sure that we're attractive. So, we're very pleased at our executive retention is going very well. I think we are very much focused on our employee value proposition. And when you think about the actions you've taken like a record number of 120,000 promotions, the training that we're providing people that's really valued. And then, frankly, things like the way that we have approached vaccines, right? So we've now vaccinated 85,000 of our people in their families directly in addition to what we're supporting through like in the U.S. through our carriers. And as I talked a little bit about in the script, what we find is people really care about the fact that they are working for a company that focuses on financials and all of the other -- what we call 360 degree values. So, what we're doing in sustainability, being a leader that we're going to be carbon emission by 2025 really matters. And so, we continue to look at how can we help our people be net better off succeed personally and professionally, and be proud of a company that not only creates value, but leads with values."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of James Faucette with Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Thank you very much. Wanted to ask a couple of quick questions that are follow up on the hiring your pace of hiring and net has been quite stunning, at least over the last couple of quarters. Can you talk about a little more detail in terms of how you're finding the hiring environment, particularly for newer skill sets, and I guess, do you think you need to kind of sustain the recent pace of hiring going forward? And I guess my second question, I'll just throw it in at the same time as back to V&A, you talked about kind of the inorganic contribution and integration, but is this kind of the recent pace that we've seen? Is this also something that you expect to need to sustain and want to sustain on a go-forward basis on whether in terms of number of deals or amount that you're spending, et cetera? Thanks a lot."
},
{
"speaker": "Julie Sweet",
"text": "Okay. Thanks. I will cover the head count. So, I would just first start with in this market with a war for talent, we're very pleased with the 56,000 net additional people that we hired in Q4, as we see strong momentum, really continuing in FY'22, and you see that again in our growth rates for the first quarter, we're off to a strong start at 18% to 22% in Q1, and the full-year at the top end at 15%. And we were able to accelerate some of our hiring, and we plan to continue to do so in quarter one, in order to have the talented people that we need to match demand in the market. And so, that's to your first question on hiring. To your second question on V&A, I won't guide longer term, and to the amount of spend that we're going to do past '22 in V&A. It remains an important part of our strategy on a go-forward basis."
},
{
"speaker": "KC McClure",
"text": "Yes. And I think it's just to remember taking a step back, on two things. One is on the people side, we made a deliberate decision to accelerate hiring this quarter and next quarter, which given as you said, the environment and our ability to attract people we think makes sense so that we're not -- we're not worried about being constrained with respect to people. And we're able to do that. And I think that's a huge differentiator for us. And secondly, and we made a decision last year, and we've made a decision this year in V&A to really invest and take advantage of our ability to invest to serve our clients. And when I got clients, one of the things that we talk about is, and clients really value is that when they're partnering with us, they're partnering not just for the capabilities we have today, but because we have a track record of investing year in and year out and creating and anticipating their needs. And we point to the kinds of acquisitions like in Umlaut, like in Nevada, like Infinity Works in cloud, that we're doing it in markets all around the world to benefit them. And so, we believe this is really setting us up last year and this year, right for this next ways of growth. And it's truly differentiating in the eyes of our clients."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you. Hi, Julie. Hi, KC, Angie, congratulations on the results and outlook. First question is, it seems clear, we're in a very exciting time here for IT services. I've had this view for some time now that the acceleration of demand that you're seeing is sustainable for several years. And I don't mean to imply that getting revenue growth is easy. But if you have to worry less about revenue growth, given the investments you've already made. Do you have the opportunity to change your financial model as accelerated to get higher gross margins, better G&A leverage? Thoughts on moving to a more non-linear model with solutions may be especially important given the 620,000 people?"
},
{
"speaker": "Julie Sweet",
"text": "Yes, I'll start with that. I think, Ashwin, our financial model really remains the same in terms of three key imperatives that we have to go through each year, which is grow faster than the market take share, modest margin expansion while investing at scale and our business and our people. So, in the last part, maybe just talk about op margin. So, we are very proud of the 10% to 30%, that we have this year. That does imply obviously, that we will continue to get efficiencies in how we run our business, both in terms of how we deliver to our clients, as well as within the SG&A and how we run our own organization."
},
{
"speaker": "KC McClure",
"text": "Yes, maybe just set a couple of points. I'm glad to acknowledge that revenue growth is not easy. So, thank you for that. But we're just taking a step back to just to make sure, because I think over the last decade you've seen a real shift in the professional services industry. The nature of the exponential technology change and the need to help clients move faster, and do so more efficiently has meant that you need to be able to invest significantly. So, as we think about moving forward, like the investments we've done to build, SynOps like to and continue to evolve it to build industry solutions as you mentioned, require us to continuously innovate, invest. You saw that in our IP patent portfolio. And so, what I would say is, it's not that you sort of say, here's the revenue, and then can you just fundamentally ship because there is significant cost. Having all aspects of our business grow like this is not simply, because there's demand. It's the solutions we're bringing them. And as I've talked about in prior earnings call, it isn't linear today even, because we've automated so much of what we do when you look at something like our operations business, you look at my wizard, and we continue to do so. And that's really part of the business now. And so, I think it's important to kind of understand what's helping drive the demand for our services. The way we're gaining market share is not simply because there's a lot of demand in the market, but the solutions we're bringing. And this is our big differentiator, because we can go all the way from strategy to operations right? All of the examples we're giving involve multiple assets or services and you can't just build that overnight either, right? So, the fact that we're becoming integrated in talent strategy in our outsourcing and we also call managed services is about being trusted. And the fact that we could deliver during the pandemic and be a trusted partner puts us in a very different place than others who might be trying to build these capabilities."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Got it, got it. Thank you for that. And then the other question is over the last 18 months, your revenue growth has absorbed the negative impact of less P&E. Is that coming back, do you have updated thoughts on back to office, what's the assumption for that in your outlook?"
},
{
"speaker": "Julie Sweet",
"text": "So, I'll let KC answer specifically, but I will say that if any of us can actually predict, how we're going to go to the office, I'd like to meet that person. It is good to say, it's been a humbling experience, right? How many times have we all gotten ready to go back and I don't know about you, but like five different things that we're going to be in person the next two months, I've just turned back to Zoom or Teams. So, it's been an interesting time the new normal but KC, why don't you take us through just to see assumptions we're using?"
},
{
"speaker": "KC McClure",
"text": "Yes, so Ashwin, just I'll first start with revenue, our revenue guidance the 12 to 15, it does not include any specific up tick from reimbursable travel, and if that assumption changes will reflect that in our updated guidance. And as Julie said, just in terms of increases to travel assumed in our overall P&L for '22, it is difficult to predict, but we do have an increased build into particularly in the back half of the year for some travel costs."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Got it. Thank you for that."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Jason Kupferberg with Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"text": "Thanks, guys. Good morning. I wanted to start just with the visibility question. The reason I asked is obviously your cost of currency revenue growth here in Q4 was quite robust. So, it wasn't really above the top end of your guidance, whereas in recent quarters, you had been handily exceeding the top end of your expectation. So, I'm just wondering, is this simply because your visibility has improved, so you've gotten more comfortable, you don't necessarily need to put extra cushion into the guidance or did some bookings not ramp as fast as expected in the quarter and then just a related question for fiscal '22 as you set the initial outlook for this year, any change in approach versus this time last year again perhaps because your visibility has improved? Thanks."
},
{
"speaker": "KC McClure",
"text": "Yes, I will answer both questions in really the same way, which is for the fourth quarter, we were slightly above our FX adjusted guided range, but we always try to aim to be in the top quadrant, top part of our guided range. And really just this year, it's been a story of an unprecedented ramp. So, we're really pleased that we were able to kind of nail down where we thought we would end up the quarter. And it's the same thing really for '22, it's not any change in visibility, it's not any change in the way we're doing things. We always call it as we see it, these are our best estimates. And with the 12 and 15 all parts, all points are in possibility. That's why they're in the range, but we continue like we always do to aim for the top quadrant in top part of the range, no change."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay. Okay, good to know. And just a follow-up, what are your expectations for book-to-bill, in consulting and overall for the first quarter and for the full fiscal year? And then just what you're thinking about for consulting versus outsourcing revenue growth this year? Thanks, guys. Congrats."
},
{
"speaker": "KC McClure",
"text": "Yes, thank you. Yes, so we feel good about our pipeline as we head into the fiscal year, I would say, I will just comment on Q1 bookings, we do feel really good about where we are, historically, we do see some seasonality in Q1 and large deals can make things lumpy, but we feel really good about our positioning for the first quarter. And in terms of revenue growth, I'll just say that for quarter one, we see consulting continuing in strong double-digits and outsourcing in the double-digit range."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay, got it."
},
{
"speaker": "Angie Park",
"text": "Great, operator, we have time."
},
{
"speaker": "KC McClure",
"text": "Yes, for the full-year, I mean consulting should continue to be strong double-digits and outsourcing depending on where we landed, the range will be high single to low double-digits."
},
{
"speaker": "Jason Kupferberg",
"text": "Thank you."
},
{
"speaker": "Angie Park",
"text": "Great, thanks. Operator, we have time for one more question and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Of course, and that last question comes from the line of Tien-tsin Huang with JPMorgan. Please go ahead."
},
{
"speaker": "Tien-tsin Huang",
"text": "Thank you so much. Really impressive growth at scale here, I wanted to ask on Industry X, it was $5 billion in revenues, so it's up 36% I wrote down, so I think Julie said it's the next frontier here. Does this have potential to be as big as cloud? I'm just trying to think about the sizing of Industry X recognizing it's early, but also its importance?"
},
{
"speaker": "Julie Sweet",
"text": "Yes, I mean I think we're not really sizing that today. I mean, if we think about cloud as the entire enterprise, so sort of hard to sort of do that. What we'd say is, this will be I mean, we're already at $5 billion and we consider it the next digital frontier and it's super early, right, some technologies have just really been coming online in the last year or two that are cloud based. And when you look at like what we're doing for example, like Vivienne Westwood, one of the largest independent global fashion companies, we're doing a new PLM solution for them. We're doing so for Ahlstrom, Ahlstrom a ultimate global leader in transportation where you doing the same in a power company so that the range of what we're doing I mean is both broad based in terms of industry. And so, we do think of this as really a big growth driver for the future, but not sizing it today."
},
{
"speaker": "Tien-tsin Huang",
"text": "Okay, no worries. Just thought it was interesting, because the scope of it can be quite large. Just my quick follow-up, I know you had you feel a lot of questions on acquisitions, already. Digital assets are being valued pretty highly here across the board. Looks like you're still implying a reasonable revenue multiple with your inorganic contribution, have you seen any changes on the valuation side? I know, you're still a destination for many companies, but just curious the valuations have changed in any way you're thinking?"
},
{
"speaker": "Julie Sweet",
"text": "KC, do you want to answer that?"
},
{
"speaker": "KC McClure",
"text": "You know, clearly, valuations, we participate in the overall market, you've seen what valuations have done in the overall market, but I would just say that, we have pretty high hurdle rates in terms of what we expect from our business cases. And we track that very closely, as you would expect of us. And we're very pleased with our ongoing performance of our portfolio against the hurdle rates that we put forth in this business cases."
},
{
"speaker": "Tien-tsin Huang",
"text": "Yes, it's impressive. Thank you both."
},
{
"speaker": "KC McClure",
"text": "Okay, thank you."
},
{
"speaker": "Julie Sweet",
"text": "All right, well now it's time to wrap up. In closing, I want to thank all of our people and our Managing Directors for what you all do every day, our people at actions and results in FY'21 has really put us in a terrific position as we go into FY'22 to create even more value ahead. And I know I and the entire leadership team are super excited and confident about what's to come. And I'll simply end by thanking all of our shareholders for your continued trust and support. Be well everyone. Thanks."
},
{
"speaker": "Operator",
"text": "And ladies and gentlemen, today's conference will be available for replay after 10 A.M. Eastern today through December 16. You may access AT&T Replay System at anytime by dialing 1-866-207-1041, entering the access code 6704907. International participants may dial 402-970-0847 and those numbers again are 1-866-207-1041 and 402-970-0847 again entering the access code 6704907. That does conclude your conference for today. Thank you for your participation and for using AT&T Conference Service. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 3 | 2,021 | 2021-06-24 08:00:00 | Company Representatives: Julie Sweet - Chief Executive Officer KC McClure - Chief Financial Officer Angie Park - Managing Director, Head of Investor Relations
Operator: Ladies and gentlemen, thank you for standing by and welcome to Accenture’s Third Quarter Fiscal 2021 Earnings Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions]. And as a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Managing Director, Head of Investor Relations, Ms. Angie Park. Please go ahead.
Angie Park: Thank you, operator, and thanks everyone for joining us today on our third quarter fiscal 2021 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director and Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chief Executive Officer and KC McClure, our Chief Financial Officer. We hope you’ve had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the fourth quarter and full fiscal year 2021. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today’s news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today we will reference certain non-GAAP financial metrics, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet : Thank you, Angie, and thank you everyone for joining us. We had another outstanding quarter reflecting our laser focus on creating 360 degree client value and the importance of our scale, experience, industry knowledge and trust to the world's leading companies and governments as they continue to digitally transform their enterprises. We had a record 20 clients with bookings over $100 million and a total of $15.4 billion in bookings. We delivered 16% revenue growth in local currency, 3% above the top of our guided range with outstanding profitability and free cash flow. We estimate that we continue to take significant market share. Our growth was broad based across geographic markets and industries with 11 out of 13 industries growing double digits this quarter and reflects our ability to bring together our unmatched breadth of services from strategy and consulting to interactive technology and operations to create the solutions which achieve the value and speed that makes a difference to our clients. We continue to meet our clients’ strong demand adding a net 32,000 talented people this quarter alone. We offer an employee value proposition that allows us to attract top talent, develop our people with world class training and provide them with vibrant career paths. We are pleased with our record 117,000 promotions year-to-date, including almost 1,200 promotions to Managing Director, and while delivering these results we have raised the bar again in terms of investment. We now expect to invest about $4 billion in strategic acquisitions this fiscal year with 39 acquisitions closed or announced year-to-date. This includes announcing this quarter, two acquisitions with purchase prices over $1 billion each. The acquisition by Accenture Federal Services of Novetta in the U.S., an advanced analytics company which we expect to close in August, and with Umlaut, a world class engineering services company headquartered in Germany, which we expect to close in Q1. These 39 acquisitions are well balanced with 10 in North America, 17 in Europe, and 12 in growth markets. Our level of investment demonstrates as well how scale, experience and trust matters. Scale, in terms of our financial capacity; experience, in terms of our track record of the successful integration of approximately 200 companies since 2013, and the trust we have earned in the market that attracts leading companies to want to join the Accenture family. We invest in acquisitions to scale in areas where we see a big market opportunity, to add skills and new capabilities and to further deepen our industry and functional expertise, all to drive continued innovation and the next waves of growth. Finally, because we believe strongly in our commitment to share its success with our communities, we recently announced that we would donate $100 for every one of our zen 540,000 employees or $54 million to urgently address the needs of our communities due to pandemic, including $25 million for India. KC, over to you.
KC McClure : Thank you, Julie, and thanks to all of you for taking the time to join us on today's call. As you heard in Julie’s comments, we are extremely pleased with our results in the third quarter, which continue to reflect very strong momentum across all dimensions of our business. Based on the strength of our third quarter results, and the confidence we have in our fourth quarter to continue to expand our market leadership position, we are increasing our full year outlook which I will cover in more detail later in the call. Before I get into the details, let me summarize the major headlines of our third quarter results, which reflect continued superior execution against our three financial imperatives. Revenue increased nearly $2.3 billion, reflecting growth of 16% in local currency. Results were approximately $300 million above the top end of our guided range, driven by broad based over performance across the business with double digit growth in all three markets, four of five industry groups and in technology services and operations. As we expected, both strategy and consulting and the resources industry group returned to grow. These results demonstrate the power of our business model and our unique ability to seamlessly integrate our services at scale. We estimate that our growth continues to significantly outpace the market. Operating margin was 16%, an increase of 40 basis points for the quarter. Importantly, we no longer have the margin expansion tailwind from lower travel as we anniversary the benefit of the compare this quarter. We continue to absorb significant investments in our people and our business as we are always focused on positioning our business for the future, and we delivered very strong EPS of $2.40, up 26% over fiscal ‘20. Finally, we delivered strong free cash flow of $2.2 billion in the quarter and $6.2 billion year-to-date while also continuing all elements of our capital allocation program, including returning roughly $1.4 billion to shareholders this quarter via dividends and share repurchases. We've made investments of $1.5 billion in acquisitions through Q3 and we now expect to invest about $4 billion in acquisitions this fiscal year, which does not include the Umlaut acquisition which we anticipate to close in FY’22. I want to take a moment to highlight that as you can see from our results and guidance this year, we are able to step up our acquisition spend and continue to expand operating margin. And while I won't comment on the specifics of FY ‘22 until September, based on our current line of sight, you should think of next year's inorganic contribution in the range of 4% and we expect margin – modest margin expansion as we continue to run our business with rigor and discipline. With that, let me turn to some of the details starting with new bookings. New bookings were $15.4 billion for the quarter, with a very strong book-to-bill of 1.2. Consulting bookings were $8 billion, with a book-to-bill of 1.1. Outsourcing bookings were $7.4 billion with a book-to-bill of 1.2. We were very pleased with our new bookings, which represent 39% growth in U.S. dollars and reflect a record 20 clients with bookings over $100 million. Each service dimension; strategy and consulting, technology services and operations delivered double digit bookings growth in local currency. Turning now to revenues. Revenues for the quarter were $13.3 billion, a 21% increase in U.S. dollars and a 16% increase in local currency. Consulting revenues for the quarter were $7.3 billion, up 21% in U.S. dollars and 16% in local currency. Outsourcing revenues were $6 billion, up 20% U.S. dollars and up 16% in local currency. Taking a closer look at our service dimensions, operations grew very strong double digit, technology services grew strong double digits, and strategy and consulting grew high single digits. Turning to our geographic markets, in North America revenue growth was 18% local currency, driven by double digit growth in public service, software and platforms and consumer goods, retail and travel services. In Europe, revenues grew 14% local currency. We saw double digit growth in consumer goods, retail and travel services and industrial, and high single digit growth in banking and capital markets. Looking closer at the countries, Europe was driven by double digit growth in the U.K., Italy and Germany. In growth markets we delivered 15% revenue growth in local currency, led by double digit growth in consumer goods, retail and travel services, banking and capital markets and public service. From a country perspective, growth markets was led by double digit growth in Japan and Brazil. Moving down the income statement, gross margin for the quarter was 33.2% compared with 32.1% for the same period last year. Sales and market expense for the quarter was 10.6% compared with 10.2% for the third quarter last year. General and administrative expense is 6.6% compared to 6.3% for the same quarter last year. Operating income was $2.1 billion in the third quarter, reflecting a 16% operating margin, up 40 basis points compared with Q3 last year. Our effective tax rate for the quarter was 25% compared with an effective tax rate of 25.5% for the third quarter last year. Diluted earnings per share were $2.40 compared to EPS of $1.90 in the third quarter last year. Day Service Outstanding were 36 days compared to 34 days last quarter and 41 days in the third quarter of last year. Free cash flow for the quarter was $2.2 billion, resulting from cash generated by operating activities of $2.4 billion, net of property and equipment editions of $158 million. Our cash balance at May 31 was $10 billion, compared with $8.4 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the third quarter we repurchased or redeemed 3 million shares for $835 million at an average purchase price of $276.98 per share. As of May 31 we had approximately $4.2 billion of share repurchase authority remaining. Also in May, we paid a quarterly cash dividend $0.88 per share for a total of $559 million. This represents a 10% increase over last year, and our Board of Directors declared a quarterly cash dividend of $0.88 per share to be paid on August 13, also a 10% increase over last year. So in summary, we are extremely pleased with our results to-date, and are now focused on Q4 and closing out a very strong year. Now, let me turn it back to Julie.
Julie Sweet : Thanks KC. I’ll start with the environment. The dynamics in the market we are seeing are not only of recovery from the lower spending pattern at the onset of the pandemic, but a more sustained growth in demand as companies race to modernize and accelerate their digital initiatives with compressed transformation. Pre-COVID our research showed a digital achievement gap with leaders growing 2x faster than laggers and we estimate that gap has now widened to 5x, with leaders stepping up their investment in technology and innovation, and lead progress taking accelerated steps to catch up. Cloud is an even more critical enabler as companies are increasing their focus on enterprise wide transformations and rapidly moving to digital and cloud powered models. These needs of our clients are driving strong momentum in our business, with an acceleration of continued strong double digit growth across Applied Intelligence, Cloud, Industry X, Intelligent Operations and Security, with interactive and intelligent platform services returning to strong double digit growth this quarter. These strategic priorities are multi-service and are powered by our unparalleled technology ecosystem relationship. Let me share some color to bring this demand to life. I want to particularly highlight Cloud, which continues to have very strong double digit growth rates, as well as the subset of Accenture Cloud First with growth was even stronger and has exceeded our expectations when we formed Cloud First last September. With our Cloud First services we are helping agencies served by concept, Italy's National Procurement Agency to deliver on Italy's National Recovery and Resilience Plan. We are developing and running industry specific cloud based platforms to standardize and improve their efficiency and speed, reducing the time to launch new contracts and ultimately providing much improved services for Italy’s citizens. We are using our Intelligent Platform services to help DuPont, a company with a rich history of business reinvention. We imagine its financial structure to coordinate operations across its large geographic footprint. After going through a strategic and deliberate restructuring through M&A, we will now help DuPont implement essential finance processing suites that will help them to consolidate their multiple financial systems and chart of accounts into one and close the books faster. This will provide real-time review of results for all of the business units, all in the cloud, giving DuPont more agility, speed and certainty in a complex and volatile market. We are helping Jaguar Land Rover transform its global marketing model to deliver a more personalized customer experience with creativity and technology at its core. We were selected for our technology capabilities, data led performance and experience led approach. We will use the strength of the experience, creative and digital capabilities of interactive, and the marketing delivery capabilities of operations with our SynOps platform, which we already used as part of Jaguar Land Rover warranty operations. SynOps will deliver AI powered insights and highly automated production around the world. Security is top of mind for our clients as the threat landscape expands. Our very strong double digit growth is driven by the breadth and depth of our services, from advisory to cyber defense, to managed security. For example, facing ever increasing cyber threats and continued financial pressures as a result of COVID-19, Accenture is helping a UKI bank by bringing together the whole breadth of these capabilities to provide innovative solutions to support the bank's future security strategy. Across many of these examples are our implied intelligence services. We were excited this quarter to announce Accenture federal services agreement to acquire Novetta, an advanced analytics company serving U.S. Federal Organizations that is demonstrating what's possible with analytics, machine learning, cyber and cloud engineering. This will augment our already strong capabilities and scale in these critical areas, providing even more diversification across our federal business, specifically in the national security space which is seeing substantial growth. I wanted to give a special recognition to our colleagues serving the public sector around the world throughout the pandemic. Your seven consecutive quarters of double digit growth reflect your absolute commitment to the important missions of government serving their citizens. Turning now to Industry X, our digital, engineering and manufacturing services. We believe that product development, design engineering, manufacturing and the supply chain make up the next big digital transformation frontier. The impact of COVID-19 is accelerating the need to transform these core operations, and for nearly a decade we have been investing to build the unique capabilities and ecosystem partnerships to combine the power of data and digital with traditional engineering services. We are very pleased with the announcement of our agreement to acquire Umlaut, which will add more than 4,200 industry leading engineers and consultants across 17 countries, and expand our capabilities across a range of industries, including automotive, aerospace and defense, telecommunications, energy and utilities. Some recent examples of our Industry X services include helping a German telecom company continuously develop and enhance their internet television service by utilizing embedded engineering in their set top boxes and managing new features on the platform. Helping a large media conglomerates accelerate their primary revenue streams and digital products and advertising, with our product and platform engineering expertise to design, build, test and deploy new products, services and features; and working with a global automotive OEM to execute online remote software updates for their in-car computer systems to allow seamless deployment of new software versions. We are also working with an American multinational manufacturer of confectionery pet food and other food products to deploy a digital twin platform to optimize production in its manufacturing facilities, improve margins and reduce waste. We’re working with a large electric company in Japan to help their power plants – to help bring their power plants into the future by digitizing their operations and standards across each department. And with a large oil and gas company to build their internal digital capabilities to substantially reduce time to market for new digital solutions that extends to its customers while supporting the company's key safety and sustainability goals throughout the use of the digital factory. Taking a step back, the examples I have provided today, all require deep industry knowledge and innovation. Our breadth and depth across industries enables us to tailor industry solutions, while bringing cross industry expertise as we help our clients facing industry convergence and by using the lessons of other industries. We are proud this quarter that Fast Company recognized us for our innovation across multiple initiatives in its World Changing Ideas Awards. Our cross-industry expertise is one of the powerful sources of our ability to innovate. For example, using our deep banking industry and technical expertise, we rapidly developed for a commercial bank which was not a traditional small business administration lender; a program under the U.S. paycheck protection program that allowed them to make loans to thousands of small businesses struggling with the impacts of the pandemic. We then pivoted to apply this approach to stand up’s Facebook’s small business grants program for black owned businesses, enabling the distribution of 10,000 grants to black-owned businesses in the U.S. This grants program is an important part of Facebook's overall commitment to invest $200 million in building programs and tools for black owned businesses. Finally, let me turn to our incredible people. Their health and safety remain our top priority. We are supporting our people by facilitating vaccinations, including standing up clinics in many of our offices such as in India where already 50,000 of our people, their families and contractors have been vaccinated. We have been focused on taking the lessons as an almost 100% remote workforce during the pandemic to a new way of working, moving from a remote or hybrid model to an omni-connected experience. People will work in the office, from home and at client sites, and its likely many of our clients will be doing the same. So our approach focuses on the experience of connecting to continue to serve our clients in a differentiated way and create an environment that our people feel a sense of belonging. The rich diversity and ingenuity of our people from our Board of Directors to our new hires, helps us deliver 360 degree value for the benefit of all. We now have more than 250,000 women representing approximately 46% of our workforce. As you may recall, shortly after the murder of George Floyd in the U.S., on this call I shared with you our commitment to take three actions in the U.S.: setting external goals to increase representation, training our people and making a bigger impact in our communities. One year later I am pleased to report that we not only took each action, but have made measurable progress, including increasing our representation, having 95% of our U.S. people complete our new anti-racism training and making substantial new investments in our communities. You can find a full progress update on our website, because we believe transparency and accountability are hallmarks of good governance and essential to building trust. As we see the rise or continuation of all kinds of hate crimes against diverse communities, including violence against Asians, the LGBTI community, antisemitism and Islamophobia, I want to reaffirm my and Accenture’s unwavering commitment to equality and justice for all and zero tolerance for racism, bigotry and hate of any kind. KC, back to you.
KC McClure: Thanks Julie. Let me now turn to our business outlook. For the fourth quarter of fiscal ’21, we expect revenue to be in the range of $13.1 billion to $13.5 billion. This assumes the impact of FX will be positive 4% compared to the fourth quarter of fiscal ‘20 and reflects an estimated 17% to 21% growth in local currency. For the full fiscal year ’21, based upon how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in U.S. dollars will be approximately positive 3.5% compared to fiscal ‘20. For the full fiscal ’21, we now expect our revenues to be in the range of 10% to 11% growth in local currency over fiscal ’20, including approximately negative 1% from a decline in revenues from reimbursable travel, based on a 2% reduction the first half of the year and no material impact in the second half of the year. Importantly, organic revenue is the driver of the increase to our updated guidance as we still expect the inorganic contribution to remain at about 2.5% for the full year. For operating margin, we now expect fiscal year ‘21 to be 15.1% a 40 basis point expansion over fiscal ‘20 results. We now expect our annual adjusted effective tax rate to be in the range of 23% to 24%. This compares to an adjusted effective tax rate of 23.9% in fiscal ‘20. For earnings per share, we now expect full year diluted EPS for fiscal ‘21 to be in the range of $9.07 to $9.16. We now expect adjusted full year diluted EPS to be in the range of $8.71 to $8.80 or 17% to 18% growth over adjusted fiscal ‘20 results. For the full fiscal ‘21 we now expect operating cash flow to be in the range of $8.65 billion to $9.15 billion. Property and equipment additions to be approximately $650 million and free cash flow to be in the range of $8 billion to $8.5 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.4 to 1.5. Finally, we continue to expect to return at least $5.8 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so that we can take your questions. Angie?
Angie Park: Thanks KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call.
Operator: Thank you. [Operator Instructions] It comes from the line of Lisa Ellis with MoffettNathanson. Please go ahead.
Lisa Ellis: Hey, good morning and thank you. Great results here! A couple of questions; one is a little more tactical, one more strategic. The first one, in bookings KC, can you just remind us one, how acquisitions are not reflected in bookings and then on a related note, is the composition of your bookings changing at all? I'm just specifically thinking about these big $100 million plus transformation programs. Are you seeing a notable change in duration or anything like that? Just trying to understand the booking number a little bit and then I’ll follow up. Thank you.
KC McClure: Okay, great, thanks Lisa. So let me just decompose bookings a little bit. So we were really pleased with our bookings this quarter right, $15.4 billion, and again that grew 39% in U.S. dollars, really strong book-to-bill 1.2%. And in terms of – when you look at it, there was very strong bookings in both consulting and outsourcing, as well as all three geographic markets. And if you look at specifically in our V&A, which also was represented across all of those dimensions, there will be a slight impact in the bookings based on the backlog that we bring in from these acquisitions, but it's not overall significant. But let me just peel it back in terms of when you look underneath that 15.4, I’d say there's really kind of three things I’d point out. First was that there was really a good mix of all categories of our sales. As Julie mentioned, we had a record 20 clients, over $100 million of sales and that as you know positions us really well for the future. But if you go all the way down through the categories, all the way through our smaller deals, they’ve represented very well and that can help us with revenue in the current quarter. The second thing that I would point out is that our bookings were very broad based across all of our services, and that include strategy and consulting. And the third thing was that it was aligned to our strategic priorities as we pointed out, you know driven by cloud industry [accent] (ph) security for example. So you know with those points I'll hand it back to you to ask the second question or if there's any other color that you want.
Lisa Ellis: Terrific! Thank you. The second one, maybe Julie this is for you. I just wanted – was hoping to comment on acquisitions. You know this is – obviously you’ve up-ticked acquisitions, made a couple of bigger ones than Accenture has historically done. Can you just talk about – you know is this just kind of opportunistic or has something kind of shifted in terms of your willingness to do larger acquisitions or specific market opportunities you're going after. Thank you.
Julie Sweet: Sure Lisa. And well, so we've always said we have the capacity to do larger acquisitions, but we’re very disciplined about what we will acquire, and so these were you know opportunities that were very aligned to our strategic priorities. So you know Novetta being both, investment and public sector, but primarily all about you know advanced analytics, machine learning, cyber and cloud engineering, and also importantly diversification for our federal business, because they are in the national intelligence space and Umlaut is in engineering, which was just an opportunity as a company that we know very well, that really is giving us an opportunity to accelerate our scale in Industry X and we've seen the digitization of manufacturing and engineering be a major priority post COVID. Now we've been investing for nearly a decade in this space. We predicted this would happen. As you can see by the number, the amount of work that we're already doing, and this was a great opportunity for a company that we know well, and you know our strategy continues to be – we're going to make acquisitions to scale and big market opportunities to add new skills and opportunities as you know that we built a lot of interactive through acquisitions, for example those renewed skills and capabilities, and then to deepen industry and functional knowledge. And so this is the continuation of that and you know I think the advantage we have is our financial capacity to make investments and to increase our investment you know for the benefit of our clients and all of our stakeholders when we see the right opportunities and we’re going to continue to have that discipline around making strategic acquisitions.
Lisa Ellis: Terrific! Good stuff. Thank you.
Operator: Thank you. Our next question comes from the line of Ashwin Shirvaikar of Citi. Please go ahead.
Ashwin Shirvaikar: Hey! Thanks and a great quarter. Congratulations on that from me as well. The question I had is about the momentum that you are seeing in the business and it seems to have actually accelerated from what you're seeing in the past quarters. I wanted to ask you with regards to whether this changes how you think about managing the business in the interim, in order to continue to deliver what you’re seeing from a demand perspective, particularly as we see attrition go up and so on and that's an across the board statement, not just an Accenture statement. So any thoughts with regards to how you're thinking of delivery?
KC McClure: Yeah, Ashwin I’ll take this and maybe I'll frame up a few things for you and hand it over to Julie as well. So let me just maybe frame up how we’re thinking about you mentioned the demands you know in overall business and thinking about the quarter and our year-to-date from a financial perspective. You know these results are really exceptional when you think about it in the context of our historical performance, so I’ll start there. I mean clearly we’re benefiting from an easier compare in a strong market demand and we see that continuing, but even with that bookings at $44 billion growing 25% year-to-date and that’s off the base of record sales through Q3 last year. And then you couple that with 54 clients with bookings over $100 million through Q3, which is more in the first nine months of this year, than the whole of last year ‘20, FY‘20 and FY‘19 and I mention that as you talk about things in different ways, you may need to manage differently just to talk about the scale in our bookings. As we look at the scale in revenue, we grew record $2.3 billion in revenue this quarter year-over-year. When you think about our industries, where we’re clearly the leader with the breadth and depth of industries, with 11 of the 13 growing double digits and as I mentioned before in our guidance, the increase in our full year outlook, it's driven by organic revenue given that inorganic is contribution staying pretty much the same. And then you end that all with profitability of 40 basis points expansion this quarter. We had very strong profitability and we're no longer benefiting from a travel tailwind and we continue to invest at scale in our business and our people. So you know with that, let me hand it over more to Julie to round out some of the question you had on demand and attrition.
Julie Sweet: Yes, so Ashwin it’s a great question around you know managing our business and so I want to just take you all back to right before the pandemic. I remember back then and on March 1 we put in a new growth model we call the nextgen growth model and that was designed for helping us manage our business as we saw the scale increasing, right, and that change in growth model was focused on being able to have more of our leaders closer to our clients, we changed the P&L as you recall to the geographic. And so we’ve already put in place a model that is designed to allow us to continue to scale, and so this for us was anticipated, and it’s exciting to see how we are very uniquely positioned as our clients’ needs have accelerated, because that’s what’s driving the demand right. The needs of our clients have accelerated post-COVID to do compressed transformation, and we have the right operating model in place. As we think about attrition, you now it’s ticked up to pre-COVID levels in a hot market although not the highest we’ve ever seen, and so as you said it’s an industry phenomenon, we are comfortable – I mean our core competency is about managing our supply and demand, but more importantly our core competency is being a great company to work for. And as you saw with our numbers this quarter, we hired net 32,000 incredible people and that is just a testimony to our ability to attract great talent, as well as continue to train our people. We’ve trained over 100,000 people since the pandemic started, pivoting to the areas of our clients’ needs. So we feel good about it, and of course this is what you expect from us, so we’ll continuously improve.
Ashwin Shirvaikar: Thanks for that. All good points and I agree. I guess the next question it with regards to you know – and ordinary I don’t focus on a particular acquisition, but this Umlaut seems to be, I have to ask is this the first of many as you expand into a much bigger engineering services type presence. That is a relatively massive end market, so just strategically how are you thinking of this?
Julie Sweet: Well the sort of big picture, we believe that the digital engineering and manufacturing space is the next frontier for our clients, right. There’s been a lot and there’s still a lot to do with respect to the front office and the back office for lack of a better term, that you know our clients are building a digital core, they’re transforming operations and they’re trying to find new ways of growth. But the areas that have been not as digitized over the last several years as companies have pivoted, has been in core operations, manufacturing and supply chain. Now we predicted this just as we predicted back in 2013, that someday everybody would be a digital business, and so we’ve been investing. We’ve already made, I don’t know, seven, eight, nine acquisitions over the last several years to build these capabilities, and you saw that with all the examples that we did in the script. And so this is about rapidly scaling with some of the best engineers in the world, right, because we see the market opportunity, but most importantly the need from our clients, and so you should expect that will continue to build these both organically and inorganically, but obviously this is a great add in terms of scale for us.
Ashwin Shirvaikar: Great! Thank you. Congratulations!
Operator: Thank you. Our next question comes from the line of Jason Kupferberg with Bank of America. Please go ahead.
Jason Kupferberg : Thanks guys. Good morning. I’m wondering if you can estimate for us perhaps how much the acceleration in all this enterprise, digital transformation has enhanced your structural organic revenue growth profile, relative to pre-pandemic levels, because it certainly sounds like this trend continues to have lags.
Julie Sweet: Yeah, I mean I think the way to think about it is that we’re taking market share and we are really well positioned to capture the growth that’s available because of the needs of our clients. And so you’re obviously seeing that uptick in organic growth and we think this will be sustained demand. I think it’s too early and we’re not going to kind of get back into sort of giving sort of a view of FY‘22, but what we would say is we do believe that what you’re seeing right now in demand isn’t just like you know a recovery because spending decreased, but actually sustained demand and that we are incredibly well positioned to capture that, because clients are looking for outcomes and the breadth of our services. You know they’re turning to us because we can give them solutions, not just individual services. They want the innovation that we’re bringing; you know the things like our SynOps platform. They are very appreciative and focused on the fact that we care about the 360 degree value, so that we’re helping improve their own skills, as well as achieving their goals and finally, you know and I think something that is really critical right now and why we are so well positioned is they see it’s a company that creates value and leads with values. And so trust really matters when you are doing major transformation and you know I’ll give you one example. We’ve had over 80 clients in the last 12 months just come and sit down with us to learn more about our diversity supplier program, because it really matters to them and they see us as a leader, right. These are the things that make us an incredibly attractive and trusted partner. And so we think that you know this is really an enduring differentiation at a time when there is going to be subsisting demand for compressed transformation.
Jason Kupferberg : Okay, understood. Just a quick two part follow up here, your thoughts on Q4 book-to-bill and what were the areas of the business that surprised you most in terms of revenue this quarter, because obviously the overall upside was quite significant. Thank you.
Julie Sweet: Yes, Jason just in terms of how we think about the fourth quarter. I mean so obviously we’ve had $44 billion of booking year-to-date and even with that, we still have a strong pipeline and we feel good about our position for Q4 as it relates to bookings. And in terms of what did better, you know as I mentioned earlier, it really was broad based, every part of our business did a bit better.
Jason Kupferberg : Okay, thanks for the comments.
Operator: Thank you. Our next question comes from the line of Rod Bourgeois with DeepDive. Please go ahead.
Rod Bourgeois: Hey guys! Hey, I just wanted to ask about the margin outlook given the increased acquisition contribution that you’ll be digesting in fiscal ‘22. I just like to ask about the margin levers that you’ll be able to pull in order to still achieve overall operating margin expansion. And also, I guess besides digesting this added acquisition content, are you also needing to spend more on people costs given the war for talent that’s out there. So question about margin levers and also the investments in people? Thanks.
KC McClure: Yes, thanks Rod. So I mean, let’s start with the second one first. So yes, in terms of for the people side of it, obviously there’s a lot of demand in the market. We’re in a hot market right now and historically we’ve seen wages increase and that vary by skills and geographies and that’s happening now, but you see that Rod flowing through our results already to-date and through our guidance. So it’s really up to us to manage our business with rigor discipline as we always do, you know us well, you know managing our pyramid, increasing the use of automation and just overall delivery efficiencies. So that’s the first part on wages as it relates to operating margin. And just coming back to the same point on V&A, so let me just give you a little bit more color on V&A coupled with what I talked about a little bit earlier and of course, I’m not going to give any specific guidance for FY ‘22 until September. But we do expect to have a higher level of inorganic contribution next year, probably around something closer to 4% and that’s really due to the fact that we’re deploying about $4 billion in FY ‘21, a larger portion that’s closer to the later part of the year, and we expect to benefit from more of that revenue in FY ‘22. We also expect at this time to deploy somewhere around $4 billion in FY ‘22, that’s including Umlaut, which we expect to close next year, early in the year. And of course as Julie said, we’ve always said we have the ability to do more, but that’s our line of sight today, and it’s up to us to manage our, to all the levers that we have in our disposal, to continue within the premise of clients and our overhead and structural costs, to make sure that we continue to drive modest margin expansion while investing at scale in our business and our people.
Rod Bourgeois: Great! And then just a quick follow-up on the revenue progression that’s happening. Clearly, this is a big industry recovery, some of that cyclical, some of it secular, and you have certain COVID-impacted verticals that are coming back online. I guess as we head into the next fiscal year, are there on the other side, are there any revenue contributions that will taper as the COVID crisis ends? Are there any, is there any sort of lumpy work that might taper off as you head into the next fiscal year amidst all of the other momentum that’s happening in the business?
Julie Sweet: I mean there is nothing material. I mean like think about the public sector for example. We did a lot of COVID surge work, but now you’ve got the fiscal stimulus that’s around the world and you see the digitization of the public sector like we gave the example of concept in Italy. So there is nothing material that we think will be difficult to manage, because you’re seeing really, when you see that in the results, kind of across industries, there this need to digitize, so nothing material that we think to mention.
Rod Bourgeois: Thank you.
Operator: Thank you. Our next question comes from the line of Bryan Bergin with Cowen. Please go ahead.
Bryan Bergin: Good morning, thank you. I’m curious, over the last two to three quarters, have you seen a notable change in clients’ appetite for price increases as broader transformation demand is ramped up?
KC McClure: Yes, so let me talk to you a little bit about what we’re seeing in terms of pricing overall. So just importantly, as a reminder, we talked about pricing. We define it as the contract profitability or margin on the work that we sell Bryan. And as always the environment remains competitive, and in many areas of our business we did see pricing was lower and that’s really based on a combination of the fact that the market is competitive and disciplined investments that we’re making, and so all of that is baked into our operating margin guidance for the year.
Bryan Bergin: Okay. And then one on Accenture Operations, I’m curious if you’re seeing any change in the size and scope of engagements that clients are outsourcing too. Can you just comment on some of the strengths or the drivers of the continued strength that you’ve shown in that business?
Julie Sweet: Yes, it’s a great question. It’s not so much about the size, it’s really about the intent. I mean what you’re seeing is clients really saying, in a world where I’ve got to digitize the entire enterprise, right, where do I want to focus my own resources and leadership and where can I leverage Accenture and their investments? And this is where we really got ahead of the market, right, where we developed SynOps and what we’re providing them is both cost efficiencies, but really outcomes of actual insights that come from being able to digitize. And then you add on top of that, where we have more clients thinking about having us takeover, we have a strong pipeline and you know taking over more people, because we have such a great employee value proposition and so they’re starting – you know when we think about the future of work, think about it, we’re seeing more of our clients really see it as a combination of their own employees automation or bots, and then partners like Accenture that really integrate with their own employees and we’re just a leader here. And so it’s more about the trends of the need to digitize that is what you’re seeing reflected, digitized at speed.
Bryan Bergin: Thank you.
Operator: Thank you. Our next question comes from the line of Bryan Keane with Deutsche Bank. Please go ahead.
Bryan Keane: Hi guys, congrats on the results. I wanted to ask about Strategy Consulting. It had been a laggard, but saw that it moved positively into high single-digit. Just a little bit on the outlook there. Do you continue to see that maybe reach some of the demand you’re seeing in some of your other industry groups?
KC McClure: Yes. Hey, Bryan. Thanks for the question. You’re right, we were very pleased with the acceleration to high single-digits in the quarter in strategy consulting, which is what we expected. In terms of how we look at just consulting overall type of work go forward, we see it being strong double-digit for the fourth quarter and the second half of the year that would mean we round up really kind of at a strong double-digit growth perspective.
Julie Sweet: And Bryan as a reminder, because I remind you all every single quarter, right, clients aren’t focused on is it strategy and consulting or technology or operations. They are looking for outcomes and what makes us so unique is that all of these things, whether it’s Cloud or Intelligent Operations or marketing transformation bring together our services and with more confidence and certainty and that’s really how we think about it.
Bryan Keane: Got it. And then just as a follow-up. The increase in M&A, just curious on how you guys are thinking about capital allocation, in particular the dividends and the share repurchase. Does that change at all with a little more M&A?
KC McClure: Obviously, we’ll give you – I’ll give you specifics in September Bryan for next year, but overall our capital allocation framework really remains intact.
Julie Sweet: I mean, you should all just think about this as we’re going to deliver on our commitments and we are investing to drive the next waves of growth and we are taking advantage of our ability to do so in this market.
Bryan Keane: Great! Thanks so much.
Angie Park : Last question. Operator, we have time for one more question, then Julie will wrap up the call.
Operator: Thank you and that question will come from Tien-tsin Huang with JPMorgan. Please go ahead.
Tien-tsin Huang: Hey! Thanks so much. Amazing results! Sorry if this was already asked, I had to jump off earlier. Just on the record number of deals over $100 million. I’m just curious how the pipeline is for such deals going forward. Is there an opportunity to replenish? Just what is the – what do you see out there in terms of large deal potential from here?
KC McClure: Yes. Hey Tien-tsin, we still have a strong pipeline overall and that includes in the large deal category.
Tien-tsin Huang: Okay, good. And then just on the four point inorganic contribution, I heard that for next year. How about on the margin impact there, I think KC you mentioned that there’ll be a little bit impact on the margin. You’ll still be able to expand. Just wanted to make sure I heard that correctly? Thanks.
KC McClure: Yes. So yes, we want to – so what I did say is that we do expect inorganic contribution next year about 4% and our line of sight now is about $4 billion of capital spend next year ‘22, but we expect modest margin expansion to continue in ‘22.
Tien-tsin Huang: Okay, very good. I appreciate that guys. Well done!
KC McClure: Thank you.
Julie Sweet: Great, Tien-tsin. Okay, in closing, we really appreciate everyone joining us today. We believe that we are unique because of both what we do and how we do it and we are a company that as I’ve shared before, creates value and leads with values. I want to thank all of our people and our leaders for what you’re doing every day. And finally, I want to thank all of our shareholders for your continued trust and support. We will make sure to earn it every day. Be well.
Operator: Ladies and gentlemen, this conference will be available for replay after 10:00 AM Eastern today through September 23. You may access the AT&T replay system at any time by dialing 1-866-207-1041 and entering access code 1334620. International participants may dial 402-970-0847. Those numbers again are 1-866-207-1041 and 402-970-0847 with access code 1334620. That does conclude our conference for today. We thank you for your participation and for using AT&T Concerning Service. You may now disconnect. | [
{
"speaker": "Company Representatives",
"text": "Julie Sweet - Chief Executive Officer KC McClure - Chief Financial Officer Angie Park - Managing Director, Head of Investor Relations"
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by and welcome to Accenture’s Third Quarter Fiscal 2021 Earnings Call. At this time all participants are in a listen-only mode. Later we will conduct a question-and-answer session. [Operator Instructions]. And as a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Managing Director, Head of Investor Relations, Ms. Angie Park. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, operator, and thanks everyone for joining us today on our third quarter fiscal 2021 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director and Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chief Executive Officer and KC McClure, our Chief Financial Officer. We hope you’ve had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the fourth quarter and full fiscal year 2021. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today’s news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today we will reference certain non-GAAP financial metrics, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie, and thank you everyone for joining us. We had another outstanding quarter reflecting our laser focus on creating 360 degree client value and the importance of our scale, experience, industry knowledge and trust to the world's leading companies and governments as they continue to digitally transform their enterprises. We had a record 20 clients with bookings over $100 million and a total of $15.4 billion in bookings. We delivered 16% revenue growth in local currency, 3% above the top of our guided range with outstanding profitability and free cash flow. We estimate that we continue to take significant market share. Our growth was broad based across geographic markets and industries with 11 out of 13 industries growing double digits this quarter and reflects our ability to bring together our unmatched breadth of services from strategy and consulting to interactive technology and operations to create the solutions which achieve the value and speed that makes a difference to our clients. We continue to meet our clients’ strong demand adding a net 32,000 talented people this quarter alone. We offer an employee value proposition that allows us to attract top talent, develop our people with world class training and provide them with vibrant career paths. We are pleased with our record 117,000 promotions year-to-date, including almost 1,200 promotions to Managing Director, and while delivering these results we have raised the bar again in terms of investment. We now expect to invest about $4 billion in strategic acquisitions this fiscal year with 39 acquisitions closed or announced year-to-date. This includes announcing this quarter, two acquisitions with purchase prices over $1 billion each. The acquisition by Accenture Federal Services of Novetta in the U.S., an advanced analytics company which we expect to close in August, and with Umlaut, a world class engineering services company headquartered in Germany, which we expect to close in Q1. These 39 acquisitions are well balanced with 10 in North America, 17 in Europe, and 12 in growth markets. Our level of investment demonstrates as well how scale, experience and trust matters. Scale, in terms of our financial capacity; experience, in terms of our track record of the successful integration of approximately 200 companies since 2013, and the trust we have earned in the market that attracts leading companies to want to join the Accenture family. We invest in acquisitions to scale in areas where we see a big market opportunity, to add skills and new capabilities and to further deepen our industry and functional expertise, all to drive continued innovation and the next waves of growth. Finally, because we believe strongly in our commitment to share its success with our communities, we recently announced that we would donate $100 for every one of our zen 540,000 employees or $54 million to urgently address the needs of our communities due to pandemic, including $25 million for India. KC, over to you."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie, and thanks to all of you for taking the time to join us on today's call. As you heard in Julie’s comments, we are extremely pleased with our results in the third quarter, which continue to reflect very strong momentum across all dimensions of our business. Based on the strength of our third quarter results, and the confidence we have in our fourth quarter to continue to expand our market leadership position, we are increasing our full year outlook which I will cover in more detail later in the call. Before I get into the details, let me summarize the major headlines of our third quarter results, which reflect continued superior execution against our three financial imperatives. Revenue increased nearly $2.3 billion, reflecting growth of 16% in local currency. Results were approximately $300 million above the top end of our guided range, driven by broad based over performance across the business with double digit growth in all three markets, four of five industry groups and in technology services and operations. As we expected, both strategy and consulting and the resources industry group returned to grow. These results demonstrate the power of our business model and our unique ability to seamlessly integrate our services at scale. We estimate that our growth continues to significantly outpace the market. Operating margin was 16%, an increase of 40 basis points for the quarter. Importantly, we no longer have the margin expansion tailwind from lower travel as we anniversary the benefit of the compare this quarter. We continue to absorb significant investments in our people and our business as we are always focused on positioning our business for the future, and we delivered very strong EPS of $2.40, up 26% over fiscal ‘20. Finally, we delivered strong free cash flow of $2.2 billion in the quarter and $6.2 billion year-to-date while also continuing all elements of our capital allocation program, including returning roughly $1.4 billion to shareholders this quarter via dividends and share repurchases. We've made investments of $1.5 billion in acquisitions through Q3 and we now expect to invest about $4 billion in acquisitions this fiscal year, which does not include the Umlaut acquisition which we anticipate to close in FY’22. I want to take a moment to highlight that as you can see from our results and guidance this year, we are able to step up our acquisition spend and continue to expand operating margin. And while I won't comment on the specifics of FY ‘22 until September, based on our current line of sight, you should think of next year's inorganic contribution in the range of 4% and we expect margin – modest margin expansion as we continue to run our business with rigor and discipline. With that, let me turn to some of the details starting with new bookings. New bookings were $15.4 billion for the quarter, with a very strong book-to-bill of 1.2. Consulting bookings were $8 billion, with a book-to-bill of 1.1. Outsourcing bookings were $7.4 billion with a book-to-bill of 1.2. We were very pleased with our new bookings, which represent 39% growth in U.S. dollars and reflect a record 20 clients with bookings over $100 million. Each service dimension; strategy and consulting, technology services and operations delivered double digit bookings growth in local currency. Turning now to revenues. Revenues for the quarter were $13.3 billion, a 21% increase in U.S. dollars and a 16% increase in local currency. Consulting revenues for the quarter were $7.3 billion, up 21% in U.S. dollars and 16% in local currency. Outsourcing revenues were $6 billion, up 20% U.S. dollars and up 16% in local currency. Taking a closer look at our service dimensions, operations grew very strong double digit, technology services grew strong double digits, and strategy and consulting grew high single digits. Turning to our geographic markets, in North America revenue growth was 18% local currency, driven by double digit growth in public service, software and platforms and consumer goods, retail and travel services. In Europe, revenues grew 14% local currency. We saw double digit growth in consumer goods, retail and travel services and industrial, and high single digit growth in banking and capital markets. Looking closer at the countries, Europe was driven by double digit growth in the U.K., Italy and Germany. In growth markets we delivered 15% revenue growth in local currency, led by double digit growth in consumer goods, retail and travel services, banking and capital markets and public service. From a country perspective, growth markets was led by double digit growth in Japan and Brazil. Moving down the income statement, gross margin for the quarter was 33.2% compared with 32.1% for the same period last year. Sales and market expense for the quarter was 10.6% compared with 10.2% for the third quarter last year. General and administrative expense is 6.6% compared to 6.3% for the same quarter last year. Operating income was $2.1 billion in the third quarter, reflecting a 16% operating margin, up 40 basis points compared with Q3 last year. Our effective tax rate for the quarter was 25% compared with an effective tax rate of 25.5% for the third quarter last year. Diluted earnings per share were $2.40 compared to EPS of $1.90 in the third quarter last year. Day Service Outstanding were 36 days compared to 34 days last quarter and 41 days in the third quarter of last year. Free cash flow for the quarter was $2.2 billion, resulting from cash generated by operating activities of $2.4 billion, net of property and equipment editions of $158 million. Our cash balance at May 31 was $10 billion, compared with $8.4 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the third quarter we repurchased or redeemed 3 million shares for $835 million at an average purchase price of $276.98 per share. As of May 31 we had approximately $4.2 billion of share repurchase authority remaining. Also in May, we paid a quarterly cash dividend $0.88 per share for a total of $559 million. This represents a 10% increase over last year, and our Board of Directors declared a quarterly cash dividend of $0.88 per share to be paid on August 13, also a 10% increase over last year. So in summary, we are extremely pleased with our results to-date, and are now focused on Q4 and closing out a very strong year. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thanks KC. I’ll start with the environment. The dynamics in the market we are seeing are not only of recovery from the lower spending pattern at the onset of the pandemic, but a more sustained growth in demand as companies race to modernize and accelerate their digital initiatives with compressed transformation. Pre-COVID our research showed a digital achievement gap with leaders growing 2x faster than laggers and we estimate that gap has now widened to 5x, with leaders stepping up their investment in technology and innovation, and lead progress taking accelerated steps to catch up. Cloud is an even more critical enabler as companies are increasing their focus on enterprise wide transformations and rapidly moving to digital and cloud powered models. These needs of our clients are driving strong momentum in our business, with an acceleration of continued strong double digit growth across Applied Intelligence, Cloud, Industry X, Intelligent Operations and Security, with interactive and intelligent platform services returning to strong double digit growth this quarter. These strategic priorities are multi-service and are powered by our unparalleled technology ecosystem relationship. Let me share some color to bring this demand to life. I want to particularly highlight Cloud, which continues to have very strong double digit growth rates, as well as the subset of Accenture Cloud First with growth was even stronger and has exceeded our expectations when we formed Cloud First last September. With our Cloud First services we are helping agencies served by concept, Italy's National Procurement Agency to deliver on Italy's National Recovery and Resilience Plan. We are developing and running industry specific cloud based platforms to standardize and improve their efficiency and speed, reducing the time to launch new contracts and ultimately providing much improved services for Italy’s citizens. We are using our Intelligent Platform services to help DuPont, a company with a rich history of business reinvention. We imagine its financial structure to coordinate operations across its large geographic footprint. After going through a strategic and deliberate restructuring through M&A, we will now help DuPont implement essential finance processing suites that will help them to consolidate their multiple financial systems and chart of accounts into one and close the books faster. This will provide real-time review of results for all of the business units, all in the cloud, giving DuPont more agility, speed and certainty in a complex and volatile market. We are helping Jaguar Land Rover transform its global marketing model to deliver a more personalized customer experience with creativity and technology at its core. We were selected for our technology capabilities, data led performance and experience led approach. We will use the strength of the experience, creative and digital capabilities of interactive, and the marketing delivery capabilities of operations with our SynOps platform, which we already used as part of Jaguar Land Rover warranty operations. SynOps will deliver AI powered insights and highly automated production around the world. Security is top of mind for our clients as the threat landscape expands. Our very strong double digit growth is driven by the breadth and depth of our services, from advisory to cyber defense, to managed security. For example, facing ever increasing cyber threats and continued financial pressures as a result of COVID-19, Accenture is helping a UKI bank by bringing together the whole breadth of these capabilities to provide innovative solutions to support the bank's future security strategy. Across many of these examples are our implied intelligence services. We were excited this quarter to announce Accenture federal services agreement to acquire Novetta, an advanced analytics company serving U.S. Federal Organizations that is demonstrating what's possible with analytics, machine learning, cyber and cloud engineering. This will augment our already strong capabilities and scale in these critical areas, providing even more diversification across our federal business, specifically in the national security space which is seeing substantial growth. I wanted to give a special recognition to our colleagues serving the public sector around the world throughout the pandemic. Your seven consecutive quarters of double digit growth reflect your absolute commitment to the important missions of government serving their citizens. Turning now to Industry X, our digital, engineering and manufacturing services. We believe that product development, design engineering, manufacturing and the supply chain make up the next big digital transformation frontier. The impact of COVID-19 is accelerating the need to transform these core operations, and for nearly a decade we have been investing to build the unique capabilities and ecosystem partnerships to combine the power of data and digital with traditional engineering services. We are very pleased with the announcement of our agreement to acquire Umlaut, which will add more than 4,200 industry leading engineers and consultants across 17 countries, and expand our capabilities across a range of industries, including automotive, aerospace and defense, telecommunications, energy and utilities. Some recent examples of our Industry X services include helping a German telecom company continuously develop and enhance their internet television service by utilizing embedded engineering in their set top boxes and managing new features on the platform. Helping a large media conglomerates accelerate their primary revenue streams and digital products and advertising, with our product and platform engineering expertise to design, build, test and deploy new products, services and features; and working with a global automotive OEM to execute online remote software updates for their in-car computer systems to allow seamless deployment of new software versions. We are also working with an American multinational manufacturer of confectionery pet food and other food products to deploy a digital twin platform to optimize production in its manufacturing facilities, improve margins and reduce waste. We’re working with a large electric company in Japan to help their power plants – to help bring their power plants into the future by digitizing their operations and standards across each department. And with a large oil and gas company to build their internal digital capabilities to substantially reduce time to market for new digital solutions that extends to its customers while supporting the company's key safety and sustainability goals throughout the use of the digital factory. Taking a step back, the examples I have provided today, all require deep industry knowledge and innovation. Our breadth and depth across industries enables us to tailor industry solutions, while bringing cross industry expertise as we help our clients facing industry convergence and by using the lessons of other industries. We are proud this quarter that Fast Company recognized us for our innovation across multiple initiatives in its World Changing Ideas Awards. Our cross-industry expertise is one of the powerful sources of our ability to innovate. For example, using our deep banking industry and technical expertise, we rapidly developed for a commercial bank which was not a traditional small business administration lender; a program under the U.S. paycheck protection program that allowed them to make loans to thousands of small businesses struggling with the impacts of the pandemic. We then pivoted to apply this approach to stand up’s Facebook’s small business grants program for black owned businesses, enabling the distribution of 10,000 grants to black-owned businesses in the U.S. This grants program is an important part of Facebook's overall commitment to invest $200 million in building programs and tools for black owned businesses. Finally, let me turn to our incredible people. Their health and safety remain our top priority. We are supporting our people by facilitating vaccinations, including standing up clinics in many of our offices such as in India where already 50,000 of our people, their families and contractors have been vaccinated. We have been focused on taking the lessons as an almost 100% remote workforce during the pandemic to a new way of working, moving from a remote or hybrid model to an omni-connected experience. People will work in the office, from home and at client sites, and its likely many of our clients will be doing the same. So our approach focuses on the experience of connecting to continue to serve our clients in a differentiated way and create an environment that our people feel a sense of belonging. The rich diversity and ingenuity of our people from our Board of Directors to our new hires, helps us deliver 360 degree value for the benefit of all. We now have more than 250,000 women representing approximately 46% of our workforce. As you may recall, shortly after the murder of George Floyd in the U.S., on this call I shared with you our commitment to take three actions in the U.S.: setting external goals to increase representation, training our people and making a bigger impact in our communities. One year later I am pleased to report that we not only took each action, but have made measurable progress, including increasing our representation, having 95% of our U.S. people complete our new anti-racism training and making substantial new investments in our communities. You can find a full progress update on our website, because we believe transparency and accountability are hallmarks of good governance and essential to building trust. As we see the rise or continuation of all kinds of hate crimes against diverse communities, including violence against Asians, the LGBTI community, antisemitism and Islamophobia, I want to reaffirm my and Accenture’s unwavering commitment to equality and justice for all and zero tolerance for racism, bigotry and hate of any kind. KC, back to you."
},
{
"speaker": "KC McClure",
"text": "Thanks Julie. Let me now turn to our business outlook. For the fourth quarter of fiscal ’21, we expect revenue to be in the range of $13.1 billion to $13.5 billion. This assumes the impact of FX will be positive 4% compared to the fourth quarter of fiscal ‘20 and reflects an estimated 17% to 21% growth in local currency. For the full fiscal year ’21, based upon how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in U.S. dollars will be approximately positive 3.5% compared to fiscal ‘20. For the full fiscal ’21, we now expect our revenues to be in the range of 10% to 11% growth in local currency over fiscal ’20, including approximately negative 1% from a decline in revenues from reimbursable travel, based on a 2% reduction the first half of the year and no material impact in the second half of the year. Importantly, organic revenue is the driver of the increase to our updated guidance as we still expect the inorganic contribution to remain at about 2.5% for the full year. For operating margin, we now expect fiscal year ‘21 to be 15.1% a 40 basis point expansion over fiscal ‘20 results. We now expect our annual adjusted effective tax rate to be in the range of 23% to 24%. This compares to an adjusted effective tax rate of 23.9% in fiscal ‘20. For earnings per share, we now expect full year diluted EPS for fiscal ‘21 to be in the range of $9.07 to $9.16. We now expect adjusted full year diluted EPS to be in the range of $8.71 to $8.80 or 17% to 18% growth over adjusted fiscal ‘20 results. For the full fiscal ‘21 we now expect operating cash flow to be in the range of $8.65 billion to $9.15 billion. Property and equipment additions to be approximately $650 million and free cash flow to be in the range of $8 billion to $8.5 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.4 to 1.5. Finally, we continue to expect to return at least $5.8 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so that we can take your questions. Angie?"
},
{
"speaker": "Angie Park",
"text": "Thanks KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] It comes from the line of Lisa Ellis with MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Hey, good morning and thank you. Great results here! A couple of questions; one is a little more tactical, one more strategic. The first one, in bookings KC, can you just remind us one, how acquisitions are not reflected in bookings and then on a related note, is the composition of your bookings changing at all? I'm just specifically thinking about these big $100 million plus transformation programs. Are you seeing a notable change in duration or anything like that? Just trying to understand the booking number a little bit and then I’ll follow up. Thank you."
},
{
"speaker": "KC McClure",
"text": "Okay, great, thanks Lisa. So let me just decompose bookings a little bit. So we were really pleased with our bookings this quarter right, $15.4 billion, and again that grew 39% in U.S. dollars, really strong book-to-bill 1.2%. And in terms of – when you look at it, there was very strong bookings in both consulting and outsourcing, as well as all three geographic markets. And if you look at specifically in our V&A, which also was represented across all of those dimensions, there will be a slight impact in the bookings based on the backlog that we bring in from these acquisitions, but it's not overall significant. But let me just peel it back in terms of when you look underneath that 15.4, I’d say there's really kind of three things I’d point out. First was that there was really a good mix of all categories of our sales. As Julie mentioned, we had a record 20 clients, over $100 million of sales and that as you know positions us really well for the future. But if you go all the way down through the categories, all the way through our smaller deals, they’ve represented very well and that can help us with revenue in the current quarter. The second thing that I would point out is that our bookings were very broad based across all of our services, and that include strategy and consulting. And the third thing was that it was aligned to our strategic priorities as we pointed out, you know driven by cloud industry [accent] (ph) security for example. So you know with those points I'll hand it back to you to ask the second question or if there's any other color that you want."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific! Thank you. The second one, maybe Julie this is for you. I just wanted – was hoping to comment on acquisitions. You know this is – obviously you’ve up-ticked acquisitions, made a couple of bigger ones than Accenture has historically done. Can you just talk about – you know is this just kind of opportunistic or has something kind of shifted in terms of your willingness to do larger acquisitions or specific market opportunities you're going after. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure Lisa. And well, so we've always said we have the capacity to do larger acquisitions, but we’re very disciplined about what we will acquire, and so these were you know opportunities that were very aligned to our strategic priorities. So you know Novetta being both, investment and public sector, but primarily all about you know advanced analytics, machine learning, cyber and cloud engineering, and also importantly diversification for our federal business, because they are in the national intelligence space and Umlaut is in engineering, which was just an opportunity as a company that we know very well, that really is giving us an opportunity to accelerate our scale in Industry X and we've seen the digitization of manufacturing and engineering be a major priority post COVID. Now we've been investing for nearly a decade in this space. We predicted this would happen. As you can see by the number, the amount of work that we're already doing, and this was a great opportunity for a company that we know well, and you know our strategy continues to be – we're going to make acquisitions to scale and big market opportunities to add new skills and opportunities as you know that we built a lot of interactive through acquisitions, for example those renewed skills and capabilities, and then to deepen industry and functional knowledge. And so this is the continuation of that and you know I think the advantage we have is our financial capacity to make investments and to increase our investment you know for the benefit of our clients and all of our stakeholders when we see the right opportunities and we’re going to continue to have that discipline around making strategic acquisitions."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific! Good stuff. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Ashwin Shirvaikar of Citi. Please go ahead."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Hey! Thanks and a great quarter. Congratulations on that from me as well. The question I had is about the momentum that you are seeing in the business and it seems to have actually accelerated from what you're seeing in the past quarters. I wanted to ask you with regards to whether this changes how you think about managing the business in the interim, in order to continue to deliver what you’re seeing from a demand perspective, particularly as we see attrition go up and so on and that's an across the board statement, not just an Accenture statement. So any thoughts with regards to how you're thinking of delivery?"
},
{
"speaker": "KC McClure",
"text": "Yeah, Ashwin I’ll take this and maybe I'll frame up a few things for you and hand it over to Julie as well. So let me just maybe frame up how we’re thinking about you mentioned the demands you know in overall business and thinking about the quarter and our year-to-date from a financial perspective. You know these results are really exceptional when you think about it in the context of our historical performance, so I’ll start there. I mean clearly we’re benefiting from an easier compare in a strong market demand and we see that continuing, but even with that bookings at $44 billion growing 25% year-to-date and that’s off the base of record sales through Q3 last year. And then you couple that with 54 clients with bookings over $100 million through Q3, which is more in the first nine months of this year, than the whole of last year ‘20, FY‘20 and FY‘19 and I mention that as you talk about things in different ways, you may need to manage differently just to talk about the scale in our bookings. As we look at the scale in revenue, we grew record $2.3 billion in revenue this quarter year-over-year. When you think about our industries, where we’re clearly the leader with the breadth and depth of industries, with 11 of the 13 growing double digits and as I mentioned before in our guidance, the increase in our full year outlook, it's driven by organic revenue given that inorganic is contribution staying pretty much the same. And then you end that all with profitability of 40 basis points expansion this quarter. We had very strong profitability and we're no longer benefiting from a travel tailwind and we continue to invest at scale in our business and our people. So you know with that, let me hand it over more to Julie to round out some of the question you had on demand and attrition."
},
{
"speaker": "Julie Sweet",
"text": "Yes, so Ashwin it’s a great question around you know managing our business and so I want to just take you all back to right before the pandemic. I remember back then and on March 1 we put in a new growth model we call the nextgen growth model and that was designed for helping us manage our business as we saw the scale increasing, right, and that change in growth model was focused on being able to have more of our leaders closer to our clients, we changed the P&L as you recall to the geographic. And so we’ve already put in place a model that is designed to allow us to continue to scale, and so this for us was anticipated, and it’s exciting to see how we are very uniquely positioned as our clients’ needs have accelerated, because that’s what’s driving the demand right. The needs of our clients have accelerated post-COVID to do compressed transformation, and we have the right operating model in place. As we think about attrition, you now it’s ticked up to pre-COVID levels in a hot market although not the highest we’ve ever seen, and so as you said it’s an industry phenomenon, we are comfortable – I mean our core competency is about managing our supply and demand, but more importantly our core competency is being a great company to work for. And as you saw with our numbers this quarter, we hired net 32,000 incredible people and that is just a testimony to our ability to attract great talent, as well as continue to train our people. We’ve trained over 100,000 people since the pandemic started, pivoting to the areas of our clients’ needs. So we feel good about it, and of course this is what you expect from us, so we’ll continuously improve."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thanks for that. All good points and I agree. I guess the next question it with regards to you know – and ordinary I don’t focus on a particular acquisition, but this Umlaut seems to be, I have to ask is this the first of many as you expand into a much bigger engineering services type presence. That is a relatively massive end market, so just strategically how are you thinking of this?"
},
{
"speaker": "Julie Sweet",
"text": "Well the sort of big picture, we believe that the digital engineering and manufacturing space is the next frontier for our clients, right. There’s been a lot and there’s still a lot to do with respect to the front office and the back office for lack of a better term, that you know our clients are building a digital core, they’re transforming operations and they’re trying to find new ways of growth. But the areas that have been not as digitized over the last several years as companies have pivoted, has been in core operations, manufacturing and supply chain. Now we predicted this just as we predicted back in 2013, that someday everybody would be a digital business, and so we’ve been investing. We’ve already made, I don’t know, seven, eight, nine acquisitions over the last several years to build these capabilities, and you saw that with all the examples that we did in the script. And so this is about rapidly scaling with some of the best engineers in the world, right, because we see the market opportunity, but most importantly the need from our clients, and so you should expect that will continue to build these both organically and inorganically, but obviously this is a great add in terms of scale for us."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Great! Thank you. Congratulations!"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Jason Kupferberg with Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"text": "Thanks guys. Good morning. I’m wondering if you can estimate for us perhaps how much the acceleration in all this enterprise, digital transformation has enhanced your structural organic revenue growth profile, relative to pre-pandemic levels, because it certainly sounds like this trend continues to have lags."
},
{
"speaker": "Julie Sweet",
"text": "Yeah, I mean I think the way to think about it is that we’re taking market share and we are really well positioned to capture the growth that’s available because of the needs of our clients. And so you’re obviously seeing that uptick in organic growth and we think this will be sustained demand. I think it’s too early and we’re not going to kind of get back into sort of giving sort of a view of FY‘22, but what we would say is we do believe that what you’re seeing right now in demand isn’t just like you know a recovery because spending decreased, but actually sustained demand and that we are incredibly well positioned to capture that, because clients are looking for outcomes and the breadth of our services. You know they’re turning to us because we can give them solutions, not just individual services. They want the innovation that we’re bringing; you know the things like our SynOps platform. They are very appreciative and focused on the fact that we care about the 360 degree value, so that we’re helping improve their own skills, as well as achieving their goals and finally, you know and I think something that is really critical right now and why we are so well positioned is they see it’s a company that creates value and leads with values. And so trust really matters when you are doing major transformation and you know I’ll give you one example. We’ve had over 80 clients in the last 12 months just come and sit down with us to learn more about our diversity supplier program, because it really matters to them and they see us as a leader, right. These are the things that make us an incredibly attractive and trusted partner. And so we think that you know this is really an enduring differentiation at a time when there is going to be subsisting demand for compressed transformation."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay, understood. Just a quick two part follow up here, your thoughts on Q4 book-to-bill and what were the areas of the business that surprised you most in terms of revenue this quarter, because obviously the overall upside was quite significant. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Yes, Jason just in terms of how we think about the fourth quarter. I mean so obviously we’ve had $44 billion of booking year-to-date and even with that, we still have a strong pipeline and we feel good about our position for Q4 as it relates to bookings. And in terms of what did better, you know as I mentioned earlier, it really was broad based, every part of our business did a bit better."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay, thanks for the comments."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Rod Bourgeois with DeepDive. Please go ahead."
},
{
"speaker": "Rod Bourgeois",
"text": "Hey guys! Hey, I just wanted to ask about the margin outlook given the increased acquisition contribution that you’ll be digesting in fiscal ‘22. I just like to ask about the margin levers that you’ll be able to pull in order to still achieve overall operating margin expansion. And also, I guess besides digesting this added acquisition content, are you also needing to spend more on people costs given the war for talent that’s out there. So question about margin levers and also the investments in people? Thanks."
},
{
"speaker": "KC McClure",
"text": "Yes, thanks Rod. So I mean, let’s start with the second one first. So yes, in terms of for the people side of it, obviously there’s a lot of demand in the market. We’re in a hot market right now and historically we’ve seen wages increase and that vary by skills and geographies and that’s happening now, but you see that Rod flowing through our results already to-date and through our guidance. So it’s really up to us to manage our business with rigor discipline as we always do, you know us well, you know managing our pyramid, increasing the use of automation and just overall delivery efficiencies. So that’s the first part on wages as it relates to operating margin. And just coming back to the same point on V&A, so let me just give you a little bit more color on V&A coupled with what I talked about a little bit earlier and of course, I’m not going to give any specific guidance for FY ‘22 until September. But we do expect to have a higher level of inorganic contribution next year, probably around something closer to 4% and that’s really due to the fact that we’re deploying about $4 billion in FY ‘21, a larger portion that’s closer to the later part of the year, and we expect to benefit from more of that revenue in FY ‘22. We also expect at this time to deploy somewhere around $4 billion in FY ‘22, that’s including Umlaut, which we expect to close next year, early in the year. And of course as Julie said, we’ve always said we have the ability to do more, but that’s our line of sight today, and it’s up to us to manage our, to all the levers that we have in our disposal, to continue within the premise of clients and our overhead and structural costs, to make sure that we continue to drive modest margin expansion while investing at scale in our business and our people."
},
{
"speaker": "Rod Bourgeois",
"text": "Great! And then just a quick follow-up on the revenue progression that’s happening. Clearly, this is a big industry recovery, some of that cyclical, some of it secular, and you have certain COVID-impacted verticals that are coming back online. I guess as we head into the next fiscal year, are there on the other side, are there any revenue contributions that will taper as the COVID crisis ends? Are there any, is there any sort of lumpy work that might taper off as you head into the next fiscal year amidst all of the other momentum that’s happening in the business?"
},
{
"speaker": "Julie Sweet",
"text": "I mean there is nothing material. I mean like think about the public sector for example. We did a lot of COVID surge work, but now you’ve got the fiscal stimulus that’s around the world and you see the digitization of the public sector like we gave the example of concept in Italy. So there is nothing material that we think will be difficult to manage, because you’re seeing really, when you see that in the results, kind of across industries, there this need to digitize, so nothing material that we think to mention."
},
{
"speaker": "Rod Bourgeois",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Bryan Bergin with Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Good morning, thank you. I’m curious, over the last two to three quarters, have you seen a notable change in clients’ appetite for price increases as broader transformation demand is ramped up?"
},
{
"speaker": "KC McClure",
"text": "Yes, so let me talk to you a little bit about what we’re seeing in terms of pricing overall. So just importantly, as a reminder, we talked about pricing. We define it as the contract profitability or margin on the work that we sell Bryan. And as always the environment remains competitive, and in many areas of our business we did see pricing was lower and that’s really based on a combination of the fact that the market is competitive and disciplined investments that we’re making, and so all of that is baked into our operating margin guidance for the year."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And then one on Accenture Operations, I’m curious if you’re seeing any change in the size and scope of engagements that clients are outsourcing too. Can you just comment on some of the strengths or the drivers of the continued strength that you’ve shown in that business?"
},
{
"speaker": "Julie Sweet",
"text": "Yes, it’s a great question. It’s not so much about the size, it’s really about the intent. I mean what you’re seeing is clients really saying, in a world where I’ve got to digitize the entire enterprise, right, where do I want to focus my own resources and leadership and where can I leverage Accenture and their investments? And this is where we really got ahead of the market, right, where we developed SynOps and what we’re providing them is both cost efficiencies, but really outcomes of actual insights that come from being able to digitize. And then you add on top of that, where we have more clients thinking about having us takeover, we have a strong pipeline and you know taking over more people, because we have such a great employee value proposition and so they’re starting – you know when we think about the future of work, think about it, we’re seeing more of our clients really see it as a combination of their own employees automation or bots, and then partners like Accenture that really integrate with their own employees and we’re just a leader here. And so it’s more about the trends of the need to digitize that is what you’re seeing reflected, digitized at speed."
},
{
"speaker": "Bryan Bergin",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Bryan Keane with Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hi guys, congrats on the results. I wanted to ask about Strategy Consulting. It had been a laggard, but saw that it moved positively into high single-digit. Just a little bit on the outlook there. Do you continue to see that maybe reach some of the demand you’re seeing in some of your other industry groups?"
},
{
"speaker": "KC McClure",
"text": "Yes. Hey, Bryan. Thanks for the question. You’re right, we were very pleased with the acceleration to high single-digits in the quarter in strategy consulting, which is what we expected. In terms of how we look at just consulting overall type of work go forward, we see it being strong double-digit for the fourth quarter and the second half of the year that would mean we round up really kind of at a strong double-digit growth perspective."
},
{
"speaker": "Julie Sweet",
"text": "And Bryan as a reminder, because I remind you all every single quarter, right, clients aren’t focused on is it strategy and consulting or technology or operations. They are looking for outcomes and what makes us so unique is that all of these things, whether it’s Cloud or Intelligent Operations or marketing transformation bring together our services and with more confidence and certainty and that’s really how we think about it."
},
{
"speaker": "Bryan Keane",
"text": "Got it. And then just as a follow-up. The increase in M&A, just curious on how you guys are thinking about capital allocation, in particular the dividends and the share repurchase. Does that change at all with a little more M&A?"
},
{
"speaker": "KC McClure",
"text": "Obviously, we’ll give you – I’ll give you specifics in September Bryan for next year, but overall our capital allocation framework really remains intact."
},
{
"speaker": "Julie Sweet",
"text": "I mean, you should all just think about this as we’re going to deliver on our commitments and we are investing to drive the next waves of growth and we are taking advantage of our ability to do so in this market."
},
{
"speaker": "Bryan Keane",
"text": "Great! Thanks so much."
},
{
"speaker": "Angie Park",
"text": "Last question. Operator, we have time for one more question, then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Thank you and that question will come from Tien-tsin Huang with JPMorgan. Please go ahead."
},
{
"speaker": "Tien-tsin Huang",
"text": "Hey! Thanks so much. Amazing results! Sorry if this was already asked, I had to jump off earlier. Just on the record number of deals over $100 million. I’m just curious how the pipeline is for such deals going forward. Is there an opportunity to replenish? Just what is the – what do you see out there in terms of large deal potential from here?"
},
{
"speaker": "KC McClure",
"text": "Yes. Hey Tien-tsin, we still have a strong pipeline overall and that includes in the large deal category."
},
{
"speaker": "Tien-tsin Huang",
"text": "Okay, good. And then just on the four point inorganic contribution, I heard that for next year. How about on the margin impact there, I think KC you mentioned that there’ll be a little bit impact on the margin. You’ll still be able to expand. Just wanted to make sure I heard that correctly? Thanks."
},
{
"speaker": "KC McClure",
"text": "Yes. So yes, we want to – so what I did say is that we do expect inorganic contribution next year about 4% and our line of sight now is about $4 billion of capital spend next year ‘22, but we expect modest margin expansion to continue in ‘22."
},
{
"speaker": "Tien-tsin Huang",
"text": "Okay, very good. I appreciate that guys. Well done!"
},
{
"speaker": "KC McClure",
"text": "Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Great, Tien-tsin. Okay, in closing, we really appreciate everyone joining us today. We believe that we are unique because of both what we do and how we do it and we are a company that as I’ve shared before, creates value and leads with values. I want to thank all of our people and our leaders for what you’re doing every day. And finally, I want to thank all of our shareholders for your continued trust and support. We will make sure to earn it every day. Be well."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this conference will be available for replay after 10:00 AM Eastern today through September 23. You may access the AT&T replay system at any time by dialing 1-866-207-1041 and entering access code 1334620. International participants may dial 402-970-0847. Those numbers again are 1-866-207-1041 and 402-970-0847 with access code 1334620. That does conclude our conference for today. We thank you for your participation and for using AT&T Concerning Service. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 2 | 2,021 | 2021-03-18 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by. Welcome to Accenture’s Second Quarter Fiscal 2021 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Ms. Angie Park. Please go ahead.
Angie Park: Thank you, operator and thanks everyone for joining us today on our second quarter fiscal 2021 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director and Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chief Executive Officer and KC McClure, our Chief Financial Officer. We hope you have had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the third quarter and full fiscal year 2021. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today’s news release and discussed in our Annual Report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial metrics, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Angie and thank you everyone for joining us. Today, we are proud to announce outstanding financial results for the second quarter of fiscal ‘21 and our return to pre-COVID level financial results a quarter earlier than we expected and with a tough compare. Let’s first go back 12 months ago, on March 19, only 8 days after the pandemic was declared, when we were all together to announce our outstanding fiscal year ‘20 Q2 financial results. Results you may not remember, because at the time, we were all focused on the go-forward potential impact of the pandemic. In Q2 of fiscal year ‘20, we had 8% revenue growth in local currency, our then highest bookings ever of $14.2 billion and strong underlying profitability and free cash flow. We also announced that 18 clients that quarter had bookings over $100 million. With this backdrop of fiscal year ‘20 Q2, the significance of this Q2’s results in fiscal year ‘21 becomes even more clear. We have delivered 5.4% revenue growth in local currency, which includes a reduction of 2 percentage points from a decline in revenue from reimbursable travel costs, meaning, apples-to-apples, 5.4% is in the zone of fiscal year ‘20 Q2 revenue when you exclude the travel costs related revenue. We have delivered bookings of $16 billion, beating our previous record set in Q2 last year by $1.8 billion and we have delivered strong profitability and free cash flow. This quarter, 18 clients had bookings over $100 million and we continue to take market share faster than pre-COVID. In H1, we have accelerated our investment in B&A, with approximately $1.1 billion of capital deployed and we are increasing our programmatic B&A investment to at least $2 billion for FY ‘21 from the $1.7 billion we previously communicated. And for the last 12 months, we have remained consistent. We gave guidance every quarter which we met or beat. We deliberately invested in our people and preserved our talent to continue to serve our clients as demand came back and we continued to significantly invest in our business and our communities. And throughout, we have lived our core values, including maintaining without pause our commitment to make more progress on diversity and inclusion and sustainability. These financial results reflect these choices, the strength of our core values and the power of our laser focus on creating client value and being a trusted partner as well as our incredibly talented people, strong ecosystem relationships and the resilience of our growth strategy as well as the substantial investments we have made year in and year out, since we set out to be the leader in digital cloud and security and continuous innovation. They also reflect the operational rigor and discipline that long has been a hallmark of our success. I want to thank our people for their hard work and continued dedication to our clients and for delivering on our commitments. KC, over to you.
KC McClure: Thank you, Julie and thanks to all of you for taking the time to join us on today’s call. We were very pleased with our overall results in the second quarter, which exceeded our expectations and reflects strong momentum across our business. We are particularly pleased with our record new bookings and strong revenue growth, which demonstrates our leading position in the market as a trusted partner to deliver value for our clients. Based on the strength of our second quarter results and the confidence in the second half of the fiscal year, we are increasing all elements of our full year outlook, which I will cover in more detail later in our call. Now, let me begin by summarizing a few of the highlights for the quarter. Revenues grew 5.4% in local currency and continue to include a reduction of approximately 2 percentage points from a decline in revenues from reimbursable travel costs. Q2 revenues were nearly $140 million above our guided range driven by broad-based over-delivery across all dimensions: markets, services and industries, as our business built back even faster than anticipated. We also continued to extend our leadership position, with growth significantly above the market. We saw broad improvement in industry trends. Approximately, 50% of our revenues came from 7 industries that were less impacted by the pandemic, which in aggregate accelerated this quarter to low double-digit growth. At the same time, we saw continued improvement from clients in highly impacted industries, which collectively represents over 20% of our revenues and declined mid single-digits. Operating margin was 13.7%, an increase of 30 basis points for the quarter and 40 basis points year-to-date, reflecting strong underlying profitability as we continued to invest in our business and our people, including the one-time bonus we just announced. We continued to benefit from lower spend on travel, meetings and events and we delivered very strong EPS of $2.03, up 10% over fiscal ‘20, after adjusting both years for gains on an investment. And finally, we generated significant free cash flow of $2.4 billion in the quarter and $4 billion year-to-date. We continue to execute on our strategic capital allocation objective, with roughly $3.1 billion returned to shareholders via dividends and share repurchases year-to-date. We have made investments of $1.1 billion in acquisitions, primarily attributed to 19 transactions in the first half of the year and we expect to invest at least $2 billion in acquisitions this fiscal year. With that, let me turn to some of the details starting with new bookings. New bookings were a record at $16 billion, representing a 13% growth in U.S. dollar over previous record in Q2 of last year. We had very strong overall book-to-bill of 1.3 in the quarter and 1.2 year-to-date. Consulting bookings were $8 billion, a record high with a book-to-bill of 1.2. Outsourcing bookings were also a record at $8 billion, with a book-to-bill of 1.4. Similar to last quarter, our bookings were driven by both technology services and operations. We were pleased with the strength of our bookings in strategy and consulting, with a book-to-bill of 1.2. Turning now to revenues, revenues for the quarter were $12.1 billion an 8% increase in U.S. dollars and 5.4% in local currency, including a reduction of approximately 2% from a decline in revenues from reimbursable travel costs. Consolidated revenues for the quarter were $6.4 billion, up 4% in U.S. dollars and up 1% local currency, including a reduction of approximately 3% from a decline in revenues from reimbursable travel costs. Outsourcing revenues were $5.6 billion, up 14% in U.S. dollars and 11% in local currency. Taking a closer look at our service dimensions, both operations and technology services grew double-digits. As expected, strategy and consulting services declined high single-digits and we expect strategy and consulting to return to growth in Q3. Turning to our geographic markets, the industry dynamics that I mentioned earlier continued to play out in a similar manner across all three markets. In North America, revenue growth was 7% in local currency. In Europe, revenues grew 3% in local currency, driven by mid single-digit growth in Italy and the UK. In growth markets, we delivered 6% revenue growth in local currency driven by double-digit growth in Japan. Moving down the income statement, gross margin for the quarter was 29.7% compared with 30.2% for the same period last year. Sales and marketing expense for the quarter was 9.4% compared with 10.4% for the second quarter last year. General and administrative expenses, was 7.6% compared to 6 point – excuse me, 6.6% compared to 6.4% for the same quarter last year. Operating income was $1.7 billion in the second quarter, reflecting a 13.7% operating margin, up 30 basis points compared with Q2 last year. Before I continue as a reminder, in Q2 last year, we recognized an investment gain, which impacted our tax rate and increased EPS by $0.07. This quarter, we again recognized an investment gain, which impacted our tax rate and increased EPS by $0.21. The following comparisons exclude these impacts and reflect adjusted results. Our adjusted effective tax rate for the quarter was 17.5% compared with the adjusted effective tax rate of 17.1% for the second quarter last year. Adjusted diluted earnings per share were $2.03 compared with an adjusted EPS of $1.84 in the second quarter last year. This reflects a 10% year-over-year increase. Days service outstanding were 34 days compared to 38 days last quarter and 39 days in the second quarter of last year. Free cash flow for the quarter was $2.4 billion, resulting from cash generated by operating activities of $2.5 billion, net of property and equipment additions of $93 million. Our cash balance at February 28 was $9.2 billion compared with $8.4 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the second quarter, we repurchased or redeemed 4.6 million shares for $1.2 billion at an average price of $255.29 per share. As of February 28, we had approximately $5 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $0.88 per share for a total of $561 million. This represented a 10% increase over last year. And our Board of Directors declared a quarterly cash dividend of $0.88 per share, to be paid on May 14, a 10% increase over last year. So at the halfway point of fiscal ‘21, we feel really good about our results to-date and our positioning for the remainder of the year, realizing that the pace of recovery is hard to accurately predict. Now, let me turn it back to Julie.
Julie Sweet: Thank you, KC. Let me start with the environment. We continued to see compressed transformation, where companies have to simultaneously transform multiple parts of their enterprise and reskill their people in what previously would have been sequential programs. They are doing so to replatform their businesses in the cloud, address cost pressures, build resilience and security, adjust their operations and customer experiences and find new sources of growth. COVID has hit a giant fast forward button to the future and we believe the demand to innovate at unprecedented speed and scale with rapid adoption of cloud, AI and other disruptive technologies, is accelerating. For digital leaders, we see them no longer strictly competing for market share, but to build their vision of the future faster than the competition. And for digital laggards, they are determined to not simply catch up, but to leapfrog. While COVID has accelerated the demand, the reality is that the extent of transformation ahead is enormous. The move from approximately 20% to 80% in the cloud alone is a huge undertaking and it is just the start as companies will then continue to invest to grow and innovate on their new cloud foundations, which leads me to the role we are playing. In Q2, our engines of growth across Accenture have lowered to the life to meet these needs of our clients and we see strong momentum going into Q3. I will share some color and examples. We called the once in a digital era replatforming of businesses into the cloud in September 2020 when we created Accenture Cloud First to bring industry cloud and state-of-the-art change management and transformation together. We saw this quarter’s strong double-digit growth in cloud overall as well as the subset of Accenture Cloud First, which growth was even higher. Intelligent platform services, which is essential to building the digital core of our clients is back to high single-digit growth as companies resume this critical aspect of their transformation. Applied intelligence, with our data and AI solutions and security both sizable, but still in the early stages of the scale we expect long-term, both had strong double-digit growth in Q2. Operations grew double-digits as companies seek to digitize their enterprises, leveraging our deep industry and functional expertise in AI-driven SynOps platform. Interactive improved and grew high single-digits as companies continue to shift to digital channels need cost efficiencies around sales and marketing to invest in new capabilities, seek more data-driven marketing campaigns and compete for customers and employees on the experience they provide. Industry X, which is helping diversify our sources of revenue in the enterprise, grew strong double-digits, driven by the need for product and engineers to accelerate the time to market of smarter and more sustainable products and the need to enhance the efficiency and flexibility of manufacturing facilities and the ability to interconnect machines and operate remotely. These engines of growth are multi-service, bringing the best of Accenture’s strategy in consulting, interactive technology and operation services together to create value. We are distinctive, because no other competitor has our scale and breadth of services, which allows us to seamlessly serve the different dimensions of compressed transformations. We also are able to give our clients speed and cost levers through our managed services to digitize using our assets and platforms and address cost pressures. Furthermore, our distinctive capabilities in industry, innovation and investment are clear differentiators. Our strong strategy and consulting practitioners bring deep industry expertise to all functions of the enterprise and help bring together our services to deliver to our clients, often informed by cross-industry insights, such as for payments and omni-channel engagement. Our ability and commitment to consistently invest in acquisitions, R&D and our people is unmatched in our industry and our clients know that through our investment and focus on innovation, we will help future-proof them, such as our innovation in emerging technologies like the work Accenture Labs is doing, testing applications using neuromorphic computing, where circuits are modeled after systems in the human brain and nervous system to deliver new AI capabilities and our 360-degree value strategy, which seeks to bring talent upskilling, diversity and inclusion and sustainability to our work, is resonating with our clients as they seek to make progress as they transform. Two great examples of compressed transformation, strong leaders and our 360-degree value strategy are AIG and Shiseido. We are partnering with AIG, a leading global insurance organization, to help them drive their AIG 200 program, which is designed to achieve underwriting excellence, modernize their operating infrastructure, enhance user and customer experience and become a more unified company. This quarter, we acquired AIG’s shared services operations, which we will transform to serve AIG to create a modern digital shared services platform with end-to-end processes that will improve the user experience using our SynOps platform. And consistent with our 360-degree value strategy, we are investing in upskilling our new employees. We have entered into a strategic partnership with Shiseido, a leading global beauty company headquartered in Japan. Shiseido has launched a fundamental business transformation aiming to become a global leader in premium skin beauty by 2030 under its new medium to long-term strategy, Win 2023 and Beyond. We are partnering with Shiseido to accelerate digital transformation and create personalized and seamless customer experiences, design, develop and implement a cloud-based system that will help it adopt processes that enable continuous financial reporting that are forecasting accuracy and more precise inventory management. We are helping them use AI, analytics and automation to create new business value and helping their employees gain high level digital skills. We are working with Specsavers, the UK base leader in optometry, audiology and other healthcare services, to reimagine and transform their entire IT organization through our living systems approach. We are leveraging new ways of working in agile foundations to capture efficiencies and reduce costs, while positioning the company for growth and diversification to drive business resilience. With our managed security services, we are helping a central bank in Asia to strengthen their resilience against cyber threats, builds in the flexibility to securely grow their payment transactions from millions to billions at speed and scale. Our Industry X team is helping Formula One re-launch its F1 TV Grand Prix racing product. By using the cloud-based Accenture video solution, live streams from 20 trackside and onboard cameras and a growing range of connected devices, we are continuously innovating to embed intelligence in their platforms to deliver the best possible viewer experience. Now, let me turn to Accenture’s greatest and undeniable competitive advantage, our nearly 537,000 people. They are at the heart of our outstanding results. Fundamental to our core values is to care deeply for our people and we placed significant importance on providing a meaningful employee experience. For almost every person around the world, living and working during the pandemic has been challenging. To help our people succeed both professionally and personally during this time, we have put in place many programs. For example, we are partnering with Bright Horizons in the U.S. through development of an innovative program for school aged children to receive proctoring for their virtual studies and homework. We have extended telemedicine to parents of our employees in India and we are providing industry leading mental wellness programs, including Thriving Mind, a holistic well-being program that teaches us about the science behind stress and how to recharge your brain’s battery. We are proud that more than 160,000 of our people have completed the program with impressive results, including nearly 9 out of 10 participants reported feeling significantly better able to handle challenges in the workplace. Equally important is our focus on vibrant career paths. We have maintained pay increases, bonuses and promotions both in our normal December time period as well as an added round of promotions in February, enabling us to promote in total at the same level as the prior year. Additionally, we will expand our regular midyear promotions this coming June to include managing directors, a first in our company’s history as one more way, we continue to create new opportunities for our people. And today, we are announcing a special one-time bonus for all of our people below managing director to recognize the contributions and dedication to our clients during this difficult year. Continuous learning also is a defining feature of Accenture. We continued to invest in our people and their market leading skills, with a 28% increase in training hours and 25% increase in hours per person just this quarter. And coming back to our ability to attract talent, we know that people want to work for companies that not only create value, but also lead with values. We are proud this quarter to have been named for the 14th consecutive year on Ethisphere’s World’s Most Ethical Companies list and for the 19th consecutive year on Fortune’s World’s Most Admired Companies. Our strategic decision to preserve our talent last year, including our recruiters, provided a strong base to meet the surge in demand we have experienced. Recruiting, hiring and managing supply and demand has always been a core competency and we are confident in our ability to attract talent and continue to meet the increased demand. We increased hiring approximately 50% both year-over-year and since last quarter. And we have on-boarded over 100,000 people virtually over the last 12 months, with new innovative approaches. I would like to recognize the extraordinary leadership and efforts of our Chief Leadership and Human Resources Officer, Ellyn Shook and her outstanding team around the globe for how they have helped care for our people throughout the pandemic, guided us through health and safety of COVID, are ensuring that we are continuously reskilling our people and have helped us manage and realize the incredible expansion of our talent to meet the needs of our clients. Over to you, KC, for a look ahead.
KC McClure: Thanks, Julie. Let me now turn to our business outlook. For the third quarter of fiscal ‘21, we expect revenues to be in the range of $12.55 billion to $12.95 billion. This assumes the impact of FX will be about positive 4.5% compared to the third quarter of fiscal ‘20 and reflects an estimated 10% to 13% growth in local currency. For the full fiscal year ‘21, based upon how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in U.S. dollars will be approximately positive 3% compared to fiscal ‘20. For the full fiscal ‘21, we now expect our revenue to be in the range of 6.5% to 8.5% growth in local currency over fiscal ‘20, including approximately negative 1% from a decline in revenues from reimbursable travel, based on a 2% reduction in the first half of the year and no material impact in the second half of the year. For operating margin, we now expect fiscal year ‘21 to be 15% to 15.1%, a 30 to 40 basis point expansion of our fiscal ‘20 results. We continue to expect our annual adjusted effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.9% in fiscal ‘20. For earnings per share, we now expect full year diluted EPS for fiscal ‘21 to be in the range of $8.67 to $8.85. We now expect adjusted full year diluted EPS to be in the range of $8.32 to $8.50 or 12% to 14% growth over adjusted fiscal ‘20 results. For the full fiscal ‘21, we now expect operating cash flow to be in the range of $7.65 billion to $8.15 billion, property and equipment additions to be approximately $650 million, and free cash flow to be in the range of $7 billion to $7.5 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to adjusted net income ratio of 1.3 to 1.4. Finally, we now expect to return at least $5.8 billion, an increase of $500 million through dividends and share repurchases as we remain committed to returning a substantial portion of cash to our shareholders. With that, let’s open it up so that we can take your questions. Angie?
Angie Park: Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask the questions. Operator, would you provide instructions for those on the call?
Operator: Thank you. [Operator Instructions] Your first question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead.
Tien-tsin Huang: Hey, thanks. Terrific results here. I can’t remember. I was thinking the last time you guys raised your margin outlook, especially against such strong bookings and investments like cloud first, you talked about plus this one-time bonus to employees, etcetera? So what’s different this time to allow you to do that to raise margins modestly against some good momentum here? And I will ask my follow-up just together with this, which is given the big bookings, thinking about contract execution, do you feel good about sort of the level of expectations you need to deliver here to keep this momentum going, because I know you put a lot of hard work into driving up the bookings here, but I am curious if there is anything different to consider here with contract execution looking ahead? Thanks.
KC McClure: Okay. Thanks, Tien-tsin. So in terms of operating margins, let me just cover with you what’s the driver this year of our 30 to 40 basis points operating margin expansion. And you are right it is unusual for us to expand our operating margin halfway through the year. And so implied in our guidance for the year, there is obviously continued healthy margin expansion in the back half. That’s in addition, Tien-tsin to the 40 basis points that we have already done year-to-date. And then as I mentioned, which does include the impact of the one-time bonus that we are doing for employees below managing director. And I will just maybe highlight a few things in terms of drivers for the expansion this year. I mean, as always, we first look to strong revenue growth and we have that again this year. And that’s coming along with increased contract profitability. We do have increased contract profitability coming through in our gross margin in the first half of the year and that’s really the first lever that we always look at. Within this year uniquely are a couple of things. One is utilization. So, we are getting some additional margin expansion this year based on our higher utilization rate. We talked about that last quarter that we are looking to bring that down to more normal levels. It did go up this quarter. We are still working on that. But clearly, in the first half of the year and into the second half, there will be some benefit to operating margin expansion on that. And the second part is due to the lower travel events and meetings of spend this year. So, we are going to benefit from that overall for the full year, but that benefit really is in the first half of the year. As the baseline last year in the back half is as you know, we really didn’t travel or have meetings, so it’s not a benefit that we will have in the back half of the year. And so I think overall, the key thing though in operating margin is that we always look to drive strong underlying profitability, because we want to ensure that we are investing first in our business because we want to drive long-term shareholder value. And so that’s really the critical part that we are able to continue to invest in our business and in our people and in acquisitions, but while at the same time expanding operating margin significantly.
Julie Sweet: Yes. And Tien-tsin, why don’t I take the – I will take the question about execution, we are very confident about our ability to execute. And let me just remind you that one of the things that’s really benefiting us is just our absolute excellent performance when the pandemic started and we had to move all of our people from our centers, while our clients were having to move remotely. As you will recall, I shared that we closed the books for 70 public companies and we did so without missing a beat that we on average pre-pandemic, have a new release every 15 minutes, 24 hours a day, on the technology say 7 days a week and we have continued with that execution. And in fact, one of the things that we believe is driving our growth is that we enhanced our standing with our clients because of how we have been able to execute, while at the same time, we help many of them move online. So we feel very good. Our centers and our people across the globe in terms of delivery are just amazing. And I should thank them, because at the end of the day, that’s what really matters for our people and we really just have exceptional people.
Tien-tsin Huang: Yes, thanks both.
Operator: Your next question comes from the line of Lisa Ellis from MoffettNathanson. Please go ahead.
Lisa Ellis: Hey, good morning. Nice results here. Julie, I wanted to kind of rewind the clock back to early 2020, which obviously feels like eons ago now, but when you reorganized Accenture to pivot to more focus on the geographies and geographic expansion. Now that we’re a year plus in and the dust had settled a little bit, can you just kind of bring us back to that and reflect on what’s working well with that pivot, what’s working maybe less well, or it’s been more challenging than you expected. And what’s different about operating in growth markets? Just realizing that those – that the growth markets are an important part of the growth story for Accenture going forward. Thank you.
Julie Sweet: Sure. Great question. One of the things that we look back on internally as a leadership team was that we actually were very bold in our ambition in my first year as CEO to actually put that new model in place only 6 months into the fiscal year and change our P&L in the middle of the fiscal year. And we look back and often use it as a lesson as to speed matters because as you think about our execution during the last 12 months, we did so with a new leadership team and a new way of working. And what it really demonstrated was we made the right strategic move. Driving the move from industry to geography were a few things. And remember, what we did was we also put digital everywhere. So we simplified because digital is now the core of our business. But the first thing is what we call the Client Proximity Imperative. We had such scale in all of our markets. We wanted to put our leaders really closer to our clients, while at the same time really enhancing the ability to move innovation around the world. And we did that by massively simplifying. And so we – at the one hand, where – we made a geographic P&L. But on the other hand, we made critical changes to actually make it easier to move innovation around the world. And secondly, we felt as if the ability to simplify and then have teams come together across our services would really unlock value. And of course, you did that before we had COVID, but we’ve seen the acceleration of the need for that because our clients are really looking for ability to bring outcomes. And so just think about the work that we are doing right now. Like I take BBVA, which you may know, it’s a customer-centric global financial services company headquartered in Spain. And we have worked with them to move – they wanted to increase their digital sales. And that brings together operation, all of our interactive capabilities, like paid media, search engine optimization, analytics and marketing operation, plus our deep industry experience. And with our support over the last 12 months, they have grown their digital sales more than 50% and they saw an increase in digital customers by more than 50%. The ability to bring those services together seamlessly to deliver those outcomes has really been enabled by that growth model that both simplified, recognize that the core of our business is now digital cloud and security, and enable us to really meet the needs of the client globally. In terms of growth markets, there is really nothing different there. I mean the geographic model helps us both focus on the opportunity in each of the markets, while at the same time, really connecting the innovation and being able to serve global clients better.
Lisa Ellis: Terrific. Thanks. Maybe my quick follow-up is maybe for KC, a follow-up on Tien-tsin’s question. I know you said you’re – yes, you’re running a little hot on utilization right now. And you commented on that as well last quarter. I’m curious though, with the shift to remote work, one, do you think that shift is going to remain more permanent? And will it allow you to actually maintain a higher level of utilization on a more permanent basis?
KC McClure: Yes. So thanks, Lisa, for the question. Yes, I will just reiterate. We are trying to – we are working to get it back – our utilization back into a more normal range as they did tick up this quarter. And this really is tied to the increased demand that came back harder than we expected, right? So – but we continue to believe that the right answer for our people is to lower it back into our more normal historical ranges. And in terms of the structural – is there a structural change? I believe, just now that over time, there is really not a structural change in utilization. There is probably some increase right now due to remote working, but we don’t see on a go forward any long-term structural change in our utilization rate.
Julie Sweet: Yes. And just to remember, Lisa, like we have a very important value proposition that includes being able to do continuous learning, but also the right level of time to do strategic thinking, for example, and to come together around important initiatives. And so that’s why we believe that, over time, we really should get back into kind of a more normal regardless of where people are working from.
Lisa Ellis: Terrific. Thank you. Thanks a lot.
Operator: Your next question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead.
Ashwin Shirvaikar: Thank you. Hi, Julie. Hi, KC. Congratulations. These are tremendous results.
Julie Sweet: Hi, Ashwin.
Ashwin Shirvaikar: Just I hate to keep bringing up margin again and again. But one thing I did not necessarily hear you explicitly call out was pricing, which you might expect given sort of a price for value component, given the pivot, the mix, as you primarily do digital cloud and security, and also, frankly, a shortage of resources. It was also going to be my follow-up question, is that your attrition has ticked up, but still below historical levels. I see all the steps you took towards employee health, wellness, eventually controlling attrition. But as demand accelerates across the industry, do you expect inflation to return to historical, like mid upper teens type levels?
KC McClureb: Yes. So Thanks, Ashwin, for the question. So I’ll cover the pricing point, and I’ll hand it over to Julie to talk about attrition. So maybe let’s start with context overall and what we’re seeing in the overall market and the business environment. So as we have been saying and we continue to see that the business environment does remain competitive and in some areas, we experienced pricing pressure, but we are seeing signs of stability, right? So that’s probably the first key point. In terms of the pricing that we have across our different markets or our services, as you know, the pricing can vary depending on what it is that we’re selling and in what markets that we’re doing that commercial arrangement. But what is important, what stays the same is that we always look to make sure that we are doing a smart commercial arrangement that benefits both our clients and Accenture. And that’s a key part of our 360-degree value. But as it relates to what we’re actually delivering in terms of profitability, I do want to highlight that within our operating margin and within gross margin, we did, we haven’t expanded the delivery of client profitability and contract profitability. So that’s a key part of our operating margin expansion for the year. And Julie, you want to talk about attrition?
Julie Sweet: Yes Ashwin. Look, I think it’s – I think we would expect that we’re going to go back to sort of industry norms on attrition, although we will always work hard to not do that, right. And we do believe that we’re benefiting right now from the way we have cared for and – our people and the decisions we made to preserve our talent and invest in keeping them through the lower demand areas. So – but certainly, we’re tuned as a company to be able to grow and recruit at this level and at the more normal levels, as you said, in the higher teens.
Ashwin Shirvaikar: Thank you. Good result.
Operator: Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead.
Bryan Keane: Hi, guys and congratulations from me as well. Just thinking, Julie, about this more structurally longer term, is this growth rate – the back half growth rate obviously being really strong in the back half, double-digit growth, implied for both the third and the fourth quarter. How has the pandemic changed things that this could be maybe more sustainable than just kind of a onetime pickup in growth and maybe the growth could be? I know we’ve talked about in the past 5% to 8% constant currency growth. Just wondering if that formula has potentially changed in the future due to the pull forward of some of the digital transformation from the pandemic?
KC McClure: So we knew someone was going to try to get us to look ahead for next year, but…
Bryan Keane: You got me.
KC McClure: So but we’re not going to. But let me just – so instead of trying to look ahead to next year and thinking about it, let’s maybe just focus on how we are looking at our business right now. So if you think about the last 6 years when we started digital, we rotated our business so that now the core of our business is digital, cloud, security and all of our services, meaning not just – that’s not from a technical perspective. And so think about what we have built are engines of growth as the core of our business, which is what we went through when you think about cloud, Industry X, applied intelligence, operation, the things we went through on our script today. And so we have these engines of growth which we continue to invest in. And I think what’s really important in the way we think about our business is we’re – for example, cloud, we already scaled. We told you last quarter, it was $12 million in FY ‘20 but it’s growing double-digits because we’re at the very early stages of it. And when you think about Accenture Cloud First, we brought together, right, all of our services, from strategy and consulting, to experience, to cloud, industry experience, because not only are companies having to migrate to the cloud, but they need to create value, like we’re working with an American entertainment company, where we’re helping them use – leverage the cloud to accelerate the time to market of new video services, right? So it’s not about the migration. It’s about the value. And so think about our business as having built these engines of growth, some of which already have massive scale and are continuing. And then others, like Industry X, Industry X is a way that we are going to continue to diversify our revenue sources for resilience over the long-term. We made two acquisitions this quarter, [indiscernible] Solutions and Myrtle Consulting Group, to help build our manufacturing and supply chain. We’re going to continue to invest there. We think about that as the next interactive, right, in terms of building this new area. And we’re at this amazing tipping point right now where we’re seeing an acceleration of digitization in manufacturing and in product engineering. And so we continue to think about how do we both make sure these growth engines is going, but never have to have another rotation because we’re always investing. And I mean, the last point I would just say is our capacity to invest in acquisitions has been a huge differentiator in building the business we have today, as being the core of our business is now these engines of growth. And we continue to execute on that in all of our major strategic areas and the next scale plays. And I’d call out the two we made this quarter in cloud, for example, Infinity Works and Edenhouse.
Bryan Keane: Got it. Got it. And just KC, a quick follow-up, will travel and reimbursables, will that go up back to the norms of previous past? I’m just trying to figure out if some of that, obviously – some of that travel work doesn’t have to continue until the model slightly changes on that front.
KC McClure: Yes. So that’s a great question, Bryan. So let me just first tell you what we’ve assumed as it relates to kind of our revenue. So we do not have in our revenue guidance an increase in travel revenue from travel-related expenses. Now obviously, we’re continuing to meet with our clients and do well, and engage with them, as you can see from our record bookings and our really strong revenue growth. But we don’t have any of that in – we don’t have that significantly embedded in our revenue. In terms of for the rest of the year, we’ll continue to see where we are with the travel and expand events and meetings. As we go throughout the rest of the year and into next year, so it’s kind of too early to tell. Julie, if you want to add anything?
Julie Sweet: Yes. I agree. I mean, look, I’m having lots of conversations with companies who are just trying to figure this out, right? Will travel – will it actually explode once people feel safe because they need to reconnect? Will it structurally shift? And I would say that it’s really – we think it’s too early and company, it’s really kind of allover the map. And that hopefully will have a lot better sense as we get through the next 6 months. And we see vaccination variance and healthy – how comfortable people are. But it’s still pretty unclear.
Bryan Keane: Got it. Thanks for taking the questions.
Operator: Your next question comes from the line of Dave Koning from Baird. Please go ahead.
Dave Koning: Hey, guys. Thanks, nice job. And I guess my first question, outsourcing growth was the strongest, I think, in 6 years, and that’s really not on an easy comp either. You had a pretty normal Q2 of last year in terms of growth. I’m wondering, is there something within outsourcing that has kind of step function change to just a better level than normal or something happening there that’s really triggering growth in such a stable part of your business typically?
Julie Sweet: Well, it’s a great question. And this really is a big driver of how well we’re doing now because in this – when you have compressed transformation where the companies need to do so much at the same time, there is a really sharp focus on, what do I need to do? How do I source the talent, right? And that conversation has absolutely gone faster. But also, how can I digitize every part of the organization? And what Accenture has, which is very unique, is this investment we’ve been making for years in the SynOps platform, for example, in operations, and in technology, things like myWizard and myConcerto, which builds in best-of-class AI, machine learning, rapid testing. And these are platforms that we continuously invest in. And so when you – happening is here is that we’re helping them digitize. We are helping them focus on, what do they really need to have in-house versus can leverage in order to go faster. But one thing I want to be really, really clear about is, although our strategy and consulting business continued to have a high single-digit decline, it was better than we expected, strategy and consulting is absolutely essential to all of these results, including outsourcing. Because what we are bringing to them, right? It’s not simply always at a lower cost. It’s increase is in sales through our marketing operations, like the BBVA example I gave, right? It’s manufacturing in at AIG, which I talked about, it’s insurance, right, as well as deep process skills. It is helping them transform the ways they are working by being integrated with us where we’re bringing modern ways of working and digital. And so this is what distinguishes us as a company for our clients. It’s not – you for guys, it’s type of work, outsourcing versus consulting, which is basically managed services, it’s project work. For our clients, it’s our ability to bring all these services together, which is why I emphasize that each of the examples I gave in my script, and I gave you many more, really are polling all of these things together for an outcome and when you are going to compress transformation, that’s more important than ever.
Dave Koning: Great, thanks. That’s great. And I guess my just quick follow-up. Every vertical accelerated in the quarter except for resources. And so I’m just wondering, on that vertical specifically, that got a little worse, but that hits really easy comps in the back half, anything to kind of call out there on momentum kind of reaccelerating in the future?
KC McClure: Yes. Thanks, Dave. So resources, it came in, in the zone that we expected it to. And I’d just point out a couple of things. So we’ve talked about the industry is more impacted by the pandemic, and resources clearly has one of those, which is energy and that continued to be under pressure. And I would also say that our clients in the chemical industry also have been feeling some pressure as well but we have seen stability in our utilities portfolio which is good. And go forward, as we look into Q3, we do see an improvement in the resources growth rate.
Julie Sweet: Yes. And by the way, this is where Industry X is going to be so critical. For example, we’re working with a North America, one of the largest oil integrators in the world, in re-imagining their plants from both health and safety security and efficiency perspective. I was just in our brand-new OT security lab in Houston last week. Yes, I actually did go on a business trip. And a big focus of OT security is across all of our volt process and discrete manufacturing. So there – obviously, as an industry – set of industries, they have been impacted. But if you think about where we’re focused and how we’re going to help them from efficiency and safety and security, it’s great. We’re well positioned.
Dave Koning: Great. Thanks guys.
Operator: Your next question comes from the line of James Faucette from Morgan Stanley. Please go ahead.
James Faucette: Great. Thank you very much. And wanted to go back to one of the comments you made in the prepared remarks in terms of increasing your programmatic B&A. And wondering if you could just give us a little color of how we should think about contribution from that, specific areas of focus, durability, etcetera. Just trying to understand how you are thinking about that initiative, which seems really important?
KC McClure: Yes. So thanks for the question. You’re absolutely right. I mean, our ability to invest significantly in our business, and that includes B&A, is a key competitive advantage. And I would just say, we’ve been at this for a long time, to your point. It’s been a core part of our strategy since 2013. On average, we’ve done about 20% of our operating cash flow to B&A, and that’s our updated guidance of about up to $2 billion – at least $2 billion, puts us in that same zone. So – but it’s not just being able to acquire. It’s successful integration. And so you can see that, that typically provides about 2% of inorganic contribution in this year. It’s going to be more, in the 2.5% zone. So we really are very focused on that as a key part of our strategy, and we will look to continue to invest. And as we’ve said, we can always – we can do more than the $2 billion if the opportunity presents itself, but it is a key part of our investment portfolio.
James Faucette: Thanks. And just turning operationally for my follow-up question, can you give some color on how much of the strong demand that you’re seeing is driven by your partner network this year? And where you’re seeing most strength there? And I guess, how you would think about that part of business generation evolving over the next few quarters and periods?
Julie Sweet: Our ecosystem partners are absolutely essential to our growth. I called them out in our script. We’re really proud to be the number one or number two partner, with all of the major ecosystem partners. And what we uniquely bring is, because of the strength of our relationships, we can really bring integrated value propositions to our clients. And so, those relationships are very high priority and to – and important to our future growth.
James Faucette: Thanks, Julie. Thanks, KC.
Julie Sweet: Thank you.
Angie Park: Operator, we have time for one more question and then Julie will wrap up the call.
Operator: Okay. That question comes from the line of Bryan Bergin from Cowen. Please go ahead.
Bryan Bergin: Hi, good morning. Thank you. Question on the outsourcing and operation strength, so you highlighted the AIG Shared Services deal this quarter, have you seen a pickup in captive acquisition opportunities that you’ve acted upon here over the last several quarters? And I’m curious how we should think about this mix contributing to your outperformance and the pipeline going forward?
Julie Sweet: Well, we’ve shared in prior calls that we do see more interest in captives. We’re starting to see us execute on some of them. But I think it’s too early to say whether that’s going to be a big part of the mix or not. For the reasons I’ve talked about, we can go in and help digitize. KC, do you want to add anything?
KC McClure: No. I would just say, in terms of what we see, in terms of the mix, for H2, we still see a double-digit growth in outsourcing. And for the full year, I think they will end up with high single to low double-digit positive growth in terms – to give you some sense of the mix.
Bryan Bergin: Okay, I appreciate that. And then just on H&PS and Financial Services, so those both clearly had outsized performance in the quarter. Can you just talk about the key contributors underlying those two?
KC McClureb: Yes. So, we were really pleased with H&PS and Financial Services growth this quarter. H&PS continues to be growth that we’ve seen in public service and the work that we’ve been doing during – not just only, but clearly led by a lot of the work that we’re doing within the COVID space. And then in financial services, we’re pleased that we do have strength in our banking and capital markets, and that’s a statement globally as it relates to – particularly – and not only in our business in Europe, but all over, including North America. So very strong performance in both of those, and we expect that to continue.
Julie Sweet: Yes. And it’s the things that are – it’s cloud, right. It’s – there is a big movement to cloud. It’s digital experience. It’s more like the example I gave in BBVA. It’s basically all the trends that we’ve talked about are playing out really across industry and financial services is one of the less – more moderate impacted industries, and they are investing.
Bryan Bergin: Thank you very much.
Julie Sweet: Okay, great. Well, thank you again for joining today. And thank you again to all of our incredible people around the globe. And as always, I just want to end by thanking our shareholders for your continued trust in us. May everyone stay well and healthy.
Operator: Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to Accenture’s Second Quarter Fiscal 2021 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Ms. Angie Park. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, operator and thanks everyone for joining us today on our second quarter fiscal 2021 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director and Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chief Executive Officer and KC McClure, our Chief Financial Officer. We hope you have had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the third quarter and full fiscal year 2021. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today’s news release and discussed in our Annual Report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial metrics, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie and thank you everyone for joining us. Today, we are proud to announce outstanding financial results for the second quarter of fiscal ‘21 and our return to pre-COVID level financial results a quarter earlier than we expected and with a tough compare. Let’s first go back 12 months ago, on March 19, only 8 days after the pandemic was declared, when we were all together to announce our outstanding fiscal year ‘20 Q2 financial results. Results you may not remember, because at the time, we were all focused on the go-forward potential impact of the pandemic. In Q2 of fiscal year ‘20, we had 8% revenue growth in local currency, our then highest bookings ever of $14.2 billion and strong underlying profitability and free cash flow. We also announced that 18 clients that quarter had bookings over $100 million. With this backdrop of fiscal year ‘20 Q2, the significance of this Q2’s results in fiscal year ‘21 becomes even more clear. We have delivered 5.4% revenue growth in local currency, which includes a reduction of 2 percentage points from a decline in revenue from reimbursable travel costs, meaning, apples-to-apples, 5.4% is in the zone of fiscal year ‘20 Q2 revenue when you exclude the travel costs related revenue. We have delivered bookings of $16 billion, beating our previous record set in Q2 last year by $1.8 billion and we have delivered strong profitability and free cash flow. This quarter, 18 clients had bookings over $100 million and we continue to take market share faster than pre-COVID. In H1, we have accelerated our investment in B&A, with approximately $1.1 billion of capital deployed and we are increasing our programmatic B&A investment to at least $2 billion for FY ‘21 from the $1.7 billion we previously communicated. And for the last 12 months, we have remained consistent. We gave guidance every quarter which we met or beat. We deliberately invested in our people and preserved our talent to continue to serve our clients as demand came back and we continued to significantly invest in our business and our communities. And throughout, we have lived our core values, including maintaining without pause our commitment to make more progress on diversity and inclusion and sustainability. These financial results reflect these choices, the strength of our core values and the power of our laser focus on creating client value and being a trusted partner as well as our incredibly talented people, strong ecosystem relationships and the resilience of our growth strategy as well as the substantial investments we have made year in and year out, since we set out to be the leader in digital cloud and security and continuous innovation. They also reflect the operational rigor and discipline that long has been a hallmark of our success. I want to thank our people for their hard work and continued dedication to our clients and for delivering on our commitments. KC, over to you."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie and thanks to all of you for taking the time to join us on today’s call. We were very pleased with our overall results in the second quarter, which exceeded our expectations and reflects strong momentum across our business. We are particularly pleased with our record new bookings and strong revenue growth, which demonstrates our leading position in the market as a trusted partner to deliver value for our clients. Based on the strength of our second quarter results and the confidence in the second half of the fiscal year, we are increasing all elements of our full year outlook, which I will cover in more detail later in our call. Now, let me begin by summarizing a few of the highlights for the quarter. Revenues grew 5.4% in local currency and continue to include a reduction of approximately 2 percentage points from a decline in revenues from reimbursable travel costs. Q2 revenues were nearly $140 million above our guided range driven by broad-based over-delivery across all dimensions: markets, services and industries, as our business built back even faster than anticipated. We also continued to extend our leadership position, with growth significantly above the market. We saw broad improvement in industry trends. Approximately, 50% of our revenues came from 7 industries that were less impacted by the pandemic, which in aggregate accelerated this quarter to low double-digit growth. At the same time, we saw continued improvement from clients in highly impacted industries, which collectively represents over 20% of our revenues and declined mid single-digits. Operating margin was 13.7%, an increase of 30 basis points for the quarter and 40 basis points year-to-date, reflecting strong underlying profitability as we continued to invest in our business and our people, including the one-time bonus we just announced. We continued to benefit from lower spend on travel, meetings and events and we delivered very strong EPS of $2.03, up 10% over fiscal ‘20, after adjusting both years for gains on an investment. And finally, we generated significant free cash flow of $2.4 billion in the quarter and $4 billion year-to-date. We continue to execute on our strategic capital allocation objective, with roughly $3.1 billion returned to shareholders via dividends and share repurchases year-to-date. We have made investments of $1.1 billion in acquisitions, primarily attributed to 19 transactions in the first half of the year and we expect to invest at least $2 billion in acquisitions this fiscal year. With that, let me turn to some of the details starting with new bookings. New bookings were a record at $16 billion, representing a 13% growth in U.S. dollar over previous record in Q2 of last year. We had very strong overall book-to-bill of 1.3 in the quarter and 1.2 year-to-date. Consulting bookings were $8 billion, a record high with a book-to-bill of 1.2. Outsourcing bookings were also a record at $8 billion, with a book-to-bill of 1.4. Similar to last quarter, our bookings were driven by both technology services and operations. We were pleased with the strength of our bookings in strategy and consulting, with a book-to-bill of 1.2. Turning now to revenues, revenues for the quarter were $12.1 billion an 8% increase in U.S. dollars and 5.4% in local currency, including a reduction of approximately 2% from a decline in revenues from reimbursable travel costs. Consolidated revenues for the quarter were $6.4 billion, up 4% in U.S. dollars and up 1% local currency, including a reduction of approximately 3% from a decline in revenues from reimbursable travel costs. Outsourcing revenues were $5.6 billion, up 14% in U.S. dollars and 11% in local currency. Taking a closer look at our service dimensions, both operations and technology services grew double-digits. As expected, strategy and consulting services declined high single-digits and we expect strategy and consulting to return to growth in Q3. Turning to our geographic markets, the industry dynamics that I mentioned earlier continued to play out in a similar manner across all three markets. In North America, revenue growth was 7% in local currency. In Europe, revenues grew 3% in local currency, driven by mid single-digit growth in Italy and the UK. In growth markets, we delivered 6% revenue growth in local currency driven by double-digit growth in Japan. Moving down the income statement, gross margin for the quarter was 29.7% compared with 30.2% for the same period last year. Sales and marketing expense for the quarter was 9.4% compared with 10.4% for the second quarter last year. General and administrative expenses, was 7.6% compared to 6 point – excuse me, 6.6% compared to 6.4% for the same quarter last year. Operating income was $1.7 billion in the second quarter, reflecting a 13.7% operating margin, up 30 basis points compared with Q2 last year. Before I continue as a reminder, in Q2 last year, we recognized an investment gain, which impacted our tax rate and increased EPS by $0.07. This quarter, we again recognized an investment gain, which impacted our tax rate and increased EPS by $0.21. The following comparisons exclude these impacts and reflect adjusted results. Our adjusted effective tax rate for the quarter was 17.5% compared with the adjusted effective tax rate of 17.1% for the second quarter last year. Adjusted diluted earnings per share were $2.03 compared with an adjusted EPS of $1.84 in the second quarter last year. This reflects a 10% year-over-year increase. Days service outstanding were 34 days compared to 38 days last quarter and 39 days in the second quarter of last year. Free cash flow for the quarter was $2.4 billion, resulting from cash generated by operating activities of $2.5 billion, net of property and equipment additions of $93 million. Our cash balance at February 28 was $9.2 billion compared with $8.4 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the second quarter, we repurchased or redeemed 4.6 million shares for $1.2 billion at an average price of $255.29 per share. As of February 28, we had approximately $5 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $0.88 per share for a total of $561 million. This represented a 10% increase over last year. And our Board of Directors declared a quarterly cash dividend of $0.88 per share, to be paid on May 14, a 10% increase over last year. So at the halfway point of fiscal ‘21, we feel really good about our results to-date and our positioning for the remainder of the year, realizing that the pace of recovery is hard to accurately predict. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. Let me start with the environment. We continued to see compressed transformation, where companies have to simultaneously transform multiple parts of their enterprise and reskill their people in what previously would have been sequential programs. They are doing so to replatform their businesses in the cloud, address cost pressures, build resilience and security, adjust their operations and customer experiences and find new sources of growth. COVID has hit a giant fast forward button to the future and we believe the demand to innovate at unprecedented speed and scale with rapid adoption of cloud, AI and other disruptive technologies, is accelerating. For digital leaders, we see them no longer strictly competing for market share, but to build their vision of the future faster than the competition. And for digital laggards, they are determined to not simply catch up, but to leapfrog. While COVID has accelerated the demand, the reality is that the extent of transformation ahead is enormous. The move from approximately 20% to 80% in the cloud alone is a huge undertaking and it is just the start as companies will then continue to invest to grow and innovate on their new cloud foundations, which leads me to the role we are playing. In Q2, our engines of growth across Accenture have lowered to the life to meet these needs of our clients and we see strong momentum going into Q3. I will share some color and examples. We called the once in a digital era replatforming of businesses into the cloud in September 2020 when we created Accenture Cloud First to bring industry cloud and state-of-the-art change management and transformation together. We saw this quarter’s strong double-digit growth in cloud overall as well as the subset of Accenture Cloud First, which growth was even higher. Intelligent platform services, which is essential to building the digital core of our clients is back to high single-digit growth as companies resume this critical aspect of their transformation. Applied intelligence, with our data and AI solutions and security both sizable, but still in the early stages of the scale we expect long-term, both had strong double-digit growth in Q2. Operations grew double-digits as companies seek to digitize their enterprises, leveraging our deep industry and functional expertise in AI-driven SynOps platform. Interactive improved and grew high single-digits as companies continue to shift to digital channels need cost efficiencies around sales and marketing to invest in new capabilities, seek more data-driven marketing campaigns and compete for customers and employees on the experience they provide. Industry X, which is helping diversify our sources of revenue in the enterprise, grew strong double-digits, driven by the need for product and engineers to accelerate the time to market of smarter and more sustainable products and the need to enhance the efficiency and flexibility of manufacturing facilities and the ability to interconnect machines and operate remotely. These engines of growth are multi-service, bringing the best of Accenture’s strategy in consulting, interactive technology and operation services together to create value. We are distinctive, because no other competitor has our scale and breadth of services, which allows us to seamlessly serve the different dimensions of compressed transformations. We also are able to give our clients speed and cost levers through our managed services to digitize using our assets and platforms and address cost pressures. Furthermore, our distinctive capabilities in industry, innovation and investment are clear differentiators. Our strong strategy and consulting practitioners bring deep industry expertise to all functions of the enterprise and help bring together our services to deliver to our clients, often informed by cross-industry insights, such as for payments and omni-channel engagement. Our ability and commitment to consistently invest in acquisitions, R&D and our people is unmatched in our industry and our clients know that through our investment and focus on innovation, we will help future-proof them, such as our innovation in emerging technologies like the work Accenture Labs is doing, testing applications using neuromorphic computing, where circuits are modeled after systems in the human brain and nervous system to deliver new AI capabilities and our 360-degree value strategy, which seeks to bring talent upskilling, diversity and inclusion and sustainability to our work, is resonating with our clients as they seek to make progress as they transform. Two great examples of compressed transformation, strong leaders and our 360-degree value strategy are AIG and Shiseido. We are partnering with AIG, a leading global insurance organization, to help them drive their AIG 200 program, which is designed to achieve underwriting excellence, modernize their operating infrastructure, enhance user and customer experience and become a more unified company. This quarter, we acquired AIG’s shared services operations, which we will transform to serve AIG to create a modern digital shared services platform with end-to-end processes that will improve the user experience using our SynOps platform. And consistent with our 360-degree value strategy, we are investing in upskilling our new employees. We have entered into a strategic partnership with Shiseido, a leading global beauty company headquartered in Japan. Shiseido has launched a fundamental business transformation aiming to become a global leader in premium skin beauty by 2030 under its new medium to long-term strategy, Win 2023 and Beyond. We are partnering with Shiseido to accelerate digital transformation and create personalized and seamless customer experiences, design, develop and implement a cloud-based system that will help it adopt processes that enable continuous financial reporting that are forecasting accuracy and more precise inventory management. We are helping them use AI, analytics and automation to create new business value and helping their employees gain high level digital skills. We are working with Specsavers, the UK base leader in optometry, audiology and other healthcare services, to reimagine and transform their entire IT organization through our living systems approach. We are leveraging new ways of working in agile foundations to capture efficiencies and reduce costs, while positioning the company for growth and diversification to drive business resilience. With our managed security services, we are helping a central bank in Asia to strengthen their resilience against cyber threats, builds in the flexibility to securely grow their payment transactions from millions to billions at speed and scale. Our Industry X team is helping Formula One re-launch its F1 TV Grand Prix racing product. By using the cloud-based Accenture video solution, live streams from 20 trackside and onboard cameras and a growing range of connected devices, we are continuously innovating to embed intelligence in their platforms to deliver the best possible viewer experience. Now, let me turn to Accenture’s greatest and undeniable competitive advantage, our nearly 537,000 people. They are at the heart of our outstanding results. Fundamental to our core values is to care deeply for our people and we placed significant importance on providing a meaningful employee experience. For almost every person around the world, living and working during the pandemic has been challenging. To help our people succeed both professionally and personally during this time, we have put in place many programs. For example, we are partnering with Bright Horizons in the U.S. through development of an innovative program for school aged children to receive proctoring for their virtual studies and homework. We have extended telemedicine to parents of our employees in India and we are providing industry leading mental wellness programs, including Thriving Mind, a holistic well-being program that teaches us about the science behind stress and how to recharge your brain’s battery. We are proud that more than 160,000 of our people have completed the program with impressive results, including nearly 9 out of 10 participants reported feeling significantly better able to handle challenges in the workplace. Equally important is our focus on vibrant career paths. We have maintained pay increases, bonuses and promotions both in our normal December time period as well as an added round of promotions in February, enabling us to promote in total at the same level as the prior year. Additionally, we will expand our regular midyear promotions this coming June to include managing directors, a first in our company’s history as one more way, we continue to create new opportunities for our people. And today, we are announcing a special one-time bonus for all of our people below managing director to recognize the contributions and dedication to our clients during this difficult year. Continuous learning also is a defining feature of Accenture. We continued to invest in our people and their market leading skills, with a 28% increase in training hours and 25% increase in hours per person just this quarter. And coming back to our ability to attract talent, we know that people want to work for companies that not only create value, but also lead with values. We are proud this quarter to have been named for the 14th consecutive year on Ethisphere’s World’s Most Ethical Companies list and for the 19th consecutive year on Fortune’s World’s Most Admired Companies. Our strategic decision to preserve our talent last year, including our recruiters, provided a strong base to meet the surge in demand we have experienced. Recruiting, hiring and managing supply and demand has always been a core competency and we are confident in our ability to attract talent and continue to meet the increased demand. We increased hiring approximately 50% both year-over-year and since last quarter. And we have on-boarded over 100,000 people virtually over the last 12 months, with new innovative approaches. I would like to recognize the extraordinary leadership and efforts of our Chief Leadership and Human Resources Officer, Ellyn Shook and her outstanding team around the globe for how they have helped care for our people throughout the pandemic, guided us through health and safety of COVID, are ensuring that we are continuously reskilling our people and have helped us manage and realize the incredible expansion of our talent to meet the needs of our clients. Over to you, KC, for a look ahead."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Let me now turn to our business outlook. For the third quarter of fiscal ‘21, we expect revenues to be in the range of $12.55 billion to $12.95 billion. This assumes the impact of FX will be about positive 4.5% compared to the third quarter of fiscal ‘20 and reflects an estimated 10% to 13% growth in local currency. For the full fiscal year ‘21, based upon how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in U.S. dollars will be approximately positive 3% compared to fiscal ‘20. For the full fiscal ‘21, we now expect our revenue to be in the range of 6.5% to 8.5% growth in local currency over fiscal ‘20, including approximately negative 1% from a decline in revenues from reimbursable travel, based on a 2% reduction in the first half of the year and no material impact in the second half of the year. For operating margin, we now expect fiscal year ‘21 to be 15% to 15.1%, a 30 to 40 basis point expansion of our fiscal ‘20 results. We continue to expect our annual adjusted effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.9% in fiscal ‘20. For earnings per share, we now expect full year diluted EPS for fiscal ‘21 to be in the range of $8.67 to $8.85. We now expect adjusted full year diluted EPS to be in the range of $8.32 to $8.50 or 12% to 14% growth over adjusted fiscal ‘20 results. For the full fiscal ‘21, we now expect operating cash flow to be in the range of $7.65 billion to $8.15 billion, property and equipment additions to be approximately $650 million, and free cash flow to be in the range of $7 billion to $7.5 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to adjusted net income ratio of 1.3 to 1.4. Finally, we now expect to return at least $5.8 billion, an increase of $500 million through dividends and share repurchases as we remain committed to returning a substantial portion of cash to our shareholders. With that, let’s open it up so that we can take your questions. Angie?"
},
{
"speaker": "Angie Park",
"text": "Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask the questions. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Your first question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-tsin Huang",
"text": "Hey, thanks. Terrific results here. I can’t remember. I was thinking the last time you guys raised your margin outlook, especially against such strong bookings and investments like cloud first, you talked about plus this one-time bonus to employees, etcetera? So what’s different this time to allow you to do that to raise margins modestly against some good momentum here? And I will ask my follow-up just together with this, which is given the big bookings, thinking about contract execution, do you feel good about sort of the level of expectations you need to deliver here to keep this momentum going, because I know you put a lot of hard work into driving up the bookings here, but I am curious if there is anything different to consider here with contract execution looking ahead? Thanks."
},
{
"speaker": "KC McClure",
"text": "Okay. Thanks, Tien-tsin. So in terms of operating margins, let me just cover with you what’s the driver this year of our 30 to 40 basis points operating margin expansion. And you are right it is unusual for us to expand our operating margin halfway through the year. And so implied in our guidance for the year, there is obviously continued healthy margin expansion in the back half. That’s in addition, Tien-tsin to the 40 basis points that we have already done year-to-date. And then as I mentioned, which does include the impact of the one-time bonus that we are doing for employees below managing director. And I will just maybe highlight a few things in terms of drivers for the expansion this year. I mean, as always, we first look to strong revenue growth and we have that again this year. And that’s coming along with increased contract profitability. We do have increased contract profitability coming through in our gross margin in the first half of the year and that’s really the first lever that we always look at. Within this year uniquely are a couple of things. One is utilization. So, we are getting some additional margin expansion this year based on our higher utilization rate. We talked about that last quarter that we are looking to bring that down to more normal levels. It did go up this quarter. We are still working on that. But clearly, in the first half of the year and into the second half, there will be some benefit to operating margin expansion on that. And the second part is due to the lower travel events and meetings of spend this year. So, we are going to benefit from that overall for the full year, but that benefit really is in the first half of the year. As the baseline last year in the back half is as you know, we really didn’t travel or have meetings, so it’s not a benefit that we will have in the back half of the year. And so I think overall, the key thing though in operating margin is that we always look to drive strong underlying profitability, because we want to ensure that we are investing first in our business because we want to drive long-term shareholder value. And so that’s really the critical part that we are able to continue to invest in our business and in our people and in acquisitions, but while at the same time expanding operating margin significantly."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And Tien-tsin, why don’t I take the – I will take the question about execution, we are very confident about our ability to execute. And let me just remind you that one of the things that’s really benefiting us is just our absolute excellent performance when the pandemic started and we had to move all of our people from our centers, while our clients were having to move remotely. As you will recall, I shared that we closed the books for 70 public companies and we did so without missing a beat that we on average pre-pandemic, have a new release every 15 minutes, 24 hours a day, on the technology say 7 days a week and we have continued with that execution. And in fact, one of the things that we believe is driving our growth is that we enhanced our standing with our clients because of how we have been able to execute, while at the same time, we help many of them move online. So we feel very good. Our centers and our people across the globe in terms of delivery are just amazing. And I should thank them, because at the end of the day, that’s what really matters for our people and we really just have exceptional people."
},
{
"speaker": "Tien-tsin Huang",
"text": "Yes, thanks both."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Lisa Ellis from MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Hey, good morning. Nice results here. Julie, I wanted to kind of rewind the clock back to early 2020, which obviously feels like eons ago now, but when you reorganized Accenture to pivot to more focus on the geographies and geographic expansion. Now that we’re a year plus in and the dust had settled a little bit, can you just kind of bring us back to that and reflect on what’s working well with that pivot, what’s working maybe less well, or it’s been more challenging than you expected. And what’s different about operating in growth markets? Just realizing that those – that the growth markets are an important part of the growth story for Accenture going forward. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure. Great question. One of the things that we look back on internally as a leadership team was that we actually were very bold in our ambition in my first year as CEO to actually put that new model in place only 6 months into the fiscal year and change our P&L in the middle of the fiscal year. And we look back and often use it as a lesson as to speed matters because as you think about our execution during the last 12 months, we did so with a new leadership team and a new way of working. And what it really demonstrated was we made the right strategic move. Driving the move from industry to geography were a few things. And remember, what we did was we also put digital everywhere. So we simplified because digital is now the core of our business. But the first thing is what we call the Client Proximity Imperative. We had such scale in all of our markets. We wanted to put our leaders really closer to our clients, while at the same time really enhancing the ability to move innovation around the world. And we did that by massively simplifying. And so we – at the one hand, where – we made a geographic P&L. But on the other hand, we made critical changes to actually make it easier to move innovation around the world. And secondly, we felt as if the ability to simplify and then have teams come together across our services would really unlock value. And of course, you did that before we had COVID, but we’ve seen the acceleration of the need for that because our clients are really looking for ability to bring outcomes. And so just think about the work that we are doing right now. Like I take BBVA, which you may know, it’s a customer-centric global financial services company headquartered in Spain. And we have worked with them to move – they wanted to increase their digital sales. And that brings together operation, all of our interactive capabilities, like paid media, search engine optimization, analytics and marketing operation, plus our deep industry experience. And with our support over the last 12 months, they have grown their digital sales more than 50% and they saw an increase in digital customers by more than 50%. The ability to bring those services together seamlessly to deliver those outcomes has really been enabled by that growth model that both simplified, recognize that the core of our business is now digital cloud and security, and enable us to really meet the needs of the client globally. In terms of growth markets, there is really nothing different there. I mean the geographic model helps us both focus on the opportunity in each of the markets, while at the same time, really connecting the innovation and being able to serve global clients better."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific. Thanks. Maybe my quick follow-up is maybe for KC, a follow-up on Tien-tsin’s question. I know you said you’re – yes, you’re running a little hot on utilization right now. And you commented on that as well last quarter. I’m curious though, with the shift to remote work, one, do you think that shift is going to remain more permanent? And will it allow you to actually maintain a higher level of utilization on a more permanent basis?"
},
{
"speaker": "KC McClure",
"text": "Yes. So thanks, Lisa, for the question. Yes, I will just reiterate. We are trying to – we are working to get it back – our utilization back into a more normal range as they did tick up this quarter. And this really is tied to the increased demand that came back harder than we expected, right? So – but we continue to believe that the right answer for our people is to lower it back into our more normal historical ranges. And in terms of the structural – is there a structural change? I believe, just now that over time, there is really not a structural change in utilization. There is probably some increase right now due to remote working, but we don’t see on a go forward any long-term structural change in our utilization rate."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And just to remember, Lisa, like we have a very important value proposition that includes being able to do continuous learning, but also the right level of time to do strategic thinking, for example, and to come together around important initiatives. And so that’s why we believe that, over time, we really should get back into kind of a more normal regardless of where people are working from."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific. Thank you. Thanks a lot."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you. Hi, Julie. Hi, KC. Congratulations. These are tremendous results."
},
{
"speaker": "Julie Sweet",
"text": "Hi, Ashwin."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Just I hate to keep bringing up margin again and again. But one thing I did not necessarily hear you explicitly call out was pricing, which you might expect given sort of a price for value component, given the pivot, the mix, as you primarily do digital cloud and security, and also, frankly, a shortage of resources. It was also going to be my follow-up question, is that your attrition has ticked up, but still below historical levels. I see all the steps you took towards employee health, wellness, eventually controlling attrition. But as demand accelerates across the industry, do you expect inflation to return to historical, like mid upper teens type levels?"
},
{
"speaker": "KC McClureb",
"text": "Yes. So Thanks, Ashwin, for the question. So I’ll cover the pricing point, and I’ll hand it over to Julie to talk about attrition. So maybe let’s start with context overall and what we’re seeing in the overall market and the business environment. So as we have been saying and we continue to see that the business environment does remain competitive and in some areas, we experienced pricing pressure, but we are seeing signs of stability, right? So that’s probably the first key point. In terms of the pricing that we have across our different markets or our services, as you know, the pricing can vary depending on what it is that we’re selling and in what markets that we’re doing that commercial arrangement. But what is important, what stays the same is that we always look to make sure that we are doing a smart commercial arrangement that benefits both our clients and Accenture. And that’s a key part of our 360-degree value. But as it relates to what we’re actually delivering in terms of profitability, I do want to highlight that within our operating margin and within gross margin, we did, we haven’t expanded the delivery of client profitability and contract profitability. So that’s a key part of our operating margin expansion for the year. And Julie, you want to talk about attrition?"
},
{
"speaker": "Julie Sweet",
"text": "Yes Ashwin. Look, I think it’s – I think we would expect that we’re going to go back to sort of industry norms on attrition, although we will always work hard to not do that, right. And we do believe that we’re benefiting right now from the way we have cared for and – our people and the decisions we made to preserve our talent and invest in keeping them through the lower demand areas. So – but certainly, we’re tuned as a company to be able to grow and recruit at this level and at the more normal levels, as you said, in the higher teens."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you. Good result."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hi, guys and congratulations from me as well. Just thinking, Julie, about this more structurally longer term, is this growth rate – the back half growth rate obviously being really strong in the back half, double-digit growth, implied for both the third and the fourth quarter. How has the pandemic changed things that this could be maybe more sustainable than just kind of a onetime pickup in growth and maybe the growth could be? I know we’ve talked about in the past 5% to 8% constant currency growth. Just wondering if that formula has potentially changed in the future due to the pull forward of some of the digital transformation from the pandemic?"
},
{
"speaker": "KC McClure",
"text": "So we knew someone was going to try to get us to look ahead for next year, but…"
},
{
"speaker": "Bryan Keane",
"text": "You got me."
},
{
"speaker": "KC McClure",
"text": "So but we’re not going to. But let me just – so instead of trying to look ahead to next year and thinking about it, let’s maybe just focus on how we are looking at our business right now. So if you think about the last 6 years when we started digital, we rotated our business so that now the core of our business is digital, cloud, security and all of our services, meaning not just – that’s not from a technical perspective. And so think about what we have built are engines of growth as the core of our business, which is what we went through when you think about cloud, Industry X, applied intelligence, operation, the things we went through on our script today. And so we have these engines of growth which we continue to invest in. And I think what’s really important in the way we think about our business is we’re – for example, cloud, we already scaled. We told you last quarter, it was $12 million in FY ‘20 but it’s growing double-digits because we’re at the very early stages of it. And when you think about Accenture Cloud First, we brought together, right, all of our services, from strategy and consulting, to experience, to cloud, industry experience, because not only are companies having to migrate to the cloud, but they need to create value, like we’re working with an American entertainment company, where we’re helping them use – leverage the cloud to accelerate the time to market of new video services, right? So it’s not about the migration. It’s about the value. And so think about our business as having built these engines of growth, some of which already have massive scale and are continuing. And then others, like Industry X, Industry X is a way that we are going to continue to diversify our revenue sources for resilience over the long-term. We made two acquisitions this quarter, [indiscernible] Solutions and Myrtle Consulting Group, to help build our manufacturing and supply chain. We’re going to continue to invest there. We think about that as the next interactive, right, in terms of building this new area. And we’re at this amazing tipping point right now where we’re seeing an acceleration of digitization in manufacturing and in product engineering. And so we continue to think about how do we both make sure these growth engines is going, but never have to have another rotation because we’re always investing. And I mean, the last point I would just say is our capacity to invest in acquisitions has been a huge differentiator in building the business we have today, as being the core of our business is now these engines of growth. And we continue to execute on that in all of our major strategic areas and the next scale plays. And I’d call out the two we made this quarter in cloud, for example, Infinity Works and Edenhouse."
},
{
"speaker": "Bryan Keane",
"text": "Got it. Got it. And just KC, a quick follow-up, will travel and reimbursables, will that go up back to the norms of previous past? I’m just trying to figure out if some of that, obviously – some of that travel work doesn’t have to continue until the model slightly changes on that front."
},
{
"speaker": "KC McClure",
"text": "Yes. So that’s a great question, Bryan. So let me just first tell you what we’ve assumed as it relates to kind of our revenue. So we do not have in our revenue guidance an increase in travel revenue from travel-related expenses. Now obviously, we’re continuing to meet with our clients and do well, and engage with them, as you can see from our record bookings and our really strong revenue growth. But we don’t have any of that in – we don’t have that significantly embedded in our revenue. In terms of for the rest of the year, we’ll continue to see where we are with the travel and expand events and meetings. As we go throughout the rest of the year and into next year, so it’s kind of too early to tell. Julie, if you want to add anything?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. I agree. I mean, look, I’m having lots of conversations with companies who are just trying to figure this out, right? Will travel – will it actually explode once people feel safe because they need to reconnect? Will it structurally shift? And I would say that it’s really – we think it’s too early and company, it’s really kind of allover the map. And that hopefully will have a lot better sense as we get through the next 6 months. And we see vaccination variance and healthy – how comfortable people are. But it’s still pretty unclear."
},
{
"speaker": "Bryan Keane",
"text": "Got it. Thanks for taking the questions."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Dave Koning from Baird. Please go ahead."
},
{
"speaker": "Dave Koning",
"text": "Hey, guys. Thanks, nice job. And I guess my first question, outsourcing growth was the strongest, I think, in 6 years, and that’s really not on an easy comp either. You had a pretty normal Q2 of last year in terms of growth. I’m wondering, is there something within outsourcing that has kind of step function change to just a better level than normal or something happening there that’s really triggering growth in such a stable part of your business typically?"
},
{
"speaker": "Julie Sweet",
"text": "Well, it’s a great question. And this really is a big driver of how well we’re doing now because in this – when you have compressed transformation where the companies need to do so much at the same time, there is a really sharp focus on, what do I need to do? How do I source the talent, right? And that conversation has absolutely gone faster. But also, how can I digitize every part of the organization? And what Accenture has, which is very unique, is this investment we’ve been making for years in the SynOps platform, for example, in operations, and in technology, things like myWizard and myConcerto, which builds in best-of-class AI, machine learning, rapid testing. And these are platforms that we continuously invest in. And so when you – happening is here is that we’re helping them digitize. We are helping them focus on, what do they really need to have in-house versus can leverage in order to go faster. But one thing I want to be really, really clear about is, although our strategy and consulting business continued to have a high single-digit decline, it was better than we expected, strategy and consulting is absolutely essential to all of these results, including outsourcing. Because what we are bringing to them, right? It’s not simply always at a lower cost. It’s increase is in sales through our marketing operations, like the BBVA example I gave, right? It’s manufacturing in at AIG, which I talked about, it’s insurance, right, as well as deep process skills. It is helping them transform the ways they are working by being integrated with us where we’re bringing modern ways of working and digital. And so this is what distinguishes us as a company for our clients. It’s not – you for guys, it’s type of work, outsourcing versus consulting, which is basically managed services, it’s project work. For our clients, it’s our ability to bring all these services together, which is why I emphasize that each of the examples I gave in my script, and I gave you many more, really are polling all of these things together for an outcome and when you are going to compress transformation, that’s more important than ever."
},
{
"speaker": "Dave Koning",
"text": "Great, thanks. That’s great. And I guess my just quick follow-up. Every vertical accelerated in the quarter except for resources. And so I’m just wondering, on that vertical specifically, that got a little worse, but that hits really easy comps in the back half, anything to kind of call out there on momentum kind of reaccelerating in the future?"
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks, Dave. So resources, it came in, in the zone that we expected it to. And I’d just point out a couple of things. So we’ve talked about the industry is more impacted by the pandemic, and resources clearly has one of those, which is energy and that continued to be under pressure. And I would also say that our clients in the chemical industry also have been feeling some pressure as well but we have seen stability in our utilities portfolio which is good. And go forward, as we look into Q3, we do see an improvement in the resources growth rate."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And by the way, this is where Industry X is going to be so critical. For example, we’re working with a North America, one of the largest oil integrators in the world, in re-imagining their plants from both health and safety security and efficiency perspective. I was just in our brand-new OT security lab in Houston last week. Yes, I actually did go on a business trip. And a big focus of OT security is across all of our volt process and discrete manufacturing. So there – obviously, as an industry – set of industries, they have been impacted. But if you think about where we’re focused and how we’re going to help them from efficiency and safety and security, it’s great. We’re well positioned."
},
{
"speaker": "Dave Koning",
"text": "Great. Thanks guys."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of James Faucette from Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Great. Thank you very much. And wanted to go back to one of the comments you made in the prepared remarks in terms of increasing your programmatic B&A. And wondering if you could just give us a little color of how we should think about contribution from that, specific areas of focus, durability, etcetera. Just trying to understand how you are thinking about that initiative, which seems really important?"
},
{
"speaker": "KC McClure",
"text": "Yes. So thanks for the question. You’re absolutely right. I mean, our ability to invest significantly in our business, and that includes B&A, is a key competitive advantage. And I would just say, we’ve been at this for a long time, to your point. It’s been a core part of our strategy since 2013. On average, we’ve done about 20% of our operating cash flow to B&A, and that’s our updated guidance of about up to $2 billion – at least $2 billion, puts us in that same zone. So – but it’s not just being able to acquire. It’s successful integration. And so you can see that, that typically provides about 2% of inorganic contribution in this year. It’s going to be more, in the 2.5% zone. So we really are very focused on that as a key part of our strategy, and we will look to continue to invest. And as we’ve said, we can always – we can do more than the $2 billion if the opportunity presents itself, but it is a key part of our investment portfolio."
},
{
"speaker": "James Faucette",
"text": "Thanks. And just turning operationally for my follow-up question, can you give some color on how much of the strong demand that you’re seeing is driven by your partner network this year? And where you’re seeing most strength there? And I guess, how you would think about that part of business generation evolving over the next few quarters and periods?"
},
{
"speaker": "Julie Sweet",
"text": "Our ecosystem partners are absolutely essential to our growth. I called them out in our script. We’re really proud to be the number one or number two partner, with all of the major ecosystem partners. And what we uniquely bring is, because of the strength of our relationships, we can really bring integrated value propositions to our clients. And so, those relationships are very high priority and to – and important to our future growth."
},
{
"speaker": "James Faucette",
"text": "Thanks, Julie. Thanks, KC."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Angie Park",
"text": "Operator, we have time for one more question and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Okay. That question comes from the line of Bryan Bergin from Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, good morning. Thank you. Question on the outsourcing and operation strength, so you highlighted the AIG Shared Services deal this quarter, have you seen a pickup in captive acquisition opportunities that you’ve acted upon here over the last several quarters? And I’m curious how we should think about this mix contributing to your outperformance and the pipeline going forward?"
},
{
"speaker": "Julie Sweet",
"text": "Well, we’ve shared in prior calls that we do see more interest in captives. We’re starting to see us execute on some of them. But I think it’s too early to say whether that’s going to be a big part of the mix or not. For the reasons I’ve talked about, we can go in and help digitize. KC, do you want to add anything?"
},
{
"speaker": "KC McClure",
"text": "No. I would just say, in terms of what we see, in terms of the mix, for H2, we still see a double-digit growth in outsourcing. And for the full year, I think they will end up with high single to low double-digit positive growth in terms – to give you some sense of the mix."
},
{
"speaker": "Bryan Bergin",
"text": "Okay, I appreciate that. And then just on H&PS and Financial Services, so those both clearly had outsized performance in the quarter. Can you just talk about the key contributors underlying those two?"
},
{
"speaker": "KC McClureb",
"text": "Yes. So, we were really pleased with H&PS and Financial Services growth this quarter. H&PS continues to be growth that we’ve seen in public service and the work that we’ve been doing during – not just only, but clearly led by a lot of the work that we’re doing within the COVID space. And then in financial services, we’re pleased that we do have strength in our banking and capital markets, and that’s a statement globally as it relates to – particularly – and not only in our business in Europe, but all over, including North America. So very strong performance in both of those, and we expect that to continue."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And it’s the things that are – it’s cloud, right. It’s – there is a big movement to cloud. It’s digital experience. It’s more like the example I gave in BBVA. It’s basically all the trends that we’ve talked about are playing out really across industry and financial services is one of the less – more moderate impacted industries, and they are investing."
},
{
"speaker": "Bryan Bergin",
"text": "Thank you very much."
},
{
"speaker": "Julie Sweet",
"text": "Okay, great. Well, thank you again for joining today. And thank you again to all of our incredible people around the globe. And as always, I just want to end by thanking our shareholders for your continued trust in us. May everyone stay well and healthy."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 1 | 2,021 | 2020-12-17 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by. Welcome to the Accenture's First Quarter Fiscal 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instruction will be given at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Ms. Angie Park. Please go ahead.
Angie Park: Thank you, operator, and thanks, everyone, for joining us today on our first quarter fiscal 2021 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the second quarter and full fiscal year 2021. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking, and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed on this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Today, we are very pleased to announce strong financial results for our first quarter. I will begin by thanking our 514,000 people for their hard work and dedication to delivering value for our clients, which is what these results represent. Last quarter, I shared that as we began our fiscal year 2021, we were turning a page, no longer navigating a crisis, but facing a new reality with a laser focus on delivering value to our clients at this time of great need and on returning to pre-COVID growth rates by the second-half of our fiscal year. I also shared how we began fiscal year 2021 stronger than pre-crisis. Our results in Q1 made clear how we have strengthened our market position, as well as our ability to pivot our business with agility. Not only have we delivered a strong quarter, but we took exciting new actions to continue to strengthen our market position for FY 2021 and the future. Let's start with our financial results. We delivered revenue growth of 2% in local currency, well ahead of our guidance with broad-based improvement across the globe. We continue to extend our leadership position with our growth estimated over the trailing four quarters to be more than four times the market, which refers to our basket of publicly traded companies. We delivered exceptionally strong new bookings of $12.9 billion, a 25% increase over Q1 last year, including 16 clients with over $100 million in bookings. We continued to invest substantially in our business, including closing 10 acquisitions this quarter in strategic areas, such as Cloud, Intelligent Operations and Industry X. And as KC will walk through, we delivered strong profitability and returned substantial cash to shareholders. Now, let me highlight the actions we've taken in Q1 to better serve our clients, attract the best talent and extend our leadership as a responsible business and trusted partner. We created Accenture Cloud First with the planned $3 billion three-year investment to help clients in what has become a once in a digital era replatforming of global business in the cloud. We launched our new purpose, our growth strategy to deliver 360-degree value to our clients and our largest and most significant new brand campaign in a decade. In our annual cycle in December, we promoted 605 Managing Directors with a record 39% women, and I appointed 663 Senior Managing Directors, including a record 29% women. I'm excited to announce today that we met our previous goal of 25% women Managing Directors globally by the end of 2020, and have raised the bar again, setting a new goal of 30% by the end of 2025. With 45% women overall, we are on track to meet our goal of 50-50 gender equality by 2025. We set external goals in the U.S., UK and South Africa to achieve greater race and ethnicity representation overall, and among Managing Directors in these countries by 2025. We remain the only major professional services company in our industry around the world, public or private to set these types of external goals and to have our level of transparency. We believe our diversity and commitment to inclusion and equality have been and will continue to be critical to our success and a differentiator into attracting the best talent. And building on our long-standing and well-recognized commitment to the environment, we announced industry-leading goals for 2025 to achieve net zero emissions, move to zero waste and plan for water risk. As you can see, we have been busy moving forward in our new reality. KC, over to you.
KC McClure: Thank you, Julie. Happy holidays to all of you, and thanks for taking the time to join us on today's call. We were very pleased with our overall results in the first quarter, which exceeded our expectations and represent a positive first step to achieving our full-year objectives. The focused execution of our strategy continues to extend our leadership position in the marketplace, as we deliver significant value to our clients and our shareholders in an uncertain and volatile environment. So let me begin by summarizing a few of the highlights of the quarter. Revenues grew 2% in local currency and continue to include a reduction of approximately 2 percentage points from a decline in revenues from reimbursable travel costs. Q1 revenues were more than $200 million above our guided range, driven by broad-based over-delivery across markets, services and industries. We also continue to extend our leadership positions with growth significantly above the market. The diversity of our business continues to serve us well, and the industry trends remain consistent with the last few quarters. Approximately 50% of our revenues came from seven industries that were less impacted by the pandemic, and in aggregate continue to grow high single digits, with continued double-digit growth in public service, software platforms and life sciences. At the same time, we saw continued pressure but at a more moderate level from clients in highly impacted industries, which include: travel, energy, high-tech, including aerospace and defence, retail and industrial. While performance varied, this group represents over 20% of our revenues and declined low double digits. Our operating margin was 16.1% for the quarter, an increase of 50 basis points. We delivered expansion while making significant investments in our business and our people to extend our market leadership. We continue to benefit from lower spend on travel and events. And we delivered very strong EPS of $2.17, up 8% over fiscal 2020, after adjusting both years for gains on an investment. And finally, we delivered significant free cash flow of $1.5 billion and returned $1.3 billion to shareholders through repurchases and dividends. We also invested approximately $500 million in acquisitions and we expect to invest at least $1.7 billion in acquisitions this fiscal year. With those high level comments, let me turn to some of the details, starting with new bookings. New bookings were $12.9 billion for the quarter, reflecting an overall book-to-bill of 1.1. Consulting bookings were $6.6 billion with a book-to-bill of 1.0. Outsourcing bookings were $6.3 billion with a book-to-bill of 1.2. We were very pleased with our bookings this quarter, which grew 25%, driven by both technology services and operations. We were also pleased with the strength of our bookings in strategy and consulting, with a book-to-bill of 1.1. Looking forward, we continue to feel very good about our pipeline. Turning now to revenues. Revenues for the quarter were $11.8 billion, a 4% increase in U.S. dollars and 2% in local currency, including a reduction of approximately 2% from a decline in revenues from reimbursable travel costs. Consulting revenues for the quarter were $6.3 billion, a decline of 1% in U.S. dollars and a decline of 2% in local currency, including a reduction of approximately 3% from a decline in revenues from reimbursable travel costs. Outsourcing revenues were $5.4 billion, up 9% in U.S. dollars and 8% in local currency. Taking a closer look at our service dimensions, operations grew double digits, technology services grew mid-single digits, and strategy and consulting services declined low double digit. Turning to our geographic markets. The industry dynamics that I mentioned earlier continue to play out in a similar manner across all three markets. In North America, revenue growth was 4% in local currency. In Europe, revenue declined 1% in local currency. We saw mid-single digit growth in Italy, with UK improving to flat. In growth markets, we delivered 3% revenue growth in local currency, led by high single digit growth in both Japan and Australia. Moving down the income statement. Gross margin for the quarter was 33.1%, compared with 32.1% for the same period last year. Sales and marketing expense for the quarter was 10.4%, compared with 10.5% for the first quarter last year. General and administrative expense was 6.6%, compared to 6.1% for the same quarter last year. Operating income was $1.9 billion for the first quarter, reflecting a 16.1% operating margin, up 50 basis points compared with Q1 last year. As a reminder, last year in fiscal '20, we’ve recognized an investment gain which impacted our tax rates and increased EPS by $0.08 in the quarter. This year in Q1, we again recognized investment gain which impacted our tax rate and increased EPS by $0.15. The following comparisons exclude these impacts and reflect adjusted results. Our adjusted effective tax rate for the quarter was 23.7%, compared with an adjusted effective tax rate of 23.9% for the first quarter last year. Adjusted diluted earnings per share were $2.17, compared with adjusted diluted earnings per share of $2.01 for the first quarter of last year. Days service outstanding work 38 days compared to 35 days last quarter and 43 days in Q1 of last year. Free cash flow for the quarter was $1.5 billion, resulting from cash generated by operating activities of $1.6 billion. Net of property and equipment additions of $93 million. Our cash balance at November 30th was $8.6 billion, compared with $8.4 billion in August 31st. With regards to our ongoing objective to return cash to shareholders. In the first quarter, we’ve repurchased or redeemed 3.3 million shares for $769 million at an average price of $229.98 per share. At November 30th, we had approximately 5.8 billion of share repurchase authority remaining. Also in November, we paid a quarterly cash dividend of $0.88 per share for a total of $558 million. This represents a 10% increase over last year. And our board of directors declared a quarterly cash dividend of $0.88 per share to be paid on February 12th, a 10% increase over the last year. So, in summary, we were very pleased with our Q1 results, and we're off to a good start in fiscal '21. Now, let me turn it back to Julie.
Julie Sweet: Thank you, KC. Let me start with the environment. We saw in Q1 a broad base increase in demand that is faster than we anticipated 90 days ago. This means that as our clients have the confidence and ability to spend, they are turning to Accenture. But the uncertainty and volatility of the biggest health, economic and social crisis in our lifetimes remains, particularly as the world continues to face a deepening health impact pre-widespread vaccination. From an overall demand perspective, the trends that we discussed last quarter are continuing. Companies need to accelerate their digital transformation across their enterprises and move to the cloud, address cost pressures, build resilience and security, adjust their operations and customer engagement to a remote everything environment and changing expectations and find new sources of growth. What is becoming even more clear however, is that we are in an era of compressed transformation, in which the winners by industry will be those who are earliest to replatform their businesses in the cloud, and have the digital core and new ways of working that allows them to continuously improve their operations and find new sources of growth, which for most leading companies is requiring them to simultaneously transform multiple parts of their enterprises and their talent. For the pre-COVID digital leaders, they are racing to widen the gap, and for the digital laggards, they are racing to leapfrog. We are uniquely positioned to help the leaders and the laggards because of the depth and breadth of our capabilities. We bring the trust, experience, speed and scale that are essential to achieve compressed transformation. Now let's bring some of these demand trends to life through the lens of our Q1, and look at our own broad-based improvement. First, replatforming to the cloud. In fiscal year '20, our cloud revenue was approximately $12 billion with low double digit growth, which accelerated in Q1 with significantly higher double digit growth, driven by Accenture Cloud First. In fact, across low to highly impacted industries, and all geographic markets, we saw strong double digit growth, the race to replatform to the cloud and create new business value is clear across all our services. Our clients need our deep technical and engineering skills, and our unmatched set of relationships with the world's leading technology ecosystem companies, which are critical partners to us and to our clients. We were pleased that in Q1 industry analysts recognized us as the leading systems integrator for each of AWS, Azure and Google Cloud Platform, as well as the leading multi cloud managed services provider. Fundamental to accelerating our clients’ replatforming in the cloud, however, are our leading strategy and consulting capabilities, which give us the industry and functional insights to move rapidly and achieve early business value. For example, we are working with Takeda, a global values-based R&D-driven biopharmaceutical leader to modernize their technology platforms, including moving 80% of applications to the cloud, accelerate data services and establish an internal engine for innovation, while equipping employees with new skills and ways of working and reducing their carbon footprint. The business impact is illustrated by the plans for Takeda's plasma derived therapies business unit, which is harnessing the power of the cloud and these data services to create state-of-the-art digitally connected donation centers and modernize the donor experience, optimizing the plasma collection process, and contributing to the goal of increasing plasma collection and manufacturing by at least 65% by 2024. We are working with the Norwegian Health Net [ph] to create a health analytics platform, which is using the power of the cloud to analyze and interpret data, and ultimately improve patient outcomes, by reducing research turnaround times and access to data from months to a matter of minutes or days. And we are working with Generali, a major player in the global insurance industry to help replatform approximately 70% of its IT footprint to the cloud, to improve service quality, innovate and build a set of new cloud ready core insurance applications for emerging markets, while achieving a sustainable reduction in its total cost of ownership, and helping to upscale its workforce. In Intelligent Platform Services, which returned to low single digit growth this quarter, we saw building momentum fueled by our clients rotating to Software-as-a-Service, as well as new digital platforms. In a quick trip around the world, we see this compressed transformation playing out from the rapid transformation of the finance functions of Nickel Bank, a subsidiary of BNP Paribas, and a fast growing Neo-bank in France, with the implementation of leading software-as-a-service and ERP solutions, to the cloud based marketing transformation of a global bank with a large U.S. footprint with a SaaS implementation across its worldwide private banking network, to one of the largest implementations in the chemicals industry of a modern digital ERP system, hosted on the cloud for Indorama Ventures, a world class chemicals company with global operations headquartered in Asia, that will provide a single source of information globally, and cloud-based solutions to enhance its operations, employee development capabilities, and customer and supplier experiences. So that's the cloud. Now let's turn to digitizing operations across the Enterprise. In operations, which returned to double digit growth this quarter, we are helping our clients transform by digitizing their operations with our SynOps platform, increasing agility and reducing cost. Operations as-a-service that enables us to continue diversify our value to clients by expanding across functions and industries, we have an unmatched global footprint ability to invest an innovation engine powered by the broader Accenture. We were excited to welcome to the Accenture family this quarter N3, an Atlanta-based B2B sales firm, with more than 2,000 employees that combined specialized talent in AI and machine learning to enable smarter, more efficient sales interactions and drive sales growth in virtual environments. The power of Accenture's breadth and depth comes together at Halliburton, a leading provider of products and services to the energy industry, and a leader in driving true enterprise wide transformation enabled by digital and technology. Last quarter, we shared how we are helping Halliburton move to cloud-based digital platforms. This quarter, we announced that we are teaming with Halliburton to accelerate its digital supply chain transformation, and support digitization within Halliburton's manufacturing functions to improve service levels and business outcomes. We will leverage SynOps which we already use as part of Halliburton's digital transformation of its finance and accounting function, and our strategy and consulting expertise. In Industry X, we are digitizing manufacturing and operations and creating intelligent products and platforms. In fiscal year '20, Industry X was approximately $3 billion and grew low double digits, which is continued in Q1. We see COVID deepening the need to transform manufacturing in a contactless world with disrupted supply chains and greater cost pressures. One of our latest wins with that CNH Industrial, the manufacturer of capital goods across the agriculture, construction equipment and commercial vehicle sectors, where we are improving the global operating model to develop smart connected products and services that will grow revenue, while building a digitally enabled workforce and enhancing security and sustainability. Finally, let's look at the trends around new ways of engaging customers, patients, citizens and employees. In interactive, which is all about the business of experience, the crisis had a significant impact due to severe disruptions in industries like travel and retail, and due to our clients being focused on shoring up their experience of their businesses, rather than the next generation of experiences. This quarter we saw building momentum with a return to low single digit growth from a low single digit decline in H2 of FY'20 as clients focus on creating new experiences in the new environment. For example, Accenture Federal Services is working with the Federal Retirement Thrift Investment Board to reimagine retirement services for the digital age and improve the customer experience for a retirement savings plan serving 6.1 million civilian employees and members of the armed services with over $644 billion in assets. I want to take a moment to talk about another bold move we made this quarter. In October, we simultaneously launched a new purpose, our growth strategy to deliver 360-degree value to our clients, and a new brand campaign created by our own Droga5 team that joined our family in 2019. Our new purpose is to, deliver on the promise of technology and human ingenuity. Our purpose is what we are uniquely able to do and our growth strategy is our action plan to bring this purpose to life. Our strategy to deliver 360-degree value to our clients is a direct response to the rising demand we see for talent transformation, and help achieving responsible business goals. We define 360-degree value as delivering the financial business case experiences and unique value a client maybe seeking, and striving where possible to partner with our clients to achieve greater progress on inclusion and diversity, reskill their employees and achieve their sustainability goals. At the heart of this strategy is embedding responsible business by design into our work for clients in addition to our own operations. Our new brand, Let There Be Change, captures our purpose and the depth and breadth of Accenture's expertise. Together, our purpose, strategy and brand better reflect Accenture's unique role in helping companies reimagine and rebuild differently for the benefit of all. Over to you KC, for a look ahead.
KC McClure: Thanks, Julie. Before I get into our business outlook, as I did last quarter, I would like to remind you that given the coronavirus pandemic, there are a number of factors that we may not be able to accurately predict, including the duration and magnitude of the impact, the pace of the recovery, as well as those described in our most recent quarterly filings. Now, with that said, let me turn to our business outlook. For the second quarter of fiscal '21, we expect revenues to be in the range of $11.55 billion to $11.95 billion. This assumes the impact of FX will be about positive 3% compared to the second quarter of fiscal '20, and reflects an estimated 1% to 4% in local currency and includes a reduction of approximately 2 percentage points from a decline in revenue from reimbursable travel costs. The entire range for Q2 reflects the continued build back of our business over Q1. For the full fiscal year '21, based on how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately positive 3% compared to fiscal '20. For the full fiscal '21, we now expect our revenues to be in the range of 4% to 6% growth in local currency over fiscal '20, including approximately negative 1% from a decline in revenues from reimbursable travel, based on a 2% reduction in the first-half of the year and no material impact in the second-half of the year. For operating margin, we continue to expect fiscal '21 to be 14.8% to 15.0%, a 10 to 30 basis point expansion over fiscal '20 results. We continue to expect our annual adjusted effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.9% in fiscal '20. For earnings per share, we now expect our full year diluted EPS for fiscal '21 to be in the range of $8.17 to $8.40. We now expect adjusted full year diluted EPS to be in the range of $8.02 to $8.25 or 8% to 11% growth over adjusted fiscal '20 results. For the full fiscal '21, we now expect operating cash flow to be in the range of $6.65 billion to $7.15 billion. Property and equipment additions to be approximately $650 million, and free cash flow to be in the range of $6 billion to $6.5 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $5.3 billion through dividends and share repurchases, as we remain committed to returning a substantial portion of cash to our shareholders. With that, let's open it up so we can take your questions. Angie?
Angie Park: Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: Thank you. [Operator Instructions] Your first question comes from the line of Lisa Ellis from MoffettNathanson. Please go ahead.
Lisa Ellis: Good morning, guys. Great to hear all of you and happy holidays. I would just ask my two right up-front. Looking at the utilization number of 93% in the quarter, I peeked back and that is the highest number you've reported in more than 10 years. So two questions, one more strategic and one more numbers related on that. I guess, first, can utilization be structurally higher now with the shift to remote work and so we should expect these kinds of levels going forward? Or are you kind of getting to the point that you're labor constrained and you're going to be ramping hiring and that number will come down a bit? That's the more, I guess, strategic question. And then maybe for KC, was higher utilization the primary driver of the 100 basis point increase in gross margins? Or is that also being affected by the reduction in travel costs? Thank you.
KC McClure: Okay. Hi, Lisa. Thanks for your question. Happy holidays. So maybe I'll start with your second question first. Just on gross margin. So we did have expansion in gross margin and there were a few drivers to that. The first is contract profitability was up this quarter. And in contract profitability, we did benefit from lower travel, so that does help our contract profitability overall. So that is the first thing, I would say, benefited our gross margin. And you do see that the fact that we have higher utilization also does help our gross margin as well. So both of those points were included in drivers of our gross margin. And when you look at utilization, we did have a very high productivity this quarter. It did click up in parts and that was pretty broad-based and that was also driven by our over-delivery of Q1 revenue. We did continue to recruit throughout the summer, and obviously into this quarter, you can see that our headcount is up sequentially. And so we don't see any issues meeting demand and attracting talent. And to your point on, is there a structural change from working remotely, the answer is really no. We were just able to get more productivity out of all of our groups this quarter. And looking forward, we do think that's going to kind of ease back into kind of a more normal range, which still is very high productivity, but not continuing at these levels.
Lisa Ellis: Terrific. Thank you.
Operator: Your next question comes from the line of Tien-Tsin Huang from JPMorgan. Please go ahead.
Tien-Tsin Huang: Hey, thanks. Good morning. Good results here. I want to just ask about the outlook here and what's changed in the last 90 days. I know you received – looking at revenue while you're up $200 million over your guidance, you overcame low-double-digit declines in strategy and in consulting. From a macro standpoint, we got what vaccines have been approved and cases are up, but your bookings are strong again. So I'm just trying to think you seem really well set up for the second-half to be quite strong, even if strategy and consulting comes back slowly. So do you feel more confident in the outlook for strategy and consulting? Or is the composition of work just changing versus what you thought maybe 90 days ago? Any thoughts on that?
KC McClure: Yes. So let me just talk a little bit about what drove our overperformance in Q1, and how that impacts our view of Q2 and H2, Tien-Tsin. So, when you look at Q1, we were obviously very pleased with our performance, and we have rather significant over-delivery against our expectations. And that was really driven by broad-based over-delivery, in all three of our markets, in all of our industry groups and all of our services all did a bit better. And as I mentioned in our script, when you take a look at the industries and the higher impacted industries, which represent over 20% of our revenues, they did improve from Q4 of a decline of mid-teens to low double digits. And as Julie talked quite a bit about the fact that that was really driven broad-based by our strong demand in cloud. And so that is an area that performed better than we expected. But if you also look at the lower impacted industries, which are 50% of our revenue, they continue to grow high single digits like Q4, but they actually did improve also within that sense. And so let me maybe connect this a little bit to how we did our sales this quarter. So we had a very strong start to the year, as you could see in our sales of $12.9 billion, which is about $2.5 billion more than what we've done in the last two quarter ones, last two fiscal years. And when you peel that back, Tien-Tsin, you can see that it was really driven by all categories of our sales side, so the large, which Julie highlighted that we have 16 clients over $100 million in sales, but all the way through and significantly driven by an improvement in our smaller deals, which came in better than we expected. And that can help us with revenue yield in the current quarter. So when I take a look at that, that's what happened with Q1. And then when you look at that compared to 90 days ago, obviously, that's better. And when you look at -- then what for Q2, we obviously have a better outlook for Q2 than we did 90 days ago with our 1% to 4% growth range. Really important to note that all of points in that range are an improvement over Q1. So we continue to build back our business from the lows of H2. And we would be really pleased with anywhere that we land in that range. Now, when you look at the second-half of the year, we haven't changed our views on the second-half of the year from 90 days ago. And just to be very specific, we still see that we would have high single-digit to low double-digit growth in the back-half of the year. And just as a reminder, the four factors that we talked about last quarter that we're going to drive that remain the same. And just very briefly, they are first, that we continue to expect an improvement in the macroeconomic environment. We don't see another -- we're not anticipating another macroeconomic shock that's built into our guidance. We expect to see more of a benefit from the significant transformational deals that we sold last year. And at the same time, to your question, we do expect strategy and consulting to reconnect with growth. And our performance in Q1 and our outlook for Q2 do encourage us even more on that statement this quarter. And the fourth thing is that we have the benefit of an easier compare that obviously remains the same. And we are also still going to anniversary the reimbursable revenue headwind, that's 2% in the first-half of the year and that won't be a headwind in the back-half of the year. So, of course, we're still meeting with our clients, you can see that by the fact that we were able to book $27 billion in the last two quarters. But we are not planning on having significant increases in revenue related to travel in the back-half of the year. So hopefully, that gives you a sense of how we see the business compared to what is stay the same now from 90 days ago, which is our outlook in H2. But obviously, we're very pleased with the improvements and performance in Q1 and outlook for Q2 than we had 90 days ago.
Julie Sweet: And, Tien-Tsin, let me just kind of give you a little more color from the clients’ perspective, because -- and this is what I talked a little bit about in my script, right?. If you just sort of remember, pre-COVID, we said we were in the early innings of transformation with the beginning of the decade, it’d be enterprise-wide, right? COVID hits, technology becomes the lifeline. And you really see companies understanding kind of the two truths of our world, right? There is - every business is now a technology business and exponential technology change is going to continue, right? And now it's about the speed. And this is why we're seeing what I'm calling compressed transformation, where you continue to see companies say we are going to take on this transformation more broadly. So look at the example of Takeda. They're both moving to the cloud, improving their data and making sure that they're getting near-term business value. You take a Halliburton, cloud, finance, supply chain. So there's this speed of change and we see that in the confidence. We're nine months in now. The first part of the crisis, people were getting their footing, getting back up and running. And it's interesting, we did some research in July across 10 markets and nearly 80% of the executives that we surveyed said that they were planning on investing in digital transformation. And that was up from 50% in May. And we're continuing just to see this recognition of the need to get there faster. And then what's important to understand is that, all of this is happening, though, in the context of the cost pressures, the changing expectations. And this is where a decade and in some cases multiple decades of investment from Accenture has put us in a very unique position, because no other company in our industry can simultaneously do operations and that help a company reduce their supply chain in their finance function and reduce costs and digitize. At the same time, we're helping them migrate to the cloud and give them that view, which because all of this has interdependencies. You want to get end-to-end process change. And we have literally been building these capabilities for years and years. And this is where the scale and the breadth matter.
Tien-Tsin Huang: It sounds very clear. I appreciate for the complete answer, guys, here, and it seems like the outlook is set up pretty well here. Thank you.
Operator: Your next question comes from the line of Matthew O'Neill from Goldman Sachs. Please go ahead.
Matthew O'Neill: Yes, thank you so much for taking my question. I was hoping we could drill down a little bit deeper into Accenture Cloud First, I think it's just on 90 days since the formal announcement. Curious, understanding a lot of sort of anecdotes in the prepared remarks around Takeda, Halliburton, et cetera. But where you're seeing the most immediate need to deploy the $3 billion that you identified for an investment, earliest and first? And sort of mirroring that where the greatest demand is coming from the client side, understanding, there's kind of a broad-based, I think COVID-driven catalyst to potentially get off the fence and move one's business to become fully digital cloud, et cetera, et cetera?
Julie Sweet: Sure. So, Matthew, thanks for the question. So maybe just take, let's just first start why our companies having to accelerate faster to the cloud. And there's a few clear reasons. So first of all, there's a cost pressure, because when they move to the cloud, there's immediate savings just in the migration and there's obviously to get that kind of savings. Second, the cloud is really important for resilience and security. And in this current environment in particular, you can see why that matters. The crisis really exposed the vulnerabilities of a lot of the on premise IT estates. And then that has been compounded, of course, by the expansion of the threat surface through more remote working. And so the resilience and security of the cloud is also an immediate driver as to the need to do that. What I would say is probably most important and really the rapid acceleration is the need for the power of the cloud to enable the data driven transformations. And so you saw that in the example that we gave, with Takeda, where they're changing the customer experience, which requires near real time access to data in order to personalize and to be able to actually do that. And what I think is very unique, I know is very unique about Accenture is that this is where our strategy and consulting capabilities are so important, because the reason to go to the cloud is not simply cost and resilience and security, it's about the business value. And here's how we're helping clients get early business value. And you have to deeply understand the industry, the patients, the customer, and also what data is valuable among all of the data and which workloads go first. And so, it really is driven by all of these things at once, which is why our capabilities around changed management, around talent transformation and leadership are important, because, by the way, everybody wants to go higher at cloud talent in this thing. And so, it's not going to be enough available to our ability to reskill, which you saw in each of these examples that we gave in the script like Generali and Takeda is also a critical. So that's sort of the big picture. Now, when you think about where we're going to do investment, we talked about we did 10 acquisitions this quarter, four of them were in cloud. They were in each of our three markets and they were about building scale for the most part in more markets. And so, as we think about the acquisition strategy which will be a big component of the $3 billion, it's about building scale and markets around the world as well as acquiring niche capabilities. The second big area of that $3 billion investment though, is creating more and more of the assets that will allow our clients to move quickly. Everything from the myNav asset that we talked about, that does a fast diagnostic with benchmarks to help clients figure out what kind of a strategy to have and how to get value to the migrating navigate advisor that helps you figure out the reduction in carbon, to the industry blueprints that we're creating, and the solutions that are repeatable like in digital manufacturing on the cloud. So this will be an important part of our continued investment. And again, it really comes right back to -- no other company has both these deep engineering and infrastructure skills, the deep relationships. And then the strategy and consulting capabilities to actually move industries to the cloud to create business value solutions. And you don't build that overnight. We have been building our strategy and consulting business for decades. We have been an early adopter for cloud for decades. And let's not forget, we're our own best credential when it comes to all of these capabilities.
Matthew O'Neill: That's really helpful and interesting. I guess, as a quick follow-up, I was just curious, you mentioned in the script Droga5 acquisition and more broadly Accenture Interactive. And wondering if there's significant sort of cross sell and upsell opportunity as you integrate more assets like Droga5 and present a more comprehensive suite to both the existing and new clients for things that they might not have maybe originally known or thought of Accenture for first and foremost. Is that a part of the equation here?
Julie Sweet: Absolutely. And when you think about Accenture Interactive, like we are doing amazing work like our own brand and purpose work for ourselves via again our best credential. But what these capabilities bring is we're actually embedding them in all of our services. Our clients come to us for outcomes and experience is a really important part of it. Again, when you think about the work we are doing with Prudential that we talked about last quarter, that was fundamentally a different way of engaging with the customer. Takeda, a different way of engaging with the donor, the researchers in the Norway example about how they're going to engage. We are embedding this experience, and how to do that in all of our work, and so that's why I often talk about, I know you all certainly look at our services, separately our four services, our clients look at our outcomes. And what differentiates us is our ability to embed the business of experience across Accenture, as well as going to market of course, like a Droga5 that continues to do amazing, pure work in terms of brand for example.
Matthew O'Neill: Thanks so much. Really helpful. Thinking about that in the context of sort of experience and outcome. I'll jump back in the queue.
Operator: Your next question comes from the line of Bryan Bergin from Cowen. Please go ahead.
Bryan Bergin: Hi, good morning. Thank you. I wanted to ask on bookings. Was there anything pulled forward in bookings relative to your prior expectation? Or do you still anticipate a building cadence for the year? And can you comment on bookings conversion pace and considering the outperformance you've had the last two quarters. I'm just curious how you're seeing the pace of these larger transformational engagements?
KC McClure: Yes, thanks. We were really pleased with our bookings this quarter. As I mentioned, they did grow 25%, and as you just pointed out, and I mentioned as well, we did have a stronger Q1 than we had in the last two years. If you peel that back it's really because the demand, again, which was very broad-based. It was really also driven by cloud, which we've talked a lot about Industry X security. So they're also aligned to our strategic priorities. If you look at it, what drove the strength in bookings, again, broad base, when you look at it by type of work. We have particular strengths in outsourcing, that really was up quite a bit with very strong book-to-bill. But, within the 16 clients that we booked over $100 million, they were represented, what I liked about that is by outsourcing as well as consulting type work, it was a nice mix, all five of our industry groups were in there too. So again, it points to very broad-based. And if you look at the services, again, no surprise based on cloud, security and Industry X tech services, very strong. And I mentioned, I just want to highlight again, that we are pleased with our progress in strategy and consulting, they had a 1.1 book-to-build in the quarter. So, overall, we felt really pleased. And as it relates to kind of what we see ahead, we feel very good about our pipeline. And if you're taking on the question about conversion or revenue yield in bigger deals, we did see that our bookings were strong across all parts of our sales, large all the way through, but particularly to the smaller deals, and they do yield more revenue in the current quarter. So that's also true. And then as you see -- when you look really at our duration, it's not that the duration of the bookings in themselves have changed, it's really more of the services that are in the mix. So, as we have more strategy and consulting bookings coming online, they obviously tend to be of a shorter duration. So nothing's really changed in the duration of each of our individual services. It's really more of the mix of the bookings within each quarter.
Julie Sweet: Yes. And so next quarter, we expect a very nice, very strong quarter in bookings.
Bryan Bergin: Okay. And then just over the last several years, you've had special businesses here that competitors have not that have enabled you to grow faster than the market. I'm thinking about operations and interactive specifically, as critical growth engines. From here, do you anticipate a rotation of the growth engine? So is Cloud First and Industry X, are those the new engines that you expect to drive above market? I'm just curious, how you consider those now relative to competitors that are also heavily investing in those areas. And doing so earlier today than they did around interactive before?
KC McClure: Sure, great question. So let me just start with, we have been investing in cloud for a decade, which is a very hard to replicate. And so we start with a $12 billion business that is growing strong double digits. So we would expect to continue to take market share there. And in this environments, where you have a rapid acceleration, and you're moving mission critical workloads, we would expect to continue to differentiate, because of our decades of experience and our relationships with the world's leading technology ecosystem players. So cloud will continue to be a big trend. Think about Industry X, and we've talked about this now for some time, it's kind of the next Accenture Interactive. And as you know, we've been investing in Industry X for some time. The COVID, what we're seeing the early signs of is that like in other areas, Industry X is we think going to accelerate over the next couple of years, because that was still a newer part of the enterprise that was being digitized the manufacturing and operations space. But as we now need to have like, a lot of health concerns about can you do manufacturing in a more contactless way, the supply chains have been disrupted. And so we have said, for some time Industry X is going to be the next growth engine. And the early signs are is that it's likely to be accelerating as well. So we'll see how that continues to play out. And remember, Accenture Interactive is an ongoing growth engine. I mean, we have three big platforms. You have the move to the cloud, which then has the data and the business value innovation on top. So it's not just moving there, it's everything that comes. And so that is an early innings, 20% into the cloud, but it's not just about the move, it's our unique ability to create business value to access the data and you're seeing that in the examples of what we're doing. This depends on where you are on that journey. So that is an ongoing platform for waves and waves of instant growth. The second being everything we do around intelligent operations, our operations business, our ability to move to modern digital platforms like what we talked about in IPS today. So that, again, provides we're early innings in the digitization of operations. And then Accenture Interactive, the business of experience that's an ongoing business in terms of that will always have to continue to evolve. And so, we see that the impact of the COVID crisis, we're starting to move out of that and building momentum. We continue to expect that to be a growth engine. And once again, this is where you can't make up for quickly the scale that we've achieved, because we've been investing for years and creating these capabilities. And then finally, you have this area of Industry X, and not to mention security and data, which will all continue to be of growing engines for us.
Bryan Bergin: Thank you.
Operator: Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead.
Bryan Keane: Good morning, guys, and congrats on the solid results. I wanted to ask on Interactive, just trying to understand the trajectory there. What did it kind of do in the fourth quarter? Did it even turn negative growth? And then now it's at low single, so does it kind of move up from here? I know there's been a lot of questions before on Interactive, given would that business be weaker during kind of a slowdown and it looks like it's hanging in there. So just curious on the trajectory where it was last quarter and kind of what you expect it to do throughout the year?
KC McClure: Yes, so in each two so kind of a whole six months, it was a low single digit decline, and now we're in a low positive growth rate. And it's building momentum. So, for example, we're helping a big European bank with their digital sales, new things. So everyone's now starting to kind of reconnect with new experiences.
Bryan Keane: Got it. And then just on the other strategic priority on security, low double digit growth, is that about the right growth rate for that, too? Or does that also accelerate as we get into the back-half when we see the pickup in the growth rates?
KC McClure: Look, I think on security, we're super pleased with that about double digit growth. So, whether it's going to be low or strong, it'll probably ebb and flow. But the consistency of that double digit growth in security has been impressive to-date, and we continue to see that to be the trajectory. Thanks.
Angie Park: Great. Operator, we have time for one more question, and then Julie will wrap up the call.
Operator: Okay, that question comes from the line of James Faucette from Morgan Stanley. Please go ahead.
James Faucette: Thank you very much. I wanted to ask, you mentioned that you have some targets for M&A this year. From a spend perspective, can you talk a little bit about what you're seeing from a valuation perspective and how we should expect those to contribute to growth in the coming fiscal year or during the current fiscal year and beyond? And what kind of areas you're targeting more specifically?
KC McClure: Yes, thanks. So in terms of our D&A, we expect to spend at least $1.7 billion and there's no change to what we started out at the beginning of the year, the 2% expectation of additional revenue growth for this year. And it's aligned to really a lot of our all of our strategic priorities that we went through.
James Faucette: And then thinking about that and I realized look that's consistent with what you've said before. But I'm just wondering how we should project that then into the future? Is this kind of the right level of acquisitions for Accenture? Or should we expect that to grow? Or do you think we're in a peak period? Just trying to think about that part of capital allocation. Thanks.
KC McClure: Yes, sure. So we've always aimed around 20%, 25% of our operating cash flow in our capital allocation program to be for D&A. But we've always had the ability and we continue to have the ability to do more should any opportunity arise. So there's really no change to how we view D&A of our capital allocation. Thanks.
James Faucette: Thanks.
Julie Sweet: Great. So thank you, everyone, for joining us on today's call. We're very pleased with our strong start in fiscal '21. Thank you again to our incredible people across the globe. And thank you to our shareholders for your continued trust. Best wishes to all for a safe, healthy and joyful holiday season.
Operator: Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to the Accenture's First Quarter Fiscal 2021 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instruction will be given at that time. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Ms. Angie Park. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, operator, and thanks, everyone, for joining us today on our first quarter fiscal 2021 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the second quarter and full fiscal year 2021. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking, and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed on this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Today, we are very pleased to announce strong financial results for our first quarter. I will begin by thanking our 514,000 people for their hard work and dedication to delivering value for our clients, which is what these results represent. Last quarter, I shared that as we began our fiscal year 2021, we were turning a page, no longer navigating a crisis, but facing a new reality with a laser focus on delivering value to our clients at this time of great need and on returning to pre-COVID growth rates by the second-half of our fiscal year. I also shared how we began fiscal year 2021 stronger than pre-crisis. Our results in Q1 made clear how we have strengthened our market position, as well as our ability to pivot our business with agility. Not only have we delivered a strong quarter, but we took exciting new actions to continue to strengthen our market position for FY 2021 and the future. Let's start with our financial results. We delivered revenue growth of 2% in local currency, well ahead of our guidance with broad-based improvement across the globe. We continue to extend our leadership position with our growth estimated over the trailing four quarters to be more than four times the market, which refers to our basket of publicly traded companies. We delivered exceptionally strong new bookings of $12.9 billion, a 25% increase over Q1 last year, including 16 clients with over $100 million in bookings. We continued to invest substantially in our business, including closing 10 acquisitions this quarter in strategic areas, such as Cloud, Intelligent Operations and Industry X. And as KC will walk through, we delivered strong profitability and returned substantial cash to shareholders. Now, let me highlight the actions we've taken in Q1 to better serve our clients, attract the best talent and extend our leadership as a responsible business and trusted partner. We created Accenture Cloud First with the planned $3 billion three-year investment to help clients in what has become a once in a digital era replatforming of global business in the cloud. We launched our new purpose, our growth strategy to deliver 360-degree value to our clients and our largest and most significant new brand campaign in a decade. In our annual cycle in December, we promoted 605 Managing Directors with a record 39% women, and I appointed 663 Senior Managing Directors, including a record 29% women. I'm excited to announce today that we met our previous goal of 25% women Managing Directors globally by the end of 2020, and have raised the bar again, setting a new goal of 30% by the end of 2025. With 45% women overall, we are on track to meet our goal of 50-50 gender equality by 2025. We set external goals in the U.S., UK and South Africa to achieve greater race and ethnicity representation overall, and among Managing Directors in these countries by 2025. We remain the only major professional services company in our industry around the world, public or private to set these types of external goals and to have our level of transparency. We believe our diversity and commitment to inclusion and equality have been and will continue to be critical to our success and a differentiator into attracting the best talent. And building on our long-standing and well-recognized commitment to the environment, we announced industry-leading goals for 2025 to achieve net zero emissions, move to zero waste and plan for water risk. As you can see, we have been busy moving forward in our new reality. KC, over to you."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie. Happy holidays to all of you, and thanks for taking the time to join us on today's call. We were very pleased with our overall results in the first quarter, which exceeded our expectations and represent a positive first step to achieving our full-year objectives. The focused execution of our strategy continues to extend our leadership position in the marketplace, as we deliver significant value to our clients and our shareholders in an uncertain and volatile environment. So let me begin by summarizing a few of the highlights of the quarter. Revenues grew 2% in local currency and continue to include a reduction of approximately 2 percentage points from a decline in revenues from reimbursable travel costs. Q1 revenues were more than $200 million above our guided range, driven by broad-based over-delivery across markets, services and industries. We also continue to extend our leadership positions with growth significantly above the market. The diversity of our business continues to serve us well, and the industry trends remain consistent with the last few quarters. Approximately 50% of our revenues came from seven industries that were less impacted by the pandemic, and in aggregate continue to grow high single digits, with continued double-digit growth in public service, software platforms and life sciences. At the same time, we saw continued pressure but at a more moderate level from clients in highly impacted industries, which include: travel, energy, high-tech, including aerospace and defence, retail and industrial. While performance varied, this group represents over 20% of our revenues and declined low double digits. Our operating margin was 16.1% for the quarter, an increase of 50 basis points. We delivered expansion while making significant investments in our business and our people to extend our market leadership. We continue to benefit from lower spend on travel and events. And we delivered very strong EPS of $2.17, up 8% over fiscal 2020, after adjusting both years for gains on an investment. And finally, we delivered significant free cash flow of $1.5 billion and returned $1.3 billion to shareholders through repurchases and dividends. We also invested approximately $500 million in acquisitions and we expect to invest at least $1.7 billion in acquisitions this fiscal year. With those high level comments, let me turn to some of the details, starting with new bookings. New bookings were $12.9 billion for the quarter, reflecting an overall book-to-bill of 1.1. Consulting bookings were $6.6 billion with a book-to-bill of 1.0. Outsourcing bookings were $6.3 billion with a book-to-bill of 1.2. We were very pleased with our bookings this quarter, which grew 25%, driven by both technology services and operations. We were also pleased with the strength of our bookings in strategy and consulting, with a book-to-bill of 1.1. Looking forward, we continue to feel very good about our pipeline. Turning now to revenues. Revenues for the quarter were $11.8 billion, a 4% increase in U.S. dollars and 2% in local currency, including a reduction of approximately 2% from a decline in revenues from reimbursable travel costs. Consulting revenues for the quarter were $6.3 billion, a decline of 1% in U.S. dollars and a decline of 2% in local currency, including a reduction of approximately 3% from a decline in revenues from reimbursable travel costs. Outsourcing revenues were $5.4 billion, up 9% in U.S. dollars and 8% in local currency. Taking a closer look at our service dimensions, operations grew double digits, technology services grew mid-single digits, and strategy and consulting services declined low double digit. Turning to our geographic markets. The industry dynamics that I mentioned earlier continue to play out in a similar manner across all three markets. In North America, revenue growth was 4% in local currency. In Europe, revenue declined 1% in local currency. We saw mid-single digit growth in Italy, with UK improving to flat. In growth markets, we delivered 3% revenue growth in local currency, led by high single digit growth in both Japan and Australia. Moving down the income statement. Gross margin for the quarter was 33.1%, compared with 32.1% for the same period last year. Sales and marketing expense for the quarter was 10.4%, compared with 10.5% for the first quarter last year. General and administrative expense was 6.6%, compared to 6.1% for the same quarter last year. Operating income was $1.9 billion for the first quarter, reflecting a 16.1% operating margin, up 50 basis points compared with Q1 last year. As a reminder, last year in fiscal '20, we’ve recognized an investment gain which impacted our tax rates and increased EPS by $0.08 in the quarter. This year in Q1, we again recognized investment gain which impacted our tax rate and increased EPS by $0.15. The following comparisons exclude these impacts and reflect adjusted results. Our adjusted effective tax rate for the quarter was 23.7%, compared with an adjusted effective tax rate of 23.9% for the first quarter last year. Adjusted diluted earnings per share were $2.17, compared with adjusted diluted earnings per share of $2.01 for the first quarter of last year. Days service outstanding work 38 days compared to 35 days last quarter and 43 days in Q1 of last year. Free cash flow for the quarter was $1.5 billion, resulting from cash generated by operating activities of $1.6 billion. Net of property and equipment additions of $93 million. Our cash balance at November 30th was $8.6 billion, compared with $8.4 billion in August 31st. With regards to our ongoing objective to return cash to shareholders. In the first quarter, we’ve repurchased or redeemed 3.3 million shares for $769 million at an average price of $229.98 per share. At November 30th, we had approximately 5.8 billion of share repurchase authority remaining. Also in November, we paid a quarterly cash dividend of $0.88 per share for a total of $558 million. This represents a 10% increase over last year. And our board of directors declared a quarterly cash dividend of $0.88 per share to be paid on February 12th, a 10% increase over the last year. So, in summary, we were very pleased with our Q1 results, and we're off to a good start in fiscal '21. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. Let me start with the environment. We saw in Q1 a broad base increase in demand that is faster than we anticipated 90 days ago. This means that as our clients have the confidence and ability to spend, they are turning to Accenture. But the uncertainty and volatility of the biggest health, economic and social crisis in our lifetimes remains, particularly as the world continues to face a deepening health impact pre-widespread vaccination. From an overall demand perspective, the trends that we discussed last quarter are continuing. Companies need to accelerate their digital transformation across their enterprises and move to the cloud, address cost pressures, build resilience and security, adjust their operations and customer engagement to a remote everything environment and changing expectations and find new sources of growth. What is becoming even more clear however, is that we are in an era of compressed transformation, in which the winners by industry will be those who are earliest to replatform their businesses in the cloud, and have the digital core and new ways of working that allows them to continuously improve their operations and find new sources of growth, which for most leading companies is requiring them to simultaneously transform multiple parts of their enterprises and their talent. For the pre-COVID digital leaders, they are racing to widen the gap, and for the digital laggards, they are racing to leapfrog. We are uniquely positioned to help the leaders and the laggards because of the depth and breadth of our capabilities. We bring the trust, experience, speed and scale that are essential to achieve compressed transformation. Now let's bring some of these demand trends to life through the lens of our Q1, and look at our own broad-based improvement. First, replatforming to the cloud. In fiscal year '20, our cloud revenue was approximately $12 billion with low double digit growth, which accelerated in Q1 with significantly higher double digit growth, driven by Accenture Cloud First. In fact, across low to highly impacted industries, and all geographic markets, we saw strong double digit growth, the race to replatform to the cloud and create new business value is clear across all our services. Our clients need our deep technical and engineering skills, and our unmatched set of relationships with the world's leading technology ecosystem companies, which are critical partners to us and to our clients. We were pleased that in Q1 industry analysts recognized us as the leading systems integrator for each of AWS, Azure and Google Cloud Platform, as well as the leading multi cloud managed services provider. Fundamental to accelerating our clients’ replatforming in the cloud, however, are our leading strategy and consulting capabilities, which give us the industry and functional insights to move rapidly and achieve early business value. For example, we are working with Takeda, a global values-based R&D-driven biopharmaceutical leader to modernize their technology platforms, including moving 80% of applications to the cloud, accelerate data services and establish an internal engine for innovation, while equipping employees with new skills and ways of working and reducing their carbon footprint. The business impact is illustrated by the plans for Takeda's plasma derived therapies business unit, which is harnessing the power of the cloud and these data services to create state-of-the-art digitally connected donation centers and modernize the donor experience, optimizing the plasma collection process, and contributing to the goal of increasing plasma collection and manufacturing by at least 65% by 2024. We are working with the Norwegian Health Net [ph] to create a health analytics platform, which is using the power of the cloud to analyze and interpret data, and ultimately improve patient outcomes, by reducing research turnaround times and access to data from months to a matter of minutes or days. And we are working with Generali, a major player in the global insurance industry to help replatform approximately 70% of its IT footprint to the cloud, to improve service quality, innovate and build a set of new cloud ready core insurance applications for emerging markets, while achieving a sustainable reduction in its total cost of ownership, and helping to upscale its workforce. In Intelligent Platform Services, which returned to low single digit growth this quarter, we saw building momentum fueled by our clients rotating to Software-as-a-Service, as well as new digital platforms. In a quick trip around the world, we see this compressed transformation playing out from the rapid transformation of the finance functions of Nickel Bank, a subsidiary of BNP Paribas, and a fast growing Neo-bank in France, with the implementation of leading software-as-a-service and ERP solutions, to the cloud based marketing transformation of a global bank with a large U.S. footprint with a SaaS implementation across its worldwide private banking network, to one of the largest implementations in the chemicals industry of a modern digital ERP system, hosted on the cloud for Indorama Ventures, a world class chemicals company with global operations headquartered in Asia, that will provide a single source of information globally, and cloud-based solutions to enhance its operations, employee development capabilities, and customer and supplier experiences. So that's the cloud. Now let's turn to digitizing operations across the Enterprise. In operations, which returned to double digit growth this quarter, we are helping our clients transform by digitizing their operations with our SynOps platform, increasing agility and reducing cost. Operations as-a-service that enables us to continue diversify our value to clients by expanding across functions and industries, we have an unmatched global footprint ability to invest an innovation engine powered by the broader Accenture. We were excited to welcome to the Accenture family this quarter N3, an Atlanta-based B2B sales firm, with more than 2,000 employees that combined specialized talent in AI and machine learning to enable smarter, more efficient sales interactions and drive sales growth in virtual environments. The power of Accenture's breadth and depth comes together at Halliburton, a leading provider of products and services to the energy industry, and a leader in driving true enterprise wide transformation enabled by digital and technology. Last quarter, we shared how we are helping Halliburton move to cloud-based digital platforms. This quarter, we announced that we are teaming with Halliburton to accelerate its digital supply chain transformation, and support digitization within Halliburton's manufacturing functions to improve service levels and business outcomes. We will leverage SynOps which we already use as part of Halliburton's digital transformation of its finance and accounting function, and our strategy and consulting expertise. In Industry X, we are digitizing manufacturing and operations and creating intelligent products and platforms. In fiscal year '20, Industry X was approximately $3 billion and grew low double digits, which is continued in Q1. We see COVID deepening the need to transform manufacturing in a contactless world with disrupted supply chains and greater cost pressures. One of our latest wins with that CNH Industrial, the manufacturer of capital goods across the agriculture, construction equipment and commercial vehicle sectors, where we are improving the global operating model to develop smart connected products and services that will grow revenue, while building a digitally enabled workforce and enhancing security and sustainability. Finally, let's look at the trends around new ways of engaging customers, patients, citizens and employees. In interactive, which is all about the business of experience, the crisis had a significant impact due to severe disruptions in industries like travel and retail, and due to our clients being focused on shoring up their experience of their businesses, rather than the next generation of experiences. This quarter we saw building momentum with a return to low single digit growth from a low single digit decline in H2 of FY'20 as clients focus on creating new experiences in the new environment. For example, Accenture Federal Services is working with the Federal Retirement Thrift Investment Board to reimagine retirement services for the digital age and improve the customer experience for a retirement savings plan serving 6.1 million civilian employees and members of the armed services with over $644 billion in assets. I want to take a moment to talk about another bold move we made this quarter. In October, we simultaneously launched a new purpose, our growth strategy to deliver 360-degree value to our clients, and a new brand campaign created by our own Droga5 team that joined our family in 2019. Our new purpose is to, deliver on the promise of technology and human ingenuity. Our purpose is what we are uniquely able to do and our growth strategy is our action plan to bring this purpose to life. Our strategy to deliver 360-degree value to our clients is a direct response to the rising demand we see for talent transformation, and help achieving responsible business goals. We define 360-degree value as delivering the financial business case experiences and unique value a client maybe seeking, and striving where possible to partner with our clients to achieve greater progress on inclusion and diversity, reskill their employees and achieve their sustainability goals. At the heart of this strategy is embedding responsible business by design into our work for clients in addition to our own operations. Our new brand, Let There Be Change, captures our purpose and the depth and breadth of Accenture's expertise. Together, our purpose, strategy and brand better reflect Accenture's unique role in helping companies reimagine and rebuild differently for the benefit of all. Over to you KC, for a look ahead."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Before I get into our business outlook, as I did last quarter, I would like to remind you that given the coronavirus pandemic, there are a number of factors that we may not be able to accurately predict, including the duration and magnitude of the impact, the pace of the recovery, as well as those described in our most recent quarterly filings. Now, with that said, let me turn to our business outlook. For the second quarter of fiscal '21, we expect revenues to be in the range of $11.55 billion to $11.95 billion. This assumes the impact of FX will be about positive 3% compared to the second quarter of fiscal '20, and reflects an estimated 1% to 4% in local currency and includes a reduction of approximately 2 percentage points from a decline in revenue from reimbursable travel costs. The entire range for Q2 reflects the continued build back of our business over Q1. For the full fiscal year '21, based on how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately positive 3% compared to fiscal '20. For the full fiscal '21, we now expect our revenues to be in the range of 4% to 6% growth in local currency over fiscal '20, including approximately negative 1% from a decline in revenues from reimbursable travel, based on a 2% reduction in the first-half of the year and no material impact in the second-half of the year. For operating margin, we continue to expect fiscal '21 to be 14.8% to 15.0%, a 10 to 30 basis point expansion over fiscal '20 results. We continue to expect our annual adjusted effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.9% in fiscal '20. For earnings per share, we now expect our full year diluted EPS for fiscal '21 to be in the range of $8.17 to $8.40. We now expect adjusted full year diluted EPS to be in the range of $8.02 to $8.25 or 8% to 11% growth over adjusted fiscal '20 results. For the full fiscal '21, we now expect operating cash flow to be in the range of $6.65 billion to $7.15 billion. Property and equipment additions to be approximately $650 million, and free cash flow to be in the range of $6 billion to $6.5 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $5.3 billion through dividends and share repurchases, as we remain committed to returning a substantial portion of cash to our shareholders. With that, let's open it up so we can take your questions. Angie?"
},
{
"speaker": "Angie Park",
"text": "Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Your first question comes from the line of Lisa Ellis from MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Good morning, guys. Great to hear all of you and happy holidays. I would just ask my two right up-front. Looking at the utilization number of 93% in the quarter, I peeked back and that is the highest number you've reported in more than 10 years. So two questions, one more strategic and one more numbers related on that. I guess, first, can utilization be structurally higher now with the shift to remote work and so we should expect these kinds of levels going forward? Or are you kind of getting to the point that you're labor constrained and you're going to be ramping hiring and that number will come down a bit? That's the more, I guess, strategic question. And then maybe for KC, was higher utilization the primary driver of the 100 basis point increase in gross margins? Or is that also being affected by the reduction in travel costs? Thank you."
},
{
"speaker": "KC McClure",
"text": "Okay. Hi, Lisa. Thanks for your question. Happy holidays. So maybe I'll start with your second question first. Just on gross margin. So we did have expansion in gross margin and there were a few drivers to that. The first is contract profitability was up this quarter. And in contract profitability, we did benefit from lower travel, so that does help our contract profitability overall. So that is the first thing, I would say, benefited our gross margin. And you do see that the fact that we have higher utilization also does help our gross margin as well. So both of those points were included in drivers of our gross margin. And when you look at utilization, we did have a very high productivity this quarter. It did click up in parts and that was pretty broad-based and that was also driven by our over-delivery of Q1 revenue. We did continue to recruit throughout the summer, and obviously into this quarter, you can see that our headcount is up sequentially. And so we don't see any issues meeting demand and attracting talent. And to your point on, is there a structural change from working remotely, the answer is really no. We were just able to get more productivity out of all of our groups this quarter. And looking forward, we do think that's going to kind of ease back into kind of a more normal range, which still is very high productivity, but not continuing at these levels."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tien-Tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Hey, thanks. Good morning. Good results here. I want to just ask about the outlook here and what's changed in the last 90 days. I know you received – looking at revenue while you're up $200 million over your guidance, you overcame low-double-digit declines in strategy and in consulting. From a macro standpoint, we got what vaccines have been approved and cases are up, but your bookings are strong again. So I'm just trying to think you seem really well set up for the second-half to be quite strong, even if strategy and consulting comes back slowly. So do you feel more confident in the outlook for strategy and consulting? Or is the composition of work just changing versus what you thought maybe 90 days ago? Any thoughts on that?"
},
{
"speaker": "KC McClure",
"text": "Yes. So let me just talk a little bit about what drove our overperformance in Q1, and how that impacts our view of Q2 and H2, Tien-Tsin. So, when you look at Q1, we were obviously very pleased with our performance, and we have rather significant over-delivery against our expectations. And that was really driven by broad-based over-delivery, in all three of our markets, in all of our industry groups and all of our services all did a bit better. And as I mentioned in our script, when you take a look at the industries and the higher impacted industries, which represent over 20% of our revenues, they did improve from Q4 of a decline of mid-teens to low double digits. And as Julie talked quite a bit about the fact that that was really driven broad-based by our strong demand in cloud. And so that is an area that performed better than we expected. But if you also look at the lower impacted industries, which are 50% of our revenue, they continue to grow high single digits like Q4, but they actually did improve also within that sense. And so let me maybe connect this a little bit to how we did our sales this quarter. So we had a very strong start to the year, as you could see in our sales of $12.9 billion, which is about $2.5 billion more than what we've done in the last two quarter ones, last two fiscal years. And when you peel that back, Tien-Tsin, you can see that it was really driven by all categories of our sales side, so the large, which Julie highlighted that we have 16 clients over $100 million in sales, but all the way through and significantly driven by an improvement in our smaller deals, which came in better than we expected. And that can help us with revenue yield in the current quarter. So when I take a look at that, that's what happened with Q1. And then when you look at that compared to 90 days ago, obviously, that's better. And when you look at -- then what for Q2, we obviously have a better outlook for Q2 than we did 90 days ago with our 1% to 4% growth range. Really important to note that all of points in that range are an improvement over Q1. So we continue to build back our business from the lows of H2. And we would be really pleased with anywhere that we land in that range. Now, when you look at the second-half of the year, we haven't changed our views on the second-half of the year from 90 days ago. And just to be very specific, we still see that we would have high single-digit to low double-digit growth in the back-half of the year. And just as a reminder, the four factors that we talked about last quarter that we're going to drive that remain the same. And just very briefly, they are first, that we continue to expect an improvement in the macroeconomic environment. We don't see another -- we're not anticipating another macroeconomic shock that's built into our guidance. We expect to see more of a benefit from the significant transformational deals that we sold last year. And at the same time, to your question, we do expect strategy and consulting to reconnect with growth. And our performance in Q1 and our outlook for Q2 do encourage us even more on that statement this quarter. And the fourth thing is that we have the benefit of an easier compare that obviously remains the same. And we are also still going to anniversary the reimbursable revenue headwind, that's 2% in the first-half of the year and that won't be a headwind in the back-half of the year. So, of course, we're still meeting with our clients, you can see that by the fact that we were able to book $27 billion in the last two quarters. But we are not planning on having significant increases in revenue related to travel in the back-half of the year. So hopefully, that gives you a sense of how we see the business compared to what is stay the same now from 90 days ago, which is our outlook in H2. But obviously, we're very pleased with the improvements and performance in Q1 and outlook for Q2 than we had 90 days ago."
},
{
"speaker": "Julie Sweet",
"text": "And, Tien-Tsin, let me just kind of give you a little more color from the clients’ perspective, because -- and this is what I talked a little bit about in my script, right?. If you just sort of remember, pre-COVID, we said we were in the early innings of transformation with the beginning of the decade, it’d be enterprise-wide, right? COVID hits, technology becomes the lifeline. And you really see companies understanding kind of the two truths of our world, right? There is - every business is now a technology business and exponential technology change is going to continue, right? And now it's about the speed. And this is why we're seeing what I'm calling compressed transformation, where you continue to see companies say we are going to take on this transformation more broadly. So look at the example of Takeda. They're both moving to the cloud, improving their data and making sure that they're getting near-term business value. You take a Halliburton, cloud, finance, supply chain. So there's this speed of change and we see that in the confidence. We're nine months in now. The first part of the crisis, people were getting their footing, getting back up and running. And it's interesting, we did some research in July across 10 markets and nearly 80% of the executives that we surveyed said that they were planning on investing in digital transformation. And that was up from 50% in May. And we're continuing just to see this recognition of the need to get there faster. And then what's important to understand is that, all of this is happening, though, in the context of the cost pressures, the changing expectations. And this is where a decade and in some cases multiple decades of investment from Accenture has put us in a very unique position, because no other company in our industry can simultaneously do operations and that help a company reduce their supply chain in their finance function and reduce costs and digitize. At the same time, we're helping them migrate to the cloud and give them that view, which because all of this has interdependencies. You want to get end-to-end process change. And we have literally been building these capabilities for years and years. And this is where the scale and the breadth matter."
},
{
"speaker": "Tien-Tsin Huang",
"text": "It sounds very clear. I appreciate for the complete answer, guys, here, and it seems like the outlook is set up pretty well here. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Matthew O'Neill from Goldman Sachs. Please go ahead."
},
{
"speaker": "Matthew O'Neill",
"text": "Yes, thank you so much for taking my question. I was hoping we could drill down a little bit deeper into Accenture Cloud First, I think it's just on 90 days since the formal announcement. Curious, understanding a lot of sort of anecdotes in the prepared remarks around Takeda, Halliburton, et cetera. But where you're seeing the most immediate need to deploy the $3 billion that you identified for an investment, earliest and first? And sort of mirroring that where the greatest demand is coming from the client side, understanding, there's kind of a broad-based, I think COVID-driven catalyst to potentially get off the fence and move one's business to become fully digital cloud, et cetera, et cetera?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. So, Matthew, thanks for the question. So maybe just take, let's just first start why our companies having to accelerate faster to the cloud. And there's a few clear reasons. So first of all, there's a cost pressure, because when they move to the cloud, there's immediate savings just in the migration and there's obviously to get that kind of savings. Second, the cloud is really important for resilience and security. And in this current environment in particular, you can see why that matters. The crisis really exposed the vulnerabilities of a lot of the on premise IT estates. And then that has been compounded, of course, by the expansion of the threat surface through more remote working. And so the resilience and security of the cloud is also an immediate driver as to the need to do that. What I would say is probably most important and really the rapid acceleration is the need for the power of the cloud to enable the data driven transformations. And so you saw that in the example that we gave, with Takeda, where they're changing the customer experience, which requires near real time access to data in order to personalize and to be able to actually do that. And what I think is very unique, I know is very unique about Accenture is that this is where our strategy and consulting capabilities are so important, because the reason to go to the cloud is not simply cost and resilience and security, it's about the business value. And here's how we're helping clients get early business value. And you have to deeply understand the industry, the patients, the customer, and also what data is valuable among all of the data and which workloads go first. And so, it really is driven by all of these things at once, which is why our capabilities around changed management, around talent transformation and leadership are important, because, by the way, everybody wants to go higher at cloud talent in this thing. And so, it's not going to be enough available to our ability to reskill, which you saw in each of these examples that we gave in the script like Generali and Takeda is also a critical. So that's sort of the big picture. Now, when you think about where we're going to do investment, we talked about we did 10 acquisitions this quarter, four of them were in cloud. They were in each of our three markets and they were about building scale for the most part in more markets. And so, as we think about the acquisition strategy which will be a big component of the $3 billion, it's about building scale and markets around the world as well as acquiring niche capabilities. The second big area of that $3 billion investment though, is creating more and more of the assets that will allow our clients to move quickly. Everything from the myNav asset that we talked about, that does a fast diagnostic with benchmarks to help clients figure out what kind of a strategy to have and how to get value to the migrating navigate advisor that helps you figure out the reduction in carbon, to the industry blueprints that we're creating, and the solutions that are repeatable like in digital manufacturing on the cloud. So this will be an important part of our continued investment. And again, it really comes right back to -- no other company has both these deep engineering and infrastructure skills, the deep relationships. And then the strategy and consulting capabilities to actually move industries to the cloud to create business value solutions. And you don't build that overnight. We have been building our strategy and consulting business for decades. We have been an early adopter for cloud for decades. And let's not forget, we're our own best credential when it comes to all of these capabilities."
},
{
"speaker": "Matthew O'Neill",
"text": "That's really helpful and interesting. I guess, as a quick follow-up, I was just curious, you mentioned in the script Droga5 acquisition and more broadly Accenture Interactive. And wondering if there's significant sort of cross sell and upsell opportunity as you integrate more assets like Droga5 and present a more comprehensive suite to both the existing and new clients for things that they might not have maybe originally known or thought of Accenture for first and foremost. Is that a part of the equation here?"
},
{
"speaker": "Julie Sweet",
"text": "Absolutely. And when you think about Accenture Interactive, like we are doing amazing work like our own brand and purpose work for ourselves via again our best credential. But what these capabilities bring is we're actually embedding them in all of our services. Our clients come to us for outcomes and experience is a really important part of it. Again, when you think about the work we are doing with Prudential that we talked about last quarter, that was fundamentally a different way of engaging with the customer. Takeda, a different way of engaging with the donor, the researchers in the Norway example about how they're going to engage. We are embedding this experience, and how to do that in all of our work, and so that's why I often talk about, I know you all certainly look at our services, separately our four services, our clients look at our outcomes. And what differentiates us is our ability to embed the business of experience across Accenture, as well as going to market of course, like a Droga5 that continues to do amazing, pure work in terms of brand for example."
},
{
"speaker": "Matthew O'Neill",
"text": "Thanks so much. Really helpful. Thinking about that in the context of sort of experience and outcome. I'll jump back in the queue."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Bergin from Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, good morning. Thank you. I wanted to ask on bookings. Was there anything pulled forward in bookings relative to your prior expectation? Or do you still anticipate a building cadence for the year? And can you comment on bookings conversion pace and considering the outperformance you've had the last two quarters. I'm just curious how you're seeing the pace of these larger transformational engagements?"
},
{
"speaker": "KC McClure",
"text": "Yes, thanks. We were really pleased with our bookings this quarter. As I mentioned, they did grow 25%, and as you just pointed out, and I mentioned as well, we did have a stronger Q1 than we had in the last two years. If you peel that back it's really because the demand, again, which was very broad-based. It was really also driven by cloud, which we've talked a lot about Industry X security. So they're also aligned to our strategic priorities. If you look at it, what drove the strength in bookings, again, broad base, when you look at it by type of work. We have particular strengths in outsourcing, that really was up quite a bit with very strong book-to-bill. But, within the 16 clients that we booked over $100 million, they were represented, what I liked about that is by outsourcing as well as consulting type work, it was a nice mix, all five of our industry groups were in there too. So again, it points to very broad-based. And if you look at the services, again, no surprise based on cloud, security and Industry X tech services, very strong. And I mentioned, I just want to highlight again, that we are pleased with our progress in strategy and consulting, they had a 1.1 book-to-build in the quarter. So, overall, we felt really pleased. And as it relates to kind of what we see ahead, we feel very good about our pipeline. And if you're taking on the question about conversion or revenue yield in bigger deals, we did see that our bookings were strong across all parts of our sales, large all the way through, but particularly to the smaller deals, and they do yield more revenue in the current quarter. So that's also true. And then as you see -- when you look really at our duration, it's not that the duration of the bookings in themselves have changed, it's really more of the services that are in the mix. So, as we have more strategy and consulting bookings coming online, they obviously tend to be of a shorter duration. So nothing's really changed in the duration of each of our individual services. It's really more of the mix of the bookings within each quarter."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And so next quarter, we expect a very nice, very strong quarter in bookings."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And then just over the last several years, you've had special businesses here that competitors have not that have enabled you to grow faster than the market. I'm thinking about operations and interactive specifically, as critical growth engines. From here, do you anticipate a rotation of the growth engine? So is Cloud First and Industry X, are those the new engines that you expect to drive above market? I'm just curious, how you consider those now relative to competitors that are also heavily investing in those areas. And doing so earlier today than they did around interactive before?"
},
{
"speaker": "KC McClure",
"text": "Sure, great question. So let me just start with, we have been investing in cloud for a decade, which is a very hard to replicate. And so we start with a $12 billion business that is growing strong double digits. So we would expect to continue to take market share there. And in this environments, where you have a rapid acceleration, and you're moving mission critical workloads, we would expect to continue to differentiate, because of our decades of experience and our relationships with the world's leading technology ecosystem players. So cloud will continue to be a big trend. Think about Industry X, and we've talked about this now for some time, it's kind of the next Accenture Interactive. And as you know, we've been investing in Industry X for some time. The COVID, what we're seeing the early signs of is that like in other areas, Industry X is we think going to accelerate over the next couple of years, because that was still a newer part of the enterprise that was being digitized the manufacturing and operations space. But as we now need to have like, a lot of health concerns about can you do manufacturing in a more contactless way, the supply chains have been disrupted. And so we have said, for some time Industry X is going to be the next growth engine. And the early signs are is that it's likely to be accelerating as well. So we'll see how that continues to play out. And remember, Accenture Interactive is an ongoing growth engine. I mean, we have three big platforms. You have the move to the cloud, which then has the data and the business value innovation on top. So it's not just moving there, it's everything that comes. And so that is an early innings, 20% into the cloud, but it's not just about the move, it's our unique ability to create business value to access the data and you're seeing that in the examples of what we're doing. This depends on where you are on that journey. So that is an ongoing platform for waves and waves of instant growth. The second being everything we do around intelligent operations, our operations business, our ability to move to modern digital platforms like what we talked about in IPS today. So that, again, provides we're early innings in the digitization of operations. And then Accenture Interactive, the business of experience that's an ongoing business in terms of that will always have to continue to evolve. And so, we see that the impact of the COVID crisis, we're starting to move out of that and building momentum. We continue to expect that to be a growth engine. And once again, this is where you can't make up for quickly the scale that we've achieved, because we've been investing for years and creating these capabilities. And then finally, you have this area of Industry X, and not to mention security and data, which will all continue to be of growing engines for us."
},
{
"speaker": "Bryan Bergin",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Good morning, guys, and congrats on the solid results. I wanted to ask on Interactive, just trying to understand the trajectory there. What did it kind of do in the fourth quarter? Did it even turn negative growth? And then now it's at low single, so does it kind of move up from here? I know there's been a lot of questions before on Interactive, given would that business be weaker during kind of a slowdown and it looks like it's hanging in there. So just curious on the trajectory where it was last quarter and kind of what you expect it to do throughout the year?"
},
{
"speaker": "KC McClure",
"text": "Yes, so in each two so kind of a whole six months, it was a low single digit decline, and now we're in a low positive growth rate. And it's building momentum. So, for example, we're helping a big European bank with their digital sales, new things. So everyone's now starting to kind of reconnect with new experiences."
},
{
"speaker": "Bryan Keane",
"text": "Got it. And then just on the other strategic priority on security, low double digit growth, is that about the right growth rate for that, too? Or does that also accelerate as we get into the back-half when we see the pickup in the growth rates?"
},
{
"speaker": "KC McClure",
"text": "Look, I think on security, we're super pleased with that about double digit growth. So, whether it's going to be low or strong, it'll probably ebb and flow. But the consistency of that double digit growth in security has been impressive to-date, and we continue to see that to be the trajectory. Thanks."
},
{
"speaker": "Angie Park",
"text": "Great. Operator, we have time for one more question, and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Okay, that question comes from the line of James Faucette from Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Thank you very much. I wanted to ask, you mentioned that you have some targets for M&A this year. From a spend perspective, can you talk a little bit about what you're seeing from a valuation perspective and how we should expect those to contribute to growth in the coming fiscal year or during the current fiscal year and beyond? And what kind of areas you're targeting more specifically?"
},
{
"speaker": "KC McClure",
"text": "Yes, thanks. So in terms of our D&A, we expect to spend at least $1.7 billion and there's no change to what we started out at the beginning of the year, the 2% expectation of additional revenue growth for this year. And it's aligned to really a lot of our all of our strategic priorities that we went through."
},
{
"speaker": "James Faucette",
"text": "And then thinking about that and I realized look that's consistent with what you've said before. But I'm just wondering how we should project that then into the future? Is this kind of the right level of acquisitions for Accenture? Or should we expect that to grow? Or do you think we're in a peak period? Just trying to think about that part of capital allocation. Thanks."
},
{
"speaker": "KC McClure",
"text": "Yes, sure. So we've always aimed around 20%, 25% of our operating cash flow in our capital allocation program to be for D&A. But we've always had the ability and we continue to have the ability to do more should any opportunity arise. So there's really no change to how we view D&A of our capital allocation. Thanks."
},
{
"speaker": "James Faucette",
"text": "Thanks."
},
{
"speaker": "Julie Sweet",
"text": "Great. So thank you, everyone, for joining us on today's call. We're very pleased with our strong start in fiscal '21. Thank you again to our incredible people across the globe. And thank you to our shareholders for your continued trust. Best wishes to all for a safe, healthy and joyful holiday season."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 4 | 2,022 | 2022-09-22 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to Accenture's Fourth Quarter Fiscal 2022 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Managing Director, Head of Investor Relations, Ms. Angie Park. Please go ahead.
Angie Park: Thank you, operator, and thanks, everyone, for joining us today on our fourth quarter and full fiscal 2022 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for both the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the first quarter and full fiscal year 2023. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and effect are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie.
Julie Sweet: Thank you, Angie, and everyone joining us today. And thank you to our 721,000 people around the globe for delivering a truly extraordinary year. We measure our success by both our financial results and the broader 360-degree value we create for all our stakeholders, our clients, people, shareholders, partners and communities. Strong financial results allow us to deliver more 360-degree value. Let me share a few highlights of this extraordinary year. In FY '22, we delivered record bookings of $72 billion. As our clients continue to execute compressed transformations, we had 100 clients with quarterly bookings greater than $100 million compared to $72 million last fiscal year. We delivered revenues of $62 billion, representing a record 26% growth in local currency, adding $11 billion in revenue for the year. We continue to take significant market share growing more than 2x the market. Our financial results reflect our commitment to creating value for our clients every day, which is why they are turning to us as their trusted partner across the enterprise. We now have 267 Diamond clients, our largest client relationships compared to 229 last fiscal year. We expanded operating margin by 10 basis points and had EPS growth of 22% over adjusted FY '21 EPS, demonstrating our ability to grow profitably and at scale. We achieved this profitable growth while continuing to invest significantly in our business and people with $3.4 billion deployed across 38 acquisitions that are well balanced across markets, services and strategic priorities; $1.1 billion invested in R&D assets, platforms and industry solutions, including growing our portfolio of patents and pending patents to more than 8,300; and $1.1 billion invested in the training and development of our people to grow the skills needed to serve our clients. We continue to offer an employee value proposition that includes providing vibrant career paths and opportunities for our people with approximately 157,000 promotions and over 40 million training hours while expanding our workforce by almost 100,000 and achieving 47% women as we continue our progress towards gender parity by 2025. We believe our unwavering commitment to diversity, broadly defined and inclusion is an essential element of our ability to deliver market-leading financial results because our diversity and inclusiveness makes us smarter, more innovative and more attractive to top talent. We achieved over 85% renewable electricity powering our offices and centers around the world on our way to 100% by 2023. We prioritize creating value around the world and the communities where we work and live, both through investments and job creation and through our direct support of meaningful local initiatives, including our apprenticeship programs in the U.S., UK, Switzerland and Latin America and our growing partnership with Youth Business International, which will help an additional estimated 240,000 young entrepreneurs, ages 18 to 35, build skills and success in a digital future on top of the 370,000 young entrepreneurs already supported through this partnership in many different communities throughout the world. This year, we are proud to achieve our highest brand value and rank to date on BrandZ's prestigious Top 100 Most Valuable Global Brands list, increasing 28% to over $82 billion and ranking number 26. Over to you, KC.
KC McClure: Thank you, Julie, and thanks to all of you for joining us on today's call. We were very pleased with our results in the fourth quarter, which completes another outstanding year for Accenture. Once again, our results continue to provide strong validation of our leadership position in the marketplace, the relevance of our services to our clients and our ability to consistently deliver on our shareholder value proposition, including both our financial results and creating 360-degree value for all our stakeholders. So let me begin by summarizing a few highlights from the quarter across our three financial imperatives. Revenue grew 22.4% in local currency, driven by double-digit growth across all markets, services and industries. We once again extended our leadership position with growth estimated to be more than 2x the market, which refers to our basket of publicly traded companies. Operating margin was 14.7%, an increase of 10 basis points for the quarter. We continue to drive margin expansion while making significant investments in our people and our business. We delivered very strong EPS of $2.60, which represents 18% growth compared to EPS last year. And finally, we delivered free cash flow of $3.6 billion, driven by superior DSO management. Now let me turn to some of the details. New bookings were $18.4 billion for the quarter, our second highest ever with a book-to-bill of 1.2. Consulting bookings were $8.4 billion with a book-to-bill of 1. Outsourcing bookings of $9.9 billion were a record with a book-to-bill of 1.4. We were very pleased with our strong bookings this quarter, which reflects 22% growth in U.S. dollars and 31% growth in local currency, including 26 clients with bookings over $100 million in the quarter. Turning now to revenues. Revenues for the quarter were $15.4 billion, a 15% increase in U.S. dollars and 22.4% in local currency. Consolidated revenues for the quarter were $8.3 billion, up 14% in U.S. dollars and 22% in local currency. Outsourcing revenues were $7.1 billion, up 16% in U.S. dollars and 23% in local currency. Taking a closer look at our sales dimensions. Technology services grew very strong double digits, operations grew strong double digits and strategy and consulting grew double digits. Turning to our geographic markets. In North America, revenue growth was 18% in local currency, driven by double-digit growth in public service, software and platforms and consumer goods, retail and travel services. In Europe, revenues grew 26% in local currency, led by double-digit growth in industrial, banking and capital markets and consumer goods, retail and travel services. Looking closer to the countries, Europe was driven by double-digit growth in Germany, the UK, Italy and France. In growth markets, we delivered 26% revenue growth in local currency, driven by double-digit growth in banking and capital markets, consumer goods, retail and travel services and public service. From a country perspective, growth markets was led by double-digit growth in Japan and Australia. Moving down the income statement. Gross margin for the quarter was 32.1% compared with 33.3% for the same period last year. Sales and marketing expense for the quarter was 10.2% compared with 11.3% for the fourth quarter last year. General and administrative expense was 7.1% compared to 7.4% for the same quarter last year. Operating income was $2.3 billion in the fourth quarter, reflecting a 14.7% operating margin, up 10 basis points compared with Q4 last year. Our effective tax rate for the quarter was 24.6% compared with an effective tax rate of 25% for the fourth quarter last year. Diluted earnings per share were $2.60 compared with EPS of $2.20 in the fourth quarter last year. Days service outstanding were 43 days compared to 44 days last quarter and 38 days in the fourth quarter of last year. Free cash flow for the quarter was $3.6 billion, resulting from cash generated by operating activities of $3.8 billion, net of property and equipment additions of $177 million. Our cash balance at August 31 was $7.9 billion compared with $8.2 billion at August 31 last year. With regards to our ongoing objective to return cash to shareholders. In the fourth quarter, we repurchased or redeemed 2.1 million shares for $605 million at an average price of $293.23 per share. Also in August, we paid our fourth quarterly cash dividend of $0.97 per share for a total of $614 million. And our Board of Directors declared a quarterly cash dividend of $1.12 per share to be paid on November 15, a 15% increase over last year. And approved $3 billion of additional share repurchase authority. Now, I would like to take a moment to summarize our outstanding year. We were extremely pleased with our performance in fiscal year '22, greatly exceeding almost all aspects of our original outlook that we provided last September. We delivered $71.7 billion in new bookings, reflecting 21% growth in U.S. dollars, hitting 100 clients with quarterly bookings of $100 million, which positions us well as we begin FY '23. We added significant scale with a record $11 billion in incremental revenue, almost double what we added in fiscal '21. Revenue of $61.6 billion for the year reflects growth of 26% in local currency. Operating margin of 15.2% reflects a 10 basis point expansion over FY '21. We were extremely pleased that we were able to deliver within our original guided range particularly with the continued significant investment in our business and people, including higher wages. Earnings per share were $10.71, reflecting 22% growth over adjusted FY '21 EPS, which is our highest growth in over a decade, reinforcing our ability to grow at scale profitably. As a reminder, we adjusted earnings last year to exclude gains on an investment. Free cash flow of $8.8 billion was significantly above our original guided range, reflecting a very strong free cash flow to net income ratio of 1.3. And with regards to our ongoing objective to return cash to shareholders, we exceeded our original guidance for capital allocation by returning $6.6 billion of cash to shareholders while investing approximately $3.4 billion across 38 acquisitions. In addition to these excellent financial results, let me turn to the 360-degree value we are creating for all our stakeholders. Through our partnership with Save the Children, we are preparing young people for a more sustainable and exclusive future by skilling an estimated 70,000 people to drive social and environmental change. For more information on the 360-degree value we are creating, please go to the Accenture 360-degree value reporting experience, which reflects new information each quarter. So again, FY '22 was a truly extraordinary year and we are now focused on delivering in fiscal '23. And now let me turn it back to Julie.
Julie Sweet: Thank you, KC. We succeed by being close to our clients, understanding and anticipating their needs, helping them from strategy to execution with the best solutions for their businesses, whether for growth, cost optimization or both and resilience. And it all starts with technology. With the breadth and depth of our existing capabilities, combined with our incredible learning organization, we are able to pivot as necessary, positioning us to serve our clients' changing needs and capture new market opportunities all while being laser-focused on our own operational excellence. I will give some color on the demand we are seeing. First of all, against the backdrop of the current macroeconomic environment, we delivered $18.4 billion in new bookings in Q4, a year-over-year increase of 31% in local currency. While industries and markets are being affected differently, there are two common themes: all strategies lead to technology, particularly cloud, data, AI and security, which are fundamental to its strong digital core. Our cloud business is now $26 billion and grew 48%, with Cloud First being the biggest driver of the growth. Companies are also seeking to execute compressed transformations, the second theme. These mean bold programs on accelerated time frames often spanning multiple parts of the enterprise at the same time. Managed services have become increasingly strategic as companies seek to move faster and leverage our digital platform and talent, and they are turning to Accenture because of our excellence across the enterprise. We are unmatched in terms of breadth and depth of capabilities and industry coverage. We continue to see a growing number of companies embrace the need to harness the five key forces of change that we have identified for the next decade. Total enterprise reinvention, talent, sustainability, the Metaverse Continuum and the ongoing tech revolution, which in turn will fuel our growth. Let me bring this demand to life. First, total enterprise reinvention. We are helping our clients transform every part of their business with technology from building a digital core to optimizing operations to achieve agility, efficiency and resilience to accelerating their growth agendas. While it is still early stages, there are leading companies that have begun systematically transforming multiple parts of their enterprise from moving to the cloud and adopting new ways of working to digitizing manufacturing, to reimagining shared services to creating entirely new business models. Unilever, one of the world's largest consumer goods companies is an example of a company that is leading in total enterprise reinvention. Together, we are setting a new industry standard by reinventing technology delivery with cutting-edge automation, delivering cloud migration at scale, the largest ERP migration to the cloud and the industry and shifting to technology solutions that support their growth strategy. They have changed their business model from a matrix structure to being organized around five distinct business groups. Each business group is fully responsible and accountable for their strategy, growth and profit delivery globally. Now we are helping them build a B2B marketplace that will help millions of small retailers in emerging markets grow their business and create what the Company called shared prosperity. We helped launch in seven markets in just 12 months, implemented a cloud-native, scalable commerce platform powered by data and advanced analytics, and we are managing front-end back-office operations and campaigns delivered in partnership with the Accenture Song team. Because across our industries, we are as relevant to the boardroom to the CFO to the business unit leader to the GM of the factory, and we understand the connections across the enterprise we are uniquely positioned to help our clients as they seek to often simultaneously drive growth, efficiency, cost reduction and increased resilience. For example, we are helping Lupin Limited, a global pharmaceutical company, become an intelligent enterprise by enabling its data-driven transformation journey. A new digital platform will unlock enterprise data to increase efficiencies and decision-makers will now have real-time visibility into integrated data across 100 countries and 15 manufacturing and research facilities. This consolidated view of global business operations and performance will help the Company navigate supply chain disruptions and accelerate product innovation and speed to market while supporting the Company's mission to provide affordable health care to people around the world. We see continued demand for our industry capabilities, which are all about digitizing engineering and manufacturing -- this is the next digital frontier. Industry X revenues grew 38% in FY '22 to total $7 billion. We are helping EDF, a French multinational utility company digitize the construction of a nuclear power station that will provide low carbon energy for more than 6 million U.K. homes. As part of a total enterprise reinvention, our Industry X team transformed EDF digital construction processes by creating a global digital factory model on a secure cloud infrastructure, driving cost efficiency. Construction methods that used to be paper and blueprint based will be digitized and AI will consolidate parts information from millions of pages of supplier guides. Digital dashboards will provide real-time data visibility across all systems and digital twins will help identify areas for automation across power plants, all of which drive safety, efficiency and quality. We are leveraging our expertise of nuclear construction in our cutting-edge cloud, digital and AI capabilities to help EDF deliver on one of the largest capital projects in Europe and accelerate its mission, helping Britain achieve net-zero. And our operation services, now a $9 billion business with 19% growth in FY '22 are fundamental to total enterprise reinvention for our clients because they help our clients digitize faster, access digital talent and reduce cost. For example, we are collaborating with one of the world's largest commercial vehicle manufacturers to develop an independent finance operation, leveraging our deep functional expertise in finance and accounting. With our managed services, we will implement a new platform underpinned by SynOps. Automation, data and analytics will drive and provide real-time decisions while digitizing processes to improve efficiency and user experience, all leading to significant cost reductions, better decision-making and savings. And as our clients build their digital core, security continues to be more important than ever, With over $6 billion in revenue and 45% growth, our integrated security capabilities from identity to threat intelligence to manage security services to incident response are critical as our clients respond to increasing risk as the security landscape widens. We are working with an Asian multinational conglomerate to deliver a comprehensive managed security services, security operations center and holistic security solution to detect, monitor and respond to global security threats 24/7. We will also manage tools to continuously monitor end-user devices to detect and respond to cyber threats, like ransomware and malware and will perform regular threat hunting activities to detect new cyber hacking techniques. This will provide its business units with timely detection and defense against cyber attacks, deliver threat intel for proactive defense, reduce false alarms by 90% and minimize emergency incidents to less than 1% of total incidents. Moving from total enterprise reinvention to the other five forces. Next, talent. Our clients look to us to help them access, create and unlock the potential of talent. We collaborated with Sky, one of Europe's leading media and entertainment companies to modernize its employee experience in human resources operations in the era of hybrid working. By migrating to a Software-as-a-Service multi-platform human capital management solution, all in the cloud, employees will be empowered with anytime, anywhere self-service solutions and access to real-time data and dashboards across all markets in one place. The solution supports all people, management functions from recruiting and onboarding to performance management and learning as well as compensation, benefits and payroll integration. Employees have the full picture of their work experience at their fingertips helping them to build their careers and perform at even higher levels. Now, sustainability. With $1 billion in revenues in FY '22, we continue to believe clients will increasingly need our sustainability services in the decade to come. We collaborated with Swisscom, Switzerland's number one firm for communications, IT and entertainment, on a climate strategy to reduce the Company's emissions and help its customers reduce their emissions by 1 million tons of carbon by 2025 and equal to 2% of Switzerland's total carbon emissions by leveraging technology such as cloud, data, AI, 5G and IoT. These technologies will address faster and higher capacity data transmission with remote management and control of connected devices. We are also helping the Company explore strategies to incorporate technologies within the emerging Scope 4 classification that can help further reduce carbon emissions from customers, allowing Swisscom to positively impact the planet and provide their customers with a larger number of green products and services to choose from. Moving to the metaverse and the ongoing tech revolutions. We continue to invest ahead of our clients' needs and have more than a decade of experience and leadership in metaverse-related capabilities. In fact, we expect to onboard over 150,000 new joiners using Accenture's end floor, and we use our experience and expertise to help our clients as we believe the Metaverse Continuum provides greater possibilities in the wave of digital transformation, and it is still early days. For example, we are helping Tokyo Land Corporation, a Japanese leading leasing, construction and retail real estate company, leverage the metaverse to transform the customer experience through digital twin technology leveraging computer-generated imaging to recreate walk-throughs of its condominiums online to greatly improve its in-person model retour. Customers will be able to visualize the property online, including different home equipment options and the Company will attract more buyers and increase sales while reducing marketing costs and the environmental impact of the construction, operation and removal of the model room. Into the future, we will help create continuous touch points with customers throughout the real estate life cycle and develop new collaborative digital businesses such as purchasing furniture and home appliances and ordering renovation services. And with our continued focus on innovation and the ongoing tech revolution, we continue to invest in our business for the future. For example, in Q4, we invested in Pixel a leader in cutting-edge earth imaging space technology. Back to you, KC.
KC McClure: Thanks, Julie. Now let me turn to our business outlook. For the first quarter of fiscal '23, we expect revenues to be in the range of $15.2 billion to $15.75 billion. This assumes the impact of FX will be approximately negative 8.5% compared to the first quarter of fiscal '22 and reflects an estimated 10% to 14% growth in local currency. For the full fiscal year '23, based upon how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results in U.S. dollars will be approximately negative 6% compared to fiscal '22. For the full fiscal '23, we expect our revenues to be in the range of 8% to 11% growth in local currency over fiscal '22, which includes an inorganic contribution of about 2.5%. For operating margin, we expect fiscal year '23 to be 15.3% to 15.5%, a 10 to 30 basis point expansion over fiscal '22 results. We expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an effective tax rate of 24% in fiscal '22. For earnings per share, we expect full year diluted EPS for fiscal '23 to be in the range of $11.09 to $11.41 or 4% to 7% growth over fiscal '22 results. For the full fiscal '23, we expect operating cash flow to be in the range of $8.5 billion to $9 billion, property and equipment additions to be approximately $800 million and free cash flow to be in the range of $7.7 billion to $8.2 billion. Our free cash flow guidance reflects a free cash flow to net income ratio of 1.1. Finally, we expect to return at least $7.1 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to shareholders. With that, let's open it up so that we can take your questions. Angie?
Angie Park: Thanks, KC. I would ask that you each keep one to question and a follow-up to allow us to as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: [Operator Instructions] Our first question will come from the line of Lisa Ellis with MoffettNathanson. Please go ahead.
Lisa Ellis: Good stuff here. Just a question about the outlook for fiscal '23. Can you elaborate a bit further on what underlying macroeconomic outlook that you have embedded in guidance above and beyond the 6 points of FX translation. And maybe the broader question is sort of how, if at all, are you seeing the rising rate environment inflation sort of escalating dynamics of what we've been seeing all year long affecting your business?
Julie Sweet: Great. Thanks, Lisa. So yes, let me give you a little bit of color around our guidance assumptions. So our revenue range of 8% to 11% for fiscal '23, it includes 2.5% inorganic contribution, and that's compared to about 5% that we did in '22. And that would represent then about 8.5% organic growth at the upper end of our range. And so, we continue to see really strong demand for our services, Lisa. And as you've seen, the most recent estimate for IT Services continues to show the growth for our industry will be about 5%. So anywhere in our range, it will show us continuing to take share. But at the same time, while our growth is not directly correlated with GDP, we read the same things that you do. And the latest GDP estimate for most of the world's largest economies are lower in 2023 than 2022. So again, we're calling for double-digit growth at the top part of our range. Another year of double-digit growth, which would have us adding significant scale, yet again on top of our current $62 billion business.
Julie Sweet: Maybe I'll add, Lisa, is that -- when we think about the macro environment, what we're really thinking about is what do our clients need, right? So as -- so -- and I talked a little bit about this last quarter, right, is this environment affects different industries differently. So, you've got those who are really tied to the supply chain disruption and the inflation continuing to focus on cost. But you also see that as the uncertainty increases. So over the last 90 to 120 days, you saw changes in the estimates around the GDP growth for 2023, it makes all clients really think about, okay, what's my resilience? Is there more that I can do? Can I take advantage of the environment to push through deeper cost cuts that require you to change behaviors? And so we really think about the environment as what does that mean we need to do to help our clients and how do we continue to pivot. And it's very similar if you think about what we did in the early days of the pandemic, where we've pivoted a lot to, for example, cloud using all of our learning organization. So that's the focus. So it's always an opportunity to better serve our clients.
Lisa Ellis: Okay. Yes. Great color. And then just quick follow-up on bookings, realizing they're obviously always lumpy to quarter-to-quarter and the overall number this quarter was extraordinarily strong, continuing that 1.12 book-to-bill. But is there any -- was it sort of an unusual shift in mix into outsourcing and less consulting? Is there any color or call out there? Or is that just sort of the vagaries of the kind of quarterly fluctuations?
KC McClure: Sure. And so Lisa, as you mentioned, we feel really good about our bookings in Q4. It was our second highest bookings ever our highest also being this year in the second quarter. What I really liked about it was driven by broad-based demand. So across all markets and our services, and we peel it back. We had good book-to-bill in all dimensions of our business. And with outsourcing a record of almost $10 billion, and that was almost $1.3 billion more than what we did for our last record. And we do continue to see a strong pipeline going into the year, even with those the second best record bookings. But I will say that as we often do, we have seasonally lower bookings in quarter one and we are seeing that again this year.
Operator: Thank you. Our next question comes from the line of Tien-tsin Huang with JPMorgan. Please go ahead.
Tien-Tsin Huang: Just tacking on what Lisa just asked there with this larger book-to-bill in outsourcing relative to consulting. Is the shift to larger deals, does that tell you or should it tell us anything about client priorities? And I'm curious if that changes or even improves your visibility overall for fiscal '23, given you have so much more in the way of larger deals in the backlog.
Julie Sweet: Yes. I mean I don't -- I mean, obviously, we've got larger deals. You have more visibility around larger deals just because they're larger deals and you see how it is. And certainly, how we think about the business so much, I mean, I think if you just take a -- your underlying question is what are clients focused on, right? And so what we do see is -- and what we actually -- more than just see what we are recommending is that leadership teams remain sort of focused on prioritizing where they can get good time to value, making sure that they are doing things that are material, not having 1,000 different pilots as opposed to actually getting to scale. And so a lot of that does lead to a focus on larger transformation deals, and it's tied to what we call total enterprise reinvention, right? What we're talking to clients about is systematically reinventing. And actually, we've got some research coming out at the end of September that says 68% of CFOs say they today have either three or more transformation programs either going right now or about to start in parallel. And so, what that really does mean that is that you've got more companies do what we've been talking about since the early days of the pandemic, which is systematic transformation. We'll try to do it faster and that does lead to larger programs. And probably the bigger impact for us is less about visibility, but those obviously convert to revenue differently.
KC McClure: Yes. And maybe Tien-Tsin, I'll just add in terms of -- if you just look at our bookings this year from an outsourcing type of work compared to consulting type of work compared to our history over the last few years, there's really no difference, right? We actually have a slight percentage uptick in what we closed out this year in consulting type of work looking versus outsourcing. So there's no real difference in our mix.
Tien-Tsin Huang: Very good. No, that's really helpful. Just on the -- my follow-up on margins, if you don't mind. Just thinking about investment priorities, organic versus inorganic, I know it's a lower inorganic assumption on growth this year. But -- any update there in terms of the balance? And I'm wondering, I wrote down, I think you said 48% growth in cloud for the year. And I think back to the Cloud First investment you did, I think it was a $3 billion investment. It seems like you got a good return out of that. So, we see more investments like that at this point in the cycle? So yes, just think about organic versus inorganic investing.
KC McClure: Yes. So, I'll take the inorganic point, and then I'll hand it over to Julie to give some more color. So, first of all, there's no change overall to our capital allocation strategy, right? So, we will continue to use V&A to fuel our organic growth. And so, you'll see the 2.5%, Tien-Tsin, is an inorganic contribution. It's generally in the zone of what we've done in previous years. And so maybe I'll also just take a chance to talk about what that means in terms of how we're going to invest in our business next year and how that relates to how we're seeing our profit because I think it's really important to point out that we're really proud of what we accomplished this past year in '22, where we did 10 basis points of expansion. And Tien-tsin, we were continuing to invest at scale in our business, right? And also in our people, particularly this year with managing wage inflation. So as we look through next year, we expect to continue to invest in our business. We expect wage inflation to continue. It's across all industries and across the globe. And for us, it's going to vary by geography by scale. And we will navigate that like we did this past year with a focus on pricing, which we all know can lag compensation a bit. But I just want to point out that we did see the benefit of improved pricing in our P&L in '22. And so again, we're going to do all of this while changing the mix of people in our contracts, the use of technology to absorb the higher investments that we're making organically and the higher investments that we're making in our people. But -- so it's really important that we continue on our investment profile. And with that, like I'd be really happy next year to land anywhere within the 10 to 30 basis points of op margin expansion. And I would say that based on how we're going to invest throughout the year, there's a bit more potential for us to have a more variability in the quarters as we go throughout fiscal year '23 on our way to 10 to 30 basis points of expansion for the year.
Julie Sweet: Yes. And Tien-Tsin, I just -- Tien-Tsin, I would just emphasize, we believe it is very important to continue to invest at higher levels in our business every year and that's our commitment. And it's been -- we think a big reason for our success is that through every cycle, we continue to invest.
Operator: Thank you. Our next question will come from the line of Keith Bachman with BMO. Please go ahead.
Keith Bachman: I wanted to ask to start with on the outlook. In particular, Julie, if there's any comments directional or otherwise, you could give on bookings. I understand you provided the revenue guidance in constant currency, even the backlog runoff of the booking -- tremendous bookings you've given so far, the revenue guidance seems very reasonable, if not a touch conservative. But as you indicated in your prepared remarks, you had record bookings this year. You're facing -- your clients are facing a deeper economic challenge. So, is there any comments you could give whether book-to-bill or the growth rates or any parameters on how we should be thinking about bookings this year? Because it seems like the trajectory there could be different from the revenue growth.
Julie Sweet: Well, I'll let KC start, and then I'll add on.
KC McClure: Yes. So Keith, maybe I'll start with a little bit more color on how we actually see revenue kind of breaking out for the year. So from a type of work perspective for the full year '23, we do see consulting revenue growth to be within the context of the 8% to 11% that we gave out overall, which remember has been 6% FX headwind embedded in that. We see consulting revenue to be high single digits to double digits. And outsourcing, we see being double digits. And when you think about what our bookings expectations are, while we don't guide to bookings, you should -- our view remains the same. We look for over a rolling four quarters period of time for book-to-bill to be over one.
Julie Sweet: Great. And Keith, what I would just say is that -- remember, our focus is helping our clients create value within whatever environment that they are operating in, right? So -- and which is very different depending on your industry. So like pick right now, providers in the U.S., right? They are focused on cost cutting because they went through a tough time with COVID, they're behind in digitization, so they're investing there. And they have to because they're facing one of the most difficult labor markets they've ever had to now sort of resistance and difficulty in automating before. That is a completely different that a global consumer company like Unilever, we talked about in our script, who's reinventing everything that been on this journey for a few years, looking to the next thing, right? And they're dealing with supply chain disruptions, right, cost inputs. And so, that is how we continue to succeed is by understanding the depth of difference in our industry. We're using knowledge that we had from other industry to now accelerate what the providers are doing because they're now implementing SaaS solutions to connect their patients that we've been doing for years in retail, right, and in banking and in lots of other industries. So that our outlook for the year reflects our confidence that we are going to continue to be able to use that knowledge, stay close to our clients and deliver on what they need.
Keith Bachman: Okay. Okay. My follow-up is then focused on free cash flow. The free cash flow guidance is a touch certainly lighter than what we had modeled and I think Street had modeled your margins continue to move higher. So I was just wondering what the puts and takes that you might want to call out with the free cash flow guidance for the year. And then I will see the floor. Many thanks.
KC McClure: Yes. Thanks, Keith. So, as you know, when we set our guidance, we always first start with looking at the ratio. So the ratio that we have in our free cash flow guidance is a very strong $1.1 billion free cash flow to net income ratio. So, we're happy with that. We also are allowing in that guidance a bit of an uptick in DSO from our current level. And then also, we are assuming we are going to have the FX impact of 6% that will obviously impact our free cash flow as well. And as you know, it's not unusual for us to start guidance at the beginning of the year with a free cash flow guidance range, that's below where we delivered the previous year.
Operator: Thank you. Our next question comes from the line of Bryan Keane with Deutsche Bank. Please go ahead.
Bryan Keane: Obviously, a lot of folks are asking about the macro. So just curious how the macro has changed for you guys over the last three months and how that's influenced your business because it doesn't really show up much in results? So just curious how you would frame that?
Julie Sweet: Well, as KC said earlier, our guidance for the year takes into account the current estimates for 2023 for GDP, which, as we all know, over the last sort of 90 days have decreased. So, we take that into consideration. And where we see that really affecting our business is our ability to help our clients and think about what to do, right? How do you execute a faster transformation? Are there new opportunities? I'm talking to a consumer goods client now, where we're helping them think about, well, how do we cut marketing and get more effective because they need growth, but marketing is one of the biggest spend areas for a consumer goods company. And by the way, let's not waste a good environment to be able to catalyze cultural and behavioral change as they think about things. So that's where we are seeing it. And otherwise, our guidance reflects -- as you know, it's not a one for one, but we obviously take into account the economic environment.
Bryan Keane: Got it. Yes. Yes, I was just looking at Europe, in particular, up 26% in local currency, given all the concerns around Europe. It's just a pretty amazing number. It doesn't seem to have come off much from the growth rates you've been putting up.
Julie Sweet: Yes. We're very proud of our European team because they are really close to our clients.
KC McClure: Yes. And maybe, Brett, I'll give you a little bit of color on that as it relates to Q1. Let me give you a peel back a little bit on the revenue outlook that we have for the first quarter -- and when we look at the markets, we see all the markets for the first quarter within that 10% to 14% revenue range that we gave. They all have the potential to be double digits, and that includes Europe. And then also for the consulting type of work in Q1, we see a high single-digit to low double-digit growth range within that 10 to 14. And I would peel back consulting a little bit for you, too. Within consulting, we see the detect portion of consulting the systems integration, we'll have continued strong demand and S&C, we expect to be in lower single digits.
Bryan Keane: No, that's really helpful and then just a quick follow-up, just thinking on KC on visibility. How has visibility changed at all, if at all, for Accenture? When you look out further on in the quarters as we get to Q4, it's obviously almost 12 months away, so it's probably a little bit hard to figure out exactly the right growth rates, but just thinking about the visibility of the business.
KC McClure: I would say, Brian, that in terms of looking at the back half of the year, I mean, that's no different than the way it is, honestly, every year. We talked a lot about what we just mentioned on how we look at the macro in the market. But the back half of the year, we always -- it's always less certain at this time of the year than obviously the first quarter and the first half. Again, it's no different than what we have experienced every year.
Julie Sweet: And as always, clients still -- most of our clients are calendar year, and they'll set their budgets, and we'll know more about that in January. So it's really the same.
KC McClure: It is. It is.
Bryan Keane: Got it, great. Congrats on the results.
Julie Sweet: Thanks.
KC McClure: Thank you.
Operator: Thank you. Our next question comes from James Faucette with Morgan Stanley. Please go ahead.
James Faucette: Appreciate all the commentary today as usual. Looking at kind of the supply and kind of how you're managing your own employees, et cetera, how does the shift in client priorities manifest itself in where and how your services are being delivered? And how is that influencing your talent strategy right now around pace of hiring, where you hire, et cetera?
Julie Sweet: Well, as you know, our -- we have a very deep competency in supply and demand. And actually, over the course of the last couple of years, we continue to innovate. We have an incredible what we call integrated talent control tower that is able to predict earlier and earlier in our sales cycle, where the skills will be needed and what type of skills. And so for us, this is just normal business, right? And keep in mind, technology demand is really incredible, right? I mean you saw that in our results. All strategies lead to technology. And we're super pleased with not only our performance there, but what we're seeing ahead as clients continue to build the digital core as fundamental to all of their other strategic needs. And our talent supply chain is able to see that, predict it, understand the skills and keep moving forward.
James Faucette: That's great. And then turning to pricing, just wondering what the tone and tenor of pricing conversations have been? How those have progressed. And how are you building in? Or how should we think about what's being built into your formulation of outlook around magnitude of potential uplift to revenue from pricing versus margins, et cetera?
KC McClure: So let me just remind you that when I'm talking about pricing in my answer, I'm talking about the margin on the work that we've sold. And I'm really pleased that we've continued to see improvements in pricing. And we are seeing the benefits. I mentioned this earlier, but I'll just repeat it. We are seeing the benefits come through in our P&L. And we continue to focus on improvements in pricing as we enter into fiscal year '23. So I'm really I'm really pleased with the progress we've made.
Operator: Thank you. And our next question will come from the line of Jason Kupferberg with Bank of America. Please go ahead.
Jason Kupferberg: KC, I just wanted to pick up on your comment on one of the prior questions around -- I think you said strategy and consulting, up in the low single-digit range in Q1. So Curious if that's the same kind of range you anticipate for the full year fiscal '23? And is that below corporate average level, just reflective of the more kind of discretionary nature and growth-oriented nature of those services?
KC McClure: Yes. Thanks, Jason. In terms of Q1, it's really just a few simple things. One, we got a tough compare. Two, is there's less -- when I mentioned less inorganic that really does also hit in essence in the S&C part. And then as Julie talked about, a lot of our S&C practitioners are really focused on some -- a lot of the larger transformational deals. And that just has Jason, a different revenue yield, and it bleeds in later throughout the year.
Jason Kupferberg: Okay. Understood. Maybe just turning to the supply side for a second. It looks like attrition was unchanged in Q4 versus Q3. And wondering what you're expecting there in fiscal '23 as well as what you're expecting for wage inflation relative to 2022 and whether or not some of the broader layoffs across other parts of the tech industry, is that taking some of the pressure off some of your supply metrics at all?
KC McClure: Yes. So I'll start, Jason, with the last part. I mean we had -- I'm really pleased with the way we were able to grow at scale profitably while managing the wage inflation in FY '22. And as we said a little bit earlier, but just to repeat, we do expect wage inflation to continue, and we have factored that into our guidance.
Julie Sweet: Yes. And look, I would just say to you that technology skills are in demand by both companies as well as our competitors because technology is at the core of strategy. And so, we're expecting to have a continued tight labor market, and we continue to expect us to really excel because despite that market, as you know, even this last year, we added 100,000 people. So, I don't -- the fact that there has been some layoffs in certain markets isn't really, I think, going to change much.
Angie Park: Operator, we have time for one more question, and then Julie will wrap up the call.
Operator: Thank you. And that question will come from the line of Bryan Bergin with Cowen. Please go ahead.
Bryan Bergin: I wanted to start on the growth outlook. Can you just give us a sense on how you're thinking about the second half trajectory just in the fiscal '23 range, just given a significant uncertainty? Just curious how you went about building that second half forecast. And then just within the year, are you expecting the strategic priorities to hold the double-digit growth? So across Song and Cloud First and Next or are any of those a little bit more exposed to potential slowdown and uncertainty?
KC McClure: Yes. So, I'll maybe just start with the overall outlook that we have read. You can see that we started with 8 to 11. I already gave the color on that. So -- and within that, obviously, we have a strong start at 10% to 14% growth. And in terms of really what that looks like for the rest of the year, I mean we'll continue to give guidance like we typically do as we progress through FY '23. I mean, as Julie mentioned, we see continued strong demand in our technology -- our areas of technology. And other than that, we don't really give any more guidance and kind of view on revenue outlook than what I've already shared.
Julie Sweet: Yes. And just -- I think it's always important that we are continuously thinking about both the near term, this fiscal year and the longer term and anchoring on the five forces of change for the next decade. And so, total enterprise reinvention, talent we talked about the investments we're making in sustainability. We just made a great acquisition that's on Carbon Intelligence, which is all about consulting around carbon getting to net-zero strategies. The Metaverse Continuum, small today. We're the leading enterprise user our own way of onboarding, but lots and lots of interest, and we're already making those investments and then the ongoing tech revolution. And so that's why as you think about our results, right, we are investing today and tomorrow and really are looking at the demand that we see over the next decade.
Bryan Bergin: Okay. Okay. And then it looks like just on M&A, it looks like you did close on more in 4Q than you had initially anticipated. So how should we think about the planned spend in fiscal '23 for M&A underlying the 2.5% growth contribution? And then just how do you start off the year in 1Q? What's the inorganic assumption in that outlook?
KC McClure: Yes, sure. So you're right, we did end up spending $3.4 billion for the year in '22 because we were able to get some of the regulatory approvals done this last fiscal year '22 that we weren't sure of the timing. And you'll see that because of that, while we're going to continue to always provide the inorganic outlook on a full year basis. So, that 2.5% is a full year. We're not -- we don't really do that by quarter because that again can also be lumpy. We're not going to continue to provide the capital allocation amount as we go into '23, just because it can really vary by the end of the year, and we'll be able to -- you'll be able to see it and we'll report it every quarter.
Julie Sweet: Yes, it's probably worth reminding that last Q1, we had Umlaut and Novetta, which were both very large acquisitions come in, in Q1. So probably just good to remind everyone that's part of what's driving the Q1 S&C results too. Great. So before we wrap up, I do want to mention that Angie Park, who has been our Head of Investor Relations for the past six years, has been promoted to become the CFO for our really outstanding technology services business. Angie has been an absolutely incredible Head of IR and we're particularly grateful for how she has helped lead us through some of the most turbulent times in the history of Accenture. I know from speaking to our investors and analysts how much they've appreciated Angie's steady hand, her commitment to transparency and connection. And I know we'll all miss her in this role, but are extremely excited to see her start the next chapter of what has already been an incredible career. So thank you very much, Angie. And I am also pleased to welcome Katy O'Connor who will become our new Head of Investor Relations. She's got incredible experience. She's held many finance roles during her 25 years at Accenture. So please join me in welcoming Katy and I know she's looking forward to getting to know all of you in the days ahead. In closing, I do want to thank again all of our people and our managing directors for what you're doing every day. Our people, our actions and our results in FY '22 have positioned us to be very strongly going into FY '23 and create even more 360-degree value. And finally and very importantly, thank you to all of our shareholders for your continued trust and support. Thank you.
Operator: Ladies and gentlemen, that does conclude our conference for today. The replay will be available after 10 a.m. Eastern today through December 16, 2022. You may access the AT&T executive replay system at any time by dialing 1 (866) 207-1041 and entering the access code 4002764. International participants may dial (402) 970-0847. Those numbers again are 1 (866) 207-1041 and (402) 970-0847 with access code 4002764. That does conclude our conference for today. We thank you for your participation and for using AT&T conferencing service. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to Accenture's Fourth Quarter Fiscal 2022 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Managing Director, Head of Investor Relations, Ms. Angie Park. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, operator, and thanks, everyone, for joining us today on our fourth quarter and full fiscal 2022 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for both the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the first quarter and full fiscal year 2023. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and effect are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie, and everyone joining us today. And thank you to our 721,000 people around the globe for delivering a truly extraordinary year. We measure our success by both our financial results and the broader 360-degree value we create for all our stakeholders, our clients, people, shareholders, partners and communities. Strong financial results allow us to deliver more 360-degree value. Let me share a few highlights of this extraordinary year. In FY '22, we delivered record bookings of $72 billion. As our clients continue to execute compressed transformations, we had 100 clients with quarterly bookings greater than $100 million compared to $72 million last fiscal year. We delivered revenues of $62 billion, representing a record 26% growth in local currency, adding $11 billion in revenue for the year. We continue to take significant market share growing more than 2x the market. Our financial results reflect our commitment to creating value for our clients every day, which is why they are turning to us as their trusted partner across the enterprise. We now have 267 Diamond clients, our largest client relationships compared to 229 last fiscal year. We expanded operating margin by 10 basis points and had EPS growth of 22% over adjusted FY '21 EPS, demonstrating our ability to grow profitably and at scale. We achieved this profitable growth while continuing to invest significantly in our business and people with $3.4 billion deployed across 38 acquisitions that are well balanced across markets, services and strategic priorities; $1.1 billion invested in R&D assets, platforms and industry solutions, including growing our portfolio of patents and pending patents to more than 8,300; and $1.1 billion invested in the training and development of our people to grow the skills needed to serve our clients. We continue to offer an employee value proposition that includes providing vibrant career paths and opportunities for our people with approximately 157,000 promotions and over 40 million training hours while expanding our workforce by almost 100,000 and achieving 47% women as we continue our progress towards gender parity by 2025. We believe our unwavering commitment to diversity, broadly defined and inclusion is an essential element of our ability to deliver market-leading financial results because our diversity and inclusiveness makes us smarter, more innovative and more attractive to top talent. We achieved over 85% renewable electricity powering our offices and centers around the world on our way to 100% by 2023. We prioritize creating value around the world and the communities where we work and live, both through investments and job creation and through our direct support of meaningful local initiatives, including our apprenticeship programs in the U.S., UK, Switzerland and Latin America and our growing partnership with Youth Business International, which will help an additional estimated 240,000 young entrepreneurs, ages 18 to 35, build skills and success in a digital future on top of the 370,000 young entrepreneurs already supported through this partnership in many different communities throughout the world. This year, we are proud to achieve our highest brand value and rank to date on BrandZ's prestigious Top 100 Most Valuable Global Brands list, increasing 28% to over $82 billion and ranking number 26. Over to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie, and thanks to all of you for joining us on today's call. We were very pleased with our results in the fourth quarter, which completes another outstanding year for Accenture. Once again, our results continue to provide strong validation of our leadership position in the marketplace, the relevance of our services to our clients and our ability to consistently deliver on our shareholder value proposition, including both our financial results and creating 360-degree value for all our stakeholders. So let me begin by summarizing a few highlights from the quarter across our three financial imperatives. Revenue grew 22.4% in local currency, driven by double-digit growth across all markets, services and industries. We once again extended our leadership position with growth estimated to be more than 2x the market, which refers to our basket of publicly traded companies. Operating margin was 14.7%, an increase of 10 basis points for the quarter. We continue to drive margin expansion while making significant investments in our people and our business. We delivered very strong EPS of $2.60, which represents 18% growth compared to EPS last year. And finally, we delivered free cash flow of $3.6 billion, driven by superior DSO management. Now let me turn to some of the details. New bookings were $18.4 billion for the quarter, our second highest ever with a book-to-bill of 1.2. Consulting bookings were $8.4 billion with a book-to-bill of 1. Outsourcing bookings of $9.9 billion were a record with a book-to-bill of 1.4. We were very pleased with our strong bookings this quarter, which reflects 22% growth in U.S. dollars and 31% growth in local currency, including 26 clients with bookings over $100 million in the quarter. Turning now to revenues. Revenues for the quarter were $15.4 billion, a 15% increase in U.S. dollars and 22.4% in local currency. Consolidated revenues for the quarter were $8.3 billion, up 14% in U.S. dollars and 22% in local currency. Outsourcing revenues were $7.1 billion, up 16% in U.S. dollars and 23% in local currency. Taking a closer look at our sales dimensions. Technology services grew very strong double digits, operations grew strong double digits and strategy and consulting grew double digits. Turning to our geographic markets. In North America, revenue growth was 18% in local currency, driven by double-digit growth in public service, software and platforms and consumer goods, retail and travel services. In Europe, revenues grew 26% in local currency, led by double-digit growth in industrial, banking and capital markets and consumer goods, retail and travel services. Looking closer to the countries, Europe was driven by double-digit growth in Germany, the UK, Italy and France. In growth markets, we delivered 26% revenue growth in local currency, driven by double-digit growth in banking and capital markets, consumer goods, retail and travel services and public service. From a country perspective, growth markets was led by double-digit growth in Japan and Australia. Moving down the income statement. Gross margin for the quarter was 32.1% compared with 33.3% for the same period last year. Sales and marketing expense for the quarter was 10.2% compared with 11.3% for the fourth quarter last year. General and administrative expense was 7.1% compared to 7.4% for the same quarter last year. Operating income was $2.3 billion in the fourth quarter, reflecting a 14.7% operating margin, up 10 basis points compared with Q4 last year. Our effective tax rate for the quarter was 24.6% compared with an effective tax rate of 25% for the fourth quarter last year. Diluted earnings per share were $2.60 compared with EPS of $2.20 in the fourth quarter last year. Days service outstanding were 43 days compared to 44 days last quarter and 38 days in the fourth quarter of last year. Free cash flow for the quarter was $3.6 billion, resulting from cash generated by operating activities of $3.8 billion, net of property and equipment additions of $177 million. Our cash balance at August 31 was $7.9 billion compared with $8.2 billion at August 31 last year. With regards to our ongoing objective to return cash to shareholders. In the fourth quarter, we repurchased or redeemed 2.1 million shares for $605 million at an average price of $293.23 per share. Also in August, we paid our fourth quarterly cash dividend of $0.97 per share for a total of $614 million. And our Board of Directors declared a quarterly cash dividend of $1.12 per share to be paid on November 15, a 15% increase over last year. And approved $3 billion of additional share repurchase authority. Now, I would like to take a moment to summarize our outstanding year. We were extremely pleased with our performance in fiscal year '22, greatly exceeding almost all aspects of our original outlook that we provided last September. We delivered $71.7 billion in new bookings, reflecting 21% growth in U.S. dollars, hitting 100 clients with quarterly bookings of $100 million, which positions us well as we begin FY '23. We added significant scale with a record $11 billion in incremental revenue, almost double what we added in fiscal '21. Revenue of $61.6 billion for the year reflects growth of 26% in local currency. Operating margin of 15.2% reflects a 10 basis point expansion over FY '21. We were extremely pleased that we were able to deliver within our original guided range particularly with the continued significant investment in our business and people, including higher wages. Earnings per share were $10.71, reflecting 22% growth over adjusted FY '21 EPS, which is our highest growth in over a decade, reinforcing our ability to grow at scale profitably. As a reminder, we adjusted earnings last year to exclude gains on an investment. Free cash flow of $8.8 billion was significantly above our original guided range, reflecting a very strong free cash flow to net income ratio of 1.3. And with regards to our ongoing objective to return cash to shareholders, we exceeded our original guidance for capital allocation by returning $6.6 billion of cash to shareholders while investing approximately $3.4 billion across 38 acquisitions. In addition to these excellent financial results, let me turn to the 360-degree value we are creating for all our stakeholders. Through our partnership with Save the Children, we are preparing young people for a more sustainable and exclusive future by skilling an estimated 70,000 people to drive social and environmental change. For more information on the 360-degree value we are creating, please go to the Accenture 360-degree value reporting experience, which reflects new information each quarter. So again, FY '22 was a truly extraordinary year and we are now focused on delivering in fiscal '23. And now let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. We succeed by being close to our clients, understanding and anticipating their needs, helping them from strategy to execution with the best solutions for their businesses, whether for growth, cost optimization or both and resilience. And it all starts with technology. With the breadth and depth of our existing capabilities, combined with our incredible learning organization, we are able to pivot as necessary, positioning us to serve our clients' changing needs and capture new market opportunities all while being laser-focused on our own operational excellence. I will give some color on the demand we are seeing. First of all, against the backdrop of the current macroeconomic environment, we delivered $18.4 billion in new bookings in Q4, a year-over-year increase of 31% in local currency. While industries and markets are being affected differently, there are two common themes: all strategies lead to technology, particularly cloud, data, AI and security, which are fundamental to its strong digital core. Our cloud business is now $26 billion and grew 48%, with Cloud First being the biggest driver of the growth. Companies are also seeking to execute compressed transformations, the second theme. These mean bold programs on accelerated time frames often spanning multiple parts of the enterprise at the same time. Managed services have become increasingly strategic as companies seek to move faster and leverage our digital platform and talent, and they are turning to Accenture because of our excellence across the enterprise. We are unmatched in terms of breadth and depth of capabilities and industry coverage. We continue to see a growing number of companies embrace the need to harness the five key forces of change that we have identified for the next decade. Total enterprise reinvention, talent, sustainability, the Metaverse Continuum and the ongoing tech revolution, which in turn will fuel our growth. Let me bring this demand to life. First, total enterprise reinvention. We are helping our clients transform every part of their business with technology from building a digital core to optimizing operations to achieve agility, efficiency and resilience to accelerating their growth agendas. While it is still early stages, there are leading companies that have begun systematically transforming multiple parts of their enterprise from moving to the cloud and adopting new ways of working to digitizing manufacturing, to reimagining shared services to creating entirely new business models. Unilever, one of the world's largest consumer goods companies is an example of a company that is leading in total enterprise reinvention. Together, we are setting a new industry standard by reinventing technology delivery with cutting-edge automation, delivering cloud migration at scale, the largest ERP migration to the cloud and the industry and shifting to technology solutions that support their growth strategy. They have changed their business model from a matrix structure to being organized around five distinct business groups. Each business group is fully responsible and accountable for their strategy, growth and profit delivery globally. Now we are helping them build a B2B marketplace that will help millions of small retailers in emerging markets grow their business and create what the Company called shared prosperity. We helped launch in seven markets in just 12 months, implemented a cloud-native, scalable commerce platform powered by data and advanced analytics, and we are managing front-end back-office operations and campaigns delivered in partnership with the Accenture Song team. Because across our industries, we are as relevant to the boardroom to the CFO to the business unit leader to the GM of the factory, and we understand the connections across the enterprise we are uniquely positioned to help our clients as they seek to often simultaneously drive growth, efficiency, cost reduction and increased resilience. For example, we are helping Lupin Limited, a global pharmaceutical company, become an intelligent enterprise by enabling its data-driven transformation journey. A new digital platform will unlock enterprise data to increase efficiencies and decision-makers will now have real-time visibility into integrated data across 100 countries and 15 manufacturing and research facilities. This consolidated view of global business operations and performance will help the Company navigate supply chain disruptions and accelerate product innovation and speed to market while supporting the Company's mission to provide affordable health care to people around the world. We see continued demand for our industry capabilities, which are all about digitizing engineering and manufacturing -- this is the next digital frontier. Industry X revenues grew 38% in FY '22 to total $7 billion. We are helping EDF, a French multinational utility company digitize the construction of a nuclear power station that will provide low carbon energy for more than 6 million U.K. homes. As part of a total enterprise reinvention, our Industry X team transformed EDF digital construction processes by creating a global digital factory model on a secure cloud infrastructure, driving cost efficiency. Construction methods that used to be paper and blueprint based will be digitized and AI will consolidate parts information from millions of pages of supplier guides. Digital dashboards will provide real-time data visibility across all systems and digital twins will help identify areas for automation across power plants, all of which drive safety, efficiency and quality. We are leveraging our expertise of nuclear construction in our cutting-edge cloud, digital and AI capabilities to help EDF deliver on one of the largest capital projects in Europe and accelerate its mission, helping Britain achieve net-zero. And our operation services, now a $9 billion business with 19% growth in FY '22 are fundamental to total enterprise reinvention for our clients because they help our clients digitize faster, access digital talent and reduce cost. For example, we are collaborating with one of the world's largest commercial vehicle manufacturers to develop an independent finance operation, leveraging our deep functional expertise in finance and accounting. With our managed services, we will implement a new platform underpinned by SynOps. Automation, data and analytics will drive and provide real-time decisions while digitizing processes to improve efficiency and user experience, all leading to significant cost reductions, better decision-making and savings. And as our clients build their digital core, security continues to be more important than ever, With over $6 billion in revenue and 45% growth, our integrated security capabilities from identity to threat intelligence to manage security services to incident response are critical as our clients respond to increasing risk as the security landscape widens. We are working with an Asian multinational conglomerate to deliver a comprehensive managed security services, security operations center and holistic security solution to detect, monitor and respond to global security threats 24/7. We will also manage tools to continuously monitor end-user devices to detect and respond to cyber threats, like ransomware and malware and will perform regular threat hunting activities to detect new cyber hacking techniques. This will provide its business units with timely detection and defense against cyber attacks, deliver threat intel for proactive defense, reduce false alarms by 90% and minimize emergency incidents to less than 1% of total incidents. Moving from total enterprise reinvention to the other five forces. Next, talent. Our clients look to us to help them access, create and unlock the potential of talent. We collaborated with Sky, one of Europe's leading media and entertainment companies to modernize its employee experience in human resources operations in the era of hybrid working. By migrating to a Software-as-a-Service multi-platform human capital management solution, all in the cloud, employees will be empowered with anytime, anywhere self-service solutions and access to real-time data and dashboards across all markets in one place. The solution supports all people, management functions from recruiting and onboarding to performance management and learning as well as compensation, benefits and payroll integration. Employees have the full picture of their work experience at their fingertips helping them to build their careers and perform at even higher levels. Now, sustainability. With $1 billion in revenues in FY '22, we continue to believe clients will increasingly need our sustainability services in the decade to come. We collaborated with Swisscom, Switzerland's number one firm for communications, IT and entertainment, on a climate strategy to reduce the Company's emissions and help its customers reduce their emissions by 1 million tons of carbon by 2025 and equal to 2% of Switzerland's total carbon emissions by leveraging technology such as cloud, data, AI, 5G and IoT. These technologies will address faster and higher capacity data transmission with remote management and control of connected devices. We are also helping the Company explore strategies to incorporate technologies within the emerging Scope 4 classification that can help further reduce carbon emissions from customers, allowing Swisscom to positively impact the planet and provide their customers with a larger number of green products and services to choose from. Moving to the metaverse and the ongoing tech revolutions. We continue to invest ahead of our clients' needs and have more than a decade of experience and leadership in metaverse-related capabilities. In fact, we expect to onboard over 150,000 new joiners using Accenture's end floor, and we use our experience and expertise to help our clients as we believe the Metaverse Continuum provides greater possibilities in the wave of digital transformation, and it is still early days. For example, we are helping Tokyo Land Corporation, a Japanese leading leasing, construction and retail real estate company, leverage the metaverse to transform the customer experience through digital twin technology leveraging computer-generated imaging to recreate walk-throughs of its condominiums online to greatly improve its in-person model retour. Customers will be able to visualize the property online, including different home equipment options and the Company will attract more buyers and increase sales while reducing marketing costs and the environmental impact of the construction, operation and removal of the model room. Into the future, we will help create continuous touch points with customers throughout the real estate life cycle and develop new collaborative digital businesses such as purchasing furniture and home appliances and ordering renovation services. And with our continued focus on innovation and the ongoing tech revolution, we continue to invest in our business for the future. For example, in Q4, we invested in Pixel a leader in cutting-edge earth imaging space technology. Back to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Now let me turn to our business outlook. For the first quarter of fiscal '23, we expect revenues to be in the range of $15.2 billion to $15.75 billion. This assumes the impact of FX will be approximately negative 8.5% compared to the first quarter of fiscal '22 and reflects an estimated 10% to 14% growth in local currency. For the full fiscal year '23, based upon how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results in U.S. dollars will be approximately negative 6% compared to fiscal '22. For the full fiscal '23, we expect our revenues to be in the range of 8% to 11% growth in local currency over fiscal '22, which includes an inorganic contribution of about 2.5%. For operating margin, we expect fiscal year '23 to be 15.3% to 15.5%, a 10 to 30 basis point expansion over fiscal '22 results. We expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an effective tax rate of 24% in fiscal '22. For earnings per share, we expect full year diluted EPS for fiscal '23 to be in the range of $11.09 to $11.41 or 4% to 7% growth over fiscal '22 results. For the full fiscal '23, we expect operating cash flow to be in the range of $8.5 billion to $9 billion, property and equipment additions to be approximately $800 million and free cash flow to be in the range of $7.7 billion to $8.2 billion. Our free cash flow guidance reflects a free cash flow to net income ratio of 1.1. Finally, we expect to return at least $7.1 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to shareholders. With that, let's open it up so that we can take your questions. Angie?"
},
{
"speaker": "Angie Park",
"text": "Thanks, KC. I would ask that you each keep one to question and a follow-up to allow us to as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question will come from the line of Lisa Ellis with MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Good stuff here. Just a question about the outlook for fiscal '23. Can you elaborate a bit further on what underlying macroeconomic outlook that you have embedded in guidance above and beyond the 6 points of FX translation. And maybe the broader question is sort of how, if at all, are you seeing the rising rate environment inflation sort of escalating dynamics of what we've been seeing all year long affecting your business?"
},
{
"speaker": "Julie Sweet",
"text": "Great. Thanks, Lisa. So yes, let me give you a little bit of color around our guidance assumptions. So our revenue range of 8% to 11% for fiscal '23, it includes 2.5% inorganic contribution, and that's compared to about 5% that we did in '22. And that would represent then about 8.5% organic growth at the upper end of our range. And so, we continue to see really strong demand for our services, Lisa. And as you've seen, the most recent estimate for IT Services continues to show the growth for our industry will be about 5%. So anywhere in our range, it will show us continuing to take share. But at the same time, while our growth is not directly correlated with GDP, we read the same things that you do. And the latest GDP estimate for most of the world's largest economies are lower in 2023 than 2022. So again, we're calling for double-digit growth at the top part of our range. Another year of double-digit growth, which would have us adding significant scale, yet again on top of our current $62 billion business."
},
{
"speaker": "Julie Sweet",
"text": "Maybe I'll add, Lisa, is that -- when we think about the macro environment, what we're really thinking about is what do our clients need, right? So as -- so -- and I talked a little bit about this last quarter, right, is this environment affects different industries differently. So, you've got those who are really tied to the supply chain disruption and the inflation continuing to focus on cost. But you also see that as the uncertainty increases. So over the last 90 to 120 days, you saw changes in the estimates around the GDP growth for 2023, it makes all clients really think about, okay, what's my resilience? Is there more that I can do? Can I take advantage of the environment to push through deeper cost cuts that require you to change behaviors? And so we really think about the environment as what does that mean we need to do to help our clients and how do we continue to pivot. And it's very similar if you think about what we did in the early days of the pandemic, where we've pivoted a lot to, for example, cloud using all of our learning organization. So that's the focus. So it's always an opportunity to better serve our clients."
},
{
"speaker": "Lisa Ellis",
"text": "Okay. Yes. Great color. And then just quick follow-up on bookings, realizing they're obviously always lumpy to quarter-to-quarter and the overall number this quarter was extraordinarily strong, continuing that 1.12 book-to-bill. But is there any -- was it sort of an unusual shift in mix into outsourcing and less consulting? Is there any color or call out there? Or is that just sort of the vagaries of the kind of quarterly fluctuations?"
},
{
"speaker": "KC McClure",
"text": "Sure. And so Lisa, as you mentioned, we feel really good about our bookings in Q4. It was our second highest bookings ever our highest also being this year in the second quarter. What I really liked about it was driven by broad-based demand. So across all markets and our services, and we peel it back. We had good book-to-bill in all dimensions of our business. And with outsourcing a record of almost $10 billion, and that was almost $1.3 billion more than what we did for our last record. And we do continue to see a strong pipeline going into the year, even with those the second best record bookings. But I will say that as we often do, we have seasonally lower bookings in quarter one and we are seeing that again this year."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Tien-tsin Huang with JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Just tacking on what Lisa just asked there with this larger book-to-bill in outsourcing relative to consulting. Is the shift to larger deals, does that tell you or should it tell us anything about client priorities? And I'm curious if that changes or even improves your visibility overall for fiscal '23, given you have so much more in the way of larger deals in the backlog."
},
{
"speaker": "Julie Sweet",
"text": "Yes. I mean I don't -- I mean, obviously, we've got larger deals. You have more visibility around larger deals just because they're larger deals and you see how it is. And certainly, how we think about the business so much, I mean, I think if you just take a -- your underlying question is what are clients focused on, right? And so what we do see is -- and what we actually -- more than just see what we are recommending is that leadership teams remain sort of focused on prioritizing where they can get good time to value, making sure that they are doing things that are material, not having 1,000 different pilots as opposed to actually getting to scale. And so a lot of that does lead to a focus on larger transformation deals, and it's tied to what we call total enterprise reinvention, right? What we're talking to clients about is systematically reinventing. And actually, we've got some research coming out at the end of September that says 68% of CFOs say they today have either three or more transformation programs either going right now or about to start in parallel. And so, what that really does mean that is that you've got more companies do what we've been talking about since the early days of the pandemic, which is systematic transformation. We'll try to do it faster and that does lead to larger programs. And probably the bigger impact for us is less about visibility, but those obviously convert to revenue differently."
},
{
"speaker": "KC McClure",
"text": "Yes. And maybe Tien-Tsin, I'll just add in terms of -- if you just look at our bookings this year from an outsourcing type of work compared to consulting type of work compared to our history over the last few years, there's really no difference, right? We actually have a slight percentage uptick in what we closed out this year in consulting type of work looking versus outsourcing. So there's no real difference in our mix."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Very good. No, that's really helpful. Just on the -- my follow-up on margins, if you don't mind. Just thinking about investment priorities, organic versus inorganic, I know it's a lower inorganic assumption on growth this year. But -- any update there in terms of the balance? And I'm wondering, I wrote down, I think you said 48% growth in cloud for the year. And I think back to the Cloud First investment you did, I think it was a $3 billion investment. It seems like you got a good return out of that. So, we see more investments like that at this point in the cycle? So yes, just think about organic versus inorganic investing."
},
{
"speaker": "KC McClure",
"text": "Yes. So, I'll take the inorganic point, and then I'll hand it over to Julie to give some more color. So, first of all, there's no change overall to our capital allocation strategy, right? So, we will continue to use V&A to fuel our organic growth. And so, you'll see the 2.5%, Tien-Tsin, is an inorganic contribution. It's generally in the zone of what we've done in previous years. And so maybe I'll also just take a chance to talk about what that means in terms of how we're going to invest in our business next year and how that relates to how we're seeing our profit because I think it's really important to point out that we're really proud of what we accomplished this past year in '22, where we did 10 basis points of expansion. And Tien-tsin, we were continuing to invest at scale in our business, right? And also in our people, particularly this year with managing wage inflation. So as we look through next year, we expect to continue to invest in our business. We expect wage inflation to continue. It's across all industries and across the globe. And for us, it's going to vary by geography by scale. And we will navigate that like we did this past year with a focus on pricing, which we all know can lag compensation a bit. But I just want to point out that we did see the benefit of improved pricing in our P&L in '22. And so again, we're going to do all of this while changing the mix of people in our contracts, the use of technology to absorb the higher investments that we're making organically and the higher investments that we're making in our people. But -- so it's really important that we continue on our investment profile. And with that, like I'd be really happy next year to land anywhere within the 10 to 30 basis points of op margin expansion. And I would say that based on how we're going to invest throughout the year, there's a bit more potential for us to have a more variability in the quarters as we go throughout fiscal year '23 on our way to 10 to 30 basis points of expansion for the year."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And Tien-Tsin, I just -- Tien-Tsin, I would just emphasize, we believe it is very important to continue to invest at higher levels in our business every year and that's our commitment. And it's been -- we think a big reason for our success is that through every cycle, we continue to invest."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from the line of Keith Bachman with BMO. Please go ahead."
},
{
"speaker": "Keith Bachman",
"text": "I wanted to ask to start with on the outlook. In particular, Julie, if there's any comments directional or otherwise, you could give on bookings. I understand you provided the revenue guidance in constant currency, even the backlog runoff of the booking -- tremendous bookings you've given so far, the revenue guidance seems very reasonable, if not a touch conservative. But as you indicated in your prepared remarks, you had record bookings this year. You're facing -- your clients are facing a deeper economic challenge. So, is there any comments you could give whether book-to-bill or the growth rates or any parameters on how we should be thinking about bookings this year? Because it seems like the trajectory there could be different from the revenue growth."
},
{
"speaker": "Julie Sweet",
"text": "Well, I'll let KC start, and then I'll add on."
},
{
"speaker": "KC McClure",
"text": "Yes. So Keith, maybe I'll start with a little bit more color on how we actually see revenue kind of breaking out for the year. So from a type of work perspective for the full year '23, we do see consulting revenue growth to be within the context of the 8% to 11% that we gave out overall, which remember has been 6% FX headwind embedded in that. We see consulting revenue to be high single digits to double digits. And outsourcing, we see being double digits. And when you think about what our bookings expectations are, while we don't guide to bookings, you should -- our view remains the same. We look for over a rolling four quarters period of time for book-to-bill to be over one."
},
{
"speaker": "Julie Sweet",
"text": "Great. And Keith, what I would just say is that -- remember, our focus is helping our clients create value within whatever environment that they are operating in, right? So -- and which is very different depending on your industry. So like pick right now, providers in the U.S., right? They are focused on cost cutting because they went through a tough time with COVID, they're behind in digitization, so they're investing there. And they have to because they're facing one of the most difficult labor markets they've ever had to now sort of resistance and difficulty in automating before. That is a completely different that a global consumer company like Unilever, we talked about in our script, who's reinventing everything that been on this journey for a few years, looking to the next thing, right? And they're dealing with supply chain disruptions, right, cost inputs. And so, that is how we continue to succeed is by understanding the depth of difference in our industry. We're using knowledge that we had from other industry to now accelerate what the providers are doing because they're now implementing SaaS solutions to connect their patients that we've been doing for years in retail, right, and in banking and in lots of other industries. So that our outlook for the year reflects our confidence that we are going to continue to be able to use that knowledge, stay close to our clients and deliver on what they need."
},
{
"speaker": "Keith Bachman",
"text": "Okay. Okay. My follow-up is then focused on free cash flow. The free cash flow guidance is a touch certainly lighter than what we had modeled and I think Street had modeled your margins continue to move higher. So I was just wondering what the puts and takes that you might want to call out with the free cash flow guidance for the year. And then I will see the floor. Many thanks."
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks, Keith. So, as you know, when we set our guidance, we always first start with looking at the ratio. So the ratio that we have in our free cash flow guidance is a very strong $1.1 billion free cash flow to net income ratio. So, we're happy with that. We also are allowing in that guidance a bit of an uptick in DSO from our current level. And then also, we are assuming we are going to have the FX impact of 6% that will obviously impact our free cash flow as well. And as you know, it's not unusual for us to start guidance at the beginning of the year with a free cash flow guidance range, that's below where we delivered the previous year."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from the line of Bryan Keane with Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Obviously, a lot of folks are asking about the macro. So just curious how the macro has changed for you guys over the last three months and how that's influenced your business because it doesn't really show up much in results? So just curious how you would frame that?"
},
{
"speaker": "Julie Sweet",
"text": "Well, as KC said earlier, our guidance for the year takes into account the current estimates for 2023 for GDP, which, as we all know, over the last sort of 90 days have decreased. So, we take that into consideration. And where we see that really affecting our business is our ability to help our clients and think about what to do, right? How do you execute a faster transformation? Are there new opportunities? I'm talking to a consumer goods client now, where we're helping them think about, well, how do we cut marketing and get more effective because they need growth, but marketing is one of the biggest spend areas for a consumer goods company. And by the way, let's not waste a good environment to be able to catalyze cultural and behavioral change as they think about things. So that's where we are seeing it. And otherwise, our guidance reflects -- as you know, it's not a one for one, but we obviously take into account the economic environment."
},
{
"speaker": "Bryan Keane",
"text": "Got it. Yes. Yes, I was just looking at Europe, in particular, up 26% in local currency, given all the concerns around Europe. It's just a pretty amazing number. It doesn't seem to have come off much from the growth rates you've been putting up."
},
{
"speaker": "Julie Sweet",
"text": "Yes. We're very proud of our European team because they are really close to our clients."
},
{
"speaker": "KC McClure",
"text": "Yes. And maybe, Brett, I'll give you a little bit of color on that as it relates to Q1. Let me give you a peel back a little bit on the revenue outlook that we have for the first quarter -- and when we look at the markets, we see all the markets for the first quarter within that 10% to 14% revenue range that we gave. They all have the potential to be double digits, and that includes Europe. And then also for the consulting type of work in Q1, we see a high single-digit to low double-digit growth range within that 10 to 14. And I would peel back consulting a little bit for you, too. Within consulting, we see the detect portion of consulting the systems integration, we'll have continued strong demand and S&C, we expect to be in lower single digits."
},
{
"speaker": "Bryan Keane",
"text": "No, that's really helpful and then just a quick follow-up, just thinking on KC on visibility. How has visibility changed at all, if at all, for Accenture? When you look out further on in the quarters as we get to Q4, it's obviously almost 12 months away, so it's probably a little bit hard to figure out exactly the right growth rates, but just thinking about the visibility of the business."
},
{
"speaker": "KC McClure",
"text": "I would say, Brian, that in terms of looking at the back half of the year, I mean, that's no different than the way it is, honestly, every year. We talked a lot about what we just mentioned on how we look at the macro in the market. But the back half of the year, we always -- it's always less certain at this time of the year than obviously the first quarter and the first half. Again, it's no different than what we have experienced every year."
},
{
"speaker": "Julie Sweet",
"text": "And as always, clients still -- most of our clients are calendar year, and they'll set their budgets, and we'll know more about that in January. So it's really the same."
},
{
"speaker": "KC McClure",
"text": "It is. It is."
},
{
"speaker": "Bryan Keane",
"text": "Got it, great. Congrats on the results."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "KC McClure",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from James Faucette with Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Appreciate all the commentary today as usual. Looking at kind of the supply and kind of how you're managing your own employees, et cetera, how does the shift in client priorities manifest itself in where and how your services are being delivered? And how is that influencing your talent strategy right now around pace of hiring, where you hire, et cetera?"
},
{
"speaker": "Julie Sweet",
"text": "Well, as you know, our -- we have a very deep competency in supply and demand. And actually, over the course of the last couple of years, we continue to innovate. We have an incredible what we call integrated talent control tower that is able to predict earlier and earlier in our sales cycle, where the skills will be needed and what type of skills. And so for us, this is just normal business, right? And keep in mind, technology demand is really incredible, right? I mean you saw that in our results. All strategies lead to technology. And we're super pleased with not only our performance there, but what we're seeing ahead as clients continue to build the digital core as fundamental to all of their other strategic needs. And our talent supply chain is able to see that, predict it, understand the skills and keep moving forward."
},
{
"speaker": "James Faucette",
"text": "That's great. And then turning to pricing, just wondering what the tone and tenor of pricing conversations have been? How those have progressed. And how are you building in? Or how should we think about what's being built into your formulation of outlook around magnitude of potential uplift to revenue from pricing versus margins, et cetera?"
},
{
"speaker": "KC McClure",
"text": "So let me just remind you that when I'm talking about pricing in my answer, I'm talking about the margin on the work that we've sold. And I'm really pleased that we've continued to see improvements in pricing. And we are seeing the benefits. I mentioned this earlier, but I'll just repeat it. We are seeing the benefits come through in our P&L. And we continue to focus on improvements in pricing as we enter into fiscal year '23. So I'm really I'm really pleased with the progress we've made."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question will come from the line of Jason Kupferberg with Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"text": "KC, I just wanted to pick up on your comment on one of the prior questions around -- I think you said strategy and consulting, up in the low single-digit range in Q1. So Curious if that's the same kind of range you anticipate for the full year fiscal '23? And is that below corporate average level, just reflective of the more kind of discretionary nature and growth-oriented nature of those services?"
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks, Jason. In terms of Q1, it's really just a few simple things. One, we got a tough compare. Two, is there's less -- when I mentioned less inorganic that really does also hit in essence in the S&C part. And then as Julie talked about, a lot of our S&C practitioners are really focused on some -- a lot of the larger transformational deals. And that just has Jason, a different revenue yield, and it bleeds in later throughout the year."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay. Understood. Maybe just turning to the supply side for a second. It looks like attrition was unchanged in Q4 versus Q3. And wondering what you're expecting there in fiscal '23 as well as what you're expecting for wage inflation relative to 2022 and whether or not some of the broader layoffs across other parts of the tech industry, is that taking some of the pressure off some of your supply metrics at all?"
},
{
"speaker": "KC McClure",
"text": "Yes. So I'll start, Jason, with the last part. I mean we had -- I'm really pleased with the way we were able to grow at scale profitably while managing the wage inflation in FY '22. And as we said a little bit earlier, but just to repeat, we do expect wage inflation to continue, and we have factored that into our guidance."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And look, I would just say to you that technology skills are in demand by both companies as well as our competitors because technology is at the core of strategy. And so, we're expecting to have a continued tight labor market, and we continue to expect us to really excel because despite that market, as you know, even this last year, we added 100,000 people. So, I don't -- the fact that there has been some layoffs in certain markets isn't really, I think, going to change much."
},
{
"speaker": "Angie Park",
"text": "Operator, we have time for one more question, and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Thank you. And that question will come from the line of Bryan Bergin with Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "I wanted to start on the growth outlook. Can you just give us a sense on how you're thinking about the second half trajectory just in the fiscal '23 range, just given a significant uncertainty? Just curious how you went about building that second half forecast. And then just within the year, are you expecting the strategic priorities to hold the double-digit growth? So across Song and Cloud First and Next or are any of those a little bit more exposed to potential slowdown and uncertainty?"
},
{
"speaker": "KC McClure",
"text": "Yes. So, I'll maybe just start with the overall outlook that we have read. You can see that we started with 8 to 11. I already gave the color on that. So -- and within that, obviously, we have a strong start at 10% to 14% growth. And in terms of really what that looks like for the rest of the year, I mean we'll continue to give guidance like we typically do as we progress through FY '23. I mean, as Julie mentioned, we see continued strong demand in our technology -- our areas of technology. And other than that, we don't really give any more guidance and kind of view on revenue outlook than what I've already shared."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And just -- I think it's always important that we are continuously thinking about both the near term, this fiscal year and the longer term and anchoring on the five forces of change for the next decade. And so, total enterprise reinvention, talent we talked about the investments we're making in sustainability. We just made a great acquisition that's on Carbon Intelligence, which is all about consulting around carbon getting to net-zero strategies. The Metaverse Continuum, small today. We're the leading enterprise user our own way of onboarding, but lots and lots of interest, and we're already making those investments and then the ongoing tech revolution. And so that's why as you think about our results, right, we are investing today and tomorrow and really are looking at the demand that we see over the next decade."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. Okay. And then it looks like just on M&A, it looks like you did close on more in 4Q than you had initially anticipated. So how should we think about the planned spend in fiscal '23 for M&A underlying the 2.5% growth contribution? And then just how do you start off the year in 1Q? What's the inorganic assumption in that outlook?"
},
{
"speaker": "KC McClure",
"text": "Yes, sure. So you're right, we did end up spending $3.4 billion for the year in '22 because we were able to get some of the regulatory approvals done this last fiscal year '22 that we weren't sure of the timing. And you'll see that because of that, while we're going to continue to always provide the inorganic outlook on a full year basis. So, that 2.5% is a full year. We're not -- we don't really do that by quarter because that again can also be lumpy. We're not going to continue to provide the capital allocation amount as we go into '23, just because it can really vary by the end of the year, and we'll be able to -- you'll be able to see it and we'll report it every quarter."
},
{
"speaker": "Julie Sweet",
"text": "Yes, it's probably worth reminding that last Q1, we had Umlaut and Novetta, which were both very large acquisitions come in, in Q1. So probably just good to remind everyone that's part of what's driving the Q1 S&C results too. Great. So before we wrap up, I do want to mention that Angie Park, who has been our Head of Investor Relations for the past six years, has been promoted to become the CFO for our really outstanding technology services business. Angie has been an absolutely incredible Head of IR and we're particularly grateful for how she has helped lead us through some of the most turbulent times in the history of Accenture. I know from speaking to our investors and analysts how much they've appreciated Angie's steady hand, her commitment to transparency and connection. And I know we'll all miss her in this role, but are extremely excited to see her start the next chapter of what has already been an incredible career. So thank you very much, Angie. And I am also pleased to welcome Katy O'Connor who will become our new Head of Investor Relations. She's got incredible experience. She's held many finance roles during her 25 years at Accenture. So please join me in welcoming Katy and I know she's looking forward to getting to know all of you in the days ahead. In closing, I do want to thank again all of our people and our managing directors for what you're doing every day. Our people, our actions and our results in FY '22 have positioned us to be very strongly going into FY '23 and create even more 360-degree value. And finally and very importantly, thank you to all of our shareholders for your continued trust and support. Thank you."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude our conference for today. The replay will be available after 10 a.m. Eastern today through December 16, 2022. You may access the AT&T executive replay system at any time by dialing 1 (866) 207-1041 and entering the access code 4002764. International participants may dial (402) 970-0847. Those numbers again are 1 (866) 207-1041 and (402) 970-0847 with access code 4002764. That does conclude our conference for today. We thank you for your participation and for using AT&T conferencing service. You may now disconnect."
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] | Accenture plc | 972,190 |
ACN | 3 | 2,022 | 2022-06-23 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by. Welcome to Accenture's Third Quarter Fiscal 2022 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Angie Park, Managing Director and Head of Investor Relations. Please go ahead.
Angie Park: Thank you, operator. And thanks everyone for joining us today on our third quarter fiscal 2022 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, and Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the fourth quarter and full fiscal year 2022. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie.
Julie Sweet: Thank you, Angie. And thank you everyone for joining. And thank you to our 710,000 people around the globe for their extraordinary work and commitment to our clients, which resulted in delivering another very strong quarter of financial results and creating significant 360 degree value beyond our financials for all our stakeholders. Here are a few highlights of the 360 degree value we created this quarter. Starting with our people, we continue to invest in their skills and they completed 10.6 million training hours, which averages to 16 hours per person this quarter. We are incredibly pleased to be recognized as a top 10 Great Place to Work for 2022 in countries representing 76% of our people, Argentina, Brazil, France, India, Japan, Mexico, the Philippines, UK and the United States. Specifically on the US list, we are particularly proud that Accenture jumped 38 spots in one year to rank number six. Overall, this is the 14th consecutive year that Accenture has been recognized by great place to work. Also a particular note in India, not only were we ranked number 10 by Great Place to Work, Business Today recognized Accenture in India as number four of the best companies to work for marking our 11th consecutive year on the list. All these recognitions reflect a tangible demonstration of our commitment to our people. The strong demand for our people and services and trust from our clients are once again seen in our strong bookings of $17 billion which represents 15% growth in local currency. Compressed transformation continues with another 18 clients with bookings over $100 million, bringing the total year-to-date to 74, which is 20 more than the same time last year. We had revenue growth of 27% in local currency, continuing to take significant market share growing nearly three times the market while delivering margin expansion of 10 basis points. Our ongoing investment in our communities was reflected this quarter, and how we are leveraging our expertise in digital learning and collaboration, partnering with UNICEF’s Generation Unlimited on the new passport to earning platform program to equip 10 million young people ages 15 to 24 with digital skills across 10 countries to prepare them for work. This program went live this quarter in India, the first and largest country of the 10. As always, well as always, we are staying close to our clients and our ecosystem partners to help them succeed today, and to anticipate the needs of the future. And our very strong financial results this quarter reinforced the trust our clients and partners have in our ability to do so. Over to you, KC.
KC McClure: Thank you, Julie. And thanks to all of you for taking the time to join us on today's call. We delivered very strong overall results in the third quarter, reflecting very strong double digit revenue growth across all dimensions of our business, as well as continued operating margin expansion, as we continue to invest at scale in our business and our people. We continue to lead the industry with these results, demonstrating the relevance of our services, and our trusted client and ecosystem partnerships. We continue to deliver on our shareholder value proposition, including both our financial results and creating 360 degree value for all our stakeholders. Let me summarize a few of the highlights of the quarter across our three financial imperatives. Revenues grew 27% in local currency. And we're above the top end of our guided range driven once again by broad based over delivery across all markets, services and industries. With all 13 industries growing double digits. We once again extended our leadership position, adding an incremental $9 billion in revenue year-to-date, with growth estimated to be nearly three times the market, which refers to our basket of publicly traded companies. Operating margin up 16.1% for the quarter was an increase of 10 basis points. We continue to drive margin expansions while making significant investments in our people and our business. We delivered EPS of $2.79, which represents 60% growth over fiscal ‘21 results, and includes $0.15 or 6% negative impact related to the disposition of our business in Russia. Finally, we delivered free cash flow, up $2.9 billion and returned $1.6 billion to shareholders through repurchases and dividends. We've made investments of $2.2 billion in acquisitions, primarily attributed to 27 transactions year-to-date. And we now expect to invest about $2.5 billion in acquisitions this year, with another $1 billion that we expect to close in Q1 given required regulatory approvals With that, let me turn to some of the details. New bookings were $17 billion for the quarter and overall book-to-bill of 1.0. Consulting bookings were $9.1 billion with a book-to-bill of 1. Outsourcing bookings were $7.8 billion with a book-to-bill of 1.1. We were very pleased with our bookings this quarter, which represent our second highest ever, and were in line to our expectations. Our bookings reflect 15% growth in local currency and 18 clients with bookings over $100 million. Looking forward, we continue to have a strong pipeline. Turning now to revenue. Revenues for the quarter were $16.2 billion, a 22% increase in US dollars and 27% in local currency reflecting the foreign exchange headwind of 5% compared to the 4% headwind provided in our business outlook last quarter. Adjusted for the actual foreign exchange impact, we were $160 million above our guided range. Consulting revenues for the quarter were $9 billion, up 24% in US dollars and 30% in local currency. Outsourcing revenues were $7.1 billion, up 19% in US dollars and 23% in local currency. Taking a closer look at our service dimension, strategy and consulting and technology services, both grew very strong double digits and operations grew strong double digit. Turning to our geographic markets. In North America, revenue growth was 23% in local currency driven by double digit growth and consumer goods retail and travel services, public service, software platforms and communications and media. In Europe, revenues grew 30% in local currency led by double digit growth in industrial, consumer goods, retail and travel services, and banking and capital markets. Looking closer at the countries, Europe was driven by double digit growth in Germany, the UK, France and Italy. In growth markets, we delivered 30% revenue growth in local currency driven by double digit growth in consumer goods, retail and travel services, banking and capital markets and public service. From a country perspective, growth markets was led by double digit growth in Japan and Australia. Moving down the income statement, gross margin for the quarter was 32.9%, compared with 33.2% for the same period last year. Sales and marketing expense for the quarter was 10.3% compared with 10.6% for the third quarter last year. General and administrative expense was 6.5% compared to 6.6% for the same quarter last year. Operating income was $2.6 billion in the third quarter, reflecting a 16.1% operating margin, up 10 basis points compared with Q3 of last year. Our effective tax rate for the quarter was 27.1% compared with an effective tax rate of 25% for the third quarter of last year. Diluted earnings per share were $2.79 including a $0.15 or 6% negative impact related to the disposition of our business in Russia, compared with diluted EPS of $2.40 in the third quarter last year. Days services outstanding were 44 days, compared to 41 days last quarter and 36 days in the third quarter of last year. Free cash flow for the quarter was $2.9 billion resulting from cash generated by operating activities of $3.1 billion, net of property and equipment additions of $195 million. Our cash balance at May 31 was $6.7 billion compared with $8.2 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the third quarter, we repurchased or redeemed 3.1 million shares for $972 million at an average price of $313.43 per share. As of May 31, we had approximately $3.7 billion of share repurchase authority remaining. Also, in May, we paid a quarterly cash dividend of $0.97 per share, for a total of $614 million. This represents a 10% increase over last year, and our Board of Directors declared a quarterly cash dividend of $0.97 cents per share to be paid on August 15, a 10% increase over last year. Finally, turning to the 360 degree value we are creating for all our stakeholders. We were very pleased to be ranked number 13 on 3BL Media's 100 Best Corporate Citizens in the United States report, which recognizes outstanding ESG transparency and performance against the Russell 1000, which are the largest companies in the US equity markets. For more information on a 360 degree value weeks, we are creating go to center 360 degree value reporting experience, which reflects new information each quarter. So in summary, we are extremely pleased with our results to date, and are now very focused on Q4 and closing out another very strong year. Now let me turn it back to Julie.
Julie Sweet: Thank you, KC. As we shared at our recent Investor and Analyst Day, we believe there are five forces that our clients must harness over the next decade and that in turn will drive our growth. Total enterprise reinvention, talent, sustainability, the Metaverse continuum and the ongoing tech revolution. Today, we continue to see strong demand across our markets, services and industries, which is being driven primarily by two of these five forces. Total enterprise reinvention, which involves transformation of every part of every business, leveraging technology, with new ways of working and engaging with customers and employees, and new opportunities for growth and talent, which requires every business to be able to access talent, be a talent creator, not just a talent consumer and to unlock the potential of their people. Compressed transformation continues with our clients seeking to execute bold programs in accelerated timeframes, often spanning multiple parts of the enterprise at the same time, when in the past, they may have taken a more sequential approach. This desire for speed with strong execution is driving our growth as clients partner with us because of the breadth and depth of our capabilities, the insights that come from our scale, global footprint and our deep functional industry and cross industry expertise. And they partner with us because they trust us. And because we are trusted partners with the technology ecosystem, which are also critical to our clients transformation. While the current macroeconomic environment affects industries and markets differently. The common theme across our clients is that all strategies whether for growth, cost or resilience, lead to technology, particularly cloud data and AI, and our clients turn to us to be able to effectively use technology to achieve their goals. Let me bring this demand environment to life. We help our clients execute total enterprise reinvention by helping them build their digital core, optimize operations and accelerate growth. Cloud Data and AI are fundamental to a strong digital core. We are working with the Clorox company, a leading multinational manufacturer and marketer of homecare, household and health and beauty products for consumers, as well as products and technologies for professional customers. The company is undertaking a broad digital transformation that will touch every aspect of the enterprise. We will help the company modernize business processes, streamline their operating model, leverages advanced data and analytic insights and establish a future ready technology foundation to deliver new levels of customer and consumer experiences, accelerate go- to-market activities and enable a more agile and resilient supply chain so they can lead and shape the consumer goods industry. We are helping new look, a global fashion retailer migrate its existing ecommerce platform to the cloud and strengthen its technology foundation to enable a seamless experience across stores, online, mobile and social media. AI and machine learning will create greater efficiency, increased sales and provide the flexibility to scale for growth and overcome industry disruption. The company is committed to infusing sustainability into their transformation roadmap, using innovation as an accelerator toward their own 2040 sustainability targets, all of which promises to keep the company in step with the store of the future, the speed of the fashion industry and the demands of their stakeholders. And as we build the digital course of our clients, security is more important than ever. Our integrated capabilities from identity to threat intelligence to manage security services to incident response are critical as our clients respond to increasing risks and expand their digital footprint. We are helping a large healthcare services provider assess their cybersecurity and business resilience levels. With much of their growth coming through mergers and acquisitions, technology and security have become more challenging to manage with multiple security providers, data centers and environments. We help design a cloud strategy and secure their backups in the cloud with an end-to-end cybersecurity approach that will provide flexibility as they continue to acquire more companies. We are also providing a managed security service from cyber resilience to threat intelligence to monitor their infrastructure and their security products, improving their ability to protect against future attacks. Our clients value our unique combination of capabilities from strategy and consulting to technology to manage services, because it enables us to deliver holistic solutions and expands their access to digital talent. We are helping INFRONEER Holdings, a Japan based infrastructure construction services company, digitally transform operations in finance and HR through a data driven approach. Through our managed services capabilities in our SynOps platform, we will help the company shift to intelligent operations by standardizing and automating key business processes, driving efficiency and productivity, reducing operating costs and providing greater opportunity for their people to focus on high value and strategic growth areas such as business design and digital experience. Shifting to the next digital frontier in the enterprise, our industry X capabilities are digitizing engineering and manufacturing to reimagine the products our clients make and how they make them and to build a greater resiliency, productivity and sustainability. We are partnering with a German multinational corporate manufacturer of luxury vehicles to develop an in-car software platform that will power the Central Intelligence Unit for personalized driver interaction information, convenience functions and entertainment. The platform provides a continuous flow of customer data to the automaker, enabling it to enhance vehicle functionality and create the superior customer experience, the automaker is renowned for. We are helping Albras, the largest producer of primary aluminum in Brazil to increase its productivity, energy efficiency and minimize greenhouse gas emissions by creating a new smelter control system operated over a new IoT architecture that utilizes cloud platforms for data storage and machine learning. Data insights will enable better visibility of gas emissions around the clock, allowing operations to be proactively managed, leading to increase energy efficiency and operational safety, as well as additional sustainability strategies to reduce their carbon footprint. Sustainability, one of the five forces shaping the next decade continues to be a growing priority area for our clients. And they value our ability to help them achieve their sustainability goals as part of their larger transformation such as the Albras example and directly as part of sustainability focused engagements, such as the work we are doing for Pos Malaysia Berhad, the national operator running Malaysia's largest post and parcel delivery network, we are helping Pos Malaysia Berhad to embrace a data driven approach to reducing emissions, cutting waste and upgrading its employees’ digital skills, best-in- class solutions for environmental, social and governance benchmarking, plus a sustainability implementation roadmap and skills for the future program will lead to dramatic reductions in direct waste and Scope 1 and 2 carbon emissions along with rapid progress and workforce upskilling. We continue to build our capabilities in this area both organically and inorganically. We are pleased that this quarter we announced three new sustainability acquisitions; Greenfish, akzente and Avieco, extending our reach and enhancing our ability to deliver deep skills and expertise to clients in ESG measurement and non-financial reporting, net zero strategy and regulation and real time data analytics. Our unmatched ability to access, create and unlock talent is valued by our clients as a key component of their compressed transformations, such as Pos Malaysia Berhad. In other cases, we help provide our clients access to talent through our managed services, and we help them become talent creators by having their shared services groups join Accenture where they can benefit from our ability to transform, upskill and provide new career pathways. For example, we are working with BNL a leading Italian banking group and subsidiary at BNP Paribas on a compressed transformation just 18 months from start to finish that will leverage our SynOps platform, maximize our clients’ existing talent and reduce total cost of ownership. We will consolidate data to provide deeper analytic insights and a better customer experience with tailored services and faster fulfillment times for customer requests. As part of this transformation, more than 500 people from their team will move to Accenture, where we will leverage their industry specific skills while also providing opportunities for professional development, enabling BNL to focus on strategic growth and benefit from this upskilling. We also do work with our clients that is primarily focused on their talent agenda. For example, we're collaborating with a large utility who is creating 1000s of clean energy jobs in areas like renewable electricity generation, energy saving homes and buildings and sustainable transportation. They're doing so for unemployed, underemployed and low to middle income residents. We are developing a recruitment, employment and tracking platform that matches people’s skills, with available positions leveraging AI and market insights. This solution reduces hiring time, improves the candidate experience and unlocks talent potential to create jobs for the underrepresented residents who need the most. We are uniquely positioned to help our clients drive cost efficiencies and their growth agenda. As you may have seen Accenture Interactive will now go-to-market as Accenture Song to reflect the fundamental change in the way companies must engage with customers, and the incredible speed at which they need to operate and innovate. Song is uniquely operating at the intersection of creativity, technology and intelligence. To help our clients reinvent connections and meaningful experiences, including sales, commerce, marketing, new business platforms, and the Metaverse continuum. We are helping a North American multi brand retailers scale their digital business and accelerate growth while reducing operational costs up to $100 million over the next five years. Together, we are designing and implementing a new multiproduct platform to improve the customer experience and enable the use of data and insights to drive increased engagement and better business performance overall. While still very early, we are seeing our clients look to take advantage of the Metaverse, another of the five forces. For example, we are collaborating with an international property developer, MQDC to develop their business model and design their customer experience in the Metaverse. As you can tell, this continues to be an exciting time for Accenture as the depth and breadth of our business allows us to help our clients with innovative and impactful work. Back to you, KC.
KC McClure: Thanks Julie. Turning to our business outlook. For the fourth quarter of fiscal ’22, we expect revenues to be in the range of $15 billion to $15.5 billion. This assumes the impact of FX will be about negative eight, compared to the fourth quarter of fiscal ‘21 and reflects an estimated 20% to 24% growth in local currency. For the full fiscal year ’22, based on how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in US dollars will be approximately negative 4.5% compared to fiscal ‘21. For the full fiscal ’22, we now expect our revenue to be in the range of 25.5% to 26.5% growth in local currency over fiscal ‘21 which continues to assume an inorganic contribution of roughly 5%. For operating margin, we continue to expect fiscal year ‘22 to be 15.2%, a 10 basis point expansion over fiscal ‘21 results. We now expect our annual effective tax rate to be in the range of 23.5% to 24.5%. This compares to an adjusted effective tax rate of 23.1% in fiscal ‘21. For earnings per share, we now expect our full year diluted EPS for fiscal ‘22 to be in the range of $10.61 to $10.70 or 21% to 22% growth over adjusted fiscal’ 21 results. This guidance range reflects a negative $0.14 impact from the updated FX guidance, partially offset by the increase in revenue guidance. For the full fiscal ’22, we continue to expect operating cash flow to be in the range of $8.7 billion to $9.2 billion. Property and equipment additions to be approximately $700 million and free cash flow to be in the range of $8 billion to $8.5 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $6.5 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to shareholders. With that, let's open it up so we can take your questions. Angie?
Angie Park: Thanks KC. I would ask that you each key to one question and a follow up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: [Operator Instructions] And our first question is from Tien-Tsin Huang.
Tien Huang: Thank you so much. Good morning. Really good results here. I want to ask on the -- let me ask bookings, which came in line with your expectations. In the book-to-bill and a quarter look like more a like pre-pandemic levels on tough comps. So, KC, I heard the strong pipeline comment. Just wondering, can we expect book-to-bill above 1.0 but maybe below the 1.1 or higher that we saw during the pandemic, just trying to better understand how the pace of bookings might be changing here beyond the comp?
KC McClure: Yes, thanks, Tien-Tsin. So let me just start with anchoring to what we saw this quarter in bookings and our pipeline, and I'll talk then a little bit about what we expect for Q4. So as you mentioned, we were really pleased with our book-to-bill this quarter. And you talked about our tough comps, we did 30% growth in consulting. And we have year-to-date of 1.1 book-to-bill in consulting through Q3. We're very pleased with that. And outsourcing, we did 23% revenue growth, again over tough comps from last year in the quarter at 1.2 year-to-date book-to-bill. So as we look ahead at Q4, we do see continued very strong revenue growth of 20% to 24%. So you heard that in our guidance. And we do think bookings and outsourcing, bookings for both, excuse me, revenue for both consulting and outsourcing, both going to be in that range. So we have another strong quarter in consulting and outsourcing revenue growth. And on top of that Tien-Tsin, we do see another strong sales quarter in Q4. And we feel good about both our consulting and our outsourcing pipeline. So hopefully that gave you enough color on where we see bookings and the rest of the year playing out.
Tien Huang: Got it. So balance across the two, which is great. So maybe my quick follow up that everyone's been asking us. So I thought I'd ask you guys, Julie, specifically here maybe for you just how recession ready is Accenture, right? With what the stock market is telling us? How's Accenture different or maybe similarly positioned to what we've seen in past down cycles? Any quick comments on them? Thank you.
Julie Sweet: So I think, Tien-Tsin, so we don't predict the macroeconomic. So what we do is really focused on what has helped us to be successful. And obviously, every financial situation is going to be different to pandemic, we don't know how this is going to be versus what was happening a decade ago. And so let me just focus on why we are in a strong position. And that is, first of all, what's driving today is total enterprise reinvention. And so that means companies are trying to transform using tech data and AI around the enterprise. And we've been investing for a decade to be in the position that were relevant to the enterprise. And so we can do everything as you saw in our examples from HR and finance to manufacturing, right to in the insurance industry, underwriting and claims, right, so and it's really the entire enterprise that we're relevant to, and that'll gives us a huge power to help our clients. And you see that's happening right now with the inflationary environment, you've got consumer goods companies focused very much on cost, as well as growth. And we're able to help them do both, right. And on the other hand, you've got, say the energy companies that have had a really rough cycle, who now have the ability to invest more continuing on their cost discipline, but trying to also drive their transition to clean energy right into advance their digitization. And so our diversity in both what we can do, and our diversity in industries, is extraordinarily helpful. And then as you think about why we're a leader today, I just want to sort of make sure people understand the power of the fact that we can do everything from strategy to consulting, to manage services. So if you just take a consumer goods company, one of the biggest areas of spend is in marketing. We have amazing strategists at Accenture, right. It's a huge group, it's really, really relevant. And what they bring is not simply here, let's go after your marketing spend that looks like the biggest spend, what they can say is, and let me explain to you that the trend is to digitize to use hubs to not be as geographic specific. And let me show you where we've actually executed that and are managing that service for some of the leading companies. That's what our strategists can uniquely bring. And we can talk to our clients and say, and we can either help you build the capability, or we can do it on your behalf because we can access the talent, we can move you more quickly. And so as we think about why are we strong today, and how do we deliver on our enduring shareholder value proposition and growing faster than market delivering large and expansive, returning to shareholders and delivering 360 degree value? It's really based on this unique set of capabilities, these very strong trusted relationships. And then, of course, all of this underpinned by technology, where we're a powerhouse and we are the leading partner of the largest and technology companies in the world. Operator, next question.
Operator: We will next go to the line of Lisa Ellis with MoffettNathanson.
Lisa Ellis: Hi, good morning. Thanks for taking my question. I guess I'll take the attrition one, it looks like attrition after coming down a bit the last couple of quarters re uptick a bit this quarter. Can you just talk about perhaps any color there any underlying dynamics? And how is the attrition environment looking going forward? Thank you.
Julie Sweet: Yes, sure, Lisa. I mean, usually we see an uptick in attrition from Q2 to Q3. We actually also see seasonally another uptick in Q4, which we'll expect to see. So this is kind of in line with prior patterns. And again, it's primarily driven by India at the lower end of our pyramid, which is highly competitive. At the same time, we're able to hire for the demand we see. And so, and also, as we've commented before, our overall executive retention, which is the people who are driving our business every day, it continues to be high. So not a lot of change and these are really seasonal upticks.
Lisa Ellis: Okay, got it. And maybe a follow up on that. And then also on Tien-Tsin’s question related to R word, the recession word. What are the types of steps can you just remind us? Like, if you do start to see a slowdown in the business, kind of what are the adjustments that Accenture makes or can make quite quickly to react to changing demand environment, realizing that you're often at the kind of front end of the spear on that, given your strength in consulting in a lot of shorter duration projects.
Julie Sweet: So, I mean, at the core of our businesses, how we manage supply and demand, right, and so we're, our ability to, we do have high attrition, right? So our ability to not for example, when I say high attrition, meaning our industry has higher, high attrition, and so our ability to not hire to replace that attrition, right. So our core competency is managing supply and demand. And we have an ear to the ground with our clients, but we also have a lot of analytics around what we're seeing in open demand, what we're seeing in our pipeline. So we manage our business with great rigor and discipline, and we'll continue to do that throughout the cycle and of course, I just want to make sure we're not walking past an incredible quarter from revenue and a booking. And as KC said, we see continued strong demand going into the next quarter with another strong bookings quarter and another strong revenue quarter.
Operator: And next we go to line of Jason Kupferberg with Bank of America.
Jason Kupferberg: Good morning, guys. I just wanted to start with a clarification on the full year EPS guidance, it sounds like you're now absorbing an extra $0.29 of headwind, relative to where you were last quarter or the $0.15 from exiting Russia and the $0.14 from incremental FX headwind. Is that accurate?
KC McClure: So, Jason, that is accurate in that. The $0.15 for Russia. That's absolutely accurate. And then we have an additional $0.14 from the updated from the guidance that we gave you last quarter that we are absorbing. So you're correct.
Jason Kupferberg: Right. So you're still maintaining the lower half of the EPS guidance from last quarter, despite absorbing an extra $0.29. Okay. I just wanted to make, okay.
KC McClure: That’s right. I mean, I think the key thing that you're asking and the key point, I want to make sure that we are getting across is that there's no change to our business, right, fundamentals and our business performance.
Jason Kupferberg: That's right.
KC McClure: We actually had a bit of an increase in our revenue guidance, which helps us partially offset the $0.14 drag that we have from FX. So really strong, we continue to see really strong fiscal operations, we just can't absorb completely, all of that large FX movement that we saw from last quarter to this quarter. That's all.
Jason Kupferberg: Of course. And I guess it's encouraging to hear that there doesn't seem to really be much change at all in the demand environment. Obviously, there's been a lot of worry and wonder about that. But can you maybe just talk to us about like nuances of how client conversations have been evolving over the past three months? Any change in clients decision making patterns or clients doing more recession preparation on their end?
Julie Sweet: Sure. And so, first of all, as always, we call it like we see it. So today, we see strong demand and we're not seeing a change in decision making. What we are seeing is a shift depending and the industry and the market on what clients are asking for it. So for example, in the industry is like a consumer goods industry, you're seeing a lot more focused on costs than a year ago, right, with CEO saying, hey, Julie, I always used to talk to you about growth. Can we talk about growth and cost? Right, you're seeing more investment going into help me do more with less. And at the core of that is Cloud Data AI, you also see a big focus on can we go faster. And I was just meeting with a CEO last week who said, Julie, I just -- can you just look at our strategy? And are we being transformational enough, right? Are we challenging ourselves to go fast enough? And this is where the experience that we have of doing this particularly over the last two years where we saw this compressed transformation is so important. I was just speaking with an energy company last week, where they, like a lot of companies early on when digital transformation started, say, five, six years ago on the front office, they've been doing a bunch of experiments of digital twins around and they're saying to us, okay, Julie, help us understand where we're going to get the most value, but how do we scale and that's the unique combination we have of like, we can understand from a strategic perspective, where's the biggest value, but I can then take like, let me take you this company over here, different industry that's been doing digital twins that we've just been massively scaling over the 18 months, let's share with you the lessons learned on how to do that, because it is the next digital frontier, there isn't as much experience. And now we'll help you go faster. So the context is different depending on the industry. I mean every CEO is of course, focused on the macroeconomic, and people like to use that as a catalyst for doing some of the harder things around cutting costs. And what we do as Accenture because we can help on all aspects of that. We also can embed in a growth conversation. You saw the example we used as big retailer in earnings where we're helping them grow and we're taking out $100 million in costs at the same time, right. And that's what makes us so unique and that's why we will just continue to stay very focused. We're doing a lot in supply chain that those conversations accelerated in Europe for obvious reasons. But they're really it's a global phenomenon. And we're doing a ton here. And of course, as we think about our business, when we look at the demand, we also look at, do we need to upskill anyplace because we're seeing more demand, say in supply chain, or more demand in a particular industry? And that's where the agility of our learning, as you may recall, in the first six months after the pandemic we upskilled 100,000 people to shift to cloud and collaboration technology. So that's how we stay very close. And then we use these other tools, we have like our ability to upskill to make sure that we are responding to what our clients need.
Operator: And our next question is from Ashwin Shirvaikar.
Ashwin Shirvaikar: Thank you. Good quarter, folks. Demand trends still seem strong. I appreciate the qualitative remark on the revenue focus versus cost focus. We already saw take down here in the percent of revenues from consulting as well. I guess the question is around whether you believe that consulting, outsourcing balance might maybe get back down to 50:50 if you anticipate air pocket down the road, because outsourcing work just tends to have longer ramps. Could you to kind of talk through that?
KC McClure: Yes, sure. Ashwin, happy to and so just in terms, I'll start with the last part first, in terms of just our mix, right, we and I'm not going to guide anything into next year. But if you just look historically, at our mix, it can move around 1% or 2% between consulting and outsourcing. But it's generally been as , three years in the zone of like about 55% consulting and about 45% outsourcing, So that and we're seeing the same this year. So that's the first point. And then in terms of consulting, we are really pleased with our performance to date. And as you know, when we, I gave you some -- I gave guidance for consulting for Q4, but just a reminder, there are book-to-bill is really strong for the year in consulting. And anything is as you know, over one around one book-to-bill consulting, we consider strong, we also look at it over trailing four quarters, right. So but I -- we will give guidance for you in September of -- in September for next year. And that's where we can give you some sense of what the outsourcing is, consulting type of work will be next year. But now, you can look at our patterns and see it's about 55%, 45%.
Ashwin Shirvaikar: Got it, no, thank you for that. I guess the follow up is on M&A. I think you might have mentioned in the past quarter that your M&A spend target this year was closer to $4 billion, it looks like you might not get there. Any color around where valuations easing? What's sort of going on with regards to sort of the strategic approach to M&A? Are you now looking, is that also changing, given the revenue versus cost focus? Or is that just a longer term view? Thought around that would be great.
KC McClure: Yes, I'll let Julie talk about the strategy. But just to recap what I did say, you're right, we had previously said we thought it would be about $4 billion. We now think it is going, we’ve done $2.2 billion to date, 27 transactions year-to-date. We now think it will be about $2.5 billion. And that's because there's about $ billion, Ashwin, that is going to go into next year because of required regulatory approvals. So that really is the biggest difference between the $2.5 billion and $4 billion that we talked about.
Julie Sweet: Yes. And from a strategic point of view, we continue to believe that the mergers and acquisition, V&A as we call it is critical to the way we grow. And there's three big reasons, right. The first is we will do it for scale. So you saw us do a lot of cloud acquisitions, for example, because we wanted to capture the momentum in the market and to build scale in area, in countries like we did a big one in France, for example, where we didn't have the scale and we had a lot of market momentum. The second reason we do it, is to move into adjacencies. So you saw a spilled Accenture Song and interactive over years, we've used that very effectively with industry X. So you saw that enough big acquisition last year, for example and that continues. And you starting to see that now in sustainability. We just announced three acquisitions. So where we're really built going into new areas with new skills and capabilities and then third, we're always looking to sort of continue to add in our industry and functional expertise and that strategy has served as well. And we continue to believe that that's an important part of our growth going forward.
Operator: Our next question is from Bryan Keane with Deutsche Bank.
Bryan Keane: Hi, guys. Good morning and congrats on the results. Wanted to specifically to ask about Europe continues to show robust growth, 30% growth, and I think, KC call that Germany, France, UK, Italy. So lots of concern about the unfortunate situation and war in Ukraine. Is there anything that you guys are seeing that could be in the go forward impacting Europe? Because right now, we're not seeing any weakness in those results.
Julie Sweet: And we're not seeing any weakness in those results. And so we continue to really stay close to our clients. There's, as I talked a little bit about earlier, there's a shift in focus in many of the more impacted industries, and across the board around things like energy efficiency, right. And so our strengths in, for example, manufacturing and sustainability is helping us drive conversations and helping our clients get more energy efficient, for obvious reasons, given the background in Europe, supply chain, lots going on in supply chain, as you think about what we're doing there, we're doing everything from helping them have greater insight. So we're working with a food retailer, for example, to understand how they can anticipate disruptions better and earlier using data and analytics. So supply chain is a big topic. And then costs because everyone's anticipating, it leads to continuation of the inflationary environment that we're seeing globally. And so cost becomes a big focus. So it's today, again, all roads lead to not just technology data and AI, but how do you use it to transform the business? Which is our sweet spot, right? That is what we do. We partner with the technology companies and our clients to help them use these technologies to get results. And that's what we're doing today. And that's the environment that we're seeing our clients need.
Bryan Keane: Got it, no, that's helpful. And then maybe just as a quick follow up, KC. Any thoughts on the latest on pricing and Accenture’s ability to maintain or even get pricing increases in some different areas where the demand is strongest? Thanks so much and congrats again.
KC McClure: Okay. Yes, so we were -- we were pleased that we did see, again, improvement, Bryan in our pricing. And again, reminder that pricing, when we talked about pricing, it's the margin on the work that we sold. And we really need to continue to focus on that, which is what we are doing to offset what we're continuing to see in wage inflation in our business, which as we all know is in all industries, it really is across the globe. So and we are seeing some improvement coming from pricing in our P&L. So I'm pleased with that. And at the same time, as you would expect, we're changing the mix of people on our contracts, and also using technology to help offset the impact of wage increases. So again, very focused on pricing. That's the biggest lever that we have but there -- that they all of these improvements together are still lagging the compensation increases. But we're still very, very satisfied.
Operator: And our next question is from Bryan Bergin with Cowen.
Bryan Bergin: Hi, good morning. Thank you. Follow through on bookings, any changes in bookings profiles as it relates to contract duration? And are you seeing any uptick in the interest of clients to sell captive operations here? I'm curious if that type of transaction is picked up.
KC McClure: There really is no change at all in terms of the profile for bookings as it relates to duration.
Julie Sweet: Yes. And I'd say on the captive side, it's more of a steady, kind of, it's been steady. I don't think I'd say picked up or not picked up. It's been steady for the last couple of years.
Bryan Bergin: Okay, and then just a question on Accenture Song. Can you talk about some of the operational changes that have been reported in that business as it relates to the consolidation of agency brands and what that does for you?
Julie Sweet: Yes. I think a couple of things, I start with the rebranding is really more around reflecting what we’re doing today in Accenture Interactive and that brand was kind of old because it started a decade ago, right where, and it doesn't really reflect kind of the particularly post pandemic, which is really a complete use of technology, bringing in creative using data and AI and moving very, very fast. So this is where you've got examples like we've given in the past, like a Jaguar Land Rover, where they're using managed services to personalize experiences, and they're moving very, very quickly. And so Song just really captures better what, in fact, we are doing there. And from an operational perspective, it's just a natural evolution to bring together some of the brands that we've acquired over the years as you know, we built Accenture Song through a very deliberate, M&A strategy. And so I think it bit more of just kind of the natural evolution.
Angie Park: Great. And operator, we have time for one more question, and then Julie will wrap up the call.
Operator: Very good. That will come from James Faucette with Morgan Stanley.
James Faucette: Great, thank you very much. And thanks for all the details this morning. Wanted to ask a couple more nuanced questions around Accenture’s operations right now. And first, starting with the bench. How would you characterize your bench right now? Are there pockets of resources that are underutilized versus over utilized? And how much of an operational impact could that be having right now, if any?
KC McClure: James, thanks for the question. I will just make just focus on the key metrics that we look at. And we report every quarter as it talks about our people and the usage of our people, clients. We're at 91%, which is really in the zone of utilization that we like to be in, it's a little running a little bit hot throughout the past year and a half since pandemic and we're at 91%. So that's a very healthy range that we're good with.
James Faucette: Got it. And then a lot of the conversation this morning, obviously is focused on macro and demand, et cetera. But are there any industry groups and/or service dimensions that you're expecting to accelerate versus decelerate, especially as you know the customers seem to be at least modifying a little bit. The conversations they are having to focus a little more on cost versus growth, et cetera. Are there key parts of that -- those different industries and segments that could see changes as a result?
KC McClure: Maybe I'll just anchor to what we saw this quarter. And I can hand it over to Julie to give a little bit of color on that. But we did see all 13 industries this quarter have double digit revenue growth, right. And when we talked about bookings, we had strength across all of our markets, services and industry.
Julie Sweet: Yes, and I would just add that, remember, an industry isn't a monolith, right? So you had coming out of the pandemic, in almost every industry, you had some percentage, we've talked about this, who went really fast. Now you've got others who are saying, wait a minute, we're seeing the impact of some of the leaders move faster on their digital transformations. And so for example, those who moved early to the cloud, we're now talking about the next phase of how do you utilize the cloud to drive new things. Remember, our little formula cloud is. The cloud is the foundation, data is the driver and AI is the differentiator. And so if you've moved to the cloud, now, you're using the data in that differently, right, as opposed to those who still need to move to the cloud. Like we are very early in the transition. And so the way we think about it is if you have a total enterprise we walk our clients through, what's the digital core, you need to have? Where are you on the maturity scale? And how do you prioritize? And so while we look at the industries is growing double digits, what's actually happening within the industry really depends on where you are on the maturity curve. And that's what drives our business, right? Because we can help the clients who are leaders go to the next level, and we're helping the ones that are behind trying to leapfrog. And so I think it's important to look at in that sense is that you need to have granular deep understanding of the industries and help our clients. We help our clients with that to know where to go next.
James Faucette: All right, thanks for that color. Well, thanks everyone. Great. Thanks James. All right. In closing, we really appreciate everyone for joining us today. And thank you again to all of our people and our leaders for another outstanding quarter in every dimension from our financial results to our 360 degree value beyond our financials. And thank you to all of our shareholders for your continued trust and support. We'll work hard every day to continue to earn it all the best.
Operator: Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to Accenture's Third Quarter Fiscal 2022 Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to Angie Park, Managing Director and Head of Investor Relations. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, operator. And thanks everyone for joining us today on our third quarter fiscal 2022 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, and Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the fourth quarter and full fiscal year 2022. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie. And thank you everyone for joining. And thank you to our 710,000 people around the globe for their extraordinary work and commitment to our clients, which resulted in delivering another very strong quarter of financial results and creating significant 360 degree value beyond our financials for all our stakeholders. Here are a few highlights of the 360 degree value we created this quarter. Starting with our people, we continue to invest in their skills and they completed 10.6 million training hours, which averages to 16 hours per person this quarter. We are incredibly pleased to be recognized as a top 10 Great Place to Work for 2022 in countries representing 76% of our people, Argentina, Brazil, France, India, Japan, Mexico, the Philippines, UK and the United States. Specifically on the US list, we are particularly proud that Accenture jumped 38 spots in one year to rank number six. Overall, this is the 14th consecutive year that Accenture has been recognized by great place to work. Also a particular note in India, not only were we ranked number 10 by Great Place to Work, Business Today recognized Accenture in India as number four of the best companies to work for marking our 11th consecutive year on the list. All these recognitions reflect a tangible demonstration of our commitment to our people. The strong demand for our people and services and trust from our clients are once again seen in our strong bookings of $17 billion which represents 15% growth in local currency. Compressed transformation continues with another 18 clients with bookings over $100 million, bringing the total year-to-date to 74, which is 20 more than the same time last year. We had revenue growth of 27% in local currency, continuing to take significant market share growing nearly three times the market while delivering margin expansion of 10 basis points. Our ongoing investment in our communities was reflected this quarter, and how we are leveraging our expertise in digital learning and collaboration, partnering with UNICEF’s Generation Unlimited on the new passport to earning platform program to equip 10 million young people ages 15 to 24 with digital skills across 10 countries to prepare them for work. This program went live this quarter in India, the first and largest country of the 10. As always, well as always, we are staying close to our clients and our ecosystem partners to help them succeed today, and to anticipate the needs of the future. And our very strong financial results this quarter reinforced the trust our clients and partners have in our ability to do so. Over to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie. And thanks to all of you for taking the time to join us on today's call. We delivered very strong overall results in the third quarter, reflecting very strong double digit revenue growth across all dimensions of our business, as well as continued operating margin expansion, as we continue to invest at scale in our business and our people. We continue to lead the industry with these results, demonstrating the relevance of our services, and our trusted client and ecosystem partnerships. We continue to deliver on our shareholder value proposition, including both our financial results and creating 360 degree value for all our stakeholders. Let me summarize a few of the highlights of the quarter across our three financial imperatives. Revenues grew 27% in local currency. And we're above the top end of our guided range driven once again by broad based over delivery across all markets, services and industries. With all 13 industries growing double digits. We once again extended our leadership position, adding an incremental $9 billion in revenue year-to-date, with growth estimated to be nearly three times the market, which refers to our basket of publicly traded companies. Operating margin up 16.1% for the quarter was an increase of 10 basis points. We continue to drive margin expansions while making significant investments in our people and our business. We delivered EPS of $2.79, which represents 60% growth over fiscal ‘21 results, and includes $0.15 or 6% negative impact related to the disposition of our business in Russia. Finally, we delivered free cash flow, up $2.9 billion and returned $1.6 billion to shareholders through repurchases and dividends. We've made investments of $2.2 billion in acquisitions, primarily attributed to 27 transactions year-to-date. And we now expect to invest about $2.5 billion in acquisitions this year, with another $1 billion that we expect to close in Q1 given required regulatory approvals With that, let me turn to some of the details. New bookings were $17 billion for the quarter and overall book-to-bill of 1.0. Consulting bookings were $9.1 billion with a book-to-bill of 1. Outsourcing bookings were $7.8 billion with a book-to-bill of 1.1. We were very pleased with our bookings this quarter, which represent our second highest ever, and were in line to our expectations. Our bookings reflect 15% growth in local currency and 18 clients with bookings over $100 million. Looking forward, we continue to have a strong pipeline. Turning now to revenue. Revenues for the quarter were $16.2 billion, a 22% increase in US dollars and 27% in local currency reflecting the foreign exchange headwind of 5% compared to the 4% headwind provided in our business outlook last quarter. Adjusted for the actual foreign exchange impact, we were $160 million above our guided range. Consulting revenues for the quarter were $9 billion, up 24% in US dollars and 30% in local currency. Outsourcing revenues were $7.1 billion, up 19% in US dollars and 23% in local currency. Taking a closer look at our service dimension, strategy and consulting and technology services, both grew very strong double digits and operations grew strong double digit. Turning to our geographic markets. In North America, revenue growth was 23% in local currency driven by double digit growth and consumer goods retail and travel services, public service, software platforms and communications and media. In Europe, revenues grew 30% in local currency led by double digit growth in industrial, consumer goods, retail and travel services, and banking and capital markets. Looking closer at the countries, Europe was driven by double digit growth in Germany, the UK, France and Italy. In growth markets, we delivered 30% revenue growth in local currency driven by double digit growth in consumer goods, retail and travel services, banking and capital markets and public service. From a country perspective, growth markets was led by double digit growth in Japan and Australia. Moving down the income statement, gross margin for the quarter was 32.9%, compared with 33.2% for the same period last year. Sales and marketing expense for the quarter was 10.3% compared with 10.6% for the third quarter last year. General and administrative expense was 6.5% compared to 6.6% for the same quarter last year. Operating income was $2.6 billion in the third quarter, reflecting a 16.1% operating margin, up 10 basis points compared with Q3 of last year. Our effective tax rate for the quarter was 27.1% compared with an effective tax rate of 25% for the third quarter of last year. Diluted earnings per share were $2.79 including a $0.15 or 6% negative impact related to the disposition of our business in Russia, compared with diluted EPS of $2.40 in the third quarter last year. Days services outstanding were 44 days, compared to 41 days last quarter and 36 days in the third quarter of last year. Free cash flow for the quarter was $2.9 billion resulting from cash generated by operating activities of $3.1 billion, net of property and equipment additions of $195 million. Our cash balance at May 31 was $6.7 billion compared with $8.2 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the third quarter, we repurchased or redeemed 3.1 million shares for $972 million at an average price of $313.43 per share. As of May 31, we had approximately $3.7 billion of share repurchase authority remaining. Also, in May, we paid a quarterly cash dividend of $0.97 per share, for a total of $614 million. This represents a 10% increase over last year, and our Board of Directors declared a quarterly cash dividend of $0.97 cents per share to be paid on August 15, a 10% increase over last year. Finally, turning to the 360 degree value we are creating for all our stakeholders. We were very pleased to be ranked number 13 on 3BL Media's 100 Best Corporate Citizens in the United States report, which recognizes outstanding ESG transparency and performance against the Russell 1000, which are the largest companies in the US equity markets. For more information on a 360 degree value weeks, we are creating go to center 360 degree value reporting experience, which reflects new information each quarter. So in summary, we are extremely pleased with our results to date, and are now very focused on Q4 and closing out another very strong year. Now let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. As we shared at our recent Investor and Analyst Day, we believe there are five forces that our clients must harness over the next decade and that in turn will drive our growth. Total enterprise reinvention, talent, sustainability, the Metaverse continuum and the ongoing tech revolution. Today, we continue to see strong demand across our markets, services and industries, which is being driven primarily by two of these five forces. Total enterprise reinvention, which involves transformation of every part of every business, leveraging technology, with new ways of working and engaging with customers and employees, and new opportunities for growth and talent, which requires every business to be able to access talent, be a talent creator, not just a talent consumer and to unlock the potential of their people. Compressed transformation continues with our clients seeking to execute bold programs in accelerated timeframes, often spanning multiple parts of the enterprise at the same time, when in the past, they may have taken a more sequential approach. This desire for speed with strong execution is driving our growth as clients partner with us because of the breadth and depth of our capabilities, the insights that come from our scale, global footprint and our deep functional industry and cross industry expertise. And they partner with us because they trust us. And because we are trusted partners with the technology ecosystem, which are also critical to our clients transformation. While the current macroeconomic environment affects industries and markets differently. The common theme across our clients is that all strategies whether for growth, cost or resilience, lead to technology, particularly cloud data and AI, and our clients turn to us to be able to effectively use technology to achieve their goals. Let me bring this demand environment to life. We help our clients execute total enterprise reinvention by helping them build their digital core, optimize operations and accelerate growth. Cloud Data and AI are fundamental to a strong digital core. We are working with the Clorox company, a leading multinational manufacturer and marketer of homecare, household and health and beauty products for consumers, as well as products and technologies for professional customers. The company is undertaking a broad digital transformation that will touch every aspect of the enterprise. We will help the company modernize business processes, streamline their operating model, leverages advanced data and analytic insights and establish a future ready technology foundation to deliver new levels of customer and consumer experiences, accelerate go- to-market activities and enable a more agile and resilient supply chain so they can lead and shape the consumer goods industry. We are helping new look, a global fashion retailer migrate its existing ecommerce platform to the cloud and strengthen its technology foundation to enable a seamless experience across stores, online, mobile and social media. AI and machine learning will create greater efficiency, increased sales and provide the flexibility to scale for growth and overcome industry disruption. The company is committed to infusing sustainability into their transformation roadmap, using innovation as an accelerator toward their own 2040 sustainability targets, all of which promises to keep the company in step with the store of the future, the speed of the fashion industry and the demands of their stakeholders. And as we build the digital course of our clients, security is more important than ever. Our integrated capabilities from identity to threat intelligence to manage security services to incident response are critical as our clients respond to increasing risks and expand their digital footprint. We are helping a large healthcare services provider assess their cybersecurity and business resilience levels. With much of their growth coming through mergers and acquisitions, technology and security have become more challenging to manage with multiple security providers, data centers and environments. We help design a cloud strategy and secure their backups in the cloud with an end-to-end cybersecurity approach that will provide flexibility as they continue to acquire more companies. We are also providing a managed security service from cyber resilience to threat intelligence to monitor their infrastructure and their security products, improving their ability to protect against future attacks. Our clients value our unique combination of capabilities from strategy and consulting to technology to manage services, because it enables us to deliver holistic solutions and expands their access to digital talent. We are helping INFRONEER Holdings, a Japan based infrastructure construction services company, digitally transform operations in finance and HR through a data driven approach. Through our managed services capabilities in our SynOps platform, we will help the company shift to intelligent operations by standardizing and automating key business processes, driving efficiency and productivity, reducing operating costs and providing greater opportunity for their people to focus on high value and strategic growth areas such as business design and digital experience. Shifting to the next digital frontier in the enterprise, our industry X capabilities are digitizing engineering and manufacturing to reimagine the products our clients make and how they make them and to build a greater resiliency, productivity and sustainability. We are partnering with a German multinational corporate manufacturer of luxury vehicles to develop an in-car software platform that will power the Central Intelligence Unit for personalized driver interaction information, convenience functions and entertainment. The platform provides a continuous flow of customer data to the automaker, enabling it to enhance vehicle functionality and create the superior customer experience, the automaker is renowned for. We are helping Albras, the largest producer of primary aluminum in Brazil to increase its productivity, energy efficiency and minimize greenhouse gas emissions by creating a new smelter control system operated over a new IoT architecture that utilizes cloud platforms for data storage and machine learning. Data insights will enable better visibility of gas emissions around the clock, allowing operations to be proactively managed, leading to increase energy efficiency and operational safety, as well as additional sustainability strategies to reduce their carbon footprint. Sustainability, one of the five forces shaping the next decade continues to be a growing priority area for our clients. And they value our ability to help them achieve their sustainability goals as part of their larger transformation such as the Albras example and directly as part of sustainability focused engagements, such as the work we are doing for Pos Malaysia Berhad, the national operator running Malaysia's largest post and parcel delivery network, we are helping Pos Malaysia Berhad to embrace a data driven approach to reducing emissions, cutting waste and upgrading its employees’ digital skills, best-in- class solutions for environmental, social and governance benchmarking, plus a sustainability implementation roadmap and skills for the future program will lead to dramatic reductions in direct waste and Scope 1 and 2 carbon emissions along with rapid progress and workforce upskilling. We continue to build our capabilities in this area both organically and inorganically. We are pleased that this quarter we announced three new sustainability acquisitions; Greenfish, akzente and Avieco, extending our reach and enhancing our ability to deliver deep skills and expertise to clients in ESG measurement and non-financial reporting, net zero strategy and regulation and real time data analytics. Our unmatched ability to access, create and unlock talent is valued by our clients as a key component of their compressed transformations, such as Pos Malaysia Berhad. In other cases, we help provide our clients access to talent through our managed services, and we help them become talent creators by having their shared services groups join Accenture where they can benefit from our ability to transform, upskill and provide new career pathways. For example, we are working with BNL a leading Italian banking group and subsidiary at BNP Paribas on a compressed transformation just 18 months from start to finish that will leverage our SynOps platform, maximize our clients’ existing talent and reduce total cost of ownership. We will consolidate data to provide deeper analytic insights and a better customer experience with tailored services and faster fulfillment times for customer requests. As part of this transformation, more than 500 people from their team will move to Accenture, where we will leverage their industry specific skills while also providing opportunities for professional development, enabling BNL to focus on strategic growth and benefit from this upskilling. We also do work with our clients that is primarily focused on their talent agenda. For example, we're collaborating with a large utility who is creating 1000s of clean energy jobs in areas like renewable electricity generation, energy saving homes and buildings and sustainable transportation. They're doing so for unemployed, underemployed and low to middle income residents. We are developing a recruitment, employment and tracking platform that matches people’s skills, with available positions leveraging AI and market insights. This solution reduces hiring time, improves the candidate experience and unlocks talent potential to create jobs for the underrepresented residents who need the most. We are uniquely positioned to help our clients drive cost efficiencies and their growth agenda. As you may have seen Accenture Interactive will now go-to-market as Accenture Song to reflect the fundamental change in the way companies must engage with customers, and the incredible speed at which they need to operate and innovate. Song is uniquely operating at the intersection of creativity, technology and intelligence. To help our clients reinvent connections and meaningful experiences, including sales, commerce, marketing, new business platforms, and the Metaverse continuum. We are helping a North American multi brand retailers scale their digital business and accelerate growth while reducing operational costs up to $100 million over the next five years. Together, we are designing and implementing a new multiproduct platform to improve the customer experience and enable the use of data and insights to drive increased engagement and better business performance overall. While still very early, we are seeing our clients look to take advantage of the Metaverse, another of the five forces. For example, we are collaborating with an international property developer, MQDC to develop their business model and design their customer experience in the Metaverse. As you can tell, this continues to be an exciting time for Accenture as the depth and breadth of our business allows us to help our clients with innovative and impactful work. Back to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks Julie. Turning to our business outlook. For the fourth quarter of fiscal ’22, we expect revenues to be in the range of $15 billion to $15.5 billion. This assumes the impact of FX will be about negative eight, compared to the fourth quarter of fiscal ‘21 and reflects an estimated 20% to 24% growth in local currency. For the full fiscal year ’22, based on how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in US dollars will be approximately negative 4.5% compared to fiscal ‘21. For the full fiscal ’22, we now expect our revenue to be in the range of 25.5% to 26.5% growth in local currency over fiscal ‘21 which continues to assume an inorganic contribution of roughly 5%. For operating margin, we continue to expect fiscal year ‘22 to be 15.2%, a 10 basis point expansion over fiscal ‘21 results. We now expect our annual effective tax rate to be in the range of 23.5% to 24.5%. This compares to an adjusted effective tax rate of 23.1% in fiscal ‘21. For earnings per share, we now expect our full year diluted EPS for fiscal ‘22 to be in the range of $10.61 to $10.70 or 21% to 22% growth over adjusted fiscal’ 21 results. This guidance range reflects a negative $0.14 impact from the updated FX guidance, partially offset by the increase in revenue guidance. For the full fiscal ’22, we continue to expect operating cash flow to be in the range of $8.7 billion to $9.2 billion. Property and equipment additions to be approximately $700 million and free cash flow to be in the range of $8 billion to $8.5 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $6.5 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to shareholders. With that, let's open it up so we can take your questions. Angie?"
},
{
"speaker": "Angie Park",
"text": "Thanks KC. I would ask that you each key to one question and a follow up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question is from Tien-Tsin Huang."
},
{
"speaker": "Tien Huang",
"text": "Thank you so much. Good morning. Really good results here. I want to ask on the -- let me ask bookings, which came in line with your expectations. In the book-to-bill and a quarter look like more a like pre-pandemic levels on tough comps. So, KC, I heard the strong pipeline comment. Just wondering, can we expect book-to-bill above 1.0 but maybe below the 1.1 or higher that we saw during the pandemic, just trying to better understand how the pace of bookings might be changing here beyond the comp?"
},
{
"speaker": "KC McClure",
"text": "Yes, thanks, Tien-Tsin. So let me just start with anchoring to what we saw this quarter in bookings and our pipeline, and I'll talk then a little bit about what we expect for Q4. So as you mentioned, we were really pleased with our book-to-bill this quarter. And you talked about our tough comps, we did 30% growth in consulting. And we have year-to-date of 1.1 book-to-bill in consulting through Q3. We're very pleased with that. And outsourcing, we did 23% revenue growth, again over tough comps from last year in the quarter at 1.2 year-to-date book-to-bill. So as we look ahead at Q4, we do see continued very strong revenue growth of 20% to 24%. So you heard that in our guidance. And we do think bookings and outsourcing, bookings for both, excuse me, revenue for both consulting and outsourcing, both going to be in that range. So we have another strong quarter in consulting and outsourcing revenue growth. And on top of that Tien-Tsin, we do see another strong sales quarter in Q4. And we feel good about both our consulting and our outsourcing pipeline. So hopefully that gave you enough color on where we see bookings and the rest of the year playing out."
},
{
"speaker": "Tien Huang",
"text": "Got it. So balance across the two, which is great. So maybe my quick follow up that everyone's been asking us. So I thought I'd ask you guys, Julie, specifically here maybe for you just how recession ready is Accenture, right? With what the stock market is telling us? How's Accenture different or maybe similarly positioned to what we've seen in past down cycles? Any quick comments on them? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "So I think, Tien-Tsin, so we don't predict the macroeconomic. So what we do is really focused on what has helped us to be successful. And obviously, every financial situation is going to be different to pandemic, we don't know how this is going to be versus what was happening a decade ago. And so let me just focus on why we are in a strong position. And that is, first of all, what's driving today is total enterprise reinvention. And so that means companies are trying to transform using tech data and AI around the enterprise. And we've been investing for a decade to be in the position that were relevant to the enterprise. And so we can do everything as you saw in our examples from HR and finance to manufacturing, right to in the insurance industry, underwriting and claims, right, so and it's really the entire enterprise that we're relevant to, and that'll gives us a huge power to help our clients. And you see that's happening right now with the inflationary environment, you've got consumer goods companies focused very much on cost, as well as growth. And we're able to help them do both, right. And on the other hand, you've got, say the energy companies that have had a really rough cycle, who now have the ability to invest more continuing on their cost discipline, but trying to also drive their transition to clean energy right into advance their digitization. And so our diversity in both what we can do, and our diversity in industries, is extraordinarily helpful. And then as you think about why we're a leader today, I just want to sort of make sure people understand the power of the fact that we can do everything from strategy to consulting, to manage services. So if you just take a consumer goods company, one of the biggest areas of spend is in marketing. We have amazing strategists at Accenture, right. It's a huge group, it's really, really relevant. And what they bring is not simply here, let's go after your marketing spend that looks like the biggest spend, what they can say is, and let me explain to you that the trend is to digitize to use hubs to not be as geographic specific. And let me show you where we've actually executed that and are managing that service for some of the leading companies. That's what our strategists can uniquely bring. And we can talk to our clients and say, and we can either help you build the capability, or we can do it on your behalf because we can access the talent, we can move you more quickly. And so as we think about why are we strong today, and how do we deliver on our enduring shareholder value proposition and growing faster than market delivering large and expansive, returning to shareholders and delivering 360 degree value? It's really based on this unique set of capabilities, these very strong trusted relationships. And then, of course, all of this underpinned by technology, where we're a powerhouse and we are the leading partner of the largest and technology companies in the world. Operator, next question."
},
{
"speaker": "Operator",
"text": "We will next go to the line of Lisa Ellis with MoffettNathanson."
},
{
"speaker": "Lisa Ellis",
"text": "Hi, good morning. Thanks for taking my question. I guess I'll take the attrition one, it looks like attrition after coming down a bit the last couple of quarters re uptick a bit this quarter. Can you just talk about perhaps any color there any underlying dynamics? And how is the attrition environment looking going forward? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Yes, sure, Lisa. I mean, usually we see an uptick in attrition from Q2 to Q3. We actually also see seasonally another uptick in Q4, which we'll expect to see. So this is kind of in line with prior patterns. And again, it's primarily driven by India at the lower end of our pyramid, which is highly competitive. At the same time, we're able to hire for the demand we see. And so, and also, as we've commented before, our overall executive retention, which is the people who are driving our business every day, it continues to be high. So not a lot of change and these are really seasonal upticks."
},
{
"speaker": "Lisa Ellis",
"text": "Okay, got it. And maybe a follow up on that. And then also on Tien-Tsin’s question related to R word, the recession word. What are the types of steps can you just remind us? Like, if you do start to see a slowdown in the business, kind of what are the adjustments that Accenture makes or can make quite quickly to react to changing demand environment, realizing that you're often at the kind of front end of the spear on that, given your strength in consulting in a lot of shorter duration projects."
},
{
"speaker": "Julie Sweet",
"text": "So, I mean, at the core of our businesses, how we manage supply and demand, right, and so we're, our ability to, we do have high attrition, right? So our ability to not for example, when I say high attrition, meaning our industry has higher, high attrition, and so our ability to not hire to replace that attrition, right. So our core competency is managing supply and demand. And we have an ear to the ground with our clients, but we also have a lot of analytics around what we're seeing in open demand, what we're seeing in our pipeline. So we manage our business with great rigor and discipline, and we'll continue to do that throughout the cycle and of course, I just want to make sure we're not walking past an incredible quarter from revenue and a booking. And as KC said, we see continued strong demand going into the next quarter with another strong bookings quarter and another strong revenue quarter."
},
{
"speaker": "Operator",
"text": "And next we go to line of Jason Kupferberg with Bank of America."
},
{
"speaker": "Jason Kupferberg",
"text": "Good morning, guys. I just wanted to start with a clarification on the full year EPS guidance, it sounds like you're now absorbing an extra $0.29 of headwind, relative to where you were last quarter or the $0.15 from exiting Russia and the $0.14 from incremental FX headwind. Is that accurate?"
},
{
"speaker": "KC McClure",
"text": "So, Jason, that is accurate in that. The $0.15 for Russia. That's absolutely accurate. And then we have an additional $0.14 from the updated from the guidance that we gave you last quarter that we are absorbing. So you're correct."
},
{
"speaker": "Jason Kupferberg",
"text": "Right. So you're still maintaining the lower half of the EPS guidance from last quarter, despite absorbing an extra $0.29. Okay. I just wanted to make, okay."
},
{
"speaker": "KC McClure",
"text": "That’s right. I mean, I think the key thing that you're asking and the key point, I want to make sure that we are getting across is that there's no change to our business, right, fundamentals and our business performance."
},
{
"speaker": "Jason Kupferberg",
"text": "That's right."
},
{
"speaker": "KC McClure",
"text": "We actually had a bit of an increase in our revenue guidance, which helps us partially offset the $0.14 drag that we have from FX. So really strong, we continue to see really strong fiscal operations, we just can't absorb completely, all of that large FX movement that we saw from last quarter to this quarter. That's all."
},
{
"speaker": "Jason Kupferberg",
"text": "Of course. And I guess it's encouraging to hear that there doesn't seem to really be much change at all in the demand environment. Obviously, there's been a lot of worry and wonder about that. But can you maybe just talk to us about like nuances of how client conversations have been evolving over the past three months? Any change in clients decision making patterns or clients doing more recession preparation on their end?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. And so, first of all, as always, we call it like we see it. So today, we see strong demand and we're not seeing a change in decision making. What we are seeing is a shift depending and the industry and the market on what clients are asking for it. So for example, in the industry is like a consumer goods industry, you're seeing a lot more focused on costs than a year ago, right, with CEO saying, hey, Julie, I always used to talk to you about growth. Can we talk about growth and cost? Right, you're seeing more investment going into help me do more with less. And at the core of that is Cloud Data AI, you also see a big focus on can we go faster. And I was just meeting with a CEO last week who said, Julie, I just -- can you just look at our strategy? And are we being transformational enough, right? Are we challenging ourselves to go fast enough? And this is where the experience that we have of doing this particularly over the last two years where we saw this compressed transformation is so important. I was just speaking with an energy company last week, where they, like a lot of companies early on when digital transformation started, say, five, six years ago on the front office, they've been doing a bunch of experiments of digital twins around and they're saying to us, okay, Julie, help us understand where we're going to get the most value, but how do we scale and that's the unique combination we have of like, we can understand from a strategic perspective, where's the biggest value, but I can then take like, let me take you this company over here, different industry that's been doing digital twins that we've just been massively scaling over the 18 months, let's share with you the lessons learned on how to do that, because it is the next digital frontier, there isn't as much experience. And now we'll help you go faster. So the context is different depending on the industry. I mean every CEO is of course, focused on the macroeconomic, and people like to use that as a catalyst for doing some of the harder things around cutting costs. And what we do as Accenture because we can help on all aspects of that. We also can embed in a growth conversation. You saw the example we used as big retailer in earnings where we're helping them grow and we're taking out $100 million in costs at the same time, right. And that's what makes us so unique and that's why we will just continue to stay very focused. We're doing a lot in supply chain that those conversations accelerated in Europe for obvious reasons. But they're really it's a global phenomenon. And we're doing a ton here. And of course, as we think about our business, when we look at the demand, we also look at, do we need to upskill anyplace because we're seeing more demand, say in supply chain, or more demand in a particular industry? And that's where the agility of our learning, as you may recall, in the first six months after the pandemic we upskilled 100,000 people to shift to cloud and collaboration technology. So that's how we stay very close. And then we use these other tools, we have like our ability to upskill to make sure that we are responding to what our clients need."
},
{
"speaker": "Operator",
"text": "And our next question is from Ashwin Shirvaikar."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you. Good quarter, folks. Demand trends still seem strong. I appreciate the qualitative remark on the revenue focus versus cost focus. We already saw take down here in the percent of revenues from consulting as well. I guess the question is around whether you believe that consulting, outsourcing balance might maybe get back down to 50:50 if you anticipate air pocket down the road, because outsourcing work just tends to have longer ramps. Could you to kind of talk through that?"
},
{
"speaker": "KC McClure",
"text": "Yes, sure. Ashwin, happy to and so just in terms, I'll start with the last part first, in terms of just our mix, right, we and I'm not going to guide anything into next year. But if you just look historically, at our mix, it can move around 1% or 2% between consulting and outsourcing. But it's generally been as , three years in the zone of like about 55% consulting and about 45% outsourcing, So that and we're seeing the same this year. So that's the first point. And then in terms of consulting, we are really pleased with our performance to date. And as you know, when we, I gave you some -- I gave guidance for consulting for Q4, but just a reminder, there are book-to-bill is really strong for the year in consulting. And anything is as you know, over one around one book-to-bill consulting, we consider strong, we also look at it over trailing four quarters, right. So but I -- we will give guidance for you in September of -- in September for next year. And that's where we can give you some sense of what the outsourcing is, consulting type of work will be next year. But now, you can look at our patterns and see it's about 55%, 45%."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Got it, no, thank you for that. I guess the follow up is on M&A. I think you might have mentioned in the past quarter that your M&A spend target this year was closer to $4 billion, it looks like you might not get there. Any color around where valuations easing? What's sort of going on with regards to sort of the strategic approach to M&A? Are you now looking, is that also changing, given the revenue versus cost focus? Or is that just a longer term view? Thought around that would be great."
},
{
"speaker": "KC McClure",
"text": "Yes, I'll let Julie talk about the strategy. But just to recap what I did say, you're right, we had previously said we thought it would be about $4 billion. We now think it is going, we’ve done $2.2 billion to date, 27 transactions year-to-date. We now think it will be about $2.5 billion. And that's because there's about $ billion, Ashwin, that is going to go into next year because of required regulatory approvals. So that really is the biggest difference between the $2.5 billion and $4 billion that we talked about."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And from a strategic point of view, we continue to believe that the mergers and acquisition, V&A as we call it is critical to the way we grow. And there's three big reasons, right. The first is we will do it for scale. So you saw us do a lot of cloud acquisitions, for example, because we wanted to capture the momentum in the market and to build scale in area, in countries like we did a big one in France, for example, where we didn't have the scale and we had a lot of market momentum. The second reason we do it, is to move into adjacencies. So you saw a spilled Accenture Song and interactive over years, we've used that very effectively with industry X. So you saw that enough big acquisition last year, for example and that continues. And you starting to see that now in sustainability. We just announced three acquisitions. So where we're really built going into new areas with new skills and capabilities and then third, we're always looking to sort of continue to add in our industry and functional expertise and that strategy has served as well. And we continue to believe that that's an important part of our growth going forward."
},
{
"speaker": "Operator",
"text": "Our next question is from Bryan Keane with Deutsche Bank."
},
{
"speaker": "Bryan Keane",
"text": "Hi, guys. Good morning and congrats on the results. Wanted to specifically to ask about Europe continues to show robust growth, 30% growth, and I think, KC call that Germany, France, UK, Italy. So lots of concern about the unfortunate situation and war in Ukraine. Is there anything that you guys are seeing that could be in the go forward impacting Europe? Because right now, we're not seeing any weakness in those results."
},
{
"speaker": "Julie Sweet",
"text": "And we're not seeing any weakness in those results. And so we continue to really stay close to our clients. There's, as I talked a little bit about earlier, there's a shift in focus in many of the more impacted industries, and across the board around things like energy efficiency, right. And so our strengths in, for example, manufacturing and sustainability is helping us drive conversations and helping our clients get more energy efficient, for obvious reasons, given the background in Europe, supply chain, lots going on in supply chain, as you think about what we're doing there, we're doing everything from helping them have greater insight. So we're working with a food retailer, for example, to understand how they can anticipate disruptions better and earlier using data and analytics. So supply chain is a big topic. And then costs because everyone's anticipating, it leads to continuation of the inflationary environment that we're seeing globally. And so cost becomes a big focus. So it's today, again, all roads lead to not just technology data and AI, but how do you use it to transform the business? Which is our sweet spot, right? That is what we do. We partner with the technology companies and our clients to help them use these technologies to get results. And that's what we're doing today. And that's the environment that we're seeing our clients need."
},
{
"speaker": "Bryan Keane",
"text": "Got it, no, that's helpful. And then maybe just as a quick follow up, KC. Any thoughts on the latest on pricing and Accenture’s ability to maintain or even get pricing increases in some different areas where the demand is strongest? Thanks so much and congrats again."
},
{
"speaker": "KC McClure",
"text": "Okay. Yes, so we were -- we were pleased that we did see, again, improvement, Bryan in our pricing. And again, reminder that pricing, when we talked about pricing, it's the margin on the work that we sold. And we really need to continue to focus on that, which is what we are doing to offset what we're continuing to see in wage inflation in our business, which as we all know is in all industries, it really is across the globe. So and we are seeing some improvement coming from pricing in our P&L. So I'm pleased with that. And at the same time, as you would expect, we're changing the mix of people on our contracts, and also using technology to help offset the impact of wage increases. So again, very focused on pricing. That's the biggest lever that we have but there -- that they all of these improvements together are still lagging the compensation increases. But we're still very, very satisfied."
},
{
"speaker": "Operator",
"text": "And our next question is from Bryan Bergin with Cowen."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, good morning. Thank you. Follow through on bookings, any changes in bookings profiles as it relates to contract duration? And are you seeing any uptick in the interest of clients to sell captive operations here? I'm curious if that type of transaction is picked up."
},
{
"speaker": "KC McClure",
"text": "There really is no change at all in terms of the profile for bookings as it relates to duration."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And I'd say on the captive side, it's more of a steady, kind of, it's been steady. I don't think I'd say picked up or not picked up. It's been steady for the last couple of years."
},
{
"speaker": "Bryan Bergin",
"text": "Okay, and then just a question on Accenture Song. Can you talk about some of the operational changes that have been reported in that business as it relates to the consolidation of agency brands and what that does for you?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. I think a couple of things, I start with the rebranding is really more around reflecting what we’re doing today in Accenture Interactive and that brand was kind of old because it started a decade ago, right where, and it doesn't really reflect kind of the particularly post pandemic, which is really a complete use of technology, bringing in creative using data and AI and moving very, very fast. So this is where you've got examples like we've given in the past, like a Jaguar Land Rover, where they're using managed services to personalize experiences, and they're moving very, very quickly. And so Song just really captures better what, in fact, we are doing there. And from an operational perspective, it's just a natural evolution to bring together some of the brands that we've acquired over the years as you know, we built Accenture Song through a very deliberate, M&A strategy. And so I think it bit more of just kind of the natural evolution."
},
{
"speaker": "Angie Park",
"text": "Great. And operator, we have time for one more question, and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Very good. That will come from James Faucette with Morgan Stanley."
},
{
"speaker": "James Faucette",
"text": "Great, thank you very much. And thanks for all the details this morning. Wanted to ask a couple more nuanced questions around Accenture’s operations right now. And first, starting with the bench. How would you characterize your bench right now? Are there pockets of resources that are underutilized versus over utilized? And how much of an operational impact could that be having right now, if any?"
},
{
"speaker": "KC McClure",
"text": "James, thanks for the question. I will just make just focus on the key metrics that we look at. And we report every quarter as it talks about our people and the usage of our people, clients. We're at 91%, which is really in the zone of utilization that we like to be in, it's a little running a little bit hot throughout the past year and a half since pandemic and we're at 91%. So that's a very healthy range that we're good with."
},
{
"speaker": "James Faucette",
"text": "Got it. And then a lot of the conversation this morning, obviously is focused on macro and demand, et cetera. But are there any industry groups and/or service dimensions that you're expecting to accelerate versus decelerate, especially as you know the customers seem to be at least modifying a little bit. The conversations they are having to focus a little more on cost versus growth, et cetera. Are there key parts of that -- those different industries and segments that could see changes as a result?"
},
{
"speaker": "KC McClure",
"text": "Maybe I'll just anchor to what we saw this quarter. And I can hand it over to Julie to give a little bit of color on that. But we did see all 13 industries this quarter have double digit revenue growth, right. And when we talked about bookings, we had strength across all of our markets, services and industry."
},
{
"speaker": "Julie Sweet",
"text": "Yes, and I would just add that, remember, an industry isn't a monolith, right? So you had coming out of the pandemic, in almost every industry, you had some percentage, we've talked about this, who went really fast. Now you've got others who are saying, wait a minute, we're seeing the impact of some of the leaders move faster on their digital transformations. And so for example, those who moved early to the cloud, we're now talking about the next phase of how do you utilize the cloud to drive new things. Remember, our little formula cloud is. The cloud is the foundation, data is the driver and AI is the differentiator. And so if you've moved to the cloud, now, you're using the data in that differently, right, as opposed to those who still need to move to the cloud. Like we are very early in the transition. And so the way we think about it is if you have a total enterprise we walk our clients through, what's the digital core, you need to have? Where are you on the maturity scale? And how do you prioritize? And so while we look at the industries is growing double digits, what's actually happening within the industry really depends on where you are on the maturity curve. And that's what drives our business, right? Because we can help the clients who are leaders go to the next level, and we're helping the ones that are behind trying to leapfrog. And so I think it's important to look at in that sense is that you need to have granular deep understanding of the industries and help our clients. We help our clients with that to know where to go next."
},
{
"speaker": "James Faucette",
"text": "All right, thanks for that color. Well, thanks everyone. Great. Thanks James. All right. In closing, we really appreciate everyone for joining us today. And thank you again to all of our people and our leaders for another outstanding quarter in every dimension from our financial results to our 360 degree value beyond our financials. And thank you to all of our shareholders for your continued trust and support. We'll work hard every day to continue to earn it all the best."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 2 | 2,022 | 2022-03-17 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to Accenture's Second Quarter Fiscal 2022 Earnings. [Operator Instructions] And as a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Ms. Angie Park, Managing Director, Head of Investor Relations. Please go ahead.
Angie Park: Thank you, operator, and thanks, everyone, for joining us today on our second quarter fiscal 2022 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the third quarter and full fiscal year 2022. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie.
Julie Sweet: Thank you, Angie, and thank you, everyone, for joining. I would like to begin by honoring the incredible bravery of the Ukrainian people in the face of the unlawful invasion by Russia and extending our deep sympathy and concern over the horrific losses of life. While these words don't feel adequate to capture what is happening, we are taking actions to help in the small ways we can, which I will share more about later in the call. Turning now to the quarter. I will start by thanking our almost 700,000 people around the world for your incredible dedication and work to create 360-degree value for our clients and all our stakeholders. Thank you to our clients who are making bold moves to transform and putting their trust in us to help them. Finally, thank you to our technology ecosystem partners we work with every day to innovate and create more value for our clients. Now a few highlights from the quarter. We had record bookings of almost $20 billion and continued improved pricing, which refers to contract profitability or margin on the work that we sell across the business with 36 clients with bookings over $100 million. We had record revenue growth of 28% in local currency, bringing total revenue added through H1 to $6.2 billion, which is what we added in all of FY '21. And our EPS grew 25% year-over-year with flat operating margin and continued significant investment in our business and our people. Our workforce grew by 24,000 people, demonstrating again our ability to attract top talent at the scale needed by our clients. We were the top scoring company on the Bloomberg Gender-Equality Index out of more than 400 organizations globally. We were recognized in Ethisphere's World's Most Ethical Companies for the 15th year in a row and by JUST Capital for the sixth consecutive year. Our people completed another 9.2 million training hours this quarter. And we continue to gain market share, growing more than 3x the market. With such an exceptional quarter, I would like to particularly recognize and thank the incredibly strong delivery teams that underlie these results. Our clients know that our commitments are backed by the outstanding work our people do every day, working side-by-side with them, from shaping the future to building the best systems and platforms to creating amazing new experiences and brands to running critical functions for our clients and everything in between. Before handing over to KC, let me pause to reflect on the current macro environment. It was almost exactly 2 years ago that we did earnings only 8 days after the pandemic was declared. Then, as now, the world faced incredible uncertainty. We are all watching the events unfold in Ukraine, and there are many potential scenarios which are difficult to predict. While the circumstances are very different, our focus is the same: on the well-being of our people, serving our clients and staying close to their evolving needs and helping our communities. We emerged from the pandemic an even stronger and more relevant company, and we will use this strength to successfully navigate this environment and fulfill these same 3 goals. Over to you, KC.
KC McClure: Thank you, Julie, and thanks to all of you for taking the time to join us on today's call. We were extremely pleased with our overall results in the second quarter, which exceeded our expectations with record new bookings of almost $20 billion, $2.8 billion higher than our previous record set last quarter. Our results reflect very strong double-digit revenue growth across all dimensions of our business, which reinforce the relevance of our offerings and capabilities in the market to deliver value for our clients. We had a very strong Q2 and first half of the year. While we know the environment is uncertain given the ongoing conflict in Ukraine, we always call it as we see it. And based on the best information we have today, we are increasing key elements of our full year guidance, which I will cover in more detail later in our call. Now, let me begin by summarizing a few of the highlights for the quarter. Revenues grew 28% local currency, increasing $3 billion over Q2 last year and nearly $300 million above the top end of our guided range, driven by broad-based over-delivery across all markets, services and industries with all 13 industries growing double digits. We also continued to extend our leadership position with growth estimated to be more than 3x the market, which refers to our basket of publicly-traded companies. We delivered EPS in the quarter of $2.54, reflecting 25% growth over adjusted EPS last year, and operating margin of 13.7% was consistent with Q2 of last year. And 10 basis points expansion year-to-date reflects continued significant investments in our people and our business. Finally, we delivered free cash flow of $2 billion and returned $2.3 billion to shareholders through repurchases and dividends. We have made investments of $1.8 billion in acquisitions, primarily attributed to 21 transactions in the first half of the year. And we continue to expect to invest approximately $4 billion in acquisitions this fiscal year. With that, let me turn to some of the details. New bookings were a record at $19.6 billion for the quarter, representing growth of 22% in USD over a very strong Q2 last year, with an overall book-to-bill of 1.3. Consulting bookings were $10.9 billion, a record high, with a book-to-bill of 1.3. Outsourcing bookings were also a record at $8.7 billion with a book-to-bill of 1.3. We were very pleased with our new bookings, which were driven by both technology services and strategy and consulting, as well as 36 clients with bookings over $100 million. Turning now to revenues. Revenues for the quarter were $15 billion, a 24% increase in U.S. dollars and 28% in local currency. Consulting revenues for the quarter were $8.3 billion, up 29% in U.S. dollars and 34% in local currency. Outsourcing revenues were $6.7 billion, up 19% in U.S. dollars and 23% in local currency. Taking a closer look at our service dimensions, strategy and consulting, technology services and operations all grew very strong double digits. Turning to our geographic markets. In North America, revenue growth was 26% in local currency, driven by double-digit growth in Software & Platforms, Consumer Goods, Retail & Services -- Travel Services and Public Service. In Europe, revenues grew 31% in local currency, led by double-digit growth in Consumer Goods, Retail & Travel Services, Industrial and Banking & Capital Markets. Looking closer at the countries. Europe was driven by double-digit growth in the U.K., Germany, France and Italy. In Growth Markets, we delivered 30% revenue growth in local currency, driven by double-digit growth in Consumer Goods, Retail & Travel Services, Banking & Capital Markets and Public Service. From a country perspective, Growth Markets was led by double-digit growth in Japan, Australia and Brazil. Moving down the income statement. Gross margin for the quarter was 30.1% compared with 29.7% for the same period last year. Sales and marketing expense for the quarter was 9.4%, consistent with the second quarter last year. General and administrative expense was 7% compared to 6.6% for the same quarter last year. Operating income was $2.1 billion in the second quarter, reflecting a 13.7% operating margin, consistent with Q2 last year. Before I continue, as a reminder, we recognized an investment gain in Q2 last year, which impacted our tax rate and increased EPS by $0.21. The following comparisons exclude these impacts and reflect adjusted results. Our effective tax rate for the quarter was 19.2% compared with an adjusted effective tax rate of 17.5% for the second quarter last year. Diluted earnings per share were $2.54 compared with an adjusted diluted EPS of $2.03 in the second quarter last year. Days service outstanding were 41 days compared to 42 days last quarter and 34 days in the second quarter of last year. Free cash flow for the quarter was $2 billion, resulting from cash generated by operating activities of $2.2 billion, net of property and equipment additions of $165 million. Our cash balance at February 28 was $5.5 billion compared with $8.2 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the second quarter, we repurchased or redeemed 4.6 million shares for $1.7 billion at an average price of $369.19 per share. As of February 28, we had approximately $4.6 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $0.97 per share for a total of $617 million. This represents a 10% increase over last year. And our Board of Directors declared a quarterly cash dividend of $0.97 per share to be paid on May 13, a 10% increase over last year. So, at the halfway point of fiscal '22, we have delivered very strong results. Now, let me turn it back to Julie.
Julie Sweet: Thank you, KC. Let's begin with the demand environment. We are experiencing double-digit growth in all parts of our business across all markets, industries and services. All our growth priorities, Applied Intelligence, Cloud, Industry X, Intelligent Operations, Intelligent Platform Services, Interactive, Security and transformational change management all are growing double digits. Many of our clients are taking on bold transformation programs, often spanning multiple parts of the enterprise in an accelerated time frame, which we call compressed transformation, as they recognized the need to transform every part of their enterprise with technology, data and AI and new ways of working. What is also clear is that the sheer speed at which an enterprise now needs to move and the breadth of the expertise required to transform demands partnerships. For example, our wide range of managed services from Intelligent Operations to application development and maintenance to Cloud, infrastructure and security, our strategic capabilities that enable our clients to digitize faster, access hard-to-hire talent, transform more quickly due to our deep expertise and achieve outcomes from greater efficiency to improved customer satisfaction, to enhance security, to faster development, to higher growth. Our managed services are unique because they combine our strong strategy and consulting capabilities to anticipate and shape the future and be at the cutting-edge of industry, function and technology. We also see our clients looking for partners who can create 360-degree value, upskilling our people, focusing on enhancing diversity and building in sustainability, which is our focus. Stepping back, when you think about the extraordinary growth we are experiencing and how we navigated the pandemic, we believe our commitment to create 360-degree value for all our stakeholders and our unmatched diversity of people, services, industries, functions, markets, ecosystem partners and investments, together with our leadership and technology, have made us both relevant to the world's largest companies and resilient. I will now bring to life how we are partnering with our clients with a snapshot of the range of solutions we are bringing across industries and across the enterprise. Let's start with enterprise functions. In chemicals and natural resources, we are expanding our relationship with a leading chemical manufacturer to carve out one of their business units serving the automotive industry to better focus on sustainable solutions. As part of this carve-out, we will build the backbone of this new entity with a cloud-based infrastructure, ERP platforms and Intelligent Operations managed services for technology, HR and finance, all in just over 1 year. This compressed transformation will create new value, reduce operating costs by up to 30%, enhance portfolio flexibility and enable future growth in new areas. In consumer goods and services, we are working with a large multinational personal care corporation to build an integrated digital core with standardized processes, IT enterprise platforms and instant access to consolidated data in the cloud, which will enable a more efficient and flexible supply chain and digital order processing. This will provide more time to sell, reduce human error, create a better customer experience and deliver a stronger bottom line. We will also streamline financial operations, leading to greater agility and cost benefits to remain competitive in any environment and delight their consumers. Now I will turn to our solutions helping transform the core operations of our clients. In high tech, we are supporting Airbus, a leading aircraft manufacturer in several areas of their business, including digital design, manufacturing and services. With our acquisition of umlaut, we're also helping Airbus engineering and manufacturing teams to develop the new A350F. At the same time, we will also onboard and manage training for new frontline employees using a realistic digital twin pilot, optimizing onboarding time and significantly reducing the learning curve of shop floor workers without disturbing production. In Banking & Capital Markets, we are helping BBVA, a global financial services firm, synchronize and speed up its digital journey. With the power of analytics, AI and automation, we will create an intelligent data-driven banking operation with greater agility and productivity, lowering costs by up to 30% by leveraging our strategic managed services, improving their customer experience and becoming an integral part of their talent strategy to provide new growth opportunities, upskilling and security opportunities. This builds on our work with this digital leader that spans over 25 years, including international expansion, capital market strategy and digital sales and services. In Health, we are helping Highmark Health, a national blended health organization to make Health care more personalized and proactive through the power of technology and data. By leveraging the cloud and operational hub, we'll bridge business units, consolidate enterprise data, provide faster insights and personalize the customer experience with the flexibility to evolve as needs change. By maximizing its key asset data, Highmark Health will see faster time to market, reduce operational costs and increase innovation and most importantly, better health outcomes. And we are helping clients accelerate their growth agenda. In consumer goods and services, we are collaborating with Del Monte, the iconic fresh and packaged food company, to establish effective B2B2C and direct-to-consumer commerce platforms. We will transition and scale their existing platforms into a one commerce ecosystem to make it easier to create and launch new products, driving significant growth in their e-commerce revenue. We are helping with clients to help shape and deliver on the significant emerging opportunity of the Metaverse. We've been an early innovator in this area backing -- going back a number of years, investing in R&D, our people and our own metaverse, One Accenture Park, all of which positions us to help our clients accelerate their Metaverse strategies and initiatives. In communications and media, we are helping Telstra, Australia's leading telecommunications company, to deploy 5G connectivity and technology to deliver immersive fan experiences at Melbourne's Marvel Stadium. From booking a seat to parking, to engaging with a match, fans will soon be able to experience a new augmented reality stadium experience before, during and after they attend the game. And if you missed the release yesterday, please be sure to read our new technology vision, which is titled, Meet Me in the Metaverse, and is available on our website. And we are building the digital cores of our clients from replatforming in cloud to building core systems as described in many of the examples above, to helping them secure their enterprise as the security landscape widens. In Life Sciences, we are working with Merck, a global pharmaceutical leader to create robust intangible value across the organization, which will help enable growth, accelerate the development of life-changing therapies for patients around the world. We will develop a more flexible and responsive IT infrastructure in the cloud, leveraging data and analytics and product-centric methodologies to power innovation, insight and speed. At the same time, we are cultivating IT talent through a new operating model that drives upskilling, diversity and development. Also in Life Sciences, we are expanding our partnership with an international drug wholesale company, which advances development and delivery of health care products, including life-saving cancer treatments and COVID vaccines around the world to support their suite of cybersecurity towers by creating an integrated delivery model to increase resilience, accountability, collaboration and feedback across monitoring, engineering, data protection, risk and compliance and identity while also reducing costs. And we are helping our clients...
Unidentified Company Representative: [Technical Difficulty]
Julie Sweet: I'm sorry?
Unidentified Company Representative: The call dropped.
Julie Sweet: Has the call dropped?
Unidentified Company Representative: No, I think it's still going.
Julie Sweet: Sorry about that, everyone. I just want to make sure, confirm that we're good. Apologies. If you can hear me, we heard the call apparently dropped. We're good. Okay. So let's go back to we're helping our clients put sustainability in their core. We are helping a leading steel and mining company move to low-carbon steelmaking and employ decarbonization technologies. As an end-to-end partner supporting the company's ambitious decarbonization program, we will help standardize and implement the technical solution among its sites. I would now like to briefly comment on how Accenture as a company and our people have mobilized to support our Ukrainian colleagues and provide humanitarian aid. When people ask me what makes Accenture special, our actions like these are what come to mind. While we do not have operations or people who work in the Ukraine, we have many Ukrainians who work for us, particularly in Poland. For their extended families who are in Ukraine, we quickly put in place Ukrainian language telehealth and other remote support services. And for those family members who are leaving the Ukraine, we are providing the settlement assistance. I also am proud of our people who have volunteered to drive refugees from the border to help get them settled. With a decade of experience helping refugees, we knew that not-for-profit organizations operating in Ukraine and the border countries providing humanitarian relief would have an initial immediate need for cash. We are currently donating $5 million in cash to these organizations. In addition, our people have donated nearly $1.5 million in our employee giving program, and we are providing 100% match funding. Our people also have sprung into action to anticipate the next needs of refugees. In Poland, we are piloting the first addition of an Accenture Academy for women refugees from Ukraine to build their technology skills starting in cybersecurity. Finally, as we've shared, we are discontinuing our business in Russia. We are working to support our nearly 2,300 employees there, and we want to thank them for their dedication and commitment to Accenture over the years. Back to you, KC.
KC McClure: Thanks, Julie. Before I get into our business outlook, I would like to provide some context as events are rapidly evolving and there's significant amount of uncertainty. Our third quarter and full year guidance does not include any assumption for a significant escalation or expansion of economic disruption or the conflict's current scope. Now let me turn to our business outlook. For the third quarter of fiscal '22, we expect revenues to be in the range of $15.7 billion to $16.15 billion. This assumes the impact of FX will be about negative 4 compared to the third quarter of fiscal '21 and reflects an estimated 22% to 26% growth in local currency. For the full fiscal year '22, based upon how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in U.S. dollars will be approximately negative 3% compared to fiscal '21. For the full fiscal '22, we now expect our revenues to be in the range of 24% to 26% growth in local currency over fiscal '21, which continues to assume an inorganic contribution of about 5%. For operating margin, we now expect fiscal year '22 to be 15.2%, a 10 basis point expansion of our fiscal '21 results. We continue to expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.1% in fiscal '21. For earnings per share, we now expect our full year diluted EPS for fiscal '22 to be in the range of $10.61 to $10.81 or 21% to 23% growth over adjusted fiscal '21 results. For the full fiscal '22, we now expect operating cash flow to be in the range of $8.7 billion to $9.2 billion, property and equipment additions to be approximately $700 million and free cash flow to be in the range of $8 billion to $8.5 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we now expect to return at least $6.5 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so that we can take your questions. Angie?
A - Angie Park: Thanks, KC. [Operator Instructions] Operator, would you provide instructions for those on the call?
Operator: [Operator Instructions] Our first question comes from the line of Lisa Ellis with MoffettNathanson.
Lisa Ellis: Good stuff here. And yes, Julie, we could hear you the whole time. I don't think the call dropped. Can you talk a little bit about, given you guys are very global and very much on the front lines with major corporations, how -- what impact or changes are you seeing companies start to make with the work they're doing with Accenture in response to the macroeconomic environment, meaning to deal with inflation or supply chain challenges or sanction enforcement or anything like that? What are some of these -- are you seeing -- starting to see some conversations going, some shifts or interest in doing different types of programs with you?
Julie Sweet: Thanks, Lisa. Great question because we're talking to our clients all the time. And I guess, let me just start with, I think the experience of the pandemic has just built in more of a sense of resilience and agility. And so we're seeing really a lot of what I call calm in response to the macro environment. I mean the reality is that it's very early. And while there are lots of like predictions around what could happen with inflation, what could happen with supply chain, people are not overreacting. And instead, what I'd say is they're remaining very focused on the priorities they had before the crisis because as you talk about, inflation is already a reality, right? And we're already living that. And so for inflation, depending on the industry, like, for example, consumer goods, there's been a lot of focus on growth and cost, right, with cost being even higher up because you're seeing that you can't push through all of the -- and price increases, all of the increases in input. Of course, as you think about the potential scenarios around like disruption of agriculture and so on, we could see that potentially going higher, but it's too early to tell. And instead, companies are saying, look, we've got to make sure that we're on pace, and we're executing. The same as I think about energy prices. Supply chain, if anything, there's just been an increased focus on we need to think as much about resilience, right, as cost in supply chain. And we absolutely have to digitize so we've got more insight. And so I think the trends that we were already seeing to address, things coming out of the pandemic, the changing economic environment around inflation are simply being focused on even more. And this premium on are we building in agility and are we going at the right pace, that's really the nature of the conversations.
Lisa Ellis: Got it. Okay. Okay. And then maybe my follow-up, KC, for you. I'll ask the inevitable margin question. It looked like -- I know Julie made a comment about contract pricing being up. It looks like gross margins are up, but SG&A also was up a bit, and then you're coming in at the lower end of your margin expectation. Can you just talk a little bit about the drivers there, what's going on in the underlying cost base?
KC McClure: Yes. Sure. Thanks, Lisa. So let me first start with, we were really pleased with our performance in operating margin. So we've expanded 10 basis points to the first half of the year. And we were flat in the second quarter. And really, that was driven by revenue growth, as we mentioned, with -- that had improved pricing on our record bookings. So very pleased with profit this quarter, including the 25% growth that we delivered in EPS. And so let's -- let me just peel that back a bit. So we're in a hypergrowth environment where we're hiring at elevated levels to meet this demand. So at the same time, as you know, we're navigating wage inflation. So Lisa, we remain very focused on pricing, knowing that it's going to take some time for the improved pricing, which lags compensation to flow through our P&L, but we did see some impact to that in this second quarter results. I think probably more importantly, it's really very important that we significantly invest in our people and our business and we're doing so at even higher levels than last year. So we're absorbing that also in our up margin as well as the step-up that we've talked about in our acquisition spend. So just in summary, we're halfway through the year. We're 10 basis points of margin expansion. We think we'll continue to that level of margin expansion in the back half of the year. Really pleased with that. And that would mean an EPS growth, which is stellar at 21% to 23% growth for the year.
Operator: Our next question comes from the line of Brian Keane with Deutsche Bank.
Bryan Keane: Congratulations on these great results. I had 2 questions. I guess the first one is, given the disruption to some of the digital engineering IT service firms in Eastern Europe, are you seeing additional demand from clients looking to other vendors?
Julie Sweet: Thanks, Bryan. It's really too early to see that. We're seeing clients staying very focused on their business and what we're doing with them.
Bryan Keane: Got it. And the other thing that jumped out at me is the 3x growth rate versus the market. I think typically, Accenture has been more of a 2x in recent years. So can you just talk to us about why the expansion and share gains that's happened over just recently here?
Julie Sweet: Yes. Thanks, Bryan. It's really, I think, a combination of things, right, but let's just always start with our clients. Prepandemic, what we saw were clients much more into -- they did transformation quite sequentially, right? The pandemic was a major shock. You saw the leaders who are kind of coming into that saying we've got to go even faster. And you saw a bunch of companies saying, we need to leapfrog, right? We need to move online. We need to do digital transformation. And that meant that we saw companies starting to take on -- not sequential transformation, but what we call compressed transformation, where they're, at the same time, doing manufacturing as well as sales. And you saw that in some of the examples that I gave today where you've got entirely new backbones being created across multiple enterprise functions, where you've got both new platforms being put into place and manufacturing. And they're doing that in order to lead because of what they see in the business. And when you think about who is able to help navigate, because you don't do that kind of transformation with like a different partner for every transformation, right? Accenture is very distinctive in our industry because we are able to transform every part of the enterprise. And that's one of the things I was trying to emphasize. Like we can do -- we're going to finance in HR, right? We've got the growth agenda, sales, marketing and service, right? We've been investing for a decade in Industry X, which is really taking off. We talked about the digital frontier. And so you have in Accenture a partner that can do that. And you see that over the course of the last 2 years in the record numbers compared to prepandemic of clients with over $100 million in bookings. And it's really -- it's recognizing, it's representing that level of demand. And we're quite unique. Like we've talked about this for years, right? All of our different services, our deep industry knowledge. And when you're moving fast, you need a partner that really can span the enterprise and has that deep knowledge of the industry. And that is, of course, driving the growth, right? Because we are capturing the momentum in every part of the enterprise that's happening now.
Operator: Our next question comes from the line of Tien-Tsin Huang with JPMorgan.
Tien-Tsin Huang: Great results here. Just wanted to clarify your assumptions on the really strong outlook. Can we assume that your approach towards guidance is similar to the approach you took at the onset of the pandemic? And are you assuming any slowdown in Europe in your guide? I know there's a lot of questions we're giving on macro within Europe, so figured I'd just ask it here.
KC McClure: Yes. So thanks, Tien-Tsin. So let me just cover what we're assuming in our guidance. So -- and maybe I'll first start with our guidance does take into account the revenue impact of discontinuing our business in Russia and the cost to wind that down. Now with respect to the broader risk, our guidance, we're calling it like we see it, Tien-Tsin. So the same way that we did -- we always do, we did during the pandemic. And today, we don't see a significant disruption in our business. Now it's still very early, and it's difficult to predict. So our guidance does not take into account any significant escalation or expansion of economic disruption or the conflict's current scope. Now as it pertains to Europe, we are not seeing a significant disruption in our business in Europe. You've seen that reflected as well in our very strong bookings and revenue growth. And for the back half of the year, our guidance continues to assume a very strong double-digit growth, including in Europe.
Tien-Tsin Huang: Okay. Great. Look, we trust your outlook. I just want to make sure I understood the approach here. Just my quick follow-up, just the 36 clients, over $100 million, big number. I'm just curious if the pipeline for larger deals, how does that look from here your ability to replenish? I know we're in March now, but just curious what you're thinking on larger deals looking ahead here.
KC McClure: Yes. So I'll comment on the pipeline, Tien-Tsin, and see if Julie wants to add anything else. But we continue to feel good about our pipeline even with another quarter of record bookings just completed. We were very pleased with our bookings, obviously, in Q2 and for the first half of the year. But bookings can be lumpy from quarter-to-quarter. So we focus on the trailing 12-month book-to-bill as I know many of you do, too. But we, overall, still feel really good about our pipeline.
Julie Sweet: Yes. And Tien-Tsin, the only one thing I want to add maybe back to your last question is, we are doing exactly what we did at the pandemic, which is we're calling it like we see it, right? So we'll update every quarter. And we've got -- we're really close to the clients, right? And as we said at the beginning, it is too early. So we're not trying to build in, be overly conservative or overly optimistic. Like we really just call it down the fairway. And next quarter, we'll update and we'll go from there.
Operator: Our next question comes from the line of Jason Kupferberg with Bank of America.
Jason Kupferberg: Just wanted to ask about the bookings, obviously, extremely strong here. I was just curious on the consulting and outsourcing side. How much above your internal expectations did they come in? And how should we think about book-to-bill in the back half of the year? I know year-to-date, it's nicely elevated at 1.2x. So should we just expect some normalization there in the back half?
KC McClure: Jason, I would say that our bookings -- our record bookings did come in higher than we expected. That was a broad-based over-delivery across all markets, all services and industries as well as consulting and outsourcing type of work. And again, we look at an overall book-to-bill, as I just mentioned to Bryan, in a trailing 12 months, 4 quarters at a time. So, we feel good about where we are and our positioning and our pipeline and our bookings to date as we head into H2.
Jason Kupferberg: Okay. All right. Understood. And then can you just remind us which countries within Central and Eastern Europe you have the most meaningful headcount, obviously, excluding Russia? But I know you mentioned Poland earlier, but just so we have a broader picture of the headcount distribution in the region?
Julie Sweet: Sure. Poland and Romania would be the sort of the two where we've got delivery centers. We don't have big local market, but Poland and Romania.
Operator: Our next question comes from the line of Keith Bachman with Bank of Montreal.
Keith Bachman: Julie, I wanted to direct this to you. And the nature of the question is, I wanted to get your view about the durability of double-digit growth. And I'm not focused on this year. So, our model goes back to 2006 for Accenture. So, 2006 to 2021, Accenture grew on average, by about 8 points, which includes some M&A. Half of those years were in the double-digit range, half were not. And so, I'm just trying to think and I think investors are really focused on the phenomenal year that you're having this year, but it sets up: a, a very difficult compare, including 5 points of M&A; and b, a lot of companies, including my firm, came out of COVID and said, we need to do a lot of things differently. So, stressing -- trying to fix our IT infrastructure and -- may have created some pull-ins. The things we're going to do over the next 5 years, many firms are doing over the next 1 year. So, I wanted to get your -- with that as a context, how do you see, as you look out to 2023 and beyond, how do you view Accenture's ability to sustain double-digit growth?
Julie Sweet: I love that you look at it over the long term because that's how we do. And so, the way we think about growth isn't about, is it double digit or not, right? We've had a very enduring and I think it served us well, belief that we should be growing more than the market, right? And so that is what we focus on, is that we are always continuing to take market share. And that is an enduring commitment that we sort of -- that we anchor to. Now, the way we do that is that we stay very close to clients so that we know not only what they need today, but also, we can anticipate what they need tomorrow, right? And that's really important. So yesterday, for example, we talked about the Metaverse continuum where we have been investing for a decade. We think the Metaverse and Web3 is as significant as when, in 2013, we called that every business would be a digital business. And that will be a huge transformation over the next decade that will also be part of -- sort of next waves of growth. At the same time, it's really important to look at where we are now, which is still extraordinarily early in the digital transformation of every part of the enterprise, right? We estimate, for example, that only about 30% of workloads have been -- have moved to the cloud. And once you get to the cloud, that's when you actually use those technologies to grow and innovate. You saw that in some of the examples that we gave today where you're having the cloud piece, but then you're figuring out how to use the data and the AI to really transform. When you look at replatforming on the leading SaaS platform, similarly, extraordinarily early. So, everyone feels, right, the big focus on digital because that was the wake-up call from the pandemic. But the actual transformation and just putting in the foundation is still very early stages, and then it's what you do on that foundation. Then if you look at from a technology development point of view, let's take manufacturing and supply chain. Many of the technologies have that are advanced have only been introduced in the last couple of years, right, the advanced cloud-based technologies. And so, technology itself, like there's still new functionality that doesn't even exist in some of the major platforms that's still being created. And so, we consider the manufacturing and supply chain as the next digital frontier. And of course, that was a big play for us, which we've been doing for the last decade because it's a move from IT to OT as you think about the budgets that we're accessing, right? And so overall, like as much as we feel there's so much going on, you still have many, many companies who’ve not started the compressed transformation. You're very early in the platforming of what's today, let alone the next things that we can already see like Web3.
Keith Bachman: Okay. Great. Very helpful. KC, I'll make my follow-up a bit more poignant question, and just want to try to understand the operating margin comments that you made before. And specifically, is wage inflation impacting that negatively, influencing some of the comments you made about potential for operating margin expansion this year?
KC McClure: Yes. So in terms of wage inflation, I will -- it's really a pretty similar case to what we've discussed last quarter. So maybe it just kind of goes back through that again. So obviously, it's occurring in all the industries, and it's across the globe. And our clients have also obviously experienced this as well in this very tight labor market. But for us, as it relates to wage inflation, we see for our business that we're going to continue to have wage increases in the market for certain skills, and that's going to continue to vary by geography. And we're also looking at have the Consumer Price Index and any increases there and how that might potentially spill over into inflation at the lower end of our pyramid. And so we're focusing on pricing to absorb our higher labor costs. And again, as it relates to pricing, what we're seeing is that it's going to take some time, Keith, for the improved pricing, which we did have in the second quarter, again, on our record bookings. We see that flow through -- see that flow through our P&L. We did see some of that impact in the second quarter, but that obviously lags the impact of compensation increases.
Julie Sweet: And I'm just going to add -- and I just want to add that I'm very happy with where we are on profitability. I mean if you think about what we are navigating, right, hyper growth has increased costs from all the recruiting, right? We did a big step-up in acquisitions last year. We're absorbing that dilution this year, right? We've increased significantly the investments in our business, which are all about driving growth today, but also tomorrow, right? We're in an unprecedented labor market with wage inflation, which we are absorbing and still delivering at 10 basis points operating margin expansion. So I feel really good about where we are as a company, both for this year and all the things that we're doing to position ourselves to continue to grow in market-leading ways.
Operator: Our next question comes from Ashwin Shirvaikar with Citi.
Ashwin Shirvaikar: Julie, KC, congratulations on the quarter and outlook. I wanted to start with the M&A question. I believe there was no M&A since last earnings. Perhaps I may have missed a smaller deal or 2. Is that just a quirk of timing? Or is it that you just recently did larger deals and are integrating? Or might there be other factors at play?
KC McClure: Yes. Maybe I'll just state some facts and you can -- yes, so Ash, we're about halfway through the year. And we did have a lot of acquisitions closed in Q1. You're right, we did have less close in Q2. But acquisition closing, they can be lumpy. We can't always control the timing. So we've deployed $1.8 billion of acquisition spend year-to-date. We continue to expect about $4 billion of acquisition spend in FY '22. But of course, we're only going to do deals that make sense. And so it could be plus or minus the $4 billion. And we'll update you next quarter. But let me...
Julie Sweet: Yes. And I just like I wish we could manage it sort of like say, we're going to do this many and then we're going to absorb. But it really is just about timing goes up and down. And also, we have a lot of rigor and discipline. We're only going to do deals that we believe in, right? So we're not trying to manage in any way to a quarter. We've got a capital allocation. If we can do that with great deals, we're going to do it, and so that's the approach. I will take the opportunity just to say one of the ones we did announce, we did close 2 this quarter. But one of the ones we announced I'm super excited about, which is AFD.TECH, which is in the network space, 1,600 people in France. And it's important because as you think about what's happening in digitization, our increasing move into really leading in network is important. And it's just another great example of how we use acquisitions to accelerate our strategic growth priorities. It's an important part of Accenture Cloud First.
Ashwin Shirvaikar: No doubt. I agree with that. And I wanted to ask a broader question. This has unfortunately been asked in a few different ways. But I think you captured it well in your takeoff sentence when you mentioned an incredibly high level of uncertainty. But I believe that since the compressed transformation move started, this is probably the first major test of secular trend versus cyclical uncertainty. And I know you're calling outlook like you see it. But is this time different? Can the strength of secular overcome cyclical challenges?
Julie Sweet: Look, we all rose to dealing with the types of things that may come out of this crisis other than perhaps the military scenarios, right, whether it's more inflation, the need for energy conservation due to higher energy prices, the disruption in supply chain, agriculture. All roads lead to some combination of technology and human ingenuity, right, which is what we bring together. And so, you've got great solutions like managed services to accelerate both cost takeout and finding new ways to grow, new ways to access markets, right? You've got energy efficiency that's going to come from technology improvements. And so, as you think about what we do, right, we're the company that's going to be able to help companies navigate these macro trends. And so, we really believe that the technology -- importance of technology and then being able to apply it to get tangible outcomes is going to be critical. And so, we believe we'll be resilient through this, through whatever this is going to be as well.
Operator: Our next question comes from the line of Surinder Thind with Jefferies.
Surinder Thind: The first question I'd like to ask is just about talent and your ability to acquire it more globally. Obviously, in the earlier announcement about the apprenticeship program or the expansion of it in the U.S., can you talk a little bit about as you build out the bottom base of the pyramid for your delivery.How does something like that impact like bill rates or the clients' willingness to accept bill rates when you're using individuals with non-4-year degrees and so forth?
Julie Sweet: Interesting question. I would say that our clients really focus on skills. They don't focus on degrees. And so, what they're looking for are the skills. And that's a broader trend. In fact, we predicted that 3 years from now, Chief Human Resources officers will all be talking about skills. And as part of this trend, you need to be -- not a consumer, but a creator of talent, understand skills and then be able to reskill.
Surinder Thind: Fair enough. And does that also impact your cost as well, though? Are you able to employ them at a better cost base, I guess? How should I think about the arbitrage opportunity there if clients are willing to pay for the full skill?
Julie Sweet: I wouldn't think about the arbitrary opportunity. We pay market-relevant pay. And it's the focus on skills. Even if you look at our -- the way we draft our recruiting thing, it is about skills. And so, there isn't something that because you've got a 2-year degree versus a 4-year degree, now you're paid less. It's about skills. So, there's a market price for these skills. So, I wouldn't think of it as labor arbitrage.
Surinder Thind: Got it. And then as a follow-up question, just a big-picture, longer-term question just about the delivery model. Do the current geopolitical events maybe change your perception of where you may want to operate or expand to? There's generally been in the trend of the last few years, much more global delivery. Obviously, you guys are very global. But in terms of just trying to get as much talent in every country everywhere, how does that kind of change the way that you might be thinking about delivery, whether it's being more concentrated in certain regions or areas or avoiding other regions and areas?
Julie Sweet: What I would say is since the time of the pandemic, when we had this global shock, right, we continued to evolve our ability to move work and be flexible. And so, our focus is really on that agility and making sure that we have the right kinds of talent, both geographically dispersed, but also the ability to move talent around.
Angie Park: Operator, we have time for one more question, and then Julie will wrap the call.
Operator: Our last question will come from the line of Brian Essex with Goldman Sachs.
Brian Essex: Great. I echo my congratulations on the results for the quarter. I guess, I wanted to follow up to the last question, maybe a little different angle, focused on the supply side. So, I guess with that` in mind, Julie, are you seeing -- obviously, in a post-pandemic era or hopefully coming out of the pandemic, companies are used to operating in a hybrid world, more agnostic to where work is performed. Any trends that you -- or overarching trends that you can call out either by skill level or by geography where they might, and specifically, would love to focus it on how they're managing costs? So, are they looking to shift work to particular geographies? Do you see demand in particular geographies? Are there certain trends that you can call out with regard to the skilling of labor forces in particular geographies that are notable where you might see some cost benefit or better ability to supply to meet demand?
Julie Sweet: I'm talking about talent all the time with our clients. And I'd say that it's slightly different than what your focus is. Here are the two big things, which are all around accessing talent. So, in accessing talent, means you have to be able to attract and retain it, and you've got to be able to get it at scale. So the bigger focus is around what does it take to attract and retain in a hybrid work environment. And so more companies are focused on where they did -- they used to want everybody in the office, having more of a hybrid model, and that has knock-on cost effects as you decrease your real estate. And so that's been a big focus. But the actual -- the thing we talk to clients about is it's more about how do you attract people who today, all of our research shows that if you're not having to be there in a frontline worker, you want some combination, and then that does have costs. And so that's a huge focus around talent. The second piece on access, if you look at the way our managed services are being driven, it is really 2 big things. One is it's faster to digitize because you use our platforms. And the second is the access to hard-to-get talent, right? And so let's just take security. We have 10,000 security professionals who do everything from threat assessment to the rebuilding and designing platforms to managed services. And in today's world, with the security landscape broadening, right, that access to that kind of talent is incredible. And so just the real focus is on access and what does it take to access it, including through partnerships. And those are the kinds of conversations that we have.
Brian Essex: Got it. That's super helpful. And maybe just one quick follow-up on resources. What have you seen historically? I know we've got accelerating energy prices, oil in particular. What have you seen historically with regard to follow-on for alternative projects and greater investment in the energy sector, in particular, in response to prices? How high is it been correlated, particularly on the discretionary side and maybe your experience in terms of how you've seen follow-through with spend in that sector?
Julie Sweet: Yes. Well, listen, I was just at CERAWeek, which is the world's largest energy conference for a couple of days just last week, so I spent a lot of time with everyone in the energy sector. And I think rather than looking at it historically, let's look at it like what are people talking about now. So first of all, despite the increases in prices, say, in oil and gas, no one is saying, "Hey, now we've got to let up on cost." In fact, the exact opposite. Because the oil and gas industry, in fact, the entire energy industry has a major challenge ahead of investing to move to sustainable energy solutions. And so what I would say is that there is an absolutely laser focus on continuing what that industry had to do during the pandemic because how it was fit and focus on cost and now accelerate innovation and moving to sustainable energy solutions. And that's where we gave the example today of how we're helping in decarbonization. We announced this week what we're doing with Ecopetrol and AWS around water management, right? And so we're playing -- we're obviously very well situated. We have a deep, deep expertise in utilities and oil and gas and the entire energy sector in -- at their core both enterprise as well as in the grid, at the refinery and then helping really create those sustainable solutions. We see this as a major opportunity for our clients that we want to help them on.
Angie Park: Great. Thank you very much. I'm going to close the call now. Thanks, everyone, for joining us, and thank you again to our incredible people and to our shareholders for your continued trust. Please make sure to join us for our Virtual Investor and Analyst Day on Thursday, April 7. We're looking forward to being back together. Thanks, everyone.
Operator: Ladies and gentlemen, this conference will be available for replay after 10:00 a.m. Eastern today through June 23. You may access the AT&T replay system at any time by dialing 1-866-207-1041 and entering access code 6300496. International participants may dial 402-970-0847. That does conclude our conference for today. We thank you for your participation and for using AT&T conferencing service. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to Accenture's Second Quarter Fiscal 2022 Earnings. [Operator Instructions] And as a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Ms. Angie Park, Managing Director, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, operator, and thanks, everyone, for joining us today on our second quarter fiscal 2022 earnings announcement. As the operator just mentioned, I'm Angie Park, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the third quarter and full fiscal year 2022. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and as such are subject to known and unknown risks and uncertainties including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie, and thank you, everyone, for joining. I would like to begin by honoring the incredible bravery of the Ukrainian people in the face of the unlawful invasion by Russia and extending our deep sympathy and concern over the horrific losses of life. While these words don't feel adequate to capture what is happening, we are taking actions to help in the small ways we can, which I will share more about later in the call. Turning now to the quarter. I will start by thanking our almost 700,000 people around the world for your incredible dedication and work to create 360-degree value for our clients and all our stakeholders. Thank you to our clients who are making bold moves to transform and putting their trust in us to help them. Finally, thank you to our technology ecosystem partners we work with every day to innovate and create more value for our clients. Now a few highlights from the quarter. We had record bookings of almost $20 billion and continued improved pricing, which refers to contract profitability or margin on the work that we sell across the business with 36 clients with bookings over $100 million. We had record revenue growth of 28% in local currency, bringing total revenue added through H1 to $6.2 billion, which is what we added in all of FY '21. And our EPS grew 25% year-over-year with flat operating margin and continued significant investment in our business and our people. Our workforce grew by 24,000 people, demonstrating again our ability to attract top talent at the scale needed by our clients. We were the top scoring company on the Bloomberg Gender-Equality Index out of more than 400 organizations globally. We were recognized in Ethisphere's World's Most Ethical Companies for the 15th year in a row and by JUST Capital for the sixth consecutive year. Our people completed another 9.2 million training hours this quarter. And we continue to gain market share, growing more than 3x the market. With such an exceptional quarter, I would like to particularly recognize and thank the incredibly strong delivery teams that underlie these results. Our clients know that our commitments are backed by the outstanding work our people do every day, working side-by-side with them, from shaping the future to building the best systems and platforms to creating amazing new experiences and brands to running critical functions for our clients and everything in between. Before handing over to KC, let me pause to reflect on the current macro environment. It was almost exactly 2 years ago that we did earnings only 8 days after the pandemic was declared. Then, as now, the world faced incredible uncertainty. We are all watching the events unfold in Ukraine, and there are many potential scenarios which are difficult to predict. While the circumstances are very different, our focus is the same: on the well-being of our people, serving our clients and staying close to their evolving needs and helping our communities. We emerged from the pandemic an even stronger and more relevant company, and we will use this strength to successfully navigate this environment and fulfill these same 3 goals. Over to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie, and thanks to all of you for taking the time to join us on today's call. We were extremely pleased with our overall results in the second quarter, which exceeded our expectations with record new bookings of almost $20 billion, $2.8 billion higher than our previous record set last quarter. Our results reflect very strong double-digit revenue growth across all dimensions of our business, which reinforce the relevance of our offerings and capabilities in the market to deliver value for our clients. We had a very strong Q2 and first half of the year. While we know the environment is uncertain given the ongoing conflict in Ukraine, we always call it as we see it. And based on the best information we have today, we are increasing key elements of our full year guidance, which I will cover in more detail later in our call. Now, let me begin by summarizing a few of the highlights for the quarter. Revenues grew 28% local currency, increasing $3 billion over Q2 last year and nearly $300 million above the top end of our guided range, driven by broad-based over-delivery across all markets, services and industries with all 13 industries growing double digits. We also continued to extend our leadership position with growth estimated to be more than 3x the market, which refers to our basket of publicly-traded companies. We delivered EPS in the quarter of $2.54, reflecting 25% growth over adjusted EPS last year, and operating margin of 13.7% was consistent with Q2 of last year. And 10 basis points expansion year-to-date reflects continued significant investments in our people and our business. Finally, we delivered free cash flow of $2 billion and returned $2.3 billion to shareholders through repurchases and dividends. We have made investments of $1.8 billion in acquisitions, primarily attributed to 21 transactions in the first half of the year. And we continue to expect to invest approximately $4 billion in acquisitions this fiscal year. With that, let me turn to some of the details. New bookings were a record at $19.6 billion for the quarter, representing growth of 22% in USD over a very strong Q2 last year, with an overall book-to-bill of 1.3. Consulting bookings were $10.9 billion, a record high, with a book-to-bill of 1.3. Outsourcing bookings were also a record at $8.7 billion with a book-to-bill of 1.3. We were very pleased with our new bookings, which were driven by both technology services and strategy and consulting, as well as 36 clients with bookings over $100 million. Turning now to revenues. Revenues for the quarter were $15 billion, a 24% increase in U.S. dollars and 28% in local currency. Consulting revenues for the quarter were $8.3 billion, up 29% in U.S. dollars and 34% in local currency. Outsourcing revenues were $6.7 billion, up 19% in U.S. dollars and 23% in local currency. Taking a closer look at our service dimensions, strategy and consulting, technology services and operations all grew very strong double digits. Turning to our geographic markets. In North America, revenue growth was 26% in local currency, driven by double-digit growth in Software & Platforms, Consumer Goods, Retail & Services -- Travel Services and Public Service. In Europe, revenues grew 31% in local currency, led by double-digit growth in Consumer Goods, Retail & Travel Services, Industrial and Banking & Capital Markets. Looking closer at the countries. Europe was driven by double-digit growth in the U.K., Germany, France and Italy. In Growth Markets, we delivered 30% revenue growth in local currency, driven by double-digit growth in Consumer Goods, Retail & Travel Services, Banking & Capital Markets and Public Service. From a country perspective, Growth Markets was led by double-digit growth in Japan, Australia and Brazil. Moving down the income statement. Gross margin for the quarter was 30.1% compared with 29.7% for the same period last year. Sales and marketing expense for the quarter was 9.4%, consistent with the second quarter last year. General and administrative expense was 7% compared to 6.6% for the same quarter last year. Operating income was $2.1 billion in the second quarter, reflecting a 13.7% operating margin, consistent with Q2 last year. Before I continue, as a reminder, we recognized an investment gain in Q2 last year, which impacted our tax rate and increased EPS by $0.21. The following comparisons exclude these impacts and reflect adjusted results. Our effective tax rate for the quarter was 19.2% compared with an adjusted effective tax rate of 17.5% for the second quarter last year. Diluted earnings per share were $2.54 compared with an adjusted diluted EPS of $2.03 in the second quarter last year. Days service outstanding were 41 days compared to 42 days last quarter and 34 days in the second quarter of last year. Free cash flow for the quarter was $2 billion, resulting from cash generated by operating activities of $2.2 billion, net of property and equipment additions of $165 million. Our cash balance at February 28 was $5.5 billion compared with $8.2 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the second quarter, we repurchased or redeemed 4.6 million shares for $1.7 billion at an average price of $369.19 per share. As of February 28, we had approximately $4.6 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $0.97 per share for a total of $617 million. This represents a 10% increase over last year. And our Board of Directors declared a quarterly cash dividend of $0.97 per share to be paid on May 13, a 10% increase over last year. So, at the halfway point of fiscal '22, we have delivered very strong results. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. Let's begin with the demand environment. We are experiencing double-digit growth in all parts of our business across all markets, industries and services. All our growth priorities, Applied Intelligence, Cloud, Industry X, Intelligent Operations, Intelligent Platform Services, Interactive, Security and transformational change management all are growing double digits. Many of our clients are taking on bold transformation programs, often spanning multiple parts of the enterprise in an accelerated time frame, which we call compressed transformation, as they recognized the need to transform every part of their enterprise with technology, data and AI and new ways of working. What is also clear is that the sheer speed at which an enterprise now needs to move and the breadth of the expertise required to transform demands partnerships. For example, our wide range of managed services from Intelligent Operations to application development and maintenance to Cloud, infrastructure and security, our strategic capabilities that enable our clients to digitize faster, access hard-to-hire talent, transform more quickly due to our deep expertise and achieve outcomes from greater efficiency to improved customer satisfaction, to enhance security, to faster development, to higher growth. Our managed services are unique because they combine our strong strategy and consulting capabilities to anticipate and shape the future and be at the cutting-edge of industry, function and technology. We also see our clients looking for partners who can create 360-degree value, upskilling our people, focusing on enhancing diversity and building in sustainability, which is our focus. Stepping back, when you think about the extraordinary growth we are experiencing and how we navigated the pandemic, we believe our commitment to create 360-degree value for all our stakeholders and our unmatched diversity of people, services, industries, functions, markets, ecosystem partners and investments, together with our leadership and technology, have made us both relevant to the world's largest companies and resilient. I will now bring to life how we are partnering with our clients with a snapshot of the range of solutions we are bringing across industries and across the enterprise. Let's start with enterprise functions. In chemicals and natural resources, we are expanding our relationship with a leading chemical manufacturer to carve out one of their business units serving the automotive industry to better focus on sustainable solutions. As part of this carve-out, we will build the backbone of this new entity with a cloud-based infrastructure, ERP platforms and Intelligent Operations managed services for technology, HR and finance, all in just over 1 year. This compressed transformation will create new value, reduce operating costs by up to 30%, enhance portfolio flexibility and enable future growth in new areas. In consumer goods and services, we are working with a large multinational personal care corporation to build an integrated digital core with standardized processes, IT enterprise platforms and instant access to consolidated data in the cloud, which will enable a more efficient and flexible supply chain and digital order processing. This will provide more time to sell, reduce human error, create a better customer experience and deliver a stronger bottom line. We will also streamline financial operations, leading to greater agility and cost benefits to remain competitive in any environment and delight their consumers. Now I will turn to our solutions helping transform the core operations of our clients. In high tech, we are supporting Airbus, a leading aircraft manufacturer in several areas of their business, including digital design, manufacturing and services. With our acquisition of umlaut, we're also helping Airbus engineering and manufacturing teams to develop the new A350F. At the same time, we will also onboard and manage training for new frontline employees using a realistic digital twin pilot, optimizing onboarding time and significantly reducing the learning curve of shop floor workers without disturbing production. In Banking & Capital Markets, we are helping BBVA, a global financial services firm, synchronize and speed up its digital journey. With the power of analytics, AI and automation, we will create an intelligent data-driven banking operation with greater agility and productivity, lowering costs by up to 30% by leveraging our strategic managed services, improving their customer experience and becoming an integral part of their talent strategy to provide new growth opportunities, upskilling and security opportunities. This builds on our work with this digital leader that spans over 25 years, including international expansion, capital market strategy and digital sales and services. In Health, we are helping Highmark Health, a national blended health organization to make Health care more personalized and proactive through the power of technology and data. By leveraging the cloud and operational hub, we'll bridge business units, consolidate enterprise data, provide faster insights and personalize the customer experience with the flexibility to evolve as needs change. By maximizing its key asset data, Highmark Health will see faster time to market, reduce operational costs and increase innovation and most importantly, better health outcomes. And we are helping clients accelerate their growth agenda. In consumer goods and services, we are collaborating with Del Monte, the iconic fresh and packaged food company, to establish effective B2B2C and direct-to-consumer commerce platforms. We will transition and scale their existing platforms into a one commerce ecosystem to make it easier to create and launch new products, driving significant growth in their e-commerce revenue. We are helping with clients to help shape and deliver on the significant emerging opportunity of the Metaverse. We've been an early innovator in this area backing -- going back a number of years, investing in R&D, our people and our own metaverse, One Accenture Park, all of which positions us to help our clients accelerate their Metaverse strategies and initiatives. In communications and media, we are helping Telstra, Australia's leading telecommunications company, to deploy 5G connectivity and technology to deliver immersive fan experiences at Melbourne's Marvel Stadium. From booking a seat to parking, to engaging with a match, fans will soon be able to experience a new augmented reality stadium experience before, during and after they attend the game. And if you missed the release yesterday, please be sure to read our new technology vision, which is titled, Meet Me in the Metaverse, and is available on our website. And we are building the digital cores of our clients from replatforming in cloud to building core systems as described in many of the examples above, to helping them secure their enterprise as the security landscape widens. In Life Sciences, we are working with Merck, a global pharmaceutical leader to create robust intangible value across the organization, which will help enable growth, accelerate the development of life-changing therapies for patients around the world. We will develop a more flexible and responsive IT infrastructure in the cloud, leveraging data and analytics and product-centric methodologies to power innovation, insight and speed. At the same time, we are cultivating IT talent through a new operating model that drives upskilling, diversity and development. Also in Life Sciences, we are expanding our partnership with an international drug wholesale company, which advances development and delivery of health care products, including life-saving cancer treatments and COVID vaccines around the world to support their suite of cybersecurity towers by creating an integrated delivery model to increase resilience, accountability, collaboration and feedback across monitoring, engineering, data protection, risk and compliance and identity while also reducing costs. And we are helping our clients..."
},
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"speaker": "Unidentified Company Representative",
"text": "[Technical Difficulty]"
},
{
"speaker": "Julie Sweet",
"text": "I'm sorry?"
},
{
"speaker": "Unidentified Company Representative",
"text": "The call dropped."
},
{
"speaker": "Julie Sweet",
"text": "Has the call dropped?"
},
{
"speaker": "Unidentified Company Representative",
"text": "No, I think it's still going."
},
{
"speaker": "Julie Sweet",
"text": "Sorry about that, everyone. I just want to make sure, confirm that we're good. Apologies. If you can hear me, we heard the call apparently dropped. We're good. Okay. So let's go back to we're helping our clients put sustainability in their core. We are helping a leading steel and mining company move to low-carbon steelmaking and employ decarbonization technologies. As an end-to-end partner supporting the company's ambitious decarbonization program, we will help standardize and implement the technical solution among its sites. I would now like to briefly comment on how Accenture as a company and our people have mobilized to support our Ukrainian colleagues and provide humanitarian aid. When people ask me what makes Accenture special, our actions like these are what come to mind. While we do not have operations or people who work in the Ukraine, we have many Ukrainians who work for us, particularly in Poland. For their extended families who are in Ukraine, we quickly put in place Ukrainian language telehealth and other remote support services. And for those family members who are leaving the Ukraine, we are providing the settlement assistance. I also am proud of our people who have volunteered to drive refugees from the border to help get them settled. With a decade of experience helping refugees, we knew that not-for-profit organizations operating in Ukraine and the border countries providing humanitarian relief would have an initial immediate need for cash. We are currently donating $5 million in cash to these organizations. In addition, our people have donated nearly $1.5 million in our employee giving program, and we are providing 100% match funding. Our people also have sprung into action to anticipate the next needs of refugees. In Poland, we are piloting the first addition of an Accenture Academy for women refugees from Ukraine to build their technology skills starting in cybersecurity. Finally, as we've shared, we are discontinuing our business in Russia. We are working to support our nearly 2,300 employees there, and we want to thank them for their dedication and commitment to Accenture over the years. Back to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Before I get into our business outlook, I would like to provide some context as events are rapidly evolving and there's significant amount of uncertainty. Our third quarter and full year guidance does not include any assumption for a significant escalation or expansion of economic disruption or the conflict's current scope. Now let me turn to our business outlook. For the third quarter of fiscal '22, we expect revenues to be in the range of $15.7 billion to $16.15 billion. This assumes the impact of FX will be about negative 4 compared to the third quarter of fiscal '21 and reflects an estimated 22% to 26% growth in local currency. For the full fiscal year '22, based upon how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in U.S. dollars will be approximately negative 3% compared to fiscal '21. For the full fiscal '22, we now expect our revenues to be in the range of 24% to 26% growth in local currency over fiscal '21, which continues to assume an inorganic contribution of about 5%. For operating margin, we now expect fiscal year '22 to be 15.2%, a 10 basis point expansion of our fiscal '21 results. We continue to expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.1% in fiscal '21. For earnings per share, we now expect our full year diluted EPS for fiscal '22 to be in the range of $10.61 to $10.81 or 21% to 23% growth over adjusted fiscal '21 results. For the full fiscal '22, we now expect operating cash flow to be in the range of $8.7 billion to $9.2 billion, property and equipment additions to be approximately $700 million and free cash flow to be in the range of $8 billion to $8.5 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we now expect to return at least $6.5 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so that we can take your questions. Angie?"
},
{
"speaker": "A - Angie Park",
"text": "Thanks, KC. [Operator Instructions] Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Lisa Ellis with MoffettNathanson."
},
{
"speaker": "Lisa Ellis",
"text": "Good stuff here. And yes, Julie, we could hear you the whole time. I don't think the call dropped. Can you talk a little bit about, given you guys are very global and very much on the front lines with major corporations, how -- what impact or changes are you seeing companies start to make with the work they're doing with Accenture in response to the macroeconomic environment, meaning to deal with inflation or supply chain challenges or sanction enforcement or anything like that? What are some of these -- are you seeing -- starting to see some conversations going, some shifts or interest in doing different types of programs with you?"
},
{
"speaker": "Julie Sweet",
"text": "Thanks, Lisa. Great question because we're talking to our clients all the time. And I guess, let me just start with, I think the experience of the pandemic has just built in more of a sense of resilience and agility. And so we're seeing really a lot of what I call calm in response to the macro environment. I mean the reality is that it's very early. And while there are lots of like predictions around what could happen with inflation, what could happen with supply chain, people are not overreacting. And instead, what I'd say is they're remaining very focused on the priorities they had before the crisis because as you talk about, inflation is already a reality, right? And we're already living that. And so for inflation, depending on the industry, like, for example, consumer goods, there's been a lot of focus on growth and cost, right, with cost being even higher up because you're seeing that you can't push through all of the -- and price increases, all of the increases in input. Of course, as you think about the potential scenarios around like disruption of agriculture and so on, we could see that potentially going higher, but it's too early to tell. And instead, companies are saying, look, we've got to make sure that we're on pace, and we're executing. The same as I think about energy prices. Supply chain, if anything, there's just been an increased focus on we need to think as much about resilience, right, as cost in supply chain. And we absolutely have to digitize so we've got more insight. And so I think the trends that we were already seeing to address, things coming out of the pandemic, the changing economic environment around inflation are simply being focused on even more. And this premium on are we building in agility and are we going at the right pace, that's really the nature of the conversations."
},
{
"speaker": "Lisa Ellis",
"text": "Got it. Okay. Okay. And then maybe my follow-up, KC, for you. I'll ask the inevitable margin question. It looked like -- I know Julie made a comment about contract pricing being up. It looks like gross margins are up, but SG&A also was up a bit, and then you're coming in at the lower end of your margin expectation. Can you just talk a little bit about the drivers there, what's going on in the underlying cost base?"
},
{
"speaker": "KC McClure",
"text": "Yes. Sure. Thanks, Lisa. So let me first start with, we were really pleased with our performance in operating margin. So we've expanded 10 basis points to the first half of the year. And we were flat in the second quarter. And really, that was driven by revenue growth, as we mentioned, with -- that had improved pricing on our record bookings. So very pleased with profit this quarter, including the 25% growth that we delivered in EPS. And so let's -- let me just peel that back a bit. So we're in a hypergrowth environment where we're hiring at elevated levels to meet this demand. So at the same time, as you know, we're navigating wage inflation. So Lisa, we remain very focused on pricing, knowing that it's going to take some time for the improved pricing, which lags compensation to flow through our P&L, but we did see some impact to that in this second quarter results. I think probably more importantly, it's really very important that we significantly invest in our people and our business and we're doing so at even higher levels than last year. So we're absorbing that also in our up margin as well as the step-up that we've talked about in our acquisition spend. So just in summary, we're halfway through the year. We're 10 basis points of margin expansion. We think we'll continue to that level of margin expansion in the back half of the year. Really pleased with that. And that would mean an EPS growth, which is stellar at 21% to 23% growth for the year."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Brian Keane with Deutsche Bank."
},
{
"speaker": "Bryan Keane",
"text": "Congratulations on these great results. I had 2 questions. I guess the first one is, given the disruption to some of the digital engineering IT service firms in Eastern Europe, are you seeing additional demand from clients looking to other vendors?"
},
{
"speaker": "Julie Sweet",
"text": "Thanks, Bryan. It's really too early to see that. We're seeing clients staying very focused on their business and what we're doing with them."
},
{
"speaker": "Bryan Keane",
"text": "Got it. And the other thing that jumped out at me is the 3x growth rate versus the market. I think typically, Accenture has been more of a 2x in recent years. So can you just talk to us about why the expansion and share gains that's happened over just recently here?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. Thanks, Bryan. It's really, I think, a combination of things, right, but let's just always start with our clients. Prepandemic, what we saw were clients much more into -- they did transformation quite sequentially, right? The pandemic was a major shock. You saw the leaders who are kind of coming into that saying we've got to go even faster. And you saw a bunch of companies saying, we need to leapfrog, right? We need to move online. We need to do digital transformation. And that meant that we saw companies starting to take on -- not sequential transformation, but what we call compressed transformation, where they're, at the same time, doing manufacturing as well as sales. And you saw that in some of the examples that I gave today where you've got entirely new backbones being created across multiple enterprise functions, where you've got both new platforms being put into place and manufacturing. And they're doing that in order to lead because of what they see in the business. And when you think about who is able to help navigate, because you don't do that kind of transformation with like a different partner for every transformation, right? Accenture is very distinctive in our industry because we are able to transform every part of the enterprise. And that's one of the things I was trying to emphasize. Like we can do -- we're going to finance in HR, right? We've got the growth agenda, sales, marketing and service, right? We've been investing for a decade in Industry X, which is really taking off. We talked about the digital frontier. And so you have in Accenture a partner that can do that. And you see that over the course of the last 2 years in the record numbers compared to prepandemic of clients with over $100 million in bookings. And it's really -- it's recognizing, it's representing that level of demand. And we're quite unique. Like we've talked about this for years, right? All of our different services, our deep industry knowledge. And when you're moving fast, you need a partner that really can span the enterprise and has that deep knowledge of the industry. And that is, of course, driving the growth, right? Because we are capturing the momentum in every part of the enterprise that's happening now."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Tien-Tsin Huang with JPMorgan."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Great results here. Just wanted to clarify your assumptions on the really strong outlook. Can we assume that your approach towards guidance is similar to the approach you took at the onset of the pandemic? And are you assuming any slowdown in Europe in your guide? I know there's a lot of questions we're giving on macro within Europe, so figured I'd just ask it here."
},
{
"speaker": "KC McClure",
"text": "Yes. So thanks, Tien-Tsin. So let me just cover what we're assuming in our guidance. So -- and maybe I'll first start with our guidance does take into account the revenue impact of discontinuing our business in Russia and the cost to wind that down. Now with respect to the broader risk, our guidance, we're calling it like we see it, Tien-Tsin. So the same way that we did -- we always do, we did during the pandemic. And today, we don't see a significant disruption in our business. Now it's still very early, and it's difficult to predict. So our guidance does not take into account any significant escalation or expansion of economic disruption or the conflict's current scope. Now as it pertains to Europe, we are not seeing a significant disruption in our business in Europe. You've seen that reflected as well in our very strong bookings and revenue growth. And for the back half of the year, our guidance continues to assume a very strong double-digit growth, including in Europe."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Okay. Great. Look, we trust your outlook. I just want to make sure I understood the approach here. Just my quick follow-up, just the 36 clients, over $100 million, big number. I'm just curious if the pipeline for larger deals, how does that look from here your ability to replenish? I know we're in March now, but just curious what you're thinking on larger deals looking ahead here."
},
{
"speaker": "KC McClure",
"text": "Yes. So I'll comment on the pipeline, Tien-Tsin, and see if Julie wants to add anything else. But we continue to feel good about our pipeline even with another quarter of record bookings just completed. We were very pleased with our bookings, obviously, in Q2 and for the first half of the year. But bookings can be lumpy from quarter-to-quarter. So we focus on the trailing 12-month book-to-bill as I know many of you do, too. But we, overall, still feel really good about our pipeline."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And Tien-Tsin, the only one thing I want to add maybe back to your last question is, we are doing exactly what we did at the pandemic, which is we're calling it like we see it, right? So we'll update every quarter. And we've got -- we're really close to the clients, right? And as we said at the beginning, it is too early. So we're not trying to build in, be overly conservative or overly optimistic. Like we really just call it down the fairway. And next quarter, we'll update and we'll go from there."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jason Kupferberg with Bank of America."
},
{
"speaker": "Jason Kupferberg",
"text": "Just wanted to ask about the bookings, obviously, extremely strong here. I was just curious on the consulting and outsourcing side. How much above your internal expectations did they come in? And how should we think about book-to-bill in the back half of the year? I know year-to-date, it's nicely elevated at 1.2x. So should we just expect some normalization there in the back half?"
},
{
"speaker": "KC McClure",
"text": "Jason, I would say that our bookings -- our record bookings did come in higher than we expected. That was a broad-based over-delivery across all markets, all services and industries as well as consulting and outsourcing type of work. And again, we look at an overall book-to-bill, as I just mentioned to Bryan, in a trailing 12 months, 4 quarters at a time. So, we feel good about where we are and our positioning and our pipeline and our bookings to date as we head into H2."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay. All right. Understood. And then can you just remind us which countries within Central and Eastern Europe you have the most meaningful headcount, obviously, excluding Russia? But I know you mentioned Poland earlier, but just so we have a broader picture of the headcount distribution in the region?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. Poland and Romania would be the sort of the two where we've got delivery centers. We don't have big local market, but Poland and Romania."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Keith Bachman with Bank of Montreal."
},
{
"speaker": "Keith Bachman",
"text": "Julie, I wanted to direct this to you. And the nature of the question is, I wanted to get your view about the durability of double-digit growth. And I'm not focused on this year. So, our model goes back to 2006 for Accenture. So, 2006 to 2021, Accenture grew on average, by about 8 points, which includes some M&A. Half of those years were in the double-digit range, half were not. And so, I'm just trying to think and I think investors are really focused on the phenomenal year that you're having this year, but it sets up: a, a very difficult compare, including 5 points of M&A; and b, a lot of companies, including my firm, came out of COVID and said, we need to do a lot of things differently. So, stressing -- trying to fix our IT infrastructure and -- may have created some pull-ins. The things we're going to do over the next 5 years, many firms are doing over the next 1 year. So, I wanted to get your -- with that as a context, how do you see, as you look out to 2023 and beyond, how do you view Accenture's ability to sustain double-digit growth?"
},
{
"speaker": "Julie Sweet",
"text": "I love that you look at it over the long term because that's how we do. And so, the way we think about growth isn't about, is it double digit or not, right? We've had a very enduring and I think it served us well, belief that we should be growing more than the market, right? And so that is what we focus on, is that we are always continuing to take market share. And that is an enduring commitment that we sort of -- that we anchor to. Now, the way we do that is that we stay very close to clients so that we know not only what they need today, but also, we can anticipate what they need tomorrow, right? And that's really important. So yesterday, for example, we talked about the Metaverse continuum where we have been investing for a decade. We think the Metaverse and Web3 is as significant as when, in 2013, we called that every business would be a digital business. And that will be a huge transformation over the next decade that will also be part of -- sort of next waves of growth. At the same time, it's really important to look at where we are now, which is still extraordinarily early in the digital transformation of every part of the enterprise, right? We estimate, for example, that only about 30% of workloads have been -- have moved to the cloud. And once you get to the cloud, that's when you actually use those technologies to grow and innovate. You saw that in some of the examples that we gave today where you're having the cloud piece, but then you're figuring out how to use the data and the AI to really transform. When you look at replatforming on the leading SaaS platform, similarly, extraordinarily early. So, everyone feels, right, the big focus on digital because that was the wake-up call from the pandemic. But the actual transformation and just putting in the foundation is still very early stages, and then it's what you do on that foundation. Then if you look at from a technology development point of view, let's take manufacturing and supply chain. Many of the technologies have that are advanced have only been introduced in the last couple of years, right, the advanced cloud-based technologies. And so, technology itself, like there's still new functionality that doesn't even exist in some of the major platforms that's still being created. And so, we consider the manufacturing and supply chain as the next digital frontier. And of course, that was a big play for us, which we've been doing for the last decade because it's a move from IT to OT as you think about the budgets that we're accessing, right? And so overall, like as much as we feel there's so much going on, you still have many, many companies who’ve not started the compressed transformation. You're very early in the platforming of what's today, let alone the next things that we can already see like Web3."
},
{
"speaker": "Keith Bachman",
"text": "Okay. Great. Very helpful. KC, I'll make my follow-up a bit more poignant question, and just want to try to understand the operating margin comments that you made before. And specifically, is wage inflation impacting that negatively, influencing some of the comments you made about potential for operating margin expansion this year?"
},
{
"speaker": "KC McClure",
"text": "Yes. So in terms of wage inflation, I will -- it's really a pretty similar case to what we've discussed last quarter. So maybe it just kind of goes back through that again. So obviously, it's occurring in all the industries, and it's across the globe. And our clients have also obviously experienced this as well in this very tight labor market. But for us, as it relates to wage inflation, we see for our business that we're going to continue to have wage increases in the market for certain skills, and that's going to continue to vary by geography. And we're also looking at have the Consumer Price Index and any increases there and how that might potentially spill over into inflation at the lower end of our pyramid. And so we're focusing on pricing to absorb our higher labor costs. And again, as it relates to pricing, what we're seeing is that it's going to take some time, Keith, for the improved pricing, which we did have in the second quarter, again, on our record bookings. We see that flow through -- see that flow through our P&L. We did see some of that impact in the second quarter, but that obviously lags the impact of compensation increases."
},
{
"speaker": "Julie Sweet",
"text": "And I'm just going to add -- and I just want to add that I'm very happy with where we are on profitability. I mean if you think about what we are navigating, right, hyper growth has increased costs from all the recruiting, right? We did a big step-up in acquisitions last year. We're absorbing that dilution this year, right? We've increased significantly the investments in our business, which are all about driving growth today, but also tomorrow, right? We're in an unprecedented labor market with wage inflation, which we are absorbing and still delivering at 10 basis points operating margin expansion. So I feel really good about where we are as a company, both for this year and all the things that we're doing to position ourselves to continue to grow in market-leading ways."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ashwin Shirvaikar with Citi."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Julie, KC, congratulations on the quarter and outlook. I wanted to start with the M&A question. I believe there was no M&A since last earnings. Perhaps I may have missed a smaller deal or 2. Is that just a quirk of timing? Or is it that you just recently did larger deals and are integrating? Or might there be other factors at play?"
},
{
"speaker": "KC McClure",
"text": "Yes. Maybe I'll just state some facts and you can -- yes, so Ash, we're about halfway through the year. And we did have a lot of acquisitions closed in Q1. You're right, we did have less close in Q2. But acquisition closing, they can be lumpy. We can't always control the timing. So we've deployed $1.8 billion of acquisition spend year-to-date. We continue to expect about $4 billion of acquisition spend in FY '22. But of course, we're only going to do deals that make sense. And so it could be plus or minus the $4 billion. And we'll update you next quarter. But let me..."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And I just like I wish we could manage it sort of like say, we're going to do this many and then we're going to absorb. But it really is just about timing goes up and down. And also, we have a lot of rigor and discipline. We're only going to do deals that we believe in, right? So we're not trying to manage in any way to a quarter. We've got a capital allocation. If we can do that with great deals, we're going to do it, and so that's the approach. I will take the opportunity just to say one of the ones we did announce, we did close 2 this quarter. But one of the ones we announced I'm super excited about, which is AFD.TECH, which is in the network space, 1,600 people in France. And it's important because as you think about what's happening in digitization, our increasing move into really leading in network is important. And it's just another great example of how we use acquisitions to accelerate our strategic growth priorities. It's an important part of Accenture Cloud First."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "No doubt. I agree with that. And I wanted to ask a broader question. This has unfortunately been asked in a few different ways. But I think you captured it well in your takeoff sentence when you mentioned an incredibly high level of uncertainty. But I believe that since the compressed transformation move started, this is probably the first major test of secular trend versus cyclical uncertainty. And I know you're calling outlook like you see it. But is this time different? Can the strength of secular overcome cyclical challenges?"
},
{
"speaker": "Julie Sweet",
"text": "Look, we all rose to dealing with the types of things that may come out of this crisis other than perhaps the military scenarios, right, whether it's more inflation, the need for energy conservation due to higher energy prices, the disruption in supply chain, agriculture. All roads lead to some combination of technology and human ingenuity, right, which is what we bring together. And so, you've got great solutions like managed services to accelerate both cost takeout and finding new ways to grow, new ways to access markets, right? You've got energy efficiency that's going to come from technology improvements. And so, as you think about what we do, right, we're the company that's going to be able to help companies navigate these macro trends. And so, we really believe that the technology -- importance of technology and then being able to apply it to get tangible outcomes is going to be critical. And so, we believe we'll be resilient through this, through whatever this is going to be as well."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Surinder Thind with Jefferies."
},
{
"speaker": "Surinder Thind",
"text": "The first question I'd like to ask is just about talent and your ability to acquire it more globally. Obviously, in the earlier announcement about the apprenticeship program or the expansion of it in the U.S., can you talk a little bit about as you build out the bottom base of the pyramid for your delivery.How does something like that impact like bill rates or the clients' willingness to accept bill rates when you're using individuals with non-4-year degrees and so forth?"
},
{
"speaker": "Julie Sweet",
"text": "Interesting question. I would say that our clients really focus on skills. They don't focus on degrees. And so, what they're looking for are the skills. And that's a broader trend. In fact, we predicted that 3 years from now, Chief Human Resources officers will all be talking about skills. And as part of this trend, you need to be -- not a consumer, but a creator of talent, understand skills and then be able to reskill."
},
{
"speaker": "Surinder Thind",
"text": "Fair enough. And does that also impact your cost as well, though? Are you able to employ them at a better cost base, I guess? How should I think about the arbitrage opportunity there if clients are willing to pay for the full skill?"
},
{
"speaker": "Julie Sweet",
"text": "I wouldn't think about the arbitrary opportunity. We pay market-relevant pay. And it's the focus on skills. Even if you look at our -- the way we draft our recruiting thing, it is about skills. And so, there isn't something that because you've got a 2-year degree versus a 4-year degree, now you're paid less. It's about skills. So, there's a market price for these skills. So, I wouldn't think of it as labor arbitrage."
},
{
"speaker": "Surinder Thind",
"text": "Got it. And then as a follow-up question, just a big-picture, longer-term question just about the delivery model. Do the current geopolitical events maybe change your perception of where you may want to operate or expand to? There's generally been in the trend of the last few years, much more global delivery. Obviously, you guys are very global. But in terms of just trying to get as much talent in every country everywhere, how does that kind of change the way that you might be thinking about delivery, whether it's being more concentrated in certain regions or areas or avoiding other regions and areas?"
},
{
"speaker": "Julie Sweet",
"text": "What I would say is since the time of the pandemic, when we had this global shock, right, we continued to evolve our ability to move work and be flexible. And so, our focus is really on that agility and making sure that we have the right kinds of talent, both geographically dispersed, but also the ability to move talent around."
},
{
"speaker": "Angie Park",
"text": "Operator, we have time for one more question, and then Julie will wrap the call."
},
{
"speaker": "Operator",
"text": "Our last question will come from the line of Brian Essex with Goldman Sachs."
},
{
"speaker": "Brian Essex",
"text": "Great. I echo my congratulations on the results for the quarter. I guess, I wanted to follow up to the last question, maybe a little different angle, focused on the supply side. So, I guess with that` in mind, Julie, are you seeing -- obviously, in a post-pandemic era or hopefully coming out of the pandemic, companies are used to operating in a hybrid world, more agnostic to where work is performed. Any trends that you -- or overarching trends that you can call out either by skill level or by geography where they might, and specifically, would love to focus it on how they're managing costs? So, are they looking to shift work to particular geographies? Do you see demand in particular geographies? Are there certain trends that you can call out with regard to the skilling of labor forces in particular geographies that are notable where you might see some cost benefit or better ability to supply to meet demand?"
},
{
"speaker": "Julie Sweet",
"text": "I'm talking about talent all the time with our clients. And I'd say that it's slightly different than what your focus is. Here are the two big things, which are all around accessing talent. So, in accessing talent, means you have to be able to attract and retain it, and you've got to be able to get it at scale. So the bigger focus is around what does it take to attract and retain in a hybrid work environment. And so more companies are focused on where they did -- they used to want everybody in the office, having more of a hybrid model, and that has knock-on cost effects as you decrease your real estate. And so that's been a big focus. But the actual -- the thing we talk to clients about is it's more about how do you attract people who today, all of our research shows that if you're not having to be there in a frontline worker, you want some combination, and then that does have costs. And so that's a huge focus around talent. The second piece on access, if you look at the way our managed services are being driven, it is really 2 big things. One is it's faster to digitize because you use our platforms. And the second is the access to hard-to-get talent, right? And so let's just take security. We have 10,000 security professionals who do everything from threat assessment to the rebuilding and designing platforms to managed services. And in today's world, with the security landscape broadening, right, that access to that kind of talent is incredible. And so just the real focus is on access and what does it take to access it, including through partnerships. And those are the kinds of conversations that we have."
},
{
"speaker": "Brian Essex",
"text": "Got it. That's super helpful. And maybe just one quick follow-up on resources. What have you seen historically? I know we've got accelerating energy prices, oil in particular. What have you seen historically with regard to follow-on for alternative projects and greater investment in the energy sector, in particular, in response to prices? How high is it been correlated, particularly on the discretionary side and maybe your experience in terms of how you've seen follow-through with spend in that sector?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. Well, listen, I was just at CERAWeek, which is the world's largest energy conference for a couple of days just last week, so I spent a lot of time with everyone in the energy sector. And I think rather than looking at it historically, let's look at it like what are people talking about now. So first of all, despite the increases in prices, say, in oil and gas, no one is saying, \"Hey, now we've got to let up on cost.\" In fact, the exact opposite. Because the oil and gas industry, in fact, the entire energy industry has a major challenge ahead of investing to move to sustainable energy solutions. And so what I would say is that there is an absolutely laser focus on continuing what that industry had to do during the pandemic because how it was fit and focus on cost and now accelerate innovation and moving to sustainable energy solutions. And that's where we gave the example today of how we're helping in decarbonization. We announced this week what we're doing with Ecopetrol and AWS around water management, right? And so we're playing -- we're obviously very well situated. We have a deep, deep expertise in utilities and oil and gas and the entire energy sector in -- at their core both enterprise as well as in the grid, at the refinery and then helping really create those sustainable solutions. We see this as a major opportunity for our clients that we want to help them on."
},
{
"speaker": "Angie Park",
"text": "Great. Thank you very much. I'm going to close the call now. Thanks, everyone, for joining us, and thank you again to our incredible people and to our shareholders for your continued trust. Please make sure to join us for our Virtual Investor and Analyst Day on Thursday, April 7. We're looking forward to being back together. Thanks, everyone."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this conference will be available for replay after 10:00 a.m. Eastern today through June 23. You may access the AT&T replay system at any time by dialing 1-866-207-1041 and entering access code 6300496. International participants may dial 402-970-0847. That does conclude our conference for today. We thank you for your participation and for using AT&T conferencing service. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 1 | 2,022 | 2021-12-16 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by. Welcome to the Accenture First Quarter Fiscal 2022 Earnings Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the conference over to our host, Ms. Angie Park, Managing Director and Head of Investor Relations. Please go ahead.
Angie Park: Thank you, operator, and thanks, everyone, for joining us today on our first quarter fiscal 2022 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director and Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the second quarter and full fiscal year 2022. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today we will reference certain non-GAAP financial metrics, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our Web site at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Angie, and thank you everyone for joining us. I would like to start by thanking our 674,000 people around the world for your extraordinary work and commitment to our clients. Our results again, this quarter reflect how you are living our purpose every day to deliver on the promise of technology and human ingenuity. As more and more companies embrace compressed transformation, our clients are turning to us as their trusted partner, as reflected in our outstanding growth of 27% this quarter. We added 15 new diamond clients bringing the total to 244. Diamond clients are our largest relationships. And to give some context, we added 13 diamonds in all of FY '21. We also had record bookings of $16.8 billion, 30% growth year-over-year with 20 clients with bookings over $100 million. And we expanded operating margin 20 basis points in Q1 with adjusted EPS growth of 28%. While we continue to invest in our business and people, including $1.7 billion in acquisitions, and in just the first quarter, we invested $250 million in learning for our people, with 8.6 million training hours for approximately 14 hours per person. The extraordinary demand we see in the market reflects the imperative of digital transformation. Companies are making critical decisions about who will be their strategic partners. And they are selecting us because of our talented people, our deep industry and technology capabilities, and our commitment to both create value and lead with value. We predicted back in 2013 that every business would be a digital business. And we have executed a clear strategy to rotate our business to anticipate and be ready to serve our clients. And when the pandemic hit, we were ready with capabilities that scale reflected in 70% of our revenue at that time being from digital cloud and security, with strong relationships with the world's leading technology companies, which in some cases go back decades, with a focus on growing our people through learning, allowing us to rapidly re-skill, with an unwavering commitment to inclusion and diversity and equality and caring for our people professionally and personally, making us a talent magnet in a tight labor market, adding 50,000 talented individuals in Q1. And it is our breadth of capabilities across strategy and consulting interactive technology and operations, which is unique in our industry that allows us to work side by side with our clients to deliver results. And we believe our goal to create 360 degree value for our clients, people, shareholders, partners and communities is an essential part of our success. Certainly our commitment to creating vibrant career paths for our people is an important part of this value and we just completed our annual promotion process. I want to congratulate our 1,030 new promotes to Managing Director, 143 new appointments to Senior Managing Directors and the more than 90,000 people we promoted around the world in Q1 overall. Today we launched our 360 value reporting experience, a new way to show our progress and the value we create in all directions for all of our stakeholders. More on that later. KC, over to you.
KC McClure: Thank you, Julie. Happy Holidays to all of you, and thanks for taking the time to join us on today's call. We were very pleased with our overall results in the first quarter, which exceeded our expectations, setting a new bookings records at $16.8 billion, with consulting bookings exceeding the previous record by more than $1 billion. Our results reflected strong double-digit revenue growth across all dimensions of our business, all markets, services and industry groups. And we saw improved pricing in many parts of our business. Based on the strength of our first quarter results and the demand we see in the market, we are significantly increasing our full year revenue and EPS outlook. Now let me summarize a few of the highlights of the quarter. Revenues grew 27% in local currency, increasing more than $3.2 billion over Q1 last year, and more than $600 million above our guided range, with broad based over delivery across all markets, services and industries with all 13 industry groups growing double digits. We continue to extend our leadership position with growth we estimate to be more than 5x the market which refers to our basket of publicly traded companies. Operating margin of 16.3% for the quarter, an increase -- with an increase of 20 basis points. We continue to drive margin expansion while making significant investments in our people, in our business, including acquisitions. We delivered very strong EPS of $2.78, up 28% over adjusted fiscal '21 results. Finally, we delivered free cash flow of $349 million and return $1.5 billion to shareholders through repurchases and dividends. We also invested approximately $1.7 billion in acquisitions, and we continue to expect to invest approximately $4 billion in acquisitions this fiscal year. With those high level comments, let me turn to some of the details, starting with new bookings. New bookings were record at $16.8 billion for the quarter, representing 30% growth in U.S dollars, and were $800 million higher than our previous record. With an overall book-to-bill of 1.1. Consulting bookings were record at $9.4 billion with a book-to-bill of 1.1. Outsourcing bookings were $7.4 billion with a book-to-bill of 1.1. We were very pleased with our bookings this quarter, which reflected 20 clients with bookings over $100 million. All of our service dimensions, strategy consulting, technology services and operations, as well as our geographic markets delivered strong double-digit bookings growth in U.S dollars. Turning now to revenues. Revenues for the quarter were $15 billion, a 27% increase in U.S dollars and in local currency. Consulting revenues for the quarter were $8.4 billion, up 33% in U.S dollars and 32% in local currency. Outsourcing revenues were $6.6 billion, up 21% U.S dollars and in local currency. Taking a closer look at our service dimension, strategy and consulting, technology services and operations all grew very strong double-digit. Turning to our geographic markets. In North America, revenue growth was 26% in local currency, driven by double-digit growth in public service, software and platforms, and consumer goods, retail and travel services. In Europe, revenues grew 28% local currency, led by double-digit growth in consumer goods, retail and travel services, industrial and banking and capital markets. Looking closer to countries, Europe was driven by double-digit growth in Germany, U.K., France and Italy. In growth markets, we delivered 30% revenue growth in local currency, driven by double-digit growth in consumer goods, retail and travel services, banking and capital markets and public service. From a country perspective, growth markets was led by double-digit growth in Japan and Australia. Moving down the income statement. Gross margin for the quarter was 32.9%, compared with 33.1% for the same period last year. Sales and marketing expense for the quarter was 9.7% compared with 10.4% for the first quarter last year. General and administrative expenses were 6.9% compared to 6.6% for the same quarter last year. Operating income was $2.4 billion in the first quarter, reflecting a 16.3% operating margin, up 20 basis points compared with Q1 last year. Before I continue, as a reminder, we recognized an investment gain in Q1 last year, which impacted our tax rates and increased EPS by $0.15. The following comparisons exclude these impacts and reflect adjusted results. Our effective tax rate for the quarter was 24.4% compared with an adjusted effective tax rate of 23.7% for the first quarter last year. Diluted earnings per share were $2.78 compared with adjusted diluted EPS of $2.17 in the first quarter last year. Days service outstanding were 42 days, compared to 38 days last quarter and 38 days in the first quarter of last year. Free cash flow for the quarter was $349 million, resulting from cash generated by operating activities of $531 million, net of property and equipment additions of $182 million. Our cash balance at November 30 was $5.6 billion compared with $8.2 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the first quarter, we repurchased or redeemed 2.4 million shares for $845 million at an average price of $346.19 per share. At November 30, we had approximately $5.6 billion of share repurchase authority remaining. Also in November, we paid a quarterly cash dividend of $0.97 per share for a total of $613 million. This represents a 10% increase over last year. And our Board of Directors declared a quarterly cash dividend of $0.97 per share to be paid on February 15, a 10% increase over last year. So in summary, we are very pleased with our Q1 results and we are off to a very strong start in FY '22. Now, let me turn it back to Julie.
Julie Sweet: Thank you, KC. Starting with the demand environment, as we expected across industries and the globe, technology continues to be the single biggest driver of change, accelerating, disrupting and creating new opportunities. More companies are embracing compressed transformation underpinned by cloud and digital and are moving to build their digital core and use technology to transform how they operate and to find new ways to compete and grow as you would expect for 27% revenue growth. We are seeing broad based demand across all markets, services and industries with double-digit growth across all our strategic growth priorities, including Applied Intelligence, Cloud, Industry X, Interactive, Intelligent Operations, Intelligent Platform Services, Security and Transformational Change Management. Let me bring this demand to life. First, compressed transformation is occurring across the globe and the key enabler is the cloud across the continuum from public to hybrid to increasingly the edge, and the move to leading SaaS platforms along with the convergence of cloud and data. For example, we are working with a leading global supplier of tires and mobility solutions to migrate to the cloud, modernize its IT platforms, use data to accelerate growth and value and shift to a digital supply chain. We created a state-of-the-art system to track inventory, sales, warranty information and returns, all in the cloud, all in real time and have already helped to increase customer satisfaction 35% with improved cost optimization and increased revenue up next. We're also helping Mount Sinai Health System, New York City's largest academic medical system transform, modernize and increase its resilience by migrating its clinical systems, non-clinical systems and clinical data to a stable, secure cloud based infrastructure to proactively detect and prevent threats, adapt to business and regulatory changes, together with a potential to save millions over the next 5 years, savings that can be reinvested to fund strategic innovative programs and help rescale teams. Our deep industry expertise is helping companies find new solutions and path to growth and helping their customers. For example, we are collaborating with Opay, a leading Finnish Financial Group to use automation, advanced analytics and other emerging technologies to increase business agility, reduce cost, and deliver enhanced customer and employee experiences. Opay will adopt the Intelligent Automation Platform, Accenture myWizard to enable the company to extract greater value from its technology investments. We are working with TUGA, a leading utilities provider in Germany to create and operate a game changing meter-to-cash IT platform in the cloud. It will help reduce operating costs by up to 40%, accelerate time to market and free up resources for energy transition and innovations like smart metering, helping customers make environmentally conscious decisions and energy providers stay responsive and reliable. And as we talked about last quarter, our Sustainability Services are focused on helping our clients across industries move from commitment to action at scale. We see these services is critical to our clients agendas. I'm pleased to announce that we have signed an agreement to acquire Zestgroup, a Dutch sustainability services company with 140 employees that specializes in energy transition services and sourcing renewables and other clean energy sources. We look forward to welcoming them and working together to help clients move at speed to achieve net zero carbon. We continue to help our clients to enter the next digital frontier of Industry X. We're excited to have completed the acquisition of umlaut and are seeing the power of our combination already. Together we're working with a global technology leader to transform from a traditional engineering platform to a more agile model based engineering platform that uses simulation and analysis from design and development all the way through the product lifecycle. We were also working with an American wireless operator to help improve daily operations and transform their network security by combining our deep security risk assessment and communications industry skills. Of course, growth is at the heart of every client's agenda and Interactive is helping our clients capture new growth with their customers with our unique combination of creativity, technology, data, AI and industry expertise. For example, we are applying our digital global capabilities to help Capri Holdings Limited, a global fashion luxury group consisting of the iconic brands Versace, Jimmy Choo and Michael Kors, translate its rich in-store luxury shopping experience to a digital experience that aligns with shifting customer behaviors and accelerate sustainable growth. As a strategic partner with Volkswagen Group, a German motor vehicle manufacturer, we're helping Audi and VW to pave the way for sustainable growth through precise continuous commerce and rich experiences along the entire car buying journey. We are combining the power of AI of predictive analytics to deliver the right experiences at the right time to accelerate revenue growth through an expanded digital commerce ecosystem. We're also working with VLI, a Brazilian logistics solutions company and Trato [ph] its new platform business to provide a digital one stop shop for self employed truckers to enhance their growth, to improve logistics by offering options for more profitable freight products as well as to provide them access to critical services such as insurance, loans and health care, all by combining data [ph] analytics and AI. We see an increasing demand to create the platforms that power the digital products and experiences our clients seek for their customers. We're helping CLO, a leader in electronic payments in Latin America become more competitive by migrating to the cloud, which will accelerate new product development and enables cutting edge technologies. This will make it easier to launch innovative products, reduce time to market by two-thirds and lower costs, all while enhancing their customers experience. And of course security is critical to all our clients. We were proud to be selected by the Department of Homeland Security's Cybersecurity and Infrastructure Security Agency, CISA in the U.S., America's risk advisor defending against today's threats, with advanced cyber services to help the Department of Homeland Security protect federal, civilian and executive branch systems against cyber attacks like ransomware, botnets and malware campaigns. Even as companies undergo compressed transformation, exponential technology changes continue. We are investing to anticipate the future and we are working with our clients to innovate and take advantage of emerging technologies to compete and win. Our R&D is powered by Accenture Labs and Ventures and extends across every part of our business so that we can quickly translate research into real results for our clients. For example, we are working with ESPN to explore how emerging technologies can enable new ways for fans to experience sports at the ESPN edge innovation center, leveraging the years of early investments we've made in extended reality. We've been a key participant in shaping the innovation in enterprise, blockchain technologies across the globe, with applications in financial markets, supply chain and digital identity, which now are creating value for our clients. From partnering with the Digital Dollar Foundation to explore a U.S central bank digital currency to working with Hong Kong Exchanges and Clearing Limited to build a new integrated settlement platform using digital asset modeling language, Smart Contract. And while the metaverse has recently burst into the public eye, we've been an early innovator in applying the technology. In fact, we often innovate on cutting edge technologies by deploying them at Accenture first. We are proud to have the largest enterprise metaverse to what we call the Nth Floor and are deploying over 60,000 virtual reality headsets and have created one Accenture Park, a virtual campus for onboarding and immersive learning, including meeting rooms and collaborative experiences. Our VR environments provide our people with a human connection and learning experiences in an immersive digital world. We are also working with clients to help explore and shape their early forays into the metaverse through new digital experiences enabled by virtual reality and responding to their interests in new products enabled by NFTs, or non-fungible tokens, new ways to conduct commerce as the metaverse takes shape. Many of these client examples reflect our goal to create 360 degree value. This goal reflects our growth strategy, our purpose, our core values and our culture of shared success. It is also how we operate Accenture and we measure our success by how well we are achieving this goal for all our stakeholders. And today, we are proud to present our new 360 degree value reporting experience, a new way to share our progress, which is available on our website. With this comprehensive digital tool, you'll find all our reporting and data in one place, measuring how we're doing. We've expanded our ESG reporting with three additional ESG framework, the Sustainability Accounting Standards Board, SASB, the Task Force on Climate-related Financial Disclosures, TCFD and the World Economic Forum International Business Council WEF, IBC metrics, while continuing to report against the Global Reporting Initiative GRI standards, the UNGC 10 principles and the Carbon Disclosure Project, CDP because we believe that transparency builds trust and helps us all make more progress. Back to you, KC.
KC McClure: Thanks, Julie. Now, let me turn to our business outlook. For the second quarter fiscal '22, we expect revenues to be in the range of $14.3 billion to $14.75 billion. This assumes the impact of FX will be about negative 4% compared to the second quarter of fiscal '21 and reflects an estimated 22% to 26% growth in local currency. For the full fiscal year '22, based on how the rates have been trending over the last few weeks, we now expect the impact of FX on a result in U.S dollars will be approximately negative 3% compared to fiscal '21. For the full fiscal '22, we now expect our revenue to be in the range of 19% to 22% growth in local currency over fiscal '21, which continued to assume an inorganic contribution of 5%. For operating margin, we continue to expect fiscal year '22 to be 15.2% to 15.4%, a 10 to 30 basis point expansion over fiscal '21 results. We continue to expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.1% in fiscal '21. For earnings per share, we now expect our full year diluted EPS for fiscal '22 to be in the range of $10.32 to $10.60 or 17% to 20% growth over adjusted fiscal '21 results. For the full fiscal '22, we now expect operating cash flow to be in the range of $8.4 billion to $8.9 billion, property and equipment additions to be approximately $700 million and free cash flow to be in the range of $7.7 billion to $8.2 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $6.3 billion through dividends and share repurchases as we remain committed to returning a substantial portion of cash to our shareholders. With that, let's open it up, so we can take your questions. Angie? Angie Park Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask the question. Operator, would you provide instructions for those on the call?
Operator: Of course. [Operator Instructions] And the first question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead.
Tien-tsin Huang: Thank you so much. Yes, really remarkable growth here in [technical difficulty] $600 million. I think that's the largest number of growth [technical difficulty] got to ask what surprise you [technical difficulty] with the compressed transformation and [technical difficulty] more on …
Julie Sweet: Hi, I think we were -- Tien-tsin, we are having a little trouble hearing you, but I think I got it. You want to know what drove our over delivery -- are the over delivery $600 million?
Tien-tsin Huang: You got it.
KC McClure: Okay, that's what I thought. So first of all, good morning to you. So the first thing I would say is that overall in terms of our revenue production this quarter, everyone did better. It really was broad based over delivery across all of our markets, all of our industries and our services. And when you want to -- when you peel that back, you really start with bookings. So we have broad based over delivery also in our bookings. And so you see that flowing through our revenue production, Tien-tsin. And on that bookings production, well, we had 20 clients with bookings over $100 million. It really was broad based growth in our bookings, across, the larger deals all the way down to midsize and smaller deals. And then so that also really did help us drive more revenue. And importantly, we were able to meet this demand, because we have the people able here to work on the extra demand coming from the bookings. So we were really very pleased with the overall broad base delivery in the first quarter. And that is why we see that coming into the second quarter, and then a big part, obviously, of our full year revenue increase.
Tien-tsin Huang: Got it. Thanks [technical difficulty] hope you can hear me okay. My follow-up just maybe for Julie [technical difficulty] 360 degree in [technical difficulty] been hearing a lot about that here. [Technical difficulty] becomes a bigger factor [technical difficulty]. Is that part of the [technical difficulty] care of pushing this [technical difficulty] 360 degree?
Julie Sweet: Yes, no, it's a great question, Tien-tsin. And I think there's a couple of things that are going on. So first of all, we absolutely see in more of the requests for proposals, our clients asking to understand your position on sustainability, for example. So we’re -- we've been -- and we've seen that trend for at least the last 12 months that it's more important formally in our RFPs. But we also see it in the conversations we're having with clients, that they are asking a lot about this, they're very much focused. And so when we talk about it, it's important to them. And so, when we launch this strategy around 360 degree value over a year ago now, it was based on the conversations we were already having with clients, right. We launched it, because our clients were saying, we have to achieve this. And the biggest issues, I think in the world that we look for is how do you move from commitment to action. And so there's -- and part of that is, therefore clients also want to partner with companies that are equally committed, and it matters to them things like 50% of our centers around the world are using renewable energy, right? It matters to them, the work that we're doing on IT -- green IT software, so that eventually we'll be able to have much more sustainable software development. So it's definitely a buyer value. We see it formally. We see it informally. And we see it in terms of what they're trying to do, which is why our sustainability services are also so important, and you heard some of the examples today.
Tien-tsin Huang: That's excellent. Thank you, guys.
Julie Sweet: Thanks.
KC McClure: Thanks.
Operator: And our next question comes from the line of Bryan Bergin with Cowen. Please go ahead.
Bryan Bergin: Hi, good morning. Thank you. So you often talk about the market share gains. I'm curious if you've seen an inflection in win rates over the last few quarters, or has there been a significant uptick in overall demand in the market with consistent win rates that is driving this level of growth?
Julie Sweet: Good morning, Bryan. It's the latter. So let me just start with -- we've seen a really consistent win rate. But maybe I'll peel back to what we talked about in the fourth quarter. When we were coming into the year, we felt really good about our pipeline. Even in a seasonably lower quarter, we thought -- we saw good bookings for the first quarter. And obviously, you saw that come through. And our bookings are record bookings this quarter. But I will say even with that, we feel really good about our pipeline, even after the record bookings and that's the statement across all markets and services.
Bryan Bergin: Okay. And then my follow-up, so when we think about headcount progression, it would seem you're on a path to hit a million people here over the next 3 years or so. So as you've gotten larger, can you talk about what you've had to do differently to enable the strong execution across so many global resources. And just how are you thinking about what you were going to need to do more of as you get even larger?
Julie Sweet: Sure. That's a great question, Bryan. Let me take that. And I think there's three things to focus on. One is how we manage the business. So just to take you back to March 1, 2020 when we announced our next gen growth model, one of the explicit reasons we reorganized at the time, focused on geographies we said was to enable us to scale. And so that's enabled us because we're still fundamentally a people business. It's also driven by a lot of assets, but you need to be able to be close to clients and people. And so that change really allowed us to be where we are now, where we're scaling. But it also, in addition to the scaling, it helps us be more agile. Like you'll remember, we put that into place and we created Accenture Cloud first 4 months later, right, which has been a huge success. And it's the agility by simplifying our structure at the same time. So first, it's -- how we manage our business in terms of an organizational perspective, and having simplified our business. The second piece is the focus on employee experience. Our -- one of our eight leadership essentials is caring for our people, personally and professionally. And this is a very important part of how we are able to scale and drive our culture. And you'll see in our attrition, it again is at the lower end of the pyramid in India, and we have significantly lower attrition at the executive and above. And that is very much we believe, because of how we focus on our people. And the last piece, which is our culture. You notice that we talked about the metaverse and what we've launched in our script today. That's another way of how we're driving our culture. We are constantly innovative -- innovating. So in a world where people can have as many physical experiences today, we created this immersive experience, which connects people, right, which builds connections. And so the focus on being smart about how we manage our people and staying close to them and our clients, our leadership and how we promote and develop and then constantly innovating to build the connection and the culture. We call it omni connections are absolutely critical when you're scaling.
Bryan Bergin: Thank you.
Julie Sweet: Okay.
Operator: And we do have a question from the line of Lisa Ellis with MoffettNathanson. Please go ahead.
Lisa Ellis: Hi. Good morning. Thanks for taking my question. A couple of macro questions from me. Can you talk about how inflation is affecting your business? Specifically, is it a tailwind to revenues? Because you're seeing -- you're able to pass through labor cost inflation on to clients? And if so, are there other factors as well that you might call out on inflation? Thank you.
KC McClure: Yes, maybe I'll start and then Julie, if there's -- you can add in, in terms of what we're seeing with our clients. But maybe, Lisa -- maybe we'll start with inflation, and I'll take it from maybe from a wage increase perspective. So, to state the obvious wage inflation is on all our minds, it's occurring in all industries and it's across the globe, and our clients are all experiencing a tight labor market. So for us as it relates to inflation in wages, we see for our business that we will continue to have wage increases in the market for certain skills, and that varies by geographies and we expect it really to continue. So what are we doing? It's not so different from what other clients are doing. We're focused on pricing to absorb our higher labor costs. And one other thing that we pointed out, Lisa, that we were very pleased with the improved pricing that we had this quarter on our record bookings, but we have more work to do. And so as one of the things that I want to just point out that it's just going to take some time for the improved pricing to flow through our P&L, and that's going to lead to higher compensation that we see. It may even result for us in some operating margin contraction in Q2, although we expect to continue to expand margin by 10 to 30 basis points for the full year. So I mean, that's just maybe a bit of a glimpse on what it means for us, as we run our own P&L. And I'll hand it over to Julie to give some thoughts on what she's thinking and talking with our clients.
Julie Sweet: Yes, great. And so, look, we're all managing different aspects, there's wage inflation. There's -- inflation, it's obviously on products. And so -- and it varies by industry in terms of the extent of the impact. And what we really see our clients doing is, because there's a lot of uncertainty about how inflation is going to develop in 2022 is being laser-focused on cost efficiencies and growth, right, because for many industries, they can't pass on the improved pricing, or they're like us, right. It takes a while to be able to do that. And so it is helping as well, drive some of the demand for both things, helping them grow, but also do that efficiently.
Lisa Ellis: Terrific. Thank you. And then just for my follow-up, maybe a follow-up on Tien-tsin's question. So clearly, the level of demand you're seeing is sort of surprised even you guys have a very good handle on it all the time. So if you can just give some color around what your senses about what's happening, like what's happening out in the marketplace. You said it's very broad based across industries across geographies. And so maybe just sort of from a narrative perspective, what's your sense of what's happening differently or differently than you expected even 3 months ago in terms of -- that's driving dramatic increase in demand? Thank you.
Julie Sweet: Sure. I think a big aspect of it is embracing the need for speed. And so you are continuing to see more and more companies doing the compressed transformation, the willingness to take on more at the same time and even to do that faster. And just think we have a couple of calls I had just this past week, clients that we've been working with, on some -- for some time speaking about their cloud journey, I wouldn’t call me up Monday and say, okay, we're going to pull forward Wave 2. We've got to go faster. It's harder than we thought we need to go faster. And in so there's this, as companies are kind of getting into it, they're seeing that they want to go even faster, they're also seeing the impact of those who come ahead. I was recently talking to the CEO of a company where we're doing a major cloud and data platform, and his point, so as we speak, okay, now I get it, I can only go so fast, but can you go faster, because I now see what I can really do one side replatform, right. And so, this embracing more change and speed, we do think is helping drive this demand. And we predicted the sort of -- remember, we talked about compressed transformation, that it's really only been in about a third of industries, and that it was going to continue to expand. But the point is, the first round of compressed transformation is just the first round. And as you begin to see the power of what it is to be in the cloud, the next steps of opportunities are being seen by the clients. And so I do think it's mostly around a recognition of the value of replatforming and the need for speed competitively.
Lisa Ellis: Terrific. Thank you and happy holidays.
Julie Sweet: Happy holidays.
Operator: And we do have a question from the line of Jason Kupferberg with Bank of America. Please go ahead.
Jason Kupferberg: Thanks, guys. Congrats on these numbers. Happy holidays. Maybe a little bit more to follow-up on some of these top line questions. You mentioned the pipeline still remains robust after the very strong Q1 bookings. So how should we be thinking about second quarter bookings growth in both consulting and outsourcing relative to the Q1 levels?
KC McClure: Thanks, Jason, Happy Holidays to you too. We do feel good about our pipeline and -- for the second quarter and for the remainder of the year. So, but bookings can be lumpy. So there's nothing that I would project to, obviously one way or the other against Q1, Jason. But for both outsourcing and consulting, and across all of our markets and the services within those we do feel really good.
Jason Kupferberg: Okay. Okay, got it. Got it. So we will have to account for some of that lumpiness. And I'm wondering also, if there's been any noticeable change in average project sizes or conversion cycles of backlog into revenue. And then just anything you may want to comment on regarding updated assumptions for consulting and outsourcing revenue growth in full year fiscal '22? Thanks, again.
Julie Sweet: Sure. So there's really no change, Jason, to anything that we're seeing in duration or in conversion. I mean, it all depends on the mix of the work that we're selling. But every individual type of service there's no change within those durations or mixes. And then just in terms of what we're seeing for the full year, I'll just comment on the type of work we see. Consulting, strong double digits, even probably stronger than what we saw, obviously, at the beginning of the year. And outsourcing now, a double-digit growth.
Julie Sweet: Yes, and it's probably worth reminding what KC said earlier, right, our expectations were exceeded across all sizes. And obviously, when small deals are also over delivering that in quarter revenue, right. So it's really -- it is broad based.
Jason Kupferberg: Okay, appreciate all that. Thanks, again, guys.
KC McClure: Sure.
Operator: And we do have a question from the line of Rod Bourgeois with DeepDive Equity Research. Please go ahead.
Rod Bourgeois: Hey, guys. Congrats on the results and the color that you're providing here. I just have one question. I'd like if you could comment on your newer offerings, it'd be helpful to know which of your newer offerings are showing the most uptick against this growth wave? If you could weigh the relative amount of lift that you're getting from offerings like Industry X, Cloud, Automation, et cetera, is there a certain newer offering that's getting more uptick than the others? Or is it again -- I mean maybe you can go beyond the everything is good comment and give a little more color on the specific offerings? Thanks.
KC McClure: Sure. Thanks, Rod. I'll give you a little bit more color, maybe on some of the numbers and hand it over to Julie to add anything she'd like to. But what you'll see is on Cloud, Industry X, Interactive Security, I mean they're all at scale, they're all strong or very strong double-digit growth. And so, there's really not what I would call out individually. Julie also mentioned another other list of our strategic priorities within her commentary at the beginning of the call. So I won't be redundant and go through this again. But Julie is there anything you want to add in terms of additional color?
Julie Sweet: Well, sure. I mean, so first of all, you just have to remember scale, right. So Accenture Cloud First was a $12 billion business. Our cloud business overall, is $12 billion business is down $80 billion business, right. So that's what we announced last quarter. And so when cloud is very strong, double-digit growth is obviously adding big dollars, but across each of the strategic priorities. So obviously, it would be a different scale. But, look, you have to look at the cloud, right? Because the cloud is the enabler. Think about it this, cloud is the enabler, data is the driver and then AI will be the differentiator for our clients. And so you saw many, many of the examples, really bringing these things together, right, so that you've got to get to the cloud, you got to get a handle on your data, right, and then be able to use AI. And we saw that in many of the examples that I gave in the script today. And so the first big step is, of course, replatforming in the cloud, both through migration and SaaS [ph] products. So just if you kind of have that mental model, I think it's helpful and then that goes across the organization.
Rod Bourgeois: Well explained. Thanks.
Angie Park: Next question.
Operator: And we have a question from David Togut with Evercore ISI. Please go ahead.
David Togut: Good morning, and congrats on these superior results. I'd like to ask about the sustainability of the compressed digital transformation. Can you give us some proof points that you're still in the early innings of this transformation, especially in some of your largest practices like Cloud First and Interactive?
Julie Sweet: Sure. So a few things, right. So -- and we shared this last quarter that if you look at -- you have to build your digital core, right? So if you look at platforms like Oracle, SAP and they're moving to the cloud, those are all well below 50% of their installed base having moved, right? The sort of move to the cloud itself, the percentages are still around 30%-ish, maybe a little bit more in terms of workloads that have moved to the cloud, right? So if you just sort of look at kind of where are we just technically, right, you see a lot of waves. Then you look at our own research, where we talked about leaders and leapfroggers. And what we see is that about 10% on average of every company are really leaders and performing much better than the bottom 25%. But that's only still a part of their organization. They're still working on lots of compressed transformation, you've got these leapfroggers are coming from behind, that's about -- we estimate about a third are really doing compressed transformation. And those compressed transformation is wave on wave, right. Once you get to the cloud, and what do you do with the data. So, we continue to see this as really being a multiyear journey. And I will tell you that a lot of people will talk about the pandemic accelerated, years of transformation into months. That's only in thinking, right? It is really hard to re-platform, right. And then -- and it's really hard to move, get your data under control, and then be able to do that. Once you do it, it opens up so much. But there's a lot of hard work for our clients ahead, and we're privileged to get to be their partner.
David Togut: Thanks for that. Just as a quick follow-up, could you comment on where you are with Industry X in terms of the innings of the growth of this business? I mean, clearly, we've got huge supply chain problems currently. I mean, how long do you think supply -- the supply chain problems will last as you look around the globe?
Julie Sweet: Well, that's always -- we talk about that with our clients all the time, right? Because, look, the supply chain problems there's kind of the immediate issues, but there's the longer term issues like the ports are not, up to snuff in most of the markets around the world, right? There's fundamental shifts going on, in terms of how do you get -- how do you build resilience, which has been moving from sort of cost to resilience. And so, the work of supply chain is multi year. But I think it's important, just -- I always go back to kind of where we were. The new technologies have really only come online, some of the newer platforms like Blue Yonder Luminate or SAP. As for supply chain work in the last couple of years, right. And so they're just starting to really get the momentum and the implementation. And so I would say the digital supply chain work is very, very early innings and the same with manufacturing. That's why we call it the next frontier. It's a big focus. I mean, I think Gartner had a survey that said 93%, or 91% of directors believe it's the biggest transformation opportunity. But we're in very, very early innings still.
David Togut: Thank you. Happy holidays.
Julie Sweet: Happy holidays.
Operator: And our next question comes from the line of Jamie Friedman with Susquehanna Please go ahead.
Jamie Friedman: Hi. Good morning. Nice work here. Good way to finish the year. I was just -- oh, I don't think anyone asked about travel yet. And if they did, I apologize, if I missed it. But KC, what are you contemplating in terms of travel for fiscal '22 at this point?
KC McClure: Jamie, on travel, it's no change to the assumptions that we had at the beginning of the year. So two components to travel, revenue from reimbursable travel, we don't have that in our guidance at the beginning of the year and there's no travel revenue assumed. And if it changes, we'll let you know. And then in terms of travel, outside of contract travel to clients, we continue to have an uptick in our expenses forecasted for the back half of the year, which again continues to be difficult to accurately estimate.
Jamie Friedman: Thanks for that. And then either Julie or KC, do you have any early view on calendar '22 IT budgets for your clients? Are those -- I know you'll make your own weather a lot of time, but those rising to what degree? Is it the pace different than it was say last calendar?
KC McClure: I mean, I would just say that this is kind of when the budgets are getting finalized. So we'll have much more insight next quarter because they get finalized into January. But what we're seeing is, which is reflected in our guidance is continued strong demand.
Jamie Friedman: Got it. Thank you very much.
Angie Park: Right. Operator, we have time for one more question. And then Julie will wrap up the call.
Operator: Of course. And that last question then comes from the line of Bryan Keane with Deutsche Bank. Please go ahead.
Bryan Keane: Hi, guys. Happy holidays. The first question I want to ask was, the surprise jump in diamond client adds? I think it was 15 in the quarter, and you did 13 all of last fiscal year. So just trying to get a sense is that something Accenture is specifically doing with the sales force to grab those larger clients? Or is that just a function of the demand environment that people are knocking down your door, even these larger clients that you would think you would already be working with you're not, and they're just continue to add to the number of diamond clients for you guys?
Julie Sweet: Yes, it's really a function of what we've been talking about, it's compressed transformation, right? It's a function of more clients taking on more change, right, because that's what builds this level of bookings. And we've been talking about that trend, really from the first 6 months after the pandemic, where we had more clients do over $100 million bookings in the first 6 months of that fiscal year. And we continue to see that building as clients recognize how much change they need to do, and that they have to go faster. So that's really what we see is the function.
Bryan Keane: Got it. Got it. And then KC, when just looking at the numbers on for the revenue growth, obviously a 27% constant currency number for the quarter. And then the guide, I think, for 2Q was above street expectations 22% to 26%. I guess, what does that imply for the back half of the year. Obviously, it would be a much different growth rate in the back half. Is that some conservatism versus just tougher comps? Can you talk about the back half for '22?
KC McClure: Sure. What that implies in the back half is very -- it's still very strong and that it's double digits across the back half of the year at the low end and the upper end of our guidance range, which implies also really strong organic growth in the back half of the year. And a continuing build of our business in the back half of the year, coming out of the first half of the year, overall.
Bryan Keane: But nothing specific to call out in terms of any weakness you see in the back half, but it's just a function of how the demand lays out?
KC McClure: Correct.
Bryan Keane: Got it. Thanks so much, and Happy Holidays again.
KC McClure: Same to you.
Julie Sweet: Thanks, Bryan. Okay. I think that was our last question. So thank you for joining us on today's call. And thank you again to our really incredible people across the globe. And thanks to all of our shareholders for your continued trust. We work to earn it every day and we really appreciate it. So best wishes to all for a safe, healthy and joyful holiday season.
Operator: And ladies and gentlemen, today's conference will be available for replay after 10 A.M. Eastern today through March 17 at midnight. You may access to AT&T replay system at any time by dialing 1-866-207-1041, entering the access code 5745754. International participants may dial 402-970-0847. And those numbers again are 1-866-207-1041 and 402-970-0847, again entering the access code 5745754. That does conclude your conference for today. Thank you for your participation and for using AT&T Conferencing Service. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to the Accenture First Quarter Fiscal 2022 Earnings Conference Call. At this time, all participants are in listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the conference over to our host, Ms. Angie Park, Managing Director and Head of Investor Relations. Please go ahead."
},
{
"speaker": "Angie Park",
"text": "Thank you, operator, and thanks, everyone, for joining us today on our first quarter fiscal 2022 earnings announcement. As the operator just mentioned, I am Angie Park, Managing Director and Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the second quarter and full fiscal year 2022. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today we will reference certain non-GAAP financial metrics, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our Web site at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie, and thank you everyone for joining us. I would like to start by thanking our 674,000 people around the world for your extraordinary work and commitment to our clients. Our results again, this quarter reflect how you are living our purpose every day to deliver on the promise of technology and human ingenuity. As more and more companies embrace compressed transformation, our clients are turning to us as their trusted partner, as reflected in our outstanding growth of 27% this quarter. We added 15 new diamond clients bringing the total to 244. Diamond clients are our largest relationships. And to give some context, we added 13 diamonds in all of FY '21. We also had record bookings of $16.8 billion, 30% growth year-over-year with 20 clients with bookings over $100 million. And we expanded operating margin 20 basis points in Q1 with adjusted EPS growth of 28%. While we continue to invest in our business and people, including $1.7 billion in acquisitions, and in just the first quarter, we invested $250 million in learning for our people, with 8.6 million training hours for approximately 14 hours per person. The extraordinary demand we see in the market reflects the imperative of digital transformation. Companies are making critical decisions about who will be their strategic partners. And they are selecting us because of our talented people, our deep industry and technology capabilities, and our commitment to both create value and lead with value. We predicted back in 2013 that every business would be a digital business. And we have executed a clear strategy to rotate our business to anticipate and be ready to serve our clients. And when the pandemic hit, we were ready with capabilities that scale reflected in 70% of our revenue at that time being from digital cloud and security, with strong relationships with the world's leading technology companies, which in some cases go back decades, with a focus on growing our people through learning, allowing us to rapidly re-skill, with an unwavering commitment to inclusion and diversity and equality and caring for our people professionally and personally, making us a talent magnet in a tight labor market, adding 50,000 talented individuals in Q1. And it is our breadth of capabilities across strategy and consulting interactive technology and operations, which is unique in our industry that allows us to work side by side with our clients to deliver results. And we believe our goal to create 360 degree value for our clients, people, shareholders, partners and communities is an essential part of our success. Certainly our commitment to creating vibrant career paths for our people is an important part of this value and we just completed our annual promotion process. I want to congratulate our 1,030 new promotes to Managing Director, 143 new appointments to Senior Managing Directors and the more than 90,000 people we promoted around the world in Q1 overall. Today we launched our 360 value reporting experience, a new way to show our progress and the value we create in all directions for all of our stakeholders. More on that later. KC, over to you."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie. Happy Holidays to all of you, and thanks for taking the time to join us on today's call. We were very pleased with our overall results in the first quarter, which exceeded our expectations, setting a new bookings records at $16.8 billion, with consulting bookings exceeding the previous record by more than $1 billion. Our results reflected strong double-digit revenue growth across all dimensions of our business, all markets, services and industry groups. And we saw improved pricing in many parts of our business. Based on the strength of our first quarter results and the demand we see in the market, we are significantly increasing our full year revenue and EPS outlook. Now let me summarize a few of the highlights of the quarter. Revenues grew 27% in local currency, increasing more than $3.2 billion over Q1 last year, and more than $600 million above our guided range, with broad based over delivery across all markets, services and industries with all 13 industry groups growing double digits. We continue to extend our leadership position with growth we estimate to be more than 5x the market which refers to our basket of publicly traded companies. Operating margin of 16.3% for the quarter, an increase -- with an increase of 20 basis points. We continue to drive margin expansion while making significant investments in our people, in our business, including acquisitions. We delivered very strong EPS of $2.78, up 28% over adjusted fiscal '21 results. Finally, we delivered free cash flow of $349 million and return $1.5 billion to shareholders through repurchases and dividends. We also invested approximately $1.7 billion in acquisitions, and we continue to expect to invest approximately $4 billion in acquisitions this fiscal year. With those high level comments, let me turn to some of the details, starting with new bookings. New bookings were record at $16.8 billion for the quarter, representing 30% growth in U.S dollars, and were $800 million higher than our previous record. With an overall book-to-bill of 1.1. Consulting bookings were record at $9.4 billion with a book-to-bill of 1.1. Outsourcing bookings were $7.4 billion with a book-to-bill of 1.1. We were very pleased with our bookings this quarter, which reflected 20 clients with bookings over $100 million. All of our service dimensions, strategy consulting, technology services and operations, as well as our geographic markets delivered strong double-digit bookings growth in U.S dollars. Turning now to revenues. Revenues for the quarter were $15 billion, a 27% increase in U.S dollars and in local currency. Consulting revenues for the quarter were $8.4 billion, up 33% in U.S dollars and 32% in local currency. Outsourcing revenues were $6.6 billion, up 21% U.S dollars and in local currency. Taking a closer look at our service dimension, strategy and consulting, technology services and operations all grew very strong double-digit. Turning to our geographic markets. In North America, revenue growth was 26% in local currency, driven by double-digit growth in public service, software and platforms, and consumer goods, retail and travel services. In Europe, revenues grew 28% local currency, led by double-digit growth in consumer goods, retail and travel services, industrial and banking and capital markets. Looking closer to countries, Europe was driven by double-digit growth in Germany, U.K., France and Italy. In growth markets, we delivered 30% revenue growth in local currency, driven by double-digit growth in consumer goods, retail and travel services, banking and capital markets and public service. From a country perspective, growth markets was led by double-digit growth in Japan and Australia. Moving down the income statement. Gross margin for the quarter was 32.9%, compared with 33.1% for the same period last year. Sales and marketing expense for the quarter was 9.7% compared with 10.4% for the first quarter last year. General and administrative expenses were 6.9% compared to 6.6% for the same quarter last year. Operating income was $2.4 billion in the first quarter, reflecting a 16.3% operating margin, up 20 basis points compared with Q1 last year. Before I continue, as a reminder, we recognized an investment gain in Q1 last year, which impacted our tax rates and increased EPS by $0.15. The following comparisons exclude these impacts and reflect adjusted results. Our effective tax rate for the quarter was 24.4% compared with an adjusted effective tax rate of 23.7% for the first quarter last year. Diluted earnings per share were $2.78 compared with adjusted diluted EPS of $2.17 in the first quarter last year. Days service outstanding were 42 days, compared to 38 days last quarter and 38 days in the first quarter of last year. Free cash flow for the quarter was $349 million, resulting from cash generated by operating activities of $531 million, net of property and equipment additions of $182 million. Our cash balance at November 30 was $5.6 billion compared with $8.2 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the first quarter, we repurchased or redeemed 2.4 million shares for $845 million at an average price of $346.19 per share. At November 30, we had approximately $5.6 billion of share repurchase authority remaining. Also in November, we paid a quarterly cash dividend of $0.97 per share for a total of $613 million. This represents a 10% increase over last year. And our Board of Directors declared a quarterly cash dividend of $0.97 per share to be paid on February 15, a 10% increase over last year. So in summary, we are very pleased with our Q1 results and we are off to a very strong start in FY '22. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. Starting with the demand environment, as we expected across industries and the globe, technology continues to be the single biggest driver of change, accelerating, disrupting and creating new opportunities. More companies are embracing compressed transformation underpinned by cloud and digital and are moving to build their digital core and use technology to transform how they operate and to find new ways to compete and grow as you would expect for 27% revenue growth. We are seeing broad based demand across all markets, services and industries with double-digit growth across all our strategic growth priorities, including Applied Intelligence, Cloud, Industry X, Interactive, Intelligent Operations, Intelligent Platform Services, Security and Transformational Change Management. Let me bring this demand to life. First, compressed transformation is occurring across the globe and the key enabler is the cloud across the continuum from public to hybrid to increasingly the edge, and the move to leading SaaS platforms along with the convergence of cloud and data. For example, we are working with a leading global supplier of tires and mobility solutions to migrate to the cloud, modernize its IT platforms, use data to accelerate growth and value and shift to a digital supply chain. We created a state-of-the-art system to track inventory, sales, warranty information and returns, all in the cloud, all in real time and have already helped to increase customer satisfaction 35% with improved cost optimization and increased revenue up next. We're also helping Mount Sinai Health System, New York City's largest academic medical system transform, modernize and increase its resilience by migrating its clinical systems, non-clinical systems and clinical data to a stable, secure cloud based infrastructure to proactively detect and prevent threats, adapt to business and regulatory changes, together with a potential to save millions over the next 5 years, savings that can be reinvested to fund strategic innovative programs and help rescale teams. Our deep industry expertise is helping companies find new solutions and path to growth and helping their customers. For example, we are collaborating with Opay, a leading Finnish Financial Group to use automation, advanced analytics and other emerging technologies to increase business agility, reduce cost, and deliver enhanced customer and employee experiences. Opay will adopt the Intelligent Automation Platform, Accenture myWizard to enable the company to extract greater value from its technology investments. We are working with TUGA, a leading utilities provider in Germany to create and operate a game changing meter-to-cash IT platform in the cloud. It will help reduce operating costs by up to 40%, accelerate time to market and free up resources for energy transition and innovations like smart metering, helping customers make environmentally conscious decisions and energy providers stay responsive and reliable. And as we talked about last quarter, our Sustainability Services are focused on helping our clients across industries move from commitment to action at scale. We see these services is critical to our clients agendas. I'm pleased to announce that we have signed an agreement to acquire Zestgroup, a Dutch sustainability services company with 140 employees that specializes in energy transition services and sourcing renewables and other clean energy sources. We look forward to welcoming them and working together to help clients move at speed to achieve net zero carbon. We continue to help our clients to enter the next digital frontier of Industry X. We're excited to have completed the acquisition of umlaut and are seeing the power of our combination already. Together we're working with a global technology leader to transform from a traditional engineering platform to a more agile model based engineering platform that uses simulation and analysis from design and development all the way through the product lifecycle. We were also working with an American wireless operator to help improve daily operations and transform their network security by combining our deep security risk assessment and communications industry skills. Of course, growth is at the heart of every client's agenda and Interactive is helping our clients capture new growth with their customers with our unique combination of creativity, technology, data, AI and industry expertise. For example, we are applying our digital global capabilities to help Capri Holdings Limited, a global fashion luxury group consisting of the iconic brands Versace, Jimmy Choo and Michael Kors, translate its rich in-store luxury shopping experience to a digital experience that aligns with shifting customer behaviors and accelerate sustainable growth. As a strategic partner with Volkswagen Group, a German motor vehicle manufacturer, we're helping Audi and VW to pave the way for sustainable growth through precise continuous commerce and rich experiences along the entire car buying journey. We are combining the power of AI of predictive analytics to deliver the right experiences at the right time to accelerate revenue growth through an expanded digital commerce ecosystem. We're also working with VLI, a Brazilian logistics solutions company and Trato [ph] its new platform business to provide a digital one stop shop for self employed truckers to enhance their growth, to improve logistics by offering options for more profitable freight products as well as to provide them access to critical services such as insurance, loans and health care, all by combining data [ph] analytics and AI. We see an increasing demand to create the platforms that power the digital products and experiences our clients seek for their customers. We're helping CLO, a leader in electronic payments in Latin America become more competitive by migrating to the cloud, which will accelerate new product development and enables cutting edge technologies. This will make it easier to launch innovative products, reduce time to market by two-thirds and lower costs, all while enhancing their customers experience. And of course security is critical to all our clients. We were proud to be selected by the Department of Homeland Security's Cybersecurity and Infrastructure Security Agency, CISA in the U.S., America's risk advisor defending against today's threats, with advanced cyber services to help the Department of Homeland Security protect federal, civilian and executive branch systems against cyber attacks like ransomware, botnets and malware campaigns. Even as companies undergo compressed transformation, exponential technology changes continue. We are investing to anticipate the future and we are working with our clients to innovate and take advantage of emerging technologies to compete and win. Our R&D is powered by Accenture Labs and Ventures and extends across every part of our business so that we can quickly translate research into real results for our clients. For example, we are working with ESPN to explore how emerging technologies can enable new ways for fans to experience sports at the ESPN edge innovation center, leveraging the years of early investments we've made in extended reality. We've been a key participant in shaping the innovation in enterprise, blockchain technologies across the globe, with applications in financial markets, supply chain and digital identity, which now are creating value for our clients. From partnering with the Digital Dollar Foundation to explore a U.S central bank digital currency to working with Hong Kong Exchanges and Clearing Limited to build a new integrated settlement platform using digital asset modeling language, Smart Contract. And while the metaverse has recently burst into the public eye, we've been an early innovator in applying the technology. In fact, we often innovate on cutting edge technologies by deploying them at Accenture first. We are proud to have the largest enterprise metaverse to what we call the Nth Floor and are deploying over 60,000 virtual reality headsets and have created one Accenture Park, a virtual campus for onboarding and immersive learning, including meeting rooms and collaborative experiences. Our VR environments provide our people with a human connection and learning experiences in an immersive digital world. We are also working with clients to help explore and shape their early forays into the metaverse through new digital experiences enabled by virtual reality and responding to their interests in new products enabled by NFTs, or non-fungible tokens, new ways to conduct commerce as the metaverse takes shape. Many of these client examples reflect our goal to create 360 degree value. This goal reflects our growth strategy, our purpose, our core values and our culture of shared success. It is also how we operate Accenture and we measure our success by how well we are achieving this goal for all our stakeholders. And today, we are proud to present our new 360 degree value reporting experience, a new way to share our progress, which is available on our website. With this comprehensive digital tool, you'll find all our reporting and data in one place, measuring how we're doing. We've expanded our ESG reporting with three additional ESG framework, the Sustainability Accounting Standards Board, SASB, the Task Force on Climate-related Financial Disclosures, TCFD and the World Economic Forum International Business Council WEF, IBC metrics, while continuing to report against the Global Reporting Initiative GRI standards, the UNGC 10 principles and the Carbon Disclosure Project, CDP because we believe that transparency builds trust and helps us all make more progress. Back to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Now, let me turn to our business outlook. For the second quarter fiscal '22, we expect revenues to be in the range of $14.3 billion to $14.75 billion. This assumes the impact of FX will be about negative 4% compared to the second quarter of fiscal '21 and reflects an estimated 22% to 26% growth in local currency. For the full fiscal year '22, based on how the rates have been trending over the last few weeks, we now expect the impact of FX on a result in U.S dollars will be approximately negative 3% compared to fiscal '21. For the full fiscal '22, we now expect our revenue to be in the range of 19% to 22% growth in local currency over fiscal '21, which continued to assume an inorganic contribution of 5%. For operating margin, we continue to expect fiscal year '22 to be 15.2% to 15.4%, a 10 to 30 basis point expansion over fiscal '21 results. We continue to expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an adjusted effective tax rate of 23.1% in fiscal '21. For earnings per share, we now expect our full year diluted EPS for fiscal '22 to be in the range of $10.32 to $10.60 or 17% to 20% growth over adjusted fiscal '21 results. For the full fiscal '22, we now expect operating cash flow to be in the range of $8.4 billion to $8.9 billion, property and equipment additions to be approximately $700 million and free cash flow to be in the range of $7.7 billion to $8.2 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $6.3 billion through dividends and share repurchases as we remain committed to returning a substantial portion of cash to our shareholders. With that, let's open it up, so we can take your questions. Angie? Angie Park Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask the question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Of course. [Operator Instructions] And the first question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-tsin Huang",
"text": "Thank you so much. Yes, really remarkable growth here in [technical difficulty] $600 million. I think that's the largest number of growth [technical difficulty] got to ask what surprise you [technical difficulty] with the compressed transformation and [technical difficulty] more on …"
},
{
"speaker": "Julie Sweet",
"text": "Hi, I think we were -- Tien-tsin, we are having a little trouble hearing you, but I think I got it. You want to know what drove our over delivery -- are the over delivery $600 million?"
},
{
"speaker": "Tien-tsin Huang",
"text": "You got it."
},
{
"speaker": "KC McClure",
"text": "Okay, that's what I thought. So first of all, good morning to you. So the first thing I would say is that overall in terms of our revenue production this quarter, everyone did better. It really was broad based over delivery across all of our markets, all of our industries and our services. And when you want to -- when you peel that back, you really start with bookings. So we have broad based over delivery also in our bookings. And so you see that flowing through our revenue production, Tien-tsin. And on that bookings production, well, we had 20 clients with bookings over $100 million. It really was broad based growth in our bookings, across, the larger deals all the way down to midsize and smaller deals. And then so that also really did help us drive more revenue. And importantly, we were able to meet this demand, because we have the people able here to work on the extra demand coming from the bookings. So we were really very pleased with the overall broad base delivery in the first quarter. And that is why we see that coming into the second quarter, and then a big part, obviously, of our full year revenue increase."
},
{
"speaker": "Tien-tsin Huang",
"text": "Got it. Thanks [technical difficulty] hope you can hear me okay. My follow-up just maybe for Julie [technical difficulty] 360 degree in [technical difficulty] been hearing a lot about that here. [Technical difficulty] becomes a bigger factor [technical difficulty]. Is that part of the [technical difficulty] care of pushing this [technical difficulty] 360 degree?"
},
{
"speaker": "Julie Sweet",
"text": "Yes, no, it's a great question, Tien-tsin. And I think there's a couple of things that are going on. So first of all, we absolutely see in more of the requests for proposals, our clients asking to understand your position on sustainability, for example. So we’re -- we've been -- and we've seen that trend for at least the last 12 months that it's more important formally in our RFPs. But we also see it in the conversations we're having with clients, that they are asking a lot about this, they're very much focused. And so when we talk about it, it's important to them. And so, when we launch this strategy around 360 degree value over a year ago now, it was based on the conversations we were already having with clients, right. We launched it, because our clients were saying, we have to achieve this. And the biggest issues, I think in the world that we look for is how do you move from commitment to action. And so there's -- and part of that is, therefore clients also want to partner with companies that are equally committed, and it matters to them things like 50% of our centers around the world are using renewable energy, right? It matters to them, the work that we're doing on IT -- green IT software, so that eventually we'll be able to have much more sustainable software development. So it's definitely a buyer value. We see it formally. We see it informally. And we see it in terms of what they're trying to do, which is why our sustainability services are also so important, and you heard some of the examples today."
},
{
"speaker": "Tien-tsin Huang",
"text": "That's excellent. Thank you, guys."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "KC McClure",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Bryan Bergin with Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, good morning. Thank you. So you often talk about the market share gains. I'm curious if you've seen an inflection in win rates over the last few quarters, or has there been a significant uptick in overall demand in the market with consistent win rates that is driving this level of growth?"
},
{
"speaker": "Julie Sweet",
"text": "Good morning, Bryan. It's the latter. So let me just start with -- we've seen a really consistent win rate. But maybe I'll peel back to what we talked about in the fourth quarter. When we were coming into the year, we felt really good about our pipeline. Even in a seasonably lower quarter, we thought -- we saw good bookings for the first quarter. And obviously, you saw that come through. And our bookings are record bookings this quarter. But I will say even with that, we feel really good about our pipeline, even after the record bookings and that's the statement across all markets and services."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And then my follow-up, so when we think about headcount progression, it would seem you're on a path to hit a million people here over the next 3 years or so. So as you've gotten larger, can you talk about what you've had to do differently to enable the strong execution across so many global resources. And just how are you thinking about what you were going to need to do more of as you get even larger?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. That's a great question, Bryan. Let me take that. And I think there's three things to focus on. One is how we manage the business. So just to take you back to March 1, 2020 when we announced our next gen growth model, one of the explicit reasons we reorganized at the time, focused on geographies we said was to enable us to scale. And so that's enabled us because we're still fundamentally a people business. It's also driven by a lot of assets, but you need to be able to be close to clients and people. And so that change really allowed us to be where we are now, where we're scaling. But it also, in addition to the scaling, it helps us be more agile. Like you'll remember, we put that into place and we created Accenture Cloud first 4 months later, right, which has been a huge success. And it's the agility by simplifying our structure at the same time. So first, it's -- how we manage our business in terms of an organizational perspective, and having simplified our business. The second piece is the focus on employee experience. Our -- one of our eight leadership essentials is caring for our people, personally and professionally. And this is a very important part of how we are able to scale and drive our culture. And you'll see in our attrition, it again is at the lower end of the pyramid in India, and we have significantly lower attrition at the executive and above. And that is very much we believe, because of how we focus on our people. And the last piece, which is our culture. You notice that we talked about the metaverse and what we've launched in our script today. That's another way of how we're driving our culture. We are constantly innovative -- innovating. So in a world where people can have as many physical experiences today, we created this immersive experience, which connects people, right, which builds connections. And so the focus on being smart about how we manage our people and staying close to them and our clients, our leadership and how we promote and develop and then constantly innovating to build the connection and the culture. We call it omni connections are absolutely critical when you're scaling."
},
{
"speaker": "Bryan Bergin",
"text": "Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Okay."
},
{
"speaker": "Operator",
"text": "And we do have a question from the line of Lisa Ellis with MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Hi. Good morning. Thanks for taking my question. A couple of macro questions from me. Can you talk about how inflation is affecting your business? Specifically, is it a tailwind to revenues? Because you're seeing -- you're able to pass through labor cost inflation on to clients? And if so, are there other factors as well that you might call out on inflation? Thank you."
},
{
"speaker": "KC McClure",
"text": "Yes, maybe I'll start and then Julie, if there's -- you can add in, in terms of what we're seeing with our clients. But maybe, Lisa -- maybe we'll start with inflation, and I'll take it from maybe from a wage increase perspective. So, to state the obvious wage inflation is on all our minds, it's occurring in all industries and it's across the globe, and our clients are all experiencing a tight labor market. So for us as it relates to inflation in wages, we see for our business that we will continue to have wage increases in the market for certain skills, and that varies by geographies and we expect it really to continue. So what are we doing? It's not so different from what other clients are doing. We're focused on pricing to absorb our higher labor costs. And one other thing that we pointed out, Lisa, that we were very pleased with the improved pricing that we had this quarter on our record bookings, but we have more work to do. And so as one of the things that I want to just point out that it's just going to take some time for the improved pricing to flow through our P&L, and that's going to lead to higher compensation that we see. It may even result for us in some operating margin contraction in Q2, although we expect to continue to expand margin by 10 to 30 basis points for the full year. So I mean, that's just maybe a bit of a glimpse on what it means for us, as we run our own P&L. And I'll hand it over to Julie to give some thoughts on what she's thinking and talking with our clients."
},
{
"speaker": "Julie Sweet",
"text": "Yes, great. And so, look, we're all managing different aspects, there's wage inflation. There's -- inflation, it's obviously on products. And so -- and it varies by industry in terms of the extent of the impact. And what we really see our clients doing is, because there's a lot of uncertainty about how inflation is going to develop in 2022 is being laser-focused on cost efficiencies and growth, right, because for many industries, they can't pass on the improved pricing, or they're like us, right. It takes a while to be able to do that. And so it is helping as well, drive some of the demand for both things, helping them grow, but also do that efficiently."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific. Thank you. And then just for my follow-up, maybe a follow-up on Tien-tsin's question. So clearly, the level of demand you're seeing is sort of surprised even you guys have a very good handle on it all the time. So if you can just give some color around what your senses about what's happening, like what's happening out in the marketplace. You said it's very broad based across industries across geographies. And so maybe just sort of from a narrative perspective, what's your sense of what's happening differently or differently than you expected even 3 months ago in terms of -- that's driving dramatic increase in demand? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure. I think a big aspect of it is embracing the need for speed. And so you are continuing to see more and more companies doing the compressed transformation, the willingness to take on more at the same time and even to do that faster. And just think we have a couple of calls I had just this past week, clients that we've been working with, on some -- for some time speaking about their cloud journey, I wouldn’t call me up Monday and say, okay, we're going to pull forward Wave 2. We've got to go faster. It's harder than we thought we need to go faster. And in so there's this, as companies are kind of getting into it, they're seeing that they want to go even faster, they're also seeing the impact of those who come ahead. I was recently talking to the CEO of a company where we're doing a major cloud and data platform, and his point, so as we speak, okay, now I get it, I can only go so fast, but can you go faster, because I now see what I can really do one side replatform, right. And so, this embracing more change and speed, we do think is helping drive this demand. And we predicted the sort of -- remember, we talked about compressed transformation, that it's really only been in about a third of industries, and that it was going to continue to expand. But the point is, the first round of compressed transformation is just the first round. And as you begin to see the power of what it is to be in the cloud, the next steps of opportunities are being seen by the clients. And so I do think it's mostly around a recognition of the value of replatforming and the need for speed competitively."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific. Thank you and happy holidays."
},
{
"speaker": "Julie Sweet",
"text": "Happy holidays."
},
{
"speaker": "Operator",
"text": "And we do have a question from the line of Jason Kupferberg with Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"text": "Thanks, guys. Congrats on these numbers. Happy holidays. Maybe a little bit more to follow-up on some of these top line questions. You mentioned the pipeline still remains robust after the very strong Q1 bookings. So how should we be thinking about second quarter bookings growth in both consulting and outsourcing relative to the Q1 levels?"
},
{
"speaker": "KC McClure",
"text": "Thanks, Jason, Happy Holidays to you too. We do feel good about our pipeline and -- for the second quarter and for the remainder of the year. So, but bookings can be lumpy. So there's nothing that I would project to, obviously one way or the other against Q1, Jason. But for both outsourcing and consulting, and across all of our markets and the services within those we do feel really good."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay. Okay, got it. Got it. So we will have to account for some of that lumpiness. And I'm wondering also, if there's been any noticeable change in average project sizes or conversion cycles of backlog into revenue. And then just anything you may want to comment on regarding updated assumptions for consulting and outsourcing revenue growth in full year fiscal '22? Thanks, again."
},
{
"speaker": "Julie Sweet",
"text": "Sure. So there's really no change, Jason, to anything that we're seeing in duration or in conversion. I mean, it all depends on the mix of the work that we're selling. But every individual type of service there's no change within those durations or mixes. And then just in terms of what we're seeing for the full year, I'll just comment on the type of work we see. Consulting, strong double digits, even probably stronger than what we saw, obviously, at the beginning of the year. And outsourcing now, a double-digit growth."
},
{
"speaker": "Julie Sweet",
"text": "Yes, and it's probably worth reminding what KC said earlier, right, our expectations were exceeded across all sizes. And obviously, when small deals are also over delivering that in quarter revenue, right. So it's really -- it is broad based."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay, appreciate all that. Thanks, again, guys."
},
{
"speaker": "KC McClure",
"text": "Sure."
},
{
"speaker": "Operator",
"text": "And we do have a question from the line of Rod Bourgeois with DeepDive Equity Research. Please go ahead."
},
{
"speaker": "Rod Bourgeois",
"text": "Hey, guys. Congrats on the results and the color that you're providing here. I just have one question. I'd like if you could comment on your newer offerings, it'd be helpful to know which of your newer offerings are showing the most uptick against this growth wave? If you could weigh the relative amount of lift that you're getting from offerings like Industry X, Cloud, Automation, et cetera, is there a certain newer offering that's getting more uptick than the others? Or is it again -- I mean maybe you can go beyond the everything is good comment and give a little more color on the specific offerings? Thanks."
},
{
"speaker": "KC McClure",
"text": "Sure. Thanks, Rod. I'll give you a little bit more color, maybe on some of the numbers and hand it over to Julie to add anything she'd like to. But what you'll see is on Cloud, Industry X, Interactive Security, I mean they're all at scale, they're all strong or very strong double-digit growth. And so, there's really not what I would call out individually. Julie also mentioned another other list of our strategic priorities within her commentary at the beginning of the call. So I won't be redundant and go through this again. But Julie is there anything you want to add in terms of additional color?"
},
{
"speaker": "Julie Sweet",
"text": "Well, sure. I mean, so first of all, you just have to remember scale, right. So Accenture Cloud First was a $12 billion business. Our cloud business overall, is $12 billion business is down $80 billion business, right. So that's what we announced last quarter. And so when cloud is very strong, double-digit growth is obviously adding big dollars, but across each of the strategic priorities. So obviously, it would be a different scale. But, look, you have to look at the cloud, right? Because the cloud is the enabler. Think about it this, cloud is the enabler, data is the driver and then AI will be the differentiator for our clients. And so you saw many, many of the examples, really bringing these things together, right, so that you've got to get to the cloud, you got to get a handle on your data, right, and then be able to use AI. And we saw that in many of the examples that I gave in the script today. And so the first big step is, of course, replatforming in the cloud, both through migration and SaaS [ph] products. So just if you kind of have that mental model, I think it's helpful and then that goes across the organization."
},
{
"speaker": "Rod Bourgeois",
"text": "Well explained. Thanks."
},
{
"speaker": "Angie Park",
"text": "Next question."
},
{
"speaker": "Operator",
"text": "And we have a question from David Togut with Evercore ISI. Please go ahead."
},
{
"speaker": "David Togut",
"text": "Good morning, and congrats on these superior results. I'd like to ask about the sustainability of the compressed digital transformation. Can you give us some proof points that you're still in the early innings of this transformation, especially in some of your largest practices like Cloud First and Interactive?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. So a few things, right. So -- and we shared this last quarter that if you look at -- you have to build your digital core, right? So if you look at platforms like Oracle, SAP and they're moving to the cloud, those are all well below 50% of their installed base having moved, right? The sort of move to the cloud itself, the percentages are still around 30%-ish, maybe a little bit more in terms of workloads that have moved to the cloud, right? So if you just sort of look at kind of where are we just technically, right, you see a lot of waves. Then you look at our own research, where we talked about leaders and leapfroggers. And what we see is that about 10% on average of every company are really leaders and performing much better than the bottom 25%. But that's only still a part of their organization. They're still working on lots of compressed transformation, you've got these leapfroggers are coming from behind, that's about -- we estimate about a third are really doing compressed transformation. And those compressed transformation is wave on wave, right. Once you get to the cloud, and what do you do with the data. So, we continue to see this as really being a multiyear journey. And I will tell you that a lot of people will talk about the pandemic accelerated, years of transformation into months. That's only in thinking, right? It is really hard to re-platform, right. And then -- and it's really hard to move, get your data under control, and then be able to do that. Once you do it, it opens up so much. But there's a lot of hard work for our clients ahead, and we're privileged to get to be their partner."
},
{
"speaker": "David Togut",
"text": "Thanks for that. Just as a quick follow-up, could you comment on where you are with Industry X in terms of the innings of the growth of this business? I mean, clearly, we've got huge supply chain problems currently. I mean, how long do you think supply -- the supply chain problems will last as you look around the globe?"
},
{
"speaker": "Julie Sweet",
"text": "Well, that's always -- we talk about that with our clients all the time, right? Because, look, the supply chain problems there's kind of the immediate issues, but there's the longer term issues like the ports are not, up to snuff in most of the markets around the world, right? There's fundamental shifts going on, in terms of how do you get -- how do you build resilience, which has been moving from sort of cost to resilience. And so, the work of supply chain is multi year. But I think it's important, just -- I always go back to kind of where we were. The new technologies have really only come online, some of the newer platforms like Blue Yonder Luminate or SAP. As for supply chain work in the last couple of years, right. And so they're just starting to really get the momentum and the implementation. And so I would say the digital supply chain work is very, very early innings and the same with manufacturing. That's why we call it the next frontier. It's a big focus. I mean, I think Gartner had a survey that said 93%, or 91% of directors believe it's the biggest transformation opportunity. But we're in very, very early innings still."
},
{
"speaker": "David Togut",
"text": "Thank you. Happy holidays."
},
{
"speaker": "Julie Sweet",
"text": "Happy holidays."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Jamie Friedman with Susquehanna Please go ahead."
},
{
"speaker": "Jamie Friedman",
"text": "Hi. Good morning. Nice work here. Good way to finish the year. I was just -- oh, I don't think anyone asked about travel yet. And if they did, I apologize, if I missed it. But KC, what are you contemplating in terms of travel for fiscal '22 at this point?"
},
{
"speaker": "KC McClure",
"text": "Jamie, on travel, it's no change to the assumptions that we had at the beginning of the year. So two components to travel, revenue from reimbursable travel, we don't have that in our guidance at the beginning of the year and there's no travel revenue assumed. And if it changes, we'll let you know. And then in terms of travel, outside of contract travel to clients, we continue to have an uptick in our expenses forecasted for the back half of the year, which again continues to be difficult to accurately estimate."
},
{
"speaker": "Jamie Friedman",
"text": "Thanks for that. And then either Julie or KC, do you have any early view on calendar '22 IT budgets for your clients? Are those -- I know you'll make your own weather a lot of time, but those rising to what degree? Is it the pace different than it was say last calendar?"
},
{
"speaker": "KC McClure",
"text": "I mean, I would just say that this is kind of when the budgets are getting finalized. So we'll have much more insight next quarter because they get finalized into January. But what we're seeing is, which is reflected in our guidance is continued strong demand."
},
{
"speaker": "Jamie Friedman",
"text": "Got it. Thank you very much."
},
{
"speaker": "Angie Park",
"text": "Right. Operator, we have time for one more question. And then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Of course. And that last question then comes from the line of Bryan Keane with Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hi, guys. Happy holidays. The first question I want to ask was, the surprise jump in diamond client adds? I think it was 15 in the quarter, and you did 13 all of last fiscal year. So just trying to get a sense is that something Accenture is specifically doing with the sales force to grab those larger clients? Or is that just a function of the demand environment that people are knocking down your door, even these larger clients that you would think you would already be working with you're not, and they're just continue to add to the number of diamond clients for you guys?"
},
{
"speaker": "Julie Sweet",
"text": "Yes, it's really a function of what we've been talking about, it's compressed transformation, right? It's a function of more clients taking on more change, right, because that's what builds this level of bookings. And we've been talking about that trend, really from the first 6 months after the pandemic, where we had more clients do over $100 million bookings in the first 6 months of that fiscal year. And we continue to see that building as clients recognize how much change they need to do, and that they have to go faster. So that's really what we see is the function."
},
{
"speaker": "Bryan Keane",
"text": "Got it. Got it. And then KC, when just looking at the numbers on for the revenue growth, obviously a 27% constant currency number for the quarter. And then the guide, I think, for 2Q was above street expectations 22% to 26%. I guess, what does that imply for the back half of the year. Obviously, it would be a much different growth rate in the back half. Is that some conservatism versus just tougher comps? Can you talk about the back half for '22?"
},
{
"speaker": "KC McClure",
"text": "Sure. What that implies in the back half is very -- it's still very strong and that it's double digits across the back half of the year at the low end and the upper end of our guidance range, which implies also really strong organic growth in the back half of the year. And a continuing build of our business in the back half of the year, coming out of the first half of the year, overall."
},
{
"speaker": "Bryan Keane",
"text": "But nothing specific to call out in terms of any weakness you see in the back half, but it's just a function of how the demand lays out?"
},
{
"speaker": "KC McClure",
"text": "Correct."
},
{
"speaker": "Bryan Keane",
"text": "Got it. Thanks so much, and Happy Holidays again."
},
{
"speaker": "KC McClure",
"text": "Same to you."
},
{
"speaker": "Julie Sweet",
"text": "Thanks, Bryan. Okay. I think that was our last question. So thank you for joining us on today's call. And thank you again to our really incredible people across the globe. And thanks to all of our shareholders for your continued trust. We work to earn it every day and we really appreciate it. So best wishes to all for a safe, healthy and joyful holiday season."
},
{
"speaker": "Operator",
"text": "And ladies and gentlemen, today's conference will be available for replay after 10 A.M. Eastern today through March 17 at midnight. You may access to AT&T replay system at any time by dialing 1-866-207-1041, entering the access code 5745754. International participants may dial 402-970-0847. And those numbers again are 1-866-207-1041 and 402-970-0847, again entering the access code 5745754. That does conclude your conference for today. Thank you for your participation and for using AT&T Conferencing Service. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 4 | 2,023 | 2023-09-28 08:00:00 | Operator: Thank you for standing by. Welcome to Accenture's Fourth Quarter Fiscal 2023 Earnings Call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the conference over to our host, Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead.
Katie O'Conor: Thank you, operator, and thanks everyone for joining us today on our fourth quarter and full fiscal 2023 earnings announcement. As the operator just mentioned, I am Katie O’Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for both the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the first quarter and full fiscal year 2024. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including, but not limited to those factors set forth in today’s news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Katie, and everyone joining us. And thank you to the approximately 733,000 Accenture people, who have worked hard to be at the center of our client's business across our fiscal year ‘23. Our laser focus on creating 360-degree value for our clients and all our stakeholders is reflected in our overall strong results for the year. With record bookings of $72 billion, we had a record 106 clients with quarterly bookings greater than $100 million in FY ‘23, up from 100 last year. We now have 300 Diamond clients, our largest client relationships, an increase of 33 from last year, demonstrating yet again the depth and breadth of our capabilities and the trust our clients have in us. We delivered revenues of $64 billion for the year, representing 8% growth in local currency, while continuing to take market share. We expanded adjusted operating margin by 20 basis points and delivered adjusted EPS growth of 9%, while continuing to significantly invest in our business and our people with capital deployed of over $2.5 billion across 25 acquisitions, $1.3 billion in R&D assets, platforms, and industry solutions, and $1.1 billion invested in the training and development of our people. And we generated free cash flow of $9 billion, allowing us to return over $7 billion of cash to shareholders. And we are delivering a little ahead of schedule on our business optimization actions we announced in March to reduce structural costs to create greater resilience. We also continue to attract, retain, and inspire outstanding people through our talent strategy. We're making progress toward our commitment to Net Zero by 2025, and we invested in our communities to help ensure we have vibrant places where we work and live. I will give more detail a little later in the call. Taking a step back, coming off two fiscal years of double-digit growth and a truly extraordinary FY ‘22, we are very pleased with our FY ‘23 results and the moves we have made to optimize our business. We are also rapidly taking an early leadership position in gen AI, which will be an important part of the reinvention of our clients in the next decade. Last quarter, we shared that we had sold 100 projects with roughly $100 million in sales over the prior four months. Demand accelerated in Q4 with another approximately $200 million in gen AI sales to bring our total to over $300 million for the year. We also are embracing the use of gen AI in our own delivery of services and the way we work across Accenture. As we reflect on how our market has developed over the last year, we and our clients have had to navigate a macro environment that is tougher than we anticipated at the beginning of FY ‘23. While it's played out differently across markets and industries, we have seen greater caution globally, with lower discretionary spend, slower decision-making, and in particular for us, a significant impact from the challenges the comm, media, and tech industries have faced. For example, in Q4, where we grew 4% in local currency, if we exclude CMT, we grew 7% globally, 6% in North America, 9% in Europe, and 8% in growth markets. Against that backdrop, as we enter FY ‘24, we remain laser focused on creating value for our clients. While the pace of spending has changed, the fundamentals have not. All strategies continue to lead to technology. And companies will need to reinvent every part of their enterprise using tech, data, and AI to optimize operations and accelerate growth. To do so, they must build a digital core. We are continuing to see significant demand in areas like cloud migration and modernization, modern ERP and data and AI, and the emergence of gen AI in particular, all of which represent areas of great opportunity. And it's still early. For example, we estimate that only 40% of workloads are in the cloud today, only one-third of clients have modernized their ERP platforms, and less than 10% have what we define as mature data and AI capabilities. We believe helping build a strong digital core and then using it to reinvent will be the drivers of our growth. Our ability to advise, shape, and deliver value-led transformation, leveraging the breadth of our services and industry expertise from strategy and consulting, to technology, to our managed services across industries and geographic markets, along with our privileged position with our ecosystem partners, is what makes Accenture unique. And you can see this unique positioning in the number of our Diamond clients, clients who turn to us for large-scale transformation. Over to you, KC.
KC McClure: Thank you, Julie. And thanks to all of you for joining us on today's call. We were pleased with our results in the fourth quarter, which were within our guided range and aligned to our expectations, completing another strong year for Accenture. Our results reflect the diversity of our business and once again illustrate our ability to run our business with discipline and deliver significant value for our shareholders. So let me begin by summarizing a few highlights for the quarter. Revenues grew 4% local currency, driven by high-single or double-digit growth in five of our 13 industries. As we called out last quarter, we expected increased pressure in our CMT industry group and we saw declines of 12% local currency this quarter. As Julie mentioned, excluding CMT, our business grew 7% globally. We delivered adjusted EPS in the quarter of $2.71, reflecting 4% growth over EPS last year. Adjusted operating margin was 14.9%, an increase of 20 basis points over Q4 last year, and includes significant -- continued significant investments in our people and our business. And finally, we delivered free cash flow of $3.2 billion, driven by very strong DSO management. Now, let me turn to some of the details. New bookings were $16.6 billion for the quarter, a 10% decline in local currency, with an overall book to bill of 1. Consulting bookings were $8.5 billion with a book to bill of 1. Managed services bookings were $8.2 billion with a book to bill of 1. Turning now to revenues, revenues for the quarter were $16 billion, a 4% increase in both US dollar and local currency, representing continued market share gains. Now, as a reminder, we assessed market growth against our investable basket, which is roughly two dozen of our closest global public company competitors, which represent about a third of our addressable market. We used a consistent methodology to compare our financial results and theirs, adjusted to exclude the impact of significant acquisitions through the data of their last publicly available results on a rolling four quarter basis. Consulting revenues for the quarter were $8.2 billion, a decline of 2% in both U.S. dollar and local currency. Managed services revenues were $7.8 billion, up 10% in both U.S. dollars and local currency. Taking a closer look at our service dimensions, technology services grew mid-single-digits, operations grew high-single-digits, and strategy and consulting declined mid-single-digits. Turning to our geographic markets. In North America, revenue growth was 1% in local currency, driven by growth in public service, health, and utilities. These increases were partially offset by declines in communications and media, software and platforms, banking and capital markets, and high tech. In Europe, revenues grew 7% in local currency, led by growth in banking and capital markets, industrial and public service. Revenue growth was driven by Germany and France. In growth markets, we delivered 6% revenue growth in local currency, driven by growth in chemicals and natural resources, industrial and energy. Revenue growth was driven by Japan. Moving down the income statement, gross margin for the quarter was 32.4%, compared with 32.1% for the same period last year. Sales and marketing expense for the quarter was 10.8%, compared with 10.2% for the fourth quarter last year. General and administrative expense was 6.7%, compared to 7.1% for the same quarter last year. Before I continue, I want to note that in Q4, we recorded $472 million in costs associated with our business optimization actions, which decreased operating margin by 290 basis points and EPS by $0.56, and also impacted our tax rates. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.4 billion in the fourth quarter, reflecting a 14.9% adjusted operating margin and an increase of 20 basis points from operating margin in Q4 last year. Our adjusted effective tax rate for the quarter was 27.4%, compared with an effective tax rate of 24.6% for the fourth quarter last year. Adjusted diluting earnings per share were $2.71, compared with EPS of $2.60 in the fourth quarter last year. Days services outstanding were 42 days, compared to 42 days last quarter, and 43 days in the fourth quarter of last year. Free cash flow for the quarter was $3.2 billion, resulting from cash generated by operating activities of $3.4 billion, net of property and equipment additions of $180 million. Our cash balance at August 31 was $9 billion, compared with $7.9 billion at August 31 last year. With regards to our ongoing objective to return cash to shareholders, in the fourth quarter, we repurchased or redeemed 3.2 million shares for $1 billion, an average price of $312.35 per share. Also in August, we paid our fourth quarterly cash dividend of $1.12 per share for a total of $706 million. And our Board of Directors declared a quarterly cash dividend of $1.29 per share to be paid on November 15, a 15% increase over last year, and approved $4 billion of additional share repurchase authority. Now, I'd like to take a moment to summarize the year, as we've navigated a challenging macro environment and successfully executed our business to deliver or exceed all aspects of our original guidance that we provided last September on an adjusted basis. We delivered $72.2 billion in new bookings, reflecting 5% growth in local currency. Revenue of $64.1 billion for the year, reflecting strong growth of 8% local currency, and reflecting continued market share gains. Before I continue for the full-year, we recorded $1.1 billion in costs associated with business optimization actions, which decreased operating margin by 170 basis points, and EPS by $1.28. We also recognized a gain on our investment in Duck Creek Technologies, which impacted our tax rate and increased EPS by $0.38. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating margin of 15.4%, a 20-basis point expansion over FY ‘22. Adjusted earnings per share was $11.67, reflecting 9% growth over FY ‘22 EPS. Free cash flow of $9 billion was significantly above our original guided range, reflecting a very strong free cash flow to net income ratio of 1.3. And with regards to our ongoing objective to return cash to shareholders, we exceeded our original guidance for capital allocation by returning $7.2 billion of cash to shareholders, while investing approximately $2.5 billion across 25 acquisitions. In closing, we remain committed to delivering on our enduring shareholder value proposition, while creating 360-degree value for all our stakeholders, clients, our people, our shareholders, partners, and our communities. And now let me turn it back to Julie.
Julie Sweet: Thank you, KC. Let me now bring to life for you the demand we saw from our clients this quarter as they build their digital core and reinvent. We saw this demand across markets and industries. Our cloud momentum continued with very strong double-digit growth in Q4, as clients prioritized building a strong and secure foundation for reinvention. We're partnering with a multinational financial services company on a cloud-based transformation to deliver enhanced, personalized, and secure customer experiences, and to increase employee productivity. Together, we're developing an integrated hosting strategy that unifies their hybrid multi-cloud landscape and lays the foundation for their digital transformation over the next decade. This partnership enables innovative solutions across all bank functions and is backed by a trusted and secure foundation that supports advanced workloads and complex AI and data solutions. Working from a compliant cloud platform will safeguard the customer data, privacy, and financial assets, positioning the organization to stand out for its innovation and customer focus. And we are supporting a U.S.-based energy company on a total enterprise reinvention strategy to unify different technologies and business processes around a common digital core. We'll help leading the deployment of a cloud-based IT platform that integrates customer management, finance, HR, supply chains, asset management, and operations, improving the ability to assess and optimize operational performance. We also are helping manage and integrate the responsibilities and activities of the vendors involved in the project, standardize data from legacy applications, and enable company employees to understand and manage the new processes and technologies. Data-driven decision-making will be improved, allowing the company to cultivate better collaboration within their business, helping them operate more efficiently and better serve their customers. We are partnering with Coca-Cola Bottlers Japan to accelerate their path to becoming a world-class bottler and data-driven organization. The partnership includes establishing an innovative joint venture of significant scale of approximately 870 people that will accelerate transforming their digital core, optimizing their enterprise operations, leveraging the power of cloud, data, and AI to increase the value delivered from their core business functions. In support of their broader strategic business plan, Accenture will provide specialized talent, industry expertise, and leading-edge technology automation and managed services to help Coca-Cola Bottlers Japan adopt a strategy of continuous enterprise reinvention. Data and AI are an important part of building the digital core, and we see that work both embedded in our larger transformations, as you just heard, and in work focused on data and AI modernization. Accenture Federal Services is helping the defense health agency operate and enhance the Joint Medical Common Operating Picture platform by implementing data synchronization across multiple network domains and near real-time collaboration and information sharing, we will provide a comprehensive picture into Department of Defense medical assets. This increases visibility into unit health, equipment, and supplies and allows for faster and more informed decision-making. We are a strategic partner for the Saudi Data and AI Authority to boost the Kingdom's transformation to a data-driven economy and help the Kingdom become a world leader in generation and deployment of AI technology. We're working closely with Sadiya to support cutting-edge research, promote digital innovation in public life, and boost national capabilities and talent. We're especially pleased with the double-digit growth we have in the Middle East, a small, but growing part of our business. Security is essential to a digital core, and we had very strong double-digit growth in our security business in Q4. We're working with a major energy network in the U.K. on the transformation of its cybersecurity systems. We will provide an entire managed service for their cybersecurity capability, including migration to a more powerful security platform, continuous and active threat monitoring, and response services, as well as security tools management. Our solutions will help provide improved security, reduce exposure to potential global security threats, and ultimately better safeguard the safe delivery of gas to millions of U.K. homes and businesses. As clients continue to reimagine and prioritize the customer experience, Song delivered strong double-digit growth in Q4. We are helping smart Europe, maker of the next generation of smart vehicles, products, and services of the iconic brand from smart Automobile Company -- Co Limited., a joint venture between Mercedes-Benz and Geely. We are helping them reinvent car shopping by creating an ecosystem that supports a seamless, fully digital-driven buying experience. By putting data at the core, the system allows personalization of the customer journey, makes recommendations based on real-time data, and includes enhanced offerings such as extended insurance coverage. It will help smart Europe reposition its brand and support the launch of its intelligent, fully electrical car lines. We also continue to see demand for our supply chain in Industry X capabilities, the next digital frontier, which grew strong double-digits in Q4. In Industry X, we are partnering with a global chemical and materials company on a digital transformation of their manufacturing core and commercial capabilities. Through our Industry X capabilities, we have built a unified connected worker platform for operators, maintenance technicians, and job planners, along with a cloud-based data lake to help generate insight from disparate sources of manufacturing data. The program is already live in dozens of manufacturing sites and is expected to create significant revenue growth over the next few years for our clients. And in supply chain, we have partnered with a large global food and beverage conglomerate to strengthen supply chain resilience, so consumers have continued access to their products in stores and online. By creating a digital twin of its supply chain, we will develop stress test models to help identify supply disruptions with the highest risk before they occur. Across these examples, you can see our unique capabilities of both being a technology powerhouse, along with our industry and functional expertise from strategy and consulting to technology, to managing services -- managed services to help our clients reinvent. Now let's turn to generative AI. As a reminder, last quarter we announced a $3 billion investment in AI. While still in the early stages, gen AI technology is maturing rapidly and we believe it will be a significant source of value for us and our clients over time. We now have about 300 projects and I want to share a little color in how this demand is coming through. We have projects across all our industries with banking, public service, consumer goods, and utilities leading an activity. Clients are doing a variety of different types of work from strategy and use case implementations to tech enablement, to scaling, to model customization, tuning and training, to talent and responsible AI. For example, we're working with a multinational telecom company, Telefonica Brazil, also known as Vivo, to deliver a generative AI solution that helps its agents respond quicker to landlords' queries about property rental for network towers. The application quickly reads landlords' queries and proposes a set of actions to help fulfill requests, reducing the time it takes agents to respond. It also structures the response with a set of relevant answers to increase the response quality and ensure all queries are answered in a helpful manner. The solution has already reduced agent response time by 30% and increased the user experience score by 66%. Some of the key ingredients of our success in gen AI are: first, ecosystem partnerships. As always, we are starting with deep relationships and leadership in the ecosystem, from the hyperscalers to the model builders to the startups and academics. It is important to emphasize that we are early in the maturity of gen AI for enterprise, and our depth, experience, and insight on these [plant-forwards] (ph) is essential to guiding our clients. Second, Talent. We start with a deep technical knowledge and understanding of AI and gen AI and blend that with our industry and functional expertise to know how to reinvent across the enterprise, including processes and operating models, bringing together the depth and breadth of our expertise. And that is where Accenture is different, building the bridge from as is to the future. And we have already trained approximately 600,000 of our people in the fundamentals of AI. Now with generative AI, the pace and impact is growing rapidly. And we are now taking a further step to equip more than 250,000 people and using new AI tools equitably, sustainably and without bias. And with investments in our AI Academy focused on deep AI and gen AI specialization, we are also progressing towards our goal of doubling our deeply skilled data and AI practitioners from 40,000 to 80,000. Third, responsible AI is essential. At Accenture, we have an industry-leading responsible AI compliance program, which is embedded in how we use and deliver AI. And we're using the experience and lessons learned by us to help our clients build out their own responsible AI program, which is necessary to address the risks and get the full value from AI. Finally, we are embracing gen AI across our services, developing new cutting-edge tools and solutions, inventing gen AI in the way we work. Our approach takes into account where the technology is today, the need to deploy it responsibly, and the recognition that we do work in highly complex environments. While all companies want to explore and understand gen AI, what we find is that clients who are more mature digitally want to go faster, while others would like to test the waters with proofs of concepts and synthetic data, and others prefer to wait until they have built more of their modern digital core. The extent and pace of this generative AI progression will become more clear over the coming quarters as the technology and the market continue to mature and progress. Now turning to our people, who have made all of this happen. Core to our success is our ability to attract and retain and inspire our outstanding talent. Essential to our success is our robust talent strategy, and in particular, our ability to attract diverse talent and our Net Better Off approach to retaining our great talent. We continue to lead in our ability to attract people with different backgrounds, different perspectives, and different lived experiences. These differences ensure that we’ve -- have and attract the cognitive diversity to deliver a variety of perspectives, observations, and insights, which are critical to drive the innovation needed to reinvent. Our success is reflected in our being the top-scoring company on the Bloomberg Gender Equality Index for the second year in a row, and we also earned the number one position on the Refinitiv Global Diversity and Inclusion Index for the fourth time in six years. This index ranks over 15,000 organizations globally and identifies the top 100 publicly traded companies with the most diverse and inclusive workplaces. Our talent strategy includes inspiring and retaining our best talent through our Net Better Off approach. We want our people to feel they are Net Better Off for working at Accenture. This strategy has four dimensions, focusing on people feeling healthy and well, physically, emotionally, and financially, feeling connected with a sense of belonging, feeling their work as purpose and filing feeling they are continuing to build market-relevant skills. This year, for example, our people participated in approximately 40 million training hours, and we were a recipient of the Brandon Hall Gold Award for best benefits, wellness, and well-being programs. Building on our longstanding commitment to the environment, we are pleased to have hit a significant milestone on our path to Net Zero, approaching -- seeing 100% renewable electricity across all of our Accenture offices. I will wrap up with a comment on our work and communities. Vibrant communities are important to our business success, and therefore we continue to prioritize creating value in these communities around the world. For example, Accenture is helping to welcome refugees, recognizing how they enrich our communities with their courage, strength, and talent. In June 2023, on World Refugee Day, we committed to partner with organizations to help skill and support an estimated 16,000 refugee job seekers and migrants and to hire 100 refugees in Europe over the next three years. Back to you, KC.
KC McClure: Thanks, Julie. Now let me turn to our business outlook. For the first quarter of fiscal '24, we expect revenues to be in the range of $15.85 billion to $16.45 billion. This assumes the impact of FX will be approximately positive 2.5%, compared to the first quarter of fiscal ‘23 and reflects an estimated negative 2% to positive 2% growth in local currency. For the full fiscal year ‘24, based upon how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results in U.S. dollars will be flat compared to fiscal ‘23. For the full fiscal ‘24, we expect our revenue to be in the range of 2% to 5% growth in local currency over fiscal ‘23, which includes an inorganic contribution of about 2%. We expect business optimization actions to impact fiscal '24 GAAP operating margin by 70 basis points and EPS by $0.56. The following guidance for full-year fiscal 2024 excludes these impacts. For adjusted operating margin, we expect fiscal year ‘24 to be 15.5% to 15.7%, a 10 basis point to 30 basis point expansion over adjusted fiscal ‘23 results. We expect our annual adjusted effective tax rate to be in the range of 23.5% to 25.5%. This compares to an adjusted effective tax rate of 23.9% in fiscal ‘23. We expect our full-year adjusted earnings per share for fiscal '24 to be in the range of $11.97 to $12.32 or 3% to 6% growth over adjusted fiscal ‘23 results. For the full fiscal ‘24, we expect operating cash flow to be in the range of $9.3 billion to $9.9 billion, property and equipment additions to be approximately $600 million, and free cash flow to be in the range of $8.7 billion to $9.3 billion. Our free cash flow guidance reflects a free cash flow to net income ratio of 1.2. Finally, we expect to return at least $7.7 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. And with that, let's open it up so we can take your questions. Katie?
Katie O'Conor: Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: Thank you. [Operator Instructions] Our first question will come from the line of Tien-Tsin Huang of JPMorgan.
Tien-Tsin Huang: Hey, thank you. Good morning, Julie and Casey, I just wanted to dig in first on CMT, if you don't mind. Just curious there if the challenges are -- have changed at all, has it isolated just a few clients or is it more broad-based? And what's the strategy here to turn demand around? Are you seeing any green shoots there? Thanks.
Julie Sweet: Yes. Great, thanks Tien-Tsin. So it is broad-based, I mean, we have -- we're seeing it broad-based across the globe and across clients. And we continue to see those challenges. So we do think that it's going to -- we do know that it's going to develop a little bit differently based on markets. The challenges in the U.S. are more difficult. They're more focused on both technology and the technology companies and comms, whereas Europe, it's a little different, the complexion. And so, over the course of the year, we expect that the improvement will come at a little different pace depending on the market. And in terms of how we're addressing it, it's really two-fold. So first of all, we're going to continue to pivot within that industry to areas like helping within the confines of how much they are spending, trying to help them cut costs, working on things like customer service investing in more network capabilities. And what we're also doing is pivoting our business to the higher areas of growth, and you see that with acquisitions, like we did answer technologies and Industry X in the U.S., we did Flutura in India and data and AI. And so we've got a lot of areas of growth and you can see that when you take out CMT with the -- how the rest of our business is growing and it's just going to take a little time to make that pivot and that's why what you're seeing in our guidance is that we're going to build over the year as the actions we're taking to continue to pivot the business play out.
Tien-Tsin Huang: Understood on that one. Thank you. Just my quick follow-up on gen AI, I know the sales doubled there and you went through a lot of good detail. I'm just curious, is it -- are the deal sizes getting larger? Is it pulling through more large projects from what you've seen recently? I'm just curious how that might evolve here as we get into the new fiscal year?
Julie Sweet: Sure, so at this point, and remember, when we give you gen AI numbers, we're being very clear it's pure gen AI, so we're not like, you know, sort of talking about data and all of those things. So the real gen AI projects right now are still in that sort of million dollar-ish on average range. And we expect that's going to continue for a while, right? That’s what we're seeing because there's a lot of experimentation. Now what it's doing though is leading clients to look harder at, well, where do I go faster, right, in terms of the digital core? You know, and so we started seeing a tick up, for example, in data migration, right? But it is still extremely early, but that's how we think it's going to, you know, play out over even the coming year, right, as people get more excited about it and it also points out the challenges. But keep in mind that, you know, implementing gen AI is not like, it's like, it's not easy. Entire environments need to be set up. It's quite complex, actually. So it really plays into our strengths of being able to help them understand what it takes, where their gaps are, and then how to take the next step on the journey to get there, even as we see clients being cautious, they're really focused on help us save money, so we can take those next steps.
Tien-Tsin Huang: Yes. No, it should bode well for Accenture. Thank you.
Julie Sweet: Thanks.
Operator: We’ll go next to the line of James Faucette with Morgan Stanley.
James Faucette: Great. Thank you very much. Wanted to, kind of, follow-up on a couple of questions there. One of the other areas that had seen some strength and seems like it's weakened a little bit has been managed services. Can you talk through, kind of, what's happening there and one of the things that we're also seeing is, hear is -- or hearing is that there's some variation in demand right now, especially geographically, maybe with Europe being a little weaker, but other markets being a little stronger. Can you just give color on managed services and what's happening geographically?
KC McClure: Yes. Thanks, James, for the question. I will -- maybe I'll start with, just kind of giving you a little bit of color on what we're seeing on managed services as it relates to guidance and just maybe broader guidance kind of overall. So I'll just start with our full-year, right? So we started with our full-year guidance, which is 2% to 5% growth for the year. I think the key part, as Julie mentioned, is that we expect that we're going to build as we go throughout the year. And you can see that in our range for Q1, which starts negative 2 and has 2 at the top end of our range. And then if you look at Q1, for the most part, what we are reflecting in our Q1 guidance is really more the same across the various dimensions of our business that we saw in Q4. And -- but we have a backdrop of a tougher compare in the first quarter of FY ’24, that's our toughest compare for the full-year. And then if you look at the full year, maybe three things to add. From a macro, we're not assuming that there's an improvement in the discretionary spend environment or the macro as we look at the year. The second on your -- to get to the type of work question, we're going to build as we go throughout the year and we see consulting for the full-year being at low-single-digit. And managed services is going to be a healthy mid to high-single-digit growth for the full-year. And then, depending on how the revenue builds, the last point would be on operating margin. We do expect to see more variability in the quarters as we go through fiscal ‘24 on our way to 10 basis points to 30 basis points of expansion for the year. So hopefully that gave you a little bit of color. Julie, if you want to talk a little bit more about specifics in managed services?
Julie Sweet: And what I would say on managed services, managed services continue to be really important for our clients, because it's both a cost play, but also a faster digitization play. But it will play out a little bit. So, for example, at Accenture, right, we've got trust and safety and other managed services in the CMT. And so that's going to affect some of our results depending on the quarter and the compare and how things kind of roll out. So that's why what we're thinking about next year will be somewhere in the mid to high-single-digits, but we don't see a fundamental issue around managed services. In fact, we think they are a really strategic priority for many of our clients, but it will play out a little bit differently based on industries. We see less of it based on sort of market per se because clients really need the managed services.
James Faucette: Got it. And then just as a quick follow-up, can you talk a little bit about your inorganic strategy, just what contribution has been, and particularly in light of the increased capital return program for ‘24, if we should anticipate that that will have any impact on what you guys historically have done from an inorganic contribution? Thanks.
KC McClure: Sure. In terms of inorganic contribution, for ‘23, it was about 2% was the inorganic contribution and for ‘24, James, we're considering another about 2% in ‘24.
Julie Sweet: Yes. And, look, on our inorganic strategy remember that the way we think about it is, can we get into new areas through our inorganic, like what we did with Anser Advisory and Industry X, which is capital products. It's basically we're very small there before the acquisition, that's an $80 billion addressable market. So that's an acquisition to start to grow there. We think about it as being important to invest in our industry and functional expertise. So in France this year, we -- this last quarter, we did an insurance acquisition in strategy and consulting. And we think about it in terms of scale. So we bought a data and AI practice in terms -- in India this quarter. And so as we are pivoting to the higher areas of growth right now, a real advantage we have is the ability to leverage our investment capacity in order to do that pivot. And of course we're -- right now, we're kind of assuming 2%, but we have the ability to do more if we have the right opportunities. And so we really do think about this as a huge competitive advantage in our industry, in our ability to drive growth and to be in the hot areas of the market.
James Faucette: That's great. Thank you so much.
Operator: We'll go next to the line of Lisa Ellis with MoffettNathanson.
Lisa Ellis: Hey, good morning. Thanks for taking my question. I might start on the business optimization program. Can you just give a little bit more detail in terms of what -- where exactly you are, what's completed, what remains in 2024, and maybe a little bit of more detail on how we should expect that impact to sequence in throughout fiscal ‘24? And then just remind us whether that's then the end of it and we should expect to kind of move back toward GAAP reporting at the end of ‘24?
Julie Sweet: Yes. Thanks, Lisa. So just in terms of -- just as a reminder, so we -- when we announced our business optimization program, we said it would be about $1.5 billion, and that would go through FY ‘24. So we still are saying $1.5 billion through FY ‘24. As it relates to next year, right, we expect to incur approximately $450 million. We were -- we did record $1.1 billion in FY ‘23, which is a little bit more than we expected to do in ‘23. So we were able to get a bit more into the P&L in last fiscal year '23. And I'm happy to go through the impacts on EPS, but you saw that it will be a $0.56 impact on EPS for ‘24, and I'm happy to go through some of the questions that you have. Yes. And also as we go throughout the year, the two -- we take the business optimization out of our results as we go throughout the quarters, so that doesn't -- that's not their driver for why we'll have more margin variability as we go throughout the year. And we'll see how it plays out. It really depends on the countries and different things that we have to go through in terms of process and procedures. And so we're not giving an update as we go throughout the year on the full-year estimate, but we're not breaking that up by quarter.
Lisa Ellis: Got it. Okay, okay. Great, thank you. And then maybe my follow-up, just to -- a quick follow-up on the managed services question, maybe just a little bit taking a step back, Julie, I think over the last few quarters, as we've been seeing some of the softness in strategy and consulting and this shorter duration discretionary work, you've been highlighting pretty consistently that has not really bled over into the larger transformation programs. And I just wanted to kind of ask if you could kind of update us on the latest you're seeing on that given that we saw a little bit of a slowdown in some of the managed services bookings this quarter. Thank you.
Julie Sweet: Sure. I mean, what I would say is that overall -- first of all, the large transformational programs include managed services, but they also include building, like so putting new modern ERP programs in place, right? So it's not only kind of managed services just to kind of set the stage for that. And just as you think about the fundamentals, because we think of the transformation deals, managed services are often a way to pay for them. They're often also a way to go faster and modernize, but we really look at those transformational programs in the round. So when you think about the fundamentals that our clients are facing, there is more reinvention ahead than they have done so far. So huge opportunity ahead. And you see that in where they are in the cloud journey, only 40% workloads, right? We estimate less than 10% of our clients are mature in data and AI. Only a third have put in the modern ERP programs. And so as you think about what they have to do, managed services will continue to play a huge role in paying for it and in actually modernizing much of it, as well the other big implementations. We do see, however, right, when you kind of go to the market-- and by the way, that's why we're super well positioned, right? Our strategy is to be that partner and then reinvention begets more, right? So you first build the digital core and then you've got a lot of work on top of that. And that is our growth strategy. Now, if you come to what we're seeing in the market, right? So always best to hear from what's going on in the ground. Last week, I was very busy and I was with about 20 different CEOs and they had three messages, right? Tech is super important, that's number one. Number two, they already have major programs underway and they know they need to do a lot more. But number three is they're feeling cautious about the macro and we've already seen that in the small deals. But they're asking us to help them save money and be more focused right now, even on the bigger programs. And so what I would say is and that's reflected in our guidance is that, the macro is having an effect on the pace of spending right now. Now, again, plays into our strengths in terms of being able to be the reinvention partner, being able to really think about the journey and positions us super well as they navigate that macro. But that is -- the reality is that there is this sense of caution and it's bleeding over to kind of overall, overall demands.
KC McClure: Right. And Lisa, maybe I'll just add, bookings can be lumpy, particularly in managed services. And we look at bookings -- book to bill over rolling four quarters and our goal in managed services is to be 1.2 or above. And that's exactly where we are on a four-quarter basis.
Lisa Ellis: Great. Thank you. Thanks a lot.
Operator: We'll go next to the line of Keith Bachman with BMO.
Keith Bachman: Hi, thank you very much. I wanted to ask -- go back to M&A if I could start with you, Julie. You're guiding to 2 points of M&A contribution to your full-year guidance which is consistent with sort of the past years, but the number here much bigger. 2 points is meaningfully than what it was even three or four years ago in terms of, A, the capital required to do those deals; and B, the integration therefore of the head count? And I just wanted to hear your, kind of, philosophically, it doesn't seem like 2 points can continue on for perpetuity, but just how do you think about any, kind of, balance sheet constraints or also the integration required to make sure the people side of the business -- because again, implicitly the deals are getting larger. And then as part of that, could you just speak to -- do you look at the same size deals or do you need to kind of flex up a little bit in terms of looking at larger opportunities? And then I have a follow up. Sorry about the background noise.
KC McClure: No problem, Keith. Thanks, I'll handle the capital allocation part and I'll hand it over to Julie. So just from a capital allocation standpoint, Julie referenced this a little bit earlier, but our capital allocation framework is really durable, but it is also very flexible. So we've been able to continue to return a significant portion of our cash through dividends and share repurchases. Well over the time we've been flexing at various times the amount of money that we spend in V&A and we can continue with that framework. So just again as a focus, we had about 80% of our free cash flow return to shareholders through dividends and repurchases in FY ‘23 and we actually have a $500 million, $0.5 billion increase in our guidance baked in for next year. So just shows that our capital allocation framework can flex as needed while still doing a great return.
Julie Sweet: And what I would say is that I'm really proud that how we do M&A is a core competency of Accenture, right? So we've now been on this journey. I helped start it when I was the general counsel. I remember that was -- I came in and they were like, we kind of need to increase this and I've done a lot of that in my prior life and what you see is that, as we've grown, we've continued to build the capabilities. We have a very mature machine around integration, but we also have an operating model where we have leaders close to the acquisitions, doing the integration. And they really do vary from very small to larger ones. We've done over $1 billion and we could do even bigger ones with our capital. The point is that, we know how to integrate and we've been doing this now for many, many years.
Keith Bachman: Okay, fair enough and thank you, Julie. My follow-up is just how do you think about headcount for Accenture through the year? You're just kind of finishing off your risk, but how do you think about headcount as we process through FY ‘24 and I'm really thinking on an organic basis, excluding the M&A. Many thanks and that's it for me.
KC McClure: Yes. Thanks, Keith. Really what I would say is managing supply and demand. As you know, it's a core competency of ours and we're going to manage our supply skills based on wherever we see the growth. So we didn't expect that we would need to add a lot of people in -- from Q3 to Q4 as we said and that's exactly what happened. And so we're going to continue to hire for the skills that we need and we're going to focus on the automation and as Julie mentioned, the lot of re-skilling of our people.
Operator: Thank you. We'll go next to the line of Darrin Peller with Wolfe Research.
Darrin Peller: Thanks, guys. I just wanted to ask in terms of visibility that you'd say you have now in the environment relative to prior years on the outlook side. I mean, has anything changed and just maybe if you could reiterate for us where you're seeing the pockets of strength in a little bit more of a specific manner around example that customers need right now that might be -- that might buck the trend of what you typically see in a downturn macroeconomically. Just curious kind of what's fighting through the demand weakness no matter what just because it's really mission critical right now. Thanks again.
KC McClure: Yes. Great, thanks, Darrin. In terms of visibility, right, as we sit here at the beginning of a new fiscal year, as -- we're really confident that we're taking all the right steps to successfully deliver for a full-year and as you know well, we always aim for the top part of the range. But just like every other year at this time, the back half of the year is less certain, because we'll know more when the budgets are set which is really in the back -- which is in the H2 of our year. But as we mentioned, we are going to build throughout the year and why do we say that? Well, first of all, we're confident in the steps that we're taking that Julie highlighted many examples to pivot to the higher growth areas. And we expect that we'll see that come through in the back half of the year and that's also backed up by the investments that we'll make. The second part is that we do have the revenue from the larger scale transformations. It is out there, right? And so we just need to layer in some of the new growth area work that we'll get to as we approach the back half of the year. And the last part, as you're aware, I mean, we do have the benefit of each year comparison in the back half.
Julie Sweet: Yes. And then in terms of demand, it's exactly what we've been talking about. The number one area of demand is building that digital core. So you've got clients like the financial service client I mentioned in the script that's not in the cloud at all and is basically needing to migrate to the cloud, right? Then you've got those who are in the cloud but they haven't modernized their ERP. You saw a lot of examples of that. Then you've got security, right? Absolutely has to happen. And then lots of focus on now on data and AI, particularly for those who've already been investing, so they're in the cloud, they've got their modern ERP, and now they want to really accelerate AI. So what's not happening, right, is discretionary spend globally as we saw throughout the year, starting in North America, people are not doing smaller systems integration. They're not doing smaller strategy and consulting, they're prioritizing and focusing on larger deals. And even there, there's prioritizing, especially depending on the industry where you've got more challenges to say, can we -- we've got a lot underway, we're cautious about the environment, so help us Accenture cut costs, so we can afford all of the reinvention ahead of us and help us prioritize what we start next. And that's kind of the overall, sort of, more cautious spending. But I just want to reemphasize, nothing has changed about the fact that our clients have more ahead of them than behind them in terms of building the digital core and then using it to reinvent. And we're the only one in our industry that can both build the technology and at this scale have the industry and the functional expertise to then be positioned to help them use that technology to reinvent. So we are super optimistic about this industry in our position.
Darrin Peller: That makes sense, Julie. And just -- I guess, as a follow-up to that, the ramp time, you know, you talked about a billion dollars investment in AI last time, and we've obviously seen some evidence of success, but early days still. So now that you've had the luxury of a few more months, the ramp time you'd expect to see that really become a much, much bigger part of the business. Can you just quickly touch on that again? This is around AI and generative AI. Thanks, [Indiscernible].
Julie Sweet: I'm sure -- my team are going to love the luxury of a few more months. You know, so thank you for that, I'm going to tell them that. See you guys, you've had a few more months. So look, as I talked a little bit about in our script, we're still learning. Remember, these are like, you know, a million dollar sort of things. We're starting tom, you know, look at our -- work it in our own delivery. So it's going to take a few more quarters till I've really got a well-informed view of that. But what I will say is, gen AI is an amazing technology. It's going to do great things. And what I tell all my clients, can't use it unless you're in the cloud, have data, and you've, you know, modernized your core. So that's our opportunity.
Darrin Peller: Thanks, guys.
Operator: And we'll go next to the line of Jason Kupferberg with Bank of America.
Jason Kupferberg: Good morning, guys. Thanks for taking the question. I wanted to pick up on your earlier comment, I think you said that you're not assuming any improvement in discretionary spending in the overall environment there during F ‘24. So I know you guys typically start the year with a relatively conservative approach to guidance that certainly served you quite well in fiscal ‘23. So against that backdrop, can you tell us a little bit about what you're thinking regarding growth for each of the three business dimensions in F ‘24?
Julie Sweet: Yes. So, Jason, let me just kind of give you a little bit more color on guidance, right? So, as we mentioned, we're not assuming in our guidance any improvement in the macro discretionary spend, but we're going to pivot two years of growth. So the macro is going to be kind of this, you know, it's not going to help us or hurt us this year is kind of what really essentially what we're saying. In terms of, you know, color, I'll kind of stick to what we have in the type of work, maybe is the best way of thinking about it. And again, I think just consulting, it's going to build as we go throughout the year. And overall, I think, it's important to know that we are going to build in this environment. We're going to build as we go throughout the year.
Jason Kupferberg: Okay, and then on -- just on bookings, any thoughts on the first quarter or the full-year? I know there's some seasonal elements that typically consider in the November quarter? Thank you.
Julie Sweet: Yes, sure. So let me just talk about maybe a little bit of bookings. You know, in bookings, we're going to start with the fourth quarter. I mean, if did come in a little bit lighter than we expected, and they can be lumpy, and we saw some deals, kind of, push out. Of the quarter, when it came to small deals, we didn't see any change in the discretionary spend environment. And just to reiterate that we're really pleased with the 21 clients that we had, over $100 million. Julie talked about that, if just reinforces our strategy to be the client's transformational partner of choice and to be at their core. And lastly, as it relates to ‘23, you know, we look at bookings that we're rolling for quarters and I mentioned this on managed services, but just overall we're at a 1.1 book to bill, which I'm really pleased about for the fourth quarters. And then for next year, looking at ‘24 Q1, you're right, it's seasonally a little lighter for us. However, we have a solid pipeline and we do expect that FY ’24 Q1 bookings will reflect growth over FY ’23 Q1.
Jason Kupferberg: Thank you.
Katie O'Conor: Operator, we have time for one more question and then Julie will wrap up the call.
Operator: Thank you. And that question will come from the line of Bryan Keane with Deutsche Bank. Mr. Keane, your line is open.
Bryan Keane: Hi, guys. Good morning. Wanted to just follow up on strategy and consulting. I know that that was an area that we were hoping at one point during the year that it was going to turn back to positive growth by the fourth quarter. And then I know we didn't think that was going to happen as of last quarter. So I'm just curious, as we go through the year into fiscal year '24, when do you think S&C might turn towards positive growth?
KC McClure: Yes. Thanks, Bryan. So, look, in terms of our full year range, at the top end of our full year range, which again, always where we try to be, it does reflect S&C reconnecting with growth, and that clearly is our goal. Now when -- really the pace is going to differ by market, right, so it's hard to tell exactly when it will be throughout the year. Of course, we'll update you as we go through. And North America is our biggest market, it will be a bit more challenged.
Bryan Keane: Got it. I'll leave it there because I know we're at the end of the call. Thanks so much.
Katie O'Conor: Thanks so much. Take care.
Julie Sweet: All right. In closing, I really do want to thank again all of our people and our managing directors what they do every day, which is truly extraordinary and gives us a lot of confidence in the future. And I want to thank all of our shareholders for your continued trust and support. I assure you, we are working hard every day to continue to earn it. Thank you.
Operator: Thank you. And this conference is available for replay beginning at 10 AM Eastern time today and running through December 19 at midnight. You may access the AT&T replay system by dialing 866-207-1041 and entering the access code of 5848756. International participants may dial 402-970-0847. Those numbers again are 866-207-1041 or 402-970-0847, with the access code of 5848756. That does conclude our conference for today. Thank you for your participation and for using AT&T event conferencing. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Thank you for standing by. Welcome to Accenture's Fourth Quarter Fiscal 2023 Earnings Call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the conference over to our host, Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Katie O'Conor",
"text": "Thank you, operator, and thanks everyone for joining us today on our fourth quarter and full fiscal 2023 earnings announcement. As the operator just mentioned, I am Katie O’Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for both the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the first quarter and full fiscal year 2024. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including, but not limited to those factors set forth in today’s news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Katie, and everyone joining us. And thank you to the approximately 733,000 Accenture people, who have worked hard to be at the center of our client's business across our fiscal year ‘23. Our laser focus on creating 360-degree value for our clients and all our stakeholders is reflected in our overall strong results for the year. With record bookings of $72 billion, we had a record 106 clients with quarterly bookings greater than $100 million in FY ‘23, up from 100 last year. We now have 300 Diamond clients, our largest client relationships, an increase of 33 from last year, demonstrating yet again the depth and breadth of our capabilities and the trust our clients have in us. We delivered revenues of $64 billion for the year, representing 8% growth in local currency, while continuing to take market share. We expanded adjusted operating margin by 20 basis points and delivered adjusted EPS growth of 9%, while continuing to significantly invest in our business and our people with capital deployed of over $2.5 billion across 25 acquisitions, $1.3 billion in R&D assets, platforms, and industry solutions, and $1.1 billion invested in the training and development of our people. And we generated free cash flow of $9 billion, allowing us to return over $7 billion of cash to shareholders. And we are delivering a little ahead of schedule on our business optimization actions we announced in March to reduce structural costs to create greater resilience. We also continue to attract, retain, and inspire outstanding people through our talent strategy. We're making progress toward our commitment to Net Zero by 2025, and we invested in our communities to help ensure we have vibrant places where we work and live. I will give more detail a little later in the call. Taking a step back, coming off two fiscal years of double-digit growth and a truly extraordinary FY ‘22, we are very pleased with our FY ‘23 results and the moves we have made to optimize our business. We are also rapidly taking an early leadership position in gen AI, which will be an important part of the reinvention of our clients in the next decade. Last quarter, we shared that we had sold 100 projects with roughly $100 million in sales over the prior four months. Demand accelerated in Q4 with another approximately $200 million in gen AI sales to bring our total to over $300 million for the year. We also are embracing the use of gen AI in our own delivery of services and the way we work across Accenture. As we reflect on how our market has developed over the last year, we and our clients have had to navigate a macro environment that is tougher than we anticipated at the beginning of FY ‘23. While it's played out differently across markets and industries, we have seen greater caution globally, with lower discretionary spend, slower decision-making, and in particular for us, a significant impact from the challenges the comm, media, and tech industries have faced. For example, in Q4, where we grew 4% in local currency, if we exclude CMT, we grew 7% globally, 6% in North America, 9% in Europe, and 8% in growth markets. Against that backdrop, as we enter FY ‘24, we remain laser focused on creating value for our clients. While the pace of spending has changed, the fundamentals have not. All strategies continue to lead to technology. And companies will need to reinvent every part of their enterprise using tech, data, and AI to optimize operations and accelerate growth. To do so, they must build a digital core. We are continuing to see significant demand in areas like cloud migration and modernization, modern ERP and data and AI, and the emergence of gen AI in particular, all of which represent areas of great opportunity. And it's still early. For example, we estimate that only 40% of workloads are in the cloud today, only one-third of clients have modernized their ERP platforms, and less than 10% have what we define as mature data and AI capabilities. We believe helping build a strong digital core and then using it to reinvent will be the drivers of our growth. Our ability to advise, shape, and deliver value-led transformation, leveraging the breadth of our services and industry expertise from strategy and consulting, to technology, to our managed services across industries and geographic markets, along with our privileged position with our ecosystem partners, is what makes Accenture unique. And you can see this unique positioning in the number of our Diamond clients, clients who turn to us for large-scale transformation. Over to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie. And thanks to all of you for joining us on today's call. We were pleased with our results in the fourth quarter, which were within our guided range and aligned to our expectations, completing another strong year for Accenture. Our results reflect the diversity of our business and once again illustrate our ability to run our business with discipline and deliver significant value for our shareholders. So let me begin by summarizing a few highlights for the quarter. Revenues grew 4% local currency, driven by high-single or double-digit growth in five of our 13 industries. As we called out last quarter, we expected increased pressure in our CMT industry group and we saw declines of 12% local currency this quarter. As Julie mentioned, excluding CMT, our business grew 7% globally. We delivered adjusted EPS in the quarter of $2.71, reflecting 4% growth over EPS last year. Adjusted operating margin was 14.9%, an increase of 20 basis points over Q4 last year, and includes significant -- continued significant investments in our people and our business. And finally, we delivered free cash flow of $3.2 billion, driven by very strong DSO management. Now, let me turn to some of the details. New bookings were $16.6 billion for the quarter, a 10% decline in local currency, with an overall book to bill of 1. Consulting bookings were $8.5 billion with a book to bill of 1. Managed services bookings were $8.2 billion with a book to bill of 1. Turning now to revenues, revenues for the quarter were $16 billion, a 4% increase in both US dollar and local currency, representing continued market share gains. Now, as a reminder, we assessed market growth against our investable basket, which is roughly two dozen of our closest global public company competitors, which represent about a third of our addressable market. We used a consistent methodology to compare our financial results and theirs, adjusted to exclude the impact of significant acquisitions through the data of their last publicly available results on a rolling four quarter basis. Consulting revenues for the quarter were $8.2 billion, a decline of 2% in both U.S. dollar and local currency. Managed services revenues were $7.8 billion, up 10% in both U.S. dollars and local currency. Taking a closer look at our service dimensions, technology services grew mid-single-digits, operations grew high-single-digits, and strategy and consulting declined mid-single-digits. Turning to our geographic markets. In North America, revenue growth was 1% in local currency, driven by growth in public service, health, and utilities. These increases were partially offset by declines in communications and media, software and platforms, banking and capital markets, and high tech. In Europe, revenues grew 7% in local currency, led by growth in banking and capital markets, industrial and public service. Revenue growth was driven by Germany and France. In growth markets, we delivered 6% revenue growth in local currency, driven by growth in chemicals and natural resources, industrial and energy. Revenue growth was driven by Japan. Moving down the income statement, gross margin for the quarter was 32.4%, compared with 32.1% for the same period last year. Sales and marketing expense for the quarter was 10.8%, compared with 10.2% for the fourth quarter last year. General and administrative expense was 6.7%, compared to 7.1% for the same quarter last year. Before I continue, I want to note that in Q4, we recorded $472 million in costs associated with our business optimization actions, which decreased operating margin by 290 basis points and EPS by $0.56, and also impacted our tax rates. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.4 billion in the fourth quarter, reflecting a 14.9% adjusted operating margin and an increase of 20 basis points from operating margin in Q4 last year. Our adjusted effective tax rate for the quarter was 27.4%, compared with an effective tax rate of 24.6% for the fourth quarter last year. Adjusted diluting earnings per share were $2.71, compared with EPS of $2.60 in the fourth quarter last year. Days services outstanding were 42 days, compared to 42 days last quarter, and 43 days in the fourth quarter of last year. Free cash flow for the quarter was $3.2 billion, resulting from cash generated by operating activities of $3.4 billion, net of property and equipment additions of $180 million. Our cash balance at August 31 was $9 billion, compared with $7.9 billion at August 31 last year. With regards to our ongoing objective to return cash to shareholders, in the fourth quarter, we repurchased or redeemed 3.2 million shares for $1 billion, an average price of $312.35 per share. Also in August, we paid our fourth quarterly cash dividend of $1.12 per share for a total of $706 million. And our Board of Directors declared a quarterly cash dividend of $1.29 per share to be paid on November 15, a 15% increase over last year, and approved $4 billion of additional share repurchase authority. Now, I'd like to take a moment to summarize the year, as we've navigated a challenging macro environment and successfully executed our business to deliver or exceed all aspects of our original guidance that we provided last September on an adjusted basis. We delivered $72.2 billion in new bookings, reflecting 5% growth in local currency. Revenue of $64.1 billion for the year, reflecting strong growth of 8% local currency, and reflecting continued market share gains. Before I continue for the full-year, we recorded $1.1 billion in costs associated with business optimization actions, which decreased operating margin by 170 basis points, and EPS by $1.28. We also recognized a gain on our investment in Duck Creek Technologies, which impacted our tax rate and increased EPS by $0.38. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating margin of 15.4%, a 20-basis point expansion over FY ‘22. Adjusted earnings per share was $11.67, reflecting 9% growth over FY ‘22 EPS. Free cash flow of $9 billion was significantly above our original guided range, reflecting a very strong free cash flow to net income ratio of 1.3. And with regards to our ongoing objective to return cash to shareholders, we exceeded our original guidance for capital allocation by returning $7.2 billion of cash to shareholders, while investing approximately $2.5 billion across 25 acquisitions. In closing, we remain committed to delivering on our enduring shareholder value proposition, while creating 360-degree value for all our stakeholders, clients, our people, our shareholders, partners, and our communities. And now let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. Let me now bring to life for you the demand we saw from our clients this quarter as they build their digital core and reinvent. We saw this demand across markets and industries. Our cloud momentum continued with very strong double-digit growth in Q4, as clients prioritized building a strong and secure foundation for reinvention. We're partnering with a multinational financial services company on a cloud-based transformation to deliver enhanced, personalized, and secure customer experiences, and to increase employee productivity. Together, we're developing an integrated hosting strategy that unifies their hybrid multi-cloud landscape and lays the foundation for their digital transformation over the next decade. This partnership enables innovative solutions across all bank functions and is backed by a trusted and secure foundation that supports advanced workloads and complex AI and data solutions. Working from a compliant cloud platform will safeguard the customer data, privacy, and financial assets, positioning the organization to stand out for its innovation and customer focus. And we are supporting a U.S.-based energy company on a total enterprise reinvention strategy to unify different technologies and business processes around a common digital core. We'll help leading the deployment of a cloud-based IT platform that integrates customer management, finance, HR, supply chains, asset management, and operations, improving the ability to assess and optimize operational performance. We also are helping manage and integrate the responsibilities and activities of the vendors involved in the project, standardize data from legacy applications, and enable company employees to understand and manage the new processes and technologies. Data-driven decision-making will be improved, allowing the company to cultivate better collaboration within their business, helping them operate more efficiently and better serve their customers. We are partnering with Coca-Cola Bottlers Japan to accelerate their path to becoming a world-class bottler and data-driven organization. The partnership includes establishing an innovative joint venture of significant scale of approximately 870 people that will accelerate transforming their digital core, optimizing their enterprise operations, leveraging the power of cloud, data, and AI to increase the value delivered from their core business functions. In support of their broader strategic business plan, Accenture will provide specialized talent, industry expertise, and leading-edge technology automation and managed services to help Coca-Cola Bottlers Japan adopt a strategy of continuous enterprise reinvention. Data and AI are an important part of building the digital core, and we see that work both embedded in our larger transformations, as you just heard, and in work focused on data and AI modernization. Accenture Federal Services is helping the defense health agency operate and enhance the Joint Medical Common Operating Picture platform by implementing data synchronization across multiple network domains and near real-time collaboration and information sharing, we will provide a comprehensive picture into Department of Defense medical assets. This increases visibility into unit health, equipment, and supplies and allows for faster and more informed decision-making. We are a strategic partner for the Saudi Data and AI Authority to boost the Kingdom's transformation to a data-driven economy and help the Kingdom become a world leader in generation and deployment of AI technology. We're working closely with Sadiya to support cutting-edge research, promote digital innovation in public life, and boost national capabilities and talent. We're especially pleased with the double-digit growth we have in the Middle East, a small, but growing part of our business. Security is essential to a digital core, and we had very strong double-digit growth in our security business in Q4. We're working with a major energy network in the U.K. on the transformation of its cybersecurity systems. We will provide an entire managed service for their cybersecurity capability, including migration to a more powerful security platform, continuous and active threat monitoring, and response services, as well as security tools management. Our solutions will help provide improved security, reduce exposure to potential global security threats, and ultimately better safeguard the safe delivery of gas to millions of U.K. homes and businesses. As clients continue to reimagine and prioritize the customer experience, Song delivered strong double-digit growth in Q4. We are helping smart Europe, maker of the next generation of smart vehicles, products, and services of the iconic brand from smart Automobile Company -- Co Limited., a joint venture between Mercedes-Benz and Geely. We are helping them reinvent car shopping by creating an ecosystem that supports a seamless, fully digital-driven buying experience. By putting data at the core, the system allows personalization of the customer journey, makes recommendations based on real-time data, and includes enhanced offerings such as extended insurance coverage. It will help smart Europe reposition its brand and support the launch of its intelligent, fully electrical car lines. We also continue to see demand for our supply chain in Industry X capabilities, the next digital frontier, which grew strong double-digits in Q4. In Industry X, we are partnering with a global chemical and materials company on a digital transformation of their manufacturing core and commercial capabilities. Through our Industry X capabilities, we have built a unified connected worker platform for operators, maintenance technicians, and job planners, along with a cloud-based data lake to help generate insight from disparate sources of manufacturing data. The program is already live in dozens of manufacturing sites and is expected to create significant revenue growth over the next few years for our clients. And in supply chain, we have partnered with a large global food and beverage conglomerate to strengthen supply chain resilience, so consumers have continued access to their products in stores and online. By creating a digital twin of its supply chain, we will develop stress test models to help identify supply disruptions with the highest risk before they occur. Across these examples, you can see our unique capabilities of both being a technology powerhouse, along with our industry and functional expertise from strategy and consulting to technology, to managing services -- managed services to help our clients reinvent. Now let's turn to generative AI. As a reminder, last quarter we announced a $3 billion investment in AI. While still in the early stages, gen AI technology is maturing rapidly and we believe it will be a significant source of value for us and our clients over time. We now have about 300 projects and I want to share a little color in how this demand is coming through. We have projects across all our industries with banking, public service, consumer goods, and utilities leading an activity. Clients are doing a variety of different types of work from strategy and use case implementations to tech enablement, to scaling, to model customization, tuning and training, to talent and responsible AI. For example, we're working with a multinational telecom company, Telefonica Brazil, also known as Vivo, to deliver a generative AI solution that helps its agents respond quicker to landlords' queries about property rental for network towers. The application quickly reads landlords' queries and proposes a set of actions to help fulfill requests, reducing the time it takes agents to respond. It also structures the response with a set of relevant answers to increase the response quality and ensure all queries are answered in a helpful manner. The solution has already reduced agent response time by 30% and increased the user experience score by 66%. Some of the key ingredients of our success in gen AI are: first, ecosystem partnerships. As always, we are starting with deep relationships and leadership in the ecosystem, from the hyperscalers to the model builders to the startups and academics. It is important to emphasize that we are early in the maturity of gen AI for enterprise, and our depth, experience, and insight on these [plant-forwards] (ph) is essential to guiding our clients. Second, Talent. We start with a deep technical knowledge and understanding of AI and gen AI and blend that with our industry and functional expertise to know how to reinvent across the enterprise, including processes and operating models, bringing together the depth and breadth of our expertise. And that is where Accenture is different, building the bridge from as is to the future. And we have already trained approximately 600,000 of our people in the fundamentals of AI. Now with generative AI, the pace and impact is growing rapidly. And we are now taking a further step to equip more than 250,000 people and using new AI tools equitably, sustainably and without bias. And with investments in our AI Academy focused on deep AI and gen AI specialization, we are also progressing towards our goal of doubling our deeply skilled data and AI practitioners from 40,000 to 80,000. Third, responsible AI is essential. At Accenture, we have an industry-leading responsible AI compliance program, which is embedded in how we use and deliver AI. And we're using the experience and lessons learned by us to help our clients build out their own responsible AI program, which is necessary to address the risks and get the full value from AI. Finally, we are embracing gen AI across our services, developing new cutting-edge tools and solutions, inventing gen AI in the way we work. Our approach takes into account where the technology is today, the need to deploy it responsibly, and the recognition that we do work in highly complex environments. While all companies want to explore and understand gen AI, what we find is that clients who are more mature digitally want to go faster, while others would like to test the waters with proofs of concepts and synthetic data, and others prefer to wait until they have built more of their modern digital core. The extent and pace of this generative AI progression will become more clear over the coming quarters as the technology and the market continue to mature and progress. Now turning to our people, who have made all of this happen. Core to our success is our ability to attract and retain and inspire our outstanding talent. Essential to our success is our robust talent strategy, and in particular, our ability to attract diverse talent and our Net Better Off approach to retaining our great talent. We continue to lead in our ability to attract people with different backgrounds, different perspectives, and different lived experiences. These differences ensure that we’ve -- have and attract the cognitive diversity to deliver a variety of perspectives, observations, and insights, which are critical to drive the innovation needed to reinvent. Our success is reflected in our being the top-scoring company on the Bloomberg Gender Equality Index for the second year in a row, and we also earned the number one position on the Refinitiv Global Diversity and Inclusion Index for the fourth time in six years. This index ranks over 15,000 organizations globally and identifies the top 100 publicly traded companies with the most diverse and inclusive workplaces. Our talent strategy includes inspiring and retaining our best talent through our Net Better Off approach. We want our people to feel they are Net Better Off for working at Accenture. This strategy has four dimensions, focusing on people feeling healthy and well, physically, emotionally, and financially, feeling connected with a sense of belonging, feeling their work as purpose and filing feeling they are continuing to build market-relevant skills. This year, for example, our people participated in approximately 40 million training hours, and we were a recipient of the Brandon Hall Gold Award for best benefits, wellness, and well-being programs. Building on our longstanding commitment to the environment, we are pleased to have hit a significant milestone on our path to Net Zero, approaching -- seeing 100% renewable electricity across all of our Accenture offices. I will wrap up with a comment on our work and communities. Vibrant communities are important to our business success, and therefore we continue to prioritize creating value in these communities around the world. For example, Accenture is helping to welcome refugees, recognizing how they enrich our communities with their courage, strength, and talent. In June 2023, on World Refugee Day, we committed to partner with organizations to help skill and support an estimated 16,000 refugee job seekers and migrants and to hire 100 refugees in Europe over the next three years. Back to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Now let me turn to our business outlook. For the first quarter of fiscal '24, we expect revenues to be in the range of $15.85 billion to $16.45 billion. This assumes the impact of FX will be approximately positive 2.5%, compared to the first quarter of fiscal ‘23 and reflects an estimated negative 2% to positive 2% growth in local currency. For the full fiscal year ‘24, based upon how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results in U.S. dollars will be flat compared to fiscal ‘23. For the full fiscal ‘24, we expect our revenue to be in the range of 2% to 5% growth in local currency over fiscal ‘23, which includes an inorganic contribution of about 2%. We expect business optimization actions to impact fiscal '24 GAAP operating margin by 70 basis points and EPS by $0.56. The following guidance for full-year fiscal 2024 excludes these impacts. For adjusted operating margin, we expect fiscal year ‘24 to be 15.5% to 15.7%, a 10 basis point to 30 basis point expansion over adjusted fiscal ‘23 results. We expect our annual adjusted effective tax rate to be in the range of 23.5% to 25.5%. This compares to an adjusted effective tax rate of 23.9% in fiscal ‘23. We expect our full-year adjusted earnings per share for fiscal '24 to be in the range of $11.97 to $12.32 or 3% to 6% growth over adjusted fiscal ‘23 results. For the full fiscal ‘24, we expect operating cash flow to be in the range of $9.3 billion to $9.9 billion, property and equipment additions to be approximately $600 million, and free cash flow to be in the range of $8.7 billion to $9.3 billion. Our free cash flow guidance reflects a free cash flow to net income ratio of 1.2. Finally, we expect to return at least $7.7 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. And with that, let's open it up so we can take your questions. Katie?"
},
{
"speaker": "Katie O'Conor",
"text": "Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question will come from the line of Tien-Tsin Huang of JPMorgan."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Hey, thank you. Good morning, Julie and Casey, I just wanted to dig in first on CMT, if you don't mind. Just curious there if the challenges are -- have changed at all, has it isolated just a few clients or is it more broad-based? And what's the strategy here to turn demand around? Are you seeing any green shoots there? Thanks."
},
{
"speaker": "Julie Sweet",
"text": "Yes. Great, thanks Tien-Tsin. So it is broad-based, I mean, we have -- we're seeing it broad-based across the globe and across clients. And we continue to see those challenges. So we do think that it's going to -- we do know that it's going to develop a little bit differently based on markets. The challenges in the U.S. are more difficult. They're more focused on both technology and the technology companies and comms, whereas Europe, it's a little different, the complexion. And so, over the course of the year, we expect that the improvement will come at a little different pace depending on the market. And in terms of how we're addressing it, it's really two-fold. So first of all, we're going to continue to pivot within that industry to areas like helping within the confines of how much they are spending, trying to help them cut costs, working on things like customer service investing in more network capabilities. And what we're also doing is pivoting our business to the higher areas of growth, and you see that with acquisitions, like we did answer technologies and Industry X in the U.S., we did Flutura in India and data and AI. And so we've got a lot of areas of growth and you can see that when you take out CMT with the -- how the rest of our business is growing and it's just going to take a little time to make that pivot and that's why what you're seeing in our guidance is that we're going to build over the year as the actions we're taking to continue to pivot the business play out."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Understood on that one. Thank you. Just my quick follow-up on gen AI, I know the sales doubled there and you went through a lot of good detail. I'm just curious, is it -- are the deal sizes getting larger? Is it pulling through more large projects from what you've seen recently? I'm just curious how that might evolve here as we get into the new fiscal year?"
},
{
"speaker": "Julie Sweet",
"text": "Sure, so at this point, and remember, when we give you gen AI numbers, we're being very clear it's pure gen AI, so we're not like, you know, sort of talking about data and all of those things. So the real gen AI projects right now are still in that sort of million dollar-ish on average range. And we expect that's going to continue for a while, right? That’s what we're seeing because there's a lot of experimentation. Now what it's doing though is leading clients to look harder at, well, where do I go faster, right, in terms of the digital core? You know, and so we started seeing a tick up, for example, in data migration, right? But it is still extremely early, but that's how we think it's going to, you know, play out over even the coming year, right, as people get more excited about it and it also points out the challenges. But keep in mind that, you know, implementing gen AI is not like, it's like, it's not easy. Entire environments need to be set up. It's quite complex, actually. So it really plays into our strengths of being able to help them understand what it takes, where their gaps are, and then how to take the next step on the journey to get there, even as we see clients being cautious, they're really focused on help us save money, so we can take those next steps."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Yes. No, it should bode well for Accenture. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "We’ll go next to the line of James Faucette with Morgan Stanley."
},
{
"speaker": "James Faucette",
"text": "Great. Thank you very much. Wanted to, kind of, follow-up on a couple of questions there. One of the other areas that had seen some strength and seems like it's weakened a little bit has been managed services. Can you talk through, kind of, what's happening there and one of the things that we're also seeing is, hear is -- or hearing is that there's some variation in demand right now, especially geographically, maybe with Europe being a little weaker, but other markets being a little stronger. Can you just give color on managed services and what's happening geographically?"
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks, James, for the question. I will -- maybe I'll start with, just kind of giving you a little bit of color on what we're seeing on managed services as it relates to guidance and just maybe broader guidance kind of overall. So I'll just start with our full-year, right? So we started with our full-year guidance, which is 2% to 5% growth for the year. I think the key part, as Julie mentioned, is that we expect that we're going to build as we go throughout the year. And you can see that in our range for Q1, which starts negative 2 and has 2 at the top end of our range. And then if you look at Q1, for the most part, what we are reflecting in our Q1 guidance is really more the same across the various dimensions of our business that we saw in Q4. And -- but we have a backdrop of a tougher compare in the first quarter of FY ’24, that's our toughest compare for the full-year. And then if you look at the full year, maybe three things to add. From a macro, we're not assuming that there's an improvement in the discretionary spend environment or the macro as we look at the year. The second on your -- to get to the type of work question, we're going to build as we go throughout the year and we see consulting for the full-year being at low-single-digit. And managed services is going to be a healthy mid to high-single-digit growth for the full-year. And then, depending on how the revenue builds, the last point would be on operating margin. We do expect to see more variability in the quarters as we go through fiscal ‘24 on our way to 10 basis points to 30 basis points of expansion for the year. So hopefully that gave you a little bit of color. Julie, if you want to talk a little bit more about specifics in managed services?"
},
{
"speaker": "Julie Sweet",
"text": "And what I would say on managed services, managed services continue to be really important for our clients, because it's both a cost play, but also a faster digitization play. But it will play out a little bit. So, for example, at Accenture, right, we've got trust and safety and other managed services in the CMT. And so that's going to affect some of our results depending on the quarter and the compare and how things kind of roll out. So that's why what we're thinking about next year will be somewhere in the mid to high-single-digits, but we don't see a fundamental issue around managed services. In fact, we think they are a really strategic priority for many of our clients, but it will play out a little bit differently based on industries. We see less of it based on sort of market per se because clients really need the managed services."
},
{
"speaker": "James Faucette",
"text": "Got it. And then just as a quick follow-up, can you talk a little bit about your inorganic strategy, just what contribution has been, and particularly in light of the increased capital return program for ‘24, if we should anticipate that that will have any impact on what you guys historically have done from an inorganic contribution? Thanks."
},
{
"speaker": "KC McClure",
"text": "Sure. In terms of inorganic contribution, for ‘23, it was about 2% was the inorganic contribution and for ‘24, James, we're considering another about 2% in ‘24."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And, look, on our inorganic strategy remember that the way we think about it is, can we get into new areas through our inorganic, like what we did with Anser Advisory and Industry X, which is capital products. It's basically we're very small there before the acquisition, that's an $80 billion addressable market. So that's an acquisition to start to grow there. We think about it as being important to invest in our industry and functional expertise. So in France this year, we -- this last quarter, we did an insurance acquisition in strategy and consulting. And we think about it in terms of scale. So we bought a data and AI practice in terms -- in India this quarter. And so as we are pivoting to the higher areas of growth right now, a real advantage we have is the ability to leverage our investment capacity in order to do that pivot. And of course we're -- right now, we're kind of assuming 2%, but we have the ability to do more if we have the right opportunities. And so we really do think about this as a huge competitive advantage in our industry, in our ability to drive growth and to be in the hot areas of the market."
},
{
"speaker": "James Faucette",
"text": "That's great. Thank you so much."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Lisa Ellis with MoffettNathanson."
},
{
"speaker": "Lisa Ellis",
"text": "Hey, good morning. Thanks for taking my question. I might start on the business optimization program. Can you just give a little bit more detail in terms of what -- where exactly you are, what's completed, what remains in 2024, and maybe a little bit of more detail on how we should expect that impact to sequence in throughout fiscal ‘24? And then just remind us whether that's then the end of it and we should expect to kind of move back toward GAAP reporting at the end of ‘24?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. Thanks, Lisa. So just in terms of -- just as a reminder, so we -- when we announced our business optimization program, we said it would be about $1.5 billion, and that would go through FY ‘24. So we still are saying $1.5 billion through FY ‘24. As it relates to next year, right, we expect to incur approximately $450 million. We were -- we did record $1.1 billion in FY ‘23, which is a little bit more than we expected to do in ‘23. So we were able to get a bit more into the P&L in last fiscal year '23. And I'm happy to go through the impacts on EPS, but you saw that it will be a $0.56 impact on EPS for ‘24, and I'm happy to go through some of the questions that you have. Yes. And also as we go throughout the year, the two -- we take the business optimization out of our results as we go throughout the quarters, so that doesn't -- that's not their driver for why we'll have more margin variability as we go throughout the year. And we'll see how it plays out. It really depends on the countries and different things that we have to go through in terms of process and procedures. And so we're not giving an update as we go throughout the year on the full-year estimate, but we're not breaking that up by quarter."
},
{
"speaker": "Lisa Ellis",
"text": "Got it. Okay, okay. Great, thank you. And then maybe my follow-up, just to -- a quick follow-up on the managed services question, maybe just a little bit taking a step back, Julie, I think over the last few quarters, as we've been seeing some of the softness in strategy and consulting and this shorter duration discretionary work, you've been highlighting pretty consistently that has not really bled over into the larger transformation programs. And I just wanted to kind of ask if you could kind of update us on the latest you're seeing on that given that we saw a little bit of a slowdown in some of the managed services bookings this quarter. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure. I mean, what I would say is that overall -- first of all, the large transformational programs include managed services, but they also include building, like so putting new modern ERP programs in place, right? So it's not only kind of managed services just to kind of set the stage for that. And just as you think about the fundamentals, because we think of the transformation deals, managed services are often a way to pay for them. They're often also a way to go faster and modernize, but we really look at those transformational programs in the round. So when you think about the fundamentals that our clients are facing, there is more reinvention ahead than they have done so far. So huge opportunity ahead. And you see that in where they are in the cloud journey, only 40% workloads, right? We estimate less than 10% of our clients are mature in data and AI. Only a third have put in the modern ERP programs. And so as you think about what they have to do, managed services will continue to play a huge role in paying for it and in actually modernizing much of it, as well the other big implementations. We do see, however, right, when you kind of go to the market-- and by the way, that's why we're super well positioned, right? Our strategy is to be that partner and then reinvention begets more, right? So you first build the digital core and then you've got a lot of work on top of that. And that is our growth strategy. Now, if you come to what we're seeing in the market, right? So always best to hear from what's going on in the ground. Last week, I was very busy and I was with about 20 different CEOs and they had three messages, right? Tech is super important, that's number one. Number two, they already have major programs underway and they know they need to do a lot more. But number three is they're feeling cautious about the macro and we've already seen that in the small deals. But they're asking us to help them save money and be more focused right now, even on the bigger programs. And so what I would say is and that's reflected in our guidance is that, the macro is having an effect on the pace of spending right now. Now, again, plays into our strengths in terms of being able to be the reinvention partner, being able to really think about the journey and positions us super well as they navigate that macro. But that is -- the reality is that there is this sense of caution and it's bleeding over to kind of overall, overall demands."
},
{
"speaker": "KC McClure",
"text": "Right. And Lisa, maybe I'll just add, bookings can be lumpy, particularly in managed services. And we look at bookings -- book to bill over rolling four quarters and our goal in managed services is to be 1.2 or above. And that's exactly where we are on a four-quarter basis."
},
{
"speaker": "Lisa Ellis",
"text": "Great. Thank you. Thanks a lot."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Keith Bachman with BMO."
},
{
"speaker": "Keith Bachman",
"text": "Hi, thank you very much. I wanted to ask -- go back to M&A if I could start with you, Julie. You're guiding to 2 points of M&A contribution to your full-year guidance which is consistent with sort of the past years, but the number here much bigger. 2 points is meaningfully than what it was even three or four years ago in terms of, A, the capital required to do those deals; and B, the integration therefore of the head count? And I just wanted to hear your, kind of, philosophically, it doesn't seem like 2 points can continue on for perpetuity, but just how do you think about any, kind of, balance sheet constraints or also the integration required to make sure the people side of the business -- because again, implicitly the deals are getting larger. And then as part of that, could you just speak to -- do you look at the same size deals or do you need to kind of flex up a little bit in terms of looking at larger opportunities? And then I have a follow up. Sorry about the background noise."
},
{
"speaker": "KC McClure",
"text": "No problem, Keith. Thanks, I'll handle the capital allocation part and I'll hand it over to Julie. So just from a capital allocation standpoint, Julie referenced this a little bit earlier, but our capital allocation framework is really durable, but it is also very flexible. So we've been able to continue to return a significant portion of our cash through dividends and share repurchases. Well over the time we've been flexing at various times the amount of money that we spend in V&A and we can continue with that framework. So just again as a focus, we had about 80% of our free cash flow return to shareholders through dividends and repurchases in FY ‘23 and we actually have a $500 million, $0.5 billion increase in our guidance baked in for next year. So just shows that our capital allocation framework can flex as needed while still doing a great return."
},
{
"speaker": "Julie Sweet",
"text": "And what I would say is that I'm really proud that how we do M&A is a core competency of Accenture, right? So we've now been on this journey. I helped start it when I was the general counsel. I remember that was -- I came in and they were like, we kind of need to increase this and I've done a lot of that in my prior life and what you see is that, as we've grown, we've continued to build the capabilities. We have a very mature machine around integration, but we also have an operating model where we have leaders close to the acquisitions, doing the integration. And they really do vary from very small to larger ones. We've done over $1 billion and we could do even bigger ones with our capital. The point is that, we know how to integrate and we've been doing this now for many, many years."
},
{
"speaker": "Keith Bachman",
"text": "Okay, fair enough and thank you, Julie. My follow-up is just how do you think about headcount for Accenture through the year? You're just kind of finishing off your risk, but how do you think about headcount as we process through FY ‘24 and I'm really thinking on an organic basis, excluding the M&A. Many thanks and that's it for me."
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks, Keith. Really what I would say is managing supply and demand. As you know, it's a core competency of ours and we're going to manage our supply skills based on wherever we see the growth. So we didn't expect that we would need to add a lot of people in -- from Q3 to Q4 as we said and that's exactly what happened. And so we're going to continue to hire for the skills that we need and we're going to focus on the automation and as Julie mentioned, the lot of re-skilling of our people."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to the line of Darrin Peller with Wolfe Research."
},
{
"speaker": "Darrin Peller",
"text": "Thanks, guys. I just wanted to ask in terms of visibility that you'd say you have now in the environment relative to prior years on the outlook side. I mean, has anything changed and just maybe if you could reiterate for us where you're seeing the pockets of strength in a little bit more of a specific manner around example that customers need right now that might be -- that might buck the trend of what you typically see in a downturn macroeconomically. Just curious kind of what's fighting through the demand weakness no matter what just because it's really mission critical right now. Thanks again."
},
{
"speaker": "KC McClure",
"text": "Yes. Great, thanks, Darrin. In terms of visibility, right, as we sit here at the beginning of a new fiscal year, as -- we're really confident that we're taking all the right steps to successfully deliver for a full-year and as you know well, we always aim for the top part of the range. But just like every other year at this time, the back half of the year is less certain, because we'll know more when the budgets are set which is really in the back -- which is in the H2 of our year. But as we mentioned, we are going to build throughout the year and why do we say that? Well, first of all, we're confident in the steps that we're taking that Julie highlighted many examples to pivot to the higher growth areas. And we expect that we'll see that come through in the back half of the year and that's also backed up by the investments that we'll make. The second part is that we do have the revenue from the larger scale transformations. It is out there, right? And so we just need to layer in some of the new growth area work that we'll get to as we approach the back half of the year. And the last part, as you're aware, I mean, we do have the benefit of each year comparison in the back half."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And then in terms of demand, it's exactly what we've been talking about. The number one area of demand is building that digital core. So you've got clients like the financial service client I mentioned in the script that's not in the cloud at all and is basically needing to migrate to the cloud, right? Then you've got those who are in the cloud but they haven't modernized their ERP. You saw a lot of examples of that. Then you've got security, right? Absolutely has to happen. And then lots of focus on now on data and AI, particularly for those who've already been investing, so they're in the cloud, they've got their modern ERP, and now they want to really accelerate AI. So what's not happening, right, is discretionary spend globally as we saw throughout the year, starting in North America, people are not doing smaller systems integration. They're not doing smaller strategy and consulting, they're prioritizing and focusing on larger deals. And even there, there's prioritizing, especially depending on the industry where you've got more challenges to say, can we -- we've got a lot underway, we're cautious about the environment, so help us Accenture cut costs, so we can afford all of the reinvention ahead of us and help us prioritize what we start next. And that's kind of the overall, sort of, more cautious spending. But I just want to reemphasize, nothing has changed about the fact that our clients have more ahead of them than behind them in terms of building the digital core and then using it to reinvent. And we're the only one in our industry that can both build the technology and at this scale have the industry and the functional expertise to then be positioned to help them use that technology to reinvent. So we are super optimistic about this industry in our position."
},
{
"speaker": "Darrin Peller",
"text": "That makes sense, Julie. And just -- I guess, as a follow-up to that, the ramp time, you know, you talked about a billion dollars investment in AI last time, and we've obviously seen some evidence of success, but early days still. So now that you've had the luxury of a few more months, the ramp time you'd expect to see that really become a much, much bigger part of the business. Can you just quickly touch on that again? This is around AI and generative AI. Thanks, [Indiscernible]."
},
{
"speaker": "Julie Sweet",
"text": "I'm sure -- my team are going to love the luxury of a few more months. You know, so thank you for that, I'm going to tell them that. See you guys, you've had a few more months. So look, as I talked a little bit about in our script, we're still learning. Remember, these are like, you know, a million dollar sort of things. We're starting tom, you know, look at our -- work it in our own delivery. So it's going to take a few more quarters till I've really got a well-informed view of that. But what I will say is, gen AI is an amazing technology. It's going to do great things. And what I tell all my clients, can't use it unless you're in the cloud, have data, and you've, you know, modernized your core. So that's our opportunity."
},
{
"speaker": "Darrin Peller",
"text": "Thanks, guys."
},
{
"speaker": "Operator",
"text": "And we'll go next to the line of Jason Kupferberg with Bank of America."
},
{
"speaker": "Jason Kupferberg",
"text": "Good morning, guys. Thanks for taking the question. I wanted to pick up on your earlier comment, I think you said that you're not assuming any improvement in discretionary spending in the overall environment there during F ‘24. So I know you guys typically start the year with a relatively conservative approach to guidance that certainly served you quite well in fiscal ‘23. So against that backdrop, can you tell us a little bit about what you're thinking regarding growth for each of the three business dimensions in F ‘24?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. So, Jason, let me just kind of give you a little bit more color on guidance, right? So, as we mentioned, we're not assuming in our guidance any improvement in the macro discretionary spend, but we're going to pivot two years of growth. So the macro is going to be kind of this, you know, it's not going to help us or hurt us this year is kind of what really essentially what we're saying. In terms of, you know, color, I'll kind of stick to what we have in the type of work, maybe is the best way of thinking about it. And again, I think just consulting, it's going to build as we go throughout the year. And overall, I think, it's important to know that we are going to build in this environment. We're going to build as we go throughout the year."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay, and then on -- just on bookings, any thoughts on the first quarter or the full-year? I know there's some seasonal elements that typically consider in the November quarter? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Yes, sure. So let me just talk about maybe a little bit of bookings. You know, in bookings, we're going to start with the fourth quarter. I mean, if did come in a little bit lighter than we expected, and they can be lumpy, and we saw some deals, kind of, push out. Of the quarter, when it came to small deals, we didn't see any change in the discretionary spend environment. And just to reiterate that we're really pleased with the 21 clients that we had, over $100 million. Julie talked about that, if just reinforces our strategy to be the client's transformational partner of choice and to be at their core. And lastly, as it relates to ‘23, you know, we look at bookings that we're rolling for quarters and I mentioned this on managed services, but just overall we're at a 1.1 book to bill, which I'm really pleased about for the fourth quarters. And then for next year, looking at ‘24 Q1, you're right, it's seasonally a little lighter for us. However, we have a solid pipeline and we do expect that FY ’24 Q1 bookings will reflect growth over FY ’23 Q1."
},
{
"speaker": "Jason Kupferberg",
"text": "Thank you."
},
{
"speaker": "Katie O'Conor",
"text": "Operator, we have time for one more question and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Thank you. And that question will come from the line of Bryan Keane with Deutsche Bank. Mr. Keane, your line is open."
},
{
"speaker": "Bryan Keane",
"text": "Hi, guys. Good morning. Wanted to just follow up on strategy and consulting. I know that that was an area that we were hoping at one point during the year that it was going to turn back to positive growth by the fourth quarter. And then I know we didn't think that was going to happen as of last quarter. So I'm just curious, as we go through the year into fiscal year '24, when do you think S&C might turn towards positive growth?"
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks, Bryan. So, look, in terms of our full year range, at the top end of our full year range, which again, always where we try to be, it does reflect S&C reconnecting with growth, and that clearly is our goal. Now when -- really the pace is going to differ by market, right, so it's hard to tell exactly when it will be throughout the year. Of course, we'll update you as we go through. And North America is our biggest market, it will be a bit more challenged."
},
{
"speaker": "Bryan Keane",
"text": "Got it. I'll leave it there because I know we're at the end of the call. Thanks so much."
},
{
"speaker": "Katie O'Conor",
"text": "Thanks so much. Take care."
},
{
"speaker": "Julie Sweet",
"text": "All right. In closing, I really do want to thank again all of our people and our managing directors what they do every day, which is truly extraordinary and gives us a lot of confidence in the future. And I want to thank all of our shareholders for your continued trust and support. I assure you, we are working hard every day to continue to earn it. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And this conference is available for replay beginning at 10 AM Eastern time today and running through December 19 at midnight. You may access the AT&T replay system by dialing 866-207-1041 and entering the access code of 5848756. International participants may dial 402-970-0847. Those numbers again are 866-207-1041 or 402-970-0847, with the access code of 5848756. That does conclude our conference for today. Thank you for your participation and for using AT&T event conferencing. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 3 | 2,023 | 2023-06-22 08:00:00 | Operator: Thank you for standing by. Welcome to Accenture's Third Quarter Fiscal 2023 Earnings Call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the conference over to our host, Katie O’Conor, Managing Director, Head of Investor Relations. Please go ahead.
Katie O’Conor: Thank you, operator, and thanks everyone joining us today on our third quarter fiscal 2023 earnings announced. As the operator just mentioned, I am Katie O’Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market position before KC provides our business outlook for the fourth quarter and full fiscal year 2023. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including, but not limited to those factors set forth in today’s news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in the call. During our call today, we will reinforce certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Katie and thank you to everyone joining today, and thank you to our people around the world for their dedication and commitment, which is how we are able to consistently deliver 360 degree value for all our stakeholders, our clients, our people, our shareholders, our partners and our communities. Turning to the quarter, I will start with the financials. While the macro environment continues to be uncertain overall, in Q3 we delivered solid revenue and sales with very strong profitability and very strong free cash flow, while continuing to significantly invest in our business. Now getting into the highlights, we had bookings of $17.2 billion, including 26 clients with quarterly bookings greater than $100 million, bringing the total year to date 85, which is 11 more than the same time last year. We delivered revenues of $16.6 billion, representing 5% growth with North America growing 2%, Europe at 7% and growth markets at 9%, all in local currency, bringing us to $48.1 billion of revenue at 10% growth fiscal year to date. Revenues were impacted by lower than expected small deal sales, especially in strategy and consulting and systems integration and lower than expected results in the communications, media and high-tech industry group for the quarter. Excluding [CMT] (ph), our business grew 8% globally, 7% in North America, 9% in Europe and 10% in growth market in local currency. We expanded adjusted operating margin by 20 basis points, grew adjusted EPS 14% over last year and delivered free cash flow of $3.1 billion. And over the past 11 quarters we have operated at 91% or higher utilization, leveraging our digital enterprise to connect our sales, staffing, hiring and skill needs to make proactive real time decisions. We are on track with the business optimization actions to lower costs in fiscal 2024 and beyond, while continuing to significantly invest in our business with five acquisitions in strategic areas this quarter, bringing the total investment in acquisitions year to date to $1.3 billion. We invested in Cloud, Data and AI with the acquisition Nextira in North America, Objectivity in the UK and Einr in Norway. We also invested in sustainability with the acquisition of Green Domus in Brazil and in modern ERP services with Bourne Digital in Australia. We continued to take market share growing about two times the market. Now turning to other aspects of the 360 degree value we delivered this quarter. We continue to invest in learning for our people with 9 million training hours in the quarter, representing an average of 13 hours per person, giving them the skills to grow as our clients' needs evolve. We're incredibly pleased that we were recognized as a top 10 place to work in seven countries. Argentina, Brazil, Chile, India, Mexico, the Philippines and the U. S. Collectively, these countries represent nearly 70% of people. Vibrant communities are important for our business success and digital scaling helps ensure vibrant communities thrive. In collaboration with L'Oreal and our NGO partner, [Shambu] (ph) Foundation, we are supporting women in India to build digital literacy skills alongside the technical skills needed to access jobs in the beauty industry. Together, we have collectively created sustainable livelihoods for 2,500 women across 10 states in India, accelerating equality, delivering social impact in the community and continuing our commitment to embed diversity and inclusion in everything we do. Finally, this year we are proud to earn the number 22 position on [Brand Z's] (ph) prestigious top 100 most valuable global brands list, our highest rank today. Over to you KC.
KC McClure: Thank you, Julie, and thanks to all of you for taking the time to join us on today's call. We are pleased with our third quarter results and we are on track to deliver or exceed all aspects of our guidance provided in September on an adjusted basis. Now let me summarize a few of the highlights for the quarter. Revenues grew 5% local currency, driven by high single or double digit growth in seven of our 13 industries. While we've been highlighting the pressures in our CMT industry group all year, this quarter the revenue was lower than expected with a decline of 8% in local currency. We delivered adjusted EPS in the quarter of $3.19, reflecting 14% growth over EPS last year. Adjusted operating margin was 16.3%, an increase of 20 basis points over Q3 last year and includes continued significant investments in our people and our business. Finally, we delivered free cash flow of $3.1 billion and returned $1.5 billion to shareholders through repurchases and dividends. Year to date, we have invested $1.3 billion in acquisitions, primarily attributed to 20 transactions. With those high level comments, let me turn to some of the details, starting with new bookings. New bookings were $17.2 billion for the quarter, representing growth of 4% in local currency with an overall book to bill of 1.0. We were very pleased with our 26 clients with quarterly bookings over $100 million. Consulting bookings were $8.9 billion with a book to bill of 1. Managed services were $8.3 billion with a book to bill of 1.1. Turning now to revenues, revenues for the quarter were $16.6 billion, a 3% increase in U.S. dollars and 5% in local currency, reflecting a foreign exchange headwind of approximately 2.5% compared to the approximately 3.5% headwind provided in our business outlook last quarter. Consulting revenues for the quarter were $8.7 billion, a decline of 4% in U.S. dollars and 1% local currency. We see the same level of consulting decline in Q4. Managed services revenues were $7.9 billion, up 10% in U.S. dollars and 13% in local currency. Taking a closer look at our service dimensions, technology services grew high single digits. Operations grew double digits and we expect high single digit growth in Q4. Strategy and consulting declined high single digits this quarter and we see declines continuing in Q4. Regarding our market share, we extended our leadership position with growth estimated to be about two times the market which refers to our basket of publicly traded companies. Now as a reminder, we assess market growth against our investable basket which is roughly two dozen of our closest global public company competitors, which represents about third of our addressable market. We used a consistent methodology to compare our financial results and theirs, adjusted to exclude the impact of significant acquisitions through the date of their last publicly available results. Turning to our geographic markets. In North America, revenue growth was 2% in local currency driven by growth in Public Service for our U.S. federal business, Health and Utilities. These increases were partially offset by declines in Communications and Media, High-tech, Software and Platforms and Banking and Capital Markets. In Europe, revenue grew 7% local currency, led by growth in Banking and Capital Markets, Industrial and Public Service. Revenue growth was driven by Italy, Germany and France. In Growth Markets, we delivered 9% revenue growth in local currency, driven by growth in Public Service, Chemicals and Natural Resources and Banking and Capital Markets. Revenue growth was driven by Japan. Moving down the income statement. Gross margin for the quarter was 33.4% compared with 32.9% for the same period last year. Sales and marketing expense for the quarter was 10.5% compared to 10.3% for the third quarter last year. General and administrative expense was 6.5% compared to 6.5% for the same quarter last year. Before I continue, I want to note that in Q3 we recorded $347 million in costs associated with the business optimization actions we announced last quarter, which decreased operating margin by 210 basis points and EPS by $0.42. This quarter, we also recognized a gain in our investment in Duck Creek Technologies, which impacted our tax rate and increased EPS by $0.38. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.7 billion in the third quarter and adjusted 16.3% operating margin, an increase of 20 basis points from operating margin in the third quarter of last year. Our adjusted effective tax rate for the quarter was 24% compared with an effective tax rate of 27.1% for the third quarter last year. Adjusted diluted earnings per share were $3.19 compared with diluted EPS of $2.79 in the third quarter last year. Days source outstanding were 42 days compared to 42 days last quarter and 44 days in the third quarter of last year. Free cash flow for the quarter was $3.1 billion, resulting from cash generated by operating activities of $3.3 billion net of property and equipment additions of $142 million. Our cash balance at May 31 was $8.5 billion compared with $7.9 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the third quarter, we repurchased or redeemed 2.8 million shares for $789 million at an average price of [$279.65] (ph) per share. As of May 31, we had approximately $3.5 billion of share repurchase authority remaining. Also in May, we paid a quarterly cash dividend of $1.12 per share for a total of $708 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.12 per share to be paid on August, a 15% increase over last year. So in closing, we remain committed to delivering on our long-standing financial objectives, growing faster than the market and taking share, generating modest margin expansion and stronger earnings, while at the same time, investing at scale for long-term market leadership, generating strong free cash flow and returning cash to shareholders. Now let me turn it back to Julie.
Julie Sweet : Thank you, KC. As we look at demand in our larger deals, we continue to see two common themes that I've highlighted before. First, the rapid rise of generative AI interest among our clients highlights yet again that all strategies lead to technology, particularly cloud, data, AI and security. And second, companies remain focused on total enterprise reinvention as they execute compressed transformation to achieve lower costs, stronger growth, more agility and greater resilience faster. Now let me give you more color on the quarter to bring this to life. Starting with the digital core, our cloud momentum continues with very strong double-digit growth in Q3 as clients priorities building a strong and secure foundation for reinvention. We have been working with ENI, a global energy company for more than 30 years. Now we are helping them as they continue their hybrid cloud transformation and embark on a total enterprise reinvention strategy with a focus on sustainability, digital transformation and security. We are managing their IT infrastructure and telecommunications integration and helping implement new operating models, all hosted in the ENI green data center, one of the largest data bunkers in the industry to securely hold the company's data. The ENI green data center houses one of the most powerful nongovernmental supercomputers in the world, enabling the highest use of data across the value chain from exploration and production to the energy of the future. New operating models will help exploit the full value of data, AI and cybersecurity for faster adoption of new business processes. This transformation is the first step toward creating a secure digital core that will accelerate ENI's energy transition, drive innovation in AI and R&D and build even greater resilience. Clients are also working with us to do multifaceted compressed transformation that utilize all of our deep industry and functional expertise in our SNC services, along with our outstanding technology services. We are helping DuPont, a global multi-industrial specialty products company with a compressed transformation to standardize their finance processes and achieve operational excellence. Building on our trusted relationship of over 35 years, we are now supporting our client with its strategic pivot to innovation-based growth across electronics, sustainable water and protection solutions, industrial technologies and next-generation automotive. We've been supporting their transformation to an agile cloud-based IT infrastructure to maximize data access, drive efficiency and modernize their landscape. Our work with DuPont is focused on achieving greater resilience, reducing costs and increasing revenue growth and shaping its portfolio through M&A with industry-leading innovation for long-term success. With companies expanding their digital footprint and cyber risk widening security continues to rise in importance as a fundamental part of the digital core with very strong double-digit growth in Q3. We are working with a food and beverage company to strengthen their cybersecurity and prevent vulnerabilities along the supply chain. Building on previous operations transformation work, we are now providing managed security services, which will cover perimeter security, detection and response as well as threat intelligence and monitoring dark web activities. We also will provide day-to-day identity, data and privacy management, helping provide a holistic security approach for our client. We're helping a global universal bank future-proof their cryptographic landscape and corresponding risks for over 1,000 applications, procedures and data. Based on the analysis, we will develop and implement an end-to-end mitigation strategy, including evaluation of solution vendor strategies, mitigation principles as well as change management procedures. We will also design and implement post-quantum methods and new architecture blueprints, which will help scale the solution, all to help the bank achieve post-quantum computing readiness. Our Managed Services continued to grow double digits in Q3, demonstrating the relevance of our approach to run, digitize and transform our clients' operations. We're providing a global health care and insurance company with managed services to help run its complex claims and membership processes. As part of our long-standing relationship with the company, we will improve the efficiency and quality of these tasks and simplify the customer journey, ensuring members can easily access the support they need when they need it. Its employees will now have more time to focus on boosting customer satisfaction by better serving its millions of customers around the world. A new cost solution has also been introduced to determine fair and accurate pricing for the company when purchasing services and products from vendors to reduce costs across the business. We recently worked with a major media brand to launch a streaming platform that will help attract new subscribers, expanding their content portfolio and power-targeted broadcasting and advertising offerings, all while lowering costs. We helped engineer aspects of the new platform from the content supply chain to the player experience, ensuring that customers have a seamless viewing experience across all devices and platforms and enabling the company to use data insights to continually enhance its platform. We delivered the program as part of a managed services arrangement, demonstrating the industry and engineering innovation that we bring to help clients reinvent their business with cloud, data and AI. As clients continue to reimagine and prioritize customer experience, Song experienced strong double-digit growth again in Q3. We are partnering with Virgin Media O2, a British media and telecommunications company to reimagine their customer experience. Accenture Song will design a new, more predictive and personalized customer journey, enabled by an AI-powered cloud-based digital core. Customer care journeys will be omnichannel, combining customer calls, chat and instant messaging to increase first-time resolution and upselling, leading to greater customer satisfaction. We also will deploy our managed services capabilities to support contact center activity using AI to provide timely agent assistance and route calls intelligently to drive precision and reduce call volume. Our work will help build brand loyalty supporting Virgin Media O2's mission to be a more customer-first business. We see continued demand for our Industry X capabilities, which grew strong double [indiscernible]. We are working with one of the world's leading consumer products companies on a transformation of its manufacturing practices to achieve energy savings. We are developing a comprehensive program to collect and analyze energy consumption data from their production plans and use data-driven analytics to identify energy savings and greenhouse gas reduction opportunities. We are also helping to track energy efficiency gains and deliver value through operational improvements in the manufacturing process. As clients progress on their total enterprise reinvestment journeys, talent is at the forefront. We are working with an international consumer goods and services provider in the European market on a digital transformation of its core human resources organization and talent acquisition processes. We will design and implement an approach that includes program management, process design, training and development and additional services. Together, we will create greater efficiencies in the human resources function, leading to a data-driven culture focused on better employee experiences. Now stepping back, our strategy is to be at the center of our clients' business and help them continuously reinvent themselves to reach new levels of performance and to set themselves apart as leaders in their industries. And our clients are at different starting points. All are interested in AI, and particularly generative AI. But most recognize the work ahead of them to get their data, people and processes ready for AI. To reinvent requires a strong modern digital core. And as they embark on this journey, clients are looking to us for unmatched global scale, deep industry and functional knowledge, breadth of services from strategy and consulting to technology to managed services. With that context, I want to turn to generative AI and AI more broadly. No previous technology wave has captured the intention of leaders and the general public as fast as gen AI. We are now embarking on the age of AI, and companies will need to reinvent how they operate with AI at the core. And it is also early. Think of it as the cloud over a decade ago. Foundation models and products based on them are still maturing with many products announced but fewer at the general availability stage and ready for wide deployment. And with our position as the largest partner with most of the major technology companies, we are at the center of helping our clients navigate their choices in the evolving landscape. We've been investing in AI for years. And so while it is early days, we see generative AI as a key piece of the digital core and a big catalyst for even bigger and bolder total enterprise reinvention going forward. In fact, in a survey of global executives that we completed just last week, 97% of executives said gen AI will be transformative to their company and industry and 67% of organizations are planning to increase their level of spending in technology are prioritizing investments in data and AI. Our approach to AI is clear. Just as we have successfully done with cloud, we are investing to take an early lead and position for the opportunity ahead. Last week, we announced a $3 billion investment in AI, a big step to accelerate our clients' reinvention journey, which includes us doubling our data and AI workforce from 40,000 to 80,000 strong, including the expansion of our center for advanced AI that today has over 1,600 generative AI experts bringing new assets such as our AI navigator for enterprise to life and developing new GenAI-powered industry solutions. And across this all, we are leading with responsible AI to be the most trusted source in helping our clients mitigate the risks as they drive value. And this isn't just about tomorrow. We have sold over 100 generative AI products -- projects over the last four months. Let me give you a flavor of these across a few industries. We are working with Mitsui Sumitomo Insurance, a Japan-based subsidiary of MS&AD Insurance Group Holdings to improve customer service by using generative AI and simplify operations for accident response. The generative AI solution will draw from the company's knowledge base, including policy causes and related laws and regulations, which will generate appropriate response plans in a timely manner, dramatically improving the accuracy and speed of explanations to customers. We're working with a global broadcast company to explore how generative AI can be used to drive audience engagement and growth through deeper and more personalized customer experiences. Together, we recently launched testing that leverages generative AI and large language models to explore how we can automatically create content for the company's customer-facing platforms. The content will help enhance engagement, grow the consumer base across new coverage areas and channels. We believe it will demonstrate how generative AI can be used to create content at scale for a wide variety of experiences and events. We are working with [Linda Basel] (ph) Industries, a leader in the chemicals industry to increase its enterprise data and analytic capabilities and help unlock new value. We will develop a strategic data-led digital transformation program across multiple parts of their business and embed new capabilities in areas like sustainability, customer data, digital manufacturing and generative AI to drive more insightful and predictive decision-making. Companies are coming to us for help with the strategy in the business case to understand how and where to apply AI, and gen AI specifically, to get their digital core in shape, to help assess which ecosystem partners and models to use, to rewire their processes to be AI-driven, to upgrade and reskill their talent with new ways of working and to navigate the risks and challenges responsibly. In short, we believe clients need our full range of services and we are well positioned to be the leading trusted AI partner for the enterprise as they move from exploration to experimentation to reinvention. Over to you, KC.
KC McClure : Thanks, Julie. Now turning to our business outlook. For the fourth quarter of fiscal 2023, we expect revenues to be in the range of $15.75 billion to $16.35 billion. This assumes the impact of FX will be about flat compared to the fourth quarter of fiscal 2022 and reflects an estimated 2% to 6% growth in local currency. For the full fiscal 2023, based upon how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately negative 4% compared to fiscal 2022. For the full fiscal 2023, we now expect revenue to be in the range of 8% to 9% growth in local currency over fiscal 2022, which assumes an inorganic contribution of about 2%. We continue to expect business optimization costs of $800 million in fiscal 2023 to reduce EPS by $0.96. The gain on our investment in Duck Creek Technologies will increase EPS by $0.38. Our guidance for full year 2023 excludes these impacts. For adjusted op margin, we now expect fiscal year 2023 to be 15.4%, a 20 basis point expansion over fiscal 2022 results. We now expect our adjusted annual effective tax rate to be in the range of 23.5% to 24.5%. This compares to an effective tax rate of 24% in fiscal 2022. We now expect our full year adjusted earnings per share for fiscal 2023 to be in the range of $11.52 to $11.63 or 8% to 9% growth over fiscal 2022 results. For the full fiscal 2023, we continue to expect operating cash flow to be in the range of $8.7 billion to $9.2 billion. We now expect property and equipment additions to be approximately $600 million and free cash flow to be in the range of $8.1 billion to $8.6 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $7.1 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so we can take your questions. Katie?
Katie O’Conor: Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: [Operator Instructions] We'll go to the line of Lisa Ellis with MoffettNathanson.
Lisa Ellis: Hey, good morning. Thanks for taking my question. Let's dive in on the Strategy and Consulting. I know it was a high single-digit decline this quarter just looking back at your comments from last quarter. I think that came in a little bit softer than you expected, but then also called out many new projects coming in related to gen AI and other technologies. Can you just talk a little bit about kind of what's changed, what that evolution looks like and kind of what's your confidence level in the time horizon that we'll see Strategy and Consulting improve over the next couple of quarters? Thank you.
Julie Sweet: Sure. Thanks, Lisa. So I'll first give some color on that. So, the big difference in our expectations from last quarter and where we ended up really was all in the small deals. And we saw a further -- they came in lower than, and we saw that extend to Europe and the Growth Markets. Now that was both in S&C and systems integration. But that's the big reason that we have a difference in sort of where we thought where we would be this quarter. Now our job is to continue to pivot to higher -- where there is higher growth, and we're working on that in digital manufacturing, supply chain, data and AI. But that will take a little time. And what we're seeing is that, there's a lot of extensions going on in small deals, but it's the newer small projects, while at the same time, we continue to have very strong bookings and interest and huge opportunity in transformation. So I think our clients are kind of holding back on the small stuff and doing the bigger stuff, which obviously converts to revenue differently. But you see where Strategy and Consulting makes a big difference there, like in the DuPont example that I gave in the script where you have to have so much expertise in the industry, as well as the functions, as well as technology. What that means is that, it is going to take a little while for the turnaround. And we're not going to go to next year because we really want to see how Q4 evolves, and KC will give a little bit of color on how we are thinking about our Q4. And what I would also say is that, things like gen AI are a big opportunity, but it is early. So we did in the last four months 100 projects. That represents about $100 million in sales. That's kind of the average size of those projects where it is. And so, we're going to continue to pivot there, but it just takes a little bit of time. So why don't I let KC give you a little color on how we're thinking about Q4.
KC McClure: Yes. Great. Thanks, Julie. Yes. So let me just kind of maybe step back and look at Q4 and the overall guidance for the full year. So first, I did mention this, but I just want to -- just reiterate that we are on track for our business optimization actions. So we're going to do about $800 million of cost for the full year 2023. Additional color is that, for Q4, as we look at bookings, we think they'll be about the same as what we did in Q3 of this year and have about the same complexion. Julie talked a bit about small deals. What I will tell you in terms of our revenue guidance for Q4, which is 2% to 6%. At the top end of our revenue guidance, that reflects some improvement in small deal performance, while the bottom end allows for some further deterioration. And we commented also in our scripts about CMT. And so, within our overall range of 2% to 6%, we do allow for CMT to get a little bit worse. And then lastly, to bring it on home as it relates to North America, because these two factors do impact North America performance in the context of our overall 2% to 6% range for the quarter. North America, which was 2% growth this quarter, it would likely be flat around the midpoint of our guidance range and it reflects a slight decline at the bottom of our range. And as Julie mentioned, obviously, we will give you more color, as I always do on next year when we get into September, and we'll see how Q4 plays out.
Lisa Ellis: Terrific. Thank you. And then maybe for my follow-up, maybe a more strategic question. I mean, Julie, you talked a lot about gen AI in the prepared remarks, particularly around the revenue opportunities that you're seeing in your clients. But can you give your view on how you see gen AI impacting the IT services industry overall? Like a lot of people make an analogy to sort of the impact of offshoring on the industry and sort of other big sort of step function changes to the operations and the kind of composition and the way IT services is done. Can you kind of give your latest perspective on that, how you see it affecting Accenture and your industry more broadly? Thank you.
Julie Sweet: Sure. Yes. And I think another good analogy actually, maybe even less so than the offshore is more about like SaaS, right? Because you remember when we talked about when SaaS came, what would be the opportunities. And there was a lot of worry about how SaaS would interrupt IT services. And obviously, it's been just a huge opportunity. So I think, Lisa, if you think about this, so obviously a big opportunity for us to help our clients. We see it as two other areas of opportunities. So the first is help our clients, big opportunity. The second is, the opportunity for us to improve the delivery of services to our clients, right? Now what is -- and that, we think, is a huge opportunity for us. So think about it first. In context of Managed Services every year, right, we have to find at least 10% of productivity. So we talk a lot about our platform, things like myWizard and that. That's all AI-enabled. Like just year-to-date in operations, not using gen AI, right, we have automated 13,000 jobs and then we've reskilled those people and redeployed them. Our business model requires us to get at least 10% productivity year in and year out. As we're kind of getting to the maturity of automation and AI before generative AI, we see generative AI as our ability to continue to give at least that 10% productivity year in and year out. So in the managed services area, we see that more as the ability to continue doing what we have to do as kind of the next generation of technology. Where we're super excited is in software development that is more around our systems integration and our big transformations around platforms because while we do automate there, we think gen AI may provide a real opportunity to do even more. And remember, our strategy is to deliver compressed transformation. So the more that we can find ways to deliver faster and less costly, that's going to be a big differentiator. So we're leaning in hard. At the same time, these technologies are [indiscernible] early. And so for example, we're doing a lot of experimentation now. It's really good for things like documentation, but complex integrations, being able to use them for highly architectured systems, which is what our large enterprises do. GenAI isn't there yet, right? So think it's going to take some time. We also don't yet know the cost. And one of the things we are really -- a lot of clients are looking at for us to help them with the business case because most of the studies, including our own, are all about what potentially uses of it. But because these products aren't out yet, we know that -- it's much more expensive to use gen AI, it's much more energy efficient. And so the actual ROI, so there's the art of the possible, but what's actually the return, it's still really early days. So we're very excited that we can get new kinds of productivity, particularly on things like consulting and systems integration but it's early days yet. And we are leaning in because we think it's a big opportunity for us to differentiate. And that's why we are investing $3 billion over the next three years because we think this is like another cloud first moment where we were out early, we invested at scale. The last thing I would say is, there's also an opportunity for us to use it in our own enterprise. And of course, we like -- part of our strategy is to be our own best credential. And we're prioritizing it, using it wherever we think we can use it for us and then take it to market to help our clients. So overall, we think that like prior big changes, right, first, the change to cloud, right, and before that to servers, that it always creates new opportunities as long as you have the ability to invest, like we do, you've got leading partnerships, we've just announced yesterday expanded partnerships with all of the three big cloud providers; and you have that agile innovation mindset that says embrace change and move fast.
Lisa Ellis: Thank you.
Operator: We'll go next to the line of Ashwin Shirvaikar of Citi.
Ashwin Shirvaikar: Thank you and good morning both. I guess…
Julie Sweet: Good morning, Ashwin.
Ashwin Shirvaikar: Hi. Can you hear me?
Julie Sweet: Yes.
Ashwin Shirvaikar: Okay. Sorry. I was hoping that you could provide a little bit more information. I know you said that you'll comment specifically on fiscal 2024 after -- in September as you normally do. But that seems to be one of the primary questions that people are asking. So more about the framework of how you're going about the planning process for that, just given that there are so many moving parts when we kind of think of macro, when we think of AI, when we think of headcount trends, the tough comps in the first half. Maybe just kind of framework that for us and that would be quite helpful.
Julie Sweet: Sure. So just a few things, Ashwin. So first of all, the most important thing right now just as a framework is, stay close to our clients, and really understand. And the thing is, our clients do need ways to get value in the short term as well as to transform. And so, we're working hard on finding new ways to get value to them faster. That's where the gen AI, for example, comes in. And so, over the next quarter, we're going to be developing new opportunities, new campaigns, new ways of pushing out our investments in gen AI to help us address the small deal pressure that we're seeing. We don't have a crystal ball that is going to say what the economy is going to do, how fast clients are going to get comfortable. Because you remember, we saw this over this quarter to more industries, including industries that are doing well. There's just a level of caution right now. And so, how we're looking at it is certain things we can't control, focus on not only doing the big large transformational deals, but finding new ways to develop returns faster, which is why the work we're doing on gen AI is so important. And you're seeing that kind of early focus with 100 projects in four months. So we're going to keep doing that. Secondly is, stay focused on those transformational deals, right? This provides a base level of resilience in our business. So we've got to absolutely try to do -- maximize the small deals, but it is really important that we continue to be the transformation partner of choice. And that is where bringing together all of these services and making sure that we've got the right proposition is super important. So that is a core part of our strategy. And so that's really how we're thinking about it.
Ashwin Shirvaikar: Thank you for that. And I guess the next question is with regard to hiring expectations. And there's a near-term aspect to that and the longer term so let me ask both. Near term, just kind of given what you said with regards to macro and so on and, of course, the headcount cuts announced a couple of quarters back, what should we expect in the next one or two quarters? And the longer-term question is, with AI, do you think that headcount growth dissociates from rev growth trends over time?
Julie Sweet: Let me just take the second one first, right, is, again -- and we've been talking about this for years, right, because AI has been such a big part of our strategy and automation, right, is that we will continue to manage it just like I talked about in my last answer, like where we've already automated 13,000 jobs this quarter and we've reskilled. And so, we will continue to manage that headcount as a result of AI in the way that we've been doing it for years. So no real change in that because we have a digital enterprise system that looks at what we need and sales. And what's really core is that we can reskill people as they are being freed up, and then we can adjust how much we have to hire. And of course, with attrition that in our industry is high relative to other industries, it gives us a lot of flexibility over time to get that people hiring right. So that's how I would think about it. And then for the way that we're going to hire, we saw a year-over-year increase of about 3% over last year. 11 consecutive quarters of 91% utilization. So you should just expect that every quarter we're going to manage carefully that headcount based on where we see the growth and to do that well. And I think we've proven our ability to do that.
KC McClure: That's right. And I would just add just maybe on Q4, in particular. As Julie talked about, we did not add any heads really between -- any people between Q2 and Q3, which is what we expected. And then just Q4, we don't really see a need to grow our overall headcount as we continue to focus on the automation and reskilling that Julie talked about.
Ashwin Shirvaikar: Got it. Thank you.
Operator: We'll go next to the line of Tien-Tsin Huang with JPMorgan.
Tien-Tsin Huang : Hi. Thank you so much. Good morning, guys. I just want -- I think you went through the small deal outlook to Lisa and Ashwin's question. So how about large deals? Can that momentum continue? I think you're up from about 17 to 26 large deals year-over-year. So just curious about...
Julie Sweet: Yes, large deal momentum is continuing. Yes.
Tien-Tsin Huang : Yes. So yes, -- no, I'm just going to ask that, how does that look going into the fourth quarter here? And are signed deals converting on time. My follow-up to that.
Julie Sweet: Yes. So as KC said earlier, our bookings are going to be about the same, and that includes a lot of momentum in large deals, right? So we saw 26 clients with bookings over $100 million this quarter. We're ahead of last year by 11 at this point. We can see -- continue to see that momentum. And we're actually really excited about the demand there, right? Because as you can imagine, things like gen AI are just accelerating the ability to say, "Hey, we have to do bigger deals." And by the way, that may be impacting some of what we're seeing on the smaller deals because we do see more excitement about -- because the thing is the problem with gen AI for most companies is if you don't have the data, you can't use it. And so that gets you right back to the big transformations of your digital core. KC, anything to add?
KC McClure: No, I think that's it.
Tien-Tsin Huang : So on the AI front, you did mention, I think, the cloud-first. As you draw that parallel when you guys -- I think that was three years ago, you did a $3 billion cloud first investment. That's paid off very well for you. So I'm curious, do you expect a similar return here on the $3 billion you're putting into AI? How should we measure that? Or is it going to perhaps convert differently in terms of the returns?
Julie Sweet: Tien-Tsin, that's a great clever way to try to get us to talk about more of the future. But what I would say is, we've got a great track record of investing and getting a great return. And so, we think that it's going to pay off well.
Tien-Tsin Huang : Yes, no, I like [indiscernible] and the coincidence of similarity there. Thank you, guys.
Julie Sweet: Thank you.
Operator: We'll go next to the line of Jason Kupferberg of Bank of America.
Jason Kupferberg: Hi. Thanks, guys. Just wanted to start actually picking up a little bit on Tien-Tsin's question around the larger deals. It sounds like that's going to persist the strength there in Q4. And I think that will be at least a few quarters in a row at that point of those larger deals showing relative strength. Can you just talk just qualitatively about to what extent those provide a foundation for top line growth in fiscal 2024? I would assume that those deals generally ramp to full run within, what, two to three quarters or so?
KC McClure: So in terms of what you should think about on our larger deals, they really do -- it really does vary in terms of how they fill in over the quarters going into next year and sometimes depending on what the work is, particularly in managed services, and there's larger deals, they can go out -- they can go into another fiscal year. So that's no real change in what we have experienced in terms of how the bookings fill in by the -- what I would say, the sales category size. What you're seeing is that, we do have a good foundation as we look out, right? And we've had a good foundation throughout this year everything that we've been booking in the transformational deals. But what really does also matter as you get into the year and then into -- closer to the quarters is how do you fill in with some of the smaller bookings.
Julie Sweet: If said another way, if small deals don't come back. We're going to have -- that's an important part of sort of understanding, which is why we want to see how Q4 works out before we look at next year.
Jason Kupferberg: Totally understand, totally understand. Let me switch over to bookings just for a follow-up. And by the way, thank you for the level set on AI. It's not too surprising that just a tiny fraction of your total bookings given how it's still early days. But I wanted to actually ask on the Managed Services bookings. Just curious versus your internal expectations how those came in, in the quarter. I know they can be pretty lumpy. But it does seem like looking ahead to Q4, the managed services bookings will slow a bit on an LTM basis just based on some of the commentary that you provided around Q4 bookings mix.
KC McClure: Yes. So let me just talk about overall Managed Services. Yes, we're very pleased overall with our Managed Services bookings, right? They were up 9% this quarter and they're up 22% on a year-to-date basis. So we're very pleased with the bookings overall and the result of revenue, which continue to be very strong. We also have a very strong book-to-bill with the trailing of 1.1. And when I talked about Q4, Jason, we'll have about the same complexion of bookings in terms of the breakout of type of work. And I would -- and I will highlight just the continued strength within our bookings of our operations business, which, again, Julie had a lot of great examples in her script. It really is around when clients are focusing on digitizing their core, cutting costs of operations business is a differentiator and obviously very strategic.
Jason Kupferberg: Thanks, KC.
Operator: We'll go next to the line of Bryan Keane with Deutsche Bank.
Bryan Keane : Hi, guys. Good morning. Also, just kind of a follow-up on generative AI and the understanding and timing. I get that it's early, but the big question everybody is asking is how long will it take before it moves the needle in bookings and revenue? Is that a couple of years out still? Or is that the time frame and the rapidness of the use of the technology should push it earlier than a normal technology wave?
Julie Sweet: Well, Bryan, I think in general, we think gen AI is going to go faster than, say, cloud, right, which took more like a decade. I would focus on -- so first of all, we're being very rigorous when we talk about gen AI, because we're really saying like what are the actual gen AI. The big growth, we think, is going to be in all the companies that then have to get their data done faster. And we're not lumping that together. And so, I don't know what others are going to do, but we're really being very pure in saying like, "Hey, this is pure gen AI." And if you think about where companies are, our research shows like only 5% to 10% of companies are mature right now with data and AI, and they're the ones that are really going to be able to use gen AI at scale. About -- we just had this research done that came in last week that hasn't been published yet. About 50% of companies have not started on their data or AI journey and everything in between -- some are good in data but not AI. They're having a hard time to scale. So where we think growth is going to come particularly next year, the bigger growth is going to be not in like the pure gen AI, but it's going to be in helping companies finish getting their end-of-life data migrated to the cloud. Because you need your data in the cloud, right? It's going to come in the data strategy and the -- all the governance and getting it architected while some of the stuff around gen AI gets sorted out. So for example, like cost is not there yet. And how do you take data from one cloud and there's cost to take it and put it another cloud. All of that, we're going to be working with our clients and our technology partners to really create the right business cases. But the growth we think in the near term is going to be from accelerating the digital core. And that's why we feel really good about the bigger transformational deals continuing next year because there's so much work to do.
Bryan Keane : No, that's helpful. And then just as a follow-up, are there M&A opportunities of scale to grow in generative AI? Or is it still early in the days there, so there's not really a lot of M&A you can do?
Julie Sweet: It's really early. I mean, there's a lot of companies popping up as we know, and we're going to continue to scan. But one of the great things that we have is the ability to train, right? We've already trained in the last quarter another 1,000 people in gen AI. And by the way, since 2019, we have been requiring all of our 700,000 people to take a course on AI. So we have a really good baseline. And so, we think that it's going to be a lot like when we move to digital, a lot of organic. And this is where we're so competitively well positioned because we have great credentials in how we have trained our own table to rotate.
Bryan Keane: Great. Thanks so much.
Operator: We'll go next to the line of Rod Bourgeois of DeepDive Equity Research.
Rod Bourgeois : Hi, guys. You sometimes comment about pricing and contract profitability. So I wanted to ask if you could provide an update on pricing and contract terms, particularly on a like-for-like basis in both consulting and outsourcing. Thanks.
KC McClure: Yes. Rod, so let me just comment on pricing and what we're seeing. So just let me start with as a reminder, when we talk about pricing that we define that as contractility or the margin on the work that we sell. And so what we're seeing in pricing is after five quarters of consecutive improvement in pricing, we mentioned last quarter that it's stabilized. And this quarter, we see the pricing is lower in some areas of our business. I continue to be very pleased with how we are managing pricing, particularly navigating the more challenging wage environment that we've experienced over the last few years. So very pleased with how we're performing in pricing and our overall contract profitability that we have this year. .
Rod Bourgeois : Okay. Great. And then maybe just to wrap up, as the consulting business has slowed some here, can you talk about what demand themes have slowed the most and maybe the outlook for those themes, I mean, maybe across your various solution areas, like cloud and ERP and security and data. Are there certain of the themes that have slowed the most? Thanks.
Julie Sweet: Yes. Look, on our consulting on the systems integration side, it's really more a tale about the small deals, right? So what we're seeing is that, sort of some of the small things versus the bigger, so a lot of the big transformations are continuing. So that's -- we're not seeing -- I mean, basically anything around the digital core, moving to cloud, all of that's going really well at the bigger levels. It's more about starting new projects right now. And so -- which is why we expect that demand to come back when people are less cautious.
Rod Bourgeois : Okay. Thank you.
Katie O’Conor: Operator we have time for one more question and then Julie will wrap-up the call.
Operator: Thank you. And that will come from the line of James Faucette with Morgan Stanley.
James Faucette: Thanks very much. Just a couple of follow-up questions from me here. First, on AI and AI-related projects. How do you envision pricing, project constructs, terms and statements of work to change with the introduction of and adoption of generative AI generally?
Julie Sweet: I mean, we're not anticipating any big changes in those areas.
James Faucette: Got it, got it. And then you mentioned, in reference to generative AI, like the [B&A] (ph) opportunities are pretty small right now and really nascent. But how are you thinking about B&A more generally going forward? Should we expect ongoing sustained and pretty stable levels of inorganic contribution? And -- or should we expect there to be some changes as expectations and emphasis shifts a little bit more to AI.
Julie Sweet: Well, no, a couple of things. So first of all, no shift in how we view inorganic, which is a core part of our business model, right? So we expect to get about 2% of our revenue growth from this year from inorganic, and this has been a stable part of our strategy. And I just want to be clear that the shift to AI is just -- let's go back to total enterprise reinvention. What are clients doing? They are reinventing every part using tech data and AI. So when you look at our growth priorities, cloud, both the move to the cloud, but also cloud-based platforms, all growing very significantly, right, at the top level overall. And so, it's about building a digital core. And then the opportunity to take AI is to then reinvent the processes and the ways of working, which is, by the way, a huge opportunity for Accenture because we're not just about the technology. Our strength is in being able to do all of that. So I think it's really important that it's not an emphasis shift on AI. It's a rapidly accelerated opportunity because companies who were kind of resistant or not focused on it are now focusing on it. So I think that's important. Then the last piece is we will -- our focus is not going to suddenly in M&A be around just data and AI. And in fact, we think that there's going to be much more organic because there isn't a lot out there. But we use AI, right, to scale things like consulting, industry expertise, digital expertise. We've done that for digital manufacturing, supply chain. We also use it to get into new areas. So I'm super excited that yesterday we announced that we acquired Answer Advisors, which is a primarily US-focused, North America-focused company and capital projects. That's a really small business today in the U.S. and we just acquired a great company with 900 professionals in a market that has an $88 billion addressable market in North America, growing really well. That's a whole new area of net new growth for our North America business. So we use our ability to invest, right, to scale great things and continuously seed new areas of growth for Accenture. And you've seen us do that over and over again. We did it with Song, we did it with Industry X and digital manufacturing. We're now in supply chain and we're moving into capital projects. So that is just a huge advantage as you think about, not just the next couple of years, but growth over the decade for Accenture.
James Faucette: That’s great color. Thank you so much.
Julie Sweet: Great. Well, thanks, everyone. In closing, I want to thank all of our shareholders for your continued trust and support and all our people for what you are doing for our clients and for each other every day. Thanks, everyone, for joining. Look forward to being back together in a quarter.
Operator: Thank you. And this conference will be available for replay beginning at 10 a.m. Eastern Time today and running through September 28 at midnight. You may access AT&T replay system at any time by dialing (866) 207-1041 and entering the access code of 4564655. International participants may dial (402) 970-0847. Those numbers again are (866) 207-1041 or (402) 970-0847 with the access code of 4564655. That does conclude our conference for today. Thank you for your participation and for using AT&T Event Conferencing. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Thank you for standing by. Welcome to Accenture's Third Quarter Fiscal 2023 Earnings Call. At this time all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, today's conference is being recorded. I would now like to turn the conference over to our host, Katie O’Conor, Managing Director, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Katie O’Conor",
"text": "Thank you, operator, and thanks everyone joining us today on our third quarter fiscal 2023 earnings announced. As the operator just mentioned, I am Katie O’Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market position before KC provides our business outlook for the fourth quarter and full fiscal year 2023. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we will discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including, but not limited to those factors set forth in today’s news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in the call. During our call today, we will reinforce certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Katie and thank you to everyone joining today, and thank you to our people around the world for their dedication and commitment, which is how we are able to consistently deliver 360 degree value for all our stakeholders, our clients, our people, our shareholders, our partners and our communities. Turning to the quarter, I will start with the financials. While the macro environment continues to be uncertain overall, in Q3 we delivered solid revenue and sales with very strong profitability and very strong free cash flow, while continuing to significantly invest in our business. Now getting into the highlights, we had bookings of $17.2 billion, including 26 clients with quarterly bookings greater than $100 million, bringing the total year to date 85, which is 11 more than the same time last year. We delivered revenues of $16.6 billion, representing 5% growth with North America growing 2%, Europe at 7% and growth markets at 9%, all in local currency, bringing us to $48.1 billion of revenue at 10% growth fiscal year to date. Revenues were impacted by lower than expected small deal sales, especially in strategy and consulting and systems integration and lower than expected results in the communications, media and high-tech industry group for the quarter. Excluding [CMT] (ph), our business grew 8% globally, 7% in North America, 9% in Europe and 10% in growth market in local currency. We expanded adjusted operating margin by 20 basis points, grew adjusted EPS 14% over last year and delivered free cash flow of $3.1 billion. And over the past 11 quarters we have operated at 91% or higher utilization, leveraging our digital enterprise to connect our sales, staffing, hiring and skill needs to make proactive real time decisions. We are on track with the business optimization actions to lower costs in fiscal 2024 and beyond, while continuing to significantly invest in our business with five acquisitions in strategic areas this quarter, bringing the total investment in acquisitions year to date to $1.3 billion. We invested in Cloud, Data and AI with the acquisition Nextira in North America, Objectivity in the UK and Einr in Norway. We also invested in sustainability with the acquisition of Green Domus in Brazil and in modern ERP services with Bourne Digital in Australia. We continued to take market share growing about two times the market. Now turning to other aspects of the 360 degree value we delivered this quarter. We continue to invest in learning for our people with 9 million training hours in the quarter, representing an average of 13 hours per person, giving them the skills to grow as our clients' needs evolve. We're incredibly pleased that we were recognized as a top 10 place to work in seven countries. Argentina, Brazil, Chile, India, Mexico, the Philippines and the U. S. Collectively, these countries represent nearly 70% of people. Vibrant communities are important for our business success and digital scaling helps ensure vibrant communities thrive. In collaboration with L'Oreal and our NGO partner, [Shambu] (ph) Foundation, we are supporting women in India to build digital literacy skills alongside the technical skills needed to access jobs in the beauty industry. Together, we have collectively created sustainable livelihoods for 2,500 women across 10 states in India, accelerating equality, delivering social impact in the community and continuing our commitment to embed diversity and inclusion in everything we do. Finally, this year we are proud to earn the number 22 position on [Brand Z's] (ph) prestigious top 100 most valuable global brands list, our highest rank today. Over to you KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie, and thanks to all of you for taking the time to join us on today's call. We are pleased with our third quarter results and we are on track to deliver or exceed all aspects of our guidance provided in September on an adjusted basis. Now let me summarize a few of the highlights for the quarter. Revenues grew 5% local currency, driven by high single or double digit growth in seven of our 13 industries. While we've been highlighting the pressures in our CMT industry group all year, this quarter the revenue was lower than expected with a decline of 8% in local currency. We delivered adjusted EPS in the quarter of $3.19, reflecting 14% growth over EPS last year. Adjusted operating margin was 16.3%, an increase of 20 basis points over Q3 last year and includes continued significant investments in our people and our business. Finally, we delivered free cash flow of $3.1 billion and returned $1.5 billion to shareholders through repurchases and dividends. Year to date, we have invested $1.3 billion in acquisitions, primarily attributed to 20 transactions. With those high level comments, let me turn to some of the details, starting with new bookings. New bookings were $17.2 billion for the quarter, representing growth of 4% in local currency with an overall book to bill of 1.0. We were very pleased with our 26 clients with quarterly bookings over $100 million. Consulting bookings were $8.9 billion with a book to bill of 1. Managed services were $8.3 billion with a book to bill of 1.1. Turning now to revenues, revenues for the quarter were $16.6 billion, a 3% increase in U.S. dollars and 5% in local currency, reflecting a foreign exchange headwind of approximately 2.5% compared to the approximately 3.5% headwind provided in our business outlook last quarter. Consulting revenues for the quarter were $8.7 billion, a decline of 4% in U.S. dollars and 1% local currency. We see the same level of consulting decline in Q4. Managed services revenues were $7.9 billion, up 10% in U.S. dollars and 13% in local currency. Taking a closer look at our service dimensions, technology services grew high single digits. Operations grew double digits and we expect high single digit growth in Q4. Strategy and consulting declined high single digits this quarter and we see declines continuing in Q4. Regarding our market share, we extended our leadership position with growth estimated to be about two times the market which refers to our basket of publicly traded companies. Now as a reminder, we assess market growth against our investable basket which is roughly two dozen of our closest global public company competitors, which represents about third of our addressable market. We used a consistent methodology to compare our financial results and theirs, adjusted to exclude the impact of significant acquisitions through the date of their last publicly available results. Turning to our geographic markets. In North America, revenue growth was 2% in local currency driven by growth in Public Service for our U.S. federal business, Health and Utilities. These increases were partially offset by declines in Communications and Media, High-tech, Software and Platforms and Banking and Capital Markets. In Europe, revenue grew 7% local currency, led by growth in Banking and Capital Markets, Industrial and Public Service. Revenue growth was driven by Italy, Germany and France. In Growth Markets, we delivered 9% revenue growth in local currency, driven by growth in Public Service, Chemicals and Natural Resources and Banking and Capital Markets. Revenue growth was driven by Japan. Moving down the income statement. Gross margin for the quarter was 33.4% compared with 32.9% for the same period last year. Sales and marketing expense for the quarter was 10.5% compared to 10.3% for the third quarter last year. General and administrative expense was 6.5% compared to 6.5% for the same quarter last year. Before I continue, I want to note that in Q3 we recorded $347 million in costs associated with the business optimization actions we announced last quarter, which decreased operating margin by 210 basis points and EPS by $0.42. This quarter, we also recognized a gain in our investment in Duck Creek Technologies, which impacted our tax rate and increased EPS by $0.38. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.7 billion in the third quarter and adjusted 16.3% operating margin, an increase of 20 basis points from operating margin in the third quarter of last year. Our adjusted effective tax rate for the quarter was 24% compared with an effective tax rate of 27.1% for the third quarter last year. Adjusted diluted earnings per share were $3.19 compared with diluted EPS of $2.79 in the third quarter last year. Days source outstanding were 42 days compared to 42 days last quarter and 44 days in the third quarter of last year. Free cash flow for the quarter was $3.1 billion, resulting from cash generated by operating activities of $3.3 billion net of property and equipment additions of $142 million. Our cash balance at May 31 was $8.5 billion compared with $7.9 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the third quarter, we repurchased or redeemed 2.8 million shares for $789 million at an average price of [$279.65] (ph) per share. As of May 31, we had approximately $3.5 billion of share repurchase authority remaining. Also in May, we paid a quarterly cash dividend of $1.12 per share for a total of $708 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.12 per share to be paid on August, a 15% increase over last year. So in closing, we remain committed to delivering on our long-standing financial objectives, growing faster than the market and taking share, generating modest margin expansion and stronger earnings, while at the same time, investing at scale for long-term market leadership, generating strong free cash flow and returning cash to shareholders. Now let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. As we look at demand in our larger deals, we continue to see two common themes that I've highlighted before. First, the rapid rise of generative AI interest among our clients highlights yet again that all strategies lead to technology, particularly cloud, data, AI and security. And second, companies remain focused on total enterprise reinvention as they execute compressed transformation to achieve lower costs, stronger growth, more agility and greater resilience faster. Now let me give you more color on the quarter to bring this to life. Starting with the digital core, our cloud momentum continues with very strong double-digit growth in Q3 as clients priorities building a strong and secure foundation for reinvention. We have been working with ENI, a global energy company for more than 30 years. Now we are helping them as they continue their hybrid cloud transformation and embark on a total enterprise reinvention strategy with a focus on sustainability, digital transformation and security. We are managing their IT infrastructure and telecommunications integration and helping implement new operating models, all hosted in the ENI green data center, one of the largest data bunkers in the industry to securely hold the company's data. The ENI green data center houses one of the most powerful nongovernmental supercomputers in the world, enabling the highest use of data across the value chain from exploration and production to the energy of the future. New operating models will help exploit the full value of data, AI and cybersecurity for faster adoption of new business processes. This transformation is the first step toward creating a secure digital core that will accelerate ENI's energy transition, drive innovation in AI and R&D and build even greater resilience. Clients are also working with us to do multifaceted compressed transformation that utilize all of our deep industry and functional expertise in our SNC services, along with our outstanding technology services. We are helping DuPont, a global multi-industrial specialty products company with a compressed transformation to standardize their finance processes and achieve operational excellence. Building on our trusted relationship of over 35 years, we are now supporting our client with its strategic pivot to innovation-based growth across electronics, sustainable water and protection solutions, industrial technologies and next-generation automotive. We've been supporting their transformation to an agile cloud-based IT infrastructure to maximize data access, drive efficiency and modernize their landscape. Our work with DuPont is focused on achieving greater resilience, reducing costs and increasing revenue growth and shaping its portfolio through M&A with industry-leading innovation for long-term success. With companies expanding their digital footprint and cyber risk widening security continues to rise in importance as a fundamental part of the digital core with very strong double-digit growth in Q3. We are working with a food and beverage company to strengthen their cybersecurity and prevent vulnerabilities along the supply chain. Building on previous operations transformation work, we are now providing managed security services, which will cover perimeter security, detection and response as well as threat intelligence and monitoring dark web activities. We also will provide day-to-day identity, data and privacy management, helping provide a holistic security approach for our client. We're helping a global universal bank future-proof their cryptographic landscape and corresponding risks for over 1,000 applications, procedures and data. Based on the analysis, we will develop and implement an end-to-end mitigation strategy, including evaluation of solution vendor strategies, mitigation principles as well as change management procedures. We will also design and implement post-quantum methods and new architecture blueprints, which will help scale the solution, all to help the bank achieve post-quantum computing readiness. Our Managed Services continued to grow double digits in Q3, demonstrating the relevance of our approach to run, digitize and transform our clients' operations. We're providing a global health care and insurance company with managed services to help run its complex claims and membership processes. As part of our long-standing relationship with the company, we will improve the efficiency and quality of these tasks and simplify the customer journey, ensuring members can easily access the support they need when they need it. Its employees will now have more time to focus on boosting customer satisfaction by better serving its millions of customers around the world. A new cost solution has also been introduced to determine fair and accurate pricing for the company when purchasing services and products from vendors to reduce costs across the business. We recently worked with a major media brand to launch a streaming platform that will help attract new subscribers, expanding their content portfolio and power-targeted broadcasting and advertising offerings, all while lowering costs. We helped engineer aspects of the new platform from the content supply chain to the player experience, ensuring that customers have a seamless viewing experience across all devices and platforms and enabling the company to use data insights to continually enhance its platform. We delivered the program as part of a managed services arrangement, demonstrating the industry and engineering innovation that we bring to help clients reinvent their business with cloud, data and AI. As clients continue to reimagine and prioritize customer experience, Song experienced strong double-digit growth again in Q3. We are partnering with Virgin Media O2, a British media and telecommunications company to reimagine their customer experience. Accenture Song will design a new, more predictive and personalized customer journey, enabled by an AI-powered cloud-based digital core. Customer care journeys will be omnichannel, combining customer calls, chat and instant messaging to increase first-time resolution and upselling, leading to greater customer satisfaction. We also will deploy our managed services capabilities to support contact center activity using AI to provide timely agent assistance and route calls intelligently to drive precision and reduce call volume. Our work will help build brand loyalty supporting Virgin Media O2's mission to be a more customer-first business. We see continued demand for our Industry X capabilities, which grew strong double [indiscernible]. We are working with one of the world's leading consumer products companies on a transformation of its manufacturing practices to achieve energy savings. We are developing a comprehensive program to collect and analyze energy consumption data from their production plans and use data-driven analytics to identify energy savings and greenhouse gas reduction opportunities. We are also helping to track energy efficiency gains and deliver value through operational improvements in the manufacturing process. As clients progress on their total enterprise reinvestment journeys, talent is at the forefront. We are working with an international consumer goods and services provider in the European market on a digital transformation of its core human resources organization and talent acquisition processes. We will design and implement an approach that includes program management, process design, training and development and additional services. Together, we will create greater efficiencies in the human resources function, leading to a data-driven culture focused on better employee experiences. Now stepping back, our strategy is to be at the center of our clients' business and help them continuously reinvent themselves to reach new levels of performance and to set themselves apart as leaders in their industries. And our clients are at different starting points. All are interested in AI, and particularly generative AI. But most recognize the work ahead of them to get their data, people and processes ready for AI. To reinvent requires a strong modern digital core. And as they embark on this journey, clients are looking to us for unmatched global scale, deep industry and functional knowledge, breadth of services from strategy and consulting to technology to managed services. With that context, I want to turn to generative AI and AI more broadly. No previous technology wave has captured the intention of leaders and the general public as fast as gen AI. We are now embarking on the age of AI, and companies will need to reinvent how they operate with AI at the core. And it is also early. Think of it as the cloud over a decade ago. Foundation models and products based on them are still maturing with many products announced but fewer at the general availability stage and ready for wide deployment. And with our position as the largest partner with most of the major technology companies, we are at the center of helping our clients navigate their choices in the evolving landscape. We've been investing in AI for years. And so while it is early days, we see generative AI as a key piece of the digital core and a big catalyst for even bigger and bolder total enterprise reinvention going forward. In fact, in a survey of global executives that we completed just last week, 97% of executives said gen AI will be transformative to their company and industry and 67% of organizations are planning to increase their level of spending in technology are prioritizing investments in data and AI. Our approach to AI is clear. Just as we have successfully done with cloud, we are investing to take an early lead and position for the opportunity ahead. Last week, we announced a $3 billion investment in AI, a big step to accelerate our clients' reinvention journey, which includes us doubling our data and AI workforce from 40,000 to 80,000 strong, including the expansion of our center for advanced AI that today has over 1,600 generative AI experts bringing new assets such as our AI navigator for enterprise to life and developing new GenAI-powered industry solutions. And across this all, we are leading with responsible AI to be the most trusted source in helping our clients mitigate the risks as they drive value. And this isn't just about tomorrow. We have sold over 100 generative AI products -- projects over the last four months. Let me give you a flavor of these across a few industries. We are working with Mitsui Sumitomo Insurance, a Japan-based subsidiary of MS&AD Insurance Group Holdings to improve customer service by using generative AI and simplify operations for accident response. The generative AI solution will draw from the company's knowledge base, including policy causes and related laws and regulations, which will generate appropriate response plans in a timely manner, dramatically improving the accuracy and speed of explanations to customers. We're working with a global broadcast company to explore how generative AI can be used to drive audience engagement and growth through deeper and more personalized customer experiences. Together, we recently launched testing that leverages generative AI and large language models to explore how we can automatically create content for the company's customer-facing platforms. The content will help enhance engagement, grow the consumer base across new coverage areas and channels. We believe it will demonstrate how generative AI can be used to create content at scale for a wide variety of experiences and events. We are working with [Linda Basel] (ph) Industries, a leader in the chemicals industry to increase its enterprise data and analytic capabilities and help unlock new value. We will develop a strategic data-led digital transformation program across multiple parts of their business and embed new capabilities in areas like sustainability, customer data, digital manufacturing and generative AI to drive more insightful and predictive decision-making. Companies are coming to us for help with the strategy in the business case to understand how and where to apply AI, and gen AI specifically, to get their digital core in shape, to help assess which ecosystem partners and models to use, to rewire their processes to be AI-driven, to upgrade and reskill their talent with new ways of working and to navigate the risks and challenges responsibly. In short, we believe clients need our full range of services and we are well positioned to be the leading trusted AI partner for the enterprise as they move from exploration to experimentation to reinvention. Over to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Now turning to our business outlook. For the fourth quarter of fiscal 2023, we expect revenues to be in the range of $15.75 billion to $16.35 billion. This assumes the impact of FX will be about flat compared to the fourth quarter of fiscal 2022 and reflects an estimated 2% to 6% growth in local currency. For the full fiscal 2023, based upon how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately negative 4% compared to fiscal 2022. For the full fiscal 2023, we now expect revenue to be in the range of 8% to 9% growth in local currency over fiscal 2022, which assumes an inorganic contribution of about 2%. We continue to expect business optimization costs of $800 million in fiscal 2023 to reduce EPS by $0.96. The gain on our investment in Duck Creek Technologies will increase EPS by $0.38. Our guidance for full year 2023 excludes these impacts. For adjusted op margin, we now expect fiscal year 2023 to be 15.4%, a 20 basis point expansion over fiscal 2022 results. We now expect our adjusted annual effective tax rate to be in the range of 23.5% to 24.5%. This compares to an effective tax rate of 24% in fiscal 2022. We now expect our full year adjusted earnings per share for fiscal 2023 to be in the range of $11.52 to $11.63 or 8% to 9% growth over fiscal 2022 results. For the full fiscal 2023, we continue to expect operating cash flow to be in the range of $8.7 billion to $9.2 billion. We now expect property and equipment additions to be approximately $600 million and free cash flow to be in the range of $8.1 billion to $8.6 billion. Our free cash flow guidance reflects a very strong free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $7.1 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so we can take your questions. Katie?"
},
{
"speaker": "Katie O’Conor",
"text": "Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] We'll go to the line of Lisa Ellis with MoffettNathanson."
},
{
"speaker": "Lisa Ellis",
"text": "Hey, good morning. Thanks for taking my question. Let's dive in on the Strategy and Consulting. I know it was a high single-digit decline this quarter just looking back at your comments from last quarter. I think that came in a little bit softer than you expected, but then also called out many new projects coming in related to gen AI and other technologies. Can you just talk a little bit about kind of what's changed, what that evolution looks like and kind of what's your confidence level in the time horizon that we'll see Strategy and Consulting improve over the next couple of quarters? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure. Thanks, Lisa. So I'll first give some color on that. So, the big difference in our expectations from last quarter and where we ended up really was all in the small deals. And we saw a further -- they came in lower than, and we saw that extend to Europe and the Growth Markets. Now that was both in S&C and systems integration. But that's the big reason that we have a difference in sort of where we thought where we would be this quarter. Now our job is to continue to pivot to higher -- where there is higher growth, and we're working on that in digital manufacturing, supply chain, data and AI. But that will take a little time. And what we're seeing is that, there's a lot of extensions going on in small deals, but it's the newer small projects, while at the same time, we continue to have very strong bookings and interest and huge opportunity in transformation. So I think our clients are kind of holding back on the small stuff and doing the bigger stuff, which obviously converts to revenue differently. But you see where Strategy and Consulting makes a big difference there, like in the DuPont example that I gave in the script where you have to have so much expertise in the industry, as well as the functions, as well as technology. What that means is that, it is going to take a little while for the turnaround. And we're not going to go to next year because we really want to see how Q4 evolves, and KC will give a little bit of color on how we are thinking about our Q4. And what I would also say is that, things like gen AI are a big opportunity, but it is early. So we did in the last four months 100 projects. That represents about $100 million in sales. That's kind of the average size of those projects where it is. And so, we're going to continue to pivot there, but it just takes a little bit of time. So why don't I let KC give you a little color on how we're thinking about Q4."
},
{
"speaker": "KC McClure",
"text": "Yes. Great. Thanks, Julie. Yes. So let me just kind of maybe step back and look at Q4 and the overall guidance for the full year. So first, I did mention this, but I just want to -- just reiterate that we are on track for our business optimization actions. So we're going to do about $800 million of cost for the full year 2023. Additional color is that, for Q4, as we look at bookings, we think they'll be about the same as what we did in Q3 of this year and have about the same complexion. Julie talked a bit about small deals. What I will tell you in terms of our revenue guidance for Q4, which is 2% to 6%. At the top end of our revenue guidance, that reflects some improvement in small deal performance, while the bottom end allows for some further deterioration. And we commented also in our scripts about CMT. And so, within our overall range of 2% to 6%, we do allow for CMT to get a little bit worse. And then lastly, to bring it on home as it relates to North America, because these two factors do impact North America performance in the context of our overall 2% to 6% range for the quarter. North America, which was 2% growth this quarter, it would likely be flat around the midpoint of our guidance range and it reflects a slight decline at the bottom of our range. And as Julie mentioned, obviously, we will give you more color, as I always do on next year when we get into September, and we'll see how Q4 plays out."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific. Thank you. And then maybe for my follow-up, maybe a more strategic question. I mean, Julie, you talked a lot about gen AI in the prepared remarks, particularly around the revenue opportunities that you're seeing in your clients. But can you give your view on how you see gen AI impacting the IT services industry overall? Like a lot of people make an analogy to sort of the impact of offshoring on the industry and sort of other big sort of step function changes to the operations and the kind of composition and the way IT services is done. Can you kind of give your latest perspective on that, how you see it affecting Accenture and your industry more broadly? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure. Yes. And I think another good analogy actually, maybe even less so than the offshore is more about like SaaS, right? Because you remember when we talked about when SaaS came, what would be the opportunities. And there was a lot of worry about how SaaS would interrupt IT services. And obviously, it's been just a huge opportunity. So I think, Lisa, if you think about this, so obviously a big opportunity for us to help our clients. We see it as two other areas of opportunities. So the first is help our clients, big opportunity. The second is, the opportunity for us to improve the delivery of services to our clients, right? Now what is -- and that, we think, is a huge opportunity for us. So think about it first. In context of Managed Services every year, right, we have to find at least 10% of productivity. So we talk a lot about our platform, things like myWizard and that. That's all AI-enabled. Like just year-to-date in operations, not using gen AI, right, we have automated 13,000 jobs and then we've reskilled those people and redeployed them. Our business model requires us to get at least 10% productivity year in and year out. As we're kind of getting to the maturity of automation and AI before generative AI, we see generative AI as our ability to continue to give at least that 10% productivity year in and year out. So in the managed services area, we see that more as the ability to continue doing what we have to do as kind of the next generation of technology. Where we're super excited is in software development that is more around our systems integration and our big transformations around platforms because while we do automate there, we think gen AI may provide a real opportunity to do even more. And remember, our strategy is to deliver compressed transformation. So the more that we can find ways to deliver faster and less costly, that's going to be a big differentiator. So we're leaning in hard. At the same time, these technologies are [indiscernible] early. And so for example, we're doing a lot of experimentation now. It's really good for things like documentation, but complex integrations, being able to use them for highly architectured systems, which is what our large enterprises do. GenAI isn't there yet, right? So think it's going to take some time. We also don't yet know the cost. And one of the things we are really -- a lot of clients are looking at for us to help them with the business case because most of the studies, including our own, are all about what potentially uses of it. But because these products aren't out yet, we know that -- it's much more expensive to use gen AI, it's much more energy efficient. And so the actual ROI, so there's the art of the possible, but what's actually the return, it's still really early days. So we're very excited that we can get new kinds of productivity, particularly on things like consulting and systems integration but it's early days yet. And we are leaning in because we think it's a big opportunity for us to differentiate. And that's why we are investing $3 billion over the next three years because we think this is like another cloud first moment where we were out early, we invested at scale. The last thing I would say is, there's also an opportunity for us to use it in our own enterprise. And of course, we like -- part of our strategy is to be our own best credential. And we're prioritizing it, using it wherever we think we can use it for us and then take it to market to help our clients. So overall, we think that like prior big changes, right, first, the change to cloud, right, and before that to servers, that it always creates new opportunities as long as you have the ability to invest, like we do, you've got leading partnerships, we've just announced yesterday expanded partnerships with all of the three big cloud providers; and you have that agile innovation mindset that says embrace change and move fast."
},
{
"speaker": "Lisa Ellis",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Ashwin Shirvaikar of Citi."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you and good morning both. I guess…"
},
{
"speaker": "Julie Sweet",
"text": "Good morning, Ashwin."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Hi. Can you hear me?"
},
{
"speaker": "Julie Sweet",
"text": "Yes."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Okay. Sorry. I was hoping that you could provide a little bit more information. I know you said that you'll comment specifically on fiscal 2024 after -- in September as you normally do. But that seems to be one of the primary questions that people are asking. So more about the framework of how you're going about the planning process for that, just given that there are so many moving parts when we kind of think of macro, when we think of AI, when we think of headcount trends, the tough comps in the first half. Maybe just kind of framework that for us and that would be quite helpful."
},
{
"speaker": "Julie Sweet",
"text": "Sure. So just a few things, Ashwin. So first of all, the most important thing right now just as a framework is, stay close to our clients, and really understand. And the thing is, our clients do need ways to get value in the short term as well as to transform. And so, we're working hard on finding new ways to get value to them faster. That's where the gen AI, for example, comes in. And so, over the next quarter, we're going to be developing new opportunities, new campaigns, new ways of pushing out our investments in gen AI to help us address the small deal pressure that we're seeing. We don't have a crystal ball that is going to say what the economy is going to do, how fast clients are going to get comfortable. Because you remember, we saw this over this quarter to more industries, including industries that are doing well. There's just a level of caution right now. And so, how we're looking at it is certain things we can't control, focus on not only doing the big large transformational deals, but finding new ways to develop returns faster, which is why the work we're doing on gen AI is so important. And you're seeing that kind of early focus with 100 projects in four months. So we're going to keep doing that. Secondly is, stay focused on those transformational deals, right? This provides a base level of resilience in our business. So we've got to absolutely try to do -- maximize the small deals, but it is really important that we continue to be the transformation partner of choice. And that is where bringing together all of these services and making sure that we've got the right proposition is super important. So that is a core part of our strategy. And so that's really how we're thinking about it."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you for that. And I guess the next question is with regard to hiring expectations. And there's a near-term aspect to that and the longer term so let me ask both. Near term, just kind of given what you said with regards to macro and so on and, of course, the headcount cuts announced a couple of quarters back, what should we expect in the next one or two quarters? And the longer-term question is, with AI, do you think that headcount growth dissociates from rev growth trends over time?"
},
{
"speaker": "Julie Sweet",
"text": "Let me just take the second one first, right, is, again -- and we've been talking about this for years, right, because AI has been such a big part of our strategy and automation, right, is that we will continue to manage it just like I talked about in my last answer, like where we've already automated 13,000 jobs this quarter and we've reskilled. And so, we will continue to manage that headcount as a result of AI in the way that we've been doing it for years. So no real change in that because we have a digital enterprise system that looks at what we need and sales. And what's really core is that we can reskill people as they are being freed up, and then we can adjust how much we have to hire. And of course, with attrition that in our industry is high relative to other industries, it gives us a lot of flexibility over time to get that people hiring right. So that's how I would think about it. And then for the way that we're going to hire, we saw a year-over-year increase of about 3% over last year. 11 consecutive quarters of 91% utilization. So you should just expect that every quarter we're going to manage carefully that headcount based on where we see the growth and to do that well. And I think we've proven our ability to do that."
},
{
"speaker": "KC McClure",
"text": "That's right. And I would just add just maybe on Q4, in particular. As Julie talked about, we did not add any heads really between -- any people between Q2 and Q3, which is what we expected. And then just Q4, we don't really see a need to grow our overall headcount as we continue to focus on the automation and reskilling that Julie talked about."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Tien-Tsin Huang with JPMorgan."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Hi. Thank you so much. Good morning, guys. I just want -- I think you went through the small deal outlook to Lisa and Ashwin's question. So how about large deals? Can that momentum continue? I think you're up from about 17 to 26 large deals year-over-year. So just curious about..."
},
{
"speaker": "Julie Sweet",
"text": "Yes, large deal momentum is continuing. Yes."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Yes. So yes, -- no, I'm just going to ask that, how does that look going into the fourth quarter here? And are signed deals converting on time. My follow-up to that."
},
{
"speaker": "Julie Sweet",
"text": "Yes. So as KC said earlier, our bookings are going to be about the same, and that includes a lot of momentum in large deals, right? So we saw 26 clients with bookings over $100 million this quarter. We're ahead of last year by 11 at this point. We can see -- continue to see that momentum. And we're actually really excited about the demand there, right? Because as you can imagine, things like gen AI are just accelerating the ability to say, \"Hey, we have to do bigger deals.\" And by the way, that may be impacting some of what we're seeing on the smaller deals because we do see more excitement about -- because the thing is the problem with gen AI for most companies is if you don't have the data, you can't use it. And so that gets you right back to the big transformations of your digital core. KC, anything to add?"
},
{
"speaker": "KC McClure",
"text": "No, I think that's it."
},
{
"speaker": "Tien-Tsin Huang",
"text": "So on the AI front, you did mention, I think, the cloud-first. As you draw that parallel when you guys -- I think that was three years ago, you did a $3 billion cloud first investment. That's paid off very well for you. So I'm curious, do you expect a similar return here on the $3 billion you're putting into AI? How should we measure that? Or is it going to perhaps convert differently in terms of the returns?"
},
{
"speaker": "Julie Sweet",
"text": "Tien-Tsin, that's a great clever way to try to get us to talk about more of the future. But what I would say is, we've got a great track record of investing and getting a great return. And so, we think that it's going to pay off well."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Yes, no, I like [indiscernible] and the coincidence of similarity there. Thank you, guys."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Jason Kupferberg of Bank of America."
},
{
"speaker": "Jason Kupferberg",
"text": "Hi. Thanks, guys. Just wanted to start actually picking up a little bit on Tien-Tsin's question around the larger deals. It sounds like that's going to persist the strength there in Q4. And I think that will be at least a few quarters in a row at that point of those larger deals showing relative strength. Can you just talk just qualitatively about to what extent those provide a foundation for top line growth in fiscal 2024? I would assume that those deals generally ramp to full run within, what, two to three quarters or so?"
},
{
"speaker": "KC McClure",
"text": "So in terms of what you should think about on our larger deals, they really do -- it really does vary in terms of how they fill in over the quarters going into next year and sometimes depending on what the work is, particularly in managed services, and there's larger deals, they can go out -- they can go into another fiscal year. So that's no real change in what we have experienced in terms of how the bookings fill in by the -- what I would say, the sales category size. What you're seeing is that, we do have a good foundation as we look out, right? And we've had a good foundation throughout this year everything that we've been booking in the transformational deals. But what really does also matter as you get into the year and then into -- closer to the quarters is how do you fill in with some of the smaller bookings."
},
{
"speaker": "Julie Sweet",
"text": "If said another way, if small deals don't come back. We're going to have -- that's an important part of sort of understanding, which is why we want to see how Q4 works out before we look at next year."
},
{
"speaker": "Jason Kupferberg",
"text": "Totally understand, totally understand. Let me switch over to bookings just for a follow-up. And by the way, thank you for the level set on AI. It's not too surprising that just a tiny fraction of your total bookings given how it's still early days. But I wanted to actually ask on the Managed Services bookings. Just curious versus your internal expectations how those came in, in the quarter. I know they can be pretty lumpy. But it does seem like looking ahead to Q4, the managed services bookings will slow a bit on an LTM basis just based on some of the commentary that you provided around Q4 bookings mix."
},
{
"speaker": "KC McClure",
"text": "Yes. So let me just talk about overall Managed Services. Yes, we're very pleased overall with our Managed Services bookings, right? They were up 9% this quarter and they're up 22% on a year-to-date basis. So we're very pleased with the bookings overall and the result of revenue, which continue to be very strong. We also have a very strong book-to-bill with the trailing of 1.1. And when I talked about Q4, Jason, we'll have about the same complexion of bookings in terms of the breakout of type of work. And I would -- and I will highlight just the continued strength within our bookings of our operations business, which, again, Julie had a lot of great examples in her script. It really is around when clients are focusing on digitizing their core, cutting costs of operations business is a differentiator and obviously very strategic."
},
{
"speaker": "Jason Kupferberg",
"text": "Thanks, KC."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Bryan Keane with Deutsche Bank."
},
{
"speaker": "Bryan Keane",
"text": "Hi, guys. Good morning. Also, just kind of a follow-up on generative AI and the understanding and timing. I get that it's early, but the big question everybody is asking is how long will it take before it moves the needle in bookings and revenue? Is that a couple of years out still? Or is that the time frame and the rapidness of the use of the technology should push it earlier than a normal technology wave?"
},
{
"speaker": "Julie Sweet",
"text": "Well, Bryan, I think in general, we think gen AI is going to go faster than, say, cloud, right, which took more like a decade. I would focus on -- so first of all, we're being very rigorous when we talk about gen AI, because we're really saying like what are the actual gen AI. The big growth, we think, is going to be in all the companies that then have to get their data done faster. And we're not lumping that together. And so, I don't know what others are going to do, but we're really being very pure in saying like, \"Hey, this is pure gen AI.\" And if you think about where companies are, our research shows like only 5% to 10% of companies are mature right now with data and AI, and they're the ones that are really going to be able to use gen AI at scale. About -- we just had this research done that came in last week that hasn't been published yet. About 50% of companies have not started on their data or AI journey and everything in between -- some are good in data but not AI. They're having a hard time to scale. So where we think growth is going to come particularly next year, the bigger growth is going to be not in like the pure gen AI, but it's going to be in helping companies finish getting their end-of-life data migrated to the cloud. Because you need your data in the cloud, right? It's going to come in the data strategy and the -- all the governance and getting it architected while some of the stuff around gen AI gets sorted out. So for example, like cost is not there yet. And how do you take data from one cloud and there's cost to take it and put it another cloud. All of that, we're going to be working with our clients and our technology partners to really create the right business cases. But the growth we think in the near term is going to be from accelerating the digital core. And that's why we feel really good about the bigger transformational deals continuing next year because there's so much work to do."
},
{
"speaker": "Bryan Keane",
"text": "No, that's helpful. And then just as a follow-up, are there M&A opportunities of scale to grow in generative AI? Or is it still early in the days there, so there's not really a lot of M&A you can do?"
},
{
"speaker": "Julie Sweet",
"text": "It's really early. I mean, there's a lot of companies popping up as we know, and we're going to continue to scan. But one of the great things that we have is the ability to train, right? We've already trained in the last quarter another 1,000 people in gen AI. And by the way, since 2019, we have been requiring all of our 700,000 people to take a course on AI. So we have a really good baseline. And so, we think that it's going to be a lot like when we move to digital, a lot of organic. And this is where we're so competitively well positioned because we have great credentials in how we have trained our own table to rotate."
},
{
"speaker": "Bryan Keane",
"text": "Great. Thanks so much."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Rod Bourgeois of DeepDive Equity Research."
},
{
"speaker": "Rod Bourgeois",
"text": "Hi, guys. You sometimes comment about pricing and contract profitability. So I wanted to ask if you could provide an update on pricing and contract terms, particularly on a like-for-like basis in both consulting and outsourcing. Thanks."
},
{
"speaker": "KC McClure",
"text": "Yes. Rod, so let me just comment on pricing and what we're seeing. So just let me start with as a reminder, when we talk about pricing that we define that as contractility or the margin on the work that we sell. And so what we're seeing in pricing is after five quarters of consecutive improvement in pricing, we mentioned last quarter that it's stabilized. And this quarter, we see the pricing is lower in some areas of our business. I continue to be very pleased with how we are managing pricing, particularly navigating the more challenging wage environment that we've experienced over the last few years. So very pleased with how we're performing in pricing and our overall contract profitability that we have this year. ."
},
{
"speaker": "Rod Bourgeois",
"text": "Okay. Great. And then maybe just to wrap up, as the consulting business has slowed some here, can you talk about what demand themes have slowed the most and maybe the outlook for those themes, I mean, maybe across your various solution areas, like cloud and ERP and security and data. Are there certain of the themes that have slowed the most? Thanks."
},
{
"speaker": "Julie Sweet",
"text": "Yes. Look, on our consulting on the systems integration side, it's really more a tale about the small deals, right? So what we're seeing is that, sort of some of the small things versus the bigger, so a lot of the big transformations are continuing. So that's -- we're not seeing -- I mean, basically anything around the digital core, moving to cloud, all of that's going really well at the bigger levels. It's more about starting new projects right now. And so -- which is why we expect that demand to come back when people are less cautious."
},
{
"speaker": "Rod Bourgeois",
"text": "Okay. Thank you."
},
{
"speaker": "Katie O’Conor",
"text": "Operator we have time for one more question and then Julie will wrap-up the call."
},
{
"speaker": "Operator",
"text": "Thank you. And that will come from the line of James Faucette with Morgan Stanley."
},
{
"speaker": "James Faucette",
"text": "Thanks very much. Just a couple of follow-up questions from me here. First, on AI and AI-related projects. How do you envision pricing, project constructs, terms and statements of work to change with the introduction of and adoption of generative AI generally?"
},
{
"speaker": "Julie Sweet",
"text": "I mean, we're not anticipating any big changes in those areas."
},
{
"speaker": "James Faucette",
"text": "Got it, got it. And then you mentioned, in reference to generative AI, like the [B&A] (ph) opportunities are pretty small right now and really nascent. But how are you thinking about B&A more generally going forward? Should we expect ongoing sustained and pretty stable levels of inorganic contribution? And -- or should we expect there to be some changes as expectations and emphasis shifts a little bit more to AI."
},
{
"speaker": "Julie Sweet",
"text": "Well, no, a couple of things. So first of all, no shift in how we view inorganic, which is a core part of our business model, right? So we expect to get about 2% of our revenue growth from this year from inorganic, and this has been a stable part of our strategy. And I just want to be clear that the shift to AI is just -- let's go back to total enterprise reinvention. What are clients doing? They are reinventing every part using tech data and AI. So when you look at our growth priorities, cloud, both the move to the cloud, but also cloud-based platforms, all growing very significantly, right, at the top level overall. And so, it's about building a digital core. And then the opportunity to take AI is to then reinvent the processes and the ways of working, which is, by the way, a huge opportunity for Accenture because we're not just about the technology. Our strength is in being able to do all of that. So I think it's really important that it's not an emphasis shift on AI. It's a rapidly accelerated opportunity because companies who were kind of resistant or not focused on it are now focusing on it. So I think that's important. Then the last piece is we will -- our focus is not going to suddenly in M&A be around just data and AI. And in fact, we think that there's going to be much more organic because there isn't a lot out there. But we use AI, right, to scale things like consulting, industry expertise, digital expertise. We've done that for digital manufacturing, supply chain. We also use it to get into new areas. So I'm super excited that yesterday we announced that we acquired Answer Advisors, which is a primarily US-focused, North America-focused company and capital projects. That's a really small business today in the U.S. and we just acquired a great company with 900 professionals in a market that has an $88 billion addressable market in North America, growing really well. That's a whole new area of net new growth for our North America business. So we use our ability to invest, right, to scale great things and continuously seed new areas of growth for Accenture. And you've seen us do that over and over again. We did it with Song, we did it with Industry X and digital manufacturing. We're now in supply chain and we're moving into capital projects. So that is just a huge advantage as you think about, not just the next couple of years, but growth over the decade for Accenture."
},
{
"speaker": "James Faucette",
"text": "That’s great color. Thank you so much."
},
{
"speaker": "Julie Sweet",
"text": "Great. Well, thanks, everyone. In closing, I want to thank all of our shareholders for your continued trust and support and all our people for what you are doing for our clients and for each other every day. Thanks, everyone, for joining. Look forward to being back together in a quarter."
},
{
"speaker": "Operator",
"text": "Thank you. And this conference will be available for replay beginning at 10 a.m. Eastern Time today and running through September 28 at midnight. You may access AT&T replay system at any time by dialing (866) 207-1041 and entering the access code of 4564655. International participants may dial (402) 970-0847. Those numbers again are (866) 207-1041 or (402) 970-0847 with the access code of 4564655. That does conclude our conference for today. Thank you for your participation and for using AT&T Event Conferencing. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 2 | 2,023 | 2023-03-23 08:00:00 | Operator: And ladies and gentlemen, thank you for standing by and welcome to the Accenture’s Second Quarter Fiscal 2023 Earnings Call. [Operator Instructions] As a reminder, today’s conference is being recorded. I would now like to turn the conference over to Katie O’Conor, Managing Director and Head of Investor Relations. Please go ahead.
Katie O’Conor: Thank you, operator and thanks everyone for joining us today on our second quarter fiscal 2023 earnings announcement. As the operator just mentioned, I am Katie O’Conor, Managing Director, Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you have had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the third quarter and full fiscal year 2023. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today’s news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Katie and thank you to everyone joining today and thank you to our 738,000 people around the globe for your incredible work and commitment to our clients, which has resulted in our delivering another strong quarter of financial results and the broader 360-degree value we continue to create for all our stakeholders. Let me share a few highlights of value we created in our continued disciplined execution. I am very pleased with our record bookings for Q2 at $22.1 billion, our highest ever including 35 clients with quarterly bookings greater than $100 million, our second highest quarter on record for such bookings, representing the continued trust that our clients have in us. We delivered revenues of $15.8 billion, representing 9% growth in local currency, bringing us to $31.6 billion of revenue at 12% growth through H1 and we continued gaining market share, growing approximately 2x the market. We continued our inorganic investments with six acquisitions in strategic areas, including cloud with the acquisition of SKS in Europe, which will expand our specialized technology consulting and regulatory capabilities, enabling us to better serve our financial services clients; security with the acquisition of Morphus in Brazil, a cyber defense risk management, cyber threat intelligence service provider; and supply chain with the acquisition of Inspirage in the U.S., which will enhance our technology capabilities to accelerate innovation for clients through emerging technologies such as touchless supply chain and digital twins. We also continued our investment in our people with 10.3 million training hours, a 12% increase year-over-year. We are optimizing our business to lower costs in fiscal year 2024 and beyond, while continuing to invest in our business and our people to capture the significant growth opportunities ahead. KC will be giving you more detail on these actions. Finally, we believe our focus on creating 360-degree value differentiates us in our market. We earned the number one position in our industry for the 10th year in a row and number 32 overall on Fortune’s list of the World’s Most Admired Companies. We ranked number one in our industry and number four overall on the JUST Capital list of America’s Most JUST Companies. And we have been recognized by Ethisphere as one of the world’s most ethical companies for the 16th year in a row. I am very pleased that our results demonstrate once again that our strategy to be the execution partner of choice for transformation, lead in the five forces and have a diverse business across markets, industries and services continues to allow us to lead and take market share. And in a world in which all strategies lead to technology, we have distinguished ourselves in our impact to the market. Over to you, KC.
KC McClure: Thank you, Julie and thanks to all of you for taking the time to join us on today’s call. We were pleased with our overall results in the second quarter, setting a new bookings record at $22.1 billion, $2.5 billion higher than our previous record set in Q2 of last year, with consulting bookings close to matching our previous record. We delivered revenue growth for the quarter at the top end of our guided range as we continue to deliver on our shareholder value propositions. Before I summarize results for the quarter, let me spend a moment on the business optimization actions we are taking to reduce costs for fiscal ‘24 and beyond, which includes streamlining operations, transforming our non-billable corporate functions and consolidating office space. We estimate cost of $1.5 billion through fiscal year 2024, of which we expect to incur approximately $800 million in FY ‘23 and $700 million in FY ‘24, comprised of approximately $1.2 billion in severance and $300 million for the consolidation of office space. These actions are expected to impact roughly 2.5% or 19,000 of our current workforce, of which over half are non-billable corporate functions and include over 800 of our more than 10,000 leaders across our markets and services. Nearly half of the 19,000 people will depart by the end of fiscal year ‘23. Now, let me summarize a few of the highlights for the quarter. Revenues grew 9% local currency, driven by broad-based growth across all markets with more than half of our 13 industries growing double-digits. We also continue to extend our leadership position with growth estimated to be about 2x the market, which refers to our basket of publicly traded companies. In Q2, we recorded $244 million in cost associated with the business optimization actions, which impacted operating margin by 150 basis points and EPS by $0.30. The following comparisons exclude these impacts and reflect adjusted results. We delivered adjusted EPS in the quarter of $2.69, reflecting 6% growth over EPS last year. Adjusted operating margin of 13.8% increased 10 basis points, with 20 basis points expansion year-to-date and includes continued significant investments in our people and our business. Finally, we delivered free cash flow of $2.2 billion and returned $1.8 billion to shareholders through repurchases and dividends. Year-to-date, we have invested $1.1 billion in acquisitions, primarily attributed to 15 transactions. With those high level comments, let me turn to some of the details, starting with new bookings. New bookings were a record at $22.1 billion for the quarter, representing growth of 17% in local currency with an overall book-to-bill of 1.4. Consulting bookings were $10.7 billion with a book-to-bill of 1.3. Managed service bookings were also a record at $11.4 billion with a book-to-bill of 1.5. We were very pleased with the strength of our new bookings, which were broad-based, delivering a very strong book-to-bill across all of our geographic markets and across our services with a book-to-bill of 1.5 in operations, 1.4 in technology and 1.3 in strategy and consulting. Turning now to revenues. Revenues for the quarter were $15.8 billion, a 5% increase in U.S. dollars and 9% in local currency and were at the top end of our range, adjusting for a foreign exchange headwind of approximately 4% compared to the 5% provided last quarter. Consulting revenues for the quarter were $8.3 billion, a decline of 1% in U.S. dollars and an increase of 4% in local currency. Managed services revenue were $7.5 billion, up 12% in U.S. dollars and 16% in local currency. Taking a closer look at our service dimensions, technology services and operations grew double-digits and strategy and consulting declined mid single-digits. Turning to our geographic markets. In North America, revenue growth was 5% in local currency, driven by growth in public service, health and utilities. These increases were partially offset by a decline in communications and media and high tech. Revenue growth was driven by the United States. In Europe, revenues grew 12% in local currency, led by growth in industrial, banking and capital markets and public service. Revenue growth was driven by Germany, Italy and France. In Growth Markets, we delivered 14% revenue growth in local currency, driven by growth in banking and capital markets, chemical and natural resources and public service. Revenue growth was led by Japan. Moving down the income statement. Gross margin for the quarter was 30.6% compared with 30.1% for the same period last year. Sales and marketing expense for the quarter was 9.9% compared to 9.4% for the second quarter last year. General and administrative expense was 6.8% compared to 7% for the same quarter last year. Adjusted operating income was $2.2 billion in the second quarter, reflecting an adjusted 13.8% operating margin, an increase of 10 basis points from operating margin in the second quarter of last year. Our effective tax rate for the quarter was 20.4% compared with an effective tax rate of 19.2% for the second quarter last year. Adjusted diluted earnings per share were $2.69 compared with diluted EPS of $2.54 in the second quarter last year. Days service outstanding were 42 days compared to 48 days last quarter and 41 days in the second quarter of last year. Free cash flow for the quarter was $2.2 billion compared to approximately $400 million last quarter, resulting from cash generated by operating activities of $2.3 billion, net of property and equipment additions of $108 million. Our cash balance of – at February 28 was $6.2 billion compared with $7.9 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the second quarter, we repurchased or redeemed 4.1 million shares for $1.1 billion at an average price of $273.55 per share. As of February 28, we had approximately $4.2 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $1.12 per share for a total of $708 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.12 per share to be paid on May 15, a 15% increase over last year. Finally, turning to the 360-degree value we are creating for all our stakeholders, we are partnering with Save the Children to connect with new audiences and invigorate donors through fundraising and creative campaign excellence. So at the halfway point of fiscal ‘23, we are pleased with our results. Now, let me turn it back to Julie.
Julie Sweet: Thank you, KC. I will start with the overall demand environment, which is more of the same. We believe that the ongoing volatility and uncertainty in the macro environment is making it even clearer to clients that they need to change more, not less. And that two of the five key forces of change that we have identified for the next decade, the need for total enterprise reinvention and the ability to access, create and unlock the potential of talent are critical to succeed in the near, medium and long-term. We see two common themes. First, all strategies continue to lead to technology, particularly cloud, data, AI and security. This is reflected in the latest market estimates, which are down slightly, but are still hovering around 5%. And second, companies remain focused on executing compressed transformations to achieve lower cost, stronger growth, more agility and greater resilience faster. We remain laser focused on pivoting to our clients’ changing needs and being relevant across the enterprise from the frontline to core operations to corporate functions. Our ability to advise, shape and deliver value-led transformations, leveraging the breadth of our services from strategy and consulting to our strategic managed services across all industries and geographic markets is what differentiates Accenture. Now, I will give you more color on the quarter and in particular, how total enterprise reinvention and talent are critical to our clients. For example, we are helping Shionogi & Co. Limited, a Japanese pharmaceutical company with a compressed transformation to improve its business process efficiency and create a more agile organization. We will enter into a joint venture with the company that will provide managed services capability to oversee back office functions such as human resources, finance and accounting, public relations, facility management, procurement and marketing. The joint venture will also be charged with the management of the pharmacovigilance function from safety management operations to post-marketing operations to regulatory compliance. As part of this transformation, we will upscale over 400 employees, enabling them to play a greater role in the growth and development of the wider business, hence demonstrating the value of all our services from strategy and consulting, our deep industry knowledge to technology and operations coming together to enable the clients transformation. I would like to take a moment to recognize Egawa-san, our Head of the Japan market unit and our extraordinary people in Japan for how they are consistently creating value for our clients with double-digit revenue growth for each of the past 5 years. As clients focus on building their digital core with a modern cloud-based infrastructure, our cloud business continues to grow very strong double-digits. For example, we are working with the state of Missouri to replace its legacy applications and infrastructure with a modern ERP in the cloud, introducing new capabilities in finance, supply chain management, human capital management, payroll and budgeting. As the current ERP system no longer fully meets the business needs of the state, they are looking for a modern system that is efficient, scalable and flexible, all delivered by a best-in-class implementation partner. This compressed transformation, one of the earliest and most complex ERP implementations for any state will help reduce operating expenses, provide opportunities for upskilling and improve customer experience and services. We are partnering with minority and women-owned businesses on this transformation and we will bring in apprentices, the program’s lifecycle part of our shared commitment with the state of Missouri to foster diversity and inclusion. With our cloud-first strategy, our approach has been to help clients migrate to the cloud and then partner with them on their journey to grow and innovate in the cloud. Our cloud growth is driven by both migration and clients who are moving forward on this journey, such as Enel, one of our largest utilities clients who has taken their mass migration to cloud a few years ago to the next level, changing their operating model, tools and talent and largely automating IT operations. We are now helping them accelerate the modernization of their application landscape, reduce greenhouse gas emissions by up to 80%, support a significant acquisition and divestment agenda and pivot to platform-based business model for integrated retail delivery beyond meter services, grid and renewable energy. Using cloud as their operating systems is helping this market leader manage increasing levels of complexity by bringing together data, AI and applications to optimize their operations and accelerate growth. A strong and secure digital core also is essential to total enterprise reinvention. We are seeing continued very strong demand for our security services, which experienced another quarter of very strong double-digit growth. We are working with Empresas CMPC SA, a Chilean pulp and paper company and a cybersecurity transformation of their plant operations. We will implement a security program across its 48 industrial sites focused on threat detection, management and response as well as governance and workforce training. Through our global and local Industry X capabilities, we will help strengthen the company’s cybersecurity expenses through continuous monitoring of its physical locations and equipment. We continue to lead in managed services, which experienced strong growth again this quarter at 16%. Managed services are strategic for our clients, because they enable clients to move faster, leveraging our digital platform expertise and talent as well as delivering cost efficiencies. And our clients are turning to Accenture because of the depth and breadth of our industry, functional and technology expertise that we bring together into the transformation journey. Our approach to managed services is to both run and transform and run and modernize. We deliver cost savings as table stakes. For example, we are partnering with the UK’s Department for Work and Pensions, which is responsible for welfare pensions and child maintenance policy to modernize its legacy systems, eliminating backlogs and delivering a better experience for citizens and employees. We developed a cloud-based intelligent optimization platform that combines robotic process automation, AI, analytics and machine learning to provide bots as a service to create the equivalent of a virtual workforce available 24/7. With routine tests now automated, the organization has already saved 2.4 million human hours, which can be reallocated to more complex higher value tasks. Let me pause to thank our global H&PS colleagues for their amazing contributions as evidenced by 14 consecutive quarters of double-digit growth. As our clients continue to prioritize cost optimization as well as growth in Vigilance, Song is more relevant than ever. In Song, which grew strong double-digits this quarter, clients are focused on more capital efficient growth that creates efficiency, drive short-term growth and optimizes existing assets with clear outcomes and shorter time horizons to keep up with the pace of change with customers and technology. We have moved quickly to help clients seize new opportunities in contact centers, not only for enhanced customer service, but also customer acquisition and growth. We are working with a global biopharmaceutical leader in North America to reinvent digital marketing at scale. Driven by data and using technologies integrated with SynOps, the company will be able to create, produce and deliver consistent world class content that informs and educates healthcare providers and patient communities around the world, helping to deliver innovative health services. We are working with the Prada Group, the Italian luxury fashion player, to offer its customers an entirely new customization experience through an online 3D configurator. Accenture Song created a digital twin of Prada’s iconic show called America’s Cup, which allows shoppers to fully customize it from material to color to trim across the overlay, lining, sole and other parts. With more than 50 million possible configurations, more than any web platform could handle, this innovative approach allows customers to see high resolution 3D models of their custom builds with the same quality and fidelity as a physical shoe. Song solution to online product customization is fully scalable to the cloud. It gives Prada the flexibility to apply the same strategy to other products, ensuring the outstanding experience that their shoppers expect. As I continue to move across the enterprise, industries and markets, I want to also highlight Industry X, which grew very strong double digits again this quarter, and which we believe is the next digital frontier where our digital engineering capabilities are advancing sustainability services. For example, we are working with Recharge Industries, a battery research and production company in Australia, to help design and engineer one of the world’s largest lithium-ion battery facilities. Once built, the facility will generate up to 30-gigawatt hours of storage capacity per year. Finally, moving to the metaverse and the ongoing tech revolution. We’ve talked about the importance of artificial intelligence in building the digital core for our clients. While generative AI has recently burst into the popular imagination, at Accenture, we’ve been working with the technology from its earliest stages and are already applying it at clients. For example, we’re working with a multinational bank to transform how it manages high volumes of post-trade processing e-mails every day. We are leveraging a generative AI solution as it is built to understand the context of e-mails with high accuracy. It automatically routes large numbers of e-mails, daily to relevant teams and draft responses with recommended actions and related information. Our work will help reduce manual effort and risk, boost worker efficiency and improve interactions with customers. And finally, on that note, we will release our Tech Vision 2023 on March 30. The 4th and 5th key forces of change we have identified for the next decade at a metaverse and ongoing tech revolution. And this year’s tech vision is particularly relevant and actionable as our clients face a rapidly changing landscape in which generative AI, metaverse cloud, science, tech and other technologies are driving more opportunities for change and reinvention. This year’s vision will explore how these technologies and more are blending the physical world and the virtual world into a shared reality, creating a huge opportunity for our clients and for Accenture. Now turning to our business outlook. For the third quarter of fiscal ‘23, we expect revenues to be in the range of $16.1 billion to $16.7 billion. This assumes the impact of FX will be about negative 3.5% compared to the third quarter of fiscal ‘22 and reflects an estimated 3% to 7% growth in local currency. For the full fiscal year ‘23, based upon how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately negative 4.5% compared to fiscal ‘22. For the full fiscal ‘23, we now expect our revenue to be in the range of 8% to 10% growth in local currency over fiscal ‘22, which assumes an inorganic contribution of 2%. We expect business optimization actions to impact fiscal ‘23 GAAP operating margin by 120 basis points and EPS by $0.96. We expect our anticipated gain on our investment in Duck Creek Technologies to impact EPS by $0.39. Our guidance for full year fiscal ‘23 excludes these impacts. For adjusted operating margin, we expect fiscal year ‘23 to be 15.3% to 15.5%, a 10 to 30 basis point expansion over fiscal ‘22 results. We expect our adjusted annual effective tax rate to be in the range of 23% to 25%. This compares to an effective tax rate of 24% in fiscal ‘22. We expect our full year adjusted earnings per share for fiscal ‘23 to be in the range of $11.41 to $11.63, or 7% to 9% growth over fiscal ‘22 results. For the full fiscal ‘23, we now expect operating cash flow to be in the range of $8.7 billion to $9.2 billion, property and equipment additions to be approximately $700 million and free cash flow to be in the range of $8 billion to $8.5 billion, $300 million higher than our previous guidance. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1. Finally, we continue to expect to return at least $7.1 billion through dividends and share repurchases as we remain committed to returning a substantial portion of cash to our shareholders. With that, let’s open it up so we can take your questions. Katie?
Katie O’Conor: Thanks, KC. [Operator Instructions] Operator, would you please provide instructions for those on the call?
Operator: [Operator Instructions] Our first question comes from the line of Tien-Tsin Huang with JPMorgan. Please go ahead.
Tien-Tsin Huang: Hi, thanks so much. I had to ask, given the great bookings here, your confidence in being able to replenish those bookings as we look to the third quarter and ahead? I’m sure a lot of people are thinking what’s going on in the month of February and March as well. I know your guidance implies some reacceleration in the fourth quarter, but just curious about your ability to replenish on the bookings side? Thanks.
KC McClure: Yes. Thanks, Tien-Tsin. So we do feel good about our pipeline even after our record bookings this quarter. And our sales outlook for the next quarter, Q3 is solid. We expect to have slightly lighter bookings than what we’ve had compared to the record quarter that we just had.
Julie Sweet: And maybe just to add a little color. Look, as you can see in our bookings, there is just continued strong demand for the larger transformational deals, right? And the need to, in particular, build the digital core. And I’m personally working right now with clients across insurance, healthcare, consumer goods, banking and telecom, all of whom are very focused on how do we upgrade our – get rid of our technical debt, how do we build more resilience. They are trying to build digital products, but they have got really old systems. And so we remain in the early innings of building the kind of digital core that really need to transform every part of the enterprise. And so we continue to feel good, not just about our pipeline, but about the demand we’re seeing really rooted in our view that all companies are going to have to do total enterprise reinvention across the enterprise that it’s really a continuous cycle starting with a digital – a strong digital core. And there is a lot of work to do on building those cores out.
Tien-Tsin Huang: Good. Glad to hear. Very encouraging. So given that, given both your comments and the optimization, I’m just trying to think about is it more playing offense versus defense? So I’m just trying to think about – I know a lot of your clients are going through similar optimization efforts as well. How does this one fit given that? And should we still think about this within the 10 to 30 basis points of typical margin expansion that we think about sort of philosophically? Or could this be incremental?
KC McClure: Yes. So just let me answer the last part first, is you should view this as creating the room in our P&L to ensure that we can continue to deliver on that enduring shareholder value model, including the 10 to 30 basis points, which for a short period of time will be on an adjusted basis. So – and as you think about it, it is – I like that, is it offense or defense. It is offensive. I mean if you look at where we are today, right, we’ve got record bookings, a strong quarter of – strong view of the year, 8% to 10%, 91% chargeability. We’re going after structural cost, right, to ensure that we’re in a better position. As you know, we’ve been dealing with the difficult challenges of compounding wage inflation. And we’ve been doing that with pricing, but we’ve also been doing that with cost efficiencies and digitizing. And we have identified an opportunity to go after more structural costs to kind of create that resilience and that room in the P&L as we look forward. So very much in our view, getting ahead of and dealing with these structural issues that have been created over the last couple of years.
Tien-Tsin Huang: Awesome. That’s great. Great results then. Thank you.
Julie Sweet: Thank you.
Operator: And our next question comes from the line of James Faucette with Morgan Stanley. Please go ahead.
James Faucette: Great. Thank you very much. Wanted to follow-up on a couple of those items. First, can you talk a little bit about what you’re seeing around the actual conversion and decision cycles? Obviously, the bookings themselves speak well to being able to do conversions, but are we seeing any changes in the sales cycle times or the types of projects that customers may want to engage in?
Julie Sweet: Well, let me just start with the type of projects. I mean what we’ve been seeing over the last several quarters is just a laser focus on cost, right? So most programs, clients want to see a shorter return on investments, right, more focused on cost. They love cost and growth, but it has to be, in most cases, a shorter return on the investment. At the same time, it’s important that not all industries are in the same place, right? So if you’ve got industries like, say, in the high-tech area, and some spots on retail, for example, cost optimization is very dominant, right? If you have – you’ve got some of the other less affected industries, say, insurance, energy, it’s – everyone wants to be more resilient and lower cost. But they are really trying to deal with their technical debt, they are thinking about growth, how do you reimagine the customer experience. And so I would say a common theme is that in this kind of an environment, everyone does want to be optimizing costs, but where they are focusing is different by industry is what I would say first. And then just to your first part of your question about are you seeing changes in decision making and I’d let KC talk to you about the yields in our pipeline because you all saw, in general, seeing a trend toward these larger deals. So there is – and we talked about this in the last couple of quarters, we’re seeing less of the smaller deals in SMC and to some extent, SI, particularly in North America, where we’re seeing more caution. North America had record sales this quarter. But in areas tending towards the bigger transformational deals, not the smaller SNC and to some extent, SI deals. And those – that transformational pipeline, which is our strategy, right, like if you think about it, what have we been trying to drive for the last few years? We want to be at the center of our clients’ business, we want to be able to be relevant, really help them transform and then be well positioned to continue to be that partner. And I would just say, Enel in my script, is a great example of that. I mean they are hugely innovative utility. They were very early in cloud. We help them get to the cloud. And now they are modernizing and once again being super innovative. That’s exactly the way we want to work with our clients, be their core and then be there for their next big transformation. Maybe, KC, if you want to just comment on the yields real quick.
KC McClure: Yes, sure. No problem. So when we – let me focus really on consulting bookings because it is important to understand the impact of F&C and our consulting bookings and also how to what we’re doing in our larger transformation deals because they do convert to revenue at a slower pace. So as I mentioned in my script, I was very pleased with our SNC bookings and our overall consulting bookings, which were very close to the record that we had last year. And SNC participates, and is a critical part of winning the larger deals, which we have 35 clients over $100 million. And so what you’ll see is in SNC, you may see a conversion that’s a little bit slower than we typically have because we still do have some pressure in our smaller deals, particularly in North America. And so maybe I’ll just – how does that all work in terms of yield then? What that means for next quarter? As we look at SNC, I mentioned that we had a modest decline, a decline in mid-single digits this quarter. We think we will be in the same zone overall in Q3, and we’re going to look to reconnect with SNC growth in Q4. It may take us a little bit more time than that. But I just want to make that connection to your question as it relates to our very strong consulting bookings in SNC. They were definitely part of that discussion and clearly part of that the reason why we are able to get the 35 clients in a $100 million, but you will see that come into our P&L at a little bit slower conversion.
James Faucette: Thank you. That’s really helpful. And then just quickly, on D&A, it seems like we’ve seen a little bit of a deceleration there. How are you thinking about D&A going forward? And what was inorganic contribution in the quarter and how should we think about that for the year? Thanks.
KC McClure: So I’ll just maybe reiterate the contribution for the year. So we now see inorganic contribution to be about 2%. And acquisitions can be lumpy. And we – as you know, we can’t always really control the timing, but there is no change to our strategy. In any given year, you’ll hear us kind of go up or down a bit on the percentage of contribution. No change.
James Faucette: Great. Thank you.
Operator: And our next question comes from the line of Bryan Keane with Deutsche Bank. Please go ahead.
Bryan Keane: Hi, guys. Good morning. Wanted to just ask about…
Julie Sweet: Good morning.
Bryan Keane: Good morning. I just wanted to ask about the communications, media and technology group that did come in at flat local currency and is kind of a standout versus the others. Can you just talk a little bit about what’s happening there and what the outlook might be?
Julie Sweet: Yes. That’s primarily happening in North America where we’ve got comms and media and high-tech are more challenged, cutting back spending for sort of obvious reasons. And then our software and platforms business, which has been really a strong business for us for the last few years has – it’s still slightly positive, but has come down a lot, and I think for kind of obvious reasons that we’re all reading in the press. And so we do think this will last for a bit of time as you look at sort of some of the ways they are approaching spending in that. And – but it will eventually come back, and these are great companies. And we’re helping them in many places, but their spending is just lower right now. So that’s – I think long-term, we’re very positive. These are all great companies. And this why it’s so great that we’re diverse, right, that we serve so many and not just diversity in industries but in markets because you’re seeing a different picture, for example, in comms and media in Europe, where it was growing double digits last quarter in growth markets where it was positive. So the diversity of our business really plays to our strength and why we’re continuing to deliver strong financial results.
Bryan Keane: Got it. Got it. And I was just trying to reconcile in my head the strong bookings, but the actions also taken to lower costs in fiscal year ‘24. What does that signal, I guess, for the demand environment in fiscal year ‘24? Should we expect slightly lower growth rates than typical as a result of the actions taken?
Julie Sweet: No. I mean the actions, I can just kind of reground you on like what we’ve been saying, right, which is we’ve been achieving hypergrowth and there is been wage inflation like none of us have ever experienced and it’s compounding. And we’ve been addressing that through a combination of improved pricing, cost efficiencies, and so this is really us taking a step back and being able to more structurally address the impact of compounding wage inflation. So it’s a real positive for how we’re moving forward. And think of it as really being – creating more room in the P&L so that when you think about our enduring shareholder value proposition is we still expect next year to grow faster than the market. We expect to invest at scale in our business, to deliver 10 to 30 basis point margin expansion on an adjusted basis, to have a disciplined capital allocation, including a meaningful return to our shareholders. So that is a commitment – this is an offensive mood to say, yes, today, we’ve got great demand, we’ve got great utilization, and we can take out more structural costs to put us in a better position as we move forward.
Bryan Keane: Okay. Great. That’s really helpful. Congrats.
Julie Sweet: Thanks.
Operator: And our next question comes from the line of Lisa Ellis with MoffettNathanson. Please go ahead.
Lisa Ellis: Terrific. Thanks for taking my question. Maybe just a kind of follow-up on the sort of connecting the dots questions. I noticed that your headcount growth slowed a bit this quarter, up 6% year-on-year and was flat sequentially. Can you kind of connect the dots that side, what you are seeing and sort of what you’re thinking about on the hiring side with the fact that you have record bookings in the quarter and then typically, those two things kind of move a little bit more in tandem? Thank you.
KC McClure: Yes, sure. Thanks, Lisa. So maybe I’ll just first start with just looking back over the last two previous quarters. We added 28,000 people in the previous quarters. So let’s first start there. And you’re right, Lisa, when you take a look at what we were able to accomplish this quarter, first of all, we had record bookings. We drove 9% – 9.3% revenue growth, and we had 91% utilization of our people, right? So we have the skills and all the people we needed to deliver to the demand in the market. And if I look – answering your question, looking forward, we sequentially did not add headcount from Q1 to Q2. We see that being about the same in Q2 to Q3. And then looking forward, based on the outlook that we have now, we do see that we would add additional heads in the fourth quarter.
Lisa Ellis: Okay. Great. And then my follow-up is related to AI. Maybe this one is, Julie, for you. Just can you talk a bit about how you apply AI in your own operations? I know every time this topic kind of stirs up, there is this question of whether it’s a positive or a negative for the operations of IT services firms. Can you just talk about how you sort of applied internally and how you think about that over the long-term? Thank you.
Julie Sweet: Sure. In fact, I was just at a client this week where we are helping them really transform their whole IT department. And one of the things they want from us is our myWizard platform, which is a great way of explaining how over the last several years, we have built a platform that integrates the best-in-class technology. So, we didn’t write our own code, right. We use the best technologies. And the way it uses AI, for example, is that when a ticket comes in to address something, an IT issue, AI looks at it, identifies whether or not it’s been a problem solved before, in some cases, can solve the problem, in other cases, routes it to the right people. And then it learns from every ticket. So, in the past, when we have talked about – with you about why is it – how do you think about revenue and people, we said, look, we have already been breaking that for years now because we are using so much technology and AI in how we are delivering all of our technology jobs. The same thing is true, for example, with testing, which is incredibly automated, using different technology, including AI. We are continuing to use AI in the way we run our business, for example, in how we look at our accounts payable and receivables and finding ways where we can optimate to have better efficiencies there. We are using it today in the way we are delivering our consulting services as well and definitely very much so in how we look at sales and being able to predict based on lots of factors. Should we be running after the sale or not, or can we show the data that these – this is not the right kind of sale, we are not the right fit. So, we have increasingly been using AI, both in how we deliver services as well as in how we run ourselves. Of course, our SynOps platform for operations is also AI-enabled. It’s one of the reasons why clients turn to us because it’s helping them digitize faster. They are not having to build these things. So, long-term, we see these technology changes, things like generative AI is playing to our strengths because to use these technologies, it requires deep understanding of the industry, the use cases, the process changes. When people talk about the new kinds of generative AI, which we are super excited about, being like a co-pilot to human beings, the entire process has to be changed in order to make that work. You have got to up-skill the people and you have to be able to do all of that in a very responsible way. So, we are already working with. There has been a lot of demand to understand this. And in understanding it, understanding actually how hard it is to be able to implement at scale in an enterprise versus, I am assuming you are – we are all having fun playing with it, but how you build that into an enterprise is very different and a great opportunity, and we are partnering with all the major players to help them take the technology go from technology to implementation to impact.
Lisa Ellis: Thank you.
Julie Sweet: Thanks Lisa.
Operator: And our next question comes from the line of David Togut with Evercore ISI. Please go ahead.
David Togut: Thank you. Good morning. Could you delve into demand trends in the financial services vertical in a little greater depth, especially given the evolving banking crisis we have seen in the last month or so, particularly with some of the regional banks struggling? And maybe as part of that, if you could just remind us of your profile within bank-related IT services, smaller banks versus regionals and money centers.
Julie Sweet: Sure. As a client base, we skew towards the larger banks across all of the markets. So, we don’t comment on individual clients, but we don’t have any big exposure to kind of the smaller regional banks and in general. So, as you sort of think about the stepping brake, obviously, the developments on the banks for the – are still early in the last couple of weeks. So, as I talk about demand trends for our clients, which are generally the bigger banks, a couple of things really stand out. So, first of all, there is a lot of focus on their technical debt, because the banks, a lot of them are still in the mainframe. Our mainframe practice really across industry has growing like gangbusters right now as clients across the industry are really having to take on some of that harder technical debt, which they need to do because the more and more they digitize their services, which is a continuing trend in financial services, if the systems behind it aren’t agile, then it can take a lot of time to introduce new services. You have got to – oftentimes, we will have multiple systems. You will have to test things. You can’t go as fast. And so the banks are kind of reaching their limits in terms of what they can do without touching their core. So, we expect the sort of addressing the core to be a really important driver. We are seeing, in asset management, more and more views – more and more companies in asset management, really digitizing. They had been kind of slower behind the banks. And then insurance, we are working with leading insurers across the world who not only are kind of trying to catch up because banking was ahead of insurance, but finding sort of new and exciting opportunities on how to use data, in particular, to grow their business, how to transform their experience and claims. So, financial services which covers banking, capital markets and insurance, we continue to see as a vibrant area. Where things are slowing down a bit in the U.S. where we have been a big player is in integration. We will see that might pick up again. Let’s just see how all of this shakes out. But that has slowed down for a bit. Hopefully, that gives you some color.
David Togut: It does. Thanks so much.
Operator: Our next question comes from the line of Jason Kupferberg with Bank of America. Please go ahead.
Jason Kupferberg: Good morning. Thanks guys. I just wanted to ask about Q3 bookings. If you can discuss consulting versus managed services, just expectations there? I mean I think the year-over-year comparison for consulting at least gets a bit easier.
KC McClure: Yes. Thanks Jason. I am not going to comment specifically on kind of individual breakout of the bookings. But maybe I will just reiterate what I mentioned to Tien-Tsin. So, we had record bookings this quarter. We do see that next quarter. We will have lighter bookings than what we had this quarter in terms of the record bookings. Overall, what you can see, Jason, you know us well, is that the mix right now is much more favored halfway through the year to managed services, all the reasons that Julie talked about. We were really pleased with consulting this quarter that did – we thought it was going to be strong, and it came in even stronger. And so that, we are very encouraged by that, and we do have a strong pipeline, and we continue to see solid bookings for Q3.
Jason Kupferberg: Okay. Understood. And then just on the cost side, what’s the estimated savings from the cost takeout program? And I know the charges will aggregate to $1.5 billion, but I just wanted to understand kind of what the fully annualized run rate of savings is? And are you essentially reinvesting the savings? I mean I know at least for this year, we are not changing the underlying margin guidance. So, just wanted to get a picture of how much of this is being reinvested, or are you essentially just offsetting some other headwinds around wage inflation, etcetera?
KC McClure: Thanks for the question. Let me just first start with FY ‘23. So, the actions that we are taking are not about FY ‘23. They are about FY ‘24 and beyond. So, in terms of what we will do with those savings, it really is going to depend, Jason, on how the market develops, the growth opportunities that we have next year. And as Julie said, the key part of what we are really focused on is just going to give us more room to continue to execute our enduring shareholder value proposition, what she mentioned. And I know you know that.
Jason Kupferberg: Yes. Alright. So, just…
Julie Sweet: Keep your model – to be clear, keep your model 10 basis point to 30 basis point adjusted margin expansion. We are going to invest in our business and we are going to grow faster than the market.
Jason Kupferberg: We love the consistency. Thank you.
Julie Sweet: Thanks.
Operator: And our next question comes from the line of Darrin Peller with Wolfe Research. Please go ahead.
Darrin Peller: Hey. Thanks guys. I mean when you put the pieces together with the bookings we are seeing and the actual changes in the efficiency, it really does sound like we are finally seeing more of a divergence in linearity between headcount growth and bookings capabilities and revenue contribution. So, I mean I know you mentioned AI, obviously, is a big theme. But is there other factors that we can point to that are structurally part of the model now, or is it a function of the mix type of bookings or anything else?
KC McClure: Yes. Maybe I will just talk a little bit about what you are seeing in terms of headcount, Darrin, and what we are recording in revenue in terms of how we are generating our revenue. And Julie, if you want to add in, you certainly can. But in terms of what you are seeing is we have been very focused on hiring, balancing our supply, demand to what we need to both sell and drive the revenue to meet our client demand and continue to take market share. And part of what you are seeing throughout the year is we have been continuing – you have heard us talk about us really focusing on continued strong pricing. Again, reminder, that when we talk about pricing, it’s the margin on the work that we sold. And that has been improving over the last five quarters. It’s not stable, which we are really happy with. And so some of that is part – there is a part of that that’s helping to drive our revenue production as well.
Julie Sweet: And I would just say, a lot of its mix, right. If you have longer transformational deals like the numbers of people that you need to drive are different. So, I wouldn’t say there is some big, wait a minute, we have got some new inflection point where you have disconnected more. As I talked about earlier, we have been disconnecting to some degree, for a while now, but there is no big change in that perspective. Just as we have executed our strategy. And I think it’s so important to understand that it has been a deliberate strategy to say we want to do transformational deals. We want to take our SNC people who have deep industry and functional knowledge, put them together with our technology people to do either big implementations, right, that are changing the digital core or transformations that are coupled with managed services and just how that works out. And so while we love when the economy is booming and SNC and the small deals are also booming, the strategy is to be at the core so that we continue – we help them with one big project, we understand their company and met it more. We take them on the next big project, and we are really getting that kind of stickiness in our relationships. And so we will kind of deal with the sort of softness in the smaller deals. But over time, this is exactly what we want to do. And in fact, if you think about this year, consulting – last quarter, we thought consulting this year would be mid-single digits to high-single digits. We now see it as mid-single digits for the year, and we are fine with that, right, because that’s about kind of lower SNC and SI smaller deals. North America in December, we thought it was going to be mid-single to high-single digits. We now see that as the mid-single digits for the year. Again, it’s because sort of the caution that’s impacting the smaller deals, record sales, great large transformational deals, and that’s just going to how it deals with. And that’s why, as KC said before, SNC, we are going to see a very similar performance next quarter probably, and it may take a little bit longer to reconnect with growth. But remember, we don’t look at that as separate. We see SNC as a competitive differentiator for these larger transformational deals, which is our strategy.
Darrin Peller: That actually makes a lot of sense. One follow-up on that and related is the cyclicality of business is it’s not surprising, you would see some of the smaller deals get impacted first by pause or concern among enterprise spending. When we think about the larger transformational side, the pipeline is longer. The sales cycle is longer there. So, having that strong still is probably not – if you do – given how well you guys execute, it’s not shocking, I guess. But on the same side, the magnitude of strength was better than I think we expected. And so looking ahead, what in your experience, cyclically, when do you see that sort of slow down if the economy does take a step down?
Julie Sweet: Look, it’s never say never I guess the economy slowing down and what we do it, but I really stay focused. We try to stay focused on our strategy being relevant across cycles, so – and basically growing stronger than the market. And so the market is still faster than market, it’s still kind of hovering around 5%. And so that’s what we kind of watch more than the economy because technology is so core to every strategy that when the economy goes down, what are you seeing, well, people are saying, we got to optimize. We have got a lower cost. We have got to do managed services. So, we watch more – the economy can kind of do an uplift, right. But what we are trying to always do is grow faster than the market. So, that’s the big indicator for us. And you see it’s a very strong market. And it makes sense. I mean I will just tell you like the amount of the just technical debt across these industries and how much work to do, we are still very much in early innings of what needs to be done to take advantage of cool things like generative AI. You got to have data.
Darrin Peller: Yes. Awesome. Alright. Thanks Julie. Thanks KC.
KC McClure: Thank you. Operator, we have time for one more question and then Julie will wrap up the call.
Operator: Thank you. And that last question comes from the line of Bryan Bergin with TD Cowen. Please go ahead.
Bryan Bergin: Hi guys. Good morning. Thank you. I wanted to ask on consolidation activity. And whether – how much of this has helped to really offset some of the areas that have pulled back in the shorter cycle work? And I guess has that picked up meaningfully? And if you were to step back and look at those 35 deals over $100 billion, can you give us a sense of the mix of those that might include an aspect of vendor consolidation?
Julie Sweet: Vendor consolidation is certainly a part of what’s going on in the market, but there are some industries that did that a long time ago in some clients. So, I am not – I don’t have the numbers off hand of what we have in our 35 clients. But I am not seeing that as sort of the big driver of our growth. Right now, we are often telling clients who like basically need to get revenue faster, but more – it’s interesting, the vendor consolidation for many of our clients is less about cost and more that a lot of the industries, like say, consumer goods, telecom where they have lots of different countries. It’s very hard to move to a platform business and sort of build things consistently if you have a ton of different vendors, right, because you want the stuff done in the same way. And so the – it’s interesting the vendor consolidation play for many is more about how do we actually implement a strategy of kind of moving to global platforms being able to have a single approach to data, super hard to do if you have got 50 vendors to 100 vendors. So, I would just say it’s tied to exactly the kind of strategies that we are advising clients on, but no big theme for us.
Bryan Bergin: Okay. And then just a quick follow-up, with the record bookings in managed services, any near-term margin impacts we should consider as you ramp up and invest in those? Any considerations on adjusted operating margin cadence as you go through the second half?
KC McClure: Yes. No, there is nothing unusual.
Bryan Bergin: Alright. Thank you.
Julie Sweet: Thank you. So, in closing, I want to thank all of our shareholders for your continued trust and support in all our people for what you are doing for our clients and for each other every day. Thanks everyone for joining.
Operator: And ladies and gentlemen, today’s conference will be available for replay after 10:00 a.m. Eastern today through June 22nd. You may access the AT&T replay system at any time by dialing 1-866-207-1041 and entering the access code 4319130. International participants may dial 402-970-0847 and those numbers again are 1-866-207-1041 and 402-970-0847 and entering the access code 4319130. That does conclude your conference for today. Thank you for your participation and for using AT&T conferencing service. You may now disconnect. | [
{
"speaker": "Operator",
"text": "And ladies and gentlemen, thank you for standing by and welcome to the Accenture’s Second Quarter Fiscal 2023 Earnings Call. [Operator Instructions] As a reminder, today’s conference is being recorded. I would now like to turn the conference over to Katie O’Conor, Managing Director and Head of Investor Relations. Please go ahead."
},
{
"speaker": "Katie O’Conor",
"text": "Thank you, operator and thanks everyone for joining us today on our second quarter fiscal 2023 earnings announcement. As the operator just mentioned, I am Katie O’Conor, Managing Director, Head of Investor Relations. On today’s call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you have had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today’s call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the third quarter and full fiscal year 2023. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we will discuss on this call, including our business outlook, are forward-looking and as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today’s news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Katie and thank you to everyone joining today and thank you to our 738,000 people around the globe for your incredible work and commitment to our clients, which has resulted in our delivering another strong quarter of financial results and the broader 360-degree value we continue to create for all our stakeholders. Let me share a few highlights of value we created in our continued disciplined execution. I am very pleased with our record bookings for Q2 at $22.1 billion, our highest ever including 35 clients with quarterly bookings greater than $100 million, our second highest quarter on record for such bookings, representing the continued trust that our clients have in us. We delivered revenues of $15.8 billion, representing 9% growth in local currency, bringing us to $31.6 billion of revenue at 12% growth through H1 and we continued gaining market share, growing approximately 2x the market. We continued our inorganic investments with six acquisitions in strategic areas, including cloud with the acquisition of SKS in Europe, which will expand our specialized technology consulting and regulatory capabilities, enabling us to better serve our financial services clients; security with the acquisition of Morphus in Brazil, a cyber defense risk management, cyber threat intelligence service provider; and supply chain with the acquisition of Inspirage in the U.S., which will enhance our technology capabilities to accelerate innovation for clients through emerging technologies such as touchless supply chain and digital twins. We also continued our investment in our people with 10.3 million training hours, a 12% increase year-over-year. We are optimizing our business to lower costs in fiscal year 2024 and beyond, while continuing to invest in our business and our people to capture the significant growth opportunities ahead. KC will be giving you more detail on these actions. Finally, we believe our focus on creating 360-degree value differentiates us in our market. We earned the number one position in our industry for the 10th year in a row and number 32 overall on Fortune’s list of the World’s Most Admired Companies. We ranked number one in our industry and number four overall on the JUST Capital list of America’s Most JUST Companies. And we have been recognized by Ethisphere as one of the world’s most ethical companies for the 16th year in a row. I am very pleased that our results demonstrate once again that our strategy to be the execution partner of choice for transformation, lead in the five forces and have a diverse business across markets, industries and services continues to allow us to lead and take market share. And in a world in which all strategies lead to technology, we have distinguished ourselves in our impact to the market. Over to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie and thanks to all of you for taking the time to join us on today’s call. We were pleased with our overall results in the second quarter, setting a new bookings record at $22.1 billion, $2.5 billion higher than our previous record set in Q2 of last year, with consulting bookings close to matching our previous record. We delivered revenue growth for the quarter at the top end of our guided range as we continue to deliver on our shareholder value propositions. Before I summarize results for the quarter, let me spend a moment on the business optimization actions we are taking to reduce costs for fiscal ‘24 and beyond, which includes streamlining operations, transforming our non-billable corporate functions and consolidating office space. We estimate cost of $1.5 billion through fiscal year 2024, of which we expect to incur approximately $800 million in FY ‘23 and $700 million in FY ‘24, comprised of approximately $1.2 billion in severance and $300 million for the consolidation of office space. These actions are expected to impact roughly 2.5% or 19,000 of our current workforce, of which over half are non-billable corporate functions and include over 800 of our more than 10,000 leaders across our markets and services. Nearly half of the 19,000 people will depart by the end of fiscal year ‘23. Now, let me summarize a few of the highlights for the quarter. Revenues grew 9% local currency, driven by broad-based growth across all markets with more than half of our 13 industries growing double-digits. We also continue to extend our leadership position with growth estimated to be about 2x the market, which refers to our basket of publicly traded companies. In Q2, we recorded $244 million in cost associated with the business optimization actions, which impacted operating margin by 150 basis points and EPS by $0.30. The following comparisons exclude these impacts and reflect adjusted results. We delivered adjusted EPS in the quarter of $2.69, reflecting 6% growth over EPS last year. Adjusted operating margin of 13.8% increased 10 basis points, with 20 basis points expansion year-to-date and includes continued significant investments in our people and our business. Finally, we delivered free cash flow of $2.2 billion and returned $1.8 billion to shareholders through repurchases and dividends. Year-to-date, we have invested $1.1 billion in acquisitions, primarily attributed to 15 transactions. With those high level comments, let me turn to some of the details, starting with new bookings. New bookings were a record at $22.1 billion for the quarter, representing growth of 17% in local currency with an overall book-to-bill of 1.4. Consulting bookings were $10.7 billion with a book-to-bill of 1.3. Managed service bookings were also a record at $11.4 billion with a book-to-bill of 1.5. We were very pleased with the strength of our new bookings, which were broad-based, delivering a very strong book-to-bill across all of our geographic markets and across our services with a book-to-bill of 1.5 in operations, 1.4 in technology and 1.3 in strategy and consulting. Turning now to revenues. Revenues for the quarter were $15.8 billion, a 5% increase in U.S. dollars and 9% in local currency and were at the top end of our range, adjusting for a foreign exchange headwind of approximately 4% compared to the 5% provided last quarter. Consulting revenues for the quarter were $8.3 billion, a decline of 1% in U.S. dollars and an increase of 4% in local currency. Managed services revenue were $7.5 billion, up 12% in U.S. dollars and 16% in local currency. Taking a closer look at our service dimensions, technology services and operations grew double-digits and strategy and consulting declined mid single-digits. Turning to our geographic markets. In North America, revenue growth was 5% in local currency, driven by growth in public service, health and utilities. These increases were partially offset by a decline in communications and media and high tech. Revenue growth was driven by the United States. In Europe, revenues grew 12% in local currency, led by growth in industrial, banking and capital markets and public service. Revenue growth was driven by Germany, Italy and France. In Growth Markets, we delivered 14% revenue growth in local currency, driven by growth in banking and capital markets, chemical and natural resources and public service. Revenue growth was led by Japan. Moving down the income statement. Gross margin for the quarter was 30.6% compared with 30.1% for the same period last year. Sales and marketing expense for the quarter was 9.9% compared to 9.4% for the second quarter last year. General and administrative expense was 6.8% compared to 7% for the same quarter last year. Adjusted operating income was $2.2 billion in the second quarter, reflecting an adjusted 13.8% operating margin, an increase of 10 basis points from operating margin in the second quarter of last year. Our effective tax rate for the quarter was 20.4% compared with an effective tax rate of 19.2% for the second quarter last year. Adjusted diluted earnings per share were $2.69 compared with diluted EPS of $2.54 in the second quarter last year. Days service outstanding were 42 days compared to 48 days last quarter and 41 days in the second quarter of last year. Free cash flow for the quarter was $2.2 billion compared to approximately $400 million last quarter, resulting from cash generated by operating activities of $2.3 billion, net of property and equipment additions of $108 million. Our cash balance of – at February 28 was $6.2 billion compared with $7.9 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the second quarter, we repurchased or redeemed 4.1 million shares for $1.1 billion at an average price of $273.55 per share. As of February 28, we had approximately $4.2 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $1.12 per share for a total of $708 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.12 per share to be paid on May 15, a 15% increase over last year. Finally, turning to the 360-degree value we are creating for all our stakeholders, we are partnering with Save the Children to connect with new audiences and invigorate donors through fundraising and creative campaign excellence. So at the halfway point of fiscal ‘23, we are pleased with our results. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. I will start with the overall demand environment, which is more of the same. We believe that the ongoing volatility and uncertainty in the macro environment is making it even clearer to clients that they need to change more, not less. And that two of the five key forces of change that we have identified for the next decade, the need for total enterprise reinvention and the ability to access, create and unlock the potential of talent are critical to succeed in the near, medium and long-term. We see two common themes. First, all strategies continue to lead to technology, particularly cloud, data, AI and security. This is reflected in the latest market estimates, which are down slightly, but are still hovering around 5%. And second, companies remain focused on executing compressed transformations to achieve lower cost, stronger growth, more agility and greater resilience faster. We remain laser focused on pivoting to our clients’ changing needs and being relevant across the enterprise from the frontline to core operations to corporate functions. Our ability to advise, shape and deliver value-led transformations, leveraging the breadth of our services from strategy and consulting to our strategic managed services across all industries and geographic markets is what differentiates Accenture. Now, I will give you more color on the quarter and in particular, how total enterprise reinvention and talent are critical to our clients. For example, we are helping Shionogi & Co. Limited, a Japanese pharmaceutical company with a compressed transformation to improve its business process efficiency and create a more agile organization. We will enter into a joint venture with the company that will provide managed services capability to oversee back office functions such as human resources, finance and accounting, public relations, facility management, procurement and marketing. The joint venture will also be charged with the management of the pharmacovigilance function from safety management operations to post-marketing operations to regulatory compliance. As part of this transformation, we will upscale over 400 employees, enabling them to play a greater role in the growth and development of the wider business, hence demonstrating the value of all our services from strategy and consulting, our deep industry knowledge to technology and operations coming together to enable the clients transformation. I would like to take a moment to recognize Egawa-san, our Head of the Japan market unit and our extraordinary people in Japan for how they are consistently creating value for our clients with double-digit revenue growth for each of the past 5 years. As clients focus on building their digital core with a modern cloud-based infrastructure, our cloud business continues to grow very strong double-digits. For example, we are working with the state of Missouri to replace its legacy applications and infrastructure with a modern ERP in the cloud, introducing new capabilities in finance, supply chain management, human capital management, payroll and budgeting. As the current ERP system no longer fully meets the business needs of the state, they are looking for a modern system that is efficient, scalable and flexible, all delivered by a best-in-class implementation partner. This compressed transformation, one of the earliest and most complex ERP implementations for any state will help reduce operating expenses, provide opportunities for upskilling and improve customer experience and services. We are partnering with minority and women-owned businesses on this transformation and we will bring in apprentices, the program’s lifecycle part of our shared commitment with the state of Missouri to foster diversity and inclusion. With our cloud-first strategy, our approach has been to help clients migrate to the cloud and then partner with them on their journey to grow and innovate in the cloud. Our cloud growth is driven by both migration and clients who are moving forward on this journey, such as Enel, one of our largest utilities clients who has taken their mass migration to cloud a few years ago to the next level, changing their operating model, tools and talent and largely automating IT operations. We are now helping them accelerate the modernization of their application landscape, reduce greenhouse gas emissions by up to 80%, support a significant acquisition and divestment agenda and pivot to platform-based business model for integrated retail delivery beyond meter services, grid and renewable energy. Using cloud as their operating systems is helping this market leader manage increasing levels of complexity by bringing together data, AI and applications to optimize their operations and accelerate growth. A strong and secure digital core also is essential to total enterprise reinvention. We are seeing continued very strong demand for our security services, which experienced another quarter of very strong double-digit growth. We are working with Empresas CMPC SA, a Chilean pulp and paper company and a cybersecurity transformation of their plant operations. We will implement a security program across its 48 industrial sites focused on threat detection, management and response as well as governance and workforce training. Through our global and local Industry X capabilities, we will help strengthen the company’s cybersecurity expenses through continuous monitoring of its physical locations and equipment. We continue to lead in managed services, which experienced strong growth again this quarter at 16%. Managed services are strategic for our clients, because they enable clients to move faster, leveraging our digital platform expertise and talent as well as delivering cost efficiencies. And our clients are turning to Accenture because of the depth and breadth of our industry, functional and technology expertise that we bring together into the transformation journey. Our approach to managed services is to both run and transform and run and modernize. We deliver cost savings as table stakes. For example, we are partnering with the UK’s Department for Work and Pensions, which is responsible for welfare pensions and child maintenance policy to modernize its legacy systems, eliminating backlogs and delivering a better experience for citizens and employees. We developed a cloud-based intelligent optimization platform that combines robotic process automation, AI, analytics and machine learning to provide bots as a service to create the equivalent of a virtual workforce available 24/7. With routine tests now automated, the organization has already saved 2.4 million human hours, which can be reallocated to more complex higher value tasks. Let me pause to thank our global H&PS colleagues for their amazing contributions as evidenced by 14 consecutive quarters of double-digit growth. As our clients continue to prioritize cost optimization as well as growth in Vigilance, Song is more relevant than ever. In Song, which grew strong double-digits this quarter, clients are focused on more capital efficient growth that creates efficiency, drive short-term growth and optimizes existing assets with clear outcomes and shorter time horizons to keep up with the pace of change with customers and technology. We have moved quickly to help clients seize new opportunities in contact centers, not only for enhanced customer service, but also customer acquisition and growth. We are working with a global biopharmaceutical leader in North America to reinvent digital marketing at scale. Driven by data and using technologies integrated with SynOps, the company will be able to create, produce and deliver consistent world class content that informs and educates healthcare providers and patient communities around the world, helping to deliver innovative health services. We are working with the Prada Group, the Italian luxury fashion player, to offer its customers an entirely new customization experience through an online 3D configurator. Accenture Song created a digital twin of Prada’s iconic show called America’s Cup, which allows shoppers to fully customize it from material to color to trim across the overlay, lining, sole and other parts. With more than 50 million possible configurations, more than any web platform could handle, this innovative approach allows customers to see high resolution 3D models of their custom builds with the same quality and fidelity as a physical shoe. Song solution to online product customization is fully scalable to the cloud. It gives Prada the flexibility to apply the same strategy to other products, ensuring the outstanding experience that their shoppers expect. As I continue to move across the enterprise, industries and markets, I want to also highlight Industry X, which grew very strong double digits again this quarter, and which we believe is the next digital frontier where our digital engineering capabilities are advancing sustainability services. For example, we are working with Recharge Industries, a battery research and production company in Australia, to help design and engineer one of the world’s largest lithium-ion battery facilities. Once built, the facility will generate up to 30-gigawatt hours of storage capacity per year. Finally, moving to the metaverse and the ongoing tech revolution. We’ve talked about the importance of artificial intelligence in building the digital core for our clients. While generative AI has recently burst into the popular imagination, at Accenture, we’ve been working with the technology from its earliest stages and are already applying it at clients. For example, we’re working with a multinational bank to transform how it manages high volumes of post-trade processing e-mails every day. We are leveraging a generative AI solution as it is built to understand the context of e-mails with high accuracy. It automatically routes large numbers of e-mails, daily to relevant teams and draft responses with recommended actions and related information. Our work will help reduce manual effort and risk, boost worker efficiency and improve interactions with customers. And finally, on that note, we will release our Tech Vision 2023 on March 30. The 4th and 5th key forces of change we have identified for the next decade at a metaverse and ongoing tech revolution. And this year’s tech vision is particularly relevant and actionable as our clients face a rapidly changing landscape in which generative AI, metaverse cloud, science, tech and other technologies are driving more opportunities for change and reinvention. This year’s vision will explore how these technologies and more are blending the physical world and the virtual world into a shared reality, creating a huge opportunity for our clients and for Accenture. Now turning to our business outlook. For the third quarter of fiscal ‘23, we expect revenues to be in the range of $16.1 billion to $16.7 billion. This assumes the impact of FX will be about negative 3.5% compared to the third quarter of fiscal ‘22 and reflects an estimated 3% to 7% growth in local currency. For the full fiscal year ‘23, based upon how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately negative 4.5% compared to fiscal ‘22. For the full fiscal ‘23, we now expect our revenue to be in the range of 8% to 10% growth in local currency over fiscal ‘22, which assumes an inorganic contribution of 2%. We expect business optimization actions to impact fiscal ‘23 GAAP operating margin by 120 basis points and EPS by $0.96. We expect our anticipated gain on our investment in Duck Creek Technologies to impact EPS by $0.39. Our guidance for full year fiscal ‘23 excludes these impacts. For adjusted operating margin, we expect fiscal year ‘23 to be 15.3% to 15.5%, a 10 to 30 basis point expansion over fiscal ‘22 results. We expect our adjusted annual effective tax rate to be in the range of 23% to 25%. This compares to an effective tax rate of 24% in fiscal ‘22. We expect our full year adjusted earnings per share for fiscal ‘23 to be in the range of $11.41 to $11.63, or 7% to 9% growth over fiscal ‘22 results. For the full fiscal ‘23, we now expect operating cash flow to be in the range of $8.7 billion to $9.2 billion, property and equipment additions to be approximately $700 million and free cash flow to be in the range of $8 billion to $8.5 billion, $300 million higher than our previous guidance. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.1. Finally, we continue to expect to return at least $7.1 billion through dividends and share repurchases as we remain committed to returning a substantial portion of cash to our shareholders. With that, let’s open it up so we can take your questions. Katie?"
},
{
"speaker": "Katie O’Conor",
"text": "Thanks, KC. [Operator Instructions] Operator, would you please provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Tien-Tsin Huang with JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Hi, thanks so much. I had to ask, given the great bookings here, your confidence in being able to replenish those bookings as we look to the third quarter and ahead? I’m sure a lot of people are thinking what’s going on in the month of February and March as well. I know your guidance implies some reacceleration in the fourth quarter, but just curious about your ability to replenish on the bookings side? Thanks."
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks, Tien-Tsin. So we do feel good about our pipeline even after our record bookings this quarter. And our sales outlook for the next quarter, Q3 is solid. We expect to have slightly lighter bookings than what we’ve had compared to the record quarter that we just had."
},
{
"speaker": "Julie Sweet",
"text": "And maybe just to add a little color. Look, as you can see in our bookings, there is just continued strong demand for the larger transformational deals, right? And the need to, in particular, build the digital core. And I’m personally working right now with clients across insurance, healthcare, consumer goods, banking and telecom, all of whom are very focused on how do we upgrade our – get rid of our technical debt, how do we build more resilience. They are trying to build digital products, but they have got really old systems. And so we remain in the early innings of building the kind of digital core that really need to transform every part of the enterprise. And so we continue to feel good, not just about our pipeline, but about the demand we’re seeing really rooted in our view that all companies are going to have to do total enterprise reinvention across the enterprise that it’s really a continuous cycle starting with a digital – a strong digital core. And there is a lot of work to do on building those cores out."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Good. Glad to hear. Very encouraging. So given that, given both your comments and the optimization, I’m just trying to think about is it more playing offense versus defense? So I’m just trying to think about – I know a lot of your clients are going through similar optimization efforts as well. How does this one fit given that? And should we still think about this within the 10 to 30 basis points of typical margin expansion that we think about sort of philosophically? Or could this be incremental?"
},
{
"speaker": "KC McClure",
"text": "Yes. So just let me answer the last part first, is you should view this as creating the room in our P&L to ensure that we can continue to deliver on that enduring shareholder value model, including the 10 to 30 basis points, which for a short period of time will be on an adjusted basis. So – and as you think about it, it is – I like that, is it offense or defense. It is offensive. I mean if you look at where we are today, right, we’ve got record bookings, a strong quarter of – strong view of the year, 8% to 10%, 91% chargeability. We’re going after structural cost, right, to ensure that we’re in a better position. As you know, we’ve been dealing with the difficult challenges of compounding wage inflation. And we’ve been doing that with pricing, but we’ve also been doing that with cost efficiencies and digitizing. And we have identified an opportunity to go after more structural costs to kind of create that resilience and that room in the P&L as we look forward. So very much in our view, getting ahead of and dealing with these structural issues that have been created over the last couple of years."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Awesome. That’s great. Great results then. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of James Faucette with Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Great. Thank you very much. Wanted to follow-up on a couple of those items. First, can you talk a little bit about what you’re seeing around the actual conversion and decision cycles? Obviously, the bookings themselves speak well to being able to do conversions, but are we seeing any changes in the sales cycle times or the types of projects that customers may want to engage in?"
},
{
"speaker": "Julie Sweet",
"text": "Well, let me just start with the type of projects. I mean what we’ve been seeing over the last several quarters is just a laser focus on cost, right? So most programs, clients want to see a shorter return on investments, right, more focused on cost. They love cost and growth, but it has to be, in most cases, a shorter return on the investment. At the same time, it’s important that not all industries are in the same place, right? So if you’ve got industries like, say, in the high-tech area, and some spots on retail, for example, cost optimization is very dominant, right? If you have – you’ve got some of the other less affected industries, say, insurance, energy, it’s – everyone wants to be more resilient and lower cost. But they are really trying to deal with their technical debt, they are thinking about growth, how do you reimagine the customer experience. And so I would say a common theme is that in this kind of an environment, everyone does want to be optimizing costs, but where they are focusing is different by industry is what I would say first. And then just to your first part of your question about are you seeing changes in decision making and I’d let KC talk to you about the yields in our pipeline because you all saw, in general, seeing a trend toward these larger deals. So there is – and we talked about this in the last couple of quarters, we’re seeing less of the smaller deals in SMC and to some extent, SI, particularly in North America, where we’re seeing more caution. North America had record sales this quarter. But in areas tending towards the bigger transformational deals, not the smaller SNC and to some extent, SI deals. And those – that transformational pipeline, which is our strategy, right, like if you think about it, what have we been trying to drive for the last few years? We want to be at the center of our clients’ business, we want to be able to be relevant, really help them transform and then be well positioned to continue to be that partner. And I would just say, Enel in my script, is a great example of that. I mean they are hugely innovative utility. They were very early in cloud. We help them get to the cloud. And now they are modernizing and once again being super innovative. That’s exactly the way we want to work with our clients, be their core and then be there for their next big transformation. Maybe, KC, if you want to just comment on the yields real quick."
},
{
"speaker": "KC McClure",
"text": "Yes, sure. No problem. So when we – let me focus really on consulting bookings because it is important to understand the impact of F&C and our consulting bookings and also how to what we’re doing in our larger transformation deals because they do convert to revenue at a slower pace. So as I mentioned in my script, I was very pleased with our SNC bookings and our overall consulting bookings, which were very close to the record that we had last year. And SNC participates, and is a critical part of winning the larger deals, which we have 35 clients over $100 million. And so what you’ll see is in SNC, you may see a conversion that’s a little bit slower than we typically have because we still do have some pressure in our smaller deals, particularly in North America. And so maybe I’ll just – how does that all work in terms of yield then? What that means for next quarter? As we look at SNC, I mentioned that we had a modest decline, a decline in mid-single digits this quarter. We think we will be in the same zone overall in Q3, and we’re going to look to reconnect with SNC growth in Q4. It may take us a little bit more time than that. But I just want to make that connection to your question as it relates to our very strong consulting bookings in SNC. They were definitely part of that discussion and clearly part of that the reason why we are able to get the 35 clients in a $100 million, but you will see that come into our P&L at a little bit slower conversion."
},
{
"speaker": "James Faucette",
"text": "Thank you. That’s really helpful. And then just quickly, on D&A, it seems like we’ve seen a little bit of a deceleration there. How are you thinking about D&A going forward? And what was inorganic contribution in the quarter and how should we think about that for the year? Thanks."
},
{
"speaker": "KC McClure",
"text": "So I’ll just maybe reiterate the contribution for the year. So we now see inorganic contribution to be about 2%. And acquisitions can be lumpy. And we – as you know, we can’t always really control the timing, but there is no change to our strategy. In any given year, you’ll hear us kind of go up or down a bit on the percentage of contribution. No change."
},
{
"speaker": "James Faucette",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Bryan Keane with Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hi, guys. Good morning. Wanted to just ask about…"
},
{
"speaker": "Julie Sweet",
"text": "Good morning."
},
{
"speaker": "Bryan Keane",
"text": "Good morning. I just wanted to ask about the communications, media and technology group that did come in at flat local currency and is kind of a standout versus the others. Can you just talk a little bit about what’s happening there and what the outlook might be?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. That’s primarily happening in North America where we’ve got comms and media and high-tech are more challenged, cutting back spending for sort of obvious reasons. And then our software and platforms business, which has been really a strong business for us for the last few years has – it’s still slightly positive, but has come down a lot, and I think for kind of obvious reasons that we’re all reading in the press. And so we do think this will last for a bit of time as you look at sort of some of the ways they are approaching spending in that. And – but it will eventually come back, and these are great companies. And we’re helping them in many places, but their spending is just lower right now. So that’s – I think long-term, we’re very positive. These are all great companies. And this why it’s so great that we’re diverse, right, that we serve so many and not just diversity in industries but in markets because you’re seeing a different picture, for example, in comms and media in Europe, where it was growing double digits last quarter in growth markets where it was positive. So the diversity of our business really plays to our strength and why we’re continuing to deliver strong financial results."
},
{
"speaker": "Bryan Keane",
"text": "Got it. Got it. And I was just trying to reconcile in my head the strong bookings, but the actions also taken to lower costs in fiscal year ‘24. What does that signal, I guess, for the demand environment in fiscal year ‘24? Should we expect slightly lower growth rates than typical as a result of the actions taken?"
},
{
"speaker": "Julie Sweet",
"text": "No. I mean the actions, I can just kind of reground you on like what we’ve been saying, right, which is we’ve been achieving hypergrowth and there is been wage inflation like none of us have ever experienced and it’s compounding. And we’ve been addressing that through a combination of improved pricing, cost efficiencies, and so this is really us taking a step back and being able to more structurally address the impact of compounding wage inflation. So it’s a real positive for how we’re moving forward. And think of it as really being – creating more room in the P&L so that when you think about our enduring shareholder value proposition is we still expect next year to grow faster than the market. We expect to invest at scale in our business, to deliver 10 to 30 basis point margin expansion on an adjusted basis, to have a disciplined capital allocation, including a meaningful return to our shareholders. So that is a commitment – this is an offensive mood to say, yes, today, we’ve got great demand, we’ve got great utilization, and we can take out more structural costs to put us in a better position as we move forward."
},
{
"speaker": "Bryan Keane",
"text": "Okay. Great. That’s really helpful. Congrats."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Lisa Ellis with MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "Terrific. Thanks for taking my question. Maybe just a kind of follow-up on the sort of connecting the dots questions. I noticed that your headcount growth slowed a bit this quarter, up 6% year-on-year and was flat sequentially. Can you kind of connect the dots that side, what you are seeing and sort of what you’re thinking about on the hiring side with the fact that you have record bookings in the quarter and then typically, those two things kind of move a little bit more in tandem? Thank you."
},
{
"speaker": "KC McClure",
"text": "Yes, sure. Thanks, Lisa. So maybe I’ll just first start with just looking back over the last two previous quarters. We added 28,000 people in the previous quarters. So let’s first start there. And you’re right, Lisa, when you take a look at what we were able to accomplish this quarter, first of all, we had record bookings. We drove 9% – 9.3% revenue growth, and we had 91% utilization of our people, right? So we have the skills and all the people we needed to deliver to the demand in the market. And if I look – answering your question, looking forward, we sequentially did not add headcount from Q1 to Q2. We see that being about the same in Q2 to Q3. And then looking forward, based on the outlook that we have now, we do see that we would add additional heads in the fourth quarter."
},
{
"speaker": "Lisa Ellis",
"text": "Okay. Great. And then my follow-up is related to AI. Maybe this one is, Julie, for you. Just can you talk a bit about how you apply AI in your own operations? I know every time this topic kind of stirs up, there is this question of whether it’s a positive or a negative for the operations of IT services firms. Can you just talk about how you sort of applied internally and how you think about that over the long-term? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure. In fact, I was just at a client this week where we are helping them really transform their whole IT department. And one of the things they want from us is our myWizard platform, which is a great way of explaining how over the last several years, we have built a platform that integrates the best-in-class technology. So, we didn’t write our own code, right. We use the best technologies. And the way it uses AI, for example, is that when a ticket comes in to address something, an IT issue, AI looks at it, identifies whether or not it’s been a problem solved before, in some cases, can solve the problem, in other cases, routes it to the right people. And then it learns from every ticket. So, in the past, when we have talked about – with you about why is it – how do you think about revenue and people, we said, look, we have already been breaking that for years now because we are using so much technology and AI in how we are delivering all of our technology jobs. The same thing is true, for example, with testing, which is incredibly automated, using different technology, including AI. We are continuing to use AI in the way we run our business, for example, in how we look at our accounts payable and receivables and finding ways where we can optimate to have better efficiencies there. We are using it today in the way we are delivering our consulting services as well and definitely very much so in how we look at sales and being able to predict based on lots of factors. Should we be running after the sale or not, or can we show the data that these – this is not the right kind of sale, we are not the right fit. So, we have increasingly been using AI, both in how we deliver services as well as in how we run ourselves. Of course, our SynOps platform for operations is also AI-enabled. It’s one of the reasons why clients turn to us because it’s helping them digitize faster. They are not having to build these things. So, long-term, we see these technology changes, things like generative AI is playing to our strengths because to use these technologies, it requires deep understanding of the industry, the use cases, the process changes. When people talk about the new kinds of generative AI, which we are super excited about, being like a co-pilot to human beings, the entire process has to be changed in order to make that work. You have got to up-skill the people and you have to be able to do all of that in a very responsible way. So, we are already working with. There has been a lot of demand to understand this. And in understanding it, understanding actually how hard it is to be able to implement at scale in an enterprise versus, I am assuming you are – we are all having fun playing with it, but how you build that into an enterprise is very different and a great opportunity, and we are partnering with all the major players to help them take the technology go from technology to implementation to impact."
},
{
"speaker": "Lisa Ellis",
"text": "Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thanks Lisa."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of David Togut with Evercore ISI. Please go ahead."
},
{
"speaker": "David Togut",
"text": "Thank you. Good morning. Could you delve into demand trends in the financial services vertical in a little greater depth, especially given the evolving banking crisis we have seen in the last month or so, particularly with some of the regional banks struggling? And maybe as part of that, if you could just remind us of your profile within bank-related IT services, smaller banks versus regionals and money centers."
},
{
"speaker": "Julie Sweet",
"text": "Sure. As a client base, we skew towards the larger banks across all of the markets. So, we don’t comment on individual clients, but we don’t have any big exposure to kind of the smaller regional banks and in general. So, as you sort of think about the stepping brake, obviously, the developments on the banks for the – are still early in the last couple of weeks. So, as I talk about demand trends for our clients, which are generally the bigger banks, a couple of things really stand out. So, first of all, there is a lot of focus on their technical debt, because the banks, a lot of them are still in the mainframe. Our mainframe practice really across industry has growing like gangbusters right now as clients across the industry are really having to take on some of that harder technical debt, which they need to do because the more and more they digitize their services, which is a continuing trend in financial services, if the systems behind it aren’t agile, then it can take a lot of time to introduce new services. You have got to – oftentimes, we will have multiple systems. You will have to test things. You can’t go as fast. And so the banks are kind of reaching their limits in terms of what they can do without touching their core. So, we expect the sort of addressing the core to be a really important driver. We are seeing, in asset management, more and more views – more and more companies in asset management, really digitizing. They had been kind of slower behind the banks. And then insurance, we are working with leading insurers across the world who not only are kind of trying to catch up because banking was ahead of insurance, but finding sort of new and exciting opportunities on how to use data, in particular, to grow their business, how to transform their experience and claims. So, financial services which covers banking, capital markets and insurance, we continue to see as a vibrant area. Where things are slowing down a bit in the U.S. where we have been a big player is in integration. We will see that might pick up again. Let’s just see how all of this shakes out. But that has slowed down for a bit. Hopefully, that gives you some color."
},
{
"speaker": "David Togut",
"text": "It does. Thanks so much."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Jason Kupferberg with Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"text": "Good morning. Thanks guys. I just wanted to ask about Q3 bookings. If you can discuss consulting versus managed services, just expectations there? I mean I think the year-over-year comparison for consulting at least gets a bit easier."
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks Jason. I am not going to comment specifically on kind of individual breakout of the bookings. But maybe I will just reiterate what I mentioned to Tien-Tsin. So, we had record bookings this quarter. We do see that next quarter. We will have lighter bookings than what we had this quarter in terms of the record bookings. Overall, what you can see, Jason, you know us well, is that the mix right now is much more favored halfway through the year to managed services, all the reasons that Julie talked about. We were really pleased with consulting this quarter that did – we thought it was going to be strong, and it came in even stronger. And so that, we are very encouraged by that, and we do have a strong pipeline, and we continue to see solid bookings for Q3."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay. Understood. And then just on the cost side, what’s the estimated savings from the cost takeout program? And I know the charges will aggregate to $1.5 billion, but I just wanted to understand kind of what the fully annualized run rate of savings is? And are you essentially reinvesting the savings? I mean I know at least for this year, we are not changing the underlying margin guidance. So, just wanted to get a picture of how much of this is being reinvested, or are you essentially just offsetting some other headwinds around wage inflation, etcetera?"
},
{
"speaker": "KC McClure",
"text": "Thanks for the question. Let me just first start with FY ‘23. So, the actions that we are taking are not about FY ‘23. They are about FY ‘24 and beyond. So, in terms of what we will do with those savings, it really is going to depend, Jason, on how the market develops, the growth opportunities that we have next year. And as Julie said, the key part of what we are really focused on is just going to give us more room to continue to execute our enduring shareholder value proposition, what she mentioned. And I know you know that."
},
{
"speaker": "Jason Kupferberg",
"text": "Yes. Alright. So, just…"
},
{
"speaker": "Julie Sweet",
"text": "Keep your model – to be clear, keep your model 10 basis point to 30 basis point adjusted margin expansion. We are going to invest in our business and we are going to grow faster than the market."
},
{
"speaker": "Jason Kupferberg",
"text": "We love the consistency. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "And our next question comes from the line of Darrin Peller with Wolfe Research. Please go ahead."
},
{
"speaker": "Darrin Peller",
"text": "Hey. Thanks guys. I mean when you put the pieces together with the bookings we are seeing and the actual changes in the efficiency, it really does sound like we are finally seeing more of a divergence in linearity between headcount growth and bookings capabilities and revenue contribution. So, I mean I know you mentioned AI, obviously, is a big theme. But is there other factors that we can point to that are structurally part of the model now, or is it a function of the mix type of bookings or anything else?"
},
{
"speaker": "KC McClure",
"text": "Yes. Maybe I will just talk a little bit about what you are seeing in terms of headcount, Darrin, and what we are recording in revenue in terms of how we are generating our revenue. And Julie, if you want to add in, you certainly can. But in terms of what you are seeing is we have been very focused on hiring, balancing our supply, demand to what we need to both sell and drive the revenue to meet our client demand and continue to take market share. And part of what you are seeing throughout the year is we have been continuing – you have heard us talk about us really focusing on continued strong pricing. Again, reminder, that when we talk about pricing, it’s the margin on the work that we sold. And that has been improving over the last five quarters. It’s not stable, which we are really happy with. And so some of that is part – there is a part of that that’s helping to drive our revenue production as well."
},
{
"speaker": "Julie Sweet",
"text": "And I would just say, a lot of its mix, right. If you have longer transformational deals like the numbers of people that you need to drive are different. So, I wouldn’t say there is some big, wait a minute, we have got some new inflection point where you have disconnected more. As I talked about earlier, we have been disconnecting to some degree, for a while now, but there is no big change in that perspective. Just as we have executed our strategy. And I think it’s so important to understand that it has been a deliberate strategy to say we want to do transformational deals. We want to take our SNC people who have deep industry and functional knowledge, put them together with our technology people to do either big implementations, right, that are changing the digital core or transformations that are coupled with managed services and just how that works out. And so while we love when the economy is booming and SNC and the small deals are also booming, the strategy is to be at the core so that we continue – we help them with one big project, we understand their company and met it more. We take them on the next big project, and we are really getting that kind of stickiness in our relationships. And so we will kind of deal with the sort of softness in the smaller deals. But over time, this is exactly what we want to do. And in fact, if you think about this year, consulting – last quarter, we thought consulting this year would be mid-single digits to high-single digits. We now see it as mid-single digits for the year, and we are fine with that, right, because that’s about kind of lower SNC and SI smaller deals. North America in December, we thought it was going to be mid-single to high-single digits. We now see that as the mid-single digits for the year. Again, it’s because sort of the caution that’s impacting the smaller deals, record sales, great large transformational deals, and that’s just going to how it deals with. And that’s why, as KC said before, SNC, we are going to see a very similar performance next quarter probably, and it may take a little bit longer to reconnect with growth. But remember, we don’t look at that as separate. We see SNC as a competitive differentiator for these larger transformational deals, which is our strategy."
},
{
"speaker": "Darrin Peller",
"text": "That actually makes a lot of sense. One follow-up on that and related is the cyclicality of business is it’s not surprising, you would see some of the smaller deals get impacted first by pause or concern among enterprise spending. When we think about the larger transformational side, the pipeline is longer. The sales cycle is longer there. So, having that strong still is probably not – if you do – given how well you guys execute, it’s not shocking, I guess. But on the same side, the magnitude of strength was better than I think we expected. And so looking ahead, what in your experience, cyclically, when do you see that sort of slow down if the economy does take a step down?"
},
{
"speaker": "Julie Sweet",
"text": "Look, it’s never say never I guess the economy slowing down and what we do it, but I really stay focused. We try to stay focused on our strategy being relevant across cycles, so – and basically growing stronger than the market. And so the market is still faster than market, it’s still kind of hovering around 5%. And so that’s what we kind of watch more than the economy because technology is so core to every strategy that when the economy goes down, what are you seeing, well, people are saying, we got to optimize. We have got a lower cost. We have got to do managed services. So, we watch more – the economy can kind of do an uplift, right. But what we are trying to always do is grow faster than the market. So, that’s the big indicator for us. And you see it’s a very strong market. And it makes sense. I mean I will just tell you like the amount of the just technical debt across these industries and how much work to do, we are still very much in early innings of what needs to be done to take advantage of cool things like generative AI. You got to have data."
},
{
"speaker": "Darrin Peller",
"text": "Yes. Awesome. Alright. Thanks Julie. Thanks KC."
},
{
"speaker": "KC McClure",
"text": "Thank you. Operator, we have time for one more question and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Thank you. And that last question comes from the line of Bryan Bergin with TD Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi guys. Good morning. Thank you. I wanted to ask on consolidation activity. And whether – how much of this has helped to really offset some of the areas that have pulled back in the shorter cycle work? And I guess has that picked up meaningfully? And if you were to step back and look at those 35 deals over $100 billion, can you give us a sense of the mix of those that might include an aspect of vendor consolidation?"
},
{
"speaker": "Julie Sweet",
"text": "Vendor consolidation is certainly a part of what’s going on in the market, but there are some industries that did that a long time ago in some clients. So, I am not – I don’t have the numbers off hand of what we have in our 35 clients. But I am not seeing that as sort of the big driver of our growth. Right now, we are often telling clients who like basically need to get revenue faster, but more – it’s interesting, the vendor consolidation for many of our clients is less about cost and more that a lot of the industries, like say, consumer goods, telecom where they have lots of different countries. It’s very hard to move to a platform business and sort of build things consistently if you have a ton of different vendors, right, because you want the stuff done in the same way. And so the – it’s interesting the vendor consolidation play for many is more about how do we actually implement a strategy of kind of moving to global platforms being able to have a single approach to data, super hard to do if you have got 50 vendors to 100 vendors. So, I would just say it’s tied to exactly the kind of strategies that we are advising clients on, but no big theme for us."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And then just a quick follow-up, with the record bookings in managed services, any near-term margin impacts we should consider as you ramp up and invest in those? Any considerations on adjusted operating margin cadence as you go through the second half?"
},
{
"speaker": "KC McClure",
"text": "Yes. No, there is nothing unusual."
},
{
"speaker": "Bryan Bergin",
"text": "Alright. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thank you. So, in closing, I want to thank all of our shareholders for your continued trust and support in all our people for what you are doing for our clients and for each other every day. Thanks everyone for joining."
},
{
"speaker": "Operator",
"text": "And ladies and gentlemen, today’s conference will be available for replay after 10:00 a.m. Eastern today through June 22nd. You may access the AT&T replay system at any time by dialing 1-866-207-1041 and entering the access code 4319130. International participants may dial 402-970-0847 and those numbers again are 1-866-207-1041 and 402-970-0847 and entering the access code 4319130. That does conclude your conference for today. Thank you for your participation and for using AT&T conferencing service. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 1 | 2,023 | 2022-12-16 10:00:00 | Operator: Thank you for standing by. Welcome to the Accenture's First Quarter Fiscal 2023 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Katie O'Conor. Please go ahead.
Katie O'Conor: Thank you, operator, and thanks, everyone, for joining us today on our first quarter fiscal 2023 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you'll hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the second quarter and full fiscal year 2023. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and, as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie.
Julie Sweet: Thank you to everyone joining us today and especially to our people around the world for their extraordinary work and commitment to our clients, which resulted in delivering another strong quarter of financial results and the broader 360-degree value we continue to create for all our stakeholders, our clients, our people, our shareholders, our partners and our communities. Let me share a few highlights of this 360-degree value and our continued disciplined execution. We delivered strong bookings of $16.2 billion, with 24 clients with quarterly new bookings over $100 million, demonstrating our clients’ continued commitment to transformation and our ability to understand and anticipate our clients' needs, whether for growth, cost optimization or resilience and our ability to deliver compressed transformations. We delivered revenues of $15.7 billion, representing 15% revenue growth in local currency, with double-digit growth in each market. We estimate that we are growing more than 2x the market, while delivering margin expansion of 20 basis points. We continue to invest in our people, with 10.4 million training hours this quarter, representing an average of 15 hours per person, providing learning opportunities and upscaling to enable us to pivot as our clients' needs evolve. We earned the number one position on the Refinitiv Diversity and Inclusion Index for the third time in the past five years and a top score on the Workplace Pride Global Benchmark, recognizing Accenture as the leader in our industry. We believe our unwavering commitment to diversity and inclusion is both the right thing to do and an essential element of our business strategy and strong financial performance. We have reached 97% renewable electricity, closing in on our goal of 100% by the end of 2023. Our own progress in sustainability is important to our ability to lead in helping our clients harness this key force of change and in attracting top talent. Finally, I want to congratulate our more than 1,200 new promotes to Managing Director, 119 new appointments to Senior Managing Director and the more than 90,000 people we promoted around the world in Q1 overall, reflecting our commitment to providing vibrant career paths. Over to you KC.
KC McClure: Thank you, Julie. Happy holidays to all of you, and thanks for taking the time to join us on today's call. We were pleased with our overall results in the first quarter, where we continue to drive growth across markets, services and industries to extend our leadership position in the market. We ran our business with rigor and discipline and expanded operating margin while investing at scale, and we continue to deliver on our shareholder value proposition to both our financial results and by creating 360-degree value for all our stakeholders. Let me begin by summarizing a few key highlights across our three financial imperatives from the quarter. Revenues grew 15% in local currency, reflecting a foreign exchange headwind of about 9.5% compared to the 8.5% provided in our business outlook last quarter. Adjusted for the actual foreign exchange impact in the quarter, we were approximately $150 million above our guided range with double-digit growth across all of our markets and industry groups, with 10 of the 13 industries growing double digits and three high single digits. We continue to take market share with growth estimated to be more than 2x the market, which refers to our basket of publicly traded companies. Operating margin was 16.5% for the quarter, an increase of 20 basis points. We continue to drive margin expansion while making significant investments in our people and our business, including acquisitions. We delivered very strong EPS of $3.08, up 11%, while absorbing a substantial FX headwind. Finally, we delivered free cash flow of $397 million and returned $2.1 billion to shareholders through repurchases and dividends. We also invested $686 million in acquisitions. With those high-level comments, let me turn to some of the details, starting with new bookings. New bookings were $16.2 billion for the quarter with a book-to-bill of one and growth of 6% in local currency. Consulting bookings were $8.1 billion, with a book-to-bill of one. Managed Services bookings, which we formally refer to as Outsourcing, were $8.1 billion with a book-to-bill of 1.1. In addition, we continue to see improved pricing on our new bookings, which refer to contract profitability or margin on the work that we sell. Turning now to revenues. Revenues for the quarter were $15.7 billion, a 5% increase in U.S. dollars and 15% in local currency. Consulting revenues for the quarter were $8.4 billion, up 1% in U.S. dollars and 10% in local currency. Managed Services revenues were $7.3 billion, up 11% in U.S. dollars and 20% local currency. Taking a closer look at our service dimensions, Technology services grew strong double digits, Operations grew double digits and, as expected, Strategy & Consulting grew low single digits. Turning to our geographic markets. In North America, revenue growth was 11% in local currency, driven by double-digit growth in Public Service, consumer Retail and Travel Services, Industrial and Health. In Europe, revenues grew 17% in local currency, led by double-digit growth in Industrial, Banking & Capital Markets and high single-digit growth in Consumer Goods, Retail & Travel Services. Looking closer to the countries, Europe was driven by double-digit growth in Germany, the United Kingdom, Italy and France. In Growth Markets, we delivered 19% revenue growth in local currency, driven by double-digit growth in Banking & Capital Markets, Public Service, and Chemicals & Natural Resources. From a country perspective, gross markets was led by double-digit growth in Japan. Moving down the income statement. Gross margin for the quarter was 32.9%, consistent with the same period last year. Sales and marketing expense for the quarter was 9.8% compared with 9.7% for the first quarter last year. General and administrative expense was 6.6% compared to 6.9% for the same quarter last year. Operating income was $2.6 billion in the first quarter, reflecting a 16.5% operating margin, up 20 basis points compared with Q1 last year. Our effective tax rate for the quarter was 23.3% compared with an effective tax rate of 24.4% for the first quarter last year. Diluted earnings per share were $3.08 compared with diluted EPS of $2.78 in the first quarter last year. Days service outstanding were 48 days compared to 43 days last quarter and 42 days in the first quarter of last year. Free cash flow for the quarter was $397 million, resulting from cash generated by operating activities of $495 million net of property and equipment additions of $99 million. Our cash balance at November 30 was $5.9 billion compared with $7.9 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the first quarter, we repurchased or redeemed 5.2 million shares for $1.4 billion at an average price of $272.3 per share. At November 30, we had approximately $4.9 billion of share repurchase authority remaining. Also in November, we paid a quarterly cash dividend of $1.12 per share for a total of $706 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.12 per share to be paid on February 15, a 15% increase over last year. Finally, turning to the 360-degree value we are creating for all our stakeholders. We are extremely proud to be recognized as one of the seven company all stars on the Wall Street Journal Management Top 250 List for Excellence in customer satisfaction, employee engagement and development, innovation, social responsibility and financial strength, and we also received the top score for social responsibility overall. In summary, we were pleased with our results in the first quarter, and we're off to a strong start for the year. And now let me turn it back to Julie.
Julie Sweet: Thanks, KC. We remain laser-focused on staying close to our clients, advising them how to navigate the macro, providing the right solutions to enable compressed transformations and adjusting to their changing needs. Let me give some further color on what we're seeing in the market and how we see the demand environment shaping up. Over the last quarter, as we can all read, the economic estimates for 2023 continue to decline. While the latest industry estimates for 2023's technology spending continue to show robust growth of 5% or so, we will see how the market evolves as clients finalize 2023 budgets. So what does today's market mean for our clients? We believe that the current macro is making it even clearer to clients that they need to change more, not less, and that two of the five key forces of change that we have identified for the next decade: the need for total enterprise reinvention enabled by tech data and AI; and the ability to access, create and unlock the potential of talent, are critical to succeed in the near, medium and long term. We see this continuing across industries and markets with two common themes. First, all strategies continue to lead to technology, particularly cloud, data, AI and security. And second, companies remain focused on executing compressed transformation to achieve lower costs, stronger growth, more agility and greater resilience faster. What does this mean for Accenture? Our strategy positions us for continued industry leadership because we have a unique set of strengths that our clients need to navigate today and succeed tomorrow. We are able to do so because of our deep strategy and consulting expertise across industries, allowing us to be a trusted adviser during different economic cycles as we bring the expertise, coupled with the real-life practical experience they need. Our ability to help clients achieve total enterprise reinvention through our depth across the enterprise, from the frontline to core operations to corporate functions, as well as our ability to advise our clients shape and deliver value-led transformations, and through our breadth of services, from strategy and consulting to our strategic managed services, which help clients digitize faster, access talent and lower costs. And our global footprint allows us to act at scale and with speed. Together, this positions us as the compressed transformation partner of choice, as you can see, and yet another strong quarter of clients who selected us for work of more than $100 million this quarter. I am pleased to see how quickly we are pivoting to meet the evolving needs of our clients. We have seen a higher level of sales and pipeline coming from cost-focused initiatives, often also including growth or capability enhancements. We are leveraging our breadth of services, deep-client and ecosystem relationships and industry and functional expertise to help our clients and Accenture shift to the highest value opportunities. Our track record of delivery at speed and scale over many years with clients -- remember, 99 of our top 100 clients have been with us for over 10 years, this gives our clients confidence that by partnering with us, they will deliver on their commitments. Investments in our assets and solutions such as myWizard and SynOps, which underlie both strategy and consulting, technology and operations managed services, as well as our delivery of compressed transformation, enables us to differentiate with our insights and services. Our ability to invest in acquisitions helps us to expand our relevance across the enterprise from building a digital core with Sentia and Albert, to optimizing upper duration to achieve agility, efficiency and resilience with Pilatus, to accelerating their growth agendas with RAMP, and our substantial investment in the skills of our people allows us to pivot to new areas of demand to be an attractive destination for top talent. Now let's turn to the quarter. To bring to life this demand environment across the five key forces of change for our clients: total enterprise reinvention, talent, sustainability, the metaverse and the ongoing tech revolution, which in turn drag our growth. First, total enterprise reinvention, we continue to help our clients achieve a new performance frontier by building their digital core, optimizing operations and accelerating growth, leveraging cloud, data and AI and new ways of working. We are helping Roche, a Swiss multinational health care company specializing in pharmaceuticals and diagnostics, with a total enterprise reinvention, building a digital infrastructure to match changing business needs. Using data integration, we have changed the way tumor boards are organized and conducted, empowering counter teams to be more efficient and effective in determining next steps for cancer care. And we have built a digital ecosystem that will create innovative products and solutions to drive diabetes care. Now as part of one of the largest ERP modernizations in the world, we are working together to deploy a digital backbone that will unify and harmonize nearly 700 business processes for more than 100,000 end users. The integrated platform will simplify the system landscape and connect activities across the value chain from R&D and manufacturing to patient treatment. Cloud, a $26 billion business in FY '22 grew 48%, with even stronger growth in Cloud First and continues to grow very strong double digits. In fact, we believe that the cloud continuum will become the new operative system for the future enterprise. Migrating to the cloud to drive efficiencies is just the first step. As we anticipated with our Cloud First strategy and investments, we are seeing our clients make significant investments to modernize, improve and innovate in the cloud, leveraging data and AI to drive new business value. For example, Accenture Federal Services is partnering with the Centers for Disease Control and Prevention, a U.S. federal agency under the Department of Health and Human Services, to accelerate its migration to the cloud across the enterprise and modernize its IT portfolio. Through this work, we will also help to achieve CDC's mission to protect people from health, safety and security threats by supporting the development of integrated, real-time public health data and surveillance systems. As our clients build their digital core, security continues to be more important than ever, as reflected in our very strong double-digit growth in Q1. We are expanding our cybersecurity footprint for a large health care network in Brazil to elevate their cybersecurity posture to a new hot level of preparedness. We are growing the organization's security profile with a cyber as a service solution that will enhance the cyber readiness of their infrastructure and operations. This new project not only consolidates the work that up to four different providers typically do, it also is the largest cybersecurity contract ever signed in Brazil by any provider. High demand for our strategic Managed Services, reflecting $7.3 billion in revenue and 20% growth in the quarter, demonstrates the importance of these services to our client strategies as it enables clients to move faster, leveraging our digital platform's expertise and talent. Our Managed Services are differentiated by our ability to bring in our deep expertise from across the enterprise, including Song, which grew double digits in the first quarter. For example, we're expanding our partnership with Allianz, an Italian and main bank of Allianz Group, to continue the bank's digital transformation with a new platform in the cloud, a modern IT architecture and a new operating model. Our Song team is helping to create a new customer mobile app to improve customer experience. And our end-to-end managed services capabilities, tailored to the financial services industry, will help the bank grow and scale its position in the market, ensure regulatory compliance and lower total cost of ownership. We continue to see strong demand for our industry edge capabilities, digitizing engineering and manufacturing, which we see as the next digital frontier with continued very strong double-digit growth in Q1. We are helping Celanese, a global chemical and specialty materials company on their digital transformation journey that will increase their manufacturing production resiliency, productivity and predictability of plant operations. We're teaming with ecosystem partners to design and implement a scalable digital twin platform at one of their largest manufacturing facilities, which plans to increase revenues through increased plant output, reduce costs through improved productivity, product quality and equipment reliability and improve overall safety in the workplace. We also are supporting an enterprise cloud transformation to provide a scalable platform for future enterprise growth and innovation. Next, talent. Our clients continue to look to us to access, create and unlocked talent as a critical element of their transformation. We're helping a global chemical manufacturer with an end-to-end IT transformation as part of their multiyear digital journey. The Company faces increasing IT costs, aging assets and tools and overreliance on contractors. We're implementing a full Managed Services model that will help modernize its IT, and this digital transformation includes a talent transformation. Together, we will upskill their people and data cloud and AI through our Accenture Academy so that everyone grows together, helping the Company leapfrog its competitors with innovative industry-leading solutions. Now, sustainability. We continue to prioritize embedding sustainability into our clients' digital transformation and on providing a direct sustainability service. For example, we are expanding our partnership with the European Multinational Aerospace Corporation to help improve their environmental and social impact across the enterprise. In recent years, we have worked together to digitize the Company's supply chain and manufacturing operations using a digital twin to improve productivity and reduce waste. Now we are working together to advance their sustainability agenda. We're supporting their aviation decarbonization road map, from accelerating the use of sustainable aviation fuel to helping design low-emissions aircraft. We are finding new ways to help make the supply chain more transparent and ethical, helping the Company replace hazardous materials from the product life cycle with safer, greener alternatives. And we are outlining a strategy to help them meet its net zero targets and internally foster a culture that is focused on sustainability. Finally, the metaverse and the ongoing tech revolution. While still in the early innings, we believe the metaverse will not only change how people work, but it will also profoundly change every part of every business, from how we interact with customers, what products and services they offer, how they are made and distributed, how you engage with your people from employee onboarding to personal productivity. We're partnering with NTT DOCOMO, a Japanese mobile operator to speed up the adoption of Web3, a new blockchain-based version of the Internet that promises a digital economy with greater social impact. We will develop and grow a secure technology platform for Web3, which will enable new products, services and community building. Training will ensure that Web3 engineers and business leaders collaborate with organizations effectively and securely on the platform. NTT DoCoMo's work on societal issues will now expand with the use of Web3, helping companies and governments transform social infrastructures and provide solutions that would improve people's lives. We continue to invest ahead of our clients' teams to the future, with a keen focus on innovation and the ongoing tech revolution. Back to you, KC.
KC McClure: Thanks, Julie. Turning now to our business outlook. For the second quarter of fiscal '23, we expect revenues to be in the range of $15.2 billion to $15.75 billion. This assumes the impact of FX will be about negative 5% compared to the second quarter of fiscal '22 and reflects an estimated 6% to 10% growth in local currency. For the full fiscal year '23, based upon how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately negative 5% compared to fiscal '22. For the full fiscal '23, we continue to expect our revenue to be in the range of 8% to 11% growth in local currency over fiscal '22, which continue to assume an inorganic contribution of about 2.5%. For operating margin, we continue to expect fiscal '23 to be 15.3% to 15.5%, a 10 to 30 basis point expansion over fiscal '22 results. I mentioned last quarter, we may see more variability in quarters as we go throughout fiscal year '23, and that's playing out as we expected, with contraction in the second quarter expected and potentially overall for H1. We continue to expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an effective tax rate of 24% in fiscal '22. For earnings per share, based on the change to FX, we now expect our full year diluted EPS for fiscal '23 to be in the range of $11.20 to $11.52 or 5% to 8% growth over fiscal '22 results. Full fiscal '23, we continue to expect operating cash flow to be in the range of $8.5 billion to $9 billion, property and equipment additions to be approximately $800 million and free cash flow to be in the range of $7.7 billion to $8.2 billion. Our free cash flow guidance continues to reflect a strong free cash flow to net income ratio of 1.1%. Finally, we continue to expect to return at least $7.1 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. And with that, let's open it up so we can take your questions. Katie?
Katie O'Conor: Thanks, KC. I would ask that you each keep one to question and a follow-up to allow us to as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: [Operator Instructions] Your first question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead.
Bryan Keane: Happy holidays. Really good results, strong results here. The one area that was a little softer was the Strategy & Consulting area, and I think you guys called that out as expected. Just thinking about Strategy & Consulting that you knew it was going to be a little bit softer, and it's becoming a little bit softer. Is that just more the move towards the cost agenda versus growth and just thinking about what we can expect there going forward?
KC McClure: Hi, Bryan, thanks for the question. As you mentioned, our Strategy & Consulting results for Q1, they did come in as expected. But let's talk about what we're seeing go forward. And we do see a slight decline in Strategy & Consulting for Q2 before we're going to reconnect with growth in H2. And why is that for Q2? It's really a couple of things. We do see that we are going to have some impact from less revenue from smaller deals that which Julie will talk a little bit about here. And second, we do continue to see our S&C practitioners focus on high impact transformational deals, and they're going to bleed into revenue a little bit later in the year. There's a really important to our clients, but the revenue conversions at a slower pace.
Julie Sweet: Yes. Bryan, maybe -- I want to maybe say -- to make sort of two points. So first of all, specifically on S&C, I think it's important to understand we really have a tale of two worlds. So our S&C work is growing high single-digit to low double-digit when it's tied to areas around cloud, enterprise and industry platforms, talent, cost reduction, everything tied to building to the core. So underneath our results, like that's growing great. The other world, right, is S&C that's tied to things like ad spend, creative marketing strategy and campaigns and other sort of front-office initiatives are contracting, right? And that's, of course, the strength of Accenture, is that we've got a very broad range of services even within the Strategy & Consulting as well as a broad range of industries. And so while the -- at the top line, you saw it 3% this quarter, there'll be a slight decline next quarter, underneath that, you've got a lot of strength in everything that's really driving our results. And I think that's really important to just understand. But then, I want to take a step back and just maybe comment on the demand environment. KC just mentioned kind of the impact in S&C and smaller deals. So first of all, like we're obviously super pleased with Q1, right? Great growth, and we're really happy with how we're seeing the year start. Now at the same time, what do we see over the last 90 days, what we saw what everybody saw, right, which was the macros continue to have uncertainty and you've got GDP estimates declining over the past 90 days. And on the one hand, our clients clearly are remaining ambitious, right, they're committed to revamping their business. And you see that in the 24 clients with quarterly new bookings over $100 million, right, which is an increase over this time last year. At the same time, they're more and more focused on cost and resilience. And many are having to make pretty hard choices, right, because the macro affects the industries differently. So you've got some industries, retail consumer goods, that are much more challenged than say, energy. But at the same time, and we talked about starting to see this last quarter, kind of regardless of industry, as the macro uncertainty has increased, right, they're being a little bit more cautious. So we're seeing some delays in decision-making. We see changes in the pace of spending, and we're seeing some pausing of the smaller deals. And all of this impacts the smaller deals more than the bigger deals because we're continuing to see that big transformation focus. So that impacts our revenue and profit build over the year, which is part of what we're seeing in S&C in the second quarter with the decline. And then, I just want to remind everyone that this is exactly the environment that you see the strength of Accenture. It is because we are so broadly diverse. I mean you saw it in the examples in my script, all around the world, all around industries. But who else could be in Asia doing border security, in the U.S., working with the state of Missouri on a talent and tech implementation; in Europe, working with a European grocer doing IT modernization, cost reduction and customer experience? Just moving around the world, you're back into Asia, working with a telecom operator, digitizing their platform, creating a new customer experience. And so, you just continue to see that our strategy that we've had for decades to be across industries, a global footprint and depth and breadth of services. I mean Managed Services is on fire because we could digitize faster, get that compressed transformation, help them access the talent and lower cost. So back to you, Bryan.
Operator: Your next question comes from the line of Tien-Tsin Huang from JPMorgan. Please go ahead.
Tien-Tsin Huang: Okay. Just to – and good morning. I just add to the Bryan's last question here, just as on the visibility side, especially in consulting relative to Managed Services. And given, Julie, what you just said there, any change in your thinking on mix of growth across Consulting versus Managed Services, asking for both, I guess, bookings as well as revenue here?
KC McClure: Yes. I'll take – Hey, Tien-Tsin. I'll take the -- in terms of the outlook for how we see growth going by our various – by our two types of work. So for the full year, at the top end of our range, we see Consulting high single digits, and we see Managed Services continue to grow double digits. And as it relates to outlook and bookings, what we're seeing is that we do have a strong pipeline and we actually see continued strong pricing in that pipeline. And we do see that we will have a solid bookings quarter in Q2, and that includes Consulting. It's likely -- it will likely be lower though than the record bookings in Consulting that we had last quarter, and we expect to continue to see really strong bookings in Managed Services.
Julie Sweet: Yes, and we're going to continue to focus our Strategy & Consulting expertise on these platform and cloud-led transformation.
Tien-Tsin Huang: Gotcha. Okay. Perfect. Then a quick follow, if you don't mind. I heard the pricing favorable utilization looks like it's steady attrition nicely, better or lower, 13%, I think I saw on the sheet there. So just same question on visibility with respect to cost and margin, if you're flexing or changing anything here, I know the range overall is the same, but it feels like you've got a good line of sight in terms of your costs. I just wanted to confirm that.
KC McClure: Yes. Sure. So I'll talk a little bit about on the attrition point, and then we can get into kind of what we're seeing overall in our cost and our visibility in that regard. So attrition was down to 13%, and I think all of you know, but there's a structural pattern of attrition that typically comes down from Q4 to Q1. This year came down at a tick more, and we're really pleased with that. And that means we have to hire fewer replacement people, it means less recruiting costs, and you saw that in our improvement in G&A this quarter, and it's less ramp up for new hires. And so Tien-Tsin, in terms of visibility of what we see, I mean, we expect to continue to hire for the specific skills that we need. With upskilling, we may not need to hire as many people as we go throughout the year. But we have a very deep -- and we have a very deep competency in our supply and demand balancing and we're always focused on. And in terms of profit, let me talk a little bit about what we're seeing in operating margin. So operating margin, we're pleased with the 20 basis point expansion that we have in Q1 and really pleased to be confirming our 10 to 30 basis points expansion for the year. And as I said last quarter, we'd be pleased to land anywhere within the 10 to 30 basis point range. But let me give you a little bit more color about what we're seeing in Q2 and then just the visibility, as you ask, about the rest of the year. So I mentioned last quarter, we may see more variability in the quarters as we get through fiscal '23. And as I mentioned in the script, that is exactly playing out. Now, there's a few reasons for that. So in Q2 overall, the first thing, and I think all of you know, it's a structurally lower profit quarter just to begin with, in part because of the holidays. As well as for us, it's when most of our compensation increases kick in. So while we've planned for those comp increases, it does take some time to work through our P&L. And then in addition, in Q2, the impact of the changes of smaller deal volumes that Julie described, it's going to impact Q2 revenue. And that -- when you take everything into consideration, that's why we expect the Q2 operating margin decline in Q2 and potentially for the first half of the year. And so with that, then the math shows that most of our margin expansion will be in the back half of the year. And how -- why is it that we see that? We have a strong pipeline, as I mentioned. We have continued strong pricing improvements in our pipeline. And as always, we have some simple, but important levers on how we run our business. We are going to in addition to pricing, focused on cost efficiencies and delivery efficiencies within how we run our contracts. We're going to manage supply and demand, as we always do, with even more rigor and discipline. And we're going to continue to work on digitizing and cost-effective running the operations of Accenture.
Operator: Your next question comes from the line of Lisa Ellis from SVB MoffettNathanson. Please go ahead.
Lisa Ellis: I wanted to ask, Julie, a bit about the progress on compressed transformations. I think you started using that phrase about two years ago sort of in the earlier days of the pandemic. And now as you're working with clients looking out into 2023, can you just give some color on sort of like how far they are along in the compressed transformation? Is this -- do we -- are we still only in the third or fourth inning? Or a lot of your clients sort of in full rollout mode and we've got a couple of years left? Just trying to get a sense for sort of that big push we've seen, how far through the process are we? How much of this sort of sustained growth can we expect going forward?
Julie Sweet: Thanks, Lisa. It's a great question. And there's a couple of ways that you look at it. So what we saw particularly in the early days was that leaders before the pandemic kind of we're doubling down and becoming more ambitious. And from that time, you've got more and more companies then looking to see their competitors and sort of being pushed to themselves being more ambitious. And so, I think I shared last quarter that we got some recent research that said something like 68% of CFOs we surveyed are working in companies that have three or more transformation programs in progress in parallel. That being said, it's still very much the early days because we're so early in building the digital core that's enabling these transformations. So while we've had a big acceleration on the migration to the cloud, it's still kind of early innings, 35% or so. And most of the companies report, that although the -- when they get to the cloud they haven't actually been able to access the services and get the value yet, and that's why you're continuing just to see this drive in our cloud business, particularly Cloud First, because we continue to do all the migration work. And then those we've migrated are now coming to us and say, "Hey, look, we sign these big consumption contracts. We're trying to figure out how to transform our business and we don't know how to." So you basically got people who have moved fast, have lots more to do, and that's this concept of total enterprise reinvention. And then you have many companies that are just starting to really take on these more ambitious programs. So, we see this as a decade of transformation.
Lisa Ellis: Okay. Good. Then a quick one on M&A. I think you highlighted, KC, about close to $700 million in this past quarter in M&A. Can you guys just give a little more color on what you're seeing in the environment? Have you seen some of the private valuations come in? And are you seeing sort of an uptick in activity in that space?
Julie Sweet: Yes. I mean great companies never come at cheap prices, is what I would say. So -- and we really try to focus on buying highly valued companies. So we really aren't seeing that. The broader environment, yes, but where we're focusing, we're not really seeing any big differences. And we think that's the right answer, right, we want to buy great companies.
Operator: Your next question comes from the line of Dave Koning from Baird. Please go ahead.
David Koning: And I guess my question, I've noticed your -- the strategic priorities continue to grow significantly. And they grew at the same pace, at least the qualitative like numbers you wrote were at the same pace as last quarter. Is that -- I mean, is that like very close to, I guess, the same growth? Like did it decelerate at all? Or is that actually very similar? And what percent of revenues are those? Just I'm kind of thinking through the rest of the business must have decelerated a little more of that.
KC McClure: Yes. So, overall -- let me say first, Happy Holidays. It's good to talk to you. In terms of overall, our strategic priorities, as you mentioned, and you're right, you would expect in a quarter where we grew 15%, we did have higher growth overall in terms of what we have in our strategic priorities. They would -- in total, they did grow at a faster pace than the rest of Accenture at 15%, which is the intent overall of our strategic priority. And so -- which does account for the majority of our revenue.
Julie Sweet: Yes. Look, as you go forward, we talked a little bit about earlier, you've got parts of our business like some of the customer focus ad spending and marketing that's -- where clients are more challenged to be able to prioritize those areas, you also see some changing in industry. So, we're all reading about comms, media and tech, right? So, we are going to see -- we expect kind of a slowdown in spending from those clients as they reposition and think about sort of their -- what the changes they need to make, and we're helping them do that. So again, the diversity of our business really helps us balance. You do have, at any given time in an environment like this, areas that -- where the clients are having to make different choices and we're trying to pivot to help them and be really relevant to their current needs. And that's why it was so important to see the -- we've been talking about this for a couple of quarters, the importance of cost and to see that really coming through in our sales and pipeline, just demonstrates how our breadth of services allows us to pivot to the needs of our clients.
David Koning: Yes. Got you. And just one quick follow-up. You mentioned in Consulting, I think Tien-Tsin asked, you mentioned in Consulting, I think, bookings being down. Was that sequentially or year-over-year? And is that on a constant currency basis?
KC McClure: Yes. So just first of all, bookings overall in terms -- let's just talk about bookings overall, Dave. They were up in local currency by 6%. But when you take the FX headwind, they were down overall in U.S. dollars. And what I mentioned was -- we expect a strong bookings quarter in Q2. The question that Tien-Tsin had was about the Consulting bookings expectation for Q2, and we expect a strong bookings in Q2. I just want to remind you that that's where we -- that was also the quarter though, last year, where we had our record Consulting bookings last year of about $11 billion. And so I just wanted to set the expectation that will be strong, it may not surpass the $11 billion that we did last quarter, last year in Q2.
Operator: Your next question comes from the line of James Faucette from Morgan Stanley. Please go ahead.
James Faucette: Great. Just wanted to follow up on the D&A question, and I completely get the point around valuations and wanting to look at the best companies. But are there any specific capabilities we should think about that you would be targeting especially as you're seeing clients evolve a bit their needs in the current environment?
Julie Sweet: So a few things, right? So first of all, since the pandemic began, we've been very focused on building scale in markets around cloud, data and AI because that's so critical to building the digital core. So last quarter, we bought something in the Nordics, for example, that was all about getting scale. We bought something in France around mainframes because that's a very specific skillset that is relevant to moving some industries like financial services off of these core systems. And so we'd expect to continue to invest there. And we did this quarter, for example, with eLogic and with Sensis, these were acquisitions that we did this quarter, all in sort of the cloud and cloud platform technology space. Data and AI solutions will continue to be important. And again, we try to focus both on scale and getting scale in market. So we made a really exciting acquisition in Japan this quarter around data and AI solutions because we see that such a big market for us and we see a lot of interest, and it was just a great company. So, if you think about what clients are focused on building their digital core, that's going to continue to be a focus. The next digital frontier, so supply chain, digitizing supply chain and manufacturing, so we made a couple of acquisitions there this quarter, MacGregor, Stellantis. And so really, we keep very close to our strategy, which is tied to clients. They want reinvention across the enterprise, so continuing to build areas like in the digital frontier, making sure we've got scale and all of the capabilities needed across the digital core will continue to be a focus.
James Faucette: That's great. And then just as a quick follow-up, and it's kind of related to accounting or some of the accounting metrics that are moving in. Looking at DSOs, you guys almost always have industry-leading DSOs. But for you specifically, it looks like it's a little bit higher than last year. Can you talk us through puts and takes and what's moving that around? And should we expect to see improvement from here? Or is this something, just from a monitoring working capital, that this is the kind of level we should expect going forward?
KC McClure: Yes. Thanks for the question. And you're right, we do have industry-leading DSO, and we continue to have industry-leading DSOs. So let's talk about what we're seeing this quarter. So we had 48 days this quarter. And I think as you know, we do have a structural uptick every year from Q4 to Q1. And this is about a day of higher uptick than we would traditionally have, but it's nothing that we're concerned about. And we do feel really good about our DSO coming down by the end of the year. As I mentioned in our free cash flow guidance at the beginning of the year, we did allow for a couple of days uptick in DSO, and that's what we still expect. And maybe I'll talk a little bit about the free cash flow. So when you take a look at that in free cash flow and our expectations, overall for free cash flow for the year, you heard me reiterate the free cash flow guidance for the year. So that allows for us to have a few days uptick in DSO. And so, we're still really -- feel that the $1.1 billion is a really very strong free cash flow guidance, and it takes into account and increased DSO for the year.
Operator: Your next question comes from the line of Bryan Bergin from Cowen. Please go ahead.
Bryan Bergin: I wanted to follow up on the growth outlook and a little bit of the client behavior. So I'm curious if you've seen any actual change in backlog or prior book sales being deferred or potentially coming out there? So I hear you on the macro uncertainty, and I'm curious if their incidence of clients actually taking work out versus more so dragging on new bookings?
KC McClure: Yes. So, I -- we haven't seen any real change. What you're talking about is what's happening with the work that we've already sold, we're not seeing any real change in anything that's already in our book of business in terms of what's happening with the macro. And Julie, I don't know if there's anything else you want to add?
Julie Sweet: Yes -- no. And really I think what's important is that regardless of industry or country, the focus still is on transformation, right? There is nobody saying, "I'm going to change less," right? Unfortunately, the companies are having -- sometimes are having a harder time, right, doing what they'd like to do because they're under pressure. And again, that's where our relationships really matter because we're the trusted partner, right? And if you got to know that whatever you are going to spend money on, it's going to have to deliver value, it's a flight to quality, right? And so, we've seen that since the early days of the pandemic, and it continues in this environment. And remember, that the idea of total enterprise reinvention is things are connected. Like I gave the example of the European grocer, right? One company that can transform IT, do an ad strategy, provide personalized customer experience and lower overall cost, right, that is not easy to do, and it requires industry expertise and expertise in many parts of the enterprise. And that's really where our resilience comes from. And by the way, also our ability to pivot, right, to pivot, and that particular one started as a cost play, and we were able to show the client how not only could they reduce cost, but they could actually drive more growth by connecting these things and understanding the intersections. And that's what we're focused on, right? We always start with what do our clients need. And right now, they need to be more efficient, they need to do more with less, they need to optimize what they have and we're investing. And I will tell you that one of the things that's so critical are assets and solutions. Because I was just doing or earlier this week, and I always ask the client what do you think about what you've seen, and they're like, it's amazing like you have this myWizard platform, it's got data, it's got AI, it's stuff that we can even begin to build, and you not only have it built but it's been used in thousands of clients. So that's the kind of place where our ability to invest, not just now, but over the last decade, really matters to clients. And compared to anybody out there, right, the amount of money that we're putting in acquisitions and solutions is really tremendous in driving value for our clients.
Bryan Bergin: Okay. That's good to hear. Follow-up, just geographic and vertical growth performance was quite broad-based here. Did you expect that to continue through the balance of the year? And I was particularly surprised on Europe and Growth Markets actually outperforming North America, is that going to persist or do you see that changing?
Julie Sweet: By the way, my CEO of Europe and my CEO of Growth Markets like that out to their friends in North America as well. So, a little good-natured competition there, but KC, why don't you...
KC McClure: Yes. And so in terms of what we expect to see for the year, we do expect to see Europe and Growth Markets for the full year be in the double-digit range. And we do expect that North America, which is -- as the CEO of North America says, "I have a much, much bigger business," will grow at a mid- to high single-digit range for the year. And Julie, I don't know if there's anything else that you want to add on...
Julie Sweet: Yes, on North America, I mean, they had unbelievable growth last year on a huge book of business. So growing anywhere in the high single digit to double digit again this year is quite impressive. I mean their growth was 26% last year. So, we are very pleased with kind of the growth we see ahead.
Katie O'Conor: Operator, we have time for one more question, and then Julie will wrap up the call. Please go ahead.
Operator: Okay. That question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead.
Ashwin Shirvaikar: Let me say a good quarter in a tough environment and also Happy Holidays. Let me -- I'll ask both the questions together. The first one is I see the sequential hiring growth, and obviously, many other tech companies cutting back. And I'm wondering if your positive hiring is partly a function of the rapid decline in attrition, so you might not have put the brakes on hiring yet? So, what should we expect for hiring? And could you comment on wage inflation?
KC McClure: Yes, sure. Hi, Ashwin, nice to speak with you. So just in terms of what we expect for hiring, first of all, as you know, our ability to manage supply and demand is a core competency of ours, and we're always focused on it. And so, we did hire about -- we added about 17,000 people this quarter, as you mentioned. And we will continue to hire for the specific skills that we need. I think I made reference to that earlier, which means we may not need to hire as many people as we go throughout the year, but we'll balance that as we go through. And on wage inflation, I'll just go back to what we said when we set guidance, we did see wage inflation continuing. We do have comp increases that are kicking in that we've planned for, of course, and included in our pricing. But they are higher than they've been, and that's a statement across all industries, all geographies. And of course, that we're no different in that regard.
Ashwin Shirvaikar: Understood. And then on bookings, obviously, a good quarter overall. And you've referenced the underlying sort of Consulting versus Managed Services a couple of times. I want to kind of take that forward and ask the revenue conversion question because, obviously, Consulting, one might think of shorter cycle and it gets into revenue faster; Managed Services, longer ramps and things like that. Is that a fair observation still just looking at what you signed? And how might that affect sort of the calendar 2023 layout, if you will?
KC McClure: Yes. I think here's the way I would look at it. In terms of when you look at Managed Services and Consulting, as a broad statement, you have more the benefit of Managed Services is that you have already sold a fair amount of work, right? So while they are longer deals and they made the deals that you sell in that quarter may turn into revenue a little shorter than they would in A consulting sale, for example, which is typically a shorter duration, you have more work already sold as you go into a quarter. So there's a terrific benefit to that, which is why we like this diversity, right? We have that as well as in Consulting. They do -- the length and shape of them really do vary. And when you look at it overall, Ashwin, if you go back, and I know you followed us for a long time, and just look at our mix, of Managed Services to Consulting, it doesn't really change the bookings, really don't change much as you go throughout our history, in terms of the percent -- the proportion of each.
Julie Sweet: Yes. I mean this year, the bigger shift that we called out is just the smaller deal volume that's tied more to the macro and the sort of the shift on to these mega transformation deals, some of which are Consulting, some of which are Managed Services, they just bleed through revenue differently. So, that's more of the impact this year that we see right now. Okay. Well, thank you very much, and happy holidays. Good. So in closing, I want to thank all of our shareholders for your continued trust and support and all of our people for what you do every day. And I'd like to wish everyone a happy and healthy holiday season. Thank you.
Operator: That does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Thank you for standing by. Welcome to the Accenture's First Quarter Fiscal 2023 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Katie O'Conor. Please go ahead."
},
{
"speaker": "Katie O'Conor",
"text": "Thank you, operator, and thanks, everyone, for joining us today on our first quarter fiscal 2023 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you'll hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide a brief update on our market positioning, before KC provides our business outlook for the second quarter and full fiscal year 2023. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and, as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you to everyone joining us today and especially to our people around the world for their extraordinary work and commitment to our clients, which resulted in delivering another strong quarter of financial results and the broader 360-degree value we continue to create for all our stakeholders, our clients, our people, our shareholders, our partners and our communities. Let me share a few highlights of this 360-degree value and our continued disciplined execution. We delivered strong bookings of $16.2 billion, with 24 clients with quarterly new bookings over $100 million, demonstrating our clients’ continued commitment to transformation and our ability to understand and anticipate our clients' needs, whether for growth, cost optimization or resilience and our ability to deliver compressed transformations. We delivered revenues of $15.7 billion, representing 15% revenue growth in local currency, with double-digit growth in each market. We estimate that we are growing more than 2x the market, while delivering margin expansion of 20 basis points. We continue to invest in our people, with 10.4 million training hours this quarter, representing an average of 15 hours per person, providing learning opportunities and upscaling to enable us to pivot as our clients' needs evolve. We earned the number one position on the Refinitiv Diversity and Inclusion Index for the third time in the past five years and a top score on the Workplace Pride Global Benchmark, recognizing Accenture as the leader in our industry. We believe our unwavering commitment to diversity and inclusion is both the right thing to do and an essential element of our business strategy and strong financial performance. We have reached 97% renewable electricity, closing in on our goal of 100% by the end of 2023. Our own progress in sustainability is important to our ability to lead in helping our clients harness this key force of change and in attracting top talent. Finally, I want to congratulate our more than 1,200 new promotes to Managing Director, 119 new appointments to Senior Managing Director and the more than 90,000 people we promoted around the world in Q1 overall, reflecting our commitment to providing vibrant career paths. Over to you KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie. Happy holidays to all of you, and thanks for taking the time to join us on today's call. We were pleased with our overall results in the first quarter, where we continue to drive growth across markets, services and industries to extend our leadership position in the market. We ran our business with rigor and discipline and expanded operating margin while investing at scale, and we continue to deliver on our shareholder value proposition to both our financial results and by creating 360-degree value for all our stakeholders. Let me begin by summarizing a few key highlights across our three financial imperatives from the quarter. Revenues grew 15% in local currency, reflecting a foreign exchange headwind of about 9.5% compared to the 8.5% provided in our business outlook last quarter. Adjusted for the actual foreign exchange impact in the quarter, we were approximately $150 million above our guided range with double-digit growth across all of our markets and industry groups, with 10 of the 13 industries growing double digits and three high single digits. We continue to take market share with growth estimated to be more than 2x the market, which refers to our basket of publicly traded companies. Operating margin was 16.5% for the quarter, an increase of 20 basis points. We continue to drive margin expansion while making significant investments in our people and our business, including acquisitions. We delivered very strong EPS of $3.08, up 11%, while absorbing a substantial FX headwind. Finally, we delivered free cash flow of $397 million and returned $2.1 billion to shareholders through repurchases and dividends. We also invested $686 million in acquisitions. With those high-level comments, let me turn to some of the details, starting with new bookings. New bookings were $16.2 billion for the quarter with a book-to-bill of one and growth of 6% in local currency. Consulting bookings were $8.1 billion, with a book-to-bill of one. Managed Services bookings, which we formally refer to as Outsourcing, were $8.1 billion with a book-to-bill of 1.1. In addition, we continue to see improved pricing on our new bookings, which refer to contract profitability or margin on the work that we sell. Turning now to revenues. Revenues for the quarter were $15.7 billion, a 5% increase in U.S. dollars and 15% in local currency. Consulting revenues for the quarter were $8.4 billion, up 1% in U.S. dollars and 10% in local currency. Managed Services revenues were $7.3 billion, up 11% in U.S. dollars and 20% local currency. Taking a closer look at our service dimensions, Technology services grew strong double digits, Operations grew double digits and, as expected, Strategy & Consulting grew low single digits. Turning to our geographic markets. In North America, revenue growth was 11% in local currency, driven by double-digit growth in Public Service, consumer Retail and Travel Services, Industrial and Health. In Europe, revenues grew 17% in local currency, led by double-digit growth in Industrial, Banking & Capital Markets and high single-digit growth in Consumer Goods, Retail & Travel Services. Looking closer to the countries, Europe was driven by double-digit growth in Germany, the United Kingdom, Italy and France. In Growth Markets, we delivered 19% revenue growth in local currency, driven by double-digit growth in Banking & Capital Markets, Public Service, and Chemicals & Natural Resources. From a country perspective, gross markets was led by double-digit growth in Japan. Moving down the income statement. Gross margin for the quarter was 32.9%, consistent with the same period last year. Sales and marketing expense for the quarter was 9.8% compared with 9.7% for the first quarter last year. General and administrative expense was 6.6% compared to 6.9% for the same quarter last year. Operating income was $2.6 billion in the first quarter, reflecting a 16.5% operating margin, up 20 basis points compared with Q1 last year. Our effective tax rate for the quarter was 23.3% compared with an effective tax rate of 24.4% for the first quarter last year. Diluted earnings per share were $3.08 compared with diluted EPS of $2.78 in the first quarter last year. Days service outstanding were 48 days compared to 43 days last quarter and 42 days in the first quarter of last year. Free cash flow for the quarter was $397 million, resulting from cash generated by operating activities of $495 million net of property and equipment additions of $99 million. Our cash balance at November 30 was $5.9 billion compared with $7.9 billion at August 31. With regards to our ongoing objective to return cash to shareholders, in the first quarter, we repurchased or redeemed 5.2 million shares for $1.4 billion at an average price of $272.3 per share. At November 30, we had approximately $4.9 billion of share repurchase authority remaining. Also in November, we paid a quarterly cash dividend of $1.12 per share for a total of $706 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.12 per share to be paid on February 15, a 15% increase over last year. Finally, turning to the 360-degree value we are creating for all our stakeholders. We are extremely proud to be recognized as one of the seven company all stars on the Wall Street Journal Management Top 250 List for Excellence in customer satisfaction, employee engagement and development, innovation, social responsibility and financial strength, and we also received the top score for social responsibility overall. In summary, we were pleased with our results in the first quarter, and we're off to a strong start for the year. And now let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thanks, KC. We remain laser-focused on staying close to our clients, advising them how to navigate the macro, providing the right solutions to enable compressed transformations and adjusting to their changing needs. Let me give some further color on what we're seeing in the market and how we see the demand environment shaping up. Over the last quarter, as we can all read, the economic estimates for 2023 continue to decline. While the latest industry estimates for 2023's technology spending continue to show robust growth of 5% or so, we will see how the market evolves as clients finalize 2023 budgets. So what does today's market mean for our clients? We believe that the current macro is making it even clearer to clients that they need to change more, not less, and that two of the five key forces of change that we have identified for the next decade: the need for total enterprise reinvention enabled by tech data and AI; and the ability to access, create and unlock the potential of talent, are critical to succeed in the near, medium and long term. We see this continuing across industries and markets with two common themes. First, all strategies continue to lead to technology, particularly cloud, data, AI and security. And second, companies remain focused on executing compressed transformation to achieve lower costs, stronger growth, more agility and greater resilience faster. What does this mean for Accenture? Our strategy positions us for continued industry leadership because we have a unique set of strengths that our clients need to navigate today and succeed tomorrow. We are able to do so because of our deep strategy and consulting expertise across industries, allowing us to be a trusted adviser during different economic cycles as we bring the expertise, coupled with the real-life practical experience they need. Our ability to help clients achieve total enterprise reinvention through our depth across the enterprise, from the frontline to core operations to corporate functions, as well as our ability to advise our clients shape and deliver value-led transformations, and through our breadth of services, from strategy and consulting to our strategic managed services, which help clients digitize faster, access talent and lower costs. And our global footprint allows us to act at scale and with speed. Together, this positions us as the compressed transformation partner of choice, as you can see, and yet another strong quarter of clients who selected us for work of more than $100 million this quarter. I am pleased to see how quickly we are pivoting to meet the evolving needs of our clients. We have seen a higher level of sales and pipeline coming from cost-focused initiatives, often also including growth or capability enhancements. We are leveraging our breadth of services, deep-client and ecosystem relationships and industry and functional expertise to help our clients and Accenture shift to the highest value opportunities. Our track record of delivery at speed and scale over many years with clients -- remember, 99 of our top 100 clients have been with us for over 10 years, this gives our clients confidence that by partnering with us, they will deliver on their commitments. Investments in our assets and solutions such as myWizard and SynOps, which underlie both strategy and consulting, technology and operations managed services, as well as our delivery of compressed transformation, enables us to differentiate with our insights and services. Our ability to invest in acquisitions helps us to expand our relevance across the enterprise from building a digital core with Sentia and Albert, to optimizing upper duration to achieve agility, efficiency and resilience with Pilatus, to accelerating their growth agendas with RAMP, and our substantial investment in the skills of our people allows us to pivot to new areas of demand to be an attractive destination for top talent. Now let's turn to the quarter. To bring to life this demand environment across the five key forces of change for our clients: total enterprise reinvention, talent, sustainability, the metaverse and the ongoing tech revolution, which in turn drag our growth. First, total enterprise reinvention, we continue to help our clients achieve a new performance frontier by building their digital core, optimizing operations and accelerating growth, leveraging cloud, data and AI and new ways of working. We are helping Roche, a Swiss multinational health care company specializing in pharmaceuticals and diagnostics, with a total enterprise reinvention, building a digital infrastructure to match changing business needs. Using data integration, we have changed the way tumor boards are organized and conducted, empowering counter teams to be more efficient and effective in determining next steps for cancer care. And we have built a digital ecosystem that will create innovative products and solutions to drive diabetes care. Now as part of one of the largest ERP modernizations in the world, we are working together to deploy a digital backbone that will unify and harmonize nearly 700 business processes for more than 100,000 end users. The integrated platform will simplify the system landscape and connect activities across the value chain from R&D and manufacturing to patient treatment. Cloud, a $26 billion business in FY '22 grew 48%, with even stronger growth in Cloud First and continues to grow very strong double digits. In fact, we believe that the cloud continuum will become the new operative system for the future enterprise. Migrating to the cloud to drive efficiencies is just the first step. As we anticipated with our Cloud First strategy and investments, we are seeing our clients make significant investments to modernize, improve and innovate in the cloud, leveraging data and AI to drive new business value. For example, Accenture Federal Services is partnering with the Centers for Disease Control and Prevention, a U.S. federal agency under the Department of Health and Human Services, to accelerate its migration to the cloud across the enterprise and modernize its IT portfolio. Through this work, we will also help to achieve CDC's mission to protect people from health, safety and security threats by supporting the development of integrated, real-time public health data and surveillance systems. As our clients build their digital core, security continues to be more important than ever, as reflected in our very strong double-digit growth in Q1. We are expanding our cybersecurity footprint for a large health care network in Brazil to elevate their cybersecurity posture to a new hot level of preparedness. We are growing the organization's security profile with a cyber as a service solution that will enhance the cyber readiness of their infrastructure and operations. This new project not only consolidates the work that up to four different providers typically do, it also is the largest cybersecurity contract ever signed in Brazil by any provider. High demand for our strategic Managed Services, reflecting $7.3 billion in revenue and 20% growth in the quarter, demonstrates the importance of these services to our client strategies as it enables clients to move faster, leveraging our digital platform's expertise and talent. Our Managed Services are differentiated by our ability to bring in our deep expertise from across the enterprise, including Song, which grew double digits in the first quarter. For example, we're expanding our partnership with Allianz, an Italian and main bank of Allianz Group, to continue the bank's digital transformation with a new platform in the cloud, a modern IT architecture and a new operating model. Our Song team is helping to create a new customer mobile app to improve customer experience. And our end-to-end managed services capabilities, tailored to the financial services industry, will help the bank grow and scale its position in the market, ensure regulatory compliance and lower total cost of ownership. We continue to see strong demand for our industry edge capabilities, digitizing engineering and manufacturing, which we see as the next digital frontier with continued very strong double-digit growth in Q1. We are helping Celanese, a global chemical and specialty materials company on their digital transformation journey that will increase their manufacturing production resiliency, productivity and predictability of plant operations. We're teaming with ecosystem partners to design and implement a scalable digital twin platform at one of their largest manufacturing facilities, which plans to increase revenues through increased plant output, reduce costs through improved productivity, product quality and equipment reliability and improve overall safety in the workplace. We also are supporting an enterprise cloud transformation to provide a scalable platform for future enterprise growth and innovation. Next, talent. Our clients continue to look to us to access, create and unlocked talent as a critical element of their transformation. We're helping a global chemical manufacturer with an end-to-end IT transformation as part of their multiyear digital journey. The Company faces increasing IT costs, aging assets and tools and overreliance on contractors. We're implementing a full Managed Services model that will help modernize its IT, and this digital transformation includes a talent transformation. Together, we will upskill their people and data cloud and AI through our Accenture Academy so that everyone grows together, helping the Company leapfrog its competitors with innovative industry-leading solutions. Now, sustainability. We continue to prioritize embedding sustainability into our clients' digital transformation and on providing a direct sustainability service. For example, we are expanding our partnership with the European Multinational Aerospace Corporation to help improve their environmental and social impact across the enterprise. In recent years, we have worked together to digitize the Company's supply chain and manufacturing operations using a digital twin to improve productivity and reduce waste. Now we are working together to advance their sustainability agenda. We're supporting their aviation decarbonization road map, from accelerating the use of sustainable aviation fuel to helping design low-emissions aircraft. We are finding new ways to help make the supply chain more transparent and ethical, helping the Company replace hazardous materials from the product life cycle with safer, greener alternatives. And we are outlining a strategy to help them meet its net zero targets and internally foster a culture that is focused on sustainability. Finally, the metaverse and the ongoing tech revolution. While still in the early innings, we believe the metaverse will not only change how people work, but it will also profoundly change every part of every business, from how we interact with customers, what products and services they offer, how they are made and distributed, how you engage with your people from employee onboarding to personal productivity. We're partnering with NTT DOCOMO, a Japanese mobile operator to speed up the adoption of Web3, a new blockchain-based version of the Internet that promises a digital economy with greater social impact. We will develop and grow a secure technology platform for Web3, which will enable new products, services and community building. Training will ensure that Web3 engineers and business leaders collaborate with organizations effectively and securely on the platform. NTT DoCoMo's work on societal issues will now expand with the use of Web3, helping companies and governments transform social infrastructures and provide solutions that would improve people's lives. We continue to invest ahead of our clients' teams to the future, with a keen focus on innovation and the ongoing tech revolution. Back to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Turning now to our business outlook. For the second quarter of fiscal '23, we expect revenues to be in the range of $15.2 billion to $15.75 billion. This assumes the impact of FX will be about negative 5% compared to the second quarter of fiscal '22 and reflects an estimated 6% to 10% growth in local currency. For the full fiscal year '23, based upon how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in U.S. dollars will be approximately negative 5% compared to fiscal '22. For the full fiscal '23, we continue to expect our revenue to be in the range of 8% to 11% growth in local currency over fiscal '22, which continue to assume an inorganic contribution of about 2.5%. For operating margin, we continue to expect fiscal '23 to be 15.3% to 15.5%, a 10 to 30 basis point expansion over fiscal '22 results. I mentioned last quarter, we may see more variability in quarters as we go throughout fiscal year '23, and that's playing out as we expected, with contraction in the second quarter expected and potentially overall for H1. We continue to expect our annual effective tax rate to be in the range of 23% to 25%. This compares to an effective tax rate of 24% in fiscal '22. For earnings per share, based on the change to FX, we now expect our full year diluted EPS for fiscal '23 to be in the range of $11.20 to $11.52 or 5% to 8% growth over fiscal '22 results. Full fiscal '23, we continue to expect operating cash flow to be in the range of $8.5 billion to $9 billion, property and equipment additions to be approximately $800 million and free cash flow to be in the range of $7.7 billion to $8.2 billion. Our free cash flow guidance continues to reflect a strong free cash flow to net income ratio of 1.1%. Finally, we continue to expect to return at least $7.1 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. And with that, let's open it up so we can take your questions. Katie?"
},
{
"speaker": "Katie O'Conor",
"text": "Thanks, KC. I would ask that you each keep one to question and a follow-up to allow us to as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Your first question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Happy holidays. Really good results, strong results here. The one area that was a little softer was the Strategy & Consulting area, and I think you guys called that out as expected. Just thinking about Strategy & Consulting that you knew it was going to be a little bit softer, and it's becoming a little bit softer. Is that just more the move towards the cost agenda versus growth and just thinking about what we can expect there going forward?"
},
{
"speaker": "KC McClure",
"text": "Hi, Bryan, thanks for the question. As you mentioned, our Strategy & Consulting results for Q1, they did come in as expected. But let's talk about what we're seeing go forward. And we do see a slight decline in Strategy & Consulting for Q2 before we're going to reconnect with growth in H2. And why is that for Q2? It's really a couple of things. We do see that we are going to have some impact from less revenue from smaller deals that which Julie will talk a little bit about here. And second, we do continue to see our S&C practitioners focus on high impact transformational deals, and they're going to bleed into revenue a little bit later in the year. There's a really important to our clients, but the revenue conversions at a slower pace."
},
{
"speaker": "Julie Sweet",
"text": "Yes. Bryan, maybe -- I want to maybe say -- to make sort of two points. So first of all, specifically on S&C, I think it's important to understand we really have a tale of two worlds. So our S&C work is growing high single-digit to low double-digit when it's tied to areas around cloud, enterprise and industry platforms, talent, cost reduction, everything tied to building to the core. So underneath our results, like that's growing great. The other world, right, is S&C that's tied to things like ad spend, creative marketing strategy and campaigns and other sort of front-office initiatives are contracting, right? And that's, of course, the strength of Accenture, is that we've got a very broad range of services even within the Strategy & Consulting as well as a broad range of industries. And so while the -- at the top line, you saw it 3% this quarter, there'll be a slight decline next quarter, underneath that, you've got a lot of strength in everything that's really driving our results. And I think that's really important to just understand. But then, I want to take a step back and just maybe comment on the demand environment. KC just mentioned kind of the impact in S&C and smaller deals. So first of all, like we're obviously super pleased with Q1, right? Great growth, and we're really happy with how we're seeing the year start. Now at the same time, what do we see over the last 90 days, what we saw what everybody saw, right, which was the macros continue to have uncertainty and you've got GDP estimates declining over the past 90 days. And on the one hand, our clients clearly are remaining ambitious, right, they're committed to revamping their business. And you see that in the 24 clients with quarterly new bookings over $100 million, right, which is an increase over this time last year. At the same time, they're more and more focused on cost and resilience. And many are having to make pretty hard choices, right, because the macro affects the industries differently. So you've got some industries, retail consumer goods, that are much more challenged than say, energy. But at the same time, and we talked about starting to see this last quarter, kind of regardless of industry, as the macro uncertainty has increased, right, they're being a little bit more cautious. So we're seeing some delays in decision-making. We see changes in the pace of spending, and we're seeing some pausing of the smaller deals. And all of this impacts the smaller deals more than the bigger deals because we're continuing to see that big transformation focus. So that impacts our revenue and profit build over the year, which is part of what we're seeing in S&C in the second quarter with the decline. And then, I just want to remind everyone that this is exactly the environment that you see the strength of Accenture. It is because we are so broadly diverse. I mean you saw it in the examples in my script, all around the world, all around industries. But who else could be in Asia doing border security, in the U.S., working with the state of Missouri on a talent and tech implementation; in Europe, working with a European grocer doing IT modernization, cost reduction and customer experience? Just moving around the world, you're back into Asia, working with a telecom operator, digitizing their platform, creating a new customer experience. And so, you just continue to see that our strategy that we've had for decades to be across industries, a global footprint and depth and breadth of services. I mean Managed Services is on fire because we could digitize faster, get that compressed transformation, help them access the talent and lower cost. So back to you, Bryan."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tien-Tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Okay. Just to – and good morning. I just add to the Bryan's last question here, just as on the visibility side, especially in consulting relative to Managed Services. And given, Julie, what you just said there, any change in your thinking on mix of growth across Consulting versus Managed Services, asking for both, I guess, bookings as well as revenue here?"
},
{
"speaker": "KC McClure",
"text": "Yes. I'll take – Hey, Tien-Tsin. I'll take the -- in terms of the outlook for how we see growth going by our various – by our two types of work. So for the full year, at the top end of our range, we see Consulting high single digits, and we see Managed Services continue to grow double digits. And as it relates to outlook and bookings, what we're seeing is that we do have a strong pipeline and we actually see continued strong pricing in that pipeline. And we do see that we will have a solid bookings quarter in Q2, and that includes Consulting. It's likely -- it will likely be lower though than the record bookings in Consulting that we had last quarter, and we expect to continue to see really strong bookings in Managed Services."
},
{
"speaker": "Julie Sweet",
"text": "Yes, and we're going to continue to focus our Strategy & Consulting expertise on these platform and cloud-led transformation."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Gotcha. Okay. Perfect. Then a quick follow, if you don't mind. I heard the pricing favorable utilization looks like it's steady attrition nicely, better or lower, 13%, I think I saw on the sheet there. So just same question on visibility with respect to cost and margin, if you're flexing or changing anything here, I know the range overall is the same, but it feels like you've got a good line of sight in terms of your costs. I just wanted to confirm that."
},
{
"speaker": "KC McClure",
"text": "Yes. Sure. So I'll talk a little bit about on the attrition point, and then we can get into kind of what we're seeing overall in our cost and our visibility in that regard. So attrition was down to 13%, and I think all of you know, but there's a structural pattern of attrition that typically comes down from Q4 to Q1. This year came down at a tick more, and we're really pleased with that. And that means we have to hire fewer replacement people, it means less recruiting costs, and you saw that in our improvement in G&A this quarter, and it's less ramp up for new hires. And so Tien-Tsin, in terms of visibility of what we see, I mean, we expect to continue to hire for the specific skills that we need. With upskilling, we may not need to hire as many people as we go throughout the year. But we have a very deep -- and we have a very deep competency in our supply and demand balancing and we're always focused on. And in terms of profit, let me talk a little bit about what we're seeing in operating margin. So operating margin, we're pleased with the 20 basis point expansion that we have in Q1 and really pleased to be confirming our 10 to 30 basis points expansion for the year. And as I said last quarter, we'd be pleased to land anywhere within the 10 to 30 basis point range. But let me give you a little bit more color about what we're seeing in Q2 and then just the visibility, as you ask, about the rest of the year. So I mentioned last quarter, we may see more variability in the quarters as we get through fiscal '23. And as I mentioned in the script, that is exactly playing out. Now, there's a few reasons for that. So in Q2 overall, the first thing, and I think all of you know, it's a structurally lower profit quarter just to begin with, in part because of the holidays. As well as for us, it's when most of our compensation increases kick in. So while we've planned for those comp increases, it does take some time to work through our P&L. And then in addition, in Q2, the impact of the changes of smaller deal volumes that Julie described, it's going to impact Q2 revenue. And that -- when you take everything into consideration, that's why we expect the Q2 operating margin decline in Q2 and potentially for the first half of the year. And so with that, then the math shows that most of our margin expansion will be in the back half of the year. And how -- why is it that we see that? We have a strong pipeline, as I mentioned. We have continued strong pricing improvements in our pipeline. And as always, we have some simple, but important levers on how we run our business. We are going to in addition to pricing, focused on cost efficiencies and delivery efficiencies within how we run our contracts. We're going to manage supply and demand, as we always do, with even more rigor and discipline. And we're going to continue to work on digitizing and cost-effective running the operations of Accenture."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Lisa Ellis from SVB MoffettNathanson. Please go ahead."
},
{
"speaker": "Lisa Ellis",
"text": "I wanted to ask, Julie, a bit about the progress on compressed transformations. I think you started using that phrase about two years ago sort of in the earlier days of the pandemic. And now as you're working with clients looking out into 2023, can you just give some color on sort of like how far they are along in the compressed transformation? Is this -- do we -- are we still only in the third or fourth inning? Or a lot of your clients sort of in full rollout mode and we've got a couple of years left? Just trying to get a sense for sort of that big push we've seen, how far through the process are we? How much of this sort of sustained growth can we expect going forward?"
},
{
"speaker": "Julie Sweet",
"text": "Thanks, Lisa. It's a great question. And there's a couple of ways that you look at it. So what we saw particularly in the early days was that leaders before the pandemic kind of we're doubling down and becoming more ambitious. And from that time, you've got more and more companies then looking to see their competitors and sort of being pushed to themselves being more ambitious. And so, I think I shared last quarter that we got some recent research that said something like 68% of CFOs we surveyed are working in companies that have three or more transformation programs in progress in parallel. That being said, it's still very much the early days because we're so early in building the digital core that's enabling these transformations. So while we've had a big acceleration on the migration to the cloud, it's still kind of early innings, 35% or so. And most of the companies report, that although the -- when they get to the cloud they haven't actually been able to access the services and get the value yet, and that's why you're continuing just to see this drive in our cloud business, particularly Cloud First, because we continue to do all the migration work. And then those we've migrated are now coming to us and say, \"Hey, look, we sign these big consumption contracts. We're trying to figure out how to transform our business and we don't know how to.\" So you basically got people who have moved fast, have lots more to do, and that's this concept of total enterprise reinvention. And then you have many companies that are just starting to really take on these more ambitious programs. So, we see this as a decade of transformation."
},
{
"speaker": "Lisa Ellis",
"text": "Okay. Good. Then a quick one on M&A. I think you highlighted, KC, about close to $700 million in this past quarter in M&A. Can you guys just give a little more color on what you're seeing in the environment? Have you seen some of the private valuations come in? And are you seeing sort of an uptick in activity in that space?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. I mean great companies never come at cheap prices, is what I would say. So -- and we really try to focus on buying highly valued companies. So we really aren't seeing that. The broader environment, yes, but where we're focusing, we're not really seeing any big differences. And we think that's the right answer, right, we want to buy great companies."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Dave Koning from Baird. Please go ahead."
},
{
"speaker": "David Koning",
"text": "And I guess my question, I've noticed your -- the strategic priorities continue to grow significantly. And they grew at the same pace, at least the qualitative like numbers you wrote were at the same pace as last quarter. Is that -- I mean, is that like very close to, I guess, the same growth? Like did it decelerate at all? Or is that actually very similar? And what percent of revenues are those? Just I'm kind of thinking through the rest of the business must have decelerated a little more of that."
},
{
"speaker": "KC McClure",
"text": "Yes. So, overall -- let me say first, Happy Holidays. It's good to talk to you. In terms of overall, our strategic priorities, as you mentioned, and you're right, you would expect in a quarter where we grew 15%, we did have higher growth overall in terms of what we have in our strategic priorities. They would -- in total, they did grow at a faster pace than the rest of Accenture at 15%, which is the intent overall of our strategic priority. And so -- which does account for the majority of our revenue."
},
{
"speaker": "Julie Sweet",
"text": "Yes. Look, as you go forward, we talked a little bit about earlier, you've got parts of our business like some of the customer focus ad spending and marketing that's -- where clients are more challenged to be able to prioritize those areas, you also see some changing in industry. So, we're all reading about comms, media and tech, right? So, we are going to see -- we expect kind of a slowdown in spending from those clients as they reposition and think about sort of their -- what the changes they need to make, and we're helping them do that. So again, the diversity of our business really helps us balance. You do have, at any given time in an environment like this, areas that -- where the clients are having to make different choices and we're trying to pivot to help them and be really relevant to their current needs. And that's why it was so important to see the -- we've been talking about this for a couple of quarters, the importance of cost and to see that really coming through in our sales and pipeline, just demonstrates how our breadth of services allows us to pivot to the needs of our clients."
},
{
"speaker": "David Koning",
"text": "Yes. Got you. And just one quick follow-up. You mentioned in Consulting, I think Tien-Tsin asked, you mentioned in Consulting, I think, bookings being down. Was that sequentially or year-over-year? And is that on a constant currency basis?"
},
{
"speaker": "KC McClure",
"text": "Yes. So just first of all, bookings overall in terms -- let's just talk about bookings overall, Dave. They were up in local currency by 6%. But when you take the FX headwind, they were down overall in U.S. dollars. And what I mentioned was -- we expect a strong bookings quarter in Q2. The question that Tien-Tsin had was about the Consulting bookings expectation for Q2, and we expect a strong bookings in Q2. I just want to remind you that that's where we -- that was also the quarter though, last year, where we had our record Consulting bookings last year of about $11 billion. And so I just wanted to set the expectation that will be strong, it may not surpass the $11 billion that we did last quarter, last year in Q2."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of James Faucette from Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Great. Just wanted to follow up on the D&A question, and I completely get the point around valuations and wanting to look at the best companies. But are there any specific capabilities we should think about that you would be targeting especially as you're seeing clients evolve a bit their needs in the current environment?"
},
{
"speaker": "Julie Sweet",
"text": "So a few things, right? So first of all, since the pandemic began, we've been very focused on building scale in markets around cloud, data and AI because that's so critical to building the digital core. So last quarter, we bought something in the Nordics, for example, that was all about getting scale. We bought something in France around mainframes because that's a very specific skillset that is relevant to moving some industries like financial services off of these core systems. And so we'd expect to continue to invest there. And we did this quarter, for example, with eLogic and with Sensis, these were acquisitions that we did this quarter, all in sort of the cloud and cloud platform technology space. Data and AI solutions will continue to be important. And again, we try to focus both on scale and getting scale in market. So we made a really exciting acquisition in Japan this quarter around data and AI solutions because we see that such a big market for us and we see a lot of interest, and it was just a great company. So, if you think about what clients are focused on building their digital core, that's going to continue to be a focus. The next digital frontier, so supply chain, digitizing supply chain and manufacturing, so we made a couple of acquisitions there this quarter, MacGregor, Stellantis. And so really, we keep very close to our strategy, which is tied to clients. They want reinvention across the enterprise, so continuing to build areas like in the digital frontier, making sure we've got scale and all of the capabilities needed across the digital core will continue to be a focus."
},
{
"speaker": "James Faucette",
"text": "That's great. And then just as a quick follow-up, and it's kind of related to accounting or some of the accounting metrics that are moving in. Looking at DSOs, you guys almost always have industry-leading DSOs. But for you specifically, it looks like it's a little bit higher than last year. Can you talk us through puts and takes and what's moving that around? And should we expect to see improvement from here? Or is this something, just from a monitoring working capital, that this is the kind of level we should expect going forward?"
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks for the question. And you're right, we do have industry-leading DSO, and we continue to have industry-leading DSOs. So let's talk about what we're seeing this quarter. So we had 48 days this quarter. And I think as you know, we do have a structural uptick every year from Q4 to Q1. And this is about a day of higher uptick than we would traditionally have, but it's nothing that we're concerned about. And we do feel really good about our DSO coming down by the end of the year. As I mentioned in our free cash flow guidance at the beginning of the year, we did allow for a couple of days uptick in DSO, and that's what we still expect. And maybe I'll talk a little bit about the free cash flow. So when you take a look at that in free cash flow and our expectations, overall for free cash flow for the year, you heard me reiterate the free cash flow guidance for the year. So that allows for us to have a few days uptick in DSO. And so, we're still really -- feel that the $1.1 billion is a really very strong free cash flow guidance, and it takes into account and increased DSO for the year."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Bergin from Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "I wanted to follow up on the growth outlook and a little bit of the client behavior. So I'm curious if you've seen any actual change in backlog or prior book sales being deferred or potentially coming out there? So I hear you on the macro uncertainty, and I'm curious if their incidence of clients actually taking work out versus more so dragging on new bookings?"
},
{
"speaker": "KC McClure",
"text": "Yes. So, I -- we haven't seen any real change. What you're talking about is what's happening with the work that we've already sold, we're not seeing any real change in anything that's already in our book of business in terms of what's happening with the macro. And Julie, I don't know if there's anything else you want to add?"
},
{
"speaker": "Julie Sweet",
"text": "Yes -- no. And really I think what's important is that regardless of industry or country, the focus still is on transformation, right? There is nobody saying, \"I'm going to change less,\" right? Unfortunately, the companies are having -- sometimes are having a harder time, right, doing what they'd like to do because they're under pressure. And again, that's where our relationships really matter because we're the trusted partner, right? And if you got to know that whatever you are going to spend money on, it's going to have to deliver value, it's a flight to quality, right? And so, we've seen that since the early days of the pandemic, and it continues in this environment. And remember, that the idea of total enterprise reinvention is things are connected. Like I gave the example of the European grocer, right? One company that can transform IT, do an ad strategy, provide personalized customer experience and lower overall cost, right, that is not easy to do, and it requires industry expertise and expertise in many parts of the enterprise. And that's really where our resilience comes from. And by the way, also our ability to pivot, right, to pivot, and that particular one started as a cost play, and we were able to show the client how not only could they reduce cost, but they could actually drive more growth by connecting these things and understanding the intersections. And that's what we're focused on, right? We always start with what do our clients need. And right now, they need to be more efficient, they need to do more with less, they need to optimize what they have and we're investing. And I will tell you that one of the things that's so critical are assets and solutions. Because I was just doing or earlier this week, and I always ask the client what do you think about what you've seen, and they're like, it's amazing like you have this myWizard platform, it's got data, it's got AI, it's stuff that we can even begin to build, and you not only have it built but it's been used in thousands of clients. So that's the kind of place where our ability to invest, not just now, but over the last decade, really matters to clients. And compared to anybody out there, right, the amount of money that we're putting in acquisitions and solutions is really tremendous in driving value for our clients."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. That's good to hear. Follow-up, just geographic and vertical growth performance was quite broad-based here. Did you expect that to continue through the balance of the year? And I was particularly surprised on Europe and Growth Markets actually outperforming North America, is that going to persist or do you see that changing?"
},
{
"speaker": "Julie Sweet",
"text": "By the way, my CEO of Europe and my CEO of Growth Markets like that out to their friends in North America as well. So, a little good-natured competition there, but KC, why don't you..."
},
{
"speaker": "KC McClure",
"text": "Yes. And so in terms of what we expect to see for the year, we do expect to see Europe and Growth Markets for the full year be in the double-digit range. And we do expect that North America, which is -- as the CEO of North America says, \"I have a much, much bigger business,\" will grow at a mid- to high single-digit range for the year. And Julie, I don't know if there's anything else that you want to add on..."
},
{
"speaker": "Julie Sweet",
"text": "Yes, on North America, I mean, they had unbelievable growth last year on a huge book of business. So growing anywhere in the high single digit to double digit again this year is quite impressive. I mean their growth was 26% last year. So, we are very pleased with kind of the growth we see ahead."
},
{
"speaker": "Katie O'Conor",
"text": "Operator, we have time for one more question, and then Julie will wrap up the call. Please go ahead."
},
{
"speaker": "Operator",
"text": "Okay. That question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Let me say a good quarter in a tough environment and also Happy Holidays. Let me -- I'll ask both the questions together. The first one is I see the sequential hiring growth, and obviously, many other tech companies cutting back. And I'm wondering if your positive hiring is partly a function of the rapid decline in attrition, so you might not have put the brakes on hiring yet? So, what should we expect for hiring? And could you comment on wage inflation?"
},
{
"speaker": "KC McClure",
"text": "Yes, sure. Hi, Ashwin, nice to speak with you. So just in terms of what we expect for hiring, first of all, as you know, our ability to manage supply and demand is a core competency of ours, and we're always focused on it. And so, we did hire about -- we added about 17,000 people this quarter, as you mentioned. And we will continue to hire for the specific skills that we need. I think I made reference to that earlier, which means we may not need to hire as many people as we go throughout the year, but we'll balance that as we go through. And on wage inflation, I'll just go back to what we said when we set guidance, we did see wage inflation continuing. We do have comp increases that are kicking in that we've planned for, of course, and included in our pricing. But they are higher than they've been, and that's a statement across all industries, all geographies. And of course, that we're no different in that regard."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Understood. And then on bookings, obviously, a good quarter overall. And you've referenced the underlying sort of Consulting versus Managed Services a couple of times. I want to kind of take that forward and ask the revenue conversion question because, obviously, Consulting, one might think of shorter cycle and it gets into revenue faster; Managed Services, longer ramps and things like that. Is that a fair observation still just looking at what you signed? And how might that affect sort of the calendar 2023 layout, if you will?"
},
{
"speaker": "KC McClure",
"text": "Yes. I think here's the way I would look at it. In terms of when you look at Managed Services and Consulting, as a broad statement, you have more the benefit of Managed Services is that you have already sold a fair amount of work, right? So while they are longer deals and they made the deals that you sell in that quarter may turn into revenue a little shorter than they would in A consulting sale, for example, which is typically a shorter duration, you have more work already sold as you go into a quarter. So there's a terrific benefit to that, which is why we like this diversity, right? We have that as well as in Consulting. They do -- the length and shape of them really do vary. And when you look at it overall, Ashwin, if you go back, and I know you followed us for a long time, and just look at our mix, of Managed Services to Consulting, it doesn't really change the bookings, really don't change much as you go throughout our history, in terms of the percent -- the proportion of each."
},
{
"speaker": "Julie Sweet",
"text": "Yes. I mean this year, the bigger shift that we called out is just the smaller deal volume that's tied more to the macro and the sort of the shift on to these mega transformation deals, some of which are Consulting, some of which are Managed Services, they just bleed through revenue differently. So, that's more of the impact this year that we see right now. Okay. Well, thank you very much, and happy holidays. Good. So in closing, I want to thank all of our shareholders for your continued trust and support and all of our people for what you do every day. And I'd like to wish everyone a happy and healthy holiday season. Thank you."
},
{
"speaker": "Operator",
"text": "That does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 4 | 2,024 | 2024-09-26 08:00:00 | Operator: Thank you for standing-by. Welcome to Accenture's Fourth Quarter Fiscal 2024 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, today’s conference is being recorded. And I will now turn the conference over to our host, Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead.
Katie O'Conor: Thank you, operator, and thanks, everyone for joining us today on our fourth quarter and full fiscal 2024 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; KC McClure, our current Chief Financial Officer; and Angie Park, our incoming Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning before Angie provides our business outlook for the first quarter and full fiscal year 2025. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including but not limited to, those factors set forth in today's news release and as discussed in our Annual Report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release, or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Katie, and everyone joining. And thank you to our 774,000 people around the world who have worked every day to be at the center of our clients' business and deliver 360 degree value for all our stakeholders. Our performance this year clearly demonstrates the resilience and agility of our business model, the power of our scale and reinvention in action. FY '24 was marked by a challenging market environment, and we have rapidly shifted to where our clients are buying, large reinventions that utilize the scale of Accenture's expertise and ecosystem relationships. And we have yet again put reinvention into action at Accenture with our significant investment and yearly (ph) leadership in what we believe will be the most transformative technology of the next decade, GenAI. As a result, over the last four quarters, we have successfully positioned Accenture for strong growth in FY ‘25. When market conditions improve, we will be well positioned to capitalize them. In FY ‘24, we continue to deliver on our enduring shareholder value proposition to grow faster than the market and take share, deliver earnings growth and margin expansion while investing at scale with strong free cash flow, disciplined capital allocation and significant cash return to shareholders. Turning to our results and the foundation for growth we have built for FY '25. With our clients prioritizing large scale transformations, we doubled down on our strategy to be the reinvention partner of our clients. Our success is reflected in our full fiscal year bookings of $81 billion, representing 14% growth in local currency, including 33 clients with quarterly bookings greater than $100 million in the fourth quarter, bringing the total of such bookings to 125 for the year, 19 more than last year. We are proud to now have 310 Diamond clients, our largest client relationships, an increase of 10 from last year, expanding our base of deep client relationships and the vantage point we have on the market. We delivered revenues of $65 billion for the year, representing 2% growth in local currency, while continuing to take market share on a rolling four quarter basis against our basket of our closest global publicly traded competitors, which is how we calculate market share. We expanded adjusted operating margin by 10 basis points and delivered adjusted EPS growth of 2%, while continuing to significantly invest in our business and our people with $6.6 billion in Strategic Acquisitions, $1.2 billion in R&D, and $1.1 billion in Learning and Development. We generated free cash flow of $8.6 billion allowing us to return $7.8 billion of cash to shareholders. We completed the business optimization actions we announced in March 2023 to reduce structural costs. For the full fiscal year, we had $3 billion in new GenAI bookings, including $1 billion in Q4. And for the full fiscal year, we had nearly $900 million in revenue. The magnitude of this achievement is seen in the comparison to FY '23, where we had approximately $300 million in sales and roughly $100 million in revenue from GenAI. This was an area where our clients continued to buy small deals, and we focused on accelerating our growth here. We have continued to steadily increase our data and AI workforce, reaching approximately 57,000 practitioners against our goal of 80,000 by the end of FY '26. We invested in our people to continue to develop their marketable skills and to help us reinvent our services using GenAI. Our people had approximately 44 million training hours this year, representing an increase of 10%, predominantly due to GenAI training. In addition to being a talent creator through our investment in learning, our talent strategy to succeed over the next decade is to have the best access to talent and to unlock the potential of our talent through, among other actions, ensuring our people feel they are net better off for working at Accenture across four dimensions: marketable skills, working for a purpose, well-being financial, mental and physical and relationships, where our people feel they belong and can thrive. In addition, our leadership in the market requires that we lead in innovation, which in turn requires access to broad pools of talent that provide the variety of perspectives, observations and insights, which are essential to continuously innovate. These strategies depend on us fostering a diverse and inclusive workplace, and our superior execution of these strategies is demonstrated by our global recognition for the third year with the number one spot on the FTSE, Global Diversity and Inclusion Index, an objective measurement of over 15,000 organizations and our recent achievement of having 50-50 gender equality in our advanced technology centers in India, which have over 220,000 people. Our long-term growth depends on thriving communities, and we continue to successfully create value in the communities where we operate, such as our work helping address the United Kingdom's digital inclusion gap, partnering with Tech [indiscernible] on a new program, regenerative AI, that aims to empower people and socioeconomically disadvantaged communities across the country to build their digital skills. Finally, I want to acknowledge how proud we are to have earned the number two spot on Times World's Best Companies list and the top spot on the World's Best Management Consulting Firms list by Forbes. Over to you KC.
KC McClure: Thank you, Julie, and thanks to all of you for joining us on today's call. We're very pleased with our results in the fourth quarter, which were aligned to our expectations and reflect improvement across all dimensions of our business. We continue to invest for long-term market leadership, while delivering significant value for our shareholders. So let me begin by summarizing a few highlights for the quarter. Revenue grew 5% in local currency, driven by mid-single digit growth or higher in seven of our 13 industries, including public service, industrial, software and platforms, health, high tech, energy, and life sciences. We had growth in all three markets, all three services as well as return to growth in consulting type of work for the first time in six quarters. Organic revenue improved as well to slightly positive growth, and we continue to take market share. Adjusted operating margin was 15%, an increase of 10 basis points over Q4 last year. We continue to drive margin expansion while making significant investments in our business and our people. We delivered adjusted EPS of $2.79, which represents 3% growth compared to adjusted EPS last year. And finally, we delivered free cash flow of $3.2 billion and returned $1.4 billion to shareholders through repurchases and dividends. With those high level comments, let me turn to some of the details. New bookings were $20.1 billion for the quarter, representing 21% growth in U.S. dollars and 24% growth in local currency with an overall book-to-bill of 1.2. Consulting bookings were $8.6 billion with a book-to-bill of 1. Managed services were $11.6 billion, with a book-to-bill of 1.4. Turning now to revenues. Revenues for the quarter were $16.4 billion above the mid-point of our guided range, reflecting a 3% increase in U.S. dollars and 5% in local currency. Consulting revenues for the quarter were $8.3 billion, up 1% in U.S. dollars and 3% in local currency. Managed services revenue were $8.1 billion, up 5% in U.S. dollars and 7% in local currency. Taking a closer look at our service dimensions, technology services and strategy and consulting both grew mid-single digits and operations grew low-single digits. Turning to our geographic markets. In North America, revenue grew 6% in local currency driven by growth in public service and industrial. In EMEA, revenue grew 2% local currency led by growth in public service and life sciences, partially offset by a decline in banking and capital markets. Revenue growth was driven by Italy and the United Kingdom, partially offset by a decline in France. In growth markets, revenue grew 9% in local currency, led by growth in banking and capital markets, software and platforms, and industrial. Revenue growth was driven by Argentina and Japan. Moving down the income statement. Gross margin for the quarter was 32.5% compared with 32.4% for the same period last year. Sales and marketing expense for the quarter was 10.7% compared with 10.8% for the fourth quarter last year. General and administrative expenses were 6.8% compared to 6.7% for the same quarter last year. Before I continue, I want to note that results in Q4 of FY '24 and FY '23 include costs associated with business optimization actions, which impacted operating margin and EPS. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.5 billion in the fourth quarter, reflecting a 15% adjusted operating margin, up 10 basis points compared with Q4 last year. Our adjusted effective tax rate for the quarter was 26.2% compared with an adjusted effective tax rate of 27.4% for the fourth quarter last year. Adjusted diluted earnings per share were $2.79 compared with adjusted EPS of $2.71 in the fourth quarter last year. Days service outstanding were 46 days compared to 43 days last quarter and 42 days in the fourth quarter of last year. Free cash flow for the quarter was $3.2 billion, resulting from cash generated by operating activities of $3.4 billion, net of property and equipment additions of $214 million. Our cash balance at August 31 was $5 billion compared with $9 billion at August 31 last year. With regards to our ongoing objective to return cash to shareholders. In the fourth quarter, we repurchased or redeemed 2.1 million shares for $628 million at an average price of $303.07 per share. Also in August, we paid our fourth quarterly cash dividend of $1.28 per share for a total of $808 million. And our Board of Directors declared a quarterly cash dividend of $1.48 per share to be paid on November 15, a 15% increase over last year, and approved $4 billion of additional share repurchase authority. Now I'd like to take a moment to summarize the year. Our fiscal '24 results illustrate the diversity and durability of our business as well as our ability to continue to manage our business with rigor and discipline. We delivered record bookings of $81.2 billion, reflecting 13% growth in U.S. dollars and 14% growth in local currency, with a record 125 quarterly client bookings over $100 million, which positions us well as we begin FY '25. Revenue of $64.9 billion for the year reflects growth of 2% local currency. Before I continue, I want to note that results for the full fiscal year '24 and fiscal '23 include costs associated with business optimization actions, and fiscal '23 results also reflect a gain on investment in Duck Creek Technologies, which impacted operating margin, our tax rate and EPS. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating margin of 15.5%, a 10 basis point expansion over FY '23. Adjusted earnings per share were $11.95, reflecting a 2% growth over adjusted FY '23 EPS. Free cash flow of $8.6 billion reflected a very strong free cash flow to net income ratio of 1.2. And with regards to our ongoing objective to return cash to shareholders, we returned $7.8 billion of cash to shareholders while investing approximately $6.6 billion across 46 acquisitions. In closing, we feel good about how we managed our business while navigating a challenging macro environment in FY '24 and we remain committed to delivering on our enduring shareholder value proposition while creating 360 degree value for all our stakeholders. And now back to you, Julie.
Julie Sweet: Thank you, KC. Our FY '24 growth was driven by our clients seeking to reinvent using tech, data, AI and new ways of working. Reinvention requires a strong digital core. In FY '25, a significant driver of our growth will continue to be helping our clients with digital transformation, including building out their digital core and then using it to drive productivity and growth. We see the advent of GenAI and its tremendous potential acting as a catalyst for reinvention. Our clients turn to us for our unique combination of services across strategy, consulting, song, Industry X, technology and operations. Our strategists and deep industry functional customer and technology consultants work hand-in-hand with our clients and across services to shape and deliver these reinventions. Our investments in our advanced platforms, our assets and solutions, our process expertise, the insights from our scale and diversification, and our ability to both design and build the solutions, combined with our managed services are key differentiators for us. At the same time, we see AI as the new digital. Like digital, AI is both the technology and a new way of working, and the full value will only come from strategies built on both productivity and growth. And it will be used in every part of the enterprise. We believe the introduction of GenAI signifies a transformative era that is set to drive growth for us and our clients over the next decade much like digital technology has in the last decade and continues to do so. As part of that, we expect that the work to prepare enterprise data, which is the fuel for AI will be an increasing part of our growth. To accomplish reinvention and take advantage of AI, businesses need to focus on talent, their ability to access the best people at the right time, place and cost, the ability to be a talent creator to keep their people market relevant and their ability to unlock the potential of their talent is critical. We see talent as a top C-suite agenda item. Today, our managed services are an important part of our clients' long-term talent strategy. Our ability to harness AI is helping them close talent gaps and our strong expertise across talent, change, HR and organizations differentiates all our services. Our launch of LearnVantage, which provides comprehensive technology learning and training services, helps our clients reskill and upskill their people so they can be a talent creator. Let me give you a few examples of the types of reinventions we are doing. In Financial Services, banking and insurance are on their reinvention journey, while retirement services a $15 billion global addressable market growing at about 6% has lagged behind. We have invested to grow our capabilities and talent to capture this next wave of growth. We are working with TIAA, the largest U.S. provider of lifetime income to accelerate the transformation of the company's retirement record-keeping capabilities and operations. Leveraging the power of AI, automation in the cloud, we are helping the company implement new technologies, making record-keeping processes more efficient over time and easier for their customers. Through this strategic partnership, we are supporting parts of TIAA's record-keeping operations, including back end processes and technology. For example, retirement plan sponsors will experience faster plan changes and participants will find it easier to initiate account openings and investment selections. Together, we are making retirement planning more accessible, efficient and personalized for individuals and clients, helping TIAA need its mission of a more secure in retirement for more Americans. Today, we work with 75% of the world's largest communication services providers. With our strong industry and technology expertise, we are modernizing a global Telecom's core IT operations to drive growth. Through our managed services program, we are consolidating IT vendors, increasing productivity by an estimated 60% and reducing cost by half. We are also infusing our GenAI tools to enhance the software development life cycle and automate manual tasks such as resolving technical issues with customer orders, invoices or service availability. Now this will free up employees to focus on strategic growth initiatives and improve the overall customer experience. We are also implementing new ways of working, and then we'll train and upscale the team to use the new GenAI tools more effectively, helping to create more profitable outcomes for the company. These changes will create a stronger management framework and prepare the company for expansion into new markets. Security continues to be one of the fastest growing parts of our business, reaching $9 billion in revenue this year, representing 23% growth. We are partnering with the Kuwait Government Central Agency for information technology to revolutionize the security posture of its public services and national critical infrastructure. We are implementing and managing a scalable platform powered by GenAI, enabling the agency to act on evolving cyber threats up to 60% quicker than with traditional technologies, including detection response and containment models. In the past, security analysts manually research threats with limited information before handing the incident to the impacted government entity losing valuable time as the attack progressed. But now using a new platform, when analysts open a potential incident, they can quickly drill down into details about the users, systems under attack, type of attack and more with just one click. Thanks to GenAI's ability to process significant amounts of data and automatically elaborate context as a threat is detected, we are supporting our experts in making faster decisions with confidence as we progressively onboard over 60 government entities and while we also develop local talent. The strategic collaboration underscores our commitment to safeguarding Kuwait's digital assets and empowering the nation's journey towards enhanced cybersecurity resilience. A key area for companies to seek reinvention is in marketing, where the potential to use tech, data and creativity to drive growth, drive tangible outcomes for the enterprise. We are very proud to be working with HP and American multinational information technology company and a new global partnership to develop the right data sets, technology and creative for their B2B powerhouse business and brand that fulfils their goal to move away from the traditional agency model to true marketing capability transformation to significantly improve the impact, efficacy and efficiency of their marketing investment with the ability to drive tangible business results. In every industry, there is a challenge or opportunity that GenAI can now uniquely solve. Our deep understanding of both the industry and the technology positions us to be the best at creating real value from GenAI with our clients. For example, in insurance, companies can't typically process 100% of their coverage submissions. This creates a bottleneck for revenue growth. The ability to leverage GenAI to read 100% of submissions allows insurance companies to better assess risk as well as quote and write more policies and do it all more quickly and cost effectively. Utilizing a new set of solutions we created, we're working with QBE Insurance Group, a multinational insurance company headquartered in Sydney, to scale industry-leading AI powered underwriting solutions, replicated across multiple lines of business to help the company to make faster and more accurate business decisions. A series of Board, executive level and all employee learning sessions were conducted to help drive the design and build those solutions that analyze new business submissions for completeness, appetite check and risk evaluation insights. They can now process 100% of submissions received from brokers, greatly accelerating market response time. After nine months in market, these solutions are winning multiple industry innovation awards and early results indicate an increase in both quote to buying rate and premium. This collaboration will enable QBE Insurance Group to identify and select risk more effectively, improve broker and customer experience and support growth. We are collaborating with a major integrated downstream energy provider to drive significant improvements in safety, sustainability and operational performance with three new GenAI powered solutions. We aim to continue to improve safety by using proactive insights from GenAI to inform planners of potential incidents instead of reactively waiting for specific warning signs to appear. This means 90% faster data access, reducing planning time from hours to minutes per task. Another solution will help detect methane leaks in real time and prioritize their resolutions. We also helped build a smart solution for operators and process engineers to drive custom insights to optimize refinery performance and reduce downtime. The energy provider is on a path to set a new industry standard for innovation and refinery operations. One of the most powerful impactful uses of GenAI today across industry is in consumer experience transformation. We are working with Mondelez International, a world leader in snacking with well-known brands like Oreo, belVita and Cadbury to transform their marketing organization with GenAI to help drive consumer behavior. As part of this program, we're standing up a refreshed operating model with a primary focus on upskilling their employees in GenAI technologies. We are also helping enable a new capability to scale content creation and generate personalized text, images and videos across markets. This means exceptional creative can be developed in hours, not weeks, allowing content to be catered to consumers quickly as demands change. The strong digital core we established also allows the company to collect and process real-time data using GenAI to create new contextualized insights that can be easily accessed, shared and used by decision makers across the company. This work will increase the effectiveness and efficiency of messaging to create more impactful experiences. Now let's turn to our acquisitions. Over the last decade, we have built a finely tuned acquisition capability, becoming known in the market as a good home with approximately 70% on average of our acquisitions sole sourced. While our ability to identify and evaluate our acquisitions is critical, it is our ability to integrate them successfully that has made our acquisition capabilities so formidable. As we look forward, we are excited about the opportunity to better serve our clients and differentiate in the market to the acquisitions we've made this last fiscal year. As a reminder, we do acquisitions ultimately to drive our organic growth. Our global footprint, deep client relationships across industries as well as strong ecosystem gives us a unique perspective on growth opportunities. We use acquisitions to scale quickly in growth areas, to build new skills in adjacent markets and to deepen our technology, industry and functional expertise. Over the years, acquisitions have built major areas of growth like what we call Song today in our security practice. Here are a few examples of where we are investing now to lead in the next waves of growth. Starting with capital projects, an over $440 billion addressable global market growing approximately 5%. In FY '22, globally, we had approximately $300 million in capital projects revenue. We entered the U.S. market in FY '23 with the acquisition of Anser Advisory. Since the beginning of FY '24, we expanded our reach into Canada with Comtech in Q1, and this Q4, we acquired BOSLAN in EMEA. We recognized over $800 million in revenue on capital projects this fiscal year '24. Health is an industry still early in digitization, where we see significant opportunity over the next decade. It is a $70 billion addressable global market growing approximately 6%. This year, we added Cognosante in the U.S., creating a new federal health portfolio in our federal service business. We also acquired Nautilus Consulting in the U.K., a digital consultancy specializing in electronic patient records. And we announced our intent to acquire consus.health, a health care consultancy in Germany that offer services ranging from medical strategy and patient management to procurement and logistics, infrastructure management and construction planning services. And in Europe, public service, an industry that is early in digitization with significant investment allocated for transformation, our acquisitions are accelerating our growth and setting us up to take shares in a $46 billion market that is growing approximately 5%. We acquired Arns, Aris (ph) in Germany, a technology services provider supporting the public sector transformation across Europe. In Italy, we acquired Intellera Consulting, one of Italy's main professional services providers operating the public administration and health care sectors, and Customer Management IT and SirfinPA, jointly owned consultancies, supporting the public sector and specializing in justice and public safety. Now it gives me great pleasure to hand over to Angie Park, who'll become our new CFO on December 1, who will take us through our guidance for FY '25. Angie?
Angie Park: Thanks, Julie. Now let me turn to our business outlook. For the first quarter of fiscal '25, we expect revenues to be in the range of $16.85 billion to $17.45 billion. This assumes the impact of FX will be approximately positive 1.5% compared to the first quarter of fiscal '24 and reflects an estimated 2% to 6% growth in local currency. For the full fiscal '25, based upon how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results in U.S. dollars will be approximately positive 1.5% compared to fiscal '24. For the full fiscal '25, we expect our revenue to be in the range of 3% to 6% growth in local currency over fiscal '24, which includes an inorganic contribution of a bit more than 3%. And we expect to invest about $3 billion in acquisitions this fiscal year. For operating margin, we expect fiscal year '25 to be 15.6% to 15.8%, a 10 basis point to 30 basis point expansion over adjusted fiscal '24 results. We expect our annual effective tax rate to be in the range of 22.5% to 24.5%. This compares to an adjusted effective tax rate of 23.6% in fiscal '24. We expect our full year diluted earnings per share for fiscal '25 to be in the range of $12.55 to $12.91, or 5% to 8% growth over adjusted fiscal '24 results. For the full fiscal '25, we expect operating cash flow to be in the range of $9.4 billion to $10.1 billion, property and equipment additions to be approximately $600 million and free cash flow to be in the range of $8.8 billion to $9.5 billion. Our free cash flow guidance reflects a free cash flow to net income ratio of 1.1 to 1.2. We expect to return at least $8.3 billion through dividends and share repurchases as we remain committed to returning a substantial portion of cash to our shareholders. Finally, as part of our routine review of our capital structure, we expect to tap the long-term debt market in the near term to increase our liquidity for general corporate purposes as we look to optimize our capital structure and reduce our cost of capital. We expect to raise a modest amount of debt. In connection with that, there would be no change to our capital allocation strategy, which includes how we look at and use D&A (ph) or our strong credit ratings and our net leverage will remain low. We have incorporated the potential for long-term debt into our guidance, including the interest expense. With that, let's open it up, so that we can take your questions. Katie?
Katie O'Conor: Thanks, Angie. We will now take your question. I would ask that you each keep to one question and a follow up to allow as many participants to ask a question. Operator, would you provide instructions for those on the call?
Operator: Thank you. [Operator Instructions] We'll go to the line of Tien-Tsin Huang of JPMorgan. Please go ahead.
Tien-Tsin Huang: Hey. Thank you so much. Yeah, really strong bookings. I wanted to think about how that translates into revenue visibility. If you don't mind, I know Accenture doesn't normally talk about ACV, but can you maybe comment on the current relationship between ACV and TCV and how that's evolving? It seems really important to us as we think about revenue and visibility. Duration looks like it's up, but you also have a lot of large deals converting as well, so can you comment on that?
Angie Park: Hi, Tien-Tsin. Good morning. It's Angie. So let me cover guidance because maybe it will help to paint a picture of how we're thinking about the full fiscal year. I think it's really important. Let's start with how we ended Q4. If you think about the 5% growth that we posted in the fourth quarter, what we highlighted was that we did have slight growth in organic, which is important as we exit the year. And as you just talked about, over the last few quarters, we've really pivoted our business to what our clients are buying, which are the large transformation deals. And what that does is it positions us better than compared to the same time last year on the revenue that we've already sold. From an inorganic contribution, I do want to highlight that overall, we expect a bit over 3% for the year, which would imply with our guidance of 3% to 6%, that at the bottom end of the range, organic is flat. And then at the top end of the range, we're growing 3% in organic growth. And then as you peel it back and you look at the revenue growth that we see, it is broad based, and we saw that coming out of Q4, we see it across the market and across all of our industry groups. And then as -- when you look at it by type of work as well, what we see right now is that both consulting and managed services, we see low to mid-single digit growth rates for the year. And so stepping back with the color and how we're looking at our guidance, we're very pleased with how we have set ourselves up that and positioned ourselves for fiscal '25.
Julie Sweet: Yeah. And so Tien-Tsin, what that means is, we're not commenting specifically on ACV and TCV because as you said that isn't. But the way to think about the confidence level and going to the year, right, is that we told you that we had a strategy to have more megas. We've shared with you that we had 19 more of these bookings than last year, $100 million or more. So you can see there's a big quantum. And so as you think about going into the year, we've got a bigger base of revenue coming from these larger deals coming online than we did going into fiscal year '24. And so that's really how we're trying to help you all think about it is by being clear about that strategy and how -- and the quantum of that, and that's how we then think about the year. So hopefully, that gives you some more insights together with the view on the guidance.
Tien-Tsin Huang: No, it does and it's very reasonable as well, just to say that loud out. Just on the acquisition side, Julie, I think I asked it last quarter, so I'll ask again. I know you've been very busy. I like the examples that you gave around the productivity you're getting from some of the deals and the examples you gave again. But how about just overall appetite this year, are you still seeing good opportunities? Could we see a stepdown or a pause in the short term, anything else to add?
Julie Sweet: Yeah. So what I would say is, as Angie just said, our inorganic plan for the year, like, in terms of -- as you think about revenue guidance, we kind of -- we're going into the year with nearly 3%, and we think we'll -- right now, the plan for is a little bit above 3% is what we're seeing for fiscal year '25. And that reflects an expected plan right now of about $3 billion of deployed capital. So a step down from last year and probably more backend loaded as we look at our pipeline. Now obviously, we always have the ability to flex up or down. We only tie it to the opportunities in the market, but that’s how we’re seeing this year as we think about our investments.
Tien-Tsin Huang: Perfect. Thank you. Well done. Thanks.
Julie Sweet: Thank you.
Operator: We'll go next to the line of James Faucette with Morgan Stanley.
Unidentified Participant: Great. Thanks for taking our question, guys. This is Antonio (ph) on for James. I wanted to actually dig into the technology segment. I know cloud is a big component of this. Could you talk through how clients spend on these cloud migration projects has been trending over the last 90 days and how we should think about cloud growth going into fiscal year '25? And then I have a follow-up after.
Julie Sweet: Hi, Antonio. I'm not going to think about it in the last 90 days is just think about like sort of where we've been and where we think we're going, right?
Unidentified Participant: Yeah.
Julie Sweet: So, in cloud, you still have a lot of migration that's happening, but on more of the high-performance compute applications. So things like mainframe, right? So -- and you also still have some clients who are very, very early in their cloud journey. And one of the things I talked about in the script, for example, was like retirement services. Like that's an entire segment where they're very, very early in the cloud journey. And so at the same time, you've got companies that are very early, just starting their cloud journey. You have those who are farther along who are now getting to the harder applications like mainframe. And then we still have a lot of modernization because what happened in the pandemic, people who were trying to get to the cloud to get the infrastructure savings, have not yet done the modernization. And that modernization, of course, feeds into all the things we do, right, brings the industry and the functional expertise. And so as we look going into FY '25, we continue to see those strengths. So we expect that cloud is going to continue to be a significant driver of growth but on all of those dimensions, right? And the high performance compute as well requires very deep industry knowledge, like doing mainframe in the context of health is very different than the context of banking. So hopefully, that helps you.
Unidentified Participant: Got it. No, that's helpful. And then, I wanted to ask on the organic headcount. It actually looks like that ticked up quite a bit. Could you comment on your hiring strategy and in what geographies you're sort of looking to shape that?
Angie Park: Yeah. Why don't I start and then Julie add (ph) any additional comments as well. So as you can see, I mean, I want to start with how we're exiting the year. We saw slight organic growth in Q4, and we see that momentum into FY '25. You will have also seen that we added about 24,000 people this year in Q4, which is reflective of the momentum that we see in the business. And as always, right, looking ahead, we will always hire for the skills and the demand that we see. And just more broadly, I would just remind us that as you think about us, as a business, our core competency is balancing supply -- managing supply and demand. And you see that through our utilization rates, which continue to be in the 92% range.
Julie Sweet: And we're hiring -- from a talent strategy, right, we are hiring primarily in India. So a lot of that hiring is technology in India and, of course, also addresses -- we are refreshing our pyramid at this time. So you've got kind of the new college graduates coming in. So there's really no change in our talent strategy. We hire all over the world. And in technology, which is a big driver of the growth that we're seeing now and going into FY '25, that is a lot of hiring in India.
Unidentified Participant: Great. Thank you, both.
Operator: We'll go next to the line of Jason Kupferberg with Bank of America.
Jason Kupferberg: Good morning, guys. Thanks. I wanted to pick up on the commentary about the consulting outlook for fiscal '25. You said up low to mid-single digits. I think that's very consistent with the exit rate of 3% coming out of fiscal '24. So does that imply that you are not building much of a discretionary spending recovery into this initial F '25 guide?
Angie Park: Yeah. Hi, Jason. Good morning. How are you? And let me just give you a little bit of color on that as you think about the types of work and the question that you just asked. If you think about our range overall, so we're at 3% to 6% for the full year. And what this assumes is, at the top end, we see more of the thing, right, in terms of the discretionary spending environment. While at the bottom end, it allows for further deterioration in the discretionary spend environment over what we experienced in FY '24.
Jason Kupferberg: Okay. That's very helpful. And then maybe one for Julie. I just wanted to get your broad take on the macro backdrop. I mean, I guess, what are decision makers telling you right now versus three months ago? What are they waiting to see to open the discretionary budget a little bit more?
Julie Sweet: Yeah. Well, the environment is really more of the same and that environment has been kind of a cautious environment. Right now, they're going into budget season. So as always, we'll really see in January and on February, but there hasn't been much of a change, right? The macro is kind of the same. Obviously, there's some events going to come up in the fall that people are thinking about, but there's not like a big tone change, right? And I think, because if you look at the macroeconomic environment, FY '25 is going to click down in the U.S., maybe a little bit better in Europe. But overall, not a lot of improvement. So we're not hearing -- I'm not hearing from CEOs, and I'm talking to them almost every day, some big like, hey, now we're ready to go spend more, right, in discretionary spending. So it's really just more of the same. And by the way, one of the changes that we made this last fiscal year '24 was normally we do for decades, our big promotion period was in December, and then a small one in June. And so in fiscal year '24, we switched these, right? We said we have a lot more visibility in our business in January or February because that's where budgets are set. So we did that this past year and had a really big promotion, a very nice promotion, I would say, not really big, but very nice promotion in this past June. We've now permanently shifted that promotion cycle. So we will do our big promotion cycle in June and our smaller one in December to better match when our clients are setting their budgets and we have better visibility. And that's what we're seeing again. The justification for that is clear that we're really no IT spending and spending on our services in the budgets in January, February.
Jason Kupferberg: Thanks for all the color.
Julie Sweet: Thanks.
Operator: We'll go next to the line of Keith Bachman with BMO.
Keith Bachman: Hi. Good morning. Thank you very much. I wanted to revisit on M&A, if I could, and just get some clarification. In FY '24, you spent, as you noted $6.6 billion, which was up about 160% year-over-year. And if we sort of do the math on what your normalized multiples are to revenue, it looks like you're starting the year of FY '25 with 3 points of M&A help. And so I just want to understand, is that the right way to think about it? And then Julie, you had indicated that you plan to spend $3 billion more in M&A this year, and it will be, as you said, backend weighted. But I'm just struggling why M&A is that $3 billion number is even second half weighted, why M&A isn't 4% or more for the year?
Angie Park: Let me just start with peeling back our inorganic contribution a bit. As we look at the deals that we closed in '24, it's nearly 3% contribution, right? And so with the backend loaded approach in our capital deployed, we do see a bit over 3%, and that's just the math.
Julie Sweet: Yeah. It's just timing, right? It's not quite 3% going in because a lot of this closed at the end of Q4, right? And so it's just its timing, right? And it's the way we see our pipeline developing, right? Because we have a view of what we're going to -- we think we're going to spend in Q1 and Q2 and how that rolls in.
Keith Bachman: Okay. Let me transition the bookings then. As you think about FY ‘25, and I know you don't guide to bookings, it's more of an output, but any puts and takes that you want us to think about in terms of the book-to-bill ratio in FY '25 that might be higher or lower? Any kind of cadence there? And if you don't mind, was there an M&A help in the August quarter bookings as well or signings, excuse me?
Angie Park: Why don't I start, in terms of the way to think about our bookings, we were super pleased with the $81 billion of bookings that we had for the year, which was 14% growth, which included the 125 quarterly client bookings over $100 million. And so I think that, that we were super pleased with. And you saw that in our book-to-bill and our growth rate in managed services was driven by our large transformation deals. For us, over time of our four trailing quarters, we're always looking for our consulting book-to-bill to be 1.0 or better and for our managed services to be 1.2 or better and nothing has changed there.
Julie Sweet: Yeah. And there was nothing in M&A about our bookings in Q4.
Keith Bachman: Okay. Many thanks.
Julie Sweet: Thanks.
Operator: We'll go next to the line of Bryan Keane with Deutsche Bank.
Bryan Keane: Good morning. Julie, I just want to ask about GenAI. I think bookings were up almost about $300 million in the third quarter sequentially, up about $100 million this quarter. Anything about the cadence there of GenAI and fall through there that you can help us understand?
Julie Sweet: Sure. So yeah, so we ended with $3 billion bookings for the year, and we'd expect in FY '25, another healthy increase. We know there's clear demand. We're starting to see more of our clients move from proof-of-concept to sort of larger implementations, which is important. So the size of those bookings is kind of, is clicking up. And also, we're continuing to see kind of at least every other one has got data pull-through and even that's kind of moving up. So we're kind of going into the year, we'd see -- we'd expect another healthy increase in our bookings and our revenue from that and also that data will continue to kind of be a bigger and bigger part of that building out of the digital core because one of the biggest limitations on using GenAI today and why it's going to take a while is our client needs data and our clients have a lot of work to do on data, which is, of course, a big opportunity for us.
Bryan Keane: Got it. And then just a clarification on the guide. I know the fourth quarter organic growth was positive, and we're talking about fiscal year '25 revenue guide of 3% to 6% on a constant currency basis. And if you back out the acquisitions, I think you guys said on the low end, we're talking about flat organic growth, that would be a slight step down from the fourth quarter, which is -- would be a little surprising given some of the momentum that you guys are seeing in bookings and in headcount growth. So just wanted to make sure I understood what that low end might imply and why would there necessarily be a step down from where the fourth quarter kind of ended? Thank you.
Julie Sweet: Yeah. No. And the way we're thinking about it, right, we're going into the year with momentum. We had executed on the strategy around the bigger deals. So we have a stronger base of revenue. We've got the acquisitions. And so on the bottom end of the range, what we would see, like the most likely reason to be there is if there was a deterioration in the discretionary spend environment, right? So we're trying to just kind of give some flexibility. We’re not seeing that, right? We sell more of the same this quarter. And so as we kind of go into the year, at the top end of the range, it’s the current environment going forward. And at the bottom of the range, if you were to ask me today, what is that mostly accommodated is if there was a deterioration in spending, right, so -- because of kind of the way we’ve positioned ourselves.
Bryan Keane: Great. Thank you.
Julie Sweet: Thanks.
Operator: We'll go next to the line of Dan Dolev with Mizuho.
Dan Dolev: Hi. Thanks for taking my questions. Great results and great guidance here. Two questions on GenAI. Are you seeing more of your conversations being less replacement and reallocation and purely incremental on G&A? And then I have a follow-up.
Julie Sweet: Well, I think it starts with, we're not seeing a change in what our clients are spending on IT, right? So -- but what we are seeing is the continued trend of trying to save money on IT to free up the spending on areas of GenAI. So on the one hand, right now, we haven't seen a change in overall spending. We'll see what the budgets come in January, February, but we're not expecting a big change. But what we also are seeing is that as they're saving money, they want to invest it in things like GenAI and data. So that's really the dynamic that's going on, save to invest, but we haven't seen signs of overall change.
Dan Dolev: Got it. And then a quick follow-up on margins. Can you maybe touch on the GenAI services margin, how it stands versus your traditional business? I think that would be really helpful for investors. Thank you.
Julie Sweet: Are you -- I mean, are GenAI margin and sort of -- is that different from when we're doing GenAI versus other GenAI technology?
Dan Dolev: Correct. GenAI services versus your traditional consulting business.
Julie Sweet: Look, GenAI is still a small part of our business, and I wouldn't really think about it as having a particularly different margin profile at this time. And as you probably heard in our -- in my script that a lot of time we're starting to embed GenAI in our larger deals and so we're not really thinking about it as like a sort of a separate way. So I wouldn't think about it too differently than our usual business.
Dan Dolev: Got it. Thanks. Well, great momentum. Thank you.
Julie Sweet: Thanks.
Operator: We'll go next to the line of Jim Schneider with Goldman Sachs.
Jim Schneider: Good morning. Thanks for taking my question. Very helpful commentary on the client outlook on limited discretionary spend. But can you maybe help us understand or unpack, when you talk to them, what are they looking for to release discretionary spend? Is it more macro factors, whether that be rates, election or regulatory or is it more micro factors tied to their IT budgets? And if it's the latter, what are the things they're looking for in terms of getting increased clarity on those priorities going into 2025?
Julie Sweet: Sure. It's a good question. And it's really -- overall, there is a sense of the macro, right? Because if you look at the -- a lot of our clients are global. If you look at the macroeconomic, there isn't a big change. There's kind of going into next year, like the U.S., which is a big market, it looks like it's going to be down a little bit. Europe's up a little bit, but still not great. And so kind of if you start with they're not seeing a big change in the macro. But then you really have to look at it industry by industry because each industry has factors. So for example, in the energy industries, they're super focused on how much investment they have to do and the change – and the shift in climate change and renewables. So there's a big appetite for major investment. So there's no catalyst that says, oh, like I've got a ton of thought. They've got a lot of big investments, right? If you look at consumer goods, where a lot of the consumer goods companies are not able to get pricing. They've got to get up volume, which means they've got to drive down their -- they've got to improve their efficiency and their manufacturing costs, and that takes big investments because manufacturing. Our latest research says like two-thirds of the journey in digitization is still to come. And so those are big investments. And so I can kind of take you through industry by industry. The reality is, it's obviously good growth for us is the digitization journey is still very early in many, many industries, that's like public service is another great example. So they've got big transformations going. And at the end of the day, if you're a big enterprise, like, the deals that are smaller, right, they do not move the needle. And when you've got big investments, that's where they're focused because they see now the potential of things like GenAI, and everyone's like we got to get going, that's really what's driving it. So that's why we're not having a bunch of discussions about like I can't wait to unlock that spending. Our discussions are entirely on help us move faster with our bigger information. That's really what we're focused on.
Jim Schneider: That's very helpful. Thanks. And then maybe as a follow-on, you referenced several verticals there. Can you maybe, as you prospectively look into fiscal '25, call out maybe one or two verticals where you expect the most improvement and maybe one or two where you see potential risk of deterioration? Thank you.
Angie Park: Yeah. Hey, Jim. Nice to talk to you. I think that as we look across FY '25 in our overall guide of 3% to 6%. We see broad-based growth across -- it's really broad-based across all of our industries as well as our services and markets.
Jim Schneider: Great. Thank you.
Katie O’Conor: Operator, we have time for one more question, and then we’ll wrap up the call.
Operator: Thank you. And that will come from Bryan Bergin with TD Cowen.
Bryan Bergin: Hi. Good morning. Thank you. On GenAI, can you give us a sense of the size of some of the largest individual programs have reached? And then as it relates to internal productivity progress, may be comment on any of the service lines where you're seeing the earliest impacts as it relates to productivity or any metrics that you can share in more advance programs?
Julie Sweet: Sure. I don't want to start like giving tons of data on this. But like you went from deals that were -- in GenAI that were, on average, kind of sub-$1 million, right, that you've now got some that are above $10 million, right? So that's still the smaller end because you're sort of moving into production and scale. But you're starting to see these things move from POCs to larger bookings. And then with respect to internal productivity and our guidance, of course, takes into account what we're seeing. As I've been talking about is that the first area that we anticipate -- remember, we're trying to embrace GenAI fastest because we think it's a big differentiator with our clients. And so in our managed services is where we're seeing the most because that's where we have a platform. So you all remember we used to talk about myWizard. Now we talk about GenWizard, right? But what we're seeing is that the technology and the productivity is like similar ways before. So if you go back to 2015, 2016, when we first introduced myWizard, right? So it's not really different than the kinds of productivity that we've been experiencing. And here, of course, there's an added wrinkle in that GenAI, in order for us to use it with our clients, they have to allow us to use it and they have to prioritize. And they have a lot of other areas where they want to use GenAI that's not necessarily in their technology productivity where they're already many of our clients are using our platforms, they're using AI, etc. So there's a lot of factors that kind of go into the pace of how quickly we can use it even if we're ready to use it now in many places. So hopefully, that's helpful because it is a little bit different in that sense because our clients have to prioritize where they want to use GenAI, too.
Bryan Bergin: Okay. That's helpful. Thank you. And then I appreciate your commentary on the capital returns on the balance sheet and understanding this has overall been a tougher environment, while M&A outlay has been on the upper end. But just curious how we should be thinking about the potential magnitude of leverage in the model going forward? Just any guardrails we should consider?
Angie Park: Yeah. And a couple of things that I would say around that. We indicated that it's going to be modest. We'll maintain our strong credit ratings and net leverage will be low. And so -- and included in our guidance that we provided you, we have also allowed for the potential for the interest expense and in our overall guidance, which is in addition to the variability that we may see in operating margin throughout the year.
Bryan Bergin: Okay. Thank you.
Julie Sweet: Great. Well, thank you, everyone, for joining us. Before I wrap up, I want to thank KC, who's been an amazing partner and friend these last five years. They've been quite some five years, as we all know, just a few things in the environment that we've gotten together work with. And so I'm really excited for KC and her next chapter. And KC, would you like to say a few words?
Katie O'Conor: I would, thanks, Julie. I just want to offer my sincere thanks to the investor and analyst community for the decade plus of console and support. It's really meant a lot to me. It's really been appreciated. Thanks a lot, and best wishes to all of you.
Julie Sweet: So I want to thank everyone for joining us and thank all of our people for what you do every day, allowing us to create 360 degree value and giving us a lot of confidence in our success in FY ‘25. And thanks again, KC, and welcome Angie to your new role, and we’ll see you all in the next quarter.
Angie Park: Thank you.
Operator: This conference will be available for replay beginning at 10:00 a.m. Eastern Time today and running through mid-night on December 18. You may access the AT&T replay system at any time by dialing 1-866-207-1041 and entering the access code of 9225580. International callers may dial (402) 970-0847. Those numbers again are 1-866-207-1041 or (402) 970-0847 with the access code of 9225580. That does conclude our conference for today. Thank you for your participation and for using AT&T Event Conferencing. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Thank you for standing-by. Welcome to Accenture's Fourth Quarter Fiscal 2024 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, today’s conference is being recorded. And I will now turn the conference over to our host, Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Katie O'Conor",
"text": "Thank you, operator, and thanks, everyone for joining us today on our fourth quarter and full fiscal 2024 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; KC McClure, our current Chief Financial Officer; and Angie Park, our incoming Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the fourth quarter and full fiscal year. Julie will then provide a brief update on our market positioning before Angie provides our business outlook for the first quarter and full fiscal year 2025. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including but not limited to, those factors set forth in today's news release and as discussed in our Annual Report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release, or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Katie, and everyone joining. And thank you to our 774,000 people around the world who have worked every day to be at the center of our clients' business and deliver 360 degree value for all our stakeholders. Our performance this year clearly demonstrates the resilience and agility of our business model, the power of our scale and reinvention in action. FY '24 was marked by a challenging market environment, and we have rapidly shifted to where our clients are buying, large reinventions that utilize the scale of Accenture's expertise and ecosystem relationships. And we have yet again put reinvention into action at Accenture with our significant investment and yearly (ph) leadership in what we believe will be the most transformative technology of the next decade, GenAI. As a result, over the last four quarters, we have successfully positioned Accenture for strong growth in FY ‘25. When market conditions improve, we will be well positioned to capitalize them. In FY ‘24, we continue to deliver on our enduring shareholder value proposition to grow faster than the market and take share, deliver earnings growth and margin expansion while investing at scale with strong free cash flow, disciplined capital allocation and significant cash return to shareholders. Turning to our results and the foundation for growth we have built for FY '25. With our clients prioritizing large scale transformations, we doubled down on our strategy to be the reinvention partner of our clients. Our success is reflected in our full fiscal year bookings of $81 billion, representing 14% growth in local currency, including 33 clients with quarterly bookings greater than $100 million in the fourth quarter, bringing the total of such bookings to 125 for the year, 19 more than last year. We are proud to now have 310 Diamond clients, our largest client relationships, an increase of 10 from last year, expanding our base of deep client relationships and the vantage point we have on the market. We delivered revenues of $65 billion for the year, representing 2% growth in local currency, while continuing to take market share on a rolling four quarter basis against our basket of our closest global publicly traded competitors, which is how we calculate market share. We expanded adjusted operating margin by 10 basis points and delivered adjusted EPS growth of 2%, while continuing to significantly invest in our business and our people with $6.6 billion in Strategic Acquisitions, $1.2 billion in R&D, and $1.1 billion in Learning and Development. We generated free cash flow of $8.6 billion allowing us to return $7.8 billion of cash to shareholders. We completed the business optimization actions we announced in March 2023 to reduce structural costs. For the full fiscal year, we had $3 billion in new GenAI bookings, including $1 billion in Q4. And for the full fiscal year, we had nearly $900 million in revenue. The magnitude of this achievement is seen in the comparison to FY '23, where we had approximately $300 million in sales and roughly $100 million in revenue from GenAI. This was an area where our clients continued to buy small deals, and we focused on accelerating our growth here. We have continued to steadily increase our data and AI workforce, reaching approximately 57,000 practitioners against our goal of 80,000 by the end of FY '26. We invested in our people to continue to develop their marketable skills and to help us reinvent our services using GenAI. Our people had approximately 44 million training hours this year, representing an increase of 10%, predominantly due to GenAI training. In addition to being a talent creator through our investment in learning, our talent strategy to succeed over the next decade is to have the best access to talent and to unlock the potential of our talent through, among other actions, ensuring our people feel they are net better off for working at Accenture across four dimensions: marketable skills, working for a purpose, well-being financial, mental and physical and relationships, where our people feel they belong and can thrive. In addition, our leadership in the market requires that we lead in innovation, which in turn requires access to broad pools of talent that provide the variety of perspectives, observations and insights, which are essential to continuously innovate. These strategies depend on us fostering a diverse and inclusive workplace, and our superior execution of these strategies is demonstrated by our global recognition for the third year with the number one spot on the FTSE, Global Diversity and Inclusion Index, an objective measurement of over 15,000 organizations and our recent achievement of having 50-50 gender equality in our advanced technology centers in India, which have over 220,000 people. Our long-term growth depends on thriving communities, and we continue to successfully create value in the communities where we operate, such as our work helping address the United Kingdom's digital inclusion gap, partnering with Tech [indiscernible] on a new program, regenerative AI, that aims to empower people and socioeconomically disadvantaged communities across the country to build their digital skills. Finally, I want to acknowledge how proud we are to have earned the number two spot on Times World's Best Companies list and the top spot on the World's Best Management Consulting Firms list by Forbes. Over to you KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie, and thanks to all of you for joining us on today's call. We're very pleased with our results in the fourth quarter, which were aligned to our expectations and reflect improvement across all dimensions of our business. We continue to invest for long-term market leadership, while delivering significant value for our shareholders. So let me begin by summarizing a few highlights for the quarter. Revenue grew 5% in local currency, driven by mid-single digit growth or higher in seven of our 13 industries, including public service, industrial, software and platforms, health, high tech, energy, and life sciences. We had growth in all three markets, all three services as well as return to growth in consulting type of work for the first time in six quarters. Organic revenue improved as well to slightly positive growth, and we continue to take market share. Adjusted operating margin was 15%, an increase of 10 basis points over Q4 last year. We continue to drive margin expansion while making significant investments in our business and our people. We delivered adjusted EPS of $2.79, which represents 3% growth compared to adjusted EPS last year. And finally, we delivered free cash flow of $3.2 billion and returned $1.4 billion to shareholders through repurchases and dividends. With those high level comments, let me turn to some of the details. New bookings were $20.1 billion for the quarter, representing 21% growth in U.S. dollars and 24% growth in local currency with an overall book-to-bill of 1.2. Consulting bookings were $8.6 billion with a book-to-bill of 1. Managed services were $11.6 billion, with a book-to-bill of 1.4. Turning now to revenues. Revenues for the quarter were $16.4 billion above the mid-point of our guided range, reflecting a 3% increase in U.S. dollars and 5% in local currency. Consulting revenues for the quarter were $8.3 billion, up 1% in U.S. dollars and 3% in local currency. Managed services revenue were $8.1 billion, up 5% in U.S. dollars and 7% in local currency. Taking a closer look at our service dimensions, technology services and strategy and consulting both grew mid-single digits and operations grew low-single digits. Turning to our geographic markets. In North America, revenue grew 6% in local currency driven by growth in public service and industrial. In EMEA, revenue grew 2% local currency led by growth in public service and life sciences, partially offset by a decline in banking and capital markets. Revenue growth was driven by Italy and the United Kingdom, partially offset by a decline in France. In growth markets, revenue grew 9% in local currency, led by growth in banking and capital markets, software and platforms, and industrial. Revenue growth was driven by Argentina and Japan. Moving down the income statement. Gross margin for the quarter was 32.5% compared with 32.4% for the same period last year. Sales and marketing expense for the quarter was 10.7% compared with 10.8% for the fourth quarter last year. General and administrative expenses were 6.8% compared to 6.7% for the same quarter last year. Before I continue, I want to note that results in Q4 of FY '24 and FY '23 include costs associated with business optimization actions, which impacted operating margin and EPS. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.5 billion in the fourth quarter, reflecting a 15% adjusted operating margin, up 10 basis points compared with Q4 last year. Our adjusted effective tax rate for the quarter was 26.2% compared with an adjusted effective tax rate of 27.4% for the fourth quarter last year. Adjusted diluted earnings per share were $2.79 compared with adjusted EPS of $2.71 in the fourth quarter last year. Days service outstanding were 46 days compared to 43 days last quarter and 42 days in the fourth quarter of last year. Free cash flow for the quarter was $3.2 billion, resulting from cash generated by operating activities of $3.4 billion, net of property and equipment additions of $214 million. Our cash balance at August 31 was $5 billion compared with $9 billion at August 31 last year. With regards to our ongoing objective to return cash to shareholders. In the fourth quarter, we repurchased or redeemed 2.1 million shares for $628 million at an average price of $303.07 per share. Also in August, we paid our fourth quarterly cash dividend of $1.28 per share for a total of $808 million. And our Board of Directors declared a quarterly cash dividend of $1.48 per share to be paid on November 15, a 15% increase over last year, and approved $4 billion of additional share repurchase authority. Now I'd like to take a moment to summarize the year. Our fiscal '24 results illustrate the diversity and durability of our business as well as our ability to continue to manage our business with rigor and discipline. We delivered record bookings of $81.2 billion, reflecting 13% growth in U.S. dollars and 14% growth in local currency, with a record 125 quarterly client bookings over $100 million, which positions us well as we begin FY '25. Revenue of $64.9 billion for the year reflects growth of 2% local currency. Before I continue, I want to note that results for the full fiscal year '24 and fiscal '23 include costs associated with business optimization actions, and fiscal '23 results also reflect a gain on investment in Duck Creek Technologies, which impacted operating margin, our tax rate and EPS. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating margin of 15.5%, a 10 basis point expansion over FY '23. Adjusted earnings per share were $11.95, reflecting a 2% growth over adjusted FY '23 EPS. Free cash flow of $8.6 billion reflected a very strong free cash flow to net income ratio of 1.2. And with regards to our ongoing objective to return cash to shareholders, we returned $7.8 billion of cash to shareholders while investing approximately $6.6 billion across 46 acquisitions. In closing, we feel good about how we managed our business while navigating a challenging macro environment in FY '24 and we remain committed to delivering on our enduring shareholder value proposition while creating 360 degree value for all our stakeholders. And now back to you, Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. Our FY '24 growth was driven by our clients seeking to reinvent using tech, data, AI and new ways of working. Reinvention requires a strong digital core. In FY '25, a significant driver of our growth will continue to be helping our clients with digital transformation, including building out their digital core and then using it to drive productivity and growth. We see the advent of GenAI and its tremendous potential acting as a catalyst for reinvention. Our clients turn to us for our unique combination of services across strategy, consulting, song, Industry X, technology and operations. Our strategists and deep industry functional customer and technology consultants work hand-in-hand with our clients and across services to shape and deliver these reinventions. Our investments in our advanced platforms, our assets and solutions, our process expertise, the insights from our scale and diversification, and our ability to both design and build the solutions, combined with our managed services are key differentiators for us. At the same time, we see AI as the new digital. Like digital, AI is both the technology and a new way of working, and the full value will only come from strategies built on both productivity and growth. And it will be used in every part of the enterprise. We believe the introduction of GenAI signifies a transformative era that is set to drive growth for us and our clients over the next decade much like digital technology has in the last decade and continues to do so. As part of that, we expect that the work to prepare enterprise data, which is the fuel for AI will be an increasing part of our growth. To accomplish reinvention and take advantage of AI, businesses need to focus on talent, their ability to access the best people at the right time, place and cost, the ability to be a talent creator to keep their people market relevant and their ability to unlock the potential of their talent is critical. We see talent as a top C-suite agenda item. Today, our managed services are an important part of our clients' long-term talent strategy. Our ability to harness AI is helping them close talent gaps and our strong expertise across talent, change, HR and organizations differentiates all our services. Our launch of LearnVantage, which provides comprehensive technology learning and training services, helps our clients reskill and upskill their people so they can be a talent creator. Let me give you a few examples of the types of reinventions we are doing. In Financial Services, banking and insurance are on their reinvention journey, while retirement services a $15 billion global addressable market growing at about 6% has lagged behind. We have invested to grow our capabilities and talent to capture this next wave of growth. We are working with TIAA, the largest U.S. provider of lifetime income to accelerate the transformation of the company's retirement record-keeping capabilities and operations. Leveraging the power of AI, automation in the cloud, we are helping the company implement new technologies, making record-keeping processes more efficient over time and easier for their customers. Through this strategic partnership, we are supporting parts of TIAA's record-keeping operations, including back end processes and technology. For example, retirement plan sponsors will experience faster plan changes and participants will find it easier to initiate account openings and investment selections. Together, we are making retirement planning more accessible, efficient and personalized for individuals and clients, helping TIAA need its mission of a more secure in retirement for more Americans. Today, we work with 75% of the world's largest communication services providers. With our strong industry and technology expertise, we are modernizing a global Telecom's core IT operations to drive growth. Through our managed services program, we are consolidating IT vendors, increasing productivity by an estimated 60% and reducing cost by half. We are also infusing our GenAI tools to enhance the software development life cycle and automate manual tasks such as resolving technical issues with customer orders, invoices or service availability. Now this will free up employees to focus on strategic growth initiatives and improve the overall customer experience. We are also implementing new ways of working, and then we'll train and upscale the team to use the new GenAI tools more effectively, helping to create more profitable outcomes for the company. These changes will create a stronger management framework and prepare the company for expansion into new markets. Security continues to be one of the fastest growing parts of our business, reaching $9 billion in revenue this year, representing 23% growth. We are partnering with the Kuwait Government Central Agency for information technology to revolutionize the security posture of its public services and national critical infrastructure. We are implementing and managing a scalable platform powered by GenAI, enabling the agency to act on evolving cyber threats up to 60% quicker than with traditional technologies, including detection response and containment models. In the past, security analysts manually research threats with limited information before handing the incident to the impacted government entity losing valuable time as the attack progressed. But now using a new platform, when analysts open a potential incident, they can quickly drill down into details about the users, systems under attack, type of attack and more with just one click. Thanks to GenAI's ability to process significant amounts of data and automatically elaborate context as a threat is detected, we are supporting our experts in making faster decisions with confidence as we progressively onboard over 60 government entities and while we also develop local talent. The strategic collaboration underscores our commitment to safeguarding Kuwait's digital assets and empowering the nation's journey towards enhanced cybersecurity resilience. A key area for companies to seek reinvention is in marketing, where the potential to use tech, data and creativity to drive growth, drive tangible outcomes for the enterprise. We are very proud to be working with HP and American multinational information technology company and a new global partnership to develop the right data sets, technology and creative for their B2B powerhouse business and brand that fulfils their goal to move away from the traditional agency model to true marketing capability transformation to significantly improve the impact, efficacy and efficiency of their marketing investment with the ability to drive tangible business results. In every industry, there is a challenge or opportunity that GenAI can now uniquely solve. Our deep understanding of both the industry and the technology positions us to be the best at creating real value from GenAI with our clients. For example, in insurance, companies can't typically process 100% of their coverage submissions. This creates a bottleneck for revenue growth. The ability to leverage GenAI to read 100% of submissions allows insurance companies to better assess risk as well as quote and write more policies and do it all more quickly and cost effectively. Utilizing a new set of solutions we created, we're working with QBE Insurance Group, a multinational insurance company headquartered in Sydney, to scale industry-leading AI powered underwriting solutions, replicated across multiple lines of business to help the company to make faster and more accurate business decisions. A series of Board, executive level and all employee learning sessions were conducted to help drive the design and build those solutions that analyze new business submissions for completeness, appetite check and risk evaluation insights. They can now process 100% of submissions received from brokers, greatly accelerating market response time. After nine months in market, these solutions are winning multiple industry innovation awards and early results indicate an increase in both quote to buying rate and premium. This collaboration will enable QBE Insurance Group to identify and select risk more effectively, improve broker and customer experience and support growth. We are collaborating with a major integrated downstream energy provider to drive significant improvements in safety, sustainability and operational performance with three new GenAI powered solutions. We aim to continue to improve safety by using proactive insights from GenAI to inform planners of potential incidents instead of reactively waiting for specific warning signs to appear. This means 90% faster data access, reducing planning time from hours to minutes per task. Another solution will help detect methane leaks in real time and prioritize their resolutions. We also helped build a smart solution for operators and process engineers to drive custom insights to optimize refinery performance and reduce downtime. The energy provider is on a path to set a new industry standard for innovation and refinery operations. One of the most powerful impactful uses of GenAI today across industry is in consumer experience transformation. We are working with Mondelez International, a world leader in snacking with well-known brands like Oreo, belVita and Cadbury to transform their marketing organization with GenAI to help drive consumer behavior. As part of this program, we're standing up a refreshed operating model with a primary focus on upskilling their employees in GenAI technologies. We are also helping enable a new capability to scale content creation and generate personalized text, images and videos across markets. This means exceptional creative can be developed in hours, not weeks, allowing content to be catered to consumers quickly as demands change. The strong digital core we established also allows the company to collect and process real-time data using GenAI to create new contextualized insights that can be easily accessed, shared and used by decision makers across the company. This work will increase the effectiveness and efficiency of messaging to create more impactful experiences. Now let's turn to our acquisitions. Over the last decade, we have built a finely tuned acquisition capability, becoming known in the market as a good home with approximately 70% on average of our acquisitions sole sourced. While our ability to identify and evaluate our acquisitions is critical, it is our ability to integrate them successfully that has made our acquisition capabilities so formidable. As we look forward, we are excited about the opportunity to better serve our clients and differentiate in the market to the acquisitions we've made this last fiscal year. As a reminder, we do acquisitions ultimately to drive our organic growth. Our global footprint, deep client relationships across industries as well as strong ecosystem gives us a unique perspective on growth opportunities. We use acquisitions to scale quickly in growth areas, to build new skills in adjacent markets and to deepen our technology, industry and functional expertise. Over the years, acquisitions have built major areas of growth like what we call Song today in our security practice. Here are a few examples of where we are investing now to lead in the next waves of growth. Starting with capital projects, an over $440 billion addressable global market growing approximately 5%. In FY '22, globally, we had approximately $300 million in capital projects revenue. We entered the U.S. market in FY '23 with the acquisition of Anser Advisory. Since the beginning of FY '24, we expanded our reach into Canada with Comtech in Q1, and this Q4, we acquired BOSLAN in EMEA. We recognized over $800 million in revenue on capital projects this fiscal year '24. Health is an industry still early in digitization, where we see significant opportunity over the next decade. It is a $70 billion addressable global market growing approximately 6%. This year, we added Cognosante in the U.S., creating a new federal health portfolio in our federal service business. We also acquired Nautilus Consulting in the U.K., a digital consultancy specializing in electronic patient records. And we announced our intent to acquire consus.health, a health care consultancy in Germany that offer services ranging from medical strategy and patient management to procurement and logistics, infrastructure management and construction planning services. And in Europe, public service, an industry that is early in digitization with significant investment allocated for transformation, our acquisitions are accelerating our growth and setting us up to take shares in a $46 billion market that is growing approximately 5%. We acquired Arns, Aris (ph) in Germany, a technology services provider supporting the public sector transformation across Europe. In Italy, we acquired Intellera Consulting, one of Italy's main professional services providers operating the public administration and health care sectors, and Customer Management IT and SirfinPA, jointly owned consultancies, supporting the public sector and specializing in justice and public safety. Now it gives me great pleasure to hand over to Angie Park, who'll become our new CFO on December 1, who will take us through our guidance for FY '25. Angie?"
},
{
"speaker": "Angie Park",
"text": "Thanks, Julie. Now let me turn to our business outlook. For the first quarter of fiscal '25, we expect revenues to be in the range of $16.85 billion to $17.45 billion. This assumes the impact of FX will be approximately positive 1.5% compared to the first quarter of fiscal '24 and reflects an estimated 2% to 6% growth in local currency. For the full fiscal '25, based upon how the rates have been trending over the last few weeks, we currently assume the impact of FX on our results in U.S. dollars will be approximately positive 1.5% compared to fiscal '24. For the full fiscal '25, we expect our revenue to be in the range of 3% to 6% growth in local currency over fiscal '24, which includes an inorganic contribution of a bit more than 3%. And we expect to invest about $3 billion in acquisitions this fiscal year. For operating margin, we expect fiscal year '25 to be 15.6% to 15.8%, a 10 basis point to 30 basis point expansion over adjusted fiscal '24 results. We expect our annual effective tax rate to be in the range of 22.5% to 24.5%. This compares to an adjusted effective tax rate of 23.6% in fiscal '24. We expect our full year diluted earnings per share for fiscal '25 to be in the range of $12.55 to $12.91, or 5% to 8% growth over adjusted fiscal '24 results. For the full fiscal '25, we expect operating cash flow to be in the range of $9.4 billion to $10.1 billion, property and equipment additions to be approximately $600 million and free cash flow to be in the range of $8.8 billion to $9.5 billion. Our free cash flow guidance reflects a free cash flow to net income ratio of 1.1 to 1.2. We expect to return at least $8.3 billion through dividends and share repurchases as we remain committed to returning a substantial portion of cash to our shareholders. Finally, as part of our routine review of our capital structure, we expect to tap the long-term debt market in the near term to increase our liquidity for general corporate purposes as we look to optimize our capital structure and reduce our cost of capital. We expect to raise a modest amount of debt. In connection with that, there would be no change to our capital allocation strategy, which includes how we look at and use D&A (ph) or our strong credit ratings and our net leverage will remain low. We have incorporated the potential for long-term debt into our guidance, including the interest expense. With that, let's open it up, so that we can take your questions. Katie?"
},
{
"speaker": "Katie O'Conor",
"text": "Thanks, Angie. We will now take your question. I would ask that you each keep to one question and a follow up to allow as many participants to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] We'll go to the line of Tien-Tsin Huang of JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Hey. Thank you so much. Yeah, really strong bookings. I wanted to think about how that translates into revenue visibility. If you don't mind, I know Accenture doesn't normally talk about ACV, but can you maybe comment on the current relationship between ACV and TCV and how that's evolving? It seems really important to us as we think about revenue and visibility. Duration looks like it's up, but you also have a lot of large deals converting as well, so can you comment on that?"
},
{
"speaker": "Angie Park",
"text": "Hi, Tien-Tsin. Good morning. It's Angie. So let me cover guidance because maybe it will help to paint a picture of how we're thinking about the full fiscal year. I think it's really important. Let's start with how we ended Q4. If you think about the 5% growth that we posted in the fourth quarter, what we highlighted was that we did have slight growth in organic, which is important as we exit the year. And as you just talked about, over the last few quarters, we've really pivoted our business to what our clients are buying, which are the large transformation deals. And what that does is it positions us better than compared to the same time last year on the revenue that we've already sold. From an inorganic contribution, I do want to highlight that overall, we expect a bit over 3% for the year, which would imply with our guidance of 3% to 6%, that at the bottom end of the range, organic is flat. And then at the top end of the range, we're growing 3% in organic growth. And then as you peel it back and you look at the revenue growth that we see, it is broad based, and we saw that coming out of Q4, we see it across the market and across all of our industry groups. And then as -- when you look at it by type of work as well, what we see right now is that both consulting and managed services, we see low to mid-single digit growth rates for the year. And so stepping back with the color and how we're looking at our guidance, we're very pleased with how we have set ourselves up that and positioned ourselves for fiscal '25."
},
{
"speaker": "Julie Sweet",
"text": "Yeah. And so Tien-Tsin, what that means is, we're not commenting specifically on ACV and TCV because as you said that isn't. But the way to think about the confidence level and going to the year, right, is that we told you that we had a strategy to have more megas. We've shared with you that we had 19 more of these bookings than last year, $100 million or more. So you can see there's a big quantum. And so as you think about going into the year, we've got a bigger base of revenue coming from these larger deals coming online than we did going into fiscal year '24. And so that's really how we're trying to help you all think about it is by being clear about that strategy and how -- and the quantum of that, and that's how we then think about the year. So hopefully, that gives you some more insights together with the view on the guidance."
},
{
"speaker": "Tien-Tsin Huang",
"text": "No, it does and it's very reasonable as well, just to say that loud out. Just on the acquisition side, Julie, I think I asked it last quarter, so I'll ask again. I know you've been very busy. I like the examples that you gave around the productivity you're getting from some of the deals and the examples you gave again. But how about just overall appetite this year, are you still seeing good opportunities? Could we see a stepdown or a pause in the short term, anything else to add?"
},
{
"speaker": "Julie Sweet",
"text": "Yeah. So what I would say is, as Angie just said, our inorganic plan for the year, like, in terms of -- as you think about revenue guidance, we kind of -- we're going into the year with nearly 3%, and we think we'll -- right now, the plan for is a little bit above 3% is what we're seeing for fiscal year '25. And that reflects an expected plan right now of about $3 billion of deployed capital. So a step down from last year and probably more backend loaded as we look at our pipeline. Now obviously, we always have the ability to flex up or down. We only tie it to the opportunities in the market, but that’s how we’re seeing this year as we think about our investments."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Perfect. Thank you. Well done. Thanks."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of James Faucette with Morgan Stanley."
},
{
"speaker": "Unidentified Participant",
"text": "Great. Thanks for taking our question, guys. This is Antonio (ph) on for James. I wanted to actually dig into the technology segment. I know cloud is a big component of this. Could you talk through how clients spend on these cloud migration projects has been trending over the last 90 days and how we should think about cloud growth going into fiscal year '25? And then I have a follow-up after."
},
{
"speaker": "Julie Sweet",
"text": "Hi, Antonio. I'm not going to think about it in the last 90 days is just think about like sort of where we've been and where we think we're going, right?"
},
{
"speaker": "Unidentified Participant",
"text": "Yeah."
},
{
"speaker": "Julie Sweet",
"text": "So, in cloud, you still have a lot of migration that's happening, but on more of the high-performance compute applications. So things like mainframe, right? So -- and you also still have some clients who are very, very early in their cloud journey. And one of the things I talked about in the script, for example, was like retirement services. Like that's an entire segment where they're very, very early in the cloud journey. And so at the same time, you've got companies that are very early, just starting their cloud journey. You have those who are farther along who are now getting to the harder applications like mainframe. And then we still have a lot of modernization because what happened in the pandemic, people who were trying to get to the cloud to get the infrastructure savings, have not yet done the modernization. And that modernization, of course, feeds into all the things we do, right, brings the industry and the functional expertise. And so as we look going into FY '25, we continue to see those strengths. So we expect that cloud is going to continue to be a significant driver of growth but on all of those dimensions, right? And the high performance compute as well requires very deep industry knowledge, like doing mainframe in the context of health is very different than the context of banking. So hopefully, that helps you."
},
{
"speaker": "Unidentified Participant",
"text": "Got it. No, that's helpful. And then, I wanted to ask on the organic headcount. It actually looks like that ticked up quite a bit. Could you comment on your hiring strategy and in what geographies you're sort of looking to shape that?"
},
{
"speaker": "Angie Park",
"text": "Yeah. Why don't I start and then Julie add (ph) any additional comments as well. So as you can see, I mean, I want to start with how we're exiting the year. We saw slight organic growth in Q4, and we see that momentum into FY '25. You will have also seen that we added about 24,000 people this year in Q4, which is reflective of the momentum that we see in the business. And as always, right, looking ahead, we will always hire for the skills and the demand that we see. And just more broadly, I would just remind us that as you think about us, as a business, our core competency is balancing supply -- managing supply and demand. And you see that through our utilization rates, which continue to be in the 92% range."
},
{
"speaker": "Julie Sweet",
"text": "And we're hiring -- from a talent strategy, right, we are hiring primarily in India. So a lot of that hiring is technology in India and, of course, also addresses -- we are refreshing our pyramid at this time. So you've got kind of the new college graduates coming in. So there's really no change in our talent strategy. We hire all over the world. And in technology, which is a big driver of the growth that we're seeing now and going into FY '25, that is a lot of hiring in India."
},
{
"speaker": "Unidentified Participant",
"text": "Great. Thank you, both."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Jason Kupferberg with Bank of America."
},
{
"speaker": "Jason Kupferberg",
"text": "Good morning, guys. Thanks. I wanted to pick up on the commentary about the consulting outlook for fiscal '25. You said up low to mid-single digits. I think that's very consistent with the exit rate of 3% coming out of fiscal '24. So does that imply that you are not building much of a discretionary spending recovery into this initial F '25 guide?"
},
{
"speaker": "Angie Park",
"text": "Yeah. Hi, Jason. Good morning. How are you? And let me just give you a little bit of color on that as you think about the types of work and the question that you just asked. If you think about our range overall, so we're at 3% to 6% for the full year. And what this assumes is, at the top end, we see more of the thing, right, in terms of the discretionary spending environment. While at the bottom end, it allows for further deterioration in the discretionary spend environment over what we experienced in FY '24."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay. That's very helpful. And then maybe one for Julie. I just wanted to get your broad take on the macro backdrop. I mean, I guess, what are decision makers telling you right now versus three months ago? What are they waiting to see to open the discretionary budget a little bit more?"
},
{
"speaker": "Julie Sweet",
"text": "Yeah. Well, the environment is really more of the same and that environment has been kind of a cautious environment. Right now, they're going into budget season. So as always, we'll really see in January and on February, but there hasn't been much of a change, right? The macro is kind of the same. Obviously, there's some events going to come up in the fall that people are thinking about, but there's not like a big tone change, right? And I think, because if you look at the macroeconomic environment, FY '25 is going to click down in the U.S., maybe a little bit better in Europe. But overall, not a lot of improvement. So we're not hearing -- I'm not hearing from CEOs, and I'm talking to them almost every day, some big like, hey, now we're ready to go spend more, right, in discretionary spending. So it's really just more of the same. And by the way, one of the changes that we made this last fiscal year '24 was normally we do for decades, our big promotion period was in December, and then a small one in June. And so in fiscal year '24, we switched these, right? We said we have a lot more visibility in our business in January or February because that's where budgets are set. So we did that this past year and had a really big promotion, a very nice promotion, I would say, not really big, but very nice promotion in this past June. We've now permanently shifted that promotion cycle. So we will do our big promotion cycle in June and our smaller one in December to better match when our clients are setting their budgets and we have better visibility. And that's what we're seeing again. The justification for that is clear that we're really no IT spending and spending on our services in the budgets in January, February."
},
{
"speaker": "Jason Kupferberg",
"text": "Thanks for all the color."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Keith Bachman with BMO."
},
{
"speaker": "Keith Bachman",
"text": "Hi. Good morning. Thank you very much. I wanted to revisit on M&A, if I could, and just get some clarification. In FY '24, you spent, as you noted $6.6 billion, which was up about 160% year-over-year. And if we sort of do the math on what your normalized multiples are to revenue, it looks like you're starting the year of FY '25 with 3 points of M&A help. And so I just want to understand, is that the right way to think about it? And then Julie, you had indicated that you plan to spend $3 billion more in M&A this year, and it will be, as you said, backend weighted. But I'm just struggling why M&A is that $3 billion number is even second half weighted, why M&A isn't 4% or more for the year?"
},
{
"speaker": "Angie Park",
"text": "Let me just start with peeling back our inorganic contribution a bit. As we look at the deals that we closed in '24, it's nearly 3% contribution, right? And so with the backend loaded approach in our capital deployed, we do see a bit over 3%, and that's just the math."
},
{
"speaker": "Julie Sweet",
"text": "Yeah. It's just timing, right? It's not quite 3% going in because a lot of this closed at the end of Q4, right? And so it's just its timing, right? And it's the way we see our pipeline developing, right? Because we have a view of what we're going to -- we think we're going to spend in Q1 and Q2 and how that rolls in."
},
{
"speaker": "Keith Bachman",
"text": "Okay. Let me transition the bookings then. As you think about FY ‘25, and I know you don't guide to bookings, it's more of an output, but any puts and takes that you want us to think about in terms of the book-to-bill ratio in FY '25 that might be higher or lower? Any kind of cadence there? And if you don't mind, was there an M&A help in the August quarter bookings as well or signings, excuse me?"
},
{
"speaker": "Angie Park",
"text": "Why don't I start, in terms of the way to think about our bookings, we were super pleased with the $81 billion of bookings that we had for the year, which was 14% growth, which included the 125 quarterly client bookings over $100 million. And so I think that, that we were super pleased with. And you saw that in our book-to-bill and our growth rate in managed services was driven by our large transformation deals. For us, over time of our four trailing quarters, we're always looking for our consulting book-to-bill to be 1.0 or better and for our managed services to be 1.2 or better and nothing has changed there."
},
{
"speaker": "Julie Sweet",
"text": "Yeah. And there was nothing in M&A about our bookings in Q4."
},
{
"speaker": "Keith Bachman",
"text": "Okay. Many thanks."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Bryan Keane with Deutsche Bank."
},
{
"speaker": "Bryan Keane",
"text": "Good morning. Julie, I just want to ask about GenAI. I think bookings were up almost about $300 million in the third quarter sequentially, up about $100 million this quarter. Anything about the cadence there of GenAI and fall through there that you can help us understand?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. So yeah, so we ended with $3 billion bookings for the year, and we'd expect in FY '25, another healthy increase. We know there's clear demand. We're starting to see more of our clients move from proof-of-concept to sort of larger implementations, which is important. So the size of those bookings is kind of, is clicking up. And also, we're continuing to see kind of at least every other one has got data pull-through and even that's kind of moving up. So we're kind of going into the year, we'd see -- we'd expect another healthy increase in our bookings and our revenue from that and also that data will continue to kind of be a bigger and bigger part of that building out of the digital core because one of the biggest limitations on using GenAI today and why it's going to take a while is our client needs data and our clients have a lot of work to do on data, which is, of course, a big opportunity for us."
},
{
"speaker": "Bryan Keane",
"text": "Got it. And then just a clarification on the guide. I know the fourth quarter organic growth was positive, and we're talking about fiscal year '25 revenue guide of 3% to 6% on a constant currency basis. And if you back out the acquisitions, I think you guys said on the low end, we're talking about flat organic growth, that would be a slight step down from the fourth quarter, which is -- would be a little surprising given some of the momentum that you guys are seeing in bookings and in headcount growth. So just wanted to make sure I understood what that low end might imply and why would there necessarily be a step down from where the fourth quarter kind of ended? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Yeah. No. And the way we're thinking about it, right, we're going into the year with momentum. We had executed on the strategy around the bigger deals. So we have a stronger base of revenue. We've got the acquisitions. And so on the bottom end of the range, what we would see, like the most likely reason to be there is if there was a deterioration in the discretionary spend environment, right? So we're trying to just kind of give some flexibility. We’re not seeing that, right? We sell more of the same this quarter. And so as we kind of go into the year, at the top end of the range, it’s the current environment going forward. And at the bottom of the range, if you were to ask me today, what is that mostly accommodated is if there was a deterioration in spending, right, so -- because of kind of the way we’ve positioned ourselves."
},
{
"speaker": "Bryan Keane",
"text": "Great. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Dan Dolev with Mizuho."
},
{
"speaker": "Dan Dolev",
"text": "Hi. Thanks for taking my questions. Great results and great guidance here. Two questions on GenAI. Are you seeing more of your conversations being less replacement and reallocation and purely incremental on G&A? And then I have a follow-up."
},
{
"speaker": "Julie Sweet",
"text": "Well, I think it starts with, we're not seeing a change in what our clients are spending on IT, right? So -- but what we are seeing is the continued trend of trying to save money on IT to free up the spending on areas of GenAI. So on the one hand, right now, we haven't seen a change in overall spending. We'll see what the budgets come in January, February, but we're not expecting a big change. But what we also are seeing is that as they're saving money, they want to invest it in things like GenAI and data. So that's really the dynamic that's going on, save to invest, but we haven't seen signs of overall change."
},
{
"speaker": "Dan Dolev",
"text": "Got it. And then a quick follow-up on margins. Can you maybe touch on the GenAI services margin, how it stands versus your traditional business? I think that would be really helpful for investors. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Are you -- I mean, are GenAI margin and sort of -- is that different from when we're doing GenAI versus other GenAI technology?"
},
{
"speaker": "Dan Dolev",
"text": "Correct. GenAI services versus your traditional consulting business."
},
{
"speaker": "Julie Sweet",
"text": "Look, GenAI is still a small part of our business, and I wouldn't really think about it as having a particularly different margin profile at this time. And as you probably heard in our -- in my script that a lot of time we're starting to embed GenAI in our larger deals and so we're not really thinking about it as like a sort of a separate way. So I wouldn't think about it too differently than our usual business."
},
{
"speaker": "Dan Dolev",
"text": "Got it. Thanks. Well, great momentum. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "We'll go next to the line of Jim Schneider with Goldman Sachs."
},
{
"speaker": "Jim Schneider",
"text": "Good morning. Thanks for taking my question. Very helpful commentary on the client outlook on limited discretionary spend. But can you maybe help us understand or unpack, when you talk to them, what are they looking for to release discretionary spend? Is it more macro factors, whether that be rates, election or regulatory or is it more micro factors tied to their IT budgets? And if it's the latter, what are the things they're looking for in terms of getting increased clarity on those priorities going into 2025?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. It's a good question. And it's really -- overall, there is a sense of the macro, right? Because if you look at the -- a lot of our clients are global. If you look at the macroeconomic, there isn't a big change. There's kind of going into next year, like the U.S., which is a big market, it looks like it's going to be down a little bit. Europe's up a little bit, but still not great. And so kind of if you start with they're not seeing a big change in the macro. But then you really have to look at it industry by industry because each industry has factors. So for example, in the energy industries, they're super focused on how much investment they have to do and the change – and the shift in climate change and renewables. So there's a big appetite for major investment. So there's no catalyst that says, oh, like I've got a ton of thought. They've got a lot of big investments, right? If you look at consumer goods, where a lot of the consumer goods companies are not able to get pricing. They've got to get up volume, which means they've got to drive down their -- they've got to improve their efficiency and their manufacturing costs, and that takes big investments because manufacturing. Our latest research says like two-thirds of the journey in digitization is still to come. And so those are big investments. And so I can kind of take you through industry by industry. The reality is, it's obviously good growth for us is the digitization journey is still very early in many, many industries, that's like public service is another great example. So they've got big transformations going. And at the end of the day, if you're a big enterprise, like, the deals that are smaller, right, they do not move the needle. And when you've got big investments, that's where they're focused because they see now the potential of things like GenAI, and everyone's like we got to get going, that's really what's driving it. So that's why we're not having a bunch of discussions about like I can't wait to unlock that spending. Our discussions are entirely on help us move faster with our bigger information. That's really what we're focused on."
},
{
"speaker": "Jim Schneider",
"text": "That's very helpful. Thanks. And then maybe as a follow-on, you referenced several verticals there. Can you maybe, as you prospectively look into fiscal '25, call out maybe one or two verticals where you expect the most improvement and maybe one or two where you see potential risk of deterioration? Thank you."
},
{
"speaker": "Angie Park",
"text": "Yeah. Hey, Jim. Nice to talk to you. I think that as we look across FY '25 in our overall guide of 3% to 6%. We see broad-based growth across -- it's really broad-based across all of our industries as well as our services and markets."
},
{
"speaker": "Jim Schneider",
"text": "Great. Thank you."
},
{
"speaker": "Katie O’Conor",
"text": "Operator, we have time for one more question, and then we’ll wrap up the call."
},
{
"speaker": "Operator",
"text": "Thank you. And that will come from Bryan Bergin with TD Cowen."
},
{
"speaker": "Bryan Bergin",
"text": "Hi. Good morning. Thank you. On GenAI, can you give us a sense of the size of some of the largest individual programs have reached? And then as it relates to internal productivity progress, may be comment on any of the service lines where you're seeing the earliest impacts as it relates to productivity or any metrics that you can share in more advance programs?"
},
{
"speaker": "Julie Sweet",
"text": "Sure. I don't want to start like giving tons of data on this. But like you went from deals that were -- in GenAI that were, on average, kind of sub-$1 million, right, that you've now got some that are above $10 million, right? So that's still the smaller end because you're sort of moving into production and scale. But you're starting to see these things move from POCs to larger bookings. And then with respect to internal productivity and our guidance, of course, takes into account what we're seeing. As I've been talking about is that the first area that we anticipate -- remember, we're trying to embrace GenAI fastest because we think it's a big differentiator with our clients. And so in our managed services is where we're seeing the most because that's where we have a platform. So you all remember we used to talk about myWizard. Now we talk about GenWizard, right? But what we're seeing is that the technology and the productivity is like similar ways before. So if you go back to 2015, 2016, when we first introduced myWizard, right? So it's not really different than the kinds of productivity that we've been experiencing. And here, of course, there's an added wrinkle in that GenAI, in order for us to use it with our clients, they have to allow us to use it and they have to prioritize. And they have a lot of other areas where they want to use GenAI that's not necessarily in their technology productivity where they're already many of our clients are using our platforms, they're using AI, etc. So there's a lot of factors that kind of go into the pace of how quickly we can use it even if we're ready to use it now in many places. So hopefully, that's helpful because it is a little bit different in that sense because our clients have to prioritize where they want to use GenAI, too."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. That's helpful. Thank you. And then I appreciate your commentary on the capital returns on the balance sheet and understanding this has overall been a tougher environment, while M&A outlay has been on the upper end. But just curious how we should be thinking about the potential magnitude of leverage in the model going forward? Just any guardrails we should consider?"
},
{
"speaker": "Angie Park",
"text": "Yeah. And a couple of things that I would say around that. We indicated that it's going to be modest. We'll maintain our strong credit ratings and net leverage will be low. And so -- and included in our guidance that we provided you, we have also allowed for the potential for the interest expense and in our overall guidance, which is in addition to the variability that we may see in operating margin throughout the year."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Great. Well, thank you, everyone, for joining us. Before I wrap up, I want to thank KC, who's been an amazing partner and friend these last five years. They've been quite some five years, as we all know, just a few things in the environment that we've gotten together work with. And so I'm really excited for KC and her next chapter. And KC, would you like to say a few words?"
},
{
"speaker": "Katie O'Conor",
"text": "I would, thanks, Julie. I just want to offer my sincere thanks to the investor and analyst community for the decade plus of console and support. It's really meant a lot to me. It's really been appreciated. Thanks a lot, and best wishes to all of you."
},
{
"speaker": "Julie Sweet",
"text": "So I want to thank everyone for joining us and thank all of our people for what you do every day, allowing us to create 360 degree value and giving us a lot of confidence in our success in FY ‘25. And thanks again, KC, and welcome Angie to your new role, and we’ll see you all in the next quarter."
},
{
"speaker": "Angie Park",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "This conference will be available for replay beginning at 10:00 a.m. Eastern Time today and running through mid-night on December 18. You may access the AT&T replay system at any time by dialing 1-866-207-1041 and entering the access code of 9225580. International callers may dial (402) 970-0847. Those numbers again are 1-866-207-1041 or (402) 970-0847 with the access code of 9225580. That does conclude our conference for today. Thank you for your participation and for using AT&T Event Conferencing. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 3 | 2,024 | 2024-06-20 08:00:00 | Operator: Ladies and gentlemen, thank you for standing by. Welcome to Accenture's Third Quarter Fiscal 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Katie O'Conor. Please go ahead.
Katie O'Conor: Thank you, operator, and thanks everyone for joining us today on our third quarter fiscal 2024 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short-time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the fourth quarter and full fiscal year 2024. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including but not limited to, those factors set forth in today's news release and as discussed in our Annual Report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release, or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Katie, and everyone joining. And thank you to our 750,000 people around the world who work every day to deliver 360-degree value for all our stakeholders. Before we get into the quarter, I want to thank KC, who's been an excellent partner for these last five years, and our three other extraordinary leaders who are stepping down in the next two quarters, Jean-Marc, Ellyn, and Paul. Each have given over 36 years of service and demonstrated strong stewardship in developing outstanding successors, including Angie, who you all know from her former role as Head of Investor Relations, who will succeed KC on December 1. As always, we are executing a smooth leadership transition to the next generation with our strong bench of great leaders. Now, on to the quarter. I am pleased this quarter to bring to life yet again the resilience and agility of our business, as our actions to remain laser-focused on our clients' needs and quickly adapt to market conditions can be seen in our results, which are building a foundation for stronger growth as we go into Q4 and next fiscal year. As you know, this fiscal year, our client spending developed differently than we expected at the beginning of the fiscal year. And these conditions continue, with clients prioritizing large-scale transformations, which convert to revenue more slowly, while limiting discretionary spending, particularly in smaller projects, with delays in decision-making and a slower pace of spending as well. In response, we have moved quickly to adjust by leveraging our unique strengths, our end-to-end services, including deep industry and functional expertise that enable these large-scale transformations or what we call reinventions. We're also leveraging our deep technology expertise and ecosystem partnerships and our learning machine and culture that gives us the agility to shift to new areas of demand, including, for example, GenAI while continuing to invest at scale for future growth. Here is how these strengths and our strategy are demonstrating results three quarters into the fiscal year. With our clients prioritizing large-scale transformations, we have accelerated our strategy to be the reinvention partner of our clients. Our success is reflected in our bookings of $21.1 billion, including another 23 clients with quarterly bookings greater than $100 million, bringing the total of such clients with these bookings to 92 year-to-date, seven more than last year at this time. This focus on being the reinvention partner is an important part of our strategy to return to stronger growth. As we enter next year, as this work ramps, the revenue from these large-scale bookings is expected to continue to layer in throughout the year, and we are also well-positioned to capture increases in discretionary spend when it comes back because of the strategic positioning these deals bring at our clients. We also have leaned into the new area of growth, GenAI, which is comprised of smaller projects as our clients primarily are in experimentation mode, and this quarter we hit two important milestones. With over $900 million in new GenAI bookings this quarter, we now have $2 billion in GenAI sales year-to-date, and we have also achieved $500 million in revenue year-to-date. This compares to approximately $300 million in sales and roughly $100 million in revenue from GenAI in FY 2023. Leading in GenAI positions us to help our clients take the actions needed to reinvent and to benefit from GenAI, which frequently means large-scale transformations. We are also taking an early lead with an eye toward long-term leadership in this critical technology, which is still in the early stages of maturity and adoption, despite its rapid evolution. We have built our expertise in making strategic acquisitions over the last decade, leveraging a strong balance sheet, and we have used this expertise to expand into new growth areas, scale in hot areas and geographies, and continue to build strength in our industry and functional consulting. We deployed $2.3 billion of capital across our geographic markets in Q3 across 12 acquisitions, bringing the total number of acquisitions to 35 with invested capital of $5.2 billion year-to-date as compared to $2.5 billion for the entire FY 2023. As a learning organization and talent creator, we continue to invest in our people with approximately 13 million training hours this quarter. This averages 19 hours per person, representing an increase predominantly due to GenAI as we continue to prepare our workforce for the infusion of GenAI across our business in the coming years. We also continue to steadily increase our data and AI workforce, reaching approximately 55,000 skilled data and AI practitioners against our goal of doubling our data and AI workforce from 40,000 to 80,000 by the end of FY 2026. We continue to take market share on a rolling four-quarter basis against our basket of our closest global publicly traded competitors, which is how we calculate market share, with revenues of $16.5 billion for the quarter, up 1.4% in local currency and slightly above the midpoint of our FX adjusted range. We expanded adjusted operating margin by 10 basis points and delivered free cash flow of $3 billion. I want to congratulate our 97,000 people we have promoted around the world through June 1, including 702 to Managing Director and 64 to Senior Managing Director, reflecting our commitment to providing vibrant career paths. We are recognized as a Top 10 Place to Work in 10 countries, representing more than 70% of our people, number two in Argentina, Brazil, and the Philippines, number four in Singapore, number five in Costa Rica, Finland, and Indonesia, number seven in the US, and number 10 in Chile on the Great Place to Work list of Best Workplaces and number two on Business Today's Best Companies to Work For in India. And in recognition of our strong brand, we are proud to earn the number 20 position on Kantar BrandZ's prestigious Top 100 Most Valuable Global Brands list, our highest rank to date, with an 11% increase in brand value to $81.9 billion. Our scale across strategy, consulting, technology, and operations, and our breadth and depth across industries and functions make us uniquely capable of helping our clients reinvent using technology, data, AI, and new ways of working. Before turning to KC, I want to give a little more color on our acquisitions this quarter, which yet again demonstrate the strategic importance of both our ability to invest, and our expertise in identifying, attracting, and integrating great companies joining Accenture. Let's start with new areas of growth. We completed our acquisition of Udacity to scale our technology learning and training services and to help our clients reskill and upskill their people. Udacity is a critical part of our LearnVantage digital learning platform, which we announced last quarter as a new area of growth for the future. Building on our expertise in customer-focused consulting, we invested to help drive our clients' growth agendas. We acquired Unlimited, an award-winning customer engagement agency with a deep understanding of human behavior as evidenced by its proprietary human understanding lab and AI-powered data insights platform. We acquired The Lumery in Australia, a marketing technology consultancy that helps leading organizations deliver seamless customer experiences and transform their marketing services. It provides industry and platform consulting services, including marketing, advisory, and planning, implementation across entire technology stacks, operational excellence, and simplification. We closed our acquisition of GemSeek in Bulgaria, a leading customer experience analytics provider helping global businesses understand customers through insights, analytics, and AI-powered predictive models. And we closed MindCurv, a global digital -- a cloud-native digital [indiscernible] experience and data analytics company specializing in composable software, digital engineering, and commerce services. Now, let's turn to scaling and hot industries. We acquired Cognosante, a provider of innovative technology solutions for US federal health, defense, intelligence, and civilian agencies. With this acquisition, federal services is creating a new federal health portfolio for its business. We invested in Customer Management IT and SirfinPA, which will provide the public sector with technology, support, and justice and public safety in Italy. We see public service and, in particular, health, intelligence, and defense as highly strategic industry focus areas globally for the next several years. And we invested in Teamexpat, focusing on testing integration for lithography systems in the semiconductor industry, another attractive industry segment. Our investment in Flo Group, a leading European consultancy and Oracle business partner, who specializes in global supply chain logistics is helping us scale in supply chain, also a major growth area. Finally, we're scaling in attractive geographic markets. We acquired CLIMB, a technology-based consultancy based in Japan, where we continue to experience very strong revenue growth. Over to you, KC.
KC McClure: Thank you, Julie. And thanks to all of you for taking the time to join us on today's call. We are pleased with our Q3 results, which were in line with our expectations and reflect continued investment at scale. We continue to serve as a trusted partner for our clients, while running our business with rigor and discipline. Now, let me summarize a few of the highlights for the quarter. Revenues grew 1.4% local currency with mid-single digit growth or higher in seven of our 13 industries, including public service, industrial, high-tech, life sciences, energy, utilities, and health. We also continue to see improvement in our CMT industry group. And we continue to take smart share. As a reminder, we assess market growth against our investable basket, which is roughly two dozen of our closest global public competitors, which represents about a third of our addressable market. We use a consistent methodology to compare our financial results to theirs, adjusted to exclude the impact of significant acquisitions to the date of their last publicly available results on a rolling four-quarter basis. Adjusted operating margin was 16.4%, an increase of 10 basis points over Q3 last year, and includes continued significant investments in our people and our business. Finally, we delivered free cash flow of $3 billion and returned $2.2 billion to shareholders through repurchases and dividends. Year-to-date, we've invested $5.2 billion across 35 acquisitions. With those high-level comments, let me turn to some of the details, starting with new bookings. New bookings were $21.1 billion for the quarter, representing 22% growth in US dollars and 26% growth in local currency, with an overall book-to-bill of 1.3. Consulting bookings were $9.3 billion with a book-to-bill of 1.1. Managed services bookings were $11.8 billion with a book-to-bill of 1.5. Turning now to revenues. Revenues for the quarter were $16.5 billion, a 1% decline in US dollars and a 1.4% increase in local currency, and slightly above the midpoint of our FX adjusted guidance range, as the FX headwind was approximately 2% compared to the 1% headwind estimated at the beginning of the quarter. Consulting revenues for the quarter were $8.5 billion, a decline of 3% in US dollars and a decline of 1% in local currency. Managed services revenues were $8 billion, up 2% US dollars and up 4% local currency. Taking a closer look at our service dimensions, technology services and strategy and consulting grew low single digits and operations was flat. Turning to our geographic markets, in North America, revenue grew 1% local currency, led by growth in public service, partially offset by decline in banking and capital markets. In EMEA, revenues declined 2% local currency with growth in public service, offset by declines in banking and capital markets and communications and media. Revenue growth in Italy was offset by a decline in France. In growth markets, revenue grew 8% local currency, led by growth in banking and capital markets and industrial. Revenue growth was driven by Argentina and Japan, partially offset by a decline in Australia. Moving down the income statement, gross margin for the quarter was 33.4%, consistent with the same period last year. Sales and marketing expense for the quarter was 10.6%, compared to 10.5% for the third quarter last year. General and administrative expense was 6.3%, compared to 6.5% for the same quarter last year. Before I continue, I want you to note that in Q3 of FY 2024 and FY 2023, we recorded $77 million and $347 million in costs associated with our business optimization actions, respectively. These costs decreased operating margin by 40 basis points and EPS by $0.08 this quarter and operating margin by 210 basis points and EPS by $0.42 in Q3 of last year. In Q3 of last year, we also recognized a gain on our investment in Duck Creek Technologies, which impacted our tax rate and increased EPS by $0.38. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.7 billion in the third quarter, reflecting an adjusted operating margin of 16.4%, an increase of 10 basis points from adjusted operating margin in the third quarter of last year. Our adjusted effective tax rate for the quarter was 25.5%, compared with an adjusted effective tax rate of 24% for the third quarter last year. Adjusted diluted earnings per share were $3.13, compared with adjusted diluted EPS of $3.19 in the third quarter last year. Days sales outstanding was 43 days, compared to 43 days last quarter and 42 days in the third quarter of last year. Free cash flow for the quarter was $3 billion, resulting from cash generated by operating activities of $3.1 billion, net of property and equipment additions of $124 million. Our cash balance at May 31 was $5.5 billion, compared with $9 billion at August 31. With regard to our ongoing objective to return cash to shareholders. In the third quarter we repurchased or redeemed 4.3 million shares for $1.4 billion, an average price of $320.41 per share. As of May 31, we had approximately 3.3 billion of share repurchase authority remaining. Also in May, we paid a quarterly cash dividend of $1.29 per share for a total of $811 million. This represents a 15% increase over last year. And our board of directors declared a quarterly cash dividend of $1.29 per share to be paid on August 15, a 15% increase over last year. In closing, we feel good about our results in Q3 and are now working hard to deliver Q4. We remain focused on capturing growth opportunities while continuing to invest in our business for long-term market leadership. Now let me turn it back to Julie.
Julie Sweet: Thank you, KC. As I mentioned earlier, we're seeing more of the same in terms of the demand environment. Now let me give a little context on how we're executing our strategy to be the reinvention partner of choice and why we're uniquely positioned to be helping our clients on AI. It is important to remember that while there is a near universal recognition now of the importance of AI, which is at the heart of reinvention, the ability to use GenAI at scale varies widely with clients on a continuum. With those which have strong digital cores genuinely seeking to move more quickly, while most clients are coming to the realization of the investments needed to truly implement AI across the enterprise, starting with a strong digital core from migrating applications and data to the cloud, building a new cognitive layer, implementing modern ERP and applications across the enterprise to a strong security layer. And nearly all clients are finding it difficult to scale GenAI projects because the AI technology is a small part of what is needed. To reinvent using technology, data, and AI, you must also change your processes and ways of working, rescale and upscale your people, and build new capabilities around responsible AI, all with a deep understanding of industry, function, and technology to unlock the value. And many clients need to first find more efficiencies to enable scaled investment in their digital cores and all these capabilities, particularly in data foundations. In short, GenAI is acting as a catalyst for companies to more aggressively go after cost, build the digital core, and truly change the ways they work, which creates significant opportunity for us. And this is why clients are coming to us. We are able to help our clients with this AI rotation because of our broad services across strategy and consulting technology and operations, as well as everything customer through Song and digital manufacturing and engineering through Industry X and our relevance across the functions of the enterprises and 13 industries. Our privileged position in the technology ecosystem has never been more important. We are working closely with our ecosystem partners to help our clients understand the right data and AI backbone that is needed and how to achieve tangible business value. Now let me give you a few examples of the complex work of reinvention and building a digital core. We are partnering with Currys, a leading European technology retailer to unlock new growth and cost savings by accelerating its adoption of new technologies. First, we will move their operations from a legacy data center to a new cloud platform using pre-built and customized solutions to create a powerful digital core. This unified data foundation allows us to deploy automation and generative AI in key growth areas, such as repair centers, customer service, e-commerce, procurement, and in-store experiences, delivering faster, more efficient services to their customers. The move to a new platform supports the company's sustainability goals, reducing energy consumption by transitioning to a more efficient cloud infrastructure. Now, Currys' employees will be empowered to serve their customers better by offering high-touch experiences, both online and in-stores. We're working with Independence Health Group, IHG, a leading health organization headquartered in Southeastern Pennsylvania on a transformation journey to modernize end-to-end operations, improving the way they serve current and future generations of customers. We will help migrate nearly 2 million members to a new digital-first platform, expected to drive immediate improvements in existing business processes. This will lay the foundation to leverage advanced technology and generative AI to proactively manage members' health. We are also helping reskill and retrain their operations staff, creating opportunities for employee development. With this reinvention, Independence continues its ongoing efforts to increase service quality, improve experiences, and enable better health outcomes, positioning them for new areas of growth in the rapidly changing healthcare landscape. Digital core work also requires deep industry expertise as we work with our clients to design the right tech, data, and AI to reinvent their enterprise and their industry. We are helping Macy's, an iconic American retailer with a technology modernization effort. As a strategic technology execution partner, we will migrate their mainframe systems to a cloud platform, a move that will enhance their operational efficiency and scalability. This will allow Macy's to be more agile and enable growth. We are helping the Central Bank of the United Arab Emirates, the regulatory body responsible for the country's banking and insurance sector with a digital transformation to strengthen the financial system's stability and contribute to growth, innovation, and diversification in the sector, in line with the UAE's national vision. Our program will deliver advanced analytics along with AI-driven automation to improve supervisory capabilities and streamline activities for licensed financial institutions by creating best-in-class processes to support regulatory compliance. We will also modernize the bank's enterprise data management by implementing a single unified portal to provide a holistic view of the financial services ecosystem, all of which will enhance the UAE's position as a global financial center. We are partnering with Virgin Media O2, a leading carrier services provider in the UK to support regional businesses to realize the promise of 5G, opening new revenue streams and stimulating growth in the telco market. We will bring to market solutions built on our edge orchestration platform, which combines edge computing, data AI, GenAI, and embedded security. This will enable use cases such as quality inspections, safe workplace management, and behavior monitoring to improve operations and customer experience. Whether it's enabling safe communication on building sites, creating a fan experience while handling crowds and busy venues, or supporting vital devices and clinician workflow in healthcare, Virgin Media O2 can now offer businesses a range of flexible, secure, and affordable solutions that boost efficiency, growth, and performance. And with our managed services and customer operations, we can work together with Virgin Media O2 to scale this growth. Security is a critical part of reinvention in the digital core. We saw continued very strong double-digit growth in our security business this quarter. We are partnering with the US Navy to enhance its cybersecurity operations with cutting-edge capabilities that will strengthen its data security posture and support mission readiness. More than ever, data and information are critically important to national security. Our solution sets are configured to provide defensive cyber operations across Navy networks to help safeguard digital assets and mission operations. Together, we will help ensure the US Navy can combat evolving cyber threats, protect our sailors at sea, and defend American interests around the world. Once clients have a strong foundation, they can explore new opportunities to drive growth and efficiencies with GenAI. We are helping a leading global food and beverage company who already built a strong digital core as part of its reinvention journey to now leverage the power of generative AI to create new value. Together, we developed a digital shelf console pilot, a GenAI engine that accelerates content creation for e-commerce and optimizes it to drive sales. The engine empowers marketers to audit and customize content at scale, expected to reduce time to deliver one year's worth of content to just eight working days and save costs of up to 80% quickly and effectively. Once they scale, this enables the company to produce more targeted content with significant time and cost efficiency, increase sales, and transform customer experiences. We have partnered with National Australia Bank, one of the country's largest financial institutions to strategically implement and scale generative AI to create material value at speed, enhance relationship-driven customer service, and drive operational efficiencies. We worked on a methodical build of a secure and robust GenAI platform built within the bank's existing strategic data platform with the creation of 200 generative AI use cases in backlog. To date, over 20 use cases have been tested across the bank with eight of these enterprise-grade pilots underway and a number of those scaling and already delivering value. We also co-created a methodology for delivering GenAI projects from experiments to scalable deployment, ensuring each stage delivers tangible business benefits. While doing so, National Australia Bank and Accenture are putting safety at the core of the approach through responsible AI and risk policies alongside developing in-house AI expertise and literacy. One of the areas of richest opportunities for our clients is customer experience transformation, which uses the unique capabilities of Song across creative customer insights and deep technology expertise. Song grew mid-single digits this quarter. We are helping Saudia Airlines, the national flag carrier of Saudi Arabia, to launch an innovative digital platform to transform the travelers experience. Powered by GenAI, the platform will provide a one-stop solution enabling customers to seamlessly plan their journeys, book flights, and modify their trips in just a few words, all while providing a personalized and conversational experience. The platform is continuously evolving and will integrate more services over time. This modernization will support Saudia Airlines' vision of redefining the standards of travel in a digital world. We continue to see strong demand for digital manufacturing and engineering services. Industry X grew high single digits in Q3. We are supporting a large Asia-Pacific automobile manufacturer on their reinvention towards software-defined vehicles. We will help accelerate software development and create a software center of excellence to optimize quality, cost pressures, and delivery times. This center of excellence will manage four key workstreams, advanced driver assistance systems, in-vehicle infotainment, electrical and electronics, and powertrain. By leveraging our expertise and strategic partnerships, we are empowering them to strengthen and evolve its in-vehicle software, providing advanced functions and services throughout the vehicle's lifecycle. This enables the company to drive innovation, enhance driver and passenger experiences, and realize the full potential of software-defined vehicles. And we will continue to leverage all of our strengths to manage the current macro conditions and constrained spending while investing in leadership for the future. Back to you, KC.
KC McClure: Thanks, Julie. Now turning to our business outlook. For the fourth quarter of fiscal 2024, we expect revenues to be in the range of $16.05 billion to $16.65 billion. This assumes the impact of FX will be about negative 2% compared to the fourth quarter of fiscal 2023 and reflects an estimated 2% to 6% growth in local currency. For the full fiscal year 2024, based upon how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in US dollars will be negative 0.7 compared to fiscal 2023. For the full fiscal 2024, we now expect our revenues to be in the range of 1.5% to 2.5% of growth in local currency over fiscal 2023, which assumes an inorganic contribution approaching 3%. We continue to expect business optimization actions to impact fiscal 2024 GAAP operating margin by 70 basis points and EPS by $0.56. For adjusted operating margin, we continue to expect fiscal 2024 to be 15.5%, a 10 basis point expansion of fiscal 2023 results. We now expect our adjusted annual effective tax rate to be in the range of 23.5% to 24.5%. This compares to an adjusted effective tax rate of 23.9% in fiscal 2023. We now expect our full year adjusted earnings per share for fiscal 2024 to be in the range of $11.85 to $12, or 2% to 3% growth over fiscal 2023 results. For the full fiscal 2024, we continue to expect operating cash flow to be in the range of $9.3 billion to $9.9 billion, property and equipment additions to be approximately $600 million, and free cash flow to be in the range of $8.7 billion to $9.3 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.2. Finally, we continue to expect to return at least $7.7 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so we can take your questions. Katie?
Katie O'Conor: Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: Thank you. [Operator Instructions] Your first question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead.
Tien-Tsin Huang: Thank you so much, and congrats to KC and Angie. I'm excited for both of you guys. I just wanted to ask upfront, just for Julie, maybe you mentioned stronger growth next year. Hoping you can just elaborate on that at a high level. I know there's a lot of moving pieces. On one hand, you have a big backlog, a lot of large deals. You have strong inorganic growth, but on the other hand, the sector is struggling with this weak discretionary spend, and there's uncertainty with global elections in the second half of the year. So just -- I know you can't give formal guidance until next year. I know consensus is at, what, 6%? Can you just give us maybe just some high-level considerations that are worth underlining as we're recasting our outlook for next year? Thank you.
Julie Sweet: Sure, and thanks for the question, Tien-tsin. So, let's just anchor on our strategy for growth and what you're seeing in three quarters into the year, because obviously, expectations at the beginning of this year were different in terms of how things develop with spending. So, what did we do? We leaned into what do clients need, and they need these reinventions, they need these big, large-scale transformations. And so, what you've seen us to do is, like, you've got to go with what the clients need, and that's what they're buying. And so, we have accelerated our leaning into these large transformation deals, which is why you see that we have seven more than last year at this time of clients with bookings of over $100 million. Now, these convert to revenue more slowly, but as we're accelerating, you'll know that they ramp up and they will start to layer in. And we are very uniquely positioned in this market to be able to do these large-scale transformations because they require the combination of services, everything from the ability to help them move faster through our managed services, our industry expertise. Everyone wants to do that with the eye towards GenAI, so even though the transformations are often in preparation for GenAI, they want to work with the partner who really understands GenAI, and so how do we get there faster. And so, as you think about the reinvention strategy, that's a strategy we've been executing for a couple of years, and we uniquely can lean in, and that -- you're seeing the results of that this quarter with the acceleration of -- compared to last year, of clients with that level of bookings and those, of course, then ramp next year. The second is, our leaning into where we are seeing growth in smaller deals because remember that discretionary spending is constrained, overall spending constrained, and particularly in smaller projects. But what did we do, right? We see GenAI as the new growth. We have an incredible ability to pivot our people. You can see the specialists in data and AI growing. We started at 40,000, we're at 55,000 now against our goal of 80,000 by the end of 2026. We're also training our people. You saw that big increase, because we're preparing our people. You're now doing a transformation. It may not be GenAI, but you have to understand GenAI. And so, we're uniquely able to train our people at scale to understand GenAI. And how is that translating? We'll look at our bookings this quarter now getting to $2 billion, three quarters into the year as compared to $300 million last year and $500 million in revenue. So starting to be meaningful, right? In terms of the numbers, we were at $100 million for all of last year. So we expect to continue to lean into GenAI. And what it's doing is very interesting from where we were, say, three quarters ago. It's acting as the catalyst to understand what you have to do. So I'll finish here and then I'll just, of course, mention our ability to invest in inorganic. But right now from a perspective of like the pull through, we're still reprioritizing. But every other GenAI project now is leading to some data project, because people are understanding, hey, this is a great technology and I'm not ready. So we feel really good about being very well positioned as spending increases, when it does increase because of what we're doing. And then finally, remember we invest in acquisitions to drive organic growth. Like that is -- so it's all about future growth. And I gave a lot in the script today to just help bring to life just how strategic our ability to invest is as we think about future growth. So not trying to comment at all on FY 2025. We'll call it like we see it. But we also want to be clear that our strategy is working and these deals will ramp up.
KC McClure: Yes, maybe I'll just add, Tien-tsin, just how we feel just within this fiscal year. So, we're very pleased with where we landed in Q3. When you look to Q4, we do have, and you see that in our growth rate, a clear uptick in our growth rate for the fourth quarter. And I think importantly included in that is the expectation that our consulting type of work in Q4, Tien-tsin, will return to growth and that we haven't had growth in consulting type of work since Q2 of last year.
Tien-Tsin Huang: Good. No, thank you both for that. I'll be less wordy with my follow-up. Just on the inorganic piece, can this pace continue?
KC McClure: I'll let Julie talk about -- add on here. But in terms of our -- let's talk about capital allocation. And we've always said this, we have the ability, and I think it's a differentiator of ours, to be able to invest and approach the market as whenever we see something that we want to execute. And that remains unchanged. And we've been able -- and you've seen us do that over all the different business cycles. And importantly, when we do that, we're able to continue all parts of our capital allocation in terms of share buybacks and dividends as well. So, from a financial standpoint, we have a very strong balance sheet. We have the ability to continue to flex up and down as we see fit from a capital allocation standpoint, Tien-tsin.
Julie Sweet: Yes, Tien-tsin, and I think we'll make the decision as we go into next year as to what level we want to drive for next year. So, I think we'll comment next quarter.
Tien-Tsin Huang: That's perfect. I know you've been able to amplify the growth of what you bought. So, that's why I asked. Thank you.
Julie Sweet: Thanks.
Operator: Your next question comes from the line of Dave Koning from Baird. Please go ahead.
Dave Koning: Yes. Hey, guys. Thanks so much. One thing I noticed, debt was up to $1.6 billion or so. Sequentially, it was the highest. Really, in 20 years, you've almost had no debt, and you have a lot of cash. So, I guess, what's the strategy around borrowing money now? And maybe it's just geographic cash positions, too.
KC McClure: Yes. No, that's a great question. So, in terms of our cash, you said that we started the year at $9 billion, and now we're little bit -- we are about $5.5 billion. And we do have some debt. It's very small, as you mentioned, for a company of our size. We do have a -- we had a credit facility that we put in right during the pandemic, and we continue to have a credit facility. It's about $5.5 billion. It's a five-year credit facility and what you just see, Dave, is that we're just exercising some of that credit facility, kind of normal treasury operation.
Dave Koning: Okay. And maybe just as a follow-up, margins this year up at the lower end of kind of normal and certainly scale, just the growth this year being a little slower, maybe the acquisitions. And just as we kind of look forward, the margin puts and takes, how should we think that with acquisition spending maybe a little higher, does the next few quarters remain kind of putting a little pressure on margins or how should we think of just the moving parts of margins going forward?
KC McClure: Yes, sure. So I'll just obviously keep my comments to this year, to 2024, but -- and maybe I'll just point out where we are and what we are continuing to assume. So we stated last quarter that we'd be at 10 basis points of operating margin expansion and we reconfirmed that, Dave, for the full year, again this quarter, and we feel confident in our ability to do that. So if you look at -- we run our business to operating margin. If you look at gross margin and overall what we've been saying on pricing and just importantly, when we talk about pricing, we mean the margin on the work that we sell. What I think is really important for us is that, we've been able to operate our business with rigor and discipline in how we run ourselves in an operation -- in efficient operations of Accenture and be our own best credential as we absorb kind of higher selling costs, which you would expect. We're looking at our record $60 billion of bookings and also the continued pressure and pricing that we've had across the business. So with that, we feel really good. And if you look at it, we grew 1% in quarter one. As an example, we were able to do 20 basis points of margin expansion. We grew 1% this quarter, and we were able to do 10 basis points of margin expansion. So we feel good about the way we run our business with rigor and discipline.
Dave Koning: Great. Thanks and nice bookings.
KC McClure: Thank you.
Julie Sweet: Thank you.
Operator: Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead.
Bryan Keane: Hi, guys. Good morning and congrats, KC. A great run at Accenture. You were awesome. So, I want to ask on managed services on the bookings, the $11.8 billion, that was an outsized number. How much of that is new bookings versus renewals? And maybe give us some flavor on what caused that spike in growth.
KC McClure: Yes. Maybe I will give you the -- I'll talk a little bit about the numbers. In terms of, it is a record bookings for managed services. As Julie's -- and as we've been talking, it is obviously based on the larger transformational deals that we're doing. Well, those larger transformational deals, just to be clear, Bryan, they do have both consulting and outsourcing -- excuse me, managed services type of work with them. They do have, as you would expect, a larger portion of managed services type of work. So when you see what we were able to do this year, we're already at 92, seven more than last year. And we did have a very strong managed services bookings, as you noted, in Q3. We don't really do a breakout in terms of extensions or new, but there's always -- we always have a healthy mix, I would say, of both. That's what we strive to over rolling four quarters in our business always and no difference there.
Julie Sweet: Yeah. And just maybe a little color, Bryan. As you think about this idea of reinvention, Virgin Media O2 was a great example, because there, right, we have a combination using our Edge platform to provide -- help O2 provides -- Virgin Media O2 to provide these new services. And at the same time, we're supporting it with our customer operations, supporting their growth so that they can scale. And right now, clients, of course, they're looking for growth, they're also looking for transformation and efficiency. The other thing I'd say is, this is a great example of how we're embracing GenAI. You've heard us talk in the past about our myWizard platform, which helps in our managed services. We now -- that's become Gen Wizard and we're seeing that our embracing -- early embracing of using Gen AI where it's ready to be used has been a real differentiator in our technology managed services. So, we're very focused on helping our client, who move faster using our expertise and leverage our digital investments in order for them to transform and reinvent faster and you're seeing that focus.
Bryan Keane: Got it. And just a follow-up, just looking at some of the dimensions breakout, when I look at operations being flat, just any call-outs for that. I know it was negative last quarter, so it's turned a little bit here, but just trying to understand the growth there and the prospects. Thanks.
Julie Sweet: Yes, no, it's -- we're really pleased that it's, that ticked up this quarter and it's a very strategic part of our business. Think about it really is like sort of two-ways, right? So we remain number-one in our industry in finance and accounting and we're embracing again GenAI there to help differentiate our platform. And so, there's a focus that we're seeing in our clients as they're saying, okay, we need to -- we really understand how much more we need to digitize and we need to do that in the enterprise, they're excited about our ability over-time. Again, it's very early days still in Gen AI over-time to help build our -- we're building our SynOps platform, we're building in GenAI and that helps them have less to build-in in their enterprise side by partnering with us. And so that's -- we think a really great differentiator. And then we continue to diversify into areas that are in the core of our business, whether -- core of our industries for our clients, whether it's claims and underwriting and insurance, or supply-chain for consumer goods and industrial or core banking in the financial services. So we feel really good about the business and kind of continue -- and its continued prospects.
Bryan Keane: Thank you.
Julie Sweet: Thanks, Bryan.
Operator: Your next question comes from the your next question comes from the line of Rod Bourgeois from DeepDive Equity Research. Please go ahead.
Rod Bourgeois: Hey guys, and very best wishes to KC as well. Julie, you mentioned that the demand environment is sort of more of the same. At the same time, it appears you've seen some growth mending in certain key areas. I'm particularly interested in the growth improvement in the CMT vertical and in strategy and consulting. Can you talk about what's enabling those growth improvements and a sense of the outlooks for CMT and S&C? Thanks.
Julie Sweet: So, really want to compliment our entire team on the work that they're doing with our clients in CMT. So, as we've been talking about that for now for a little while and we start to see things like the Virgin Media O2 deal. So our teams are working with our clients on what do they need. And they're focused on getting rid of technology debt, because that's critical in order to use some of these new technologies. They're focused on using the new technologies. So we have a number of clients that -- while it's still small, are working on GenAI. And then being very focused on efficiencies. And then finally network. So, really across the board what I would say is the industry was challenged. We have been just focused on going to where they need help and you're seeing that result in our results. And then on strategy and consulting, again, it's all about being focused on what do our clients need. And so, we've pivoted many more people, for example, toward cost and strategy. So cost takeout is a big theme, and particularly for our strategy. We are seeing a lot of growth still in things like implementing modern ERP platforms with the focus on the digital core. And again, at Accenture, it's not just technology, right? It's about we're the number one player with all of these technology ecosystem players, but our clients want to do it faster. They need the industry expertise. And so, you saw a number of examples in the script about how we're putting in these platforms and we're doing so within an industry context. And so, I'd say cost takeout and move the cloud data platforms wrapped around with industry and functional expertise, that's where we're seeing the growth. And we just continue to remain laser focused on more people, more focus, working with the clients on what they need to buy.
Rod Bourgeois: Great. Thanks for that. And you're seeing revenue mix incrementally shift into managed services, and I'm curious if you think some of that mix shift towards managed services is due to secular forces, or are you purely seeing that mix shift as just a cyclical phenomenon?
KC McClure: Yes, I think, it's -- in terms of what the real driver is, it's the larger deals that have a little bit of both in those -- both components of a sector and cyclical and what you're talking about. So it really is just based on the larger deal.
Julie Sweet: So just think about Accenture is very uniquely positioned in this market. Clients are prioritizing large scale transformations. And doing those and getting the efficiencies and moving faster, managed services is a highly strategic component of being able to do that. And this is where Accenture, with such scale in both strategy, in both consulting type of work with managed services is really able to lean into what are clients buying now.
Rod Bourgeois: Got it. Thank you.
Operator: Your next question comes from the line of Bryan Bergin from TD Cowen. Please go ahead.
Bryan Bergin: Hi. Good morning and congrats KC and the other leaders on the retirements and appointments. First question I wanted to ask on the consulting existing revenue-base performance, can you just talk about how base business runoff kind of progressed within the minus 1% local currency performance? I heard your comment on the 4Q consulting or just returning to growth. I'm trying to understand if that's a reflection of sustainable stabilization potentially and really gauge whether you're reaching a point where the new consulting bookings conversion should more than offset the existing base runoff moving ahead.
Julie Sweet: Yes. So, Brian, in terms of what we'll give -- what we'll talk about is really is what I just mentioned on Q4. I guess -- and I understand what you mean by a base runoff. We don't really think of it that way. We kind of look at it as maybe our terms will be whether we have booked and backlog and what are we already -- and what's new coming in from these sales. And so, I get -- so just kind of going with those two points, the way we evaluate and we talk about it, Brian, is from a year-over-year basis, looking at both the components of what we've already sold for the next quarter and then what we see in our pipeline and how we see those sales will convert to revenue, that's how we kind of assess what we think that we will be overall. And again, very pleased that consulting -- we do feel that and see that it will return to growth. And I think it's a milestone that we haven't had in a number of quarters, so we'll pleased with that. And we'll comment on anything else for next year, next year, I mean in September.
Bryan Bergin: Okay. And then bookings, obviously, very solid here. Can you just comment on pipeline and any bookings expectations worth calling out for 4Q?
Julie Sweet: Yes. Overall, we feel good about our pipeline. And we don't put -- we don't give guidance to next quarter bookings. But we feel good.
Bryan Bergin: Thanks.
Julie Sweet: Thank you.
Operator: Your next question comes from the line of James Faucette from Morgan Stanley. Please go ahead.
James Faucette: Great. Thank you very much. I wanted to follow up on the acquisition activity. It's obviously been really robust, providing a lot of good opportunities. Can you give us any sense collectively across the acquisitions you've been doing and maybe what you are looking at in terms of what the growth rates of those businesses are generally or collectively when you do the acquisitions? And I know there's a target to accelerate those, how the growth rates tend to change as those companies are absorbed into [index center] (ph), even if directionally.
Julie Sweet: Yes, I mean, I think in terms of -- make sure I'm answering your question is, when we look at overall at our acquisitions, they all come with -- they're typically higher growth business cases that we have from the companies that we buy and we have a base case that comes with the organization and we assess that growth rate. And then we obviously put in pretty significant synergy cases that are -- without going through kind of metrics that are a pretty high bar for those acquisitions to deliver to, along with a broader center. And that's why integration is so important in what we do, because we're not just having a great business case, that is maybe half of what you need to do, but the key really is in how you integrate to deliver to that, and we have a very strong track record. And so, what you'll see is, you could just maybe get the sense to your question, is look at how many we've done over the last five years and you can see how we've been able to continue to grow our business throughout that time. And it is really continuing to fill our organic growth.
James Faucette: Got it. And then quickly, one of the areas where you've leaned in on and was mentioned in the prepared remarks is the government and healthcare sector, really strong growth there obviously. How should we be thinking about that as a long-term or medium-term potential grower in that segment and any -- and how are you thinking about the investment needed to continue to drive that? Thanks.
Julie Sweet: Thanks. We feel really good about that vertical. Obviously there's a lot of transformation that's going on in public service. You see health is a big driver, defense is a big driver. There's a lot of infrastructure support, whether it's IRA in the U.S. or what the EU has been doing as well. And of course, a lot of the digital transformation hasn't happened in the public service and health, And so, we see that now being the time and you're seeing that in the results. So we feel very confident and we think about the investment like we do all our industries. I mean, remember, we have 13 industry groups. We have -- the diversification is a key part of both our resilience and our growth strategy. And so, at any given time, we're investing differently depending on the growth trajectory. And as we called out this quarter, we've been investing significantly in public service, because we see the next several years this being a big growth area and we're making those investments now.
Katie O'Conor: Operator, we have time for one more question, and then Julie will wrap up the call.
Operator: Okay. That question comes from the line of Keith Bachman from BMO. Please go ahead.
Keith Bachman: Hi. Many thanks. And first, Casey and Paul, special congratulations as you make the transition. I wanted to ask a question, and I'll just make it concurrently in the interest of time. And Julie, I think I'll direct this to you. Number one, on BPO, one of your competitors just talked pretty openly about pricing's been under pretty material duress as of late, and I wondered if you would echo that? And I'm really curious as to why. Why do you think pricing has been under duress? And how do you think about impacting future growth? And then the second area that I wanted to ask about is, Song. Thank you for the comment on mid-single digit growth. And I'm really interested how you think GenAI will impact over your digital agency over the next 12 to 24 months. And the reason I ask the question is, we also spend a lot of time with companies like Adobe that have significant -- generative AI is going to have a significant impact on digital agencies. And some of the agencies are talking about seat reductions because of the value associated with generative AI. And I'm just wondering if you could comment on how you think generative AI will impact the growth potential of Song. And that's it for me. Many thanks.
Julie Sweet: Great. KC, why don't you quickly cut pricing, and then I'll do Song.
KC McClure: Keith, I would say just in terms of pricing, and we've been commenting on this for quite some time. You are correct in that, we've had overall in our entire business continued pricing pressure. So, I mean, that's the way I would reflect on that statement -- on your question [indiscernible].
Julie Sweet: Yes, it's overall is a tight market, So that's what you normally see. On Song, here's where we are so unique, because our business is not an agency business, right? The agencies are part of an incredibly differentiated value proposition where you have creative and technology and digital and by the way managed services. And so, we see this as a huge opportunity because we are embracing it as fast as possible to help our clients get value, but we put it together with all of these other services. So we were happy to see the uptick in growth this quarter with Song and long term where we really think it's great. And remember, this is our playbook, right? We embrace technology. We've done it in every wave. We've done it when we did managed services. Remember in 2015, we had SynOps and myWizard. Our business is to help our clients be more efficient and grow. That is what we do. And we use technology in how we deliver it. And we help them use technology and how they operate. And so, we see GenAI as yet another way that we're going to embrace it. We're going to be fast. And we're going to do what we do for clients. And that is a very exciting opportunity, so we feel really good about our Song business. Great. So, thanks everyone for the questions and the time today. In closing I want to again, as always, thank all of our shareholders for your continued trust and support, and all of our people for what you're doing for our clients and for each other every day. Thanks so much for joining.
Operator: Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by. Welcome to Accenture's Third Quarter Fiscal 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Katie O'Conor. Please go ahead."
},
{
"speaker": "Katie O'Conor",
"text": "Thank you, operator, and thanks everyone for joining us today on our third quarter fiscal 2024 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short-time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the third quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the fourth quarter and full fiscal year 2024. We will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including but not limited to, those factors set forth in today's news release and as discussed in our Annual Report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release, or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Katie, and everyone joining. And thank you to our 750,000 people around the world who work every day to deliver 360-degree value for all our stakeholders. Before we get into the quarter, I want to thank KC, who's been an excellent partner for these last five years, and our three other extraordinary leaders who are stepping down in the next two quarters, Jean-Marc, Ellyn, and Paul. Each have given over 36 years of service and demonstrated strong stewardship in developing outstanding successors, including Angie, who you all know from her former role as Head of Investor Relations, who will succeed KC on December 1. As always, we are executing a smooth leadership transition to the next generation with our strong bench of great leaders. Now, on to the quarter. I am pleased this quarter to bring to life yet again the resilience and agility of our business, as our actions to remain laser-focused on our clients' needs and quickly adapt to market conditions can be seen in our results, which are building a foundation for stronger growth as we go into Q4 and next fiscal year. As you know, this fiscal year, our client spending developed differently than we expected at the beginning of the fiscal year. And these conditions continue, with clients prioritizing large-scale transformations, which convert to revenue more slowly, while limiting discretionary spending, particularly in smaller projects, with delays in decision-making and a slower pace of spending as well. In response, we have moved quickly to adjust by leveraging our unique strengths, our end-to-end services, including deep industry and functional expertise that enable these large-scale transformations or what we call reinventions. We're also leveraging our deep technology expertise and ecosystem partnerships and our learning machine and culture that gives us the agility to shift to new areas of demand, including, for example, GenAI while continuing to invest at scale for future growth. Here is how these strengths and our strategy are demonstrating results three quarters into the fiscal year. With our clients prioritizing large-scale transformations, we have accelerated our strategy to be the reinvention partner of our clients. Our success is reflected in our bookings of $21.1 billion, including another 23 clients with quarterly bookings greater than $100 million, bringing the total of such clients with these bookings to 92 year-to-date, seven more than last year at this time. This focus on being the reinvention partner is an important part of our strategy to return to stronger growth. As we enter next year, as this work ramps, the revenue from these large-scale bookings is expected to continue to layer in throughout the year, and we are also well-positioned to capture increases in discretionary spend when it comes back because of the strategic positioning these deals bring at our clients. We also have leaned into the new area of growth, GenAI, which is comprised of smaller projects as our clients primarily are in experimentation mode, and this quarter we hit two important milestones. With over $900 million in new GenAI bookings this quarter, we now have $2 billion in GenAI sales year-to-date, and we have also achieved $500 million in revenue year-to-date. This compares to approximately $300 million in sales and roughly $100 million in revenue from GenAI in FY 2023. Leading in GenAI positions us to help our clients take the actions needed to reinvent and to benefit from GenAI, which frequently means large-scale transformations. We are also taking an early lead with an eye toward long-term leadership in this critical technology, which is still in the early stages of maturity and adoption, despite its rapid evolution. We have built our expertise in making strategic acquisitions over the last decade, leveraging a strong balance sheet, and we have used this expertise to expand into new growth areas, scale in hot areas and geographies, and continue to build strength in our industry and functional consulting. We deployed $2.3 billion of capital across our geographic markets in Q3 across 12 acquisitions, bringing the total number of acquisitions to 35 with invested capital of $5.2 billion year-to-date as compared to $2.5 billion for the entire FY 2023. As a learning organization and talent creator, we continue to invest in our people with approximately 13 million training hours this quarter. This averages 19 hours per person, representing an increase predominantly due to GenAI as we continue to prepare our workforce for the infusion of GenAI across our business in the coming years. We also continue to steadily increase our data and AI workforce, reaching approximately 55,000 skilled data and AI practitioners against our goal of doubling our data and AI workforce from 40,000 to 80,000 by the end of FY 2026. We continue to take market share on a rolling four-quarter basis against our basket of our closest global publicly traded competitors, which is how we calculate market share, with revenues of $16.5 billion for the quarter, up 1.4% in local currency and slightly above the midpoint of our FX adjusted range. We expanded adjusted operating margin by 10 basis points and delivered free cash flow of $3 billion. I want to congratulate our 97,000 people we have promoted around the world through June 1, including 702 to Managing Director and 64 to Senior Managing Director, reflecting our commitment to providing vibrant career paths. We are recognized as a Top 10 Place to Work in 10 countries, representing more than 70% of our people, number two in Argentina, Brazil, and the Philippines, number four in Singapore, number five in Costa Rica, Finland, and Indonesia, number seven in the US, and number 10 in Chile on the Great Place to Work list of Best Workplaces and number two on Business Today's Best Companies to Work For in India. And in recognition of our strong brand, we are proud to earn the number 20 position on Kantar BrandZ's prestigious Top 100 Most Valuable Global Brands list, our highest rank to date, with an 11% increase in brand value to $81.9 billion. Our scale across strategy, consulting, technology, and operations, and our breadth and depth across industries and functions make us uniquely capable of helping our clients reinvent using technology, data, AI, and new ways of working. Before turning to KC, I want to give a little more color on our acquisitions this quarter, which yet again demonstrate the strategic importance of both our ability to invest, and our expertise in identifying, attracting, and integrating great companies joining Accenture. Let's start with new areas of growth. We completed our acquisition of Udacity to scale our technology learning and training services and to help our clients reskill and upskill their people. Udacity is a critical part of our LearnVantage digital learning platform, which we announced last quarter as a new area of growth for the future. Building on our expertise in customer-focused consulting, we invested to help drive our clients' growth agendas. We acquired Unlimited, an award-winning customer engagement agency with a deep understanding of human behavior as evidenced by its proprietary human understanding lab and AI-powered data insights platform. We acquired The Lumery in Australia, a marketing technology consultancy that helps leading organizations deliver seamless customer experiences and transform their marketing services. It provides industry and platform consulting services, including marketing, advisory, and planning, implementation across entire technology stacks, operational excellence, and simplification. We closed our acquisition of GemSeek in Bulgaria, a leading customer experience analytics provider helping global businesses understand customers through insights, analytics, and AI-powered predictive models. And we closed MindCurv, a global digital -- a cloud-native digital [indiscernible] experience and data analytics company specializing in composable software, digital engineering, and commerce services. Now, let's turn to scaling and hot industries. We acquired Cognosante, a provider of innovative technology solutions for US federal health, defense, intelligence, and civilian agencies. With this acquisition, federal services is creating a new federal health portfolio for its business. We invested in Customer Management IT and SirfinPA, which will provide the public sector with technology, support, and justice and public safety in Italy. We see public service and, in particular, health, intelligence, and defense as highly strategic industry focus areas globally for the next several years. And we invested in Teamexpat, focusing on testing integration for lithography systems in the semiconductor industry, another attractive industry segment. Our investment in Flo Group, a leading European consultancy and Oracle business partner, who specializes in global supply chain logistics is helping us scale in supply chain, also a major growth area. Finally, we're scaling in attractive geographic markets. We acquired CLIMB, a technology-based consultancy based in Japan, where we continue to experience very strong revenue growth. Over to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie. And thanks to all of you for taking the time to join us on today's call. We are pleased with our Q3 results, which were in line with our expectations and reflect continued investment at scale. We continue to serve as a trusted partner for our clients, while running our business with rigor and discipline. Now, let me summarize a few of the highlights for the quarter. Revenues grew 1.4% local currency with mid-single digit growth or higher in seven of our 13 industries, including public service, industrial, high-tech, life sciences, energy, utilities, and health. We also continue to see improvement in our CMT industry group. And we continue to take smart share. As a reminder, we assess market growth against our investable basket, which is roughly two dozen of our closest global public competitors, which represents about a third of our addressable market. We use a consistent methodology to compare our financial results to theirs, adjusted to exclude the impact of significant acquisitions to the date of their last publicly available results on a rolling four-quarter basis. Adjusted operating margin was 16.4%, an increase of 10 basis points over Q3 last year, and includes continued significant investments in our people and our business. Finally, we delivered free cash flow of $3 billion and returned $2.2 billion to shareholders through repurchases and dividends. Year-to-date, we've invested $5.2 billion across 35 acquisitions. With those high-level comments, let me turn to some of the details, starting with new bookings. New bookings were $21.1 billion for the quarter, representing 22% growth in US dollars and 26% growth in local currency, with an overall book-to-bill of 1.3. Consulting bookings were $9.3 billion with a book-to-bill of 1.1. Managed services bookings were $11.8 billion with a book-to-bill of 1.5. Turning now to revenues. Revenues for the quarter were $16.5 billion, a 1% decline in US dollars and a 1.4% increase in local currency, and slightly above the midpoint of our FX adjusted guidance range, as the FX headwind was approximately 2% compared to the 1% headwind estimated at the beginning of the quarter. Consulting revenues for the quarter were $8.5 billion, a decline of 3% in US dollars and a decline of 1% in local currency. Managed services revenues were $8 billion, up 2% US dollars and up 4% local currency. Taking a closer look at our service dimensions, technology services and strategy and consulting grew low single digits and operations was flat. Turning to our geographic markets, in North America, revenue grew 1% local currency, led by growth in public service, partially offset by decline in banking and capital markets. In EMEA, revenues declined 2% local currency with growth in public service, offset by declines in banking and capital markets and communications and media. Revenue growth in Italy was offset by a decline in France. In growth markets, revenue grew 8% local currency, led by growth in banking and capital markets and industrial. Revenue growth was driven by Argentina and Japan, partially offset by a decline in Australia. Moving down the income statement, gross margin for the quarter was 33.4%, consistent with the same period last year. Sales and marketing expense for the quarter was 10.6%, compared to 10.5% for the third quarter last year. General and administrative expense was 6.3%, compared to 6.5% for the same quarter last year. Before I continue, I want you to note that in Q3 of FY 2024 and FY 2023, we recorded $77 million and $347 million in costs associated with our business optimization actions, respectively. These costs decreased operating margin by 40 basis points and EPS by $0.08 this quarter and operating margin by 210 basis points and EPS by $0.42 in Q3 of last year. In Q3 of last year, we also recognized a gain on our investment in Duck Creek Technologies, which impacted our tax rate and increased EPS by $0.38. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.7 billion in the third quarter, reflecting an adjusted operating margin of 16.4%, an increase of 10 basis points from adjusted operating margin in the third quarter of last year. Our adjusted effective tax rate for the quarter was 25.5%, compared with an adjusted effective tax rate of 24% for the third quarter last year. Adjusted diluted earnings per share were $3.13, compared with adjusted diluted EPS of $3.19 in the third quarter last year. Days sales outstanding was 43 days, compared to 43 days last quarter and 42 days in the third quarter of last year. Free cash flow for the quarter was $3 billion, resulting from cash generated by operating activities of $3.1 billion, net of property and equipment additions of $124 million. Our cash balance at May 31 was $5.5 billion, compared with $9 billion at August 31. With regard to our ongoing objective to return cash to shareholders. In the third quarter we repurchased or redeemed 4.3 million shares for $1.4 billion, an average price of $320.41 per share. As of May 31, we had approximately 3.3 billion of share repurchase authority remaining. Also in May, we paid a quarterly cash dividend of $1.29 per share for a total of $811 million. This represents a 15% increase over last year. And our board of directors declared a quarterly cash dividend of $1.29 per share to be paid on August 15, a 15% increase over last year. In closing, we feel good about our results in Q3 and are now working hard to deliver Q4. We remain focused on capturing growth opportunities while continuing to invest in our business for long-term market leadership. Now let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. As I mentioned earlier, we're seeing more of the same in terms of the demand environment. Now let me give a little context on how we're executing our strategy to be the reinvention partner of choice and why we're uniquely positioned to be helping our clients on AI. It is important to remember that while there is a near universal recognition now of the importance of AI, which is at the heart of reinvention, the ability to use GenAI at scale varies widely with clients on a continuum. With those which have strong digital cores genuinely seeking to move more quickly, while most clients are coming to the realization of the investments needed to truly implement AI across the enterprise, starting with a strong digital core from migrating applications and data to the cloud, building a new cognitive layer, implementing modern ERP and applications across the enterprise to a strong security layer. And nearly all clients are finding it difficult to scale GenAI projects because the AI technology is a small part of what is needed. To reinvent using technology, data, and AI, you must also change your processes and ways of working, rescale and upscale your people, and build new capabilities around responsible AI, all with a deep understanding of industry, function, and technology to unlock the value. And many clients need to first find more efficiencies to enable scaled investment in their digital cores and all these capabilities, particularly in data foundations. In short, GenAI is acting as a catalyst for companies to more aggressively go after cost, build the digital core, and truly change the ways they work, which creates significant opportunity for us. And this is why clients are coming to us. We are able to help our clients with this AI rotation because of our broad services across strategy and consulting technology and operations, as well as everything customer through Song and digital manufacturing and engineering through Industry X and our relevance across the functions of the enterprises and 13 industries. Our privileged position in the technology ecosystem has never been more important. We are working closely with our ecosystem partners to help our clients understand the right data and AI backbone that is needed and how to achieve tangible business value. Now let me give you a few examples of the complex work of reinvention and building a digital core. We are partnering with Currys, a leading European technology retailer to unlock new growth and cost savings by accelerating its adoption of new technologies. First, we will move their operations from a legacy data center to a new cloud platform using pre-built and customized solutions to create a powerful digital core. This unified data foundation allows us to deploy automation and generative AI in key growth areas, such as repair centers, customer service, e-commerce, procurement, and in-store experiences, delivering faster, more efficient services to their customers. The move to a new platform supports the company's sustainability goals, reducing energy consumption by transitioning to a more efficient cloud infrastructure. Now, Currys' employees will be empowered to serve their customers better by offering high-touch experiences, both online and in-stores. We're working with Independence Health Group, IHG, a leading health organization headquartered in Southeastern Pennsylvania on a transformation journey to modernize end-to-end operations, improving the way they serve current and future generations of customers. We will help migrate nearly 2 million members to a new digital-first platform, expected to drive immediate improvements in existing business processes. This will lay the foundation to leverage advanced technology and generative AI to proactively manage members' health. We are also helping reskill and retrain their operations staff, creating opportunities for employee development. With this reinvention, Independence continues its ongoing efforts to increase service quality, improve experiences, and enable better health outcomes, positioning them for new areas of growth in the rapidly changing healthcare landscape. Digital core work also requires deep industry expertise as we work with our clients to design the right tech, data, and AI to reinvent their enterprise and their industry. We are helping Macy's, an iconic American retailer with a technology modernization effort. As a strategic technology execution partner, we will migrate their mainframe systems to a cloud platform, a move that will enhance their operational efficiency and scalability. This will allow Macy's to be more agile and enable growth. We are helping the Central Bank of the United Arab Emirates, the regulatory body responsible for the country's banking and insurance sector with a digital transformation to strengthen the financial system's stability and contribute to growth, innovation, and diversification in the sector, in line with the UAE's national vision. Our program will deliver advanced analytics along with AI-driven automation to improve supervisory capabilities and streamline activities for licensed financial institutions by creating best-in-class processes to support regulatory compliance. We will also modernize the bank's enterprise data management by implementing a single unified portal to provide a holistic view of the financial services ecosystem, all of which will enhance the UAE's position as a global financial center. We are partnering with Virgin Media O2, a leading carrier services provider in the UK to support regional businesses to realize the promise of 5G, opening new revenue streams and stimulating growth in the telco market. We will bring to market solutions built on our edge orchestration platform, which combines edge computing, data AI, GenAI, and embedded security. This will enable use cases such as quality inspections, safe workplace management, and behavior monitoring to improve operations and customer experience. Whether it's enabling safe communication on building sites, creating a fan experience while handling crowds and busy venues, or supporting vital devices and clinician workflow in healthcare, Virgin Media O2 can now offer businesses a range of flexible, secure, and affordable solutions that boost efficiency, growth, and performance. And with our managed services and customer operations, we can work together with Virgin Media O2 to scale this growth. Security is a critical part of reinvention in the digital core. We saw continued very strong double-digit growth in our security business this quarter. We are partnering with the US Navy to enhance its cybersecurity operations with cutting-edge capabilities that will strengthen its data security posture and support mission readiness. More than ever, data and information are critically important to national security. Our solution sets are configured to provide defensive cyber operations across Navy networks to help safeguard digital assets and mission operations. Together, we will help ensure the US Navy can combat evolving cyber threats, protect our sailors at sea, and defend American interests around the world. Once clients have a strong foundation, they can explore new opportunities to drive growth and efficiencies with GenAI. We are helping a leading global food and beverage company who already built a strong digital core as part of its reinvention journey to now leverage the power of generative AI to create new value. Together, we developed a digital shelf console pilot, a GenAI engine that accelerates content creation for e-commerce and optimizes it to drive sales. The engine empowers marketers to audit and customize content at scale, expected to reduce time to deliver one year's worth of content to just eight working days and save costs of up to 80% quickly and effectively. Once they scale, this enables the company to produce more targeted content with significant time and cost efficiency, increase sales, and transform customer experiences. We have partnered with National Australia Bank, one of the country's largest financial institutions to strategically implement and scale generative AI to create material value at speed, enhance relationship-driven customer service, and drive operational efficiencies. We worked on a methodical build of a secure and robust GenAI platform built within the bank's existing strategic data platform with the creation of 200 generative AI use cases in backlog. To date, over 20 use cases have been tested across the bank with eight of these enterprise-grade pilots underway and a number of those scaling and already delivering value. We also co-created a methodology for delivering GenAI projects from experiments to scalable deployment, ensuring each stage delivers tangible business benefits. While doing so, National Australia Bank and Accenture are putting safety at the core of the approach through responsible AI and risk policies alongside developing in-house AI expertise and literacy. One of the areas of richest opportunities for our clients is customer experience transformation, which uses the unique capabilities of Song across creative customer insights and deep technology expertise. Song grew mid-single digits this quarter. We are helping Saudia Airlines, the national flag carrier of Saudi Arabia, to launch an innovative digital platform to transform the travelers experience. Powered by GenAI, the platform will provide a one-stop solution enabling customers to seamlessly plan their journeys, book flights, and modify their trips in just a few words, all while providing a personalized and conversational experience. The platform is continuously evolving and will integrate more services over time. This modernization will support Saudia Airlines' vision of redefining the standards of travel in a digital world. We continue to see strong demand for digital manufacturing and engineering services. Industry X grew high single digits in Q3. We are supporting a large Asia-Pacific automobile manufacturer on their reinvention towards software-defined vehicles. We will help accelerate software development and create a software center of excellence to optimize quality, cost pressures, and delivery times. This center of excellence will manage four key workstreams, advanced driver assistance systems, in-vehicle infotainment, electrical and electronics, and powertrain. By leveraging our expertise and strategic partnerships, we are empowering them to strengthen and evolve its in-vehicle software, providing advanced functions and services throughout the vehicle's lifecycle. This enables the company to drive innovation, enhance driver and passenger experiences, and realize the full potential of software-defined vehicles. And we will continue to leverage all of our strengths to manage the current macro conditions and constrained spending while investing in leadership for the future. Back to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Now turning to our business outlook. For the fourth quarter of fiscal 2024, we expect revenues to be in the range of $16.05 billion to $16.65 billion. This assumes the impact of FX will be about negative 2% compared to the fourth quarter of fiscal 2023 and reflects an estimated 2% to 6% growth in local currency. For the full fiscal year 2024, based upon how the rates have been trending over the last few weeks, we now expect the impact of FX on our results in US dollars will be negative 0.7 compared to fiscal 2023. For the full fiscal 2024, we now expect our revenues to be in the range of 1.5% to 2.5% of growth in local currency over fiscal 2023, which assumes an inorganic contribution approaching 3%. We continue to expect business optimization actions to impact fiscal 2024 GAAP operating margin by 70 basis points and EPS by $0.56. For adjusted operating margin, we continue to expect fiscal 2024 to be 15.5%, a 10 basis point expansion of fiscal 2023 results. We now expect our adjusted annual effective tax rate to be in the range of 23.5% to 24.5%. This compares to an adjusted effective tax rate of 23.9% in fiscal 2023. We now expect our full year adjusted earnings per share for fiscal 2024 to be in the range of $11.85 to $12, or 2% to 3% growth over fiscal 2023 results. For the full fiscal 2024, we continue to expect operating cash flow to be in the range of $9.3 billion to $9.9 billion, property and equipment additions to be approximately $600 million, and free cash flow to be in the range of $8.7 billion to $9.3 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.2. Finally, we continue to expect to return at least $7.7 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so we can take your questions. Katie?"
},
{
"speaker": "Katie O'Conor",
"text": "Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Your first question comes from the line of Tien-tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Thank you so much, and congrats to KC and Angie. I'm excited for both of you guys. I just wanted to ask upfront, just for Julie, maybe you mentioned stronger growth next year. Hoping you can just elaborate on that at a high level. I know there's a lot of moving pieces. On one hand, you have a big backlog, a lot of large deals. You have strong inorganic growth, but on the other hand, the sector is struggling with this weak discretionary spend, and there's uncertainty with global elections in the second half of the year. So just -- I know you can't give formal guidance until next year. I know consensus is at, what, 6%? Can you just give us maybe just some high-level considerations that are worth underlining as we're recasting our outlook for next year? Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Sure, and thanks for the question, Tien-tsin. So, let's just anchor on our strategy for growth and what you're seeing in three quarters into the year, because obviously, expectations at the beginning of this year were different in terms of how things develop with spending. So, what did we do? We leaned into what do clients need, and they need these reinventions, they need these big, large-scale transformations. And so, what you've seen us to do is, like, you've got to go with what the clients need, and that's what they're buying. And so, we have accelerated our leaning into these large transformation deals, which is why you see that we have seven more than last year at this time of clients with bookings of over $100 million. Now, these convert to revenue more slowly, but as we're accelerating, you'll know that they ramp up and they will start to layer in. And we are very uniquely positioned in this market to be able to do these large-scale transformations because they require the combination of services, everything from the ability to help them move faster through our managed services, our industry expertise. Everyone wants to do that with the eye towards GenAI, so even though the transformations are often in preparation for GenAI, they want to work with the partner who really understands GenAI, and so how do we get there faster. And so, as you think about the reinvention strategy, that's a strategy we've been executing for a couple of years, and we uniquely can lean in, and that -- you're seeing the results of that this quarter with the acceleration of -- compared to last year, of clients with that level of bookings and those, of course, then ramp next year. The second is, our leaning into where we are seeing growth in smaller deals because remember that discretionary spending is constrained, overall spending constrained, and particularly in smaller projects. But what did we do, right? We see GenAI as the new growth. We have an incredible ability to pivot our people. You can see the specialists in data and AI growing. We started at 40,000, we're at 55,000 now against our goal of 80,000 by the end of 2026. We're also training our people. You saw that big increase, because we're preparing our people. You're now doing a transformation. It may not be GenAI, but you have to understand GenAI. And so, we're uniquely able to train our people at scale to understand GenAI. And how is that translating? We'll look at our bookings this quarter now getting to $2 billion, three quarters into the year as compared to $300 million last year and $500 million in revenue. So starting to be meaningful, right? In terms of the numbers, we were at $100 million for all of last year. So we expect to continue to lean into GenAI. And what it's doing is very interesting from where we were, say, three quarters ago. It's acting as the catalyst to understand what you have to do. So I'll finish here and then I'll just, of course, mention our ability to invest in inorganic. But right now from a perspective of like the pull through, we're still reprioritizing. But every other GenAI project now is leading to some data project, because people are understanding, hey, this is a great technology and I'm not ready. So we feel really good about being very well positioned as spending increases, when it does increase because of what we're doing. And then finally, remember we invest in acquisitions to drive organic growth. Like that is -- so it's all about future growth. And I gave a lot in the script today to just help bring to life just how strategic our ability to invest is as we think about future growth. So not trying to comment at all on FY 2025. We'll call it like we see it. But we also want to be clear that our strategy is working and these deals will ramp up."
},
{
"speaker": "KC McClure",
"text": "Yes, maybe I'll just add, Tien-tsin, just how we feel just within this fiscal year. So, we're very pleased with where we landed in Q3. When you look to Q4, we do have, and you see that in our growth rate, a clear uptick in our growth rate for the fourth quarter. And I think importantly included in that is the expectation that our consulting type of work in Q4, Tien-tsin, will return to growth and that we haven't had growth in consulting type of work since Q2 of last year."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Good. No, thank you both for that. I'll be less wordy with my follow-up. Just on the inorganic piece, can this pace continue?"
},
{
"speaker": "KC McClure",
"text": "I'll let Julie talk about -- add on here. But in terms of our -- let's talk about capital allocation. And we've always said this, we have the ability, and I think it's a differentiator of ours, to be able to invest and approach the market as whenever we see something that we want to execute. And that remains unchanged. And we've been able -- and you've seen us do that over all the different business cycles. And importantly, when we do that, we're able to continue all parts of our capital allocation in terms of share buybacks and dividends as well. So, from a financial standpoint, we have a very strong balance sheet. We have the ability to continue to flex up and down as we see fit from a capital allocation standpoint, Tien-tsin."
},
{
"speaker": "Julie Sweet",
"text": "Yes, Tien-tsin, and I think we'll make the decision as we go into next year as to what level we want to drive for next year. So, I think we'll comment next quarter."
},
{
"speaker": "Tien-Tsin Huang",
"text": "That's perfect. I know you've been able to amplify the growth of what you bought. So, that's why I asked. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Dave Koning from Baird. Please go ahead."
},
{
"speaker": "Dave Koning",
"text": "Yes. Hey, guys. Thanks so much. One thing I noticed, debt was up to $1.6 billion or so. Sequentially, it was the highest. Really, in 20 years, you've almost had no debt, and you have a lot of cash. So, I guess, what's the strategy around borrowing money now? And maybe it's just geographic cash positions, too."
},
{
"speaker": "KC McClure",
"text": "Yes. No, that's a great question. So, in terms of our cash, you said that we started the year at $9 billion, and now we're little bit -- we are about $5.5 billion. And we do have some debt. It's very small, as you mentioned, for a company of our size. We do have a -- we had a credit facility that we put in right during the pandemic, and we continue to have a credit facility. It's about $5.5 billion. It's a five-year credit facility and what you just see, Dave, is that we're just exercising some of that credit facility, kind of normal treasury operation."
},
{
"speaker": "Dave Koning",
"text": "Okay. And maybe just as a follow-up, margins this year up at the lower end of kind of normal and certainly scale, just the growth this year being a little slower, maybe the acquisitions. And just as we kind of look forward, the margin puts and takes, how should we think that with acquisition spending maybe a little higher, does the next few quarters remain kind of putting a little pressure on margins or how should we think of just the moving parts of margins going forward?"
},
{
"speaker": "KC McClure",
"text": "Yes, sure. So I'll just obviously keep my comments to this year, to 2024, but -- and maybe I'll just point out where we are and what we are continuing to assume. So we stated last quarter that we'd be at 10 basis points of operating margin expansion and we reconfirmed that, Dave, for the full year, again this quarter, and we feel confident in our ability to do that. So if you look at -- we run our business to operating margin. If you look at gross margin and overall what we've been saying on pricing and just importantly, when we talk about pricing, we mean the margin on the work that we sell. What I think is really important for us is that, we've been able to operate our business with rigor and discipline in how we run ourselves in an operation -- in efficient operations of Accenture and be our own best credential as we absorb kind of higher selling costs, which you would expect. We're looking at our record $60 billion of bookings and also the continued pressure and pricing that we've had across the business. So with that, we feel really good. And if you look at it, we grew 1% in quarter one. As an example, we were able to do 20 basis points of margin expansion. We grew 1% this quarter, and we were able to do 10 basis points of margin expansion. So we feel good about the way we run our business with rigor and discipline."
},
{
"speaker": "Dave Koning",
"text": "Great. Thanks and nice bookings."
},
{
"speaker": "KC McClure",
"text": "Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hi, guys. Good morning and congrats, KC. A great run at Accenture. You were awesome. So, I want to ask on managed services on the bookings, the $11.8 billion, that was an outsized number. How much of that is new bookings versus renewals? And maybe give us some flavor on what caused that spike in growth."
},
{
"speaker": "KC McClure",
"text": "Yes. Maybe I will give you the -- I'll talk a little bit about the numbers. In terms of, it is a record bookings for managed services. As Julie's -- and as we've been talking, it is obviously based on the larger transformational deals that we're doing. Well, those larger transformational deals, just to be clear, Bryan, they do have both consulting and outsourcing -- excuse me, managed services type of work with them. They do have, as you would expect, a larger portion of managed services type of work. So when you see what we were able to do this year, we're already at 92, seven more than last year. And we did have a very strong managed services bookings, as you noted, in Q3. We don't really do a breakout in terms of extensions or new, but there's always -- we always have a healthy mix, I would say, of both. That's what we strive to over rolling four quarters in our business always and no difference there."
},
{
"speaker": "Julie Sweet",
"text": "Yeah. And just maybe a little color, Bryan. As you think about this idea of reinvention, Virgin Media O2 was a great example, because there, right, we have a combination using our Edge platform to provide -- help O2 provides -- Virgin Media O2 to provide these new services. And at the same time, we're supporting it with our customer operations, supporting their growth so that they can scale. And right now, clients, of course, they're looking for growth, they're also looking for transformation and efficiency. The other thing I'd say is, this is a great example of how we're embracing GenAI. You've heard us talk in the past about our myWizard platform, which helps in our managed services. We now -- that's become Gen Wizard and we're seeing that our embracing -- early embracing of using Gen AI where it's ready to be used has been a real differentiator in our technology managed services. So, we're very focused on helping our client, who move faster using our expertise and leverage our digital investments in order for them to transform and reinvent faster and you're seeing that focus."
},
{
"speaker": "Bryan Keane",
"text": "Got it. And just a follow-up, just looking at some of the dimensions breakout, when I look at operations being flat, just any call-outs for that. I know it was negative last quarter, so it's turned a little bit here, but just trying to understand the growth there and the prospects. Thanks."
},
{
"speaker": "Julie Sweet",
"text": "Yes, no, it's -- we're really pleased that it's, that ticked up this quarter and it's a very strategic part of our business. Think about it really is like sort of two-ways, right? So we remain number-one in our industry in finance and accounting and we're embracing again GenAI there to help differentiate our platform. And so, there's a focus that we're seeing in our clients as they're saying, okay, we need to -- we really understand how much more we need to digitize and we need to do that in the enterprise, they're excited about our ability over-time. Again, it's very early days still in Gen AI over-time to help build our -- we're building our SynOps platform, we're building in GenAI and that helps them have less to build-in in their enterprise side by partnering with us. And so that's -- we think a really great differentiator. And then we continue to diversify into areas that are in the core of our business, whether -- core of our industries for our clients, whether it's claims and underwriting and insurance, or supply-chain for consumer goods and industrial or core banking in the financial services. So we feel really good about the business and kind of continue -- and its continued prospects."
},
{
"speaker": "Bryan Keane",
"text": "Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thanks, Bryan."
},
{
"speaker": "Operator",
"text": "Your next question comes from the your next question comes from the line of Rod Bourgeois from DeepDive Equity Research. Please go ahead."
},
{
"speaker": "Rod Bourgeois",
"text": "Hey guys, and very best wishes to KC as well. Julie, you mentioned that the demand environment is sort of more of the same. At the same time, it appears you've seen some growth mending in certain key areas. I'm particularly interested in the growth improvement in the CMT vertical and in strategy and consulting. Can you talk about what's enabling those growth improvements and a sense of the outlooks for CMT and S&C? Thanks."
},
{
"speaker": "Julie Sweet",
"text": "So, really want to compliment our entire team on the work that they're doing with our clients in CMT. So, as we've been talking about that for now for a little while and we start to see things like the Virgin Media O2 deal. So our teams are working with our clients on what do they need. And they're focused on getting rid of technology debt, because that's critical in order to use some of these new technologies. They're focused on using the new technologies. So we have a number of clients that -- while it's still small, are working on GenAI. And then being very focused on efficiencies. And then finally network. So, really across the board what I would say is the industry was challenged. We have been just focused on going to where they need help and you're seeing that result in our results. And then on strategy and consulting, again, it's all about being focused on what do our clients need. And so, we've pivoted many more people, for example, toward cost and strategy. So cost takeout is a big theme, and particularly for our strategy. We are seeing a lot of growth still in things like implementing modern ERP platforms with the focus on the digital core. And again, at Accenture, it's not just technology, right? It's about we're the number one player with all of these technology ecosystem players, but our clients want to do it faster. They need the industry expertise. And so, you saw a number of examples in the script about how we're putting in these platforms and we're doing so within an industry context. And so, I'd say cost takeout and move the cloud data platforms wrapped around with industry and functional expertise, that's where we're seeing the growth. And we just continue to remain laser focused on more people, more focus, working with the clients on what they need to buy."
},
{
"speaker": "Rod Bourgeois",
"text": "Great. Thanks for that. And you're seeing revenue mix incrementally shift into managed services, and I'm curious if you think some of that mix shift towards managed services is due to secular forces, or are you purely seeing that mix shift as just a cyclical phenomenon?"
},
{
"speaker": "KC McClure",
"text": "Yes, I think, it's -- in terms of what the real driver is, it's the larger deals that have a little bit of both in those -- both components of a sector and cyclical and what you're talking about. So it really is just based on the larger deal."
},
{
"speaker": "Julie Sweet",
"text": "So just think about Accenture is very uniquely positioned in this market. Clients are prioritizing large scale transformations. And doing those and getting the efficiencies and moving faster, managed services is a highly strategic component of being able to do that. And this is where Accenture, with such scale in both strategy, in both consulting type of work with managed services is really able to lean into what are clients buying now."
},
{
"speaker": "Rod Bourgeois",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Bergin from TD Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi. Good morning and congrats KC and the other leaders on the retirements and appointments. First question I wanted to ask on the consulting existing revenue-base performance, can you just talk about how base business runoff kind of progressed within the minus 1% local currency performance? I heard your comment on the 4Q consulting or just returning to growth. I'm trying to understand if that's a reflection of sustainable stabilization potentially and really gauge whether you're reaching a point where the new consulting bookings conversion should more than offset the existing base runoff moving ahead."
},
{
"speaker": "Julie Sweet",
"text": "Yes. So, Brian, in terms of what we'll give -- what we'll talk about is really is what I just mentioned on Q4. I guess -- and I understand what you mean by a base runoff. We don't really think of it that way. We kind of look at it as maybe our terms will be whether we have booked and backlog and what are we already -- and what's new coming in from these sales. And so, I get -- so just kind of going with those two points, the way we evaluate and we talk about it, Brian, is from a year-over-year basis, looking at both the components of what we've already sold for the next quarter and then what we see in our pipeline and how we see those sales will convert to revenue, that's how we kind of assess what we think that we will be overall. And again, very pleased that consulting -- we do feel that and see that it will return to growth. And I think it's a milestone that we haven't had in a number of quarters, so we'll pleased with that. And we'll comment on anything else for next year, next year, I mean in September."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And then bookings, obviously, very solid here. Can you just comment on pipeline and any bookings expectations worth calling out for 4Q?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. Overall, we feel good about our pipeline. And we don't put -- we don't give guidance to next quarter bookings. But we feel good."
},
{
"speaker": "Bryan Bergin",
"text": "Thanks."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of James Faucette from Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Great. Thank you very much. I wanted to follow up on the acquisition activity. It's obviously been really robust, providing a lot of good opportunities. Can you give us any sense collectively across the acquisitions you've been doing and maybe what you are looking at in terms of what the growth rates of those businesses are generally or collectively when you do the acquisitions? And I know there's a target to accelerate those, how the growth rates tend to change as those companies are absorbed into [index center] (ph), even if directionally."
},
{
"speaker": "Julie Sweet",
"text": "Yes, I mean, I think in terms of -- make sure I'm answering your question is, when we look at overall at our acquisitions, they all come with -- they're typically higher growth business cases that we have from the companies that we buy and we have a base case that comes with the organization and we assess that growth rate. And then we obviously put in pretty significant synergy cases that are -- without going through kind of metrics that are a pretty high bar for those acquisitions to deliver to, along with a broader center. And that's why integration is so important in what we do, because we're not just having a great business case, that is maybe half of what you need to do, but the key really is in how you integrate to deliver to that, and we have a very strong track record. And so, what you'll see is, you could just maybe get the sense to your question, is look at how many we've done over the last five years and you can see how we've been able to continue to grow our business throughout that time. And it is really continuing to fill our organic growth."
},
{
"speaker": "James Faucette",
"text": "Got it. And then quickly, one of the areas where you've leaned in on and was mentioned in the prepared remarks is the government and healthcare sector, really strong growth there obviously. How should we be thinking about that as a long-term or medium-term potential grower in that segment and any -- and how are you thinking about the investment needed to continue to drive that? Thanks."
},
{
"speaker": "Julie Sweet",
"text": "Thanks. We feel really good about that vertical. Obviously there's a lot of transformation that's going on in public service. You see health is a big driver, defense is a big driver. There's a lot of infrastructure support, whether it's IRA in the U.S. or what the EU has been doing as well. And of course, a lot of the digital transformation hasn't happened in the public service and health, And so, we see that now being the time and you're seeing that in the results. So we feel very confident and we think about the investment like we do all our industries. I mean, remember, we have 13 industry groups. We have -- the diversification is a key part of both our resilience and our growth strategy. And so, at any given time, we're investing differently depending on the growth trajectory. And as we called out this quarter, we've been investing significantly in public service, because we see the next several years this being a big growth area and we're making those investments now."
},
{
"speaker": "Katie O'Conor",
"text": "Operator, we have time for one more question, and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Okay. That question comes from the line of Keith Bachman from BMO. Please go ahead."
},
{
"speaker": "Keith Bachman",
"text": "Hi. Many thanks. And first, Casey and Paul, special congratulations as you make the transition. I wanted to ask a question, and I'll just make it concurrently in the interest of time. And Julie, I think I'll direct this to you. Number one, on BPO, one of your competitors just talked pretty openly about pricing's been under pretty material duress as of late, and I wondered if you would echo that? And I'm really curious as to why. Why do you think pricing has been under duress? And how do you think about impacting future growth? And then the second area that I wanted to ask about is, Song. Thank you for the comment on mid-single digit growth. And I'm really interested how you think GenAI will impact over your digital agency over the next 12 to 24 months. And the reason I ask the question is, we also spend a lot of time with companies like Adobe that have significant -- generative AI is going to have a significant impact on digital agencies. And some of the agencies are talking about seat reductions because of the value associated with generative AI. And I'm just wondering if you could comment on how you think generative AI will impact the growth potential of Song. And that's it for me. Many thanks."
},
{
"speaker": "Julie Sweet",
"text": "Great. KC, why don't you quickly cut pricing, and then I'll do Song."
},
{
"speaker": "KC McClure",
"text": "Keith, I would say just in terms of pricing, and we've been commenting on this for quite some time. You are correct in that, we've had overall in our entire business continued pricing pressure. So, I mean, that's the way I would reflect on that statement -- on your question [indiscernible]."
},
{
"speaker": "Julie Sweet",
"text": "Yes, it's overall is a tight market, So that's what you normally see. On Song, here's where we are so unique, because our business is not an agency business, right? The agencies are part of an incredibly differentiated value proposition where you have creative and technology and digital and by the way managed services. And so, we see this as a huge opportunity because we are embracing it as fast as possible to help our clients get value, but we put it together with all of these other services. So we were happy to see the uptick in growth this quarter with Song and long term where we really think it's great. And remember, this is our playbook, right? We embrace technology. We've done it in every wave. We've done it when we did managed services. Remember in 2015, we had SynOps and myWizard. Our business is to help our clients be more efficient and grow. That is what we do. And we use technology in how we deliver it. And we help them use technology and how they operate. And so, we see GenAI as yet another way that we're going to embrace it. We're going to be fast. And we're going to do what we do for clients. And that is a very exciting opportunity, so we feel really good about our Song business. Great. So, thanks everyone for the questions and the time today. In closing I want to again, as always, thank all of our shareholders for your continued trust and support, and all of our people for what you're doing for our clients and for each other every day. Thanks so much for joining."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 2 | 2,024 | 2024-03-21 08:00:00 | Operator: Good morning. Thank you for standing by, welcome to Accenture's Second Quarter Fiscal 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode, later we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Katie O'Conor. Please go ahead.
Katie O'Conor: Thank you, operator. And thanks, everyone, for joining us today on our second quarter fiscal 2024 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short-time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC, will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the third quarter and full fiscal year 2024, we will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking, and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and quarterly report reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie.
Julie Sweet: Thank you, Katie and everyone joining, and thank you to our 742,000 people around the world who work every day to deliver 360 degree value for all our stakeholders. I'm pleased with our performance in an uncertain macro. Our results highlight the benefit of the deep trust our clients have in us, our capabilities to do the most complex work at the heart of their businesses, the privileged position we hold within the ecosystem and our ability to invest for the next waves of growth. We continue to see momentum in the quarter and how we are executing on our strategy to be the trusted reinvention partner of our clients, with a record 39 clients with quarterly bookings greater than $100 million. These large transformational wins position us to capture more growth as spending increases. We also had over $600 million in new GenAI bookings taking us to $1.1 billion in GenAI sales in the first-half of the fiscal year, expanding our early lead in GenAI, which is core to our clients reinvention. We now have over 53,000 skilled data and AI practitioners against our goal of doubling our data and AI workforce from 40,000 to 80,000 by the end of fiscal year 2026. We are laser-focused on the needs of our clients and this focus is reflected in our bookings of $21.6 billion, representing our second highest quarter on record. This included $10 billion of bookings in North America, our highest ever. We continue to take market-share with revenues of $15.8 billion for the quarter, flat compared to last year and slightly above the midpoint of our range. As we turn the page on the calendar year, we saw another turn of the dial unconstraining spending by our clients, including spending on our services, particularly in parts of EMEA and North America. This was evident in the composition of our new bookings, which came in differently than expected. We see clients continuing to prioritize investing in large-scale transformations which convert to revenue more slowly, while further limiting discretionary spending particularly in smaller projects. We also saw continued delays in decision-making and a slower pace of spending. We are pleased that despite these conditions our focused efforts to return to growth resulted in North America and CMT, showing improvement over last quarter. We are running our business with rigor and discipline and we remain on-track with the business optimization actions we announced last year to reduce structural costs to create greater resilience. We delivered adjusted EPS growth of 3%, we continue to invest significantly in our business to drive additional growth in highly strategic areas with $2.1 billion of capital deployed across our geographic markets in Q2 in 11 acquisitions, bringing the total investment in acquisitions to $2.9 billion in H1 across a total of 23 acquisitions. We also continue to invest in learning for our people with approximately $10 million -- 10 million training hours in the quarter, representing an average of 14 hours per person. In recognition of the 360 degree value we create, we are proud that we earned the number one position in our industry for the 11th year in a row and number 33 overall in Fortune’s list of the World's Most Admired Companies. We ranked number one in our industry and number three overall on the JUST Capital CNBC list of America's Most Just Companies. And we have been recognized by Ethisphere as one of the World's Most Ethical Companies for the 17th year in a row. An important part of our growth strategy is to use our strong balance sheet to invest in order to scale higher-growth areas and expand into new growth areas. We have a strong track-record of delivering on this strategy. Here are some highlights from the quarter. In North America, we invested in supply-chain, an area with significant reinvention ahead with the additions of inside sourcing in [indiscernible] and on-process technology. We acquired Navisite site to help clients across multiple cloud providers enterprise applications and digital technologies, modernize their digital core, and in Song, we acquired Work & Co to help our clients drive growth by designing and bringing digital brand strategies to market and operationalizing world-class digital products at scale. In EMEA, we are investing to help clients build their digital core and drive growth. In the UK, we invested in 6point6, which will help our clients transform their digital capabilities and modernize their legacy systems. We also acquired in the UK, Redkite with its full stack data expertise that will help our clients accelerate their performance with data driven intelligence and AI. And in Germany we added Vocatus, which will accelerate our clients' growth strategies using behavioral economics modeling to develop pricing strategy and sales concepts for B2B and B2C models. Similarly, in good markets our acquisitions position us to drive our clients' growth agendas by expanding our capabilities in marketing and customer experience with Rabbit's Tale in Thailand and [GIC] (ph) in Singapore, helping clients in Indonesia, capitalize on their fast-growing digital economy. Our ability to invest to fuel our organic growth is a competitive advantage and as our clients continue to transform, we announced earlier this month that we will invest $1 billion over the next three years in Accenture LearnVantage, which will provide comprehensive technology learning and training services to help our clients re-skill and upskill their people. Our investment includes the acquisition of Udacity, a digital education pioneer, which we expect to close by the summer. Once closed, we will have revenue in the zone of $100 million annually. These services are highly strategic and they enhance our position as a reinvention parts are of choice, because talent is at the top of the agenda for CEOs. For example, we are helping Merck, a global biopharmaceutical company known as MSD outside of the United States and Canada launching groundbreaking Generative AI training program for their employees to create world class digital leaders. As a renowned thought leader in the biopharmaceutical market, Merck has long-lead the way in investing in its people and helping them build the skills and expertise needed to develop breakthrough therapies. Digital, data, analytics and AI play a pivotal role in discovering, developing, manufacturing, and providing access for patients to medicines and vaccines. By once again investing in its people, Mark will be able to continue delivering on its promise to use the power of leading-edge science to save and improve lives around the world. Over to you KC.
KC McClure: Thank you, Julie. And thanks to all of you for taking the time to join us on today's call. We were pleased with our overall results in the second quarter with our second highest quarter of new bookings. We continue to invest at scale to strengthen our leadership position, while delivering value for our shareholders. Now let me summarize a few of the highlights of the quarter. Revenues were flat in local currency, with mid-single digit growth or higher in six of our 13 industries, including public service, life science, utilities, energy, health and high-tech. While our CMT industry group improved this quarter, we continue to see pressure as expected. And we continue to take market share. As a reminder, we assessed market growth against our investable basket which is roughly two dozen of our closest global public competitors, which represents about a third of our addressable market and we use a consistent methodology to compare our financial results to theirs. Adjusted to exclude the impact of significant acquisitions. Through the date of their last publicly available results on a rolling four quarter basis. Adjusted operating margin of 13.7% decreased 10 basis points, compared to Q2 last year and year-to-date operating margin is flat. This includes continued significant investments in our people and in our business. We delivered adjusted EPS in the quarter of $2.77, reflecting 3% growth over adjusted EPS last year. Finally, we delivered free cash flow of $2 billion and returned $2.1 billion to shareholders through repurchases and dividends. In the first half of the year, we've invested $2.9 billion in acquisitions across 23 transactions. With those high-level comments, let me turn to some of the details, starting with new bookings. New bookings were $21.6 billion for the quarter, representing a 2% decline in both US dollar and local currency, with an overall book-to-bill of 1.4. Consulting bookings were $10.5 billion with a book-to-bill of 1.3. Managed services bookings were $11.1 billion with a book-to-bill of 1.4. Turning now to revenues, revenues for the quarter were $15.8 billion, flat in both US dollars and in local currency, and we're slightly above the midpoint of our guided range. Consulting revenues for the quarter were $8 billion, a decline of 3% in both US dollars and local-currency. Managed service revenues were $7.8 billion, up 3% in both US dollars and local-currency. Taking a closer look at our service dimensions, technology services grew low-single digits and operations and strategy and consulting declined low-single digits. Turning to our geographic markets. In North-America revenue was flat in local currency with growth in public service, offset by declines in banking, capital markets, software and platforms and communications and media. In EMEA, revenues declined 2% in local currency with growth in public service, offset by declines in communications and media and banking capital markets. Revenue growth in Italy was offset by declines in the United Kingdom, France and Ireland. In growth markets, revenue grew 6% in local currency, led by growth in banking, capital markets, industrial, public service and chemicals and natural resources. Revenue growth was driven by Japan and Argentina, partially offset by declines in Australia and Brazil. Moving down the income statement, gross margin for the quarter was 30.9% compared with 30.6% for the same-period last year. So marketing expense for the quarter was 10.3% compared to 9.9% for the second quarter last year. General and administrative expense was 6.9% compared to 6.8% for the same quarter last year. Before I continue, I want to note that in Q2 of FY 2024 and FY 2023, we recorded $150 million and $244 million in costs associated with our business optimization actions respectively. These costs decreased operating margin by 70 basis-points and EPS by $0.14 this quarter and operating margin by 150 basis-points and EPS by $0.30 in Q2 of last year. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.2 billion in the second quarter, reflecting an adjusted operating margin of 13.7%, a decrease of 10 basis-points from adjusted operating margin in the second quarter of last year. Our adjusted effective tax rate for the quarter was 18.8% compared with an adjusted effective tax rate of 20.4% for the second quarter last year. Adjusted diluting earnings per share were $2.77 compared with adjusted diluted EPS of $2.69 in the second quarter last year. Days services outstanding were 43 days compared to 49 days last quarter and 42 days in the second quarter of last year. Free cash flow for the quarter was $2 billion resulting from cash generated by operating activities of $2.1 billion, net of property and equipment additions of $110 million. Our cash balance at February 29th was $5.1 billion compared with $9 billion at August 31st. With regards to our ongoing objective to return cash to shareholders, in the second quarter we repurchased or redeemed 3.8 million shares for $1.3 billion at an average price of $352.35 per share. As of February 29th, we had approximately $4.6 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $1.29 per share for a total of $813 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.29 per share to be paid on May 15th, a 15% increase over last year. In closing, we remain laser focused on capturing growth opportunities in the market and delivering value for our clients. As you know and expect of us, we will operate with rigor and discipline, while continuing to invest for long-term market leadership. Now, let me turn it back to Julie.
Julie Sweet: Thank you, KC. Let me give a little more color on the demand environment, all strategies continue to lead to technology and reinvention. Our clients are navigating an uncertain macro-environment due to economic, geopolitical and industry-specific conditions. And in response, we are seeing them thoughtfully prioritize larger transformations, building out their digital core to partnering, to improve productivity, to free-up more investment capacity to focus on growth and other initiatives with near-term ROI. Our focus on being at the center of our client's business doing their most complex transformational work provides us with resilience see overtime, as demonstrated by the fact that our top 100 clients have been clients for over 10 years. There is now near universal recognition of the importance of AI, which is the heart of reinvention. The ability to use AI at scale, however, varies widely with clients on a continuum with those which have strong digital cores generally seeking to move more quickly, while most clients are coming to grips with the investments needed to truly implement AI across the enterprise and nearly all are finding it difficult to scale, because the AI technology is a small part of what is needed. To reinvent using technology, data and AI you must have the right digital core, change your processes and ways of working, reskill and upskill your people and build new capabilities around responsible AI. All with a deep understanding of industry and function in order to unlock the value. And many clients need to first find more efficiency to enable scaled investment in all these capabilities, particularly in their data foundations. We are able to help our clients with this AI rotation because of our broad services across strategy and consulting, technology and operations as well as everything customer through Song and digital manufacturing and engineering through Industry X. And our relevance across the functions of the enterprises in 13 industries. Our privileged position in the technology ecosystem has perhaps never been more important. Generative AI is rapidly evolving and still in the early stages of maturity and adoption. And we are working closely with our ecosystem partners to help our clients understand the right data and AI backbone that is needed and how to achieve tangible business value. I will now bring to life the complex work we are doing at the heart of our clients' businesses. Building on the back of a long trusted partnership, we are working with Mondelez International, a world-leader in snacking with well-known brands like Oreo, belVita and Cadbury. To continue to drive growth and be an industry-leader. Having laid the foundations of a strong shared services modeled model powered by leading technology platforms and data and AI foundation we are now working on an ambitious reinvention of their digital core. We will design and implement a single cloud-based platform. We'll also modernizing the finance function and transforming their supply-chain planning and warehouse management capabilities. This will enable faster availability of products for customers to have more sales growth and maximum profitability. This new digital core will also allow Mondelez to further reinvent how they satisfy customers through the adoption of new technologies like Generative AI. Cloud continues to be the foundation of the digital core. Our cloud business grew high-single digit this quarter as clients do work across the cloud continuum from migration to modernization, to new business models to working at the intelligent edge. For example, we're helping Riyadh Air, a digitally native airline based in Saudi Arabia, become the world's first fully cloud-based airline. We will equip the brand-new airline with a cloud-only infrastructure enhanced cyber security and AI driven operations. Our capabilities will ensure that Riyadh Air’s digital core is future-proof and remains legacy free, enabling the airline to use cutting-edge technologies such as cloud, data and AI to scale quickly and deliver a seamless and more personalized travel experience for its customers and employees. This will also help the company to scale as it plans to operate over 100 destinations by 2030. We are partnering with Belden, a global networking solution organization on a cloud transformation program that will help them become a platform business. Unlocking the power of edge, data and AI to drive new business opportunities and enhance the customer experience. This platform will be powered by edge to cloud technology, allowing them to collect and analyze real-time data from industrial environments and improve operational efficiencies. This will provide valuable data driven insights to Belden and to their clients in industries where real-time insights are crucial. This reinvention will enable them to break-down operational technology silos, allowing them to become a key player in the digital twin domain. We will also help enable this new service in the market, this strategic partnership will support Belden's reinvention from a product company into a data engineering and insights company that leverages the power of platforms. We are focused on helping our clients, leverage the power of AI quickly, generating tangible business value, leveraging our investment in differentiated tools that accelerate results. Our AI Navigator has helped clients across industries outline their value case, AI architecture and AI solutions and our recently-announced AI switchboard is already helping clients with the complex new need for integration across LLM models. For example, one of the largest [indiscernible] companies is currently testing the switchboard to compare how the same prompt would be interpreted by different models and how they perform before deciding on which model to use. Ultimately an enterprise-wide AI rotation requires a strong data foundation, we are working with Telstra, Australia's leading telecommunications and technology company on a radical simplification and modernization of its data ecosystem, accelerating its efforts to become AI powered. We are modernizing and consulting over 50 disparate enterprise data sources into a small integrated set forming Telstra's governed and secure data and AI core, allowing Telstra to rapidly scale bespoke Generative AI capabilities in the future. Our work will also support the company's efforts to develop responsible ethic and secure market leading AI frameworks, while helping their teams provide quicker, more effective and more personalized customer interactions. One of the areas of riches opportunities for our clients is customer experience transformation, including with Generative AI, which uses the unique capabilities of Song across creative customer insights and deep technology expertise. Song grew low-single digits this quarter, we continue to help clients reimagine marketing to drive growth. We're helping ExxonMobil, an energy super major transform and optimize its end-to-end fuels marketing operations to drive future growth. With our global capabilities, our managed services will leverage our SynOps platform to drive automation and deliver measurable efficiencies across the fuels marketing business. We are strengthening our partnership with Best Buy, a leading consumer electronics retailer across multiple fronts to reimagine the customer experience, optimize costs and drive growth. By leveraging data and Generative AI, we are helping to transform their contact center operations and improve customer and employee experience. We are also pleased to have entered into an agreement with Best Buy for lifecycle management of our own Accenture devices in North America and our creating a joint offering end-to-end field service advice support for clients. We have already applied this new offering to a major TV provider, marking our first entry into this new market. These strategic initiatives underscore our commitment to helping Best Buy, achieve superior customer experiences, operational efficiencies and growth. Security is essential to reinvention, moving beyond IT to protecting the core assets of the business and evolving the critical role of security as technologies change. We saw very strong double-digit growth in our security business this quarter. We are working with one of the largest electric utility holding companies in the United States to integrate their operational technology into a seamless unified cyber security solution. Together, we will enhance our security capabilities by implementing advanced monitoring and response, vulnerability management and security automation. This will help reduce the risk of secure of cyber events in their grid environment protecting critical infrastructure serving tens of millions of people. We continue to see strong demand for digital manufacturing and engineering services. Industry X grew double-digits in Q2. We're working with Indo Count Industries Limited, a global leader in the home textile space on digital transformation to simplify operations, support its ambitious growth plans and maximize e-commerce opportunities. We will build a cloud-enabled digital core, powered by data and analytics that will help standardize, digitize and automate processes and operations. From supply chain to logistics to manufacturing, the new platform will enable more efficient inventory management, quality standardization optimal energy consumption and better customer experiences. Together we will reinvent their operations and help expand our business in India, Middle-East and North America, the UK and Europe. And we continue our support for corporate green transformation by promoting carbon footprint compliance to the calculation and visualization of greenhouse gas emissions. To create a market where consumers can choose environmentally conscious products and services [indiscernible] visualize the carbon footprint of each product is necessary. For example we're assisting, Matsumoto Precision, a precision machine parts processing company based in Japan to gain more detailed insight into the sustainability of their projection and achieve their decarbonization goal. We implemented a solution through our manufacturing platform that uses individual manufacturing performance information to record and report the CO2 emission on a per product basis. This will allow Matsumoto Precision to enhance understanding of the environmental impact of their business and contribute more effectively to the realization of a decarbonized society. Back to you, KC.
KC McClure: Thanks, Julie. Now let me turn to our business outlook. For the third quarter of fiscal 2024, we expect revenues to be in the range of $16.25 billion to $16.85 billion. This assumes the impact of FX will be about negative 1% compared to the third quarter of fiscal 2023 and reflects an estimated negative 1% to 3% positive growth in local-currency. For the full fiscal year 2024, based upon how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in US dollars will be about flat compared to fiscal 2023. For the full fiscal 2024, we now expect revenue to be in the range of 1% to 3% growth in local-currency over fiscal 2023, which assumes an inorganic contribution approaching 3%. We continue to expect business optimization actions to impact fiscal 2024 GAAP operating margin by 70 basis-points and EPS by $0.56. For adjusted operating margin, we now expect fiscal year 2024 to be 15.5%, a 10 basis point expansion over fiscal 2023 results. We now expect our adjusted annual effective tax rate to be in the range of 22.5% to 24.5%. This compares to an effective tax rate of 23.9% in fiscal 2023. We now expect our full year adjusted earnings per share for fiscal 2024 to be in the range of $11.97 to $12.20 or 3% to 5% growth over fiscal 2023 results. For the full fiscal 2024, we continue to expect operating cash flow to be in the range of $9.3 billion to $9.9 billion. Property and equipment additions to be approximately $600 million and free cash flow to be in the range of $8.7 billion to $9.3 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.2. Finally, we continue to expect to return at least $7.7 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to shareholders. With that, let's open it up so that we can take your questions. Katie?
Katie O'Conor: Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call.
Operator: Thank you. [Operator Instructions] And one moment please for your first question. Your first question comes from the line of Tien-Tsin Huang from JPMorgan. Please go ahead.
Tien-Tsin Huang: Hi. Thank you. Good morning to all of you. Julie, just a big picture, maybe two simple of a question, but just curious to get your thoughts on where we are in the cycle for IT services spend, because we've been doing sector softness for quite some time now, Accenture has done well, you have very large deal activity come through, short-term cycle stuff is always little pressured as you said, where are we in terms of seeing maybe things bottoming or short-cycle discretionary spend returning?
Julie Sweet: Yes. I mean, Tien-Tsin, I think it's hard to predict at this point anything other than what we see right now. Right? So what's different than 90 days ago. Well, as we said in December, we really get visibility into our clients' budgets in January, we say that every year, right? And so, as the calendar year, we turn the page, what we saw was a further tightening of spending at our clients. Particularly [indiscernible] our services and particularly on the smaller projects. So from that sort of trend perspective, 90 days ago we didn't see the same level. Now you kind of turn the dial a little bit more constraints and that's where we see the budgets being set for calendar year 2024, right? And as you said though, in this environment we're taking market share and we're seeing building momentum on our strategy to be the reinvention partner with a record 39 clients with bookings over $100 million. So what does that tell you, right? So, the clients understand the importance of the technology-led transformation. And the fundamentals remain the same. There is a lot more reinvention ahead. We're still -- when you look at where is cloud, both migration and modernization, we say about 80% of the opportunities ahead. Data and AI, but 90% of the opportunities ahead. Re platforming in cloud-based platforms. About 65% of that opportunity ahead, based on who has actually adopted that more modern platforms and security. Well, I think security can be kind of forever ahead, but at least 65% ahead. And that's before you get to thinking about areas like digital manufacturing, engineering services, where that technology has only been coming online, even in the last couple of years sort of the modern technology. And of course, customer also extraordinarily early days. So, where we really focused on is meeting clients where they are today. So that prioritize the large transformational deals and then be positioned to capture the spending when it increases. And we see the sort of the industry has been very strong, because all clients have to get there. They need to get to the technology transformation. They need to get the reinvention and that's why you're seeing -- even as the constraints you're seeing that early interest in GenAI. I mean, $1 billion sales in the first-six months of the year, that is the fastest we have ever built sales in an emerging technology. And what it tells you is that, clients understand the importance of AI that they're going to have to reinvent every part of the enterprise and that's exactly where everything we've done for the last decades at Accenture. Being the company that can go from strategy to build, to operations, deepen industry and functional expertise, because the strategy and consulting all comes together for this moment to be the partner for reinvention across the enterprise, not just to build the technology, but to use it to reinvent and that's exactly what you see in these results, which is why I'm super confident about the industry and the future.
Tien-Tsin Huang: Yes. No, I'm confident that Accenture will be there to catch-all that like you said, but maybe as my follow-up with the GenAI bookings any trends on deal size. And in confidence that, that some of these early bookings will convert to become a part of this whole large $100 million plus deal activity across more pull-through from GenAI, that question makes sense.
Julie Sweet: So couple of things. What you see in our resilience is that, we are doing these bookings over $100 million and that's what kind of layers that. That just gives you that base rate of resilience during this period. As we said, we're seeing further constraint on the smaller projects. That's why you've got the updated guidance, right? But the pace of these larger deals, we feel really good about from a resilience perspective. And then, you know how this straight, you're at the client, you are at the heart of their business, you're really doing the strategic work that's what all these large deals represent. And then as spending increases you catch the pent-up demand and that's kind of how we see it and that's how we've run it in the past. And by the way, of course, as you know, we're really investing inorganically to capture more growth which you also start to see. Particularly at the back-end of our fiscal year. Thanks, Tien-Tsin.
Operator: Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead.
Bryan Keane: Hi, good morning. KC, if Accenture does 1% constant currency in the third quarter, that's kind of the midpoint of the range. I guess the implied midpoint for 4Q is a ramp-up to 6% constant currency. What kind of visibility do you have going into a number of the midpoint like that in the fourth quarter?
KC McClure: Yes. Hi, Bryan. Thanks for your question. And you're right, you're obviously your math is correct, that that would be what our guidance would say. In terms of visibility, look, it's really no different than what we have anytime in the past in this part of the year for our full-year guidance. Obviously, we are not forecasting that the whole year we just have the back-half of the year, there's no difference in visibility as it relates to what we've done in any other time of the year -- any other year at this time. And we do our same at analysis and outlook to provide you with our guidance of the 1% to 3%.
Bryan Keane: Got it, got it. And then, Julie. Just thinking about the clients need to update their data in order to leverage AI and scale. Why isn't that translating into stronger demand in the business, you would think that everybody would turn-around and spend considerably on short-term to get that ramp-up in order to get AI to leverage it, but it doesn't quite translate. I'm just trying to figure out the disconnect there?
Julie Sweet: Yes, so there is two things. So first of all, it's about prioritization. Right? So their overall constrained on spending. So, you make choices as opposed to it being additive. So they are not able to allocate extra budget, they're prioritizing their budget. So you're seeing more of a substitution right now as opposed to, hey, we need to do this, let's add to the budget and that's tied to the uncertain macro, that's putting people constraint. I had one banker say, if the corporates have put themselves on a diet, given the macro. Right? The second thing, Bryan is, you have to remember that you can't just jump to the great data foundation. You need to be in the cloud. You've got to have modern platforms. And so what you should read into the higher clients -- the clients during these higher bookings rate is that, they're doing the big transformations oftentimes to be ready to put in the data foundation, right? There's only still 40% of workloads are in the cloud. 20% of those roughly haven't been modernized. Many of our clients haven't put in the platform, if you don't have the major ERP platforms that are modern, you don't create a data foundation to fuel GenAI in isolation. So you've got to build the digital core. And as we've said, there's a lot more to go. And that's what's driving these larger complex transformations like, people will not like to do these big transformations in a sense of the other big, they're hard, they're complicated and they need to do them in order to ultimately be able to use the AI, not just in a part of the business or as a proof-of-concept, but really to transform and get the value they now see and so it's -- again, you can't jump to AI, you've got to put all the pieces, and a lot of clients aren't there yet. Which is our opportunity.
Bryan Keane: Got it. Thank you for taking the questions.
KC McClure: Thanks, Bryan.
Julie Sweet: Thanks, Bryan.
Operator: Your next question comes from the line of James Faucette from Morgan Stanley. Please go-ahead.
James Faucette: Great. Thank you very much. Wanted to follow-up on the questions around, particularly AI, etcetera. I recognize like everybody is kind of at different stages. How should we think about: first, the timeline in terms of preparing and getting ready to implement news solutions, etcetera, and then moving into the full implementation? And how we should think about that affecting Accenture’s business? And like you mentioned, you've talked about some record bookings or the number of new customers over $100 million, like how that will ramp-in the timeframe?
Julie Sweet: Yes, so maybe just -- let me just start with like the strategy around capturing the growth opportunity from GenAI. So, this is the same playbook that we have used in every wave of new technology evolution. When we went from mainframe to client-server then to cloud and Software as a Service and then to RPA and AI driven automation when you saw things like myWizard and SynOps. We have the same strategy, the strategy starts with, we want to be the first-mover to help our clients use the technology. And that's why what we're doing with our investments of $3 billion to create solutions for them and you see that coming through with our sales in Generative AI, which, as I've said on earlier, are the fastest we've ever seen in sort of these new technologies where there's a lot of interest and we're the leader. So we want to be the first-mover in helping our clients use it. The second part of our strategy is to be the first-mover in using the technology itself to serve our clients. And we did that would like the digital, with AI automation, with all of our platforms. And with that said, it's a proven formula, because if we invest big to be early and be the first-mover, then we're positioned to capture all the opportunity in our -- with our clients, because they need to adapt it and transform. And as I just went through, that requires a lot the digital core, then you've got to actually use it to change new ways of working to upskill your talent and build new capabilities like responsible AI. When we are able to be the first-mover, which we are already starting now to use GenAI and how we deliver, that enhances our competitive position. It makes us more differentiated and, of course, it also then allows our clients overtime the more we use the GenAI to achieve the results they need at a lower cost, which frees up their investment capacity to do the massive reinvention. And of course, we are in the best positioned to be their partner as they reinvest in using the tech and AI to [Technical Difficulty] lot of the digital core that's got to-be-built, you can't jump that step. It's not a magic technology. But then as you build it, you then have to go function by function to change the ways you work to actually get the productivity and the growth. So we really see this as being kind of the next decade of what our clients are going to be focused on and we are positioning ourselves to be their partner and be the first-mover in both places.
KC McClure: Yes. And maybe I'll take the layering in question on the larger deals and talk a little bit about how that's going to work for the back-half of the year as it relates to guidance. So we have the larger deals that were terrific in our second quarter and our whole first-half of the year. But you're right, they do layer-in slower than the smaller deals and we see pressure in the volume of our smaller deals. And that's why we have the 1% to 3% guidance for the full-year. Now we do feel-good about delivering to this guidance and what that means for H2, and that really is for a few reasons that we've talked about before, but let me just kind of reiterate. The first is that, our competitive advantage is that we have the ability to invest. You saw us do that in H1 and Julie talked about that, with investing more in acquisitions this year, in the first half than we did all of last year. And that's really important because that drives inorganic growth. But again, we do that really to fuel organic growth, but we see that coming online in the back half of the year. The second thing is that, we have done these larger transformation deals, but also the ones from the previous years. And we see that continuing to benefit us as it relates to revenue as they will layer on in the back half of the year. And that really just speaks to the resilience of our strategy, both in terms of being what Julie has talked about, being where our clients need us and our inorganic strategy to continue to benefit to pivot to scale in new areas of growth. And so, that's how that all comes together in terms of revenue conversion from those larger deals and when they come online, James. And maybe I'll just also add, what that means from a type of work for the entire year. What we now see from the context of the 1% to 3% is, our consulting type of work will be about flattish. And we see our managed services growing to about mid-single digit growth for the year.
James Faucette: Great. Thanks for the color to both of you. And then quickly KC, just in terms of that investment. How do we think about like how that affects the margin expansion. I mean typically one, you're doing acquisitions, there a little bit of time before you can start to get people to the same type of trajectory as Accenture on margin expansion, but just trying to get a sense of how we should think about that impacting as well?
KC McClure: Yes. Thanks for that. Well, first of all, I'm just -- I just want to put out that I'm really pleased with our profitability in the first half of the year and the outlook for profitability for the full year. Our margin is flat, but we have EPS growth for the first half of the year, profit growth of 5%. And that really just points to the rigor and discipline that we continue to operate our business in. But really importantly, as Julie talked about, all the investments we're making in our business and our people continue. So as you look at the back-half of the year, we now see the 10 basis points expansion is where we see it. Again, very important, continue to have high levels of investment in our people and our business. And EPS, we see for the whole year at about 3% to 5%. One thing I will point out just to help all of you. We did benefit from the first-half of the year in our EPS with higher non-operating income, which makes lot of sense on interest income, on our higher cash balance. In the first-half, you see our cash went from 9% to 5%. So great cash, we can -- no concerns will continue with our capital allocation strategy, but just as you model in the back half of the year, you'll see that not surprisingly with lower cash flow will have lower interest income. So just as you're working through your EPS for the first-half and second-half, that's something that you might want to consider.
James Faucette: Super helpful. Thank you.
Operator: Your next question comes from the line of Bryan Bergin from TD Cowen. Please go ahead.
Bryan Bergin: Hi, good morning. Thank you. So Julie, I'm curious just based on your conversations with leaders, what might be the catalyst here to have clients release spending programs and kind of lean back into shorter cycle work. As economic data generally holds up, are we just in a slower for longer backdrop or just kind of hoping that you can share some color on how you're thinking about a recovery internally and what enterprises really are watching and waiting for?
Julie Sweet: Look, I think there's going to be a couple dynamics, right? Remember they just set budgets. So we're kind of assuming there are the budgets for their calendar year and we see in general, most of this constraint is tied to the uncertain macro. So those are the kind of things. They set budgets and they've got uncertain macro.
KC McClure: Yes. And just a reminder that everything that we're talking about in terms of giving guidance. I know all of you know this, but just as a reminder, our fiscal year-ends on August. Right? So there -- it's a little bit over halfway through the calendar year.
Bryan Bergin: Okay, okay, that makes sense. And then as it relates to GenAI, just kind of a revolutionary versus evolutionary kind of questioning here. Just given how much work needs to be done for most clients to really do anything with large language models, how do we interpret that as a driver of your growth? So meaning, does GenAI enabled you to potentially drive a higher-level of growth when spending does become more normal or should we think about this more as a next tech wave that enable comparable levels of normalized growth just because of how long this might all take for large enterprises to get there?
Julie Sweet: Yes, what I'd say is, this is this is more about -- like we think of this as like prior technology waves. Right? Each one has been a little bit faster in terms of that, but especially when you look at kind of where our clients are on the continuum of building out that digital core, there is a lot to go and you really need that to fully realize it. So we see this is more like our prior kind of the way these things have evolved in the past. Right now, that's what we see.
Bryan Bergin: Okay. Thank you.
Operator: Your next question comes from the line of Dave Koning from Baird. Please go-ahead.
Dave Koning: Yes. Hey guys. Thanks so much. I guess my question, are you seeing your clients probably having much lower attrition, just like every company has low employee attrition, right now. Are you seeing them take their own employees, their own IT employees and just do more internally right now? And is that a little bit of just the demand issue right now?
Julie Sweet: We certainly are seeing -- obviously, our clients have invested in more technology internally at our advice. Right? We've said to them during the pandemic with technology being so important, they should be building up their technologies. So there is clients, they've got a lot of clients, not all of it, because it really depends on your positioning to some of our clients, that's really not the differentiator. So they want a smaller IT and they've got others who built it up and it really depends on where they are. But sure, I mean, we certainly got clients doing more -- doing more in-house as part of it and we've got other clients outsourcing more. So like, it's really all over the map, because it's very company specific as to what makes sense for their strategy.
Dave Koning: Yes. Okay, thanks. And just one quick follow-up for KC. The tax rate, clearly you lowered guidance just on the tax-rate itself. Is that something one-off to this year or is that something now that just seems more normalized?
KC McClure: Yes. So, there's really four things that every year are the same, that really influence our tax rate. And just really is how those things come together. There are geographic mix of income, any settlements from previous years, any increase that we need to do on prior year tax liabilities, and lastly, the impact of our equity on our tax rate. So these four things really are confluences the same every year, depending on how they fall. That's going to influence where we land on our tax rate. And so, we -- this year we saw them favorably in aggregate. So we're able to keep our 2 point range, but drop by 1%.
Dave Koning: Okay. Well, thank you guys.
Julie Sweet: Thank you.
Operator: Your next question comes from the line of Jamie Friedman from Susquehanna. Please go-ahead.
Jamie Friedman: Hi. Good morning, everyone. I have a really big picture question. I'm curious, Julie, how you feel about Accenture’s role in the broader context of technology like software and cloud? And I realize in your prior very thoughtful answer about technology architectures. That was a great structure as was your innovation session back on February 16th. But it does seem like other parts of tech are doing better than services. So I'm just interested in your perspective on services in the context of broader tech spending?
Julie Sweet: No, absolutely. It's a great question. Services are where you can dial back more easily than when you're signing-up for licenses for technology that you need. So you'd imagine and just what we're seeing that, when you are constraining overall spending, your discretionary spending, you go to like service providers where you're saying, I can pause for that. I can wait for that. And at the same time you've got in other parts of it, like with software where you've got to fix things you really need to invest in and you've got different licenses. So it's really not different than other cycles. Services have a bigger opportunity to say, it's a little more discretionary, let's wait. Even if I bought the licenses, I'm going to wait to actually incur the costs, because a lot of times the cost of the services can be significantly higher than the software licenses, because you've got all the change that you've got to do and all that around. So again, we don't see anything sort of different than when you've got an uncertain macro you look around for your discretionary spending and you cut that. And that's why, of course, you're seeing still the big transformations happening because it's not discretionary and they really got to re-platform in that. So it's like nothing mysterious about is kind of what I consider kind of normal in this kind of a macro.
KC McClure: That's right. An. I think just as a reminder, even with all that we still have the record spend with us with $40 billion of bookings for the first half of the year.
Jamie Friedman: Yes, those are great things. All right, I'll jump back. I'll jump back in the queue. Thank you, Julie. Thanks KC.
Katie O'Conor: Operator we have time for one more question and then Julie will wrap-up the call.
Operator: Okay. That question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead.
Ashwin Shirvaikar: Thank you. Hi, Julie. Hi, KC.
Julie Sweet: Hi, Ashwin.
Ashwin Shirvaikar: Going back to -- Hey. Going back to the question of bookings, are clients actually visiting existing bookings ones that they sign maybe last year and at times prior, relooking at them using the lens of applying sort of rapidly evolving GenAI capabilities. To what extent is that happening and then that kind of implies, obviously -- can we can reuse those past bookings and backlog as an indicator of future growth and how soon that can layer-in?
Julie Sweet: Yes. I'll take that. Just maybe more just the financial kind of mechanical part of it. We have not seen a change in us working the work that's already been contracted, what we would call our backlog and what we talked about was really spending on new sales, new services and their smaller projects and that's the dynamic that we have factored into our guidance for the year.
Ashwin Shirvaikar: Got it. And then the other question was on LearnVantage and Udacity, I thought that was a particularly interesting deal. If you could walk us through maybe the mechanics of that deal? And every company is investing in talent care, there seems to be a bit different approach maybe. Can you just talk about the rationale, the downstream impact and so on?
Julie Sweet: Sure, thank you. Because it's -- I'm super passionate about what we're doing with LearnVantage, because it is so critical for our clients. Talent is the number one agenda item for CEOs. The number one. And when you think about what reinvention means, the clients have to do and AI rotation and they have to do a talent rotation. And what LearnVantage does is, it first and foremost provides the ability for everything from the Board to the C-Suite to business users, to the technologists to get the technology training they need to make the right decisions on AI, for example. To be able to become deeper in the new technologies. And so it really goes from the Board to the technologist. And with Udacity what we're able to provide is essentially the same approach Accenture uses, right? So, we spent over $1 billion ourselves. You saw our latest average 14 hours per employee. And we have -- we use learning science to learn and do. Most of our clients are unable to do that. The big differentiator for us in the market here is that, we Accenture know when you train someone we have to then put them on a job, and they have to get paid to do something, so they are work ready. So we're bringing that expertise now at scale to our clients. And what Udacity does is the same thing, they use exports mentors, they have a real project work that they then coach people on. So it's that same sort of approach of learn and do, but our companies -- our clients don't have all the work that we do, so Udacity has created this ability. And so -- and it's coupled then with Accenture's deep understanding of what it takes to train and be work ready. So we're really excited about it. Our clients are excited about it, they've been coming to us. We've been doing this learning and this enables us now to do it at scale. And again, we want to be the reinvention partner. So the more that we can fill all of the needs of our clients around that, the better position that we will be. So we see LearnVantage is highly, highly strategic. And by the way, it also has, we have a managed service today to actually manage the learning services that companies are now doing internally, which we also expect to -- we're investing and expect to grow. So, very excited. And then finally, [indiscernible] responsibility is our -- as corporates to bring our people along the journey. And so when people worry about things like AI in displacement, we feel that our ability to bring like who then upskilling expertise to help our clients be able to bring their people is really, really important. It's important for our communities. It's important to their Board’s and we also consider it really important because it's the right thing to do.
Ashwin Shirvaikar: Got it.
Julie Sweet: Great. So thanks, everyone. In closing. I want to thank all of our shareholders for your continued trust and support all of our people for what you do every day. To assure you that we are working every day to continue to earn that trust. Thank you.
Operator: That does conclude your conference for today. Thank you for your participation and for using AT&T Teleconference. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning. Thank you for standing by, welcome to Accenture's Second Quarter Fiscal 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode, later we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Managing Director, Head of Investor Relations, Katie O'Conor. Please go ahead."
},
{
"speaker": "Katie O'Conor",
"text": "Thank you, operator. And thanks, everyone, for joining us today on our second quarter fiscal 2024 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short-time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. KC, will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before KC provides our business outlook for the third quarter and full fiscal year 2024, we will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking, and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and quarterly report reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Katie and everyone joining, and thank you to our 742,000 people around the world who work every day to deliver 360 degree value for all our stakeholders. I'm pleased with our performance in an uncertain macro. Our results highlight the benefit of the deep trust our clients have in us, our capabilities to do the most complex work at the heart of their businesses, the privileged position we hold within the ecosystem and our ability to invest for the next waves of growth. We continue to see momentum in the quarter and how we are executing on our strategy to be the trusted reinvention partner of our clients, with a record 39 clients with quarterly bookings greater than $100 million. These large transformational wins position us to capture more growth as spending increases. We also had over $600 million in new GenAI bookings taking us to $1.1 billion in GenAI sales in the first-half of the fiscal year, expanding our early lead in GenAI, which is core to our clients reinvention. We now have over 53,000 skilled data and AI practitioners against our goal of doubling our data and AI workforce from 40,000 to 80,000 by the end of fiscal year 2026. We are laser-focused on the needs of our clients and this focus is reflected in our bookings of $21.6 billion, representing our second highest quarter on record. This included $10 billion of bookings in North America, our highest ever. We continue to take market-share with revenues of $15.8 billion for the quarter, flat compared to last year and slightly above the midpoint of our range. As we turn the page on the calendar year, we saw another turn of the dial unconstraining spending by our clients, including spending on our services, particularly in parts of EMEA and North America. This was evident in the composition of our new bookings, which came in differently than expected. We see clients continuing to prioritize investing in large-scale transformations which convert to revenue more slowly, while further limiting discretionary spending particularly in smaller projects. We also saw continued delays in decision-making and a slower pace of spending. We are pleased that despite these conditions our focused efforts to return to growth resulted in North America and CMT, showing improvement over last quarter. We are running our business with rigor and discipline and we remain on-track with the business optimization actions we announced last year to reduce structural costs to create greater resilience. We delivered adjusted EPS growth of 3%, we continue to invest significantly in our business to drive additional growth in highly strategic areas with $2.1 billion of capital deployed across our geographic markets in Q2 in 11 acquisitions, bringing the total investment in acquisitions to $2.9 billion in H1 across a total of 23 acquisitions. We also continue to invest in learning for our people with approximately $10 million -- 10 million training hours in the quarter, representing an average of 14 hours per person. In recognition of the 360 degree value we create, we are proud that we earned the number one position in our industry for the 11th year in a row and number 33 overall in Fortune’s list of the World's Most Admired Companies. We ranked number one in our industry and number three overall on the JUST Capital CNBC list of America's Most Just Companies. And we have been recognized by Ethisphere as one of the World's Most Ethical Companies for the 17th year in a row. An important part of our growth strategy is to use our strong balance sheet to invest in order to scale higher-growth areas and expand into new growth areas. We have a strong track-record of delivering on this strategy. Here are some highlights from the quarter. In North America, we invested in supply-chain, an area with significant reinvention ahead with the additions of inside sourcing in [indiscernible] and on-process technology. We acquired Navisite site to help clients across multiple cloud providers enterprise applications and digital technologies, modernize their digital core, and in Song, we acquired Work & Co to help our clients drive growth by designing and bringing digital brand strategies to market and operationalizing world-class digital products at scale. In EMEA, we are investing to help clients build their digital core and drive growth. In the UK, we invested in 6point6, which will help our clients transform their digital capabilities and modernize their legacy systems. We also acquired in the UK, Redkite with its full stack data expertise that will help our clients accelerate their performance with data driven intelligence and AI. And in Germany we added Vocatus, which will accelerate our clients' growth strategies using behavioral economics modeling to develop pricing strategy and sales concepts for B2B and B2C models. Similarly, in good markets our acquisitions position us to drive our clients' growth agendas by expanding our capabilities in marketing and customer experience with Rabbit's Tale in Thailand and [GIC] (ph) in Singapore, helping clients in Indonesia, capitalize on their fast-growing digital economy. Our ability to invest to fuel our organic growth is a competitive advantage and as our clients continue to transform, we announced earlier this month that we will invest $1 billion over the next three years in Accenture LearnVantage, which will provide comprehensive technology learning and training services to help our clients re-skill and upskill their people. Our investment includes the acquisition of Udacity, a digital education pioneer, which we expect to close by the summer. Once closed, we will have revenue in the zone of $100 million annually. These services are highly strategic and they enhance our position as a reinvention parts are of choice, because talent is at the top of the agenda for CEOs. For example, we are helping Merck, a global biopharmaceutical company known as MSD outside of the United States and Canada launching groundbreaking Generative AI training program for their employees to create world class digital leaders. As a renowned thought leader in the biopharmaceutical market, Merck has long-lead the way in investing in its people and helping them build the skills and expertise needed to develop breakthrough therapies. Digital, data, analytics and AI play a pivotal role in discovering, developing, manufacturing, and providing access for patients to medicines and vaccines. By once again investing in its people, Mark will be able to continue delivering on its promise to use the power of leading-edge science to save and improve lives around the world. Over to you KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie. And thanks to all of you for taking the time to join us on today's call. We were pleased with our overall results in the second quarter with our second highest quarter of new bookings. We continue to invest at scale to strengthen our leadership position, while delivering value for our shareholders. Now let me summarize a few of the highlights of the quarter. Revenues were flat in local currency, with mid-single digit growth or higher in six of our 13 industries, including public service, life science, utilities, energy, health and high-tech. While our CMT industry group improved this quarter, we continue to see pressure as expected. And we continue to take market share. As a reminder, we assessed market growth against our investable basket which is roughly two dozen of our closest global public competitors, which represents about a third of our addressable market and we use a consistent methodology to compare our financial results to theirs. Adjusted to exclude the impact of significant acquisitions. Through the date of their last publicly available results on a rolling four quarter basis. Adjusted operating margin of 13.7% decreased 10 basis points, compared to Q2 last year and year-to-date operating margin is flat. This includes continued significant investments in our people and in our business. We delivered adjusted EPS in the quarter of $2.77, reflecting 3% growth over adjusted EPS last year. Finally, we delivered free cash flow of $2 billion and returned $2.1 billion to shareholders through repurchases and dividends. In the first half of the year, we've invested $2.9 billion in acquisitions across 23 transactions. With those high-level comments, let me turn to some of the details, starting with new bookings. New bookings were $21.6 billion for the quarter, representing a 2% decline in both US dollar and local currency, with an overall book-to-bill of 1.4. Consulting bookings were $10.5 billion with a book-to-bill of 1.3. Managed services bookings were $11.1 billion with a book-to-bill of 1.4. Turning now to revenues, revenues for the quarter were $15.8 billion, flat in both US dollars and in local currency, and we're slightly above the midpoint of our guided range. Consulting revenues for the quarter were $8 billion, a decline of 3% in both US dollars and local-currency. Managed service revenues were $7.8 billion, up 3% in both US dollars and local-currency. Taking a closer look at our service dimensions, technology services grew low-single digits and operations and strategy and consulting declined low-single digits. Turning to our geographic markets. In North-America revenue was flat in local currency with growth in public service, offset by declines in banking, capital markets, software and platforms and communications and media. In EMEA, revenues declined 2% in local currency with growth in public service, offset by declines in communications and media and banking capital markets. Revenue growth in Italy was offset by declines in the United Kingdom, France and Ireland. In growth markets, revenue grew 6% in local currency, led by growth in banking, capital markets, industrial, public service and chemicals and natural resources. Revenue growth was driven by Japan and Argentina, partially offset by declines in Australia and Brazil. Moving down the income statement, gross margin for the quarter was 30.9% compared with 30.6% for the same-period last year. So marketing expense for the quarter was 10.3% compared to 9.9% for the second quarter last year. General and administrative expense was 6.9% compared to 6.8% for the same quarter last year. Before I continue, I want to note that in Q2 of FY 2024 and FY 2023, we recorded $150 million and $244 million in costs associated with our business optimization actions respectively. These costs decreased operating margin by 70 basis-points and EPS by $0.14 this quarter and operating margin by 150 basis-points and EPS by $0.30 in Q2 of last year. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.2 billion in the second quarter, reflecting an adjusted operating margin of 13.7%, a decrease of 10 basis-points from adjusted operating margin in the second quarter of last year. Our adjusted effective tax rate for the quarter was 18.8% compared with an adjusted effective tax rate of 20.4% for the second quarter last year. Adjusted diluting earnings per share were $2.77 compared with adjusted diluted EPS of $2.69 in the second quarter last year. Days services outstanding were 43 days compared to 49 days last quarter and 42 days in the second quarter of last year. Free cash flow for the quarter was $2 billion resulting from cash generated by operating activities of $2.1 billion, net of property and equipment additions of $110 million. Our cash balance at February 29th was $5.1 billion compared with $9 billion at August 31st. With regards to our ongoing objective to return cash to shareholders, in the second quarter we repurchased or redeemed 3.8 million shares for $1.3 billion at an average price of $352.35 per share. As of February 29th, we had approximately $4.6 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $1.29 per share for a total of $813 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.29 per share to be paid on May 15th, a 15% increase over last year. In closing, we remain laser focused on capturing growth opportunities in the market and delivering value for our clients. As you know and expect of us, we will operate with rigor and discipline, while continuing to invest for long-term market leadership. Now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. Let me give a little more color on the demand environment, all strategies continue to lead to technology and reinvention. Our clients are navigating an uncertain macro-environment due to economic, geopolitical and industry-specific conditions. And in response, we are seeing them thoughtfully prioritize larger transformations, building out their digital core to partnering, to improve productivity, to free-up more investment capacity to focus on growth and other initiatives with near-term ROI. Our focus on being at the center of our client's business doing their most complex transformational work provides us with resilience see overtime, as demonstrated by the fact that our top 100 clients have been clients for over 10 years. There is now near universal recognition of the importance of AI, which is the heart of reinvention. The ability to use AI at scale, however, varies widely with clients on a continuum with those which have strong digital cores generally seeking to move more quickly, while most clients are coming to grips with the investments needed to truly implement AI across the enterprise and nearly all are finding it difficult to scale, because the AI technology is a small part of what is needed. To reinvent using technology, data and AI you must have the right digital core, change your processes and ways of working, reskill and upskill your people and build new capabilities around responsible AI. All with a deep understanding of industry and function in order to unlock the value. And many clients need to first find more efficiency to enable scaled investment in all these capabilities, particularly in their data foundations. We are able to help our clients with this AI rotation because of our broad services across strategy and consulting, technology and operations as well as everything customer through Song and digital manufacturing and engineering through Industry X. And our relevance across the functions of the enterprises in 13 industries. Our privileged position in the technology ecosystem has perhaps never been more important. Generative AI is rapidly evolving and still in the early stages of maturity and adoption. And we are working closely with our ecosystem partners to help our clients understand the right data and AI backbone that is needed and how to achieve tangible business value. I will now bring to life the complex work we are doing at the heart of our clients' businesses. Building on the back of a long trusted partnership, we are working with Mondelez International, a world-leader in snacking with well-known brands like Oreo, belVita and Cadbury. To continue to drive growth and be an industry-leader. Having laid the foundations of a strong shared services modeled model powered by leading technology platforms and data and AI foundation we are now working on an ambitious reinvention of their digital core. We will design and implement a single cloud-based platform. We'll also modernizing the finance function and transforming their supply-chain planning and warehouse management capabilities. This will enable faster availability of products for customers to have more sales growth and maximum profitability. This new digital core will also allow Mondelez to further reinvent how they satisfy customers through the adoption of new technologies like Generative AI. Cloud continues to be the foundation of the digital core. Our cloud business grew high-single digit this quarter as clients do work across the cloud continuum from migration to modernization, to new business models to working at the intelligent edge. For example, we're helping Riyadh Air, a digitally native airline based in Saudi Arabia, become the world's first fully cloud-based airline. We will equip the brand-new airline with a cloud-only infrastructure enhanced cyber security and AI driven operations. Our capabilities will ensure that Riyadh Air’s digital core is future-proof and remains legacy free, enabling the airline to use cutting-edge technologies such as cloud, data and AI to scale quickly and deliver a seamless and more personalized travel experience for its customers and employees. This will also help the company to scale as it plans to operate over 100 destinations by 2030. We are partnering with Belden, a global networking solution organization on a cloud transformation program that will help them become a platform business. Unlocking the power of edge, data and AI to drive new business opportunities and enhance the customer experience. This platform will be powered by edge to cloud technology, allowing them to collect and analyze real-time data from industrial environments and improve operational efficiencies. This will provide valuable data driven insights to Belden and to their clients in industries where real-time insights are crucial. This reinvention will enable them to break-down operational technology silos, allowing them to become a key player in the digital twin domain. We will also help enable this new service in the market, this strategic partnership will support Belden's reinvention from a product company into a data engineering and insights company that leverages the power of platforms. We are focused on helping our clients, leverage the power of AI quickly, generating tangible business value, leveraging our investment in differentiated tools that accelerate results. Our AI Navigator has helped clients across industries outline their value case, AI architecture and AI solutions and our recently-announced AI switchboard is already helping clients with the complex new need for integration across LLM models. For example, one of the largest [indiscernible] companies is currently testing the switchboard to compare how the same prompt would be interpreted by different models and how they perform before deciding on which model to use. Ultimately an enterprise-wide AI rotation requires a strong data foundation, we are working with Telstra, Australia's leading telecommunications and technology company on a radical simplification and modernization of its data ecosystem, accelerating its efforts to become AI powered. We are modernizing and consulting over 50 disparate enterprise data sources into a small integrated set forming Telstra's governed and secure data and AI core, allowing Telstra to rapidly scale bespoke Generative AI capabilities in the future. Our work will also support the company's efforts to develop responsible ethic and secure market leading AI frameworks, while helping their teams provide quicker, more effective and more personalized customer interactions. One of the areas of riches opportunities for our clients is customer experience transformation, including with Generative AI, which uses the unique capabilities of Song across creative customer insights and deep technology expertise. Song grew low-single digits this quarter, we continue to help clients reimagine marketing to drive growth. We're helping ExxonMobil, an energy super major transform and optimize its end-to-end fuels marketing operations to drive future growth. With our global capabilities, our managed services will leverage our SynOps platform to drive automation and deliver measurable efficiencies across the fuels marketing business. We are strengthening our partnership with Best Buy, a leading consumer electronics retailer across multiple fronts to reimagine the customer experience, optimize costs and drive growth. By leveraging data and Generative AI, we are helping to transform their contact center operations and improve customer and employee experience. We are also pleased to have entered into an agreement with Best Buy for lifecycle management of our own Accenture devices in North America and our creating a joint offering end-to-end field service advice support for clients. We have already applied this new offering to a major TV provider, marking our first entry into this new market. These strategic initiatives underscore our commitment to helping Best Buy, achieve superior customer experiences, operational efficiencies and growth. Security is essential to reinvention, moving beyond IT to protecting the core assets of the business and evolving the critical role of security as technologies change. We saw very strong double-digit growth in our security business this quarter. We are working with one of the largest electric utility holding companies in the United States to integrate their operational technology into a seamless unified cyber security solution. Together, we will enhance our security capabilities by implementing advanced monitoring and response, vulnerability management and security automation. This will help reduce the risk of secure of cyber events in their grid environment protecting critical infrastructure serving tens of millions of people. We continue to see strong demand for digital manufacturing and engineering services. Industry X grew double-digits in Q2. We're working with Indo Count Industries Limited, a global leader in the home textile space on digital transformation to simplify operations, support its ambitious growth plans and maximize e-commerce opportunities. We will build a cloud-enabled digital core, powered by data and analytics that will help standardize, digitize and automate processes and operations. From supply chain to logistics to manufacturing, the new platform will enable more efficient inventory management, quality standardization optimal energy consumption and better customer experiences. Together we will reinvent their operations and help expand our business in India, Middle-East and North America, the UK and Europe. And we continue our support for corporate green transformation by promoting carbon footprint compliance to the calculation and visualization of greenhouse gas emissions. To create a market where consumers can choose environmentally conscious products and services [indiscernible] visualize the carbon footprint of each product is necessary. For example we're assisting, Matsumoto Precision, a precision machine parts processing company based in Japan to gain more detailed insight into the sustainability of their projection and achieve their decarbonization goal. We implemented a solution through our manufacturing platform that uses individual manufacturing performance information to record and report the CO2 emission on a per product basis. This will allow Matsumoto Precision to enhance understanding of the environmental impact of their business and contribute more effectively to the realization of a decarbonized society. Back to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Now let me turn to our business outlook. For the third quarter of fiscal 2024, we expect revenues to be in the range of $16.25 billion to $16.85 billion. This assumes the impact of FX will be about negative 1% compared to the third quarter of fiscal 2023 and reflects an estimated negative 1% to 3% positive growth in local-currency. For the full fiscal year 2024, based upon how the rates have been trending over the last few weeks, we continue to expect the impact of FX on our results in US dollars will be about flat compared to fiscal 2023. For the full fiscal 2024, we now expect revenue to be in the range of 1% to 3% growth in local-currency over fiscal 2023, which assumes an inorganic contribution approaching 3%. We continue to expect business optimization actions to impact fiscal 2024 GAAP operating margin by 70 basis-points and EPS by $0.56. For adjusted operating margin, we now expect fiscal year 2024 to be 15.5%, a 10 basis point expansion over fiscal 2023 results. We now expect our adjusted annual effective tax rate to be in the range of 22.5% to 24.5%. This compares to an effective tax rate of 23.9% in fiscal 2023. We now expect our full year adjusted earnings per share for fiscal 2024 to be in the range of $11.97 to $12.20 or 3% to 5% growth over fiscal 2023 results. For the full fiscal 2024, we continue to expect operating cash flow to be in the range of $9.3 billion to $9.9 billion. Property and equipment additions to be approximately $600 million and free cash flow to be in the range of $8.7 billion to $9.3 billion. Our free cash flow guidance continues to reflect a very strong free cash flow to net income ratio of 1.2. Finally, we continue to expect to return at least $7.7 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to shareholders. With that, let's open it up so that we can take your questions. Katie?"
},
{
"speaker": "Katie O'Conor",
"text": "Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] And one moment please for your first question. Your first question comes from the line of Tien-Tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Hi. Thank you. Good morning to all of you. Julie, just a big picture, maybe two simple of a question, but just curious to get your thoughts on where we are in the cycle for IT services spend, because we've been doing sector softness for quite some time now, Accenture has done well, you have very large deal activity come through, short-term cycle stuff is always little pressured as you said, where are we in terms of seeing maybe things bottoming or short-cycle discretionary spend returning?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. I mean, Tien-Tsin, I think it's hard to predict at this point anything other than what we see right now. Right? So what's different than 90 days ago. Well, as we said in December, we really get visibility into our clients' budgets in January, we say that every year, right? And so, as the calendar year, we turn the page, what we saw was a further tightening of spending at our clients. Particularly [indiscernible] our services and particularly on the smaller projects. So from that sort of trend perspective, 90 days ago we didn't see the same level. Now you kind of turn the dial a little bit more constraints and that's where we see the budgets being set for calendar year 2024, right? And as you said though, in this environment we're taking market share and we're seeing building momentum on our strategy to be the reinvention partner with a record 39 clients with bookings over $100 million. So what does that tell you, right? So, the clients understand the importance of the technology-led transformation. And the fundamentals remain the same. There is a lot more reinvention ahead. We're still -- when you look at where is cloud, both migration and modernization, we say about 80% of the opportunities ahead. Data and AI, but 90% of the opportunities ahead. Re platforming in cloud-based platforms. About 65% of that opportunity ahead, based on who has actually adopted that more modern platforms and security. Well, I think security can be kind of forever ahead, but at least 65% ahead. And that's before you get to thinking about areas like digital manufacturing, engineering services, where that technology has only been coming online, even in the last couple of years sort of the modern technology. And of course, customer also extraordinarily early days. So, where we really focused on is meeting clients where they are today. So that prioritize the large transformational deals and then be positioned to capture the spending when it increases. And we see the sort of the industry has been very strong, because all clients have to get there. They need to get to the technology transformation. They need to get the reinvention and that's why you're seeing -- even as the constraints you're seeing that early interest in GenAI. I mean, $1 billion sales in the first-six months of the year, that is the fastest we have ever built sales in an emerging technology. And what it tells you is that, clients understand the importance of AI that they're going to have to reinvent every part of the enterprise and that's exactly where everything we've done for the last decades at Accenture. Being the company that can go from strategy to build, to operations, deepen industry and functional expertise, because the strategy and consulting all comes together for this moment to be the partner for reinvention across the enterprise, not just to build the technology, but to use it to reinvent and that's exactly what you see in these results, which is why I'm super confident about the industry and the future."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Yes. No, I'm confident that Accenture will be there to catch-all that like you said, but maybe as my follow-up with the GenAI bookings any trends on deal size. And in confidence that, that some of these early bookings will convert to become a part of this whole large $100 million plus deal activity across more pull-through from GenAI, that question makes sense."
},
{
"speaker": "Julie Sweet",
"text": "So couple of things. What you see in our resilience is that, we are doing these bookings over $100 million and that's what kind of layers that. That just gives you that base rate of resilience during this period. As we said, we're seeing further constraint on the smaller projects. That's why you've got the updated guidance, right? But the pace of these larger deals, we feel really good about from a resilience perspective. And then, you know how this straight, you're at the client, you are at the heart of their business, you're really doing the strategic work that's what all these large deals represent. And then as spending increases you catch the pent-up demand and that's kind of how we see it and that's how we've run it in the past. And by the way, of course, as you know, we're really investing inorganically to capture more growth which you also start to see. Particularly at the back-end of our fiscal year. Thanks, Tien-Tsin."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hi, good morning. KC, if Accenture does 1% constant currency in the third quarter, that's kind of the midpoint of the range. I guess the implied midpoint for 4Q is a ramp-up to 6% constant currency. What kind of visibility do you have going into a number of the midpoint like that in the fourth quarter?"
},
{
"speaker": "KC McClure",
"text": "Yes. Hi, Bryan. Thanks for your question. And you're right, you're obviously your math is correct, that that would be what our guidance would say. In terms of visibility, look, it's really no different than what we have anytime in the past in this part of the year for our full-year guidance. Obviously, we are not forecasting that the whole year we just have the back-half of the year, there's no difference in visibility as it relates to what we've done in any other time of the year -- any other year at this time. And we do our same at analysis and outlook to provide you with our guidance of the 1% to 3%."
},
{
"speaker": "Bryan Keane",
"text": "Got it, got it. And then, Julie. Just thinking about the clients need to update their data in order to leverage AI and scale. Why isn't that translating into stronger demand in the business, you would think that everybody would turn-around and spend considerably on short-term to get that ramp-up in order to get AI to leverage it, but it doesn't quite translate. I'm just trying to figure out the disconnect there?"
},
{
"speaker": "Julie Sweet",
"text": "Yes, so there is two things. So first of all, it's about prioritization. Right? So their overall constrained on spending. So, you make choices as opposed to it being additive. So they are not able to allocate extra budget, they're prioritizing their budget. So you're seeing more of a substitution right now as opposed to, hey, we need to do this, let's add to the budget and that's tied to the uncertain macro, that's putting people constraint. I had one banker say, if the corporates have put themselves on a diet, given the macro. Right? The second thing, Bryan is, you have to remember that you can't just jump to the great data foundation. You need to be in the cloud. You've got to have modern platforms. And so what you should read into the higher clients -- the clients during these higher bookings rate is that, they're doing the big transformations oftentimes to be ready to put in the data foundation, right? There's only still 40% of workloads are in the cloud. 20% of those roughly haven't been modernized. Many of our clients haven't put in the platform, if you don't have the major ERP platforms that are modern, you don't create a data foundation to fuel GenAI in isolation. So you've got to build the digital core. And as we've said, there's a lot more to go. And that's what's driving these larger complex transformations like, people will not like to do these big transformations in a sense of the other big, they're hard, they're complicated and they need to do them in order to ultimately be able to use the AI, not just in a part of the business or as a proof-of-concept, but really to transform and get the value they now see and so it's -- again, you can't jump to AI, you've got to put all the pieces, and a lot of clients aren't there yet. Which is our opportunity."
},
{
"speaker": "Bryan Keane",
"text": "Got it. Thank you for taking the questions."
},
{
"speaker": "KC McClure",
"text": "Thanks, Bryan."
},
{
"speaker": "Julie Sweet",
"text": "Thanks, Bryan."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of James Faucette from Morgan Stanley. Please go-ahead."
},
{
"speaker": "James Faucette",
"text": "Great. Thank you very much. Wanted to follow-up on the questions around, particularly AI, etcetera. I recognize like everybody is kind of at different stages. How should we think about: first, the timeline in terms of preparing and getting ready to implement news solutions, etcetera, and then moving into the full implementation? And how we should think about that affecting Accenture’s business? And like you mentioned, you've talked about some record bookings or the number of new customers over $100 million, like how that will ramp-in the timeframe?"
},
{
"speaker": "Julie Sweet",
"text": "Yes, so maybe just -- let me just start with like the strategy around capturing the growth opportunity from GenAI. So, this is the same playbook that we have used in every wave of new technology evolution. When we went from mainframe to client-server then to cloud and Software as a Service and then to RPA and AI driven automation when you saw things like myWizard and SynOps. We have the same strategy, the strategy starts with, we want to be the first-mover to help our clients use the technology. And that's why what we're doing with our investments of $3 billion to create solutions for them and you see that coming through with our sales in Generative AI, which, as I've said on earlier, are the fastest we've ever seen in sort of these new technologies where there's a lot of interest and we're the leader. So we want to be the first-mover in helping our clients use it. The second part of our strategy is to be the first-mover in using the technology itself to serve our clients. And we did that would like the digital, with AI automation, with all of our platforms. And with that said, it's a proven formula, because if we invest big to be early and be the first-mover, then we're positioned to capture all the opportunity in our -- with our clients, because they need to adapt it and transform. And as I just went through, that requires a lot the digital core, then you've got to actually use it to change new ways of working to upskill your talent and build new capabilities like responsible AI. When we are able to be the first-mover, which we are already starting now to use GenAI and how we deliver, that enhances our competitive position. It makes us more differentiated and, of course, it also then allows our clients overtime the more we use the GenAI to achieve the results they need at a lower cost, which frees up their investment capacity to do the massive reinvention. And of course, we are in the best positioned to be their partner as they reinvest in using the tech and AI to [Technical Difficulty] lot of the digital core that's got to-be-built, you can't jump that step. It's not a magic technology. But then as you build it, you then have to go function by function to change the ways you work to actually get the productivity and the growth. So we really see this as being kind of the next decade of what our clients are going to be focused on and we are positioning ourselves to be their partner and be the first-mover in both places."
},
{
"speaker": "KC McClure",
"text": "Yes. And maybe I'll take the layering in question on the larger deals and talk a little bit about how that's going to work for the back-half of the year as it relates to guidance. So we have the larger deals that were terrific in our second quarter and our whole first-half of the year. But you're right, they do layer-in slower than the smaller deals and we see pressure in the volume of our smaller deals. And that's why we have the 1% to 3% guidance for the full-year. Now we do feel-good about delivering to this guidance and what that means for H2, and that really is for a few reasons that we've talked about before, but let me just kind of reiterate. The first is that, our competitive advantage is that we have the ability to invest. You saw us do that in H1 and Julie talked about that, with investing more in acquisitions this year, in the first half than we did all of last year. And that's really important because that drives inorganic growth. But again, we do that really to fuel organic growth, but we see that coming online in the back half of the year. The second thing is that, we have done these larger transformation deals, but also the ones from the previous years. And we see that continuing to benefit us as it relates to revenue as they will layer on in the back half of the year. And that really just speaks to the resilience of our strategy, both in terms of being what Julie has talked about, being where our clients need us and our inorganic strategy to continue to benefit to pivot to scale in new areas of growth. And so, that's how that all comes together in terms of revenue conversion from those larger deals and when they come online, James. And maybe I'll just also add, what that means from a type of work for the entire year. What we now see from the context of the 1% to 3% is, our consulting type of work will be about flattish. And we see our managed services growing to about mid-single digit growth for the year."
},
{
"speaker": "James Faucette",
"text": "Great. Thanks for the color to both of you. And then quickly KC, just in terms of that investment. How do we think about like how that affects the margin expansion. I mean typically one, you're doing acquisitions, there a little bit of time before you can start to get people to the same type of trajectory as Accenture on margin expansion, but just trying to get a sense of how we should think about that impacting as well?"
},
{
"speaker": "KC McClure",
"text": "Yes. Thanks for that. Well, first of all, I'm just -- I just want to put out that I'm really pleased with our profitability in the first half of the year and the outlook for profitability for the full year. Our margin is flat, but we have EPS growth for the first half of the year, profit growth of 5%. And that really just points to the rigor and discipline that we continue to operate our business in. But really importantly, as Julie talked about, all the investments we're making in our business and our people continue. So as you look at the back-half of the year, we now see the 10 basis points expansion is where we see it. Again, very important, continue to have high levels of investment in our people and our business. And EPS, we see for the whole year at about 3% to 5%. One thing I will point out just to help all of you. We did benefit from the first-half of the year in our EPS with higher non-operating income, which makes lot of sense on interest income, on our higher cash balance. In the first-half, you see our cash went from 9% to 5%. So great cash, we can -- no concerns will continue with our capital allocation strategy, but just as you model in the back half of the year, you'll see that not surprisingly with lower cash flow will have lower interest income. So just as you're working through your EPS for the first-half and second-half, that's something that you might want to consider."
},
{
"speaker": "James Faucette",
"text": "Super helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Bergin from TD Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, good morning. Thank you. So Julie, I'm curious just based on your conversations with leaders, what might be the catalyst here to have clients release spending programs and kind of lean back into shorter cycle work. As economic data generally holds up, are we just in a slower for longer backdrop or just kind of hoping that you can share some color on how you're thinking about a recovery internally and what enterprises really are watching and waiting for?"
},
{
"speaker": "Julie Sweet",
"text": "Look, I think there's going to be a couple dynamics, right? Remember they just set budgets. So we're kind of assuming there are the budgets for their calendar year and we see in general, most of this constraint is tied to the uncertain macro. So those are the kind of things. They set budgets and they've got uncertain macro."
},
{
"speaker": "KC McClure",
"text": "Yes. And just a reminder that everything that we're talking about in terms of giving guidance. I know all of you know this, but just as a reminder, our fiscal year-ends on August. Right? So there -- it's a little bit over halfway through the calendar year."
},
{
"speaker": "Bryan Bergin",
"text": "Okay, okay, that makes sense. And then as it relates to GenAI, just kind of a revolutionary versus evolutionary kind of questioning here. Just given how much work needs to be done for most clients to really do anything with large language models, how do we interpret that as a driver of your growth? So meaning, does GenAI enabled you to potentially drive a higher-level of growth when spending does become more normal or should we think about this more as a next tech wave that enable comparable levels of normalized growth just because of how long this might all take for large enterprises to get there?"
},
{
"speaker": "Julie Sweet",
"text": "Yes, what I'd say is, this is this is more about -- like we think of this as like prior technology waves. Right? Each one has been a little bit faster in terms of that, but especially when you look at kind of where our clients are on the continuum of building out that digital core, there is a lot to go and you really need that to fully realize it. So we see this is more like our prior kind of the way these things have evolved in the past. Right now, that's what we see."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Dave Koning from Baird. Please go-ahead."
},
{
"speaker": "Dave Koning",
"text": "Yes. Hey guys. Thanks so much. I guess my question, are you seeing your clients probably having much lower attrition, just like every company has low employee attrition, right now. Are you seeing them take their own employees, their own IT employees and just do more internally right now? And is that a little bit of just the demand issue right now?"
},
{
"speaker": "Julie Sweet",
"text": "We certainly are seeing -- obviously, our clients have invested in more technology internally at our advice. Right? We've said to them during the pandemic with technology being so important, they should be building up their technologies. So there is clients, they've got a lot of clients, not all of it, because it really depends on your positioning to some of our clients, that's really not the differentiator. So they want a smaller IT and they've got others who built it up and it really depends on where they are. But sure, I mean, we certainly got clients doing more -- doing more in-house as part of it and we've got other clients outsourcing more. So like, it's really all over the map, because it's very company specific as to what makes sense for their strategy."
},
{
"speaker": "Dave Koning",
"text": "Yes. Okay, thanks. And just one quick follow-up for KC. The tax rate, clearly you lowered guidance just on the tax-rate itself. Is that something one-off to this year or is that something now that just seems more normalized?"
},
{
"speaker": "KC McClure",
"text": "Yes. So, there's really four things that every year are the same, that really influence our tax rate. And just really is how those things come together. There are geographic mix of income, any settlements from previous years, any increase that we need to do on prior year tax liabilities, and lastly, the impact of our equity on our tax rate. So these four things really are confluences the same every year, depending on how they fall. That's going to influence where we land on our tax rate. And so, we -- this year we saw them favorably in aggregate. So we're able to keep our 2 point range, but drop by 1%."
},
{
"speaker": "Dave Koning",
"text": "Okay. Well, thank you guys."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Jamie Friedman from Susquehanna. Please go-ahead."
},
{
"speaker": "Jamie Friedman",
"text": "Hi. Good morning, everyone. I have a really big picture question. I'm curious, Julie, how you feel about Accenture’s role in the broader context of technology like software and cloud? And I realize in your prior very thoughtful answer about technology architectures. That was a great structure as was your innovation session back on February 16th. But it does seem like other parts of tech are doing better than services. So I'm just interested in your perspective on services in the context of broader tech spending?"
},
{
"speaker": "Julie Sweet",
"text": "No, absolutely. It's a great question. Services are where you can dial back more easily than when you're signing-up for licenses for technology that you need. So you'd imagine and just what we're seeing that, when you are constraining overall spending, your discretionary spending, you go to like service providers where you're saying, I can pause for that. I can wait for that. And at the same time you've got in other parts of it, like with software where you've got to fix things you really need to invest in and you've got different licenses. So it's really not different than other cycles. Services have a bigger opportunity to say, it's a little more discretionary, let's wait. Even if I bought the licenses, I'm going to wait to actually incur the costs, because a lot of times the cost of the services can be significantly higher than the software licenses, because you've got all the change that you've got to do and all that around. So again, we don't see anything sort of different than when you've got an uncertain macro you look around for your discretionary spending and you cut that. And that's why, of course, you're seeing still the big transformations happening because it's not discretionary and they really got to re-platform in that. So it's like nothing mysterious about is kind of what I consider kind of normal in this kind of a macro."
},
{
"speaker": "KC McClure",
"text": "That's right. An. I think just as a reminder, even with all that we still have the record spend with us with $40 billion of bookings for the first half of the year."
},
{
"speaker": "Jamie Friedman",
"text": "Yes, those are great things. All right, I'll jump back. I'll jump back in the queue. Thank you, Julie. Thanks KC."
},
{
"speaker": "Katie O'Conor",
"text": "Operator we have time for one more question and then Julie will wrap-up the call."
},
{
"speaker": "Operator",
"text": "Okay. That question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thank you. Hi, Julie. Hi, KC."
},
{
"speaker": "Julie Sweet",
"text": "Hi, Ashwin."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Going back to -- Hey. Going back to the question of bookings, are clients actually visiting existing bookings ones that they sign maybe last year and at times prior, relooking at them using the lens of applying sort of rapidly evolving GenAI capabilities. To what extent is that happening and then that kind of implies, obviously -- can we can reuse those past bookings and backlog as an indicator of future growth and how soon that can layer-in?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. I'll take that. Just maybe more just the financial kind of mechanical part of it. We have not seen a change in us working the work that's already been contracted, what we would call our backlog and what we talked about was really spending on new sales, new services and their smaller projects and that's the dynamic that we have factored into our guidance for the year."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Got it. And then the other question was on LearnVantage and Udacity, I thought that was a particularly interesting deal. If you could walk us through maybe the mechanics of that deal? And every company is investing in talent care, there seems to be a bit different approach maybe. Can you just talk about the rationale, the downstream impact and so on?"
},
{
"speaker": "Julie Sweet",
"text": "Sure, thank you. Because it's -- I'm super passionate about what we're doing with LearnVantage, because it is so critical for our clients. Talent is the number one agenda item for CEOs. The number one. And when you think about what reinvention means, the clients have to do and AI rotation and they have to do a talent rotation. And what LearnVantage does is, it first and foremost provides the ability for everything from the Board to the C-Suite to business users, to the technologists to get the technology training they need to make the right decisions on AI, for example. To be able to become deeper in the new technologies. And so it really goes from the Board to the technologist. And with Udacity what we're able to provide is essentially the same approach Accenture uses, right? So, we spent over $1 billion ourselves. You saw our latest average 14 hours per employee. And we have -- we use learning science to learn and do. Most of our clients are unable to do that. The big differentiator for us in the market here is that, we Accenture know when you train someone we have to then put them on a job, and they have to get paid to do something, so they are work ready. So we're bringing that expertise now at scale to our clients. And what Udacity does is the same thing, they use exports mentors, they have a real project work that they then coach people on. So it's that same sort of approach of learn and do, but our companies -- our clients don't have all the work that we do, so Udacity has created this ability. And so -- and it's coupled then with Accenture's deep understanding of what it takes to train and be work ready. So we're really excited about it. Our clients are excited about it, they've been coming to us. We've been doing this learning and this enables us now to do it at scale. And again, we want to be the reinvention partner. So the more that we can fill all of the needs of our clients around that, the better position that we will be. So we see LearnVantage is highly, highly strategic. And by the way, it also has, we have a managed service today to actually manage the learning services that companies are now doing internally, which we also expect to -- we're investing and expect to grow. So, very excited. And then finally, [indiscernible] responsibility is our -- as corporates to bring our people along the journey. And so when people worry about things like AI in displacement, we feel that our ability to bring like who then upskilling expertise to help our clients be able to bring their people is really, really important. It's important for our communities. It's important to their Board’s and we also consider it really important because it's the right thing to do."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Got it."
},
{
"speaker": "Julie Sweet",
"text": "Great. So thanks, everyone. In closing. I want to thank all of our shareholders for your continued trust and support all of our people for what you do every day. To assure you that we are working every day to continue to earn that trust. Thank you."
},
{
"speaker": "Operator",
"text": "That does conclude your conference for today. Thank you for your participation and for using AT&T Teleconference. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 1 | 2,024 | 2023-12-19 08:00:00 | Operator: Thank you all for standing by. Welcome to Accenture's First Quarter Fiscal 2024 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead.
Katie O'Conor: Thank you, operator, and thanks everyone for joining us today on our first quarter fiscal 2024 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter; Julie will then provide a brief update on our market positioning before KC provides our business outlook for the second quarter and full fiscal year 2024; we will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie.
Julie Sweet: Thank you, Katie and everyone joining, and thanks to our 743,000 people around the world for their incredible dedication and commitment every day, which is how we are able to consistently deliver 360 degree value for all our stakeholders. I am pleased that we delivered on our commitments this quarter, while continuing to invest significantly in strategic areas to drive the next waves of growth, including extending our early leadership in generative AI, and we did so against a macro backdrop that continues to be challenging. Starting with our financial results. Our bookings were $18.4 billion, representing 12% growth in local currency. We had 30 clients with quarterly bookings greater than $100 million in the quarter and over half were in North America, representing the trust our clients have in us to be at the center of their major programs, spending and ongoing reinvention. We delivered revenues of $16.2 billion for the quarter, at the top-end of our FX adjusted range, representing growth -- 1% growth in local currency. We continue to take market share. As expected, we continue to see lower discretionary spend, which particularly impacts our consulting type of work as well as slower decision making and our CMT industry group continues to be challenged. We remain on track with the business optimization actions we announced in March to reduce structural costs to create greater resilience. And finally, we expanded adjusted operating margin by 20 basis points and delivered adjusted EPS growth of 6%, while continuing to invest in our business and our people. Turning now to our investments. We closed 12 acquisitions this quarter for a total of $788 million in strategic areas across our geographic markets. In North America, we are continuing to build out our new growth area of capital projects, an $88 billion addressable market in North America, which we entered in August with the acquisition of Anser Advisory. In Q1, we added Comtech, a consulting and program management company for infrastructure projects in Canada. We also invested in the next digital frontier with our supply chain acquisition of The Shelby Group. We expanded our cloud capabilities with the acquisitions of Ocelot Consulting and Incapsulate. And we invested in digital marketing in the healthcare industry with the acquisition of ConcentricLife. In EMEA, we expanded our cybersecurity capabilities with the acquisition of Innotec in Spain, enhanced our business process services in the insurance industry with the acquisition of ON Service GROUP in Germany, and invested in digital healthcare and talent with the acquisitions of Nautilus Consulting and The Storytellers in the UK. Finally, in Growth Markets, we are focused on the cloud opportunity with the acquisition of Solnet in New Zealand, along with cybersecurity with the acquisition of MNEMO in Mexico, and on digital marketing services with the Song acquisition of SIGNAL in Japan. Our ability to invest at scale to fuel our organic growth is a competitive advantage. For example, in EMEA, we are focusing on pivoting our CMT business. We are investing with Vodafone to create a strategic partnership to commercialize its market-leading shared services operations and unlock new sources of growth and efficiency, enhance speed to market and new customer opportunities for their operating companies and partner markets. Together, we plan to create a new data and AI-driven shared services model and a scaled, commercially-driven and more efficient organization with higher-quality services and enhanced speed to market for its portfolio of offerings. The new unit will utilize Accenture's world-class technology, transformation and managed services such as its digital solutions and platforms and deep AI expertise. It will also tap into our well-known learning capabilities to continuously create new skilling and career paths for our -- for its people. This move speaks to Vodafone's ambition to work in new ways, reduce structural complexity, reinvent their company and the industry. And of course, we continue to invest in learning for our people with approximately 8 million training hours in the quarter, representing an average of 12 hours per person. Turning to generative AI, our growth and investments. We continue to take an early leadership position in GenAI, which will be an important part of the reinvention of our clients in the next decade. Last quarter, we shared that we had sold approximately 300 projects with $300 million in sales in all of FY '23. Demand continued to accelerate in Q1 with over $450 million in GenAI sales. As you know, we are investing $3 billion in AI over three years. For many of our clients, 2023 was a year of generative AI experimentation. We are now focusing on helping our clients in 2024 realize value at scale. We are excited about the recent launch of our specialized services to help companies customize and manage foundation models. We're seeing that the true value of generative AI is to deliver on personalization and business relevance. This is driven by context and accuracy, data readiness along with foundation model choices and customization are some of the most important steps and decisions that companies will make in the next year as they pursue value. Our clients are going to use an array of models to achieve their business objectives. Our proprietary switchboard allows a user to select the combination of models to address business context or factors like cost or accuracy. And we will offer rigorous training and certification programs to organizations using these new services to customize and scale GenAI solutions and transform every link in their value chain. We are also investing in AI acquisitions. For example, we recently announced our intent to acquire Ammagamma, an Italy-based firm that helps companies advance their uses of AI and generative AI technologies. With this acquisition, we will add 90 experienced AI professionals, many specializing in generative AI along with the expertise that includes engineering, mathematics, economics, historians, philosophers and designers, who will join our growing network of professionals in our advanced center for AI. And we are progressing towards our goal of doubling our deeply skilled data and AI practitioners from 40,000 to 80,000, with an additional 5,000 practitioners as of Q1. Finally, a few additional highlights of the 360 degree value that we created this quarter. We recently achieved our highest brand value and rank to date on Interbrand's prestigious Best Global Brands list, increasing to $21.3 billion and ranking number 30. We jumped from number 17 to number 10 on the 2023 World's Best Workplaces list by Fortune and Great Place to Work. This recognition is particularly noteworthy, because it is based on feedback from our people. We were recognized for the seventh year in a row on the Wall Street Journal list of Best-Managed Companies for excellence in customer satisfaction, employee engagement and development, innovation, social responsibility, and financial strength. And we also received the top score for social responsibility and are among the top 10 for customer satisfaction. We continue to lead in our ability to attract people with different backgrounds, different perspectives, and different lived experiences. Our success is reflected in the top score on the Human Rights Campaign Corporate Equality Index in the U.S. for the 16th consecutive year for leading equitable workplace policies, practices and benefits for LGBTQ+ people. And today, we are proud to present an update to our 360-degree value reporting experience, which is available on our website, because we believe that transparency builds trust and helps us all make more progress. Over to you, KC.
KC McClure: Thank you, Julie. Happy holidays to all of you, and thanks for taking the time to join us on today's call. We are pleased with our Q1 results, which were in-line with our expectations and include continued investments at scale to strengthen our position as a leader in the market. Once again, our results illustrate our ability to manage our business with rigor and discipline and deliver value for our shareholders. So, let me begin by summarizing a few of the highlights for the quarter. Revenues grew 1% local currency with mid-single digit growth or higher in five of our 13 industries, including public service, industrial, utilities, health and energy. As expected, we saw continued pressure in our CMT industry group. And we continue to take market share. As a reminder, we assess market growth against our investable basket, which is roughly two dozen of our closest global public competitors, which represents about a third of our addressable market. We use a consistent methodology to compare our financial results to theirs, adjusted to exclude the impact of any significant acquisitions through the date of their last publicly available results on a rolling four-quarter basis. We delivered adjusted EPS in the quarter of $3.27, reflecting 6% growth over EPS last year. Adjusted operating margin was 16.7% for the quarter, an increase of 20 basis points over Q1 last year and includes significant investments in our people and our business. Finally, we delivered free cash flow of $430 million and returned $2 billion to shareholders through repurchases and dividends. We also invested $788 million in acquisitions across 12 transactions in the quarter. With those high-level comments, let me turn to some of the details, starting with new bookings. New bookings were $18.4 billion for the quarter, representing 14% growth in U.S. dollars and 12% growth in local currency, with a book-to-bill of 1.1. Consulting bookings were $8.6 billion, with a book-to-bill of 1.0. Managed services bookings were $9.8 billion, with a book-to-bill of 1.3. Turning now to revenues. Revenues for the quarter were $16.2 billion, a 3% increase in U.S. dollars and 1% local currency, and we're at the top-end of our guided range adjusted for a foreign exchange tailwind of approximately 1.5% compared to the 2.5% estimate provided last quarter. Consulting revenues for the quarter were $8.5 billion, flat in U.S. dollars and a decline of 2% in local currency. Managed services revenues were $7.8 billion, up 6% in U.S. dollars and 5% in local currency. Taking a closer look at our service dimensions: technology services grew mid-single digits, operations was flat, and strategy and consulting declined mid-single digits. Turning to our geographic markets. In North America, revenue declined 1% in local currency. Growth was led by public service, offset by declines in communications and media, software and platforms, and banking and capital markets. Before I continue, I want to highlight that for this fiscal year '24, we have reorganized our geographic segments. Europe is now EMEA and includes the Middle East and Africa, which were previously included in Growth Markets. The reclassification for prior years can be found in our Investor Relations website. In EMEA, revenues grew 2% in local currency, led by growth in public service and banking and capital markets, partially offset by a decline in communications and media. Revenue growth was driven by Italy, Austria, and France, partially offset by a decline in the United Kingdom. In Growth Markets, we delivered 5% revenue growth in local currency, driven by growth in chemicals and natural resources, public service, and banking and capital markets. Revenue growth was led by Japan. Moving down the income statement. Gross margin for the quarter was 33.6% compared to 32.9% for the first quarter of last year. Sales and marketing expense for the quarter was 10.5% compared with 9.8% for the first quarter of last year. General and administrative expense was 6.4% compared to 6.6% for the same quarter last year. Before I continue, I want to note that in Q1, we recorded $140 million in costs associated with our business optimization actions, which decreased operating margin by 90 basis points and EPS by $0.17. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.7 billion in the first quarter, reflecting a 16.7% operating margin, an increase of 20 basis points from operating margin in Q1 last year. Our adjusted effective tax rate for the quarter was 23.2% compared with an effective tax rate of 23.3% for the first quarter last year. Adjusted diluted earnings per share were $3.27 compared with diluted EPS of $3.08 in the first quarter last year. Days services outstanding were 49 days compared to 42 days last quarter and 48 days in the first quarter of last year. Free cash flow for the quarter was $430 million, resulting from cash generated by operating activities of $499 million, net of property and equipment additions of $69 million. Our cash balance at November 30th was $7.1 billion compared with $9 billion at August 31st. With regards to our ongoing objective to return cash to shareholders, in the first quarter, we repurchased or redeemed 3.8 million shares for $1.2 billion at an average price of $311.90 per share. At November 30th, we had approximately $5.4 billion of share repurchase authority remaining. Also in November, we paid a quarterly cash dividend of $1.29 per share for a total of $810 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.29 per share to be paid on February 15th, a 15% increase over last year. So, in closing, we remain committed to delivering on our long-standing financial objectives, growing faster than market and taking share, generating modest margin expansion and stronger earnings, while at the same time investing at scale for our long-term market leadership, generating strong free cash flow and returning a significant portion of that cash to shareholders. And now, let me turn it back to Julie.
Julie Sweet: Thank you, KC. As we begin our second quarter, we remain laser-focused on creating value for our clients. The pace of spending continues to be impacted by the macro environment. Our business in the UK in particular, in Q1, saw even greater challenges than we expected last quarter. The fundamentals of our industry remain unchanged. All strategies continue to lead to technology and companies need to reinvent every part of their enterprise using tech, data and AI to optimize operations and accelerate growth. To do so, they must build a digital core. Strategy and consulting, which brings our deep industry and functional expertise is critical to how we differentiate by helping our clients ensure they drive business value from their digital core. We are continuing to see significant demand in areas like cloud migration and modernization, modern ERP and data and AI, including GenAI, platforms and security, all of which represent areas of great opportunity and is still early with more digital core to be built in the future than has been done to date. Let me bring to life the significant opportunities still ahead with examples from the quarter. Our cloud momentum continued in Q1 with strong double-digit growth, reflecting the ongoing significant market opportunity. We estimate only 40% of enterprise workloads are in the cloud, of which only 20% or so are modernized, an 80% opportunity remaining. Clients are continuing to prioritize the digital core as evidenced by strong demand for cloud migration. We're working with a leading insurance provider to continue their cloud transformation. Together, we are migrating hundreds of applications to a cloud-based platform, enabling the company to exit their data centers by 2025. To date, we have migrated more than half of their apps to the cloud. And this is not just a migration. We are modernizing applications and accelerating automation to integrate disparate data more easily from acquisitions and help the company move into new markets. And we are helping reshape their organizational mindset, drive cultural change and find new ways of working, including the creation of a new IT service model to lead complex transformations with agility and speed. This transformation will reduce legacy complexity and technical debt, enable more cost effective back-office operations, and drive growth and innovation, ultimately helping the company provide more affordable and personalized insurance solutions for families and businesses. And for those clients who have made significant progress on their migration, they are investing to modernize and innovate across the cloud continuum, extending cloud to the edge, unlocking greater value with more opportunities still ahead. For example, we recently announced an expansion of our strategic partnership with McDonald's to help it execute their technology strategy and leverage the company's scale to unlock greater speed and efficiency for customers, restaurant teams and employees. This new work supports McDonald's ambition to connect restaurants worldwide with cloud technology and apply generative AI solutions across McDonald's platforms. Accenture also will support the acceleration of automation innovation and the enhancement of the digital capabilities of McDonald's employees. Accenture's deep understanding of the McDonald's business, industry and technology will help unlock opportunities in their ongoing digital investments as McDonald's reinvents the customer experience and stays ahead of their customers' changing needs. Turning to data and AI. We estimate that less than 10% of companies have mature data and AI capabilities. This is a critical part of building the digital core and we see this embedded in our larger transformations, in work focused on data and AI modernization and in the opportunities of generative AI. We help leaders such as BBVA, a global financial services group, to stay ahead of the curve by continuing to reinvent its business model with GenAI. For example, we are building a GenAI-powered financial coach assistant to help them disrupt customer centricity in the banking industry while they reinvent their digital core to also become even more efficient. This work is a continuation of our ongoing GenAI implementation which is transforming BBVA's operations and digital marketing and is helping employees be more productive. Thanks to its strong digital core, BBVA can continue to reinvent across their enterprise by applying GenAI. We're also helping a global hospitality group to support its content production capability and marketing communications across its hotel brands, tailoring content to guests' evolving needs. This new data-driven content supply chain model will create personalized, flexible and efficient marketing communications content across every customer touchpoint. Spanning both physical and digital communications, this service will be available to all marketing professionals enabling content production management from its initial brief to performance measurement and content optimization. This will increase the effectiveness of its digital marketing programs, drive more traffic to its branded website, and deliver exceptional customer experiences, all while reducing costs. Platforms are a core component of the digital core and are critical to our clients' transformations. We estimate 60% of the opportunity is still ahead as clients upgrade their core platforms. We are working with OCBC Group, a Singapore-based multinational banking and financial services corporation, on a two-year transformation journey to modernize their human resources organization. We will shift key HR functions such as hiring, talent management, and career development to the cloud and create a next-generation HR operating model with enhanced capabilities. Together, we will drive operational efficiency with a strategic focus on future talent readiness, employee experience, and AI-driven decision-making. And by providing a scalable framework to meet evolving business needs, we'll free up HR capacity to provide high-value advisory work and empower business and HR leaders with analytics and insights to facilitate better talent decisions. Security is also essential to a digital core, and we continue to see very strong double-digit growth in our security business this quarter. While the opportunity to continue to grow and expand, we estimate that currently only 36% of business leaders are confident that their organizations are cyber resilient, representing at least 64% of untapped potential. An example of our important work with our clients to build secure organizations is Fortrea, a global contract research organization of about 19,000 people that provides clinical trial and research services for life sciences companies in more than 90 countries. We're working with Fortrea to deliver database outcomes and health-related insights, which require adherence to regional and local industry and government regulations. As they continue to grow and enter new markets, they need a partner to ensure that their cybersecurity program remains resilient and compliant with security best practices. We will co-create, architect, and operate a series of global cybersecurity services and capabilities through our managed services. Our partnership will help Fortrea grow its business, utilizing flexible risk and security strategies. We are focused on helping clients reimagine marketing and their customer experience to drive growth. Song demand continues to remain strong with double-digit growth in Q1. We are collaborating with Peugeot, a French automotive brand, to lead strategic and creative direction for its global communications. The partnership supports Peugeot's ambition to engage a younger audience and become a leader in the electric vehicle market. Accenture Song will manage global communications across all traditional and digital media channels. The first campaign will be a full 360 integrated launch of the all-new electric fastback SUV E-3008 in early 2024. Finally, we continue to see strong demand for digital manufacturing and engineering services. We estimate that only 5% of enterprises have scaled, matured digital capabilities across their organizations. Industry X grew strong double digits in Q1. We are working with a leading global -- a leading German multinational car manufacturer to engineer the next generation of infotainment system. Using our deep industry expertise and software engineering capabilities, we will support the implementation of a new flexible platform that enables the next level of in-car experience with cutting-edge customer features while minimizing complexity and maximizing the software we use across hardware generations. We're working with a global food manufacturer on a total enterprise reinvention strategy to modernize its supply chain, reduce operating costs, and position it for the future. We will transform key supply chain processes such as planning, procurement, manufacturing, and distribution. AI and intelligent automation will optimize end-to-end supply chain operations and achieve greater efficiency and agility. It will also help the company leverage data for better decision making and implement portfolio optimization to ensure the right assets are focused on for investment to maximize returns and minimize risks. This self-funded program is expected to generate significant productivity gains with ongoing savings fueling further capability builds and bottom-line growth. Back to you, KC.
KC McClure: Thanks, Julie. Now, let me turn to our business outlook. For the second quarter of fiscal '24, we expect revenues to be in the range of $15.4 billion to $16 billion. This assumes the impact of FX will be about negative 0.5% compared to the second quarter of fiscal '23 and reflects an estimated negative 2% to positive 2% growth in local currency. For the full fiscal year '24, based upon how the rates have been trending over the last few weeks, we continue to assume the impact of FX on our results in U.S. dollars will be about flat compared to fiscal '23. For the full fiscal '24, we continue to expect our revenue to be in the range of 2% to 5% growth in local currency over fiscal '23, with the inorganic contribution now expected to be more than 2%. We continue to expect business optimization actions to impact fiscal '24 GAAP operating margin by 70 basis points and EPS by $0.56. The following guidance for full year '24 excludes these impacts. For adjusted operating margin, we continue to expect fiscal year '24 to be 15.5% to 15.7%, a 10 basis point to 30 basis point expansion over adjusted fiscal '23 results. We continue to expect our annual adjusted effective tax rate to be in the range of 23.5% to 25.5%. This compares to an adjusted effective tax rate of 23.9% in fiscal '23. We continue to expect our full year adjusted earnings per share for fiscal '24 to be in the range of $11.97 to $12.32 or 3% to 6% growth over adjusted fiscal '23 results. For the full fiscal '24, we continue to expect operating cash flow to be in the range of $9.3 billion to $9.9 billion, property and equipment additions to be approximately $600 million, and free cash flow to be in the range of $8.7 billion to $9.3 billion. Our free cash flow guidance reflects a free cash flow to net income ratio of 1.2. Finally, we continue to expect to return at least $7.7 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so we can take your questions. Katie?
Katie O'Conor: Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: Thank you. [Operator Instructions] Your first question comes from the line of Jason Kupferberg from Bank of America. Please go ahead.
Jason Kupferberg: Good morning, guys. Happy holidays. I just wanted to start with a question on the revenue guidance for Q2. The midpoint there would suggest 1 point of deceleration, but we do have an easier comparison, and there was a return to positive growth in consulting bookings. So, just hoping you can help us reconcile that and then maybe comment on the second half reacceleration that is continuing to be implied in the guide, maybe slightly steeper than previously thought. Thank you.
KC McClure: Yeah, great. Thanks, Jason. Happy holidays to you, too. So first, let me first start in terms of our guidance. I'll first start with Q1. And as you heard us say, we were really pleased with our Q1 performance. And as you stated, our Q2 guidance is the same as Q1. And maybe a couple of things that I'll point out compared to what we thought 90 days ago, and as Julie mentioned, we do see some differences in EMEA, particularly in the UK, where we're focused on repositioning the business back to growth, and that's going to take some time. But Jason, what is the same is that we are still operating in an environment, which is the same that we described last quarter, where the discretionary spend and the decision making is slow. And so right now, as you expect, and you know that we do this every year, we're talking to our clients right now about their '24 budgets. And so that's all, again, to be expected. When we look forward into H2, to start with just what the math is, we continue to see higher growth in the back half of the year. That's going to start with higher growth in Q3. And our confidence in our H2 increased growth is really based on a few things. Again, reiterating what we talked about at the beginning of the year versus our results in Q1, so we're confident, again, that we were able to deliver across the board as we expected in the first quarter. And also then, as Julie mentioned quite a bit, we made a lot of investments in our business in the quarter, and that's helping us pivot to higher growth areas. In addition to that, as we talked about last quarter, the same remains, we do have our revenue positioned in the back half of our year from these larger transformation deals. So that has not changed. We continue to see that. And then, we just need to continue to layer in our new sales as we get closer to the back half of the year. So, we're really very pleased to reiterate the 2% to 5% revenue guidance that we had at the beginning of the year.
Jason Kupferberg: Okay. That's helpful. And just as a quick follow-up, what should we expect in terms of second quarter bookings for consulting and management -- managed services year-over-year? I know managed services has a particularly tough comp. Thanks again.
KC McClure: Yeah. So, Jason, I know I've been giving color and basically kind of guiding to future quarter bookings, but as you know really well covering up for so long, bookings can really be lumpy. So, I'm not going to give that color anymore, go forward. What I would say is the best way to think about demand for our business is the revenue guide that we give. And we gave revenue guidance for the second quarter as well as our 2% to 5% for the full year. And obviously, we'll continue to do that. And I'll just put in that we do feel good about our pipeline. We have a very solid pipeline.
Operator: Your next question comes from the line of Tien-Tsin Huang from JPMorgan. Please go ahead.
Tien-Tsin Huang: Hey, perfect. Yeah, I just want to follow up to Jason's question just with the bookings, which is better than expected, and your large deal backlog is quite large now. Just the visibility on the timeliness of those conversions? Have you seen any signs of pushout or delays or that kind of thing? Just trying to understand the conversion potential.
KC McClure: Yeah. So maybe just a couple of things on that. So I think, conversion can be really mainly impacted by the mix, right? So, the mix of deals that we have. So, let's just start with, overall, we haven't seen any change in the conversion based on the mix of work. So, strategy and consulting which converts faster than with operations. There's been no change within those different parts of our business, no change in the conversion. What we have talked about, and we've been consistent, that there's really been -- there's no change over the last 90 days in our discretionary spend environment, and that is consistent with our expectations. So -- and we haven't been reliant, and we're not reliant on a change in that macro to get to our full-year guidance. So, what does that mean? Hopefully you guys can hear me. The lower -- a little trouble in the line. Okay. Is that there -- as we have lower discretionary spend, that does impact the conversion, Tien-Tsin, as you know, but we have factored that all into our guidance.
Tien-Tsin Huang: Understood, KC. Thanks for that. And just my quick follow-up. I know you've been really busy with acquisitions, and Julie, you listed a bunch of them. Is there a change here in the rhythm of acquisitions or your appetite? It sounds like the revenue contribution is up a nudge, but -- up a little bit. But you tell me. I didn't know if there was a change in your thinking here on the deal. Thanks.
KC McClure: Yeah. I'm going to maybe give a little bit of color and then I'll certainly hand it over to Julie. Just more from a financial perspective, I think -- and as you know this really well, but our competitive advantage really is our investment capacity that allows us to pivot to higher areas of growth. And we can do that and invest through every cycle, and you've seen us do that. And I really think that is clearly a differentiator for us. You see that with our strong start this quarter. Julie talked about the 12 acquisitions, $800 million of spend, and we have five more that we've announced for Q2. All of that, and we're reconfirming op margin expansion of 10 basis points to 30 basis points. I think it's important to see that in terms of our strategy, we're continuing to do this to really fuel organic growth. And lastly, I think one of the parts that really distinguishes us is our capital allocation framework, which is durable yet flexible. So, we're able to flex up and do inorganic to the degree that we see that we'd like to, while at the same time, continuing to increase our return to our shareholders. So, I think it's really, really great.
Julie Sweet: Great. Yeah. And there's no change in the strategies in the sense of we're still trying to -- we're still investing to either scale in hot areas or add new types of skills. So, you see that we're executing in capital projects like we described, right? In August, we did the -- yeah, in August, we did the Anser Advisory. We just added Canada. And then, of course, adding the niche skills in consulting and whether it's industry or functional. So, no change in strategy. But I would reiterate that it is really a huge competitive advantage for us that we can invest across the cycles. You saw that we did that in the first year after the pandemic, where we significantly increased, and again, always to drive organic growth and position ourselves for those next waves. So, you're going to see the AI acquisitions. You saw health in the UK, another great area of growth, capital projects. So, think about our strengths here is how we accelerate pivoting to growth.
KC McClure: And then, I'll just add, Tien-Tsin, that you heard me mention in guidance, that we are going to do now more than 2% in organic contribution for this year.
Julie Sweet: Yeah.
Tien-Tsin Huang: Yeah. No, I'm sure you'll amplify the growth of what you buy. Just wanted to check on that. That's helpful. Thank you.
Julie Sweet: Thanks.
Operator: Your next question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead.
Ashwin Shirvaikar: Thanks, and congratulations on the performance. Happy holidays from me. I wanted to ask about, as you have conversations with your clients with regards to budget and spending priorities into next year, if you can comment, first of all, on that? And then, it's only a couple of quarters since sort of the GenAI kind of took hold, but it's a fast-moving technology, and I want to kind of inquire into whether the nature of those discussions has changed or become more meaningful, gone past proofs of concept and so on.
Julie Sweet: Great. And happy holidays to you, too. Great question. So first, with respect to -- on your first point around what's happening in the market on client budgets is what I would say is that we're having lots of discussions that are pretty similar to what we've been talking about, which is, how do you prioritize in a more cautionary environment? So, we'll really know how that will play out in January as always because this is when we -- they finalize. But what I'd say is it's a consistent thing I've been talking about, which is in a cautionary environment, in a tough macro, we're helping clients prioritize. And they're in the things that we talked about in the script again today, things like building the digital core. It's using the technology to drive both growth and cost. And I would just say on the macro side, right, is that, our clients, we recognize you cannot cut yourself to growth. And if you think about the examples that I used in today's script, most of them were both cost and growth, right? Because that is what our clients are focused on, is how are they going to grow revenue despite whatever the environment is. And that, of course, is our unique capabilities to be able to do both. And then, with respect to GenAI, so first of all, I just want to say $450 million in sales this quarter, we're very pleased with. I mean, it demonstrates we are leading here. All of last year, it was $300 million. And to your point, the conversations are changing. You have examples like BBVA, which we talked about earlier in my script, where we're starting to use it at scale. Our clients want to get out of proofs of concept to material value, and we're super well positioned. Why? GenAI is not plug and play. It is not just technology. In fact, it's closer to any other technology. Think about cloud, that's farther away from the heart of the business. In order to scale, you have to deeply understand the technology, which is still rapidly changing, and the business value. And this is Accenture's leadership position, right? We have strategy. We have consulting, deep industry and functional expertise. We're the biggest partner with every major player. We're working with them at a product level and we can bring those two things together. So, think of 2024 as being the shift for our clients from experimentation to scale, and we believe we're at the best position to lead that shift to value.
Ashwin Shirvaikar: Understood. I want to ask also about operations performance. It did decelerate meaningfully. I think it was high-single-digit growth, and now it's flat. Is that also a reflection you mentioned just now, maybe a pivot from cost savings to revenue generation maybe is beginning? Is that what's happening or are there other factors in here?
KC McClure: Yeah. Maybe just in terms of the quarter performance, operations came in as expected. As we talked about at the beginning of the year, Ashwin, we do have some impacts in CMT that impact operations, and so we'll see that growth may fluctuate as we go throughout the year. As part, though, of our overall guidance for the full year of managed services continuing to be mid-single to high-single-digit growth for the year.
Julie Sweet: Yeah. And in fact, I would say, it's the opposite. Operations, which was impacted, by the way, by CMT, for example, look, it's going to build similar to the way Accenture is going to build over the course of the year. Actually, the sweet spot of operations is that it does both cost and growth. So, the BBVA example includes operations, Fortrea includes operations. So, these are -- our managed services are highly strategic because they are typically able to do both. Think about IT transformation. Our managed services are as much about modernizing. So, in IT, modernized tech is what drives growth. So, we really see our strength being that our managed services are strategic. And one of the reasons is that we do them in the context of understanding the industry and the function. So, we're not back office. We're bringing that strategy and consulting expertise to make sure that it isn't just a cost play. And that's an important differentiator for us.
Ashwin Shirvaikar: Got it. Thank you both.
Julie Sweet: Thank you.
Operator: Your next question comes from the line of Bryan Bergin from TD Cowen. Please go ahead.
Bryan Bergin: Hi, guys. Good morning. Happy holidays. I wanted to start on your some of the expectations around shorter cycle and discretionary work within S&C and SI. Do you have a sense of stabilization forming there or cuts still occurring in those areas? And maybe can you give us a sense on how you expect consulting to do in the second quarter?
Julie Sweet: Yeah. So, look, we're -- as KC said earlier, we're operating kind of the same environment we have for the last few quarters, right? Discretionary spend is down. And we're right in the middle of the budget cycle, so next quarter, we'll have a much better view of what's there. But if you sort of look around in the environment, there aren't a lot of green shoots on the economic side. And obviously, the volatility on the geopolitical side continues. And so, as KC said, we're not planning right now for kind of a change in the macro, which means that we're not planning for a change in discretionary spending. We just don't see that being meaningfully different as we go into 2024. And obviously, we'll update you. But that's why when you think about the question earlier on revenue conversion, our level of smaller deals is just down. It's going to stay down for a while, which means that how revenues going to -- how sales are going to bleed into revenue is going to be consistent with what we've been seeing. So -- and then, you want to comment?
KC McClure: Yeah. Just in terms of, Bryan, on the overall growth, there's no change from what we said at the beginning of the year in terms of our full-year outlook for consulting type of work. We see low-single-digit positive growth for the full year. That's in our 2% to 5%. And Q1 came in as we expected, which was negative 2%.
Bryan Bergin: Okay. That's helpful. And then, just a clarification around the M&A. So first, I don't know if you mentioned M&A in the first quarter, the contribution to growth, and we're saying greater than 2% for the full year. Just to be clear, that's just rounding around 2% or upwards of 3%? Thanks.
KC McClure: Yeah. So, we're saying more than 2% for the full year, and it can fluctuate by quarter, so we really just stick to our guidance for the overall year.
Julie Sweet: Right. And if we get close to 3%, we'll talk about that. But right now it's more than 2%.
KC McClure: More than 2%.
Julie Sweet: Right. Because we gave you guidance, so it's down definitely more than 2%. And remember, we only do deals that we think are good deals. So, what we see right now is a lot of good deals that is going to get us to above 2%. And if that -- we have a lot of financial flexibility, so if that changes, we'll update if it gets above 3%.
Bryan Bergin: Thanks. Happy holidays.
Julie Sweet: Happy holidays.
KC McClure: Same to you.
Operator: Your next question comes from the line of Dave Koning from Baird. Please go ahead.
Dave Koning: Yeah. Hey, guys. Thanks so much. One thing I noticed, I guess, gross margin growth, year-over-year expansion in gross margin was the strongest in about nine quarters or so. Is that just lower attrition, offshore shift? Maybe walk through why that's gotten nicely better.
KC McClure: Yeah. Hey, Dave. Thanks for the question. So, as you know, we run our business to operating margin, which we did 20 basis point expansion this quarter. And I will mention that if I didn't already, that the 10 basis point to 30 basis point that we have for the year, we might see more variability as we go throughout the quarters. But now back to gross margin, you're right, we did see expansion this quarter, but it's really hard to look at that in isolation. And why is that? Well, there's various things that can go in and out of gross margin in terms of increased or decreased spend. So, for example, one would be acquisitions. There's a lot of -- some of the investment acquisitions, some of that spend will go into gross margin, and that can be lumpy as we go throughout. As you know, it also depends on where people spend their time. So for example, you saw that, yes, we had improvement in gross margin, but then we also had increased sales and marketing costs, which is a result of people spending more time out in the market selling to create the $18.4 billion in sales that we have. So that's why -- again, we look at those components, but really at the end of the day, we always continue to run our business to op margin.
Dave Koning: Got you. Thanks for that. And then, maybe as a follow-up just to Jason's question at the beginning on kind of the back-end loaded growth. If I just put in normal sequential patterns in Q3 and Q4, I get to about 2% constant currency, so the low-end of guide. Is there a scenario given bookings were really good this quarter that it actually, the progression sequentially in the back half of the year is better than normal and then that kind of gets to the better parts of the guidance range for revenue?
KC McClure: Yeah. So, I think, obviously when you do -- what you're just kind of talking about is a bit of the math. What I would tell is give you the year-over-year way we look at it in terms of our guidance, right? So, we had 1% growth this quarter with strong bookings, right, 1% revenue growth with strong bookings. We see Q2 shaping up the same way year-over-year. And again, just reinforcing that we do see fuel in our sequential growth in the back half of the year based on the transformation deals that we have signed. That's no different than what we talked about at the beginning of the year. We've layered in then the sales that we expect as we go throughout. And that -- there's no difference to how we're doing our range that gets us to the 2% to 5% range. I would say at the top end of our range, again, as we said, last quarter, just when we said guidance, that when -- to get to the top end of our guidance range, you would see S&C reconnecting with growth would be one thing that we'd see. And you would probably also see the mid- to high-single digits that we've been referencing consistently in managed services be more like high-single digits. So hopefully that helps, Dave.
Dave Koning: Yeah, that's helpful. Thanks, guys. Nice job.
Julie Sweet: Thank you.
Operator: Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead.
Bryan Keane: Hi, guys. Good morning. I just wanted to ask on the clarification on the UK market in particular. I know the economy has been weak there for a couple years. So -- and I know it's been a call out for kind of the quarter. What exactly happened in the UK? And then, what's the outlook for that?
Julie Sweet: In the UK, as you said it, it has been kind of challenge for a couple of years, and we have a big banking capital markets business there, and we're really trying to pivot to more growth there in other areas. That's why you saw the acquisitions that we did, for example, this quarter. And what we're seeing is that it's just taking longer than we anticipated to really move into the other areas. And banking capital markets, which we've talked about, has been more challenged, particularly in the UK. And so, it's really about how long it's taking us to pivot. And we think it's going to take some time. So, I'm not going to call exactly when, but we do think it's going to take some time, and it's taking more time than we anticipated going into the fiscal year. So, we've got a good team. We're on it. And again, this is where you're going to see us do more acquisitions to diversify our business there as we reposition that.
KC McClure: Yeah. Maybe just also, Bryan, just for context, it's about 6% of our overall business, a little bit more than $4 billion that we have in the UK.
Bryan Keane: Got it. No, that's helpful. And then, KC, just to make sure we understand, the comments on the margins, given the movement in acquisition and the pick of an acquisition, there could be some fluctuations in given quarters. You're not going to have it perfectly 10 -- in the range of 10 basis points to 30 basis points per quarter. Any quarters to call in particular where it could fall below the range given the ramp of acquisitions and the ramp of investments? Thanks.
KC McClure: Yeah. I don't want to really guide to the quarter because 10 basis points or 20 basis points on a quarter, that's spend, Bryan, as you know. That's kind of big and small in terms of the dollar amount that we're talking about. So, we're going to guide overall to the full year of 10 basis points to 30 basis points for the full year. And I just wanted to point out that we might have some periods where it's just a little bit more variable than what you've seen us do over the years.
Bryan Keane: Got it. Thank you. Happy holidays.
KC McClure: Thanks, Bryan.
Operator: Your next question comes from the line of Darrin Peller from Wolfe Research. Please go ahead.
Darrin Peller: Hey, thanks guys. Just want to touch on headcount growth. I mean, it's still -- I think it's still a bit decelerating. And so, what are the expectations going forward, I mean, just given the backdrop of an acceleration on the revenue in the second half of the year? And then, Julie, maybe we could just touch on the linearity of the business one more time. Just if we could revisit the mix of the kind of business you're seeing now and the revenue per head you'd expect, or maybe just directionally, what you'd anticipate based on the mix we're seeing and what demand is for?
KC McClure: Yeah. So, thanks for that, Darrin. So, I'll talk about -- in terms of our people, in terms of number of people we have, first, I'll start with, as you know, managing supply-demand is really our core competency. And you can see that in our ability to manage our utilization at high levels. And I'll just point out that for the last 13 quarters, our utilization has been 91% or higher. And so, we hire for the skills that we need and we hire where we need them. And what you're pointing out is that we had about a 1% increase year-over-year in our headcount, as well as about a 1% sequentially. And that's in-line with what we -- how we see revenue going for the rest of the year. So there's really no change there. And as it relates to the revenue per head and the non-linearity, I mean, we do have automation. We do have value-based projects. So, while there still is a, obviously, connection to the amount of people that we have, we have been able to break that. There are parts where we are able to not fully disconnect, but not completely rely on headcount to drive revenue.
Julie Sweet: And Darrin, in terms of just demand, right, so I'd kind of anchor to, first of all, we're seeing demand for transformational deals. So, in an environment like this, the thing that I look at most is, are we continuing to have our clients do more than $100 million of bookings, right, which is in our industry, we are a real standout here. And what does that mean? That means that we continue to be at the heart of where clients are spending to do material transformations. That's where you want to be so that you're positioned when inevitably discretionary spending, the pace goes back up, the macro changes, you want to be at the heart. So, at times like this, that's what I'm really looking at. And that's where you're seeing -- I will tell you, this is one of the most exciting times in the market. Like you just take what we are announcing today on McDonald's. I talked about in the script, right? Incredible company, technology driven. We've been their long-time partner. Just expanded the partnership to take it all the way to the edge and reinvent their restaurants and their crew experience. This is going to be really cutting work at the edge, because that's where we're starting to see the leaders in cloud go, and we're leading there. Those are the kinds of things that then you see how they're going to expand. There's so much opportunity still in these big areas of cloud, of data, and AI. But cloud itself, yes, we've done a lot of migration. There's still more migration to go, but even more importantly, you've got to take it all the way to the edge. So, from a demand perspective, we continue to see the transformations that move the needle for cost and growth, and that's what we're expecting. From a mix perspective, we're not seeing a big change between managed services and consulting. The mix we're seeing is that in this environment, you're seeing less of the smaller deals, which convert to revenue faster, and more on the larger deals. And that's been around for a while, and that's what you're going to continue to see. And we are laser-focused on making sure we are winning in the reinvention, the transformation, and at the same time massively pivoting to GenAI, right? And our clients have so much work to do to be able to use GenAI, but you can see the momentum in our business, right, from that change from $300 million of all of last year to $450 million in a quarter. And I'll just remind you, that's not the pull-through. That's not data. We are very pure because we really want to be sharing with all of you where is GenAI in the market. So, we're pretty excited about where we are today and what's ahead.
Darrin Peller: That's really helpful. Look, you guys have obviously managed well through what was a softer discretionary demand environment. So, I guess, my question would be, if we thought about what a normalized run rate of revenues on really S&C would be, if we just said today's a normal, no longer softer discretionary environment, where do you think the difference is? I mean, I know it's probably hard to give an exact or precise estimate, but how much upside is there when we get that back?
Julie Sweet: Well, we have a good -- a really strong strategy in consulting business. And so, we're very positive about that business growing. But beyond that, I think, Darrin, we're not going to start to predict growth rates. But in the meantime, it is a huge differentiator. Nobody has that combination that we have, and that is what is driving the resilience of our business to be at the core of our clients' agenda. Thanks so much, Darrin.
Darrin Peller: Great. Thanks, guys.
Katie O'Conor: Operator, we have time for one more question, and then Julie will wrap up the call.
Operator: Okay. That question comes from the line of James Faucette from Morgan Stanley. Please go ahead.
James Faucette: Great, thank you so much. I want to just ask a couple of follow-up questions to those that have already been asked. First on the inorganic contribution, appreciate that it's going to be better than 2%. Can you talk a little bit about whether that increased activity is -- or how you would balance that increased activity between just better valuations and more opportunities from a purely financial perspective in the market versus it sounds like some of the acquisitions you're doing, you're just trying to push into new strategic areas, and just wondering how you're balancing those strategic imperatives versus perhaps a little better valuations?
Julie Sweet: Yeah. I mean, I wouldn't call out -- I wouldn't say that this activity is because of better valuations, right? At any given time when we look at the market, right, and we see where are the growth opportunities, we want to move quickly and we look at organic versus inorganic ways of moving quickly. We never do anything purely inorganic, right, or purely organic. And so, think about our acquisitions as being matched to what is the opportunity in the market and what's the best way to capture that growth quickly, right? And so, the strategy of categories is the same, right? So, there are new areas that we want to go into, like capital markets. That's an investment decision. We go into a certain number of those. We're executing now with rigor. We went and bought Anser Advisory. Now we bought the next one in Canada, right? So that's just about -- it's a great growth area and we're trying to pivot. And the best way to do that to build something that we don't have already organically is to make some inorganic acquisitions and then that becomes organic growth and we're able to kick in our recruiting machine. If you think about the UK, health is a great area. We just bought a health company, right? So, you look at the market and you say, "If I want to diversify, what's the fastest way to diversify into new areas?" And that's where often inorganic can help us do that through these niche acquisitions and consulting and industry. And then, you've got just massive opportunities like cloud and security, where you saw some of those acquisitions in supply chain. And that's all about both adding phenomenal talent quickly and scaling to go after a market that's today, right? So, that's how we think about it. It's extremely rigorous. We always have a decision what's the best way to get there organically or inorganically. And inorganic is always about acceleration and driving organic growth. So, it's very consistent. We've been doing it in a very disciplined way. And in these kinds of environments, we believe the companies that invest win. And that is why we do actions like we did last year to increase our business resilience and enable us to be really well positioned to invest when others are not.
James Faucette: That's great color. I appreciate that. And similarly, just on bookings activity and AI contribution, there are clear acceleration in the AI level of activity, et cetera. When you're talking to clients and that kind of thing, how are they thinking about AI budget allocation versus other initiatives, et cetera, right now? Are they looking at it as, "Hey, this is an incremental investment that we need to be making given the pace of change in technology," or are they trying to really use that spend or have that spend be to offset some other projects maybe that they're going to curtail a little bit sooner? Just trying to think about as that continues to build, how we should think about it being incremental versus substitutive within a lot of the budgets.
Julie Sweet: Right now we're seeing a lot of reprioritization, right, because -- I mean, obviously the market is growing. Like, we're growing. The market is growing. So, spending in technology is increasing. It's not increasing as fast as it was increasing a couple of years ago, right? So, spending on technology is increasing. But within that, you're seeing more prioritization. And our research, everybody's research is saying, hey, more spending on AI. For lots of companies, it's also more spending mostly on building that digital core, because many companies don't have the data estates in order -- they're not in the cloud. They don't have the data in order to use the GenAI. So, think of it as a real focus on building a digital core to enable as well. So, market is still growing. It's more about prioritization of where that spending is going. Okay. Great. Thank you so much. So, in closing, I want to thank all of our shareholders for your continued trust and support in all of our people for what you do every single day. And I wish everyone a happy and a healthy holiday season. Thank you for joining today.
Operator: That does conclude your conference for today. Thank you for your participation and for using AT&T Teleconference. You may now disconnect. | [
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"speaker": "Operator",
"text": "Thank you all for standing by. Welcome to Accenture's First Quarter Fiscal 2024 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to our host, Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead."
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"speaker": "Katie O'Conor",
"text": "Thank you, operator, and thanks everyone for joining us today on our first quarter fiscal 2024 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, Chair and Chief Executive Officer; and KC McClure, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results; KC will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter; Julie will then provide a brief update on our market positioning before KC provides our business outlook for the second quarter and full fiscal year 2024; we will then take your questions before Julie provides a wrap up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking, and as such, are subject to known and unknown risks and uncertainties, including, but not limited to, those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate, to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now, let me turn the call over to Julie."
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"speaker": "Julie Sweet",
"text": "Thank you, Katie and everyone joining, and thanks to our 743,000 people around the world for their incredible dedication and commitment every day, which is how we are able to consistently deliver 360 degree value for all our stakeholders. I am pleased that we delivered on our commitments this quarter, while continuing to invest significantly in strategic areas to drive the next waves of growth, including extending our early leadership in generative AI, and we did so against a macro backdrop that continues to be challenging. Starting with our financial results. Our bookings were $18.4 billion, representing 12% growth in local currency. We had 30 clients with quarterly bookings greater than $100 million in the quarter and over half were in North America, representing the trust our clients have in us to be at the center of their major programs, spending and ongoing reinvention. We delivered revenues of $16.2 billion for the quarter, at the top-end of our FX adjusted range, representing growth -- 1% growth in local currency. We continue to take market share. As expected, we continue to see lower discretionary spend, which particularly impacts our consulting type of work as well as slower decision making and our CMT industry group continues to be challenged. We remain on track with the business optimization actions we announced in March to reduce structural costs to create greater resilience. And finally, we expanded adjusted operating margin by 20 basis points and delivered adjusted EPS growth of 6%, while continuing to invest in our business and our people. Turning now to our investments. We closed 12 acquisitions this quarter for a total of $788 million in strategic areas across our geographic markets. In North America, we are continuing to build out our new growth area of capital projects, an $88 billion addressable market in North America, which we entered in August with the acquisition of Anser Advisory. In Q1, we added Comtech, a consulting and program management company for infrastructure projects in Canada. We also invested in the next digital frontier with our supply chain acquisition of The Shelby Group. We expanded our cloud capabilities with the acquisitions of Ocelot Consulting and Incapsulate. And we invested in digital marketing in the healthcare industry with the acquisition of ConcentricLife. In EMEA, we expanded our cybersecurity capabilities with the acquisition of Innotec in Spain, enhanced our business process services in the insurance industry with the acquisition of ON Service GROUP in Germany, and invested in digital healthcare and talent with the acquisitions of Nautilus Consulting and The Storytellers in the UK. Finally, in Growth Markets, we are focused on the cloud opportunity with the acquisition of Solnet in New Zealand, along with cybersecurity with the acquisition of MNEMO in Mexico, and on digital marketing services with the Song acquisition of SIGNAL in Japan. Our ability to invest at scale to fuel our organic growth is a competitive advantage. For example, in EMEA, we are focusing on pivoting our CMT business. We are investing with Vodafone to create a strategic partnership to commercialize its market-leading shared services operations and unlock new sources of growth and efficiency, enhance speed to market and new customer opportunities for their operating companies and partner markets. Together, we plan to create a new data and AI-driven shared services model and a scaled, commercially-driven and more efficient organization with higher-quality services and enhanced speed to market for its portfolio of offerings. The new unit will utilize Accenture's world-class technology, transformation and managed services such as its digital solutions and platforms and deep AI expertise. It will also tap into our well-known learning capabilities to continuously create new skilling and career paths for our -- for its people. This move speaks to Vodafone's ambition to work in new ways, reduce structural complexity, reinvent their company and the industry. And of course, we continue to invest in learning for our people with approximately 8 million training hours in the quarter, representing an average of 12 hours per person. Turning to generative AI, our growth and investments. We continue to take an early leadership position in GenAI, which will be an important part of the reinvention of our clients in the next decade. Last quarter, we shared that we had sold approximately 300 projects with $300 million in sales in all of FY '23. Demand continued to accelerate in Q1 with over $450 million in GenAI sales. As you know, we are investing $3 billion in AI over three years. For many of our clients, 2023 was a year of generative AI experimentation. We are now focusing on helping our clients in 2024 realize value at scale. We are excited about the recent launch of our specialized services to help companies customize and manage foundation models. We're seeing that the true value of generative AI is to deliver on personalization and business relevance. This is driven by context and accuracy, data readiness along with foundation model choices and customization are some of the most important steps and decisions that companies will make in the next year as they pursue value. Our clients are going to use an array of models to achieve their business objectives. Our proprietary switchboard allows a user to select the combination of models to address business context or factors like cost or accuracy. And we will offer rigorous training and certification programs to organizations using these new services to customize and scale GenAI solutions and transform every link in their value chain. We are also investing in AI acquisitions. For example, we recently announced our intent to acquire Ammagamma, an Italy-based firm that helps companies advance their uses of AI and generative AI technologies. With this acquisition, we will add 90 experienced AI professionals, many specializing in generative AI along with the expertise that includes engineering, mathematics, economics, historians, philosophers and designers, who will join our growing network of professionals in our advanced center for AI. And we are progressing towards our goal of doubling our deeply skilled data and AI practitioners from 40,000 to 80,000, with an additional 5,000 practitioners as of Q1. Finally, a few additional highlights of the 360 degree value that we created this quarter. We recently achieved our highest brand value and rank to date on Interbrand's prestigious Best Global Brands list, increasing to $21.3 billion and ranking number 30. We jumped from number 17 to number 10 on the 2023 World's Best Workplaces list by Fortune and Great Place to Work. This recognition is particularly noteworthy, because it is based on feedback from our people. We were recognized for the seventh year in a row on the Wall Street Journal list of Best-Managed Companies for excellence in customer satisfaction, employee engagement and development, innovation, social responsibility, and financial strength. And we also received the top score for social responsibility and are among the top 10 for customer satisfaction. We continue to lead in our ability to attract people with different backgrounds, different perspectives, and different lived experiences. Our success is reflected in the top score on the Human Rights Campaign Corporate Equality Index in the U.S. for the 16th consecutive year for leading equitable workplace policies, practices and benefits for LGBTQ+ people. And today, we are proud to present an update to our 360-degree value reporting experience, which is available on our website, because we believe that transparency builds trust and helps us all make more progress. Over to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thank you, Julie. Happy holidays to all of you, and thanks for taking the time to join us on today's call. We are pleased with our Q1 results, which were in-line with our expectations and include continued investments at scale to strengthen our position as a leader in the market. Once again, our results illustrate our ability to manage our business with rigor and discipline and deliver value for our shareholders. So, let me begin by summarizing a few of the highlights for the quarter. Revenues grew 1% local currency with mid-single digit growth or higher in five of our 13 industries, including public service, industrial, utilities, health and energy. As expected, we saw continued pressure in our CMT industry group. And we continue to take market share. As a reminder, we assess market growth against our investable basket, which is roughly two dozen of our closest global public competitors, which represents about a third of our addressable market. We use a consistent methodology to compare our financial results to theirs, adjusted to exclude the impact of any significant acquisitions through the date of their last publicly available results on a rolling four-quarter basis. We delivered adjusted EPS in the quarter of $3.27, reflecting 6% growth over EPS last year. Adjusted operating margin was 16.7% for the quarter, an increase of 20 basis points over Q1 last year and includes significant investments in our people and our business. Finally, we delivered free cash flow of $430 million and returned $2 billion to shareholders through repurchases and dividends. We also invested $788 million in acquisitions across 12 transactions in the quarter. With those high-level comments, let me turn to some of the details, starting with new bookings. New bookings were $18.4 billion for the quarter, representing 14% growth in U.S. dollars and 12% growth in local currency, with a book-to-bill of 1.1. Consulting bookings were $8.6 billion, with a book-to-bill of 1.0. Managed services bookings were $9.8 billion, with a book-to-bill of 1.3. Turning now to revenues. Revenues for the quarter were $16.2 billion, a 3% increase in U.S. dollars and 1% local currency, and we're at the top-end of our guided range adjusted for a foreign exchange tailwind of approximately 1.5% compared to the 2.5% estimate provided last quarter. Consulting revenues for the quarter were $8.5 billion, flat in U.S. dollars and a decline of 2% in local currency. Managed services revenues were $7.8 billion, up 6% in U.S. dollars and 5% in local currency. Taking a closer look at our service dimensions: technology services grew mid-single digits, operations was flat, and strategy and consulting declined mid-single digits. Turning to our geographic markets. In North America, revenue declined 1% in local currency. Growth was led by public service, offset by declines in communications and media, software and platforms, and banking and capital markets. Before I continue, I want to highlight that for this fiscal year '24, we have reorganized our geographic segments. Europe is now EMEA and includes the Middle East and Africa, which were previously included in Growth Markets. The reclassification for prior years can be found in our Investor Relations website. In EMEA, revenues grew 2% in local currency, led by growth in public service and banking and capital markets, partially offset by a decline in communications and media. Revenue growth was driven by Italy, Austria, and France, partially offset by a decline in the United Kingdom. In Growth Markets, we delivered 5% revenue growth in local currency, driven by growth in chemicals and natural resources, public service, and banking and capital markets. Revenue growth was led by Japan. Moving down the income statement. Gross margin for the quarter was 33.6% compared to 32.9% for the first quarter of last year. Sales and marketing expense for the quarter was 10.5% compared with 9.8% for the first quarter of last year. General and administrative expense was 6.4% compared to 6.6% for the same quarter last year. Before I continue, I want to note that in Q1, we recorded $140 million in costs associated with our business optimization actions, which decreased operating margin by 90 basis points and EPS by $0.17. The following comparisons exclude these impacts and reflect adjusted results. Adjusted operating income was $2.7 billion in the first quarter, reflecting a 16.7% operating margin, an increase of 20 basis points from operating margin in Q1 last year. Our adjusted effective tax rate for the quarter was 23.2% compared with an effective tax rate of 23.3% for the first quarter last year. Adjusted diluted earnings per share were $3.27 compared with diluted EPS of $3.08 in the first quarter last year. Days services outstanding were 49 days compared to 42 days last quarter and 48 days in the first quarter of last year. Free cash flow for the quarter was $430 million, resulting from cash generated by operating activities of $499 million, net of property and equipment additions of $69 million. Our cash balance at November 30th was $7.1 billion compared with $9 billion at August 31st. With regards to our ongoing objective to return cash to shareholders, in the first quarter, we repurchased or redeemed 3.8 million shares for $1.2 billion at an average price of $311.90 per share. At November 30th, we had approximately $5.4 billion of share repurchase authority remaining. Also in November, we paid a quarterly cash dividend of $1.29 per share for a total of $810 million. This represents a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.29 per share to be paid on February 15th, a 15% increase over last year. So, in closing, we remain committed to delivering on our long-standing financial objectives, growing faster than market and taking share, generating modest margin expansion and stronger earnings, while at the same time investing at scale for our long-term market leadership, generating strong free cash flow and returning a significant portion of that cash to shareholders. And now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, KC. As we begin our second quarter, we remain laser-focused on creating value for our clients. The pace of spending continues to be impacted by the macro environment. Our business in the UK in particular, in Q1, saw even greater challenges than we expected last quarter. The fundamentals of our industry remain unchanged. All strategies continue to lead to technology and companies need to reinvent every part of their enterprise using tech, data and AI to optimize operations and accelerate growth. To do so, they must build a digital core. Strategy and consulting, which brings our deep industry and functional expertise is critical to how we differentiate by helping our clients ensure they drive business value from their digital core. We are continuing to see significant demand in areas like cloud migration and modernization, modern ERP and data and AI, including GenAI, platforms and security, all of which represent areas of great opportunity and is still early with more digital core to be built in the future than has been done to date. Let me bring to life the significant opportunities still ahead with examples from the quarter. Our cloud momentum continued in Q1 with strong double-digit growth, reflecting the ongoing significant market opportunity. We estimate only 40% of enterprise workloads are in the cloud, of which only 20% or so are modernized, an 80% opportunity remaining. Clients are continuing to prioritize the digital core as evidenced by strong demand for cloud migration. We're working with a leading insurance provider to continue their cloud transformation. Together, we are migrating hundreds of applications to a cloud-based platform, enabling the company to exit their data centers by 2025. To date, we have migrated more than half of their apps to the cloud. And this is not just a migration. We are modernizing applications and accelerating automation to integrate disparate data more easily from acquisitions and help the company move into new markets. And we are helping reshape their organizational mindset, drive cultural change and find new ways of working, including the creation of a new IT service model to lead complex transformations with agility and speed. This transformation will reduce legacy complexity and technical debt, enable more cost effective back-office operations, and drive growth and innovation, ultimately helping the company provide more affordable and personalized insurance solutions for families and businesses. And for those clients who have made significant progress on their migration, they are investing to modernize and innovate across the cloud continuum, extending cloud to the edge, unlocking greater value with more opportunities still ahead. For example, we recently announced an expansion of our strategic partnership with McDonald's to help it execute their technology strategy and leverage the company's scale to unlock greater speed and efficiency for customers, restaurant teams and employees. This new work supports McDonald's ambition to connect restaurants worldwide with cloud technology and apply generative AI solutions across McDonald's platforms. Accenture also will support the acceleration of automation innovation and the enhancement of the digital capabilities of McDonald's employees. Accenture's deep understanding of the McDonald's business, industry and technology will help unlock opportunities in their ongoing digital investments as McDonald's reinvents the customer experience and stays ahead of their customers' changing needs. Turning to data and AI. We estimate that less than 10% of companies have mature data and AI capabilities. This is a critical part of building the digital core and we see this embedded in our larger transformations, in work focused on data and AI modernization and in the opportunities of generative AI. We help leaders such as BBVA, a global financial services group, to stay ahead of the curve by continuing to reinvent its business model with GenAI. For example, we are building a GenAI-powered financial coach assistant to help them disrupt customer centricity in the banking industry while they reinvent their digital core to also become even more efficient. This work is a continuation of our ongoing GenAI implementation which is transforming BBVA's operations and digital marketing and is helping employees be more productive. Thanks to its strong digital core, BBVA can continue to reinvent across their enterprise by applying GenAI. We're also helping a global hospitality group to support its content production capability and marketing communications across its hotel brands, tailoring content to guests' evolving needs. This new data-driven content supply chain model will create personalized, flexible and efficient marketing communications content across every customer touchpoint. Spanning both physical and digital communications, this service will be available to all marketing professionals enabling content production management from its initial brief to performance measurement and content optimization. This will increase the effectiveness of its digital marketing programs, drive more traffic to its branded website, and deliver exceptional customer experiences, all while reducing costs. Platforms are a core component of the digital core and are critical to our clients' transformations. We estimate 60% of the opportunity is still ahead as clients upgrade their core platforms. We are working with OCBC Group, a Singapore-based multinational banking and financial services corporation, on a two-year transformation journey to modernize their human resources organization. We will shift key HR functions such as hiring, talent management, and career development to the cloud and create a next-generation HR operating model with enhanced capabilities. Together, we will drive operational efficiency with a strategic focus on future talent readiness, employee experience, and AI-driven decision-making. And by providing a scalable framework to meet evolving business needs, we'll free up HR capacity to provide high-value advisory work and empower business and HR leaders with analytics and insights to facilitate better talent decisions. Security is also essential to a digital core, and we continue to see very strong double-digit growth in our security business this quarter. While the opportunity to continue to grow and expand, we estimate that currently only 36% of business leaders are confident that their organizations are cyber resilient, representing at least 64% of untapped potential. An example of our important work with our clients to build secure organizations is Fortrea, a global contract research organization of about 19,000 people that provides clinical trial and research services for life sciences companies in more than 90 countries. We're working with Fortrea to deliver database outcomes and health-related insights, which require adherence to regional and local industry and government regulations. As they continue to grow and enter new markets, they need a partner to ensure that their cybersecurity program remains resilient and compliant with security best practices. We will co-create, architect, and operate a series of global cybersecurity services and capabilities through our managed services. Our partnership will help Fortrea grow its business, utilizing flexible risk and security strategies. We are focused on helping clients reimagine marketing and their customer experience to drive growth. Song demand continues to remain strong with double-digit growth in Q1. We are collaborating with Peugeot, a French automotive brand, to lead strategic and creative direction for its global communications. The partnership supports Peugeot's ambition to engage a younger audience and become a leader in the electric vehicle market. Accenture Song will manage global communications across all traditional and digital media channels. The first campaign will be a full 360 integrated launch of the all-new electric fastback SUV E-3008 in early 2024. Finally, we continue to see strong demand for digital manufacturing and engineering services. We estimate that only 5% of enterprises have scaled, matured digital capabilities across their organizations. Industry X grew strong double digits in Q1. We are working with a leading global -- a leading German multinational car manufacturer to engineer the next generation of infotainment system. Using our deep industry expertise and software engineering capabilities, we will support the implementation of a new flexible platform that enables the next level of in-car experience with cutting-edge customer features while minimizing complexity and maximizing the software we use across hardware generations. We're working with a global food manufacturer on a total enterprise reinvention strategy to modernize its supply chain, reduce operating costs, and position it for the future. We will transform key supply chain processes such as planning, procurement, manufacturing, and distribution. AI and intelligent automation will optimize end-to-end supply chain operations and achieve greater efficiency and agility. It will also help the company leverage data for better decision making and implement portfolio optimization to ensure the right assets are focused on for investment to maximize returns and minimize risks. This self-funded program is expected to generate significant productivity gains with ongoing savings fueling further capability builds and bottom-line growth. Back to you, KC."
},
{
"speaker": "KC McClure",
"text": "Thanks, Julie. Now, let me turn to our business outlook. For the second quarter of fiscal '24, we expect revenues to be in the range of $15.4 billion to $16 billion. This assumes the impact of FX will be about negative 0.5% compared to the second quarter of fiscal '23 and reflects an estimated negative 2% to positive 2% growth in local currency. For the full fiscal year '24, based upon how the rates have been trending over the last few weeks, we continue to assume the impact of FX on our results in U.S. dollars will be about flat compared to fiscal '23. For the full fiscal '24, we continue to expect our revenue to be in the range of 2% to 5% growth in local currency over fiscal '23, with the inorganic contribution now expected to be more than 2%. We continue to expect business optimization actions to impact fiscal '24 GAAP operating margin by 70 basis points and EPS by $0.56. The following guidance for full year '24 excludes these impacts. For adjusted operating margin, we continue to expect fiscal year '24 to be 15.5% to 15.7%, a 10 basis point to 30 basis point expansion over adjusted fiscal '23 results. We continue to expect our annual adjusted effective tax rate to be in the range of 23.5% to 25.5%. This compares to an adjusted effective tax rate of 23.9% in fiscal '23. We continue to expect our full year adjusted earnings per share for fiscal '24 to be in the range of $11.97 to $12.32 or 3% to 6% growth over adjusted fiscal '23 results. For the full fiscal '24, we continue to expect operating cash flow to be in the range of $9.3 billion to $9.9 billion, property and equipment additions to be approximately $600 million, and free cash flow to be in the range of $8.7 billion to $9.3 billion. Our free cash flow guidance reflects a free cash flow to net income ratio of 1.2. Finally, we continue to expect to return at least $7.7 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open it up so we can take your questions. Katie?"
},
{
"speaker": "Katie O'Conor",
"text": "Thanks, KC. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Your first question comes from the line of Jason Kupferberg from Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"text": "Good morning, guys. Happy holidays. I just wanted to start with a question on the revenue guidance for Q2. The midpoint there would suggest 1 point of deceleration, but we do have an easier comparison, and there was a return to positive growth in consulting bookings. So, just hoping you can help us reconcile that and then maybe comment on the second half reacceleration that is continuing to be implied in the guide, maybe slightly steeper than previously thought. Thank you."
},
{
"speaker": "KC McClure",
"text": "Yeah, great. Thanks, Jason. Happy holidays to you, too. So first, let me first start in terms of our guidance. I'll first start with Q1. And as you heard us say, we were really pleased with our Q1 performance. And as you stated, our Q2 guidance is the same as Q1. And maybe a couple of things that I'll point out compared to what we thought 90 days ago, and as Julie mentioned, we do see some differences in EMEA, particularly in the UK, where we're focused on repositioning the business back to growth, and that's going to take some time. But Jason, what is the same is that we are still operating in an environment, which is the same that we described last quarter, where the discretionary spend and the decision making is slow. And so right now, as you expect, and you know that we do this every year, we're talking to our clients right now about their '24 budgets. And so that's all, again, to be expected. When we look forward into H2, to start with just what the math is, we continue to see higher growth in the back half of the year. That's going to start with higher growth in Q3. And our confidence in our H2 increased growth is really based on a few things. Again, reiterating what we talked about at the beginning of the year versus our results in Q1, so we're confident, again, that we were able to deliver across the board as we expected in the first quarter. And also then, as Julie mentioned quite a bit, we made a lot of investments in our business in the quarter, and that's helping us pivot to higher growth areas. In addition to that, as we talked about last quarter, the same remains, we do have our revenue positioned in the back half of our year from these larger transformation deals. So that has not changed. We continue to see that. And then, we just need to continue to layer in our new sales as we get closer to the back half of the year. So, we're really very pleased to reiterate the 2% to 5% revenue guidance that we had at the beginning of the year."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay. That's helpful. And just as a quick follow-up, what should we expect in terms of second quarter bookings for consulting and management -- managed services year-over-year? I know managed services has a particularly tough comp. Thanks again."
},
{
"speaker": "KC McClure",
"text": "Yeah. So, Jason, I know I've been giving color and basically kind of guiding to future quarter bookings, but as you know really well covering up for so long, bookings can really be lumpy. So, I'm not going to give that color anymore, go forward. What I would say is the best way to think about demand for our business is the revenue guide that we give. And we gave revenue guidance for the second quarter as well as our 2% to 5% for the full year. And obviously, we'll continue to do that. And I'll just put in that we do feel good about our pipeline. We have a very solid pipeline."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tien-Tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Hey, perfect. Yeah, I just want to follow up to Jason's question just with the bookings, which is better than expected, and your large deal backlog is quite large now. Just the visibility on the timeliness of those conversions? Have you seen any signs of pushout or delays or that kind of thing? Just trying to understand the conversion potential."
},
{
"speaker": "KC McClure",
"text": "Yeah. So maybe just a couple of things on that. So I think, conversion can be really mainly impacted by the mix, right? So, the mix of deals that we have. So, let's just start with, overall, we haven't seen any change in the conversion based on the mix of work. So, strategy and consulting which converts faster than with operations. There's been no change within those different parts of our business, no change in the conversion. What we have talked about, and we've been consistent, that there's really been -- there's no change over the last 90 days in our discretionary spend environment, and that is consistent with our expectations. So -- and we haven't been reliant, and we're not reliant on a change in that macro to get to our full-year guidance. So, what does that mean? Hopefully you guys can hear me. The lower -- a little trouble in the line. Okay. Is that there -- as we have lower discretionary spend, that does impact the conversion, Tien-Tsin, as you know, but we have factored that all into our guidance."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Understood, KC. Thanks for that. And just my quick follow-up. I know you've been really busy with acquisitions, and Julie, you listed a bunch of them. Is there a change here in the rhythm of acquisitions or your appetite? It sounds like the revenue contribution is up a nudge, but -- up a little bit. But you tell me. I didn't know if there was a change in your thinking here on the deal. Thanks."
},
{
"speaker": "KC McClure",
"text": "Yeah. I'm going to maybe give a little bit of color and then I'll certainly hand it over to Julie. Just more from a financial perspective, I think -- and as you know this really well, but our competitive advantage really is our investment capacity that allows us to pivot to higher areas of growth. And we can do that and invest through every cycle, and you've seen us do that. And I really think that is clearly a differentiator for us. You see that with our strong start this quarter. Julie talked about the 12 acquisitions, $800 million of spend, and we have five more that we've announced for Q2. All of that, and we're reconfirming op margin expansion of 10 basis points to 30 basis points. I think it's important to see that in terms of our strategy, we're continuing to do this to really fuel organic growth. And lastly, I think one of the parts that really distinguishes us is our capital allocation framework, which is durable yet flexible. So, we're able to flex up and do inorganic to the degree that we see that we'd like to, while at the same time, continuing to increase our return to our shareholders. So, I think it's really, really great."
},
{
"speaker": "Julie Sweet",
"text": "Great. Yeah. And there's no change in the strategies in the sense of we're still trying to -- we're still investing to either scale in hot areas or add new types of skills. So, you see that we're executing in capital projects like we described, right? In August, we did the -- yeah, in August, we did the Anser Advisory. We just added Canada. And then, of course, adding the niche skills in consulting and whether it's industry or functional. So, no change in strategy. But I would reiterate that it is really a huge competitive advantage for us that we can invest across the cycles. You saw that we did that in the first year after the pandemic, where we significantly increased, and again, always to drive organic growth and position ourselves for those next waves. So, you're going to see the AI acquisitions. You saw health in the UK, another great area of growth, capital projects. So, think about our strengths here is how we accelerate pivoting to growth."
},
{
"speaker": "KC McClure",
"text": "And then, I'll just add, Tien-Tsin, that you heard me mention in guidance, that we are going to do now more than 2% in organic contribution for this year."
},
{
"speaker": "Julie Sweet",
"text": "Yeah."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Yeah. No, I'm sure you'll amplify the growth of what you buy. Just wanted to check on that. That's helpful. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ashwin Shirvaikar from Citi. Please go ahead."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Thanks, and congratulations on the performance. Happy holidays from me. I wanted to ask about, as you have conversations with your clients with regards to budget and spending priorities into next year, if you can comment, first of all, on that? And then, it's only a couple of quarters since sort of the GenAI kind of took hold, but it's a fast-moving technology, and I want to kind of inquire into whether the nature of those discussions has changed or become more meaningful, gone past proofs of concept and so on."
},
{
"speaker": "Julie Sweet",
"text": "Great. And happy holidays to you, too. Great question. So first, with respect to -- on your first point around what's happening in the market on client budgets is what I would say is that we're having lots of discussions that are pretty similar to what we've been talking about, which is, how do you prioritize in a more cautionary environment? So, we'll really know how that will play out in January as always because this is when we -- they finalize. But what I'd say is it's a consistent thing I've been talking about, which is in a cautionary environment, in a tough macro, we're helping clients prioritize. And they're in the things that we talked about in the script again today, things like building the digital core. It's using the technology to drive both growth and cost. And I would just say on the macro side, right, is that, our clients, we recognize you cannot cut yourself to growth. And if you think about the examples that I used in today's script, most of them were both cost and growth, right? Because that is what our clients are focused on, is how are they going to grow revenue despite whatever the environment is. And that, of course, is our unique capabilities to be able to do both. And then, with respect to GenAI, so first of all, I just want to say $450 million in sales this quarter, we're very pleased with. I mean, it demonstrates we are leading here. All of last year, it was $300 million. And to your point, the conversations are changing. You have examples like BBVA, which we talked about earlier in my script, where we're starting to use it at scale. Our clients want to get out of proofs of concept to material value, and we're super well positioned. Why? GenAI is not plug and play. It is not just technology. In fact, it's closer to any other technology. Think about cloud, that's farther away from the heart of the business. In order to scale, you have to deeply understand the technology, which is still rapidly changing, and the business value. And this is Accenture's leadership position, right? We have strategy. We have consulting, deep industry and functional expertise. We're the biggest partner with every major player. We're working with them at a product level and we can bring those two things together. So, think of 2024 as being the shift for our clients from experimentation to scale, and we believe we're at the best position to lead that shift to value."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Understood. I want to ask also about operations performance. It did decelerate meaningfully. I think it was high-single-digit growth, and now it's flat. Is that also a reflection you mentioned just now, maybe a pivot from cost savings to revenue generation maybe is beginning? Is that what's happening or are there other factors in here?"
},
{
"speaker": "KC McClure",
"text": "Yeah. Maybe just in terms of the quarter performance, operations came in as expected. As we talked about at the beginning of the year, Ashwin, we do have some impacts in CMT that impact operations, and so we'll see that growth may fluctuate as we go throughout the year. As part, though, of our overall guidance for the full year of managed services continuing to be mid-single to high-single-digit growth for the year."
},
{
"speaker": "Julie Sweet",
"text": "Yeah. And in fact, I would say, it's the opposite. Operations, which was impacted, by the way, by CMT, for example, look, it's going to build similar to the way Accenture is going to build over the course of the year. Actually, the sweet spot of operations is that it does both cost and growth. So, the BBVA example includes operations, Fortrea includes operations. So, these are -- our managed services are highly strategic because they are typically able to do both. Think about IT transformation. Our managed services are as much about modernizing. So, in IT, modernized tech is what drives growth. So, we really see our strength being that our managed services are strategic. And one of the reasons is that we do them in the context of understanding the industry and the function. So, we're not back office. We're bringing that strategy and consulting expertise to make sure that it isn't just a cost play. And that's an important differentiator for us."
},
{
"speaker": "Ashwin Shirvaikar",
"text": "Got it. Thank you both."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Bergin from TD Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi, guys. Good morning. Happy holidays. I wanted to start on your some of the expectations around shorter cycle and discretionary work within S&C and SI. Do you have a sense of stabilization forming there or cuts still occurring in those areas? And maybe can you give us a sense on how you expect consulting to do in the second quarter?"
},
{
"speaker": "Julie Sweet",
"text": "Yeah. So, look, we're -- as KC said earlier, we're operating kind of the same environment we have for the last few quarters, right? Discretionary spend is down. And we're right in the middle of the budget cycle, so next quarter, we'll have a much better view of what's there. But if you sort of look around in the environment, there aren't a lot of green shoots on the economic side. And obviously, the volatility on the geopolitical side continues. And so, as KC said, we're not planning right now for kind of a change in the macro, which means that we're not planning for a change in discretionary spending. We just don't see that being meaningfully different as we go into 2024. And obviously, we'll update you. But that's why when you think about the question earlier on revenue conversion, our level of smaller deals is just down. It's going to stay down for a while, which means that how revenues going to -- how sales are going to bleed into revenue is going to be consistent with what we've been seeing. So -- and then, you want to comment?"
},
{
"speaker": "KC McClure",
"text": "Yeah. Just in terms of, Bryan, on the overall growth, there's no change from what we said at the beginning of the year in terms of our full-year outlook for consulting type of work. We see low-single-digit positive growth for the full year. That's in our 2% to 5%. And Q1 came in as we expected, which was negative 2%."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. That's helpful. And then, just a clarification around the M&A. So first, I don't know if you mentioned M&A in the first quarter, the contribution to growth, and we're saying greater than 2% for the full year. Just to be clear, that's just rounding around 2% or upwards of 3%? Thanks."
},
{
"speaker": "KC McClure",
"text": "Yeah. So, we're saying more than 2% for the full year, and it can fluctuate by quarter, so we really just stick to our guidance for the overall year."
},
{
"speaker": "Julie Sweet",
"text": "Right. And if we get close to 3%, we'll talk about that. But right now it's more than 2%."
},
{
"speaker": "KC McClure",
"text": "More than 2%."
},
{
"speaker": "Julie Sweet",
"text": "Right. Because we gave you guidance, so it's down definitely more than 2%. And remember, we only do deals that we think are good deals. So, what we see right now is a lot of good deals that is going to get us to above 2%. And if that -- we have a lot of financial flexibility, so if that changes, we'll update if it gets above 3%."
},
{
"speaker": "Bryan Bergin",
"text": "Thanks. Happy holidays."
},
{
"speaker": "Julie Sweet",
"text": "Happy holidays."
},
{
"speaker": "KC McClure",
"text": "Same to you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Dave Koning from Baird. Please go ahead."
},
{
"speaker": "Dave Koning",
"text": "Yeah. Hey, guys. Thanks so much. One thing I noticed, I guess, gross margin growth, year-over-year expansion in gross margin was the strongest in about nine quarters or so. Is that just lower attrition, offshore shift? Maybe walk through why that's gotten nicely better."
},
{
"speaker": "KC McClure",
"text": "Yeah. Hey, Dave. Thanks for the question. So, as you know, we run our business to operating margin, which we did 20 basis point expansion this quarter. And I will mention that if I didn't already, that the 10 basis point to 30 basis point that we have for the year, we might see more variability as we go throughout the quarters. But now back to gross margin, you're right, we did see expansion this quarter, but it's really hard to look at that in isolation. And why is that? Well, there's various things that can go in and out of gross margin in terms of increased or decreased spend. So, for example, one would be acquisitions. There's a lot of -- some of the investment acquisitions, some of that spend will go into gross margin, and that can be lumpy as we go throughout. As you know, it also depends on where people spend their time. So for example, you saw that, yes, we had improvement in gross margin, but then we also had increased sales and marketing costs, which is a result of people spending more time out in the market selling to create the $18.4 billion in sales that we have. So that's why -- again, we look at those components, but really at the end of the day, we always continue to run our business to op margin."
},
{
"speaker": "Dave Koning",
"text": "Got you. Thanks for that. And then, maybe as a follow-up just to Jason's question at the beginning on kind of the back-end loaded growth. If I just put in normal sequential patterns in Q3 and Q4, I get to about 2% constant currency, so the low-end of guide. Is there a scenario given bookings were really good this quarter that it actually, the progression sequentially in the back half of the year is better than normal and then that kind of gets to the better parts of the guidance range for revenue?"
},
{
"speaker": "KC McClure",
"text": "Yeah. So, I think, obviously when you do -- what you're just kind of talking about is a bit of the math. What I would tell is give you the year-over-year way we look at it in terms of our guidance, right? So, we had 1% growth this quarter with strong bookings, right, 1% revenue growth with strong bookings. We see Q2 shaping up the same way year-over-year. And again, just reinforcing that we do see fuel in our sequential growth in the back half of the year based on the transformation deals that we have signed. That's no different than what we talked about at the beginning of the year. We've layered in then the sales that we expect as we go throughout. And that -- there's no difference to how we're doing our range that gets us to the 2% to 5% range. I would say at the top end of our range, again, as we said, last quarter, just when we said guidance, that when -- to get to the top end of our guidance range, you would see S&C reconnecting with growth would be one thing that we'd see. And you would probably also see the mid- to high-single digits that we've been referencing consistently in managed services be more like high-single digits. So hopefully that helps, Dave."
},
{
"speaker": "Dave Koning",
"text": "Yeah, that's helpful. Thanks, guys. Nice job."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Bryan Keane from Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hi, guys. Good morning. I just wanted to ask on the clarification on the UK market in particular. I know the economy has been weak there for a couple years. So -- and I know it's been a call out for kind of the quarter. What exactly happened in the UK? And then, what's the outlook for that?"
},
{
"speaker": "Julie Sweet",
"text": "In the UK, as you said it, it has been kind of challenge for a couple of years, and we have a big banking capital markets business there, and we're really trying to pivot to more growth there in other areas. That's why you saw the acquisitions that we did, for example, this quarter. And what we're seeing is that it's just taking longer than we anticipated to really move into the other areas. And banking capital markets, which we've talked about, has been more challenged, particularly in the UK. And so, it's really about how long it's taking us to pivot. And we think it's going to take some time. So, I'm not going to call exactly when, but we do think it's going to take some time, and it's taking more time than we anticipated going into the fiscal year. So, we've got a good team. We're on it. And again, this is where you're going to see us do more acquisitions to diversify our business there as we reposition that."
},
{
"speaker": "KC McClure",
"text": "Yeah. Maybe just also, Bryan, just for context, it's about 6% of our overall business, a little bit more than $4 billion that we have in the UK."
},
{
"speaker": "Bryan Keane",
"text": "Got it. No, that's helpful. And then, KC, just to make sure we understand, the comments on the margins, given the movement in acquisition and the pick of an acquisition, there could be some fluctuations in given quarters. You're not going to have it perfectly 10 -- in the range of 10 basis points to 30 basis points per quarter. Any quarters to call in particular where it could fall below the range given the ramp of acquisitions and the ramp of investments? Thanks."
},
{
"speaker": "KC McClure",
"text": "Yeah. I don't want to really guide to the quarter because 10 basis points or 20 basis points on a quarter, that's spend, Bryan, as you know. That's kind of big and small in terms of the dollar amount that we're talking about. So, we're going to guide overall to the full year of 10 basis points to 30 basis points for the full year. And I just wanted to point out that we might have some periods where it's just a little bit more variable than what you've seen us do over the years."
},
{
"speaker": "Bryan Keane",
"text": "Got it. Thank you. Happy holidays."
},
{
"speaker": "KC McClure",
"text": "Thanks, Bryan."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Darrin Peller from Wolfe Research. Please go ahead."
},
{
"speaker": "Darrin Peller",
"text": "Hey, thanks guys. Just want to touch on headcount growth. I mean, it's still -- I think it's still a bit decelerating. And so, what are the expectations going forward, I mean, just given the backdrop of an acceleration on the revenue in the second half of the year? And then, Julie, maybe we could just touch on the linearity of the business one more time. Just if we could revisit the mix of the kind of business you're seeing now and the revenue per head you'd expect, or maybe just directionally, what you'd anticipate based on the mix we're seeing and what demand is for?"
},
{
"speaker": "KC McClure",
"text": "Yeah. So, thanks for that, Darrin. So, I'll talk about -- in terms of our people, in terms of number of people we have, first, I'll start with, as you know, managing supply-demand is really our core competency. And you can see that in our ability to manage our utilization at high levels. And I'll just point out that for the last 13 quarters, our utilization has been 91% or higher. And so, we hire for the skills that we need and we hire where we need them. And what you're pointing out is that we had about a 1% increase year-over-year in our headcount, as well as about a 1% sequentially. And that's in-line with what we -- how we see revenue going for the rest of the year. So there's really no change there. And as it relates to the revenue per head and the non-linearity, I mean, we do have automation. We do have value-based projects. So, while there still is a, obviously, connection to the amount of people that we have, we have been able to break that. There are parts where we are able to not fully disconnect, but not completely rely on headcount to drive revenue."
},
{
"speaker": "Julie Sweet",
"text": "And Darrin, in terms of just demand, right, so I'd kind of anchor to, first of all, we're seeing demand for transformational deals. So, in an environment like this, the thing that I look at most is, are we continuing to have our clients do more than $100 million of bookings, right, which is in our industry, we are a real standout here. And what does that mean? That means that we continue to be at the heart of where clients are spending to do material transformations. That's where you want to be so that you're positioned when inevitably discretionary spending, the pace goes back up, the macro changes, you want to be at the heart. So, at times like this, that's what I'm really looking at. And that's where you're seeing -- I will tell you, this is one of the most exciting times in the market. Like you just take what we are announcing today on McDonald's. I talked about in the script, right? Incredible company, technology driven. We've been their long-time partner. Just expanded the partnership to take it all the way to the edge and reinvent their restaurants and their crew experience. This is going to be really cutting work at the edge, because that's where we're starting to see the leaders in cloud go, and we're leading there. Those are the kinds of things that then you see how they're going to expand. There's so much opportunity still in these big areas of cloud, of data, and AI. But cloud itself, yes, we've done a lot of migration. There's still more migration to go, but even more importantly, you've got to take it all the way to the edge. So, from a demand perspective, we continue to see the transformations that move the needle for cost and growth, and that's what we're expecting. From a mix perspective, we're not seeing a big change between managed services and consulting. The mix we're seeing is that in this environment, you're seeing less of the smaller deals, which convert to revenue faster, and more on the larger deals. And that's been around for a while, and that's what you're going to continue to see. And we are laser-focused on making sure we are winning in the reinvention, the transformation, and at the same time massively pivoting to GenAI, right? And our clients have so much work to do to be able to use GenAI, but you can see the momentum in our business, right, from that change from $300 million of all of last year to $450 million in a quarter. And I'll just remind you, that's not the pull-through. That's not data. We are very pure because we really want to be sharing with all of you where is GenAI in the market. So, we're pretty excited about where we are today and what's ahead."
},
{
"speaker": "Darrin Peller",
"text": "That's really helpful. Look, you guys have obviously managed well through what was a softer discretionary demand environment. So, I guess, my question would be, if we thought about what a normalized run rate of revenues on really S&C would be, if we just said today's a normal, no longer softer discretionary environment, where do you think the difference is? I mean, I know it's probably hard to give an exact or precise estimate, but how much upside is there when we get that back?"
},
{
"speaker": "Julie Sweet",
"text": "Well, we have a good -- a really strong strategy in consulting business. And so, we're very positive about that business growing. But beyond that, I think, Darrin, we're not going to start to predict growth rates. But in the meantime, it is a huge differentiator. Nobody has that combination that we have, and that is what is driving the resilience of our business to be at the core of our clients' agenda. Thanks so much, Darrin."
},
{
"speaker": "Darrin Peller",
"text": "Great. Thanks, guys."
},
{
"speaker": "Katie O'Conor",
"text": "Operator, we have time for one more question, and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Okay. That question comes from the line of James Faucette from Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Great, thank you so much. I want to just ask a couple of follow-up questions to those that have already been asked. First on the inorganic contribution, appreciate that it's going to be better than 2%. Can you talk a little bit about whether that increased activity is -- or how you would balance that increased activity between just better valuations and more opportunities from a purely financial perspective in the market versus it sounds like some of the acquisitions you're doing, you're just trying to push into new strategic areas, and just wondering how you're balancing those strategic imperatives versus perhaps a little better valuations?"
},
{
"speaker": "Julie Sweet",
"text": "Yeah. I mean, I wouldn't call out -- I wouldn't say that this activity is because of better valuations, right? At any given time when we look at the market, right, and we see where are the growth opportunities, we want to move quickly and we look at organic versus inorganic ways of moving quickly. We never do anything purely inorganic, right, or purely organic. And so, think about our acquisitions as being matched to what is the opportunity in the market and what's the best way to capture that growth quickly, right? And so, the strategy of categories is the same, right? So, there are new areas that we want to go into, like capital markets. That's an investment decision. We go into a certain number of those. We're executing now with rigor. We went and bought Anser Advisory. Now we bought the next one in Canada, right? So that's just about -- it's a great growth area and we're trying to pivot. And the best way to do that to build something that we don't have already organically is to make some inorganic acquisitions and then that becomes organic growth and we're able to kick in our recruiting machine. If you think about the UK, health is a great area. We just bought a health company, right? So, you look at the market and you say, \"If I want to diversify, what's the fastest way to diversify into new areas?\" And that's where often inorganic can help us do that through these niche acquisitions and consulting and industry. And then, you've got just massive opportunities like cloud and security, where you saw some of those acquisitions in supply chain. And that's all about both adding phenomenal talent quickly and scaling to go after a market that's today, right? So, that's how we think about it. It's extremely rigorous. We always have a decision what's the best way to get there organically or inorganically. And inorganic is always about acceleration and driving organic growth. So, it's very consistent. We've been doing it in a very disciplined way. And in these kinds of environments, we believe the companies that invest win. And that is why we do actions like we did last year to increase our business resilience and enable us to be really well positioned to invest when others are not."
},
{
"speaker": "James Faucette",
"text": "That's great color. I appreciate that. And similarly, just on bookings activity and AI contribution, there are clear acceleration in the AI level of activity, et cetera. When you're talking to clients and that kind of thing, how are they thinking about AI budget allocation versus other initiatives, et cetera, right now? Are they looking at it as, \"Hey, this is an incremental investment that we need to be making given the pace of change in technology,\" or are they trying to really use that spend or have that spend be to offset some other projects maybe that they're going to curtail a little bit sooner? Just trying to think about as that continues to build, how we should think about it being incremental versus substitutive within a lot of the budgets."
},
{
"speaker": "Julie Sweet",
"text": "Right now we're seeing a lot of reprioritization, right, because -- I mean, obviously the market is growing. Like, we're growing. The market is growing. So, spending in technology is increasing. It's not increasing as fast as it was increasing a couple of years ago, right? So, spending on technology is increasing. But within that, you're seeing more prioritization. And our research, everybody's research is saying, hey, more spending on AI. For lots of companies, it's also more spending mostly on building that digital core, because many companies don't have the data estates in order -- they're not in the cloud. They don't have the data in order to use the GenAI. So, think of it as a real focus on building a digital core to enable as well. So, market is still growing. It's more about prioritization of where that spending is going. Okay. Great. Thank you so much. So, in closing, I want to thank all of our shareholders for your continued trust and support in all of our people for what you do every single day. And I wish everyone a happy and a healthy holiday season. Thank you for joining today."
},
{
"speaker": "Operator",
"text": "That does conclude your conference for today. Thank you for your participation and for using AT&T Teleconference. You may now disconnect."
}
] | Accenture plc | 972,190 |
ACN | 2 | 2,025 | 2025-03-20 08:00:00 | Operator: Good day, and welcome to Accenture's Second Quarter Fiscal 2025 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note today's event is being recorded. I would now like to turn the conference over to Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead.
Katie O'Conor: Thank you, operator, and thanks, everyone for joining us today on our second quarter fiscal 2025 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer, and Angie Park, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. Angie will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before Angie provides our business outlook for the third quarter and full fiscal year 2025. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie.
Julie Sweet: Thank you, Katie, and everyone joining this morning, and thank you to our more than 800,000 people around the world for their extraordinary work and commitment to our clients, which resulted in a very strong quarter, creating 360-degree value for all our stakeholders. Starting with our quarter, we are very pleased with our results as we continue to deliver on our strategy to return to strong growth in FY ‘25. I will share some highlights from the quarter and then turn to an update on new developments since we were together in December in our federal business and the current environment more broadly. Our clients continue to prioritize large scale transformations and we are their reinvention partner of choice as reflected in our bookings of $20.9 billion, including 32 clients with quarterly bookings greater than $100 million. We grew 8.5% in local currency with revenue of $16.7 billion at the top end of our guided range and we continue to take market share on a rolling four quarter basis against our basket of our closest global publicly traded competitors, which is how we calculate market share. We had another milestone quarter in Gen AI with $1.4 billion in new bookings and approximately $600 million in revenue. Operating margin contracted 20 basis points compared to adjusted operating margin last year, and we delivered EPS growth of 2% over Q2 FY ‘24 adjusted EPS. We continue to invest significantly in our business to drive additional growth in highly strategic areas with over $250 million deployed primarily across six strategic acquisitions and we invested in our people with approximately 15 million training hours this quarter, designed to help us bring the latest in solutions and technology to our clients, provide our people with marketable skills, and reinvent our services using Gen AI. We increased our data and AI workforce to approximately 72,000, continuing progress against our goal of 80,000 by the end of FY 2026. We continue to invest in creating and maintaining thriving communities, which is a component of our long-term growth strategy. This quarter, in India, we launched a transformative hospitality skilling program in collaboration with our client, Marriott International, which prepares disadvantaged use (ph) for entry-level jobs in the hospitality sector, including training for digital skills. Because we help our clients execute on some of their most important priorities, and we need to attract and retain the best people, recognition of Accenture as an ethical and admired company is critical for our clients' confidence and to attract these great talent. We are pleased that we have been recognized by Ethisphere, as one of the World's Most Ethical Companies for the 18th year in a row and for the third consecutive year, we ranked number one in our industry and among the top five overall on JUST Capital America's Most Just Companies. In addition, thanks to our clients, partners, and the wider business community, we earned the number one position in our industry for the 12th year in a row and number 30 overall, our highest paid on Fortune's list of the World's Most Admired Companies. Now for two updates. First, Accenture Federal Services. Federal represented approximately 8% of our global revenue and 16% of our Americas revenue in FY ‘24. As you know, the new administration has a clear goal to run the Federal government more efficiently. During this process, many new procurement actions have slowed, which is negatively impacting our sales and revenue. In addition, recently, the General Service Administration has instructed all federal agencies to review their contracts with the top 10 highest paid consulting firms contracting with the U.S. government, which includes Accenture Federal Services. The GSA's guidance would determinate contracts that are not deemed mission critical by the federal -- by the relevant federal agencies. While we continue to believe our work for federal clients is mission critical, we anticipate ongoing uncertainty as the government's priorities evolve and these assessments unfold. Based on our significant experience across federal and commercial clients, we see major opportunities over time for us to help consolidate, modernize, and reinvent the federal government to drive a whole new level of efficiency. Second, in recent weeks, we are seeing an elevated level of what was already significant uncertainty in the global economic and geopolitical environment, marking a shift from our first quarter FY ‘25 earnings report in December. At the same time, we believe the fundamentals of our industry remain strong and we are very well positioned with our clients because all strategies continue to lead to reinvention through new ways of working, tech, data, and AI. We are confident in executing our strategy to help clients reinvest. As you would expect, we are laser focused on bringing tremendous value to our clients. Our strengths lie in our agility as the market we operate and changes, utilizing our deep client and ecosystem relationships and our leading position in Gen AI and technology more broadly. We are also well diversified across markets, industries, and types of work, which enables us to continue to lead in a changing market context as we have done before. Over to you, Angie.
Angie Park: Thank you, Julie, and thanks to all of you for taking the time to join us on today's call. We were very pleased with our results in the second quarter, particularly our continued strong top line growth, which was once again broad based across geographic markets, industry groups, and consulting and managed services. Let me begin by summarizing a few highlights from the quarter. Revenues grew 8.5% in local currency, which was at the top end of our guided range, with nine of our 13 industries growing high-single digit or higher, and we continue to take market share. We delivered EPS in the quarter of $2.82, reflecting 2% growth over adjusted EPS last year. Operating margin of 13.5% for the quarter decreased 20 basis points compared to adjusted Q2 results last year and includes significant investments in our people and our business. Finally, we delivered free cash flow of $2.7 billion and returned $2.4 billion to shareholders through repurchases and dividends. In the first half of the year, we have invested almost $500 million, primarily attributed to 11 acquisitions. With those high level comments, let me turn to some of the details starting with new bookings. New bookings were $20.9 billion for the quarter, a 3% decrease in U.S. dollars and flat in local currency with an overall book-to-bill of 1.3. Consulting bookings were $10.5 billion with a book-to-bill of 1.3. Managed Services bookings were $10.4 billion with a book-to-bill of 1.2. Turning now to revenues. Revenues for the quarter were $16.7 billion, a 5% increase in U.S. dollars and 8.5% in local currency. The foreign exchange impact for the quarter was approximately negative 3% compared with a negative 2.5% estimate provided last quarter. Consulting revenues for the quarter were $8.3 billion, up 3% in U.S. dollars and 6% in local currency. Managed Services revenue were $8.4 billion, up 8% in U.S. dollars and 11% in local currency, driven by double-digit growth in technology managed services, which includes application managed services and infrastructure managed services, and high-single digit growth in operations. Turning to our geographic markets. In Americas, revenues grew 11% in local currency, growth was led by banking and capital markets, industrial, health, and consumer goods, retail, and travel services. Revenue growth was driven by the United States. In EMEA, we delivered 8% growth in local currency, led by growth in public service, life sciences and consumer goods, retail, and travel services. Revenue growth was driven by the United Kingdom. In Asia-Pacific, revenue grew 1% in local currency, driven by growth in insurance and utilities, partially offset by a decline in chemicals and natural resources. Revenue growth was led by Japan, partially offset by a decline in Singapore. Moving down the income statement. Gross margin for the quarter was 29.9% compared to 30.9% for the second quarter last year. Sales and marketing expense for the quarter was 10.1% compared with 10.3% for the second quarter last year. General and administrative expense was 6.3% compared to 6.9% for the same quarter last year. Before I continue, I want to note that in Q2 of last year, we recorded $115 million in costs associated with our business optimization actions, which decreased operating margin by 70 basis points in EPS by $0.14. The following comparisons exclude these impacts and reflect adjusted results. Operating income was $2.2 billion in the second quarter, reflecting a 13.5% operating margin, a 20 basis point decrease from adjusted operating margin in Q2 of last year. Our effective tax rate for the quarter was 20.4% compared with an adjusted effective tax rate of 18.8% for the second quarter last year. Diluted earnings per share were $2.82 compared with adjusted diluted EPS of $2.77 in the second quarter last year, reflecting 2% growth. Days services outstanding were 48 days compared to 50 days last quarter and 43 days in the second quarter of last year. Free cash flow for the quarter was $2.7 billion, resulting from cash generated by operating activities of $2.9 billion net of property and equipment additions of $171 million. Our cash balance at February 28 was $8.5 billion compared with $5 billion at the end of -- at August 31. With regard to our ongoing objective to return cash to shareholders, in the second quarter, we repurchased or redeemed 4 million shares for $1.4 billion at an average price of $361.16 per share. As of February 28, we had approximately $5 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $1.48 per share for a total of $929 million. This represented a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.48 per share to be paid on May 15, a 15% increase over last year. And now let me turn it back to Julie.
Julie Sweet: Thank you, Angie. Starting with the demand environment, our clients continue to be focused on reinvention and Gen AI is a catalyst for reinvention. They are focused on building the digital core with more AI being built-in, which is driving our growth, and on areas such as the customer and core operations, including supply chain and Industry X. For our clients, the twin themes of achieving both cost efficiency and growth continue. The number of clients embracing Gen AI is increasing significantly and we are starting to see some tangible examples of scale in data and AI. We are partnering with Telstra, Australia's leading telecommunications company to create a new joint venture to accelerate its data and AI roadmap and fast track the business into a new era of AI-driven reinvention. Through the joint venture, we will work together to simplify and modernize their data systems and set up a comprehensive AI foundation to deploy advanced AI solutions across their organization. Value driving AI use cases have been identified across the business that are suitable for scaling and will enhance network resilience, deliver seamless connectivity, and better customer experience. Using our AI Refinery platform, we will reimagine business processes by implementing Agentic AI. Specialized AI tools will support their employees to work smarter and faster and teams to operate more efficiently and effectively. In addition, we will help evolve Telstra's Data and AI Academy, a company-wide upskilling initiative leveraging our learning and development programs, helping to build data and AI fluency and feature critical skills across its workforce. Building on Telstra's globally leading responsible AI practices, the JV is designed to sustain and improve on this by identifying and mitigating AI risks while building trust and adoption as it scales AI across the organization. This partnership with Telstra illustrates to clients that there are creative ways to accelerate their own use of data and AI. Clients in Australia from banking, retail, and utilities are working with us to design their own innovative ways to jumpstart their reinvention with data and AI. We continue to see our clients building their digital core as a foundation for reinvention and increasingly asking us to incorporate emerging technologies like AI, as well as data into this work. Cloud saw double-digit growth this quarter and security had very strong double-digit growth. We are working together with a multinational food processing company to help reinvent themselves as a data-driven organization, revolutionizing their enterprise. This includes the end-to-end supply chain and frontline sales function to support rapid growth. Our unique partnership model uses our library of AI and Gen AI assets to quickly deliver productivity, with the potential of generating over $0.5 billion in value to self-fund their reinvention. The savings are reinvested into an ongoing build out of a robust digital core, which becomes the foundation to support and enable any new technologies, processes or systems the company may adopt in the future. For example, the company is using Gen AI to forecast inventory risks and generate next best action recommendation, saving them millions of dollars annually. If excess inventory on a product is selling slower than expected in a region, Gen AI tools proactively prompt promotional sale or halt production before the inventory results in a margin loss. In another instance, an AI-based communication platform was deployed that eliminates up to five different language barriers between supervisors and frontline workers, and plants, (ph) reducing costly errors from miscommunications and delays. With many households having at least one of their products, this company's commitment to ongoing transformation will position them to continue to build, design, and run a future ready enterprise, rethink work, and drive innovation. We are helping one of the world's largest auto manufacturers modernize their security operations to protect the company's critical IT systems and stay ahead of the rapidly evolving security landscape. We will implement a modern threat detection and response platform that will enable the company to integrate its data across the enterprise, identifying cyber threats and responding to incidents faster. We are building a new Gen AI security engine on Accenture's My Security platform, which will help automate cloud migration tasks, moving the threat detection capability from the legacy platform to the new one without interruption. This is expected to increase the company's operational excellence, enhance cyber resiliency, increase risk visibility, and drive a significant improvement in efficiency. With the new platform, the company will be able to better safeguard digital assets, including information critical to automotive design and manufacturing. This collaboration will help better protect the company, its partners, and customers setting the stage for advanced AI, smart manufacturing, and increased innovation. To capture the value of technologies like Generative AI, companies need a digital core and now to stay ahead and truly scale AI, companies also need what we call a cognitive digital brain, and always on and always learning system, as we shared in our Tech Vision 2025. Our industry expertise is critical to building the digital core and digital brain, a deep knowledge of the processes today and how they can be reinvented for tomorrow is key. Our proven track record of digital transformation and our ability to bring experience in strategy, consulting, industry, process, and technology services, and decades of experience in managed services for our clients, allows us to truly reinvent using AI, including digital agents to create transformational value at scale. We are deepening our partnership with Repsol, a leading multi-energy company and a client for more than a decade to advance its digital program and scale Agentic AI, reinventing key business operations to drive sustainable growth. Over the past three years, we have built a secured cloud based digital core with a unified data foundation. Now we will use our AI Refinery platform to deploy customized AI agents across functions such as planning, forecasting, and customer service, making processes more dynamic and less complex. Employees will be able to work more efficiently and provide customers with accurate personalized products and services. For example, AI agents can analyze available data to offer timely and relevant bundled energy solutions, enhancing Repsol's position as an integrated provider. We will upscale employees in AI and digital technologies through an expanded training program to support adoption. We are also exploring digital twins and robotic solutions to enhance planned maintenance and other tasks in industrial and logistics centers. Repsol is positioning itself as an early adopter of AI in the energy sector, increasing efficiency, boosting productivity, and promoting new ways of working to better serve customers. The transformation and digitization of manufacturing is an important area of growth and Industry X grew high-single digits this quarter. We are working with KION, a global leader in supply chain solutions to use AI powered digital twins to create smarter, safer and more adaptable warehouses that can evolve with the world around them and handle nearly any supply chain challenge, marking the next digital frontier. Picture a busy warehouse during peak shopping season, workers navigating narrow aisles and conveyor belts, forklifts, loading and unloading freight. Now imagine robots working seamlessly with human teams to fulfill orders faster and more safely. We are making this a reality by creating digital versions of physical assets such as conveyors and forklifts and integrating autonomous robots with human workers on an AI-driven platform that accurately stimulates millions of complex factory processes to help ensure safety and avoid disruptions before robots hit the factory floor. We are also predicting and adapting to real world challenges as they happen, such as how events like Black Friday sales or a product going viral might affect warehouse operations, adjusting robot brains in real-time. With these investments -- with these advancements, warehouse workers' responsibilities will evolve as they work alongside AI systems, making them more desirable candidates for higher skilled roles. Song grew double-digits this quarter as more clients seek to reinvent customer and experience. We have the unique ability to integrate creative data and AI, tech, and strategy while leveraging our industry and operations expertise to unlock marketing and sales as a growth enabler for our clients while delivering efficiencies. We are partnering with a multinational conglomerate in the communications industry to streamline and optimize their media strategy and operations for their mobile division. We've implemented a new digital platform with a unified data foundation, which will provide transparency and real time access to expedite campaign position. The company will also reduce the number of media agencies to a single partner, Accenture Song, to maximize media spend outcomes. Accenture's marketing operations Managed Services will leverage automation and AI to increase efficiencies in manual routine tasks, which will allow employees to focus on more strategic work. These changes will also allow the company to shift from focusing solely on media related data to incorporating broader insights to make more strategic and informed decisions that benefit the entire company, such as predicting customer content preferences, which can drive more efficient media placement and sales. Talent continues to be at the top of the agenda for CEOs and governments and reinvention requires working in new ways and the development of new skills. LearnVantage positions us to help to be able to help clients develop talent and skills to drive future growth. Our clients are using LearnVantage to strengthen learning development, turbocharging the learner's experience. For example, we are bridging the skills gap and creating certification pathways for learners, using LearnVantage in the Kingdom of Saudi Arabia. This will fast-track their careers and support their adoption of Gen AI. And a big box retailer has accelerated learning opportunities for entry level to highly technical skill sets, deepened understanding of current industry skills by role -- needs by role, and empowered employees with guided learning based on the skills they need for their role. Finally, a look at how we continue to execute on our goal to strategically deploy $2 billion, $3 billion in B&A this fiscal year. We are investing in our Industry X and supply chain capabilities with our acquisitions this quarter of AOX and Staufen AG in Germany. We also acquired IQT Group in Italy, a managed services provider, which will help utility providers build and modernize integrated electricity and water networks. To continue to lead in Gen AI, we acquired Halfspace in Denmark to help our clients in the Nordics region leverage and scale AI to make better, more informed decisions faster, and to enable us to scale faster in financial services, we acquired Altus Consulting in the UK, a leader in consulting and digital transformation. Also this quarter, we purchased a digital twin technology platform for banks from Percipient, a Singapore based fintech company with deep expertise in banking technology transformation. Back to you, Angie.
Angie Park: Thanks, Julie. Before I get into the details of our outlook, as Julie mentioned, we have seen an elevated level of uncertainty, including in our federal business. Because this change is very recent, our revenue guidance range for both Q3 and the full year reflects our best view based upon what we see today, which may evolve differently from our estimates and assumptions. With that said, let me turn now to the business outlook. For the third quarter of fiscal '25, we expect revenues to be in the range of $16.9 billion to $17.5 billion. This assumes the impact of FX will be about negative 0.5% compared to the third quarter of fiscal '24 and reflects an estimated 3% to 7% growth in local currency. For the full fiscal year '25, based upon how the rates have been trending over the last few weeks, we continue to assume the impact of FX on our results in U.S. dollars will be approximately negative 0.5% compared to fiscal '24. For the full fiscal '25, we now expect our revenue to be in the range of 5% to 7% growth in local currency over fiscal '24. We continue to expect an inorganic contribution of a bit more than 3% with about 4% in the first half and about 2% in the second half. And we now expect to invest about $2 billion to $3 billion in acquisitions this fiscal year. For operating margin, we now expect fiscal year '25 to be 15.6% to 15.7%, a 10 basis point to 20 basis point expansion over adjusted fiscal '24 results. We continue to expect our annual effective tax rate to be in the range of 22.5% to 24.5%. This compares to an adjusted effective tax rate of 23.6% in fiscal '24. We now expect our full year diluted earnings per share for fiscal '25 to be in the range of $12.55 to $12.79 or 5% to 7% growth over adjusted fiscal '24 results. For the full fiscal '25, we continue to expect operating cash flow in the range of $9.4 billion to $10.1 billion, property and equipment additions to be approximately $600 million, and free cash flow to be in the range of $8.8 billion to $9.5 billion. Our free cash flow guidance continues to reflect a free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $8.3 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to shareholders. As we move into the second half of the year, we remain laser focused on managing our business with rigor and discipline. With that, let's open it up, so we can take your questions.
Katie O'Conor: Thanks, Angie. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: Absolutely. [Operator Instructions] Our first question today comes from Jason Kupferberg with Bank of America. Please go ahead.
Jason Kupferberg: Good morning, guys. Thanks for all of this. So I just wanted to start outside of U.S. Federal, so the other 92% of the business. Can you just clarify to what extent you are or not seeing clients hit the pause button at all on new initiatives, any change in pace of converting pipeline to backlog or backlog into revenue? You can certainly appreciate that your tone is a little bit more cautious, maybe the visibility isn't quite as high, but are you seeing tangible signs of any pause in client activity at this point in time?
Angie Park: Hi, Jason. Good morning. Thanks for your question. For us, there's really -- we've seen no change overall.
Julie Sweet: Yeah. And, as you can imagine, some of these changes are relatively recent, and so we're in a lot of discussions. In some cases, those discussions are about accelerating, particularly in the cost discussions, right, like, can we go a little faster to get to our programs for places where we're contracting. And we are at the heart of many of the discussions where businesses are trying to process what this might mean, so -- but we're not seeing any pauses now.
Jason Kupferberg: Okay. So we got to watch and wait on that. So let's go to U.S. Federal just for a minute. Can you just clarify for us what the growth rate was in U.S. Federal revenue in the quarter and what you're assuming for the second half of the year in U.S. Federal?
Angie Park: Jason, why don't I take that because I think it's important to give a little bit of context on our Q3 and our full year guidance. And certainly, as it relates to Q2 specifically for Federal, we really don't provide that during the year, and as you know, we provide that at the end of the year. So let me just start with -- because I do think this is important. When you think about -- we were really pleased with the quarter, our second quarter and the first half of the year. And for the second quarter, we did deliver revenue at the top end of our range and we're very pleased that we were able to update our guidance to 5% to 7% by taking off the bottom. So -- and why is that? So, we're pleased with how our business is positioned with the larger deals coming online, which was a very deliberate part of our strategy. And then as you think about Q3 and the full year, it includes our current estimates and assumptions of the potential impacts of federal and the overall environment. And then, if I just break apart organic and inorganic, from an inorganic contribution, we continue to expect a bit over 3% with H2 about 2%, which is consistent with what we shared last quarter in our assumptions. And then for the year, what that means is, from an organic perspective, we now expect 2% to 4% in organic growth for the year. And by type of work to provide that context as well, consulting, we continue to expect to be in the mid-single digit range growth and we now see managed services at high-single digits.
Jason Kupferberg: Okay. Understood.
Angie Park: And importantly, and then -- Okay. Thank you.
Operator: Thank you. And our next question comes from Tien-Tsin Huang with JP Morgan. Please go ahead.
Tien-Tsin Huang: Hey. Thank you so much. So great to hear from you, Julie and Angie. Just maybe I will ask, instead of demand, I want to ask on the margin outlook and the change there. How much of that is organic versus inorganic in terms of the change? And is it just -- I'm always getting questions, is there cost -- is it just costing more to do business? Is there a cost to execution here going up? Is there a pricing change? What more can you share?
Angie Park: Sure. And as it relates -- thank you, Tien-Tsin. As it relates to inorganic, our capital deployed, we've updated -- we may be a bit lighter at $2 billion to $3 billion, but relative from a margin profile, no change there. And so let me just peel this back a little bit. In this quarter, we did see a decrease in our gross margins, primarily due to higher subcontractor costs and the impact of our business optimization actions, which reduced severance costs in Q2 of last year. And as you know, this fluctuates quarter-to-quarter, which is really why we manage the overall operating margin. And as you think about our operating margin for the year, based upon where we are, we now expect a 10 basis points to 20 basis points expansion for the year, while continuing to invest significantly in our business and our people. And look, we're seeing the variability in the operating margin throughout the year that we expected. So what are we focused on? Pricing, which this quarter was relatively stable. How we deliver our contracts and how we run our business, which includes managing supply and demand and digitizing and making our own operations more efficient. So we feel really good about our full year guidance of 10 basis points to 20 basis points, which includes EPS growth at 5% to 7%.
Julie Sweet: Yeah. And, Tien-Tsin, we always update -- we typically update about this time. We just don't see -- we didn't see the 30 basis points. It's a super competitive market. So while pricing is relatively stable as we've been talking about, it's a competitive market, so.
Tien-Tsin Huang: Got it. No, that's all clear. Thanks for going through that. Just my follow-up, I think Jason asked about Federal already. Is there -- maybe to ask it differently, just is there a way to frame the real revenue at risk? I know mission-critical is, maybe hard to define it here on the call, but is there anything that you can share in terms of what's really at risk or not at risk thinking about duration or is it really more of an issue of replenishing work, etc.? Just trying to get a better understanding of visibility there. Thank you.
Angie Park: Sure. And so, Tien-Tsin, what I would say is, and what we've been clear about is the guided range we're giving for the quarter and for the year reflects our best view of the impact that's coming from both the slowing of new procurement actions and the assessments of the work that we're doing, and so we don't get into different pieces of it, but [Technical Difficulty] those two things, the range of outcomes and that's reflected in the range. I mean, it is 8% of our business. We have lots of other parts of our business that are about that size that we are always looking at estimates and assumptions. And so this is our best view of it today and the range reflects it.
Tien-Tsin Huang: Got it. Your view is better than mine and glad to see the bottom end of the range taken up here. Thank you.
Operator: Thank you. And our next question comes from Bryan Keane of Deutsche Bank. Please go ahead.
Bryan Keane: Hey, guys. Thanks for taking the questions. I guess my first one is, Julie, just thinking about how budgets were set and how conversations may be changed from January, February to March, could you give us some color on that?
Julie Sweet: Yeah. I'd start with, as we went into this calendar year, we did not see kind of -- like kind of across the board a meaningful increase in budgets for our services. So we saw more of the same, which is consistent with what we've been talking about, and as we went into the budgets -- as the budgets were set, it was kind of more of the same. And it's pretty early right now in terms of processing, right, what just happened and there's a lot of different things that can happen, right? So you sometimes see clients reprioritizing like maybe they'll go faster on the cost cutting than on some of the building in that, and it -- even those -- that kind of a conversation, it's super early, right? And so what we are seeing though is a continuation that these conversations always turn to, okay, we got to go faster and we got to go bigger. And this theme around cost and growth because that's really the unique way that we can help clients. So one of the examples that I gave in the script around a major manufacturer of food supplies is all about like when you are better managing inventory and supply chain, that's both driving growth and at the same time, self-funding big transformation programs. So I think right now, if you think about just what is the impact of an elevated level of uncertainty, it's the same thing as what we've been seeing like, more desire to do larger transformation. And while we're at it, because I'm sure the question will come, discretionary spending this quarter, Q2 was overall about the same, still constrained. There were some pockets of improvement, for example, in banking and capital markets in the Americas, but again, going into the calendar year, discretionary spending was overall about the same constraint, and particularly in small deals that we've been seeing. So yeah, that's kind of where we are.
Angie Park: And I would just add, Julie, thanks for that. I would just add that as you think about our guidance for the full year as well, and what it assumes is discretionary spend does not have to improve at the top end of the range, while it continues to allow for further deterioration at the bottom.
Bryan Keane: Yeah, Angie. As my follow-up, I was going to ask, if you take the midpoint of that third quarter constant currency revenue, you get to about 5%. It implies fourth quarter revenue range looks a little wider than usual and maybe a couple of points lower than the third quarter. So just kind of what's built-in? Are you building in a little bit of a slowdown in organic growth in that fourth quarter or is that just some level of elevated uncertainty that goes into the fourth quarter number? Thanks so much.
Angie Park: Bryan, your math is right. So we have seen an elevated level of uncertainty, and so we spoke about that. And you're correct that if you think about our inorganic contribution of a bit more than 3% for the full year, it was roughly 4% in the first half. We're expecting about 2% in the second half, which means, really importantly, that our organic growth for the full year is now 2% to 4%.
Bryan Keane: Okay. Thanks so much.
Operator: And our next question comes from David Koning with Baird. Please go ahead.
David Koning: Yeah. Hey, guys. Good job. And I guess my first question, health and public services typically is kind of flattish sequentially in Q2. It was down about 5% sequentially and I guess kind of asking Jason's question too, is some of that U.S. Federal or are there other parts of health and public services that were weaker than normal? I'm just trying to understand that.
Julie Sweet: Hi, David. Good morning. Nothing to read into that. We didn't see any material impact within H&PS, it just ebbs and flows over the quarters, so nothing to really comment there.
David Koning: Okay. And just as a follow-up, I think you might have mentioned pricing was pretty stable. I looked back the last seven quarters, you called pricing as being down a bit. I mean, are we starting to get back to a more stable environment for pricing?
Julie Sweet: So as you think about our pricing, we did comment that it was relatively stable. The market continues to be very competitive. And so what you can count on us to do is, we're always focused on it. And just as a reminder, pricing is the contract profitability or margin on the work that we sell.
David Koning: Yeah. Great. Thanks, guys.
Julie Sweet: Thank you.
Operator: And our next question today comes from James Faucette with Morgan Stanley. Please go ahead.
James Faucette: Great. Thank you very much. As we talk about the little bit of the slowdown that you've seen in recent weeks, how would you characterize it geographically or industry vertical? Just trying to get a little more color there. And what do you think those customers are looking for in terms of their proceed or continue to pause or hesitate type of decision making?
Julie Sweet: Thanks, James. I want to be clear, we haven't seen a slowdown in the last few weeks. What we commented on, which I think is kind of everyone is well aware of is in the last few weeks, there's been an elevated level of what was already significant uncertainty and there's a couple of big themes around that, obviously tariffs, and that's a global discussion that is not just an Americas discussion. And also consumer sentiment, which is a little bit more of an Americas discussion. And so we're really just commenting on what I think we're all seeing and that's only been in the last few weeks, and so we're already, of course, in the heart of the discussions of clients globally who are talking about it. And you're seeing, for example, in Europe, there was an announcement of like major spending in areas like defense where we've been investing and are well-positioned, and by the way, I do want to shout out to my UK team. Hopefully, all of you noticed that the UK is back and we're driving our revenue, and it's a great example of how we address challenges by leveraging our ability to invest. We've done a lot of acquisitions there. The agility, the use of data, and AI, which are all driving the repositioning that you're starting to now see in the UK. So again, we have a lot of diversification of our business. And when you think about the Americas and the agenda now in federal with respect to consolidating, modernizing, and reinventing the federal government, we're incredibly well-positioned because we've been driving already a lot of efficiency in the federal government with the work we've been doing for decades. And we're now bringing that reinvention that we've been doing now for a few years, those commercial solutions, we've got the ability to bring that to the federal government as they move forward with their agenda. So diverse -- the conversation is global. Lots of opportunities depend on the market and we have a really strong position, and I'll just flag again the 32 clients this quarter who did over $100 million of bookings.
James Faucette: That's great and great clarification there. I appreciate that. And then wanted to touch quickly on your AI and AI initiatives, etc. Can you give a little bit of color of how that's developing with your software partners? What kinds of improvements or adjustments in go-to-market that may entail? Just trying to get a sense for how you're working with the broader ecosystem to really drive results.
Julie Sweet: Well, James, the ecosystem is absolutely critical here and this is where decades of relationships really matter, because this is -- Gen AI is a new technology. The adoption of AI more broadly is new. It wasn't being adopted as much, and so we work so closely with our partners and the client really in three-way conversations and work in order to reinvent and do that. This is not -- we're not taking things off the shelf and say, here go do this. And, as you know, we are the leader in ecosystem -- with our ecosystem partners and that has been a major differentiating factor when you look at our growth, particularly in these large deals where the ecosystem is absolutely at the heart of it. And by the way, I'm glad that you look -- you commented on the Gen AI because I think it's important as we think about how Gen AI is developing that we don't walk past, that in H1, we did $1.1 billion in revenue, and last year, in FY ‘24, we did $900 million for the entire year. So you're starting to see the leadership that we have in Gen AI really come through on the revenue side.
James Faucette: Thank you.
Operator: Thank you. And our next question today comes from Bryan Bergin with TD Cowen. Please go ahead.
Bryan Bergin: Hi. Good morning. Thank you, Julie. Hope you're feeling well. I want to start on bookings. Can you just give us a sense on 2Q bookings? How they landed relative to your plan? Understanding just elevated uncertainty may extend signings, I'm just curious if that did in fact play out in 2Q? And can you comment on how you feel you're set up for the second half in bookings?
Julie Sweet: Well, just as a reminder, that elevated uncertainty has been in the last few weeks and so, no impact on our bookings. And Angie, do you want to add anything?
Angie Park: Hi, Bryan. So for us, we were pleased with our bookings this quarter of $20.9 billion, and importantly, our book-to-bill was 1.3. And again, reinforcing and being the partner of choice for our clients with 32 clients with quarterly bookings over $100 million, so we feel really good about that.
Bryan Bergin: Okay. And then on the workforce, can you comment on how you're managing that mix of subcontractors versus employees? And is that higher sub-con mix in the quarter just some form of a transition component as you've taken actions on bench across the organization or are there certain service types where you're having to lean a little bit more on that sub-con mix?
Angie Park: Bryan, I think that as you think about our sub-contractor and our workforce mix, certainly that can fluctuate quarter-to-quarter based upon the work that we're doing for our clients, and as it relates to this quarter, you saw that we added about two -- a little bit over 2,000 people in Q2. And as always, what we are all about is managing our supply and demand, including through the use of technology and reskilling. And so for us -- as you think about our workforce overall, sub-contractors can fluctuate and at the same time, what we focus on is our utilization, which continues to be 91%, which is exactly the range that we want to be in.
Bryan Bergin: Okay. Understood. Thank you.
Julie Sweet: Thank you.
Operator: And our next question is coming from Keith Bachman at BMO Capital Markets. Please go ahead.
Keith Bachman: Yes. Good morning. Thank you. Perhaps I'll ask my two just concurrently since they're on similar veins. On the first one, one of the previous questions was asking about AI, more from the demand side or revenue side, I wanted to go back to the supply side and delivery side, and while -- I think it's still really early in the life of Gen AI because most of the work is actually still test, not inferencing. But are you seeing any changes in the nature of your economic relationship with your customers? In other words, are customers asking for some of the savings or is there any change in that narrative on how the supply side and economic relationship broadly speaking with your customers may unfold as Gen AI matures a little bit? And then the second part of the question is, I wanted to just jump into Song for a bit. And sort of the same type of question. I spent the last day with Adobe and at their user group conference and there's tremendous efficiency gains associated with both marketing and creativity. And just, Julie, any comments, I know you mentioned Song had double-digit growth, which is quite impressive. How do you see the durable growth rate of Song? And so that's it for me. And Julie, all the best to you in particular.
Julie Sweet: Thanks, Keith. So I think in the first question, what we've been seeing with Gen AI is what we've seen in the past when we have new technologies, like, I take you back to 2015 when we first announced MyWizard, which we now call GenWizard, as we've introduced Gen AI and that was that major shift that occurred with respect to automation, which by the way is still relevant, right? And so that -- we are not seeing a different change. We've been continuously -- remember like, particularly, on the managed service side, our contracts assume that there's going to be more efficiency driven from technology. Gen AI is allowing that to kind of go up over time. But like the way that the model is working is just very similar to what we've seen with prior waves of big efficiencies from technology. So we're not seeing new patterns evolve there. And of course, we are -- really our strategy is to lead in both helping our clients use Gen AI, but also to lead in our own use of Gen AI. And at the same time, it is still early in the technology. It's still expensive. So you have to get to the right ROI, in terms of when to use it. It requires our clients to have foundations in place. This isn't just sort of push a button and we can have Gen AI, and so we should expect that -- remember that this is still a very early in the technology cycle. Excuse me, with respect to Song, one of the big areas that we're helping our clients on is build the data foundation in order to use the Gen AI because those efficiencies that you're seeing, and as you know, we're Adobe's major partner, require the right data foundation and they require really the reinvention of processes. We've seen that in our own marketing where we've been using Agentic AI, but you had to completely change the way that you're doing marketing. And so Song's durability is being at the heart of building the digital core and helping them do the reinvention while leading in our own use of Gen AI, which is what we continue to be focused on. So I feel very good about Song. And importantly, our diversification is we want to be relevant to all parts of the enterprise and the growth agenda, which is what Song positions us in addition to our entire -- the ability to be at the core operations and at the enterprise. So really very pleased with how our strategy to be relevant across the enterprise continues to give us resilience in the market.
Keith Bachman: Thank you, Julie.
Julie Sweet: Thank you.
Operator: Thank you. And our next question today comes from Jonathan Lee at Guggenheim Partners. Please go ahead.
Jonathan Lee: Great. Thanks for taking our questions. I want to clarify the change in the revenue outlook here. Your original outlook contemplated status quo at the high end of the outlook, is that still the case? And is that indexed to what you're seeing today with the elevated uncertainty, but not necessarily any sort of slowdown?
Angie Park: Hi, Jonathan. Thanks for the question, and yes, that's correct. So with our assumptions, the range of 5% to 7%, which we raised for the full year is that discretionary spend, does not have to improve at the top end of the range, and while at the bottom of the range, it allows for further deterioration.
Jonathan Lee: Thanks for that color, Angie. And then on the pricing front, it's good to hear about the pricing stability you're seeing despite the competitive environment. How do we think through the timing in which it takes stable pricing to flow through the P&L, especially as it looks like we're still digesting some of the pricing headwinds we've been seeing over the last few quarters?
Angie Park: As you think about pricing, it does take time for it to layer in, and certainly, it depends on the mix of the deals that we're selling as well. So we'll see that come through over time.
Jonathan Lee: Appreciate that.
Angie Park: Thank you.
Katie O'Conor: Operator, we have time for one more question, and then Julie will wrap up the call.
Operator: Thank you. Our final question comes from Darrin Peller at Wolfe Research. Please go ahead.
Darrin Peller: Guys, thanks. And Julie, I just want to wish you -- echo that and wish you my best as well. When we think about what we're seeing in terms of the larger transformational contracts that benefit -- that are benefiting you so much this year despite slower discretionary or not a real improvement in discretionary yet. Just remind us again where you are on that path. I mean, again, bookings was a question before. It was up one or -- maybe it was more or less flat year-over-year, but your book-to-bill is still very strong, obviously. And so just help us understand what you're seeing in terms of the most transformational contracts right now that can give us room despite sort of whatever outcomes are on the discretionary. And then one quick follow-up. Julie, I know when we spoke last, you talked about how there was so much in terms of like waiting by executive CIOs, CEOs, and others on tariffs and some of the policies you talked about earlier, if we do get some resolution on that in the next couple of months, April 2, could be a big day for the administration in terms of explaining. I mean, how much have you heard from your customers on how much they're just really waiting? There's pent-up demand budget. Just help us understand that a little more if you can.
Julie Sweet: Sure. So on the demand side, the 32 clients with bookings over $100 million just continue to show that we're executing on that strategy, but what clients want to buy are larger transformational deals. They want the reinvention and we continue to execute on that too again because that's like -- we're going where the demand is, right? So that same sort of view of continuing to make sure, having those larger deals that will continue to layer in is the strategy and really no change there because that's the demand, right? And we need to be focused on where clients are buying. And then again, what I would say on the -- how things might layer in. CEOs are actually focused on how do I succeed regardless of the level of uncertainty. So the conversations we're having are not, hey, what happens if the tariffs that -- this gets resolved, etc., it's okay. We have a higher level of uncertainty than we did 90 days ago, and so how do we then reinvent faster, right? What do we need to shift to? CEOs, and this is not from -- this has been going on for now for a few years, right? They're embracing that their responsibility is to grow regardless of what has been, in my tenure as CEO, in the last six years, a series of a lot of different events. And that's why as we think about our own business, right? We continue to anchor on the characteristics that have allowed us to be the leader over these different cycles, that's the deep client relationships. Our top 100 clients we've been with for over 10 years, the diversification of geographies, industries, I do want to give a shout out to all my industry teams. The industry groups all -- we had broad based growth, but it allows us for that diversification as well as types of work and then the all-important ecosystem relationships and our leadership in Gen AI and technology. Those are the building blocks of our resilient business and we all, our CEOs and ourselves have to be agile to succeed in whatever market and that is what our range reflects. The fact that we took the bottom off of the range reflects our belief in our resilient model as we continue to navigate.
Darrin Peller: That's really helpful, Julie. Just a quick follow-up would be on AI, again on DeepSeek, just given the developments. I mean, has there been more of an emphasis around it just given the ability to use even more efficient systems or just help us understand in terms of -- I know you've said before, 10% of customers might actually have the infrastructure ready. So we still have a lot of work to do to prepare. Has there been an acceleration in the momentum or is it the same as it was the last couple of quarters? Thanks again, guys.
Julie Sweet: Thank you very much. We are seeing increasing numbers of clients embracing Gen AI. And really that is, in our view, DeepSeek is an interesting development. It's an example of the ongoing technology developments, but the reason they're embracing it is that they're seeing the proven value and that is why we continue to grow because we're the ones in our client base helping our clients get to that value. And you saw that in a lot of the examples we've been giving. So there's an increasing number of clients embracing it as companies are seeing it and there is no view that you can sit back, right, and wait on this. And that two years in, is very evident in our conversations with clients.
Darrin Peller: Thank you.
Julie Sweet: Well, thank you again for joining. Before we wrap up, I have two updates. First, as many of you know, last month, I did announce that I had recently been diagnosed with breast cancer. Just want to let everyone know I'm feeling good. My treatment is on-track and my prognosis continues to be excellent. I have received so many well wishes, including on this call and I just want to thank everyone for all of their support. It has meant a lot. I also want to thank Katie O'Conor, our Head of Investor Relations. She has been an amazing partner to me and to Casey, and to now Angie for the last three years. We've asked her to take on a very important new role as the CFO of Avanade, our joint venture with Microsoft. I know we're all going to miss her in this role and we're super excited to see Katie take on this next chapter of her very impressive career. So thank you very much, Katie. And I'm also very pleased to welcome Alexia Quadrani, who will become our new Head of Investor Relations. Alexia joins us from the Walt Disney Company, where she was the Executive Vice President of Investor Relations and Shareholder Services. And prior to that, she spent over 20 years as an Equity Analyst at JP Morgan. I know she's really looking forward to getting to know all of you in the days ahead and I'm super happy to welcome her to Accenture. And finally, in closing, I want to thank all of our shareholders for your continued trust and support. We are working every day to continue to earn that trust. And finally, a huge thank you to all of our people for what you're doing every day, and I will speak with all of you next quarter. Thanks again for joining.
Katie O'Conor: Thank you.
Operator: Thank you. The conference has now concluded, and we thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to Accenture's Second Quarter Fiscal 2025 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today's presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note today's event is being recorded. I would now like to turn the conference over to Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Katie O'Conor",
"text": "Thank you, operator, and thanks, everyone for joining us today on our second quarter fiscal 2025 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer, and Angie Park, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. Angie will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the second quarter. Julie will then provide a brief update on our market positioning before Angie provides our business outlook for the third quarter and full fiscal year 2025. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook are forward-looking and as such are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our annual report on Form 10-K and quarterly reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in this call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures where appropriate to GAAP in our news release or in the Investor Relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Katie, and everyone joining this morning, and thank you to our more than 800,000 people around the world for their extraordinary work and commitment to our clients, which resulted in a very strong quarter, creating 360-degree value for all our stakeholders. Starting with our quarter, we are very pleased with our results as we continue to deliver on our strategy to return to strong growth in FY ‘25. I will share some highlights from the quarter and then turn to an update on new developments since we were together in December in our federal business and the current environment more broadly. Our clients continue to prioritize large scale transformations and we are their reinvention partner of choice as reflected in our bookings of $20.9 billion, including 32 clients with quarterly bookings greater than $100 million. We grew 8.5% in local currency with revenue of $16.7 billion at the top end of our guided range and we continue to take market share on a rolling four quarter basis against our basket of our closest global publicly traded competitors, which is how we calculate market share. We had another milestone quarter in Gen AI with $1.4 billion in new bookings and approximately $600 million in revenue. Operating margin contracted 20 basis points compared to adjusted operating margin last year, and we delivered EPS growth of 2% over Q2 FY ‘24 adjusted EPS. We continue to invest significantly in our business to drive additional growth in highly strategic areas with over $250 million deployed primarily across six strategic acquisitions and we invested in our people with approximately 15 million training hours this quarter, designed to help us bring the latest in solutions and technology to our clients, provide our people with marketable skills, and reinvent our services using Gen AI. We increased our data and AI workforce to approximately 72,000, continuing progress against our goal of 80,000 by the end of FY 2026. We continue to invest in creating and maintaining thriving communities, which is a component of our long-term growth strategy. This quarter, in India, we launched a transformative hospitality skilling program in collaboration with our client, Marriott International, which prepares disadvantaged use (ph) for entry-level jobs in the hospitality sector, including training for digital skills. Because we help our clients execute on some of their most important priorities, and we need to attract and retain the best people, recognition of Accenture as an ethical and admired company is critical for our clients' confidence and to attract these great talent. We are pleased that we have been recognized by Ethisphere, as one of the World's Most Ethical Companies for the 18th year in a row and for the third consecutive year, we ranked number one in our industry and among the top five overall on JUST Capital America's Most Just Companies. In addition, thanks to our clients, partners, and the wider business community, we earned the number one position in our industry for the 12th year in a row and number 30 overall, our highest paid on Fortune's list of the World's Most Admired Companies. Now for two updates. First, Accenture Federal Services. Federal represented approximately 8% of our global revenue and 16% of our Americas revenue in FY ‘24. As you know, the new administration has a clear goal to run the Federal government more efficiently. During this process, many new procurement actions have slowed, which is negatively impacting our sales and revenue. In addition, recently, the General Service Administration has instructed all federal agencies to review their contracts with the top 10 highest paid consulting firms contracting with the U.S. government, which includes Accenture Federal Services. The GSA's guidance would determinate contracts that are not deemed mission critical by the federal -- by the relevant federal agencies. While we continue to believe our work for federal clients is mission critical, we anticipate ongoing uncertainty as the government's priorities evolve and these assessments unfold. Based on our significant experience across federal and commercial clients, we see major opportunities over time for us to help consolidate, modernize, and reinvent the federal government to drive a whole new level of efficiency. Second, in recent weeks, we are seeing an elevated level of what was already significant uncertainty in the global economic and geopolitical environment, marking a shift from our first quarter FY ‘25 earnings report in December. At the same time, we believe the fundamentals of our industry remain strong and we are very well positioned with our clients because all strategies continue to lead to reinvention through new ways of working, tech, data, and AI. We are confident in executing our strategy to help clients reinvest. As you would expect, we are laser focused on bringing tremendous value to our clients. Our strengths lie in our agility as the market we operate and changes, utilizing our deep client and ecosystem relationships and our leading position in Gen AI and technology more broadly. We are also well diversified across markets, industries, and types of work, which enables us to continue to lead in a changing market context as we have done before. Over to you, Angie."
},
{
"speaker": "Angie Park",
"text": "Thank you, Julie, and thanks to all of you for taking the time to join us on today's call. We were very pleased with our results in the second quarter, particularly our continued strong top line growth, which was once again broad based across geographic markets, industry groups, and consulting and managed services. Let me begin by summarizing a few highlights from the quarter. Revenues grew 8.5% in local currency, which was at the top end of our guided range, with nine of our 13 industries growing high-single digit or higher, and we continue to take market share. We delivered EPS in the quarter of $2.82, reflecting 2% growth over adjusted EPS last year. Operating margin of 13.5% for the quarter decreased 20 basis points compared to adjusted Q2 results last year and includes significant investments in our people and our business. Finally, we delivered free cash flow of $2.7 billion and returned $2.4 billion to shareholders through repurchases and dividends. In the first half of the year, we have invested almost $500 million, primarily attributed to 11 acquisitions. With those high level comments, let me turn to some of the details starting with new bookings. New bookings were $20.9 billion for the quarter, a 3% decrease in U.S. dollars and flat in local currency with an overall book-to-bill of 1.3. Consulting bookings were $10.5 billion with a book-to-bill of 1.3. Managed Services bookings were $10.4 billion with a book-to-bill of 1.2. Turning now to revenues. Revenues for the quarter were $16.7 billion, a 5% increase in U.S. dollars and 8.5% in local currency. The foreign exchange impact for the quarter was approximately negative 3% compared with a negative 2.5% estimate provided last quarter. Consulting revenues for the quarter were $8.3 billion, up 3% in U.S. dollars and 6% in local currency. Managed Services revenue were $8.4 billion, up 8% in U.S. dollars and 11% in local currency, driven by double-digit growth in technology managed services, which includes application managed services and infrastructure managed services, and high-single digit growth in operations. Turning to our geographic markets. In Americas, revenues grew 11% in local currency, growth was led by banking and capital markets, industrial, health, and consumer goods, retail, and travel services. Revenue growth was driven by the United States. In EMEA, we delivered 8% growth in local currency, led by growth in public service, life sciences and consumer goods, retail, and travel services. Revenue growth was driven by the United Kingdom. In Asia-Pacific, revenue grew 1% in local currency, driven by growth in insurance and utilities, partially offset by a decline in chemicals and natural resources. Revenue growth was led by Japan, partially offset by a decline in Singapore. Moving down the income statement. Gross margin for the quarter was 29.9% compared to 30.9% for the second quarter last year. Sales and marketing expense for the quarter was 10.1% compared with 10.3% for the second quarter last year. General and administrative expense was 6.3% compared to 6.9% for the same quarter last year. Before I continue, I want to note that in Q2 of last year, we recorded $115 million in costs associated with our business optimization actions, which decreased operating margin by 70 basis points in EPS by $0.14. The following comparisons exclude these impacts and reflect adjusted results. Operating income was $2.2 billion in the second quarter, reflecting a 13.5% operating margin, a 20 basis point decrease from adjusted operating margin in Q2 of last year. Our effective tax rate for the quarter was 20.4% compared with an adjusted effective tax rate of 18.8% for the second quarter last year. Diluted earnings per share were $2.82 compared with adjusted diluted EPS of $2.77 in the second quarter last year, reflecting 2% growth. Days services outstanding were 48 days compared to 50 days last quarter and 43 days in the second quarter of last year. Free cash flow for the quarter was $2.7 billion, resulting from cash generated by operating activities of $2.9 billion net of property and equipment additions of $171 million. Our cash balance at February 28 was $8.5 billion compared with $5 billion at the end of -- at August 31. With regard to our ongoing objective to return cash to shareholders, in the second quarter, we repurchased or redeemed 4 million shares for $1.4 billion at an average price of $361.16 per share. As of February 28, we had approximately $5 billion of share repurchase authority remaining. Also in February, we paid a quarterly cash dividend of $1.48 per share for a total of $929 million. This represented a 15% increase over last year. And our Board of Directors declared a quarterly cash dividend of $1.48 per share to be paid on May 15, a 15% increase over last year. And now let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie. Starting with the demand environment, our clients continue to be focused on reinvention and Gen AI is a catalyst for reinvention. They are focused on building the digital core with more AI being built-in, which is driving our growth, and on areas such as the customer and core operations, including supply chain and Industry X. For our clients, the twin themes of achieving both cost efficiency and growth continue. The number of clients embracing Gen AI is increasing significantly and we are starting to see some tangible examples of scale in data and AI. We are partnering with Telstra, Australia's leading telecommunications company to create a new joint venture to accelerate its data and AI roadmap and fast track the business into a new era of AI-driven reinvention. Through the joint venture, we will work together to simplify and modernize their data systems and set up a comprehensive AI foundation to deploy advanced AI solutions across their organization. Value driving AI use cases have been identified across the business that are suitable for scaling and will enhance network resilience, deliver seamless connectivity, and better customer experience. Using our AI Refinery platform, we will reimagine business processes by implementing Agentic AI. Specialized AI tools will support their employees to work smarter and faster and teams to operate more efficiently and effectively. In addition, we will help evolve Telstra's Data and AI Academy, a company-wide upskilling initiative leveraging our learning and development programs, helping to build data and AI fluency and feature critical skills across its workforce. Building on Telstra's globally leading responsible AI practices, the JV is designed to sustain and improve on this by identifying and mitigating AI risks while building trust and adoption as it scales AI across the organization. This partnership with Telstra illustrates to clients that there are creative ways to accelerate their own use of data and AI. Clients in Australia from banking, retail, and utilities are working with us to design their own innovative ways to jumpstart their reinvention with data and AI. We continue to see our clients building their digital core as a foundation for reinvention and increasingly asking us to incorporate emerging technologies like AI, as well as data into this work. Cloud saw double-digit growth this quarter and security had very strong double-digit growth. We are working together with a multinational food processing company to help reinvent themselves as a data-driven organization, revolutionizing their enterprise. This includes the end-to-end supply chain and frontline sales function to support rapid growth. Our unique partnership model uses our library of AI and Gen AI assets to quickly deliver productivity, with the potential of generating over $0.5 billion in value to self-fund their reinvention. The savings are reinvested into an ongoing build out of a robust digital core, which becomes the foundation to support and enable any new technologies, processes or systems the company may adopt in the future. For example, the company is using Gen AI to forecast inventory risks and generate next best action recommendation, saving them millions of dollars annually. If excess inventory on a product is selling slower than expected in a region, Gen AI tools proactively prompt promotional sale or halt production before the inventory results in a margin loss. In another instance, an AI-based communication platform was deployed that eliminates up to five different language barriers between supervisors and frontline workers, and plants, (ph) reducing costly errors from miscommunications and delays. With many households having at least one of their products, this company's commitment to ongoing transformation will position them to continue to build, design, and run a future ready enterprise, rethink work, and drive innovation. We are helping one of the world's largest auto manufacturers modernize their security operations to protect the company's critical IT systems and stay ahead of the rapidly evolving security landscape. We will implement a modern threat detection and response platform that will enable the company to integrate its data across the enterprise, identifying cyber threats and responding to incidents faster. We are building a new Gen AI security engine on Accenture's My Security platform, which will help automate cloud migration tasks, moving the threat detection capability from the legacy platform to the new one without interruption. This is expected to increase the company's operational excellence, enhance cyber resiliency, increase risk visibility, and drive a significant improvement in efficiency. With the new platform, the company will be able to better safeguard digital assets, including information critical to automotive design and manufacturing. This collaboration will help better protect the company, its partners, and customers setting the stage for advanced AI, smart manufacturing, and increased innovation. To capture the value of technologies like Generative AI, companies need a digital core and now to stay ahead and truly scale AI, companies also need what we call a cognitive digital brain, and always on and always learning system, as we shared in our Tech Vision 2025. Our industry expertise is critical to building the digital core and digital brain, a deep knowledge of the processes today and how they can be reinvented for tomorrow is key. Our proven track record of digital transformation and our ability to bring experience in strategy, consulting, industry, process, and technology services, and decades of experience in managed services for our clients, allows us to truly reinvent using AI, including digital agents to create transformational value at scale. We are deepening our partnership with Repsol, a leading multi-energy company and a client for more than a decade to advance its digital program and scale Agentic AI, reinventing key business operations to drive sustainable growth. Over the past three years, we have built a secured cloud based digital core with a unified data foundation. Now we will use our AI Refinery platform to deploy customized AI agents across functions such as planning, forecasting, and customer service, making processes more dynamic and less complex. Employees will be able to work more efficiently and provide customers with accurate personalized products and services. For example, AI agents can analyze available data to offer timely and relevant bundled energy solutions, enhancing Repsol's position as an integrated provider. We will upscale employees in AI and digital technologies through an expanded training program to support adoption. We are also exploring digital twins and robotic solutions to enhance planned maintenance and other tasks in industrial and logistics centers. Repsol is positioning itself as an early adopter of AI in the energy sector, increasing efficiency, boosting productivity, and promoting new ways of working to better serve customers. The transformation and digitization of manufacturing is an important area of growth and Industry X grew high-single digits this quarter. We are working with KION, a global leader in supply chain solutions to use AI powered digital twins to create smarter, safer and more adaptable warehouses that can evolve with the world around them and handle nearly any supply chain challenge, marking the next digital frontier. Picture a busy warehouse during peak shopping season, workers navigating narrow aisles and conveyor belts, forklifts, loading and unloading freight. Now imagine robots working seamlessly with human teams to fulfill orders faster and more safely. We are making this a reality by creating digital versions of physical assets such as conveyors and forklifts and integrating autonomous robots with human workers on an AI-driven platform that accurately stimulates millions of complex factory processes to help ensure safety and avoid disruptions before robots hit the factory floor. We are also predicting and adapting to real world challenges as they happen, such as how events like Black Friday sales or a product going viral might affect warehouse operations, adjusting robot brains in real-time. With these investments -- with these advancements, warehouse workers' responsibilities will evolve as they work alongside AI systems, making them more desirable candidates for higher skilled roles. Song grew double-digits this quarter as more clients seek to reinvent customer and experience. We have the unique ability to integrate creative data and AI, tech, and strategy while leveraging our industry and operations expertise to unlock marketing and sales as a growth enabler for our clients while delivering efficiencies. We are partnering with a multinational conglomerate in the communications industry to streamline and optimize their media strategy and operations for their mobile division. We've implemented a new digital platform with a unified data foundation, which will provide transparency and real time access to expedite campaign position. The company will also reduce the number of media agencies to a single partner, Accenture Song, to maximize media spend outcomes. Accenture's marketing operations Managed Services will leverage automation and AI to increase efficiencies in manual routine tasks, which will allow employees to focus on more strategic work. These changes will also allow the company to shift from focusing solely on media related data to incorporating broader insights to make more strategic and informed decisions that benefit the entire company, such as predicting customer content preferences, which can drive more efficient media placement and sales. Talent continues to be at the top of the agenda for CEOs and governments and reinvention requires working in new ways and the development of new skills. LearnVantage positions us to help to be able to help clients develop talent and skills to drive future growth. Our clients are using LearnVantage to strengthen learning development, turbocharging the learner's experience. For example, we are bridging the skills gap and creating certification pathways for learners, using LearnVantage in the Kingdom of Saudi Arabia. This will fast-track their careers and support their adoption of Gen AI. And a big box retailer has accelerated learning opportunities for entry level to highly technical skill sets, deepened understanding of current industry skills by role -- needs by role, and empowered employees with guided learning based on the skills they need for their role. Finally, a look at how we continue to execute on our goal to strategically deploy $2 billion, $3 billion in B&A this fiscal year. We are investing in our Industry X and supply chain capabilities with our acquisitions this quarter of AOX and Staufen AG in Germany. We also acquired IQT Group in Italy, a managed services provider, which will help utility providers build and modernize integrated electricity and water networks. To continue to lead in Gen AI, we acquired Halfspace in Denmark to help our clients in the Nordics region leverage and scale AI to make better, more informed decisions faster, and to enable us to scale faster in financial services, we acquired Altus Consulting in the UK, a leader in consulting and digital transformation. Also this quarter, we purchased a digital twin technology platform for banks from Percipient, a Singapore based fintech company with deep expertise in banking technology transformation. Back to you, Angie."
},
{
"speaker": "Angie Park",
"text": "Thanks, Julie. Before I get into the details of our outlook, as Julie mentioned, we have seen an elevated level of uncertainty, including in our federal business. Because this change is very recent, our revenue guidance range for both Q3 and the full year reflects our best view based upon what we see today, which may evolve differently from our estimates and assumptions. With that said, let me turn now to the business outlook. For the third quarter of fiscal '25, we expect revenues to be in the range of $16.9 billion to $17.5 billion. This assumes the impact of FX will be about negative 0.5% compared to the third quarter of fiscal '24 and reflects an estimated 3% to 7% growth in local currency. For the full fiscal year '25, based upon how the rates have been trending over the last few weeks, we continue to assume the impact of FX on our results in U.S. dollars will be approximately negative 0.5% compared to fiscal '24. For the full fiscal '25, we now expect our revenue to be in the range of 5% to 7% growth in local currency over fiscal '24. We continue to expect an inorganic contribution of a bit more than 3% with about 4% in the first half and about 2% in the second half. And we now expect to invest about $2 billion to $3 billion in acquisitions this fiscal year. For operating margin, we now expect fiscal year '25 to be 15.6% to 15.7%, a 10 basis point to 20 basis point expansion over adjusted fiscal '24 results. We continue to expect our annual effective tax rate to be in the range of 22.5% to 24.5%. This compares to an adjusted effective tax rate of 23.6% in fiscal '24. We now expect our full year diluted earnings per share for fiscal '25 to be in the range of $12.55 to $12.79 or 5% to 7% growth over adjusted fiscal '24 results. For the full fiscal '25, we continue to expect operating cash flow in the range of $9.4 billion to $10.1 billion, property and equipment additions to be approximately $600 million, and free cash flow to be in the range of $8.8 billion to $9.5 billion. Our free cash flow guidance continues to reflect a free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $8.3 billion through dividends and share repurchases as we remain committed to returning a substantial portion of our cash to shareholders. As we move into the second half of the year, we remain laser focused on managing our business with rigor and discipline. With that, let's open it up, so we can take your questions."
},
{
"speaker": "Katie O'Conor",
"text": "Thanks, Angie. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Absolutely. [Operator Instructions] Our first question today comes from Jason Kupferberg with Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"text": "Good morning, guys. Thanks for all of this. So I just wanted to start outside of U.S. Federal, so the other 92% of the business. Can you just clarify to what extent you are or not seeing clients hit the pause button at all on new initiatives, any change in pace of converting pipeline to backlog or backlog into revenue? You can certainly appreciate that your tone is a little bit more cautious, maybe the visibility isn't quite as high, but are you seeing tangible signs of any pause in client activity at this point in time?"
},
{
"speaker": "Angie Park",
"text": "Hi, Jason. Good morning. Thanks for your question. For us, there's really -- we've seen no change overall."
},
{
"speaker": "Julie Sweet",
"text": "Yeah. And, as you can imagine, some of these changes are relatively recent, and so we're in a lot of discussions. In some cases, those discussions are about accelerating, particularly in the cost discussions, right, like, can we go a little faster to get to our programs for places where we're contracting. And we are at the heart of many of the discussions where businesses are trying to process what this might mean, so -- but we're not seeing any pauses now."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay. So we got to watch and wait on that. So let's go to U.S. Federal just for a minute. Can you just clarify for us what the growth rate was in U.S. Federal revenue in the quarter and what you're assuming for the second half of the year in U.S. Federal?"
},
{
"speaker": "Angie Park",
"text": "Jason, why don't I take that because I think it's important to give a little bit of context on our Q3 and our full year guidance. And certainly, as it relates to Q2 specifically for Federal, we really don't provide that during the year, and as you know, we provide that at the end of the year. So let me just start with -- because I do think this is important. When you think about -- we were really pleased with the quarter, our second quarter and the first half of the year. And for the second quarter, we did deliver revenue at the top end of our range and we're very pleased that we were able to update our guidance to 5% to 7% by taking off the bottom. So -- and why is that? So, we're pleased with how our business is positioned with the larger deals coming online, which was a very deliberate part of our strategy. And then as you think about Q3 and the full year, it includes our current estimates and assumptions of the potential impacts of federal and the overall environment. And then, if I just break apart organic and inorganic, from an inorganic contribution, we continue to expect a bit over 3% with H2 about 2%, which is consistent with what we shared last quarter in our assumptions. And then for the year, what that means is, from an organic perspective, we now expect 2% to 4% in organic growth for the year. And by type of work to provide that context as well, consulting, we continue to expect to be in the mid-single digit range growth and we now see managed services at high-single digits."
},
{
"speaker": "Jason Kupferberg",
"text": "Okay. Understood."
},
{
"speaker": "Angie Park",
"text": "And importantly, and then -- Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from Tien-Tsin Huang with JP Morgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Hey. Thank you so much. So great to hear from you, Julie and Angie. Just maybe I will ask, instead of demand, I want to ask on the margin outlook and the change there. How much of that is organic versus inorganic in terms of the change? And is it just -- I'm always getting questions, is there cost -- is it just costing more to do business? Is there a cost to execution here going up? Is there a pricing change? What more can you share?"
},
{
"speaker": "Angie Park",
"text": "Sure. And as it relates -- thank you, Tien-Tsin. As it relates to inorganic, our capital deployed, we've updated -- we may be a bit lighter at $2 billion to $3 billion, but relative from a margin profile, no change there. And so let me just peel this back a little bit. In this quarter, we did see a decrease in our gross margins, primarily due to higher subcontractor costs and the impact of our business optimization actions, which reduced severance costs in Q2 of last year. And as you know, this fluctuates quarter-to-quarter, which is really why we manage the overall operating margin. And as you think about our operating margin for the year, based upon where we are, we now expect a 10 basis points to 20 basis points expansion for the year, while continuing to invest significantly in our business and our people. And look, we're seeing the variability in the operating margin throughout the year that we expected. So what are we focused on? Pricing, which this quarter was relatively stable. How we deliver our contracts and how we run our business, which includes managing supply and demand and digitizing and making our own operations more efficient. So we feel really good about our full year guidance of 10 basis points to 20 basis points, which includes EPS growth at 5% to 7%."
},
{
"speaker": "Julie Sweet",
"text": "Yeah. And, Tien-Tsin, we always update -- we typically update about this time. We just don't see -- we didn't see the 30 basis points. It's a super competitive market. So while pricing is relatively stable as we've been talking about, it's a competitive market, so."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Got it. No, that's all clear. Thanks for going through that. Just my follow-up, I think Jason asked about Federal already. Is there -- maybe to ask it differently, just is there a way to frame the real revenue at risk? I know mission-critical is, maybe hard to define it here on the call, but is there anything that you can share in terms of what's really at risk or not at risk thinking about duration or is it really more of an issue of replenishing work, etc.? Just trying to get a better understanding of visibility there. Thank you."
},
{
"speaker": "Angie Park",
"text": "Sure. And so, Tien-Tsin, what I would say is, and what we've been clear about is the guided range we're giving for the quarter and for the year reflects our best view of the impact that's coming from both the slowing of new procurement actions and the assessments of the work that we're doing, and so we don't get into different pieces of it, but [Technical Difficulty] those two things, the range of outcomes and that's reflected in the range. I mean, it is 8% of our business. We have lots of other parts of our business that are about that size that we are always looking at estimates and assumptions. And so this is our best view of it today and the range reflects it."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Got it. Your view is better than mine and glad to see the bottom end of the range taken up here. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from Bryan Keane of Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hey, guys. Thanks for taking the questions. I guess my first one is, Julie, just thinking about how budgets were set and how conversations may be changed from January, February to March, could you give us some color on that?"
},
{
"speaker": "Julie Sweet",
"text": "Yeah. I'd start with, as we went into this calendar year, we did not see kind of -- like kind of across the board a meaningful increase in budgets for our services. So we saw more of the same, which is consistent with what we've been talking about, and as we went into the budgets -- as the budgets were set, it was kind of more of the same. And it's pretty early right now in terms of processing, right, what just happened and there's a lot of different things that can happen, right? So you sometimes see clients reprioritizing like maybe they'll go faster on the cost cutting than on some of the building in that, and it -- even those -- that kind of a conversation, it's super early, right? And so what we are seeing though is a continuation that these conversations always turn to, okay, we got to go faster and we got to go bigger. And this theme around cost and growth because that's really the unique way that we can help clients. So one of the examples that I gave in the script around a major manufacturer of food supplies is all about like when you are better managing inventory and supply chain, that's both driving growth and at the same time, self-funding big transformation programs. So I think right now, if you think about just what is the impact of an elevated level of uncertainty, it's the same thing as what we've been seeing like, more desire to do larger transformation. And while we're at it, because I'm sure the question will come, discretionary spending this quarter, Q2 was overall about the same, still constrained. There were some pockets of improvement, for example, in banking and capital markets in the Americas, but again, going into the calendar year, discretionary spending was overall about the same constraint, and particularly in small deals that we've been seeing. So yeah, that's kind of where we are."
},
{
"speaker": "Angie Park",
"text": "And I would just add, Julie, thanks for that. I would just add that as you think about our guidance for the full year as well, and what it assumes is discretionary spend does not have to improve at the top end of the range, while it continues to allow for further deterioration at the bottom."
},
{
"speaker": "Bryan Keane",
"text": "Yeah, Angie. As my follow-up, I was going to ask, if you take the midpoint of that third quarter constant currency revenue, you get to about 5%. It implies fourth quarter revenue range looks a little wider than usual and maybe a couple of points lower than the third quarter. So just kind of what's built-in? Are you building in a little bit of a slowdown in organic growth in that fourth quarter or is that just some level of elevated uncertainty that goes into the fourth quarter number? Thanks so much."
},
{
"speaker": "Angie Park",
"text": "Bryan, your math is right. So we have seen an elevated level of uncertainty, and so we spoke about that. And you're correct that if you think about our inorganic contribution of a bit more than 3% for the full year, it was roughly 4% in the first half. We're expecting about 2% in the second half, which means, really importantly, that our organic growth for the full year is now 2% to 4%."
},
{
"speaker": "Bryan Keane",
"text": "Okay. Thanks so much."
},
{
"speaker": "Operator",
"text": "And our next question comes from David Koning with Baird. Please go ahead."
},
{
"speaker": "David Koning",
"text": "Yeah. Hey, guys. Good job. And I guess my first question, health and public services typically is kind of flattish sequentially in Q2. It was down about 5% sequentially and I guess kind of asking Jason's question too, is some of that U.S. Federal or are there other parts of health and public services that were weaker than normal? I'm just trying to understand that."
},
{
"speaker": "Julie Sweet",
"text": "Hi, David. Good morning. Nothing to read into that. We didn't see any material impact within H&PS, it just ebbs and flows over the quarters, so nothing to really comment there."
},
{
"speaker": "David Koning",
"text": "Okay. And just as a follow-up, I think you might have mentioned pricing was pretty stable. I looked back the last seven quarters, you called pricing as being down a bit. I mean, are we starting to get back to a more stable environment for pricing?"
},
{
"speaker": "Julie Sweet",
"text": "So as you think about our pricing, we did comment that it was relatively stable. The market continues to be very competitive. And so what you can count on us to do is, we're always focused on it. And just as a reminder, pricing is the contract profitability or margin on the work that we sell."
},
{
"speaker": "David Koning",
"text": "Yeah. Great. Thanks, guys."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And our next question today comes from James Faucette with Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Great. Thank you very much. As we talk about the little bit of the slowdown that you've seen in recent weeks, how would you characterize it geographically or industry vertical? Just trying to get a little more color there. And what do you think those customers are looking for in terms of their proceed or continue to pause or hesitate type of decision making?"
},
{
"speaker": "Julie Sweet",
"text": "Thanks, James. I want to be clear, we haven't seen a slowdown in the last few weeks. What we commented on, which I think is kind of everyone is well aware of is in the last few weeks, there's been an elevated level of what was already significant uncertainty and there's a couple of big themes around that, obviously tariffs, and that's a global discussion that is not just an Americas discussion. And also consumer sentiment, which is a little bit more of an Americas discussion. And so we're really just commenting on what I think we're all seeing and that's only been in the last few weeks, and so we're already, of course, in the heart of the discussions of clients globally who are talking about it. And you're seeing, for example, in Europe, there was an announcement of like major spending in areas like defense where we've been investing and are well-positioned, and by the way, I do want to shout out to my UK team. Hopefully, all of you noticed that the UK is back and we're driving our revenue, and it's a great example of how we address challenges by leveraging our ability to invest. We've done a lot of acquisitions there. The agility, the use of data, and AI, which are all driving the repositioning that you're starting to now see in the UK. So again, we have a lot of diversification of our business. And when you think about the Americas and the agenda now in federal with respect to consolidating, modernizing, and reinventing the federal government, we're incredibly well-positioned because we've been driving already a lot of efficiency in the federal government with the work we've been doing for decades. And we're now bringing that reinvention that we've been doing now for a few years, those commercial solutions, we've got the ability to bring that to the federal government as they move forward with their agenda. So diverse -- the conversation is global. Lots of opportunities depend on the market and we have a really strong position, and I'll just flag again the 32 clients this quarter who did over $100 million of bookings."
},
{
"speaker": "James Faucette",
"text": "That's great and great clarification there. I appreciate that. And then wanted to touch quickly on your AI and AI initiatives, etc. Can you give a little bit of color of how that's developing with your software partners? What kinds of improvements or adjustments in go-to-market that may entail? Just trying to get a sense for how you're working with the broader ecosystem to really drive results."
},
{
"speaker": "Julie Sweet",
"text": "Well, James, the ecosystem is absolutely critical here and this is where decades of relationships really matter, because this is -- Gen AI is a new technology. The adoption of AI more broadly is new. It wasn't being adopted as much, and so we work so closely with our partners and the client really in three-way conversations and work in order to reinvent and do that. This is not -- we're not taking things off the shelf and say, here go do this. And, as you know, we are the leader in ecosystem -- with our ecosystem partners and that has been a major differentiating factor when you look at our growth, particularly in these large deals where the ecosystem is absolutely at the heart of it. And by the way, I'm glad that you look -- you commented on the Gen AI because I think it's important as we think about how Gen AI is developing that we don't walk past, that in H1, we did $1.1 billion in revenue, and last year, in FY ‘24, we did $900 million for the entire year. So you're starting to see the leadership that we have in Gen AI really come through on the revenue side."
},
{
"speaker": "James Faucette",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from Bryan Bergin with TD Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hi. Good morning. Thank you, Julie. Hope you're feeling well. I want to start on bookings. Can you just give us a sense on 2Q bookings? How they landed relative to your plan? Understanding just elevated uncertainty may extend signings, I'm just curious if that did in fact play out in 2Q? And can you comment on how you feel you're set up for the second half in bookings?"
},
{
"speaker": "Julie Sweet",
"text": "Well, just as a reminder, that elevated uncertainty has been in the last few weeks and so, no impact on our bookings. And Angie, do you want to add anything?"
},
{
"speaker": "Angie Park",
"text": "Hi, Bryan. So for us, we were pleased with our bookings this quarter of $20.9 billion, and importantly, our book-to-bill was 1.3. And again, reinforcing and being the partner of choice for our clients with 32 clients with quarterly bookings over $100 million, so we feel really good about that."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And then on the workforce, can you comment on how you're managing that mix of subcontractors versus employees? And is that higher sub-con mix in the quarter just some form of a transition component as you've taken actions on bench across the organization or are there certain service types where you're having to lean a little bit more on that sub-con mix?"
},
{
"speaker": "Angie Park",
"text": "Bryan, I think that as you think about our sub-contractor and our workforce mix, certainly that can fluctuate quarter-to-quarter based upon the work that we're doing for our clients, and as it relates to this quarter, you saw that we added about two -- a little bit over 2,000 people in Q2. And as always, what we are all about is managing our supply and demand, including through the use of technology and reskilling. And so for us -- as you think about our workforce overall, sub-contractors can fluctuate and at the same time, what we focus on is our utilization, which continues to be 91%, which is exactly the range that we want to be in."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. Understood. Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And our next question is coming from Keith Bachman at BMO Capital Markets. Please go ahead."
},
{
"speaker": "Keith Bachman",
"text": "Yes. Good morning. Thank you. Perhaps I'll ask my two just concurrently since they're on similar veins. On the first one, one of the previous questions was asking about AI, more from the demand side or revenue side, I wanted to go back to the supply side and delivery side, and while -- I think it's still really early in the life of Gen AI because most of the work is actually still test, not inferencing. But are you seeing any changes in the nature of your economic relationship with your customers? In other words, are customers asking for some of the savings or is there any change in that narrative on how the supply side and economic relationship broadly speaking with your customers may unfold as Gen AI matures a little bit? And then the second part of the question is, I wanted to just jump into Song for a bit. And sort of the same type of question. I spent the last day with Adobe and at their user group conference and there's tremendous efficiency gains associated with both marketing and creativity. And just, Julie, any comments, I know you mentioned Song had double-digit growth, which is quite impressive. How do you see the durable growth rate of Song? And so that's it for me. And Julie, all the best to you in particular."
},
{
"speaker": "Julie Sweet",
"text": "Thanks, Keith. So I think in the first question, what we've been seeing with Gen AI is what we've seen in the past when we have new technologies, like, I take you back to 2015 when we first announced MyWizard, which we now call GenWizard, as we've introduced Gen AI and that was that major shift that occurred with respect to automation, which by the way is still relevant, right? And so that -- we are not seeing a different change. We've been continuously -- remember like, particularly, on the managed service side, our contracts assume that there's going to be more efficiency driven from technology. Gen AI is allowing that to kind of go up over time. But like the way that the model is working is just very similar to what we've seen with prior waves of big efficiencies from technology. So we're not seeing new patterns evolve there. And of course, we are -- really our strategy is to lead in both helping our clients use Gen AI, but also to lead in our own use of Gen AI. And at the same time, it is still early in the technology. It's still expensive. So you have to get to the right ROI, in terms of when to use it. It requires our clients to have foundations in place. This isn't just sort of push a button and we can have Gen AI, and so we should expect that -- remember that this is still a very early in the technology cycle. Excuse me, with respect to Song, one of the big areas that we're helping our clients on is build the data foundation in order to use the Gen AI because those efficiencies that you're seeing, and as you know, we're Adobe's major partner, require the right data foundation and they require really the reinvention of processes. We've seen that in our own marketing where we've been using Agentic AI, but you had to completely change the way that you're doing marketing. And so Song's durability is being at the heart of building the digital core and helping them do the reinvention while leading in our own use of Gen AI, which is what we continue to be focused on. So I feel very good about Song. And importantly, our diversification is we want to be relevant to all parts of the enterprise and the growth agenda, which is what Song positions us in addition to our entire -- the ability to be at the core operations and at the enterprise. So really very pleased with how our strategy to be relevant across the enterprise continues to give us resilience in the market."
},
{
"speaker": "Keith Bachman",
"text": "Thank you, Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from Jonathan Lee at Guggenheim Partners. Please go ahead."
},
{
"speaker": "Jonathan Lee",
"text": "Great. Thanks for taking our questions. I want to clarify the change in the revenue outlook here. Your original outlook contemplated status quo at the high end of the outlook, is that still the case? And is that indexed to what you're seeing today with the elevated uncertainty, but not necessarily any sort of slowdown?"
},
{
"speaker": "Angie Park",
"text": "Hi, Jonathan. Thanks for the question, and yes, that's correct. So with our assumptions, the range of 5% to 7%, which we raised for the full year is that discretionary spend, does not have to improve at the top end of the range, and while at the bottom of the range, it allows for further deterioration."
},
{
"speaker": "Jonathan Lee",
"text": "Thanks for that color, Angie. And then on the pricing front, it's good to hear about the pricing stability you're seeing despite the competitive environment. How do we think through the timing in which it takes stable pricing to flow through the P&L, especially as it looks like we're still digesting some of the pricing headwinds we've been seeing over the last few quarters?"
},
{
"speaker": "Angie Park",
"text": "As you think about pricing, it does take time for it to layer in, and certainly, it depends on the mix of the deals that we're selling as well. So we'll see that come through over time."
},
{
"speaker": "Jonathan Lee",
"text": "Appreciate that."
},
{
"speaker": "Angie Park",
"text": "Thank you."
},
{
"speaker": "Katie O'Conor",
"text": "Operator, we have time for one more question, and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Thank you. Our final question comes from Darrin Peller at Wolfe Research. Please go ahead."
},
{
"speaker": "Darrin Peller",
"text": "Guys, thanks. And Julie, I just want to wish you -- echo that and wish you my best as well. When we think about what we're seeing in terms of the larger transformational contracts that benefit -- that are benefiting you so much this year despite slower discretionary or not a real improvement in discretionary yet. Just remind us again where you are on that path. I mean, again, bookings was a question before. It was up one or -- maybe it was more or less flat year-over-year, but your book-to-bill is still very strong, obviously. And so just help us understand what you're seeing in terms of the most transformational contracts right now that can give us room despite sort of whatever outcomes are on the discretionary. And then one quick follow-up. Julie, I know when we spoke last, you talked about how there was so much in terms of like waiting by executive CIOs, CEOs, and others on tariffs and some of the policies you talked about earlier, if we do get some resolution on that in the next couple of months, April 2, could be a big day for the administration in terms of explaining. I mean, how much have you heard from your customers on how much they're just really waiting? There's pent-up demand budget. Just help us understand that a little more if you can."
},
{
"speaker": "Julie Sweet",
"text": "Sure. So on the demand side, the 32 clients with bookings over $100 million just continue to show that we're executing on that strategy, but what clients want to buy are larger transformational deals. They want the reinvention and we continue to execute on that too again because that's like -- we're going where the demand is, right? So that same sort of view of continuing to make sure, having those larger deals that will continue to layer in is the strategy and really no change there because that's the demand, right? And we need to be focused on where clients are buying. And then again, what I would say on the -- how things might layer in. CEOs are actually focused on how do I succeed regardless of the level of uncertainty. So the conversations we're having are not, hey, what happens if the tariffs that -- this gets resolved, etc., it's okay. We have a higher level of uncertainty than we did 90 days ago, and so how do we then reinvent faster, right? What do we need to shift to? CEOs, and this is not from -- this has been going on for now for a few years, right? They're embracing that their responsibility is to grow regardless of what has been, in my tenure as CEO, in the last six years, a series of a lot of different events. And that's why as we think about our own business, right? We continue to anchor on the characteristics that have allowed us to be the leader over these different cycles, that's the deep client relationships. Our top 100 clients we've been with for over 10 years, the diversification of geographies, industries, I do want to give a shout out to all my industry teams. The industry groups all -- we had broad based growth, but it allows us for that diversification as well as types of work and then the all-important ecosystem relationships and our leadership in Gen AI and technology. Those are the building blocks of our resilient business and we all, our CEOs and ourselves have to be agile to succeed in whatever market and that is what our range reflects. The fact that we took the bottom off of the range reflects our belief in our resilient model as we continue to navigate."
},
{
"speaker": "Darrin Peller",
"text": "That's really helpful, Julie. Just a quick follow-up would be on AI, again on DeepSeek, just given the developments. I mean, has there been more of an emphasis around it just given the ability to use even more efficient systems or just help us understand in terms of -- I know you've said before, 10% of customers might actually have the infrastructure ready. So we still have a lot of work to do to prepare. Has there been an acceleration in the momentum or is it the same as it was the last couple of quarters? Thanks again, guys."
},
{
"speaker": "Julie Sweet",
"text": "Thank you very much. We are seeing increasing numbers of clients embracing Gen AI. And really that is, in our view, DeepSeek is an interesting development. It's an example of the ongoing technology developments, but the reason they're embracing it is that they're seeing the proven value and that is why we continue to grow because we're the ones in our client base helping our clients get to that value. And you saw that in a lot of the examples we've been giving. So there's an increasing number of clients embracing it as companies are seeing it and there is no view that you can sit back, right, and wait on this. And that two years in, is very evident in our conversations with clients."
},
{
"speaker": "Darrin Peller",
"text": "Thank you."
},
{
"speaker": "Julie Sweet",
"text": "Well, thank you again for joining. Before we wrap up, I have two updates. First, as many of you know, last month, I did announce that I had recently been diagnosed with breast cancer. Just want to let everyone know I'm feeling good. My treatment is on-track and my prognosis continues to be excellent. I have received so many well wishes, including on this call and I just want to thank everyone for all of their support. It has meant a lot. I also want to thank Katie O'Conor, our Head of Investor Relations. She has been an amazing partner to me and to Casey, and to now Angie for the last three years. We've asked her to take on a very important new role as the CFO of Avanade, our joint venture with Microsoft. I know we're all going to miss her in this role and we're super excited to see Katie take on this next chapter of her very impressive career. So thank you very much, Katie. And I'm also very pleased to welcome Alexia Quadrani, who will become our new Head of Investor Relations. Alexia joins us from the Walt Disney Company, where she was the Executive Vice President of Investor Relations and Shareholder Services. And prior to that, she spent over 20 years as an Equity Analyst at JP Morgan. I know she's really looking forward to getting to know all of you in the days ahead and I'm super happy to welcome her to Accenture. And finally, in closing, I want to thank all of our shareholders for your continued trust and support. We are working every day to continue to earn that trust. And finally, a huge thank you to all of our people for what you're doing every day, and I will speak with all of you next quarter. Thanks again for joining."
},
{
"speaker": "Katie O'Conor",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. The conference has now concluded, and we thank you all for attending today's presentation. You may now disconnect your lines and have a wonderful day."
}
] | Accenture plc | 972,190 |
ACN | 1 | 2,025 | 2024-12-19 08:00:00 | Operator: Good day and welcome to Accenture's First Quarter Fiscal 2025 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note today's event is being recorded. I would now like to turn the conference over to Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead.
Katie O'Conor : Thank you, operator, and thanks everyone for joining us today on our first quarter fiscal 2025 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer, and Angie Park, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. Angie will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide an update on our market positioning before Angie provides our business outlook for the second quarter and full fiscal year 2025. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and, as such, are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in the call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate to GAAP in our news release or in the investor relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie.
Julie Sweet : Thank you, Katie, and everyone joining. And thank you to our nearly 799,000 people around the world for their extraordinary work and commitment to our clients, which resulted in a strong quarter of financial results, creating 360-degree value for all our stakeholders. I am very pleased with our performance this quarter, as we delivered on our strategy to position Accenture for strong growth and fiscal year 2025. Here are a few highlights of the 360-degree value we created. Our clients continue to prioritize large-scale transformations, and we are their reinvention partner of choice, as reflected in our bookings of $18.7 billion, including 30 clients with quarterly bookings greater than a $100 million. We grew 8% in local currency this quarter with revenue of $17.7 billion approximately $240 million above the top end of our guided range and continue to take market share on a rolling four-quarter basis against our basket of our closest global publicly traded competitors, which is how we calculate market share. We had another milestone quarter in GenAI with $1.2 billion in bookings and approximately $500 million in revenue. Operating margin was flat compared to adjusted operating margin last year. EPS grew 10% over Q1 adjusted FY24 EPS. While we continue to invest in our business and our people with $242 million deployed primarily across five acquisitions and with approximately 14 million training hours this quarter designed to help us bring the latest in solutions and technology to our clients, provide our people with marketable skills, and reinvent our services using GenAI. This averages 19 hours per person. We increased our data and AI workforce to approximately 69,000, continuing progress against our goal of 80,000 by the end of fiscal year 2026. We are proud to be recognized by Fortune as one of the world's best workplaces, jumping from #10 to #6. This recognition is important, as it is based on feedback from our people around the world. An essential part of our strategy is having access to the best people and being an attractive workplace is critical to our success. And in recognition of our strong brand, we are proud to earn our highest brand value to date on Interbrand's Prestigious Best Global Brands List, increasing to $21.9 billion and ranking #31. We continue to invest in creating and maintaining thriving communities, which our long-term growth depends on. This quarter, among other things, Accenture has partnered with the NGO Instituto PROA in Brazil to help transform the lives of low-income youth by providing them with digital skills to enter the workforce. I am very pleased with our results this quarter and our return to broad-based growth due to our strategy to be our client reinvention partner of choice. We also have a resilient business model with diversity across markets, industries, and the types of work our clients come to us for, both consulting type of work and managed services. Over to you, Angie.
Angie Park : Thank you, Julie, and happy holidays to all of you, and thanks for taking the time to join us on today's call. We were very pleased with our results in the first quarter, which exceeded our expectations and reflects momentum across our business. We are particularly pleased with our strong revenue growth, which was broad-based across geographic markets, industry groups, and consulting and managed services, demonstrating we are a leader in the market as a trusted reinvention partner for our clients. Based on the strength of our first quarter results, we are increasing our full year revenue outlook, which I will cover more detail later in our call. So, let me begin by summarizing a few highlights in the quarter. Revenues grew 8% in local currency above the top end of our guided range with six of our 13 industries growing double digits, and we continue to take market share. We delivered EPS in the quarter of $3.59, reflecting 10% growth over adjusted EPS last year. Operating margin was 16.7% for the quarter, consistent with adjusted Q1 results last year and includes significant investments in our people in our business. Finally, we delivered free cash flow of $870 million and returned $1.8 billion to shareholders through repurchases and dividends. We also invested $242 million primarily attributed to five acquisitions in the quarter. With those high-level comments, let me turn to some of the details starting with new bookings. New bookings were $18.7 billion for the quarter representing 1% growth in both U.S. Dollars and local currency with an overall book-to-bill of 1.1. Consulting bookings were $9.2 billion with a book-to-bill of 1.0. Managed services bookings were $9.5 billion with a book-to-bill of 1.1. Turning now to revenue. Revenues for the quarter were $17.7 billion, a 9% increase in U.S. Dollars and 8% in local currency, approximately $240 million above the top end of our guided range. The foreign exchange impact for the quarter was approximately positive 1% compared with the positive 1.5% estimate provided last quarter. Consulting revenues for the quarter were $9 billion, up 7% in U.S. Dollars and 6% in local currency. Managed services revenue were $8.6 billion, up 11% in both U.S. Dollars and local currency, driven by double-digit growth in technology-managed services, which includes our application-managed services and infrastructure-managed services, and high single-digit growth in operations. Turning to our geographic markets, in the Americas, revenues grew 11% in local currency. Growth was led by industrial, software and platforms, banking and capital markets, and consumer goods, retail, and travel services. Revenue growth was driven by the United States and Argentina. In EMEA, revenues grew 6% in local currency, led by growth in public service, life sciences, and health, partially offset by a decline in banking and capital markets. Revenue growth was driven by the United Kingdom and Italy, partially offset by a decline in France. In Asia Pacific, we delivered 4% revenue growth in local currency driven by growth in utilities, industrial, and health, partially offset by a decline in chemicals and natural resources. Revenue growth was led by Japan, which represents approximately half of Asia Pacific, partially offset by declines in Singapore and Australia. Moving down the income statement, gross margin for the quarter was 32.9% compared to 33.6% for the first quarter last year. Sales and marketing expense for the quarter was 10.2% compared with 10.5% for the first quarter last year. General and administrative expense was 6% compared to 6.4% for the same quarter last year. Before I continue, I want to note that in Q1 of last year, we recorded $140 million in costs associated with our business optimization actions, which decreased operating margin by 90 basis points in EPS by $0.17. Following comparisons exclude these impacts and reflect adjusted results. Operating income was $2.9 billion in the first quarter reflecting a 16.7% operating margin consistent with adjusted operating margin in Q1 of last year. Our effective tax rate for the quarter was 21.6% compared with an effective tax rate of 23.2% for the first quarter last year. Diluted earnings per share were $3.59 compared with adjusted EPS of $3.27 in the first quarter last year reflecting 10% growth over adjusted EPS in Q1 last year. Day services outstanding were 50 days compared to 46 days last quarter and 49 days in the first quarter of last year. Free cash flow for the quarter was $870 million resulting from cash generated by operating activities of $1 billion, net of property and equipment additions of $152 million. Following the completion of our $5 billion inaugural debt offering, our cash balance at November 30th was $8.3 billion compared with $5 billion at August 31st. With regards to our ongoing objective to return cash to shareholders, in the first quarter, we repurchased or redeemed 2.5 million shares for $898 million at an average price of $355.03 per share. As of November 30th, we had approximately $5.9 billion of share repurchase authority remaining. Also, in November, we paid a quarterly cash dividend of $1.48 per share for a total of $926 million. This represented a 15% increase over last year and our Board of Directors declared a quarterly cash dividend of $1.48 for share to be paid on February 14th, a 15% increase over last year. So in summary, we are very pleased with our Q1 results, and we are off to a strong start in FY25. And now, let me turn it back to Julie.
Julie Sweet : Thank you, Angie. Starting with the demand environment, we saw more of the same. Our clients are focused on reinvention, which means large-scale transformations. We do not currently see an improvement in overall spending by our clients, particularly on smaller deals. When those market conditions improve, we will be well-positioned to capitalize on them, as we continue to meet the demand for the critical programs our clients are prioritizing. As expected, building the strong digital core required for reinvention was a strong driver of our growth this quarter. GenAI continues to be a catalyst for reinvention across the enterprise and building out the data foundation necessary to capitalize on AI, as an increasing part of that growth. Themes around achieving both cost efficiencies and growth continue across the demand we're seeing. Through the examples from Q1, you can see both our strategy to be the reinvention partner of choice and how we are bringing together our services, our ecosystem relationships, and our scaled investments in cutting-edge platforms like SynOps and GenWizard, as well as technologies like GenAI to drive value for our clients. We are helping our clients build their digital core, including in the cloud, which saw double-digit growth this quarter. Accenture Federal Services is working with the U.S. Air Force, the nation's military service air branch, on a cloud monetization journey to manage its complex IT environment so that military personnel can maintain their competitive edge. We will develop a multi-cloud ecosystem using services from multiple providers to create a robust, secure, and integrated infrastructure. This will enhance how different systems and devices work together and communicate to quickly implement cutting-edge tools and technologies. We also provide managed services that foster collaboration and enable personnel to quickly make data-driven decisions about their cloud usage and costs while adapting to changing mission requirements. This partnership will enable the U.S. Air Force to get the most out of their cloud investments to achieve real-time cross-cost transparency, accelerated cost savings, increased efficiency, and improved agility. Our industry expertise is critical to building the right digital core. We are partnering with the BCC ICCREA Group, Italy's largest cooperative banking group, through a joint venture with its IT subsidiary on a reinvention journey to help over 100 affiliated banks grow. Our managed services will modernize the IT platform and migrate applications to the cloud, enhancing resiliency, stability, and service quality. We will also consolidate data and build an integrated cloud platform for advanced analytics and AI, strengthening their digital core. GenAI will be applied to increase internal IT efficiency and reduce customer response time on digital interaction channels. We will expand digital offerings, employee onboarding, and payments using our suite of shared finance services solutions. A change management communications program will offer targeted up-skilling and re-skilling opportunities to ensure employees use new technologies and methodologies effectively. Together we will help BCC, ICCREA Group, reduce costs and drive innovation, enabling the banking group to be more competitive and bring new products and services to market faster. Security is an absolutely essential component of every company's digital core, and we again saw very strong double-digit growth. We are the partner-of-choice in part because we bring both the understanding of cross industry threats and industry specific threats with our deep experience across 13 industry groups. We are supporting a leading aircraft manufacturer and its cybersecurity across aerospace and defense on critical infrastructure and production systems. We will provide managed services and solutions for their cyber security capability, leading to a more powerful and secure program, bringing security by design and industrial assets and the extended enterprise. Our solutions will help provide improved security and meet regulatory compliance. We are also helping with the digitization of manufacturing and supply chains. Industry X grew double digits this quarter. We are continuing to evolve our long-time partnership with a global leader [in tire] (ph) manufacturing to revolutionize the way factories operate and to reduce time-to-market for new products, accelerating innovation. We will build a hybrid data foundation in the cloud, integrating millions of data points. We will also implement advanced analytics, AI, and digital twin technologies to optimize operations processes such as quality checks. This will enable the company to trace the root cause of a failed batch of tires back to a machine or process in minutes instead of days. And predictive maintenance will pinpoint what parts of their process or machinery may be impacting quality and productivity, preventing costly down times. Engineering teams will benefit from machine learning and simulation tools to generate and optimize the design of new products. We will also implement new ways of working to attract tech-savvy talent and cultivate a learning culture where employees in over 100 factories are upskilled on the AI powered tools. The company will look to increase growth opportunities and support their digital first strategy, all while remaining competitive in the market. We are partnering with PUMA India, a leader in sports lifestyle products, to reinvent their supply chain and distribution network. This will meet the ever-evolving customer demand for order delivery in a highly competitive, omni-channel market where quick commerce is becoming the norm. We will use data and AI to identify and set up localized fulfillment centers, optimizing their size and location based on customer sales. Digital twins of these facilities will simulate various process designs and physical automation scenarios to identify bottlenecks. This will help redefine warehouse layouts and improve material flow for more efficient order and return processing, delivering orders up to 70% faster with express delivery for online orders expected to double. Supply chain costs are also expected to decrease by up to 10%, and additional features like solar power and EV charging stations at fulfillment centers will further reduce costs and support sustainability goals. PUMA India will be the first amongst sports brands in the region to build this type of cutting-edge operating model, enhancing customer loyalty to drive future growth. We are reinventing all things customer through Song, which grew high single digits this quarter. We have the ability to integrate creative, data and AI, tech and strategy while leveraging our industry and operations expertise to unlike marketing as a growth enabler for our clients while delivering efficiencies. We are helping Spotify optimize its advertising business by finding opportunities to drive efficiency as it scales globally. Our marketing operations managed services support their ad operations under a single roof, touching a significant amount of their ad revenue across 150 markets. We've infused automation across their operational workflows to help significantly reduce the time and effort required to launch advertisers' campaigns, getting them to market more quickly to help ensure revenue realization and advertiser satisfaction. We continue to expand beyond ad operations, actively launching new capabilities across analytics and insights, data integrity and enrichment, customer support, and more. Our partnership helps Spotify to focus on its core competencies so it can achieve long-term relevance and growth in an increasingly competitive market. We are collaborating with CaixaBank, a leading financial group in Spain, on their plan to enhance customer and employee experiences. We will increase productivity and efficiency by leveraging AI and GenAI to build multiple solutions, such as the bank's chat bot, which has significantly reduced response times and improved the quality of answers for clients, and an employee assistant tool that utilizes natural language conversations and solution searches. We will also build a customer service claim solution that analyzes documents and supports agents and lawyers in proposing the right responses, reducing processing time, and assisting specialized teams. This will help CaixaBank reinvent with GenAI and we are creating real value from GenAI across industries and countries. We are partnering with Vale, a Brazilian mining and logistics company, to transform its environmental licensing program, speeding up permit applications and expanding its sustainability goals. We created Smart Licensing, an end-to-end licensing management platform that uses GenAI to scan application materials and environmental studies to promote compliance with regulatory and environmental requirements. This creates actionable summaries reducing internal document reviews from days to minutes. We've trained over 500 people to use Smart Licensing and established a change management team to combine previously segmented teams, helping Vale plan and execute more efficiency while further reducing environmental impact. We are partnering with Indosat, a Digital Telecommunications Company and its subsidiary, Lintasarta, a leading provider of data communication, Internet, and IT services to launch Indonesia's first sovereign AI cloud platform. This will accelerate their AI-driven digital transformation and support the country's vision of becoming a digitally empowered nation by 2045. The collaboration will initially focus on AI solutions for Indonesia's financial services sector, one of the key pillars of the country's economy. Accenture's AI refinery platform will provide scaled AI capabilities with pre-built solutions that have a modular architecture to meet clients' needs wherever they are in their AI journey, significantly reducing time to value. This partnership will help Indonesian companies to drive reinvention by harnessing the power of scaled GenAI, propelling innovation, operational efficiency, and sustainable growth in a competitive market. Talent continues to be at the top of the agenda for CEOs and governments, and our LearnVantage services position us to be able to help clients invest in their workforce. Our partnership with S&P Global, a leading provider of financial data analytics and ratings, is driving GenAI innovation across the financial services industry, empowering their workforce to adopt GenAI at scale to enhance productivity and deliver revenue growth. They are equipping nearly 40,000 of their employees with the necessary skills, leveraging Accenture LearnVantage Services, a comprehensive GenAI learning program. This program includes curate and customized content to drive AI fluency and address the industry's evolving talent requirements. Finally, a quick look at how we're continually using our investments and acquisitions to drive our future growth. To continue to scale LearnVantage, we acquired award solutions in the U.S., which expands our learning offerings tailored to the unique needs of the network leaders, network operations and performance engineers, and IT professionals in the telecom space. To enable us to scale [faster in health] (ph), a $70 billion adjustable market growing approximately 6%. We acquired consus.health, a leading German healthcare management consultancy. Health is an industry still early in digitalization, and our investments are positioning us for the continued growth we see over the next several years. And supply chain continues to be in early in digitalization, and we are investing to continue to drive growth. This quarter, we acquired Camelot, an international SAP-focused management and technology consulting firm from Germany with specific strengths in supply chain, data and analytics and Joshua Tree Group in the U.S., supply chain consulting firm specializing in distribution center performance. Back to you, Angie.
Angie Park : Thanks, Julie. Now, let me turn to our business outlook. For the second quarter of fiscal 2025, we expect revenues to be in the range of $16.2 billion to $16.8 billion. This assumes the impact of FX will be about negative 2.5% compared to the second quarter of fiscal 2024 and reflects an estimated 5% to 9% growth in local currency. For the full fiscal year 2025, based upon how the rates have been trending over the last few weeks, we now assume the impact of FX on our results in U.S. Dollars will be approximately negative 0.5% compared to fiscal 2024. For the full fiscal 2025, we now expect our revenue to be in the range of 4% to 7% growth in local currency over fiscal 2024, which includes an inorganic contribution of a bit more than 3%, which we expect will be about 4% in the first half and about 2% in the second half. And we continue to expect to invest about $3 billion in acquisitions this fiscal year. For operating margin, we continue to expect fiscal year 2025 to be 15.6% to 15.8% at 10 to 30 basis point expansion over adjusted Fiscal 2024 results. We continue to expect our annual effective tax rate to be in the range of 22.5% to 24.5%. This compares to an adjusted effective tax rate of 23.6% in fiscal 2024. We now expect our full year diluted earnings per share for fiscal 2025 to be in the range of $12.43 to $12.79 or 4% to 7% growth over adjusted fiscal 2024 results, reflecting the raise in our revenue outlook and adjusting for the revised FX assumption. For the full fiscal '25, we continue to expect operating cash flow to be in the range of $9.4 billion to $10.1 billion, property and equipment additions to be approximately $600 million and free cash flow to be in the range of $8.8 billion to $9.5 billion. Our free cash flow guidance continues to reflect a free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $8.3 billion through dividends and share repurchases, as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open to -- so that we can take your questions. Katie?
Katie O'Conor: Thanks, Angie. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?
Operator: Absolutely. [Operator Instructions] Today's first question comes from Tien-Tsin Huang with JPMorgan. Please go ahead.
Tien-Tsin Huang: Thank you good morning. It's really encouraging to see the revenue come in here above the guidance range. I think it's the widest margin in nearly two years. Julie, you said that the demand environment is more or less the same. So I'm curious what you [attribute] (ph) this new pattern to and if market conditions are maybe improving underneath here. Any comments?
Julie Sweet: Thanks, Tien-Tsin. This is the strategy that we've been outlining for the last few quarters, where last year, when we saw the -- spending, particularly on the smaller deals, we pivoted to really focusing on getting -- winning more reinvention partners of choice, so increasing the number of our deals that were over $100 million in a quarter. You'll remember last year, we actually had [125] (ph) of those. And the idea was to increase -- go after the demand, which is in the larger reinventions and that, that would position us to get back to a strong growth in '25 as those deals begin to layer in. And so what you're seeing is the result of -- what we're really proud of was quite a bit of agility last year that when the market changed, we changed, because as you know, these are not easy deals to do quickly. And we quickly pivoted last year, went after the demand and then put ourselves in this position. And that's why we did underscore that the market environment has not changed. This is the result of the strategy we executed, which we're uniquely able to do because we have all the skills and capabilities, we have the mix of consulting and managed services. And so this is what we were talking about last quarter when we said we are going to get back to strong growth based on execution of this strategy. And of course, these are super critical strategic programs. And so when spending does come back and the market does improve, we're at the heart of our clients' business, and we should be well capitalized to pick up on not spending.
Tien-Tsin Huang: Yes. No, the last point is important, short-term stuff comes back. Hope you should see that pretty quickly as well on top of this. So good, thanks. And my follow up, just have to ask it, I get a lot of questions on the U.S. federal government and Accenture's exposure there. I think it's about 8% of revenue based on some of your annual report disclosures. So just curious, given some of the change in administration and the discussion around efficiency, have your expectations? Or are you going to change your strategy here on the U.S. federal government side? Any comments there would be terrific. Thanks for the time.
Julie Sweet: Yes. Well, we're really excited because our core competencies in federal, right, are around driving efficiencies. They're around helping -- keep our country secure. We're working with the U.S. federal agency on securing critical infrastructure, right, and on changing citizen services. We work across very important agencies. And so we believe that we're super well positioned to continue to help the mission of the federal government to secure itself, to help citizens and to drive more efficiencies, which will be tied very much to cloud, data and AI. And what really makes us uniquely positioned is that we believe that there is going to be an even greater appetite of taking commercial solutions to the federal government. And we are very uniquely positioned because we have strong government expertise, but we've got commercial and private sector solutions. We are the leader with every major ecosystem partner. And you saw that -- I was talking today about the U.S. Air Force and what we are doing on the cloud modernization. And our work is mission critical. I mean, the vast majority of what we do is mission critical to the federal government. So we see a real opportunity to continue to partner with the new administration as we've partnered with all administrations, and also with all of the leaders in the federal government every day are waking up to really drive those three things. So really, really feel good about where we are positioned in the federal government to help this agenda.
Tien-Tsin Huang : Awesome, thank you.
Operator: Thank you. And our next question today comes from Jason Kupferberg with Bank of America. Please go ahead.
Jason Kupferberg: Good morning guys. Happy holidays. I know that last quarter, you indicated the high end of the initial revenue guide. For this fiscal year, did not require any material improvement in consulting. Just wondering if that's still the case as you're now raising the top end a little bit? Or are you now assuming any improvement in consulting since you're almost four months into the new fiscal year?
Angie Park: Yeah, hi Jason. Good morning. And I'll take that. For us, with the raise in -- to 4% to 7% for the full year, there's really no change in what we shared with you before, which is that at the top end of the range, we continue to see more of the same, whereas at the bottom of the range, we see a bit more -- we allow for a little bit more deterioration. So no change there.
Julie Sweet: Yes. And our over delivery, I mean, we're very pleased, obviously, with consulting and managed service growth this quarter. And these large deals came in a little bit better, which is how we overdelivered and now raising the guidance.
Jason Kupferberg: Great to hear. And then I'm just looking at the net headcount adds cumulatively over the past two quarters. I think we're almost 50,000. That was a pretty big step up from what the prior trend looked like. So can you give us any sense of how much of that was from acquisitions versus organic? And I guess is there any reason to not look at this accelerated hiring as kind of a bullish indicator?
Angie Park: So let me take that question. And as it relates to the net people adds that we had in Q1. So we did add about 24,000 people in the first quarter, which is really reflective of the momentum that we see in our business. And managing supply and demand is a core competency of ours. And what you see is the continued high utilization rates at around 90%. Looking ahead, we'll continue to hire for the demand that we see and the skills that we need. And I'll give you a little bit more context that the hiring that we saw this quarter, similar to last was that it was concentrated in India.
Julie Sweet: Yes. And I would just say that underlying our guidance, you are seeing organic momentum, right? So at the high-end of our guidance, for the year, we are going to exit at -- the range of organic growth in our guidance is 1 to 4, right? So I think that is -- it is a positive sign that we're hiring and some of it is coming from acquisitions, but we are seeing organic momentum in our business.
Jason Kupferberg : Thanks for the comments.
Operator: Thank you. And our next question comes from Bryan Keane with Deutsche Bank. Please go ahead.
Bryan Keane: Hi guys. Congrats on the solid result. And Happy holidays. Kind of asking the guidance question a little bit differently. The 4% to 7% constant currency revenue guide for the fiscal year 2025, is a touch below just the first quarter number of 8% on a constant currency basis. So just trying to think about if there is any reason why the growth would decelerate off the first quarter level as we get more into fiscal year 2025?
Angie Park: Hi, Bryan, happy holidays to you as well. Let me give you -- here's how we were thinking about our guidance for the full year and the raise to 4% to 7%. If you think about where we are, we had a strong start in Q1. We have strong guidance in Q2, which was really driven -- it was broad-based and driven by our organic growth. At the same time, you heard Julie say, the macro remains the same. There's no change in the overall environment. And I want to reinforce importantly what I said earlier, which was we do expect -- we continue to expect inorganic contribution of about -- of a bit over 3%. And one of the things that we provided to you was how that will come in. So H1, we expect somewhere around about 4%, second half about 2%, and that will give you more of an understanding of how we see organic playing out for the year. And we will continue to see organic throughout this fiscal year. And then as it relates to -- if you think about it, we're one quarter in. We've got one quarter under our belt. We've got three more to go. And as Julie said earlier, we're executing on our strategy, and you can count on us to continue to do so.
Bryan Keane: Got it. Got it. That's helpful. And then maybe you guys could just talk a little bit about the industry group, the Financial Services. A lot of times, that kind of leads out of economic slowdowns. But it sounds like Banking & Capital Markets was a little bit softer, but some other areas of strength and just trying to figure out where that is in the industry right now because we're kind of getting mixed messages from some of the other IT service providers. Thanks so much.
Julie Sweet: Yes. So -- and I think it's a little bit different by market, right? So we are seeing the results a bit different by market. I will say, by the way, that we were pleased to see the U.K., as you might have heard, is coming back as we reposition the U.K. But with the dynamics in the U.S. market where it is a little bit better, in EMEA, it was a little bit worse, and you've got a mixed picture on the interest rates, what the expectations are. And so I'd say that -- and that is probably not a surprise. Yesterday, probably complicated that a little bit in the U.S., right? And so on the one hand, we are seeing a lot of interest, for example, in Banking & Capital Markets on things like GenAI. On the other hand, there is a lot that's being kind of processed with what's going to happen with interest rates and that. And so I -- we see -- obviously, it is getting better, but it is a mixed picture by region.
Angie Park: Yes. And just as a reminder, Bryan, as we look at Financial Services overall, we exited Q4 last year with a minus 2%, and we saw the uptick in the first quarter at 4% globally which reflects the dynamics that Julie was just describing, which really plays for our strength, as you think about the diversity of our business across markets and industries.
Bryan Keane: Great. Thanks again.
Operator: Thank you. And our next question today comes from Darrin Peller at Wolfe Research. Please go ahead.
Darrin Peller: Guys, thanks. Great results. Could we just touch on your potential for visibility this year into budgets and the timing you'd expect again? I know last -- I think earlier this year, it was generally in the January, February time frame, which had moved back up a little bit. But do you still anticipate that kind of visibility at that part of the year? Or we could get a better picture on whether discretionary is really going to pick up or not? And then maybe just as a dovetail on that, maybe just conversations you are happening right now around AI for next year. Obviously, the bookings keep looking really strong for you guys, which is great. Any more specifics on where you are seeing it incrementally improve? Thanks guys.
Julie Sweet: Yes. So a great understanding of Accenture. January is sort of -- January, February as we really see what the client budget is going to be looking at. So that's where we get the most visibility. And so we'll be reporting more on that in the next quarter. So you're absolutely right, we do anticipate getting that visibility in January, February. And then with respect to AI, we are continuing to see in our conversations, and I probably talked to 30 CEOs in the last 2 months, right? So spend a lot of time, and also around the world. So it's been a busy travel quarter. I've been in Europe, I've been in Southeast Asia, Australia, the U.S. So -- and pretty consistently, clients are seeking to do more in AI, but they are in such different places. I mean I'll be with one bank where we're talking about what is GenAI, AI, why does it matter? And the fact that they are not yet in the cloud. And I'll be talking to another bank where they've been fully in the cloud and they want to be the first out to use GenAI. And so I think it is hard to generalize. You are still seeing that because the overall spending environment is the same, that they're -- that those who really want to go into -- in AI are more prioritizing spending as opposed to spending more, right? Where we see the biggest opportunity when companies start to get more confident to spend more is going to be and moving faster with their data foundation that fuels AI and then AI. But right now it still generally feels more like a prioritization within current budget. And so we'll see what happens in January and February. And that's why our strategy has been to pivot there, right? So to go after [more than] (ph) our fair share of those budgets.
Darrin Peller: All right. That's really helpful. And then just when we look at the opportunity for what you're -- where you're hiring, you mentioned India, but we've heard a lot of customers are starting to think about a little bit even more onshore. And so just maybe talk a little bit more about the mix again. It had gone for a while more offshore looking for better price optimization. But where are we on that right now? Are you seeing any evidence of a shift back to nearshore, onshore? Thanks again guys. Great job.
Julie Sweet: No big trend. What I'd say is we focus on the G2000. So a lot of our companies are global. And so they really are looking for optimization of right skills because a big piece of why people, for example, use India is about skills, right? 10 years ago, it was about labor arbitrage, right? Today, it is about like the ability to get these skills at scale. What I would say is that we, at Accenture, are continuing to develop more because in some cases, it is language, right, as you're kind of doing more transformation, new parts of the enterprise where you want maybe lanes with skills or time zones. So we have a global network in -- with 100 centers around the world. In the U.S., for example, we've been opening some new centers in underserved environments. We just opened a center in the Bronx recently. So -- but all of it is kind of aimed at being very sophisticated, and we see ourselves as part of the integrated talent strategy of our clients. And it's like right skills, right time zone, right price, continues to be the guiding with I would say an emphasis on skills.
Darrin Peller : Great. Thanks Julie, thanks Angie.
Operator: Thank you. And our next question today comes from Jim Schneider with Goldman Sachs. Please go ahead.
Jim Schneider: Good morning. Thanks for taking my question. Julie, understand that your outlook, and you’re not really seeing any differences on macro side, and your outlook look like sort of idiosyncratic growth. But can you maybe discussed a little bit about when you talk with clients, what's the sort of range of outcomes for discretionary increases in the 2025 budget outlook? And how big a factor is rates specifically as a macro impact when they're thinking about that? And do you think that changes materially given the Fed message yesterday?
Julie Sweet: The rates definitely depends on industry, right? So if you're a more capital-intensive industry or you're an industry that wants to grow more in acquisitions, the rates -- there's lots of puts and takes in doing the range. And I think it's just too early based on yesterday's there's been a lot of speculation. I mean our business is very much focused on like -- when there's change, and it doesn't matter what the change is, good or bad change, that's where we really partner with our clients successfully because if they've now got new constraints because the rates are higher, then they want more opportunity to cut costs. If the rate are going to fuel things like capital projects, we've got our capital projects business, right? So what we focus on, and I think what we are so successful is we have these deep relationships with our clients. Our top 100, we've been them over 10 years. We understand them. And we are always looking at this and say, okay, what that mean, anticipating what they are helping. So that's -- so whatever the change is, that's where Accenture really can help them pivot. And it's part of our strength that we're so relevant to both growth and cost.
Jim Schneider: That's helpful. Thank you. And then with respect to the AI work, you talked about some of the context of the client conversations you're having. But quantitatively, are you seeing any kind of major changes in terms of the size and scope of the individual projects? And what are clients saying about sort of their pivot or when they might pivot to sort of larger, more transformative projects within GenAI?
Julie Sweet: Yes. We are already starting to see that, right? We are starting to see the clients -- and the characteristics are pretty clear. If you have a client that's been investing in their digital core, include security and data for many years, and we have many of those that we've helped, they're now able to start to scale, and we are starting to do that, and we're seeing those partnerships. Where you have clients where we've been helping them prove it and maybe scale in a part of the business, but they really haven't got their data foundation or they're not moving into the cloud, then what they're working with us is how do we accelerate that. And what you probably heard as we were talking through some of the examples today is that there's a lot of data foundation now being built along with getting into modern cloud platforms. And so we are seeing an acceleration of the data work, which is absolutely fundamental to using GenAI.
Jim Schneider: Thank you.
Operator: And our next question today comes from Dave Koning with Baird. Please go ahead.
Dave Koning: Yeah, hi guys. Great job. And I guess my question, just on the fiscal Q2 guide. Historically, Q2 has been a pretty flat sequential quarter. And you are guiding, I believe to down about $1 billion to $1.5 billion sequentially this quarter. I know a little of that may be a few hundred million FX, I get that. But what -- was there anything in Q1 that kind of naturally falling off in Q2 this year, that's a little unnormal or some sequential pattern that's a little different?
Angie Park: Yes, David, happy holidays and good morning. As we think about our Q2 guide of 5% to 9%, it's a very solid guide, based upon what we see. And there's nothing unique in Q2 that I would call out. And in fact, just anchoring back to our over delivery that we saw in the first quarter was really a function of the larger deals coming online a bit better than we expected, and we continue to see that, which gave us confidence in driving -- in raising our guidance for the full year. So nothing to call out for Q2.
Dave Koning: Got you. Yes. You definitely crushed Q1. And then, I guess, one just a nerdy kind of financial question, but now that you fully have like the debt in place, should we think about a sequential pickup in interest expense? I think it was $30 million in Q1. Does that go to like $50 million in Q2 or something like that?
Angie Park: Yes. Different than giving you the specific numbers in terms of how to think about it, yes that is correct because when you – there is certain things, of course, that we see in our income below operations. And what you saw there was the interest -- the net interest income was lower as a result of we did have average lower cash balances, also lower interest rates. And then we also had the interest expense from our long-term debt. So -- but all of that has been factored in the guidance that we've given and so it's in there.
Dave Koning: Gotcha. Thanks guys. Great job.
Operator: Thank you. And our next question today comes from James Faucette with Morgan Stanley. Please go ahead.
James Faucette: Great. Thank you very much. I want to just quickly ask a follow-up on capital structure and allocation. It sounds like you are still quite committed to pursuing both acquisitions, as well as capital return. Last year, we looked at -- we did some essentially debt raise to help fund those priorities. Where are we at from that perspective? Or do you feel like we're in a pretty good overall cash position and continue to be able to do that? Or should we expect that at some point, at least over the next couple of years, we can see further decreases in debt and debt raising to fund the capital allocation priorities?
Angie Park: Yes. Hi James. Nice to talk to you. Why don't I start. We were pleased to execute our inaugural bond offering of $5 billion, which we did in October. And when we step back, it was really a routine review of our capital structure where we tap the long-term debt market to increase our liquidity for general corporate accounting purposes, and what it does is, it ultimately, it optimizes our capital structure and reduces our cost of capital. That said, let me just reinforce for you, there is no change to our capital allocation as strategy, which also includes how we look at and use G&A.
Julie Sweet: And this year, we are going back to kind of more of a business as usual. We think it's going to be somewhere around $3 billion. But as we've always said, if there is opportunities or not, we've got the balance sheet. So we could raise debt, but there's no strategy to increase debt. But we might, if we had the right opportunities. I mean, last year, we had a great opportunity to double down on strategic acquisitions, and it served us well as we've gone into this year. But this year, we are back to kind of standard around $3 billion, which is kind of the right percentage. So we'll communicate as we go. We always have that flexibility. And I think that's the strength if you think about Accenture is having a strong balance sheet and to have the flexibility to go after opportunities in the market that drive long-term growth. And that's how we think about the decisions about whether or not to do debt or not.
James Faucette: That's great color there. And then I wanted to ask about the consulting bookings, seeing nice growth and acceleration there. I'm wondering -- and I know it is hard given the breadth of Accenture's customer base, but I'm wondering if you can help us maybe generalize what you're seeing in consulting bookings and if there's a change there? And I guess I'm wondering if we're seeing a focus on cost control versus potential revenue generation or new technology evaluation or how it folds into AI. Just any color you could provide on what the tenor of those consulting bookings look like right now?
Julie Sweet: Yes. So maybe just keep in mind that what we're generally bringing to our clients are multiservice solution. So you might do, as we talked about, we're doing managed services in security, and that requires industry consulting as a part of it to make sure that we're doing all the work. A lot of the reinvention is a lot of process that. So I think I would anchor on -- there are really are two themes that at least -- when they come to us. They want cost efficiency. Every industry wants a cost efficiency now, and they're looking for growth or other outcomes, speed to market. You heard a lot -- when we talked about, like what we're doing with like CaixaBank, that was both speed to market, as well as efficiencies. And so that's one of the things that we focus on, and that really gives us -- it's our unique differentiation because we got things like Song, that's everything about customer, and we can put to that. We understand the industry. So the twin themes here is cost efficiency and growth.
James Faucette: Great. Thank you so much.
Operator: Thank you. Our next question today comes from Keith Bachman with BMO Capital Markets. Please go ahead.
Keith Bachman: Hi, good morning. Many thanks and happy holidays to everyone. My first question I wanted to ask is around pricing dynamics. And you've indicated that the macro backdrop is fairly steady. You're gaining share through skills, and I wanted to ask specifically about some of the legacy areas such as application maintenance, maybe the BPO work. One of your competitors suggested that pricing is pretty challenging because there aren't enough deals and a lot of folks chasing those deals, but could you specifically address what you're seeing as pricing dynamics during the quarter? Any changes?
Julie Sweet: It's a very competitive market, which is what we've been saying every quarter and we did see lower pricing across the business, which has been pretty consistent. What I would say is, that which makes sense, right you're in a constrained -- as we said, that the clients have constrained spending, particularly on small deals and so you'd expect it to be constrained. What I would say, though that AMS, Application Managed Services, is not legacy if you do it the way we do it, right? So what we offer to our clients is we have the talent, the full-stack engineers, the GenAI, we have a platform called GenWizard. And so clients are coming to us to say, hey, can you take off my old applications. They're coming on us to modernize while taking costs down. And you see that for -- and what the work we're doing, it's very advanced in how we are doing it. So we basically call it run to the new right? It's like have us help you run your applications in order to rotate to the new. So we see this as a critical way that we are at the heart of their business in modernizing their digital core. It's not legacy. Same thing with our operations business.
Keith Bachman: Yes. Okay. That makes a ton of sense. Thank you Julie. My follow-up question is, some of our recent discussions, and to be fair, with software companies, have suggested that Europe's softened in the last 30, 45 days and -- which makes sense, if you just read the newspapers about what's going on in Europe. But have you guys seen any change in the dynamics underpinning Europe and/or change the perspective that you may have as it relates to European demand over the next 12 months? And that's it for me. And many thanks again, and happy holidays.
Julie Sweet: Thanks. So our view of European demand is -- over the next 12 months, is baked into the rise of in our guidance, right? And we are all reading the same papers. Europe is definitely more, Middle East is obviously different. Europe is definitely in a more challenging environment. And you see that with our growth rate is there on a relative basis as well. But we feel very good about -- we have an excellent business in EMEA. We are very relevant to our clients. And so we feel good about the -- us -- our demand environment, and that's fully reflected in the raise in guidance that we just gave you. Thank you. Can we have the next question?
Katie O’Conor: Operator, we have time for one more question, and then Julie will wrap up the call.
Operator: Absolutely. And our final question comes from Bryan Bergin with TD Cowen. Please go ahead.
Bryan Bergin: Hey, guys. Good morning. Happy holidays. I wanted to ask on the service lines here. Can you comment on performance across strategic consulting, tech services and operations?
Julie Sweet: Yes. All very -- all strong this quarter.
Angie Park: Yes. Bryan, the thing that I would add to that is we did see broad-based growth. And if you look at it from a consulting and a managed services type of work perspective, we had mid-single-digit growth in consulting and 11% growth in managed services. And as you think about the rate that we have for the year, which is 4% to 7% underneath that, we see consulting now in the mid-single range growth and managed services in the mid-to-high range growth.
Bryan Bergin: Okay. And then a follow-up here on the workforce and contract profitability. So you know the most headcount was added across India. Can you just comment on what you're seeing there as far as wage inflation dynamics, just given most services companies and GCCs have been leaning in, and particularly amid the competitive pricing environment? Just talk about the levers you have here to mitigate gross margin pressure.
Angie Park: Yes, I'll start, Bryan. No real change in terms of the market dynamics of what we see reflected around wage inflation. And of course, we are always paying market relevant pay based upon the skills and the locations of our people. And we continue to see that the same, and then as it relates to pricing, as Julie mentioned, it is -- it continues to be highly competitive. At the same time, as you know of us, right, we are managing that. We're focused on pricing as well as on our differentiation, and we're focused on cost and delivery efficiencies in our business and how we operate.
Bryan Bergin : All right. Understood. Happy holidays.
Angie Park : Thank you Bryan.
Julie Sweet: Good happy holiday. Well, in closing, I want to thank all of our shareholders for your continued trust and support and all of our people for what you do every single day. I wish everyone a very happy and healthy holiday season. Thank you for joining us today, and we look forward to being back here in a quarter. So thanks, everyone.
Operator: Thank you. This concludes today's conference call, and we thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day. | [
{
"speaker": "Operator",
"text": "Good day and welcome to Accenture's First Quarter Fiscal 2025 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note today's event is being recorded. I would now like to turn the conference over to Katie O'Conor, Managing Director, Head of Investor Relations. Please go ahead."
},
{
"speaker": "Katie O'Conor",
"text": "Thank you, operator, and thanks everyone for joining us today on our first quarter fiscal 2025 earnings announcement. As the operator just mentioned, I'm Katie O'Conor, Managing Director, Head of Investor Relations. On today's call, you will hear from Julie Sweet, our Chair and Chief Executive Officer, and Angie Park, our Chief Financial Officer. We hope you've had an opportunity to review the news release we issued a short time ago. Let me quickly outline the agenda for today's call. Julie will begin with an overview of our results. Angie will take you through the financial details, including the income statement and balance sheet, along with some key operational metrics for the first quarter. Julie will then provide an update on our market positioning before Angie provides our business outlook for the second quarter and full fiscal year 2025. We will then take your questions before Julie provides a wrap-up at the end of the call. Some of the matters we'll discuss on this call, including our business outlook, are forward-looking and, as such, are subject to known and unknown risks and uncertainties, including but not limited to those factors set forth in today's news release and discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q and other SEC filings. These risks and uncertainties could cause actual results to differ materially from those expressed in the call. During our call today, we will reference certain non-GAAP financial measures, which we believe provide useful information for investors. We include reconciliations of non-GAAP financial measures, where appropriate to GAAP in our news release or in the investor relations section of our website at accenture.com. As always, Accenture assumes no obligation to update the information presented on this conference call. Now let me turn the call over to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Katie, and everyone joining. And thank you to our nearly 799,000 people around the world for their extraordinary work and commitment to our clients, which resulted in a strong quarter of financial results, creating 360-degree value for all our stakeholders. I am very pleased with our performance this quarter, as we delivered on our strategy to position Accenture for strong growth and fiscal year 2025. Here are a few highlights of the 360-degree value we created. Our clients continue to prioritize large-scale transformations, and we are their reinvention partner of choice, as reflected in our bookings of $18.7 billion, including 30 clients with quarterly bookings greater than a $100 million. We grew 8% in local currency this quarter with revenue of $17.7 billion approximately $240 million above the top end of our guided range and continue to take market share on a rolling four-quarter basis against our basket of our closest global publicly traded competitors, which is how we calculate market share. We had another milestone quarter in GenAI with $1.2 billion in bookings and approximately $500 million in revenue. Operating margin was flat compared to adjusted operating margin last year. EPS grew 10% over Q1 adjusted FY24 EPS. While we continue to invest in our business and our people with $242 million deployed primarily across five acquisitions and with approximately 14 million training hours this quarter designed to help us bring the latest in solutions and technology to our clients, provide our people with marketable skills, and reinvent our services using GenAI. This averages 19 hours per person. We increased our data and AI workforce to approximately 69,000, continuing progress against our goal of 80,000 by the end of fiscal year 2026. We are proud to be recognized by Fortune as one of the world's best workplaces, jumping from #10 to #6. This recognition is important, as it is based on feedback from our people around the world. An essential part of our strategy is having access to the best people and being an attractive workplace is critical to our success. And in recognition of our strong brand, we are proud to earn our highest brand value to date on Interbrand's Prestigious Best Global Brands List, increasing to $21.9 billion and ranking #31. We continue to invest in creating and maintaining thriving communities, which our long-term growth depends on. This quarter, among other things, Accenture has partnered with the NGO Instituto PROA in Brazil to help transform the lives of low-income youth by providing them with digital skills to enter the workforce. I am very pleased with our results this quarter and our return to broad-based growth due to our strategy to be our client reinvention partner of choice. We also have a resilient business model with diversity across markets, industries, and the types of work our clients come to us for, both consulting type of work and managed services. Over to you, Angie."
},
{
"speaker": "Angie Park",
"text": "Thank you, Julie, and happy holidays to all of you, and thanks for taking the time to join us on today's call. We were very pleased with our results in the first quarter, which exceeded our expectations and reflects momentum across our business. We are particularly pleased with our strong revenue growth, which was broad-based across geographic markets, industry groups, and consulting and managed services, demonstrating we are a leader in the market as a trusted reinvention partner for our clients. Based on the strength of our first quarter results, we are increasing our full year revenue outlook, which I will cover more detail later in our call. So, let me begin by summarizing a few highlights in the quarter. Revenues grew 8% in local currency above the top end of our guided range with six of our 13 industries growing double digits, and we continue to take market share. We delivered EPS in the quarter of $3.59, reflecting 10% growth over adjusted EPS last year. Operating margin was 16.7% for the quarter, consistent with adjusted Q1 results last year and includes significant investments in our people in our business. Finally, we delivered free cash flow of $870 million and returned $1.8 billion to shareholders through repurchases and dividends. We also invested $242 million primarily attributed to five acquisitions in the quarter. With those high-level comments, let me turn to some of the details starting with new bookings. New bookings were $18.7 billion for the quarter representing 1% growth in both U.S. Dollars and local currency with an overall book-to-bill of 1.1. Consulting bookings were $9.2 billion with a book-to-bill of 1.0. Managed services bookings were $9.5 billion with a book-to-bill of 1.1. Turning now to revenue. Revenues for the quarter were $17.7 billion, a 9% increase in U.S. Dollars and 8% in local currency, approximately $240 million above the top end of our guided range. The foreign exchange impact for the quarter was approximately positive 1% compared with the positive 1.5% estimate provided last quarter. Consulting revenues for the quarter were $9 billion, up 7% in U.S. Dollars and 6% in local currency. Managed services revenue were $8.6 billion, up 11% in both U.S. Dollars and local currency, driven by double-digit growth in technology-managed services, which includes our application-managed services and infrastructure-managed services, and high single-digit growth in operations. Turning to our geographic markets, in the Americas, revenues grew 11% in local currency. Growth was led by industrial, software and platforms, banking and capital markets, and consumer goods, retail, and travel services. Revenue growth was driven by the United States and Argentina. In EMEA, revenues grew 6% in local currency, led by growth in public service, life sciences, and health, partially offset by a decline in banking and capital markets. Revenue growth was driven by the United Kingdom and Italy, partially offset by a decline in France. In Asia Pacific, we delivered 4% revenue growth in local currency driven by growth in utilities, industrial, and health, partially offset by a decline in chemicals and natural resources. Revenue growth was led by Japan, which represents approximately half of Asia Pacific, partially offset by declines in Singapore and Australia. Moving down the income statement, gross margin for the quarter was 32.9% compared to 33.6% for the first quarter last year. Sales and marketing expense for the quarter was 10.2% compared with 10.5% for the first quarter last year. General and administrative expense was 6% compared to 6.4% for the same quarter last year. Before I continue, I want to note that in Q1 of last year, we recorded $140 million in costs associated with our business optimization actions, which decreased operating margin by 90 basis points in EPS by $0.17. Following comparisons exclude these impacts and reflect adjusted results. Operating income was $2.9 billion in the first quarter reflecting a 16.7% operating margin consistent with adjusted operating margin in Q1 of last year. Our effective tax rate for the quarter was 21.6% compared with an effective tax rate of 23.2% for the first quarter last year. Diluted earnings per share were $3.59 compared with adjusted EPS of $3.27 in the first quarter last year reflecting 10% growth over adjusted EPS in Q1 last year. Day services outstanding were 50 days compared to 46 days last quarter and 49 days in the first quarter of last year. Free cash flow for the quarter was $870 million resulting from cash generated by operating activities of $1 billion, net of property and equipment additions of $152 million. Following the completion of our $5 billion inaugural debt offering, our cash balance at November 30th was $8.3 billion compared with $5 billion at August 31st. With regards to our ongoing objective to return cash to shareholders, in the first quarter, we repurchased or redeemed 2.5 million shares for $898 million at an average price of $355.03 per share. As of November 30th, we had approximately $5.9 billion of share repurchase authority remaining. Also, in November, we paid a quarterly cash dividend of $1.48 per share for a total of $926 million. This represented a 15% increase over last year and our Board of Directors declared a quarterly cash dividend of $1.48 for share to be paid on February 14th, a 15% increase over last year. So in summary, we are very pleased with our Q1 results, and we are off to a strong start in FY25. And now, let me turn it back to Julie."
},
{
"speaker": "Julie Sweet",
"text": "Thank you, Angie. Starting with the demand environment, we saw more of the same. Our clients are focused on reinvention, which means large-scale transformations. We do not currently see an improvement in overall spending by our clients, particularly on smaller deals. When those market conditions improve, we will be well-positioned to capitalize on them, as we continue to meet the demand for the critical programs our clients are prioritizing. As expected, building the strong digital core required for reinvention was a strong driver of our growth this quarter. GenAI continues to be a catalyst for reinvention across the enterprise and building out the data foundation necessary to capitalize on AI, as an increasing part of that growth. Themes around achieving both cost efficiencies and growth continue across the demand we're seeing. Through the examples from Q1, you can see both our strategy to be the reinvention partner of choice and how we are bringing together our services, our ecosystem relationships, and our scaled investments in cutting-edge platforms like SynOps and GenWizard, as well as technologies like GenAI to drive value for our clients. We are helping our clients build their digital core, including in the cloud, which saw double-digit growth this quarter. Accenture Federal Services is working with the U.S. Air Force, the nation's military service air branch, on a cloud monetization journey to manage its complex IT environment so that military personnel can maintain their competitive edge. We will develop a multi-cloud ecosystem using services from multiple providers to create a robust, secure, and integrated infrastructure. This will enhance how different systems and devices work together and communicate to quickly implement cutting-edge tools and technologies. We also provide managed services that foster collaboration and enable personnel to quickly make data-driven decisions about their cloud usage and costs while adapting to changing mission requirements. This partnership will enable the U.S. Air Force to get the most out of their cloud investments to achieve real-time cross-cost transparency, accelerated cost savings, increased efficiency, and improved agility. Our industry expertise is critical to building the right digital core. We are partnering with the BCC ICCREA Group, Italy's largest cooperative banking group, through a joint venture with its IT subsidiary on a reinvention journey to help over 100 affiliated banks grow. Our managed services will modernize the IT platform and migrate applications to the cloud, enhancing resiliency, stability, and service quality. We will also consolidate data and build an integrated cloud platform for advanced analytics and AI, strengthening their digital core. GenAI will be applied to increase internal IT efficiency and reduce customer response time on digital interaction channels. We will expand digital offerings, employee onboarding, and payments using our suite of shared finance services solutions. A change management communications program will offer targeted up-skilling and re-skilling opportunities to ensure employees use new technologies and methodologies effectively. Together we will help BCC, ICCREA Group, reduce costs and drive innovation, enabling the banking group to be more competitive and bring new products and services to market faster. Security is an absolutely essential component of every company's digital core, and we again saw very strong double-digit growth. We are the partner-of-choice in part because we bring both the understanding of cross industry threats and industry specific threats with our deep experience across 13 industry groups. We are supporting a leading aircraft manufacturer and its cybersecurity across aerospace and defense on critical infrastructure and production systems. We will provide managed services and solutions for their cyber security capability, leading to a more powerful and secure program, bringing security by design and industrial assets and the extended enterprise. Our solutions will help provide improved security and meet regulatory compliance. We are also helping with the digitization of manufacturing and supply chains. Industry X grew double digits this quarter. We are continuing to evolve our long-time partnership with a global leader [in tire] (ph) manufacturing to revolutionize the way factories operate and to reduce time-to-market for new products, accelerating innovation. We will build a hybrid data foundation in the cloud, integrating millions of data points. We will also implement advanced analytics, AI, and digital twin technologies to optimize operations processes such as quality checks. This will enable the company to trace the root cause of a failed batch of tires back to a machine or process in minutes instead of days. And predictive maintenance will pinpoint what parts of their process or machinery may be impacting quality and productivity, preventing costly down times. Engineering teams will benefit from machine learning and simulation tools to generate and optimize the design of new products. We will also implement new ways of working to attract tech-savvy talent and cultivate a learning culture where employees in over 100 factories are upskilled on the AI powered tools. The company will look to increase growth opportunities and support their digital first strategy, all while remaining competitive in the market. We are partnering with PUMA India, a leader in sports lifestyle products, to reinvent their supply chain and distribution network. This will meet the ever-evolving customer demand for order delivery in a highly competitive, omni-channel market where quick commerce is becoming the norm. We will use data and AI to identify and set up localized fulfillment centers, optimizing their size and location based on customer sales. Digital twins of these facilities will simulate various process designs and physical automation scenarios to identify bottlenecks. This will help redefine warehouse layouts and improve material flow for more efficient order and return processing, delivering orders up to 70% faster with express delivery for online orders expected to double. Supply chain costs are also expected to decrease by up to 10%, and additional features like solar power and EV charging stations at fulfillment centers will further reduce costs and support sustainability goals. PUMA India will be the first amongst sports brands in the region to build this type of cutting-edge operating model, enhancing customer loyalty to drive future growth. We are reinventing all things customer through Song, which grew high single digits this quarter. We have the ability to integrate creative, data and AI, tech and strategy while leveraging our industry and operations expertise to unlike marketing as a growth enabler for our clients while delivering efficiencies. We are helping Spotify optimize its advertising business by finding opportunities to drive efficiency as it scales globally. Our marketing operations managed services support their ad operations under a single roof, touching a significant amount of their ad revenue across 150 markets. We've infused automation across their operational workflows to help significantly reduce the time and effort required to launch advertisers' campaigns, getting them to market more quickly to help ensure revenue realization and advertiser satisfaction. We continue to expand beyond ad operations, actively launching new capabilities across analytics and insights, data integrity and enrichment, customer support, and more. Our partnership helps Spotify to focus on its core competencies so it can achieve long-term relevance and growth in an increasingly competitive market. We are collaborating with CaixaBank, a leading financial group in Spain, on their plan to enhance customer and employee experiences. We will increase productivity and efficiency by leveraging AI and GenAI to build multiple solutions, such as the bank's chat bot, which has significantly reduced response times and improved the quality of answers for clients, and an employee assistant tool that utilizes natural language conversations and solution searches. We will also build a customer service claim solution that analyzes documents and supports agents and lawyers in proposing the right responses, reducing processing time, and assisting specialized teams. This will help CaixaBank reinvent with GenAI and we are creating real value from GenAI across industries and countries. We are partnering with Vale, a Brazilian mining and logistics company, to transform its environmental licensing program, speeding up permit applications and expanding its sustainability goals. We created Smart Licensing, an end-to-end licensing management platform that uses GenAI to scan application materials and environmental studies to promote compliance with regulatory and environmental requirements. This creates actionable summaries reducing internal document reviews from days to minutes. We've trained over 500 people to use Smart Licensing and established a change management team to combine previously segmented teams, helping Vale plan and execute more efficiency while further reducing environmental impact. We are partnering with Indosat, a Digital Telecommunications Company and its subsidiary, Lintasarta, a leading provider of data communication, Internet, and IT services to launch Indonesia's first sovereign AI cloud platform. This will accelerate their AI-driven digital transformation and support the country's vision of becoming a digitally empowered nation by 2045. The collaboration will initially focus on AI solutions for Indonesia's financial services sector, one of the key pillars of the country's economy. Accenture's AI refinery platform will provide scaled AI capabilities with pre-built solutions that have a modular architecture to meet clients' needs wherever they are in their AI journey, significantly reducing time to value. This partnership will help Indonesian companies to drive reinvention by harnessing the power of scaled GenAI, propelling innovation, operational efficiency, and sustainable growth in a competitive market. Talent continues to be at the top of the agenda for CEOs and governments, and our LearnVantage services position us to be able to help clients invest in their workforce. Our partnership with S&P Global, a leading provider of financial data analytics and ratings, is driving GenAI innovation across the financial services industry, empowering their workforce to adopt GenAI at scale to enhance productivity and deliver revenue growth. They are equipping nearly 40,000 of their employees with the necessary skills, leveraging Accenture LearnVantage Services, a comprehensive GenAI learning program. This program includes curate and customized content to drive AI fluency and address the industry's evolving talent requirements. Finally, a quick look at how we're continually using our investments and acquisitions to drive our future growth. To continue to scale LearnVantage, we acquired award solutions in the U.S., which expands our learning offerings tailored to the unique needs of the network leaders, network operations and performance engineers, and IT professionals in the telecom space. To enable us to scale [faster in health] (ph), a $70 billion adjustable market growing approximately 6%. We acquired consus.health, a leading German healthcare management consultancy. Health is an industry still early in digitalization, and our investments are positioning us for the continued growth we see over the next several years. And supply chain continues to be in early in digitalization, and we are investing to continue to drive growth. This quarter, we acquired Camelot, an international SAP-focused management and technology consulting firm from Germany with specific strengths in supply chain, data and analytics and Joshua Tree Group in the U.S., supply chain consulting firm specializing in distribution center performance. Back to you, Angie."
},
{
"speaker": "Angie Park",
"text": "Thanks, Julie. Now, let me turn to our business outlook. For the second quarter of fiscal 2025, we expect revenues to be in the range of $16.2 billion to $16.8 billion. This assumes the impact of FX will be about negative 2.5% compared to the second quarter of fiscal 2024 and reflects an estimated 5% to 9% growth in local currency. For the full fiscal year 2025, based upon how the rates have been trending over the last few weeks, we now assume the impact of FX on our results in U.S. Dollars will be approximately negative 0.5% compared to fiscal 2024. For the full fiscal 2025, we now expect our revenue to be in the range of 4% to 7% growth in local currency over fiscal 2024, which includes an inorganic contribution of a bit more than 3%, which we expect will be about 4% in the first half and about 2% in the second half. And we continue to expect to invest about $3 billion in acquisitions this fiscal year. For operating margin, we continue to expect fiscal year 2025 to be 15.6% to 15.8% at 10 to 30 basis point expansion over adjusted Fiscal 2024 results. We continue to expect our annual effective tax rate to be in the range of 22.5% to 24.5%. This compares to an adjusted effective tax rate of 23.6% in fiscal 2024. We now expect our full year diluted earnings per share for fiscal 2025 to be in the range of $12.43 to $12.79 or 4% to 7% growth over adjusted fiscal 2024 results, reflecting the raise in our revenue outlook and adjusting for the revised FX assumption. For the full fiscal '25, we continue to expect operating cash flow to be in the range of $9.4 billion to $10.1 billion, property and equipment additions to be approximately $600 million and free cash flow to be in the range of $8.8 billion to $9.5 billion. Our free cash flow guidance continues to reflect a free cash flow to net income ratio of 1.1 to 1.2. Finally, we continue to expect to return at least $8.3 billion through dividends and share repurchases, as we remain committed to returning a substantial portion of our cash to our shareholders. With that, let's open to -- so that we can take your questions. Katie?"
},
{
"speaker": "Katie O'Conor",
"text": "Thanks, Angie. I would ask that you each keep to one question and a follow-up to allow as many participants as possible to ask a question. Operator, would you provide instructions for those on the call?"
},
{
"speaker": "Operator",
"text": "Absolutely. [Operator Instructions] Today's first question comes from Tien-Tsin Huang with JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Thank you good morning. It's really encouraging to see the revenue come in here above the guidance range. I think it's the widest margin in nearly two years. Julie, you said that the demand environment is more or less the same. So I'm curious what you [attribute] (ph) this new pattern to and if market conditions are maybe improving underneath here. Any comments?"
},
{
"speaker": "Julie Sweet",
"text": "Thanks, Tien-Tsin. This is the strategy that we've been outlining for the last few quarters, where last year, when we saw the -- spending, particularly on the smaller deals, we pivoted to really focusing on getting -- winning more reinvention partners of choice, so increasing the number of our deals that were over $100 million in a quarter. You'll remember last year, we actually had [125] (ph) of those. And the idea was to increase -- go after the demand, which is in the larger reinventions and that, that would position us to get back to a strong growth in '25 as those deals begin to layer in. And so what you're seeing is the result of -- what we're really proud of was quite a bit of agility last year that when the market changed, we changed, because as you know, these are not easy deals to do quickly. And we quickly pivoted last year, went after the demand and then put ourselves in this position. And that's why we did underscore that the market environment has not changed. This is the result of the strategy we executed, which we're uniquely able to do because we have all the skills and capabilities, we have the mix of consulting and managed services. And so this is what we were talking about last quarter when we said we are going to get back to strong growth based on execution of this strategy. And of course, these are super critical strategic programs. And so when spending does come back and the market does improve, we're at the heart of our clients' business, and we should be well capitalized to pick up on not spending."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Yes. No, the last point is important, short-term stuff comes back. Hope you should see that pretty quickly as well on top of this. So good, thanks. And my follow up, just have to ask it, I get a lot of questions on the U.S. federal government and Accenture's exposure there. I think it's about 8% of revenue based on some of your annual report disclosures. So just curious, given some of the change in administration and the discussion around efficiency, have your expectations? Or are you going to change your strategy here on the U.S. federal government side? Any comments there would be terrific. Thanks for the time."
},
{
"speaker": "Julie Sweet",
"text": "Yes. Well, we're really excited because our core competencies in federal, right, are around driving efficiencies. They're around helping -- keep our country secure. We're working with the U.S. federal agency on securing critical infrastructure, right, and on changing citizen services. We work across very important agencies. And so we believe that we're super well positioned to continue to help the mission of the federal government to secure itself, to help citizens and to drive more efficiencies, which will be tied very much to cloud, data and AI. And what really makes us uniquely positioned is that we believe that there is going to be an even greater appetite of taking commercial solutions to the federal government. And we are very uniquely positioned because we have strong government expertise, but we've got commercial and private sector solutions. We are the leader with every major ecosystem partner. And you saw that -- I was talking today about the U.S. Air Force and what we are doing on the cloud modernization. And our work is mission critical. I mean, the vast majority of what we do is mission critical to the federal government. So we see a real opportunity to continue to partner with the new administration as we've partnered with all administrations, and also with all of the leaders in the federal government every day are waking up to really drive those three things. So really, really feel good about where we are positioned in the federal government to help this agenda."
},
{
"speaker": "Tien-Tsin Huang",
"text": "Awesome, thank you."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from Jason Kupferberg with Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"text": "Good morning guys. Happy holidays. I know that last quarter, you indicated the high end of the initial revenue guide. For this fiscal year, did not require any material improvement in consulting. Just wondering if that's still the case as you're now raising the top end a little bit? Or are you now assuming any improvement in consulting since you're almost four months into the new fiscal year?"
},
{
"speaker": "Angie Park",
"text": "Yeah, hi Jason. Good morning. And I'll take that. For us, with the raise in -- to 4% to 7% for the full year, there's really no change in what we shared with you before, which is that at the top end of the range, we continue to see more of the same, whereas at the bottom of the range, we see a bit more -- we allow for a little bit more deterioration. So no change there."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And our over delivery, I mean, we're very pleased, obviously, with consulting and managed service growth this quarter. And these large deals came in a little bit better, which is how we overdelivered and now raising the guidance."
},
{
"speaker": "Jason Kupferberg",
"text": "Great to hear. And then I'm just looking at the net headcount adds cumulatively over the past two quarters. I think we're almost 50,000. That was a pretty big step up from what the prior trend looked like. So can you give us any sense of how much of that was from acquisitions versus organic? And I guess is there any reason to not look at this accelerated hiring as kind of a bullish indicator?"
},
{
"speaker": "Angie Park",
"text": "So let me take that question. And as it relates to the net people adds that we had in Q1. So we did add about 24,000 people in the first quarter, which is really reflective of the momentum that we see in our business. And managing supply and demand is a core competency of ours. And what you see is the continued high utilization rates at around 90%. Looking ahead, we'll continue to hire for the demand that we see and the skills that we need. And I'll give you a little bit more context that the hiring that we saw this quarter, similar to last was that it was concentrated in India."
},
{
"speaker": "Julie Sweet",
"text": "Yes. And I would just say that underlying our guidance, you are seeing organic momentum, right? So at the high-end of our guidance, for the year, we are going to exit at -- the range of organic growth in our guidance is 1 to 4, right? So I think that is -- it is a positive sign that we're hiring and some of it is coming from acquisitions, but we are seeing organic momentum in our business."
},
{
"speaker": "Jason Kupferberg",
"text": "Thanks for the comments."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from Bryan Keane with Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"text": "Hi guys. Congrats on the solid result. And Happy holidays. Kind of asking the guidance question a little bit differently. The 4% to 7% constant currency revenue guide for the fiscal year 2025, is a touch below just the first quarter number of 8% on a constant currency basis. So just trying to think about if there is any reason why the growth would decelerate off the first quarter level as we get more into fiscal year 2025?"
},
{
"speaker": "Angie Park",
"text": "Hi, Bryan, happy holidays to you as well. Let me give you -- here's how we were thinking about our guidance for the full year and the raise to 4% to 7%. If you think about where we are, we had a strong start in Q1. We have strong guidance in Q2, which was really driven -- it was broad-based and driven by our organic growth. At the same time, you heard Julie say, the macro remains the same. There's no change in the overall environment. And I want to reinforce importantly what I said earlier, which was we do expect -- we continue to expect inorganic contribution of about -- of a bit over 3%. And one of the things that we provided to you was how that will come in. So H1, we expect somewhere around about 4%, second half about 2%, and that will give you more of an understanding of how we see organic playing out for the year. And we will continue to see organic throughout this fiscal year. And then as it relates to -- if you think about it, we're one quarter in. We've got one quarter under our belt. We've got three more to go. And as Julie said earlier, we're executing on our strategy, and you can count on us to continue to do so."
},
{
"speaker": "Bryan Keane",
"text": "Got it. Got it. That's helpful. And then maybe you guys could just talk a little bit about the industry group, the Financial Services. A lot of times, that kind of leads out of economic slowdowns. But it sounds like Banking & Capital Markets was a little bit softer, but some other areas of strength and just trying to figure out where that is in the industry right now because we're kind of getting mixed messages from some of the other IT service providers. Thanks so much."
},
{
"speaker": "Julie Sweet",
"text": "Yes. So -- and I think it's a little bit different by market, right? So we are seeing the results a bit different by market. I will say, by the way, that we were pleased to see the U.K., as you might have heard, is coming back as we reposition the U.K. But with the dynamics in the U.S. market where it is a little bit better, in EMEA, it was a little bit worse, and you've got a mixed picture on the interest rates, what the expectations are. And so I'd say that -- and that is probably not a surprise. Yesterday, probably complicated that a little bit in the U.S., right? And so on the one hand, we are seeing a lot of interest, for example, in Banking & Capital Markets on things like GenAI. On the other hand, there is a lot that's being kind of processed with what's going to happen with interest rates and that. And so I -- we see -- obviously, it is getting better, but it is a mixed picture by region."
},
{
"speaker": "Angie Park",
"text": "Yes. And just as a reminder, Bryan, as we look at Financial Services overall, we exited Q4 last year with a minus 2%, and we saw the uptick in the first quarter at 4% globally which reflects the dynamics that Julie was just describing, which really plays for our strength, as you think about the diversity of our business across markets and industries."
},
{
"speaker": "Bryan Keane",
"text": "Great. Thanks again."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from Darrin Peller at Wolfe Research. Please go ahead."
},
{
"speaker": "Darrin Peller",
"text": "Guys, thanks. Great results. Could we just touch on your potential for visibility this year into budgets and the timing you'd expect again? I know last -- I think earlier this year, it was generally in the January, February time frame, which had moved back up a little bit. But do you still anticipate that kind of visibility at that part of the year? Or we could get a better picture on whether discretionary is really going to pick up or not? And then maybe just as a dovetail on that, maybe just conversations you are happening right now around AI for next year. Obviously, the bookings keep looking really strong for you guys, which is great. Any more specifics on where you are seeing it incrementally improve? Thanks guys."
},
{
"speaker": "Julie Sweet",
"text": "Yes. So a great understanding of Accenture. January is sort of -- January, February as we really see what the client budget is going to be looking at. So that's where we get the most visibility. And so we'll be reporting more on that in the next quarter. So you're absolutely right, we do anticipate getting that visibility in January, February. And then with respect to AI, we are continuing to see in our conversations, and I probably talked to 30 CEOs in the last 2 months, right? So spend a lot of time, and also around the world. So it's been a busy travel quarter. I've been in Europe, I've been in Southeast Asia, Australia, the U.S. So -- and pretty consistently, clients are seeking to do more in AI, but they are in such different places. I mean I'll be with one bank where we're talking about what is GenAI, AI, why does it matter? And the fact that they are not yet in the cloud. And I'll be talking to another bank where they've been fully in the cloud and they want to be the first out to use GenAI. And so I think it is hard to generalize. You are still seeing that because the overall spending environment is the same, that they're -- that those who really want to go into -- in AI are more prioritizing spending as opposed to spending more, right? Where we see the biggest opportunity when companies start to get more confident to spend more is going to be and moving faster with their data foundation that fuels AI and then AI. But right now it still generally feels more like a prioritization within current budget. And so we'll see what happens in January and February. And that's why our strategy has been to pivot there, right? So to go after [more than] (ph) our fair share of those budgets."
},
{
"speaker": "Darrin Peller",
"text": "All right. That's really helpful. And then just when we look at the opportunity for what you're -- where you're hiring, you mentioned India, but we've heard a lot of customers are starting to think about a little bit even more onshore. And so just maybe talk a little bit more about the mix again. It had gone for a while more offshore looking for better price optimization. But where are we on that right now? Are you seeing any evidence of a shift back to nearshore, onshore? Thanks again guys. Great job."
},
{
"speaker": "Julie Sweet",
"text": "No big trend. What I'd say is we focus on the G2000. So a lot of our companies are global. And so they really are looking for optimization of right skills because a big piece of why people, for example, use India is about skills, right? 10 years ago, it was about labor arbitrage, right? Today, it is about like the ability to get these skills at scale. What I would say is that we, at Accenture, are continuing to develop more because in some cases, it is language, right, as you're kind of doing more transformation, new parts of the enterprise where you want maybe lanes with skills or time zones. So we have a global network in -- with 100 centers around the world. In the U.S., for example, we've been opening some new centers in underserved environments. We just opened a center in the Bronx recently. So -- but all of it is kind of aimed at being very sophisticated, and we see ourselves as part of the integrated talent strategy of our clients. And it's like right skills, right time zone, right price, continues to be the guiding with I would say an emphasis on skills."
},
{
"speaker": "Darrin Peller",
"text": "Great. Thanks Julie, thanks Angie."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from Jim Schneider with Goldman Sachs. Please go ahead."
},
{
"speaker": "Jim Schneider",
"text": "Good morning. Thanks for taking my question. Julie, understand that your outlook, and you’re not really seeing any differences on macro side, and your outlook look like sort of idiosyncratic growth. But can you maybe discussed a little bit about when you talk with clients, what's the sort of range of outcomes for discretionary increases in the 2025 budget outlook? And how big a factor is rates specifically as a macro impact when they're thinking about that? And do you think that changes materially given the Fed message yesterday?"
},
{
"speaker": "Julie Sweet",
"text": "The rates definitely depends on industry, right? So if you're a more capital-intensive industry or you're an industry that wants to grow more in acquisitions, the rates -- there's lots of puts and takes in doing the range. And I think it's just too early based on yesterday's there's been a lot of speculation. I mean our business is very much focused on like -- when there's change, and it doesn't matter what the change is, good or bad change, that's where we really partner with our clients successfully because if they've now got new constraints because the rates are higher, then they want more opportunity to cut costs. If the rate are going to fuel things like capital projects, we've got our capital projects business, right? So what we focus on, and I think what we are so successful is we have these deep relationships with our clients. Our top 100, we've been them over 10 years. We understand them. And we are always looking at this and say, okay, what that mean, anticipating what they are helping. So that's -- so whatever the change is, that's where Accenture really can help them pivot. And it's part of our strength that we're so relevant to both growth and cost."
},
{
"speaker": "Jim Schneider",
"text": "That's helpful. Thank you. And then with respect to the AI work, you talked about some of the context of the client conversations you're having. But quantitatively, are you seeing any kind of major changes in terms of the size and scope of the individual projects? And what are clients saying about sort of their pivot or when they might pivot to sort of larger, more transformative projects within GenAI?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. We are already starting to see that, right? We are starting to see the clients -- and the characteristics are pretty clear. If you have a client that's been investing in their digital core, include security and data for many years, and we have many of those that we've helped, they're now able to start to scale, and we are starting to do that, and we're seeing those partnerships. Where you have clients where we've been helping them prove it and maybe scale in a part of the business, but they really haven't got their data foundation or they're not moving into the cloud, then what they're working with us is how do we accelerate that. And what you probably heard as we were talking through some of the examples today is that there's a lot of data foundation now being built along with getting into modern cloud platforms. And so we are seeing an acceleration of the data work, which is absolutely fundamental to using GenAI."
},
{
"speaker": "Jim Schneider",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And our next question today comes from Dave Koning with Baird. Please go ahead."
},
{
"speaker": "Dave Koning",
"text": "Yeah, hi guys. Great job. And I guess my question, just on the fiscal Q2 guide. Historically, Q2 has been a pretty flat sequential quarter. And you are guiding, I believe to down about $1 billion to $1.5 billion sequentially this quarter. I know a little of that may be a few hundred million FX, I get that. But what -- was there anything in Q1 that kind of naturally falling off in Q2 this year, that's a little unnormal or some sequential pattern that's a little different?"
},
{
"speaker": "Angie Park",
"text": "Yes, David, happy holidays and good morning. As we think about our Q2 guide of 5% to 9%, it's a very solid guide, based upon what we see. And there's nothing unique in Q2 that I would call out. And in fact, just anchoring back to our over delivery that we saw in the first quarter was really a function of the larger deals coming online a bit better than we expected, and we continue to see that, which gave us confidence in driving -- in raising our guidance for the full year. So nothing to call out for Q2."
},
{
"speaker": "Dave Koning",
"text": "Got you. Yes. You definitely crushed Q1. And then, I guess, one just a nerdy kind of financial question, but now that you fully have like the debt in place, should we think about a sequential pickup in interest expense? I think it was $30 million in Q1. Does that go to like $50 million in Q2 or something like that?"
},
{
"speaker": "Angie Park",
"text": "Yes. Different than giving you the specific numbers in terms of how to think about it, yes that is correct because when you – there is certain things, of course, that we see in our income below operations. And what you saw there was the interest -- the net interest income was lower as a result of we did have average lower cash balances, also lower interest rates. And then we also had the interest expense from our long-term debt. So -- but all of that has been factored in the guidance that we've given and so it's in there."
},
{
"speaker": "Dave Koning",
"text": "Gotcha. Thanks guys. Great job."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question today comes from James Faucette with Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"text": "Great. Thank you very much. I want to just quickly ask a follow-up on capital structure and allocation. It sounds like you are still quite committed to pursuing both acquisitions, as well as capital return. Last year, we looked at -- we did some essentially debt raise to help fund those priorities. Where are we at from that perspective? Or do you feel like we're in a pretty good overall cash position and continue to be able to do that? Or should we expect that at some point, at least over the next couple of years, we can see further decreases in debt and debt raising to fund the capital allocation priorities?"
},
{
"speaker": "Angie Park",
"text": "Yes. Hi James. Nice to talk to you. Why don't I start. We were pleased to execute our inaugural bond offering of $5 billion, which we did in October. And when we step back, it was really a routine review of our capital structure where we tap the long-term debt market to increase our liquidity for general corporate accounting purposes, and what it does is, it ultimately, it optimizes our capital structure and reduces our cost of capital. That said, let me just reinforce for you, there is no change to our capital allocation as strategy, which also includes how we look at and use G&A."
},
{
"speaker": "Julie Sweet",
"text": "And this year, we are going back to kind of more of a business as usual. We think it's going to be somewhere around $3 billion. But as we've always said, if there is opportunities or not, we've got the balance sheet. So we could raise debt, but there's no strategy to increase debt. But we might, if we had the right opportunities. I mean, last year, we had a great opportunity to double down on strategic acquisitions, and it served us well as we've gone into this year. But this year, we are back to kind of standard around $3 billion, which is kind of the right percentage. So we'll communicate as we go. We always have that flexibility. And I think that's the strength if you think about Accenture is having a strong balance sheet and to have the flexibility to go after opportunities in the market that drive long-term growth. And that's how we think about the decisions about whether or not to do debt or not."
},
{
"speaker": "James Faucette",
"text": "That's great color there. And then I wanted to ask about the consulting bookings, seeing nice growth and acceleration there. I'm wondering -- and I know it is hard given the breadth of Accenture's customer base, but I'm wondering if you can help us maybe generalize what you're seeing in consulting bookings and if there's a change there? And I guess I'm wondering if we're seeing a focus on cost control versus potential revenue generation or new technology evaluation or how it folds into AI. Just any color you could provide on what the tenor of those consulting bookings look like right now?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. So maybe just keep in mind that what we're generally bringing to our clients are multiservice solution. So you might do, as we talked about, we're doing managed services in security, and that requires industry consulting as a part of it to make sure that we're doing all the work. A lot of the reinvention is a lot of process that. So I think I would anchor on -- there are really are two themes that at least -- when they come to us. They want cost efficiency. Every industry wants a cost efficiency now, and they're looking for growth or other outcomes, speed to market. You heard a lot -- when we talked about, like what we're doing with like CaixaBank, that was both speed to market, as well as efficiencies. And so that's one of the things that we focus on, and that really gives us -- it's our unique differentiation because we got things like Song, that's everything about customer, and we can put to that. We understand the industry. So the twin themes here is cost efficiency and growth."
},
{
"speaker": "James Faucette",
"text": "Great. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question today comes from Keith Bachman with BMO Capital Markets. Please go ahead."
},
{
"speaker": "Keith Bachman",
"text": "Hi, good morning. Many thanks and happy holidays to everyone. My first question I wanted to ask is around pricing dynamics. And you've indicated that the macro backdrop is fairly steady. You're gaining share through skills, and I wanted to ask specifically about some of the legacy areas such as application maintenance, maybe the BPO work. One of your competitors suggested that pricing is pretty challenging because there aren't enough deals and a lot of folks chasing those deals, but could you specifically address what you're seeing as pricing dynamics during the quarter? Any changes?"
},
{
"speaker": "Julie Sweet",
"text": "It's a very competitive market, which is what we've been saying every quarter and we did see lower pricing across the business, which has been pretty consistent. What I would say is, that which makes sense, right you're in a constrained -- as we said, that the clients have constrained spending, particularly on small deals and so you'd expect it to be constrained. What I would say, though that AMS, Application Managed Services, is not legacy if you do it the way we do it, right? So what we offer to our clients is we have the talent, the full-stack engineers, the GenAI, we have a platform called GenWizard. And so clients are coming to us to say, hey, can you take off my old applications. They're coming on us to modernize while taking costs down. And you see that for -- and what the work we're doing, it's very advanced in how we are doing it. So we basically call it run to the new right? It's like have us help you run your applications in order to rotate to the new. So we see this as a critical way that we are at the heart of their business in modernizing their digital core. It's not legacy. Same thing with our operations business."
},
{
"speaker": "Keith Bachman",
"text": "Yes. Okay. That makes a ton of sense. Thank you Julie. My follow-up question is, some of our recent discussions, and to be fair, with software companies, have suggested that Europe's softened in the last 30, 45 days and -- which makes sense, if you just read the newspapers about what's going on in Europe. But have you guys seen any change in the dynamics underpinning Europe and/or change the perspective that you may have as it relates to European demand over the next 12 months? And that's it for me. And many thanks again, and happy holidays."
},
{
"speaker": "Julie Sweet",
"text": "Thanks. So our view of European demand is -- over the next 12 months, is baked into the rise of in our guidance, right? And we are all reading the same papers. Europe is definitely more, Middle East is obviously different. Europe is definitely in a more challenging environment. And you see that with our growth rate is there on a relative basis as well. But we feel very good about -- we have an excellent business in EMEA. We are very relevant to our clients. And so we feel good about the -- us -- our demand environment, and that's fully reflected in the raise in guidance that we just gave you. Thank you. Can we have the next question?"
},
{
"speaker": "Katie O’Conor",
"text": "Operator, we have time for one more question, and then Julie will wrap up the call."
},
{
"speaker": "Operator",
"text": "Absolutely. And our final question comes from Bryan Bergin with TD Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"text": "Hey, guys. Good morning. Happy holidays. I wanted to ask on the service lines here. Can you comment on performance across strategic consulting, tech services and operations?"
},
{
"speaker": "Julie Sweet",
"text": "Yes. All very -- all strong this quarter."
},
{
"speaker": "Angie Park",
"text": "Yes. Bryan, the thing that I would add to that is we did see broad-based growth. And if you look at it from a consulting and a managed services type of work perspective, we had mid-single-digit growth in consulting and 11% growth in managed services. And as you think about the rate that we have for the year, which is 4% to 7% underneath that, we see consulting now in the mid-single range growth and managed services in the mid-to-high range growth."
},
{
"speaker": "Bryan Bergin",
"text": "Okay. And then a follow-up here on the workforce and contract profitability. So you know the most headcount was added across India. Can you just comment on what you're seeing there as far as wage inflation dynamics, just given most services companies and GCCs have been leaning in, and particularly amid the competitive pricing environment? Just talk about the levers you have here to mitigate gross margin pressure."
},
{
"speaker": "Angie Park",
"text": "Yes, I'll start, Bryan. No real change in terms of the market dynamics of what we see reflected around wage inflation. And of course, we are always paying market relevant pay based upon the skills and the locations of our people. And we continue to see that the same, and then as it relates to pricing, as Julie mentioned, it is -- it continues to be highly competitive. At the same time, as you know of us, right, we are managing that. We're focused on pricing as well as on our differentiation, and we're focused on cost and delivery efficiencies in our business and how we operate."
},
{
"speaker": "Bryan Bergin",
"text": "All right. Understood. Happy holidays."
},
{
"speaker": "Angie Park",
"text": "Thank you Bryan."
},
{
"speaker": "Julie Sweet",
"text": "Good happy holiday. Well, in closing, I want to thank all of our shareholders for your continued trust and support and all of our people for what you do every single day. I wish everyone a very happy and healthy holiday season. Thank you for joining us today, and we look forward to being back here in a quarter. So thanks, everyone."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's conference call, and we thank you all for attending today's presentation. You may now disconnect your lines, and have a wonderful day."
}
] | Accenture plc | 972,190 |
ADBE | 4 | 2,020 | 2020-12-10 11:00:00 | Jonathan Vaas: Good morning and thank you for joining us. Welcome to the Adobe Q4 Earnings and 2020 Financial Analyst Meeting. I'm Jonathan Vaas, VP of Investor Relations for Adobe. You should have a copy of the press release we filed this morning as well as our investor relations datasheet. We've got a great program planned for you today, which is in many ways similar to what we've done in the past, and in a few ways different. This year marks my 10th analyst meeting at Adobe. The first was the year we had just launched Creative Cloud. And it's amazing to reflect on how that business has grown since then. For my first nine analyst meetings, I was one of the many employees helping behind the scenes. And this year, I have the privilege of introducing the executive speakers as the head of Adobe's Investor Relations program, a role I assumed earlier this year, just after we had made the shift to working remotely. I've really enjoyed all of the conversations with investors and analysts about Adobe's business this year, and I look forward to meeting many of you in person at some point. That leads to the other way today's program is a little bit different than what we've done in the past. This is our first virtual analyst meeting. I, for one, will really miss the opportunity to meet many of you and chat after the event, but we've also been learning this year about the power of communicating digitally and seeing that we are able to meet to reach a broader audience with a webcast than we might with an in person event. Due to the format, we've streamlined the planned presentation today. But a long form slide deck has been posted to Adobe's IR site that has all of the detailed information you're used to seeing. Let's take a look at the agenda. Shantanu will kick things off today by talking a bit about the quarter and fiscal year we just completed and then moving over to Adobe's vision and strategy for the future. Abhay will then talk about the company's vision from a technology lens. Scott will highlight our Creative Cloud strategy. Anil will go over our Experience Cloud strategy, and Gloria will talk about our strategy related to our people, as well as other Adobe stakeholders. Finally, John will provide a detailed financial summary and share Adobe's growth strategy. And then we'll go to live Q&A. Before we get started, as a reminder, some of the information we'll be providing today includes forward-looking statements that are subject to risk and uncertainty. Actual results may differ from these statements, and we encourage you to review the risk factors in our SEC filings for more information. Additionally, we'll be providing both GAAP and non-GAAP financial information. Reconciliations between the two can be found on Adobe's Investor Relations website. I will now pass it over to Adobe's President and CEO, Shantanu Narayen.
Shantanu Narayen : Thank you, Jonathan. I'd also like to add my welcome. Thank you for joining our annual financial analyst meeting. Today's format is a little different than what we are used to. But to make the most of this year's medium, we'll use the time today to cover strategy, business momentum, as well as our financial performance. We posted the complete deck similar to what we've done in prior years. But rather than speak to every slide, we'll have the management team share their highlights in their areas. And we've always saved some time for Q&A at the end of our presentations. First and most importantly, I hope you're all staying safe and healthy. It's really tragic to see the recent spate of casualties, but the progress in vaccines gives us all hope that the worst will soon be behind us. And clearly, none of us could have predicted how everything would change overnight, and the world as we know it would change so dramatically. Digital has even more become the primary way for people to connect, work, learn and be entertained. This new reality has only increased the importance and relevance of our solutions and accelerated the tailwinds that benefit our business. This combined with our business fundamentals, unparalleled innovation, and world class execution continues to drive our growth. 2020 was another momentous year for Adobe. And like all companies, our primary focus has been to protect the health and safety of our employees and continue to serve our customers. We took swift and decisive action to direct our employees to work from home, suspend travel and cancel in-person events. And we focused on helping our customers make their own transition to digital overnight. For example, we provisioned 30 million students with Creative Cloud, so that they could create from home. We implemented the government rapid response program to assist local governments. With our Honor Heroes campaign, we galvanized our community to create artwork honoring the true heroes – essential workers. And we set the bar high for digital events with Adobe Summit, as well as Adobe Max. In fact, Adobe Max garnered 21 million views. We continue to harness the trillions of transactions powered by the Adobe Experience cloud to provide a unique real-time perspective on the economy with the Adobe Digital Economy Index. And we pioneered new areas such as the Content Authenticity Initiative, which provides attribution functionality that creators can attach to their work to create more transparency around how content has been posted and edited. Our leadership extends to not only what we do, but how we do it. And we're proud of the continued industry recognition that we receive. We continue to be a top riser on the Interbrand Global Best Brands of the Year for the fifth year in a row. We're consistently named one of the best places to work by both Fortune and Glassdoor. And in an area that's becoming increasingly important to US investors, we're a leader whether it's in the Dow Jones Sustainability Index or the Bloomberg Equality Index. But it's a product company at our core. It is our innovation engine that I'm most proud of as we continue to fire on all cylinders. With Creative Cloud, we continue to remain the clear leader in a category that's exploding. We delivered significant product innovation that extended our applications to multiple surfaces. We added greater collaboration capabilities to all of our leading applications. And we continue to break ground in new categories, while improving engagement as well as customer satisfaction. The Document Cloud continues to have huge demand in this digital environment, with PDF and Adobe Sign all being mission critical across many businesses. We delivered more capabilities, or verbs as we refer to it, across desktop, web, mobile, and through our frictionless PDF services. And with Experience Cloud, we continue to build out the world's most comprehensive customer experience management portfolio. And the new capabilities in the Adobe Experience platform have now been expanded to include real-time customer profiles. We delivered new services, intelligence services to further the use of artificial intelligence and machine learning in organizations. We delivered new solutions like Customer Journey Analytics, which unifies cross channel data. And I'm excited that we recently closed the acquisition of Workfront, which is a leading work management solution for marketers. On the financial side, after crossing the $10 billion mark in 2019, we haven't missed a beat. And as you can see from our targets, we expect to exceed the $15 billion mark in 2021. And we're incredibly pleased to drive both top and bottom line growth, while generating cash and continuing to return to shareholders. In fact, in 2020, we achieved $12.87 billion in revenue, which represents 15% year-over-year growth. In Q4, we surpassed $10 billion in digital media ARR, which is a significant milestone for us as a company. With the strong financial discipline that you've all been accustomed to, we continue to generate impressive cash flows from operations and generated over $5 billion in fiscal 2020. And we continue to focus on earnings per share with the earnings per share on a non-GAAP basis of $10.10, which represents 28% year-over-year growth. I truly believe that these financial accomplishments set us apart from all other software companies, and the best is yet to come. Adobe's mission is to change the world through digital experiences. And it has never been more relevant as people seek new ways to communicate, learn, and conduct businesses virtually. The benefits of our innovation help billions across the globe. And the impact is experienced across every aspect of society. It motivates our employees to focus on having more impact and to invent the future. When you think about the macro trends that we all experience, every industry is experiencing a tectonic shift towards all things digital. And I believe that the events of this year have only accelerated. The genie is not going to go back into the bottle. And even regulated industries that have traditionally been slower to embrace digital have certainly picked up the pace this year. We have industries like healthcare that are transforming, whether it's through personalized medicine, telehealth and new ways, frankly, to engage patients. On the creative side, it continues to be the golden age of design and creativity, and design continues to be a key competitive advantage because everyone at their heart is a creator. They want to express themselves across new devices with new modalities. And creativity is so essential to how we connect, how we cope, and how we learn. Education has also been reimagined because digital is central to how students learn today, whether it's through remote education, as well as by unlocking new forms of creative storytelling. And digital is also breaking longstanding barriers to access to education, which is something great because it's making it more accessible. The way we work will never be the same again. And it's great to see how the PC has experienced a tremendous revival as the computing workhorse. Documents are at the center of how work gets done. Paper to digital transformation is only accelerating, and every business process is going digital because every business is now a digital business. Digital has become the primary way for all businesses to engage with their customers. And it's true that customer expectations are also at an all-time high because ecommerce is exploding. In fact, an annual holiday report that's powered by Adobe Analytics predicts that online holiday spending will reach $189 billion, which represents 33% year-over-year growth. And underpinning all of this is a massive shift towards artificial intelligence and machine learning, which will only further these forces at play. At Adobe, our strategy is at the nexus of this digital revolution. And through technology, we believe we're transforming work, learn and play. We're relentlessly focused on looking around the corner. How do we drive towards the next big market opportunity to solve customer pain points and anticipate their needs? We've pioneered and we're leading three massive growing categories – creativity, digital documents, and customer experience management. And we're relentless about expanding the customer segments we serve, adding more addressable market opportunity because we want to empower everyone, from the student to the small business owner to the largest enterprise in the world. And I believe we win by creating pathbreaking technology platforms that will lead the industry for decades, and today work across the entire computing paradigm from the largest clouds to the smallest devices, and are built with a service oriented architecture that also enables us to have new monetization models. In fact, our three industry leading cloud offerings are more mission critical than ever before across every geography and audience. With Creative Cloud, we're unleashing creativity for all giving anyone anywhere the tools to express their creativity. With Document Cloud, we're accelerating document productivity, modernizing how people view, share and engage with digital documents. And with Experience Cloud, we're powering digital businesses of all sizes, giving them everything that they need to design and deliver great customer experiences. And underpinning our three clouds is the magic and power of Adobe Sensei, a significant differentiator for Adobe and an enabler to more rapid innovation. As it relates to the creative business, everywhere we look, whether it's entertainment, education or the enterprise, content is fueling the digital economy. And that's driving an explosion of creators, tools and assets that all represent tailwinds for our business. The reality is that creativity is for everyone, from the students submitting their next school assignment to the creative professional making an ad. Everybody has a story to tell. And when you look at the categories, whether it's web content or mobile application, creation, imaging, video, animation, screen design, augmented reality, AR, 3D, they're all surging in this era of digital storytelling. Creativity is essential because more than ever before, this year has shown us the power of creativity in enabling people to express themselves to connect and to cope. We believe that creativity is one of the fundamental skills in the 21st century. And as machines get faster and smarter, skills that are uniquely human like creativity will become increasingly more essential. Creativity is also now multiplayer. Because whatever your skill level, today's creative process is becoming more iterative and collaborative. And all creative professionals must manage these multiple work streams across increasingly remote and dispersed teams, requiring seamless, cloud-based enabled collaboration and workflows that drive this productivity. Social communities like Behance that we have and Live tutorials are also providing new ways to learn and to be inspired. For us, Adobe Creative Cloud's vision is to be the one-stop shop, from inspiration to monetization. You'll hear from Scott later, but let me expand a little bit on our strategy. First, we want to advance every creative category. And we're a category leader in core creative categories, including photography, design, video, illustration, and layout. And we're expanding our leadership in new and emerging categories, including screen design and immersive meeting media, like 3D, VR and AR. And what this strategy has enabled us to do is to acquire new creators through single lab offerings, and then demonstrate the benefits of the entire Creative Cloud offering over time. We're focused on building multi-surface systems, building solutions for every surface and system because we want to enable anybody to create wherever and whenever inspiration strikes. We truly believe that these devices are not just consumption devices anymore, but every device should also be a creation device. We're focused on adding collaboration services because we can ensure that content can be seamlessly managed in the cloud and accessed from any device. And what this enables us to do on the business side is to increase engagement, but also to acquire new stakeholders and expand our customer base with these new monetization opportunities. We want to engage and inspire the community. And our vibrant communities, which are a critical driver of both acquisition and engagement, are succeeding. In fact, we've grown to over 25 million members on Behance, which represents a huge opportunity for further upsell into the broader Creative Cloud ecosystem. And programs like Adobe Live enable us to provide forums for creators and to promote active use and learning. We've always maintained that retention is the new growth, and that is more relevant than ever before as we've crossed $10 billion in digital media annualized recurring revenue from our current subscribers. At the end of the day, we're focused on democratizing creativity, enabling anyone from a student to a social media influencer, from a professional photographer, filmmaker and designer to express their creativity. And we delivered on new applications like Photoshop and Illustrator on tablets, consumer apps like Photoshop Camera and easy-to-use storytelling apps like Premiere Rush and Spark, which are all attracting new users and expanding our base. But in addition to this tremendous product innovation, we have a data-driven operating model which is enabling our ability to capture this expansive opportunity because we have a tremendously sophisticated understanding of our customer and we're able to serve up personalized experiences and offers at every part of this digital funnel and journey. And what this enables us to do is unlock engagement, as well as provides us with new upsell opportunities. And when you put this all together, mapping the products and services that we're targeting across these expansive segments and adjusting for factors like non-genuine usage, the Creative Cloud total addressable market is projected to be approximately $41 billion in 2023. $20 billion of that addressable market is coming from creative pros, which includes Creative Cloud apps, and new services like Adobe Stock. $21 billion of the addressable market opportunity is coming from the broader communicator and consumer segments, which includes products like Spark and Premiere Rush, as well as the non pro users of Creative Cloud, as well as Stock. And our aspiration to unleash creativity will continue to be this north star that we will execute against for many years to come. Among the key growth drivers that I'd like to highlight for this business include the ability to acquire new customers through category single applications for screen design, video and 3D, using mobile increasingly as a funnel through the creation of mobile IDs through mobile monetization services, as well as upsell to the multi-surface systems and new services such as Adobe Stock, as well as continued global acquisition and expansion. Turning to our second growth opportunity. It's clear and obvious that digital documents are now mission critical in powering the modern business. And we have seen this massive acceleration as businesses all shifted to remote work overnight. The truth is that artificial intelligence and machine learning, the cloud and mobile are all redefining the notion of productivity. It's reshaping how we work. It's enabling greater flexibility. And it's requiring more collaboration across global dispersed teams. And artificial intelligence is only amplifying this productivity. We're seeing a massive adoption of paper to digital processes and workflows. And the paper-based tasks of the past are all now being moved digital. And the other aspect that's happening, the cloud ecosystems are driving a new business opportunity, what we call the API economy, which is revolutionizing how apps and services are both being built, as well as being monetized. What drives this is the fact that PDF continues to be the lingua franca for how things happen on the Internet. We have over 2 billion mobile and desktop devices that have had Reader or Acrobat installed. In fact, we have 300 billion PDFs that are opened in Document Cloud applications over the last 12 months. And so, strategically as we think about the opportunity, the first is to expand what we call our Sensei-powered Acrobat verbs and it's to enable all document actions, editing, sharing, scanning and signing. It's to unlock the value that exists in trillions of PDFs that have been created by deciphering these unstructured PDFs and making them truly responsive on mobile devices. In fact, one of the innovations we're particularly proud of is called liquid mode in the Acrobat Reader, which both deciphers and automatically reformats text, images and tables for quick navigation and consumption, and is powered by Adobe Sensei. We think mobile fuels this new business opportunity because PDF usage has absolutely exploded across mobile devices. Making this Acrobat experience more frictionless across mobile and web is truly leveraging the ubiquitous PDF format that we have. And we're expanding both the free and paid mobile customer base. We're also increasingly capturing the PDF demand with Acrobat Web because what we are doing is converting the massive demand for PDF web, such as create and edit through search through our frictionless services. With every business going digital, the third aspect of the strategy is to enable the paper to digital transformation through services that we have, like Acrobat and Adobe Sign, but also to leverage what we deliver through the Adobe Experience platform and the Adobe Experience Manager, as well as Adobe Experience Manager Forms. And we want to unleash an entirely new PDF ecosystem with documents services, which provides APIs to third-party developers, and they will then find new and exciting ways to use PDF and we will be able to monetize those services. So, let me expand on just a few of these opportunities. There are about 50 million searches for PDF actions every month. And what we want to enable is, through a single click, best-in-class Web experience, deliver quick access to actions that the customer wants, and allow them to deliver and discover a more comprehensive set of Acrobat offerings. This is similar to what we've done with the successful Reader upsell motion, which is to drive engagement around PDF, to enable people to complete their tasks, and then upsell people from the free product to Acrobat subscriptions. The other aspect of our Document Cloud strategy is to deliver a unified Document Cloud platform. This includes Acrobat, AEM Forms and Adobe Sign, which are central to the way work is getting done today. And we have a tremendous go-to-market advantage because it's the sophistication of our data-driven operating model that gives us a really incredible understanding of our customers, how to reach them, how to serve them effectively, and we have the ability to truly optimize everything on the funnel from acquisition, all the way through retention. We're continuing to expand the Sign scale and reach into fast growing new verticals, with significant go-to-market partnerships, including with Microsoft, Workday, ServiceNow, and Notarize. And we will continue to invest in the brand equity associated with PDF as the lingua franca of the Internet. We're incredibly excited about the second growth pillar, the Document Cloud strategy and the broader addressable market that it represents. And we expect the addressable market to grow to $21 billion in 2023. We're benefiting from the move to subscriptions, we're benefiting from visitor acquisition, we're benefiting from mobile, and the PDF mobile opportunity itself represents approximately $11 billion of this addressable market. And on the document services platform, we're driving growth with electronic signatures and new embedded services, which we believe represents $10 billion in addressable opportunity. Our third growth initiative is all about customer experience management. And we continue to believe that it represents a massive opportunity with the acceleration that we all see and digital transformation. Because the reality is that today every business is a digital business. And the imperative for digital customer engagement has never been greater. Because every business has to understand their customers and deliver personalized experiences. Because all of us, as consumers, we buy experiences, not just products. The reality today is that customers are expecting this engaged personalized digital experience, and we want these interactions to feel easy and efficient. They need to be well designed, they need to be context aware, and they need to be seamless across channels and secure and delivered at the exact microsecond at which we expect it. And delivering a next generation platform to deliver and drive this experience is easier said than done because it requires businesses to completely merge content, data and artificial intelligence to deliver this compelling, relevant personalized experience in real time. And the truth is that companies must design for this brilliance, but wire for intelligence. Adobe created the digital marketing category. And we're now the leader in a much broader opportunity – the customer experience management category. Our strategy is to deliver a comprehensive set of applications and services grouped in solution areas such as content and commerce, customer journey management, customer data and insights. And now with the closing of our Workfront acquisition, work management. And Anil Chakravarthy will spend a little bit more time talking about our strategy. The second aspect is to deliver this next generation technology platform, Adobe Experience platform, which provides the underlying infrastructure to make CXM a reality and is years ahead of anything that any competitor has provided. Because it truly brings together hundreds of data points to create this unified customer profile that companies can activate to deliver the personalized experience at scale. Our vision is also to deliver an industry-leading marketing system of record. With the Workfront acquisition now being closed, we have the leading growth management product for marketers. And while, unlike most companies, most of our growth is organic, we do use inorganic opportunities strategically, and we have an incredibly successful track record of acquiring, growing and scaling these companies. We have a longstanding set of partners and an ecosystem with Workfront with over 1,000 joint customers. And Workfront is already equipped with APIs for not just Experience Cloud, but also Creative Cloud, which represents opportunities to further leverage and deliver synergies across our businesses. One of the key assets that we have is the ability to deliver a scaled go-to-market, cutting across the entire C suite, given the affinity that both customer CIOs and CMOS have for Adobe. Because all businesses are now working to rearchitect their systems around the customer, which requires this strong partnership between the chief marketing officer and the chief information officer. And this enables us to scale our go-to-market across the entire C suite, which is driving higher value contracts as well as services. And we continue to have an explosive partner ecosystem that believes in our vision, and is delivering unique expertise to our joint customers. Our total addressable market, when we think about it for the Adobe Experience Cloud, is estimated to be approximately $85 billion in 2023. And that's comprised of customer data and insights, which continues to be a huge opportunity because intelligence is increasingly the lifeblood of every organization. So, this represents an approximately $26 billion addressable opportunity. The explosion of content and commerce where we're the absolute leader is driving a $44 billion opportunity. And customer journey management, which includes products like campaign and email marketing, as well as B2B marketing and demand generation, which includes account-based marketing and lead management, is expected to be a $15 billion opportunity. As we've said before, these are large and growing categories, which are top of mind for every business. To summarize, we believe that we have the right strategy that's being applied to an exceptional opportunity that is approximately $147 billion in 2023. We have a proven capability to both create and continuously lead these categories. We're thinking bigger about our businesses and the customers that we serve, from consumers and students to communicators and the creative professionals and the entire C suite. We have leading products, services and platforms to unleash creativity, accelerate document productivity, and to power digital businesses. Our secret sauce is the over 20,000 talented employees that we have that are all rallied around our mission and the impact that they can have. We have a revered brand all across the globe. We have world class financial discipline that's driving both top and bottom line growth with an impressive margin. This is truly an expansive opportunity. And we're well positioned to capture it. I certainly believe that Adobe's best days are ahead of us. We expect to cross $15 billion in revenue next year. We have a huge addressable market, industry-leading applications, services and platform and an unparalleled innovation engine. Let me just quickly touch on some growth drivers that we believe will continue to propel this momentum on the Creative Cloud. In addition to our leading applications across every category, mobile as a funnel as well as our product monetization opportunity is huge. Services such as Stock are becoming meaningful parts of the ARR growth. New categories like video, Web services, as well as 3D and on. On the Document Cloud side, the continued adoption of web-based PDF services, mobile-based PDF services and Acrobat subscriptions, the ability to deliver Adobe Sign to target both the small and medium business as well as the larger enterprise through both seat expansion as well as through document workflows. And on the Experience Cloud, continuing to deliver this next generation technology platform delivering Sensei intelligence services, the ability to leverage a partner ecosystem and to cross and upsell in both mid-market and commercial as well as to drive new logo growth and to continue to make sure that we deliver value, drive customer success and maintain retention. And now, what I'd like to do is to have a Abhay Parasnis, both our CTO as well as somebody who has recently taken on responsibility as Chief Product officer for Document Cloud, to talk about our technology vision. Abhay?
Abhay Parasnis : Thanks, Shantanu. Good morning, everyone. It's great to talk to all of you again. Shantanu talked about the broader opportunity and strategic imperatives for Adobe. I would like to take next few minutes to talk about our technology vision and share my excitement for the road ahead. Being a product company at our core, we have always taken a long-term view of building deep technology platforms that are highly defensible and drive industry breakthroughs. With everything going on this year, I'm especially proud of the sheer breadth and depth of innovations our teams have delivered. Illustrator on iPad and Neural Filters in Photoshop, liquid mode and Acrobat Web in Document Cloud, and AEM cloud and real-time CDP and Experience Cloud are just few examples of innovations we have delivered. And this incredible pace of innovation is only exceeded by the massive scale at which we operate today. With trillions of activations served from Experience Cloud to hundreds of millions of mobile app downloads and more than 2 billion devices running Reader and Acrobat software today, we truly have unmatched scale from cloud to the edge. Now, a key aspect of our technology strategy is to develop a consistent architectural viewpoint across all of our products. We think of this unified architecture at three levels. Multi service experiences for our apps, a rich portfolio of services and API's, and our Sensei AI stack built on shared content and data platforms. Everything we do across our three clouds is guided by this unified technology vision and gives us a significant strategic advantage. Increasingly, we are thinking beyond discrete app silos to delivering new modalities and fluid multi surface experiences across desktop, mobile and Web. For example, in Creative Cloud, we are adding modern Web and collaboration technologies to core imaging and video workflows in applications like Photoshop and Premiere, evolving them into complete creative systems. Similarly, in Document Cloud, we are taking the best-in-class PDF runtimes on PCs and bringing them to both Web and mobile platforms for a consistent multi-surface PDF experience. And in Experience Cloud, we are uniquely focused on a new kind of customer experience, one that's real time and hyper-personalized across every single touch point. At the services tier, we are not only building an increasingly rich portfolio of services, but we are focused on three cross cutting themes. First, we are embedding collaboration deeply at the core of all our applications, converting our best-in-class single user apps like Photoshop or Acrobat to multi-user collaborative solutions. And because we uniquely understand our file types and workflows, we can enable a much richer contextual collaboration for users, as opposed to a generic file sharing or communication platform. Second, using the shared content and data platforms, we are enabling unique cross cloud use cases, going from creators to knowledge workers to marketers. This is something that only Adobe can deliver. Lastly, we are increasingly focused on the API economy opportunity by exposing our services via open APIs to developers and ISVs in the ecosystem. You will see us aggressively focus on this new vector. Last, but not the least, I've talked to all of you about Adobe Sensei, our generational bet on AI. Sensei is already having a profound impact with our teams delivering hundreds of Sensei-powered features across our three clouds. We started Sensei with AI features delivered within existing apps. But by leveraging our unique understanding of our users' workflows and usage patterns, we have built a specialized Sensei platform, one that's focused on creativity, documents and customer experience domains. With this platform in place, we are now positioned to push the limits with completely new kinds of AI first apps. Liquid Mode in Document Cloud is one great example of this. This was a multi-year journey and required us to solve some unique and hard problems. Using the latest techniques in AI, machine learning and computer vision, we trained Sensei to deeply understand the trillions of PDS that exists in the world. And then using that intelligence, we are able to generate structure out of unstructured PDFs that are across the world. Initially, we are using this to create a delightful experience on mobile devices, but the possibilities ahead are truly exciting, with document intelligence breakthroughs in areas like semantic understanding or document summarization. And like Liquid Mode in Doc Cloud, we are also working on unique Sensei services for creative intelligence and experience intelligence. Sensei is a key R&D priority with long-term strategic advantage, one that's letting us build truly differentiated capabilities and delight customers with Sensei-powered Adobe magic. As our customers rely on Adobe for ever-more mission critical needs, we are laser focused on engineering excellence and getting the basics right every single day. We are one of the first SaaS companies that has built a multi-cloud foundation, enabling us to deliver across various public, private and hybrid cloud environments. And doing so with high levels of operational excellence as well as cost efficacy. Also, with Adobe's Common Controls framework, we are able to meet enterprise expectations for security, compliance, and privacy requirements, as well as global regulatory landscape. Lastly, we continue to play a thought leadership role in the industry with various standards and other efforts like our Content Authenticity Initiative and Open Data Initiative. In closing, the opportunity ahead for Adobe is truly exciting. From future of creativity to reimagining documents to opportunity to completely rewired customer experience. We have a world class engineering team with a deep culture of innovation and investments in foundational technology platforms that enable us to deliver with speed and scale. I have never been more confident about Adobe's technology agenda, and I'm super excited about our ability to go invent the future. Now, let me hand over to Scott Belsky, Chief Product officer for Creative Cloud, to talk about Creative Cloud strategy. Over to you, Scott.
Scott Belsky : Thanks, Abhay. So, while I've outlined more details of our Creative Cloud strategy in the deck, I'm excited to share a quick summary right now. Big picture, we are seeing tremendous growth momentum in Creative Cloud because creativity has never been more important than it is now. And we saw this at our most recent Max conference, which has become the premier global creativity conference. That's blew away all previous records with over 21 million views worldwide. Why is creativity so critical right now? Well, for starters, everyone wants to stand out – at work, at school, on social and even in their family projects. And creative expression is how they do it. Within the enterprise, companies more and more recognize that creativity is this competitive advantage. And employees want to stand out, whether it is with their presentations, how they visualize data, or become more active stakeholders in their own product and marketing experiences. In the workplace of the future, creativity is how people will thrive, and frankly, keep their jobs as AI takes over more and more of these productivity focused roles. All of these shifts up-level the role of creativity and create a tremendous opportunity for Creative Cloud and a responsibility for us to evolve our offerings to meet the needs of new creators. So, let's take a look at the five pillars of our strategy for Creative Cloud. First, we are innovating to advance every creative category. Our professional customers want to push the boundaries of their fields and achieve more in less time. One way we're enabling this is through Adobe Sensei, which Abhay talked about, our artificial intelligence engine. In Photoshop, for instance, we recently launched Neural Filters, a new platform powered by Sensei that allows customers to make sweeping changes with just a scroll of a slider. These Neural Filters are truly magical. You can turn night into day and literally turn a frown into a smile. And neural filters are just one example of our Sensei-powered breakthroughs. At Max, we launched dozens of new Sensei features across our creative categories, and we're helping customers explore new mediums, like 3D and immersive, with tools such as Substance, Dimension and Arrow. The pandemic has forced many teams to turn to 3D tools as they can render an image or video rather than have an in-person shoot. One great example is Ben & Jerry's, who levered our 3D and immersive products to execute a critical campaign about getting ice cream delivered during the pandemic. They found what many companies are finding that 3D rendered images are indistinguishable from traditional photos and they're far more efficient and actually less expensive to produce. So, we expect a surging interest in that field to continue, especially as new mediums like augmented reality go mainstream. These innovations add value for creative professionals and help ensure that Creative Cloud remains the logical choice for modern teams struggling with content velocity, our way of talking about the insatiable need for more formats and more platforms and just more content more personalized every day. And we're committed to extending their creativity in new directions. The next pillar of our strategy for Creative Cloud is a continued transformation of our category-leading products to become cloud-based multi-surface systems. Creativity is no longer confined to the desktop. And we made a lot of progress in extending our flagship products across more surfaces. Over the last year, we've brought Photoshop and Illustrator to the iPad, and we launched Adobe Fresco, the industry's most powerful drawing and painting app on Windows and Apple tablets last year, and brought it to the phone this year. Customers tell us that the portability of iPad apps unlocks huge advantages. Designers for [indiscernible] Japanese theme parks, for instance, use illustrator on the iPad to sketch out new features while they're actually inside the park. It really lets them see how the design will actually fit in in-person in-place. So, here's what we've learned from this evolution from product to service from multi-system platform expansion. We know that customers who use our products across multiple devices have higher satisfaction and better retention, and we know that offering a more modern interface on mobile devices is inviting for new customers and is an effective way to bring new customers into Creative Cloud from the mobile app stores. So, we're continuing to extend our applications on to new surfaces, including the Web, which will engage an even broader set of customers and unlock another level of possibility for Creative Cloud. Another major part of our strategy is the development and seamless integration of powerful services that enable collaboration. No doubt, we've entered a new era of creativity that is deeply, deeply collaborative. The next generation of our customers grew up in the age of Google Docs. They expect everything to be collaborative by default. And we've enabled this through our investments in Creative Cloud services over the last few years. We launched Creative Cloud Libraries, which helps teams share creative ingredients from fonts and colors to vectors and images. We rolled out Cloud Documents, which allows customers to easily share their work with collaborators and stakeholders. And with services like stock and fonts funds integrated at the point of need within our products, we're ensuring that teams have all the content they need to start a project without ever leaving Creative Cloud. Finally, we're making it much easier for stakeholders to review and share comments directly in our desktop products. All of these collaborative features make Creative Cloud the single source of truth for creative assets, ensuring greater lifetime value. These services also unlock new business opportunities and expand our footprint by engaging stakeholders beyond the traditional creative team, whether it be for review purposes, copywriting, or leveraging templates for social media marketing. Another area of focus is engagement and community inspiration. We're bringing many kinds of new customers into Creative Cloud these days. But to keep them, we have to ensure that they are engaged, that they're learning new skills, and that they're continuously inspired to try new tools and techniques. We're improving engagement by reimagining the new user journey, providing a more personalized experience for every customer that is infused with community and educational content. And we become very, very data driven as we optimize these flows. We're providing many more ways for people to learn new skills. Traffic to Adobe Live, our rich offering of live streams, by Behance members using our products and tutorials has doubled this year. And we have doubled our content in response. And the engagement with these live streams is truly remarkable. Over the last year, the average watch time is more than an hour and 20 minutes. We've also enabled live streaming in our iPad apps, so that any customer can easily go live from within the product and share the URL on social networks. Others can click the link and learn by looking over the shoulder of an experienced creator and download the app to give it a try as well. And we personalize learning experiences within our products. And as the more we personalize, the better we meet each customer exactly where they are. And because the greatest inspiration, of course, comes from seeing what others are creating, we're doing more to convene a global community of creatives. We've built a new community set of features in products like Lightroom. And Behance, our global creative community near and dear to my heart, has grown to 25 million members with over 1 million people visiting the site every single day. All of these efforts not only grow the top of the funnel, but also make it more likely that these new customers will be successful, inspired and engaged. Finally, let's talk about democratizing creativity, which Shantanu mentioned in the beginning. We want to empower the world to create with a new generation of web and mobile products that are freemium and easy to use, and that leverage Adobe's core technology. When anyone searches the web, to edit a photo or make a flyer, we will present easy-to-use Web apps that help them complete their project and encourage them to go further to take it to the next level. On mobile, Photoshop Express, Premiere Rush and Adobe Spark empower everyday consumers to create content that stands out on social media. In the year ahead, we're bringing these products closer together to enable customers to work across them and to extend their work to the web. And we're doing this in a way only Adobe can. We're bringing powerful time saving features, many powered by Sensei to these mobile and Web apps. We're also prioritizing interoperability with the rest of Creative Cloud, so that more casual creators can work together with creative professionals, and so that they can take their work to the next level in an app like Photoshop or Illustrator when they're ready to do so. I'm excited to share more on these product investments in the year ahead. So, to sum it up, our view of our market is expanding to $41 billion in TAM in 2023 because the importance of creativity is growing fast and the number of creators worldwide is exploding. Our work over the next few years will ensure that Creative Cloud stays at the cutting edge of creativity in new mediums, that it supports the growth of collaborative creativity, and that it welcomes new generations of creators, with a new generation of tools and with the learning, inspiration and community that will keep people engaged and successful. Thank you. And now, I'll turn it over to my colleague Anil, who oversees the digital experience business to talk about Experience Cloud. Anil?
Anil Chakravarthy : [Technical Difficulty] also responsible for our worldwide field organization. I want to give you some context and color on the Experience Cloud strategy that Shantanu outlined. You should have the full presentation that we have provided. In the first half of 2020, when COVID hit, we saw businesses focus on their employee safety and wellbeing and ensuring business continuity. We pivoted and worked with our customers to navigate that new normal. In the second half, we saw businesses doubling down on customer experience management in response to heightened customer expectations. Customers are digital first now. And from every business, they expect engaging and personalized experiences. And this has put more pressure than ever on businesses to accelerate their digital engagement. It's also accentuated how hard it is for businesses to deliver a great experience to their customers across all touchpoints. In the current environment, that has been no small feat. Businesses need to account for external factors like privacy regulations and data sovereignty, and master internal challenges like fragmented customer data and manual inefficient processes. So, it's become clear that companies need a next generation technology platform for customer experience management. And this has created a massive $85 billion market opportunity for CXM, and Adobe is uniquely positioned to address this. Our mission is more relevant than ever. And our strategy of powering digital businesses is resonating with brands across industries and around the world. Now we saw that in spades in 2020. 93% of our top 100 customers have three or more Experience Cloud solutions, and our average ARR with them has grown to $8 million, nearly three times what it was in 2015. Let me highlight one of those top customers, Verizon. Over the last five years, Verizon has standardized on Adobe for CXM across their consumer, business and media groups. The Adobe Experience platform provides real time responses in 250 milliseconds at cloud scale across billions of profiles. Verizon is leveraging AEP to deliver personalized communications, optimize customer journeys, increase conversions, and create customer loyalty. As a result, our ARR from Verizon has grown 700% over the last five years. This is a great example of the growth trends we see across our customer base. Turning to our strategy for Experience Cloud. It's based on Adobe's own successful transformation journey. We've taken the principles and insights from our data driven operating model and created a customizable playbook that any customer can use to power their digital business with next generation customer experience management. We have five pillars in our strategy, as Shantanu outlined. First, it's a comprehensive set of applications and services for customer data and insights, content and commerce and customer journey management. Now these apps and services are delivered on an integrated Adobe Experience platform. AEP is a next gen platform to deliver real-time personalization at scale, with nearly 17 trillion segment evaluations per day, leveraging first party data, cloud scale, powered by Adobe Sensei, and extended by our open ecosystem of partners and developers. Now, we do the hard work of delivering the best of both worlds to our customers, comprehensive apps and services, integrated on to a common cloud scale platform. I've been in the world of data for a long time now. And it's clear to me that AEP is years ahead of our competitors in capabilities and production deployments. Third, we're excited about our recent acquisition of Workfront, and we've heard great feedback from customers and partners. We're laying a strong foundation for a marketing system of record that will enable our customers to have greater efficiency and agility in executing their campaigns and to optimize their campaigns with real time insights. Fourth part of our strategy, we've been a trusted partner to CMOs since we created the digital marketing category and now we are trusted partners to CIOs as well. And in mid-2020, we combined our worldwide field operations and digital experience into a single organization that I lead, and that has enabled us to scale our go-to-market to address the needs of enterprises from mid-market customers to the largest brands in the world. Finally, we work really closely with our global ecosystem of over 2,800 SIs and technology partners to drive business value and sustained growth. So, in closing, I'm incredibly excited about the opportunities ahead of us. Experience Cloud is a growth business, and we will combine our go-to-market and product organization to be well positioned to fire on all cylinders. When you look at our products, our platform, our innovation powered by Adobe Sensei, our customer relationships, our brand and the investments we're making, Adobe is the clear leader in customer experience management. And we are in the best position to help businesses deliver personalized, engaging digital experiences to all of their customers. Thank you. And now, let me bring up our Chief People Officer, Gloria Chen.
Gloria Chen : Thanks, Anil. And hello, everyone. A year ago, as Chief Strategy Officer, I spoke to you about Adobe's growth story, our total addressable market, and the tremendous opportunities across our business. As you've heard today, our strategy is more expansive than ever. And I'm confident in our ability to succeed because of our proven track record of transformation, something I've seen firsthand multiple times in my 20 plus years at the company. And I believe our secret sauce has been the combination of a winning strategy, great people, and an exceptional purpose-driven culture. My pivot from corporate strategy to employee strategy earlier this year was a natural move. People are our greatest asset. And as Chief People Officer, I'm excited to be carrying the torch for our values, our history of progressive people centered benefits and programs and our commitment to the growth and development of over 22,000 employees around the world, now including Workfront, who joined us earlier this week. Increasingly, companies are viewed by employees, customers and stakeholders as an extension of their identity, values and community. In 2020, our core values were on full display, being genuine, exceptional, innovative, and involved. As we responded to COVID, we put the health and safety of our people first. We increased communications, rolled out work from home benefits, and encouraged scheduling flexibility. We took care of our communities, providing customers with flexibility and students with free Creative Cloud licenses. And our employees really stepped up this year, with 70% engaging in volunteerism online. Our employees have responded with gratitude and pride in our approach and are more engaged and productive than ever. As a people-centered company, we've always focused on fostering an inclusive culture, what we call Adobe For All. Because we believe that when employees can be their authentic selves, they do their best work. And when we have diverse teams, we're more innovative and reflective of the customers we serve. For employees to feel supported in and outside of work, we invest in learning and development programs, community networks, and family friendly benefits. We're a leader in pay parity across gender and ethnicity and we're examining opportunity parity for fairness in promotions and horizontal movement. We're building current and future talent pipeline, investing in young artists in underserved communities, university partnerships, and mid-career rescaling and apprenticeships. This year's events made it clear that while we've made progress, there's more that we can do. As a company, we're about action, not words. And together with our Black Employee Network, we've launched the Taking Action Initiative focused on community, advocacy and growth. And during our global Adobe For All week, we outlined aspirational goals to increase representation. Across our recruiting and development programs, our campaign celebrating women and black creators and our efforts to ensure that our products are inclusive, we are driving change aligned to our core values. Another topic that's been top of mind for everyone is the future of work after the pandemic. So, let's talk briefly about that. This year, we learned that there's so much that we're able to do effectively while we work from home. We've launched new products, produce global customer events and onboarded hundreds of interns and employees around the world. Digital transformation is here. And we'll continue to reimagine customer and employee experience as a company. At the same time, we continue to believe that in real life experiences are critical to nurturing culture and trust, learning and development and innovation. Each team will need to strike the right balance for them, but in general, we will be giving most employees the flexibility to work from home part of the time and making this the default as opposed to the exception. As for fully remote workers, this is something we already have today, especially amongst sales and consulting staff. Broadly expanding remote work is a significant decision that is not just about individual preference, but also has implications for collaboration, cohesion and culture. We have more to learn here, and so we'll be starting by updating our criteria for remote work in the coming months and iterating thoughtfully, as we always do. This is clearly a journey, one that we expect will continue to evolve. As I reflect on the year, it's been a privilege for me to contribute to Adobe in this new capacity. Our employees achieved this record year through their dedication, camaraderie and resilience. 2020 has shown us the power of Adobe's values in action, and I'm confident that Adobe's best days are ahead of us. And now, I'd like to turn it over to our CFO, John Murphy.
John Murphy : Thanks, Gloria. Based on what has been shared this morning, it's clear there are tremendous opportunities for Adobe. Now, I'd like to give you a view of our business momentum and how we drive our growth going forward. Today's presentation will cover both Q4 and fiscal year 2020 results. Before we jump into the numbers, in Q4, we made a change to our segment reporting to align with the way we manage our digital experience business in light of the Advertising Cloud shift we made earlier this year. We created a new segment called Publishing and Advertising, combining Advertising Cloud with the existing Publishing segment. As a result of this change, our digital experience subscription book of business now aligns exactly to the components that make up our Digital Experience subscription revenue. And it's great to have those aligned as that's where we're strategically driving segment growth. This reporting change is reflected in the numbers we will show for Q4 and FY 2020. And we've revised our financial information from FY 2018 to present day to maintain compatibility. Now, let's turn to our Q4 performance. Adobe achieved record revenue of $3.42 billion, which represents 14% year-over-year growth. GAAP diluted earnings per share in Q4 was $4.64. And non-GAAP diluted earnings per share was $2.81. Business and financial highlights in Q4 include Digital Media revenue of $2.5 billion, which represents 20% year-over-year growth, record net new Digital Media ARR of $548 million, Digital experience revenue of $819 million, which represents 10% year-over-year growth. Digital Experience subscription revenue grew 14% year-over-year. We had record cash flow from operations of $1.78 billion, and we exited with remaining performance obligation or RPO of $11.34 billion. And we repurchased 1.6 million shares of our stock during the quarter. Overall, this is a really strong performance in Q4. Now for some Q4 financial highlights and growth drivers for each of our strategic businesses. In Q4, Adobe achieved $2.08 billion in Creative revenue, representing 20% year-over-year growth and added $425 million of net new Creative ARR. We exited the year with $8.72 billion in Creative ARR, which is also 20% growth year-over-year. Creative ARR growth drivers include acquisition of new users across all geographies and segments, single app and CC complete subscriptions and strong performance in the imaging, video and stock categories. Adobe Document Cloud achieved $411 million in Q4 revenue, growing 21% year-over-year. We added a record $123 million of Document Cloud ARR in the quarter, and Document Cloud ARR exiting the year was $1.46 billion, growing 35% year-over-year. Document cloud ARR growth drivers include strong demand for Acrobat subscriptions, as well as demand coming through the Reader funnel and on mobile, and a significant momentum in Sign. In Q4, we also benefitted from greater-than-expected perpetual revenue in our Document Cloud offering. Digital Experience achieved segment revenue of $819 million in Q4, representing 10% year-over-year growth, and subscription revenue of $696 million, representing 14% year-over-year growth. The growth drivers for Experience Cloud in Q4 included accelerating adoption of Adobe Experience Cloud platform and app services, content and commerce momentum, particularly with our AEM cloud service offering and continued recovery in the mid-market segment, as well as success signing up deals of greater than $1 million in annual deal value. For the full 2020 fiscal year, Adobe achieved record revenue of $12.87 billion, which represents 15% year-over-year growth. GAAP EPS for the year was $10.83 and non-GAAP EPS was $10.10. Contributing to our strong execution in FY 2020 was Digital Media segment revenue of $9.23 billion, representing 20% year-over-year growth; Creative revenue of $7.74 billion, representing 19% year-over-year growth; Adobe Document Cloud revenue of $1.5 billion, representing 22% year-over-year growth, exiting the year with $10.18 billion of Digital Media ARR, an annual increase of $1.85 billion; Digital Experience segment revenue of $3.13 billion, following the segment reporting change, representing 12% year-over-year growth; Digital Experience subscription revenue of $2.66 billion represents 17% year-over-year growth. We generated $5.73 billion in operating cash flows during the year, and we grew RPO by $1.52 billion and returned $3 billion in cash to our stockholders through our stock repurchase program. Next, let me provide more information around our strategic cloud businesses. We'll begin with our Digital Media segment, starting with Creative Cloud. We've highlighted a number of areas where we drove tremendous momentum in the Creative business. We continue attracting new customers with approximately 75% of our subscribers in fiscal 2020 being new to our Creative Cloud franchise. Over 45 million students have access to Adobe Spark, nearly doubling since last year, showing how we're developing creative skills for the next generation. Mobile continues to be an important funnel for us, with over 300 million mobile IDs created cumulatively, and over 80% year-over-year growth in mobile units as mobile monetization has become an important driver of ARR growth. Premiere Pro, Adobe Stock service growth and new media types are an important customer acquisition vehicle for us. Turning to revenue and ARR. We've seen another record year with our Creative Cloud. The Creative Cloud view shows an incredibly healthy business at scale, with sustained revenue growth over the last several years. We continue to see significant user acquisition across creative professionals, communicators, and consumers and revenue growth from services such as Adobe Stock continues to be strong. Key creative growth drivers exiting fiscal 2020 include new user growth fueled by organic traffic which remains elevated, as well as targeted campaigns and promotions. Demand for single apps, particularly our video and photography offerings, strong retention and engagement, which held at pre COVID levels exiting the year, expansion into emerging markets, the gradual recovery in the SMB segment, driving demand for our team offering including through the reseller channel; and ETLAs with educational institutions. This is such a great slide because it shows a mix of our Creative revenue in FY 2017 and FY 2020. Today, over 97% of our Creative revenue is subscription based revenue, while the business has grown 85%. Much of our success here comes from a deep understanding of our customers, which continues to drive higher retention for us. As Scott and Abhay shared, this growth is also driven by our vast innovation engine across products and services as we expand into new markets. When you look at the makeup of ARR, a majority of the revenue continues to come from all app subscriptions across individual team and enterprise, while a growing portion comes from single app subscriptions consistent with our strategy of expanding our market opportunity as we attract new users in the consumer and communicator categories. With most comprehensive set of creative offerings against every design, category and service, we're using single on apps mobile as a proven on-ramp for new subscribers, while we continue to grow our all apps business across all segments, and as an upsell opportunity for single app and mobile users. The strength of Creative Cloud is derived from our diversified and resilient business, with offerings tailored for everyone from individuals to small businesses, education and enterprises. We also have a deep understanding of how our customers want to engage with us. And you can see here the slight mix shift towards individual offerings through Adobe.com, while we continue to grow our team and ETLA offerings. Next, we're going to move on to Document Cloud. This business is thriving and has contributed significantly to the company's success this year, with over 70% of our channel units now being subscriptions and over 75% of subscribers in fiscal 2020 being new to the Acrobat franchise. As with the Creative business, our mobile strategy is driving Adobe ID creation at the top of the funnel. While mobile monetization is contributing to ARR growth, our focus on acquiring new customers coupled with our shift from perpetual base to subscriptions is working. The Document Cloud strategy of accelerating document productivity, going from paper to digital is really resonating in remote work environment. The Adobe Sign business has seen a growth inflection this year. In fact, we saw this inflection point before the pandemic hit, and we expect this trend to continue into FY 2021. As Gloria shared, we envision businesses with people working in flexible ways. Things will not default back to the way they were. To borrow Shantanu's phrase, the genie will not go back in the bottle. There's just an explosive opportunity for new user growth as we continue to capitalize on work from home or flexible work. We have multiple growth initiatives, including web-based PDF, Sign as a service and the API economy that gives this business more legs. Turning to revenue and ARR. Document Cloud is another Adobe business that has powered past the billion dollar mark, approaching $1.5 billion in both revenue and ARR. It's just a tremendous opportunity ahead for us. The key Document Cloud growth drivers exiting fiscal 2020 include new user acquisition of Acrobat subscriptions across all customer segments, monetization of our Reader install base on mobile, demand for our subscription offerings across all geos and enterprise adoption, including strength in Adobe Sign. Keep in mind that we also offer Acrobat and PDF services through CC individual and all app subscriptions, which is another driver of growth in this business. Here you can see the phenomenal growth we're driven on subscriptions. While the non-recurring perpetual revenue accounts for a small portion of our revenue, it's in line with our strategy. This represents a continuing opportunity to transition that install base over to subscriptions. And you can see that the total business has nearly doubled in the last three years and as we transitioned more of the business to recurring revenue sources. Unlike Creative Cloud, for Document Cloud, we continue to offer perpetual as a vehicle to have people come to the franchise. We have the flexibility of our offerings, given the breadth of our customer base, which has switched primarily to subscription. Looking at Digital Media as a whole, including both Creative and Document Cloud ARR, you have a view that any CFO would love to see. It's showing the stacking effects of recurring subscription revenue up into the right, ending the year with over $10 billion of annualized recurring revenue. When you think of the revenue base when we launched Creative Cloud less than a decade ago, it's amazing to see how we have expanded the market opportunity while transitioning nearly all the revenue from perpetual to recurring. This shows you the power and durability of our subscription model. Numbers like this don't happen without an extremely sophisticated system, our data-driven operating model, which is purpose built to acquire more customers across geographies and to engage and drive higher retention. DDON, as we call it, is our weapon for finding and understanding the personalized offerings for our customers. The best part about DDON is that we use our own software, Adobe Experience platform, to drive this. Which brings me to the Digital Experience segment. Let's take a deeper look at Adobe's Digital Experience business. First of all, we're very excited to close the Workfront acquisition earlier this week, and we welcome the Workfront team to Adobe. When it comes to M&A at Adobe, we look at the technology and the people. Adobe has a great track record and history of acquiring companies, driving synergies and accelerating growth. With Workfront, we're focused on our ability to accelerate growth through the marketing use case. As Anil shared, what's particularly exciting for us is that we have the opportunity to create an industry-leading marketing system of record. We're confident that our shareholders and customers will get maximum value, and this is a huge opportunity to accelerate subscription revenue growth for years to come. Workfront represents a sizable addressable market for Digital Experience. The targets we're providing for FY 2021 and Q1 are inclusive of Workfront. And we are looking forward to hitting the ground running integrating the business in our Digital Experience segment and expanding our opportunity with customer experience management. Digital Experience is a category we created a little over a decade ago, bridging from content creation all the way to marketing, execution, measurement, optimization, and monetization. This year, we achieved $3.13 billion in segment revenue. But more importantly, we have seen digital transformation and customer experience management resonating with our enterprise customers. More than ever before, for enterprises to succeed and provide the sort of personalized real time experiences our customers expect, they require a technology partner that can help them transform their businesses the way we've reinvented our own digital media business with our data-driven operating model and focus on customer experience management. In my conversations with my peers across the C suite, it's clear no matter their industry, they recognize the value in the digital transformation investment. And you can see the momentum here when you look at the makeup of our top 100 customers and accounts, where, in 2020, approximately 93% of those customers are using three or more of our solutions and the average ARR has more than doubled over the last five years. We've talked a lot about our focus on growing subscription SaaS revenue in this business. And you can see here how our focus on driving subscription revenue has driven segment growth over a multi-year period. The growth in our Digital Experience business has been driven across subscription offerings, with particular strength in enterprise adoption of content and commerce offerings, including AEM cloud service. Our Adobe Experience platform is gaining tremendous traction with a number of referenceable customers, such as Verizon, creating momentum. And we're also seeing continued recovery in the mid-market following the macroeconomic challenges we saw there early in the pandemic. Looking at the business by revenue type. Since 2018, we've held the services and other categories relatively flat, as we said we would, as we have focused on growing the recurring subscription SaaS revenue, which has grown at a 29% CAGR since 2018. In order to accomplish this, we've continued our strategy of leveraging the partner ecosystem that Anil talked about earlier, relying on those partners to implement our solutions and provide services to help our enterprise customers realize the value we are delivering. Here's a view of the revenue mix by category across our three strategic growth pillars of customer journey management, content and commerce, and data and insights. These are all market leading solutions that are fundamental to customer experience management, which we built on a common data and content platform. The growth of these businesses is driven by customer demands to help maintain a digital presence and transact online, deliver personalized experiences to their customers and unify and activate their data. With an $85 billion market opportunity, we are investing to drive long-term growth in these categories. And our comprehensive set of solutions and innovations in platform puts us years ahead of the competition and solving these challenges for the enterprise. Now, let's focus a little more on the income statement and cash flow and our capital allocation strategy. There's another slide most of you folks would love to see which is revenue growth and margin expansion, both on a GAAP and non-GAAP basis, with non-GAAP operating margin well over 40% for the year. Contributing to our margin expansion has been the sustainable revenue growth that we have worked on for decades, the operating leverage in our subscription model and our strategic decision to exit the transactional Advertising Cloud business, as well as actions taken in response to the COVID pandemic and related cost savings associated with travel and reduced facilities operations. When we get to our FY 2021 targets, I'll provide some color on how you should think about those savings in those categories specifically going forward. Here you can see the balance of RPO, which were 15% year-over-year exiting fiscal 2020. This represents contracted business that is committed to flow into revenue in the future, making our revenue sources extremely predictable. The components of RPO are deferred revenue and unbilled backlog. And as we noted earlier this year, we've seen a mix shift from deferred revenue to unbilled backlog in fiscal 2020 as more of our digital media business has come through Adobe.com, where subscriptions are billed monthly rather than invoiced annually in advance, meaning they don't hit deferred revenue the way a lot of our channel and enterprise business would. As a result, the strength in acquisition of adobe.com continues to drive the mix shift from deferred revenue to unbilled backlog. Moving to cash flow. In fiscal 2020, we saw an acceleration of our operating cash flow growth, achieving a record $5.73 billion for the year. In terms of uses of cash, we continue to prioritize investment in growing the business, both organically as well as through inorganic opportunities like the acquisition of Workfront. And, as always, we focus on returning capital to shareholders through our stock repurchase program. Exiting FY 2020, we had approximately $6 billion of cash and short-term investments as well as an unused billion dollar credit facility. This is a healthy liquidity position with an investment grade credit rating and plenty of debt capacity. And as I mentioned, we have a long track record of making sure we return excess cash to our shareholders through structured repurchases. On that point, you can see how we've continued increasing our investment in stock repurchases, reducing the share count over time. Today, we're announcing a new $15 billion repurchase authority in addition to the amount remaining under our current authority, which will run through the end of fiscal 2024, demonstrating our commitment to accelerating return of capital to investors. Now, I'd like to cover how you should think about financial strategy and our addressable markets, which underpin our preliminary targets for FY 2021. Let's start with our strategy. I'm going to touch on a few things on this slide. Adobe has a unique financial profile that we've discussed that drives our strategy. We invest for top line growth and our operational discipline drives margin expansion and earnings growth over the long term. With a diversified portfolio of leading products and services, we are investing to drive continued top line growth and expand into new categories with a massive market opportunity that's in front of us. What accelerates our growth are going to be investments that we've made in new businesses such as Adobe Stock, Sign and our mobile applications, which have contributed over $500 million of ARR growth since 2017. With data driven dynamic planning capabilities, we exercise disciplined spend management principles, we focus on margin expansion and long-term earnings growth. We focus on integrating acquisitions quickly to ensure the same organic operating discipline is embedded in newly acquired businesses. And strict management of our balance sheet, prudent use of debt financing and cash has driven exceptional operating cash flow growth for many years, affording Adobe the opportunity to continue to invest in our existing businesses and capture promising inorganic growth opportunities and return capital to shareholders. As you've heard earlier in today's presentations, we have updated our addressable markets. And you can see that we are excited to capture the opportunity ahead through the extensive list of growth drivers and product innovations across Creative Cloud, Document Cloud and Experience Cloud. With Creative Cloud, we're driving continued growth through broader customer segments by reaching beyond creative professionals to communicators and consumers and by engaging and inspiring our creative community to drive customer lifetime value. With document cloud, we see growth inflection through acquiring and monetizing new customers across desktop, mobile and web. And finally, we continue to leverage and build upon our data driven operating model to manage the business in real time. All this leads to a $62 billion addressable market for digital media in 2023. Likewise, with the most comprehensive set of solutions for customer experience management applications and services and the addition of Workfront, our addressable market for Digital Experience has grown. We expect to drive multi-year growth of the data and insights category with our scaled next generation customer data platform. The segment change we made in Q4 reflects the way we manage our business and our strategic focus. The Digital Experience organization is optimized to drive subscription and SaaS revenue growth, while gaining share of an $85 billion addressable market for Digital Experience. Before getting into our fiscal 2021 targets, I'm going to walk through some of the assumptions we've built in. We expect to see continued gradual macroeconomic improvement during the year. And as such, we're modeling continued recovery for the small and medium businesses into FY 2021, which was a segment that was hit particularly hard earlier in the pandemic and then showed signs of improvement during Q3 and Q4. We anticipate an increase in our effective tax rate due to additional taxes on our foreign operations following the changes we made to our international trading structure in FY 2020. Our FY 2020 tax rate included one-time benefits to recognize deferred tax assets resulting from these changes. These deductible assets will be amortized over multi-year period, lowering our cash tax rate over that time. Targets include initial estimates associated with our acquisition of Workfront. These estimates involve numerous assumptions given the purchase accounting process has not been completed. The purchase accounting is expected to result in an increased amortization of intangible assets and significant deferred revenue haircut, resulting in an expected contribution of about $25 million to Q1 revenue. And as you know, we measure ARR on a constant currency basis during the fiscal year and revalue ARR at year-end for current currency rates. FX changes between December of 2019 and this year have resulted in a $77 million increase in Digital Media ARR. The effect of this revision is reflected in our updated investor datasheet. ARR results this year will be measured against this amount during FY 2021. The cost savings associated with the current remote work environment will continue into the first half of FY 2021. In terms of OpEx growth, we will be investing in top line growth opportunities and our hiring is expected to return to an ordinary pace, particularly for R&D and sales and marketing roles. And we expect T&E and facilities expenses to ramp in the second half as things open back up. Lastly, FY 2021 is a 53-week fiscal year for us, with the additional week falling in Q1. As we noted in the press release, we estimate the extra week will benefit Q1 with approximately $240 million in additional revenue over a 13-week quarter, as well as an additional $25 million in net new Digital Media ARR. So, without further ado, here are the targets we are providing for fiscal year 2021. Total Adobe revenue of approximately $15.15 billion. Digital Media segment year-over-year revenue growth of approximately 19%. Net new Digital Media ARR of approximately $1.75 billion. Digital Experience segment year-over-year revenue growth of approximately 19%. Digital Experience subscription revenue year-over-year growth of approximately 22%. A tax rate of approximately 19% on a GAAP basis and 17.5% on a non-GAAP basis. Share counts of approximately 482 million shares. GAAP earnings per share of approximately $8.57 and non-GAAP earnings per share of approximately $11.20. For Q1 of 2021, we are targeting a revenue of approximately $3.75 billion, with Digital Media segment year-over-year revenue growth of approximately 26%, net new Digital Media ARR of approximately $410 million, Digital Experience segment year-over-year revenue growth of approximately 19%, Digital Experience year-over-year subscription revenue growth of approximately 22%, tax rate of approximately 15.5% on a GAAP basis and 17.5% on a non-GAAP basis. Share accounts of approximately 484 million shares, GAAP earnings per share of approximately $2.19 and non-GAAP earnings per share of approximately $2.78. In terms of seasonality, while 2020 was not a typical year given the pandemic, resulting in a particularly strong Q3 with everybody working from home as we spoke about last quarter, we're assuming things have been back for the summer of 2021. And we would expect Digital Media net new ARR in FY 2021 to grow sequentially from Q1 to Q2, dip seasonally in Q3 as we have experienced in the past and have a strong finish to Q4 as we typically do. And in terms of EPS growth, we expect strong growth in Q1 followed by more modest growth in quarters two, three and four as we lap the COVID related savings from FY 2020 as well as resulting from a higher effective tax rates in fiscal 2021. To wrap up, Adobe saw a record performance in FY 2020, something we're all proud about, and the business momentum is strong as we look towards FY 2021. And we continue to be a market leader delivering growth and expanding margin at scale. In fact, record profit and cash flow. We have a large expanding market opportunity as we've shared and we're driving category creation and expansion, innovations and growing customer universe, targeting over $15 billion in revenue over the next 12 months. And we are just going to operate with a proven track record for driving long term top line and bottom line growth. Now, we're going to go to a short video and then Jonathan will kick off the Q&A. [Video Presentation]
Jonathan Vaas: What a great video. I certainly can't imagine staying productive without Adobe Sign and Adobe Acrobat. Thanks, John.
A - Jonathan Vaas: We are now going to move to live Q&A with all six of our executive speakers. For those of you who wish to ask a question, please go ahead and queue up now with our conference call operator, if you haven't done so already. And when you ask a question, please remember to mute your webcast to avoid any feedback. And due to the format, there may be a few seconds of latency. So please keep any interjections to a minimum. With that, operator, we'll take the first question.
Operator: [Operator Instructions]. Brent Thill of Jefferies, please go ahead.
Brent Thill: Thank you for the great overview today. Shantanu, there have been some investor questions just on the current quarter around Digital Media and the percentage of upside relative to plan was a little lower than some had thought. And many are asking, is there anything to consider in the Digital Media business for the quarter? And then, maybe more importantly, looking into next year in Digital Experience, it seems like you're seeing some great momentum. Maybe Anil can talk about what is driving that increased confidence, momentum in that business? Thank you.
Shantanu Narayen: I'm happy to answer both questions and give you some color. First, as it related to Digital Media, we had record Q4 performance in Digital Media, $548 million in net new ARR, which is just phenomenal performance. I would say both Q3 and Q4 were very strong. And certainly, I think when you look at the back half of the year, as it relates to Digital Media, it was incredible performance. And when you look at our Q1 targets, as well as when you look at the targets for the entire fiscal 2021, as you know, these are the highest targets that we have given at the beginning of the year. And so, the growth drivers that we see in digital media just continue unabated. Everything from acquiring customers, upselling them, I think we tried, therefore, to give you real color between the individual apps and the full apps. And our data driven operating model allows us to be pretty sophisticated. And so, relative even to our targets for Q4, as far as we're concerned, it was a beat, which showed the momentum that we had in the business. So, Digital Media ARR, nothing. We continue to believe in the expansion of the total addressable market and really pleased with our performance. As it relates to Digital Experience as well, I think the momentum there, what happened was, clearly in Q2 and Q3, as all companies were dealing with the pandemic, what was top of mind was customer continuity and safety of the employees. As soon as that pivoted, everybody was talking about digital as the only way out of the pandemic. And so, they started to look at who were the clear leaders in customer experience management and the conversations really accelerated for us. That was the momentum. The Adobe Experience platform being a clear leader, which is why as you look at our expectations for 2021 and what we believe will continue to be accelerating beyond that, we're pleased. And net-net, we're really excited about our 2021 targets.
Operator: Our next question comes from Brad Zelnick of Credit Suisse.
Brad Zelnick: Jonathan, no disrespect to Mike, but I think your 10th year, you've delivered a great event. So, thank you for that. And it's clear that the best is yet to come from Adobe. I have one question from Shantanu and another for John. For Shantanu. Shantanu, I'm struggling a bit to reconcile the optimism of expressed by the growth rates in what are – no doubt – very large, very exciting markets in which you participate and in many cases lead, but your growth expectations and current run rates would suggest you expect to lose share across the board. So, just curious if you think it's a fair observation and what I might be missing. And for John. John, I wanted to ask about slide 112 in the deck, which you presented about Creative Cloud. How should we think about conversion of single app to all apps? And what are some levers here to highlight the value of the entire Creative Cloud suite? And maybe just related to that, what's the non-genuine usage opportunity that's left? Thank you so much, guys.
Shantanu Narayen: I'll start off with that. And like you said, we appreciate the leadership that Jonathan has showed in helping pull together what is hopefully the only virtual event that we do and we can get back to more normalcy next year. I think as it relates to the opportunities that we have in the market and how we're thinking about it, we're certainly the market leaders and in each one of the categories that we're talking about. First, while we don't think it's a zero sum game, we're actually continuing to be the leader in each one of those categories. So, I don't know specifically how you're looking at it and feeling like we're not, but we are actually gaining market share. And we've become the true end-to-end leader, whether it's on the creative side as it relates to entire category of applications. Certainly, I think in digital experience, you're going to see a consolidation of where all of these solutions are done, the experience platform, what we said around customer data and insights. So, we're very excited about our prospects in each one of them. We continue to believe that we will be number one and will continue to gain market share. So, that's really the way that we look at it in terms of the expansion opportunity ahead of us.
John Murphy: And in terms of Creative Cloud and conversion of single apps to all apps, as we said, we've got so many opportunities to attract different customers and different types of customers to the platform. And we're definitely growing our communicator segment and the consumer segment. But as we've seen, particularly during the pandemic and the work from home, the need to create and use digital solutions to do that is really touching so many different segments of customers. So, the value there for us, obviously, seen in the growth of ARR overall, is fantastic and gives us an opportunity to continue to monetize access to that base of customers over time. We haven't sized the non-genuine environment in a very long time. It's probably a sizable opportunity. But we chip away at that when we have a very good entry price point for our single apps for customers that may be using non genuine product. And so, as they see the innovations that are available with our cloud based solutions and our mobile solutions, it's certainly a way that attracts people that may not have even realized they're using non-genuine product to actually use the most up-to-date innovative products that we have. So, it's really an important aspect for us, Brad, in terms of addressing all of the different segments that we can address and attract more and more people to the franchise.
Operator: We will now take our next question from Mark Moerdler, Bernstein Research.
Mark Moerdler: Congratulations on the quarter. Adobe's been very thoughtful and measured in modeling your TAM in the past. And as you've written, the TAM has been a really good leading indicator of future growth. I think most would find the large year-over-year TAM expansion, specifically for Creative Cloud, is a bit surprising. Can you give us some more color on what you're modeling in that's driving such a big TAM expansion? Why you feel so confident what's changed? Any color would be appreciated.
Shantanu Narayen: As you know, and you've followed us for a while, we take our addressable market very seriously, unlike some companies who just throw the kitchen sink in what they believe is their addressable market. And so, let me touch a little bit on when you look at digital media and the TAM, some of the growth vectors. With mobile. Firstly, mobile has become – we talked about the 300 million IDs that we've already created. And mobile has become a pretty impressive funnel in terms of both attracting new customers to the platform, the ways in which we are monetizing the mobile only services, but how that also serves as an on-ramp. And this was one that, until we had real offerings in the mobile space and the ability to have these multi surface – we also have storage options in terms of some of our products across multiple surfaces. So, that's clearly one of the drivers that is continuing to grow. I think as the nature of our products, target the communicators in addition to the creative pros and the consumers, all of these applications as well, we feel like that's another part of the addressable opportunity. Certainly, what we've seen with Stock, the busines is doing really well and this notion of content- authoring paradigm where people start to author the content using a piece of content, we think that that also drives further acceleration in that particular business the amount of stakeholders who've seen us deliver more and more collaboration services and the collaboration services allow us to also monetize that. On the Document side and on the Creative side, what we've targeted with respect to the web, that's why I gave you some insight as to the magnitude of how much people are doing PDF searches on the web and what kind of an industry that's become, that same sort of task-based approach is certainly true in Creative. That's a brand new opportunity. And the confidence that we have in being able to convert all of that traffic and all of that acquisition funnel into monetization models gives us a lot of confidence. And so, when you look at the services, whether it's Stock or Sign, what's happening with respect to document workflows – and I think, as we said during the prepared presentation, the fact is this digital inflection point, it's only going to increase in terms of the number of people who use it. And that's why we also touched on regulated industries, which in the past may have been a little bit more slow or less enthusiastic about digital, there's no opportunity left for them. So, all of that really adds up to why the TAM continues to build for us.
Operator: We can now take our next question from Alex Zukin of RBC.
Alex Zukin: Congrats on a wonderful quarter and a great analyst presentation. Shantanu, I wanted to ask you kind of similar to the previous question, how should we think about the headwinds and tailwinds in the business as we come out of the pandemic? Where are you most enthusiastic about the growth vectors in both Digital Media and Experience? John, I think, obviously, investors are pleasantly surprised at some of the modest margin leverage you're showing for next year, given the one-time T&E savings from this year, coupled with what's likely a dilutive acquisition. So, I guess, how should we think about the impact on margins of the durable efficiencies around go-to-market post-COVID and the trade-off between operating leverage and growth?
Shantanu Narayen: From my perspective, Alex, definitely, it's the tailwinds that's the story of the company. And it's across all three businesses. I think on the Creative side, this notion of more content creation and more content consumption across all of the media types is certainly driving more usage of our particular products. Global expansion, we didn't talk about that as well. But global just continues to be, as digitization becomes a phenomenon, a tailwind in our business. I think the Document side is probably going to see the biggest tailwinds as it relates to what happens. Part of the reason on making sure that we had Gloria touch on how we thought about remote work and what was happening as we think about our own business and how we think about remote work. So, I see significant tailwinds in the Document business, both as it relates to the usage of electronic documents, as well as the automation of business workflows. And that drives Digital Experience. And Digital Experience, which one of us is now going to go back and stand in line for a driver's license or for a permit to do anything else? And so, I think you're just going to see more and more – if anything, the pandemic and the health crisis has raised the urgency. And I think John alluded to this, which is every CFO and every C level executive that I talk to, what's top of mind right now is digital transformation. So, they're all saying, okay, vaccines are on the way, once the vaccines come, we're not going back to business as usual. And whether you're in travel or hospitality or whether you're in some of the other industries that have unfortunately been impacted a little bit more, digital engagement is the only way around it. So, net-net, I really don't look at our businesses and feel like they're headwinds associated with the business. We will continue to be dependent on the macroeconomic environment, which has actually continued to be fairly robust. And so, we're excited about our prospects. And I think the solutions that we deliver become, frankly, more important, rather than less important.
John Murphy: On the margin question, Alex, I think when we think about how we target growth – we are a growth company, and so we want to continue to invest in growth. And we've been able to demonstrate over time that, as we drive growth, we're able to expand more margins over time. You think about our original targets for FY 2020, we still had expanding margin coming out against FY 2019. And while we're really pleased to deliver this level of operating margin in Q4, we do expect 2021 to have operating margins down from our Q4 high, but still expanding over FY 2020. So, we're definitely committed to that. The reason for that is that we'll be lapping much of the COVID related savings, and we'd expect to realize some of those savings in the first half. But as the gradual phased reentry happens later, in the latter half of the year, we expect to be able to invest because that's going to drive growth. And we want to continue to strike the right balance between investing for growth and benefiting from those continued first half savings. Not to mention, we will be impacted by the deferred revenue haircut for the Workfront acquisition. But even so, we're still going to be expanding our margin in FY 2021 over FY 2020.
Alex Zukin: Congrats, again, on another great job.
Operator: We can now take our next question from Jennifer Lowe of UBS.
Jennifer Lowe: Two for me. First, maybe asking the opposite question of the ones that Brad asked earlier. But looking at the composition of ARR by full suite versus single app, given all the discussion around single app as an on-ramp and an attractive landing point for communicators and consumers and you seem to be seeing a lot of momentum there, why hasn't single app grown as a percentage of that mix? And as you continue to lean into that sales motion, could it be more 50/50 over time? Or is the expectation that, in communicators and consumers, they'll ultimately be full and it just stays balanced? I just need color there. And then secondly, for John, Alex mentioned that the presumption is Workfront is dilutive. But I'm just curious if we could get a little bit more color. So, we've got the Q1 revenue impact. But is there any more color to add around either margin impacting Q1 or what's baked into the full year guide for Workfront? Thanks.
Shantanu Narayen: Jennifer, I'll take the one on the single app. And as you know, you have to look at both the units view as well as the ARR view. And the units view continues to grow. But remember, that also is an area where, as we ramp them to the platform, it's the single apps. That's the way in which we acquire them. But we're doing a better and better job of being able to convert them into the full app. So, I think what you have to just recognize is that the single app pricing and ARPU is a little bit lower. And so, that same pie chart that we showed, that's the revenue look or the ARR look associated with it. And when you look at the units look, clearly, it will show a different picture in terms of the higher proportion of what's happening through single apps. And so, that's a model that all the way back to Creative Suite, we know how to do that, attract new customers to the platform and drive that in. So, that's the answer to your question around single apps and the full app model, and it's actually working for us.
John Murphy: Jennifer, in terms of Workfront, the Workfront acquisition, it's just closed, so we don't have the full purchase accounting completed yet. We are expecting a significant deferred revenue haircut as is fairly typical with these acquisitions. And as a result, there'll be slight dilution. But as you can see in our full-year targets, we're still targeting significant margin expansion over FY 020. And that just kind of shows the leverage in our operating model, our ability to continue to invest for growth, and still expand our margins and our earnings.
Operator: We can now take our next question from Jay Vleeschhouwer of Griffin Securities.
Jay Vleeschhouwer: Shantanu, you noted the closing this week of the Workfront acquisition. And it also happens to be this week the 15th anniversary of the Macromedia acquisition. And it's pretty evident what the long term value of that acquisition has been in terms of the impact on the company. And the question, therefore, for Adobe today is, do you think that the long-term lasting value of the foundational technologies that you have or investing in DX can have a 10 year or more lasting value for Adobe or do you think that perhaps the half-life, so to say, of foundational or critical technologies might be shorter? And if so, what are the implications there for R&D spending and the like? And then secondly, a recurring theme from the company this year, particularly in summit, has been application and intelligence services and Abhay referred to this. Looking ahead over the next number of years, what do you think the contribution from those discrete new services might be? aside from the incumbents of Sign and Stock, I'm asking really more about the newer ones that you have in mind. And are those services something that you might begin to disclose more specifically over time as they become material?
Shantanu Narayen: Jay, let me take both. December is not only, as you point out, the anniversary of the Macromedia acquisition in 2005, I can even have the privilege of going back and say, December was also when we did an acquisition for GoLive in 1998. That was one of my first acquisitions. And that sort of embarked us on the web journey as well, which has clearly proven to be also one of those seminal moments. But more seriously, I think when we look at what we've done with Workfront, we've always had – and understood the technology component of what it means to deliver these services, but the amount of spend, the amount of ability to drive efficiency as it relates to the internal workflows and processes associated with it – because it's not just about the campaign itself, it's about the creation of the campaign. And we've talked about this expression, content velocity, for a while. And so, when people want the ability to create these campaigns and personalize it and get this out and global, it's not just about the technology platform, but it's also very much about the work management associated with it, which is why we're excited about Workfront and what it does for us. I think as a company, they perhaps focused – or defocused and spent a little bit more time on the broader opportunity. And we just think focusing on content and focusing on creation, while I think most people are correctly pointing to what we can do as it relates to what happens on the marketing side, the fact is that we also have a significant number of customers who use Workfront in conjunction with the Creative Cloud. And you've written about our desire to continue to integrate the Creative Cloud, as well as the Experience Cloud with that entire content creation, management, monetization measurement opportunity that we have, and I think this can be a significant accelerant to that as well. So, you have seminal products, whether it was Macromedia, whether it was Day Software when we talked about content that actually created these significant opportunities for us in terms of platforms and now tying that together, the glue, which is why when you look at one of the slides in the deck and how Anil describes where Workfront is, it's really the glue that actually ties together all of our marketing application. So, I think to your point, we feel like that could be a really significant enabler of increasing more people into the entire marketing campaign workflow. And in addition to that, really providing more integration capabilities across each of our solutions. I think to your second point associated with services, what is phenomenal about both our creative business and our document business is actually the breadth of our offering. I think this is related to some of the questions. We have mobile offerings, we have services offerings, we have single apps offerings, we have full offerings, we have freemium offerings. And I think as the business scales, I understand the need from investors to say, hey, how can you give us color? That's part of the reason why John was giving a little bit more color on how material the combination of mobile and Stock and Sign have given. So I know we will continue to figure out how we can provide more insight, but I think it's to answer the question of the incredible momentum that we're seeing around both the Creative Cloud and the Document Cloud, what's underlying it. And there's very, very significant amount of depth associated with that entire business which is what's fueling our business. And I've been reminded that it's also close to the eighth anniversary of when Scott and Behance joined us in 2012. So, Scott, it's good to have you onboard as well. But thanks for the question, Jay.
Operator: We can now take our next question from Kirk Materne of Evercore ISI.
Kirk Materne: Shantanu, I was wondering if you can just double click a little bit on the Experience Cloud business just in terms of the three pillars there, customer data, content and customer journey. And is there one area in particular, or maybe two, that you're particularly excited about as we head into calendar 2021 or are those just big opportunities for all of them? But just kind of curious of your thoughts on those kind of pillars and where you see each of those positioned for next year. And then, John, just on the Workfront acquisition, I realize you gave us the $25 million in revenue for the first quarter. I assume it's fair to assume – I assume it's fair that that would ramp from there, given the purchase write-down. I know you probably don't want to give a full-year number on revenue, but I assume that should scale from that starting point throughout the rest of the year. Thanks.
Shantanu Narayen: Kirk, whenever I get asked questions – at least you didn't ask me the question that I can never answer, which is one of my favorite products because as products in the portfolio, I don't distinguish between them. Maybe the ones that I would highlight is the momentum that we've seen around the Adobe Experience Manager cloud version, that has been really phenomenal. And so, we've seen some really good success. As we moved, everybody is again thinking about content, how they improve their agility. And so, I think the content and commerce, which represents a large opportunity and the fact that we've integrated how you can create a content site and enable commerce for it, whether it's in B2C or B2B, we're seeing just a tremendous demand for it. Because every company that didn't have the ability to transact business online was seeing a fair amount of headwinds in the pandemic. So, content and commerce, we continue to believe is one of the underpinnings of our business and continue to be a driver associated with it. And the second one that I'll talk about is where experience platform, a big part of it is reported within the data and insights and what we are seeing associated with now all of this data coming back in the unified profile. So, I think that is really one of the areas that we've also seen significant momentum in Q3 and in Q4. People want to know how they can create that profile, how they can deliver it. So, if they were two out of the three, though, we say all three of them are growth opportunities, I'd probably prioritize it like that, Kirk.
John Murphy: Absolutely. You're correct. The $25 million that we are targeting for Workfront in the first quarter, of course, depending on what the purchase accounting pans out to be, we have kind of modeled out for a year or two based on our estimates on the deferred revenue haircut. So, we are expecting between $140 million and $150 million. But, again, really dependent upon when we finalize the purchase accounting later this quarter. But it will ramp.
Shantanu Narayen: And big picture on that, Kirk, certainly, our expectations for the Workfront acquisition, net of all the accounting things that John alluded to, that they would be accretive to the growth profile of the company in terms of where the opportunity is and what we expect to do with that business. So, I just want to make sure we separate how internally we're looking at the growth and what we're driving towards is our plan, relative to what will be reported, as John mentioned, on the accounting side.
Operator: And we can now take our next question from Keith Bachman of BMO.
Keith Bachman: I'll ask Shantanu directly to you. One is a consistent question from me. As the Document Cloud continues to put up very strong numbers in terms of ARR and you're guiding the growth of the Document Cloud TAM opportunity, again, between 2022 and 2023 at 60% growth, which is far higher than the ARR growth. So, I just wanted to see what you think the conclusion should be to the current run rate of ARR growth, call it, mid-30s and a pretty significant growth of the TAM? Does that suggest that the growth rate can actually accelerate? And then, I'll just ask my second question. Thanks very much for the disclosure surrounding the Creative Cloud, including the users and the dollar TAM. Very helpful and interesting. Where would you rank order, so to speak, the growth potential being driven by the consumers, communicators or creative pros as we think about our model over the next couple of years? Thanks very much.
Shantanu Narayen: I think there were two questions in there. I think the first one as it relates to where we are – ensuring that our document products are being adopted, remember the document products get adopted both as part of the Document Cloud and what are reported in the Document Cloud ARR. But also Acrobat is a huge part of what we report within the Creative Cloud and what's happening within the Creative Cloud. So, the growth that we're seeing in documents is reflected in both, because in many ways, what we see is that the adoption of PDF as a collaborative medium as well as for workflow in the creative segment is also extremely large. So I think of it as really fueling two large growth opportunities. But certainly, I think the acceleration that we've seen in that business and the continued focus and investment that we're going to make in that business gives us a lot of confidence of being able to continuously grow the document business from our perspective. I think as you look at which customer segments, much like Jennifer's question, as it related to ARR, the numbers associated with it versus the ARR could have potentially different answers. And certainly, I think on the consumer side, what we are seeing with the mobile ID creation, what we're seeing in imaging, maybe which appeals primarily as a new category to the consumers, the communicators is a large space, it's always been a big part of the halo. And so, the numbers are probably in terms of new customer acquisition, largest in consumers, then in communicators, then in creative pros. But the opportunity to drive ARR continues to be across all three because of the different price points, as well as, in many cases, the way we upsell into those particular customer segments. So, that's the way we look at it. Again, I've done this enough where I know people want a simple m multiplied by n in order to be able to do it. But I think what actually makes us so differentiated and such a sustainable business is really the fact that we have these breadth and depth of offerings and the DDON that we've talked to you about, where we know how to personalize each offering. And it's also different by geography. Maybe that's one of the things that I should mention. And it's different, for example, in education. Education had a phenomenal year, and that seeing that next generation of creative professionals, but in many cases, whether it's a K-12 license or a license for an entire educational institution, the ARR may be small. So, hopefully, that gives you a little bit of color as to how we think about each of those segments. But the nice thing is now we have a product folio that cuts across all of them.
Operator: We can now take our next question from Ken Wong of Guggenheim Securities.
Ken Wong: Just one for me. I wanted to just touch on the slides you guys put up there with the –future expansion where the average ARR from the top 100 customers went from $3 million to $8 million, which is very impressive. Just wondering what kind of headroom do you think you have with that top 100 as more adopt your kind of full CDP. And then also, how far down the customer list could you possibly maybe see a similar $3 million to $8 million type uplift from your customer base.
Shantanu Narayen: I think one of the impressive things, Ken, that Anil has done is really focused on what he calls the transformational accounts, which is, in many ways, I think has he has taken on responsibility for the entire product, as well as on the go-to-market. I think an analysis showed that while we were getting significant traction with a number of customers that we had, it's really this focus on transformational accounts and creating a good go-to-market has demonstrated that there's massive headroom associated with this with our customers. I think the Verizon example was a good example to articulate and show how each of our products. And the second part of that, honestly, is the fact that we're also far better at demonstrating what the ROI is. And again, Anil, I think, touched on the ROI associated with the Experience Cloud. So, as you take the ROI as well as you take the focus that we have on these transformational accounts, you add the ability to do Workfront, we just continue to think that there's massive opportunity. That's the beachhead. But that doesn't mean in any way, shape or form that there's a limited set of transformational accounts. Rather, it's the recipe to continue to deliver value, become strategic to these customers, and drive significant ARR. And as it relates to the breadth and depth of that customer base, again, going back to the question that I think was asked around Experience Cloud and what's driving it, the AEM cloud service is not just a service that can apply to large enterprises who maybe want to create new websites as it relates to campaigns, the fact that it's easily provisioned and easily on ramp actually makes it a very appropriate solution for what we refer to as commercial or mid-market or small and medium business customers, and integrating things like analytics into it and commerce into it with the Magento service enables us to really say, we could be your one-stop shop for getting a Web presence, as well as for transacting commerce on the web. So, clearly, the aspirations are to enable people to have a quick and one-stop on-ramp.
Operator: We can now take our next question from Walter Pritchard of Citi.
Walter Pritchard: I have two questions. One for John and one for Abhay. John, one of the slides, you talked about 75% of the individual subscribers new to Creative Cloud franchise in fiscal 2020. Can you clarify the other 25%? Are they coming from mobile apps that were the prior year? Where's the other 25% coming from? I think the disclosure in the past was a little bit different. I'm just trying to frame that. And then, I have follow-up.
John Murphy: They're coming from a couple different places. Certainly, mobile, as we talked about before, is a huge on-ramp for us. And we've been having so many new Adobe IDs created on mobile. We also have perpetual, is the other part of that as well. So, definitely strong performance across both of those in Q4.
Shantanu Narayen: And then for Abhay, if he's still on, just around – you talked about opening up more APIs. And I know in Sign, one of your competitors there is quite strong, leveraging that. Could you talk about where you expect to see sort of the tangible revenue impact as you embark on that effort and productize some of that that you're building around API based access for products?
Abhay Parasnis: I think at a macro level, and we shared a little bit, both Shantanu talked about in the Document Cloud strategy and I covered, across all our businesses, but especially in Document Cloud, PDF has always been a very vibrant ecosystem play, as you know, for us where it's connected into a lot of ISVs and solutions across industry verticals, line of business applications. And so, what we are starting to now do is opening up APIs and working with three kinds of players. There are large ISVs, like Microsoft, Workday, ServiceNow where we are connecting our applications and APIs directly into their ecosystems and applications and have kind of joint attached motion there. But then we are also opening it up for the broader developer ecosystem. And as you know, even on our DX enterprise business, we have products like Magento and ecosystems of large developers who connect to our platforms, whether it's AEM, Magento. And we are opening up our APIs around signatures, PDF to that kind of long tail of developers. So, I would say, large ISVs like Microsoft, ServiceNow, Workday that we have announced partnerships around and integrating, and then a broad long tail developer reach play, where they are embedding our APIs and services for more inline into their applications and taking it to market. The last thing I'll say, and kind of we shared also, is AI. The other piece of the API strategy is also opening up our intelligence services around Sensei platform and exposing those also beyond our applications for developers and ISVs, which are very unique and differentiated. So, that's the other component of that.
Operator: We can now take our next question from Derrick Wood of Cowen and Company.
Derrick Wood: Two questions from me. Shantanu, maybe I'd start on kind of doubling down on the communicators market and just curious about who some of the more popular personas are out there and maybe how COVID has been a catalyst and what you guys are doing to kind of lean into that market more. And then for John, on the Digital Experience side, seems like there's a lot of margin leverage to be driven out of that business, restructuring on the Ad Cloud side is one step. Sounds like maybe more revenue leverage out of AEPs and other. But can you just talk about some of the things you guys are doing to drive better leverage on both the gross and operating margin as we look over the next year or two?
Shantanu Narayen: Let me start. As it relates to the communicators, what I think most people don't maybe fully appreciate is what is happening on the Web with respect to wanting to do certain creative tasks and being able to fulfill those tasks with what we are doing around search engine and everything associated with the actions that people want to do. They want to remove the background for a picture, they want to post it for social media. And just the communicators that we refer to are also what were perhaps referred to in the past as knowledge workers because we just fundamentally believe that every piece of printed material or presented material benefits from this more interactive graphics rich. And so, what we are seeing is the ability for people to say, I want a single click ability to finish my task. And then once they finish that task, expose me to all of the other riches that exists in Adobe's creative product. So, I think that's a big driver of what the communicator has. We certainly see that with Spark. We see that across Lightroom as people want to share their images. But we also see it in our category-leading applications. Video is the other place where the usage of video in virtually every piece of communication is rapidly accelerating. So, hopefully, that gives you a couple of examples of where the communicator organic demand is coming from.
John Murphy: And Derek, in relation to digital experience, looking at the TAM, we have such a great opportunity. And as you've seen, we expect acceleration. And then, with Workfront, even further acceleration. Workfront had stumbled there [ph] before we actually acquired them a little bit. But we know that the demand is there for that solution. And coupled with our capabilities, we know we can actually accelerate that back. So, there's definitely revenue leverage in the digital experience business. And as we said, the way we realigned the Digital Experience business by moving ad cloud out of that segment because we're operating it a bit differently, we wanted to make sure that we're operating the Digital Experience business the way a healthy SaaS company should view it. We have aspirations for very strong margins there. If you think about healthy SaaS companies growing their margins, the rule of 40. So, we're definitely excited about that. The other thing we're doing is we're going to continue to invest, as we said, in hiring, not only in R&D, but also in sales capacity because we're not opportunity constrained. We just definitely need to take advantage of the ability to capture all this opportunity, particularly now, the way that we've aligned the solutions within Digital Experience and they're resonating with our customers. And then of course, with Workfront, we can accelerate it even more.
Jonathan Vaas: Operator, let's take two more questions and then we'll do a brief wrap up. Thank you.
Operator: We can now take our next question from Sterling Auty of JP Morgan.
Sterling Auty: Shantanu, how would you characterize, in the digital marketing, advertising, Adobe Experience area, with all the products ranging from the original Omniture, all the way through to Marketo, and all the homegrown solutions as well, where are you in the evolution of taking that entire stack into a fully integrated Kubernetes-enabled, cloud-delivered platform? Are you complete? Is there still phases left to deliver? And how might that investment impact gross margins moving forward?
Shantanu Narayen: Sterling, when we have the kind of innovation opportunity ahead of us, let me first start off by saying we've made tremendous progress. So, the delivery of the Adobe Experience platform was a momentous milestone, Sterling, not just because we delivered all this new functionality, but we started to have, whether it's Adobe campaign functionality integrated into the experience platform to be able to do customer journey, whether it was the Adobe analytics, what you refer to as the Omniture functionality and being able to get insight of all of that data. And so, the progress that we've made in being able to drive all of these solutions into a common platform, it's never done. To some degree – I remember that people would ask me, how much innovation do you have on the creative products. And here we are decades later. And the list of what we can do with these products dwarfs what we ever had 20 years ago. So, as I think about the Experience platform and I think about what every enterprise has to do to rewire it, I think we're in a fantastic position, given the engineering efforts over the last few years to have this integrated platform that nobody else has. It runs on cloud. I think you've seen with the progress and success that we've had around Microsoft and what we've done with Microsoft on Azure, it's certainly cloud aware. The announcement that we made with IBM, with the ability for all of these to also run in a hybrid cloud, where people, whether it's for regulatory reasons or other reasons, want to run it on their private cloud network, we've made progress and there's clearly interest on companies like VMware and IBM to partner with us on that. So, I'm really confident about the architectural thing. But the way we look at it is you're constantly architecting for new architectures. You're constantly doing work in AI and ML and providing more and more insights. Some of the ways in which we've actually added tremendous value is in the reporting and the analysis and the insight that each one of these has been doing. But the breadth and depth of our offerings, I think there's still significant headroom of what we can do. Because the way you have to think about it is, if we believe that with DDOM we're one of the most mature companies in terms of having a digital funnel and how we operate that's driven our success, we're pioneers not just in delivering technology, but in how we've moved it. And that movement for every company now, rethinking their business process, rethinking their computer architecture, we're at such an early stage that we're going to have to keep innovating around that space. And so, we think of it right now as an overall growth opportunity. We have made, as you saw, the strategic decisions around how we think about margin in that particular business. And so, we will continue to see margins expand in that business. But I think what you should be most excited about as an investor is the fact that we're investing in this immense opportunity and extending our lead. And so, I think that's the way we think about it. You look at the overall margins of the company again, and I think John alluded to this, despite investing in Workfront, despite investing in sales capacity, despite saying that we will accelerate growth, we're showing you margin expansion for the entire company. So, we know how to do this, which is drive top line growth and bottom line growth at an impressive margin. So, that's how at least I think about it.
Operator: We'll now take our final question from Keith Weiss with Morgan Stanley.
Stan Zlotsky: This is actually Stan Zlotsky sitting in for Keith. Two questions from our end. If we look at the Creative Cloud and the progression of the pie chart that you guys put up there from 2017 to 2020, we can see that there's a fairly pronounced shift in ARR from team to individual. And maybe just following up on the question that Jennifer asked earlier, as we move into 2021 and beyond, how should we think about the progression of the shift moving forward? Will we see more continuous push from individual? Or are we starting to reach a more normalized equilibrium within those two categories? And then a very quick follow-up.
Shantanu Narayen: Well, I think what you should see and what you will expect is, first and foremost, the pie expanding. And as it relates to the total addressable market, the main thing that you have to think about is this is market expansion, we're growing the value associated with our customers. I think at steady state, at some point in the prior business, which may be a predictor, it was closer to 50/50. But the thing that, again, I will reemphasize is that a lot of that is we drive into individual and then convert into the entire offering. And so, that's it. And so, big picture, I would focus more on the growth of the pie, the exact mix between those two. We look at both of them and feel like they're growing really well. And I'm happy to answer your second question as well, Stan.
Stan Zlotsky: Just digging into the slightly rejiggering of your reporting segments and increasingly the new Publishing and Advertising segment. What are you seeing behind the scenes in your business? And how should we think about the print and publishing segment? Obviously, it's a very small part of the overall revenue component. But why create this dedicated segment and pull out the advertising from Experience Cloud? Thank you.
Shantanu Narayen: What we were trying to do was give you more insight and color into how we were running the different businesses and I think that's a key part of it. I think the print business, which was, a lot of you know, the genesis of the company. It's a business that continues to do well, but it wasn't a growth category as much as a high profitability category. We talked about in the Advertising Cloud, getting out of a lot of the transaction based revenue that we were seeing. And [technical difficulty] investors should take is [technical difficulty] pure play what is being reported as part of the Digital Experience segment that there's a clear alignment between what you see on bookings and what you see on revenue. As you've seen, the consulting services has been proactively driven down as a percentage of the revenue as we have a thriving ecosystem. I think the advertising cloud will not be a growth opportunity for us. There are some strategic partners who like the fact that we can continue to deliver it. But I would take that as a signal of we're really focused on the large growth opportunities where we have a differentiated solution. And it's purely subscription based revenue because that's in alignment with how we think about the largest opportunities. And so, we're focused as a company on making sure that we do it. I'm actually really pleased with how we transitioned that and how we communicated to customers. And so, this focus on the software as a service component of all of our businesses, we believe that that drives top line growth, we believe that that drives margin, and we believe that that's consistent with where we want to be as a company.
Shantanu Narayen: And given that was the last question, I want to, again, first and foremost thank you all for joining us today in what was this virtual format. I really hope you share the passion that we feel for the mission, the tremendous market opportunity ahead of us, the depth that we have in our technology platforms, and really the significant customer value that we're delivering and providing. We really believe that the global brand, the customer base that we have, the ubiquity of our software, and the dedicated employees provides a real competitive advantage. That, frankly, is the envy of the industry. From my perspective, 2020 was an amazing year. We expect the momentum to continue in 2021 and beyond. And I certainly believe that our best years are ahead of us. As a number of you said, let me also wish you all a healthy, safe holiday season. And we really look forward to continuing to share the momentum and the story that we have in the new year. So, thank you for joining us. And with that, I'll hand it back over to Jonathan.
Jonathan Vaas: Thanks, Shantanu. And thanks again to everyone on the phone and on the webcast for joining us today. As Shantanu mentioned earlier, I also hope that we'll have an opportunity next fall to do this in person again. But we're really pleased that you joined us for the virtual event. Stay safe out there. Happy holidays to everyone. We look forward to seeing you at the Q1 call in March. And I'm sure I will be speaking to many of you very soon. This concludes the event. | [
{
"speaker": "Jonathan Vaas",
"text": "Good morning and thank you for joining us. Welcome to the Adobe Q4 Earnings and 2020 Financial Analyst Meeting. I'm Jonathan Vaas, VP of Investor Relations for Adobe. You should have a copy of the press release we filed this morning as well as our investor relations datasheet. We've got a great program planned for you today, which is in many ways similar to what we've done in the past, and in a few ways different. This year marks my 10th analyst meeting at Adobe. The first was the year we had just launched Creative Cloud. And it's amazing to reflect on how that business has grown since then. For my first nine analyst meetings, I was one of the many employees helping behind the scenes. And this year, I have the privilege of introducing the executive speakers as the head of Adobe's Investor Relations program, a role I assumed earlier this year, just after we had made the shift to working remotely. I've really enjoyed all of the conversations with investors and analysts about Adobe's business this year, and I look forward to meeting many of you in person at some point. That leads to the other way today's program is a little bit different than what we've done in the past. This is our first virtual analyst meeting. I, for one, will really miss the opportunity to meet many of you and chat after the event, but we've also been learning this year about the power of communicating digitally and seeing that we are able to meet to reach a broader audience with a webcast than we might with an in person event. Due to the format, we've streamlined the planned presentation today. But a long form slide deck has been posted to Adobe's IR site that has all of the detailed information you're used to seeing. Let's take a look at the agenda. Shantanu will kick things off today by talking a bit about the quarter and fiscal year we just completed and then moving over to Adobe's vision and strategy for the future. Abhay will then talk about the company's vision from a technology lens. Scott will highlight our Creative Cloud strategy. Anil will go over our Experience Cloud strategy, and Gloria will talk about our strategy related to our people, as well as other Adobe stakeholders. Finally, John will provide a detailed financial summary and share Adobe's growth strategy. And then we'll go to live Q&A. Before we get started, as a reminder, some of the information we'll be providing today includes forward-looking statements that are subject to risk and uncertainty. Actual results may differ from these statements, and we encourage you to review the risk factors in our SEC filings for more information. Additionally, we'll be providing both GAAP and non-GAAP financial information. Reconciliations between the two can be found on Adobe's Investor Relations website. I will now pass it over to Adobe's President and CEO, Shantanu Narayen."
},
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"speaker": "Shantanu Narayen",
"text": "Thank you, Jonathan. I'd also like to add my welcome. Thank you for joining our annual financial analyst meeting. Today's format is a little different than what we are used to. But to make the most of this year's medium, we'll use the time today to cover strategy, business momentum, as well as our financial performance. We posted the complete deck similar to what we've done in prior years. But rather than speak to every slide, we'll have the management team share their highlights in their areas. And we've always saved some time for Q&A at the end of our presentations. First and most importantly, I hope you're all staying safe and healthy. It's really tragic to see the recent spate of casualties, but the progress in vaccines gives us all hope that the worst will soon be behind us. And clearly, none of us could have predicted how everything would change overnight, and the world as we know it would change so dramatically. Digital has even more become the primary way for people to connect, work, learn and be entertained. This new reality has only increased the importance and relevance of our solutions and accelerated the tailwinds that benefit our business. This combined with our business fundamentals, unparalleled innovation, and world class execution continues to drive our growth. 2020 was another momentous year for Adobe. And like all companies, our primary focus has been to protect the health and safety of our employees and continue to serve our customers. We took swift and decisive action to direct our employees to work from home, suspend travel and cancel in-person events. And we focused on helping our customers make their own transition to digital overnight. For example, we provisioned 30 million students with Creative Cloud, so that they could create from home. We implemented the government rapid response program to assist local governments. With our Honor Heroes campaign, we galvanized our community to create artwork honoring the true heroes – essential workers. And we set the bar high for digital events with Adobe Summit, as well as Adobe Max. In fact, Adobe Max garnered 21 million views. We continue to harness the trillions of transactions powered by the Adobe Experience cloud to provide a unique real-time perspective on the economy with the Adobe Digital Economy Index. And we pioneered new areas such as the Content Authenticity Initiative, which provides attribution functionality that creators can attach to their work to create more transparency around how content has been posted and edited. Our leadership extends to not only what we do, but how we do it. And we're proud of the continued industry recognition that we receive. We continue to be a top riser on the Interbrand Global Best Brands of the Year for the fifth year in a row. We're consistently named one of the best places to work by both Fortune and Glassdoor. And in an area that's becoming increasingly important to US investors, we're a leader whether it's in the Dow Jones Sustainability Index or the Bloomberg Equality Index. But it's a product company at our core. It is our innovation engine that I'm most proud of as we continue to fire on all cylinders. With Creative Cloud, we continue to remain the clear leader in a category that's exploding. We delivered significant product innovation that extended our applications to multiple surfaces. We added greater collaboration capabilities to all of our leading applications. And we continue to break ground in new categories, while improving engagement as well as customer satisfaction. The Document Cloud continues to have huge demand in this digital environment, with PDF and Adobe Sign all being mission critical across many businesses. We delivered more capabilities, or verbs as we refer to it, across desktop, web, mobile, and through our frictionless PDF services. And with Experience Cloud, we continue to build out the world's most comprehensive customer experience management portfolio. And the new capabilities in the Adobe Experience platform have now been expanded to include real-time customer profiles. We delivered new services, intelligence services to further the use of artificial intelligence and machine learning in organizations. We delivered new solutions like Customer Journey Analytics, which unifies cross channel data. And I'm excited that we recently closed the acquisition of Workfront, which is a leading work management solution for marketers. On the financial side, after crossing the $10 billion mark in 2019, we haven't missed a beat. And as you can see from our targets, we expect to exceed the $15 billion mark in 2021. And we're incredibly pleased to drive both top and bottom line growth, while generating cash and continuing to return to shareholders. In fact, in 2020, we achieved $12.87 billion in revenue, which represents 15% year-over-year growth. In Q4, we surpassed $10 billion in digital media ARR, which is a significant milestone for us as a company. With the strong financial discipline that you've all been accustomed to, we continue to generate impressive cash flows from operations and generated over $5 billion in fiscal 2020. And we continue to focus on earnings per share with the earnings per share on a non-GAAP basis of $10.10, which represents 28% year-over-year growth. I truly believe that these financial accomplishments set us apart from all other software companies, and the best is yet to come. Adobe's mission is to change the world through digital experiences. And it has never been more relevant as people seek new ways to communicate, learn, and conduct businesses virtually. The benefits of our innovation help billions across the globe. And the impact is experienced across every aspect of society. It motivates our employees to focus on having more impact and to invent the future. When you think about the macro trends that we all experience, every industry is experiencing a tectonic shift towards all things digital. And I believe that the events of this year have only accelerated. The genie is not going to go back into the bottle. And even regulated industries that have traditionally been slower to embrace digital have certainly picked up the pace this year. We have industries like healthcare that are transforming, whether it's through personalized medicine, telehealth and new ways, frankly, to engage patients. On the creative side, it continues to be the golden age of design and creativity, and design continues to be a key competitive advantage because everyone at their heart is a creator. They want to express themselves across new devices with new modalities. And creativity is so essential to how we connect, how we cope, and how we learn. Education has also been reimagined because digital is central to how students learn today, whether it's through remote education, as well as by unlocking new forms of creative storytelling. And digital is also breaking longstanding barriers to access to education, which is something great because it's making it more accessible. The way we work will never be the same again. And it's great to see how the PC has experienced a tremendous revival as the computing workhorse. Documents are at the center of how work gets done. Paper to digital transformation is only accelerating, and every business process is going digital because every business is now a digital business. Digital has become the primary way for all businesses to engage with their customers. And it's true that customer expectations are also at an all-time high because ecommerce is exploding. In fact, an annual holiday report that's powered by Adobe Analytics predicts that online holiday spending will reach $189 billion, which represents 33% year-over-year growth. And underpinning all of this is a massive shift towards artificial intelligence and machine learning, which will only further these forces at play. At Adobe, our strategy is at the nexus of this digital revolution. And through technology, we believe we're transforming work, learn and play. We're relentlessly focused on looking around the corner. How do we drive towards the next big market opportunity to solve customer pain points and anticipate their needs? We've pioneered and we're leading three massive growing categories – creativity, digital documents, and customer experience management. And we're relentless about expanding the customer segments we serve, adding more addressable market opportunity because we want to empower everyone, from the student to the small business owner to the largest enterprise in the world. And I believe we win by creating pathbreaking technology platforms that will lead the industry for decades, and today work across the entire computing paradigm from the largest clouds to the smallest devices, and are built with a service oriented architecture that also enables us to have new monetization models. In fact, our three industry leading cloud offerings are more mission critical than ever before across every geography and audience. With Creative Cloud, we're unleashing creativity for all giving anyone anywhere the tools to express their creativity. With Document Cloud, we're accelerating document productivity, modernizing how people view, share and engage with digital documents. And with Experience Cloud, we're powering digital businesses of all sizes, giving them everything that they need to design and deliver great customer experiences. And underpinning our three clouds is the magic and power of Adobe Sensei, a significant differentiator for Adobe and an enabler to more rapid innovation. As it relates to the creative business, everywhere we look, whether it's entertainment, education or the enterprise, content is fueling the digital economy. And that's driving an explosion of creators, tools and assets that all represent tailwinds for our business. The reality is that creativity is for everyone, from the students submitting their next school assignment to the creative professional making an ad. Everybody has a story to tell. And when you look at the categories, whether it's web content or mobile application, creation, imaging, video, animation, screen design, augmented reality, AR, 3D, they're all surging in this era of digital storytelling. Creativity is essential because more than ever before, this year has shown us the power of creativity in enabling people to express themselves to connect and to cope. We believe that creativity is one of the fundamental skills in the 21st century. And as machines get faster and smarter, skills that are uniquely human like creativity will become increasingly more essential. Creativity is also now multiplayer. Because whatever your skill level, today's creative process is becoming more iterative and collaborative. And all creative professionals must manage these multiple work streams across increasingly remote and dispersed teams, requiring seamless, cloud-based enabled collaboration and workflows that drive this productivity. Social communities like Behance that we have and Live tutorials are also providing new ways to learn and to be inspired. For us, Adobe Creative Cloud's vision is to be the one-stop shop, from inspiration to monetization. You'll hear from Scott later, but let me expand a little bit on our strategy. First, we want to advance every creative category. And we're a category leader in core creative categories, including photography, design, video, illustration, and layout. And we're expanding our leadership in new and emerging categories, including screen design and immersive meeting media, like 3D, VR and AR. And what this strategy has enabled us to do is to acquire new creators through single lab offerings, and then demonstrate the benefits of the entire Creative Cloud offering over time. We're focused on building multi-surface systems, building solutions for every surface and system because we want to enable anybody to create wherever and whenever inspiration strikes. We truly believe that these devices are not just consumption devices anymore, but every device should also be a creation device. We're focused on adding collaboration services because we can ensure that content can be seamlessly managed in the cloud and accessed from any device. And what this enables us to do on the business side is to increase engagement, but also to acquire new stakeholders and expand our customer base with these new monetization opportunities. We want to engage and inspire the community. And our vibrant communities, which are a critical driver of both acquisition and engagement, are succeeding. In fact, we've grown to over 25 million members on Behance, which represents a huge opportunity for further upsell into the broader Creative Cloud ecosystem. And programs like Adobe Live enable us to provide forums for creators and to promote active use and learning. We've always maintained that retention is the new growth, and that is more relevant than ever before as we've crossed $10 billion in digital media annualized recurring revenue from our current subscribers. At the end of the day, we're focused on democratizing creativity, enabling anyone from a student to a social media influencer, from a professional photographer, filmmaker and designer to express their creativity. And we delivered on new applications like Photoshop and Illustrator on tablets, consumer apps like Photoshop Camera and easy-to-use storytelling apps like Premiere Rush and Spark, which are all attracting new users and expanding our base. But in addition to this tremendous product innovation, we have a data-driven operating model which is enabling our ability to capture this expansive opportunity because we have a tremendously sophisticated understanding of our customer and we're able to serve up personalized experiences and offers at every part of this digital funnel and journey. And what this enables us to do is unlock engagement, as well as provides us with new upsell opportunities. And when you put this all together, mapping the products and services that we're targeting across these expansive segments and adjusting for factors like non-genuine usage, the Creative Cloud total addressable market is projected to be approximately $41 billion in 2023. $20 billion of that addressable market is coming from creative pros, which includes Creative Cloud apps, and new services like Adobe Stock. $21 billion of the addressable market opportunity is coming from the broader communicator and consumer segments, which includes products like Spark and Premiere Rush, as well as the non pro users of Creative Cloud, as well as Stock. And our aspiration to unleash creativity will continue to be this north star that we will execute against for many years to come. Among the key growth drivers that I'd like to highlight for this business include the ability to acquire new customers through category single applications for screen design, video and 3D, using mobile increasingly as a funnel through the creation of mobile IDs through mobile monetization services, as well as upsell to the multi-surface systems and new services such as Adobe Stock, as well as continued global acquisition and expansion. Turning to our second growth opportunity. It's clear and obvious that digital documents are now mission critical in powering the modern business. And we have seen this massive acceleration as businesses all shifted to remote work overnight. The truth is that artificial intelligence and machine learning, the cloud and mobile are all redefining the notion of productivity. It's reshaping how we work. It's enabling greater flexibility. And it's requiring more collaboration across global dispersed teams. And artificial intelligence is only amplifying this productivity. We're seeing a massive adoption of paper to digital processes and workflows. And the paper-based tasks of the past are all now being moved digital. And the other aspect that's happening, the cloud ecosystems are driving a new business opportunity, what we call the API economy, which is revolutionizing how apps and services are both being built, as well as being monetized. What drives this is the fact that PDF continues to be the lingua franca for how things happen on the Internet. We have over 2 billion mobile and desktop devices that have had Reader or Acrobat installed. In fact, we have 300 billion PDFs that are opened in Document Cloud applications over the last 12 months. And so, strategically as we think about the opportunity, the first is to expand what we call our Sensei-powered Acrobat verbs and it's to enable all document actions, editing, sharing, scanning and signing. It's to unlock the value that exists in trillions of PDFs that have been created by deciphering these unstructured PDFs and making them truly responsive on mobile devices. In fact, one of the innovations we're particularly proud of is called liquid mode in the Acrobat Reader, which both deciphers and automatically reformats text, images and tables for quick navigation and consumption, and is powered by Adobe Sensei. We think mobile fuels this new business opportunity because PDF usage has absolutely exploded across mobile devices. Making this Acrobat experience more frictionless across mobile and web is truly leveraging the ubiquitous PDF format that we have. And we're expanding both the free and paid mobile customer base. We're also increasingly capturing the PDF demand with Acrobat Web because what we are doing is converting the massive demand for PDF web, such as create and edit through search through our frictionless services. With every business going digital, the third aspect of the strategy is to enable the paper to digital transformation through services that we have, like Acrobat and Adobe Sign, but also to leverage what we deliver through the Adobe Experience platform and the Adobe Experience Manager, as well as Adobe Experience Manager Forms. And we want to unleash an entirely new PDF ecosystem with documents services, which provides APIs to third-party developers, and they will then find new and exciting ways to use PDF and we will be able to monetize those services. So, let me expand on just a few of these opportunities. There are about 50 million searches for PDF actions every month. And what we want to enable is, through a single click, best-in-class Web experience, deliver quick access to actions that the customer wants, and allow them to deliver and discover a more comprehensive set of Acrobat offerings. This is similar to what we've done with the successful Reader upsell motion, which is to drive engagement around PDF, to enable people to complete their tasks, and then upsell people from the free product to Acrobat subscriptions. The other aspect of our Document Cloud strategy is to deliver a unified Document Cloud platform. This includes Acrobat, AEM Forms and Adobe Sign, which are central to the way work is getting done today. And we have a tremendous go-to-market advantage because it's the sophistication of our data-driven operating model that gives us a really incredible understanding of our customers, how to reach them, how to serve them effectively, and we have the ability to truly optimize everything on the funnel from acquisition, all the way through retention. We're continuing to expand the Sign scale and reach into fast growing new verticals, with significant go-to-market partnerships, including with Microsoft, Workday, ServiceNow, and Notarize. And we will continue to invest in the brand equity associated with PDF as the lingua franca of the Internet. We're incredibly excited about the second growth pillar, the Document Cloud strategy and the broader addressable market that it represents. And we expect the addressable market to grow to $21 billion in 2023. We're benefiting from the move to subscriptions, we're benefiting from visitor acquisition, we're benefiting from mobile, and the PDF mobile opportunity itself represents approximately $11 billion of this addressable market. And on the document services platform, we're driving growth with electronic signatures and new embedded services, which we believe represents $10 billion in addressable opportunity. Our third growth initiative is all about customer experience management. And we continue to believe that it represents a massive opportunity with the acceleration that we all see and digital transformation. Because the reality is that today every business is a digital business. And the imperative for digital customer engagement has never been greater. Because every business has to understand their customers and deliver personalized experiences. Because all of us, as consumers, we buy experiences, not just products. The reality today is that customers are expecting this engaged personalized digital experience, and we want these interactions to feel easy and efficient. They need to be well designed, they need to be context aware, and they need to be seamless across channels and secure and delivered at the exact microsecond at which we expect it. And delivering a next generation platform to deliver and drive this experience is easier said than done because it requires businesses to completely merge content, data and artificial intelligence to deliver this compelling, relevant personalized experience in real time. And the truth is that companies must design for this brilliance, but wire for intelligence. Adobe created the digital marketing category. And we're now the leader in a much broader opportunity – the customer experience management category. Our strategy is to deliver a comprehensive set of applications and services grouped in solution areas such as content and commerce, customer journey management, customer data and insights. And now with the closing of our Workfront acquisition, work management. And Anil Chakravarthy will spend a little bit more time talking about our strategy. The second aspect is to deliver this next generation technology platform, Adobe Experience platform, which provides the underlying infrastructure to make CXM a reality and is years ahead of anything that any competitor has provided. Because it truly brings together hundreds of data points to create this unified customer profile that companies can activate to deliver the personalized experience at scale. Our vision is also to deliver an industry-leading marketing system of record. With the Workfront acquisition now being closed, we have the leading growth management product for marketers. And while, unlike most companies, most of our growth is organic, we do use inorganic opportunities strategically, and we have an incredibly successful track record of acquiring, growing and scaling these companies. We have a longstanding set of partners and an ecosystem with Workfront with over 1,000 joint customers. And Workfront is already equipped with APIs for not just Experience Cloud, but also Creative Cloud, which represents opportunities to further leverage and deliver synergies across our businesses. One of the key assets that we have is the ability to deliver a scaled go-to-market, cutting across the entire C suite, given the affinity that both customer CIOs and CMOS have for Adobe. Because all businesses are now working to rearchitect their systems around the customer, which requires this strong partnership between the chief marketing officer and the chief information officer. And this enables us to scale our go-to-market across the entire C suite, which is driving higher value contracts as well as services. And we continue to have an explosive partner ecosystem that believes in our vision, and is delivering unique expertise to our joint customers. Our total addressable market, when we think about it for the Adobe Experience Cloud, is estimated to be approximately $85 billion in 2023. And that's comprised of customer data and insights, which continues to be a huge opportunity because intelligence is increasingly the lifeblood of every organization. So, this represents an approximately $26 billion addressable opportunity. The explosion of content and commerce where we're the absolute leader is driving a $44 billion opportunity. And customer journey management, which includes products like campaign and email marketing, as well as B2B marketing and demand generation, which includes account-based marketing and lead management, is expected to be a $15 billion opportunity. As we've said before, these are large and growing categories, which are top of mind for every business. To summarize, we believe that we have the right strategy that's being applied to an exceptional opportunity that is approximately $147 billion in 2023. We have a proven capability to both create and continuously lead these categories. We're thinking bigger about our businesses and the customers that we serve, from consumers and students to communicators and the creative professionals and the entire C suite. We have leading products, services and platforms to unleash creativity, accelerate document productivity, and to power digital businesses. Our secret sauce is the over 20,000 talented employees that we have that are all rallied around our mission and the impact that they can have. We have a revered brand all across the globe. We have world class financial discipline that's driving both top and bottom line growth with an impressive margin. This is truly an expansive opportunity. And we're well positioned to capture it. I certainly believe that Adobe's best days are ahead of us. We expect to cross $15 billion in revenue next year. We have a huge addressable market, industry-leading applications, services and platform and an unparalleled innovation engine. Let me just quickly touch on some growth drivers that we believe will continue to propel this momentum on the Creative Cloud. In addition to our leading applications across every category, mobile as a funnel as well as our product monetization opportunity is huge. Services such as Stock are becoming meaningful parts of the ARR growth. New categories like video, Web services, as well as 3D and on. On the Document Cloud side, the continued adoption of web-based PDF services, mobile-based PDF services and Acrobat subscriptions, the ability to deliver Adobe Sign to target both the small and medium business as well as the larger enterprise through both seat expansion as well as through document workflows. And on the Experience Cloud, continuing to deliver this next generation technology platform delivering Sensei intelligence services, the ability to leverage a partner ecosystem and to cross and upsell in both mid-market and commercial as well as to drive new logo growth and to continue to make sure that we deliver value, drive customer success and maintain retention. And now, what I'd like to do is to have a Abhay Parasnis, both our CTO as well as somebody who has recently taken on responsibility as Chief Product officer for Document Cloud, to talk about our technology vision. Abhay?"
},
{
"speaker": "Abhay Parasnis",
"text": "Thanks, Shantanu. Good morning, everyone. It's great to talk to all of you again. Shantanu talked about the broader opportunity and strategic imperatives for Adobe. I would like to take next few minutes to talk about our technology vision and share my excitement for the road ahead. Being a product company at our core, we have always taken a long-term view of building deep technology platforms that are highly defensible and drive industry breakthroughs. With everything going on this year, I'm especially proud of the sheer breadth and depth of innovations our teams have delivered. Illustrator on iPad and Neural Filters in Photoshop, liquid mode and Acrobat Web in Document Cloud, and AEM cloud and real-time CDP and Experience Cloud are just few examples of innovations we have delivered. And this incredible pace of innovation is only exceeded by the massive scale at which we operate today. With trillions of activations served from Experience Cloud to hundreds of millions of mobile app downloads and more than 2 billion devices running Reader and Acrobat software today, we truly have unmatched scale from cloud to the edge. Now, a key aspect of our technology strategy is to develop a consistent architectural viewpoint across all of our products. We think of this unified architecture at three levels. Multi service experiences for our apps, a rich portfolio of services and API's, and our Sensei AI stack built on shared content and data platforms. Everything we do across our three clouds is guided by this unified technology vision and gives us a significant strategic advantage. Increasingly, we are thinking beyond discrete app silos to delivering new modalities and fluid multi surface experiences across desktop, mobile and Web. For example, in Creative Cloud, we are adding modern Web and collaboration technologies to core imaging and video workflows in applications like Photoshop and Premiere, evolving them into complete creative systems. Similarly, in Document Cloud, we are taking the best-in-class PDF runtimes on PCs and bringing them to both Web and mobile platforms for a consistent multi-surface PDF experience. And in Experience Cloud, we are uniquely focused on a new kind of customer experience, one that's real time and hyper-personalized across every single touch point. At the services tier, we are not only building an increasingly rich portfolio of services, but we are focused on three cross cutting themes. First, we are embedding collaboration deeply at the core of all our applications, converting our best-in-class single user apps like Photoshop or Acrobat to multi-user collaborative solutions. And because we uniquely understand our file types and workflows, we can enable a much richer contextual collaboration for users, as opposed to a generic file sharing or communication platform. Second, using the shared content and data platforms, we are enabling unique cross cloud use cases, going from creators to knowledge workers to marketers. This is something that only Adobe can deliver. Lastly, we are increasingly focused on the API economy opportunity by exposing our services via open APIs to developers and ISVs in the ecosystem. You will see us aggressively focus on this new vector. Last, but not the least, I've talked to all of you about Adobe Sensei, our generational bet on AI. Sensei is already having a profound impact with our teams delivering hundreds of Sensei-powered features across our three clouds. We started Sensei with AI features delivered within existing apps. But by leveraging our unique understanding of our users' workflows and usage patterns, we have built a specialized Sensei platform, one that's focused on creativity, documents and customer experience domains. With this platform in place, we are now positioned to push the limits with completely new kinds of AI first apps. Liquid Mode in Document Cloud is one great example of this. This was a multi-year journey and required us to solve some unique and hard problems. Using the latest techniques in AI, machine learning and computer vision, we trained Sensei to deeply understand the trillions of PDS that exists in the world. And then using that intelligence, we are able to generate structure out of unstructured PDFs that are across the world. Initially, we are using this to create a delightful experience on mobile devices, but the possibilities ahead are truly exciting, with document intelligence breakthroughs in areas like semantic understanding or document summarization. And like Liquid Mode in Doc Cloud, we are also working on unique Sensei services for creative intelligence and experience intelligence. Sensei is a key R&D priority with long-term strategic advantage, one that's letting us build truly differentiated capabilities and delight customers with Sensei-powered Adobe magic. As our customers rely on Adobe for ever-more mission critical needs, we are laser focused on engineering excellence and getting the basics right every single day. We are one of the first SaaS companies that has built a multi-cloud foundation, enabling us to deliver across various public, private and hybrid cloud environments. And doing so with high levels of operational excellence as well as cost efficacy. Also, with Adobe's Common Controls framework, we are able to meet enterprise expectations for security, compliance, and privacy requirements, as well as global regulatory landscape. Lastly, we continue to play a thought leadership role in the industry with various standards and other efforts like our Content Authenticity Initiative and Open Data Initiative. In closing, the opportunity ahead for Adobe is truly exciting. From future of creativity to reimagining documents to opportunity to completely rewired customer experience. We have a world class engineering team with a deep culture of innovation and investments in foundational technology platforms that enable us to deliver with speed and scale. I have never been more confident about Adobe's technology agenda, and I'm super excited about our ability to go invent the future. Now, let me hand over to Scott Belsky, Chief Product officer for Creative Cloud, to talk about Creative Cloud strategy. Over to you, Scott."
},
{
"speaker": "Scott Belsky",
"text": "Thanks, Abhay. So, while I've outlined more details of our Creative Cloud strategy in the deck, I'm excited to share a quick summary right now. Big picture, we are seeing tremendous growth momentum in Creative Cloud because creativity has never been more important than it is now. And we saw this at our most recent Max conference, which has become the premier global creativity conference. That's blew away all previous records with over 21 million views worldwide. Why is creativity so critical right now? Well, for starters, everyone wants to stand out – at work, at school, on social and even in their family projects. And creative expression is how they do it. Within the enterprise, companies more and more recognize that creativity is this competitive advantage. And employees want to stand out, whether it is with their presentations, how they visualize data, or become more active stakeholders in their own product and marketing experiences. In the workplace of the future, creativity is how people will thrive, and frankly, keep their jobs as AI takes over more and more of these productivity focused roles. All of these shifts up-level the role of creativity and create a tremendous opportunity for Creative Cloud and a responsibility for us to evolve our offerings to meet the needs of new creators. So, let's take a look at the five pillars of our strategy for Creative Cloud. First, we are innovating to advance every creative category. Our professional customers want to push the boundaries of their fields and achieve more in less time. One way we're enabling this is through Adobe Sensei, which Abhay talked about, our artificial intelligence engine. In Photoshop, for instance, we recently launched Neural Filters, a new platform powered by Sensei that allows customers to make sweeping changes with just a scroll of a slider. These Neural Filters are truly magical. You can turn night into day and literally turn a frown into a smile. And neural filters are just one example of our Sensei-powered breakthroughs. At Max, we launched dozens of new Sensei features across our creative categories, and we're helping customers explore new mediums, like 3D and immersive, with tools such as Substance, Dimension and Arrow. The pandemic has forced many teams to turn to 3D tools as they can render an image or video rather than have an in-person shoot. One great example is Ben & Jerry's, who levered our 3D and immersive products to execute a critical campaign about getting ice cream delivered during the pandemic. They found what many companies are finding that 3D rendered images are indistinguishable from traditional photos and they're far more efficient and actually less expensive to produce. So, we expect a surging interest in that field to continue, especially as new mediums like augmented reality go mainstream. These innovations add value for creative professionals and help ensure that Creative Cloud remains the logical choice for modern teams struggling with content velocity, our way of talking about the insatiable need for more formats and more platforms and just more content more personalized every day. And we're committed to extending their creativity in new directions. The next pillar of our strategy for Creative Cloud is a continued transformation of our category-leading products to become cloud-based multi-surface systems. Creativity is no longer confined to the desktop. And we made a lot of progress in extending our flagship products across more surfaces. Over the last year, we've brought Photoshop and Illustrator to the iPad, and we launched Adobe Fresco, the industry's most powerful drawing and painting app on Windows and Apple tablets last year, and brought it to the phone this year. Customers tell us that the portability of iPad apps unlocks huge advantages. Designers for [indiscernible] Japanese theme parks, for instance, use illustrator on the iPad to sketch out new features while they're actually inside the park. It really lets them see how the design will actually fit in in-person in-place. So, here's what we've learned from this evolution from product to service from multi-system platform expansion. We know that customers who use our products across multiple devices have higher satisfaction and better retention, and we know that offering a more modern interface on mobile devices is inviting for new customers and is an effective way to bring new customers into Creative Cloud from the mobile app stores. So, we're continuing to extend our applications on to new surfaces, including the Web, which will engage an even broader set of customers and unlock another level of possibility for Creative Cloud. Another major part of our strategy is the development and seamless integration of powerful services that enable collaboration. No doubt, we've entered a new era of creativity that is deeply, deeply collaborative. The next generation of our customers grew up in the age of Google Docs. They expect everything to be collaborative by default. And we've enabled this through our investments in Creative Cloud services over the last few years. We launched Creative Cloud Libraries, which helps teams share creative ingredients from fonts and colors to vectors and images. We rolled out Cloud Documents, which allows customers to easily share their work with collaborators and stakeholders. And with services like stock and fonts funds integrated at the point of need within our products, we're ensuring that teams have all the content they need to start a project without ever leaving Creative Cloud. Finally, we're making it much easier for stakeholders to review and share comments directly in our desktop products. All of these collaborative features make Creative Cloud the single source of truth for creative assets, ensuring greater lifetime value. These services also unlock new business opportunities and expand our footprint by engaging stakeholders beyond the traditional creative team, whether it be for review purposes, copywriting, or leveraging templates for social media marketing. Another area of focus is engagement and community inspiration. We're bringing many kinds of new customers into Creative Cloud these days. But to keep them, we have to ensure that they are engaged, that they're learning new skills, and that they're continuously inspired to try new tools and techniques. We're improving engagement by reimagining the new user journey, providing a more personalized experience for every customer that is infused with community and educational content. And we become very, very data driven as we optimize these flows. We're providing many more ways for people to learn new skills. Traffic to Adobe Live, our rich offering of live streams, by Behance members using our products and tutorials has doubled this year. And we have doubled our content in response. And the engagement with these live streams is truly remarkable. Over the last year, the average watch time is more than an hour and 20 minutes. We've also enabled live streaming in our iPad apps, so that any customer can easily go live from within the product and share the URL on social networks. Others can click the link and learn by looking over the shoulder of an experienced creator and download the app to give it a try as well. And we personalize learning experiences within our products. And as the more we personalize, the better we meet each customer exactly where they are. And because the greatest inspiration, of course, comes from seeing what others are creating, we're doing more to convene a global community of creatives. We've built a new community set of features in products like Lightroom. And Behance, our global creative community near and dear to my heart, has grown to 25 million members with over 1 million people visiting the site every single day. All of these efforts not only grow the top of the funnel, but also make it more likely that these new customers will be successful, inspired and engaged. Finally, let's talk about democratizing creativity, which Shantanu mentioned in the beginning. We want to empower the world to create with a new generation of web and mobile products that are freemium and easy to use, and that leverage Adobe's core technology. When anyone searches the web, to edit a photo or make a flyer, we will present easy-to-use Web apps that help them complete their project and encourage them to go further to take it to the next level. On mobile, Photoshop Express, Premiere Rush and Adobe Spark empower everyday consumers to create content that stands out on social media. In the year ahead, we're bringing these products closer together to enable customers to work across them and to extend their work to the web. And we're doing this in a way only Adobe can. We're bringing powerful time saving features, many powered by Sensei to these mobile and Web apps. We're also prioritizing interoperability with the rest of Creative Cloud, so that more casual creators can work together with creative professionals, and so that they can take their work to the next level in an app like Photoshop or Illustrator when they're ready to do so. I'm excited to share more on these product investments in the year ahead. So, to sum it up, our view of our market is expanding to $41 billion in TAM in 2023 because the importance of creativity is growing fast and the number of creators worldwide is exploding. Our work over the next few years will ensure that Creative Cloud stays at the cutting edge of creativity in new mediums, that it supports the growth of collaborative creativity, and that it welcomes new generations of creators, with a new generation of tools and with the learning, inspiration and community that will keep people engaged and successful. Thank you. And now, I'll turn it over to my colleague Anil, who oversees the digital experience business to talk about Experience Cloud. Anil?"
},
{
"speaker": "Anil Chakravarthy",
"text": "[Technical Difficulty] also responsible for our worldwide field organization. I want to give you some context and color on the Experience Cloud strategy that Shantanu outlined. You should have the full presentation that we have provided. In the first half of 2020, when COVID hit, we saw businesses focus on their employee safety and wellbeing and ensuring business continuity. We pivoted and worked with our customers to navigate that new normal. In the second half, we saw businesses doubling down on customer experience management in response to heightened customer expectations. Customers are digital first now. And from every business, they expect engaging and personalized experiences. And this has put more pressure than ever on businesses to accelerate their digital engagement. It's also accentuated how hard it is for businesses to deliver a great experience to their customers across all touchpoints. In the current environment, that has been no small feat. Businesses need to account for external factors like privacy regulations and data sovereignty, and master internal challenges like fragmented customer data and manual inefficient processes. So, it's become clear that companies need a next generation technology platform for customer experience management. And this has created a massive $85 billion market opportunity for CXM, and Adobe is uniquely positioned to address this. Our mission is more relevant than ever. And our strategy of powering digital businesses is resonating with brands across industries and around the world. Now we saw that in spades in 2020. 93% of our top 100 customers have three or more Experience Cloud solutions, and our average ARR with them has grown to $8 million, nearly three times what it was in 2015. Let me highlight one of those top customers, Verizon. Over the last five years, Verizon has standardized on Adobe for CXM across their consumer, business and media groups. The Adobe Experience platform provides real time responses in 250 milliseconds at cloud scale across billions of profiles. Verizon is leveraging AEP to deliver personalized communications, optimize customer journeys, increase conversions, and create customer loyalty. As a result, our ARR from Verizon has grown 700% over the last five years. This is a great example of the growth trends we see across our customer base. Turning to our strategy for Experience Cloud. It's based on Adobe's own successful transformation journey. We've taken the principles and insights from our data driven operating model and created a customizable playbook that any customer can use to power their digital business with next generation customer experience management. We have five pillars in our strategy, as Shantanu outlined. First, it's a comprehensive set of applications and services for customer data and insights, content and commerce and customer journey management. Now these apps and services are delivered on an integrated Adobe Experience platform. AEP is a next gen platform to deliver real-time personalization at scale, with nearly 17 trillion segment evaluations per day, leveraging first party data, cloud scale, powered by Adobe Sensei, and extended by our open ecosystem of partners and developers. Now, we do the hard work of delivering the best of both worlds to our customers, comprehensive apps and services, integrated on to a common cloud scale platform. I've been in the world of data for a long time now. And it's clear to me that AEP is years ahead of our competitors in capabilities and production deployments. Third, we're excited about our recent acquisition of Workfront, and we've heard great feedback from customers and partners. We're laying a strong foundation for a marketing system of record that will enable our customers to have greater efficiency and agility in executing their campaigns and to optimize their campaigns with real time insights. Fourth part of our strategy, we've been a trusted partner to CMOs since we created the digital marketing category and now we are trusted partners to CIOs as well. And in mid-2020, we combined our worldwide field operations and digital experience into a single organization that I lead, and that has enabled us to scale our go-to-market to address the needs of enterprises from mid-market customers to the largest brands in the world. Finally, we work really closely with our global ecosystem of over 2,800 SIs and technology partners to drive business value and sustained growth. So, in closing, I'm incredibly excited about the opportunities ahead of us. Experience Cloud is a growth business, and we will combine our go-to-market and product organization to be well positioned to fire on all cylinders. When you look at our products, our platform, our innovation powered by Adobe Sensei, our customer relationships, our brand and the investments we're making, Adobe is the clear leader in customer experience management. And we are in the best position to help businesses deliver personalized, engaging digital experiences to all of their customers. Thank you. And now, let me bring up our Chief People Officer, Gloria Chen."
},
{
"speaker": "Gloria Chen",
"text": "Thanks, Anil. And hello, everyone. A year ago, as Chief Strategy Officer, I spoke to you about Adobe's growth story, our total addressable market, and the tremendous opportunities across our business. As you've heard today, our strategy is more expansive than ever. And I'm confident in our ability to succeed because of our proven track record of transformation, something I've seen firsthand multiple times in my 20 plus years at the company. And I believe our secret sauce has been the combination of a winning strategy, great people, and an exceptional purpose-driven culture. My pivot from corporate strategy to employee strategy earlier this year was a natural move. People are our greatest asset. And as Chief People Officer, I'm excited to be carrying the torch for our values, our history of progressive people centered benefits and programs and our commitment to the growth and development of over 22,000 employees around the world, now including Workfront, who joined us earlier this week. Increasingly, companies are viewed by employees, customers and stakeholders as an extension of their identity, values and community. In 2020, our core values were on full display, being genuine, exceptional, innovative, and involved. As we responded to COVID, we put the health and safety of our people first. We increased communications, rolled out work from home benefits, and encouraged scheduling flexibility. We took care of our communities, providing customers with flexibility and students with free Creative Cloud licenses. And our employees really stepped up this year, with 70% engaging in volunteerism online. Our employees have responded with gratitude and pride in our approach and are more engaged and productive than ever. As a people-centered company, we've always focused on fostering an inclusive culture, what we call Adobe For All. Because we believe that when employees can be their authentic selves, they do their best work. And when we have diverse teams, we're more innovative and reflective of the customers we serve. For employees to feel supported in and outside of work, we invest in learning and development programs, community networks, and family friendly benefits. We're a leader in pay parity across gender and ethnicity and we're examining opportunity parity for fairness in promotions and horizontal movement. We're building current and future talent pipeline, investing in young artists in underserved communities, university partnerships, and mid-career rescaling and apprenticeships. This year's events made it clear that while we've made progress, there's more that we can do. As a company, we're about action, not words. And together with our Black Employee Network, we've launched the Taking Action Initiative focused on community, advocacy and growth. And during our global Adobe For All week, we outlined aspirational goals to increase representation. Across our recruiting and development programs, our campaign celebrating women and black creators and our efforts to ensure that our products are inclusive, we are driving change aligned to our core values. Another topic that's been top of mind for everyone is the future of work after the pandemic. So, let's talk briefly about that. This year, we learned that there's so much that we're able to do effectively while we work from home. We've launched new products, produce global customer events and onboarded hundreds of interns and employees around the world. Digital transformation is here. And we'll continue to reimagine customer and employee experience as a company. At the same time, we continue to believe that in real life experiences are critical to nurturing culture and trust, learning and development and innovation. Each team will need to strike the right balance for them, but in general, we will be giving most employees the flexibility to work from home part of the time and making this the default as opposed to the exception. As for fully remote workers, this is something we already have today, especially amongst sales and consulting staff. Broadly expanding remote work is a significant decision that is not just about individual preference, but also has implications for collaboration, cohesion and culture. We have more to learn here, and so we'll be starting by updating our criteria for remote work in the coming months and iterating thoughtfully, as we always do. This is clearly a journey, one that we expect will continue to evolve. As I reflect on the year, it's been a privilege for me to contribute to Adobe in this new capacity. Our employees achieved this record year through their dedication, camaraderie and resilience. 2020 has shown us the power of Adobe's values in action, and I'm confident that Adobe's best days are ahead of us. And now, I'd like to turn it over to our CFO, John Murphy."
},
{
"speaker": "John Murphy",
"text": "Thanks, Gloria. Based on what has been shared this morning, it's clear there are tremendous opportunities for Adobe. Now, I'd like to give you a view of our business momentum and how we drive our growth going forward. Today's presentation will cover both Q4 and fiscal year 2020 results. Before we jump into the numbers, in Q4, we made a change to our segment reporting to align with the way we manage our digital experience business in light of the Advertising Cloud shift we made earlier this year. We created a new segment called Publishing and Advertising, combining Advertising Cloud with the existing Publishing segment. As a result of this change, our digital experience subscription book of business now aligns exactly to the components that make up our Digital Experience subscription revenue. And it's great to have those aligned as that's where we're strategically driving segment growth. This reporting change is reflected in the numbers we will show for Q4 and FY 2020. And we've revised our financial information from FY 2018 to present day to maintain compatibility. Now, let's turn to our Q4 performance. Adobe achieved record revenue of $3.42 billion, which represents 14% year-over-year growth. GAAP diluted earnings per share in Q4 was $4.64. And non-GAAP diluted earnings per share was $2.81. Business and financial highlights in Q4 include Digital Media revenue of $2.5 billion, which represents 20% year-over-year growth, record net new Digital Media ARR of $548 million, Digital experience revenue of $819 million, which represents 10% year-over-year growth. Digital Experience subscription revenue grew 14% year-over-year. We had record cash flow from operations of $1.78 billion, and we exited with remaining performance obligation or RPO of $11.34 billion. And we repurchased 1.6 million shares of our stock during the quarter. Overall, this is a really strong performance in Q4. Now for some Q4 financial highlights and growth drivers for each of our strategic businesses. In Q4, Adobe achieved $2.08 billion in Creative revenue, representing 20% year-over-year growth and added $425 million of net new Creative ARR. We exited the year with $8.72 billion in Creative ARR, which is also 20% growth year-over-year. Creative ARR growth drivers include acquisition of new users across all geographies and segments, single app and CC complete subscriptions and strong performance in the imaging, video and stock categories. Adobe Document Cloud achieved $411 million in Q4 revenue, growing 21% year-over-year. We added a record $123 million of Document Cloud ARR in the quarter, and Document Cloud ARR exiting the year was $1.46 billion, growing 35% year-over-year. Document cloud ARR growth drivers include strong demand for Acrobat subscriptions, as well as demand coming through the Reader funnel and on mobile, and a significant momentum in Sign. In Q4, we also benefitted from greater-than-expected perpetual revenue in our Document Cloud offering. Digital Experience achieved segment revenue of $819 million in Q4, representing 10% year-over-year growth, and subscription revenue of $696 million, representing 14% year-over-year growth. The growth drivers for Experience Cloud in Q4 included accelerating adoption of Adobe Experience Cloud platform and app services, content and commerce momentum, particularly with our AEM cloud service offering and continued recovery in the mid-market segment, as well as success signing up deals of greater than $1 million in annual deal value. For the full 2020 fiscal year, Adobe achieved record revenue of $12.87 billion, which represents 15% year-over-year growth. GAAP EPS for the year was $10.83 and non-GAAP EPS was $10.10. Contributing to our strong execution in FY 2020 was Digital Media segment revenue of $9.23 billion, representing 20% year-over-year growth; Creative revenue of $7.74 billion, representing 19% year-over-year growth; Adobe Document Cloud revenue of $1.5 billion, representing 22% year-over-year growth, exiting the year with $10.18 billion of Digital Media ARR, an annual increase of $1.85 billion; Digital Experience segment revenue of $3.13 billion, following the segment reporting change, representing 12% year-over-year growth; Digital Experience subscription revenue of $2.66 billion represents 17% year-over-year growth. We generated $5.73 billion in operating cash flows during the year, and we grew RPO by $1.52 billion and returned $3 billion in cash to our stockholders through our stock repurchase program. Next, let me provide more information around our strategic cloud businesses. We'll begin with our Digital Media segment, starting with Creative Cloud. We've highlighted a number of areas where we drove tremendous momentum in the Creative business. We continue attracting new customers with approximately 75% of our subscribers in fiscal 2020 being new to our Creative Cloud franchise. Over 45 million students have access to Adobe Spark, nearly doubling since last year, showing how we're developing creative skills for the next generation. Mobile continues to be an important funnel for us, with over 300 million mobile IDs created cumulatively, and over 80% year-over-year growth in mobile units as mobile monetization has become an important driver of ARR growth. Premiere Pro, Adobe Stock service growth and new media types are an important customer acquisition vehicle for us. Turning to revenue and ARR. We've seen another record year with our Creative Cloud. The Creative Cloud view shows an incredibly healthy business at scale, with sustained revenue growth over the last several years. We continue to see significant user acquisition across creative professionals, communicators, and consumers and revenue growth from services such as Adobe Stock continues to be strong. Key creative growth drivers exiting fiscal 2020 include new user growth fueled by organic traffic which remains elevated, as well as targeted campaigns and promotions. Demand for single apps, particularly our video and photography offerings, strong retention and engagement, which held at pre COVID levels exiting the year, expansion into emerging markets, the gradual recovery in the SMB segment, driving demand for our team offering including through the reseller channel; and ETLAs with educational institutions. This is such a great slide because it shows a mix of our Creative revenue in FY 2017 and FY 2020. Today, over 97% of our Creative revenue is subscription based revenue, while the business has grown 85%. Much of our success here comes from a deep understanding of our customers, which continues to drive higher retention for us. As Scott and Abhay shared, this growth is also driven by our vast innovation engine across products and services as we expand into new markets. When you look at the makeup of ARR, a majority of the revenue continues to come from all app subscriptions across individual team and enterprise, while a growing portion comes from single app subscriptions consistent with our strategy of expanding our market opportunity as we attract new users in the consumer and communicator categories. With most comprehensive set of creative offerings against every design, category and service, we're using single on apps mobile as a proven on-ramp for new subscribers, while we continue to grow our all apps business across all segments, and as an upsell opportunity for single app and mobile users. The strength of Creative Cloud is derived from our diversified and resilient business, with offerings tailored for everyone from individuals to small businesses, education and enterprises. We also have a deep understanding of how our customers want to engage with us. And you can see here the slight mix shift towards individual offerings through Adobe.com, while we continue to grow our team and ETLA offerings. Next, we're going to move on to Document Cloud. This business is thriving and has contributed significantly to the company's success this year, with over 70% of our channel units now being subscriptions and over 75% of subscribers in fiscal 2020 being new to the Acrobat franchise. As with the Creative business, our mobile strategy is driving Adobe ID creation at the top of the funnel. While mobile monetization is contributing to ARR growth, our focus on acquiring new customers coupled with our shift from perpetual base to subscriptions is working. The Document Cloud strategy of accelerating document productivity, going from paper to digital is really resonating in remote work environment. The Adobe Sign business has seen a growth inflection this year. In fact, we saw this inflection point before the pandemic hit, and we expect this trend to continue into FY 2021. As Gloria shared, we envision businesses with people working in flexible ways. Things will not default back to the way they were. To borrow Shantanu's phrase, the genie will not go back in the bottle. There's just an explosive opportunity for new user growth as we continue to capitalize on work from home or flexible work. We have multiple growth initiatives, including web-based PDF, Sign as a service and the API economy that gives this business more legs. Turning to revenue and ARR. Document Cloud is another Adobe business that has powered past the billion dollar mark, approaching $1.5 billion in both revenue and ARR. It's just a tremendous opportunity ahead for us. The key Document Cloud growth drivers exiting fiscal 2020 include new user acquisition of Acrobat subscriptions across all customer segments, monetization of our Reader install base on mobile, demand for our subscription offerings across all geos and enterprise adoption, including strength in Adobe Sign. Keep in mind that we also offer Acrobat and PDF services through CC individual and all app subscriptions, which is another driver of growth in this business. Here you can see the phenomenal growth we're driven on subscriptions. While the non-recurring perpetual revenue accounts for a small portion of our revenue, it's in line with our strategy. This represents a continuing opportunity to transition that install base over to subscriptions. And you can see that the total business has nearly doubled in the last three years and as we transitioned more of the business to recurring revenue sources. Unlike Creative Cloud, for Document Cloud, we continue to offer perpetual as a vehicle to have people come to the franchise. We have the flexibility of our offerings, given the breadth of our customer base, which has switched primarily to subscription. Looking at Digital Media as a whole, including both Creative and Document Cloud ARR, you have a view that any CFO would love to see. It's showing the stacking effects of recurring subscription revenue up into the right, ending the year with over $10 billion of annualized recurring revenue. When you think of the revenue base when we launched Creative Cloud less than a decade ago, it's amazing to see how we have expanded the market opportunity while transitioning nearly all the revenue from perpetual to recurring. This shows you the power and durability of our subscription model. Numbers like this don't happen without an extremely sophisticated system, our data-driven operating model, which is purpose built to acquire more customers across geographies and to engage and drive higher retention. DDON, as we call it, is our weapon for finding and understanding the personalized offerings for our customers. The best part about DDON is that we use our own software, Adobe Experience platform, to drive this. Which brings me to the Digital Experience segment. Let's take a deeper look at Adobe's Digital Experience business. First of all, we're very excited to close the Workfront acquisition earlier this week, and we welcome the Workfront team to Adobe. When it comes to M&A at Adobe, we look at the technology and the people. Adobe has a great track record and history of acquiring companies, driving synergies and accelerating growth. With Workfront, we're focused on our ability to accelerate growth through the marketing use case. As Anil shared, what's particularly exciting for us is that we have the opportunity to create an industry-leading marketing system of record. We're confident that our shareholders and customers will get maximum value, and this is a huge opportunity to accelerate subscription revenue growth for years to come. Workfront represents a sizable addressable market for Digital Experience. The targets we're providing for FY 2021 and Q1 are inclusive of Workfront. And we are looking forward to hitting the ground running integrating the business in our Digital Experience segment and expanding our opportunity with customer experience management. Digital Experience is a category we created a little over a decade ago, bridging from content creation all the way to marketing, execution, measurement, optimization, and monetization. This year, we achieved $3.13 billion in segment revenue. But more importantly, we have seen digital transformation and customer experience management resonating with our enterprise customers. More than ever before, for enterprises to succeed and provide the sort of personalized real time experiences our customers expect, they require a technology partner that can help them transform their businesses the way we've reinvented our own digital media business with our data-driven operating model and focus on customer experience management. In my conversations with my peers across the C suite, it's clear no matter their industry, they recognize the value in the digital transformation investment. And you can see the momentum here when you look at the makeup of our top 100 customers and accounts, where, in 2020, approximately 93% of those customers are using three or more of our solutions and the average ARR has more than doubled over the last five years. We've talked a lot about our focus on growing subscription SaaS revenue in this business. And you can see here how our focus on driving subscription revenue has driven segment growth over a multi-year period. The growth in our Digital Experience business has been driven across subscription offerings, with particular strength in enterprise adoption of content and commerce offerings, including AEM cloud service. Our Adobe Experience platform is gaining tremendous traction with a number of referenceable customers, such as Verizon, creating momentum. And we're also seeing continued recovery in the mid-market following the macroeconomic challenges we saw there early in the pandemic. Looking at the business by revenue type. Since 2018, we've held the services and other categories relatively flat, as we said we would, as we have focused on growing the recurring subscription SaaS revenue, which has grown at a 29% CAGR since 2018. In order to accomplish this, we've continued our strategy of leveraging the partner ecosystem that Anil talked about earlier, relying on those partners to implement our solutions and provide services to help our enterprise customers realize the value we are delivering. Here's a view of the revenue mix by category across our three strategic growth pillars of customer journey management, content and commerce, and data and insights. These are all market leading solutions that are fundamental to customer experience management, which we built on a common data and content platform. The growth of these businesses is driven by customer demands to help maintain a digital presence and transact online, deliver personalized experiences to their customers and unify and activate their data. With an $85 billion market opportunity, we are investing to drive long-term growth in these categories. And our comprehensive set of solutions and innovations in platform puts us years ahead of the competition and solving these challenges for the enterprise. Now, let's focus a little more on the income statement and cash flow and our capital allocation strategy. There's another slide most of you folks would love to see which is revenue growth and margin expansion, both on a GAAP and non-GAAP basis, with non-GAAP operating margin well over 40% for the year. Contributing to our margin expansion has been the sustainable revenue growth that we have worked on for decades, the operating leverage in our subscription model and our strategic decision to exit the transactional Advertising Cloud business, as well as actions taken in response to the COVID pandemic and related cost savings associated with travel and reduced facilities operations. When we get to our FY 2021 targets, I'll provide some color on how you should think about those savings in those categories specifically going forward. Here you can see the balance of RPO, which were 15% year-over-year exiting fiscal 2020. This represents contracted business that is committed to flow into revenue in the future, making our revenue sources extremely predictable. The components of RPO are deferred revenue and unbilled backlog. And as we noted earlier this year, we've seen a mix shift from deferred revenue to unbilled backlog in fiscal 2020 as more of our digital media business has come through Adobe.com, where subscriptions are billed monthly rather than invoiced annually in advance, meaning they don't hit deferred revenue the way a lot of our channel and enterprise business would. As a result, the strength in acquisition of adobe.com continues to drive the mix shift from deferred revenue to unbilled backlog. Moving to cash flow. In fiscal 2020, we saw an acceleration of our operating cash flow growth, achieving a record $5.73 billion for the year. In terms of uses of cash, we continue to prioritize investment in growing the business, both organically as well as through inorganic opportunities like the acquisition of Workfront. And, as always, we focus on returning capital to shareholders through our stock repurchase program. Exiting FY 2020, we had approximately $6 billion of cash and short-term investments as well as an unused billion dollar credit facility. This is a healthy liquidity position with an investment grade credit rating and plenty of debt capacity. And as I mentioned, we have a long track record of making sure we return excess cash to our shareholders through structured repurchases. On that point, you can see how we've continued increasing our investment in stock repurchases, reducing the share count over time. Today, we're announcing a new $15 billion repurchase authority in addition to the amount remaining under our current authority, which will run through the end of fiscal 2024, demonstrating our commitment to accelerating return of capital to investors. Now, I'd like to cover how you should think about financial strategy and our addressable markets, which underpin our preliminary targets for FY 2021. Let's start with our strategy. I'm going to touch on a few things on this slide. Adobe has a unique financial profile that we've discussed that drives our strategy. We invest for top line growth and our operational discipline drives margin expansion and earnings growth over the long term. With a diversified portfolio of leading products and services, we are investing to drive continued top line growth and expand into new categories with a massive market opportunity that's in front of us. What accelerates our growth are going to be investments that we've made in new businesses such as Adobe Stock, Sign and our mobile applications, which have contributed over $500 million of ARR growth since 2017. With data driven dynamic planning capabilities, we exercise disciplined spend management principles, we focus on margin expansion and long-term earnings growth. We focus on integrating acquisitions quickly to ensure the same organic operating discipline is embedded in newly acquired businesses. And strict management of our balance sheet, prudent use of debt financing and cash has driven exceptional operating cash flow growth for many years, affording Adobe the opportunity to continue to invest in our existing businesses and capture promising inorganic growth opportunities and return capital to shareholders. As you've heard earlier in today's presentations, we have updated our addressable markets. And you can see that we are excited to capture the opportunity ahead through the extensive list of growth drivers and product innovations across Creative Cloud, Document Cloud and Experience Cloud. With Creative Cloud, we're driving continued growth through broader customer segments by reaching beyond creative professionals to communicators and consumers and by engaging and inspiring our creative community to drive customer lifetime value. With document cloud, we see growth inflection through acquiring and monetizing new customers across desktop, mobile and web. And finally, we continue to leverage and build upon our data driven operating model to manage the business in real time. All this leads to a $62 billion addressable market for digital media in 2023. Likewise, with the most comprehensive set of solutions for customer experience management applications and services and the addition of Workfront, our addressable market for Digital Experience has grown. We expect to drive multi-year growth of the data and insights category with our scaled next generation customer data platform. The segment change we made in Q4 reflects the way we manage our business and our strategic focus. The Digital Experience organization is optimized to drive subscription and SaaS revenue growth, while gaining share of an $85 billion addressable market for Digital Experience. Before getting into our fiscal 2021 targets, I'm going to walk through some of the assumptions we've built in. We expect to see continued gradual macroeconomic improvement during the year. And as such, we're modeling continued recovery for the small and medium businesses into FY 2021, which was a segment that was hit particularly hard earlier in the pandemic and then showed signs of improvement during Q3 and Q4. We anticipate an increase in our effective tax rate due to additional taxes on our foreign operations following the changes we made to our international trading structure in FY 2020. Our FY 2020 tax rate included one-time benefits to recognize deferred tax assets resulting from these changes. These deductible assets will be amortized over multi-year period, lowering our cash tax rate over that time. Targets include initial estimates associated with our acquisition of Workfront. These estimates involve numerous assumptions given the purchase accounting process has not been completed. The purchase accounting is expected to result in an increased amortization of intangible assets and significant deferred revenue haircut, resulting in an expected contribution of about $25 million to Q1 revenue. And as you know, we measure ARR on a constant currency basis during the fiscal year and revalue ARR at year-end for current currency rates. FX changes between December of 2019 and this year have resulted in a $77 million increase in Digital Media ARR. The effect of this revision is reflected in our updated investor datasheet. ARR results this year will be measured against this amount during FY 2021. The cost savings associated with the current remote work environment will continue into the first half of FY 2021. In terms of OpEx growth, we will be investing in top line growth opportunities and our hiring is expected to return to an ordinary pace, particularly for R&D and sales and marketing roles. And we expect T&E and facilities expenses to ramp in the second half as things open back up. Lastly, FY 2021 is a 53-week fiscal year for us, with the additional week falling in Q1. As we noted in the press release, we estimate the extra week will benefit Q1 with approximately $240 million in additional revenue over a 13-week quarter, as well as an additional $25 million in net new Digital Media ARR. So, without further ado, here are the targets we are providing for fiscal year 2021. Total Adobe revenue of approximately $15.15 billion. Digital Media segment year-over-year revenue growth of approximately 19%. Net new Digital Media ARR of approximately $1.75 billion. Digital Experience segment year-over-year revenue growth of approximately 19%. Digital Experience subscription revenue year-over-year growth of approximately 22%. A tax rate of approximately 19% on a GAAP basis and 17.5% on a non-GAAP basis. Share counts of approximately 482 million shares. GAAP earnings per share of approximately $8.57 and non-GAAP earnings per share of approximately $11.20. For Q1 of 2021, we are targeting a revenue of approximately $3.75 billion, with Digital Media segment year-over-year revenue growth of approximately 26%, net new Digital Media ARR of approximately $410 million, Digital Experience segment year-over-year revenue growth of approximately 19%, Digital Experience year-over-year subscription revenue growth of approximately 22%, tax rate of approximately 15.5% on a GAAP basis and 17.5% on a non-GAAP basis. Share accounts of approximately 484 million shares, GAAP earnings per share of approximately $2.19 and non-GAAP earnings per share of approximately $2.78. In terms of seasonality, while 2020 was not a typical year given the pandemic, resulting in a particularly strong Q3 with everybody working from home as we spoke about last quarter, we're assuming things have been back for the summer of 2021. And we would expect Digital Media net new ARR in FY 2021 to grow sequentially from Q1 to Q2, dip seasonally in Q3 as we have experienced in the past and have a strong finish to Q4 as we typically do. And in terms of EPS growth, we expect strong growth in Q1 followed by more modest growth in quarters two, three and four as we lap the COVID related savings from FY 2020 as well as resulting from a higher effective tax rates in fiscal 2021. To wrap up, Adobe saw a record performance in FY 2020, something we're all proud about, and the business momentum is strong as we look towards FY 2021. And we continue to be a market leader delivering growth and expanding margin at scale. In fact, record profit and cash flow. We have a large expanding market opportunity as we've shared and we're driving category creation and expansion, innovations and growing customer universe, targeting over $15 billion in revenue over the next 12 months. And we are just going to operate with a proven track record for driving long term top line and bottom line growth. Now, we're going to go to a short video and then Jonathan will kick off the Q&A. [Video Presentation]"
},
{
"speaker": "Jonathan Vaas",
"text": "What a great video. I certainly can't imagine staying productive without Adobe Sign and Adobe Acrobat. Thanks, John."
},
{
"speaker": "A - Jonathan Vaas",
"text": "We are now going to move to live Q&A with all six of our executive speakers. For those of you who wish to ask a question, please go ahead and queue up now with our conference call operator, if you haven't done so already. And when you ask a question, please remember to mute your webcast to avoid any feedback. And due to the format, there may be a few seconds of latency. So please keep any interjections to a minimum. With that, operator, we'll take the first question."
},
{
"speaker": "Operator",
"text": "[Operator Instructions]. Brent Thill of Jefferies, please go ahead."
},
{
"speaker": "Brent Thill",
"text": "Thank you for the great overview today. Shantanu, there have been some investor questions just on the current quarter around Digital Media and the percentage of upside relative to plan was a little lower than some had thought. And many are asking, is there anything to consider in the Digital Media business for the quarter? And then, maybe more importantly, looking into next year in Digital Experience, it seems like you're seeing some great momentum. Maybe Anil can talk about what is driving that increased confidence, momentum in that business? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "I'm happy to answer both questions and give you some color. First, as it related to Digital Media, we had record Q4 performance in Digital Media, $548 million in net new ARR, which is just phenomenal performance. I would say both Q3 and Q4 were very strong. And certainly, I think when you look at the back half of the year, as it relates to Digital Media, it was incredible performance. And when you look at our Q1 targets, as well as when you look at the targets for the entire fiscal 2021, as you know, these are the highest targets that we have given at the beginning of the year. And so, the growth drivers that we see in digital media just continue unabated. Everything from acquiring customers, upselling them, I think we tried, therefore, to give you real color between the individual apps and the full apps. And our data driven operating model allows us to be pretty sophisticated. And so, relative even to our targets for Q4, as far as we're concerned, it was a beat, which showed the momentum that we had in the business. So, Digital Media ARR, nothing. We continue to believe in the expansion of the total addressable market and really pleased with our performance. As it relates to Digital Experience as well, I think the momentum there, what happened was, clearly in Q2 and Q3, as all companies were dealing with the pandemic, what was top of mind was customer continuity and safety of the employees. As soon as that pivoted, everybody was talking about digital as the only way out of the pandemic. And so, they started to look at who were the clear leaders in customer experience management and the conversations really accelerated for us. That was the momentum. The Adobe Experience platform being a clear leader, which is why as you look at our expectations for 2021 and what we believe will continue to be accelerating beyond that, we're pleased. And net-net, we're really excited about our 2021 targets."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brad Zelnick of Credit Suisse."
},
{
"speaker": "Brad Zelnick",
"text": "Jonathan, no disrespect to Mike, but I think your 10th year, you've delivered a great event. So, thank you for that. And it's clear that the best is yet to come from Adobe. I have one question from Shantanu and another for John. For Shantanu. Shantanu, I'm struggling a bit to reconcile the optimism of expressed by the growth rates in what are – no doubt – very large, very exciting markets in which you participate and in many cases lead, but your growth expectations and current run rates would suggest you expect to lose share across the board. So, just curious if you think it's a fair observation and what I might be missing. And for John. John, I wanted to ask about slide 112 in the deck, which you presented about Creative Cloud. How should we think about conversion of single app to all apps? And what are some levers here to highlight the value of the entire Creative Cloud suite? And maybe just related to that, what's the non-genuine usage opportunity that's left? Thank you so much, guys."
},
{
"speaker": "Shantanu Narayen",
"text": "I'll start off with that. And like you said, we appreciate the leadership that Jonathan has showed in helping pull together what is hopefully the only virtual event that we do and we can get back to more normalcy next year. I think as it relates to the opportunities that we have in the market and how we're thinking about it, we're certainly the market leaders and in each one of the categories that we're talking about. First, while we don't think it's a zero sum game, we're actually continuing to be the leader in each one of those categories. So, I don't know specifically how you're looking at it and feeling like we're not, but we are actually gaining market share. And we've become the true end-to-end leader, whether it's on the creative side as it relates to entire category of applications. Certainly, I think in digital experience, you're going to see a consolidation of where all of these solutions are done, the experience platform, what we said around customer data and insights. So, we're very excited about our prospects in each one of them. We continue to believe that we will be number one and will continue to gain market share. So, that's really the way that we look at it in terms of the expansion opportunity ahead of us."
},
{
"speaker": "John Murphy",
"text": "And in terms of Creative Cloud and conversion of single apps to all apps, as we said, we've got so many opportunities to attract different customers and different types of customers to the platform. And we're definitely growing our communicator segment and the consumer segment. But as we've seen, particularly during the pandemic and the work from home, the need to create and use digital solutions to do that is really touching so many different segments of customers. So, the value there for us, obviously, seen in the growth of ARR overall, is fantastic and gives us an opportunity to continue to monetize access to that base of customers over time. We haven't sized the non-genuine environment in a very long time. It's probably a sizable opportunity. But we chip away at that when we have a very good entry price point for our single apps for customers that may be using non genuine product. And so, as they see the innovations that are available with our cloud based solutions and our mobile solutions, it's certainly a way that attracts people that may not have even realized they're using non-genuine product to actually use the most up-to-date innovative products that we have. So, it's really an important aspect for us, Brad, in terms of addressing all of the different segments that we can address and attract more and more people to the franchise."
},
{
"speaker": "Operator",
"text": "We will now take our next question from Mark Moerdler, Bernstein Research."
},
{
"speaker": "Mark Moerdler",
"text": "Congratulations on the quarter. Adobe's been very thoughtful and measured in modeling your TAM in the past. And as you've written, the TAM has been a really good leading indicator of future growth. I think most would find the large year-over-year TAM expansion, specifically for Creative Cloud, is a bit surprising. Can you give us some more color on what you're modeling in that's driving such a big TAM expansion? Why you feel so confident what's changed? Any color would be appreciated."
},
{
"speaker": "Shantanu Narayen",
"text": "As you know, and you've followed us for a while, we take our addressable market very seriously, unlike some companies who just throw the kitchen sink in what they believe is their addressable market. And so, let me touch a little bit on when you look at digital media and the TAM, some of the growth vectors. With mobile. Firstly, mobile has become – we talked about the 300 million IDs that we've already created. And mobile has become a pretty impressive funnel in terms of both attracting new customers to the platform, the ways in which we are monetizing the mobile only services, but how that also serves as an on-ramp. And this was one that, until we had real offerings in the mobile space and the ability to have these multi surface – we also have storage options in terms of some of our products across multiple surfaces. So, that's clearly one of the drivers that is continuing to grow. I think as the nature of our products, target the communicators in addition to the creative pros and the consumers, all of these applications as well, we feel like that's another part of the addressable opportunity. Certainly, what we've seen with Stock, the busines is doing really well and this notion of content- authoring paradigm where people start to author the content using a piece of content, we think that that also drives further acceleration in that particular business the amount of stakeholders who've seen us deliver more and more collaboration services and the collaboration services allow us to also monetize that. On the Document side and on the Creative side, what we've targeted with respect to the web, that's why I gave you some insight as to the magnitude of how much people are doing PDF searches on the web and what kind of an industry that's become, that same sort of task-based approach is certainly true in Creative. That's a brand new opportunity. And the confidence that we have in being able to convert all of that traffic and all of that acquisition funnel into monetization models gives us a lot of confidence. And so, when you look at the services, whether it's Stock or Sign, what's happening with respect to document workflows – and I think, as we said during the prepared presentation, the fact is this digital inflection point, it's only going to increase in terms of the number of people who use it. And that's why we also touched on regulated industries, which in the past may have been a little bit more slow or less enthusiastic about digital, there's no opportunity left for them. So, all of that really adds up to why the TAM continues to build for us."
},
{
"speaker": "Operator",
"text": "We can now take our next question from Alex Zukin of RBC."
},
{
"speaker": "Alex Zukin",
"text": "Congrats on a wonderful quarter and a great analyst presentation. Shantanu, I wanted to ask you kind of similar to the previous question, how should we think about the headwinds and tailwinds in the business as we come out of the pandemic? Where are you most enthusiastic about the growth vectors in both Digital Media and Experience? John, I think, obviously, investors are pleasantly surprised at some of the modest margin leverage you're showing for next year, given the one-time T&E savings from this year, coupled with what's likely a dilutive acquisition. So, I guess, how should we think about the impact on margins of the durable efficiencies around go-to-market post-COVID and the trade-off between operating leverage and growth?"
},
{
"speaker": "Shantanu Narayen",
"text": "From my perspective, Alex, definitely, it's the tailwinds that's the story of the company. And it's across all three businesses. I think on the Creative side, this notion of more content creation and more content consumption across all of the media types is certainly driving more usage of our particular products. Global expansion, we didn't talk about that as well. But global just continues to be, as digitization becomes a phenomenon, a tailwind in our business. I think the Document side is probably going to see the biggest tailwinds as it relates to what happens. Part of the reason on making sure that we had Gloria touch on how we thought about remote work and what was happening as we think about our own business and how we think about remote work. So, I see significant tailwinds in the Document business, both as it relates to the usage of electronic documents, as well as the automation of business workflows. And that drives Digital Experience. And Digital Experience, which one of us is now going to go back and stand in line for a driver's license or for a permit to do anything else? And so, I think you're just going to see more and more – if anything, the pandemic and the health crisis has raised the urgency. And I think John alluded to this, which is every CFO and every C level executive that I talk to, what's top of mind right now is digital transformation. So, they're all saying, okay, vaccines are on the way, once the vaccines come, we're not going back to business as usual. And whether you're in travel or hospitality or whether you're in some of the other industries that have unfortunately been impacted a little bit more, digital engagement is the only way around it. So, net-net, I really don't look at our businesses and feel like they're headwinds associated with the business. We will continue to be dependent on the macroeconomic environment, which has actually continued to be fairly robust. And so, we're excited about our prospects. And I think the solutions that we deliver become, frankly, more important, rather than less important."
},
{
"speaker": "John Murphy",
"text": "On the margin question, Alex, I think when we think about how we target growth – we are a growth company, and so we want to continue to invest in growth. And we've been able to demonstrate over time that, as we drive growth, we're able to expand more margins over time. You think about our original targets for FY 2020, we still had expanding margin coming out against FY 2019. And while we're really pleased to deliver this level of operating margin in Q4, we do expect 2021 to have operating margins down from our Q4 high, but still expanding over FY 2020. So, we're definitely committed to that. The reason for that is that we'll be lapping much of the COVID related savings, and we'd expect to realize some of those savings in the first half. But as the gradual phased reentry happens later, in the latter half of the year, we expect to be able to invest because that's going to drive growth. And we want to continue to strike the right balance between investing for growth and benefiting from those continued first half savings. Not to mention, we will be impacted by the deferred revenue haircut for the Workfront acquisition. But even so, we're still going to be expanding our margin in FY 2021 over FY 2020."
},
{
"speaker": "Alex Zukin",
"text": "Congrats, again, on another great job."
},
{
"speaker": "Operator",
"text": "We can now take our next question from Jennifer Lowe of UBS."
},
{
"speaker": "Jennifer Lowe",
"text": "Two for me. First, maybe asking the opposite question of the ones that Brad asked earlier. But looking at the composition of ARR by full suite versus single app, given all the discussion around single app as an on-ramp and an attractive landing point for communicators and consumers and you seem to be seeing a lot of momentum there, why hasn't single app grown as a percentage of that mix? And as you continue to lean into that sales motion, could it be more 50/50 over time? Or is the expectation that, in communicators and consumers, they'll ultimately be full and it just stays balanced? I just need color there. And then secondly, for John, Alex mentioned that the presumption is Workfront is dilutive. But I'm just curious if we could get a little bit more color. So, we've got the Q1 revenue impact. But is there any more color to add around either margin impacting Q1 or what's baked into the full year guide for Workfront? Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Jennifer, I'll take the one on the single app. And as you know, you have to look at both the units view as well as the ARR view. And the units view continues to grow. But remember, that also is an area where, as we ramp them to the platform, it's the single apps. That's the way in which we acquire them. But we're doing a better and better job of being able to convert them into the full app. So, I think what you have to just recognize is that the single app pricing and ARPU is a little bit lower. And so, that same pie chart that we showed, that's the revenue look or the ARR look associated with it. And when you look at the units look, clearly, it will show a different picture in terms of the higher proportion of what's happening through single apps. And so, that's a model that all the way back to Creative Suite, we know how to do that, attract new customers to the platform and drive that in. So, that's the answer to your question around single apps and the full app model, and it's actually working for us."
},
{
"speaker": "John Murphy",
"text": "Jennifer, in terms of Workfront, the Workfront acquisition, it's just closed, so we don't have the full purchase accounting completed yet. We are expecting a significant deferred revenue haircut as is fairly typical with these acquisitions. And as a result, there'll be slight dilution. But as you can see in our full-year targets, we're still targeting significant margin expansion over FY 020. And that just kind of shows the leverage in our operating model, our ability to continue to invest for growth, and still expand our margins and our earnings."
},
{
"speaker": "Operator",
"text": "We can now take our next question from Jay Vleeschhouwer of Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Shantanu, you noted the closing this week of the Workfront acquisition. And it also happens to be this week the 15th anniversary of the Macromedia acquisition. And it's pretty evident what the long term value of that acquisition has been in terms of the impact on the company. And the question, therefore, for Adobe today is, do you think that the long-term lasting value of the foundational technologies that you have or investing in DX can have a 10 year or more lasting value for Adobe or do you think that perhaps the half-life, so to say, of foundational or critical technologies might be shorter? And if so, what are the implications there for R&D spending and the like? And then secondly, a recurring theme from the company this year, particularly in summit, has been application and intelligence services and Abhay referred to this. Looking ahead over the next number of years, what do you think the contribution from those discrete new services might be? aside from the incumbents of Sign and Stock, I'm asking really more about the newer ones that you have in mind. And are those services something that you might begin to disclose more specifically over time as they become material?"
},
{
"speaker": "Shantanu Narayen",
"text": "Jay, let me take both. December is not only, as you point out, the anniversary of the Macromedia acquisition in 2005, I can even have the privilege of going back and say, December was also when we did an acquisition for GoLive in 1998. That was one of my first acquisitions. And that sort of embarked us on the web journey as well, which has clearly proven to be also one of those seminal moments. But more seriously, I think when we look at what we've done with Workfront, we've always had – and understood the technology component of what it means to deliver these services, but the amount of spend, the amount of ability to drive efficiency as it relates to the internal workflows and processes associated with it – because it's not just about the campaign itself, it's about the creation of the campaign. And we've talked about this expression, content velocity, for a while. And so, when people want the ability to create these campaigns and personalize it and get this out and global, it's not just about the technology platform, but it's also very much about the work management associated with it, which is why we're excited about Workfront and what it does for us. I think as a company, they perhaps focused – or defocused and spent a little bit more time on the broader opportunity. And we just think focusing on content and focusing on creation, while I think most people are correctly pointing to what we can do as it relates to what happens on the marketing side, the fact is that we also have a significant number of customers who use Workfront in conjunction with the Creative Cloud. And you've written about our desire to continue to integrate the Creative Cloud, as well as the Experience Cloud with that entire content creation, management, monetization measurement opportunity that we have, and I think this can be a significant accelerant to that as well. So, you have seminal products, whether it was Macromedia, whether it was Day Software when we talked about content that actually created these significant opportunities for us in terms of platforms and now tying that together, the glue, which is why when you look at one of the slides in the deck and how Anil describes where Workfront is, it's really the glue that actually ties together all of our marketing application. So, I think to your point, we feel like that could be a really significant enabler of increasing more people into the entire marketing campaign workflow. And in addition to that, really providing more integration capabilities across each of our solutions. I think to your second point associated with services, what is phenomenal about both our creative business and our document business is actually the breadth of our offering. I think this is related to some of the questions. We have mobile offerings, we have services offerings, we have single apps offerings, we have full offerings, we have freemium offerings. And I think as the business scales, I understand the need from investors to say, hey, how can you give us color? That's part of the reason why John was giving a little bit more color on how material the combination of mobile and Stock and Sign have given. So I know we will continue to figure out how we can provide more insight, but I think it's to answer the question of the incredible momentum that we're seeing around both the Creative Cloud and the Document Cloud, what's underlying it. And there's very, very significant amount of depth associated with that entire business which is what's fueling our business. And I've been reminded that it's also close to the eighth anniversary of when Scott and Behance joined us in 2012. So, Scott, it's good to have you onboard as well. But thanks for the question, Jay."
},
{
"speaker": "Operator",
"text": "We can now take our next question from Kirk Materne of Evercore ISI."
},
{
"speaker": "Kirk Materne",
"text": "Shantanu, I was wondering if you can just double click a little bit on the Experience Cloud business just in terms of the three pillars there, customer data, content and customer journey. And is there one area in particular, or maybe two, that you're particularly excited about as we head into calendar 2021 or are those just big opportunities for all of them? But just kind of curious of your thoughts on those kind of pillars and where you see each of those positioned for next year. And then, John, just on the Workfront acquisition, I realize you gave us the $25 million in revenue for the first quarter. I assume it's fair to assume – I assume it's fair that that would ramp from there, given the purchase write-down. I know you probably don't want to give a full-year number on revenue, but I assume that should scale from that starting point throughout the rest of the year. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Kirk, whenever I get asked questions – at least you didn't ask me the question that I can never answer, which is one of my favorite products because as products in the portfolio, I don't distinguish between them. Maybe the ones that I would highlight is the momentum that we've seen around the Adobe Experience Manager cloud version, that has been really phenomenal. And so, we've seen some really good success. As we moved, everybody is again thinking about content, how they improve their agility. And so, I think the content and commerce, which represents a large opportunity and the fact that we've integrated how you can create a content site and enable commerce for it, whether it's in B2C or B2B, we're seeing just a tremendous demand for it. Because every company that didn't have the ability to transact business online was seeing a fair amount of headwinds in the pandemic. So, content and commerce, we continue to believe is one of the underpinnings of our business and continue to be a driver associated with it. And the second one that I'll talk about is where experience platform, a big part of it is reported within the data and insights and what we are seeing associated with now all of this data coming back in the unified profile. So, I think that is really one of the areas that we've also seen significant momentum in Q3 and in Q4. People want to know how they can create that profile, how they can deliver it. So, if they were two out of the three, though, we say all three of them are growth opportunities, I'd probably prioritize it like that, Kirk."
},
{
"speaker": "John Murphy",
"text": "Absolutely. You're correct. The $25 million that we are targeting for Workfront in the first quarter, of course, depending on what the purchase accounting pans out to be, we have kind of modeled out for a year or two based on our estimates on the deferred revenue haircut. So, we are expecting between $140 million and $150 million. But, again, really dependent upon when we finalize the purchase accounting later this quarter. But it will ramp."
},
{
"speaker": "Shantanu Narayen",
"text": "And big picture on that, Kirk, certainly, our expectations for the Workfront acquisition, net of all the accounting things that John alluded to, that they would be accretive to the growth profile of the company in terms of where the opportunity is and what we expect to do with that business. So, I just want to make sure we separate how internally we're looking at the growth and what we're driving towards is our plan, relative to what will be reported, as John mentioned, on the accounting side."
},
{
"speaker": "Operator",
"text": "And we can now take our next question from Keith Bachman of BMO."
},
{
"speaker": "Keith Bachman",
"text": "I'll ask Shantanu directly to you. One is a consistent question from me. As the Document Cloud continues to put up very strong numbers in terms of ARR and you're guiding the growth of the Document Cloud TAM opportunity, again, between 2022 and 2023 at 60% growth, which is far higher than the ARR growth. So, I just wanted to see what you think the conclusion should be to the current run rate of ARR growth, call it, mid-30s and a pretty significant growth of the TAM? Does that suggest that the growth rate can actually accelerate? And then, I'll just ask my second question. Thanks very much for the disclosure surrounding the Creative Cloud, including the users and the dollar TAM. Very helpful and interesting. Where would you rank order, so to speak, the growth potential being driven by the consumers, communicators or creative pros as we think about our model over the next couple of years? Thanks very much."
},
{
"speaker": "Shantanu Narayen",
"text": "I think there were two questions in there. I think the first one as it relates to where we are – ensuring that our document products are being adopted, remember the document products get adopted both as part of the Document Cloud and what are reported in the Document Cloud ARR. But also Acrobat is a huge part of what we report within the Creative Cloud and what's happening within the Creative Cloud. So, the growth that we're seeing in documents is reflected in both, because in many ways, what we see is that the adoption of PDF as a collaborative medium as well as for workflow in the creative segment is also extremely large. So I think of it as really fueling two large growth opportunities. But certainly, I think the acceleration that we've seen in that business and the continued focus and investment that we're going to make in that business gives us a lot of confidence of being able to continuously grow the document business from our perspective. I think as you look at which customer segments, much like Jennifer's question, as it related to ARR, the numbers associated with it versus the ARR could have potentially different answers. And certainly, I think on the consumer side, what we are seeing with the mobile ID creation, what we're seeing in imaging, maybe which appeals primarily as a new category to the consumers, the communicators is a large space, it's always been a big part of the halo. And so, the numbers are probably in terms of new customer acquisition, largest in consumers, then in communicators, then in creative pros. But the opportunity to drive ARR continues to be across all three because of the different price points, as well as, in many cases, the way we upsell into those particular customer segments. So, that's the way we look at it. Again, I've done this enough where I know people want a simple m multiplied by n in order to be able to do it. But I think what actually makes us so differentiated and such a sustainable business is really the fact that we have these breadth and depth of offerings and the DDON that we've talked to you about, where we know how to personalize each offering. And it's also different by geography. Maybe that's one of the things that I should mention. And it's different, for example, in education. Education had a phenomenal year, and that seeing that next generation of creative professionals, but in many cases, whether it's a K-12 license or a license for an entire educational institution, the ARR may be small. So, hopefully, that gives you a little bit of color as to how we think about each of those segments. But the nice thing is now we have a product folio that cuts across all of them."
},
{
"speaker": "Operator",
"text": "We can now take our next question from Ken Wong of Guggenheim Securities."
},
{
"speaker": "Ken Wong",
"text": "Just one for me. I wanted to just touch on the slides you guys put up there with the –future expansion where the average ARR from the top 100 customers went from $3 million to $8 million, which is very impressive. Just wondering what kind of headroom do you think you have with that top 100 as more adopt your kind of full CDP. And then also, how far down the customer list could you possibly maybe see a similar $3 million to $8 million type uplift from your customer base."
},
{
"speaker": "Shantanu Narayen",
"text": "I think one of the impressive things, Ken, that Anil has done is really focused on what he calls the transformational accounts, which is, in many ways, I think has he has taken on responsibility for the entire product, as well as on the go-to-market. I think an analysis showed that while we were getting significant traction with a number of customers that we had, it's really this focus on transformational accounts and creating a good go-to-market has demonstrated that there's massive headroom associated with this with our customers. I think the Verizon example was a good example to articulate and show how each of our products. And the second part of that, honestly, is the fact that we're also far better at demonstrating what the ROI is. And again, Anil, I think, touched on the ROI associated with the Experience Cloud. So, as you take the ROI as well as you take the focus that we have on these transformational accounts, you add the ability to do Workfront, we just continue to think that there's massive opportunity. That's the beachhead. But that doesn't mean in any way, shape or form that there's a limited set of transformational accounts. Rather, it's the recipe to continue to deliver value, become strategic to these customers, and drive significant ARR. And as it relates to the breadth and depth of that customer base, again, going back to the question that I think was asked around Experience Cloud and what's driving it, the AEM cloud service is not just a service that can apply to large enterprises who maybe want to create new websites as it relates to campaigns, the fact that it's easily provisioned and easily on ramp actually makes it a very appropriate solution for what we refer to as commercial or mid-market or small and medium business customers, and integrating things like analytics into it and commerce into it with the Magento service enables us to really say, we could be your one-stop shop for getting a Web presence, as well as for transacting commerce on the web. So, clearly, the aspirations are to enable people to have a quick and one-stop on-ramp."
},
{
"speaker": "Operator",
"text": "We can now take our next question from Walter Pritchard of Citi."
},
{
"speaker": "Walter Pritchard",
"text": "I have two questions. One for John and one for Abhay. John, one of the slides, you talked about 75% of the individual subscribers new to Creative Cloud franchise in fiscal 2020. Can you clarify the other 25%? Are they coming from mobile apps that were the prior year? Where's the other 25% coming from? I think the disclosure in the past was a little bit different. I'm just trying to frame that. And then, I have follow-up."
},
{
"speaker": "John Murphy",
"text": "They're coming from a couple different places. Certainly, mobile, as we talked about before, is a huge on-ramp for us. And we've been having so many new Adobe IDs created on mobile. We also have perpetual, is the other part of that as well. So, definitely strong performance across both of those in Q4."
},
{
"speaker": "Shantanu Narayen",
"text": "And then for Abhay, if he's still on, just around – you talked about opening up more APIs. And I know in Sign, one of your competitors there is quite strong, leveraging that. Could you talk about where you expect to see sort of the tangible revenue impact as you embark on that effort and productize some of that that you're building around API based access for products?"
},
{
"speaker": "Abhay Parasnis",
"text": "I think at a macro level, and we shared a little bit, both Shantanu talked about in the Document Cloud strategy and I covered, across all our businesses, but especially in Document Cloud, PDF has always been a very vibrant ecosystem play, as you know, for us where it's connected into a lot of ISVs and solutions across industry verticals, line of business applications. And so, what we are starting to now do is opening up APIs and working with three kinds of players. There are large ISVs, like Microsoft, Workday, ServiceNow where we are connecting our applications and APIs directly into their ecosystems and applications and have kind of joint attached motion there. But then we are also opening it up for the broader developer ecosystem. And as you know, even on our DX enterprise business, we have products like Magento and ecosystems of large developers who connect to our platforms, whether it's AEM, Magento. And we are opening up our APIs around signatures, PDF to that kind of long tail of developers. So, I would say, large ISVs like Microsoft, ServiceNow, Workday that we have announced partnerships around and integrating, and then a broad long tail developer reach play, where they are embedding our APIs and services for more inline into their applications and taking it to market. The last thing I'll say, and kind of we shared also, is AI. The other piece of the API strategy is also opening up our intelligence services around Sensei platform and exposing those also beyond our applications for developers and ISVs, which are very unique and differentiated. So, that's the other component of that."
},
{
"speaker": "Operator",
"text": "We can now take our next question from Derrick Wood of Cowen and Company."
},
{
"speaker": "Derrick Wood",
"text": "Two questions from me. Shantanu, maybe I'd start on kind of doubling down on the communicators market and just curious about who some of the more popular personas are out there and maybe how COVID has been a catalyst and what you guys are doing to kind of lean into that market more. And then for John, on the Digital Experience side, seems like there's a lot of margin leverage to be driven out of that business, restructuring on the Ad Cloud side is one step. Sounds like maybe more revenue leverage out of AEPs and other. But can you just talk about some of the things you guys are doing to drive better leverage on both the gross and operating margin as we look over the next year or two?"
},
{
"speaker": "Shantanu Narayen",
"text": "Let me start. As it relates to the communicators, what I think most people don't maybe fully appreciate is what is happening on the Web with respect to wanting to do certain creative tasks and being able to fulfill those tasks with what we are doing around search engine and everything associated with the actions that people want to do. They want to remove the background for a picture, they want to post it for social media. And just the communicators that we refer to are also what were perhaps referred to in the past as knowledge workers because we just fundamentally believe that every piece of printed material or presented material benefits from this more interactive graphics rich. And so, what we are seeing is the ability for people to say, I want a single click ability to finish my task. And then once they finish that task, expose me to all of the other riches that exists in Adobe's creative product. So, I think that's a big driver of what the communicator has. We certainly see that with Spark. We see that across Lightroom as people want to share their images. But we also see it in our category-leading applications. Video is the other place where the usage of video in virtually every piece of communication is rapidly accelerating. So, hopefully, that gives you a couple of examples of where the communicator organic demand is coming from."
},
{
"speaker": "John Murphy",
"text": "And Derek, in relation to digital experience, looking at the TAM, we have such a great opportunity. And as you've seen, we expect acceleration. And then, with Workfront, even further acceleration. Workfront had stumbled there [ph] before we actually acquired them a little bit. But we know that the demand is there for that solution. And coupled with our capabilities, we know we can actually accelerate that back. So, there's definitely revenue leverage in the digital experience business. And as we said, the way we realigned the Digital Experience business by moving ad cloud out of that segment because we're operating it a bit differently, we wanted to make sure that we're operating the Digital Experience business the way a healthy SaaS company should view it. We have aspirations for very strong margins there. If you think about healthy SaaS companies growing their margins, the rule of 40. So, we're definitely excited about that. The other thing we're doing is we're going to continue to invest, as we said, in hiring, not only in R&D, but also in sales capacity because we're not opportunity constrained. We just definitely need to take advantage of the ability to capture all this opportunity, particularly now, the way that we've aligned the solutions within Digital Experience and they're resonating with our customers. And then of course, with Workfront, we can accelerate it even more."
},
{
"speaker": "Jonathan Vaas",
"text": "Operator, let's take two more questions and then we'll do a brief wrap up. Thank you."
},
{
"speaker": "Operator",
"text": "We can now take our next question from Sterling Auty of JP Morgan."
},
{
"speaker": "Sterling Auty",
"text": "Shantanu, how would you characterize, in the digital marketing, advertising, Adobe Experience area, with all the products ranging from the original Omniture, all the way through to Marketo, and all the homegrown solutions as well, where are you in the evolution of taking that entire stack into a fully integrated Kubernetes-enabled, cloud-delivered platform? Are you complete? Is there still phases left to deliver? And how might that investment impact gross margins moving forward?"
},
{
"speaker": "Shantanu Narayen",
"text": "Sterling, when we have the kind of innovation opportunity ahead of us, let me first start off by saying we've made tremendous progress. So, the delivery of the Adobe Experience platform was a momentous milestone, Sterling, not just because we delivered all this new functionality, but we started to have, whether it's Adobe campaign functionality integrated into the experience platform to be able to do customer journey, whether it was the Adobe analytics, what you refer to as the Omniture functionality and being able to get insight of all of that data. And so, the progress that we've made in being able to drive all of these solutions into a common platform, it's never done. To some degree – I remember that people would ask me, how much innovation do you have on the creative products. And here we are decades later. And the list of what we can do with these products dwarfs what we ever had 20 years ago. So, as I think about the Experience platform and I think about what every enterprise has to do to rewire it, I think we're in a fantastic position, given the engineering efforts over the last few years to have this integrated platform that nobody else has. It runs on cloud. I think you've seen with the progress and success that we've had around Microsoft and what we've done with Microsoft on Azure, it's certainly cloud aware. The announcement that we made with IBM, with the ability for all of these to also run in a hybrid cloud, where people, whether it's for regulatory reasons or other reasons, want to run it on their private cloud network, we've made progress and there's clearly interest on companies like VMware and IBM to partner with us on that. So, I'm really confident about the architectural thing. But the way we look at it is you're constantly architecting for new architectures. You're constantly doing work in AI and ML and providing more and more insights. Some of the ways in which we've actually added tremendous value is in the reporting and the analysis and the insight that each one of these has been doing. But the breadth and depth of our offerings, I think there's still significant headroom of what we can do. Because the way you have to think about it is, if we believe that with DDOM we're one of the most mature companies in terms of having a digital funnel and how we operate that's driven our success, we're pioneers not just in delivering technology, but in how we've moved it. And that movement for every company now, rethinking their business process, rethinking their computer architecture, we're at such an early stage that we're going to have to keep innovating around that space. And so, we think of it right now as an overall growth opportunity. We have made, as you saw, the strategic decisions around how we think about margin in that particular business. And so, we will continue to see margins expand in that business. But I think what you should be most excited about as an investor is the fact that we're investing in this immense opportunity and extending our lead. And so, I think that's the way we think about it. You look at the overall margins of the company again, and I think John alluded to this, despite investing in Workfront, despite investing in sales capacity, despite saying that we will accelerate growth, we're showing you margin expansion for the entire company. So, we know how to do this, which is drive top line growth and bottom line growth at an impressive margin. So, that's how at least I think about it."
},
{
"speaker": "Operator",
"text": "We'll now take our final question from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Stan Zlotsky",
"text": "This is actually Stan Zlotsky sitting in for Keith. Two questions from our end. If we look at the Creative Cloud and the progression of the pie chart that you guys put up there from 2017 to 2020, we can see that there's a fairly pronounced shift in ARR from team to individual. And maybe just following up on the question that Jennifer asked earlier, as we move into 2021 and beyond, how should we think about the progression of the shift moving forward? Will we see more continuous push from individual? Or are we starting to reach a more normalized equilibrium within those two categories? And then a very quick follow-up."
},
{
"speaker": "Shantanu Narayen",
"text": "Well, I think what you should see and what you will expect is, first and foremost, the pie expanding. And as it relates to the total addressable market, the main thing that you have to think about is this is market expansion, we're growing the value associated with our customers. I think at steady state, at some point in the prior business, which may be a predictor, it was closer to 50/50. But the thing that, again, I will reemphasize is that a lot of that is we drive into individual and then convert into the entire offering. And so, that's it. And so, big picture, I would focus more on the growth of the pie, the exact mix between those two. We look at both of them and feel like they're growing really well. And I'm happy to answer your second question as well, Stan."
},
{
"speaker": "Stan Zlotsky",
"text": "Just digging into the slightly rejiggering of your reporting segments and increasingly the new Publishing and Advertising segment. What are you seeing behind the scenes in your business? And how should we think about the print and publishing segment? Obviously, it's a very small part of the overall revenue component. But why create this dedicated segment and pull out the advertising from Experience Cloud? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "What we were trying to do was give you more insight and color into how we were running the different businesses and I think that's a key part of it. I think the print business, which was, a lot of you know, the genesis of the company. It's a business that continues to do well, but it wasn't a growth category as much as a high profitability category. We talked about in the Advertising Cloud, getting out of a lot of the transaction based revenue that we were seeing. And [technical difficulty] investors should take is [technical difficulty] pure play what is being reported as part of the Digital Experience segment that there's a clear alignment between what you see on bookings and what you see on revenue. As you've seen, the consulting services has been proactively driven down as a percentage of the revenue as we have a thriving ecosystem. I think the advertising cloud will not be a growth opportunity for us. There are some strategic partners who like the fact that we can continue to deliver it. But I would take that as a signal of we're really focused on the large growth opportunities where we have a differentiated solution. And it's purely subscription based revenue because that's in alignment with how we think about the largest opportunities. And so, we're focused as a company on making sure that we do it. I'm actually really pleased with how we transitioned that and how we communicated to customers. And so, this focus on the software as a service component of all of our businesses, we believe that that drives top line growth, we believe that that drives margin, and we believe that that's consistent with where we want to be as a company."
},
{
"speaker": "Shantanu Narayen",
"text": "And given that was the last question, I want to, again, first and foremost thank you all for joining us today in what was this virtual format. I really hope you share the passion that we feel for the mission, the tremendous market opportunity ahead of us, the depth that we have in our technology platforms, and really the significant customer value that we're delivering and providing. We really believe that the global brand, the customer base that we have, the ubiquity of our software, and the dedicated employees provides a real competitive advantage. That, frankly, is the envy of the industry. From my perspective, 2020 was an amazing year. We expect the momentum to continue in 2021 and beyond. And I certainly believe that our best years are ahead of us. As a number of you said, let me also wish you all a healthy, safe holiday season. And we really look forward to continuing to share the momentum and the story that we have in the new year. So, thank you for joining us. And with that, I'll hand it back over to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, Shantanu. And thanks again to everyone on the phone and on the webcast for joining us today. As Shantanu mentioned earlier, I also hope that we'll have an opportunity next fall to do this in person again. But we're really pleased that you joined us for the virtual event. Stay safe out there. Happy holidays to everyone. We look forward to seeing you at the Q1 call in March. And I'm sure I will be speaking to many of you very soon. This concludes the event."
}
] | Adobe Inc. | 24,321 |
ADBE | 3 | 2,020 | 2020-09-15 17:00:00 | Operator: Good day and welcome to the Adobe Third Quarter Fiscal Year 2020 Earnings Conference Call. Today's call is being recorded. All participants are in a listen-only mode. Later, we will conduct a question-and-answer session instructions will be provided at that time. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead, sir.
Jonathan Vaas: Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s President and CEO, and John Murphy, Executive Vice President and CFO. On this call, we will discuss Adobe’s third quarter fiscal year 2020 financial results. By now, you should have a copy of the press release, which crossed the wire approximately one hour ago. We’ve also posted PDFs of our prepared remarks and financial results on Adobe’s Investor Relations website. Before we get started, we want to emphasize that some of the information discussed in this call, including our financial targets and product plans, is based on information as of today, September 15, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, you should review the Forward-Looking Statements Disclosure in our press release issued today, as well as Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Reconciliation between the two are available in our earnings release and on Adobe’s Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe’s Investor Relations website for approximately 45 days. The call audio and the webcast may not be re-recorded, or otherwise reproduced or distributed without Adobe’s prior written permission. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon. I hope all of you are safe and taking good care. The ongoing pandemic continues to result in a challenging environment everywhere around the world. People are seeking new ways to communicate, learn and conduct business virtually. Content creation and consumption are exploding in a world where connecting visually has become even more essential. Students are adapting to learning remotely instead of in a classroom. Entire industries, from media and entertainment to pharma, retail, automotive and financial services, have had to pivot overnight to digital operations to engage with customers and ensure business continuity. Electronic workflows and signatures are the only way to efficiently complete business transactions. The world has changed in a way that none of us could have foreseen. This reality has created new tailwinds for Adobe. Our mission to change the world through Digital Experiences has never been more critical. Our strategy of unleashing creativity for all, accelerating document productivity and powering digital businesses is more relevant than ever and driving our strong performance across every geography and audience. Adobe had an outstanding third quarter. We saw strength across Creative Cloud, Document Cloud and Experience Cloud. We achieved $3.23 billion in revenue in Q3, representing 14% year-over-year growth. GAAP earnings per share for the quarter was $1.97, representing 22% year-over-year growth, and non-GAAP earnings per share was $2.57, representing 25% year-over-year growth. In our Digital Media business, we drove strong revenue growth in both Creative Cloud and Document Cloud in Q3, achieving $2.34 billion in revenue, representing 19% year-over-year growth. Net new Digital Media Annualized Recurring Revenue or ARR was $458 million, and total Digital Media ARR exiting Q3 grew to $9.63 billion. We believe that everyone has a story to tell and our goal is to give all creators, from students to social media influencers, business communicators and creative professionals, the ability to create and amplify their stories. Creation and consumption across phones, tablets and desktops is exploding. Web content, mobile application creation, imaging, video, animation, screen design, AR and 3D are all surging in this new era of digital storytelling and business transformation. Enabling the capture, authoring and collaboration across each of these categories and inspiring our global communities, Creative Cloud is driving this massive content revolution. Q3 Creative Cloud performance was outstanding, with net new Creative Cloud ARR of $360 million and revenue of $1.96 billion. Driving our Q3 Creative Cloud performance was record traffic to Adobe.com, our acquisition engine, using proprietary models for attribution and optimization; strength in our Creative Cloud single-app and complete offerings across all geographies; growth in our creative mobile apps, delivering discrete revenue as well as a funnel to our multi-surface Creative Cloud offerings; improvement in retention, driven by increased engagement and product usage among individuals, teams and enterprises; outstanding performance in the imaging and video categories with Photoshop, Lightroom and Premiere Pro; and strong performance in the education segment across students, educators and institutions. Adobe MAX, the world’s largest creativity conference, will be hosted virtually in October. In addition to showcasing exciting new Creative Cloud products and services, our programming includes 56 hours of around-the-world content and features incredible creators like actor Keanu Reeves, photographer Annie Leibovitz and award-winning filmmaker Ava DuVernay. We expect a record turnout and are thrilled to already have over 200,000 registrations. With Adobe Document Cloud, we’ve reinvented how people create, edit, share and sign digital documents with Acrobat and PDF. While digital documents have always helped small, mid-sized and large businesses realize productivity and efficiency gains, they have now become central to businesses operating remotely. Supported with a rich set of APIs, Adobe Document Cloud enables seamless workflows and collaboration across devices. Q3 Document Cloud performance was exceptional, with net new Document Cloud ARR of $98 million and record revenue of $375 million. Q3 highlights included strong growth in gross new ARR coming from the Adobe Reader funnel; significant gains in Acrobat web monthly average use; Acrobat Mobile installs up 33% year-to-date; significant momentum with Adobe Sign, including our announcement to pursue FedRAMP Moderate status; key customer wins, including Citi, PwC, Pepsi, HSBC, Merkle and J-Power; and the release of the Adobe Document Cloud Resource Hub for Education, a one-stop destination outlining how Document Cloud can assist with remote learning. The shelter-in-place requirements instituted across the globe created a heightened sense of urgency among all companies to accelerate their digital transformation. Overnight, small, mid-sized and large B2C and B2B companies shifted every aspect of their customer relationships, from acquisition all the way through renewals, to digital. As a company that’s been through its own digital transformation, we have a deep understanding of what it takes to be a digital business and that experience makes us the ideal partner to help other companies do the same. Over the past decade, we have put the right technology, processes and people in place to precisely and persistently measure and manage performance every day at scale across each of our businesses. We developed a cross-company, real-time, data-driven operating model that leverages all of our Experience Cloud technology. The CXM playbook, which relies on continuous product, platform and process innovation, has fundamentally changed the way we run our Company and today we are helping our customers build their own CXM playbooks. The industry’s most comprehensive offering, Adobe Experience Cloud features industry-leading applications and services built on the Adobe Experience Platform, leveraging Adobe Sensei, our AI and Machine Learning framework. Digital Experience revenue was $838 million in Q3. Subscription revenue excluding Advertising Cloud grew 14% year-over-year. Q3 highlights include increased adoption of Adobe Experience Platform and the launch of new capabilities that allow marketers to accelerate data collection across channels to enable faster, personalized experiences based on real-time insights; general availability of Data Governance capabilities in the Real-time Customer Data Platform; early traction with our Customer Journey Analytics service, which provides customers a complete view of the Customer Journey, online and offline; acceleration in the deployment of our Adobe Experience Manager Cloud Service; significant quarter-over-quarter growth for Commerce offerings; Working with our Advertising Cloud customers to wind-down our transaction-based offerings; key customer wins, included Eli Lilly, Truist, Nike, Lowe’s, Shell, Lloyds and the U.S. Department of Commerce; a partnership with IBM and Red Hat to enable Experience Cloud deployment in hybrid cloud environments that further strengthens real-time data security for enterprises in regulated industries; and recognition as a Leader in six Gartner Magic Quadrant and Forrester Wave reports. In the Gartner Magic Quadrant for CRM Lead Management, Adobe was the leader, achieving the best scores across Ability to Execute and Completeness of Vision. Adobe’s record results would not be possible without the ongoing contributions and unwavering dedication of our employees around the world. They have demonstrated incredible resilience by quickly pivoting to a remote work environment without missing a beat. I am proud and grateful. Great companies are defined by how they manage through difficult times. Our strong corporate culture, focus on innovation, exceptional customers and partners, and always doing right by our communities, drives us and our success. We are excited about the tremendous opportunity ahead of us and look forward to continuing our strong momentum in 2020 and beyond. John?
John Murphy: Thanks, Shantanu. Adobe delivered outstanding performance in Q3, highlighted by strong net new Digital Media ARR, Digital Experience subscription revenue growth and record operating cash flows. Despite challenging macroeconomic conditions, the ongoing remote work and learning-from-home environment provided an opportunity to offset normal Q3 Summer seasonality. Our success was driven by Adobe’s unique ability to draw insights across our business in real-time utilizing our data-driven operating model. This enables us to understand demand for our solutions, make strategic investments to capitalize on the highest returns, and drive engagement and conversion across our channels, most notably our web properties. Throughout the quarter, we generated sustained levels of traffic and demand across our Adobe.com offerings, including during the summer holidays where purchasing patterns have historically softened. Utilizing our proprietary attribution technologies, we made variable marketing investments that enabled us to attract and engage new customers, delivering the strongest Q3 on record for Adobe, while at the same time maintaining fiscal discipline to accelerate earnings growth. As a result, in Q3 Adobe achieved record revenue of $3.23 billion, which represents 14% year-over-year growth. On a constant currency basis, total Adobe revenue grew 15% year-over-year. GAAP diluted earnings per share in Q3 was $1.97 and non-GAAP diluted earnings per share was $2.57. Business and financial highlights included Digital Media revenue of $2.34 billion; net new Digital Media ARR of $458 million; Digital Experience revenue of $838 million; record cash flow from operations of $1.44 billion; remaining performance obligation of $10.34 billion exiting the quarter; and repurchasing approximately 1.5 million shares of our stock during the quarter. Adobe’s strong third quarter performance shows the continued momentum across our cloud businesses. From knowledge workers to creative professionals, from small businesses to large enterprises, people are driven to engage digitally and are seeking tools that enable them to communicate more proficiently across digital platforms. In our Digital Media segment, we achieved 19% year-over-year revenue growth in Q3. On a constant-currency basis, Digital Media grew 20% year-over-year, and we exited the quarter with $9.63 billion of Digital Media ARR. Within Digital Media, we achieved another strong quarter with our Creative business. We achieved Creative revenue of $1.96 billion, which represents 19% year-over-year growth, and we added $360 million of net new Creative ARR. Our Creative growth in Q3 was driven by investing to acquire new users across all geographies and segments; continuing our relentless focus on engagement to drive retention and renewal of existing customers; successfully closing enterprise term licenses with educational institutions, as well as growing our education business through individual subscriptions by students; driving awareness and licensing of our professional video products; focusing on converting free mobile app users to paid mobile subscriptions, including strong growth in Lightroom Mobile; and utilizing insights from our data-driven operating model to run targeted campaigns and promotions. Adobe Document Cloud delivered another quarter of strong revenue growth. We achieved Document Cloud revenue of $375 million, which represents 22% year-over-year growth, and we added a record $98 million of net new Document Cloud ARR. As with our Creative business, Document Cloud is benefiting from the changing nature of work and the continued importance of digital document solutions, as individuals, enterprises and governments look to pivot away from paper-based dependencies to digital workflows. Our Document Cloud growth in Q3 was driven by investing and driving awareness in our Acrobat web business; continuing to build momentum with our mobile monetization efforts with Acrobat Reader; increasing demand for Acrobat subscriptions across all geos; and building, progressing and closing pipeline for our enterprise offerings, with particular strength in Adobe Sign, which grew enterprise bookings more than 200% year-over-year. While we saw some recovery in the SMB segment during Q3 across Digital Media, smaller businesses continue to be impacted by the macroeconomic environment. We expect this to continue to impact our Team offering across the reseller channel and on Adobe.com. Turning to our Digital Experience segment, in Q3, we achieved revenue of $838 million, which represents 2% year-over-year growth. Digital Experience subscription revenue was $729 million, representing 7% year-over-year growth. Excluding Advertising Cloud, Digital Experience subscription revenue grew 14% year-over-year. We continue to wind down the transaction-driven ad network business in Advertising Cloud. During Q3, enterprise sales and services implementations settled into a new normal of virtual engagements. We drove strong pipeline and customer acquisition across our Digital Experience solutions, as the digital transformation imperative continues to resonate with our customers. We saw acceleration of our Commerce business, and we drove increased adoption of our AEM Cloud Service and Adobe Experience Platform, which we expect to be growth drivers over the next decade. We saw particular strength with the number of transactions greater than $1 million in new annual subscription value that we closed in the quarter. While enterprises and smaller businesses continue to be impacted by the macroeconomic environment, spending in customer experience management is reemerging as the primary imperative to enable businesses to engage with their customers and ignite growth. Overall, while our focus is on investing for profitable growth, particularly in research and development, we drove significant savings from travel and entertainment and facilities operations as our employees work from home. After ensuring that our current resources are focused on the key priorities, we expect to ramp our hiring in Q4 and FY21 to capitalize on our large addressable markets. From a quarter-over-quarter currency perspective, FX increased revenue by $15 million. Net of impacts from hedging, the sequential currency increase to revenue was $10 million. From a year-over-year currency perspective, FX decreased revenue by $14 million. Net of impacts from hedging, the year-over-year currency decrease to revenue was $25 million. Adobe’s effective tax rate in Q3 was 10% on both a GAAP and a non-GAAP basis, in line with our targets. Our trade DSO was 37 days, which compares to 44 days in the year-ago quarter, and 40 days last quarter. Remaining Performance Obligation or RPO grew by 18% year-over-year to $10.34 billion exiting Q3 and grew sequentially by 4% quarter-over-quarter. Deferred revenue exiting the quarter was $3.45 billion. As I mentioned last quarter, our Adobe.com offerings, typically billed monthly, are reported as unbilled backlog, whereas channel offerings billed annually up front are reported as deferred revenue. The strength in acquisition on Adobe.com during the quarter continues to drive a mix-shift from deferred revenue to unbilled backlog. Our ending cash and short-term investment position exiting Q3 was $5.26 billion, and cash flows from operations in Q3 were a record $1.44 billion. In Q3, we repurchased approximately 1.5 million shares at a cost of $617 million. We currently have $2.9 billion remaining of our $8 billion repurchase authority granted in May 2018, which goes through 2021. For Q4, factoring current macroeconomic conditions, typical year-end seasonal strength and the strategic shift related to our Advertising Cloud business, we are targeting: total Adobe revenue of approximately $3.35 billion; Digital Media segment year-over-year revenue growth of approximately 18%; net new Digital Media ARR of approximately $540 million; Digital Experience segment revenue approximately flat year-over-year; Digital Experience subscription revenue growing approximately 1% year-over-year, or 12% when excluding Advertising Cloud revenue; tax rate of approximately minus 90% on a GAAP basis and 10% on a non-GAAP basis; share count of approximately 485 million shares; GAAP earnings per share of approximately $4.29; and non-GAAP earnings per share of approximately $2.64. The GAAP tax rate is benefitting from planned changes to optimize our international structure in Q4 to better align ownership of certain intellectual property rights with how our business operates, as we discussed during our Q1 call earlier this year. In summary, we expect a strong Q4 to conclude another year of record revenues and earnings for Adobe. Through these times, the resilience of our employees and our business model have been evident. As our market-leading solutions continue to resonate with individuals and enterprises across the globe, we remain excited about the growth opportunities ahead. Back to you, Jonathan.
Jonathan Vaas: Thanks, John. As we announced earlier this year, Adobe MAX, our annual creativity conference, will be an online event this October. Information about the event can be found at max.adobe.com. Today we also announced that Adobe will host its fourth quarter and fiscal year 2020 earnings conference call and financial analyst meeting online on December 10th, where we will provide an overview of the Company’s strategy and financial targets for fiscal year 2021. Invitations will be sent to our analyst and investor list in the coming weeks. If you wish to listen to a playback of today’s conference call, a webcast archive will be available on Adobe’s IR site later today. You can also listen to a phone replay by calling the numbers shown above. The phone playback service will be available beginning at 5 pm Pacific Time today and ending at 5 premium Pacific Time on September 22nd. We would now be happy to take your questions, and we ask that you limit your questions to one per person. Operator?
Operator: Thank you. [Operator Instructions] We'll take our first question from Kirk Materne with Evercore ISI.
Kirk Materne: Yes. Thanks very much and congrats on the quarter. Shantanu, something maybe to start the day -- or my question’s actually just going to be around the Experience Cloud business. Obviously, you guys are divesting the Advertising Cloud part of that. But, just in terms of the commentary, it seems like the pipeline's building nicely, RPO was up nicely in the quarter, yet revenue guidance for next quarter is down a little bit. I was wondering if you could just square that up, because it sounds like your enthusiasm for that opportunity still remains very-high. But, I think, some people might be wondering, why maybe is revenue not sort of matching up with that? Thanks.
Shantanu Narayen: Sure, happy to. And as you pointed out, I mean, firstly, digital transformation is a massive addressable opportunity. And it's clear that we are the leaders. We had a great quarter. Bookings grew north of 15%. As you saw, we had good revenue. We successfully have introduced brand new products, which we believe are going to be the growth drivers from what we did with the Adobe Experience Platform, what we did with Customer Journey Analytics, the Customer Data Platform, as well as what we are doing around both, Commerce as well as the Adobe Experience Cloud in the Cloud Service. So, the business and the interest frankly, because there isn't a small and medium business or large enterprise that isn't interested in how digital can help them deal with the current health situation. So, bookings have been strong, business has been strong. I think, as it relates to revenue, you have to continue to think about the wind-down of the Advertising Cloud business, which continues to happen. We expect bookings to be strong. And then, the other issue for us is really, as the macroeconomic environment, you think about the spending patterns, but net-net for us, we thought the business did really well. It was a great rebound, from what we had expected in Q2, which was both on the consulting side as well as on the net ASP, we thought it would be slightly slow. So, we're really excited. And we're in the sweet spot of what is clearly a growth business.
Operator: We'll take our next question from Saket Kalia with Barclays Capital.
Saket Kalia: Shantanu, maybe just to stay on the Digital Experience business. Zooming out a little bit strategically, I think Anil Chakravarthy is still getting settled in as leader of the DX business and field operations. I guess, the question is, what are some of his objectives, particularly in the DX business that you're most excited about for next year?
Shantanu Narayen: So, Saket, first, I will say this, his has been the fastest ramp that I have seen of any executive that we've got. So, he is doing an absolutely fantastic job, and a great addition to what you know is already a very strong management team that I'm blessed with at Adobe. Maybe I would say three things. The first is on the product side, he's really got his hands around the platform and the innovation associated with the platform, the delivery of Customer Journey Analytics. We had a great quarter with the Adobe Experience Platform and a number of customers adopting it, what we are doing around CDP and the real-time nature of what we can do as well as intelligent services that are leveraging Adobe Sensei. So, on the product and innovation making sure that we have this platform that we integrate all our products is really added a lot of value there. But that will continue to be the area where I think we can completely differentiate ourselves relative to anybody else. Because while others are talking about providing this unified profile, as you know, we have tens of billions profiles already in Adobe Experience Platform. I think, the second area is with the unified organization really focusing on the customers and the customer centricity and what we are doing with partners. The structure for U.S. and international is set up. And he is focused on aggressively evangelizing both, our vision as well as the differentiation in the marketplace. And one side benefit, Saket, of everybody working from home is we can engage with customers so much better, and routine day consists of significant customer engagement. So, that's clearly the area that he's focused on, because he needs to be out there as the leader of this. And third, I would say, the culture. Adobe's culture has always been a unique point and focus on talent and hiring, and where there is significant opportunity, making sure that we have the best talent. So, he's already been able to recruit some key people as additions to his management team. But, there is a lot to do and there is a lot that he's done. And so, we're very excited about having him onboard.
Saket Kalia: Got it. Very helpful. Thanks, guys.
Operator: Thank you. We'll take our next question from Brent Thill with Jefferies.
Brent Thill: Good afternoon. Shantanu, Q4, the Digital Media guide well above the Street. You’ve clearly seen a lot of great tailwinds in that business. I'm curious if you could just kind of unpack the drivers and what you're seeing for the upside surprise relative to Street numbers?
Shantanu Narayen: Yes. Brent, I'm surprised you didn't talk about the Q3 upside as well. I mean, we just saw [Multiple Speakers]. Fair enough. We saw tremendous performance. I mean, as you see, what's happening in both creativity and document productivity, Brent, I mean, the business is just firing on all cylinders. And that has to do both with products, as well as, frankly, with services. We didn't maybe comment specifically on the services, but the services, the stock business just continues to do well, there's no question we're gaining market share. The sign business has grown very successfully. But if you continue to think about, I think, what's driving that business, the first is, we sharpened our focus on usage and engagement. And the usage and engagement that we did really help improve retention rates back to the pre-COVID levels. So, that focus will just continue. We have a very large book of business. The education, education had a good quarter. So, we have continued focus on education. Individual apps, we talked about Lightroom, Photoshop and Premiere Pro as areas where there is a lot of interest in our business. And also, the sophistication of what we talked about, namely the marketing attribution, and models, it just helps us spend money so efficiently and sustain the durability of the acquisition of new customers and trends. So, as you pointed out, when we look at the second half performance, it just demonstrates how both, Creative Cloud and Document Cloud frankly are the preeminent platforms. And we should continue to see good strength from our Q3 back into Q4. So, we're excited.
Operator: Thank you. We'll take our next question from Kash Rangan with Bank of America.
Kash Rangan: Nice to go right after Brent here. Thank you so much, and congratulations on your quarter. Shantanu, you talked about how the pandemic has actually resulted in better customer engagement. But, as we come out of the pandemic, if there's ever such a thing called coming out of this pandemic if we got vaccine, how does the business perform? And do you feel that this actually lengthens the cycle for the transformation, or do you think we could be in a pocket, halo effect where things get pulled in a little bit, because we’ve got all this time to do more work and there is a bit of catch up and then of course a longer term secular trajectory Digital Transformation is unchanged? I mean, how are we to think about for the environment? Environment is actually unusually supportive of your result -- not only your results but all of the software companies, so that you might get a little bit of pull back if we enter into a normal economy. Sorry to word it that way, but just curious to get your thoughts. Thank you.
Shantanu Narayen: Yes. Kash, we've been talking about the trends that are going to be tailwinds across each of our businesses, whether it was Creativity, Document Productivity or a specifically to your question, Digital Transformation. The genie's not going to vote back in the bottle. I mean, we've certainly seen, as you point out, an inflection in the business, as it relates to the demand in digital transformation. But, my perspective on this business is, it's just going to gain importance. I think, as the macroeconomic environment improves, the spending will actually open up in terms of what people spend. And we've been touching on customer experience management as a imperative and a priority for enterprise spend for a while, and I don't think that changes. So, I think everybody's recognizing that not having a commerce website, not being able to engage digitally with customers -- and I think the two areas where we're seeing the most excitement is this unified profile. Because people now absolutely recognize where you have a physical presence and you have a digital presence, you have to absolutely create a unified experience, and that I think is only going to accelerate. So you will see more physical perhaps once the vaccine is present. But, that's not going to change the need to provide this unified experience. And on the marketing spend side, more and more is going to go digital and people will want to run more of these digital campaigns with customers. So, I think the basic trends of personalization of unified profile of customer experience management are only going to continue once the pandemic. And I actually feel like that should hopefully signal an improvement in the macroeconomic environment for everybody. I think, a lot of what's happened right now is people want to spend in digital, but their spending ability may be limited. And as that spending ability opens up as the economy improves, I don't think it changes the priority. I think, it frankly opens up spending.
Kash Rangan: Very insightful. Thank you very much. Congrats.
Shantanu Narayen: Thanks, Kash.
Operator: Thank you. We'll take our next question from Brad Zelnick with Credit Suisse.
Brad Zelnick: Excellent. Thank you so much, and congrats on the really strong Q3. John, my question is for you. In your prepared remarks, you talked about the variable marketing investments that enabled Adobe to attract and engage new customers, which clearly worked well. Can you comment on what you're seeing in terms of ROI trends on marketing spend and reasons to believe they may or perhaps may not be sustainable? Thanks.
John Murphy: Sure. Thanks again, Brad for the question. I think, when we look at our capabilities with DDOM or data-driven operating model, the level of precision, which we’re able to see performance in our business real time really allows us to surgically invest where we know we can be successful. And so, you can see that in the performance obviously in our books in Q3 and where we think we can drive a metric in Q4. So, we have a lot of confidence in investing for appropriate return. And also looking at the breadth of the different markets we're trying to attract to the platform's both CC and BC. So, we monitor that very carefully. We don't just throw money at in variable marketing just to see where it lands. We're actually measuring very completely every dollar that we invest in that space.
Shantanu Narayen: And Brad, maybe if I were to add just a little bit on top of that, what you have to do is again, harking back to what we said is the overall addressable market opportunity for all of our businesses and on the Creative and Document Cloud route as we talk about a greater than $30 billion addressable opportunity. This sophistication just helps us target all those people with more efficiency. And, as John said, the constant changing nature of where that marketing goes, we definitely view that as a differentiation for us in terms of what product, what service, what geography across what channel.
Operator: Thank you. We'll take our next question from Jennifer Lowe with UBS.
Jennifer Lowe: Great, thank you. I wanted to touch on the gross margin within the Digital Experience business. And as talked about earlier, my understanding was that as the Ad Cloud winds down, there should be a gross margin benefit attached to that. But, if I look at the GAAP gross margins in Digital Experience, they’re actually down a little bit quarter-over-quarter. So, sort of related to that first, how should we think about the costs associated with Ad Cloud rolling off the cost of goods sold line, over the coming quarters? And secondly, how should we think about the margin profile of that business once that wind down has happened?
Shantanu Narayen: I can add, and then Jennifer, John, certainly feel free. I mean, overall, on that business, I think there was a slight performance in what we saw in the Ad Cloud revenue in the quarter. So, that might account for what you are referring to. I think, big picture, we just look at it and say, this is a growth business. What we've been able to do by aligning is to make sure that we're focused on the highest priority growth objectives. And so, it's still a growth business that's a real focus for us. But, as it relates to the overall margins, I mean, the Company performed exceedingly well. I would argue, maybe we were a little conservative, frankly, because we were unclear of the macroeconomic environment in terms of hiring, but we're certainly going to be opening up the hiring in research and development to continue to do differentiate ourselves. And on the Digital Experience, now that we've consolidated the organization, we've eliminated all the inefficiencies. We made the strategic change on Advertising Cloud. Now, we feel like it's all going to be profitable growth as we invest in the Digital Experience business.
John Murphy: Quarter-over-quarter, it’s really a part of the overall performance of Ad Cloud as we had been transparent for customers, we helped them transition to other services, but we also helped them run campaigns that were scheduled. In addition, the volume of activity across our other products did actually increase some of our cloud -- specially our cloud costs or third party cloud costs. So, that's something that we are marking very closely so that we can leverage the volume and negotiate our contracts appropriately and drive efficiencies across our clouds.
Operator: Thank you. We'll take our next question from Jay Vleeschhouwer with Griffin Securities.
Jay Vleeschhouwer: Thank you. Good evening. Shantanu, the Company has often spoken in the past, for instance, at Summit presentations, that you've identified about four dozen used cases for DX. And the question is, setting aside Ad Cloud and whatever part of that mix they may have accounted for, what trends or evolutions have you been seeing in the number or mix of use cases within DX? And then, related to that perhaps you could also update us on the applications and intelligence services that you previewed back at Summit earlier this year, at how that might flow into the various use cases and more importantly, the DX growth that you're anticipating?
Shantanu Narayen: Sure. Jay, I think what's been consistent in the business and areas that continue to show both, growth as well as interest from customers is first and foremost content and data. And so, I think when we think about what's happening with content, the use case of people increasingly moving to cloud services on the Adobe Experience Manager side, creating new mobile applications than engaging directly with customers, I think that just continues to be an area of significant growth. On the data side, as we have added more capabilities, both to Adobe Analytics, as well as with the Adobe Experience Platform of being able to say what is the insight that people are getting, I mean, we're all looking at data, even more stringently in this environment. And so, the use case associated with going from collecting that data to getting insights on that data, the demand for that particular area of our solutions, including in intelligent services, whereas as you know, we have intelligence services that are associated with each of the solutions. That's an area of increase. I would say, the third area is this unified profile and just being able to get all of the data, that's clearly a trend, Jay. Because people recognize that they have all these silos. And that was even more accentuated by what's happening in the health. So, the need and desire to get this unified profile, so that they can serve the customer adequately, that use case. And when we are talking about Customer Journey Analytics, how you do the equivalent of what we have done with DDOM, I think that's the use case that's clearly resonating with customers. Commerce, I would say, the commerce use case and how you have to find different models, whether it's a subscription based business model of transacting with customers, whether it's loyalty based business model, so I think the commerce and using commerce to accomplish new business models, I think that use case has also increased. And the last thing I would say is between B2B and B2C? We've talked about that distinction blurring. But, I think all B2B companies, still stating how can we both work directly and engage with customers as well as through a network of partners, I hear that over and over again. So whether you're a company providing goods through a distribution channel, whether you're a car manufacturer, all of them recognize that they have to bridge this gap between being deemed a B2B company and a B2C company.
Operator: We’ll take our next question from Sterling Auty with JP Morgan.
Sterling Auty: You mentioned in your prepared remarks that the SMB segment showed some improvement in the quarter. Can you just give us maybe from a high level, how much does the business have at this point to SMB? And even into that prosumer area where maybe some of the stimulus being talked about would have a bigger impact.
Shantanu Narayen: Yes. Sterling, we looked at both those trends quite a bit as we went through the quarter. And, I would say, as it relates to the stimulus, when the first package came out, this was early, we saw appreciable difference in sort of the payment successes and what happened with the individual subscribers. So, we saw a correlation associated with that, subsequent ones have not. And as I said, the engagement work that we did helped us get retention back up to the levels that we had pre-COVID. So, I don't know whether that was a initial catalyst. But to us, it just demonstrated the increased importance of the solutions that we provide. As it relates to the small and medium business segment, again, that is through the team offering a lot of that happens through the channel. And Q3 we saw some strengthen that. So, I don't know that we've broken out Sterling, what percentages exactly on individual versus team versus enterprise. It is a big part of our business because small and medium businesses certainly use both our creative and document tools, but we were pleased with what we expected. As it relates to our Q3 targets, we're still going to be a little cautious about seeing the rebound in that SMB. So, we're not necessarily expecting significant new acquisition in that, but we were pleased with what we saw in Q2. And long-term, we just continue to think that our solutions help them become a digital enterprise, which is going to become more important.
Operator: We'll take our next question from Alex Zukin with RBC Capital Markets.
Alex Zukin: So, maybe a combo question for Shantanu and for John. Shantanu, you're seeing kind of now two straight quarters of all time highs for traffic on Adobe.com. And according to our data, it would actually appear the trend is only accelerating. So, I guess the question is back to that durability, kind of what's driving that acceleration? And how would you think about the durability of that 20-plus-percent Digital Media ARR growth trends as you sit here today? And then ultimately, maybe John remind us, what kind of rules should we remember in our models, as DM ARR stays above 20%? Is that -- what kind of churn assumptions we should think about when looking at Digital Media revenue growth next year?
Shantanu Narayen: Yes. Alex, as it relates to the overall macro demand, it's just the amount of content that's being created is just absolutely exploding and it actually doesn't matter whether you're, as we talked about, an individual who has a story that they want to tell a small and medium business who has to transact businesses online, and therefore has to create the appropriate content, whether it's a large enterprise that is increasingly engaging digital, and therefore wants the appropriate personalized content. And I think that trend will only continue to speak well for Adobe. We look at some other trends like the number of people engaging with us on Behance, which is our community. We're getting more part of Behance being used than ever before. What we are doing with Spark, which is allowing prosumers and others who have a task-based offering to come. So, we just continue to think that the amount of content being created and the amount of content being consumed is only going to go up. And we have the premier offering in that space, not only from the product side, but from also the DDOM side. And so, I think it really continues to augur well for us. And, we will certainly give you more color as we come up to fiscal '21 on what we expect moving forward. But, we're excited about the opportunity.
John Murphy: Yes. In regards to your comments and we touched and Shantanu said, the efforts that we’re putting to engaging our customers and making sure that they are using the right product for the right use case has really driven retention efforts really well in that engagement. And of course, the fact that we'll be able to see a return to kind of pre-COVID levels is indicative of people seeing value in the products that they’re using.
Alex Zukin: Got it. Thank you, guys.
Operator: Thank you. We'll take our next question from Keith Weiss with Morgan Stanley.
Stan Zlotsky: Perfect. Thank you so much, guys. This is Stan Zlotsky sitting in for Keith. A quick question for John. Very strong margins in Q3, record margins on operating margin side. What should we keep in mind as far as margins as we head into Q4, and what's embedded in the EPS guidance for the quarter? Thank you.
John Murphy: Sure. Thanks, Stan. When we entered Q3 and really looked at really focusing our resources on the top priorities. Once we got through that activity and we felt really comfortable with the performance that we were seeing, we realized that we probably being a little conservative were slower out of the gate ramping our hiring. We're committed to ramping our hiring now going into Q4 and into FY21to really drive the opportunities that we see to drive performance in these opportunities. So, we're investing in R&D and you'll see that kind of manifest in our Q4 hiring and into FY21. And we do believe that some of the other OpEx savings that we’ve had, onetime savings around travel and facilities and in-person events are going to change as we start to reopen our offices when it's safe. And so, we don't expect the level -- the lack of spending in those areas in Q3 to be sustainable going forward. So, that is something to consider when you look at the operating margin performance in Q3.
Stan Zlotsky: Perfect. Thank you so much.
Operator: Thank you. We'll take our next question from Walter Pritchard with Citi.
Walter Pritchard: Hi. I'm wondering, John, or Shantanu, if you could talk about retention, and you highlighted out of your prepared remarks around improvement in retention. And maybe just directionally, you talked a little bit about some headwinds there a quarter ago, where you are now versus retention in sort of the steady state? How much you dipped down, and if it varies much by the various segments of your Digital Media business?
Shantanu Narayen: I think, Walter, maybe looking at it now in retrospect, I don't know if -- when COVID first hit, whether there was a shock to the system and therefore people reacted. And I think that has settled down, as we said in -- a couple of times. It's definitely gone back to the pre-COVID levels. I think, I would also give our team tremendous credit for what we've done around engagement. I mean, the good news for us, Walter, is we have such a variety and portfolio of products that we can use. And, let's take Acrobat where we haven't spent -- we haven't got as many questions. I mean, from everything we can do around Acrobat on the web, to what we can do with the Reader funnel to Acrobat. And so, we really just are a world class machine on both the acquisition and increasingly on the engagement retention. So, my best guess is there was a little bit of a shock to the system. That has definitely stabilized, that provided the impetus for us to really focus on engaging more with customers and delivering the value. And last but not least, I think it just shows how mission critical these products are. And so, again, it's very different by offering to the second part of your question. But, within enterprises, within creative pros, we just continue to see a really good retention and really good acquisition.
Walter Pritchard: Thank you.
Operator: Thank you. We'll take our next question from Derrick Wood from Cowen and Company.
Derrick Wood: Great. Thanks for taking my question. Shantanu, you mentioned that the education vertical had a good quarter, and I think there was some uncertainty around health of spending here, given all the change institutions have had to go through. I guess, since we're in back-to-school mode right now, though, obviously a much more virtual bend to it. Can you talk about what you've seen out of the education vertical in terms of demand and usage patterns and how that works typically in back-to-school season, and kind of what insights that gives you as we progress through the school year?
Shantanu Narayen: Sure, Derrick. And again, I mean, first, let me acknowledge that I think for both parents of young kids as well as those who have college going kids, I mean, there is still a quite a bit of uncertainty of what happens. But, as it relates to the strength, I mean, we saw strength, both in terms of students, educators, as well as in institutions. And so, we saw strength across the board. Part of what I would attribute that to is, when it first struck and everybody was from home, if you have a young kid or a college going kid, you want to continue to invest in making sure that they have access to the best software. I think, we did a good job of provisioning Creative Cloud and ensuring that they have access to Creative Cloud. And then, we pretty actively went out with our field organization, both in terms of licensing products, as well as the enterprise type licenses that you can have for institutions to demonstrate it. And the last thing I would say is, we are seeing more and more curricula in these institutions also add so much more on creativity as part of their curricula. So, I think that's a trend that is also helping our business.
Derrick Wood: Thanks.
Operator: Thank you. We'll take our next question from Ken Wong with Guggenheim Securities. Mr. Wong, please unmute if you’re muted.
Ken Wong: Oh, sorry about that. Thanks for taking my question. John, you mentioned in the prepared remarks, seeing an acceleration of Adobe Commerce. Just when thinking about how you guys licensed the product, when should we expect to see that benefit revenue? Is that something you're already capturing or is that down the line at renewal time?
John Murphy: Yes, it really is both. Thanks, Ken, for your question. So, we certainly saw commerce revenue perform this quarter and certainly the bookings associated with the demand for commerce offerings increase this quarter. So, we just see the momentum there. People are really resonating with the product. They're seeing that it's a great add-on as well when they're looking at some of our other solutions in digital transformation in the segment. So, we think there's a nice tailwind there in commerce.
Shantanu Narayen: And to your second question Ken -- I mean, John, we certainly have bands. And since we have bands and we don't charge based on necessarily the immediate transaction, what happens is as people come up for renewal, which was the second part of your question, Ken, yes, the intention is that they both true-up as appropriate and/or move to a higher band.
Ken Wong: Great. Thanks, guys.
Jonathan Vaas: Operator, we're coming up on the top of the hour. We'll take two more quick questions. Thanks.
Operator: Thank you. We'll take our next question from Mark Moerdler with Bernstein Research.
Mark Moerdler: Thank you, and congrats on the strong quarter. I was impressed in the comment on the 200% year-over-year growth in enterprise bookings driven by Adobe Sign. Can you give more color? Is this growth in full Document Cloud, is this a portion of that? Any color on the percentage of document sign -- Document Cloud that is now from enterprise agreements? I appreciate it. Thanks.
Shantanu Narayen: Sure, Mark. And as you point out, and we didn't get too many questions, I mean, the Document Cloud really had a very strong business. And at the macro level, the strength of Acrobat, all the verbs that we have including Sign, the frictionless Acrobat web and the platform APIs, we're really convinced we have the right platform for document creation, sharing, signing, exporting and scanning. I mean, scan also, the number of installs of scan, what we are seeing on mobile, so across all of our PDF solutions. When we are talking about the business as it related to Sign, Sign actually grew faster than the Document Cloud business. And the 200% statistic that we gave has to do with Sign standalone. The way we are going to market, we introduced Sign also in the channel just very recently. So, while that's early, we're seeing good traction with Sign in the channel. The primary route to market is either through Acrobat for individuals or through the enterprises. In the enterprises, we are seeing two forms of traction. The first is where people are using Sign as the core sign solution for all of their business processes. I think, some of the partnerships that we've announced as well with Microsoft as well as with ServiceNow, we expect to see that continue to grow. And in addition to that, we've actually seen some really good traction with our document experience -- experience document sellers also demonstrating how the combination of Adobe Experience Manager, which is the core website, plus what you can do around forms and signs for business processes, how that's growing. So, across the board, we saw some really good strength in that business.
Operator: We'll take our last question from Keith Bachman with Bank of Montreal.
Keith Bachman: Hi, Shantanu. It's Keith. And I wanted to follow up on that and stay with the Document Cloud. Over the last 11 quarters, Document Cloud ARR growth is, the low is kind of 31%, the high is 36%. And even in a challenging last two quarters, the May and August quarters, it's been towards the high end of the range. And my question is, as the economy improves, could you talk a little bit about the durability? In other words, can ARR growth continue in that 34% to 35% range as you look out over the next couple of quarters? And B, also just talk a little bit about the competitive landscape, how you see your competitive offering or solution set stacking up, so to speak, against your primary competitor?
Shantanu Narayen: Sure, Keith. I mean, first, as it relates to the sustainability and durability of the Document Cloud business, it wasn't an accident that at our last analyst meeting, we talked about Document Cloud being a separate, huge standalone opportunity and accelerating document productivity. That's why we spend as much time as we have on that. Traditionally, people, Keith, used to talk about the business moving from perpetual to subscription. It has so far exceeded all of that opportunity to really focus on creating brand new customer acquisition. The web as a funnel represents a huge growth opportunity for us. I've talked also about when you think about what's happening with organic searches and the ability for people to want to share information and how that's going to be a driver of the funnel. We're excited about the API economy and what we can do to make sure that any PDF that's created anywhere or any PDF that's scanned or signed that it uses Adobe technology. And so, at the end of the day, we just look at what we have with documents and the fact that we have PDF and the fact that we have reader ubiquity as a completely differentiated solution with respect to anybody else. And this business is such a large opportunity. This is not a zero-sum game. This is something that we just continue to believe is going to fuel our business for a long time. We frankly think we're in the catbird seat, and we have the best combined offering. We have great partnerships in this space. We're innovating so much on mobile, what we've done with this feature that we call liquid mode with AI to be able to make PDFs responsive. And so, I think while the pandemic, to the question that somebody else also asked, has perhaps accelerated this movement towards electronic documents, I don't think people are going to go back because they all see the benefits and the efficiencies of being documents. So, that's how we think about that business. And we'll certainly be happy to share a lot more at our earnings call. Since that was the last question, I do hope, Keith, that both you as well as others will attend MAX because we do intend to unveil the next generation of creative innovation at MAX. As I said, we have over 200,000 people already. But net-net, I would say Q3 was an outstanding quarter. I feel really good about the strategy that we have and the contributions of our employees who have executed incredibly well in what is truly a difficult environment. We all believe that digital is going to be mission-critical. It's going to be a driver of the economy globally. And between Creative, Document and Enterprise, we have three large markets that are growth markets where our innovation agenda is stronger. I will say, we're really pleased with how we rallied around reprioritizing to get the most critical initiatives to proceed with the right urgency. And as John mentioned, we feel very well positioned to invest in growth initiatives that will continue to drive what we aspire to be, which is a growth company that also delivers great profitability. But, stay safe, stay healthy. We really appreciate all of you joining us today. And we look forward to seeing you at MAX. Over to you, Jonathan.
Jonathan Vaas: This concludes the call. Thanks, everyone. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Adobe Third Quarter Fiscal Year 2020 Earnings Conference Call. Today's call is being recorded. All participants are in a listen-only mode. Later, we will conduct a question-and-answer session instructions will be provided at that time. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s President and CEO, and John Murphy, Executive Vice President and CFO. On this call, we will discuss Adobe’s third quarter fiscal year 2020 financial results. By now, you should have a copy of the press release, which crossed the wire approximately one hour ago. We’ve also posted PDFs of our prepared remarks and financial results on Adobe’s Investor Relations website. Before we get started, we want to emphasize that some of the information discussed in this call, including our financial targets and product plans, is based on information as of today, September 15, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, you should review the Forward-Looking Statements Disclosure in our press release issued today, as well as Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Reconciliation between the two are available in our earnings release and on Adobe’s Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe’s Investor Relations website for approximately 45 days. The call audio and the webcast may not be re-recorded, or otherwise reproduced or distributed without Adobe’s prior written permission. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon. I hope all of you are safe and taking good care. The ongoing pandemic continues to result in a challenging environment everywhere around the world. People are seeking new ways to communicate, learn and conduct business virtually. Content creation and consumption are exploding in a world where connecting visually has become even more essential. Students are adapting to learning remotely instead of in a classroom. Entire industries, from media and entertainment to pharma, retail, automotive and financial services, have had to pivot overnight to digital operations to engage with customers and ensure business continuity. Electronic workflows and signatures are the only way to efficiently complete business transactions. The world has changed in a way that none of us could have foreseen. This reality has created new tailwinds for Adobe. Our mission to change the world through Digital Experiences has never been more critical. Our strategy of unleashing creativity for all, accelerating document productivity and powering digital businesses is more relevant than ever and driving our strong performance across every geography and audience. Adobe had an outstanding third quarter. We saw strength across Creative Cloud, Document Cloud and Experience Cloud. We achieved $3.23 billion in revenue in Q3, representing 14% year-over-year growth. GAAP earnings per share for the quarter was $1.97, representing 22% year-over-year growth, and non-GAAP earnings per share was $2.57, representing 25% year-over-year growth. In our Digital Media business, we drove strong revenue growth in both Creative Cloud and Document Cloud in Q3, achieving $2.34 billion in revenue, representing 19% year-over-year growth. Net new Digital Media Annualized Recurring Revenue or ARR was $458 million, and total Digital Media ARR exiting Q3 grew to $9.63 billion. We believe that everyone has a story to tell and our goal is to give all creators, from students to social media influencers, business communicators and creative professionals, the ability to create and amplify their stories. Creation and consumption across phones, tablets and desktops is exploding. Web content, mobile application creation, imaging, video, animation, screen design, AR and 3D are all surging in this new era of digital storytelling and business transformation. Enabling the capture, authoring and collaboration across each of these categories and inspiring our global communities, Creative Cloud is driving this massive content revolution. Q3 Creative Cloud performance was outstanding, with net new Creative Cloud ARR of $360 million and revenue of $1.96 billion. Driving our Q3 Creative Cloud performance was record traffic to Adobe.com, our acquisition engine, using proprietary models for attribution and optimization; strength in our Creative Cloud single-app and complete offerings across all geographies; growth in our creative mobile apps, delivering discrete revenue as well as a funnel to our multi-surface Creative Cloud offerings; improvement in retention, driven by increased engagement and product usage among individuals, teams and enterprises; outstanding performance in the imaging and video categories with Photoshop, Lightroom and Premiere Pro; and strong performance in the education segment across students, educators and institutions. Adobe MAX, the world’s largest creativity conference, will be hosted virtually in October. In addition to showcasing exciting new Creative Cloud products and services, our programming includes 56 hours of around-the-world content and features incredible creators like actor Keanu Reeves, photographer Annie Leibovitz and award-winning filmmaker Ava DuVernay. We expect a record turnout and are thrilled to already have over 200,000 registrations. With Adobe Document Cloud, we’ve reinvented how people create, edit, share and sign digital documents with Acrobat and PDF. While digital documents have always helped small, mid-sized and large businesses realize productivity and efficiency gains, they have now become central to businesses operating remotely. Supported with a rich set of APIs, Adobe Document Cloud enables seamless workflows and collaboration across devices. Q3 Document Cloud performance was exceptional, with net new Document Cloud ARR of $98 million and record revenue of $375 million. Q3 highlights included strong growth in gross new ARR coming from the Adobe Reader funnel; significant gains in Acrobat web monthly average use; Acrobat Mobile installs up 33% year-to-date; significant momentum with Adobe Sign, including our announcement to pursue FedRAMP Moderate status; key customer wins, including Citi, PwC, Pepsi, HSBC, Merkle and J-Power; and the release of the Adobe Document Cloud Resource Hub for Education, a one-stop destination outlining how Document Cloud can assist with remote learning. The shelter-in-place requirements instituted across the globe created a heightened sense of urgency among all companies to accelerate their digital transformation. Overnight, small, mid-sized and large B2C and B2B companies shifted every aspect of their customer relationships, from acquisition all the way through renewals, to digital. As a company that’s been through its own digital transformation, we have a deep understanding of what it takes to be a digital business and that experience makes us the ideal partner to help other companies do the same. Over the past decade, we have put the right technology, processes and people in place to precisely and persistently measure and manage performance every day at scale across each of our businesses. We developed a cross-company, real-time, data-driven operating model that leverages all of our Experience Cloud technology. The CXM playbook, which relies on continuous product, platform and process innovation, has fundamentally changed the way we run our Company and today we are helping our customers build their own CXM playbooks. The industry’s most comprehensive offering, Adobe Experience Cloud features industry-leading applications and services built on the Adobe Experience Platform, leveraging Adobe Sensei, our AI and Machine Learning framework. Digital Experience revenue was $838 million in Q3. Subscription revenue excluding Advertising Cloud grew 14% year-over-year. Q3 highlights include increased adoption of Adobe Experience Platform and the launch of new capabilities that allow marketers to accelerate data collection across channels to enable faster, personalized experiences based on real-time insights; general availability of Data Governance capabilities in the Real-time Customer Data Platform; early traction with our Customer Journey Analytics service, which provides customers a complete view of the Customer Journey, online and offline; acceleration in the deployment of our Adobe Experience Manager Cloud Service; significant quarter-over-quarter growth for Commerce offerings; Working with our Advertising Cloud customers to wind-down our transaction-based offerings; key customer wins, included Eli Lilly, Truist, Nike, Lowe’s, Shell, Lloyds and the U.S. Department of Commerce; a partnership with IBM and Red Hat to enable Experience Cloud deployment in hybrid cloud environments that further strengthens real-time data security for enterprises in regulated industries; and recognition as a Leader in six Gartner Magic Quadrant and Forrester Wave reports. In the Gartner Magic Quadrant for CRM Lead Management, Adobe was the leader, achieving the best scores across Ability to Execute and Completeness of Vision. Adobe’s record results would not be possible without the ongoing contributions and unwavering dedication of our employees around the world. They have demonstrated incredible resilience by quickly pivoting to a remote work environment without missing a beat. I am proud and grateful. Great companies are defined by how they manage through difficult times. Our strong corporate culture, focus on innovation, exceptional customers and partners, and always doing right by our communities, drives us and our success. We are excited about the tremendous opportunity ahead of us and look forward to continuing our strong momentum in 2020 and beyond. John?"
},
{
"speaker": "John Murphy",
"text": "Thanks, Shantanu. Adobe delivered outstanding performance in Q3, highlighted by strong net new Digital Media ARR, Digital Experience subscription revenue growth and record operating cash flows. Despite challenging macroeconomic conditions, the ongoing remote work and learning-from-home environment provided an opportunity to offset normal Q3 Summer seasonality. Our success was driven by Adobe’s unique ability to draw insights across our business in real-time utilizing our data-driven operating model. This enables us to understand demand for our solutions, make strategic investments to capitalize on the highest returns, and drive engagement and conversion across our channels, most notably our web properties. Throughout the quarter, we generated sustained levels of traffic and demand across our Adobe.com offerings, including during the summer holidays where purchasing patterns have historically softened. Utilizing our proprietary attribution technologies, we made variable marketing investments that enabled us to attract and engage new customers, delivering the strongest Q3 on record for Adobe, while at the same time maintaining fiscal discipline to accelerate earnings growth. As a result, in Q3 Adobe achieved record revenue of $3.23 billion, which represents 14% year-over-year growth. On a constant currency basis, total Adobe revenue grew 15% year-over-year. GAAP diluted earnings per share in Q3 was $1.97 and non-GAAP diluted earnings per share was $2.57. Business and financial highlights included Digital Media revenue of $2.34 billion; net new Digital Media ARR of $458 million; Digital Experience revenue of $838 million; record cash flow from operations of $1.44 billion; remaining performance obligation of $10.34 billion exiting the quarter; and repurchasing approximately 1.5 million shares of our stock during the quarter. Adobe’s strong third quarter performance shows the continued momentum across our cloud businesses. From knowledge workers to creative professionals, from small businesses to large enterprises, people are driven to engage digitally and are seeking tools that enable them to communicate more proficiently across digital platforms. In our Digital Media segment, we achieved 19% year-over-year revenue growth in Q3. On a constant-currency basis, Digital Media grew 20% year-over-year, and we exited the quarter with $9.63 billion of Digital Media ARR. Within Digital Media, we achieved another strong quarter with our Creative business. We achieved Creative revenue of $1.96 billion, which represents 19% year-over-year growth, and we added $360 million of net new Creative ARR. Our Creative growth in Q3 was driven by investing to acquire new users across all geographies and segments; continuing our relentless focus on engagement to drive retention and renewal of existing customers; successfully closing enterprise term licenses with educational institutions, as well as growing our education business through individual subscriptions by students; driving awareness and licensing of our professional video products; focusing on converting free mobile app users to paid mobile subscriptions, including strong growth in Lightroom Mobile; and utilizing insights from our data-driven operating model to run targeted campaigns and promotions. Adobe Document Cloud delivered another quarter of strong revenue growth. We achieved Document Cloud revenue of $375 million, which represents 22% year-over-year growth, and we added a record $98 million of net new Document Cloud ARR. As with our Creative business, Document Cloud is benefiting from the changing nature of work and the continued importance of digital document solutions, as individuals, enterprises and governments look to pivot away from paper-based dependencies to digital workflows. Our Document Cloud growth in Q3 was driven by investing and driving awareness in our Acrobat web business; continuing to build momentum with our mobile monetization efforts with Acrobat Reader; increasing demand for Acrobat subscriptions across all geos; and building, progressing and closing pipeline for our enterprise offerings, with particular strength in Adobe Sign, which grew enterprise bookings more than 200% year-over-year. While we saw some recovery in the SMB segment during Q3 across Digital Media, smaller businesses continue to be impacted by the macroeconomic environment. We expect this to continue to impact our Team offering across the reseller channel and on Adobe.com. Turning to our Digital Experience segment, in Q3, we achieved revenue of $838 million, which represents 2% year-over-year growth. Digital Experience subscription revenue was $729 million, representing 7% year-over-year growth. Excluding Advertising Cloud, Digital Experience subscription revenue grew 14% year-over-year. We continue to wind down the transaction-driven ad network business in Advertising Cloud. During Q3, enterprise sales and services implementations settled into a new normal of virtual engagements. We drove strong pipeline and customer acquisition across our Digital Experience solutions, as the digital transformation imperative continues to resonate with our customers. We saw acceleration of our Commerce business, and we drove increased adoption of our AEM Cloud Service and Adobe Experience Platform, which we expect to be growth drivers over the next decade. We saw particular strength with the number of transactions greater than $1 million in new annual subscription value that we closed in the quarter. While enterprises and smaller businesses continue to be impacted by the macroeconomic environment, spending in customer experience management is reemerging as the primary imperative to enable businesses to engage with their customers and ignite growth. Overall, while our focus is on investing for profitable growth, particularly in research and development, we drove significant savings from travel and entertainment and facilities operations as our employees work from home. After ensuring that our current resources are focused on the key priorities, we expect to ramp our hiring in Q4 and FY21 to capitalize on our large addressable markets. From a quarter-over-quarter currency perspective, FX increased revenue by $15 million. Net of impacts from hedging, the sequential currency increase to revenue was $10 million. From a year-over-year currency perspective, FX decreased revenue by $14 million. Net of impacts from hedging, the year-over-year currency decrease to revenue was $25 million. Adobe’s effective tax rate in Q3 was 10% on both a GAAP and a non-GAAP basis, in line with our targets. Our trade DSO was 37 days, which compares to 44 days in the year-ago quarter, and 40 days last quarter. Remaining Performance Obligation or RPO grew by 18% year-over-year to $10.34 billion exiting Q3 and grew sequentially by 4% quarter-over-quarter. Deferred revenue exiting the quarter was $3.45 billion. As I mentioned last quarter, our Adobe.com offerings, typically billed monthly, are reported as unbilled backlog, whereas channel offerings billed annually up front are reported as deferred revenue. The strength in acquisition on Adobe.com during the quarter continues to drive a mix-shift from deferred revenue to unbilled backlog. Our ending cash and short-term investment position exiting Q3 was $5.26 billion, and cash flows from operations in Q3 were a record $1.44 billion. In Q3, we repurchased approximately 1.5 million shares at a cost of $617 million. We currently have $2.9 billion remaining of our $8 billion repurchase authority granted in May 2018, which goes through 2021. For Q4, factoring current macroeconomic conditions, typical year-end seasonal strength and the strategic shift related to our Advertising Cloud business, we are targeting: total Adobe revenue of approximately $3.35 billion; Digital Media segment year-over-year revenue growth of approximately 18%; net new Digital Media ARR of approximately $540 million; Digital Experience segment revenue approximately flat year-over-year; Digital Experience subscription revenue growing approximately 1% year-over-year, or 12% when excluding Advertising Cloud revenue; tax rate of approximately minus 90% on a GAAP basis and 10% on a non-GAAP basis; share count of approximately 485 million shares; GAAP earnings per share of approximately $4.29; and non-GAAP earnings per share of approximately $2.64. The GAAP tax rate is benefitting from planned changes to optimize our international structure in Q4 to better align ownership of certain intellectual property rights with how our business operates, as we discussed during our Q1 call earlier this year. In summary, we expect a strong Q4 to conclude another year of record revenues and earnings for Adobe. Through these times, the resilience of our employees and our business model have been evident. As our market-leading solutions continue to resonate with individuals and enterprises across the globe, we remain excited about the growth opportunities ahead. Back to you, Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, John. As we announced earlier this year, Adobe MAX, our annual creativity conference, will be an online event this October. Information about the event can be found at max.adobe.com. Today we also announced that Adobe will host its fourth quarter and fiscal year 2020 earnings conference call and financial analyst meeting online on December 10th, where we will provide an overview of the Company’s strategy and financial targets for fiscal year 2021. Invitations will be sent to our analyst and investor list in the coming weeks. If you wish to listen to a playback of today’s conference call, a webcast archive will be available on Adobe’s IR site later today. You can also listen to a phone replay by calling the numbers shown above. The phone playback service will be available beginning at 5 pm Pacific Time today and ending at 5 premium Pacific Time on September 22nd. We would now be happy to take your questions, and we ask that you limit your questions to one per person. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] We'll take our first question from Kirk Materne with Evercore ISI."
},
{
"speaker": "Kirk Materne",
"text": "Yes. Thanks very much and congrats on the quarter. Shantanu, something maybe to start the day -- or my question’s actually just going to be around the Experience Cloud business. Obviously, you guys are divesting the Advertising Cloud part of that. But, just in terms of the commentary, it seems like the pipeline's building nicely, RPO was up nicely in the quarter, yet revenue guidance for next quarter is down a little bit. I was wondering if you could just square that up, because it sounds like your enthusiasm for that opportunity still remains very-high. But, I think, some people might be wondering, why maybe is revenue not sort of matching up with that? Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, happy to. And as you pointed out, I mean, firstly, digital transformation is a massive addressable opportunity. And it's clear that we are the leaders. We had a great quarter. Bookings grew north of 15%. As you saw, we had good revenue. We successfully have introduced brand new products, which we believe are going to be the growth drivers from what we did with the Adobe Experience Platform, what we did with Customer Journey Analytics, the Customer Data Platform, as well as what we are doing around both, Commerce as well as the Adobe Experience Cloud in the Cloud Service. So, the business and the interest frankly, because there isn't a small and medium business or large enterprise that isn't interested in how digital can help them deal with the current health situation. So, bookings have been strong, business has been strong. I think, as it relates to revenue, you have to continue to think about the wind-down of the Advertising Cloud business, which continues to happen. We expect bookings to be strong. And then, the other issue for us is really, as the macroeconomic environment, you think about the spending patterns, but net-net for us, we thought the business did really well. It was a great rebound, from what we had expected in Q2, which was both on the consulting side as well as on the net ASP, we thought it would be slightly slow. So, we're really excited. And we're in the sweet spot of what is clearly a growth business."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Saket Kalia with Barclays Capital."
},
{
"speaker": "Saket Kalia",
"text": "Shantanu, maybe just to stay on the Digital Experience business. Zooming out a little bit strategically, I think Anil Chakravarthy is still getting settled in as leader of the DX business and field operations. I guess, the question is, what are some of his objectives, particularly in the DX business that you're most excited about for next year?"
},
{
"speaker": "Shantanu Narayen",
"text": "So, Saket, first, I will say this, his has been the fastest ramp that I have seen of any executive that we've got. So, he is doing an absolutely fantastic job, and a great addition to what you know is already a very strong management team that I'm blessed with at Adobe. Maybe I would say three things. The first is on the product side, he's really got his hands around the platform and the innovation associated with the platform, the delivery of Customer Journey Analytics. We had a great quarter with the Adobe Experience Platform and a number of customers adopting it, what we are doing around CDP and the real-time nature of what we can do as well as intelligent services that are leveraging Adobe Sensei. So, on the product and innovation making sure that we have this platform that we integrate all our products is really added a lot of value there. But that will continue to be the area where I think we can completely differentiate ourselves relative to anybody else. Because while others are talking about providing this unified profile, as you know, we have tens of billions profiles already in Adobe Experience Platform. I think, the second area is with the unified organization really focusing on the customers and the customer centricity and what we are doing with partners. The structure for U.S. and international is set up. And he is focused on aggressively evangelizing both, our vision as well as the differentiation in the marketplace. And one side benefit, Saket, of everybody working from home is we can engage with customers so much better, and routine day consists of significant customer engagement. So, that's clearly the area that he's focused on, because he needs to be out there as the leader of this. And third, I would say, the culture. Adobe's culture has always been a unique point and focus on talent and hiring, and where there is significant opportunity, making sure that we have the best talent. So, he's already been able to recruit some key people as additions to his management team. But, there is a lot to do and there is a lot that he's done. And so, we're very excited about having him onboard."
},
{
"speaker": "Saket Kalia",
"text": "Got it. Very helpful. Thanks, guys."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Brent Thill with Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Good afternoon. Shantanu, Q4, the Digital Media guide well above the Street. You’ve clearly seen a lot of great tailwinds in that business. I'm curious if you could just kind of unpack the drivers and what you're seeing for the upside surprise relative to Street numbers?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. Brent, I'm surprised you didn't talk about the Q3 upside as well. I mean, we just saw [Multiple Speakers]. Fair enough. We saw tremendous performance. I mean, as you see, what's happening in both creativity and document productivity, Brent, I mean, the business is just firing on all cylinders. And that has to do both with products, as well as, frankly, with services. We didn't maybe comment specifically on the services, but the services, the stock business just continues to do well, there's no question we're gaining market share. The sign business has grown very successfully. But if you continue to think about, I think, what's driving that business, the first is, we sharpened our focus on usage and engagement. And the usage and engagement that we did really help improve retention rates back to the pre-COVID levels. So, that focus will just continue. We have a very large book of business. The education, education had a good quarter. So, we have continued focus on education. Individual apps, we talked about Lightroom, Photoshop and Premiere Pro as areas where there is a lot of interest in our business. And also, the sophistication of what we talked about, namely the marketing attribution, and models, it just helps us spend money so efficiently and sustain the durability of the acquisition of new customers and trends. So, as you pointed out, when we look at the second half performance, it just demonstrates how both, Creative Cloud and Document Cloud frankly are the preeminent platforms. And we should continue to see good strength from our Q3 back into Q4. So, we're excited."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Kash Rangan with Bank of America."
},
{
"speaker": "Kash Rangan",
"text": "Nice to go right after Brent here. Thank you so much, and congratulations on your quarter. Shantanu, you talked about how the pandemic has actually resulted in better customer engagement. But, as we come out of the pandemic, if there's ever such a thing called coming out of this pandemic if we got vaccine, how does the business perform? And do you feel that this actually lengthens the cycle for the transformation, or do you think we could be in a pocket, halo effect where things get pulled in a little bit, because we’ve got all this time to do more work and there is a bit of catch up and then of course a longer term secular trajectory Digital Transformation is unchanged? I mean, how are we to think about for the environment? Environment is actually unusually supportive of your result -- not only your results but all of the software companies, so that you might get a little bit of pull back if we enter into a normal economy. Sorry to word it that way, but just curious to get your thoughts. Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. Kash, we've been talking about the trends that are going to be tailwinds across each of our businesses, whether it was Creativity, Document Productivity or a specifically to your question, Digital Transformation. The genie's not going to vote back in the bottle. I mean, we've certainly seen, as you point out, an inflection in the business, as it relates to the demand in digital transformation. But, my perspective on this business is, it's just going to gain importance. I think, as the macroeconomic environment improves, the spending will actually open up in terms of what people spend. And we've been touching on customer experience management as a imperative and a priority for enterprise spend for a while, and I don't think that changes. So, I think everybody's recognizing that not having a commerce website, not being able to engage digitally with customers -- and I think the two areas where we're seeing the most excitement is this unified profile. Because people now absolutely recognize where you have a physical presence and you have a digital presence, you have to absolutely create a unified experience, and that I think is only going to accelerate. So you will see more physical perhaps once the vaccine is present. But, that's not going to change the need to provide this unified experience. And on the marketing spend side, more and more is going to go digital and people will want to run more of these digital campaigns with customers. So, I think the basic trends of personalization of unified profile of customer experience management are only going to continue once the pandemic. And I actually feel like that should hopefully signal an improvement in the macroeconomic environment for everybody. I think, a lot of what's happened right now is people want to spend in digital, but their spending ability may be limited. And as that spending ability opens up as the economy improves, I don't think it changes the priority. I think, it frankly opens up spending."
},
{
"speaker": "Kash Rangan",
"text": "Very insightful. Thank you very much. Congrats."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Kash."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Brad Zelnick with Credit Suisse."
},
{
"speaker": "Brad Zelnick",
"text": "Excellent. Thank you so much, and congrats on the really strong Q3. John, my question is for you. In your prepared remarks, you talked about the variable marketing investments that enabled Adobe to attract and engage new customers, which clearly worked well. Can you comment on what you're seeing in terms of ROI trends on marketing spend and reasons to believe they may or perhaps may not be sustainable? Thanks."
},
{
"speaker": "John Murphy",
"text": "Sure. Thanks again, Brad for the question. I think, when we look at our capabilities with DDOM or data-driven operating model, the level of precision, which we’re able to see performance in our business real time really allows us to surgically invest where we know we can be successful. And so, you can see that in the performance obviously in our books in Q3 and where we think we can drive a metric in Q4. So, we have a lot of confidence in investing for appropriate return. And also looking at the breadth of the different markets we're trying to attract to the platform's both CC and BC. So, we monitor that very carefully. We don't just throw money at in variable marketing just to see where it lands. We're actually measuring very completely every dollar that we invest in that space."
},
{
"speaker": "Shantanu Narayen",
"text": "And Brad, maybe if I were to add just a little bit on top of that, what you have to do is again, harking back to what we said is the overall addressable market opportunity for all of our businesses and on the Creative and Document Cloud route as we talk about a greater than $30 billion addressable opportunity. This sophistication just helps us target all those people with more efficiency. And, as John said, the constant changing nature of where that marketing goes, we definitely view that as a differentiation for us in terms of what product, what service, what geography across what channel."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Jennifer Lowe with UBS."
},
{
"speaker": "Jennifer Lowe",
"text": "Great, thank you. I wanted to touch on the gross margin within the Digital Experience business. And as talked about earlier, my understanding was that as the Ad Cloud winds down, there should be a gross margin benefit attached to that. But, if I look at the GAAP gross margins in Digital Experience, they’re actually down a little bit quarter-over-quarter. So, sort of related to that first, how should we think about the costs associated with Ad Cloud rolling off the cost of goods sold line, over the coming quarters? And secondly, how should we think about the margin profile of that business once that wind down has happened?"
},
{
"speaker": "Shantanu Narayen",
"text": "I can add, and then Jennifer, John, certainly feel free. I mean, overall, on that business, I think there was a slight performance in what we saw in the Ad Cloud revenue in the quarter. So, that might account for what you are referring to. I think, big picture, we just look at it and say, this is a growth business. What we've been able to do by aligning is to make sure that we're focused on the highest priority growth objectives. And so, it's still a growth business that's a real focus for us. But, as it relates to the overall margins, I mean, the Company performed exceedingly well. I would argue, maybe we were a little conservative, frankly, because we were unclear of the macroeconomic environment in terms of hiring, but we're certainly going to be opening up the hiring in research and development to continue to do differentiate ourselves. And on the Digital Experience, now that we've consolidated the organization, we've eliminated all the inefficiencies. We made the strategic change on Advertising Cloud. Now, we feel like it's all going to be profitable growth as we invest in the Digital Experience business."
},
{
"speaker": "John Murphy",
"text": "Quarter-over-quarter, it’s really a part of the overall performance of Ad Cloud as we had been transparent for customers, we helped them transition to other services, but we also helped them run campaigns that were scheduled. In addition, the volume of activity across our other products did actually increase some of our cloud -- specially our cloud costs or third party cloud costs. So, that's something that we are marking very closely so that we can leverage the volume and negotiate our contracts appropriately and drive efficiencies across our clouds."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Jay Vleeschhouwer with Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. Shantanu, the Company has often spoken in the past, for instance, at Summit presentations, that you've identified about four dozen used cases for DX. And the question is, setting aside Ad Cloud and whatever part of that mix they may have accounted for, what trends or evolutions have you been seeing in the number or mix of use cases within DX? And then, related to that perhaps you could also update us on the applications and intelligence services that you previewed back at Summit earlier this year, at how that might flow into the various use cases and more importantly, the DX growth that you're anticipating?"
},
{
"speaker": "Shantanu Narayen",
"text": "Sure. Jay, I think what's been consistent in the business and areas that continue to show both, growth as well as interest from customers is first and foremost content and data. And so, I think when we think about what's happening with content, the use case of people increasingly moving to cloud services on the Adobe Experience Manager side, creating new mobile applications than engaging directly with customers, I think that just continues to be an area of significant growth. On the data side, as we have added more capabilities, both to Adobe Analytics, as well as with the Adobe Experience Platform of being able to say what is the insight that people are getting, I mean, we're all looking at data, even more stringently in this environment. And so, the use case associated with going from collecting that data to getting insights on that data, the demand for that particular area of our solutions, including in intelligent services, whereas as you know, we have intelligence services that are associated with each of the solutions. That's an area of increase. I would say, the third area is this unified profile and just being able to get all of the data, that's clearly a trend, Jay. Because people recognize that they have all these silos. And that was even more accentuated by what's happening in the health. So, the need and desire to get this unified profile, so that they can serve the customer adequately, that use case. And when we are talking about Customer Journey Analytics, how you do the equivalent of what we have done with DDOM, I think that's the use case that's clearly resonating with customers. Commerce, I would say, the commerce use case and how you have to find different models, whether it's a subscription based business model of transacting with customers, whether it's loyalty based business model, so I think the commerce and using commerce to accomplish new business models, I think that use case has also increased. And the last thing I would say is between B2B and B2C? We've talked about that distinction blurring. But, I think all B2B companies, still stating how can we both work directly and engage with customers as well as through a network of partners, I hear that over and over again. So whether you're a company providing goods through a distribution channel, whether you're a car manufacturer, all of them recognize that they have to bridge this gap between being deemed a B2B company and a B2C company."
},
{
"speaker": "Operator",
"text": "We’ll take our next question from Sterling Auty with JP Morgan."
},
{
"speaker": "Sterling Auty",
"text": "You mentioned in your prepared remarks that the SMB segment showed some improvement in the quarter. Can you just give us maybe from a high level, how much does the business have at this point to SMB? And even into that prosumer area where maybe some of the stimulus being talked about would have a bigger impact."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. Sterling, we looked at both those trends quite a bit as we went through the quarter. And, I would say, as it relates to the stimulus, when the first package came out, this was early, we saw appreciable difference in sort of the payment successes and what happened with the individual subscribers. So, we saw a correlation associated with that, subsequent ones have not. And as I said, the engagement work that we did helped us get retention back up to the levels that we had pre-COVID. So, I don't know whether that was a initial catalyst. But to us, it just demonstrated the increased importance of the solutions that we provide. As it relates to the small and medium business segment, again, that is through the team offering a lot of that happens through the channel. And Q3 we saw some strengthen that. So, I don't know that we've broken out Sterling, what percentages exactly on individual versus team versus enterprise. It is a big part of our business because small and medium businesses certainly use both our creative and document tools, but we were pleased with what we expected. As it relates to our Q3 targets, we're still going to be a little cautious about seeing the rebound in that SMB. So, we're not necessarily expecting significant new acquisition in that, but we were pleased with what we saw in Q2. And long-term, we just continue to think that our solutions help them become a digital enterprise, which is going to become more important."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Alex Zukin with RBC Capital Markets."
},
{
"speaker": "Alex Zukin",
"text": "So, maybe a combo question for Shantanu and for John. Shantanu, you're seeing kind of now two straight quarters of all time highs for traffic on Adobe.com. And according to our data, it would actually appear the trend is only accelerating. So, I guess the question is back to that durability, kind of what's driving that acceleration? And how would you think about the durability of that 20-plus-percent Digital Media ARR growth trends as you sit here today? And then ultimately, maybe John remind us, what kind of rules should we remember in our models, as DM ARR stays above 20%? Is that -- what kind of churn assumptions we should think about when looking at Digital Media revenue growth next year?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. Alex, as it relates to the overall macro demand, it's just the amount of content that's being created is just absolutely exploding and it actually doesn't matter whether you're, as we talked about, an individual who has a story that they want to tell a small and medium business who has to transact businesses online, and therefore has to create the appropriate content, whether it's a large enterprise that is increasingly engaging digital, and therefore wants the appropriate personalized content. And I think that trend will only continue to speak well for Adobe. We look at some other trends like the number of people engaging with us on Behance, which is our community. We're getting more part of Behance being used than ever before. What we are doing with Spark, which is allowing prosumers and others who have a task-based offering to come. So, we just continue to think that the amount of content being created and the amount of content being consumed is only going to go up. And we have the premier offering in that space, not only from the product side, but from also the DDOM side. And so, I think it really continues to augur well for us. And, we will certainly give you more color as we come up to fiscal '21 on what we expect moving forward. But, we're excited about the opportunity."
},
{
"speaker": "John Murphy",
"text": "Yes. In regards to your comments and we touched and Shantanu said, the efforts that we’re putting to engaging our customers and making sure that they are using the right product for the right use case has really driven retention efforts really well in that engagement. And of course, the fact that we'll be able to see a return to kind of pre-COVID levels is indicative of people seeing value in the products that they’re using."
},
{
"speaker": "Alex Zukin",
"text": "Got it. Thank you, guys."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Stan Zlotsky",
"text": "Perfect. Thank you so much, guys. This is Stan Zlotsky sitting in for Keith. A quick question for John. Very strong margins in Q3, record margins on operating margin side. What should we keep in mind as far as margins as we head into Q4, and what's embedded in the EPS guidance for the quarter? Thank you."
},
{
"speaker": "John Murphy",
"text": "Sure. Thanks, Stan. When we entered Q3 and really looked at really focusing our resources on the top priorities. Once we got through that activity and we felt really comfortable with the performance that we were seeing, we realized that we probably being a little conservative were slower out of the gate ramping our hiring. We're committed to ramping our hiring now going into Q4 and into FY21to really drive the opportunities that we see to drive performance in these opportunities. So, we're investing in R&D and you'll see that kind of manifest in our Q4 hiring and into FY21. And we do believe that some of the other OpEx savings that we’ve had, onetime savings around travel and facilities and in-person events are going to change as we start to reopen our offices when it's safe. And so, we don't expect the level -- the lack of spending in those areas in Q3 to be sustainable going forward. So, that is something to consider when you look at the operating margin performance in Q3."
},
{
"speaker": "Stan Zlotsky",
"text": "Perfect. Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Walter Pritchard with Citi."
},
{
"speaker": "Walter Pritchard",
"text": "Hi. I'm wondering, John, or Shantanu, if you could talk about retention, and you highlighted out of your prepared remarks around improvement in retention. And maybe just directionally, you talked a little bit about some headwinds there a quarter ago, where you are now versus retention in sort of the steady state? How much you dipped down, and if it varies much by the various segments of your Digital Media business?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think, Walter, maybe looking at it now in retrospect, I don't know if -- when COVID first hit, whether there was a shock to the system and therefore people reacted. And I think that has settled down, as we said in -- a couple of times. It's definitely gone back to the pre-COVID levels. I think, I would also give our team tremendous credit for what we've done around engagement. I mean, the good news for us, Walter, is we have such a variety and portfolio of products that we can use. And, let's take Acrobat where we haven't spent -- we haven't got as many questions. I mean, from everything we can do around Acrobat on the web, to what we can do with the Reader funnel to Acrobat. And so, we really just are a world class machine on both the acquisition and increasingly on the engagement retention. So, my best guess is there was a little bit of a shock to the system. That has definitely stabilized, that provided the impetus for us to really focus on engaging more with customers and delivering the value. And last but not least, I think it just shows how mission critical these products are. And so, again, it's very different by offering to the second part of your question. But, within enterprises, within creative pros, we just continue to see a really good retention and really good acquisition."
},
{
"speaker": "Walter Pritchard",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Derrick Wood from Cowen and Company."
},
{
"speaker": "Derrick Wood",
"text": "Great. Thanks for taking my question. Shantanu, you mentioned that the education vertical had a good quarter, and I think there was some uncertainty around health of spending here, given all the change institutions have had to go through. I guess, since we're in back-to-school mode right now, though, obviously a much more virtual bend to it. Can you talk about what you've seen out of the education vertical in terms of demand and usage patterns and how that works typically in back-to-school season, and kind of what insights that gives you as we progress through the school year?"
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, Derrick. And again, I mean, first, let me acknowledge that I think for both parents of young kids as well as those who have college going kids, I mean, there is still a quite a bit of uncertainty of what happens. But, as it relates to the strength, I mean, we saw strength, both in terms of students, educators, as well as in institutions. And so, we saw strength across the board. Part of what I would attribute that to is, when it first struck and everybody was from home, if you have a young kid or a college going kid, you want to continue to invest in making sure that they have access to the best software. I think, we did a good job of provisioning Creative Cloud and ensuring that they have access to Creative Cloud. And then, we pretty actively went out with our field organization, both in terms of licensing products, as well as the enterprise type licenses that you can have for institutions to demonstrate it. And the last thing I would say is, we are seeing more and more curricula in these institutions also add so much more on creativity as part of their curricula. So, I think that's a trend that is also helping our business."
},
{
"speaker": "Derrick Wood",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Ken Wong with Guggenheim Securities. Mr. Wong, please unmute if you’re muted."
},
{
"speaker": "Ken Wong",
"text": "Oh, sorry about that. Thanks for taking my question. John, you mentioned in the prepared remarks, seeing an acceleration of Adobe Commerce. Just when thinking about how you guys licensed the product, when should we expect to see that benefit revenue? Is that something you're already capturing or is that down the line at renewal time?"
},
{
"speaker": "John Murphy",
"text": "Yes, it really is both. Thanks, Ken, for your question. So, we certainly saw commerce revenue perform this quarter and certainly the bookings associated with the demand for commerce offerings increase this quarter. So, we just see the momentum there. People are really resonating with the product. They're seeing that it's a great add-on as well when they're looking at some of our other solutions in digital transformation in the segment. So, we think there's a nice tailwind there in commerce."
},
{
"speaker": "Shantanu Narayen",
"text": "And to your second question Ken -- I mean, John, we certainly have bands. And since we have bands and we don't charge based on necessarily the immediate transaction, what happens is as people come up for renewal, which was the second part of your question, Ken, yes, the intention is that they both true-up as appropriate and/or move to a higher band."
},
{
"speaker": "Ken Wong",
"text": "Great. Thanks, guys."
},
{
"speaker": "Jonathan Vaas",
"text": "Operator, we're coming up on the top of the hour. We'll take two more quick questions. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Mark Moerdler with Bernstein Research."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you, and congrats on the strong quarter. I was impressed in the comment on the 200% year-over-year growth in enterprise bookings driven by Adobe Sign. Can you give more color? Is this growth in full Document Cloud, is this a portion of that? Any color on the percentage of document sign -- Document Cloud that is now from enterprise agreements? I appreciate it. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, Mark. And as you point out, and we didn't get too many questions, I mean, the Document Cloud really had a very strong business. And at the macro level, the strength of Acrobat, all the verbs that we have including Sign, the frictionless Acrobat web and the platform APIs, we're really convinced we have the right platform for document creation, sharing, signing, exporting and scanning. I mean, scan also, the number of installs of scan, what we are seeing on mobile, so across all of our PDF solutions. When we are talking about the business as it related to Sign, Sign actually grew faster than the Document Cloud business. And the 200% statistic that we gave has to do with Sign standalone. The way we are going to market, we introduced Sign also in the channel just very recently. So, while that's early, we're seeing good traction with Sign in the channel. The primary route to market is either through Acrobat for individuals or through the enterprises. In the enterprises, we are seeing two forms of traction. The first is where people are using Sign as the core sign solution for all of their business processes. I think, some of the partnerships that we've announced as well with Microsoft as well as with ServiceNow, we expect to see that continue to grow. And in addition to that, we've actually seen some really good traction with our document experience -- experience document sellers also demonstrating how the combination of Adobe Experience Manager, which is the core website, plus what you can do around forms and signs for business processes, how that's growing. So, across the board, we saw some really good strength in that business."
},
{
"speaker": "Operator",
"text": "We'll take our last question from Keith Bachman with Bank of Montreal."
},
{
"speaker": "Keith Bachman",
"text": "Hi, Shantanu. It's Keith. And I wanted to follow up on that and stay with the Document Cloud. Over the last 11 quarters, Document Cloud ARR growth is, the low is kind of 31%, the high is 36%. And even in a challenging last two quarters, the May and August quarters, it's been towards the high end of the range. And my question is, as the economy improves, could you talk a little bit about the durability? In other words, can ARR growth continue in that 34% to 35% range as you look out over the next couple of quarters? And B, also just talk a little bit about the competitive landscape, how you see your competitive offering or solution set stacking up, so to speak, against your primary competitor?"
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, Keith. I mean, first, as it relates to the sustainability and durability of the Document Cloud business, it wasn't an accident that at our last analyst meeting, we talked about Document Cloud being a separate, huge standalone opportunity and accelerating document productivity. That's why we spend as much time as we have on that. Traditionally, people, Keith, used to talk about the business moving from perpetual to subscription. It has so far exceeded all of that opportunity to really focus on creating brand new customer acquisition. The web as a funnel represents a huge growth opportunity for us. I've talked also about when you think about what's happening with organic searches and the ability for people to want to share information and how that's going to be a driver of the funnel. We're excited about the API economy and what we can do to make sure that any PDF that's created anywhere or any PDF that's scanned or signed that it uses Adobe technology. And so, at the end of the day, we just look at what we have with documents and the fact that we have PDF and the fact that we have reader ubiquity as a completely differentiated solution with respect to anybody else. And this business is such a large opportunity. This is not a zero-sum game. This is something that we just continue to believe is going to fuel our business for a long time. We frankly think we're in the catbird seat, and we have the best combined offering. We have great partnerships in this space. We're innovating so much on mobile, what we've done with this feature that we call liquid mode with AI to be able to make PDFs responsive. And so, I think while the pandemic, to the question that somebody else also asked, has perhaps accelerated this movement towards electronic documents, I don't think people are going to go back because they all see the benefits and the efficiencies of being documents. So, that's how we think about that business. And we'll certainly be happy to share a lot more at our earnings call. Since that was the last question, I do hope, Keith, that both you as well as others will attend MAX because we do intend to unveil the next generation of creative innovation at MAX. As I said, we have over 200,000 people already. But net-net, I would say Q3 was an outstanding quarter. I feel really good about the strategy that we have and the contributions of our employees who have executed incredibly well in what is truly a difficult environment. We all believe that digital is going to be mission-critical. It's going to be a driver of the economy globally. And between Creative, Document and Enterprise, we have three large markets that are growth markets where our innovation agenda is stronger. I will say, we're really pleased with how we rallied around reprioritizing to get the most critical initiatives to proceed with the right urgency. And as John mentioned, we feel very well positioned to invest in growth initiatives that will continue to drive what we aspire to be, which is a growth company that also delivers great profitability. But, stay safe, stay healthy. We really appreciate all of you joining us today. And we look forward to seeing you at MAX. Over to you, Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "This concludes the call. Thanks, everyone."
}
] | Adobe Inc. | 24,321 |
ADBE | 2 | 2,020 | 2020-06-11 17:00:00 | Operator: Good afternoon and welcome to the Adobe Q2 FY ‘20 Quarterly Earnings Call. [Operator Instructions] Today’s conference is being recorded. I would like to turn the conference over to our Vice President of Investor Relations, Jonathan Vaas. Please go ahead, sir.
Jonathan Vaas: Good afternoon and thank you for joining us. With me on the call today from their home offices are Shantanu Narayen, Adobe’s President and CEO; John Murphy, Executive Vice President and CFO, as well as Mike Saviage, who in March announced his retirement as Adobe’s Head of Investor Relations and is continuing to assist with the transition. On this call we will discuss Adobe’s second quarter fiscal year 2020 financial results. By now, you should have a copy of the press release, which crossed the wire approximately 1 hour ago. We have also posted PDFs of our prepared remarks and an updated datasheet on Adobe’s Investor Relations website. Before we get started, we want to emphasize that some of the information discussed in this call, including our financial targets and product plans is based on information as of today, June 11 and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks and uncertainties, you should review the Forward-Looking Statements Disclosure in our press release we issued today, as well as Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe’s Investor Relations website for approximately 45 days. The call audio and the webcast may not be re-recorded or otherwise reproduced or distributed without Adobe’s prior written permission. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan and good afternoon. I hope you and your families are safe and healthy. Adobe’s second quarter coincided with what we hope was the peak of the COVID-19 pandemic. Around the world, people shifted their attention to their health and their families. Businesses focused on protecting their employees, financial stability and continuing to serve their customers. Unfortunately, millions of people have lost their jobs and small and medium-sized businesses have been hit particularly hard. Through this crisis, Adobe’s focus remains on employee health and safety, serving our customers and on ensuring business continuity. We took early and decisive action to direct our teams to work from home, suspend travel and cancel in-person events through 2020 to flatten the curve. To support the communities in which we live and work we have donated over $5 million and 22,000 hours of virtual volunteer time to COVID-19 relief organizations. We are also proud to be part of the coalition that developed the COVID-19 Testing Data Response Platform, providing test screening, appointments and insights for public health officials and government. We immediately instituted work streams to control discretionary expenses and evaluate our strategic priorities to double down on those that will drive the greatest growth and profitability for the long-term. Through all of this, the resiliency and flexibility of our employees has been awe-inspiring. I am proud of how our employees transitioned to this new reality. Adobe is the digital experiences company, with millions of global customers relying on our products every day to create the world’s content, automate critical document processes and engage with their customers digitally. Adobe’s leadership in three large and growing categories, Creative Cloud, Document Cloud and Experience Cloud, is driving our performance. Adobe drove strong Q2 performance across Adobe Creative Cloud, Adobe Document Cloud, and Adobe Experience Cloud. We delivered $3.13 billion in revenue in Q2, representing 14% year-over-year growth. GAAP earnings per share for the quarter, was $2.27 and non-GAAP earnings per share was $2.45. In our Digital Media business, we drove strong revenue growth in both Creative Cloud and Document Cloud in Q2. Net new Digital Media annualized recurring revenue or ARR was $443 million and total Digital Media ARR exiting Q2 grew to $9.17 billion. Q2 Creative revenue was $1.87 billion, which represents 17% year-over-year growth. Net new Creative Cloud ARR was $352 million. The past couple of months have shown us that in times of uncertainty people are turning to creative expression to learn, cope and make an impact. Adobe Creative Cloud is the center of this new creative renaissance, unleashing creativity for all and empowering millions of people around the world to tell their stories. As schools faced physical closures and moved online, we focused our attention on enabling them to create from home. We immediately provisioned 30 million students at home with Creative Cloud and provided teachers distance learning support. In Q2, we saw historic highs in adobe.com traffic across both Creative Cloud and Document Cloud. Demand for our professional video products was particularly high with strong engagement for Adobe Premiere Pro and After Effects. We continue to see steady growth from social content creators using Premiere Rush, which saw a 75% increase in monthly active users quarter-over-quarter. Mobile traffic, member sign-ups and monetization continues to accelerate. Adobe Fresco has seen a greater than 40% increase in downloads since the start of 2020. Photoshop Express has surpassed 20 million in monthly active users. Our teams are gearing up for a significant Creative Cloud update later this month featuring exciting new product innovation as well as new capabilities designed to facilitate collaboration between creators, particularly important in this environment. We are excited to make Photoshop Camera generally available on iOS and Android this week, bringing the magic of Photoshop to the point of capture. Photoshop Camera is a fun and easy consumer app targeted at social creators, an increasingly important segment for Adobe. At Adobe, we believe everyone is a creator and we need to make products suitable for different skill levels. Adobe Spark, available both on the web and as a mobile app, is targeted at the large group of communicators who need to create social graphics, web pages and short videos for their business, school or community. As part of the strategic review of our Creative business, we have decided to increase our investment in two exciting areas, providing new solutions that address the unmet needs of the communicator segment and ensuring that the web browser is a first-class authoring platform. We are proud of the role we play in inspiring the global creative community. With our Honor Heroes campaign, we galvanized our community to create artwork honoring essential workers on the frontlines. We created an Adobe Fresco-compatible Digital Coloring Book and launched a creative campaign with musician Marshmello challenging fans to create a video for his latest single, Be Kind. Document Cloud revenue in Q2 was a record $360 million and we grew Document Cloud ARR to $1.24 billion. With Adobe Document Cloud, we are accelerating document productivity, enabling our customers to engage, transact and collaborate seamlessly in a remote work environment. As we did with Creative Cloud, we implemented several programs to support our customers. This included making our web-based PDF services on adobe.com free and implementing a Government Rapid Response program to assist local governments by providing extended trials for Adobe Document Cloud. The shift to remote work has driven a surge in demand for digital documents, with use of web-based PDF services, up nearly 40% quarter-over-quarter and the number of documents shared in Acrobat, increasing 50% year-over-year. We continued to drive strong adoption for Adobe Sign, our cloud-based electronic signature solution, with usage increasing 175% since the start of our fiscal year. Mobile usage exploded with Acrobat Reader installations increasing 43% year-over-year and Adobe Scan installations up 66% year-over-year. We are proud of the role our technology is playing in enabling our government customers to accelerate their transition to digital. The City of Seattle’s digital workplace division deployed Adobe Sign across its departments when the city quickly shifted to telework. The State of Utah is using Adobe Acrobat and Sign as part of its telework initiative to facilitate emergency response and streamline communication across the state. As part of the strategic review of our Document business, we are increasing investment in Adobe Sign and our PDF services on the web and availability of PDF functionality through APIs to capitalize on the wholesale shift to remote work and digital-first document processes. In our Digital Experience business, we achieved Experience Cloud revenue of $826 million for the quarter. As outlined at our last earnings call, we saw anticipated delays in enterprise bookings and consulting services implementations as companies prioritized employee and financial well-being. The extreme economic challenges that enterprise customers in certain verticals experienced as well as weakness in our commercial segment that targets small and medium sized businesses also adversely impacted bookings. In addition, the significant global decline in advertising spending impacted our Advertising Cloud revenue. Despite the short-term challenges, the mandate to digitally transform has taken on heightened urgency. Enterprises continue to recognize Adobe’s leadership in Customer Experience Management. Key customer wins in the quarter included IBM, Walgreens, Safeway, Astellas Pharma, and Allianz. We are dedicated to our customers’ success and proud to see the impact our technology is having. Government organizations such as the U.S. Census Bureau are relying on Adobe Experience Cloud to modernize citizen experiences. 3M and Verizon are reaping the benefits of the Adobe Experience Platform and we now cumulatively have over 10 billion active customer profiles running on Adobe Experience Platform. Adobe Experience Cloud was named a leader with the highest position among 19 vendors in the Gartner Magic Quadrant for Multi-channel Marketing Hubs as well as a leader by Forrester in the B2B and B2C Commerce Suites Wave reports. We successfully transitioned Adobe Summit to an exclusively digital event, where we debuted new Adobe Experience Cloud innovation, including Intelligent Services, Customer Journey Analytics and the Customer Experience Management Playbook. The Adobe Summit Live virtual experience enabled us to engage a far larger audience than an in-person event and set the bar for virtual events. Cumulatively, we have engaged with more than 0.5 million visitors. While it was difficult to imagine only conducting business with CMOs and CIOs virtually, a side benefit of everyone working at home is that we are able to schedule and engage with far more customers across multiple continents. In all these discussions with business leaders, it is clear that investments in digital and specifically customer experience are more important than ever. As a result of the strategic review of our Digital Experience business, it is clear that we have an unparalleled value proposition and market leading solutions across content and commerce, customer journey management and customer data and insights, all powered by the Adobe Experience Platform. To further our lead, we are increasing our investment in AI and machine learning, next-generation applications and services on the Adobe Experience Platform, and accelerated integration of our content and commerce offerings. Our current advertising offerings consist of Advertising Cloud software solutions as well as Advertising Cloud transaction-driven solutions. We will continue to offer our Advertising Cloud software solutions to our Digital Experience customers, but this will not be an area of growth moving forward. CMOs want a single source of reporting and attribution for their advertising investment, which we can uniquely offer through the combination of Advertising Cloud and the Adobe Experience Cloud. We have decided to accelerate our previously stated strategy of eliminating the low-margin Advertising Cloud transaction-driven offerings. These offerings are no longer core to our overall value proposition of delivering on customer experience management nor contributing to our subscription-based bookings and revenue and in fact are extremely resource intensive. The impact of this strategic shift was evident in our Q2 revenue, cost of goods sold and gross margin results and will be factored into future Digital Experience targets. Earlier this year, we hired Anil Chakravarthy to drive the immense enterprise opportunity. Over the past few months, Anil continued to expand his charter with responsibility for strategy, product engineering and marketing, consulting and customer success for the Digital Experience business. Coincident with the long-planned retirement of Matt Thompson, Adobe’s Executive Vice President of Worldwide Field Operations, Anil will now be adding responsibility for the entire Worldwide Enterprise Field organization. Over the past 13 years, Matt has played a pivotal role in the company’s transformation to a subscription software model in the Digital Media business as well as the creation of the Digital Marketing category. He has built a world class go-to-market organization and championed customer centricity. I will miss our partnership and wish Matt well in his retirement. Matt has built a deep management bench and I am confident that this combined organization will thrive under Anil’s leadership. Adobe is the market leader in customer experience management and we have invested in deep product integration, platform innovation and a robust ecosystem. We are well positioned to execute on the growing total addressable market for CXM. At Adobe, we are guided by our belief that it’s not only what we do, but how we do it that is core to our success. We believe that everyone deserves respect and equal treatment and we are outraged at the senseless violence against the Black community in the U.S. This is a painful reminder of the injustice and systematic racism that exists in our country. We can and must do better and we are committed to doing so at Adobe. Great companies are defined by how they lead through adversity. We have successfully navigated several crises and have always used them as a catalyst to make strategic and structural change to emerge stronger. I am particularly proud of how our employees embraced the current challenges and rallied to ensure that innovation, customer centricity and adherence to our core values remains front and center. Our employees, broad and diverse portfolio of products, strong balance sheet and rigorous operating cadence put us in a rarified atmosphere among companies of our size and scale. We will emerge stronger than ever. John?
John Murphy: Thanks, Shantanu. In the second quarter of FY ‘20, Adobe achieved record revenue of $3.13 billion, which represents 14% year-over-year growth. GAAP diluted earnings per share in Q2 was $2.27 and non-GAAP diluted earnings per share was $2.45. Business and financial highlights in Q2 included Digital Media revenue of $2.23 billion, net new Digital Media ARR of $443 million, Digital Experience revenue of $826 million, expanding profitability with strong earnings per share, cash flows from operations of $1.18 billion, and repurchasing approximately 2.6 million shares of our stock during the quarter. Adobe’s strong second quarter performance demonstrates our continued top and bottom line growth despite an ongoing global pandemic. We are well positioned to navigate the continuing crisis given our resilient business model and a healthy balance sheet. In the work-from-home and distance learning environment, our strategy of fueling content creation, digital workflows and digital transformation is more relevant than ever, as digital engagement continues to underpin the global economy. In our Digital Media segment, we achieved 18% year-over-year revenue growth in Q2. On an FX adjusted basis using rates in effect as of the start of our Q2, Digital Media revenue grew 19% year-over-year. During Q2 we added $443 million of net new Digital Media ARR, our strongest Q2 on record. Total Digital Media ARR exiting the quarter was $9.17 billion. Within Digital Media, we achieved another strong quarter with our Creative business. Creative revenue grew 17% year-over-year and we increased Creative ARR by $352 million. During the second quarter, we saw increased demand for our solutions on Adobe.com amid the work-from-home environment, and usage of our products spiked notably during the quarter. Q2 Creative growth drivers included strong new user growth across all geographies, including single app adoption by individuals, adoption of our professional video products, including single-app Premiere Pro subscriptions as engagement from communicators and Youtubers increased significantly, strength in migrating students and trial users to paid subscriptions, significant unit growth for paid mobile subscriptions and continued focus on targeted campaigns using insights from our data driven operating model, which drove significant growth in web traffic during the quarter. Adobe Document Cloud delivered another quarter of strong revenue growth. We achieved record Document Cloud revenue of $360 million, which represents 22% year-over-year growth, and we added $91 million of net new Document Cloud ARR during the quarter. As with our Creative business, Document Cloud benefited from tailwinds associated with knowledge workers and communicators working from home, and we had a particularly strong quarter driving new business for Adobe Sign, with net new ARR more than doubling year-over-year. Document Cloud performance during Q2 was driven by strength on Adobe.com across the individual and SMB segments, significant growth in consumer adoption of mobile apps and PDF services, shortened deal cycles for enterprise Acrobat and Sign customers as the imperative to translate paper processes to digital accelerates across the globe, increased pipeline and improved execution in the government segment, particularly for our Sign solution and conversion of free mobile app users and our Reader install base to paid subscriptions. Across Digital Media consistent with our expectations, we experienced some weakness for the SMB offerings in the reseller channel and Adobe.com. Turning to our Digital Experience segment, our primary focus is to grow software-based subscription revenue across our portfolio of products. Our Adobe Experience Cloud revenue includes subscription revenue, which includes revenues from Advertising Cloud, professional services revenue, and other, which includes perpetual, OEM and support revenue. In Q2, we achieved quarterly Digital Experience revenue of $826 million, which represents 5% year-over-year growth. Digital Experience subscription revenue was $707 million, representing 8% year-over-year growth. Digital Experience subscription revenue, excluding Advertising Cloud revenue, grew 18% year-over-year. As outlined on our Q1 earnings call, our Advertising Cloud revenue was negatively impacted given the COVID-19 situation. As we saw the extent of the global decline in advertising spend, we made the strategic decision mid-quarter to cease pursuing transaction-driven Advertising Cloud deals. Together this resulted in a shortfall of approximately $50 million relative to our targeted Q2 revenue. A significant portion of the revenue from the transaction-driven Advertising Cloud offerings is recognized on a gross basis, with the related cost of media purchased recognized as cost of goods sold, resulting in low gross margin percentages for these offerings. While the discontinuation of these offerings will negatively impact revenue, it will enable us to drive improvements to our overall gross margins, DSO and the profitability of our Digital Experience segment, as already evident in this quarter’s results. We now expect approximately $200 million total Advertising Cloud revenue for the full fiscal year, with $70 million for the second half, decelerating from the first half of the year. As comparison, we achieved $360 million in Advertising Cloud revenue in fiscal 2019 and our original 2020 targets assumed that Advertising Cloud would grow at rates consistent with the overall subscription revenue for Digital Experience. In Q2, our professional services revenue in Digital Experience declined approximately 8% year-over-year. While there were some delays in converting consulting backlog to revenue early in Q2, we saw progress in implementations as the quarter progressed. Through a challenging quarter we continued to build pipeline and saw strength in our content and commerce offerings, particularly in the enterprise segment. As with consulting, we saw some momentum late in the quarter in our commercial segment that targets small and medium businesses. Across Adobe as we navigate the economic downturn we are managing the business carefully to drive growth and profitability. We reduced discretionary spending and delivered a strong operating margin. Our operating expense declined sequentially quarter-over-quarter as a result of a reduction in the pace of hiring, savings across travel and entertainment and in-person event cancellations. Having completed our strategic review and reprioritization, we will now turn our focus to investing appropriately for continued long-term growth. From a quarter-over-quarter currency perspective, FX decreased revenue by $18 million. We had $5 million in hedge gains in Q2 FY ‘20 versus $7 million in hedge gains in Q1 FY ‘20. Thus, the net sequential currency decrease to revenue considering hedging gains was $20 million. From a year-over-year currency perspective, FX decreased revenue by $37 million. The $5 million in hedge gains in Q2 FY20, versus the $9 million in hedge gains in Q2 FY ‘19 resulted in a net year-over-year currency decrease to revenue considering hedging gains of $41 million. Adobe’s effective tax rate in Q2 was minus 10% on a GAAP basis and 10% on a non-GAAP basis, in line with our Q2 targets. Our trade DSO was 40 days, which compares to 42 days in the year-ago quarter, and 41 days last quarter. Remaining Performance Obligation or RPO grew by 19% year-over-year to $9.92 billion exiting Q2 and was relatively flat quarter-over-quarter. Adobe.com cloud offerings, typically billed monthly, are reported as unbilled backlog, whereas channel offerings billed annually up front are reported as deferred revenue. The strength in acquisition from Adobe.com during the quarter drove a mix-shift from deferred revenue to unbilled backlog. We exited Q2 with $3.46 billion in deferred revenue. Our ending cash and short-term investment position exiting Q2 was $4.35 billion, and cash flows from operations was $1.18 billion in the quarter. Consistent with macroeconomic trends, we saw some increase in customer requests for billing concessions. We continue to be focused on working with our customers to ensure their success while managing our cash flows. In Q2, we repurchased approximately 2.6 million shares at a cost of $850 million. We currently have $3.4 billion remaining of our $8 billion repurchase authority granted in May 2018, which goes through 2021. In light of the macroeconomic environment and the strategic shifts for Advertising Cloud, we are withdrawing the annual fiscal 2020 targets. Our targets factor current macroeconomic conditions, continued impacts of the pandemic and typical Q3 seasonality across the summer months of June, July and August. For Q3, we are targeting revenue of approximately $3.15 billion, Digital Media segment year-over-year revenue growth of approximately 16%, net new Digital Media ARR of approximately $340 million, Digital Experience segment revenue flat year-over-year, Digital Experience subscription revenue growing 5% year-over-year or 14% when excluding Advertising Cloud revenue, tax rate of approximately 10% on a GAAP and non-GAAP basis, share count of approximately 485 million shares, GAAP earnings per share of approximately $1.78 and non-GAAP earnings per share of approximately $2.40. We expect typical seasonal strength in Q4 across our Digital Media and Digital Experience business. We expect our operating expenses to increase in line with growth rates in previous years as we continue to invest for growth. In summary, our resilient business model, healthy balance sheet and data driven operating model enabled us to successfully navigate this unprecedented macroeconomic environment. We are extremely proud of how our employees have continued to innovate and remain productive. Our long-term opportunity remains robust given digital technologies will increasingly drive the global economy. I will now turn the call back over to Jonathan.
Jonathan Vaas: Thanks, John. As we announced last month, we have shifted Adobe MAX, our annual creativity conference, to be an online event this October. Information about the event can be found online at max.adobe.com. We plan to host a virtual financial analyst meeting later in the fall. Invitations will be sent to our analyst and investor email list this summer. If you wish to listen to a playback of today’s conference call, a webcast archive of the call will be available on Adobe’s IR site later today. You can also listen to a phone replay by calling the numbers shown above. The phone playback service will be available beginning at 5 p.m. Pacific Time today and ending at 5 p.m. Pacific Time on June 18. We would now be happy to take your questions and we ask that you limit your questions to one per person. Operator?
Operator: Thank you. [Operator Instructions] We will take our first question today from Brent Thill with Jefferies.
Brent Thill: Good afternoon. Shantanu, for the third quarter of Digital Experience, you are guiding to flat revenue growth and I think many are just curious given the digital tailwinds, why such a steep headwind on this business? And also, as follow-up, if you could just talk to the field changes with Matt’s departure and Anil picking up, just assurance around the field that there won’t be any major changes that would be great? Thank you.
Shantanu Narayen: Sure, Brent. Happy to answer both of the questions. I mean first as it relates to Digital Experience, I think as we said, while we saw a little bit of slowness in interest at the beginning of the quarter, we certainly as people dealt with the employee issues as well as financial stability, the interest and demand in digital experience absolutely continues to grow stronger. With respect to Matt and Anil’s transition, we really don’t expect any issue. Matt has been planning for this for a long time; Anil has certainly in his role as CEO at Informatica managed a field. There is a deep bench, Matt is available for a transition and he is certainly going to remain a friend of the company. And so I would not anticipate any issues whatsoever with respect to the field transition because the next layer is completely in place and has tremendous experience with Adobe. I think as it relates to the revenue expectations for Q3, Brent, I think maybe I can touch a little bit on what we said with the Advertising Cloud again just to make sure everybody understands that which is the opportunity, if you take a step back around both Digital Experience and Customer Experience Management, there is no question that it’s larger than prior to this pandemic. And as you know Brent, we have an unbelievably unique portfolio of products and so what we did was we said, let’s take the opportunity to really prioritize the largest growth vectors as well as look at profitability. Content and commerce had a great quarter, customer experience orchestration continues to be really important. Analytics and InSight is really important. And Advertising Cloud as it relates to the solutions that we have for attribution and InSight, they add a significant amount of value for our customers. However, again as we said given in Advertising Cloud, they are two separate businesses, the software driven and the transaction driven. We did take the opportunity to accelerate our moving away from the lower margin transaction business, something as you remember, we actually signaled at our Analyst Meeting last year. And so when you take out the revenue impact associated with that you will find that the strength of the business continues. As it relates to bookings, in Q2 we achieved – the book of business for subscription bookings was greater than 15%. That in this current climate I would say it was excellent performance. And so we continue to feel really positive about the business, but hopefully that gives some color. And the last thing I’ll say is even if you think about our Q2, Brent, when we guided to $3.175 billion and we said that we had $50 million in advertising revenue that we decisively decided to stop pursuing, with the numbers that we posted you could see that we had a really good quarter.
Brent Thill: Thank you.
Operator: Next, we will hear from Keith Weiss with Morgan Stanley.
Keith Weiss: Thanks. Thank you, guys, for taking the question and very nice job on the quarter. Shifting focus to the Digital Media side of the equation, John, in your comments you talked about seeing some weakness in the commercial and SMB side of the equation, frankly with $443 million in net new AR addition, it doesn’t really show through in terms of the numbers. So it’s pretty remarkable that you saw kind of strength even with the weakness, but can you walk us through kind of the puts and takes on that, like what were the areas that were weaker and sort of what were the areas that had such strong outperformance that you guys were able to even with that exceed your like 380 target?
Shantanu Narayen: Yes, maybe I will start as well, Keith. And then John can certainly add. I mean overall clearly when you think about the creative and the document business, working from home, shelter in place, and the ability to both create and tell their story as well as what is happening with the documents, you are right, I mean we had guided to about $385 million, it’s a record for a Q2 for us in our business, so it was strong. I think what we were trying to also give color was the different routes to market. And when you think about the routes to market certainly adobe.com, the traffic right through the quarter was very strong. Because as you know, we have a data driven operating model, we use the effective marketing tools to continue to drive visit our acquisition across the globe. I think small and medium businesses we would all say it was probably the most impacted as you think about our customer segment. And therefore, through the channel what we were trying to indicate was the revenue was lower than we would have normally seen. We fully expect that that business is going to come back as that segment continues to get strong, but document cloud, sign, video, single apps, all did really strong Keith as it relates to what happened on adobe.com. So it was more a route to market and there is probably some aspect of folks who typically transacted through the channel who are also probably coming to adobe.com as a result.
Keith Weiss: Got it. Excellent.
John Murphy: I wouldn’t add anything. Shantanu covered all the points there.
Keith Weiss: Excellent. Thank you very much guys.
Operator: Next, we will hear from Jennifer Lowe with UBS.
Jennifer Lowe: Great, thank you. Actually I wanted to follow-up on Keith’s question a little bit, maybe get a bit more granular because we certainly heard about some of the things that work in your favor this quarter, you put that in contrast of guidance which seems to imply things being down sequentially pretty significantly. How – I know these things are hard to parse out, but maybe just looking at the linearity of net new ARR as you move through the quarter, with their sort of upswing and then sort of slowdown in demand as you kind of saw surge as people move to shelter in place and work from home and that drove a specific level of demand that you don’t expect to continue in Q3, because it seems like a lot of these things are durable. So I’m just curious if you have any way of parsing out what might have been sort of a point in time around shifts in how people work and maybe consumer demand attached to being at home relative to things which seem like they – they should be favorable durable shifts for the business?
Shantanu Narayen: Yes, Jennifer again, I think as the shelter-in-place, work at home began, when we last spoke to you it was I think 10 days into the quarter and we said that we had actually seen limited impact of COVID and then we did see an increase as it related to the traffic, which actually continued quite high right through the quarter. So we continue to see the strength in that particular business. On the acquisition side, it’s early, but the first few days of the quarter again we continue to see the strength in Q3. I think as you know and have followed us for a while Q3 tends to be our seasonally weak quarter. We have such a great insight into the business as it relates to the data driven operating model. So while the overall against the addressable market is certainly a durable trend. I think we are factoring in normal seasonality. We are not assuming that things will get better as it relates to the small and medium business. But overall, whether it’s the Document Cloud or the Creative Cloud, we continue to feel good. I think if there was one thing that we probably overestimated the impact of COVID as it related to the consumer space. And now I think that number of you are like wow, that was great outperformance and we, if you look at our Q3 numbers as well it will clearly demonstrate continued momentum in that business.
Jennifer Lowe: Okay, thank you.
Operator: Saket Kalia with Barclays Capital has our next question.
Saket Kalia: Okay, great. Thanks guys here for taking my questions and hope all is well. Shantanu, maybe for you, can you just talk about the bigger picture, with the decision on Advertising Cloud? It seems like the margin benefit of slightly lower focus in the transactional part of the ad cloud kind of has an interesting byproduct with the margin. And so perhaps the bigger question is, do you feel the team is perhaps going to balance profitability a little bit more with growth in the DX business than it has in the past?
Shantanu Narayen: Well, first Saket, unlike other companies in the enterprise space, we have never pursued revenue, that is not good profitable revenue which I know other companies do. And so I know I would say what we did really well in the quarter, let’s say, how do we take a step back, understand strategically, what are the, really long-term growth opportunities and how is the business going to get transformed as a result of what we saw. In that particular context, when every company on the planet, whether it’s a small and medium, or large business is saying how do I engage digitally with customers, it’s clear that the content and commerce associated with our offerings, what we can do around customer journey, orchestration and the core analytics and insight is really where all of these built on experience platform is where we are unparalleled in terms of the unique differentiation. On the advertising side, they really were two businesses, and this is something that we have talked about, which is there is a software driven business that shows how attribution works that really can benefit from the Adobe Analytics InSight in terms of making sure you are spending that money well and so that we will continue to offer, but we don’t know if that’s going to be a huge growth opportunity. It was the transaction business, which is very resource-intensive and that one we had always signaled that we were going to be reducing that business, but we certainly used pandemic as a catalyst to say let’s make a change right now, so we can double down our resources on what really represent durable, long-term opportunities. So hopefully that gives you a little bit of color on strategically, why waste the crisis in terms of making the changes that you know you can make to be a stronger company.
Saket Kalia: Very helpful. Thanks.
Operator: Our next question will come from Brad Zelnick with Credit Suisse.
Brad Zelnick: Great, thank you so much and congrats to you all on the great quarter. My question is for John, John, in your prepared remarks you stated that coming away from the strategic review, we will now turn our focus to investing appropriately for continued long-term growth. Can you expand on what exactly you mean by that? And how is that any different than what Adobe has always done?
John Murphy: Yes, that’s an interesting question, Brad. I think when we look at Q2 because of the pandemic, we obviously benefited in earnings and our margin related to expenses that basically slowed down because we couldn’t hire the way we would typically hire. We couldn’t travel the way we wanted to travel and certainly the cancellation of the in-person events. And we certainly are growth-oriented company. So the point really was to say, hey, we are going to invest in growth going forward. We have got great opportunities in front of us that Shantanu laid out. And so the operating margin that we achieved in Q2 is one that I would pencil line as a trend line is really what I was trying to get to. And we got great opportunities to invest for growth and we have proven as we continue to grow revenue, we continue to grow profitability in the long run.
Shantanu Narayen: And Brad, maybe just to add a little bit to what John added. I mean we actually took very decisive action at the beginning of the quarter, because we did not know how widespread how long the pandemic would be to make sure that we controlled our expenses. When you look at the opportunities that we have on the Document Cloud, when you look at the opportunities that we have with Experience Platform, the ability to continue on variable market and to make sure that we are acquiring the right customers that will deliver the right long-term value, I think that’s really important for us to continue to make sure that we are opening up the company back to the long-term opportunities that we have because going to be an even more unique place than the smaller company. So, to your point earlier, Brad, it is something that we always do. I think John was also referring to the early actions that we took and saying, hey, we understand our business and so it’s time to really focus on the long-term opportunities that will continue to drive both top and bottom line growth.
Brad Zelnick: Thanks again.
Operator: We will now hear from Mark Moerdler with Bernstein Research.
Mark Moerdler: Thank you very much for taking my question and again congrats on the quarter, given all the moving parts it was a tough thing to work your way through. Document Cloud and Sign were really strong this quarter, and you mentioned COVID-19 was a tailwind. Can you give us some color about how you think about those tailwinds going forward? Do they abate as people start to move back? Do they continue as they move back? Any color would be much appreciated. As a quick follow-up, can you give any color on how much of revenues now came through adobe.com versus traditionally? Thank you.
Shantanu Narayen: Mark, I think this is similar to the question that Jennifer asked which is everybody is going to go back to business as usual. I mean if you take, Adobe as a company and how we also think about reentry, I think the new normal is going to be people working in remote locations, engaging more digitally, making sure that digitization continues to be a really important phenomenon. So I think as it relates to the document, as, Mark, we have been excited about it. We always talked about the move from perpetual to subscriptions. We had talked about PDF services on the web and as we said that’s all substantial growth making sure PDF API functionality is available for anybody who wants to document as part of any system that they are trying to accomplish. And so we don’t think that abates. We think that these will just continue to be secular tailwind trends that we will benefit from. And I think that again going back maybe to Brad’s question is the reason why we feel optimistic given everything that we’ve seen to make sure that we continue to capitalize on those particular opportunity. And so the document business has always been a growth, it just accelerated and we think that that’s a trend that will be durable.
Operator: Next we’ll hear from Kirk Materne with Evercore ISI.
Kirk Materne: Thanks very much. So I want to stay in the same topic, in terms of the Document Cloud. So Shantanu given that this might be the new normal, and maybe demand is getting pulled forward, are you applying more resources to that area from our sales capacity perspective either verticalizing even further, just – what are you doing, I guess to capture maybe what is the pull forward and it turns out, people are thinking about the digitization of documents? And then John, just on a related topic your bookings impact Document ARR, Document Cloud ARR been up 30%, I think the last two quarters. It seems to be an upward bias perhaps on revenue in that segment. Is that a fair assumption going forward? Thanks.
Shantanu Narayen: Kirk, your first question to good one. And again, going back to what we were able to do during this, we have made it so that the offerings that we have that combine the strength of what we are doing on Adobe Sign with the strength that we have on content in the Digital Experience business and what we were delivering with forms, whether that was for the public sector, we have our entire field organization now out there evangelizing what we can do on the document side. So that gives you one example of a significant shift as it relates to making sure that we have our entire organization aligned around the go-to-market. I think in terms of partnerships and partnerships that we have done on the document side and Sign and API functionality. We’ve always talked about the opportunity that we have with Microsoft and the integration. We also announced a really strategic partnership with ServiceNow. If you think what ServiceNow is able to do, which is really change how workflows happened in an enterprise every single one of those workflows then needs the statement of record as it relates to PDF but then makes that a tangible. So again, that one we have been able to do. So really great question and that’s one of the ways in which we are able to pivot like a nimble small company rather than – and use our brand rather than weight. And so that’s an example of the entire DX field organization also now has an offering associated with Sign that they can take into every one of our customers.
John Murphy: And I think on the – in terms of a bias towards Document Cloud revenue growth versus Creative, both are just huge opportunities and we continue to see growth opportunities coming for both. Certainly, obviously the pandemic kind of – may be accentuated the move to digital document workflows and e-signatures. But as we talked about, we see some of these smaller business has come back, we certainly expect them to come back in the creative side as well because content creation is not going away as it’s imperative going forward for these businesses. So I think we just are excited about the opportunity in both of those files and all the solution associated with them.
Kirk Materne: Thank you.
Operator: Jay Vleeschhouwer with Griffin Securities has our next question.
Jay Vleeschhouwer: Thank you. Good evening. Shantanu, John, does the strategic mix shift in DX improve the feasibility of you getting back to a 65% or better gross margin in DX, which is where you were before the TubeMogul acquisition? And perhaps as part of your overall strategy, you could also talk about the role of increasing self-serve, which we’ve talked about on prior calls. Additionally at Summit, Adobe had some very interesting things to say about some new initiatives and technologies such as scalable content, optimized personalization, pervasive commerce, which is really interesting one, and then of course applications and intelligent services. So maybe talk about the latter in terms of how are you thinking about resources for those and incremental business opportunities in those?
Shantanu Narayen: As always Jay that was three questions mirrored in one, but I appreciate all of them. I think as it relates to the COGS I think and the gross margin, you have actually seen that improve even as you look at the data sheet that you have for Q2. So I think it’s something like $35 million or something on quarter-over-quarter. So I think you see the improvement in the COGS. We are constantly looking at our COGS and we want to make sure we improve. I think your question around Summit and the excitement that we have around all the things that we announced is another reason why when you have that differentiated solution that’s really where I think our value add to a customer is so much higher, and there is a lot of interest, there’s a lot of interest as people look at it and say, all of this data that they are now drowning in how can they use Adobe’s intelligent services so that it automatically personalizes whatever is required for a user across multiple channels. So you are right, I mean Summit for us was very interesting and that we were able to transact with a lot more folks, we got a lot more awareness out, we were able to, actually advance what we would do with Summit that were globally rolled out. I would say it’s probably a little less mature pipeline and that’s one thing that you miss the ability to move that forward. But all of that’s now we expect that trend as we move into the second half in 2021 because that is going to be top of mind. So that’s a little bit of how we’re looking at it.
Jay Vleeschhouwer: Okay, thank you.
Operator: We’ll now hear from Kash Rangan with Bank of America.
Kash Rangan: Thank you very much. First off, I want to just congratulate my friend, Brent Thill on his 25 years of being a software analyst. Shantanu in case you do not know, that’s my value add for you today. But my question for you Shantanu as far as Adobe, what are the lessons learned by Adobe in this quarter operating virtually as a company? And what are the windows of – or snippets of insight you could offer to us about go to market, of product development, partnership, marketing, the things that you were able to accomplish virtually and as a result, how much of it is here to stay as you look into 2021 and beyond? And the kind of savings, costs, expenses, whatever it is of revenue opportunities, how should we frame Adobe post pandemic?
Shantanu Narayen: Yes, Kash, I mean it’s something that we are all focused on a lot as a company. I mean first I will reiterate in fact that overnight as a company 20,000 employees all around the world were productive. I mean in my internal note to the company, as part of this earnings I said I was just blown away. We had our first ever virtual close, the IT organization, in terms of how they’ve made sure that we are all productive through video conferences. I would actually say when you look at existing projects, most people would say that their productivity is actually greater than 100% because they are saving on travel, they are saving on the ability to be very productive without too many meetings and so I think as it relates to the new normal on the product engineering side, it’s been phenomenally successful. I think we need a little bit more focus on what happens with respect to creating new projects, so that one of the brainstorming that happens as it relates to the virtual white boarding. So that’s something that we will continue to focus on. On the dealing with customers which was the other part, so internally we feel very good. On the dealing with customers, I think that went through a little bit of a slow phase as customers were first thinking about their internal, but frankly right now I mean sometimes you feel like you’ve conquered time and space because you can have meetings with people across four continents on the same day, makes for a long day Kash, but it actually feels really good that we’re now engaging with customers. So we just feel that our ability to attract talent also wherever they might live that’s going to improve. And so net, net, I would say, for a company like Adobe internally, our productivity is overall higher, but even more important, I think it serves at such an inflection point because every single company is now going to say, hey, I need to go talk to Adobe, whether it’s about creative, whether it’s about documents or whether about Digital Experience. So I think the macro tailwinds is probably going to be the longer lasting benefit to a company like Adobe and certainly, Brent congratulations on 25 years. I mean, the two of you have been great sort of followers of the company and very insightful. So congratulations.
Operator: We’ll now hear from Keith Bachman with Bank of Montreal.
Keith Bachman: Hi, thank you very much. Shantanu, I want to direct this to you. In the past, you’ve talked about the growth of Creative, Creative being both people or units as well as price mix and suggested that the growth of users, has been a greater contributor to the net growth rates of creative. And I just wanted to see given the pandemic over the next few quarters, is that still true? And how are you thinking about potential price increases when you’re normally introduced new products with the Creative Suite? And then also just wanted to sneak in one to see if you can give us an update on Magento and traction and integration and any kind of anecdotes on run rates associated with that property? Thanks very much.
Shantanu Narayen: I think on your first question, there is no question that the creative market and everybody who has a story to tell, it is only getting larger. I mean, as we said we were proud of $30 million provisioned, also for education, which is going to be I think a great base for us to build on, and I wouldn’t say it is one segment or the other. I think really Keith, it’s all of the different segments. Mobile did very well, we have different price points, we have Spark for communicators. And again it is our vision is very clear. It is a one-stop shop for everything from inspiration to monetization. So expect us to continue to see more offerings, more price points, and using our DDOM frankly to both acquire them as well as to make sure that we serve them appropriately. I’m glad you asked the question on commerce. Commerce usage has certainly gone up very dramatically in terms of how we’ve seen the enterprise adoption of our commerce solutions was very strong in the quarter. I think it’s important for all of you to also remember that the way we do that is it’s typically licensed base with a band of how many transactions. So it’s really not about – the transaction doesn’t immediately result in revenue, but whether it’s a true-up or whether it’s an increased band that they will have to go. So, new customer acquisition was good in that. Usage as certainly gone up, it is almost like you’re having Black Friday or Cyber Monday every day, but we will continue to hopefully see that as we talk about renewals, how they get into higher bands.
Jonathan Vaas: Operator, we are coming up on the top of the hour. We’ll take one more question please.
Operator: Your question will come from Alex Zukin with RBC Capital Markets.
Alex Zukin: Shantanu, thank you guys for squeezing me in and congrats to Brent for his 25 years. I guess maybe, Shantanu, can you talk a little bit about as you look at the linearity of the quarter, particularly the Digital Experience business kind of taking out the Advertising Cloud piece, where are we in terms of sales cycle normalization in your mind? And then maybe as a, just a quick follow-up on the margins, given the new positive tailwind to gross margin from some of these initiatives, is it fair to say that the new operating margin profile should be somewhere between the 1Q and 2Q levels?
Shantanu Narayen: John, certainly you can add on the margin, I think Alex, as it relates to the linearity during the quarter I think the month of March and this is probably true for most of the businesses that was where the real impact was felt and then April actually became worse. I think as we got into May, people started to engage a lot more we saw signs of improvement. I think John touched on that as well. And so I think that’s the way I would highlight it for a month, month and half, everybody knew Digital was an imperative, but they had other fires that they were fighting. And then as it related to March, I mean, May, sorry, it all started to open up and we are having far more conversations with customers. So hopefully that gives you some feeling about linearity, which is why we are optimistic about moving forward as we have that pipeline. How we will deal with. And the operating margin will be between the Q1 and Q2 levels. If you think about it, you’re not going to see any big change dramatically, but as John said, I think we will continue to invest in. And I realized we ran a little bit long with the prepared remarks, and so we may not be able to get all of the questions, but let me again say I am really proud. I am proud of what the company was able to accomplish in Q2. And I’m even more excited about what the future growth opportunities are for Adobe because there is no question that digital is going to be even more of a driver of the economy. It’s going to amplify the urgency for individuals to be creative and collaborators, it’s going to improve the urgency for enterprises to engage digitally and when you think about the portfolio of products that we have, learning is no longer – learning to be creative will no longer be a luxury, dealing with electronic documents is going to be the way business is transacted, the PDF platform and ecosystem is thriving, and on the DX side, engaging digitally with customers is going to be mission critical irrespective of the size of the business. And so we are proud of our unique business model, growth is a priority for us, but we will always focus as we have with great cash flow and high profitability. I’m proud again as I said that we used this crisis to further refine our strategy and align the organization on what truly matters, which is sustained innovation and delighting our customers. Please stay safe, stay healthy. And thank you very much for joining us today.
Jonathan Vaas: This concludes our call. Thanks everyone. | [
{
"speaker": "Operator",
"text": "Good afternoon and welcome to the Adobe Q2 FY ‘20 Quarterly Earnings Call. [Operator Instructions] Today’s conference is being recorded. I would like to turn the conference over to our Vice President of Investor Relations, Jonathan Vaas. Please go ahead, sir."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon and thank you for joining us. With me on the call today from their home offices are Shantanu Narayen, Adobe’s President and CEO; John Murphy, Executive Vice President and CFO, as well as Mike Saviage, who in March announced his retirement as Adobe’s Head of Investor Relations and is continuing to assist with the transition. On this call we will discuss Adobe’s second quarter fiscal year 2020 financial results. By now, you should have a copy of the press release, which crossed the wire approximately 1 hour ago. We have also posted PDFs of our prepared remarks and an updated datasheet on Adobe’s Investor Relations website. Before we get started, we want to emphasize that some of the information discussed in this call, including our financial targets and product plans is based on information as of today, June 11 and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks and uncertainties, you should review the Forward-Looking Statements Disclosure in our press release we issued today, as well as Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe’s Investor Relations website for approximately 45 days. The call audio and the webcast may not be re-recorded or otherwise reproduced or distributed without Adobe’s prior written permission. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan and good afternoon. I hope you and your families are safe and healthy. Adobe’s second quarter coincided with what we hope was the peak of the COVID-19 pandemic. Around the world, people shifted their attention to their health and their families. Businesses focused on protecting their employees, financial stability and continuing to serve their customers. Unfortunately, millions of people have lost their jobs and small and medium-sized businesses have been hit particularly hard. Through this crisis, Adobe’s focus remains on employee health and safety, serving our customers and on ensuring business continuity. We took early and decisive action to direct our teams to work from home, suspend travel and cancel in-person events through 2020 to flatten the curve. To support the communities in which we live and work we have donated over $5 million and 22,000 hours of virtual volunteer time to COVID-19 relief organizations. We are also proud to be part of the coalition that developed the COVID-19 Testing Data Response Platform, providing test screening, appointments and insights for public health officials and government. We immediately instituted work streams to control discretionary expenses and evaluate our strategic priorities to double down on those that will drive the greatest growth and profitability for the long-term. Through all of this, the resiliency and flexibility of our employees has been awe-inspiring. I am proud of how our employees transitioned to this new reality. Adobe is the digital experiences company, with millions of global customers relying on our products every day to create the world’s content, automate critical document processes and engage with their customers digitally. Adobe’s leadership in three large and growing categories, Creative Cloud, Document Cloud and Experience Cloud, is driving our performance. Adobe drove strong Q2 performance across Adobe Creative Cloud, Adobe Document Cloud, and Adobe Experience Cloud. We delivered $3.13 billion in revenue in Q2, representing 14% year-over-year growth. GAAP earnings per share for the quarter, was $2.27 and non-GAAP earnings per share was $2.45. In our Digital Media business, we drove strong revenue growth in both Creative Cloud and Document Cloud in Q2. Net new Digital Media annualized recurring revenue or ARR was $443 million and total Digital Media ARR exiting Q2 grew to $9.17 billion. Q2 Creative revenue was $1.87 billion, which represents 17% year-over-year growth. Net new Creative Cloud ARR was $352 million. The past couple of months have shown us that in times of uncertainty people are turning to creative expression to learn, cope and make an impact. Adobe Creative Cloud is the center of this new creative renaissance, unleashing creativity for all and empowering millions of people around the world to tell their stories. As schools faced physical closures and moved online, we focused our attention on enabling them to create from home. We immediately provisioned 30 million students at home with Creative Cloud and provided teachers distance learning support. In Q2, we saw historic highs in adobe.com traffic across both Creative Cloud and Document Cloud. Demand for our professional video products was particularly high with strong engagement for Adobe Premiere Pro and After Effects. We continue to see steady growth from social content creators using Premiere Rush, which saw a 75% increase in monthly active users quarter-over-quarter. Mobile traffic, member sign-ups and monetization continues to accelerate. Adobe Fresco has seen a greater than 40% increase in downloads since the start of 2020. Photoshop Express has surpassed 20 million in monthly active users. Our teams are gearing up for a significant Creative Cloud update later this month featuring exciting new product innovation as well as new capabilities designed to facilitate collaboration between creators, particularly important in this environment. We are excited to make Photoshop Camera generally available on iOS and Android this week, bringing the magic of Photoshop to the point of capture. Photoshop Camera is a fun and easy consumer app targeted at social creators, an increasingly important segment for Adobe. At Adobe, we believe everyone is a creator and we need to make products suitable for different skill levels. Adobe Spark, available both on the web and as a mobile app, is targeted at the large group of communicators who need to create social graphics, web pages and short videos for their business, school or community. As part of the strategic review of our Creative business, we have decided to increase our investment in two exciting areas, providing new solutions that address the unmet needs of the communicator segment and ensuring that the web browser is a first-class authoring platform. We are proud of the role we play in inspiring the global creative community. With our Honor Heroes campaign, we galvanized our community to create artwork honoring essential workers on the frontlines. We created an Adobe Fresco-compatible Digital Coloring Book and launched a creative campaign with musician Marshmello challenging fans to create a video for his latest single, Be Kind. Document Cloud revenue in Q2 was a record $360 million and we grew Document Cloud ARR to $1.24 billion. With Adobe Document Cloud, we are accelerating document productivity, enabling our customers to engage, transact and collaborate seamlessly in a remote work environment. As we did with Creative Cloud, we implemented several programs to support our customers. This included making our web-based PDF services on adobe.com free and implementing a Government Rapid Response program to assist local governments by providing extended trials for Adobe Document Cloud. The shift to remote work has driven a surge in demand for digital documents, with use of web-based PDF services, up nearly 40% quarter-over-quarter and the number of documents shared in Acrobat, increasing 50% year-over-year. We continued to drive strong adoption for Adobe Sign, our cloud-based electronic signature solution, with usage increasing 175% since the start of our fiscal year. Mobile usage exploded with Acrobat Reader installations increasing 43% year-over-year and Adobe Scan installations up 66% year-over-year. We are proud of the role our technology is playing in enabling our government customers to accelerate their transition to digital. The City of Seattle’s digital workplace division deployed Adobe Sign across its departments when the city quickly shifted to telework. The State of Utah is using Adobe Acrobat and Sign as part of its telework initiative to facilitate emergency response and streamline communication across the state. As part of the strategic review of our Document business, we are increasing investment in Adobe Sign and our PDF services on the web and availability of PDF functionality through APIs to capitalize on the wholesale shift to remote work and digital-first document processes. In our Digital Experience business, we achieved Experience Cloud revenue of $826 million for the quarter. As outlined at our last earnings call, we saw anticipated delays in enterprise bookings and consulting services implementations as companies prioritized employee and financial well-being. The extreme economic challenges that enterprise customers in certain verticals experienced as well as weakness in our commercial segment that targets small and medium sized businesses also adversely impacted bookings. In addition, the significant global decline in advertising spending impacted our Advertising Cloud revenue. Despite the short-term challenges, the mandate to digitally transform has taken on heightened urgency. Enterprises continue to recognize Adobe’s leadership in Customer Experience Management. Key customer wins in the quarter included IBM, Walgreens, Safeway, Astellas Pharma, and Allianz. We are dedicated to our customers’ success and proud to see the impact our technology is having. Government organizations such as the U.S. Census Bureau are relying on Adobe Experience Cloud to modernize citizen experiences. 3M and Verizon are reaping the benefits of the Adobe Experience Platform and we now cumulatively have over 10 billion active customer profiles running on Adobe Experience Platform. Adobe Experience Cloud was named a leader with the highest position among 19 vendors in the Gartner Magic Quadrant for Multi-channel Marketing Hubs as well as a leader by Forrester in the B2B and B2C Commerce Suites Wave reports. We successfully transitioned Adobe Summit to an exclusively digital event, where we debuted new Adobe Experience Cloud innovation, including Intelligent Services, Customer Journey Analytics and the Customer Experience Management Playbook. The Adobe Summit Live virtual experience enabled us to engage a far larger audience than an in-person event and set the bar for virtual events. Cumulatively, we have engaged with more than 0.5 million visitors. While it was difficult to imagine only conducting business with CMOs and CIOs virtually, a side benefit of everyone working at home is that we are able to schedule and engage with far more customers across multiple continents. In all these discussions with business leaders, it is clear that investments in digital and specifically customer experience are more important than ever. As a result of the strategic review of our Digital Experience business, it is clear that we have an unparalleled value proposition and market leading solutions across content and commerce, customer journey management and customer data and insights, all powered by the Adobe Experience Platform. To further our lead, we are increasing our investment in AI and machine learning, next-generation applications and services on the Adobe Experience Platform, and accelerated integration of our content and commerce offerings. Our current advertising offerings consist of Advertising Cloud software solutions as well as Advertising Cloud transaction-driven solutions. We will continue to offer our Advertising Cloud software solutions to our Digital Experience customers, but this will not be an area of growth moving forward. CMOs want a single source of reporting and attribution for their advertising investment, which we can uniquely offer through the combination of Advertising Cloud and the Adobe Experience Cloud. We have decided to accelerate our previously stated strategy of eliminating the low-margin Advertising Cloud transaction-driven offerings. These offerings are no longer core to our overall value proposition of delivering on customer experience management nor contributing to our subscription-based bookings and revenue and in fact are extremely resource intensive. The impact of this strategic shift was evident in our Q2 revenue, cost of goods sold and gross margin results and will be factored into future Digital Experience targets. Earlier this year, we hired Anil Chakravarthy to drive the immense enterprise opportunity. Over the past few months, Anil continued to expand his charter with responsibility for strategy, product engineering and marketing, consulting and customer success for the Digital Experience business. Coincident with the long-planned retirement of Matt Thompson, Adobe’s Executive Vice President of Worldwide Field Operations, Anil will now be adding responsibility for the entire Worldwide Enterprise Field organization. Over the past 13 years, Matt has played a pivotal role in the company’s transformation to a subscription software model in the Digital Media business as well as the creation of the Digital Marketing category. He has built a world class go-to-market organization and championed customer centricity. I will miss our partnership and wish Matt well in his retirement. Matt has built a deep management bench and I am confident that this combined organization will thrive under Anil’s leadership. Adobe is the market leader in customer experience management and we have invested in deep product integration, platform innovation and a robust ecosystem. We are well positioned to execute on the growing total addressable market for CXM. At Adobe, we are guided by our belief that it’s not only what we do, but how we do it that is core to our success. We believe that everyone deserves respect and equal treatment and we are outraged at the senseless violence against the Black community in the U.S. This is a painful reminder of the injustice and systematic racism that exists in our country. We can and must do better and we are committed to doing so at Adobe. Great companies are defined by how they lead through adversity. We have successfully navigated several crises and have always used them as a catalyst to make strategic and structural change to emerge stronger. I am particularly proud of how our employees embraced the current challenges and rallied to ensure that innovation, customer centricity and adherence to our core values remains front and center. Our employees, broad and diverse portfolio of products, strong balance sheet and rigorous operating cadence put us in a rarified atmosphere among companies of our size and scale. We will emerge stronger than ever. John?"
},
{
"speaker": "John Murphy",
"text": "Thanks, Shantanu. In the second quarter of FY ‘20, Adobe achieved record revenue of $3.13 billion, which represents 14% year-over-year growth. GAAP diluted earnings per share in Q2 was $2.27 and non-GAAP diluted earnings per share was $2.45. Business and financial highlights in Q2 included Digital Media revenue of $2.23 billion, net new Digital Media ARR of $443 million, Digital Experience revenue of $826 million, expanding profitability with strong earnings per share, cash flows from operations of $1.18 billion, and repurchasing approximately 2.6 million shares of our stock during the quarter. Adobe’s strong second quarter performance demonstrates our continued top and bottom line growth despite an ongoing global pandemic. We are well positioned to navigate the continuing crisis given our resilient business model and a healthy balance sheet. In the work-from-home and distance learning environment, our strategy of fueling content creation, digital workflows and digital transformation is more relevant than ever, as digital engagement continues to underpin the global economy. In our Digital Media segment, we achieved 18% year-over-year revenue growth in Q2. On an FX adjusted basis using rates in effect as of the start of our Q2, Digital Media revenue grew 19% year-over-year. During Q2 we added $443 million of net new Digital Media ARR, our strongest Q2 on record. Total Digital Media ARR exiting the quarter was $9.17 billion. Within Digital Media, we achieved another strong quarter with our Creative business. Creative revenue grew 17% year-over-year and we increased Creative ARR by $352 million. During the second quarter, we saw increased demand for our solutions on Adobe.com amid the work-from-home environment, and usage of our products spiked notably during the quarter. Q2 Creative growth drivers included strong new user growth across all geographies, including single app adoption by individuals, adoption of our professional video products, including single-app Premiere Pro subscriptions as engagement from communicators and Youtubers increased significantly, strength in migrating students and trial users to paid subscriptions, significant unit growth for paid mobile subscriptions and continued focus on targeted campaigns using insights from our data driven operating model, which drove significant growth in web traffic during the quarter. Adobe Document Cloud delivered another quarter of strong revenue growth. We achieved record Document Cloud revenue of $360 million, which represents 22% year-over-year growth, and we added $91 million of net new Document Cloud ARR during the quarter. As with our Creative business, Document Cloud benefited from tailwinds associated with knowledge workers and communicators working from home, and we had a particularly strong quarter driving new business for Adobe Sign, with net new ARR more than doubling year-over-year. Document Cloud performance during Q2 was driven by strength on Adobe.com across the individual and SMB segments, significant growth in consumer adoption of mobile apps and PDF services, shortened deal cycles for enterprise Acrobat and Sign customers as the imperative to translate paper processes to digital accelerates across the globe, increased pipeline and improved execution in the government segment, particularly for our Sign solution and conversion of free mobile app users and our Reader install base to paid subscriptions. Across Digital Media consistent with our expectations, we experienced some weakness for the SMB offerings in the reseller channel and Adobe.com. Turning to our Digital Experience segment, our primary focus is to grow software-based subscription revenue across our portfolio of products. Our Adobe Experience Cloud revenue includes subscription revenue, which includes revenues from Advertising Cloud, professional services revenue, and other, which includes perpetual, OEM and support revenue. In Q2, we achieved quarterly Digital Experience revenue of $826 million, which represents 5% year-over-year growth. Digital Experience subscription revenue was $707 million, representing 8% year-over-year growth. Digital Experience subscription revenue, excluding Advertising Cloud revenue, grew 18% year-over-year. As outlined on our Q1 earnings call, our Advertising Cloud revenue was negatively impacted given the COVID-19 situation. As we saw the extent of the global decline in advertising spend, we made the strategic decision mid-quarter to cease pursuing transaction-driven Advertising Cloud deals. Together this resulted in a shortfall of approximately $50 million relative to our targeted Q2 revenue. A significant portion of the revenue from the transaction-driven Advertising Cloud offerings is recognized on a gross basis, with the related cost of media purchased recognized as cost of goods sold, resulting in low gross margin percentages for these offerings. While the discontinuation of these offerings will negatively impact revenue, it will enable us to drive improvements to our overall gross margins, DSO and the profitability of our Digital Experience segment, as already evident in this quarter’s results. We now expect approximately $200 million total Advertising Cloud revenue for the full fiscal year, with $70 million for the second half, decelerating from the first half of the year. As comparison, we achieved $360 million in Advertising Cloud revenue in fiscal 2019 and our original 2020 targets assumed that Advertising Cloud would grow at rates consistent with the overall subscription revenue for Digital Experience. In Q2, our professional services revenue in Digital Experience declined approximately 8% year-over-year. While there were some delays in converting consulting backlog to revenue early in Q2, we saw progress in implementations as the quarter progressed. Through a challenging quarter we continued to build pipeline and saw strength in our content and commerce offerings, particularly in the enterprise segment. As with consulting, we saw some momentum late in the quarter in our commercial segment that targets small and medium businesses. Across Adobe as we navigate the economic downturn we are managing the business carefully to drive growth and profitability. We reduced discretionary spending and delivered a strong operating margin. Our operating expense declined sequentially quarter-over-quarter as a result of a reduction in the pace of hiring, savings across travel and entertainment and in-person event cancellations. Having completed our strategic review and reprioritization, we will now turn our focus to investing appropriately for continued long-term growth. From a quarter-over-quarter currency perspective, FX decreased revenue by $18 million. We had $5 million in hedge gains in Q2 FY ‘20 versus $7 million in hedge gains in Q1 FY ‘20. Thus, the net sequential currency decrease to revenue considering hedging gains was $20 million. From a year-over-year currency perspective, FX decreased revenue by $37 million. The $5 million in hedge gains in Q2 FY20, versus the $9 million in hedge gains in Q2 FY ‘19 resulted in a net year-over-year currency decrease to revenue considering hedging gains of $41 million. Adobe’s effective tax rate in Q2 was minus 10% on a GAAP basis and 10% on a non-GAAP basis, in line with our Q2 targets. Our trade DSO was 40 days, which compares to 42 days in the year-ago quarter, and 41 days last quarter. Remaining Performance Obligation or RPO grew by 19% year-over-year to $9.92 billion exiting Q2 and was relatively flat quarter-over-quarter. Adobe.com cloud offerings, typically billed monthly, are reported as unbilled backlog, whereas channel offerings billed annually up front are reported as deferred revenue. The strength in acquisition from Adobe.com during the quarter drove a mix-shift from deferred revenue to unbilled backlog. We exited Q2 with $3.46 billion in deferred revenue. Our ending cash and short-term investment position exiting Q2 was $4.35 billion, and cash flows from operations was $1.18 billion in the quarter. Consistent with macroeconomic trends, we saw some increase in customer requests for billing concessions. We continue to be focused on working with our customers to ensure their success while managing our cash flows. In Q2, we repurchased approximately 2.6 million shares at a cost of $850 million. We currently have $3.4 billion remaining of our $8 billion repurchase authority granted in May 2018, which goes through 2021. In light of the macroeconomic environment and the strategic shifts for Advertising Cloud, we are withdrawing the annual fiscal 2020 targets. Our targets factor current macroeconomic conditions, continued impacts of the pandemic and typical Q3 seasonality across the summer months of June, July and August. For Q3, we are targeting revenue of approximately $3.15 billion, Digital Media segment year-over-year revenue growth of approximately 16%, net new Digital Media ARR of approximately $340 million, Digital Experience segment revenue flat year-over-year, Digital Experience subscription revenue growing 5% year-over-year or 14% when excluding Advertising Cloud revenue, tax rate of approximately 10% on a GAAP and non-GAAP basis, share count of approximately 485 million shares, GAAP earnings per share of approximately $1.78 and non-GAAP earnings per share of approximately $2.40. We expect typical seasonal strength in Q4 across our Digital Media and Digital Experience business. We expect our operating expenses to increase in line with growth rates in previous years as we continue to invest for growth. In summary, our resilient business model, healthy balance sheet and data driven operating model enabled us to successfully navigate this unprecedented macroeconomic environment. We are extremely proud of how our employees have continued to innovate and remain productive. Our long-term opportunity remains robust given digital technologies will increasingly drive the global economy. I will now turn the call back over to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, John. As we announced last month, we have shifted Adobe MAX, our annual creativity conference, to be an online event this October. Information about the event can be found online at max.adobe.com. We plan to host a virtual financial analyst meeting later in the fall. Invitations will be sent to our analyst and investor email list this summer. If you wish to listen to a playback of today’s conference call, a webcast archive of the call will be available on Adobe’s IR site later today. You can also listen to a phone replay by calling the numbers shown above. The phone playback service will be available beginning at 5 p.m. Pacific Time today and ending at 5 p.m. Pacific Time on June 18. We would now be happy to take your questions and we ask that you limit your questions to one per person. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] We will take our first question today from Brent Thill with Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Good afternoon. Shantanu, for the third quarter of Digital Experience, you are guiding to flat revenue growth and I think many are just curious given the digital tailwinds, why such a steep headwind on this business? And also, as follow-up, if you could just talk to the field changes with Matt’s departure and Anil picking up, just assurance around the field that there won’t be any major changes that would be great? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, Brent. Happy to answer both of the questions. I mean first as it relates to Digital Experience, I think as we said, while we saw a little bit of slowness in interest at the beginning of the quarter, we certainly as people dealt with the employee issues as well as financial stability, the interest and demand in digital experience absolutely continues to grow stronger. With respect to Matt and Anil’s transition, we really don’t expect any issue. Matt has been planning for this for a long time; Anil has certainly in his role as CEO at Informatica managed a field. There is a deep bench, Matt is available for a transition and he is certainly going to remain a friend of the company. And so I would not anticipate any issues whatsoever with respect to the field transition because the next layer is completely in place and has tremendous experience with Adobe. I think as it relates to the revenue expectations for Q3, Brent, I think maybe I can touch a little bit on what we said with the Advertising Cloud again just to make sure everybody understands that which is the opportunity, if you take a step back around both Digital Experience and Customer Experience Management, there is no question that it’s larger than prior to this pandemic. And as you know Brent, we have an unbelievably unique portfolio of products and so what we did was we said, let’s take the opportunity to really prioritize the largest growth vectors as well as look at profitability. Content and commerce had a great quarter, customer experience orchestration continues to be really important. Analytics and InSight is really important. And Advertising Cloud as it relates to the solutions that we have for attribution and InSight, they add a significant amount of value for our customers. However, again as we said given in Advertising Cloud, they are two separate businesses, the software driven and the transaction driven. We did take the opportunity to accelerate our moving away from the lower margin transaction business, something as you remember, we actually signaled at our Analyst Meeting last year. And so when you take out the revenue impact associated with that you will find that the strength of the business continues. As it relates to bookings, in Q2 we achieved – the book of business for subscription bookings was greater than 15%. That in this current climate I would say it was excellent performance. And so we continue to feel really positive about the business, but hopefully that gives some color. And the last thing I’ll say is even if you think about our Q2, Brent, when we guided to $3.175 billion and we said that we had $50 million in advertising revenue that we decisively decided to stop pursuing, with the numbers that we posted you could see that we had a really good quarter."
},
{
"speaker": "Brent Thill",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Next, we will hear from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Thanks. Thank you, guys, for taking the question and very nice job on the quarter. Shifting focus to the Digital Media side of the equation, John, in your comments you talked about seeing some weakness in the commercial and SMB side of the equation, frankly with $443 million in net new AR addition, it doesn’t really show through in terms of the numbers. So it’s pretty remarkable that you saw kind of strength even with the weakness, but can you walk us through kind of the puts and takes on that, like what were the areas that were weaker and sort of what were the areas that had such strong outperformance that you guys were able to even with that exceed your like 380 target?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, maybe I will start as well, Keith. And then John can certainly add. I mean overall clearly when you think about the creative and the document business, working from home, shelter in place, and the ability to both create and tell their story as well as what is happening with the documents, you are right, I mean we had guided to about $385 million, it’s a record for a Q2 for us in our business, so it was strong. I think what we were trying to also give color was the different routes to market. And when you think about the routes to market certainly adobe.com, the traffic right through the quarter was very strong. Because as you know, we have a data driven operating model, we use the effective marketing tools to continue to drive visit our acquisition across the globe. I think small and medium businesses we would all say it was probably the most impacted as you think about our customer segment. And therefore, through the channel what we were trying to indicate was the revenue was lower than we would have normally seen. We fully expect that that business is going to come back as that segment continues to get strong, but document cloud, sign, video, single apps, all did really strong Keith as it relates to what happened on adobe.com. So it was more a route to market and there is probably some aspect of folks who typically transacted through the channel who are also probably coming to adobe.com as a result."
},
{
"speaker": "Keith Weiss",
"text": "Got it. Excellent."
},
{
"speaker": "John Murphy",
"text": "I wouldn’t add anything. Shantanu covered all the points there."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you very much guys."
},
{
"speaker": "Operator",
"text": "Next, we will hear from Jennifer Lowe with UBS."
},
{
"speaker": "Jennifer Lowe",
"text": "Great, thank you. Actually I wanted to follow-up on Keith’s question a little bit, maybe get a bit more granular because we certainly heard about some of the things that work in your favor this quarter, you put that in contrast of guidance which seems to imply things being down sequentially pretty significantly. How – I know these things are hard to parse out, but maybe just looking at the linearity of net new ARR as you move through the quarter, with their sort of upswing and then sort of slowdown in demand as you kind of saw surge as people move to shelter in place and work from home and that drove a specific level of demand that you don’t expect to continue in Q3, because it seems like a lot of these things are durable. So I’m just curious if you have any way of parsing out what might have been sort of a point in time around shifts in how people work and maybe consumer demand attached to being at home relative to things which seem like they – they should be favorable durable shifts for the business?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, Jennifer again, I think as the shelter-in-place, work at home began, when we last spoke to you it was I think 10 days into the quarter and we said that we had actually seen limited impact of COVID and then we did see an increase as it related to the traffic, which actually continued quite high right through the quarter. So we continue to see the strength in that particular business. On the acquisition side, it’s early, but the first few days of the quarter again we continue to see the strength in Q3. I think as you know and have followed us for a while Q3 tends to be our seasonally weak quarter. We have such a great insight into the business as it relates to the data driven operating model. So while the overall against the addressable market is certainly a durable trend. I think we are factoring in normal seasonality. We are not assuming that things will get better as it relates to the small and medium business. But overall, whether it’s the Document Cloud or the Creative Cloud, we continue to feel good. I think if there was one thing that we probably overestimated the impact of COVID as it related to the consumer space. And now I think that number of you are like wow, that was great outperformance and we, if you look at our Q3 numbers as well it will clearly demonstrate continued momentum in that business."
},
{
"speaker": "Jennifer Lowe",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "Saket Kalia with Barclays Capital has our next question."
},
{
"speaker": "Saket Kalia",
"text": "Okay, great. Thanks guys here for taking my questions and hope all is well. Shantanu, maybe for you, can you just talk about the bigger picture, with the decision on Advertising Cloud? It seems like the margin benefit of slightly lower focus in the transactional part of the ad cloud kind of has an interesting byproduct with the margin. And so perhaps the bigger question is, do you feel the team is perhaps going to balance profitability a little bit more with growth in the DX business than it has in the past?"
},
{
"speaker": "Shantanu Narayen",
"text": "Well, first Saket, unlike other companies in the enterprise space, we have never pursued revenue, that is not good profitable revenue which I know other companies do. And so I know I would say what we did really well in the quarter, let’s say, how do we take a step back, understand strategically, what are the, really long-term growth opportunities and how is the business going to get transformed as a result of what we saw. In that particular context, when every company on the planet, whether it’s a small and medium, or large business is saying how do I engage digitally with customers, it’s clear that the content and commerce associated with our offerings, what we can do around customer journey, orchestration and the core analytics and insight is really where all of these built on experience platform is where we are unparalleled in terms of the unique differentiation. On the advertising side, they really were two businesses, and this is something that we have talked about, which is there is a software driven business that shows how attribution works that really can benefit from the Adobe Analytics InSight in terms of making sure you are spending that money well and so that we will continue to offer, but we don’t know if that’s going to be a huge growth opportunity. It was the transaction business, which is very resource-intensive and that one we had always signaled that we were going to be reducing that business, but we certainly used pandemic as a catalyst to say let’s make a change right now, so we can double down our resources on what really represent durable, long-term opportunities. So hopefully that gives you a little bit of color on strategically, why waste the crisis in terms of making the changes that you know you can make to be a stronger company."
},
{
"speaker": "Saket Kalia",
"text": "Very helpful. Thanks."
},
{
"speaker": "Operator",
"text": "Our next question will come from Brad Zelnick with Credit Suisse."
},
{
"speaker": "Brad Zelnick",
"text": "Great, thank you so much and congrats to you all on the great quarter. My question is for John, John, in your prepared remarks you stated that coming away from the strategic review, we will now turn our focus to investing appropriately for continued long-term growth. Can you expand on what exactly you mean by that? And how is that any different than what Adobe has always done?"
},
{
"speaker": "John Murphy",
"text": "Yes, that’s an interesting question, Brad. I think when we look at Q2 because of the pandemic, we obviously benefited in earnings and our margin related to expenses that basically slowed down because we couldn’t hire the way we would typically hire. We couldn’t travel the way we wanted to travel and certainly the cancellation of the in-person events. And we certainly are growth-oriented company. So the point really was to say, hey, we are going to invest in growth going forward. We have got great opportunities in front of us that Shantanu laid out. And so the operating margin that we achieved in Q2 is one that I would pencil line as a trend line is really what I was trying to get to. And we got great opportunities to invest for growth and we have proven as we continue to grow revenue, we continue to grow profitability in the long run."
},
{
"speaker": "Shantanu Narayen",
"text": "And Brad, maybe just to add a little bit to what John added. I mean we actually took very decisive action at the beginning of the quarter, because we did not know how widespread how long the pandemic would be to make sure that we controlled our expenses. When you look at the opportunities that we have on the Document Cloud, when you look at the opportunities that we have with Experience Platform, the ability to continue on variable market and to make sure that we are acquiring the right customers that will deliver the right long-term value, I think that’s really important for us to continue to make sure that we are opening up the company back to the long-term opportunities that we have because going to be an even more unique place than the smaller company. So, to your point earlier, Brad, it is something that we always do. I think John was also referring to the early actions that we took and saying, hey, we understand our business and so it’s time to really focus on the long-term opportunities that will continue to drive both top and bottom line growth."
},
{
"speaker": "Brad Zelnick",
"text": "Thanks again."
},
{
"speaker": "Operator",
"text": "We will now hear from Mark Moerdler with Bernstein Research."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you very much for taking my question and again congrats on the quarter, given all the moving parts it was a tough thing to work your way through. Document Cloud and Sign were really strong this quarter, and you mentioned COVID-19 was a tailwind. Can you give us some color about how you think about those tailwinds going forward? Do they abate as people start to move back? Do they continue as they move back? Any color would be much appreciated. As a quick follow-up, can you give any color on how much of revenues now came through adobe.com versus traditionally? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "Mark, I think this is similar to the question that Jennifer asked which is everybody is going to go back to business as usual. I mean if you take, Adobe as a company and how we also think about reentry, I think the new normal is going to be people working in remote locations, engaging more digitally, making sure that digitization continues to be a really important phenomenon. So I think as it relates to the document, as, Mark, we have been excited about it. We always talked about the move from perpetual to subscriptions. We had talked about PDF services on the web and as we said that’s all substantial growth making sure PDF API functionality is available for anybody who wants to document as part of any system that they are trying to accomplish. And so we don’t think that abates. We think that these will just continue to be secular tailwind trends that we will benefit from. And I think that again going back maybe to Brad’s question is the reason why we feel optimistic given everything that we’ve seen to make sure that we continue to capitalize on those particular opportunity. And so the document business has always been a growth, it just accelerated and we think that that’s a trend that will be durable."
},
{
"speaker": "Operator",
"text": "Next we’ll hear from Kirk Materne with Evercore ISI."
},
{
"speaker": "Kirk Materne",
"text": "Thanks very much. So I want to stay in the same topic, in terms of the Document Cloud. So Shantanu given that this might be the new normal, and maybe demand is getting pulled forward, are you applying more resources to that area from our sales capacity perspective either verticalizing even further, just – what are you doing, I guess to capture maybe what is the pull forward and it turns out, people are thinking about the digitization of documents? And then John, just on a related topic your bookings impact Document ARR, Document Cloud ARR been up 30%, I think the last two quarters. It seems to be an upward bias perhaps on revenue in that segment. Is that a fair assumption going forward? Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Kirk, your first question to good one. And again, going back to what we were able to do during this, we have made it so that the offerings that we have that combine the strength of what we are doing on Adobe Sign with the strength that we have on content in the Digital Experience business and what we were delivering with forms, whether that was for the public sector, we have our entire field organization now out there evangelizing what we can do on the document side. So that gives you one example of a significant shift as it relates to making sure that we have our entire organization aligned around the go-to-market. I think in terms of partnerships and partnerships that we have done on the document side and Sign and API functionality. We’ve always talked about the opportunity that we have with Microsoft and the integration. We also announced a really strategic partnership with ServiceNow. If you think what ServiceNow is able to do, which is really change how workflows happened in an enterprise every single one of those workflows then needs the statement of record as it relates to PDF but then makes that a tangible. So again, that one we have been able to do. So really great question and that’s one of the ways in which we are able to pivot like a nimble small company rather than – and use our brand rather than weight. And so that’s an example of the entire DX field organization also now has an offering associated with Sign that they can take into every one of our customers."
},
{
"speaker": "John Murphy",
"text": "And I think on the – in terms of a bias towards Document Cloud revenue growth versus Creative, both are just huge opportunities and we continue to see growth opportunities coming for both. Certainly, obviously the pandemic kind of – may be accentuated the move to digital document workflows and e-signatures. But as we talked about, we see some of these smaller business has come back, we certainly expect them to come back in the creative side as well because content creation is not going away as it’s imperative going forward for these businesses. So I think we just are excited about the opportunity in both of those files and all the solution associated with them."
},
{
"speaker": "Kirk Materne",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Jay Vleeschhouwer with Griffin Securities has our next question."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. Shantanu, John, does the strategic mix shift in DX improve the feasibility of you getting back to a 65% or better gross margin in DX, which is where you were before the TubeMogul acquisition? And perhaps as part of your overall strategy, you could also talk about the role of increasing self-serve, which we’ve talked about on prior calls. Additionally at Summit, Adobe had some very interesting things to say about some new initiatives and technologies such as scalable content, optimized personalization, pervasive commerce, which is really interesting one, and then of course applications and intelligent services. So maybe talk about the latter in terms of how are you thinking about resources for those and incremental business opportunities in those?"
},
{
"speaker": "Shantanu Narayen",
"text": "As always Jay that was three questions mirrored in one, but I appreciate all of them. I think as it relates to the COGS I think and the gross margin, you have actually seen that improve even as you look at the data sheet that you have for Q2. So I think it’s something like $35 million or something on quarter-over-quarter. So I think you see the improvement in the COGS. We are constantly looking at our COGS and we want to make sure we improve. I think your question around Summit and the excitement that we have around all the things that we announced is another reason why when you have that differentiated solution that’s really where I think our value add to a customer is so much higher, and there is a lot of interest, there’s a lot of interest as people look at it and say, all of this data that they are now drowning in how can they use Adobe’s intelligent services so that it automatically personalizes whatever is required for a user across multiple channels. So you are right, I mean Summit for us was very interesting and that we were able to transact with a lot more folks, we got a lot more awareness out, we were able to, actually advance what we would do with Summit that were globally rolled out. I would say it’s probably a little less mature pipeline and that’s one thing that you miss the ability to move that forward. But all of that’s now we expect that trend as we move into the second half in 2021 because that is going to be top of mind. So that’s a little bit of how we’re looking at it."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Okay, thank you."
},
{
"speaker": "Operator",
"text": "We’ll now hear from Kash Rangan with Bank of America."
},
{
"speaker": "Kash Rangan",
"text": "Thank you very much. First off, I want to just congratulate my friend, Brent Thill on his 25 years of being a software analyst. Shantanu in case you do not know, that’s my value add for you today. But my question for you Shantanu as far as Adobe, what are the lessons learned by Adobe in this quarter operating virtually as a company? And what are the windows of – or snippets of insight you could offer to us about go to market, of product development, partnership, marketing, the things that you were able to accomplish virtually and as a result, how much of it is here to stay as you look into 2021 and beyond? And the kind of savings, costs, expenses, whatever it is of revenue opportunities, how should we frame Adobe post pandemic?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, Kash, I mean it’s something that we are all focused on a lot as a company. I mean first I will reiterate in fact that overnight as a company 20,000 employees all around the world were productive. I mean in my internal note to the company, as part of this earnings I said I was just blown away. We had our first ever virtual close, the IT organization, in terms of how they’ve made sure that we are all productive through video conferences. I would actually say when you look at existing projects, most people would say that their productivity is actually greater than 100% because they are saving on travel, they are saving on the ability to be very productive without too many meetings and so I think as it relates to the new normal on the product engineering side, it’s been phenomenally successful. I think we need a little bit more focus on what happens with respect to creating new projects, so that one of the brainstorming that happens as it relates to the virtual white boarding. So that’s something that we will continue to focus on. On the dealing with customers which was the other part, so internally we feel very good. On the dealing with customers, I think that went through a little bit of a slow phase as customers were first thinking about their internal, but frankly right now I mean sometimes you feel like you’ve conquered time and space because you can have meetings with people across four continents on the same day, makes for a long day Kash, but it actually feels really good that we’re now engaging with customers. So we just feel that our ability to attract talent also wherever they might live that’s going to improve. And so net, net, I would say, for a company like Adobe internally, our productivity is overall higher, but even more important, I think it serves at such an inflection point because every single company is now going to say, hey, I need to go talk to Adobe, whether it’s about creative, whether it’s about documents or whether about Digital Experience. So I think the macro tailwinds is probably going to be the longer lasting benefit to a company like Adobe and certainly, Brent congratulations on 25 years. I mean, the two of you have been great sort of followers of the company and very insightful. So congratulations."
},
{
"speaker": "Operator",
"text": "We’ll now hear from Keith Bachman with Bank of Montreal."
},
{
"speaker": "Keith Bachman",
"text": "Hi, thank you very much. Shantanu, I want to direct this to you. In the past, you’ve talked about the growth of Creative, Creative being both people or units as well as price mix and suggested that the growth of users, has been a greater contributor to the net growth rates of creative. And I just wanted to see given the pandemic over the next few quarters, is that still true? And how are you thinking about potential price increases when you’re normally introduced new products with the Creative Suite? And then also just wanted to sneak in one to see if you can give us an update on Magento and traction and integration and any kind of anecdotes on run rates associated with that property? Thanks very much."
},
{
"speaker": "Shantanu Narayen",
"text": "I think on your first question, there is no question that the creative market and everybody who has a story to tell, it is only getting larger. I mean, as we said we were proud of $30 million provisioned, also for education, which is going to be I think a great base for us to build on, and I wouldn’t say it is one segment or the other. I think really Keith, it’s all of the different segments. Mobile did very well, we have different price points, we have Spark for communicators. And again it is our vision is very clear. It is a one-stop shop for everything from inspiration to monetization. So expect us to continue to see more offerings, more price points, and using our DDOM frankly to both acquire them as well as to make sure that we serve them appropriately. I’m glad you asked the question on commerce. Commerce usage has certainly gone up very dramatically in terms of how we’ve seen the enterprise adoption of our commerce solutions was very strong in the quarter. I think it’s important for all of you to also remember that the way we do that is it’s typically licensed base with a band of how many transactions. So it’s really not about – the transaction doesn’t immediately result in revenue, but whether it’s a true-up or whether it’s an increased band that they will have to go. So, new customer acquisition was good in that. Usage as certainly gone up, it is almost like you’re having Black Friday or Cyber Monday every day, but we will continue to hopefully see that as we talk about renewals, how they get into higher bands."
},
{
"speaker": "Jonathan Vaas",
"text": "Operator, we are coming up on the top of the hour. We’ll take one more question please."
},
{
"speaker": "Operator",
"text": "Your question will come from Alex Zukin with RBC Capital Markets."
},
{
"speaker": "Alex Zukin",
"text": "Shantanu, thank you guys for squeezing me in and congrats to Brent for his 25 years. I guess maybe, Shantanu, can you talk a little bit about as you look at the linearity of the quarter, particularly the Digital Experience business kind of taking out the Advertising Cloud piece, where are we in terms of sales cycle normalization in your mind? And then maybe as a, just a quick follow-up on the margins, given the new positive tailwind to gross margin from some of these initiatives, is it fair to say that the new operating margin profile should be somewhere between the 1Q and 2Q levels?"
},
{
"speaker": "Shantanu Narayen",
"text": "John, certainly you can add on the margin, I think Alex, as it relates to the linearity during the quarter I think the month of March and this is probably true for most of the businesses that was where the real impact was felt and then April actually became worse. I think as we got into May, people started to engage a lot more we saw signs of improvement. I think John touched on that as well. And so I think that’s the way I would highlight it for a month, month and half, everybody knew Digital was an imperative, but they had other fires that they were fighting. And then as it related to March, I mean, May, sorry, it all started to open up and we are having far more conversations with customers. So hopefully that gives you some feeling about linearity, which is why we are optimistic about moving forward as we have that pipeline. How we will deal with. And the operating margin will be between the Q1 and Q2 levels. If you think about it, you’re not going to see any big change dramatically, but as John said, I think we will continue to invest in. And I realized we ran a little bit long with the prepared remarks, and so we may not be able to get all of the questions, but let me again say I am really proud. I am proud of what the company was able to accomplish in Q2. And I’m even more excited about what the future growth opportunities are for Adobe because there is no question that digital is going to be even more of a driver of the economy. It’s going to amplify the urgency for individuals to be creative and collaborators, it’s going to improve the urgency for enterprises to engage digitally and when you think about the portfolio of products that we have, learning is no longer – learning to be creative will no longer be a luxury, dealing with electronic documents is going to be the way business is transacted, the PDF platform and ecosystem is thriving, and on the DX side, engaging digitally with customers is going to be mission critical irrespective of the size of the business. And so we are proud of our unique business model, growth is a priority for us, but we will always focus as we have with great cash flow and high profitability. I’m proud again as I said that we used this crisis to further refine our strategy and align the organization on what truly matters, which is sustained innovation and delighting our customers. Please stay safe, stay healthy. And thank you very much for joining us today."
},
{
"speaker": "Jonathan Vaas",
"text": "This concludes our call. Thanks everyone."
}
] | Adobe Inc. | 24,321 |
ADBE | 1 | 2,020 | 2020-03-12 17:00:00 | Operator: Good afternoon. I would like to welcome you to the Adobe First Quarter Fiscal Year 2020 Earnings Conference Call. Today’s call is being recorded. There will be a question-and-answer session following the prepared remarks. I would like to now turn the call over to Mr. Mike Saviage, Vice President of Investor Relations. Please go ahead, sir.
Mike Saviage: Good afternoon. Thank you for joining us today. Joining me on the call are Adobe’s President and CEO, Shantanu Narayen; and John Murphy, Executive Vice President and CFO. On our call today, we will discuss Adobe’s first quarter fiscal year 2020 financial results. By now, you should have a copy of our earnings press release, which crossed the wire approximately one hour ago. We have also posted PDFs of our earnings call prepared remarks and slides, and an updated Investor Data Sheet on adobe.com. If you would like a copy of these documents, you can go to Adobe’s Investor Relations page and find them listed under Quick Links. Before we get started, we want to emphasize that some of the information discussed on this call, particularly our revenue and operating model targets and our forward-looking product plans, is based on information as of today, March 12, 2020, and contains forward-looking statements that involve risk and uncertainty. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, you should review the forward-looking statements disclosure in the earnings press release we issued today, as well as Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is available in our earnings release and on Adobe’s Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe’s Investor Relations website for approximately 45 days and is the property of Adobe. The call audio and the webcast archive may not be rerecorded or otherwise reproduced or distributed without prior written permission from Adobe. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Mike, and good afternoon. We delivered another record quarter in Q1, achieving $3.09 billion in revenue representing 19% year-over-year growth. GAAP earnings per share for the quarter was $1.96 and non-GAAP earnings per share was $2.27. Our strategy of unleashing creativity for all, accelerating document productivity, and powering digital businesses continues to drive strong top and bottomline performance. Adobe’s unique advantage of enabling everyone from students to creative professionals to small businesses and large enterprises, to create and deliver exceptional digital experiences is enabling our customers’ success and fueling our business momentum. With Creative Cloud, Document Cloud, and Experience Cloud, we are growing across all geographies and industries and appealing to a broader set of customers than ever before. In our Digital Media business, we achieved record revenue in both Creative Cloud and Document Cloud in Q1. Net new Digital Media annualized recurring revenue, or ARR was $400 million and total Digital Media ARR exiting Q1 grew to $8.73 billion. Q1 Creative revenue was $1.82 billion, which represents 22% year-over-year growth. The desire to create rich and expressive experiences is universal. Adobe is giving everyone, including newer customer segments like business communicators and social media creators the inspiration and tools to tell their story. We are proud of the impact our flagship digital imaging solutions have had in shaping culture and creative expression. This year, Photoshop turns 30 years old. Photoshop has helped push the limits of creativity across a broad range of creative disciplines from photography to graphic design. It is truly the heart of the creative world, and we continue to develop a steady stream of innovative new Photoshop capabilities and applications across surfaces. Demand for our mobile applications like Photoshop on iPad, Lightroom, and Photoshop Express continues to grow. With more than 35 million new Adobe IDs in Q1, mobile is proving to be a strong pipeline for paid mobile only, as well as desktop subscriptions. Film has always had the incredible power to connect us through compelling stories, and Adobe continues to be the leader in video production software. At the recent Sundance Film Festival, more than 80% of the films created used Creative Cloud. Now more than ever, we believe every voice needs to be heard. As part of our efforts to empower diverse voices and support the next-generation of film makers, Adobe launched the inaugural Women at Sundance Adobe Fellowship and renewed our commitment to the Sundance Ignite program, which supports young film makers. This quarter, Adobe Character Animator took home an Emmy for breaking new ground in television animation. This recognition reflects our continued ability to create innovative applications and establish new categories. Adobe Spark, our easy-to-use application for creating social graphics, videos, and web pages, is now a top destination for hundreds of basic creative tasks. We are seeing great momentum with Spark, with organic search alone contributing more than 1 million new registered users per quarter. Business communicators and social marketers are increasingly turning to Spark to help them engage with their audiences in compelling ways. Creativity is a fundamental skill in the digital age and we remain committed to building STEAM skills for the next generation. We recently announced a one-of-a-kind partnership with Teach for America to provide educator training, workshops and tools to put creativity front-and-center in the classroom. Together, in this first phase, our goal is to reach 15,000 teachers and 500,000 students in the U.S. who otherwise wouldn’t have access to creative tools or programs. Our efforts to improve digital literacy extend across the globe. While visiting India recently, I had the opportunity to meet with students who were finalists in an Adobe creativity competition. In conjunction with the 150th anniversary of Mahatma Gandhi’s birth, students from 20,000 schools were encouraged to depict how Gandhi’s values can help our modern world prosper. I was inspired and moved by students’ messages of humanity and the brilliant ways they chose to tell their stories using Creative Cloud. With Adobe Document Cloud, we are accelerating document productivity, modernizing how people work with documents across all devices. Document Cloud revenue in Q1 was $351 million and we grew Document Cloud ARR to $1.15 billion. This momentum is being driven by strong customer acquisition and the expanding portfolio of PDF mobile and web applications. Key wins in the quarter included Equifax, Gannett, Shell, and Cummins. Acrobat continues to be the gold standard for creating, editing, scanning, signing, and sharing digital documents. As more people are working on the go, our mobile app usage continues to rise. More than 600 million people have installed Acrobat on their mobile devices. As digital transformation continues at organizations across the globe, Adobe Sign continues to power paper to digital work flows across all industries, including the majority of Fortune 100 companies. This quarter, we extended the reach of Adobe Sign with an enhanced integration with SharePoint that enables people to easily create and sign digital forms. We recently launched the ability to convert to and from PDF via one-click access on the web, providing a seamless on-ramp to PDF services and an Acrobat subscription. We are providing PDF functionality through APIs and expanding integrations with partners. Our recent integration with Google Drive gives its more than 1 billion users instant access to Acrobat’s best-in-class tools to create, view, annotate, modify, and share PDFs without leaving Google Drive. In our Digital Experience business, we achieved revenue of $858 million in Q1, which represents 15% year-over-year growth. Now, more than ever, every business across B2C and B2B, and mid-market to enterprise must be a digital business, driving opportunity for Adobe Experience Cloud. The industry’s most comprehensive offering, Adobe Experience Cloud features innovative applications and services built on the Adobe Experience Platform and leveraging Adobe Sensei’s AI and machine learning framework. Key wins this quarter included Intuit, PayPal, Bank of America, CommonSpirit Health, Travelzoo, State of Oklahoma, Kohl’s, National Instruments, Toyota Motor, and Accenture. Only Adobe has data from trillions of transactions, tens of millions of products and thousands of retailers which gives us the unique ability to assess the global digital economy in real-time. Building on the success of our annual Holiday Shopping report, we are developing an economic index to help companies get a better understanding of local and global trends, so they can anticipate changes and manage their businesses effectively in this dynamic market. A great experience starts with compelling content and is informed by data and insights. Harnessing the power of Adobe Experience Platform to stitch together siloed data across the enterprise, our recently released Customer Journey Analytics service gives our customers a set of analytics tools that provides a complete picture of the customer journey, online and offline. We are continuing to drive strong performance with Adobe Experience Manager for omnichannel content delivery. This quarter, we launched Adobe Experience Manager as a cloud service enabling brands to go live with personalized campaigns and experiences across any channel, device or mobile app in days instead of months. It provides agility and flexibility for enterprises and mid-sized companies with brands like Under Armour, Coca-Cola and Morningstar becoming early customers. Adobe Commerce Cloud enables our customers to make every moment personal and every experience shoppable. With new functionality that enables merchants to natively add high-quality media assets to their websites and create personalized recommendations, we drove more than 50% year-over-year bookings growth. For the third consecutive year, our industry leadership was validated in the Gartner Magic Quadrant for Digital Experience Platforms and achieved the strongest position in Completeness of Vision. The Digital Experience opportunity is immense, our roadmap is robust and we are excited to have Anil Chakravarthy lead this business. Anil brings a powerful combination of business and product leadership, and his impact is already being felt. We are proud to have created a unique employee culture that embraces diversity and inclusion, and supports the communities in which we live and work. This commitment has made Adobe one of Fortune’s 100 Best Companies for the past 20 years. This quarter, we were honored for our sustainability efforts on the CDP A List for climate change for the fourth consecutive year and we were included in the Bloomberg Gender Equality Index, recognizing our transparency in gender reporting and advancing women’s equality in the workplace. While Q1 was a typically strong quarter, I know what’s top-of-mind for all of us is navigating the impact of COVID-19. The well-being of our employees and customers is our number one priority. In addition to encouraging employees in impacted regions to work from home for the next two weeks, we are restricting travel and canceling in-person events. In keeping with that strategy, we made the tough decision to cancel the in-person Adobe Summit in Las Vegas and replace it with a digital event at the end of the month. We are proactively engaging digitally with our current customers to support their businesses and continuing to drive enterprise pipeline globally. We are fortunate that the company’s revenue and earnings are relatively predictable as a result of our move to a subscription-based business model. We have seen little to no impact on adobe.com for Creative Cloud and Document Cloud demand thus far, and we will continue to acquire and engage customers digitally. In my conversations with business leaders across the globe, it is evident that investments in digital will continue to be critical, but dealing with the implications of COVID-19 is the immediate priority. As a result, we expect some enterprises will delay bookings, postpone services implementation and reduce expenses. We will be using Adobe digital solutions to mitigate impact and to engage with our customers. While the situation is concerning and there’s tremendous uncertainty, the long-term fundamentals of our business remain undiminished. Adobe is at the center of three massive market opportunities across creativity, digital documents, and customer experience management, which will fuel growth in the near- and long-term. Businesses must transform to deliver a personalized digital relationship with every customer. The paper-to-digital revolution continues. Creativity and design have never been more relevant. We will continue to lead in these categories and manage the company for the long run, while we navigate through this environment. At times like this, the best companies like Adobe continue to innovate, drive increased focus and emerge stronger than ever before. John?
John Murphy: Thanks, Shantanu. In the first quarter of FY’20, Adobe achieved record revenue of $3.09 billion, which represents 19% year-over-year growth. GAAP diluted earnings per share in Q1 was $1.96 and non-GAAP diluted earnings per share was $2.27. Our earnings per share results include a charge related to the cancellation of corporate events including Adobe Summit due to the COVID-19 situation, which lowered both GAAP and non-GAAP EPS by $0.07 in the quarter. Business and financial highlights in Q1 included Digital Media revenue of $2.17 billion, net new Digital Media ARR of $400 million, a record for Q1, Digital Experience revenue of $858 million, generating strong cash flow from operations of $1.32 billion, growing Remaining Performance Obligation or RPO to $9.91 billion and repurchasing 2.4 million shares of our stock during the quarter. In our Digital Media segment, we achieved 22% year-over-year revenue growth in Q1. The addition of $400 million net new Digital Media ARR grew the total exiting the quarter to $8.73 billion. Creative revenue grew 22% year-over-year and we increased Creative ARR by $329 million. Q1 Creative growth driver included strong new user growth starting early in the quarter with Cyber Monday followed by continued customer acquisition throughout the quarter. Single app adoption as we target new users who are more inclined to adopt Creative Cloud through the use of a specialized application such as Photoshop, Illustrator, Premiere and Acrobat. Mobile app subscriptions including adoption of Photoshop on the iPad, continued momentum with creative services including Adobe Stock, where revenue again grew by 30% year-over-year and continued focus on engagement and retention. Strong Adobe Document Cloud revenue growth continued in Q1. We achieved record Document Cloud revenue of $351 million, which represents 24% year-over-year growth and we added $71 million of net new Document Cloud ARR during the quarter. Document Cloud performance during Q1 was driven by consumer adoption of mobile apps, PDF services and Acrobat subscriptions, conversion of free mobile app users to paid subscriptions for services such as Create PDF Online, strong performance with enterprise customers including new logos and renewals and Document Cloud services adoption including continued momentum with Adobe Sign revenue which grew greater than 20% year-over-year in Q1. In Digital Media, the COVID-19 situation did not impact our overall business on adobe.com in Q1. However, we did experience weakness in China, which is primarily a channel-based reseller market. In our Digital Experience segment, we achieved quarterly revenue of $858 million, which represents 15% year-over-year growth in Q1. Subscription revenue for the quarter was $739 million, growing 21% year-over-year and we grew our Digital Experience bookings by greater than 20% year-over-year. Q1 Digital Experience highlights include success with our Content and Commerce solutions, where we drove notable adoption of Adobe Experience Manager and Adobe Commerce Cloud. During the quarter, we continued to focus on closing Adobe Experience Platform opportunities while growing the pipeline. Our strategy and value proposition continued to resonate with customers who wish to increase their digital engagement with their customers. In Digital Experience, the impact of the COVID-19 situation in Q1 was some unanticipated deal slippage during the last 10 days of the quarter. From a quarter-over-quarter currency perspective, FX increased revenue by $1 million. We had $7 million in hedge gains in Q1 FY’20 versus $12 million in hedge gains in Q4 FY’19, thus the net sequential currency decrease to revenue considering hedging gains was $4 million. From a year-over-year currency perspective, FX decreased revenue by $27 million, with $7 million in hedge gains in Q1 FY’20 versus the $9 million in hedge gains in Q1 FY’19 resulted in a net year-over-year currency decrease to revenue considering hedging gains of $29 million. Adobe’s effective tax rate in Q1 was minus 4% on a GAAP basis and 10% on a non-GAAP basis. Both rates were lower than targeted due to a larger than expected deduction associated with the vesting of stock-based compensation. The reduction of the quarterly tax rate benefited GAAP and non-GAAP EPS by $0.17 and $0.03, respectively, in the quarter. Our trade DSO was 41 days, which compares to 46 days in the year ago quarter and 47 days last quarter. Remaining Performance Obligation or RPO grew by 22% year-over-year to $9.91 billion exiting Q1, which compares to $9.82 billion exiting Q4. The sequential quarter-over-quarter growth was consistent with normal seasonality. Deferred revenue exiting Q1 was $3.61 billion. Our ending cash and short-term investment position exiting Q1 was $4.17 billion and cash flow from operations was $1.32 billion in the quarter. In Q1, we repurchased approximately 2.4 million shares at a cost of $795 million. We currently have $4.25 billion remaining of our $8 billion repurchase authority, which goes through 2021. Turning to our financial targets, I would like to review two areas as you think about modeling the rest of our fiscal year. First, our Q1 tax rates came in lower than planned as I discussed earlier and we now anticipate both our GAAP and non-GAAP rates to be lower than we originally targeted for the full year. We continue to focus on managing costs and optimizing Adobe’s international structure to deliver more value to our customers and investors. We anticipate making changes to our international structure during Q2 and Q4 this year that will better align ownership of certain intellectual property rights with how our business operates, while allowing us to remain tax efficient. We now anticipate our GAAP quarterly tax rates to be minus 10%, 10% and minus 85% in Q2, Q3, and Q4, respectively. The changes to our international structure do not impact our non-GAAP tax rates and we expect our non-GAAP quarterly tax rate to be 10% in Q2, Q3 and Q4. The second area is the consideration of business impact we could see because of COVID-19. We have factored into our Q2 targets the expected impact of the global uncertainty caused by the COVID-19 situation as we understand it to date. While our revenue and earnings are relatively predictable as a result of our subscription-based business model, we do expect to be impacted in the following areas, enterprises deferring bookings decisions, delaying consulting services implementations and reducing marketing spend, consumers reducing spending in countries more adversely impacted by the COVID-19 situation, and software license revenue driven by channel partners. These impacts are expected to be more prominent in countries and industries most affected by the crisis. In Q2 FY’20, we are targeting revenue of approximately $3.175 billion, Digital Media segment year-over-year revenue growth of approximately 19%, net new Digital Media ARR of approximately $385 million, Digital Experience segment year-over-year revenue growth of approximately 12%, net non-operating expense of approximately $14 million, tax rate of approximately minus 10% on a GAAP basis and 10% on a non-GAAP basis, share count of approximately 486 million shares, GAAP earnings per share of approximately $2.10 and non-GAAP earnings per share of approximately $2.35. In summary, we continue to believe we are well-positioned as a market leader in large growing categories. The benefits of running a real-time business and the high percentage of our revenue that is recurring enables us to monitor and take action in how we drive revenue or control costs, all of which should enable us to deliver solid results as the world navigates the COVID-19 situation. Finally, I want to share with you the news that Mike Saviage has decided to retire from Adobe later this year. As the Head of Investor Relations, Mike has been an important champion of Adobe’s growth and transformation story over the past three decades. We will be appointing an internal replacement and Mike will be on board for the next few months to help us transition the new leader. I want to thank Mike for his many contributions to Adobe and wish him well on his retirement. I will now turn the call back over to Mike.
Mike Saviage: Thanks, John, and thank you for those comments. As we announced last week, we have shifted Adobe Summit, our Annual Digital Experience user conference, to be an online event and virtual conference starting on Tuesday, March 31st. As the event draws closer, we will provide instructions on the summit.adobe.com website for how to access online keynote presentations and educational sessions along with the timing of them. If you wish to listen to a playback of today’s conference call, a webcast archive of the call will be available on our IR site later today. Alternatively, can you listen to a phone replay by calling 888-203-1112, use conference ID number 4347041. International callers should dial 719-457-0820. The phone playback service will be available beginning at 5 p.m. Pacific Time today and ending at 5 p.m. Pacific Time on March 19, 2020. We will now be happy to take your questions. We ask that you limit your questions to one per person. Operator?
Operator: Thank you. [Operator Instructions] We will take our first question from Brent Thill with Jefferies. Please go ahead.
Brent Thill: Thanks. Good afternoon, Mike. Congrats on three decades. I am very happy for you. Shantanu, just on the Creative business, there are many questions around obviously no one knows how long the current situation is going to last, but many are kind of asking how insulated you believe the Creative business is. The guidance for this next quarter was encouraging and probably a little bit better than most thought. So if you could just walk through how you are thinking about that business over the next several quarters?
Shantanu Narayen: Sure, Brent. Clearly, I think, let me start out by saying that, we would all acknowledge that the situation is pretty unprecedented. And so, as it relates to the Creative business, maybe I will give you color not just for Q1, but also actually for the first few days of March and I will talk about that in the context of the customers that we serve. And maybe again, as sort of a preview to what John talked about, let me just tell you a little bit about the options that we considered. I mean, clearly, given the situation we could have sort of chosen to give no forward-looking guidance, we could have provided a range given the uncertainty or what we thought was most appropriate was given we have fairly good visibility on a direct basis, to guide based on a number and then provide more color. On Creative Cloud specifically, Brent, and on Document Cloud, in the direct-to-consumer on adobe.com, we saw actually little to no impact on Q1 on adobe.com across all geographies for both Creative and Document Cloud products; and thus far, it’s early in Q2, the overall traffic and conversion pattern have actually continued. In China, where we have a little bit more of an indirect route to market for CC and DC, which is through resellers, we know that the business is small but we saw some impact in Q1, and as you saw, despite that, we had pretty awesome overall ARR for Digital Media in Q1. In South Korea, we have actually seen relatively stable business in our Digital Media business today. In Italy, what we saw was that as the situation worsened, we saw some impact in the reseller business, but we actually appear to have seen some additional strength on adobe.com, and the fact that I guess, we have multiple routes to market there sort of helps ameliorate that. So, I mean, in sort of conclusion, we are continuing to monitor. We think that clearly long-term the Creative Expression business continues to be really strong. And specifically as it relates to Q2, absent the COVID situation, we would have probably again had sequential increase to Digital Media ARR where we’re trying to factor what we have seen a little bit of the uncertainty in the reseller impact and enterprise. And even in revenue, we have a little perpetual revenue. So, I know that was a little bit of a long answer, but hopefully that gives color in terms of all of the work that’s gone in over the last 10 days. We have already done a couple of business reviews, and this is as of what we know today, while there’s uncertainty, that’s our best estimate of how we think this plays out in Q2.
Brent Thill: Thanks for all the color.
Operator: We will take our next question from Keith Weiss with Morgan Stanley. Please go ahead.
Keith Weiss: Excellent. Thank you, guys. Thank you for taking the question. Mike, it’s been great working with you. You are way too young to be retiring, but that’s your business. Shantanu, thank you so much for kind of giving that detail on how you guys are thinking about the outlook, I think, it definitely helps investors understand how you are thinking about it and that you are imparting some conservatism into the guidance for kind of what’s going on out there. I was hoping to get some view from John on how you guys are thinking about the expense side of the equation? How aggressively that you will sort of look to match sort of the expense growth rates, is that kind of what you are seeing in the environment. Is there -- are you going to be looking to kind of protect the margins and protect the contribution margins in the business as the demand fluctuates?
John Murphy: Sure. Thanks, Keith. As we think about our ability to understand our business, we have got a great ability through our DDOM model our data driven operating model to understand how we can actually drive growth, while still expanding margins and protecting the profitability of the company. And that thesis hasn’t changed. We are still a growth company and we do focus on the profitability of the company. So, we are able to shift our expenses and our spending and our investments to appropriately capture the opportunity, but at the same time be able to hit our goals of expanding operating margin as we set out at Analyst Day this year.
Shantanu Narayen: And Keith, maybe I will add a couple more things, I mean, I think, we have always done a good job of balancing the topline and bottomline. I have no doubt that companies like Adobe actually will emerge stronger as a result of this. And what John has already instituted is we are looking at every expense associated with it. There’s certainly some areas where we have great online solutions to help our customers, where we will be investing more and there are other areas where we will be far more prudent as it relates to what happens. And maybe, John, you can also specifically comment on what happened in Q1 as it relates to that one-time charge just so that everybody understands that?
John Murphy: Yeah. So when we decided to cancel the in-person corporate events that caused us to pull in the expenses into Q1. So we made that decision before we finished Q1. So we took that charge. Its $40 million associated with that. The -- typically much of that expense would be in Q2 and would be offset actually by revenue we would get through registration fees for participants, as well as sponsorship dollars as well. So the way we have approached it is obviously the sponsors, the participants, we will not be taking that money in, so we pulled all that expense forward. So that one-time charge that you had in Q1 associated with this, all this activity was obviously a significant impact. Our margin would have been 41.6% otherwise had we not had to take that charge.
Keith Weiss: Super helpful. Thanks so much, guys.
Operator: We will take our next question from Kash Rangan with Bank of America. Please go ahead.
Kash Rangan: Hi. Thank you very much for all the details, Shantanu. You talked about how things finished up in the February quarter. I am more curious about your guidance for the May quarter. What are the assumptions especially as it relates to the geography that we are all most concerned about that could potentially worsen from a COVID perspective. What kind of growth rates and what kind of U-shaped or V-shaped recovery are you assuming for your two businesses in the U.S? Thank you so much and stay safe everybody.
Shantanu Narayen: Well, Kash, I think, we would all agree that the situation is rapidly evolving. I was interesting just even watching after the 1 o’clock the six or seven announcements that went out. And so, clearly, we are trying to give you the best color that we have as of today and not sure that I can predict or anybody can actually predict what happens. But, I think, we gave you color in Digital Media, which is we continue to expect to see the notion of both creativity and accelerating document productivity, and where there’s a direct engagement with customers, to continue to invest in engaging with them digitally and continuing to drive our business, because there is clear value associated with that. I think maybe just similarly, I can give you a little color on the Enterprise. I mean, as you know, with Enterprise selling, the end of the quarter represents a fairly large chunk of business for most people. And while that does not have impact on revenue and you never expect to close your entire pipeline, I think, as we said in the prepared remarks as well, Kash, we saw some unanticipated slippage at the end of the quarter. And so the way we have tried to think about it for Q2, I have had a ton of conversations from CEOs across all industries, and I think, the two themes that are absolutely consistent, the first theme is everybody is first and foremost making sure that they take care of the well-being of their employees. They are all dealing with travel restrictions. They are all dealing with the outbreak. The second thing that they all tell me is that, hey, this if anything will accentuate the need to engage digitally not just internal to the corporation to keep the corporation going, but externally, in order to engage with customers. But given what’s happening with travel, we just expect that there is going to be some delays associated with it, we have tried to factor that in. And the way I would describe that is absent any COVID, we would have certainly seen Digital Experience being targeted higher than what we targeted. So I think we have tried to factor it in. And maybe just a little bit more color on that, Kash, when you look at the revenue components for our business, there are three components. There’s the revenue that comes off of bookings, bookings translating into revenue. There’s usage based Advertising Cloud revenue that goes into that. And there’s delivery based revenue when services are delivered and implemented. We suspect that the services will go out a little bit. The importance remains, but as people are concerned about people traveling that will perhaps slow down a little bit and depending on the industry or vertical, that will be different. Some of it may be more immediate in terms of the bounce back some of it may be a little bit more detailed. And so what we know is that we expect bookings will probably take a little longer. We think services delivery may go a little bit longer. We feel like the Advertising Cloud might be impacted. Those are all factored into how we thought about it. If the world falls apart, that could certainly change. But we will continue to monitor it. What I have not heard from anybody is any issue associated with keeping digital front and center, because, I think, this demonstrates more than ever before if you can’t engage with your customers digitally, you are dead in the water. So hopefully that helps.
Kash Rangan: Absolutely. Thank you so much.
Operator: We will take our next question from Sterling Auty with JP Morgan. Please go ahead.
Sterling Auty: Yeah. Thanks. Hi, guys. So, Shantanu, I am just curious if anything with COVID-19 would actually impact any new product introductions in terms of feature functionality or any changes that maybe you would have considered in the near-term around pricing in any of the geographies?
Shantanu Narayen: Sterling, not to the best, I mean, we are excited. We will be doing our first digital summit. So Anil Chakravarthy is busy. I mean all the exciting things that we were going to announce in person. The plan is to announce it actually virtually coming up, a couple of exciting things there. I mean, the Adobe Experience Manager that we just introduced, which is a cloud based approach, that’s significantly, again, I think, as we said reduces the time for people to do to through self-serve and get new websites, and campaigns up and running. So on the Experience side, it was really going to be an event where we describe everything that’s on. Now with the Creative Cloud space as well, I mean, I think, if there’s one group that works more from home and has more flexible work policy, it tends to be the product team. So, I think, overall navigating what it means for nobody to be in offices, Sterling. But I think we are actually as well placed as anybody in terms of doing it. The one other thing I will mention is, we are actually for universities, given how much universities closure that there is. We are making available our creative and other tools available for people for this online training. And so, I think, while the situation is crazy, I think, there are a whole bunch of our solutions, whether it’s all the documents that are going to be shared right now, what’s going to happen with signatures, whether what you are going to do with respect to helping people engage digitally. So nothing yet that’s changed. It all depends on how long the situation continues from my perspective, Sterling.
Sterling Auty: And Mike, congratulations, it’s been one hell of a run. You have done a great job as IR. So congratulations and enjoy your retirement.
Mike Saviage: Thanks, Sterling.
Operator: We will take our next question from Saket Kalia with Barclays Capital. Please go ahead.
Saket Kalia: Hey, guys. Thanks for taking my question here and I echo my congrats to you as well, Mike, on your retirement. Shantanu, maybe for you, just thinking a little higher level, can you just talk a little bit about bringing on Anil Chakravarthy on to the team and maybe what some of his longer term goals are in the Digital Experience business?
Shantanu Narayen: Sure. Saket, I mean, I think, we are clearly the undisputed leader and have the most comprehensive offering as it relates to and we created the digital marketing category. I think as we focused on what we call as generational technology platform development. We recognized that the ability to create this unified profile and to really make sure that your first party data, you are taking more advantage of it, were two massive opportunities that every enterprise was going to have to figure out how to take advantage of, much like Adobe did with our DDOM. Anil’s background as it relates to what he had done both at Informatica and prior to that and the fact that as CEO he had the ability to look across the entire business. Both of those are going to be extremely important for us as we continue to invest in product and as we continue to focus on ensuring that the CIO and the people who engage with data, which is an area that he is completely familiar with are ones that we continue to invest in and differentiate our solution. It’s early. As I said, his presence is already being felt. But what he has been really up to is going and meeting with a number of customers. I may have to ground him for a little while right now, but he also actually had the ability to go meet with all the product people. So I think both on the product and the customer stuff, just continuing to make sure that we extend our lead and have a unified leader. Those were really the two reasons for having him on-board.
Saket Kalia: Great. Thanks.
Shantanu Narayen: Thank you.
Operator: We will take our next question from Jay Vleeschhouwer with Griffin Securities. Please go ahead.
Jay Vleeschhouwer: Thank you. Good evening. A shorter-term question, Shantanu and for you, John, as well, I noticed that you had a small sequential decrease from Q4 [Audio Gap]
Shantanu Narayen: … opportunity, we have tailwinds, we have growth in three areas. I think what you saw was really concerted effort again by John to rationalize as we had done these M&A’s and to make sure that we are not duplicating functions. And so, I think, as part of every annual planning process, we first prune to make sure that we are investing in the right areas, and I think, we did a really good job of looking at that. So for somebody like you who follows us and sees that sort of ebb and flow, it’s just a continuous process that we do. We have opportunities. I mean, we are going to continue I think again based on the question that I think Keith asked. We will be prudent about how we look at this stuff. But even if you look at our targets for Q2, I think, you will see that we are one of the companies that’s best positioned in the entire industry opportunities and we are going to continue to hire, but we will be prudent and we will continue to monitor this.
Jay Vleeschhouwer: Thanks, Shantanu.
Operator: We will take our next question from Kirk Materne with Evercore ISI. Please go ahead.
Kirk Materne: Yeah. Thanks very much. And I guess at the outset, I’d say, thanks very much for the guidance with COVID and I realize things are moving quickly, but even just the color you have given today I think will help us think through this as it continues to evolve. My question, Shantanu, would be on the Experience Cloud, obviously, a year later, I think, you have integrated the acquisitions, if you weren’t talking about COVID right now. How is your feeling about just sort of the integration of the product and the setup for that business as we head into calendar 2020?
Shantanu Narayen: Yeah. I think, Kirk, what we would have said absent COVID was good Q1, greater than 20% increase in the book of business, revenue growing nicely, highlighting the progress that we would have made. I think I shared a number of customers we have had the Experience Platform customers go live. I would have talked about cloud AEM. I think we touched on Adobe Commerce and that’s only because I wouldn’t have had time to talk about what we are doing with B2B and B2C. How we have integrated Marketo into that. And so, I think, that fundamental customer demand for digital and for engagement, nothing changes. And so that’s what I would have said if it weren’t for this situation with Q1. In effect, what John and I would have been here, talking about record performance in Q1, continued momentum from Q4, robust cash flows, strong EPS performance, and I think, all of you guys would have been saying why aren’t you raising targets if it weren’t for COVID and so, I think, I continue to feel good about the long-term opportunity.
Kirk Materne: That’s great. Thanks. And Mike, congrats on your retirement.
Mike Saviage: Thanks, Kirk.
Operator: We will take our next question from Brad Zelnick with Credit Suisse. Please go ahead.
Brad Zelnick: Great. Thank you so much, and Mike, I got to echo my congrats. I always thought maybe I would be able to retire before you but not with how the markets have been performing over the last few weeks, for sure. I think I am going to be working a long time. But anyway, Shantanu, thank you so much for all the color you provided on Digital Media so far, but just want to understand its resiliency. Because realistically, if we think about your end markets it includes a lot of small businesses and hobbyists, where there may be more stress or not thought of as much as top of wallet item? Are you may be able to share what that represents as the percentage of the overall ARR, even ballpark if you can? And what are the leading indicators are that you see through your DDOM to be able to see things like engagement, renewal rates, maybe even by SKU as it relates to this segment of the market? Thanks.
Shantanu Narayen: You are right, Brad, in that the real blessing of that business is how broad and how diverse it is and how our tools, whether they be on the creative side or whether they be on the document side are as pervasive and market leaders as they are. We tried to give the color even during this current situation and the impact, and as we said on adobe.com, there’s been little to no impact. We have become really good at how we engage with these customers. And the thing that also gives us long-term confidence in that, Brad, is the different price points. And so you have to think about it with respect to the different price points that we have and we have got really good at understanding where the mobile offerings need to be. With all these people being at home, they will have to do some things and hopefully expressing their creativity we just have to continue to help them do that. And so, yeah, we are not saying that we are completely going to be unimpacted, but so far and just looking at what we have seen thus far, these tools and creativity and the importance of design, nothing that’s happened in the last few weeks diminishes the importance of that.
Brad Zelnick: Thanks very much, Shantanu and be healthy everyone. Thanks.
Shantanu Narayen: Thanks, Brad.
Operator: We will take our next question from Jennifer Lowe with UBS. Please go ahead.
Jennifer Lowe: Great. Thank you and I would like to echo the congrats to Mike on a well deserved retirement after a pretty impressive run. So just looking at the slipped deals that were discussed in the call, obviously, it’s sort of unprecedented times and there’s a lot of moving pieces there. But is there any sort of commonality to the deals that seemed to slip in terms of size, whether those were new versus up-sell transactions, whether they were sort of just logistical issues that cropped up? I am just trying to get a better sense of where it’s just tougher to get business done at this point? Thanks.
Shantanu Narayen: There weren’t really any patterns, Jennifer. I mean, I think, there was a couple of -- if people were at home and you expect that to have people in the office to close. So just some examples of in certain countries where people were maybe not at work, I mean, you followed Enterprise Software for a long time. There are a number of stakeholders that are required. We do use Adobe Signature to close them. But I would say, it’s what little bit more of just getting the stakeholders involved. And I would actually attribute it to a large degree to the preoccupation correctly of dealing with employees and employees’ well-being. I am sure this is true of your company as well. Everybody’s just dealing with are employees safe, how do we make sure, all of that. So I would attribute it more to that, and we will just have to continue to monitor what happens. But the conversations that I am having and we are so -- one of the things we are doing is actually proactively reaching out to every single customer of what is the right way to engage with them digitally in terms of saying, here’s how we can help. I think all of you are probably seeing more communication. I should acknowledge that a number of the deals that slipped actually did close in the time that was past it, but it’s uncertain times. So hopefully that gives you some color into what we were observing.
Jennifer Lowe: Okay. Thank you.
Operator: [Operator Instructions] We will hear next from Walter Pritchard with Citi. Please go ahead.
Walter Pritchard: Hi. Thanks. Two questions, one, just on Sign, you talked pretty positively about this business for a number of quarters. I am wondering if you could update us on what is the strongest demand drivers there, are they kind of direct deals out selling as part of larger engagements or is it more transactional attached to Acrobat and especially the mid-market low end?
Shantanu Narayen: I think, Walter, it’s actually all across the map. We had a good quarter as it related to Sign revenue. And make no mistake, the Reader distribution and wanting to do stuff with PDF and work flows associated with PDF, that’s a big part of that business. We have talked about how we are going to make those APIs available as well so that people can embed it. We talked a little about the integration with Google, but it’s all across. I mean, as an ingredient service or as we talk about it, Sign is certainly part of the solution across all those segments. As a complete offering with respect to what we have with PDF across Acrobat and in the enterprise and with Adobe Experience Manager. But it really is across the board. And I think you are going to see more demand for those services right now because physical signatures are going to be less easy to manage than electronic signatures.
Walter Pritchard: Got it. And then just John, I am not sure if you are breaking this out but I guess we are getting this question quite a bit. On the DX business with the transactional piece where you broke out those three pieces, any way to give us, let us know if that’s the smallest of the piece or any range in terms of revenue exposure from transactional in DX would be helpful?
John Murphy: Yeah. No. If you go back to the Analyst Meeting, we broke out each of those three components for you. And so you can see that it’s actually roughly 20% of the business, 20%, 25% of the total DX business in terms of Ad Cloud and Professional Services piece.
Walter Pritchard: Okay. That hasn’t changed?
John Murphy: No.
Walter Pritchard: Okay. Thank you very much.
Mike Saviage: Operator, we are coming up on the top of the hour. We will take one more question, please.
Operator: Thank you. We will take our last question from Keith Bachman with BMO. Please go ahead.
Keith Bachman: Hi. Thank you very much. Shantanu, I just wanted to revisit a little bit on the Experience revenue. You are guiding the current quarter, the second quarter rather to 12% year-over-year growth. Back in December, you talked about the growth potential for 2020 being plus or minus 16%. How should we think about the rest of the year in the Digital Experience segment, given macro’s really tough and the COVID virus is making it challenging, but also including any kind of competitive comments that you want to make surrounding it? Thanks.
Shantanu Narayen: Yeah. I think, what we see, frankly, right now is the color associated with what’s happening in Q2. As you know, in December we provide targets based on the product roadmap. And from my perspective, Q1 execution and performance was terrific. And while we are giving you as much color as we know for Q2 as of today, given the unprecedented times, we are really not going to comment on the second half. We will continue to monitor. None of this changes long-term trends and so that’s how we think about it.
John Murphy: And maybe I could just add in there, because we did give a lot of in the prepared remarks about updating tax rates for the year because of the fluctuation. And I know in terms of modeling the folks have been asking what do we think about beyond FY’20 and so as we I said at the Analyst Meeting we expected an increase in FY’21. And so based on these changes that I had highlighted in my prepared remarks on the tax rates, you can kind of expect FY’21 to be roughly a 17% non-GAAP rate, 19% on a GAAP basis.
Shantanu Narayen: And since that was the last question, let me also echo, I think, all of your sentiments, which is thank Mike for his outstanding contributions to Adobe. I have certainly observed firsthand his passion for the business and his IR leadership has been invaluable to me as a partner as we have transformed the company. I told him that we have been doing this call together since 2001 and I will certainly miss him and wish him well. But with his help, we will make sure that we have a smooth transition. So thank you, Mike. As it relates to the business, Q1 was strong, we will continue to execute on our strategy and focus on the three large opportunities ahead of us, unleashing creativity, accelerating document productivity, empowering digital businesses. And I don’t think that the recent situation changes the relevance or importance of any of this for our customers and it will only magnify the need to go digital with more urgency. Given the situation is fluid we tried to give you as much insight into what’s happening in our business. The demand for Creative Document and Enterprise is strong. But the impact as we said of COVID will probably be felt a little bit more in the short-term in the enterprise business. But again, we believe that we are better positioned than most to continue to innovate, to drive both top and bottomline, and emerge stronger and more mission critical. We really hope you guys will join us for our digital summit and much like a number of you have said, stay safe and thank you for joining us today.
Operator: Thank you. This concludes our call. | [
{
"speaker": "Operator",
"text": "Good afternoon. I would like to welcome you to the Adobe First Quarter Fiscal Year 2020 Earnings Conference Call. Today’s call is being recorded. There will be a question-and-answer session following the prepared remarks. I would like to now turn the call over to Mr. Mike Saviage, Vice President of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Mike Saviage",
"text": "Good afternoon. Thank you for joining us today. Joining me on the call are Adobe’s President and CEO, Shantanu Narayen; and John Murphy, Executive Vice President and CFO. On our call today, we will discuss Adobe’s first quarter fiscal year 2020 financial results. By now, you should have a copy of our earnings press release, which crossed the wire approximately one hour ago. We have also posted PDFs of our earnings call prepared remarks and slides, and an updated Investor Data Sheet on adobe.com. If you would like a copy of these documents, you can go to Adobe’s Investor Relations page and find them listed under Quick Links. Before we get started, we want to emphasize that some of the information discussed on this call, particularly our revenue and operating model targets and our forward-looking product plans, is based on information as of today, March 12, 2020, and contains forward-looking statements that involve risk and uncertainty. Actual results may differ materially from those set forth in such statements. For a discussion of these risks and uncertainties, you should review the forward-looking statements disclosure in the earnings press release we issued today, as well as Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. A reconciliation between the two is available in our earnings release and on Adobe’s Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe’s Investor Relations website for approximately 45 days and is the property of Adobe. The call audio and the webcast archive may not be rerecorded or otherwise reproduced or distributed without prior written permission from Adobe. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Mike, and good afternoon. We delivered another record quarter in Q1, achieving $3.09 billion in revenue representing 19% year-over-year growth. GAAP earnings per share for the quarter was $1.96 and non-GAAP earnings per share was $2.27. Our strategy of unleashing creativity for all, accelerating document productivity, and powering digital businesses continues to drive strong top and bottomline performance. Adobe’s unique advantage of enabling everyone from students to creative professionals to small businesses and large enterprises, to create and deliver exceptional digital experiences is enabling our customers’ success and fueling our business momentum. With Creative Cloud, Document Cloud, and Experience Cloud, we are growing across all geographies and industries and appealing to a broader set of customers than ever before. In our Digital Media business, we achieved record revenue in both Creative Cloud and Document Cloud in Q1. Net new Digital Media annualized recurring revenue, or ARR was $400 million and total Digital Media ARR exiting Q1 grew to $8.73 billion. Q1 Creative revenue was $1.82 billion, which represents 22% year-over-year growth. The desire to create rich and expressive experiences is universal. Adobe is giving everyone, including newer customer segments like business communicators and social media creators the inspiration and tools to tell their story. We are proud of the impact our flagship digital imaging solutions have had in shaping culture and creative expression. This year, Photoshop turns 30 years old. Photoshop has helped push the limits of creativity across a broad range of creative disciplines from photography to graphic design. It is truly the heart of the creative world, and we continue to develop a steady stream of innovative new Photoshop capabilities and applications across surfaces. Demand for our mobile applications like Photoshop on iPad, Lightroom, and Photoshop Express continues to grow. With more than 35 million new Adobe IDs in Q1, mobile is proving to be a strong pipeline for paid mobile only, as well as desktop subscriptions. Film has always had the incredible power to connect us through compelling stories, and Adobe continues to be the leader in video production software. At the recent Sundance Film Festival, more than 80% of the films created used Creative Cloud. Now more than ever, we believe every voice needs to be heard. As part of our efforts to empower diverse voices and support the next-generation of film makers, Adobe launched the inaugural Women at Sundance Adobe Fellowship and renewed our commitment to the Sundance Ignite program, which supports young film makers. This quarter, Adobe Character Animator took home an Emmy for breaking new ground in television animation. This recognition reflects our continued ability to create innovative applications and establish new categories. Adobe Spark, our easy-to-use application for creating social graphics, videos, and web pages, is now a top destination for hundreds of basic creative tasks. We are seeing great momentum with Spark, with organic search alone contributing more than 1 million new registered users per quarter. Business communicators and social marketers are increasingly turning to Spark to help them engage with their audiences in compelling ways. Creativity is a fundamental skill in the digital age and we remain committed to building STEAM skills for the next generation. We recently announced a one-of-a-kind partnership with Teach for America to provide educator training, workshops and tools to put creativity front-and-center in the classroom. Together, in this first phase, our goal is to reach 15,000 teachers and 500,000 students in the U.S. who otherwise wouldn’t have access to creative tools or programs. Our efforts to improve digital literacy extend across the globe. While visiting India recently, I had the opportunity to meet with students who were finalists in an Adobe creativity competition. In conjunction with the 150th anniversary of Mahatma Gandhi’s birth, students from 20,000 schools were encouraged to depict how Gandhi’s values can help our modern world prosper. I was inspired and moved by students’ messages of humanity and the brilliant ways they chose to tell their stories using Creative Cloud. With Adobe Document Cloud, we are accelerating document productivity, modernizing how people work with documents across all devices. Document Cloud revenue in Q1 was $351 million and we grew Document Cloud ARR to $1.15 billion. This momentum is being driven by strong customer acquisition and the expanding portfolio of PDF mobile and web applications. Key wins in the quarter included Equifax, Gannett, Shell, and Cummins. Acrobat continues to be the gold standard for creating, editing, scanning, signing, and sharing digital documents. As more people are working on the go, our mobile app usage continues to rise. More than 600 million people have installed Acrobat on their mobile devices. As digital transformation continues at organizations across the globe, Adobe Sign continues to power paper to digital work flows across all industries, including the majority of Fortune 100 companies. This quarter, we extended the reach of Adobe Sign with an enhanced integration with SharePoint that enables people to easily create and sign digital forms. We recently launched the ability to convert to and from PDF via one-click access on the web, providing a seamless on-ramp to PDF services and an Acrobat subscription. We are providing PDF functionality through APIs and expanding integrations with partners. Our recent integration with Google Drive gives its more than 1 billion users instant access to Acrobat’s best-in-class tools to create, view, annotate, modify, and share PDFs without leaving Google Drive. In our Digital Experience business, we achieved revenue of $858 million in Q1, which represents 15% year-over-year growth. Now, more than ever, every business across B2C and B2B, and mid-market to enterprise must be a digital business, driving opportunity for Adobe Experience Cloud. The industry’s most comprehensive offering, Adobe Experience Cloud features innovative applications and services built on the Adobe Experience Platform and leveraging Adobe Sensei’s AI and machine learning framework. Key wins this quarter included Intuit, PayPal, Bank of America, CommonSpirit Health, Travelzoo, State of Oklahoma, Kohl’s, National Instruments, Toyota Motor, and Accenture. Only Adobe has data from trillions of transactions, tens of millions of products and thousands of retailers which gives us the unique ability to assess the global digital economy in real-time. Building on the success of our annual Holiday Shopping report, we are developing an economic index to help companies get a better understanding of local and global trends, so they can anticipate changes and manage their businesses effectively in this dynamic market. A great experience starts with compelling content and is informed by data and insights. Harnessing the power of Adobe Experience Platform to stitch together siloed data across the enterprise, our recently released Customer Journey Analytics service gives our customers a set of analytics tools that provides a complete picture of the customer journey, online and offline. We are continuing to drive strong performance with Adobe Experience Manager for omnichannel content delivery. This quarter, we launched Adobe Experience Manager as a cloud service enabling brands to go live with personalized campaigns and experiences across any channel, device or mobile app in days instead of months. It provides agility and flexibility for enterprises and mid-sized companies with brands like Under Armour, Coca-Cola and Morningstar becoming early customers. Adobe Commerce Cloud enables our customers to make every moment personal and every experience shoppable. With new functionality that enables merchants to natively add high-quality media assets to their websites and create personalized recommendations, we drove more than 50% year-over-year bookings growth. For the third consecutive year, our industry leadership was validated in the Gartner Magic Quadrant for Digital Experience Platforms and achieved the strongest position in Completeness of Vision. The Digital Experience opportunity is immense, our roadmap is robust and we are excited to have Anil Chakravarthy lead this business. Anil brings a powerful combination of business and product leadership, and his impact is already being felt. We are proud to have created a unique employee culture that embraces diversity and inclusion, and supports the communities in which we live and work. This commitment has made Adobe one of Fortune’s 100 Best Companies for the past 20 years. This quarter, we were honored for our sustainability efforts on the CDP A List for climate change for the fourth consecutive year and we were included in the Bloomberg Gender Equality Index, recognizing our transparency in gender reporting and advancing women’s equality in the workplace. While Q1 was a typically strong quarter, I know what’s top-of-mind for all of us is navigating the impact of COVID-19. The well-being of our employees and customers is our number one priority. In addition to encouraging employees in impacted regions to work from home for the next two weeks, we are restricting travel and canceling in-person events. In keeping with that strategy, we made the tough decision to cancel the in-person Adobe Summit in Las Vegas and replace it with a digital event at the end of the month. We are proactively engaging digitally with our current customers to support their businesses and continuing to drive enterprise pipeline globally. We are fortunate that the company’s revenue and earnings are relatively predictable as a result of our move to a subscription-based business model. We have seen little to no impact on adobe.com for Creative Cloud and Document Cloud demand thus far, and we will continue to acquire and engage customers digitally. In my conversations with business leaders across the globe, it is evident that investments in digital will continue to be critical, but dealing with the implications of COVID-19 is the immediate priority. As a result, we expect some enterprises will delay bookings, postpone services implementation and reduce expenses. We will be using Adobe digital solutions to mitigate impact and to engage with our customers. While the situation is concerning and there’s tremendous uncertainty, the long-term fundamentals of our business remain undiminished. Adobe is at the center of three massive market opportunities across creativity, digital documents, and customer experience management, which will fuel growth in the near- and long-term. Businesses must transform to deliver a personalized digital relationship with every customer. The paper-to-digital revolution continues. Creativity and design have never been more relevant. We will continue to lead in these categories and manage the company for the long run, while we navigate through this environment. At times like this, the best companies like Adobe continue to innovate, drive increased focus and emerge stronger than ever before. John?"
},
{
"speaker": "John Murphy",
"text": "Thanks, Shantanu. In the first quarter of FY’20, Adobe achieved record revenue of $3.09 billion, which represents 19% year-over-year growth. GAAP diluted earnings per share in Q1 was $1.96 and non-GAAP diluted earnings per share was $2.27. Our earnings per share results include a charge related to the cancellation of corporate events including Adobe Summit due to the COVID-19 situation, which lowered both GAAP and non-GAAP EPS by $0.07 in the quarter. Business and financial highlights in Q1 included Digital Media revenue of $2.17 billion, net new Digital Media ARR of $400 million, a record for Q1, Digital Experience revenue of $858 million, generating strong cash flow from operations of $1.32 billion, growing Remaining Performance Obligation or RPO to $9.91 billion and repurchasing 2.4 million shares of our stock during the quarter. In our Digital Media segment, we achieved 22% year-over-year revenue growth in Q1. The addition of $400 million net new Digital Media ARR grew the total exiting the quarter to $8.73 billion. Creative revenue grew 22% year-over-year and we increased Creative ARR by $329 million. Q1 Creative growth driver included strong new user growth starting early in the quarter with Cyber Monday followed by continued customer acquisition throughout the quarter. Single app adoption as we target new users who are more inclined to adopt Creative Cloud through the use of a specialized application such as Photoshop, Illustrator, Premiere and Acrobat. Mobile app subscriptions including adoption of Photoshop on the iPad, continued momentum with creative services including Adobe Stock, where revenue again grew by 30% year-over-year and continued focus on engagement and retention. Strong Adobe Document Cloud revenue growth continued in Q1. We achieved record Document Cloud revenue of $351 million, which represents 24% year-over-year growth and we added $71 million of net new Document Cloud ARR during the quarter. Document Cloud performance during Q1 was driven by consumer adoption of mobile apps, PDF services and Acrobat subscriptions, conversion of free mobile app users to paid subscriptions for services such as Create PDF Online, strong performance with enterprise customers including new logos and renewals and Document Cloud services adoption including continued momentum with Adobe Sign revenue which grew greater than 20% year-over-year in Q1. In Digital Media, the COVID-19 situation did not impact our overall business on adobe.com in Q1. However, we did experience weakness in China, which is primarily a channel-based reseller market. In our Digital Experience segment, we achieved quarterly revenue of $858 million, which represents 15% year-over-year growth in Q1. Subscription revenue for the quarter was $739 million, growing 21% year-over-year and we grew our Digital Experience bookings by greater than 20% year-over-year. Q1 Digital Experience highlights include success with our Content and Commerce solutions, where we drove notable adoption of Adobe Experience Manager and Adobe Commerce Cloud. During the quarter, we continued to focus on closing Adobe Experience Platform opportunities while growing the pipeline. Our strategy and value proposition continued to resonate with customers who wish to increase their digital engagement with their customers. In Digital Experience, the impact of the COVID-19 situation in Q1 was some unanticipated deal slippage during the last 10 days of the quarter. From a quarter-over-quarter currency perspective, FX increased revenue by $1 million. We had $7 million in hedge gains in Q1 FY’20 versus $12 million in hedge gains in Q4 FY’19, thus the net sequential currency decrease to revenue considering hedging gains was $4 million. From a year-over-year currency perspective, FX decreased revenue by $27 million, with $7 million in hedge gains in Q1 FY’20 versus the $9 million in hedge gains in Q1 FY’19 resulted in a net year-over-year currency decrease to revenue considering hedging gains of $29 million. Adobe’s effective tax rate in Q1 was minus 4% on a GAAP basis and 10% on a non-GAAP basis. Both rates were lower than targeted due to a larger than expected deduction associated with the vesting of stock-based compensation. The reduction of the quarterly tax rate benefited GAAP and non-GAAP EPS by $0.17 and $0.03, respectively, in the quarter. Our trade DSO was 41 days, which compares to 46 days in the year ago quarter and 47 days last quarter. Remaining Performance Obligation or RPO grew by 22% year-over-year to $9.91 billion exiting Q1, which compares to $9.82 billion exiting Q4. The sequential quarter-over-quarter growth was consistent with normal seasonality. Deferred revenue exiting Q1 was $3.61 billion. Our ending cash and short-term investment position exiting Q1 was $4.17 billion and cash flow from operations was $1.32 billion in the quarter. In Q1, we repurchased approximately 2.4 million shares at a cost of $795 million. We currently have $4.25 billion remaining of our $8 billion repurchase authority, which goes through 2021. Turning to our financial targets, I would like to review two areas as you think about modeling the rest of our fiscal year. First, our Q1 tax rates came in lower than planned as I discussed earlier and we now anticipate both our GAAP and non-GAAP rates to be lower than we originally targeted for the full year. We continue to focus on managing costs and optimizing Adobe’s international structure to deliver more value to our customers and investors. We anticipate making changes to our international structure during Q2 and Q4 this year that will better align ownership of certain intellectual property rights with how our business operates, while allowing us to remain tax efficient. We now anticipate our GAAP quarterly tax rates to be minus 10%, 10% and minus 85% in Q2, Q3, and Q4, respectively. The changes to our international structure do not impact our non-GAAP tax rates and we expect our non-GAAP quarterly tax rate to be 10% in Q2, Q3 and Q4. The second area is the consideration of business impact we could see because of COVID-19. We have factored into our Q2 targets the expected impact of the global uncertainty caused by the COVID-19 situation as we understand it to date. While our revenue and earnings are relatively predictable as a result of our subscription-based business model, we do expect to be impacted in the following areas, enterprises deferring bookings decisions, delaying consulting services implementations and reducing marketing spend, consumers reducing spending in countries more adversely impacted by the COVID-19 situation, and software license revenue driven by channel partners. These impacts are expected to be more prominent in countries and industries most affected by the crisis. In Q2 FY’20, we are targeting revenue of approximately $3.175 billion, Digital Media segment year-over-year revenue growth of approximately 19%, net new Digital Media ARR of approximately $385 million, Digital Experience segment year-over-year revenue growth of approximately 12%, net non-operating expense of approximately $14 million, tax rate of approximately minus 10% on a GAAP basis and 10% on a non-GAAP basis, share count of approximately 486 million shares, GAAP earnings per share of approximately $2.10 and non-GAAP earnings per share of approximately $2.35. In summary, we continue to believe we are well-positioned as a market leader in large growing categories. The benefits of running a real-time business and the high percentage of our revenue that is recurring enables us to monitor and take action in how we drive revenue or control costs, all of which should enable us to deliver solid results as the world navigates the COVID-19 situation. Finally, I want to share with you the news that Mike Saviage has decided to retire from Adobe later this year. As the Head of Investor Relations, Mike has been an important champion of Adobe’s growth and transformation story over the past three decades. We will be appointing an internal replacement and Mike will be on board for the next few months to help us transition the new leader. I want to thank Mike for his many contributions to Adobe and wish him well on his retirement. I will now turn the call back over to Mike."
},
{
"speaker": "Mike Saviage",
"text": "Thanks, John, and thank you for those comments. As we announced last week, we have shifted Adobe Summit, our Annual Digital Experience user conference, to be an online event and virtual conference starting on Tuesday, March 31st. As the event draws closer, we will provide instructions on the summit.adobe.com website for how to access online keynote presentations and educational sessions along with the timing of them. If you wish to listen to a playback of today’s conference call, a webcast archive of the call will be available on our IR site later today. Alternatively, can you listen to a phone replay by calling 888-203-1112, use conference ID number 4347041. International callers should dial 719-457-0820. The phone playback service will be available beginning at 5 p.m. Pacific Time today and ending at 5 p.m. Pacific Time on March 19, 2020. We will now be happy to take your questions. We ask that you limit your questions to one per person. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] We will take our first question from Brent Thill with Jefferies. Please go ahead."
},
{
"speaker": "Brent Thill",
"text": "Thanks. Good afternoon, Mike. Congrats on three decades. I am very happy for you. Shantanu, just on the Creative business, there are many questions around obviously no one knows how long the current situation is going to last, but many are kind of asking how insulated you believe the Creative business is. The guidance for this next quarter was encouraging and probably a little bit better than most thought. So if you could just walk through how you are thinking about that business over the next several quarters?"
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, Brent. Clearly, I think, let me start out by saying that, we would all acknowledge that the situation is pretty unprecedented. And so, as it relates to the Creative business, maybe I will give you color not just for Q1, but also actually for the first few days of March and I will talk about that in the context of the customers that we serve. And maybe again, as sort of a preview to what John talked about, let me just tell you a little bit about the options that we considered. I mean, clearly, given the situation we could have sort of chosen to give no forward-looking guidance, we could have provided a range given the uncertainty or what we thought was most appropriate was given we have fairly good visibility on a direct basis, to guide based on a number and then provide more color. On Creative Cloud specifically, Brent, and on Document Cloud, in the direct-to-consumer on adobe.com, we saw actually little to no impact on Q1 on adobe.com across all geographies for both Creative and Document Cloud products; and thus far, it’s early in Q2, the overall traffic and conversion pattern have actually continued. In China, where we have a little bit more of an indirect route to market for CC and DC, which is through resellers, we know that the business is small but we saw some impact in Q1, and as you saw, despite that, we had pretty awesome overall ARR for Digital Media in Q1. In South Korea, we have actually seen relatively stable business in our Digital Media business today. In Italy, what we saw was that as the situation worsened, we saw some impact in the reseller business, but we actually appear to have seen some additional strength on adobe.com, and the fact that I guess, we have multiple routes to market there sort of helps ameliorate that. So, I mean, in sort of conclusion, we are continuing to monitor. We think that clearly long-term the Creative Expression business continues to be really strong. And specifically as it relates to Q2, absent the COVID situation, we would have probably again had sequential increase to Digital Media ARR where we’re trying to factor what we have seen a little bit of the uncertainty in the reseller impact and enterprise. And even in revenue, we have a little perpetual revenue. So, I know that was a little bit of a long answer, but hopefully that gives color in terms of all of the work that’s gone in over the last 10 days. We have already done a couple of business reviews, and this is as of what we know today, while there’s uncertainty, that’s our best estimate of how we think this plays out in Q2."
},
{
"speaker": "Brent Thill",
"text": "Thanks for all the color."
},
{
"speaker": "Operator",
"text": "We will take our next question from Keith Weiss with Morgan Stanley. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you, guys. Thank you for taking the question. Mike, it’s been great working with you. You are way too young to be retiring, but that’s your business. Shantanu, thank you so much for kind of giving that detail on how you guys are thinking about the outlook, I think, it definitely helps investors understand how you are thinking about it and that you are imparting some conservatism into the guidance for kind of what’s going on out there. I was hoping to get some view from John on how you guys are thinking about the expense side of the equation? How aggressively that you will sort of look to match sort of the expense growth rates, is that kind of what you are seeing in the environment. Is there -- are you going to be looking to kind of protect the margins and protect the contribution margins in the business as the demand fluctuates?"
},
{
"speaker": "John Murphy",
"text": "Sure. Thanks, Keith. As we think about our ability to understand our business, we have got a great ability through our DDOM model our data driven operating model to understand how we can actually drive growth, while still expanding margins and protecting the profitability of the company. And that thesis hasn’t changed. We are still a growth company and we do focus on the profitability of the company. So, we are able to shift our expenses and our spending and our investments to appropriately capture the opportunity, but at the same time be able to hit our goals of expanding operating margin as we set out at Analyst Day this year."
},
{
"speaker": "Shantanu Narayen",
"text": "And Keith, maybe I will add a couple more things, I mean, I think, we have always done a good job of balancing the topline and bottomline. I have no doubt that companies like Adobe actually will emerge stronger as a result of this. And what John has already instituted is we are looking at every expense associated with it. There’s certainly some areas where we have great online solutions to help our customers, where we will be investing more and there are other areas where we will be far more prudent as it relates to what happens. And maybe, John, you can also specifically comment on what happened in Q1 as it relates to that one-time charge just so that everybody understands that?"
},
{
"speaker": "John Murphy",
"text": "Yeah. So when we decided to cancel the in-person corporate events that caused us to pull in the expenses into Q1. So we made that decision before we finished Q1. So we took that charge. Its $40 million associated with that. The -- typically much of that expense would be in Q2 and would be offset actually by revenue we would get through registration fees for participants, as well as sponsorship dollars as well. So the way we have approached it is obviously the sponsors, the participants, we will not be taking that money in, so we pulled all that expense forward. So that one-time charge that you had in Q1 associated with this, all this activity was obviously a significant impact. Our margin would have been 41.6% otherwise had we not had to take that charge."
},
{
"speaker": "Keith Weiss",
"text": "Super helpful. Thanks so much, guys."
},
{
"speaker": "Operator",
"text": "We will take our next question from Kash Rangan with Bank of America. Please go ahead."
},
{
"speaker": "Kash Rangan",
"text": "Hi. Thank you very much for all the details, Shantanu. You talked about how things finished up in the February quarter. I am more curious about your guidance for the May quarter. What are the assumptions especially as it relates to the geography that we are all most concerned about that could potentially worsen from a COVID perspective. What kind of growth rates and what kind of U-shaped or V-shaped recovery are you assuming for your two businesses in the U.S? Thank you so much and stay safe everybody."
},
{
"speaker": "Shantanu Narayen",
"text": "Well, Kash, I think, we would all agree that the situation is rapidly evolving. I was interesting just even watching after the 1 o’clock the six or seven announcements that went out. And so, clearly, we are trying to give you the best color that we have as of today and not sure that I can predict or anybody can actually predict what happens. But, I think, we gave you color in Digital Media, which is we continue to expect to see the notion of both creativity and accelerating document productivity, and where there’s a direct engagement with customers, to continue to invest in engaging with them digitally and continuing to drive our business, because there is clear value associated with that. I think maybe just similarly, I can give you a little color on the Enterprise. I mean, as you know, with Enterprise selling, the end of the quarter represents a fairly large chunk of business for most people. And while that does not have impact on revenue and you never expect to close your entire pipeline, I think, as we said in the prepared remarks as well, Kash, we saw some unanticipated slippage at the end of the quarter. And so the way we have tried to think about it for Q2, I have had a ton of conversations from CEOs across all industries, and I think, the two themes that are absolutely consistent, the first theme is everybody is first and foremost making sure that they take care of the well-being of their employees. They are all dealing with travel restrictions. They are all dealing with the outbreak. The second thing that they all tell me is that, hey, this if anything will accentuate the need to engage digitally not just internal to the corporation to keep the corporation going, but externally, in order to engage with customers. But given what’s happening with travel, we just expect that there is going to be some delays associated with it, we have tried to factor that in. And the way I would describe that is absent any COVID, we would have certainly seen Digital Experience being targeted higher than what we targeted. So I think we have tried to factor it in. And maybe just a little bit more color on that, Kash, when you look at the revenue components for our business, there are three components. There’s the revenue that comes off of bookings, bookings translating into revenue. There’s usage based Advertising Cloud revenue that goes into that. And there’s delivery based revenue when services are delivered and implemented. We suspect that the services will go out a little bit. The importance remains, but as people are concerned about people traveling that will perhaps slow down a little bit and depending on the industry or vertical, that will be different. Some of it may be more immediate in terms of the bounce back some of it may be a little bit more detailed. And so what we know is that we expect bookings will probably take a little longer. We think services delivery may go a little bit longer. We feel like the Advertising Cloud might be impacted. Those are all factored into how we thought about it. If the world falls apart, that could certainly change. But we will continue to monitor it. What I have not heard from anybody is any issue associated with keeping digital front and center, because, I think, this demonstrates more than ever before if you can’t engage with your customers digitally, you are dead in the water. So hopefully that helps."
},
{
"speaker": "Kash Rangan",
"text": "Absolutely. Thank you so much."
},
{
"speaker": "Operator",
"text": "We will take our next question from Sterling Auty with JP Morgan. Please go ahead."
},
{
"speaker": "Sterling Auty",
"text": "Yeah. Thanks. Hi, guys. So, Shantanu, I am just curious if anything with COVID-19 would actually impact any new product introductions in terms of feature functionality or any changes that maybe you would have considered in the near-term around pricing in any of the geographies?"
},
{
"speaker": "Shantanu Narayen",
"text": "Sterling, not to the best, I mean, we are excited. We will be doing our first digital summit. So Anil Chakravarthy is busy. I mean all the exciting things that we were going to announce in person. The plan is to announce it actually virtually coming up, a couple of exciting things there. I mean, the Adobe Experience Manager that we just introduced, which is a cloud based approach, that’s significantly, again, I think, as we said reduces the time for people to do to through self-serve and get new websites, and campaigns up and running. So on the Experience side, it was really going to be an event where we describe everything that’s on. Now with the Creative Cloud space as well, I mean, I think, if there’s one group that works more from home and has more flexible work policy, it tends to be the product team. So, I think, overall navigating what it means for nobody to be in offices, Sterling. But I think we are actually as well placed as anybody in terms of doing it. The one other thing I will mention is, we are actually for universities, given how much universities closure that there is. We are making available our creative and other tools available for people for this online training. And so, I think, while the situation is crazy, I think, there are a whole bunch of our solutions, whether it’s all the documents that are going to be shared right now, what’s going to happen with signatures, whether what you are going to do with respect to helping people engage digitally. So nothing yet that’s changed. It all depends on how long the situation continues from my perspective, Sterling."
},
{
"speaker": "Sterling Auty",
"text": "And Mike, congratulations, it’s been one hell of a run. You have done a great job as IR. So congratulations and enjoy your retirement."
},
{
"speaker": "Mike Saviage",
"text": "Thanks, Sterling."
},
{
"speaker": "Operator",
"text": "We will take our next question from Saket Kalia with Barclays Capital. Please go ahead."
},
{
"speaker": "Saket Kalia",
"text": "Hey, guys. Thanks for taking my question here and I echo my congrats to you as well, Mike, on your retirement. Shantanu, maybe for you, just thinking a little higher level, can you just talk a little bit about bringing on Anil Chakravarthy on to the team and maybe what some of his longer term goals are in the Digital Experience business?"
},
{
"speaker": "Shantanu Narayen",
"text": "Sure. Saket, I mean, I think, we are clearly the undisputed leader and have the most comprehensive offering as it relates to and we created the digital marketing category. I think as we focused on what we call as generational technology platform development. We recognized that the ability to create this unified profile and to really make sure that your first party data, you are taking more advantage of it, were two massive opportunities that every enterprise was going to have to figure out how to take advantage of, much like Adobe did with our DDOM. Anil’s background as it relates to what he had done both at Informatica and prior to that and the fact that as CEO he had the ability to look across the entire business. Both of those are going to be extremely important for us as we continue to invest in product and as we continue to focus on ensuring that the CIO and the people who engage with data, which is an area that he is completely familiar with are ones that we continue to invest in and differentiate our solution. It’s early. As I said, his presence is already being felt. But what he has been really up to is going and meeting with a number of customers. I may have to ground him for a little while right now, but he also actually had the ability to go meet with all the product people. So I think both on the product and the customer stuff, just continuing to make sure that we extend our lead and have a unified leader. Those were really the two reasons for having him on-board."
},
{
"speaker": "Saket Kalia",
"text": "Great. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We will take our next question from Jay Vleeschhouwer with Griffin Securities. Please go ahead."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. A shorter-term question, Shantanu and for you, John, as well, I noticed that you had a small sequential decrease from Q4 [Audio Gap]"
},
{
"speaker": "Shantanu Narayen",
"text": "… opportunity, we have tailwinds, we have growth in three areas. I think what you saw was really concerted effort again by John to rationalize as we had done these M&A’s and to make sure that we are not duplicating functions. And so, I think, as part of every annual planning process, we first prune to make sure that we are investing in the right areas, and I think, we did a really good job of looking at that. So for somebody like you who follows us and sees that sort of ebb and flow, it’s just a continuous process that we do. We have opportunities. I mean, we are going to continue I think again based on the question that I think Keith asked. We will be prudent about how we look at this stuff. But even if you look at our targets for Q2, I think, you will see that we are one of the companies that’s best positioned in the entire industry opportunities and we are going to continue to hire, but we will be prudent and we will continue to monitor this."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thanks, Shantanu."
},
{
"speaker": "Operator",
"text": "We will take our next question from Kirk Materne with Evercore ISI. Please go ahead."
},
{
"speaker": "Kirk Materne",
"text": "Yeah. Thanks very much. And I guess at the outset, I’d say, thanks very much for the guidance with COVID and I realize things are moving quickly, but even just the color you have given today I think will help us think through this as it continues to evolve. My question, Shantanu, would be on the Experience Cloud, obviously, a year later, I think, you have integrated the acquisitions, if you weren’t talking about COVID right now. How is your feeling about just sort of the integration of the product and the setup for that business as we head into calendar 2020?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yeah. I think, Kirk, what we would have said absent COVID was good Q1, greater than 20% increase in the book of business, revenue growing nicely, highlighting the progress that we would have made. I think I shared a number of customers we have had the Experience Platform customers go live. I would have talked about cloud AEM. I think we touched on Adobe Commerce and that’s only because I wouldn’t have had time to talk about what we are doing with B2B and B2C. How we have integrated Marketo into that. And so, I think, that fundamental customer demand for digital and for engagement, nothing changes. And so that’s what I would have said if it weren’t for this situation with Q1. In effect, what John and I would have been here, talking about record performance in Q1, continued momentum from Q4, robust cash flows, strong EPS performance, and I think, all of you guys would have been saying why aren’t you raising targets if it weren’t for COVID and so, I think, I continue to feel good about the long-term opportunity."
},
{
"speaker": "Kirk Materne",
"text": "That’s great. Thanks. And Mike, congrats on your retirement."
},
{
"speaker": "Mike Saviage",
"text": "Thanks, Kirk."
},
{
"speaker": "Operator",
"text": "We will take our next question from Brad Zelnick with Credit Suisse. Please go ahead."
},
{
"speaker": "Brad Zelnick",
"text": "Great. Thank you so much, and Mike, I got to echo my congrats. I always thought maybe I would be able to retire before you but not with how the markets have been performing over the last few weeks, for sure. I think I am going to be working a long time. But anyway, Shantanu, thank you so much for all the color you provided on Digital Media so far, but just want to understand its resiliency. Because realistically, if we think about your end markets it includes a lot of small businesses and hobbyists, where there may be more stress or not thought of as much as top of wallet item? Are you may be able to share what that represents as the percentage of the overall ARR, even ballpark if you can? And what are the leading indicators are that you see through your DDOM to be able to see things like engagement, renewal rates, maybe even by SKU as it relates to this segment of the market? Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "You are right, Brad, in that the real blessing of that business is how broad and how diverse it is and how our tools, whether they be on the creative side or whether they be on the document side are as pervasive and market leaders as they are. We tried to give the color even during this current situation and the impact, and as we said on adobe.com, there’s been little to no impact. We have become really good at how we engage with these customers. And the thing that also gives us long-term confidence in that, Brad, is the different price points. And so you have to think about it with respect to the different price points that we have and we have got really good at understanding where the mobile offerings need to be. With all these people being at home, they will have to do some things and hopefully expressing their creativity we just have to continue to help them do that. And so, yeah, we are not saying that we are completely going to be unimpacted, but so far and just looking at what we have seen thus far, these tools and creativity and the importance of design, nothing that’s happened in the last few weeks diminishes the importance of that."
},
{
"speaker": "Brad Zelnick",
"text": "Thanks very much, Shantanu and be healthy everyone. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Brad."
},
{
"speaker": "Operator",
"text": "We will take our next question from Jennifer Lowe with UBS. Please go ahead."
},
{
"speaker": "Jennifer Lowe",
"text": "Great. Thank you and I would like to echo the congrats to Mike on a well deserved retirement after a pretty impressive run. So just looking at the slipped deals that were discussed in the call, obviously, it’s sort of unprecedented times and there’s a lot of moving pieces there. But is there any sort of commonality to the deals that seemed to slip in terms of size, whether those were new versus up-sell transactions, whether they were sort of just logistical issues that cropped up? I am just trying to get a better sense of where it’s just tougher to get business done at this point? Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "There weren’t really any patterns, Jennifer. I mean, I think, there was a couple of -- if people were at home and you expect that to have people in the office to close. So just some examples of in certain countries where people were maybe not at work, I mean, you followed Enterprise Software for a long time. There are a number of stakeholders that are required. We do use Adobe Signature to close them. But I would say, it’s what little bit more of just getting the stakeholders involved. And I would actually attribute it to a large degree to the preoccupation correctly of dealing with employees and employees’ well-being. I am sure this is true of your company as well. Everybody’s just dealing with are employees safe, how do we make sure, all of that. So I would attribute it more to that, and we will just have to continue to monitor what happens. But the conversations that I am having and we are so -- one of the things we are doing is actually proactively reaching out to every single customer of what is the right way to engage with them digitally in terms of saying, here’s how we can help. I think all of you are probably seeing more communication. I should acknowledge that a number of the deals that slipped actually did close in the time that was past it, but it’s uncertain times. So hopefully that gives you some color into what we were observing."
},
{
"speaker": "Jennifer Lowe",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] We will hear next from Walter Pritchard with Citi. Please go ahead."
},
{
"speaker": "Walter Pritchard",
"text": "Hi. Thanks. Two questions, one, just on Sign, you talked pretty positively about this business for a number of quarters. I am wondering if you could update us on what is the strongest demand drivers there, are they kind of direct deals out selling as part of larger engagements or is it more transactional attached to Acrobat and especially the mid-market low end?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think, Walter, it’s actually all across the map. We had a good quarter as it related to Sign revenue. And make no mistake, the Reader distribution and wanting to do stuff with PDF and work flows associated with PDF, that’s a big part of that business. We have talked about how we are going to make those APIs available as well so that people can embed it. We talked a little about the integration with Google, but it’s all across. I mean, as an ingredient service or as we talk about it, Sign is certainly part of the solution across all those segments. As a complete offering with respect to what we have with PDF across Acrobat and in the enterprise and with Adobe Experience Manager. But it really is across the board. And I think you are going to see more demand for those services right now because physical signatures are going to be less easy to manage than electronic signatures."
},
{
"speaker": "Walter Pritchard",
"text": "Got it. And then just John, I am not sure if you are breaking this out but I guess we are getting this question quite a bit. On the DX business with the transactional piece where you broke out those three pieces, any way to give us, let us know if that’s the smallest of the piece or any range in terms of revenue exposure from transactional in DX would be helpful?"
},
{
"speaker": "John Murphy",
"text": "Yeah. No. If you go back to the Analyst Meeting, we broke out each of those three components for you. And so you can see that it’s actually roughly 20% of the business, 20%, 25% of the total DX business in terms of Ad Cloud and Professional Services piece."
},
{
"speaker": "Walter Pritchard",
"text": "Okay. That hasn’t changed?"
},
{
"speaker": "John Murphy",
"text": "No."
},
{
"speaker": "Walter Pritchard",
"text": "Okay. Thank you very much."
},
{
"speaker": "Mike Saviage",
"text": "Operator, we are coming up on the top of the hour. We will take one more question, please."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our last question from Keith Bachman with BMO. Please go ahead."
},
{
"speaker": "Keith Bachman",
"text": "Hi. Thank you very much. Shantanu, I just wanted to revisit a little bit on the Experience revenue. You are guiding the current quarter, the second quarter rather to 12% year-over-year growth. Back in December, you talked about the growth potential for 2020 being plus or minus 16%. How should we think about the rest of the year in the Digital Experience segment, given macro’s really tough and the COVID virus is making it challenging, but also including any kind of competitive comments that you want to make surrounding it? Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Yeah. I think, what we see, frankly, right now is the color associated with what’s happening in Q2. As you know, in December we provide targets based on the product roadmap. And from my perspective, Q1 execution and performance was terrific. And while we are giving you as much color as we know for Q2 as of today, given the unprecedented times, we are really not going to comment on the second half. We will continue to monitor. None of this changes long-term trends and so that’s how we think about it."
},
{
"speaker": "John Murphy",
"text": "And maybe I could just add in there, because we did give a lot of in the prepared remarks about updating tax rates for the year because of the fluctuation. And I know in terms of modeling the folks have been asking what do we think about beyond FY’20 and so as we I said at the Analyst Meeting we expected an increase in FY’21. And so based on these changes that I had highlighted in my prepared remarks on the tax rates, you can kind of expect FY’21 to be roughly a 17% non-GAAP rate, 19% on a GAAP basis."
},
{
"speaker": "Shantanu Narayen",
"text": "And since that was the last question, let me also echo, I think, all of your sentiments, which is thank Mike for his outstanding contributions to Adobe. I have certainly observed firsthand his passion for the business and his IR leadership has been invaluable to me as a partner as we have transformed the company. I told him that we have been doing this call together since 2001 and I will certainly miss him and wish him well. But with his help, we will make sure that we have a smooth transition. So thank you, Mike. As it relates to the business, Q1 was strong, we will continue to execute on our strategy and focus on the three large opportunities ahead of us, unleashing creativity, accelerating document productivity, empowering digital businesses. And I don’t think that the recent situation changes the relevance or importance of any of this for our customers and it will only magnify the need to go digital with more urgency. Given the situation is fluid we tried to give you as much insight into what’s happening in our business. The demand for Creative Document and Enterprise is strong. But the impact as we said of COVID will probably be felt a little bit more in the short-term in the enterprise business. But again, we believe that we are better positioned than most to continue to innovate, to drive both top and bottomline, and emerge stronger and more mission critical. We really hope you guys will join us for our digital summit and much like a number of you have said, stay safe and thank you for joining us today."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes our call."
}
] | Adobe Inc. | 24,321 |
ADBE | 4 | 2,021 | 2021-12-16 11:00:00 | Operator: Please welcome Jonathan Vaas, Vice President of Investor Relations.
Jonathan Vaas: Good morning, and thanks everyone for joining us today. I'm Jonathan Vaas. And welcome to our financial analyst meeting. You should have a copy of the press release, which we filed this morning at approximately 5 A.M. Pacific Time, as well as a copy of our slides that we posted to the Investor Relations Web site. I'm hopeful to have an opportunity to meet with many of you in person this year. For now, I'm really pleased to be able to be here with Adobe's leadership team, and engage once again virtually, and we have a great program for you today. With a webcast format, the live presentation we'll be doing today will be a streamlined version of the long form information that we posted to the Investor Relations Web site that has all of the information you're used to receiving from Adobe. So, we'll cover a portion of those slides today, and then we'll go ahead and do Q&A at the end. Let's take a quick look at the agenda. Shantanu will kick things off with a brief welcome, and then, Ann will present Adobe's vision and strategy for the future. Anil will go over our digital experience strategy, and David will cover digital media strategy after that. And then, Dan Durn, who joined in October as Adobe's Chief Financial Officer, will provide a detailed financial summary, as well as discussing Adobe's long-term strategy. Then Shantanu will wrap things up sharing his vision of the long-term opportunity, and we'll go to live Q&A. Before we get started, as a reminder some of the information we'll be providing includes forward-looking statements that are subject to risk and uncertainty. Actual results may differ from those statements, and we encourage you to review the risk factors in our SEC filings for more information. Additionally, we'll be providing both GAAP and non-GAAP financial metrics. Reconciliations between the two are available on Adobe's Investor Relations Web site. I will now pass it over to Adobe's Chairman and CEO, Shantanu Narayen.
Shantanu Narayen: Good morning, and thanks, Jonathan. Welcome to this Virtual 2022 Financial Analysts Meeting. Adobe had another outstanding year in 2021. I'm incredibly proud of the dedication and resilience of Adobe's 25,000 employees all around the world in delivering breakthrough technologies for our customers. I'd like to start with a recap of the tremendous accomplishments we had across every dimension in 2021. As a product geek at heart, I take immense pride in our team driving hundreds of innovations across Adobe Creative Cloud, Document Cloud, and Experience Cloud. Earlier this week, we introduced Creative Cloud Express, to enable anyone to express their ideas simply and beautifully. Creative Cloud Express the start of a brand-new journey to introduce first-time creators to Adobe Creative tools, while adding significant value to all of our current Creative Cloud subscribers. I think it marks a new chapter of creation, collaboration, and sharing on the web, and leverages the unique technology and capabilities of Adobe's flagship products. It also builds on the collaboration capabilities we debuted at MAX, including Illustrator and Photoshop on the web, Creative Cloud Spaces, and Creative Cloud Canvas. With the addition of Frame.io, we're now incorporating review and approval functionality to deliver a powerful collaboration platform for end-to-end video collaboration. And we're continuing to add magic to our flagship applications, and we're enabling them to run natively on new hardware like Apple's M1 chip, as well as Microsoft Windows Surface and Pen. In Document Cloud, Acrobat Web now supports 21 frictionless verbs create, export, extract, and edit for both text and images and PDF. We've seen tremendous growth in Acrobat online, as people tap our powerful, free, browser-based document tools to handle important tasks on the fly, without the need to download any software. In addition, we made outstanding progress with PDF support within both the Chrome as well as Edge browsers. And on the Experience Cloud platform, we extended our real-time customer data platform to B2B customers, bringing together individual and account profiles across systems to give B2B companies a single view of their customer for the very first time. We launched Adobe Journey Optimizer, harnessing over 20 years of industry-leading e-mail, marketing, and cross-channel campaign management expertise to empower brands to design and deliver personalized experiences across the entire customer journey in a single application. With the new acquisition of Adobe Workfront, we're now empowering companies to optimize business outcomes by connecting creative and marketing professionals to manage all creative workflows across the entire marketing lifecycle. In addition, we've advanced our industry leadership in key areas across our portfolio. Clearly underpinning our three clouds is the magic and power of Adobe Sensei, our artificial intelligence and machine learning framework, a significant differentiator for Adobe and an enabler to more rapid innovation. We continued our investment in the Adobe Experience platform as the foundational platform for strong governance capabilities across our Experience Cloud business, accelerating innovations like real-time customer data platform and Adobe Journey optimizer on a global scale. We take our responsibility in the creative community very seriously. And as part of the content authenticity initiative, we've published a drop specification as an open standard to combat online disinformation. I'm amazed at the resiliency of our employees and we pioneered all new digital event experiences with Adobe Summit and Adobe MAX, extending our reach and engaging millions of people around the world. I'm also tremendously proud of the industry recognition we continue to receive for our brand, our workplace, our culture, and our practices. And just to name a few examples, we were again named a top riser on Interbrand's Best Global brands list. We're named to Fortune's 100 Best Companies to Work For, for the 21st year, People Magazines Company's Companies That Care list for the fifth year, Fast Company's Brands that Matter list. And I think what's more significant for a lot of investors moving forward, the Dow Jones Sustainability Index for the fifth year, and one that I'm particularly proud of a 100% score for being the best place to work for disability inclusion. When you look at our financial results, it puts us in an incredibly rare position in the industry. Not many companies can drive the top line and bottom line growth with an impressive margin the way we do. And we powered through $15 billion in 2021, and we accomplished some significant milestones in Q4, our first $1 billion digital experience revenue quarter, our first $3 billion digital media, and $2 billion in cash flow; just some incredible financial statistics. Dan Durn, our new CFO, will cover our Q4 as well as our FY'21 results in greater detail. Since he joined Adobe in October, I've really appreciated his experience and partnership, and I look forward to him sharing his perspective as well as having significant impact on Adobe's growth in the decade to come. I'm also delighted to announce that Anil Chakravarthy and David Wadhwani had been promoted to the President of the Digital Experience and Digital Media Businesses, respectively. I value their leadership and contributions, and they will share more color around each of our businesses. While 2021 was awesome, I'm actually most excited about what's to come for 2022 and beyond in the over 20 years that I've been at Adobe. We have this immense market opportunity. We have an incredible technology innovation roadmap and the best leadership team of any company on the planet. And I think what we've done is provided 2022 targets that demonstrate the strength of the underlying business, three incredibly large growing opportunities across our clouds, continued focus on execution based on the current economic climate. I think the one change that we all are experiencing is as the company scales beyond $15 billion, we also have to focus on FX expectations, given the recent strength of the U.S. dollar. But as excited as I am to talk about 2022, today is really sharing about Adobe's tremendous growth story and how we're going to be driving the next decade of growth, because that's really what underpins our growing over $200 billion addressable market opportunity. As you'll hear throughout the day from our leadership team, our growth has anchored across these five key pillars, our proven track record and our focus on creating and leading categories, the ever-increasing expanding set of customers that we serve, from consumers to creative pros to first time creators, to small and medium businesses, to the largest enterprises in the world, our ability to deliver incredible technology platforms that enable whole new classes of applications and accelerate our innovative cadence. The important shift we continue to make from building applications to enabling new business models, app, services, artificial intelligence and platforms, that's paying dividends. And last but not least, an incredible global ecosystem of partners that spans the entire customer lifecycle from experience creation and marketing to delivery and ongoing support. And I think the message for you as investors is across every dimension, across every business, our aspirations are higher, and we're thinking bigger. There's this incredible once-in-a-lifetime expansive opportunity in front of us, and I think we're uniquely positioned to capture it. And now to provide color on the strategy on how we're going to expand markets and categories, I'd like to welcome Ann Lewnes, who recently celebrated her 15th year at Adobe, our incredible Chief Marketing Officer, who's also taken on the additional responsibility for corporate strategy. Ann?
Ann Lewnes: Thank you, Shantanu, and good morning everyone. Over the past two years, we've witnessed a profound global shift to all things digital. Everyone, from students to small businesses to the largest global brands has had to make this dramatic pivot. Technology innovation, the proliferation of new devices and platforms, and the increased desire and ability for anyone to create and deliver great digital experiences have all accelerated the move to a truly digital world. And there's no going back. Whether it's through your phone, tablet or PC, it's easy for anyone, anywhere to create, work, learn, connect, shop, unwind, and launch and grow businesses. While there continue to be massive challenges in the world, digital has also empowered us through the democratization of creativity, the development of rich digital experiences, the ability to work and learn from home, to shop and sell products online or to connect with those you love. We are moving society forward. Digital has fundamentally changed everything. According to Adobe Analytics, online spending during the 2021 holiday season is projected to be $200 billion, and total e-commerce spending is projected to reach $1 trillion in 2022. It's clear that digital is a requirement to conducting business today. From your favorite local restaurant to Fortune 500 companies, across every country and every industry, digital is powering today's businesses. Companies or automating mission-critical document processes like HR and legal to drive increased efficiency and agility. At the same time, customers now expect rich personalized digital experiences that are relevant, engaging and consistent across any device. It's well documented that digital first businesses drive greater long-term growth and customer loyalty. And Adobe our own technology has enabled us to transform into a digital first business. Companies like Adobe are measuring every single customer interaction, to understand behavior, intent, and ultimately to drive business impact. We do that by providing personalized digital experiences at scale through adobe.com. across all of our digital channels, and increasingly through our products. Digital has not only changed the way we live in work, but also how we connect with one another. Anyone can create or participate in an online community, whether it's with your family, friends, colleagues, or those with whom you share interests and passions. And with the emergence of the creator economy, it's possible for enterprising content creators to build both a large following and monetize their passions, products or services. Today there are seemingly unlimited number of social platforms and ways to engage with one's desired audience. The ease with which you can share, promote and monetize content, products, and services has enabled a whole new level of connection and commerce. We're also finding new ways to work together even when we're apart through the proliferation of collaboration solutions, like Frame.io, which we acquired in Q4. Adobe's mission to change the world through digital experiences is more important than ever before. The digital world runs on Adobe's tools and platforms, and through our unparalleled innovation, creativity, scale, and advanced data-driven operating model, we are continuing to catalyze the growth of digital. Hundreds of millions of people across the globe use our products every single day, and we're impacting every aspect of society. Adobe continues to be uniquely positioned to lead in this next digital era. Our three industry leading cloud offerings are mission critical across every geography and audience, with Creative Cloud, we're unleashing creativity for all, giving anyone, anywhere the tools to express their creativity. With Document Cloud, we're accelerating document productivity, modernizing how people view, share, and engage with documents and with Experience Cloud we're powering digital businesses of all sizes, giving them everything they need to design and deliver great customer experiences. Underpinning our three clouds is the power of Adobe Sensei, our advanced AI/ML framework that enables us to deliver a steady stream of unparalleled innovation. Over the last year, we've seen the critical role that creativity has played in the world. Creative Cloud is empowering everyone from the high school student to the social media influencer to the most demanding creative professional to tell their story. The Creative Cloud TAM is projected to be approximately $63 billion in 2024, $25 billion of that TAM comes from our core base of creative professionals who purchase Creative Cloud applications and services like Adobe Stock. New growth drivers in this segment include 3D and other immersive experiences, as well as web-first collaboration tools like Frame.io, $13 billion of the TAM is coming from communicators, non-professional creators, including small businesses, students and marketers. As you'll hear from David, many communicators are already using Creative Cloud, and we hope to see even, serve even more of them with products like Creative Cloud Express, which we just launched on Monday. The remaining $7 billion of TAM comes from consumers, including hobbyists and social media users. The biggest growth drivers here are mobile applications in categories like video and imaging, such as Adobe's Photoshop Express. Digital documents are a core to the future of work, PDFs and document workflows empower everyone from individuals to the largest enterprises to be productive anytime, anywhere. We're excited about the Document Cloud strategy and the large addressable market, which is projected to grow to $32 billion by 2024, $10 billion of that TAM is coming from knowledge workers, business professionals who typically use our core Acrobat desktop subscription offerings. Growth is expected to come from the expansion of digital document use cases, e-signatures and increase collaboration capabilities. $8 billion of the TAM is coming from communicators who are using Acrobat web and mobile applications to create, scan, and edit PDF files for both business and personal use. Growth in this segment is projected to come from expanding the premium PDF base and capturing demand from new funnels with offerings designed for web and mobile use cases. Finally, $14 billion of the TAM is coming from enterprises, who are using document services, including Acrobat and e-signature solutions, as well as APIs that developers use to seamlessly integrate with key line of business applications. Growth drivers in this segment include API's to build powerful document workflows, and expanded use cases. Whether it's B2B or B2C, businesses of every size across every category are investing in customer experience management. Adobe Experience Cloud empowers companies to deliver predictive personalized real-time digital experiences across every phase of the customer lifecycle. Our total addressable market for Adobe Experience Cloud is estimated to be $110 billion in 2024, $33 billion of the TAM is coming from the data insights and audiences category, which includes Adobe Experience platform, real time CDP, and Adobe Analytics, including our new customer journey analytics offering. Future growth drivers include the increasing demand for a unified customer profile, and personalization at scale, $49 billion of TAM is coming from the content and commerce category, which includes our Adobe Experience Manager and Adobe Commerce offerings. The volume of content needed by businesses to engage customers across every touchpoint is exploding. And the pace at which it must be deployed is accelerating, the need for a seamlessly integrated commerce capability is accelerating at that same pace, $18 billion of the TAM is coming from the customer journeys category, which includes Adobe Campaign, Marketo Engage, and our new Adobe Journey Optimizer. Growth in this segment is expected to come from the continued need for businesses to engage with their customers across an ever increasing array of channels. New to the TAM this year is the $10 billion marketing workflow category, which includes Adobe Workfront acquired last year. Growth here is expected to come from the increasing need for teams to efficiently plan, track and execute marketing campaigns. Adobe has always been relentlessly focused on looking around the corner, inventing new growth opportunities and successfully driving growth within our existing businesses. We have pioneered and are leading three massive categories, creativity, digital documents, and customer experience management. This week, we announced Creative Cloud Express, our exciting new unified web and mobile offering that's perfect for anyone looking to quickly and easily make and share standout content. Creative Cloud Express is great for first time creators and communicators, but will also provide value to our current Creative Cloud subscribers. It's a great example of how we continue to expand our customer base and grow our TAM. We win by creating enduring technology platforms from Sensei to the Adobe Experience platform. They're the foundation for product innovation and our industry leading applications and services. Since transitioning Creative Cloud to a subscription model 10 years ago, we have continued to innovate our business models, building applications, services and platforms to bring value to market faster, better serve new customers, and leverage new monetization models. It would be impossible to do all this alone. We have built a large ecosystem of partners from agencies to solution integrators to ISPs that customize and extend our solutions to the needs of our joint customers. We continue to see massive opportunities from Creative Cloud, Document Cloud and Experience Cloud, with the market tailwinds, our world-class innovation and the best employees in the world, we believe we're well positioned for our next decade of growth. And now, I'd like to introduce Anil Chakravarthy, President of our Digital Experience business. [Advertisement]
Anil Chakravarthy: Thank you, Ann. Hello everyone. Good to be here with you. And I look forward to sharing more on our momentum, opportunity and strategy for the Digital Experience business. It's really an exciting time for us as Ann shared. Let me begin by discussing a couple of highlights from Q4. We had strong performance across the board. Our segment revenue crossed over a $1 billion for the first time with 23% year-over-year growth. Our subscription revenue grew to $886 million up 27% year-over-year and our subscription bookings in Q4 were up 50% year-over-year. And with that, we were up over 40% year-over-year for full-year FY'21. A lot of that was powered by the success of our Adobe Experience platform, and the native apps that run on it. It's foundational to our Digital Experience business. We invested early in the platform, and have a significant head start having launched the platform in 2019. Our growth has accelerated. Earlier this year, we disclosed that we had passed over $100 million in revenue and at the end of Q4, we surpassed $250 million in book of business. And we've seen a 300% year-over-year growth in customer count. The scale that we're operating in production is massive, over 21 trillion segment evaluations per day and our ecosystem is extremely broad with over 300 partner integrations. And as Shantanu and Ann both mentioned, we have really accelerated our innovation over the past 18 months with new native applications and services powered by Sensei. A great example of this is Major League Baseball; they are leveraging digital to transform experiences for their customers with a focus on reaching that next generation of fans. And this is across all their channels at home, on the go and in menu in the ballpark, they're focused on personalization at scale, delivering that right experience at the right time, via the right channel to all of their fans. And it's not just Major League Baseball, it's clear that every business is a digital business, and customer experience management is critical to business success. The changes in the tailwinds that we have seen during the pandemic are here to stay. And this has contributed to a strong momentum in our Digital Experience business; couple of examples here again, significant growth in average annual recurring revenue across our Top 1125 accounts. We've seen strong growth across all accounts greater than a million dollars in ARR and all of our customers are building long-term partnerships with us. As an example, the combined total contract value of our Top 10 accounts is $760 million, which is three times higher than what it was at the end of FY'19. When we think about customer experience management, it is imperative for every company today to deliver personalization at scale to millions of customers. That's how they reach and engage all their customers across the world. And it's critical for them to do that, to deliver that next level of digital business growth. It's all about personalized experiences that are tailored to the individuals, delivered in real time, and delivered seamlessly across online and offline channels based on first party data, and making sure that they honor customer preference and privacy. And that's what we focus on, our strategy is battle tested and helps companies across the world achieve personalization at scale. We offer customers, the best of both worlds, integrated, AI enabled comprehensives applications, delivered on a real time cloud scale platform. We have strong momentum with Workfront with the ability to unify marketing workflow, and increase marketing agility for all customers. And we are the strategic partner for customer experience management; I hear this from customers all around the world every day. And our ecosystem of partners is expansive with over 4,000 partners as Ann mentioned across ISVs, tech partners, system integrators and agencies. This is how we make this happen for our customers through the Adobe Experience Cloud. We focus on four key categories, content and commerce, data insights and audiences, customer journeys and marketing workflow, all delivered on a common platform, which is the Adobe Experience platform. We've had a strong innovation engine over the last 18 months and that's continuing both on the application layer as well as the platform with AI and machine learning capabilities in the platform powered by Adobe Sensei. This is a huge moat for us with the combination of a comprehensive set of applications and an integrated platform. In closing, I am incredibly excited about the opportunity we have for the Digital Experience business. We have strong momentum and we're the clear leader in the Customer Experience Management category. We have a large growth opportunity to help every company deliver personalization at scale to millions of customers around the world. And we have the best technology across our Adobe experience platform and the native applications with the ability grow rapidly as we have shown over the last couple of years. With that, it's my pleasure to turn it over to David to cover the Digital Media business. David?
David Wadhwani: Great. Thanks, Anil, and hello everyone. I've been back at Adobe now for about six months and I'm really excited about what I see. As some of you know, I ran the Digital Media business during the transition to Creative Cloud, and while the business has certainly matured since the early days of that transition, some things haven't changed. Our product teams keep delivering incredible innovation and our business continues to show strong momentum. Now, before we dive into what I'm personally excited about for FY'22 and beyond, I want to hit on some Q4 highlights. Our Digital Media business in the quarter delivered $571 million of net new ARR in total. With that Creative Cloud crossed $10 billion in ARR. And we saw continued strength in our Creative Cloud offers, while seeing outside growth for substance, which grew a 100% year-over-year, thanks to increasing demand for 3D and the emerging Metaverse platforms. We also saw outsized growth in our mobile applications, which grew over 55% year-over-year. Our mobile applications have now generated over 400 million mobile IDs to-date. And it's been a great source of new user acquisition for us. On the Document Cloud size we grew ARR of 31% for the year ending at $1.9 billion. A bit of color behind these numbers, we now have 2.5 billion mobile and desktop devices with reader or Acrobat installed on them. We're seeing explosive growth in Acrobat Web, where we saw monthly active users grow over a 100% since last year. And our strategy of integrating Adobe Sign and Acrobat is clearly paying off for us with 85% year-over-year growth in Adobe Sign transactions in Acrobat. In aggregate, we ended the year with approximately 12.2 billion of ARR. And while we posted a great FY'21, we have even more exciting opportunities ahead for us. Let's start by talking a little bit about Creative Cloud. The big picture here is that we're living in a time where content and creativity and design has never been more valued, where content is fueling the global economy, where the digital consumption is exploding, and where virtually every business needs a digital presence. We're living in a world where creative expression is considered a 21st century skill in education. And we're living in a world, where we're seeing emerging 3D and immersive technologies like the Metaverse creating demand for all new types of content. All of this continues to drive incredible tailwinds for Creative Cloud. In particular though, I wanted to spend a minute on the rise of the creator economy, where we're seeing a growing number of individuals, solopreneurs and small business owners, creating businesses from their passions and monetizing their content, their goods, or their services online. The creator economy is already big with nearly a 100 million small businesses on social media. And with the majority of them saying that their online presence is more important to their success than their physical presence. Now despite it being big, it continues to grow at an incredible rate with nearly 4.5 million new businesses minted in the U.S. alone last year, which was a record. This has been a significant contributor to our success and a major contributor to the over 600 million free and paid monthly active users across our Digital Media products, who are not considered creative professionals. And of course this expansive opportunity needs an expand strategy that drives our mission for creativity for all. In the next few minutes, I'll lay out how Adobe can help anyone who wants to express themselves in creative ways from a small business owner to the highest end production house. Adobe has a solution for them because of our investment in five key areas. And since we just launched Creative Cloud Express, I wanted to start by discussing how we empower the world with content first task-based creativity. Let's go ahead and start by looking at a video of Creative Cloud Express and what it can do. [Advertisement] Creative Cloud Express is the result of years of in-market learning from our web and mobile products. And it's built on four key pillars. First, we remove all barriers to adoption. It's free to get started, it doesn't require a desktop download because it's a 100% web and mobile, it doesn't have a learning curve and users can create an account and publish content in minutes. Second, it's got an unparalleled content library. So, novice users can build beautiful images and social media posts, digital flyers and more in minutes. This includes 175 stock images from Adobe Stock, 20,000 fonts and 1,000 of templates and design assets. And it's all powered by a universal search capability that surfaces the right content and recommendations at the right time. Third, it leverages decades of Adobe's product innovation. As you'd expect, we have great workflows with our Creative Cloud applications, but it also include a slew of Sensei-based quick actions that make creating and editing images, videos and PDF easier than ever before. And fourth, we understand that people create content with the intent to distribute it. So Creative Cloud Express has integrations for single click publishing to social media services. And you can expect to see that our recent acquisition of ContentCal will benefit CCX users with even more social planning and publishing capabilities in the very near future. Creative Cloud Express is easy to use and it's easy to get started with, users can have a lot of success with the free tier, but they're also presented with premium features and content for at affordable monthly price. CCX is also entitled with most CC existing plans, which we expect will drive higher engagement and retention in our core Creative Cloud customer base. And the go-to market motion is very familiar to us. We will combine our digital acquisition funnels and our product led growth motion tuned for web and mobile. This gives us an opportunity to continually iterate and optimize user journeys while ramping this business over time. We also plan to leverage our existing footprint across education, reseller, and enterprise to scale the business. We're thrilled to have Creative Cloud Express in market today it's been amazing to see what people can make with it. And we really couldn't be more excited about this moment and what this means for a start of a whole new journey for Adobe. So moving beyond Creative Cloud Express, we also have a lot going on across Creative Cloud as a whole. We're advancing the state-of-art in imaging, video and design and more by building new capabilities across desktop web and mobile. For example, we're introduced Photoshop and Illustrator for web at Adobe MAX, and we released a series of new Sensei driven AI ML capabilities including neural filters and auto masking in Photoshop and auto captioning in premier just to name a few. We also continue to - our focus on democratizing 3D and immersive. Substance 3D now supports end-to-end 3D workflows, users can design parametric 3D assets and designer compose rendering virtual scenes in stager, add texture, color, effects and painter, and create 3D materials with sampler. This enables fully virtual photo shoot saving companies a lot of money and a lot of time and speeds up asset and scene creation for inclusion and games, videos, and the emerging Metaverse platforms. Collaboration is another big area of focus for us. We're putting -- we're integrating collaboration directly into our apps and existing creative workflows. We're very excited about the Frame.io acquisition and see tremendous opportunity across individual corporate and media workflows with that product. We shipped a public beta of share for review work workflows at MAX, and we demoed spaces on canvas, which we believe will enable teams to organize their creative assets and host live working sessions. And last, but certainly not least, we continue to produce content that inspires and educates our users through services like Adobe Live. We help users monetize their work through services like Adobe Stock, and we help them connect and inspire each other through services like Behance, which now is closing in on almost 29 million members. These five strategic pillars work together to ensure that anyone with creative needs can find a solution at Adobe, whether they're a creative professional, trying to keep up with the increasing content demand, or they're a communicator participating in the creator economy or a consumer looking to up their game in photography or a student developing 21st century skills. We use our data driven operating model DDOM to engage them as they express their interests online by perhaps searching for something like compositing in Photoshop or designing a Twitter post. Based on their intent, we then route them to one of our Creative Cloud apps, one of our mobile apps or one of our frictionless web quick actions. We make sure that they have early success and we introduce them to other capabilities in Creative Cloud or Creative Cloud Express before converting them to and engaging them as a paid user. This digital motion combined with our reseller partners, our direct sales teams gives us an amazing global footprint and reach. So in summary, everything is going digital and content is for fueling the digital economy. The result is a massive and growing TAM for Creative Cloud as Ann talked about earlier and our offerings, which now include Creative Cloud Express continue to expand to meet market demand for both professionals and non-professionals. We couldn't be more excited about the opportunity ahead for the creative business. And as you know, the other part of the Digital Media business is of course our Document Cloud, which is also experiencing significant tailwinds. Demand for PDF has never been greater. In fact, web searches for PDF have doubled in the last decade, and we believe the reason for this is that PDF has become the de facto format for unstructured data. PDF has also been the de facto standard for business-to-business collaboration where nowhere is this more pronounced of course them with e-signatures. This makes PDF an essential part of modernizing any business workflow. And Adobe is uniquely positioned to take advantage of this trend. Our apps are installed on over 2.5 billion devices and we've opened and in our apps. We've opened or created 320 billion PDFs in the last 12 months alone. We continue to be a leading destination for PDF viewing and we saw a 100 million free and paid signups over the last year. And we see that Acrobat can be a gateway to related services. Adobe Sign transactions in Acrobat, as I mentioned earlier, have increased 85% year-over-year, as we continue to deepen the integration between the two offers. Our strategy here is clearly working and we're investing across five key motions to make sure it continues to. First, our document verb strategy has been very effective. We now have 21 verbs market, everything from edit PDF to convert PDF, to rotate PDF, and we're seeing continued -- we're continuing to optimize our digital acquisition and increasing our share of voice across the 80 million PDF related searches that happen every month. Second, we're proliferating e-signatures by integrating them into Acrobat across all services, desktop, web, and mobile. Given our early success here over the last year, you can expect to see us continue bringing these products closer together in the years ahead. Third, we remain committed to making PDF more intelligent for both interacting and reading. Adobe is reinventing mobile PDF viewing with liquid mode. We're accelerating document productivity with automated form field detection, and we're helping transform unstructured data to structured actionable data with our AI, ML based extract function. Fourth, we're unlocking business workflows through our PDF and sign APIs. This empowers developers to build document automation solutions that transform how their businesses work. And fifth we're leveraging our diversified go to market motions to reach anyone with a document need. Our global resellers and inside sales teams give us amazing access to a broad base of business demand. Our enterprise sales team allows us to sell tops down to CIOs, looking to transform their business. And perhaps most importantly, our digital funnel continues to drive individuals' users into our conversion funnels. Knowledge workers, communicators, IT decision makers and developers all have frictionless onboarding pathways. Our data driven operating model helps customers discover Adobe technology when they're searching for PDF related verbs and we engage them in ways that provide quick success on web mobile and desktop before upselling them to premium features, premium features products, services, or APIs that broaden their engagement with Adobe over time. In short, Document Cloud is incredibly well positioned for the years ahead. I hope this gives you a sense of why we're excited about both the creative and document businesses. In summary, both businesses are benefiting from significant tail winds that are underpinning their large and growing TAMs, both businesses are realizing the market benefits by leveraging our amazing brand awareness, our go to market footprint and our incredible pipeline of innovation. And both businesses have the opportunity supercharge their existing data driven operating model by pairing it with a product led growth motion, as our capabilities increasingly are accessed by users on web and mobile. So we're really excited about the year ahead. And with that, I wanted to turn it over to Dan.
Dan Durn: Thanks, David, and before I jump in, I also want to thank him for letting me borrow his sweater today. Let me begin by saying how thrilled I am to be here today and be a part of this amazing team at Adobe. Having just been here for a few months, it's obvious what a special company this is, and I couldn't be more excited about what's ahead. Now, let me jump in with Adobe's Q4 results. Adobe achieved revenue of $4.11 billion, a significant milestone, which represents 20% year-over-year growth. GAAP diluted EPS was $2.57 and non-GAAP diluted EPS was $3.20. Digital Media segment revenue was $3.01 billion, the business's first $3 billion quarter, which represents 21% year-over-year growth with net new digital media ARR of $571 million. Digital Experience achieved its first billion dollar quarter, which represents 23% year-over-year growth. Digital Experience subscription revenue was $886 million representing 27% year-over-year growth. We had record cash flows from operations of $2.05 billion in the quarter, and we repurchased approximately 1.6 million shares of our stock. Turning to our three strategic clouds, it was a tremendous finish to the year. In Q4, Adobe achieved $2.48 billion in Creative revenue, and added $430 million of net new Creative ARR. We exited the year with more than $10 billion of ending Creative ARR with strong performance throughout the year. Growth drivers in the quarter included acquisition of new users on adobe.com, strength in our teams offering, seasonal Q4 strength in the enterprise and success co selling frame.io with our Creative Cloud Enterprise offerings. However, while we saw increased demand for offerings during the Black Friday and Cyber Monday weeks, we did not see the traditional spikes we have had in previous years. This is consistent with this year's industry trends in line with e-commerce holiday shopping data from the Adobe Digital Economy Index. Adobe Document Cloud achieved $532 million in Q4, revenue continues to be -- and continues to be our fastest growing business. We added a record $141 million of net new Document Cloud ARR in the quarter with ending ARR of $1.93 billion growing 31% year-over-year. Our Integrated Document platform is clearly resonating with customers around the globe. We continue to see momentum with enterprises, small businesses and individuals using web and mobile first tools. In Digital Experience, we achieved our first billion dollar revenue quarter. We're seeing strong demand for our real time experience platform and app services, as large enterprises are making investments in Adobe to drive customer experience management and personalization at scale. We drove record Q4 net subscription bookings and for the full fiscal year, we grew net ASP greater than 40% year-over-year. Let's look quickly at the annual numbers. Adobe's financial performance in the year was outstanding, with both top line acceleration and margin expansion in the year, resulting in more than $7 billion of operating cash flow and remaining performance obligations grew 23% year-over-year to nearly $14 billion, absolutely world class performance. Now let's discuss what a unique investment opportunity Adobe is. These are some of the outstanding qualities of Adobe that have energized me about the opportunity and it's what ultimately brought me here today. There's a fundamental shift towards digitization, that's accelerating around the globe. And I believe Adobe is better positioned than any other company to capitalize on these opportunities. Combining that with Adobe's financial track record, as well as industry defining products and platforms, the result is an immense runway ahead of this company for growth. Let me elaborate a bit more on my view of this opportunity. In the years ahead, there's going to be fundamental shifts in all aspects of our lives, all of them digitally enabled. Digital enablement will increasingly shape and define how we live, how we create, how we communicate, how we collaborate, how companies serve their customers, how companies compete, and how economies function. These changes are both powerful, and pervasive. I call it the digitization of everything. The digitization of everything is accelerating. And I believe what happens in the next 10 years is going to define the rest of the century, similar to what happened in the Industrial Revolution. Except now, digital content and data are going to be the fuel of the digital economy. This is a generational opportunity. And we're talking about unlocking trillions of dollars of economic value in the global economy. When you look at Adobe's foundational strengths, there's very few companies that is leveraged to the digitization of the global economy, as well as we are. From the way people create and communicate to the future of productivity and digital collaboration in a distributed work environment, to the digitization of businesses, driving customer engagement with data driven insights to personalize customer experiences, but do it at massive scale to AI and machine learning. Global trends towards digitization have so many intersections with Adobe's unique strengths. Again, digital content and data are the fuel of the digital economy. And I believe no one is better positioned than Adobe to be the digital enabler of the world. How many companies on the planet have this profile? How many companies have this opportunity, not very many. When I think about our near-term strengths, combined with our long-term opportunities, there's a uniqueness here, that's incredibly exciting. Let's double click on the company's financial performance and take a closer look at what I'm talking about. Starting with revenue growth, you can see consistent sustained revenue growth over the last four years as the company has grown subscription revenues at a 24% CAGR. That has been the strategy continuing to grow while producing a revenue stream that's even more ratable and predictable. I'm incredibly impressed by this team's acumen, what they've been able to accomplish, as well as by the contribution to revenue growth from newer initiatives, including Adobe Stock, Substance 3D, Acrobat Web, Sign, Creative Cloud mobile apps, and the Adobe Experience platform. Underlying this financial performance is an incredibly diverse business, from our broad base of customers to diversified products and platforms, comprehensive business models, and go to market reach that spans across all geographies. With growing and diverse revenue streams, the company's been able to expand profitability over the last four years, while accelerating the top line. Adobe's disciplined execution and investment rigor has enabled the company to balance long-term investments while also focusing on profitability. This time period also includes the integration of several strategic acquisitions Magento, Marketo, Algorithmic, Workfront, Frame.io, it's impressive the way Adobe has managed to combine expanded profitability with strong sustained top line growth and M&A integration. Let's talk about RPO, contractually committed future revenues which make Adobe's future performance incredibly predictable and reliable. Exiting fiscal year 2021, RPO grew 23% on the strength of our Enterprise bookings. RPO consists of deferred revenue and unbilled backlog with the current portion expected to flow into revenue over the next 12 months. It's also important to note that most of our adobe.com subscriptions are billed monthly and don't show up as deferred revenue, the remaining contractual commitments of those subscriptions, which average about six months in length at any given time, are included in unbilled backlog. The cash flow performance really speaks for itself, as you can see the way our operating cash flows have accelerated over the last two fiscal years. Sustained growth and profitability at scale is not easy to achieve. The momentum at Adobe is strong, as evidenced by our first $2 billion quarter of operating cash flows. A strong capital structure with robust investment grade credit rating positions us to continue to drive growth and provides flexibility making access to capital affordable for Adobe. Let's talk about our capital allocation strategy. First, we focus on investing in the business to drive long-term growth. Given the tremendous opportunities in front of us, some of our recent innovative R&D initiatives include our next generation data platform, as well as Creative Cloud Express, which we announced earlier this week. We're going to continue to invest in sales and marketing to scale those businesses globally. Second, our cash and investment balances as well as our debt capacity, enable inorganic growth opportunities. You've seen the way we've accelerated growth and made a creative strategic addition over the last fiscal year with Workfront and Frame.io. Lastly, and importantly, we focus on returning capital to our shareholders. Our stock repurchase program is funded through growth in our operating cash flows, and you can see how successful we've been in driving down the average shares outstanding over the last 4 years. Since 2018, we've returned approximately $12 billion to shareholders through our stock repurchase program. Exiting Q4, we have $13.1 billion of remaining stock repurchase authority through the end of our fiscal 2024. The hallmark of a great technology company is consistent innovation in category defining products. Adobe's done that across all its businesses, and we'll dive into each of them next to discuss the performance drivers. First, creative, the company has driven sustained ARR and revenue growth, which accelerated from fiscal 2020 to fiscal 2021. Let me tell you about the underlying data-driven operating model used to drive this performance. It all starts with innovation, and the most comprehensive industry defining portfolio of products. Our brilliant marketing campaigns generate awareness about Adobe's offerings and drive traffic to adobe.com to engage customers to try, buy, use, and renew. It's about taking creators on a journey. First with simpler applications, including our mobile, tablet, and web applications, connecting them with vibrant creative communities, and then providing journeys that empower them to do more as they advance, including services like Adobe Stock, Cloud libraries, and collaboration features. Now, with the addition of Frame.io, and Creative Cloud Express, we're continuing to grow the business by broadening the aperture and reaching new creators and stakeholders that will power the world's content. We continue to drive strong growth for Document Cloud. Again, you see this in sustained revenue growth with ARR growing even faster, as the business shifts to being increasingly subscription based, with approximately 90% of Document Cloud revenues in FY 2021 now being subscription. The main Document Cloud growth driver continues to be new user acquisition. We're seeing strong growth of Acrobat on adobe.com across geographies, growth on the web, as well as in mobile, and seed expansion in the enterprise. PDF and doc that workflows are mission critical to the way people work and collaborate in the digital first world. As Anil mentioned earlier, there's tremendous growth opportunity within our cohort of large customers. As we focus on cross-selling and moving them along the maturity curve towards the transformational adoption of our entire platform instead of customer experience management solutions. The average ARR and total contract value of our largest customers demonstrate how massive this opportunity is. And we grow by adding new logos to our customer base and then expanding within those accounts, a multiyear journey. As impressive as this company's track record is, I believe there's even more growth ahead of us. I fundamentally believe there's a trillion-dollar market cap opportunity in Adobe's future, having crossed the $15 billion mark in revenue, what is the path to $30 billion look like? And then from there, how are we going to get to $45 billion? It starts with an estimated $205 billion TAM, and a huge ecosystem that we built around our market leading products and services. How are we going to get there? We're going to continue to broaden our appeal to a wider universe of customers, engage and retain our current customers across all geographies. We're also going to grow by innovating and investing to enter new categories that further complement and expand our growth trajectory and better enable our customers in the digital era. When we execute on that strategy over the next decade, our scale and success, we'll put Adobe in a class that only a few software companies have achieved. Having passed the $15 billion revenue mark, we're going to start reporting revenues in constant currency given the potential impact of foreign exchange movements. Following the year in which FX was a tailwind to reported revenues. The recent U.S. dollar strength is expected to result in a headwind to our reported revenue and growth rates for fiscal year 2022. Consistent with our annual practice, we've revalued our digital media ARR balance to account for the movements and the FX rates. For operating expenses, we continue to save on travel and facilities in fiscal year 2021. While many of our employees continue to work from home, we expect these expenses to ramp throughout FY 2022. We also plan to invest in increasing headcount in integrating Frame.io. We believe these are critical investments and we're making -- we believe these are critical investments we're making and we're going to focus relentlessly on the organic growth opportunities ahead Lastly, fiscal year 2021 was a 53-week fiscal year with an extra week in Q1. That week added approximately to $267 million of revenue and $25 million of net new digital media ARR the math around the return to a 52-week fiscal year is expected to be a two-point headwind on our full-year, FY'22 growth rates and a seven-point headwind in Q1. Here's Adobe's fiscal year 2022 annual targets. We show our segment growth targets on an actual and adjusted basis and constant currency factoring for the additional week last year: Total Adobe revenue of approximately $17.9 billion, net new digital media ARR of approximately $1.9 billion, digital media segment revenue growth of approximately 14% year-over-year, or 17% on an adjusted basis, digital experience segment revenue growth of approximately 14% year-over-year or 17% on an adjusted basis, digital experience subscription revenue growth of approximately 16% year-over-year or 19% on an adjusted basis, tax rate of approximately 17.5% on a GAAP basis and 17% on a non-GAAP basis, GAAP earnings per share of approximately $10.25 and non-GAAP earnings per share of approximately $13.70. For Q1 of fiscal 2022, we're targeting revenue of approximately $4.23 billion. Net new digital media ARR of approximately $400 million, digital media segment revenue growth of approximately 8% year-over-year or 17% on an adjusted basis, digital experience segment revenue growth of approximately 11% year-over-year or 18% on an adjusted basis, digital experience subscription revenue growth of approximately 13% year-over-year or 20% on an adjusted basis, tax rate of approximately 16% on a GAAP basis and 17% on a non-GAAP basis, GAAP earnings per share of approximately $2.63 and non-GAAP earnings per share of approximately $3.35. I want to conclude by sharing what this company has achieved over the last four years, whether it's revenue growth and profitability, outstanding cash flow generation and shareholder returns, Adobe's track record demonstrates why this company is in a class of its own. I firmly believe that our best days are ahead. Thanks so much for your time today. I'm going to now pass it back to Shantanu.
Shantanu Narayen: Thank you, Dan. And thanks and welcome Ann, Anil and David for outlining the opportunities across our three industry leading clouds. As I said earlier, I'm incredibly excited about Adobe's future and our ability to not only lead, but also create new categories. I think if you zoom out a little bit and think about it from a macro perspective, all over the world, it's clear that digital is empowering individuals, transforming businesses and connecting communities. And frankly, digital is going to play a much bigger role in work, life and entertainment going forward. We've seen the rise of the creator economy and the democratization of creativity. Work and education are now hybrid and here to stay in that form. Cloud and web technology advances are powering unprecedented levels of real time collaboration. Document workflows are increasingly going to be automated. And most important mandate for a digital business is more urgent than ever before, as customers now expect digital first experiences that are both contextual as well as personalized. E-commerce growth is building on the record highs achieved during the pandemic. From a technology base, artificial intelligence and machine learning have become indispensable facilitators of our daily lives. And so I think in short, digital technologies are enabling more people to create, collaborate, learn, work, be productive, and make a living than ever before. I love our mission and the ability to change the world through digital experiences, puts us as the nexus of all of these trends. We're incredibly well positioned to drive meaningful impact across every aspect of society and that'll benefit billions of people around the world for years to come. As we think about the company at Adobe, we believe it's not just what we do, but it's also how you do that it really matters. From the very beginning, John Warnock and Charles Geschke, our founders committed to building a company that does the right thing. And the sense of purpose has guided our evolution and growth over the past four decades. I think we're all witnessing the shift in the role that companies have to play in social issues and the expectations that stakeholders and investors have for corporations. As you reflect on how companies have responded to the COVID-19 pandemic, it's remarkable. With that stakeholders around the world are looking to the private sector to become more active in social issues. And people are making decisions on the products that they buy and the places that they work based on where companies stand. As our products have become ubiquitous, and we've helped many more companies harness the transformative power of our digital technologies, our responsibility and our commitment to corporate citizenship has also grown dramatically. And I believe that the issues on which Adobe is uniquely positioned to make an impact are on Adobe for all, making sure we create a diverse and inclusive culture for our employee, as well as position that for our customers and partners .On the belief that technology will transform, and in addition to providing technology, we have a responsibility to understand what that means. And I think most important to being able to allow everyone who has a story to tell their story, the notion of creativity for all. The reality is that we've been leaning into these for several areas already. And our efforts are making a real impact across the company and our customer communities for many years. But I think it's this purpose that motivates our employees to focus on having more impact and frankly inventing the future. I love the fact that our strategy has remained relatively consistent for the past decade. Our strategy to unleash creativity for all to accelerate document productivity and to power digital businesses is more mission critical than ever before. I think most companies would be thrilled frankly, to have one of these growth opportunities. And we're fortunate that we have three businesses that are absolutely in the sweet spot of where the world needs technology to play a more important role. We have the right strategy. It's applied to an exceptional and growing opportunity. And so we're no way opportunity constrained. I'm going to end with how I started. I believe that Adobe is uniquely positioned to drive the next decade of growth. We have a proven capability to create and lead categories and we're always looking around the corner to the whitespace that exists that will provide new opportunities for Adobe. We're thinking bigger about every part of our business, how we scale and how we expand the customers that we serve. We continue to focus on innovation, delivering leading products, services, and platforms as we leverage artificial intelligence and machine learning. We're continuously thinking about innovating in business models as well to rapidly deliver more value to a larger set of customers to capitalize on global growth opportunities, and to enable new monetization models that are emerging. And at the end of the day, our technologies support a vibrant and growing ecosystem of partners that create, customize and extend our solutions to meet the unique needs of our joint customers. But at the end of the day, our greatest asset as being an intellectual property company and what's truly driving our growth is our highly engaged global employee base, over 25,000 strong to whom I'm eternally grateful. Thank you again for joining us today. I believe 2021 was a fantastic year, and we clearly expect that momentum to continue in 2022 and beyond. As we look forward to our 40th anniversary next year, Adobe stands in an enviable position, an impressive track record of innovation, category and brand leadership, great financial performance and multiple growth opportunities. Coupled with the expanding market opportunity, the depth of our technology platforms, and the motivated employee base, I certainly believe that Adobe's best days are ahead of us. And with that, we'll roll a video while we assemble the management team for our Q&A. [Advertisement] Okay, are we on for Q&A? Great, I know we're on for Q&A. Before we get started, let me introduce two other members of the Executive team who are also here with us to answer the questions that you might have. Gloria Chen, our Chief Human Resources Officer, who has also run strategy in the past, as it relates to any questions that people have about the pandemic, or what we are doing with our global employee base, how do we continue to make sure we ensure that we have the best talented and motivated employees, and Scott Belsky, our Chief Product Officer of Creative Cloud, frankly, the visionary behind all of the great innovation that we're delivering across desktop, mobile collaboration, including the new web related functionality that we showed at MAX as well as what we did with Creative Cloud Express. And so with that, I'll turn it over to Jonathan to help navigate the Q&A.
Jonathan Vaas: Thanks, Shantanu. So, we've shared a lot of information today, you can clearly see the team's enthusiasm around the growth opportunity ahead. Now, we'd like to go ahead and take your questions. So for folks who are on the phone, if you haven't already done so, please go ahead and queue up for questions. Quick reminder, we do ask that each of you limit yourself to just one question per person that'll allow us to get through as many people as possible. And with that, I'd like to go to the operator. Operator, could we go ahead and take the first question, please?
Operator: Absolutely. [Operator Instructions] First question will come from Saket Kalia with Barclays. Please go ahead.
Saket Kalia: Okay, great. Hey, folks, thanks for taking my question here, and congrats Anil and David on the promotion, and welcome, Dan.
Dan Durn: Thank you.
Saket Kalia: Maybe the question is -- maybe to start us off, I'd love if we can address the digital media net new ARR in the quarter, particularly within Creative. I think, Dan, you had mentioned that we hadn't seen spikes that maybe as high as we've historically seen around Cyber Monday and Black Friday. I was wondering if the team could just go in a little bit deeper into the result versus the guide, and then maybe comment on the competitive backdrop within Creative specifically?
Shantanu Narayen: Why don't I start with that, Saket, and then I'll certainly have others add. I mean, as we look at the Digital Media ARR accomplishment over the quarter, firstly, it was record quarter as well as it was a record year. And when we think about what our Digital Media guide was, I mean, we certainly expected Frame to close in the quarter, and it closed pretty early in the quarter. And so what we do is, we think about a range of outcomes and what that might do. And certainly we wanted to focus on Frame as well, but it was probably not explicitly factored into the quarter. When you consider it from different customer segments, the Team business actually performed really well right through the quarter. And so, the Teams is offering and the strength in the small and medium business was great. Enterprise, we actually actively redirected and pivoted the team to think about video and Frame and how we were continuously selling it, as I said, it closed early in the quarter. And so, Enterprise had the traditional Q4 strength as well, that we normally expect. The individual demand was actually fairly strong right through the year. As Dan mentioned, maybe the one slight change is that as you think about what's happening with online shopping, while we continue to see demand up into the right, we perhaps did not see as much of the spike, as you would have perhaps seen traditionally in either the Black Friday or the Cyber Monday weeks. But apart from that, strength and demand continues to be strong. And clearly, we factored that into our guidance for fiscal 2022, which is the strongest ARR guide that we've ever guided to. I think as it relates to the product and the differentiation, maybe I'll have Scott touch on that, and then David can certainly speak to other issues of the business.
Scott Belsky: Sure. In terms of product differentiation for Creative Cloud, I mean, what a year we had. We delivered some of the mind-blowing Adobe Magic throughout our actual Pro products, neuro filters in Photoshop, for example, a lot of the collaboration features and we really made a proclamation that Creative Cloud going forward will be as much about collaboration, as it is about Creativity, which if you think about it invites many more stakeholders of Creativity into the fold. And that's where we're seeing across all of our enterprise as well as small businesses. Everyone wants to be a stakeholder and have a say and be able to jump in and give feedback. And so we're building our products for the future to enable that. I also want to mention, of course, last week you launched Creative Cloud Express, this is just the start of an amazing new chapter for us. We've had a number of products in the market in our incubation zone. We call it as we learn about how to really fulfill our mission of creativity for all. And now we've galvanized all of the learnings, all of the signals. And we just couldn't be more excited about the new journey we're on here with that product in particular.
David Wadhwani: And I'm happy to add a little bit more from the business perspective as well, all the innovation that Scott's talked about and has been driving. One of the big things that you have to recognize is that it's really what's driving the TAM growth that Ann talked about earlier, both in terms of expanding the base of people we can access with something like Creative Cloud Express, and also increasing the value that we're providing to our Creative Pro base. So, as you start looking at, where we're going with the business, we're building on the momentum, as we talked about, we had almost $2 billion of net new ARR added in FY'21, we had our strongest guide ever and it's really on the back of that. One more thing with regard to Creative Cloud Express and how that will start to drive opportunity for us, it can start by actually adding a lot of new users to the franchise, one of the things that we've been doing a phenomenal job with and I think this expands is bringing new users to Adobe, getting them successful with what they're doing, and then start to mature them up the value curve into Creative Cloud subscription or now Creative Cloud Express subscription, but we're also making this available to all Creative Cloud customers. This is something that we see a lot of Creative Cloud customers occasionally want speed and content first development. For those users, we see the opportunity to really drive higher engagement and retention, even beyond where we already are. And then as you start to have more plans that are separated for the kinds of things people want to do, it gives us the opportunity to drive more price optimization across the lines as well. So we're very excited about where we're heading and what this really adds to the mix we have.
Saket Kalia: Got it. Thanks very much, guys. Very helpful.
Operator: And our next question will come from Alex Zukin with Wolfe Research. Please go ahead.
Alex Zukin: Hey, guys, thanks for taking the question. Maybe I'll go a little bit more directions, we're getting a lot of questions from investors. If I look at the guide, if I look at the performance of Digital Media era for, and we assume the Frame.io was not in the guide, it’s the first time, I think ever that you've actually not outperformed your guidance for the quarter. And so I realized that there definitely were some issues in Q4 that may have impacted that. So, just give us a sense of mix like what it was, now let's look back and you had looked back at the COVID impacts those in the first half, second half, the holiday season, how should we think about the confidence in your guide for next year vis-à-vis your historical cadence or historical pattern and seasonality?
Shantanu Narayen: Yes, Alex, I mean I'll take that. And if you think about it, first, as you know, people who've covered us for a long time, we take our guidance very seriously. And let me maybe roll back a little bit to what we accomplished in 2020 and then how we guided for 2021. As you know, we guided a little bit below what our 2020 guidance was, in 2021, when we started, and we certainly outperformed that guidance as it relates to digital media ARR accomplishment in 2021. And if you look at how we've guided for 2022, it's actually a little bit closer to our 2021 guide, as a starting point. And so clearly, we continue to be incredibly optimistic associated with the underlying strength of the business, the overall need for creativity just continues. We don't believe in any way, shape, or form there was sort of pull-ins and I know that sort of exists for other companies, we just continue to see secular strength. And some of the new initiatives that we have underway. I mean, we really pivoted the team to be thinking about enterprise and video, we have Creative Cloud Express, the usage is going to build dramatically, we already have the largest communicator business, I think among the Creative community. So, we're incredibly optimistic about how that business looks. And then if you look at it from a quarterization perspective, again, let's just go back and look at what we guided in Q1 of 2021, as you know, when we guided to a number we were factoring in the $24 million that we outlined was an additional part of what we accomplished as part of the 13 versus 14-week. And so if you look at it, it's very much in line. In other words, the trends of the business continue and the optimism in the business continues. So that's how I would think about it, Alex.
Alex Zukin: That's super helpful, and maybe just one for Anil on CDP, the last time we talked about the CDP products, I think you talked about being surpassing the $100 million in ARR margins, clearly [indiscernible] from your commentary sounds like perform really, really well. And really, it broke down for the entire digital experience. Where are we with that business today, if there's any way to dimensionalize work for the project from an ARR perspective?
Anil Chakravarthy: We see a lot of momentum, the market clearly customers looking at us and saying they have the right vision. And we have the right product to really think about a range of use cases that's supported by the Adobe Experience platform, and we've done a really nice job of integrating our applications with the Adobe Experience platform, so that you are able to populate the data from our analytics platform, and then use the data for activation across all kinds of channels. So, in terms of scale, in terms of performance, in terms of the range of use cases, data governance, et cetera, it's really enterprise ready right now. And enterprises are beginning to see that this is at the heart of their Digital Experience and their digital customer engagement. So we feel like we're in a really good place right now with that.
Alex Zukin: Perfect. Thank you, guys.
Operator: Up next, we will hear from Keith Weiss with Morgan Stanley. Please go ahead.
Keith Weiss: Excellent, thank you guys for taking the questions. I want to dig a little bit into I think David, you started getting into this with the positioning of Express and how we should think about that. How does the Express positioning relate to kind of what you guys were trying to do with Spark and those mobile offerings in terms of an entry ramp? Is it kind of in between those two? To what extent should we think about this as defensive to some of the emerging competitors that are ramping up in the marketplace? And is there any risk of downshifting of the existing Creative Cloud customers, who need a lighter weight solution. Now here is a cheaper offering if you will. Is there any potential that you can see some downshifting within the base of people trying to price optimize there, or to the contrary, does this allow you to sort of pull price up on the core Creative Cloud? You just help us with those kinds of questions on the positioning around the portfolio now?
Shantanu Narayen: Okay. Maybe I'll start, Keith, and then David, certainly you can add to it. If you take a step back, I think this just speaks to the enormous opportunity that exists for creators. And if you look at our offerings already today, Keith, I mean, we have an incredible diversity of offerings. We have Photoshop Express on mobile that's doing great as it relates to the ARR. And we have the Creative Cloud product that also allows now the substance 3D products, that's probably the most expensive. And so I think with online and our DDOM, we now have absolutely the ability to target and personalize our offerings against a broader set of customers and to make sure that we make it all net positive and net from a customer satisfaction as well as a net positive from the ARR that we accomplish. A couple of other things, I mean, first, our creative business with the Communicator segment is already the largest creative business in the world. I mean, when you think about what's happening with Photoshop or Lightroom or the express set of products, and I think what express really does is it actually adds value to every single Creative Cloud subscriber. I mean, they are Creative Cloud subscribers, who are incredibly proficient in video, who sometimes want to do a quick flyer associated with it. And so I think this brings more and more and more people into the fold. It's similar frankly to what we've done with the Document Cloud, where when you think about what's happening with this organic demand that we've created for PDF. And so net, net, I think it's a creative, and then I'll hand it over to David to speak specifically about how this might roll out, but it is actually an enabler for us, and it unifies frankly all of the different creative offerings that we've already had for the Communicator segment.
David Wadhwani: Yes. Just adding to that, we look at this as a really pivotal moment in terms of our ability to fulfill a need that we know our customers have. If you think back to what we talk talked about earlier, we have 400 million IDs that have been created on mobile devices already. We have 600 million monthly active users across our Digital Media products that are not creative professionals. And Creative Cloud Express represents an opportunity to give all of them something that we can onboard them in an effective way. As Shantanu also talked about, one of the things that we find really exciting about this is that our Creative Cloud base as well is looking for sometimes often they're looking for the power and precision of our creative flagship applications, but sometimes they just want a velocity driven content first creative, creation model two. And by giving Creative Cloud Express to most of our Creative Cloud plans, we expect to drive even higher engagement and retention there. And the last thing I want to say is that this fundamentally expands how we think about our go to market motion. And we have talked for the last many years about our data driven operating model and how that drives our ability to pull and acquire users bring them into our acquisition funnels with product led growth because of our increasing investment in mobile and web, we have the ability to do a lot more quick iteration and optimize the user journeys, so that conversion of that 600 million mile into paid and premium customers and engagement with them continues. And the last thing I will say is that, I don't think you can look at this market as you've got non-professionals and professionals. We have a lot of non-professionals that really want to use the power and precision of Creative Cloud. And so we look at this as this ongoing seamless journey from the first time you come in, you want to do something with creative expression, you can do it for free with Creative Cloud Express. We then move you up that chain. So you have the premium content and availability of the premium features and content and Creative Cloud Express paid plan. And then we see people are able to actually move all the way up to the power and precision of Creative Cloud. So it's really a seamless end-to-end journey.
Keith Weiss: Got it. Is that what you were talking about when you mentioned price optimization? Is it just having more tiering within that pricing?
David Wadhwani: Yes, certainly. Keith, so we've talked about price optimization being it. I mean, for the first time as you saw with the 3D products, we did not included as part of Creative Cloud all applications because of the value. But certainly I think as we get a better feel for all of the different offerings that we have, there are some offerings that are probably under-priced relative to the value that they're providing. But our focus just continue be attract more people to the platform and deliver more product value. Scott, we would add something on Creative Cloud?
Scott Belsky: No, I was just going to say, I mean, I think David, you covered certainly the opportunity for Creative Cloud Express for the broader franchise. But one of the very exciting things that we've learned over the last few years is a really around the distinct customer needs that we're just not covered frankly by Spark or Photoshop Express other things we were doing or other kind of competitive tools out there. And I just wanted to share a few of those because I think they're really relevant. I mean, first of all, we're seeing a lot of these customers that come in, wanting to make something with a template, they want to be able to go further. So our product team is actually very excited about the prospect of a customer being able to make something and then take it to the next level using one of our more pro-ish applications like Photoshop or Illustrator, also the desire for artificial intelligence. A lot of customers come in from small businesses, etc, and they have an idea of what they want to make, but they want some assistance and making something remarkable. They want fonts to be recommended to them. They want colors that will perform better on social media. And so we have an opportunity to do that. And then finally, the idea of a multimedia editor was another really important insight for us in the development of Creative Cloud Express. Because what we learned is that while a lot of customers come in through the top of the funnel, because they want to make a flyer, they want to edit a video, they want to edit an image. When they come in, they actually realize, I'll add some animation. Maybe I'll add some sound. And before you know it, it's a multimedia creation. And so we're very much building Creative Cloud Express not just for where the customer is now, but where we see the market going, people are going to want to stand out with their media. And that's something that I believe Adobe can uniquely deliver with this product.
Keith Weiss: Outstanding. Super helpful, guys. Thank you.
Operator: Up next, we'll hear from Kirk Materne with Evercore ISI. Please go ahead.
Kirk Materne: Yes. Thanks very much. No, I was wonder if you could just talk a little bit more about some of the strength you're seeing in the enterprise side on the experience cloud front, obviously RPO was really strong. I assume a lot of that strength came from the experience club side. And what continues into next year, because when you look at the fiscal '22 guide, obviously CECL assume some of that's just work front being anniversary, but could you kind of tell us what you're sort of assuming continues in the strengths of business this year, going into next year? Like what has momentum in that business that you feel good about and where are some of the potential points of leverage in terms of upside next year? Thanks.
Scott Belsky: Well, we definitely see some of the tailwinds we saw during the pandemic continuing and every company, B2C companies, B2B companies, and companies that are experimenting with new business models, direct-to-consumer for example, they're all starting to invest across the board in digital experience. And we see that play out across all of the categories that are laid out, definitely with one view of the customer, a single view of the customer that carries through the unified profile that we have in the Adobe Experience Platform that is at the heart of all customer engagement. So if you kind of map it to how we think of our DDOM, everything from discover to try, to buy, to use, to renew that whole journey needs a common unified profile, so that you can deliver a consistent experience across all channels. And that's a major investment that all companies are making. And so what we've been able to do is to really take advantage of all of the knowledge we have and the applications we have across all of these areas and populate that data in the Adobe Experience Platform. And that gives us a clear head start for with every company and then say, then opening it up by saying that it is open to developers. The data model is an open data model. It runs on top of a cloud, so that it's horizontally scalable that has really made it something that any enterprise of any size can use, but they can also get started in a particular geography or in a particular business unit or a customer segment and scale from there. So I'm really excited. I think across our categories, we definitely see a lot of strength and more as we now see some of the trends that we've just talked about with the creator economy and so on, that'll continue to add more use cases that'll be built on top of the platform.
Shantanu Narayen: And Kirk, if I were to add a little bit more to that, I mean, when you take a step back and think about what we've accomplished, we created the digital marketing category, and we said, there is a much larger opportunity as it relates to this customer experience management, the innovation that went into the building of the experience platform and the unification frankly of everything that analysts talked about, whether it's content and commerce, whether it's data and insights, whether it's the marketing flow associated with work front, which is also doing well. There really isn't another company that enables somebody whether you're the marketer, the Chief Revenue Officer, the Chief Digital Officer to very quickly say, I want to get all my data, whether it's online or offline into one particular place and even more important to activate it. And so I think from my perspective, the momentum associated with having this unified platform and you can get customers really up and running so rapidly, that's pretty amazing. The second thing I would say is that we've done a really good job with the Digital Strategy Group, as well as what Anil had outlined earlier about these transformative accounts. And so, again, as we shared in the data, the ability to sell multiple solutions, the ability to upsell, the ability to co-sell, I think that's also gives us a lot of confidence, but now we have the platform, we have the apps and services on it. We have the AI associated with it, and I think if you take a step back, there isn't a company that doesn't want to talk to us about (a), Adobe, how did you do it? And (b), how do we really make sure that we can get this up and running and activated faster? So, I really hope in 2022, you'll see how we make increasing progress in terms of not only just the selling, but the provisioning and frankly the value realization and I think we've done a good job on that front as well under Anil's leadership.
Kirk Materne: Thank you.
Operator: All right. Up next, we'll hear from Mark Moerdler with Bernstein Research. Please go ahead.
Mark Moerdler: Thank you very much for taking my question, and congrats on the quarter and the year. I'd like to drill in a little bit, because I'm getting a lot of questions obviously. Dan following up on your prepared presentation, you discussed how subscription is sustained 24% growth. And when you look at the overall guidance, I'd like you to help us better unpack what the opportunities that are impacting for you are specifically your Digital Media side and then also on the experience side. Also, can you give us any sense on how much you are figuring FX via headwinds in ARR and revenue, I'd much appreciate it.
Dan Durn: Sure. Thanks for the question. I think the best place to start is underlying performance of the business. I think we're exposed to great market opportunities; company's got the right strategy performing well against those strategies. As we think about performance in the current environment, against that backdrop of good performance. We want to strip out noise in the one year look ahead, set of numbers and I think there's two things that we point to when we separate the noise from what's been communicated. First is FX, second is the extra 53 week versus 52 week. And so, let's go one layer deep in each of those. As we think about the 53 versus 52. Week, that's about a 2% add or to growth for the overall company in fiscal '21. And as we window into fiscal '22, that's going to be about a two-point headwind because that extra week occurred in Q1 and you look at Q1 FY '22. It's about a seven-point headwind from just that one extra week alone as we look along quarter forward. As we take a look at FX and we think about the currency moves not surprisingly, FX for our business over 2021 also added about a two-point tailwind from a growth perspective, broadly speaking across the business. As we look forward into the next year, it creates about a one-point headwind given the recent moves that we've seen over the last couple of weeks, I'm sorry, last couple months of the dollar strengthening versus a variety of currencies around the globe. That gives you a sense of the magnitude of the moves from both of those two factors as we extract underlying performance from a bit of the noise we see, if we were to go to one click further down and take a look at how both of those factors affect the Digital Media business versus the Digital Experience business. I would say from the 52 versus 53 week dynamic, you'll see more of that upside and more of that headwind from a growth standpoint, impacting the DME business, then you do the DX business, but it's just a slight difference between the two businesses, depending on how we engage commercially with our customers. And I can go into that a little more detail, if you'd like. On the FX side, you see a similar dynamic, you see slightly accentuated performance to the upside and downside tailwind and headwind from FX on the Digital Media business than you do on the DX business. It's a slight change, but you see a slight bias to the upside and downside of DME versus DX. I think that unpacks the numbers and gets to the true underlying performance of the company. And as you take a step back and look at how our businesses have performed over the last couple years, you'll see what we've just guided is about in line with where we've been for the last couple years. So again, the company continues to perform pretty well.
Shantanu Narayen: And maybe Mark, I'll just add a couple of things to that. First is, as Dan tells me, which is first welcome to the big leagues. And so, I guess when you're $15 billion of revenue, it's neither practical and it's frankly too expensive to hedge all the FX exposure that you were accustomed to maybe we're doing, so if you strip out that FX part and if you think about ARR, just very tactically to be clear. What we do is, we have an ARR at the beginning of the year with the strength of the dollar in November, you could argue it's the hardest compare on a pure FX, and then we both devalue the beginning book of business on ARR. And then we're using that dollar rate for the ARR for the quarter, and so then again, if you think about it, at a $1.9 billion guide that we have for ARR. Clearly, the underlying strength of business and the units that is not what's impacting the business, so, just I think that's the other way that I unpack what was the impact of FX, as well as to specifically tell you how we take the dollar rate at the beginning of the year for the ARR calculation.
Mark Moerdler: That's extremely helpful. I really appreciate, Dan, if you don't on the difference between the two businesses. Can you drill it a little bit more why that extra week is so much worse a little bit on digital?
Dan Durn: Yes. As you look at how we engage with customers, you engage with customers, through adobe.com and other channels on a daily basis, and you're exposed to every single extra day of that week to the upside and the downside depending on which year you're in. On the DX business, the vast majority of our, not the vast majority -- the majority of our revenues will all get booked on a daily basis, but there are parts of that business that engage with customers on a monthly basis. And as you can imagine when that extra week falls in a month and you engage with customers on a monthly basis, you won't see the upside or the downside on that business. So, on a like-for-like basis, you'll see more of that dynamic flowed into the Digital Media business than you will the DX business. But again, as you think about a two-point tailwind FX in FY '21 and a one-point headwind in FY '22. You're talking about slight separation to the upside and downside, and depending on what year you're in to this dynamic.
Mark Moerdler: Perfect. I very much appreciate it. Thank you for the detail.
Dan Durn: Yes, you're welcome.
Operator: Next, we'll hear from Gregg Moskowitz with Mizuho. Please go ahead.
Gregg Moskowitz: Okay, thank you for taking the question and thank you for hosting this event. One of your competitors in the Document Cloud space recently cited softening demand and execution issues. Naturally your business is a lot broader than theirs. But have you seen any changes as it relates to customer engagement within Document Cloud?
Shantanu Narayen: Gregg, we had a phenomenal quarter and Document Cloud. I think we had record net new ARR $141 million in net new ARR for the Document Cloud. I think the team has done a really good job of integrating that. So maybe I'll have David speak a little bit to how just integrating sign as well into the Acrobat business as one of the verbs is really I think helping really make it more pervasive. David?
David Wadhwani: Yes, as Chuck said, we're very excited about the momentum we see in the Document Cloud business as a whole. We have -- we benefit from this incredible reach we have. As I mentioned earlier, between our inside sales folks and our reseller partners, really anyone that has a document need is coming and flowing into our funnel. And then certainly with the benefit of the enterprise selling in the top down, we're able to go and have solution-oriented conversations with them, but one of the key areas that we've been focused on over the last 12 months that has really been productive for us is to leverage our footprint in terms of our desktop applications predominantly things like Reader across mobile, desktop and web and drive awareness and utilization of our services through that. As I mentioned earlier, we saw an 85% year-over-year increase in terms of Adobe Sign transactions that were successfully committed -- completed or initiated in Acrobat and you can expect to see us continue to do that. We want signatures and Adobe Sign to be available to anyone that uses Acrobat going forward and will continue to double down on that strategy.
Shantanu Narayen: And may be just one last thing to add on that, Gregg, I mean, one of the exciting things that again, I think the team has done is now this extension that we have in Chrome, as well as what we are doing and we announced the extension of the partnership with Microsoft. So again, I think the distribution of Adobe PDF with all the magic that we have with Liquid Mode and Mobile and Sign, I think that just really enables us given we have the APIs and the developer motions to really even further extend that. But this notion of automating document workflows, it's just going to continue to go up into the right.
Gregg Moskowitz: That's terrific. And then, a quick one for Dan, you spoke about FX and the extra week a moment ago. But how much is an increased or more normalized level of T&E expected to impact your operating margins in fiscal '22, how should we think about that?
Dan Durn: Yes, so as I think we look into 2022, we in the prepared comments talked about as the world begins to open up, we're going to get on airplanes, we're going to spend time with customers, you'll see some of the facilities costs come back, this is about growing and scaling our business and engaging with customers and solving their highest value problems. So you will see some of those costs come back. And that's reflected in our guide. And so when we take a look at the opportunity in front of us, and we think about the runway for growth, we think about how well we're positioned in each of our respective businesses. And we think about where the world's going and the key enablement role we as a company can play to enable that digitization of the world, we're going to invest for growth, we're going to invest in market leading and defining products. And we're going to continue to lead the way we've done in the past. So you'll see some of that complement the investments we're going to make. And then as you think about the Adobe Experience platform, and you think about Creative Cloud Express, we're going to invest in sales and marketing to grow and scale those businesses globally. So we're going to be oriented to growth. And you'll see that reflected in both the performance and the decision making going forward.
Gregg Moskowitz: Great, thank you.
Operator: And up next, we'll hear from Brent Thill with Jefferies. Please go ahead.
Brent Thill: Dan, welcome to the team. Just on the margin side, I mean, I think we all understand your margins have gone up 590 basis points in the last three years. So tapping the airbrakes a little bit on margin makes sense. But when you think about the long-term trajectory still for Adobe on the margin, you believe you're capped in the mid-40s, do you still believe long-term, the margins can trend more towards 15, and I have a quick follow-up for Shantanu.
Shantanu Narayen: I think 60s comes after 50s, Brent. If you're thinking about numbers on that scale, we have as Dan said, such incredible opportunities, and one of the statistics that he showed that was really, hopefully, Brent, and you know us how we think about the businesses, which is we're investing in these long-term really growth rates. But we've been able to do all these acquisitions, and really do a fantastic job of keeping our margin. And so, I think it again is all about the growth opportunity, you know it, we have an unbelievable leverage model. And so the leverage model will demonstrate itself. And if you look at our 2022 targets, it actually continues to show a lot of optimism in what we can do. I think Frame.io is a little dilutive. And again, as he said, some of these things, the Experience Cloud, and what we are doing with getting more Experience Cloud adoption globally, what we are doing around Document Cloud and Creative Cloud and Creative Cloud Express, I mean, we want to make sure that we are spending wisely, Ann is the expert on attribution, not just within the company, but in the world. And so, we'll continue to do it. But we do believe that, and this is the question that you've also asked in the past, which is the value that customers are getting is there an ability to continue to drive higher price offerings, and all of them are there. I mean, we're just excited about all of these different things, but I wouldn't count on 50 anytime soon right now, I'd rather count on accelerated growth, Brent.
Brent Thill: Okay, very clear, Shantanu just for the quarter, forget the guide. I think many of the analysts have asked this question, what happened in Q4, and this is not a quarter that we're all used to seeing from you. So from your perspective, is this just the digital digestion from a huge adoption, we've seen the last year is Adobe execution. I don't think it's competitive. But I think many are still asking all of us the question throughout this Analysts Day with the stock down, what happened from your perspective?
Shantanu Narayen: Brent, so let me maybe again touch a little bit on the Adobe Digital Index, and then I'll come back to our business. If you look at the Adobe Digital Index, what has clearly happened over the last 12 months, 18 months, even pre-pandemic, but certainly during the pandemic, is this more and more activity happening online. That is a secular trend that's actually not going to change. We see it, there's more energy, there's more traffic, there's more activity associated with what's going online. If you look at what I think a lot of companies are looking at, the traditional spikes that you may have seen, a couple of weeks the Black Friday week or the Cyber Monday week, I think those are maybe a little bit more muted, because it's a little bit more of that traffic, you're seeing actually a steady growth as opposed to those spikes. So, if I take a step back and think about our Digital Media business teams, and the small and medium business, nice performance, if I look at the Enterprise, as I said, traditional close to the quarter, if I look at the individual business, a little bit of those spikes that we would have seen, we did see growth, we did see growth in both of those weeks, but it was perhaps a little bit less than that. And then you're back to again, the secular demand. So as I think about the business, it's not about the long-term demand. It's not about the market leadership of our products, I think it's just a little bit of how maybe online shopping globally has changed a little bit in terms of what the experience is. So that's what I attribute it to and we're back on Q1, look at our guide and let's go execute against the opportunities that we have. So I'll really point to a little bit of those couple of weeks. And it's not just Adobe, it's certainly represented, if you look at the Adobe Digital Index, and what we thought was the growth rate going to be for the entire community and how that got a little muted. So that's the way I would look at it.
Brent Thill: Thanks, Shantanu.
Shantanu Narayen: Hey, operator, we're coming up on the top of the hour. Let's take two more questions, please.
Operator: Absolutely. Our next question will come from Brad Sills with Bank of America Securities. Please go ahead.
Brad Sills: Great. Thanks guys for taking the question here. I wanted to double click a little bit on the TAM expansion that you've seen, from your perspective with the core Creative Professional enter the market, I think two years ago, you're $15 billion, now you're forecasting $25 billion, is there a certain persona that you think is driving a lot of that expansion in the TAM, just in the core business versus say a couple of years ago, when you look forward towards the addressable market?
Shantanu Narayen: Yes, there are three things that are really driving that first is just, with the increased demand for content, we're seeing more Creative professionals come into the market. So we're seeing the base of people we can sell to as Creative professionals continuing to grow, we also are able to provide more value as people are trying to accelerate the velocity of content, they have to build content more quickly. So, things that Scott and team are doing around the addition of collaboration means that we're able to add more value, the Frame.io acquisition is a great example of that. But we've also added some core new collaborative capabilities to Creative Cloud itself. And third is the emergence of these new content types. We've been all tracking the growth of 3D. But also now with the emergence of the Metaverse, we're starting to see more demand for new types of content. And if you look at the performance of Substance 3D, and the fact that that business as an example grew 100% year-over-year, it shows you that the business and the growth that we're seeing is tracking to the TAM expansion that Ann talked about earlier.
Brad Sills: Got it, great. And one more if I could please, with all the effort and work you've done integrating the suite for Experience Cloud between Magento and Core CMS, now you have Workfront, are there different entry points that the enterprise customers are starting within that suite now that you've delivered on a more integrated offering there?
Shantanu Narayen: Yes, absolutely. We're starting to see customers who start with commerce. And now they want to have a much better web presence. And they work with us on content management. And they want to focus on marketing agility, and efficiency, and that leads to Workfront. So that's a different entry point that we see now. We also see a number of our customers, as they think especially about different patterns in commerce, B2B commerce, B2B2C commerce, et cetera, they are expanding from the Content Management presence they have with us, and taking us up on our vision of making it a truly shoppable experience. And so that's starting to move in the other direction as well.
Brad Sills: Great to hear, thank you so much.
Operator: And lastly, we'll hear from Kash Rangan with Goldman Sachs. Please go ahead.
Kash Rangan: The good thing about going last is I've got three minutes. And you're stuck with me for three minutes. I'm kidding. I'll try to make this. I'll kind of make this brief. Shantanu and Dan, I was intrigued by your comment that you plan to double the size of the company to $30 billion and beyond that to $45 billion. And dovetailing that to Shantanu's observations that you're looking to accelerate, as opposed to go for margin expansion, which is great. And with that construct in mind, certainly when I look at your guidance, it doesn't suggest any deceleration but maybe a little bit of conservatism if anything. If you could just talk about the levers in your business, Shantanu, that could cause the company to better than expected or downside levers as well for fiscal '22 that would be great. But more longer term, you look at Metaverse, constant Metaverse and how Satya Nadella talks about the equivalent of Metaverse on the business side how we work, combination of virtual presence. The outlines of view of the word that is fairly compelling. I'm curious how you have thought about, how Adobe is positioned for that word the Metaverse in the consumer context and enterprise virtual work context as laid out by Satya? Thank you so much.
Shantanu Narayen: Well, thanks for the question, Kash, and before I get to the Metaverse, maybe the one thing we didn't quite cover is if you look at the big trends that people are talking about cash, the one thing we're maybe not in is EVs and batteries, right? So that's perhaps the one area of digital that Adobe is still not really involved in. As I think about web 3D, and as I think about the Metaverse, what it really means and implies is that things that you are accustomed to doing in the physical world, increasingly more and more of that you're going to do in the virtual world. And so if you think about it that way, whether, you're doing shopping, whether you're playing games, whether you are co-creating with other people, whether you're expanding it. The aspect of creating all of that Metaverse was what better company in the planet than Adobe to be able to do that. So that's at one dimension, which is this exponential need for content is only going to increase. I think the other way I think about what's happening in the Metaverse. And if you think about it from that point of view is, where prior only physical goods in creativity were deemed worthy of buying. I think now even all these virtual goods are going to have a value associated with it. And so when you think about what's happening with NFD and block chain, again, Adobe, I think is incredibly well positioned. We've already demonstrated some leadership in that with what we've done in Photoshop. And so I think the commerce aspects associated with not just large businesses and we've talked about the large businesses, but even individual businesses, I think Adobe is uniquely positioned. I think like that Adobe is probably a little bit more conservative than others in order to, in terms of putting it directly in our forecast for the year, but make no mistake. I mean, we are thinking about how these new opportunities, the fact that, we bought a 3D company a while ago, the fact that we have Aero, and we're working with all of the OS provider in terms of thinking about augmented reality and virtual reality. We're absolutely in the middle of it. We're not just counting it in terms of what happens in terms of revenue of the top. But if you take even more of a step and go to your question associated with how do we think about the opportunity? I will actually say, Kash, as we were all preparing as a group to prepare this. We had so much material and we were talking about how do we try and condense it. So I really hope you look at what Jonathan forced us to do, which is the deck has much more information in it. We were trying to really provide sort of abstract of all of that material. And I think it just reflects the interest that we have. I mean all three of our businesses and let's go maybe digital experience. We've been talking about that for a while and you're seeing just some tremendous adoption of our solutions in that. Digital is only going to go up and to the right. And I think Adobe is incredibly well positioned. The real-time customer data platform, the experience platform, how we've unified our products, it actually reminds me of the really heavy lifting that we did many years ago in what we did on our content creation tools with the unified profiles and the data and insights to deliver value to our customers. So, it feels really good. I think what we are doing around Document Cloud on the web across surfaces, PDF, liquid mode in terms of the AI, we're really spending a lot of time thinking about how businesses are going to automate, what it means to have a hybrid work environment, which is clearly a trend and really making sure that we unify that with respect to our innovation, so really fantastic job by the teams there across all surfaces. And certainly Creative Cloud, the heritage of the company, this notion of everyone who has a story to tell, I actually tend to think of it as the webs now come alive, the web come alive. And perhaps one of the things we didn't talk about, the biggest asset even on the web is Adobe's file formats. So the ability to deal with a Photoshop file format, the ability to deal with Illustrator for logos, the ability to deal with in design, if you want to create these flyers and actually for the creative community to participate in this massive community that's being created, we've done all the heavy lifting that now makes that magic possible. And we have a broader set of offerings than ever before in terms of being able to target people wherever you are in the world, we have pricing flexibility and we have a DDOM that allows us to do it. So I just take us step back and look at it and say, you know what? Adobe is really uniquely positioned. We have a fabulous team. We didn't talk enough about that, certainly my colleagues here and Dana, who is not on the stage, but our GC is an executive team, as well as the 25,000 employees. Don't take for granted what we have in terms of this motivated stuff. And so I just look at it and say, "We're focused on top line growth to the questions that Brent and others ask." We're always going to be focused on making sure that we have profitable growth and focus on the margin as well. But I feel just uniquely excited about the opportunities that we have. The one thing I miss is unfortunately we're not altogether. And please stay safe. Stay healthy during this holiday season. I think that's the really important thing, but as a management team and as an employee base, I could not be more excited about the future that Adobe has. And so, thank you very much all of you for joining us virtually and thank you for the team for all of the work that went into the preparation. Have a nice day. | [
{
"speaker": "Operator",
"text": "Please welcome Jonathan Vaas, Vice President of Investor Relations."
},
{
"speaker": "Jonathan Vaas",
"text": "Good morning, and thanks everyone for joining us today. I'm Jonathan Vaas. And welcome to our financial analyst meeting. You should have a copy of the press release, which we filed this morning at approximately 5 A.M. Pacific Time, as well as a copy of our slides that we posted to the Investor Relations Web site. I'm hopeful to have an opportunity to meet with many of you in person this year. For now, I'm really pleased to be able to be here with Adobe's leadership team, and engage once again virtually, and we have a great program for you today. With a webcast format, the live presentation we'll be doing today will be a streamlined version of the long form information that we posted to the Investor Relations Web site that has all of the information you're used to receiving from Adobe. So, we'll cover a portion of those slides today, and then we'll go ahead and do Q&A at the end. Let's take a quick look at the agenda. Shantanu will kick things off with a brief welcome, and then, Ann will present Adobe's vision and strategy for the future. Anil will go over our digital experience strategy, and David will cover digital media strategy after that. And then, Dan Durn, who joined in October as Adobe's Chief Financial Officer, will provide a detailed financial summary, as well as discussing Adobe's long-term strategy. Then Shantanu will wrap things up sharing his vision of the long-term opportunity, and we'll go to live Q&A. Before we get started, as a reminder some of the information we'll be providing includes forward-looking statements that are subject to risk and uncertainty. Actual results may differ from those statements, and we encourage you to review the risk factors in our SEC filings for more information. Additionally, we'll be providing both GAAP and non-GAAP financial metrics. Reconciliations between the two are available on Adobe's Investor Relations Web site. I will now pass it over to Adobe's Chairman and CEO, Shantanu Narayen."
},
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"speaker": "Shantanu Narayen",
"text": "Good morning, and thanks, Jonathan. Welcome to this Virtual 2022 Financial Analysts Meeting. Adobe had another outstanding year in 2021. I'm incredibly proud of the dedication and resilience of Adobe's 25,000 employees all around the world in delivering breakthrough technologies for our customers. I'd like to start with a recap of the tremendous accomplishments we had across every dimension in 2021. As a product geek at heart, I take immense pride in our team driving hundreds of innovations across Adobe Creative Cloud, Document Cloud, and Experience Cloud. Earlier this week, we introduced Creative Cloud Express, to enable anyone to express their ideas simply and beautifully. Creative Cloud Express the start of a brand-new journey to introduce first-time creators to Adobe Creative tools, while adding significant value to all of our current Creative Cloud subscribers. I think it marks a new chapter of creation, collaboration, and sharing on the web, and leverages the unique technology and capabilities of Adobe's flagship products. It also builds on the collaboration capabilities we debuted at MAX, including Illustrator and Photoshop on the web, Creative Cloud Spaces, and Creative Cloud Canvas. With the addition of Frame.io, we're now incorporating review and approval functionality to deliver a powerful collaboration platform for end-to-end video collaboration. And we're continuing to add magic to our flagship applications, and we're enabling them to run natively on new hardware like Apple's M1 chip, as well as Microsoft Windows Surface and Pen. In Document Cloud, Acrobat Web now supports 21 frictionless verbs create, export, extract, and edit for both text and images and PDF. We've seen tremendous growth in Acrobat online, as people tap our powerful, free, browser-based document tools to handle important tasks on the fly, without the need to download any software. In addition, we made outstanding progress with PDF support within both the Chrome as well as Edge browsers. And on the Experience Cloud platform, we extended our real-time customer data platform to B2B customers, bringing together individual and account profiles across systems to give B2B companies a single view of their customer for the very first time. We launched Adobe Journey Optimizer, harnessing over 20 years of industry-leading e-mail, marketing, and cross-channel campaign management expertise to empower brands to design and deliver personalized experiences across the entire customer journey in a single application. With the new acquisition of Adobe Workfront, we're now empowering companies to optimize business outcomes by connecting creative and marketing professionals to manage all creative workflows across the entire marketing lifecycle. In addition, we've advanced our industry leadership in key areas across our portfolio. Clearly underpinning our three clouds is the magic and power of Adobe Sensei, our artificial intelligence and machine learning framework, a significant differentiator for Adobe and an enabler to more rapid innovation. We continued our investment in the Adobe Experience platform as the foundational platform for strong governance capabilities across our Experience Cloud business, accelerating innovations like real-time customer data platform and Adobe Journey optimizer on a global scale. We take our responsibility in the creative community very seriously. And as part of the content authenticity initiative, we've published a drop specification as an open standard to combat online disinformation. I'm amazed at the resiliency of our employees and we pioneered all new digital event experiences with Adobe Summit and Adobe MAX, extending our reach and engaging millions of people around the world. I'm also tremendously proud of the industry recognition we continue to receive for our brand, our workplace, our culture, and our practices. And just to name a few examples, we were again named a top riser on Interbrand's Best Global brands list. We're named to Fortune's 100 Best Companies to Work For, for the 21st year, People Magazines Company's Companies That Care list for the fifth year, Fast Company's Brands that Matter list. And I think what's more significant for a lot of investors moving forward, the Dow Jones Sustainability Index for the fifth year, and one that I'm particularly proud of a 100% score for being the best place to work for disability inclusion. When you look at our financial results, it puts us in an incredibly rare position in the industry. Not many companies can drive the top line and bottom line growth with an impressive margin the way we do. And we powered through $15 billion in 2021, and we accomplished some significant milestones in Q4, our first $1 billion digital experience revenue quarter, our first $3 billion digital media, and $2 billion in cash flow; just some incredible financial statistics. Dan Durn, our new CFO, will cover our Q4 as well as our FY'21 results in greater detail. Since he joined Adobe in October, I've really appreciated his experience and partnership, and I look forward to him sharing his perspective as well as having significant impact on Adobe's growth in the decade to come. I'm also delighted to announce that Anil Chakravarthy and David Wadhwani had been promoted to the President of the Digital Experience and Digital Media Businesses, respectively. I value their leadership and contributions, and they will share more color around each of our businesses. While 2021 was awesome, I'm actually most excited about what's to come for 2022 and beyond in the over 20 years that I've been at Adobe. We have this immense market opportunity. We have an incredible technology innovation roadmap and the best leadership team of any company on the planet. And I think what we've done is provided 2022 targets that demonstrate the strength of the underlying business, three incredibly large growing opportunities across our clouds, continued focus on execution based on the current economic climate. I think the one change that we all are experiencing is as the company scales beyond $15 billion, we also have to focus on FX expectations, given the recent strength of the U.S. dollar. But as excited as I am to talk about 2022, today is really sharing about Adobe's tremendous growth story and how we're going to be driving the next decade of growth, because that's really what underpins our growing over $200 billion addressable market opportunity. As you'll hear throughout the day from our leadership team, our growth has anchored across these five key pillars, our proven track record and our focus on creating and leading categories, the ever-increasing expanding set of customers that we serve, from consumers to creative pros to first time creators, to small and medium businesses, to the largest enterprises in the world, our ability to deliver incredible technology platforms that enable whole new classes of applications and accelerate our innovative cadence. The important shift we continue to make from building applications to enabling new business models, app, services, artificial intelligence and platforms, that's paying dividends. And last but not least, an incredible global ecosystem of partners that spans the entire customer lifecycle from experience creation and marketing to delivery and ongoing support. And I think the message for you as investors is across every dimension, across every business, our aspirations are higher, and we're thinking bigger. There's this incredible once-in-a-lifetime expansive opportunity in front of us, and I think we're uniquely positioned to capture it. And now to provide color on the strategy on how we're going to expand markets and categories, I'd like to welcome Ann Lewnes, who recently celebrated her 15th year at Adobe, our incredible Chief Marketing Officer, who's also taken on the additional responsibility for corporate strategy. Ann?"
},
{
"speaker": "Ann Lewnes",
"text": "Thank you, Shantanu, and good morning everyone. Over the past two years, we've witnessed a profound global shift to all things digital. Everyone, from students to small businesses to the largest global brands has had to make this dramatic pivot. Technology innovation, the proliferation of new devices and platforms, and the increased desire and ability for anyone to create and deliver great digital experiences have all accelerated the move to a truly digital world. And there's no going back. Whether it's through your phone, tablet or PC, it's easy for anyone, anywhere to create, work, learn, connect, shop, unwind, and launch and grow businesses. While there continue to be massive challenges in the world, digital has also empowered us through the democratization of creativity, the development of rich digital experiences, the ability to work and learn from home, to shop and sell products online or to connect with those you love. We are moving society forward. Digital has fundamentally changed everything. According to Adobe Analytics, online spending during the 2021 holiday season is projected to be $200 billion, and total e-commerce spending is projected to reach $1 trillion in 2022. It's clear that digital is a requirement to conducting business today. From your favorite local restaurant to Fortune 500 companies, across every country and every industry, digital is powering today's businesses. Companies or automating mission-critical document processes like HR and legal to drive increased efficiency and agility. At the same time, customers now expect rich personalized digital experiences that are relevant, engaging and consistent across any device. It's well documented that digital first businesses drive greater long-term growth and customer loyalty. And Adobe our own technology has enabled us to transform into a digital first business. Companies like Adobe are measuring every single customer interaction, to understand behavior, intent, and ultimately to drive business impact. We do that by providing personalized digital experiences at scale through adobe.com. across all of our digital channels, and increasingly through our products. Digital has not only changed the way we live in work, but also how we connect with one another. Anyone can create or participate in an online community, whether it's with your family, friends, colleagues, or those with whom you share interests and passions. And with the emergence of the creator economy, it's possible for enterprising content creators to build both a large following and monetize their passions, products or services. Today there are seemingly unlimited number of social platforms and ways to engage with one's desired audience. The ease with which you can share, promote and monetize content, products, and services has enabled a whole new level of connection and commerce. We're also finding new ways to work together even when we're apart through the proliferation of collaboration solutions, like Frame.io, which we acquired in Q4. Adobe's mission to change the world through digital experiences is more important than ever before. The digital world runs on Adobe's tools and platforms, and through our unparalleled innovation, creativity, scale, and advanced data-driven operating model, we are continuing to catalyze the growth of digital. Hundreds of millions of people across the globe use our products every single day, and we're impacting every aspect of society. Adobe continues to be uniquely positioned to lead in this next digital era. Our three industry leading cloud offerings are mission critical across every geography and audience, with Creative Cloud, we're unleashing creativity for all, giving anyone, anywhere the tools to express their creativity. With Document Cloud, we're accelerating document productivity, modernizing how people view, share, and engage with documents and with Experience Cloud we're powering digital businesses of all sizes, giving them everything they need to design and deliver great customer experiences. Underpinning our three clouds is the power of Adobe Sensei, our advanced AI/ML framework that enables us to deliver a steady stream of unparalleled innovation. Over the last year, we've seen the critical role that creativity has played in the world. Creative Cloud is empowering everyone from the high school student to the social media influencer to the most demanding creative professional to tell their story. The Creative Cloud TAM is projected to be approximately $63 billion in 2024, $25 billion of that TAM comes from our core base of creative professionals who purchase Creative Cloud applications and services like Adobe Stock. New growth drivers in this segment include 3D and other immersive experiences, as well as web-first collaboration tools like Frame.io, $13 billion of the TAM is coming from communicators, non-professional creators, including small businesses, students and marketers. As you'll hear from David, many communicators are already using Creative Cloud, and we hope to see even, serve even more of them with products like Creative Cloud Express, which we just launched on Monday. The remaining $7 billion of TAM comes from consumers, including hobbyists and social media users. The biggest growth drivers here are mobile applications in categories like video and imaging, such as Adobe's Photoshop Express. Digital documents are a core to the future of work, PDFs and document workflows empower everyone from individuals to the largest enterprises to be productive anytime, anywhere. We're excited about the Document Cloud strategy and the large addressable market, which is projected to grow to $32 billion by 2024, $10 billion of that TAM is coming from knowledge workers, business professionals who typically use our core Acrobat desktop subscription offerings. Growth is expected to come from the expansion of digital document use cases, e-signatures and increase collaboration capabilities. $8 billion of the TAM is coming from communicators who are using Acrobat web and mobile applications to create, scan, and edit PDF files for both business and personal use. Growth in this segment is projected to come from expanding the premium PDF base and capturing demand from new funnels with offerings designed for web and mobile use cases. Finally, $14 billion of the TAM is coming from enterprises, who are using document services, including Acrobat and e-signature solutions, as well as APIs that developers use to seamlessly integrate with key line of business applications. Growth drivers in this segment include API's to build powerful document workflows, and expanded use cases. Whether it's B2B or B2C, businesses of every size across every category are investing in customer experience management. Adobe Experience Cloud empowers companies to deliver predictive personalized real-time digital experiences across every phase of the customer lifecycle. Our total addressable market for Adobe Experience Cloud is estimated to be $110 billion in 2024, $33 billion of the TAM is coming from the data insights and audiences category, which includes Adobe Experience platform, real time CDP, and Adobe Analytics, including our new customer journey analytics offering. Future growth drivers include the increasing demand for a unified customer profile, and personalization at scale, $49 billion of TAM is coming from the content and commerce category, which includes our Adobe Experience Manager and Adobe Commerce offerings. The volume of content needed by businesses to engage customers across every touchpoint is exploding. And the pace at which it must be deployed is accelerating, the need for a seamlessly integrated commerce capability is accelerating at that same pace, $18 billion of the TAM is coming from the customer journeys category, which includes Adobe Campaign, Marketo Engage, and our new Adobe Journey Optimizer. Growth in this segment is expected to come from the continued need for businesses to engage with their customers across an ever increasing array of channels. New to the TAM this year is the $10 billion marketing workflow category, which includes Adobe Workfront acquired last year. Growth here is expected to come from the increasing need for teams to efficiently plan, track and execute marketing campaigns. Adobe has always been relentlessly focused on looking around the corner, inventing new growth opportunities and successfully driving growth within our existing businesses. We have pioneered and are leading three massive categories, creativity, digital documents, and customer experience management. This week, we announced Creative Cloud Express, our exciting new unified web and mobile offering that's perfect for anyone looking to quickly and easily make and share standout content. Creative Cloud Express is great for first time creators and communicators, but will also provide value to our current Creative Cloud subscribers. It's a great example of how we continue to expand our customer base and grow our TAM. We win by creating enduring technology platforms from Sensei to the Adobe Experience platform. They're the foundation for product innovation and our industry leading applications and services. Since transitioning Creative Cloud to a subscription model 10 years ago, we have continued to innovate our business models, building applications, services and platforms to bring value to market faster, better serve new customers, and leverage new monetization models. It would be impossible to do all this alone. We have built a large ecosystem of partners from agencies to solution integrators to ISPs that customize and extend our solutions to the needs of our joint customers. We continue to see massive opportunities from Creative Cloud, Document Cloud and Experience Cloud, with the market tailwinds, our world-class innovation and the best employees in the world, we believe we're well positioned for our next decade of growth. And now, I'd like to introduce Anil Chakravarthy, President of our Digital Experience business. [Advertisement]"
},
{
"speaker": "Anil Chakravarthy",
"text": "Thank you, Ann. Hello everyone. Good to be here with you. And I look forward to sharing more on our momentum, opportunity and strategy for the Digital Experience business. It's really an exciting time for us as Ann shared. Let me begin by discussing a couple of highlights from Q4. We had strong performance across the board. Our segment revenue crossed over a $1 billion for the first time with 23% year-over-year growth. Our subscription revenue grew to $886 million up 27% year-over-year and our subscription bookings in Q4 were up 50% year-over-year. And with that, we were up over 40% year-over-year for full-year FY'21. A lot of that was powered by the success of our Adobe Experience platform, and the native apps that run on it. It's foundational to our Digital Experience business. We invested early in the platform, and have a significant head start having launched the platform in 2019. Our growth has accelerated. Earlier this year, we disclosed that we had passed over $100 million in revenue and at the end of Q4, we surpassed $250 million in book of business. And we've seen a 300% year-over-year growth in customer count. The scale that we're operating in production is massive, over 21 trillion segment evaluations per day and our ecosystem is extremely broad with over 300 partner integrations. And as Shantanu and Ann both mentioned, we have really accelerated our innovation over the past 18 months with new native applications and services powered by Sensei. A great example of this is Major League Baseball; they are leveraging digital to transform experiences for their customers with a focus on reaching that next generation of fans. And this is across all their channels at home, on the go and in menu in the ballpark, they're focused on personalization at scale, delivering that right experience at the right time, via the right channel to all of their fans. And it's not just Major League Baseball, it's clear that every business is a digital business, and customer experience management is critical to business success. The changes in the tailwinds that we have seen during the pandemic are here to stay. And this has contributed to a strong momentum in our Digital Experience business; couple of examples here again, significant growth in average annual recurring revenue across our Top 1125 accounts. We've seen strong growth across all accounts greater than a million dollars in ARR and all of our customers are building long-term partnerships with us. As an example, the combined total contract value of our Top 10 accounts is $760 million, which is three times higher than what it was at the end of FY'19. When we think about customer experience management, it is imperative for every company today to deliver personalization at scale to millions of customers. That's how they reach and engage all their customers across the world. And it's critical for them to do that, to deliver that next level of digital business growth. It's all about personalized experiences that are tailored to the individuals, delivered in real time, and delivered seamlessly across online and offline channels based on first party data, and making sure that they honor customer preference and privacy. And that's what we focus on, our strategy is battle tested and helps companies across the world achieve personalization at scale. We offer customers, the best of both worlds, integrated, AI enabled comprehensives applications, delivered on a real time cloud scale platform. We have strong momentum with Workfront with the ability to unify marketing workflow, and increase marketing agility for all customers. And we are the strategic partner for customer experience management; I hear this from customers all around the world every day. And our ecosystem of partners is expansive with over 4,000 partners as Ann mentioned across ISVs, tech partners, system integrators and agencies. This is how we make this happen for our customers through the Adobe Experience Cloud. We focus on four key categories, content and commerce, data insights and audiences, customer journeys and marketing workflow, all delivered on a common platform, which is the Adobe Experience platform. We've had a strong innovation engine over the last 18 months and that's continuing both on the application layer as well as the platform with AI and machine learning capabilities in the platform powered by Adobe Sensei. This is a huge moat for us with the combination of a comprehensive set of applications and an integrated platform. In closing, I am incredibly excited about the opportunity we have for the Digital Experience business. We have strong momentum and we're the clear leader in the Customer Experience Management category. We have a large growth opportunity to help every company deliver personalization at scale to millions of customers around the world. And we have the best technology across our Adobe experience platform and the native applications with the ability grow rapidly as we have shown over the last couple of years. With that, it's my pleasure to turn it over to David to cover the Digital Media business. David?"
},
{
"speaker": "David Wadhwani",
"text": "Great. Thanks, Anil, and hello everyone. I've been back at Adobe now for about six months and I'm really excited about what I see. As some of you know, I ran the Digital Media business during the transition to Creative Cloud, and while the business has certainly matured since the early days of that transition, some things haven't changed. Our product teams keep delivering incredible innovation and our business continues to show strong momentum. Now, before we dive into what I'm personally excited about for FY'22 and beyond, I want to hit on some Q4 highlights. Our Digital Media business in the quarter delivered $571 million of net new ARR in total. With that Creative Cloud crossed $10 billion in ARR. And we saw continued strength in our Creative Cloud offers, while seeing outside growth for substance, which grew a 100% year-over-year, thanks to increasing demand for 3D and the emerging Metaverse platforms. We also saw outsized growth in our mobile applications, which grew over 55% year-over-year. Our mobile applications have now generated over 400 million mobile IDs to-date. And it's been a great source of new user acquisition for us. On the Document Cloud size we grew ARR of 31% for the year ending at $1.9 billion. A bit of color behind these numbers, we now have 2.5 billion mobile and desktop devices with reader or Acrobat installed on them. We're seeing explosive growth in Acrobat Web, where we saw monthly active users grow over a 100% since last year. And our strategy of integrating Adobe Sign and Acrobat is clearly paying off for us with 85% year-over-year growth in Adobe Sign transactions in Acrobat. In aggregate, we ended the year with approximately 12.2 billion of ARR. And while we posted a great FY'21, we have even more exciting opportunities ahead for us. Let's start by talking a little bit about Creative Cloud. The big picture here is that we're living in a time where content and creativity and design has never been more valued, where content is fueling the global economy, where the digital consumption is exploding, and where virtually every business needs a digital presence. We're living in a world where creative expression is considered a 21st century skill in education. And we're living in a world, where we're seeing emerging 3D and immersive technologies like the Metaverse creating demand for all new types of content. All of this continues to drive incredible tailwinds for Creative Cloud. In particular though, I wanted to spend a minute on the rise of the creator economy, where we're seeing a growing number of individuals, solopreneurs and small business owners, creating businesses from their passions and monetizing their content, their goods, or their services online. The creator economy is already big with nearly a 100 million small businesses on social media. And with the majority of them saying that their online presence is more important to their success than their physical presence. Now despite it being big, it continues to grow at an incredible rate with nearly 4.5 million new businesses minted in the U.S. alone last year, which was a record. This has been a significant contributor to our success and a major contributor to the over 600 million free and paid monthly active users across our Digital Media products, who are not considered creative professionals. And of course this expansive opportunity needs an expand strategy that drives our mission for creativity for all. In the next few minutes, I'll lay out how Adobe can help anyone who wants to express themselves in creative ways from a small business owner to the highest end production house. Adobe has a solution for them because of our investment in five key areas. And since we just launched Creative Cloud Express, I wanted to start by discussing how we empower the world with content first task-based creativity. Let's go ahead and start by looking at a video of Creative Cloud Express and what it can do. [Advertisement] Creative Cloud Express is the result of years of in-market learning from our web and mobile products. And it's built on four key pillars. First, we remove all barriers to adoption. It's free to get started, it doesn't require a desktop download because it's a 100% web and mobile, it doesn't have a learning curve and users can create an account and publish content in minutes. Second, it's got an unparalleled content library. So, novice users can build beautiful images and social media posts, digital flyers and more in minutes. This includes 175 stock images from Adobe Stock, 20,000 fonts and 1,000 of templates and design assets. And it's all powered by a universal search capability that surfaces the right content and recommendations at the right time. Third, it leverages decades of Adobe's product innovation. As you'd expect, we have great workflows with our Creative Cloud applications, but it also include a slew of Sensei-based quick actions that make creating and editing images, videos and PDF easier than ever before. And fourth, we understand that people create content with the intent to distribute it. So Creative Cloud Express has integrations for single click publishing to social media services. And you can expect to see that our recent acquisition of ContentCal will benefit CCX users with even more social planning and publishing capabilities in the very near future. Creative Cloud Express is easy to use and it's easy to get started with, users can have a lot of success with the free tier, but they're also presented with premium features and content for at affordable monthly price. CCX is also entitled with most CC existing plans, which we expect will drive higher engagement and retention in our core Creative Cloud customer base. And the go-to market motion is very familiar to us. We will combine our digital acquisition funnels and our product led growth motion tuned for web and mobile. This gives us an opportunity to continually iterate and optimize user journeys while ramping this business over time. We also plan to leverage our existing footprint across education, reseller, and enterprise to scale the business. We're thrilled to have Creative Cloud Express in market today it's been amazing to see what people can make with it. And we really couldn't be more excited about this moment and what this means for a start of a whole new journey for Adobe. So moving beyond Creative Cloud Express, we also have a lot going on across Creative Cloud as a whole. We're advancing the state-of-art in imaging, video and design and more by building new capabilities across desktop web and mobile. For example, we're introduced Photoshop and Illustrator for web at Adobe MAX, and we released a series of new Sensei driven AI ML capabilities including neural filters and auto masking in Photoshop and auto captioning in premier just to name a few. We also continue to - our focus on democratizing 3D and immersive. Substance 3D now supports end-to-end 3D workflows, users can design parametric 3D assets and designer compose rendering virtual scenes in stager, add texture, color, effects and painter, and create 3D materials with sampler. This enables fully virtual photo shoot saving companies a lot of money and a lot of time and speeds up asset and scene creation for inclusion and games, videos, and the emerging Metaverse platforms. Collaboration is another big area of focus for us. We're putting -- we're integrating collaboration directly into our apps and existing creative workflows. We're very excited about the Frame.io acquisition and see tremendous opportunity across individual corporate and media workflows with that product. We shipped a public beta of share for review work workflows at MAX, and we demoed spaces on canvas, which we believe will enable teams to organize their creative assets and host live working sessions. And last, but certainly not least, we continue to produce content that inspires and educates our users through services like Adobe Live. We help users monetize their work through services like Adobe Stock, and we help them connect and inspire each other through services like Behance, which now is closing in on almost 29 million members. These five strategic pillars work together to ensure that anyone with creative needs can find a solution at Adobe, whether they're a creative professional, trying to keep up with the increasing content demand, or they're a communicator participating in the creator economy or a consumer looking to up their game in photography or a student developing 21st century skills. We use our data driven operating model DDOM to engage them as they express their interests online by perhaps searching for something like compositing in Photoshop or designing a Twitter post. Based on their intent, we then route them to one of our Creative Cloud apps, one of our mobile apps or one of our frictionless web quick actions. We make sure that they have early success and we introduce them to other capabilities in Creative Cloud or Creative Cloud Express before converting them to and engaging them as a paid user. This digital motion combined with our reseller partners, our direct sales teams gives us an amazing global footprint and reach. So in summary, everything is going digital and content is for fueling the digital economy. The result is a massive and growing TAM for Creative Cloud as Ann talked about earlier and our offerings, which now include Creative Cloud Express continue to expand to meet market demand for both professionals and non-professionals. We couldn't be more excited about the opportunity ahead for the creative business. And as you know, the other part of the Digital Media business is of course our Document Cloud, which is also experiencing significant tailwinds. Demand for PDF has never been greater. In fact, web searches for PDF have doubled in the last decade, and we believe the reason for this is that PDF has become the de facto format for unstructured data. PDF has also been the de facto standard for business-to-business collaboration where nowhere is this more pronounced of course them with e-signatures. This makes PDF an essential part of modernizing any business workflow. And Adobe is uniquely positioned to take advantage of this trend. Our apps are installed on over 2.5 billion devices and we've opened and in our apps. We've opened or created 320 billion PDFs in the last 12 months alone. We continue to be a leading destination for PDF viewing and we saw a 100 million free and paid signups over the last year. And we see that Acrobat can be a gateway to related services. Adobe Sign transactions in Acrobat, as I mentioned earlier, have increased 85% year-over-year, as we continue to deepen the integration between the two offers. Our strategy here is clearly working and we're investing across five key motions to make sure it continues to. First, our document verb strategy has been very effective. We now have 21 verbs market, everything from edit PDF to convert PDF, to rotate PDF, and we're seeing continued -- we're continuing to optimize our digital acquisition and increasing our share of voice across the 80 million PDF related searches that happen every month. Second, we're proliferating e-signatures by integrating them into Acrobat across all services, desktop, web, and mobile. Given our early success here over the last year, you can expect to see us continue bringing these products closer together in the years ahead. Third, we remain committed to making PDF more intelligent for both interacting and reading. Adobe is reinventing mobile PDF viewing with liquid mode. We're accelerating document productivity with automated form field detection, and we're helping transform unstructured data to structured actionable data with our AI, ML based extract function. Fourth, we're unlocking business workflows through our PDF and sign APIs. This empowers developers to build document automation solutions that transform how their businesses work. And fifth we're leveraging our diversified go to market motions to reach anyone with a document need. Our global resellers and inside sales teams give us amazing access to a broad base of business demand. Our enterprise sales team allows us to sell tops down to CIOs, looking to transform their business. And perhaps most importantly, our digital funnel continues to drive individuals' users into our conversion funnels. Knowledge workers, communicators, IT decision makers and developers all have frictionless onboarding pathways. Our data driven operating model helps customers discover Adobe technology when they're searching for PDF related verbs and we engage them in ways that provide quick success on web mobile and desktop before upselling them to premium features, premium features products, services, or APIs that broaden their engagement with Adobe over time. In short, Document Cloud is incredibly well positioned for the years ahead. I hope this gives you a sense of why we're excited about both the creative and document businesses. In summary, both businesses are benefiting from significant tail winds that are underpinning their large and growing TAMs, both businesses are realizing the market benefits by leveraging our amazing brand awareness, our go to market footprint and our incredible pipeline of innovation. And both businesses have the opportunity supercharge their existing data driven operating model by pairing it with a product led growth motion, as our capabilities increasingly are accessed by users on web and mobile. So we're really excited about the year ahead. And with that, I wanted to turn it over to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, David, and before I jump in, I also want to thank him for letting me borrow his sweater today. Let me begin by saying how thrilled I am to be here today and be a part of this amazing team at Adobe. Having just been here for a few months, it's obvious what a special company this is, and I couldn't be more excited about what's ahead. Now, let me jump in with Adobe's Q4 results. Adobe achieved revenue of $4.11 billion, a significant milestone, which represents 20% year-over-year growth. GAAP diluted EPS was $2.57 and non-GAAP diluted EPS was $3.20. Digital Media segment revenue was $3.01 billion, the business's first $3 billion quarter, which represents 21% year-over-year growth with net new digital media ARR of $571 million. Digital Experience achieved its first billion dollar quarter, which represents 23% year-over-year growth. Digital Experience subscription revenue was $886 million representing 27% year-over-year growth. We had record cash flows from operations of $2.05 billion in the quarter, and we repurchased approximately 1.6 million shares of our stock. Turning to our three strategic clouds, it was a tremendous finish to the year. In Q4, Adobe achieved $2.48 billion in Creative revenue, and added $430 million of net new Creative ARR. We exited the year with more than $10 billion of ending Creative ARR with strong performance throughout the year. Growth drivers in the quarter included acquisition of new users on adobe.com, strength in our teams offering, seasonal Q4 strength in the enterprise and success co selling frame.io with our Creative Cloud Enterprise offerings. However, while we saw increased demand for offerings during the Black Friday and Cyber Monday weeks, we did not see the traditional spikes we have had in previous years. This is consistent with this year's industry trends in line with e-commerce holiday shopping data from the Adobe Digital Economy Index. Adobe Document Cloud achieved $532 million in Q4, revenue continues to be -- and continues to be our fastest growing business. We added a record $141 million of net new Document Cloud ARR in the quarter with ending ARR of $1.93 billion growing 31% year-over-year. Our Integrated Document platform is clearly resonating with customers around the globe. We continue to see momentum with enterprises, small businesses and individuals using web and mobile first tools. In Digital Experience, we achieved our first billion dollar revenue quarter. We're seeing strong demand for our real time experience platform and app services, as large enterprises are making investments in Adobe to drive customer experience management and personalization at scale. We drove record Q4 net subscription bookings and for the full fiscal year, we grew net ASP greater than 40% year-over-year. Let's look quickly at the annual numbers. Adobe's financial performance in the year was outstanding, with both top line acceleration and margin expansion in the year, resulting in more than $7 billion of operating cash flow and remaining performance obligations grew 23% year-over-year to nearly $14 billion, absolutely world class performance. Now let's discuss what a unique investment opportunity Adobe is. These are some of the outstanding qualities of Adobe that have energized me about the opportunity and it's what ultimately brought me here today. There's a fundamental shift towards digitization, that's accelerating around the globe. And I believe Adobe is better positioned than any other company to capitalize on these opportunities. Combining that with Adobe's financial track record, as well as industry defining products and platforms, the result is an immense runway ahead of this company for growth. Let me elaborate a bit more on my view of this opportunity. In the years ahead, there's going to be fundamental shifts in all aspects of our lives, all of them digitally enabled. Digital enablement will increasingly shape and define how we live, how we create, how we communicate, how we collaborate, how companies serve their customers, how companies compete, and how economies function. These changes are both powerful, and pervasive. I call it the digitization of everything. The digitization of everything is accelerating. And I believe what happens in the next 10 years is going to define the rest of the century, similar to what happened in the Industrial Revolution. Except now, digital content and data are going to be the fuel of the digital economy. This is a generational opportunity. And we're talking about unlocking trillions of dollars of economic value in the global economy. When you look at Adobe's foundational strengths, there's very few companies that is leveraged to the digitization of the global economy, as well as we are. From the way people create and communicate to the future of productivity and digital collaboration in a distributed work environment, to the digitization of businesses, driving customer engagement with data driven insights to personalize customer experiences, but do it at massive scale to AI and machine learning. Global trends towards digitization have so many intersections with Adobe's unique strengths. Again, digital content and data are the fuel of the digital economy. And I believe no one is better positioned than Adobe to be the digital enabler of the world. How many companies on the planet have this profile? How many companies have this opportunity, not very many. When I think about our near-term strengths, combined with our long-term opportunities, there's a uniqueness here, that's incredibly exciting. Let's double click on the company's financial performance and take a closer look at what I'm talking about. Starting with revenue growth, you can see consistent sustained revenue growth over the last four years as the company has grown subscription revenues at a 24% CAGR. That has been the strategy continuing to grow while producing a revenue stream that's even more ratable and predictable. I'm incredibly impressed by this team's acumen, what they've been able to accomplish, as well as by the contribution to revenue growth from newer initiatives, including Adobe Stock, Substance 3D, Acrobat Web, Sign, Creative Cloud mobile apps, and the Adobe Experience platform. Underlying this financial performance is an incredibly diverse business, from our broad base of customers to diversified products and platforms, comprehensive business models, and go to market reach that spans across all geographies. With growing and diverse revenue streams, the company's been able to expand profitability over the last four years, while accelerating the top line. Adobe's disciplined execution and investment rigor has enabled the company to balance long-term investments while also focusing on profitability. This time period also includes the integration of several strategic acquisitions Magento, Marketo, Algorithmic, Workfront, Frame.io, it's impressive the way Adobe has managed to combine expanded profitability with strong sustained top line growth and M&A integration. Let's talk about RPO, contractually committed future revenues which make Adobe's future performance incredibly predictable and reliable. Exiting fiscal year 2021, RPO grew 23% on the strength of our Enterprise bookings. RPO consists of deferred revenue and unbilled backlog with the current portion expected to flow into revenue over the next 12 months. It's also important to note that most of our adobe.com subscriptions are billed monthly and don't show up as deferred revenue, the remaining contractual commitments of those subscriptions, which average about six months in length at any given time, are included in unbilled backlog. The cash flow performance really speaks for itself, as you can see the way our operating cash flows have accelerated over the last two fiscal years. Sustained growth and profitability at scale is not easy to achieve. The momentum at Adobe is strong, as evidenced by our first $2 billion quarter of operating cash flows. A strong capital structure with robust investment grade credit rating positions us to continue to drive growth and provides flexibility making access to capital affordable for Adobe. Let's talk about our capital allocation strategy. First, we focus on investing in the business to drive long-term growth. Given the tremendous opportunities in front of us, some of our recent innovative R&D initiatives include our next generation data platform, as well as Creative Cloud Express, which we announced earlier this week. We're going to continue to invest in sales and marketing to scale those businesses globally. Second, our cash and investment balances as well as our debt capacity, enable inorganic growth opportunities. You've seen the way we've accelerated growth and made a creative strategic addition over the last fiscal year with Workfront and Frame.io. Lastly, and importantly, we focus on returning capital to our shareholders. Our stock repurchase program is funded through growth in our operating cash flows, and you can see how successful we've been in driving down the average shares outstanding over the last 4 years. Since 2018, we've returned approximately $12 billion to shareholders through our stock repurchase program. Exiting Q4, we have $13.1 billion of remaining stock repurchase authority through the end of our fiscal 2024. The hallmark of a great technology company is consistent innovation in category defining products. Adobe's done that across all its businesses, and we'll dive into each of them next to discuss the performance drivers. First, creative, the company has driven sustained ARR and revenue growth, which accelerated from fiscal 2020 to fiscal 2021. Let me tell you about the underlying data-driven operating model used to drive this performance. It all starts with innovation, and the most comprehensive industry defining portfolio of products. Our brilliant marketing campaigns generate awareness about Adobe's offerings and drive traffic to adobe.com to engage customers to try, buy, use, and renew. It's about taking creators on a journey. First with simpler applications, including our mobile, tablet, and web applications, connecting them with vibrant creative communities, and then providing journeys that empower them to do more as they advance, including services like Adobe Stock, Cloud libraries, and collaboration features. Now, with the addition of Frame.io, and Creative Cloud Express, we're continuing to grow the business by broadening the aperture and reaching new creators and stakeholders that will power the world's content. We continue to drive strong growth for Document Cloud. Again, you see this in sustained revenue growth with ARR growing even faster, as the business shifts to being increasingly subscription based, with approximately 90% of Document Cloud revenues in FY 2021 now being subscription. The main Document Cloud growth driver continues to be new user acquisition. We're seeing strong growth of Acrobat on adobe.com across geographies, growth on the web, as well as in mobile, and seed expansion in the enterprise. PDF and doc that workflows are mission critical to the way people work and collaborate in the digital first world. As Anil mentioned earlier, there's tremendous growth opportunity within our cohort of large customers. As we focus on cross-selling and moving them along the maturity curve towards the transformational adoption of our entire platform instead of customer experience management solutions. The average ARR and total contract value of our largest customers demonstrate how massive this opportunity is. And we grow by adding new logos to our customer base and then expanding within those accounts, a multiyear journey. As impressive as this company's track record is, I believe there's even more growth ahead of us. I fundamentally believe there's a trillion-dollar market cap opportunity in Adobe's future, having crossed the $15 billion mark in revenue, what is the path to $30 billion look like? And then from there, how are we going to get to $45 billion? It starts with an estimated $205 billion TAM, and a huge ecosystem that we built around our market leading products and services. How are we going to get there? We're going to continue to broaden our appeal to a wider universe of customers, engage and retain our current customers across all geographies. We're also going to grow by innovating and investing to enter new categories that further complement and expand our growth trajectory and better enable our customers in the digital era. When we execute on that strategy over the next decade, our scale and success, we'll put Adobe in a class that only a few software companies have achieved. Having passed the $15 billion revenue mark, we're going to start reporting revenues in constant currency given the potential impact of foreign exchange movements. Following the year in which FX was a tailwind to reported revenues. The recent U.S. dollar strength is expected to result in a headwind to our reported revenue and growth rates for fiscal year 2022. Consistent with our annual practice, we've revalued our digital media ARR balance to account for the movements and the FX rates. For operating expenses, we continue to save on travel and facilities in fiscal year 2021. While many of our employees continue to work from home, we expect these expenses to ramp throughout FY 2022. We also plan to invest in increasing headcount in integrating Frame.io. We believe these are critical investments and we're making -- we believe these are critical investments we're making and we're going to focus relentlessly on the organic growth opportunities ahead Lastly, fiscal year 2021 was a 53-week fiscal year with an extra week in Q1. That week added approximately to $267 million of revenue and $25 million of net new digital media ARR the math around the return to a 52-week fiscal year is expected to be a two-point headwind on our full-year, FY'22 growth rates and a seven-point headwind in Q1. Here's Adobe's fiscal year 2022 annual targets. We show our segment growth targets on an actual and adjusted basis and constant currency factoring for the additional week last year: Total Adobe revenue of approximately $17.9 billion, net new digital media ARR of approximately $1.9 billion, digital media segment revenue growth of approximately 14% year-over-year, or 17% on an adjusted basis, digital experience segment revenue growth of approximately 14% year-over-year or 17% on an adjusted basis, digital experience subscription revenue growth of approximately 16% year-over-year or 19% on an adjusted basis, tax rate of approximately 17.5% on a GAAP basis and 17% on a non-GAAP basis, GAAP earnings per share of approximately $10.25 and non-GAAP earnings per share of approximately $13.70. For Q1 of fiscal 2022, we're targeting revenue of approximately $4.23 billion. Net new digital media ARR of approximately $400 million, digital media segment revenue growth of approximately 8% year-over-year or 17% on an adjusted basis, digital experience segment revenue growth of approximately 11% year-over-year or 18% on an adjusted basis, digital experience subscription revenue growth of approximately 13% year-over-year or 20% on an adjusted basis, tax rate of approximately 16% on a GAAP basis and 17% on a non-GAAP basis, GAAP earnings per share of approximately $2.63 and non-GAAP earnings per share of approximately $3.35. I want to conclude by sharing what this company has achieved over the last four years, whether it's revenue growth and profitability, outstanding cash flow generation and shareholder returns, Adobe's track record demonstrates why this company is in a class of its own. I firmly believe that our best days are ahead. Thanks so much for your time today. I'm going to now pass it back to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you, Dan. And thanks and welcome Ann, Anil and David for outlining the opportunities across our three industry leading clouds. As I said earlier, I'm incredibly excited about Adobe's future and our ability to not only lead, but also create new categories. I think if you zoom out a little bit and think about it from a macro perspective, all over the world, it's clear that digital is empowering individuals, transforming businesses and connecting communities. And frankly, digital is going to play a much bigger role in work, life and entertainment going forward. We've seen the rise of the creator economy and the democratization of creativity. Work and education are now hybrid and here to stay in that form. Cloud and web technology advances are powering unprecedented levels of real time collaboration. Document workflows are increasingly going to be automated. And most important mandate for a digital business is more urgent than ever before, as customers now expect digital first experiences that are both contextual as well as personalized. E-commerce growth is building on the record highs achieved during the pandemic. From a technology base, artificial intelligence and machine learning have become indispensable facilitators of our daily lives. And so I think in short, digital technologies are enabling more people to create, collaborate, learn, work, be productive, and make a living than ever before. I love our mission and the ability to change the world through digital experiences, puts us as the nexus of all of these trends. We're incredibly well positioned to drive meaningful impact across every aspect of society and that'll benefit billions of people around the world for years to come. As we think about the company at Adobe, we believe it's not just what we do, but it's also how you do that it really matters. From the very beginning, John Warnock and Charles Geschke, our founders committed to building a company that does the right thing. And the sense of purpose has guided our evolution and growth over the past four decades. I think we're all witnessing the shift in the role that companies have to play in social issues and the expectations that stakeholders and investors have for corporations. As you reflect on how companies have responded to the COVID-19 pandemic, it's remarkable. With that stakeholders around the world are looking to the private sector to become more active in social issues. And people are making decisions on the products that they buy and the places that they work based on where companies stand. As our products have become ubiquitous, and we've helped many more companies harness the transformative power of our digital technologies, our responsibility and our commitment to corporate citizenship has also grown dramatically. And I believe that the issues on which Adobe is uniquely positioned to make an impact are on Adobe for all, making sure we create a diverse and inclusive culture for our employee, as well as position that for our customers and partners .On the belief that technology will transform, and in addition to providing technology, we have a responsibility to understand what that means. And I think most important to being able to allow everyone who has a story to tell their story, the notion of creativity for all. The reality is that we've been leaning into these for several areas already. And our efforts are making a real impact across the company and our customer communities for many years. But I think it's this purpose that motivates our employees to focus on having more impact and frankly inventing the future. I love the fact that our strategy has remained relatively consistent for the past decade. Our strategy to unleash creativity for all to accelerate document productivity and to power digital businesses is more mission critical than ever before. I think most companies would be thrilled frankly, to have one of these growth opportunities. And we're fortunate that we have three businesses that are absolutely in the sweet spot of where the world needs technology to play a more important role. We have the right strategy. It's applied to an exceptional and growing opportunity. And so we're no way opportunity constrained. I'm going to end with how I started. I believe that Adobe is uniquely positioned to drive the next decade of growth. We have a proven capability to create and lead categories and we're always looking around the corner to the whitespace that exists that will provide new opportunities for Adobe. We're thinking bigger about every part of our business, how we scale and how we expand the customers that we serve. We continue to focus on innovation, delivering leading products, services, and platforms as we leverage artificial intelligence and machine learning. We're continuously thinking about innovating in business models as well to rapidly deliver more value to a larger set of customers to capitalize on global growth opportunities, and to enable new monetization models that are emerging. And at the end of the day, our technologies support a vibrant and growing ecosystem of partners that create, customize and extend our solutions to meet the unique needs of our joint customers. But at the end of the day, our greatest asset as being an intellectual property company and what's truly driving our growth is our highly engaged global employee base, over 25,000 strong to whom I'm eternally grateful. Thank you again for joining us today. I believe 2021 was a fantastic year, and we clearly expect that momentum to continue in 2022 and beyond. As we look forward to our 40th anniversary next year, Adobe stands in an enviable position, an impressive track record of innovation, category and brand leadership, great financial performance and multiple growth opportunities. Coupled with the expanding market opportunity, the depth of our technology platforms, and the motivated employee base, I certainly believe that Adobe's best days are ahead of us. And with that, we'll roll a video while we assemble the management team for our Q&A. [Advertisement] Okay, are we on for Q&A? Great, I know we're on for Q&A. Before we get started, let me introduce two other members of the Executive team who are also here with us to answer the questions that you might have. Gloria Chen, our Chief Human Resources Officer, who has also run strategy in the past, as it relates to any questions that people have about the pandemic, or what we are doing with our global employee base, how do we continue to make sure we ensure that we have the best talented and motivated employees, and Scott Belsky, our Chief Product Officer of Creative Cloud, frankly, the visionary behind all of the great innovation that we're delivering across desktop, mobile collaboration, including the new web related functionality that we showed at MAX as well as what we did with Creative Cloud Express. And so with that, I'll turn it over to Jonathan to help navigate the Q&A."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, Shantanu. So, we've shared a lot of information today, you can clearly see the team's enthusiasm around the growth opportunity ahead. Now, we'd like to go ahead and take your questions. So for folks who are on the phone, if you haven't already done so, please go ahead and queue up for questions. Quick reminder, we do ask that each of you limit yourself to just one question per person that'll allow us to get through as many people as possible. And with that, I'd like to go to the operator. Operator, could we go ahead and take the first question, please?"
},
{
"speaker": "Operator",
"text": "Absolutely. [Operator Instructions] First question will come from Saket Kalia with Barclays. Please go ahead."
},
{
"speaker": "Saket Kalia",
"text": "Okay, great. Hey, folks, thanks for taking my question here, and congrats Anil and David on the promotion, and welcome, Dan."
},
{
"speaker": "Dan Durn",
"text": "Thank you."
},
{
"speaker": "Saket Kalia",
"text": "Maybe the question is -- maybe to start us off, I'd love if we can address the digital media net new ARR in the quarter, particularly within Creative. I think, Dan, you had mentioned that we hadn't seen spikes that maybe as high as we've historically seen around Cyber Monday and Black Friday. I was wondering if the team could just go in a little bit deeper into the result versus the guide, and then maybe comment on the competitive backdrop within Creative specifically?"
},
{
"speaker": "Shantanu Narayen",
"text": "Why don't I start with that, Saket, and then I'll certainly have others add. I mean, as we look at the Digital Media ARR accomplishment over the quarter, firstly, it was record quarter as well as it was a record year. And when we think about what our Digital Media guide was, I mean, we certainly expected Frame to close in the quarter, and it closed pretty early in the quarter. And so what we do is, we think about a range of outcomes and what that might do. And certainly we wanted to focus on Frame as well, but it was probably not explicitly factored into the quarter. When you consider it from different customer segments, the Team business actually performed really well right through the quarter. And so, the Teams is offering and the strength in the small and medium business was great. Enterprise, we actually actively redirected and pivoted the team to think about video and Frame and how we were continuously selling it, as I said, it closed early in the quarter. And so, Enterprise had the traditional Q4 strength as well, that we normally expect. The individual demand was actually fairly strong right through the year. As Dan mentioned, maybe the one slight change is that as you think about what's happening with online shopping, while we continue to see demand up into the right, we perhaps did not see as much of the spike, as you would have perhaps seen traditionally in either the Black Friday or the Cyber Monday weeks. But apart from that, strength and demand continues to be strong. And clearly, we factored that into our guidance for fiscal 2022, which is the strongest ARR guide that we've ever guided to. I think as it relates to the product and the differentiation, maybe I'll have Scott touch on that, and then David can certainly speak to other issues of the business."
},
{
"speaker": "Scott Belsky",
"text": "Sure. In terms of product differentiation for Creative Cloud, I mean, what a year we had. We delivered some of the mind-blowing Adobe Magic throughout our actual Pro products, neuro filters in Photoshop, for example, a lot of the collaboration features and we really made a proclamation that Creative Cloud going forward will be as much about collaboration, as it is about Creativity, which if you think about it invites many more stakeholders of Creativity into the fold. And that's where we're seeing across all of our enterprise as well as small businesses. Everyone wants to be a stakeholder and have a say and be able to jump in and give feedback. And so we're building our products for the future to enable that. I also want to mention, of course, last week you launched Creative Cloud Express, this is just the start of an amazing new chapter for us. We've had a number of products in the market in our incubation zone. We call it as we learn about how to really fulfill our mission of creativity for all. And now we've galvanized all of the learnings, all of the signals. And we just couldn't be more excited about the new journey we're on here with that product in particular."
},
{
"speaker": "David Wadhwani",
"text": "And I'm happy to add a little bit more from the business perspective as well, all the innovation that Scott's talked about and has been driving. One of the big things that you have to recognize is that it's really what's driving the TAM growth that Ann talked about earlier, both in terms of expanding the base of people we can access with something like Creative Cloud Express, and also increasing the value that we're providing to our Creative Pro base. So, as you start looking at, where we're going with the business, we're building on the momentum, as we talked about, we had almost $2 billion of net new ARR added in FY'21, we had our strongest guide ever and it's really on the back of that. One more thing with regard to Creative Cloud Express and how that will start to drive opportunity for us, it can start by actually adding a lot of new users to the franchise, one of the things that we've been doing a phenomenal job with and I think this expands is bringing new users to Adobe, getting them successful with what they're doing, and then start to mature them up the value curve into Creative Cloud subscription or now Creative Cloud Express subscription, but we're also making this available to all Creative Cloud customers. This is something that we see a lot of Creative Cloud customers occasionally want speed and content first development. For those users, we see the opportunity to really drive higher engagement and retention, even beyond where we already are. And then as you start to have more plans that are separated for the kinds of things people want to do, it gives us the opportunity to drive more price optimization across the lines as well. So we're very excited about where we're heading and what this really adds to the mix we have."
},
{
"speaker": "Saket Kalia",
"text": "Got it. Thanks very much, guys. Very helpful."
},
{
"speaker": "Operator",
"text": "And our next question will come from Alex Zukin with Wolfe Research. Please go ahead."
},
{
"speaker": "Alex Zukin",
"text": "Hey, guys, thanks for taking the question. Maybe I'll go a little bit more directions, we're getting a lot of questions from investors. If I look at the guide, if I look at the performance of Digital Media era for, and we assume the Frame.io was not in the guide, it’s the first time, I think ever that you've actually not outperformed your guidance for the quarter. And so I realized that there definitely were some issues in Q4 that may have impacted that. So, just give us a sense of mix like what it was, now let's look back and you had looked back at the COVID impacts those in the first half, second half, the holiday season, how should we think about the confidence in your guide for next year vis-à-vis your historical cadence or historical pattern and seasonality?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, Alex, I mean I'll take that. And if you think about it, first, as you know, people who've covered us for a long time, we take our guidance very seriously. And let me maybe roll back a little bit to what we accomplished in 2020 and then how we guided for 2021. As you know, we guided a little bit below what our 2020 guidance was, in 2021, when we started, and we certainly outperformed that guidance as it relates to digital media ARR accomplishment in 2021. And if you look at how we've guided for 2022, it's actually a little bit closer to our 2021 guide, as a starting point. And so clearly, we continue to be incredibly optimistic associated with the underlying strength of the business, the overall need for creativity just continues. We don't believe in any way, shape, or form there was sort of pull-ins and I know that sort of exists for other companies, we just continue to see secular strength. And some of the new initiatives that we have underway. I mean, we really pivoted the team to be thinking about enterprise and video, we have Creative Cloud Express, the usage is going to build dramatically, we already have the largest communicator business, I think among the Creative community. So, we're incredibly optimistic about how that business looks. And then if you look at it from a quarterization perspective, again, let's just go back and look at what we guided in Q1 of 2021, as you know, when we guided to a number we were factoring in the $24 million that we outlined was an additional part of what we accomplished as part of the 13 versus 14-week. And so if you look at it, it's very much in line. In other words, the trends of the business continue and the optimism in the business continues. So that's how I would think about it, Alex."
},
{
"speaker": "Alex Zukin",
"text": "That's super helpful, and maybe just one for Anil on CDP, the last time we talked about the CDP products, I think you talked about being surpassing the $100 million in ARR margins, clearly [indiscernible] from your commentary sounds like perform really, really well. And really, it broke down for the entire digital experience. Where are we with that business today, if there's any way to dimensionalize work for the project from an ARR perspective?"
},
{
"speaker": "Anil Chakravarthy",
"text": "We see a lot of momentum, the market clearly customers looking at us and saying they have the right vision. And we have the right product to really think about a range of use cases that's supported by the Adobe Experience platform, and we've done a really nice job of integrating our applications with the Adobe Experience platform, so that you are able to populate the data from our analytics platform, and then use the data for activation across all kinds of channels. So, in terms of scale, in terms of performance, in terms of the range of use cases, data governance, et cetera, it's really enterprise ready right now. And enterprises are beginning to see that this is at the heart of their Digital Experience and their digital customer engagement. So we feel like we're in a really good place right now with that."
},
{
"speaker": "Alex Zukin",
"text": "Perfect. Thank you, guys."
},
{
"speaker": "Operator",
"text": "Up next, we will hear from Keith Weiss with Morgan Stanley. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "Excellent, thank you guys for taking the questions. I want to dig a little bit into I think David, you started getting into this with the positioning of Express and how we should think about that. How does the Express positioning relate to kind of what you guys were trying to do with Spark and those mobile offerings in terms of an entry ramp? Is it kind of in between those two? To what extent should we think about this as defensive to some of the emerging competitors that are ramping up in the marketplace? And is there any risk of downshifting of the existing Creative Cloud customers, who need a lighter weight solution. Now here is a cheaper offering if you will. Is there any potential that you can see some downshifting within the base of people trying to price optimize there, or to the contrary, does this allow you to sort of pull price up on the core Creative Cloud? You just help us with those kinds of questions on the positioning around the portfolio now?"
},
{
"speaker": "Shantanu Narayen",
"text": "Okay. Maybe I'll start, Keith, and then David, certainly you can add to it. If you take a step back, I think this just speaks to the enormous opportunity that exists for creators. And if you look at our offerings already today, Keith, I mean, we have an incredible diversity of offerings. We have Photoshop Express on mobile that's doing great as it relates to the ARR. And we have the Creative Cloud product that also allows now the substance 3D products, that's probably the most expensive. And so I think with online and our DDOM, we now have absolutely the ability to target and personalize our offerings against a broader set of customers and to make sure that we make it all net positive and net from a customer satisfaction as well as a net positive from the ARR that we accomplish. A couple of other things, I mean, first, our creative business with the Communicator segment is already the largest creative business in the world. I mean, when you think about what's happening with Photoshop or Lightroom or the express set of products, and I think what express really does is it actually adds value to every single Creative Cloud subscriber. I mean, they are Creative Cloud subscribers, who are incredibly proficient in video, who sometimes want to do a quick flyer associated with it. And so I think this brings more and more and more people into the fold. It's similar frankly to what we've done with the Document Cloud, where when you think about what's happening with this organic demand that we've created for PDF. And so net, net, I think it's a creative, and then I'll hand it over to David to speak specifically about how this might roll out, but it is actually an enabler for us, and it unifies frankly all of the different creative offerings that we've already had for the Communicator segment."
},
{
"speaker": "David Wadhwani",
"text": "Yes. Just adding to that, we look at this as a really pivotal moment in terms of our ability to fulfill a need that we know our customers have. If you think back to what we talk talked about earlier, we have 400 million IDs that have been created on mobile devices already. We have 600 million monthly active users across our Digital Media products that are not creative professionals. And Creative Cloud Express represents an opportunity to give all of them something that we can onboard them in an effective way. As Shantanu also talked about, one of the things that we find really exciting about this is that our Creative Cloud base as well is looking for sometimes often they're looking for the power and precision of our creative flagship applications, but sometimes they just want a velocity driven content first creative, creation model two. And by giving Creative Cloud Express to most of our Creative Cloud plans, we expect to drive even higher engagement and retention there. And the last thing I want to say is that this fundamentally expands how we think about our go to market motion. And we have talked for the last many years about our data driven operating model and how that drives our ability to pull and acquire users bring them into our acquisition funnels with product led growth because of our increasing investment in mobile and web, we have the ability to do a lot more quick iteration and optimize the user journeys, so that conversion of that 600 million mile into paid and premium customers and engagement with them continues. And the last thing I will say is that, I don't think you can look at this market as you've got non-professionals and professionals. We have a lot of non-professionals that really want to use the power and precision of Creative Cloud. And so we look at this as this ongoing seamless journey from the first time you come in, you want to do something with creative expression, you can do it for free with Creative Cloud Express. We then move you up that chain. So you have the premium content and availability of the premium features and content and Creative Cloud Express paid plan. And then we see people are able to actually move all the way up to the power and precision of Creative Cloud. So it's really a seamless end-to-end journey."
},
{
"speaker": "Keith Weiss",
"text": "Got it. Is that what you were talking about when you mentioned price optimization? Is it just having more tiering within that pricing?"
},
{
"speaker": "David Wadhwani",
"text": "Yes, certainly. Keith, so we've talked about price optimization being it. I mean, for the first time as you saw with the 3D products, we did not included as part of Creative Cloud all applications because of the value. But certainly I think as we get a better feel for all of the different offerings that we have, there are some offerings that are probably under-priced relative to the value that they're providing. But our focus just continue be attract more people to the platform and deliver more product value. Scott, we would add something on Creative Cloud?"
},
{
"speaker": "Scott Belsky",
"text": "No, I was just going to say, I mean, I think David, you covered certainly the opportunity for Creative Cloud Express for the broader franchise. But one of the very exciting things that we've learned over the last few years is a really around the distinct customer needs that we're just not covered frankly by Spark or Photoshop Express other things we were doing or other kind of competitive tools out there. And I just wanted to share a few of those because I think they're really relevant. I mean, first of all, we're seeing a lot of these customers that come in, wanting to make something with a template, they want to be able to go further. So our product team is actually very excited about the prospect of a customer being able to make something and then take it to the next level using one of our more pro-ish applications like Photoshop or Illustrator, also the desire for artificial intelligence. A lot of customers come in from small businesses, etc, and they have an idea of what they want to make, but they want some assistance and making something remarkable. They want fonts to be recommended to them. They want colors that will perform better on social media. And so we have an opportunity to do that. And then finally, the idea of a multimedia editor was another really important insight for us in the development of Creative Cloud Express. Because what we learned is that while a lot of customers come in through the top of the funnel, because they want to make a flyer, they want to edit a video, they want to edit an image. When they come in, they actually realize, I'll add some animation. Maybe I'll add some sound. And before you know it, it's a multimedia creation. And so we're very much building Creative Cloud Express not just for where the customer is now, but where we see the market going, people are going to want to stand out with their media. And that's something that I believe Adobe can uniquely deliver with this product."
},
{
"speaker": "Keith Weiss",
"text": "Outstanding. Super helpful, guys. Thank you."
},
{
"speaker": "Operator",
"text": "Up next, we'll hear from Kirk Materne with Evercore ISI. Please go ahead."
},
{
"speaker": "Kirk Materne",
"text": "Yes. Thanks very much. No, I was wonder if you could just talk a little bit more about some of the strength you're seeing in the enterprise side on the experience cloud front, obviously RPO was really strong. I assume a lot of that strength came from the experience club side. And what continues into next year, because when you look at the fiscal '22 guide, obviously CECL assume some of that's just work front being anniversary, but could you kind of tell us what you're sort of assuming continues in the strengths of business this year, going into next year? Like what has momentum in that business that you feel good about and where are some of the potential points of leverage in terms of upside next year? Thanks."
},
{
"speaker": "Scott Belsky",
"text": "Well, we definitely see some of the tailwinds we saw during the pandemic continuing and every company, B2C companies, B2B companies, and companies that are experimenting with new business models, direct-to-consumer for example, they're all starting to invest across the board in digital experience. And we see that play out across all of the categories that are laid out, definitely with one view of the customer, a single view of the customer that carries through the unified profile that we have in the Adobe Experience Platform that is at the heart of all customer engagement. So if you kind of map it to how we think of our DDOM, everything from discover to try, to buy, to use, to renew that whole journey needs a common unified profile, so that you can deliver a consistent experience across all channels. And that's a major investment that all companies are making. And so what we've been able to do is to really take advantage of all of the knowledge we have and the applications we have across all of these areas and populate that data in the Adobe Experience Platform. And that gives us a clear head start for with every company and then say, then opening it up by saying that it is open to developers. The data model is an open data model. It runs on top of a cloud, so that it's horizontally scalable that has really made it something that any enterprise of any size can use, but they can also get started in a particular geography or in a particular business unit or a customer segment and scale from there. So I'm really excited. I think across our categories, we definitely see a lot of strength and more as we now see some of the trends that we've just talked about with the creator economy and so on, that'll continue to add more use cases that'll be built on top of the platform."
},
{
"speaker": "Shantanu Narayen",
"text": "And Kirk, if I were to add a little bit more to that, I mean, when you take a step back and think about what we've accomplished, we created the digital marketing category, and we said, there is a much larger opportunity as it relates to this customer experience management, the innovation that went into the building of the experience platform and the unification frankly of everything that analysts talked about, whether it's content and commerce, whether it's data and insights, whether it's the marketing flow associated with work front, which is also doing well. There really isn't another company that enables somebody whether you're the marketer, the Chief Revenue Officer, the Chief Digital Officer to very quickly say, I want to get all my data, whether it's online or offline into one particular place and even more important to activate it. And so I think from my perspective, the momentum associated with having this unified platform and you can get customers really up and running so rapidly, that's pretty amazing. The second thing I would say is that we've done a really good job with the Digital Strategy Group, as well as what Anil had outlined earlier about these transformative accounts. And so, again, as we shared in the data, the ability to sell multiple solutions, the ability to upsell, the ability to co-sell, I think that's also gives us a lot of confidence, but now we have the platform, we have the apps and services on it. We have the AI associated with it, and I think if you take a step back, there isn't a company that doesn't want to talk to us about (a), Adobe, how did you do it? And (b), how do we really make sure that we can get this up and running and activated faster? So, I really hope in 2022, you'll see how we make increasing progress in terms of not only just the selling, but the provisioning and frankly the value realization and I think we've done a good job on that front as well under Anil's leadership."
},
{
"speaker": "Kirk Materne",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "All right. Up next, we'll hear from Mark Moerdler with Bernstein Research. Please go ahead."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you very much for taking my question, and congrats on the quarter and the year. I'd like to drill in a little bit, because I'm getting a lot of questions obviously. Dan following up on your prepared presentation, you discussed how subscription is sustained 24% growth. And when you look at the overall guidance, I'd like you to help us better unpack what the opportunities that are impacting for you are specifically your Digital Media side and then also on the experience side. Also, can you give us any sense on how much you are figuring FX via headwinds in ARR and revenue, I'd much appreciate it."
},
{
"speaker": "Dan Durn",
"text": "Sure. Thanks for the question. I think the best place to start is underlying performance of the business. I think we're exposed to great market opportunities; company's got the right strategy performing well against those strategies. As we think about performance in the current environment, against that backdrop of good performance. We want to strip out noise in the one year look ahead, set of numbers and I think there's two things that we point to when we separate the noise from what's been communicated. First is FX, second is the extra 53 week versus 52 week. And so, let's go one layer deep in each of those. As we think about the 53 versus 52. Week, that's about a 2% add or to growth for the overall company in fiscal '21. And as we window into fiscal '22, that's going to be about a two-point headwind because that extra week occurred in Q1 and you look at Q1 FY '22. It's about a seven-point headwind from just that one extra week alone as we look along quarter forward. As we take a look at FX and we think about the currency moves not surprisingly, FX for our business over 2021 also added about a two-point tailwind from a growth perspective, broadly speaking across the business. As we look forward into the next year, it creates about a one-point headwind given the recent moves that we've seen over the last couple of weeks, I'm sorry, last couple months of the dollar strengthening versus a variety of currencies around the globe. That gives you a sense of the magnitude of the moves from both of those two factors as we extract underlying performance from a bit of the noise we see, if we were to go to one click further down and take a look at how both of those factors affect the Digital Media business versus the Digital Experience business. I would say from the 52 versus 53 week dynamic, you'll see more of that upside and more of that headwind from a growth standpoint, impacting the DME business, then you do the DX business, but it's just a slight difference between the two businesses, depending on how we engage commercially with our customers. And I can go into that a little more detail, if you'd like. On the FX side, you see a similar dynamic, you see slightly accentuated performance to the upside and downside tailwind and headwind from FX on the Digital Media business than you do on the DX business. It's a slight change, but you see a slight bias to the upside and downside of DME versus DX. I think that unpacks the numbers and gets to the true underlying performance of the company. And as you take a step back and look at how our businesses have performed over the last couple years, you'll see what we've just guided is about in line with where we've been for the last couple years. So again, the company continues to perform pretty well."
},
{
"speaker": "Shantanu Narayen",
"text": "And maybe Mark, I'll just add a couple of things to that. First is, as Dan tells me, which is first welcome to the big leagues. And so, I guess when you're $15 billion of revenue, it's neither practical and it's frankly too expensive to hedge all the FX exposure that you were accustomed to maybe we're doing, so if you strip out that FX part and if you think about ARR, just very tactically to be clear. What we do is, we have an ARR at the beginning of the year with the strength of the dollar in November, you could argue it's the hardest compare on a pure FX, and then we both devalue the beginning book of business on ARR. And then we're using that dollar rate for the ARR for the quarter, and so then again, if you think about it, at a $1.9 billion guide that we have for ARR. Clearly, the underlying strength of business and the units that is not what's impacting the business, so, just I think that's the other way that I unpack what was the impact of FX, as well as to specifically tell you how we take the dollar rate at the beginning of the year for the ARR calculation."
},
{
"speaker": "Mark Moerdler",
"text": "That's extremely helpful. I really appreciate, Dan, if you don't on the difference between the two businesses. Can you drill it a little bit more why that extra week is so much worse a little bit on digital?"
},
{
"speaker": "Dan Durn",
"text": "Yes. As you look at how we engage with customers, you engage with customers, through adobe.com and other channels on a daily basis, and you're exposed to every single extra day of that week to the upside and the downside depending on which year you're in. On the DX business, the vast majority of our, not the vast majority -- the majority of our revenues will all get booked on a daily basis, but there are parts of that business that engage with customers on a monthly basis. And as you can imagine when that extra week falls in a month and you engage with customers on a monthly basis, you won't see the upside or the downside on that business. So, on a like-for-like basis, you'll see more of that dynamic flowed into the Digital Media business than you will the DX business. But again, as you think about a two-point tailwind FX in FY '21 and a one-point headwind in FY '22. You're talking about slight separation to the upside and downside, and depending on what year you're in to this dynamic."
},
{
"speaker": "Mark Moerdler",
"text": "Perfect. I very much appreciate it. Thank you for the detail."
},
{
"speaker": "Dan Durn",
"text": "Yes, you're welcome."
},
{
"speaker": "Operator",
"text": "Next, we'll hear from Gregg Moskowitz with Mizuho. Please go ahead."
},
{
"speaker": "Gregg Moskowitz",
"text": "Okay, thank you for taking the question and thank you for hosting this event. One of your competitors in the Document Cloud space recently cited softening demand and execution issues. Naturally your business is a lot broader than theirs. But have you seen any changes as it relates to customer engagement within Document Cloud?"
},
{
"speaker": "Shantanu Narayen",
"text": "Gregg, we had a phenomenal quarter and Document Cloud. I think we had record net new ARR $141 million in net new ARR for the Document Cloud. I think the team has done a really good job of integrating that. So maybe I'll have David speak a little bit to how just integrating sign as well into the Acrobat business as one of the verbs is really I think helping really make it more pervasive. David?"
},
{
"speaker": "David Wadhwani",
"text": "Yes, as Chuck said, we're very excited about the momentum we see in the Document Cloud business as a whole. We have -- we benefit from this incredible reach we have. As I mentioned earlier, between our inside sales folks and our reseller partners, really anyone that has a document need is coming and flowing into our funnel. And then certainly with the benefit of the enterprise selling in the top down, we're able to go and have solution-oriented conversations with them, but one of the key areas that we've been focused on over the last 12 months that has really been productive for us is to leverage our footprint in terms of our desktop applications predominantly things like Reader across mobile, desktop and web and drive awareness and utilization of our services through that. As I mentioned earlier, we saw an 85% year-over-year increase in terms of Adobe Sign transactions that were successfully committed -- completed or initiated in Acrobat and you can expect to see us continue to do that. We want signatures and Adobe Sign to be available to anyone that uses Acrobat going forward and will continue to double down on that strategy."
},
{
"speaker": "Shantanu Narayen",
"text": "And may be just one last thing to add on that, Gregg, I mean, one of the exciting things that again, I think the team has done is now this extension that we have in Chrome, as well as what we are doing and we announced the extension of the partnership with Microsoft. So again, I think the distribution of Adobe PDF with all the magic that we have with Liquid Mode and Mobile and Sign, I think that just really enables us given we have the APIs and the developer motions to really even further extend that. But this notion of automating document workflows, it's just going to continue to go up into the right."
},
{
"speaker": "Gregg Moskowitz",
"text": "That's terrific. And then, a quick one for Dan, you spoke about FX and the extra week a moment ago. But how much is an increased or more normalized level of T&E expected to impact your operating margins in fiscal '22, how should we think about that?"
},
{
"speaker": "Dan Durn",
"text": "Yes, so as I think we look into 2022, we in the prepared comments talked about as the world begins to open up, we're going to get on airplanes, we're going to spend time with customers, you'll see some of the facilities costs come back, this is about growing and scaling our business and engaging with customers and solving their highest value problems. So you will see some of those costs come back. And that's reflected in our guide. And so when we take a look at the opportunity in front of us, and we think about the runway for growth, we think about how well we're positioned in each of our respective businesses. And we think about where the world's going and the key enablement role we as a company can play to enable that digitization of the world, we're going to invest for growth, we're going to invest in market leading and defining products. And we're going to continue to lead the way we've done in the past. So you'll see some of that complement the investments we're going to make. And then as you think about the Adobe Experience platform, and you think about Creative Cloud Express, we're going to invest in sales and marketing to grow and scale those businesses globally. So we're going to be oriented to growth. And you'll see that reflected in both the performance and the decision making going forward."
},
{
"speaker": "Gregg Moskowitz",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "And up next, we'll hear from Brent Thill with Jefferies. Please go ahead."
},
{
"speaker": "Brent Thill",
"text": "Dan, welcome to the team. Just on the margin side, I mean, I think we all understand your margins have gone up 590 basis points in the last three years. So tapping the airbrakes a little bit on margin makes sense. But when you think about the long-term trajectory still for Adobe on the margin, you believe you're capped in the mid-40s, do you still believe long-term, the margins can trend more towards 15, and I have a quick follow-up for Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "I think 60s comes after 50s, Brent. If you're thinking about numbers on that scale, we have as Dan said, such incredible opportunities, and one of the statistics that he showed that was really, hopefully, Brent, and you know us how we think about the businesses, which is we're investing in these long-term really growth rates. But we've been able to do all these acquisitions, and really do a fantastic job of keeping our margin. And so, I think it again is all about the growth opportunity, you know it, we have an unbelievable leverage model. And so the leverage model will demonstrate itself. And if you look at our 2022 targets, it actually continues to show a lot of optimism in what we can do. I think Frame.io is a little dilutive. And again, as he said, some of these things, the Experience Cloud, and what we are doing with getting more Experience Cloud adoption globally, what we are doing around Document Cloud and Creative Cloud and Creative Cloud Express, I mean, we want to make sure that we are spending wisely, Ann is the expert on attribution, not just within the company, but in the world. And so, we'll continue to do it. But we do believe that, and this is the question that you've also asked in the past, which is the value that customers are getting is there an ability to continue to drive higher price offerings, and all of them are there. I mean, we're just excited about all of these different things, but I wouldn't count on 50 anytime soon right now, I'd rather count on accelerated growth, Brent."
},
{
"speaker": "Brent Thill",
"text": "Okay, very clear, Shantanu just for the quarter, forget the guide. I think many of the analysts have asked this question, what happened in Q4, and this is not a quarter that we're all used to seeing from you. So from your perspective, is this just the digital digestion from a huge adoption, we've seen the last year is Adobe execution. I don't think it's competitive. But I think many are still asking all of us the question throughout this Analysts Day with the stock down, what happened from your perspective?"
},
{
"speaker": "Shantanu Narayen",
"text": "Brent, so let me maybe again touch a little bit on the Adobe Digital Index, and then I'll come back to our business. If you look at the Adobe Digital Index, what has clearly happened over the last 12 months, 18 months, even pre-pandemic, but certainly during the pandemic, is this more and more activity happening online. That is a secular trend that's actually not going to change. We see it, there's more energy, there's more traffic, there's more activity associated with what's going online. If you look at what I think a lot of companies are looking at, the traditional spikes that you may have seen, a couple of weeks the Black Friday week or the Cyber Monday week, I think those are maybe a little bit more muted, because it's a little bit more of that traffic, you're seeing actually a steady growth as opposed to those spikes. So, if I take a step back and think about our Digital Media business teams, and the small and medium business, nice performance, if I look at the Enterprise, as I said, traditional close to the quarter, if I look at the individual business, a little bit of those spikes that we would have seen, we did see growth, we did see growth in both of those weeks, but it was perhaps a little bit less than that. And then you're back to again, the secular demand. So as I think about the business, it's not about the long-term demand. It's not about the market leadership of our products, I think it's just a little bit of how maybe online shopping globally has changed a little bit in terms of what the experience is. So that's what I attribute it to and we're back on Q1, look at our guide and let's go execute against the opportunities that we have. So I'll really point to a little bit of those couple of weeks. And it's not just Adobe, it's certainly represented, if you look at the Adobe Digital Index, and what we thought was the growth rate going to be for the entire community and how that got a little muted. So that's the way I would look at it."
},
{
"speaker": "Brent Thill",
"text": "Thanks, Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Hey, operator, we're coming up on the top of the hour. Let's take two more questions, please."
},
{
"speaker": "Operator",
"text": "Absolutely. Our next question will come from Brad Sills with Bank of America Securities. Please go ahead."
},
{
"speaker": "Brad Sills",
"text": "Great. Thanks guys for taking the question here. I wanted to double click a little bit on the TAM expansion that you've seen, from your perspective with the core Creative Professional enter the market, I think two years ago, you're $15 billion, now you're forecasting $25 billion, is there a certain persona that you think is driving a lot of that expansion in the TAM, just in the core business versus say a couple of years ago, when you look forward towards the addressable market?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, there are three things that are really driving that first is just, with the increased demand for content, we're seeing more Creative professionals come into the market. So we're seeing the base of people we can sell to as Creative professionals continuing to grow, we also are able to provide more value as people are trying to accelerate the velocity of content, they have to build content more quickly. So, things that Scott and team are doing around the addition of collaboration means that we're able to add more value, the Frame.io acquisition is a great example of that. But we've also added some core new collaborative capabilities to Creative Cloud itself. And third is the emergence of these new content types. We've been all tracking the growth of 3D. But also now with the emergence of the Metaverse, we're starting to see more demand for new types of content. And if you look at the performance of Substance 3D, and the fact that that business as an example grew 100% year-over-year, it shows you that the business and the growth that we're seeing is tracking to the TAM expansion that Ann talked about earlier."
},
{
"speaker": "Brad Sills",
"text": "Got it, great. And one more if I could please, with all the effort and work you've done integrating the suite for Experience Cloud between Magento and Core CMS, now you have Workfront, are there different entry points that the enterprise customers are starting within that suite now that you've delivered on a more integrated offering there?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, absolutely. We're starting to see customers who start with commerce. And now they want to have a much better web presence. And they work with us on content management. And they want to focus on marketing agility, and efficiency, and that leads to Workfront. So that's a different entry point that we see now. We also see a number of our customers, as they think especially about different patterns in commerce, B2B commerce, B2B2C commerce, et cetera, they are expanding from the Content Management presence they have with us, and taking us up on our vision of making it a truly shoppable experience. And so that's starting to move in the other direction as well."
},
{
"speaker": "Brad Sills",
"text": "Great to hear, thank you so much."
},
{
"speaker": "Operator",
"text": "And lastly, we'll hear from Kash Rangan with Goldman Sachs. Please go ahead."
},
{
"speaker": "Kash Rangan",
"text": "The good thing about going last is I've got three minutes. And you're stuck with me for three minutes. I'm kidding. I'll try to make this. I'll kind of make this brief. Shantanu and Dan, I was intrigued by your comment that you plan to double the size of the company to $30 billion and beyond that to $45 billion. And dovetailing that to Shantanu's observations that you're looking to accelerate, as opposed to go for margin expansion, which is great. And with that construct in mind, certainly when I look at your guidance, it doesn't suggest any deceleration but maybe a little bit of conservatism if anything. If you could just talk about the levers in your business, Shantanu, that could cause the company to better than expected or downside levers as well for fiscal '22 that would be great. But more longer term, you look at Metaverse, constant Metaverse and how Satya Nadella talks about the equivalent of Metaverse on the business side how we work, combination of virtual presence. The outlines of view of the word that is fairly compelling. I'm curious how you have thought about, how Adobe is positioned for that word the Metaverse in the consumer context and enterprise virtual work context as laid out by Satya? Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Well, thanks for the question, Kash, and before I get to the Metaverse, maybe the one thing we didn't quite cover is if you look at the big trends that people are talking about cash, the one thing we're maybe not in is EVs and batteries, right? So that's perhaps the one area of digital that Adobe is still not really involved in. As I think about web 3D, and as I think about the Metaverse, what it really means and implies is that things that you are accustomed to doing in the physical world, increasingly more and more of that you're going to do in the virtual world. And so if you think about it that way, whether, you're doing shopping, whether you're playing games, whether you are co-creating with other people, whether you're expanding it. The aspect of creating all of that Metaverse was what better company in the planet than Adobe to be able to do that. So that's at one dimension, which is this exponential need for content is only going to increase. I think the other way I think about what's happening in the Metaverse. And if you think about it from that point of view is, where prior only physical goods in creativity were deemed worthy of buying. I think now even all these virtual goods are going to have a value associated with it. And so when you think about what's happening with NFD and block chain, again, Adobe, I think is incredibly well positioned. We've already demonstrated some leadership in that with what we've done in Photoshop. And so I think the commerce aspects associated with not just large businesses and we've talked about the large businesses, but even individual businesses, I think Adobe is uniquely positioned. I think like that Adobe is probably a little bit more conservative than others in order to, in terms of putting it directly in our forecast for the year, but make no mistake. I mean, we are thinking about how these new opportunities, the fact that, we bought a 3D company a while ago, the fact that we have Aero, and we're working with all of the OS provider in terms of thinking about augmented reality and virtual reality. We're absolutely in the middle of it. We're not just counting it in terms of what happens in terms of revenue of the top. But if you take even more of a step and go to your question associated with how do we think about the opportunity? I will actually say, Kash, as we were all preparing as a group to prepare this. We had so much material and we were talking about how do we try and condense it. So I really hope you look at what Jonathan forced us to do, which is the deck has much more information in it. We were trying to really provide sort of abstract of all of that material. And I think it just reflects the interest that we have. I mean all three of our businesses and let's go maybe digital experience. We've been talking about that for a while and you're seeing just some tremendous adoption of our solutions in that. Digital is only going to go up and to the right. And I think Adobe is incredibly well positioned. The real-time customer data platform, the experience platform, how we've unified our products, it actually reminds me of the really heavy lifting that we did many years ago in what we did on our content creation tools with the unified profiles and the data and insights to deliver value to our customers. So, it feels really good. I think what we are doing around Document Cloud on the web across surfaces, PDF, liquid mode in terms of the AI, we're really spending a lot of time thinking about how businesses are going to automate, what it means to have a hybrid work environment, which is clearly a trend and really making sure that we unify that with respect to our innovation, so really fantastic job by the teams there across all surfaces. And certainly Creative Cloud, the heritage of the company, this notion of everyone who has a story to tell, I actually tend to think of it as the webs now come alive, the web come alive. And perhaps one of the things we didn't talk about, the biggest asset even on the web is Adobe's file formats. So the ability to deal with a Photoshop file format, the ability to deal with Illustrator for logos, the ability to deal with in design, if you want to create these flyers and actually for the creative community to participate in this massive community that's being created, we've done all the heavy lifting that now makes that magic possible. And we have a broader set of offerings than ever before in terms of being able to target people wherever you are in the world, we have pricing flexibility and we have a DDOM that allows us to do it. So I just take us step back and look at it and say, you know what? Adobe is really uniquely positioned. We have a fabulous team. We didn't talk enough about that, certainly my colleagues here and Dana, who is not on the stage, but our GC is an executive team, as well as the 25,000 employees. Don't take for granted what we have in terms of this motivated stuff. And so I just look at it and say, \"We're focused on top line growth to the questions that Brent and others ask.\" We're always going to be focused on making sure that we have profitable growth and focus on the margin as well. But I feel just uniquely excited about the opportunities that we have. The one thing I miss is unfortunately we're not altogether. And please stay safe. Stay healthy during this holiday season. I think that's the really important thing, but as a management team and as an employee base, I could not be more excited about the future that Adobe has. And so, thank you very much all of you for joining us virtually and thank you for the team for all of the work that went into the preparation. Have a nice day."
}
] | Adobe Inc. | 24,321 |
ADBE | 3 | 2,021 | 2021-09-21 17:00:00 | Operator: Today's call is being recorded. At this time, I'll turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon. And thank you for joining us. With me on the call, today are Shantanu Narayen, Adobe's President and CEO, and John Murphy, Executive Vice President, and CFO. On this call, which is being recorded, we will discuss Adobe's Third Quarter fiscal year 2021 financial results. You can find our Q3 press release, as well as PDFs of our prepared remarks. And financial results on Adobe's Investor Relations website. The information discussed in this call, including our financial targets and product plans, is as of today, September 21st, and contains forward-looking statements that involve risks, uncertainties, and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today's press release and in Adobe's SEC filings. On this call, we will discuss GAAP and non - GAAP financial measures. Reconciliations between the two are available in our earnings release and on Adobe's Investor Relations website, I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon. I hope you are all staying safe and healthy. Adobe had another outstanding quarter as people across the globe continue to embrace new ways of storytelling, learning, and customer engagement in our digital-first environment. This quarter we delivered significant new product innovations, announced the exciting acquisition of frame.IO and continued to increase customer engagement across an ever-expanding customer base. We're executing on our strategy of unleashing creativity for all accelerating document productivity and powering digital businesses as reflected in our strong performance. In Q3, Adobe achieved 3.94 billion in revenue, representing 22% year-over-year growth. GAAP earnings per share for the quarter were $2.52 and non-GAAP earnings per share were $3.11. In Q3, we drove record performance in our Digital Media business, achieving 2.87 billion in revenue, representing 23% year-over-year growth. Net new digital media, annualized recurring revenue, or ARR, was 455 million and total Digital Media ARR exiting Q3 grew to 11.67 billion. Creativity has always played a central role in the human experience. Over the last year, we have all witnessed the way creativity has sustained us. We've shared photographs with loved ones on different continents. Taught art classes to students at their kitchen tables, and launched entirely new businesses online. Building on decades of leadership, Adobe continues to pave the way in core creative categories, including photography and design. while pushing the boundaries across a wide range of emerging categories, such as AR and 3D. Whether it's the latest binge-worthy streaming plus series, a social media video that sparks a movement, or a corporate video, creation and consumption of video is experiencing explosive growth. In August, we announced an agreement to acquire frame.io, a leading cloud-based video collaboration platform. Video editing is rarely a solo activity, and it's traditionally been highly inefficient. Frame.io streamlines the video production process by enabling editors and key projects stakeholders to seamlessly collaborate using cloud-first workflows. The combination of our leading video editing offerings, including Photoshop, Premiere Pro, and after-effects with frame.io’s cloud-based review and approval functionality will radically accelerate the creative process and deliver an end-to-end video platform. The addition of frame.io creates an opportunity for Adobe in conjunction with the partner ecosystem to expand beyond video editors to a broader set of customers, teams, and enterprises. We hope to close the frame.io transaction in Q4 and look forward to welcoming the team to Adobe. Next month, we will host Adobe MAX, the world's largest creativity conference. Max has always been the place to be inspired, connect with the creative community and experience the latest Creative Cloud innovations. Our programming will feature iconic speakers, including Oscar-winning winning writer, director, producer Chloe Zhao, actress Tilda Swinton, and SNL star and executive producer Kenan Thompson. This year's fully digital experience allows us to expand our reach and engage with more people across our global creative community than ever before. Max will be hosted on Adobe’s custom digital event platform built on Adobe Experience Cloud. In Q3, we achieved Creative revenue of 2.37 billion with strong new user acquisition, engagement, and renewal across all creative products and geographies with particular strength in our Creative Cloud for Teams offering. Q3 Creative Cloud highlights include innovative enhancements to our photography offerings, including new services and AI-driven capabilities in Lightroom, Creative Cloud applications now running natively on Apple's new silicon M1 chip, Delivering a boost in performance. The release of Adobe substance 3D collection, a suite of interoperable tools and services that support 3D creativity. Partnerships, such as The Great Untold with Netflix, enabling next-gen creators to tell their stories. And key customer wins at the department of education of the Philippines, Facebook, Nike, Rutgers University and the U.S. Department of the Interior. Document Cloud is accelerating Document productivity by powering the paper to digital revolution and enabling all Document actions to be frictionless across the web, desktop, and mobile. From complex legal documents to sales contracts to employee welcome kits documents are at the core of work. Using the power AI with Adobe Sensei, Document Cloud is automating workflows and adding new value across all Document verbs. In Q3 document, cloud achieved record revenue of $493 million, growing 31% year-over-year., Driving this performance was increased unit demand for acrobat subscriptions globally, and strength in the SMB segments. Q3 Document Cloud highlights include continued adoption of Adobe Sign and Acrobat with transactions growing over Ten-X in the last three years. Growth across Acrobat web and frictionless PDF, which optimize the customer journey and capture organic search-driven demand. Increased adoption and usage of mobile applications, including Acrobat, scan, and sign with over 100 million monthly active users; proliferation of liquid mode and adaptive and responsive mobile experience with over 300 million PDF files, we flowed in the last year. Key customer wins at Daimler AG, Fujifilm, Micron, and PwC. Businesses of every size across every category are investing in customer experience management. Adobe Experience Cloud is powering CXM for B2B and B2C companies with applications focused on customer journey management, data insights and audiences, content, and personalization, commerce, and marketing workflows. Adobe experience cloud empowers companies to deliver predictive, personalized, real-time digital experiences across every touchpoint of the customer lifecycle. In the digital economy, companies are relying on digital presence and commerce as the dominant channel to drive business growth. According to the Adobe digital economy index, U.S. consumers spent over 541 billion in e-commerce from January through August. 58% more than what we saw two years ago. In Q3, we delivered Experience Cloud revenue of 985 million driven by strong performance across both subscription and professional services. Q3 subscription revenue was 864 million, representing 29% year-over-year growth. As businesses reopened around the world, interest in Adobe CXM solutions as an enterprise priority is resulting in increased spending in both software and services. Q3 Experience Cloud highlights include product innovations, including new personalization capabilities in Adobe Experience Cloud to help customers move from third-party cookies to first-party data strategies. Workfront momentum, reflecting the need for workflow and collaboration to deliver global campaigns, and growing customer interest in our pioneering marketing system of record. Key partnerships in commerce with Walmart to integrate their omnichannel fulfillment technologies. And with PayPal to offer a robust, secure, and integrated payment solution for companies of all sizes. Continued industry analysts’ recognition, including being recognized as a leader in the Forester Wave. Digital experienced platforms and achieving the highest score of all participating vendors for current offering. Adobe was also named a leader in the 2021 Gartner Magic Quadrant for personalization engines and a leader in the Gartner Magic Quadrant for digital commerce. Strong customer adoption of Adobe Sensei-powered capabilities in the Adobe Experience Cloud as over 80% of customers now rely on our AI-powered capabilities. To drive data insights and optimization. Key customer wins at Accor, the Australian government, Bertelsmann, Capital One, CVS Pharmacy, Daimler AG, Facebook, Ford Motor Company, Fidelity Brokerage Services, Honeywell, Real Madrid, and the GAAP. Adobe strength has always come from our most important asset, our people. We want to thank our 25000-plus employees for their dedication and resilience. Our customers and partners for their trust, as we continue to navigate a dynamic external environment. I'm proud of the continued industry recognition we received as a great and equitable place to work. This quarter, Adobe received a 100% score on the Disability Equality index for Best Places to Work for disability inclusion. And we were named to people magazines, companies that carrier list for the fifth consecutive. Toby here. Last week we held our Adobe for all virtual conference designed to bring employees together around our shared values of diversity, equity, and inclusion. As part of that event, we reaffirmed pay parity. We continue to pioneer opportunity parity to ensure that employees are offered equal career development and growth across all demographic groups. As part of our ongoing efforts to bring in more diverse talent, Adobe has established partnerships with historically black colleges and universities and Hispanic serving institutions. This new program offers a million dollars donation to schools, scholarships, internships, and Korea readiness programs. Our goal with these deeply focused partnerships is to provide opportunities for students to learn technology and creative skills. The health and safety of our employees remain our top priority. Our offices are slowly reopening to fully vaccinated employees on a voluntary basis. As we look ahead to the future of work in Adobe, we will remain hybrid and flexible and continue to do what's best for our employees and our business. I'm confident that Adobe's culture of innovation, category-defining products, strong brand, and the unwavering dedication of our employees will drive our continued business success and a strong close to the fiscal year. John.
John Murphy: Thanks, Shantanu. Our financial results, future strong growth across revenue, Digital Media, ARR, digital experience, subscription revenue, RPO, and EPS, demonstrating the power of our category-defining offerings. And a digital-first world, Adobe's market opportunity is larger than ever, and we are investing for sustained growth through product innovation and by driving awareness and demand for our products with customers of all sizes. With our data-driven operating model or DDOM, we continue to leverage our Experience Cloud technology to create personalized experiences for our customers in real-time. Driving traffic to Adobe.com and app stores to acquire new customers. As a result, in Q3, Adobe achieved a record revenue of 3.94 billion, which represents 22% year-over-year growth. Business and financial highlights included GAAP diluted earnings per share of $2.52 and non-GAAP diluted earnings per share of $3.11. Digital media revenue of $2.87 billion, net new Digital Media ARR of 455 million digital experience revenue of 985 million, cash flows from operations of 1.42 billion, RPO of 12.63 billion exiting the quarter, and repurchasing approximately 1.7 million shares of our stock during the quarter. In our Digital Media segment, we achieved 23% year-over-year growth in Q3 and we exited the quarter with 11.67 billion of Digital Media ARR. As anticipated, with regions beginning to reopen across the globe. We saw pronounced summer seasonality in Q3. This is consistent with the experience of businesses across industries, as evidenced by data from the Adobe digital index, which showed that June and July marked the highest consumer travel season in two years. This correlated with lower web traffic while individuals enjoyed their summer holidays. We do see continued recovery in the SMB segment associated with the reopening. We achieved Creative revenue of 2.37 billion, which represents 21% year-over-year growth. And we added 348 million of net new Creative ARR. Our strong Q3 results demonstrate continued demand for our offerings and execution driven by our D - Dominant (ph)t sights. Third Quarter creative growth drivers included strong engagement, retention, and renewal across all creative products and customer segments. New user acquisition for Creative Cloud All Apps that driven by global marketing campaigns. Continued recovery in the SMB segment with our Creative Cloud for Teams offering, including through our reseller channel. Driving subscriptions for our flagship products, including our photography and video applications on both desktop and mobile. And the adoption of our 3D and immersive applications, including Adobe substance. Adobe achieved Document Cloud revenue of 493 million, which represents 31% year-over-year. growth. And we added $107 million of net new Document Cloud ARR in the quarter. Digital documents are essential to the changing nature of work, and we saw the paper to digital transformation continue in Q3 as Document Cloud remained our fastest-growing business. Third-quarter Document Cloud growth drivers included adoption driven by the increase in the need to collaborate and a hybrid work environment. Increasing unit demand for Acrobat subscriptions globally strengthened new licensing and renewal for our Acrobat for teams offering in the SMB segment and continued adoption of our Acrobat web and the Acrobat mobile offerings. Turning to our Digital Experience segment in Q3, we achieved revenue of $985 million, which represents 26% year-over-year growth. Digital experience subscription revenue was 864 million, representing 29% year-over-year growth. We continue to see subscription revenue acceleration in digital experience as large and mid-sized enterprises increased their investments in customer experience management. Business performance and digital experience during the quarter were driven by strong deal volume, including several large Adobe Experience platform deals. Momentum in Adobe commerce with strong revenue growth and new customer acquisition. Merchant services growth through new strategic partnerships, increasing adoption of our Workfront and Customer Journey Management offerings. Strong customer retention as we focus relentlessly, a value realization for our customers and demand for Adobe's professional services. Operating expenses increased in Q3 as we continue to make strategic investments and increased headcount. We began to reopen our facilities and return to moderate levels of business travel. The majority of our employees continue to work from home, while the return to business travel is expected to ramp slowly. And we expect to further ramp our hiring in Q4. From a quarter-over-quarter currency perspective, the impact of FX net of accounting for hedging activities caused a sequential currency increase to revenue of $10 million. From a year-over-year currency perspective, the impact of FX net of accounting for hedging activities caused the currency increase to revenue of $80 million. Adobe's effective tax rate in Q3 was 14.5% on a GAAP basis and 16% on a non-GAAP basis. The sequential reduction in our GAAP tax rate is primarily due to a decrease in U.S. tax accrued on foreign earnings and tax benefits associated with share-based payment. That's our trade DSO was 36 days, which compares to 37 days in the year-ago quarter and 35 days last quarter. RPO grew by 22% year-over-year to 12.63 billion exiting Q3 benefiting from strong enterprise licensing during the quarter. Our ending cash and short-term investment position exiting Q3 was 6.16 billion cash flow from operations in Q3 were 1.42 billion sequentially down from Q2 due to increases in prepaid expenses, income tax payments, and a decrease in accrued expenses. We repurchased approximately 1.7 million shares in the quarter at a cost of $1 billion. We currently have $14.1 billion remaining of our $15 billion authority granted in December 2020, Q4 targets factor current macroeconomic conditions, and typical year-end seasonal strength, including an expected increase in back-to-school spending and year-end enterprise licensing strength. Total Adobe revenue of approximately $4.07 billion, digital Media segment revenue growth of approximately 20% year-over-year, net new digital media ARR, of approximately $550 million digital experienced segment revenue growth of approximately 22% year-over-year. Digital experienced subscription revenue growth of approximately 26% year-over-year, a tax rate of approximately 17% on a GAAP basis and 16% on a non-GAAP basis. the share count of approximately 480 million shares, GAAP earnings per share of approximately $2.52, and non-GAAP earnings per share of approximately $3.18. Given Adobe's year-to-date performance and our Q4, we are clearly on track to exceed our updated annual targets for fiscal 2021 provided in March. With the massive opportunities across creativity, digital documents, and customer experience management, we continue to invest and drive strong business results. I will now turn the call over to the operator to take your questions.
Operator: Thank you. [Operator Instructions].We'll take our first question from Alex Zukin with Wolfe Research.
Alex Zukin: Hey guys, thanks for taking the question. Maybe just -- can we double-click on the seasonality commentary in the quarter? Because if we look at the beat versus guidance on net new digital media ARR, it looks, at the same time you had the weakest beat, but then the strongest guide in the last three years, which kind of speaks to and confirm some of those seasonality comments that you made. But can we just dive in to get a better sense of exactly what drove that for the Creative Cloud business? And then separately, what you're seeing in the enterprise adoption, particularly around AEP and on the CDP front, that's driving some of the really strong guidance there.
Shantanu Narayen: Happy to do that, Alex. So first on your DME question, as it related to the ARR. Overall, we were pleased and I think it really speaks to the strength of our DDOM and the insights that we get associated with the business. I think going into the quarter, we had expected that the consumer with a little bit more return to normalcy as what's happening in the environment. Now, this may have been a little prior to the Delta Variant that we expected travel to increase and therefore, as a result, as summer seasonality and summer holidays was really sort of a two-year time off from what they had to do. So as expected, we saw a little bit of less web traffic on that particular front. The SMB was a highlight for us. SMB, which was impacted a little bit more we're continuing to see strengths associated with the SMB. And to your point about the guide I mean, I think our optimism and the relevance of our products and what's happening with digital as a tailwind really leads us to guide as you pointed out to 550, which would be the largest ever guide that we've given for a Q4. And if you take a step back relative to the approximately 1750 ARR guide that we had given at the beginning of the year, or the 1.8 billion that we've given in March we're going to exceed easily all of those numbers. So, as it relates to individual categories, imaging continues to do really well, video continues to do well, the Acrobat business, which is reflected both in the Creative Cloud, and the Document Cloud is doing well. MAX is going to be exciting. So, net-net, I would say that the growth prospects for that particular business and the growth drivers remain intact. But again, very much in line. And this is what we feel good about the insights that we're getting on the business. So that's to answer your question on DME. And again, remember, we have a seasonally strong quarter, in Q4 for DME, the enterprise deals tend to be a Q4. We also see education start to ramp up in Q4 so that hopefully gives you some color as to what happened in Q3. And what we expect in Q4. And on the DX side to your second question, really pleased with what we saw in the adoption of the Adobe Experience Platform and the applications on top of that, the Adobe Journey optimizer, the customer journey analytics, continued to see strength. I think we're very unique and differentiated in the platform that we have the real-time nature of what we're doing with personalization. And again there, I think if last year there was a lot of interest in that particular digital transformation and customer experience management. I think people recognize that this needs to be an enterprise spend priority for all of the businesses irrespective of size, which is why both in terms of Q3 performance as well as the Q4 targets, we continue to think that digital experience will also do well. So hopefully that gives you color on both Alex.
Alex Zukin: It does. Thanks. Thanks a lot, Shantanu.
Operator: We'll take our next question from Kirk Materne with Evercore ISI. Please go ahead.
Kirk Materne: Oh, yes. Thanks very much and congrats on the quarter. Shantanu, I was wondering if you could expand a little bit more in a couple of the bigger experienced platform wins that you had. These existing customers, competitive, I guess, if you had to step back, what's helping you all win these larger deals? I was also impressed with 80% of your clients seem to be using some of the ai powered capabilities, which seems to be a really high uptake rate or take rates. So, we're just kind of curious if you expand on some of the larger enterprises - experience platform deals you had this quarter. Thanks.
Shantanu Narayen: Sure Kirk and at the end of the day, I think the macro trend that everybody is finding is that a digital presence and commerce and data and insights and analytics is absolutely table stakes for anybody doing business. And so, I think everybody started with a website. Everybody started with the analytics. But I think where we've delivered the Adobe Experience platform and what we're talking about our personalization, I think that's a key differentiator and whether you're a B2B company or a B2C company, you just have to invest in this particular business and I think the team has done a particularly good job both of messaging and different industries, the healthcare industry, for example, continues to do well and there's more interest associated with that. The consumer businesses are starting to see a little bit of a comeback as there's a little bit more normalcy and so a lot of them -- we're going after existing customers. We're going after new logos and selling more, but I would say it's the strength of the Experience platform, the ability to have these profiles, the behavioral data they were collecting in real-time. The marketing message associated with telling them that they really need to focus on getting their first-party data to be an asset that they could put on their balance sheet. And the nature of what's happening with digital commerce. I think all of those are trends and then we win the deals, because of the strength of our offering and the fact that we're a really pure play marketing that is significantly differentiated relative to anybody else.
Operator: We'll take our next question from Gregg Moskowitz with Mizuho. Please go ahead.
Gregg Moskowitz: Thank you very much for taking the question. Shantanu, I know that you only have three-quarters of that data thus far, but is Workfront driving larger, average deal sizes in DX? Is that something that's already showing through?
Shantanu Narayen: Hi, it's a great question, Gregg. And then maybe as I had responded to Kirk as well, I should have talked about the big thing that we're hearing from our customers in that space, Gregg, is they have more and more campaigns. They want to do agility of the campaigns. These are global and how do they not only have an integrated suite of products, but how do they get the workflow to be more efficient, especially as you're all working in a hybrid, or working from the home environment. So Workfront is definitely helping us, it's helping us with existing customers, it's helping us with deal sizes. And in many ways, it's the glue both to enable, if you have people, technology, and processes, it's helping with the processes part. But the promise of what we've also said there in terms of this pioneering marketing system of record, that's another area for the interest. And I think this was always a great Company. I think they were looking to become more general purpose. I think what Anil and the team have done, or really focusing on marketing workflows and solving it for all of the different personas. That's definitely resonating, but all of the large deals that we do Workfront’s, definitely a part of the interest and a part of the bill of materials associated with that.
Gregg Moskowitz: Very helpful. Thank you very much.
Shantanu Narayen: Thanks, Gregg.
Operator: We Will take our next question from Keith Weiss with Morgan Stanley. Please go ahead.
Keith Weiss: Thank you, guys, for taking the question and very nice quarter and maybe digging in a little bit more on the M&A side of the equation, we've definitely heard really good things about Workfront are getting into a lot of deals upfront Perhaps, can you characterize the sort of the performance of Workfront versus your expectations and kind of contribution you're seeing in the quarter. Secondarily with Frame.io, Just for clarification, is that in the forward ARR guys, so is that included in the 550 for Q4? And then perhaps more broadly, just on M&A strategy. The last two big deals seem to have a common thread in terms of collaboration. Is that just a self-idealist putting together two data points and drawing the trend line, or is that sort of a particular area of focus for Adobe in terms of adding to the portfolio on a go-forward basis? Thank you, guys.
Shantanu Narayen: So, Keith, I actually think there were three questions in that, so let me parse each one of the first, I think as it relates to Workfront, we're very clearly targeting a need that exists and we had originally, I think said something like Workfront will do a 140. You're a 150 million in revenue for FY 21. And then I think we've said that it's on track to significantly beat that and that continues to be the case. As we do these larger deals, Keith, we don't breakout Workfront. And so that's the way we think about the business. But Workfront is definitely appealing to that. Your second question as it relates to two Frame.io. Uh, no, it is not in the ARR (ph.) guide. I mean clearly until we close the deal, we would not. And so, when that happens, as we said, we expect that to happen in Q4. We'll certainly update you on what happens as it relates to the frame. But we're excited about that and your third question as it relates to collaboration as a team, it's part of what we've been talking about for a while. If you remember what we've done with XD in terms of being able to do live editing. I think what we've done with the multi-surface applications, where our applications run on mobile devices, or iPads, or tablets, as well as desktops, is just one of those teams that people are working from different locations. People are increasingly working with people, and so I think we have the ability to really provide value for our existing customers and attract new customers. I think with a frame, in particular, we're excited because it expands dramatically. The potential of the number of people who will become participants in the video workflow. And if they become, I hope you like the videos that we placed at the beginning of the earnings call and it's -- all of that stuff is being done remotely. We're pleased. And as you know, we are always portfolio Keith about the acquisitions and making sure it's a case where we can bring significant value both to our shareholders and to our customers.
Keith Weiss: That spend especially the color guys.
Shantanu Narayen: Thank you.
Operator: We'll take our next question from Michael Turin with Wells Fargo Securities. Please go ahead.
Michael Turrin: Hey, there. Good afternoon. Thanks for taking the questions. On margins -- in the year-to-date, margins are now above 46%. I think you previously referenced the potential for more of a second-half step-down there, so just - how should we think about the margin profile here in our other benefits, you'd point to that could be normalized assuming more of a return to normal.
Shantanu Narayen: John, do you want to start and then I can add?
John Murphy: Yeah, that'd be great. Yeah. You're right. The margins at 46% this quarter we had indicated that with the more of a reopening across different regions, we would start to see our facilities come online, or business. travel, and come back and certainly continue our hiring ramps with the Delta Variant probably slowed that down a little bit. And so that contributed to the margin expansion you saw in Q3. But the overall was an outstanding quarter for older businesses. and what it says, the long road, the path to margin expansion is really to revenue growth given the leverage in our mode and after the contributions from the revenue performance with quarter continued expense and things, I just talked about that contributed overall to the performance. But we expect those expenses to come back in a Phase reentering out maybe a little slower than we originally thought when we talked about the second half, but that being said, when I think about our original targets in December, its implied margin expansion. When we did our updated targets in Q1, it was an even larger margin expansion from what we saw. But we're executing against these huge March opportunities, and we'll continue to do that with an eye and I continued top-line growth, such as areas of [Indiscernible] you touched on, which is 3D and immersive Adobe Experience Platform, sign stock mobile, all of that.
Shantanu Narayen: Well said, John, and maybe the only other thing I would add is that in I - certainly, I think when you look at some of the TENEO facilities expenses, it's a little lock efficient in terms of what's happening on expenses. But our big position is when you have a 100 and plus billion-dollar addressable market, I think driving profitable growth is where we're focused on, which is why I think John also referred to we continue to be in the market to hire talent, to make sure that we can continue to address all the market opportunities that we have. And so, where folks, just don't drive profitable growth.
Operator: Thank you. We'll take our next question from Jay Vleeschhouwer with Griffin Securities, please go ahead.
Jay Vleeschhouwer: Thank you. Good evening. Shantanu and John. Shantanu, for you, first as I'm sure you recall over the last number of years, particularly at a conference like MAX, we've talked about the integration, and many ways, the unique integration that you have between Digital Media and the DX business. and you'll recall it's gone by a certain acronym over time. The question is, can you quantify or in some way. Describe the business effect of that combination and even going back to the old days of how this neutrality does in fact, help you drive business through the integration across the two segments. Relatedly, with regard to. DX specifically, you'll recall that over the last number of years, the Company has often referred to you're having about four dozen or so use cases that you were targeting for DX, and that was a number of years ago. So perhaps you could talk about how the number of targeted use cases has increased for DX in the last number of years, particularly now with the introduction of payment services and other new capabilities.
Shantanu Narayen: Sure, Jay, first I think as it relates to your question around the integration between the clouds, as you know, first, let's even talk about Acrobat, right? Because so much of the Acrobat business is reflected both in Creative Cloud and Document Cloud and so that's one very tangible example of how. We've integrated the clouds. I think taking a step back, the area that I would say is of most interest to customers right now is what we have referred to in the past also as content velocity, which is people are creating more digital assets. They're spending more on content and how they both ensured that all of that content seamlessly is distributed, whether it's a marketing campaign, whether it's something that goes on a mobile application, whether it's something that goes on the website. And so, I think that's the hard problem that we've been able to help facilitate for our customers, which is creating all of this content and making sure that it's -- the delivery is accelerated through marketing campaigns is an area of real integration between DME, as well as Dx. And where that shows up also in the revenue is the continued growth of M and M assets, specifically because that's where the assets are really flowing between these two solutions. So hopefully that gives you a little bit of the flavor. I think to the earlier questions that Gregg and Kurt had asked. I mean, it is also on the workflow, that's when people are looking at it and saying, wow, if my freelancers have created content, how's that now being reflected in the DX. So that's what I would answer your first question. I think as it relates to the DX use cases, and we should certainly do an update, it's increased very dramatically. And the ones that I would say maybe as a highlight is the B2B use cases, the number of large B2B companies that are coming to us and saying, ''Hey, we recognize that whether it's for lead generation, whether it's for identification of customers, whether it's for even doing commerce, that's been a fairly big driver. '' I would say regulated industries, which if the original push around customer experience management was B2C, and consumer-base companies. Now I think you're seeing way more of those workflows and use cases and in regulated industries, so that's another one that I would do. I would say the global aspect of this, which is you have companies. Whether you're an automotive Company, or you're a fast-food Company and you want to do this Globally, I think that's a use-case that we've seen a fairly dramatic increase, but so hopefully that gives you one. And then this is where the partner ecosystem candidly also is driving so much more. And so, the partner ecosystem is also building a lot of their value-added solutions on top of our horizontal platform. So-net I would say doesn't matter what business you are, what size you are. Part of DX is relevant to what you need to do in order to engage with your customers.
Jay Vleeschhouwer: Thank you very much.
Operator: We'll take our next question from Saket Kalia with Barclays. please go ahead.
Saket Kalia: Okay. Great. Hey guys. Thanks for taking my question here. John may be for you just to -- maybe just to switch gears a bit. I was wondering if you could just talk about seasonality in the Document Cloud business specifically? I think the net new ARR there has historically sort of been up into the right through the year. I guess the question is, are we getting to point in that business where the seasonality could start to look a little bit more like Creative, or are there any things to maybe consider for Document Cloud ARR seasonality this quarter?
John Murphy: When we look -- think about the situation we've been in the pandemic and the need for more paper to digital transformation that's impacting, not just enterprises and institutions that have obviously you've seen great growth in, but individuals as well as they're engaging with the services that they use. As we said, I think when you look at the individual offerings that we have across Creative and Document Cloud, we just saw a little bit lower-traffic there, but that's associated where we believe with individuals enjoying our holidays and its pretty indicative using our own Adobe Digital Index data. That's. So, the gyms a lot over the highest travel months in two years. So that seasonality is hitting it a little bit, but again, we've got such a strong presence in both institutions, education, all the governments, and enterprises on Document Cloud that we still see great growth and strengthening. It's demonstrated and just the continued growth to that business, which is our fastest-growing business right now.
Saket Kalia: Very helpful. Thanks.
John Murphy: Thanks, Saket.
Operator: We'll take our next question from Ken Wong with Guggenheim Securities Please go ahead.
Ken Wong: Great. Thank you for taking my question. This one is for you Shantanu. You guys have a history of bringing your professional tool down to the consumer, you had light edition, you have mobile editions. I think in your prepared remarks, you mentioned the addition of Frame.io, creating additional opportunities the sort of across the customer base, teams, and enterprises, I guess do you envision this as a platform that could be brought down to Consumer prosumers? Or is it still a man (ph.) they going to be in that professional bucket?
Shantanu Narayen: Ken? It's a very important area of expansion for us. I mean, I think the Creative has always been a segment that looks to us to deliver mission-critical products that enable them to make a livelihood. But the halo effect of that, when you look at what we talked about at our analyst meetings and you know, how big is communicated business already is as well as the outreach of that even into the consumer business. But stay tuned on that front. I think as we talk about our product roadmap and the excitement that we have to fulfill this vision of creativity for all and target a broader and broader and broader set of customers with some great solutions using our artificial intelligence and Sensei technology, we have some very exciting things underway. That will start to be served to customers. So, we're very excited about that opportunity, it's a big opportunity. It's already a big business for us. I mean, when we talk about the fact that we're adding over 0.5 billion of net new ARR as our expectation for Q4. A portion of that is also going to what you would call communicators or prosumers. And we're going to be delivering more and more really phenomenal products, targeted at that customer segment.
Ken Wong: Got it. Fantastic. Looking forward to MAX. Thanks, guys.
Shantanu Narayen: Thank you.
Operator: We'll take our next question from Kash Rangan with Goldman Sachs, please go ahead.
Kash Rangan: Thank you very much. Congratulations Shantanu and team, a fantastic quarter. Shantanu, I remember, I think what's the MAX 2019 we talked about video and how that could be as big of an opportunity as photos and I'm curious to get your thoughts on the total available market that is new and incremental to Adobe's Creative business as a result of the acquisition that you made afraid Particularly you used the word dramatically expansive scope of what you could do, meaning collaborators in addition to content creators, can you just talk about what you mean by that, you can just put a final point. This is means that the greatest term will be then, what Wall Street thinks we just always been the case for the past ten years or so. And secondly, not that it's a negative, but what would the seasonal pattern and in summer joined some side of activity where people don't vacation, et cetera. Is there at all any risk that digital transformation takes a bit of a backseat as we go shopping, not online, they will go to stores, therefore, e-commerce activity might actually start out on it, but the secular trend is too pretty solid. But jumps on the adjustment have reinforced some adjustment or maybe not, but I just want to get your thoughts on that, Thank you so much.
Shantanu Narayen: Thanks, Kash, I mean, as it relates to your first question around video, I think we've been signaling for a while that video is really one of the exciting expansion opportunities for us and that's really played out. It's played out from the products that we've delivered. Premier and after effects continuing to be the leaders in that category, sadly Photoshop and illustrator used a lot. But if you look at what's happening with all these streaming plus services, right? I mean, there isn't a Company that isn't delivering streaming plus service. And so, I think the insatiable demand for video among consumers is only requiring more and more companies to have these streaming services and deliver more genre as it relates to video. All of that works right now, I mean, we talked a little bit about what we're doing as a partnership with Netflix as well. All of that is happening now with people in different locations through a collaborative process. So anytime you can take a creative. idea and make that happen quicker, faster to the right audience. That's only going to be incredibly valuable to our customers. And so, I think that trend is only going to continue. And so, we feel really good about what's happening in that particular space with the video frame, we used to use frame-up. A bunch in the production of our own videos and it's been exciting as we've talked to different people who after the acquisition of frame have come and said; Hey, Adobe, that's such a great product, but we think we can do more with it. So, I think that gives us a lot of optimism around whether it's the scriptwriter, whether it's, the reviewer of that, whether it's a creative agency, just being able to or all the corporate videos that's being done. And so certainly, I think as you add that as enterprise product as well, you can certainly get a lot more TAM associated with it. We will update our TAM's cash as we typically do. I think Jonathan referred or will talk about how we do our Q4 as well as our 2022. And we'll talk to you about terms on that front, but really excited about that. I think the external partnerships that exist for the frame and how it's plugged in, not just to the Adobe solutions, but other solutions are also an area of strength. And I think to your second question around shopping and online when we look at our DX business and the success that we had in Q3. I mean, a big part of that is more and more companies are thirdly doing the multi-channel omnichannel, whatever they want to call it. And I think that's only going to continue to be a driver of our Digital Experience Solutions. Because today that stable stakes and so we just look at it and say whether you're shopping in-store over they are shopping online. You need a solution that treats you like a customer that we know of. And so, I think that's going to only be an imperative for companies. I mean, one thing we should have probably talked about also is if you look at our Q3 results. I mean, there were stronger than what we had said. There were a couple of non-recurring items as part of that and some of that actually had to do with usage in commerce. And so, we are seeing that usage also ramp up. So, I just wanted to get that. Also, are there as we talked about shopping online and shopping in a store. And in terms of the demand for our DME solutions, we expect as -- as we said, the seasonal Q4 will be the strength and as education comes back and there's more and more end of the quarter activity, not just within the Adobe, but all companies. That's going to lead to increased demand and acceleration.
Kash Rangan: That's fantastic. Thank you so much.
Shantanu Narayen: Thanks. Ken.
Operator: We'll take our next question from Derrick Wood with Cowen and Company. Please go ahead.
Derrick Wood: Thanks for taking my question, John, I wanted to come back to the Document Cloud business. Because it looks, perhaps, to me, that there was some outside strength from licensed products that may have been in lieu of revenue coming from ARR products. and I think you can see this with total Document Cloud revenue growth actually accelerating even though total ARR growth decelerated. So is that the right assessment and we'd be looking at total revenue, not ARR and I guess. So, is there any reason for a mix shift towards more licensed products and as you look into Q4, given it's a big ELA, quarter, should we expect that to continue?
John Murphy: Yes. No. I mean, we -- well, certainly, yeah. You're going to see strength in ELA as [Indiscernible] and I spoke of in terms of Q4, just to see the expansion in Q3 as well. But we still migrate basic customers as well. So ARR is still going to be important for us and where you want to drive more ARR. I think those strengthen our growth, frankly, over the last -- over a year really has been really impressive. It's always going to give us this opportunity, to drive healthy subscription growth. But LA is not going to give us outsized revenue in Q4, it's going to be a sizable contribution, but we're driving subscriptions and that's, that's a strategy. And we do still have customers that buy perpetual, and so it will be some fluctuations in that.
Derrick Wood: Yes. Got it. Okay. Thanks.
Operator: We'll take our next question from Parker Lane with Stifel. Please go ahead.
Parker Lane: Hi, thanks for taking my question, Sean, I was wondering if you could talk about the nature of Creative wins in the public sector with organizations like the Department of Interior, what do these types of organizations historically relied upon for Creative needs and hopefully, they're embracing the features of the Creative Cloud versus using maybe a particular application like Photoshop or a distinct set of applications. Thanks.
Shantanu Narayen: To your point, I think the public sector has always been an important part, but I think it's just the amount of content that people are creating is increasing. And when the amount of content that people are creating, then content management becomes an important issue. Workflow becomes an important issue. And the standardization of the products. And one of the things we did really well is what we called our named user deployment and how, you know, when we have these enterprise licensing agreements, we offer enterprises the ability to download and distribute within the companies. And the more we do training and evangelism of the products, that leads to adoption. So, I would say there's an element of standardization, there's an element of more content. I mean, even if you're a public sector Company right now, I mean, what you transact online is becoming dramatically greater than it's ever been because the physical presence is seeing cutback as a result of what's happened in the pandemic. I think all of those are macro trends that are going to continue, but we've also done a really good job of actively making sure we evangelize what these solutions are. Good fall, we do more training within these enterprises. We allow these named user deployments, as I said, with ten leads to true. Well, ups and the ability to get them into a higher band. So, I think the execution on the sales front associated with going into these enterprises, that's getting better and better.
Parker Lane: Great feedback. Thank you.
Jonathan Vaas: Operator. We're coming up on the top of the hour. We have time for two more questions. Thanks.
Operator: Thank you. We'll take our second last question from Brad Sills, Bank of America Securities.
Brad Sills: Great. Thanks, guys for taking my question here. Just with your view across the broader marketing stack here with Experience Cloud. I'm curious what you're observing with regard to these Customer 360 initiatives. Are you finding customers are taking more of multiproduct deals here to get that view across multiple channels here, e-commerce, marketing automation, CMS? You've got workflow automation in there. Are there any combinations of any of that that you're seeing trending more recently, been in the past? Thank you so much.
Shantanu Narayen: It clearly has been a push for us, Brad, in terms of, you know, what we're doing, which is how do we sell the entire suite offering? And I think every year we give you an update on how. That is actually indeed, how we are selling it. And so, from our perspective, the marketing stack, what's completely unique about us, is the data and insights that we're getting, the ability to do commerce, and the digital presence. I think as it relates to customers, we have 60 waivers unique and I think we're years ahead of it. Any other large Company that has space is this real-time nature of what we've delivered, it's scalable, we've got billions of profiles. And so, I think a lot of other companies are talking about how they take something that may be in the record somewhere and do things with it. But for us, it's the activation of that data. And that's where I think most people are really excited about what Adobe has to offer. And the other thing that I think is really happened, is people recognize that they have to get control of their first-party data. I think a lot of interest used to exist about customer acquisition and third-party data. But I think right. Now it's about dupi have even control of our first-party data. Do we have control of our behavior? And what is happening on multiple channels? And the fact that that can be very easily answered as it relates to what we have done with the Adobe Experience Platform. Last but not least. I mean, remember we're the only Company that can go in. And say, hey, we have a B2B business and a B2C business. And when we talk about how we're using this in terms of the playbook on Adobe.com, I think that really opens up a lot of people's ideas as to how they can use this and utilize it. And so, I think the playbook that we delivered for D dom earlier this year and how we talk about what they can do. I think that's what -- that really resonates with customers.
Brad Sills: That's great to hear. Thanks, Jonathan.
Shantanu Narayen: Thank you.
Operator: We'll take our final question from Brent Thill with Jefferies. Please go ahead.
Brent Thill: Shantanu, the DX DRaaS accelerating from Q2. Can you just walk through the drivers of what you're seeing in terms of that acceleration? And maybe for John, just as it relates to seasonality with Magento and commerce in the Q4, anything to keep in mind there as you just feel like this -- to keep powering through the tougher comps given -- given the [Indiscernible] you're seeing in that business. Thanks.
Shantanu Narayen: Brian, I think what really drove that revenue was both subscriptions as well as the services. As you know, the services, were again, really reliant on a large partner ecosystem. But if over the last 18 months. As we've always talked about, the interest is high. How they are all implementing it. And so as they continue to implement it, and as they continue to say, we need to invest in these solutions, I think that's driving it, and I think to your point, if you take a step back, we -- I think guided to something like 19% revenue at the beginning of the year, and 22% in subscriptions, we had increased that in March, 22023 respectively, and we just posted 2629 and so and if you look at it for Q4 as well as you point out with the large comps, we continue to be excited about that opportunity. So, I think there is. This is a front-end center, it's an enterprise priority. And I think since people are staying, we've got to deal with this new reality, there's no time to waste in terms of implementing it. Again, there were, as we said, a couple of non-recurring items. some of those had to do with usage in commerce and that actually is also indicative that maybe a little bit more depends on the quarter, but it's up to the right as far as we're concerned in terms of the business opportunity in the business.
Brent Thill: Thank you.
John Murphy: Go ahead.
Shantanu Narayen: No, go ahead. Sorry, Jonathan, I didn't hear you.
John Murphy: Yeah, no problem. Just going to just kind of over the top on Brent's question on seasonality-related commerce, of course, in Q4 as a strong commerce quarter anyway. Given the holidays, spending trend. And so, we're excited about the opportunity there as well, it's just trying to set us up into the right, I think we have great momentum.
Shantanu Narayen: And overall, since that was the last question, I mean, again, I think we were really pleased with our performance in Q3. We do expect a strong end of the year for our business. As you saw from our targets, it's clear that your win, this unique position that we have three large growth opportunities ahead of us and we're executing well against all three of those and the innovation and the roadmap that exists across all three of those clouds just gives us continued optimism that we will serve our customers well and we feel fortunate. I think the future of work and the fact that it's more hybrid will only continue to emphasize digital as a priority for companies of every size. And so, whether that's an increase in content for personalization, whether that's more automation of digital documents, and whether that's every business thing we need to understand how to do customer experience management. I believe Adobe is very unique. We position to drive those particular macroeconomic trends. But thank you for joining us today, we look forward to the max, as well as the Q4 earnings call. And with that, I will turn it back over to Jonathan.
Jonathan Vaas: Thanks, Jonathan here. And thanks to everyone for joining us on the call today. As we mentioned in the press. Released today, we look forward to connecting with you again on Thursday, December 16th, for our Q4 earnings and virtual financial analyst day, we will be sending out more details in the coming weeks. And if you have any questions, feel free to contact us at ir@adobe.com, I look forward to speaking with many of you soon, and we appreciate your interest in Adobe, this concludes the call. | [
{
"speaker": "Operator",
"text": "Today's call is being recorded. At this time, I'll turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon. And thank you for joining us. With me on the call, today are Shantanu Narayen, Adobe's President and CEO, and John Murphy, Executive Vice President, and CFO. On this call, which is being recorded, we will discuss Adobe's Third Quarter fiscal year 2021 financial results. You can find our Q3 press release, as well as PDFs of our prepared remarks. And financial results on Adobe's Investor Relations website. The information discussed in this call, including our financial targets and product plans, is as of today, September 21st, and contains forward-looking statements that involve risks, uncertainties, and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today's press release and in Adobe's SEC filings. On this call, we will discuss GAAP and non - GAAP financial measures. Reconciliations between the two are available in our earnings release and on Adobe's Investor Relations website, I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon. I hope you are all staying safe and healthy. Adobe had another outstanding quarter as people across the globe continue to embrace new ways of storytelling, learning, and customer engagement in our digital-first environment. This quarter we delivered significant new product innovations, announced the exciting acquisition of frame.IO and continued to increase customer engagement across an ever-expanding customer base. We're executing on our strategy of unleashing creativity for all accelerating document productivity and powering digital businesses as reflected in our strong performance. In Q3, Adobe achieved 3.94 billion in revenue, representing 22% year-over-year growth. GAAP earnings per share for the quarter were $2.52 and non-GAAP earnings per share were $3.11. In Q3, we drove record performance in our Digital Media business, achieving 2.87 billion in revenue, representing 23% year-over-year growth. Net new digital media, annualized recurring revenue, or ARR, was 455 million and total Digital Media ARR exiting Q3 grew to 11.67 billion. Creativity has always played a central role in the human experience. Over the last year, we have all witnessed the way creativity has sustained us. We've shared photographs with loved ones on different continents. Taught art classes to students at their kitchen tables, and launched entirely new businesses online. Building on decades of leadership, Adobe continues to pave the way in core creative categories, including photography and design. while pushing the boundaries across a wide range of emerging categories, such as AR and 3D. Whether it's the latest binge-worthy streaming plus series, a social media video that sparks a movement, or a corporate video, creation and consumption of video is experiencing explosive growth. In August, we announced an agreement to acquire frame.io, a leading cloud-based video collaboration platform. Video editing is rarely a solo activity, and it's traditionally been highly inefficient. Frame.io streamlines the video production process by enabling editors and key projects stakeholders to seamlessly collaborate using cloud-first workflows. The combination of our leading video editing offerings, including Photoshop, Premiere Pro, and after-effects with frame.io’s cloud-based review and approval functionality will radically accelerate the creative process and deliver an end-to-end video platform. The addition of frame.io creates an opportunity for Adobe in conjunction with the partner ecosystem to expand beyond video editors to a broader set of customers, teams, and enterprises. We hope to close the frame.io transaction in Q4 and look forward to welcoming the team to Adobe. Next month, we will host Adobe MAX, the world's largest creativity conference. Max has always been the place to be inspired, connect with the creative community and experience the latest Creative Cloud innovations. Our programming will feature iconic speakers, including Oscar-winning winning writer, director, producer Chloe Zhao, actress Tilda Swinton, and SNL star and executive producer Kenan Thompson. This year's fully digital experience allows us to expand our reach and engage with more people across our global creative community than ever before. Max will be hosted on Adobe’s custom digital event platform built on Adobe Experience Cloud. In Q3, we achieved Creative revenue of 2.37 billion with strong new user acquisition, engagement, and renewal across all creative products and geographies with particular strength in our Creative Cloud for Teams offering. Q3 Creative Cloud highlights include innovative enhancements to our photography offerings, including new services and AI-driven capabilities in Lightroom, Creative Cloud applications now running natively on Apple's new silicon M1 chip, Delivering a boost in performance. The release of Adobe substance 3D collection, a suite of interoperable tools and services that support 3D creativity. Partnerships, such as The Great Untold with Netflix, enabling next-gen creators to tell their stories. And key customer wins at the department of education of the Philippines, Facebook, Nike, Rutgers University and the U.S. Department of the Interior. Document Cloud is accelerating Document productivity by powering the paper to digital revolution and enabling all Document actions to be frictionless across the web, desktop, and mobile. From complex legal documents to sales contracts to employee welcome kits documents are at the core of work. Using the power AI with Adobe Sensei, Document Cloud is automating workflows and adding new value across all Document verbs. In Q3 document, cloud achieved record revenue of $493 million, growing 31% year-over-year., Driving this performance was increased unit demand for acrobat subscriptions globally, and strength in the SMB segments. Q3 Document Cloud highlights include continued adoption of Adobe Sign and Acrobat with transactions growing over Ten-X in the last three years. Growth across Acrobat web and frictionless PDF, which optimize the customer journey and capture organic search-driven demand. Increased adoption and usage of mobile applications, including Acrobat, scan, and sign with over 100 million monthly active users; proliferation of liquid mode and adaptive and responsive mobile experience with over 300 million PDF files, we flowed in the last year. Key customer wins at Daimler AG, Fujifilm, Micron, and PwC. Businesses of every size across every category are investing in customer experience management. Adobe Experience Cloud is powering CXM for B2B and B2C companies with applications focused on customer journey management, data insights and audiences, content, and personalization, commerce, and marketing workflows. Adobe experience cloud empowers companies to deliver predictive, personalized, real-time digital experiences across every touchpoint of the customer lifecycle. In the digital economy, companies are relying on digital presence and commerce as the dominant channel to drive business growth. According to the Adobe digital economy index, U.S. consumers spent over 541 billion in e-commerce from January through August. 58% more than what we saw two years ago. In Q3, we delivered Experience Cloud revenue of 985 million driven by strong performance across both subscription and professional services. Q3 subscription revenue was 864 million, representing 29% year-over-year growth. As businesses reopened around the world, interest in Adobe CXM solutions as an enterprise priority is resulting in increased spending in both software and services. Q3 Experience Cloud highlights include product innovations, including new personalization capabilities in Adobe Experience Cloud to help customers move from third-party cookies to first-party data strategies. Workfront momentum, reflecting the need for workflow and collaboration to deliver global campaigns, and growing customer interest in our pioneering marketing system of record. Key partnerships in commerce with Walmart to integrate their omnichannel fulfillment technologies. And with PayPal to offer a robust, secure, and integrated payment solution for companies of all sizes. Continued industry analysts’ recognition, including being recognized as a leader in the Forester Wave. Digital experienced platforms and achieving the highest score of all participating vendors for current offering. Adobe was also named a leader in the 2021 Gartner Magic Quadrant for personalization engines and a leader in the Gartner Magic Quadrant for digital commerce. Strong customer adoption of Adobe Sensei-powered capabilities in the Adobe Experience Cloud as over 80% of customers now rely on our AI-powered capabilities. To drive data insights and optimization. Key customer wins at Accor, the Australian government, Bertelsmann, Capital One, CVS Pharmacy, Daimler AG, Facebook, Ford Motor Company, Fidelity Brokerage Services, Honeywell, Real Madrid, and the GAAP. Adobe strength has always come from our most important asset, our people. We want to thank our 25000-plus employees for their dedication and resilience. Our customers and partners for their trust, as we continue to navigate a dynamic external environment. I'm proud of the continued industry recognition we received as a great and equitable place to work. This quarter, Adobe received a 100% score on the Disability Equality index for Best Places to Work for disability inclusion. And we were named to people magazines, companies that carrier list for the fifth consecutive. Toby here. Last week we held our Adobe for all virtual conference designed to bring employees together around our shared values of diversity, equity, and inclusion. As part of that event, we reaffirmed pay parity. We continue to pioneer opportunity parity to ensure that employees are offered equal career development and growth across all demographic groups. As part of our ongoing efforts to bring in more diverse talent, Adobe has established partnerships with historically black colleges and universities and Hispanic serving institutions. This new program offers a million dollars donation to schools, scholarships, internships, and Korea readiness programs. Our goal with these deeply focused partnerships is to provide opportunities for students to learn technology and creative skills. The health and safety of our employees remain our top priority. Our offices are slowly reopening to fully vaccinated employees on a voluntary basis. As we look ahead to the future of work in Adobe, we will remain hybrid and flexible and continue to do what's best for our employees and our business. I'm confident that Adobe's culture of innovation, category-defining products, strong brand, and the unwavering dedication of our employees will drive our continued business success and a strong close to the fiscal year. John."
},
{
"speaker": "John Murphy",
"text": "Thanks, Shantanu. Our financial results, future strong growth across revenue, Digital Media, ARR, digital experience, subscription revenue, RPO, and EPS, demonstrating the power of our category-defining offerings. And a digital-first world, Adobe's market opportunity is larger than ever, and we are investing for sustained growth through product innovation and by driving awareness and demand for our products with customers of all sizes. With our data-driven operating model or DDOM, we continue to leverage our Experience Cloud technology to create personalized experiences for our customers in real-time. Driving traffic to Adobe.com and app stores to acquire new customers. As a result, in Q3, Adobe achieved a record revenue of 3.94 billion, which represents 22% year-over-year growth. Business and financial highlights included GAAP diluted earnings per share of $2.52 and non-GAAP diluted earnings per share of $3.11. Digital media revenue of $2.87 billion, net new Digital Media ARR of 455 million digital experience revenue of 985 million, cash flows from operations of 1.42 billion, RPO of 12.63 billion exiting the quarter, and repurchasing approximately 1.7 million shares of our stock during the quarter. In our Digital Media segment, we achieved 23% year-over-year growth in Q3 and we exited the quarter with 11.67 billion of Digital Media ARR. As anticipated, with regions beginning to reopen across the globe. We saw pronounced summer seasonality in Q3. This is consistent with the experience of businesses across industries, as evidenced by data from the Adobe digital index, which showed that June and July marked the highest consumer travel season in two years. This correlated with lower web traffic while individuals enjoyed their summer holidays. We do see continued recovery in the SMB segment associated with the reopening. We achieved Creative revenue of 2.37 billion, which represents 21% year-over-year growth. And we added 348 million of net new Creative ARR. Our strong Q3 results demonstrate continued demand for our offerings and execution driven by our D - Dominant (ph)t sights. Third Quarter creative growth drivers included strong engagement, retention, and renewal across all creative products and customer segments. New user acquisition for Creative Cloud All Apps that driven by global marketing campaigns. Continued recovery in the SMB segment with our Creative Cloud for Teams offering, including through our reseller channel. Driving subscriptions for our flagship products, including our photography and video applications on both desktop and mobile. And the adoption of our 3D and immersive applications, including Adobe substance. Adobe achieved Document Cloud revenue of 493 million, which represents 31% year-over-year. growth. And we added $107 million of net new Document Cloud ARR in the quarter. Digital documents are essential to the changing nature of work, and we saw the paper to digital transformation continue in Q3 as Document Cloud remained our fastest-growing business. Third-quarter Document Cloud growth drivers included adoption driven by the increase in the need to collaborate and a hybrid work environment. Increasing unit demand for Acrobat subscriptions globally strengthened new licensing and renewal for our Acrobat for teams offering in the SMB segment and continued adoption of our Acrobat web and the Acrobat mobile offerings. Turning to our Digital Experience segment in Q3, we achieved revenue of $985 million, which represents 26% year-over-year growth. Digital experience subscription revenue was 864 million, representing 29% year-over-year growth. We continue to see subscription revenue acceleration in digital experience as large and mid-sized enterprises increased their investments in customer experience management. Business performance and digital experience during the quarter were driven by strong deal volume, including several large Adobe Experience platform deals. Momentum in Adobe commerce with strong revenue growth and new customer acquisition. Merchant services growth through new strategic partnerships, increasing adoption of our Workfront and Customer Journey Management offerings. Strong customer retention as we focus relentlessly, a value realization for our customers and demand for Adobe's professional services. Operating expenses increased in Q3 as we continue to make strategic investments and increased headcount. We began to reopen our facilities and return to moderate levels of business travel. The majority of our employees continue to work from home, while the return to business travel is expected to ramp slowly. And we expect to further ramp our hiring in Q4. From a quarter-over-quarter currency perspective, the impact of FX net of accounting for hedging activities caused a sequential currency increase to revenue of $10 million. From a year-over-year currency perspective, the impact of FX net of accounting for hedging activities caused the currency increase to revenue of $80 million. Adobe's effective tax rate in Q3 was 14.5% on a GAAP basis and 16% on a non-GAAP basis. The sequential reduction in our GAAP tax rate is primarily due to a decrease in U.S. tax accrued on foreign earnings and tax benefits associated with share-based payment. That's our trade DSO was 36 days, which compares to 37 days in the year-ago quarter and 35 days last quarter. RPO grew by 22% year-over-year to 12.63 billion exiting Q3 benefiting from strong enterprise licensing during the quarter. Our ending cash and short-term investment position exiting Q3 was 6.16 billion cash flow from operations in Q3 were 1.42 billion sequentially down from Q2 due to increases in prepaid expenses, income tax payments, and a decrease in accrued expenses. We repurchased approximately 1.7 million shares in the quarter at a cost of $1 billion. We currently have $14.1 billion remaining of our $15 billion authority granted in December 2020, Q4 targets factor current macroeconomic conditions, and typical year-end seasonal strength, including an expected increase in back-to-school spending and year-end enterprise licensing strength. Total Adobe revenue of approximately $4.07 billion, digital Media segment revenue growth of approximately 20% year-over-year, net new digital media ARR, of approximately $550 million digital experienced segment revenue growth of approximately 22% year-over-year. Digital experienced subscription revenue growth of approximately 26% year-over-year, a tax rate of approximately 17% on a GAAP basis and 16% on a non-GAAP basis. the share count of approximately 480 million shares, GAAP earnings per share of approximately $2.52, and non-GAAP earnings per share of approximately $3.18. Given Adobe's year-to-date performance and our Q4, we are clearly on track to exceed our updated annual targets for fiscal 2021 provided in March. With the massive opportunities across creativity, digital documents, and customer experience management, we continue to invest and drive strong business results. I will now turn the call over to the operator to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions].We'll take our first question from Alex Zukin with Wolfe Research."
},
{
"speaker": "Alex Zukin",
"text": "Hey guys, thanks for taking the question. Maybe just -- can we double-click on the seasonality commentary in the quarter? Because if we look at the beat versus guidance on net new digital media ARR, it looks, at the same time you had the weakest beat, but then the strongest guide in the last three years, which kind of speaks to and confirm some of those seasonality comments that you made. But can we just dive in to get a better sense of exactly what drove that for the Creative Cloud business? And then separately, what you're seeing in the enterprise adoption, particularly around AEP and on the CDP front, that's driving some of the really strong guidance there."
},
{
"speaker": "Shantanu Narayen",
"text": "Happy to do that, Alex. So first on your DME question, as it related to the ARR. Overall, we were pleased and I think it really speaks to the strength of our DDOM and the insights that we get associated with the business. I think going into the quarter, we had expected that the consumer with a little bit more return to normalcy as what's happening in the environment. Now, this may have been a little prior to the Delta Variant that we expected travel to increase and therefore, as a result, as summer seasonality and summer holidays was really sort of a two-year time off from what they had to do. So as expected, we saw a little bit of less web traffic on that particular front. The SMB was a highlight for us. SMB, which was impacted a little bit more we're continuing to see strengths associated with the SMB. And to your point about the guide I mean, I think our optimism and the relevance of our products and what's happening with digital as a tailwind really leads us to guide as you pointed out to 550, which would be the largest ever guide that we've given for a Q4. And if you take a step back relative to the approximately 1750 ARR guide that we had given at the beginning of the year, or the 1.8 billion that we've given in March we're going to exceed easily all of those numbers. So, as it relates to individual categories, imaging continues to do really well, video continues to do well, the Acrobat business, which is reflected both in the Creative Cloud, and the Document Cloud is doing well. MAX is going to be exciting. So, net-net, I would say that the growth prospects for that particular business and the growth drivers remain intact. But again, very much in line. And this is what we feel good about the insights that we're getting on the business. So that's to answer your question on DME. And again, remember, we have a seasonally strong quarter, in Q4 for DME, the enterprise deals tend to be a Q4. We also see education start to ramp up in Q4 so that hopefully gives you some color as to what happened in Q3. And what we expect in Q4. And on the DX side to your second question, really pleased with what we saw in the adoption of the Adobe Experience Platform and the applications on top of that, the Adobe Journey optimizer, the customer journey analytics, continued to see strength. I think we're very unique and differentiated in the platform that we have the real-time nature of what we're doing with personalization. And again there, I think if last year there was a lot of interest in that particular digital transformation and customer experience management. I think people recognize that this needs to be an enterprise spend priority for all of the businesses irrespective of size, which is why both in terms of Q3 performance as well as the Q4 targets, we continue to think that digital experience will also do well. So hopefully that gives you color on both Alex."
},
{
"speaker": "Alex Zukin",
"text": "It does. Thanks. Thanks a lot, Shantanu."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Kirk Materne with Evercore ISI. Please go ahead."
},
{
"speaker": "Kirk Materne",
"text": "Oh, yes. Thanks very much and congrats on the quarter. Shantanu, I was wondering if you could expand a little bit more in a couple of the bigger experienced platform wins that you had. These existing customers, competitive, I guess, if you had to step back, what's helping you all win these larger deals? I was also impressed with 80% of your clients seem to be using some of the ai powered capabilities, which seems to be a really high uptake rate or take rates. So, we're just kind of curious if you expand on some of the larger enterprises - experience platform deals you had this quarter. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Sure Kirk and at the end of the day, I think the macro trend that everybody is finding is that a digital presence and commerce and data and insights and analytics is absolutely table stakes for anybody doing business. And so, I think everybody started with a website. Everybody started with the analytics. But I think where we've delivered the Adobe Experience platform and what we're talking about our personalization, I think that's a key differentiator and whether you're a B2B company or a B2C company, you just have to invest in this particular business and I think the team has done a particularly good job both of messaging and different industries, the healthcare industry, for example, continues to do well and there's more interest associated with that. The consumer businesses are starting to see a little bit of a comeback as there's a little bit more normalcy and so a lot of them -- we're going after existing customers. We're going after new logos and selling more, but I would say it's the strength of the Experience platform, the ability to have these profiles, the behavioral data they were collecting in real-time. The marketing message associated with telling them that they really need to focus on getting their first-party data to be an asset that they could put on their balance sheet. And the nature of what's happening with digital commerce. I think all of those are trends and then we win the deals, because of the strength of our offering and the fact that we're a really pure play marketing that is significantly differentiated relative to anybody else."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Gregg Moskowitz with Mizuho. Please go ahead."
},
{
"speaker": "Gregg Moskowitz",
"text": "Thank you very much for taking the question. Shantanu, I know that you only have three-quarters of that data thus far, but is Workfront driving larger, average deal sizes in DX? Is that something that's already showing through?"
},
{
"speaker": "Shantanu Narayen",
"text": "Hi, it's a great question, Gregg. And then maybe as I had responded to Kirk as well, I should have talked about the big thing that we're hearing from our customers in that space, Gregg, is they have more and more campaigns. They want to do agility of the campaigns. These are global and how do they not only have an integrated suite of products, but how do they get the workflow to be more efficient, especially as you're all working in a hybrid, or working from the home environment. So Workfront is definitely helping us, it's helping us with existing customers, it's helping us with deal sizes. And in many ways, it's the glue both to enable, if you have people, technology, and processes, it's helping with the processes part. But the promise of what we've also said there in terms of this pioneering marketing system of record, that's another area for the interest. And I think this was always a great Company. I think they were looking to become more general purpose. I think what Anil and the team have done, or really focusing on marketing workflows and solving it for all of the different personas. That's definitely resonating, but all of the large deals that we do Workfront’s, definitely a part of the interest and a part of the bill of materials associated with that."
},
{
"speaker": "Gregg Moskowitz",
"text": "Very helpful. Thank you very much."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Gregg."
},
{
"speaker": "Operator",
"text": "We Will take our next question from Keith Weiss with Morgan Stanley. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "Thank you, guys, for taking the question and very nice quarter and maybe digging in a little bit more on the M&A side of the equation, we've definitely heard really good things about Workfront are getting into a lot of deals upfront Perhaps, can you characterize the sort of the performance of Workfront versus your expectations and kind of contribution you're seeing in the quarter. Secondarily with Frame.io, Just for clarification, is that in the forward ARR guys, so is that included in the 550 for Q4? And then perhaps more broadly, just on M&A strategy. The last two big deals seem to have a common thread in terms of collaboration. Is that just a self-idealist putting together two data points and drawing the trend line, or is that sort of a particular area of focus for Adobe in terms of adding to the portfolio on a go-forward basis? Thank you, guys."
},
{
"speaker": "Shantanu Narayen",
"text": "So, Keith, I actually think there were three questions in that, so let me parse each one of the first, I think as it relates to Workfront, we're very clearly targeting a need that exists and we had originally, I think said something like Workfront will do a 140. You're a 150 million in revenue for FY 21. And then I think we've said that it's on track to significantly beat that and that continues to be the case. As we do these larger deals, Keith, we don't breakout Workfront. And so that's the way we think about the business. But Workfront is definitely appealing to that. Your second question as it relates to two Frame.io. Uh, no, it is not in the ARR (ph.) guide. I mean clearly until we close the deal, we would not. And so, when that happens, as we said, we expect that to happen in Q4. We'll certainly update you on what happens as it relates to the frame. But we're excited about that and your third question as it relates to collaboration as a team, it's part of what we've been talking about for a while. If you remember what we've done with XD in terms of being able to do live editing. I think what we've done with the multi-surface applications, where our applications run on mobile devices, or iPads, or tablets, as well as desktops, is just one of those teams that people are working from different locations. People are increasingly working with people, and so I think we have the ability to really provide value for our existing customers and attract new customers. I think with a frame, in particular, we're excited because it expands dramatically. The potential of the number of people who will become participants in the video workflow. And if they become, I hope you like the videos that we placed at the beginning of the earnings call and it's -- all of that stuff is being done remotely. We're pleased. And as you know, we are always portfolio Keith about the acquisitions and making sure it's a case where we can bring significant value both to our shareholders and to our customers."
},
{
"speaker": "Keith Weiss",
"text": "That spend especially the color guys."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Michael Turin with Wells Fargo Securities. Please go ahead."
},
{
"speaker": "Michael Turrin",
"text": "Hey, there. Good afternoon. Thanks for taking the questions. On margins -- in the year-to-date, margins are now above 46%. I think you previously referenced the potential for more of a second-half step-down there, so just - how should we think about the margin profile here in our other benefits, you'd point to that could be normalized assuming more of a return to normal."
},
{
"speaker": "Shantanu Narayen",
"text": "John, do you want to start and then I can add?"
},
{
"speaker": "John Murphy",
"text": "Yeah, that'd be great. Yeah. You're right. The margins at 46% this quarter we had indicated that with the more of a reopening across different regions, we would start to see our facilities come online, or business. travel, and come back and certainly continue our hiring ramps with the Delta Variant probably slowed that down a little bit. And so that contributed to the margin expansion you saw in Q3. But the overall was an outstanding quarter for older businesses. and what it says, the long road, the path to margin expansion is really to revenue growth given the leverage in our mode and after the contributions from the revenue performance with quarter continued expense and things, I just talked about that contributed overall to the performance. But we expect those expenses to come back in a Phase reentering out maybe a little slower than we originally thought when we talked about the second half, but that being said, when I think about our original targets in December, its implied margin expansion. When we did our updated targets in Q1, it was an even larger margin expansion from what we saw. But we're executing against these huge March opportunities, and we'll continue to do that with an eye and I continued top-line growth, such as areas of [Indiscernible] you touched on, which is 3D and immersive Adobe Experience Platform, sign stock mobile, all of that."
},
{
"speaker": "Shantanu Narayen",
"text": "Well said, John, and maybe the only other thing I would add is that in I - certainly, I think when you look at some of the TENEO facilities expenses, it's a little lock efficient in terms of what's happening on expenses. But our big position is when you have a 100 and plus billion-dollar addressable market, I think driving profitable growth is where we're focused on, which is why I think John also referred to we continue to be in the market to hire talent, to make sure that we can continue to address all the market opportunities that we have. And so, where folks, just don't drive profitable growth."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our next question from Jay Vleeschhouwer with Griffin Securities, please go ahead."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. Shantanu and John. Shantanu, for you, first as I'm sure you recall over the last number of years, particularly at a conference like MAX, we've talked about the integration, and many ways, the unique integration that you have between Digital Media and the DX business. and you'll recall it's gone by a certain acronym over time. The question is, can you quantify or in some way. Describe the business effect of that combination and even going back to the old days of how this neutrality does in fact, help you drive business through the integration across the two segments. Relatedly, with regard to. DX specifically, you'll recall that over the last number of years, the Company has often referred to you're having about four dozen or so use cases that you were targeting for DX, and that was a number of years ago. So perhaps you could talk about how the number of targeted use cases has increased for DX in the last number of years, particularly now with the introduction of payment services and other new capabilities."
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, Jay, first I think as it relates to your question around the integration between the clouds, as you know, first, let's even talk about Acrobat, right? Because so much of the Acrobat business is reflected both in Creative Cloud and Document Cloud and so that's one very tangible example of how. We've integrated the clouds. I think taking a step back, the area that I would say is of most interest to customers right now is what we have referred to in the past also as content velocity, which is people are creating more digital assets. They're spending more on content and how they both ensured that all of that content seamlessly is distributed, whether it's a marketing campaign, whether it's something that goes on a mobile application, whether it's something that goes on the website. And so, I think that's the hard problem that we've been able to help facilitate for our customers, which is creating all of this content and making sure that it's -- the delivery is accelerated through marketing campaigns is an area of real integration between DME, as well as Dx. And where that shows up also in the revenue is the continued growth of M and M assets, specifically because that's where the assets are really flowing between these two solutions. So hopefully that gives you a little bit of the flavor. I think to the earlier questions that Gregg and Kurt had asked. I mean, it is also on the workflow, that's when people are looking at it and saying, wow, if my freelancers have created content, how's that now being reflected in the DX. So that's what I would answer your first question. I think as it relates to the DX use cases, and we should certainly do an update, it's increased very dramatically. And the ones that I would say maybe as a highlight is the B2B use cases, the number of large B2B companies that are coming to us and saying, ''Hey, we recognize that whether it's for lead generation, whether it's for identification of customers, whether it's for even doing commerce, that's been a fairly big driver. '' I would say regulated industries, which if the original push around customer experience management was B2C, and consumer-base companies. Now I think you're seeing way more of those workflows and use cases and in regulated industries, so that's another one that I would do. I would say the global aspect of this, which is you have companies. Whether you're an automotive Company, or you're a fast-food Company and you want to do this Globally, I think that's a use-case that we've seen a fairly dramatic increase, but so hopefully that gives you one. And then this is where the partner ecosystem candidly also is driving so much more. And so, the partner ecosystem is also building a lot of their value-added solutions on top of our horizontal platform. So-net I would say doesn't matter what business you are, what size you are. Part of DX is relevant to what you need to do in order to engage with your customers."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Saket Kalia with Barclays. please go ahead."
},
{
"speaker": "Saket Kalia",
"text": "Okay. Great. Hey guys. Thanks for taking my question here. John may be for you just to -- maybe just to switch gears a bit. I was wondering if you could just talk about seasonality in the Document Cloud business specifically? I think the net new ARR there has historically sort of been up into the right through the year. I guess the question is, are we getting to point in that business where the seasonality could start to look a little bit more like Creative, or are there any things to maybe consider for Document Cloud ARR seasonality this quarter?"
},
{
"speaker": "John Murphy",
"text": "When we look -- think about the situation we've been in the pandemic and the need for more paper to digital transformation that's impacting, not just enterprises and institutions that have obviously you've seen great growth in, but individuals as well as they're engaging with the services that they use. As we said, I think when you look at the individual offerings that we have across Creative and Document Cloud, we just saw a little bit lower-traffic there, but that's associated where we believe with individuals enjoying our holidays and its pretty indicative using our own Adobe Digital Index data. That's. So, the gyms a lot over the highest travel months in two years. So that seasonality is hitting it a little bit, but again, we've got such a strong presence in both institutions, education, all the governments, and enterprises on Document Cloud that we still see great growth and strengthening. It's demonstrated and just the continued growth to that business, which is our fastest-growing business right now."
},
{
"speaker": "Saket Kalia",
"text": "Very helpful. Thanks."
},
{
"speaker": "John Murphy",
"text": "Thanks, Saket."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Ken Wong with Guggenheim Securities Please go ahead."
},
{
"speaker": "Ken Wong",
"text": "Great. Thank you for taking my question. This one is for you Shantanu. You guys have a history of bringing your professional tool down to the consumer, you had light edition, you have mobile editions. I think in your prepared remarks, you mentioned the addition of Frame.io, creating additional opportunities the sort of across the customer base, teams, and enterprises, I guess do you envision this as a platform that could be brought down to Consumer prosumers? Or is it still a man (ph.) they going to be in that professional bucket?"
},
{
"speaker": "Shantanu Narayen",
"text": "Ken? It's a very important area of expansion for us. I mean, I think the Creative has always been a segment that looks to us to deliver mission-critical products that enable them to make a livelihood. But the halo effect of that, when you look at what we talked about at our analyst meetings and you know, how big is communicated business already is as well as the outreach of that even into the consumer business. But stay tuned on that front. I think as we talk about our product roadmap and the excitement that we have to fulfill this vision of creativity for all and target a broader and broader and broader set of customers with some great solutions using our artificial intelligence and Sensei technology, we have some very exciting things underway. That will start to be served to customers. So, we're very excited about that opportunity, it's a big opportunity. It's already a big business for us. I mean, when we talk about the fact that we're adding over 0.5 billion of net new ARR as our expectation for Q4. A portion of that is also going to what you would call communicators or prosumers. And we're going to be delivering more and more really phenomenal products, targeted at that customer segment."
},
{
"speaker": "Ken Wong",
"text": "Got it. Fantastic. Looking forward to MAX. Thanks, guys."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Kash Rangan with Goldman Sachs, please go ahead."
},
{
"speaker": "Kash Rangan",
"text": "Thank you very much. Congratulations Shantanu and team, a fantastic quarter. Shantanu, I remember, I think what's the MAX 2019 we talked about video and how that could be as big of an opportunity as photos and I'm curious to get your thoughts on the total available market that is new and incremental to Adobe's Creative business as a result of the acquisition that you made afraid Particularly you used the word dramatically expansive scope of what you could do, meaning collaborators in addition to content creators, can you just talk about what you mean by that, you can just put a final point. This is means that the greatest term will be then, what Wall Street thinks we just always been the case for the past ten years or so. And secondly, not that it's a negative, but what would the seasonal pattern and in summer joined some side of activity where people don't vacation, et cetera. Is there at all any risk that digital transformation takes a bit of a backseat as we go shopping, not online, they will go to stores, therefore, e-commerce activity might actually start out on it, but the secular trend is too pretty solid. But jumps on the adjustment have reinforced some adjustment or maybe not, but I just want to get your thoughts on that, Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Kash, I mean, as it relates to your first question around video, I think we've been signaling for a while that video is really one of the exciting expansion opportunities for us and that's really played out. It's played out from the products that we've delivered. Premier and after effects continuing to be the leaders in that category, sadly Photoshop and illustrator used a lot. But if you look at what's happening with all these streaming plus services, right? I mean, there isn't a Company that isn't delivering streaming plus service. And so, I think the insatiable demand for video among consumers is only requiring more and more companies to have these streaming services and deliver more genre as it relates to video. All of that works right now, I mean, we talked a little bit about what we're doing as a partnership with Netflix as well. All of that is happening now with people in different locations through a collaborative process. So anytime you can take a creative. idea and make that happen quicker, faster to the right audience. That's only going to be incredibly valuable to our customers. And so, I think that trend is only going to continue. And so, we feel really good about what's happening in that particular space with the video frame, we used to use frame-up. A bunch in the production of our own videos and it's been exciting as we've talked to different people who after the acquisition of frame have come and said; Hey, Adobe, that's such a great product, but we think we can do more with it. So, I think that gives us a lot of optimism around whether it's the scriptwriter, whether it's, the reviewer of that, whether it's a creative agency, just being able to or all the corporate videos that's being done. And so certainly, I think as you add that as enterprise product as well, you can certainly get a lot more TAM associated with it. We will update our TAM's cash as we typically do. I think Jonathan referred or will talk about how we do our Q4 as well as our 2022. And we'll talk to you about terms on that front, but really excited about that. I think the external partnerships that exist for the frame and how it's plugged in, not just to the Adobe solutions, but other solutions are also an area of strength. And I think to your second question around shopping and online when we look at our DX business and the success that we had in Q3. I mean, a big part of that is more and more companies are thirdly doing the multi-channel omnichannel, whatever they want to call it. And I think that's only going to continue to be a driver of our Digital Experience Solutions. Because today that stable stakes and so we just look at it and say whether you're shopping in-store over they are shopping online. You need a solution that treats you like a customer that we know of. And so, I think that's going to only be an imperative for companies. I mean, one thing we should have probably talked about also is if you look at our Q3 results. I mean, there were stronger than what we had said. There were a couple of non-recurring items as part of that and some of that actually had to do with usage in commerce. And so, we are seeing that usage also ramp up. So, I just wanted to get that. Also, are there as we talked about shopping online and shopping in a store. And in terms of the demand for our DME solutions, we expect as -- as we said, the seasonal Q4 will be the strength and as education comes back and there's more and more end of the quarter activity, not just within the Adobe, but all companies. That's going to lead to increased demand and acceleration."
},
{
"speaker": "Kash Rangan",
"text": "That's fantastic. Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks. Ken."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Derrick Wood with Cowen and Company. Please go ahead."
},
{
"speaker": "Derrick Wood",
"text": "Thanks for taking my question, John, I wanted to come back to the Document Cloud business. Because it looks, perhaps, to me, that there was some outside strength from licensed products that may have been in lieu of revenue coming from ARR products. and I think you can see this with total Document Cloud revenue growth actually accelerating even though total ARR growth decelerated. So is that the right assessment and we'd be looking at total revenue, not ARR and I guess. So, is there any reason for a mix shift towards more licensed products and as you look into Q4, given it's a big ELA, quarter, should we expect that to continue?"
},
{
"speaker": "John Murphy",
"text": "Yes. No. I mean, we -- well, certainly, yeah. You're going to see strength in ELA as [Indiscernible] and I spoke of in terms of Q4, just to see the expansion in Q3 as well. But we still migrate basic customers as well. So ARR is still going to be important for us and where you want to drive more ARR. I think those strengthen our growth, frankly, over the last -- over a year really has been really impressive. It's always going to give us this opportunity, to drive healthy subscription growth. But LA is not going to give us outsized revenue in Q4, it's going to be a sizable contribution, but we're driving subscriptions and that's, that's a strategy. And we do still have customers that buy perpetual, and so it will be some fluctuations in that."
},
{
"speaker": "Derrick Wood",
"text": "Yes. Got it. Okay. Thanks."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Parker Lane with Stifel. Please go ahead."
},
{
"speaker": "Parker Lane",
"text": "Hi, thanks for taking my question, Sean, I was wondering if you could talk about the nature of Creative wins in the public sector with organizations like the Department of Interior, what do these types of organizations historically relied upon for Creative needs and hopefully, they're embracing the features of the Creative Cloud versus using maybe a particular application like Photoshop or a distinct set of applications. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "To your point, I think the public sector has always been an important part, but I think it's just the amount of content that people are creating is increasing. And when the amount of content that people are creating, then content management becomes an important issue. Workflow becomes an important issue. And the standardization of the products. And one of the things we did really well is what we called our named user deployment and how, you know, when we have these enterprise licensing agreements, we offer enterprises the ability to download and distribute within the companies. And the more we do training and evangelism of the products, that leads to adoption. So, I would say there's an element of standardization, there's an element of more content. I mean, even if you're a public sector Company right now, I mean, what you transact online is becoming dramatically greater than it's ever been because the physical presence is seeing cutback as a result of what's happened in the pandemic. I think all of those are macro trends that are going to continue, but we've also done a really good job of actively making sure we evangelize what these solutions are. Good fall, we do more training within these enterprises. We allow these named user deployments, as I said, with ten leads to true. Well, ups and the ability to get them into a higher band. So, I think the execution on the sales front associated with going into these enterprises, that's getting better and better."
},
{
"speaker": "Parker Lane",
"text": "Great feedback. Thank you."
},
{
"speaker": "Jonathan Vaas",
"text": "Operator. We're coming up on the top of the hour. We have time for two more questions. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take our second last question from Brad Sills, Bank of America Securities."
},
{
"speaker": "Brad Sills",
"text": "Great. Thanks, guys for taking my question here. Just with your view across the broader marketing stack here with Experience Cloud. I'm curious what you're observing with regard to these Customer 360 initiatives. Are you finding customers are taking more of multiproduct deals here to get that view across multiple channels here, e-commerce, marketing automation, CMS? You've got workflow automation in there. Are there any combinations of any of that that you're seeing trending more recently, been in the past? Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "It clearly has been a push for us, Brad, in terms of, you know, what we're doing, which is how do we sell the entire suite offering? And I think every year we give you an update on how. That is actually indeed, how we are selling it. And so, from our perspective, the marketing stack, what's completely unique about us, is the data and insights that we're getting, the ability to do commerce, and the digital presence. I think as it relates to customers, we have 60 waivers unique and I think we're years ahead of it. Any other large Company that has space is this real-time nature of what we've delivered, it's scalable, we've got billions of profiles. And so, I think a lot of other companies are talking about how they take something that may be in the record somewhere and do things with it. But for us, it's the activation of that data. And that's where I think most people are really excited about what Adobe has to offer. And the other thing that I think is really happened, is people recognize that they have to get control of their first-party data. I think a lot of interest used to exist about customer acquisition and third-party data. But I think right. Now it's about dupi have even control of our first-party data. Do we have control of our behavior? And what is happening on multiple channels? And the fact that that can be very easily answered as it relates to what we have done with the Adobe Experience Platform. Last but not least. I mean, remember we're the only Company that can go in. And say, hey, we have a B2B business and a B2C business. And when we talk about how we're using this in terms of the playbook on Adobe.com, I think that really opens up a lot of people's ideas as to how they can use this and utilize it. And so, I think the playbook that we delivered for D dom earlier this year and how we talk about what they can do. I think that's what -- that really resonates with customers."
},
{
"speaker": "Brad Sills",
"text": "That's great to hear. Thanks, Jonathan."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We'll take our final question from Brent Thill with Jefferies. Please go ahead."
},
{
"speaker": "Brent Thill",
"text": "Shantanu, the DX DRaaS accelerating from Q2. Can you just walk through the drivers of what you're seeing in terms of that acceleration? And maybe for John, just as it relates to seasonality with Magento and commerce in the Q4, anything to keep in mind there as you just feel like this -- to keep powering through the tougher comps given -- given the [Indiscernible] you're seeing in that business. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Brian, I think what really drove that revenue was both subscriptions as well as the services. As you know, the services, were again, really reliant on a large partner ecosystem. But if over the last 18 months. As we've always talked about, the interest is high. How they are all implementing it. And so as they continue to implement it, and as they continue to say, we need to invest in these solutions, I think that's driving it, and I think to your point, if you take a step back, we -- I think guided to something like 19% revenue at the beginning of the year, and 22% in subscriptions, we had increased that in March, 22023 respectively, and we just posted 2629 and so and if you look at it for Q4 as well as you point out with the large comps, we continue to be excited about that opportunity. So, I think there is. This is a front-end center, it's an enterprise priority. And I think since people are staying, we've got to deal with this new reality, there's no time to waste in terms of implementing it. Again, there were, as we said, a couple of non-recurring items. some of those had to do with usage in commerce and that actually is also indicative that maybe a little bit more depends on the quarter, but it's up to the right as far as we're concerned in terms of the business opportunity in the business."
},
{
"speaker": "Brent Thill",
"text": "Thank you."
},
{
"speaker": "John Murphy",
"text": "Go ahead."
},
{
"speaker": "Shantanu Narayen",
"text": "No, go ahead. Sorry, Jonathan, I didn't hear you."
},
{
"speaker": "John Murphy",
"text": "Yeah, no problem. Just going to just kind of over the top on Brent's question on seasonality-related commerce, of course, in Q4 as a strong commerce quarter anyway. Given the holidays, spending trend. And so, we're excited about the opportunity there as well, it's just trying to set us up into the right, I think we have great momentum."
},
{
"speaker": "Shantanu Narayen",
"text": "And overall, since that was the last question, I mean, again, I think we were really pleased with our performance in Q3. We do expect a strong end of the year for our business. As you saw from our targets, it's clear that your win, this unique position that we have three large growth opportunities ahead of us and we're executing well against all three of those and the innovation and the roadmap that exists across all three of those clouds just gives us continued optimism that we will serve our customers well and we feel fortunate. I think the future of work and the fact that it's more hybrid will only continue to emphasize digital as a priority for companies of every size. And so, whether that's an increase in content for personalization, whether that's more automation of digital documents, and whether that's every business thing we need to understand how to do customer experience management. I believe Adobe is very unique. We position to drive those particular macroeconomic trends. But thank you for joining us today, we look forward to the max, as well as the Q4 earnings call. And with that, I will turn it back over to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, Jonathan here. And thanks to everyone for joining us on the call today. As we mentioned in the press. Released today, we look forward to connecting with you again on Thursday, December 16th, for our Q4 earnings and virtual financial analyst day, we will be sending out more details in the coming weeks. And if you have any questions, feel free to contact us at ir@adobe.com, I look forward to speaking with many of you soon, and we appreciate your interest in Adobe, this concludes the call."
}
] | Adobe Inc. | 24,321 |
ADBE | 2 | 2,021 | 2021-06-17 17:00:00 | Operator: Good day, everyone, and welcome to the Second Quarter Fiscal Year ‘21 Adobe Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead, sir.
Jonathan Vaas: Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's President and CEO; and John Murphy, Executive Vice President and CFO. On this call, we will discuss Adobe's second quarter fiscal year 2021 financial results. By now, you should have a copy of the press release, which crossed the wire approximately one hour ago. We've also posted PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. Before we get started, I want to emphasize that some of the information discussed in this call, including our financial targets and product plans, is based on information as of today, June 17, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the forward-looking statements disclosure in the press release we issued today, as well as Adobe’s SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe.com for approximately 45-days. The call audio and the webcast may not be re-recorded, or otherwise reproduced or distributed without Adobe’s prior written permission. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Adobe had another outstanding quarter as the shift to a digital-first world continues to accelerate. From students to creative professionals to small businesses to the world’s largest global enterprises, digital is transforming how we work, learn and play. Adobe’s mission to change the world through digital experiences has never been more relevant. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is working. Fueled by our ground-breaking innovation, proven capability to create and lead categories and our expansive global customer base, our opportunity and momentum has never been greater. In Q2, Adobe achieved $3.84 billion in revenue, representing 23% year-over-year growth. GAAP earnings per share for the quarter was $2.32 and non-GAAP earnings per share was $3.03. In our Digital Media business, we drove strong revenue growth in Q2 in both Creative Cloud and Document Cloud, achieving $2.79 billion in revenue, representing 25% year-over-year growth. Net new Digital Media Annualized Recurring Revenue or ARR was $518 million, and total Digital Media ARR exiting Q2 grew to $11.21 billion. Over the last year, we have seen the critical role creativity has played in the world. Creative Cloud is empowering everyone, from the most demanding professional, to the high school student, to the next generation of social media creators, to tell their stories. Adobe is the leader in core creative categories such as imaging, design, video and illustration, and we are expanding our leadership in exciting new media types, including screen design and prototyping, 3D and AR. In a world that requires anyone to be able to create from anywhere, we are building products and services for every surface and platform. Our vibrant creative communities continue to be a tremendous source of inspiration and our goal remains to provide access to a larger and increasingly diverse set of creators and design teams, furthering our strategy of unleashing creativity for all. Q2 Creative Cloud performance was strong, with net new Creative Cloud ARR of $405 million and revenue of $2.32 billion, representing 24% year-over-year growth. Q2 highlights include, new product innovations, including updates to Lightroom, Photoshop and Illustrator that deliver enhanced creation and collaboration capabilities and greater speed and performance. Next week, we will unveil new innovations for Substance, our 3D solution, designed to improve the creation process with new tools to help assemble, style and sculpt. Increasing engagement and retention across offerings, including greater customer uptake of training, participation in community events and continuous product enhancements derived from insights about customer usage and value. Momentum in our Creative Cloud Teams offering globally, reinforcing the growth in adoption of Creative Cloud within small and medium businesses. Strong customer acquisition in core creative and emerging categories, especially photography and video, supported by exciting marketing campaigns globally for Photoshop and Premiere; and accelerating demand for 3D&I in key verticals such as gaming, automotive, fashion & e-commerce. Continued growth of mobile traffic, leading to new customer acquisition of mobile offerings, like Lightroom Mobile and Photoshop Express, and a strong funnel for desktop applications, strong growth for Adobe Stock, with an increasingly robust content library and growing submissions that provide sustained earnings for our contributors. Global momentum, with accelerated demand in EMEA and Asia Pacific. Key customer wins, including ByteDance, Netflix, Microsoft and Unity. And new partnerships to inspire the next generation of creators, including one with Netflix that gives emerging creators access to tools, resources and mentorship to bring their stories to life, and another with Khan Academy, designed to provide teachers and students in underserved communities with access to digital tools and learning resources. In this digital-first business environment, seamless document workflows across every device and platform are more important than ever for the modern workforce to collaborate and be productive. Document Cloud is accelerating document productivity by powering the paper-to-digital transformation and enabling all document actions including editing, sharing, scanning and signing to be frictionless across web, desktop and mobile applications. We delivered strong Document Cloud revenue in Q2, with net new Document Cloud ARR of $113 million, and outstanding revenue of $469 million, representing 30% year-over-year growth. Q2 highlights include new product innovations, including new features in Acrobat Liquid Mode that further improve accessibility on mobile devices; new Adobe Scan functionality that enables users to combine, save and store scans more efficiently; and new Sign capabilities in Acrobat to help small and medium-sized businesses improve their digital footprint with easily embeddable forms and digital payments. Strength in Acrobat across all routes to market and offerings, with enterprise bookings growth up over 60% year-over-year; accelerated demand for Sign, with new Sign customers doubling year-over-year and an increasing share of Acrobat users leveraging Sign capabilities; explosive growth in Acrobat Web services, driven by significant improvements in SEO for a new set of customers. In Q2, we drove 30 million visits to frictionless PDF pages and now offer capabilities for over 20 different document verbs; continued growth of mobile traffic, including over 110 million mobile downloads of Adobe Scan and one billion scans to-date, and a greater than 20% year-over-year increase in Acrobat mobile app adoption; momentum across all geographies, with accelerated demand in Europe, Latin America, Australia and New Zealand; and key customer wins, including ADP, AstraZeneca, GlaxoSmithKline, Toyota and Wells Fargo. I am thrilled to welcome back David Wadhwani, who has rejoined Adobe as Executive Vice President and Chief Business Officer of our Digital Media business. His impressive track record and passion for Adobe and our customers make him the ideal person to lead our Digital Media business through its next phase of growth. Digital transformation has become an imperative for businesses of every size in every industry. According to our recent Adobe Digital Economy Index, e-commerce spending is projected to be $4.2 trillion globally this year, and reach $1 trillion in the U.S. alone in 2022. We predict that U.S. online spending on the upcoming Prime Day will surpass the $10.9 billion mark that Cyber Monday reached in 2020. Across both B2C and B2B, companies around the globe are investing in digital to deliver personalized and engaging customer experiences. Experience Cloud is the most comprehensive solution for content and commerce, data insights and audiences, customer journeys and marketing workflow. With unified customer profiles and an open and extensible architecture, Adobe Experience Platform is the clear platform of choice for enterprises to deliver real-time personalization at scale, powering more than 17 trillion audience segment evaluations every day. Experience Cloud revenue was $938 million in Q2, representing 21% year-over-year growth, and subscription revenue was $817 million, representing 25% year-over-year growth. In April, we held our annual digital experience conference, Adobe Summit, virtually. We drove an unprecedented 20 million views of Summit content from individuals around the globe, underscoring the significant interest and demand for customer experience management. Highlights of product announcements include, Adobe Journey Optimizer, which helps marketers optimize the customer journey across outbound and inbound customer touchpoints; Adobe Customer Journey Analytics, which enables brands to integrate and standardize their online and offline data and is years ahead of any competitive offering; the next generation of Adobe’s Real-time Customer Data Platform to help brands optimize their acquisition and engagement strategies in a first-party data world; a preview of a pioneering marketing system of record, built on Workfront technology, designed to manage complex marketing workflows for greater efficiency and agility; and new intelligent commerce capabilities and a strategic partnership with FedEx that will allow every small and medium business to offer expedited shipping capabilities as part of their commerce platform. Beyond Summit, Q2 accomplishments include, strength in core offerings, including explosive bookings growth for Adobe Experience Platform, and associated services like Customer Journey Analytics and Real-time CDP, which combined blew past the $100 million book of business mark in Q2. Success with large multi-solution deals in transformational accounts and improving close rates across geographies, customer segments and product pillars. Building the future workforce by offering college instructors and students' globally free access and curriculum for Adobe Analytics, the industry-leading customer data analytics platform. Continued industry analyst recognition across all customer experience management segments, including being named a leader in the Forrester Wave for Enterprise Marketing Software Suites, achieving the top spot each of the five times the report has been published and leadership in the Gartner Multichannel Marketing Hubs Magic Quadrant for the fourth year in a row. And key customer wins with brands like Nike, NatWest, NTT Docomo and T-Mobile. We are proud of the tremendous results and momentum across our business. As we plan for a post-pandemic world, we will remain flexible as different regions recover at different times. While offices in Australia and parts of Asia have been open for some time, and conditions in the U.S. and parts of Europe are improving, we will continue to support our employees in places like India and Brazil where the situation remains challenging. Over the last year, we have been building a blueprint for the future of work at Adobe, which will be hybrid and flexible. In the U.S., we will be piloting a return to our San Jose office, starting with a small group of fully vaccinated employees in July. We are committed to leveraging the best of in-person and digital interactions to harness what makes Adobe special, our creativity, innovation and culture, driven by our most important asset, people. I want to thank all of our employees for their dedication and resilience during a year that was not only marked by the pandemic, but by violence and racial injustice. I am proud of the progress we have made in advancing our efforts around diversity, equity and inclusion. We have made strides in our strategy to accelerate the representation, growth and advancement of the Black community. But as Juneteenth approaches later this week, we know we have so much left to do. As we celebrate Pride Month in June, we are honoring and spotlighting our LGBTQ+ communities both inside and outside of Adobe. These efforts represent Adobe’s longstanding commitment to supporting our diverse employee base and making an impact in the communities where we live and work, a principle our co-founders, John Warnock and Chuck Geschke, instilled in us. In Q2, we lost our beloved co-founder Chuck Geschke. Chuck left an indelible mark on Adobe, the technology industry and the world. While we miss him tremendously, it gives me great comfort knowing that Chuck was so proud of the company that Adobe has become. Adobe’s strong culture, revered brand, innovative product roadmap and the world’s best employees, customers and partners position us for continued success in 2021 and beyond. John?
John Murphy: Thanks, Shantanu. Q2 was an excellent quarter for Adobe, with strong revenue growth, enterprise bookings in Digital Experience and net new ARR in Digital Media, showing how our solutions are resonating with customers of all types in an increasingly digital world. With our data-driven operating model or DDOM, we continue to utilize our own Experience Cloud technology to optimize customer journeys, driving increasing amounts of traffic to Adobe.com to acquire new customers and raise awareness of our products. We continue to invest for growth in sales and marketing, while also increasing headcount in Q2 to drive product innovation. As a result, in Q2 Adobe achieved revenue of $3.84 billion, which represents 23% year-over-year growth. Business and financial highlights included: GAAP diluted earnings per share of $2.32 and non-GAAP diluted earnings per share of $3.03; Digital Media revenue of $2.79 billion; net new Digital Media ARR of $518 million; Digital Experience revenue of $938 million; record cash flows from operations of $1.99 billion; RPO of $12.23 billion exiting the quarter; and repurchasing approximately 2.1 million shares of our stock during the quarter. In our Digital Media segment, we achieved 25% year-over-year revenue growth in Q2, and we exited the quarter with $11.21 billion of Digital Media ARR. We achieved Creative revenue of $2.32 billion, which represents 24% year-over-year growth, and we added $405 million of net new Creative ARR. Second quarter Creative growth drivers included: strong retention and renewal across all Creative products and customer segments; new user acquisition, driven by global marketing campaigns utilizing our DDOM insights; accelerated recovery in the SMB segment with our Creative Cloud for Teams offering; success in enterprise licensing, driven by account expansion at renewal; momentum with our Adobe Stock business, which continues to outpace industry peers in terms of revenue growth; driving subscriptions in the education segment, both with individuals and institutions; and generating net new ARR through app store sales of our mobile and iPad applications. Adobe achieved Document Cloud revenue of $469 million, which represents 30% year-over-year growth, and we added $113 million of net new Document Cloud ARR in the quarter. Second quarter Document Cloud growth drivers included: increasing unit demand for Acrobat subscriptions across all geos; strong subscription licensing of our Teams offering in the SMB segment; success in enterprise licensing, with broad seat expansion across enterprise accounts. Accelerated adoption of our Acrobat Web offering, driving top-of-funnel awareness and conversion to paid subscriptions; continued strength with Adobe Sign, which grew ARR greater than 40% year-over-year exiting the quarter; and driving improved conversion on Adobe.com. Turning to our Digital Experience segment, in Q2 we achieved revenue of $938 million, which represents 21% year-over-year growth. Digital Experience subscription revenue was $817 million, representing 25% year-over-year growth. On the heels of Adobe Summit, we had success in Q2 generating pipeline and closing strategic customer deals across our portfolio of customer experience management or CXM solutions. Deal volume was sustained throughout the quarter, with several large transactions closing earlier in the quarter, contributing to our revenue performance in Q2. We continue to see broad macroeconomic recovery, including in the commercial segment, and enterprises of all sizes are investing in digital transformation. Business performance in Digital Experience during the quarter was driven by: strong bookings for Adobe Experience Platform or AEP, and native applications built on AEP, including Real-Time CDP and Customer Journey Analytics, which continue to build momentum; recent innovations and partnerships driving awareness and adoption of our Analytics, Commerce and Campaign solutions; continued success with our Workfront offering, as we realize the value of combining a best-in-class workflow solution with our CXM offerings to create an industry-leading marketing system of record; momentum signing up transformational, multi-solution engagements with enterprise customers across geographies; and strengthening customer renewal and expansion rates. Savings from T&E and site operations are continuing as our employees work from home. We are investing in our facilities as we reimagine the future of work, and many of our employees return to offices and business travel during Q3. From a quarter-over-quarter currency perspective, FX increased revenue by $10 million, both before and after applying the net impacts from hedging. From a year-over-year currency perspective, FX increased revenue by $94 million. Net of impacts from hedging, the year-over-year currency increase to revenue was $78 million. Adobe’s effective tax rate in Q2 was 19.5% on a GAAP basis and 16% on a non-GAAP basis, in line with our expectations for the quarter. Our trade DSO was 35-days, which compares to 40-days in the year-ago quarter, and 38-days last quarter. RPO grew by 23% year-over-year to $12.23 billion exiting Q2, benefitting from strong enterprise licensing during the quarter. Deferred Revenue exiting the quarter was $4.28 billion, growing 24% year-over-year. Our ending cash and short-term investment position exiting Q2 was $5.77 billion. Cash flows from operations in Q2 were a record $1.99 billion. We repurchased approximately 2.1 million shares in the quarter at a cost of $983 million. We currently have $15.1 billion in remaining authority, of which $100 million was granted in May 2018, and $15 billion was granted in December 2020. The following Q3 targets factor current macroeconomic conditions and expected return of summer seasonality associated with the months of June, July and August. Total Adobe revenue of approximately $3.88 billion; digital Media segment revenue growth of approximately 22% year-over-year; net new Digital Media ARR of approximately $440 million; Digital Experience segment revenue growth of approximately 21% year-over-year; Digital Experience subscription revenue growth of approximately 25% year-over-year; tax rate of approximately 19% on a GAAP basis and 16% on a non-GAAP basis; share count of approximately 480 million shares; GAAP earnings per share of approximately $2.27; and non-GAAP earnings per share of approximately $3. We are pleased with our first-half performance, and we expect the momentum to continue, with typical Q4 strength. With the momentum we are seeing across creativity, digital documents and customer experience management, we are on track for another record year with a strong first half already in the books. Few companies of our scale can boast 20% plus revenue growth, world-class operating margins and a recurring-revenue model built for long-term growth and profitability. I will now turn the call over to the operator to take your questions.
Operator: Thank you. [Operator Instructions] First we'll go to Keith Weiss from Morgan Stanley. Your line is open.
Keith Weiss: Thank you, guys for taking the question and really nice quarter. I think it's pretty remarkable in a quarter where a lot of investors were worried about a difficult comp, net new ARR growth actually accelerated in the quarter. And I was hoping you could dig into that a little bit. It's obvious you guys are building momentum, there's a broader base of customers that are coming into the Digital Media fold. Can you talk a little bit about who that is and kind of where you're seeing the most success in sort of broadening that scope and enabling that building momentum within this business, which is already quite large and well growing?
Shantanu Narayen: Thanks, Keith. As you said, it was a really great quarter. And we actually saw great linearity associated with the Digital Media ARR throughout the quarter as well. And as you know, we have this incredible data-driven operating model that allows us to deal with all aspects of the customer funnel from discover, which is done through our marketing attribution all the way through usage and engagement. In terms of the new customers who are coming onto the platform, mobile and communicators is a way we define that Keith are a significant portion of the new customer base. Specialists on the other hand as it relates to 3D&I. Acrobat, as we also mentioned, had a very strong offering. And so I would say the photography and video offerings are really targeting everybody from creative professionals, to communicators, to consumers as is Acrobat. But then we're also seeing some really good adoption of Acrobat across the spectrum. And in our prepared remarks, the last thing I'd say is we also talked about the revival of the Teams business. And as we all know, the small and medium business segment I think was most impacted last year. So, really pleased with it, Keith. So across product offerings, across geographies and across some of the new businesses and services as you said, we saw good strength in Q2.
Keith Weiss: Got it. And if I can sneak one in for John on the guide into Q3, the net new ARR guide is about down 15% sequentially. I think there's more than we see seasonally. Is there anything we should be aware of in terms of either kind of one-time items, if you will in Q2, or something we should be looking out for in Q3 that explains that broader than or sort of bigger than normal seasonality, or seasonal decline into Q3?
John Murphy: Yeah. Thanks, Keith. When I look at the guide for Q3, it's the largest guide we've done for ARR into Q3. As we talked about last couple of quarters, last year was kind of a really strange year, right, we didn't see the seasonality we typically saw because of the pandemic and everybody being locked down. As things are starting to open up, we're anticipating kind of a return to some of that seasonality that we saw in the past. And so we've factored that into the guide. But we're really excited that we can actually target the highest ARR guide ever in Q3. So overall, great performance and we can see the momentum is still in the business.
Keith Weiss: Outstanding, great job, guys.
John Murphy: Thank you.
Operator: Next we'll go to Alex Zukin from Wolfe Research. Your line is open.
Alex Zukin: Hey, guys, thanks for taking the question. So I'll take the other side of the business. On the Digital Experience side. I mean, again, every indicator, whether it was RPO, whether it was the Digital Experience revenue and subscription revenue was strong. Can you talk to what you saw on the quarter, what's changed since the pandemic, and maybe some of the pipelines? And how we should think about that business from here from a growth perspective?
Shantanu Narayen: As you point out, Alex, it was a strong quarter. And right through the pandemic, we've been talking about how the interest in our Digital Experience solutions and the belief, when I have conversations with CEOs across every single vertical is that the only way to engage with customers is going to be digital. And I think people are starting to recognize that that investment is an investment that they have to pay. So first, I think from a macro perspective, it's clear that digital transformation and within digital transformation, customer experience management is front and center as something that they want to spend money on. The second thing I would say is, the execution against our new experience platform. And both John and I touched on Customer Journey Analytics and the other services that we're building on top of that, those are clearly resonating with customers, because whether you're B2B or whether you're a B2C, you have to have the ability right now to deliver the personalized experience. So I think the second thing I would say is that the innovation that we're delivering, and the fact that we had summit, and the ability to engage with these customers, certainly I think was an accelerant for the business. The third thing I would say is the ecosystem and the ability of the ecosystem to very quickly ensure that these customers derive value from the investment that we're making. I think that helps both in terms of converting bookings to revenue, but it also helps in terms of growing the book of business with enterprises. So, I would speak to all three of them. I think if you look at our targets as well, in terms of over 20% revenue growth, close to 25% subscription revenue growth that we're seeing in that business, I think we continue to be optimistic that we have the right product that clearly meets a customer need. And, the execution in the company against that business has been strong.
Alex Zukin: And maybe just squeezing quick one in for John. On cash flow, well ahead of our estimates here for the second quarter, what's the right way? What's driving that? Is that just as simple as strong collections on larger deals? And thinking through the year, obviously, we're not guiding or updating guidance, but just anything to think through the net new ways to look at the free cash flow margin of the business and the growth of free cash flows?
John Murphy: Yeah, sure. Yeah, we certainly were pleased to deliver numbers like that. We had some timing of payments, for sure. And as you saw, our DSO really dropped pretty significantly quarter-to-quarter. So all that really contributed to it, as well as the timing of some large payments [Indiscernible], as well as timing of when we have some dispersions as well. So it's really -- overall just great performance for the company. And sometimes you'll see a little bit of a shift quarter-to-quarter, but we're certainly given the capability of the company and the operating leverage in the model where we are generating a lot of cash right now.
Alex Zukin: Got it. Thank you guys.
John Murphy: You bet.
Operator: And next we'll go to Saket Kalia from Barclays. Your line is open.
Saket Kalia: Hi, guys, thanks for taking my question here. Shantanu, maybe for you to go back to the Creative business. Can you just anecdotally talk about any difference in product mix, specifically? I guess, as more potential users got back to work, including Creative professionals, did you see any change in the mix of single apps versus all app subscriptions perhaps?
Shantanu Narayen: Saket, I think we saw strength across all of the businesses. I would say that the single app business, as you know, is a really great initial funnel for us to drive the business. And so we continue to see new adoption as it relates to the single app. And then, from a revenue perspective, think of it as, the single apps is probably half the business in the quarter. And then, we use that as a funnel to drive to the all apps. So I wouldn't say there was really a dramatic difference between Q1 and Q2, I think we just continue to see the trend of attracting new customers. And then from a revenue point of view, certainly, we believe that the Creative Cloud all apps is where we both derive value for our customers and drive more ARR for us long-term.
Saket Kalia: Got it. Very helpful. Thanks, guys.
Shantanu Narayen: Thank you.
Operator: Next, we'll go to Tyler Radke from Citi. Your line is open.
Tyler Radke: Hey, thanks for taking my question. I wanted to ask you about the Digital Experience side of the business. I think if you, depending on your assumption for Workfront and you kind of normalized for the extra week in the quarter last quarter, it showed a nice kind of reacceleration in that business. Could you just help us understand how you're expecting that pace of reacceleration to play out throughout the rest of the year? And then, kind of where your longer-term aspirational targets on where you'd like to see that growth rate of the business?
Shantanu Narayen: Well, Tyler, the way I would first start off by answering that question is by talking about the TAM, where I think we keep talking about how big TAM that is, for the entire business. And so, when you have the kind of $80 billion plus dollar TAM that we have, we just continue to be really optimistic about that business. And, from my perspective, we have the largest delever that we had. And if you look at the DX business, it's about focus on transformational accounts across all deal bands, as well as different segmentation of the market. We tend to think of the corporate market, commercial market and the strategic markets, we're seeing strength across those particular businesses. And as I mentioned earlier to a previous question, the ability to convert bookings into revenue and to upsell them to more, but what we've done with the experience platform and the ability to have all of the new services built on that, it's really very unique in the industry, because that's sort of how we look at it. And so, you should expect to see, again, Q4 be sort of the strongest close that typically happens in enterprise software. And, we're clearly on track to exceed the target for DX for the entire year, when you look at our performance in the first-half and our guide for Q3, and John's comment about expecting Q4 to be seasonally strong.
Tyler Radke: Great. And if I could just sneak in another question, I wanted to ask you just broadly, I know, you haven't raised price in a while, and you're obviously pretty sensitive of that during the pandemic. But just as you think of things reopening and obviously some concerns around there, around an inflationary environment, just curious how your conversations regarding prices evolved over the last three months? Thank you.
Shantanu Narayen: From our perspective, what is most exciting about the Creative Cloud and the Document Cloud business, assuming Tyler that your question is about those two parts of the business is, it's really new customer acquisition, that's really been the driver of that entire business. And we're doing that across different offerings. We're doing that across different geographies. I think the value that we provide to customers, it doesn't matter whether it's an inflationary economy or not, we continue to believe that we're deriving tremendous value for our customers. And so the conversations that happen around Adobe are around the product roadmap and innovation and attracting new customers way more than trying to, at this point, look at a price optimization, and so we have a massive TAM ahead of us. That's really the focus.
Tyler Radke: Thank you.
Operator: And next we'll go to Brent Thill from Jefferies. Your line is open.
Brent Thill: Hi, Shantanu, on the digital experience business, many of your SI partners have been commenting that there are capacity constrained that their utilization rates are, in their words through the roof. I'm curious if you're running into constraints on the implementation side, what you're seeing to offset that? Is that more of a random data point? Are you seeing that across the board from some of the SI partners?
Shantanu Narayen: I would say, Brent that clearly the demand for our solutions and expertise, whether it's on content and commerce, whether it's around data and insights, whether it's around the new workflow stuff that we've done, what's exciting for us is that there's a lot of demand on the ecosystem to have us help them with training. I think you'll periodically see some of them feel like they're capacity constrained and that's a little bit more as a result of the war for talent. But overall, I think, we will continue to help support them in any way. And I think net-net it’s a good sign for the business. On the product side, we are going to really make sure that we continue to make it easier to provision, easier to use, easier to get value. And we've been seeing some good customer sentiment associated with our work on that front. So hopefully, that's an isolated incident as it relates to that SI partners ability to get it. But it's certainly true as it relates to the overall market and the ability and the interest in our solution. So I think that part is certainly true.
Brent Thill: Quick follow-up for John, just on the second-half margins. As things reopen, how are you thinking about this? I mean, you are this quarter about a point away from your all time quarterly high and out margin. Do things have to come back in a little bit over time, given the reinvest in the opening world or not?
John Murphy: Yeah. Thanks, Brent. Yeah, we definitely think it will come down slightly in Q3 and Q4, as we open up. I mean, we're continuing to invest, as we talked about, we're hiring in R&D. We're definitely investing in sales and variable marketing to really drive the business and execute against the huge TAMs that we have across all three businesses. So with the momentum that we have in the business world, we will make sure that we capitalize on that momentum and invest to be able to capture it. But certainly, as things are opening up, we'll see those expenses come back online, as we more people, it'll get phased in reentry approach for us through Q3 and Q4. But certainly, business travel will start to pick up as well.
Shantanu Narayen: And Brent, maybe I'll just add, when we look at some of the key new categories that we're continuing to invest in, and you're seeing the results associated with it, I mean, to your question about the Real-Time CDP and the associated services, Sign, Stock, Mobile and our mobile offerings, we remarked also about 3D&I and specialist offerings associated with that. And so, it really behooves us to continue to as we always have judiciously, invest in marketing to continue to attract new customers to the platform, which will again, as John said, be seen on the sales and marketing expense. But net-net, I mean, we're really excited about the growth that we're seeing.
John Murphy: Yeah, and just to think about Shantanu I mean year-over-year you are going to see margin expansion went even above what our original targets were. Thanks.
Operator: And next we'll go to Kash Rangan from Goldman Sachs. Your line is open.
Kash Rangan: Hi, thank you very much. Congratulations to the Adobe team and spectacular results. Shantanu, I want to just go back to Creative TAM, just the topic that continues to fascinate me. I mean, seven, eight years into the transition, the Creative business is as big as it can be $10 billion, nearly 100 and growing 22% to 24%. As you unfold the layers of the Creative market, what is it that you finding that might have surprised you? And could we see that TAM for Creative as the business unfolds even larger than your original expectations? And also as a subtext to that you think address video and how video is shaping up? Now I remember once you said that video could be as largest photo oriented business, any thoughts there would be great. And also if you have any thoughts on what might be David's involvement with the Creative business? And should we expect to see any refinements enhancements modifications of the strategy on the Digital Media front with David coming back on board? Thank you so much. Congrats.
Shantanu Narayen: Thanks, Kash. And I love the way all of you so far have been when we say one question, putting in a three part question. But Kash, I think…
Kash Rangan: You can take any one.
Shantanu Narayen: It's okay. I mean, they're all good questions. And so I think first Kash on the $40 billion plus TAM as you know, we have clearly transitioned the business from Creative Cloud focused customer, to just being a Creative Cloud, the communicators, the services that we've added associated with Stock photography and Sign. And, I think we continue to have very exciting opportunities in terms of continuing to expand that TAM. And I think it all stems from design and creativity has never been more important, right. We talked about how it's the golden age of design and creativity. But for you, as a consumer, whether you're interacting with a screen at a terminal or in a retail store, or how you order something, I mean, it's all about content creation. And when you think about how much content we've all consumed in the pandemic at home, it's just gone through the roof. And we announced the partnership with Netflix, and what we're doing with Khan Academy to make sure content creation is as seamless and productive. So I think that's driving it. And people love to say we want to be in the content and design business to personalize it, as well as a career. So I would say that's the first thing that we're certainly seeing. International expansion, we've talked about how we continue to focus on international markets. And, it originally started with dealing with piracy, but across the small and medium business TAM, as those companies are also creating a marketplace for themselves with our content management solutions, our commerce solutions, content velocity is critical there. So I think all those are clearly tailwinds for the ever increasing TAM. I think we increased it from $31 billion to $41 billion when we talked about it at the Next FA meeting. And we'll certainly update that when we have our Next. I think, as it relates to David, I'm really excited. As I said, David played a significant role in the introduction of Creative Cloud when he was here. And I think the fact that we were able to excite them and recruit them back, just I think speaks to the tremendous opportunity that he also sees for the business. And from my point of view, we have all of these unicorns within the Creative Cloud. And I'm looking to partner with David, whether it's expanding on our enterprise footprint, whether it's continuing to make sure that we get the opportunity around Sign addressed, what we are doing associated with the mobile offerings. I mean, each one of these is a large business by itself and having somebody of his caliber to continue to work with, Scott on the product side and Abhay on the Document Cloud side, it's great to have that kind of bench when we have the kind of opportunity that we have. So hopefully, that answers the question around David as well, Kash.
Kash Rangan: Brilliant. Thank you so much.
Operator: Next we'll go to Sterling Auty from JP Morgan. Your line is open.
Sterling Auty: Yeah, thanks. Hi, guys. Shantanu, I thought your comments about Chuck were spot on. I'm sure he'd be very proud to see the performance of the company and directionally where it's headed. I'm kind of curious on the Digital Experience side, in terms of the product roadmap and changes and improvements that you made last year, how those have been resonating with customers currently? And are there any key new innovation milestones that we should be looking for, that could further improve the growth in that business over the coming couple of quarters?
Shantanu Narayen: Thanks for your comments on Chuck, Sterling. A number of you I know have written to me, which I appreciate the impact that each one of you also felt when you interacted with Chuck. So, I really have appreciated all of those comments. As it relates to the customer experience management questions, Sterling, I think we're in the really early innings. We have some tremendous ideas ahead of us and with Anil Chakravarthy, I'll touch on a couple. I mean, the Real-Time Customer Data Platform is just really the infrastructure for every engagement that a customer has. We touched on the Journey Optimizer, which is think about optimizing the customer journey across outbound and inbound customer touchpoints, both in physical and electronic. I mean that’s just a massive opportunity in terms of communicating, whether it's by email, whether it's SMS, whether it's any of these new platforms that emerge. The Customer Journey Analytics, my perspective on Customer Journey Analytics is, we used to do the fantastic job on web analytics, but this is increasingly becoming what is the analytics across all of the different online and offline data. And it's the way you run a business. And we're living proof of, when we talk about our DDOM, how we can use that, so I think the Customer Journey Analytics is also in terms of the ideas that we have on its infancy. And maybe the last one I'll touch on, is what we've been previewing in terms of this marketing system of record and workflow. Trillions are being spent in marketing and the process associated with rolling out those campaigns, understanding the efficacy of those campaigns, making those campaigns international. I think that all of that is really, really, ahead of us in terms of what we can do. So we're very excited. And for all of these companies, as they have to transition with what's happening in browsers, and dealing with a first-party data world or dealing with privacy concerns, all of that, frankly, is opportunities for us because we step up and enable them to engage with their customers and focus on their product offering rather than all this other stuff, because we know how to do that well.
Sterling Auty: That makes sense. Thank you.
Shantanu Narayen: One last thing, maybe on that is the B2B. I think we've always -- most people talk about this and think about the B2C business, Sterling, which is, yeah, they understand travel and hospitality, they understand retail, they understand banking, but this is now happening, where it doesn't matter what business you're in. The ability to drive from leads to revenue for a B2B business is also digital. I mean, if you're a company in the pharma industry, and you're not able to go visit doctors, and talk to them about the innovation that you're doing, it’s going to move digital. So I think there's just so much on that particular front.
Sterling Auty: Thank you.
Operator: And next, we have Brad Sills from Bank of America Securities. Your line is open.
Brad Sills: Oh, great. Thanks, guys, for taking my question. And congratulations on a nice quarter here. I just wanted to ask a question on reopening. As you look towards, as we look towards reopening in U.S. and North America and Europe, what impact do you think that's going to have on the Digital Media businesses? It's an accelerant, do you think? Or, and also a Digital Experience what are your thoughts on that? Thank you.
Shantanu Narayen: I think they're really tied to the macro-economic environments. And I think you're seeing that the return to work, the macro-economic environment is coming back stronger than it's been across all of the customer segments. And for us, we don't view ourselves as in terms of the solutions we're providing these digital are not a stay at home or work kind of solution. They're just mission-critical, irrespective of which you have. And so, what I think we'll see is that, as people come back to work, the small and medium businesses will recognize that it's an opportunity for them to engage. So I think you'll see more investment there. I think you'll see certainly, as Europe and other parts of those economy open up that'll help. I think Japan, the level of vaccination is low, so I think as they come back to work, that's only going to lead to more optimism. And so I think when you think about consumer confidence, and you think about businesses want to invest, I think both of those are only going to be helped by a return to normalcy and a return to work. That's sort of my perspective.
Brad Sills: Thank you so much, Shantanu.
Shantanu Narayen: Thank you.
Operator: And next we have Jay Vleeschhouwer from Griffin Securities. Your line is open.
Jay Vleeschhouwer: Thank you. Good evening, Shantanu, you mentioned summit, and it was clear from the conference that there were multiple internal initiatives you're working on that would seem very likely to have important implications for you over the next number of years. And since you didn't refer to them directly, perhaps you could comment on some of those, including, for example, what was referred to as your quote future creative stack, additionally, project Firefly and your API strategy, some very interesting references to your Adobe commerce merchant services, including payments and some other things you're working on? And then lastly, the build out of ATM is a cloud service globally targeted for this year. So those are some pretty interesting things from the conference of perhaps you could talk about? And then for the follow-up, in answer to an earlier question you referred to ‘war for talent.’ And in your case, you've had a V-shaped recovery in terms of your own job openings. You added an unusually large number of people in a non-acquisition quarter. Maybe for John, you could talk about whether you think you could or should continue to increase your headcount at the same pace as in Q2.
Shantanu Narayen: Thanks for the question, Jay. As you know, I can wax eloquent about product stuff for a long time, but let me touch on at least the two ones that you did. I think as it related to the cloud-based content management, the intent is very straightforward, which is how do you transition anybody who wishes to self-provision a cloud-based content offering. And think about, if you're a small and medium business, or if you're a large company trying to do a product campaign, you need to get a website, you need to get it localized, you need to get it up and running, you need to be able to do commerce. And so the fact that we've got this easy to provision cloud-based content management, which is the leader in the category, but in addition to that, as you mentioned, the APIs now so people can actually embed this APIs that we have for our content management solution directly. So we're very excited about that. We mentioned last quarter that it saw significant adoption. And so I think that will continue to be a driver for the business. I think, as it relates to your other question around what we are doing on the content stack, we've always mentioned that, for us content and data are the two areas where we differentiate ourselves. The asset management problem is still a problem where we have a significant amount of innovation that we're continuing to deliver. And so, we're really excited. I mean, net-net, I think Anil and the product team on the DX side, have outlined a number of initiatives. Other companies talk about a lot of the stuff, but they don't have their products integrated. They don't have the ability to seamlessly provision and so I think that's where we are going to continue to focus. And maybe an underappreciated area Jay is how easy, these are now to set up and provision and for practitioners of this business, to be really able to do it. I think your second question is a very interesting one, which is you're absolutely right, the merchant services ecosystem that Magento has, we've actually done a really good job of building that out. I mean, certainly, companies like PayPal that we've talked about, we've talked about what we can do with FedEx. More recently, there are a number of other such initiatives that are underway, some of which we're not at liberty to talk about, right yet. But I think, dealing with payments, dealing with shipping, dealing with working capital, a lot of interesting ideas where we're very well-positioned to both deliver value as well as to monetize it.
John Murphy: And Jay, on the headcount commentary, just to I mean we certainly have a number of positions open, that we're actively recruiting against. But we're committed to investing to be able to capture the larger opportunity. So we're going to continue to hire in for innovation and we're going to continue to invest in sales headcount as well as leverage our ability with variable marketing to really drive performance. So, I don't think this is the time to pull back given the momentum in the business.
Jay Vleeschhouwer: Thanks, Shantanu. Thanks, John.
Shantanu Narayen: Thanks, Jay.
Operator: And next we'll go to Keith Bachman from Bank of Montreal. Your line is open.
Keith Bachman: Hi, many thanks. First, I wanted to ask a clarification and then Shantanu a question. John, can you give us the contribution of Workfront this quarter? And then secondly for Shantanu, I wanted to go back to the Experience Cloud. And feedback that we've recently gotten is very positive on the Real-Time CDP and the Customer Journey Analytics, as you mentioned. I'm trying to go back to what's the potential growth rate here. So A, was Experience Cloud you think impacted more during COVID than other parts of the business? Because I'm trying to understand whether there might be a harder snap back. And then B, when you think about the growth potential here, Gartner comes out with some numbers that areas in the Experience Cloud have grown 15%. Your own TAM analysis that you put out suggested the market in ‘23 growth is more like 25%? How do you think about the business between those two potential growth rates?
Shantanu Narayen: Yeah, the way I would answer the question, first, on the Workfront stuff, I mean, it becomes -- we, I think, do a great job of talking to you about how it's going on the integration. And it's going really well. We don't break it out after a while, because it's part of so many of these large transformational deals, as well as integrated into other solutions. But Workfront is going really well, it's the basis for a lot of the workflow that we're doing across each of our solutions. And we're on track to beat the targets that we gave for Workfront. So I do want to say that that went well. I think as it relates to the overall TAM, which was your second question, we look at it as it's $80 billion plus, so there's plenty of available and I think a lot of legacy software is going to get rolled out. And so for us, it's not just about what the growth rate is in that market, people are going to recognize that having modern architecture for dealing with consumer engagement is going to become a bigger and bigger imperative. And, frankly, the smart companies are opening up their budgets to start to invest in it sooner rather than later, as we said on B2B and B2C. So, we're really pleased with the 20% plus growth that we're seeing, 25 points of subscription revenue growth, we think is really good. We want to continue to focus on subscription revenue as the true measure of that business. And I think as we continue to deliver on the innovation and product roadmap, I think, we would hope to continue to see those growth rates, even as the business grows much larger.
Keith Bachman: Okay. Thank you, Shantanu.
Shantanu Narayen: Thank you.
Jonathan Vaas: Operator, we're coming up on the top of the hour. We'll take one more question, please.
Operator: Thank you. Our last question comes from Gregg Moskowitz from Mizuho. Your line is open.
Gregg Moskowitz: Great. Thank you for taking the questions. Shantanu, the Document Cloud enterprise bookings growth up more than 60% year-over-year, obviously really impressive. What would you primarily attribute that to? And then just for John quickly following another upside quarter with an accelerated recovery in SMB, would you say that you have returned to pre-pandemic levels?
Shantanu Narayen: I think as it relates to your first question around Document Cloud, I mean, again, there isn't a business that is not saying, hey, how do we help automate inefficient paper-based processes. And so the value proposition of the PDF file format, the value proposition of Acrobat, as an essential productivity tool for knowledge workers, the availability of Sign, what we're doing with forms and embedded payments, I think it's the combination of all of that, whether you're, again, somebody trying to deliver vaccines for employees, or somebody trying to create a new travel authorization or expense. I mean, documents are the fundamental currency of modern business and automating that only has value. And I think our team has done a good job. We don't go to market saying, here's a Document Cloud solution, or here's an Experience Cloud solution. We go and saying, here's the use case for if you're in travel and hospitality or retail, or financial services, or pharma. And I would say, government and healthcare have also become larger customers of these kinds of solutions, because of the necessity for regulated industries, who previously may have relied on paper to say, you know what we need to get into the modern era and deal with electronic documents. So I would say, those are all the reasons and good execution, clearly on the part of our team, as we're selling increasingly at a much higher level in all of these companies. I'll let John speak and then I'll come for the close, given this is the last question.
John Murphy: Great. Thanks, Shantanu. Thanks, Gregg. Yeah, we've been kind of talking about the last couple quarters, the gradual recovery of the SMB segment, which was hit so severely when the pandemic hit last year. And we saw that continue here in Q2, and really kind of reach that pre-pandemic level of conversion, retention, at least for sure in the U.S., and there's just tons of opportunity now as the rest of the world begins to open up as well for that to continue to improve.
Gregg Moskowitz: Very helpful. Thank you.
John Murphy: You bet.
Shantanu Narayen: And thank you all for joining us. I think from my perspective, I'm really pleased with our performance in Q2. It was an outstanding quarter. And to the question that was asked earlier, with many parts of the world returning to some sense of normalcy, that should only be good for our business, because digital is this incredible tailwind where it's just a one way street in terms of people wanting to invest. We do expect, therefore, a slight seasonality associated with our business. But we definitely have an expectation of a strong finish. And if you look at our first-half performance, if you look at our targets for Q3, and the belief in the seasonally strong Q4 finish, that's going to be another outstanding year where we are going to exceed a lot of the targets that we talked about, if not all, at the beginning of the year. We're driving bookings, we're driving revenue performance from bookings as a result of making sure people get value for it. We're driving a lot of new businesses that have become material in the company, and so the breadth of our portfolio is impressive, because digital is not just a nice to have, it's become super critical. And as I've always said, having three areas of explosive growth puts us in really rarefied atmosphere. And growing 20% plus on the top-line growing the bottom line, as impressively as we have with strong cash flow, I think really demonstrates how we're driving value for our customers and value for our shareholders. So, thank you for joining us today and have a great summer. With that, I'll pass it back to Jonathan.
Jonathan Vaas: Thanks, Shantanu, and thank you everyone for joining. This now concludes the call.
Operator: And that does conclude our call for today. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, everyone, and welcome to the Second Quarter Fiscal Year ‘21 Adobe Earnings Conference Call. Today's call is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's President and CEO; and John Murphy, Executive Vice President and CFO. On this call, we will discuss Adobe's second quarter fiscal year 2021 financial results. By now, you should have a copy of the press release, which crossed the wire approximately one hour ago. We've also posted PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. Before we get started, I want to emphasize that some of the information discussed in this call, including our financial targets and product plans, is based on information as of today, June 17, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the forward-looking statements disclosure in the press release we issued today, as well as Adobe’s SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe.com for approximately 45-days. The call audio and the webcast may not be re-recorded, or otherwise reproduced or distributed without Adobe’s prior written permission. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Adobe had another outstanding quarter as the shift to a digital-first world continues to accelerate. From students to creative professionals to small businesses to the world’s largest global enterprises, digital is transforming how we work, learn and play. Adobe’s mission to change the world through digital experiences has never been more relevant. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is working. Fueled by our ground-breaking innovation, proven capability to create and lead categories and our expansive global customer base, our opportunity and momentum has never been greater. In Q2, Adobe achieved $3.84 billion in revenue, representing 23% year-over-year growth. GAAP earnings per share for the quarter was $2.32 and non-GAAP earnings per share was $3.03. In our Digital Media business, we drove strong revenue growth in Q2 in both Creative Cloud and Document Cloud, achieving $2.79 billion in revenue, representing 25% year-over-year growth. Net new Digital Media Annualized Recurring Revenue or ARR was $518 million, and total Digital Media ARR exiting Q2 grew to $11.21 billion. Over the last year, we have seen the critical role creativity has played in the world. Creative Cloud is empowering everyone, from the most demanding professional, to the high school student, to the next generation of social media creators, to tell their stories. Adobe is the leader in core creative categories such as imaging, design, video and illustration, and we are expanding our leadership in exciting new media types, including screen design and prototyping, 3D and AR. In a world that requires anyone to be able to create from anywhere, we are building products and services for every surface and platform. Our vibrant creative communities continue to be a tremendous source of inspiration and our goal remains to provide access to a larger and increasingly diverse set of creators and design teams, furthering our strategy of unleashing creativity for all. Q2 Creative Cloud performance was strong, with net new Creative Cloud ARR of $405 million and revenue of $2.32 billion, representing 24% year-over-year growth. Q2 highlights include, new product innovations, including updates to Lightroom, Photoshop and Illustrator that deliver enhanced creation and collaboration capabilities and greater speed and performance. Next week, we will unveil new innovations for Substance, our 3D solution, designed to improve the creation process with new tools to help assemble, style and sculpt. Increasing engagement and retention across offerings, including greater customer uptake of training, participation in community events and continuous product enhancements derived from insights about customer usage and value. Momentum in our Creative Cloud Teams offering globally, reinforcing the growth in adoption of Creative Cloud within small and medium businesses. Strong customer acquisition in core creative and emerging categories, especially photography and video, supported by exciting marketing campaigns globally for Photoshop and Premiere; and accelerating demand for 3D&I in key verticals such as gaming, automotive, fashion & e-commerce. Continued growth of mobile traffic, leading to new customer acquisition of mobile offerings, like Lightroom Mobile and Photoshop Express, and a strong funnel for desktop applications, strong growth for Adobe Stock, with an increasingly robust content library and growing submissions that provide sustained earnings for our contributors. Global momentum, with accelerated demand in EMEA and Asia Pacific. Key customer wins, including ByteDance, Netflix, Microsoft and Unity. And new partnerships to inspire the next generation of creators, including one with Netflix that gives emerging creators access to tools, resources and mentorship to bring their stories to life, and another with Khan Academy, designed to provide teachers and students in underserved communities with access to digital tools and learning resources. In this digital-first business environment, seamless document workflows across every device and platform are more important than ever for the modern workforce to collaborate and be productive. Document Cloud is accelerating document productivity by powering the paper-to-digital transformation and enabling all document actions including editing, sharing, scanning and signing to be frictionless across web, desktop and mobile applications. We delivered strong Document Cloud revenue in Q2, with net new Document Cloud ARR of $113 million, and outstanding revenue of $469 million, representing 30% year-over-year growth. Q2 highlights include new product innovations, including new features in Acrobat Liquid Mode that further improve accessibility on mobile devices; new Adobe Scan functionality that enables users to combine, save and store scans more efficiently; and new Sign capabilities in Acrobat to help small and medium-sized businesses improve their digital footprint with easily embeddable forms and digital payments. Strength in Acrobat across all routes to market and offerings, with enterprise bookings growth up over 60% year-over-year; accelerated demand for Sign, with new Sign customers doubling year-over-year and an increasing share of Acrobat users leveraging Sign capabilities; explosive growth in Acrobat Web services, driven by significant improvements in SEO for a new set of customers. In Q2, we drove 30 million visits to frictionless PDF pages and now offer capabilities for over 20 different document verbs; continued growth of mobile traffic, including over 110 million mobile downloads of Adobe Scan and one billion scans to-date, and a greater than 20% year-over-year increase in Acrobat mobile app adoption; momentum across all geographies, with accelerated demand in Europe, Latin America, Australia and New Zealand; and key customer wins, including ADP, AstraZeneca, GlaxoSmithKline, Toyota and Wells Fargo. I am thrilled to welcome back David Wadhwani, who has rejoined Adobe as Executive Vice President and Chief Business Officer of our Digital Media business. His impressive track record and passion for Adobe and our customers make him the ideal person to lead our Digital Media business through its next phase of growth. Digital transformation has become an imperative for businesses of every size in every industry. According to our recent Adobe Digital Economy Index, e-commerce spending is projected to be $4.2 trillion globally this year, and reach $1 trillion in the U.S. alone in 2022. We predict that U.S. online spending on the upcoming Prime Day will surpass the $10.9 billion mark that Cyber Monday reached in 2020. Across both B2C and B2B, companies around the globe are investing in digital to deliver personalized and engaging customer experiences. Experience Cloud is the most comprehensive solution for content and commerce, data insights and audiences, customer journeys and marketing workflow. With unified customer profiles and an open and extensible architecture, Adobe Experience Platform is the clear platform of choice for enterprises to deliver real-time personalization at scale, powering more than 17 trillion audience segment evaluations every day. Experience Cloud revenue was $938 million in Q2, representing 21% year-over-year growth, and subscription revenue was $817 million, representing 25% year-over-year growth. In April, we held our annual digital experience conference, Adobe Summit, virtually. We drove an unprecedented 20 million views of Summit content from individuals around the globe, underscoring the significant interest and demand for customer experience management. Highlights of product announcements include, Adobe Journey Optimizer, which helps marketers optimize the customer journey across outbound and inbound customer touchpoints; Adobe Customer Journey Analytics, which enables brands to integrate and standardize their online and offline data and is years ahead of any competitive offering; the next generation of Adobe’s Real-time Customer Data Platform to help brands optimize their acquisition and engagement strategies in a first-party data world; a preview of a pioneering marketing system of record, built on Workfront technology, designed to manage complex marketing workflows for greater efficiency and agility; and new intelligent commerce capabilities and a strategic partnership with FedEx that will allow every small and medium business to offer expedited shipping capabilities as part of their commerce platform. Beyond Summit, Q2 accomplishments include, strength in core offerings, including explosive bookings growth for Adobe Experience Platform, and associated services like Customer Journey Analytics and Real-time CDP, which combined blew past the $100 million book of business mark in Q2. Success with large multi-solution deals in transformational accounts and improving close rates across geographies, customer segments and product pillars. Building the future workforce by offering college instructors and students' globally free access and curriculum for Adobe Analytics, the industry-leading customer data analytics platform. Continued industry analyst recognition across all customer experience management segments, including being named a leader in the Forrester Wave for Enterprise Marketing Software Suites, achieving the top spot each of the five times the report has been published and leadership in the Gartner Multichannel Marketing Hubs Magic Quadrant for the fourth year in a row. And key customer wins with brands like Nike, NatWest, NTT Docomo and T-Mobile. We are proud of the tremendous results and momentum across our business. As we plan for a post-pandemic world, we will remain flexible as different regions recover at different times. While offices in Australia and parts of Asia have been open for some time, and conditions in the U.S. and parts of Europe are improving, we will continue to support our employees in places like India and Brazil where the situation remains challenging. Over the last year, we have been building a blueprint for the future of work at Adobe, which will be hybrid and flexible. In the U.S., we will be piloting a return to our San Jose office, starting with a small group of fully vaccinated employees in July. We are committed to leveraging the best of in-person and digital interactions to harness what makes Adobe special, our creativity, innovation and culture, driven by our most important asset, people. I want to thank all of our employees for their dedication and resilience during a year that was not only marked by the pandemic, but by violence and racial injustice. I am proud of the progress we have made in advancing our efforts around diversity, equity and inclusion. We have made strides in our strategy to accelerate the representation, growth and advancement of the Black community. But as Juneteenth approaches later this week, we know we have so much left to do. As we celebrate Pride Month in June, we are honoring and spotlighting our LGBTQ+ communities both inside and outside of Adobe. These efforts represent Adobe’s longstanding commitment to supporting our diverse employee base and making an impact in the communities where we live and work, a principle our co-founders, John Warnock and Chuck Geschke, instilled in us. In Q2, we lost our beloved co-founder Chuck Geschke. Chuck left an indelible mark on Adobe, the technology industry and the world. While we miss him tremendously, it gives me great comfort knowing that Chuck was so proud of the company that Adobe has become. Adobe’s strong culture, revered brand, innovative product roadmap and the world’s best employees, customers and partners position us for continued success in 2021 and beyond. John?"
},
{
"speaker": "John Murphy",
"text": "Thanks, Shantanu. Q2 was an excellent quarter for Adobe, with strong revenue growth, enterprise bookings in Digital Experience and net new ARR in Digital Media, showing how our solutions are resonating with customers of all types in an increasingly digital world. With our data-driven operating model or DDOM, we continue to utilize our own Experience Cloud technology to optimize customer journeys, driving increasing amounts of traffic to Adobe.com to acquire new customers and raise awareness of our products. We continue to invest for growth in sales and marketing, while also increasing headcount in Q2 to drive product innovation. As a result, in Q2 Adobe achieved revenue of $3.84 billion, which represents 23% year-over-year growth. Business and financial highlights included: GAAP diluted earnings per share of $2.32 and non-GAAP diluted earnings per share of $3.03; Digital Media revenue of $2.79 billion; net new Digital Media ARR of $518 million; Digital Experience revenue of $938 million; record cash flows from operations of $1.99 billion; RPO of $12.23 billion exiting the quarter; and repurchasing approximately 2.1 million shares of our stock during the quarter. In our Digital Media segment, we achieved 25% year-over-year revenue growth in Q2, and we exited the quarter with $11.21 billion of Digital Media ARR. We achieved Creative revenue of $2.32 billion, which represents 24% year-over-year growth, and we added $405 million of net new Creative ARR. Second quarter Creative growth drivers included: strong retention and renewal across all Creative products and customer segments; new user acquisition, driven by global marketing campaigns utilizing our DDOM insights; accelerated recovery in the SMB segment with our Creative Cloud for Teams offering; success in enterprise licensing, driven by account expansion at renewal; momentum with our Adobe Stock business, which continues to outpace industry peers in terms of revenue growth; driving subscriptions in the education segment, both with individuals and institutions; and generating net new ARR through app store sales of our mobile and iPad applications. Adobe achieved Document Cloud revenue of $469 million, which represents 30% year-over-year growth, and we added $113 million of net new Document Cloud ARR in the quarter. Second quarter Document Cloud growth drivers included: increasing unit demand for Acrobat subscriptions across all geos; strong subscription licensing of our Teams offering in the SMB segment; success in enterprise licensing, with broad seat expansion across enterprise accounts. Accelerated adoption of our Acrobat Web offering, driving top-of-funnel awareness and conversion to paid subscriptions; continued strength with Adobe Sign, which grew ARR greater than 40% year-over-year exiting the quarter; and driving improved conversion on Adobe.com. Turning to our Digital Experience segment, in Q2 we achieved revenue of $938 million, which represents 21% year-over-year growth. Digital Experience subscription revenue was $817 million, representing 25% year-over-year growth. On the heels of Adobe Summit, we had success in Q2 generating pipeline and closing strategic customer deals across our portfolio of customer experience management or CXM solutions. Deal volume was sustained throughout the quarter, with several large transactions closing earlier in the quarter, contributing to our revenue performance in Q2. We continue to see broad macroeconomic recovery, including in the commercial segment, and enterprises of all sizes are investing in digital transformation. Business performance in Digital Experience during the quarter was driven by: strong bookings for Adobe Experience Platform or AEP, and native applications built on AEP, including Real-Time CDP and Customer Journey Analytics, which continue to build momentum; recent innovations and partnerships driving awareness and adoption of our Analytics, Commerce and Campaign solutions; continued success with our Workfront offering, as we realize the value of combining a best-in-class workflow solution with our CXM offerings to create an industry-leading marketing system of record; momentum signing up transformational, multi-solution engagements with enterprise customers across geographies; and strengthening customer renewal and expansion rates. Savings from T&E and site operations are continuing as our employees work from home. We are investing in our facilities as we reimagine the future of work, and many of our employees return to offices and business travel during Q3. From a quarter-over-quarter currency perspective, FX increased revenue by $10 million, both before and after applying the net impacts from hedging. From a year-over-year currency perspective, FX increased revenue by $94 million. Net of impacts from hedging, the year-over-year currency increase to revenue was $78 million. Adobe’s effective tax rate in Q2 was 19.5% on a GAAP basis and 16% on a non-GAAP basis, in line with our expectations for the quarter. Our trade DSO was 35-days, which compares to 40-days in the year-ago quarter, and 38-days last quarter. RPO grew by 23% year-over-year to $12.23 billion exiting Q2, benefitting from strong enterprise licensing during the quarter. Deferred Revenue exiting the quarter was $4.28 billion, growing 24% year-over-year. Our ending cash and short-term investment position exiting Q2 was $5.77 billion. Cash flows from operations in Q2 were a record $1.99 billion. We repurchased approximately 2.1 million shares in the quarter at a cost of $983 million. We currently have $15.1 billion in remaining authority, of which $100 million was granted in May 2018, and $15 billion was granted in December 2020. The following Q3 targets factor current macroeconomic conditions and expected return of summer seasonality associated with the months of June, July and August. Total Adobe revenue of approximately $3.88 billion; digital Media segment revenue growth of approximately 22% year-over-year; net new Digital Media ARR of approximately $440 million; Digital Experience segment revenue growth of approximately 21% year-over-year; Digital Experience subscription revenue growth of approximately 25% year-over-year; tax rate of approximately 19% on a GAAP basis and 16% on a non-GAAP basis; share count of approximately 480 million shares; GAAP earnings per share of approximately $2.27; and non-GAAP earnings per share of approximately $3. We are pleased with our first-half performance, and we expect the momentum to continue, with typical Q4 strength. With the momentum we are seeing across creativity, digital documents and customer experience management, we are on track for another record year with a strong first half already in the books. Few companies of our scale can boast 20% plus revenue growth, world-class operating margins and a recurring-revenue model built for long-term growth and profitability. I will now turn the call over to the operator to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] First we'll go to Keith Weiss from Morgan Stanley. Your line is open."
},
{
"speaker": "Keith Weiss",
"text": "Thank you, guys for taking the question and really nice quarter. I think it's pretty remarkable in a quarter where a lot of investors were worried about a difficult comp, net new ARR growth actually accelerated in the quarter. And I was hoping you could dig into that a little bit. It's obvious you guys are building momentum, there's a broader base of customers that are coming into the Digital Media fold. Can you talk a little bit about who that is and kind of where you're seeing the most success in sort of broadening that scope and enabling that building momentum within this business, which is already quite large and well growing?"
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Keith. As you said, it was a really great quarter. And we actually saw great linearity associated with the Digital Media ARR throughout the quarter as well. And as you know, we have this incredible data-driven operating model that allows us to deal with all aspects of the customer funnel from discover, which is done through our marketing attribution all the way through usage and engagement. In terms of the new customers who are coming onto the platform, mobile and communicators is a way we define that Keith are a significant portion of the new customer base. Specialists on the other hand as it relates to 3D&I. Acrobat, as we also mentioned, had a very strong offering. And so I would say the photography and video offerings are really targeting everybody from creative professionals, to communicators, to consumers as is Acrobat. But then we're also seeing some really good adoption of Acrobat across the spectrum. And in our prepared remarks, the last thing I'd say is we also talked about the revival of the Teams business. And as we all know, the small and medium business segment I think was most impacted last year. So, really pleased with it, Keith. So across product offerings, across geographies and across some of the new businesses and services as you said, we saw good strength in Q2."
},
{
"speaker": "Keith Weiss",
"text": "Got it. And if I can sneak one in for John on the guide into Q3, the net new ARR guide is about down 15% sequentially. I think there's more than we see seasonally. Is there anything we should be aware of in terms of either kind of one-time items, if you will in Q2, or something we should be looking out for in Q3 that explains that broader than or sort of bigger than normal seasonality, or seasonal decline into Q3?"
},
{
"speaker": "John Murphy",
"text": "Yeah. Thanks, Keith. When I look at the guide for Q3, it's the largest guide we've done for ARR into Q3. As we talked about last couple of quarters, last year was kind of a really strange year, right, we didn't see the seasonality we typically saw because of the pandemic and everybody being locked down. As things are starting to open up, we're anticipating kind of a return to some of that seasonality that we saw in the past. And so we've factored that into the guide. But we're really excited that we can actually target the highest ARR guide ever in Q3. So overall, great performance and we can see the momentum is still in the business."
},
{
"speaker": "Keith Weiss",
"text": "Outstanding, great job, guys."
},
{
"speaker": "John Murphy",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Next we'll go to Alex Zukin from Wolfe Research. Your line is open."
},
{
"speaker": "Alex Zukin",
"text": "Hey, guys, thanks for taking the question. So I'll take the other side of the business. On the Digital Experience side. I mean, again, every indicator, whether it was RPO, whether it was the Digital Experience revenue and subscription revenue was strong. Can you talk to what you saw on the quarter, what's changed since the pandemic, and maybe some of the pipelines? And how we should think about that business from here from a growth perspective?"
},
{
"speaker": "Shantanu Narayen",
"text": "As you point out, Alex, it was a strong quarter. And right through the pandemic, we've been talking about how the interest in our Digital Experience solutions and the belief, when I have conversations with CEOs across every single vertical is that the only way to engage with customers is going to be digital. And I think people are starting to recognize that that investment is an investment that they have to pay. So first, I think from a macro perspective, it's clear that digital transformation and within digital transformation, customer experience management is front and center as something that they want to spend money on. The second thing I would say is, the execution against our new experience platform. And both John and I touched on Customer Journey Analytics and the other services that we're building on top of that, those are clearly resonating with customers, because whether you're B2B or whether you're a B2C, you have to have the ability right now to deliver the personalized experience. So I think the second thing I would say is that the innovation that we're delivering, and the fact that we had summit, and the ability to engage with these customers, certainly I think was an accelerant for the business. The third thing I would say is the ecosystem and the ability of the ecosystem to very quickly ensure that these customers derive value from the investment that we're making. I think that helps both in terms of converting bookings to revenue, but it also helps in terms of growing the book of business with enterprises. So, I would speak to all three of them. I think if you look at our targets as well, in terms of over 20% revenue growth, close to 25% subscription revenue growth that we're seeing in that business, I think we continue to be optimistic that we have the right product that clearly meets a customer need. And, the execution in the company against that business has been strong."
},
{
"speaker": "Alex Zukin",
"text": "And maybe just squeezing quick one in for John. On cash flow, well ahead of our estimates here for the second quarter, what's the right way? What's driving that? Is that just as simple as strong collections on larger deals? And thinking through the year, obviously, we're not guiding or updating guidance, but just anything to think through the net new ways to look at the free cash flow margin of the business and the growth of free cash flows?"
},
{
"speaker": "John Murphy",
"text": "Yeah, sure. Yeah, we certainly were pleased to deliver numbers like that. We had some timing of payments, for sure. And as you saw, our DSO really dropped pretty significantly quarter-to-quarter. So all that really contributed to it, as well as the timing of some large payments [Indiscernible], as well as timing of when we have some dispersions as well. So it's really -- overall just great performance for the company. And sometimes you'll see a little bit of a shift quarter-to-quarter, but we're certainly given the capability of the company and the operating leverage in the model where we are generating a lot of cash right now."
},
{
"speaker": "Alex Zukin",
"text": "Got it. Thank you guys."
},
{
"speaker": "John Murphy",
"text": "You bet."
},
{
"speaker": "Operator",
"text": "And next we'll go to Saket Kalia from Barclays. Your line is open."
},
{
"speaker": "Saket Kalia",
"text": "Hi, guys, thanks for taking my question here. Shantanu, maybe for you to go back to the Creative business. Can you just anecdotally talk about any difference in product mix, specifically? I guess, as more potential users got back to work, including Creative professionals, did you see any change in the mix of single apps versus all app subscriptions perhaps?"
},
{
"speaker": "Shantanu Narayen",
"text": "Saket, I think we saw strength across all of the businesses. I would say that the single app business, as you know, is a really great initial funnel for us to drive the business. And so we continue to see new adoption as it relates to the single app. And then, from a revenue perspective, think of it as, the single apps is probably half the business in the quarter. And then, we use that as a funnel to drive to the all apps. So I wouldn't say there was really a dramatic difference between Q1 and Q2, I think we just continue to see the trend of attracting new customers. And then from a revenue point of view, certainly, we believe that the Creative Cloud all apps is where we both derive value for our customers and drive more ARR for us long-term."
},
{
"speaker": "Saket Kalia",
"text": "Got it. Very helpful. Thanks, guys."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Next, we'll go to Tyler Radke from Citi. Your line is open."
},
{
"speaker": "Tyler Radke",
"text": "Hey, thanks for taking my question. I wanted to ask you about the Digital Experience side of the business. I think if you, depending on your assumption for Workfront and you kind of normalized for the extra week in the quarter last quarter, it showed a nice kind of reacceleration in that business. Could you just help us understand how you're expecting that pace of reacceleration to play out throughout the rest of the year? And then, kind of where your longer-term aspirational targets on where you'd like to see that growth rate of the business?"
},
{
"speaker": "Shantanu Narayen",
"text": "Well, Tyler, the way I would first start off by answering that question is by talking about the TAM, where I think we keep talking about how big TAM that is, for the entire business. And so, when you have the kind of $80 billion plus dollar TAM that we have, we just continue to be really optimistic about that business. And, from my perspective, we have the largest delever that we had. And if you look at the DX business, it's about focus on transformational accounts across all deal bands, as well as different segmentation of the market. We tend to think of the corporate market, commercial market and the strategic markets, we're seeing strength across those particular businesses. And as I mentioned earlier to a previous question, the ability to convert bookings into revenue and to upsell them to more, but what we've done with the experience platform and the ability to have all of the new services built on that, it's really very unique in the industry, because that's sort of how we look at it. And so, you should expect to see, again, Q4 be sort of the strongest close that typically happens in enterprise software. And, we're clearly on track to exceed the target for DX for the entire year, when you look at our performance in the first-half and our guide for Q3, and John's comment about expecting Q4 to be seasonally strong."
},
{
"speaker": "Tyler Radke",
"text": "Great. And if I could just sneak in another question, I wanted to ask you just broadly, I know, you haven't raised price in a while, and you're obviously pretty sensitive of that during the pandemic. But just as you think of things reopening and obviously some concerns around there, around an inflationary environment, just curious how your conversations regarding prices evolved over the last three months? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "From our perspective, what is most exciting about the Creative Cloud and the Document Cloud business, assuming Tyler that your question is about those two parts of the business is, it's really new customer acquisition, that's really been the driver of that entire business. And we're doing that across different offerings. We're doing that across different geographies. I think the value that we provide to customers, it doesn't matter whether it's an inflationary economy or not, we continue to believe that we're deriving tremendous value for our customers. And so the conversations that happen around Adobe are around the product roadmap and innovation and attracting new customers way more than trying to, at this point, look at a price optimization, and so we have a massive TAM ahead of us. That's really the focus."
},
{
"speaker": "Tyler Radke",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And next we'll go to Brent Thill from Jefferies. Your line is open."
},
{
"speaker": "Brent Thill",
"text": "Hi, Shantanu, on the digital experience business, many of your SI partners have been commenting that there are capacity constrained that their utilization rates are, in their words through the roof. I'm curious if you're running into constraints on the implementation side, what you're seeing to offset that? Is that more of a random data point? Are you seeing that across the board from some of the SI partners?"
},
{
"speaker": "Shantanu Narayen",
"text": "I would say, Brent that clearly the demand for our solutions and expertise, whether it's on content and commerce, whether it's around data and insights, whether it's around the new workflow stuff that we've done, what's exciting for us is that there's a lot of demand on the ecosystem to have us help them with training. I think you'll periodically see some of them feel like they're capacity constrained and that's a little bit more as a result of the war for talent. But overall, I think, we will continue to help support them in any way. And I think net-net it’s a good sign for the business. On the product side, we are going to really make sure that we continue to make it easier to provision, easier to use, easier to get value. And we've been seeing some good customer sentiment associated with our work on that front. So hopefully, that's an isolated incident as it relates to that SI partners ability to get it. But it's certainly true as it relates to the overall market and the ability and the interest in our solution. So I think that part is certainly true."
},
{
"speaker": "Brent Thill",
"text": "Quick follow-up for John, just on the second-half margins. As things reopen, how are you thinking about this? I mean, you are this quarter about a point away from your all time quarterly high and out margin. Do things have to come back in a little bit over time, given the reinvest in the opening world or not?"
},
{
"speaker": "John Murphy",
"text": "Yeah. Thanks, Brent. Yeah, we definitely think it will come down slightly in Q3 and Q4, as we open up. I mean, we're continuing to invest, as we talked about, we're hiring in R&D. We're definitely investing in sales and variable marketing to really drive the business and execute against the huge TAMs that we have across all three businesses. So with the momentum that we have in the business world, we will make sure that we capitalize on that momentum and invest to be able to capture it. But certainly, as things are opening up, we'll see those expenses come back online, as we more people, it'll get phased in reentry approach for us through Q3 and Q4. But certainly, business travel will start to pick up as well."
},
{
"speaker": "Shantanu Narayen",
"text": "And Brent, maybe I'll just add, when we look at some of the key new categories that we're continuing to invest in, and you're seeing the results associated with it, I mean, to your question about the Real-Time CDP and the associated services, Sign, Stock, Mobile and our mobile offerings, we remarked also about 3D&I and specialist offerings associated with that. And so, it really behooves us to continue to as we always have judiciously, invest in marketing to continue to attract new customers to the platform, which will again, as John said, be seen on the sales and marketing expense. But net-net, I mean, we're really excited about the growth that we're seeing."
},
{
"speaker": "John Murphy",
"text": "Yeah, and just to think about Shantanu I mean year-over-year you are going to see margin expansion went even above what our original targets were. Thanks."
},
{
"speaker": "Operator",
"text": "And next we'll go to Kash Rangan from Goldman Sachs. Your line is open."
},
{
"speaker": "Kash Rangan",
"text": "Hi, thank you very much. Congratulations to the Adobe team and spectacular results. Shantanu, I want to just go back to Creative TAM, just the topic that continues to fascinate me. I mean, seven, eight years into the transition, the Creative business is as big as it can be $10 billion, nearly 100 and growing 22% to 24%. As you unfold the layers of the Creative market, what is it that you finding that might have surprised you? And could we see that TAM for Creative as the business unfolds even larger than your original expectations? And also as a subtext to that you think address video and how video is shaping up? Now I remember once you said that video could be as largest photo oriented business, any thoughts there would be great. And also if you have any thoughts on what might be David's involvement with the Creative business? And should we expect to see any refinements enhancements modifications of the strategy on the Digital Media front with David coming back on board? Thank you so much. Congrats."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Kash. And I love the way all of you so far have been when we say one question, putting in a three part question. But Kash, I think…"
},
{
"speaker": "Kash Rangan",
"text": "You can take any one."
},
{
"speaker": "Shantanu Narayen",
"text": "It's okay. I mean, they're all good questions. And so I think first Kash on the $40 billion plus TAM as you know, we have clearly transitioned the business from Creative Cloud focused customer, to just being a Creative Cloud, the communicators, the services that we've added associated with Stock photography and Sign. And, I think we continue to have very exciting opportunities in terms of continuing to expand that TAM. And I think it all stems from design and creativity has never been more important, right. We talked about how it's the golden age of design and creativity. But for you, as a consumer, whether you're interacting with a screen at a terminal or in a retail store, or how you order something, I mean, it's all about content creation. And when you think about how much content we've all consumed in the pandemic at home, it's just gone through the roof. And we announced the partnership with Netflix, and what we're doing with Khan Academy to make sure content creation is as seamless and productive. So I think that's driving it. And people love to say we want to be in the content and design business to personalize it, as well as a career. So I would say that's the first thing that we're certainly seeing. International expansion, we've talked about how we continue to focus on international markets. And, it originally started with dealing with piracy, but across the small and medium business TAM, as those companies are also creating a marketplace for themselves with our content management solutions, our commerce solutions, content velocity is critical there. So I think all those are clearly tailwinds for the ever increasing TAM. I think we increased it from $31 billion to $41 billion when we talked about it at the Next FA meeting. And we'll certainly update that when we have our Next. I think, as it relates to David, I'm really excited. As I said, David played a significant role in the introduction of Creative Cloud when he was here. And I think the fact that we were able to excite them and recruit them back, just I think speaks to the tremendous opportunity that he also sees for the business. And from my point of view, we have all of these unicorns within the Creative Cloud. And I'm looking to partner with David, whether it's expanding on our enterprise footprint, whether it's continuing to make sure that we get the opportunity around Sign addressed, what we are doing associated with the mobile offerings. I mean, each one of these is a large business by itself and having somebody of his caliber to continue to work with, Scott on the product side and Abhay on the Document Cloud side, it's great to have that kind of bench when we have the kind of opportunity that we have. So hopefully, that answers the question around David as well, Kash."
},
{
"speaker": "Kash Rangan",
"text": "Brilliant. Thank you so much."
},
{
"speaker": "Operator",
"text": "Next we'll go to Sterling Auty from JP Morgan. Your line is open."
},
{
"speaker": "Sterling Auty",
"text": "Yeah, thanks. Hi, guys. Shantanu, I thought your comments about Chuck were spot on. I'm sure he'd be very proud to see the performance of the company and directionally where it's headed. I'm kind of curious on the Digital Experience side, in terms of the product roadmap and changes and improvements that you made last year, how those have been resonating with customers currently? And are there any key new innovation milestones that we should be looking for, that could further improve the growth in that business over the coming couple of quarters?"
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks for your comments on Chuck, Sterling. A number of you I know have written to me, which I appreciate the impact that each one of you also felt when you interacted with Chuck. So, I really have appreciated all of those comments. As it relates to the customer experience management questions, Sterling, I think we're in the really early innings. We have some tremendous ideas ahead of us and with Anil Chakravarthy, I'll touch on a couple. I mean, the Real-Time Customer Data Platform is just really the infrastructure for every engagement that a customer has. We touched on the Journey Optimizer, which is think about optimizing the customer journey across outbound and inbound customer touchpoints, both in physical and electronic. I mean that’s just a massive opportunity in terms of communicating, whether it's by email, whether it's SMS, whether it's any of these new platforms that emerge. The Customer Journey Analytics, my perspective on Customer Journey Analytics is, we used to do the fantastic job on web analytics, but this is increasingly becoming what is the analytics across all of the different online and offline data. And it's the way you run a business. And we're living proof of, when we talk about our DDOM, how we can use that, so I think the Customer Journey Analytics is also in terms of the ideas that we have on its infancy. And maybe the last one I'll touch on, is what we've been previewing in terms of this marketing system of record and workflow. Trillions are being spent in marketing and the process associated with rolling out those campaigns, understanding the efficacy of those campaigns, making those campaigns international. I think that all of that is really, really, ahead of us in terms of what we can do. So we're very excited. And for all of these companies, as they have to transition with what's happening in browsers, and dealing with a first-party data world or dealing with privacy concerns, all of that, frankly, is opportunities for us because we step up and enable them to engage with their customers and focus on their product offering rather than all this other stuff, because we know how to do that well."
},
{
"speaker": "Sterling Auty",
"text": "That makes sense. Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "One last thing, maybe on that is the B2B. I think we've always -- most people talk about this and think about the B2C business, Sterling, which is, yeah, they understand travel and hospitality, they understand retail, they understand banking, but this is now happening, where it doesn't matter what business you're in. The ability to drive from leads to revenue for a B2B business is also digital. I mean, if you're a company in the pharma industry, and you're not able to go visit doctors, and talk to them about the innovation that you're doing, it’s going to move digital. So I think there's just so much on that particular front."
},
{
"speaker": "Sterling Auty",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And next, we have Brad Sills from Bank of America Securities. Your line is open."
},
{
"speaker": "Brad Sills",
"text": "Oh, great. Thanks, guys, for taking my question. And congratulations on a nice quarter here. I just wanted to ask a question on reopening. As you look towards, as we look towards reopening in U.S. and North America and Europe, what impact do you think that's going to have on the Digital Media businesses? It's an accelerant, do you think? Or, and also a Digital Experience what are your thoughts on that? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "I think they're really tied to the macro-economic environments. And I think you're seeing that the return to work, the macro-economic environment is coming back stronger than it's been across all of the customer segments. And for us, we don't view ourselves as in terms of the solutions we're providing these digital are not a stay at home or work kind of solution. They're just mission-critical, irrespective of which you have. And so, what I think we'll see is that, as people come back to work, the small and medium businesses will recognize that it's an opportunity for them to engage. So I think you'll see more investment there. I think you'll see certainly, as Europe and other parts of those economy open up that'll help. I think Japan, the level of vaccination is low, so I think as they come back to work, that's only going to lead to more optimism. And so I think when you think about consumer confidence, and you think about businesses want to invest, I think both of those are only going to be helped by a return to normalcy and a return to work. That's sort of my perspective."
},
{
"speaker": "Brad Sills",
"text": "Thank you so much, Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And next we have Jay Vleeschhouwer from Griffin Securities. Your line is open."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening, Shantanu, you mentioned summit, and it was clear from the conference that there were multiple internal initiatives you're working on that would seem very likely to have important implications for you over the next number of years. And since you didn't refer to them directly, perhaps you could comment on some of those, including, for example, what was referred to as your quote future creative stack, additionally, project Firefly and your API strategy, some very interesting references to your Adobe commerce merchant services, including payments and some other things you're working on? And then lastly, the build out of ATM is a cloud service globally targeted for this year. So those are some pretty interesting things from the conference of perhaps you could talk about? And then for the follow-up, in answer to an earlier question you referred to ‘war for talent.’ And in your case, you've had a V-shaped recovery in terms of your own job openings. You added an unusually large number of people in a non-acquisition quarter. Maybe for John, you could talk about whether you think you could or should continue to increase your headcount at the same pace as in Q2."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks for the question, Jay. As you know, I can wax eloquent about product stuff for a long time, but let me touch on at least the two ones that you did. I think as it related to the cloud-based content management, the intent is very straightforward, which is how do you transition anybody who wishes to self-provision a cloud-based content offering. And think about, if you're a small and medium business, or if you're a large company trying to do a product campaign, you need to get a website, you need to get it localized, you need to get it up and running, you need to be able to do commerce. And so the fact that we've got this easy to provision cloud-based content management, which is the leader in the category, but in addition to that, as you mentioned, the APIs now so people can actually embed this APIs that we have for our content management solution directly. So we're very excited about that. We mentioned last quarter that it saw significant adoption. And so I think that will continue to be a driver for the business. I think, as it relates to your other question around what we are doing on the content stack, we've always mentioned that, for us content and data are the two areas where we differentiate ourselves. The asset management problem is still a problem where we have a significant amount of innovation that we're continuing to deliver. And so, we're really excited. I mean, net-net, I think Anil and the product team on the DX side, have outlined a number of initiatives. Other companies talk about a lot of the stuff, but they don't have their products integrated. They don't have the ability to seamlessly provision and so I think that's where we are going to continue to focus. And maybe an underappreciated area Jay is how easy, these are now to set up and provision and for practitioners of this business, to be really able to do it. I think your second question is a very interesting one, which is you're absolutely right, the merchant services ecosystem that Magento has, we've actually done a really good job of building that out. I mean, certainly, companies like PayPal that we've talked about, we've talked about what we can do with FedEx. More recently, there are a number of other such initiatives that are underway, some of which we're not at liberty to talk about, right yet. But I think, dealing with payments, dealing with shipping, dealing with working capital, a lot of interesting ideas where we're very well-positioned to both deliver value as well as to monetize it."
},
{
"speaker": "John Murphy",
"text": "And Jay, on the headcount commentary, just to I mean we certainly have a number of positions open, that we're actively recruiting against. But we're committed to investing to be able to capture the larger opportunity. So we're going to continue to hire in for innovation and we're going to continue to invest in sales headcount as well as leverage our ability with variable marketing to really drive performance. So, I don't think this is the time to pull back given the momentum in the business."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thanks, Shantanu. Thanks, John."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jay."
},
{
"speaker": "Operator",
"text": "And next we'll go to Keith Bachman from Bank of Montreal. Your line is open."
},
{
"speaker": "Keith Bachman",
"text": "Hi, many thanks. First, I wanted to ask a clarification and then Shantanu a question. John, can you give us the contribution of Workfront this quarter? And then secondly for Shantanu, I wanted to go back to the Experience Cloud. And feedback that we've recently gotten is very positive on the Real-Time CDP and the Customer Journey Analytics, as you mentioned. I'm trying to go back to what's the potential growth rate here. So A, was Experience Cloud you think impacted more during COVID than other parts of the business? Because I'm trying to understand whether there might be a harder snap back. And then B, when you think about the growth potential here, Gartner comes out with some numbers that areas in the Experience Cloud have grown 15%. Your own TAM analysis that you put out suggested the market in ‘23 growth is more like 25%? How do you think about the business between those two potential growth rates?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yeah, the way I would answer the question, first, on the Workfront stuff, I mean, it becomes -- we, I think, do a great job of talking to you about how it's going on the integration. And it's going really well. We don't break it out after a while, because it's part of so many of these large transformational deals, as well as integrated into other solutions. But Workfront is going really well, it's the basis for a lot of the workflow that we're doing across each of our solutions. And we're on track to beat the targets that we gave for Workfront. So I do want to say that that went well. I think as it relates to the overall TAM, which was your second question, we look at it as it's $80 billion plus, so there's plenty of available and I think a lot of legacy software is going to get rolled out. And so for us, it's not just about what the growth rate is in that market, people are going to recognize that having modern architecture for dealing with consumer engagement is going to become a bigger and bigger imperative. And, frankly, the smart companies are opening up their budgets to start to invest in it sooner rather than later, as we said on B2B and B2C. So, we're really pleased with the 20% plus growth that we're seeing, 25 points of subscription revenue growth, we think is really good. We want to continue to focus on subscription revenue as the true measure of that business. And I think as we continue to deliver on the innovation and product roadmap, I think, we would hope to continue to see those growth rates, even as the business grows much larger."
},
{
"speaker": "Keith Bachman",
"text": "Okay. Thank you, Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Jonathan Vaas",
"text": "Operator, we're coming up on the top of the hour. We'll take one more question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our last question comes from Gregg Moskowitz from Mizuho. Your line is open."
},
{
"speaker": "Gregg Moskowitz",
"text": "Great. Thank you for taking the questions. Shantanu, the Document Cloud enterprise bookings growth up more than 60% year-over-year, obviously really impressive. What would you primarily attribute that to? And then just for John quickly following another upside quarter with an accelerated recovery in SMB, would you say that you have returned to pre-pandemic levels?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think as it relates to your first question around Document Cloud, I mean, again, there isn't a business that is not saying, hey, how do we help automate inefficient paper-based processes. And so the value proposition of the PDF file format, the value proposition of Acrobat, as an essential productivity tool for knowledge workers, the availability of Sign, what we're doing with forms and embedded payments, I think it's the combination of all of that, whether you're, again, somebody trying to deliver vaccines for employees, or somebody trying to create a new travel authorization or expense. I mean, documents are the fundamental currency of modern business and automating that only has value. And I think our team has done a good job. We don't go to market saying, here's a Document Cloud solution, or here's an Experience Cloud solution. We go and saying, here's the use case for if you're in travel and hospitality or retail, or financial services, or pharma. And I would say, government and healthcare have also become larger customers of these kinds of solutions, because of the necessity for regulated industries, who previously may have relied on paper to say, you know what we need to get into the modern era and deal with electronic documents. So I would say, those are all the reasons and good execution, clearly on the part of our team, as we're selling increasingly at a much higher level in all of these companies. I'll let John speak and then I'll come for the close, given this is the last question."
},
{
"speaker": "John Murphy",
"text": "Great. Thanks, Shantanu. Thanks, Gregg. Yeah, we've been kind of talking about the last couple quarters, the gradual recovery of the SMB segment, which was hit so severely when the pandemic hit last year. And we saw that continue here in Q2, and really kind of reach that pre-pandemic level of conversion, retention, at least for sure in the U.S., and there's just tons of opportunity now as the rest of the world begins to open up as well for that to continue to improve."
},
{
"speaker": "Gregg Moskowitz",
"text": "Very helpful. Thank you."
},
{
"speaker": "John Murphy",
"text": "You bet."
},
{
"speaker": "Shantanu Narayen",
"text": "And thank you all for joining us. I think from my perspective, I'm really pleased with our performance in Q2. It was an outstanding quarter. And to the question that was asked earlier, with many parts of the world returning to some sense of normalcy, that should only be good for our business, because digital is this incredible tailwind where it's just a one way street in terms of people wanting to invest. We do expect, therefore, a slight seasonality associated with our business. But we definitely have an expectation of a strong finish. And if you look at our first-half performance, if you look at our targets for Q3, and the belief in the seasonally strong Q4 finish, that's going to be another outstanding year where we are going to exceed a lot of the targets that we talked about, if not all, at the beginning of the year. We're driving bookings, we're driving revenue performance from bookings as a result of making sure people get value for it. We're driving a lot of new businesses that have become material in the company, and so the breadth of our portfolio is impressive, because digital is not just a nice to have, it's become super critical. And as I've always said, having three areas of explosive growth puts us in really rarefied atmosphere. And growing 20% plus on the top-line growing the bottom line, as impressively as we have with strong cash flow, I think really demonstrates how we're driving value for our customers and value for our shareholders. So, thank you for joining us today and have a great summer. With that, I'll pass it back to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, Shantanu, and thank you everyone for joining. This now concludes the call."
},
{
"speaker": "Operator",
"text": "And that does conclude our call for today. Thank you for your participation. You may now disconnect."
}
] | Adobe Inc. | 24,321 |
ADBE | 1 | 2,021 | 2021-03-24 17:00:00 | Operator: Good day, everyone, and welcome to the Adobe Q1 FY 2021 Earnings Conference Call. Today's call is being recorded. All lines are currently in a listen-only mode. There will be time for a question-and-answer session at the end of today's presentation. Instructions will be given at that time. At this time, I would like to turn things over to Jonathan Vaas, VP of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's President and CEO; and John Murphy, Executive Vice President and CFO. On this call we will discuss Adobe's first quarter fiscal year 2021 financial results. By now, you should have a copy of the press release, which crossed the wire approximately one hour ago. We've also posted PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. Before we get started I want to emphasize that some of the information discussed in this call, including our financial targets and product plans, is based on information as of today, March 23, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the Forward-Looking Statements Disclosure in the press release we issued today, as well as Adobe's SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Reconciliations between the two are available in our earnings release and on Adobe's Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe's Investor Relations website for approximately 45 days. The call audio and the webcast may not be re-recorded, or otherwise reproduced or distributed without Adobe's prior written permission. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon. I hope you are all well and staying safe. It is hard to believe that it has been over a year since the pandemic began and the world changed forever. During this unprecedented time, we have gone from a world with digital to a digital-first world. Digital experiences have played a vital role in making every aspect of our lives possible, from keeping families and co-workers connected, to enabling new ways of learning, to powering digital commerce and ensuring continuity of essential business operations. Overnight, we have transitioned to a global digital economy. Adobe's mission is to change the world through digital experiences. At Adobe, we are helping fuel the digital economy with our continuous innovation, our large and diverse set of global customers and partners and the unique expertise we have garnered from undergoing our own digital transformation. Our strategy of unleashing creativity, accelerating document productivity and powering digital businesses is mission-critical and driving our top and bottom line growth. Adobe had an outstanding first quarter with strong results across Creative Cloud, Document Cloud and Experience Cloud. We achieved $3.91 billion in revenue in Q1, representing 26% year-over-year growth. GAAP earnings per share for the quarter was $2.61, representing 33% year-over-year growth, and non-GAAP earnings per share was $3.14, representing 38% year-over-year growth. In our Digital Media business, we drove strong revenue growth in both Creative Cloud and Document Cloud in Q1, achieving $2.86 billion in revenue, representing 32% year-over-year growth. Net new Digital Media Annualized Recurring Revenue or ARR was $435 million, and total Digital Media ARR exiting Q1 grew to $10.69 billion. This past year, we have seen the tremendous power creativity has to inspire, connect and entertain us. Whether it is a student uploading his video assignment, a social media influencer advocating for change, or a small business owner designing her first website, everyone has a story to tell. Creative Cloud remains a market leader in core creative categories, including imaging, design, video, screen design and illustration, and we are expanding that leadership into emerging media types like 3D and AR. Creation and consumption across phones, tablets and desktops is exploding. We're building solutions for every surface and platform, enabling customers of every skill level to create whenever and wherever inspiration strikes. Our Behance community has grown to 25 million people and programs like Adobe Live provide ongoing forums for creatives to engage as a global community. In November, we turned Adobe MAX, our annual creativity conference, into a global digital event culminating in 10 million livestreams. Creative Cloud has truly become the world's creative engine, and our future opportunities are endless. Q1 Creative Cloud performance was strong, with net new Creative Cloud ARR of $337 million and revenue of $2.38 billion. Q1 highlights include: strength in our student offering, enabling next-gen creators to tell their stories in the midst of an unprecedented remote learning environment; momentum in our Teams offering, demonstrating the increased demand for collaboration solutions globally; growth in our core creative categories, including imaging, led by Photoshop and Lightroom; demand for Premiere Pro, the leader in the exploding video category, and the overwhelming favorite at the Sundance Film Festival for the third year in a row, with 68% of films using it; significant growth in our creative mobile applications, including Lightroom mobile and Photoshop Express; an increase in demand for Creative Cloud services like Adobe Stock, which helped fill the void created when live photography and video shoots had to be postponed; and all of this results in record traffic to Adobe.com, our world-class acquisition and growth engine, and our hub for customer engagement across all surfaces. We continue to deliver groundbreaking product innovation, including Neural Filters and Super Resolution features in Photoshop that harness the power of AI and machine learning to simplify complex workflows and enhance images in seconds, extending our applications to multiple surfaces with Illustrator on the iPad and Fresco on the iPhone and building collaboration capabilities with Creative Cloud libraries. In support of our commitment to digital citizenship, we are leading the Content Authenticity Initiative, now with over 150 members, to set the standard for transparency and attribution across the content ecosystem. We recently founded the Coalition for Content Provenance and Authenticity to advance broad adoption of content authenticity standards. This year has shown us the mission-critical role that digital documents increasingly play in powering a modern business of any size. In a world where work needs to be done from anywhere and with anyone, digital workflows have become the critical underpinning to drive productivity and efficiency across global teams. With Document Cloud, we're accelerating document productivity, redefining how people view, edit, share, scan and sign documents across desktops, web, mobile and through frictionless PDF services. Through our document services, we're unleashing the PDF ecosystem with APIs for third-party developers to customize the digital document experience. Q1 Document Cloud performance was stellar, with net new Document Cloud ARR of $98 million and record revenue of $480 million. Q1 highlights include: outstanding Acrobat growth across all routes to market; significant traffic increases to our Acrobat Web experience, which delivers the ability to successfully complete PDF verb functionality in the browser, driven by best-in-class search engine optimization; powerful new Acrobat capabilities to accomplish converting, protecting and merging PDFs in the browser, furthering our strategy to make the PDF experience frictionless across devices and platforms; demand for our Acrobat Mobile and Adobe Scan apps; strong momentum for Adobe Sign, which is enabling critical e-signature workflows in businesses and government institutions around the world; delivery of an enhanced PDF reading experience with Acrobat Liquid Mode, which leverages Adobe Sensei to automatically reformat PDFs for quick and easy consumption; and key customer wins, including Amazon, Aon Services, Bank of America, Federal Aviation Administration, Merck and National Australia Bank. The pandemic accelerated the need for digital transformation among businesses of all sizes across both B2C and B2B. Small and midsized businesses had to quickly set up digital storefronts, enterprises that had not yet made substantial digital investments took the leap and those with significant digital footprints doubled down further. As the world begins to reopen, digital businesses will be the winners. Only companies that have a deep understanding of their customers' preferences and the ability to personalize experiences at every stage of the customer journey will survive and thrive. Adobe created the customer experience management category 10 years ago that we continue to lead. Experience Cloud, built on a next-gen open platform, is the most comprehensive solution for content and commerce, data insights and audiences, customer journeys, and most recently, marketing workflow. Through our acquisition of Workfront, Adobe has a unique opportunity to create a unified marketing system of record, bringing workflow management, efficiency and productivity gains to marketing teams challenged with siloed applications. Over a 1,000 shared customers are already benefitting from the integration and synergies between Experience Cloud and Workfront. Experience Cloud revenue was $934 million in Q1 with subscription revenue of $812 million, representing 27% year-over-year growth. Q1 highlights include momentum for Adobe Experience Platform, which continues to be the platform of choice for enterprise customers to deliver real-time personalization at scale; increasing demand for our commerce offerings. The Adobe Digital Index predicts that the pandemic has permanently boosted online spend by 20%, and 2022 will be the first $1 trillion year in e-commerce; solid performance in the Workfront business, demonstrating the need for a unified marketing workflow solution to drive productivity across global teams; enhancements in Customer Journey Analytics, delivering advanced anomaly detection, contribution analysis and intelligent alerts that identify hidden data patterns to more precisely understand customer behavior; powering the digital modernization of government agencies across state, county and city levels in all 50 U.S. states. Governments are revamping their online presence, making websites and apps easier to navigate; ensuring content is personalized and updated in real-time and creating intuitive forms that work on any device. Key customer wins, including Abbott Labs, Deutsche Post, Coca-Cola, FedEx, Kaiser Permanente, Mondelez, State of Illinois and Sydney Water Corporation; and industry analyst recognition in the Gartner Magic Quadrant for Digital Experience Platforms and the Forrester Agile Content Management Systems Wave report. This is the fourth year in a row that Adobe was placed as a leader in the DXP Magic Quadrant and the sixth consecutive time Forrester has recognized Adobe's industry leadership in their CMS-focused Wave reports. Adobe Summit, our annual digital experience conference, will be hosted virtually at the end of April across the globe. In addition to unveiling exciting new technology innovation in Experience Cloud, we will have customers and inspirational leaders from companies that have been on the front lines, including Albert Bourla, CEO of Pfizer; and Rajesh Subramaniam, President and COO of FedEx. Adobe's fortitude is rooted in an unwavering focus on our employees, groundbreaking innovation and our purpose, which is to harness the best of Adobe to make a significant impact in the world. At Adobe, it's not only about what we do, but how we do it. I am proud of our continued industry recognition, including being named to multiple lists celebrating Adobe as a great and equitable place to work for all, and being recognized on Fast Company's Most Innovative Companies List, Fortune's Most Admired Companies List and the CDP's Climate Change A-list. I am especially thankful to our 23,000 employees around the globe, whose dedication and talents delivered extraordinary results across every dimension of our business during these unprecedented times. Q1 was a record quarter for Adobe. As a result of our outstanding performance, tremendous opportunity across our business and continued confidence in our global execution, we are raising our annual targets. John?
John Murphy: Thanks, Shantanu. Q1 was a fantastic start to the year for Adobe, with strong financial results across all of our businesses. We accelerated revenue growth, expanded operating margins, and continued to drive demand across our portfolio of products and services, which are clearly resonating with enterprises and individuals in a world where digital has become the default. Harnessing the power of data, we continue to utilize our data-driven operating model DDOM to drive traffic to Adobe.com, generate demand for our products, acquire new customers and increase engagement. We are investing in massive market opportunities, delivering innovations across our products, and Workfront had a great first quarter as part of the Adobe family. As a result, in Q1 Adobe achieved record revenue of $3.91 billion, which represents 26% year-over-year growth. Recall that Q1 was a 14-week quarter for us versus the typical 13-week quarter. Business and financial highlights included: GAAP diluted earnings per share of $2.61 and non-GAAP diluted earnings per share of $3.14; Digital Media revenue of $2.86 billion; Net new Digital Media ARR of $435 million; Digital Experience revenue of $934 million; Cash flows from operations of $1.77 billion; Remaining Performance Obligation of $11.61 billion exiting the quarter; and repurchasing approximately 1.9 million shares of our stock during the quarter. In Q1 we saw continuing recovery in the business environment both in the U.S. and internationally, particularly with small and medium businesses, which contributed to our strong financial performance in the quarter. In our Digital Media segment, we achieved 32% year-over-year revenue growth in Q1, and we exited the quarter with $10.69 billion of Digital Media ARR. We achieved Creative revenue of $2.38 billion, which represents 31% year-over-year growth, and we added $337 million of net new Creative ARR. Our Creative growth in Q1 was driven by strong consumer demand for our Creative solutions on Adobe.com; driving improvements in usage, retention and engagement across our products; growth in our mobile business, through app store subscriptions and top-of-funnel awareness; continued recovery in the SMB segment, which we target with our Creative Cloud for Teams offering; and investing in targeted campaigns and promotions to drive awareness and acquire new users, including in emerging markets. Adobe Document Cloud delivered another quarter of accelerated revenue growth. We achieved Document Cloud revenue of $480 million, which represents 37% year-over-year growth, and we added $98 million of net new Document Cloud ARR. Documents are the currency of business, and the imperative for digitization has never been greater. Our Document Cloud growth in Q1 was driven by increasing demand for Acrobat subscriptions across all geos; strong enterprise term licensing with institutions; utilizing DDOM insights to drive improved conversion on Adobe.com; success in the reseller channel, both for subscriptions and our perpetual offering, including seat growth in the SMB segment; and strength in Adobe Sign, which grew revenue more than 50% year-over-year in the quarter. Turning to our Digital Experience segment, in Q1 we achieved revenue of $934 million, which represents 24% year-over-year growth. Digital Experience subscription revenue was $812 million, representing 27% year-over-year growth. Our Q1 results continue to validate the strength of our industry-leading Customer Experience Management or CXM solutions. Large enterprises across industries and geographies are standardizing on Adobe to manage customer interactions, gain actionable insights and unify their customer data with Adobe Experience Platform. In our Commerce business we continued to sign large deals with new customers and drive upsells at renewal points, enabling every business to transact online. Optimizing customer journeys across all channels in a digital-first world is critical to enterprises, and we see momentum with our larger customers adopting our complete Experience Cloud offering to drive omni-channel personalization at scale. We are driving the global CXM mandate across B2B and B2C, from large enterprises to midsized companies, across multiple verticals. Recent wins included expanding our reach in the public sector, where we are enabling critical constituent-facing services, and adoption in the midmarket of our new AEM Cloud Service, Adobe Commerce and Marketo Engage. Lastly, we are off to a fast start in integrating Workfront and driving the strategic value proposition of combining best-in-class workflow technology with Adobe's leading CXM and Creative solutions. Workfront contributed $38 million of revenue in Q1 after purchase accounting adjustments to deferred revenue. We continue to drive savings from travel and entertainment and facilities operations as our employees work from home. We are expanding investment in hiring globally, particularly for R&D and sales and marketing roles, in order to capitalize on our large addressable markets. From a quarter-over-quarter currency perspective, FX increased revenue by $37 million. Net of impacts from hedging, the sequential currency increase to revenue was $34 million. From a year-over-year currency perspective, FX increased revenue by $62 million. Net of impacts from hedging, the year-over-year currency increase to revenue was $44 million. Adobe's effective tax rate in Q1 was 12% on a GAAP basis and 16% on a non-GAAP basis. The tax rate came in lower than expected primarily due to a favorable tax ruling in the quarter which allowed us to reduce our withholding taxes and receive refunds for certain prior payments, and to a lesser extent, larger than expected tax benefits associated with share-based payments, and favorable resolutions of other income tax matters. Our trade DSO was 38 days, which compares to 41 days in the year-ago quarter, and 37 days last quarter. Remaining Performance Obligation grew by 17% year-over-year to $11.61 billion exiting Q1. Deferred Revenue exiting the quarter was $4.29 billion, growing 19% year-over-year. Our ending cash and short-term investment position exiting Q1 was $4.96 billion, which is sequentially down quarter-over-quarter due to the acquisition of Workfront. Cash flows from operations in Q1 were $1.77 billion. We repurchased approximately 1.9 million shares in the quarter at a cost of $888 million. We currently have $1.1 billion remaining of our $8 billion repurchase authority granted in May 2018, which we expect to be exhausted by the end of this fiscal year. In December 2020 we announced that our Board authorized an additional $15 billion stock repurchase program through fiscal year 2024, which will be funded from future cash flow generation. For Q2, we are targeting total Adobe revenue of approximately $3.72 billion; Digital Media segment year-over-year revenue growth of approximately 21%; net new Digital Media ARR of approximately $450 million; Digital Experience segment revenue growth of approximately 18%; Digital Experience subscription revenue growth of approximately 20%; tax rate of approximately 19.5% on a GAAP basis and 16% on a non-GAAP basis; share count of approximately 482 million shares; GAAP earnings per share of approximately $2.09; and non-GAAP earnings per share of approximately $2.81. In light of Adobe's strong Q1 business performance and the momentum reflected in our second quarter targets, we are increasing our annual targets for fiscal 2021. We are now targeting total Adobe revenue of approximately $15.45 billion; Digital Media segment year-over-year revenue growth of approximately 22%; net new Digital Media ARR of approximately $1.8 billion; Digital Experience segment revenue growth of approximately 20%; Digital Experience subscription revenue growth of approximately 23%; tax rate of approximately 17.5% on a GAAP basis and 16% on a non-GAAP basis; share count of approximately 481 million shares; GAAP earnings per share of approximately $9.13; non-GAAP earnings per share of approximately $11.85. In Digital Media ARR, we expect a return to normal pre-COVID summer seasonality, which can lead to sequentially lower net new ARR in Q3, followed by year-end strength in Q4. We expect operating margin to be relatively flat from Q2 to Q3 and then dip slightly in Q4 as we get back to spending on travel and reoccupying our facilities. In summary, Q1 was a great start, and we expect fiscal 2021 to be another record year. Combining our strength in customer acquisition and engagement, our leading technologies and talented employee base, Adobe is poised to continue our track record of impressive top- and bottom-line growth. Lastly, as reported in our press release earlier today, I have expressed my intent to retire this year. It is a very difficult decision for me because I love Adobe. And you may ask why now? I have been very fortunate in my career and I still have the passion and energy to fully dedicate myself to my philanthropic interests as well as prioritize my family and friends. We have navigated our way extremely well during the pandemic and our Q1 results and raised targets are evidence that the company is on solid footing. So I feel comfortable that this is the right time for me. Our highly tenured finance and operations team is top notch and I plan on helping Shantanu through a transition period as the company launches a search for my successor. Now, I'll turn it back to Shantanu.
Shantanu Narayen: John has played a critical role in Adobe's strong performance for which I am deeply grateful. John and the entire finance and operations organization have helped drive top and bottom line growth with a relentless focus on shareholder value. In addition to his accomplishments as CFO, John embodies Adobe's values, always operating with the highest integrity and ethical standards. John will work with me to ensure a smooth transition and I'm happy that John will be able to focus on his family and philanthropic pursuits and wish him all the best. Adobe's global brand, unparalleled innovation, broad spectrum of customers and partners, and dedicated employees provide an unmatched competitive advantage. I remain bullish that technology will continue to transform work, learn and play, resulting in a brighter future for all of us. I will now turn the call over to the operator to take your questions.
Operator: Thank you. [Operator Instructions] And we will go first to Kash Rangan of Goldman Sachs.
Kash Rangan: Hello. Thank you very much, and congratulations on a spectacular quarter. Shantanu, my question, again, naggingly, annoyingly, is about Creative TAM. You've been very consistent in talking about how large the TAM for Creative is. I think goes back to 10 years prior. Can you talk -- and you mentioned today on this call that it's seemingly endless in terms of the opportunity. Can you expand on that? Why is that the case? There is a view, not that I share, that once the economy opens up that the creative folks are going to get out and enjoy their summer vacations and do less creative stuff, so we take a bit of a back step on digital transformation. I don't know how you feel about that, but if you can just talk to that tactical opening of the economy and if that might impede digital transformation or maybe not, and then talk about why your confidence in the TAM of Creative is even greater than it was, say, five years back? Thank you so much.
Shantanu Narayen: Happy to do that, Kash, and it's good to have you back on our calls now at Goldman. So first, let me just say that, when you think about content and design, there is no question that it's fueling the global economy and the way we segment our business as we think about what we are doing for Creative pros, what we are doing for communicators, and what we are doing for consumers. And first to, I think, just share some numbers associated with that, I think we've said there are 49 million Creative professionals who use our products to make a living. There are 700 million communicators, and approximately 4 billion consumers. And so when you think about the TAM, whether that's $20 billion for the Creative pros, $15 billion for communicators, or $6 billion for consumers in 2023, I mean, that represents a $41 billion addressable market opportunity given the importance of design. So it's a massive opportunity. What gives us confidence? I think when we think about strategically what we are trying to do, certainly, the first thing we're trying to do is advance every Creative category. And I'll just give you one example, Kash. I mean, what's happening with immersive media and when you think about 3D to 2D and being able to do all these virtual shoots as the amount of content, that's an emerging business. I had a really great quarter that continues on what we had said about video being one of the growth initiatives for us. So, I think the new media types and advancing it is certainly critical. I think multi-surface systems, what we can do associated with making sure mobile, mobile has been a really good growth opportunity for us. And the way we look at that, it's both as a result of the funnel that it provides for both mobile and desktop, but also as part of a system, so people can create whenever they want. So even if they are going to be out in summer, as you say, they'll have access to all of our Creative tools wherever they go. The third one I would say is what we are doing with collaboration and the team and everything associated with allowing people to collaborate. Services, I mean, Stock had another great quarter. We grew that business approximately 30% year-over-year, and the notion of just continuing to make sure that we do creativity for all, I think, the world is going to be in a place where Creative expression is going to dominate everything associated with education and productivity. So all of that gives us really high confidence associated with the opportunity and our execution. And then, if you think about it for Q1, really just quickly, I mean, Q1 was a record quarter. We continued to see really great demand on the web associated with what's happening, and the absolute ARR was strong again. And this is, as you point out, despite the recovery being complete. And so we just feel like we're in an absolutely sweet spot as it relates to what people want to do with our tools and services.
Kash Rangan: Thank you very much. Congratulations.
Shantanu Narayen: Thanks, Kash.
Operator: Our next question will come from Jennifer Lowe of UBS.
Jennifer Lowe: Great, thank you. Maybe just following along sort of the commentary on recovery. One of the things that stood out to me is the strength that you saw in SMB this quarter. So maybe two questions on that. First, are you kind of back to pre-COVID levels at this point in terms of SMB momentum? Or is there still more to gain there? And then secondly, just specific on Experience Cloud, I know even pre-COVID there were some execution challenges that you were experiencing in the SMB space. So have those execution challenges been sort of fully addressed and you're seeing some of those more mid-market oriented products that you've acquired executing the way you'd like them to? That's it for me. Thanks.
Shantanu Narayen: Yes, first, I think as it relates to the SMB segment, as we mentioned, both in the Document Cloud and Creative Cloud and to your question specifically around Experience Cloud, we did see continued momentum and growth. So I still think that when you think about what's happening in the world, it's still not fully back, right, to normal and we're still in a sort of a pandemic situation. So I clearly think there's upside. And every day you have good news in certain geographies and unfortunately not so good news. And so that only augurs well for us as we look at our business moving forward. But if I take a big picture view associated with Experience Cloud, which was the second part of your question, digital transformation, just talking to all the CEOs that I'm talking to, those who've already invested in digital are absolutely doubling down because they recognize that this is the way to further differentiate. And those who are not are clearly investing in the people, technology and processes to be in this market, whether it's transformational accounts at the enterprise level that Anil talked about at the Financial Analyst Meeting or whether it's at the small and medium business, your question associated with what we are able to do to enable them to have a digital storefront, which is an absolute necessity for doing business today. There's a lot of interest and demand in both of those. I know a lot of you, as I read your reports, the checks that you're doing, you're hearing the interest in our solutions and the talk from both the customers and the partners is high. And so we are going to see more demand for this. We had a good quarter. If you look at how we are targeting DX, we clearly expect acceleration of revenue without -- with and without Workfront, Q3 over Q2 and Q4 over Q3. So we're really excited and I think we're in the sweet spot on all three of our growth areas.
Jennifer Lowe: Great. Thank you.
Operator: And the next question will come from Mark Moerdler of Bernstein Research.
Mark Moerdler: Thank you very much, and congratulations on the quarter and a great start to the year. John, we're going to miss you, but completely understand the desire to spend more time with family and philanthropy. So enjoy it. Two quarters ago, you called out your increased focus on driving Experience Cloud margin improvement. Can you give us an update on where you are in driving Experience Cloud margin improvement? And any sense what you think about long-term margins could be for what Experience Cloud is today versus the future? Thank you.
Shantanu Narayen: Well, Mark, I'll let John speak to his decision after this as well. But I think the decision to be made associated with reducing our focus on the transaction-based advertising revenue, if you look at everything that's happening associated with that business, there are other companies in that space. I think that was a good way to do it, what we've done with the Experience platform. And with Anil coming in, taking a soup to nuts approach associated with that entire P&L and the business opportunity, he's been able to align and simplify and improve it. And so, I mean, you don't accomplish the kinds of margins that we accomplished in the year without a focus across all of our businesses. And so we have an incredibly good leverage model, but there's more. I mean, Digital Experience is still in that area where we're growing revenue, I mean 20% is what we've targeted for the entire year. We had 27% of subscription revenue in Q1. And so it really is one of those areas that's a growth opportunity and you will see that translate into the bottom line over time. But, John, maybe I'll have you also add to that.
John Murphy: Yes, no; absolutely. I think the continued focus that we have both on gross margin and on operating margin in the businesses is key. And Mark, thanks for the words. I'm definitely going to miss you guys as well, but I will be here for a while during the transition. You can imagine it was a difficult decision to make. You think about these things for a while. But I decided even last year during the pandemic, and you kind of refocus on some priorities. And so I'm really fortunate for the great career I've had and thankful to Shantanu and Adobe to allow me this opportunity to pursue my passions.
Mark Moerdler: Thank you. I appreciate it and congrats.
Shantanu Narayen: Thank you.
Operator: Next, we'll go to Brent Thill of Jefferies.
Brent Thill: Good afternoon, Shantanu. You had mentioned a couple of years ago at Summit that the customer data platform architecture was a revolutionary architecture and was going to bring some really interesting opportunities to Adobe. It sounds like some of those customers are going live now. And I'm just curious to get your perspective on where you're at on that journey and what you're starting to see in Experience Cloud with CDP coming online?
Shantanu Narayen: Brent, we have seen some -- quite a bit of success. I think we have some really blue chip customers that we talked about -- the conversations that I'm having with each of these customers. And people talk about Customer 360. We're the only major company that has anything out there of this scale to be able to do real-time personalization at scale. We have billions of profiles that are already going through this. Absolutely blue chip customers, whether it's financial services, whether it's in other online like retail -- what we are doing with telecommunications. And so not only do we have that, but it has really served as a basis for what we've done with the customer journey analytics. So, if you take a step back and the big areas that we talked about content, commerce, data insights and audiences, which is such a key part -- I think that becomes even more important with what's happening in the spooky world so that you can have access to all your first party data and profiles. So, I think the decision to invest in that was right. The success that we're seeing in the marketplace and the leadership, I think, positions us incredibly well, Brent. And you'll hear a lot more about that at Summit, certainly. I think the Workfront acquisition also has had the unique opportunity to be able to add to what we have in terms of our solutions and get workflow also and attribution associated with it. So I feel really good. But I feel really good about the infrastructure with CDP. And we focus a lot more on the real-time nature of what we can do with personalization as the key differentiation. But some great customer wins.
Brent Thill: Just a quick follow-up for John. On the 20% growth you're now guiding, just back to Jen's question. Does that assume a full recovery for SMB or is that still contemplating that there's still some improvement that you could squeeze out of that segment of the market?
John Murphy: Thanks, Brent. Yes, no, for sure it really reflects a continued recovery. But it's not -- we don't expect to be back to pre-COVID levels. I think as we saw as we exited FY '20, that momentum and kind of recovery was just gradual and continual recovery. And we're into the benefit of that.
Brent Thill: Okay, thanks.
Shantanu Narayen: Hey Brent, you followed us for a significant amount of time. We don't bank on anything dramatically changing. We look at the demand that we have and current trends. We're not macroeconomic experts. And so as the recovery happens more, but we're not banking on it. Just to be clear.
Brent Thill: Thanks, gentlemen.
Operator: And we'll go now to Kirk Materne of Evercore ISI.
Kirk Materne: Hi, thanks very much. Shantanu, I was just kind of curious. As we come out of the pandemic, your businesses has executed incredibly well. Are there parts of the business though that would benefit from getting back in front of the customer base? I'm thinking about sort of the Experience Cloud business in particular. You guys have, obviously, been able to execute really well in a virtual world. But I do wonder if there's areas whether it's Experience Cloud, maybe in the education market, areas like that, where being able to get out and talk to the customers again would actually be beneficial. I was just curious if you had any thoughts on that.
Shantanu Narayen: I think so. I mean the world has done a pretty amazing job of pivoting to working at home and being able to do as much as you can. And I've talked about the fact that being able to visit with customers all across the globe without travel is in many ways a real ability to scale. But I also am one who believes that being in front of the customers and getting the partners that we have together and accelerating the rollout and sharing best practices and that social part is only going to help. I don't think the world is going back to everybody being in the office, but I do believe that it will be an accelerant. Because people's desire to also invest more as the economic situation improves can only be another tailwind for us. And so we've done a pretty incredible job. I mean when you look at our numbers. But there's no question in my mind. I mean if we can go travel and if we can meet with those customers and do it, there's only upside associated with that.
Kirk Materne: And then, maybe just one quick one for.
Shantanu Narayen: What we notice that we can do as well as -- sorry, both in terms of what we can do as well as their own confidence, right, in continuing to expand their investments.
Kirk Materne: Thanks for that. And then just maybe a quick one for John. John, on the Workfront revenue came in a little bit higher than your initial expectations. Was that just mainly around sort of deferred accounting? I realize you probably took a fairly conservative view on that given you had to close the acquisition, you talked to us in December. But it sounds like you got off to a good start. Is there any uplift maybe in the bookings or revenue just in terms of the combination or is that mainly just sort of a factor of accounting? Thanks.
John Murphy: Yes, thanks, Ken. No, the Workfront actually really did have great performance. So outside of the accounting adjustments for purchase accounting, we saw momentum in the business. And we had kind of suggested maybe about $140 million, $150 million in Workfront revenue impacting FY '21, but we think it'll be a bit more than that given the performance because the combined offering is really resonating with our customer base. That was really the, from the business case of doing this acquisition to begin with. We'll take the next question, operator.
Operator: We'll go to that next question and that will come from Jay Vleeschhouwer of Griffin Securities.
Jay Vleeschhouwer: Thank you. Good evening. Shantanu, for you first. At the Analyst Meeting in December, the company had some very interesting things to say about your technology and where you were investing. You referred, for example, in the case of Creative to what you called a deeply collaborative shared system. In the case of Doc Cloud, you referred to intelligence applied to PDF, as with Liquid Mode; all of that in the context of your applications and intelligent services. The question is, could you foresee the role for or need for new configurations or a new kind of segmentation of the product line, new SKUs, new packaging, anything of that sort particularly as you become more domain-specific oriented? And then for John, over the last three quarters you've had a very steep almost V-shaped recovery in your job openings from almost none back in June/July, to now over 1,000 and up four months in a row year-over-year. Could you talk about that in terms of your onboarding and the context of how you were thinking about OpEx growth for the year?
Shantanu Narayen: Jay, maybe I'll take your question and since they haven't been asked many questions yet on Document Cloud, I'll use Document Cloud with the technology lens to answer your question. I mean first, Liquid Mode, I was on the road. I was traveling on the road last week and the entire preparation for this I was doing on a mobile device with Liquid Mode. And I will tell you, Liquid Mode for me was an absolute lifesaver in terms of being able to look at all these documents and do everything collaboratively on the road. So an unabashed plug for those who haven't tried Liquid Mode or haven't tried Adobe Scan to really see how it changes. And the way we think about it is when you apply that kind of AI to fundamentally change the nature and understanding the structure and semantics of documents, it opens up so many different possibilities on the segmentation. I mean we now have revenue that we drive through Reader and Reader distribution and upsells because we understand what people are trying to do and understand the intent. We're driving revenue through search engine optimization that we do on PDF because we have a one-click way of having them do more and more PDF functionality. We have a new revenue monetization model associated with APIs and being able to have people use PDF and embed that in their particular workflows. And we've always had Acrobat Sign, had a great quarter. Again, I think John may have mention that we grew 50%. And so to your point, I mean AI and technology and being able to make that available and accessible in different ways is not just serving the customers better but it's clearly providing us new opportunities to monetize it that previously did not exist. And so I think you'll continue to see that in the innovation roadmap whether it's Summit or MAX. You'll see some really cool things which will not just push the envelope for our Creative pros but also make it way more accessible, productive and fun for communicators and consumers. John?
John Murphy: Yes, in regards to the job openings, the headcount growth, when we entered the pandemic last year, we did pause hiring initiatives we talked about to really focus our resources on our highest priorities, and we did that and successfully navigated the pandemic and really came out taking advantage of the opportunities in front of us. And so with that, of course, we talked about it in Q3 that we were going to start to ramp hiring. And so we have done that and we continue to look to invest, as I said, in R&D and sales capacity as well as variable marketing. In terms of the impact on OpEx, we had originally planned for margin expansion in FY '21 over FY '20, and we've updated targets actually indicating even greater margin expansion even though it accounts for our phased reentry as we come back to traveling, as we reopen our facilities. So for us, it's the ability to grow the top line and the leverage in our operating model allows us to be able to do that. So for us, margin expansion is really all driven off of revenue growth and ultimately we can perform both very well on the top line and on the bottom line.
Jay Vleeschhouwer: Thank you.
Operator: And next, we will go to Saket Kalia of Barclays Capital.
Saket Kalia: Okay, great. Hey. Thanks for taking my question here, guys, and congrats, John, on the well-deserved retirement. Shantanu, maybe for you on the Creative business, can you just talk about the product pipeline to that growing individual user base for the rest of 2021? Broad brushes, of course. And how you feel about Adobe's ability to help them grow or progress in their journey to higher-end Creative Cloud apps? And, John, if I can just fit in one housekeeping question that maybe might be helpful, I was wondering if you can just quantify how much the extra week added to total revenue and net new ARR in the quarter?
Shantanu Narayen: Yes, Saket, I mean, maybe I'll speak to that and I'll also give you my color on sort of what happened with ARR. But first as it relates to how we're expanding both the user base and acquisitions, I mean, the net new ARR, when you look at it, it's primarily all new net new ARR in terms of customer acquisition. And whether it's the mobile-only applications that we are providing, whether it's the web-based ability to do things in the browser, whether it's collaboration, that's certainly the way in which we are expanding our offering. And frankly, the way we do it is that anybody who uses one of our on-ramp products whether it's an individual category apps that is then using the entire CC all apps or whether it's the consumer app where they start to get exposed to things like maybe layers in Photoshop or a timeline in Premiere Rush, they have the ability to then be upsold as well as to become more productive by going to Premiere or Photoshop. So it's very much been a part of our strategy all along, which is how do you attract customers to the platform and how do you think about then making sure that as they grow in their Creative endeavors that we have the right on-ramp whether it's an offer that we provide at the right time, whether it's engagement that we do with Adobe CreativeLive. I mean, CreativeLive has really become in that community of Behance a great way for people to continue to grow and learn. And I think there are a whole cottage industry also of people who've done training and learning and education on Creative products. So that's the strategy, which is meet the customer where they are whether it's on a surface or whether it's a degree of specialization, and then make sure that as they expand their Creative pursuits that we're the right product for that. And so if you think about it, I mean, digital media ARR, what really happens is it's not -- while revenue may be more representative of the number of weeks in a quarter, and so if you take the 14 weeks over 13 weeks, you can argue that it was probably eight points of revenue that was extra as a result of the 14 week. But ARR is not as cyclical because ARR when you have an enterprise part of the business, it's probably going to be back-end loaded by most enterprise much like enterprise. So that's why we look at the Q1 ARR, which was a record for Creative, as a really solid performance. So, hopefully that gives you a flavor. Revenue for Creative is little bit more dependent on the number of weeks, but ARR is sort of you have these things that we do, which are cyclical, and that drives the strong growth that we saw across both Creative and Documents.
Saket Kalia: Very helpful, Shantanu. Thanks.
Shantanu Narayen: Thank you.
Operator: And next we will go to Ken Wong of Guggenheim Securities.
Ken Wong: Great, thanks for taking my question. I just wanted to dive in a little bit on the Digital Experience business. Would love some color behind the confidence in the 23% DX sub growth. Is this purely just improving macro or are you guys seeing better deal flows, bigger deals, specific products that are contributing to this uptick? And any help there would be fantastic.
Shantanu Narayen: Yes, I think the confidence comes from first, the performance in Q1. As we said, we had 27% subscription revenue growth. I think the confidence comes from the conversations that we're all having with companies all across the globe, from the pipeline that we have, from what we know in terms of Summit. And again, as in their response to the previous question that was asked, this is not banking on any macroeconomic environment changes for the rest of the year. So it's based on what we know today and the interest. Commerce is an area that is seeing a fair amount of interest, the real-time customer data platform. The experience platform is seeing a significant amount of interest. Workfront, as we said, and John mentioned that it's not the deferred revenue. It's the performance as well that's driving the upside in that particular business. Customer journey analytics and being able to address this in a multichannel, that's seeing a lot of interest. I think you're going to see some new products also in terms of how we evolve our campaign product and analytics product to be more business performance related. And frankly, to a large extent, Ken, all of this is also predicated on how we run our business, right? And our DDOM and understanding what it takes to run an online business, and we're world class at that, and we're building products for ourselves. And so that gives us a lot of confidence that it will help every other customer out there.
Ken Wong: Great, thanks a lot for that insight.
Operator: And next we will go to Sterling Auty of J.P. Morgan.
Sterling Auty: Yes, thanks. Hi, guys. First, John, congratulations on a wonderful tenure as CFO of Adobe. Just one question from my side, you touched upon Adobe Sign and the 50% growth that you saw on the quarter. It seems like meaningful acceleration from what we saw year or so ago, where I think that business was growing about 25%. I'm going to take a stab, any sense would you be willing to quantify and size the Adobe Sign business at this point? And then second, in terms of the accelerating growth, I think you mentioned government. But what are you particularly seeing that's driving the uptake of that e-signature business?
Shantanu Narayen: I think our key differentiating there, Sterling, is the fact that PDF as a format continues to be the format the people are using for automating these workflows. I think the fact that we have Adobe Reader, which is the operating environment in which all of the workflows are happening, I think we've done a better job with awareness, frankly, of what we have and that, hopefully, some of you have seen the incredibly new Creative campaigns that we're running associated with that. We're actually getting a fair amount of wins from other competitive products that people might have been using in terms of moving over to Adobe. The partnerships that we have with Microsoft and ServiceNow in terms of being embedded, whether it's in SharePoint or Outlook or partnering with ServiceNow. So, I think we're executing on the product side. I think we have some key differentiation, and this is not a zero-sum game. It's such a large opportunity, and I think the work-from-home has also certainly benefited us and everybody else in that space. So all of those I think are reasons why Sign just continues to be a real growth opportunity for us. The last thing I would mention is the ability to embed our Sign stuff within other people's offerings as well. I think we made some good progress on that one as well so all of these give us confidence. And to your question, Sterling, we don't break it up because it's hard, right? Sometimes you have an enterprise deal where you have all of them using Acrobat and Sign. And so even on the individual case, you have the ability to use a certain amount of Sign capability with an Acrobat. And so I think our strength is in the combined offering.
Sterling Auty: Got it. Thank you.
Operator: And next we will go to Keith Bachman of Bank of Montreal.
Keith Bachman: Hi, thank you very much. Shantanu, I was wondering if you could give an update on the Commerce Cloud. And I'll break it into two parts. A, could you talk a little bit about growth rates and profiles? In other words, are you moving into larger situations with more scalable demands? And, B, could you talk a little bit about you moved through acquisition into the commerce area, and it fits into the DDOM model. And yet you're still partnering on the services side of the equation of the service cloud. I just wanted to see if you could juxtapose your strategies surrounding willingness to move into commerce via M&A and any thoughts on is partnering still the right strategy for the services side? Thank you.
Shantanu Narayen: Yes, at the end of the day, Keith, we are a software company. And so I think -- actually just to give you a little bit of an update on numbers -- the beauty of when we acquired Magento and put it in the Commerce Cloud was first it was B2B and B2C. That was an attractive area for us. Second, it was physical goods and digital growth. That was an interesting opportunity for us. I think the third thing that was important for us was the fact that we had the ability to have both a large ecosystem of partners who were implementing this as well as an open-source community that was able to extend the functionality and, in effect, the extended R&D model. On the partner side, I think we've gone something from 2,800 or so partners that they had to well over 4,000. So the interest in partnering with us on the Commerce Cloud is high. And our model, as we've always said, this goes back also to the earlier question that somebody had on the P&L associated with Digital Experience. Our model is software, and we're happy actually to have a large ecosystem of partners that work with it. And maybe the last thing I would say on that particular front is that we're really continuing to expand what we do on the Merchant Services offering. So partners like PayPal and what we can do in conjunction with them and other credit card and other partners. I think that's going to also be a good area of continued growth for us.
Keith Bachman: Okay. Thank you, Shantanu.
Shantanu Narayen: Thank you.
Jonathan Vaas: Operator, we'll take two more questions and then wrap up. Thanks.
Operator: Certainly. And next we will go to Derrick Wood of Cowen & Company.
Derrick Wood: Great. Thanks. Question on Document Cloud and maybe the first part for John. It looks like perpetual is quite strong, and I suspect that came from strength in the ETLA activity. But can you talk to how you're thinking about perpetual mix as we look through the rest of the year and whether we could see another spike in any given quarter? And then, maybe more for Shantanu. Just kind of a refresher around the strategy within Document Cloud on getting more customers to shift to subscription and how to think about those efforts over the next couple of years.
Shantanu Narayen: Awesome. Maybe I'll go with the strategy and then, John, you can certainly add to that, which [indiscernible]. First, from a strategic point of view, if you go to Adobe.com, it's primarily subscription. And so we've done a fantastic job of converting that business to subscription. When you look at it globally and you consider some other markets where a lot of it is going through the resellers, even that has predominantly become subscription. But we'd be crazy not to have people if they do want some perpetual to buy the perpetual and then convert it to subscription because we still know that. So, I think to your Uber point, yes, we did see some strength in perpetual. China, I think, had also a pretty strong quarter as it related to Acrobat. And that may be a little bit more perpetual. Our strategy is clearly moving into the cloud. Our strategy is clearly demonstrating the value of where people see the ongoing innovation that we're providing. But that business, unlike the other business, we just want to attract more and more customers to any one of those offerings. And that's why we've continued to have the Acrobat perpetual offer out there. But it's becoming smaller and smaller. As a part of the business it's definitely becoming smaller and smaller. I know on Adobe.com it's virtually de minimis.
Derrick Wood: Great, thanks.
Operator: And we will go to our final question, and that will be from Keith Weiss of Morgan Stanley.
Keith Weiss: Excellent. Thank you, guys, for sneaking me in and again my congratulations to John on the retirement, well-deserved. And also, really nice quarter. I wanted to ask you guys about a concern that I hear from investors and kind of get your take on it. While you guys are seeing a recovery on the SMB side of the equation, the fact of the matter is the Digital Media business did really well through all of last year, even in the height of the pandemic. In the upcoming May quarter, you guys saw really good ARR growth, it was up on a year-on-year basis, which exceeded a lot of people's expectations. But now there's a concern that it's a really tough comp ahead that you guys saw work-from-home benefits or benefit that were due to sort of what was going on with the crisis that that might create a difficult compare. Can you talk about whether there is like a difficult compare ahead? And is there a different sort of tone or nature of the business that you're seeing now versus what you saw last year at this time as we were in the crisis?
Shantanu Narayen: I think Keith, the question that we ask ourselves is the big shifts that we've seen in terms of how people work, the need to create, the different kinds of media types that exist. Is there anything that's going to fundamentally change when the economy changes? And we don't think so, because we just continue to believe that that importance of all of those areas and the tailwinds that exist in the market will continue to exist. I mean I think in terms of our numbers and you look at what we are doing, we've said, it's -- we've raised the target a little bit from what we had, the $1.75 billion to the $1.8 billion. And this is 10 years into it, driving a record ARR. I would say that that reflects the much larger market opportunity that we've created for ourselves. And so, the way I actually look at it, Keith, is that it's brought more attention to what's possible with our tools. And once people experience the benefits of what they're doing with us, it's going to be hard to go back to not using those kinds of technologies, which is what gives us a lot of interest. Hopefully, and you were certainly there, Keith, at the Analyst Meeting. That's why we tried to lay out completely what we see in terms of communicators and consumers and Creative pros. And I mean the business is doing really well. We're expanding the Digital Media segment revenue for the year, we're expanding revenue. And so that's all based on what we see as demand for what we have created and the tremendous amount of innovation that's ahead of us. So I think all of those give us a lot of confidence in the fundamental nature of the growth opportunities that we're focused on. And since that was the last question, I mean maybe just a couple of points. I would like to, and I know a lot of you did, also publicly thank John. This was I know for John a very personal decision, and I'm happy that he is going to be able to focus on what's important to him which is family and his philanthropic interests, and I'm deeply grateful. And on the overall business, it's hard. It's hard to believe that a year has passed since the pandemic impacted the world, but I think what's really incredible is digital is not just a nice to have right now, it's absolutely mission critical. And most companies would be thrilled to have one area of growth. We have three areas of growth: creativity, storytelling, design, what's happening with the future of work and remote work and the limitations of what you can do with in-person interaction, which will lead to more automation of digital documents and how every business in the planet is going to focus on engaging digitally with their customers, so massive opportunity. I think Q1 was a really strong quarter. We have a compelling strategy, an outstanding innovation roadmap. And I really have to thank all our employees who've pivoted to work from home and executed magnificently in what had been difficult circumstances, and which is why the momentum let us to increase our targets for '21. And as I always say, I think the top line and bottom line performance really set us apart as an investment for people. But stay safe, stay healthy, and we really look forward to having you attend Summit where we will unveil the next generation of enterprise innovation. Thank you for joining us, and I'll pass it back to Jonathan.
Jonathan Vaas: Okay. Thanks, Shantanu. And this concludes the call. Thanks, everyone.
Operator: And again, everyone, this does conclude today's call. Thank you for your participation. You may now disconnect. | [
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"speaker": "Operator",
"text": "Good day, everyone, and welcome to the Adobe Q1 FY 2021 Earnings Conference Call. Today's call is being recorded. All lines are currently in a listen-only mode. There will be time for a question-and-answer session at the end of today's presentation. Instructions will be given at that time. At this time, I would like to turn things over to Jonathan Vaas, VP of Investor Relations. Please go ahead."
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"speaker": "Jonathan Vaas",
"text": "Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's President and CEO; and John Murphy, Executive Vice President and CFO. On this call we will discuss Adobe's first quarter fiscal year 2021 financial results. By now, you should have a copy of the press release, which crossed the wire approximately one hour ago. We've also posted PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. Before we get started I want to emphasize that some of the information discussed in this call, including our financial targets and product plans, is based on information as of today, March 23, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the Forward-Looking Statements Disclosure in the press release we issued today, as well as Adobe's SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Reconciliations between the two are available in our earnings release and on Adobe's Investor Relations website. Call participants are advised that the audio of this conference call is being webcast live and is also being recorded for playback purposes. An archive of the webcast will be made available on Adobe's Investor Relations website for approximately 45 days. The call audio and the webcast may not be re-recorded, or otherwise reproduced or distributed without Adobe's prior written permission. I will now turn the call over to Shantanu."
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"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon. I hope you are all well and staying safe. It is hard to believe that it has been over a year since the pandemic began and the world changed forever. During this unprecedented time, we have gone from a world with digital to a digital-first world. Digital experiences have played a vital role in making every aspect of our lives possible, from keeping families and co-workers connected, to enabling new ways of learning, to powering digital commerce and ensuring continuity of essential business operations. Overnight, we have transitioned to a global digital economy. Adobe's mission is to change the world through digital experiences. At Adobe, we are helping fuel the digital economy with our continuous innovation, our large and diverse set of global customers and partners and the unique expertise we have garnered from undergoing our own digital transformation. Our strategy of unleashing creativity, accelerating document productivity and powering digital businesses is mission-critical and driving our top and bottom line growth. Adobe had an outstanding first quarter with strong results across Creative Cloud, Document Cloud and Experience Cloud. We achieved $3.91 billion in revenue in Q1, representing 26% year-over-year growth. GAAP earnings per share for the quarter was $2.61, representing 33% year-over-year growth, and non-GAAP earnings per share was $3.14, representing 38% year-over-year growth. In our Digital Media business, we drove strong revenue growth in both Creative Cloud and Document Cloud in Q1, achieving $2.86 billion in revenue, representing 32% year-over-year growth. Net new Digital Media Annualized Recurring Revenue or ARR was $435 million, and total Digital Media ARR exiting Q1 grew to $10.69 billion. This past year, we have seen the tremendous power creativity has to inspire, connect and entertain us. Whether it is a student uploading his video assignment, a social media influencer advocating for change, or a small business owner designing her first website, everyone has a story to tell. Creative Cloud remains a market leader in core creative categories, including imaging, design, video, screen design and illustration, and we are expanding that leadership into emerging media types like 3D and AR. Creation and consumption across phones, tablets and desktops is exploding. We're building solutions for every surface and platform, enabling customers of every skill level to create whenever and wherever inspiration strikes. Our Behance community has grown to 25 million people and programs like Adobe Live provide ongoing forums for creatives to engage as a global community. In November, we turned Adobe MAX, our annual creativity conference, into a global digital event culminating in 10 million livestreams. Creative Cloud has truly become the world's creative engine, and our future opportunities are endless. Q1 Creative Cloud performance was strong, with net new Creative Cloud ARR of $337 million and revenue of $2.38 billion. Q1 highlights include: strength in our student offering, enabling next-gen creators to tell their stories in the midst of an unprecedented remote learning environment; momentum in our Teams offering, demonstrating the increased demand for collaboration solutions globally; growth in our core creative categories, including imaging, led by Photoshop and Lightroom; demand for Premiere Pro, the leader in the exploding video category, and the overwhelming favorite at the Sundance Film Festival for the third year in a row, with 68% of films using it; significant growth in our creative mobile applications, including Lightroom mobile and Photoshop Express; an increase in demand for Creative Cloud services like Adobe Stock, which helped fill the void created when live photography and video shoots had to be postponed; and all of this results in record traffic to Adobe.com, our world-class acquisition and growth engine, and our hub for customer engagement across all surfaces. We continue to deliver groundbreaking product innovation, including Neural Filters and Super Resolution features in Photoshop that harness the power of AI and machine learning to simplify complex workflows and enhance images in seconds, extending our applications to multiple surfaces with Illustrator on the iPad and Fresco on the iPhone and building collaboration capabilities with Creative Cloud libraries. In support of our commitment to digital citizenship, we are leading the Content Authenticity Initiative, now with over 150 members, to set the standard for transparency and attribution across the content ecosystem. We recently founded the Coalition for Content Provenance and Authenticity to advance broad adoption of content authenticity standards. This year has shown us the mission-critical role that digital documents increasingly play in powering a modern business of any size. In a world where work needs to be done from anywhere and with anyone, digital workflows have become the critical underpinning to drive productivity and efficiency across global teams. With Document Cloud, we're accelerating document productivity, redefining how people view, edit, share, scan and sign documents across desktops, web, mobile and through frictionless PDF services. Through our document services, we're unleashing the PDF ecosystem with APIs for third-party developers to customize the digital document experience. Q1 Document Cloud performance was stellar, with net new Document Cloud ARR of $98 million and record revenue of $480 million. Q1 highlights include: outstanding Acrobat growth across all routes to market; significant traffic increases to our Acrobat Web experience, which delivers the ability to successfully complete PDF verb functionality in the browser, driven by best-in-class search engine optimization; powerful new Acrobat capabilities to accomplish converting, protecting and merging PDFs in the browser, furthering our strategy to make the PDF experience frictionless across devices and platforms; demand for our Acrobat Mobile and Adobe Scan apps; strong momentum for Adobe Sign, which is enabling critical e-signature workflows in businesses and government institutions around the world; delivery of an enhanced PDF reading experience with Acrobat Liquid Mode, which leverages Adobe Sensei to automatically reformat PDFs for quick and easy consumption; and key customer wins, including Amazon, Aon Services, Bank of America, Federal Aviation Administration, Merck and National Australia Bank. The pandemic accelerated the need for digital transformation among businesses of all sizes across both B2C and B2B. Small and midsized businesses had to quickly set up digital storefronts, enterprises that had not yet made substantial digital investments took the leap and those with significant digital footprints doubled down further. As the world begins to reopen, digital businesses will be the winners. Only companies that have a deep understanding of their customers' preferences and the ability to personalize experiences at every stage of the customer journey will survive and thrive. Adobe created the customer experience management category 10 years ago that we continue to lead. Experience Cloud, built on a next-gen open platform, is the most comprehensive solution for content and commerce, data insights and audiences, customer journeys, and most recently, marketing workflow. Through our acquisition of Workfront, Adobe has a unique opportunity to create a unified marketing system of record, bringing workflow management, efficiency and productivity gains to marketing teams challenged with siloed applications. Over a 1,000 shared customers are already benefitting from the integration and synergies between Experience Cloud and Workfront. Experience Cloud revenue was $934 million in Q1 with subscription revenue of $812 million, representing 27% year-over-year growth. Q1 highlights include momentum for Adobe Experience Platform, which continues to be the platform of choice for enterprise customers to deliver real-time personalization at scale; increasing demand for our commerce offerings. The Adobe Digital Index predicts that the pandemic has permanently boosted online spend by 20%, and 2022 will be the first $1 trillion year in e-commerce; solid performance in the Workfront business, demonstrating the need for a unified marketing workflow solution to drive productivity across global teams; enhancements in Customer Journey Analytics, delivering advanced anomaly detection, contribution analysis and intelligent alerts that identify hidden data patterns to more precisely understand customer behavior; powering the digital modernization of government agencies across state, county and city levels in all 50 U.S. states. Governments are revamping their online presence, making websites and apps easier to navigate; ensuring content is personalized and updated in real-time and creating intuitive forms that work on any device. Key customer wins, including Abbott Labs, Deutsche Post, Coca-Cola, FedEx, Kaiser Permanente, Mondelez, State of Illinois and Sydney Water Corporation; and industry analyst recognition in the Gartner Magic Quadrant for Digital Experience Platforms and the Forrester Agile Content Management Systems Wave report. This is the fourth year in a row that Adobe was placed as a leader in the DXP Magic Quadrant and the sixth consecutive time Forrester has recognized Adobe's industry leadership in their CMS-focused Wave reports. Adobe Summit, our annual digital experience conference, will be hosted virtually at the end of April across the globe. In addition to unveiling exciting new technology innovation in Experience Cloud, we will have customers and inspirational leaders from companies that have been on the front lines, including Albert Bourla, CEO of Pfizer; and Rajesh Subramaniam, President and COO of FedEx. Adobe's fortitude is rooted in an unwavering focus on our employees, groundbreaking innovation and our purpose, which is to harness the best of Adobe to make a significant impact in the world. At Adobe, it's not only about what we do, but how we do it. I am proud of our continued industry recognition, including being named to multiple lists celebrating Adobe as a great and equitable place to work for all, and being recognized on Fast Company's Most Innovative Companies List, Fortune's Most Admired Companies List and the CDP's Climate Change A-list. I am especially thankful to our 23,000 employees around the globe, whose dedication and talents delivered extraordinary results across every dimension of our business during these unprecedented times. Q1 was a record quarter for Adobe. As a result of our outstanding performance, tremendous opportunity across our business and continued confidence in our global execution, we are raising our annual targets. John?"
},
{
"speaker": "John Murphy",
"text": "Thanks, Shantanu. Q1 was a fantastic start to the year for Adobe, with strong financial results across all of our businesses. We accelerated revenue growth, expanded operating margins, and continued to drive demand across our portfolio of products and services, which are clearly resonating with enterprises and individuals in a world where digital has become the default. Harnessing the power of data, we continue to utilize our data-driven operating model DDOM to drive traffic to Adobe.com, generate demand for our products, acquire new customers and increase engagement. We are investing in massive market opportunities, delivering innovations across our products, and Workfront had a great first quarter as part of the Adobe family. As a result, in Q1 Adobe achieved record revenue of $3.91 billion, which represents 26% year-over-year growth. Recall that Q1 was a 14-week quarter for us versus the typical 13-week quarter. Business and financial highlights included: GAAP diluted earnings per share of $2.61 and non-GAAP diluted earnings per share of $3.14; Digital Media revenue of $2.86 billion; Net new Digital Media ARR of $435 million; Digital Experience revenue of $934 million; Cash flows from operations of $1.77 billion; Remaining Performance Obligation of $11.61 billion exiting the quarter; and repurchasing approximately 1.9 million shares of our stock during the quarter. In Q1 we saw continuing recovery in the business environment both in the U.S. and internationally, particularly with small and medium businesses, which contributed to our strong financial performance in the quarter. In our Digital Media segment, we achieved 32% year-over-year revenue growth in Q1, and we exited the quarter with $10.69 billion of Digital Media ARR. We achieved Creative revenue of $2.38 billion, which represents 31% year-over-year growth, and we added $337 million of net new Creative ARR. Our Creative growth in Q1 was driven by strong consumer demand for our Creative solutions on Adobe.com; driving improvements in usage, retention and engagement across our products; growth in our mobile business, through app store subscriptions and top-of-funnel awareness; continued recovery in the SMB segment, which we target with our Creative Cloud for Teams offering; and investing in targeted campaigns and promotions to drive awareness and acquire new users, including in emerging markets. Adobe Document Cloud delivered another quarter of accelerated revenue growth. We achieved Document Cloud revenue of $480 million, which represents 37% year-over-year growth, and we added $98 million of net new Document Cloud ARR. Documents are the currency of business, and the imperative for digitization has never been greater. Our Document Cloud growth in Q1 was driven by increasing demand for Acrobat subscriptions across all geos; strong enterprise term licensing with institutions; utilizing DDOM insights to drive improved conversion on Adobe.com; success in the reseller channel, both for subscriptions and our perpetual offering, including seat growth in the SMB segment; and strength in Adobe Sign, which grew revenue more than 50% year-over-year in the quarter. Turning to our Digital Experience segment, in Q1 we achieved revenue of $934 million, which represents 24% year-over-year growth. Digital Experience subscription revenue was $812 million, representing 27% year-over-year growth. Our Q1 results continue to validate the strength of our industry-leading Customer Experience Management or CXM solutions. Large enterprises across industries and geographies are standardizing on Adobe to manage customer interactions, gain actionable insights and unify their customer data with Adobe Experience Platform. In our Commerce business we continued to sign large deals with new customers and drive upsells at renewal points, enabling every business to transact online. Optimizing customer journeys across all channels in a digital-first world is critical to enterprises, and we see momentum with our larger customers adopting our complete Experience Cloud offering to drive omni-channel personalization at scale. We are driving the global CXM mandate across B2B and B2C, from large enterprises to midsized companies, across multiple verticals. Recent wins included expanding our reach in the public sector, where we are enabling critical constituent-facing services, and adoption in the midmarket of our new AEM Cloud Service, Adobe Commerce and Marketo Engage. Lastly, we are off to a fast start in integrating Workfront and driving the strategic value proposition of combining best-in-class workflow technology with Adobe's leading CXM and Creative solutions. Workfront contributed $38 million of revenue in Q1 after purchase accounting adjustments to deferred revenue. We continue to drive savings from travel and entertainment and facilities operations as our employees work from home. We are expanding investment in hiring globally, particularly for R&D and sales and marketing roles, in order to capitalize on our large addressable markets. From a quarter-over-quarter currency perspective, FX increased revenue by $37 million. Net of impacts from hedging, the sequential currency increase to revenue was $34 million. From a year-over-year currency perspective, FX increased revenue by $62 million. Net of impacts from hedging, the year-over-year currency increase to revenue was $44 million. Adobe's effective tax rate in Q1 was 12% on a GAAP basis and 16% on a non-GAAP basis. The tax rate came in lower than expected primarily due to a favorable tax ruling in the quarter which allowed us to reduce our withholding taxes and receive refunds for certain prior payments, and to a lesser extent, larger than expected tax benefits associated with share-based payments, and favorable resolutions of other income tax matters. Our trade DSO was 38 days, which compares to 41 days in the year-ago quarter, and 37 days last quarter. Remaining Performance Obligation grew by 17% year-over-year to $11.61 billion exiting Q1. Deferred Revenue exiting the quarter was $4.29 billion, growing 19% year-over-year. Our ending cash and short-term investment position exiting Q1 was $4.96 billion, which is sequentially down quarter-over-quarter due to the acquisition of Workfront. Cash flows from operations in Q1 were $1.77 billion. We repurchased approximately 1.9 million shares in the quarter at a cost of $888 million. We currently have $1.1 billion remaining of our $8 billion repurchase authority granted in May 2018, which we expect to be exhausted by the end of this fiscal year. In December 2020 we announced that our Board authorized an additional $15 billion stock repurchase program through fiscal year 2024, which will be funded from future cash flow generation. For Q2, we are targeting total Adobe revenue of approximately $3.72 billion; Digital Media segment year-over-year revenue growth of approximately 21%; net new Digital Media ARR of approximately $450 million; Digital Experience segment revenue growth of approximately 18%; Digital Experience subscription revenue growth of approximately 20%; tax rate of approximately 19.5% on a GAAP basis and 16% on a non-GAAP basis; share count of approximately 482 million shares; GAAP earnings per share of approximately $2.09; and non-GAAP earnings per share of approximately $2.81. In light of Adobe's strong Q1 business performance and the momentum reflected in our second quarter targets, we are increasing our annual targets for fiscal 2021. We are now targeting total Adobe revenue of approximately $15.45 billion; Digital Media segment year-over-year revenue growth of approximately 22%; net new Digital Media ARR of approximately $1.8 billion; Digital Experience segment revenue growth of approximately 20%; Digital Experience subscription revenue growth of approximately 23%; tax rate of approximately 17.5% on a GAAP basis and 16% on a non-GAAP basis; share count of approximately 481 million shares; GAAP earnings per share of approximately $9.13; non-GAAP earnings per share of approximately $11.85. In Digital Media ARR, we expect a return to normal pre-COVID summer seasonality, which can lead to sequentially lower net new ARR in Q3, followed by year-end strength in Q4. We expect operating margin to be relatively flat from Q2 to Q3 and then dip slightly in Q4 as we get back to spending on travel and reoccupying our facilities. In summary, Q1 was a great start, and we expect fiscal 2021 to be another record year. Combining our strength in customer acquisition and engagement, our leading technologies and talented employee base, Adobe is poised to continue our track record of impressive top- and bottom-line growth. Lastly, as reported in our press release earlier today, I have expressed my intent to retire this year. It is a very difficult decision for me because I love Adobe. And you may ask why now? I have been very fortunate in my career and I still have the passion and energy to fully dedicate myself to my philanthropic interests as well as prioritize my family and friends. We have navigated our way extremely well during the pandemic and our Q1 results and raised targets are evidence that the company is on solid footing. So I feel comfortable that this is the right time for me. Our highly tenured finance and operations team is top notch and I plan on helping Shantanu through a transition period as the company launches a search for my successor. Now, I'll turn it back to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "John has played a critical role in Adobe's strong performance for which I am deeply grateful. John and the entire finance and operations organization have helped drive top and bottom line growth with a relentless focus on shareholder value. In addition to his accomplishments as CFO, John embodies Adobe's values, always operating with the highest integrity and ethical standards. John will work with me to ensure a smooth transition and I'm happy that John will be able to focus on his family and philanthropic pursuits and wish him all the best. Adobe's global brand, unparalleled innovation, broad spectrum of customers and partners, and dedicated employees provide an unmatched competitive advantage. I remain bullish that technology will continue to transform work, learn and play, resulting in a brighter future for all of us. I will now turn the call over to the operator to take your questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] And we will go first to Kash Rangan of Goldman Sachs."
},
{
"speaker": "Kash Rangan",
"text": "Hello. Thank you very much, and congratulations on a spectacular quarter. Shantanu, my question, again, naggingly, annoyingly, is about Creative TAM. You've been very consistent in talking about how large the TAM for Creative is. I think goes back to 10 years prior. Can you talk -- and you mentioned today on this call that it's seemingly endless in terms of the opportunity. Can you expand on that? Why is that the case? There is a view, not that I share, that once the economy opens up that the creative folks are going to get out and enjoy their summer vacations and do less creative stuff, so we take a bit of a back step on digital transformation. I don't know how you feel about that, but if you can just talk to that tactical opening of the economy and if that might impede digital transformation or maybe not, and then talk about why your confidence in the TAM of Creative is even greater than it was, say, five years back? Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Happy to do that, Kash, and it's good to have you back on our calls now at Goldman. So first, let me just say that, when you think about content and design, there is no question that it's fueling the global economy and the way we segment our business as we think about what we are doing for Creative pros, what we are doing for communicators, and what we are doing for consumers. And first to, I think, just share some numbers associated with that, I think we've said there are 49 million Creative professionals who use our products to make a living. There are 700 million communicators, and approximately 4 billion consumers. And so when you think about the TAM, whether that's $20 billion for the Creative pros, $15 billion for communicators, or $6 billion for consumers in 2023, I mean, that represents a $41 billion addressable market opportunity given the importance of design. So it's a massive opportunity. What gives us confidence? I think when we think about strategically what we are trying to do, certainly, the first thing we're trying to do is advance every Creative category. And I'll just give you one example, Kash. I mean, what's happening with immersive media and when you think about 3D to 2D and being able to do all these virtual shoots as the amount of content, that's an emerging business. I had a really great quarter that continues on what we had said about video being one of the growth initiatives for us. So, I think the new media types and advancing it is certainly critical. I think multi-surface systems, what we can do associated with making sure mobile, mobile has been a really good growth opportunity for us. And the way we look at that, it's both as a result of the funnel that it provides for both mobile and desktop, but also as part of a system, so people can create whenever they want. So even if they are going to be out in summer, as you say, they'll have access to all of our Creative tools wherever they go. The third one I would say is what we are doing with collaboration and the team and everything associated with allowing people to collaborate. Services, I mean, Stock had another great quarter. We grew that business approximately 30% year-over-year, and the notion of just continuing to make sure that we do creativity for all, I think, the world is going to be in a place where Creative expression is going to dominate everything associated with education and productivity. So all of that gives us really high confidence associated with the opportunity and our execution. And then, if you think about it for Q1, really just quickly, I mean, Q1 was a record quarter. We continued to see really great demand on the web associated with what's happening, and the absolute ARR was strong again. And this is, as you point out, despite the recovery being complete. And so we just feel like we're in an absolutely sweet spot as it relates to what people want to do with our tools and services."
},
{
"speaker": "Kash Rangan",
"text": "Thank you very much. Congratulations."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Kash."
},
{
"speaker": "Operator",
"text": "Our next question will come from Jennifer Lowe of UBS."
},
{
"speaker": "Jennifer Lowe",
"text": "Great, thank you. Maybe just following along sort of the commentary on recovery. One of the things that stood out to me is the strength that you saw in SMB this quarter. So maybe two questions on that. First, are you kind of back to pre-COVID levels at this point in terms of SMB momentum? Or is there still more to gain there? And then secondly, just specific on Experience Cloud, I know even pre-COVID there were some execution challenges that you were experiencing in the SMB space. So have those execution challenges been sort of fully addressed and you're seeing some of those more mid-market oriented products that you've acquired executing the way you'd like them to? That's it for me. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, first, I think as it relates to the SMB segment, as we mentioned, both in the Document Cloud and Creative Cloud and to your question specifically around Experience Cloud, we did see continued momentum and growth. So I still think that when you think about what's happening in the world, it's still not fully back, right, to normal and we're still in a sort of a pandemic situation. So I clearly think there's upside. And every day you have good news in certain geographies and unfortunately not so good news. And so that only augurs well for us as we look at our business moving forward. But if I take a big picture view associated with Experience Cloud, which was the second part of your question, digital transformation, just talking to all the CEOs that I'm talking to, those who've already invested in digital are absolutely doubling down because they recognize that this is the way to further differentiate. And those who are not are clearly investing in the people, technology and processes to be in this market, whether it's transformational accounts at the enterprise level that Anil talked about at the Financial Analyst Meeting or whether it's at the small and medium business, your question associated with what we are able to do to enable them to have a digital storefront, which is an absolute necessity for doing business today. There's a lot of interest and demand in both of those. I know a lot of you, as I read your reports, the checks that you're doing, you're hearing the interest in our solutions and the talk from both the customers and the partners is high. And so we are going to see more demand for this. We had a good quarter. If you look at how we are targeting DX, we clearly expect acceleration of revenue without -- with and without Workfront, Q3 over Q2 and Q4 over Q3. So we're really excited and I think we're in the sweet spot on all three of our growth areas."
},
{
"speaker": "Jennifer Lowe",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "And the next question will come from Mark Moerdler of Bernstein Research."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you very much, and congratulations on the quarter and a great start to the year. John, we're going to miss you, but completely understand the desire to spend more time with family and philanthropy. So enjoy it. Two quarters ago, you called out your increased focus on driving Experience Cloud margin improvement. Can you give us an update on where you are in driving Experience Cloud margin improvement? And any sense what you think about long-term margins could be for what Experience Cloud is today versus the future? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "Well, Mark, I'll let John speak to his decision after this as well. But I think the decision to be made associated with reducing our focus on the transaction-based advertising revenue, if you look at everything that's happening associated with that business, there are other companies in that space. I think that was a good way to do it, what we've done with the Experience platform. And with Anil coming in, taking a soup to nuts approach associated with that entire P&L and the business opportunity, he's been able to align and simplify and improve it. And so, I mean, you don't accomplish the kinds of margins that we accomplished in the year without a focus across all of our businesses. And so we have an incredibly good leverage model, but there's more. I mean, Digital Experience is still in that area where we're growing revenue, I mean 20% is what we've targeted for the entire year. We had 27% of subscription revenue in Q1. And so it really is one of those areas that's a growth opportunity and you will see that translate into the bottom line over time. But, John, maybe I'll have you also add to that."
},
{
"speaker": "John Murphy",
"text": "Yes, no; absolutely. I think the continued focus that we have both on gross margin and on operating margin in the businesses is key. And Mark, thanks for the words. I'm definitely going to miss you guys as well, but I will be here for a while during the transition. You can imagine it was a difficult decision to make. You think about these things for a while. But I decided even last year during the pandemic, and you kind of refocus on some priorities. And so I'm really fortunate for the great career I've had and thankful to Shantanu and Adobe to allow me this opportunity to pursue my passions."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you. I appreciate it and congrats."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Next, we'll go to Brent Thill of Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Good afternoon, Shantanu. You had mentioned a couple of years ago at Summit that the customer data platform architecture was a revolutionary architecture and was going to bring some really interesting opportunities to Adobe. It sounds like some of those customers are going live now. And I'm just curious to get your perspective on where you're at on that journey and what you're starting to see in Experience Cloud with CDP coming online?"
},
{
"speaker": "Shantanu Narayen",
"text": "Brent, we have seen some -- quite a bit of success. I think we have some really blue chip customers that we talked about -- the conversations that I'm having with each of these customers. And people talk about Customer 360. We're the only major company that has anything out there of this scale to be able to do real-time personalization at scale. We have billions of profiles that are already going through this. Absolutely blue chip customers, whether it's financial services, whether it's in other online like retail -- what we are doing with telecommunications. And so not only do we have that, but it has really served as a basis for what we've done with the customer journey analytics. So, if you take a step back and the big areas that we talked about content, commerce, data insights and audiences, which is such a key part -- I think that becomes even more important with what's happening in the spooky world so that you can have access to all your first party data and profiles. So, I think the decision to invest in that was right. The success that we're seeing in the marketplace and the leadership, I think, positions us incredibly well, Brent. And you'll hear a lot more about that at Summit, certainly. I think the Workfront acquisition also has had the unique opportunity to be able to add to what we have in terms of our solutions and get workflow also and attribution associated with it. So I feel really good. But I feel really good about the infrastructure with CDP. And we focus a lot more on the real-time nature of what we can do with personalization as the key differentiation. But some great customer wins."
},
{
"speaker": "Brent Thill",
"text": "Just a quick follow-up for John. On the 20% growth you're now guiding, just back to Jen's question. Does that assume a full recovery for SMB or is that still contemplating that there's still some improvement that you could squeeze out of that segment of the market?"
},
{
"speaker": "John Murphy",
"text": "Thanks, Brent. Yes, no, for sure it really reflects a continued recovery. But it's not -- we don't expect to be back to pre-COVID levels. I think as we saw as we exited FY '20, that momentum and kind of recovery was just gradual and continual recovery. And we're into the benefit of that."
},
{
"speaker": "Brent Thill",
"text": "Okay, thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Hey Brent, you followed us for a significant amount of time. We don't bank on anything dramatically changing. We look at the demand that we have and current trends. We're not macroeconomic experts. And so as the recovery happens more, but we're not banking on it. Just to be clear."
},
{
"speaker": "Brent Thill",
"text": "Thanks, gentlemen."
},
{
"speaker": "Operator",
"text": "And we'll go now to Kirk Materne of Evercore ISI."
},
{
"speaker": "Kirk Materne",
"text": "Hi, thanks very much. Shantanu, I was just kind of curious. As we come out of the pandemic, your businesses has executed incredibly well. Are there parts of the business though that would benefit from getting back in front of the customer base? I'm thinking about sort of the Experience Cloud business in particular. You guys have, obviously, been able to execute really well in a virtual world. But I do wonder if there's areas whether it's Experience Cloud, maybe in the education market, areas like that, where being able to get out and talk to the customers again would actually be beneficial. I was just curious if you had any thoughts on that."
},
{
"speaker": "Shantanu Narayen",
"text": "I think so. I mean the world has done a pretty amazing job of pivoting to working at home and being able to do as much as you can. And I've talked about the fact that being able to visit with customers all across the globe without travel is in many ways a real ability to scale. But I also am one who believes that being in front of the customers and getting the partners that we have together and accelerating the rollout and sharing best practices and that social part is only going to help. I don't think the world is going back to everybody being in the office, but I do believe that it will be an accelerant. Because people's desire to also invest more as the economic situation improves can only be another tailwind for us. And so we've done a pretty incredible job. I mean when you look at our numbers. But there's no question in my mind. I mean if we can go travel and if we can meet with those customers and do it, there's only upside associated with that."
},
{
"speaker": "Kirk Materne",
"text": "And then, maybe just one quick one for."
},
{
"speaker": "Shantanu Narayen",
"text": "What we notice that we can do as well as -- sorry, both in terms of what we can do as well as their own confidence, right, in continuing to expand their investments."
},
{
"speaker": "Kirk Materne",
"text": "Thanks for that. And then just maybe a quick one for John. John, on the Workfront revenue came in a little bit higher than your initial expectations. Was that just mainly around sort of deferred accounting? I realize you probably took a fairly conservative view on that given you had to close the acquisition, you talked to us in December. But it sounds like you got off to a good start. Is there any uplift maybe in the bookings or revenue just in terms of the combination or is that mainly just sort of a factor of accounting? Thanks."
},
{
"speaker": "John Murphy",
"text": "Yes, thanks, Ken. No, the Workfront actually really did have great performance. So outside of the accounting adjustments for purchase accounting, we saw momentum in the business. And we had kind of suggested maybe about $140 million, $150 million in Workfront revenue impacting FY '21, but we think it'll be a bit more than that given the performance because the combined offering is really resonating with our customer base. That was really the, from the business case of doing this acquisition to begin with. We'll take the next question, operator."
},
{
"speaker": "Operator",
"text": "We'll go to that next question and that will come from Jay Vleeschhouwer of Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. Shantanu, for you first. At the Analyst Meeting in December, the company had some very interesting things to say about your technology and where you were investing. You referred, for example, in the case of Creative to what you called a deeply collaborative shared system. In the case of Doc Cloud, you referred to intelligence applied to PDF, as with Liquid Mode; all of that in the context of your applications and intelligent services. The question is, could you foresee the role for or need for new configurations or a new kind of segmentation of the product line, new SKUs, new packaging, anything of that sort particularly as you become more domain-specific oriented? And then for John, over the last three quarters you've had a very steep almost V-shaped recovery in your job openings from almost none back in June/July, to now over 1,000 and up four months in a row year-over-year. Could you talk about that in terms of your onboarding and the context of how you were thinking about OpEx growth for the year?"
},
{
"speaker": "Shantanu Narayen",
"text": "Jay, maybe I'll take your question and since they haven't been asked many questions yet on Document Cloud, I'll use Document Cloud with the technology lens to answer your question. I mean first, Liquid Mode, I was on the road. I was traveling on the road last week and the entire preparation for this I was doing on a mobile device with Liquid Mode. And I will tell you, Liquid Mode for me was an absolute lifesaver in terms of being able to look at all these documents and do everything collaboratively on the road. So an unabashed plug for those who haven't tried Liquid Mode or haven't tried Adobe Scan to really see how it changes. And the way we think about it is when you apply that kind of AI to fundamentally change the nature and understanding the structure and semantics of documents, it opens up so many different possibilities on the segmentation. I mean we now have revenue that we drive through Reader and Reader distribution and upsells because we understand what people are trying to do and understand the intent. We're driving revenue through search engine optimization that we do on PDF because we have a one-click way of having them do more and more PDF functionality. We have a new revenue monetization model associated with APIs and being able to have people use PDF and embed that in their particular workflows. And we've always had Acrobat Sign, had a great quarter. Again, I think John may have mention that we grew 50%. And so to your point, I mean AI and technology and being able to make that available and accessible in different ways is not just serving the customers better but it's clearly providing us new opportunities to monetize it that previously did not exist. And so I think you'll continue to see that in the innovation roadmap whether it's Summit or MAX. You'll see some really cool things which will not just push the envelope for our Creative pros but also make it way more accessible, productive and fun for communicators and consumers. John?"
},
{
"speaker": "John Murphy",
"text": "Yes, in regards to the job openings, the headcount growth, when we entered the pandemic last year, we did pause hiring initiatives we talked about to really focus our resources on our highest priorities, and we did that and successfully navigated the pandemic and really came out taking advantage of the opportunities in front of us. And so with that, of course, we talked about it in Q3 that we were going to start to ramp hiring. And so we have done that and we continue to look to invest, as I said, in R&D and sales capacity as well as variable marketing. In terms of the impact on OpEx, we had originally planned for margin expansion in FY '21 over FY '20, and we've updated targets actually indicating even greater margin expansion even though it accounts for our phased reentry as we come back to traveling, as we reopen our facilities. So for us, it's the ability to grow the top line and the leverage in our operating model allows us to be able to do that. So for us, margin expansion is really all driven off of revenue growth and ultimately we can perform both very well on the top line and on the bottom line."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And next, we will go to Saket Kalia of Barclays Capital."
},
{
"speaker": "Saket Kalia",
"text": "Okay, great. Hey. Thanks for taking my question here, guys, and congrats, John, on the well-deserved retirement. Shantanu, maybe for you on the Creative business, can you just talk about the product pipeline to that growing individual user base for the rest of 2021? Broad brushes, of course. And how you feel about Adobe's ability to help them grow or progress in their journey to higher-end Creative Cloud apps? And, John, if I can just fit in one housekeeping question that maybe might be helpful, I was wondering if you can just quantify how much the extra week added to total revenue and net new ARR in the quarter?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, Saket, I mean, maybe I'll speak to that and I'll also give you my color on sort of what happened with ARR. But first as it relates to how we're expanding both the user base and acquisitions, I mean, the net new ARR, when you look at it, it's primarily all new net new ARR in terms of customer acquisition. And whether it's the mobile-only applications that we are providing, whether it's the web-based ability to do things in the browser, whether it's collaboration, that's certainly the way in which we are expanding our offering. And frankly, the way we do it is that anybody who uses one of our on-ramp products whether it's an individual category apps that is then using the entire CC all apps or whether it's the consumer app where they start to get exposed to things like maybe layers in Photoshop or a timeline in Premiere Rush, they have the ability to then be upsold as well as to become more productive by going to Premiere or Photoshop. So it's very much been a part of our strategy all along, which is how do you attract customers to the platform and how do you think about then making sure that as they grow in their Creative endeavors that we have the right on-ramp whether it's an offer that we provide at the right time, whether it's engagement that we do with Adobe CreativeLive. I mean, CreativeLive has really become in that community of Behance a great way for people to continue to grow and learn. And I think there are a whole cottage industry also of people who've done training and learning and education on Creative products. So that's the strategy, which is meet the customer where they are whether it's on a surface or whether it's a degree of specialization, and then make sure that as they expand their Creative pursuits that we're the right product for that. And so if you think about it, I mean, digital media ARR, what really happens is it's not -- while revenue may be more representative of the number of weeks in a quarter, and so if you take the 14 weeks over 13 weeks, you can argue that it was probably eight points of revenue that was extra as a result of the 14 week. But ARR is not as cyclical because ARR when you have an enterprise part of the business, it's probably going to be back-end loaded by most enterprise much like enterprise. So that's why we look at the Q1 ARR, which was a record for Creative, as a really solid performance. So, hopefully that gives you a flavor. Revenue for Creative is little bit more dependent on the number of weeks, but ARR is sort of you have these things that we do, which are cyclical, and that drives the strong growth that we saw across both Creative and Documents."
},
{
"speaker": "Saket Kalia",
"text": "Very helpful, Shantanu. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And next we will go to Ken Wong of Guggenheim Securities."
},
{
"speaker": "Ken Wong",
"text": "Great, thanks for taking my question. I just wanted to dive in a little bit on the Digital Experience business. Would love some color behind the confidence in the 23% DX sub growth. Is this purely just improving macro or are you guys seeing better deal flows, bigger deals, specific products that are contributing to this uptick? And any help there would be fantastic."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, I think the confidence comes from first, the performance in Q1. As we said, we had 27% subscription revenue growth. I think the confidence comes from the conversations that we're all having with companies all across the globe, from the pipeline that we have, from what we know in terms of Summit. And again, as in their response to the previous question that was asked, this is not banking on any macroeconomic environment changes for the rest of the year. So it's based on what we know today and the interest. Commerce is an area that is seeing a fair amount of interest, the real-time customer data platform. The experience platform is seeing a significant amount of interest. Workfront, as we said, and John mentioned that it's not the deferred revenue. It's the performance as well that's driving the upside in that particular business. Customer journey analytics and being able to address this in a multichannel, that's seeing a lot of interest. I think you're going to see some new products also in terms of how we evolve our campaign product and analytics product to be more business performance related. And frankly, to a large extent, Ken, all of this is also predicated on how we run our business, right? And our DDOM and understanding what it takes to run an online business, and we're world class at that, and we're building products for ourselves. And so that gives us a lot of confidence that it will help every other customer out there."
},
{
"speaker": "Ken Wong",
"text": "Great, thanks a lot for that insight."
},
{
"speaker": "Operator",
"text": "And next we will go to Sterling Auty of J.P. Morgan."
},
{
"speaker": "Sterling Auty",
"text": "Yes, thanks. Hi, guys. First, John, congratulations on a wonderful tenure as CFO of Adobe. Just one question from my side, you touched upon Adobe Sign and the 50% growth that you saw on the quarter. It seems like meaningful acceleration from what we saw year or so ago, where I think that business was growing about 25%. I'm going to take a stab, any sense would you be willing to quantify and size the Adobe Sign business at this point? And then second, in terms of the accelerating growth, I think you mentioned government. But what are you particularly seeing that's driving the uptake of that e-signature business?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think our key differentiating there, Sterling, is the fact that PDF as a format continues to be the format the people are using for automating these workflows. I think the fact that we have Adobe Reader, which is the operating environment in which all of the workflows are happening, I think we've done a better job with awareness, frankly, of what we have and that, hopefully, some of you have seen the incredibly new Creative campaigns that we're running associated with that. We're actually getting a fair amount of wins from other competitive products that people might have been using in terms of moving over to Adobe. The partnerships that we have with Microsoft and ServiceNow in terms of being embedded, whether it's in SharePoint or Outlook or partnering with ServiceNow. So, I think we're executing on the product side. I think we have some key differentiation, and this is not a zero-sum game. It's such a large opportunity, and I think the work-from-home has also certainly benefited us and everybody else in that space. So all of those I think are reasons why Sign just continues to be a real growth opportunity for us. The last thing I would mention is the ability to embed our Sign stuff within other people's offerings as well. I think we made some good progress on that one as well so all of these give us confidence. And to your question, Sterling, we don't break it up because it's hard, right? Sometimes you have an enterprise deal where you have all of them using Acrobat and Sign. And so even on the individual case, you have the ability to use a certain amount of Sign capability with an Acrobat. And so I think our strength is in the combined offering."
},
{
"speaker": "Sterling Auty",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "And next we will go to Keith Bachman of Bank of Montreal."
},
{
"speaker": "Keith Bachman",
"text": "Hi, thank you very much. Shantanu, I was wondering if you could give an update on the Commerce Cloud. And I'll break it into two parts. A, could you talk a little bit about growth rates and profiles? In other words, are you moving into larger situations with more scalable demands? And, B, could you talk a little bit about you moved through acquisition into the commerce area, and it fits into the DDOM model. And yet you're still partnering on the services side of the equation of the service cloud. I just wanted to see if you could juxtapose your strategies surrounding willingness to move into commerce via M&A and any thoughts on is partnering still the right strategy for the services side? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, at the end of the day, Keith, we are a software company. And so I think -- actually just to give you a little bit of an update on numbers -- the beauty of when we acquired Magento and put it in the Commerce Cloud was first it was B2B and B2C. That was an attractive area for us. Second, it was physical goods and digital growth. That was an interesting opportunity for us. I think the third thing that was important for us was the fact that we had the ability to have both a large ecosystem of partners who were implementing this as well as an open-source community that was able to extend the functionality and, in effect, the extended R&D model. On the partner side, I think we've gone something from 2,800 or so partners that they had to well over 4,000. So the interest in partnering with us on the Commerce Cloud is high. And our model, as we've always said, this goes back also to the earlier question that somebody had on the P&L associated with Digital Experience. Our model is software, and we're happy actually to have a large ecosystem of partners that work with it. And maybe the last thing I would say on that particular front is that we're really continuing to expand what we do on the Merchant Services offering. So partners like PayPal and what we can do in conjunction with them and other credit card and other partners. I think that's going to also be a good area of continued growth for us."
},
{
"speaker": "Keith Bachman",
"text": "Okay. Thank you, Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Jonathan Vaas",
"text": "Operator, we'll take two more questions and then wrap up. Thanks."
},
{
"speaker": "Operator",
"text": "Certainly. And next we will go to Derrick Wood of Cowen & Company."
},
{
"speaker": "Derrick Wood",
"text": "Great. Thanks. Question on Document Cloud and maybe the first part for John. It looks like perpetual is quite strong, and I suspect that came from strength in the ETLA activity. But can you talk to how you're thinking about perpetual mix as we look through the rest of the year and whether we could see another spike in any given quarter? And then, maybe more for Shantanu. Just kind of a refresher around the strategy within Document Cloud on getting more customers to shift to subscription and how to think about those efforts over the next couple of years."
},
{
"speaker": "Shantanu Narayen",
"text": "Awesome. Maybe I'll go with the strategy and then, John, you can certainly add to that, which [indiscernible]. First, from a strategic point of view, if you go to Adobe.com, it's primarily subscription. And so we've done a fantastic job of converting that business to subscription. When you look at it globally and you consider some other markets where a lot of it is going through the resellers, even that has predominantly become subscription. But we'd be crazy not to have people if they do want some perpetual to buy the perpetual and then convert it to subscription because we still know that. So, I think to your Uber point, yes, we did see some strength in perpetual. China, I think, had also a pretty strong quarter as it related to Acrobat. And that may be a little bit more perpetual. Our strategy is clearly moving into the cloud. Our strategy is clearly demonstrating the value of where people see the ongoing innovation that we're providing. But that business, unlike the other business, we just want to attract more and more customers to any one of those offerings. And that's why we've continued to have the Acrobat perpetual offer out there. But it's becoming smaller and smaller. As a part of the business it's definitely becoming smaller and smaller. I know on Adobe.com it's virtually de minimis."
},
{
"speaker": "Derrick Wood",
"text": "Great, thanks."
},
{
"speaker": "Operator",
"text": "And we will go to our final question, and that will be from Keith Weiss of Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you, guys, for sneaking me in and again my congratulations to John on the retirement, well-deserved. And also, really nice quarter. I wanted to ask you guys about a concern that I hear from investors and kind of get your take on it. While you guys are seeing a recovery on the SMB side of the equation, the fact of the matter is the Digital Media business did really well through all of last year, even in the height of the pandemic. In the upcoming May quarter, you guys saw really good ARR growth, it was up on a year-on-year basis, which exceeded a lot of people's expectations. But now there's a concern that it's a really tough comp ahead that you guys saw work-from-home benefits or benefit that were due to sort of what was going on with the crisis that that might create a difficult compare. Can you talk about whether there is like a difficult compare ahead? And is there a different sort of tone or nature of the business that you're seeing now versus what you saw last year at this time as we were in the crisis?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think Keith, the question that we ask ourselves is the big shifts that we've seen in terms of how people work, the need to create, the different kinds of media types that exist. Is there anything that's going to fundamentally change when the economy changes? And we don't think so, because we just continue to believe that that importance of all of those areas and the tailwinds that exist in the market will continue to exist. I mean I think in terms of our numbers and you look at what we are doing, we've said, it's -- we've raised the target a little bit from what we had, the $1.75 billion to the $1.8 billion. And this is 10 years into it, driving a record ARR. I would say that that reflects the much larger market opportunity that we've created for ourselves. And so, the way I actually look at it, Keith, is that it's brought more attention to what's possible with our tools. And once people experience the benefits of what they're doing with us, it's going to be hard to go back to not using those kinds of technologies, which is what gives us a lot of interest. Hopefully, and you were certainly there, Keith, at the Analyst Meeting. That's why we tried to lay out completely what we see in terms of communicators and consumers and Creative pros. And I mean the business is doing really well. We're expanding the Digital Media segment revenue for the year, we're expanding revenue. And so that's all based on what we see as demand for what we have created and the tremendous amount of innovation that's ahead of us. So I think all of those give us a lot of confidence in the fundamental nature of the growth opportunities that we're focused on. And since that was the last question, I mean maybe just a couple of points. I would like to, and I know a lot of you did, also publicly thank John. This was I know for John a very personal decision, and I'm happy that he is going to be able to focus on what's important to him which is family and his philanthropic interests, and I'm deeply grateful. And on the overall business, it's hard. It's hard to believe that a year has passed since the pandemic impacted the world, but I think what's really incredible is digital is not just a nice to have right now, it's absolutely mission critical. And most companies would be thrilled to have one area of growth. We have three areas of growth: creativity, storytelling, design, what's happening with the future of work and remote work and the limitations of what you can do with in-person interaction, which will lead to more automation of digital documents and how every business in the planet is going to focus on engaging digitally with their customers, so massive opportunity. I think Q1 was a really strong quarter. We have a compelling strategy, an outstanding innovation roadmap. And I really have to thank all our employees who've pivoted to work from home and executed magnificently in what had been difficult circumstances, and which is why the momentum let us to increase our targets for '21. And as I always say, I think the top line and bottom line performance really set us apart as an investment for people. But stay safe, stay healthy, and we really look forward to having you attend Summit where we will unveil the next generation of enterprise innovation. Thank you for joining us, and I'll pass it back to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Okay. Thanks, Shantanu. And this concludes the call. Thanks, everyone."
},
{
"speaker": "Operator",
"text": "And again, everyone, this does conclude today's call. Thank you for your participation. You may now disconnect."
}
] | Adobe Inc. | 24,321 |
ADBE | 4 | 2,022 | 2022-12-15 17:00:00 | Operator: Good day, and welcome to the Q4 and FY’22 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I’d like to turn the conference over to Jonathan Vaas, Vice President of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's fourth quarter and fiscal year 2022 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, December 15th, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today's press release and in Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates and adjusted growth rates in constant currency that also account for an extra week in fiscal 2021. During this presentation, Adobe's executives will refer to constant currency and adjusted growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon, and thank you for joining us. 2022 was an exciting and eventful year for Adobe. We achieved record revenue of $17.61 billion, representing 15% year-over-year growth. GAAP earnings per share was $10.10 and non-GAAP earnings per share was $13.71. We delivered record operating cash flows with a focus on profitability. Our strong performance in the uncertain macroeconomic environment underscores the resilience of our business and the mission-critical role of our products in a digital-first world. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is driving momentum across every geography and customer segment, making us one of the most innovative, diversified, and profitable software companies in the world. We continue to execute against our product roadmap, serve a vast customer universe from individuals to large enterprises and deliver strong top and bottom line growth. Adobe Creative Cloud, Document Cloud and Experience Cloud have become the foundation of Digital Experiences, starting with the first creative spark, to the creation and development of all content and media, to the personalized delivery across every channel. In Q4, we achieved revenue of $4.53 billion, representing 14% year-over-year growth. In our Digital Media business, we had our best quarter ever on net new ARR, delivering $576 million, and our Digital Experience business achieved its first $1 billion subscription revenue quarter, growing 16% year-over-year. I will now pass it to David.
David Wadhwani: Thanks, Shantanu, and hello, everyone. The demand for digital content across every creative category, customer segment and media type is accelerating at a rapid pace. Creative Cloud remains the leading creativity platform, offering a comprehensive portfolio of products for every discipline across imaging, photography, design, video, web, animation and 3D. Core products such as Photoshop, Lightroom, Illustrator, Premiere Pro and Acrobat continue to lead their categories as we add new features and enhance their capabilities with Adobe Sensei, our AI engine. The rapid progress we’re making with Adobe Express is attracting millions of new users and delivering additional value to Creative Cloud members who are also interested in lightweight, task-oriented tools. New collaboration capabilities, like Share for Review, are integrated directly into Creative Cloud and Document Cloud applications to enable seamless creation, sharing and review across creative and document workflows. Our ongoing product innovation ensures that Adobe remains the preeminent destination for a wide and growing base of individuals, students, creative professionals, small business owners and enterprises to create and monetize amazing content more quickly and easily than ever before. Q4 was a record quarter for Creative Cloud. We achieved net new Creative Cloud ARR of $453 million and revenue of $2.68 billion, which grew 13% year-over-year. This strong performance was a result of: demand for our flagship applications, including Photoshop, Lightroom, Illustrator, Premiere Pro and Acrobat; expansion in SMB and enterprise, driven by strong execution of our year-end pipeline across direct sales and our reseller channel; accelerating growth in Substance 3D and Frame.io, underscoring the continued strength and significant opportunities in our newer businesses; momentum in Express, our template-based web and mobile product for creating everything from year-end sales promotions to holiday cards to social media posts. Express’ unparalleled collection of stock images, videos, fonts, design assets and templates and its unique integration of AI magic from Photoshop, Premiere Pro and Acrobat enable us to deliver the best of Adobe to customers of every skill level. Q4 continued to see exciting growth with millions of monthly active users, greater than 40% quarter-over-quarter visitor growth in the U.S., and an NPS greater than 50. Key customer wins include Electronic Arts, Meta, NBC Universal, Publicis, Roku, Target and United Nations. In October, we were thrilled to be back live with thousands of members from our creative community at Adobe MAX. The conference has always been an opportunity to showcase our incredible innovation, and we drove over a quarter of a billion video views across all channels. Our announcements included: powerful new AI capabilities in Photoshop, such as a one-click Delete and Fill tool to remove and replace objects, and a new Photo Restoration neural filter that instantly fixes damaged photos; a Share for Review service in Photoshop and Illustrator that enables designers to easily collaborate with key stakeholders; the first-to-market Camera to Cloud integration between Frame.io and RED Digital Camera and Fujifilm, significantly reducing production costs and time; advances in Substance 3D that empower brands such as Electronic Arts, Hugo Boss, NASCAR, NVIDIA and The Coca-Cola Company to create engaging immersive experiences; a new partnership between the Content Authenticity Initiative and Leica and Nikon to implement provenance technology into cameras, allowing photographers to embed when, where and how images were captured; and early demonstrations of Adobe’s Generative AI technology integrated into our tools, which promises to transform the creative process, making it more accessible, fast and efficient than ever before. Now turning to the Document Cloud business, digital documents have become synonymous with productivity in our personal and professional lives, whether it’s an offer to purchase a new home, a bank deposit form, a school permission slip or a sales contract. Document Cloud is the leader in digital documents, offering innovative solutions across every device and for every skill level. Our strategy to enable all common document actions, including editing, sharing, reviewing, scanning and signing across desktop, mobile and web, is paying strong dividends. In Q4, Document Cloud had record revenue of $619 million, which represents 19% year-over-year growth and strong net new ARR of $123 million, with ending ARR growing 23% year-over-year. Q4 highlights include: new Acrobat functionality for SMBs, including the ability to send branded agreement templates and combine payments with e-signed documents; new capabilities between Document Cloud and Creative Cloud to help knowledge workers and creative professionals seamlessly collaborate and improve their productivity; scan innovation that allows users to simultaneously scan the left and right pages of a book as well as scan both sides of an ID card on one page; strong organic growth in both traffic and searches for PDF capabilities, which serve as a critical funnel to Acrobat web; significant growth in Sign transactions within Acrobat, underscoring the need for integrated document solutions; outstanding growth in API transactions. API calls nearly doubled quarter-over-quarter, demonstrating the strategic necessity of integrating PDF capabilities within enterprise applications; key customer wins include BioNTech, Cigna, Deloitte, Mitsubishi Electric, Raytheon, Shell Information Technology and the U.S. Department of State. Q4 was the strongest net new ARR quarter ever for Digital Media, driven by outstanding execution against multiple growth drivers in our core business. In addition, we’re excited about the pending Figma acquisition, which represents a tremendous opportunity to accelerate the future of creativity and productivity for millions of people. Overall, the regulatory process is proceeding as expected. The transaction is being reviewed globally, including by the Department of Justice and the Competition and Markets Authority in the UK. We are currently engaged in the DOJ’s second request process. We expect that the transaction will also be reviewed in the EU. We continue to feel positive about the facts underlying the transaction and expect to receive approval to close the transaction in 2023. I’ll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello everyone. Every business in every category now depends on digital to engage and transact with their customers. Adobe’s Holiday Shopping Report, which analyzes trillions of data points in Adobe Analytics, found that Cyber Monday drove an all-time high of $11.3 billion in online spending, with mobile shopping now accounting for 55% of sales on Thanksgiving, and Buy Now Pay Later orders jumping 85% during Cyber Week. We predict spend will exceed $210 billion this holiday season. No company is better positioned than Adobe to capitalize on this large global opportunity. In my customer conversations, it’s clear that the current macroeconomic climate requires businesses to prioritize investments, and digital remains mission-critical to drive operational efficiency, improve customer engagement and maximize long-term value realization. We are driving a mix of diversified revenue streams through subscription and consulting services across new and existing customers, demonstrating the strength of our business. Experience Cloud is powering digital businesses in every industry across B2B and B2C with our leading solutions spanning data insights and audiences, content and commerce, customer journeys and marketing workflow, and it is unique in that it helps businesses drive customer demand, engagement and growth while simultaneously delivering productivity gains. Our comprehensive set of applications, including Real-Time CDP, are built natively on our highly differentiated Adobe Experience Platform, providing companies with a unified profile of each of their customers to deliver the most personalized, real-time experiences at scale. Adobe Experience Platform processes 29 trillion segment evaluations per day and executes a response time of less than 250 milliseconds, illustrating the impact of its real-time capabilities at scale. In Q4, we continued to drive strong growth in our Experience Cloud business, achieving $1.15 billion in revenue. Subscription revenue was $1.01 billion, our first billion-dollar quarter and representing 16% year-over-year growth. Adobe is differentiated in our ability to power the entire customer experience, from ideation to content creation to personalized delivery to monetization. Chipotle is a great example. They are using Creative Cloud to design content for web and mobile channels and Experience Cloud to highlight new product offerings based on consumer preferences and support a faster, easier and more customized online ordering process. In government, the State of Illinois is using Experience Cloud and Document Cloud to provide simpler and more equitable access to state services for over 12 million residents. It's especially inspiring to witness the positive social impact of Adobe technology. The National Center for Missing and Exploited Children has long used Photoshop to create age-progressed photos and uses Experience Cloud to facilitate the recovery of missing children. Additional Q4 highlights include: strong demand for Adobe Experience Platform and native applications, inclusive of Real-Time CDP, Adobe Journey Optimizer and Customer Journey Analytics, which are rapidly becoming the digital underpinning of large brands globally; accelerating demand for Adobe Experience Manager, demonstrating Adobe’s role in helping businesses effectively manage their content supply chain, from creation to monetization; a new Marketing Mix Modeling service as part of our data insights and audiences offering, which enables marketers to harness the power of Adobe Sensei to assess marketing ROI in weeks rather than months and forecast resources for campaigns more effectively; strong growth in partner and Adobe professional services, underscoring our customers’ continued focus on implementation and value realization; key customer wins, including BlackRock, Chipotle, Delta Air Lines, DFS Group, Disney Parks, Elevance Health, GM, Office Depot, Publicis, Santander and Wells Fargo. Adobe continued to receive strong industry analyst recognition, including leadership in the Gartner Magic Quadrant for B2B Marketing Automation Platforms, the Forrester Wave for Collaborative Work Management and the Forrester Wave for Enterprise Marketing Suites. I’ll now pass it to Dan.
Dan Durn: Thanks, Anil. Our earnings report today covers both, Q4 and fiscal year 2022 results. As you know, in 2022 we experienced significant headwinds from the strengthening of the U.S. dollar, increased tax rates and the impacts from the Russia-Ukraine war. Despite those headwinds, in fiscal ‘22 Adobe achieved record revenue of $17.61 billion, which represents 12% year-over-year growth, or 15% growth in constant currency on an adjusted basis. GAAP EPS for the year was $10.10, and non-GAAP EPS was $13.71. We exceeded our initial Non-GAAP EPS target for fiscal year ‘22, which speaks to the discipline, strong execution and resilient operating model of the Company. Fiscal year 22 business and financial highlights included: Digital Media revenue of $12.84 billion; net new Digital Media ARR of $1.91 billion; Digital Experience revenue of $4.42 billion; cash flows from operations of $7.84 billion; RPO of $15.19 billion exiting the year; and repurchasing approximately 15.7 million shares of our stock during the year at a cost of $6.30 billion. In the fourth quarter of fiscal year ‘22, Adobe achieved revenue of $4.53 billion, which represents 10% year-over-year growth, or 14% in constant currency. GAAP diluted earnings per share in Q4 was $2.53 and non-GAAP diluted earnings per share was a record $3.60. Q4 business and financial highlights included: Digital Media revenue of $3.30 billion; record net new Digital Media ARR of $576 million; Digital Experience revenue of $1.15 billion; record cash flows from operations of $2.33 billion; adding over $1 billion to RPO sequentially in the quarter; and repurchasing approximately 5 million shares of our stock. In our Digital Media segment, we achieved Q4 revenue of $3.30 billion, which represents 10% year-over-year growth, or 14% in constant currency. We exited the quarter with $13.97 billion of Digital Media ARR. We achieved Creative revenue of $2.68 billion, which represents 8% year-over-year growth, or 13% in constant currency, and we added $453 million of net new Creative ARR in the quarter. Driving this performance was good linearity throughout the quarter as well as strong customer purchasing during the peak holiday shopping weeks. Fourth quarter Creative growth drivers included: new user growth, fueled by customer demand, targeted campaigns and promotions, and yearend seasonal strength, which drove strong web traffic and conversion rates in the quarter; adoption of our Creative Cloud All Apps offerings across customer segments, from enterprise, to Team, to individual and education; strength of the new Acrobat within our Creative Cloud offering, demonstrating the importance of digital documents and workflows to the creative community; sales of individual applications, including a strong quarter for our imaging and photography offerings; continued growth of newer businesses, including Express, Substance, Frame and Stock; and a solid finish to the year in SMB and enterprise. Adobe achieved Document Cloud revenue of $619 million, which represents 16% year-over-year growth, or 19% in constant currency. We added $123 million of net new Document Cloud ARR in the quarter. Fourth quarter Document Cloud growth drivers included: Acrobat subscription demand across all customer segments; continued growth of Acrobat web, fueled by online searches for PDF and product-led growth; strong performance of our new Acrobat offering integrated with Sign, driving upsell ARR as well as new customer adoption; and year-end seasonal strength in SMB, including through our reseller channel. Turning to our Digital Experience segment, in Q4 we achieved revenue of $1.15 billion and subscription revenue of $1.01 billion, both of which represent 14% year-over-year growth, or 16% in constant currency. Fourth quarter Digital Experience growth drivers included: expected year-end strength, with significant bookings of our newer offerings in EMEA that builds on our momentum in North America; success closing numerous transformational deals that span our portfolio of solutions; momentum with our Adobe Experience Platform and native applications, including RealTime CDP; strength with our Content and Workfront solutions, which are integral components of our content supply chain strategy; and increased customer demand for professional services, as enterprises focus on implementation and accelerating time to value realization from digital investments. In Q4, we focused on making disciplined investments to drive growth and awareness of our products. We continue to have world-class gross and operating margins and drove strong EPS performance in the quarter. Adobe’s effective tax rate in Q4 was 22.5% on a GAAP basis and 17.5% on a non-GAAP basis. The GAAP tax rate came in lower than expected primarily due to lower-than-projected tax on our foreign earnings. RPO exiting the quarter was $15.19 billion, growing 9% year-over-year, or 12% when factoring in a 3 percentage-point FX headwind. Our ending cash and short-term investment position exiting Q4 was $6.10 billion, and cash flows from operations in the quarter were a record $2.33 billion, up 14% year-over-year. We now intend to use cash on hand to repay the current portion of our debt on or before the due date, which we expect will reduce our interest expense in fiscal year ‘23. In Q4 we entered into a $1.75 billion share repurchase agreement, and we currently have $6.55 billion remaining of our $15 billion authorization granted in December 2020 which goes through 2024. As a reminder, we measure ARR on a constant currency basis during a fiscal year and revalue ARR at year-end for current currency rates. FX rate changes between December of 2021 and this year have resulted in a $712 million decrease to the Digital Media ARR balance entering fiscal year ‘23, which is now $13.26 billion after the revaluation. This is reflected in our updated investor data sheet, and ARR results will be measured against this amount during fiscal year ‘23. We provided preliminary fiscal year ‘23 targets at our Financial Analyst Meeting in October that take into account the macroeconomic environment and the growth drivers for our various businesses. While there is ongoing macro uncertainty, given the massive long-term opportunity in digital and the momentum in our business, we are pleased to reiterate those financial targets. In summary, for fiscal year ‘23 we are targeting: total Adobe revenue of $19.1 to $19.3 billion; Digital Media net new ARR of approximately $1.65 billion; Digital Media segment revenue of $13.9 to $14.0 billion; Digital Experience segment revenue of $4.925 billion to $5.025 billion; Digital Experience subscription revenue of $4.375 billion to $4.425 billion; tax rate of approximately 22% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $10.75 to $11.05; and non-GAAP earnings per share of $15.15 to $15.45. As a reminder, these targets do not contemplate our planned acquisition of Figma. We expect normal seasonality throughout the year, with Q1 being sequentially down and seasonally light for new business, sequential growth from Q1 to Q2, a dip in Q3 on account of summer seasonality, and a strong finish to the year in Q4. For Q1 fiscal year ‘23 we are targeting: total Adobe revenue of $4.60 billion to $4.64 billion; Digital Media net new ARR of approximately $375 million; Digital Media segment revenue of $3.35 billion to $3.375 billion; Digital Experience segment revenue of $1.16 billion to $1.18 billion; Digital Experience subscription revenue of $1.025 billion to $1.045 billion; tax rate of approximately 22% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $2.60 to $2.65; and non-GAAP earnings per share of $3.65 to $3.70. In summary, Adobe finished FY22 strong, executing on our strategies across Creative Cloud, Document Cloud and Experience Cloud. I expect this performance to carry into next year, as Adobe’s sustained top-line growth and world-class profitability continue to position us well for fiscal year ‘23 and beyond. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. As the company celebrates its 40th anniversary, it is a perfect time to reflect on our past and our future. Adobe was founded on simple but enduring principles that remain with us today. Innovation is at our core, employees are our greatest asset and our customers, communities and shareholders are central to our success. Over the past four decades, Adobe’s continuous innovation and leadership have empowered billions of people around the globe to imagine, create and deliver the best Digital Experiences. Our strong brand and company culture enable us to attract and retain the world’s best employees. We are proud to once again be named to Interbrand’s Best Global Brands list as a top riser for the 7th year in a row and to Wall Street Journal’s Best Managed Companies, ranking number one for Employee Engagement and Development. We have everything it takes to continue our success in the future: massive market opportunities; a proven ability to create and expand categories that transform markets; an expansive product portfolio that serves a growing universe of customers; revolutionary technology platforms that advance our industry leadership and competitive advantage; an expanding ecosystem that delivers even greater value to customers; strong business fundamentals; and the most dedicated and talented employees. I have never been more certain that Adobe’s best days are ahead. Thank you and we will now take questions. Operator?
Operator: Thank you. [Operator Instructions] We'll go ahead and take our first question from Mark Moerdler with Bernstein Research. Please go ahead.
Mark Moerdler: Thank you very much, and congratulations on the quarter and the guidance, by the way. Can you give us, David, some more color on Adobe Express and your ability to convert free users to paid users? Are you seeing any impact to creative customers trying to switch to Express? And how do you assure express paid adoption with that impact on Creative Cloud?
David Wadhwani: Yes. We're very excited about sort of the state of Express. Express just finished its first year in market. We have millions of monthly active users. As I mentioned, we saw very strong growth sequentially quarter-over-quarter in the U.S., which is our primary focus market, 40% quarter-over-quarter growth in visitors, terrific NPS of over 50%. And that's really on the backs of hundreds of millions of stock content that we have, the 20,000 fonts that we've added that is unique to our offering, the highest quality templates. And the constant addition of best-breed features from our other Adobe products like Photoshop and Premier and Acrobat. We've had over 100 releases in the first year that Express has been out. So, we're very excited about that. And so, the Express business itself continues to do well, both in terms of free users and in terms of conversion of those users. But to your question, we also are seeing very strong adoption of Express within our existing CC customer base. So, we see a lot of people, of course, buying our core flagship applications for the power and precision that they have and that they represent, but there are times in those users that are looking to just get something done quickly. And the fact that Express is also entitled to those users gives them the ability to have the power and precision and the speed and ease. And so as users are coming, we're bringing in more users than we've ever had in audiences, we haven't reached by finding intent-based search for things. We're bringing those users in, which is giving us incredible top of funnel. We're driving the conversion. And we're also able to drive utilization increases in CC customers, which is driving retention of that business overall as well. So, the funnel and that migration of that base is very healthy and playing out as expected.
Operator: We'll go ahead and move on to our next question from Brad Sills with Bank of America.
Brad Sills: I wanted to ask another question about Creative Cloud Express. Obviously, you're seeing some success here with that top of funnel business. Is there any color you can provide on where you see the upgrade path for some of those customers? Are there -- is there a certain upsell motion that we could see conversion of other products, even potentially the full suite in that installed base as it's growing? Thank you.
David Wadhwani: Yes. As we talked about when we launched Creative Cloud Express, the primary focus right now is bringing people into Adobe Express and just making them successful, whether it's at the free tier or whether it's at the paid tier or whether it's a pay tier eventually migrating up into the core flagship applications. Our primary focus has been and continues to be right now around usage, repeat usage and utilization. We are seeing, though, while that's our primary focus, we are seeing a lot of really interesting data coming in suggesting that we -- that the upgrade has are -- while still early and not our primary focus are working. For example, in many higher ed institutions where we've started to deploy Adobe Express, we're starting to see not just the increase in terms of usage of Express, but we're also starting to see increase in demand for Adobe Creative Cloud flagship applications. And again, part of this is we know and we believe that everyone should be creative and creativity is the new productivity. But as people start to leverage and benefit from that creativity, they naturally want more power and precision as well. So that they do go well hand in hand.
Operator: We'll move on to our next question from Sterling Auty with SVB MoffettNathanson. Please go ahead.
Sterling Auty: So, I'm curious, is there anything operationally that you can do in preparation for the Figma acquisition, either from an expense structure or development side now before close? And if so, what are those moves that you're making?
Shantanu Narayen: Yes, Sterling, maybe I can speak to that. I mean, first, it's nice to see that since the deal was announced, the excitement associated with both what we can do as combined companies as well as, as you can see from our results, the interest in the core business. And so, we're excited overall associated with it. Certainly, as the regulatory bodies are looking at it, we can focus on thinking about strategically. We are getting a lot of great feedback from customers. But these are two separate independent companies. And as it relates to our own cost structure as well as our technology, we feel really good about all the prioritizations we've made. And so, we feel like we're uniquely positioned when it closes to immediately take advantage of it.
Operator: We'll move on to our next question from Brad Zelnick with Deutsche Bank. Please go ahead.
Brad Zelnick: My congrats as well on a strong finish to the year. Following up on Sterling's question, it's good to hear the Figma close process is moving forward as expected. Can you give us an update on how their business is trending, just relative to your commentary at the time the deal was announced, especially given the evolution of the macro environment since then? Thanks.
Shantanu Narayen: Brad, as you know, they're a private company. And so, we're certainly not at liberty to talk about it. And they have to continue to execute on their opportunity by themselves.
Brad Zelnick: Okay. Understood. Thank you, Shantanu.
Operator: We'll move on to our next question from Mark Murphy with JPMorgan. Please go ahead.
Mark Murphy: Thank you very much, and I'll add my congrats. So Shantanu, the amount of energy and excitement in the audience was quite impressive down at the MAX conference. And I'm wondering which of the innovations that you unveiled has created the most enthusiasm, which you might -- you think might also be monetizable? And I'm wondering whether it could be generative AI or that Share for Review capability, the intertwine capability or anything else really coming to the forefront.
Shantanu Narayen: Well, Mark, firstly, thanks for being there, and it's clear that you were also looking at all of the cool new innovative stuff that was delivered. I always worry about questions like that because it's, you know, which of my children do I love the most. But let me just speak to, I think, thematically, what David and Scott showed, which is the core applications. We just continue to make sure the core applications are more accessible, more productive, more fun. And so I think that's one area, thematically, that the team has done an outstanding job of making sure that we continue to deliver innovative capabilities. You mentioned Intertwine and Illustrator. I think the second thing, thematically, we talk about how do we get more people into the franchise. David also referred to that when he answered the two questions on Express, which is, the more we get people into the franchise, whether it's through our trial products, whether it's through Express, whether it's through participating in the collaborative process. I think that only adds to the available market for Adobe. And so, I think the work that we're doing in collaboration is really continuing to democratize what we can do. So, I'm pretty excited about that. I think the AI and the sneaks that you talked about, that really -- the potential for that when you see whether it was the individual fonts that were being done or whether your ability through a text, to be able to get your content done exactly the way it is. I'm sure you've been tracking also what's happened, Mark, in terms of the chat GPT and what you can do with respect to text. So, I think that entire space, our vision has always been anybody who has a creative idea, how do you get that creative idea to life. And so, I think moving from the hundreds of millions to billions of people who can use it. You're right, that has profound impact in terms of getting more people on our platform. And I think you'll see us be quite aggressive about delivering more of that functionality in an augmented way, perhaps first starting with Express. But I think we're excited about all of that. And the Frame acquisition certainly also is off. I think David and Dan spoke to Substance. So, we feel really good about the multiple growth drivers.
David Wadhwani: If I can adjust a little bit to that. The three examples you brought are really interesting examples because intertwine is an example of the ongoing innovation in our existing flagship application. So that continues to drive an keep people engaged and onboarding into the applications and keep those -- keeps everything fresh and differentiated. Share for Review that initial release, while still early, we've been amazed by the repeat use of that once people start using it. And that represents a great growth loop for us. Because, as you know, anyone that gets shared a document, whether it's a Photoshop document or an Illustrator document or any other document is also an opportunity as a stakeholder to turn into a future user of Adobe products, whether it happens to be the Photoshop document to Photoshop usage or whether it happens to be driving people to try Adobe Express. So, those growth loops are really interesting and important to us as well. And I just wanted to make sure people saw that opportunity.
Operator: The next question will come from Jay Vleeschhouwer with Griffin Securities. Please go ahead.
Jay Vleeschhouwer: Shantanu, I'd like to ask about a term that you used often at MAX. And in fact, a new three-letter acronym that you use as well, namely product-led growth. And the question is Adobe has arguably been a product-led growth company for the more than 30 years that I've known you. And I'm wondering now what does product-led growth mean differently today from what it might have meant historically? And relatedly, how are you thinking about the cross-sell and upsell opportunity that you also spoke about at MAX, specifically for 2023.
Shantanu Narayen: Yes. Jay, thanks for recognizing that our innovation has really come through an extremely close relationship with customers. So, I think in the past, in the desktop era, what product-led growth really was all about was making sure that as we engage with the customers, as we engage with the community, that we were able to use that. I think the best example perhaps in the desktop era was what we did with Lightroom. And when we first came up with Lightroom, given the fact that we had Photoshop already as a product, just getting the millions of people to use it even before we release the product, having all those evangelists and a great product, I think was a great example. What the team in both Creative Cloud and frankly, in the Experience Cloud, are doing is actually also following on the great work that we pioneered in the Document Cloud. And so, in the Document Cloud, I think product-led growth really related to as we think about what people were doing on searches when we introduced our web-based offerings for Acrobat, that's when we just started to see this velocity of how we engage with customers and prioritizing what's clearly top of mind for them, our ability to immediately satisfy them, I think, escalated quite a bit. When David came in, David really said, we've got to take this to a whole new level with product-led growth, and it's integrating both the community as well as, frankly, right now, engagement and engagement marketing in the product. And so when you get into product sessions right now, and you see the product manager and the engineering manager as well as the product marketing manager, all of them are on the same page. We have data. We have things instrumented in the products and your ability to do both AB testing and here's where we use our own products and the products that Anil does. And so, product-led growth right now is about saying, at any given time, we probably have three tests in market for a particular feature as well. And we're using that to really learn from the customer interactions and to deliver better quality products sooner. But David has really been the pioneer. So, David, if you'd like to add? And then maybe a little bit, Anil, on what we are doing for that in Digital Experience as well.
David Wadhwani: Yes, Shantanu, I think that was a pretty complete summary. The only thing I would add is that there's an interesting inflection point that we are in terms of our product development cycles that give us an opportunity to take what we've always been doing, to your point, with product-led growth and drive even more use of it, which is the introduction of all the web applications that we have. So, we now have Photoshop Web, we have Illustrator Web, we have Acrobat Web, we have Adobe Express, and you combine that with the sharing focus that we have with Share for Review as an example. And we have new growth loops that we can start optimizing, and that's been a huge area of focus for the teams.
Anil Chakravarthy: Yes. I just wanted to add, Shantanu, as you said, several of our enterprise customers are starting to deploy their own product-led growth using our analytics technology, a banking customer, for example, one of our best customers. They have their online mortgage application, and they want to track who is able to use it successfully, who's able to complete applications completely online, and they're using our analytics technology to do that and see what works and what they need to do to fix it. So, we're starting to see like exactly, as you said, our technology being both used inside Adobe to drive our own PLG as well as customers doing it.
Shantanu Narayen: And Jay, maybe to get to your second question and taking a step back, I do have to say, when we look at our annual targets that we had provided for Digital Media ARR at the beginning of the year of $1.9 billion. And I know even with our Q4 guide, I think people had some questions about where is the momentum. And I think the team crushed that, which I feel really good about. And so, a lot of that is happening as a result of just first, attracting and acquiring customers to the platform. And then what you're referring to is the cross-sell, upsell, whether it's people who first engage with us on a mobile device, whether it's people in Acrobat. We've used Adobe Reader as a very, very good on-ramp to allow people to engage with PDF functionality and then either get a license for our Acrobat web product or for the desktop product. Individual apps, the success and the driving of individual apps has always been an on ramp, and we then do a really good job because we use Adobe Experience platform to then convert them and even promotional pricing. I know we've had some questions in the past. And we have incredible data that shows us when people come in, whether that's on educational pricing and then they graduate or on promotional pricing, converting them to customers. So, I think there are numerous ways in which we've demonstrated that by personalizing our offer to every creative or knowledge worker that we're able to monetize that as well after they derive the value from it.
Operator: We'll move on to Derrick Wood with Cowen & Company. Please go ahead.
Derrick Wood: Congrats on a strong net new ARR customer -- quarter. I wanted to ask about the composition of this number. The growth dynamic between Creative Cloud and Document Cloud was a little surprising. I mean Creative Cloud had, I think, the second strongest sequential percentage growth Q4 ever. But looking at Document Cloud, net new ARR didn't grow much sequentially in what's typically a stronger uptick in Q4. Can you just give a little more color on the seasonal dynamics you saw between Creative and Document Cloud in the quarter?
David Wadhwani: Sure. Yes, I'm happy to do that. So first of all, yes, as Shantanu mentioned, we're very pleased with how FY22 has gone and how the quarter closed out, we saw a lot of strength in the core businesses. And our primary focus across these businesses continues to be around new customer acquisition, new customer ads. We also have a lot of diversity in terms of the drivers that we have and the leverage we have to drive the business. As we mentioned, we saw great strength across all of our creative segments imaging, photo, video, design. We also grew a lot of -- focused a lot in terms of new campaigns that are targeting new audiences for creative as well with a new campaign called Everyone can Photoshop, that's bringing customers in directly into the products and has been very productive in terms of driving top of funnel and conversion. On the -- in terms of new businesses for Creative, we're seeing a lot of strength from new businesses like Frame and Substance that have contributed more this quarter than ever before. And to your point, we've also been seeing a lot of strength in the core business around Acrobat. We're running a Acrobat’s Got It campaign really targeted at new customers in SMB where we show them all the capabilities that Acrobat has now, including specifically focused on signatures and things that really help them drive the business. So overall, the business is doing very well. The one dynamic that -- if you look at from an Acrobat perspective that we're really proud of too, is that we saw -- for the year, we saw growth of ARR at 23% despite the complicated macro. And it's important to remember that some portion of this is also -- the Acrobat business is also represented in the creative business. So, the Acrobat growth number is probably a bit understated in this point.
Operator: We'll move on to our next question from Michael Turrin with Wells Fargo Securities. Please go ahead.
Michael Turrin: Maybe one on the digital price side. We fielded some questions there just around guidance for next year in the current backdrop. You're holding on targets, grew well at 16% in constant currency for the quarter. So, can you just talk more around how much visibility you have in the targets there and it's how you closed the year at all, particularly given that EMEA comment provides incremental confidence in those targets going forward. Thank you.
Anil Chakravarthy: Thanks for the question. We are pleased with the performance of the Digital Experience business. I mean just as a quick reminder, at the beginning of the year, we had guided DX at 17% of digital growth for the year, which is what we achieved in a really tough year with all the different macro issues. So if I really take a step back, we're -- first of all, we're in a really strong position with our product portfolio. We are a clear leader in the market with the investments we made at the Adobe Experience platform starting 5 years ago. And that is really paying off with the book of business that we are seeing and all the customer adoption that we are seeing. And what we are hearing from our conversations with our customers is that they're really eager to invest in a platform that enables them to meet the mission-critical priorities around digital. And that's what we are enabling them and personalization in real time at scale. So, this is a significantly large opportunity. And what we believe is that as we go through this time, single product companies are going to come under a lot of scrutiny. So, while we definitely see deals getting scrutinized and going up to higher levels for approval, we also see that customers really want to invest in a market leader like us for their investments, it's going to last the next 10, 15 years to -- for the digital investment. So pleased with where we are.
Shantanu Narayen: Maybe Anil, I'll just add a couple of things to what you said. I mean the first is that value realization has been top of mind for a lot of these customers. And so, I think if you look at the business as well, the services part, it's very clear that people want to implement it. And what I think is unique about Adobe's offerings in this particular space is that we help both with the customer engagement and frankly, the top of funnel as well as we help with productivity and cost. And so, it doesn't matter which side of that equation you are as, as an enterprise, I think both of them find that the Adobe Experience Cloud as well as, frankly, what we are doing with Sign actually help them on both fronts. And so we're pleased associated with that, and we have good visibility. I want to complement Anil and his team on the execution against the pipeline and transformational deals also, I think, just reflect the overarching interest that people have in making sure digital continues to be an imperative. And so, we're not going to be immune to the macroeconomic, but I like our differentiated solution and our execution.
Operator: And our next question comes from Brent Thill with Jefferies. Please go ahead.
Brent Thill: Thanks. Dan, in terms of your guide, are you implying the environment gets worse or stays the same. And for Shantanu, can you just talk about the next 6 to 9 months as we potentially go into a tougher economic headwind, how you're reshaping and rethinking your go-to-market or any steps that you can take to ensure you can cut through what is coming in.
Dan Durn: Yes. So, from a guide standpoint, we spent a lot of time talking about the environment we're in during FA day. Against that backdrop, you can see the momentum of the business. You can see the execution against the opportunities. What I really like about the way we're positioned in the market. There's a diversification of the company. It's end markets, it's product segments, it's business models, it gives us a resilience in the environment that we're in, and we see that in the momentum we're carrying into next year. There's really no change to the view of the environment that we're in, and you see that reflected in the targets that we set for 2023. So, we feel good about the way we're executing against a complicated macro environment, and we'll continue to stay focused on adding value to our customers, but there's a diversification and a resilience to who we are and a mission criticality of what we sell to our customers. And then you could see that in the comment that Shantanu made. You can see us impacting the company's top line. You can see us impacting the productivity with which they serve their customers, and that puts us in a pretty unique position.
Shantanu Narayen: And Brent, as it relates to your second question, I'll unpack that in maybe two ways. First is we're really pleased with what we did and even when the pandemic first started about prioritizing what was really critical for us. And I think the prioritization exercise when you're really focused on your top imperatives, that's really helped bring clarity and alignment within the company that I don't think should be undersold in terms of how effective that has been for execution. As it relates to the next 6 or 9 months and you think about the three routes to market, digital continues to be an area of strength. I mean, I know through our Adobe Digital Index we talk about what we are seeing in terms of people continuing to engage with the customers -- companies that they want to transact with electronically. And so, on the digital side, we will just continue to make sure we focus on acquiring the customers. David spoke to some of the effective campaigns. Clearly, we understand the attribution of that. And we just have to remain vigilant on making sure that we're attracting the customers on the new platforms where they exist. And for retention, which is a key issue as well, just how they continue to get value from the offerings that they have. The partner ecosystem, whether that's for the small and medium business or whether that's for what we are doing with the SI and VAR community on Digital Experience, just continuing to enable them, continuing to engage with them. I think that's a part. Clearly, the small and medium business did see a rebound after what they went through last year, which was a really bad situation. So I think we have to remain vigilant on that. And I think on the direct sales part, as we look at our pipeline, December, despite the fact that it's our first month of our quarter, we will continue to focus on execution against that to take advantage of whatever budget flush exists in companies. And then, as you start to come to what happens in Japan in February as it's the end of their fiscal year, continuing to focus on Europe. Brent, Europe was actually one of the highlights for us in the quarter. I think Adobe Experience platform has done well. And so, we remain cautious clearly about the macroeconomic, but I think we have visibility into making sure that we can continue to execute, Brent.
Operator: We'll go ahead and move on to our next question from Keith Bachman with BMO. Please go ahead.
Keith Bachman: Hi. Thank you very much. And apologize in advance for some background noise. Shantanu and David, I wanted to direct this to you, if I could. The ARR net new in the quarter was very good, particularly relative to expectations. If we look back over a little longer period of time though than the quarter, growth has slowed in net new ARR, even if it's assuming of flattening out. And what I didn't -- what we didn't really get -- I think as much as we would have liked at the Analyst Day was, what do you think the key drivers of the net new ARR and creative have been or total ARR, if you want? And what are the key things that you're focused on before Figma that would cause an improvement in AR growth? I assume that one has been perhaps Adobe Express as a more compelling entry point. Is there anything else that you can call out as some things that you believe that Adobe is focused on like really some issues in the past that you think are going to be resolved and therefore before Figma but improve despite the macro or help growth in the creative side? Many thanks.
David Wadhwani: Yes. I'm happy to jump in and Shantanu can add anything. So at a high level, if you look at what we've talked about at Analyst Day, our strategy is very clear, which is new users and retention are the core drivers and focus areas. As Shantanu mentioned, we're being very focused and very intentional in terms of those two things. When it comes to new subscribers, we added more new commercial subscribers this year than we've ever added in our history. And that is a really important intentional sort of activities we are doing. Many of those new users are -- tend to be nonprofessionals, right, or they tend to be earlier in career professionals. And so, they are coming in and leveraging our initial single app plan or Adobe Express, as an example, and we're very happy to have them take that on because we believe very strongly that the opportunities to drive and upsell them from Express to single app and from single app to all apps, is going to be something that is persistent and something that is very ready and available to us at the time we need. The main thing, though, is about getting them into the products and making them successful. And so with that focus, we've been very -- we've also been maniacally operational about retention of those bases. I think people have asked questions, as you broaden the net, you bring in other users that are not typical Adobe users, what's happening to the retention rates. I think we also shared that we're seeing usage of products continues to stay very strong as we bring in these new audiences. And we're starting -- and we're seeing retention continue to tick up and improve. And in fact, retention now is better than it was pre-pandemic as an example. So, we continue to bring in new users. We continue to retain those new users and we see organic opportunities to move them up and upgrade them. Shantanu mentioned a great example of education. We continue to see a lot of people come in with our education pricing. And then, we have the opportunity, two years or three years later when they graduate to upgrade them to full commercial pricing. And those activities are playing out as expected, and we see a lot more opportunity to it. But it all comes down to bringing new users in, getting them using the products a lot and retaining them.
Shantanu Narayen: And maybe to add to that, Keith. I mean, when you think about the newer businesses that we're talking about, video just continues to be a really key growth driver, 3D and immersive imaging and photography. But if you take a step back, I think that two things happening in the macroeconomic environment that are actually going to be tailwinds. The first is the fact that it is the golden age of design. Everybody would like to express themselves. There are more screens on which all of this content is being consumed. So, I think the insatiable consumer demand for content, I think, is certainly driving a lot of more content that's being created. One of the exciting areas that I think David and Anil have talked about is what we are calling content supply chain. And when you take even the larger companies, they are all trying to get a handle of as they engage digitally with customers how much content is being created? Where is it being created? Where is it being delivered? How do I localize it? What's the efficacy of that content? And so, I think this content supply chain and everything we have with our creative applications, our asset management, the fact that we then deliver that content, I think we continue to believe that that's going to be a growth driver for the entire business as well. So, I wouldn't underestimate the insatiable consumer demand but I also wouldn't underestimate what's happening as enterprises recognize that the way to engage with people is to personalize that content.
Jonathan Vaas: Hey operator, we're at the top of the hour. We'll make time for one more question, and then we'll wrap up. Thanks.
Operator: You bet. We'll go ahead and take our last question from Alex Zukin with Wolf Research. Please go ahead.
Alex Zukin: I apologize for any background noise. I guess we've heard a lot about the continuing growth initiatives in the demand environment, sounding like it's pretty resistant to any macro pressures I believe you're seeing at the moment. I'll ask the kind of other side of the equation. As you think about the levers that you have on the margin side, the discipline that you've been exhibiting. It does seem like over the last quarter and maybe the past few quarters, that margin story, that margin discipline has continued to exceed at least our expectations. So, as we look at the next year, as you think about the levers that you have in the business if the parts of the business should slow. Can you go through maybe walk through a little bit of where you see the opportunity to either, A, lean in or B, pull back? And also, how we should think about cash conversion in that scenario from a cash flow perspective. Thanks again.
Dan Durn: Yes. So from an operating performance standpoint, you rightfully point out, the Company is performing really, really well. But we're doing what we've always done inside the company, which is drive growth, deliver industry-leading products and innovation to our customers, help them become more effective on the critical path of driving revenue for their business. But we do it in a very disciplined way that drives margin and cash flow while driving growth. And we talked a lot about Rule of 40 at our FA day. If I were to take a step back and reflect on FY22, it's complicated macro environment, and we’re operating at a rule of 60 for the year. So, we feel really good about our ability to operate. And so as I look forward into next year, we're going to continue to lead. We're going to continue to innovate. We're going to continue to make our customers successful, but we'll continue to do what we've always done, which is ruthlessly prioritized where we make our investments, constantly review the portfolio, prioritize the things that are going to drive long-term value for our customers and do it in a very disciplined way. So, that's the operating tone inside the company. Nothing's changed on that front. We feel really good about how we're executing in the environment and the momentum we're carrying into 2023. From a cash flow standpoint, it all starts with driving that discipline in the business and we'll continue to drive cash flow and deploy that excess cash on a quarterly basis to create value with the shareholders.
Shantanu Narayen: And Alex, given that was the last question, let me start off by saying as we celebrate our 40th anniversary, it's both humbling and inspiring to think about the impact that Adobe has had on the communication world and what we've been able to do. And it's rare to be able to say at this level that we believe that our best years are ahead of us. If I take a step back and I look at what we had done in 2022, there are three things that stand out for me, the Digital Media ARR and just continuing to drive new customer acquisition and deliver innovative products across both, the Creative Cloud and Document Cloud. We've done a really good job of demonstrating why creativity and design is going to be more important and also combining creativity with productivity. On the DX side, the organic creation of the Adobe Experience platform and its apps, and the success that we've seen associated with that, the fact that we just had a first $1 billion quarter as it related to subscription revenues, I think that just reflects both the fact that we created this category. And unlike all of the other enterprise software companies who are in that space, we're just ruthlessly focused on this. And it is unique in that it helps both the top line and bottom line for enterprises. And to the question that you specifically asked, Alex, I mean, profitability, despite the FX impact that impacted hundreds of millions of dollars when you look back and say, at the end of the year, we exceeded our non-GAAP EPS that we had said a year ago/ I think that is a really amazing performance by the finance and operations team of making sure that we continue to remain focused. And I think as it relates to go-forward, we've clearly talked about why we're excited about the innovative road map, why we're excited about all of the things that are going to come up in 2023 and beyond. And so, I think it was a good year. We will continue to remain focused. I want to thank our employees who really are the unsung heroes of all of this execution and the work that they do. And for every one of you, thank you again for your interest in Adobe and happy holidays and wishing you all a joyous holiday season.
Jonathan Vaas: Thanks, everyone. This concludes the call.
Operator: With that, that does conclude today's call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Q4 and FY’22 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I’d like to turn the conference over to Jonathan Vaas, Vice President of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's fourth quarter and fiscal year 2022 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, December 15th, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today's press release and in Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates and adjusted growth rates in constant currency that also account for an extra week in fiscal 2021. During this presentation, Adobe's executives will refer to constant currency and adjusted growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon, and thank you for joining us. 2022 was an exciting and eventful year for Adobe. We achieved record revenue of $17.61 billion, representing 15% year-over-year growth. GAAP earnings per share was $10.10 and non-GAAP earnings per share was $13.71. We delivered record operating cash flows with a focus on profitability. Our strong performance in the uncertain macroeconomic environment underscores the resilience of our business and the mission-critical role of our products in a digital-first world. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is driving momentum across every geography and customer segment, making us one of the most innovative, diversified, and profitable software companies in the world. We continue to execute against our product roadmap, serve a vast customer universe from individuals to large enterprises and deliver strong top and bottom line growth. Adobe Creative Cloud, Document Cloud and Experience Cloud have become the foundation of Digital Experiences, starting with the first creative spark, to the creation and development of all content and media, to the personalized delivery across every channel. In Q4, we achieved revenue of $4.53 billion, representing 14% year-over-year growth. In our Digital Media business, we had our best quarter ever on net new ARR, delivering $576 million, and our Digital Experience business achieved its first $1 billion subscription revenue quarter, growing 16% year-over-year. I will now pass it to David."
},
{
"speaker": "David Wadhwani",
"text": "Thanks, Shantanu, and hello, everyone. The demand for digital content across every creative category, customer segment and media type is accelerating at a rapid pace. Creative Cloud remains the leading creativity platform, offering a comprehensive portfolio of products for every discipline across imaging, photography, design, video, web, animation and 3D. Core products such as Photoshop, Lightroom, Illustrator, Premiere Pro and Acrobat continue to lead their categories as we add new features and enhance their capabilities with Adobe Sensei, our AI engine. The rapid progress we’re making with Adobe Express is attracting millions of new users and delivering additional value to Creative Cloud members who are also interested in lightweight, task-oriented tools. New collaboration capabilities, like Share for Review, are integrated directly into Creative Cloud and Document Cloud applications to enable seamless creation, sharing and review across creative and document workflows. Our ongoing product innovation ensures that Adobe remains the preeminent destination for a wide and growing base of individuals, students, creative professionals, small business owners and enterprises to create and monetize amazing content more quickly and easily than ever before. Q4 was a record quarter for Creative Cloud. We achieved net new Creative Cloud ARR of $453 million and revenue of $2.68 billion, which grew 13% year-over-year. This strong performance was a result of: demand for our flagship applications, including Photoshop, Lightroom, Illustrator, Premiere Pro and Acrobat; expansion in SMB and enterprise, driven by strong execution of our year-end pipeline across direct sales and our reseller channel; accelerating growth in Substance 3D and Frame.io, underscoring the continued strength and significant opportunities in our newer businesses; momentum in Express, our template-based web and mobile product for creating everything from year-end sales promotions to holiday cards to social media posts. Express’ unparalleled collection of stock images, videos, fonts, design assets and templates and its unique integration of AI magic from Photoshop, Premiere Pro and Acrobat enable us to deliver the best of Adobe to customers of every skill level. Q4 continued to see exciting growth with millions of monthly active users, greater than 40% quarter-over-quarter visitor growth in the U.S., and an NPS greater than 50. Key customer wins include Electronic Arts, Meta, NBC Universal, Publicis, Roku, Target and United Nations. In October, we were thrilled to be back live with thousands of members from our creative community at Adobe MAX. The conference has always been an opportunity to showcase our incredible innovation, and we drove over a quarter of a billion video views across all channels. Our announcements included: powerful new AI capabilities in Photoshop, such as a one-click Delete and Fill tool to remove and replace objects, and a new Photo Restoration neural filter that instantly fixes damaged photos; a Share for Review service in Photoshop and Illustrator that enables designers to easily collaborate with key stakeholders; the first-to-market Camera to Cloud integration between Frame.io and RED Digital Camera and Fujifilm, significantly reducing production costs and time; advances in Substance 3D that empower brands such as Electronic Arts, Hugo Boss, NASCAR, NVIDIA and The Coca-Cola Company to create engaging immersive experiences; a new partnership between the Content Authenticity Initiative and Leica and Nikon to implement provenance technology into cameras, allowing photographers to embed when, where and how images were captured; and early demonstrations of Adobe’s Generative AI technology integrated into our tools, which promises to transform the creative process, making it more accessible, fast and efficient than ever before. Now turning to the Document Cloud business, digital documents have become synonymous with productivity in our personal and professional lives, whether it’s an offer to purchase a new home, a bank deposit form, a school permission slip or a sales contract. Document Cloud is the leader in digital documents, offering innovative solutions across every device and for every skill level. Our strategy to enable all common document actions, including editing, sharing, reviewing, scanning and signing across desktop, mobile and web, is paying strong dividends. In Q4, Document Cloud had record revenue of $619 million, which represents 19% year-over-year growth and strong net new ARR of $123 million, with ending ARR growing 23% year-over-year. Q4 highlights include: new Acrobat functionality for SMBs, including the ability to send branded agreement templates and combine payments with e-signed documents; new capabilities between Document Cloud and Creative Cloud to help knowledge workers and creative professionals seamlessly collaborate and improve their productivity; scan innovation that allows users to simultaneously scan the left and right pages of a book as well as scan both sides of an ID card on one page; strong organic growth in both traffic and searches for PDF capabilities, which serve as a critical funnel to Acrobat web; significant growth in Sign transactions within Acrobat, underscoring the need for integrated document solutions; outstanding growth in API transactions. API calls nearly doubled quarter-over-quarter, demonstrating the strategic necessity of integrating PDF capabilities within enterprise applications; key customer wins include BioNTech, Cigna, Deloitte, Mitsubishi Electric, Raytheon, Shell Information Technology and the U.S. Department of State. Q4 was the strongest net new ARR quarter ever for Digital Media, driven by outstanding execution against multiple growth drivers in our core business. In addition, we’re excited about the pending Figma acquisition, which represents a tremendous opportunity to accelerate the future of creativity and productivity for millions of people. Overall, the regulatory process is proceeding as expected. The transaction is being reviewed globally, including by the Department of Justice and the Competition and Markets Authority in the UK. We are currently engaged in the DOJ’s second request process. We expect that the transaction will also be reviewed in the EU. We continue to feel positive about the facts underlying the transaction and expect to receive approval to close the transaction in 2023. I’ll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello everyone. Every business in every category now depends on digital to engage and transact with their customers. Adobe’s Holiday Shopping Report, which analyzes trillions of data points in Adobe Analytics, found that Cyber Monday drove an all-time high of $11.3 billion in online spending, with mobile shopping now accounting for 55% of sales on Thanksgiving, and Buy Now Pay Later orders jumping 85% during Cyber Week. We predict spend will exceed $210 billion this holiday season. No company is better positioned than Adobe to capitalize on this large global opportunity. In my customer conversations, it’s clear that the current macroeconomic climate requires businesses to prioritize investments, and digital remains mission-critical to drive operational efficiency, improve customer engagement and maximize long-term value realization. We are driving a mix of diversified revenue streams through subscription and consulting services across new and existing customers, demonstrating the strength of our business. Experience Cloud is powering digital businesses in every industry across B2B and B2C with our leading solutions spanning data insights and audiences, content and commerce, customer journeys and marketing workflow, and it is unique in that it helps businesses drive customer demand, engagement and growth while simultaneously delivering productivity gains. Our comprehensive set of applications, including Real-Time CDP, are built natively on our highly differentiated Adobe Experience Platform, providing companies with a unified profile of each of their customers to deliver the most personalized, real-time experiences at scale. Adobe Experience Platform processes 29 trillion segment evaluations per day and executes a response time of less than 250 milliseconds, illustrating the impact of its real-time capabilities at scale. In Q4, we continued to drive strong growth in our Experience Cloud business, achieving $1.15 billion in revenue. Subscription revenue was $1.01 billion, our first billion-dollar quarter and representing 16% year-over-year growth. Adobe is differentiated in our ability to power the entire customer experience, from ideation to content creation to personalized delivery to monetization. Chipotle is a great example. They are using Creative Cloud to design content for web and mobile channels and Experience Cloud to highlight new product offerings based on consumer preferences and support a faster, easier and more customized online ordering process. In government, the State of Illinois is using Experience Cloud and Document Cloud to provide simpler and more equitable access to state services for over 12 million residents. It's especially inspiring to witness the positive social impact of Adobe technology. The National Center for Missing and Exploited Children has long used Photoshop to create age-progressed photos and uses Experience Cloud to facilitate the recovery of missing children. Additional Q4 highlights include: strong demand for Adobe Experience Platform and native applications, inclusive of Real-Time CDP, Adobe Journey Optimizer and Customer Journey Analytics, which are rapidly becoming the digital underpinning of large brands globally; accelerating demand for Adobe Experience Manager, demonstrating Adobe’s role in helping businesses effectively manage their content supply chain, from creation to monetization; a new Marketing Mix Modeling service as part of our data insights and audiences offering, which enables marketers to harness the power of Adobe Sensei to assess marketing ROI in weeks rather than months and forecast resources for campaigns more effectively; strong growth in partner and Adobe professional services, underscoring our customers’ continued focus on implementation and value realization; key customer wins, including BlackRock, Chipotle, Delta Air Lines, DFS Group, Disney Parks, Elevance Health, GM, Office Depot, Publicis, Santander and Wells Fargo. Adobe continued to receive strong industry analyst recognition, including leadership in the Gartner Magic Quadrant for B2B Marketing Automation Platforms, the Forrester Wave for Collaborative Work Management and the Forrester Wave for Enterprise Marketing Suites. I’ll now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Our earnings report today covers both, Q4 and fiscal year 2022 results. As you know, in 2022 we experienced significant headwinds from the strengthening of the U.S. dollar, increased tax rates and the impacts from the Russia-Ukraine war. Despite those headwinds, in fiscal ‘22 Adobe achieved record revenue of $17.61 billion, which represents 12% year-over-year growth, or 15% growth in constant currency on an adjusted basis. GAAP EPS for the year was $10.10, and non-GAAP EPS was $13.71. We exceeded our initial Non-GAAP EPS target for fiscal year ‘22, which speaks to the discipline, strong execution and resilient operating model of the Company. Fiscal year 22 business and financial highlights included: Digital Media revenue of $12.84 billion; net new Digital Media ARR of $1.91 billion; Digital Experience revenue of $4.42 billion; cash flows from operations of $7.84 billion; RPO of $15.19 billion exiting the year; and repurchasing approximately 15.7 million shares of our stock during the year at a cost of $6.30 billion. In the fourth quarter of fiscal year ‘22, Adobe achieved revenue of $4.53 billion, which represents 10% year-over-year growth, or 14% in constant currency. GAAP diluted earnings per share in Q4 was $2.53 and non-GAAP diluted earnings per share was a record $3.60. Q4 business and financial highlights included: Digital Media revenue of $3.30 billion; record net new Digital Media ARR of $576 million; Digital Experience revenue of $1.15 billion; record cash flows from operations of $2.33 billion; adding over $1 billion to RPO sequentially in the quarter; and repurchasing approximately 5 million shares of our stock. In our Digital Media segment, we achieved Q4 revenue of $3.30 billion, which represents 10% year-over-year growth, or 14% in constant currency. We exited the quarter with $13.97 billion of Digital Media ARR. We achieved Creative revenue of $2.68 billion, which represents 8% year-over-year growth, or 13% in constant currency, and we added $453 million of net new Creative ARR in the quarter. Driving this performance was good linearity throughout the quarter as well as strong customer purchasing during the peak holiday shopping weeks. Fourth quarter Creative growth drivers included: new user growth, fueled by customer demand, targeted campaigns and promotions, and yearend seasonal strength, which drove strong web traffic and conversion rates in the quarter; adoption of our Creative Cloud All Apps offerings across customer segments, from enterprise, to Team, to individual and education; strength of the new Acrobat within our Creative Cloud offering, demonstrating the importance of digital documents and workflows to the creative community; sales of individual applications, including a strong quarter for our imaging and photography offerings; continued growth of newer businesses, including Express, Substance, Frame and Stock; and a solid finish to the year in SMB and enterprise. Adobe achieved Document Cloud revenue of $619 million, which represents 16% year-over-year growth, or 19% in constant currency. We added $123 million of net new Document Cloud ARR in the quarter. Fourth quarter Document Cloud growth drivers included: Acrobat subscription demand across all customer segments; continued growth of Acrobat web, fueled by online searches for PDF and product-led growth; strong performance of our new Acrobat offering integrated with Sign, driving upsell ARR as well as new customer adoption; and year-end seasonal strength in SMB, including through our reseller channel. Turning to our Digital Experience segment, in Q4 we achieved revenue of $1.15 billion and subscription revenue of $1.01 billion, both of which represent 14% year-over-year growth, or 16% in constant currency. Fourth quarter Digital Experience growth drivers included: expected year-end strength, with significant bookings of our newer offerings in EMEA that builds on our momentum in North America; success closing numerous transformational deals that span our portfolio of solutions; momentum with our Adobe Experience Platform and native applications, including RealTime CDP; strength with our Content and Workfront solutions, which are integral components of our content supply chain strategy; and increased customer demand for professional services, as enterprises focus on implementation and accelerating time to value realization from digital investments. In Q4, we focused on making disciplined investments to drive growth and awareness of our products. We continue to have world-class gross and operating margins and drove strong EPS performance in the quarter. Adobe’s effective tax rate in Q4 was 22.5% on a GAAP basis and 17.5% on a non-GAAP basis. The GAAP tax rate came in lower than expected primarily due to lower-than-projected tax on our foreign earnings. RPO exiting the quarter was $15.19 billion, growing 9% year-over-year, or 12% when factoring in a 3 percentage-point FX headwind. Our ending cash and short-term investment position exiting Q4 was $6.10 billion, and cash flows from operations in the quarter were a record $2.33 billion, up 14% year-over-year. We now intend to use cash on hand to repay the current portion of our debt on or before the due date, which we expect will reduce our interest expense in fiscal year ‘23. In Q4 we entered into a $1.75 billion share repurchase agreement, and we currently have $6.55 billion remaining of our $15 billion authorization granted in December 2020 which goes through 2024. As a reminder, we measure ARR on a constant currency basis during a fiscal year and revalue ARR at year-end for current currency rates. FX rate changes between December of 2021 and this year have resulted in a $712 million decrease to the Digital Media ARR balance entering fiscal year ‘23, which is now $13.26 billion after the revaluation. This is reflected in our updated investor data sheet, and ARR results will be measured against this amount during fiscal year ‘23. We provided preliminary fiscal year ‘23 targets at our Financial Analyst Meeting in October that take into account the macroeconomic environment and the growth drivers for our various businesses. While there is ongoing macro uncertainty, given the massive long-term opportunity in digital and the momentum in our business, we are pleased to reiterate those financial targets. In summary, for fiscal year ‘23 we are targeting: total Adobe revenue of $19.1 to $19.3 billion; Digital Media net new ARR of approximately $1.65 billion; Digital Media segment revenue of $13.9 to $14.0 billion; Digital Experience segment revenue of $4.925 billion to $5.025 billion; Digital Experience subscription revenue of $4.375 billion to $4.425 billion; tax rate of approximately 22% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $10.75 to $11.05; and non-GAAP earnings per share of $15.15 to $15.45. As a reminder, these targets do not contemplate our planned acquisition of Figma. We expect normal seasonality throughout the year, with Q1 being sequentially down and seasonally light for new business, sequential growth from Q1 to Q2, a dip in Q3 on account of summer seasonality, and a strong finish to the year in Q4. For Q1 fiscal year ‘23 we are targeting: total Adobe revenue of $4.60 billion to $4.64 billion; Digital Media net new ARR of approximately $375 million; Digital Media segment revenue of $3.35 billion to $3.375 billion; Digital Experience segment revenue of $1.16 billion to $1.18 billion; Digital Experience subscription revenue of $1.025 billion to $1.045 billion; tax rate of approximately 22% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $2.60 to $2.65; and non-GAAP earnings per share of $3.65 to $3.70. In summary, Adobe finished FY22 strong, executing on our strategies across Creative Cloud, Document Cloud and Experience Cloud. I expect this performance to carry into next year, as Adobe’s sustained top-line growth and world-class profitability continue to position us well for fiscal year ‘23 and beyond. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. As the company celebrates its 40th anniversary, it is a perfect time to reflect on our past and our future. Adobe was founded on simple but enduring principles that remain with us today. Innovation is at our core, employees are our greatest asset and our customers, communities and shareholders are central to our success. Over the past four decades, Adobe’s continuous innovation and leadership have empowered billions of people around the globe to imagine, create and deliver the best Digital Experiences. Our strong brand and company culture enable us to attract and retain the world’s best employees. We are proud to once again be named to Interbrand’s Best Global Brands list as a top riser for the 7th year in a row and to Wall Street Journal’s Best Managed Companies, ranking number one for Employee Engagement and Development. We have everything it takes to continue our success in the future: massive market opportunities; a proven ability to create and expand categories that transform markets; an expansive product portfolio that serves a growing universe of customers; revolutionary technology platforms that advance our industry leadership and competitive advantage; an expanding ecosystem that delivers even greater value to customers; strong business fundamentals; and the most dedicated and talented employees. I have never been more certain that Adobe’s best days are ahead. Thank you and we will now take questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] We'll go ahead and take our first question from Mark Moerdler with Bernstein Research. Please go ahead."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you very much, and congratulations on the quarter and the guidance, by the way. Can you give us, David, some more color on Adobe Express and your ability to convert free users to paid users? Are you seeing any impact to creative customers trying to switch to Express? And how do you assure express paid adoption with that impact on Creative Cloud?"
},
{
"speaker": "David Wadhwani",
"text": "Yes. We're very excited about sort of the state of Express. Express just finished its first year in market. We have millions of monthly active users. As I mentioned, we saw very strong growth sequentially quarter-over-quarter in the U.S., which is our primary focus market, 40% quarter-over-quarter growth in visitors, terrific NPS of over 50%. And that's really on the backs of hundreds of millions of stock content that we have, the 20,000 fonts that we've added that is unique to our offering, the highest quality templates. And the constant addition of best-breed features from our other Adobe products like Photoshop and Premier and Acrobat. We've had over 100 releases in the first year that Express has been out. So, we're very excited about that. And so, the Express business itself continues to do well, both in terms of free users and in terms of conversion of those users. But to your question, we also are seeing very strong adoption of Express within our existing CC customer base. So, we see a lot of people, of course, buying our core flagship applications for the power and precision that they have and that they represent, but there are times in those users that are looking to just get something done quickly. And the fact that Express is also entitled to those users gives them the ability to have the power and precision and the speed and ease. And so as users are coming, we're bringing in more users than we've ever had in audiences, we haven't reached by finding intent-based search for things. We're bringing those users in, which is giving us incredible top of funnel. We're driving the conversion. And we're also able to drive utilization increases in CC customers, which is driving retention of that business overall as well. So, the funnel and that migration of that base is very healthy and playing out as expected."
},
{
"speaker": "Operator",
"text": "We'll go ahead and move on to our next question from Brad Sills with Bank of America."
},
{
"speaker": "Brad Sills",
"text": "I wanted to ask another question about Creative Cloud Express. Obviously, you're seeing some success here with that top of funnel business. Is there any color you can provide on where you see the upgrade path for some of those customers? Are there -- is there a certain upsell motion that we could see conversion of other products, even potentially the full suite in that installed base as it's growing? Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Yes. As we talked about when we launched Creative Cloud Express, the primary focus right now is bringing people into Adobe Express and just making them successful, whether it's at the free tier or whether it's at the paid tier or whether it's a pay tier eventually migrating up into the core flagship applications. Our primary focus has been and continues to be right now around usage, repeat usage and utilization. We are seeing, though, while that's our primary focus, we are seeing a lot of really interesting data coming in suggesting that we -- that the upgrade has are -- while still early and not our primary focus are working. For example, in many higher ed institutions where we've started to deploy Adobe Express, we're starting to see not just the increase in terms of usage of Express, but we're also starting to see increase in demand for Adobe Creative Cloud flagship applications. And again, part of this is we know and we believe that everyone should be creative and creativity is the new productivity. But as people start to leverage and benefit from that creativity, they naturally want more power and precision as well. So that they do go well hand in hand."
},
{
"speaker": "Operator",
"text": "We'll move on to our next question from Sterling Auty with SVB MoffettNathanson. Please go ahead."
},
{
"speaker": "Sterling Auty",
"text": "So, I'm curious, is there anything operationally that you can do in preparation for the Figma acquisition, either from an expense structure or development side now before close? And if so, what are those moves that you're making?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, Sterling, maybe I can speak to that. I mean, first, it's nice to see that since the deal was announced, the excitement associated with both what we can do as combined companies as well as, as you can see from our results, the interest in the core business. And so, we're excited overall associated with it. Certainly, as the regulatory bodies are looking at it, we can focus on thinking about strategically. We are getting a lot of great feedback from customers. But these are two separate independent companies. And as it relates to our own cost structure as well as our technology, we feel really good about all the prioritizations we've made. And so, we feel like we're uniquely positioned when it closes to immediately take advantage of it."
},
{
"speaker": "Operator",
"text": "We'll move on to our next question from Brad Zelnick with Deutsche Bank. Please go ahead."
},
{
"speaker": "Brad Zelnick",
"text": "My congrats as well on a strong finish to the year. Following up on Sterling's question, it's good to hear the Figma close process is moving forward as expected. Can you give us an update on how their business is trending, just relative to your commentary at the time the deal was announced, especially given the evolution of the macro environment since then? Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Brad, as you know, they're a private company. And so, we're certainly not at liberty to talk about it. And they have to continue to execute on their opportunity by themselves."
},
{
"speaker": "Brad Zelnick",
"text": "Okay. Understood. Thank you, Shantanu."
},
{
"speaker": "Operator",
"text": "We'll move on to our next question from Mark Murphy with JPMorgan. Please go ahead."
},
{
"speaker": "Mark Murphy",
"text": "Thank you very much, and I'll add my congrats. So Shantanu, the amount of energy and excitement in the audience was quite impressive down at the MAX conference. And I'm wondering which of the innovations that you unveiled has created the most enthusiasm, which you might -- you think might also be monetizable? And I'm wondering whether it could be generative AI or that Share for Review capability, the intertwine capability or anything else really coming to the forefront."
},
{
"speaker": "Shantanu Narayen",
"text": "Well, Mark, firstly, thanks for being there, and it's clear that you were also looking at all of the cool new innovative stuff that was delivered. I always worry about questions like that because it's, you know, which of my children do I love the most. But let me just speak to, I think, thematically, what David and Scott showed, which is the core applications. We just continue to make sure the core applications are more accessible, more productive, more fun. And so I think that's one area, thematically, that the team has done an outstanding job of making sure that we continue to deliver innovative capabilities. You mentioned Intertwine and Illustrator. I think the second thing, thematically, we talk about how do we get more people into the franchise. David also referred to that when he answered the two questions on Express, which is, the more we get people into the franchise, whether it's through our trial products, whether it's through Express, whether it's through participating in the collaborative process. I think that only adds to the available market for Adobe. And so, I think the work that we're doing in collaboration is really continuing to democratize what we can do. So, I'm pretty excited about that. I think the AI and the sneaks that you talked about, that really -- the potential for that when you see whether it was the individual fonts that were being done or whether your ability through a text, to be able to get your content done exactly the way it is. I'm sure you've been tracking also what's happened, Mark, in terms of the chat GPT and what you can do with respect to text. So, I think that entire space, our vision has always been anybody who has a creative idea, how do you get that creative idea to life. And so, I think moving from the hundreds of millions to billions of people who can use it. You're right, that has profound impact in terms of getting more people on our platform. And I think you'll see us be quite aggressive about delivering more of that functionality in an augmented way, perhaps first starting with Express. But I think we're excited about all of that. And the Frame acquisition certainly also is off. I think David and Dan spoke to Substance. So, we feel really good about the multiple growth drivers."
},
{
"speaker": "David Wadhwani",
"text": "If I can adjust a little bit to that. The three examples you brought are really interesting examples because intertwine is an example of the ongoing innovation in our existing flagship application. So that continues to drive an keep people engaged and onboarding into the applications and keep those -- keeps everything fresh and differentiated. Share for Review that initial release, while still early, we've been amazed by the repeat use of that once people start using it. And that represents a great growth loop for us. Because, as you know, anyone that gets shared a document, whether it's a Photoshop document or an Illustrator document or any other document is also an opportunity as a stakeholder to turn into a future user of Adobe products, whether it happens to be the Photoshop document to Photoshop usage or whether it happens to be driving people to try Adobe Express. So, those growth loops are really interesting and important to us as well. And I just wanted to make sure people saw that opportunity."
},
{
"speaker": "Operator",
"text": "The next question will come from Jay Vleeschhouwer with Griffin Securities. Please go ahead."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Shantanu, I'd like to ask about a term that you used often at MAX. And in fact, a new three-letter acronym that you use as well, namely product-led growth. And the question is Adobe has arguably been a product-led growth company for the more than 30 years that I've known you. And I'm wondering now what does product-led growth mean differently today from what it might have meant historically? And relatedly, how are you thinking about the cross-sell and upsell opportunity that you also spoke about at MAX, specifically for 2023."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. Jay, thanks for recognizing that our innovation has really come through an extremely close relationship with customers. So, I think in the past, in the desktop era, what product-led growth really was all about was making sure that as we engage with the customers, as we engage with the community, that we were able to use that. I think the best example perhaps in the desktop era was what we did with Lightroom. And when we first came up with Lightroom, given the fact that we had Photoshop already as a product, just getting the millions of people to use it even before we release the product, having all those evangelists and a great product, I think was a great example. What the team in both Creative Cloud and frankly, in the Experience Cloud, are doing is actually also following on the great work that we pioneered in the Document Cloud. And so, in the Document Cloud, I think product-led growth really related to as we think about what people were doing on searches when we introduced our web-based offerings for Acrobat, that's when we just started to see this velocity of how we engage with customers and prioritizing what's clearly top of mind for them, our ability to immediately satisfy them, I think, escalated quite a bit. When David came in, David really said, we've got to take this to a whole new level with product-led growth, and it's integrating both the community as well as, frankly, right now, engagement and engagement marketing in the product. And so when you get into product sessions right now, and you see the product manager and the engineering manager as well as the product marketing manager, all of them are on the same page. We have data. We have things instrumented in the products and your ability to do both AB testing and here's where we use our own products and the products that Anil does. And so, product-led growth right now is about saying, at any given time, we probably have three tests in market for a particular feature as well. And we're using that to really learn from the customer interactions and to deliver better quality products sooner. But David has really been the pioneer. So, David, if you'd like to add? And then maybe a little bit, Anil, on what we are doing for that in Digital Experience as well."
},
{
"speaker": "David Wadhwani",
"text": "Yes, Shantanu, I think that was a pretty complete summary. The only thing I would add is that there's an interesting inflection point that we are in terms of our product development cycles that give us an opportunity to take what we've always been doing, to your point, with product-led growth and drive even more use of it, which is the introduction of all the web applications that we have. So, we now have Photoshop Web, we have Illustrator Web, we have Acrobat Web, we have Adobe Express, and you combine that with the sharing focus that we have with Share for Review as an example. And we have new growth loops that we can start optimizing, and that's been a huge area of focus for the teams."
},
{
"speaker": "Anil Chakravarthy",
"text": "Yes. I just wanted to add, Shantanu, as you said, several of our enterprise customers are starting to deploy their own product-led growth using our analytics technology, a banking customer, for example, one of our best customers. They have their online mortgage application, and they want to track who is able to use it successfully, who's able to complete applications completely online, and they're using our analytics technology to do that and see what works and what they need to do to fix it. So, we're starting to see like exactly, as you said, our technology being both used inside Adobe to drive our own PLG as well as customers doing it."
},
{
"speaker": "Shantanu Narayen",
"text": "And Jay, maybe to get to your second question and taking a step back, I do have to say, when we look at our annual targets that we had provided for Digital Media ARR at the beginning of the year of $1.9 billion. And I know even with our Q4 guide, I think people had some questions about where is the momentum. And I think the team crushed that, which I feel really good about. And so, a lot of that is happening as a result of just first, attracting and acquiring customers to the platform. And then what you're referring to is the cross-sell, upsell, whether it's people who first engage with us on a mobile device, whether it's people in Acrobat. We've used Adobe Reader as a very, very good on-ramp to allow people to engage with PDF functionality and then either get a license for our Acrobat web product or for the desktop product. Individual apps, the success and the driving of individual apps has always been an on ramp, and we then do a really good job because we use Adobe Experience platform to then convert them and even promotional pricing. I know we've had some questions in the past. And we have incredible data that shows us when people come in, whether that's on educational pricing and then they graduate or on promotional pricing, converting them to customers. So, I think there are numerous ways in which we've demonstrated that by personalizing our offer to every creative or knowledge worker that we're able to monetize that as well after they derive the value from it."
},
{
"speaker": "Operator",
"text": "We'll move on to Derrick Wood with Cowen & Company. Please go ahead."
},
{
"speaker": "Derrick Wood",
"text": "Congrats on a strong net new ARR customer -- quarter. I wanted to ask about the composition of this number. The growth dynamic between Creative Cloud and Document Cloud was a little surprising. I mean Creative Cloud had, I think, the second strongest sequential percentage growth Q4 ever. But looking at Document Cloud, net new ARR didn't grow much sequentially in what's typically a stronger uptick in Q4. Can you just give a little more color on the seasonal dynamics you saw between Creative and Document Cloud in the quarter?"
},
{
"speaker": "David Wadhwani",
"text": "Sure. Yes, I'm happy to do that. So first of all, yes, as Shantanu mentioned, we're very pleased with how FY22 has gone and how the quarter closed out, we saw a lot of strength in the core businesses. And our primary focus across these businesses continues to be around new customer acquisition, new customer ads. We also have a lot of diversity in terms of the drivers that we have and the leverage we have to drive the business. As we mentioned, we saw great strength across all of our creative segments imaging, photo, video, design. We also grew a lot of -- focused a lot in terms of new campaigns that are targeting new audiences for creative as well with a new campaign called Everyone can Photoshop, that's bringing customers in directly into the products and has been very productive in terms of driving top of funnel and conversion. On the -- in terms of new businesses for Creative, we're seeing a lot of strength from new businesses like Frame and Substance that have contributed more this quarter than ever before. And to your point, we've also been seeing a lot of strength in the core business around Acrobat. We're running a Acrobat’s Got It campaign really targeted at new customers in SMB where we show them all the capabilities that Acrobat has now, including specifically focused on signatures and things that really help them drive the business. So overall, the business is doing very well. The one dynamic that -- if you look at from an Acrobat perspective that we're really proud of too, is that we saw -- for the year, we saw growth of ARR at 23% despite the complicated macro. And it's important to remember that some portion of this is also -- the Acrobat business is also represented in the creative business. So, the Acrobat growth number is probably a bit understated in this point."
},
{
"speaker": "Operator",
"text": "We'll move on to our next question from Michael Turrin with Wells Fargo Securities. Please go ahead."
},
{
"speaker": "Michael Turrin",
"text": "Maybe one on the digital price side. We fielded some questions there just around guidance for next year in the current backdrop. You're holding on targets, grew well at 16% in constant currency for the quarter. So, can you just talk more around how much visibility you have in the targets there and it's how you closed the year at all, particularly given that EMEA comment provides incremental confidence in those targets going forward. Thank you."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks for the question. We are pleased with the performance of the Digital Experience business. I mean just as a quick reminder, at the beginning of the year, we had guided DX at 17% of digital growth for the year, which is what we achieved in a really tough year with all the different macro issues. So if I really take a step back, we're -- first of all, we're in a really strong position with our product portfolio. We are a clear leader in the market with the investments we made at the Adobe Experience platform starting 5 years ago. And that is really paying off with the book of business that we are seeing and all the customer adoption that we are seeing. And what we are hearing from our conversations with our customers is that they're really eager to invest in a platform that enables them to meet the mission-critical priorities around digital. And that's what we are enabling them and personalization in real time at scale. So, this is a significantly large opportunity. And what we believe is that as we go through this time, single product companies are going to come under a lot of scrutiny. So, while we definitely see deals getting scrutinized and going up to higher levels for approval, we also see that customers really want to invest in a market leader like us for their investments, it's going to last the next 10, 15 years to -- for the digital investment. So pleased with where we are."
},
{
"speaker": "Shantanu Narayen",
"text": "Maybe Anil, I'll just add a couple of things to what you said. I mean the first is that value realization has been top of mind for a lot of these customers. And so, I think if you look at the business as well, the services part, it's very clear that people want to implement it. And what I think is unique about Adobe's offerings in this particular space is that we help both with the customer engagement and frankly, the top of funnel as well as we help with productivity and cost. And so, it doesn't matter which side of that equation you are as, as an enterprise, I think both of them find that the Adobe Experience Cloud as well as, frankly, what we are doing with Sign actually help them on both fronts. And so we're pleased associated with that, and we have good visibility. I want to complement Anil and his team on the execution against the pipeline and transformational deals also, I think, just reflect the overarching interest that people have in making sure digital continues to be an imperative. And so, we're not going to be immune to the macroeconomic, but I like our differentiated solution and our execution."
},
{
"speaker": "Operator",
"text": "And our next question comes from Brent Thill with Jefferies. Please go ahead."
},
{
"speaker": "Brent Thill",
"text": "Thanks. Dan, in terms of your guide, are you implying the environment gets worse or stays the same. And for Shantanu, can you just talk about the next 6 to 9 months as we potentially go into a tougher economic headwind, how you're reshaping and rethinking your go-to-market or any steps that you can take to ensure you can cut through what is coming in."
},
{
"speaker": "Dan Durn",
"text": "Yes. So, from a guide standpoint, we spent a lot of time talking about the environment we're in during FA day. Against that backdrop, you can see the momentum of the business. You can see the execution against the opportunities. What I really like about the way we're positioned in the market. There's a diversification of the company. It's end markets, it's product segments, it's business models, it gives us a resilience in the environment that we're in, and we see that in the momentum we're carrying into next year. There's really no change to the view of the environment that we're in, and you see that reflected in the targets that we set for 2023. So, we feel good about the way we're executing against a complicated macro environment, and we'll continue to stay focused on adding value to our customers, but there's a diversification and a resilience to who we are and a mission criticality of what we sell to our customers. And then you could see that in the comment that Shantanu made. You can see us impacting the company's top line. You can see us impacting the productivity with which they serve their customers, and that puts us in a pretty unique position."
},
{
"speaker": "Shantanu Narayen",
"text": "And Brent, as it relates to your second question, I'll unpack that in maybe two ways. First is we're really pleased with what we did and even when the pandemic first started about prioritizing what was really critical for us. And I think the prioritization exercise when you're really focused on your top imperatives, that's really helped bring clarity and alignment within the company that I don't think should be undersold in terms of how effective that has been for execution. As it relates to the next 6 or 9 months and you think about the three routes to market, digital continues to be an area of strength. I mean, I know through our Adobe Digital Index we talk about what we are seeing in terms of people continuing to engage with the customers -- companies that they want to transact with electronically. And so, on the digital side, we will just continue to make sure we focus on acquiring the customers. David spoke to some of the effective campaigns. Clearly, we understand the attribution of that. And we just have to remain vigilant on making sure that we're attracting the customers on the new platforms where they exist. And for retention, which is a key issue as well, just how they continue to get value from the offerings that they have. The partner ecosystem, whether that's for the small and medium business or whether that's for what we are doing with the SI and VAR community on Digital Experience, just continuing to enable them, continuing to engage with them. I think that's a part. Clearly, the small and medium business did see a rebound after what they went through last year, which was a really bad situation. So I think we have to remain vigilant on that. And I think on the direct sales part, as we look at our pipeline, December, despite the fact that it's our first month of our quarter, we will continue to focus on execution against that to take advantage of whatever budget flush exists in companies. And then, as you start to come to what happens in Japan in February as it's the end of their fiscal year, continuing to focus on Europe. Brent, Europe was actually one of the highlights for us in the quarter. I think Adobe Experience platform has done well. And so, we remain cautious clearly about the macroeconomic, but I think we have visibility into making sure that we can continue to execute, Brent."
},
{
"speaker": "Operator",
"text": "We'll go ahead and move on to our next question from Keith Bachman with BMO. Please go ahead."
},
{
"speaker": "Keith Bachman",
"text": "Hi. Thank you very much. And apologize in advance for some background noise. Shantanu and David, I wanted to direct this to you, if I could. The ARR net new in the quarter was very good, particularly relative to expectations. If we look back over a little longer period of time though than the quarter, growth has slowed in net new ARR, even if it's assuming of flattening out. And what I didn't -- what we didn't really get -- I think as much as we would have liked at the Analyst Day was, what do you think the key drivers of the net new ARR and creative have been or total ARR, if you want? And what are the key things that you're focused on before Figma that would cause an improvement in AR growth? I assume that one has been perhaps Adobe Express as a more compelling entry point. Is there anything else that you can call out as some things that you believe that Adobe is focused on like really some issues in the past that you think are going to be resolved and therefore before Figma but improve despite the macro or help growth in the creative side? Many thanks."
},
{
"speaker": "David Wadhwani",
"text": "Yes. I'm happy to jump in and Shantanu can add anything. So at a high level, if you look at what we've talked about at Analyst Day, our strategy is very clear, which is new users and retention are the core drivers and focus areas. As Shantanu mentioned, we're being very focused and very intentional in terms of those two things. When it comes to new subscribers, we added more new commercial subscribers this year than we've ever added in our history. And that is a really important intentional sort of activities we are doing. Many of those new users are -- tend to be nonprofessionals, right, or they tend to be earlier in career professionals. And so, they are coming in and leveraging our initial single app plan or Adobe Express, as an example, and we're very happy to have them take that on because we believe very strongly that the opportunities to drive and upsell them from Express to single app and from single app to all apps, is going to be something that is persistent and something that is very ready and available to us at the time we need. The main thing, though, is about getting them into the products and making them successful. And so with that focus, we've been very -- we've also been maniacally operational about retention of those bases. I think people have asked questions, as you broaden the net, you bring in other users that are not typical Adobe users, what's happening to the retention rates. I think we also shared that we're seeing usage of products continues to stay very strong as we bring in these new audiences. And we're starting -- and we're seeing retention continue to tick up and improve. And in fact, retention now is better than it was pre-pandemic as an example. So, we continue to bring in new users. We continue to retain those new users and we see organic opportunities to move them up and upgrade them. Shantanu mentioned a great example of education. We continue to see a lot of people come in with our education pricing. And then, we have the opportunity, two years or three years later when they graduate to upgrade them to full commercial pricing. And those activities are playing out as expected, and we see a lot more opportunity to it. But it all comes down to bringing new users in, getting them using the products a lot and retaining them."
},
{
"speaker": "Shantanu Narayen",
"text": "And maybe to add to that, Keith. I mean, when you think about the newer businesses that we're talking about, video just continues to be a really key growth driver, 3D and immersive imaging and photography. But if you take a step back, I think that two things happening in the macroeconomic environment that are actually going to be tailwinds. The first is the fact that it is the golden age of design. Everybody would like to express themselves. There are more screens on which all of this content is being consumed. So, I think the insatiable consumer demand for content, I think, is certainly driving a lot of more content that's being created. One of the exciting areas that I think David and Anil have talked about is what we are calling content supply chain. And when you take even the larger companies, they are all trying to get a handle of as they engage digitally with customers how much content is being created? Where is it being created? Where is it being delivered? How do I localize it? What's the efficacy of that content? And so, I think this content supply chain and everything we have with our creative applications, our asset management, the fact that we then deliver that content, I think we continue to believe that that's going to be a growth driver for the entire business as well. So, I wouldn't underestimate the insatiable consumer demand but I also wouldn't underestimate what's happening as enterprises recognize that the way to engage with people is to personalize that content."
},
{
"speaker": "Jonathan Vaas",
"text": "Hey operator, we're at the top of the hour. We'll make time for one more question, and then we'll wrap up. Thanks."
},
{
"speaker": "Operator",
"text": "You bet. We'll go ahead and take our last question from Alex Zukin with Wolf Research. Please go ahead."
},
{
"speaker": "Alex Zukin",
"text": "I apologize for any background noise. I guess we've heard a lot about the continuing growth initiatives in the demand environment, sounding like it's pretty resistant to any macro pressures I believe you're seeing at the moment. I'll ask the kind of other side of the equation. As you think about the levers that you have on the margin side, the discipline that you've been exhibiting. It does seem like over the last quarter and maybe the past few quarters, that margin story, that margin discipline has continued to exceed at least our expectations. So, as we look at the next year, as you think about the levers that you have in the business if the parts of the business should slow. Can you go through maybe walk through a little bit of where you see the opportunity to either, A, lean in or B, pull back? And also, how we should think about cash conversion in that scenario from a cash flow perspective. Thanks again."
},
{
"speaker": "Dan Durn",
"text": "Yes. So from an operating performance standpoint, you rightfully point out, the Company is performing really, really well. But we're doing what we've always done inside the company, which is drive growth, deliver industry-leading products and innovation to our customers, help them become more effective on the critical path of driving revenue for their business. But we do it in a very disciplined way that drives margin and cash flow while driving growth. And we talked a lot about Rule of 40 at our FA day. If I were to take a step back and reflect on FY22, it's complicated macro environment, and we’re operating at a rule of 60 for the year. So, we feel really good about our ability to operate. And so as I look forward into next year, we're going to continue to lead. We're going to continue to innovate. We're going to continue to make our customers successful, but we'll continue to do what we've always done, which is ruthlessly prioritized where we make our investments, constantly review the portfolio, prioritize the things that are going to drive long-term value for our customers and do it in a very disciplined way. So, that's the operating tone inside the company. Nothing's changed on that front. We feel really good about how we're executing in the environment and the momentum we're carrying into 2023. From a cash flow standpoint, it all starts with driving that discipline in the business and we'll continue to drive cash flow and deploy that excess cash on a quarterly basis to create value with the shareholders."
},
{
"speaker": "Shantanu Narayen",
"text": "And Alex, given that was the last question, let me start off by saying as we celebrate our 40th anniversary, it's both humbling and inspiring to think about the impact that Adobe has had on the communication world and what we've been able to do. And it's rare to be able to say at this level that we believe that our best years are ahead of us. If I take a step back and I look at what we had done in 2022, there are three things that stand out for me, the Digital Media ARR and just continuing to drive new customer acquisition and deliver innovative products across both, the Creative Cloud and Document Cloud. We've done a really good job of demonstrating why creativity and design is going to be more important and also combining creativity with productivity. On the DX side, the organic creation of the Adobe Experience platform and its apps, and the success that we've seen associated with that, the fact that we just had a first $1 billion quarter as it related to subscription revenues, I think that just reflects both the fact that we created this category. And unlike all of the other enterprise software companies who are in that space, we're just ruthlessly focused on this. And it is unique in that it helps both the top line and bottom line for enterprises. And to the question that you specifically asked, Alex, I mean, profitability, despite the FX impact that impacted hundreds of millions of dollars when you look back and say, at the end of the year, we exceeded our non-GAAP EPS that we had said a year ago/ I think that is a really amazing performance by the finance and operations team of making sure that we continue to remain focused. And I think as it relates to go-forward, we've clearly talked about why we're excited about the innovative road map, why we're excited about all of the things that are going to come up in 2023 and beyond. And so, I think it was a good year. We will continue to remain focused. I want to thank our employees who really are the unsung heroes of all of this execution and the work that they do. And for every one of you, thank you again for your interest in Adobe and happy holidays and wishing you all a joyous holiday season."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, everyone. This concludes the call."
},
{
"speaker": "Operator",
"text": "With that, that does conclude today's call. Thank you for your participation. You may now disconnect."
}
] | Adobe Inc. | 24,321 |
ADBE | 3 | 2,022 | 2022-09-15 10:00:00 | Operator: Good day. And welcome to the Q3 FY 2022 Adobe Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead, sir.
Jonathan Vaas: Good morning and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s third quarter fiscal year 2022 financial results. You can find our Q3 press release as well as PDF’s of our prepared remarks and financial results on Adobe’s Investor Relations website. The information discussed on this call, including our financial targets and product plans is as of today, September 15th and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today’s press release and then Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates, as well as adjusted growth rates in constant currency. During this presentation, Adobe’s executives will refer to constant currency growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan, and thank you for joining us. Adobe had another record quarter, achieving $4.43 billion in revenue, which represents 15% year-over-year growth. GAAP earnings per share for the quarter was $2.42 and non-GAAP earnings per share was $3.40. In our Digital Media business, we achieved $3.23 billion in revenue. Net new Digital Media annualized recurring revenue or ARR was $449 million and total Digital Media ARR exiting Q3 grew to $13.40 billion. In our Experience Cloud business, we achieved $1.12 billion in revenue and subscription revenue was $981 million. In this digital-first world, Adobe Creative Cloud, Document Cloud and Experience Cloud have become even more mission-critical to an increasingly wide range of customers, from students to creative professionals to small businesses to the world’s largest enterprises. Fueled by our groundbreaking technology, track record of creating and leading categories and consistently strong execution, our opportunity is larger than ever before. Adobe’s greatness has been rooted in defining new categories and platforms and delivering cutting-edge solutions through both organic innovation and inorganic acquisitions. Throughout our history, Adobe’s innovations have touched billions of lives around the globe. From revolutionizing imaging and creative expression with Photoshop, to pioneering electronic documents through PDF, to creating the digital marketing category with Adobe Experience Cloud, Adobe continues to invent and transform categories. We are in the golden age of design and we believe we have a unique opportunity to usher in a new era of collaborative creative computing. I am thrilled to share that today we announced our intention to acquire Figma, a leading web-first design platform that will help us accelerate this vision. Figma enables designers, developers and all stakeholders to collaborate in the product design process from ideation to design to delivery. The combination of Adobe and Figma will significantly expand our reach and market opportunity while making the creative process more accessible and productive to more people. I will now turn it over to David to share more about our vision for Adobe and Figma and momentum in the Digital Media business. David?
David Wadhwani: It’s an exciting day for Adobe and Figma. Figma’s mission is to help teams collaborate visually and make design accessible to all. Dylan Field, Figma’s CEO, and his team launched Figma as the first design tool purpose-built for the web in 2012. Figma and FigJam make it possible for all stakeholders designing interactive mobile and web applications to collaborate through multi-player workflows, sophisticated design systems and a rich extensible developer ecosystem. Figma has built an incredible product and an outstanding business, delivering world-class ARR growth and net dollar retention with a disciplined and efficient operating model. Figma has attracted a new generation of millions of designers and developers and a loyal student following. To give you a sense of their scale and financial success, Figma is expected to add approximately $200 million in net new ARR this year, surpassing $400 million in total ARR exiting 2022, with greater than 150% net dollar retention rate. With a total addressable market of $16.5 billion by 2025, Figma is just getting started. Adobe has always been focused on empowering everyone to create digital experiences, and the combination of Adobe and Figma is the perfect better together opportunity. The combination of Adobe and Figma will create new opportunities and accelerate our strategy in a few ways. First, reimagining the future of creativity and productivity, Adobe and Figma share a passion for helping individuals and teams be more creative and productive. Adobe and Figma now have a new opportunity to make content creation more efficient, collaborative and fun by bringing together Adobe Express, Acrobat and FigJam, an online whiteboarding solution for teams. With the combination of these products, we can offer tremendous value to hundreds of millions of customers. Second, accelerating creativity on the web, as creativity becomes increasingly collaborative, the web makes it easier for teams to create together. Figma’s web-based, multi-player platform can accelerate the delivery of Adobe’s Creative Cloud technologies on the web, making the creative process accessible to more people. This will dramatically increase Adobe’s reach and addressable market opportunity. Third, advancing product design, web and mobile applications are increasingly underpinning how we live and work. This is driving explosive growth in the product design category. The combination of Adobe and Figma will benefit all stakeholders in the product design process, from designers to product managers to developers, by bringing powerful capabilities from Adobe’s imaging, photography, illustration, video, 3D and font technologies into the Figma platform over time. And fourth, empowering and expanding the community, throughout our history, Adobe’s community has been a constant source of inspiration and a catalyst for innovation. Figma has a thriving community who develop and share everything from tutorials, templates and plug-ins with their large and growing ecosystem. The combination of our communities will bring designers and developers closer together to unlock the future of collaborative design. Adobe and Figma could not be a better match, our people, innovative technology and joint mission to democratize creativity and collaboration will deliver increased value to a growing base of customers. I look forward to welcoming Dylan and the entire Figma team to Adobe once the transaction closes. The acquisition of Figma could not come at a more exciting time for Adobe’s Digital Media business, which surpassed $13 billion in ARR this quarter, growing 16% year-over-year exiting the quarter. Adobe Creative Cloud remains the world’s creative engine, empowering everyone to create whenever and wherever inspiration strikes. In Q3, we achieved net new Creative Cloud ARR of $330 million and revenue of $2.63 billion, which grew 14% year-over-year. Q3 highlights include; strong momentum for Adobe Express, with significant growth in new users. Adobe Express is serving an expansive universe of creative professionals, communicators and knowledge workers, from students to small business owners to social influencers. It’s exciting to see the rapid innovation we are delivering to enable millions of customers to create standout multimedia content. Adobe Express has thousands of templates, millions of stock assets and quick action functionality that make it easy to do any creative task. Millions of new users are coming to Adobe Express, driven by viral adoption and our creative marketing campaigns. Fast Company recently named Adobe Express one of the best new productivity apps of 2022. Strength in our Photoshop and Lightroom offerings across desktop and mobile, tailwinds in our video segment for Premiere Pro and Frame.io, our integrated video editing and collaboration offering, demand for our Substance products, as brands across every industry embrace 3D and immersive content as a new medium, and momentum in the Adobe Stock business, emphasizing the importance of content velocity for businesses of all sizes. And finally, we are really excited about Adobe MAX, the world’s largest creativity conference. It will be held in Los Angeles and streamed live for our global community. In addition to unveiling amazing new Creative Cloud innovations, we will hear from luminaries including renowned film directors, artists and musicians. Now on to our Document Cloud business. Digital documents are enabling individuals and businesses to be productive in a digital-first world. With more than 300 billion PDFs opened and more than 8 billion digital signatures processed each year, Adobe Document Cloud is accelerating document productivity and workflows across web, desktop and mobile. Document Cloud had its best Q3 ever, achieving net new Document Cloud ARR of $119 million and record revenue of $607 million, which grew 25% year-over-year. Q3 highlights include; continued adoption of PDF across every computing surface, with over 2.6 billion cumulative installs of Acrobat and Reader; significant enhancements to the Acrobat web experience, making popular verbs like view, edit and collaborate easier than ever and adding accessibility capabilities such as Read out Loud and High Contrast support. Acrobat Web MAU continues to see tremendous growth, driven by the high volume of web searches for document actions. Strong growth in Adobe Sign, driven by integrated e-signature functionality in Acrobat; integrated workflows between Acrobat Desktop, Acrobat Web and Adobe Express; and key enterprise customer wins, including Amazon, Boeing, Chubb, Lloyds Bank and ServiceNow. Demand for our industry-leading Digital Media products remains strong across a growing base of customers. We are accelerating momentum across the business with continued product innovation, strong go-to-market capabilities and a proven data-driven operating model. I will now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello everyone. One thing has become abundantly clear in this environment, digital has become the critical channel to engage customers and drive growth. Across the globe, companies in every industry are prioritizing investments in software solutions and services that enable them to anticipate and meet the expectations of their consumers. Customer Experience Management is an imperative and Adobe is the category leader. Adobe Experience Cloud delivers predictive, personalized, real-time digital experiences, from acquisition to monetization to retention, across content and commerce, customer journeys, data insights and audiences and marketing workflow. In particular, we are driving strong enterprise adoption of Adobe Experience Platform and Real-Time CDP which are foundational to this next-generation enterprise architecture. FC Bayern, one of the world’s most successful football clubs, is leveraging Adobe Experience Cloud and Real-Time CDP to transform their fan experience. This gives them a holistic view of every fan’s engagement online and offline, enabling them to deliver personalized experiences such as discounts at the stadium or an immersive shopping experience for viewers at home. In Q3, we continued to drive strong Experience Cloud growth, achieving a record $1.12 billion in revenue. Subscription revenue was $981 million for the quarter, representing 15% year-over-year growth. Q3 highlights include; strong momentum for Adobe Experience Platform and AEP-native applications, with the book of business more than doubling year over year; significant growth for Adobe Commerce, underscoring the demand for digital storefronts and marketplaces; Experience Cloud was named a leader for the sixth consecutive year in the Gartner Magic Quadrant for Digital Commerce and achieved the highest position in the Forrester Wave for Enterprise Marketing Suites; and key customer wins, including Crédit Agricole, Morgan Stanley, NASA, Qualcomm, T-Mobile and UnitedHealth Group. Looking forward, Adobe is leading an explosive growth category that is increasingly important to enterprises of all sizes. Adobe is well-positioned to help enterprises deliver exceptional customer experiences with industry-leading platforms and applications, a strong track record of deploying solutions successfully for thousands of customers and a proven ability to deliver the next-generation architecture for Customer Experience Management. Dan, over to you.
Dan Durn: Thanks, Anil. Today I will start by summarizing Adobe’s performance in Q3 fiscal 2022, highlighting growth drivers across our businesses, then I will discuss the announced acquisition of Figma and I will finish with financial targets. Adobe delivered a solid Q3, continuing to demonstrate that our products are mission critical to our customer’s success in any macro environment, from the millions of individuals who use our offerings to create digital content, to the small businesses that run their document workflows on Adobe, to the large enterprises that have transformed how they interact with their end users by providing personalization at scale. Q3 business and financial highlights included; record revenue of $4.43 billion; GAAP diluted earnings per share of $2.42 and non-GAAP diluted earnings per share of $3.40; Digital Media revenue of $3.23 billion; net new Digital Media ARR of $449 million; Digital Experience revenue of $1.12 billion; cash flows from operations of $1.70 billion; RPO of $14.11 billion exiting the quarter; and repurchasing approximately 5.1 million shares of our stock during the quarter. In our Digital Media segment, we achieved 13% year-over-year revenue growth in Q3 or 16% in constant currency. We exited the quarter with $13.40 billion of Digital Media ARR. We saw expected summer seasonality in the quarter, with the overall acquisition and engagement environment for our offerings remaining strong. We achieved Creative revenue of $2.63 billion, which represents 11% year-over-year growth or 14% in constant currency. We added $330 million of net new Creative ARR in the quarter. Third quarter Creative growth drivers included; momentum in small and medium businesses with our Teams offering, where we continue to drive strong new customer acquisition and are seeing engagement and retention at all-time highs; strong growth in our Illustrator and InDesign businesses; demand for our flagship photography, imaging and video applications; Adobe Stock where we continue to drive strong book of business growth; and momentum in our new growth initiatives, such as Frame.io and Substance, each of which grew ending ARR greater than 50% year-over-year exiting the quarter. Adobe achieved Document Cloud revenue of $607 million, which represents 23% year-over-year growth or 25% in constant currency. We added $119 million of net new Document Cloud ARR in the quarter, our strongest Q3 to-date. Third quarter Document Cloud growth drivers included; accelerated adoption of PDF and Adobe Reader across multiple surfaces; growth of Acrobat Web, fueled by online searches for PDF and document actions; strong performance of Acrobat and Adobe Sign; performance of our reseller channel continuing to drive new Document Cloud subscriptions, particularly with small and medium businesses; and continued seat expansion in the enterprise. In August we began to roll out the new Acrobat integrated with Sign offering, which included updated pricing. Turning to our Digital Experience segment, in Q3 we achieved revenue of $1.12 billion, which represents 14% year-over-year growth or 15% in constant currency. Digital Experience subscription revenue was $981 million. Third quarter Digital Experience growth drivers included; strong retention, upsell and enterprise bookings in the quarter across our solutions, particularly in the U.S.; success closing numerous million-dollar deals, as well as larger transformational deals that span our portfolio of solutions; continued momentum with our foundational Adobe Experience Platform and Real-Time CDP business, with our book of business for Platform and AEP-native applications more than doubling year-over-year exiting the quarter; success integrating our solutions with workflow, including Workfront, which grew revenue greater than 35% year-over-year in the quarter; and higher customer demand for professional services, as enterprises focus on implementations and value realization. In Q3, we focused on making disciplined investments to drive growth, including a strong class of university hires and marketing campaigns to raise awareness of new and flagship offerings. We continue to have world-class operating margins and drove strong EPS performance in the quarter. Adobe’s effective tax rate in Q3 was 22% on a GAAP basis and 17.5% on a non-GAAP basis. The GAAP tax rate came in lower primarily due to benefits associated with share-based payments. The non-GAAP tax rate came in lower primarily due to additional U.S. income tax credits. RPO exiting the quarter was $14.11 billion, growing 12% year-over-year or 15% when factoring in a 3% foreign exchange headwind. Our ending cash and short-term investment position exiting Q3 was $5.76 billion and cash flows from operations in the quarter were $1.70 billion, up 20% year-over-year. In Q3 we repurchased approximately 5.1 million shares at a cost of $1.80 billion, including shares received for the final settlement of our ASR entered into in December 2021. We currently have $8.3 billion remaining of our $15 billion authorization granted in December 2020 which goes through 2024. As Shantanu and David mentioned, we are thrilled about the opportunity to acquire Figma, which will accelerate Adobe’s strategy. Under the definitive agreement, we have agreed to acquire Figma for approximately $20 billion, comprised of approximately half cash and half stock, subject to customary adjustments. Approximately 6 million additional restricted stock units will be granted to Figma’s CEO and employees that will vest over four years subsequent to closing. The transaction is expected to close in 2023, subject to regulatory approvals. We plan to finance the cash portion of the consideration with cash on hand, and if necessary, a term loan, to be paid down from our operating cash flows following the closing. Figma’s products address a $16.5 billion market opportunity and the company has an impressive financial profile. This year they are expected to add $200 million in net new ARR, surpassing $400 million total ARR by the end of the year, with greater than 150% net dollar retention. They have a disciplined, efficient operating model, with gross margins of approximately 90% and positive operating cash flows. Figma have strong business momentum, a large and expanding customer base and we are incredibly excited about what we can bring to this combination from a financial perspective. While this transaction is primarily about creating new markets, expanding adjacent opportunities and accelerating growth, we are committed to maintaining Adobe’s strong profitability and maximizing EPS for our investors. In year one and two after closing, the transaction will be dilutive to Adobe’s non-GAAP EPS and we expect it to be breakeven in year three and accretive at the end of year three. While the transaction has not yet closed, I want to provide color on the path to non-GAAP EPS accretion as a combined company exiting year three, assuming Adobe’s operating margin for the second half of fiscal 2022 as the baseline. The combination will accelerate top-line growth for both Adobe and Figma based on three primary drivers; one, we extend Figma’s reach to our customers and through our global go-to-market footprint; two, Figma accelerates the delivery of new Adobe offerings on the web to the next generation of users; and three, we jointly introduce new offerings to market as we unlock the possibilities of collaborative creativity. Clearly the explosive revenue growth of Figma combined with their efficient operating model would result in an expanding standalone operating margin. Figma’s innovative technology platform will accelerate our R&D roadmap including the delivery of our Creative Cloud technologies on the web, which will allow Adobe to focus and manage our future R&D investments. We will quickly pay down any term loan, if necessary, after close and then resume stock repurchases to reduce Adobe’s share count. While the transaction is pending, at a minimum we expect to maintain share repurchases sufficient to offset the dilution of equity issuances to Adobe employees. We will now provide Q4 targets, which factor in the overall macroeconomic environment; FX headwinds, as the U.S. dollar has continued to strengthen against foreign currencies; and typical year-end seasonal strength in demand for our offerings. As a result, for Q4 we are targeting; total Adobe revenue of approximately $4.52 billion; net new Digital Media ARR of approximately $550 million; Digital Media segment revenue growth of approximately 10% year-over-year or 14% in constant currency; Digital Experience segment revenue growth of approximately 13% year-over-year or 15% in constant currency; Digital Experience subscription revenue growth of approximately 13% year-over-year or 15% in constant currency; tax rate of approximately 23% on a GAAP basis and 17.5% on a non-GAAP basis; and GAAP earnings per share of approximately $2.44 and non-GAAP earnings per share of approximately $3.50. In summary, Adobe continues to drive performance across Creative Cloud, Document Cloud and Experience Cloud, while making transformational investments in strategic growth initiatives. I look forward to sharing more about our growth opportunities next month in Los Angeles at Adobe’s Financial Analyst meeting. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. It was great to be back on the road this quarter meeting customers and partners as businesses return to a new hybrid work model. I was inspired and energized welcoming our new hires and meeting Adobe employees across multiple sites who will together drive the next phase of innovation, growth and culture. Adobe’s strength has always come from our most important asset, people. I am incredibly proud of the recognition we continue to receive as a great place to work. This quarter, Adobe was named to Fast Company’s Best Workplace for Innovators and Fortune’s Best Workplaces in Tech. Next week, we will hold our Adobe for All conference to bring employees together to celebrate our shared values of diversity, equity and inclusion. It is an exciting time at Adobe. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is working. We are delivering on our innovative product roadmap, driving growth across new and established businesses and delighting a growing universe of customers. In addition to achieving all this success, we continue to look around the corner for new transformational opportunities that will drive decades of growth for Adobe. We believe that every individual, team and business will strive to be more creative and productive in this digital era. Adobe has a unique opportunity to usher in a world of collaborative creativity. In my conversations with Dylan at Figma, it became abundantly clear that together we could accelerate this new vision, delivering great value to our customers and shareholders. I look forward to welcoming Figma into the Adobe family upon close of the transaction. We look forward to seeing you at MAX and closing the year strong. Now, we will take questions. Operator?
Operator: Thank you. [Operator Instructions] Our first question comes from a Kash Rangan of Goldman Sachs.
Kash Rangan: Hello. Thank you very much. Congratulations on really massive step forward to the management team. Shantanu and team, I wonder if you can talk about the persona of Figma and if there is any overlap at all between what Adobe wanted to be in the future with its a Creative family and where Figma is growing -- was going, and if you net it out, what is the incremental opportunity. It looks like $16 billion TAM, but your own Creative business, you outline as having a more than a $40 billion TAM. So I am wondering what the TAM could look like for Figma in the future as it integrates into Adobe, you identify new personas. And for Dan three years to breakeven, it sounds like there are some conservative assumptions built in especially because Figma is generating cash. I am wondering what your assumptions are for that the rather lengthy duration to breakeven. Thank you so much and congrats.
Shantanu Narayen: Thanks, Kash, and congratulations to you as well for the conference that is happening right now and given our quiet period as you know we can’t attend. But let me take a step back and talk about why we believe this is a fundamentally transformative move for Adobe. When we think about the future of what’s happening with creativity, and in a sense, what’s going to happen as it relates to multiple people engaging in that with respect to collaboration, we just believe that this is going to be an incredible value and a way to attract a whole bunch of new customers to the combined platform. When you think about Adobe, certainly we target knowledge workers, we target communicators, we target creative professionals. Figma really focuses a lot also on developers, they focus very much on the other stakeholders, who are involved in the product design process. So when we talk about the fact that Figma has a $16 billion TAM, that’s referring to the TAM as it exist today, in terms of what they are doing, both as it relates to product design, as well as that would relates to collaborative whiteboarding and ideation, which as you know, say, FigJam this incredible product that has, I believe, a much, much larger available addressable opportunity. But if you take a really what we think is the massive opportunity and putting this together. I think there are four aspects that are really exciting for us. First, there is going to be a next-generation of Creative collaboration that happens in the industry, and we believe that the combination of the two companies enable us to really position Adobe and deliver great value for this Creative collaboration industry. Second, we continue to believe that we can accelerate what it means to create on the web. What Figma has done is they have delivered a really incredible technology platform and solved the number of the issues that need to be solved to allow multiple people to collaborate on the web. Third, we think that we can advance product design and if you take the decades of Adobe technology that exists, our imaging technology, our vector technology, the video technology that we have and think about what that means to bring that to the web and dramatically increase the number of customers who can then benefit from it. And last but not least, I think, to your question. This is now really addresses that sort of Holy Grail of anybody creating a mobile application, anybody creating a website, anybody creating an application for any device that has a screen, combining what we can do on the designers, developers and the stakeholders to make that happen. So I think today, what we shared with you is what they talk about as their addressable market opportunity, what we talk about as ours. But I think the real benefit of this combination is creating brand new markets, much like we have done with Digital Experience and other industries that we are part of. So thank you and we are really excited about this.
Dan Durn: Yeah. Then from an accretion standpoint, first and foremost, this deal is about growth. This is about positioning the company to define new categories and drive growth for decades to come. And as we think about that growth trajectory, walked into -- walked through a number of those drivers. It’s about extending the performance of that platform as part of the combined company, getting it access to our customers and our go-to-market global -- go-to-market footprint. It’s about accelerating the delivery of new Adobe offerings on the web and then jointly introduce new offerings as we unlock those possibilities in collaborative creativity. This gives us an opportunity to focus and manage the R&D investments as we drive that roadmap and striking the balance between accelerating the growth and preserving that growth trajectory, but doing it in a disciplined way. We are going to deliver a tremendous amount of value over time to investors. Starting in year two post close, you will see our EPS growth rate faster than our overall revenue growth, will be accretive exiting year three and we are poised to deliver a lot of value.
Kash Rangan: Wonderful. Thank you so much and best wishes.
Operator: Our next question comes from Brad Zelnick of Deutsche Bank.
Brad Zelnick: Thank you very much and congratulations. This is obviously a big moment for Adobe. It’s pretty clear what Figma brings to the table in terms of innovation, collaboration and communities, and I appreciate the comments about Figma helping to further webify core Adobe products. But what do you say to the perspective that this $20 billion acquisition seems more reactive versus proactive? And perhaps more importantly, how do we get comfortable that Adobe’s organic innovation engine is alive and well for capturing the trends and opportunities that lie ahead in Creative?
Shantanu Narayen: Brad, it’s a good question and I understand that in these markets, in particular, acquisitions and maybe large ones are viewed with some skepticism. We certainly believe and I will talk about it that Figma will be a transformative deal for the customers and industries and it dramatically increases our TAM. We can deliver great value to an increasing set of customers. But I also want to reassure all of you and if you look at our results, this in no way changes our focus or our excitement on our current portfolio. We are growing well, and we are demonstrating strength across all of our three cloud offerings and we continue to execute against our current initiatives. And so if you look at the multiple internal businesses that are achieving velocity, whether it’s Adobe Experience platform and the apps that are built natively on top of it, what’s happening with 3D and immersive, what’s happening with Acrobat Forms, what’s happening with Frame. This is additive. And when opportunities like this present themselves, Brad, I think it’s the great companies that look at it and say, are you going to focus on the here and now only or are you going to seize on the opportunity that really positions Adobe for the next few decades. And so it’s a great question. We understand that there will be questions associated with valuation. We certainly believe that it provides valuation to our shareholders as well. When you look at what this means for us, but in no way diminishes my excitement around our current portfolio.
Brad Zelnick: Very fair. Thank you and look forward to seeing it all on display at MAX next month. Thanks, guys. Congrats.
Shantanu Narayen: Thank you, Brad.
Operator: We can go to Alex Zukin of Wolfe Research.
Alex Zukin: Hey, guys. So I will start with a non-Figma question and then layer in Figma. I guess, Shantanu, can you talk, or David, can you guys give us the kind of lay of the land on the demand environment, how it trended throughout the quarter, obviously, a lot of companies are seeing some elongation of deal cycles, descoping, even our channel checks on the Digital Experience side suggested that their deals are taking longer to close as they are requiring a lot more signatures. So, I guess, first of all, what are you seeing in the demand environment and what are -- because one of the questions we are getting from investors is why now, given that we may be entering a more recessionary environment, couldn’t you have done this type of a transaction cheaper later, so that’s kind of how I want to weave this in?
Shantanu Narayen: Yeah. Let me address the first part, which was your second part of the question, which is why now. Again, and as I said, we just believe that this new vision that we can create for, what we can do with collaborative creativity, there’s no time like the present to start working on top of it. And when opportunities like this present themselves, you have to act upon it rather than kicking that can down the road, Alex. So, from my perspective, we know how to make this deliver great value to our customers. I will have David also speak to the demand environment and the Creative side. On the Enterprise side, as we said, we had strong results. I mean the AEP plus apps business, that book of business is doubling, which really reflects the foundational aspects of what we are delivering. But it -- again, I go back to -- opportunities like this present themselves rarely and Figma is one of those rare companies that has achieved the kind of escape velocity and technology platform that they have. But we equally believe that it’s even rarer for a company like Adobe to be able to take advantage of what they deliver and actually accelerate it and provide greater value and so from my perspective, there’s no time like the present.
David Wadhwani: Yeah. And on the Digital Media side, we began the year with a guide of $1.9 billion, and of course, we hope to beat that. And in the context of everything happening in the macro, if you look at Q1, Q2, Q3 and our guide for Q4, we are at $1.88 billion and in the context of everything happening in the world, we are very proud of this performance. And of course, we are an aggressive company. We hope to beat that number. And all the leading indicators remained strong. New user acquisition is strong, engagement and retention continues to be strong, monthly active users continue to be strong. And so we feel really good about the macro -- about our ability to navigate the macro despite what’s happening in the world around us. And then in the context of as we start looking for opportunities to grow, we have so much product innovation coming out at -- and we will see a lot of it at MAX, accelerating what’s happening in our flagship applications, what’s happening around Express and the kinds of capabilities we are putting in there. We are seeing great growth and momentum in terms of use and NPS there, Photoshop and Illustrator coming to the web. We have a lot of share for review collaborative capabilities coming as well. And then as you look at the conversation around Figma, we have known Dylan for years and we have shared very common values and vision, and the opportunities to grow that business faster and the synergies we have in mind are -- just allow us to take what is already a strong business and make it even stronger and faster.
Alex Zukin: Perfect. Thank you, guys.
Operator: The next question is from Brent Thill of Jefferies.
Brent Thill: Shan, you -- everyone’s admired your ability to stay disciplined on M&A over the last decade and I guess many are kind of feeling like you broke the mold on this, and I think, everyone just wants to hear on the multiple, even if revenue doubled again, it would be over 25 times ARR. So what was it that was so special, and if you think about in the last few years, you have always said XD could carry you, why -- what happened with XD, what happens with XD now as it scales?
Shantanu Narayen: So two things to that, Brent. The first is, I understand that what you are saying in effect is some people will say, hey, show me how this value is accruing to Adobe shareholders as well and we certainly believe that otherwise we wouldn’t be doing it and we do believe that it will be value-generating for the Adobe shareholders. I think as it relates to XD and as it relates to Figma, I mean, we certainly, for designers, we are targeting what needed to happen as it related to screen design with the desktop product. I think the much newer market that emerged, which Figma effectively both addressed and pioneered was the ability to do this in a collaborative way and dramatically increase the scale, and they over the last decade, have really invested in and solve some of the hard technical problems that existed to make this happen on the web friction-free. So from our perspective, the Creative products continue to be strong, the ability to really tie the designers and developers is really where there’s this unique opportunity, as well as to create new markets. I mean I will give you one more sort of what-if scenario in terms of how we think about it, which is you combine what they have done with whiteboarding and ideation, and what will be the future of work, and if you think about the presence of Acrobat and what we have with Acrobat or if you think about the notion of brainstorming and what happens with FigJam, with what happens with Adobe Express, I think the opportunities are tremendous. I understand that there will be some sentiment associated with the price, and ball’s in our court to go demonstrate how we execute against our current initiatives, as well as to demonstrate the value of this new one.
Brent Thill: Thanks, Shantanu.
Operator: We can go to Keith Weiss of Morgan Stanley.
Keith Weiss: Excellent. Thank you guys for taking the question. One just a real brief one on Figma, I don’t want to beat that horse too much and then some questions on the core business. On Figma, we have definitely heard a lot about them in the field and it’s a great asset you guys are acquiring. It does seem like it overlaps pretty directly with InDesign. So can you talk a little bit about sort of the -- is there a rationalization of those two products or is Figma just kind of the go-forward product there? And then on the core business, last week -- not last week, last quarter you gave us a little bit of an update on kind of how pricing was impacted -- impacting Digital Media and net new ARR. I was hoping to get an update on sort of how the pricing impact flow through this quarter. And then on the margin front, it looks like you guys pulled back on hiring a little bit, can you talk to us about the pace of investments on a go-forward basis and whether that’s going to be a little bit more measured given the macro impact starting to build up? Thank you very much.
David Wadhwani: Yeah. I will start by talking about InDesign and Figma. They are very different products at the core. InDesign is around building print and publishing workflows and doing layout. Figma is really all about enabling product design and a collaborative product design model. In fact, if you look at InDesign, it’s our traditional base of users, predominantly designers that are using it. One of the things that’s really interesting about Figma is the makeup of their user base. In fact, two-thirds of their users are not designers, they are developers and other stakeholders in the process, and the foundation of that collaborative model is what makes this such a special and accretive acquisition for us. If you think about going forward, the primary focus is going to be about bringing Figma into the family and then taking all of the capabilities we have across illustration and video and creative imaging and building it on top of the Figma platform to enable a whole new generation of capabilities that are going to resonate with digital native and next-generation creative professionals, and we are very excited about them. The two products are quite different.
Dan Durn: Yeah. Then from an investment standpoint, one of the great things about Adobe is, is we have got tremendous growth opportunities. We have got an opportunity to drive the core franchise to $30 billion to $40 billion of revenue. But we are going to do what we have always done, which is invest in a disciplined way and drive that growth with strong profitability and strong cash flow and so we will do what we have always done. We are going to orient towards growth. We are back utilizing our facilities. We are investing to scale our business. We are investing in our products, go-to-market marketing. We are driving PLG motions, but we are going to do it in a disciplined way that delivers strong profitability and cash flow, while growing this business in a strong and robust way. So we will do what we have always done, operating a disciplined business.
Keith Weiss: Got it. And on the pricing side?
David Wadhwani: Yeah. On the pricing side, first of all, pricing for us is all about value. The business that we have been building is all based on new user acquisition, upselling, and of course, occasionally pricing moves and the pricing is always associated with added value. So on the Creative side we have been adding lots of apps. We have been enabling Frame.io integration into Creative -- into our Creative Cloud applications. We have been building a lot of share and review workflows, as an example, a lot of stock and content images in there as well and then on the Acrobat Pro side, we have been doing a lot more deep integration with Sign around bulk signatures, branding, web forms payments. So the foundation is that pricing is always connected to the real value that we are adding, and in doing that, we continue to see pricing play out the way we expected and all of this was baked into what we had planned for the year.
Operator: Next question comes from Brad Sills of Bank of America Securities.
Brad Sills: Oh! Great. Thanks so much. Another question here on Figma, it looks like the company is well positioned for designer, developer use cases, much like Frame.io for video editing, bringing you into more of those use cases really extending the reach for Creative Cloud. I guess the question is, where does Creative Cloud end up, where does that footprint end and the Figma footprint began? In other words, could you see a scenario where this acquisition and these use cases bring through -- pull-through more sales of Creative Cloud subscriptions?
Shantanu Narayen: I think the three ways in which we look at that. First, in terms of the customers for Figma, I think, as David mentioned, the number of developers who are part of this products set is actually extremely extensive. But in addition to the product set associated with Figma design for developers, as well as stakeholders, I do want to again emphasize the product fit as it relates to FigJam for anybody who’s a knowledge worker and anybody who wants to ideate. So if you think about the value of ideation and brainstorming. I mean the reality is, they have tens of millions of people who signed up and trialed Figma. We have hundreds of millions of people who have used our products and so the adjacency in terms of enabling both of those combined sets of customers to use each other’s products, we continue to believe that drives great value. So this is really about, in our sense and then if you take Acrobat and the penetration that Acrobat has, everybody who’s using Acrobat also wants to both share, as well as ideate and brainstorm. So I know there’s a lot of questions around Figma design, which is clearly achieved escape velocity. I would urge you also to spend a little time looking at FigJam as I know you have and then you would really understand that, that also dramatically expands the customer base. So, yes, getting Creative Cloud to a more diverse set of customers on the web, allowing collaboration and enabling it much like you said with Frame. That’s very much part of the strategy and that’s why even in the press release, we talk about accelerating creativity on the web as one of the key pillars.
Brad Sills: Thanks so much, Shantanu. Dan, one for you, please, if I could, you have talked about in the past some healthy pipeline build for Q4 backing your confidence for Digital Media ARR guidance based on some good pipeline activity there for Q4, any update on that, please? Thank you.
Dan Durn: Yeah. No. It’s playing out as we expected as we take a look at the enterprise business, closing million dollar plus deals, transformational deals as we look forward off of that momentum into Q4. Pipeline is building nicely. Team is doing a good job executing against the opportunity and it’s playing out as expected.
Brad Sills: Thank you so much.
Operator: The next question is from Jay Vleeschhouwer of Griffin Securities.
Jay Vleeschhouwer: Thank you. Good morning. Shantanu, in some of your remarks and Dan in one of your bullet points regarding the rationale for Figma, you made some interesting references to their platform and accelerating your products on the Cloud. Are you suggesting perhaps that there’s something in their DevOps, let’s call it, that may lead ultimately to a material change in Adobe’s product release cadence or product packaging? How do you see your portfolio evolving and your underlying R&D, let’s call it, infrastructure or process, because there’s something into in terms of how they develop products that I think you are hoping to splice in that kind of DNA? And then, secondly, it’s not unprecedented for Adobe to purchase a dynamic competitor, we can go back many years, we have done this before. Maybe put this into context of some of those prior acquisitions where you bought a competitor that had meaningful either competitive impact or complementary technology and thinking, of course, about the material impact that the Macromedia acquisition had many years ago.
Shantanu Narayen: So, Jay, let me first cover the first one and there’s no doubt that what Figma has been able to do on the web by solving a lot of these multiplayer high scalability requirements to allow the tens of millions of people to use Figma design and even more important FigJam on the web, is an engineering marvel. And having access to that technology and being able to take advantage of it to dramatically increase anybody who’s participating in our design products, whether they would be stakeholders and developers will, I think, dramatically increase our TAM as well. And so, first and foremost, their DevOps is great. I mean we certainly have a lot of that expertise on the Digital Experience side of the house as it relates to the trillions of transactions. But for the Creative, we really believe that this is one of the key pieces of technology that we are getting that are going to be really amazing. I think as it relates to your second question, we really view these as, when you have the right altitude, for us it’s all about how do you take things that might seem competitive, but are actually more complementary and expand the nature of the market. And for me, when I think about what we did with Macromedia, it was really about saying. We are going to target more graphics professionals and not just focus on imaging. We are going to focus on what’s happening with video on the web or gaming. And so I think it was an expansive part of how we looked at it. And that’s the same situation here. For us, it’s really not about what we had on the desktop. It’s really about expanding to the web. Multi-surface is something that we have talked about a lot. It’s about a community in many ways, Jay, and what they have done as it relates to their communities and plug-ins and how they have been able to use artificial intelligence, all of that also power we bring to bear to the combined. So from my perspective, this is really about adjacency. It’s about complementary things that we have done. Certainly, we did have a presence in screen design on the desktop. But big picture this is all about dramatically expanding it and that’s the conversation that David, Dylan, Scott and I have been having. And David, feel free to add to that.
David Wadhwani: Yeah. From the beginning of the conversations with Dylan, the primary focus has been on things that we couldn’t do individually. What are the things that we could do and bring to market that combining the two products and put -- two product sets into two companies could really enable a better-together story. And in particular, what we see is that we have this incredible wealth of technology and expertise around illustration and video and imaging and photography and 3D, all from -- coming from the lens of our flagship applications, and as Shantanu mentioned, they have built such a rich platform for collaboration. Bringing these things together allow us to re-imagine what the -- basically Creative -- content creation should look like in the future by taking our technology, integrating it on top of or building it on top of the Figma platform and then enabling a whole set of new use cases that would never have happened were it not for this combination.
Jay Vleeschhouwer: Thank you.
Operator: The next question comes from Saket Kalia of Barclays.
Saket Kalia: Okay. Great. Hey, guys. Thanks for taking my question and congrats to all on the announcement. Dan, maybe for you, just to maybe focus on the core business for a minute and then loop in Figma. Are there any puts and takes with margins this year that we should keep in mind when thinking about organic margins next year, and of course, I understand you are guiding to it, but just sort of anything that you want us to note? And then on top of that, how do you think about the EBIT profitability for Figma and where that can go over time?
Dan Durn: Sure. So let me take them in order. So as we think about our margins this year, I think, you can see the trajectory throughout the year. What I would say is what we are seeing in the back half of 2022, I think, is more reflective of the normalized environment. We talked about continuing to invest in the products, how we market those products, how we drive product led growth, how we are going to market. But also complementing it with repopulating the campuses, being back to in-person interaction, getting on planes and that’s a bit more reflective of a normalized operating environment. So that’s what I would say, think about maybe the second half of 2022 as a bit more of a normalized environment. As we think about margins in the context of Figma and the transaction, we talked a couple -- about a couple of things. We talked about this is about growth. This is delivering that growth in a disciplined way. So when I think about operating margins in that context, we talked about the second half of 2022 being that baseline more normalized run rate. And if I think about the first couple of years post close, year one, year two post close. Think about margins that are maybe 1 point to 2 points delta versus where we would be on a standalone basis. And then by the time we get to year three, I would expect it to be more neutral from an influence standpoint. And again, I also want to register the point that I mentioned earlier in Q&A. As we get past year one, we are going to start growing EPS faster than our revenue growth profile and so we feel good about that inflection point and driving it in a disciplined way. When we look at GAAP operating margins, obviously, you will see a bigger delta in the near-term. To account for the stock-based compensation, we really view that stock-based compensation to incentivize the employees to stay with the company and unlock those growth potentials and you will see that amortize over a four-year period consistent with our equity programs and then we will be back to a more normalized run rate after that amortization period. So you will see more impact on the GAAP side and we feel pretty good about the trajectory from a non-GAAP operating margin standpoint.
Saket Kalia: Very, very helpful. Thanks, Dan. Congrats again.
Dan Durn: Thanks.
Jonathan Vaas: Hey, Operator. We are coming up on the top of the hour. Let’s try to squeeze in two more questions please.
Operator: Certainly. We can go straight to Phil Winslow of Credit Suisse.
Phil Winslow: Hi. Thanks for taking my question. I just wanted to focus on a little bit more in the near-term in terms of your guidance for Q4. If we were in back to last year, you saw sort of a lower uplift around sort of the Black Friday selling period as compared to prior years. Now, obviously, going into this Q4 is always is you are a seasonally stronger business or enterprise spend period for Adobe, we are also going into that sort of that Black Friday period again, obviously. When you think about your guidance for Q4, what are you baking in compared to last year for sort of those Black Friday trends, but also that sort of seasonal uplift in the business spending?
Shantanu Narayen: I think as we said in our prepared remarks, Phil, we are guiding in typical seasonality, Q4 tends to be a strong season both in terms of the enterprise business for us and closing the enterprise business and the pipeline that we have built over the year, as well as some consumer commerce days, as you mentioned and all of that is factored into the targets that we are guiding. We are not changing that based on anything different than we have seen. So I think we continue to believe that our business is resilient and if you look at the initial targets that we are providing, we would expect to have another strong seasonal close to the year.
Phil Winslow: Great. Thanks, guys.
Operator: And the final question today comes from Kirk Materne of Evercore ISI.
Kirk Materne: Hi. Thanks very much and congrats on the acquisition. Dan, I just wanted to follow up on your comments maybe on the dilution around the deal. I think just based on what Shantanu and all of you have said about sort of the complementary nature of the deal, the ability to expand the market. I think people are asking why isn’t there more sort of synergy from a go-to-market perspective with this deal, meaning bringing Figma onto your platform would theoretically just turbocharge sales immediately given sort of your scale? So I just -- how much of that’s baked into the dilution forecast or are you -- I realize it’s early, but are you leaving that more for upside, because I think the length of the dilution given that this should be complementary from a go-to-market perspective, I think, is what’s somewhat confusing to folks? Thanks.
Shantanu Narayen: Well, certainly, for us, this is all about the top line growth and what -- if you look at actually what we would expect in terms of their continued growth and our continued growth, I think, the topline of both companies they would accelerate. And so I think maybe at the FA meeting, as we get more time, we are happy to share more color associated with it. But from my perspective, we actually think that we have a plan that allows us to really show the benefits of the combination, as well as continue to overachieve against those.
Kirk Materne: Okay.
Shantanu Narayen: And since that is the…
Kirk Materne: Yeah.
Shantanu Narayen: Go ahead.
Kirk Materne: Just a follow-up on that. I just -- too difficult for us to, meaning you both can grow faster, are these new developers that require sort of new efforts to go get them from Adobe perspective. I am just trying to get a sense of the overlap of the opportunity would seemingly think that you guys combined could actually do it more effectively together, which would create greater operating leverage to a certain degree sooner. So I am just trying to -- I realize there’s a lot of moving parts in the near term to this, but I was just kind of curious, is that what’s sort of embedded in your expectations or are you sort of leaving that for to see what happens as you get, I guess, a little bit closer to the deal closing?
Shantanu Narayen: I think for us, we are just factoring in everything, including the fact that this is a stock purchase and half of it is approximately in stock and what that means in terms of dilution. As we said, we will start to offset that. We have tremendous cash flow generation. But from our perspective, we are going to be aggressive about making sure that we continue to drive the topline and the bottomline. And so that is very much on our mind in terms of delivering great value to the customers in the industry and creating new opportunities. And from my perspective, what I do want to say, since that was the last question was, first and foremost, we are really excited about our current business. I mean the current business is growing at a great clip in this macroeconomic environment. We have multiple growth initiatives that are all demonstrating how mission-critical they are and how they are relevant they are in this new digital-first world where whether it’s work, life, play, everything is going to be impacted by digital. So, first and foremost, we are very confident about our existing portfolio and the growth trajectory of the current portfolio. The addition of Figma, from my perspective, is the ability to turbocharge that in terms of both the opportunity that the company has, as well as the ability to serve ever broadening set of customers. And so I hope you all view that within that context, which is lot of confidence about our existing business and more excitement about making sure that we are setting in place greater future opportunities. We will look forward to having a lot of you at MAX. I hope you do come there. We are planning an FA part of that section as well and so we would be happy to share more with you when we join that. And with that, I will turn it over to Jonathan.
Jonathan Vaas: Thanks, Shantanu, and thanks, everyone, for joining us this morning. This concludes the call. | [
{
"speaker": "Operator",
"text": "Good day. And welcome to the Q3 FY 2022 Adobe Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead, sir."
},
{
"speaker": "Jonathan Vaas",
"text": "Good morning and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s third quarter fiscal year 2022 financial results. You can find our Q3 press release as well as PDF’s of our prepared remarks and financial results on Adobe’s Investor Relations website. The information discussed on this call, including our financial targets and product plans is as of today, September 15th and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today’s press release and then Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates, as well as adjusted growth rates in constant currency. During this presentation, Adobe’s executives will refer to constant currency growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan, and thank you for joining us. Adobe had another record quarter, achieving $4.43 billion in revenue, which represents 15% year-over-year growth. GAAP earnings per share for the quarter was $2.42 and non-GAAP earnings per share was $3.40. In our Digital Media business, we achieved $3.23 billion in revenue. Net new Digital Media annualized recurring revenue or ARR was $449 million and total Digital Media ARR exiting Q3 grew to $13.40 billion. In our Experience Cloud business, we achieved $1.12 billion in revenue and subscription revenue was $981 million. In this digital-first world, Adobe Creative Cloud, Document Cloud and Experience Cloud have become even more mission-critical to an increasingly wide range of customers, from students to creative professionals to small businesses to the world’s largest enterprises. Fueled by our groundbreaking technology, track record of creating and leading categories and consistently strong execution, our opportunity is larger than ever before. Adobe’s greatness has been rooted in defining new categories and platforms and delivering cutting-edge solutions through both organic innovation and inorganic acquisitions. Throughout our history, Adobe’s innovations have touched billions of lives around the globe. From revolutionizing imaging and creative expression with Photoshop, to pioneering electronic documents through PDF, to creating the digital marketing category with Adobe Experience Cloud, Adobe continues to invent and transform categories. We are in the golden age of design and we believe we have a unique opportunity to usher in a new era of collaborative creative computing. I am thrilled to share that today we announced our intention to acquire Figma, a leading web-first design platform that will help us accelerate this vision. Figma enables designers, developers and all stakeholders to collaborate in the product design process from ideation to design to delivery. The combination of Adobe and Figma will significantly expand our reach and market opportunity while making the creative process more accessible and productive to more people. I will now turn it over to David to share more about our vision for Adobe and Figma and momentum in the Digital Media business. David?"
},
{
"speaker": "David Wadhwani",
"text": "It’s an exciting day for Adobe and Figma. Figma’s mission is to help teams collaborate visually and make design accessible to all. Dylan Field, Figma’s CEO, and his team launched Figma as the first design tool purpose-built for the web in 2012. Figma and FigJam make it possible for all stakeholders designing interactive mobile and web applications to collaborate through multi-player workflows, sophisticated design systems and a rich extensible developer ecosystem. Figma has built an incredible product and an outstanding business, delivering world-class ARR growth and net dollar retention with a disciplined and efficient operating model. Figma has attracted a new generation of millions of designers and developers and a loyal student following. To give you a sense of their scale and financial success, Figma is expected to add approximately $200 million in net new ARR this year, surpassing $400 million in total ARR exiting 2022, with greater than 150% net dollar retention rate. With a total addressable market of $16.5 billion by 2025, Figma is just getting started. Adobe has always been focused on empowering everyone to create digital experiences, and the combination of Adobe and Figma is the perfect better together opportunity. The combination of Adobe and Figma will create new opportunities and accelerate our strategy in a few ways. First, reimagining the future of creativity and productivity, Adobe and Figma share a passion for helping individuals and teams be more creative and productive. Adobe and Figma now have a new opportunity to make content creation more efficient, collaborative and fun by bringing together Adobe Express, Acrobat and FigJam, an online whiteboarding solution for teams. With the combination of these products, we can offer tremendous value to hundreds of millions of customers. Second, accelerating creativity on the web, as creativity becomes increasingly collaborative, the web makes it easier for teams to create together. Figma’s web-based, multi-player platform can accelerate the delivery of Adobe’s Creative Cloud technologies on the web, making the creative process accessible to more people. This will dramatically increase Adobe’s reach and addressable market opportunity. Third, advancing product design, web and mobile applications are increasingly underpinning how we live and work. This is driving explosive growth in the product design category. The combination of Adobe and Figma will benefit all stakeholders in the product design process, from designers to product managers to developers, by bringing powerful capabilities from Adobe’s imaging, photography, illustration, video, 3D and font technologies into the Figma platform over time. And fourth, empowering and expanding the community, throughout our history, Adobe’s community has been a constant source of inspiration and a catalyst for innovation. Figma has a thriving community who develop and share everything from tutorials, templates and plug-ins with their large and growing ecosystem. The combination of our communities will bring designers and developers closer together to unlock the future of collaborative design. Adobe and Figma could not be a better match, our people, innovative technology and joint mission to democratize creativity and collaboration will deliver increased value to a growing base of customers. I look forward to welcoming Dylan and the entire Figma team to Adobe once the transaction closes. The acquisition of Figma could not come at a more exciting time for Adobe’s Digital Media business, which surpassed $13 billion in ARR this quarter, growing 16% year-over-year exiting the quarter. Adobe Creative Cloud remains the world’s creative engine, empowering everyone to create whenever and wherever inspiration strikes. In Q3, we achieved net new Creative Cloud ARR of $330 million and revenue of $2.63 billion, which grew 14% year-over-year. Q3 highlights include; strong momentum for Adobe Express, with significant growth in new users. Adobe Express is serving an expansive universe of creative professionals, communicators and knowledge workers, from students to small business owners to social influencers. It’s exciting to see the rapid innovation we are delivering to enable millions of customers to create standout multimedia content. Adobe Express has thousands of templates, millions of stock assets and quick action functionality that make it easy to do any creative task. Millions of new users are coming to Adobe Express, driven by viral adoption and our creative marketing campaigns. Fast Company recently named Adobe Express one of the best new productivity apps of 2022. Strength in our Photoshop and Lightroom offerings across desktop and mobile, tailwinds in our video segment for Premiere Pro and Frame.io, our integrated video editing and collaboration offering, demand for our Substance products, as brands across every industry embrace 3D and immersive content as a new medium, and momentum in the Adobe Stock business, emphasizing the importance of content velocity for businesses of all sizes. And finally, we are really excited about Adobe MAX, the world’s largest creativity conference. It will be held in Los Angeles and streamed live for our global community. In addition to unveiling amazing new Creative Cloud innovations, we will hear from luminaries including renowned film directors, artists and musicians. Now on to our Document Cloud business. Digital documents are enabling individuals and businesses to be productive in a digital-first world. With more than 300 billion PDFs opened and more than 8 billion digital signatures processed each year, Adobe Document Cloud is accelerating document productivity and workflows across web, desktop and mobile. Document Cloud had its best Q3 ever, achieving net new Document Cloud ARR of $119 million and record revenue of $607 million, which grew 25% year-over-year. Q3 highlights include; continued adoption of PDF across every computing surface, with over 2.6 billion cumulative installs of Acrobat and Reader; significant enhancements to the Acrobat web experience, making popular verbs like view, edit and collaborate easier than ever and adding accessibility capabilities such as Read out Loud and High Contrast support. Acrobat Web MAU continues to see tremendous growth, driven by the high volume of web searches for document actions. Strong growth in Adobe Sign, driven by integrated e-signature functionality in Acrobat; integrated workflows between Acrobat Desktop, Acrobat Web and Adobe Express; and key enterprise customer wins, including Amazon, Boeing, Chubb, Lloyds Bank and ServiceNow. Demand for our industry-leading Digital Media products remains strong across a growing base of customers. We are accelerating momentum across the business with continued product innovation, strong go-to-market capabilities and a proven data-driven operating model. I will now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello everyone. One thing has become abundantly clear in this environment, digital has become the critical channel to engage customers and drive growth. Across the globe, companies in every industry are prioritizing investments in software solutions and services that enable them to anticipate and meet the expectations of their consumers. Customer Experience Management is an imperative and Adobe is the category leader. Adobe Experience Cloud delivers predictive, personalized, real-time digital experiences, from acquisition to monetization to retention, across content and commerce, customer journeys, data insights and audiences and marketing workflow. In particular, we are driving strong enterprise adoption of Adobe Experience Platform and Real-Time CDP which are foundational to this next-generation enterprise architecture. FC Bayern, one of the world’s most successful football clubs, is leveraging Adobe Experience Cloud and Real-Time CDP to transform their fan experience. This gives them a holistic view of every fan’s engagement online and offline, enabling them to deliver personalized experiences such as discounts at the stadium or an immersive shopping experience for viewers at home. In Q3, we continued to drive strong Experience Cloud growth, achieving a record $1.12 billion in revenue. Subscription revenue was $981 million for the quarter, representing 15% year-over-year growth. Q3 highlights include; strong momentum for Adobe Experience Platform and AEP-native applications, with the book of business more than doubling year over year; significant growth for Adobe Commerce, underscoring the demand for digital storefronts and marketplaces; Experience Cloud was named a leader for the sixth consecutive year in the Gartner Magic Quadrant for Digital Commerce and achieved the highest position in the Forrester Wave for Enterprise Marketing Suites; and key customer wins, including Crédit Agricole, Morgan Stanley, NASA, Qualcomm, T-Mobile and UnitedHealth Group. Looking forward, Adobe is leading an explosive growth category that is increasingly important to enterprises of all sizes. Adobe is well-positioned to help enterprises deliver exceptional customer experiences with industry-leading platforms and applications, a strong track record of deploying solutions successfully for thousands of customers and a proven ability to deliver the next-generation architecture for Customer Experience Management. Dan, over to you."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Today I will start by summarizing Adobe’s performance in Q3 fiscal 2022, highlighting growth drivers across our businesses, then I will discuss the announced acquisition of Figma and I will finish with financial targets. Adobe delivered a solid Q3, continuing to demonstrate that our products are mission critical to our customer’s success in any macro environment, from the millions of individuals who use our offerings to create digital content, to the small businesses that run their document workflows on Adobe, to the large enterprises that have transformed how they interact with their end users by providing personalization at scale. Q3 business and financial highlights included; record revenue of $4.43 billion; GAAP diluted earnings per share of $2.42 and non-GAAP diluted earnings per share of $3.40; Digital Media revenue of $3.23 billion; net new Digital Media ARR of $449 million; Digital Experience revenue of $1.12 billion; cash flows from operations of $1.70 billion; RPO of $14.11 billion exiting the quarter; and repurchasing approximately 5.1 million shares of our stock during the quarter. In our Digital Media segment, we achieved 13% year-over-year revenue growth in Q3 or 16% in constant currency. We exited the quarter with $13.40 billion of Digital Media ARR. We saw expected summer seasonality in the quarter, with the overall acquisition and engagement environment for our offerings remaining strong. We achieved Creative revenue of $2.63 billion, which represents 11% year-over-year growth or 14% in constant currency. We added $330 million of net new Creative ARR in the quarter. Third quarter Creative growth drivers included; momentum in small and medium businesses with our Teams offering, where we continue to drive strong new customer acquisition and are seeing engagement and retention at all-time highs; strong growth in our Illustrator and InDesign businesses; demand for our flagship photography, imaging and video applications; Adobe Stock where we continue to drive strong book of business growth; and momentum in our new growth initiatives, such as Frame.io and Substance, each of which grew ending ARR greater than 50% year-over-year exiting the quarter. Adobe achieved Document Cloud revenue of $607 million, which represents 23% year-over-year growth or 25% in constant currency. We added $119 million of net new Document Cloud ARR in the quarter, our strongest Q3 to-date. Third quarter Document Cloud growth drivers included; accelerated adoption of PDF and Adobe Reader across multiple surfaces; growth of Acrobat Web, fueled by online searches for PDF and document actions; strong performance of Acrobat and Adobe Sign; performance of our reseller channel continuing to drive new Document Cloud subscriptions, particularly with small and medium businesses; and continued seat expansion in the enterprise. In August we began to roll out the new Acrobat integrated with Sign offering, which included updated pricing. Turning to our Digital Experience segment, in Q3 we achieved revenue of $1.12 billion, which represents 14% year-over-year growth or 15% in constant currency. Digital Experience subscription revenue was $981 million. Third quarter Digital Experience growth drivers included; strong retention, upsell and enterprise bookings in the quarter across our solutions, particularly in the U.S.; success closing numerous million-dollar deals, as well as larger transformational deals that span our portfolio of solutions; continued momentum with our foundational Adobe Experience Platform and Real-Time CDP business, with our book of business for Platform and AEP-native applications more than doubling year-over-year exiting the quarter; success integrating our solutions with workflow, including Workfront, which grew revenue greater than 35% year-over-year in the quarter; and higher customer demand for professional services, as enterprises focus on implementations and value realization. In Q3, we focused on making disciplined investments to drive growth, including a strong class of university hires and marketing campaigns to raise awareness of new and flagship offerings. We continue to have world-class operating margins and drove strong EPS performance in the quarter. Adobe’s effective tax rate in Q3 was 22% on a GAAP basis and 17.5% on a non-GAAP basis. The GAAP tax rate came in lower primarily due to benefits associated with share-based payments. The non-GAAP tax rate came in lower primarily due to additional U.S. income tax credits. RPO exiting the quarter was $14.11 billion, growing 12% year-over-year or 15% when factoring in a 3% foreign exchange headwind. Our ending cash and short-term investment position exiting Q3 was $5.76 billion and cash flows from operations in the quarter were $1.70 billion, up 20% year-over-year. In Q3 we repurchased approximately 5.1 million shares at a cost of $1.80 billion, including shares received for the final settlement of our ASR entered into in December 2021. We currently have $8.3 billion remaining of our $15 billion authorization granted in December 2020 which goes through 2024. As Shantanu and David mentioned, we are thrilled about the opportunity to acquire Figma, which will accelerate Adobe’s strategy. Under the definitive agreement, we have agreed to acquire Figma for approximately $20 billion, comprised of approximately half cash and half stock, subject to customary adjustments. Approximately 6 million additional restricted stock units will be granted to Figma’s CEO and employees that will vest over four years subsequent to closing. The transaction is expected to close in 2023, subject to regulatory approvals. We plan to finance the cash portion of the consideration with cash on hand, and if necessary, a term loan, to be paid down from our operating cash flows following the closing. Figma’s products address a $16.5 billion market opportunity and the company has an impressive financial profile. This year they are expected to add $200 million in net new ARR, surpassing $400 million total ARR by the end of the year, with greater than 150% net dollar retention. They have a disciplined, efficient operating model, with gross margins of approximately 90% and positive operating cash flows. Figma have strong business momentum, a large and expanding customer base and we are incredibly excited about what we can bring to this combination from a financial perspective. While this transaction is primarily about creating new markets, expanding adjacent opportunities and accelerating growth, we are committed to maintaining Adobe’s strong profitability and maximizing EPS for our investors. In year one and two after closing, the transaction will be dilutive to Adobe’s non-GAAP EPS and we expect it to be breakeven in year three and accretive at the end of year three. While the transaction has not yet closed, I want to provide color on the path to non-GAAP EPS accretion as a combined company exiting year three, assuming Adobe’s operating margin for the second half of fiscal 2022 as the baseline. The combination will accelerate top-line growth for both Adobe and Figma based on three primary drivers; one, we extend Figma’s reach to our customers and through our global go-to-market footprint; two, Figma accelerates the delivery of new Adobe offerings on the web to the next generation of users; and three, we jointly introduce new offerings to market as we unlock the possibilities of collaborative creativity. Clearly the explosive revenue growth of Figma combined with their efficient operating model would result in an expanding standalone operating margin. Figma’s innovative technology platform will accelerate our R&D roadmap including the delivery of our Creative Cloud technologies on the web, which will allow Adobe to focus and manage our future R&D investments. We will quickly pay down any term loan, if necessary, after close and then resume stock repurchases to reduce Adobe’s share count. While the transaction is pending, at a minimum we expect to maintain share repurchases sufficient to offset the dilution of equity issuances to Adobe employees. We will now provide Q4 targets, which factor in the overall macroeconomic environment; FX headwinds, as the U.S. dollar has continued to strengthen against foreign currencies; and typical year-end seasonal strength in demand for our offerings. As a result, for Q4 we are targeting; total Adobe revenue of approximately $4.52 billion; net new Digital Media ARR of approximately $550 million; Digital Media segment revenue growth of approximately 10% year-over-year or 14% in constant currency; Digital Experience segment revenue growth of approximately 13% year-over-year or 15% in constant currency; Digital Experience subscription revenue growth of approximately 13% year-over-year or 15% in constant currency; tax rate of approximately 23% on a GAAP basis and 17.5% on a non-GAAP basis; and GAAP earnings per share of approximately $2.44 and non-GAAP earnings per share of approximately $3.50. In summary, Adobe continues to drive performance across Creative Cloud, Document Cloud and Experience Cloud, while making transformational investments in strategic growth initiatives. I look forward to sharing more about our growth opportunities next month in Los Angeles at Adobe’s Financial Analyst meeting. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. It was great to be back on the road this quarter meeting customers and partners as businesses return to a new hybrid work model. I was inspired and energized welcoming our new hires and meeting Adobe employees across multiple sites who will together drive the next phase of innovation, growth and culture. Adobe’s strength has always come from our most important asset, people. I am incredibly proud of the recognition we continue to receive as a great place to work. This quarter, Adobe was named to Fast Company’s Best Workplace for Innovators and Fortune’s Best Workplaces in Tech. Next week, we will hold our Adobe for All conference to bring employees together to celebrate our shared values of diversity, equity and inclusion. It is an exciting time at Adobe. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is working. We are delivering on our innovative product roadmap, driving growth across new and established businesses and delighting a growing universe of customers. In addition to achieving all this success, we continue to look around the corner for new transformational opportunities that will drive decades of growth for Adobe. We believe that every individual, team and business will strive to be more creative and productive in this digital era. Adobe has a unique opportunity to usher in a world of collaborative creativity. In my conversations with Dylan at Figma, it became abundantly clear that together we could accelerate this new vision, delivering great value to our customers and shareholders. I look forward to welcoming Figma into the Adobe family upon close of the transaction. We look forward to seeing you at MAX and closing the year strong. Now, we will take questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from a Kash Rangan of Goldman Sachs."
},
{
"speaker": "Kash Rangan",
"text": "Hello. Thank you very much. Congratulations on really massive step forward to the management team. Shantanu and team, I wonder if you can talk about the persona of Figma and if there is any overlap at all between what Adobe wanted to be in the future with its a Creative family and where Figma is growing -- was going, and if you net it out, what is the incremental opportunity. It looks like $16 billion TAM, but your own Creative business, you outline as having a more than a $40 billion TAM. So I am wondering what the TAM could look like for Figma in the future as it integrates into Adobe, you identify new personas. And for Dan three years to breakeven, it sounds like there are some conservative assumptions built in especially because Figma is generating cash. I am wondering what your assumptions are for that the rather lengthy duration to breakeven. Thank you so much and congrats."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Kash, and congratulations to you as well for the conference that is happening right now and given our quiet period as you know we can’t attend. But let me take a step back and talk about why we believe this is a fundamentally transformative move for Adobe. When we think about the future of what’s happening with creativity, and in a sense, what’s going to happen as it relates to multiple people engaging in that with respect to collaboration, we just believe that this is going to be an incredible value and a way to attract a whole bunch of new customers to the combined platform. When you think about Adobe, certainly we target knowledge workers, we target communicators, we target creative professionals. Figma really focuses a lot also on developers, they focus very much on the other stakeholders, who are involved in the product design process. So when we talk about the fact that Figma has a $16 billion TAM, that’s referring to the TAM as it exist today, in terms of what they are doing, both as it relates to product design, as well as that would relates to collaborative whiteboarding and ideation, which as you know, say, FigJam this incredible product that has, I believe, a much, much larger available addressable opportunity. But if you take a really what we think is the massive opportunity and putting this together. I think there are four aspects that are really exciting for us. First, there is going to be a next-generation of Creative collaboration that happens in the industry, and we believe that the combination of the two companies enable us to really position Adobe and deliver great value for this Creative collaboration industry. Second, we continue to believe that we can accelerate what it means to create on the web. What Figma has done is they have delivered a really incredible technology platform and solved the number of the issues that need to be solved to allow multiple people to collaborate on the web. Third, we think that we can advance product design and if you take the decades of Adobe technology that exists, our imaging technology, our vector technology, the video technology that we have and think about what that means to bring that to the web and dramatically increase the number of customers who can then benefit from it. And last but not least, I think, to your question. This is now really addresses that sort of Holy Grail of anybody creating a mobile application, anybody creating a website, anybody creating an application for any device that has a screen, combining what we can do on the designers, developers and the stakeholders to make that happen. So I think today, what we shared with you is what they talk about as their addressable market opportunity, what we talk about as ours. But I think the real benefit of this combination is creating brand new markets, much like we have done with Digital Experience and other industries that we are part of. So thank you and we are really excited about this."
},
{
"speaker": "Dan Durn",
"text": "Yeah. Then from an accretion standpoint, first and foremost, this deal is about growth. This is about positioning the company to define new categories and drive growth for decades to come. And as we think about that growth trajectory, walked into -- walked through a number of those drivers. It’s about extending the performance of that platform as part of the combined company, getting it access to our customers and our go-to-market global -- go-to-market footprint. It’s about accelerating the delivery of new Adobe offerings on the web and then jointly introduce new offerings as we unlock those possibilities in collaborative creativity. This gives us an opportunity to focus and manage the R&D investments as we drive that roadmap and striking the balance between accelerating the growth and preserving that growth trajectory, but doing it in a disciplined way. We are going to deliver a tremendous amount of value over time to investors. Starting in year two post close, you will see our EPS growth rate faster than our overall revenue growth, will be accretive exiting year three and we are poised to deliver a lot of value."
},
{
"speaker": "Kash Rangan",
"text": "Wonderful. Thank you so much and best wishes."
},
{
"speaker": "Operator",
"text": "Our next question comes from Brad Zelnick of Deutsche Bank."
},
{
"speaker": "Brad Zelnick",
"text": "Thank you very much and congratulations. This is obviously a big moment for Adobe. It’s pretty clear what Figma brings to the table in terms of innovation, collaboration and communities, and I appreciate the comments about Figma helping to further webify core Adobe products. But what do you say to the perspective that this $20 billion acquisition seems more reactive versus proactive? And perhaps more importantly, how do we get comfortable that Adobe’s organic innovation engine is alive and well for capturing the trends and opportunities that lie ahead in Creative?"
},
{
"speaker": "Shantanu Narayen",
"text": "Brad, it’s a good question and I understand that in these markets, in particular, acquisitions and maybe large ones are viewed with some skepticism. We certainly believe and I will talk about it that Figma will be a transformative deal for the customers and industries and it dramatically increases our TAM. We can deliver great value to an increasing set of customers. But I also want to reassure all of you and if you look at our results, this in no way changes our focus or our excitement on our current portfolio. We are growing well, and we are demonstrating strength across all of our three cloud offerings and we continue to execute against our current initiatives. And so if you look at the multiple internal businesses that are achieving velocity, whether it’s Adobe Experience platform and the apps that are built natively on top of it, what’s happening with 3D and immersive, what’s happening with Acrobat Forms, what’s happening with Frame. This is additive. And when opportunities like this present themselves, Brad, I think it’s the great companies that look at it and say, are you going to focus on the here and now only or are you going to seize on the opportunity that really positions Adobe for the next few decades. And so it’s a great question. We understand that there will be questions associated with valuation. We certainly believe that it provides valuation to our shareholders as well. When you look at what this means for us, but in no way diminishes my excitement around our current portfolio."
},
{
"speaker": "Brad Zelnick",
"text": "Very fair. Thank you and look forward to seeing it all on display at MAX next month. Thanks, guys. Congrats."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you, Brad."
},
{
"speaker": "Operator",
"text": "We can go to Alex Zukin of Wolfe Research."
},
{
"speaker": "Alex Zukin",
"text": "Hey, guys. So I will start with a non-Figma question and then layer in Figma. I guess, Shantanu, can you talk, or David, can you guys give us the kind of lay of the land on the demand environment, how it trended throughout the quarter, obviously, a lot of companies are seeing some elongation of deal cycles, descoping, even our channel checks on the Digital Experience side suggested that their deals are taking longer to close as they are requiring a lot more signatures. So, I guess, first of all, what are you seeing in the demand environment and what are -- because one of the questions we are getting from investors is why now, given that we may be entering a more recessionary environment, couldn’t you have done this type of a transaction cheaper later, so that’s kind of how I want to weave this in?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yeah. Let me address the first part, which was your second part of the question, which is why now. Again, and as I said, we just believe that this new vision that we can create for, what we can do with collaborative creativity, there’s no time like the present to start working on top of it. And when opportunities like this present themselves, you have to act upon it rather than kicking that can down the road, Alex. So, from my perspective, we know how to make this deliver great value to our customers. I will have David also speak to the demand environment and the Creative side. On the Enterprise side, as we said, we had strong results. I mean the AEP plus apps business, that book of business is doubling, which really reflects the foundational aspects of what we are delivering. But it -- again, I go back to -- opportunities like this present themselves rarely and Figma is one of those rare companies that has achieved the kind of escape velocity and technology platform that they have. But we equally believe that it’s even rarer for a company like Adobe to be able to take advantage of what they deliver and actually accelerate it and provide greater value and so from my perspective, there’s no time like the present."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. And on the Digital Media side, we began the year with a guide of $1.9 billion, and of course, we hope to beat that. And in the context of everything happening in the macro, if you look at Q1, Q2, Q3 and our guide for Q4, we are at $1.88 billion and in the context of everything happening in the world, we are very proud of this performance. And of course, we are an aggressive company. We hope to beat that number. And all the leading indicators remained strong. New user acquisition is strong, engagement and retention continues to be strong, monthly active users continue to be strong. And so we feel really good about the macro -- about our ability to navigate the macro despite what’s happening in the world around us. And then in the context of as we start looking for opportunities to grow, we have so much product innovation coming out at -- and we will see a lot of it at MAX, accelerating what’s happening in our flagship applications, what’s happening around Express and the kinds of capabilities we are putting in there. We are seeing great growth and momentum in terms of use and NPS there, Photoshop and Illustrator coming to the web. We have a lot of share for review collaborative capabilities coming as well. And then as you look at the conversation around Figma, we have known Dylan for years and we have shared very common values and vision, and the opportunities to grow that business faster and the synergies we have in mind are -- just allow us to take what is already a strong business and make it even stronger and faster."
},
{
"speaker": "Alex Zukin",
"text": "Perfect. Thank you, guys."
},
{
"speaker": "Operator",
"text": "The next question is from Brent Thill of Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Shan, you -- everyone’s admired your ability to stay disciplined on M&A over the last decade and I guess many are kind of feeling like you broke the mold on this, and I think, everyone just wants to hear on the multiple, even if revenue doubled again, it would be over 25 times ARR. So what was it that was so special, and if you think about in the last few years, you have always said XD could carry you, why -- what happened with XD, what happens with XD now as it scales?"
},
{
"speaker": "Shantanu Narayen",
"text": "So two things to that, Brent. The first is, I understand that what you are saying in effect is some people will say, hey, show me how this value is accruing to Adobe shareholders as well and we certainly believe that otherwise we wouldn’t be doing it and we do believe that it will be value-generating for the Adobe shareholders. I think as it relates to XD and as it relates to Figma, I mean, we certainly, for designers, we are targeting what needed to happen as it related to screen design with the desktop product. I think the much newer market that emerged, which Figma effectively both addressed and pioneered was the ability to do this in a collaborative way and dramatically increase the scale, and they over the last decade, have really invested in and solve some of the hard technical problems that existed to make this happen on the web friction-free. So from our perspective, the Creative products continue to be strong, the ability to really tie the designers and developers is really where there’s this unique opportunity, as well as to create new markets. I mean I will give you one more sort of what-if scenario in terms of how we think about it, which is you combine what they have done with whiteboarding and ideation, and what will be the future of work, and if you think about the presence of Acrobat and what we have with Acrobat or if you think about the notion of brainstorming and what happens with FigJam, with what happens with Adobe Express, I think the opportunities are tremendous. I understand that there will be some sentiment associated with the price, and ball’s in our court to go demonstrate how we execute against our current initiatives, as well as to demonstrate the value of this new one."
},
{
"speaker": "Brent Thill",
"text": "Thanks, Shantanu."
},
{
"speaker": "Operator",
"text": "We can go to Keith Weiss of Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you guys for taking the question. One just a real brief one on Figma, I don’t want to beat that horse too much and then some questions on the core business. On Figma, we have definitely heard a lot about them in the field and it’s a great asset you guys are acquiring. It does seem like it overlaps pretty directly with InDesign. So can you talk a little bit about sort of the -- is there a rationalization of those two products or is Figma just kind of the go-forward product there? And then on the core business, last week -- not last week, last quarter you gave us a little bit of an update on kind of how pricing was impacted -- impacting Digital Media and net new ARR. I was hoping to get an update on sort of how the pricing impact flow through this quarter. And then on the margin front, it looks like you guys pulled back on hiring a little bit, can you talk to us about the pace of investments on a go-forward basis and whether that’s going to be a little bit more measured given the macro impact starting to build up? Thank you very much."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. I will start by talking about InDesign and Figma. They are very different products at the core. InDesign is around building print and publishing workflows and doing layout. Figma is really all about enabling product design and a collaborative product design model. In fact, if you look at InDesign, it’s our traditional base of users, predominantly designers that are using it. One of the things that’s really interesting about Figma is the makeup of their user base. In fact, two-thirds of their users are not designers, they are developers and other stakeholders in the process, and the foundation of that collaborative model is what makes this such a special and accretive acquisition for us. If you think about going forward, the primary focus is going to be about bringing Figma into the family and then taking all of the capabilities we have across illustration and video and creative imaging and building it on top of the Figma platform to enable a whole new generation of capabilities that are going to resonate with digital native and next-generation creative professionals, and we are very excited about them. The two products are quite different."
},
{
"speaker": "Dan Durn",
"text": "Yeah. Then from an investment standpoint, one of the great things about Adobe is, is we have got tremendous growth opportunities. We have got an opportunity to drive the core franchise to $30 billion to $40 billion of revenue. But we are going to do what we have always done, which is invest in a disciplined way and drive that growth with strong profitability and strong cash flow and so we will do what we have always done. We are going to orient towards growth. We are back utilizing our facilities. We are investing to scale our business. We are investing in our products, go-to-market marketing. We are driving PLG motions, but we are going to do it in a disciplined way that delivers strong profitability and cash flow, while growing this business in a strong and robust way. So we will do what we have always done, operating a disciplined business."
},
{
"speaker": "Keith Weiss",
"text": "Got it. And on the pricing side?"
},
{
"speaker": "David Wadhwani",
"text": "Yeah. On the pricing side, first of all, pricing for us is all about value. The business that we have been building is all based on new user acquisition, upselling, and of course, occasionally pricing moves and the pricing is always associated with added value. So on the Creative side we have been adding lots of apps. We have been enabling Frame.io integration into Creative -- into our Creative Cloud applications. We have been building a lot of share and review workflows, as an example, a lot of stock and content images in there as well and then on the Acrobat Pro side, we have been doing a lot more deep integration with Sign around bulk signatures, branding, web forms payments. So the foundation is that pricing is always connected to the real value that we are adding, and in doing that, we continue to see pricing play out the way we expected and all of this was baked into what we had planned for the year."
},
{
"speaker": "Operator",
"text": "Next question comes from Brad Sills of Bank of America Securities."
},
{
"speaker": "Brad Sills",
"text": "Oh! Great. Thanks so much. Another question here on Figma, it looks like the company is well positioned for designer, developer use cases, much like Frame.io for video editing, bringing you into more of those use cases really extending the reach for Creative Cloud. I guess the question is, where does Creative Cloud end up, where does that footprint end and the Figma footprint began? In other words, could you see a scenario where this acquisition and these use cases bring through -- pull-through more sales of Creative Cloud subscriptions?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think the three ways in which we look at that. First, in terms of the customers for Figma, I think, as David mentioned, the number of developers who are part of this products set is actually extremely extensive. But in addition to the product set associated with Figma design for developers, as well as stakeholders, I do want to again emphasize the product fit as it relates to FigJam for anybody who’s a knowledge worker and anybody who wants to ideate. So if you think about the value of ideation and brainstorming. I mean the reality is, they have tens of millions of people who signed up and trialed Figma. We have hundreds of millions of people who have used our products and so the adjacency in terms of enabling both of those combined sets of customers to use each other’s products, we continue to believe that drives great value. So this is really about, in our sense and then if you take Acrobat and the penetration that Acrobat has, everybody who’s using Acrobat also wants to both share, as well as ideate and brainstorm. So I know there’s a lot of questions around Figma design, which is clearly achieved escape velocity. I would urge you also to spend a little time looking at FigJam as I know you have and then you would really understand that, that also dramatically expands the customer base. So, yes, getting Creative Cloud to a more diverse set of customers on the web, allowing collaboration and enabling it much like you said with Frame. That’s very much part of the strategy and that’s why even in the press release, we talk about accelerating creativity on the web as one of the key pillars."
},
{
"speaker": "Brad Sills",
"text": "Thanks so much, Shantanu. Dan, one for you, please, if I could, you have talked about in the past some healthy pipeline build for Q4 backing your confidence for Digital Media ARR guidance based on some good pipeline activity there for Q4, any update on that, please? Thank you."
},
{
"speaker": "Dan Durn",
"text": "Yeah. No. It’s playing out as we expected as we take a look at the enterprise business, closing million dollar plus deals, transformational deals as we look forward off of that momentum into Q4. Pipeline is building nicely. Team is doing a good job executing against the opportunity and it’s playing out as expected."
},
{
"speaker": "Brad Sills",
"text": "Thank you so much."
},
{
"speaker": "Operator",
"text": "The next question is from Jay Vleeschhouwer of Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good morning. Shantanu, in some of your remarks and Dan in one of your bullet points regarding the rationale for Figma, you made some interesting references to their platform and accelerating your products on the Cloud. Are you suggesting perhaps that there’s something in their DevOps, let’s call it, that may lead ultimately to a material change in Adobe’s product release cadence or product packaging? How do you see your portfolio evolving and your underlying R&D, let’s call it, infrastructure or process, because there’s something into in terms of how they develop products that I think you are hoping to splice in that kind of DNA? And then, secondly, it’s not unprecedented for Adobe to purchase a dynamic competitor, we can go back many years, we have done this before. Maybe put this into context of some of those prior acquisitions where you bought a competitor that had meaningful either competitive impact or complementary technology and thinking, of course, about the material impact that the Macromedia acquisition had many years ago."
},
{
"speaker": "Shantanu Narayen",
"text": "So, Jay, let me first cover the first one and there’s no doubt that what Figma has been able to do on the web by solving a lot of these multiplayer high scalability requirements to allow the tens of millions of people to use Figma design and even more important FigJam on the web, is an engineering marvel. And having access to that technology and being able to take advantage of it to dramatically increase anybody who’s participating in our design products, whether they would be stakeholders and developers will, I think, dramatically increase our TAM as well. And so, first and foremost, their DevOps is great. I mean we certainly have a lot of that expertise on the Digital Experience side of the house as it relates to the trillions of transactions. But for the Creative, we really believe that this is one of the key pieces of technology that we are getting that are going to be really amazing. I think as it relates to your second question, we really view these as, when you have the right altitude, for us it’s all about how do you take things that might seem competitive, but are actually more complementary and expand the nature of the market. And for me, when I think about what we did with Macromedia, it was really about saying. We are going to target more graphics professionals and not just focus on imaging. We are going to focus on what’s happening with video on the web or gaming. And so I think it was an expansive part of how we looked at it. And that’s the same situation here. For us, it’s really not about what we had on the desktop. It’s really about expanding to the web. Multi-surface is something that we have talked about a lot. It’s about a community in many ways, Jay, and what they have done as it relates to their communities and plug-ins and how they have been able to use artificial intelligence, all of that also power we bring to bear to the combined. So from my perspective, this is really about adjacency. It’s about complementary things that we have done. Certainly, we did have a presence in screen design on the desktop. But big picture this is all about dramatically expanding it and that’s the conversation that David, Dylan, Scott and I have been having. And David, feel free to add to that."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. From the beginning of the conversations with Dylan, the primary focus has been on things that we couldn’t do individually. What are the things that we could do and bring to market that combining the two products and put -- two product sets into two companies could really enable a better-together story. And in particular, what we see is that we have this incredible wealth of technology and expertise around illustration and video and imaging and photography and 3D, all from -- coming from the lens of our flagship applications, and as Shantanu mentioned, they have built such a rich platform for collaboration. Bringing these things together allow us to re-imagine what the -- basically Creative -- content creation should look like in the future by taking our technology, integrating it on top of or building it on top of the Figma platform and then enabling a whole set of new use cases that would never have happened were it not for this combination."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "The next question comes from Saket Kalia of Barclays."
},
{
"speaker": "Saket Kalia",
"text": "Okay. Great. Hey, guys. Thanks for taking my question and congrats to all on the announcement. Dan, maybe for you, just to maybe focus on the core business for a minute and then loop in Figma. Are there any puts and takes with margins this year that we should keep in mind when thinking about organic margins next year, and of course, I understand you are guiding to it, but just sort of anything that you want us to note? And then on top of that, how do you think about the EBIT profitability for Figma and where that can go over time?"
},
{
"speaker": "Dan Durn",
"text": "Sure. So let me take them in order. So as we think about our margins this year, I think, you can see the trajectory throughout the year. What I would say is what we are seeing in the back half of 2022, I think, is more reflective of the normalized environment. We talked about continuing to invest in the products, how we market those products, how we drive product led growth, how we are going to market. But also complementing it with repopulating the campuses, being back to in-person interaction, getting on planes and that’s a bit more reflective of a normalized operating environment. So that’s what I would say, think about maybe the second half of 2022 as a bit more of a normalized environment. As we think about margins in the context of Figma and the transaction, we talked a couple -- about a couple of things. We talked about this is about growth. This is delivering that growth in a disciplined way. So when I think about operating margins in that context, we talked about the second half of 2022 being that baseline more normalized run rate. And if I think about the first couple of years post close, year one, year two post close. Think about margins that are maybe 1 point to 2 points delta versus where we would be on a standalone basis. And then by the time we get to year three, I would expect it to be more neutral from an influence standpoint. And again, I also want to register the point that I mentioned earlier in Q&A. As we get past year one, we are going to start growing EPS faster than our revenue growth profile and so we feel good about that inflection point and driving it in a disciplined way. When we look at GAAP operating margins, obviously, you will see a bigger delta in the near-term. To account for the stock-based compensation, we really view that stock-based compensation to incentivize the employees to stay with the company and unlock those growth potentials and you will see that amortize over a four-year period consistent with our equity programs and then we will be back to a more normalized run rate after that amortization period. So you will see more impact on the GAAP side and we feel pretty good about the trajectory from a non-GAAP operating margin standpoint."
},
{
"speaker": "Saket Kalia",
"text": "Very, very helpful. Thanks, Dan. Congrats again."
},
{
"speaker": "Dan Durn",
"text": "Thanks."
},
{
"speaker": "Jonathan Vaas",
"text": "Hey, Operator. We are coming up on the top of the hour. Let’s try to squeeze in two more questions please."
},
{
"speaker": "Operator",
"text": "Certainly. We can go straight to Phil Winslow of Credit Suisse."
},
{
"speaker": "Phil Winslow",
"text": "Hi. Thanks for taking my question. I just wanted to focus on a little bit more in the near-term in terms of your guidance for Q4. If we were in back to last year, you saw sort of a lower uplift around sort of the Black Friday selling period as compared to prior years. Now, obviously, going into this Q4 is always is you are a seasonally stronger business or enterprise spend period for Adobe, we are also going into that sort of that Black Friday period again, obviously. When you think about your guidance for Q4, what are you baking in compared to last year for sort of those Black Friday trends, but also that sort of seasonal uplift in the business spending?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think as we said in our prepared remarks, Phil, we are guiding in typical seasonality, Q4 tends to be a strong season both in terms of the enterprise business for us and closing the enterprise business and the pipeline that we have built over the year, as well as some consumer commerce days, as you mentioned and all of that is factored into the targets that we are guiding. We are not changing that based on anything different than we have seen. So I think we continue to believe that our business is resilient and if you look at the initial targets that we are providing, we would expect to have another strong seasonal close to the year."
},
{
"speaker": "Phil Winslow",
"text": "Great. Thanks, guys."
},
{
"speaker": "Operator",
"text": "And the final question today comes from Kirk Materne of Evercore ISI."
},
{
"speaker": "Kirk Materne",
"text": "Hi. Thanks very much and congrats on the acquisition. Dan, I just wanted to follow up on your comments maybe on the dilution around the deal. I think just based on what Shantanu and all of you have said about sort of the complementary nature of the deal, the ability to expand the market. I think people are asking why isn’t there more sort of synergy from a go-to-market perspective with this deal, meaning bringing Figma onto your platform would theoretically just turbocharge sales immediately given sort of your scale? So I just -- how much of that’s baked into the dilution forecast or are you -- I realize it’s early, but are you leaving that more for upside, because I think the length of the dilution given that this should be complementary from a go-to-market perspective, I think, is what’s somewhat confusing to folks? Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Well, certainly, for us, this is all about the top line growth and what -- if you look at actually what we would expect in terms of their continued growth and our continued growth, I think, the topline of both companies they would accelerate. And so I think maybe at the FA meeting, as we get more time, we are happy to share more color associated with it. But from my perspective, we actually think that we have a plan that allows us to really show the benefits of the combination, as well as continue to overachieve against those."
},
{
"speaker": "Kirk Materne",
"text": "Okay."
},
{
"speaker": "Shantanu Narayen",
"text": "And since that is the…"
},
{
"speaker": "Kirk Materne",
"text": "Yeah."
},
{
"speaker": "Shantanu Narayen",
"text": "Go ahead."
},
{
"speaker": "Kirk Materne",
"text": "Just a follow-up on that. I just -- too difficult for us to, meaning you both can grow faster, are these new developers that require sort of new efforts to go get them from Adobe perspective. I am just trying to get a sense of the overlap of the opportunity would seemingly think that you guys combined could actually do it more effectively together, which would create greater operating leverage to a certain degree sooner. So I am just trying to -- I realize there’s a lot of moving parts in the near term to this, but I was just kind of curious, is that what’s sort of embedded in your expectations or are you sort of leaving that for to see what happens as you get, I guess, a little bit closer to the deal closing?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think for us, we are just factoring in everything, including the fact that this is a stock purchase and half of it is approximately in stock and what that means in terms of dilution. As we said, we will start to offset that. We have tremendous cash flow generation. But from our perspective, we are going to be aggressive about making sure that we continue to drive the topline and the bottomline. And so that is very much on our mind in terms of delivering great value to the customers in the industry and creating new opportunities. And from my perspective, what I do want to say, since that was the last question was, first and foremost, we are really excited about our current business. I mean the current business is growing at a great clip in this macroeconomic environment. We have multiple growth initiatives that are all demonstrating how mission-critical they are and how they are relevant they are in this new digital-first world where whether it’s work, life, play, everything is going to be impacted by digital. So, first and foremost, we are very confident about our existing portfolio and the growth trajectory of the current portfolio. The addition of Figma, from my perspective, is the ability to turbocharge that in terms of both the opportunity that the company has, as well as the ability to serve ever broadening set of customers. And so I hope you all view that within that context, which is lot of confidence about our existing business and more excitement about making sure that we are setting in place greater future opportunities. We will look forward to having a lot of you at MAX. I hope you do come there. We are planning an FA part of that section as well and so we would be happy to share more with you when we join that. And with that, I will turn it over to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, Shantanu, and thanks, everyone, for joining us this morning. This concludes the call."
}
] | Adobe Inc. | 24,321 |
ADBE | 2 | 2,022 | 2022-06-16 17:00:00 | Operator: Good day and welcome to the Q2 FY 2022 Adobe Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s second quarter fiscal year 2022 financial results. You can find our Q2 press release as well as PDFs of our prepared remarks and financial results on Adobe’s Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, June 16 and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today’s press release and in Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as adjusted growth rates in constant currency. During this presentation, Adobe’s executives will refer to constant currency growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks Jonathan. Good afternoon and thank you for joining us. Adobe had a strong Q2 driven by the secular shift to digital that is transforming how we live, work and play. In Q2, we achieved a record $4.39 billion in revenue representing 15% year-over-year growth. GAAP earnings per share for the quarter was $2.49 and non-GAAP earnings per share was $3.35. In our digital media business we drove strong growth in both Creative Cloud and Document Cloud achieving $3.2 billion in revenue. Net new Digital Media annualized recurring revenue or ARR was $464 million and total Digital Media ARR exiting Q2 grew to $12.95 billion. In our Experience Cloud business we achieved $1.1 billion in revenue and Subscription revenue was $961 million for the quarter. The digital economy runs on Adobe’s tools and platforms. Customers from individuals and small businesses to the largest enterprises are using our products to unleash their creativity, accelerate document productivity, and deliver personalized customer experiences. Digital experiences from the apps on our devices to the digital documents we consume, Edit and Sign, to the personalized online shopping experiences is made possible by Adobe. Our mission to enable the world's digital experiences has never been more relevant, and we remain focused on executing our long term growth initiatives. We are delivering mission critical products that serve an ever increasing base of customers and we have a track record of strong growth and profitability. In my conversations around the world, it is clear that Digital is playing a pivotal role in powering the economy and enabling the world to keep moving forward. I will now turn it over to David to share more about our momentum in the Digital Media business. David?
David Wadhwani: Thanks, Shantanu, and hello everyone. Adobe products have always been the solution of choice for the world's creators, whether they're designers, photographers, filmmakers, or illustrators. Today, the explosion of the creator economy is enabling even more individuals, solopreneurs and small business owners to express themselves in creative ways. Whether it's a hobby, a side hustle, or a full time job, every creator and business is reimagining how they build their brand and engage their audiences in a digital first world, underscoring the rapidly growing demand for content and creativity. Adobe Creative Cloud offers the most comprehensive portfolio of products and services across every creative category, including imaging, photography, design, video, and 3D and immersive. We continue to invest across our core flagship products, including a heavy dose of new AI features. As demand for content increases, content creators are looking to Adobe to help them work together efficiently. We're responding by integrating collaboration capabilities directly into our flagship applications that enable creative teams to collaborate with each other, and with stakeholders. As communicators have become a growing part of our creative cloud customer base, we've expanded our offerings to include Adobe Express; our new template based easy-to-use web and mobile product. Express creates an opportunity to serve a broader base of communicators who need lightweight task based tools to create everything from social media posts, logos and flyers for their small businesses, to party invitations and posters for their personal needs. Real Estate entrepreneur Chrishell Stause is a great example of a social media influencer, who is leveraging Adobe Express to transform how she markets her properties and engages her followers. She is one of millions of users promoting their products and services with Adobe Express. In Q2, we achieve net new creative cloud ARR of $357 million and revenue of $2.61 billion, which grew 14% year-over-year. Q2 highlights include continued innovation in the imaging category. This quarter, we launched powerful new capabilities in Photoshop, including Photo Restoration neural filter that detects and restores damaged photos in seconds. Neural filters are one of Photoshops most used AI powered features. They have now been used by millions of users and apply it to hundreds of millions of images. We're also delivering enhancements to Photoshop on the web, including new editing features, support for mobile browsers and integrated learning content. Video Production also continues to explode, and Premiere Pro remains a leader in video creation, editing, and now collaboration with Frame.io. The new integration between Frame and Premiere Pro and After Effects is streamlining review and collaboration workflows across stakeholders. Frame had another strong quarter with new customer wins including Epic Games and NBCUniversal which are using it to manage their video content supply chain something that Anil will talk more about in a few minutes. We're also seeing the emergence of new categories like 3D as customer demand for metaverse ready content continues to increase. Substance 3D had its strongest Q2 ever as customers like Hugo Boss, Mattel, and Unity rely on it to deliver immersive experiences across fashion, gaming and e-commerce. We continue to rapidly innovate in this space, including delivering native Apple hardware support for painter, designer and sampler enabling creators to work faster than ever before. The Substance team also delivered a new SDK for developers who want to integrate 3D capabilities into their applications. And finally, we're excited about the momentum we're seeing for Adobe Express with millions of monthly active users and strong growth in traffic and new users in Q2. We continue to bring the magic of Photoshop imaging Premier Video and Acrobat PDF capabilities like background removal, QR code generation, video resizing, and PDF editing to Express, and we released our new content scheduler feature thanks to our recent acquisition of ContentCal, allowing creators to quickly create, preview, schedule and publish social media content. We're also excited to kick off our “Express Your Brand Partnership” with Meta, which will enable over 200 million businesses to grow their online presence using Adobe Express. And our product led growth strategy allows us to use millions of data points to continuously test, learn and optimize the entire Express experience from search to export. Adobe Express recently received the Editor's Choice Award on the App Store, recognizing top apps for design, functionality and performance. We're very excited about the strong demand for Creative Cloud offerings globally driven by acquisition, engagement and retention from our data driven operating model across individuals, SMBs and Enterprises. Key enterprise customer wins include Activision, Bertelsmann, Hasbro, Honda Motor, Daimler AG, and CSOFT, Services Australia, State of California and WPP. In our Document Cloud business, digital document workflows are automating manual paper processes across our personal and professional lives. Whether it's a legal contract, invoice, or school permission slip, we now need to scan, edit, share and sign from anywhere. Adobe Document Cloud offers the most comprehensive intuitive tools for document productivity across every device and platform. In education, the University of East London is adopting Document Cloud to manage workflows for enrolling 17,000 students from 135 countries. In financial services, TSB Bank is transforming the online banking experience by enabling customers to quickly and securely complete common tasks like loan applications that could previously only be done in branches. In Q2, we achieved net new Document Cloud ARR of $107 million and record revenue of $595 million, which grew 28% year-over-year. Q2 highlights include strong growth in monthly active users across desktop, mobile and web. The rising volume of search traffic for Acrobat verbs remains a productive funnel to Acrobat web, which surpassed 50 million monthly active users in Q2 more than doubling year-over-year. Mobile App momentum remains strong with billions of PDFs opened in Acrobat mobile, and hundreds of millions of cumulative Adobe scan installs. Acrobat and Adobe sign integration continues to drive strong demand for Adobe sign as users increasingly send PDFs for signature directly from the unified Acrobat experience. Acrobat and Adobe Express integrations now give hundreds of millions of Acrobat users the ability to embed customized templates and make their PDFs visually stunning. And Acrobat and Sign API's are thriving as customers increasingly customize, integrate and automate document services. We're thrilled with the momentum we see in the Acrobat ecosystem, and our business performance across routes to market and customer segments, including key enterprise customer wins with automatic data processing, Duke Energy, Quanta services and U.S. Bank. We continue to see strong demand for our products in the second half of FY 2022 will continue to win in the digital media business through product innovation across Creative Cloud and Document Cloud, which are targeting a broad growing base of customers. Our tremendous scale, consistent marketing investments, proven data driven operating model and new product lead growth initiatives are accelerating our momentum across our new and established businesses. I'll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello, everyone. Even in this uncertain economy, every business continues to prioritize its digital investment. Our June Adobe Digital Index report, which leverages trillions of data points from Adobe analytics found that consumers spent a billion dollars more online in May, compared to April. Year-to-date, shoppers have spent over $377 billion online, which is roughly 9% more than the same period last year. Driving this digital momentum is the imperative for personalized customer experiences at scale. Adobe Experience Cloud is the leader in the Customer Experience Management category, offering a comprehensive set of integrated applications and services, spanning data insights and audiences, content and commerce, customer journeys and marketing workflow. Built natively on Adobe Experience platform, our real time customer data platform, real time CDP provides businesses with a single view of their customers data across every channel, allowing them to create precise segments and deliver personalized experiences, regardless of when and where a customer interacts with their brand. Adobe delivers real time data with more than 24 trillion audience segment evaluations per day. The Home Depot is the latest in a large and growing set of industry leading customers who are adopting Adobe's real time CDP as the underlying platform to power their digital business. Real Time CDP provides a comprehensive view of the Home Depot's customers across e-commerce, mobile and in-store purchases, enabling them to build customer loyalty and grow their business. In Q2, we continue to drive outstanding experience cloud growth, achieving a record $1.1 billion in revenue. Subscription revenue was $961 million for the quarter, representing 18% year-over-year growth. Q2 highlight include native integration across real time CDP customer journey analytics and Adobe journey optimizer, which is a significant differentiator, allowing brands to orchestrate, measure and optimize the entire customer experience. New innovations such as segment match enable brands to securely share customer segment data with business partners while respecting customer privacy. Major enterprises are adopting real time CDP as the platform of choice with key customer wins this quarter, including Autodesk, National Football League and U.S. Bank. Expanding experience cloud leadership in the healthcare industry by making Adobe journey optimizer and real time CDP HIPAA-ready through healthcare shield. This quarter’s customer win with CVS is a great proof point of this massive market opportunity. New services in Adobe analytics, delivering a single workspace for brands to unify data and insights from new media types such as 3D and streaming media with traditional channels to get a holistic view of customer engagement with customer journey analytics. Strong adoption of Adobe Experience Manager for unified content management, demonstrating Adobe's leadership in helping businesses effectively manage their content supply chain from creation through delivery. Tremendous growth in demand for partner and Adobe Professional Services, underscoring the urgency for implementation and value realization and key customer wins including Audio book [ph], Anthem, Bank of Nova Scotia, Humana, McDonald's, Stellantis, and Toyota. Reinforcing our leadership position, Adobe continued to receive strong industry analyst recognition, including being named number one by Gartner for both the marketing sub segment of customer experience and relationship management and digital experience platforms. We've also named the leader in the inaugural IDC MarketScape for worldwide retail and CPG customer data platforms and the IDC MarketScape for professional services. Looking ahead, our category leading solutions, strong pipeline and tremendous scale through our partner ecosystem, position us to deliver personalization at scale across every industry and drive strong growth in the second half. Dan, over to you.
Dan Durn: Thanks, Anil. Today, I will start by summarizing Adobe’s performance in Q2 fiscal 2022, highlighting growth drivers across our businesses, and I’ll finish with targets. Adobe delivered a strong quarter, surpassing our issued Q2 financial targets in an uncertain macro environment. On the top line, we grew revenue by 14% year-over-year, or 15% in constant currency, while making long term growth investments, we delivered operating margins of 35% on a GAAP basis and 45% on a non-GAAP basis continuing to be one of the most predictable and profitable growth companies in technology We have three strategic businesses growing into massive addressable markets, with differentiated products used by hundreds of millions of individuals every month. In addition to our established businesses, we are delivering innovations and new offerings that will drive transformational growth in the future. Q2 business and financial highlights included record revenue of $4.39 billion, GAAP diluted earnings per share of $2.49 and non-GAAP diluted earnings per share of $3.35. Digital Media revenue of $3.02 billion net new Digital Media ARR of $464 million. Digital Experience revenue of $1.10 billion cash flows from operations of $2.04 billion. RPO of $13.82 billion exiting the quarter, and repurchasing approximately 1.9 million shares of our stock during the [Technical difficulty] 15% year-over-year revenue growth in constant [ph] currency. We exited the quarter with 12.95 billion of Digital Media ARR. We achieved creative revenue of $2.61 billion which represents 12% year-over-year growth or 14% in constant currency. We added $357 million of net New Creative ARR in the quarter, a sequential increase of 13% from Q1. Second quarter creative growth drivers included continued strength in acquisition, engagement and retention across our customer segments. Momentum in the small and medium business segment, where our team's offering continues to drive new customer acquisition. Demand for our flagship products including Photoshop, Illustrator and Premiere. Mobile applications where our Ending ARR grew greater than 30% year-over-year exiting the quarter. Adobe Stock where we saw strong book of business growth across organizations and new customers and momentum. And momentum in new businesses with strong growth and Frame IO as well as our substance offerings, which grew Ending ARR greater than 60% year-over-year exiting the quarter. Adobe achieved Document Cloud revenue of $595 million, which represents 27% year-over-year growth, or 28% in constant currency. Document Cloud continues to be our fastest growing business given the relevance and importance of PDF the knowledge workers around the globe. We added 107 million of net new Document Cloud ARR in the quarter. Second quarter Document Cloud growth drivers included continued strength and acquisition engagement retention for Acrobat across our customer segments. Momentum in the small and medium business segment and the reseller channel continuing to drive New Document Cloud subscriptions. Continued growth of searches online for document actions funneling millions of new customers into our document franchise through Acrobat Web. Strength in mobile with Ending ARR growing greater than 40% year-over-year exiting the quarter, and strong adoption of Acrobat with integrated sign capabilities within organizations of all sizes. Our document business also had a strong quarter and sales of Acrobat perpetual licenses. Turning to our Digital Experience segment, in Q2, we achieved revenue of $1.10 billion, which represents 17% year-over-year growth or 18% in constant currency. Digital Experience subscription revenue was $961 million representing 18% year-over-year growth. Second quarter Digital Experience growth drivers included strong growth in our Adobe Experience platform business or AEP with real time CDP revenue more than doubling year-over-year. Increase in customer interest and pipeline generation for new applications built on AEP, including real time CDP, customer journey optimizer and customer journey analytics. Success with Workfront where average deal sizes grew greater than 35% year-over-year, continued customer demand and content and commerce with significant new customer acquisition and Adobe Experience Manager as a cloud service. Enterprise demand for Adobe Professional Services, driving customer success and new implementations across our solutions and strength and retention rates during the quarter driven by product differentiation and our focus on delivering customer value. Our strategy of enabling enterprises to activate first party data to provide personalization at scale in real time is resonating with customers driving our continuing digital experience growth. In Q2, we continued to focus on making disciplined investments to drive growth, including marketing campaigns and headcount additions in our R&D and sales organizations. We're pleased with our success in talent acquisition during the quarter in a competitive market. Adobe's effective tax rate in Q2 was 21% on a GAAP basis, and 18.5% on a non-GAAP basis. The increase in the GAAP tax rate is primarily due to the lower than expected tax benefits associated with stock based compensation and geographic mix of earnings. RPO exiting the quarter was $13.82 billion growing 13% year-over-year, or 15% year-over-year when factoring in a 2% foreign exchange headwind. Our ending cash and short term investment position exiting Q2 was $5.30 billion in cash flows from operations in the quarter were $2.04 billion. In Q2, we repurchased approximately 1.9 million shares at a cost of $800 million. We currently have $9.5 billion remaining of our $15 billion authorization granted in December 2020, which goes through 2024. We will now provide Q3 targets as well as an update on the annual targets we provided in December factoring in the following four items. First, in March, we stated that as a result of lower than expected tax benefits associated with stock based compensation, our effective tax rates would increase in fiscal 2022. Second, in March, we outlined the impact of the on-going war in Ukraine, and our decision to cease all new sales in Russia and Belarus, resulting in an expected $75 million revenue impact on our digital media business. Third, as a result of the continued strength of the U.S. dollar, we are now factoring in an incremental effects headwind of $175 million across Q3 and Q4 revenue. And fourth while demand for our products remains strong, we now expect the second half of the fiscal year to show more pronounced summer seasonality in Q3 and the enterprise business with a stronger sequential increasing Q4. As a result, for Q3 we are targeting total Adobe revenue of approximately $4.43 billion, net New Digital Media ARR of approximately $430 million. Digital Media segment revenue growth of approximately 13% year-over-year, or 16% in constant currency. Digital Experience segment revenue growth of approximately 12% year-over-year, or 14% in constant currency. Digital Experience subscription revenue growth of approximately 13% year-over-year, or 15% in constant currency; tax rate of approximately 22.5% on a GAAP basis, and 18.5% on a non-GAAP basis, and GAAP earnings per share of approximately $2.35 and non-GAAP earnings per share of approximately $3.33. For fiscal year 2022, we're now targeting total Adobe revenue of approximately $17.65 billion. Net New Digital Media ARR of approximately $1.90 billion. Digital Media segment revenue growth of approximately 12% year-over-year, or 17% on an adjusted basis. Digital Experience segment revenue growth of approximately 14% year-over-year, or 17% on an adjusted basis. Digital Experience subscription revenue growth of approximately 15% year-over-year, or 19% on an adjusted basis. Tax rate of approximately 21% on a GAAP basis, and 18.5% on a non-GAAP basis, and GAAP earnings per share of approximately $9.95 and non-GAAP earnings per share of approximately $13.50. In summary, I'm pleased by the way Adobe executed in Q2. We are driving growth across Creative Cloud, Document Cloud and Experience Cloud with momentum in our established businesses and early success in our new initiatives. As a result of our disciplined operating model and focused execution, we were able to dramatically reduce the expected impact of increased tax rates and FX headwinds on our EPS. The investments we're making today in people, products and marketing will enable us to drive strong growth for years to come. And we are on track for another year of record revenue and operating cash flows. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. We are proud of our strong Q2 performance across Creative Cloud Document Cloud and Experience Cloud. Adobe remains one of the greatest places to work in the industry. And I want to thank our employees for their relentless dedication. This quarter, Forbes named us a top employer for college graduates, and we were ranked on their list of America's best employers for diversity. I'm thrilled to welcome our largest cohort of interns and university graduates this summer. Demand for our category defining products and services continue to grow. We're innovating at rapid speed for new and existing customer segments, accelerating our leadership in established categories, and seeing strong momentum for our newer initiatives. Our strategy remains to focus on long term growth initiatives while delivering world class profitability. Our business fundamentals and market tailwinds are strong. And I've never been more confident in our ability to execute on the $205 billion market opportunity ahead of us. I will now turn it back over to Jonathan.
Jonathan Vaas: Thanks, Shantanu. Adobe MAX, our creativity conference will take place during the third week of October this year in Los Angeles. On day one at MAX on Tuesday, October 18 we plan to host the financial analyst meeting. Invitations including discounted registration information will be sent to our analyst and investor email list later this summer. More information about the event can be found online@max.adobe.com. We would now be happy to take your questions. And we ask that you limit your questions to one per person. Operator?
Operator: Thank you. [Operator Instructions] And we will go to our first question from Kirk Materne of Evercore ISI.
Kirk Materne: Hi guys, thanks very much and congrats on the strong results. Shantanu and Anil I was wondering if you guys could just talk a little bit about the type of conversations you're having with your enterprise customers these days, given the macro backdrop. Are you seeing any hesitancy to spend? Obviously, you guys are keeping your full year guidance, despite all these headwinds, but I was also just curious if there's any change in kind of the type of deals your is it more smaller deals but more deals? Or is the product mix changing at all on the experience cloud side? I was just wondering if you could give us some color on that because that obviously remains a very primary concern for folks these days. Thanks.
Shantanu Narayen: Thanks Kirk. Yes, we are pleased with what we saw in the quarter. In the conversations that we're having, both Anil and I would first say that the interest level in executives all around the world, is very high. Unlike last time, I would say right now, the focus is also a lot on execution. So a lot of the investments that people have made in digital, they recognize that given how critical the imperative is to engage with customers digitally. So we're actually pleased both Adobe as well as if you look at the entire systems integrator and partner network, they are finding that there's a lot of demand for implementation on Adobe products. I think the other part of the conversation that you all have with enterprise CEOs right now is they all recognize it's an uncertain time. And that's the conversation that we have. But despite that uncertain macroeconomic environment, the thing that all of them recognize is that Digital is a priority. And they really want to continue to have conversations with us as to how they can do Digital. I’ll have Anil maybe add a little bit of what he's seeing across different verticals as well. But the importance of digital remains undiminished.
Anil Chakravarthy: Yes thanks Shantanu. Just to add a little bit on the vertical color, we were really pleased with some of the wins we had in Q2. If you look at the automotive and what we had with Daimler over in Europe, where we continued our strength in sports media and entertainment with NFL, which is using the real time CDP for personalization at scale across their fan base. And in healthcare, where we had a really important win with CVS. That was a great validation of all the HIPAA readiness we built into our platform So that opens up a big market opportunity. So we were really pleased those wins and as you said digital continues to be a priority. And we're seeing that in the pipeline for the second half.
Operator: And, Kirk, did you have anything further?
Kirk Materne: No, that was that. I'll keep to my one question limit. Thanks, guys.
Operator: And we'll go next to Brent Thill of Jefferies.
Brent Thill: Good afternoon. Dan, I was curious if you could just comment on the more pronounced summer seasonality. What are you seeing this year versus perhaps in past years, and just a quick follow up on the numbers? The net new ARR guide was down Q2 to Q3. And I think last quarter; you said it would be up? Do we misinterpret what you said last quarter? I just want to make sure we clarify that. Thanks.
Shantanu Narayen: Yes, Brent, the way I would describe it as we had a strong first half, and we actually continue to see a strong demand for our unique solutions. And all of our new initiatives as well as the established businesses are doing well. I guess what we're also paying attention to is, what we all read as part of the macro environment. And when I look at what we expect for our second half, the confidence remains undiminished. The question really for us is timing. And maybe we're being a little cautious as it relates to what happens, given the summer seasonality, as Brent better than most is, sort of the July and August. So as it relates to our second half pipeline, the confidence remains undiminished. And we're just maybe a little cautious as it relates to timing. In terms of what we had said, in March, you're right, we had sort of alluded to the fact that we would have expected some sequential increase; clearly we had a strong Q2. But that's part of the reason why we wanted to give a little bit of color and be transparent on how we see it. And as you notice, we reaffirm the $1.9 billion for net new ARR for the year.
Brent Thill: Thanks, Shantanu.
Operator: And we'll go next to a question from Brad Sills of Bank of America.
Brad Sills: Oh, great. Thanks, guys, for taking my question. I wanted to ask about Creative Cloud Express. You mentioned some new features here imaging video, editing for Acrobat, it seems to me like those are, would be considered typically premium features. Is there any change in strategy with Creative Cloud Express as to where you see that playing in different segments of the market? Thank you.
David Wadhwani: Yes, thanks for the question. First of all, we're really thrilled with the reception of Creative Cloud Express, Adobe Express into the market. And frankly, it's been a lot of fun for us because it's a product that everyone at Adobe can also be using, it's amazing to see the creativity coming out of finance and legal for example. As a reminder, just to sort of up level for a second, we've been focused on the communicator and creator economy, ecosystem for years. In fact, we believe that we're the largest provider of creative tools to professionals and communicators on the back of our core products. So I want to just make sure people recognize that the core products are playing to this incredibly large market, where we see Express filling in is that Express is additive and broadens the region, that new communicator base, because of exactly what you're saying the freemium business model, there's zero friction onboarding, it's clearly showing that we're able to attract millions of new users into the franchise. And we're able to do it very efficiently by optimizing how we onboard customers from search terms that typically were not ones that we've focused on in the past. We also look at the ability to onboard those users and differentiate the offering, with the integration of these amazing features that we get from the from the desktop applications like Adobe magic. And all of this helps differentiate what we're doing with Express. And if we take a step back and look at it from a business perspective, we feel very confident that Adobe Express and the way we actually pull people into that funnel is additive to the market opportunity that we're playing. So we're really emphasizing the ability to add more capabilities there and differentiate there. I do also want to remind folks that that Express is also available to core Creative Cloud customers. And by integrating some of those features into Express, we're enabling workflows between the core Creative Cloud products and also Express and we believe that's going to have a strong retentive value on the core base and we just had, in fact, a great quarter with very strong retention for Creative Cloud as well.
Brad Sills: Thank you so much.
Shantanu Narayen: Brad maybe if I were to add, I think the team is actually having a lot of fun with all these cool features. To your point, they're showing some incredible stuff as part of the quick actions. But if you look at the depth of what they have, I mean, there is so much behind the scenes that we will be able to monetize. But clearly the focus is on usage right now, as David said. It's been fun.
Brad Sills: Great to hear. Thank you so much.
Operator: We'll go next to Alex Zukin of Wolfe Research.
Alex Zukin: Yes, hey guys, thanks for taking the question. I guess maybe just a two part. The first one, we've talked, I think a lot about pricing tailwinds during last quarter in terms of the impact for the year, and I guess can you help us just quantify the impact that you're anticipating for Q3 and Q4. Because it does, it does look to start ramping here pretty meaningfully. And then Shantanu, I guess, maybe just for you with respect to the strategic approach to M&A and kind of what's on the horizon, given the change in valuation paradigms in the market, how important is either large strategic M&A to the growth profile of the business versus tuck-ins?
Shantanu Narayen: I think as it relates to your M&A question, and then David could certainly answer the other one, clearly valuations to your point have changed quite a bit. And the first thing I'll start off by saying is, we're really pleased with our portfolio. If you look at some of the new initiatives, and we've touched on that, whether it's Adobe Express, whether it's the real time CDP customer journey analytics, what we're doing with things on the web, including PDF, we feel really good. I do feel Alex that there are going to be a number of small single product companies that are probably not going to survive, what's happening. And the valuation sort of multiple changing is actually I think, good for a larger company like Adobe. So I, it doesn't feel like we need anything, but we will always be on the lookout for things that are additive, that are adjacent, and that will provide great shareholder value and our metrics associated with ensuring great technology, great cultural fit, and adjacency remain. But we have so much going on within the company that we're excited about our current portfolio, clearly, things will be more reasonable in terms of M&A as well.
David Wadhwani: And on pricing, Alex, you're right. We did sort of introduce a modest price increase to a portion of our customer base in Q2, the new prices were in market for about a month and drove a little under 10 million of benefit, which is exactly what we were expecting. And as you can see, it's a very small part of the 464 million that we drove in Q2. Customer reaction overall to this has been good, because we've added so many new features since the last price update that it's been very positive overall. And in fact, if we get asked anything by analysts, it's why we didn't make a bigger price increase. And the reality there is we're primarily focused on adding millions of new users. We are a growth business. We want to continue to grow the user base. And we believe that with the initiatives we have around both the core and the new products, we want to run the business through acquisition of new users engagement and retention.
Alex Zukin: Got it. And sorry, Dan, just maybe just the impact on Q3 that you're anticipating in the guide for net New ARR on pricing?
David Wadhwani: Yes, that we want to provide that as part of the guide. I think the metrics that David gave you, around Q2, give you a good sense of the expected actions that we anticipate going forward.
Alex Zukin: Thank you guys.
Operator: And we'll go next to Saket Kalia of Barclays.
Saket Kalia: Okay, great. Hey, guys, thanks for taking my question here. David, maybe just to stay with you, given the questions on macro, I was wondering if we could go one level deeper into the makeup of Creative ARR. We have the very helpful disclosure from analysts say the single app versus the all-out mix, which is helpful. But how do you think about the mix from maybe consumers versus professionals if there's a way to break that down? Because of course, right now, there are lots of questions just about the health of the consumer. How do you think about that mix? And how do you think about maybe the defensiveness or the retention rates on both of those different cohorts? Does that make sense?
David Wadhwani: Yes, it makes perfect sense. Yes happy to take that one. So at a high level we think about the business through obviously multiple segmentations. But as you're looking at it, we think about it as enterprise buyers, midmarket and SMB buyers, communicators and consumers. So we have a very broad and diverse portfolio, which has served us very well in the past. And, and as you as you are alluding to, we've been through multiple recessions before so we have some good insight into how these different cohorts respond to difficult financial times. And overall, we fared very well. Enterprises we've talked about, you heard Anil and Shantanu talk about content is fueling the digital economy and needing to stay very focused on their digital investments. From a pro market perspective, we have professionals that are making their living using our products. So we feel very good about that offering, as well. From a communicators perspective, they tend to be either working in departments or small businesses, or they're part of this growing movement around the creative economy. And they're aspiring to make money or build followers with that. So it's an essential part of their, their toolset that they're going to do to grow their side hustle in their activities. And as it relates to the consumer businesses, we've been very thoughtful with pricing there, and have had very attractive pricing that we think has fared very well for us in the past around, through recession. So, overall, we think the business is diverse, and we see the business is very resilient.
Saket Kalia: Very helpful. Thanks.
Operator: And we'll go to our next question from Karl Keirstead of UBS.
Karl Keirstead: Hi, thanks very much. I'd love to ask about the digital experience guide. You said it for 14% in the third quarter, that's down about four points in constant currency from 18% in May, and is the lowest and a bit. I know it's a tougher comp is, is that the issue? Or is there anything else to call out on the DX business? Thanks a lot.
Shantanu Narayen: Nothing Karl to call out. I mean, if you look at what our targets are for the year, and if you look at it in terms of what we would expect, for both subscription and total revenue we’re in effect saying exactly the same at the beginning of the year, in what's a really tough economic environment. So the interest in our solutions remain strong. I also wanted to maybe add to a little bit of what David said to for Saket. The consumer sentiment that we continue to hear from banks, such as yourselves, is that the consumer sentiment actually continues to remain strong, both in the U.S. and in Europe. So I didn't want to have anybody feel like that's not what we're seeing as well.
Karl Keirstead: Thank you.
Operator: And we'll move to our next question from Jay Vleeschhouwer of Griffin Securities.
Jay Vleeschhouwer: Thank you. Good evening, I'd like to ask about two important attributes of your product led growth strategy. First, could you comment on the contribution from or expectations for what you call your application and intelligent services? Is that becoming meaningful at this point? And then secondly, at Summit a couple of months ago, and again this evening, we heard multiple examples of integration within and across your segments, which is long standing Adobe practice. But we've heard a great deal more about that the last couple of years. Could you comment on which of the many integrations you think either in terms of addressable market, or your own sales capacities might be the most meaningful over the next number of quarters and years?
David Wadhwani: Thanks. Thanks for the question, Jay. In terms of the application intelligence services, it fits really well into the portfolio of our Adobe Experience platform based services. So just to recap, we have three major services the real time CDP customer journey analytics, and the journey optimizer. And what we have done is really integrated these intelligence services as part of these applications that run natively on the Adobe Experience platform. And where that has been extremely valuable to us is, we have a broad base of customers through our digital experience portfolios, for example, with Adobe analytics, we have that's been the gold standard for a long time on for web traffic analysis and trends and insights. And with customer journey analytics, our enterprise customers can now get a 360 degree view of everything that's happening across the customer journey, whether it's web traffic or, or through mobile apps, social call center, and so on. And that's where the intelligence services really fit in, to really be able to expand the portfolio and derive value from how you segment those into audiences and activate them.
Jay Vleeschhouwer: Okay and the second part of the question
David Wadhwani: If you could repeat the second part of the question please?
Jay Vleeschhouwer: Oh, sure. I was trying to get some insights into which of the many integrations that you've done either within or across your segments, whether it's Digital Media DX, or combinations thereof, you think had had or will have the most meaningful impacts, assuming that not all of these integrations are created equally.
Shantanu Narayen: I’ll start off maybe on that particular question, Jay, because one of the areas that we're seeing just tremendous interest is what we are referring to as content supply chain. And both David and Anil can touch on that as well, a little bit more. But this notion of people creating campaigns, if you agree with us that the greatest value that we can provide is enabling every enterprise to do personalization at scale, the amount of content that's being created, the amount of content that's being delivered, and to understand the efficacy of the campaigns, is just absolutely top of mind. I mean, we have a large, large consumer company that has completely consolidated all of their marketing activity to really understand what this content supply chain is. And so the notion of content supply chain, and what we can do between our creative applications, the asset management that we deliver, the website and what we are doing with AEM Experienced Manager, that and work front to be able to do workflow associated with that, that is really resonating with every single customer right now.
Jay Vleeschhouwer: Great, thank you.
Operator: And we will go next to Keith Weiss of Morgan Stanley.
Keith Weiss: Thank you guys for taking the question. I have a question for Dan. And it's about sort of the guidance philosophy. And that these are what a lot of people are trying to get at is understanding holding the Digital Media ARR guide at 1.9 billion for the full year, despite the kind of increased seasonality in Q3, despite the fact like the street kind of gave you a pass, we've already taken our numbers down to like 1.8 billion. Why keep that risk out there? Why push more risk into Q4? Why put a high bar out there when obviously, it's not in the stock? All the stocks are getting killed here. It's not in our expectations, like, what is it that gives you so much confidence to like, keep that number out there.
David Wadhwani: So I guess where I'd start is, if you take a look at where we are in, in the first half, I would say the performance of the businesses is really good. We talked about it earlier conversations with the customers, what we're seeing in data and DDOM and the insights that it gives us, we see strength into the back half of the year. So we're confident in the underlying performance of the business. And, I'd go back to the earlier comments, we see the headlines we see what others are talking about. And so in an environment like this, maybe we're a little cautious about Q3, I think that's the prudent way to go. But it doesn't take away from the insights we have and the belief we have and confidence in the underlying performance and the strength we see into the second half. And so I think we've taken everything into account. And we've got the right set of targets out there that reflect what we're seeing in the business and how we expect to perform.
Keith Weiss: Got it. And I mean, any visibility into what gets better in Q4 that that's kind of enabled it because you're looking for net New AAR to go from basically down in the first half of the year to growing in the back half what, what could you give us any kind of visibility to like, what gives you guys that confidence?
Shantanu Narayen: If you look at the rhythm of how we’ve managed the business, certainly, you look at what happens with education in Q4, you look at the enterprise, which tends to be a seasonally strong Q4. You start to look at what's happening with the emerging businesses that will continue to ramp. And so, it's a combination I think somebody else alluded to pricing, and we'll have a full quarter of pricing as well. And so, when you put all of those together, every Q3 to Q4 we see a seasonal uptick. And if you look at what happened even last year, and you look at what the numbers look like it's something that we know we're going to go drive.
Keith Weiss: Got it. Thank you.
Operator: And we’ll go next to Tyler Radke with Citi.
Tyler Radke: Yes, thanks for taking the question. I wanted to ask you about the CDP space. I think you talked about your revenue, they're doubling year-over-year. I guess just a couple of questions. Number one, how significant is CDP as part of the overall experience businesses is a growth driver; and two, could you just talk a little bit about the competitive landscape. This is something that Sales force talked a lot about, on their last earnings call. We've seen amplitude recently launched a CDP. So how do you kind of see all this evolving? And how do you think this plays out? Thank you.
David Wadhwani: Thanks Tyler. Yes, but let me take the big picture first on what we see with the overall CDP market. First of all, all the interest in CDP is a great validation of the fact that the traditional CRM is not the way to go to build the next generation, customer experience. Some of the data might be there, but you really need to activate the data and construct a rich profile before you can activate that. So if we look at the CDP market, what we see is, from our perspective, it's the platform for full customer engagement. And then that involves a number of different components. You look at the data collection that's required. And we built a lot of connectors, not only with our apps, we have over 100 connectors out there for the data collection, then you need to be able to assemble that into a real time database so that you can make the next best action the next best offer. We call it personalization at scale to millions of people in milliseconds. And that real time customer profile needs to be activated. And third, it then becomes the platform for not just the apps in our portfolio. But then for example, the integration we have with Dynamics, for example, with customer service, or the integration we have with ServiceNow, and so on, it needs to become the customer data platform that serves the entire range of customer facing applications. That's the way we look at CDP. That's what makes it a broad and exciting market. And that's really where we're differentiated where when we talk to customers, I mean, I'll give you the examples of say CVS, and NFL and so on, they recognize and agree with that vision. And that's why they're betting on us. And most of the players you see do one piece of it and don't really have the either the comprehensive nature of the product in their portfolio, or the real ability to pull it off in a true real time manner.
Shantanu Narayen: Maybe the one thing I would add to all of that is, we have 32 billion profiles right now. I mean, clearly every customer has their profile kept isolated. So we're clearly the leader as it relates to you know, large companies that have a CDP in the market. That's well done.
Tyler Radke: Thank you.
Operator: And we'll move next to Gregg Moskowitz with Mizuho.
Gregg Moskowitz: Okay, thank you for taking the question. Can you talk about the Express Your Brand program, obviously, Meta has huge small business reach, but it will be helpful to get your expectations on what this partnership will do for Adobe incrementally. Thanks.
David Wadhwani: Yes, so happy to do that. It's been a it's actually a very exciting program for us. So as you know, Adobe Express is predominantly focused on communicators, small medium businesses, as they start to move more online. We've talked a lot about the rise of the creative economy, we've mentioned that there are hundreds of millions of small medium businesses that are really targeting more online communication and really focus on social media, in fact that in a recent survey, we found that the majority of small medium businesses actually say that their online presence is more important than their physical presence. And so they need to do coordinate and communicate digitally and our ability to provide with meta provide all the tools that they need end-to-end to build incredible content that stands out and participate in the online experience that that meta is providing. And, of course, also work more broadly across all the other social networks, I think, is a really great opportunity for meta, for us and certainly for the small medium business owners that are part of that program.
Gregg Moskowitz: Okay, thank you.
Jonathan Vaas: Hi, operator, we're coming up on the top of the hour. We'll take two more questions, please.
Operator: Thank you. We'll go next to Kash Rangan of Goldman Sachs.
Kash Rangan: Hey thank you very much, Shantanu and team. This upcoming maybe recession is the one that everybody has been predicting. And the company has, as David said, has been through a couple of recessions before. The company's a very different company today than it was even just a few years ago. What is your best prognosis as to how the portfolio of Adobe products behaves if we are to enter a downturn, not that we wish it but if we are to enter one, how do you think the portfolio is positioned? And in the financial angle are you prepared to at all slow down firing? The beauty of the subscription model is that the instant start on hiring and produce nice margin upset that sort of thing from a financial perspective, but curious to get your thoughts overall on this particular topic
Shantanu Narayen: Sure, let me first cover your second part cash as it relates to the bottom line. And our philosophy right now, given all of the myriad opportunities that we have is, we're planning for the upside, we know how to react to the downside, when that happens. I mean, look at what's happened with the tax rate, and the team, and the financial team and the product teams, what they were able to do to really address all of that is truly remarkable. I mean, we take it for granted at the company, but we've done an amazing, amazing job at continuing to be extremely profitable. For me, I think, when you talk about a recession, the question I ask people is, when you look at the three things that Adobe does, which is focus on content, focus on automation, focus on customer engagement, I just don't look at any of those and feel like the secular trend for that will change. So there may be some change in the rhythm of that quarter-over-quarter. But the fundamental shift of what we are doing, I mean, Anil talked about this real time CDP customer engagement is going to be the only thing that differentiates a business from another business, and the success that we're seeing in healthcare, clearly points to that as well. So, we’ll navigate it, we have an incredibly experienced management team. We're planning for the upside right now, which is all of our growth initiatives and will react as appropriate. And we are clearly not going to be in denial. But right now, it feels like a very strong time for Adobe to continue to execute against the things that we have on our plate.
David Wadhwani: Yes, just want to build a little bit on the first part of Shantanu’s answer. We talked about offsetting some of the headwinds we see. We talked about the increase in tax rate. We talked about the FX headwind into the back half of the year. In Q1, we discussed the impact we were seeing from the war in Ukraine. When we take the effects and the impact we discussed in Q1, that's a $250 million revenue, headwind in the back half of the year, the increase in tax rate is about a $0.25 a share impactful year. When I net both of those together, we would expect to see about $0.60 to $0.70 a share erosion of the earnings power of the company. And to Shantanu’s point, it really underscores a philosophy that's underpinned how this company has operated for a very long time. It's about focused execution. It's about operating discipline. And the fact that the full year targets have come down $0.20 when the map would suggest it should be much greater than that just really underscores the power of the model. We're investing for innovation. We're investing to serve our customers, but we're doing it in a very focused and disciplined way. And I think that says a lot about who we are as a company.
Kash Rangan: Thank you, Dan.
Operator: And our last question is from Brad Zelnick with Deutsche Bank.
Brad Zelnick: Excellent, thanks for squeezing me in and congrats on a strong Q2. My question is for David. David, we've seen reports of the trial, you're running in Canada for a free browser based version of Photoshop, which I assume is another Express like offering to build top of funnel interest and awareness. Can you share more about the strategy here? And how you think about the balance of more simplified products, creating incremental demand versus competing with more premium skews?
David Wadhwani: Yes, absolutely happy to talk about that. We are very excited about the work we're doing here. Frankly, not just with Adobe Express but with Photoshop, as we mentioned here with Lightroom, as we've done in the past, and also with, with Acrobat. Our focus has always been to take the strengths that we have in the desktop and build a multi surface experience for our customers across desktop, mobile and web. And as we've done that, we've noticed that web and mobile really represents an opportunity to broaden our audience in a very significant way. And we do that by capturing search, traffic and at the point of intent, bringing them into the zero friction web experience with a freemium model. And so PS web and what you're seeing there is a step along that journey for our core imaging franchise. And we absolutely anticipate it being a source of funnel opportunity, similar to the way that that Acrobat has seen Acrobat web as a source of that funnel activity. You see how strong the core Acrobat businesses and how it's performing. We have a version of Acrobat web that's available we've been able to double traffic to that. And we now have over 50 million monthly active users, leveraging Acrobat web. And we use that as a top of leveraging Acrobat web on a monthly active basis. And we're able to leverage that and convert that traffic into real business. We're playing that same playbook now with Photoshop as well. And we expect that to be a very productive opportunity.
Brad Zelnick: Thank you.
Shantanu Narayen: I think if I were to add to that, I mean, really, in effect, what we do is we look at platforms in an unbelievably expensive way. And on any platform, just making sure that we get the magic of our technology and as friction free way possible, is part of what we are continuing to do. And we have a unbelievably rigorous process also or then really understanding how to monetize it. So some of the press releases may be a little bit more sensationalistic, in terms of how they announced that, Brad. But since that was the last question, I just have to say we're proud of how we're executing against our strategy. I mean, everybody would have knowledge that it's an uncertain macroeconomic environment. But we believe that we will continue to win by delivering great innovative products that at the end of the day delight and ever increasing for our set of customers. We're making some very creative marketing campaigns. We have strong sales and go-to-market motions that are appropriate for the set of customers that we're targeting. And I think we're the being the best users of our product, which actually gives us tremendous credibility, to both innovate at a rapid pace, as well as deliver great customer satisfaction and growth to our customers worldwide. So thank you for joining us. And with that, I'll turn it over to Jonathan.
Jonathan Vaas: Great, thanks. Thanks everyone for joining the call. We look forward to speaking to many of you soon and this does conclude the event. Thank you. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Q2 FY 2022 Adobe Earnings Conference Call. Today’s conference is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s second quarter fiscal year 2022 financial results. You can find our Q2 press release as well as PDFs of our prepared remarks and financial results on Adobe’s Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, June 16 and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today’s press release and in Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as adjusted growth rates in constant currency. During this presentation, Adobe’s executives will refer to constant currency growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks Jonathan. Good afternoon and thank you for joining us. Adobe had a strong Q2 driven by the secular shift to digital that is transforming how we live, work and play. In Q2, we achieved a record $4.39 billion in revenue representing 15% year-over-year growth. GAAP earnings per share for the quarter was $2.49 and non-GAAP earnings per share was $3.35. In our digital media business we drove strong growth in both Creative Cloud and Document Cloud achieving $3.2 billion in revenue. Net new Digital Media annualized recurring revenue or ARR was $464 million and total Digital Media ARR exiting Q2 grew to $12.95 billion. In our Experience Cloud business we achieved $1.1 billion in revenue and Subscription revenue was $961 million for the quarter. The digital economy runs on Adobe’s tools and platforms. Customers from individuals and small businesses to the largest enterprises are using our products to unleash their creativity, accelerate document productivity, and deliver personalized customer experiences. Digital experiences from the apps on our devices to the digital documents we consume, Edit and Sign, to the personalized online shopping experiences is made possible by Adobe. Our mission to enable the world's digital experiences has never been more relevant, and we remain focused on executing our long term growth initiatives. We are delivering mission critical products that serve an ever increasing base of customers and we have a track record of strong growth and profitability. In my conversations around the world, it is clear that Digital is playing a pivotal role in powering the economy and enabling the world to keep moving forward. I will now turn it over to David to share more about our momentum in the Digital Media business. David?"
},
{
"speaker": "David Wadhwani",
"text": "Thanks, Shantanu, and hello everyone. Adobe products have always been the solution of choice for the world's creators, whether they're designers, photographers, filmmakers, or illustrators. Today, the explosion of the creator economy is enabling even more individuals, solopreneurs and small business owners to express themselves in creative ways. Whether it's a hobby, a side hustle, or a full time job, every creator and business is reimagining how they build their brand and engage their audiences in a digital first world, underscoring the rapidly growing demand for content and creativity. Adobe Creative Cloud offers the most comprehensive portfolio of products and services across every creative category, including imaging, photography, design, video, and 3D and immersive. We continue to invest across our core flagship products, including a heavy dose of new AI features. As demand for content increases, content creators are looking to Adobe to help them work together efficiently. We're responding by integrating collaboration capabilities directly into our flagship applications that enable creative teams to collaborate with each other, and with stakeholders. As communicators have become a growing part of our creative cloud customer base, we've expanded our offerings to include Adobe Express; our new template based easy-to-use web and mobile product. Express creates an opportunity to serve a broader base of communicators who need lightweight task based tools to create everything from social media posts, logos and flyers for their small businesses, to party invitations and posters for their personal needs. Real Estate entrepreneur Chrishell Stause is a great example of a social media influencer, who is leveraging Adobe Express to transform how she markets her properties and engages her followers. She is one of millions of users promoting their products and services with Adobe Express. In Q2, we achieve net new creative cloud ARR of $357 million and revenue of $2.61 billion, which grew 14% year-over-year. Q2 highlights include continued innovation in the imaging category. This quarter, we launched powerful new capabilities in Photoshop, including Photo Restoration neural filter that detects and restores damaged photos in seconds. Neural filters are one of Photoshops most used AI powered features. They have now been used by millions of users and apply it to hundreds of millions of images. We're also delivering enhancements to Photoshop on the web, including new editing features, support for mobile browsers and integrated learning content. Video Production also continues to explode, and Premiere Pro remains a leader in video creation, editing, and now collaboration with Frame.io. The new integration between Frame and Premiere Pro and After Effects is streamlining review and collaboration workflows across stakeholders. Frame had another strong quarter with new customer wins including Epic Games and NBCUniversal which are using it to manage their video content supply chain something that Anil will talk more about in a few minutes. We're also seeing the emergence of new categories like 3D as customer demand for metaverse ready content continues to increase. Substance 3D had its strongest Q2 ever as customers like Hugo Boss, Mattel, and Unity rely on it to deliver immersive experiences across fashion, gaming and e-commerce. We continue to rapidly innovate in this space, including delivering native Apple hardware support for painter, designer and sampler enabling creators to work faster than ever before. The Substance team also delivered a new SDK for developers who want to integrate 3D capabilities into their applications. And finally, we're excited about the momentum we're seeing for Adobe Express with millions of monthly active users and strong growth in traffic and new users in Q2. We continue to bring the magic of Photoshop imaging Premier Video and Acrobat PDF capabilities like background removal, QR code generation, video resizing, and PDF editing to Express, and we released our new content scheduler feature thanks to our recent acquisition of ContentCal, allowing creators to quickly create, preview, schedule and publish social media content. We're also excited to kick off our “Express Your Brand Partnership” with Meta, which will enable over 200 million businesses to grow their online presence using Adobe Express. And our product led growth strategy allows us to use millions of data points to continuously test, learn and optimize the entire Express experience from search to export. Adobe Express recently received the Editor's Choice Award on the App Store, recognizing top apps for design, functionality and performance. We're very excited about the strong demand for Creative Cloud offerings globally driven by acquisition, engagement and retention from our data driven operating model across individuals, SMBs and Enterprises. Key enterprise customer wins include Activision, Bertelsmann, Hasbro, Honda Motor, Daimler AG, and CSOFT, Services Australia, State of California and WPP. In our Document Cloud business, digital document workflows are automating manual paper processes across our personal and professional lives. Whether it's a legal contract, invoice, or school permission slip, we now need to scan, edit, share and sign from anywhere. Adobe Document Cloud offers the most comprehensive intuitive tools for document productivity across every device and platform. In education, the University of East London is adopting Document Cloud to manage workflows for enrolling 17,000 students from 135 countries. In financial services, TSB Bank is transforming the online banking experience by enabling customers to quickly and securely complete common tasks like loan applications that could previously only be done in branches. In Q2, we achieved net new Document Cloud ARR of $107 million and record revenue of $595 million, which grew 28% year-over-year. Q2 highlights include strong growth in monthly active users across desktop, mobile and web. The rising volume of search traffic for Acrobat verbs remains a productive funnel to Acrobat web, which surpassed 50 million monthly active users in Q2 more than doubling year-over-year. Mobile App momentum remains strong with billions of PDFs opened in Acrobat mobile, and hundreds of millions of cumulative Adobe scan installs. Acrobat and Adobe sign integration continues to drive strong demand for Adobe sign as users increasingly send PDFs for signature directly from the unified Acrobat experience. Acrobat and Adobe Express integrations now give hundreds of millions of Acrobat users the ability to embed customized templates and make their PDFs visually stunning. And Acrobat and Sign API's are thriving as customers increasingly customize, integrate and automate document services. We're thrilled with the momentum we see in the Acrobat ecosystem, and our business performance across routes to market and customer segments, including key enterprise customer wins with automatic data processing, Duke Energy, Quanta services and U.S. Bank. We continue to see strong demand for our products in the second half of FY 2022 will continue to win in the digital media business through product innovation across Creative Cloud and Document Cloud, which are targeting a broad growing base of customers. Our tremendous scale, consistent marketing investments, proven data driven operating model and new product lead growth initiatives are accelerating our momentum across our new and established businesses. I'll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello, everyone. Even in this uncertain economy, every business continues to prioritize its digital investment. Our June Adobe Digital Index report, which leverages trillions of data points from Adobe analytics found that consumers spent a billion dollars more online in May, compared to April. Year-to-date, shoppers have spent over $377 billion online, which is roughly 9% more than the same period last year. Driving this digital momentum is the imperative for personalized customer experiences at scale. Adobe Experience Cloud is the leader in the Customer Experience Management category, offering a comprehensive set of integrated applications and services, spanning data insights and audiences, content and commerce, customer journeys and marketing workflow. Built natively on Adobe Experience platform, our real time customer data platform, real time CDP provides businesses with a single view of their customers data across every channel, allowing them to create precise segments and deliver personalized experiences, regardless of when and where a customer interacts with their brand. Adobe delivers real time data with more than 24 trillion audience segment evaluations per day. The Home Depot is the latest in a large and growing set of industry leading customers who are adopting Adobe's real time CDP as the underlying platform to power their digital business. Real Time CDP provides a comprehensive view of the Home Depot's customers across e-commerce, mobile and in-store purchases, enabling them to build customer loyalty and grow their business. In Q2, we continue to drive outstanding experience cloud growth, achieving a record $1.1 billion in revenue. Subscription revenue was $961 million for the quarter, representing 18% year-over-year growth. Q2 highlight include native integration across real time CDP customer journey analytics and Adobe journey optimizer, which is a significant differentiator, allowing brands to orchestrate, measure and optimize the entire customer experience. New innovations such as segment match enable brands to securely share customer segment data with business partners while respecting customer privacy. Major enterprises are adopting real time CDP as the platform of choice with key customer wins this quarter, including Autodesk, National Football League and U.S. Bank. Expanding experience cloud leadership in the healthcare industry by making Adobe journey optimizer and real time CDP HIPAA-ready through healthcare shield. This quarter’s customer win with CVS is a great proof point of this massive market opportunity. New services in Adobe analytics, delivering a single workspace for brands to unify data and insights from new media types such as 3D and streaming media with traditional channels to get a holistic view of customer engagement with customer journey analytics. Strong adoption of Adobe Experience Manager for unified content management, demonstrating Adobe's leadership in helping businesses effectively manage their content supply chain from creation through delivery. Tremendous growth in demand for partner and Adobe Professional Services, underscoring the urgency for implementation and value realization and key customer wins including Audio book [ph], Anthem, Bank of Nova Scotia, Humana, McDonald's, Stellantis, and Toyota. Reinforcing our leadership position, Adobe continued to receive strong industry analyst recognition, including being named number one by Gartner for both the marketing sub segment of customer experience and relationship management and digital experience platforms. We've also named the leader in the inaugural IDC MarketScape for worldwide retail and CPG customer data platforms and the IDC MarketScape for professional services. Looking ahead, our category leading solutions, strong pipeline and tremendous scale through our partner ecosystem, position us to deliver personalization at scale across every industry and drive strong growth in the second half. Dan, over to you."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Today, I will start by summarizing Adobe’s performance in Q2 fiscal 2022, highlighting growth drivers across our businesses, and I’ll finish with targets. Adobe delivered a strong quarter, surpassing our issued Q2 financial targets in an uncertain macro environment. On the top line, we grew revenue by 14% year-over-year, or 15% in constant currency, while making long term growth investments, we delivered operating margins of 35% on a GAAP basis and 45% on a non-GAAP basis continuing to be one of the most predictable and profitable growth companies in technology We have three strategic businesses growing into massive addressable markets, with differentiated products used by hundreds of millions of individuals every month. In addition to our established businesses, we are delivering innovations and new offerings that will drive transformational growth in the future. Q2 business and financial highlights included record revenue of $4.39 billion, GAAP diluted earnings per share of $2.49 and non-GAAP diluted earnings per share of $3.35. Digital Media revenue of $3.02 billion net new Digital Media ARR of $464 million. Digital Experience revenue of $1.10 billion cash flows from operations of $2.04 billion. RPO of $13.82 billion exiting the quarter, and repurchasing approximately 1.9 million shares of our stock during the [Technical difficulty] 15% year-over-year revenue growth in constant [ph] currency. We exited the quarter with 12.95 billion of Digital Media ARR. We achieved creative revenue of $2.61 billion which represents 12% year-over-year growth or 14% in constant currency. We added $357 million of net New Creative ARR in the quarter, a sequential increase of 13% from Q1. Second quarter creative growth drivers included continued strength in acquisition, engagement and retention across our customer segments. Momentum in the small and medium business segment, where our team's offering continues to drive new customer acquisition. Demand for our flagship products including Photoshop, Illustrator and Premiere. Mobile applications where our Ending ARR grew greater than 30% year-over-year exiting the quarter. Adobe Stock where we saw strong book of business growth across organizations and new customers and momentum. And momentum in new businesses with strong growth and Frame IO as well as our substance offerings, which grew Ending ARR greater than 60% year-over-year exiting the quarter. Adobe achieved Document Cloud revenue of $595 million, which represents 27% year-over-year growth, or 28% in constant currency. Document Cloud continues to be our fastest growing business given the relevance and importance of PDF the knowledge workers around the globe. We added 107 million of net new Document Cloud ARR in the quarter. Second quarter Document Cloud growth drivers included continued strength and acquisition engagement retention for Acrobat across our customer segments. Momentum in the small and medium business segment and the reseller channel continuing to drive New Document Cloud subscriptions. Continued growth of searches online for document actions funneling millions of new customers into our document franchise through Acrobat Web. Strength in mobile with Ending ARR growing greater than 40% year-over-year exiting the quarter, and strong adoption of Acrobat with integrated sign capabilities within organizations of all sizes. Our document business also had a strong quarter and sales of Acrobat perpetual licenses. Turning to our Digital Experience segment, in Q2, we achieved revenue of $1.10 billion, which represents 17% year-over-year growth or 18% in constant currency. Digital Experience subscription revenue was $961 million representing 18% year-over-year growth. Second quarter Digital Experience growth drivers included strong growth in our Adobe Experience platform business or AEP with real time CDP revenue more than doubling year-over-year. Increase in customer interest and pipeline generation for new applications built on AEP, including real time CDP, customer journey optimizer and customer journey analytics. Success with Workfront where average deal sizes grew greater than 35% year-over-year, continued customer demand and content and commerce with significant new customer acquisition and Adobe Experience Manager as a cloud service. Enterprise demand for Adobe Professional Services, driving customer success and new implementations across our solutions and strength and retention rates during the quarter driven by product differentiation and our focus on delivering customer value. Our strategy of enabling enterprises to activate first party data to provide personalization at scale in real time is resonating with customers driving our continuing digital experience growth. In Q2, we continued to focus on making disciplined investments to drive growth, including marketing campaigns and headcount additions in our R&D and sales organizations. We're pleased with our success in talent acquisition during the quarter in a competitive market. Adobe's effective tax rate in Q2 was 21% on a GAAP basis, and 18.5% on a non-GAAP basis. The increase in the GAAP tax rate is primarily due to the lower than expected tax benefits associated with stock based compensation and geographic mix of earnings. RPO exiting the quarter was $13.82 billion growing 13% year-over-year, or 15% year-over-year when factoring in a 2% foreign exchange headwind. Our ending cash and short term investment position exiting Q2 was $5.30 billion in cash flows from operations in the quarter were $2.04 billion. In Q2, we repurchased approximately 1.9 million shares at a cost of $800 million. We currently have $9.5 billion remaining of our $15 billion authorization granted in December 2020, which goes through 2024. We will now provide Q3 targets as well as an update on the annual targets we provided in December factoring in the following four items. First, in March, we stated that as a result of lower than expected tax benefits associated with stock based compensation, our effective tax rates would increase in fiscal 2022. Second, in March, we outlined the impact of the on-going war in Ukraine, and our decision to cease all new sales in Russia and Belarus, resulting in an expected $75 million revenue impact on our digital media business. Third, as a result of the continued strength of the U.S. dollar, we are now factoring in an incremental effects headwind of $175 million across Q3 and Q4 revenue. And fourth while demand for our products remains strong, we now expect the second half of the fiscal year to show more pronounced summer seasonality in Q3 and the enterprise business with a stronger sequential increasing Q4. As a result, for Q3 we are targeting total Adobe revenue of approximately $4.43 billion, net New Digital Media ARR of approximately $430 million. Digital Media segment revenue growth of approximately 13% year-over-year, or 16% in constant currency. Digital Experience segment revenue growth of approximately 12% year-over-year, or 14% in constant currency. Digital Experience subscription revenue growth of approximately 13% year-over-year, or 15% in constant currency; tax rate of approximately 22.5% on a GAAP basis, and 18.5% on a non-GAAP basis, and GAAP earnings per share of approximately $2.35 and non-GAAP earnings per share of approximately $3.33. For fiscal year 2022, we're now targeting total Adobe revenue of approximately $17.65 billion. Net New Digital Media ARR of approximately $1.90 billion. Digital Media segment revenue growth of approximately 12% year-over-year, or 17% on an adjusted basis. Digital Experience segment revenue growth of approximately 14% year-over-year, or 17% on an adjusted basis. Digital Experience subscription revenue growth of approximately 15% year-over-year, or 19% on an adjusted basis. Tax rate of approximately 21% on a GAAP basis, and 18.5% on a non-GAAP basis, and GAAP earnings per share of approximately $9.95 and non-GAAP earnings per share of approximately $13.50. In summary, I'm pleased by the way Adobe executed in Q2. We are driving growth across Creative Cloud, Document Cloud and Experience Cloud with momentum in our established businesses and early success in our new initiatives. As a result of our disciplined operating model and focused execution, we were able to dramatically reduce the expected impact of increased tax rates and FX headwinds on our EPS. The investments we're making today in people, products and marketing will enable us to drive strong growth for years to come. And we are on track for another year of record revenue and operating cash flows. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. We are proud of our strong Q2 performance across Creative Cloud Document Cloud and Experience Cloud. Adobe remains one of the greatest places to work in the industry. And I want to thank our employees for their relentless dedication. This quarter, Forbes named us a top employer for college graduates, and we were ranked on their list of America's best employers for diversity. I'm thrilled to welcome our largest cohort of interns and university graduates this summer. Demand for our category defining products and services continue to grow. We're innovating at rapid speed for new and existing customer segments, accelerating our leadership in established categories, and seeing strong momentum for our newer initiatives. Our strategy remains to focus on long term growth initiatives while delivering world class profitability. Our business fundamentals and market tailwinds are strong. And I've never been more confident in our ability to execute on the $205 billion market opportunity ahead of us. I will now turn it back over to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, Shantanu. Adobe MAX, our creativity conference will take place during the third week of October this year in Los Angeles. On day one at MAX on Tuesday, October 18 we plan to host the financial analyst meeting. Invitations including discounted registration information will be sent to our analyst and investor email list later this summer. More information about the event can be found online@max.adobe.com. We would now be happy to take your questions. And we ask that you limit your questions to one per person. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] And we will go to our first question from Kirk Materne of Evercore ISI."
},
{
"speaker": "Kirk Materne",
"text": "Hi guys, thanks very much and congrats on the strong results. Shantanu and Anil I was wondering if you guys could just talk a little bit about the type of conversations you're having with your enterprise customers these days, given the macro backdrop. Are you seeing any hesitancy to spend? Obviously, you guys are keeping your full year guidance, despite all these headwinds, but I was also just curious if there's any change in kind of the type of deals your is it more smaller deals but more deals? Or is the product mix changing at all on the experience cloud side? I was just wondering if you could give us some color on that because that obviously remains a very primary concern for folks these days. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks Kirk. Yes, we are pleased with what we saw in the quarter. In the conversations that we're having, both Anil and I would first say that the interest level in executives all around the world, is very high. Unlike last time, I would say right now, the focus is also a lot on execution. So a lot of the investments that people have made in digital, they recognize that given how critical the imperative is to engage with customers digitally. So we're actually pleased both Adobe as well as if you look at the entire systems integrator and partner network, they are finding that there's a lot of demand for implementation on Adobe products. I think the other part of the conversation that you all have with enterprise CEOs right now is they all recognize it's an uncertain time. And that's the conversation that we have. But despite that uncertain macroeconomic environment, the thing that all of them recognize is that Digital is a priority. And they really want to continue to have conversations with us as to how they can do Digital. I’ll have Anil maybe add a little bit of what he's seeing across different verticals as well. But the importance of digital remains undiminished."
},
{
"speaker": "Anil Chakravarthy",
"text": "Yes thanks Shantanu. Just to add a little bit on the vertical color, we were really pleased with some of the wins we had in Q2. If you look at the automotive and what we had with Daimler over in Europe, where we continued our strength in sports media and entertainment with NFL, which is using the real time CDP for personalization at scale across their fan base. And in healthcare, where we had a really important win with CVS. That was a great validation of all the HIPAA readiness we built into our platform So that opens up a big market opportunity. So we were really pleased those wins and as you said digital continues to be a priority. And we're seeing that in the pipeline for the second half."
},
{
"speaker": "Operator",
"text": "And, Kirk, did you have anything further?"
},
{
"speaker": "Kirk Materne",
"text": "No, that was that. I'll keep to my one question limit. Thanks, guys."
},
{
"speaker": "Operator",
"text": "And we'll go next to Brent Thill of Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Good afternoon. Dan, I was curious if you could just comment on the more pronounced summer seasonality. What are you seeing this year versus perhaps in past years, and just a quick follow up on the numbers? The net new ARR guide was down Q2 to Q3. And I think last quarter; you said it would be up? Do we misinterpret what you said last quarter? I just want to make sure we clarify that. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, Brent, the way I would describe it as we had a strong first half, and we actually continue to see a strong demand for our unique solutions. And all of our new initiatives as well as the established businesses are doing well. I guess what we're also paying attention to is, what we all read as part of the macro environment. And when I look at what we expect for our second half, the confidence remains undiminished. The question really for us is timing. And maybe we're being a little cautious as it relates to what happens, given the summer seasonality, as Brent better than most is, sort of the July and August. So as it relates to our second half pipeline, the confidence remains undiminished. And we're just maybe a little cautious as it relates to timing. In terms of what we had said, in March, you're right, we had sort of alluded to the fact that we would have expected some sequential increase; clearly we had a strong Q2. But that's part of the reason why we wanted to give a little bit of color and be transparent on how we see it. And as you notice, we reaffirm the $1.9 billion for net new ARR for the year."
},
{
"speaker": "Brent Thill",
"text": "Thanks, Shantanu."
},
{
"speaker": "Operator",
"text": "And we'll go next to a question from Brad Sills of Bank of America."
},
{
"speaker": "Brad Sills",
"text": "Oh, great. Thanks, guys, for taking my question. I wanted to ask about Creative Cloud Express. You mentioned some new features here imaging video, editing for Acrobat, it seems to me like those are, would be considered typically premium features. Is there any change in strategy with Creative Cloud Express as to where you see that playing in different segments of the market? Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Yes, thanks for the question. First of all, we're really thrilled with the reception of Creative Cloud Express, Adobe Express into the market. And frankly, it's been a lot of fun for us because it's a product that everyone at Adobe can also be using, it's amazing to see the creativity coming out of finance and legal for example. As a reminder, just to sort of up level for a second, we've been focused on the communicator and creator economy, ecosystem for years. In fact, we believe that we're the largest provider of creative tools to professionals and communicators on the back of our core products. So I want to just make sure people recognize that the core products are playing to this incredibly large market, where we see Express filling in is that Express is additive and broadens the region, that new communicator base, because of exactly what you're saying the freemium business model, there's zero friction onboarding, it's clearly showing that we're able to attract millions of new users into the franchise. And we're able to do it very efficiently by optimizing how we onboard customers from search terms that typically were not ones that we've focused on in the past. We also look at the ability to onboard those users and differentiate the offering, with the integration of these amazing features that we get from the from the desktop applications like Adobe magic. And all of this helps differentiate what we're doing with Express. And if we take a step back and look at it from a business perspective, we feel very confident that Adobe Express and the way we actually pull people into that funnel is additive to the market opportunity that we're playing. So we're really emphasizing the ability to add more capabilities there and differentiate there. I do also want to remind folks that that Express is also available to core Creative Cloud customers. And by integrating some of those features into Express, we're enabling workflows between the core Creative Cloud products and also Express and we believe that's going to have a strong retentive value on the core base and we just had, in fact, a great quarter with very strong retention for Creative Cloud as well."
},
{
"speaker": "Brad Sills",
"text": "Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Brad maybe if I were to add, I think the team is actually having a lot of fun with all these cool features. To your point, they're showing some incredible stuff as part of the quick actions. But if you look at the depth of what they have, I mean, there is so much behind the scenes that we will be able to monetize. But clearly the focus is on usage right now, as David said. It's been fun."
},
{
"speaker": "Brad Sills",
"text": "Great to hear. Thank you so much."
},
{
"speaker": "Operator",
"text": "We'll go next to Alex Zukin of Wolfe Research."
},
{
"speaker": "Alex Zukin",
"text": "Yes, hey guys, thanks for taking the question. I guess maybe just a two part. The first one, we've talked, I think a lot about pricing tailwinds during last quarter in terms of the impact for the year, and I guess can you help us just quantify the impact that you're anticipating for Q3 and Q4. Because it does, it does look to start ramping here pretty meaningfully. And then Shantanu, I guess, maybe just for you with respect to the strategic approach to M&A and kind of what's on the horizon, given the change in valuation paradigms in the market, how important is either large strategic M&A to the growth profile of the business versus tuck-ins?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think as it relates to your M&A question, and then David could certainly answer the other one, clearly valuations to your point have changed quite a bit. And the first thing I'll start off by saying is, we're really pleased with our portfolio. If you look at some of the new initiatives, and we've touched on that, whether it's Adobe Express, whether it's the real time CDP customer journey analytics, what we're doing with things on the web, including PDF, we feel really good. I do feel Alex that there are going to be a number of small single product companies that are probably not going to survive, what's happening. And the valuation sort of multiple changing is actually I think, good for a larger company like Adobe. So I, it doesn't feel like we need anything, but we will always be on the lookout for things that are additive, that are adjacent, and that will provide great shareholder value and our metrics associated with ensuring great technology, great cultural fit, and adjacency remain. But we have so much going on within the company that we're excited about our current portfolio, clearly, things will be more reasonable in terms of M&A as well."
},
{
"speaker": "David Wadhwani",
"text": "And on pricing, Alex, you're right. We did sort of introduce a modest price increase to a portion of our customer base in Q2, the new prices were in market for about a month and drove a little under 10 million of benefit, which is exactly what we were expecting. And as you can see, it's a very small part of the 464 million that we drove in Q2. Customer reaction overall to this has been good, because we've added so many new features since the last price update that it's been very positive overall. And in fact, if we get asked anything by analysts, it's why we didn't make a bigger price increase. And the reality there is we're primarily focused on adding millions of new users. We are a growth business. We want to continue to grow the user base. And we believe that with the initiatives we have around both the core and the new products, we want to run the business through acquisition of new users engagement and retention."
},
{
"speaker": "Alex Zukin",
"text": "Got it. And sorry, Dan, just maybe just the impact on Q3 that you're anticipating in the guide for net New ARR on pricing?"
},
{
"speaker": "David Wadhwani",
"text": "Yes, that we want to provide that as part of the guide. I think the metrics that David gave you, around Q2, give you a good sense of the expected actions that we anticipate going forward."
},
{
"speaker": "Alex Zukin",
"text": "Thank you guys."
},
{
"speaker": "Operator",
"text": "And we'll go next to Saket Kalia of Barclays."
},
{
"speaker": "Saket Kalia",
"text": "Okay, great. Hey, guys, thanks for taking my question here. David, maybe just to stay with you, given the questions on macro, I was wondering if we could go one level deeper into the makeup of Creative ARR. We have the very helpful disclosure from analysts say the single app versus the all-out mix, which is helpful. But how do you think about the mix from maybe consumers versus professionals if there's a way to break that down? Because of course, right now, there are lots of questions just about the health of the consumer. How do you think about that mix? And how do you think about maybe the defensiveness or the retention rates on both of those different cohorts? Does that make sense?"
},
{
"speaker": "David Wadhwani",
"text": "Yes, it makes perfect sense. Yes happy to take that one. So at a high level we think about the business through obviously multiple segmentations. But as you're looking at it, we think about it as enterprise buyers, midmarket and SMB buyers, communicators and consumers. So we have a very broad and diverse portfolio, which has served us very well in the past. And, and as you as you are alluding to, we've been through multiple recessions before so we have some good insight into how these different cohorts respond to difficult financial times. And overall, we fared very well. Enterprises we've talked about, you heard Anil and Shantanu talk about content is fueling the digital economy and needing to stay very focused on their digital investments. From a pro market perspective, we have professionals that are making their living using our products. So we feel very good about that offering, as well. From a communicators perspective, they tend to be either working in departments or small businesses, or they're part of this growing movement around the creative economy. And they're aspiring to make money or build followers with that. So it's an essential part of their, their toolset that they're going to do to grow their side hustle in their activities. And as it relates to the consumer businesses, we've been very thoughtful with pricing there, and have had very attractive pricing that we think has fared very well for us in the past around, through recession. So, overall, we think the business is diverse, and we see the business is very resilient."
},
{
"speaker": "Saket Kalia",
"text": "Very helpful. Thanks."
},
{
"speaker": "Operator",
"text": "And we'll go to our next question from Karl Keirstead of UBS."
},
{
"speaker": "Karl Keirstead",
"text": "Hi, thanks very much. I'd love to ask about the digital experience guide. You said it for 14% in the third quarter, that's down about four points in constant currency from 18% in May, and is the lowest and a bit. I know it's a tougher comp is, is that the issue? Or is there anything else to call out on the DX business? Thanks a lot."
},
{
"speaker": "Shantanu Narayen",
"text": "Nothing Karl to call out. I mean, if you look at what our targets are for the year, and if you look at it in terms of what we would expect, for both subscription and total revenue we’re in effect saying exactly the same at the beginning of the year, in what's a really tough economic environment. So the interest in our solutions remain strong. I also wanted to maybe add to a little bit of what David said to for Saket. The consumer sentiment that we continue to hear from banks, such as yourselves, is that the consumer sentiment actually continues to remain strong, both in the U.S. and in Europe. So I didn't want to have anybody feel like that's not what we're seeing as well."
},
{
"speaker": "Karl Keirstead",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And we'll move to our next question from Jay Vleeschhouwer of Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening, I'd like to ask about two important attributes of your product led growth strategy. First, could you comment on the contribution from or expectations for what you call your application and intelligent services? Is that becoming meaningful at this point? And then secondly, at Summit a couple of months ago, and again this evening, we heard multiple examples of integration within and across your segments, which is long standing Adobe practice. But we've heard a great deal more about that the last couple of years. Could you comment on which of the many integrations you think either in terms of addressable market, or your own sales capacities might be the most meaningful over the next number of quarters and years?"
},
{
"speaker": "David Wadhwani",
"text": "Thanks. Thanks for the question, Jay. In terms of the application intelligence services, it fits really well into the portfolio of our Adobe Experience platform based services. So just to recap, we have three major services the real time CDP customer journey analytics, and the journey optimizer. And what we have done is really integrated these intelligence services as part of these applications that run natively on the Adobe Experience platform. And where that has been extremely valuable to us is, we have a broad base of customers through our digital experience portfolios, for example, with Adobe analytics, we have that's been the gold standard for a long time on for web traffic analysis and trends and insights. And with customer journey analytics, our enterprise customers can now get a 360 degree view of everything that's happening across the customer journey, whether it's web traffic or, or through mobile apps, social call center, and so on. And that's where the intelligence services really fit in, to really be able to expand the portfolio and derive value from how you segment those into audiences and activate them."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Okay and the second part of the question"
},
{
"speaker": "David Wadhwani",
"text": "If you could repeat the second part of the question please?"
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Oh, sure. I was trying to get some insights into which of the many integrations that you've done either within or across your segments, whether it's Digital Media DX, or combinations thereof, you think had had or will have the most meaningful impacts, assuming that not all of these integrations are created equally."
},
{
"speaker": "Shantanu Narayen",
"text": "I’ll start off maybe on that particular question, Jay, because one of the areas that we're seeing just tremendous interest is what we are referring to as content supply chain. And both David and Anil can touch on that as well, a little bit more. But this notion of people creating campaigns, if you agree with us that the greatest value that we can provide is enabling every enterprise to do personalization at scale, the amount of content that's being created, the amount of content that's being delivered, and to understand the efficacy of the campaigns, is just absolutely top of mind. I mean, we have a large, large consumer company that has completely consolidated all of their marketing activity to really understand what this content supply chain is. And so the notion of content supply chain, and what we can do between our creative applications, the asset management that we deliver, the website and what we are doing with AEM Experienced Manager, that and work front to be able to do workflow associated with that, that is really resonating with every single customer right now."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "And we will go next to Keith Weiss of Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Thank you guys for taking the question. I have a question for Dan. And it's about sort of the guidance philosophy. And that these are what a lot of people are trying to get at is understanding holding the Digital Media ARR guide at 1.9 billion for the full year, despite the kind of increased seasonality in Q3, despite the fact like the street kind of gave you a pass, we've already taken our numbers down to like 1.8 billion. Why keep that risk out there? Why push more risk into Q4? Why put a high bar out there when obviously, it's not in the stock? All the stocks are getting killed here. It's not in our expectations, like, what is it that gives you so much confidence to like, keep that number out there."
},
{
"speaker": "David Wadhwani",
"text": "So I guess where I'd start is, if you take a look at where we are in, in the first half, I would say the performance of the businesses is really good. We talked about it earlier conversations with the customers, what we're seeing in data and DDOM and the insights that it gives us, we see strength into the back half of the year. So we're confident in the underlying performance of the business. And, I'd go back to the earlier comments, we see the headlines we see what others are talking about. And so in an environment like this, maybe we're a little cautious about Q3, I think that's the prudent way to go. But it doesn't take away from the insights we have and the belief we have and confidence in the underlying performance and the strength we see into the second half. And so I think we've taken everything into account. And we've got the right set of targets out there that reflect what we're seeing in the business and how we expect to perform."
},
{
"speaker": "Keith Weiss",
"text": "Got it. And I mean, any visibility into what gets better in Q4 that that's kind of enabled it because you're looking for net New AAR to go from basically down in the first half of the year to growing in the back half what, what could you give us any kind of visibility to like, what gives you guys that confidence?"
},
{
"speaker": "Shantanu Narayen",
"text": "If you look at the rhythm of how we’ve managed the business, certainly, you look at what happens with education in Q4, you look at the enterprise, which tends to be a seasonally strong Q4. You start to look at what's happening with the emerging businesses that will continue to ramp. And so, it's a combination I think somebody else alluded to pricing, and we'll have a full quarter of pricing as well. And so, when you put all of those together, every Q3 to Q4 we see a seasonal uptick. And if you look at what happened even last year, and you look at what the numbers look like it's something that we know we're going to go drive."
},
{
"speaker": "Keith Weiss",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "And we’ll go next to Tyler Radke with Citi."
},
{
"speaker": "Tyler Radke",
"text": "Yes, thanks for taking the question. I wanted to ask you about the CDP space. I think you talked about your revenue, they're doubling year-over-year. I guess just a couple of questions. Number one, how significant is CDP as part of the overall experience businesses is a growth driver; and two, could you just talk a little bit about the competitive landscape. This is something that Sales force talked a lot about, on their last earnings call. We've seen amplitude recently launched a CDP. So how do you kind of see all this evolving? And how do you think this plays out? Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Thanks Tyler. Yes, but let me take the big picture first on what we see with the overall CDP market. First of all, all the interest in CDP is a great validation of the fact that the traditional CRM is not the way to go to build the next generation, customer experience. Some of the data might be there, but you really need to activate the data and construct a rich profile before you can activate that. So if we look at the CDP market, what we see is, from our perspective, it's the platform for full customer engagement. And then that involves a number of different components. You look at the data collection that's required. And we built a lot of connectors, not only with our apps, we have over 100 connectors out there for the data collection, then you need to be able to assemble that into a real time database so that you can make the next best action the next best offer. We call it personalization at scale to millions of people in milliseconds. And that real time customer profile needs to be activated. And third, it then becomes the platform for not just the apps in our portfolio. But then for example, the integration we have with Dynamics, for example, with customer service, or the integration we have with ServiceNow, and so on, it needs to become the customer data platform that serves the entire range of customer facing applications. That's the way we look at CDP. That's what makes it a broad and exciting market. And that's really where we're differentiated where when we talk to customers, I mean, I'll give you the examples of say CVS, and NFL and so on, they recognize and agree with that vision. And that's why they're betting on us. And most of the players you see do one piece of it and don't really have the either the comprehensive nature of the product in their portfolio, or the real ability to pull it off in a true real time manner."
},
{
"speaker": "Shantanu Narayen",
"text": "Maybe the one thing I would add to all of that is, we have 32 billion profiles right now. I mean, clearly every customer has their profile kept isolated. So we're clearly the leader as it relates to you know, large companies that have a CDP in the market. That's well done."
},
{
"speaker": "Tyler Radke",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And we'll move next to Gregg Moskowitz with Mizuho."
},
{
"speaker": "Gregg Moskowitz",
"text": "Okay, thank you for taking the question. Can you talk about the Express Your Brand program, obviously, Meta has huge small business reach, but it will be helpful to get your expectations on what this partnership will do for Adobe incrementally. Thanks."
},
{
"speaker": "David Wadhwani",
"text": "Yes, so happy to do that. It's been a it's actually a very exciting program for us. So as you know, Adobe Express is predominantly focused on communicators, small medium businesses, as they start to move more online. We've talked a lot about the rise of the creative economy, we've mentioned that there are hundreds of millions of small medium businesses that are really targeting more online communication and really focus on social media, in fact that in a recent survey, we found that the majority of small medium businesses actually say that their online presence is more important than their physical presence. And so they need to do coordinate and communicate digitally and our ability to provide with meta provide all the tools that they need end-to-end to build incredible content that stands out and participate in the online experience that that meta is providing. And, of course, also work more broadly across all the other social networks, I think, is a really great opportunity for meta, for us and certainly for the small medium business owners that are part of that program."
},
{
"speaker": "Gregg Moskowitz",
"text": "Okay, thank you."
},
{
"speaker": "Jonathan Vaas",
"text": "Hi, operator, we're coming up on the top of the hour. We'll take two more questions, please."
},
{
"speaker": "Operator",
"text": "Thank you. We'll go next to Kash Rangan of Goldman Sachs."
},
{
"speaker": "Kash Rangan",
"text": "Hey thank you very much, Shantanu and team. This upcoming maybe recession is the one that everybody has been predicting. And the company has, as David said, has been through a couple of recessions before. The company's a very different company today than it was even just a few years ago. What is your best prognosis as to how the portfolio of Adobe products behaves if we are to enter a downturn, not that we wish it but if we are to enter one, how do you think the portfolio is positioned? And in the financial angle are you prepared to at all slow down firing? The beauty of the subscription model is that the instant start on hiring and produce nice margin upset that sort of thing from a financial perspective, but curious to get your thoughts overall on this particular topic"
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, let me first cover your second part cash as it relates to the bottom line. And our philosophy right now, given all of the myriad opportunities that we have is, we're planning for the upside, we know how to react to the downside, when that happens. I mean, look at what's happened with the tax rate, and the team, and the financial team and the product teams, what they were able to do to really address all of that is truly remarkable. I mean, we take it for granted at the company, but we've done an amazing, amazing job at continuing to be extremely profitable. For me, I think, when you talk about a recession, the question I ask people is, when you look at the three things that Adobe does, which is focus on content, focus on automation, focus on customer engagement, I just don't look at any of those and feel like the secular trend for that will change. So there may be some change in the rhythm of that quarter-over-quarter. But the fundamental shift of what we are doing, I mean, Anil talked about this real time CDP customer engagement is going to be the only thing that differentiates a business from another business, and the success that we're seeing in healthcare, clearly points to that as well. So, we’ll navigate it, we have an incredibly experienced management team. We're planning for the upside right now, which is all of our growth initiatives and will react as appropriate. And we are clearly not going to be in denial. But right now, it feels like a very strong time for Adobe to continue to execute against the things that we have on our plate."
},
{
"speaker": "David Wadhwani",
"text": "Yes, just want to build a little bit on the first part of Shantanu’s answer. We talked about offsetting some of the headwinds we see. We talked about the increase in tax rate. We talked about the FX headwind into the back half of the year. In Q1, we discussed the impact we were seeing from the war in Ukraine. When we take the effects and the impact we discussed in Q1, that's a $250 million revenue, headwind in the back half of the year, the increase in tax rate is about a $0.25 a share impactful year. When I net both of those together, we would expect to see about $0.60 to $0.70 a share erosion of the earnings power of the company. And to Shantanu’s point, it really underscores a philosophy that's underpinned how this company has operated for a very long time. It's about focused execution. It's about operating discipline. And the fact that the full year targets have come down $0.20 when the map would suggest it should be much greater than that just really underscores the power of the model. We're investing for innovation. We're investing to serve our customers, but we're doing it in a very focused and disciplined way. And I think that says a lot about who we are as a company."
},
{
"speaker": "Kash Rangan",
"text": "Thank you, Dan."
},
{
"speaker": "Operator",
"text": "And our last question is from Brad Zelnick with Deutsche Bank."
},
{
"speaker": "Brad Zelnick",
"text": "Excellent, thanks for squeezing me in and congrats on a strong Q2. My question is for David. David, we've seen reports of the trial, you're running in Canada for a free browser based version of Photoshop, which I assume is another Express like offering to build top of funnel interest and awareness. Can you share more about the strategy here? And how you think about the balance of more simplified products, creating incremental demand versus competing with more premium skews?"
},
{
"speaker": "David Wadhwani",
"text": "Yes, absolutely happy to talk about that. We are very excited about the work we're doing here. Frankly, not just with Adobe Express but with Photoshop, as we mentioned here with Lightroom, as we've done in the past, and also with, with Acrobat. Our focus has always been to take the strengths that we have in the desktop and build a multi surface experience for our customers across desktop, mobile and web. And as we've done that, we've noticed that web and mobile really represents an opportunity to broaden our audience in a very significant way. And we do that by capturing search, traffic and at the point of intent, bringing them into the zero friction web experience with a freemium model. And so PS web and what you're seeing there is a step along that journey for our core imaging franchise. And we absolutely anticipate it being a source of funnel opportunity, similar to the way that that Acrobat has seen Acrobat web as a source of that funnel activity. You see how strong the core Acrobat businesses and how it's performing. We have a version of Acrobat web that's available we've been able to double traffic to that. And we now have over 50 million monthly active users, leveraging Acrobat web. And we use that as a top of leveraging Acrobat web on a monthly active basis. And we're able to leverage that and convert that traffic into real business. We're playing that same playbook now with Photoshop as well. And we expect that to be a very productive opportunity."
},
{
"speaker": "Brad Zelnick",
"text": "Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "I think if I were to add to that, I mean, really, in effect, what we do is we look at platforms in an unbelievably expensive way. And on any platform, just making sure that we get the magic of our technology and as friction free way possible, is part of what we are continuing to do. And we have a unbelievably rigorous process also or then really understanding how to monetize it. So some of the press releases may be a little bit more sensationalistic, in terms of how they announced that, Brad. But since that was the last question, I just have to say we're proud of how we're executing against our strategy. I mean, everybody would have knowledge that it's an uncertain macroeconomic environment. But we believe that we will continue to win by delivering great innovative products that at the end of the day delight and ever increasing for our set of customers. We're making some very creative marketing campaigns. We have strong sales and go-to-market motions that are appropriate for the set of customers that we're targeting. And I think we're the being the best users of our product, which actually gives us tremendous credibility, to both innovate at a rapid pace, as well as deliver great customer satisfaction and growth to our customers worldwide. So thank you for joining us. And with that, I'll turn it over to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Great, thanks. Thanks everyone for joining the call. We look forward to speaking to many of you soon and this does conclude the event. Thank you."
}
] | Adobe Inc. | 24,321 |
ADBE | 1 | 2,022 | 2022-03-22 17:00:00 | Operator: Good day and welcome to the Q1 FY 2022 Adobe Earnings Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Mr. Jonathan Vaas. Please go ahead, sir.
Jonathan Vaas: Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s first quarter fiscal year 2022 financial results. You can find our Q1 press release as well as PDFs of our prepared remarks and financial results on Adobe’s Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, March 22 and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today’s press release and in Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as adjusted growth rates in constant currency that account for an extra week in the year ago quarter. During this presentation, Adobe’s executives will refer to adjusted growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon and thank you for joining us. Before I discuss our Q1 results, I want to acknowledge the horrifying and heartbreaking crisis in Ukraine. The pain and suffering of millions of innocent civilians is incredibly tragic and our thoughts and prayers are with the Ukrainian people. Adobe joins the global community in taking a stand by stopping all new sales of our products and services in Russia. The Adobe Foundation has made grants to aid humanitarian relief efforts. I am proud of how our teams have come together and continue to successfully manage our business throughout the most challenging of times while focusing on delighting customers and the long-term growth initiatives for the company. Adobe has always had a strong purpose-driven culture and that has never been more evident than it is today. Adobe’s mission to change the world through digital experiences is more critical than ever before. Everywhere we look, whether it is in entertainment, education or the enterprise, content is fueling the global economy. The democratization of creativity, emergence of new ways to work and learn from anywhere and the business mandate for personalized customer experiences underscore the immense opportunities we have as a company. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is working. Our innovation engine is delivering category-leading products, services and platforms across Creative Cloud, Document Cloud and Experience Cloud. Adobe had a strong Q1. We achieved a record $4.26 billion in revenue, representing 17% year-over-year growth on an adjusted basis. GAAP earnings per share for the quarter were $2.66 and non-GAAP earnings per share, was $3.37. In our Digital Media business, we drove strong growth in both Creative Cloud and Document Cloud, achieving $3.11 billion in revenue. Net new Digital Media annualized recurring revenue, or ARR, was $418 million, and total Digital Media ARR exiting Q1 grew to $12.57 billion. In our Experience Cloud business, we built on our Q4 momentum, achieving $1.06 billion in revenue, and subscription revenue was $932 million for the quarter. I am pleased to have David Wadhwani, President, Digital Media; and Anil Chakravarthy, President, Digital Experience, on this call to share more about our momentum in the Digital Media and Digital Experience businesses, respectively. David?
David Wadhwani: Thanks, Shantanu and hello everyone. The acceleration to all things digital has made content and creativity more important than ever before. Everyone needs to express themselves digitally, from the individual on social media to the student creating a more compelling school project to the creative professional making the next marketing campaign. The rapid rise of the creator economy is giving individuals, solopreneurs and small business owners the opportunity to monetize their passions, their products and their services. Creative Cloud is catalyzing these trends and fulfilling our vision for Creativity For All, enabling customers of every skill level to create content that stands out. We continue to lead in core creative categories such as imaging, design, video and illustration. And we’re advancing new media types like 3D and immersive for the emerging metaverse platforms. We’re building applications for every surface and every audience across web, mobile and desktop. And we’re investing heavily in collaboration services that are deeply integrated into our flagship applications. Our new web-based solutions enable us to deliver value more quickly and broadly than ever before. Creative Cloud solutions are powered by Adobe Sensei, our AI engine, which enables customers to work faster and smarter. As a result, our creative community has never been stronger. Behance now has nearly 30 million members, and we continue to host hundreds of on-demand and live sessions weekly that serve as a source of learning and inspiration. As a result, in Q1, we achieved net new Creative ARR of $315 million and revenue of $2.55 billion, which grew 16% year-over-year on an adjusted basis. Q1 highlights include the launch of Creative Cloud Express, our new template-driven web and mobile product that makes it easy for anyone to create and share beautiful content. Its zero-friction onboarding will bring millions of small business owners, social influencers and students into the Creative Cloud family and empower them to create everything from social posts to marketing materials. Creative Cloud Express features thousands of gorgeous templates, millions of stunning stock images and videos and the world’s most complete collection of fonts. Its easy-to-use interface is continuously expanding with innovation such as enhanced search capabilities for millions of assets and new PDF Quick Actions that enable users to edit, convert, combine and organize PDFs. While we’re just a few months into our journey, we’re seeing strong traffic, millions of monthly active users and high customer satisfaction. On the video front, the explosive demand for video content shows no signs of abating. In Q1, we launched new AI-powered innovations in Premiere Pro that help merge music into video sequences and accelerate transcriptions. We also drove strong growth for Frame.io, the leading video collaboration solution Adobe acquired late last year. Frame had its best quarter ever, closing more deals than in any prior quarter while increasing deal sizes to record levels. As creativity has become a team sport, we will extend our leadership in video collaboration and bring collaboration capabilities to all creative categories. We are also seeing tremendous interest for Substance 3D and our new 3D Modeler beta as brands bring together the physical and digital worlds and begin their journeys to become metaverse-ready. Substance is already being adopted by global brands like Coca-Cola, NASCAR and NVIDIA for marketing and e-commerce. Finally, we continue to see strong demand for Creative Cloud offerings globally across all segments: individuals, SMBs, teams and enterprises with key wins at Disney, the FAA, IBM, ING Bank, Kohl’s and the New Mexico Public Education Department. On the Document Cloud side, digital documents have become the foundation of how businesses run and will continue to gain significance as hybrid work becomes the standard. Adobe is accelerating document productivity with Document Cloud, enabling all capabilities, including editing, converting, sharing, scanning and signing to be frictionless across web, desktop and mobile. PDFs are getting smarter and more accessible through our continued investment in AI and ML. And we’re enabling new workflows through our APIs by empowering developers to build customized digital document experiences for their businesses. In Q1, we achieved record revenue of $562 million and net new Document Cloud ARR of $103 million. Ending ARR for Document Cloud crossed the $2 billion mark, which represents 29% year-over-year growth. Q1 highlights include strong growth in Adobe Sign, driven by unifying e-signature functionality in Acrobat and new Sign integrations with Adobe Commerce and Workfront. On the web, we continue to see a high volume of searches for document actions such as editing, converting and sharing PDFs. As a result, Acrobat Web’s contribution to the business has nearly doubled year-over-year. On mobile, we saw billions of Acrobat mobile PDFs opened in Q1. This usage, combined with our efforts to convert users to paid subscribers on mobile, is working. Acrobat mobile ARR grew over 70% year-over-year. And lastly, our Document Cloud enterprise business continues to do well with key wins including Medallia, Mercedes-Benz, Raytheon, Ricoh Europe, Shimizu and UnitedHealth. We have responded to the needs of professionals by adding a broad array of features to our flagship applications across both Creative Cloud and Document Cloud. And we’re attracting millions of new users, including a significant number of non-pros, with Acrobat and Creative Cloud Express on web and mobile. Our increasing breadth of offerings not only expand our ability to reach new customers but also enable us to further personalize pricing across our offerings starting later in Q2. I will now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello, everyone. Over the last 2 years, the digital economy has exploded as we have experienced a profound global shift in how we work, learn and play. Telehealth visits are now the norm rather than the exception. Customers and businesses are engaging and transacting digitally. Online shopping is now essential, and the U.S. is on track to surpass $1 trillion in e-commerce sales this year, according to the Adobe Digital Economy Index. To succeed, companies must make the digital economy personal with powerful digital experiences that can be personalized to millions of customers in milliseconds. Adobe Experience Cloud is a comprehensive set of integrated AI-driven applications and services to help companies deliver experiences across all aspects of the customer journey. At its core is the Adobe Experience Platform with billions of customer profiles. Our Adobe Experience Cloud applications span the entire customer funnel, from acquisition to monetization to retention, across content and commerce, customer journeys, data insights and audiences and marketing workflow. We have made the dramatic transformation to deliver AI-driven services with over 80% of Experience Cloud customers now using Adobe Sensei, our industry-leading AI and ML framework to power experiences for their customers. Last week, we hosted Adobe Summit, the world’s largest digital experience conference. We launched exciting new Experience Cloud technology and heard from executives from some of the world’s most interesting and innovative brands, including BMW, Nike, Prada, Real Madrid and Walgreens Boots Alliance. We enabled the entire event using Experience Cloud, personalizing the experience for our global attendees. Summit content has had over 22 million views to date, underscoring the significant interest and demand for digital transformation. We continue to drive outstanding growth in our Experience Cloud business. The pandemic has caused brands around the world to realize the critical need for digital transformation. And we’re adding new logos while continuing to focus on driving significant value realization for our existing customers. In Q1, we achieved $1.06 billion in revenue. Subscription revenue was $932 million for the quarter, representing 22% year-over-year growth on an adjusted basis. Q1 highlights include a slate of exciting product innovations, including new real-time customer data capabilities with the integration of Adobe Real-Time CDP and Adobe Target. Adobe Real-Time CDP is used by a large and growing base of customers such as DICK’S Sporting Goods, Henkel, Panera, Real Madrid, ServiceNow and Verizon; new cross-cloud integrations, including a unified workflow between Workfront, Creative Cloud Enterprise and Experience Manager assets that powers end-to-end content creation and delivery; strong performance in Adobe Experience Manager, emphasizing the need for unified content management to meet the ever-increasing demand for content at speed and scale. Adobe is uniquely positioned to help customers across the content supply chain; new APIs that provide developers with the flexibility to create customized user experiences on top of Adobe Commerce; the general availability of Adobe Experience Cloud for Healthcare to deliver personalized health care experiences; an expanding partner ecosystem, including a partnership with OneTrust to simplify consent management; the next phase of e-commerce integrations with FedEx, Walmart and PayPal as well as a collaboration with The Weather Company; and key customer wins, including CrowdStrike, Deutsche Telekom, IBM, Jaguar Land Rover, JPMorgan Chase, McDonald’s and UnitedHealth. Our Experience Cloud product innovation, global customer base and vibrant partner ecosystem are driving our continued success. We are executing across our entire go-to-market motion and continue to receive strong industry recognition. This quarter, Adobe was named a leader in 3 industry analyst reports focused on core customer experience management segments, including Gartner’s Magic Quadrant for Digital Experience Platforms, the inaugural IDC MarketScape for CDPs for Front Office and the Forrester Wave for Digital Asset Management. Dan, over to you.
Dan Durn: Thanks, Anil. Today, I will start by summarizing Adobe’s performance in Q1 fiscal 2022, highlighting growth drivers across our businesses, and I’ll finish with targets for Q2. Adobe’s strong financial results demonstrate the company’s ability to execute in a challenging macroeconomic and geopolitical environment. Across our business, we are attracting new customers, signing up transformational deals, growing our recurring book of business and seeing emerging businesses ramp and, in some cases, reach escape velocity. We are witnessing the digitization of everything and Adobe’s products offer customers access to a digital future, underpinning how they live and work. Our investment in products, marketing and a data-driven operating model are continuing to drive Adobe’s growth. In Q1, Adobe achieved record revenue of $4.26 billion, which represents 9% year-over-year growth or 17% on an adjusted basis. Business and financial highlights included GAAP diluted earnings per share of $2.66 and non-GAAP diluted earnings per share of $3.37; Digital Media revenue of $3.11 billion; net new Digital Media ARR of $418 million; Digital Experience revenue of $1.06 billion; cash flows from operations of $1.77 billion; RPO of $13.83 billion exiting the quarter; and repurchasing approximately 3.8 million shares of our stock during the quarter. In our Digital Media segment, we achieved 9% year-over-year revenue growth in Q1 or 17% on an adjusted basis. We exited the quarter with $12.57 billion of Digital Media ARR. Global demand for digital content continues to explode. And with the strength of Adobe’s product innovation and our data-driven operating model, our net new Digital Media ARR in Q1 grew on a year-over-year basis after factoring out the additional week in the year-ago period. We achieved Creative revenue of $2.55 billion, which represents 7% year-over-year growth or 16% on an adjusted basis. We added $315 million of net new Creative ARR in the quarter. First quarter Creative growth drivers included strong creative engagement and retention across individual and SMB segments; new customer demand across large organizations, small and medium businesses, driving growth in our Creative Cloud for Teams offering, which was the highest Q1 on record; sustained growth of subscription licensing for individual flagship applications such as Photoshop, Illustrator and Premiere as well as strength in our Adobe Stock business; and enterprise adoption of new collaboration capabilities, including Frame.io as well as our 3D and immersive applications. We are also pleased by the adoption we see in some of our newer initiatives such as Creative Cloud Express, Substance as well as Acrobat, Photoshop and Illustrator on the Web. We are driving strong usage growth and have already attracted millions of monthly active users to our cloud-native offerings. We expect these businesses to be drivers of future ARR and revenue growth. Adobe achieved Document Cloud revenue of $562 million, which represents 17% year-over-year growth or 26% on an adjusted basis. We added $103 million of net new Document Cloud ARR in the quarter, surpassing $2 billion in ending ARR, growing at 29% year-over-year. Document Cloud continues to be our fastest-growing business, demonstrating that our strategy of accelerating document productivity is working and reflecting how Acrobat and PDF are essential to the way people work in a digital-first world. First quarter Document Cloud growth drivers included customer demand for Acrobat subscriptions, the strongest Q1 on record; new licensing and renewal for Acrobat for Teams offering in the SMB segment, both on adobe.com and through our reseller channel; momentum in Adobe Sign with strong year-over-year growth of Sign transactions within Acrobat; strong demand for our PDF solutions on mobile; and continued momentum with our frictionless onboarding of new customers through Acrobat Web with ARR growing approximately 90% year-over-year. Turning to our Digital Experience segment, in Q1, we achieved revenue of $1.06 billion, which represents 13% year-over-year growth or 20% on an adjusted basis. Digital Experience subscription revenue was $932 million, representing 15% year-over-year growth or 22% on an adjusted basis. When we look at the quarterly sequential revenue growth, we continue to see acceleration as our strategy of delivering personalization at scale is resonating with enterprise customers. First quarter Digital Experience growth drivers included new logo acquisition across our solutions; strong customer retention as a result of investments we’ve made in product innovation, greater value realization and customer experience; larger deal sizes in our Workfront business; traction upselling customers to new cloud-native solutions; and momentum with our Content & Commerce, customer data platform and Customer Journey Analytics offerings. In Q1, we continued to increase investments in initiatives that will drive long-term revenue growth, including ramping headcount across R&D and sales capacity. Travel and facilities remained at lower levels in Q1, but we’re increasing facilities utilization and travel in Q2 as we resume in-person meetings with customers and partners. Adobe’s effective tax rate in Q1 was 18% on a GAAP basis and 18.5% on a non-GAAP basis. The tax rate came in higher than expected, primarily due to less-than-expected tax benefits associated with stock-based compensation. Our trade DSO was 36 days, which compares to 38 days in the year-ago quarter and 42 days last quarter. RPO grew by 19% year-over-year to $13.83 billion exiting Q1, benefiting from enterprise bookings. Our ending cash and short-term investment position exiting Q1 was $4.70 billion and cash flows from operations in Q1 were $1.77 billion. We repurchased approximately 3.8 million shares in Q1 at a cost of $2.1 billion. Included in this purchase was the partial settlement of an accelerated share repurchase entered into during Q1 to repurchase shares at an aggregate cost of $2.4 billion. The final number of shares to be repurchased under the ASR will be based on a discount to the volume weighted average price of our common stock during the term of the agreement with the final settlement and delivery of incremental shares to Adobe scheduled to occur in early Q3. These share repurchases are part of the previously announced program, under which we currently have $10.7 billion remaining of our $15 billion authorization that was granted in December 2020 and goes through 2024. Before we get to our Q2 targets, I want to discuss the impact of the devastating situation in Ukraine. Earlier this month, Adobe announced the cessation of all new sales in Russia and Belarus. In addition, we’ve made the decision to reduce our Digital Media ARR balance by $75 million, which represents all ARR for existing business in these two countries. While we will extend subscriptions automatically in Ukraine during this period and continue to provide Digital Media services, we reduced ARR by an additional $12 million, which represents our entire Ukraine business. This results in a total ARR reduction of $87 million and an expected revenue impact of $75 million for fiscal 2022. The impact toward Digital Experience business is de minimis. For Q2, we are targeting total Adobe revenue of approximately $4.34 billion; net new Digital Media ARR of approximately $440 million; Digital Media segment revenue growth of approximately 13% year-over-year or 14% in constant currency; Digital Experience segment revenue growth of approximately 15% year-over-year or 16% in constant currency; Digital Experience subscription revenue growth of approximately 17% year-over-year or 18% in constant currency; tax rate of approximately 20% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of approximately $2.44; and non-GAAP earnings per share of approximately $3.30. As a result of the lower-than-expected deductions from stock-based compensation, our effective tax rate for fiscal 2022 is now targeted to be 19.5% on a GAAP basis and 18.5% on a non-GAAP basis. As we look towards the back half of the year, we expect quarterly sequential revenue and EPS growth in Q3 and Q4. In Digital Media, we expect strong second half ARR performance across Document Cloud and Creative Cloud, including continued strength of emerging businesses like Acrobat Web, Frame.io, Substance and Creative Cloud Express. In addition, we expect ARR contributions to increase sequentially in Q3 and Q4 from a new offering and pricing structure which starts late in Q2. We expect Digital Experience bookings to show continued momentum in the second half with a traditional strong Q4 finish. We will continue to invest in product innovation, sales capacity, marketing awareness and demand generation given our immense market opportunity. As the world reopens, we expect to increase our travel and facilities expenses. In summary, I’m pleased that Adobe delivered another record quarter in Q1 with sustained growth and world-class profitability. Adobe continues to show its resilience through unprecedented circumstances that all companies face today, and I’m confident we will emerge stronger. We are on track for another year of strong financial performance. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. This is a transformative time at Adobe. We’re engaging with hundreds of millions of customers globally, from individuals to the largest enterprises, launching new applications for new audiences and bringing our flagship category applications to new surfaces and platforms while increasing collaboration capabilities across our solutions. Adobe has a winning strategy applied to an exceptional opportunity. We’re a leader in the digital economy with Adobe Creative Cloud, Document Cloud and Experience Cloud, which combined have a total addressable market of $205 billion. Few companies can consistently deliver technology innovation, successful transformation across new categories and business models and a broad ever-growing base of customers and partners. I’d like to thank our 26,000 employees for their continued dedication and unwavering focus on delivering customer innovation and inventing the future of digital experiences. Thank you. We will now take questions. Operator?
Operator: Thank you. [Operator Instructions] We will take our first question from Brent Thill with Jefferies. Please go ahead.
Brent Thill: Good afternoon. Curious if you could shed any more color on the new pricing structure and what that means. And Shantanu, beyond Ukraine, is there anything else you’re seeing in the broader economy that’s different than you’ve seen historically? Thank you.
Shantanu Narayen: So Brent, as it relates to what we have seen first in terms of the macroeconomic situation, we actually continue to see strength. We were pleased with the strong Q1. Certainly, I think the last few weeks of the quarter, you saw some impact in Europe, specifically as it related to what happened in terms of the terrible situation in Ukraine. But I think we continue to see growth around the world. I think on the first one, as you know, and then I’ll have David also add some color, the last major comprehensive overall that we had for our pricing was in 2017. And you’ve seen since then the number of different initiatives that we have and offerings that we’ve introduced, whether it was the 3D offerings, what we’ve done on the web, what we’ve done in mobile, what we’ve done around Creative Cloud Express. So I think it was time to take a very comprehensive look, which David has done. And I think directionally, what I would say is that we want to continue to attract hundreds of millions to the platform, but we also want to get value for the tremendous innovation that we’ve provided. David, maybe you can add a little bit more.
David Wadhwani: Yes, happy to. So as Shantanu mentioned, the last pricing update and adjustment we made was in 2017. Since then, we’ve added a lot to our existing offerings. We’ve added new applications. We’ve extended broadly across multiple services. We’ve doubled down on collaboration. We’ve added millions of stock assets and thousands of fonts. And we’ve also introduced new offerings. Obviously, Acrobat across web and mobile has been growing for the last few years, and you heard us talk – last year or 2, you heard us talk about that in the prepared remarks. But also CCX is now in market across web and mobile. And the early success we’re seeing with these new offerings across web and mobile and across Acrobat and CCX has really been the catalyst for these pricing adjustments that we’re looking at doing. They let us introduce the right value with the right onboarding experience and the right pricing to attract millions of new subscribers. And they provide us the opportunity to right-size the value where engagement and usage is highest in our core existing customer base. The impact of this, we think, for Q2 will be fairly minimal because it takes time to roll this out globally, and it takes time for customers to go through their renewal cycles where their prices change. But we expect it to have a more significant impact and build-out in Q3 and Q4.
Brent Thill: Thank you.
Operator: Thank you. We will take our next question from Alex Zukin with Wolfe Research.
Alex Zukin: Hi, guys. So maybe to think – to ask Brent – to ask the question a different way, if you think about Adobe has been around for a long time through many business cycles, as we – as you look at the pipeline of activity for the back half of the year and you think about the – where – how investors should think about it in a more recessionary, inflationary environment, can you just give us some color around how you think about the pipeline development, how you think about any changes with respect to the shape of the year and seasonality? And then maybe just a financial question, I think there is just a better understanding of how the mechanics of the NRR are shaping up for Q2. Are you taking that – is the $440 million, is that guide inclusive of the impact of the Russia-Ukraine adjustment? Is it taken out of the prior year? Just a little bit more context would be helpful? Thank you, guys.
Shantanu Narayen: Sure, Alex. There were multiple questions in that. So let me – maybe first, to your point, which I agree with, when you think about the rhythm of the business and maybe the seasonal cadence, clearly, that’s been impacted by whether it’s the external events as it relates to the pandemic or more recently the war in Ukraine. But big picture, as we look at what’s happening in terms of customer adoption, what’s happening in terms of the excitement, there is no question that digital is a tailwind and will continue to be a tailwind. And our perspective is that what happened was the pandemic actually put a spotlight on the importance of everything we’re doing, whether it’s customer engagement, whether it’s content or document productivity. And so as you think about what happens seasonally, certainly, I think we would continue to see strength in Q3 and Q4. Dan referred to that in terms of the second half momentum that we would see. But even Q1, we had a strong start. So from our perspective, some of the seasonal cadence might have changed, but the secular trends in terms of up and to the right, we actually don’t see any impact associated with it. I think your second question is related to what happens specifically on Russia and Belarus and Ukraine. Since the Digital Media ARR, the book of business, we made the decision to reduce it. And so I think what you’ll see on the data sheet is what our exiting Q1 ARR is and then another number which just takes out all of the existing book of business for those three countries. You see the impact on revenue certainly in Q2, Q3 and Q4 because what it means is the revenue that we would have been able to collect. But again, in the grand scheme of things, as you can see, it’s fairly small as it relates to the business. So I think our targets, $440 million specifically, as you said, yes, it’s impacted by the ARR business in those countries. But overall, business is strong and we feel optimistic. I think in many ways, the message really is that the new growth initiatives that both Dan and David talked to, they are starting to really show traction. And so we expect to see strength in the second half of the year and certainly beyond that.
Alex Zukin: Got it. Thank you, guys.
Operator: Thank you. We will take our next question from Saket Kalia from Barclays.
Saket Kalia: Okay, great. Hey, thanks for taking my question here. David, maybe for you. Great to see the Creative Cloud Express launch recently, I guess the question for you is, how do you feel the product differentiates from some of the competition out there? And maybe without going too deep, how do you plan on investing in that product specifically to continue your lead?
David Wadhwani: Yes, thanks for the question. We’re very excited about the launch of CCX. But just to up-level for a minute, and as a reminder for everyone on the call, we’ve been talking about the communicator segment for years, both as it relates to non-pros and as it relates to the creator economy. We’ve talked about in the past that our mobile and desktop apps have hundreds of millions of registrations, which is clearly going beyond our Creative Pro base. And we’ve built a significant business. In fact, we believe that we’re the largest provider of creative tools in the world when measured by revenue across all of our segments: pros, communicators and consumers. The introduction of Creative Cloud Express though represents a lot of our learning over the last few years, starting with the business model. It’s a freemium business model. It’s predominantly web and mobile. So it’s zero friction for onboarding customers, and users are seeing success in minutes, not hours. In addition to that, we have an unprecedented library that we bring to Creative Cloud Express. We have 175 million stock images and videos. We have 20,000 fonts, largest font library online available, and thousands of templates that have been really carefully crafted and designed by some of the best creatives in the world. And this is important because at the end of the day, if you’re going to be a content-first creation tool, the content you mix together is a fundamental differentiator in terms of what you’re creating and what you’re producing. And we feel very, very good and confident about our ability to continue to expand this library and just make sure that what people are mixing to create their output is world class. But of course, we also have the power of Adobe. If you look at what we’re starting to do, and this gives you a hint of where we’re going with our quick actions across Photoshop Quick Actions, Premiere Quick Actions, Acrobat Quick Actions that have started to make their way into Creative Cloud Express, we feel really good about the pipeline of innovation we can bring from our decades of leadership across all of our segments directly into Creative Cloud Express. And then, of course, we are looking for ways to accelerate. We acquired a company called ContentCal that we’ve announced will be the foundation of rich content publishing and scheduling for Creative Cloud Express users. And then lastly, the work we’ve been doing over the last many years around the data-driven operating model that Dan talked about in his opening has been invaluable here. So we’re finding and we’re onboarding new users that would not have typically interacted with Adobe through their intent-based search. And the result is a little bit of what we alluded to. We’ve seen great traffic. We’re seeing millions of monthly active users just a few months into the launch. We have an NPS over 60 at this point in the product. So we’re really bullish on the start of where we are. And if you look at the long pipeline of Adobe-only innovation, maybe to your question, we’re super excited about that. And the last thing I’ll say here is that don’t forget the opportunity here is to drive millions of new users into our franchise. But the opportunity is also to drive high engagement and usage within our core CC base and take what has already been a very, very strong retention curve there and continue to drive engagement and retention of our CC users as well.
Saket Kalia: Very helpful. Thanks, guys.
Operator: Thank you. We will take our next question from Sterling Auty with JPMorgan.
Sterling Auty: Yes. Thanks. Hi, guys. Just maybe for clarification. With the changes, there is no update to the annual guidance. You typically don’t, but I think investors want to understand how the impact on the negative side from the changes to ARR for Russia and Ukraine impact the annual guide versus the positive uplift that you’ll get from the pricing structure. Thanks.
Shantanu Narayen: Yes. Sterling, I mean, I think color-wise, it’s really still early in the year, but I feel great about the way we’ve been navigating all of the external issues that have come. And it was a strong Q1. As we prepared for this call, we felt it was important to share with you the impact that we know of things, whether it’s the revenue or ARR for Russia, what’s happening on EPS as it relates to the tax rate as well as to provide some more of the growth drivers. But I net it out by saying while we are not updating the annual targets, as you pointed out, we’re really optimistic on the significant number of growth drivers that we have. And we will share more throughout the year because we still are all navigating what is a considerably unpredictable situation. Our strong Q1, however, and the things that we control, we feel excellent about.
Sterling Auty: Understood. Thank you.
Operator: Thank you. We will take our next question from Jay Vleeschhouwer with Griffin Securities.
Jay Vleeschhouwer: Thank you. Good evening. Shantanu, referring back to the analyst meeting 3 months ago, you and David used the term product-led growth. And I was wondering if you could elaborate on that because arguably, when you think about the company over the last 30 years or more, you’ve always, in effect, been product-led growth. So how are you thinking about that differently now in terms of a concept or various executables for that? And then for Dan, could you talk about how you’re thinking about your headcount growth relative to your expense growth for the year? You onboarded over 500 employees during the quarter, you finished Q1 with a record number of open recs. How are you thinking about filling those divisions, either to compensate for the increase in attrition you had in fiscal ‘21 versus normal organic growth that you otherwise would have done anyway?
Shantanu Narayen: Yes. Jay, when I think about the transformative things that we’ve done in the company, certainly the move to subscriptions, the entrance into digital marketing, what we’ve done with data-driven operating model to drive the sort of financial cadence of the business, they absolutely bubble to the top. But I would say those actually dwarf in comparison to the excitement that I feel about what product-led growth can continue to do. When you have hundreds of millions or billions of people using your software, a good example of what we’ve done is the constant innovation that we’re delivering on the Document Cloud side. And I think David referred to some of the statistics, whether it’s sort of doubling what we see with web traffic and really being aware of the intent-based approach that people want when they come on the web to accomplish document actions, what we are doing in mobile and doubling it. And I think product-led growth just relates to ensuring that all of our product teams have information at their fingertips as to how people are really using it so that we can rapidly iterate in terms of what customers want and delight them. And I think on the Creative Cloud, to add to what David said to Saket as well, what that means with Creative Cloud Express is as you have these millions of users, we’re constantly understanding where the search traffic is, how do you improve it. And it’s just a new way of liberating all of the product-led – product teams to focus on what’s truly important and truly needle-moving as far as customer interest and customer sentiment. And it’s something that David has pioneered. So I’ll have David add a little bit more. But I think the impact on how we serve customers, the NPS and being able to continue to recruit and retain is significant.
David Wadhwani: Yes. I think Shantanu covered most of it. Just a couple of things to add. As you correctly point out, we joke internally that actually John and Chuck created product-led growth with distributing the free Reader and then sort of upselling people from there to the Acrobat offering. And so we’ve, throughout our history, had this idea and sense of how you drive utilization and usage and engagement and then drive that to convert to users. I think what we are – where we are right now is an exciting inflection point where, as Shantanu mentioned, we’re seeing a lot more activity and engagement on web, we’re seeing a lot more activity and engagement on mobile. And that lets us have better and more seamless onboarding. So we can use everything we’ve learned around DDOM to drive better intent-based search and reach audiences that frankly we weren’t able to reach before because the onboarding experience, the actions to success and then what we do beyond that is in minutes, not hours.
Shantanu Narayen: Maybe one last thing before Dan comments. I think both Dan and David talked about retention and engagement during the quarter. And to give you a little bit more, Jay, color in terms of that, we look at churn rates. We look at reseller renewal. We look at 90-day cohort retentions. And in all of those, I think as a result of the activity that we’re doing on the product teams to help improve, we’re seeing improvement and getting to rates on all three of those that are better than they have ever been even prior to the pandemic. So I think that’s, again, another example of what gives us confidence in our offerings and our innovation going forward.
Dan Durn: And then, Jay, just to come to your second question, we talked about the business performing well. When we talk about digital content and data increasingly driving economic growth going forward in a world where everything is going digital. That means we have an immense market opportunity in front of us, greater than $200 billion in 2024 and significantly larger than that as we look forward. So our long-term growth opportunity at Adobe is not opportunity-constrained. And so when we think about our leadership and product positions, they are built on the back of a very strong innovation engine at the company. So, we are going to orient towards growth. We are going to continue to invest in R&D and the sales muscle to scale our businesses over time and continue that leadership in the markets that we participate in. But we are going to do what we have always done along the way, is do it in a disciplined way, so we are marrying the investments we make with the opportunities as they materialize and grow in a very profitable way. And so you can see the company’s history in terms of strong profitable growth, and I would expect our track record on that to continue over the long run.
Jay Vleeschhouwer: Thank you.
Operator: Thank you. We will take our next question from Keith Weiss with Morgan Stanley.
Keith Weiss: Thank you, guys for taking the question. I actually had a couple of clarifications I was hoping to ask you guys about. Shantanu, earlier in the call, you do made some comments about perhaps seeing a little bit of weakness in Europe at the end of the quarter. Can you dig in on that a little bit like where in the business, did you see that weakness? And did that persist into Q2, or was it just kind of more temperamental? So, that was number one. Number two, on the – I know we are not giving full year guidance, but when we think about the operating margin outperformance in Q1, is the commentary that that’s going to be given back later in the year, or is it just like sort of the ramp-up gets pushed out, so the savings kind of like accrue throughout the full year? And then clarification number three, when you guys gave the original $1.9 billion net new ARR addition guidance for FY ‘22, did you guys already contemplate these price increases, so was the – or the price changes, were the price changes already in that $1.9 billion guide? So that’s my three clarifications.
Shantanu Narayen: Sure. So, Keith, maybe I will answer the last question first and then talk about it, which is, as we were entering the year and what we talked at the FA meeting, if you actually – I think we also got a couple of questions as it relates to what we were going to do on pricing, and we alluded to the fact that we are constantly looking at it. And so while it was something that we were working on, we actually just pretty recently finished the entire effort. So, we didn’t have it finalized, but we always thought that it was timed with the new offerings to actually look at the pricing structure as well. And so the definite amount and the materiality of that, we will know as we go through the process. But directionally, we knew that we were going to be looking at pricing more exhaustively. I think in terms of the clarification of what we saw, when the war broke out for the last couple of weeks, that impact is not just felt in Russia and Belarus and Ukraine, you see a little bit of that traffic across the region. So, that’s really all I was alluding to. And we saw strength, and that strength continued in the U.S. right through the quarter. And so not unsurprisingly, we saw a little impact. So, that’s all I was referring to as it related to the European situation. And did you have a third question, Keith?
Keith Weiss: Yes, the third one was on operating margins.
Dan Durn: Yes. Your third question on operating margin. So, let me break it up into three time periods. Let’s talk about Q1 briefly. Let’s talk about FY ‘22 and then beyond. So, as we think about Q1, clearly, Omicron was a context around that quarter. So, our investments in things like travel, facilities weren’t as robust as originally contemplated, and you saw a little bit of uplift from a margin structure standpoint in Q1. When we take a step back, we talked about the growth profile and the leadership of our product positions, continuing to invest to scale our businesses, and a lot of those investments being R&D and sales-oriented. We will continue to do that. And the targets that we set in FA Day a few months ago implied in those – in that framework is an operating margin for the year. And so I think you will see that unfold throughout the rest of the year. And then longer term, we talked about the significant opportunities facing the company and our ability to capture that with our leadership position as the world goes increasingly digital. And as we grow and scale this business, you will see the benefits of that over time layer into the operating margin as we continue to do it in a strong, profitable and disciplined way.
Keith Weiss: Excellent. Thanks so much, guys.
Operator: Thank you. We will take our next question from Tyler Radke with Citi.
Tyler Radke: Yes. Thanks very much for taking my question. Just going back to the price increase and pricing changes. Obviously, I am sure you will be sharing a lot more specifics as we go forward. But philosophically, just how are you thinking about the pricing changes at the high end versus the kind of entry-level creative products? And particularly, just curious how you are evaluating those pricing changes in the context of the competitive landscape? Thank you.
Shantanu Narayen: So, I think philosophically, the way we are looking at it, I will repeat what I said earlier, which is we haven’t done a comprehensive look at that in multiple years. And directionally, I think the significant value that we have added has to do with people, whether you are in businesses or whether you are a user of the entire apps. I mean we continue to add new apps to the – what’s called the CC All Apps platform. And directionally, we are just saying that is the area where we have to look at all of the increased value that we have. This is not driven in any way, shape or form by any competitive response. So, let me be categorical about that. This is raised by – we continue to attract billions of people to the platform in terms of the interest. And with all of the new offerings that we have, again as David said, across web, across mobile, across the browsers, we just want to make sure that as we continue to expand the offerings, we are looking at the pricing in a good way. So, the value that we have added to whether you are in teams with collaboration or whether you are to businesses continues to be a motivator for us to look at the prices as well on all the new apps that we have added. So hopefully, that gives you color. Let me also back up and say this is for us, all really about customers and delighting customers. But because we had an earnings call, we said as this gets rolled out, we at least want to give you some heads up because otherwise, some of you would say, why didn’t you at least allude to it. As David said, this doesn’t have an impact in Q2 really. It’s a pretty small impact. So, that was the rationale and thinking associated with it. And we will certainly roll this out with customers first, and then we will share with you more of what the impact is. But that’s the way we look at how we move the business going forward.
Tyler Radke: Great. And if I could sneak in a follow-up just on the digital experience side, obviously, pretty strong growth here in Q4 and the first part of the year, above 20% on an adjusted basis. I guess was there any kind of one-time factors that drove that outperformance? And as we think about the guide for the next quarter and the deceleration implied, just anything to call out there? Thank you.
Anil Chakravarthy: Thanks for the question. We are pleased with the momentum we have seen in the digital experience business with 22% growth and subscription on an adjusted basis. The market opportunity is huge, over $100 billion of TAM. The pandemic obviously put a spotlight on it in terms of the urgency. We are seeing it continue to grow in terms of customer demand, customer interest at the Board level and at the C-level. We are in a really strong market position with what we have built with the Adobe Experience Platform and the native apps like Customer Journey Analytics and CDP that we have built with that. So, overall, we feel really excited about the path forward. And we just had the Summit conference last week, excellent pipeline building event as well as a chance to showcase our product innovation. So, we expect this to continue through the year in terms of our momentum.
Tyler Radke: Thank you.
Operator: Thank you. We will take our next question from Keith Bachman with BMO.
Keith Bachman: Hi. Thank you. I am going to follow lead with a couple of clarifications. Dan, could you comment on what the inorganic contribution was this quarter and where it manifests? So for instance Frame.io, what was the contribution there? Secondly, when you think about – I just want to clarify on the ARR write-off, so to speak. The comment was that you are ceasing all new incremental business. But are you going to continue to get ARR payments in Russia – or from Russia and Belarus from existing business that might actually contribute to ARR? Just a little bit confused on that one. And then in the spirit of Keith Weiss, I am actually going to ask a third clarification. Shantanu, in the past, you have said that in the creative side, new subscribers was the most significant contributor to growth. And I just wanted to try to understand given more competition perhaps in the lower end of the market, is that still true? Thank you.
Shantanu Narayen: I will answer the first – the third one first, Keith, as Dan does, which is if you look at the growth, the unit growth is being driven by single apps, which is new subscribers and driving to it. So that trend, in terms of continuing to drive single unit, is definitely part of how we think about it. I will answer maybe one part of also how you have to think about it, which is when you think about Russia and Belarus, we have the ARR, which is the book of business, but there is no way to really get payments. And with all of the sanctions that’s there, what we have factored is that book of business, because we are not going to be getting payments from Russia, that is the impact that Dan alluded to, which is the $75 million for the rest of the year. So, in addition to seizing new payment – in addition to stopping new sales, what you have to realize is for a service that exists as a SaaS-based service, you are unable to collect payments. And so we have reflected that impact as well in the particular geographies.
Dan Durn: Yes. And just coming back to your last piece, Keith, on Frame, now, that it’s part of the business, we are not going to be breaking this out. We talked about the momentum in the business. It’s great. The team is doing really well. The number of deals, the average deal size, business has a lot of momentum around it. And we talked about the great collaboration technology that exists there. But now that it’s a part of the business, we won’t be breaking it out explicitly.
Keith Bachman: Okay. Thank you.
Operator: Thank you. We will take our next question from Kash Rangan with Goldman Sachs.
Kash Rangan: Thank you very much. Congrats on the quarter. The numbers look quite good for Q1. So, Shantanu, I am curious, the shifting seasonality, generally when you find a more seasonal second half, that’s generally a sign of maturity in the market or macro factors or just product transition factors. But when I look at your second half, you do have relatively easier comps for DM ARR, right? And then you have the pricing optimization. So, if we net it all out, how do you feel about the business in the second half relative to going into the first quarter, granted that we have all these macroeconomic concerns? But net of the positives against – net of the negatives against the positives, how do you feel today versus three months back about the rest of the fiscal year? Thank you so much.
Shantanu Narayen: Thanks, Kash. I mean to net it out, I definitely feel more positive about business moving forward than I ever have, because just if you take a step back and look at all of – first look at Q1, we had a strong Q1. We clearly beat our targets in what is perhaps the most unpredictable situations that exist in the world. So, we feel really good about Q1. We feel really good about the new initiatives that – both in Document Cloud and Creative Cloud and in Experience Cloud that David and Anil spoke to. I did allude to the fact that when you think about the seasonal cadence and the rhythm of the business, certainly, some of that’s impacted. And perhaps the thing that you are alluding to, Kash, was in Q2 of last year, there was sort of a catch-up as “small and medium businesses” came on – come back online. And so you have to just factor what that is in. But both in terms of the revenue growth in DME for Q3 and Q4 as it relates to getting more similar to Q1 as well as the ARR, we are optimistic about the second half. The only reason we didn’t talk about Q2 is because we actually gave specific guidance and targets for Q2. So, don’t take that as anything as opposed to we have given you targets for Q2 and we are trying to give you color on what happens in Q3 and Q4. So hopefully, that helps, Kash. And on the DX side, since there have been fewer questions on the DX side, I mean what we have done, Summit was really exciting, the amount of new announcements that we have done there. Every person that I talked to in the C-suite continues to want to really focus on digital transformation and customer experience management. I am excited. I am back on the road again. It feels great. We have employees back in the office and facilities. People want to meet, and digital engagement is top of mind. So, across all three of our businesses, we didn’t talk about the document business. $100 million in ARR for the quarter, $2 billion book of business, really good adoption of our new functionality, whether it’s on the web as well as a unifying sign with Acrobat, which was a big movement that we are trying to do. So, I think all of those are positive. I think the one impact that, again, maybe Dan can just touch on is certainly, it doesn’t impact our core business. But the EPS, you just have to factor some of the revenue and other considerations that happened. But for the functional part of the business, I feel really good.
Dan Durn: Yes. So Shantanu did a good job talking about the fundamentals of the business. The other piece are the transient effects. And I would point to two of them. So, for the war in Ukraine, we de-risked the profile around the situation. And that’s the prudent thing to do, to be conservative in situations like this. So, that’s what you see in the $87 million reduction in ARR as well as the $75 million reduction from a revenue standpoint, Q2 through Q4. So, if I take that revenue and I flow it through the P&L, that’s going to be about a $0.04 a share headwind per quarter for the balance of the year, Q2 through Q4. From a tax standpoint, we talked about an 18.5% non-GAAP tax rate. That’s a 1.5 point change versus where we were at FA Day. If I were to roll that through the P&L, that’s about $0.06 a share per quarter throughout the year. We were able to overcome that in Q1. And then when I look at the share repurchase activity, clearly the company took advantage of the current environment. And that’s going to create about a $0.02 a share benefit each quarter this year versus where we were at FA Day. And so when I net all of that out on a go-forward basis, you have got about an $0.08 per share headwind in each quarter. And again, like we said in Q1, we were able to overcome that headwind in Q1 and deliver above the expectations that we had set, and we are going to continue to orient towards growth. We are going to invest to lead, but if there is opportunities to do it in a disciplined way and overcome it on a go-forward basis, we will take it a quarter at a time and let you know what we see.
Kash Rangan: Thank you, Dan. And Shantanu, just one final follow-up, the clear – I know that you want to talk about the Document Cloud and the Experience Cloud, but I remember fall of 2011, you have made a very bold transition to Creative Cloud subscription. You, in fact, outlined that you have a target of 4 million subscribers in fiscal ‘15, which seemed quite visionary back then, right? So, as you look at the inflection point going – the company is going through, what are your aspirations for Creative Cloud Express if you were to measure it in subscribers or how big of a business would you like it to be? What would be your similar prognostication as you look into the next few years? And that’s it for me. Thank you so much.
Shantanu Narayen: Kash, at the FA meeting, we talked about what the overall addressable market opportunity is. But I really feel like we can get billions of users to use our product. And then they will be the spectrum of people who will be paying us on a subscription business as well as others who will perhaps take advantage of some of the freemium offerings that we have. We are starting to see that kind of adoption with the Document Cloud certainly, right, where you have 0.5 billion people who have used our – a Reader and other products. But I think in terms of Creative Cloud Express, my hope and my aspiration is that every single person who has a story to tell uses some part of the Creative Cloud Express. We are off to a great start there, Kash. I think on the differentiation, as David said, we have the platform. We have every single piece of technology that we need to deliver a great compelling experience. And now we are also world-class at making sure that we capture search-based intent. So, we want to anticipate what people want to do with Creative, but I would be disappointed if that doesn’t just continue to be a huge growth area in terms of new users to our platform.
Jonathan Vaas: Operator, we are a little past the top of the hour. We will squeeze in one more question and then wrap up. Thank you.
Operator: Thank you. We will take our next question from Michael Turrin with Wells Fargo Securities.
Michael Turrin: Hi there. Good afternoon. Appreciate you squeezing me on. We have been expecting a return to normal expense profile. Q1 operating margins were actually flat relative to last year. Anything else you can add just around the Q1 margin results? And as we think through the puts and takes between that return to a more normalized expense profile and some of the product and pricing efforts you have mentioned ahead this year, any way to think through if price uplift can help offset some of that expense normalization you are expecting? Thank you.
Dan Durn: Yes, sure. So, if I were to look at where we landed in Q1, and we talked about not fully investing from a travel and facilities standpoint because of the Omicron environment. And as I look forward to the Q2 guide and the operating margin that is implicit in that guide and I were to break it out into some several buckets. There is going to be an influence from the transient effects of the Russia situation. We are going to do increased hiring to invest for future growth. We get full quarter impact from a merit standpoint instead of a one month impact. And then we will start to see the reopening expenses start to layer back in. Those are the four buckets that bridge you from Q1 to Q2. And I would say each of those four buckets is roughly equally weighted. And so I think that’s what gets you to a more normalized run rate as we look into Q2 and the back half of the year.
Shantanu Narayen: And since that was the last question, I wanted to, again, thank you all for joining us today. We are pleased with the performance. We think we had a really strong start to the fiscal year across all three of our businesses Creative Cloud, Document Cloud and Experience Cloud. And more than that, I think our ability to continue to delight customers and deliver on the innovative roadmap gives us a lot of confidence associated with the new initiatives taking stock and contributing to the future growth at Adobe. The spotlight, I believe, on digital will just continue. And as we get back to more normalcy, I think that will only all go well for both Adobe and our customers. And the successful Summit that we just organized, I think is another indicator of the interest that exists in our solutions. So, thank you for joining us today, and we look forward to sharing more as we go through the year. Thank you.
Jonathan Vaas: This concludes the call. Thanks, everyone.
Operator: Thank you. That does conclude today’s conference. We thank you all for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Q1 FY 2022 Adobe Earnings Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Mr. Jonathan Vaas. Please go ahead, sir."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s first quarter fiscal year 2022 financial results. You can find our Q1 press release as well as PDFs of our prepared remarks and financial results on Adobe’s Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, March 22 and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today’s press release and in Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as adjusted growth rates in constant currency that account for an extra week in the year ago quarter. During this presentation, Adobe’s executives will refer to adjusted growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe’s Investor Relations website. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon and thank you for joining us. Before I discuss our Q1 results, I want to acknowledge the horrifying and heartbreaking crisis in Ukraine. The pain and suffering of millions of innocent civilians is incredibly tragic and our thoughts and prayers are with the Ukrainian people. Adobe joins the global community in taking a stand by stopping all new sales of our products and services in Russia. The Adobe Foundation has made grants to aid humanitarian relief efforts. I am proud of how our teams have come together and continue to successfully manage our business throughout the most challenging of times while focusing on delighting customers and the long-term growth initiatives for the company. Adobe has always had a strong purpose-driven culture and that has never been more evident than it is today. Adobe’s mission to change the world through digital experiences is more critical than ever before. Everywhere we look, whether it is in entertainment, education or the enterprise, content is fueling the global economy. The democratization of creativity, emergence of new ways to work and learn from anywhere and the business mandate for personalized customer experiences underscore the immense opportunities we have as a company. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is working. Our innovation engine is delivering category-leading products, services and platforms across Creative Cloud, Document Cloud and Experience Cloud. Adobe had a strong Q1. We achieved a record $4.26 billion in revenue, representing 17% year-over-year growth on an adjusted basis. GAAP earnings per share for the quarter were $2.66 and non-GAAP earnings per share, was $3.37. In our Digital Media business, we drove strong growth in both Creative Cloud and Document Cloud, achieving $3.11 billion in revenue. Net new Digital Media annualized recurring revenue, or ARR, was $418 million, and total Digital Media ARR exiting Q1 grew to $12.57 billion. In our Experience Cloud business, we built on our Q4 momentum, achieving $1.06 billion in revenue, and subscription revenue was $932 million for the quarter. I am pleased to have David Wadhwani, President, Digital Media; and Anil Chakravarthy, President, Digital Experience, on this call to share more about our momentum in the Digital Media and Digital Experience businesses, respectively. David?"
},
{
"speaker": "David Wadhwani",
"text": "Thanks, Shantanu and hello everyone. The acceleration to all things digital has made content and creativity more important than ever before. Everyone needs to express themselves digitally, from the individual on social media to the student creating a more compelling school project to the creative professional making the next marketing campaign. The rapid rise of the creator economy is giving individuals, solopreneurs and small business owners the opportunity to monetize their passions, their products and their services. Creative Cloud is catalyzing these trends and fulfilling our vision for Creativity For All, enabling customers of every skill level to create content that stands out. We continue to lead in core creative categories such as imaging, design, video and illustration. And we’re advancing new media types like 3D and immersive for the emerging metaverse platforms. We’re building applications for every surface and every audience across web, mobile and desktop. And we’re investing heavily in collaboration services that are deeply integrated into our flagship applications. Our new web-based solutions enable us to deliver value more quickly and broadly than ever before. Creative Cloud solutions are powered by Adobe Sensei, our AI engine, which enables customers to work faster and smarter. As a result, our creative community has never been stronger. Behance now has nearly 30 million members, and we continue to host hundreds of on-demand and live sessions weekly that serve as a source of learning and inspiration. As a result, in Q1, we achieved net new Creative ARR of $315 million and revenue of $2.55 billion, which grew 16% year-over-year on an adjusted basis. Q1 highlights include the launch of Creative Cloud Express, our new template-driven web and mobile product that makes it easy for anyone to create and share beautiful content. Its zero-friction onboarding will bring millions of small business owners, social influencers and students into the Creative Cloud family and empower them to create everything from social posts to marketing materials. Creative Cloud Express features thousands of gorgeous templates, millions of stunning stock images and videos and the world’s most complete collection of fonts. Its easy-to-use interface is continuously expanding with innovation such as enhanced search capabilities for millions of assets and new PDF Quick Actions that enable users to edit, convert, combine and organize PDFs. While we’re just a few months into our journey, we’re seeing strong traffic, millions of monthly active users and high customer satisfaction. On the video front, the explosive demand for video content shows no signs of abating. In Q1, we launched new AI-powered innovations in Premiere Pro that help merge music into video sequences and accelerate transcriptions. We also drove strong growth for Frame.io, the leading video collaboration solution Adobe acquired late last year. Frame had its best quarter ever, closing more deals than in any prior quarter while increasing deal sizes to record levels. As creativity has become a team sport, we will extend our leadership in video collaboration and bring collaboration capabilities to all creative categories. We are also seeing tremendous interest for Substance 3D and our new 3D Modeler beta as brands bring together the physical and digital worlds and begin their journeys to become metaverse-ready. Substance is already being adopted by global brands like Coca-Cola, NASCAR and NVIDIA for marketing and e-commerce. Finally, we continue to see strong demand for Creative Cloud offerings globally across all segments: individuals, SMBs, teams and enterprises with key wins at Disney, the FAA, IBM, ING Bank, Kohl’s and the New Mexico Public Education Department. On the Document Cloud side, digital documents have become the foundation of how businesses run and will continue to gain significance as hybrid work becomes the standard. Adobe is accelerating document productivity with Document Cloud, enabling all capabilities, including editing, converting, sharing, scanning and signing to be frictionless across web, desktop and mobile. PDFs are getting smarter and more accessible through our continued investment in AI and ML. And we’re enabling new workflows through our APIs by empowering developers to build customized digital document experiences for their businesses. In Q1, we achieved record revenue of $562 million and net new Document Cloud ARR of $103 million. Ending ARR for Document Cloud crossed the $2 billion mark, which represents 29% year-over-year growth. Q1 highlights include strong growth in Adobe Sign, driven by unifying e-signature functionality in Acrobat and new Sign integrations with Adobe Commerce and Workfront. On the web, we continue to see a high volume of searches for document actions such as editing, converting and sharing PDFs. As a result, Acrobat Web’s contribution to the business has nearly doubled year-over-year. On mobile, we saw billions of Acrobat mobile PDFs opened in Q1. This usage, combined with our efforts to convert users to paid subscribers on mobile, is working. Acrobat mobile ARR grew over 70% year-over-year. And lastly, our Document Cloud enterprise business continues to do well with key wins including Medallia, Mercedes-Benz, Raytheon, Ricoh Europe, Shimizu and UnitedHealth. We have responded to the needs of professionals by adding a broad array of features to our flagship applications across both Creative Cloud and Document Cloud. And we’re attracting millions of new users, including a significant number of non-pros, with Acrobat and Creative Cloud Express on web and mobile. Our increasing breadth of offerings not only expand our ability to reach new customers but also enable us to further personalize pricing across our offerings starting later in Q2. I will now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello, everyone. Over the last 2 years, the digital economy has exploded as we have experienced a profound global shift in how we work, learn and play. Telehealth visits are now the norm rather than the exception. Customers and businesses are engaging and transacting digitally. Online shopping is now essential, and the U.S. is on track to surpass $1 trillion in e-commerce sales this year, according to the Adobe Digital Economy Index. To succeed, companies must make the digital economy personal with powerful digital experiences that can be personalized to millions of customers in milliseconds. Adobe Experience Cloud is a comprehensive set of integrated AI-driven applications and services to help companies deliver experiences across all aspects of the customer journey. At its core is the Adobe Experience Platform with billions of customer profiles. Our Adobe Experience Cloud applications span the entire customer funnel, from acquisition to monetization to retention, across content and commerce, customer journeys, data insights and audiences and marketing workflow. We have made the dramatic transformation to deliver AI-driven services with over 80% of Experience Cloud customers now using Adobe Sensei, our industry-leading AI and ML framework to power experiences for their customers. Last week, we hosted Adobe Summit, the world’s largest digital experience conference. We launched exciting new Experience Cloud technology and heard from executives from some of the world’s most interesting and innovative brands, including BMW, Nike, Prada, Real Madrid and Walgreens Boots Alliance. We enabled the entire event using Experience Cloud, personalizing the experience for our global attendees. Summit content has had over 22 million views to date, underscoring the significant interest and demand for digital transformation. We continue to drive outstanding growth in our Experience Cloud business. The pandemic has caused brands around the world to realize the critical need for digital transformation. And we’re adding new logos while continuing to focus on driving significant value realization for our existing customers. In Q1, we achieved $1.06 billion in revenue. Subscription revenue was $932 million for the quarter, representing 22% year-over-year growth on an adjusted basis. Q1 highlights include a slate of exciting product innovations, including new real-time customer data capabilities with the integration of Adobe Real-Time CDP and Adobe Target. Adobe Real-Time CDP is used by a large and growing base of customers such as DICK’S Sporting Goods, Henkel, Panera, Real Madrid, ServiceNow and Verizon; new cross-cloud integrations, including a unified workflow between Workfront, Creative Cloud Enterprise and Experience Manager assets that powers end-to-end content creation and delivery; strong performance in Adobe Experience Manager, emphasizing the need for unified content management to meet the ever-increasing demand for content at speed and scale. Adobe is uniquely positioned to help customers across the content supply chain; new APIs that provide developers with the flexibility to create customized user experiences on top of Adobe Commerce; the general availability of Adobe Experience Cloud for Healthcare to deliver personalized health care experiences; an expanding partner ecosystem, including a partnership with OneTrust to simplify consent management; the next phase of e-commerce integrations with FedEx, Walmart and PayPal as well as a collaboration with The Weather Company; and key customer wins, including CrowdStrike, Deutsche Telekom, IBM, Jaguar Land Rover, JPMorgan Chase, McDonald’s and UnitedHealth. Our Experience Cloud product innovation, global customer base and vibrant partner ecosystem are driving our continued success. We are executing across our entire go-to-market motion and continue to receive strong industry recognition. This quarter, Adobe was named a leader in 3 industry analyst reports focused on core customer experience management segments, including Gartner’s Magic Quadrant for Digital Experience Platforms, the inaugural IDC MarketScape for CDPs for Front Office and the Forrester Wave for Digital Asset Management. Dan, over to you."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Today, I will start by summarizing Adobe’s performance in Q1 fiscal 2022, highlighting growth drivers across our businesses, and I’ll finish with targets for Q2. Adobe’s strong financial results demonstrate the company’s ability to execute in a challenging macroeconomic and geopolitical environment. Across our business, we are attracting new customers, signing up transformational deals, growing our recurring book of business and seeing emerging businesses ramp and, in some cases, reach escape velocity. We are witnessing the digitization of everything and Adobe’s products offer customers access to a digital future, underpinning how they live and work. Our investment in products, marketing and a data-driven operating model are continuing to drive Adobe’s growth. In Q1, Adobe achieved record revenue of $4.26 billion, which represents 9% year-over-year growth or 17% on an adjusted basis. Business and financial highlights included GAAP diluted earnings per share of $2.66 and non-GAAP diluted earnings per share of $3.37; Digital Media revenue of $3.11 billion; net new Digital Media ARR of $418 million; Digital Experience revenue of $1.06 billion; cash flows from operations of $1.77 billion; RPO of $13.83 billion exiting the quarter; and repurchasing approximately 3.8 million shares of our stock during the quarter. In our Digital Media segment, we achieved 9% year-over-year revenue growth in Q1 or 17% on an adjusted basis. We exited the quarter with $12.57 billion of Digital Media ARR. Global demand for digital content continues to explode. And with the strength of Adobe’s product innovation and our data-driven operating model, our net new Digital Media ARR in Q1 grew on a year-over-year basis after factoring out the additional week in the year-ago period. We achieved Creative revenue of $2.55 billion, which represents 7% year-over-year growth or 16% on an adjusted basis. We added $315 million of net new Creative ARR in the quarter. First quarter Creative growth drivers included strong creative engagement and retention across individual and SMB segments; new customer demand across large organizations, small and medium businesses, driving growth in our Creative Cloud for Teams offering, which was the highest Q1 on record; sustained growth of subscription licensing for individual flagship applications such as Photoshop, Illustrator and Premiere as well as strength in our Adobe Stock business; and enterprise adoption of new collaboration capabilities, including Frame.io as well as our 3D and immersive applications. We are also pleased by the adoption we see in some of our newer initiatives such as Creative Cloud Express, Substance as well as Acrobat, Photoshop and Illustrator on the Web. We are driving strong usage growth and have already attracted millions of monthly active users to our cloud-native offerings. We expect these businesses to be drivers of future ARR and revenue growth. Adobe achieved Document Cloud revenue of $562 million, which represents 17% year-over-year growth or 26% on an adjusted basis. We added $103 million of net new Document Cloud ARR in the quarter, surpassing $2 billion in ending ARR, growing at 29% year-over-year. Document Cloud continues to be our fastest-growing business, demonstrating that our strategy of accelerating document productivity is working and reflecting how Acrobat and PDF are essential to the way people work in a digital-first world. First quarter Document Cloud growth drivers included customer demand for Acrobat subscriptions, the strongest Q1 on record; new licensing and renewal for Acrobat for Teams offering in the SMB segment, both on adobe.com and through our reseller channel; momentum in Adobe Sign with strong year-over-year growth of Sign transactions within Acrobat; strong demand for our PDF solutions on mobile; and continued momentum with our frictionless onboarding of new customers through Acrobat Web with ARR growing approximately 90% year-over-year. Turning to our Digital Experience segment, in Q1, we achieved revenue of $1.06 billion, which represents 13% year-over-year growth or 20% on an adjusted basis. Digital Experience subscription revenue was $932 million, representing 15% year-over-year growth or 22% on an adjusted basis. When we look at the quarterly sequential revenue growth, we continue to see acceleration as our strategy of delivering personalization at scale is resonating with enterprise customers. First quarter Digital Experience growth drivers included new logo acquisition across our solutions; strong customer retention as a result of investments we’ve made in product innovation, greater value realization and customer experience; larger deal sizes in our Workfront business; traction upselling customers to new cloud-native solutions; and momentum with our Content & Commerce, customer data platform and Customer Journey Analytics offerings. In Q1, we continued to increase investments in initiatives that will drive long-term revenue growth, including ramping headcount across R&D and sales capacity. Travel and facilities remained at lower levels in Q1, but we’re increasing facilities utilization and travel in Q2 as we resume in-person meetings with customers and partners. Adobe’s effective tax rate in Q1 was 18% on a GAAP basis and 18.5% on a non-GAAP basis. The tax rate came in higher than expected, primarily due to less-than-expected tax benefits associated with stock-based compensation. Our trade DSO was 36 days, which compares to 38 days in the year-ago quarter and 42 days last quarter. RPO grew by 19% year-over-year to $13.83 billion exiting Q1, benefiting from enterprise bookings. Our ending cash and short-term investment position exiting Q1 was $4.70 billion and cash flows from operations in Q1 were $1.77 billion. We repurchased approximately 3.8 million shares in Q1 at a cost of $2.1 billion. Included in this purchase was the partial settlement of an accelerated share repurchase entered into during Q1 to repurchase shares at an aggregate cost of $2.4 billion. The final number of shares to be repurchased under the ASR will be based on a discount to the volume weighted average price of our common stock during the term of the agreement with the final settlement and delivery of incremental shares to Adobe scheduled to occur in early Q3. These share repurchases are part of the previously announced program, under which we currently have $10.7 billion remaining of our $15 billion authorization that was granted in December 2020 and goes through 2024. Before we get to our Q2 targets, I want to discuss the impact of the devastating situation in Ukraine. Earlier this month, Adobe announced the cessation of all new sales in Russia and Belarus. In addition, we’ve made the decision to reduce our Digital Media ARR balance by $75 million, which represents all ARR for existing business in these two countries. While we will extend subscriptions automatically in Ukraine during this period and continue to provide Digital Media services, we reduced ARR by an additional $12 million, which represents our entire Ukraine business. This results in a total ARR reduction of $87 million and an expected revenue impact of $75 million for fiscal 2022. The impact toward Digital Experience business is de minimis. For Q2, we are targeting total Adobe revenue of approximately $4.34 billion; net new Digital Media ARR of approximately $440 million; Digital Media segment revenue growth of approximately 13% year-over-year or 14% in constant currency; Digital Experience segment revenue growth of approximately 15% year-over-year or 16% in constant currency; Digital Experience subscription revenue growth of approximately 17% year-over-year or 18% in constant currency; tax rate of approximately 20% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of approximately $2.44; and non-GAAP earnings per share of approximately $3.30. As a result of the lower-than-expected deductions from stock-based compensation, our effective tax rate for fiscal 2022 is now targeted to be 19.5% on a GAAP basis and 18.5% on a non-GAAP basis. As we look towards the back half of the year, we expect quarterly sequential revenue and EPS growth in Q3 and Q4. In Digital Media, we expect strong second half ARR performance across Document Cloud and Creative Cloud, including continued strength of emerging businesses like Acrobat Web, Frame.io, Substance and Creative Cloud Express. In addition, we expect ARR contributions to increase sequentially in Q3 and Q4 from a new offering and pricing structure which starts late in Q2. We expect Digital Experience bookings to show continued momentum in the second half with a traditional strong Q4 finish. We will continue to invest in product innovation, sales capacity, marketing awareness and demand generation given our immense market opportunity. As the world reopens, we expect to increase our travel and facilities expenses. In summary, I’m pleased that Adobe delivered another record quarter in Q1 with sustained growth and world-class profitability. Adobe continues to show its resilience through unprecedented circumstances that all companies face today, and I’m confident we will emerge stronger. We are on track for another year of strong financial performance. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. This is a transformative time at Adobe. We’re engaging with hundreds of millions of customers globally, from individuals to the largest enterprises, launching new applications for new audiences and bringing our flagship category applications to new surfaces and platforms while increasing collaboration capabilities across our solutions. Adobe has a winning strategy applied to an exceptional opportunity. We’re a leader in the digital economy with Adobe Creative Cloud, Document Cloud and Experience Cloud, which combined have a total addressable market of $205 billion. Few companies can consistently deliver technology innovation, successful transformation across new categories and business models and a broad ever-growing base of customers and partners. I’d like to thank our 26,000 employees for their continued dedication and unwavering focus on delivering customer innovation and inventing the future of digital experiences. Thank you. We will now take questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] We will take our first question from Brent Thill with Jefferies. Please go ahead."
},
{
"speaker": "Brent Thill",
"text": "Good afternoon. Curious if you could shed any more color on the new pricing structure and what that means. And Shantanu, beyond Ukraine, is there anything else you’re seeing in the broader economy that’s different than you’ve seen historically? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "So Brent, as it relates to what we have seen first in terms of the macroeconomic situation, we actually continue to see strength. We were pleased with the strong Q1. Certainly, I think the last few weeks of the quarter, you saw some impact in Europe, specifically as it related to what happened in terms of the terrible situation in Ukraine. But I think we continue to see growth around the world. I think on the first one, as you know, and then I’ll have David also add some color, the last major comprehensive overall that we had for our pricing was in 2017. And you’ve seen since then the number of different initiatives that we have and offerings that we’ve introduced, whether it was the 3D offerings, what we’ve done on the web, what we’ve done in mobile, what we’ve done around Creative Cloud Express. So I think it was time to take a very comprehensive look, which David has done. And I think directionally, what I would say is that we want to continue to attract hundreds of millions to the platform, but we also want to get value for the tremendous innovation that we’ve provided. David, maybe you can add a little bit more."
},
{
"speaker": "David Wadhwani",
"text": "Yes, happy to. So as Shantanu mentioned, the last pricing update and adjustment we made was in 2017. Since then, we’ve added a lot to our existing offerings. We’ve added new applications. We’ve extended broadly across multiple services. We’ve doubled down on collaboration. We’ve added millions of stock assets and thousands of fonts. And we’ve also introduced new offerings. Obviously, Acrobat across web and mobile has been growing for the last few years, and you heard us talk – last year or 2, you heard us talk about that in the prepared remarks. But also CCX is now in market across web and mobile. And the early success we’re seeing with these new offerings across web and mobile and across Acrobat and CCX has really been the catalyst for these pricing adjustments that we’re looking at doing. They let us introduce the right value with the right onboarding experience and the right pricing to attract millions of new subscribers. And they provide us the opportunity to right-size the value where engagement and usage is highest in our core existing customer base. The impact of this, we think, for Q2 will be fairly minimal because it takes time to roll this out globally, and it takes time for customers to go through their renewal cycles where their prices change. But we expect it to have a more significant impact and build-out in Q3 and Q4."
},
{
"speaker": "Brent Thill",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Alex Zukin with Wolfe Research."
},
{
"speaker": "Alex Zukin",
"text": "Hi, guys. So maybe to think – to ask Brent – to ask the question a different way, if you think about Adobe has been around for a long time through many business cycles, as we – as you look at the pipeline of activity for the back half of the year and you think about the – where – how investors should think about it in a more recessionary, inflationary environment, can you just give us some color around how you think about the pipeline development, how you think about any changes with respect to the shape of the year and seasonality? And then maybe just a financial question, I think there is just a better understanding of how the mechanics of the NRR are shaping up for Q2. Are you taking that – is the $440 million, is that guide inclusive of the impact of the Russia-Ukraine adjustment? Is it taken out of the prior year? Just a little bit more context would be helpful? Thank you, guys."
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, Alex. There were multiple questions in that. So let me – maybe first, to your point, which I agree with, when you think about the rhythm of the business and maybe the seasonal cadence, clearly, that’s been impacted by whether it’s the external events as it relates to the pandemic or more recently the war in Ukraine. But big picture, as we look at what’s happening in terms of customer adoption, what’s happening in terms of the excitement, there is no question that digital is a tailwind and will continue to be a tailwind. And our perspective is that what happened was the pandemic actually put a spotlight on the importance of everything we’re doing, whether it’s customer engagement, whether it’s content or document productivity. And so as you think about what happens seasonally, certainly, I think we would continue to see strength in Q3 and Q4. Dan referred to that in terms of the second half momentum that we would see. But even Q1, we had a strong start. So from our perspective, some of the seasonal cadence might have changed, but the secular trends in terms of up and to the right, we actually don’t see any impact associated with it. I think your second question is related to what happens specifically on Russia and Belarus and Ukraine. Since the Digital Media ARR, the book of business, we made the decision to reduce it. And so I think what you’ll see on the data sheet is what our exiting Q1 ARR is and then another number which just takes out all of the existing book of business for those three countries. You see the impact on revenue certainly in Q2, Q3 and Q4 because what it means is the revenue that we would have been able to collect. But again, in the grand scheme of things, as you can see, it’s fairly small as it relates to the business. So I think our targets, $440 million specifically, as you said, yes, it’s impacted by the ARR business in those countries. But overall, business is strong and we feel optimistic. I think in many ways, the message really is that the new growth initiatives that both Dan and David talked to, they are starting to really show traction. And so we expect to see strength in the second half of the year and certainly beyond that."
},
{
"speaker": "Alex Zukin",
"text": "Got it. Thank you, guys."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Saket Kalia from Barclays."
},
{
"speaker": "Saket Kalia",
"text": "Okay, great. Hey, thanks for taking my question here. David, maybe for you. Great to see the Creative Cloud Express launch recently, I guess the question for you is, how do you feel the product differentiates from some of the competition out there? And maybe without going too deep, how do you plan on investing in that product specifically to continue your lead?"
},
{
"speaker": "David Wadhwani",
"text": "Yes, thanks for the question. We’re very excited about the launch of CCX. But just to up-level for a minute, and as a reminder for everyone on the call, we’ve been talking about the communicator segment for years, both as it relates to non-pros and as it relates to the creator economy. We’ve talked about in the past that our mobile and desktop apps have hundreds of millions of registrations, which is clearly going beyond our Creative Pro base. And we’ve built a significant business. In fact, we believe that we’re the largest provider of creative tools in the world when measured by revenue across all of our segments: pros, communicators and consumers. The introduction of Creative Cloud Express though represents a lot of our learning over the last few years, starting with the business model. It’s a freemium business model. It’s predominantly web and mobile. So it’s zero friction for onboarding customers, and users are seeing success in minutes, not hours. In addition to that, we have an unprecedented library that we bring to Creative Cloud Express. We have 175 million stock images and videos. We have 20,000 fonts, largest font library online available, and thousands of templates that have been really carefully crafted and designed by some of the best creatives in the world. And this is important because at the end of the day, if you’re going to be a content-first creation tool, the content you mix together is a fundamental differentiator in terms of what you’re creating and what you’re producing. And we feel very, very good and confident about our ability to continue to expand this library and just make sure that what people are mixing to create their output is world class. But of course, we also have the power of Adobe. If you look at what we’re starting to do, and this gives you a hint of where we’re going with our quick actions across Photoshop Quick Actions, Premiere Quick Actions, Acrobat Quick Actions that have started to make their way into Creative Cloud Express, we feel really good about the pipeline of innovation we can bring from our decades of leadership across all of our segments directly into Creative Cloud Express. And then, of course, we are looking for ways to accelerate. We acquired a company called ContentCal that we’ve announced will be the foundation of rich content publishing and scheduling for Creative Cloud Express users. And then lastly, the work we’ve been doing over the last many years around the data-driven operating model that Dan talked about in his opening has been invaluable here. So we’re finding and we’re onboarding new users that would not have typically interacted with Adobe through their intent-based search. And the result is a little bit of what we alluded to. We’ve seen great traffic. We’re seeing millions of monthly active users just a few months into the launch. We have an NPS over 60 at this point in the product. So we’re really bullish on the start of where we are. And if you look at the long pipeline of Adobe-only innovation, maybe to your question, we’re super excited about that. And the last thing I’ll say here is that don’t forget the opportunity here is to drive millions of new users into our franchise. But the opportunity is also to drive high engagement and usage within our core CC base and take what has already been a very, very strong retention curve there and continue to drive engagement and retention of our CC users as well."
},
{
"speaker": "Saket Kalia",
"text": "Very helpful. Thanks, guys."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Sterling Auty with JPMorgan."
},
{
"speaker": "Sterling Auty",
"text": "Yes. Thanks. Hi, guys. Just maybe for clarification. With the changes, there is no update to the annual guidance. You typically don’t, but I think investors want to understand how the impact on the negative side from the changes to ARR for Russia and Ukraine impact the annual guide versus the positive uplift that you’ll get from the pricing structure. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. Sterling, I mean, I think color-wise, it’s really still early in the year, but I feel great about the way we’ve been navigating all of the external issues that have come. And it was a strong Q1. As we prepared for this call, we felt it was important to share with you the impact that we know of things, whether it’s the revenue or ARR for Russia, what’s happening on EPS as it relates to the tax rate as well as to provide some more of the growth drivers. But I net it out by saying while we are not updating the annual targets, as you pointed out, we’re really optimistic on the significant number of growth drivers that we have. And we will share more throughout the year because we still are all navigating what is a considerably unpredictable situation. Our strong Q1, however, and the things that we control, we feel excellent about."
},
{
"speaker": "Sterling Auty",
"text": "Understood. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Jay Vleeschhouwer with Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. Shantanu, referring back to the analyst meeting 3 months ago, you and David used the term product-led growth. And I was wondering if you could elaborate on that because arguably, when you think about the company over the last 30 years or more, you’ve always, in effect, been product-led growth. So how are you thinking about that differently now in terms of a concept or various executables for that? And then for Dan, could you talk about how you’re thinking about your headcount growth relative to your expense growth for the year? You onboarded over 500 employees during the quarter, you finished Q1 with a record number of open recs. How are you thinking about filling those divisions, either to compensate for the increase in attrition you had in fiscal ‘21 versus normal organic growth that you otherwise would have done anyway?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. Jay, when I think about the transformative things that we’ve done in the company, certainly the move to subscriptions, the entrance into digital marketing, what we’ve done with data-driven operating model to drive the sort of financial cadence of the business, they absolutely bubble to the top. But I would say those actually dwarf in comparison to the excitement that I feel about what product-led growth can continue to do. When you have hundreds of millions or billions of people using your software, a good example of what we’ve done is the constant innovation that we’re delivering on the Document Cloud side. And I think David referred to some of the statistics, whether it’s sort of doubling what we see with web traffic and really being aware of the intent-based approach that people want when they come on the web to accomplish document actions, what we are doing in mobile and doubling it. And I think product-led growth just relates to ensuring that all of our product teams have information at their fingertips as to how people are really using it so that we can rapidly iterate in terms of what customers want and delight them. And I think on the Creative Cloud, to add to what David said to Saket as well, what that means with Creative Cloud Express is as you have these millions of users, we’re constantly understanding where the search traffic is, how do you improve it. And it’s just a new way of liberating all of the product-led – product teams to focus on what’s truly important and truly needle-moving as far as customer interest and customer sentiment. And it’s something that David has pioneered. So I’ll have David add a little bit more. But I think the impact on how we serve customers, the NPS and being able to continue to recruit and retain is significant."
},
{
"speaker": "David Wadhwani",
"text": "Yes. I think Shantanu covered most of it. Just a couple of things to add. As you correctly point out, we joke internally that actually John and Chuck created product-led growth with distributing the free Reader and then sort of upselling people from there to the Acrobat offering. And so we’ve, throughout our history, had this idea and sense of how you drive utilization and usage and engagement and then drive that to convert to users. I think what we are – where we are right now is an exciting inflection point where, as Shantanu mentioned, we’re seeing a lot more activity and engagement on web, we’re seeing a lot more activity and engagement on mobile. And that lets us have better and more seamless onboarding. So we can use everything we’ve learned around DDOM to drive better intent-based search and reach audiences that frankly we weren’t able to reach before because the onboarding experience, the actions to success and then what we do beyond that is in minutes, not hours."
},
{
"speaker": "Shantanu Narayen",
"text": "Maybe one last thing before Dan comments. I think both Dan and David talked about retention and engagement during the quarter. And to give you a little bit more, Jay, color in terms of that, we look at churn rates. We look at reseller renewal. We look at 90-day cohort retentions. And in all of those, I think as a result of the activity that we’re doing on the product teams to help improve, we’re seeing improvement and getting to rates on all three of those that are better than they have ever been even prior to the pandemic. So I think that’s, again, another example of what gives us confidence in our offerings and our innovation going forward."
},
{
"speaker": "Dan Durn",
"text": "And then, Jay, just to come to your second question, we talked about the business performing well. When we talk about digital content and data increasingly driving economic growth going forward in a world where everything is going digital. That means we have an immense market opportunity in front of us, greater than $200 billion in 2024 and significantly larger than that as we look forward. So our long-term growth opportunity at Adobe is not opportunity-constrained. And so when we think about our leadership and product positions, they are built on the back of a very strong innovation engine at the company. So, we are going to orient towards growth. We are going to continue to invest in R&D and the sales muscle to scale our businesses over time and continue that leadership in the markets that we participate in. But we are going to do what we have always done along the way, is do it in a disciplined way, so we are marrying the investments we make with the opportunities as they materialize and grow in a very profitable way. And so you can see the company’s history in terms of strong profitable growth, and I would expect our track record on that to continue over the long run."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Thank you, guys for taking the question. I actually had a couple of clarifications I was hoping to ask you guys about. Shantanu, earlier in the call, you do made some comments about perhaps seeing a little bit of weakness in Europe at the end of the quarter. Can you dig in on that a little bit like where in the business, did you see that weakness? And did that persist into Q2, or was it just kind of more temperamental? So, that was number one. Number two, on the – I know we are not giving full year guidance, but when we think about the operating margin outperformance in Q1, is the commentary that that’s going to be given back later in the year, or is it just like sort of the ramp-up gets pushed out, so the savings kind of like accrue throughout the full year? And then clarification number three, when you guys gave the original $1.9 billion net new ARR addition guidance for FY ‘22, did you guys already contemplate these price increases, so was the – or the price changes, were the price changes already in that $1.9 billion guide? So that’s my three clarifications."
},
{
"speaker": "Shantanu Narayen",
"text": "Sure. So, Keith, maybe I will answer the last question first and then talk about it, which is, as we were entering the year and what we talked at the FA meeting, if you actually – I think we also got a couple of questions as it relates to what we were going to do on pricing, and we alluded to the fact that we are constantly looking at it. And so while it was something that we were working on, we actually just pretty recently finished the entire effort. So, we didn’t have it finalized, but we always thought that it was timed with the new offerings to actually look at the pricing structure as well. And so the definite amount and the materiality of that, we will know as we go through the process. But directionally, we knew that we were going to be looking at pricing more exhaustively. I think in terms of the clarification of what we saw, when the war broke out for the last couple of weeks, that impact is not just felt in Russia and Belarus and Ukraine, you see a little bit of that traffic across the region. So, that’s really all I was alluding to. And we saw strength, and that strength continued in the U.S. right through the quarter. And so not unsurprisingly, we saw a little impact. So, that’s all I was referring to as it related to the European situation. And did you have a third question, Keith?"
},
{
"speaker": "Keith Weiss",
"text": "Yes, the third one was on operating margins."
},
{
"speaker": "Dan Durn",
"text": "Yes. Your third question on operating margin. So, let me break it up into three time periods. Let’s talk about Q1 briefly. Let’s talk about FY ‘22 and then beyond. So, as we think about Q1, clearly, Omicron was a context around that quarter. So, our investments in things like travel, facilities weren’t as robust as originally contemplated, and you saw a little bit of uplift from a margin structure standpoint in Q1. When we take a step back, we talked about the growth profile and the leadership of our product positions, continuing to invest to scale our businesses, and a lot of those investments being R&D and sales-oriented. We will continue to do that. And the targets that we set in FA Day a few months ago implied in those – in that framework is an operating margin for the year. And so I think you will see that unfold throughout the rest of the year. And then longer term, we talked about the significant opportunities facing the company and our ability to capture that with our leadership position as the world goes increasingly digital. And as we grow and scale this business, you will see the benefits of that over time layer into the operating margin as we continue to do it in a strong, profitable and disciplined way."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thanks so much, guys."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Tyler Radke with Citi."
},
{
"speaker": "Tyler Radke",
"text": "Yes. Thanks very much for taking my question. Just going back to the price increase and pricing changes. Obviously, I am sure you will be sharing a lot more specifics as we go forward. But philosophically, just how are you thinking about the pricing changes at the high end versus the kind of entry-level creative products? And particularly, just curious how you are evaluating those pricing changes in the context of the competitive landscape? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "So, I think philosophically, the way we are looking at it, I will repeat what I said earlier, which is we haven’t done a comprehensive look at that in multiple years. And directionally, I think the significant value that we have added has to do with people, whether you are in businesses or whether you are a user of the entire apps. I mean we continue to add new apps to the – what’s called the CC All Apps platform. And directionally, we are just saying that is the area where we have to look at all of the increased value that we have. This is not driven in any way, shape or form by any competitive response. So, let me be categorical about that. This is raised by – we continue to attract billions of people to the platform in terms of the interest. And with all of the new offerings that we have, again as David said, across web, across mobile, across the browsers, we just want to make sure that as we continue to expand the offerings, we are looking at the pricing in a good way. So, the value that we have added to whether you are in teams with collaboration or whether you are to businesses continues to be a motivator for us to look at the prices as well on all the new apps that we have added. So hopefully, that gives you color. Let me also back up and say this is for us, all really about customers and delighting customers. But because we had an earnings call, we said as this gets rolled out, we at least want to give you some heads up because otherwise, some of you would say, why didn’t you at least allude to it. As David said, this doesn’t have an impact in Q2 really. It’s a pretty small impact. So, that was the rationale and thinking associated with it. And we will certainly roll this out with customers first, and then we will share with you more of what the impact is. But that’s the way we look at how we move the business going forward."
},
{
"speaker": "Tyler Radke",
"text": "Great. And if I could sneak in a follow-up just on the digital experience side, obviously, pretty strong growth here in Q4 and the first part of the year, above 20% on an adjusted basis. I guess was there any kind of one-time factors that drove that outperformance? And as we think about the guide for the next quarter and the deceleration implied, just anything to call out there? Thank you."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks for the question. We are pleased with the momentum we have seen in the digital experience business with 22% growth and subscription on an adjusted basis. The market opportunity is huge, over $100 billion of TAM. The pandemic obviously put a spotlight on it in terms of the urgency. We are seeing it continue to grow in terms of customer demand, customer interest at the Board level and at the C-level. We are in a really strong market position with what we have built with the Adobe Experience Platform and the native apps like Customer Journey Analytics and CDP that we have built with that. So, overall, we feel really excited about the path forward. And we just had the Summit conference last week, excellent pipeline building event as well as a chance to showcase our product innovation. So, we expect this to continue through the year in terms of our momentum."
},
{
"speaker": "Tyler Radke",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Keith Bachman with BMO."
},
{
"speaker": "Keith Bachman",
"text": "Hi. Thank you. I am going to follow lead with a couple of clarifications. Dan, could you comment on what the inorganic contribution was this quarter and where it manifests? So for instance Frame.io, what was the contribution there? Secondly, when you think about – I just want to clarify on the ARR write-off, so to speak. The comment was that you are ceasing all new incremental business. But are you going to continue to get ARR payments in Russia – or from Russia and Belarus from existing business that might actually contribute to ARR? Just a little bit confused on that one. And then in the spirit of Keith Weiss, I am actually going to ask a third clarification. Shantanu, in the past, you have said that in the creative side, new subscribers was the most significant contributor to growth. And I just wanted to try to understand given more competition perhaps in the lower end of the market, is that still true? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "I will answer the first – the third one first, Keith, as Dan does, which is if you look at the growth, the unit growth is being driven by single apps, which is new subscribers and driving to it. So that trend, in terms of continuing to drive single unit, is definitely part of how we think about it. I will answer maybe one part of also how you have to think about it, which is when you think about Russia and Belarus, we have the ARR, which is the book of business, but there is no way to really get payments. And with all of the sanctions that’s there, what we have factored is that book of business, because we are not going to be getting payments from Russia, that is the impact that Dan alluded to, which is the $75 million for the rest of the year. So, in addition to seizing new payment – in addition to stopping new sales, what you have to realize is for a service that exists as a SaaS-based service, you are unable to collect payments. And so we have reflected that impact as well in the particular geographies."
},
{
"speaker": "Dan Durn",
"text": "Yes. And just coming back to your last piece, Keith, on Frame, now, that it’s part of the business, we are not going to be breaking this out. We talked about the momentum in the business. It’s great. The team is doing really well. The number of deals, the average deal size, business has a lot of momentum around it. And we talked about the great collaboration technology that exists there. But now that it’s a part of the business, we won’t be breaking it out explicitly."
},
{
"speaker": "Keith Bachman",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Kash Rangan with Goldman Sachs."
},
{
"speaker": "Kash Rangan",
"text": "Thank you very much. Congrats on the quarter. The numbers look quite good for Q1. So, Shantanu, I am curious, the shifting seasonality, generally when you find a more seasonal second half, that’s generally a sign of maturity in the market or macro factors or just product transition factors. But when I look at your second half, you do have relatively easier comps for DM ARR, right? And then you have the pricing optimization. So, if we net it all out, how do you feel about the business in the second half relative to going into the first quarter, granted that we have all these macroeconomic concerns? But net of the positives against – net of the negatives against the positives, how do you feel today versus three months back about the rest of the fiscal year? Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Kash. I mean to net it out, I definitely feel more positive about business moving forward than I ever have, because just if you take a step back and look at all of – first look at Q1, we had a strong Q1. We clearly beat our targets in what is perhaps the most unpredictable situations that exist in the world. So, we feel really good about Q1. We feel really good about the new initiatives that – both in Document Cloud and Creative Cloud and in Experience Cloud that David and Anil spoke to. I did allude to the fact that when you think about the seasonal cadence and the rhythm of the business, certainly, some of that’s impacted. And perhaps the thing that you are alluding to, Kash, was in Q2 of last year, there was sort of a catch-up as “small and medium businesses” came on – come back online. And so you have to just factor what that is in. But both in terms of the revenue growth in DME for Q3 and Q4 as it relates to getting more similar to Q1 as well as the ARR, we are optimistic about the second half. The only reason we didn’t talk about Q2 is because we actually gave specific guidance and targets for Q2. So, don’t take that as anything as opposed to we have given you targets for Q2 and we are trying to give you color on what happens in Q3 and Q4. So hopefully, that helps, Kash. And on the DX side, since there have been fewer questions on the DX side, I mean what we have done, Summit was really exciting, the amount of new announcements that we have done there. Every person that I talked to in the C-suite continues to want to really focus on digital transformation and customer experience management. I am excited. I am back on the road again. It feels great. We have employees back in the office and facilities. People want to meet, and digital engagement is top of mind. So, across all three of our businesses, we didn’t talk about the document business. $100 million in ARR for the quarter, $2 billion book of business, really good adoption of our new functionality, whether it’s on the web as well as a unifying sign with Acrobat, which was a big movement that we are trying to do. So, I think all of those are positive. I think the one impact that, again, maybe Dan can just touch on is certainly, it doesn’t impact our core business. But the EPS, you just have to factor some of the revenue and other considerations that happened. But for the functional part of the business, I feel really good."
},
{
"speaker": "Dan Durn",
"text": "Yes. So Shantanu did a good job talking about the fundamentals of the business. The other piece are the transient effects. And I would point to two of them. So, for the war in Ukraine, we de-risked the profile around the situation. And that’s the prudent thing to do, to be conservative in situations like this. So, that’s what you see in the $87 million reduction in ARR as well as the $75 million reduction from a revenue standpoint, Q2 through Q4. So, if I take that revenue and I flow it through the P&L, that’s going to be about a $0.04 a share headwind per quarter for the balance of the year, Q2 through Q4. From a tax standpoint, we talked about an 18.5% non-GAAP tax rate. That’s a 1.5 point change versus where we were at FA Day. If I were to roll that through the P&L, that’s about $0.06 a share per quarter throughout the year. We were able to overcome that in Q1. And then when I look at the share repurchase activity, clearly the company took advantage of the current environment. And that’s going to create about a $0.02 a share benefit each quarter this year versus where we were at FA Day. And so when I net all of that out on a go-forward basis, you have got about an $0.08 per share headwind in each quarter. And again, like we said in Q1, we were able to overcome that headwind in Q1 and deliver above the expectations that we had set, and we are going to continue to orient towards growth. We are going to invest to lead, but if there is opportunities to do it in a disciplined way and overcome it on a go-forward basis, we will take it a quarter at a time and let you know what we see."
},
{
"speaker": "Kash Rangan",
"text": "Thank you, Dan. And Shantanu, just one final follow-up, the clear – I know that you want to talk about the Document Cloud and the Experience Cloud, but I remember fall of 2011, you have made a very bold transition to Creative Cloud subscription. You, in fact, outlined that you have a target of 4 million subscribers in fiscal ‘15, which seemed quite visionary back then, right? So, as you look at the inflection point going – the company is going through, what are your aspirations for Creative Cloud Express if you were to measure it in subscribers or how big of a business would you like it to be? What would be your similar prognostication as you look into the next few years? And that’s it for me. Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Kash, at the FA meeting, we talked about what the overall addressable market opportunity is. But I really feel like we can get billions of users to use our product. And then they will be the spectrum of people who will be paying us on a subscription business as well as others who will perhaps take advantage of some of the freemium offerings that we have. We are starting to see that kind of adoption with the Document Cloud certainly, right, where you have 0.5 billion people who have used our – a Reader and other products. But I think in terms of Creative Cloud Express, my hope and my aspiration is that every single person who has a story to tell uses some part of the Creative Cloud Express. We are off to a great start there, Kash. I think on the differentiation, as David said, we have the platform. We have every single piece of technology that we need to deliver a great compelling experience. And now we are also world-class at making sure that we capture search-based intent. So, we want to anticipate what people want to do with Creative, but I would be disappointed if that doesn’t just continue to be a huge growth area in terms of new users to our platform."
},
{
"speaker": "Jonathan Vaas",
"text": "Operator, we are a little past the top of the hour. We will squeeze in one more question and then wrap up. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Michael Turrin with Wells Fargo Securities."
},
{
"speaker": "Michael Turrin",
"text": "Hi there. Good afternoon. Appreciate you squeezing me on. We have been expecting a return to normal expense profile. Q1 operating margins were actually flat relative to last year. Anything else you can add just around the Q1 margin results? And as we think through the puts and takes between that return to a more normalized expense profile and some of the product and pricing efforts you have mentioned ahead this year, any way to think through if price uplift can help offset some of that expense normalization you are expecting? Thank you."
},
{
"speaker": "Dan Durn",
"text": "Yes, sure. So, if I were to look at where we landed in Q1, and we talked about not fully investing from a travel and facilities standpoint because of the Omicron environment. And as I look forward to the Q2 guide and the operating margin that is implicit in that guide and I were to break it out into some several buckets. There is going to be an influence from the transient effects of the Russia situation. We are going to do increased hiring to invest for future growth. We get full quarter impact from a merit standpoint instead of a one month impact. And then we will start to see the reopening expenses start to layer back in. Those are the four buckets that bridge you from Q1 to Q2. And I would say each of those four buckets is roughly equally weighted. And so I think that’s what gets you to a more normalized run rate as we look into Q2 and the back half of the year."
},
{
"speaker": "Shantanu Narayen",
"text": "And since that was the last question, I wanted to, again, thank you all for joining us today. We are pleased with the performance. We think we had a really strong start to the fiscal year across all three of our businesses Creative Cloud, Document Cloud and Experience Cloud. And more than that, I think our ability to continue to delight customers and deliver on the innovative roadmap gives us a lot of confidence associated with the new initiatives taking stock and contributing to the future growth at Adobe. The spotlight, I believe, on digital will just continue. And as we get back to more normalcy, I think that will only all go well for both Adobe and our customers. And the successful Summit that we just organized, I think is another indicator of the interest that exists in our solutions. So, thank you for joining us today, and we look forward to sharing more as we go through the year. Thank you."
},
{
"speaker": "Jonathan Vaas",
"text": "This concludes the call. Thanks, everyone."
},
{
"speaker": "Operator",
"text": "Thank you. That does conclude today’s conference. We thank you all for your participation. You may now disconnect."
}
] | Adobe Inc. | 24,321 |
ADBE | 4 | 2,023 | 2023-12-13 17:00:00 | Operator: Good day, and welcome to the Q4 and FY 2023 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon and thank you for joining us. With me on the call today are, Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; and now Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice-President and CFO. On this call, which is being recorded, we will discuss Adobe's fourth quarter and fiscal year 2023 financial results. You can find our press release as well as PDF of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans is as of today, December 13th, and contains forward-looking statements that involve risk uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant-currency revenue growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe's IR website. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon, and thank you for joining us. Q4 was our first-ever $5 billion quarter, a new record for the company. Adobe achieved revenue of $5.05 billion, representing 13% year-over-year growth. GAAP earnings per share for the quarter was $3.23 and non-GAAP earnings per share was $4.27, representing 28% and 19% year-over-year growth, respectively. Q4 was the culmination of another record year for Adobe, achieving $19.41 billion in revenue, which represents 13% annual growth. GAAP earnings per share in fiscal 2023 was $11.82 and non-GAAP earnings per share was $16.07, both representing 17% year-over-year growth. We exited the year with $17.22 billion in RPO. Our strong performance reflects the mission-critical role our products play in a digital-first world, incredible product innovation and exceptional execution. Adobe Creative Cloud, Document Cloud, and Experience Cloud have become the foundation of digital experiences, starting with the moment of inspiration to the creation and development of content and media to the personalized delivery and activation across every channel. Adobe's mission of changing the world through personalized digital experiences and our delivery of foundational technology platforms, set us up for the next decade of growth. We take pride in being one of the most inventive, diversified, and profitable software companies in the world. We believe that every massive technology shift offers generational opportunities to deliver new products and solutions to an ever-expanding set of customers. AI and generative AI is one such opportunity and we've articulated, how we intend to invest and differentiate across, data, models, and interfaces. We have delivered against this strategy and I'm pleased that a number of our groundbreaking innovations, including our Firefly models and integrations across Creative Cloud, Liquid Mode and integrations across Document Cloud and AI services in our real-time Customer Data Platform and integrations in Experience Cloud, are now seeing tremendous usage by customers. We remain excited about the strategic opportunity with Figma, to jointly advance product design, accelerate collaborative creativity on the web, and redefine the future of creativity and productivity. We continue to engage with the European Commission, the Competition and Markets Authority in the UK, and the US Department of Justice, as they conduct their regulatory reviews. The EC has provided a preliminary statement of objections and the CMA has issued provisional findings of competition concerns. We strongly disagree with these findings and are responding to the respective regulators. As per the current timelines, the EC's decision deadline is February 5th and the CMA’s is February 25th, while the DOJ does not have a formal timeline to decide whether to bring a complaint, we expect a decision soon. I'll now turn it over to David to discuss the momentum in our Digital Media business.
David Wadhwani: Thanks, Shantanu. Hello, everyone. In Q4, we achieved net new Digital Media ARR of $569 million and revenue of $3.72 billion, which grew 14% year-over-year, fueled by innovation in both our Creative and Document businesses. Starting with Creative Cloud, global demand for content is accelerating and continues to be a tailwind for the business. Creative Cloud remains the creativity platform of choice for creators across imaging photography, design, video, web, animation, and 3D. Our rapid pace of product and AI model innovation is empowering a wide and growing base of individuals, students, creative professionals, small-business owners, and enterprises to create and monetize amazing content more quickly and easily than ever before. We were thrilled to come together in person with thousands of creators at Adobe MAX in Los Angeles. And at our MAX event in Tokyo with millions more from our community engaging with us online. We reached a record 300 million social interactions in the month following MAX. Q4 was a record quarter for Creative Cloud, achieving $3 billion in revenue, which grew 14% year-over-year. Net new Creative Cloud ARR was $398 million. Business highlights include strong digital traffic, resulting from product innovation, social engagement, and our continued product-led growth efforts which drove record new commercial subscriptions in the quarter. The general availability of our generative AI Firefly models and their integrations across Creative Cloud drove tremendous customer excitement with over 4.5 billion generations since launch in March. The release of three new Firefly models, Firefly Image two model, Firefly Vector model, and Firefly Design model, offering highly differentiated levels of control with Effects, Photo Settings, and Generative Match. We also introduced Generative Credits as part of our Creative Cloud subscription plans. The general availability of Photoshop Generative Fill and Generative Expand which are seeing record adoption, they're already among the most used features in the product. Advances in Adobe Illustrator with the introduction of Text to Vector beta enabling users to generate icons, scenes, subjects, patterns, gradients. Adobe Premiere Pro advances include a significant performance improvement in the timeline for faster and smoother editing, new color preferences, and improved tone mapping. Premiere Pro is now natively integrated with Frame.io offering faster content sharing and collaboration. The combination of Adobe Express and Firefly is enabling everyone from Creative Pros to beginners to quickly move from ideation to task-based workflows in Express dramatically expanding our reach and widening our top-of-funnel. The family of generative capabilities across Express including Text to Image, Text Effects, Text to Template, and Generative Fill are driving adoption of Express and making it even faster and more fun for users of all skill levels. Express now comes pre-installed on all new Chromebooks, making it accessible to students, educators, and anyone using Chrome OS. Continued strength in Adobe Stock which had its best year ever driven by accelerating demand for high-quality image, vector, video, and 3D content. Creative Cloud, Express, and Firefly integrations with Adobe GenStudio enabling ideation, creation, and stakeholder collaboration as part of their overall content supply chain. Strong mid-market and enterprise adoption driven by up-sell to Creative Cloud offerings with Firefly. Key customer wins include Cyber Agent, Deloitte, Discovery Communications, Nexstar Media, Pepsi, Publicis, and the United Nations. We are thrilled with the momentum we're seeing in the Creative business following a year of unprecedented innovation. Customer excitement around Firefly integrations across our applications has been great to see with community engagement, social interactions, and creative marketing campaigns, driving organic brand search volume, traffic, and record demand. While we started rolling out new Creative Cloud pricing in select geographies in November, the primary driver of growth continues to be new paid subscriptions across our routes-to-market. We are excited to build on this momentum as we enter FY '24. Now turning to Document Cloud, digital documents are essential enablers of our personal and professional lives. Document Cloud is a leader in digital documents powering all common document actions including editing, sharing, reviewing, scanning, and signing. Document Cloud innovations are advancing accessibility, comprehension, productivity, automation, and security in document workflows across web, desktop, and mobile. In Q4, we achieved Document Cloud revenue of $721 million, growing 17% year-over-year. We added a record $171 million of net new Document Cloud ARR with ending ARR growing 23% year-over-year in constant currency. Business highlights include Acrobat Web growth, which continues to be an incredible source of customer acquisition, with monthly active users up over 70% year-over-year. The surge in usage of link sharing for stakeholder collaboration around PDF files, which increased 400% year-over-year, creating a viral growth loop, that is bringing tens of millions of users into the Acrobat ecosystem. This is a great example of how we are scaling our PLG motions. Strong demand for Acrobat on mobile with MAU surpassing 100 million users in Q4. Liquid Mode has now served over one billion files to customers demonstrating how indispensable this technology has become on mobile devices. Adobe Acrobat to Express workflows making it even easier to import, edit, and enhance documents to create visually stunning PDFs. Key enterprise customer wins include Alshaya, Bank of America, Department of Veterans Affairs, Mastercard, State Farm Auto Insurance, and Volkswagen. Much like the Creative business, we expect generative AI to deliver additional value and attract new customers to Document Cloud. Acrobat's generative AI capabilities, which will enable new creation, comprehension and collaboration functionality have already been rolled out in a private beta. We expect to release this in a public beta in the coming months. It's been an extraordinary year for the Digital Media business with the introduction of hundreds of transformative innovations that are reshaping the future of creativity, productivity, and digital experiences. Capping this year’s many accolades, TIME magazine recognized Adobe Liquid Mode, Photoshop Generative Fill, and Generative Expand, among the best inventions of 2023. I'll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello, everyone. Digital experiences are indispensable for every business in every category, enabling companies of all sizes to engage and transact with customers around the world. Adobe's Holiday Shopping Report, which analyzes trillions of data points, found that both Black Friday and Cyber Monday sales hit record highs of $9.8 billion and $12.4 billion, respectively, jumping 7.5% and 9.6% from last year. We predicted that holiday 2023 spend will exceed $221 billion in the US alone. Adobe Experience Cloud is optimally positioned to capitalize on this massive global opportunity. Companies across B2C and B2B are turning to Adobe Experience Cloud as the platform to accelerate experience-led growth. Our leading solutions spanning data insights and audiences, content, and commerce, customer journeys, and marketing workflow, empower businesses to drive customer demand, engagement, and growth while simultaneously delivering productivity gains. Our comprehensive set of applications, including Real-Time CDP are built natively on our highly differentiated Adobe Experience Platform, providing companies with a unified profile of each of their customers to deliver personalized, real-time experiences at scale. Generative AI accelerates our pace of innovation across the Experience Cloud portfolio enabling us to build on our capabilities to deliver personalized digital experiences. Our efforts are focused in three areas: one, augmenting our applications with an AI Assistant that significantly enhances productivity for current users, and provides an intuitive conversational interface to enable many more knowledge workers to use our products; two, reimagining existing Experience Cloud applications, like we did with Adobe Experience Manager; and three, developing entirely new solutions built for the age of generative AI, like Adobe GenStudio. In Q4, we continue to drive strong growth in the Experience Cloud business across our enterprise and mid-market customers achieving $1.27 billion in revenue. Subscription revenue was $1.12 billion, representing 12% year-over-year growth. Business highlights include, strong momentum with Adobe Experience Platform and native applications inclusive of Real-Time CDP, Adobe Journey Optimizer, and Customer Journey Analytics. AEP had its first $100 million quarter of net-new business in Q4 and exited the year with a greater than $700 million annualized book of business. Release of Adobe GenStudio, an end-to-end solution that brings together best-in-class applications across Creative Cloud, Express, and Experience Cloud with Firefly generative AI at the core to help brands meet the rising demand for content. GenStudio provides a comprehensive offering spanning content ideation, creation, production, and activation. We're seeing tremendous interest in GenStudio from brands like Henkel, Pepsi, and Verizon and agencies like Publicis, Omnicom, and Havas as they look to accelerate and optimize their content supply chains. Reimagined customer experiences with the all-new Adobe Experience Manager Sites that enable businesses and developers to quickly test and optimize web content, deliver fastest possible page load times, and maximize SEO rankings, lighthouse scores, and conversion. Adobe was recognized as a leader in over 25 industry analyst reports this year, including the Gartner Magic Quadrant for Digital Experience Platforms, B2B marketing automation platforms, and multichannel marketing hubs. In the Forrester Wave for Digital Experience Platforms which was published last week, Adobe received the highest scores for strategy. Key customer wins include Alshaya, Coca-Cola, EY, IBM, Marriott, Riyadh Air, Santander Brasil, Sony, Southern Graphics, Unilever, Vanguard, and Verizon. In our conversations with these and other customers around the world, c-Level executives are continuing to prioritize experience-led growth as a critical business imperative, despite ongoing budget scrutiny. Adobe Experience Cloud is well-positioned to keep winning with innovative products that power end-to-end customer experiences and enable companies to simultaneously drive growth and profitability. We are looking forward to continuing our leadership and momentum into 2024. I'll now pass it to Dan.
Dan Durn: Thanks, Anil. Our earnings report today covers both Q4 and FY '23 results. What a year 2023 was, fueled by a deep understanding of our customers, product innovation, and outstanding execution, we delivered strong financial results and world-class margins, positioning the company for years of continued growth. In FY '23, Adobe achieved record revenue of $19.41 billion, which represents 10% year-over-year growth or 13% growth in constant currency. GAAP EPS for the year was $11.82 and non-GAAP EPS was $16.7; each growing 17% year-over-year. FY '23 business and financial highlights included Digital Media revenue of $14.22 billion, net new Digital Media ARR of $1.91 billion, Digital Experience revenue of $4.89 billion, cash flows from operations of $7.3 billion, RPO was $17.22 billion exiting the year and repurchasing approximately 11.5 million shares of our stock during the year at a cost of $4.63 billion. In the fourth quarter of FY '23, Adobe achieved revenue of $5.05 billion, which represents 12% year-over-year growth or 13% in constant currency. GAAP-diluted earnings per share in Q4 was $3.23 and non-GAAP diluted earnings per share was a record $4.27, growing 28% and 19% year-over-year, respectively. Q4 business and financial highlights included Digital Media revenue of $3.72 billion, net new Digital Media ARR of $569 million, Digital Experience revenue of $1.27 billion, cash flows from operations of $1.6 billion. Adding approximately $1.5 billion RPO in the quarter, our highest sequential quarterly increase ever and repurchasing approximately 1.8 million shares of our stock. In our Digital Media segment, we achieved Q4 revenue of $3.72 billion, which represents 13% year-over-year growth, or 14% in constant currency. Our net-new ARR in Q4 was $569 million, which was a quarterly record in constant currency and we exited the quarter with $15.17 billion of Digital Media ARR. We achieved Creative revenue of $3 billion, which represents 12% year-over-year growth or 14% in constant currency and we added $398 million of net-new Creative ARR in the quarter. Driving this performance was strong customer acquisition throughout the quarter as well as strength during the peak holiday shopping weeks. Fourth quarter Creative growth drivers included individual subscriber growth fueled by targeted campaigns and strong web traffic. A strong quarter for Creative Cloud All Apps subscriptions across customer segments and geographies, with particular strength in emerging markets. Sales of CC single apps, including a strong quarter for Imaging and photography offerings. Continued growth of our Frame.io offering and Adobe Stock which capped off its best year ever in terms of net-new ARR. Customer demand in education driven by back-to-school purchasing as well as migrations to full-priced offerings by graduating students entering the workforce. And typical Q4 strength in the Enterprise, including significant upsell of our new Firefly and Express offerings. Adobe achieved Document Cloud revenue of $721 million, which represents 16% year-over-year growth or 17% in constant currency. We added a record $171 million of net new Document Cloud ARR in the quarter. Fourth quarter Document Cloud growth drivers included, Acrobat's subscription demand across all customer segments routes-to-market, and geographies. Continued strength of our free-to-paid funnels including Reader on the desktop and Acrobat web. Strong performance of our collaboration services including PDF link sharing and Sign, which are virally bringing new users to the Acrobat ecosystem. An outstanding quarter for Acrobat Mobile as a result of increased proliferation, usage, and conversion and year-end seasonal strength in SMB and enterprise. Turning to our Digital Experience segment, in Q4, we achieved revenue of $1.27 billion, growing 10% year-over-year, or 11% in constant currency. We achieved subscription revenue of $1.12 billion, which represents 12% year-over-year growth. Fourth quarter Digital Experience growth drivers included strong year-end bookings across solutions with particular strength in North America, continued success closing multi-solution transformational deals with large enterprises, momentum with AEP and native applications with the FY '23 exiting book of business growing greater than 60% year-over-year, strong net dollar retention for early adopters of AEP, demonstrating the value enterprises are realizing from our real-time data platform and integrated offerings, and strength across our data and insights, content and workfront solutions and growing customer interest and pipeline for our new GenStudio solution. We drove world-class operating margins in Q4 and throughout fiscal 2023 by making disciplined investments in R&D marketing and sales and we're pleased that we grew EPS faster than revenue. Adobe's effective tax rate in Q4 was 18% on a GAAP basis and 18.5% on a non-GAAP basis in line with our expectations. RPO exiting the quarter was $17.22 billion, growing 13% year-over-year. Our ending cash and short-term investment position exiting Q4 was $7.84 billion and cash flows from operations in the quarter were $1.6 billion, after making a previously discussed payment in the quarter of $826 million of US Federal taxes that we deferred from the second and third quarters of FY '23. In Q4, we entered into a $1 billion share repurchase agreement and we currently have $2.15 billion remaining of our $15 billion authorization granted in December 2020. As a reminder, we measure ARR on a constant-currency basis during the fiscal year and revalue ARR at year-end. FX rate changes between December of 2022 and this year have resulted in a $160 million increase to Digital Media ARR balance entering FY '24, which is now $15.33 billion and is reflected in our updated investor datasheet. Factoring in the momentum across our businesses and current expectations for the macroeconomic and foreign-exchange environments, for FY '24, we are targeting total Adobe revenue of $21.30 billion to $21.50 billion. Digital Media net new ARR of approximately $1.9 billion, Digital Media segment revenue of $15.75 billion to $15.85 billion, Digital Experience segment revenue of $5.275 billion to $5.375 billion, Digital Experience subscription revenue of $4.75 billion to $4.80 billion. Tax rate of approximately 18% on a GAAP basis and 18.5% on a non-GAAP basis. GAAP earnings per share of $13.45 to $13.85. And non-GAAP earnings per share of $17.60 to $18. As a reminder, and as is customary, these targets do not reflect our planned acquisition of Figma. We expect normal seasonality throughout the year with a seasonal step-down for new business into the first quarter, sequential growth from Q1 to Q2, typical Q3 summer seasonality, and a strong finish to the year in Q4. We expect our cash tax rate to improve sequentially in FY '24 by 2 percentage points as the amortization of previously capitalized R&D increases our deductions next year for tax purposes, benefiting our operating cash flows next year. For Q1 FY '24, we're targeting total Adobe revenue of $5.10 billion to $5.15 billion, Digital Media net new ARR of approximately $410 million, Digital Media segment revenue was $3.77 billion to 3.80 billion, Digital Experience segment revenue of $1.27 billion to $1.29 billion, Digital Experience subscription revenue of $1.14 billion to $1.16 billion. Tax rate of approximately 18% on a GAAP basis and 18.5% on a non-GAAP basis. GAAP earnings per share of $3.35 to $3.40. And non-GAAP earnings per share of $4.35 to $4.40. While the implied operating margin for Q1 is up sequentially, we expect a typical seasonal margin step-down starting in Q2 as a result of the annual merit increases and disciplined investments to drive growth. In summary, I couldn't be prouder of the company's performance in FY '23 and the momentum we're carrying into 2024 across Creative Cloud, Document Cloud, and Experience Cloud. Our strategy, scale, speed of execution, and profitability position us for years of sustained success. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. In addition to our financial accomplishments, we are proud to once again be recognized for our industry leadership. Content credentials and Adobe's approach to responsible AI were recognized by Fast Company as one of the year's breakthrough innovations. We were again named to the Dow Jones Sustainability Index, Glassdoor listed Adobe is one of the best places to work and Interbrand ranked us in the top 20 Best Global Brands as the rising brand for the eighth year in a row. Digital remains a massive tailwind as content demand and consumption continues to grow and businesses of all sizes are focused on transforming their customer experiences. Adobe is incredibly well-positioned to lead and capitalize on this opportunity. Thanks to our innovative roadmap expanding global customer base, strong brand, and the best employees in the world. Our fiscal '24 financial targets reflect our confidence in continuing to drive strong topline growth and world-class profitability. I am more certain than ever that Adobe's best days are ahead of us. Thank you, and we will now take questions. Operator.
Operator: [Operator Instructions] We ask that you please limit yourself to one question. [Operator Instructions] We'll take our first question from Kash Rangan with Goldman Sachs. Please go ahead.
Kash Rangan: Hi. Thank you very much. Congrats on the quarter and happy holidays. Shantanu and team, I'm wondering, going into 2024, it definitely feels like the economy is in stable footing and in general, the software metrics are all improving as the year unfolded. And very different from going from '22 to '23, yet your DM - new ARR guidance is about the same as how you started last year, but you got the benefit of generative AI, tailwinds from the economy, and got pricing and Firefly. Can you just help us understand if you isolate for those factors, what has gone into your -- into your guidance, but it seems like, if we exclude the optionality that you have, including the tailwinds in economy that guidance looks like it's very conservative. And maybe that's the right thing to do, but just wanted to understand your thought process. Thank you so much.
Shantanu Narayen: Yeah. Thanks, Kash. I mean, certainly, really thrilled with what a phenomenal year we had across all aspects of the business, whether it was the $5 billion quarter, $5 billion book of business now in DX exiting, and certainly Digital Media ARR performance. Let's -- if you reflect, I mean, you talked about the guidance that we gave at the beginning of '23 and '24, if you recall, we actually had guided to $16.50 first then we opted as you know, to $17.50, and ended with $19.13. And so to your point on the execution front, we have delivered some great innovative products. We've expanded the customer base with new products like Express and Firefly. We're certainly focused on surfaces and making sure all of our flagship products are available across all surfaces. And so we do have multiple growth drivers to your point. And we are focused on monetizing the opportunity. I mean, I would say, we take our guide very seriously, the other way of looking at it, Kash, is it’s our highest annual guide ever in terms of what the guide we've issued, it's the highest Q1 guide ever and we want to go again, execute against this large opportunity and have another record year. So, we're feeling good, the momentum is certainly there in the business. But we take our guidance at this point of the year very seriously.
Kash Rangan: Thank you so much and happy holidays. All the best for 2024.
Shantanu Narayen: Thanks. Happy holidays.
Operator: We will take our next question from Keith Weiss with Morgan Stanley. Please go ahead.
Keith Weiss: Excellent. Thank you guys for taking the question. I think this is in a similar vein to what Kash was trying to get at. But maybe a little bit more focused on Q4 in particular. When we look at the Digital Media net new ARR adds in Q4, it looks like you had a very, very strong Document Cloud, record quarter like you were saying, really strong year-on-year growth in those net adds. Creative Cloud, where we actually saw price increase and we have all the excitement in Firefly, that was actually down on a year-on-year basis. And this is the first time since 2018 we've seen Creative Cloud net new ARR below $400 million. I think that's the surprise for investors -- a negative surprise for investors that we're trying to figure out, was there something dragging the Creative Cloud side of the equation this year, or a tough comp from last year, or something that explains why the price increases in all the positive momentum and innovation out of Adobe MAX isn't translating into net new ARR growth for Creative Cloud in particular.
David Wadhwani: Yeah. Happy to take that. Keith, David here. So first of all, as you've mentioned in the DME business, we're really excited about the results for '24, over $1.9 billion in net new ARR obviously well above the guide. We see an expanding base of customers and a lot of momentum coming from gen AI as you noted. As part of this, we delivered -- what we delivered in Q4 was net new ARR -- was a record net new ARR in constant currency. Now specific to your question on Creative Cloud momentum and how to interpret the numbers that you see there, underlying all of this is very strong momentum because we delivered a record Creative Cloud new commercial subscriptions number in the year. So that is really the foundation and the base of customers coming in and really benefiting from not just what we get in this quarter, but also how we build on that going forward. So it really just sets us up well for FY '24. As you look at the numbers for Creative Cloud ARR, net-new ARR in the quarter, you have to look at it relative -- Q4 FY '23 relative to Q4 FY '22 as you mentioned. You need to consider that FY '22 had two pricing actions, that accrued to Creative Cloud that are much lower now in Q4 FY '23. So, if you normalize for the impact of the pricing that rolled off and the pricing that came on, Creative Cloud net new ARR in Q4 grew on a constant currency basis.
Shantanu Narayen: And Keith, just to punctuate the two points that David made -- David said, first, it was a record for Creative ARR as it related to subscriptions in Q4 of 2023 and Creative ARR would have grown if you had backed out the pricing. So, the business continues to be extremely healthy to your point.
Keith Weiss: Excellent. Thank you, guys.
Operator: We will take our next question from Alex Zukin with Wolfe Research. Please go ahead.
Alex Zukin: Hey, guys. Thanks for taking my question. I guess maybe looking at next year, as we look at how much of the renewal base in Creative Cloud is potentially up for that type of the pricing uplift. And as we look at Acrobat, specifically the AI functionality that you're releasing into public beta. How should we think about the tailwind to both Creative Cloud from pricing and to Document Cloud, specifically from an AI product monetization perspective for '24 -- for calendar '24?
David Wadhwani: Yeah. Happy to take that Alex, a lot packed into that question. So let me try to tease them apart. Let me first start with the question around FY '24 and impact of pricing. Before we jump straight into that I do want to take a bit of a step back and just remind everyone that Digital Media ARR is a mix of a few things, new subscriptions which as I mentioned we had a record number of new subscriptions in Q4, up-sell and cross-sell, which is transitioning people to higher plans from the plan that they're on. And then lastly offer optimization. And as you've noted in the last couple of years, we've really been broadening the number of offers we have all the way down from free price points to the all-apps price points, but even beyond that, we now have capabilities to sell add-ons to all-apps as well. And of course, all of this does include the pricing increases that you had mentioned where we've added more value. I do want to just stress, because I know there's a lot of attention on the pricing impact that we always have seen and continue to believe that the primary growth driver for ARR will be new subscriptions in '24. So, that's why we're so focused on the top-of-funnel and new customer acquisition. But specific to your question on pricing, you need to consider a few things. First, our recently announced pricing changes will impact less than half the Creative Cloud base. So there was a very specific question you asked, hopefully, that gives you the answer, but it also leaves us the opportunity to price in new value in the years ahead as we move forward. Second, the impact will be more visible in net new ARR in the back half of FY '24 as we lap the previous pricing actions that I was talking to Keith about from last year. And as we roll out the pricing over the next few quarters. So the second half of FY '24 we'll see more visibility into the benefits of that to net new ARR. Third, given that we're rolling out these prices across plans and across geos incrementally over the year, the benefit to ARR will actually be spread across FY '24 and FY '25. And fourth, if you really want to have sort of sharpen your pencil, the pricing impact on ARR in '24 is actually lower than the pricing impact was in '23 to Creative Cloud. So hopefully that gives you a sense, but again it comes back to this is why we're so excited about the momentum we're seeing in new subscriptions, which really bodes well for the business this year and in the long term. Hopefully, that gives you a pretty good sense on that. And then really quickly on Document Cloud, we're thrilled with the performance of Document Cloud, a lot of that comes down to our core strategy which has been around integrating the desktop, the web, and mobile into a single ecosystem. And really driving the monthly active usage of Document Cloud up through all of the product-led growth motions we have and converting people on the back-end of that. What we're really excited about as we bring the AI assistant to market, which by the way, as I mentioned, is now in private beta, expect it to come out in the next few months as a public beta and then, GA later in the year. But what we're really excited about there is being able to not just service that paid Acrobat based with that, but also start to bring that to the free reader base. So, lots of opportunity and excitement for the year ahead for Doc Cloud as well.
Alex Zukin: Perfect. Thank you for the very fine point and answer.
David Wadhwani: No problem.
Operator: We'll take our next question from Kirk Materne with Evercore ISI. Please go ahead.
Kirk Materne: Hi. Thanks and congrats on the quarter and happy holidays. David, I guess I'll go back to you again, in the commentary, you all talked about enterprise strength and specifically up-selling of Firefly and Express in your enterprise customer base. Can you just give us some more, I guess, qualitative color on what those discussions are like, are they lead -- is this part of the reason you're seeing sort of an uptick in new subscriptions in the enterprise, in particular? And then on Express. Can you just talk again about sort of what you're seeing in terms of leading indicators of that being an enterprise product that can continue to expand into fiscal '24. Thanks.
David Wadhwani: Yeah. Maybe I'll start and then Anil can add because does crossover our two businesses. So with Firefly and Express, very excited about the momentum that we continue to see. You heard that we crossed 4.5 billion generations now, so we continue to see really, really strong adoption and usage of it. Partially as a standalone business, but also integrated into our Photoshop and Illustrator and these existing workflows. And we're starting to see a lot of interest, not just in the context of using it as part of those existing products, but also using it as part of the ecosystem within enterprises. So, we've been working with a number of customers to not just enable them with Firefly, which is the predominance of the growth that we're seeing in Q4 for enterprise adoption but also have a number of pilot customers already engaged around custom model extension, so that they can bring their own assets and their own content into what Firefly generates. Second, we're also enabling the ability to expose it through APIs, so they can build it into their existing workflows and third, we of course connecting it in tying it all into Adobe Express, which now also has its own Firefly and additional capabilities like things, so that you can not just sort of create content using Firefly, but then start to assemble it, start to schedule, social posts around it, start to do multi-language translations that -- those are all features that are already in there and then create a stakeholder workflow from people working in Photoshop to the marketers that are trying to post externally. So, that's where things get very interesting and exciting in terms of the connection we have with GenStudio and everything that Anil is doing.
Anil Chakravarthy: Just building on that, GenStudio since we announced it at MAX, we've had a tremendous amount of interest both from enterprise customers like Henkel and Pepsi and Verizon, as well as a number of agencies as well. And primarily it goes back to what we discussed at Summit. The demand for content is expected to grow 5x over the next couple of years, and every brand in the world is looking at, hey, how can we speed up the production of quality on brand content, how can we let a number of other people in marketing, other areas of the company create their own content according to the standards -- enterprise standards and the combination of what we have in the Digital Experience portfolio like Adobe Experience Manager and assets as well as what we have in the Creative Cloud, especially around Express and Creative Cloud really let's enterprises, get that kind of agility and the cost-effectiveness of producing content at scale. So that's what we're seeing and we're seeing a tremendous amount of interest for that.
Shantanu Narayen: And maybe I'll just add a little bit to that, Kirk. I mean, I think the exciting thing about what people are doing is they're standardizing on Firefly and the fact that we have responsible generations for the entire enterprise. So the interest level has been around, how do we standardize that for all of the image or vector or other generations that they want to do for all the knowledge workers in the enterprise. So really good adoption of Firefly.
Kirk Materne: Thank you.
Operator: We will take our next question from Karl Keirstead with UBS. Please go ahead.
Karl Keirstead: Thanks. I'd like to ask about a different subject. And that's the creative Express product now that it's being sold into the enterprise. I'm wondering if you could offer some color on the adoption ramp, the competitiveness versus Canva and whether your plans around driving Express revenues versus driving user adoption have changed at all. Thank you.
Shantanu Narayen: Great. Yeah. Happy to take that. Express is off to a great start. As you remember, we went general availability in August with the latest version of it, it's been getting a lot of very, very positive reaction response. And frankly, since then in Q4 too, we've added a ton of new innovation. Firefly integration started with Text to Image and Text to Effects, but we also added Text to Template that will create a fully-formed template for you and generative fill, so you can iteratively change things on the fly. We now let you drawing paint on the campus -- canvas, we've given users much more video support. We've really built an incredible best-of-breed PDF support and workflow with Acrobat in there as well. Some of the other things that now start to bleed into the enterprise also, we have integrated social workflows so that people can schedule their post, we've enabled people to do auto-translations, so you can post to multiple geographies and languages. We've opened up our ecosystem for partner plug-ins and we have now over 50 extensions. And we've added enterprise features like AEM integration and template locking, so that the core, brand police in an organization can manage and make sure that their brand elements that they don't want changing are locked when you disseminate this more broadly. What we've seen is really. I think some very exciting broad-based benefits from this. One is, we've seen new trialists coming in, growing very quickly after this launch, which is exciting to see, we've seen education, users starting to adopt this very quickly as well, the Creative Cloud probe paid base has been coming on and growing very quickly in terms of their usage and then enterprise, as we talked about from a usage perspective and again, Express is a core part of how Anil and team are now selling GenStudio. And the last thing is like this is just setting up the momentum for the year to come. We have a mobile release coming out, which will be very exciting for users to be able to use this on the go. We have thousands of people already using that beta. We announced our Chromebooks partnership. So, anyone that buys a new Chromebook is going to have this. We have partnerships with folks like Wix for their workflows. We're going to be doing deeper integrations into Acrobat. So we are very excited about where this goes. That is a long way to answer a very simple question. We want a lot of people using this. So, our primary focus continues to be around broadening the top of funnel. Of course, as part of that, we are constantly and continually, as I mentioned, journeying people for upsell and cross-sell opportunities to the paid plan, and over to Creative Cloud and other products, but our primary focus continues to be adoption and broad proliferation.
Karl Keirstead: Got it. Thank you.
Operator: We will take our next question from Brad Zelnick with Deutsche Bank. Please go ahead.
Brad Zelnick: Great. Thanks very much. This is for Dan or maybe Anil. As we think about the momentum within the DX business, it's great to hear things like the 60% increase in your AEP, and native apps book of business, the strong net dollar retention. And you talked about overall strong year-end bookings, but what does it maybe about the pipeline ahead, bookings conversion or perhaps other factors that account for the degree of decel that you're guiding for into next year? Thanks.
Anil Chakravarthy: Thanks, Brad. I mean we are really excited about this massive multi-year opportunity, if we would look at any enterprise customers around the world, everybody recognizes the long-term imperative of transforming their customer experiences. And we're seeing that in these transformational deals that we talked about. And as you mentioned, for example, with AEP, our first $100 million net new business quarter and ending with over $700 million in our annualized book of business. With that said, definitely we're seeing macroeconomic impact, just like other enterprise software companies are. Every customer looks at the total cost of deploying the software and then what it would take to get the payback and ROI. And as a result, there is definitely some scrutiny and caution there. But that said, if we look at going into next year, we do see the pipeline across both our industry verticals as well as our mid-market customers. And we continue to be the leader in the market and we did get that recognition from both analysts and customers.
Brad Zelnick: Okay. Thank you.
Operator: We will take our next question from Brent Thill with Jefferies. Please go ahead.
Brent Thill: Dan, if you could just review the broader assumptions in your guide. I think there's still a little concern from the Street in terms of why you're guiding, where you're guiding relative to where the Street was at. And maybe just tying in Shantanu to the guidance, if you could just give us your topline view of -- do you feel like the environment's improving, do you think it's just stabilizing? Just any thoughts in terms of from a high level, what you think is happening as we go into next year?
Dan Durn: Yeah. So thanks for the question, Brent. When we take a look at the guide. If we think about where we're at, at this point in time as we're looking forward in FY '24, clearly we see a lot of momentum in the business, the company's engine of innovation has been incredibly strong. And you see the strong financial performance of the company. That's both from a top line standpoint, as well as profitability and cash-flow standpoint. So, clearly a lot of momentum around the business. As I think about where we sit today, we printed a 46.4% operating margin. As we look forward in to next year, we take into account everything we can see. As Shantanu said, we take the guidance seriously and we set expectations in a prudent way, there is an opportunity to do better than the expectations that we set. Clearly, the company is going to be driving towards that. As we think about the engine of innovation, we think the pipeline is strong, we're going to continue to invest in the drivers of growth. This company is going to orient towards growth. When I think about the investment profile, not only are we going to be disciplined. But we're going to continue to invest in those drivers of growth on the DX side. Anil talked about AEP and Apps strong book of business, strong growth, we're laying the groundwork and content supply chain with the GenStudio solution, scaling that motion, and engaging with customers to go from ideation, to creation to activation, delivering new technologies, products, AEM sites incorporating intelligence into those products. On the DME side, you can see it across the portfolio, AI assistant Acrobat, it's in private beta, and it's going to be in public beta in the coming months, you look at Firefly and Express, natively and deeply integrating these technologies throughout the product portfolio, there is going to be continual investment as it relates to that innovation. As you think about the momentum exiting this year and as you think about the guide into Q1, you can see that momentum continuing, get the operating margin up a little bit, and then throughout the year, as we said at our FA Day and the last year's earnings call, you can see a mid-40s expectation around operating margin for the company as we drive this investment cycle, as we drive leadership in our core markets and our key catalyst in the trends that are shaping those markets. So, again, taking a step back, it nets into account the macro that Anil talked about everything we see from a core business standpoint, and the investment profile that we're going to drive to lead, if there's an opportunity to do better than where we set those expectations we're certainly going to do it.
Shantanu Narayen: And maybe just to add to that, Brent, since you asked. First, let me clarify, there is nothing as it relates to the economic indicators that we saw anything that would give us cause for concern. So, let me start off by saying that, I think at our Investor Meeting, we told you that we would expect a strong quarter, I think you would acknowledge, we posted some really strong numbers and the momentum continues. And I think as it relates to Creative Cloud, it's going to be driven by new customer acquisition, which is the engine that's driven the business and maybe perhaps the sell-side looked at some of the pricing and put more of that in '24 then in '24 and '25 and that will spread out and perhaps they put a little bit more in what percentage of the base that impacts. So from my perspective, the good news about Creative is it's being driven by massive new adoption into the platform. On Document Cloud, really strong results. I think as Dan said, as we put the AI pack on there as well, that should help fuel more adoption and Digital Experience, I mean, I know that Brad also asked that question. I mean it's great to see the adoption of AEP and Apps. I mean, that is clearly the future of digital experiences, driving $100 million quarter, the $700 million in the annualized book of business, which I think will reflect the next-generation customer experience architecture. So we're feeling positive. And we're going go execute against that Brent. So, nothing that we see on the horizon would tell us either from the economic or competition, that we're not poised to have another great year and profitability as well, I mean, look at the numbers that we posted both in terms of Q4, as well as for fiscal '24 and that is that does not in any way mean that we're not going to invest in all of the cloud and the foundation models. So I feel really good.
Dan Durn: And then just one thing to add, Brent, If we were here a year ago, the expectations going into the year where FX was going to be a pretty decent headwind to the performance, you see that in the way we've reported our results and then compare it to a constant-currency basis. We started with a pretty decent spread between the as-reported numbers in constant-currency in Q1. By the time we got to Q4, you saw that spread compress, as I look forward into FY '24, it's more of a neutral footing to maybe a slight headwind. Too early to really call it with precision, but I see that setup being slightly different. And maybe just a slight headwind versus what we were seeing a year ago.
Brent Thill: Thanks for the color.
Operator: We'll will take our next question from Jay Vleeschhouwer with Griffin Securities. Please go ahead.
Jay Vleeschhouwer: Yeah. Thank you. You noted the strength in RPO in the quarter, including the record sequential increase. Can you talk about how you're thinking about RPO for fiscal '24, would you expect it to continue to be able to outgrow revenue growth by several points as you did in fiscal '23 and perhaps talk about the ingredients that will continue to drive RPO, either by segment or any other considerations that you'd like to talk about in that.
Shantanu Narayen: Yeah. Thanks, Jay. As I pull some of the threads together that we've heard on this call. Anil, talked about large transformational deals being the platform of choice with customer experience management, simultaneously driving topline and bottom-line productivity and the investments around driving those are an imperative in the market. We see a similar dynamic with the new technologies that we're bringing to market on the DME side at the business, we're streaming seeing strong pull from the enterprise. And so as I net out that environment and our performance against that opportunity, it goes to produce the type of sequential RPO progression that we saw Q3 to Q4. Every quarter won't be that large, but the backdrop around that dynamic for the company given the setup we see, it should be another strong year for RPO throughout the year.
Jay Vleeschhouwer: Thank you.
Shantanu Narayen: Operator. We're getting close to the top of the hour. We'll take two more questions and then we'll wrap up. Thanks.
Operator: We'll take our next question from Saket Kalia with Barclays. Please go ahead.
Saket Kalia: Okay. Great. Hey, guys. Thanks for taking my question, and congrats on a nice quarter. David maybe for you, I had a question just on Firefly and the subscription packets. I know that the commercial model for commercial -- I'm sorry, for Firefly credit packets, really just started about six weeks ago. But are there any early observations that you've seen just on customers' willingness to add those packets, or maybe how they're consuming the initial credit allocation that they get with the Creative Cloud subscription?
David Wadhwani: Yeah. Happy to take that. First of all I think philosophically, going back to what we said at the investor meeting at MAX, our primary focus here is to drive usage of the generative capabilities and you see that with the 4.5 billion images generated, that strategy is working. Secondly, we price the generative packs -- sorry, we integrated the generative capabilities and credits directly into our paid plans with the Express intent of driving adoption of the paid subscription plans and getting broad proliferation of the ability to use those. And what we are seeing is heavy usage within those paid plans. I think as we've mentioned in the past. I think I mentioned earlier today as well, Generative Fill, for example in Photoshop is the fastest-growing feature that we've put into Photoshop in recent memory. So the usage is great, the utilization is great. I don't personally expect the generative packs to have a large impact in the short-term, other than to drive more usage more customers to our paid existing subscription plans. But what will happen over the course of the year, in the next few years is that we will be integrating more and more generative capabilities into the existing product workflows. And that will drive and we'll be integrating capabilities like video generation, which will cost more than one generation and that will drive a natural inflation in that market and that will become a driver for growth subsequently. But this year is really primarily focused on getting people into the right paid plans of our flagship applications, our Adobe Express, and then drive usage in that sense. And then as that happens, the rest will take care of itself in the years ahead.
Saket Kalia: Makes sense. Thanks, guys.
Operator: We'll take our final question from Mark Moerdler with Bernstein Research. Please go ahead.
Mark Moerdler: Thank you for squeezing me in. I really do appreciate. Dan, I'd like to look a little bit at MAX we discussed how excited you were on Firefly and how it drives Creative Cloud seed and paid seed adoption. Now that you had a bit of time in market, can you explain how you think about how this will drive the paid seed growth, is it how strong it could be and should we expect to seeds going to be lower unit price because they're going to be entry-level, what do you think that we will get offset by these higher-priced Firefly driven sales into the enterprise. Thank you.
Dan Durn: Yeah. Thanks, Mark. I think at the core of bringing this technology to life, as a standalone application to drive an ideation part of the process, but value in deeply integrating these capabilities into the flagship applications and the workflows that define the creation process, it gives us a lot of surface area with customers and meeting them where they are in their particular needs and use-case specific needs. And so bringing people efficiently top of funnel, establishing the segmentation across that product portfolio, driving efficiency into the creation process and allowing the velocity to enter the ideation, creation, activation and then instrumentation of that to really refine how companies engage with customers. So, it lays the groundwork for us to touch more customers where they are in the ecosystem, bring them on board in a use-case specific way and then take them on digital journeys which is something the company has very skilled at with our D-DOM to cross-sell and upsell over the life of their engagement with our ecosystem.
Anil Chakravarthy: From a product perspective, when you think about it, Mark, for us, the biggest thing that we want to do is, how do we further make our products accessible, fun and affordable for increasing set of customers and I think Firefly is one of those inflection points that will help everybody get over the blank screen fear that they have and so first, as you think about Firefly as an ideation and people just coming and want to have creative inspiration. This is, whether you're an individual user, whether you're agencies, we're seeing a lot of adoption of Firefly to just start the entire Creative process and that sort of brings them as an on-ramp into Express, which would be the other part. Express is certainly the introductory pricing, the ability to get millions more into the fold and the ability, right now, it used to be that Express and other offerings in that is to all worry about, do I have the right templates. Well, AI is going to completely change that, we have our own models and so Firefly will allow anybody to take whatever creative idea that they have and make that available, so I think Firefly really helps with the Express offering. On the Creative Cloud, David mentioned this. I mean if you look at the adoption of that functionality and usage, that's being driven, whether it's in Photoshop right now, Illustrator as we add video, both in terms of providing greater value and we certainly will therefore have the uplift in pricing as well as the retentive ability for Firefly. That's where I think you're going to see a lot of the really interesting aspects of how Firefly will drive both adoption as well as monetization. And then if you go at the other end of the spectrum to the enterprise, GenStudio, every single marketer that I know and CFO and CMO, are all worried about how much am I spending on data, how do I get agility in my campaigns and the fact that Firefly is integrated into both Express as well as when we do the custom models for them, so they can upload their own models and then have the brand consistency that they want. So, Firefly really is the fact that we have our own models. A great catalyst for our business, all across the spectrum and the usage and the adoption shows that in emerging markets, as people there in emerging markets are increasingly used to create variance of content and localization of content, that's where we are also seeing a tremendous usage of these particular technologies. So really exciting. And then, you take the same technology that we have in Creative and think about its impact in both Document Cloud when we do that and the ability to have summaries and have conversational interfaces with PDF, thereby making every single PDF as David again said, both for communication, collaboration and creation far more compelling. I think you're going to see that same kind of uplift in usage and therefore monetization on the Acrobat side. And since it was the last question. I mean, for us, we look at FY '23, and we're really proud what we were able to accomplish across all spectrums topline revenue, RPO and driving book of business, Creative Cloud, Document Cloud, and Experience Cloud and profitability, and we think '24 is going to be exactly more of the same, which is continuing to drive great innovation, great product growth, great profitability. Clearly, I think there has been a set of questions around the Digital Media ARR and what I'll take is on that and we're extremely confident about how that continues to be a growth business and perhaps the pricing impact was overestimated. And as we said, this is again new growth business and it will be a multi-year pricing benefit for us as we think about the uplift that we have. So we're really pleased. We appreciate you being on the call. And like many of you wished us, happy holidays and we hope to see you soon. Thank you for joining us.
Shantanu Narayen: Thanks, everyone. Happy holidays. This concludes the call.
Operator: Once again, this concludes today's call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Q4 and FY 2023 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon and thank you for joining us. With me on the call today are, Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; and now Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice-President and CFO. On this call, which is being recorded, we will discuss Adobe's fourth quarter and fiscal year 2023 financial results. You can find our press release as well as PDF of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans is as of today, December 13th, and contains forward-looking statements that involve risk uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant-currency revenue growth rates unless otherwise stated. Reconciliations between the two are available in our earnings release and on Adobe's IR website. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon, and thank you for joining us. Q4 was our first-ever $5 billion quarter, a new record for the company. Adobe achieved revenue of $5.05 billion, representing 13% year-over-year growth. GAAP earnings per share for the quarter was $3.23 and non-GAAP earnings per share was $4.27, representing 28% and 19% year-over-year growth, respectively. Q4 was the culmination of another record year for Adobe, achieving $19.41 billion in revenue, which represents 13% annual growth. GAAP earnings per share in fiscal 2023 was $11.82 and non-GAAP earnings per share was $16.07, both representing 17% year-over-year growth. We exited the year with $17.22 billion in RPO. Our strong performance reflects the mission-critical role our products play in a digital-first world, incredible product innovation and exceptional execution. Adobe Creative Cloud, Document Cloud, and Experience Cloud have become the foundation of digital experiences, starting with the moment of inspiration to the creation and development of content and media to the personalized delivery and activation across every channel. Adobe's mission of changing the world through personalized digital experiences and our delivery of foundational technology platforms, set us up for the next decade of growth. We take pride in being one of the most inventive, diversified, and profitable software companies in the world. We believe that every massive technology shift offers generational opportunities to deliver new products and solutions to an ever-expanding set of customers. AI and generative AI is one such opportunity and we've articulated, how we intend to invest and differentiate across, data, models, and interfaces. We have delivered against this strategy and I'm pleased that a number of our groundbreaking innovations, including our Firefly models and integrations across Creative Cloud, Liquid Mode and integrations across Document Cloud and AI services in our real-time Customer Data Platform and integrations in Experience Cloud, are now seeing tremendous usage by customers. We remain excited about the strategic opportunity with Figma, to jointly advance product design, accelerate collaborative creativity on the web, and redefine the future of creativity and productivity. We continue to engage with the European Commission, the Competition and Markets Authority in the UK, and the US Department of Justice, as they conduct their regulatory reviews. The EC has provided a preliminary statement of objections and the CMA has issued provisional findings of competition concerns. We strongly disagree with these findings and are responding to the respective regulators. As per the current timelines, the EC's decision deadline is February 5th and the CMA’s is February 25th, while the DOJ does not have a formal timeline to decide whether to bring a complaint, we expect a decision soon. I'll now turn it over to David to discuss the momentum in our Digital Media business."
},
{
"speaker": "David Wadhwani",
"text": "Thanks, Shantanu. Hello, everyone. In Q4, we achieved net new Digital Media ARR of $569 million and revenue of $3.72 billion, which grew 14% year-over-year, fueled by innovation in both our Creative and Document businesses. Starting with Creative Cloud, global demand for content is accelerating and continues to be a tailwind for the business. Creative Cloud remains the creativity platform of choice for creators across imaging photography, design, video, web, animation, and 3D. Our rapid pace of product and AI model innovation is empowering a wide and growing base of individuals, students, creative professionals, small-business owners, and enterprises to create and monetize amazing content more quickly and easily than ever before. We were thrilled to come together in person with thousands of creators at Adobe MAX in Los Angeles. And at our MAX event in Tokyo with millions more from our community engaging with us online. We reached a record 300 million social interactions in the month following MAX. Q4 was a record quarter for Creative Cloud, achieving $3 billion in revenue, which grew 14% year-over-year. Net new Creative Cloud ARR was $398 million. Business highlights include strong digital traffic, resulting from product innovation, social engagement, and our continued product-led growth efforts which drove record new commercial subscriptions in the quarter. The general availability of our generative AI Firefly models and their integrations across Creative Cloud drove tremendous customer excitement with over 4.5 billion generations since launch in March. The release of three new Firefly models, Firefly Image two model, Firefly Vector model, and Firefly Design model, offering highly differentiated levels of control with Effects, Photo Settings, and Generative Match. We also introduced Generative Credits as part of our Creative Cloud subscription plans. The general availability of Photoshop Generative Fill and Generative Expand which are seeing record adoption, they're already among the most used features in the product. Advances in Adobe Illustrator with the introduction of Text to Vector beta enabling users to generate icons, scenes, subjects, patterns, gradients. Adobe Premiere Pro advances include a significant performance improvement in the timeline for faster and smoother editing, new color preferences, and improved tone mapping. Premiere Pro is now natively integrated with Frame.io offering faster content sharing and collaboration. The combination of Adobe Express and Firefly is enabling everyone from Creative Pros to beginners to quickly move from ideation to task-based workflows in Express dramatically expanding our reach and widening our top-of-funnel. The family of generative capabilities across Express including Text to Image, Text Effects, Text to Template, and Generative Fill are driving adoption of Express and making it even faster and more fun for users of all skill levels. Express now comes pre-installed on all new Chromebooks, making it accessible to students, educators, and anyone using Chrome OS. Continued strength in Adobe Stock which had its best year ever driven by accelerating demand for high-quality image, vector, video, and 3D content. Creative Cloud, Express, and Firefly integrations with Adobe GenStudio enabling ideation, creation, and stakeholder collaboration as part of their overall content supply chain. Strong mid-market and enterprise adoption driven by up-sell to Creative Cloud offerings with Firefly. Key customer wins include Cyber Agent, Deloitte, Discovery Communications, Nexstar Media, Pepsi, Publicis, and the United Nations. We are thrilled with the momentum we're seeing in the Creative business following a year of unprecedented innovation. Customer excitement around Firefly integrations across our applications has been great to see with community engagement, social interactions, and creative marketing campaigns, driving organic brand search volume, traffic, and record demand. While we started rolling out new Creative Cloud pricing in select geographies in November, the primary driver of growth continues to be new paid subscriptions across our routes-to-market. We are excited to build on this momentum as we enter FY '24. Now turning to Document Cloud, digital documents are essential enablers of our personal and professional lives. Document Cloud is a leader in digital documents powering all common document actions including editing, sharing, reviewing, scanning, and signing. Document Cloud innovations are advancing accessibility, comprehension, productivity, automation, and security in document workflows across web, desktop, and mobile. In Q4, we achieved Document Cloud revenue of $721 million, growing 17% year-over-year. We added a record $171 million of net new Document Cloud ARR with ending ARR growing 23% year-over-year in constant currency. Business highlights include Acrobat Web growth, which continues to be an incredible source of customer acquisition, with monthly active users up over 70% year-over-year. The surge in usage of link sharing for stakeholder collaboration around PDF files, which increased 400% year-over-year, creating a viral growth loop, that is bringing tens of millions of users into the Acrobat ecosystem. This is a great example of how we are scaling our PLG motions. Strong demand for Acrobat on mobile with MAU surpassing 100 million users in Q4. Liquid Mode has now served over one billion files to customers demonstrating how indispensable this technology has become on mobile devices. Adobe Acrobat to Express workflows making it even easier to import, edit, and enhance documents to create visually stunning PDFs. Key enterprise customer wins include Alshaya, Bank of America, Department of Veterans Affairs, Mastercard, State Farm Auto Insurance, and Volkswagen. Much like the Creative business, we expect generative AI to deliver additional value and attract new customers to Document Cloud. Acrobat's generative AI capabilities, which will enable new creation, comprehension and collaboration functionality have already been rolled out in a private beta. We expect to release this in a public beta in the coming months. It's been an extraordinary year for the Digital Media business with the introduction of hundreds of transformative innovations that are reshaping the future of creativity, productivity, and digital experiences. Capping this year’s many accolades, TIME magazine recognized Adobe Liquid Mode, Photoshop Generative Fill, and Generative Expand, among the best inventions of 2023. I'll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello, everyone. Digital experiences are indispensable for every business in every category, enabling companies of all sizes to engage and transact with customers around the world. Adobe's Holiday Shopping Report, which analyzes trillions of data points, found that both Black Friday and Cyber Monday sales hit record highs of $9.8 billion and $12.4 billion, respectively, jumping 7.5% and 9.6% from last year. We predicted that holiday 2023 spend will exceed $221 billion in the US alone. Adobe Experience Cloud is optimally positioned to capitalize on this massive global opportunity. Companies across B2C and B2B are turning to Adobe Experience Cloud as the platform to accelerate experience-led growth. Our leading solutions spanning data insights and audiences, content, and commerce, customer journeys, and marketing workflow, empower businesses to drive customer demand, engagement, and growth while simultaneously delivering productivity gains. Our comprehensive set of applications, including Real-Time CDP are built natively on our highly differentiated Adobe Experience Platform, providing companies with a unified profile of each of their customers to deliver personalized, real-time experiences at scale. Generative AI accelerates our pace of innovation across the Experience Cloud portfolio enabling us to build on our capabilities to deliver personalized digital experiences. Our efforts are focused in three areas: one, augmenting our applications with an AI Assistant that significantly enhances productivity for current users, and provides an intuitive conversational interface to enable many more knowledge workers to use our products; two, reimagining existing Experience Cloud applications, like we did with Adobe Experience Manager; and three, developing entirely new solutions built for the age of generative AI, like Adobe GenStudio. In Q4, we continue to drive strong growth in the Experience Cloud business across our enterprise and mid-market customers achieving $1.27 billion in revenue. Subscription revenue was $1.12 billion, representing 12% year-over-year growth. Business highlights include, strong momentum with Adobe Experience Platform and native applications inclusive of Real-Time CDP, Adobe Journey Optimizer, and Customer Journey Analytics. AEP had its first $100 million quarter of net-new business in Q4 and exited the year with a greater than $700 million annualized book of business. Release of Adobe GenStudio, an end-to-end solution that brings together best-in-class applications across Creative Cloud, Express, and Experience Cloud with Firefly generative AI at the core to help brands meet the rising demand for content. GenStudio provides a comprehensive offering spanning content ideation, creation, production, and activation. We're seeing tremendous interest in GenStudio from brands like Henkel, Pepsi, and Verizon and agencies like Publicis, Omnicom, and Havas as they look to accelerate and optimize their content supply chains. Reimagined customer experiences with the all-new Adobe Experience Manager Sites that enable businesses and developers to quickly test and optimize web content, deliver fastest possible page load times, and maximize SEO rankings, lighthouse scores, and conversion. Adobe was recognized as a leader in over 25 industry analyst reports this year, including the Gartner Magic Quadrant for Digital Experience Platforms, B2B marketing automation platforms, and multichannel marketing hubs. In the Forrester Wave for Digital Experience Platforms which was published last week, Adobe received the highest scores for strategy. Key customer wins include Alshaya, Coca-Cola, EY, IBM, Marriott, Riyadh Air, Santander Brasil, Sony, Southern Graphics, Unilever, Vanguard, and Verizon. In our conversations with these and other customers around the world, c-Level executives are continuing to prioritize experience-led growth as a critical business imperative, despite ongoing budget scrutiny. Adobe Experience Cloud is well-positioned to keep winning with innovative products that power end-to-end customer experiences and enable companies to simultaneously drive growth and profitability. We are looking forward to continuing our leadership and momentum into 2024. I'll now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Our earnings report today covers both Q4 and FY '23 results. What a year 2023 was, fueled by a deep understanding of our customers, product innovation, and outstanding execution, we delivered strong financial results and world-class margins, positioning the company for years of continued growth. In FY '23, Adobe achieved record revenue of $19.41 billion, which represents 10% year-over-year growth or 13% growth in constant currency. GAAP EPS for the year was $11.82 and non-GAAP EPS was $16.7; each growing 17% year-over-year. FY '23 business and financial highlights included Digital Media revenue of $14.22 billion, net new Digital Media ARR of $1.91 billion, Digital Experience revenue of $4.89 billion, cash flows from operations of $7.3 billion, RPO was $17.22 billion exiting the year and repurchasing approximately 11.5 million shares of our stock during the year at a cost of $4.63 billion. In the fourth quarter of FY '23, Adobe achieved revenue of $5.05 billion, which represents 12% year-over-year growth or 13% in constant currency. GAAP-diluted earnings per share in Q4 was $3.23 and non-GAAP diluted earnings per share was a record $4.27, growing 28% and 19% year-over-year, respectively. Q4 business and financial highlights included Digital Media revenue of $3.72 billion, net new Digital Media ARR of $569 million, Digital Experience revenue of $1.27 billion, cash flows from operations of $1.6 billion. Adding approximately $1.5 billion RPO in the quarter, our highest sequential quarterly increase ever and repurchasing approximately 1.8 million shares of our stock. In our Digital Media segment, we achieved Q4 revenue of $3.72 billion, which represents 13% year-over-year growth, or 14% in constant currency. Our net-new ARR in Q4 was $569 million, which was a quarterly record in constant currency and we exited the quarter with $15.17 billion of Digital Media ARR. We achieved Creative revenue of $3 billion, which represents 12% year-over-year growth or 14% in constant currency and we added $398 million of net-new Creative ARR in the quarter. Driving this performance was strong customer acquisition throughout the quarter as well as strength during the peak holiday shopping weeks. Fourth quarter Creative growth drivers included individual subscriber growth fueled by targeted campaigns and strong web traffic. A strong quarter for Creative Cloud All Apps subscriptions across customer segments and geographies, with particular strength in emerging markets. Sales of CC single apps, including a strong quarter for Imaging and photography offerings. Continued growth of our Frame.io offering and Adobe Stock which capped off its best year ever in terms of net-new ARR. Customer demand in education driven by back-to-school purchasing as well as migrations to full-priced offerings by graduating students entering the workforce. And typical Q4 strength in the Enterprise, including significant upsell of our new Firefly and Express offerings. Adobe achieved Document Cloud revenue of $721 million, which represents 16% year-over-year growth or 17% in constant currency. We added a record $171 million of net new Document Cloud ARR in the quarter. Fourth quarter Document Cloud growth drivers included, Acrobat's subscription demand across all customer segments routes-to-market, and geographies. Continued strength of our free-to-paid funnels including Reader on the desktop and Acrobat web. Strong performance of our collaboration services including PDF link sharing and Sign, which are virally bringing new users to the Acrobat ecosystem. An outstanding quarter for Acrobat Mobile as a result of increased proliferation, usage, and conversion and year-end seasonal strength in SMB and enterprise. Turning to our Digital Experience segment, in Q4, we achieved revenue of $1.27 billion, growing 10% year-over-year, or 11% in constant currency. We achieved subscription revenue of $1.12 billion, which represents 12% year-over-year growth. Fourth quarter Digital Experience growth drivers included strong year-end bookings across solutions with particular strength in North America, continued success closing multi-solution transformational deals with large enterprises, momentum with AEP and native applications with the FY '23 exiting book of business growing greater than 60% year-over-year, strong net dollar retention for early adopters of AEP, demonstrating the value enterprises are realizing from our real-time data platform and integrated offerings, and strength across our data and insights, content and workfront solutions and growing customer interest and pipeline for our new GenStudio solution. We drove world-class operating margins in Q4 and throughout fiscal 2023 by making disciplined investments in R&D marketing and sales and we're pleased that we grew EPS faster than revenue. Adobe's effective tax rate in Q4 was 18% on a GAAP basis and 18.5% on a non-GAAP basis in line with our expectations. RPO exiting the quarter was $17.22 billion, growing 13% year-over-year. Our ending cash and short-term investment position exiting Q4 was $7.84 billion and cash flows from operations in the quarter were $1.6 billion, after making a previously discussed payment in the quarter of $826 million of US Federal taxes that we deferred from the second and third quarters of FY '23. In Q4, we entered into a $1 billion share repurchase agreement and we currently have $2.15 billion remaining of our $15 billion authorization granted in December 2020. As a reminder, we measure ARR on a constant-currency basis during the fiscal year and revalue ARR at year-end. FX rate changes between December of 2022 and this year have resulted in a $160 million increase to Digital Media ARR balance entering FY '24, which is now $15.33 billion and is reflected in our updated investor datasheet. Factoring in the momentum across our businesses and current expectations for the macroeconomic and foreign-exchange environments, for FY '24, we are targeting total Adobe revenue of $21.30 billion to $21.50 billion. Digital Media net new ARR of approximately $1.9 billion, Digital Media segment revenue of $15.75 billion to $15.85 billion, Digital Experience segment revenue of $5.275 billion to $5.375 billion, Digital Experience subscription revenue of $4.75 billion to $4.80 billion. Tax rate of approximately 18% on a GAAP basis and 18.5% on a non-GAAP basis. GAAP earnings per share of $13.45 to $13.85. And non-GAAP earnings per share of $17.60 to $18. As a reminder, and as is customary, these targets do not reflect our planned acquisition of Figma. We expect normal seasonality throughout the year with a seasonal step-down for new business into the first quarter, sequential growth from Q1 to Q2, typical Q3 summer seasonality, and a strong finish to the year in Q4. We expect our cash tax rate to improve sequentially in FY '24 by 2 percentage points as the amortization of previously capitalized R&D increases our deductions next year for tax purposes, benefiting our operating cash flows next year. For Q1 FY '24, we're targeting total Adobe revenue of $5.10 billion to $5.15 billion, Digital Media net new ARR of approximately $410 million, Digital Media segment revenue was $3.77 billion to 3.80 billion, Digital Experience segment revenue of $1.27 billion to $1.29 billion, Digital Experience subscription revenue of $1.14 billion to $1.16 billion. Tax rate of approximately 18% on a GAAP basis and 18.5% on a non-GAAP basis. GAAP earnings per share of $3.35 to $3.40. And non-GAAP earnings per share of $4.35 to $4.40. While the implied operating margin for Q1 is up sequentially, we expect a typical seasonal margin step-down starting in Q2 as a result of the annual merit increases and disciplined investments to drive growth. In summary, I couldn't be prouder of the company's performance in FY '23 and the momentum we're carrying into 2024 across Creative Cloud, Document Cloud, and Experience Cloud. Our strategy, scale, speed of execution, and profitability position us for years of sustained success. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. In addition to our financial accomplishments, we are proud to once again be recognized for our industry leadership. Content credentials and Adobe's approach to responsible AI were recognized by Fast Company as one of the year's breakthrough innovations. We were again named to the Dow Jones Sustainability Index, Glassdoor listed Adobe is one of the best places to work and Interbrand ranked us in the top 20 Best Global Brands as the rising brand for the eighth year in a row. Digital remains a massive tailwind as content demand and consumption continues to grow and businesses of all sizes are focused on transforming their customer experiences. Adobe is incredibly well-positioned to lead and capitalize on this opportunity. Thanks to our innovative roadmap expanding global customer base, strong brand, and the best employees in the world. Our fiscal '24 financial targets reflect our confidence in continuing to drive strong topline growth and world-class profitability. I am more certain than ever that Adobe's best days are ahead of us. Thank you, and we will now take questions. Operator."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] We ask that you please limit yourself to one question. [Operator Instructions] We'll take our first question from Kash Rangan with Goldman Sachs. Please go ahead."
},
{
"speaker": "Kash Rangan",
"text": "Hi. Thank you very much. Congrats on the quarter and happy holidays. Shantanu and team, I'm wondering, going into 2024, it definitely feels like the economy is in stable footing and in general, the software metrics are all improving as the year unfolded. And very different from going from '22 to '23, yet your DM - new ARR guidance is about the same as how you started last year, but you got the benefit of generative AI, tailwinds from the economy, and got pricing and Firefly. Can you just help us understand if you isolate for those factors, what has gone into your -- into your guidance, but it seems like, if we exclude the optionality that you have, including the tailwinds in economy that guidance looks like it's very conservative. And maybe that's the right thing to do, but just wanted to understand your thought process. Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Yeah. Thanks, Kash. I mean, certainly, really thrilled with what a phenomenal year we had across all aspects of the business, whether it was the $5 billion quarter, $5 billion book of business now in DX exiting, and certainly Digital Media ARR performance. Let's -- if you reflect, I mean, you talked about the guidance that we gave at the beginning of '23 and '24, if you recall, we actually had guided to $16.50 first then we opted as you know, to $17.50, and ended with $19.13. And so to your point on the execution front, we have delivered some great innovative products. We've expanded the customer base with new products like Express and Firefly. We're certainly focused on surfaces and making sure all of our flagship products are available across all surfaces. And so we do have multiple growth drivers to your point. And we are focused on monetizing the opportunity. I mean, I would say, we take our guide very seriously, the other way of looking at it, Kash, is it’s our highest annual guide ever in terms of what the guide we've issued, it's the highest Q1 guide ever and we want to go again, execute against this large opportunity and have another record year. So, we're feeling good, the momentum is certainly there in the business. But we take our guidance at this point of the year very seriously."
},
{
"speaker": "Kash Rangan",
"text": "Thank you so much and happy holidays. All the best for 2024."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks. Happy holidays."
},
{
"speaker": "Operator",
"text": "We will take our next question from Keith Weiss with Morgan Stanley. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you guys for taking the question. I think this is in a similar vein to what Kash was trying to get at. But maybe a little bit more focused on Q4 in particular. When we look at the Digital Media net new ARR adds in Q4, it looks like you had a very, very strong Document Cloud, record quarter like you were saying, really strong year-on-year growth in those net adds. Creative Cloud, where we actually saw price increase and we have all the excitement in Firefly, that was actually down on a year-on-year basis. And this is the first time since 2018 we've seen Creative Cloud net new ARR below $400 million. I think that's the surprise for investors -- a negative surprise for investors that we're trying to figure out, was there something dragging the Creative Cloud side of the equation this year, or a tough comp from last year, or something that explains why the price increases in all the positive momentum and innovation out of Adobe MAX isn't translating into net new ARR growth for Creative Cloud in particular."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. Happy to take that. Keith, David here. So first of all, as you've mentioned in the DME business, we're really excited about the results for '24, over $1.9 billion in net new ARR obviously well above the guide. We see an expanding base of customers and a lot of momentum coming from gen AI as you noted. As part of this, we delivered -- what we delivered in Q4 was net new ARR -- was a record net new ARR in constant currency. Now specific to your question on Creative Cloud momentum and how to interpret the numbers that you see there, underlying all of this is very strong momentum because we delivered a record Creative Cloud new commercial subscriptions number in the year. So that is really the foundation and the base of customers coming in and really benefiting from not just what we get in this quarter, but also how we build on that going forward. So it really just sets us up well for FY '24. As you look at the numbers for Creative Cloud ARR, net-new ARR in the quarter, you have to look at it relative -- Q4 FY '23 relative to Q4 FY '22 as you mentioned. You need to consider that FY '22 had two pricing actions, that accrued to Creative Cloud that are much lower now in Q4 FY '23. So, if you normalize for the impact of the pricing that rolled off and the pricing that came on, Creative Cloud net new ARR in Q4 grew on a constant currency basis."
},
{
"speaker": "Shantanu Narayen",
"text": "And Keith, just to punctuate the two points that David made -- David said, first, it was a record for Creative ARR as it related to subscriptions in Q4 of 2023 and Creative ARR would have grown if you had backed out the pricing. So, the business continues to be extremely healthy to your point."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you, guys."
},
{
"speaker": "Operator",
"text": "We will take our next question from Alex Zukin with Wolfe Research. Please go ahead."
},
{
"speaker": "Alex Zukin",
"text": "Hey, guys. Thanks for taking my question. I guess maybe looking at next year, as we look at how much of the renewal base in Creative Cloud is potentially up for that type of the pricing uplift. And as we look at Acrobat, specifically the AI functionality that you're releasing into public beta. How should we think about the tailwind to both Creative Cloud from pricing and to Document Cloud, specifically from an AI product monetization perspective for '24 -- for calendar '24?"
},
{
"speaker": "David Wadhwani",
"text": "Yeah. Happy to take that Alex, a lot packed into that question. So let me try to tease them apart. Let me first start with the question around FY '24 and impact of pricing. Before we jump straight into that I do want to take a bit of a step back and just remind everyone that Digital Media ARR is a mix of a few things, new subscriptions which as I mentioned we had a record number of new subscriptions in Q4, up-sell and cross-sell, which is transitioning people to higher plans from the plan that they're on. And then lastly offer optimization. And as you've noted in the last couple of years, we've really been broadening the number of offers we have all the way down from free price points to the all-apps price points, but even beyond that, we now have capabilities to sell add-ons to all-apps as well. And of course, all of this does include the pricing increases that you had mentioned where we've added more value. I do want to just stress, because I know there's a lot of attention on the pricing impact that we always have seen and continue to believe that the primary growth driver for ARR will be new subscriptions in '24. So, that's why we're so focused on the top-of-funnel and new customer acquisition. But specific to your question on pricing, you need to consider a few things. First, our recently announced pricing changes will impact less than half the Creative Cloud base. So there was a very specific question you asked, hopefully, that gives you the answer, but it also leaves us the opportunity to price in new value in the years ahead as we move forward. Second, the impact will be more visible in net new ARR in the back half of FY '24 as we lap the previous pricing actions that I was talking to Keith about from last year. And as we roll out the pricing over the next few quarters. So the second half of FY '24 we'll see more visibility into the benefits of that to net new ARR. Third, given that we're rolling out these prices across plans and across geos incrementally over the year, the benefit to ARR will actually be spread across FY '24 and FY '25. And fourth, if you really want to have sort of sharpen your pencil, the pricing impact on ARR in '24 is actually lower than the pricing impact was in '23 to Creative Cloud. So hopefully that gives you a sense, but again it comes back to this is why we're so excited about the momentum we're seeing in new subscriptions, which really bodes well for the business this year and in the long term. Hopefully, that gives you a pretty good sense on that. And then really quickly on Document Cloud, we're thrilled with the performance of Document Cloud, a lot of that comes down to our core strategy which has been around integrating the desktop, the web, and mobile into a single ecosystem. And really driving the monthly active usage of Document Cloud up through all of the product-led growth motions we have and converting people on the back-end of that. What we're really excited about as we bring the AI assistant to market, which by the way, as I mentioned, is now in private beta, expect it to come out in the next few months as a public beta and then, GA later in the year. But what we're really excited about there is being able to not just service that paid Acrobat based with that, but also start to bring that to the free reader base. So, lots of opportunity and excitement for the year ahead for Doc Cloud as well."
},
{
"speaker": "Alex Zukin",
"text": "Perfect. Thank you for the very fine point and answer."
},
{
"speaker": "David Wadhwani",
"text": "No problem."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Kirk Materne with Evercore ISI. Please go ahead."
},
{
"speaker": "Kirk Materne",
"text": "Hi. Thanks and congrats on the quarter and happy holidays. David, I guess I'll go back to you again, in the commentary, you all talked about enterprise strength and specifically up-selling of Firefly and Express in your enterprise customer base. Can you just give us some more, I guess, qualitative color on what those discussions are like, are they lead -- is this part of the reason you're seeing sort of an uptick in new subscriptions in the enterprise, in particular? And then on Express. Can you just talk again about sort of what you're seeing in terms of leading indicators of that being an enterprise product that can continue to expand into fiscal '24. Thanks."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. Maybe I'll start and then Anil can add because does crossover our two businesses. So with Firefly and Express, very excited about the momentum that we continue to see. You heard that we crossed 4.5 billion generations now, so we continue to see really, really strong adoption and usage of it. Partially as a standalone business, but also integrated into our Photoshop and Illustrator and these existing workflows. And we're starting to see a lot of interest, not just in the context of using it as part of those existing products, but also using it as part of the ecosystem within enterprises. So, we've been working with a number of customers to not just enable them with Firefly, which is the predominance of the growth that we're seeing in Q4 for enterprise adoption but also have a number of pilot customers already engaged around custom model extension, so that they can bring their own assets and their own content into what Firefly generates. Second, we're also enabling the ability to expose it through APIs, so they can build it into their existing workflows and third, we of course connecting it in tying it all into Adobe Express, which now also has its own Firefly and additional capabilities like things, so that you can not just sort of create content using Firefly, but then start to assemble it, start to schedule, social posts around it, start to do multi-language translations that -- those are all features that are already in there and then create a stakeholder workflow from people working in Photoshop to the marketers that are trying to post externally. So, that's where things get very interesting and exciting in terms of the connection we have with GenStudio and everything that Anil is doing."
},
{
"speaker": "Anil Chakravarthy",
"text": "Just building on that, GenStudio since we announced it at MAX, we've had a tremendous amount of interest both from enterprise customers like Henkel and Pepsi and Verizon, as well as a number of agencies as well. And primarily it goes back to what we discussed at Summit. The demand for content is expected to grow 5x over the next couple of years, and every brand in the world is looking at, hey, how can we speed up the production of quality on brand content, how can we let a number of other people in marketing, other areas of the company create their own content according to the standards -- enterprise standards and the combination of what we have in the Digital Experience portfolio like Adobe Experience Manager and assets as well as what we have in the Creative Cloud, especially around Express and Creative Cloud really let's enterprises, get that kind of agility and the cost-effectiveness of producing content at scale. So that's what we're seeing and we're seeing a tremendous amount of interest for that."
},
{
"speaker": "Shantanu Narayen",
"text": "And maybe I'll just add a little bit to that, Kirk. I mean, I think the exciting thing about what people are doing is they're standardizing on Firefly and the fact that we have responsible generations for the entire enterprise. So the interest level has been around, how do we standardize that for all of the image or vector or other generations that they want to do for all the knowledge workers in the enterprise. So really good adoption of Firefly."
},
{
"speaker": "Kirk Materne",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "We will take our next question from Karl Keirstead with UBS. Please go ahead."
},
{
"speaker": "Karl Keirstead",
"text": "Thanks. I'd like to ask about a different subject. And that's the creative Express product now that it's being sold into the enterprise. I'm wondering if you could offer some color on the adoption ramp, the competitiveness versus Canva and whether your plans around driving Express revenues versus driving user adoption have changed at all. Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "Great. Yeah. Happy to take that. Express is off to a great start. As you remember, we went general availability in August with the latest version of it, it's been getting a lot of very, very positive reaction response. And frankly, since then in Q4 too, we've added a ton of new innovation. Firefly integration started with Text to Image and Text to Effects, but we also added Text to Template that will create a fully-formed template for you and generative fill, so you can iteratively change things on the fly. We now let you drawing paint on the campus -- canvas, we've given users much more video support. We've really built an incredible best-of-breed PDF support and workflow with Acrobat in there as well. Some of the other things that now start to bleed into the enterprise also, we have integrated social workflows so that people can schedule their post, we've enabled people to do auto-translations, so you can post to multiple geographies and languages. We've opened up our ecosystem for partner plug-ins and we have now over 50 extensions. And we've added enterprise features like AEM integration and template locking, so that the core, brand police in an organization can manage and make sure that their brand elements that they don't want changing are locked when you disseminate this more broadly. What we've seen is really. I think some very exciting broad-based benefits from this. One is, we've seen new trialists coming in, growing very quickly after this launch, which is exciting to see, we've seen education, users starting to adopt this very quickly as well, the Creative Cloud probe paid base has been coming on and growing very quickly in terms of their usage and then enterprise, as we talked about from a usage perspective and again, Express is a core part of how Anil and team are now selling GenStudio. And the last thing is like this is just setting up the momentum for the year to come. We have a mobile release coming out, which will be very exciting for users to be able to use this on the go. We have thousands of people already using that beta. We announced our Chromebooks partnership. So, anyone that buys a new Chromebook is going to have this. We have partnerships with folks like Wix for their workflows. We're going to be doing deeper integrations into Acrobat. So we are very excited about where this goes. That is a long way to answer a very simple question. We want a lot of people using this. So, our primary focus continues to be around broadening the top of funnel. Of course, as part of that, we are constantly and continually, as I mentioned, journeying people for upsell and cross-sell opportunities to the paid plan, and over to Creative Cloud and other products, but our primary focus continues to be adoption and broad proliferation."
},
{
"speaker": "Karl Keirstead",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "We will take our next question from Brad Zelnick with Deutsche Bank. Please go ahead."
},
{
"speaker": "Brad Zelnick",
"text": "Great. Thanks very much. This is for Dan or maybe Anil. As we think about the momentum within the DX business, it's great to hear things like the 60% increase in your AEP, and native apps book of business, the strong net dollar retention. And you talked about overall strong year-end bookings, but what does it maybe about the pipeline ahead, bookings conversion or perhaps other factors that account for the degree of decel that you're guiding for into next year? Thanks."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, Brad. I mean we are really excited about this massive multi-year opportunity, if we would look at any enterprise customers around the world, everybody recognizes the long-term imperative of transforming their customer experiences. And we're seeing that in these transformational deals that we talked about. And as you mentioned, for example, with AEP, our first $100 million net new business quarter and ending with over $700 million in our annualized book of business. With that said, definitely we're seeing macroeconomic impact, just like other enterprise software companies are. Every customer looks at the total cost of deploying the software and then what it would take to get the payback and ROI. And as a result, there is definitely some scrutiny and caution there. But that said, if we look at going into next year, we do see the pipeline across both our industry verticals as well as our mid-market customers. And we continue to be the leader in the market and we did get that recognition from both analysts and customers."
},
{
"speaker": "Brad Zelnick",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "We will take our next question from Brent Thill with Jefferies. Please go ahead."
},
{
"speaker": "Brent Thill",
"text": "Dan, if you could just review the broader assumptions in your guide. I think there's still a little concern from the Street in terms of why you're guiding, where you're guiding relative to where the Street was at. And maybe just tying in Shantanu to the guidance, if you could just give us your topline view of -- do you feel like the environment's improving, do you think it's just stabilizing? Just any thoughts in terms of from a high level, what you think is happening as we go into next year?"
},
{
"speaker": "Dan Durn",
"text": "Yeah. So thanks for the question, Brent. When we take a look at the guide. If we think about where we're at, at this point in time as we're looking forward in FY '24, clearly we see a lot of momentum in the business, the company's engine of innovation has been incredibly strong. And you see the strong financial performance of the company. That's both from a top line standpoint, as well as profitability and cash-flow standpoint. So, clearly a lot of momentum around the business. As I think about where we sit today, we printed a 46.4% operating margin. As we look forward in to next year, we take into account everything we can see. As Shantanu said, we take the guidance seriously and we set expectations in a prudent way, there is an opportunity to do better than the expectations that we set. Clearly, the company is going to be driving towards that. As we think about the engine of innovation, we think the pipeline is strong, we're going to continue to invest in the drivers of growth. This company is going to orient towards growth. When I think about the investment profile, not only are we going to be disciplined. But we're going to continue to invest in those drivers of growth on the DX side. Anil talked about AEP and Apps strong book of business, strong growth, we're laying the groundwork and content supply chain with the GenStudio solution, scaling that motion, and engaging with customers to go from ideation, to creation to activation, delivering new technologies, products, AEM sites incorporating intelligence into those products. On the DME side, you can see it across the portfolio, AI assistant Acrobat, it's in private beta, and it's going to be in public beta in the coming months, you look at Firefly and Express, natively and deeply integrating these technologies throughout the product portfolio, there is going to be continual investment as it relates to that innovation. As you think about the momentum exiting this year and as you think about the guide into Q1, you can see that momentum continuing, get the operating margin up a little bit, and then throughout the year, as we said at our FA Day and the last year's earnings call, you can see a mid-40s expectation around operating margin for the company as we drive this investment cycle, as we drive leadership in our core markets and our key catalyst in the trends that are shaping those markets. So, again, taking a step back, it nets into account the macro that Anil talked about everything we see from a core business standpoint, and the investment profile that we're going to drive to lead, if there's an opportunity to do better than where we set those expectations we're certainly going to do it."
},
{
"speaker": "Shantanu Narayen",
"text": "And maybe just to add to that, Brent, since you asked. First, let me clarify, there is nothing as it relates to the economic indicators that we saw anything that would give us cause for concern. So, let me start off by saying that, I think at our Investor Meeting, we told you that we would expect a strong quarter, I think you would acknowledge, we posted some really strong numbers and the momentum continues. And I think as it relates to Creative Cloud, it's going to be driven by new customer acquisition, which is the engine that's driven the business and maybe perhaps the sell-side looked at some of the pricing and put more of that in '24 then in '24 and '25 and that will spread out and perhaps they put a little bit more in what percentage of the base that impacts. So from my perspective, the good news about Creative is it's being driven by massive new adoption into the platform. On Document Cloud, really strong results. I think as Dan said, as we put the AI pack on there as well, that should help fuel more adoption and Digital Experience, I mean, I know that Brad also asked that question. I mean it's great to see the adoption of AEP and Apps. I mean, that is clearly the future of digital experiences, driving $100 million quarter, the $700 million in the annualized book of business, which I think will reflect the next-generation customer experience architecture. So we're feeling positive. And we're going go execute against that Brent. So, nothing that we see on the horizon would tell us either from the economic or competition, that we're not poised to have another great year and profitability as well, I mean, look at the numbers that we posted both in terms of Q4, as well as for fiscal '24 and that is that does not in any way mean that we're not going to invest in all of the cloud and the foundation models. So I feel really good."
},
{
"speaker": "Dan Durn",
"text": "And then just one thing to add, Brent, If we were here a year ago, the expectations going into the year where FX was going to be a pretty decent headwind to the performance, you see that in the way we've reported our results and then compare it to a constant-currency basis. We started with a pretty decent spread between the as-reported numbers in constant-currency in Q1. By the time we got to Q4, you saw that spread compress, as I look forward into FY '24, it's more of a neutral footing to maybe a slight headwind. Too early to really call it with precision, but I see that setup being slightly different. And maybe just a slight headwind versus what we were seeing a year ago."
},
{
"speaker": "Brent Thill",
"text": "Thanks for the color."
},
{
"speaker": "Operator",
"text": "We'll will take our next question from Jay Vleeschhouwer with Griffin Securities. Please go ahead."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Yeah. Thank you. You noted the strength in RPO in the quarter, including the record sequential increase. Can you talk about how you're thinking about RPO for fiscal '24, would you expect it to continue to be able to outgrow revenue growth by several points as you did in fiscal '23 and perhaps talk about the ingredients that will continue to drive RPO, either by segment or any other considerations that you'd like to talk about in that."
},
{
"speaker": "Shantanu Narayen",
"text": "Yeah. Thanks, Jay. As I pull some of the threads together that we've heard on this call. Anil, talked about large transformational deals being the platform of choice with customer experience management, simultaneously driving topline and bottom-line productivity and the investments around driving those are an imperative in the market. We see a similar dynamic with the new technologies that we're bringing to market on the DME side at the business, we're streaming seeing strong pull from the enterprise. And so as I net out that environment and our performance against that opportunity, it goes to produce the type of sequential RPO progression that we saw Q3 to Q4. Every quarter won't be that large, but the backdrop around that dynamic for the company given the setup we see, it should be another strong year for RPO throughout the year."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "Operator. We're getting close to the top of the hour. We'll take two more questions and then we'll wrap up. Thanks."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Saket Kalia with Barclays. Please go ahead."
},
{
"speaker": "Saket Kalia",
"text": "Okay. Great. Hey, guys. Thanks for taking my question, and congrats on a nice quarter. David maybe for you, I had a question just on Firefly and the subscription packets. I know that the commercial model for commercial -- I'm sorry, for Firefly credit packets, really just started about six weeks ago. But are there any early observations that you've seen just on customers' willingness to add those packets, or maybe how they're consuming the initial credit allocation that they get with the Creative Cloud subscription?"
},
{
"speaker": "David Wadhwani",
"text": "Yeah. Happy to take that. First of all I think philosophically, going back to what we said at the investor meeting at MAX, our primary focus here is to drive usage of the generative capabilities and you see that with the 4.5 billion images generated, that strategy is working. Secondly, we price the generative packs -- sorry, we integrated the generative capabilities and credits directly into our paid plans with the Express intent of driving adoption of the paid subscription plans and getting broad proliferation of the ability to use those. And what we are seeing is heavy usage within those paid plans. I think as we've mentioned in the past. I think I mentioned earlier today as well, Generative Fill, for example in Photoshop is the fastest-growing feature that we've put into Photoshop in recent memory. So the usage is great, the utilization is great. I don't personally expect the generative packs to have a large impact in the short-term, other than to drive more usage more customers to our paid existing subscription plans. But what will happen over the course of the year, in the next few years is that we will be integrating more and more generative capabilities into the existing product workflows. And that will drive and we'll be integrating capabilities like video generation, which will cost more than one generation and that will drive a natural inflation in that market and that will become a driver for growth subsequently. But this year is really primarily focused on getting people into the right paid plans of our flagship applications, our Adobe Express, and then drive usage in that sense. And then as that happens, the rest will take care of itself in the years ahead."
},
{
"speaker": "Saket Kalia",
"text": "Makes sense. Thanks, guys."
},
{
"speaker": "Operator",
"text": "We'll take our final question from Mark Moerdler with Bernstein Research. Please go ahead."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you for squeezing me in. I really do appreciate. Dan, I'd like to look a little bit at MAX we discussed how excited you were on Firefly and how it drives Creative Cloud seed and paid seed adoption. Now that you had a bit of time in market, can you explain how you think about how this will drive the paid seed growth, is it how strong it could be and should we expect to seeds going to be lower unit price because they're going to be entry-level, what do you think that we will get offset by these higher-priced Firefly driven sales into the enterprise. Thank you."
},
{
"speaker": "Dan Durn",
"text": "Yeah. Thanks, Mark. I think at the core of bringing this technology to life, as a standalone application to drive an ideation part of the process, but value in deeply integrating these capabilities into the flagship applications and the workflows that define the creation process, it gives us a lot of surface area with customers and meeting them where they are in their particular needs and use-case specific needs. And so bringing people efficiently top of funnel, establishing the segmentation across that product portfolio, driving efficiency into the creation process and allowing the velocity to enter the ideation, creation, activation and then instrumentation of that to really refine how companies engage with customers. So, it lays the groundwork for us to touch more customers where they are in the ecosystem, bring them on board in a use-case specific way and then take them on digital journeys which is something the company has very skilled at with our D-DOM to cross-sell and upsell over the life of their engagement with our ecosystem."
},
{
"speaker": "Anil Chakravarthy",
"text": "From a product perspective, when you think about it, Mark, for us, the biggest thing that we want to do is, how do we further make our products accessible, fun and affordable for increasing set of customers and I think Firefly is one of those inflection points that will help everybody get over the blank screen fear that they have and so first, as you think about Firefly as an ideation and people just coming and want to have creative inspiration. This is, whether you're an individual user, whether you're agencies, we're seeing a lot of adoption of Firefly to just start the entire Creative process and that sort of brings them as an on-ramp into Express, which would be the other part. Express is certainly the introductory pricing, the ability to get millions more into the fold and the ability, right now, it used to be that Express and other offerings in that is to all worry about, do I have the right templates. Well, AI is going to completely change that, we have our own models and so Firefly will allow anybody to take whatever creative idea that they have and make that available, so I think Firefly really helps with the Express offering. On the Creative Cloud, David mentioned this. I mean if you look at the adoption of that functionality and usage, that's being driven, whether it's in Photoshop right now, Illustrator as we add video, both in terms of providing greater value and we certainly will therefore have the uplift in pricing as well as the retentive ability for Firefly. That's where I think you're going to see a lot of the really interesting aspects of how Firefly will drive both adoption as well as monetization. And then if you go at the other end of the spectrum to the enterprise, GenStudio, every single marketer that I know and CFO and CMO, are all worried about how much am I spending on data, how do I get agility in my campaigns and the fact that Firefly is integrated into both Express as well as when we do the custom models for them, so they can upload their own models and then have the brand consistency that they want. So, Firefly really is the fact that we have our own models. A great catalyst for our business, all across the spectrum and the usage and the adoption shows that in emerging markets, as people there in emerging markets are increasingly used to create variance of content and localization of content, that's where we are also seeing a tremendous usage of these particular technologies. So really exciting. And then, you take the same technology that we have in Creative and think about its impact in both Document Cloud when we do that and the ability to have summaries and have conversational interfaces with PDF, thereby making every single PDF as David again said, both for communication, collaboration and creation far more compelling. I think you're going to see that same kind of uplift in usage and therefore monetization on the Acrobat side. And since it was the last question. I mean, for us, we look at FY '23, and we're really proud what we were able to accomplish across all spectrums topline revenue, RPO and driving book of business, Creative Cloud, Document Cloud, and Experience Cloud and profitability, and we think '24 is going to be exactly more of the same, which is continuing to drive great innovation, great product growth, great profitability. Clearly, I think there has been a set of questions around the Digital Media ARR and what I'll take is on that and we're extremely confident about how that continues to be a growth business and perhaps the pricing impact was overestimated. And as we said, this is again new growth business and it will be a multi-year pricing benefit for us as we think about the uplift that we have. So we're really pleased. We appreciate you being on the call. And like many of you wished us, happy holidays and we hope to see you soon. Thank you for joining us."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, everyone. Happy holidays. This concludes the call."
},
{
"speaker": "Operator",
"text": "Once again, this concludes today's call. Thank you for your participation. You may now disconnect."
}
] | Adobe Inc. | 24,321 |
ADBE | 3 | 2,023 | 2023-09-14 17:00:00 | Operator: Good day, and welcome to the Q3 FY 2023 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's third quarter fiscal year 2023 financial results. You can find our press release, as well as PDFs of our prepared remarks and financial results, on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, September 14, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today's press release and in Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, except per share amounts, Adobe's executives will refer to constant currency growth rates, unless otherwise stated. Reconciliations are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon. Adobe had another record Q3, achieving revenue of $4.89 billion, representing 13% year-over-year growth. GAAP earnings per share for the quarter was $3.05 and non-GAAP earnings per share was $4.09, representing 26% and 20% year-over-year growth, respectively. Driving this success is a rich and innovative product roadmap. The advances we are delivering across Creative Cloud, Document Cloud and Experience Cloud are enabling us to attract an ever-growing set of users while delivering more value to existing customers. Yesterday's exciting announcements add to this roadmap. With the commercial availability of our generative AI capabilities, natively integrated in Adobe Creative Cloud, Adobe Express and Adobe Experience Cloud, we are unleashing a new era of AI-enhanced creativity for millions of customers around the globe. We are bringing generative AI to life across our portfolio of apps and services to deliver magic and productivity gains. Our rich datasets enable us to create foundation models in categories where we have deep domain expertise. In the six months since launch, Firefly has captivated people around the world who have generated over 2 billion images. We are excited about the potential to reimagine the content supply chain for all businesses through the integration of our clouds, enabling the delivery of personalized and engaging customer experiences. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is driving our growth across every geography. By delivering innovative technology platforms and services, we continue to advance our industry leadership and delight a growing universe of customers. I'll now turn it over to David to share more about our momentum in the Digital Media business.
David Wadhwani: Thanks, Shantanu. Hello, everyone. In Q3, we achieved net new Digital Media ARR of $464 million and revenue of $3.59 billion, which grew 14% year-over-year, driven by strength in both our Creative and Document businesses. On the creative side, digital content creation and consumption are exploding across every creative category, customer segment and media type. Creative Cloud is the leading creativity platform, offering a comprehensive portfolio of products and services for every discipline across imaging, photography, design, video, animation and 3D. We're excited about the growth we are driving with our creative flagship products, and with Adobe Express, our AI-first, all-in-one creativity app that makes it fast, easy and fun for any user to design and share standout content. Yesterday's announcements highlighted several advances to our creative business: First, after an unprecedented beta that saw over 2 billion images generated, Adobe Firefly models and the Firefly web application are now commercially available. Firefly supports text prompts in over 100 languages and enables users around the world to create content that is designed to be safe for commercial use. We will continue to train and release new Firefly foundation models in areas where we have rich datasets and expertise, such as imaging, vector, video, design, 3D and more. Second, Adobe Firefly-powered features are now natively integrated into several Creative Cloud apps, including Generative Fill and Generative Expand in Photoshop, Generative Recolor in Illustrator, and Text to Image and Text Effects in Adobe Express. These deep integrations deliver more creative power than ever before to customers, enabling them to experiment, ideate, and create in completely new ways. Third, Adobe Firefly for Enterprise is now generally available for businesses to enable both creative teams and knowledge workers to confidently deploy AI-generated content. Adobe will empower customers to create custom models using proprietary assets to generate branded content and offer access to Firefly APIs so customers can embed the power of Firefly into their own content creation and automation workflows. And finally, we announced subscription offerings including new generative AI credits with the goal of enabling broad access and user adoption. Generative Credits are tokens that enable customers to turn text-based prompts into images, vectors and text effects with other content types to follow. Free and trial plans include a small number of monthly fast Generative Credits and will expose a broad base of prospects to the power of Adobe's generative AI, expanding our top-of-funnel. Paid Firefly, Express and Creative Cloud plans will include a further allocation of fast Generative Credits. After the plan-specific number of Generative Credits is reached, users will have an opportunity to buy additional fast Generative Credit subscription packs. In Q3, we added $332 million of Creative ARR and achieved $2.91 billion of revenue, growing 14% year-over-year. Business highlights include: The integration of Firefly into Photoshop and Illustrator. Over 3 million users have downloaded the Photoshop and Illustrator beta releases. The general availability of Adobe Express now includes support for editing and posting designs, videos, images, PDFs, presentations and more. Express features include Firefly-powered Text to Image and Text Effects. Express is already being used by millions of people globally. New AI and 3D features in Premiere Pro and After Effects, including Enhance Speech and Text-Based Editing in Premiere Pro and a new 3D workspace in After Effects. The Text-Based Editing feature in Premiere Pro received the 2023 Hollywood Professional Association Award for Engineering Excellence. New Lightroom mobile now integrates directly with the camera roll and introduced a streamlined interface to make editing even easier on the go. The introduction of new video assets in Adobe Stock and strong product-led growth motions, drove a record Q3 for the Stock business. Key customer wins include Amazon, Havas, Paramount, SAP, Southern Graphics, Take-Two Interactive and U.S. Department of Energy. As we have continued to add new applications and delivered innovations across our creative offerings, we announced price updates for certain Creative Cloud plans across the Americas and Europe, starting November 1, 2023. In addition to being a growth driver in the Creative Cloud business, Acrobat and PDF continue to power the Document Cloud business. Whether it's a sales contract, legal document or a back-to-school form, seamless document workflows across every device and platform are more important than ever for all of us to be productive in our professional and personal lives. Document Cloud is powering document productivity and automation across the web, desktop and mobile. In Q3, we achieved Document Cloud revenue of $685 million, growing 15% year-over-year. We added $132 million of net new Document Cloud ARR, with ending ARR growing 22% year-over-year in constant currency. Business highlights include: Significant growth in monthly active users across web, mobile, and embedded third-party app ecosystems, reflecting our growing top of funnel and the effectiveness of our product-led growth execution. Strong mobile momentum reflecting the value of Acrobat as an essential productivity application on mobile devices. Adoption of Acrobat and Acrobat Sign through increased link sharing for enhanced collaboration and approval workflows. Enhanced PDF workflows across Acrobat and Express making it seamless to create visually stunning PDFs. A new Adobe PDF Electronic Seal API, which is a cloud-based, end-to-end solution for applying electronic seals on PDFs at enterprise scale. Key customer wins include Citibank, GlaxoSmithKline, Emerson Electric, Morgan Stanley and Volkswagen. We continue to be excited about the pending Figma acquisition, which will reimagine the future of creativity and productivity. We remain engaged with regulators and have confidence in the merits of the case. We look forward to hosting Adobe MAX, the world's largest creativity conference, next month in Los Angeles, where we will welcome 10,000 members of our global community and engage with hundreds of thousands more online. We will hear from inspiring creators and unveil innovations across Creative Cloud, Firefly and Express. In summary, we are excited about the pace of innovations across our Digital Media products and continued execution across multiple growth drivers. I'll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello, everyone. Every company sees digital as an opportunity to drive experience-led growth. As I've spent time with customers across the world, it's clear that they are prioritizing investments in customer experience management technology to improve customer acquisition, engagement, retention and operational efficiency. We are driving revenue growth across content and commerce, customer journeys, data insights and audiences and marketing workflows, leveraging the Adobe Experience Platform, demonstrating the strength of our business. Brands around the globe are working with Adobe to accelerate personalization at scale through generative AI. With the announcement of Adobe GenStudio, we are revolutionizing the entire content supply chain by simplifying the creation-to-activation process with generative AI capabilities and intelligent automation. Marketers and creative teams will now be able to create and modify commercially safe content to increase the scale and speed at which experiences are delivered. In Q3, we continued to drive strong growth in our Experience Cloud business, achieving $1.23 billion in revenue, representing 11% year-over-year growth, as a growing number of enterprises turned to Adobe as their trusted partner for customer experience management. Subscription revenue was $1.1 billion, representing 13% year-over-year growth. Adobe Experience Cloud delivers predictive, personalized, real-time digital experiences, from acquisition to monetization to retention. We are driving strong enterprise adoption of Adobe Experience Platform, and native apps including Real-Time CDP, Adobe Journey Optimizer and Customer Journey Analytics. For example, the Coca-Cola Company is leveraging Adobe Real-Time CDP and Adobe Journey Optimizer to bring together 98 million customer profiles globally into a single CDP to quickly deliver personalized campaigns and experiences. smart Europe, an all-electric automotive brand, is using Adobe Experience Cloud to offer customers the ability to personalize their vehicle purchases through the integration of Adobe Workfront, Adobe Creative Cloud and Adobe Experience Manager. Business highlights include: Strong momentum across AEP and native apps with the total book of business surpassing $600 million during the quarter. Adobe Journey Optimizer book of business more than doubled year-over-year as customers increasingly drive omnichannel personalization and engagement. Continued innovation in Adobe Experience Manager with AEM Assets now natively integrated with Firefly and Express, enabling any employee across an organization to generate and reuse beautiful on-brand content. Growth of our Workfront business, reflecting our ability to serve the workflow and collaboration needs of enterprise customers and agencies. In Q3, we added Havas to the growing list of top agencies standardizing on Adobe for their content supply chain. Expanded strategic partnership with Amazon. Given customer demand, we will jointly deliver AEP on AWS and Amazon will deploy Experience Cloud across their enterprise. Adobe's leadership in Content Management Systems was recognized across three industry analyst reports, including the IDC MarketScape for Full-stack Content Management Systems, the IDC MarketScape for Hybrid Headless CMS and the Forrester Wave for Content Management Systems. Adobe was also named a Leader in the Gartner Magic Quadrant for Digital Commerce as well as the IDC MarketScape for OmniChannel Marketing Platforms for B2C Enterprises. Key customer wins include Amazon, Blue Cross Blue Shield of Florida, Dollar General, Havas, Intuit, IRS, Jet2.com, Lufthansa, Macy's, MSC Cruises, Novo Nordisk and SAP. These and other customers continue to prioritize investments in customer experience management solutions despite increased scrutiny of enterprise IT spend. Our solutions enable enterprises to simultaneously achieve the twin goals of driving new customer acquisition and serving existing customers to deliver profitable growth. Adobe is well positioned to keep winning with our differentiated offerings, track record of innovations and ability to drive ROI for companies across industries. We're looking forward to a strong close to the year. I will now pass it to Dan.
Dan Durn: Thanks, Anil. Today I will start by summarizing Adobe's performance in Q3 fiscal 2023, highlighting growth drivers across our businesses, and I'll finish with financial targets. Adobe's performance in Q3 demonstrates something that makes us exceptional, the combination of growth and profitability. In fact, at Adobe, rather than talking about trade-offs between growth or profitability, we call it an "and" statement. Growth and profitability is not new for us, we have been delivering both for a very long time and it is at the core of our operating philosophy. It all starts with prioritization, innovation and a sharp focus on execution. This philosophy shines through in our Q3 results. We are investing in technology platforms, global campaigns to attract and engage millions of customers and recruiting the best and brightest people in our industry. While doing that, Adobe is driving performance on margin and earnings, demonstrating what a special company we are. In Q3, Adobe achieved revenue of $4.89 billion, which represents 10% year-over-year growth, or 13% in constant currency. GAAP diluted earnings per share was $3.05, up 26% year-over-year, and non-GAAP diluted earnings per share was $4.09, up 20% year-over-year. Other business and financial highlights included: Digital Media revenue of $3.59 billion; net new Digital Media ARR of $464 million; Digital Experience revenue of $1.23 billion; cash flows from operations of $1.87 billion; RPO of $15.72 billion exiting the quarter; and repurchasing approximately 2.1 million shares of our stock during the quarter. In our Digital Media segment, we achieved Q3 revenue of $3.59 billion, which represents 11% year-over-year growth, or 14% in constant currency. We added $464 million of net new ARR in the quarter, our strongest Q3 on record, exiting the quarter with $14.60 billion of Digital Media ARR, growing 15% year-over-year in constant currency. We achieved Creative revenue of $2.91 billion, which represents 11% year-over-year growth, or 14% in constant currency. We added $332 million of net new Creative ARR in Q3, with strong demand across our offerings. Third quarter Creative growth drivers included: new user growth across geographies, customer segments and Creative offerings, driven by innovation and targeted campaigns utilizing insights from our data-driven operating model; outstanding top-of-funnel performance resulting from viral community excitement and success of our product-led growth strategy, driving traffic to Adobe.com; single app subscriptions for Photoshop driven by interest in the magic of Firefly, Generative Fill and Generative Expand; another great quarter for value-added services, including strong customer demand for Adobe Stock; continued customer adoption of Acrobat CC; strong engagement and retention across customer segments; and success in the enterprise, driven by transformational ETLAs that span the entire Creative portfolio, including CC All Apps for creative teams, Express for knowledge workers, Frame for collaboration, and Adobe Stock and Firefly for content. Adobe achieved Document Cloud revenue of $685 million, which represents 13% year-over-year growth, or 15% in constant currency, and we added $132 million of net new Document Cloud ARR in the quarter. Third quarter Document Cloud growth drivers included: success with new customer acquisition through our Reader and Acrobat web funnels and distribution partners, with monthly active users up over 70% year-over-year for Acrobat web; strong demand for Acrobat subscriptions across customer segments and geographies, driven by targeted offers; strength in monetization from Acrobat mobile, which grew ending ARR over 30% year-over-year in constant currency, driven by product innovation and conversion; and traction in B2B, with strong unit demand for our Team offering through the reseller and direct routes to market. Turning to our Digital Experience segment, in Q3, we achieved revenue of $1.23 billion, which represents 10% year-over-year growth, or 11% in constant currency. Q3 subscription revenue was $1.10 billion, which represents 12% year-over-year growth, or 13% in constant currency. Third quarter Digital Experience growth drivers included: demand for our Adobe Experience Platform and native applications, including Real-Time CDP, Customer Journey Analytics and Adobe Journey Optimizer. In Q3, subscription revenue for AEP and Apps grew 60% year-over-year; strength in Content and Commerce, with Adobe Experience Manager continuing to set the standard for enterprise content management; growth of our Workfront business, as workflow and collaboration are essential components of an enterprise content supply chain solution; strong retention rates in the quarter, as we continue to focus on value realization to our Digital Experience customers; and continued momentum in transformational platform deals with large enterprises adopting our end-to-end suite of applications. Adobe's effective tax rate in Q3 was 19.5% on a GAAP basis and 18.5% on a non-GAAP basis. The GAAP tax rate came in lower than expected due to tax benefits associated with the vesting of share-based payments in the quarter. RPO exiting the quarter was $15.72 billion, growing 11% year-over-year, or 13% when adjusting for a 2% FX headwind. Our ending cash and short-term investment position exiting Q3 was $7.52 billion, and cash flows from operations in the quarter were $1.87 billion. In Q3, we entered into $1 billion share repurchase agreement, and we currently have $3.15 billion remaining of our $15 billion authorization granted in December 2020. Factoring in current macroeconomic conditions and year-end seasonal strength, for Q4, we are targeting: total Adobe revenue of $4.975 billion to $5.025 billion; Digital Media net new ARR of approximately $520 million; Digital Media segment revenue of $3.67 billion to $3.70 billion; Digital Experience segment revenue of $1.25 billion to $1.27 billion; Digital Experience subscription revenue of $1.11 billion to $1.13 billion; tax rate of approximately 18% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $3.10 to $3.15; and non-GAAP earnings per share of $4.10 to $4.15. Q3 was a great quarter for Adobe, and I couldn't be more pleased with how the company is positioned to continue to deliver for our customers and investors. We're looking forward to our Investor Meeting at Adobe MAX on October 10, where we'll do a deep dive into our AI innovation. I hope to see you there. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. Adobe's strong Q3 results are a reflection of our team's exceptional execution. We recently lost our beloved co-founder John Warnock. John's brilliance and innovations changed the world. He was one of the greatest inventors of our generation and an inspiration to the technology industry. While we miss him tremendously, it gives me great comfort knowing that John was so proud of all of the innovation Adobe continues to deliver. As someone who shares John's passion for product and innovation, I'm exceptionally energized by the technology platforms we are delivering with AI at the center across our three clouds to delight customers. Our brand, technology and our talented employees position us for a strong close to the year and continued growth in the decades to come. Adobe's best days are ahead of us. Thank you. We will now take questions.
Operator: Thank you. [Operator Instructions] And our first question will come from Keith Weiss with Morgan Stanley.
Keith Weiss: Excellent. Thank you guys for taking the question and really nice quarter. Dan, actually a margin question, for you. And kind of a riddle that, like, we've been thinking about. We've been told generative AI is really expensive to run. The inference and training costs are really high. You guys have been running a beta for a while, 2 million images generated. There's a lot of functionality already in the product. And your operating margins are up. Your gross margins are up on a year-on-year basis. So, how are you able to do that? Like, where are these costs going, if you will? And on a go-forward basis, if all this stuff becomes generally available, how should we think about that gross margin impact or the overall margin impact of generative AI on a go-forward basis? Thank you.
Dan Durn: Yeah. Thanks, Keith. So, as you rightfully point out, the engine of innovation at the company is really strong. A lot of exciting announcements this week, but we've been at this now a year, bringing the magic of generative AI and Firefly to life. And we're just getting started from an innovation standpoint. Over the last six months, we've been live with the beta. And as you point out, we've generated -- our customers have generated over 2 billion images. And I know it's not lost on people. All this has done while we're delivering strong margins. But when we take a step back and think about these technologies, we have investments from a COGS standpoint, inferencing, content, from an R&D standpoint, training, creating foundation models, and David alluded to it in his prepared comments, the image model for Firefly family of models is out. But we're going to bring other media types to market as well. So, we're making substantive investments. When I go back to the framing of my prepared comments, we really have a fundamental operating philosophy that's been alive at the company for a long time: growth and profitability. We're going to prioritize, we're going to innovate, and we're going to execute with rigor, and you see that coming through in all of the financial results of the company. As we think about going -- the profile going forward, what I'll come back to is, is when we initially set fiscal 2023 targets, implicit in those targets was a 44.5% operating margin. If you think about how we just guided Q4, where we've got these four great new products and these technologies infused into the product lineup, and all of the support we're going to do as we roll these out in our MAX conference down in L.A. again to keep the enthusiasm with the customer base building, implicit in that guide is an operating margin of around 45.5%. So, as you think about us leading this industry, leading the inflection that's unfolding in front of us, that mid-40%s number we think is the right ballpark to think about the margin structure of the company as we continue to drive this technology and leadership. Looking forward to the Q4 earnings call where we will share more about our fiscal 2024 targets.
Shantanu Narayen: And maybe Keith, just 30 seconds to add to that, for investors like you who want to make sure we're not in any way not investing in the future, we are investing on training for 3D, for video, for new forms of imaging and vectors. So, what we are confident is while we continue to invest in that, the scrutiny that Dan and his team have on other expenses, that we can continue to drive top-line growth as well as cash flow and EPS. So, I think we're unique in that respect.
Keith Weiss: Definitely. Very impressive, guys. Thank you so much for taking the question.
Operator: And our next question will come from Kash Rangan with Goldman Sachs.
Kash Rangan: Sorry to hear of John Warnock's passing. My condolences. But congrats on the quarter. As we look at the pricing model for generative AI products which are based on consumption, do you think that these -- rather, how additive do you think the generative AI offerings will be to the growth profile of the company going forward? And also one for Dan. When you look at your Q4 guidance, are you contemplating -- it looks like it's not largely changed versus the Street's prior expectations. Are we not embedding any opportunities to show what the generative AI products can do? Because they seem to be largely incremental to what had been contemplated when you first gave guidance fall of last year. Thank you so much.
Shantanu Narayen: Well, Kash, maybe David and I can take the first parts of the question. And just again, for everybody on the call, I think to summarize the new offerings that we have, we've announced that we have a Firefly subscription. So, you can use a free trial number of credits, and after that, you can actually subscribe to Firefly. We have Adobe Express, which now includes an allocation of Firefly. We certainly have the Creative Cloud products and Photoshop and Illustrator that have it. We have Generation Credit Packs, and we have GenStudio for the Enterprise and to be able to deal with it. So first, I just wanted to make sure that you recognized the tremendous innovation that we're delivering associated with that. And as you know, one of the things that we have done is to really focus on both new user acquisition, which is going to be driven across all of those offerings, as well as with the price increase, given there is an allocation associated with it for existing customers, they will start to see that as they roll over and they have to renew their subscription. So, I just wanted to set that bit, and maybe then I'll ask David to add a little bit about each of these and how we see that play out.
David Wadhwani: Yeah, thanks, Shantanu. Yeah, as Shantanu said, we look at the business implications of this through those two lenses: new user adoption, first and foremost, and then sort of opportunity to continue to grow the existing book of business. On the new user side, we've said this for years, our focus continues to be on proliferation. We believe that we have a massive number of users in front of us. We continue to have our primary focus being net user adds and subscribers. And so, the goal here in proliferation is to get the right value to the right audience at the right price. And if I think about the four new offerings that Shantanu teed up, I think two of them are primed to maybe be on the earlier side of that. First, on the individual side, Express. It's been in the market for over a year now, and the new release of Express is a massive step forward in terms of the abilities that it has, both -- everything from performance to support for a broader set of things beyond design, into video and into illustration, into PDF and document workflows. So, there's just a tremendous amount of new value that we've added, including generative AI into that. So, we think that Express will be an early indicator of that success that we're talking about. The second one is the work that we're doing in the DME business in conjunction with Anil on the DX business around enterprises, so GenStudio, and enabling the broad base of marketers to actually use Express in conjunction with the Creative Studio teams using Creative Cloud to really accelerate their use of and creation of content. So that really -- in the context of the short-term contributors, we think that will be really meaningful. We also expect that -- as we do this and drive new users, we expect to see a lot of new users come into the free plans. And that's going to take a little time to ramp. We'll bring them into the Adobe family, get them using the products, and ramp them to greater value over time. So, first and foremost, proliferation on new users. The second thing is going to be on the book of business. And here, we're -- basically, the pricing changes. Just as a reminder, they have a rolling impact. We're going to start them late in Q4. And we're going to start it in certain geos only. And then, we're going to have a measured rollout in new countries over the course of the next couple of years. And then certainly also as it relates to enterprise customers, the renewal timing will probably take about three years, given the multi-year contracts that we have in place. So, net-net, we see this truly as a seminal moment for how we're going to grow the business, but it's going to take a few years to play out, and we're really excited about sort of what this means for bringing new customers into the franchise.
Shantanu Narayen: And maybe Kash, just to then tie that all together, in terms of the numbers that we've given for Digital Media ARR, because you asked the question from the beginning of the year, remember, I think we guided to $1.65 billion, if you look at what it is even with our Q4 guide that I think $200 million more than that, $1.86 billion or something to that effect. And since we guided in Q3, for Q3 and Q4, $100 million. So, we continue to be really confident and we're excited about the roadmap.
Operator: And our next question will come from Saket Kalia with Barclays.
Saket Kalia: Okay, great. Hey, guys, thanks for taking my question, and congrats on a great quarter and outlook. Anil, actually my question is for you. Obviously, a lot to talk about with Firefly in the Digital Media business. And it's very clearly a revenue opportunity there. I'm wondering how you think about the generative AI roadmap or revenue opportunity in the Digital Experience part of the business. I know we talked about the content supply chain, but how do you think about the future of generative AI in your business?
Anil Chakravarthy: Yeah, thanks, Saket. Shantanu and David already talked about the Adobe GenStudio, and we're really excited about that. This is a unique opportunity, as you said, for enterprises to really create personalized content and drive efficiencies as well in -- through automation and efficiency. When you look at the entire chain of what enterprises go through, from content creation, production, workflow, and then activation through DX, through all the apps we have on our platform, we have the unique opportunity to do that. We already have deployed it within Adobe for our own Photoshop campaign. And we're working with a number of agencies and customers to do that. So, this is a big net new opportunity for us with Adobe GenStudio. We're also working on generative AI for other DX applications as well. And at the investor meeting in October, we'll share more details. But we see a similar opportunity with generative AI to bring together the ability for a number of users across marketing departments or organizations to be able to use the Adobe Experience platform and apps and it'll act as a co-pilot to accelerate the use cases that they bring to life. So, we'll share more about that at the investor meeting.
Shantanu Narayen: Saket, maybe, just to give Anil and the team a lot of credit for what they actually accomplished in Q3 as well, the wins in Q3 in the enterprise actually included a lot of the components of GenStudio, both in the Digital Media as well as in the Digital Experience. So, certainly the transformational deals that we're talking about, a big part of that is the synergy between the two clouds. So, I wanted to point that out as well.
David Wadhwani: And if I could actually just add one quick thing is that the GenStudio work that Anil team has been doing, we've actually been using that within the Digital Media business already to release some of the campaigns that we've released this quarter. So, it's one of these things that it's great to see the impact it's having on our business, and that becomes a selling point for other businesses too.
Saket Kalia: Great to hear. Thanks.
Operator: And moving on to Gregg Moskowitz with Mizuho.
Gregg Moskowitz: Hey, thank you for taking the question. Congratulations as well on a strong quarter. So, when I look at Firefly, the amount of image generation in a six-month period is clearly pretty stunning. I'm just wondering if you're able to provide any additional color, whether it be monthly active users or some other metric that may additionally help all of us gauge the improvements that Firefly is driving to your engagement level, to your top-of-funnel, et cetera? Thank you.
David Wadhwani: Yeah, happy to talk about that. It's been a remarkable few months. I mean, we've said a few things. First is that the viral excitement that we saw because of Firefly on social has been hugely beneficial and it's certainly driven a lot of top-of-funnel opportunity for us. In addition to that, one of the things that we were very excited about is when we integrated it into our CreativePro applications, Illustrator and Photoshop primarily, we saw over 3 million downloads of those betas -- beta applications, which is something we've never seen before. That gives you a sense of like how thirsty the existing customer base is for the generative capabilities that we have as well. And lastly, one of the things that we're very excited about, and we obviously track very carefully, is what does this do in terms of giving us access to new users that don't typically come to Adobe. And both Express and Firefly, and in particular the integration of Firefly and Express, has been a real accelerant to that. So, it's been nice to see us not just getting excitement within the current base, but seeing millions of other users coming in, that would not have typically come to Adobe for a product and then giving -- and starting their journey with Adobe through Firefly and Express.
Shantanu Narayen: Two other maybe financial indicators to that, Gregg, are first the Photoshop Single App, and I think Dan referred to that. Even in the beta, that actually drove a lot of Photoshop Single App and the early indicators of how that also benefits retention in the entire book of business. So both of those are also good financial indicators of the potential of AI.
Gregg Moskowitz: Great. Thank you, both.
Operator: And we have a question from Brad Sills with Bank of America.
Brad Sills: Wonderful. Thank you so much for taking my question. I wanted to ask about a comment that I think David made earlier in the call where you're working hard to make Firefly the option for content design to be safe. I would love to double click on that, understand a little bit, how is Adobe the safe option, and how is the company making this Firefly in this new generative frontier the safe option for enterprises?
David Wadhwani: Yeah. So from the very beginning of Firefly, we took a very different approach to how we were doing generative. We started by looking at and working off the Adobe Stock base, which are contents that are licensed and very clearly we have the rights to use. And we looked at other repositories of content where they didn't have any restrictions on usage, and we've pulled that in. So, everything that we've trained on has gone through some form of moderation and has been cleared by our own legal teams for use in training. And what that means is that the content that we generate is, by definition, content that isn't then stepping on anyone else's brand and/or leveraging content that wasn't intended to be used in this way. So that's the foundation of what we've done. We've gone further than that, of course, and we've now actually -- we've been working with our Stock contributors. We've announced, in fact, yesterday we had our first payout of contributions to contributors that have been participating and adding Stock for the AI training. And we're able to leverage that base very effectively, so that if we see that we need additional training content, we can put a call to action, call for content out to them, and they're able to bring content to Adobe in a fully licensed way. So, for example, earlier this quarter, we decided that we needed a million new images of crowd scenes. And so, we put a call to action out. We were able to gather that content in. But it's fully licensed and fully moderated in terms of what comes in. So as a result, all of the content we generate is safe for commercial use. The second thing is that because of that, we're able to go to market and also indemnify customers in terms of how they're actually leveraging that content and using it for content that's being generated. And so, enterprise customers find that to be very important as we bring that in, not just in the context of Firefly standalone, but we integrate it into our Creative Cloud applications and Express applications as well. So, the whole ecosystem has been built on that. And the last thing I'll say is we've been very focused on fair generation. So, we look intentionally for diversity of people that are generated and we're looking to make sure that the content we generate doesn't create or cause any harm. And all those things are really good business decisions and differentiate us from others.
Brad Sills: Great to hear. Thanks, David.
Operator: And we have a question from Keith Bachman with BMO Capital Markets.
Keith Bachman: Yes, thank you. I wanted to go back -- David, I wanted to hear your perspective on kind of the third cloud, the Document Cloud, if you will, as we look out over the next 12 months. And the spirit of the question is there's a lot of attention, appropriately so, given Firefly and whatnot, and perhaps even lending itself in the Experience Cloud. But does gen AI provide any tailwinds associated with the Document Cloud, or is it sort of the existing drivers that will help contribute to growth as we look at next year? But any just kind of -- what are the key things that we should be thinking about for Document Cloud? Many thanks.
David Wadhwani: Yeah. First of all, we are very happy with the quarter Doc Cloud had. The ending book of business grew 22% in constant currency. And the strength of that is really driven based on top-of-funnel growth. So, Acrobat on the web had a phenomenal year-over-year growth rate. We've been working very actively to get Acrobat sort of deployed with -- as plugins within the browsers. We've got a great -- we've been doing a lot of product-led growth work in the products themselves to drive link sharing, so that more and more people are not just using our products, but as they share links, we're actually able to capture more people and build growth loops. Signatures has been also doing incredibly well. So, as we've got this broad-based proliferation of our surfaces that are available and continue to grow in terms of both free and paid usage, it creates a surface area that we can introduce a lot of really interesting things into. We haven't announced anything publicly associated with gen AI directly inside of Acrobat, but I think you can fairly safely expect to hear more about that from us soon. And what makes gen AI particularly interesting as it relates to Acrobat is the distribution that we have with Acrobat. So, if Acrobat is -- and Reader are in front of hundreds of millions of people on a monthly basis, our ability to insert generative AI into their workflows, just like we've been able to really differentiate our work on generative AI in creative by inserting it into the workflows of creative folks, I think that becomes the secret sauce to how we differentiate ourselves.
Keith Bachman: Interesting. Thanks very much.
Operator: And our next question will come from Brent Thill with Jefferies.
Brent Thill: Shantanu, you mentioned success in ETLAs. What's driving that? Especially given some of the macro jitters are still lingering, are you starting to see those jitters go away and that's a result of what's happening with the ETLAs?
Shantanu Narayen: I think in the ETLAs specifically, Brent, both to the comments that David and Anil mentioned, the first is the amount of content that people are creating, there's a lot of interest associated with ensuring that the combination of Creative Cloud plus Express that people can really understand what they are spending on their content, as well as find ways to use AI to automate it, to localize it, to improve production costs. So, I think that message is certainly resonating with people. And the fact that Express can be a productivity application for every knowledge worker in the enterprise, much like Acrobat as well. So, I think both of those are really leading to a significant amount of great conversations. I think, mobile -- David perhaps mentioned even in his prepared remarks how mobile has been one of the tailwinds that we've seen, Brent. So, I think that's also working. So, I think investment in productivity gains is clearly top of mind right now. And both of these play well into that narrative in enterprises.
Brent Thill: Thanks.
Operator: And we have a question from Alex Zukin with Wolfe Research.
Alex Zukin: Hey, guys, thanks for taking the question. And I guess a two-parter on generative AI. First just around the pricing model for generative credits, obviously, very progressive. And I guess how should we think about as we go forward? And you've seen at least on the hobbyist side, some of the usage of Firefly and within Express. How do we think about for the two cohorts of both obvious and professional creatives? How many credits are kind of a typical user or use case likely to drive in a given month? And to the question that you got kind of about Document Cloud and the impact of generative AI on that business, is it fair to think that given the pricing that's been announced, the next wave of incremental innovation, is that going to come more from a new product availability, or should we think about more pricing enabled levers to come?
Shantanu Narayen: I think, Alex, on the first question associated with how did we think about pricing, I mean, first, it's important to remember the breadth of all of the segments that we serve. In other words, how we think about K-12 all the way to the largest enterprise in the world. And I think it's fair to say that philosophically, we wanted to drive more adoption. And therefore, the pricing as it relates to what's included in the at least short run for Firefly subscriptions, Express subscriptions, GenStudio in terms of how much they can get within an enterprise is going to be the bulk of how we recognize the ARR. And I think getting that adoption and usage is where the primary focus is going to be in terms of the new user adoption, as well as for existing customers, the pricing upgrade. So that's how we think about it. We certainly need the ability to have the generative packs, but I think just getting everybody exposed to it. One of the real innovations that we did that's driven tremendous uptake in that is what we've called this context aware sort of menus within Photoshop. So, it's so front and center, you'll start to see that being rolled out in all of the other applications. So that's sort of the focus. Let's get the core subscriptions, let's get all of them exposed to it, and let's make sure that we're covering what we need to by the pricing actions that we took. So that was sort of the focus. I think on the Doc Cloud part and how we look at it, to add to again what David said, I mean, some of the things that people really want to know is how can I have a conversational interface with the PDF that I have? Not just the PDF that I have open right now, but the PDF that are all across my folder, then across my entire enterprise knowledge management system, and then across the entire universe. So, much like we're doing in creative, where you can start to upload your images to get -- you train your own models within an enterprise, [indiscernible]. The number of customers who want to talk to us now that we've sort of designed this to be commercially safe and say, hey, how do we create our own model? Whether you're a Coke or whether you're a Nike, think of them as having that, I think in the document space, the same interest will happen, which is we have all our knowledge within an enterprise associated with PDFs. Adobe helped me understand how your AI can start to deliver services like that. So, I think that's the way you should also look at the PDF opportunity that exists, just more people taking advantage of the trillions of PDFs that are out there in the world and being able to do things. The last thing maybe I'll mention on this front, Alex, is the APIs. So part of what we are also doing with PDFs is the fact that you can have all of this now accessible through APIs, it's not just the context of the PDF, the semantic understanding of that to do specific workflows. We're starting to enable all of that as well. So, hopefully that gives you some flavor. You're right, the generative credits has been designed to more for adoption right now, but we also wanted to make sure that at the high end, we were careful about how much generative credits we allow.
David Wadhwani: Yeah. And just one thing to add to that, Alex, is that one of the things we did, first of all, it was a very thoughtful, deliberate decision to go with the Generative Credit model and the limits, as you can imagine, we're very, very considered in terms of how we set them. The limits are, of course fairly low for free users. The goal there is to give them a flavor of it and then help them convert. And for paid users, especially for people in our single apps and all apps planned, one of the things we really intended to do was try and drive real proliferation of the usage. We didn't want there to be generation anxiety put in that way. We wanted them to use the product. We wanted the Generative Fill and Generative Expand. We wanted the vector creation. We wanted to build the habits of using it. And then, what will happen over time as we introduce 3D, as we introduce video and design and vectors, and as we introduce these Acrobat capabilities that Shantanu was talking about, the generative credits that are used in any given month continues to go up because they're getting more value out of it. And so that's the key thing. We want people to just start using it very actively right now and build those habits.
Alex Zukin: Super clear. Super thoughtful. If I could sneak one in for Dan. Of the $520 million in the net new ARR for Q4, just roughly, you've talked about before having some impact from the generative AI product that you were going to launch this year. Is it fair to assume it's very minimal in that $520 million?
Dan Durn: Yeah, I would say it's modest impact to the business in Q4. And again, a quarter from now when we give our FY 2024 targets, we'll have more to say of what that looks like going forward, but modest impact in Q4.
Alex Zukin: Perfect. Thank you, guys.
Operator: And we'll take a question from Brad Zelnick with Deutsche Bank.
Brad Zelnick: Great, thanks very much. David, you talked about making Firefly APIs available to customers to embed Firefly into their own content creation and workflows. Can you talk about the use cases and monetization? And is this something you foresee partners leveraging as well into their own third-party offerings?
David Wadhwani: Yes, absolutely. Our goal right now is for enterprises and third parties that we work with is to provide a few things. The first is this ability, obviously, to have API access to everything that we are building in, so that they can build it into their workflows and their automation stack. The second thing is to give them the ability to extend or train their own models as well. So, as we mentioned earlier, our core model -- foundation model is a very clean model that generates great content and you can rely on it commercially. We want our customers and partners to be able to extend that model with content that is relevant to them so that Firefly is able to generate content in their brand or in their style. So, we'll give them the ability to train their own model as well. And then, last but certainly not least, we'll give them some core workflows that will work with our existing products, whether it's Express or whether it's Creative Cloud or GenStudio as well, so that they can then integrate everything they're doing onto our core platform. And then, from a monetization perspective, you can imagine the metering concepts that we have for Generative Credits, extending to API calls as well. And of course, those will all be custom negotiated deals with partners and enterprises.
Brad Zelnick: Great. Thanks very much for taking the questions. Congrats.
Jonathan Vaas: Hey, operator, we're getting close to the top of the hour. We'll take one more question, please.
Operator: Thank you. Our next question will come from Jay Vleeschhouwer with Griffin Securities.
Jay Vleeschhouwer: Great. Thank you very much. Shantanu, over the last decade or more, one of the most important attributes of how you've managed your product portfolio have been the intra-segment and inter-segment integrations, particularly between Digital Media and DX. There is, as you know, a famous acronym for that. Now when we think about the current generation of integrations that you just announced, including yesterday, aside from the Firefly-ing of the product line and the proliferation of Firefly, what are some of the internal developmental changes that you yourselves have had to make in order to support the development of new integrations, new packaging? What are you doing differently internally? And then, externally, particularly to support the new generation of products, what are you having to invest in, in terms of customer support and enabling their adoption?
Shantanu Narayen: Yeah, Jay, I mean, certainly I think at MAX also you'll see a bunch more of the innovation. I think first internally, I'd be remiss if I didn't start off by saying how really thrilled I am with how quickly the company has embraced the possibilities of AI, how we've run all of these betas out there at a scale that, as we have said, is unprecedented, dealing with the differentiation that we can provide, whether that's how we deal with the data, understanding the indemnification, how we embed all of this AI stuff in the interfaces, and we've already shown that in Photoshop, Illustrator, Express, as well as create the new offering. So, I think the pace of innovation internally of what we have done is actually truly amazing. I mean, relative to a lot of the companies that are out there and the fact that we've gone from talking about this to very, very quickly making it commercially available, I don't want to take for granted the amount of work that went into that. I think internally it is really galvanized, because we are our own biggest user of these technologies. What we are doing associated with the campaigns and the GenStudio that we are using, as David alluded to it, our Photoshop Everyone Can campaign, or the Acrobat's Got It campaign, or how we will be further delivering campaigns for Express as well as for Firefly, all of this is built on this technology. And we use Express every day, much like we use Acrobat every day. So, I think it's really enabled us to say, are we really embracing all of this technology within the company? And that's been a big change, because I think the creative products, we've certainly had phenomenal usage within the company, but the extent to which the 30,000 employees can now use our combined offering, that is very, very different internally. So, very pleased associated with that. And I think one way in which that manifests is that all of our product reviews right now include all three groups. So, there's very little product sort of reviews that happen without people from Creative and Document and the Experience Cloud being part of it. So that's one of them. I think the work that we have already put in on the digital excellence as part of D-DOM, that also gives us a lot of confidence of, "Now that we have this breadth of offering, how do we make sure that we can personalize the offerings?" Part of the success that was driven in this quarter, Jay, was to do with the fact that the Stock and these value-added services, I think the digital excellence team in terms of the D-DOM have really got very good at segmenting our customers and understanding how we can make sure that they have the right offering. And now think of that with all of the breadth of offerings that we have across mobile and desktop and web. So, I think internally and externally, this has been again a real sort of drinking from the fire hose of how we embrace AI. And so, I think those are really two examples of how we've done it. And the third thing I would say is that in parallel, internally we've had to really change. Where prior to this, Jay, we may have said, okay, we're really going to make all of this magic happen in one of our applications. Today, that has to happen not just within the application, which we've certainly done, but it has to happen as an API so that everybody else can use it. It has to happen as a web-only playground, which is what Firefly and Express both are. So, the simultaneous release of not just investing in the model, but making sure that's available across all the surfaces, I would say that's another thing. And the last thing I'll leave you with is you've seen this for imaging. Make no mistake, those same investments, whether it's in vector or animation or 3D or -- all of those video certainly are underway. And so, I think the parallelism associated with saying how do we embrace this opportunity, I think that's also been another big change. But I think it's clear given this was the last question before I hand it over to Jonathan that a lot of the questions have been focused on understanding right now all of our announcements and the monetization associated with it. But I did want to again sort of acknowledge that we have delivered all of this innovation at a breakthrough pace. And so, we'll certainly share more as it relates to how we see this play out. At MAX, you'll see us have more information on the products. And certainly with the 2024 targets, you'll start to get more visibility into how and why we believe this is both a growth opportunity as well as embracing new customers. So, thank you for joining us. And with that, I will turn it back over to Jonathan.
Jonathan Vaas: Thanks, Shantanu, and thanks everyone for joining us today. Looking ahead, we have an exciting lineup planned for MAX starting on October 10, and we hope you'll be able to attend the entire conference. At the Investor Meeting after the day one keynote, we plan to focus on the impact of AI across our customer offerings with previews into our technology roadmap and how these innovations expand Adobe's reach. Given that, fiscal 2024 targets will be provided at our December earnings call. In addition, we're planning another investor event at Adobe Summit in March to give more insight into our addressable markets and financial performance. We hope to see you there. Thanks, everyone, and this concludes the call.
Operator: Thank you. That does conclude today's conference. We do thank you for your participation. Have an excellent day. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Q3 FY 2023 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's third quarter fiscal year 2023 financial results. You can find our press release, as well as PDFs of our prepared remarks and financial results, on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, September 14, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today's press release and in Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, except per share amounts, Adobe's executives will refer to constant currency growth rates, unless otherwise stated. Reconciliations are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon. Adobe had another record Q3, achieving revenue of $4.89 billion, representing 13% year-over-year growth. GAAP earnings per share for the quarter was $3.05 and non-GAAP earnings per share was $4.09, representing 26% and 20% year-over-year growth, respectively. Driving this success is a rich and innovative product roadmap. The advances we are delivering across Creative Cloud, Document Cloud and Experience Cloud are enabling us to attract an ever-growing set of users while delivering more value to existing customers. Yesterday's exciting announcements add to this roadmap. With the commercial availability of our generative AI capabilities, natively integrated in Adobe Creative Cloud, Adobe Express and Adobe Experience Cloud, we are unleashing a new era of AI-enhanced creativity for millions of customers around the globe. We are bringing generative AI to life across our portfolio of apps and services to deliver magic and productivity gains. Our rich datasets enable us to create foundation models in categories where we have deep domain expertise. In the six months since launch, Firefly has captivated people around the world who have generated over 2 billion images. We are excited about the potential to reimagine the content supply chain for all businesses through the integration of our clouds, enabling the delivery of personalized and engaging customer experiences. Our strategy to unleash creativity for all, accelerate document productivity and power digital businesses is driving our growth across every geography. By delivering innovative technology platforms and services, we continue to advance our industry leadership and delight a growing universe of customers. I'll now turn it over to David to share more about our momentum in the Digital Media business."
},
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"speaker": "David Wadhwani",
"text": "Thanks, Shantanu. Hello, everyone. In Q3, we achieved net new Digital Media ARR of $464 million and revenue of $3.59 billion, which grew 14% year-over-year, driven by strength in both our Creative and Document businesses. On the creative side, digital content creation and consumption are exploding across every creative category, customer segment and media type. Creative Cloud is the leading creativity platform, offering a comprehensive portfolio of products and services for every discipline across imaging, photography, design, video, animation and 3D. We're excited about the growth we are driving with our creative flagship products, and with Adobe Express, our AI-first, all-in-one creativity app that makes it fast, easy and fun for any user to design and share standout content. Yesterday's announcements highlighted several advances to our creative business: First, after an unprecedented beta that saw over 2 billion images generated, Adobe Firefly models and the Firefly web application are now commercially available. Firefly supports text prompts in over 100 languages and enables users around the world to create content that is designed to be safe for commercial use. We will continue to train and release new Firefly foundation models in areas where we have rich datasets and expertise, such as imaging, vector, video, design, 3D and more. Second, Adobe Firefly-powered features are now natively integrated into several Creative Cloud apps, including Generative Fill and Generative Expand in Photoshop, Generative Recolor in Illustrator, and Text to Image and Text Effects in Adobe Express. These deep integrations deliver more creative power than ever before to customers, enabling them to experiment, ideate, and create in completely new ways. Third, Adobe Firefly for Enterprise is now generally available for businesses to enable both creative teams and knowledge workers to confidently deploy AI-generated content. Adobe will empower customers to create custom models using proprietary assets to generate branded content and offer access to Firefly APIs so customers can embed the power of Firefly into their own content creation and automation workflows. And finally, we announced subscription offerings including new generative AI credits with the goal of enabling broad access and user adoption. Generative Credits are tokens that enable customers to turn text-based prompts into images, vectors and text effects with other content types to follow. Free and trial plans include a small number of monthly fast Generative Credits and will expose a broad base of prospects to the power of Adobe's generative AI, expanding our top-of-funnel. Paid Firefly, Express and Creative Cloud plans will include a further allocation of fast Generative Credits. After the plan-specific number of Generative Credits is reached, users will have an opportunity to buy additional fast Generative Credit subscription packs. In Q3, we added $332 million of Creative ARR and achieved $2.91 billion of revenue, growing 14% year-over-year. Business highlights include: The integration of Firefly into Photoshop and Illustrator. Over 3 million users have downloaded the Photoshop and Illustrator beta releases. The general availability of Adobe Express now includes support for editing and posting designs, videos, images, PDFs, presentations and more. Express features include Firefly-powered Text to Image and Text Effects. Express is already being used by millions of people globally. New AI and 3D features in Premiere Pro and After Effects, including Enhance Speech and Text-Based Editing in Premiere Pro and a new 3D workspace in After Effects. The Text-Based Editing feature in Premiere Pro received the 2023 Hollywood Professional Association Award for Engineering Excellence. New Lightroom mobile now integrates directly with the camera roll and introduced a streamlined interface to make editing even easier on the go. The introduction of new video assets in Adobe Stock and strong product-led growth motions, drove a record Q3 for the Stock business. Key customer wins include Amazon, Havas, Paramount, SAP, Southern Graphics, Take-Two Interactive and U.S. Department of Energy. As we have continued to add new applications and delivered innovations across our creative offerings, we announced price updates for certain Creative Cloud plans across the Americas and Europe, starting November 1, 2023. In addition to being a growth driver in the Creative Cloud business, Acrobat and PDF continue to power the Document Cloud business. Whether it's a sales contract, legal document or a back-to-school form, seamless document workflows across every device and platform are more important than ever for all of us to be productive in our professional and personal lives. Document Cloud is powering document productivity and automation across the web, desktop and mobile. In Q3, we achieved Document Cloud revenue of $685 million, growing 15% year-over-year. We added $132 million of net new Document Cloud ARR, with ending ARR growing 22% year-over-year in constant currency. Business highlights include: Significant growth in monthly active users across web, mobile, and embedded third-party app ecosystems, reflecting our growing top of funnel and the effectiveness of our product-led growth execution. Strong mobile momentum reflecting the value of Acrobat as an essential productivity application on mobile devices. Adoption of Acrobat and Acrobat Sign through increased link sharing for enhanced collaboration and approval workflows. Enhanced PDF workflows across Acrobat and Express making it seamless to create visually stunning PDFs. A new Adobe PDF Electronic Seal API, which is a cloud-based, end-to-end solution for applying electronic seals on PDFs at enterprise scale. Key customer wins include Citibank, GlaxoSmithKline, Emerson Electric, Morgan Stanley and Volkswagen. We continue to be excited about the pending Figma acquisition, which will reimagine the future of creativity and productivity. We remain engaged with regulators and have confidence in the merits of the case. We look forward to hosting Adobe MAX, the world's largest creativity conference, next month in Los Angeles, where we will welcome 10,000 members of our global community and engage with hundreds of thousands more online. We will hear from inspiring creators and unveil innovations across Creative Cloud, Firefly and Express. In summary, we are excited about the pace of innovations across our Digital Media products and continued execution across multiple growth drivers. I'll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello, everyone. Every company sees digital as an opportunity to drive experience-led growth. As I've spent time with customers across the world, it's clear that they are prioritizing investments in customer experience management technology to improve customer acquisition, engagement, retention and operational efficiency. We are driving revenue growth across content and commerce, customer journeys, data insights and audiences and marketing workflows, leveraging the Adobe Experience Platform, demonstrating the strength of our business. Brands around the globe are working with Adobe to accelerate personalization at scale through generative AI. With the announcement of Adobe GenStudio, we are revolutionizing the entire content supply chain by simplifying the creation-to-activation process with generative AI capabilities and intelligent automation. Marketers and creative teams will now be able to create and modify commercially safe content to increase the scale and speed at which experiences are delivered. In Q3, we continued to drive strong growth in our Experience Cloud business, achieving $1.23 billion in revenue, representing 11% year-over-year growth, as a growing number of enterprises turned to Adobe as their trusted partner for customer experience management. Subscription revenue was $1.1 billion, representing 13% year-over-year growth. Adobe Experience Cloud delivers predictive, personalized, real-time digital experiences, from acquisition to monetization to retention. We are driving strong enterprise adoption of Adobe Experience Platform, and native apps including Real-Time CDP, Adobe Journey Optimizer and Customer Journey Analytics. For example, the Coca-Cola Company is leveraging Adobe Real-Time CDP and Adobe Journey Optimizer to bring together 98 million customer profiles globally into a single CDP to quickly deliver personalized campaigns and experiences. smart Europe, an all-electric automotive brand, is using Adobe Experience Cloud to offer customers the ability to personalize their vehicle purchases through the integration of Adobe Workfront, Adobe Creative Cloud and Adobe Experience Manager. Business highlights include: Strong momentum across AEP and native apps with the total book of business surpassing $600 million during the quarter. Adobe Journey Optimizer book of business more than doubled year-over-year as customers increasingly drive omnichannel personalization and engagement. Continued innovation in Adobe Experience Manager with AEM Assets now natively integrated with Firefly and Express, enabling any employee across an organization to generate and reuse beautiful on-brand content. Growth of our Workfront business, reflecting our ability to serve the workflow and collaboration needs of enterprise customers and agencies. In Q3, we added Havas to the growing list of top agencies standardizing on Adobe for their content supply chain. Expanded strategic partnership with Amazon. Given customer demand, we will jointly deliver AEP on AWS and Amazon will deploy Experience Cloud across their enterprise. Adobe's leadership in Content Management Systems was recognized across three industry analyst reports, including the IDC MarketScape for Full-stack Content Management Systems, the IDC MarketScape for Hybrid Headless CMS and the Forrester Wave for Content Management Systems. Adobe was also named a Leader in the Gartner Magic Quadrant for Digital Commerce as well as the IDC MarketScape for OmniChannel Marketing Platforms for B2C Enterprises. Key customer wins include Amazon, Blue Cross Blue Shield of Florida, Dollar General, Havas, Intuit, IRS, Jet2.com, Lufthansa, Macy's, MSC Cruises, Novo Nordisk and SAP. These and other customers continue to prioritize investments in customer experience management solutions despite increased scrutiny of enterprise IT spend. Our solutions enable enterprises to simultaneously achieve the twin goals of driving new customer acquisition and serving existing customers to deliver profitable growth. Adobe is well positioned to keep winning with our differentiated offerings, track record of innovations and ability to drive ROI for companies across industries. We're looking forward to a strong close to the year. I will now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Today I will start by summarizing Adobe's performance in Q3 fiscal 2023, highlighting growth drivers across our businesses, and I'll finish with financial targets. Adobe's performance in Q3 demonstrates something that makes us exceptional, the combination of growth and profitability. In fact, at Adobe, rather than talking about trade-offs between growth or profitability, we call it an \"and\" statement. Growth and profitability is not new for us, we have been delivering both for a very long time and it is at the core of our operating philosophy. It all starts with prioritization, innovation and a sharp focus on execution. This philosophy shines through in our Q3 results. We are investing in technology platforms, global campaigns to attract and engage millions of customers and recruiting the best and brightest people in our industry. While doing that, Adobe is driving performance on margin and earnings, demonstrating what a special company we are. In Q3, Adobe achieved revenue of $4.89 billion, which represents 10% year-over-year growth, or 13% in constant currency. GAAP diluted earnings per share was $3.05, up 26% year-over-year, and non-GAAP diluted earnings per share was $4.09, up 20% year-over-year. Other business and financial highlights included: Digital Media revenue of $3.59 billion; net new Digital Media ARR of $464 million; Digital Experience revenue of $1.23 billion; cash flows from operations of $1.87 billion; RPO of $15.72 billion exiting the quarter; and repurchasing approximately 2.1 million shares of our stock during the quarter. In our Digital Media segment, we achieved Q3 revenue of $3.59 billion, which represents 11% year-over-year growth, or 14% in constant currency. We added $464 million of net new ARR in the quarter, our strongest Q3 on record, exiting the quarter with $14.60 billion of Digital Media ARR, growing 15% year-over-year in constant currency. We achieved Creative revenue of $2.91 billion, which represents 11% year-over-year growth, or 14% in constant currency. We added $332 million of net new Creative ARR in Q3, with strong demand across our offerings. Third quarter Creative growth drivers included: new user growth across geographies, customer segments and Creative offerings, driven by innovation and targeted campaigns utilizing insights from our data-driven operating model; outstanding top-of-funnel performance resulting from viral community excitement and success of our product-led growth strategy, driving traffic to Adobe.com; single app subscriptions for Photoshop driven by interest in the magic of Firefly, Generative Fill and Generative Expand; another great quarter for value-added services, including strong customer demand for Adobe Stock; continued customer adoption of Acrobat CC; strong engagement and retention across customer segments; and success in the enterprise, driven by transformational ETLAs that span the entire Creative portfolio, including CC All Apps for creative teams, Express for knowledge workers, Frame for collaboration, and Adobe Stock and Firefly for content. Adobe achieved Document Cloud revenue of $685 million, which represents 13% year-over-year growth, or 15% in constant currency, and we added $132 million of net new Document Cloud ARR in the quarter. Third quarter Document Cloud growth drivers included: success with new customer acquisition through our Reader and Acrobat web funnels and distribution partners, with monthly active users up over 70% year-over-year for Acrobat web; strong demand for Acrobat subscriptions across customer segments and geographies, driven by targeted offers; strength in monetization from Acrobat mobile, which grew ending ARR over 30% year-over-year in constant currency, driven by product innovation and conversion; and traction in B2B, with strong unit demand for our Team offering through the reseller and direct routes to market. Turning to our Digital Experience segment, in Q3, we achieved revenue of $1.23 billion, which represents 10% year-over-year growth, or 11% in constant currency. Q3 subscription revenue was $1.10 billion, which represents 12% year-over-year growth, or 13% in constant currency. Third quarter Digital Experience growth drivers included: demand for our Adobe Experience Platform and native applications, including Real-Time CDP, Customer Journey Analytics and Adobe Journey Optimizer. In Q3, subscription revenue for AEP and Apps grew 60% year-over-year; strength in Content and Commerce, with Adobe Experience Manager continuing to set the standard for enterprise content management; growth of our Workfront business, as workflow and collaboration are essential components of an enterprise content supply chain solution; strong retention rates in the quarter, as we continue to focus on value realization to our Digital Experience customers; and continued momentum in transformational platform deals with large enterprises adopting our end-to-end suite of applications. Adobe's effective tax rate in Q3 was 19.5% on a GAAP basis and 18.5% on a non-GAAP basis. The GAAP tax rate came in lower than expected due to tax benefits associated with the vesting of share-based payments in the quarter. RPO exiting the quarter was $15.72 billion, growing 11% year-over-year, or 13% when adjusting for a 2% FX headwind. Our ending cash and short-term investment position exiting Q3 was $7.52 billion, and cash flows from operations in the quarter were $1.87 billion. In Q3, we entered into $1 billion share repurchase agreement, and we currently have $3.15 billion remaining of our $15 billion authorization granted in December 2020. Factoring in current macroeconomic conditions and year-end seasonal strength, for Q4, we are targeting: total Adobe revenue of $4.975 billion to $5.025 billion; Digital Media net new ARR of approximately $520 million; Digital Media segment revenue of $3.67 billion to $3.70 billion; Digital Experience segment revenue of $1.25 billion to $1.27 billion; Digital Experience subscription revenue of $1.11 billion to $1.13 billion; tax rate of approximately 18% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $3.10 to $3.15; and non-GAAP earnings per share of $4.10 to $4.15. Q3 was a great quarter for Adobe, and I couldn't be more pleased with how the company is positioned to continue to deliver for our customers and investors. We're looking forward to our Investor Meeting at Adobe MAX on October 10, where we'll do a deep dive into our AI innovation. I hope to see you there. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. Adobe's strong Q3 results are a reflection of our team's exceptional execution. We recently lost our beloved co-founder John Warnock. John's brilliance and innovations changed the world. He was one of the greatest inventors of our generation and an inspiration to the technology industry. While we miss him tremendously, it gives me great comfort knowing that John was so proud of all of the innovation Adobe continues to deliver. As someone who shares John's passion for product and innovation, I'm exceptionally energized by the technology platforms we are delivering with AI at the center across our three clouds to delight customers. Our brand, technology and our talented employees position us for a strong close to the year and continued growth in the decades to come. Adobe's best days are ahead of us. Thank you. We will now take questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] And our first question will come from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you guys for taking the question and really nice quarter. Dan, actually a margin question, for you. And kind of a riddle that, like, we've been thinking about. We've been told generative AI is really expensive to run. The inference and training costs are really high. You guys have been running a beta for a while, 2 million images generated. There's a lot of functionality already in the product. And your operating margins are up. Your gross margins are up on a year-on-year basis. So, how are you able to do that? Like, where are these costs going, if you will? And on a go-forward basis, if all this stuff becomes generally available, how should we think about that gross margin impact or the overall margin impact of generative AI on a go-forward basis? Thank you."
},
{
"speaker": "Dan Durn",
"text": "Yeah. Thanks, Keith. So, as you rightfully point out, the engine of innovation at the company is really strong. A lot of exciting announcements this week, but we've been at this now a year, bringing the magic of generative AI and Firefly to life. And we're just getting started from an innovation standpoint. Over the last six months, we've been live with the beta. And as you point out, we've generated -- our customers have generated over 2 billion images. And I know it's not lost on people. All this has done while we're delivering strong margins. But when we take a step back and think about these technologies, we have investments from a COGS standpoint, inferencing, content, from an R&D standpoint, training, creating foundation models, and David alluded to it in his prepared comments, the image model for Firefly family of models is out. But we're going to bring other media types to market as well. So, we're making substantive investments. When I go back to the framing of my prepared comments, we really have a fundamental operating philosophy that's been alive at the company for a long time: growth and profitability. We're going to prioritize, we're going to innovate, and we're going to execute with rigor, and you see that coming through in all of the financial results of the company. As we think about going -- the profile going forward, what I'll come back to is, is when we initially set fiscal 2023 targets, implicit in those targets was a 44.5% operating margin. If you think about how we just guided Q4, where we've got these four great new products and these technologies infused into the product lineup, and all of the support we're going to do as we roll these out in our MAX conference down in L.A. again to keep the enthusiasm with the customer base building, implicit in that guide is an operating margin of around 45.5%. So, as you think about us leading this industry, leading the inflection that's unfolding in front of us, that mid-40%s number we think is the right ballpark to think about the margin structure of the company as we continue to drive this technology and leadership. Looking forward to the Q4 earnings call where we will share more about our fiscal 2024 targets."
},
{
"speaker": "Shantanu Narayen",
"text": "And maybe Keith, just 30 seconds to add to that, for investors like you who want to make sure we're not in any way not investing in the future, we are investing on training for 3D, for video, for new forms of imaging and vectors. So, what we are confident is while we continue to invest in that, the scrutiny that Dan and his team have on other expenses, that we can continue to drive top-line growth as well as cash flow and EPS. So, I think we're unique in that respect."
},
{
"speaker": "Keith Weiss",
"text": "Definitely. Very impressive, guys. Thank you so much for taking the question."
},
{
"speaker": "Operator",
"text": "And our next question will come from Kash Rangan with Goldman Sachs."
},
{
"speaker": "Kash Rangan",
"text": "Sorry to hear of John Warnock's passing. My condolences. But congrats on the quarter. As we look at the pricing model for generative AI products which are based on consumption, do you think that these -- rather, how additive do you think the generative AI offerings will be to the growth profile of the company going forward? And also one for Dan. When you look at your Q4 guidance, are you contemplating -- it looks like it's not largely changed versus the Street's prior expectations. Are we not embedding any opportunities to show what the generative AI products can do? Because they seem to be largely incremental to what had been contemplated when you first gave guidance fall of last year. Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Well, Kash, maybe David and I can take the first parts of the question. And just again, for everybody on the call, I think to summarize the new offerings that we have, we've announced that we have a Firefly subscription. So, you can use a free trial number of credits, and after that, you can actually subscribe to Firefly. We have Adobe Express, which now includes an allocation of Firefly. We certainly have the Creative Cloud products and Photoshop and Illustrator that have it. We have Generation Credit Packs, and we have GenStudio for the Enterprise and to be able to deal with it. So first, I just wanted to make sure that you recognized the tremendous innovation that we're delivering associated with that. And as you know, one of the things that we have done is to really focus on both new user acquisition, which is going to be driven across all of those offerings, as well as with the price increase, given there is an allocation associated with it for existing customers, they will start to see that as they roll over and they have to renew their subscription. So, I just wanted to set that bit, and maybe then I'll ask David to add a little bit about each of these and how we see that play out."
},
{
"speaker": "David Wadhwani",
"text": "Yeah, thanks, Shantanu. Yeah, as Shantanu said, we look at the business implications of this through those two lenses: new user adoption, first and foremost, and then sort of opportunity to continue to grow the existing book of business. On the new user side, we've said this for years, our focus continues to be on proliferation. We believe that we have a massive number of users in front of us. We continue to have our primary focus being net user adds and subscribers. And so, the goal here in proliferation is to get the right value to the right audience at the right price. And if I think about the four new offerings that Shantanu teed up, I think two of them are primed to maybe be on the earlier side of that. First, on the individual side, Express. It's been in the market for over a year now, and the new release of Express is a massive step forward in terms of the abilities that it has, both -- everything from performance to support for a broader set of things beyond design, into video and into illustration, into PDF and document workflows. So, there's just a tremendous amount of new value that we've added, including generative AI into that. So, we think that Express will be an early indicator of that success that we're talking about. The second one is the work that we're doing in the DME business in conjunction with Anil on the DX business around enterprises, so GenStudio, and enabling the broad base of marketers to actually use Express in conjunction with the Creative Studio teams using Creative Cloud to really accelerate their use of and creation of content. So that really -- in the context of the short-term contributors, we think that will be really meaningful. We also expect that -- as we do this and drive new users, we expect to see a lot of new users come into the free plans. And that's going to take a little time to ramp. We'll bring them into the Adobe family, get them using the products, and ramp them to greater value over time. So, first and foremost, proliferation on new users. The second thing is going to be on the book of business. And here, we're -- basically, the pricing changes. Just as a reminder, they have a rolling impact. We're going to start them late in Q4. And we're going to start it in certain geos only. And then, we're going to have a measured rollout in new countries over the course of the next couple of years. And then certainly also as it relates to enterprise customers, the renewal timing will probably take about three years, given the multi-year contracts that we have in place. So, net-net, we see this truly as a seminal moment for how we're going to grow the business, but it's going to take a few years to play out, and we're really excited about sort of what this means for bringing new customers into the franchise."
},
{
"speaker": "Shantanu Narayen",
"text": "And maybe Kash, just to then tie that all together, in terms of the numbers that we've given for Digital Media ARR, because you asked the question from the beginning of the year, remember, I think we guided to $1.65 billion, if you look at what it is even with our Q4 guide that I think $200 million more than that, $1.86 billion or something to that effect. And since we guided in Q3, for Q3 and Q4, $100 million. So, we continue to be really confident and we're excited about the roadmap."
},
{
"speaker": "Operator",
"text": "And our next question will come from Saket Kalia with Barclays."
},
{
"speaker": "Saket Kalia",
"text": "Okay, great. Hey, guys, thanks for taking my question, and congrats on a great quarter and outlook. Anil, actually my question is for you. Obviously, a lot to talk about with Firefly in the Digital Media business. And it's very clearly a revenue opportunity there. I'm wondering how you think about the generative AI roadmap or revenue opportunity in the Digital Experience part of the business. I know we talked about the content supply chain, but how do you think about the future of generative AI in your business?"
},
{
"speaker": "Anil Chakravarthy",
"text": "Yeah, thanks, Saket. Shantanu and David already talked about the Adobe GenStudio, and we're really excited about that. This is a unique opportunity, as you said, for enterprises to really create personalized content and drive efficiencies as well in -- through automation and efficiency. When you look at the entire chain of what enterprises go through, from content creation, production, workflow, and then activation through DX, through all the apps we have on our platform, we have the unique opportunity to do that. We already have deployed it within Adobe for our own Photoshop campaign. And we're working with a number of agencies and customers to do that. So, this is a big net new opportunity for us with Adobe GenStudio. We're also working on generative AI for other DX applications as well. And at the investor meeting in October, we'll share more details. But we see a similar opportunity with generative AI to bring together the ability for a number of users across marketing departments or organizations to be able to use the Adobe Experience platform and apps and it'll act as a co-pilot to accelerate the use cases that they bring to life. So, we'll share more about that at the investor meeting."
},
{
"speaker": "Shantanu Narayen",
"text": "Saket, maybe, just to give Anil and the team a lot of credit for what they actually accomplished in Q3 as well, the wins in Q3 in the enterprise actually included a lot of the components of GenStudio, both in the Digital Media as well as in the Digital Experience. So, certainly the transformational deals that we're talking about, a big part of that is the synergy between the two clouds. So, I wanted to point that out as well."
},
{
"speaker": "David Wadhwani",
"text": "And if I could actually just add one quick thing is that the GenStudio work that Anil team has been doing, we've actually been using that within the Digital Media business already to release some of the campaigns that we've released this quarter. So, it's one of these things that it's great to see the impact it's having on our business, and that becomes a selling point for other businesses too."
},
{
"speaker": "Saket Kalia",
"text": "Great to hear. Thanks."
},
{
"speaker": "Operator",
"text": "And moving on to Gregg Moskowitz with Mizuho."
},
{
"speaker": "Gregg Moskowitz",
"text": "Hey, thank you for taking the question. Congratulations as well on a strong quarter. So, when I look at Firefly, the amount of image generation in a six-month period is clearly pretty stunning. I'm just wondering if you're able to provide any additional color, whether it be monthly active users or some other metric that may additionally help all of us gauge the improvements that Firefly is driving to your engagement level, to your top-of-funnel, et cetera? Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Yeah, happy to talk about that. It's been a remarkable few months. I mean, we've said a few things. First is that the viral excitement that we saw because of Firefly on social has been hugely beneficial and it's certainly driven a lot of top-of-funnel opportunity for us. In addition to that, one of the things that we were very excited about is when we integrated it into our CreativePro applications, Illustrator and Photoshop primarily, we saw over 3 million downloads of those betas -- beta applications, which is something we've never seen before. That gives you a sense of like how thirsty the existing customer base is for the generative capabilities that we have as well. And lastly, one of the things that we're very excited about, and we obviously track very carefully, is what does this do in terms of giving us access to new users that don't typically come to Adobe. And both Express and Firefly, and in particular the integration of Firefly and Express, has been a real accelerant to that. So, it's been nice to see us not just getting excitement within the current base, but seeing millions of other users coming in, that would not have typically come to Adobe for a product and then giving -- and starting their journey with Adobe through Firefly and Express."
},
{
"speaker": "Shantanu Narayen",
"text": "Two other maybe financial indicators to that, Gregg, are first the Photoshop Single App, and I think Dan referred to that. Even in the beta, that actually drove a lot of Photoshop Single App and the early indicators of how that also benefits retention in the entire book of business. So both of those are also good financial indicators of the potential of AI."
},
{
"speaker": "Gregg Moskowitz",
"text": "Great. Thank you, both."
},
{
"speaker": "Operator",
"text": "And we have a question from Brad Sills with Bank of America."
},
{
"speaker": "Brad Sills",
"text": "Wonderful. Thank you so much for taking my question. I wanted to ask about a comment that I think David made earlier in the call where you're working hard to make Firefly the option for content design to be safe. I would love to double click on that, understand a little bit, how is Adobe the safe option, and how is the company making this Firefly in this new generative frontier the safe option for enterprises?"
},
{
"speaker": "David Wadhwani",
"text": "Yeah. So from the very beginning of Firefly, we took a very different approach to how we were doing generative. We started by looking at and working off the Adobe Stock base, which are contents that are licensed and very clearly we have the rights to use. And we looked at other repositories of content where they didn't have any restrictions on usage, and we've pulled that in. So, everything that we've trained on has gone through some form of moderation and has been cleared by our own legal teams for use in training. And what that means is that the content that we generate is, by definition, content that isn't then stepping on anyone else's brand and/or leveraging content that wasn't intended to be used in this way. So that's the foundation of what we've done. We've gone further than that, of course, and we've now actually -- we've been working with our Stock contributors. We've announced, in fact, yesterday we had our first payout of contributions to contributors that have been participating and adding Stock for the AI training. And we're able to leverage that base very effectively, so that if we see that we need additional training content, we can put a call to action, call for content out to them, and they're able to bring content to Adobe in a fully licensed way. So, for example, earlier this quarter, we decided that we needed a million new images of crowd scenes. And so, we put a call to action out. We were able to gather that content in. But it's fully licensed and fully moderated in terms of what comes in. So as a result, all of the content we generate is safe for commercial use. The second thing is that because of that, we're able to go to market and also indemnify customers in terms of how they're actually leveraging that content and using it for content that's being generated. And so, enterprise customers find that to be very important as we bring that in, not just in the context of Firefly standalone, but we integrate it into our Creative Cloud applications and Express applications as well. So, the whole ecosystem has been built on that. And the last thing I'll say is we've been very focused on fair generation. So, we look intentionally for diversity of people that are generated and we're looking to make sure that the content we generate doesn't create or cause any harm. And all those things are really good business decisions and differentiate us from others."
},
{
"speaker": "Brad Sills",
"text": "Great to hear. Thanks, David."
},
{
"speaker": "Operator",
"text": "And we have a question from Keith Bachman with BMO Capital Markets."
},
{
"speaker": "Keith Bachman",
"text": "Yes, thank you. I wanted to go back -- David, I wanted to hear your perspective on kind of the third cloud, the Document Cloud, if you will, as we look out over the next 12 months. And the spirit of the question is there's a lot of attention, appropriately so, given Firefly and whatnot, and perhaps even lending itself in the Experience Cloud. But does gen AI provide any tailwinds associated with the Document Cloud, or is it sort of the existing drivers that will help contribute to growth as we look at next year? But any just kind of -- what are the key things that we should be thinking about for Document Cloud? Many thanks."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. First of all, we are very happy with the quarter Doc Cloud had. The ending book of business grew 22% in constant currency. And the strength of that is really driven based on top-of-funnel growth. So, Acrobat on the web had a phenomenal year-over-year growth rate. We've been working very actively to get Acrobat sort of deployed with -- as plugins within the browsers. We've got a great -- we've been doing a lot of product-led growth work in the products themselves to drive link sharing, so that more and more people are not just using our products, but as they share links, we're actually able to capture more people and build growth loops. Signatures has been also doing incredibly well. So, as we've got this broad-based proliferation of our surfaces that are available and continue to grow in terms of both free and paid usage, it creates a surface area that we can introduce a lot of really interesting things into. We haven't announced anything publicly associated with gen AI directly inside of Acrobat, but I think you can fairly safely expect to hear more about that from us soon. And what makes gen AI particularly interesting as it relates to Acrobat is the distribution that we have with Acrobat. So, if Acrobat is -- and Reader are in front of hundreds of millions of people on a monthly basis, our ability to insert generative AI into their workflows, just like we've been able to really differentiate our work on generative AI in creative by inserting it into the workflows of creative folks, I think that becomes the secret sauce to how we differentiate ourselves."
},
{
"speaker": "Keith Bachman",
"text": "Interesting. Thanks very much."
},
{
"speaker": "Operator",
"text": "And our next question will come from Brent Thill with Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Shantanu, you mentioned success in ETLAs. What's driving that? Especially given some of the macro jitters are still lingering, are you starting to see those jitters go away and that's a result of what's happening with the ETLAs?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think in the ETLAs specifically, Brent, both to the comments that David and Anil mentioned, the first is the amount of content that people are creating, there's a lot of interest associated with ensuring that the combination of Creative Cloud plus Express that people can really understand what they are spending on their content, as well as find ways to use AI to automate it, to localize it, to improve production costs. So, I think that message is certainly resonating with people. And the fact that Express can be a productivity application for every knowledge worker in the enterprise, much like Acrobat as well. So, I think both of those are really leading to a significant amount of great conversations. I think, mobile -- David perhaps mentioned even in his prepared remarks how mobile has been one of the tailwinds that we've seen, Brent. So, I think that's also working. So, I think investment in productivity gains is clearly top of mind right now. And both of these play well into that narrative in enterprises."
},
{
"speaker": "Brent Thill",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "And we have a question from Alex Zukin with Wolfe Research."
},
{
"speaker": "Alex Zukin",
"text": "Hey, guys, thanks for taking the question. And I guess a two-parter on generative AI. First just around the pricing model for generative credits, obviously, very progressive. And I guess how should we think about as we go forward? And you've seen at least on the hobbyist side, some of the usage of Firefly and within Express. How do we think about for the two cohorts of both obvious and professional creatives? How many credits are kind of a typical user or use case likely to drive in a given month? And to the question that you got kind of about Document Cloud and the impact of generative AI on that business, is it fair to think that given the pricing that's been announced, the next wave of incremental innovation, is that going to come more from a new product availability, or should we think about more pricing enabled levers to come?"
},
{
"speaker": "Shantanu Narayen",
"text": "I think, Alex, on the first question associated with how did we think about pricing, I mean, first, it's important to remember the breadth of all of the segments that we serve. In other words, how we think about K-12 all the way to the largest enterprise in the world. And I think it's fair to say that philosophically, we wanted to drive more adoption. And therefore, the pricing as it relates to what's included in the at least short run for Firefly subscriptions, Express subscriptions, GenStudio in terms of how much they can get within an enterprise is going to be the bulk of how we recognize the ARR. And I think getting that adoption and usage is where the primary focus is going to be in terms of the new user adoption, as well as for existing customers, the pricing upgrade. So that's how we think about it. We certainly need the ability to have the generative packs, but I think just getting everybody exposed to it. One of the real innovations that we did that's driven tremendous uptake in that is what we've called this context aware sort of menus within Photoshop. So, it's so front and center, you'll start to see that being rolled out in all of the other applications. So that's sort of the focus. Let's get the core subscriptions, let's get all of them exposed to it, and let's make sure that we're covering what we need to by the pricing actions that we took. So that was sort of the focus. I think on the Doc Cloud part and how we look at it, to add to again what David said, I mean, some of the things that people really want to know is how can I have a conversational interface with the PDF that I have? Not just the PDF that I have open right now, but the PDF that are all across my folder, then across my entire enterprise knowledge management system, and then across the entire universe. So, much like we're doing in creative, where you can start to upload your images to get -- you train your own models within an enterprise, [indiscernible]. The number of customers who want to talk to us now that we've sort of designed this to be commercially safe and say, hey, how do we create our own model? Whether you're a Coke or whether you're a Nike, think of them as having that, I think in the document space, the same interest will happen, which is we have all our knowledge within an enterprise associated with PDFs. Adobe helped me understand how your AI can start to deliver services like that. So, I think that's the way you should also look at the PDF opportunity that exists, just more people taking advantage of the trillions of PDFs that are out there in the world and being able to do things. The last thing maybe I'll mention on this front, Alex, is the APIs. So part of what we are also doing with PDFs is the fact that you can have all of this now accessible through APIs, it's not just the context of the PDF, the semantic understanding of that to do specific workflows. We're starting to enable all of that as well. So, hopefully that gives you some flavor. You're right, the generative credits has been designed to more for adoption right now, but we also wanted to make sure that at the high end, we were careful about how much generative credits we allow."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. And just one thing to add to that, Alex, is that one of the things we did, first of all, it was a very thoughtful, deliberate decision to go with the Generative Credit model and the limits, as you can imagine, we're very, very considered in terms of how we set them. The limits are, of course fairly low for free users. The goal there is to give them a flavor of it and then help them convert. And for paid users, especially for people in our single apps and all apps planned, one of the things we really intended to do was try and drive real proliferation of the usage. We didn't want there to be generation anxiety put in that way. We wanted them to use the product. We wanted the Generative Fill and Generative Expand. We wanted the vector creation. We wanted to build the habits of using it. And then, what will happen over time as we introduce 3D, as we introduce video and design and vectors, and as we introduce these Acrobat capabilities that Shantanu was talking about, the generative credits that are used in any given month continues to go up because they're getting more value out of it. And so that's the key thing. We want people to just start using it very actively right now and build those habits."
},
{
"speaker": "Alex Zukin",
"text": "Super clear. Super thoughtful. If I could sneak one in for Dan. Of the $520 million in the net new ARR for Q4, just roughly, you've talked about before having some impact from the generative AI product that you were going to launch this year. Is it fair to assume it's very minimal in that $520 million?"
},
{
"speaker": "Dan Durn",
"text": "Yeah, I would say it's modest impact to the business in Q4. And again, a quarter from now when we give our FY 2024 targets, we'll have more to say of what that looks like going forward, but modest impact in Q4."
},
{
"speaker": "Alex Zukin",
"text": "Perfect. Thank you, guys."
},
{
"speaker": "Operator",
"text": "And we'll take a question from Brad Zelnick with Deutsche Bank."
},
{
"speaker": "Brad Zelnick",
"text": "Great, thanks very much. David, you talked about making Firefly APIs available to customers to embed Firefly into their own content creation and workflows. Can you talk about the use cases and monetization? And is this something you foresee partners leveraging as well into their own third-party offerings?"
},
{
"speaker": "David Wadhwani",
"text": "Yes, absolutely. Our goal right now is for enterprises and third parties that we work with is to provide a few things. The first is this ability, obviously, to have API access to everything that we are building in, so that they can build it into their workflows and their automation stack. The second thing is to give them the ability to extend or train their own models as well. So, as we mentioned earlier, our core model -- foundation model is a very clean model that generates great content and you can rely on it commercially. We want our customers and partners to be able to extend that model with content that is relevant to them so that Firefly is able to generate content in their brand or in their style. So, we'll give them the ability to train their own model as well. And then, last but certainly not least, we'll give them some core workflows that will work with our existing products, whether it's Express or whether it's Creative Cloud or GenStudio as well, so that they can then integrate everything they're doing onto our core platform. And then, from a monetization perspective, you can imagine the metering concepts that we have for Generative Credits, extending to API calls as well. And of course, those will all be custom negotiated deals with partners and enterprises."
},
{
"speaker": "Brad Zelnick",
"text": "Great. Thanks very much for taking the questions. Congrats."
},
{
"speaker": "Jonathan Vaas",
"text": "Hey, operator, we're getting close to the top of the hour. We'll take one more question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from Jay Vleeschhouwer with Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Great. Thank you very much. Shantanu, over the last decade or more, one of the most important attributes of how you've managed your product portfolio have been the intra-segment and inter-segment integrations, particularly between Digital Media and DX. There is, as you know, a famous acronym for that. Now when we think about the current generation of integrations that you just announced, including yesterday, aside from the Firefly-ing of the product line and the proliferation of Firefly, what are some of the internal developmental changes that you yourselves have had to make in order to support the development of new integrations, new packaging? What are you doing differently internally? And then, externally, particularly to support the new generation of products, what are you having to invest in, in terms of customer support and enabling their adoption?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yeah, Jay, I mean, certainly I think at MAX also you'll see a bunch more of the innovation. I think first internally, I'd be remiss if I didn't start off by saying how really thrilled I am with how quickly the company has embraced the possibilities of AI, how we've run all of these betas out there at a scale that, as we have said, is unprecedented, dealing with the differentiation that we can provide, whether that's how we deal with the data, understanding the indemnification, how we embed all of this AI stuff in the interfaces, and we've already shown that in Photoshop, Illustrator, Express, as well as create the new offering. So, I think the pace of innovation internally of what we have done is actually truly amazing. I mean, relative to a lot of the companies that are out there and the fact that we've gone from talking about this to very, very quickly making it commercially available, I don't want to take for granted the amount of work that went into that. I think internally it is really galvanized, because we are our own biggest user of these technologies. What we are doing associated with the campaigns and the GenStudio that we are using, as David alluded to it, our Photoshop Everyone Can campaign, or the Acrobat's Got It campaign, or how we will be further delivering campaigns for Express as well as for Firefly, all of this is built on this technology. And we use Express every day, much like we use Acrobat every day. So, I think it's really enabled us to say, are we really embracing all of this technology within the company? And that's been a big change, because I think the creative products, we've certainly had phenomenal usage within the company, but the extent to which the 30,000 employees can now use our combined offering, that is very, very different internally. So, very pleased associated with that. And I think one way in which that manifests is that all of our product reviews right now include all three groups. So, there's very little product sort of reviews that happen without people from Creative and Document and the Experience Cloud being part of it. So that's one of them. I think the work that we have already put in on the digital excellence as part of D-DOM, that also gives us a lot of confidence of, \"Now that we have this breadth of offering, how do we make sure that we can personalize the offerings?\" Part of the success that was driven in this quarter, Jay, was to do with the fact that the Stock and these value-added services, I think the digital excellence team in terms of the D-DOM have really got very good at segmenting our customers and understanding how we can make sure that they have the right offering. And now think of that with all of the breadth of offerings that we have across mobile and desktop and web. So, I think internally and externally, this has been again a real sort of drinking from the fire hose of how we embrace AI. And so, I think those are really two examples of how we've done it. And the third thing I would say is that in parallel, internally we've had to really change. Where prior to this, Jay, we may have said, okay, we're really going to make all of this magic happen in one of our applications. Today, that has to happen not just within the application, which we've certainly done, but it has to happen as an API so that everybody else can use it. It has to happen as a web-only playground, which is what Firefly and Express both are. So, the simultaneous release of not just investing in the model, but making sure that's available across all the surfaces, I would say that's another thing. And the last thing I'll leave you with is you've seen this for imaging. Make no mistake, those same investments, whether it's in vector or animation or 3D or -- all of those video certainly are underway. And so, I think the parallelism associated with saying how do we embrace this opportunity, I think that's also been another big change. But I think it's clear given this was the last question before I hand it over to Jonathan that a lot of the questions have been focused on understanding right now all of our announcements and the monetization associated with it. But I did want to again sort of acknowledge that we have delivered all of this innovation at a breakthrough pace. And so, we'll certainly share more as it relates to how we see this play out. At MAX, you'll see us have more information on the products. And certainly with the 2024 targets, you'll start to get more visibility into how and why we believe this is both a growth opportunity as well as embracing new customers. So, thank you for joining us. And with that, I will turn it back over to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, Shantanu, and thanks everyone for joining us today. Looking ahead, we have an exciting lineup planned for MAX starting on October 10, and we hope you'll be able to attend the entire conference. At the Investor Meeting after the day one keynote, we plan to focus on the impact of AI across our customer offerings with previews into our technology roadmap and how these innovations expand Adobe's reach. Given that, fiscal 2024 targets will be provided at our December earnings call. In addition, we're planning another investor event at Adobe Summit in March to give more insight into our addressable markets and financial performance. We hope to see you there. Thanks, everyone, and this concludes the call."
},
{
"speaker": "Operator",
"text": "Thank you. That does conclude today's conference. We do thank you for your participation. Have an excellent day."
}
] | Adobe Inc. | 24,321 |
ADBE | 2 | 2,023 | 2023-06-15 17:00:00 | Operator: Good day, and welcome to the Q2 FY '23 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jonathan Vaas, Vice President of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's second quarter fiscal year 2023 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, June 15, and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today's press release and in Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant currency growth rates, unless otherwise stated. Reconciliations are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon and thank you for joining us. Adobe had an outstanding quarter, achieving record revenue of $4.82 billion, representing 13% year-over-year growth. GAAP earnings per share for the quarter was $2.82, and non-GAAP earnings per share was $3.91. Our results demonstrate strong demand across Creative Cloud, Document Cloud and Experience Cloud with particular strength in Digital Media ARR. Adobe's mission to change the world through personalized digital experiences is more critical than ever as digital continues to rapidly transform work, life and play. Our groundbreaking innovations, including the new Adobe Express, the launch of Firefly, our family of creative generative AI models, co-pilot functionality in our creative applications, including Photoshop and Illustrator, AI-powered advancements in Acrobat; a new product analytics solution and the latest capabilities in real-time CDP are empowering an ever-expanding customer base to imagine, create and deliver standout content and experiences. We're executing against our strategy to unleash creativity for all, accelerate document productivity and power digital businesses. Every disruptive technology has presented exciting opportunities for Adobe to innovate and increase our addressable market opportunity. This has been true for cloud computing, mobile and AI. We have delivered hundreds of AI innovations through Adobe Sensei such as Neural Filters in Photoshop, Liquid Mode in Acrobat and Customer AI in Adobe Experience Platform. Our ongoing R&D investments have enabled a rapid development and deployment of Firefly, our generative AI technology. We believe generative AI will drive both further accessibility and adoption of our products. Our generative AI strategy focuses on data, models and interfaces. Our rich data sets across creativity, documents and customer experiences, enable us to train models on the highest quality assets. We will build foundation models in the categories where we have deep domain expertise, including imaging, vector, video, documents and marketing. We are bringing generative AI to life as a copilot across our incredible array of interfaces to deliver magic and productivity gains for a broader set of customers. Since its launch in March, Firefly has captured the imagination of the world with over 0.5 billion generations and we're just getting started. Our digital experience business is powering personalized customer engagement for companies around the world, enabling them to drive experience-led growth. We're delivering an innovative product road map and integrating Sensei gen AI services across Experience Cloud. Last week, we hosted a successful EMEA Summit with tremendous excitement from thousands of customers and partners reinforcing that digital is a critical imperative across industries. Adobe's category leadership and mission-critical products will continue to drive our growth. For FY '23, we now expect Creative Cloud and Document Cloud to end the year ahead of our previously issued revenue and ARR targets and Digital Experience to be slightly below our previous annual target given the current enterprise spend environment. As a result of our groundbreaking innovation and continued execution, we are pleased to raise total Adobe annual revenue and EPS targets. David, over to you.
David Wadhwani: Thanks, Shantanu, and hello, everyone. Adobe has long had a mission to unleash creativity for all and today, this is more possible than ever through the power of AI. The introduction of the new Adobe Express and Firefly will go down as a seminal moment in our creative history. These innovative products and our generative AI copilot in our flagship applications will extend our leadership in core creative categories such as imaging, design, video, illustration, animation and 3D as well as attract an increasingly expansive global audience. In Q2, we achieved net new creative ARR of $354 million and revenue of $2.85 billion, which grew 14% year-over-year. We could not be more excited about our generative AI road map that will make Adobe products more accessible to an even larger universe of people, while dramatically enhancing productivity for existing customers. Firefly is attracting tremendous customer interest and is highly differentiated in the market. It is being directly integrated into our product workflows as a copilot to accelerate ideation, exploration and the end-to-end production process. Business and innovation highlights include the beta release of Firefly, Adobe's pioneering family of creative generative AI models and adobe.com/firefly, a destination that allows users to generate and refine content. Firefly's first model is trained on Adobe stock images and other openly licensed content designed to generate commercially viable, professional quality content. Firefly powered capabilities seamlessly integrated into Photoshop are catalyzing a new era of creative power and precision. The viral response to Photoshop's new generative fill copilot has been extraordinary across social media platforms. Users have now generated over 0.5 billion assets on the Firefly website and in Photoshop, making these 2 of our most successful beta releases in company history. Building on this innovation, earlier this week, we announced Generative Recolor in Illustrator, which will similarly serve as a generative AI copilot to millions of designers to iterate and transform Vector Art. We also released an all-new Adobe Express with Firefly generative AI capabilities that revolutionizes how everyone, from students to small business owners to marketers and large organizations, creates and share standout content. Adobe Express brings the magic of our technology from Photoshop, Illustrator, Premiere and Acrobat to combine power and precision with speed and ease. The response to the public beta in particular the groundbreaking video editing capabilities has been overwhelmingly positive. The enterprise version of Adobe Express and Firefly will empower every employee in an organization to participate in the creation of content, campaigns and websites in conjunction with Experience Cloud. New AI-powered text-based editing and automatic tone mapping in Premier Pro makes video editors more productive. An expanded Frame.io platform that now supports collaboration across PDFs and images, in addition to video, increases the value of Adobe's Cross-Cloud content supply chain solution. A major Lightroom mobile update that instantly allows you to access photos from Apple iCloud and Android Gallery empowers our growing base of mobile-first and mobile-only users. Continued momentum with our ecosystem of strategic partners drives awareness of our products and top-of-funnel for Adobe. Google announced that Adobe Firefly will be a premier generative AI partner for Bard, powering text to image capabilities. NVIDIA and Adobe announced that we will collaborate on generative AI optimizations across hardware and software. Apple highlighted how Lightroom will empower users to edit photos on the Vision Pro VR headset at WWDC. Momentum across routes to market and customer segments, including key enterprise customer wins, EY, government of the Philippines, NVIDIA, Omnicom, TAFE, New South Wales and WPP. Our generative AI offerings represent additional customer value as well as multiple new monetization opportunities. First, Firefly will be available both as a standalone freemium offering for consumers as well as an enterprise offering announced last week. Second, copilot generative AI functionality within our flagship applications will drive higher ARPUs and retention. Third, subscription credit packs will be made available for customers who need to generate greater amounts of content. Fourth, we will offer developer communities access to Firefly APIs and allow enterprises the ability to create exclusive custom models with their proprietary content. And finally, the industry partnerships as well as Firefly represent exciting new top-of-funnel acquisition opportunities for Express, Creative Cloud and Document Cloud. Our priority for now is to get Firefly broadly adopted, and we will introduce specific pricing later this year. Now turning to the Document Cloud business. PDF has become the de facto standard for the world's unstructured data, and businesses of all sizes are turning to Adobe to help streamline and automate document-based workflows. Adobe Document Cloud offers a comprehensive set of ubiquitous products to accelerate document productivity across every device by seamlessly integrating PDF services into Acrobat. In Q2, we achieved Document Cloud revenue of $659 million, growing 14% year-over-year. We added $116 million of net new Document Cloud ARR with ending ARR growing 22% year-over-year. Business and innovation highlights include, significant growth in Acrobat web monthly active users, driven by searches for Acrobat verbs and further accelerated by an explosion of PDF consumption through our Chrome and Edge extensions; viral adoption of PDF collaboration services, which are both increasing active use among existing users and creating a growth loop to bring new users into the Acrobat ecosystem. Mobile momentum across both App Store downloads as well as documents consumed in liquid mode. New workflows between Acrobat and Express allow users to integrate documents seamlessly into their creative process. Express now has full fidelity PDF import and editing, which allows users to make documents visually stunning; momentum across routes to market and customer segments, including key enterprise customer wins, Boston Consulting Group, Cushman & Wakefield, Novartis, T-Mobile and WPP. Today marks the 30th anniversary of Acrobat, a significant milestone that is both inspiring and humbling. PDF and Acrobat are more relevant today than ever before. We are incredibly proud of how PDF continues to transform the world of digital documents, powering communication and productivity for billions of people every day and we know that the best is yet to come. The pending acquisition of Figma will further expand our addressable market, and we have been delighted to hear from customers, partners and industry analysts who are excited about the benefits that the combination will unlock. We continue to engage in conversations with the Competition and Markets Authority in the U.K., the European Commission and the U.S. Department of Justice as they conduct their regulatory reviews and given the merits of the case, we believe the transaction should close by the end of 2023. Adobe's Digital Media business is on a roll. We're rapidly delivering groundbreaking innovations across Creative Cloud and Document Cloud. Our increasing breadth of offerings is reaching a broader universe of customers, and our incredible go-to-market strength and proven data-driven operating model are propelling the growth of both our emerging and established businesses. Given the momentum, we are raising our net new Digital Media ARR and revenue targets for fiscal '23. I'll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello, everyone. In Q2, we continued to drive strong growth in our Experience Cloud business, achieving $1.22 billion in revenue. Subscription revenue was $1.07 billion, representing 14% year-over-year growth. Customer interest in the digital experience category remains high. Last week, we were excited to spend time with thousands of customers and partners at EMEA Summit. Businesses of all sizes and industries around the world are increasingly relying on digital channels to engage customers and deliver experience-led growth and they are turning to Adobe as their trusted partner on that journey. Adobe Experience Cloud offers the most comprehensive set of solutions for content and commerce, data insights and audiences, customer journeys and marketing workflows. Built natively on Adobe Experience platform, our real-time customer data platform provides businesses with a single view of their customers' data across every channel. Real-time CDP now delivers over 600 billion predictive insights each year, and customers are creating over 30 trillion audience segments every day. Experience Cloud is now used by 87% of Fortune 100 companies. For example, Prudential Financial uses our cross-cloud offerings to power its end-to-end customer experience management workflows from creating high-impact content with Creative Cloud and Express to delivering personalized customer experiences at scale with Adobe Experience Platform. In addition, Prada is using real-time CDP and Journey optimizer to connect digital and in-store customer experiences in real time while reimagining shopping experiences using Substance 3D. Our vision for Experience Cloud is to deliver personalized experiences at scale, and the power of generative AI accelerates our ability to do that. We are delivering Sensei gen AI innovations to reimagine the work marketers do and how they do it. With Sensei gen AI as their copilot, marketers can generate audiences with high position and design tailored customer journeys for these audiences. They can activate personalized campaigns for their audiences with on-brand visual content created with Adobe Express and Firefly and compelling offers generated by Experience Cloud applications, leveraging real-time customer profiles in AEP. Conversation in natural language interfaces powered by Sensei gen AI will make it significantly easier for any marketer to derive insights from customer journey analytics and apply these insights in real time to optimize their campaigns. These are just a few of the transformational innovations that Sensei gen AI is bringing to Experience Cloud. Business and innovation highlights include strong demand for Adobe Experience platform and native applications with our book of business now exceeding $500 million. This quarter, we unveiled new capabilities in real-time CDP that will enable brands to scale first-party data with look-alike audiences, significantly accelerating the delivery of personalized experiences. Realtime CDP is used by global brands across industries, including DICK'S Sporting Goods, General Motors, Henkel, Major League Baseball, ServiceNow and TSP Bank; the launch of Adobe Product Analytics, which combines customer journey insights with product analytics to drive a new level of product-led growth; a comprehensive content supply chain solution that connects content creation and delivery across Experience Cloud and Creative Cloud to help enterprises effectively manage their content demands. We're working with partners, including Accenture, IBM, Omnicom and Publicis to scale the delivery of content supply chain to our joint customers. Strong demand for Workfront as it rapidly becomes a solution of choice for teams to plan, orchestrate and launch personalized campaigns at scale. Global availability of Adobe Mix Modeler to provide marketers with an AI-powered, self-service solution to accurately measure campaigns across paid, owned and earned channels. New AI innovations in Adobe Experience Manager, that provide real-time content performance data and predictions on which content will perform best by audience segment. Leadership in industry analyst reports, including the IDC Marketscape for retail commerce platforms and a positive rating in Gartner's annual assessment of Adobe's enterprise strategy. Key customer wins, including DSV, ICICI Bank, JPMorgan, Kroger, Omnicom, Royal Canin, ServiceNow, T-Mobile and Volkswagen. While overall demand is strong and win rates remain healthy, as we enter the second half, we are seeing some projects being pushed out in the current enterprise spend environment, which we have reflected in our updated annual targets. In a world where digital has become the predominant channel to reach and engage customers, Adobe is uniquely positioned to keep winning with innovative products that power end-to-end customer experiences and enable enterprises to simultaneously drive growth and profitability. I'll now pass it to Dan.
Dan Durn: Thanks, Anil. Today, I'll start by summarizing Adobe's performance in Q2 fiscal 2023, highlighting growth drivers across our businesses, and I'll finish with financial targets. Adobe's Q2 results demonstrate strong demand across a diverse portfolio of products from individuals buying through digital channels to the world's largest enterprises. While we grow existing businesses and deliver world-class profitability, Adobe continues to incubate and invest in groundbreaking new technologies that will change how people work and democratize access to our tools. I couldn't be prouder of how Adobe has navigated the current environment and position the company to win. In Q2, Adobe achieved record revenue of $4.82 billion, which represents 10% year-over-year growth or 13% in constant currency. Business and financial highlights included, GAAP diluted earnings per share of $2.82; and non-GAAP diluted earnings per share of $3.91, Digital Media revenue of $3.51 billion, net new Digital Media ARR of $470 million, Digital Experience revenue of $1.22 billion, cash flows from operations of $2.14 billion, RPO of $15.22 billion exiting the quarter; and repurchasing approximately 2.7 million shares of our stock during the quarter. In our Digital Media segment, we achieved Q2 revenue of $3.51 billion, which represents 10% year-over-year growth or 14% in constant currency. We exited the quarter with $14.14 billion of Digital Media ARR, growing 15% year-over-year in constant currency. We achieved Creative revenue of $2.85 billion, which represents 9% year-over-year growth or 14% in constant currency. We added $354 million of net new creative ARR in Q2, with strong digital demand for our offerings throughout the quarter. Second quarter creative growth drivers included, new user growth across geographies, customer segments and creative offerings driven by targeted campaigns and promotions and utilizing insights from our data-driven operating model, strong traffic and conversion on adobe.com, single app subscriptions, including a strong quarter for imaging driven by Everyone Can Photoshop campaign; strong growth in photography driven by accelerated demand for Lightroom mobile, another strong quarter for Adobe Stock and other emerging businesses with exiting ARR for both Frame.io; and Substance growing greater than 50% year-over-year in constant currency; continued success rolling out our new Acrobat CC offering integrated with Sign capabilities; and success in the enterprise as our creative and collaboration solutions continue to see strong adoption. Adobe achieved Document Cloud revenue of $659 million, which represents 11% year-over-year growth or 14% in constant currency. We added $116 million of net new Document Cloud ARR in the quarter, crossing the $2.5 billion milestone with exiting ARR growing 22% year-over-year in constant currency. Second quarter Document Cloud growth drivers included: strong subscription demand for Acrobat with integrated sign capabilities across customer segments and geographies, driven by targeted offers, DDOM Insights and our Acrobat's Got It campaign, success monetizing new customers through the Acrobat web funnel with monthly active users growing greater than 50% year-over-year as our product-led growth strategy continues to perform well, strength in Acrobat mobile downloads, conversion and engagement with liquid mode usage up over 40% year-over-year, and strength in the enterprise, driven by seat expansion. This quarter perpetual sales accounted for less than 5% of Document Cloud revenue. Turning to our Digital Experience segment. In Q2, we achieved revenue of $1.22 billion, which represents 12% year-over-year growth or 14% in constant currency. Q2 subscription revenue was $1.07 billion, which represents 11% year-over-year growth or 14% in constant currency. Second quarter digital experience growth drivers included: strong demand for our Adobe Experience platform and native applications, including real-time CDP, Customer Journey Analytics and Adobe Journey Optimizer. In Q2, subscription revenue for AEP and apps grew more than 60% year-over-year; strength in content and commerce with AEM as a cloud service, seeing significant book of business growth in Q2; customer interest in our content supply chain solution. The value proposition of seamlessly connecting content creation workflows to customer experience management is resonating with enterprises and is driving accelerated growth for Workfront and our content solutions, continued value realization from our solutions leading to strong retention across our customer segments, and momentum selling transformational deals to large enterprises, adopting our platform and end-to-end suite of applications, including T-Mobile and Omnicom. Adobe's effective tax rate in Q2 was 21.5% on a GAAP basis and 18.5% on a non-GAAP basis, in line with our expectations. RPO exiting the quarter was $15.22 billion, growing 10% year-over-year or 13% when adjusting for a 3% FX headwind. Our ending cash and short-term investment position exiting Q2 was $6.60 billion, and cash flows from operations in the quarter were $2.14 billion. In Q2, we entered into a $1 billion share repurchase agreement, and we currently have $4.15 billion remaining on our $15 billion authorization that was granted in December 2020 and goes through the end of fiscal 2024. In light of the momentum across our business and factoring in current macroeconomic conditions and summer seasonality, for Q3, we're targeting, total Adobe revenue of $4.83 billion to $4.87 billion, Digital Media net new ARR of approximately $410 million, Digital Media segment revenue of $3.55 billion to $3.57 billion, Digital Experience segment revenue of $1.21 billion to $1.23 billion, Digital Experience subscription revenue of $1.08 billion to $1.10 billion, tax rate of approximately 21.5% on a GAAP basis and 18.5% on a non-GAAP basis, GAAP earnings per share of $2.82 to $2.88 and non-GAAP earnings per share of $3.95 to $4. Given the company's performance in the first half of the year and our relentless focus on driving disciplined profitable growth, we're raising our annual fiscal 2023 targets for EPS and net new Digital Media ARR. We are also raising our total Adobe revenue target for fiscal 2023 with Digital Media ahead of our previously issued targets and Digital Experience slightly lower. For fiscal 2023, we're now targeting, total Adobe revenue of $19.25 billion to $19.35 billion, Digital Media net new ARR of approximately $1.75 billion, Digital Media segment revenue of $14.10 billion to $14.15 billion, Digital Experience segment revenue of $4.85 billion to $4.90 billion, Digital Experience subscription revenue of $4.30 billion to $4.35 billion, tax rate of approximately 21.5% on a GAAP basis and 18.5% on a non-GAAP basis, GAAP earnings per share of $11.15 to $11.25 and non-GAAP earnings per share of $15.65 to $15.75. In Q4, we expect to see year-end strength in customer demand for Digital Experience and Digital Media solutions. Our updated targets for fiscal 2023 demonstrates solid operating margin expansion in the second half as compared to the second half of fiscal 2022. In summary, I'm extremely pleased with Adobe's performance in the first half of the year. Few companies are capable of delivering strong top and bottom-line growth in a challenging environment, while at the same time, delivering game-changing innovations that will drive the next decade of growth. These innovations are generating strong customer demand for our products, shaping fiscal 2023 to be another wonderful year for Adobe. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. Our strong Q2 results underscore our momentum and the significant opportunities we have across our business. I'm proud of how our employees around the world continue to raise the bar, create the future and live our purpose. We continue to invest in hiring new college grads and interns to bring the best and brightest talent to Adobe. It's an incredibly exciting time at Adobe. Demand for our category-defining products and services continues to grow. Our innovation engine is delivering Adobe Magic for an expanding set of global customers and our strong execution is enabling us to address a massive market opportunity. 2023 is going to be another phenomenal year for Adobe as we continue to deliver top line growth and margins while investing in fundamental technologies that expand Adobe's success for decades. Thank you. We will now take questions. Operator?
Operator: [Operator Instructions] And the first question comes from Michael Turrin with Wells Fargo Securities.
Michael Turrin: Nice job on the results. I mean, obviously, I think starting point is with Firefly. We've been fielding a number of questions just on how this alters the size of the market. You had some useful commentary both on monetization and your views on the market. But can you just add some context around early demand signals and how you're expecting this to show up both on the user side of the market and just the overall velocity of content generation? Thank you.
David Wadhwani: Sure. Happy to talk about that. We're really excited, if you can't tell on the call, about the Firefly and what this represents. The early customer and community response has been absolutely exhilarating for all of us. You heard us talk about over 0.5 billion assets that have already been generated. Generations from Photoshop were 80x higher than we had originally projected going into the beta. And obviously, we feel really good about both the quality of the content being created and also the ability to scale the product to support that. And we have seen incredible social buzz. The Photoshop community is doing what it always does and is using the product, both Firefly and Photoshop, in ways that we didn't even think of when we were initially building the feature set. So it's great to see all this organic development and buzz coming up. And as we talked about, we're also excited about what this means from a business opportunity perspective. On the retention side, we think the value that we add in the flagship applications are going to be great for existing users. In terms of top of funnel, we think that this helps us reach billions of new users because it makes the act of creating more accessible with regard to conversion. We are very excited about what this can mean for new user onboarding, both Photoshop and Illustrator and also in Express that makes the onboarding of new customers especially early success far more achievable for them. It introduces new offers with adobe.com/firefly as a destination that we can monetize and everything that we talked about at Summit last week around what this can be as an enterprise-grade offering. And of course, with all of this, we have an opportunity to sell subscription credit packs for upsell opportunities. So if you net all that out, we see an ARPU opportunity. We see a net number of users opportunity, and also because of retention, an LTV opportunity. Now we expect all of this to play out over many years. We're very focused right now on user acquisition. None of this, we expect to impact our Q3 numbers. And we'll start to see some of it in Q4 but we don't expect it to be material. But as I mentioned, we expect to see it ramp over the next few years. And we'll share more specifics of this in the months ahead.
Michael Turrin: Clearly lots to be excited about there. Thanks.
Operator: And the next question will come from Saket Kalia with Barclays.
Saket Kalia: Okay. Great. Hey, guys. Thanks for taking my question here. Congrats on a great quarter. David, maybe for you. I want to zero in on that point around Firefly and generating billions of potential users in the years ahead. Obviously, still very early with Firefly but as well as Adobe Express. But I'm curious, what are you seeing with Adobe Express and the ability for Firefly to generate some of that demand or pull through some of that demand for Express, both on the consumer side and the enterprise side.
David Wadhwani: Yes. Very excited on both fronts. As you may have seen, we had a beta release of Express last week and this is a massive update to Express. In fact, it's a brand-new product effectively built from the ground up, and we believe this is the product for everyone to use. The response has been absolutely incredible. Broad-based feedback has been overwhelmingly positive, as you mentioned, because of the integration of Firefly, but also how Firefly is able to integrate directly into the user flows and the user journeys for utilization and generation of video content, also for PDF integrations so people are able to bring in and build end-to-end workflows to generate amazing marketing collateral with PDF. We've seen CC users, existing subscribers for CC very excited about the workflows that we've introduced with both Illustrator and Photoshop. Illustrator users are able to take their illustrator output, bring it into Express, add animation and push it out to social. Photoshop users are taking their corpus of Photoshop templates, and they're making that the foundation for easy editing and sharing for their marketing organizations. And that's really been sort of an incredible vote of confidence from everyone that we've seen using the beta, which has also driven the announcements we had last week, specifically around Express and Firefly package together for enterprises. And the interest that we've seen coming out of the announcement in terms of enterprise interest and pipeline generation associated with that has been terrific. And what we're particularly excited about that is it brings our clouds together. So Creative pros are able to create in Photoshop and Illustrator and our other flagship applications. Marketers are able to take that content and edit it more quickly in Express. Both of these are orchestrated through Workfront and Frame.io and they're pushed into AM. So really a core part of our content supply chain. It really feels like an inflection point for Express as well.
Shantanu Narayen: And Saket, maybe if I were to add two things to that. First, I think on the consumer side, with the new Express, if you can imagine it, you can do it. And so I think it's really powerful. And within an enterprise, much like Acrobat, we want every enterprise employee to now have a combination of both Acrobat and Express.
Operator: And our next question will come from Kirk Materne with Evercore ISI.
Kirk Materne: Thanks very much and congrats on the quarter. I guess one, it's probably for David again. David, I was just kind of curious when you think about the enterprise part of the Visual Media business. How, I guess, prepared are customers from a content perspective and a data perspective to take on some of the generative AI capabilities that you guys are bringing to market? And I'm sure this blends into Anil, too, on the Adobe Experience Manager. But I was just wondering if you guys could talk about the data aspect of this and how that interplay might help, frankly, both sides of the Digital Media and the Digital Experience businesses. Thanks.
David Wadhwani: Sure. I'll say a few words and then hand it off to Anil as well. So as we've talked about, Firefly, from the beginning, has a few core principles. The first is the quality of output, right? So text. We have capability of text imaging, text-to-text effect. We have vectors in there now. We're working on video design, 3D generation as well. So we have a series of all this incredible content that we think will be a cornerstone of everything needed for enterprise content velocity. The second thing is that we're building it in a way that we can integrate into existing workflows. We've already started to announce integrations into Photoshop and Illustrator and Express. You'll also start to see us continue those integration points, but you'll also start to see us integrate it more directly into the Digital Experience workflows as well. Third is that and perhaps most importantly, we've also been able to because of the way we share and are transparent about where we get our content, we can tell customers that their content generated with Firefly is commercially safe for use. Copyrights are not being violated. Diversity and inclusion is front and center. Harmful imagery is not being generated. So we're able to give them that confidence. And also, as part of our enterprise plans, give them indemnification for the content that's being created. So those things, I think, fundamentally help them engage that.
Anil Chakravarthy: Just picking up on what you said. I think if you look at Express and Firefly and also the Sensei gen AI services that we announced for Digital Experience, comes at a time when marketing is going through a big shift from sort of mass marketing to personalized marketing at scale. And for the personalization at scale, everything has to be personalized, whether it's content or audiences, customer journeys. And that's the unique advantage we have. We have the data within the Adobe experience platform with the real-time customer profiles. We then have the models that we're working with like Firefly. And then we have the interfaces through the apps like Adobe Campaign, Adobe Experience Manager and so on. So we can put all of that together in a manner that's really consistent with the data governance that customers expect that their data is used only in their context and use that to do personalized marketing at scale. So it really fits very well together.
Shantanu Narayen: Maybe just given how much excitement we have around this, Kirk, three quick things. The first is it really allows for us to, within a company, have every marketer participate in the production and delivery of content. And so agility for an enterprise is great. Second thing maybe I'll add to what both Anil and David said. We can now create custom models. So think of it if you're a company like Coke or a company like Disney and you want to create these campaigns where you want to try out different things. The Firefly model can be customized for them. And that in conjunction with what we have with Express and AEM, really allows it to be tailored for that particular company. I also wanted to just clarify that, that entire go-to-market is completely aligned already within the company. And so we have one enterprise sales force calling on them across Express, Creative Cloud as well as Experience Cloud solutions.
Operator: And our next question will come from Alex Zukin with Wolfe Research.
Unidentified Analyst: This is [indiscernible] on for Alex Zukin. Alex is flying right now, but he says it's good to see who the [indiscernible] winners are. So now to my question, the DM business continues to outperform in an impressive way. Can you talk to some of the underlying levers and stack rank what is driving the strength? Whether it's demand for content, uptake of newer products or cross-selling success? Can you help unpack the layers of success you're seeing? And then just on gen AI, you have announced new offerings with Generative Fill and more recently, Generative Recolor. As you are seeing kind of the traction you are getting online within the creative community, how is it helping inform you about where the greatest monetization opportunity is? Thank you.
David Wadhwani: Sure. Yes, first of all, thanks for the question. Yes, we feel like we're off to a great start for the first half of the year. And as we look at it, the strength was very broad-based. Traffic to adobe.com and top of funnel was strong, frankly, all quarter long. And it's clear that our messaging is resonating well with a broader and broader set of audiences that we can reach. Second, we saw a strong conversion. Our product-led growth investments that we've been making for some time now are starting to pay dividends. Adobe.com is an area we've focused for a long time. We continue to see improvements in terms of customer journey work and conversion. And we've more recently been investing much more significantly in product-led growth motions in our core flagship applications like Photoshop and Acrobat as well. And we've been leveraging a lot of Anil's Digital Experience products that allow us to do personalization at scale in terms of in-product experiences there. And then lastly, it feels like we've really started to see some good inflection in our mobile applications, in particular, Acrobat on mobile and Lightroom mobile performed very well this quarter as well. In addition to that, as Dan mentioned in his opening comments, the emerging products like Substance and Frame continue to grow very nicely and really sort of slipstream into the content supply chain conversation that we're having with enterprise customers. And frankly, enterprise demand for content creation continues to grow. Anil said last week at EMEA Summit that our customers are expecting it to grow 5x in terms of content creation over the next few years. We continue to see more pull for creative apps. And also, we're starting to see enterprises invest much more in Acrobat penetration into their accounts. So they really want more people to have Acrobat from Adobe. So that's just to name a few things. Things are shaping up great for the year, and we're very excited about the direction of the business.
Operator: And our next question will come from Mark Moerdler with Bernstein Research.
Mark Moerdler: Thank you very much and congratulations on the strong quarter and the updated guidance. Dan, can you give us some color on how gen AI is going to impact margins? Especially 0.5 billion assets created just in the beta, the potential for substantial gen AI, once this is all launched, is going to be enormous. How should we think about that?
Dan Durn: Yes. Thanks for the question, Mark. As I reflect on the company's journey, we've got a long history of driving strong profitable growth. We deliver the innovation and the top line progression, but we do it in a very disciplined way, which drives margin and cash flow for investors. I see this playing out in a similar fashion. These are real investments. They are material investments we're making to unlock the magic of the Adobe technology platform and seamlessly integrating it across the product portfolio. When we think about the cost drivers, we think about training, we think about inference, we think about storage costs. The company is ruthlessly prioritizing how we're spending and what projects we're investing in to create a spend envelope to bring this technology to life in a very rapid fashion. You can see the discipline at play. We've been at this for several quarters. You see the strong print from a profitability standpoint in Q1. We followed through with a strong print again in Q2. And we look into the back part of the year, again, you're seeing second half year-over-year, second half over second half, showing an uptick from a profitability standpoint. So we're going to continue to stay focused on being very disciplined, how we prioritize what we do and don't do, and make sure we create the right kind of spend envelope for this technology as we bring it to life. I think it's an statement for us at the company and what we've done for a very long time here. Drive innovation, drive strong top line growth and do it in a very profitable way that's cash flow generative and value creative for investors.
David Wadhwani: Yes. And just I'll add a little bit on to that because we've been working very closely between our engineering organization and the finance organization on a number of levers to make sure that we're managing and keeping discipline and cost front of mind. The first is the model training itself. There are a number of things the team has been doing to optimize our ability to train larger models more efficiently. The second is post training inference optimization. There's a lot of, I think, cutting-edge work coming out here, both in terms of research and the work we're doing around things like pruning and distillation and quantization that make the inference execution much more efficient. Third is, as we've talked about in the past, we're working with folks like NVIDIA to make sure that the hardware and software advances go hand in glove, and we're leveraging more and more compute pathways that are on the chip itself. Four is user experience, making sure that as we expose these things to users, we do it in a way that drives more efficiency in the back end. And of course, the big unlock longer term is about hybrid generative approaches. So how do we move more of this computing to the desktop as well, that will be a major cost benefit down the road. But it's a significant effort and a lot of work to do, and we take it very seriously.
Shantanu Narayen: And Mark, I just wanted to add, in addition to all of that great work that we're doing on saving costs, I'm more excited about the top line growth that this is going to cause for us.
Operator: And our next question will come from Tyler Radke with Citibank.
Tyler Radke: Thanks for taking the question. I wanted to ask about the Document Cloud strength you saw in the quarter. I saw that the business saw a nice improvement relative to last quarter. If you could just unpack that a bit. And then secondly, as I look at the full year outlook, clearly, a really strong quarter, one of the biggest speeds we've seen in years. As I think about Q4, just kind of the initial implied guide, is there anything to call out any one-time factors around pricing we should keep in mind as we compare the year-over-year decline or is that just conservatism?
David Wadhwani: Yes. Maybe I'll talk about the Acrobat business and we can get to Q4 after that. So first of all, yes, another great quarter. It was great to see ARR growing 23%. And a lot of this is the basics of PDF demand, right? We've seen this incredible tailwind with demand for PDF continuing to grow. PDF has become the de facto standard for unstructured data. And PDF-related searches continue to grow. And this as Shantanu mentioned, and I mentioned in the prepared remarks, 30 years after PDF had launched. So it's amazing to see how things are going. We've been investing very heavily in expanding our top of funnel. We have Acrobat Web that's been driving a lot of new users. We've seen good growth directly to Acrobat Web. Acrobat Mobile has also been a source of new opportunity for us. We talked about our extensions in Chrome and Edge. And also we've mentioned in the past, our partnership with Microsoft to really make Acrobat the foundation or PDF and Reader, the foundation of all documents viewed in Edge as well. So that creates an enormous top of funnel for us, and we continue to sort of broaden that. In addition to that, we've been adding more value directly into the products with a proliferation of signatures and collaboration capabilities. And all of that, combined with our product-led growth motion, is driving strong conversion. So we feel really good about the foundation of that business.
Dan Durn: And coming to the guide, Tyler, the way I'd think about it is if we think about the journey to date this fiscal year, we had a strong print in Q1. We had a strong print in Q2. We've got a lot of momentum around this business. As we look into the back half of the year, we see that momentum continuing. We're 2 weeks into Q3. We see that momentum continuing. And as you would expect, we see a strong finish to the year in Q4. And we've got a long track record inside of the company of setting expectations and then executing against those expectations in a way that drives value for investors. And so I think the setup for the back half of the year is no different than that.
Operator: And our next question will come from Matt Swanson with RBC.
Matt Swanson: Yes. Thanks for taking my question. And I'll add my congratulations on the quarter. We've kind of talked from the beginning that a major differentiation point for Firefly is that this is an enterprise-safe generative model. Could you just give us some insights into your customer conversations and really how focused enterprises are around the potential, maybe a copyright or trademark issues that generative could create using other solutions.
Shantanu Narayen: Matt, maybe I'll take that. It's actually been off the chart the interest. We just had our Summit in London, following the successful launch that we had here where customers even in the U.S. were asking us questions. And I would say there are around three areas. All of them had perhaps experimented with other solutions. The moment Adobe came in and said this is both safe and designed for commercially safe as well as we can create the custom models, I think the interest associated with that has been off the charts. We've already created some custom models where we tweak our core model with assets that people can provide us. And that's also a secret sauce that we're unlocking and the integration of that within each of our products. So frankly, the product is not yet available, but the number of customers who want to sign on in terms of wanting to use it has been one of the most successful launches that we've had. And when I say the product is not ready, all I'm saying is it's not generally available. It's certainly available for them to put through their paces within the company.
Matt Swanson: Yes. No, that sounds fantastic. We get the users and the CEOs to agree on the same product. That's a good combination.
Shantanu Narayen: Thank you.
Operator: Our next question comes from Jay Vleeschhouwer with Griffin Securities.
Jay Vleeschhouwer: Thank you. Good evening. Shantanu, at Summit, with the content supply chain news, the company pretty much effectuated something that you've been talking about for the last number of years. That is content supply chain. And the question is about the potential business impact. Could you talk about what is fundamentally new or newly required in terms of pipeline development for that broader concept of implementing Adobe product? What you think the impact might be, for example, in your average book of business that you disclosed with your top 2,500 and top 1,000 customers each year at the analyst meeting? And you do seem to be investing still heavily in consulting capacity. So is that part of the development that you're foreseeing necessary for content supply chain?
Shantanu Narayen: A couple of points, Jay, and then certainly, Anil can add to it. First, I think, we are good user case for what's happening. The reality is that with what David talked about as it relates to product-led growth, what the content supply chain really allows us to do is start with a marketing brief that we're putting within workflow, start to create the campaigns, have AEM and our asset management solution be the place where all of these assets are and then deliver them through campaign as well as deliver them through the Adobe Experience Manager on the website. So I think the interest associated with this is all about trying to say all of the content that we are creating, how do we both make that more efficient as well as understand how we can both globalize, which has been a big driver of why people want this content supply chain. The traditional agencies, I think Anil referred to this. They all have not only, I think, procured our solution for their internal usage but they're also collectively taking this solution to joint customers. So I think it actually just really beautifully aligns within Anil's enterprise sales motion, how we can go with everything from workflow, which actually had a great quarter, so we continue to see good growth in workflow. So I think it aligns all of our offerings. And there isn't one customer that doesn't want. That's partly because of all the additional cost and scrutiny on what the expenses are right now.
Anil Chakravarthy: Yes. We are just so uniquely differentiated across the Creative Cloud and Experience Cloud. And in terms of getting this implemented for customers, as you mentioned, we have now partnerships with Accenture, with IBM, with Omnicom, with Publicis. And all of them are working very closely with us, with our field teams to make sure that the content supply chain gets implemented for every customer across different verticals and geographies, specifically for their needs.
Operator: And our next question will come from Keith Weiss with Morgan Stanley.
Elizabeth Porter: Great. Thank you very much. This is Elizabeth Porter on for Keith Weiss. Congrats on the strong quarter. And my question is again around generative AI. There's clearly a lot of investment and news across the industry. So are there generative AI capabilities that could become table stakes? And what are the areas that drive real differentiation that is monetizable for Adobe? How do you see this market evolving between those two pieces over time where Adobe really solidifies its leadership?
Shantanu Narayen: Yes. I think, for us, the entire generative AI really is all three layers that we talked about. And if you think about our generative AI strategy, it really first starts with do we have unique data that we can use on behalf of our customers for customers. And clearly, both in the creative in the document space with PDF as well as in the marketing space, the amount of data that we have is a key differentiator because that is going to dictate the models when you want to design this to be commercially safe. I think the second thing that we're really focused on is in the domains where we have incredible expertise, whether you consider it imaging or vector or documents or marketing, we are creating our own foundational models. And so when you create the foundation models, you really understand how that works, you understand how you can take it to an enterprise and create a custom model for that. But I think the real differentiator for Adobe continues to be, how does a user get value? And I think it's in the ubiquitous interfaces that we have, whether that's on the marketing side, everything where people are trying to create these campaigns or automate production or create a website or create a mobile app, similarly in documents, which we haven't touched on as much today, how they get the synthesis of the PDF, how they understand the structure of the PDF. And clearly, in creative that we've seen, both with Generative Recolor and Adobe Illustrator as well as Generative Fill in Photoshop. As long as we have the interfaces that delight customers and where all this magic comes to life, that's really, I would say, Adobe is differentiated. And you've seen that. It's not like there weren't other imaging models out there. The fact that we've captured the imagination of the community is a result of how all three of these layers really work well for Adobe better than anybody else.
Jonathan Vaas: Operator, we're right at the top of the hour. Let's take one more question and then we'll conclude.
Operator: Thank you. And that question will come from Brent Thill with Jefferies.
Brent Thill: Thanks. Shantanu, a lot of questions around why won't the DX Cloud give the Creative Cloud the [indiscernible] as well. Why are you confident this won't spill over? And given on the last question, I'll break the operator's policy and asking one for David on, when you think about just the number one question we're all getting, will AI reduce the number of seats available to you. Can you just address that? That's the number one question we continue to get. Thank you.
David Wadhwani: Great. I'll start with the second, and we can go to the first after that. So Brent, if you take a look at Adobe's history, this is what we do, right? If you look at desktop publishing, if you look at creative imaging, if you look at video editing, the result of Adobe's focus here is always about increasing productivity, increasing the importance of these new workflows, and that has always led to an increase in jobs. Let's take video editing as an example, right? We lowered the cost of production in video significantly with our work with Premier and After Effects in Audition. And what that did was it increased the ability for people to create more content. So they didn't create the same amount of content with fewer people. What they did was they found new business opportunities. They created more niche content that led to video streaming and personalization, and that created an explosion in the industry around video production. That's what we do. And we're sitting at a moment where companies are telling us that there's a 5x increase in content production coming out in the next couple of years. And you see a host of new media types coming out. And we see the opportunity here for both seat expansion as a result of this. And also because of the value we're adding into our products themselves, increase in ARPU as well. Now beyond all of this, in terms of professional video and professional content creation, I should say, there's also a massive opportunity because this catalyzes our ability much more effectively to go after the billions of creators around the world who need things like this to be creative. So we're going to help them also create standout content. So again, I take a step back and I say, we have an opportunity to get more people into the franchise. We have the ability to drive more ARPU through our products. And we have the ability to make people more successful and drive more LTV. So the foundation, I think, is very strong.
Shantanu Narayen: And Brent, if I understood the question right, I mean, the interest within the DX customer base for what we are doing on Creative Cloud, if you look at both Summits, the interest associated with how these clouds and offerings are working together is actually one of the catalysts that I think will help both the Digital Media as well as the Digital Experience business. So you're right. I mean, we are finding that every customer is saying, this is the way for us to really go all the way from when we start to create a campaign all the way to the delivery and understanding the analytics associated with that. And I think the enterprise team has really aligned around this joint selling, and we've created a bill of materials where you can actually have both the Digital Experience as well as the Creative Cloud offerings in it. And I think that's what you're going to see. In the second half, we're going to have a lot more of these combined sales that happen with every enterprise because it helps, as we've been saying, with both the top line and the bottom line. And since it was the last question, I mean, let me end by saying it was a great first half. We appreciate all the comments that you have made about the quarter. And I wanted to thank the Adobe team for real great execution as well as, again, congratulate in particular, the Acrobat team for 30 years of amazing innovation. What I'm most proud of is, if you look at just the last few months in terms of what the company has delivered across Firefly and Generative Fill and Generative Recoloring, what's happening with Acrobat across the web, in Digital Experience, the Adobe mix model, product analytics, what we are doing around content supply chain, the new offerings that are coming for an increasing set of customers that will serve real customer problems I think really all goes well for how we will continue to drive innovation and serve customers as well. So I'm really excited about the second half as well as what we're going to continue to do in terms of delivering top line and bottom line growth. And with that, I'll hand it over to Jonathan.
Jonathan Vaas: Thanks, Shantanu, and thanks, everyone, for joining the call. I look forward to speaking with many of you soon, and this concludes the event.
Operator: Thank you. That does conclude today's conference. We do thank you for your participation and have an excellent day. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Q2 FY '23 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jonathan Vaas, Vice President of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's second quarter fiscal year 2023 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, June 15, and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today's press release and in Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant currency growth rates, unless otherwise stated. Reconciliations are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon and thank you for joining us. Adobe had an outstanding quarter, achieving record revenue of $4.82 billion, representing 13% year-over-year growth. GAAP earnings per share for the quarter was $2.82, and non-GAAP earnings per share was $3.91. Our results demonstrate strong demand across Creative Cloud, Document Cloud and Experience Cloud with particular strength in Digital Media ARR. Adobe's mission to change the world through personalized digital experiences is more critical than ever as digital continues to rapidly transform work, life and play. Our groundbreaking innovations, including the new Adobe Express, the launch of Firefly, our family of creative generative AI models, co-pilot functionality in our creative applications, including Photoshop and Illustrator, AI-powered advancements in Acrobat; a new product analytics solution and the latest capabilities in real-time CDP are empowering an ever-expanding customer base to imagine, create and deliver standout content and experiences. We're executing against our strategy to unleash creativity for all, accelerate document productivity and power digital businesses. Every disruptive technology has presented exciting opportunities for Adobe to innovate and increase our addressable market opportunity. This has been true for cloud computing, mobile and AI. We have delivered hundreds of AI innovations through Adobe Sensei such as Neural Filters in Photoshop, Liquid Mode in Acrobat and Customer AI in Adobe Experience Platform. Our ongoing R&D investments have enabled a rapid development and deployment of Firefly, our generative AI technology. We believe generative AI will drive both further accessibility and adoption of our products. Our generative AI strategy focuses on data, models and interfaces. Our rich data sets across creativity, documents and customer experiences, enable us to train models on the highest quality assets. We will build foundation models in the categories where we have deep domain expertise, including imaging, vector, video, documents and marketing. We are bringing generative AI to life as a copilot across our incredible array of interfaces to deliver magic and productivity gains for a broader set of customers. Since its launch in March, Firefly has captured the imagination of the world with over 0.5 billion generations and we're just getting started. Our digital experience business is powering personalized customer engagement for companies around the world, enabling them to drive experience-led growth. We're delivering an innovative product road map and integrating Sensei gen AI services across Experience Cloud. Last week, we hosted a successful EMEA Summit with tremendous excitement from thousands of customers and partners reinforcing that digital is a critical imperative across industries. Adobe's category leadership and mission-critical products will continue to drive our growth. For FY '23, we now expect Creative Cloud and Document Cloud to end the year ahead of our previously issued revenue and ARR targets and Digital Experience to be slightly below our previous annual target given the current enterprise spend environment. As a result of our groundbreaking innovation and continued execution, we are pleased to raise total Adobe annual revenue and EPS targets. David, over to you."
},
{
"speaker": "David Wadhwani",
"text": "Thanks, Shantanu, and hello, everyone. Adobe has long had a mission to unleash creativity for all and today, this is more possible than ever through the power of AI. The introduction of the new Adobe Express and Firefly will go down as a seminal moment in our creative history. These innovative products and our generative AI copilot in our flagship applications will extend our leadership in core creative categories such as imaging, design, video, illustration, animation and 3D as well as attract an increasingly expansive global audience. In Q2, we achieved net new creative ARR of $354 million and revenue of $2.85 billion, which grew 14% year-over-year. We could not be more excited about our generative AI road map that will make Adobe products more accessible to an even larger universe of people, while dramatically enhancing productivity for existing customers. Firefly is attracting tremendous customer interest and is highly differentiated in the market. It is being directly integrated into our product workflows as a copilot to accelerate ideation, exploration and the end-to-end production process. Business and innovation highlights include the beta release of Firefly, Adobe's pioneering family of creative generative AI models and adobe.com/firefly, a destination that allows users to generate and refine content. Firefly's first model is trained on Adobe stock images and other openly licensed content designed to generate commercially viable, professional quality content. Firefly powered capabilities seamlessly integrated into Photoshop are catalyzing a new era of creative power and precision. The viral response to Photoshop's new generative fill copilot has been extraordinary across social media platforms. Users have now generated over 0.5 billion assets on the Firefly website and in Photoshop, making these 2 of our most successful beta releases in company history. Building on this innovation, earlier this week, we announced Generative Recolor in Illustrator, which will similarly serve as a generative AI copilot to millions of designers to iterate and transform Vector Art. We also released an all-new Adobe Express with Firefly generative AI capabilities that revolutionizes how everyone, from students to small business owners to marketers and large organizations, creates and share standout content. Adobe Express brings the magic of our technology from Photoshop, Illustrator, Premiere and Acrobat to combine power and precision with speed and ease. The response to the public beta in particular the groundbreaking video editing capabilities has been overwhelmingly positive. The enterprise version of Adobe Express and Firefly will empower every employee in an organization to participate in the creation of content, campaigns and websites in conjunction with Experience Cloud. New AI-powered text-based editing and automatic tone mapping in Premier Pro makes video editors more productive. An expanded Frame.io platform that now supports collaboration across PDFs and images, in addition to video, increases the value of Adobe's Cross-Cloud content supply chain solution. A major Lightroom mobile update that instantly allows you to access photos from Apple iCloud and Android Gallery empowers our growing base of mobile-first and mobile-only users. Continued momentum with our ecosystem of strategic partners drives awareness of our products and top-of-funnel for Adobe. Google announced that Adobe Firefly will be a premier generative AI partner for Bard, powering text to image capabilities. NVIDIA and Adobe announced that we will collaborate on generative AI optimizations across hardware and software. Apple highlighted how Lightroom will empower users to edit photos on the Vision Pro VR headset at WWDC. Momentum across routes to market and customer segments, including key enterprise customer wins, EY, government of the Philippines, NVIDIA, Omnicom, TAFE, New South Wales and WPP. Our generative AI offerings represent additional customer value as well as multiple new monetization opportunities. First, Firefly will be available both as a standalone freemium offering for consumers as well as an enterprise offering announced last week. Second, copilot generative AI functionality within our flagship applications will drive higher ARPUs and retention. Third, subscription credit packs will be made available for customers who need to generate greater amounts of content. Fourth, we will offer developer communities access to Firefly APIs and allow enterprises the ability to create exclusive custom models with their proprietary content. And finally, the industry partnerships as well as Firefly represent exciting new top-of-funnel acquisition opportunities for Express, Creative Cloud and Document Cloud. Our priority for now is to get Firefly broadly adopted, and we will introduce specific pricing later this year. Now turning to the Document Cloud business. PDF has become the de facto standard for the world's unstructured data, and businesses of all sizes are turning to Adobe to help streamline and automate document-based workflows. Adobe Document Cloud offers a comprehensive set of ubiquitous products to accelerate document productivity across every device by seamlessly integrating PDF services into Acrobat. In Q2, we achieved Document Cloud revenue of $659 million, growing 14% year-over-year. We added $116 million of net new Document Cloud ARR with ending ARR growing 22% year-over-year. Business and innovation highlights include, significant growth in Acrobat web monthly active users, driven by searches for Acrobat verbs and further accelerated by an explosion of PDF consumption through our Chrome and Edge extensions; viral adoption of PDF collaboration services, which are both increasing active use among existing users and creating a growth loop to bring new users into the Acrobat ecosystem. Mobile momentum across both App Store downloads as well as documents consumed in liquid mode. New workflows between Acrobat and Express allow users to integrate documents seamlessly into their creative process. Express now has full fidelity PDF import and editing, which allows users to make documents visually stunning; momentum across routes to market and customer segments, including key enterprise customer wins, Boston Consulting Group, Cushman & Wakefield, Novartis, T-Mobile and WPP. Today marks the 30th anniversary of Acrobat, a significant milestone that is both inspiring and humbling. PDF and Acrobat are more relevant today than ever before. We are incredibly proud of how PDF continues to transform the world of digital documents, powering communication and productivity for billions of people every day and we know that the best is yet to come. The pending acquisition of Figma will further expand our addressable market, and we have been delighted to hear from customers, partners and industry analysts who are excited about the benefits that the combination will unlock. We continue to engage in conversations with the Competition and Markets Authority in the U.K., the European Commission and the U.S. Department of Justice as they conduct their regulatory reviews and given the merits of the case, we believe the transaction should close by the end of 2023. Adobe's Digital Media business is on a roll. We're rapidly delivering groundbreaking innovations across Creative Cloud and Document Cloud. Our increasing breadth of offerings is reaching a broader universe of customers, and our incredible go-to-market strength and proven data-driven operating model are propelling the growth of both our emerging and established businesses. Given the momentum, we are raising our net new Digital Media ARR and revenue targets for fiscal '23. I'll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello, everyone. In Q2, we continued to drive strong growth in our Experience Cloud business, achieving $1.22 billion in revenue. Subscription revenue was $1.07 billion, representing 14% year-over-year growth. Customer interest in the digital experience category remains high. Last week, we were excited to spend time with thousands of customers and partners at EMEA Summit. Businesses of all sizes and industries around the world are increasingly relying on digital channels to engage customers and deliver experience-led growth and they are turning to Adobe as their trusted partner on that journey. Adobe Experience Cloud offers the most comprehensive set of solutions for content and commerce, data insights and audiences, customer journeys and marketing workflows. Built natively on Adobe Experience platform, our real-time customer data platform provides businesses with a single view of their customers' data across every channel. Real-time CDP now delivers over 600 billion predictive insights each year, and customers are creating over 30 trillion audience segments every day. Experience Cloud is now used by 87% of Fortune 100 companies. For example, Prudential Financial uses our cross-cloud offerings to power its end-to-end customer experience management workflows from creating high-impact content with Creative Cloud and Express to delivering personalized customer experiences at scale with Adobe Experience Platform. In addition, Prada is using real-time CDP and Journey optimizer to connect digital and in-store customer experiences in real time while reimagining shopping experiences using Substance 3D. Our vision for Experience Cloud is to deliver personalized experiences at scale, and the power of generative AI accelerates our ability to do that. We are delivering Sensei gen AI innovations to reimagine the work marketers do and how they do it. With Sensei gen AI as their copilot, marketers can generate audiences with high position and design tailored customer journeys for these audiences. They can activate personalized campaigns for their audiences with on-brand visual content created with Adobe Express and Firefly and compelling offers generated by Experience Cloud applications, leveraging real-time customer profiles in AEP. Conversation in natural language interfaces powered by Sensei gen AI will make it significantly easier for any marketer to derive insights from customer journey analytics and apply these insights in real time to optimize their campaigns. These are just a few of the transformational innovations that Sensei gen AI is bringing to Experience Cloud. Business and innovation highlights include strong demand for Adobe Experience platform and native applications with our book of business now exceeding $500 million. This quarter, we unveiled new capabilities in real-time CDP that will enable brands to scale first-party data with look-alike audiences, significantly accelerating the delivery of personalized experiences. Realtime CDP is used by global brands across industries, including DICK'S Sporting Goods, General Motors, Henkel, Major League Baseball, ServiceNow and TSP Bank; the launch of Adobe Product Analytics, which combines customer journey insights with product analytics to drive a new level of product-led growth; a comprehensive content supply chain solution that connects content creation and delivery across Experience Cloud and Creative Cloud to help enterprises effectively manage their content demands. We're working with partners, including Accenture, IBM, Omnicom and Publicis to scale the delivery of content supply chain to our joint customers. Strong demand for Workfront as it rapidly becomes a solution of choice for teams to plan, orchestrate and launch personalized campaigns at scale. Global availability of Adobe Mix Modeler to provide marketers with an AI-powered, self-service solution to accurately measure campaigns across paid, owned and earned channels. New AI innovations in Adobe Experience Manager, that provide real-time content performance data and predictions on which content will perform best by audience segment. Leadership in industry analyst reports, including the IDC Marketscape for retail commerce platforms and a positive rating in Gartner's annual assessment of Adobe's enterprise strategy. Key customer wins, including DSV, ICICI Bank, JPMorgan, Kroger, Omnicom, Royal Canin, ServiceNow, T-Mobile and Volkswagen. While overall demand is strong and win rates remain healthy, as we enter the second half, we are seeing some projects being pushed out in the current enterprise spend environment, which we have reflected in our updated annual targets. In a world where digital has become the predominant channel to reach and engage customers, Adobe is uniquely positioned to keep winning with innovative products that power end-to-end customer experiences and enable enterprises to simultaneously drive growth and profitability. I'll now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Today, I'll start by summarizing Adobe's performance in Q2 fiscal 2023, highlighting growth drivers across our businesses, and I'll finish with financial targets. Adobe's Q2 results demonstrate strong demand across a diverse portfolio of products from individuals buying through digital channels to the world's largest enterprises. While we grow existing businesses and deliver world-class profitability, Adobe continues to incubate and invest in groundbreaking new technologies that will change how people work and democratize access to our tools. I couldn't be prouder of how Adobe has navigated the current environment and position the company to win. In Q2, Adobe achieved record revenue of $4.82 billion, which represents 10% year-over-year growth or 13% in constant currency. Business and financial highlights included, GAAP diluted earnings per share of $2.82; and non-GAAP diluted earnings per share of $3.91, Digital Media revenue of $3.51 billion, net new Digital Media ARR of $470 million, Digital Experience revenue of $1.22 billion, cash flows from operations of $2.14 billion, RPO of $15.22 billion exiting the quarter; and repurchasing approximately 2.7 million shares of our stock during the quarter. In our Digital Media segment, we achieved Q2 revenue of $3.51 billion, which represents 10% year-over-year growth or 14% in constant currency. We exited the quarter with $14.14 billion of Digital Media ARR, growing 15% year-over-year in constant currency. We achieved Creative revenue of $2.85 billion, which represents 9% year-over-year growth or 14% in constant currency. We added $354 million of net new creative ARR in Q2, with strong digital demand for our offerings throughout the quarter. Second quarter creative growth drivers included, new user growth across geographies, customer segments and creative offerings driven by targeted campaigns and promotions and utilizing insights from our data-driven operating model, strong traffic and conversion on adobe.com, single app subscriptions, including a strong quarter for imaging driven by Everyone Can Photoshop campaign; strong growth in photography driven by accelerated demand for Lightroom mobile, another strong quarter for Adobe Stock and other emerging businesses with exiting ARR for both Frame.io; and Substance growing greater than 50% year-over-year in constant currency; continued success rolling out our new Acrobat CC offering integrated with Sign capabilities; and success in the enterprise as our creative and collaboration solutions continue to see strong adoption. Adobe achieved Document Cloud revenue of $659 million, which represents 11% year-over-year growth or 14% in constant currency. We added $116 million of net new Document Cloud ARR in the quarter, crossing the $2.5 billion milestone with exiting ARR growing 22% year-over-year in constant currency. Second quarter Document Cloud growth drivers included: strong subscription demand for Acrobat with integrated sign capabilities across customer segments and geographies, driven by targeted offers, DDOM Insights and our Acrobat's Got It campaign, success monetizing new customers through the Acrobat web funnel with monthly active users growing greater than 50% year-over-year as our product-led growth strategy continues to perform well, strength in Acrobat mobile downloads, conversion and engagement with liquid mode usage up over 40% year-over-year, and strength in the enterprise, driven by seat expansion. This quarter perpetual sales accounted for less than 5% of Document Cloud revenue. Turning to our Digital Experience segment. In Q2, we achieved revenue of $1.22 billion, which represents 12% year-over-year growth or 14% in constant currency. Q2 subscription revenue was $1.07 billion, which represents 11% year-over-year growth or 14% in constant currency. Second quarter digital experience growth drivers included: strong demand for our Adobe Experience platform and native applications, including real-time CDP, Customer Journey Analytics and Adobe Journey Optimizer. In Q2, subscription revenue for AEP and apps grew more than 60% year-over-year; strength in content and commerce with AEM as a cloud service, seeing significant book of business growth in Q2; customer interest in our content supply chain solution. The value proposition of seamlessly connecting content creation workflows to customer experience management is resonating with enterprises and is driving accelerated growth for Workfront and our content solutions, continued value realization from our solutions leading to strong retention across our customer segments, and momentum selling transformational deals to large enterprises, adopting our platform and end-to-end suite of applications, including T-Mobile and Omnicom. Adobe's effective tax rate in Q2 was 21.5% on a GAAP basis and 18.5% on a non-GAAP basis, in line with our expectations. RPO exiting the quarter was $15.22 billion, growing 10% year-over-year or 13% when adjusting for a 3% FX headwind. Our ending cash and short-term investment position exiting Q2 was $6.60 billion, and cash flows from operations in the quarter were $2.14 billion. In Q2, we entered into a $1 billion share repurchase agreement, and we currently have $4.15 billion remaining on our $15 billion authorization that was granted in December 2020 and goes through the end of fiscal 2024. In light of the momentum across our business and factoring in current macroeconomic conditions and summer seasonality, for Q3, we're targeting, total Adobe revenue of $4.83 billion to $4.87 billion, Digital Media net new ARR of approximately $410 million, Digital Media segment revenue of $3.55 billion to $3.57 billion, Digital Experience segment revenue of $1.21 billion to $1.23 billion, Digital Experience subscription revenue of $1.08 billion to $1.10 billion, tax rate of approximately 21.5% on a GAAP basis and 18.5% on a non-GAAP basis, GAAP earnings per share of $2.82 to $2.88 and non-GAAP earnings per share of $3.95 to $4. Given the company's performance in the first half of the year and our relentless focus on driving disciplined profitable growth, we're raising our annual fiscal 2023 targets for EPS and net new Digital Media ARR. We are also raising our total Adobe revenue target for fiscal 2023 with Digital Media ahead of our previously issued targets and Digital Experience slightly lower. For fiscal 2023, we're now targeting, total Adobe revenue of $19.25 billion to $19.35 billion, Digital Media net new ARR of approximately $1.75 billion, Digital Media segment revenue of $14.10 billion to $14.15 billion, Digital Experience segment revenue of $4.85 billion to $4.90 billion, Digital Experience subscription revenue of $4.30 billion to $4.35 billion, tax rate of approximately 21.5% on a GAAP basis and 18.5% on a non-GAAP basis, GAAP earnings per share of $11.15 to $11.25 and non-GAAP earnings per share of $15.65 to $15.75. In Q4, we expect to see year-end strength in customer demand for Digital Experience and Digital Media solutions. Our updated targets for fiscal 2023 demonstrates solid operating margin expansion in the second half as compared to the second half of fiscal 2022. In summary, I'm extremely pleased with Adobe's performance in the first half of the year. Few companies are capable of delivering strong top and bottom-line growth in a challenging environment, while at the same time, delivering game-changing innovations that will drive the next decade of growth. These innovations are generating strong customer demand for our products, shaping fiscal 2023 to be another wonderful year for Adobe. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. Our strong Q2 results underscore our momentum and the significant opportunities we have across our business. I'm proud of how our employees around the world continue to raise the bar, create the future and live our purpose. We continue to invest in hiring new college grads and interns to bring the best and brightest talent to Adobe. It's an incredibly exciting time at Adobe. Demand for our category-defining products and services continues to grow. Our innovation engine is delivering Adobe Magic for an expanding set of global customers and our strong execution is enabling us to address a massive market opportunity. 2023 is going to be another phenomenal year for Adobe as we continue to deliver top line growth and margins while investing in fundamental technologies that expand Adobe's success for decades. Thank you. We will now take questions. Operator?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And the first question comes from Michael Turrin with Wells Fargo Securities."
},
{
"speaker": "Michael Turrin",
"text": "Nice job on the results. I mean, obviously, I think starting point is with Firefly. We've been fielding a number of questions just on how this alters the size of the market. You had some useful commentary both on monetization and your views on the market. But can you just add some context around early demand signals and how you're expecting this to show up both on the user side of the market and just the overall velocity of content generation? Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Sure. Happy to talk about that. We're really excited, if you can't tell on the call, about the Firefly and what this represents. The early customer and community response has been absolutely exhilarating for all of us. You heard us talk about over 0.5 billion assets that have already been generated. Generations from Photoshop were 80x higher than we had originally projected going into the beta. And obviously, we feel really good about both the quality of the content being created and also the ability to scale the product to support that. And we have seen incredible social buzz. The Photoshop community is doing what it always does and is using the product, both Firefly and Photoshop, in ways that we didn't even think of when we were initially building the feature set. So it's great to see all this organic development and buzz coming up. And as we talked about, we're also excited about what this means from a business opportunity perspective. On the retention side, we think the value that we add in the flagship applications are going to be great for existing users. In terms of top of funnel, we think that this helps us reach billions of new users because it makes the act of creating more accessible with regard to conversion. We are very excited about what this can mean for new user onboarding, both Photoshop and Illustrator and also in Express that makes the onboarding of new customers especially early success far more achievable for them. It introduces new offers with adobe.com/firefly as a destination that we can monetize and everything that we talked about at Summit last week around what this can be as an enterprise-grade offering. And of course, with all of this, we have an opportunity to sell subscription credit packs for upsell opportunities. So if you net all that out, we see an ARPU opportunity. We see a net number of users opportunity, and also because of retention, an LTV opportunity. Now we expect all of this to play out over many years. We're very focused right now on user acquisition. None of this, we expect to impact our Q3 numbers. And we'll start to see some of it in Q4 but we don't expect it to be material. But as I mentioned, we expect to see it ramp over the next few years. And we'll share more specifics of this in the months ahead."
},
{
"speaker": "Michael Turrin",
"text": "Clearly lots to be excited about there. Thanks."
},
{
"speaker": "Operator",
"text": "And the next question will come from Saket Kalia with Barclays."
},
{
"speaker": "Saket Kalia",
"text": "Okay. Great. Hey, guys. Thanks for taking my question here. Congrats on a great quarter. David, maybe for you. I want to zero in on that point around Firefly and generating billions of potential users in the years ahead. Obviously, still very early with Firefly but as well as Adobe Express. But I'm curious, what are you seeing with Adobe Express and the ability for Firefly to generate some of that demand or pull through some of that demand for Express, both on the consumer side and the enterprise side."
},
{
"speaker": "David Wadhwani",
"text": "Yes. Very excited on both fronts. As you may have seen, we had a beta release of Express last week and this is a massive update to Express. In fact, it's a brand-new product effectively built from the ground up, and we believe this is the product for everyone to use. The response has been absolutely incredible. Broad-based feedback has been overwhelmingly positive, as you mentioned, because of the integration of Firefly, but also how Firefly is able to integrate directly into the user flows and the user journeys for utilization and generation of video content, also for PDF integrations so people are able to bring in and build end-to-end workflows to generate amazing marketing collateral with PDF. We've seen CC users, existing subscribers for CC very excited about the workflows that we've introduced with both Illustrator and Photoshop. Illustrator users are able to take their illustrator output, bring it into Express, add animation and push it out to social. Photoshop users are taking their corpus of Photoshop templates, and they're making that the foundation for easy editing and sharing for their marketing organizations. And that's really been sort of an incredible vote of confidence from everyone that we've seen using the beta, which has also driven the announcements we had last week, specifically around Express and Firefly package together for enterprises. And the interest that we've seen coming out of the announcement in terms of enterprise interest and pipeline generation associated with that has been terrific. And what we're particularly excited about that is it brings our clouds together. So Creative pros are able to create in Photoshop and Illustrator and our other flagship applications. Marketers are able to take that content and edit it more quickly in Express. Both of these are orchestrated through Workfront and Frame.io and they're pushed into AM. So really a core part of our content supply chain. It really feels like an inflection point for Express as well."
},
{
"speaker": "Shantanu Narayen",
"text": "And Saket, maybe if I were to add two things to that. First, I think on the consumer side, with the new Express, if you can imagine it, you can do it. And so I think it's really powerful. And within an enterprise, much like Acrobat, we want every enterprise employee to now have a combination of both Acrobat and Express."
},
{
"speaker": "Operator",
"text": "And our next question will come from Kirk Materne with Evercore ISI."
},
{
"speaker": "Kirk Materne",
"text": "Thanks very much and congrats on the quarter. I guess one, it's probably for David again. David, I was just kind of curious when you think about the enterprise part of the Visual Media business. How, I guess, prepared are customers from a content perspective and a data perspective to take on some of the generative AI capabilities that you guys are bringing to market? And I'm sure this blends into Anil, too, on the Adobe Experience Manager. But I was just wondering if you guys could talk about the data aspect of this and how that interplay might help, frankly, both sides of the Digital Media and the Digital Experience businesses. Thanks."
},
{
"speaker": "David Wadhwani",
"text": "Sure. I'll say a few words and then hand it off to Anil as well. So as we've talked about, Firefly, from the beginning, has a few core principles. The first is the quality of output, right? So text. We have capability of text imaging, text-to-text effect. We have vectors in there now. We're working on video design, 3D generation as well. So we have a series of all this incredible content that we think will be a cornerstone of everything needed for enterprise content velocity. The second thing is that we're building it in a way that we can integrate into existing workflows. We've already started to announce integrations into Photoshop and Illustrator and Express. You'll also start to see us continue those integration points, but you'll also start to see us integrate it more directly into the Digital Experience workflows as well. Third is that and perhaps most importantly, we've also been able to because of the way we share and are transparent about where we get our content, we can tell customers that their content generated with Firefly is commercially safe for use. Copyrights are not being violated. Diversity and inclusion is front and center. Harmful imagery is not being generated. So we're able to give them that confidence. And also, as part of our enterprise plans, give them indemnification for the content that's being created. So those things, I think, fundamentally help them engage that."
},
{
"speaker": "Anil Chakravarthy",
"text": "Just picking up on what you said. I think if you look at Express and Firefly and also the Sensei gen AI services that we announced for Digital Experience, comes at a time when marketing is going through a big shift from sort of mass marketing to personalized marketing at scale. And for the personalization at scale, everything has to be personalized, whether it's content or audiences, customer journeys. And that's the unique advantage we have. We have the data within the Adobe experience platform with the real-time customer profiles. We then have the models that we're working with like Firefly. And then we have the interfaces through the apps like Adobe Campaign, Adobe Experience Manager and so on. So we can put all of that together in a manner that's really consistent with the data governance that customers expect that their data is used only in their context and use that to do personalized marketing at scale. So it really fits very well together."
},
{
"speaker": "Shantanu Narayen",
"text": "Maybe just given how much excitement we have around this, Kirk, three quick things. The first is it really allows for us to, within a company, have every marketer participate in the production and delivery of content. And so agility for an enterprise is great. Second thing maybe I'll add to what both Anil and David said. We can now create custom models. So think of it if you're a company like Coke or a company like Disney and you want to create these campaigns where you want to try out different things. The Firefly model can be customized for them. And that in conjunction with what we have with Express and AEM, really allows it to be tailored for that particular company. I also wanted to just clarify that, that entire go-to-market is completely aligned already within the company. And so we have one enterprise sales force calling on them across Express, Creative Cloud as well as Experience Cloud solutions."
},
{
"speaker": "Operator",
"text": "And our next question will come from Alex Zukin with Wolfe Research."
},
{
"speaker": "Unidentified Analyst",
"text": "This is [indiscernible] on for Alex Zukin. Alex is flying right now, but he says it's good to see who the [indiscernible] winners are. So now to my question, the DM business continues to outperform in an impressive way. Can you talk to some of the underlying levers and stack rank what is driving the strength? Whether it's demand for content, uptake of newer products or cross-selling success? Can you help unpack the layers of success you're seeing? And then just on gen AI, you have announced new offerings with Generative Fill and more recently, Generative Recolor. As you are seeing kind of the traction you are getting online within the creative community, how is it helping inform you about where the greatest monetization opportunity is? Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Sure. Yes, first of all, thanks for the question. Yes, we feel like we're off to a great start for the first half of the year. And as we look at it, the strength was very broad-based. Traffic to adobe.com and top of funnel was strong, frankly, all quarter long. And it's clear that our messaging is resonating well with a broader and broader set of audiences that we can reach. Second, we saw a strong conversion. Our product-led growth investments that we've been making for some time now are starting to pay dividends. Adobe.com is an area we've focused for a long time. We continue to see improvements in terms of customer journey work and conversion. And we've more recently been investing much more significantly in product-led growth motions in our core flagship applications like Photoshop and Acrobat as well. And we've been leveraging a lot of Anil's Digital Experience products that allow us to do personalization at scale in terms of in-product experiences there. And then lastly, it feels like we've really started to see some good inflection in our mobile applications, in particular, Acrobat on mobile and Lightroom mobile performed very well this quarter as well. In addition to that, as Dan mentioned in his opening comments, the emerging products like Substance and Frame continue to grow very nicely and really sort of slipstream into the content supply chain conversation that we're having with enterprise customers. And frankly, enterprise demand for content creation continues to grow. Anil said last week at EMEA Summit that our customers are expecting it to grow 5x in terms of content creation over the next few years. We continue to see more pull for creative apps. And also, we're starting to see enterprises invest much more in Acrobat penetration into their accounts. So they really want more people to have Acrobat from Adobe. So that's just to name a few things. Things are shaping up great for the year, and we're very excited about the direction of the business."
},
{
"speaker": "Operator",
"text": "And our next question will come from Mark Moerdler with Bernstein Research."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you very much and congratulations on the strong quarter and the updated guidance. Dan, can you give us some color on how gen AI is going to impact margins? Especially 0.5 billion assets created just in the beta, the potential for substantial gen AI, once this is all launched, is going to be enormous. How should we think about that?"
},
{
"speaker": "Dan Durn",
"text": "Yes. Thanks for the question, Mark. As I reflect on the company's journey, we've got a long history of driving strong profitable growth. We deliver the innovation and the top line progression, but we do it in a very disciplined way, which drives margin and cash flow for investors. I see this playing out in a similar fashion. These are real investments. They are material investments we're making to unlock the magic of the Adobe technology platform and seamlessly integrating it across the product portfolio. When we think about the cost drivers, we think about training, we think about inference, we think about storage costs. The company is ruthlessly prioritizing how we're spending and what projects we're investing in to create a spend envelope to bring this technology to life in a very rapid fashion. You can see the discipline at play. We've been at this for several quarters. You see the strong print from a profitability standpoint in Q1. We followed through with a strong print again in Q2. And we look into the back part of the year, again, you're seeing second half year-over-year, second half over second half, showing an uptick from a profitability standpoint. So we're going to continue to stay focused on being very disciplined, how we prioritize what we do and don't do, and make sure we create the right kind of spend envelope for this technology as we bring it to life. I think it's an statement for us at the company and what we've done for a very long time here. Drive innovation, drive strong top line growth and do it in a very profitable way that's cash flow generative and value creative for investors."
},
{
"speaker": "David Wadhwani",
"text": "Yes. And just I'll add a little bit on to that because we've been working very closely between our engineering organization and the finance organization on a number of levers to make sure that we're managing and keeping discipline and cost front of mind. The first is the model training itself. There are a number of things the team has been doing to optimize our ability to train larger models more efficiently. The second is post training inference optimization. There's a lot of, I think, cutting-edge work coming out here, both in terms of research and the work we're doing around things like pruning and distillation and quantization that make the inference execution much more efficient. Third is, as we've talked about in the past, we're working with folks like NVIDIA to make sure that the hardware and software advances go hand in glove, and we're leveraging more and more compute pathways that are on the chip itself. Four is user experience, making sure that as we expose these things to users, we do it in a way that drives more efficiency in the back end. And of course, the big unlock longer term is about hybrid generative approaches. So how do we move more of this computing to the desktop as well, that will be a major cost benefit down the road. But it's a significant effort and a lot of work to do, and we take it very seriously."
},
{
"speaker": "Shantanu Narayen",
"text": "And Mark, I just wanted to add, in addition to all of that great work that we're doing on saving costs, I'm more excited about the top line growth that this is going to cause for us."
},
{
"speaker": "Operator",
"text": "And our next question will come from Tyler Radke with Citibank."
},
{
"speaker": "Tyler Radke",
"text": "Thanks for taking the question. I wanted to ask about the Document Cloud strength you saw in the quarter. I saw that the business saw a nice improvement relative to last quarter. If you could just unpack that a bit. And then secondly, as I look at the full year outlook, clearly, a really strong quarter, one of the biggest speeds we've seen in years. As I think about Q4, just kind of the initial implied guide, is there anything to call out any one-time factors around pricing we should keep in mind as we compare the year-over-year decline or is that just conservatism?"
},
{
"speaker": "David Wadhwani",
"text": "Yes. Maybe I'll talk about the Acrobat business and we can get to Q4 after that. So first of all, yes, another great quarter. It was great to see ARR growing 23%. And a lot of this is the basics of PDF demand, right? We've seen this incredible tailwind with demand for PDF continuing to grow. PDF has become the de facto standard for unstructured data. And PDF-related searches continue to grow. And this as Shantanu mentioned, and I mentioned in the prepared remarks, 30 years after PDF had launched. So it's amazing to see how things are going. We've been investing very heavily in expanding our top of funnel. We have Acrobat Web that's been driving a lot of new users. We've seen good growth directly to Acrobat Web. Acrobat Mobile has also been a source of new opportunity for us. We talked about our extensions in Chrome and Edge. And also we've mentioned in the past, our partnership with Microsoft to really make Acrobat the foundation or PDF and Reader, the foundation of all documents viewed in Edge as well. So that creates an enormous top of funnel for us, and we continue to sort of broaden that. In addition to that, we've been adding more value directly into the products with a proliferation of signatures and collaboration capabilities. And all of that, combined with our product-led growth motion, is driving strong conversion. So we feel really good about the foundation of that business."
},
{
"speaker": "Dan Durn",
"text": "And coming to the guide, Tyler, the way I'd think about it is if we think about the journey to date this fiscal year, we had a strong print in Q1. We had a strong print in Q2. We've got a lot of momentum around this business. As we look into the back half of the year, we see that momentum continuing. We're 2 weeks into Q3. We see that momentum continuing. And as you would expect, we see a strong finish to the year in Q4. And we've got a long track record inside of the company of setting expectations and then executing against those expectations in a way that drives value for investors. And so I think the setup for the back half of the year is no different than that."
},
{
"speaker": "Operator",
"text": "And our next question will come from Matt Swanson with RBC."
},
{
"speaker": "Matt Swanson",
"text": "Yes. Thanks for taking my question. And I'll add my congratulations on the quarter. We've kind of talked from the beginning that a major differentiation point for Firefly is that this is an enterprise-safe generative model. Could you just give us some insights into your customer conversations and really how focused enterprises are around the potential, maybe a copyright or trademark issues that generative could create using other solutions."
},
{
"speaker": "Shantanu Narayen",
"text": "Matt, maybe I'll take that. It's actually been off the chart the interest. We just had our Summit in London, following the successful launch that we had here where customers even in the U.S. were asking us questions. And I would say there are around three areas. All of them had perhaps experimented with other solutions. The moment Adobe came in and said this is both safe and designed for commercially safe as well as we can create the custom models, I think the interest associated with that has been off the charts. We've already created some custom models where we tweak our core model with assets that people can provide us. And that's also a secret sauce that we're unlocking and the integration of that within each of our products. So frankly, the product is not yet available, but the number of customers who want to sign on in terms of wanting to use it has been one of the most successful launches that we've had. And when I say the product is not ready, all I'm saying is it's not generally available. It's certainly available for them to put through their paces within the company."
},
{
"speaker": "Matt Swanson",
"text": "Yes. No, that sounds fantastic. We get the users and the CEOs to agree on the same product. That's a good combination."
},
{
"speaker": "Shantanu Narayen",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Jay Vleeschhouwer with Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. Shantanu, at Summit, with the content supply chain news, the company pretty much effectuated something that you've been talking about for the last number of years. That is content supply chain. And the question is about the potential business impact. Could you talk about what is fundamentally new or newly required in terms of pipeline development for that broader concept of implementing Adobe product? What you think the impact might be, for example, in your average book of business that you disclosed with your top 2,500 and top 1,000 customers each year at the analyst meeting? And you do seem to be investing still heavily in consulting capacity. So is that part of the development that you're foreseeing necessary for content supply chain?"
},
{
"speaker": "Shantanu Narayen",
"text": "A couple of points, Jay, and then certainly, Anil can add to it. First, I think, we are good user case for what's happening. The reality is that with what David talked about as it relates to product-led growth, what the content supply chain really allows us to do is start with a marketing brief that we're putting within workflow, start to create the campaigns, have AEM and our asset management solution be the place where all of these assets are and then deliver them through campaign as well as deliver them through the Adobe Experience Manager on the website. So I think the interest associated with this is all about trying to say all of the content that we are creating, how do we both make that more efficient as well as understand how we can both globalize, which has been a big driver of why people want this content supply chain. The traditional agencies, I think Anil referred to this. They all have not only, I think, procured our solution for their internal usage but they're also collectively taking this solution to joint customers. So I think it actually just really beautifully aligns within Anil's enterprise sales motion, how we can go with everything from workflow, which actually had a great quarter, so we continue to see good growth in workflow. So I think it aligns all of our offerings. And there isn't one customer that doesn't want. That's partly because of all the additional cost and scrutiny on what the expenses are right now."
},
{
"speaker": "Anil Chakravarthy",
"text": "Yes. We are just so uniquely differentiated across the Creative Cloud and Experience Cloud. And in terms of getting this implemented for customers, as you mentioned, we have now partnerships with Accenture, with IBM, with Omnicom, with Publicis. And all of them are working very closely with us, with our field teams to make sure that the content supply chain gets implemented for every customer across different verticals and geographies, specifically for their needs."
},
{
"speaker": "Operator",
"text": "And our next question will come from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Elizabeth Porter",
"text": "Great. Thank you very much. This is Elizabeth Porter on for Keith Weiss. Congrats on the strong quarter. And my question is again around generative AI. There's clearly a lot of investment and news across the industry. So are there generative AI capabilities that could become table stakes? And what are the areas that drive real differentiation that is monetizable for Adobe? How do you see this market evolving between those two pieces over time where Adobe really solidifies its leadership?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. I think, for us, the entire generative AI really is all three layers that we talked about. And if you think about our generative AI strategy, it really first starts with do we have unique data that we can use on behalf of our customers for customers. And clearly, both in the creative in the document space with PDF as well as in the marketing space, the amount of data that we have is a key differentiator because that is going to dictate the models when you want to design this to be commercially safe. I think the second thing that we're really focused on is in the domains where we have incredible expertise, whether you consider it imaging or vector or documents or marketing, we are creating our own foundational models. And so when you create the foundation models, you really understand how that works, you understand how you can take it to an enterprise and create a custom model for that. But I think the real differentiator for Adobe continues to be, how does a user get value? And I think it's in the ubiquitous interfaces that we have, whether that's on the marketing side, everything where people are trying to create these campaigns or automate production or create a website or create a mobile app, similarly in documents, which we haven't touched on as much today, how they get the synthesis of the PDF, how they understand the structure of the PDF. And clearly, in creative that we've seen, both with Generative Recolor and Adobe Illustrator as well as Generative Fill in Photoshop. As long as we have the interfaces that delight customers and where all this magic comes to life, that's really, I would say, Adobe is differentiated. And you've seen that. It's not like there weren't other imaging models out there. The fact that we've captured the imagination of the community is a result of how all three of these layers really work well for Adobe better than anybody else."
},
{
"speaker": "Jonathan Vaas",
"text": "Operator, we're right at the top of the hour. Let's take one more question and then we'll conclude."
},
{
"speaker": "Operator",
"text": "Thank you. And that question will come from Brent Thill with Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Thanks. Shantanu, a lot of questions around why won't the DX Cloud give the Creative Cloud the [indiscernible] as well. Why are you confident this won't spill over? And given on the last question, I'll break the operator's policy and asking one for David on, when you think about just the number one question we're all getting, will AI reduce the number of seats available to you. Can you just address that? That's the number one question we continue to get. Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Great. I'll start with the second, and we can go to the first after that. So Brent, if you take a look at Adobe's history, this is what we do, right? If you look at desktop publishing, if you look at creative imaging, if you look at video editing, the result of Adobe's focus here is always about increasing productivity, increasing the importance of these new workflows, and that has always led to an increase in jobs. Let's take video editing as an example, right? We lowered the cost of production in video significantly with our work with Premier and After Effects in Audition. And what that did was it increased the ability for people to create more content. So they didn't create the same amount of content with fewer people. What they did was they found new business opportunities. They created more niche content that led to video streaming and personalization, and that created an explosion in the industry around video production. That's what we do. And we're sitting at a moment where companies are telling us that there's a 5x increase in content production coming out in the next couple of years. And you see a host of new media types coming out. And we see the opportunity here for both seat expansion as a result of this. And also because of the value we're adding into our products themselves, increase in ARPU as well. Now beyond all of this, in terms of professional video and professional content creation, I should say, there's also a massive opportunity because this catalyzes our ability much more effectively to go after the billions of creators around the world who need things like this to be creative. So we're going to help them also create standout content. So again, I take a step back and I say, we have an opportunity to get more people into the franchise. We have the ability to drive more ARPU through our products. And we have the ability to make people more successful and drive more LTV. So the foundation, I think, is very strong."
},
{
"speaker": "Shantanu Narayen",
"text": "And Brent, if I understood the question right, I mean, the interest within the DX customer base for what we are doing on Creative Cloud, if you look at both Summits, the interest associated with how these clouds and offerings are working together is actually one of the catalysts that I think will help both the Digital Media as well as the Digital Experience business. So you're right. I mean, we are finding that every customer is saying, this is the way for us to really go all the way from when we start to create a campaign all the way to the delivery and understanding the analytics associated with that. And I think the enterprise team has really aligned around this joint selling, and we've created a bill of materials where you can actually have both the Digital Experience as well as the Creative Cloud offerings in it. And I think that's what you're going to see. In the second half, we're going to have a lot more of these combined sales that happen with every enterprise because it helps, as we've been saying, with both the top line and the bottom line. And since it was the last question, I mean, let me end by saying it was a great first half. We appreciate all the comments that you have made about the quarter. And I wanted to thank the Adobe team for real great execution as well as, again, congratulate in particular, the Acrobat team for 30 years of amazing innovation. What I'm most proud of is, if you look at just the last few months in terms of what the company has delivered across Firefly and Generative Fill and Generative Recoloring, what's happening with Acrobat across the web, in Digital Experience, the Adobe mix model, product analytics, what we are doing around content supply chain, the new offerings that are coming for an increasing set of customers that will serve real customer problems I think really all goes well for how we will continue to drive innovation and serve customers as well. So I'm really excited about the second half as well as what we're going to continue to do in terms of delivering top line and bottom line growth. And with that, I'll hand it over to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, Shantanu, and thanks, everyone, for joining the call. I look forward to speaking with many of you soon, and this concludes the event."
},
{
"speaker": "Operator",
"text": "Thank you. That does conclude today's conference. We do thank you for your participation and have an excellent day."
}
] | Adobe Inc. | 24,321 |
ADBE | 1 | 2,023 | 2023-03-15 17:00:00 | Operator: Good day and welcome to the Q1 FY 2023 Adobe Earnings Conference Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s first quarter fiscal year 2023 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe’s Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, March 15 and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today’s press release and in Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe’s executives will refer to constant currency growth rates, unless otherwise stated. Reconciliations are available in our earnings release and on Adobe’s Investor Relations website. Adobe Summit is just around the corner in Las Vegas at the Venetian Convention and Expo Center beginning on Tuesday, March 21. Following the Day 1 keynote, we will host a Q&A session with financial analysts and investors in attendance at 11:30 a.m. Pacific Time. Audio of the event will be broadcast live and the replay will be available on Adobe’s IR website. More details about Summit and the agenda are available at summit.adobe.com. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon and thank you for joining us. Adobe had a strong Q1, driving record revenue across our Creative Cloud, Document Cloud and Experience Cloud businesses. We achieved $4.66 billion in revenue, representing 13% year-over-year growth. GAAP earnings per share for the quarter, was $2.71 and non-GAAP earnings per share was $3.80. Digital is reshaping how we connect and engage with the world around us. Our performance demonstrates the critical role that Adobe products are playing in fueling the global digital economy, empowering everyone everywhere to imagine, create and bring any digital experience to life. We are executing against our strategy to unleash creativity for all, accelerate document productivity and power digital businesses, delivering on our innovative product roadmap and engaging a growing universe of customers from individuals to small businesses to the largest enterprises. Given the recent news reports, I wanted to provide an update on the process and timing of our pending acquisition of Figma. We remain excited about the opportunity to advance product design, accelerate collaborative creativity on the web, and redefine the future of creativity and productivity. The potential combination continues to be well received by customers, industry analysts and partners. In addition, we are preparing for integration as we work through the regulatory process. From the outset, we have been well prepared for all potential scenarios while realistic about the regulatory environment. We have completed the discovery phase of the U.S. DOJ second request and are prepared for next steps, whether that is an approval or a challenge. Adobe remains confident in the facts underlying the case. And based on current process timing, we believe the transaction continues to be on track for a close by the end of 2023. It goes without saying that our Q1 success demonstrates that we continue to be ruthlessly focused on executing against our immense opportunities, independent of this combination. David, over to you.
Dan Durn: Thanks, Shantanu. Hello, everyone. We are living in a visual digital-first world where content creation and consumption are exploding and where consumers, students and businesses need to create content that stands out and elevates their online profiles. As a result, more and more people are turning to Creative Cloud, which remains a preeminent destination for creativity across imaging, design, video, illustration and animation as well as new media types like 3D and augmented reality. We continue to see strong demand for our flagship applications, including Photoshop, Lightroom, Illustrator, Premiere Pro and Acrobat and are excited about the traction we are getting with Adobe Express. Q1 was a strong quarter for Creative Cloud. We achieved net new Creative ARR of $307 million and revenue of $2.76 billion, which grew 13% year-over-year. Q1 highlights include strong growth in top-of-funnel traffic, which resulted in healthy new demand for creative cloud applications across all routes to market and customer segments globally from individuals to SMBs, to large enterprises, increased demand and mobile adoption in imaging with products like Photoshop and Lightroom. Lightroom Mobile is now the default photo editor for the high-end photo editing experience on the Samsung Galaxy S-23 Series, continued momentum for Premier Pro, After Effects and Frame.io, which are leaders in video editing and collaboration. Over two-thirds of films at Sundance as well as Oscar winners, Everything Everywhere All At Once and Navalny were edited with our video products. Rapid adoption of Substance 3D by brands such as Amazon, Burberry and Louis Vuitton, the Substance 3D team was honored with a technical Oscar in recognition of 3D capabilities that are making popular films such as Spider-Man, Star Wars and Blade Runner 2049 possible. Acceleration in our Adobe Stock business driven by the demand for high-quality imaging vector, video and 3D content. Momentum for Adobe Express with significant year-over-year growth in monthly active users across segments such as students, small businesses and creative professionals. We are actively driving adoption of both new users and existing Creative Cloud subscribers who are now using Express when they want speed and ease and we look forward to an imminent release of a dramatic upgrade with enhanced performance, collaboration functionality and new authoring capabilities for video and mixed media. Exciting introduction of new products, including our beta releases of Character Animator and Adobe Podcast. Adobe Podcast is a web-based AI-powered audio recording and editing app, perfect for the growing podcast industry. It makes every recording even those done on your phone in busy spaces, sound like they were recorded in a studio. Key customer wins in the quarter include Accenture, BBC, Disney, IBM, Infosys and Nintendo. Our innovation engine continues to fire on all cylinders to reimagine the future of creativity. Last October, we previewed some of Adobe’s generative AI technology at MAX. We have been hard at work training Adobe models on our proprietary data sets, creating APIs, envisioning new services and integrating all these capabilities into our existing applications as a creative co-pilot. These innovations are developed and deployed in alignment with Adobe’s AI ethics principles of accountability, responsibility and transparency. Stay tuned for some exciting announcements slated for next week in conjunction with Adobe Summit. Digital documents are powering productivity at home and at work, whether users are filing a tax form, submitting a sales contract, requesting feedback on a marketing campaign or completing an online bank transaction. Adobe Document Cloud is a leader in digital documents, redefining how people view, edit, share, scan and sign documents across desktop, web and mobile. In Q1, Document Cloud had record revenue of $634 million, which represents 16% year-over-year growth and strong net new ARR of $103 million, with ending ARR growing 22% year-over-year in constant currency. Q1 highlights include continued demand for PDF with outstanding growth in documents opened in the Acrobat Chrome extension and the new integration that will make Acrobat Reader the default PDF viewer in Microsoft Edge for over 1 billion Windows users; significant growth in monthly active users for Acrobat web, driven by search volume for PDF related verbs and a continually optimized funnel to our web offering; continued proliferation of Acrobat driven by demand for integrated functionality such as Share for Review for collaboration and Adobe Sign for e-signatures; outstanding increase in API transactions as our ecosystem and business customers continue to customize and integrate document services; strong demand across all routes to market and customer segments globally from individuals to SMBs to large enterprises. Key customer wins include Bank of Montreal, HP, JPMorgan Chase, Ministry of Defense of Netherlands, Samsung and Verizon. Given the strong Q1, the demand for our products and our innovation roadmap, we are pleased to raise our FY ‘23 Digital Media net new ARR target. I will now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello everyone. During the 2022 holiday season, e-commerce drove a record $211 billion with 38 days of $3-plus billion in daily spend according to the Adobe Digital Economy Index. Companies across B2B and B2C need an integrated customer experience management platform that empowers them to anticipate and meet the expectations of their customers. Today, digital is especially critical in enabling companies to drive profitable growth by delivering engaging and efficient customer experiences across the entire funnel, and Adobe is uniquely positioned to power experience-led growth. Experience Cloud offers a comprehensive portfolio of products that span the entire experience life cycle from marketing planning and workflows to data insights and activation to content and commerce and customer journeys. Built natively on Adobe Experience platform, our real-time CDP provides businesses with actionable customer profiles, leveraging data from online and off-line channels to deliver personalized experiences at scale. In Q1, we continued to drive strong growth in our Experience Cloud business, achieving $1.18 billion in revenue. Subscription revenue was $1.04 billion, both representing 14% year-over-year growth. Petco is a great example of a B2C company leveraging Adobe’s comprehensive set of products to create and deliver engaging experiences. Petco uses Creative Cloud to create content and Experience Cloud, including real-time CDP and Adobe Journey Optimizer, to orchestrate personalized experiences across their pet care ecosystem, including veterinary care, grooming, training and insurance. On the B2B side, Qualcomm is harnessing experience cloud to deliver personalized experiences and improve marketing performance as well as Creative Cloud and Document Cloud to accelerate content velocity across its business lines. Additional Q1 highlights include high retention rates and strong demand for services, demonstrating our customers’ focus on long-term value realization; strong growth in Adobe Experience Platform and our native applications, inclusive of real-time CDP, Adobe Journey Optimizer and Customer Journey Analytics; momentum for Workfront, which is powering workflows to help teams around the globe collaborate and launch campaigns with ease and efficiency; significant wins over single product competitors in analytics, content management and CDP that underscore Adobe’s differentiation; leadership in industry analyst reports, including the Forrester Wave for Digital Intelligence Platforms, the Forrester Wave for Cross-Channel Marketing Hubs and Gartner’s Magic Quadrant for Digital Experience Platforms; a significant number of transformational deals, including Accenture, Carnival Aida, Costco, IBM, MetLife, Paramount, Pfizer, S&P Global, TD Bank and Tim Hortons. The Digital Experience business had a strong start to the year. Enterprises are focused on driving revenue growth through digital channels while increasing the productivity of their investments in customer experience and marketing. Experience Cloud is uniquely positioned to help enterprise customers across the world unlock profitable growth. Next week, we are excited to host Adobe Summit, the world’s largest digital experience conference. It’s our first time coming together in person in Las Vegas since 2019. And we’ll be joined online by tens of thousands of customers, partners and developers from around the world. In addition to unveiling exciting new technology innovation across Experience Cloud, we will host inspirational C-level executives from several companies at the forefront of the digital economy. I will now pass it to Dan.
Dan Durn: Thanks, Anil. Today, I’ll start by summarizing Adobe’s performance in Q1 fiscal 2023, highlighting growth drivers across our businesses, and I’ll finish with financial targets. Q1 was a strong start to the year for Adobe. I know the macroeconomy is on every investor’s mind right now, and you can see the resilience and diversification of Adobe’s business in our financial results. Businesses today are prioritizing investments in order to maximize returns and impact, both to drive their top line and to deliver operational efficiency. And individuals are looking to create content that enables them to connect and stand out across digital platforms. In this environment, the demand for our products continues to be strong as our solutions are mission-critical to customers in a world where digital content and engagement drive the global economy. Our product differentiation, engine of innovation and data-driven operating model are continuing to drive Adobe’s growth. We have a world-class balance sheet, industry-leading margins, a strong cash flow profile and a proven track record. I can’t think of a company that’s better positioned as we continue to innovate in our core business and create and scale emerging businesses to drive profitable growth. In Q1, Adobe achieved record revenue of $4.66 billion, which represents 9% year-over-year growth or 13% in constant currency. Business and financial highlights included: GAAP diluted earnings per share of $2.71 and non-GAAP diluted earnings per share of $3.80, Digital Media revenue of $3.40 billion, net new Digital Media ARR of $410 million, Digital Experience revenue of $1.18 billion, cash flows from operations of $1.69 billion, RPO of $15.21 billion exiting the quarter and repurchasing approximately 5 million shares of our stock during the quarter. In our Digital Media segment, we achieved Q1 revenue of $3.40 billion, which represents 9% year-over-year growth or 14% in constant currency. We exited the quarter with $13.67 billion of Digital Media ARR. We achieved Creative revenue of $2.76 billion, which represents 8% year-over-year growth or 13% in constant currency, and we added $307 million of net new creative ARR in the quarter. Q1 Creative growth drivers included new user growth, fueled by customer demand and targeted marketing campaigns, which drove increased web traffic in the quarter; adoption of our Creative Cloud All Apps offerings across customer segments and geographies; students graduating from our Education segment into the creative professional job market; continued strength in upselling our new Acrobat CC offering, which includes integrated sign capabilities; licensing of individual applications, including a strong quarter for our imaging and photography offerings; momentum in high-growth businesses, such as Substance and Stock, where we had a tremendous quarter generating new business; and with Frame, which we are successfully cross-selling into our video customer base; a fast start to the year selling into our large enterprise accounts. Adobe achieved Document Cloud revenue of $634 million, which represents 13% year-over-year growth or 16% in constant currency. We added $103 million of net new Document Cloud ARR in the quarter. Q1 Document Cloud growth drivers included continued growth of Acrobat web, demonstrating the success of our product-led growth strategy; strength in conversion and retention rates of our Acrobat mobile customers; demand for Acrobat subscriptions across all customer segments; success generating new customer demand for Acrobat Sign in SMB and the mid-market; and strength in the enterprise, driving seat expansion for our Acrobat business. Turning to our Digital Experience segment. In Q1, we achieved revenue of $1.18 billion and subscription revenue of $1.04 billion, which represents 12% year-over-year growth or 14% in constant currency. Q1 Digital Experience growth drivers included success closing numerous transformational deals with large enterprises that are choosing Adobe to be their end-to-end CXM platform to drive personalization at scale; momentum with our AEP and native applications with the book of business growing more than 50% year-over-year; strength with our Content and Workfront solutions as our content supply chain strategy is resonating with customers; renewal rates of our enterprise customers that continue to be strong; and sales execution across multiple geographies. Turning to the income statement and balance sheet. In Q1, we continued with our strategy of making disciplined investments to drive growth while identifying cost-saving opportunities to drive earnings. Adobe’s effective tax rate in Q1 was 22% on a GAAP basis and 18.5% on a non-GAAP basis, in line with our expectations. For fiscal 2023, Adobe’s management is adopting a fixed long-term projected non-GAAP tax rate to assess and report on operating results, which we believe provides a clear view of Adobe’s financial performance. The fixed long-term non-GAAP rate considers our current operating structure, existing tax positions, legislation and available forecast information. This rate is based on a 3-year projection and may be adjusted for changes in the future. RPO exiting the quarter was $15.21 billion, growing 10% year-over-year or 13% when factoring in a 3 percentage point FX headwind. Our ending cash and short-term investment position exiting Q1 was $5.65 billion and cash flows from operations in the quarter were $1.69 billion. Over the past year, we completed a thorough review of our short-term investments and marketable securities to ensure we are prepared for the current environment and with a bias towards the higher end of the investment-grade spectrum. Adobe does not hold substantial assets or securities at Silicon Valley Bank or any regional bank. In Q1, we entered into a $1.4 billion share repurchase agreement, and we currently have $5.2 billion remaining of our $15 billion authorization granted in December 2020, which goes through the end of fiscal 2024. In light of the strong start to the year and momentum across our business and factoring in the macroeconomic environment, for Q2, we’re targeting: total Adobe revenue of $4.75 billion to $4.78 billion, Digital Media net new ARR of approximately $420 million, Digital Media segment revenue of $3.45 billion to $3.47 billion, Digital Experience segment revenue of $1.21 billion to $1.23 billion, Digital Experience subscription revenue of $1.06 billion to $1.08 billion, tax rate of approximately 21.5% on a GAAP basis and 18.5% on a non-GAAP basis, GAAP earnings per share of $2.65 to $2.70 and non-GAAP earnings per share of $3.75 to $3.80 and. As a result of the strong performance in Q1 and trajectory of the business, we are raising our fiscal 2023 net new ARR and EPS targets. For fiscal 2023, we are now targeting Digital Media net new ARR of approximately $1.70 billion, GAAP earnings per share of $10.85 to $11.15 and non-GAAP earnings per share of $15.30 to $15.60. In summary, I’m pleased with our strong top line and bottom line execution in Q1, demonstrating the momentum we’ve established for the year. Our strong engine of innovation, combined with our operational rigor, are driving profitable growth and position us well to capture the massive growth opportunities at our doorstep. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. Adobe’s Q1 results underscore our strong momentum and the significant opportunities we have across our businesses. We’re thrilled to be back in Las Vegas for Adobe Summit next week. In addition to unveiling several new innovations across Experience Cloud, Creative Cloud and Document Cloud, we will share how we are building on our decades of AI leadership to deliver generative AI technologies that redefine creativity and customer experiences. We look forward to seeing you there. Adobe’s employees around the world motivate us to continuously raise the bar and create the future. This quarter, we were named to Glassdoor’s Best Places to Work; Bloomberg’s Gender Equality Index for the 5th year in a row; and the CDP A List, which recognizes leadership and environmental impact. Our renowned brand, mission-critical products, and vast base of customers create an unmatched advantage that will fuel our growth. Thank you, and we will now take questions. Operator?
Operator: Thank you. [Operator Instructions] And we will take our first question from the line of Brad Zelnick with Deutsche Bank. Please go ahead.
Brad Zelnick: Great. Thank you so much for taking the question. And congrats on a really strong start to the year. Dan, your guidance explicitly embeds assumptions for the macro environment. Can you share with us what those are and how those assumptions might have changed from a few months ago when you last guided? Thanks.
Dan Durn: Yes. Thanks, Brad. There is really no change in our view in the macro environment. I think we’re pretty clear at the time we set our annual guidance, the environment that we’re in. We see the environment that others see. I think you can see that the company is performing really well against that backdrop. So we feel good about how we’re situated, the way in which we’re engaging with customers and its broad diversified performance across that environment. And so we like how we’re set up, but there is really no change to the assumptions underlying the macro environment. We see the same environment that others do.
Brad Zelnick: Thank you.
Operator: And we will take our next question from the line of Alex Zukin with Wolfe Research. Please go ahead.
Alex Zukin: Yes. Hi, guys. So maybe just what do you think is the driving force behind – so many companies are talking about longer sales cycles, difficult to closing business. You had an outstanding quarter, specifically within the enterprise. So maybe what’s driving those macro headwinds for others that you’re not seeing or your resiliency specifically? And then on the topic of metrics, every metric was strong as we looked at revenues, RPO, Digital Media ARR operating margins. But maybe just can you talk about deferred revenue in the quarter? Anything there that was a headwind, because it did look like free cash flow was a little bit lighter than what we were expecting?
Shantanu Narayen: I’ll take the first, Alex, and then maybe Dan can speak to the second. I mean, I think, as Dan said, when we look at the macroeconomic situation, and you can see strong companies actually refer to this across the board, whether it’s consumers, whether it’s small and medium businesses, whether it’s enterprises globally, I think the reality is that digital for them is an imperative. And really for companies that have innovative solutions, it’s a tailwind. I think what a lot of companies are focused on is the message that enterprises are certainly sharing is that if the prior focus was growth at any cost, certainly, they are looking for more profitable growth. And I think if you look at our solutions on the creative document or enterprise side, we help them. We help them with growth, but we help them with profitable growth and engaging with customers. The second thing I would say is that there is a large TAM here, and so I think our job in this environment is making sure that we have an even larger pipeline that we go address and attract because there may be some difference in the closure rates. But I think if you look at it in aggregate, our job is looking at it and saying how do we differentiate ourselves. I think the one thing also I would say, Alex, is that a lot of the companies that have single product offerings, I think they are probably seeing more headwind because a certain company may not put one part of what they offer as a priority. And I think a lot of the companies are looking at it and saying if we’re engaging in digital, we might change our focus from content management to the implementation of the customer data platform or there might be a focus more on campaigns or ensuring that the advertising spend, the attribution associated with it. So I think the team has executed against continuing to try and drive a large opportunity. The other thing I think we feel good about is the fact that both Summit as well as in the U.S. and UK, we’re looking forward to being in person because we can engage more in person with them. So hopefully, that gives you some color of why perhaps the stronger companies are showing more macro strength than other companies.
Dan Durn: And Alex, I’ll jump in on the second part of the question. As we think about RPO being up 13% year-over-year on a constant currency basis, you think about the underlying performance of deferred revenue, unbilled backlog, it’s very similar profile across both of those dimensions of the RPO. If you think about cash flow, the one thing I would point to, we all know that there has been a change in the tax regulation around capitalization of R&D expenses. We signaled at the time we set our annual targets that we would see a step-up in cash taxes starting this quarter, and that’s really what you see profiling through operating cash.
Alex Zukin: Prefect. Thank you, guys. Congrats.
Operator: [Operator Instructions] We will take our next question from the line of Keith Weiss with Morgan Stanley. Please go ahead.
Keith Weiss: Hi, excellent. Thank you, guys for taking the question. A really nice quarter. I think my question is actually a deep dive into the prior two questions. Dan, maybe digging a little bit into sort of what Brad was asking. We are like, from a market perspective and an investor perspective, worrying about these kind of incremental impacts like Silicon Valley Bank and other bank failures. And you’re seeing continued like a reduction in headcount from big shops like Meta on a go-forward basis. So I think the market is getting incrementally worried about the underlying kind of macro impacts. But you guys went the other way. Like in Q1, you’re taking up your net new ARR additions for Digital Media. So can you walk us through specifically, is there anything mechanical or sort of tactical, if you will, that gives you guys the confidence that like even with the heightened kind of volatility that we’re seeing out there that you guys feel comfortable in Q1 taking up that full year guide? And then on the other side of the equation on the free cash flow, can you just specify for us and you can give us a sense of kind of where those cash taxes are going to go over time just to help us kind of tune in our model?
Dan Durn: Yes. So let me take them in reverse order. In terms of cash taxes, there is a 5-year amortization period around the capitalization of that R&D. So you’ll see a pretty dramatic cash tax step-up initially. But over that 5-year amortization period, it will converge on the reported tax rate. And so that’s the general profile, and that’s why you see the significant step-up in Q1 just starting that process now. In terms of the environment we are in, clearly, the company is performing well. You see the diversification of our business that’s across geographies, industry sectors, product portfolio. The company is just performing well at a broad base way on the strength of that performance and the momentum we have, the visibility we have into the full year. We think it’s the prudent thing to set expectations with investors in a way that reflects what we see as the opportunity in the company-specific performance. When I take a step back and I think about what is driving that differential performance in this environment, I think our products are mission-critical to our customers. We are on the critical path of them generating revenue. But as the world goes digital and those investments are prioritized, not only do we help companies drive top line growth, but we help them with the underlying productivity gains that go with that. It is why customers in this environment are prioritizing around things that we sell to enable their success. It addresses top line performance as well as underlying profitability of our customers. So being on the critical path, being mission critical to customers, we think this is the type of environment where the power of Adobe and the performance of the company gets to shine.
David Wadhwani: Yes. And I’ll just add a little bit specific to Digital Media. The foundation of the growth that we have, we still feel a very significant tailwind even in this market. Shantanu talked about the strength of the enterprise business. Every business needs to be a digital business. Digital content is fueling the global economy. That’s true for smaller organizations and individuals as well. If you look at the creator economy, we’re seeing more people come in to start to create their own personal online brands. So we saw a very strong digital funnel. As well, we had the highest traffic that we’ve ever had come to adobe.com. And even in small, medium businesses, the part of their business that they need to invest most in is the digital channel as Dan was talking about. You look at that diversity, you then layer on the diversity of the growth drivers that we have in the business, whether it’s new user acquisition, whether it’s upsell of existing users, whether it’s retention rates, whether it’s new businesses like Substance or Stock or the pricing and packaging opportunities that we have. Every one of those levers has been very productive for us. In terms of primary growth driver, it is and always has been new user acquisition. It is by far the biggest contributor, and a lot of the PLG work that we’ve done over the last year or 1.5 years is contributing to not just top of funnel, but also conversion of that top of funnel. In terms of upsell and migration, we’ve been investing for a decade or more in education, and we have a very efficient channel now where students that graduate effectively upgrade and migrate into full priced offerings. That drove a very strong Creative Cloud individual all apps quarter for us. Retention, we’ve been doing a lot of work in retention through PLG, but we’ve also been driving a lot of utilization of Adobe Express as part of the Creative Cloud business. All of that combined makes for a very strong retention rate. New businesses, we talked about Substance and Frame having outsized growth. And of course, the pricing and packaging work that we’ve been doing and all along continues to contribute to that, both for CC and Acrobat CCDC as a whole. So looking ahead, all of these drivers and these levers are intact, and we have lots of opportunities going forward as well.
Shantanu Narayen: And maybe just putting it altogether if you look at it and say that, hey, we did $410 million in Q1, we are targeting $420 million of net new ARR in Q2. The question you would have asked us if we hadn’t done this was what are you signaling about the second half of the year. So I think it’s a way of showing that the momentum is there in the business.
Keith Weiss: Super helpful. Thank you, guys.
Operator: And we will take our next question from the line of Jake Roberge with William Blair. Please proceed.
Jake Roberge: Hey, congrats on great results. I just want to double click on that retention commentary you said, you called out several – in several areas of the business during the prepared remarks. Is there anything specific that you’re doing differently in this period of macro uncertainty that’s driving those results? And have you started to see Express help at all with retention metrics as customers now the tier that they can actually graduate down to?
Shantanu Narayen: Well, for a couple of years right now, we’ve been really focused on what we’ve called in the past, the data-driven operating model and really being pretty focused on driving the business both with the narrative and the number. And so I think as we continue to, as David mentioned, have different products. And he is really focused on how we are acquiring them, how are we engaging them, what’s the usage, how do we make sure they are getting value for the product, how do we continuously tell them about what’s new. And then I think as David has come in and introduced the notion of product PLG, I think that part has also really started to reflect in making sure that customers know that we’re building products and features that are relevant for the pain points that they have. So I would say the underlying business, while they are sort of the digital imperative, I wouldn’t underestimate the incredible execution that the team continues to do on that or in DX. I mean how do you look at the solutions we’re selling? How do you understand cross-sell? How do you understand upsell? And I think the hours and hours of work that goes in is sometimes not appreciated, but I’m incredibly respectful and appreciative of what the teams have done. So a lot of execution is, I think, the short answer.
Jake Roberge: Great. Thanks for taking my questions.
Operator: And we will take the next question from the line of Brad Sills with Bank of America. Please go ahead.
Brad Sills: Great. Thank you so much. I wanted to ask about that top of funnel activity that you have been generating here with Communicator and the consumer segment with Creative Cloud Express, the success you’re seeing there, some exciting new announcements coming here. It sounds like on Creative Cloud Express enhancements here. Could we interpret that to mean that perhaps you’re pivoting more towards upselling those customers to some of these newer features and offerings that are coming with Creative Cloud Express away from that top of funnel activity that you’ve been very successful with thus far? Thank you.
David Wadhwani: Yes. As Shantanu talked about, it’s a holistic process. First of all, we’ve, over the last couple of years, spent a lot of time with product-led growth. What that gives us is confidence that when people come to Adobe.com and they get into the products, they are going to have a great onboarding experience. They are more likely to convert, and they are more likely to stay, which then starts to give us more confidence and growth in terms of improving what has already been a world class in terms of lifetime value. As that happens, we’ve been running more targeted campaigns with things for Photoshop and Acrobat and Illustrator as an example that are more targeted to the growth activities and the landing pages in the products themselves. And we’ve actually been connecting all of our outbound marketing activities with landing pages in the products themselves. So we have been able to really increase our demand efforts and the ROI associated with that to bring more traffic to top of funnel. In addition to that, we have been investing a lot in growth loops. So people are able to now when using the products actually share some of – share the content out to stakeholders. Those stakeholders are able to look at that content, but also become top of funnel opportunity for us. If you look at Acrobat Web, as an example, we have seen a massive increase in terms of Acrobat Web usage driven by things like Share for Review. So, that drives more top of funnel for us. And then third is partnerships. We have been working very closely with Microsoft as an example. We have announced that Reader, as an example, will be the default PDF viewer in Edge, which now gives us access to over billion users on Windows-based devices. So, it’s a cacophony of these activities that ultimately results in strong top of funnel. And then as we talked about, it’s really about the hard work and the data to drive personalized experiences at scale, leveraging a lot of Anil’s DX businesses and products to drive users all the way through to conversion.
Brad Sills: Wonderful to hear. Thank you.
Operator: And we will take our next question from the line of Michael Turrin with Wells Fargo Securities. Please go ahead.
Michael Turrin: Hey. Great. Thanks. Thanks for taking the question. One of the things that stood out is you mentioned wins over single product competitors and a few key areas on the digital experience side. Can we go a bit deeper into that as this environment and some of what’s happening on the private company side, maybe presenting opportunities you are now able to take advantage of? I would just be curious here a bit more on maybe both the DX and DM side, just what’s happening there. Thank you.
Anil Chakravarthy: Yes. Let me start on the digital experience side. We have a broad and comprehensive portfolio, and it’s integrated with the Adobe Experience Platform. So, from a customer perspective, they get the best of both worlds. They get those best-in-class applications, whether it’s content and commerce or customer journeys or data insights or workflow, marketing workflow, and they get the benefit of integration with the Adobe Experience Platform and the native apps that we have built there. So, that’s a powerful combination. It helps to really address what Shantanu was talking about, which is how do you keep growing through your digital channels and you get the revenue growth, but you also get the benefit of getting efficiency through consolidation. And that’s where we believe we really shine as customers are looking at their overall stack, similar to what they have done in other aspects of their IT enterprise architecture. They are looking at who is my go-to platform that I can really standardize on and I will build around, and so we are getting the benefit of that choice.
David Wadhwani: And on the DME side, we look at the – just like all the energy in the market around single product players, whether it’s a mobile app, whether it’s a web app or whether it’s this excitement, incredible excitement and that we have as well around generative AI really is focused on driving top of funnel because it’s driving a lot of awareness of creativity and the things that people want to do. And ultimately, as they leverage those apps, as they see themselves as more accretive, they inevitably end up at our doorstep going forward.
Operator: And we will take our next question from the line of Kash Rangan with Goldman Sachs. Please go ahead.
Kash Rangan: Thank you very much. I just want to pick up there. I think David talked about the excitement with generative AI, anybody that wants to jump in. What does this mean for Adobe? Is this just somewhat substitutive for all the opportunity that you have, or is it somewhat incremental or massively incremental? And how does Adobe monetize generative AI? Is this something that you can create a separate SKU or charge more? I am curious to get your thoughts quantitatively and qualitatively. Thank you so much.
David Wadhwani: Kash, I think there was about three or four questions, but all related. So, happy to take those really quickly. Nicely played. First of all, this is really about increasing the total number of users, we believe, very strongly. As we talked about at MAX, this is about enhancing human creativity, not replacing it. And ultimately, whether you are an individual solo printer SMB or enterprise, we are hearing the same thing, which is that you need to create more content than you are able to create today. And so this really plays well into our core strengths. As you know, we have got a decades-long focus on AI, things like neural filters and object selection. And hundreds of other features have been based on AI for us, and they have increased creativity, and they have increased productivity, and they have helped people keep up with the demand for content. They have also made it easier for people to onboard into the experiences, and so we have been able to broaden the opportunity for people to start leveraging and using our core products. We have now been able to leverage the hundreds of people that are in our research organization and really target them towards generative technology, which we believe is a huge step forward, leveraging all of the work we have done, but a huge step forward going forward. And we and everyone else in the industry are still in the early innings. So, to give you a sense of where we are going at MAX, we talked about our vision for effectively not just creating content, but really engaging and embedding it in the existing workflows to create a creative copilot we refer to it as. And since then, we have been very hard at work at creating our own model, and the model that we are focused on is around output quality. So, it’s about best-of-breed generative AI. But combining that with the Adobe magic that we have talked about over the years and all of the technology we have that takes images and makes them better, and so the output quality, we think is going to be differentiated. The second thing is around commercial reuse. There is a lot of complex questions here around copyrights, around diversity and inclusion, about harmful content that’s being created. That’s something we take very seriously, and we are embedding that into everything we do. And the third thing is really about workflow integration. Creating an image is just the start. It’s not the end. And Adobe is the only player that has a full end-to-end workflow, not just within the products and the tools that we have in the digital media business, but also everything that Anil is doing around the content workflow and the content supply chain out to the point of distribution. And in fact, because of this, we are seeing other gentech companies wanting to partner with us more and more, and so we feel like we are in a really advantaged position where we are going to come out with our own model and we are going to be partnering with others to make sure that because of our distribution and the place we play in the market, we can bring a lot of this value to actual fruition. And stay tuned, next week at Summit, where we have a lot of exciting announcements and progress to make there. And then last to your, I think fourth or fifth question.
Kash Rangan: Monetization, yes, correct.
David Wadhwani: Monetization, we are very excited about what this means for the business. New user onboarding. We think that, again, if you can start to imagine yourself as creative by using a text prompt, we can take you through that full journey and onboard you into other Adobe offerings. It’s also great for retention. We have always seen the more value that gets used in our core offerings, the better the retention rates and the better the LTV. And we think there is up-sell opportunity. We do think these are distinct new packages that we can bring to market and up-sell people to.
Operator: And we will take our next question from the line of Jay Vleeschhouwer with Griffin Securities. Please go ahead.
Jay Vleeschhouwer: Thank you. Good evening. David, for you first, when we spoke at MAX on the subject of monetization, you alluded to Adobe’s plans for new pricing and packaging, and you alluded to that this evening. But there was a third ingredient that you also alluded to at the time, which was segmentation, which sounded to me like something that you have success with back in the pre-CC days. And so is this something that you could talk about in terms of your returning to the segmentation techniques of the past that work rather well for the company? And then for Anil, it’s interesting to hear the reference to your competition with single product companies. That’s not a new phenomenon, of course. You have had multi-solution DX portfolio for some time. So, would you say, therefore that the wins or magnitude of the wins against single product competitors is more pronounced now? It’s a larger part of the DX business? And would you say that the investments that you have evidently been making over the last year in consulting capacity has been a critical enabling ingredient for the growth you are now seeing in DX?
David Wadhwani: Yes. So, starting with the DME side, Jay, for broad understanding, what we talked about at Adobe MAX was this recognition that since we introduced Creative Cloud 10 years or 11 years ago, we have now a much more comprehensive set of capabilities all the way from a freemium model with Adobe Express, all the way to our high-end creative cloud offerings, but also additional capabilities and packages beyond that like Substance and like Frame and like Stock that allow people to go beyond what they can do with the core creative products. The second thing that, in addition to that expansion that’s happened is that as we have been driving more with DDAM [ph] and more with product-led growth, we are starting to automatically segment customers, not necessarily today in terms of what they buy, but how they experience the products that they are using already. And so what that leads to is an opportunity. And then going back to all the levers that we have for ongoing growth, there is the opportunity to start segmenting them earlier in the purchase flow into offers and offers that meet their needs and optimize the value to the price in a way that benefits our customers and of course also benefits Adobe. So, you can expect to see us continuing to play with everything from how we get new users, how we up-sell users, how we retain them, new businesses we bring in, but also pricing and packaging to your point.
Shantanu Narayen: And just to punctuate that maybe a little bit, Jay. I mean the reality is that we actually have different pricing for different devices today, which is completely different. We have web-based pricing for people who come and experience this as a result of a web search that they have made more successfully through Acrobat Web, for example. And so if the question is when we have had things like design collection or web collection or video collection, I mean the reality is the CCO laps, which actually had a really good quarter, is perceived by people to be the new sort of table stakes for what is happening in creative, and we think that that’s a great offering. And as David said, I mean whether it’s Stock or whether it is Substance and our 3D offerings, what we are doing there, those are really perceived to be the differential offerings that are personalized. And for a Photoshop customer, how do we get them to use one of these other offerings. So, I think we have done a really good job on that particular front.
Anil Chakravarthy: Yes. From the DX perspective, we obviously started investing in AEP 5 years ago. Now we have lots of examples of customers who are using some of the capabilities like unified profile or the real-time CDP and the real-time performance at scale in production. So, from a customers’ perspective, if they think about a single product, they actually know what an integrated product looks like, and they realize that that’s what they would have to build together, build on their own. So, I think that’s making the choice of going with a product from Adobe, which is already integrated with also best-in-class applications versus a single product where they would have to put it together. I think that’s making the contrast more stark.
Shantanu Narayen: And there is more scrutiny, wouldn’t you say, Anil, that so I think part of what’s happening is as the IT or the Chief Marketing Officer, the Chief Digital Officer is thinking about this holistically. There is more scrutiny around who is the company that can provide us the more comprehensive solutions. So, that – you have seen, Jay, a certain difference in how customers are viewing that, which again plays to our strengths.
Jay Vleeschhouwer: Thank you.
Operator: And we will take our next question from the line of Saket Kalia with Barclays. Please go ahead.
Saket Kalia: Okay. Great. Hey guys. Thanks for taking my question here and well done in the quarter as well. I would love to dig into Figma a little bit, understanding very well that it’s still in process. And so David, maybe for you, I know you and the team see the opportunities with products like FigJam in really complementing Creative Cloud. I was wondering if you have seen other opportunities for some of that complementary sort of opportunity as you spend more time with the business. And then, Dan, maybe just a quick housekeeping question. Can you just remind us sort of what the revenue overlap looks like with Figma? I believe it’s the Adobe XD product where specifically where there is overlap, but maybe you could just remind us sort of what that revenue overlap looks like?
Shantanu Narayen: Yes. Saket, maybe I will first jump in. I mean I think just let’s remember before they answer, these are two separate companies, and so we are operating at arm’s length in terms of what they are doing. I think we have shared upfront that the XD revenue is de minimis, and so that’s the part that I wanted to get across. And then David can certainly speak to some of the strategic rationale and ideas for what we can do.
David Wadhwani: Yes. So, I think there is a ton of opportunity in terms of how we look at the Figma business and figure out Figma opportunity. First of all, as we have discussed, we believe that we can just fundamentally accelerate what they are doing today in product design. We have a global footprint. We are working with a lot of our – with enterprise customers across the globe, and the feedback that we are getting from these enterprise customers is a lot of excitement about the kind of things we can do by bringing these two companies together to just accelerate and make them more productive in terms of what they want to accomplish and just accelerate everything that they are doing. The second thing is around taking workflows between Photoshop and Illustrator and Figma and really just operationalizing them in a way that we can bring real-time collaboration capabilities based on the Figma platform to these – to the core disciplines like illustration and video editing and photography and 3D design and more. And the third is really around the evolution with FigJam, bringing that into the core for productivity use cases. So, taking FigJam and integrating it more deeply with things like Acrobat and starting to just recognize that creativity is starting to be the foundation of how new productivity applications need to present themselves. And that whole motion of enabling productivity workers to express themselves creatively is where the market is going with the rise of the creator economy. And so we see – we just see a ton of opportunities to integrate the products. We can’t – we are limited in what we can talk to them about in a moment. But what I can say is everyone from Adobe employees to Figma employees, to our customers, can’t wait for this to close so we can actually get moving on all this.
Saket Kalia: Very helpful. Thanks guys.
Jonathan Vaas: Operator, we are just about at the top of the hour. We will take one more question, please.
Operator: Thank you. We will take our next question from the line of Brent Thill with Jefferies. Please go ahead.
Brent Thill: Shantanu, on the DX business, I am just curious if you could just give us an overview of what you are seeing there. Are you still seeing the big deals? Are you seeing a smaller number of – higher number of smaller transactions, anything? Can you just talk through the pipeline? Just general kind of set up, what you are seeing in terms of the overall DX business and how customers are behaving?
Shantanu Narayen: Happy to, Brent, and I hope we get to see you next week at Summit because then you willalso get to meet a whole bunch of customers. I think – and Anil, certainly feel free to add. I mean I think we saw some really good transformational deals. I think both Dan and Anil referred to that. And so companies that are looking at Adobe to help them with their entire end-to-end customer experience management, good strength there, Brent. I mean those tend to be ones that we have worked with for many years and some that are really looking at it as a strategic. So, I would say that segment, the pipeline associated with people who are looking for a comprehensive and integrated CXM solution is pretty large. I think as it relates to what we call the solution-led segment as well, which is people who may have our analytic solutions and want content solutions or those who have both of those and want journey optimizer or customer journey analytics or certainly the commerce solutions, that’s another part of the business where we are making sure that we can up-sell. I know Anil typically at every FA meeting gives you stats and metrics on how we are making progress. So, that is one. Given we have the customer relationship and we have the customer engagement, and we have customer success managers, I think continuing to penetrate a customer account, that’s where also we see pipeline. And that’s a pipeline that’s driven, frankly, by us. I think in terms of the geographies, we continue to see strength in North America. I think when you think about EMEA, that remains an area of strength. There are some areas in Asia, some countries in Asia. So, our job there, really, Brent, has been how do you drive a large pipeline, understanding that there is going to be different companies that look at this differently in specific quarter, but we are focused on the addressable market. Anil, I don’t know if you have other stuff to add.
Anil Chakravarthy: I think the only thing I would say is I think the themes that we are going to hit on at Summit, personalization at scale, content supply chain, even for customers who are starting with a single product, they like that vision because they know that, that is what is key to driving the digital growth and driving profitable growth. So, even if they are starting with one and focusing on value realization, they have their eye on a longer term roadmap, and that benefits our relationship with them.
Shantanu Narayen: And Brent, the other thing I will say, given just the last question is, I think at Summit, you will see some of the themes. I mean certainly, content has been a theme for us for a long time. Data has been a theme for us for a long time. The focus on customer platform and CDP has been a big one. I think how this spreads its tentacles into the product and PLG as David has said, so I think we have some exciting things that we will talk about in that particular space in AI and how AI can help. So, we are not just resting on what we have today as an integrated offering. We are really the innovative product roadmap across each one of our businesses, what Dave has been doing in creative, what’s happening in documents on the web and mobile devices and what Anil is going to show. I think that’s also what gives us a lot of confidence that we are anticipating and solving customer problems. And so it was a strong start to Q1. And based on the product innovation, we really continue to be excited about the opportunity that we have at Adobe, and we look forward to seeing all of you at Summit.
Jonathan Vaas: Thanks everyone for joining the call. Like Shantanu said, we hope to see many of you next Tuesday at Summit. I look forward to talking to many of you soon and this concludes the call.
Operator: Thank you. This does conclude today’s meeting. Thank you for your attendance and you may now disconnect. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Q1 FY 2023 Adobe Earnings Conference Call. Today’s conference is being recorded. At this time, I’d like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s Chairman and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s first quarter fiscal year 2023 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe’s Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, March 15 and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For a discussion of these risks, you should review the factors discussed in today’s press release and in Adobe’s SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe’s executives will refer to constant currency growth rates, unless otherwise stated. Reconciliations are available in our earnings release and on Adobe’s Investor Relations website. Adobe Summit is just around the corner in Las Vegas at the Venetian Convention and Expo Center beginning on Tuesday, March 21. Following the Day 1 keynote, we will host a Q&A session with financial analysts and investors in attendance at 11:30 a.m. Pacific Time. Audio of the event will be broadcast live and the replay will be available on Adobe’s IR website. More details about Summit and the agenda are available at summit.adobe.com. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon and thank you for joining us. Adobe had a strong Q1, driving record revenue across our Creative Cloud, Document Cloud and Experience Cloud businesses. We achieved $4.66 billion in revenue, representing 13% year-over-year growth. GAAP earnings per share for the quarter, was $2.71 and non-GAAP earnings per share was $3.80. Digital is reshaping how we connect and engage with the world around us. Our performance demonstrates the critical role that Adobe products are playing in fueling the global digital economy, empowering everyone everywhere to imagine, create and bring any digital experience to life. We are executing against our strategy to unleash creativity for all, accelerate document productivity and power digital businesses, delivering on our innovative product roadmap and engaging a growing universe of customers from individuals to small businesses to the largest enterprises. Given the recent news reports, I wanted to provide an update on the process and timing of our pending acquisition of Figma. We remain excited about the opportunity to advance product design, accelerate collaborative creativity on the web, and redefine the future of creativity and productivity. The potential combination continues to be well received by customers, industry analysts and partners. In addition, we are preparing for integration as we work through the regulatory process. From the outset, we have been well prepared for all potential scenarios while realistic about the regulatory environment. We have completed the discovery phase of the U.S. DOJ second request and are prepared for next steps, whether that is an approval or a challenge. Adobe remains confident in the facts underlying the case. And based on current process timing, we believe the transaction continues to be on track for a close by the end of 2023. It goes without saying that our Q1 success demonstrates that we continue to be ruthlessly focused on executing against our immense opportunities, independent of this combination. David, over to you."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Shantanu. Hello, everyone. We are living in a visual digital-first world where content creation and consumption are exploding and where consumers, students and businesses need to create content that stands out and elevates their online profiles. As a result, more and more people are turning to Creative Cloud, which remains a preeminent destination for creativity across imaging, design, video, illustration and animation as well as new media types like 3D and augmented reality. We continue to see strong demand for our flagship applications, including Photoshop, Lightroom, Illustrator, Premiere Pro and Acrobat and are excited about the traction we are getting with Adobe Express. Q1 was a strong quarter for Creative Cloud. We achieved net new Creative ARR of $307 million and revenue of $2.76 billion, which grew 13% year-over-year. Q1 highlights include strong growth in top-of-funnel traffic, which resulted in healthy new demand for creative cloud applications across all routes to market and customer segments globally from individuals to SMBs, to large enterprises, increased demand and mobile adoption in imaging with products like Photoshop and Lightroom. Lightroom Mobile is now the default photo editor for the high-end photo editing experience on the Samsung Galaxy S-23 Series, continued momentum for Premier Pro, After Effects and Frame.io, which are leaders in video editing and collaboration. Over two-thirds of films at Sundance as well as Oscar winners, Everything Everywhere All At Once and Navalny were edited with our video products. Rapid adoption of Substance 3D by brands such as Amazon, Burberry and Louis Vuitton, the Substance 3D team was honored with a technical Oscar in recognition of 3D capabilities that are making popular films such as Spider-Man, Star Wars and Blade Runner 2049 possible. Acceleration in our Adobe Stock business driven by the demand for high-quality imaging vector, video and 3D content. Momentum for Adobe Express with significant year-over-year growth in monthly active users across segments such as students, small businesses and creative professionals. We are actively driving adoption of both new users and existing Creative Cloud subscribers who are now using Express when they want speed and ease and we look forward to an imminent release of a dramatic upgrade with enhanced performance, collaboration functionality and new authoring capabilities for video and mixed media. Exciting introduction of new products, including our beta releases of Character Animator and Adobe Podcast. Adobe Podcast is a web-based AI-powered audio recording and editing app, perfect for the growing podcast industry. It makes every recording even those done on your phone in busy spaces, sound like they were recorded in a studio. Key customer wins in the quarter include Accenture, BBC, Disney, IBM, Infosys and Nintendo. Our innovation engine continues to fire on all cylinders to reimagine the future of creativity. Last October, we previewed some of Adobe’s generative AI technology at MAX. We have been hard at work training Adobe models on our proprietary data sets, creating APIs, envisioning new services and integrating all these capabilities into our existing applications as a creative co-pilot. These innovations are developed and deployed in alignment with Adobe’s AI ethics principles of accountability, responsibility and transparency. Stay tuned for some exciting announcements slated for next week in conjunction with Adobe Summit. Digital documents are powering productivity at home and at work, whether users are filing a tax form, submitting a sales contract, requesting feedback on a marketing campaign or completing an online bank transaction. Adobe Document Cloud is a leader in digital documents, redefining how people view, edit, share, scan and sign documents across desktop, web and mobile. In Q1, Document Cloud had record revenue of $634 million, which represents 16% year-over-year growth and strong net new ARR of $103 million, with ending ARR growing 22% year-over-year in constant currency. Q1 highlights include continued demand for PDF with outstanding growth in documents opened in the Acrobat Chrome extension and the new integration that will make Acrobat Reader the default PDF viewer in Microsoft Edge for over 1 billion Windows users; significant growth in monthly active users for Acrobat web, driven by search volume for PDF related verbs and a continually optimized funnel to our web offering; continued proliferation of Acrobat driven by demand for integrated functionality such as Share for Review for collaboration and Adobe Sign for e-signatures; outstanding increase in API transactions as our ecosystem and business customers continue to customize and integrate document services; strong demand across all routes to market and customer segments globally from individuals to SMBs to large enterprises. Key customer wins include Bank of Montreal, HP, JPMorgan Chase, Ministry of Defense of Netherlands, Samsung and Verizon. Given the strong Q1, the demand for our products and our innovation roadmap, we are pleased to raise our FY ‘23 Digital Media net new ARR target. I will now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello everyone. During the 2022 holiday season, e-commerce drove a record $211 billion with 38 days of $3-plus billion in daily spend according to the Adobe Digital Economy Index. Companies across B2B and B2C need an integrated customer experience management platform that empowers them to anticipate and meet the expectations of their customers. Today, digital is especially critical in enabling companies to drive profitable growth by delivering engaging and efficient customer experiences across the entire funnel, and Adobe is uniquely positioned to power experience-led growth. Experience Cloud offers a comprehensive portfolio of products that span the entire experience life cycle from marketing planning and workflows to data insights and activation to content and commerce and customer journeys. Built natively on Adobe Experience platform, our real-time CDP provides businesses with actionable customer profiles, leveraging data from online and off-line channels to deliver personalized experiences at scale. In Q1, we continued to drive strong growth in our Experience Cloud business, achieving $1.18 billion in revenue. Subscription revenue was $1.04 billion, both representing 14% year-over-year growth. Petco is a great example of a B2C company leveraging Adobe’s comprehensive set of products to create and deliver engaging experiences. Petco uses Creative Cloud to create content and Experience Cloud, including real-time CDP and Adobe Journey Optimizer, to orchestrate personalized experiences across their pet care ecosystem, including veterinary care, grooming, training and insurance. On the B2B side, Qualcomm is harnessing experience cloud to deliver personalized experiences and improve marketing performance as well as Creative Cloud and Document Cloud to accelerate content velocity across its business lines. Additional Q1 highlights include high retention rates and strong demand for services, demonstrating our customers’ focus on long-term value realization; strong growth in Adobe Experience Platform and our native applications, inclusive of real-time CDP, Adobe Journey Optimizer and Customer Journey Analytics; momentum for Workfront, which is powering workflows to help teams around the globe collaborate and launch campaigns with ease and efficiency; significant wins over single product competitors in analytics, content management and CDP that underscore Adobe’s differentiation; leadership in industry analyst reports, including the Forrester Wave for Digital Intelligence Platforms, the Forrester Wave for Cross-Channel Marketing Hubs and Gartner’s Magic Quadrant for Digital Experience Platforms; a significant number of transformational deals, including Accenture, Carnival Aida, Costco, IBM, MetLife, Paramount, Pfizer, S&P Global, TD Bank and Tim Hortons. The Digital Experience business had a strong start to the year. Enterprises are focused on driving revenue growth through digital channels while increasing the productivity of their investments in customer experience and marketing. Experience Cloud is uniquely positioned to help enterprise customers across the world unlock profitable growth. Next week, we are excited to host Adobe Summit, the world’s largest digital experience conference. It’s our first time coming together in person in Las Vegas since 2019. And we’ll be joined online by tens of thousands of customers, partners and developers from around the world. In addition to unveiling exciting new technology innovation across Experience Cloud, we will host inspirational C-level executives from several companies at the forefront of the digital economy. I will now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Today, I’ll start by summarizing Adobe’s performance in Q1 fiscal 2023, highlighting growth drivers across our businesses, and I’ll finish with financial targets. Q1 was a strong start to the year for Adobe. I know the macroeconomy is on every investor’s mind right now, and you can see the resilience and diversification of Adobe’s business in our financial results. Businesses today are prioritizing investments in order to maximize returns and impact, both to drive their top line and to deliver operational efficiency. And individuals are looking to create content that enables them to connect and stand out across digital platforms. In this environment, the demand for our products continues to be strong as our solutions are mission-critical to customers in a world where digital content and engagement drive the global economy. Our product differentiation, engine of innovation and data-driven operating model are continuing to drive Adobe’s growth. We have a world-class balance sheet, industry-leading margins, a strong cash flow profile and a proven track record. I can’t think of a company that’s better positioned as we continue to innovate in our core business and create and scale emerging businesses to drive profitable growth. In Q1, Adobe achieved record revenue of $4.66 billion, which represents 9% year-over-year growth or 13% in constant currency. Business and financial highlights included: GAAP diluted earnings per share of $2.71 and non-GAAP diluted earnings per share of $3.80, Digital Media revenue of $3.40 billion, net new Digital Media ARR of $410 million, Digital Experience revenue of $1.18 billion, cash flows from operations of $1.69 billion, RPO of $15.21 billion exiting the quarter and repurchasing approximately 5 million shares of our stock during the quarter. In our Digital Media segment, we achieved Q1 revenue of $3.40 billion, which represents 9% year-over-year growth or 14% in constant currency. We exited the quarter with $13.67 billion of Digital Media ARR. We achieved Creative revenue of $2.76 billion, which represents 8% year-over-year growth or 13% in constant currency, and we added $307 million of net new creative ARR in the quarter. Q1 Creative growth drivers included new user growth, fueled by customer demand and targeted marketing campaigns, which drove increased web traffic in the quarter; adoption of our Creative Cloud All Apps offerings across customer segments and geographies; students graduating from our Education segment into the creative professional job market; continued strength in upselling our new Acrobat CC offering, which includes integrated sign capabilities; licensing of individual applications, including a strong quarter for our imaging and photography offerings; momentum in high-growth businesses, such as Substance and Stock, where we had a tremendous quarter generating new business; and with Frame, which we are successfully cross-selling into our video customer base; a fast start to the year selling into our large enterprise accounts. Adobe achieved Document Cloud revenue of $634 million, which represents 13% year-over-year growth or 16% in constant currency. We added $103 million of net new Document Cloud ARR in the quarter. Q1 Document Cloud growth drivers included continued growth of Acrobat web, demonstrating the success of our product-led growth strategy; strength in conversion and retention rates of our Acrobat mobile customers; demand for Acrobat subscriptions across all customer segments; success generating new customer demand for Acrobat Sign in SMB and the mid-market; and strength in the enterprise, driving seat expansion for our Acrobat business. Turning to our Digital Experience segment. In Q1, we achieved revenue of $1.18 billion and subscription revenue of $1.04 billion, which represents 12% year-over-year growth or 14% in constant currency. Q1 Digital Experience growth drivers included success closing numerous transformational deals with large enterprises that are choosing Adobe to be their end-to-end CXM platform to drive personalization at scale; momentum with our AEP and native applications with the book of business growing more than 50% year-over-year; strength with our Content and Workfront solutions as our content supply chain strategy is resonating with customers; renewal rates of our enterprise customers that continue to be strong; and sales execution across multiple geographies. Turning to the income statement and balance sheet. In Q1, we continued with our strategy of making disciplined investments to drive growth while identifying cost-saving opportunities to drive earnings. Adobe’s effective tax rate in Q1 was 22% on a GAAP basis and 18.5% on a non-GAAP basis, in line with our expectations. For fiscal 2023, Adobe’s management is adopting a fixed long-term projected non-GAAP tax rate to assess and report on operating results, which we believe provides a clear view of Adobe’s financial performance. The fixed long-term non-GAAP rate considers our current operating structure, existing tax positions, legislation and available forecast information. This rate is based on a 3-year projection and may be adjusted for changes in the future. RPO exiting the quarter was $15.21 billion, growing 10% year-over-year or 13% when factoring in a 3 percentage point FX headwind. Our ending cash and short-term investment position exiting Q1 was $5.65 billion and cash flows from operations in the quarter were $1.69 billion. Over the past year, we completed a thorough review of our short-term investments and marketable securities to ensure we are prepared for the current environment and with a bias towards the higher end of the investment-grade spectrum. Adobe does not hold substantial assets or securities at Silicon Valley Bank or any regional bank. In Q1, we entered into a $1.4 billion share repurchase agreement, and we currently have $5.2 billion remaining of our $15 billion authorization granted in December 2020, which goes through the end of fiscal 2024. In light of the strong start to the year and momentum across our business and factoring in the macroeconomic environment, for Q2, we’re targeting: total Adobe revenue of $4.75 billion to $4.78 billion, Digital Media net new ARR of approximately $420 million, Digital Media segment revenue of $3.45 billion to $3.47 billion, Digital Experience segment revenue of $1.21 billion to $1.23 billion, Digital Experience subscription revenue of $1.06 billion to $1.08 billion, tax rate of approximately 21.5% on a GAAP basis and 18.5% on a non-GAAP basis, GAAP earnings per share of $2.65 to $2.70 and non-GAAP earnings per share of $3.75 to $3.80 and. As a result of the strong performance in Q1 and trajectory of the business, we are raising our fiscal 2023 net new ARR and EPS targets. For fiscal 2023, we are now targeting Digital Media net new ARR of approximately $1.70 billion, GAAP earnings per share of $10.85 to $11.15 and non-GAAP earnings per share of $15.30 to $15.60. In summary, I’m pleased with our strong top line and bottom line execution in Q1, demonstrating the momentum we’ve established for the year. Our strong engine of innovation, combined with our operational rigor, are driving profitable growth and position us well to capture the massive growth opportunities at our doorstep. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. Adobe’s Q1 results underscore our strong momentum and the significant opportunities we have across our businesses. We’re thrilled to be back in Las Vegas for Adobe Summit next week. In addition to unveiling several new innovations across Experience Cloud, Creative Cloud and Document Cloud, we will share how we are building on our decades of AI leadership to deliver generative AI technologies that redefine creativity and customer experiences. We look forward to seeing you there. Adobe’s employees around the world motivate us to continuously raise the bar and create the future. This quarter, we were named to Glassdoor’s Best Places to Work; Bloomberg’s Gender Equality Index for the 5th year in a row; and the CDP A List, which recognizes leadership and environmental impact. Our renowned brand, mission-critical products, and vast base of customers create an unmatched advantage that will fuel our growth. Thank you, and we will now take questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] And we will take our first question from the line of Brad Zelnick with Deutsche Bank. Please go ahead."
},
{
"speaker": "Brad Zelnick",
"text": "Great. Thank you so much for taking the question. And congrats on a really strong start to the year. Dan, your guidance explicitly embeds assumptions for the macro environment. Can you share with us what those are and how those assumptions might have changed from a few months ago when you last guided? Thanks."
},
{
"speaker": "Dan Durn",
"text": "Yes. Thanks, Brad. There is really no change in our view in the macro environment. I think we’re pretty clear at the time we set our annual guidance, the environment that we’re in. We see the environment that others see. I think you can see that the company is performing really well against that backdrop. So we feel good about how we’re situated, the way in which we’re engaging with customers and its broad diversified performance across that environment. And so we like how we’re set up, but there is really no change to the assumptions underlying the macro environment. We see the same environment that others do."
},
{
"speaker": "Brad Zelnick",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And we will take our next question from the line of Alex Zukin with Wolfe Research. Please go ahead."
},
{
"speaker": "Alex Zukin",
"text": "Yes. Hi, guys. So maybe just what do you think is the driving force behind – so many companies are talking about longer sales cycles, difficult to closing business. You had an outstanding quarter, specifically within the enterprise. So maybe what’s driving those macro headwinds for others that you’re not seeing or your resiliency specifically? And then on the topic of metrics, every metric was strong as we looked at revenues, RPO, Digital Media ARR operating margins. But maybe just can you talk about deferred revenue in the quarter? Anything there that was a headwind, because it did look like free cash flow was a little bit lighter than what we were expecting?"
},
{
"speaker": "Shantanu Narayen",
"text": "I’ll take the first, Alex, and then maybe Dan can speak to the second. I mean, I think, as Dan said, when we look at the macroeconomic situation, and you can see strong companies actually refer to this across the board, whether it’s consumers, whether it’s small and medium businesses, whether it’s enterprises globally, I think the reality is that digital for them is an imperative. And really for companies that have innovative solutions, it’s a tailwind. I think what a lot of companies are focused on is the message that enterprises are certainly sharing is that if the prior focus was growth at any cost, certainly, they are looking for more profitable growth. And I think if you look at our solutions on the creative document or enterprise side, we help them. We help them with growth, but we help them with profitable growth and engaging with customers. The second thing I would say is that there is a large TAM here, and so I think our job in this environment is making sure that we have an even larger pipeline that we go address and attract because there may be some difference in the closure rates. But I think if you look at it in aggregate, our job is looking at it and saying how do we differentiate ourselves. I think the one thing also I would say, Alex, is that a lot of the companies that have single product offerings, I think they are probably seeing more headwind because a certain company may not put one part of what they offer as a priority. And I think a lot of the companies are looking at it and saying if we’re engaging in digital, we might change our focus from content management to the implementation of the customer data platform or there might be a focus more on campaigns or ensuring that the advertising spend, the attribution associated with it. So I think the team has executed against continuing to try and drive a large opportunity. The other thing I think we feel good about is the fact that both Summit as well as in the U.S. and UK, we’re looking forward to being in person because we can engage more in person with them. So hopefully, that gives you some color of why perhaps the stronger companies are showing more macro strength than other companies."
},
{
"speaker": "Dan Durn",
"text": "And Alex, I’ll jump in on the second part of the question. As we think about RPO being up 13% year-over-year on a constant currency basis, you think about the underlying performance of deferred revenue, unbilled backlog, it’s very similar profile across both of those dimensions of the RPO. If you think about cash flow, the one thing I would point to, we all know that there has been a change in the tax regulation around capitalization of R&D expenses. We signaled at the time we set our annual targets that we would see a step-up in cash taxes starting this quarter, and that’s really what you see profiling through operating cash."
},
{
"speaker": "Alex Zukin",
"text": "Prefect. Thank you, guys. Congrats."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] We will take our next question from the line of Keith Weiss with Morgan Stanley. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "Hi, excellent. Thank you, guys for taking the question. A really nice quarter. I think my question is actually a deep dive into the prior two questions. Dan, maybe digging a little bit into sort of what Brad was asking. We are like, from a market perspective and an investor perspective, worrying about these kind of incremental impacts like Silicon Valley Bank and other bank failures. And you’re seeing continued like a reduction in headcount from big shops like Meta on a go-forward basis. So I think the market is getting incrementally worried about the underlying kind of macro impacts. But you guys went the other way. Like in Q1, you’re taking up your net new ARR additions for Digital Media. So can you walk us through specifically, is there anything mechanical or sort of tactical, if you will, that gives you guys the confidence that like even with the heightened kind of volatility that we’re seeing out there that you guys feel comfortable in Q1 taking up that full year guide? And then on the other side of the equation on the free cash flow, can you just specify for us and you can give us a sense of kind of where those cash taxes are going to go over time just to help us kind of tune in our model?"
},
{
"speaker": "Dan Durn",
"text": "Yes. So let me take them in reverse order. In terms of cash taxes, there is a 5-year amortization period around the capitalization of that R&D. So you’ll see a pretty dramatic cash tax step-up initially. But over that 5-year amortization period, it will converge on the reported tax rate. And so that’s the general profile, and that’s why you see the significant step-up in Q1 just starting that process now. In terms of the environment we are in, clearly, the company is performing well. You see the diversification of our business that’s across geographies, industry sectors, product portfolio. The company is just performing well at a broad base way on the strength of that performance and the momentum we have, the visibility we have into the full year. We think it’s the prudent thing to set expectations with investors in a way that reflects what we see as the opportunity in the company-specific performance. When I take a step back and I think about what is driving that differential performance in this environment, I think our products are mission-critical to our customers. We are on the critical path of them generating revenue. But as the world goes digital and those investments are prioritized, not only do we help companies drive top line growth, but we help them with the underlying productivity gains that go with that. It is why customers in this environment are prioritizing around things that we sell to enable their success. It addresses top line performance as well as underlying profitability of our customers. So being on the critical path, being mission critical to customers, we think this is the type of environment where the power of Adobe and the performance of the company gets to shine."
},
{
"speaker": "David Wadhwani",
"text": "Yes. And I’ll just add a little bit specific to Digital Media. The foundation of the growth that we have, we still feel a very significant tailwind even in this market. Shantanu talked about the strength of the enterprise business. Every business needs to be a digital business. Digital content is fueling the global economy. That’s true for smaller organizations and individuals as well. If you look at the creator economy, we’re seeing more people come in to start to create their own personal online brands. So we saw a very strong digital funnel. As well, we had the highest traffic that we’ve ever had come to adobe.com. And even in small, medium businesses, the part of their business that they need to invest most in is the digital channel as Dan was talking about. You look at that diversity, you then layer on the diversity of the growth drivers that we have in the business, whether it’s new user acquisition, whether it’s upsell of existing users, whether it’s retention rates, whether it’s new businesses like Substance or Stock or the pricing and packaging opportunities that we have. Every one of those levers has been very productive for us. In terms of primary growth driver, it is and always has been new user acquisition. It is by far the biggest contributor, and a lot of the PLG work that we’ve done over the last year or 1.5 years is contributing to not just top of funnel, but also conversion of that top of funnel. In terms of upsell and migration, we’ve been investing for a decade or more in education, and we have a very efficient channel now where students that graduate effectively upgrade and migrate into full priced offerings. That drove a very strong Creative Cloud individual all apps quarter for us. Retention, we’ve been doing a lot of work in retention through PLG, but we’ve also been driving a lot of utilization of Adobe Express as part of the Creative Cloud business. All of that combined makes for a very strong retention rate. New businesses, we talked about Substance and Frame having outsized growth. And of course, the pricing and packaging work that we’ve been doing and all along continues to contribute to that, both for CC and Acrobat CCDC as a whole. So looking ahead, all of these drivers and these levers are intact, and we have lots of opportunities going forward as well."
},
{
"speaker": "Shantanu Narayen",
"text": "And maybe just putting it altogether if you look at it and say that, hey, we did $410 million in Q1, we are targeting $420 million of net new ARR in Q2. The question you would have asked us if we hadn’t done this was what are you signaling about the second half of the year. So I think it’s a way of showing that the momentum is there in the business."
},
{
"speaker": "Keith Weiss",
"text": "Super helpful. Thank you, guys."
},
{
"speaker": "Operator",
"text": "And we will take our next question from the line of Jake Roberge with William Blair. Please proceed."
},
{
"speaker": "Jake Roberge",
"text": "Hey, congrats on great results. I just want to double click on that retention commentary you said, you called out several – in several areas of the business during the prepared remarks. Is there anything specific that you’re doing differently in this period of macro uncertainty that’s driving those results? And have you started to see Express help at all with retention metrics as customers now the tier that they can actually graduate down to?"
},
{
"speaker": "Shantanu Narayen",
"text": "Well, for a couple of years right now, we’ve been really focused on what we’ve called in the past, the data-driven operating model and really being pretty focused on driving the business both with the narrative and the number. And so I think as we continue to, as David mentioned, have different products. And he is really focused on how we are acquiring them, how are we engaging them, what’s the usage, how do we make sure they are getting value for the product, how do we continuously tell them about what’s new. And then I think as David has come in and introduced the notion of product PLG, I think that part has also really started to reflect in making sure that customers know that we’re building products and features that are relevant for the pain points that they have. So I would say the underlying business, while they are sort of the digital imperative, I wouldn’t underestimate the incredible execution that the team continues to do on that or in DX. I mean how do you look at the solutions we’re selling? How do you understand cross-sell? How do you understand upsell? And I think the hours and hours of work that goes in is sometimes not appreciated, but I’m incredibly respectful and appreciative of what the teams have done. So a lot of execution is, I think, the short answer."
},
{
"speaker": "Jake Roberge",
"text": "Great. Thanks for taking my questions."
},
{
"speaker": "Operator",
"text": "And we will take the next question from the line of Brad Sills with Bank of America. Please go ahead."
},
{
"speaker": "Brad Sills",
"text": "Great. Thank you so much. I wanted to ask about that top of funnel activity that you have been generating here with Communicator and the consumer segment with Creative Cloud Express, the success you’re seeing there, some exciting new announcements coming here. It sounds like on Creative Cloud Express enhancements here. Could we interpret that to mean that perhaps you’re pivoting more towards upselling those customers to some of these newer features and offerings that are coming with Creative Cloud Express away from that top of funnel activity that you’ve been very successful with thus far? Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Yes. As Shantanu talked about, it’s a holistic process. First of all, we’ve, over the last couple of years, spent a lot of time with product-led growth. What that gives us is confidence that when people come to Adobe.com and they get into the products, they are going to have a great onboarding experience. They are more likely to convert, and they are more likely to stay, which then starts to give us more confidence and growth in terms of improving what has already been a world class in terms of lifetime value. As that happens, we’ve been running more targeted campaigns with things for Photoshop and Acrobat and Illustrator as an example that are more targeted to the growth activities and the landing pages in the products themselves. And we’ve actually been connecting all of our outbound marketing activities with landing pages in the products themselves. So we have been able to really increase our demand efforts and the ROI associated with that to bring more traffic to top of funnel. In addition to that, we have been investing a lot in growth loops. So people are able to now when using the products actually share some of – share the content out to stakeholders. Those stakeholders are able to look at that content, but also become top of funnel opportunity for us. If you look at Acrobat Web, as an example, we have seen a massive increase in terms of Acrobat Web usage driven by things like Share for Review. So, that drives more top of funnel for us. And then third is partnerships. We have been working very closely with Microsoft as an example. We have announced that Reader, as an example, will be the default PDF viewer in Edge, which now gives us access to over billion users on Windows-based devices. So, it’s a cacophony of these activities that ultimately results in strong top of funnel. And then as we talked about, it’s really about the hard work and the data to drive personalized experiences at scale, leveraging a lot of Anil’s DX businesses and products to drive users all the way through to conversion."
},
{
"speaker": "Brad Sills",
"text": "Wonderful to hear. Thank you."
},
{
"speaker": "Operator",
"text": "And we will take our next question from the line of Michael Turrin with Wells Fargo Securities. Please go ahead."
},
{
"speaker": "Michael Turrin",
"text": "Hey. Great. Thanks. Thanks for taking the question. One of the things that stood out is you mentioned wins over single product competitors and a few key areas on the digital experience side. Can we go a bit deeper into that as this environment and some of what’s happening on the private company side, maybe presenting opportunities you are now able to take advantage of? I would just be curious here a bit more on maybe both the DX and DM side, just what’s happening there. Thank you."
},
{
"speaker": "Anil Chakravarthy",
"text": "Yes. Let me start on the digital experience side. We have a broad and comprehensive portfolio, and it’s integrated with the Adobe Experience Platform. So, from a customer perspective, they get the best of both worlds. They get those best-in-class applications, whether it’s content and commerce or customer journeys or data insights or workflow, marketing workflow, and they get the benefit of integration with the Adobe Experience Platform and the native apps that we have built there. So, that’s a powerful combination. It helps to really address what Shantanu was talking about, which is how do you keep growing through your digital channels and you get the revenue growth, but you also get the benefit of getting efficiency through consolidation. And that’s where we believe we really shine as customers are looking at their overall stack, similar to what they have done in other aspects of their IT enterprise architecture. They are looking at who is my go-to platform that I can really standardize on and I will build around, and so we are getting the benefit of that choice."
},
{
"speaker": "David Wadhwani",
"text": "And on the DME side, we look at the – just like all the energy in the market around single product players, whether it’s a mobile app, whether it’s a web app or whether it’s this excitement, incredible excitement and that we have as well around generative AI really is focused on driving top of funnel because it’s driving a lot of awareness of creativity and the things that people want to do. And ultimately, as they leverage those apps, as they see themselves as more accretive, they inevitably end up at our doorstep going forward."
},
{
"speaker": "Operator",
"text": "And we will take our next question from the line of Kash Rangan with Goldman Sachs. Please go ahead."
},
{
"speaker": "Kash Rangan",
"text": "Thank you very much. I just want to pick up there. I think David talked about the excitement with generative AI, anybody that wants to jump in. What does this mean for Adobe? Is this just somewhat substitutive for all the opportunity that you have, or is it somewhat incremental or massively incremental? And how does Adobe monetize generative AI? Is this something that you can create a separate SKU or charge more? I am curious to get your thoughts quantitatively and qualitatively. Thank you so much."
},
{
"speaker": "David Wadhwani",
"text": "Kash, I think there was about three or four questions, but all related. So, happy to take those really quickly. Nicely played. First of all, this is really about increasing the total number of users, we believe, very strongly. As we talked about at MAX, this is about enhancing human creativity, not replacing it. And ultimately, whether you are an individual solo printer SMB or enterprise, we are hearing the same thing, which is that you need to create more content than you are able to create today. And so this really plays well into our core strengths. As you know, we have got a decades-long focus on AI, things like neural filters and object selection. And hundreds of other features have been based on AI for us, and they have increased creativity, and they have increased productivity, and they have helped people keep up with the demand for content. They have also made it easier for people to onboard into the experiences, and so we have been able to broaden the opportunity for people to start leveraging and using our core products. We have now been able to leverage the hundreds of people that are in our research organization and really target them towards generative technology, which we believe is a huge step forward, leveraging all of the work we have done, but a huge step forward going forward. And we and everyone else in the industry are still in the early innings. So, to give you a sense of where we are going at MAX, we talked about our vision for effectively not just creating content, but really engaging and embedding it in the existing workflows to create a creative copilot we refer to it as. And since then, we have been very hard at work at creating our own model, and the model that we are focused on is around output quality. So, it’s about best-of-breed generative AI. But combining that with the Adobe magic that we have talked about over the years and all of the technology we have that takes images and makes them better, and so the output quality, we think is going to be differentiated. The second thing is around commercial reuse. There is a lot of complex questions here around copyrights, around diversity and inclusion, about harmful content that’s being created. That’s something we take very seriously, and we are embedding that into everything we do. And the third thing is really about workflow integration. Creating an image is just the start. It’s not the end. And Adobe is the only player that has a full end-to-end workflow, not just within the products and the tools that we have in the digital media business, but also everything that Anil is doing around the content workflow and the content supply chain out to the point of distribution. And in fact, because of this, we are seeing other gentech companies wanting to partner with us more and more, and so we feel like we are in a really advantaged position where we are going to come out with our own model and we are going to be partnering with others to make sure that because of our distribution and the place we play in the market, we can bring a lot of this value to actual fruition. And stay tuned, next week at Summit, where we have a lot of exciting announcements and progress to make there. And then last to your, I think fourth or fifth question."
},
{
"speaker": "Kash Rangan",
"text": "Monetization, yes, correct."
},
{
"speaker": "David Wadhwani",
"text": "Monetization, we are very excited about what this means for the business. New user onboarding. We think that, again, if you can start to imagine yourself as creative by using a text prompt, we can take you through that full journey and onboard you into other Adobe offerings. It’s also great for retention. We have always seen the more value that gets used in our core offerings, the better the retention rates and the better the LTV. And we think there is up-sell opportunity. We do think these are distinct new packages that we can bring to market and up-sell people to."
},
{
"speaker": "Operator",
"text": "And we will take our next question from the line of Jay Vleeschhouwer with Griffin Securities. Please go ahead."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. David, for you first, when we spoke at MAX on the subject of monetization, you alluded to Adobe’s plans for new pricing and packaging, and you alluded to that this evening. But there was a third ingredient that you also alluded to at the time, which was segmentation, which sounded to me like something that you have success with back in the pre-CC days. And so is this something that you could talk about in terms of your returning to the segmentation techniques of the past that work rather well for the company? And then for Anil, it’s interesting to hear the reference to your competition with single product companies. That’s not a new phenomenon, of course. You have had multi-solution DX portfolio for some time. So, would you say, therefore that the wins or magnitude of the wins against single product competitors is more pronounced now? It’s a larger part of the DX business? And would you say that the investments that you have evidently been making over the last year in consulting capacity has been a critical enabling ingredient for the growth you are now seeing in DX?"
},
{
"speaker": "David Wadhwani",
"text": "Yes. So, starting with the DME side, Jay, for broad understanding, what we talked about at Adobe MAX was this recognition that since we introduced Creative Cloud 10 years or 11 years ago, we have now a much more comprehensive set of capabilities all the way from a freemium model with Adobe Express, all the way to our high-end creative cloud offerings, but also additional capabilities and packages beyond that like Substance and like Frame and like Stock that allow people to go beyond what they can do with the core creative products. The second thing that, in addition to that expansion that’s happened is that as we have been driving more with DDAM [ph] and more with product-led growth, we are starting to automatically segment customers, not necessarily today in terms of what they buy, but how they experience the products that they are using already. And so what that leads to is an opportunity. And then going back to all the levers that we have for ongoing growth, there is the opportunity to start segmenting them earlier in the purchase flow into offers and offers that meet their needs and optimize the value to the price in a way that benefits our customers and of course also benefits Adobe. So, you can expect to see us continuing to play with everything from how we get new users, how we up-sell users, how we retain them, new businesses we bring in, but also pricing and packaging to your point."
},
{
"speaker": "Shantanu Narayen",
"text": "And just to punctuate that maybe a little bit, Jay. I mean the reality is that we actually have different pricing for different devices today, which is completely different. We have web-based pricing for people who come and experience this as a result of a web search that they have made more successfully through Acrobat Web, for example. And so if the question is when we have had things like design collection or web collection or video collection, I mean the reality is the CCO laps, which actually had a really good quarter, is perceived by people to be the new sort of table stakes for what is happening in creative, and we think that that’s a great offering. And as David said, I mean whether it’s Stock or whether it is Substance and our 3D offerings, what we are doing there, those are really perceived to be the differential offerings that are personalized. And for a Photoshop customer, how do we get them to use one of these other offerings. So, I think we have done a really good job on that particular front."
},
{
"speaker": "Anil Chakravarthy",
"text": "Yes. From the DX perspective, we obviously started investing in AEP 5 years ago. Now we have lots of examples of customers who are using some of the capabilities like unified profile or the real-time CDP and the real-time performance at scale in production. So, from a customers’ perspective, if they think about a single product, they actually know what an integrated product looks like, and they realize that that’s what they would have to build together, build on their own. So, I think that’s making the choice of going with a product from Adobe, which is already integrated with also best-in-class applications versus a single product where they would have to put it together. I think that’s making the contrast more stark."
},
{
"speaker": "Shantanu Narayen",
"text": "And there is more scrutiny, wouldn’t you say, Anil, that so I think part of what’s happening is as the IT or the Chief Marketing Officer, the Chief Digital Officer is thinking about this holistically. There is more scrutiny around who is the company that can provide us the more comprehensive solutions. So, that – you have seen, Jay, a certain difference in how customers are viewing that, which again plays to our strengths."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And we will take our next question from the line of Saket Kalia with Barclays. Please go ahead."
},
{
"speaker": "Saket Kalia",
"text": "Okay. Great. Hey guys. Thanks for taking my question here and well done in the quarter as well. I would love to dig into Figma a little bit, understanding very well that it’s still in process. And so David, maybe for you, I know you and the team see the opportunities with products like FigJam in really complementing Creative Cloud. I was wondering if you have seen other opportunities for some of that complementary sort of opportunity as you spend more time with the business. And then, Dan, maybe just a quick housekeeping question. Can you just remind us sort of what the revenue overlap looks like with Figma? I believe it’s the Adobe XD product where specifically where there is overlap, but maybe you could just remind us sort of what that revenue overlap looks like?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. Saket, maybe I will first jump in. I mean I think just let’s remember before they answer, these are two separate companies, and so we are operating at arm’s length in terms of what they are doing. I think we have shared upfront that the XD revenue is de minimis, and so that’s the part that I wanted to get across. And then David can certainly speak to some of the strategic rationale and ideas for what we can do."
},
{
"speaker": "David Wadhwani",
"text": "Yes. So, I think there is a ton of opportunity in terms of how we look at the Figma business and figure out Figma opportunity. First of all, as we have discussed, we believe that we can just fundamentally accelerate what they are doing today in product design. We have a global footprint. We are working with a lot of our – with enterprise customers across the globe, and the feedback that we are getting from these enterprise customers is a lot of excitement about the kind of things we can do by bringing these two companies together to just accelerate and make them more productive in terms of what they want to accomplish and just accelerate everything that they are doing. The second thing is around taking workflows between Photoshop and Illustrator and Figma and really just operationalizing them in a way that we can bring real-time collaboration capabilities based on the Figma platform to these – to the core disciplines like illustration and video editing and photography and 3D design and more. And the third is really around the evolution with FigJam, bringing that into the core for productivity use cases. So, taking FigJam and integrating it more deeply with things like Acrobat and starting to just recognize that creativity is starting to be the foundation of how new productivity applications need to present themselves. And that whole motion of enabling productivity workers to express themselves creatively is where the market is going with the rise of the creator economy. And so we see – we just see a ton of opportunities to integrate the products. We can’t – we are limited in what we can talk to them about in a moment. But what I can say is everyone from Adobe employees to Figma employees, to our customers, can’t wait for this to close so we can actually get moving on all this."
},
{
"speaker": "Saket Kalia",
"text": "Very helpful. Thanks guys."
},
{
"speaker": "Jonathan Vaas",
"text": "Operator, we are just about at the top of the hour. We will take one more question, please."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from the line of Brent Thill with Jefferies. Please go ahead."
},
{
"speaker": "Brent Thill",
"text": "Shantanu, on the DX business, I am just curious if you could just give us an overview of what you are seeing there. Are you still seeing the big deals? Are you seeing a smaller number of – higher number of smaller transactions, anything? Can you just talk through the pipeline? Just general kind of set up, what you are seeing in terms of the overall DX business and how customers are behaving?"
},
{
"speaker": "Shantanu Narayen",
"text": "Happy to, Brent, and I hope we get to see you next week at Summit because then you willalso get to meet a whole bunch of customers. I think – and Anil, certainly feel free to add. I mean I think we saw some really good transformational deals. I think both Dan and Anil referred to that. And so companies that are looking at Adobe to help them with their entire end-to-end customer experience management, good strength there, Brent. I mean those tend to be ones that we have worked with for many years and some that are really looking at it as a strategic. So, I would say that segment, the pipeline associated with people who are looking for a comprehensive and integrated CXM solution is pretty large. I think as it relates to what we call the solution-led segment as well, which is people who may have our analytic solutions and want content solutions or those who have both of those and want journey optimizer or customer journey analytics or certainly the commerce solutions, that’s another part of the business where we are making sure that we can up-sell. I know Anil typically at every FA meeting gives you stats and metrics on how we are making progress. So, that is one. Given we have the customer relationship and we have the customer engagement, and we have customer success managers, I think continuing to penetrate a customer account, that’s where also we see pipeline. And that’s a pipeline that’s driven, frankly, by us. I think in terms of the geographies, we continue to see strength in North America. I think when you think about EMEA, that remains an area of strength. There are some areas in Asia, some countries in Asia. So, our job there, really, Brent, has been how do you drive a large pipeline, understanding that there is going to be different companies that look at this differently in specific quarter, but we are focused on the addressable market. Anil, I don’t know if you have other stuff to add."
},
{
"speaker": "Anil Chakravarthy",
"text": "I think the only thing I would say is I think the themes that we are going to hit on at Summit, personalization at scale, content supply chain, even for customers who are starting with a single product, they like that vision because they know that, that is what is key to driving the digital growth and driving profitable growth. So, even if they are starting with one and focusing on value realization, they have their eye on a longer term roadmap, and that benefits our relationship with them."
},
{
"speaker": "Shantanu Narayen",
"text": "And Brent, the other thing I will say, given just the last question is, I think at Summit, you will see some of the themes. I mean certainly, content has been a theme for us for a long time. Data has been a theme for us for a long time. The focus on customer platform and CDP has been a big one. I think how this spreads its tentacles into the product and PLG as David has said, so I think we have some exciting things that we will talk about in that particular space in AI and how AI can help. So, we are not just resting on what we have today as an integrated offering. We are really the innovative product roadmap across each one of our businesses, what Dave has been doing in creative, what’s happening in documents on the web and mobile devices and what Anil is going to show. I think that’s also what gives us a lot of confidence that we are anticipating and solving customer problems. And so it was a strong start to Q1. And based on the product innovation, we really continue to be excited about the opportunity that we have at Adobe, and we look forward to seeing all of you at Summit."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks everyone for joining the call. Like Shantanu said, we hope to see many of you next Tuesday at Summit. I look forward to talking to many of you soon and this concludes the call."
},
{
"speaker": "Operator",
"text": "Thank you. This does conclude today’s meeting. Thank you for your attendance and you may now disconnect."
}
] | Adobe Inc. | 24,321 |
ADBE | 4 | 2,024 | 2024-12-11 17:00:00 | Operator: Good day, and welcome to the Q4 and FY2024 Adobe earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Steve Day, SVP, DXCFO, and Corporate Finance Interim Head of IR. Please go ahead, sir.
Steve Day: Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's fourth quarter and fiscal year 2024 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, December 11th, and contains forward-looking statements that involve risk, uncertainty, and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates, as well as constant currency rates. During this presentation, Adobe's executives will refer to constant currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe's investor relations website. I will now turn the call over to Shantanu. Thanks, Steve.
Shantanu Narayen: Good afternoon, and thank you for joining us. In Q4, we achieved revenue of $5.61 billion, representing 11% year-over-year growth. In our digital media business, we delivered record net new ARR of $578 million, and our digital experience business achieved subscription revenue of $1.27 billion, representing 12% year-over-year growth. 2024 was a year of records for Adobe. We achieved record revenue of $21.51 billion, representing 11% year-over-year growth. GAAP earnings per share was $12.36, and non-GAAP earnings per share was $18.42, representing 5% and 15% year-over-year growth, respectively. We had several new milestones with our AI innovations enabling us to add more than $2 billion in digital media net new ARR and surpass $1 billion in the ending book of business for Adobe Experience Platform and native apps. The digital experience business crossed $5 billion in revenue, making us one of the mission-critical providers of marketing technology in the world. We exited the year with $19.96 billion in RPO and cash and short-term investments of $7.89 billion. 2024 was also a transformative year of product innovation. We delivered foundational technology platforms and introduced multiple generative AI models in the Adobe Firefly family, including imaging, vector design, and most recently, the Yo. Adobe now has a comprehensive set of generative AI models designed to be commercially safe for creative content, offering unprecedented levels of output quality and user control in our applications. We reimagined creativity and productivity for a broader set of customers with Adobe Express, the quick and easy create-anything app. The deep integration of Fireflies across our flagship applications in Creative Cloud, Document Cloud, and Experience Cloud is driving record customer adoption and usage. Firefly Power Generation's across our tools surpassed 16 billion, with every month this past quarter setting a new record. We enhanced document productivity with AI assistant in Adobe Acrobat and Reader, unlocking even greater value from the trillions of PDFs around the world. We've successfully scaled Adobe Experience Platform and native apps to deliver the fundamental infrastructure required for customer engagement. We're accelerating automated decisioning, empowering audiences, journeys, and channels to deliver truly personalized experiences at scale. We set the stage to drive an AI content revolution by bringing content and data together in Adobe Gen Studio, integrating high-velocity creative expression with enterprise activation. The release of Adobe Gen Studio for performance marketing integrates Creative Cloud, Express, and Experience Cloud and extends our end-to-end content supply chain solution, empowering freelancers, agencies, and enterprises to accelerate the delivery of content, advertising, and marketing campaigns. I'll now turn it over to David to discuss the momentum in our digital media business.
David Wadhwani: Thanks, Shantanu. Hello, everyone. In Q4, we achieved net new digital media ARR of $578 million and revenue of $4.15 billion, which grew 12% year-over-year, fueled by innovation in both our creative and document businesses. We ended the year with just over $2 billion of net new digital media ARR for the first time ever as a result of accelerated product innovation, record traffic to adobe.com, and engagement on social and mobile, as well as increasing value for enterprise customers through Firefly Services and GenStudio. We bring together our creative and experience clouds. On the document cloud side, PDF continues to be the global standard for digital. Adobe Acrobat is revolutionizing the way people engage with them across mobile, web, and desktop. We took a major step forward in FY2024 with the introduction of AI Assistant in Acrobat and Reader. AI Assistant and other AI features like liquid mode and Firefly are accelerating productivity through faster insights, smarter document editing, and integrated image generation. A recent productivity study found that users leveraging AI Assistant completed their document-related tasks four times faster on average. AI Assistant is now available in Acrobat across desktop, web, and mobile, and integrated into our Edge, Chrome, and Microsoft Teams extensions. In Q4, we continued to extend its value with specialized AI for contracts and scanned documents, support for additional languages, and the ability to analyze larger documents. In Acrobat Web, our integrations with Adobe Express allow users to generate images and quickly stylize content. We saw AI Assistant conversations double quarter over quarter, driving deeper customer value. In Q4, we achieved document cloud revenue of $843 million, growing 17% year-over-year. We set a record for net new Document Cloud ARR of $173 million, with ending ARR of $3.48 billion, growing 23% year-over-year. Other highlights include continued growth of monthly active users, which grew over 25% year-over-year, surpassing 650 million paid and free users. Strong top-of-funnel momentum through Acrobat web with monthly active users up nearly 50% year-over-year. Strength in Acrobat Pro single app, in both Document Cloud and Creative Cloud offerings. A great back-to-school season with a new AI Assistant in education for students. Key enterprise customer wins include Abbott Laboratories, BWI GmbH, Defense Information Systems Agency, Kaiser Permanente, Novo Nordisk, Truist, UScellular, and the US Department of State. Creative Cloud also had a strong year. As demand for content continues to grow across mobile, desktop, and streaming platforms. Adobe MAX, the premier creativity conference, showcased our FY2024 innovation and drove over 0.5 billion video views across all channels. We have made major strides with our generative AI models with the introduction of Firefly image model three enhancements to our vector models, richer design models, and the all-new Firefly video model. These models are incredibly powerful on their own, and their deep integration into our tools like Lightroom, Photoshop, Premier InDesign, and Express have brought incredible value to millions of creative professionals around the world. We have brought our creative and experienced clouds together through the introduction of Firefly services in GenStudio, addressing the growing need for scaled content production in enterprises. Firefly generations continue to accelerate and have now crossed 16 billion cumulative generations. In Q4, we achieved $3.3 billion revenue, which grew 11% year-over-year. Net new Creative Cloud ARR was $405 million. Other highlights include adoption of Adobe Express by approximately 4,000 businesses in the quarter, and an 84% year-over-year increase in the number of students with access to Express Premium as part of this year's back-to-school season. Adobe Express saw strong ecosystem growth with over 180 plugins available in the Express marketplace and integrations with leading social productivity and collaboration apps like ChatGPT, Google, Slack, Wix, Box, HubSpot, and Webflow, significantly increasing our customer reach. The launch of the Fireflies video model and its unique integration in Premiere Pro unlimited public beta garnered massive customer interest, and we look forward to making it more broadly available in early 2025. This feature drove a 70% increase in the number of Premiere Pro beta users. Enhancements to Firefly image vector and design models include four times faster image generation and new capabilities integrated into Photoshop, Illustrator, Premiere Pro, and Adobe Express. Strong adoption of Lightroom mobile with customers embracing innovations like generative remove and lens blur, as well as quick actions, which streamline editing and increase discovery and adoption of premium features. Just this morning, Adobe Lightroom was recognized as the Mac app of the year in Apple's annual App Store Awards. The launch of the new Frame.io v4 streamlines creative management for video projects, enabling end-to-end editing capabilities and seamless collaboration between editors and their stakeholders. Firefly services adoption continued to ramp as enterprises such as Pepsi and Tapestry use it to scale content production given the robust APIs and ease of creating custom models that are designed to be commercially safe. Key enterprise customer wins include Alphabet, American Express, Coca-Cola, Johnson & Johnson, LVMH, Nestle, Procter & Gamble, T-Mobile, and the US Department of Defense. Our AI product releases and business evolution in FY2024 have set the stage for another strong year ahead as we expand to new audiences, deliver more value to existing users, and increasingly integrate our digital media and digital experience clouds to create differentiated business solutions. We will do this by accelerating the adoption of freemium offers, including Express, Lightroom, and Acrobat on web and mobile, as well as expanding access to Acrobat AI Assistant delivered strong financial performance in FY2024. Growing our core creative business by continuing to expand our AI innovations in our flagship applications as well as bringing them to web and mobile. In addition, we will soon introduce a new higher-priced Fireflies offering that includes our video models as a comprehensive AI solution for creative professionals. This will allow us to monetize new users, provide additional value to existing customers, and increase ARPU. And further accelerating Fireflies services, which saw significant demand in FY2024, integrating it into GenStudio to provide enterprises with solutions to exponentially scale their content production capabilities with AI. We're thrilled with the response to our innovations in FY2024, excited to release new capabilities, and look forward to delighting customers in the year ahead. I'll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello, everyone. The Experience Cloud business had a strong close to the year, achieving revenue of $1.4 billion for the quarter and a record $5.37 billion in revenue in fiscal 2024. Subscription revenue in the quarter was $1.27 billion, representing 12% year-over-year growth. The book of business for Adobe Experience Platform and native apps, real-time CDP, customer journey analytics, and journey optimizer surpassed $1 billion in the quarter, with 48 of the Fortune 100 companies now leveraging these solutions. The market opportunity for customer experience management is large and growing. Both B2B and B2C companies are selecting Adobe as the strategic technology partner to accelerate customer acquisition, engagement, and retention. Our leading solutions spanning content, data, and customer journeys empower businesses to drive top-line growth while simultaneously delivering productivity gains. The AI innovations we have delivered enable our customers to accelerate the delivery of personalized experiences at scale and have been built to satisfy enterprise governance requirements. Adobe Experience Platform AI Assistant empowers marketers to automate tasks and generate new audiences and journeys. Adobe Experience Manager generates variations and provides dynamic and personalized content creation natively through AEM, enabling customers to deliver more compelling and engaging experiences on their websites. We are transforming the content supply chain for enterprises with Adobe Gen Studio, which natively integrates multiple Adobe applications across Creative Cloud and Experience Cloud, including Express, Firefly, Workfront, Experience Manager, Customer Journey Analytics, and Journey Optimizer. Gen Studio enables agencies and enterprises to unlock new levels of creativity and efficiency across content creation and production, workflow and planning, asset management, delivery and activation, reporting, and insights. Adobe Gen Studio for performance marketing is a great addition to the Gen Studio portfolio, offering an integrated application to create paid social ads, display ads, banners, and marketing emails by leveraging preapproved on-brand content. It brings together creative teams that define the foundational requirements of a brand, including guidelines around brand voice, channels, and images, with marketing teams that need to deliver numerous content variations with speed and agility. We are seeing strong customer demand for Adobe Gen Studio for performance marketing since its general availability at MAX. Gen Studio is the answer to address how marketing is going to transform in the era of AI for CMOs, CIOs, and CFOs. Other highlights include an expanded partnership with Amazon to make Adobe Experience Platform available on Amazon Web Services and extend our leadership across enterprises. Enterprises will soon be able to access the full power of AEP and native apps on AWS. Integration partnerships with Google's Campaign Manager 360, Meta, Microsoft Advertising, Snap, and TikTok offer marketing teams a holistic view of campaign performance directly in Adobe Gen Studio to optimize the ROI of their ad spend. Strong industry analyst recognition in major analyst reports, including the Gartner Magic Quadrant for Digital Commerce and the Forrester Wave for Cross-Channel Marketing Hubs. In particular, Gartner recognized Adobe's critical capabilities for multichannel marketing, such as our differentiated ability to adapt customer journeys in real-time based on customer behavior. AI innovations delivered in the premium tiers and add-ons helped us close our largest bookings quarter ever, with key global customer wins, including Air Canada, Alliant, American Express, Bank of America, BMW, Centene, CIBC, Cisco, Disney, Fanatics, Gap, GM, JPMorgan Chase, PayPal, Samsung, Tesco, and Wells Fargo. Digital remains a critical growth imperative for businesses around the world. Adobe Digital Insights, which analyzes trillions of data points, reported that both Black Friday and Cyber Monday sales hit record highs of $10.8 billion and $13.3 billion, jumping 10.2% and 7.3% from last year, respectively. We expect the full holiday season to hit $240.8 billion, up 8.4% year-over-year. With the availability of our new offerings in FY2025, Adobe has a unique opportunity to capitalize on the breadth of these solutions to further optimize our integrated go-to-market field organization. We're expanding our enterprise go-to-market teams to sell these integrated solutions that cut across digital media and digital experience globally under the new Gen Studio umbrella. We've seen early success for this strategy that included Express and Firefly services in Q4. As we enable our worldwide field organization in Q1, we anticipate acceleration of this pipeline throughout the rest of the year and beyond. We are confident of continuing our leadership and momentum into 2025. I will now pass it to Dan.
Dan Durn: Thanks, Anil. Our earnings report today covers both Q4 and FY2024 results, highlighting growth drivers across our businesses, and I'll finish with financial targets. We are proud of the performance we have driven in FY2024, delivering record revenue, EPS, and operating cash flows while aggressively investing in AI product innovation. New AI releases, including Express, Acrobat AI Assistant, Firefly services, DX premium tiers, and Gen Studio for performance marketing, have expanded the portfolio of products, driving proliferation and meaningful Gen AI monetization. We had a strong finish to the year, with records in digital media net new ARR and digital experience bookings. In FY2024, Adobe achieved record revenue of $21.51 billion, which represents 11% year-over-year growth as reported and in constant currency. GAAP EPS for the year was $12.36, and non-GAAP EPS was $18.42, growing 5% and 15% year-over-year, respectively. FY2024 business and financial highlights included digital media revenue of $15.86 billion, net new digital media ARR of $2.00 billion, digital experience revenue of $5.37 billion, cash flows from operations of $8.06 billion, RPO of $19.96 billion exiting the year, and repurchasing approximately 17.5 million shares of our stock during the year. In the fourth quarter of FY2024, Adobe achieved revenue of $5.61 billion, which represents 11% year-over-year growth as reported and in constant currency. GAAP diluted earnings per share in Q4 was $3.79, and non-GAAP diluted earnings per share was a record $4.81, growing 17% and 13% year-over-year, respectively. Q4 business and financial highlights included digital media revenue of $4.15 billion, net new digital media ARR of $578 million, digital experience revenue of $1.40 billion, cash flows from operations of $2.92 billion, and added $1.82 billion to RPO in the quarter. In our digital media segment, we achieved Q4 revenue of $4.15 billion, which represents 12% year-over-year growth as reported and in constant currency. We exited the quarter with $17.33 billion of digital media ARR, growing our ending ARR book of business 13% year-over-year in constant currency. Adobe achieved document cloud revenue of $843 million, which represents 17% year-over-year growth as reported and in constant currency. In the quarter, we added $173 million of net new Document Cloud ARR, growing our ending ARR book of business 23% year-over-year in constant currency. Fourth quarter Document Cloud growth drivers included strong growth across Reader and Acrobat on web and mobile, and extensions such as Edge and Chrome, Acrobat subscription demand across all customer segments, routes to market, and geographies. Accelerated adoption and monetization of AI Assistant driven by product enhancements and delivery of French and German language support. And year-end seasonal strength in the enterprise. We achieved creative revenue of $3.30 billion, which represents 10% year-over-year growth or 11% in constant currency. In the quarter, we added $405 million of net new creative ARR, growing our ending ARR book of business 11% year-over-year in constant currency. Fourth quarter Creative Cloud growth drivers included strong demand for new subscriptions for Creative Cloud all apps, across individuals, teams, enterprise, and education. Strength and Creative Cloud single latch for Acrobat Pro, Lightroom, and Photoshop. Momentum with new subscriptions in emerging markets, demand for Adobe Express across education, SMB, and enterprises. And adoption of Firefly services in the enterprise. Turning to our digital experience segment. In Q4, we achieved revenue of $1.40 billion, which represents 10% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.27 billion, growing 13% year-over-year, or 12% in constant currency. Fourth quarter digital experience growth drivers included a strong finish to the year with the largest ever bookings quarter, and robust performance across geographies, including the US and EMEA, and multiple verticals, including financial services. Strong subscription revenue growth led by Adobe Experience Manager, Adobe Journey Optimizer, real-time customer data platform, customer journey analytics, and work front. Continued strength in retention and expansion across our enterprise customers with digital experience solutions being leveraged by 85 of the Fortune 100 companies. Momentum with AEP and native apps, with FY2024 ending book of business surpassing $1.0 billion and growing greater than 40% year-over-year. And strong bookings for our Umbrella Gen Studio solution with interest and momentum for our new Gen Studio for performance marketing offering. Adobe's effective tax rate in Q4 was 15.5% on a GAAP basis and 18.5% on a non-GAAP basis. RPO exiting the quarter was $19.96 billion, growing 16% and CRPO growing third percent year-over-year as reported. Our cash flows from operations in the quarter were $2.92 billion, and ending cash and short-term investment position exiting Q4 was $7.89 billion. In Q4, we entered into a $2.5 billion share repurchase agreement, and we currently have $17.65 billion remaining of our $25 billion authorization granted in March 2024. Now turning to our FY2025 financial target. We measure ARR on a constant currency basis during the fiscal year and revalue ending ARR at year-end. FX rate changes between the end of FY2023 and the end of FY2024 have resulted in a $117 million decrease to the digital media ARR balance entering FY2025, from $17.33 to $17.22 billion, and is reflected in our investor data. We expect an approximate $200 million headwind to FY2025 revenue as a result of the effect of foreign exchange, and a smaller impact of the continued move to subscriptions from perpetual offerings. Factored into our financial targets is an ongoing strategy to introduce new tiered subscription offerings and add-ons. For FY2025, we're targeting total Adobe revenue of $23.30 to $23.55 billion. Digital Media segment revenue of $17.25 to $17.40 billion. Digital media ending ARR book of business growth of 11.0% year-over-year. Digital Experience segment revenue of $5.80 to $5.90 billion, Digital Experience subscription revenue of $5.375 to $5.425 billion. GAAP earnings per share of $15.80 to $16.10. And non-GAAP earnings per share of $20.20 to $20.50. We expect non-GAAP operating margin of approximately 46% and a non-GAAP tax rate of approximately 18.5%. For Q1, fiscal 2025, we're targeting total Adobe revenue of $5.63 to $5.68 billion. Digital media segment revenue of $4.17 to $4.20 billion, digital experience segment revenue of $1.38 to $1.40 billion, Digital Experience subscription revenue of $1.27 to $1.29 billion. GAAP earnings per share of $3.85 to $3.90. And non-GAAP earnings per share of $4.95 to $5.00. For Q1, we expect non-GAAP operating margin of approximately 47% and non-GAAP tax rate of approximately 18.5%. In summary, I'm proud of our outstanding performance, which combines robust product leadership, velocity of innovation, and financial discipline, positioning us to achieve strong revenue and EPS growth in the year ahead. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. This quarter, Adobe was once again recognized for our exceptional culture and leadership, including on Forbes' World's Best Employers, Fortune's 50 AI Innovators, and Fortune's Best Workplaces in Technology in the Wall Street Journal's Best Managed Companies list. At MAX, we announced a new global initiative aimed at helping 30 million next-generation learners develop AI literacy, content creation, and digital marketing skills, using Adobe Express to thrive in the modern workforce. Working with education partners in schools, nonprofits, and online learning platforms to provide training, certifications, and career pathways. Our strategy to unleash creativity for all, accelerate document productivity, and empower digital businesses represents a massive addressable market opportunity. Adobe continues to build on its strong foundation of transformative innovation, category and brand leadership, financial performance, and profitable growth. We're delivering Adobe Magic to an expanding set of global customers and executing on the massive market opportunity ahead. Adobe couldn't be better positioned for 2025 and beyond. Thank you, and we will now take questions. Operator,
Operator: Thank you. If you would like to signal with questions, please press star one on your touch-tone telephone. If you're joined today using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, that is star one if you would like to signal with questions. And the first question will come from Kash Rangan with Goldman Sachs. Again, Kash, if you could press star one on your touch-tone telephone. Again, star one on your touch-tone telephone. We'll go next to Michael Turn with Wells Fargo.
Michael Turn: Hey. Thanks very much. I appreciate you taking the question. David, you mentioned in your prepared remarks a few things focusing on expanding innovations, including newer higher-priced Fireflies offerings and actually accelerating Firefly by integrating further into Gen Studio. I was hoping you could just maybe expand on how you're thinking about the adoption curve of those efforts. And as a second part, Dan, if you can just add any commentary on how you're incorporating some of these newer efforts into the forecast if there's conservatism just given they're newer or just how to think about that, also useful. Thank you.
David Wadhwani: Sure. Yeah. I'll go ahead and get started. So AI obviously has been a huge area of focus for us, and, frankly, our community has been using it at amazing rates. So we're very excited you heard that 16 billion generations that we talked about in the prepared remarks. And that's really a function of the investments we've made in creating the broadest set of models. We've talked about imaging vector design in the past. We now have video and audio in beta form as well. And the foundational difference between what we do and what everyone else does in the market really comes down to three things. One is commercially safe, the way we train the models. Two is the incredible control we bake into the model. Three is the integration that we make with these models into our products. Increasingly, of course, CC flagship applications, but also in Express and Lightroom and these kinds of applications, but also in Anil's DX products as well. So that set of things is a critical part of the foundation and an adorable differentiator for us as we go forward. Now as we introduce the video model, which we expect to have in market early next year, that's going to create an opportunity to further tier our creative cloud offerings. As you surely understand, video generation is a much higher value activity than image generation. And as a result, it gives us the ability to start to tier creative cloud more actively there. In addition to that, we introduced this year, we introduced Fireflies services. That's been off to a great start. We have a lot of customers that are using that. A couple we talked about on the call include Tapestry. They're using it for scaled content production. Pepsi, for their Gatorade brand, is enabling their customers to personalize any merchandise that they are buying, in particular, starting with Gatorade bottles. And these have been very, very productive for them, and we are seeing this leveraged by a host of other companies for everything from localization at scale to personalization at scale to user engagement or just raw content production at scale as well. And then last, not to get missed in all of this, is everything we're doing with AI Assistant. AI Assistant for Acrobat is off to an incredibly strong start. And we see it continuing to accelerate. So all of this has built a great foundation for us in FY2024. It's given us a lot of signal from our customer base, and it's really we've learned a lot that we intend to apply as we optimize the value and, you know, the tiering for our customers going forward.
Dan Durn: Yeah. And just building on David's comments as it relates to the FY2025 guide, we talk about all of the great innovation that's in flight. I would say the velocity of innovation is greater today than it's ever been. We called out products like Express, AI Assistant, Firefly, premium tiers in DX, Gen Studio. The good thing is they're meaningful contributors today to the financial performance and extrapolating the momentum that we see in those products, taking a point of view on the future pipeline of innovation, how we bring that to life, deeply natively integrated into our products and further extend the value we offer to customers as well as the additional segments we can access. All of this comes together to take a perspective of what 2025 looks like based on the strong start that we have and the meaningful contribution in FY2024.
Michael Turn: Thanks very much.
Operator: And we'll take our next question from Alex Zukin with Wolfe Research.
Alex Zukin: Guys. Thanks for taking the question. I guess maybe to the point that you just alluded to in terms of AI being meaningful as part of the broader roadmap for business. Can you maybe talk about how you're thinking about the growth driver from Fireflies from Gen Studio and when kind of how will we see that percolate through the year in terms of the net new digital media ARR? Is that something that you think is more going to be showing up in the DX business? It'd be great to get some color there. And then anything, Dan, that we should think through given the new guidance methodology around seasonality, linearity, for the digital media business.
David Wadhwani: Sure. I'm happy to take that. So first of all, yeah, as we mentioned, we're really excited about the FY2024 momentum that we're seeing that we're carrying into it. And you know, we've had this conversation in the past around, you know, how we about the growth algorithm for the digital media business. So maybe let me reiterate a little bit of that. We've talked about this in the context of p times q plus v in the past. You know, where p is new users bringing in more people into the franchise. We're continuing to do that. Obviously, with the introduction of Express, we're seeing a lot of great growth there, whether it's through our phones channel reaching out to SMB, whether it's reaching out to the mid-market or whether it's working more closely with Anil and the DX business and the integrations we have between Express and the DX business reaching into large companies. We're doing a lot in terms of proliferation of Express into education. We've done a number of partnerships that we talked about with Box, ChatGPT, HubSpot, and others, but also our own products like Acrobat Workflows, from Acrobat and Reader into Express. So really pushing to drive more new customers into the franchise in addition to the continued growth that we're getting in our core creative products. Second, in terms of the core creative products, this is where the queue, the price actually increases with core value because when we're introducing Firefly models into the mix, we get the opportunity to integrate them more into the flagship applications. And as I mentioned earlier with the Fireflies web application, we have the opportunity to create more tiers across the creative products so that we can get people in the right plan for their needs. And we're very bullish about video and the breadth of our customer base that are going to need access to these video models. Again, remember, they're integrated deeply into our applications, including Premiere. We're very excited about what that could mean for us. And then lastly, the business value for customers and enterprise or corporate, that's where the value-based selling that we do along with the digital experience business really plays out. Firefly Services, as I mentioned, with Gatorade, Tapestry, and a whole host of others that have come. Everyone in this space is driving towards personalization of that content, and they absolutely need a scaled production and automation pipeline to generate more content. And that's where Firefly services does. And as it has hit this level of escape velocity, and in particular, Gen Studio so that it becomes a more holistic solution as we go into FY2025 and accelerate that. And that's, you know, Alex, that's what's leading to the guide of 11%. If you really take a step back, that's one of the best guides we've given in terms of, you know, next year ARR growth. But one thing maybe to keep in mind is the composition of growth is going to be a little different next year compared to FY2024. Again, the growth algorithm is new users, new products, and value and pricing. New users and new products will be a more significant part of the mix as we go into FY2025. And we look forward to sort of that foundational base of the business growing and driving the business.
Dan Durn: And then just to build on that, Alex, and I appreciate the question around the shape of FY2025. Here's what I'll share about it. We all know we changed the guidance methodology into 2025. The guide around the ending ARR book to business growth. We just have a strong point of view. It's a better indicator of business health trajectory. David talked about the growth algorithm, the growth agenda at the company, new subscribers, is the predominant driver of growth. Has been continues to be. The second leg Cross sell. Upsell. This is something the company is trying to really great skill at over time. Once we bring people into the Adobe ecosystem to journey them through the rich set of technologies and products that we have to bring them deeper into the ecosystem, that's an important element. And then lastly, you know, David mentioned pricing. This is about how we segment the product portfolio, the value, that we deliver to our customers. So as we think about the innovation, as we think about the growth algorithm, and as we think about increasingly monetizing the rich set of innovation that we've already brought to market, as well as in the pipeline to be brought to market. Quarterly profile, we view it as less important. Really wanna focus on revenue, and EPS. Focus, on the annual book of business growth. We think that's the most important way to look at the business. It's also how we as the management team run the business.
Alex Zukin: Understood. Thank you, guys.
Operator: And the next question will come from Kirk Materne with Evercore ISI.
Kirk Materne: Yeah. Thanks very much. David, I was wondering if I could just follow-up on your last comment on sort of obviously driving new users, new adoptions, you know, incredibly important. I just is there pricing sensitivity, meaning you're delivering so much value. I think that pricing given the value you're delivering, would be a bigger lever. You know, unless there's pricing sensitivity. Could you just walk through that a little bit more? Because it feels like you should be able to get sort of all three vectors going at the same time, whereas I know you're gonna focus more on bringing people in and making them successful. But I'm sort of I guess, is there something else on the pricing side that I'm missing why you're not getting that as well? Thanks.
David Wadhwani: Yeah. And we've talked about this in the context of proliferation versus short-term monetization and how we have to balance both of those, and that's something that we take very seriously and we look at that. If you look at the lower end of the market as we have entered with Express and Lightroom Acrobat. And by the way, this the web and mobile motion for us has been productive in bringing in a lot more new users. And so you'll expect to see us do more of that and introduce more products in that segment. In FY2025 as well. And there is certainly price sensitivity at that side of the market. When it comes to both premium users and also converted to paid users. We'll continue to enable that. When it comes to the core business, and this is the business of creative professionals, we are very focused on introducing new value that is going to create more segmentation and more tiering and, you know, get aligned value and pricing to what we are delivering there. So we do see a tremendous amount of opportunity there going forward. Because the value that we bring and the efficiency we bring to the content creation process there is very significant. Again, and then last and certainly not least, as we talked about in core enterprises, that's where we've been able to sort of cross that chasm from p times q business over to a value sale business, and we are able to start to get more automation and workflows in place there as well. So it's a mix of these things. You know, we are gonna continue to balance. We are obviously tracking, and we believe that proliferation as we've said, you know, for some time maintains is one of the top priorities because we know that if people start using our products today, we have the opportunity to continue to deliver value two for a long time to come. And so that balance is what we try to do, and it's a management judgment call, but we think we're getting it right.
Kirk Materne: I guess a quick follow-up for Dan. Dan, obviously, Black Monday fell into your first quarter, this current year. Any color you can offer in terms of what that meant, if at all, to create a cloud net new ARR this quarter?
Dan Durn: Yeah. The Black Friday, Cyber Monday played out about as expected. You know, we've been talking about a multiyear trend where commercial activity shifting left in terms of timing. We run our promotions over a larger window of time to reflect consumer behavior, and we see similar pattern commercially from our customers this year. That we've seen in prior years. If we think about online shopping this year, up 8.4%. You can see last year, that's up from 4.8%. So a nice step up this year versus last year. But you can see Cyber Monday from a contribution standpoint. Even though the growth last year was down relative to this year, Cyber Monday grew at 9.6%, this year at 7.3%. Just illustrates the flattening of the profiling consumer behavior around that. So you know, performance as expected.
Kirk Materne: Okay. Thank you.
Operator: And the next question will come from Keith Weiss with Morgan Stanley.
Keith Weiss: Excellent. Thank you guys for taking the question. A lot of excitement from you guys on the conference call about the pace of innovation going on in the business. And we hear excitement from creative professionals, and they talk about an acceleration in the pace of innovation. But apologies to state the obvious, but investors aren't feeling that excitement or aren't showing that excitement. Stock is a major underperformer on a year-to-date basis. Down again on an after-hours basis today. And I would point to it's the lack of acceleration that we're seeing in their numbers. Right? Digital media net new ARR this quarter grew just organically, grew 2%. You're guiding to decelerating growth into the forward year despite all this innovation. And I think the question that it brings up in investors' mind is there some leak in the bucket. Right? All this innovation, new monetization avenues, pricing going up, but the growth is going in the wrong direction. Like, is there a part of the equation that's not working? Is there share losses? Is there something that we're not seeing that is taking away that momentum in the numbers that's not it? We're not seeing the acceleration in the numbers if you will.
Shantanu Narayen: Okay. So maybe I'll talk about I mean, if you take a step back and think about the year, and I'll certainly address the feedback that you're sharing. From our perspective, you know, when we guided at the beginning of the year, when we reguided then in the middle of the year to $19.50 and then when we guided in Q3. I mean, the reality is we beat all those three targets that we had issued, beginning of the year, middle of the year, and end of the year. I think specifically maybe as it relates to the Q4 digital media net new ARR and thinking about it from the creative, the one thing that I'll point out there is that, actually, creative did better than probably is evident in that if you think about the contribution of Acrobat that went into the creative bucket. Versus the document cloud business. So certainly, Acrobat continues to do well. Record, as you saw, but the non-Acrobat contribution in creative actually had more growth. Than what you would see if you just look at it from a Creative Cloud ARR. I think to your bigger question about what's happening in the business, and as we think about it, you know, at the scale of the business right now, certainly, as this entire world moves towards generative AI, as David said, we're executing on both the proliferation play at the bottom with Express and Acrobat. And at the high end, with the Creative Pro and with the enterprise, we are seeing significant adoption of that. And I think Gen Studio will also be a good unlock because Gen Studio actually brings this all together in the enterprise in a way that nobody else can. And so when we think about Firefly services, you think about the custom models, you think about the ability to move all of that into campaigns at pace, we are seeing significant traction in that particular space. So you know, the business is going through a change as it relates to the lower end. But for the core creative as well as for the enterprise, it's actually, you know, headed absolutely in line with our expectations. With good acceleration. And on the consumer communicator space, I think the traction that we're seeing with Express on proliferation also gives us a lot of optimism for how that part of the business is also doing well. And so, you know, we take our target seriously. It's the beginning of the year. We wanna go keep executing and innovating on it. To the point that I think you as well as others have asked, is there, you know, opportunity in the growth agenda, not just to think about the innovation and the offerings, but to make sure that as we tier these, that the pricing and the value is appropriate, absolutely. And, you know, I think you'll continue to see us. I think David mentioned that in his prepared remarks as well as Dan did. That you'll see us also have new tiered offerings. That reflect that value that we're providing. To the creative pro as well as to the business segment.
Keith Weiss: Excellent. Thanks for the feedback.
Operator: And moving on to Keith Bachman with BMO.
Keith Bachman: Hi. Thank you very much. I wanted to ask David to you if I could on Doc Cloud specifically. Growth was certainly strong this quarter. And I just wanted to understand some of the context associated with durability. And if you could break it into some of the parts, it looks like your monthly active users, it continues to grow well. And in addition to that, how are you thinking about leveraging the value there in terms of price, specifically within the growth of Doc Cloud. And again, the broader question is just on the durability of Doc Cloud grew 23% over the course of the quarter in terms of ARR, trying to understand how durable it is and what the pieces are, and then I have a follow-up.
David Wadhwani: Yeah. I think Document Cloud has been, you know, if you think about the fact that we're 40 years into this business, it's really just the foundation is the fact that PDF has become the de facto standard for unstructured data. The world. And Adobe and Acrobat are the most trusted providers of solutions for that, and that's really what is the foundation of what is driving the business, including the fact that it's the most secure platform for leveraging and accessing the content. I think what is there are two things that are really the growth drivers of this business or a number of things. First is exactly like you said. I mean, monthly active users and free and paid is a key stat that we keep looking at. You know, we are very effective at picking free users of Reader and converting them to paid users of Acrobat. And we continue to do that across more surfaces that used to be predominantly a focus on desktop applications. As we've noted in the past, we now have edge integrations, Chrome integrations. We're also available in Teams. We're also available on mobile devices for, you know, iOS and Android. And the mix of all those continue to grow on a monthly basis. Of the things that we are doing to drive that growth is helping people see the value of sharing a link to the PDF as opposed to sharing the document itself, that in doing so, you get a lot more control in terms of the conversation and feedback and review around that. But it also drives the fact that the recipient is then guaranteed to be viewing the PDF in an Adobe surface that we can then use to close that viral loop and drive, you know, further top of funnel opportunity to convert. So that foundation is very strong. In addition to that, AI Assistant has been really a phenomenal ad, you know, unlike many other players in the space, we don't require significant, you know, security and governance reviews because people can have conversations around the documents that they view. And one of the big things that I think has been unlocked this year is moving not just by looking at a PDF that you happen to be viewing, but being to look at and have a conversation with multiple documents, some of which don't even have to be PDF. So that transition and that, you know, gives us the ability to really take Acrobat and make it more of a general-purpose productivity platform. And that's really what drove the adoption that we saw in education this year. So another way of saying that the core foundation of Acrobat continues to be strong and is actually getting stronger with the MAO increasing. But the new value we're adding with AI Assistant takes Acrobat to an entire new level in terms of value.
Shantanu Narayen: Maybe the thing I'll add to that is the durability of that to your point in languages as we roll that out in languages. As we roll it out across multiple documents, and as we roll it out in enterprises and B2B specifically. So again, significant headroom in terms of the innovation agenda of how Acrobat can be made even more meaningful as a knowledge tool within the enterprise.
Keith Bachman: Okay. It just sort of leads into my follow-up question if I could sneak it in as we've talked about during the course of this call tonight the various drivers of growth for ARR. And I just wanted to specifically ask about consumption as we think about FY2025 and the question is, is that gonna be a contributor towards ARR growth, or should investors really be thinking about trying to match my seats, if you will, and really shouldn't it be about consumption being additive growth in 2025. That's it for me. Thank you.
Shantanu Narayen: I think, Keith, you're gonna see, quote-unquote, consumption, add to ARR, in two or maybe three ways more so in 2025 than in 2024. The first, and David alluded to this, is if you have a video offering and that video offering that will be a pure consumption, you know, pricing associated with it. I think the second is in Gen Studio and for enterprises. And what they are seeing with respect to Firefly services, which again, I think David touched on, you know, how much momentum we're seeing in that business. So that is in effect a consumption business as it relates to the enterprise. So, you know, I think that will also continue to increase. And then I think you'll see us with perhaps, you know, more premium price offering. So the intention is that consumption is what's driving the increased ARR, but it may be as a result of tier in the pricing rather than a consumption model where people actually have to monitor it. So it's just another way much like AI assistance is of monetizing it. It's not like we're gonna be tracking every single generation for the user. It'll just be at a different tier. And we think that that's both a better way to deliver value as well as to get the monetization.
Operator: And moving on to Brad Zelnick with Bank of America.
Brad Zelnick: Okay. Wonderful. Thank you. I'll ask a question, David, of you, please. You in the past, you've provided some good color. It sounds like there's momentum there. It seems like this would be the year with all the Firefly services integration into the core franchises. We could see some acceleration and conversion of that funnel. So we'd love to get some update from you on that effort and how you see that unfolding throughout the year. Thank you.
David Wadhwani: For a second, you actually cut out. And so you said Firefly. We heard that. Did you mention any other product before we answer that question, Brad, just to make sure we capture your question?
Brad Zelnick: Really just Firefly services across all the franchises, you know, Photoshop, Lightroom, etcetera. You know, what could that integration effort do to the conversion activity with the top of funnel?
David Wadhwani: Yeah. So a number of So first of all, you're exactly right in terms of, you know, Firefly is a platform and a foundation that we're leveraging across many different products. As we talked about, everything from Express and Lightroom and even in Acrobat on mobile, for our broad base, but then also in our core creative products. Photoshop, Illustrator, Premiere, and, you know, as we've alluded to a number of times on this call with the introduction of video, even a standalone offer, for Firefly that we think will be, you know, more valuable from a tiering perspective there. And then into Firefly services through APIs and connection to Gen Studio. So we are looking at leveraging the power of this AI foundation in all the activities. As it relates to top of funnel and conversion, we're very excited. Let's start with new users and more closer to the low end of the market. We're very excited with the signal we're getting from Express and Lightroom on mobile and web. Again, you know, as we've talked about Express is seeing some really good new user acquisition. We added 4,000 new businesses this year. We increased education, you know, access by 84% this back to school versus last back to school. We're seeing, you know, really strong adaption through social, digital, mobile traffic as well. So we see that when we invest in mobile and web, we are getting some very positive signals. In terms of user adoption and user conversion rates. So we're using Firefly very actively to do that. And by the way, the fact that Firefly continues to be the only commercially safe, you know, model integrated into these apps does matter when it comes to, as I said, adding 4,000 new businesses. The second thing is we are seeing in the core creative business, when people try something like Photoshop, the onboarding experience is faster to success because of the use of generative AI and generative capabilities. So you'll start to see us continuing to drive more proliferation of those capabilities earlier in the user journeys, and that has been proven very productive. But we also noticed that more people use generative AI, again, we've always had good retention rates, but the more people use AI, the longer they retain as well. And so we are definitely leveraging generative AI for that entire flow in the funnel.
Operator: And as we're past the top of the hour, I just have time for one more question. Thank you.
Operator: And that question will come from Jay Vleeschhouwer with Griffin Securities.
Jay Vleeschhouwer: Thank you. Good evening. Dan, you noted that your current RPO was up 13% in the quarter. Which results in a 10% three-year CAGR for current RPO. Would you expect that over time or at least in fiscal 2025, that your current RPO growth be closer to what you just reported for Q4 or might revert more to the lower three-year CAGR? And then for David, if I could, just since there were so many mentions of tiered offerings, is the concept there more around functionality at the product level as compared to the olden days of tiering that was more about segmentation and packaging, as in the old CS days or is it more currently around the functionality that you're offering on a product-by-product basis?
Dan Durn: Yeah. Thanks, Jay. And what I definitely don't wanna do is get into guiding of CRPO. But when I take a step back and think about the rhythm and flow of the business, what we're seeing on the enterprise side, winning large transformational deals, exiting the year with the largest bookings quarter ever, having premium tiers in that product portfolio momentum around AEP and apps continuing to grow at scale, when we think about content supply chain and bringing cross-cloud opportunities together that really get at meaningful pain points of customers over time. And then we think about the innovation that we're driving through the digital media business, I feel really good about our ability to continue to drive the business going forward, and I'm very encouraged by what I see.
David Wadhwani: Yeah. And then just adding on briefly to the question on tiering. Yeah, Jay. It's if you think about what we've done over the last year, there's been a bit of experimentation. Obviously, a the generative credits model. What we saw with Acrobat was this idea of, you know, it's a separate package and separate SKU that created a tier. That people were able to access the feature through. And as we learn from all of these, we think, as Shantanu had mentioned earlier, that the right tiering model for us is gonna be a combination of feature, access to certain features, and usage limits on it. So the higher the tier, the more features you get and the more usage you get of it.
Shantanu Narayen: And since that was the last question, let me again maybe in quick summary just talk about first, you know, we had a strong 2024. But I think that really sets us up even better for a strong 2025. Given the innovation that we've had, I think as it relates to all three businesses that we have, the Creative Cloud with everything that we've done around AI, we have a lot of momentum going into the business and a really great diverse portfolio in terms of both the customers as well as our offerings. Acrobat continues to perform really well with AI Assistant as we bring it to other languages, get more vertical, use cases for that particular solution and extend it beyond a single document, we continue to think that the Document Cloud has significant opportunity ahead of us. And I think bringing that all together with digital experience, Q4 was really an extremely strong quarter as it related to us bringing all these solutions together in Gen Studio. I think much like we did with AEP and apps and data and have driven that to a billion-dollar business. I feel just the same amount of excitement with what we can do with content and AI and how we can accelerate the creation of that all the way from ideation to the multiple variation that's required. So we look forward to sharing more with you. At the end of our Q1, but in the interim, thank you for joining us. And happy holidays.
Operator: Thank you. That does conclude today's conference. We do thank you for your participation today. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Q4 and FY2024 Adobe earnings conference call. Today's conference is being recorded. At this time, I would like to turn the conference over to Steve Day, SVP, DXCFO, and Corporate Finance Interim Head of IR. Please go ahead, sir."
},
{
"speaker": "Steve Day",
"text": "Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's fourth quarter and fiscal year 2024 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, December 11th, and contains forward-looking statements that involve risk, uncertainty, and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates, as well as constant currency rates. During this presentation, Adobe's executives will refer to constant currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe's investor relations website. I will now turn the call over to Shantanu. Thanks, Steve."
},
{
"speaker": "Shantanu Narayen",
"text": "Good afternoon, and thank you for joining us. In Q4, we achieved revenue of $5.61 billion, representing 11% year-over-year growth. In our digital media business, we delivered record net new ARR of $578 million, and our digital experience business achieved subscription revenue of $1.27 billion, representing 12% year-over-year growth. 2024 was a year of records for Adobe. We achieved record revenue of $21.51 billion, representing 11% year-over-year growth. GAAP earnings per share was $12.36, and non-GAAP earnings per share was $18.42, representing 5% and 15% year-over-year growth, respectively. We had several new milestones with our AI innovations enabling us to add more than $2 billion in digital media net new ARR and surpass $1 billion in the ending book of business for Adobe Experience Platform and native apps. The digital experience business crossed $5 billion in revenue, making us one of the mission-critical providers of marketing technology in the world. We exited the year with $19.96 billion in RPO and cash and short-term investments of $7.89 billion. 2024 was also a transformative year of product innovation. We delivered foundational technology platforms and introduced multiple generative AI models in the Adobe Firefly family, including imaging, vector design, and most recently, the Yo. Adobe now has a comprehensive set of generative AI models designed to be commercially safe for creative content, offering unprecedented levels of output quality and user control in our applications. We reimagined creativity and productivity for a broader set of customers with Adobe Express, the quick and easy create-anything app. The deep integration of Fireflies across our flagship applications in Creative Cloud, Document Cloud, and Experience Cloud is driving record customer adoption and usage. Firefly Power Generation's across our tools surpassed 16 billion, with every month this past quarter setting a new record. We enhanced document productivity with AI assistant in Adobe Acrobat and Reader, unlocking even greater value from the trillions of PDFs around the world. We've successfully scaled Adobe Experience Platform and native apps to deliver the fundamental infrastructure required for customer engagement. We're accelerating automated decisioning, empowering audiences, journeys, and channels to deliver truly personalized experiences at scale. We set the stage to drive an AI content revolution by bringing content and data together in Adobe Gen Studio, integrating high-velocity creative expression with enterprise activation. The release of Adobe Gen Studio for performance marketing integrates Creative Cloud, Express, and Experience Cloud and extends our end-to-end content supply chain solution, empowering freelancers, agencies, and enterprises to accelerate the delivery of content, advertising, and marketing campaigns. I'll now turn it over to David to discuss the momentum in our digital media business."
},
{
"speaker": "David Wadhwani",
"text": "Thanks, Shantanu. Hello, everyone. In Q4, we achieved net new digital media ARR of $578 million and revenue of $4.15 billion, which grew 12% year-over-year, fueled by innovation in both our creative and document businesses. We ended the year with just over $2 billion of net new digital media ARR for the first time ever as a result of accelerated product innovation, record traffic to adobe.com, and engagement on social and mobile, as well as increasing value for enterprise customers through Firefly Services and GenStudio. We bring together our creative and experience clouds. On the document cloud side, PDF continues to be the global standard for digital. Adobe Acrobat is revolutionizing the way people engage with them across mobile, web, and desktop. We took a major step forward in FY2024 with the introduction of AI Assistant in Acrobat and Reader. AI Assistant and other AI features like liquid mode and Firefly are accelerating productivity through faster insights, smarter document editing, and integrated image generation. A recent productivity study found that users leveraging AI Assistant completed their document-related tasks four times faster on average. AI Assistant is now available in Acrobat across desktop, web, and mobile, and integrated into our Edge, Chrome, and Microsoft Teams extensions. In Q4, we continued to extend its value with specialized AI for contracts and scanned documents, support for additional languages, and the ability to analyze larger documents. In Acrobat Web, our integrations with Adobe Express allow users to generate images and quickly stylize content. We saw AI Assistant conversations double quarter over quarter, driving deeper customer value. In Q4, we achieved document cloud revenue of $843 million, growing 17% year-over-year. We set a record for net new Document Cloud ARR of $173 million, with ending ARR of $3.48 billion, growing 23% year-over-year. Other highlights include continued growth of monthly active users, which grew over 25% year-over-year, surpassing 650 million paid and free users. Strong top-of-funnel momentum through Acrobat web with monthly active users up nearly 50% year-over-year. Strength in Acrobat Pro single app, in both Document Cloud and Creative Cloud offerings. A great back-to-school season with a new AI Assistant in education for students. Key enterprise customer wins include Abbott Laboratories, BWI GmbH, Defense Information Systems Agency, Kaiser Permanente, Novo Nordisk, Truist, UScellular, and the US Department of State. Creative Cloud also had a strong year. As demand for content continues to grow across mobile, desktop, and streaming platforms. Adobe MAX, the premier creativity conference, showcased our FY2024 innovation and drove over 0.5 billion video views across all channels. We have made major strides with our generative AI models with the introduction of Firefly image model three enhancements to our vector models, richer design models, and the all-new Firefly video model. These models are incredibly powerful on their own, and their deep integration into our tools like Lightroom, Photoshop, Premier InDesign, and Express have brought incredible value to millions of creative professionals around the world. We have brought our creative and experienced clouds together through the introduction of Firefly services in GenStudio, addressing the growing need for scaled content production in enterprises. Firefly generations continue to accelerate and have now crossed 16 billion cumulative generations. In Q4, we achieved $3.3 billion revenue, which grew 11% year-over-year. Net new Creative Cloud ARR was $405 million. Other highlights include adoption of Adobe Express by approximately 4,000 businesses in the quarter, and an 84% year-over-year increase in the number of students with access to Express Premium as part of this year's back-to-school season. Adobe Express saw strong ecosystem growth with over 180 plugins available in the Express marketplace and integrations with leading social productivity and collaboration apps like ChatGPT, Google, Slack, Wix, Box, HubSpot, and Webflow, significantly increasing our customer reach. The launch of the Fireflies video model and its unique integration in Premiere Pro unlimited public beta garnered massive customer interest, and we look forward to making it more broadly available in early 2025. This feature drove a 70% increase in the number of Premiere Pro beta users. Enhancements to Firefly image vector and design models include four times faster image generation and new capabilities integrated into Photoshop, Illustrator, Premiere Pro, and Adobe Express. Strong adoption of Lightroom mobile with customers embracing innovations like generative remove and lens blur, as well as quick actions, which streamline editing and increase discovery and adoption of premium features. Just this morning, Adobe Lightroom was recognized as the Mac app of the year in Apple's annual App Store Awards. The launch of the new Frame.io v4 streamlines creative management for video projects, enabling end-to-end editing capabilities and seamless collaboration between editors and their stakeholders. Firefly services adoption continued to ramp as enterprises such as Pepsi and Tapestry use it to scale content production given the robust APIs and ease of creating custom models that are designed to be commercially safe. Key enterprise customer wins include Alphabet, American Express, Coca-Cola, Johnson & Johnson, LVMH, Nestle, Procter & Gamble, T-Mobile, and the US Department of Defense. Our AI product releases and business evolution in FY2024 have set the stage for another strong year ahead as we expand to new audiences, deliver more value to existing users, and increasingly integrate our digital media and digital experience clouds to create differentiated business solutions. We will do this by accelerating the adoption of freemium offers, including Express, Lightroom, and Acrobat on web and mobile, as well as expanding access to Acrobat AI Assistant delivered strong financial performance in FY2024. Growing our core creative business by continuing to expand our AI innovations in our flagship applications as well as bringing them to web and mobile. In addition, we will soon introduce a new higher-priced Fireflies offering that includes our video models as a comprehensive AI solution for creative professionals. This will allow us to monetize new users, provide additional value to existing customers, and increase ARPU. And further accelerating Fireflies services, which saw significant demand in FY2024, integrating it into GenStudio to provide enterprises with solutions to exponentially scale their content production capabilities with AI. We're thrilled with the response to our innovations in FY2024, excited to release new capabilities, and look forward to delighting customers in the year ahead. I'll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello, everyone. The Experience Cloud business had a strong close to the year, achieving revenue of $1.4 billion for the quarter and a record $5.37 billion in revenue in fiscal 2024. Subscription revenue in the quarter was $1.27 billion, representing 12% year-over-year growth. The book of business for Adobe Experience Platform and native apps, real-time CDP, customer journey analytics, and journey optimizer surpassed $1 billion in the quarter, with 48 of the Fortune 100 companies now leveraging these solutions. The market opportunity for customer experience management is large and growing. Both B2B and B2C companies are selecting Adobe as the strategic technology partner to accelerate customer acquisition, engagement, and retention. Our leading solutions spanning content, data, and customer journeys empower businesses to drive top-line growth while simultaneously delivering productivity gains. The AI innovations we have delivered enable our customers to accelerate the delivery of personalized experiences at scale and have been built to satisfy enterprise governance requirements. Adobe Experience Platform AI Assistant empowers marketers to automate tasks and generate new audiences and journeys. Adobe Experience Manager generates variations and provides dynamic and personalized content creation natively through AEM, enabling customers to deliver more compelling and engaging experiences on their websites. We are transforming the content supply chain for enterprises with Adobe Gen Studio, which natively integrates multiple Adobe applications across Creative Cloud and Experience Cloud, including Express, Firefly, Workfront, Experience Manager, Customer Journey Analytics, and Journey Optimizer. Gen Studio enables agencies and enterprises to unlock new levels of creativity and efficiency across content creation and production, workflow and planning, asset management, delivery and activation, reporting, and insights. Adobe Gen Studio for performance marketing is a great addition to the Gen Studio portfolio, offering an integrated application to create paid social ads, display ads, banners, and marketing emails by leveraging preapproved on-brand content. It brings together creative teams that define the foundational requirements of a brand, including guidelines around brand voice, channels, and images, with marketing teams that need to deliver numerous content variations with speed and agility. We are seeing strong customer demand for Adobe Gen Studio for performance marketing since its general availability at MAX. Gen Studio is the answer to address how marketing is going to transform in the era of AI for CMOs, CIOs, and CFOs. Other highlights include an expanded partnership with Amazon to make Adobe Experience Platform available on Amazon Web Services and extend our leadership across enterprises. Enterprises will soon be able to access the full power of AEP and native apps on AWS. Integration partnerships with Google's Campaign Manager 360, Meta, Microsoft Advertising, Snap, and TikTok offer marketing teams a holistic view of campaign performance directly in Adobe Gen Studio to optimize the ROI of their ad spend. Strong industry analyst recognition in major analyst reports, including the Gartner Magic Quadrant for Digital Commerce and the Forrester Wave for Cross-Channel Marketing Hubs. In particular, Gartner recognized Adobe's critical capabilities for multichannel marketing, such as our differentiated ability to adapt customer journeys in real-time based on customer behavior. AI innovations delivered in the premium tiers and add-ons helped us close our largest bookings quarter ever, with key global customer wins, including Air Canada, Alliant, American Express, Bank of America, BMW, Centene, CIBC, Cisco, Disney, Fanatics, Gap, GM, JPMorgan Chase, PayPal, Samsung, Tesco, and Wells Fargo. Digital remains a critical growth imperative for businesses around the world. Adobe Digital Insights, which analyzes trillions of data points, reported that both Black Friday and Cyber Monday sales hit record highs of $10.8 billion and $13.3 billion, jumping 10.2% and 7.3% from last year, respectively. We expect the full holiday season to hit $240.8 billion, up 8.4% year-over-year. With the availability of our new offerings in FY2025, Adobe has a unique opportunity to capitalize on the breadth of these solutions to further optimize our integrated go-to-market field organization. We're expanding our enterprise go-to-market teams to sell these integrated solutions that cut across digital media and digital experience globally under the new Gen Studio umbrella. We've seen early success for this strategy that included Express and Firefly services in Q4. As we enable our worldwide field organization in Q1, we anticipate acceleration of this pipeline throughout the rest of the year and beyond. We are confident of continuing our leadership and momentum into 2025. I will now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Our earnings report today covers both Q4 and FY2024 results, highlighting growth drivers across our businesses, and I'll finish with financial targets. We are proud of the performance we have driven in FY2024, delivering record revenue, EPS, and operating cash flows while aggressively investing in AI product innovation. New AI releases, including Express, Acrobat AI Assistant, Firefly services, DX premium tiers, and Gen Studio for performance marketing, have expanded the portfolio of products, driving proliferation and meaningful Gen AI monetization. We had a strong finish to the year, with records in digital media net new ARR and digital experience bookings. In FY2024, Adobe achieved record revenue of $21.51 billion, which represents 11% year-over-year growth as reported and in constant currency. GAAP EPS for the year was $12.36, and non-GAAP EPS was $18.42, growing 5% and 15% year-over-year, respectively. FY2024 business and financial highlights included digital media revenue of $15.86 billion, net new digital media ARR of $2.00 billion, digital experience revenue of $5.37 billion, cash flows from operations of $8.06 billion, RPO of $19.96 billion exiting the year, and repurchasing approximately 17.5 million shares of our stock during the year. In the fourth quarter of FY2024, Adobe achieved revenue of $5.61 billion, which represents 11% year-over-year growth as reported and in constant currency. GAAP diluted earnings per share in Q4 was $3.79, and non-GAAP diluted earnings per share was a record $4.81, growing 17% and 13% year-over-year, respectively. Q4 business and financial highlights included digital media revenue of $4.15 billion, net new digital media ARR of $578 million, digital experience revenue of $1.40 billion, cash flows from operations of $2.92 billion, and added $1.82 billion to RPO in the quarter. In our digital media segment, we achieved Q4 revenue of $4.15 billion, which represents 12% year-over-year growth as reported and in constant currency. We exited the quarter with $17.33 billion of digital media ARR, growing our ending ARR book of business 13% year-over-year in constant currency. Adobe achieved document cloud revenue of $843 million, which represents 17% year-over-year growth as reported and in constant currency. In the quarter, we added $173 million of net new Document Cloud ARR, growing our ending ARR book of business 23% year-over-year in constant currency. Fourth quarter Document Cloud growth drivers included strong growth across Reader and Acrobat on web and mobile, and extensions such as Edge and Chrome, Acrobat subscription demand across all customer segments, routes to market, and geographies. Accelerated adoption and monetization of AI Assistant driven by product enhancements and delivery of French and German language support. And year-end seasonal strength in the enterprise. We achieved creative revenue of $3.30 billion, which represents 10% year-over-year growth or 11% in constant currency. In the quarter, we added $405 million of net new creative ARR, growing our ending ARR book of business 11% year-over-year in constant currency. Fourth quarter Creative Cloud growth drivers included strong demand for new subscriptions for Creative Cloud all apps, across individuals, teams, enterprise, and education. Strength and Creative Cloud single latch for Acrobat Pro, Lightroom, and Photoshop. Momentum with new subscriptions in emerging markets, demand for Adobe Express across education, SMB, and enterprises. And adoption of Firefly services in the enterprise. Turning to our digital experience segment. In Q4, we achieved revenue of $1.40 billion, which represents 10% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.27 billion, growing 13% year-over-year, or 12% in constant currency. Fourth quarter digital experience growth drivers included a strong finish to the year with the largest ever bookings quarter, and robust performance across geographies, including the US and EMEA, and multiple verticals, including financial services. Strong subscription revenue growth led by Adobe Experience Manager, Adobe Journey Optimizer, real-time customer data platform, customer journey analytics, and work front. Continued strength in retention and expansion across our enterprise customers with digital experience solutions being leveraged by 85 of the Fortune 100 companies. Momentum with AEP and native apps, with FY2024 ending book of business surpassing $1.0 billion and growing greater than 40% year-over-year. And strong bookings for our Umbrella Gen Studio solution with interest and momentum for our new Gen Studio for performance marketing offering. Adobe's effective tax rate in Q4 was 15.5% on a GAAP basis and 18.5% on a non-GAAP basis. RPO exiting the quarter was $19.96 billion, growing 16% and CRPO growing third percent year-over-year as reported. Our cash flows from operations in the quarter were $2.92 billion, and ending cash and short-term investment position exiting Q4 was $7.89 billion. In Q4, we entered into a $2.5 billion share repurchase agreement, and we currently have $17.65 billion remaining of our $25 billion authorization granted in March 2024. Now turning to our FY2025 financial target. We measure ARR on a constant currency basis during the fiscal year and revalue ending ARR at year-end. FX rate changes between the end of FY2023 and the end of FY2024 have resulted in a $117 million decrease to the digital media ARR balance entering FY2025, from $17.33 to $17.22 billion, and is reflected in our investor data. We expect an approximate $200 million headwind to FY2025 revenue as a result of the effect of foreign exchange, and a smaller impact of the continued move to subscriptions from perpetual offerings. Factored into our financial targets is an ongoing strategy to introduce new tiered subscription offerings and add-ons. For FY2025, we're targeting total Adobe revenue of $23.30 to $23.55 billion. Digital Media segment revenue of $17.25 to $17.40 billion. Digital media ending ARR book of business growth of 11.0% year-over-year. Digital Experience segment revenue of $5.80 to $5.90 billion, Digital Experience subscription revenue of $5.375 to $5.425 billion. GAAP earnings per share of $15.80 to $16.10. And non-GAAP earnings per share of $20.20 to $20.50. We expect non-GAAP operating margin of approximately 46% and a non-GAAP tax rate of approximately 18.5%. For Q1, fiscal 2025, we're targeting total Adobe revenue of $5.63 to $5.68 billion. Digital media segment revenue of $4.17 to $4.20 billion, digital experience segment revenue of $1.38 to $1.40 billion, Digital Experience subscription revenue of $1.27 to $1.29 billion. GAAP earnings per share of $3.85 to $3.90. And non-GAAP earnings per share of $4.95 to $5.00. For Q1, we expect non-GAAP operating margin of approximately 47% and non-GAAP tax rate of approximately 18.5%. In summary, I'm proud of our outstanding performance, which combines robust product leadership, velocity of innovation, and financial discipline, positioning us to achieve strong revenue and EPS growth in the year ahead. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. This quarter, Adobe was once again recognized for our exceptional culture and leadership, including on Forbes' World's Best Employers, Fortune's 50 AI Innovators, and Fortune's Best Workplaces in Technology in the Wall Street Journal's Best Managed Companies list. At MAX, we announced a new global initiative aimed at helping 30 million next-generation learners develop AI literacy, content creation, and digital marketing skills, using Adobe Express to thrive in the modern workforce. Working with education partners in schools, nonprofits, and online learning platforms to provide training, certifications, and career pathways. Our strategy to unleash creativity for all, accelerate document productivity, and empower digital businesses represents a massive addressable market opportunity. Adobe continues to build on its strong foundation of transformative innovation, category and brand leadership, financial performance, and profitable growth. We're delivering Adobe Magic to an expanding set of global customers and executing on the massive market opportunity ahead. Adobe couldn't be better positioned for 2025 and beyond. Thank you, and we will now take questions. Operator,"
},
{
"speaker": "Operator",
"text": "Thank you. If you would like to signal with questions, please press star one on your touch-tone telephone. If you're joined today using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Again, that is star one if you would like to signal with questions. And the first question will come from Kash Rangan with Goldman Sachs. Again, Kash, if you could press star one on your touch-tone telephone. Again, star one on your touch-tone telephone. We'll go next to Michael Turn with Wells Fargo."
},
{
"speaker": "Michael Turn",
"text": "Hey. Thanks very much. I appreciate you taking the question. David, you mentioned in your prepared remarks a few things focusing on expanding innovations, including newer higher-priced Fireflies offerings and actually accelerating Firefly by integrating further into Gen Studio. I was hoping you could just maybe expand on how you're thinking about the adoption curve of those efforts. And as a second part, Dan, if you can just add any commentary on how you're incorporating some of these newer efforts into the forecast if there's conservatism just given they're newer or just how to think about that, also useful. Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Sure. Yeah. I'll go ahead and get started. So AI obviously has been a huge area of focus for us, and, frankly, our community has been using it at amazing rates. So we're very excited you heard that 16 billion generations that we talked about in the prepared remarks. And that's really a function of the investments we've made in creating the broadest set of models. We've talked about imaging vector design in the past. We now have video and audio in beta form as well. And the foundational difference between what we do and what everyone else does in the market really comes down to three things. One is commercially safe, the way we train the models. Two is the incredible control we bake into the model. Three is the integration that we make with these models into our products. Increasingly, of course, CC flagship applications, but also in Express and Lightroom and these kinds of applications, but also in Anil's DX products as well. So that set of things is a critical part of the foundation and an adorable differentiator for us as we go forward. Now as we introduce the video model, which we expect to have in market early next year, that's going to create an opportunity to further tier our creative cloud offerings. As you surely understand, video generation is a much higher value activity than image generation. And as a result, it gives us the ability to start to tier creative cloud more actively there. In addition to that, we introduced this year, we introduced Fireflies services. That's been off to a great start. We have a lot of customers that are using that. A couple we talked about on the call include Tapestry. They're using it for scaled content production. Pepsi, for their Gatorade brand, is enabling their customers to personalize any merchandise that they are buying, in particular, starting with Gatorade bottles. And these have been very, very productive for them, and we are seeing this leveraged by a host of other companies for everything from localization at scale to personalization at scale to user engagement or just raw content production at scale as well. And then last, not to get missed in all of this, is everything we're doing with AI Assistant. AI Assistant for Acrobat is off to an incredibly strong start. And we see it continuing to accelerate. So all of this has built a great foundation for us in FY2024. It's given us a lot of signal from our customer base, and it's really we've learned a lot that we intend to apply as we optimize the value and, you know, the tiering for our customers going forward."
},
{
"speaker": "Dan Durn",
"text": "Yeah. And just building on David's comments as it relates to the FY2025 guide, we talk about all of the great innovation that's in flight. I would say the velocity of innovation is greater today than it's ever been. We called out products like Express, AI Assistant, Firefly, premium tiers in DX, Gen Studio. The good thing is they're meaningful contributors today to the financial performance and extrapolating the momentum that we see in those products, taking a point of view on the future pipeline of innovation, how we bring that to life, deeply natively integrated into our products and further extend the value we offer to customers as well as the additional segments we can access. All of this comes together to take a perspective of what 2025 looks like based on the strong start that we have and the meaningful contribution in FY2024."
},
{
"speaker": "Michael Turn",
"text": "Thanks very much."
},
{
"speaker": "Operator",
"text": "And we'll take our next question from Alex Zukin with Wolfe Research."
},
{
"speaker": "Alex Zukin",
"text": "Guys. Thanks for taking the question. I guess maybe to the point that you just alluded to in terms of AI being meaningful as part of the broader roadmap for business. Can you maybe talk about how you're thinking about the growth driver from Fireflies from Gen Studio and when kind of how will we see that percolate through the year in terms of the net new digital media ARR? Is that something that you think is more going to be showing up in the DX business? It'd be great to get some color there. And then anything, Dan, that we should think through given the new guidance methodology around seasonality, linearity, for the digital media business."
},
{
"speaker": "David Wadhwani",
"text": "Sure. I'm happy to take that. So first of all, yeah, as we mentioned, we're really excited about the FY2024 momentum that we're seeing that we're carrying into it. And you know, we've had this conversation in the past around, you know, how we about the growth algorithm for the digital media business. So maybe let me reiterate a little bit of that. We've talked about this in the context of p times q plus v in the past. You know, where p is new users bringing in more people into the franchise. We're continuing to do that. Obviously, with the introduction of Express, we're seeing a lot of great growth there, whether it's through our phones channel reaching out to SMB, whether it's reaching out to the mid-market or whether it's working more closely with Anil and the DX business and the integrations we have between Express and the DX business reaching into large companies. We're doing a lot in terms of proliferation of Express into education. We've done a number of partnerships that we talked about with Box, ChatGPT, HubSpot, and others, but also our own products like Acrobat Workflows, from Acrobat and Reader into Express. So really pushing to drive more new customers into the franchise in addition to the continued growth that we're getting in our core creative products. Second, in terms of the core creative products, this is where the queue, the price actually increases with core value because when we're introducing Firefly models into the mix, we get the opportunity to integrate them more into the flagship applications. And as I mentioned earlier with the Fireflies web application, we have the opportunity to create more tiers across the creative products so that we can get people in the right plan for their needs. And we're very bullish about video and the breadth of our customer base that are going to need access to these video models. Again, remember, they're integrated deeply into our applications, including Premiere. We're very excited about what that could mean for us. And then lastly, the business value for customers and enterprise or corporate, that's where the value-based selling that we do along with the digital experience business really plays out. Firefly Services, as I mentioned, with Gatorade, Tapestry, and a whole host of others that have come. Everyone in this space is driving towards personalization of that content, and they absolutely need a scaled production and automation pipeline to generate more content. And that's where Firefly services does. And as it has hit this level of escape velocity, and in particular, Gen Studio so that it becomes a more holistic solution as we go into FY2025 and accelerate that. And that's, you know, Alex, that's what's leading to the guide of 11%. If you really take a step back, that's one of the best guides we've given in terms of, you know, next year ARR growth. But one thing maybe to keep in mind is the composition of growth is going to be a little different next year compared to FY2024. Again, the growth algorithm is new users, new products, and value and pricing. New users and new products will be a more significant part of the mix as we go into FY2025. And we look forward to sort of that foundational base of the business growing and driving the business."
},
{
"speaker": "Dan Durn",
"text": "And then just to build on that, Alex, and I appreciate the question around the shape of FY2025. Here's what I'll share about it. We all know we changed the guidance methodology into 2025. The guide around the ending ARR book to business growth. We just have a strong point of view. It's a better indicator of business health trajectory. David talked about the growth algorithm, the growth agenda at the company, new subscribers, is the predominant driver of growth. Has been continues to be. The second leg Cross sell. Upsell. This is something the company is trying to really great skill at over time. Once we bring people into the Adobe ecosystem to journey them through the rich set of technologies and products that we have to bring them deeper into the ecosystem, that's an important element. And then lastly, you know, David mentioned pricing. This is about how we segment the product portfolio, the value, that we deliver to our customers. So as we think about the innovation, as we think about the growth algorithm, and as we think about increasingly monetizing the rich set of innovation that we've already brought to market, as well as in the pipeline to be brought to market. Quarterly profile, we view it as less important. Really wanna focus on revenue, and EPS. Focus, on the annual book of business growth. We think that's the most important way to look at the business. It's also how we as the management team run the business."
},
{
"speaker": "Alex Zukin",
"text": "Understood. Thank you, guys."
},
{
"speaker": "Operator",
"text": "And the next question will come from Kirk Materne with Evercore ISI."
},
{
"speaker": "Kirk Materne",
"text": "Yeah. Thanks very much. David, I was wondering if I could just follow-up on your last comment on sort of obviously driving new users, new adoptions, you know, incredibly important. I just is there pricing sensitivity, meaning you're delivering so much value. I think that pricing given the value you're delivering, would be a bigger lever. You know, unless there's pricing sensitivity. Could you just walk through that a little bit more? Because it feels like you should be able to get sort of all three vectors going at the same time, whereas I know you're gonna focus more on bringing people in and making them successful. But I'm sort of I guess, is there something else on the pricing side that I'm missing why you're not getting that as well? Thanks."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. And we've talked about this in the context of proliferation versus short-term monetization and how we have to balance both of those, and that's something that we take very seriously and we look at that. If you look at the lower end of the market as we have entered with Express and Lightroom Acrobat. And by the way, this the web and mobile motion for us has been productive in bringing in a lot more new users. And so you'll expect to see us do more of that and introduce more products in that segment. In FY2025 as well. And there is certainly price sensitivity at that side of the market. When it comes to both premium users and also converted to paid users. We'll continue to enable that. When it comes to the core business, and this is the business of creative professionals, we are very focused on introducing new value that is going to create more segmentation and more tiering and, you know, get aligned value and pricing to what we are delivering there. So we do see a tremendous amount of opportunity there going forward. Because the value that we bring and the efficiency we bring to the content creation process there is very significant. Again, and then last and certainly not least, as we talked about in core enterprises, that's where we've been able to sort of cross that chasm from p times q business over to a value sale business, and we are able to start to get more automation and workflows in place there as well. So it's a mix of these things. You know, we are gonna continue to balance. We are obviously tracking, and we believe that proliferation as we've said, you know, for some time maintains is one of the top priorities because we know that if people start using our products today, we have the opportunity to continue to deliver value two for a long time to come. And so that balance is what we try to do, and it's a management judgment call, but we think we're getting it right."
},
{
"speaker": "Kirk Materne",
"text": "I guess a quick follow-up for Dan. Dan, obviously, Black Monday fell into your first quarter, this current year. Any color you can offer in terms of what that meant, if at all, to create a cloud net new ARR this quarter?"
},
{
"speaker": "Dan Durn",
"text": "Yeah. The Black Friday, Cyber Monday played out about as expected. You know, we've been talking about a multiyear trend where commercial activity shifting left in terms of timing. We run our promotions over a larger window of time to reflect consumer behavior, and we see similar pattern commercially from our customers this year. That we've seen in prior years. If we think about online shopping this year, up 8.4%. You can see last year, that's up from 4.8%. So a nice step up this year versus last year. But you can see Cyber Monday from a contribution standpoint. Even though the growth last year was down relative to this year, Cyber Monday grew at 9.6%, this year at 7.3%. Just illustrates the flattening of the profiling consumer behavior around that. So you know, performance as expected."
},
{
"speaker": "Kirk Materne",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "And the next question will come from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you guys for taking the question. A lot of excitement from you guys on the conference call about the pace of innovation going on in the business. And we hear excitement from creative professionals, and they talk about an acceleration in the pace of innovation. But apologies to state the obvious, but investors aren't feeling that excitement or aren't showing that excitement. Stock is a major underperformer on a year-to-date basis. Down again on an after-hours basis today. And I would point to it's the lack of acceleration that we're seeing in their numbers. Right? Digital media net new ARR this quarter grew just organically, grew 2%. You're guiding to decelerating growth into the forward year despite all this innovation. And I think the question that it brings up in investors' mind is there some leak in the bucket. Right? All this innovation, new monetization avenues, pricing going up, but the growth is going in the wrong direction. Like, is there a part of the equation that's not working? Is there share losses? Is there something that we're not seeing that is taking away that momentum in the numbers that's not it? We're not seeing the acceleration in the numbers if you will."
},
{
"speaker": "Shantanu Narayen",
"text": "Okay. So maybe I'll talk about I mean, if you take a step back and think about the year, and I'll certainly address the feedback that you're sharing. From our perspective, you know, when we guided at the beginning of the year, when we reguided then in the middle of the year to $19.50 and then when we guided in Q3. I mean, the reality is we beat all those three targets that we had issued, beginning of the year, middle of the year, and end of the year. I think specifically maybe as it relates to the Q4 digital media net new ARR and thinking about it from the creative, the one thing that I'll point out there is that, actually, creative did better than probably is evident in that if you think about the contribution of Acrobat that went into the creative bucket. Versus the document cloud business. So certainly, Acrobat continues to do well. Record, as you saw, but the non-Acrobat contribution in creative actually had more growth. Than what you would see if you just look at it from a Creative Cloud ARR. I think to your bigger question about what's happening in the business, and as we think about it, you know, at the scale of the business right now, certainly, as this entire world moves towards generative AI, as David said, we're executing on both the proliferation play at the bottom with Express and Acrobat. And at the high end, with the Creative Pro and with the enterprise, we are seeing significant adoption of that. And I think Gen Studio will also be a good unlock because Gen Studio actually brings this all together in the enterprise in a way that nobody else can. And so when we think about Firefly services, you think about the custom models, you think about the ability to move all of that into campaigns at pace, we are seeing significant traction in that particular space. So you know, the business is going through a change as it relates to the lower end. But for the core creative as well as for the enterprise, it's actually, you know, headed absolutely in line with our expectations. With good acceleration. And on the consumer communicator space, I think the traction that we're seeing with Express on proliferation also gives us a lot of optimism for how that part of the business is also doing well. And so, you know, we take our target seriously. It's the beginning of the year. We wanna go keep executing and innovating on it. To the point that I think you as well as others have asked, is there, you know, opportunity in the growth agenda, not just to think about the innovation and the offerings, but to make sure that as we tier these, that the pricing and the value is appropriate, absolutely. And, you know, I think you'll continue to see us. I think David mentioned that in his prepared remarks as well as Dan did. That you'll see us also have new tiered offerings. That reflect that value that we're providing. To the creative pro as well as to the business segment."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thanks for the feedback."
},
{
"speaker": "Operator",
"text": "And moving on to Keith Bachman with BMO."
},
{
"speaker": "Keith Bachman",
"text": "Hi. Thank you very much. I wanted to ask David to you if I could on Doc Cloud specifically. Growth was certainly strong this quarter. And I just wanted to understand some of the context associated with durability. And if you could break it into some of the parts, it looks like your monthly active users, it continues to grow well. And in addition to that, how are you thinking about leveraging the value there in terms of price, specifically within the growth of Doc Cloud. And again, the broader question is just on the durability of Doc Cloud grew 23% over the course of the quarter in terms of ARR, trying to understand how durable it is and what the pieces are, and then I have a follow-up."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. I think Document Cloud has been, you know, if you think about the fact that we're 40 years into this business, it's really just the foundation is the fact that PDF has become the de facto standard for unstructured data. The world. And Adobe and Acrobat are the most trusted providers of solutions for that, and that's really what is the foundation of what is driving the business, including the fact that it's the most secure platform for leveraging and accessing the content. I think what is there are two things that are really the growth drivers of this business or a number of things. First is exactly like you said. I mean, monthly active users and free and paid is a key stat that we keep looking at. You know, we are very effective at picking free users of Reader and converting them to paid users of Acrobat. And we continue to do that across more surfaces that used to be predominantly a focus on desktop applications. As we've noted in the past, we now have edge integrations, Chrome integrations. We're also available in Teams. We're also available on mobile devices for, you know, iOS and Android. And the mix of all those continue to grow on a monthly basis. Of the things that we are doing to drive that growth is helping people see the value of sharing a link to the PDF as opposed to sharing the document itself, that in doing so, you get a lot more control in terms of the conversation and feedback and review around that. But it also drives the fact that the recipient is then guaranteed to be viewing the PDF in an Adobe surface that we can then use to close that viral loop and drive, you know, further top of funnel opportunity to convert. So that foundation is very strong. In addition to that, AI Assistant has been really a phenomenal ad, you know, unlike many other players in the space, we don't require significant, you know, security and governance reviews because people can have conversations around the documents that they view. And one of the big things that I think has been unlocked this year is moving not just by looking at a PDF that you happen to be viewing, but being to look at and have a conversation with multiple documents, some of which don't even have to be PDF. So that transition and that, you know, gives us the ability to really take Acrobat and make it more of a general-purpose productivity platform. And that's really what drove the adoption that we saw in education this year. So another way of saying that the core foundation of Acrobat continues to be strong and is actually getting stronger with the MAO increasing. But the new value we're adding with AI Assistant takes Acrobat to an entire new level in terms of value."
},
{
"speaker": "Shantanu Narayen",
"text": "Maybe the thing I'll add to that is the durability of that to your point in languages as we roll that out in languages. As we roll it out across multiple documents, and as we roll it out in enterprises and B2B specifically. So again, significant headroom in terms of the innovation agenda of how Acrobat can be made even more meaningful as a knowledge tool within the enterprise."
},
{
"speaker": "Keith Bachman",
"text": "Okay. It just sort of leads into my follow-up question if I could sneak it in as we've talked about during the course of this call tonight the various drivers of growth for ARR. And I just wanted to specifically ask about consumption as we think about FY2025 and the question is, is that gonna be a contributor towards ARR growth, or should investors really be thinking about trying to match my seats, if you will, and really shouldn't it be about consumption being additive growth in 2025. That's it for me. Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "I think, Keith, you're gonna see, quote-unquote, consumption, add to ARR, in two or maybe three ways more so in 2025 than in 2024. The first, and David alluded to this, is if you have a video offering and that video offering that will be a pure consumption, you know, pricing associated with it. I think the second is in Gen Studio and for enterprises. And what they are seeing with respect to Firefly services, which again, I think David touched on, you know, how much momentum we're seeing in that business. So that is in effect a consumption business as it relates to the enterprise. So, you know, I think that will also continue to increase. And then I think you'll see us with perhaps, you know, more premium price offering. So the intention is that consumption is what's driving the increased ARR, but it may be as a result of tier in the pricing rather than a consumption model where people actually have to monitor it. So it's just another way much like AI assistance is of monetizing it. It's not like we're gonna be tracking every single generation for the user. It'll just be at a different tier. And we think that that's both a better way to deliver value as well as to get the monetization."
},
{
"speaker": "Operator",
"text": "And moving on to Brad Zelnick with Bank of America."
},
{
"speaker": "Brad Zelnick",
"text": "Okay. Wonderful. Thank you. I'll ask a question, David, of you, please. You in the past, you've provided some good color. It sounds like there's momentum there. It seems like this would be the year with all the Firefly services integration into the core franchises. We could see some acceleration and conversion of that funnel. So we'd love to get some update from you on that effort and how you see that unfolding throughout the year. Thank you."
},
{
"speaker": "David Wadhwani",
"text": "For a second, you actually cut out. And so you said Firefly. We heard that. Did you mention any other product before we answer that question, Brad, just to make sure we capture your question?"
},
{
"speaker": "Brad Zelnick",
"text": "Really just Firefly services across all the franchises, you know, Photoshop, Lightroom, etcetera. You know, what could that integration effort do to the conversion activity with the top of funnel?"
},
{
"speaker": "David Wadhwani",
"text": "Yeah. So a number of So first of all, you're exactly right in terms of, you know, Firefly is a platform and a foundation that we're leveraging across many different products. As we talked about, everything from Express and Lightroom and even in Acrobat on mobile, for our broad base, but then also in our core creative products. Photoshop, Illustrator, Premiere, and, you know, as we've alluded to a number of times on this call with the introduction of video, even a standalone offer, for Firefly that we think will be, you know, more valuable from a tiering perspective there. And then into Firefly services through APIs and connection to Gen Studio. So we are looking at leveraging the power of this AI foundation in all the activities. As it relates to top of funnel and conversion, we're very excited. Let's start with new users and more closer to the low end of the market. We're very excited with the signal we're getting from Express and Lightroom on mobile and web. Again, you know, as we've talked about Express is seeing some really good new user acquisition. We added 4,000 new businesses this year. We increased education, you know, access by 84% this back to school versus last back to school. We're seeing, you know, really strong adaption through social, digital, mobile traffic as well. So we see that when we invest in mobile and web, we are getting some very positive signals. In terms of user adoption and user conversion rates. So we're using Firefly very actively to do that. And by the way, the fact that Firefly continues to be the only commercially safe, you know, model integrated into these apps does matter when it comes to, as I said, adding 4,000 new businesses. The second thing is we are seeing in the core creative business, when people try something like Photoshop, the onboarding experience is faster to success because of the use of generative AI and generative capabilities. So you'll start to see us continuing to drive more proliferation of those capabilities earlier in the user journeys, and that has been proven very productive. But we also noticed that more people use generative AI, again, we've always had good retention rates, but the more people use AI, the longer they retain as well. And so we are definitely leveraging generative AI for that entire flow in the funnel."
},
{
"speaker": "Operator",
"text": "And as we're past the top of the hour, I just have time for one more question. Thank you."
},
{
"speaker": "Operator",
"text": "And that question will come from Jay Vleeschhouwer with Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. Dan, you noted that your current RPO was up 13% in the quarter. Which results in a 10% three-year CAGR for current RPO. Would you expect that over time or at least in fiscal 2025, that your current RPO growth be closer to what you just reported for Q4 or might revert more to the lower three-year CAGR? And then for David, if I could, just since there were so many mentions of tiered offerings, is the concept there more around functionality at the product level as compared to the olden days of tiering that was more about segmentation and packaging, as in the old CS days or is it more currently around the functionality that you're offering on a product-by-product basis?"
},
{
"speaker": "Dan Durn",
"text": "Yeah. Thanks, Jay. And what I definitely don't wanna do is get into guiding of CRPO. But when I take a step back and think about the rhythm and flow of the business, what we're seeing on the enterprise side, winning large transformational deals, exiting the year with the largest bookings quarter ever, having premium tiers in that product portfolio momentum around AEP and apps continuing to grow at scale, when we think about content supply chain and bringing cross-cloud opportunities together that really get at meaningful pain points of customers over time. And then we think about the innovation that we're driving through the digital media business, I feel really good about our ability to continue to drive the business going forward, and I'm very encouraged by what I see."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. And then just adding on briefly to the question on tiering. Yeah, Jay. It's if you think about what we've done over the last year, there's been a bit of experimentation. Obviously, a the generative credits model. What we saw with Acrobat was this idea of, you know, it's a separate package and separate SKU that created a tier. That people were able to access the feature through. And as we learn from all of these, we think, as Shantanu had mentioned earlier, that the right tiering model for us is gonna be a combination of feature, access to certain features, and usage limits on it. So the higher the tier, the more features you get and the more usage you get of it."
},
{
"speaker": "Shantanu Narayen",
"text": "And since that was the last question, let me again maybe in quick summary just talk about first, you know, we had a strong 2024. But I think that really sets us up even better for a strong 2025. Given the innovation that we've had, I think as it relates to all three businesses that we have, the Creative Cloud with everything that we've done around AI, we have a lot of momentum going into the business and a really great diverse portfolio in terms of both the customers as well as our offerings. Acrobat continues to perform really well with AI Assistant as we bring it to other languages, get more vertical, use cases for that particular solution and extend it beyond a single document, we continue to think that the Document Cloud has significant opportunity ahead of us. And I think bringing that all together with digital experience, Q4 was really an extremely strong quarter as it related to us bringing all these solutions together in Gen Studio. I think much like we did with AEP and apps and data and have driven that to a billion-dollar business. I feel just the same amount of excitement with what we can do with content and AI and how we can accelerate the creation of that all the way from ideation to the multiple variation that's required. So we look forward to sharing more with you. At the end of our Q1, but in the interim, thank you for joining us. And happy holidays."
},
{
"speaker": "Operator",
"text": "Thank you. That does conclude today's conference. We do thank you for your participation today."
}
] | Adobe Inc. | 24,321 |
ADBE | 3 | 2,024 | 2024-09-12 17:00:00 | Operator: Good day and welcome to the Q3 FY'24 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's third quarter fiscal year 2024 financial results. You can find our press release, as well as PDFs of our prepared remarks and financial results, on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, September 12, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon and thank you for joining us. Adobe had an outstanding third quarter. We saw strength across Creative Cloud, Document Cloud and Experience Cloud, achieving revenue of $5.41 billion, representing 11% year-over-year growth. GAAP earnings per share for the quarter was $3.76 and non-GAAP earnings per share was $4.65, representing 23% and 14% year-over-year growth, respectively. Our success reflects our strong execution against an ambitious innovation agenda to deliver value to our customers. The product advances we've launched in the past 18 months are delighting a huge and growing universe of users and enterprises, empowering them to unleash their creativity, accelerate document productivity and power their digital businesses. Our vision revolves around Adobe's deep technology platforms across Creative Cloud, Document Cloud and Experience Cloud which, when integrated, provide significant differentiation and value. We are amplifying creativity and productivity by enabling the convergence of products like Photoshop, Express and Acrobat as knowledge workers and creatives seek to make content more compelling and engaging. We're bringing together content creation and production, workflow and collaboration and campaign activation and insights across Creative Cloud, Express and Experience Cloud. New offerings including Adobe GenStudio and Firefly Services empower companies to address personalized content creation at scale with agility and enable them to address their content supply chain challenges. Adobe's customer-centric approach to AI is highly differentiated across data, models and interfaces. We train our Firefly models on data that allows us to offer customers a solution designed to be commercially safe. We have now have released Firefly models for Imaging, Vector and Design and just previewed a new Firefly Video model. Our greatest differentiation comes at the interface layer with our ability to rapidly integrate AI across our industry-leading product portfolio, making it easy for customers of all sizes to adopt and realize value from AI. Firefly-powered features in Adobe Photoshop, Illustrator, Lightroom and Premiere Pro help creators expand upon their natural creativity and accelerate productivity. Adobe Express is a quick and easy create-anything application, unlocking creative expression for millions of users. Acrobat AI Assistant helps extract greater value from PDF documents. Adobe Experience Platform AI Assistant empowers brands to automate workflows and generate new audiences and journeys. Adobe GenStudio brings together content and data, integrating high-velocity creative expression with the enterprise activation needed to deliver personalization at scale. Overall, we're delighted to see customer excitement and adoption for our AI solutions continue to grow and we have now surpassed 12 billion Firefly-powered generations across Adobe tools. I'll now turn it over to David to discuss the momentum in our Digital Media business.
David Wadhwani: Thanks, Shantanu. Hello everyone. In Q3, we achieved net new Digital Media ARR of $504 million and revenue of $4 billion, which grew 12% year-over-year, fueled by innovation in both our Creative and Document businesses. With Document Cloud, we continue to reinvent how people create, edit, share, review and sign digital documents with PDF and Acrobat across mobile, web and desktop. For decades, PDF has been the de facto standard for storing unstructured data, resulting in the creation and sharing of trillions of PDFs. The introduction of AI Assistant across Adobe Acrobat and Reader has transformed the way people interact with and extract value from these documents. In Q3, we released significant advancements including the ability to have conversations across multiple documents and support for different document formats, saving users valuable time and providing important insights. We're thrilled to see this value translate into AI Assistant usage, with over 70% quarter-over-quarter growth in AI interactions. In addition to consumption, we're focused on leveraging generative AI to expand content creation in Adobe Acrobat. We've integrated Adobe Firefly image generation into our Edit PDF workflows. We've optimized AI Assistant in Acrobat to generate content fit for presentations, emails and other forms of communication. And we're laying the groundwork for richer content creation, including the generation of Adobe Express projects. The application of this technology across verticals and industries is virtually limitless. Tata Consultancy Services recently used Adobe Premiere Pro to transcribe hours of conference videos and then used AI Assistant in Acrobat to create digestible event summaries in minutes. This allowed them to distribute newsletters on session content to attendees in real time. We're excited to leverage generative AI to add value to content creation and consumption in Acrobat and Reader in the months ahead. Given the early adoption of AI Assistant, we intend to actively promote subscription plans that include generative AI capabilities over legacy perpetual plans that do not. In Q3, we achieved Document Cloud revenue of $807 million, growing 18% year-over-year. We added $163 million of net new Document Cloud ARR. Other highlights include. Expanded Acrobat customer value with multi-document support for AI Assistant, enhanced meeting transcript capabilities and support for larger documents. Optimized AI Assistant for mobile, web, and desktop experiences, including voice-enabled conversations on Android. Continued strength of PDF-based collaboration, with shared links growing greater than 70% year-over-year. Increased top of funnel through Acrobat Web, with monthly active users growing over 35% year-over-year as a result of link sharing and our Microsoft Edge and Google Chrome extensions. Key enterprise customer wins include Amazon, Charles Schwab, Disney, Home Depot, KPMG, RedBull, Sutter Health and the US Treasury Department. With Creative Cloud, the demand for creative expression and design across media types and surfaces has never been greater. Consumers are sharing edited photos more than ever. Students need to create school presentations that stand out. Creative professionals are being asked to create more images, designs and videos faster than ever before. Small businesses are looking to engage prospects on social channels. And large enterprises are defining their content supply workflows to deliver personalization at scale. AI has the potential to empower creative professionals, communicators, consumers and organizations of all sizes to be more creative and productive. Our strategy is to build technology that will create more streamlined and precise workflows within our tools, through features like Text-to-Template in Express, Generative Fill in Photoshop, Generative Recolor in Illustrator, Generative Remove in Lightroom and the upcoming Generative Extend for video in Premiere Pro. We're exposing the power of our creative tools and the magic of generative AI through Firefly Service APIs so organizations can generate and assemble content at scale. As we integrate Firefly innovations throughout our tools, usage continues to accelerate, crossing 12 billion generations since launch. The introduction of the new Firefly Video model earlier this week at IBC is another important milestone in our journey. Our video model, like the other models in the Firefly Family is built to be commercially safe, with fine-grained control and application integration at its core. This will empower editors to realize their creative vision more productively in our video products, including Premiere Pro. With Express, we're on a multi-year strategic journey to dramatically expand our reach across customer segments. Adobe Express is our AI-first content creation application fulfilling our mission to enable creativity for all. The all-new release of Express across web and mobile earlier this year has been embraced by millions of users. They love how easy it is to create anything in Express with strong enthusiasm for our image editing features, powered by Photoshop, video editing capabilities, powered by Premiere Pro, document and presentation workflows, powered by Acrobat, and unparalleled generative AI features, powered by Adobe Firefly. Our integration of Adobe Stock and design templates with our unique Firefly Design Model ensures that content created in Express can stand out. Express empowers a broad array of individuals and businesses, from solopreneurs to the largest enterprises in the world. We're continuing to grow Express as we ramp our go-to-market activities to support recent product releases, including Express for individuals, Express for Education, Express for Teams and Express for Enterprises. As a result, in Q3 we drove 70% year-over-year growth in cumulative exports. We onboarded over 1,500 businesses and millions of students. In Q3, we achieved $3.19 billion in revenue, which grew 11% year-over-year in constant currency. Net new Creative Cloud ARR was $341 million. Other highlights include. New AI-powered features in Photoshop that accelerate core creative workflows and streamline repetitive tasks. Generative Fill in Photoshop was upgraded to Firefly Image 3, Generative Image was made generally available, and the new Selection Brush and Adjustment Brush Tools were introduced, making selective edits easier than ever. Broad-based innovations in Illustrator, including significant improvements to vector generation, enhancements to text-to-pattern and the all-new Generative Shape Fill. These advances unlock new ways for pro designers and illustrators to quickly bring their vision to life. Strong adoption of the latest version of Lightroom and Lightroom Mobile, which now includes the new Generative Remove feature. Millions of users have non-destructively removed unwanted objects from their photos with a single click. Strong demand for Firefly Services, which provide APIs, tools and services for content generation, editing and assembly, empowering organizations to automate content production while maintaining quality and control. Total API calls tripled quarter-over-quarter. Acrobat Pro single app continues to be a growth driver in Creative Cloud, reflecting the increasing adoption of PDF as a preferred format to create, collaborate and share visually compelling content. Key enterprise customer wins include The Brandtech Group, Dentsu, Estee Lauder, Google, MediaMonks, Meta, MLB, Newell Brands, PepsiCo, Stagwell Group and the US Navy. We look forward to hosting Adobe MAX, the world's largest creativity conference, next month in Miami, where we will welcome more than 10,000 members of our global community and engage with hundreds of thousands more online. We will hear from inspiring creators and unveil innovations across our clouds. In summary, we are excited about the pace and caliber of innovations across our Digital Media products and the continued execution across multiple growth drivers. I'll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello everyone. In Q3, we achieved Experience Cloud revenue of $1.35 billion. Subscription revenue was $1.23 billion, representing 12% year-over-year growth. Customer Experience Management remains top of mind for B2C and B2B companies around the world as they focus on digital strategies for customer acquisition, engagement, retention and expansion. Enterprises want an integrated platform to deliver personalized experiences at scale to their customers while maximizing the ROI of their marketing and customer experience investments. Through the integration of Experience Cloud and Creative Cloud, Adobe is uniquely positioned to combine the right content, data and journeys in real time for every customer experience. The revenue growth we are driving across our categories content, commerce and workflows, data insights and audiences, and customer journeys, all built on the Adobe Experience Platform, demonstrate the strength of our business. Global brands trust Adobe to build their content supply chain and deliver personalization at scale, making us the number one digital experience platform in the industry. Customers are embracing the opportunity to address their content supply chain challenges with Adobe GenStudio. With native integrations across Experience Cloud and Creative Cloud, GenStudio empowers marketers to quickly plan, create, store, deliver and measure marketing content and drive greater efficiency in their organizations. Financial services leader Vanguard is creating an integrated content supply chain to serve the strategic goal of deepening their relationships with a broad range of investors. Leveraging the GenStudio solution, Vanguard was able to increase quality engagement by 176% by focusing on one-to-one personalization and to realize millions in savings by improving content velocity and resource allocation with an end-to-end content creation workflow. Other highlights include. The general availability of Adobe Content Hub, further enhancing the value of Adobe Experience Manager Assets. Content Hub enables brands to reimagine how creative assets are used across their organization and with external agencies, driving content velocity and major efficiency gains. AEM Assets is used by the majority of the Fortune 50, including 8 of the 10 largest media companies, 9 of the 10 largest financial services companies and 8 of the 10 largest retailers. Increasing importance and adoption of Workfront to streamline workflows across marketing organizations and agencies. We extended our leadership in this category through the general availability of Adobe Workfront Planning, which delivers a comprehensive view of all marketing activities in an organization and enables teams to optimize marketing planning and execution. Global brands including Deloitte, Interpublic Group and NASCAR are using Workfront Planning to drive productivity gains and meet the rising demand for highly personalized marketing campaigns. Continued momentum for Adobe Experience Platform and native applications including Real-Time Customer Data Platform, Customer Journey Analytics and Adobe Journey Optimizer. We expanded our AEP portfolio with the general availability of Adobe Journey Optimizer B2B Edition, which leverages generative AI to deliver personalized experiences to buying groups, the decision-makers, practitioners and stakeholders responsible for major purchasing decisions. Strong industry analyst recognition, including the Forrester Wave for B2B Revenue Marketing Platforms, and three IDC Marketscape reports across Digital Asset Management and Headless Digital Commerce for both Enterprise and Mid-Market. Key customer wins include Dentsu, Home Depot, Humana, IBM, Johnson & Johnson, Mayo Clinic, Newell Brands, Premier League, Stagwell Group, TD Bank and UPS. We look forward to unveiling new customer experience management innovations across content, data and journeys at MAX next month, showcasing integrations across Express, Creative Cloud and Experience Cloud for freelancers, solopreneurs and marketers across agencies and enterprises. Our pace of innovation, commitment to customer value, global partner ecosystem, and category-defining solutions position us to continue our market leadership. I will now pass it to Dan.
Dan Durn: Thanks, Anil. Today I will start by summarizing Adobe's performance in Q3 fiscal 2024, highlighting growth drivers across our businesses, and I'll finish with financial targets. In Q3, Adobe achieved record revenue of $5.41 billion, which represents 11% year-over-year growth as reported and in constant currency. Our focus on both growth and profitability has been a cornerstone of our operating philosophy for years, rooted in strategic prioritization, relentless innovation, and laser-focused execution. Our Q3 results reflect this approach. We're making significant investments in our technology platforms, launching global campaigns to expand our customer base, and attracting top-tier talent, while delivering world-class cash flows and profitability. Third quarter business and financial highlights included. GAAP diluted earnings per share of $3.76 and non-GAAP diluted earnings per share of $4.65. Digital Media revenue of $4.00 billion. Net new Digital Media ARR of $504 million. Digital Experience revenue of $1.35 billion. Cash flows from operations of $2.02 billion and RPO of $18.14 billion exiting the quarter. In our Digital Media segment, we achieved Q3 revenue of $4.00 billion, which represents 11% year-over-year growth or 12% in constant currency. We exited the quarter with $16.76 billion of Digital Media ARR, growing our ending ARR book of business 13% year-over-year in constant currency. Adobe achieved Document Cloud revenue of $807 million, which represents 18% year-over-year growth as reported and in constant currency. We added $163 million of net new Document Cloud ARR, which was a record for a Q3, growing our ending ARR book of business 24% year-over-year in constant currency. Q3 Document Cloud growth drivers included. Usage and MAU growth across Adobe Reader and Acrobat. Usage and MAU growth via third-party ecosystems, including Google Chrome and Microsoft Edge extensions, which are driving free-to-paid conversion. Demand for Acrobat desktop and mobile subscriptions across all customer segments and Geographies. Strength in monetization of our AI Assistant with new Acrobat subscriptions. Strength in SMBs driven by our reseller partner network and strength in enterprise and public sector sales, with a number of large deals closing in the quarter. We achieved Creative revenue of $3.19 billion, which represents 10% year-over-year growth or 11% in constant currency. We added $341 million of net new Creative ARR in the quarter, growing our ending ARR book of business 11% year-over-year in constant currency. Q3 Creative growth drivers included. New subscriptions for Creative Cloud All Apps across customer segments, including Teams, Enterprise, and Education with back-to-school demand. Strength across our Acrobat Pro, Illustrator, Lightroom and Photoshop single apps on Adobe.com. Growing demand for our AI-first Adobe Express offerings in mobile, emerging markets and Education. Early monetization of our new Firefly Services solution in the enterprise segment. Continued momentum with new subscriptions in emerging markets and contribution from customers stepping up to our higher-value Creative plans at renewal. Turning to our Digital Experience segment, in Q3 we achieved revenue of $1.35 billion, which represents 10% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.23 billion, growing 12% year-over-year as reported and in constant currency. Q3 Digital Experience growth drivers included. Strong subscription revenue growth at scale of AEP and native applications, up greater than 50% year-over-year. Strong subscription revenue growth with Adobe Experience Manager and Workfront. Success in booking transformational deals as well as individual solution selling. Continued strength in retention and expansion across our enterprise customers and growing pipeline for our GenStudio solutions to address the content supply chain opportunity. Turning to the income statement and balance sheet. In Q3, Adobe delivered year-over-year EPS growth of 23% on a GAAP basis and 14% on a non-GAAP basis. This was primarily driven by revenue growth and disciplined prioritization of our investments, which resulted in operating margin strength in Q3. The company continues to deliver world-class margins while making significant investments in AI model training and inferencing capacity. Adobe's effective tax rate in Q3 was 17.5% on a GAAP basis and 18.5% on a non-GAAP basis. RPO exiting the quarter was $18.14 billion, growing 15% year-over-year as reported or 16% in constant currency. Current RPO grew 12% year-over-year exiting the quarter. Our ending cash and short-term investment position at the end of Q3 was $7.52 billion and cash flows from operations in the quarter were $2.02 billion. In Q3 we entered into a $2.5 billion share repurchase agreement and we currently have $20.15 billion remaining of the original $25 billion authorization granted in March 2024. We will now provide Q4 targets, which factor in current macroeconomic conditions and year-end seasonal strength. For Q4 we are targeting. Total Adobe revenue of $5.50 billion to $5.55 billion. Digital Media net new ARR of approximately $550 million. Digital Media segment revenue of $4.09 billion to $4.12 billion. Digital Experience segment revenue of $1.36 billion to $1.38 billion. Digital Experience subscription revenue of $1.23 billion to $1.25 billion. Tax rate of approximately 16% on a GAAP basis and 18.5% on a non-GAAP basis. GAAP earnings per share of $3.58 to $3.63 and non-GAAP earnings per share of $4.63 to $4.68. In summary, I am proud of our year-to-date performance, which stems from a powerful combination of product leadership, rapid innovation, diversified business and financial discipline. Given the massive markets we are catalyzing, I am confident in our ability to drive growth and industry leadership. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. Adobe's focus on responsible innovation, with customers at the center, continues to be a unifying purpose for the company. The Content Authenticity Initiative, which we founded in 2019, now counts over 3,300 members across the digital ecosystem, all committed to enhancing trust and transparency with Content Credentials. In five years, this mission has gone from a vision to reality with companies including Amazon, Google, Leica, Meta, Qualcomm, Sony, TikTok and others all committing to implementing Content Credentials. The US Department of Defense became the first federal government agency to implement Content Credentials by applying them to official DoD images. We're teaming up with Governor Gavin Newsom on a new initiative to boost digital and media literacy skills in K-12 schools and higher education institutions in California. By providing educational content, programming, and resources to schools across the state, we can help empower California's future workforce for success in an AI-powered world and use this as a blueprint for other states and countries. Next week, we will bring employees together for our annual Adobe for All conference to celebrate our vision and purpose and the impact that has on our customers and communities. I am confident that Adobe's culture, innovative product roadmap, global market opportunity, trusted brand and the unwavering commitment of our employees will continue to drive our success. Thank you and we will now take questions.
Operator: Thank you. [Operator Instructions] And the first question will come from Alex Zukin with Wolfe Research.
Alex Zukin: Hey, guys. Thanks for taking my question and congrats on what looks like a very strong quarter. It's one question, but it's a two-parter. The quarter itself, particularly on the Digital Media ARR looked very strong. It looked unseasonably strong because you haven't grown net new ARR sequentially in the 3Q, I think, in almost four years. So maybe just comment like what drove this unseasonable strength. Is it pricing, AI traction, and particularly the Document Cloud net new ARR? But at the same time given all the product momentum you went through in the script, it's a bit confusing to understand why the Q4 guide is the lowest it's ever been sequentially for Q4 on net new Digital Media ARR, which I think makes people a little nervous about maybe the go-forward, the next year performance. And so maybe just address this dichotomy because it looks kind of seasonally a little bit different than what we're used to. And I think it's weighing on the stock after hours.
Shantanu Narayen: I'm happy to start Alex and then David can certainly also add to that. I mean, to your point, we had a strong quarter, when I think about Digital Media, Document Cloud to the point that you made, Acrobat continues to perform the AI Assistant, and the SKU that we have associated with Acrobat continues to perform well. As we had said, we expect Creative to show a growth-on-growth year-over-year, and so that also played out exactly as we expected. And you know it was a strong end, when you look at it as it relates to the last few weeks' performance, we saw the typical strength that we would see going into Q4. I can see how you're saying, you're looking at the sequential guide. We're looking at it and saying it's the strongest ever Q4 target that we have put out there for Q4, Alex. And so I think we just continue to focus. We would expect Creative to again grow when you talk about growth-over-growth, net new ARR in Q4. And all of the new initiatives that we're talking about, AI, et cetera, continue to perform. So from our perspective, when we look at what we guided to the second half of the year, to your point, Q3 is stronger. We expect a seasonally strong Q4 and then continued innovation should continue to drive growth.
David Wadhwani: Yeah and maybe I'll just add a couple of things to what Shantanu, said. Again, just a little bit more context behind the strength in Document Cloud. Obviously, link sharing and what we've done with reader distribution across mobile, web, and desktop, that's really what continues to drive this business, and that underlying strength is going to continue not just in Q3, but it's going to be something that we're able to bet on and grow on going forward because we've got a lot of flow optimizations associated with that. As we look at Creative Cloud, again, we have a broader set of offerings than we've ever had, right? We have things like with Creative Cloud, we have higher-value, higher-priced offers, thanks to AI innovation that's happening in the base plans that are impacting how the Creative Cloud business is doing. We also have a broader set of offerings than we've ever had now with web and mobile, including Premium and lower-priced offerings that are driving more proliferation. And the blend of those two things also sort of comes into the strength of the quarter and how we see things going out. But as you look at the second half overall, we came into the second half with a strong expectation of how the second half is going to play out. And frankly, it's playing out as we expected in terms of the aggregate Q3, Q4 numbers. In terms of the specifics on timing, Q3 was a little stronger than you expected, and for a good reason given seasonality. I think a lot of that can be explained by a few deals that would have historically just closed in Q4, closing earlier than expected in Q3, and that changed the dynamic in terms of the linearity that you would typically see between Q3 and Q4.
Alex Zukin: Very helpful guys. Thanks again.
Operator: And our next question will come from Mark Murphy with JPMorgan.
Mark Murphy: Thank you so much and I'll have my congrats. David, I'm wondering if you can compare the AI monetization opportunity that you're sensing with the image models relative to the future potential with your audio and video models, just for instance, how many tokens might be consumed when someone is generating a video versus an image. And then tying in with that, just how optimistic are you maybe being able to solve some of the limitations with the current video generation models where the facial expressions can lack realism or they can't handle the object interactions or they don't provide enough detail or resolution in the videos?
David Wadhwani: Yes. Happy to take that. Let me just sort of take a little bit of a step back and talk about the core strategy that we have for AI and the conversion then in terms of how we think about monetization. So I think we've been incredibly consistent with what we've said dating back a year, year and a half ago where we talked about the fact that we were going to develop the broadest set of models for the creative community and we were going to differentiate the models based on quality, commercial safety, integrateability into our tools and controllability. And as you've seen very methodically over the last 18 months, we continue to bring more and more of that innovation to life. And that fundamentally is working as we've now started to integrate it much more actively into our base. If you look at it with photography, we now have in our tool generative remove, we have AI-assisted edits. In design, we have Generative Pattern, Generative Fill Shape. We have, in Photoshop, we have Gen Remove. We also have Gen Fill and I can continue on with all the generations, but we've also now started to integrate it in Firefly services for what we're enabling enterprises to be able to access and use in terms of batchwork and through APIs. If you look at sort of how that's played out, as we talked about, we're seeing accelerated use and generative credits being consumed because of that deeper integration into all of our tools. And that is playing out as we expected. When you look at then how that converts to monetization, first and foremost, we've integrated it, a lot of that value into our core products and with more value and more pricing. We're also seeing that when people use these generative features, they retain better. We're also seeing that when people come to Adobe to try our Creative Cloud applications or Express application, they're able to convert better. And so there are all these ancillary implied benefits that we're getting. But in terms of direct monetization, what we've said in the past is that the current model is around generative credits, which is, I think, where you're going with this. And we do see with every subsequent capability we integrate into the tool, total credits consumed going up. Now, what we are trying to do as we go forward, we haven't started instituting the caps yet. And part of this is, as we've said all along, we wanted to really focus our attention on proliferation and usage across our base. We see a lot of users excited about it. It's some of the most actively used features that we've ever released. And we want to avoid the generation anxiety that people feel. But we're watching very closely as the economy of generative credits evolves. And we're going to look at instituting those caps at some point when we feel the time is right and/or we're also looking at other alternative models. What we did with Acrobat AI Assistant has proven to be very effective. And so we're also considering other opportunities like having standard CC plans that have a core set of generative capabilities, but also having premium API, sorry, premium AI plans that will include things more like video and other things. So, we're very happy about the innovation that's coming. And we see the opportunity to engage very deeply in the monetization. But we want to play it out over time and proliferation continues to be our primary guide. And then lastly, in terms of quality, I don't know if you had a chance to see some of the videos we put out there, integrated directly into Premiere, also text to video, image to video, more controllability. We have also the ability now to generate not just scenes with humans and dogs and organic animals, but all these like overlays and things that creative professionals actually want to work with. And so we're very excited about the set of things that they can get out of the box and get going. And human faces and things will just continue to get better. We have a lot of great research that you'll start to see. And I hope you get to play with the models because we've taken a huge step forward there.
Shantanu Narayen: Mark, maybe I'll just add a little to what David said, which was great. I spent a couple of hours with our video team. They have just absolutely hit it out of the park. I mean, the work that they've done, which is leveraging the image models with video. And again, I think to David's point, the integration with Premiere, that's what we've always said. It's the integration of the model and the application that differentiates it. I think when other models first came out, people were like, wow, you can describe it. That's just such a small part of where the value is. And the real value is you have a video, you want to extend it. It's a game changer in terms of what we can do. So really excited about the stuff that we're doing in video. And again, to David's point, this will be monetized differently from the way we have for images, which was part of the sort of base value pricing. So, the way I answer your question is, and the third thing I would say is, remember, we have the ability to create custom models as well. And so when you ingest the video that people want to edit, the ability to extend that is not just dependent on what the model is, but also on what the new data is. And again, that represents really a unique ability for us. So, hopefully all those three demonstrate why we're leading the pack in terms of how people can derive value in the nonlinear editors, which is where the action is going to be.
Mark Murphy: Thank you very much.
Operator: And moving on to Keith Bachman with BMO.
Keith Bachman: Hi. Thank you very much. I appreciate taking the question. I wanted to pick up a little bit on how we should be thinking about, David, you just mentioned monetization. And will consumption, you think, as we start to turn the year, can consumption contribute to ARR growth as we look at FY'25? Because I think there's pervasive fears that the state of competition may in fact limit your ability to turn on that monetization, if you will, from either consumption or price. And I just wanted to see if you could lace in consumption against the backdrop of competition.
Shantanu Narayen: From our perspective, Keith, I think when you look at what we have with the apps and the models, we just continue to think that's uniquely differentiated. Firefly services, which is, you can think of that also as a consumption model where we have that, it's off to a really good start. Our ability to give enterprises the ability to automate content, create custom models within enterprises, we're seeing real traction because it's a differentiated solution in that it's designed to be commercially safe. And as it relates to the core subscription models, again, David said this, but I'll reiterate it, which is, the core subscription models for products like Photoshop and Illustrator, I think, the differentiation is the combination of the model and the technology. And in video, I think, we will find additional ways to monetize it. So, I'm not sure who specifically you're referring to as it relates to competition in this space, but from our perspective, it's just unique. I mean, if you look at the acceleration of what we've seen of generations in Photoshop, Illustrator, Lightroom, it's clear that we're actually extending the value rather than having other people to catch up.
David Wadhwani: And then one other thing I'd just emphasize there is that the commercial safety is so important to businesses of all sizes frankly and that is something that we feel very, very, very differentiated in addition to everything Shantanu said.
Keith Bachman: Okay, great. And then perhaps for my follow-up, I wanted to pick up on Alex's first question. But you're guiding net new ARR down 3% year-over-year in Q4. And I think investors are, but thereby taking that as perhaps a framework when you look at next year, but is there anything that net new ARR will be down next year? And I know you don't want to give guidance for next year, but just any kind of thoughts you want to address as it relates to the guidance associated with net new ARR being down in Q4 versus a framework that we might want to apply for the FY'25 net new ARR?
Shantanu Narayen: You're right, Keith. We're not going to give FY'25 guidance. We'll certainly share more at MAX and we would expect like we did last year that at the December earnings call, we'll give color on fiscal '25 ARR, but I'd say a couple of things. First, as it relates to again the performance of the second half because to Alex and your question, if there are questions around Q3 and Q4 and what that trend means, again, we will hope to have record net new ARR in fiscal '24, which I think is a great thing. We gave 1,950 at the end of Q2. We're clearly on track to beat that number, which we take as a positive sign. And the other thing, maybe perhaps, tactically for you folks to think about as well, as it relates to the Q4 guidance, typically, you have Black Friday and Cyber Monday in the same quarter. This time, Cyber Monday, I believe, is in Q1. And so as it relates to our Q4 performance, it's the highest target that we've ever issued. We will go out and then continue to execute and continue to innovate. So that's the way I look at the business, Keith.
Keith Bachman: Okay. Thank you, Shantanu.
Operator: And the next question will come from Saket Kalia with Barclays.
Saket Kalia: Okay, great. Hey, guys, thanks for taking my question. David, maybe for you. You touched on some of the drivers in Document, which was super helpful. But I'd love to maybe go one level deeper into some of the dynamics in that business, which of course continues to grow net new ARR at a really nice clip. So maybe we can just talk a little bit about, are there any pricing headwinds or tailwinds that we should keep in mind specifically for Document Cloud. And also maybe you can give us a sense for sort of where Document Cloud is in its journey to maybe becoming more of a subscription-heavy business. Do those make sense?
David Wadhwani: The first part does. Let me try to address the whole thing. The question on subscription-heavy, it is a very strong subscription business for us already, but I'll touch on that and hopefully, I'll address your question. So first, if we take a step back and look at Document Cloud, I mean the foundation of everything we're doing here is incredibly strong and it's a machine we've had for a long time, but it continues to perform incredibly well. And what I mean by that is the platform proliferation of what we have with Acrobat and Reader. The fact that we have 40 years into this business, the rise of PDF and PDF becoming the de facto standard for content as a unstructured content as a whole is a remarkable foundation for us to be building on. And the distribution we have across desktop, web, mobile, including web extensions is really the foundation of everything we do because that becomes the top of funnel for us. You layer on top of that the fact that generative AI in general has come out where unstructured content, especially PDF unstructured content, the 3 trillion PDFs out there that we believe are out there has suddenly inherently much more value than it did a year ago. And this whole ecosystem is set up well for us. In addition to that foundation, we've also been over the course of the last few years, really transitioning the way people share because if you think about PDFs and Acrobat in general, one of the most important things people do is they produce the PDF to share it with others, often for comment and review engagement and by increasing sharing via links versus sharing as an attachment, we see a lot more engagement and interaction that we're able to benefit from and that also helps with the top of funnel and we can provide more value. Then on that platform, what we've done is with AI Assistant, we focus on consumption for the last nine months, starting with the ability to look at a single PDF and ask questions of that PDF. Then we sort of then we added support for multi-docs, so you can now have five or six PDFs that you're having a conversation with. We added support for multiple formats. So you can look at PDFs, but you can also drag in Word documents or PowerPoint documents or a link to a meeting transcript that you have. We are adding in the process of adding language support for other languages optimizations. We're now starting to work on document type optimization. So if it's a contract, we know how to optimize the results even better than if it's a marketing document. And that's all about consumption. But in addition to consumption, we're now expanding because these conversations that happen with these documents are inherently about getting some insight and then sharing that insight. We've also started to do things that you can create richer content on the back end of it. So Firefly is embedded now in Edit PDF workflows. We have the conversational content and now able to generate emails and presentations and those kinds of things. We've now embedded in the Convert PDF workflows, the ability to output to Express and create richer media outputs and you can start to see all of this stuff coming together in a very real way already, but also in the months ahead. The last thing I want to say on this too is that what's really working out well for us is that when we are outpitching this opportunity, not just in terms of the individuals that use it, but also businesses, is that we don't have any security concerns, right. Our data governance model is the same data governance model that's happened. If you have access to the documents, you can have conversations with the documents. And so it makes it a much easier thing for enterprises to adopt because there's no systemic or governance changes. And so all of that continues to drive more adoption. And as I said on the prepared remarks, Document Cloud is substantially a subscription business, but now with AI Assistant being available to subscribers and not as directly to perpetual users, we expect that to continue to transition even further.
Saket Kalia: Super helpful. Thanks, guys.
Operator: And the next question will come from Jay Vleeschhouwer with Griffin Securities.
Jay Vleeschhouwer: Yeah. Thank you. Good evening. David, I'd like to follow up on something that you said on the second quarter call. And that was that you said at the time that you were for the rest of the year going to quote, pour gas on your GTM, and as well engage in a full-funnel campaign later in the year. So the question is, could you update us on that? I mean, it does seem to be in no small part corroborated by some of your internal investments that we've been able to see, for example, in your ICX team, your go-to-market positions across multiple products, strategy positions and so forth. But you've made this commitment for a substantial expansion, but do you think you need going forward to continually accelerate the pace of investments in go-to-market or do you think at some point, perhaps soon you can begin to taper that off and then leverage that capacity to revenue growth and thereby margin expansion?
David Wadhwani: Jay, I think, we might have to have you join our marketing organization, given how much you know about the market dynamics. But great question. And so first and foremost, again, if we're going to talk about Express, let's take a little bit of a step back and understand the dynamics of where we are in the evolution. I think what we had talked about in Q2 was that not only do we feel like we have an incredible product now, but that product is built on a brand new platform, that has the ability to develop AI functionality as a native part of that platform. So the speed of innovation that we've been adding capabilities to Express is really been a breakneck speed and we're very excited about that. Features like native integration of Firefly, so that everything that's generated here is commercially safe, which again like I said, is important to individuals and to businesses, but doing it with more control, things like style and structure match and integrated into the image viewer, the video viewer, editor and the design surfaces. So very excited about that. In addition to those basic capabilities that are so foundational, this is really the design model that we've been talking about Firefly design model. This is where it's surfacing the most, and so you combine what we're doing with templates and design model and people are able to create and they effectively get access to an infinite number of templates, right. We believe that we're moving from a template-centric, a set of tools for communicators to an AI-centric set of tools and we feel that with our design model and everything we have, we're fundamentally going to create better content that stands out ultimately. We also have great workflows that we've developed with Photoshop and Illustrator and Acrobat. And we've integrated all of this in ways that are fundamentally effective for businesses, including bulk creation and assembly capabilities. So small businesses all the way through enterprises are able to leverage this for their designer-to-marketer workflows. In addition to all of that innovation, to your point, we've really been focused on the go-to-market since last time. Since we last spoke or right before we last spoke in Q3, we expanded the offer set significantly. We've always had Express for individuals in market, but we added Express for Teams, Express for Enterprise and we just launched Express for Education, this back-to-school year with a lot better support for classrooms and teacher student workflows as well. On the marketing side, we've been ramping that very actively. It's a net new audience to Adobe. I mean, that's something to really recognize. This isn't about shifting existing audience over solely. It's about getting access to a new audience. And so for that, we have to employ both traditional means with a focus on awareness campaign, but also leveraging social, because that's where this audience is. So, you'll see us doing a lot more on social as a result. And then on the back of all that, we're ramping our direct sales. We have a very at-scale inside sales motion that we're starting to lean into. We have a very significant direct sales motion that we have in enterprises and mid-market that we're leveraging. Adobe.com journeys, we have a lot of businesses and individuals coming on Adobe.com and doing a lot more optimization in the App Store. And that's really what you're starting to see in the numbers we shared with strong usage at 70% year-over-year. Cumulative exports, strong business momentum with over 1,500 businesses sold and really great our best back-to-school season ever with millions of students now enabled on it. So, that's the foundation. And if you're, the one thing I would say is, yes, we started pouring gas on it and we're going to pour more gas on it, not less in the months and years ahead.
Shantanu Narayen: Maybe two other things, Jay, just big picture. I mean we continue to invest in all of the key long-term things, whether it's training of models, whether it's Express, whether it's AEP and apps, whether it's GenStudio, while delivering what I think are phenomenal margins. And so we'll continue to make those trade-offs in terms of growth and profitability and maybe a little tongue-in-cheek. Part of the reason why David has the ability to invest as much in marketing is he uses the best marketing technology in the world from Anil.
Anil Chakravarthy: That is true.
Jay Vleeschhouwer: Thank you.
Operator: And our next question will come from Tyler Radke with Citi.
Tyler Radke: Yes. Thanks very much for taking the question. I wanted to ask you about the Digital Experience side of the business. So RPO looks pretty strong in terms of sequential additions. The implied guide for Q4 was a bit lighter than consensus. I know you did talk about some unusual dynamics in terms of seasonality, Cyber Monday, but could you just talk about the strength and underlying dynamics you're seeing in the business heading into Q4? Thank you.
Anil Chakravarthy: Yes. When we look at the Digital Experience business, we are pleased with the overall execution of the business. We have a big opportunity with what we call personalization at scale where whether it's a B2C company or a B2B company, the ability to deliver personalized customer experiences to consumers or to hundreds of thousands of business customers, individuals within businesses. This is important for every company in the world and we have the integrated platform and the applications to be able to help them deliver those kinds of experiences. And we have the unique ability to bring together the right content, the data, customer data and the customer journeys across our Experience Cloud and the integration with Creative Cloud to deliver those personalized experiences. And that's pretty unique to what we can do at Adobe. And that's one of the things that we are seeing in the dynamic in the enterprise market is the enterprises are scrutinizing all the deals that they want to do. I think in this case, they look at our offerings and see the ability to not only help with growth, they also look at the efficiency gains that we can help them create. And that's helping us as enterprises scrutinize the spend. And when you look at our guide, we're obviously, we are focused on, most closely on our subscription business and that's the business that continues to grow strongly and we're showing good performance on the subscription business. And our overall revenue is a combination of subscriptions and services where we really are focused on working with a broad global partner ecosystem to make sure that we deliver services to our customers and help them realize value from our offerings.
Tyler Radke: Thank you.
Shantanu Narayen: Hey, operator, we're at the top of the hour. We'll sneak in one more question and then wrap up. Thank you.
Operator: Thank you. That question will come from Brent Thill with Jefferies.
Brent Thill: Thanks. Dan, just back to the guide. Can we just drill in? I know that you mentioned there were a couple of factors that were at contemplated. I'm just curious if there's anything else that you're seeing that is different in terms of end demand or any softness. I know the US decelerated a little bit, EMEA accelerated.
Shantanu Narayen: No, Brent. I mean I think we had a strong Q3 and we continue to see the momentum in the business. And it's our typical considered targets that we do and I focus on execution. So, we're not seeing anything as it relates to a change in the business dynamics. I also mentioned that the last few weeks of Q3, as you know, the summer seasonality ends, we saw the traditional strength that we expect to see on our web traffic. So, I think, MAX is coming up. We have an exciting agenda in terms of what we are going to be talking about in terms of MAX. And so I mean if I take a step back and think about it, given this is the last question, I mean, from my perspective, strong Q3 across every aspect of our business, revenue, EPS, Digital Media ARR, DX, Subs revenue, Acrobat certainly also continued to show the strength. We have momentum in the business and the innovation roadmap, I mean, across all of the key initiatives that we've been talking about, whether that's Express, GenStudio and the excitement that people have associated with automating all of that content, AEP and Apps on the data side, imaging and video, the work that the Digital Media team has done on Photoshop and on Illustrator and then what's coming down the pike on video. And Firefly Services, I think, the AI monetization as well, which I know is a theme of a number of people that have asked, whether it's Acrobat, whether it's the Premium SKUs as it relates to Experience Cloud, whether it's what's happening on Gen Fill and the usage of Gen Fill, Lightroom and Lightroom Mobile. I think we're clearly demonstrating how AI can both drive value for our customers and therefore, we acquire new customers and retain customers better. So, yes, it feels good. We look forward to seeing all of you at MAX and we're going to just continue to focus on innovation and delighting our customers. But thank you for joining us.
Jonathan Vaas: Yes. Thanks, Shantanu, and we do look forward to the Investor Event that we'll be holding in Miami at MAX on October 14th, where we will be doing a Q&A with management. We hope to see many of you there. And with that, thank you for joining the call, and this concludes the event.
Operator: Thank you. That does conclude today's conference. We do thank you for your participation. Have an excellent day. | [
{
"speaker": "Operator",
"text": "Good day and welcome to the Q3 FY'24 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's third quarter fiscal year 2024 financial results. You can find our press release, as well as PDFs of our prepared remarks and financial results, on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, September 12, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon and thank you for joining us. Adobe had an outstanding third quarter. We saw strength across Creative Cloud, Document Cloud and Experience Cloud, achieving revenue of $5.41 billion, representing 11% year-over-year growth. GAAP earnings per share for the quarter was $3.76 and non-GAAP earnings per share was $4.65, representing 23% and 14% year-over-year growth, respectively. Our success reflects our strong execution against an ambitious innovation agenda to deliver value to our customers. The product advances we've launched in the past 18 months are delighting a huge and growing universe of users and enterprises, empowering them to unleash their creativity, accelerate document productivity and power their digital businesses. Our vision revolves around Adobe's deep technology platforms across Creative Cloud, Document Cloud and Experience Cloud which, when integrated, provide significant differentiation and value. We are amplifying creativity and productivity by enabling the convergence of products like Photoshop, Express and Acrobat as knowledge workers and creatives seek to make content more compelling and engaging. We're bringing together content creation and production, workflow and collaboration and campaign activation and insights across Creative Cloud, Express and Experience Cloud. New offerings including Adobe GenStudio and Firefly Services empower companies to address personalized content creation at scale with agility and enable them to address their content supply chain challenges. Adobe's customer-centric approach to AI is highly differentiated across data, models and interfaces. We train our Firefly models on data that allows us to offer customers a solution designed to be commercially safe. We have now have released Firefly models for Imaging, Vector and Design and just previewed a new Firefly Video model. Our greatest differentiation comes at the interface layer with our ability to rapidly integrate AI across our industry-leading product portfolio, making it easy for customers of all sizes to adopt and realize value from AI. Firefly-powered features in Adobe Photoshop, Illustrator, Lightroom and Premiere Pro help creators expand upon their natural creativity and accelerate productivity. Adobe Express is a quick and easy create-anything application, unlocking creative expression for millions of users. Acrobat AI Assistant helps extract greater value from PDF documents. Adobe Experience Platform AI Assistant empowers brands to automate workflows and generate new audiences and journeys. Adobe GenStudio brings together content and data, integrating high-velocity creative expression with the enterprise activation needed to deliver personalization at scale. Overall, we're delighted to see customer excitement and adoption for our AI solutions continue to grow and we have now surpassed 12 billion Firefly-powered generations across Adobe tools. I'll now turn it over to David to discuss the momentum in our Digital Media business."
},
{
"speaker": "David Wadhwani",
"text": "Thanks, Shantanu. Hello everyone. In Q3, we achieved net new Digital Media ARR of $504 million and revenue of $4 billion, which grew 12% year-over-year, fueled by innovation in both our Creative and Document businesses. With Document Cloud, we continue to reinvent how people create, edit, share, review and sign digital documents with PDF and Acrobat across mobile, web and desktop. For decades, PDF has been the de facto standard for storing unstructured data, resulting in the creation and sharing of trillions of PDFs. The introduction of AI Assistant across Adobe Acrobat and Reader has transformed the way people interact with and extract value from these documents. In Q3, we released significant advancements including the ability to have conversations across multiple documents and support for different document formats, saving users valuable time and providing important insights. We're thrilled to see this value translate into AI Assistant usage, with over 70% quarter-over-quarter growth in AI interactions. In addition to consumption, we're focused on leveraging generative AI to expand content creation in Adobe Acrobat. We've integrated Adobe Firefly image generation into our Edit PDF workflows. We've optimized AI Assistant in Acrobat to generate content fit for presentations, emails and other forms of communication. And we're laying the groundwork for richer content creation, including the generation of Adobe Express projects. The application of this technology across verticals and industries is virtually limitless. Tata Consultancy Services recently used Adobe Premiere Pro to transcribe hours of conference videos and then used AI Assistant in Acrobat to create digestible event summaries in minutes. This allowed them to distribute newsletters on session content to attendees in real time. We're excited to leverage generative AI to add value to content creation and consumption in Acrobat and Reader in the months ahead. Given the early adoption of AI Assistant, we intend to actively promote subscription plans that include generative AI capabilities over legacy perpetual plans that do not. In Q3, we achieved Document Cloud revenue of $807 million, growing 18% year-over-year. We added $163 million of net new Document Cloud ARR. Other highlights include. Expanded Acrobat customer value with multi-document support for AI Assistant, enhanced meeting transcript capabilities and support for larger documents. Optimized AI Assistant for mobile, web, and desktop experiences, including voice-enabled conversations on Android. Continued strength of PDF-based collaboration, with shared links growing greater than 70% year-over-year. Increased top of funnel through Acrobat Web, with monthly active users growing over 35% year-over-year as a result of link sharing and our Microsoft Edge and Google Chrome extensions. Key enterprise customer wins include Amazon, Charles Schwab, Disney, Home Depot, KPMG, RedBull, Sutter Health and the US Treasury Department. With Creative Cloud, the demand for creative expression and design across media types and surfaces has never been greater. Consumers are sharing edited photos more than ever. Students need to create school presentations that stand out. Creative professionals are being asked to create more images, designs and videos faster than ever before. Small businesses are looking to engage prospects on social channels. And large enterprises are defining their content supply workflows to deliver personalization at scale. AI has the potential to empower creative professionals, communicators, consumers and organizations of all sizes to be more creative and productive. Our strategy is to build technology that will create more streamlined and precise workflows within our tools, through features like Text-to-Template in Express, Generative Fill in Photoshop, Generative Recolor in Illustrator, Generative Remove in Lightroom and the upcoming Generative Extend for video in Premiere Pro. We're exposing the power of our creative tools and the magic of generative AI through Firefly Service APIs so organizations can generate and assemble content at scale. As we integrate Firefly innovations throughout our tools, usage continues to accelerate, crossing 12 billion generations since launch. The introduction of the new Firefly Video model earlier this week at IBC is another important milestone in our journey. Our video model, like the other models in the Firefly Family is built to be commercially safe, with fine-grained control and application integration at its core. This will empower editors to realize their creative vision more productively in our video products, including Premiere Pro. With Express, we're on a multi-year strategic journey to dramatically expand our reach across customer segments. Adobe Express is our AI-first content creation application fulfilling our mission to enable creativity for all. The all-new release of Express across web and mobile earlier this year has been embraced by millions of users. They love how easy it is to create anything in Express with strong enthusiasm for our image editing features, powered by Photoshop, video editing capabilities, powered by Premiere Pro, document and presentation workflows, powered by Acrobat, and unparalleled generative AI features, powered by Adobe Firefly. Our integration of Adobe Stock and design templates with our unique Firefly Design Model ensures that content created in Express can stand out. Express empowers a broad array of individuals and businesses, from solopreneurs to the largest enterprises in the world. We're continuing to grow Express as we ramp our go-to-market activities to support recent product releases, including Express for individuals, Express for Education, Express for Teams and Express for Enterprises. As a result, in Q3 we drove 70% year-over-year growth in cumulative exports. We onboarded over 1,500 businesses and millions of students. In Q3, we achieved $3.19 billion in revenue, which grew 11% year-over-year in constant currency. Net new Creative Cloud ARR was $341 million. Other highlights include. New AI-powered features in Photoshop that accelerate core creative workflows and streamline repetitive tasks. Generative Fill in Photoshop was upgraded to Firefly Image 3, Generative Image was made generally available, and the new Selection Brush and Adjustment Brush Tools were introduced, making selective edits easier than ever. Broad-based innovations in Illustrator, including significant improvements to vector generation, enhancements to text-to-pattern and the all-new Generative Shape Fill. These advances unlock new ways for pro designers and illustrators to quickly bring their vision to life. Strong adoption of the latest version of Lightroom and Lightroom Mobile, which now includes the new Generative Remove feature. Millions of users have non-destructively removed unwanted objects from their photos with a single click. Strong demand for Firefly Services, which provide APIs, tools and services for content generation, editing and assembly, empowering organizations to automate content production while maintaining quality and control. Total API calls tripled quarter-over-quarter. Acrobat Pro single app continues to be a growth driver in Creative Cloud, reflecting the increasing adoption of PDF as a preferred format to create, collaborate and share visually compelling content. Key enterprise customer wins include The Brandtech Group, Dentsu, Estee Lauder, Google, MediaMonks, Meta, MLB, Newell Brands, PepsiCo, Stagwell Group and the US Navy. We look forward to hosting Adobe MAX, the world's largest creativity conference, next month in Miami, where we will welcome more than 10,000 members of our global community and engage with hundreds of thousands more online. We will hear from inspiring creators and unveil innovations across our clouds. In summary, we are excited about the pace and caliber of innovations across our Digital Media products and the continued execution across multiple growth drivers. I'll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello everyone. In Q3, we achieved Experience Cloud revenue of $1.35 billion. Subscription revenue was $1.23 billion, representing 12% year-over-year growth. Customer Experience Management remains top of mind for B2C and B2B companies around the world as they focus on digital strategies for customer acquisition, engagement, retention and expansion. Enterprises want an integrated platform to deliver personalized experiences at scale to their customers while maximizing the ROI of their marketing and customer experience investments. Through the integration of Experience Cloud and Creative Cloud, Adobe is uniquely positioned to combine the right content, data and journeys in real time for every customer experience. The revenue growth we are driving across our categories content, commerce and workflows, data insights and audiences, and customer journeys, all built on the Adobe Experience Platform, demonstrate the strength of our business. Global brands trust Adobe to build their content supply chain and deliver personalization at scale, making us the number one digital experience platform in the industry. Customers are embracing the opportunity to address their content supply chain challenges with Adobe GenStudio. With native integrations across Experience Cloud and Creative Cloud, GenStudio empowers marketers to quickly plan, create, store, deliver and measure marketing content and drive greater efficiency in their organizations. Financial services leader Vanguard is creating an integrated content supply chain to serve the strategic goal of deepening their relationships with a broad range of investors. Leveraging the GenStudio solution, Vanguard was able to increase quality engagement by 176% by focusing on one-to-one personalization and to realize millions in savings by improving content velocity and resource allocation with an end-to-end content creation workflow. Other highlights include. The general availability of Adobe Content Hub, further enhancing the value of Adobe Experience Manager Assets. Content Hub enables brands to reimagine how creative assets are used across their organization and with external agencies, driving content velocity and major efficiency gains. AEM Assets is used by the majority of the Fortune 50, including 8 of the 10 largest media companies, 9 of the 10 largest financial services companies and 8 of the 10 largest retailers. Increasing importance and adoption of Workfront to streamline workflows across marketing organizations and agencies. We extended our leadership in this category through the general availability of Adobe Workfront Planning, which delivers a comprehensive view of all marketing activities in an organization and enables teams to optimize marketing planning and execution. Global brands including Deloitte, Interpublic Group and NASCAR are using Workfront Planning to drive productivity gains and meet the rising demand for highly personalized marketing campaigns. Continued momentum for Adobe Experience Platform and native applications including Real-Time Customer Data Platform, Customer Journey Analytics and Adobe Journey Optimizer. We expanded our AEP portfolio with the general availability of Adobe Journey Optimizer B2B Edition, which leverages generative AI to deliver personalized experiences to buying groups, the decision-makers, practitioners and stakeholders responsible for major purchasing decisions. Strong industry analyst recognition, including the Forrester Wave for B2B Revenue Marketing Platforms, and three IDC Marketscape reports across Digital Asset Management and Headless Digital Commerce for both Enterprise and Mid-Market. Key customer wins include Dentsu, Home Depot, Humana, IBM, Johnson & Johnson, Mayo Clinic, Newell Brands, Premier League, Stagwell Group, TD Bank and UPS. We look forward to unveiling new customer experience management innovations across content, data and journeys at MAX next month, showcasing integrations across Express, Creative Cloud and Experience Cloud for freelancers, solopreneurs and marketers across agencies and enterprises. Our pace of innovation, commitment to customer value, global partner ecosystem, and category-defining solutions position us to continue our market leadership. I will now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Today I will start by summarizing Adobe's performance in Q3 fiscal 2024, highlighting growth drivers across our businesses, and I'll finish with financial targets. In Q3, Adobe achieved record revenue of $5.41 billion, which represents 11% year-over-year growth as reported and in constant currency. Our focus on both growth and profitability has been a cornerstone of our operating philosophy for years, rooted in strategic prioritization, relentless innovation, and laser-focused execution. Our Q3 results reflect this approach. We're making significant investments in our technology platforms, launching global campaigns to expand our customer base, and attracting top-tier talent, while delivering world-class cash flows and profitability. Third quarter business and financial highlights included. GAAP diluted earnings per share of $3.76 and non-GAAP diluted earnings per share of $4.65. Digital Media revenue of $4.00 billion. Net new Digital Media ARR of $504 million. Digital Experience revenue of $1.35 billion. Cash flows from operations of $2.02 billion and RPO of $18.14 billion exiting the quarter. In our Digital Media segment, we achieved Q3 revenue of $4.00 billion, which represents 11% year-over-year growth or 12% in constant currency. We exited the quarter with $16.76 billion of Digital Media ARR, growing our ending ARR book of business 13% year-over-year in constant currency. Adobe achieved Document Cloud revenue of $807 million, which represents 18% year-over-year growth as reported and in constant currency. We added $163 million of net new Document Cloud ARR, which was a record for a Q3, growing our ending ARR book of business 24% year-over-year in constant currency. Q3 Document Cloud growth drivers included. Usage and MAU growth across Adobe Reader and Acrobat. Usage and MAU growth via third-party ecosystems, including Google Chrome and Microsoft Edge extensions, which are driving free-to-paid conversion. Demand for Acrobat desktop and mobile subscriptions across all customer segments and Geographies. Strength in monetization of our AI Assistant with new Acrobat subscriptions. Strength in SMBs driven by our reseller partner network and strength in enterprise and public sector sales, with a number of large deals closing in the quarter. We achieved Creative revenue of $3.19 billion, which represents 10% year-over-year growth or 11% in constant currency. We added $341 million of net new Creative ARR in the quarter, growing our ending ARR book of business 11% year-over-year in constant currency. Q3 Creative growth drivers included. New subscriptions for Creative Cloud All Apps across customer segments, including Teams, Enterprise, and Education with back-to-school demand. Strength across our Acrobat Pro, Illustrator, Lightroom and Photoshop single apps on Adobe.com. Growing demand for our AI-first Adobe Express offerings in mobile, emerging markets and Education. Early monetization of our new Firefly Services solution in the enterprise segment. Continued momentum with new subscriptions in emerging markets and contribution from customers stepping up to our higher-value Creative plans at renewal. Turning to our Digital Experience segment, in Q3 we achieved revenue of $1.35 billion, which represents 10% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.23 billion, growing 12% year-over-year as reported and in constant currency. Q3 Digital Experience growth drivers included. Strong subscription revenue growth at scale of AEP and native applications, up greater than 50% year-over-year. Strong subscription revenue growth with Adobe Experience Manager and Workfront. Success in booking transformational deals as well as individual solution selling. Continued strength in retention and expansion across our enterprise customers and growing pipeline for our GenStudio solutions to address the content supply chain opportunity. Turning to the income statement and balance sheet. In Q3, Adobe delivered year-over-year EPS growth of 23% on a GAAP basis and 14% on a non-GAAP basis. This was primarily driven by revenue growth and disciplined prioritization of our investments, which resulted in operating margin strength in Q3. The company continues to deliver world-class margins while making significant investments in AI model training and inferencing capacity. Adobe's effective tax rate in Q3 was 17.5% on a GAAP basis and 18.5% on a non-GAAP basis. RPO exiting the quarter was $18.14 billion, growing 15% year-over-year as reported or 16% in constant currency. Current RPO grew 12% year-over-year exiting the quarter. Our ending cash and short-term investment position at the end of Q3 was $7.52 billion and cash flows from operations in the quarter were $2.02 billion. In Q3 we entered into a $2.5 billion share repurchase agreement and we currently have $20.15 billion remaining of the original $25 billion authorization granted in March 2024. We will now provide Q4 targets, which factor in current macroeconomic conditions and year-end seasonal strength. For Q4 we are targeting. Total Adobe revenue of $5.50 billion to $5.55 billion. Digital Media net new ARR of approximately $550 million. Digital Media segment revenue of $4.09 billion to $4.12 billion. Digital Experience segment revenue of $1.36 billion to $1.38 billion. Digital Experience subscription revenue of $1.23 billion to $1.25 billion. Tax rate of approximately 16% on a GAAP basis and 18.5% on a non-GAAP basis. GAAP earnings per share of $3.58 to $3.63 and non-GAAP earnings per share of $4.63 to $4.68. In summary, I am proud of our year-to-date performance, which stems from a powerful combination of product leadership, rapid innovation, diversified business and financial discipline. Given the massive markets we are catalyzing, I am confident in our ability to drive growth and industry leadership. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. Adobe's focus on responsible innovation, with customers at the center, continues to be a unifying purpose for the company. The Content Authenticity Initiative, which we founded in 2019, now counts over 3,300 members across the digital ecosystem, all committed to enhancing trust and transparency with Content Credentials. In five years, this mission has gone from a vision to reality with companies including Amazon, Google, Leica, Meta, Qualcomm, Sony, TikTok and others all committing to implementing Content Credentials. The US Department of Defense became the first federal government agency to implement Content Credentials by applying them to official DoD images. We're teaming up with Governor Gavin Newsom on a new initiative to boost digital and media literacy skills in K-12 schools and higher education institutions in California. By providing educational content, programming, and resources to schools across the state, we can help empower California's future workforce for success in an AI-powered world and use this as a blueprint for other states and countries. Next week, we will bring employees together for our annual Adobe for All conference to celebrate our vision and purpose and the impact that has on our customers and communities. I am confident that Adobe's culture, innovative product roadmap, global market opportunity, trusted brand and the unwavering commitment of our employees will continue to drive our success. Thank you and we will now take questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] And the first question will come from Alex Zukin with Wolfe Research."
},
{
"speaker": "Alex Zukin",
"text": "Hey, guys. Thanks for taking my question and congrats on what looks like a very strong quarter. It's one question, but it's a two-parter. The quarter itself, particularly on the Digital Media ARR looked very strong. It looked unseasonably strong because you haven't grown net new ARR sequentially in the 3Q, I think, in almost four years. So maybe just comment like what drove this unseasonable strength. Is it pricing, AI traction, and particularly the Document Cloud net new ARR? But at the same time given all the product momentum you went through in the script, it's a bit confusing to understand why the Q4 guide is the lowest it's ever been sequentially for Q4 on net new Digital Media ARR, which I think makes people a little nervous about maybe the go-forward, the next year performance. And so maybe just address this dichotomy because it looks kind of seasonally a little bit different than what we're used to. And I think it's weighing on the stock after hours."
},
{
"speaker": "Shantanu Narayen",
"text": "I'm happy to start Alex and then David can certainly also add to that. I mean, to your point, we had a strong quarter, when I think about Digital Media, Document Cloud to the point that you made, Acrobat continues to perform the AI Assistant, and the SKU that we have associated with Acrobat continues to perform well. As we had said, we expect Creative to show a growth-on-growth year-over-year, and so that also played out exactly as we expected. And you know it was a strong end, when you look at it as it relates to the last few weeks' performance, we saw the typical strength that we would see going into Q4. I can see how you're saying, you're looking at the sequential guide. We're looking at it and saying it's the strongest ever Q4 target that we have put out there for Q4, Alex. And so I think we just continue to focus. We would expect Creative to again grow when you talk about growth-over-growth, net new ARR in Q4. And all of the new initiatives that we're talking about, AI, et cetera, continue to perform. So from our perspective, when we look at what we guided to the second half of the year, to your point, Q3 is stronger. We expect a seasonally strong Q4 and then continued innovation should continue to drive growth."
},
{
"speaker": "David Wadhwani",
"text": "Yeah and maybe I'll just add a couple of things to what Shantanu, said. Again, just a little bit more context behind the strength in Document Cloud. Obviously, link sharing and what we've done with reader distribution across mobile, web, and desktop, that's really what continues to drive this business, and that underlying strength is going to continue not just in Q3, but it's going to be something that we're able to bet on and grow on going forward because we've got a lot of flow optimizations associated with that. As we look at Creative Cloud, again, we have a broader set of offerings than we've ever had, right? We have things like with Creative Cloud, we have higher-value, higher-priced offers, thanks to AI innovation that's happening in the base plans that are impacting how the Creative Cloud business is doing. We also have a broader set of offerings than we've ever had now with web and mobile, including Premium and lower-priced offerings that are driving more proliferation. And the blend of those two things also sort of comes into the strength of the quarter and how we see things going out. But as you look at the second half overall, we came into the second half with a strong expectation of how the second half is going to play out. And frankly, it's playing out as we expected in terms of the aggregate Q3, Q4 numbers. In terms of the specifics on timing, Q3 was a little stronger than you expected, and for a good reason given seasonality. I think a lot of that can be explained by a few deals that would have historically just closed in Q4, closing earlier than expected in Q3, and that changed the dynamic in terms of the linearity that you would typically see between Q3 and Q4."
},
{
"speaker": "Alex Zukin",
"text": "Very helpful guys. Thanks again."
},
{
"speaker": "Operator",
"text": "And our next question will come from Mark Murphy with JPMorgan."
},
{
"speaker": "Mark Murphy",
"text": "Thank you so much and I'll have my congrats. David, I'm wondering if you can compare the AI monetization opportunity that you're sensing with the image models relative to the future potential with your audio and video models, just for instance, how many tokens might be consumed when someone is generating a video versus an image. And then tying in with that, just how optimistic are you maybe being able to solve some of the limitations with the current video generation models where the facial expressions can lack realism or they can't handle the object interactions or they don't provide enough detail or resolution in the videos?"
},
{
"speaker": "David Wadhwani",
"text": "Yes. Happy to take that. Let me just sort of take a little bit of a step back and talk about the core strategy that we have for AI and the conversion then in terms of how we think about monetization. So I think we've been incredibly consistent with what we've said dating back a year, year and a half ago where we talked about the fact that we were going to develop the broadest set of models for the creative community and we were going to differentiate the models based on quality, commercial safety, integrateability into our tools and controllability. And as you've seen very methodically over the last 18 months, we continue to bring more and more of that innovation to life. And that fundamentally is working as we've now started to integrate it much more actively into our base. If you look at it with photography, we now have in our tool generative remove, we have AI-assisted edits. In design, we have Generative Pattern, Generative Fill Shape. We have, in Photoshop, we have Gen Remove. We also have Gen Fill and I can continue on with all the generations, but we've also now started to integrate it in Firefly services for what we're enabling enterprises to be able to access and use in terms of batchwork and through APIs. If you look at sort of how that's played out, as we talked about, we're seeing accelerated use and generative credits being consumed because of that deeper integration into all of our tools. And that is playing out as we expected. When you look at then how that converts to monetization, first and foremost, we've integrated it, a lot of that value into our core products and with more value and more pricing. We're also seeing that when people use these generative features, they retain better. We're also seeing that when people come to Adobe to try our Creative Cloud applications or Express application, they're able to convert better. And so there are all these ancillary implied benefits that we're getting. But in terms of direct monetization, what we've said in the past is that the current model is around generative credits, which is, I think, where you're going with this. And we do see with every subsequent capability we integrate into the tool, total credits consumed going up. Now, what we are trying to do as we go forward, we haven't started instituting the caps yet. And part of this is, as we've said all along, we wanted to really focus our attention on proliferation and usage across our base. We see a lot of users excited about it. It's some of the most actively used features that we've ever released. And we want to avoid the generation anxiety that people feel. But we're watching very closely as the economy of generative credits evolves. And we're going to look at instituting those caps at some point when we feel the time is right and/or we're also looking at other alternative models. What we did with Acrobat AI Assistant has proven to be very effective. And so we're also considering other opportunities like having standard CC plans that have a core set of generative capabilities, but also having premium API, sorry, premium AI plans that will include things more like video and other things. So, we're very happy about the innovation that's coming. And we see the opportunity to engage very deeply in the monetization. But we want to play it out over time and proliferation continues to be our primary guide. And then lastly, in terms of quality, I don't know if you had a chance to see some of the videos we put out there, integrated directly into Premiere, also text to video, image to video, more controllability. We have also the ability now to generate not just scenes with humans and dogs and organic animals, but all these like overlays and things that creative professionals actually want to work with. And so we're very excited about the set of things that they can get out of the box and get going. And human faces and things will just continue to get better. We have a lot of great research that you'll start to see. And I hope you get to play with the models because we've taken a huge step forward there."
},
{
"speaker": "Shantanu Narayen",
"text": "Mark, maybe I'll just add a little to what David said, which was great. I spent a couple of hours with our video team. They have just absolutely hit it out of the park. I mean, the work that they've done, which is leveraging the image models with video. And again, I think to David's point, the integration with Premiere, that's what we've always said. It's the integration of the model and the application that differentiates it. I think when other models first came out, people were like, wow, you can describe it. That's just such a small part of where the value is. And the real value is you have a video, you want to extend it. It's a game changer in terms of what we can do. So really excited about the stuff that we're doing in video. And again, to David's point, this will be monetized differently from the way we have for images, which was part of the sort of base value pricing. So, the way I answer your question is, and the third thing I would say is, remember, we have the ability to create custom models as well. And so when you ingest the video that people want to edit, the ability to extend that is not just dependent on what the model is, but also on what the new data is. And again, that represents really a unique ability for us. So, hopefully all those three demonstrate why we're leading the pack in terms of how people can derive value in the nonlinear editors, which is where the action is going to be."
},
{
"speaker": "Mark Murphy",
"text": "Thank you very much."
},
{
"speaker": "Operator",
"text": "And moving on to Keith Bachman with BMO."
},
{
"speaker": "Keith Bachman",
"text": "Hi. Thank you very much. I appreciate taking the question. I wanted to pick up a little bit on how we should be thinking about, David, you just mentioned monetization. And will consumption, you think, as we start to turn the year, can consumption contribute to ARR growth as we look at FY'25? Because I think there's pervasive fears that the state of competition may in fact limit your ability to turn on that monetization, if you will, from either consumption or price. And I just wanted to see if you could lace in consumption against the backdrop of competition."
},
{
"speaker": "Shantanu Narayen",
"text": "From our perspective, Keith, I think when you look at what we have with the apps and the models, we just continue to think that's uniquely differentiated. Firefly services, which is, you can think of that also as a consumption model where we have that, it's off to a really good start. Our ability to give enterprises the ability to automate content, create custom models within enterprises, we're seeing real traction because it's a differentiated solution in that it's designed to be commercially safe. And as it relates to the core subscription models, again, David said this, but I'll reiterate it, which is, the core subscription models for products like Photoshop and Illustrator, I think, the differentiation is the combination of the model and the technology. And in video, I think, we will find additional ways to monetize it. So, I'm not sure who specifically you're referring to as it relates to competition in this space, but from our perspective, it's just unique. I mean, if you look at the acceleration of what we've seen of generations in Photoshop, Illustrator, Lightroom, it's clear that we're actually extending the value rather than having other people to catch up."
},
{
"speaker": "David Wadhwani",
"text": "And then one other thing I'd just emphasize there is that the commercial safety is so important to businesses of all sizes frankly and that is something that we feel very, very, very differentiated in addition to everything Shantanu said."
},
{
"speaker": "Keith Bachman",
"text": "Okay, great. And then perhaps for my follow-up, I wanted to pick up on Alex's first question. But you're guiding net new ARR down 3% year-over-year in Q4. And I think investors are, but thereby taking that as perhaps a framework when you look at next year, but is there anything that net new ARR will be down next year? And I know you don't want to give guidance for next year, but just any kind of thoughts you want to address as it relates to the guidance associated with net new ARR being down in Q4 versus a framework that we might want to apply for the FY'25 net new ARR?"
},
{
"speaker": "Shantanu Narayen",
"text": "You're right, Keith. We're not going to give FY'25 guidance. We'll certainly share more at MAX and we would expect like we did last year that at the December earnings call, we'll give color on fiscal '25 ARR, but I'd say a couple of things. First, as it relates to again the performance of the second half because to Alex and your question, if there are questions around Q3 and Q4 and what that trend means, again, we will hope to have record net new ARR in fiscal '24, which I think is a great thing. We gave 1,950 at the end of Q2. We're clearly on track to beat that number, which we take as a positive sign. And the other thing, maybe perhaps, tactically for you folks to think about as well, as it relates to the Q4 guidance, typically, you have Black Friday and Cyber Monday in the same quarter. This time, Cyber Monday, I believe, is in Q1. And so as it relates to our Q4 performance, it's the highest target that we've ever issued. We will go out and then continue to execute and continue to innovate. So that's the way I look at the business, Keith."
},
{
"speaker": "Keith Bachman",
"text": "Okay. Thank you, Shantanu."
},
{
"speaker": "Operator",
"text": "And the next question will come from Saket Kalia with Barclays."
},
{
"speaker": "Saket Kalia",
"text": "Okay, great. Hey, guys, thanks for taking my question. David, maybe for you. You touched on some of the drivers in Document, which was super helpful. But I'd love to maybe go one level deeper into some of the dynamics in that business, which of course continues to grow net new ARR at a really nice clip. So maybe we can just talk a little bit about, are there any pricing headwinds or tailwinds that we should keep in mind specifically for Document Cloud. And also maybe you can give us a sense for sort of where Document Cloud is in its journey to maybe becoming more of a subscription-heavy business. Do those make sense?"
},
{
"speaker": "David Wadhwani",
"text": "The first part does. Let me try to address the whole thing. The question on subscription-heavy, it is a very strong subscription business for us already, but I'll touch on that and hopefully, I'll address your question. So first, if we take a step back and look at Document Cloud, I mean the foundation of everything we're doing here is incredibly strong and it's a machine we've had for a long time, but it continues to perform incredibly well. And what I mean by that is the platform proliferation of what we have with Acrobat and Reader. The fact that we have 40 years into this business, the rise of PDF and PDF becoming the de facto standard for content as a unstructured content as a whole is a remarkable foundation for us to be building on. And the distribution we have across desktop, web, mobile, including web extensions is really the foundation of everything we do because that becomes the top of funnel for us. You layer on top of that the fact that generative AI in general has come out where unstructured content, especially PDF unstructured content, the 3 trillion PDFs out there that we believe are out there has suddenly inherently much more value than it did a year ago. And this whole ecosystem is set up well for us. In addition to that foundation, we've also been over the course of the last few years, really transitioning the way people share because if you think about PDFs and Acrobat in general, one of the most important things people do is they produce the PDF to share it with others, often for comment and review engagement and by increasing sharing via links versus sharing as an attachment, we see a lot more engagement and interaction that we're able to benefit from and that also helps with the top of funnel and we can provide more value. Then on that platform, what we've done is with AI Assistant, we focus on consumption for the last nine months, starting with the ability to look at a single PDF and ask questions of that PDF. Then we sort of then we added support for multi-docs, so you can now have five or six PDFs that you're having a conversation with. We added support for multiple formats. So you can look at PDFs, but you can also drag in Word documents or PowerPoint documents or a link to a meeting transcript that you have. We are adding in the process of adding language support for other languages optimizations. We're now starting to work on document type optimization. So if it's a contract, we know how to optimize the results even better than if it's a marketing document. And that's all about consumption. But in addition to consumption, we're now expanding because these conversations that happen with these documents are inherently about getting some insight and then sharing that insight. We've also started to do things that you can create richer content on the back end of it. So Firefly is embedded now in Edit PDF workflows. We have the conversational content and now able to generate emails and presentations and those kinds of things. We've now embedded in the Convert PDF workflows, the ability to output to Express and create richer media outputs and you can start to see all of this stuff coming together in a very real way already, but also in the months ahead. The last thing I want to say on this too is that what's really working out well for us is that when we are outpitching this opportunity, not just in terms of the individuals that use it, but also businesses, is that we don't have any security concerns, right. Our data governance model is the same data governance model that's happened. If you have access to the documents, you can have conversations with the documents. And so it makes it a much easier thing for enterprises to adopt because there's no systemic or governance changes. And so all of that continues to drive more adoption. And as I said on the prepared remarks, Document Cloud is substantially a subscription business, but now with AI Assistant being available to subscribers and not as directly to perpetual users, we expect that to continue to transition even further."
},
{
"speaker": "Saket Kalia",
"text": "Super helpful. Thanks, guys."
},
{
"speaker": "Operator",
"text": "And the next question will come from Jay Vleeschhouwer with Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Yeah. Thank you. Good evening. David, I'd like to follow up on something that you said on the second quarter call. And that was that you said at the time that you were for the rest of the year going to quote, pour gas on your GTM, and as well engage in a full-funnel campaign later in the year. So the question is, could you update us on that? I mean, it does seem to be in no small part corroborated by some of your internal investments that we've been able to see, for example, in your ICX team, your go-to-market positions across multiple products, strategy positions and so forth. But you've made this commitment for a substantial expansion, but do you think you need going forward to continually accelerate the pace of investments in go-to-market or do you think at some point, perhaps soon you can begin to taper that off and then leverage that capacity to revenue growth and thereby margin expansion?"
},
{
"speaker": "David Wadhwani",
"text": "Jay, I think, we might have to have you join our marketing organization, given how much you know about the market dynamics. But great question. And so first and foremost, again, if we're going to talk about Express, let's take a little bit of a step back and understand the dynamics of where we are in the evolution. I think what we had talked about in Q2 was that not only do we feel like we have an incredible product now, but that product is built on a brand new platform, that has the ability to develop AI functionality as a native part of that platform. So the speed of innovation that we've been adding capabilities to Express is really been a breakneck speed and we're very excited about that. Features like native integration of Firefly, so that everything that's generated here is commercially safe, which again like I said, is important to individuals and to businesses, but doing it with more control, things like style and structure match and integrated into the image viewer, the video viewer, editor and the design surfaces. So very excited about that. In addition to those basic capabilities that are so foundational, this is really the design model that we've been talking about Firefly design model. This is where it's surfacing the most, and so you combine what we're doing with templates and design model and people are able to create and they effectively get access to an infinite number of templates, right. We believe that we're moving from a template-centric, a set of tools for communicators to an AI-centric set of tools and we feel that with our design model and everything we have, we're fundamentally going to create better content that stands out ultimately. We also have great workflows that we've developed with Photoshop and Illustrator and Acrobat. And we've integrated all of this in ways that are fundamentally effective for businesses, including bulk creation and assembly capabilities. So small businesses all the way through enterprises are able to leverage this for their designer-to-marketer workflows. In addition to all of that innovation, to your point, we've really been focused on the go-to-market since last time. Since we last spoke or right before we last spoke in Q3, we expanded the offer set significantly. We've always had Express for individuals in market, but we added Express for Teams, Express for Enterprise and we just launched Express for Education, this back-to-school year with a lot better support for classrooms and teacher student workflows as well. On the marketing side, we've been ramping that very actively. It's a net new audience to Adobe. I mean, that's something to really recognize. This isn't about shifting existing audience over solely. It's about getting access to a new audience. And so for that, we have to employ both traditional means with a focus on awareness campaign, but also leveraging social, because that's where this audience is. So, you'll see us doing a lot more on social as a result. And then on the back of all that, we're ramping our direct sales. We have a very at-scale inside sales motion that we're starting to lean into. We have a very significant direct sales motion that we have in enterprises and mid-market that we're leveraging. Adobe.com journeys, we have a lot of businesses and individuals coming on Adobe.com and doing a lot more optimization in the App Store. And that's really what you're starting to see in the numbers we shared with strong usage at 70% year-over-year. Cumulative exports, strong business momentum with over 1,500 businesses sold and really great our best back-to-school season ever with millions of students now enabled on it. So, that's the foundation. And if you're, the one thing I would say is, yes, we started pouring gas on it and we're going to pour more gas on it, not less in the months and years ahead."
},
{
"speaker": "Shantanu Narayen",
"text": "Maybe two other things, Jay, just big picture. I mean we continue to invest in all of the key long-term things, whether it's training of models, whether it's Express, whether it's AEP and apps, whether it's GenStudio, while delivering what I think are phenomenal margins. And so we'll continue to make those trade-offs in terms of growth and profitability and maybe a little tongue-in-cheek. Part of the reason why David has the ability to invest as much in marketing is he uses the best marketing technology in the world from Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "That is true."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And our next question will come from Tyler Radke with Citi."
},
{
"speaker": "Tyler Radke",
"text": "Yes. Thanks very much for taking the question. I wanted to ask you about the Digital Experience side of the business. So RPO looks pretty strong in terms of sequential additions. The implied guide for Q4 was a bit lighter than consensus. I know you did talk about some unusual dynamics in terms of seasonality, Cyber Monday, but could you just talk about the strength and underlying dynamics you're seeing in the business heading into Q4? Thank you."
},
{
"speaker": "Anil Chakravarthy",
"text": "Yes. When we look at the Digital Experience business, we are pleased with the overall execution of the business. We have a big opportunity with what we call personalization at scale where whether it's a B2C company or a B2B company, the ability to deliver personalized customer experiences to consumers or to hundreds of thousands of business customers, individuals within businesses. This is important for every company in the world and we have the integrated platform and the applications to be able to help them deliver those kinds of experiences. And we have the unique ability to bring together the right content, the data, customer data and the customer journeys across our Experience Cloud and the integration with Creative Cloud to deliver those personalized experiences. And that's pretty unique to what we can do at Adobe. And that's one of the things that we are seeing in the dynamic in the enterprise market is the enterprises are scrutinizing all the deals that they want to do. I think in this case, they look at our offerings and see the ability to not only help with growth, they also look at the efficiency gains that we can help them create. And that's helping us as enterprises scrutinize the spend. And when you look at our guide, we're obviously, we are focused on, most closely on our subscription business and that's the business that continues to grow strongly and we're showing good performance on the subscription business. And our overall revenue is a combination of subscriptions and services where we really are focused on working with a broad global partner ecosystem to make sure that we deliver services to our customers and help them realize value from our offerings."
},
{
"speaker": "Tyler Radke",
"text": "Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "Hey, operator, we're at the top of the hour. We'll sneak in one more question and then wrap up. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. That question will come from Brent Thill with Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Thanks. Dan, just back to the guide. Can we just drill in? I know that you mentioned there were a couple of factors that were at contemplated. I'm just curious if there's anything else that you're seeing that is different in terms of end demand or any softness. I know the US decelerated a little bit, EMEA accelerated."
},
{
"speaker": "Shantanu Narayen",
"text": "No, Brent. I mean I think we had a strong Q3 and we continue to see the momentum in the business. And it's our typical considered targets that we do and I focus on execution. So, we're not seeing anything as it relates to a change in the business dynamics. I also mentioned that the last few weeks of Q3, as you know, the summer seasonality ends, we saw the traditional strength that we expect to see on our web traffic. So, I think, MAX is coming up. We have an exciting agenda in terms of what we are going to be talking about in terms of MAX. And so I mean if I take a step back and think about it, given this is the last question, I mean, from my perspective, strong Q3 across every aspect of our business, revenue, EPS, Digital Media ARR, DX, Subs revenue, Acrobat certainly also continued to show the strength. We have momentum in the business and the innovation roadmap, I mean, across all of the key initiatives that we've been talking about, whether that's Express, GenStudio and the excitement that people have associated with automating all of that content, AEP and Apps on the data side, imaging and video, the work that the Digital Media team has done on Photoshop and on Illustrator and then what's coming down the pike on video. And Firefly Services, I think, the AI monetization as well, which I know is a theme of a number of people that have asked, whether it's Acrobat, whether it's the Premium SKUs as it relates to Experience Cloud, whether it's what's happening on Gen Fill and the usage of Gen Fill, Lightroom and Lightroom Mobile. I think we're clearly demonstrating how AI can both drive value for our customers and therefore, we acquire new customers and retain customers better. So, yes, it feels good. We look forward to seeing all of you at MAX and we're going to just continue to focus on innovation and delighting our customers. But thank you for joining us."
},
{
"speaker": "Jonathan Vaas",
"text": "Yes. Thanks, Shantanu, and we do look forward to the Investor Event that we'll be holding in Miami at MAX on October 14th, where we will be doing a Q&A with management. We hope to see many of you there. And with that, thank you for joining the call, and this concludes the event."
},
{
"speaker": "Operator",
"text": "Thank you. That does conclude today's conference. We do thank you for your participation. Have an excellent day."
}
] | Adobe Inc. | 24,321 |
ADBE | 2 | 2,024 | 2024-06-13 17:00:00 | Operator: Good day, and welcome to the Q2 FY 2024 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's second quarter fiscal year 2024 financial results. You can find our press release, as well as PDFs of our prepared remarks and financial results, on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, June 13, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon and thank you for joining us. Adobe had an outstanding quarter, achieving revenue of $5.31 billion, representing 11% year-over-year growth. GAAP earnings per share for the quarter was $3.49 and non-GAAP earnings per share was $4.48, representing 15% year-over-year growth. Our success is driven by growing customer value through an innovative product roadmap. The advances we are delivering across Creative Cloud, Document Cloud and Experience Cloud are enabling us to attract an expanding universe of users. Everyone from creators, communicators, students, entrepreneurs and businesses of all sizes are using our products to unleash their creativity, accelerate document productivity and power their digital businesses. Adobe's highly differentiated approach to AI is rooted in the belief that creativity is a uniquely human trait and that AI has the power to assist and amplify human ingenuity and enhance productivity. We're innovating across data, models and interfaces and natively integrating AI across all our offerings. In Creative Cloud, we have invested in training our Firefly family of creative generative AI models with a proprietary data set and delivering AI functionality within our flagship products including Photoshop, Illustrator, Lightroom and Premiere. We're reimagining creativity for a broader set of customers by delivering Adobe Express as an AI-first application across the web and mobile surfaces. Since its debut in March 2023, Firefly has been used to generate over 9 billion images across Adobe creative tools. In Document Cloud, we're revolutionizing document productivity with Acrobat AI Assistant, an AI powered conversational engine that can easily be deployed in minutes. This enhances the value of the trillions of PDFs which hold a significant portion of the world's information. Acrobat AI Assistant features are now available through an add-on subscription to all Reader and Acrobat enterprise and individual customers across desktop, web and mobile. At the end of May, we celebrated the five-year anniversary of Adobe Experience Platform, which we conceived and built from scratch and which is on track to be the next billion-dollar business in our Digital Experience portfolio. We released AEP AI Assistant to enhance the productivity of marketing practitioners through generative AI, while expanding access to native AEP applications. With Adobe GenStudio, we're bringing together products across our clouds including Creative Cloud, Adobe Experience Manager, Workfront, Adobe Journey Optimizer and Customer Journey Analytics as well as Adobe Express for Business to address the massive content supply chain opportunity. Our approach to empower marketers to quickly plan, create, manage, activate and measure on-brand content is resonating with customers and validating our leadership across data, content and journeys to deliver personalized experiences at scale. We're extending our applications to integrate third-party text, image and video models and partnering strategically to create multi-modal large language models offering customers greater choice in tools and further enhancing the value of our leading applications and solutions. We're driving strong usage, value and demand for our AI solutions across all customer segments and seeing early success monetizing new AI technologies across our Digital Media and Digital Experience businesses. Given this rich product roadmap, focus on execution and customer demand in the first half of the year, we are pleased to raise our annual Digital Media net new ARR, Digital Experience subscription revenue and EPS targets. I'll now turn it over to David to discuss the momentum in our Digital Media business.
David Wadhwani: Thanks, Shantanu. Hello everyone. In Q2, we achieved net new Digital Media ARR of $487 million and revenue of $3.91 billion, which grew 12% year-over-year. On the Document Cloud side, PDF has become a global standard for automating business and consumer workflows, and Acrobat is the platform of choice to view, edit, share and collaborate with these documents. We continue to see steady growth in monthly active users of our Document Cloud solutions, including Acrobat Reader, Acrobat Standard and Pro, and our signature, share and review workflows across mobile, web and desktop. The introduction of Acrobat AI Assistant, made generally available in April for English documents, marks the beginning of a new era of innovation and efficiency for the approximately 3 trillion PDFs in the world. Acrobat AI Assistant is empowering everyone to shift from reading documents to having conversations with them in order to summarize documents, extract insights, compose presentations and share learnings. AI Assistant is available as a standalone offer for use in Reader and as an add-on to Acrobat Standard and Pro. We're seeing early success driving adoption of AI Assistant as part of our commerce flows and remain optimistic about the long-term opportunities. In Q2, we achieved Document Cloud revenue of $782 million, growing 19% year-over-year. We added $165 million of net new Document Cloud ARR, which was a Q2 record, with year-over-year ending ARR growth of 24% in constant currency. Other business highlights include, general availability of Acrobat AI Assistant support for document types beyond PDF, meeting transcripts and enterprise requirements; Acrobat link sharing for PDF-based collaboration continues to grow rapidly, more than doubling year-over-year and driving viral new user adoption; free monthly active users of Acrobat Web grew over 60% year-over-year, as a result of link sharing and our Microsoft Edge and Google Chrome extensions; continued strength with free-to-paid digital conversion, as a result of product led growth optimizations; strong growth in the SMB segment for our Teams offering, driven by a combination of seat expansion and new account wins; Key enterprise customer wins with AstraZeneca, Chevron, State Government of Florida, State of Illinois, United Healthcare Services and Wells Fargo. Turning to Creative Cloud, creative professionals are leading the global charge to meet the everincreasing demand for engaging content across a variety of platforms and channels. Enterprises rely on creative professionals to produce differentiated content to drive increasingly personalized marketing campaigns. Solopreneurs and small businesses need to stand out in a crowded digital landscape with engaging videos and designs. Educators are passionate about providing students with the visual communication skills needed to thrive in the decades ahead. Consumers are increasingly looking for ways to share their stories digitally. Creative Cloud, Express and Firefly Services are uniquely positioned to catalyze this opportunity for everyone, by leveraging the promise of generative AI. Our Creative Cloud flagship applications continue to release new features that are significantly improving user onboarding while simultaneously delivering an unprecedented level of power and precision. Generative Fill and Generative Expand are already two of the top three features used by customers on the latest version of Photoshop. Text to vector support is off to a great start in Illustrator. Remove Object is the fastest growing feature in Lightroom mobile. Our preview of generative AI capabilities in Premiere won Production Hub Award of Excellence at NAB, the largest video show in North America. We are integrating our leading applications with Firefly and third-party generative AI models to deliver the richest, most engaging content. Our vision for Adobe Express is to provide a breakthrough application to make design easy for communicators worldwide, leveraging generative AI and decades of Adobe technology across web and mobile. Our launch of the all-new Express application on iOS and Android earlier this quarter is off to a strong start, with monthly active users doubling quarter over quarter. This week's Design Made Easy event, which focused on Express for Business, was another big step forward for us. Companies of all sizes are excited about the integrated power and commercial safety of Firefly, the seamless workflows with Photoshop, Illustrator and Adobe Experience Cloud and enterprise-grade brand controls that are now part of Express for Business, making it the optimal product for marketing, sales and HR teams to quickly and easily create visual content to share. We also announced the general availability of Firefly Services and Custom Models at Summit. The platform makes API calls and model customization available to developers, accessible through low-code, no-code tools and integrates with our Experience Cloud products. Firefly Services can power the creation of thousands of asset variations in minutes instead of months, and at a fraction of the cost. This allows us to monetize the volume of content being created through automation services. The increasing availability of Firefly in Creative Cloud, Express, Firefly Services and the web app is giving us opportunities to access more new users, provide more value to existing users and monetize content automation. These integrations are driving the acceleration of Firefly generations, with May seeing the most generations of any month to date. In Q2, we achieved $3.13 billion in revenue, which grew 11% year-over-year. Net new Creative Cloud ARR was $322 million. Other business highlights include, the launch of Express for Business, including support for brand controls and template locking, Firefly custom models, bulk creation and generation of variations, presentation and print capabilities, and workflows with Photoshop, Illustrator and Experience Cloud; the release of Firefly Image 3 Foundation Model with high quality image generation and more control with structure and style reference; the release of the Photoshop beta, with Reference Image and advances in Generative Fill; the debut of Generative Remove in Adobe Lightroom, enabling anyone to remove unwanted objects from any photograph non-destructively with stunning, high-quality, photo-realistic results; the release of the Premiere beta, with new audio workflows driving strong usage; the deep integration of Firefly in Substance 3D, which provides an easy way to create textures and materials from reference images; the introduction of an all new Frame.io, streamlining workflows across content types on a flexible and intuitive collaboration platform; key enterprise customer wins include Credit Agricole, FedEx, Infosys, Rakuten, Ralph Lauren, Samsung, Schneider Electric and Volvo. We're excited about the accelerating pace of innovation across the Digital Media business and pleased with the adoption of AI functionality as well as its early monetization across Document Cloud and Creative Cloud, including our flagship applications, Firefly Services and Express. We're pleased to raise our annual net new ARR target to $1.95 billion and excited to deliver on our rich product roadmap in the second half. I'll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello, everyone. In Q2, we achieved Experience Cloud revenue of $1.33 billion. Subscription revenue was $1.2 billion, representing 13% year-over-year growth. We are the industry leader in helping enterprises deliver personalized experiences at scale to their customers by combining the right content, customer data and journeys in real time. When we introduced Adobe Experience Platform five years ago, it was a revolutionary approach to address customer data and journeys. Today, we're the number one digital experience platform, and AEP with native apps is well on its way to becoming a billion-dollar business. We're now transforming the content supply chain for enterprises with Adobe GenStudio, enabling them to produce content at scale, leveraging generative AI through native integrations with Firefly services and Adobe Express for Business. Enterprise customers, both B2C and B2B, view customer experience management and personalization at scale as key areas of differentiation, making it a priority investment for Chief Marketing Officers, Chief Information Officers and Chief Digital Officers. We are excited by the customer interest and adoption of our latest innovations, including AEP AI Assistant, a generative AI-powered conversational interface that empowers practitioners to automate tasks, simulate outcomes, and generate new audiences and journeys. For example, customers like General Motors and Hanes brands have been working with AEP AI Assistant to boost productivity and accelerate time to value, while democratizing access to AEP and apps across their organizations. Marriott International is a great example of a customer that's expanded its decade-long relationship with Adobe and turned to Adobe Experience Cloud to orchestrate highly personalized guest experiences across online reservations and the Marriott Bonvoy mobile app. Adobe Real-time CDP and Adobe Journey Optimizer enabled Marriott to connect data from disparate sources and activate relevant experiences in moments that matter, helping the company match individuals with the best options across its portfolio of more than 30 brands and nearly 9,000 properties. Other business highlights include: continued momentum with AEP and native applications, growing subscription revenue 60% year-over-year in Q2; AEP innovations announced at Summit include Adobe Journey Optimizer B2B addition, a new application for B2B customers built on AEP to orchestrate account-specific buying group journeys; federated audience composition, which enables enterprises to minimize data copy and generate audiences directly from their enterprise data warehouses; and real-time CDP collaboration, a new clean room application for brands and publishers to collaborate in a privacy safe way to discover, reach, and measure their high-value audiences in a world without third-party cookies. GenStudio innovations to address enterprise content supply chain needs across workflow and planning, creation and production, asset management, delivery and activation, and reporting and insights. Recent advancements include contextual search in Adobe Experience Manager assets, which enables users to find the right asset and variation in their growing digital libraries. Adobe Workfront Planning, which provides every user with a unified view of all activities across the marketing life cycle through highly visual marketing campaign calendars and dynamic briefs. And AEM Generate Variations, which accelerates the creation of audience-specific content variations to drive personalized web experiences. Strong industry analyst recognition including Gartner's Magic Quadrant for Content Marketing Platforms and leadership for both IDC's B2C and B2B MarketScapes for digital commerce applications. Key customer wins include Amazon, British Telecom, Comcast, Mercedes-Benz, Maruti Suzuki, Nationwide Building Society, Novo Nordisk, ServiceNow, Stellantis, Ulta Beauty, and U.S. Department of the Treasury. We have enabled our vibrant partner ecosystem of system integrators and agencies to deliver advisory and implementation services across our product portfolio. We look forward to engaging with customers and major agencies at the Cannes Lions Festival later this month. Our category-leading solutions, robust pipeline, and tremendous scale position us to drive strong growth in the second half, and we are raising our subscription revenue target for the year. I will now pass it to Dan.
Dan Durn: Thanks, Anil. Today, I'll start by summarizing Adobe's performance in Q2 fiscal 2024, highlighting growth drivers across our businesses, and I'll finish with financial targets. In Q2, Adobe delivered strong top line growth and industry-leading profitability while accelerating the pace of innovations we're delivering to market across Document Cloud, Creative Cloud, and Experience Cloud. In the quarter, Adobe achieved record revenue of $5.31 billion, which represents 10% year-over-year growth or 11% in constant currency, with strength across all three clouds. This performance stems from the diversification of Adobe's business across our market-leading products, business models, customer segments, and geographies. When combined with our talented employees, strong execution and world-class financial discipline, you have the ingredients that make this company incredibly resilient. Second quarter business and financial highlights included: GAAP diluted earnings per share of $3.49 and non-GAAP diluted earnings per share of $4.48; Digital Media revenue of $3.91 billion; net new Digital Media ARR of $487 million; Digital Experience revenue of $1.33 billion; cash flows from operations of $1.94 billion; and RPO of $17.86 billion exiting the quarter. In our Digital Media segment, we achieved Q2 revenue of $3.91 billion, which represents 11% year-over-year growth or 12% in constant currency. We exited the quarter with $16.25 billion of Digital Media ARR, up 13% year-over-year in constant currency. Adobe achieved Document Cloud revenue of $782 million, which represents 19% year-over-year growth as reported and in constant currency. We added $165 million of net new Document Cloud ARR, which was a record for Q2. Q2 Document Cloud growth drivers included: demand for Acrobat subscriptions across all customer segments and geographies; new user acquisition resulting from increasing Reader MAU; a great start monetizing AI Assistant through our digital channel; strong usage and engagement from Acrobat Web as well as through our Chrome and Edge partnerships, which are driving free-to-paid conversion; growing team subscription units sold to SMBs, both through adobe.com and our research channel; and strength in our enterprise solutions, demonstrating the importance of PDF as a source of unstructured data in business workflows. We achieved Creative revenue of $3.13 billion, which represents 10% year-over-year growth or 11% in constant currency. We added $322 million of net new Creative ARR in the quarter. Q2 Creative growth drivers included: new subscriptions for Creative Cloud All Apps with particular strength in digital acquisition on adobe.com, with multiple product releases during the quarter driving customer engagement and demand; strong growth of single apps, including in imaging, photography, design, and stock; accelerating customer interest and usage for our new Express Mobile and Express for Business offerings; strong renewals as customers migrate to higher-value, higher ARPU Creative Cloud plans that include Firefly entitlements; continued subscription unit growth, with particular strength in emerging markets; and strength from SMBs adopting our team offering as well as in the enterprise segment with ETLA adoption. We're pleased with the performance of the Creative business in the first half of the year, fueled by strong commercial subscriptions in both Q1 and Q2. As we look at the momentum we're carrying into the back half, we expect to deliver year-over-year growth of Creative net new ARR in Q3 and Q4 and are raising our Digital Media net new ARR target for the fiscal year. Turning to our Digital Experience segment. In Q2, we achieved revenue of $1.33 billion, which represents 9% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.20 billion, growing 13% year-over-year as reported and in constant currency. Q2 Digital Experience growth drivers included: subscription revenue strength from transformational accounts; market leadership with AEP and native applications, with subscription revenue growing 60% year-over-year; additional subscription revenue strength across the data insights and audiences and customer journey categories; and accelerated adoption of our AEM and Workfront solutions from businesses looking to solve their content supply chain challenges. Turning to the income statement and balance sheet. In Q2, Adobe delivered year-over-year EPS growth of 24% on a GAAP basis and 15% on a non-GAAP basis. This was driven by revenue growth and disciplined prioritization of our investments, which resulted in non-GAAP operating margin strength in Q2. The company continues to deliver world-class gross margins while investing in groundbreaking AI capabilities. Adobe's effective tax rate in Q2 was 18.5% on a GAAP and non-GAAP basis, in line with our expectations for the quarter. RPO exiting the quarter was $17.86 billion, growing 17% year-over-year as reported or 18% when factoring in a 1-point currency headwind. Current RPO grew 12% exiting the quarter. Our ending cash and short-term investment position at the end of Q2 was $8.07 billion, and cash flows from operations in the quarter were $1.94 billion. In Q2, we entered into a $2.5 billion share repurchase agreement, and we currently have $22.7 billion remaining of the $25 billion authorization granted in March 2024. We will now provide Q3 targets as well as updated fiscal 2024 annual targets, factoring in current macroeconomic conditions as well as strong momentum across our business, our current FX outlook into the back half of the year with the U.S. dollar remaining stronger as compared to our original expectations when we set our FY 2024 targets in December, and an expected strong seasonal finish to the year in Q4. For Q3, we're targeting: total Adobe revenue of $5.33 billion to $5.38 billion; Digital Media net new ARR of approximately $460 million; Digital Media segment revenue of $3.95 billion to $3.98 billion; Digital Experience segment revenue of $1.325 billion to $1.345 billion; Digital Experience subscription revenue of $1.20 billion to $1.22 billion; tax rate of approximately 18% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $3.45 to $3.50; and non-GAAP earnings per share of $4.50 to $4.55. For fiscal 2024, given our first half performance, we are now targeting: total Adobe revenue of $21.40 billion to $21.50 billion; Digital Media net new ARR of approximately $1.95 billion; Digital Media segment revenue of $15.80 billion to $15.85 billion; Digital Experience segment revenue of $5.325 billion to $5.375 billion; Digital Experience subscription revenue of $4.775 billion to $4.825 billion; tax rate of approximately 20.5% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $11.80 to $12; and non-GAAP earnings per share of $18 to $18.20. In summary, I'm extremely pleased with the company's performance in the first half of the year and the momentum we see in our business. Adobe's product leadership, velocity of innovation, diversity of our business, and financial discipline make us unique, enabling us to deliver strong top and bottom line results through dynamic market conditions. I'm confident in our ability to catalyze transformative long-term trends that will position us to win over the next decade. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. Adobe remains one of the greatest places to work in the industry, and I want to thank our employees for their relentless dedication to supporting our customers and communities. We continue to invest in hiring, including new college grads and interns to bring the best and brightest talent to Adobe. This quarter, Adobe was recognized among Fortune's 100 Best Companies to Work For, Glassdoor's Best-led Companies and the Civic 50 List of the Most Community-minded Companies in the U.S. Demand for our category-defining products and services continues to grow. Our business fundamentals and market tailwinds are strong, and we look forward to building on our momentum in the second half and beyond. Thank you, and we will now take questions.
Operator: Thank you. [Operator Instructions] Our first question will come from Mark Moerdler with Bernstein.
Mark Moerdler: Thank you very much and congratulations on the quarter and especially the strong net new ARR. I'd like to ask a little more color on specifically the net new ARR that we saw in Creative Cloud. Can you give us a sense of what the contribution near term, medium term to Digital ARR from seat growth versus upsell versus consumption, things like Adobe Stock and AI credits, even rank ordering or quantifying? Anything you can give us -- to give us a sense of what's driving that number? And that would be very helpful in really understanding what's going on in the drivers of that number. Thanks.
Shantanu Narayen: Sure, Mark, let me start and then certainly, David and Dan can add. To your point, we had a strong quarter. And I think what's really driving the quarter, big picture, continues to be the innovation that we're delivering. And the way AI is actually making our applications both more affordable, easy to onboard as well as, frankly, higher-value users. New users are still a big driver of the growth that we continue to see in the business. On the Document Cloud side, a lot of that has to do with the introduction of AI Assistant and the fact that people are migrating to the higher-value products. And on Creative Cloud, I would say the things that we're doing on imaging with Firefly and what we've seen both in Photoshop and Lightroom. I think in the prepared remarks Dan certainly talked about what's happening with also each of the different segments. So the SMB segment actually had a strong quarter. Enterprise continues to have a strong quarter. So across the board, Mark, we actually saw strength in the business.
Operator: And our next question will come from Alex Zukin with Wolfe Research.
Aleksandr Zukin: Hey, guys. Thanks for taking the question and congratulations on this incredible result. I wanted to ask kind of just similar to Mark's question, just how much gen AI demand did you see in the quarter in terms of -- for sort of both the Creative Cloud portfolio and Digital Media, in Creative Studio as well as in GenStudio? And how does it kind of help to pick up more on the enterprise side of the business, on the SMB side of the business? Help us understand that progression and maybe how you're planning for it in the back half of the [indiscernible].
Shantanu Narayen: Sure, Alex. Again, maybe I'll start with that. And just taking a step back, I think we've talked about the platform that we have for gen AI that constitutes data, as well as models and finally, interfaces. On the models, we released Firefly services. We've started to see some customer wins in Firefly services. So they're using it for variations, and these are the custom models that we're creating, as well as access to APIs. I would say that's early in terms of the adoption, but the interest as customers say how they can ingest their data into our models as well as custom models, that's really ahead of us, and we expect that to continue to grow in Q3 and Q4. I think the biggest opportunity for us and why we're really excited about gen AI is in the interfaces, because that's the way people derive value, whether it's in being able to complete their tasks faster, whether it's being able to do new workflows. And I would say in that particular space, Acrobat has really seen a significant amount of usage as it relates to AI Assistant. And Photoshop, I'll have David again add, but Generative Fill and what we are doing there, what we are doing in Illustrator. And that both for existing customers as well as for prospects who now come in and say, the products are becoming increasingly more productive for us, that's what's really driving the value there. And last but not least, the AI-first applications. When we think of an application like Express, Express is all about reimagining what we can do for creatives by sort of leapfrogging existing technologies and providing an AI-first application. And so that's also off to a good start.
David Wadhwani: Yes. And just to add to a little bit of what Shantanu said, Alex. We've talked a lot about how FY 2023 was the year that AI was in the playground, and this is the year we need to bring it into production. And a lot of that is industry-wide, but we're in a pretty special position as it relates to that. So to Shantanu's point, a lot of active releases this quarter, right? Acrobat AI Assistant, Firefly updates in Photoshop, Firefly was introduced for the first time into Lightroom, Express Mobile launched, Express for Business launched. We launched Firefly services for enterprises to produce content at scale. So, as you can see, there was a ton of innovation of our core -- in our core applications around generative AI. You put that together with some of the activations that we've done at Summit, and we did at Max London and we're getting our word out very broadly. It starts to create this ability to not just look at and play with AI, but actually use it as part of your workflow. So that's been deeply integrated into everything we do. And that's the key point, the interfaces that people work out if we bring AI there, everyone becomes more productive.
Shantanu Narayen: And maybe one last thing, Alex. Sequentially, if you look at it from a route to market, Digital had a very strong quarter as it relates to what we did on adobe.com. We had talked about enterprise doing well in Q1 as well, that continued. And SMB also, the interest in our teams product also continued to do really well. So I think sequentially, I would point to SMB and Digital's strength as driving the further growth.
Aleksandr Zukin: That's super helpful. And then maybe just one on the macro. Just given your guys' purview, like what is the story that you're seeing in terms of the macro on the demand environment? Clearly again, you're commenting on solid performance in the SMB and in the enterprise. Is there any areas that you're seeing pockets of weaknesses that's really vertical-dependent? Just maybe give a comment on kind of how we should think about it as we look to the rest of the year.
Shantanu Narayen: I think from a macro perspective, what I think differentiates Adobe more than any other company is how differentiated and how diverse the set of products that we have. And again, from individual consumers all the way to enterprises, our products are mission-critical. And so at this scale, it's all about execution. And the business cycles will come and go, Alex, but we're actually continuing to focus on execution and converting the pipeline and the interest and the awareness of AI into monetization. And so, we just will be ruthlessly focused on continuing to execute against that. So nothing really to report different on the macroeconomic environment from our perspective.
Aleksandr Zukin: Awesome. Keep doing what you're doing, guys.
Operator: And our next question will come from Saket Kalia with Barclays.
Saket Kalia: Okay, great. Hey, guys, thanks for taking my question here and echo the congrats on the quarter. Maybe for both, Shantanu and David. There are clearly just so many layers to the Firefly monetization story. But I think one theme that's coming out a little bit in this call and particularly interesting route to monetize is just the increased engagement that Firefly helps drive in your flagship products, right, or I think we call it sort of the interfaces, right? An example there would be like Generative Fill for Photoshop. And you've clearly started expanding that to other flagships like Premier and Illustrator. Maybe to go one level deeper, is there a way that you think about the potential opportunity from things like higher retention rates? Or any other way that -- I know it's really tough to size, but how have you sort of thought about it even qualitatively?
David Wadhwani: Yes, it's a great question. And yes, the core has been -- from the very beginning, we've talked to you guys about our primary focus for generative AI is about user adoption and proliferation, right? And that has continued to be the primary thing on our mind. And it's the primary thing on our mind for multiple reasons. And to your point, there are many different ways that we can monetize this. First is, as you think about the growth algorithms that we always have in our head, it always starts with, as Shantanu said, new users, right? And then it's about getting more value to existing users at higher ARPU, right? So in the context of new users, first and foremost, we want to make sure that everything we're doing generative AI is embedded in our tools, starting with Express, right? So we have Express in the market. We're seeing a lot of adoption and usage of Express in the market. As that's happening, we're infusing generative AI more and more into Express in a whole host of ways. And that's really helping, everything from our marketing message for the completeness of the AI offering in there, all the way through to user engagement and success in onboarding and retention. Similarly, though, this is having the same effect in our core Creative products as well, right? The introduction of Firefly combined with some of the product-led growth work we've been doing, in particular, something called the Context Bar makes it easy for new users coming in to just be more successful out of the gate which then, of course, helps with both conversion and retention. And then with AI Assistant, the ability to sort of embed that into the purchase flow for Acrobat and get a high attach rate, we always talk about that as a would you like fries with it moment at Adobe when someone's going through the checkout flow, it's just a great way for people to say, look, this is value I want, I want to add it and buy up to the higher plans. So there are a lot of different mechanisms that we see. But by far, the strongest is going to be the fact that we are seeing people like in Creative Cloud migrating to the higher-priced plans because they include Firefly. And so we just want to get more value to these users as well.
Shantanu Narayen: And in terms of the generation, Saket, I think we talked about it. We did a great job at MAX in London talking about some of the new functionality and releasing. Photoshop, I think we're up to 9 billion generations, and actually, I think the greatest amount of generations was in May. So the momentum clearly is the more we integrate this functionality into our interfaces, the more that usage is really driving adoption as well as retention.
Saket Kalia: Very helpful. Thanks, guys.
Operator: And our next question comes from Brent Thill with Jefferies.
Brent Thill: David, on Express, you mentioned the success you're seeing. Can you maybe drill into some of the other metrics and accomplishments that you're seeing out of Express this quarter?
David Wadhwani: Yes. For starters, there's a lot of buzz of Express here at Adobe coming off the event we just had earlier this week, but it's really based on the fact that the innovation in Express is on a tear, right? A few months ago, we introduced an all-new Express for the web. This quarter, we introduced an all-new Express for mobile. We introduced Express for Business. We also now have, as we've just talked about, been more deeply integrating AI features, whether it's for imaging generation or generative fill or text effects, character animation, design generations more deeply into the flow for Express. And that combination has led to an incredible set of metrics over the last quarter, in particular, but building throughout the year. Express MAU is growing very quickly. We talked about on the -- in the script earlier that MAU on mobile has more than doubled quarter-over-quarter, which is fantastic to see. And cumulative exports, if you look at year-over-year it has grown by over 80%. So really feeling good about sort of the momentum we're seeing. But if you take a step back, I think it is important to take a step back and understand our vision. Express that is now in market is built on a brand-new platform, right? And that brand-new platform lays the groundwork for the AI era. And this will be -- Express will be the place that anyone can come and create through a combination of conversational and standard inputs. That's the vision that we have. And I think it's an opportunity for us to really leap forward in terms of what we can do on the web and mobile at Adobe. And it's taken us a little time to get here. It hasn't happened overnight. But now that we are here, we are going to pour the gas on go-to-market, right? You know what we can do with our data-driven operating model. We've been ramping up what we're doing in Digital and Adobe.com journeys. We now can do the same thing and unleash all of that expertise in the mobile app store. You know what we're capable in terms of our product-led growth motions. We've now embedded Express Workflows into Acrobat Editor. We obviously have been embedding it into Creative Cloud workflows. And also, as we showed at Summit with Anil, we've embedded it into our Experience Cloud workflows as well. In addition to all of that, we're now unleashing our inside sales force to target the small/medium businesses. Our education teams are really gearing up for the back-to-school launch for K-12 and higher ed. And our field and enterprise sales now have Express for Business. So -- and we're doing all this globally, right? It's a massive market, and we're ramping up and we're ready to go.
Brent Thill: Thank you.
Operator: And the next question comes from Gregg Moskowitz with Mizuho.
Gregg Moskowitz: Hey, thank you very much. And I'll add my congratulations. For your Creative business, how are you thinking about the Q side of the P times Q equation over the balance of the year? Based on these numbers anyway, I would certainly assume that you had really healthy unit growth in Q2. And I'm wondering if you expect that to continue.
David Wadhwani: Yes. I mean, again, I think what -- it is this mix of product innovation that we've been putting out there and the steady drumbeat of that. A lot of it getting attention because of the quality and the hooks of AI and being able to sort of bring people, onboarding them quickly and successfully into the product. And then as we talked about, the more they use these AI features, the more they retain. And we feel really good about really that whole workflow. So yes, the new user growth continues to be our primary focus. And when you add in everything we're doing with Express, we're -- again, like I said, we're off to the races and we feel very good about the momentum on new user acquisition and existing member retention.
Shantanu Narayen: And Gregg, as you're aware, I mean, certainly with Express, we also have the model of customer acquisition as it relates to people coming in through trial and free and then conversion. So we are seeing the interest level as it relates to Express, in particular, significant interest.
Gregg Moskowitz: And Shantanu, since you also called out the strength in Digital earlier, including driving new Creative All Apps subscriptions from your website, are you doing anything different that's helping to drive that behavior? And if so, is that something you think can continue as well?
Shantanu Narayen: I would, Gregg, sort of modesty say, we've been world-class at sort of driving that for a long time now. But the team, I think, continues to do an amazing job. And I would say David referred to the DDOM. Adobe Home is now sort of increasingly the way that we're driving a lot of people to get aware of our new products. And so, I would say the mobile part as well and the mobile journeys, as we've got these mobile products, whether it's Lightroom or whether it's certainly, Express, that's an area of increasing focus for us. And the traditional sort of understanding where search terms are, I think we're getting better and better at that, which leads to way more digital traffic for us. So I think it's across the board. But I'd also highlight, I mean, the commerce team that we have at Adobe that understands what the segments are and how for those particular segments we can attract people, that's great. I mean, I think in the prepared remarks, Dan also talked about the strength in emerging markets. And I think the beautiful part about AI is that since they need access to the cloud to get all of the AI functionality, emerging market growth has been really strong for us.
Gregg Moskowitz: Very helpful. Thank you.
Operator: And moving on to Keith Weiss with Morgan Stanley.
Keith Weiss: Thank you guys for taking the question. And again, congratulations on a really solid set of results in an environment where not very many software companies have been able to beat and raise in this type of uneven environment. I wanted to maybe focus in a little bit on the question that Mark Moerdler asked, in particular on what gives you guys the confidence to see a return to year-on-year growth and Creative Cloud net new ARR. It declined in Q2, it declined in Q1. And if I'm not mistaken, the decline in Q2 was a little bit steeper than what we saw in Q1. So what are the particular drivers and maybe some detail on those drivers that give you guys the confidence that, that trend line that has been actually heading in the wrong direction is going to head in the right direction now? We're actually going to see growth in those metrics in Q3 and Q4?
David Wadhwani: Yes. Thanks, Keith. This is one of the areas that I think we've shared with you the complexity of the year-over-year comparisons in the first half based on prior pricing marks that we had. But more importantly, to your point, the year-over-year complexities are now behind us. And we're very excited about the momentum of the first half and how it sets us up for the second half, frankly, across both Document Cloud and Creative Cloud. Both are really momentum stories. The 478 -- the 487, sorry, just to be clear, the $487 million that we printed this time is obviously strong performance, and it implies that both CC and DC came in over what the growth -- the guide would have implied otherwise, right? So it's giving us a lot of good momentum going into the back half. Now the momentum is really driven by three things, and just I'll try to share a little bit more context here and hopefully gives you. First is new user acquisition, right? We're seeing Express starting to perform well in terms of bringing a lot of new users into the franchise across mobile and web. AI Assistant in Reader has been a really nice start for us, and we've been very pleased with how the uptake on that's going. And then Firefly itself, as I mentioned, has been increasingly more productive in terms of bringing in onboarding users and then retaining users because of the growth. We continue -- as we drive that more holistically throughout the product set, we start to see more people using it, including, as Shantanu mentioned earlier, in emerging markets. So we are seeing very good strength and usage in emerging markets, and that has certainly been a bright spot for us, which is something that obviously represents a lot of potential and upside for us. In terms of existing customers, the migration has been going very well for us as well. So, more people are moving to the higher-priced, higher-value plans because of the Firefly capabilities. We're even seeing this in enterprises where people are moving up to the highest versions of Creative Cloud, which is what we call it, Creative Cloud Enterprise 4, because they get more access to features beyond just generation. They have more collaborative capabilities beyond just kind of sharing via e-mail. And we're starting to see that create a nice momentum in upgrade cycles in the enterprise segment as well. And then certainly, let's not forget the new offerings, too. While still early, automation and content production is something that we're driving effectively in a lot of these accounts with Firefly services. So that mix of new users, existing user migration, and also the new offerings that we have in market are driving that growth formula that we talked about, which is now P times Q plus V for value with these automation systems.
Keith Weiss: That is a great answer. Thank you so much.
Operator: And we have a question from Brad Sills with Bank of America.
Bradley Sills: Oh, great. Thank you so much. I wanted to ask a question around the generative credit component to your pricing here. It seems like with all the progress you've made embedding Firefly across the key flagship products and the engagement levels that you're seeing, we should start to see perhaps some ramp in that generative credit component to your pricing. Is that a fair assessment? Would you expect to start to see that coming in? Or should we look to other services like the video capabilities that you're going to be launching shortly as a key catalyst there? Thank you.
Shantanu Narayen: I think you're right, Brad. When we think about what we've done with imaging and video, we've done the right thing by making sure the higher-value paid plans that people don't have to think about the amount of generative capability. And so there, the balance between for free and trialist users, they're going to run into the generative capability limits and, therefore, have to subscribe. But for the people who actually have imaging and vector needs, that they're not constantly thinking about generative, I think we actually got it right. To your point, as we move to video, expect to see different plans because those plans will, by necessity, take into account the amount of work that's required to do video generation. So you're absolutely right as a sort of framework for you to think about it. The two other things that I would say is, I mean, clearly, Express is really being driven by sort of the need for AI and how people are able to describe what they want and get the final output. When David talked about exports, just to clarify what that means is people who have successfully got what they want to get done, done. And that's a key measure of how we are doing it, and AI is certainly facilitating and accelerating that. And last thing I would say, Brad is, as you know, on the Acrobat side, it's a slightly different model which we like, which is anybody who has Reader and is looking at a document, they can have an upsell to their AI Assistant. If you have Acrobat Pro, you can upsell to the AI Assistant. And if you're a brand new acquisition of a user when you're coming in, the adoption of the highest-value products, so between Standard Pro and Pro Plus Assistant, we've been pleased to see how many people are migrating to the Pro Plus Assistant. So hopefully, that gives you some color of how we think about it differently by product.
Bradley Sills: Very helpful. Thank you, Shantanu.
Operator: And we'll take a question from Brad Zelnick with Deutsche Bank.
Brad Zelnick: Great. Thank you so much and congrats to all of you. I don't want Anil to feel left out, so I'm going to ask a DX question. Anil, it's good to hear AEP is on track to become the next billion-dollar business for Adobe. Can you expand on the journey and drivers that get you there? And in particular, how important are cloud migrations? And how do you see AEP AI Assistant perhaps accelerating the journey to $1 billion? Thanks.
Anil Chakravarthy: Thank you, Brad. Appreciate it. As you know, I mean, customer experience management and especially it's been a hugely important priority area for Chief Marketing Officers and with CIOs and Chief Digital Officers as well. And for us, we are focused on personalization scale, which is really built around the AEP platform. We're the largest provider in this space. We're growing faster than any of our peers, and we're the number one Digital Experience platform as a result. And that has really helped us keep the momentum. When you think about the AEP AI Assistant, it's doing a couple of things. One, it's really making it easier for customers to deploy use cases. When you think of use cases that they have around, for example, generating audiences and running campaigns around those audiences, these are things today that require some data engineering. They require the ability to put these audiences together. So they require marketing and IT teams to work together. The AEP AI Assistant is making it much easier for marketers to be able to do it themselves and be able to deploy a lot more use cases. So as there's more usage, it will help drive more consumption and help drive the growth in terms of number of profiles, number of users, and we help -- we see it helping us grow towards that billion-dollar business.
Brad Zelnick: Great to hear, and keep up the great work, guys. Thanks.
Jonathan Vaas: Hey, operator, we're almost at the top of the hour. We'll take two last questions and then wrap up. Thanks.
Operator: Thank you. We'll take a question from Kash Rangan with Goldman Sachs.
Kash Rangan : Hi, thank you very much. You guys could have three separate earnings calls because you have three different businesses that even the smallest one is very large. So yes, sorry, Anil, Dave, and Shantanu, I may not be able to ask all the questions that I want. I'm sure we have plenty. But I'll just keep it super high level, Shantanu. Generative AI, it seems to swing back and forth. Just so early in its evolution, the possibilities seem magical sometimes, endless sometimes, sometimes it feels very disappointing. But with every quarter that Adobe is executing on this path, where do you stand with the question that we do get from investors? Will generative AI be so good that it's the end of the creative process? So we don't need creative folks, that software will do everything? That sounds a little far-fetched, but I'm just throwing it out there to see how you would react that proposition. Same in Experience Cloud as well. Could generative AI create its own marketing campaign, put marketing people out of business? Or maybe it doesn't. I'm sure you have strong views. Maybe flipped on the other side, it does create category growth on the other hand, not category compression. So sorry for that super high-level question, but that seems to be a big debate on the stock here, at least from the long-term perspective. Thank you so much.
Shantanu Narayen: Yes, Kash. I think there are two things when we talk to investors that are perhaps on their mind. I mean, I think the first is it's fair to say that the interest that exists right now from investors as it relates to AI is all associated with the infrastructure and chips and perhaps rightly so because that's where everybody is creating these models. They're all trying to train them. And there's a lot of, I think, deserved excitement associated with that part of where we are in the evolution of generative AI. If the value of AI doesn't turn to inference and how people are going to use it, then I would say all of that investment would not really reap the benefit in terms of where people are spending the money. And so we're always convinced that when you have this kind of disruptive technology, the real benefits come when people use interfaces to do whatever task they want to do quicker, faster, and when it's embedded into the workflows that they're accustomed to because then there isn't an inertia associated with using it. So with that sort of as a broad segment, I am a big believer that generative AI is going to, for all the categories that we're in, it's actually going to dramatically expand the market because it's going to make our products more accessible, more affordable, more productive in terms of what you -- what we can do. I'm still acting CMO at the company, and I see the excitement around how we can, with agility, create way more content, create variations. When Anil talked about personalization at scale, I think there are two aspects to it, right? I mean, the first was always data, and Anil and the team have done a great job with sort of the real-time customer data platform to get that. And that's hydrated with users. But the real value is when you infuse that with the right content to make that personalized experience. So I think the demand is there for way more content than people can do, and generative AI is going to be an accelerant in that as well. And so net-net, I am absolutely betting on the fact that five years from now, there will be more people saying, I'm using creative tools to accomplish what I want, and there'll be more marketers saying, I can now, with the agility that I need, truly deliver a marketing campaign and an audience that's incredibly more specific than I could in the past. And that's Adobe's job to demonstrate how we are both leading in both those categories and to continue to innovate. But I recognize and I understand the question that exists in the industry associated with AI. If the value doesn't accrue to interfaces, I'll leave you with that. I think the investment would not be as beneficial as I believe it can be.
David Wadhwani: And maybe one thing to add to that, Kash, just to build on what Shantanu was talking about. I think the other thing we get asked a fair amount is about the comparison between different models, right? So Firefly might be better at something. Midjourney might be something at something else. DALL-E might do something else. And the key thing here is that around this table, we get excited when models innovate. We get excited when Firefly does something amazing. We get excited when third-party models do something because our view, to Shantanu's point, is that the more content that gets generated out of these models, the more content that needs to be edited, whether it's color correction, tone matching, transitions, assembling clips, or masking composite images. And the reason for this is that this is not a game where there's going to be one model. Each model is going to have its own personality, what it generates, what it looks like, how fast it generates, how much it costs when it generates that, and to have some interface layer to help synthesize all of this is important. And so just sort of to note, we've said this before but I'll say it again here, you will see us building our products and tools and services leveraging Firefly for sure, but you'll also see us leveraging best-of-breed personalities from different models and integrate them all together.
Kash Rangan : Awesome, the message here is that, gen AI is going to create more growth in the category. And Shantanu, you did that with the pivot to cloud. You grew the category, so here we go again. Thank you so much.
Shantanu Narayen: Thanks, Kash.
Operator: And next will be Jake Roberge with William Blair.
Jacob Roberge: Hey, thanks for taking the question and I'll echo my congrats on the great quarter. I know it's early, but what's been the feedback and customer behavior for those users that are on Firefly services and GenStudio? And then thinking more longer term, what type of price uplift could you see from those customers over time, just given what you said about the acceleration in Firefly generations being driven by those products? Thanks.
David Wadhwani: Maybe I'll start with customer zero. Right before this meeting, I was in a meeting with our CMO. And well, sometimes it's hard to tell, he's running the CMO or CEO head, but CMO this time. And we were reviewing a full-funnel campaign that we're planning on launching later this year. And exactly as Shantanu mentioned earlier, we saw benefits in terms of cost of the campaign, faster time to market for the campaign, and the amount of content that we can create to personalize that campaign. And that is one of those things that we've been doing more and more around our DDOM, which has actually been very productive for us, as you can see this quarter, and what we're pitching to other customers. So we've been working with -- we listed some of the customers earlier, but we've been working with a long list of customers on everything from accelerating the content creation for social, accelerating content creation for regional, and then increasing the number of amount of content that's created for increased personalization, which then, of course, flows through all of the Experience Cloud products that Anil is working on to get targeted better.
Shantanu Narayen: And Jake, maybe in terms of what I would say we're seeing usage of, I think the initial usage of Firefly services in most companies was all around ideation. How can they create multiple variations of them and in the ideation process really just accelerate that ideation process? Most companies are then starting with as they're putting it into production, how can they, with the brand assets and the brand guidelines that they have, do this in terms of the variations, whether they be geographic variations or they be just variations? I mean, if you take a step back also, every single ad company right now will tell you that the more variance that you provide, the better your chances are of appropriately getting an uplift for your media spend. So I would say that most companies are starting with creating these variations for geographies. The other one that we see a fair amount of is engaging with their communities. So when they want their communities to have assets that they have blessed for usage within community campaigns, that's the other place where Firefly services are being used. And a company has a community portal where the community can come in, take something and then post whether it's on whatever social media site that you want. So I think that's the initial one. All of the agency companies are companies that have actually even publicly said how GenStudio is something that they have embraced. But even the large media companies, because the media companies are certainly interested in understanding how all of this gen AI could be used to automate as well as accelerate the amount of content that they can produce. So hopefully, that gives you some color of it. If there's been sort of the questions that they ask along the way, which hopefully and actually, luckily, we have great answers, it's all around the indemnification and how they can use it. And I would say that continues to be a really key differentiator for us. But since that is the last question, let me just say I'm proud of how we executed in Q2, both across the product innovation, delivery as well as the go-to-market because clearly, a number of you asked how we were able to put together these numbers where others have perhaps talked about the macroeconomic environment. We certainly remain focused on leveraging technology to light a broader set of customers. And at the end of the day, to the questions that we were asked, we believe that the real value of AI will be in the interfaces that individuals, enterprises use to accomplish their tasks and workflows. And we think we're incredibly well positioned. So thank you for joining us.
Jonathan Vaas: Thanks, everyone. This concludes the call.
Operator: Thank you. This does conclude today's conference. We do thank you for your participation, and have an excellent day. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Q2 FY 2024 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Jonathan Vaas, VP of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's second quarter fiscal year 2024 financial results. You can find our press release, as well as PDFs of our prepared remarks and financial results, on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, June 13, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe's Investor Relations website. I will now turn the call over to Shantanu."
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{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon and thank you for joining us. Adobe had an outstanding quarter, achieving revenue of $5.31 billion, representing 11% year-over-year growth. GAAP earnings per share for the quarter was $3.49 and non-GAAP earnings per share was $4.48, representing 15% year-over-year growth. Our success is driven by growing customer value through an innovative product roadmap. The advances we are delivering across Creative Cloud, Document Cloud and Experience Cloud are enabling us to attract an expanding universe of users. Everyone from creators, communicators, students, entrepreneurs and businesses of all sizes are using our products to unleash their creativity, accelerate document productivity and power their digital businesses. Adobe's highly differentiated approach to AI is rooted in the belief that creativity is a uniquely human trait and that AI has the power to assist and amplify human ingenuity and enhance productivity. We're innovating across data, models and interfaces and natively integrating AI across all our offerings. In Creative Cloud, we have invested in training our Firefly family of creative generative AI models with a proprietary data set and delivering AI functionality within our flagship products including Photoshop, Illustrator, Lightroom and Premiere. We're reimagining creativity for a broader set of customers by delivering Adobe Express as an AI-first application across the web and mobile surfaces. Since its debut in March 2023, Firefly has been used to generate over 9 billion images across Adobe creative tools. In Document Cloud, we're revolutionizing document productivity with Acrobat AI Assistant, an AI powered conversational engine that can easily be deployed in minutes. This enhances the value of the trillions of PDFs which hold a significant portion of the world's information. Acrobat AI Assistant features are now available through an add-on subscription to all Reader and Acrobat enterprise and individual customers across desktop, web and mobile. At the end of May, we celebrated the five-year anniversary of Adobe Experience Platform, which we conceived and built from scratch and which is on track to be the next billion-dollar business in our Digital Experience portfolio. We released AEP AI Assistant to enhance the productivity of marketing practitioners through generative AI, while expanding access to native AEP applications. With Adobe GenStudio, we're bringing together products across our clouds including Creative Cloud, Adobe Experience Manager, Workfront, Adobe Journey Optimizer and Customer Journey Analytics as well as Adobe Express for Business to address the massive content supply chain opportunity. Our approach to empower marketers to quickly plan, create, manage, activate and measure on-brand content is resonating with customers and validating our leadership across data, content and journeys to deliver personalized experiences at scale. We're extending our applications to integrate third-party text, image and video models and partnering strategically to create multi-modal large language models offering customers greater choice in tools and further enhancing the value of our leading applications and solutions. We're driving strong usage, value and demand for our AI solutions across all customer segments and seeing early success monetizing new AI technologies across our Digital Media and Digital Experience businesses. Given this rich product roadmap, focus on execution and customer demand in the first half of the year, we are pleased to raise our annual Digital Media net new ARR, Digital Experience subscription revenue and EPS targets. I'll now turn it over to David to discuss the momentum in our Digital Media business."
},
{
"speaker": "David Wadhwani",
"text": "Thanks, Shantanu. Hello everyone. In Q2, we achieved net new Digital Media ARR of $487 million and revenue of $3.91 billion, which grew 12% year-over-year. On the Document Cloud side, PDF has become a global standard for automating business and consumer workflows, and Acrobat is the platform of choice to view, edit, share and collaborate with these documents. We continue to see steady growth in monthly active users of our Document Cloud solutions, including Acrobat Reader, Acrobat Standard and Pro, and our signature, share and review workflows across mobile, web and desktop. The introduction of Acrobat AI Assistant, made generally available in April for English documents, marks the beginning of a new era of innovation and efficiency for the approximately 3 trillion PDFs in the world. Acrobat AI Assistant is empowering everyone to shift from reading documents to having conversations with them in order to summarize documents, extract insights, compose presentations and share learnings. AI Assistant is available as a standalone offer for use in Reader and as an add-on to Acrobat Standard and Pro. We're seeing early success driving adoption of AI Assistant as part of our commerce flows and remain optimistic about the long-term opportunities. In Q2, we achieved Document Cloud revenue of $782 million, growing 19% year-over-year. We added $165 million of net new Document Cloud ARR, which was a Q2 record, with year-over-year ending ARR growth of 24% in constant currency. Other business highlights include, general availability of Acrobat AI Assistant support for document types beyond PDF, meeting transcripts and enterprise requirements; Acrobat link sharing for PDF-based collaboration continues to grow rapidly, more than doubling year-over-year and driving viral new user adoption; free monthly active users of Acrobat Web grew over 60% year-over-year, as a result of link sharing and our Microsoft Edge and Google Chrome extensions; continued strength with free-to-paid digital conversion, as a result of product led growth optimizations; strong growth in the SMB segment for our Teams offering, driven by a combination of seat expansion and new account wins; Key enterprise customer wins with AstraZeneca, Chevron, State Government of Florida, State of Illinois, United Healthcare Services and Wells Fargo. Turning to Creative Cloud, creative professionals are leading the global charge to meet the everincreasing demand for engaging content across a variety of platforms and channels. Enterprises rely on creative professionals to produce differentiated content to drive increasingly personalized marketing campaigns. Solopreneurs and small businesses need to stand out in a crowded digital landscape with engaging videos and designs. Educators are passionate about providing students with the visual communication skills needed to thrive in the decades ahead. Consumers are increasingly looking for ways to share their stories digitally. Creative Cloud, Express and Firefly Services are uniquely positioned to catalyze this opportunity for everyone, by leveraging the promise of generative AI. Our Creative Cloud flagship applications continue to release new features that are significantly improving user onboarding while simultaneously delivering an unprecedented level of power and precision. Generative Fill and Generative Expand are already two of the top three features used by customers on the latest version of Photoshop. Text to vector support is off to a great start in Illustrator. Remove Object is the fastest growing feature in Lightroom mobile. Our preview of generative AI capabilities in Premiere won Production Hub Award of Excellence at NAB, the largest video show in North America. We are integrating our leading applications with Firefly and third-party generative AI models to deliver the richest, most engaging content. Our vision for Adobe Express is to provide a breakthrough application to make design easy for communicators worldwide, leveraging generative AI and decades of Adobe technology across web and mobile. Our launch of the all-new Express application on iOS and Android earlier this quarter is off to a strong start, with monthly active users doubling quarter over quarter. This week's Design Made Easy event, which focused on Express for Business, was another big step forward for us. Companies of all sizes are excited about the integrated power and commercial safety of Firefly, the seamless workflows with Photoshop, Illustrator and Adobe Experience Cloud and enterprise-grade brand controls that are now part of Express for Business, making it the optimal product for marketing, sales and HR teams to quickly and easily create visual content to share. We also announced the general availability of Firefly Services and Custom Models at Summit. The platform makes API calls and model customization available to developers, accessible through low-code, no-code tools and integrates with our Experience Cloud products. Firefly Services can power the creation of thousands of asset variations in minutes instead of months, and at a fraction of the cost. This allows us to monetize the volume of content being created through automation services. The increasing availability of Firefly in Creative Cloud, Express, Firefly Services and the web app is giving us opportunities to access more new users, provide more value to existing users and monetize content automation. These integrations are driving the acceleration of Firefly generations, with May seeing the most generations of any month to date. In Q2, we achieved $3.13 billion in revenue, which grew 11% year-over-year. Net new Creative Cloud ARR was $322 million. Other business highlights include, the launch of Express for Business, including support for brand controls and template locking, Firefly custom models, bulk creation and generation of variations, presentation and print capabilities, and workflows with Photoshop, Illustrator and Experience Cloud; the release of Firefly Image 3 Foundation Model with high quality image generation and more control with structure and style reference; the release of the Photoshop beta, with Reference Image and advances in Generative Fill; the debut of Generative Remove in Adobe Lightroom, enabling anyone to remove unwanted objects from any photograph non-destructively with stunning, high-quality, photo-realistic results; the release of the Premiere beta, with new audio workflows driving strong usage; the deep integration of Firefly in Substance 3D, which provides an easy way to create textures and materials from reference images; the introduction of an all new Frame.io, streamlining workflows across content types on a flexible and intuitive collaboration platform; key enterprise customer wins include Credit Agricole, FedEx, Infosys, Rakuten, Ralph Lauren, Samsung, Schneider Electric and Volvo. We're excited about the accelerating pace of innovation across the Digital Media business and pleased with the adoption of AI functionality as well as its early monetization across Document Cloud and Creative Cloud, including our flagship applications, Firefly Services and Express. We're pleased to raise our annual net new ARR target to $1.95 billion and excited to deliver on our rich product roadmap in the second half. I'll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello, everyone. In Q2, we achieved Experience Cloud revenue of $1.33 billion. Subscription revenue was $1.2 billion, representing 13% year-over-year growth. We are the industry leader in helping enterprises deliver personalized experiences at scale to their customers by combining the right content, customer data and journeys in real time. When we introduced Adobe Experience Platform five years ago, it was a revolutionary approach to address customer data and journeys. Today, we're the number one digital experience platform, and AEP with native apps is well on its way to becoming a billion-dollar business. We're now transforming the content supply chain for enterprises with Adobe GenStudio, enabling them to produce content at scale, leveraging generative AI through native integrations with Firefly services and Adobe Express for Business. Enterprise customers, both B2C and B2B, view customer experience management and personalization at scale as key areas of differentiation, making it a priority investment for Chief Marketing Officers, Chief Information Officers and Chief Digital Officers. We are excited by the customer interest and adoption of our latest innovations, including AEP AI Assistant, a generative AI-powered conversational interface that empowers practitioners to automate tasks, simulate outcomes, and generate new audiences and journeys. For example, customers like General Motors and Hanes brands have been working with AEP AI Assistant to boost productivity and accelerate time to value, while democratizing access to AEP and apps across their organizations. Marriott International is a great example of a customer that's expanded its decade-long relationship with Adobe and turned to Adobe Experience Cloud to orchestrate highly personalized guest experiences across online reservations and the Marriott Bonvoy mobile app. Adobe Real-time CDP and Adobe Journey Optimizer enabled Marriott to connect data from disparate sources and activate relevant experiences in moments that matter, helping the company match individuals with the best options across its portfolio of more than 30 brands and nearly 9,000 properties. Other business highlights include: continued momentum with AEP and native applications, growing subscription revenue 60% year-over-year in Q2; AEP innovations announced at Summit include Adobe Journey Optimizer B2B addition, a new application for B2B customers built on AEP to orchestrate account-specific buying group journeys; federated audience composition, which enables enterprises to minimize data copy and generate audiences directly from their enterprise data warehouses; and real-time CDP collaboration, a new clean room application for brands and publishers to collaborate in a privacy safe way to discover, reach, and measure their high-value audiences in a world without third-party cookies. GenStudio innovations to address enterprise content supply chain needs across workflow and planning, creation and production, asset management, delivery and activation, and reporting and insights. Recent advancements include contextual search in Adobe Experience Manager assets, which enables users to find the right asset and variation in their growing digital libraries. Adobe Workfront Planning, which provides every user with a unified view of all activities across the marketing life cycle through highly visual marketing campaign calendars and dynamic briefs. And AEM Generate Variations, which accelerates the creation of audience-specific content variations to drive personalized web experiences. Strong industry analyst recognition including Gartner's Magic Quadrant for Content Marketing Platforms and leadership for both IDC's B2C and B2B MarketScapes for digital commerce applications. Key customer wins include Amazon, British Telecom, Comcast, Mercedes-Benz, Maruti Suzuki, Nationwide Building Society, Novo Nordisk, ServiceNow, Stellantis, Ulta Beauty, and U.S. Department of the Treasury. We have enabled our vibrant partner ecosystem of system integrators and agencies to deliver advisory and implementation services across our product portfolio. We look forward to engaging with customers and major agencies at the Cannes Lions Festival later this month. Our category-leading solutions, robust pipeline, and tremendous scale position us to drive strong growth in the second half, and we are raising our subscription revenue target for the year. I will now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Today, I'll start by summarizing Adobe's performance in Q2 fiscal 2024, highlighting growth drivers across our businesses, and I'll finish with financial targets. In Q2, Adobe delivered strong top line growth and industry-leading profitability while accelerating the pace of innovations we're delivering to market across Document Cloud, Creative Cloud, and Experience Cloud. In the quarter, Adobe achieved record revenue of $5.31 billion, which represents 10% year-over-year growth or 11% in constant currency, with strength across all three clouds. This performance stems from the diversification of Adobe's business across our market-leading products, business models, customer segments, and geographies. When combined with our talented employees, strong execution and world-class financial discipline, you have the ingredients that make this company incredibly resilient. Second quarter business and financial highlights included: GAAP diluted earnings per share of $3.49 and non-GAAP diluted earnings per share of $4.48; Digital Media revenue of $3.91 billion; net new Digital Media ARR of $487 million; Digital Experience revenue of $1.33 billion; cash flows from operations of $1.94 billion; and RPO of $17.86 billion exiting the quarter. In our Digital Media segment, we achieved Q2 revenue of $3.91 billion, which represents 11% year-over-year growth or 12% in constant currency. We exited the quarter with $16.25 billion of Digital Media ARR, up 13% year-over-year in constant currency. Adobe achieved Document Cloud revenue of $782 million, which represents 19% year-over-year growth as reported and in constant currency. We added $165 million of net new Document Cloud ARR, which was a record for Q2. Q2 Document Cloud growth drivers included: demand for Acrobat subscriptions across all customer segments and geographies; new user acquisition resulting from increasing Reader MAU; a great start monetizing AI Assistant through our digital channel; strong usage and engagement from Acrobat Web as well as through our Chrome and Edge partnerships, which are driving free-to-paid conversion; growing team subscription units sold to SMBs, both through adobe.com and our research channel; and strength in our enterprise solutions, demonstrating the importance of PDF as a source of unstructured data in business workflows. We achieved Creative revenue of $3.13 billion, which represents 10% year-over-year growth or 11% in constant currency. We added $322 million of net new Creative ARR in the quarter. Q2 Creative growth drivers included: new subscriptions for Creative Cloud All Apps with particular strength in digital acquisition on adobe.com, with multiple product releases during the quarter driving customer engagement and demand; strong growth of single apps, including in imaging, photography, design, and stock; accelerating customer interest and usage for our new Express Mobile and Express for Business offerings; strong renewals as customers migrate to higher-value, higher ARPU Creative Cloud plans that include Firefly entitlements; continued subscription unit growth, with particular strength in emerging markets; and strength from SMBs adopting our team offering as well as in the enterprise segment with ETLA adoption. We're pleased with the performance of the Creative business in the first half of the year, fueled by strong commercial subscriptions in both Q1 and Q2. As we look at the momentum we're carrying into the back half, we expect to deliver year-over-year growth of Creative net new ARR in Q3 and Q4 and are raising our Digital Media net new ARR target for the fiscal year. Turning to our Digital Experience segment. In Q2, we achieved revenue of $1.33 billion, which represents 9% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.20 billion, growing 13% year-over-year as reported and in constant currency. Q2 Digital Experience growth drivers included: subscription revenue strength from transformational accounts; market leadership with AEP and native applications, with subscription revenue growing 60% year-over-year; additional subscription revenue strength across the data insights and audiences and customer journey categories; and accelerated adoption of our AEM and Workfront solutions from businesses looking to solve their content supply chain challenges. Turning to the income statement and balance sheet. In Q2, Adobe delivered year-over-year EPS growth of 24% on a GAAP basis and 15% on a non-GAAP basis. This was driven by revenue growth and disciplined prioritization of our investments, which resulted in non-GAAP operating margin strength in Q2. The company continues to deliver world-class gross margins while investing in groundbreaking AI capabilities. Adobe's effective tax rate in Q2 was 18.5% on a GAAP and non-GAAP basis, in line with our expectations for the quarter. RPO exiting the quarter was $17.86 billion, growing 17% year-over-year as reported or 18% when factoring in a 1-point currency headwind. Current RPO grew 12% exiting the quarter. Our ending cash and short-term investment position at the end of Q2 was $8.07 billion, and cash flows from operations in the quarter were $1.94 billion. In Q2, we entered into a $2.5 billion share repurchase agreement, and we currently have $22.7 billion remaining of the $25 billion authorization granted in March 2024. We will now provide Q3 targets as well as updated fiscal 2024 annual targets, factoring in current macroeconomic conditions as well as strong momentum across our business, our current FX outlook into the back half of the year with the U.S. dollar remaining stronger as compared to our original expectations when we set our FY 2024 targets in December, and an expected strong seasonal finish to the year in Q4. For Q3, we're targeting: total Adobe revenue of $5.33 billion to $5.38 billion; Digital Media net new ARR of approximately $460 million; Digital Media segment revenue of $3.95 billion to $3.98 billion; Digital Experience segment revenue of $1.325 billion to $1.345 billion; Digital Experience subscription revenue of $1.20 billion to $1.22 billion; tax rate of approximately 18% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $3.45 to $3.50; and non-GAAP earnings per share of $4.50 to $4.55. For fiscal 2024, given our first half performance, we are now targeting: total Adobe revenue of $21.40 billion to $21.50 billion; Digital Media net new ARR of approximately $1.95 billion; Digital Media segment revenue of $15.80 billion to $15.85 billion; Digital Experience segment revenue of $5.325 billion to $5.375 billion; Digital Experience subscription revenue of $4.775 billion to $4.825 billion; tax rate of approximately 20.5% on a GAAP basis and 18.5% on a non-GAAP basis; GAAP earnings per share of $11.80 to $12; and non-GAAP earnings per share of $18 to $18.20. In summary, I'm extremely pleased with the company's performance in the first half of the year and the momentum we see in our business. Adobe's product leadership, velocity of innovation, diversity of our business, and financial discipline make us unique, enabling us to deliver strong top and bottom line results through dynamic market conditions. I'm confident in our ability to catalyze transformative long-term trends that will position us to win over the next decade. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. Adobe remains one of the greatest places to work in the industry, and I want to thank our employees for their relentless dedication to supporting our customers and communities. We continue to invest in hiring, including new college grads and interns to bring the best and brightest talent to Adobe. This quarter, Adobe was recognized among Fortune's 100 Best Companies to Work For, Glassdoor's Best-led Companies and the Civic 50 List of the Most Community-minded Companies in the U.S. Demand for our category-defining products and services continues to grow. Our business fundamentals and market tailwinds are strong, and we look forward to building on our momentum in the second half and beyond. Thank you, and we will now take questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question will come from Mark Moerdler with Bernstein."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you very much and congratulations on the quarter and especially the strong net new ARR. I'd like to ask a little more color on specifically the net new ARR that we saw in Creative Cloud. Can you give us a sense of what the contribution near term, medium term to Digital ARR from seat growth versus upsell versus consumption, things like Adobe Stock and AI credits, even rank ordering or quantifying? Anything you can give us -- to give us a sense of what's driving that number? And that would be very helpful in really understanding what's going on in the drivers of that number. Thanks."
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, Mark, let me start and then certainly, David and Dan can add. To your point, we had a strong quarter. And I think what's really driving the quarter, big picture, continues to be the innovation that we're delivering. And the way AI is actually making our applications both more affordable, easy to onboard as well as, frankly, higher-value users. New users are still a big driver of the growth that we continue to see in the business. On the Document Cloud side, a lot of that has to do with the introduction of AI Assistant and the fact that people are migrating to the higher-value products. And on Creative Cloud, I would say the things that we're doing on imaging with Firefly and what we've seen both in Photoshop and Lightroom. I think in the prepared remarks Dan certainly talked about what's happening with also each of the different segments. So the SMB segment actually had a strong quarter. Enterprise continues to have a strong quarter. So across the board, Mark, we actually saw strength in the business."
},
{
"speaker": "Operator",
"text": "And our next question will come from Alex Zukin with Wolfe Research."
},
{
"speaker": "Aleksandr Zukin",
"text": "Hey, guys. Thanks for taking the question and congratulations on this incredible result. I wanted to ask kind of just similar to Mark's question, just how much gen AI demand did you see in the quarter in terms of -- for sort of both the Creative Cloud portfolio and Digital Media, in Creative Studio as well as in GenStudio? And how does it kind of help to pick up more on the enterprise side of the business, on the SMB side of the business? Help us understand that progression and maybe how you're planning for it in the back half of the [indiscernible]."
},
{
"speaker": "Shantanu Narayen",
"text": "Sure, Alex. Again, maybe I'll start with that. And just taking a step back, I think we've talked about the platform that we have for gen AI that constitutes data, as well as models and finally, interfaces. On the models, we released Firefly services. We've started to see some customer wins in Firefly services. So they're using it for variations, and these are the custom models that we're creating, as well as access to APIs. I would say that's early in terms of the adoption, but the interest as customers say how they can ingest their data into our models as well as custom models, that's really ahead of us, and we expect that to continue to grow in Q3 and Q4. I think the biggest opportunity for us and why we're really excited about gen AI is in the interfaces, because that's the way people derive value, whether it's in being able to complete their tasks faster, whether it's being able to do new workflows. And I would say in that particular space, Acrobat has really seen a significant amount of usage as it relates to AI Assistant. And Photoshop, I'll have David again add, but Generative Fill and what we are doing there, what we are doing in Illustrator. And that both for existing customers as well as for prospects who now come in and say, the products are becoming increasingly more productive for us, that's what's really driving the value there. And last but not least, the AI-first applications. When we think of an application like Express, Express is all about reimagining what we can do for creatives by sort of leapfrogging existing technologies and providing an AI-first application. And so that's also off to a good start."
},
{
"speaker": "David Wadhwani",
"text": "Yes. And just to add to a little bit of what Shantanu said, Alex. We've talked a lot about how FY 2023 was the year that AI was in the playground, and this is the year we need to bring it into production. And a lot of that is industry-wide, but we're in a pretty special position as it relates to that. So to Shantanu's point, a lot of active releases this quarter, right? Acrobat AI Assistant, Firefly updates in Photoshop, Firefly was introduced for the first time into Lightroom, Express Mobile launched, Express for Business launched. We launched Firefly services for enterprises to produce content at scale. So, as you can see, there was a ton of innovation of our core -- in our core applications around generative AI. You put that together with some of the activations that we've done at Summit, and we did at Max London and we're getting our word out very broadly. It starts to create this ability to not just look at and play with AI, but actually use it as part of your workflow. So that's been deeply integrated into everything we do. And that's the key point, the interfaces that people work out if we bring AI there, everyone becomes more productive."
},
{
"speaker": "Shantanu Narayen",
"text": "And maybe one last thing, Alex. Sequentially, if you look at it from a route to market, Digital had a very strong quarter as it relates to what we did on adobe.com. We had talked about enterprise doing well in Q1 as well, that continued. And SMB also, the interest in our teams product also continued to do really well. So I think sequentially, I would point to SMB and Digital's strength as driving the further growth."
},
{
"speaker": "Aleksandr Zukin",
"text": "That's super helpful. And then maybe just one on the macro. Just given your guys' purview, like what is the story that you're seeing in terms of the macro on the demand environment? Clearly again, you're commenting on solid performance in the SMB and in the enterprise. Is there any areas that you're seeing pockets of weaknesses that's really vertical-dependent? Just maybe give a comment on kind of how we should think about it as we look to the rest of the year."
},
{
"speaker": "Shantanu Narayen",
"text": "I think from a macro perspective, what I think differentiates Adobe more than any other company is how differentiated and how diverse the set of products that we have. And again, from individual consumers all the way to enterprises, our products are mission-critical. And so at this scale, it's all about execution. And the business cycles will come and go, Alex, but we're actually continuing to focus on execution and converting the pipeline and the interest and the awareness of AI into monetization. And so, we just will be ruthlessly focused on continuing to execute against that. So nothing really to report different on the macroeconomic environment from our perspective."
},
{
"speaker": "Aleksandr Zukin",
"text": "Awesome. Keep doing what you're doing, guys."
},
{
"speaker": "Operator",
"text": "And our next question will come from Saket Kalia with Barclays."
},
{
"speaker": "Saket Kalia",
"text": "Okay, great. Hey, guys, thanks for taking my question here and echo the congrats on the quarter. Maybe for both, Shantanu and David. There are clearly just so many layers to the Firefly monetization story. But I think one theme that's coming out a little bit in this call and particularly interesting route to monetize is just the increased engagement that Firefly helps drive in your flagship products, right, or I think we call it sort of the interfaces, right? An example there would be like Generative Fill for Photoshop. And you've clearly started expanding that to other flagships like Premier and Illustrator. Maybe to go one level deeper, is there a way that you think about the potential opportunity from things like higher retention rates? Or any other way that -- I know it's really tough to size, but how have you sort of thought about it even qualitatively?"
},
{
"speaker": "David Wadhwani",
"text": "Yes, it's a great question. And yes, the core has been -- from the very beginning, we've talked to you guys about our primary focus for generative AI is about user adoption and proliferation, right? And that has continued to be the primary thing on our mind. And it's the primary thing on our mind for multiple reasons. And to your point, there are many different ways that we can monetize this. First is, as you think about the growth algorithms that we always have in our head, it always starts with, as Shantanu said, new users, right? And then it's about getting more value to existing users at higher ARPU, right? So in the context of new users, first and foremost, we want to make sure that everything we're doing generative AI is embedded in our tools, starting with Express, right? So we have Express in the market. We're seeing a lot of adoption and usage of Express in the market. As that's happening, we're infusing generative AI more and more into Express in a whole host of ways. And that's really helping, everything from our marketing message for the completeness of the AI offering in there, all the way through to user engagement and success in onboarding and retention. Similarly, though, this is having the same effect in our core Creative products as well, right? The introduction of Firefly combined with some of the product-led growth work we've been doing, in particular, something called the Context Bar makes it easy for new users coming in to just be more successful out of the gate which then, of course, helps with both conversion and retention. And then with AI Assistant, the ability to sort of embed that into the purchase flow for Acrobat and get a high attach rate, we always talk about that as a would you like fries with it moment at Adobe when someone's going through the checkout flow, it's just a great way for people to say, look, this is value I want, I want to add it and buy up to the higher plans. So there are a lot of different mechanisms that we see. But by far, the strongest is going to be the fact that we are seeing people like in Creative Cloud migrating to the higher-priced plans because they include Firefly. And so we just want to get more value to these users as well."
},
{
"speaker": "Shantanu Narayen",
"text": "And in terms of the generation, Saket, I think we talked about it. We did a great job at MAX in London talking about some of the new functionality and releasing. Photoshop, I think we're up to 9 billion generations, and actually, I think the greatest amount of generations was in May. So the momentum clearly is the more we integrate this functionality into our interfaces, the more that usage is really driving adoption as well as retention."
},
{
"speaker": "Saket Kalia",
"text": "Very helpful. Thanks, guys."
},
{
"speaker": "Operator",
"text": "And our next question comes from Brent Thill with Jefferies."
},
{
"speaker": "Brent Thill",
"text": "David, on Express, you mentioned the success you're seeing. Can you maybe drill into some of the other metrics and accomplishments that you're seeing out of Express this quarter?"
},
{
"speaker": "David Wadhwani",
"text": "Yes. For starters, there's a lot of buzz of Express here at Adobe coming off the event we just had earlier this week, but it's really based on the fact that the innovation in Express is on a tear, right? A few months ago, we introduced an all-new Express for the web. This quarter, we introduced an all-new Express for mobile. We introduced Express for Business. We also now have, as we've just talked about, been more deeply integrating AI features, whether it's for imaging generation or generative fill or text effects, character animation, design generations more deeply into the flow for Express. And that combination has led to an incredible set of metrics over the last quarter, in particular, but building throughout the year. Express MAU is growing very quickly. We talked about on the -- in the script earlier that MAU on mobile has more than doubled quarter-over-quarter, which is fantastic to see. And cumulative exports, if you look at year-over-year it has grown by over 80%. So really feeling good about sort of the momentum we're seeing. But if you take a step back, I think it is important to take a step back and understand our vision. Express that is now in market is built on a brand-new platform, right? And that brand-new platform lays the groundwork for the AI era. And this will be -- Express will be the place that anyone can come and create through a combination of conversational and standard inputs. That's the vision that we have. And I think it's an opportunity for us to really leap forward in terms of what we can do on the web and mobile at Adobe. And it's taken us a little time to get here. It hasn't happened overnight. But now that we are here, we are going to pour the gas on go-to-market, right? You know what we can do with our data-driven operating model. We've been ramping up what we're doing in Digital and Adobe.com journeys. We now can do the same thing and unleash all of that expertise in the mobile app store. You know what we're capable in terms of our product-led growth motions. We've now embedded Express Workflows into Acrobat Editor. We obviously have been embedding it into Creative Cloud workflows. And also, as we showed at Summit with Anil, we've embedded it into our Experience Cloud workflows as well. In addition to all of that, we're now unleashing our inside sales force to target the small/medium businesses. Our education teams are really gearing up for the back-to-school launch for K-12 and higher ed. And our field and enterprise sales now have Express for Business. So -- and we're doing all this globally, right? It's a massive market, and we're ramping up and we're ready to go."
},
{
"speaker": "Brent Thill",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And the next question comes from Gregg Moskowitz with Mizuho."
},
{
"speaker": "Gregg Moskowitz",
"text": "Hey, thank you very much. And I'll add my congratulations. For your Creative business, how are you thinking about the Q side of the P times Q equation over the balance of the year? Based on these numbers anyway, I would certainly assume that you had really healthy unit growth in Q2. And I'm wondering if you expect that to continue."
},
{
"speaker": "David Wadhwani",
"text": "Yes. I mean, again, I think what -- it is this mix of product innovation that we've been putting out there and the steady drumbeat of that. A lot of it getting attention because of the quality and the hooks of AI and being able to sort of bring people, onboarding them quickly and successfully into the product. And then as we talked about, the more they use these AI features, the more they retain. And we feel really good about really that whole workflow. So yes, the new user growth continues to be our primary focus. And when you add in everything we're doing with Express, we're -- again, like I said, we're off to the races and we feel very good about the momentum on new user acquisition and existing member retention."
},
{
"speaker": "Shantanu Narayen",
"text": "And Gregg, as you're aware, I mean, certainly with Express, we also have the model of customer acquisition as it relates to people coming in through trial and free and then conversion. So we are seeing the interest level as it relates to Express, in particular, significant interest."
},
{
"speaker": "Gregg Moskowitz",
"text": "And Shantanu, since you also called out the strength in Digital earlier, including driving new Creative All Apps subscriptions from your website, are you doing anything different that's helping to drive that behavior? And if so, is that something you think can continue as well?"
},
{
"speaker": "Shantanu Narayen",
"text": "I would, Gregg, sort of modesty say, we've been world-class at sort of driving that for a long time now. But the team, I think, continues to do an amazing job. And I would say David referred to the DDOM. Adobe Home is now sort of increasingly the way that we're driving a lot of people to get aware of our new products. And so, I would say the mobile part as well and the mobile journeys, as we've got these mobile products, whether it's Lightroom or whether it's certainly, Express, that's an area of increasing focus for us. And the traditional sort of understanding where search terms are, I think we're getting better and better at that, which leads to way more digital traffic for us. So I think it's across the board. But I'd also highlight, I mean, the commerce team that we have at Adobe that understands what the segments are and how for those particular segments we can attract people, that's great. I mean, I think in the prepared remarks, Dan also talked about the strength in emerging markets. And I think the beautiful part about AI is that since they need access to the cloud to get all of the AI functionality, emerging market growth has been really strong for us."
},
{
"speaker": "Gregg Moskowitz",
"text": "Very helpful. Thank you."
},
{
"speaker": "Operator",
"text": "And moving on to Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Thank you guys for taking the question. And again, congratulations on a really solid set of results in an environment where not very many software companies have been able to beat and raise in this type of uneven environment. I wanted to maybe focus in a little bit on the question that Mark Moerdler asked, in particular on what gives you guys the confidence to see a return to year-on-year growth and Creative Cloud net new ARR. It declined in Q2, it declined in Q1. And if I'm not mistaken, the decline in Q2 was a little bit steeper than what we saw in Q1. So what are the particular drivers and maybe some detail on those drivers that give you guys the confidence that, that trend line that has been actually heading in the wrong direction is going to head in the right direction now? We're actually going to see growth in those metrics in Q3 and Q4?"
},
{
"speaker": "David Wadhwani",
"text": "Yes. Thanks, Keith. This is one of the areas that I think we've shared with you the complexity of the year-over-year comparisons in the first half based on prior pricing marks that we had. But more importantly, to your point, the year-over-year complexities are now behind us. And we're very excited about the momentum of the first half and how it sets us up for the second half, frankly, across both Document Cloud and Creative Cloud. Both are really momentum stories. The 478 -- the 487, sorry, just to be clear, the $487 million that we printed this time is obviously strong performance, and it implies that both CC and DC came in over what the growth -- the guide would have implied otherwise, right? So it's giving us a lot of good momentum going into the back half. Now the momentum is really driven by three things, and just I'll try to share a little bit more context here and hopefully gives you. First is new user acquisition, right? We're seeing Express starting to perform well in terms of bringing a lot of new users into the franchise across mobile and web. AI Assistant in Reader has been a really nice start for us, and we've been very pleased with how the uptake on that's going. And then Firefly itself, as I mentioned, has been increasingly more productive in terms of bringing in onboarding users and then retaining users because of the growth. We continue -- as we drive that more holistically throughout the product set, we start to see more people using it, including, as Shantanu mentioned earlier, in emerging markets. So we are seeing very good strength and usage in emerging markets, and that has certainly been a bright spot for us, which is something that obviously represents a lot of potential and upside for us. In terms of existing customers, the migration has been going very well for us as well. So, more people are moving to the higher-priced, higher-value plans because of the Firefly capabilities. We're even seeing this in enterprises where people are moving up to the highest versions of Creative Cloud, which is what we call it, Creative Cloud Enterprise 4, because they get more access to features beyond just generation. They have more collaborative capabilities beyond just kind of sharing via e-mail. And we're starting to see that create a nice momentum in upgrade cycles in the enterprise segment as well. And then certainly, let's not forget the new offerings, too. While still early, automation and content production is something that we're driving effectively in a lot of these accounts with Firefly services. So that mix of new users, existing user migration, and also the new offerings that we have in market are driving that growth formula that we talked about, which is now P times Q plus V for value with these automation systems."
},
{
"speaker": "Keith Weiss",
"text": "That is a great answer. Thank you so much."
},
{
"speaker": "Operator",
"text": "And we have a question from Brad Sills with Bank of America."
},
{
"speaker": "Bradley Sills",
"text": "Oh, great. Thank you so much. I wanted to ask a question around the generative credit component to your pricing here. It seems like with all the progress you've made embedding Firefly across the key flagship products and the engagement levels that you're seeing, we should start to see perhaps some ramp in that generative credit component to your pricing. Is that a fair assessment? Would you expect to start to see that coming in? Or should we look to other services like the video capabilities that you're going to be launching shortly as a key catalyst there? Thank you."
},
{
"speaker": "Shantanu Narayen",
"text": "I think you're right, Brad. When we think about what we've done with imaging and video, we've done the right thing by making sure the higher-value paid plans that people don't have to think about the amount of generative capability. And so there, the balance between for free and trialist users, they're going to run into the generative capability limits and, therefore, have to subscribe. But for the people who actually have imaging and vector needs, that they're not constantly thinking about generative, I think we actually got it right. To your point, as we move to video, expect to see different plans because those plans will, by necessity, take into account the amount of work that's required to do video generation. So you're absolutely right as a sort of framework for you to think about it. The two other things that I would say is, I mean, clearly, Express is really being driven by sort of the need for AI and how people are able to describe what they want and get the final output. When David talked about exports, just to clarify what that means is people who have successfully got what they want to get done, done. And that's a key measure of how we are doing it, and AI is certainly facilitating and accelerating that. And last thing I would say, Brad is, as you know, on the Acrobat side, it's a slightly different model which we like, which is anybody who has Reader and is looking at a document, they can have an upsell to their AI Assistant. If you have Acrobat Pro, you can upsell to the AI Assistant. And if you're a brand new acquisition of a user when you're coming in, the adoption of the highest-value products, so between Standard Pro and Pro Plus Assistant, we've been pleased to see how many people are migrating to the Pro Plus Assistant. So hopefully, that gives you some color of how we think about it differently by product."
},
{
"speaker": "Bradley Sills",
"text": "Very helpful. Thank you, Shantanu."
},
{
"speaker": "Operator",
"text": "And we'll take a question from Brad Zelnick with Deutsche Bank."
},
{
"speaker": "Brad Zelnick",
"text": "Great. Thank you so much and congrats to all of you. I don't want Anil to feel left out, so I'm going to ask a DX question. Anil, it's good to hear AEP is on track to become the next billion-dollar business for Adobe. Can you expand on the journey and drivers that get you there? And in particular, how important are cloud migrations? And how do you see AEP AI Assistant perhaps accelerating the journey to $1 billion? Thanks."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thank you, Brad. Appreciate it. As you know, I mean, customer experience management and especially it's been a hugely important priority area for Chief Marketing Officers and with CIOs and Chief Digital Officers as well. And for us, we are focused on personalization scale, which is really built around the AEP platform. We're the largest provider in this space. We're growing faster than any of our peers, and we're the number one Digital Experience platform as a result. And that has really helped us keep the momentum. When you think about the AEP AI Assistant, it's doing a couple of things. One, it's really making it easier for customers to deploy use cases. When you think of use cases that they have around, for example, generating audiences and running campaigns around those audiences, these are things today that require some data engineering. They require the ability to put these audiences together. So they require marketing and IT teams to work together. The AEP AI Assistant is making it much easier for marketers to be able to do it themselves and be able to deploy a lot more use cases. So as there's more usage, it will help drive more consumption and help drive the growth in terms of number of profiles, number of users, and we help -- we see it helping us grow towards that billion-dollar business."
},
{
"speaker": "Brad Zelnick",
"text": "Great to hear, and keep up the great work, guys. Thanks."
},
{
"speaker": "Jonathan Vaas",
"text": "Hey, operator, we're almost at the top of the hour. We'll take two last questions and then wrap up. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. We'll take a question from Kash Rangan with Goldman Sachs."
},
{
"speaker": "Kash Rangan",
"text": "Hi, thank you very much. You guys could have three separate earnings calls because you have three different businesses that even the smallest one is very large. So yes, sorry, Anil, Dave, and Shantanu, I may not be able to ask all the questions that I want. I'm sure we have plenty. But I'll just keep it super high level, Shantanu. Generative AI, it seems to swing back and forth. Just so early in its evolution, the possibilities seem magical sometimes, endless sometimes, sometimes it feels very disappointing. But with every quarter that Adobe is executing on this path, where do you stand with the question that we do get from investors? Will generative AI be so good that it's the end of the creative process? So we don't need creative folks, that software will do everything? That sounds a little far-fetched, but I'm just throwing it out there to see how you would react that proposition. Same in Experience Cloud as well. Could generative AI create its own marketing campaign, put marketing people out of business? Or maybe it doesn't. I'm sure you have strong views. Maybe flipped on the other side, it does create category growth on the other hand, not category compression. So sorry for that super high-level question, but that seems to be a big debate on the stock here, at least from the long-term perspective. Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes, Kash. I think there are two things when we talk to investors that are perhaps on their mind. I mean, I think the first is it's fair to say that the interest that exists right now from investors as it relates to AI is all associated with the infrastructure and chips and perhaps rightly so because that's where everybody is creating these models. They're all trying to train them. And there's a lot of, I think, deserved excitement associated with that part of where we are in the evolution of generative AI. If the value of AI doesn't turn to inference and how people are going to use it, then I would say all of that investment would not really reap the benefit in terms of where people are spending the money. And so we're always convinced that when you have this kind of disruptive technology, the real benefits come when people use interfaces to do whatever task they want to do quicker, faster, and when it's embedded into the workflows that they're accustomed to because then there isn't an inertia associated with using it. So with that sort of as a broad segment, I am a big believer that generative AI is going to, for all the categories that we're in, it's actually going to dramatically expand the market because it's going to make our products more accessible, more affordable, more productive in terms of what you -- what we can do. I'm still acting CMO at the company, and I see the excitement around how we can, with agility, create way more content, create variations. When Anil talked about personalization at scale, I think there are two aspects to it, right? I mean, the first was always data, and Anil and the team have done a great job with sort of the real-time customer data platform to get that. And that's hydrated with users. But the real value is when you infuse that with the right content to make that personalized experience. So I think the demand is there for way more content than people can do, and generative AI is going to be an accelerant in that as well. And so net-net, I am absolutely betting on the fact that five years from now, there will be more people saying, I'm using creative tools to accomplish what I want, and there'll be more marketers saying, I can now, with the agility that I need, truly deliver a marketing campaign and an audience that's incredibly more specific than I could in the past. And that's Adobe's job to demonstrate how we are both leading in both those categories and to continue to innovate. But I recognize and I understand the question that exists in the industry associated with AI. If the value doesn't accrue to interfaces, I'll leave you with that. I think the investment would not be as beneficial as I believe it can be."
},
{
"speaker": "David Wadhwani",
"text": "And maybe one thing to add to that, Kash, just to build on what Shantanu was talking about. I think the other thing we get asked a fair amount is about the comparison between different models, right? So Firefly might be better at something. Midjourney might be something at something else. DALL-E might do something else. And the key thing here is that around this table, we get excited when models innovate. We get excited when Firefly does something amazing. We get excited when third-party models do something because our view, to Shantanu's point, is that the more content that gets generated out of these models, the more content that needs to be edited, whether it's color correction, tone matching, transitions, assembling clips, or masking composite images. And the reason for this is that this is not a game where there's going to be one model. Each model is going to have its own personality, what it generates, what it looks like, how fast it generates, how much it costs when it generates that, and to have some interface layer to help synthesize all of this is important. And so just sort of to note, we've said this before but I'll say it again here, you will see us building our products and tools and services leveraging Firefly for sure, but you'll also see us leveraging best-of-breed personalities from different models and integrate them all together."
},
{
"speaker": "Kash Rangan",
"text": "Awesome, the message here is that, gen AI is going to create more growth in the category. And Shantanu, you did that with the pivot to cloud. You grew the category, so here we go again. Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Kash."
},
{
"speaker": "Operator",
"text": "And next will be Jake Roberge with William Blair."
},
{
"speaker": "Jacob Roberge",
"text": "Hey, thanks for taking the question and I'll echo my congrats on the great quarter. I know it's early, but what's been the feedback and customer behavior for those users that are on Firefly services and GenStudio? And then thinking more longer term, what type of price uplift could you see from those customers over time, just given what you said about the acceleration in Firefly generations being driven by those products? Thanks."
},
{
"speaker": "David Wadhwani",
"text": "Maybe I'll start with customer zero. Right before this meeting, I was in a meeting with our CMO. And well, sometimes it's hard to tell, he's running the CMO or CEO head, but CMO this time. And we were reviewing a full-funnel campaign that we're planning on launching later this year. And exactly as Shantanu mentioned earlier, we saw benefits in terms of cost of the campaign, faster time to market for the campaign, and the amount of content that we can create to personalize that campaign. And that is one of those things that we've been doing more and more around our DDOM, which has actually been very productive for us, as you can see this quarter, and what we're pitching to other customers. So we've been working with -- we listed some of the customers earlier, but we've been working with a long list of customers on everything from accelerating the content creation for social, accelerating content creation for regional, and then increasing the number of amount of content that's created for increased personalization, which then, of course, flows through all of the Experience Cloud products that Anil is working on to get targeted better."
},
{
"speaker": "Shantanu Narayen",
"text": "And Jake, maybe in terms of what I would say we're seeing usage of, I think the initial usage of Firefly services in most companies was all around ideation. How can they create multiple variations of them and in the ideation process really just accelerate that ideation process? Most companies are then starting with as they're putting it into production, how can they, with the brand assets and the brand guidelines that they have, do this in terms of the variations, whether they be geographic variations or they be just variations? I mean, if you take a step back also, every single ad company right now will tell you that the more variance that you provide, the better your chances are of appropriately getting an uplift for your media spend. So I would say that most companies are starting with creating these variations for geographies. The other one that we see a fair amount of is engaging with their communities. So when they want their communities to have assets that they have blessed for usage within community campaigns, that's the other place where Firefly services are being used. And a company has a community portal where the community can come in, take something and then post whether it's on whatever social media site that you want. So I think that's the initial one. All of the agency companies are companies that have actually even publicly said how GenStudio is something that they have embraced. But even the large media companies, because the media companies are certainly interested in understanding how all of this gen AI could be used to automate as well as accelerate the amount of content that they can produce. So hopefully, that gives you some color of it. If there's been sort of the questions that they ask along the way, which hopefully and actually, luckily, we have great answers, it's all around the indemnification and how they can use it. And I would say that continues to be a really key differentiator for us. But since that is the last question, let me just say I'm proud of how we executed in Q2, both across the product innovation, delivery as well as the go-to-market because clearly, a number of you asked how we were able to put together these numbers where others have perhaps talked about the macroeconomic environment. We certainly remain focused on leveraging technology to light a broader set of customers. And at the end of the day, to the questions that we were asked, we believe that the real value of AI will be in the interfaces that individuals, enterprises use to accomplish their tasks and workflows. And we think we're incredibly well positioned. So thank you for joining us."
},
{
"speaker": "Jonathan Vaas",
"text": "Thanks, everyone. This concludes the call."
},
{
"speaker": "Operator",
"text": "Thank you. This does conclude today's conference. We do thank you for your participation, and have an excellent day."
}
] | Adobe Inc. | 24,321 |
ADBE | 1 | 2,024 | 2024-03-14 17:00:00 | Operator: Good day, and welcome to the Q1 FY 2024 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, Vice President of Investor Relations. Please go ahead.
Jonathan Vaas: Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's first quarter fiscal year 2024 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, March 14, and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant-currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe's Investor Relations website. Adobe Summit is just around the corner in Las Vegas at The Venetian Convention and Expo Center beginning on Tuesday, March 26. Following the day one keynote, we will host an Investor Meeting at 2:00 PM Pacific Time. The event will be webcast live and the replay will be available on Adobe's IR website. More details about the summit are available at summit.adobe.com. I will now turn the call over to Shantanu.
Shantanu Narayen: Thanks, Jonathan. Good afternoon, and thank you for joining us. Adobe had a strong first quarter. We achieved $5.18 billion in revenue in Q1, representing 12% year-over-year growth. GAAP earnings per share for the quarter was $1.36, and non-GAAP earnings per share was $4.48, representing 18% year-over-year growth. Our performance reflects the essential role that Adobe products play in driving the global digital economy. We're delivering on our strategy to unleash creativity for all, accelerate document productivity and power digital businesses. Adobe Creative Cloud, Document Cloud and Experience Cloud are more critical than ever to the success of creators, communicators, students, entrepreneurs, and businesses of all sizes with AI serving as an accelerant for all. We are a leader in delivering generative AI across all our clouds. We're taking a highly differentiated approach across data, models and interfaces. Our proprietary data is built on decades of deep domain expertise across creative, documents and customer experience management. We leverage large language models, as well as have invested in building and delivering our proprietary models in the creative document and marketing domains. Our IP-friendly approach is a differentiator for creators and enterprises. In addition, we've innovated by delivering generative AI directly in products with releases in Adobe Photoshop, Illustrator and Express across both desktop and mobile. AI Assistant in Acrobat and Reader unlocks the tremendous value of the trillions of PDFs around the world. We're bringing generative AI to Adobe Experience Cloud and will demonstrate our AI Assistant for Customer Experience Management at Adobe Summit. Every student, communicator, creative professional and marketer is now focused on leveraging generative AI to imagine, ideate, create and deliver content and applications across a plethora of channels. Adobe is uniquely positioned through the combination of Express, Firefly, Creative Cloud, Acrobat and Experience Cloud to deliver on this immense market opportunity. The success we are already seeing with our GenStudio offering in the enterprise is validation of our leadership, and we expect that success to translate into other segments as we roll out these solutions throughout the year. We are driving strong usage, value and demand for our AI solutions across all customer segments. We're successfully monetizing our innovations with particular strength in Q1 in the Enterprise segment across our Digital Media and Digital Experience businesses. This strength is reflected in our strong RPO growth of 16% year-over-year. We're pleased with a strong Q1. We have a phenomenal product roadmap that we're executing against to bring AI innovation across our global customer base and we're just getting started. I'll now turn it over to David to discuss the momentum in our Digital Media business.
David Wadhwani: Thanks, Shantanu. Hello, everyone. In Q1, we achieved a net new Digital Media ARR of $432 million and revenue of $3.82 billion, which grew 13% year-over-year. The world's information whether it's an enterprise legal contract, a small business invoice or a personal school form lives in trillions of PDFs. We were thrilled to announce Acrobat AI Assistant, a massive leap forward on our journey to bring intelligence to PDFs. With AI Assistant, we're combining the power of generative AI with our unique understanding of the PDF file format to transform the way people interact with and instantly extract additional value from their most important documents. Enabled by a proprietary attribution engine, AI Assistant is deeply integrated into Reader and Acrobat workflows. It instantly generate summaries and insights from long documents, answers questions through a conversational interface, and provides an on-ramp for generating emails, reports and presentations. AI Assistant is governed by secure data protocols so that customers can use the capabilities with confidence. We are pleased with the initial response to the English language beta and look forward to usage ramping across our customer base as we release other languages later in the year. We will monetize this functionality through a monthly add-on offering to the hundreds of millions of Reader users as well as the Acrobat installed base across individuals, teams and enterprises. In Q1, we achieved Document Cloud revenue of $750 million, growing 18% year-over-year. We added $143 million of net new Document Cloud ARR, which was a Q1 record with year-over-year ending ARR growth of 23% in constant currency. Other business highlights include Acrobat Web continues to be an incredible source of customer acquisition with monthly active users up over 70% year-over-year and surpassing 100 million users in Q1. Acrobat extensions for Microsoft Edge and Google Chrome and our Acrobat Mobile offerings continue to accelerate free-to-paid conversion. Increased viral adoption through link sharing and stakeholder collaboration drove over 300% year-over-year growth in the number of PDF files sent. Key enterprise customer wins include Berkshire Hathaway, Merck Sharp & Dohme, Northrop Grumman, Porsche, and the U.S. Navy. On Creative Cloud, creativity is the currency of differentiation in our digital-first world. Every creator and business is focused on building their brand and engaging with their audiences through standout content. Creative Cloud remains the solution of choice for the world's creators, whether their medium is design, photography, video, illustration or 3D. Adobe Express is inspiring millions of users of all skill levels to design more quickly and easily than ever before. In the year since we announced and released Adobe Firefly, our creative generative AI model, we have aggressively integrated this functionality into both our Creative Cloud flagship applications and more recently, Adobe Express, delighting millions of users who have generated over $6.5 billion assets to date. In addition to creating proprietary foundation models, Firefly includes a web-based interface for ideation and rapid prototyping, which has seen tremendous adoption. We also recently introduced Firefly Services, an AI platform which enables every enterprise to embed and extend our technology into their creative, production and marketing workflows. Firefly Services is currently powered by our commercially safe models and includes the ability for enterprises to create their own custom models by providing their proprietary datasets as well as to embed this functionality through APIs into their email, media placement, social and web creation process. Early adopters like IBM are putting Firefly at the center of their content creation processes. IBM used Adobe Firefly to generate 200 campaign assets and over 1,000 marketing variations in moments rather than months. The campaign drove 26X higher engagement than its benchmark and reached more key audiences. In Q1, we achieved $3.07 billion in revenue, which grew 12% year-over-year. Net new Creative Cloud ARR was $289 million. Other business highlights include new the launch of the new Adobe Express mobile app beta brings the magic of Adobe Firefly AI models directly into mobile workflows. The first-of-its-kind integration with TikTok's creative assistant makes the creation and optimization of social media content quicker, easier and more effective than ever before. Express Web usage continues to ramp nicely with total exports more than doubling year-over-year and overall Express adoption is expected to accelerate even further, given the positive reception we're seeing from the mobile beta. Generative Fill in Photoshop continues to empower creators to create in new ways and accelerate image editing workflows. Q1 saw the highest adoption of Firefly powered tools in Photoshop since the release of Generative Fill in May 2023 with customers adopting these features across desktop, web and most recently, iPad, which added Generative Fill and Generative Expand in December. The beta release of AI-powered Enhance Speech and new audio workflows drove premiere beta usage to record highs. Adobe video tools were the go-to choice at Sundance Film Festival with over 80% of this year's entrants using Adobe software. The introduction of Behance Pro, a new offering to serve the rapidly growing Behance community empowers members to build their brand and find opportunities, and for businesses to hire talented creators through the Behance platform. The unveiling of new research like the preview of our music generation models and editing tools last month and our video auto dubbing models earlier today have inspired our Creative Cloud and Express customers. The introduction of Firefly Services for enterprises drove notable wins in the quarter, including Accenture, IPG and Starbucks. Other key enterprise wins include AECOM, Capital Group, Dentsu, IBM, Nintendo and RR Donnelley. Given the size of opportunity we see with generative AI, we continue to focus on driving innovation, adoption and usage of our AI solutions. In Q1, we saw strength across both clouds with record new commercial subscriptions in Creative Cloud for Q1, and strong product-led growth in Document Cloud. You can expect to see the product advances and Express with Firefly on mobile. Firefly Services and AI Assistant in Acrobat drive ARR acceleration in the second half of the year. We're excited about our product roadmap. The 6.5 billion assets generated to date include images, vectors, designs and text effects, and we can't wait to share the work we're doing on audio, video and 3D through research sneaks and product announcements in the coming months. I'll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello, everyone. Experience Cloud business had a great first quarter, achieving $1.29 billion in revenue and was our strongest Q1 on record for new business. Subscription revenue was $1.16 billion, representing 12% year-over-year growth. Companies are prioritizing digital investments to improve marketing agility and customer engagement while driving growth and profitability. Adobe's holiday shopping report which analyzes trillions of data points, showed strong online spending during the 2023 holiday season, growing 4.9% year-over-year to $222.1 billion, a new record for e-commerce as well as mobile shopping, which surpassed desktop for the first time and drove 51.1% of online sales. Our Adobe Experience Cloud applications span the entire customer funnel from acquisition to monetization to retention. As the global leader in the Digital Experience Platforms category, Adobe offers businesses a single view of their customers' data across every channel, allowing them to create precise segments and deliver personalized experiences regardless of when and where the customer interacts with their brand. Over the last five years, our organic innovations in Adobe Experience Platform, Realtime CDP, Journey Optimizer, and Customer Journey Analytics have made us the leading platform for customer experience management given the scale of the profiles, campaigns and interactions we process, which now exceed 500 trillion segment evaluations per month. Today, rollout of personalization at scale has been limited by the number of content variations you can create and the number of journeys you can deploy. We believe harnessing generative AI will be the next accelerant with Creative Cloud, Firefly Services and GenStudio, providing a comprehensive solution for the current supply-chain, and generative experienced model automating the creation of personalized journeys. Adobe GenStudio is the generative AI first application that allows marketers to quickly plan, create, store deliver and measure marketing content in a single intuitive offering. With state-of-the-art generative AI powered by Firefly Services, marketers can create on-brand content with unprecedented scale and agility to deliver personalized experiences. Adobe GenStudio natively integrates with multiple Adobe applications across Creative Cloud and Experience Cloud, including Express, Firefly, Workfront, Experience Manager, Customer Journey Analytics, and Journey Optimizer. It can be used by brands and their agency partners to unlock new levels of creativity and efficiency in marketing campaigns. Business highlights include momentum with Adobe Experience Platform and native applications with the combined annualized book of business surpassing $800 million in the quarter. Demand for Adobe Experience Manager, Workfront and GenStudio to address the enterprise content supply chain. Global agencies, including Accenture, Havas, IPG, Omnicom, and Publicis have standardized on Adobe as their technology platform of choice for their own workflows and to optimize creative collaboration with the world's leading brands. Strength in Adobe Journey Optimizer on Adobe Campaign as companies look to deliver more personalized experiences across channels and surfaces. Adobe was recognized as a leader in the Gartner Magic Quadrant for Digital Experience Platforms for the seventh consecutive year, as well as the Forrester Wave for Digital Experience Platforms. Adobe Experience Manager assets was also named a leader for the fourth consecutive time in the Forrester Wave for Digital Asset Management. Key customer wins include Carl Zeiss, Comcast, Home Depot, NASCAR, Nestle, PayPal, Rogers Communications, Santander Group, Starbucks and Walgreens. Later this month, we are excited to host Adobe Summit, the world's largest digital experience conference in Las Vegas, where we will be joined by thousands of customers, partners, and developers from around the world. We look forward to showcasing a number of product innovations, including a new generative experienced model, advances in Adobe GenStudio, a new AI Assistant in Adobe Experience Platform, new capabilities in RT CDP for first-party data activation and expanded Firefly Services offerings. We will articulate our vision and playbook for brands to achieve a new level of personalization at scale in the era of generative AI. We look forward to sharing our exciting product roadmap and hearing from our customers and how Adobe is helping them transform their business. We were off to a fast start in Q1 and look forward to continuing the momentum and leadership in Q2 and beyond. I will now pass it to Dan.
Dan Durn: Thanks, Anil. Today, I'll start by summarizing Adobe's performance in Q1 fiscal 2024, highlighting growth drivers across our businesses, and I'll finish with financial targets. In Q1, Adobe delivered another quarter of double-digit top line growth with robust margins that result from product leadership, strong execution, and financial discipline. The pace of our product innovation across Document Cloud, Creative Cloud, and Experience Cloud is leading to customers making large multi-year commitments to Adobe. And you see the result of those customer investments in our RPO performance, which accelerated to 16% year-over-year growth. In the quarter, Adobe achieved record revenue of $5.18 billion, which represents 11% year-over-year growth, or 12% in constant-currency. Business and financial highlights included GAAP-diluted earnings per share of $1.36 and non-GAAP diluted earnings per share of $4.48. Digital Media revenue of $3.82 billion, net-new Digital Media ARR of $432 million, Digital Experience revenue of $1.29 billion, cash flows from operations of $1.17 billion, RPO of $17.58 billion exiting the quarter, and repurchasing approximately 3.1 million shares of our stock during the quarter. GAAP EPS came in lower due to the $1 billion payment resulting from the termination of the Figma transaction. Absent the termination payment, our cash flows from operations would have been $1 billion more, and GAAP EPS would have been $2.19 higher. The termination payment impacts both Q1 GAAP EPS and our full-year fiscal 2024 GAAP EPS. In our Digital Media segment, we achieved Q1 revenue of $3.82 billion, which represents 12% year-over-year growth, or 13% in constant currency. We exited the quarter with $15.76 billion of Digital Media ARR, up 14% year-over-year in constant currency. Adobe achieved Document Cloud revenue of $750 million, which represents 18% year-over-year growth as reported and in constant currency. We added $143 million of net new Document Cloud ARR in the quarter. Q1 Document Cloud growth drivers included demand for Acrobat subscriptions across all customer segments and geographies. Continued growth of Acrobat Web demonstrating the success of our flagship products across multiple surfaces, growing monthly active users in our Acrobat Reader Funnel driving free-to-paid conversion. New user acquisition resulting from our Microsoft Edge and Google Chrome partnerships. Strength in our Teams business with up selling our new Acrobat offering which includes integrated signed capabilities, and strong demand from businesses of all sizes, demonstrating the mission criticality of our Document Solutions. We achieved Creative revenue of $3.07 billion, which represents 11% year-over-year growth, or 12% in constant currency. We added $289 million of net new creative ARR in the quarter with ending ARR growing 12% year-over-year in constant currency. Overall CC pricing actions performed as expected in the quarter. Q1 net new Creative ARR grew more than 20% year-over-year, excluding the impact of pricing actions associated with both Acrobat CC and All Apps in the year-ago quarter and Creative Cloud in Q1 FY '24. Q1 Creative growth drivers included new subscription growth, including strong adoption of Creative Cloud All Apps across geographies and customer segments. Strong single-app customer demand in creative categories such as imaging and photography, and continued growth of stock and Frame.io. We again saw strength in emerging markets, which we continue to believe is a massive growth opportunity and outstanding performance of Creative Cloud in the enterprise including early traction of Firefly services. Turning to our Digital Experience segment. In Q1, we achieved revenue of $1.29 billion, which represents 10% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.16 billion, growing 12%year-over-year as reported and in constant currency. Q1 was a tremendous start to the year for our Experience Cloud business with growth drivers, including: success closing transformational deals across geographies and verticals with large enterprises that are choosing Adobe to be their end-to-end customer experience management platform, continued momentum with AEP and native applications with the annualized book of business growing more than 60% year-over-year, strong customer adoption of our content, campaign and Workfront solutions, and continued strength with customer retention and expansion across our products. Customer Experience Management remains an enterprise imperative. And as a leader in the category, we see a robust pipeline as we look into Q2 and beyond. Turning to the income statement and balance sheet. Adobe's effective tax rate in Q1 was 36% on a GAAP basis and 18.5% on a non-GAAP basis. The Q1 GAAP tax rate came in higher than targeted due to the Figma termination payment. RPO exiting the quarter was a record $17.58 billion, growing 16% year-over-year as reported and in constant currency. Our ending cash and short-term investment position exiting Q1 was $6.82 billion, and cash flows from operations in the quarter were $1.17 billion. In Q1, we entered into a $2 billion share repurchase agreement, which effectively exhausted our prior $15 billion authority. As a result of our strong trajectory of growth and profitability, we are announcing a new $25 billion share repurchase program, which demonstrates Adobe's continued commitment to returning capital to our shareholders. In light of the momentum across our business and factoring in the macroeconomic environment, for Q2, we're targeting total Adobe revenue of $5.25 billion to $5.30 billion; Digital Media net-new ARR of approximately $440 million; Digital Media segment revenue of $3.87 billion to $3.90 billion; Digital Experience segment revenue of $1.31 billion to $1.33 billion; Digital Experience subscription revenue of $1.165 billion to $1.185 billion; tax rate of approximately 18.5% on a GAAP and non-GAAP basis; GAAP earnings per share of $3.35 to $3.40, and non-GAAP earnings per share of $4.35 to $4.40. In summary, fiscal 2024 is off to a strong start. By combining the power of product innovation and executional excellence, Adobe is driving consistent profitable growth. We're delivering on our product roadmap, and we have the right strategy to monetize these innovations into the back half of the year and beyond. Adobe is incredibly well-positioned to capitalize on the secular trends that will shape the next decade. Shantanu, back to you.
Shantanu Narayen: Thanks, Dan. We're the leader in three large and growing categories and have delivered groundbreaking innovation across Creative Cloud, Document Cloud and Experience Cloud. We believe that AI augments human ingenuity and expands our addressable market opportunity. I'm proud of the pace and the responsible manner in which we have embraced and delivered generative AI capabilities across our product portfolio. As a result of our strategy and execution, we're confident in our ability to attract new users and deliver value to existing customers to drive growth and profitability. I'd like to thank our 30,000 employees for their continued dedication and unwavering focus on innovation and execution. It is particularly exciting to be named to Glassdoor's Best Places to Work, Fortune's Most Admired Companies, and he JUST 100. Thank you, and we will now take questions. Operator?
Operator: Thank you. [Operator Instructions] Our first question comes from the line of Kirk Materne with Evercore ISI. Go ahead.
Kirk Materne: Yeah. Thanks. Thanks very much for taking the question. I guess maybe this is for David or Dan. Obviously, you guys called out that new creative ARR was up more than 20% year-over-year when you exclude the pricing increases which infers a pretty major pricing headwind that we're seeing right now. Can you all just try to parse out how that's going to play out over the year? I know David you mentioned ARR will go up in the back half of the year, but that it’s just tough I think to reconcile what's going on in the business on a normalized basis, and when we might see that sort of translate more into the metrics that everybody follows. Thanks.
Dan Durn: Yeah. I'll start and others can go ahead and add on. First of all, we do -- as we look at the book of the business, it is a strong start to the year with Q1 coming in at a high watermark with $432 million across the entire business. As we look specifically at Creative Cloud, I just want to sort of make sure everyone takes a step back and looks at our strategy to accelerate the business because I think the growth drivers here are very clear. We are focused on expanding access to users with things like Express on mobile. We want to introduce new offers across the business with things like AI Assistant and also existing capabilities for Firefly coming into our core Firefly, our core Photoshop and Illustrator and flagship applications. We want to access new budget pools with the introduction of Firefly Services and GenStudio as we talked about. And the early signs, as you point out in Q1 results are really suggesting that those growth drivers are taking hold. As you talked about normalizing for FY '23, FY '24 pricing actions, we grew the CC business about 20% year over year. Other key things to look at is that we set another record for new commercial subscriptions in Q1, and the business growth remains stable at -- if you look back at revenue 12% -- if you look forward at ARR 12%. So the stability and the diversity of the business is strong. And as we enter the back half of the year, we have capabilities for Creative Cloud pricing with Firefly that have already started rolling out late last year, as we talked about, and we'll be incrementally rolling out throughout the year. We're ramping Firefly Services and Express and Enterprise. As we talked about, we saw a very good beginning of that rollout at the -- toward the end of Q1. We also expect to see the second half ramping with Express Mobile and AI Assistant coming through. So we have a lot of the back-end capabilities set up so that we can start monetizing these new features which are still largely in beta starting in Q3 and beyond. And as it relates to pricing, it's what we've talked about in the past. We had two pretty significant pricing actions that benefited FY '23, the first one being the Acrobat price increases that we had put out with the new value that we had introduced with sign capabilities, and also a CC price increase that we introduced in FY '22 that was rolling into FY '23. Both of those are rolling off as we have now introduced the new pricing for CC with Firefly, and overall, the roll-off of the prior pricing is more significant than the new pricing that we've introduced.
Kirk Materne: Thanks.
Operator: And we will take our next question from Brent Thill with Jefferies. Please go ahead.
Brent Thill: Thanks. Shantanu, the magnitude of the beat this quarter was -- there was roughly half the absolute beat you've had in past quarters and then the guide obviously, lower for next quarter. I think everyone is asking is this some type of AI headwind? Is this macro? Is this execution? Can you just comment on -- and maybe it's none of these things, but can you just comment on what you think you're seeing in the current quarter?
Shantanu Narayen: Yeah. Happy to, Brent. And again, I'll reiterate that as it relates to us taking our targets pretty seriously. I mean, when we guided to $1.9 billion for the year, I mean, we had factored in both, as David mentioned, what was likely to happen in the pricing and how that rolls off, as well as the product roadmap, and when AI Assistant and Acrobat would be available, when Express, which is now in beta, would be available. So I think it factored in all of those. I guess if you are looking at it from accomplishment, we look at it and say hey, we did $410 million. I think last year we did $432 million. If we look at the guide and we're on track as it relates to the $1.9 billion, and to hopefully exceed that guide. And so from our perspective, it's playing out. Maybe the other color, Brent, that I would provide is given the desktop products are still in beta, and there we look at value and there we look at utilization. And so I think we gave you some numbers on the $6.5 billion generations that we're seeing, the really positive feedback that we're getting in Acrobat that continue to give us optimism associated with how that is. I think where there's tremendous interest and where if you look at it from an AI monetization, the two places that we're monetizing extremely in line with our expectations. The first is as it relates to the Creative Cloud pricing that we've rolled out. And as you know, the generative packs are included for the most part in how people now buy Creative Cloud, that's rolling out as expected. And the second place, where we are monetizing it is in the entire enterprise as it relates to Content and GenStudio. And I'm really happy about how that's monetizing it. I mean, that's a combination, Brent, of when we go into an enterprise for creation, whether we provide Creative Cloud or a combination of Express, what we are doing with asset management in AEM, workflow, as well as Firefly Services to enable people to do custom models as well as APIs. We're seeing way more monetization earlier, but again, very much in line with expected. So again, I look at the quarter and I feel really good, both about the product delivery as well as the way monetization is turning out. I mean, it's clear, I guess, a little bit from sort of what we've seen that expectations were perhaps a little higher, both in terms of what we would guide for Q2, but I'm really optimistic about what we have done.
Brent Thill: Thanks, Shantanu.
Operator: Your next question comes from the line of Brad Zelnick with Deutsche Bank.
Brad Zelnick: Great. Thanks so much for taking my question. My question is for Dan. You're not raising the full-year guide, and I appreciate it's still early in the year, but I think we're all hoping you can at least affirm it for us. But you also -- you pushed out the enforcement of generative credit limits for some products beyond April that were originally expected sooner. What's the thinking behind this decision? And what are you seeing thus far in terms of credit consumption and purchasing patterns of those credit packs? Thanks.
Dan Durn: Yeah. Thanks, Brad. I'll jump in on the first part, then toss it over to David for the second. So we're not updating the targets. What the targets we provided for the full year, they're, as of the December call. What we did share on the call was the material change that we saw in Q1 as a result of the Figma termination payment. We talked about the GAAP EPS impact. It rolls through Q1 and it'll certainly have an effect for the full year. And it's $2.19 as a result of the $1 billion payment. And I think with that, I think you have everything you need relative to where we set our targets, but we're not going to be updating them on this call.
David Wadhwani: Yeah. And I'm happy to add a little bit. Yeah, in terms of the timing of the -- when we start enforcing credits, don't read anything into that other than right now, we are still very much in an acquisition mode. We want to bring a lot of users in. We want to get them using the products as much as possible. We want them coming back and using it. One thing I do want to state because I know there's a lot of energy around how do these credits play out over time. In the last few weeks, we've done a couple of sneaks that could also be instructive. Last month, we snuck music composition, where you can take any music track, you can give it a music type like hip hop or orchestral or whatever, and it will transform that initial track into this new type of music. Just this morning, we snuck our ability to do auto dubbing and lip-syncing, where you give it a video of someone talking and saying English, and then you can translate it automatically to French or Spanish or Portuguese or whatever. As you can imagine those actions will not take one credit. Those actions will be much more significant in terms of what they cost. So right now, Alex, the primary point is about proliferation and usage. We're going to be bringing in a lot more new capabilities throughout the tools that will drive more usage, and we're going to be bringing in more expensive capabilities as well. And as we've talked about, you should start to see that ramp through the year, and we feel very comfortable with the adoption we're seeing. Just one last thing to call out, as we mentioned on the call, highest number of users using generative AI in Q1 ever so we're very excited about the trajectory.
Shantanu Narayen: And maybe just to add a little bit more of how we're thinking about it as it relates to the monetization of AI. I think we're in early stages as it relates to experimentation. So we're looking at both what the value utilization is as well as experimentation. The value utilization is actually really positive for us. I think, as it relates to the monetization and the experimentation, we have the generative packs, as you know, in Creative Cloud. I think you will see us more and more have that as part of the normal pricing and look at pricing because that's the way in which we want to continue to see people use it. I think in Acrobat, as you've seen, we are not actually using the generative packs. We're going to be using more of an AI Assistant model, which is a monthly model. As it relates to the Enterprise, we have both the ability to do custom models, which depends on how much content that they are creating, as well as an API and metering that we've rolled that out and we've started to sell that as part of our GenStudio solution. So I think it's fair to say, and I certainly monitor what everybody else in the industry is saying. The good news about this is the interface integration that we've done in all our apps and the utilization, and I think the experimentation will enable us to determine how we best attract the largest number of customers that we can who are new to Creative Cloud. We've talked about that as it relates to Firefly attracting new customers. Certainly, I think the number of Q1 commercial subscriptions was another record. So we're absolutely doing everything that we intended to experiment as we roll this out, Brad. So I wanted to accentuate that as well.
Brad Zelnick: Thank you so much. Very helpful.
Operator: Your next question comes from the line of Michael Turrin with Wells Fargo Securities. Please go ahead.
Michael Turrin: Hey, great. Thanks. I appreciate you taking the question David, couldn't help but notice you led off your prepared remarks section with the Document Cloud. Can you speak to the enthusiasm you're seeing on the document side? And when we think about the mix of Digital Media growth for the year, should we expect it will continue to trend towards that Document side? Or is it more the second half where some of the creative enhancements start to layer on more meaningfully we could start to see that shift back a bit? Thanks.
David Wadhwani: Yeah. Happy to talk about that. We were very -- and continue to be very happy with the performance of Document Cloud. If you really look at trying to understand sort of how that plays out Document Cloud, the growth is a combination of both our go-to-market efforts and our product innovation. On the go-to-market effort side, think about the fact that Reader continues to be a top-of-funnel for us and we continue to see Reader monthly active user growth. So the potential of people we can convert over to paid subscribers continues to grow. We also talked about the fact that Acrobat Web has been a major contributor to our growth. So we're seeing 70% year-over-year growth in terms of Web MAU, and we crossed 100 million monthly active users for the first time on the website. And of course, we're doing a lot of work with product-led growth to drive the Journey users to some of that value that drives conversion. So that's all we're doing on the go-to-market side. On the side of product innovation, our strategy over the last couple of years has been to make PDF the starting point of a workflow, right? And so that's why we integrated Sign directly into that so that people could use their PDFs and start a transaction for their business. And that continues to grow very nicely, and it's a great selling point for an integrated service. We also introduced link sharing a few years ago for commenting and reviewing with groups and teams. We saw that link sharing grow 300% year-over-year so that's a huge point of value, but it's also a huge point of viral growth. That's also what when someone receives that, it's another opportunity for us to bring them into the value of the broader offering. And you can expect to see that with AI Assistant as well. So obviously, everyone is looking at AI Assistant in Acrobat. I certainly hope all of you are using it, should make your lives more effective. Not just for insight. We think that there's a lot of opportunity for monetization of insight for AI Assistant on our core base of Acrobat users, but also for the first time doing consumption-based value. So the hundreds of millions of monthly active users of Reader will also be able to get access to AI Assistant and purchase an add-on pack there too. So it's a really broad base to look at how we monetize that, but it's also the start of the ability to take your conversation and generate emails and presentations and continue that process. So the combination of all of that is a really potent combination of go-to-market efforts and product innovation. So we continue to be bullish about this. So the second part of your question, we are -- as we've said multiple times on the call, we are very excited about all the innovation that's coming out that's just starting to ramp in terms of monetization and/or still in beta on the Creative Cloud side. We expect that to come out in Q3 and we'll start our monetization there. So we continue to feel very confident about the second half acceleration of Creative Cloud.
Michael Turrin: I appreciate all the details there. Thank you.
Operator: Your next question comes from the line of Saket Kalia with Barclays.
Saket Kalia: Okay. Great. Hey, guys, thanks for taking my question here. Maybe for both David and Shantanu. Clearly, a lot of news around video creation using generative AI during the quarter, of course, with the announcement of Sora. Maybe the question for you folks is, can we just talk a little bit about how you think about the market impact that generative AI can have in the video editing market and how maybe Firefly can participate in that trend?
Shantanu Narayen: Sure. Saket. I mean, I'll start and then David can add. I mean, firstly, I think the advances, whether it's in OpenAI or our own models that certainly, David and I have the pleasure of looking at on a weekly basis, the advances are amazing because you have to -- when you're thinking about video solve some other fundamental problems like physics, right, I mean, if you have somebody walking on a street, how do you make sure that they don't go through a building or go through the floor? And so I think some of those video advancements that we have seen within Adobe have really addressed some of those hard problems. A big picture, though, video I think will be even more of an accelerant for editing applications. I think this notion that the next Oppenheimer will be done using a text-to-video prompt is just -- it's not going to happen for decades. And so I think actually more so in video, there's going to be an accelerant for people saying how do I get an on-ramp as it relates to using text to video and then edit that using our applications. And so I think I'm really particularly excited about what we can do with premiere as well as with After Effects as it relates to video. So net-net, I would say, Saket, the technology is impressive. We have our models, we have integrated into our interfaces. We're also partnering. I had a really great conversation with Jensen recently about what we can do as they are investing in video. Certainly, he would love to partner with us, and we're looking together to see how we can push the envelope on video as well using their models, whether it's Edify or Nemo. And so I think really early days, we're seeing a whole bunch. I hope -- and David mentioned this look at some of the lip sync stuff that we've done as well, which allows you to auto-dub and translate into languages. So we intentionally released a little bit of that demo. So really great advances. But net-net video is going to be even more of a need for editing applications in order to truly take advantage of generative AI.
David Wadhwani: Yeah. And maybe I'll just add a few things. First of all, as Shantanu mentioned, the research in the industry and certainly with Sora is very impressive and exciting. It's also very consistent with the models that we're developing. So we think that there is -- there will be, as there was with video -- sorry, imaging, there will be multiple models that come out, including the Adobe model later this year, and we should start to see a lot of innovation there like we've seen in imaging. We've already started to sneak a couple of things that Shantanu talked about. So you will see text-to-video capabilities from us later this year. But you'll also see it with transparency around the training data that we have, you'll see it with more tool ability and controllability. You'll see it integrated into our tools as well. Now, all of that said, I do want to be very clear with what Shantanu said, which is that we see the proliferation of video models to be a very good thing for Adobe. And we're going to work with OpenAI around Sora. You're going to see us obviously, developing our own model. You're going to see others developing model. All of that creates a tailwind because the more people generate video clips, the more they need to edit that content, right? So whether its Premiere or After Effects, or Express, they have to assemble those clips, they have to color-correct those clips, they have to tone match, they have to enable transitions. So we're excited about what we're building, but we're just as excited about the partnerships that we see with OpenAI and others coming down this path. And if you take a step back, you should expect to see more from us in the weeks ahead with imaging and vector and design, text effects, and in the months ahead with audio and video and 3D. We're very excited about what all of this means, not just for the models, but also for our APIs and our tools.
Saket Kalia: Super helpful. Thanks.
Operator: Your next question comes from the line of Alex Zukin with Wolfe Research. Please go ahead.
Alex Zukin: Hey, guys. Thanks for taking the question. And I just -- mine is going to be more of a clarifying question because it's clear that from a number of comments, whether it's outperforming Digital Media ARR in the quarter to accelerating Creative ARR in the second half to maybe doing better than $1.9 billion in the full year for Digital Media ARR. My question is very simple. Can you reiterate -- not update, but reiterate the guide that you gave in December for Digital Media ARR in net news specifically for this year, and maybe puts and takes around how we should think about to the question earlier, the second half versus first half tailwind, headwind around pricing?
Shantanu Narayen: Yeah. So we take our guide seriously. Q1 played out as expected. It was ahead of where we were last year. Our Q2 guide is ahead of where the guide was in Q2. We're talking about acceleration into the back half of the year. If I didn't feel like our full-year guide was achievable, we would have a different conversation. We're confident in the targets that we put out there, our ability to meet them. If there's an opportunity to do better, we certainly will. So we feel good about where we sit in the first half. And as we look forward into the second half, the momentum we see from an innovation standpoint integrating into our products, what we see going from beta to GA, we feel good about the momentum into the second half.
Alex Zukin: Perfect. Thank you, guys.
Operator: And your next question comes from the line of Karl Keirstead with UBS. Go ahead.
Karl Keirstead: Thank you. Dan, maybe I'll continue with this subject that Alex was getting at. So I think what's tough about modeling ARR of late is it's very difficult to see the impact of the price actions. It feels like a black box to us. So I'm wondering if you could help us get aligned for the second half, and offer some qualitative color on the extent to which the prior period price actions roll off. Is that more of a 3Q or 4Q phenomenon? Is there any way you could help size that impact, just to feel good about David's earlier comment about that roll-off being a big part of the second-half ARR acceleration? Thank you.
Dan Durn: Yeah. So there was two pricing actions that we had taken in 2022. In May of 2022, we pushed forward a pricing action, and then October of 2022, we pushed forward the Doc Cloud line optimization, where we integrated Sign. The one-year anniversary of those pricing actions from May of 2022 and October of 2023, or -- I'm sorry, October of 2022 will be behind us on the one year anniversary. So you will still see some Q3 impact from pricing actions in the year-ago period. Q4 will be a clean look for the company, at least two months in Q4 will be a clean look. The actions that we're taking right now from both a pricing and a product standpoint on the Creative side will be more apparent in the back half of the year into the end of the year.
Karl Keirstead: Okay. That's helpful.
David Wadhwani: I think the other way I would look at it, honestly -- sorry, go ahead.
Dan Durn: Go ahead, David.
David Wadhwani: Well, the way I would look at it, in terms of the rhythm of the numbers and how you've seen sort of what transpired in 2023, and how we look at 2024, and the path to $1.9 billion and beyond, the way I would look at it is we're ahead in Q1. We're ahead in Q1. We're giving you all the reasons why we think there's more product coming and more monetization coming in the rest of the year. And that's what gives us the confidence associated with the targets. I guess there's this question of every quarter, do we reiterate targets? Do we update targets? What does that mean? And the way we've always thought of it is, if it was a way -- if we didn't have confidence, we would give you that. We have confidence associated with the numbers, but we're not in the business of every quarter, looking at every number. And let's go down one other number, which was the GAAP EPS. Certainly, there's an impact, as you know, in the GAAP EPS associated with what we did as it related to the Figma sort of transaction, and therefore the impact to GAAP EPS in Q1. So I think, from my perspective, the quarter and the year is playing out just as we did, and I feel more confident now than I did when we gave you our annual targets. I'll leave it at that.
Karl Keirstead: Yeah. We got it. Thank you.
Operator: And we will take our next question from the line of Jay Vleeschhouwer with Griffin Securities.
Jay Vleeschhouwer: Thank you. Good evening. And with respect to Firefly, it's obvious that you are significantly ramping up your investments there, at least judging by the number of relevant open positions you're looking to fill for Firefly development, many of which are seemingly fairly senior. Could you comment on your pipeline of being able to bring in the requisite amount of developmental capacity to support everything you're doing with Firefly and everything else that David in particular talked about? And relatedly, on go-to-market in the last few months, you've been opening up the aperture for sales positions globally. Could you comment on what the thinking is behind that? And again, whether the population is there for you to bring in to meet your sales headcount needs? Thank you.
David Wadhwani: Yeah. Let me take the first one and then Anil can answer the question on sales. As it relates to the momentum we're seeing with Firefly, I think there are multiple layers of it. One is obviously, we're seeing the quality of the models. We're seeing a differentiated approach as it relates to the training data, as it approaches contribution of assets from our community and how we compensate those folks. And so that's not just an Adobe perspective, but it's playing out obviously, in enterprises as they look at what are the models that they can consider using for production workflows. We're the only one with the full suite of capabilities that they can do. It's a really unique position to be in, but it's also being noticed by the research community, right? And as the community starts looking at places as if I'm a PhD that wants to go work in a particular environment, I start to ask myself a question of which environment do I want to pick. And a lot of people want to do AI in a responsible way. And that has been a very, very good opportunity for us to bring in amazing talent. So we are investing. We do believe that we have the best -- one of the best, if not the best, research labs around imaging, around video, or around audio, around 3D, and we're going to continue to attract that talent very quickly. We've already talked about we have the broadest set of creative models for imaging, for vector, for design, for audio, for 3D, for video, for fonts and text effects. And so this gives us a broad surface area to bring people in. And that momentum that starts with people coming in has been great. The second part of this too is managing access to GPUs while maintaining our margins. We've been able to sort of manage our cost structure in a way that brings in this talent and gives them the necessary GPUs to do their best work.
Anil Chakravarthy: And regarding the sales positions in Enterprises. In Enterprise, we're in a strong position because what we -- I mean, this area of customer experience management, it remains a clear imperative for Enterprise customers. Everybody is investing in this personalization at scale, and current supply chain. These help drive both growth and profitability. So when you look at these areas, these from an enterprise perspective, these are a must-have. This is not a need to have. And that's helping us really attract the right kind of talent. We just onboarded this week a VP of Sales who have prior experience and a lot of experience in Cisco and Salesforce, etc. So that's an example of we're really bringing on some excellent enterprise sales talent.
David Wadhwani: And I don't know if Jay, you were asking for -- building your model, or if you were looking for a job? But if you're interested in any of these positions, let us know more.
Jay Vleeschhouwer: More the former.
David Wadhwani: Okay.
Jonathan Vaas: Hey, operator, we're coming up on the hour. Let's try to squeeze in two more questions. Thanks.
Operator: Thank you. We will take our next question from Kash Rangan with Goldman Sachs.
Kash Rangan: Hey, thank you very much. Looks like there is more trust in AI and Excel models than what you're actually saying qualitatively on this call. I just wanted to give you an opportunity to debunk this hypothesis that is going around, that AI, it is generating videos and pictures, but the next step is it's going to do the actual editing and put out Premiere Pro use or whatnot. So that is probably the existential threat that people are debating. So why don't you see if we could take a shot at why that scenario is very unlikely that right now it's about generation of images and then your tools pick up where the generation stops and you do the processing, right? So help us understand why this can coexist with AI. That's a philosophical question. And Dan, one for you. Besides the net new ARR that you've already reported on Creative and DM, what are the other indicators such as new business bookings that you don't quantify necessarily that you qualitatively saw in Q1 that makes you feel good about the year? Thank you so much.
David Wadhwani: Great. So maybe I'll take your first part, and Dan obviously, can take the second. So as it relates to generated content, I'm going to sort of break it up into two parts. One is around the tooling and how you create the content, and the second is around automation associated with the content. I think if you take a step back before we even get into either one of those, there is no question that there's a huge appetite because of personalization at scale, the need to engage users, the need to build your personal brand online. That content is going to explode in terms of the amount of content being created, and it's going to explode because of one of two things. The first is around the ability to create audio clips, video clips, images, vectors. These are things that get users started. It's a great for ideation. You'll see in a few weeks that some of the incredible work the team has been doing around ideation on Firefly.com. And once those things are created, they do flow into our tools for the production, work and process. We're clearly seeing a huge benefit from that because the more content that gets created, the more editing that's required, and that's what's driving more commercial CC subscribers this quarter than any other Q1 before. So that's the foundation of it. The second part of this, though, from an editing perspective is the controllability of -- and the editability of not just pixels and vectors and timelines, but also the editability of the latent space itself. The latent space being the core capability -- core model capabilities that actually generate the output. We have a lot of research that we've already started releasing, the first of which was Style Match, and you'll start to see more and more of that actually coming out at summit and beyond. But we are, in my mind, very, very clearly the leader in terms of creating models that can also be tooled on top of. So that combination of the models getting better and the controllability of those models, we're in a remarkable position for that. So we benefit from that. The second part, Kash, is around automation. So as people are generating more content, you clearly need to be able to automate that content and how it's created. And that's really where Firefly Services come in. First, it's built on the strength of our Firefly models, say for commercial use integrated into our tools, but it also adds the ability to have custom models so control what kinds of information or brand and content it's trained on for both brand styles and product replica, and it's also part of an ecosystem of API services, not just generate something which is a core part of it like text to image, or Generative Fill or Generative Expand, but also process. So once you generate some images through APIs and automation, you want to be able to remove the background, you want to be able to blur the depth, you want to auto tone, you want to apply actions to that image. And then the last is you want to be able to assemble that for delivery. Firefly services don't just generate something, but they let you have that entire ecosystem, and then you can embed that using low code, no code environments into your flows, and we are already embedding it into GenStudio and all of the capabilities that we're shipping. So I think the core part of this is that as more of this content creates, you need more tool ability. The best models are going to be the models that are safe to use and have control built in from the ground up. And I think we have the best controls of anyone in the industry, and they need to be able to be done in an automated fashion that can embed into your workflow. So I think all three of those vectors point to benefits for Adobe.
Kash Rangan: That's very convincing.
Dan Durn: And then as we think about the forward-looking, a couple of points I would turn to, just think about cash flow in Q1. Strength of our cash flow, once you normalize for the $1 billion termination payment, that's up 28% year-over-year. When you think about RPO, 3 point acceleration sequentially, and when I break that up on deferred revenue, unbilled backlog, you saw that acceleration in each of those subcomponents, which as you look through that acceleration, the near-term underscores the strength of the business and it underscores the longer term strength we have around the momentum of the business. When I think about individual product commentary, we talked about it a lot on this call. You see record commercial subscriptions in the Creative business. In Q1, you see engagement going up on the products. Usage of Firefly capabilities in Photoshop was at an all-time high. In Q1, Express exports more than doubling with the introduction of Express Mobile in beta now going to GA in the coming months, AI Assistant Acrobat, same fact pattern. You can see that momentum as we look into the back half of the year. And from an enterprise standpoint, the performance in the business was really, really superb in Q1, strongest Q1 ever in the enterprise. So there's a lot of fundamental components that we're seeing around performance of the business that give us confidence as we look into the back half of the year.
Kash Rangan: Super. Thank you so much, Dan.
Operator: We'll take our next question from Keith Weiss with Morgan Stanley. Please go ahead.
Keith Weiss: Excellent. Thank you, guys, and I appreciate you squeezing me in. I'm going to take one last crack at this. Shantanu and team, we definitely, hear your confidence in the business, but obviously, the stock market reactions reflecting investors are worried about something. And the two things that worry investors more so than anything is uncertainty number one, and number two is back half ramps, right? And so I think what investors would really love to hear is Dan Durn actually say we still expect to do $1.9 billion in net new Digital Media ARR, and get some certainty there, and then also have a little bit more certainty or a little bit more explanation of what are the building blocks to that second half ramp? Which products are expected to go GA? Are we including stuff like document intelligent -- intelligence? Is there new monetization avenues that we're putting into the back half? Or is there just some mechanism within sort of the Creative Cloud pricing that's going to turn on in the back half of the year? Any further specifications in there, I think would help sort of close the gap between your confidence and sort of the lack of confidence exhibited by the after-hour reaction.
Shantanu Narayen: And let me tackle that, Keith, and maybe I'll just tackle it by taking a couple of the other questions as well, summarizing that and ending with your question associated with the financial results. I think the first question that I hear across many folks is, hey, with the advent of AI and the increase in the number of models that people are seeing, whether they be image models or video models, does that mean that the number of seats, both for Adobe and in the world, do they increase or do they decrease? To me, there's no question in my mind that when you talk about the models and interfaces that people will use to do creative content, that the number of interfaces will increase. So Adobe has to go leverage that massive opportunity. But big-picture models will only cause more opportunity for interfaces, and I think we're uniquely qualified to engage in that. So that's the first one. The second one, I would say, is that does Adobe innovate, and when we do that, do we only leverage the Adobe model, or is there a way in which we can leverage every other model that exists out there? Much like we did with plugins, with all of our Creative applications, any other model that's out there, we will certainly provide ways to integrate that into our application. So anybody who is using our application benefits not just from our model creation, but from any other model creation that's out there. The way we first started to execute against that is in the enterprise because for us, the enterprise and the ability to create custom models so people can tweak their models to be able to do things within Photoshop that are specific to a retailer or a financial service was where we focus. But long term, certainly, as I've said with our partnerships, we will have the ability for Adobe in our interfaces to leverage any other model that's out there, which again, further expands our opportunity. I think as we play out the year, when we gave our targets for the $1.9 billion in ARR and the $410 million in Digital Media ARR for Q1, it factored in both our product roadmap and how things would evolve in the year. All of the product roadmaps we knew whether it was Acrobat, whether it was Express, whether it was Firefly, whether it was Creative Cloud, or whether it's GenStudio that brings all of these together, we knew the product roadmap, which we're executing against. In the first half of the year, a lot of that was beta, and in the second half of the year, a lot of that's monetization. It's playing out as expected. If anything, I would say the excitement around that, and in particular, the enterprise is faster than expected. And so I think our ability to monetize it just -- not just through new seats but also through these new Firefly services is expanded as it relates to what we are doing. And then as it relates to your question around financial results and the go-forward execution, we gave a Q1 target, we beat the Q1 target. And that gives us confidence that the financial target that we gave at the beginning of the year, we're ahead of that. And that's how I'll play it out. You're right. You have to model it. You can look at last year's model and look at last year's model and say, hey, they got to $1.913 billion. If they're ahead, does that fundamentally change Adobe's thesis on why we get to $1.9 billion and beyond, and in my mind it doesn't. And so that's the way I would answer that question. We have to go execute against the opportunity that we have. I look forward to those who are at Summit. I'm sure we'll have a little bit more conversation. But Q1 was a strong start. It was a strong start against product execution. It was a strong start against the financial metrics that we outline, and we're going to go do it again, Keith. So that's how I'd answer your question. So thank you all for joining.
Keith Weiss: Excellent. That's super helpful.
Shantanu Narayen: And with that, I'll hand it back to Jonathan.
Jonathan Vaas: All right. Thanks, everybody. I look forward to speaking with many of you soon. And this concludes the call. We look forward to seeing you at Summit. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Q1 FY 2024 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I would like to turn the conference over to Jonathan Vaas, Vice President of Investor Relations. Please go ahead."
},
{
"speaker": "Jonathan Vaas",
"text": "Good afternoon, and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe's Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience; and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe's first quarter fiscal year 2024 financial results. You can find our press release as well as PDFs of our prepared remarks and financial results on Adobe's Investor Relations website. The information discussed on this call, including our financial targets and product plans, is as of today, March 14, and contains forward-looking statements that involve risks, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call, we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates as well as constant currency rates. During this presentation, Adobe's executives will refer to constant-currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe's Investor Relations website. Adobe Summit is just around the corner in Las Vegas at The Venetian Convention and Expo Center beginning on Tuesday, March 26. Following the day one keynote, we will host an Investor Meeting at 2:00 PM Pacific Time. The event will be webcast live and the replay will be available on Adobe's IR website. More details about the summit are available at summit.adobe.com. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Jonathan. Good afternoon, and thank you for joining us. Adobe had a strong first quarter. We achieved $5.18 billion in revenue in Q1, representing 12% year-over-year growth. GAAP earnings per share for the quarter was $1.36, and non-GAAP earnings per share was $4.48, representing 18% year-over-year growth. Our performance reflects the essential role that Adobe products play in driving the global digital economy. We're delivering on our strategy to unleash creativity for all, accelerate document productivity and power digital businesses. Adobe Creative Cloud, Document Cloud and Experience Cloud are more critical than ever to the success of creators, communicators, students, entrepreneurs, and businesses of all sizes with AI serving as an accelerant for all. We are a leader in delivering generative AI across all our clouds. We're taking a highly differentiated approach across data, models and interfaces. Our proprietary data is built on decades of deep domain expertise across creative, documents and customer experience management. We leverage large language models, as well as have invested in building and delivering our proprietary models in the creative document and marketing domains. Our IP-friendly approach is a differentiator for creators and enterprises. In addition, we've innovated by delivering generative AI directly in products with releases in Adobe Photoshop, Illustrator and Express across both desktop and mobile. AI Assistant in Acrobat and Reader unlocks the tremendous value of the trillions of PDFs around the world. We're bringing generative AI to Adobe Experience Cloud and will demonstrate our AI Assistant for Customer Experience Management at Adobe Summit. Every student, communicator, creative professional and marketer is now focused on leveraging generative AI to imagine, ideate, create and deliver content and applications across a plethora of channels. Adobe is uniquely positioned through the combination of Express, Firefly, Creative Cloud, Acrobat and Experience Cloud to deliver on this immense market opportunity. The success we are already seeing with our GenStudio offering in the enterprise is validation of our leadership, and we expect that success to translate into other segments as we roll out these solutions throughout the year. We are driving strong usage, value and demand for our AI solutions across all customer segments. We're successfully monetizing our innovations with particular strength in Q1 in the Enterprise segment across our Digital Media and Digital Experience businesses. This strength is reflected in our strong RPO growth of 16% year-over-year. We're pleased with a strong Q1. We have a phenomenal product roadmap that we're executing against to bring AI innovation across our global customer base and we're just getting started. I'll now turn it over to David to discuss the momentum in our Digital Media business."
},
{
"speaker": "David Wadhwani",
"text": "Thanks, Shantanu. Hello, everyone. In Q1, we achieved a net new Digital Media ARR of $432 million and revenue of $3.82 billion, which grew 13% year-over-year. The world's information whether it's an enterprise legal contract, a small business invoice or a personal school form lives in trillions of PDFs. We were thrilled to announce Acrobat AI Assistant, a massive leap forward on our journey to bring intelligence to PDFs. With AI Assistant, we're combining the power of generative AI with our unique understanding of the PDF file format to transform the way people interact with and instantly extract additional value from their most important documents. Enabled by a proprietary attribution engine, AI Assistant is deeply integrated into Reader and Acrobat workflows. It instantly generate summaries and insights from long documents, answers questions through a conversational interface, and provides an on-ramp for generating emails, reports and presentations. AI Assistant is governed by secure data protocols so that customers can use the capabilities with confidence. We are pleased with the initial response to the English language beta and look forward to usage ramping across our customer base as we release other languages later in the year. We will monetize this functionality through a monthly add-on offering to the hundreds of millions of Reader users as well as the Acrobat installed base across individuals, teams and enterprises. In Q1, we achieved Document Cloud revenue of $750 million, growing 18% year-over-year. We added $143 million of net new Document Cloud ARR, which was a Q1 record with year-over-year ending ARR growth of 23% in constant currency. Other business highlights include Acrobat Web continues to be an incredible source of customer acquisition with monthly active users up over 70% year-over-year and surpassing 100 million users in Q1. Acrobat extensions for Microsoft Edge and Google Chrome and our Acrobat Mobile offerings continue to accelerate free-to-paid conversion. Increased viral adoption through link sharing and stakeholder collaboration drove over 300% year-over-year growth in the number of PDF files sent. Key enterprise customer wins include Berkshire Hathaway, Merck Sharp & Dohme, Northrop Grumman, Porsche, and the U.S. Navy. On Creative Cloud, creativity is the currency of differentiation in our digital-first world. Every creator and business is focused on building their brand and engaging with their audiences through standout content. Creative Cloud remains the solution of choice for the world's creators, whether their medium is design, photography, video, illustration or 3D. Adobe Express is inspiring millions of users of all skill levels to design more quickly and easily than ever before. In the year since we announced and released Adobe Firefly, our creative generative AI model, we have aggressively integrated this functionality into both our Creative Cloud flagship applications and more recently, Adobe Express, delighting millions of users who have generated over $6.5 billion assets to date. In addition to creating proprietary foundation models, Firefly includes a web-based interface for ideation and rapid prototyping, which has seen tremendous adoption. We also recently introduced Firefly Services, an AI platform which enables every enterprise to embed and extend our technology into their creative, production and marketing workflows. Firefly Services is currently powered by our commercially safe models and includes the ability for enterprises to create their own custom models by providing their proprietary datasets as well as to embed this functionality through APIs into their email, media placement, social and web creation process. Early adopters like IBM are putting Firefly at the center of their content creation processes. IBM used Adobe Firefly to generate 200 campaign assets and over 1,000 marketing variations in moments rather than months. The campaign drove 26X higher engagement than its benchmark and reached more key audiences. In Q1, we achieved $3.07 billion in revenue, which grew 12% year-over-year. Net new Creative Cloud ARR was $289 million. Other business highlights include new the launch of the new Adobe Express mobile app beta brings the magic of Adobe Firefly AI models directly into mobile workflows. The first-of-its-kind integration with TikTok's creative assistant makes the creation and optimization of social media content quicker, easier and more effective than ever before. Express Web usage continues to ramp nicely with total exports more than doubling year-over-year and overall Express adoption is expected to accelerate even further, given the positive reception we're seeing from the mobile beta. Generative Fill in Photoshop continues to empower creators to create in new ways and accelerate image editing workflows. Q1 saw the highest adoption of Firefly powered tools in Photoshop since the release of Generative Fill in May 2023 with customers adopting these features across desktop, web and most recently, iPad, which added Generative Fill and Generative Expand in December. The beta release of AI-powered Enhance Speech and new audio workflows drove premiere beta usage to record highs. Adobe video tools were the go-to choice at Sundance Film Festival with over 80% of this year's entrants using Adobe software. The introduction of Behance Pro, a new offering to serve the rapidly growing Behance community empowers members to build their brand and find opportunities, and for businesses to hire talented creators through the Behance platform. The unveiling of new research like the preview of our music generation models and editing tools last month and our video auto dubbing models earlier today have inspired our Creative Cloud and Express customers. The introduction of Firefly Services for enterprises drove notable wins in the quarter, including Accenture, IPG and Starbucks. Other key enterprise wins include AECOM, Capital Group, Dentsu, IBM, Nintendo and RR Donnelley. Given the size of opportunity we see with generative AI, we continue to focus on driving innovation, adoption and usage of our AI solutions. In Q1, we saw strength across both clouds with record new commercial subscriptions in Creative Cloud for Q1, and strong product-led growth in Document Cloud. You can expect to see the product advances and Express with Firefly on mobile. Firefly Services and AI Assistant in Acrobat drive ARR acceleration in the second half of the year. We're excited about our product roadmap. The 6.5 billion assets generated to date include images, vectors, designs and text effects, and we can't wait to share the work we're doing on audio, video and 3D through research sneaks and product announcements in the coming months. I'll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello, everyone. Experience Cloud business had a great first quarter, achieving $1.29 billion in revenue and was our strongest Q1 on record for new business. Subscription revenue was $1.16 billion, representing 12% year-over-year growth. Companies are prioritizing digital investments to improve marketing agility and customer engagement while driving growth and profitability. Adobe's holiday shopping report which analyzes trillions of data points, showed strong online spending during the 2023 holiday season, growing 4.9% year-over-year to $222.1 billion, a new record for e-commerce as well as mobile shopping, which surpassed desktop for the first time and drove 51.1% of online sales. Our Adobe Experience Cloud applications span the entire customer funnel from acquisition to monetization to retention. As the global leader in the Digital Experience Platforms category, Adobe offers businesses a single view of their customers' data across every channel, allowing them to create precise segments and deliver personalized experiences regardless of when and where the customer interacts with their brand. Over the last five years, our organic innovations in Adobe Experience Platform, Realtime CDP, Journey Optimizer, and Customer Journey Analytics have made us the leading platform for customer experience management given the scale of the profiles, campaigns and interactions we process, which now exceed 500 trillion segment evaluations per month. Today, rollout of personalization at scale has been limited by the number of content variations you can create and the number of journeys you can deploy. We believe harnessing generative AI will be the next accelerant with Creative Cloud, Firefly Services and GenStudio, providing a comprehensive solution for the current supply-chain, and generative experienced model automating the creation of personalized journeys. Adobe GenStudio is the generative AI first application that allows marketers to quickly plan, create, store deliver and measure marketing content in a single intuitive offering. With state-of-the-art generative AI powered by Firefly Services, marketers can create on-brand content with unprecedented scale and agility to deliver personalized experiences. Adobe GenStudio natively integrates with multiple Adobe applications across Creative Cloud and Experience Cloud, including Express, Firefly, Workfront, Experience Manager, Customer Journey Analytics, and Journey Optimizer. It can be used by brands and their agency partners to unlock new levels of creativity and efficiency in marketing campaigns. Business highlights include momentum with Adobe Experience Platform and native applications with the combined annualized book of business surpassing $800 million in the quarter. Demand for Adobe Experience Manager, Workfront and GenStudio to address the enterprise content supply chain. Global agencies, including Accenture, Havas, IPG, Omnicom, and Publicis have standardized on Adobe as their technology platform of choice for their own workflows and to optimize creative collaboration with the world's leading brands. Strength in Adobe Journey Optimizer on Adobe Campaign as companies look to deliver more personalized experiences across channels and surfaces. Adobe was recognized as a leader in the Gartner Magic Quadrant for Digital Experience Platforms for the seventh consecutive year, as well as the Forrester Wave for Digital Experience Platforms. Adobe Experience Manager assets was also named a leader for the fourth consecutive time in the Forrester Wave for Digital Asset Management. Key customer wins include Carl Zeiss, Comcast, Home Depot, NASCAR, Nestle, PayPal, Rogers Communications, Santander Group, Starbucks and Walgreens. Later this month, we are excited to host Adobe Summit, the world's largest digital experience conference in Las Vegas, where we will be joined by thousands of customers, partners, and developers from around the world. We look forward to showcasing a number of product innovations, including a new generative experienced model, advances in Adobe GenStudio, a new AI Assistant in Adobe Experience Platform, new capabilities in RT CDP for first-party data activation and expanded Firefly Services offerings. We will articulate our vision and playbook for brands to achieve a new level of personalization at scale in the era of generative AI. We look forward to sharing our exciting product roadmap and hearing from our customers and how Adobe is helping them transform their business. We were off to a fast start in Q1 and look forward to continuing the momentum and leadership in Q2 and beyond. I will now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Today, I'll start by summarizing Adobe's performance in Q1 fiscal 2024, highlighting growth drivers across our businesses, and I'll finish with financial targets. In Q1, Adobe delivered another quarter of double-digit top line growth with robust margins that result from product leadership, strong execution, and financial discipline. The pace of our product innovation across Document Cloud, Creative Cloud, and Experience Cloud is leading to customers making large multi-year commitments to Adobe. And you see the result of those customer investments in our RPO performance, which accelerated to 16% year-over-year growth. In the quarter, Adobe achieved record revenue of $5.18 billion, which represents 11% year-over-year growth, or 12% in constant-currency. Business and financial highlights included GAAP-diluted earnings per share of $1.36 and non-GAAP diluted earnings per share of $4.48. Digital Media revenue of $3.82 billion, net-new Digital Media ARR of $432 million, Digital Experience revenue of $1.29 billion, cash flows from operations of $1.17 billion, RPO of $17.58 billion exiting the quarter, and repurchasing approximately 3.1 million shares of our stock during the quarter. GAAP EPS came in lower due to the $1 billion payment resulting from the termination of the Figma transaction. Absent the termination payment, our cash flows from operations would have been $1 billion more, and GAAP EPS would have been $2.19 higher. The termination payment impacts both Q1 GAAP EPS and our full-year fiscal 2024 GAAP EPS. In our Digital Media segment, we achieved Q1 revenue of $3.82 billion, which represents 12% year-over-year growth, or 13% in constant currency. We exited the quarter with $15.76 billion of Digital Media ARR, up 14% year-over-year in constant currency. Adobe achieved Document Cloud revenue of $750 million, which represents 18% year-over-year growth as reported and in constant currency. We added $143 million of net new Document Cloud ARR in the quarter. Q1 Document Cloud growth drivers included demand for Acrobat subscriptions across all customer segments and geographies. Continued growth of Acrobat Web demonstrating the success of our flagship products across multiple surfaces, growing monthly active users in our Acrobat Reader Funnel driving free-to-paid conversion. New user acquisition resulting from our Microsoft Edge and Google Chrome partnerships. Strength in our Teams business with up selling our new Acrobat offering which includes integrated signed capabilities, and strong demand from businesses of all sizes, demonstrating the mission criticality of our Document Solutions. We achieved Creative revenue of $3.07 billion, which represents 11% year-over-year growth, or 12% in constant currency. We added $289 million of net new creative ARR in the quarter with ending ARR growing 12% year-over-year in constant currency. Overall CC pricing actions performed as expected in the quarter. Q1 net new Creative ARR grew more than 20% year-over-year, excluding the impact of pricing actions associated with both Acrobat CC and All Apps in the year-ago quarter and Creative Cloud in Q1 FY '24. Q1 Creative growth drivers included new subscription growth, including strong adoption of Creative Cloud All Apps across geographies and customer segments. Strong single-app customer demand in creative categories such as imaging and photography, and continued growth of stock and Frame.io. We again saw strength in emerging markets, which we continue to believe is a massive growth opportunity and outstanding performance of Creative Cloud in the enterprise including early traction of Firefly services. Turning to our Digital Experience segment. In Q1, we achieved revenue of $1.29 billion, which represents 10% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.16 billion, growing 12%year-over-year as reported and in constant currency. Q1 was a tremendous start to the year for our Experience Cloud business with growth drivers, including: success closing transformational deals across geographies and verticals with large enterprises that are choosing Adobe to be their end-to-end customer experience management platform, continued momentum with AEP and native applications with the annualized book of business growing more than 60% year-over-year, strong customer adoption of our content, campaign and Workfront solutions, and continued strength with customer retention and expansion across our products. Customer Experience Management remains an enterprise imperative. And as a leader in the category, we see a robust pipeline as we look into Q2 and beyond. Turning to the income statement and balance sheet. Adobe's effective tax rate in Q1 was 36% on a GAAP basis and 18.5% on a non-GAAP basis. The Q1 GAAP tax rate came in higher than targeted due to the Figma termination payment. RPO exiting the quarter was a record $17.58 billion, growing 16% year-over-year as reported and in constant currency. Our ending cash and short-term investment position exiting Q1 was $6.82 billion, and cash flows from operations in the quarter were $1.17 billion. In Q1, we entered into a $2 billion share repurchase agreement, which effectively exhausted our prior $15 billion authority. As a result of our strong trajectory of growth and profitability, we are announcing a new $25 billion share repurchase program, which demonstrates Adobe's continued commitment to returning capital to our shareholders. In light of the momentum across our business and factoring in the macroeconomic environment, for Q2, we're targeting total Adobe revenue of $5.25 billion to $5.30 billion; Digital Media net-new ARR of approximately $440 million; Digital Media segment revenue of $3.87 billion to $3.90 billion; Digital Experience segment revenue of $1.31 billion to $1.33 billion; Digital Experience subscription revenue of $1.165 billion to $1.185 billion; tax rate of approximately 18.5% on a GAAP and non-GAAP basis; GAAP earnings per share of $3.35 to $3.40, and non-GAAP earnings per share of $4.35 to $4.40. In summary, fiscal 2024 is off to a strong start. By combining the power of product innovation and executional excellence, Adobe is driving consistent profitable growth. We're delivering on our product roadmap, and we have the right strategy to monetize these innovations into the back half of the year and beyond. Adobe is incredibly well-positioned to capitalize on the secular trends that will shape the next decade. Shantanu, back to you."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks, Dan. We're the leader in three large and growing categories and have delivered groundbreaking innovation across Creative Cloud, Document Cloud and Experience Cloud. We believe that AI augments human ingenuity and expands our addressable market opportunity. I'm proud of the pace and the responsible manner in which we have embraced and delivered generative AI capabilities across our product portfolio. As a result of our strategy and execution, we're confident in our ability to attract new users and deliver value to existing customers to drive growth and profitability. I'd like to thank our 30,000 employees for their continued dedication and unwavering focus on innovation and execution. It is particularly exciting to be named to Glassdoor's Best Places to Work, Fortune's Most Admired Companies, and he JUST 100. Thank you, and we will now take questions. Operator?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from the line of Kirk Materne with Evercore ISI. Go ahead."
},
{
"speaker": "Kirk Materne",
"text": "Yeah. Thanks. Thanks very much for taking the question. I guess maybe this is for David or Dan. Obviously, you guys called out that new creative ARR was up more than 20% year-over-year when you exclude the pricing increases which infers a pretty major pricing headwind that we're seeing right now. Can you all just try to parse out how that's going to play out over the year? I know David you mentioned ARR will go up in the back half of the year, but that it’s just tough I think to reconcile what's going on in the business on a normalized basis, and when we might see that sort of translate more into the metrics that everybody follows. Thanks."
},
{
"speaker": "Dan Durn",
"text": "Yeah. I'll start and others can go ahead and add on. First of all, we do -- as we look at the book of the business, it is a strong start to the year with Q1 coming in at a high watermark with $432 million across the entire business. As we look specifically at Creative Cloud, I just want to sort of make sure everyone takes a step back and looks at our strategy to accelerate the business because I think the growth drivers here are very clear. We are focused on expanding access to users with things like Express on mobile. We want to introduce new offers across the business with things like AI Assistant and also existing capabilities for Firefly coming into our core Firefly, our core Photoshop and Illustrator and flagship applications. We want to access new budget pools with the introduction of Firefly Services and GenStudio as we talked about. And the early signs, as you point out in Q1 results are really suggesting that those growth drivers are taking hold. As you talked about normalizing for FY '23, FY '24 pricing actions, we grew the CC business about 20% year over year. Other key things to look at is that we set another record for new commercial subscriptions in Q1, and the business growth remains stable at -- if you look back at revenue 12% -- if you look forward at ARR 12%. So the stability and the diversity of the business is strong. And as we enter the back half of the year, we have capabilities for Creative Cloud pricing with Firefly that have already started rolling out late last year, as we talked about, and we'll be incrementally rolling out throughout the year. We're ramping Firefly Services and Express and Enterprise. As we talked about, we saw a very good beginning of that rollout at the -- toward the end of Q1. We also expect to see the second half ramping with Express Mobile and AI Assistant coming through. So we have a lot of the back-end capabilities set up so that we can start monetizing these new features which are still largely in beta starting in Q3 and beyond. And as it relates to pricing, it's what we've talked about in the past. We had two pretty significant pricing actions that benefited FY '23, the first one being the Acrobat price increases that we had put out with the new value that we had introduced with sign capabilities, and also a CC price increase that we introduced in FY '22 that was rolling into FY '23. Both of those are rolling off as we have now introduced the new pricing for CC with Firefly, and overall, the roll-off of the prior pricing is more significant than the new pricing that we've introduced."
},
{
"speaker": "Kirk Materne",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "And we will take our next question from Brent Thill with Jefferies. Please go ahead."
},
{
"speaker": "Brent Thill",
"text": "Thanks. Shantanu, the magnitude of the beat this quarter was -- there was roughly half the absolute beat you've had in past quarters and then the guide obviously, lower for next quarter. I think everyone is asking is this some type of AI headwind? Is this macro? Is this execution? Can you just comment on -- and maybe it's none of these things, but can you just comment on what you think you're seeing in the current quarter?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yeah. Happy to, Brent. And again, I'll reiterate that as it relates to us taking our targets pretty seriously. I mean, when we guided to $1.9 billion for the year, I mean, we had factored in both, as David mentioned, what was likely to happen in the pricing and how that rolls off, as well as the product roadmap, and when AI Assistant and Acrobat would be available, when Express, which is now in beta, would be available. So I think it factored in all of those. I guess if you are looking at it from accomplishment, we look at it and say hey, we did $410 million. I think last year we did $432 million. If we look at the guide and we're on track as it relates to the $1.9 billion, and to hopefully exceed that guide. And so from our perspective, it's playing out. Maybe the other color, Brent, that I would provide is given the desktop products are still in beta, and there we look at value and there we look at utilization. And so I think we gave you some numbers on the $6.5 billion generations that we're seeing, the really positive feedback that we're getting in Acrobat that continue to give us optimism associated with how that is. I think where there's tremendous interest and where if you look at it from an AI monetization, the two places that we're monetizing extremely in line with our expectations. The first is as it relates to the Creative Cloud pricing that we've rolled out. And as you know, the generative packs are included for the most part in how people now buy Creative Cloud, that's rolling out as expected. And the second place, where we are monetizing it is in the entire enterprise as it relates to Content and GenStudio. And I'm really happy about how that's monetizing it. I mean, that's a combination, Brent, of when we go into an enterprise for creation, whether we provide Creative Cloud or a combination of Express, what we are doing with asset management in AEM, workflow, as well as Firefly Services to enable people to do custom models as well as APIs. We're seeing way more monetization earlier, but again, very much in line with expected. So again, I look at the quarter and I feel really good, both about the product delivery as well as the way monetization is turning out. I mean, it's clear, I guess, a little bit from sort of what we've seen that expectations were perhaps a little higher, both in terms of what we would guide for Q2, but I'm really optimistic about what we have done."
},
{
"speaker": "Brent Thill",
"text": "Thanks, Shantanu."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Brad Zelnick with Deutsche Bank."
},
{
"speaker": "Brad Zelnick",
"text": "Great. Thanks so much for taking my question. My question is for Dan. You're not raising the full-year guide, and I appreciate it's still early in the year, but I think we're all hoping you can at least affirm it for us. But you also -- you pushed out the enforcement of generative credit limits for some products beyond April that were originally expected sooner. What's the thinking behind this decision? And what are you seeing thus far in terms of credit consumption and purchasing patterns of those credit packs? Thanks."
},
{
"speaker": "Dan Durn",
"text": "Yeah. Thanks, Brad. I'll jump in on the first part, then toss it over to David for the second. So we're not updating the targets. What the targets we provided for the full year, they're, as of the December call. What we did share on the call was the material change that we saw in Q1 as a result of the Figma termination payment. We talked about the GAAP EPS impact. It rolls through Q1 and it'll certainly have an effect for the full year. And it's $2.19 as a result of the $1 billion payment. And I think with that, I think you have everything you need relative to where we set our targets, but we're not going to be updating them on this call."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. And I'm happy to add a little bit. Yeah, in terms of the timing of the -- when we start enforcing credits, don't read anything into that other than right now, we are still very much in an acquisition mode. We want to bring a lot of users in. We want to get them using the products as much as possible. We want them coming back and using it. One thing I do want to state because I know there's a lot of energy around how do these credits play out over time. In the last few weeks, we've done a couple of sneaks that could also be instructive. Last month, we snuck music composition, where you can take any music track, you can give it a music type like hip hop or orchestral or whatever, and it will transform that initial track into this new type of music. Just this morning, we snuck our ability to do auto dubbing and lip-syncing, where you give it a video of someone talking and saying English, and then you can translate it automatically to French or Spanish or Portuguese or whatever. As you can imagine those actions will not take one credit. Those actions will be much more significant in terms of what they cost. So right now, Alex, the primary point is about proliferation and usage. We're going to be bringing in a lot more new capabilities throughout the tools that will drive more usage, and we're going to be bringing in more expensive capabilities as well. And as we've talked about, you should start to see that ramp through the year, and we feel very comfortable with the adoption we're seeing. Just one last thing to call out, as we mentioned on the call, highest number of users using generative AI in Q1 ever so we're very excited about the trajectory."
},
{
"speaker": "Shantanu Narayen",
"text": "And maybe just to add a little bit more of how we're thinking about it as it relates to the monetization of AI. I think we're in early stages as it relates to experimentation. So we're looking at both what the value utilization is as well as experimentation. The value utilization is actually really positive for us. I think, as it relates to the monetization and the experimentation, we have the generative packs, as you know, in Creative Cloud. I think you will see us more and more have that as part of the normal pricing and look at pricing because that's the way in which we want to continue to see people use it. I think in Acrobat, as you've seen, we are not actually using the generative packs. We're going to be using more of an AI Assistant model, which is a monthly model. As it relates to the Enterprise, we have both the ability to do custom models, which depends on how much content that they are creating, as well as an API and metering that we've rolled that out and we've started to sell that as part of our GenStudio solution. So I think it's fair to say, and I certainly monitor what everybody else in the industry is saying. The good news about this is the interface integration that we've done in all our apps and the utilization, and I think the experimentation will enable us to determine how we best attract the largest number of customers that we can who are new to Creative Cloud. We've talked about that as it relates to Firefly attracting new customers. Certainly, I think the number of Q1 commercial subscriptions was another record. So we're absolutely doing everything that we intended to experiment as we roll this out, Brad. So I wanted to accentuate that as well."
},
{
"speaker": "Brad Zelnick",
"text": "Thank you so much. Very helpful."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Michael Turrin with Wells Fargo Securities. Please go ahead."
},
{
"speaker": "Michael Turrin",
"text": "Hey, great. Thanks. I appreciate you taking the question David, couldn't help but notice you led off your prepared remarks section with the Document Cloud. Can you speak to the enthusiasm you're seeing on the document side? And when we think about the mix of Digital Media growth for the year, should we expect it will continue to trend towards that Document side? Or is it more the second half where some of the creative enhancements start to layer on more meaningfully we could start to see that shift back a bit? Thanks."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. Happy to talk about that. We were very -- and continue to be very happy with the performance of Document Cloud. If you really look at trying to understand sort of how that plays out Document Cloud, the growth is a combination of both our go-to-market efforts and our product innovation. On the go-to-market effort side, think about the fact that Reader continues to be a top-of-funnel for us and we continue to see Reader monthly active user growth. So the potential of people we can convert over to paid subscribers continues to grow. We also talked about the fact that Acrobat Web has been a major contributor to our growth. So we're seeing 70% year-over-year growth in terms of Web MAU, and we crossed 100 million monthly active users for the first time on the website. And of course, we're doing a lot of work with product-led growth to drive the Journey users to some of that value that drives conversion. So that's all we're doing on the go-to-market side. On the side of product innovation, our strategy over the last couple of years has been to make PDF the starting point of a workflow, right? And so that's why we integrated Sign directly into that so that people could use their PDFs and start a transaction for their business. And that continues to grow very nicely, and it's a great selling point for an integrated service. We also introduced link sharing a few years ago for commenting and reviewing with groups and teams. We saw that link sharing grow 300% year-over-year so that's a huge point of value, but it's also a huge point of viral growth. That's also what when someone receives that, it's another opportunity for us to bring them into the value of the broader offering. And you can expect to see that with AI Assistant as well. So obviously, everyone is looking at AI Assistant in Acrobat. I certainly hope all of you are using it, should make your lives more effective. Not just for insight. We think that there's a lot of opportunity for monetization of insight for AI Assistant on our core base of Acrobat users, but also for the first time doing consumption-based value. So the hundreds of millions of monthly active users of Reader will also be able to get access to AI Assistant and purchase an add-on pack there too. So it's a really broad base to look at how we monetize that, but it's also the start of the ability to take your conversation and generate emails and presentations and continue that process. So the combination of all of that is a really potent combination of go-to-market efforts and product innovation. So we continue to be bullish about this. So the second part of your question, we are -- as we've said multiple times on the call, we are very excited about all the innovation that's coming out that's just starting to ramp in terms of monetization and/or still in beta on the Creative Cloud side. We expect that to come out in Q3 and we'll start our monetization there. So we continue to feel very confident about the second half acceleration of Creative Cloud."
},
{
"speaker": "Michael Turrin",
"text": "I appreciate all the details there. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Saket Kalia with Barclays."
},
{
"speaker": "Saket Kalia",
"text": "Okay. Great. Hey, guys, thanks for taking my question here. Maybe for both David and Shantanu. Clearly, a lot of news around video creation using generative AI during the quarter, of course, with the announcement of Sora. Maybe the question for you folks is, can we just talk a little bit about how you think about the market impact that generative AI can have in the video editing market and how maybe Firefly can participate in that trend?"
},
{
"speaker": "Shantanu Narayen",
"text": "Sure. Saket. I mean, I'll start and then David can add. I mean, firstly, I think the advances, whether it's in OpenAI or our own models that certainly, David and I have the pleasure of looking at on a weekly basis, the advances are amazing because you have to -- when you're thinking about video solve some other fundamental problems like physics, right, I mean, if you have somebody walking on a street, how do you make sure that they don't go through a building or go through the floor? And so I think some of those video advancements that we have seen within Adobe have really addressed some of those hard problems. A big picture, though, video I think will be even more of an accelerant for editing applications. I think this notion that the next Oppenheimer will be done using a text-to-video prompt is just -- it's not going to happen for decades. And so I think actually more so in video, there's going to be an accelerant for people saying how do I get an on-ramp as it relates to using text to video and then edit that using our applications. And so I think I'm really particularly excited about what we can do with premiere as well as with After Effects as it relates to video. So net-net, I would say, Saket, the technology is impressive. We have our models, we have integrated into our interfaces. We're also partnering. I had a really great conversation with Jensen recently about what we can do as they are investing in video. Certainly, he would love to partner with us, and we're looking together to see how we can push the envelope on video as well using their models, whether it's Edify or Nemo. And so I think really early days, we're seeing a whole bunch. I hope -- and David mentioned this look at some of the lip sync stuff that we've done as well, which allows you to auto-dub and translate into languages. So we intentionally released a little bit of that demo. So really great advances. But net-net video is going to be even more of a need for editing applications in order to truly take advantage of generative AI."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. And maybe I'll just add a few things. First of all, as Shantanu mentioned, the research in the industry and certainly with Sora is very impressive and exciting. It's also very consistent with the models that we're developing. So we think that there is -- there will be, as there was with video -- sorry, imaging, there will be multiple models that come out, including the Adobe model later this year, and we should start to see a lot of innovation there like we've seen in imaging. We've already started to sneak a couple of things that Shantanu talked about. So you will see text-to-video capabilities from us later this year. But you'll also see it with transparency around the training data that we have, you'll see it with more tool ability and controllability. You'll see it integrated into our tools as well. Now, all of that said, I do want to be very clear with what Shantanu said, which is that we see the proliferation of video models to be a very good thing for Adobe. And we're going to work with OpenAI around Sora. You're going to see us obviously, developing our own model. You're going to see others developing model. All of that creates a tailwind because the more people generate video clips, the more they need to edit that content, right? So whether its Premiere or After Effects, or Express, they have to assemble those clips, they have to color-correct those clips, they have to tone match, they have to enable transitions. So we're excited about what we're building, but we're just as excited about the partnerships that we see with OpenAI and others coming down this path. And if you take a step back, you should expect to see more from us in the weeks ahead with imaging and vector and design, text effects, and in the months ahead with audio and video and 3D. We're very excited about what all of this means, not just for the models, but also for our APIs and our tools."
},
{
"speaker": "Saket Kalia",
"text": "Super helpful. Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Alex Zukin with Wolfe Research. Please go ahead."
},
{
"speaker": "Alex Zukin",
"text": "Hey, guys. Thanks for taking the question. And I just -- mine is going to be more of a clarifying question because it's clear that from a number of comments, whether it's outperforming Digital Media ARR in the quarter to accelerating Creative ARR in the second half to maybe doing better than $1.9 billion in the full year for Digital Media ARR. My question is very simple. Can you reiterate -- not update, but reiterate the guide that you gave in December for Digital Media ARR in net news specifically for this year, and maybe puts and takes around how we should think about to the question earlier, the second half versus first half tailwind, headwind around pricing?"
},
{
"speaker": "Shantanu Narayen",
"text": "Yeah. So we take our guide seriously. Q1 played out as expected. It was ahead of where we were last year. Our Q2 guide is ahead of where the guide was in Q2. We're talking about acceleration into the back half of the year. If I didn't feel like our full-year guide was achievable, we would have a different conversation. We're confident in the targets that we put out there, our ability to meet them. If there's an opportunity to do better, we certainly will. So we feel good about where we sit in the first half. And as we look forward into the second half, the momentum we see from an innovation standpoint integrating into our products, what we see going from beta to GA, we feel good about the momentum into the second half."
},
{
"speaker": "Alex Zukin",
"text": "Perfect. Thank you, guys."
},
{
"speaker": "Operator",
"text": "And your next question comes from the line of Karl Keirstead with UBS. Go ahead."
},
{
"speaker": "Karl Keirstead",
"text": "Thank you. Dan, maybe I'll continue with this subject that Alex was getting at. So I think what's tough about modeling ARR of late is it's very difficult to see the impact of the price actions. It feels like a black box to us. So I'm wondering if you could help us get aligned for the second half, and offer some qualitative color on the extent to which the prior period price actions roll off. Is that more of a 3Q or 4Q phenomenon? Is there any way you could help size that impact, just to feel good about David's earlier comment about that roll-off being a big part of the second-half ARR acceleration? Thank you."
},
{
"speaker": "Dan Durn",
"text": "Yeah. So there was two pricing actions that we had taken in 2022. In May of 2022, we pushed forward a pricing action, and then October of 2022, we pushed forward the Doc Cloud line optimization, where we integrated Sign. The one-year anniversary of those pricing actions from May of 2022 and October of 2023, or -- I'm sorry, October of 2022 will be behind us on the one year anniversary. So you will still see some Q3 impact from pricing actions in the year-ago period. Q4 will be a clean look for the company, at least two months in Q4 will be a clean look. The actions that we're taking right now from both a pricing and a product standpoint on the Creative side will be more apparent in the back half of the year into the end of the year."
},
{
"speaker": "Karl Keirstead",
"text": "Okay. That's helpful."
},
{
"speaker": "David Wadhwani",
"text": "I think the other way I would look at it, honestly -- sorry, go ahead."
},
{
"speaker": "Dan Durn",
"text": "Go ahead, David."
},
{
"speaker": "David Wadhwani",
"text": "Well, the way I would look at it, in terms of the rhythm of the numbers and how you've seen sort of what transpired in 2023, and how we look at 2024, and the path to $1.9 billion and beyond, the way I would look at it is we're ahead in Q1. We're ahead in Q1. We're giving you all the reasons why we think there's more product coming and more monetization coming in the rest of the year. And that's what gives us the confidence associated with the targets. I guess there's this question of every quarter, do we reiterate targets? Do we update targets? What does that mean? And the way we've always thought of it is, if it was a way -- if we didn't have confidence, we would give you that. We have confidence associated with the numbers, but we're not in the business of every quarter, looking at every number. And let's go down one other number, which was the GAAP EPS. Certainly, there's an impact, as you know, in the GAAP EPS associated with what we did as it related to the Figma sort of transaction, and therefore the impact to GAAP EPS in Q1. So I think, from my perspective, the quarter and the year is playing out just as we did, and I feel more confident now than I did when we gave you our annual targets. I'll leave it at that."
},
{
"speaker": "Karl Keirstead",
"text": "Yeah. We got it. Thank you."
},
{
"speaker": "Operator",
"text": "And we will take our next question from the line of Jay Vleeschhouwer with Griffin Securities."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "Thank you. Good evening. And with respect to Firefly, it's obvious that you are significantly ramping up your investments there, at least judging by the number of relevant open positions you're looking to fill for Firefly development, many of which are seemingly fairly senior. Could you comment on your pipeline of being able to bring in the requisite amount of developmental capacity to support everything you're doing with Firefly and everything else that David in particular talked about? And relatedly, on go-to-market in the last few months, you've been opening up the aperture for sales positions globally. Could you comment on what the thinking is behind that? And again, whether the population is there for you to bring in to meet your sales headcount needs? Thank you."
},
{
"speaker": "David Wadhwani",
"text": "Yeah. Let me take the first one and then Anil can answer the question on sales. As it relates to the momentum we're seeing with Firefly, I think there are multiple layers of it. One is obviously, we're seeing the quality of the models. We're seeing a differentiated approach as it relates to the training data, as it approaches contribution of assets from our community and how we compensate those folks. And so that's not just an Adobe perspective, but it's playing out obviously, in enterprises as they look at what are the models that they can consider using for production workflows. We're the only one with the full suite of capabilities that they can do. It's a really unique position to be in, but it's also being noticed by the research community, right? And as the community starts looking at places as if I'm a PhD that wants to go work in a particular environment, I start to ask myself a question of which environment do I want to pick. And a lot of people want to do AI in a responsible way. And that has been a very, very good opportunity for us to bring in amazing talent. So we are investing. We do believe that we have the best -- one of the best, if not the best, research labs around imaging, around video, or around audio, around 3D, and we're going to continue to attract that talent very quickly. We've already talked about we have the broadest set of creative models for imaging, for vector, for design, for audio, for 3D, for video, for fonts and text effects. And so this gives us a broad surface area to bring people in. And that momentum that starts with people coming in has been great. The second part of this too is managing access to GPUs while maintaining our margins. We've been able to sort of manage our cost structure in a way that brings in this talent and gives them the necessary GPUs to do their best work."
},
{
"speaker": "Anil Chakravarthy",
"text": "And regarding the sales positions in Enterprises. In Enterprise, we're in a strong position because what we -- I mean, this area of customer experience management, it remains a clear imperative for Enterprise customers. Everybody is investing in this personalization at scale, and current supply chain. These help drive both growth and profitability. So when you look at these areas, these from an enterprise perspective, these are a must-have. This is not a need to have. And that's helping us really attract the right kind of talent. We just onboarded this week a VP of Sales who have prior experience and a lot of experience in Cisco and Salesforce, etc. So that's an example of we're really bringing on some excellent enterprise sales talent."
},
{
"speaker": "David Wadhwani",
"text": "And I don't know if Jay, you were asking for -- building your model, or if you were looking for a job? But if you're interested in any of these positions, let us know more."
},
{
"speaker": "Jay Vleeschhouwer",
"text": "More the former."
},
{
"speaker": "David Wadhwani",
"text": "Okay."
},
{
"speaker": "Jonathan Vaas",
"text": "Hey, operator, we're coming up on the hour. Let's try to squeeze in two more questions. Thanks."
},
{
"speaker": "Operator",
"text": "Thank you. We will take our next question from Kash Rangan with Goldman Sachs."
},
{
"speaker": "Kash Rangan",
"text": "Hey, thank you very much. Looks like there is more trust in AI and Excel models than what you're actually saying qualitatively on this call. I just wanted to give you an opportunity to debunk this hypothesis that is going around, that AI, it is generating videos and pictures, but the next step is it's going to do the actual editing and put out Premiere Pro use or whatnot. So that is probably the existential threat that people are debating. So why don't you see if we could take a shot at why that scenario is very unlikely that right now it's about generation of images and then your tools pick up where the generation stops and you do the processing, right? So help us understand why this can coexist with AI. That's a philosophical question. And Dan, one for you. Besides the net new ARR that you've already reported on Creative and DM, what are the other indicators such as new business bookings that you don't quantify necessarily that you qualitatively saw in Q1 that makes you feel good about the year? Thank you so much."
},
{
"speaker": "David Wadhwani",
"text": "Great. So maybe I'll take your first part, and Dan obviously, can take the second. So as it relates to generated content, I'm going to sort of break it up into two parts. One is around the tooling and how you create the content, and the second is around automation associated with the content. I think if you take a step back before we even get into either one of those, there is no question that there's a huge appetite because of personalization at scale, the need to engage users, the need to build your personal brand online. That content is going to explode in terms of the amount of content being created, and it's going to explode because of one of two things. The first is around the ability to create audio clips, video clips, images, vectors. These are things that get users started. It's a great for ideation. You'll see in a few weeks that some of the incredible work the team has been doing around ideation on Firefly.com. And once those things are created, they do flow into our tools for the production, work and process. We're clearly seeing a huge benefit from that because the more content that gets created, the more editing that's required, and that's what's driving more commercial CC subscribers this quarter than any other Q1 before. So that's the foundation of it. The second part of this, though, from an editing perspective is the controllability of -- and the editability of not just pixels and vectors and timelines, but also the editability of the latent space itself. The latent space being the core capability -- core model capabilities that actually generate the output. We have a lot of research that we've already started releasing, the first of which was Style Match, and you'll start to see more and more of that actually coming out at summit and beyond. But we are, in my mind, very, very clearly the leader in terms of creating models that can also be tooled on top of. So that combination of the models getting better and the controllability of those models, we're in a remarkable position for that. So we benefit from that. The second part, Kash, is around automation. So as people are generating more content, you clearly need to be able to automate that content and how it's created. And that's really where Firefly Services come in. First, it's built on the strength of our Firefly models, say for commercial use integrated into our tools, but it also adds the ability to have custom models so control what kinds of information or brand and content it's trained on for both brand styles and product replica, and it's also part of an ecosystem of API services, not just generate something which is a core part of it like text to image, or Generative Fill or Generative Expand, but also process. So once you generate some images through APIs and automation, you want to be able to remove the background, you want to be able to blur the depth, you want to auto tone, you want to apply actions to that image. And then the last is you want to be able to assemble that for delivery. Firefly services don't just generate something, but they let you have that entire ecosystem, and then you can embed that using low code, no code environments into your flows, and we are already embedding it into GenStudio and all of the capabilities that we're shipping. So I think the core part of this is that as more of this content creates, you need more tool ability. The best models are going to be the models that are safe to use and have control built in from the ground up. And I think we have the best controls of anyone in the industry, and they need to be able to be done in an automated fashion that can embed into your workflow. So I think all three of those vectors point to benefits for Adobe."
},
{
"speaker": "Kash Rangan",
"text": "That's very convincing."
},
{
"speaker": "Dan Durn",
"text": "And then as we think about the forward-looking, a couple of points I would turn to, just think about cash flow in Q1. Strength of our cash flow, once you normalize for the $1 billion termination payment, that's up 28% year-over-year. When you think about RPO, 3 point acceleration sequentially, and when I break that up on deferred revenue, unbilled backlog, you saw that acceleration in each of those subcomponents, which as you look through that acceleration, the near-term underscores the strength of the business and it underscores the longer term strength we have around the momentum of the business. When I think about individual product commentary, we talked about it a lot on this call. You see record commercial subscriptions in the Creative business. In Q1, you see engagement going up on the products. Usage of Firefly capabilities in Photoshop was at an all-time high. In Q1, Express exports more than doubling with the introduction of Express Mobile in beta now going to GA in the coming months, AI Assistant Acrobat, same fact pattern. You can see that momentum as we look into the back half of the year. And from an enterprise standpoint, the performance in the business was really, really superb in Q1, strongest Q1 ever in the enterprise. So there's a lot of fundamental components that we're seeing around performance of the business that give us confidence as we look into the back half of the year."
},
{
"speaker": "Kash Rangan",
"text": "Super. Thank you so much, Dan."
},
{
"speaker": "Operator",
"text": "We'll take our next question from Keith Weiss with Morgan Stanley. Please go ahead."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you, guys, and I appreciate you squeezing me in. I'm going to take one last crack at this. Shantanu and team, we definitely, hear your confidence in the business, but obviously, the stock market reactions reflecting investors are worried about something. And the two things that worry investors more so than anything is uncertainty number one, and number two is back half ramps, right? And so I think what investors would really love to hear is Dan Durn actually say we still expect to do $1.9 billion in net new Digital Media ARR, and get some certainty there, and then also have a little bit more certainty or a little bit more explanation of what are the building blocks to that second half ramp? Which products are expected to go GA? Are we including stuff like document intelligent -- intelligence? Is there new monetization avenues that we're putting into the back half? Or is there just some mechanism within sort of the Creative Cloud pricing that's going to turn on in the back half of the year? Any further specifications in there, I think would help sort of close the gap between your confidence and sort of the lack of confidence exhibited by the after-hour reaction."
},
{
"speaker": "Shantanu Narayen",
"text": "And let me tackle that, Keith, and maybe I'll just tackle it by taking a couple of the other questions as well, summarizing that and ending with your question associated with the financial results. I think the first question that I hear across many folks is, hey, with the advent of AI and the increase in the number of models that people are seeing, whether they be image models or video models, does that mean that the number of seats, both for Adobe and in the world, do they increase or do they decrease? To me, there's no question in my mind that when you talk about the models and interfaces that people will use to do creative content, that the number of interfaces will increase. So Adobe has to go leverage that massive opportunity. But big-picture models will only cause more opportunity for interfaces, and I think we're uniquely qualified to engage in that. So that's the first one. The second one, I would say, is that does Adobe innovate, and when we do that, do we only leverage the Adobe model, or is there a way in which we can leverage every other model that exists out there? Much like we did with plugins, with all of our Creative applications, any other model that's out there, we will certainly provide ways to integrate that into our application. So anybody who is using our application benefits not just from our model creation, but from any other model creation that's out there. The way we first started to execute against that is in the enterprise because for us, the enterprise and the ability to create custom models so people can tweak their models to be able to do things within Photoshop that are specific to a retailer or a financial service was where we focus. But long term, certainly, as I've said with our partnerships, we will have the ability for Adobe in our interfaces to leverage any other model that's out there, which again, further expands our opportunity. I think as we play out the year, when we gave our targets for the $1.9 billion in ARR and the $410 million in Digital Media ARR for Q1, it factored in both our product roadmap and how things would evolve in the year. All of the product roadmaps we knew whether it was Acrobat, whether it was Express, whether it was Firefly, whether it was Creative Cloud, or whether it's GenStudio that brings all of these together, we knew the product roadmap, which we're executing against. In the first half of the year, a lot of that was beta, and in the second half of the year, a lot of that's monetization. It's playing out as expected. If anything, I would say the excitement around that, and in particular, the enterprise is faster than expected. And so I think our ability to monetize it just -- not just through new seats but also through these new Firefly services is expanded as it relates to what we are doing. And then as it relates to your question around financial results and the go-forward execution, we gave a Q1 target, we beat the Q1 target. And that gives us confidence that the financial target that we gave at the beginning of the year, we're ahead of that. And that's how I'll play it out. You're right. You have to model it. You can look at last year's model and look at last year's model and say, hey, they got to $1.913 billion. If they're ahead, does that fundamentally change Adobe's thesis on why we get to $1.9 billion and beyond, and in my mind it doesn't. And so that's the way I would answer that question. We have to go execute against the opportunity that we have. I look forward to those who are at Summit. I'm sure we'll have a little bit more conversation. But Q1 was a strong start. It was a strong start against product execution. It was a strong start against the financial metrics that we outline, and we're going to go do it again, Keith. So that's how I'd answer your question. So thank you all for joining."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. That's super helpful."
},
{
"speaker": "Shantanu Narayen",
"text": "And with that, I'll hand it back to Jonathan."
},
{
"speaker": "Jonathan Vaas",
"text": "All right. Thanks, everybody. I look forward to speaking with many of you soon. And this concludes the call. We look forward to seeing you at Summit."
}
] | Adobe Inc. | 24,321 |
ADBE | 1 | 2,025 | 2025-03-12 17:00:00 | Operator: Good day, and welcome to the Q1 FY 2025 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Steve Day, SVP, DX CFO in Corporate Finance, Interim Head of IR. Please go ahead.
Steve Day : Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience, and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s first quarter fiscal year 2025 financial results. You can find our press release, as well as PDFs of our prepared remarks and financial results, on Adobe’s investor relations website. The information discussed on this call, including our financial targets and product plans, is as of today, March 12, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates, as well as constant currency rates. During this presentation, Adobe’s executives will refer to constant currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe’s Investor Relations website. I will now turn the call over to Shantanu.
Shantanu Narayen : Thanks Steve. Good afternoon and thank you for joining us. Adobe had a record first quarter. We achieved $5.71 billion in revenue in Q1, representing 11% year-over-year growth. GAAP earnings per share for the quarter was $4.14, and non-GAAP earnings per share was $5.08, representing 13% year-over-year growth. Our performance reflects the ongoing critical role that Adobe products play in powering the global digital economy. In addition, given Q1 performance, we are pleased to reaffirm our fiscal ‘25 targets. Next week is Adobe Summit, our flagship digital experience conference, where we will unveil the latest innovations across our portfolio. In addition, we will host our Annual Investor Meeting on March 18th and we wanted to preview what we will share about our growth strategy. Adobe’s success over the past decade has been driven by the exponential growth of the creative economy and the customer-focused innovations we’ve delivered across Creative Cloud, Document Cloud and Experience Cloud. Our groundbreaking solutions are empowering an ever-expanding universe of users to imagine, create and deliver standout content that drives exceptional experiences. Adobe's mission to change the world through personalized digital experiences is more critical than ever as digital continues to rapidly transform work, life, education and entertainment. AI represents a generational opportunity to reimagine our technology platforms to serve an increasingly large and diverse customer universe. With creativity at the core, we have been evolving our offerings and routes to market to anticipate the distinct needs of creative professionals and next generation creators, marketing professionals, agencies and enterprises and the broader set of consumers and business professionals. We believe this will drive continued growth and profitability. Creative professionals and creators need power and precision to bring their ideas to life across any media type. The next generation of creators want the flexibility of web and mobile tools, in addition to the power of the desktop. They will benefit from the variety of AI models to ideate and explore creative possibilities. Adobe will serve this growing community with the most comprehensive set of web, mobile and desktop applications, delivered through various subscription tiers. In addition to Creative Cloud, we will offer new Firefly web app subscriptions that integrate and are an onramp for our web and mobile products. While Adobe’s commercially safe Firefly models will be integral to this offering, we will support additional third-party models to be part of this creative process. The Firefly app will be the umbrella destination for new creative categories like ideation. We recently introduced and incorporated our new Firefly video model into this offering, adding to the already supported image, vector and design models. In addition to monetizing standalone subscriptions for Firefly, we will introduce multiple Creative Cloud offerings that include Firefly tiering. Marketing professionals need to create an unprecedented volume of compelling content and optimize it to deliver personalized digital experiences, across channels including mobile applications, email, social media and advertising platforms. They are looking for agility and self-service, as well as integrated workflows with their creative teams and agencies. To achieve this, enterprises require custom, commercially safe models and agents tailored to address the inefficiencies of the content supply chain. With Adobe GenStudio and Firefly Services, Adobe is transforming how brands and their agency partners collaborate on marketing campaigns, unlocking new levels of creativity, personalization and efficiency. The combination of the Adobe Experience Platform and Apps, and Adobe GenStudio is the most comprehensive marketing platform to deliver on this vision. In addition to our direct sales force, we will leverage an ecosystem of partners and agencies to sell, implement, operate and deliver business outcomes to companies of all sizes. We have accelerated One Adobe, deals by increasingly integrating our creative and marketing products into a single enterprise solution. We will continue to invest in sales capacity to deliver Adobe-wide offerings across business, education and government. Business professionals and consumers want ease of use across web and mobile through a freemium model. They are looking for quick and easy AI-first, category-defining creative applications to help them stand out. While the need for creative expression continues to grow exponentially, the real value is in integrating creativity and productivity in an all-in-one solution. The combination of Express and Acrobat, is Adobe’s opportunity to make the journey from document creation to consumption smoother than ever. AI Assistant in Acrobat, Reader and Express will accelerate the delivery of new conversational and agentic interfaces to add value to this combined offering. Revenue growth will be driven by distribution across web and mobile app stores, partnerships with major software providers and focus on SMB and enterprise sales. Our generative AI innovation is infused across the breadth of our products and its impact is influencing billions of ARR across acquisition, retention and value expansion as customers benefit from these new capabilities. This strength is also reflected in our AI-first standalone and add-on products such as Acrobat AI Assistant, Firefly App and Services and GenStudio for Performance Marketing, which have already contributed greater than $125 million, book of business exiting Q1 fiscal 2025 and we expect this AI book of business to double by the end of fiscal ‘25. In summary, by leveraging the breadth of our products and technology platforms in the era of AI and delivering new tailored offerings and solutions by customer groups, we will drive the engine of growth for the next decade. We will win by focusing on Business Professionals and Consumers and Creative and Marketing Professionals, with a unified product strategy and go-to-market. We will start to provide financial visibility into these two new groups starting this quarter and expand on this at our Investor Day at Summit next week. I’ll now turn it over to David to discuss the momentum in our Digital Media business.
David Wadhwani : Thanks Shantanu. Hello everyone. In Q1, we achieved revenue of $4.23 billion, which grew 12% year-over-year. We exited the quarter with $17.63 billion of Digital Media ARR, growing our ending ARR book of business 12.6% year-over-year. We continue to see healthy performance in both Creative Cloud and Document Cloud. Creative growth was driven by broad-based adoption across our routes to market and product portfolio with particular strength in new offerings like Firefly Services, an increasing number of One Adobe deals, and a growing base of web and mobile users. Document Cloud continued to see strong organic demand, continued optimizations in free-to-paid conversion journeys and AI Assistant being released in additional languages. We drove strong performance across Digital Media in emerging markets. The results represent a good start to the fiscal year. Creativity is going mainstream, and I want to provide more color on the audiences we serve. We live in a visual-first world where creative expression has become pervasive in every facet of life. Business Professionals and Consumers alike aim to produce visually rich, engaging content, whether it is a presentation, birthday invitation or social post. At the same time, creative professionals, creators and marketers are competing on the quality of their online presence and the personalized experiences they deliver to customers. They turn to Document Cloud, Creative Cloud and Experience Cloud to achieve their content goals. Going forward as a result of AI advancements, we see incredible opportunity to serve customers with audience-specific offerings. Business Professionals and Consumers are increasingly benefitting from deep integration between Acrobat, Express and Firefly while Creative Professionals, Creators and Marketers are investing in powerful workflows across Creative Cloud, our new web and mobile creative application, Firefly and GenStudio. PDF continues to be the global standard for digital documents for Business Professionals and Adobe Acrobat is revolutionizing the way people engage with them across mobile, web and desktop. Features like AI Assistant in Acrobat and Reader have been a game-changer for everyone from sales teams to students, looking for faster insights and smarter document editing. And the ability to share links and collect comments has increased document productivity and helped drive additional adoption. These new capabilities and our cross-surface investments have paid off, with Acrobat and Reader monthly active usage growing 23% year-over-year. Our success with Acrobat has also shown us that, whether for a sales presentation, a school project, or a social media post, Business Professionals and Consumers are looking for an easy-to-use solution that helps them create visually compelling content that stands out from the crowd of generic templates. In fact, a significant number of all documents created in Acrobat are visual documents; things like marketing content, sales pitches, presentations, infographics and cover pages. We are making good progress in addressing this need by embedding Express capabilities as a native experience in Acrobat with a goal of boosting productivity and making the journey from document consumption to content creation smoother than ever. The integration of Adobe Express features in Acrobat allows users to create richer PDFs with AI-generated cover pages, embedded infographics and customized images and empowers users to create fully formed animated videos and other rich digital outputs. We see numerous early indicators of user demand as Express usage through Acrobat has grown 10 times year-over-year. Other highlights for Business Professionals and Consumers include; Acrobat AI Assistant support for languages now includes English, French, German, Italian, Portuguese, Spanish and Japanese. Acrobat AI Assistant support for legal workflows with contract-specific features. New AI capabilities in Express, like Clip Maker for auto generation of video highlights, and Text Rewrite, to help produce more effective copy. Expanded Acrobat integrations with Microsoft Edge, Google Chrome, Gmail and Google Drive and strong adoption of link sharing for richer collaborative experiences have led to approximately 50% year-over-year growth in Acrobat web monthly active usage. Expanded Express integrations now include Miro, Box, Slack, Webflow and Hubspot. The Express ecosystem also expanded to 225 plugins, more than doubling in the last year. Strong business and student adoption. Express onboarded nearly 6,000 new businesses in Q1, representing approximately 50% quarter-over-quarter growth. Students with access to Express premium grew 85% year-over-year. Key global customer wins include AT&T, Delta Airlines, Disney, Ernst & Young, IBM, JPMorgan Chase, Microsoft, Paramount and Qatar Airlines. Creative Professionals and the next generation of creators, who make their living by designing and producing content, are focused on standing out and bringing their unique creative visions to life with pixel-perfect precision. As we mark the 35th anniversary of Photoshop, Adobe creative applications remain the solutions of choice for the world's creative professionals across imaging, design, photography, video, illustration and 3D. We also see increasing demand from the next generation of creators, who are looking for freemium, web and mobile applications as they begin their creative journeys. To better serve these users, we launched a new Photoshop mobile app and an expanded web experience, delivering Photoshop’s iconic image editing and design capabilities on the iPhone. The mobile app and all-new web experience are also included in current Photoshop plans, offering established Photoshop customers a flexible ecosystem to create and edit across surfaces. The launch garnered over 30 million social engagements in just two weeks. The release of the Adobe Firefly Video Model in February, a commercially safe generative AI video model, has been very positively received by brands and creative professionals who have already started using it to create production-ready content. Users can generate video clips from a text prompt or image, use camera angles to control shots, create distinct scenes with 3D sketches, craft atmospheric elements and develop custom motion design elements. We’re thrilled to see creative professionals in enterprises and agencies; including dentsu, PepsiCo and Stagwell, finding success with the video model. Additionally, we recently launched an all-new Firefly application, the most comprehensive destination to generate images, vectors and now videos with unmatched creative control and direct integration with our industry-leading creative apps to seamlessly move from ideation to production. In addition to generating images, videos and designs from text, the app lets users generate videos from keyframes, use 3D designs to precisely direct generations, and translate audio and video into multiple languages. We also launched two new plans as part of this release; Firefly Standard and Firefly Pro, and began the rollout of our third plan, Firefly Premium, yesterday. User engagement has been strong, with over 90% of paid users generating videos. The launch of Photoshop on web and mobile and the release of the new Firefly application, expands our growing family of web and mobile products, which now includes, Photoshop for creative imaging, Lightroom for photography, Express for design and Firefly for ideation and early production. These apps serve, as value added capabilities to our existing paid subscribers and as a frictionless, freemium onboarding experience to attract and monetize next generation creators. We’re delighted with the early interest in these new offerings. Other Creative Professional and Creator highlights include; continued strong adoption of GenAI in our products with Photoshop GenAI monthly active users at approximately 35% and Lightroom GenAI MAU at 30%. Users have generated over 20 billion assets with Firefly. The introduction of new features in Premiere Pro beta and After Effects beta are helping editors and motion designers stay ahead of deadlines with AI features like Media Intelligence, which helps users find footage faster using natural language and captions translation for 17 languages, which effortlessly expand video to global audiences. We’re honored to see visionary filmmakers around the world telling this season’s most acclaimed stories using Adobe creative applications including Academy Award winners Anora and Dune: Part Two. The launch of Adaptive Profiles and Distraction Removal in Adobe Lightroom and Adobe Camera Raw, which reduce tedious and repetitive tasks. MAX Japan brought our community together and served as an opportunity for us to launch a number of new innovations including performance improvements in Adobe Illustrator, which accelerate features like pan and zoom and loading large files up to 10 times faster. We had another great quarter in the enterprise with more customers turning to Firefly Services and Custom Models to scale on-brand content production for marketing use cases, including leading brands such as Deloitte Digital, IBM, IPG Health, Mattel and Tapestry. Tapestry, for example, has implemented a new and highly productive digital twin workflow using Custom Models and Firefly. You’ll hear more on how the combination of creativity and marketing is powering personalization at scale in enterprises. Adobe is incredibly well set up to take advantage of AI across creativity. We're rapidly delivering tailored innovations to serve the full continuum of content creation for Business Professionals and Consumers, Creative Professionals and Creators, and Marketing Professionals. Our expanding breadth of offerings is reaching a broader universe of customers, and our incredible go-to-market strength and proven data-driven operating model are propelling the growth of both flagship and new offerings. We will be unveiling more exciting product capabilities at Adobe Summit and MAX London in April. I’ll now pass it to Anil.
Anil Chakravarthy: Thanks, David. Hello everyone. Experience Cloud had a strong Q1, achieving revenue of $1.41 billion for the quarter. Subscription revenue in the quarter was $1.3 billion, representing 11% year-over-year growth. Our leading solutions spanning content, data and customer journeys enable enterprises around the world to deliver personalized experiences at scale, helping customers drive both top-line growth and productivity gains. In Q1, we delivered typical seasonal bookings and advanced our pipeline as enterprise customers initiated the execution of their critical 2025 priorities. Adobe Experience Platform and Apps play a pivotal role in enabling unified customer experiences. With the addition of AEP AI Assistant, we extended the value and impact of Experience Platform by empowering more functions across the business with conversational interfaces for data ingestion, insight generation, audience segmentation and experience delivery. We are now building on these advances and expanding AEP to enable intelligent orchestration of customer experiences with AI agents natively built in. We are empowering customers to make better use of their first-party data and to drive more relevant ad experiences based on direct customer relationships. Our portfolio spans the entire content supply chain from creation and production, workflow and planning, asset management, delivery and activation through to reporting and insights. Now we are bringing together creativity and marketing with AI to help our customers realize the full potential of personalization at scale. Up to now, marketing professionals have been constrained by the number of content variations they can create and the number of journeys they can deploy. With Adobe GenStudio, brands around the globe have been working with Adobe to bring creative and marketing teams closer together, simplify their creation-to-activation process, and unlock new levels of creativity, insights and efficiency in marketing campaigns. Other highlights include; strong demand for Adobe Experience platform and native applications, with Q1 subscription revenue growing nearly 50% year-on-year. Release of Real-Time CDP Collaboration, delivering a secure environment for advertisers and publishers to jointly discover, activate and measure high-value audiences for more relevant campaigns. Built on AEP, Real-Time CDP Collaboration is purpose-built for brands to connect and collaborate on first-party data. Users can now measure ad effectiveness directly with publishers including NBC Universal and Warner Bros. Discovery. Advertisers and agencies including Alterra Mountain Company, GroupM Wavemaker, Major League Baseball and The Coca-Cola Company piloted the solution to deliver personalized and performant ads. Launch of the AEM Cloud Service accelerator with Publicis Sapient which can reduce the labor cost of migration up to 35%. Industry analyst recognition in major analyst reports including the Gartner Magic Quadrant for Digital Experience Platforms and Gartner Magic Quadrant for Personalization Engines. Strong demand for Firefly Services and Custom Models as part of the GenStudio solution with over 1,400 custom models since launch. GenStudio for Performance Marketing wins at leading brands including AT&T, Lennar, Lenovo, Lumen, Nebraska Furniture Mart, Red Hat, Thai Airways, and University of Phoenix. Strong partnership momentum with GenStudio for Performance Marketing supporting ad creation and activation for Google, Meta, Microsoft Ads, Snap, and TikTok and several partners including Accenture, EY, IPG, Merkle and PWC offering vertical extension apps. Partnership with dentsu to bring GenAI from playground to production for our joint customers with Adobe GenStudio dentsu+. Key global customer wins including Delta Airlines, Ford, IBM, M.H. Alshaya, Microsoft, PNC Financial Services and Tyson Foods. These customer wins address the ongoing evolution of the requirements of global brands for an integrated workflow spanning creativity and marketing. This success is driven by product integration and innovation across Creative Cloud and Experience Cloud increasingly delivered through Adobe GenStudio. Our One Adobe enterprise go-to-market engine enables customers to deliver personalized and on-brand content at scale. The combination of our integrated enterprise solutions across creativity and marketing is a unique strength for Adobe. Next week, we are excited to host Adobe Summit, our flagship digital experience conference in Las Vegas, where we will be joined by thousands of customers, partners, and developers from around the world. We will share our vision for how brands can apply the power of generative AI and agentic technology to achieve personalization at scale and look forward to highlighting a number of product innovations. I will now pass it to Dan.
Dan Durn: Thanks, Anil. Adobe’s business has grown over the last decade by delivering world-class products grouped within three clouds; Creative Cloud, Document Cloud and Experience Cloud. In parallel, we have continued to expand cross-cloud offerings to better serve different Customer Groups. Examples include Acrobat which is reflected in Creative Cloud and Document Cloud; GenStudio which includes Creative Cloud, Express, Firefly Services and Experience Cloud; Enterprises who want to engage with One Adobe and combine Creative seats with marketing automation; and increasingly Acrobat and Express. We believe Adobe’s success will be driven by innovation in service of both Business Professionals and Consumers and Creative and Marketing Professionals. Reporting insights and the financial performance across these customer groups will provide a clear view of Adobe’s execution against our strategy. We will therefore provide overall Adobe revenue, Digital Media and Digital Experience segment revenue, Digital Experience Subscription revenue and Digital Media ending ARR in aggregate rather than by cloud, as well as subscription revenue for Business Professionals and Consumers and Creative and Marketing Professionals. Subscription revenue provided will primarily include revenue from SaaS, managed services and term offerings. Business Professionals and Consumers Group will consist of all subscription revenue from Document Cloud, Acrobat subscription revenue in Creative Cloud, and Adobe Express subscription revenue in Creative Cloud, all of which are part of Digital Media. Creative and Marketing Professionals Group will consist of all subscription revenue from Digital Experience, as well as all of the remaining subscription revenue from Creative Cloud in Digital Media. In today's call, I'll cover three main areas: our Q1 FY25 results focusing on key growth drivers, financial targets, and our supplemental disclosures. Now turning to the quarter. In the first quarter of FY’25, Adobe achieved revenue of $5.71 billion, which represents 10% year-over-year growth, or 11% in constant currency. GAAP diluted earnings per share in Q1 was $4.14 and non-GAAP diluted earnings per share was $5.08. Q1 business and financial highlights included: Digital media revenue of $4.23 billion; Digital Media ending ARR of $17.63 billion, growing 12.6% year-over-year. Digital Experience revenue of $1.41 billion. Cash flows from operations of $2.48 billion; and exiting the quarter, remaining performance obligations were $19.69 billion, growing 12% year-over-year and cRPO growing 11%. In our Digital Media segment, we achieved Q1 revenue of $4.23 billion, which represents 11% year-over-year growth, or 12% in constant currency. We exited the quarter with $17.63 billion of Digital Media ARR, growing our ending ARR book of business 12.6% year-over-year in constant currency. First quarter Digital Media growth drivers included, strong growth for Acrobat across all routes to market and geographies; Acrobat Web and Mobile growth driven by freemium funnel and app store optimizations. Growth in Adobe Express, fueled by top of funnel improvements, PLG journeys across Acrobat and Express, and B2B customer onboarding. Strength in user adoption and engagement of Acrobat AI Assistant driven by expansion of features including support for additional languages and contract intelligence capabilities; Growth of Creative flagship offerings driven by All Apps, Stock, Imaging and Photography; Continued momentum in Creative Web and Mobile offerings with 35% year-over-year, ending paid subscription growth; and Strong momentum in the Enterprise, driven by Firefly Services and the continued benefit from the upsell motion of generative AI-enabled offerings. Turning to our Digital Experience segment, in Q1 we achieved revenue of $1.41 billion, which represents 10% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.30 billion, growing 11% year-over-year, as reported and in constant currency. First quarter Digital Experience growth drivers included; momentum for product offerings across content, data and journeys; AEP and Apps subscription revenue growing nearly 50% year-on-year. GenStudio solution surpassing $1B in ending ARR book of business. Early momentum in GenStudio for Performance Marketing in adoption and pipeline; and improvements in overall enterprise retention. Turning now to our customer group performance. Creative and Marketing Professionals Group subscription revenue was $3.92 billion, which represents 10% year-over-year growth as reported. Business Professionals and Consumers Group subscription revenue was $1.53 billion, which represents 15% year-over-year growth as reported. Adobe’s effective tax rate in Q1 was 17.0% on a GAAP basis and 18.5% on a non-GAAP basis. RPO exiting the quarter was $19.69 billion, growing 12% year-over-year, or 13% in constant currency and cRPO growing 11% year-over-year, or 12% in constant currency. Our cash flows from operations in the quarter were a Q1 record $2.48 billion, and ending cash and short-term investment position exiting Q1 was $7.44 billion. In Q1, we entered into share repurchase agreements totaling $3.25 billion, and we currently have $14.4 billion remaining of our $25 billion authorization granted in March 2024. Let me now turn to our Q2 FY 2025 financial targets. For Q2 FY’25 we are targeting. Total Adobe revenue of $5.77 billion to $5.82 billion. Digital Media segment revenue of $4.27 billion to $4.30 billion. Digital Experience segment revenue of $1.43 billion to $1.45 billion. Digital Experience subscription revenue of $1.315 billion to $1.325 billion. GAAP earnings per share of $3.80 to $3.85; and non-GAAP earnings per share of $4.95 to $5. For Q2, we expect non-GAAP operating margin of approximately 45% and a non-GAAP tax rate of approximately 18.5%. The year is off to a good start and assuming current macroeconomic conditions, I am pleased to reaffirm our full year guidance for fiscal year 2025. This quarter’s strong performance reflects Adobe’s long-standing focus on innovation and meeting the growing needs of our broad customer base. As businesses increasingly prioritize digital transformation, we are uniquely positioned to deliver value through our highly differentiated solutions and proven go-to-market execution to unleash the power of creativity. Looking ahead, we are excited about the opportunities to drive growth for our customers as we continue to shape the future in the era of AI. We look forward to seeing you next week at our Investor Meeting at Summit 2025. Thank you and we will now take questions. Operator.
Operator: Thank you. [Operator Instructions] The first question will come from Brent Thill with Jefferies.
Brent Thill : Good afternoon Shantanu, if you took the AI book of business, it would be low single-digit percent of your total revenue for the year. I guess many are asking, when does this become more material? How long does it take? What is required? Maybe just help us walk through the AI journey and how that translates to revenue.
Shantanu Narayen : Happy to, Brent. If you take a step back and think about it, we've always talked about the AI journey as three parts. The first is ensuring that we innovate. The second is all about tracking usage and ensuring value and monetization. And I’d say, we are really pleased across all three of those journeys as we've had conversations with you folks as well in the past. A significant amount of the AI monetization is also happening in terms of attracting people to our subscription, making sure they are retained and having them drive higher-value price SKUs. So when somebody buys Creative Cloud or when somebody buys Document Cloud, in effect, they are actually monetizing AI. But in addition to that, Brent what we wanted to do was give you a flavor for the new stand-alone products that we have when we've talked about introducing Acrobat AI Assistant and rolling that out in different languages, Firefly, and making sure that we have a new subscription model associated with that on the web, Firefly Services for the enterprise and GenStudio. So the $125 million book of business that we talked about exiting Q1 only relates to that new book of business. And that's, again stuff that we said we would double. But I think in terms of the impact also on the overall business, that has had a material part. But if you play this out a little bit more and you talk about what investors can expect, I think with the new Firefly app that's come out, this is a web product with a new subscription, ability to have the video model, ability to have ideation as part of it. Think of it as then integrating Photoshop web, Express web and all of the other products, all of that is also upside. And we really -- you'll see a lot more innovation in that area and you'll see a lot more monetization in that area. And again, the last thing I'll probably say, Brent, is that the whole idea was to start to tee it up, and then again at the FA meeting, to continue to expand on how that is. But net-net, I would say, whether it is innovation, having our own models, integrating it across all of our products, brand new revenue streams like GenStudio in the enterprise and then usage and monetization, I feel really good about it.
Brent Thill: Great. Thanks Shantanu.
Operator: And the next question will come from Brent Bracelin with Piper Sandler.
Brent Bracelin: Thanks for taking my question. Good afternoon. I wanted to double-click into the demand linearity you saw in the quarter. I appreciate the commentary reaffirming 11% Digital Media ARR growth guide for the full year. But could you provide more color on trends you saw in the quarter across Creative and Document Cloud here? Thanks.
David Wadhwani : Yes, happy to do that. So again, just Digital Media ARR was a 12.6% growth, which is in-line with our expectation and also the mix was in-line with our expectations. If you take a step back and you look at the demand and sort of the way the business played out this quarter, it's consistent with what we've seen historically, and it's also -- we've seen sort of a broad-based demand for the products with a few highlights that I think are worth calling-out. First of all, as it comes to business professionals and consumers, this is obviously a huge market with billions of users that we are going after. And our strategy here is to really make sure that productivity that we deliver a solution that -- for productivity from consumption all the way to creation and that's really what we're doing with Acrobat and Express. We saw a lot of momentum in these businesses. We talked about how Acrobat is up 23% year-over-year in terms of monthly active users. We're seeing stronger conversion on those users, and that's been helping drive the business. AI Assistant, obviously, we introduced that last year continues to do very well and it is certainly helping with that strategy of faster consumption and conversational experiences. We saw 2 times quarter-over-quarter usage growth in AI Assistant. And of course, in that context, Express has been a great product. The product right now is just -- it's an amazing product to use. And so that also, we've been investing in very significantly. From a marketing standpoint but also from a partnership standpoint, we've doubled the partner ecosystem in the last year. It now includes new names like Mero and Box and Webflow and HubSpot. We have 85% more access -- 85% year-over-year growth in students with access to it. We've been ramping up our student and campus ambassador programs. We added 6,000 new small, medium businesses to the Express product as well. And even within Acrobat where we've been doing more -- we're seeing much more demand. We saw a 10 times year-over-year engagement of Express capabilities from Acrobat users. So feeling really good about that audience group. On the Creative pro and creator side, Shantanu mentioned this already, but the introduction of the Firefly video model being used by Dentsu and PepsiCo and Stagwell, Firefly new offerings from Standard to Pro. And just yesterday, we introduced Premium which is a much larger set of generative credits and all of those represent new monetization models. We introduced Photoshop mobile and web. We saw hundreds of articles, 30 million social engagements. We were just listed as the focused app on the App Store over the weekend. We saw some great new advances for AI coming into Lightroom web and mobile. Premier also saw some great advances in terms of AI. So lots of momentum in that business. And what's really exciting is that as we've done all of this innovation, as Shantanu was talking about, we also have three big milestones coming up with Summit next week then NAB shortly after that, then Max London, shortly after that. And this is starting to show up. Obviously, we've talked about generation as we crossed 20 billion generations. We are doing more than 1 billion generations now a month and 90% of people using Firefly the app also saw -- are generating video as well as part of that. But we also saw a strong growth in the enterprise. I don't know, Anil, if you want to add something?
Anil Chakravarthy : Yes, exactly. To just echo what you were saying, I think in the enterprise, we see a lot of demand for creativity and marketing and AI coming together. Every CMO that we talk to, every agency that we work with, they are all very interested in how generative AI can be used to transform how the content supply chain works. And with the GenStudio offering, which combines the creativity and the marketing and the AI, we've seen tremendous traction and we saw a number of both customer wins, as well as a number of agency partners, and we look forward to unveiling a lot more of this at Summit.
David Wadhwani : So off to a great start, I think with innovation, new offerings and you can expect to see new offerings and peers in the months ahead.
Brent Bracelin: Helpful. Look forward to talking to you next week. Thanks.
Operator: And the next question will come from Keith Weiss with Morgan Stanley.
Keith Weiss: Excellent. Thank you guys for taking the question. And thank you for the additional disclosure. I think it's a really interesting view kind of breaking down the creative and marketing professionals versus the business professionals and consumer group. And kind of following on that last question, correct me if I'm wrong, but it feels kind of bullish to me that the business professionals and consumer group has a stronger growth rate, creative at 15% creative and marketing professionals, a little bit behind because it feels like business professionals and consumer group, those products would be faster sales cycle, particularly on the consumer side of the equation, faster adoption. The creative and marketing professionals, this broader solution that you are trying to sell would have a longer sales cycle. So the question is, am I thinking about that right? And are you seeing any indications that, that creative and marketing professional group, whether it's in your pipeline or sort of the activity you're seeing, could that catch up with what we're seeing from the business professionals and consumer group?
Shantanu Narayen : Well, Keith, I mean part of our goal was really to start to provide insight into by the customer groups, how we're starting to see it. And to some degree, when people are wondering how we are actually driving creative, and the reality is that when you think about the GenStudio set of products, which we now said is a $1 billion book of business, AEP and Apps is also a $1 billion book of business and the creative professional, that's actually addressing the entire content supply chain. And so in terms of that growth rate, as we add new subscriptions like the Firefly app subscription, add more video, add more functionality in what we are doing with GenStudio, that growth rate as well, it is a very large untapped opportunity and people have been asking us questions about the strength of the creative market, as well as the strength of that market within the enterprise. And we think that's a large TAM, we'll share more. So I think you are thinking of it right, which is to say the $5 billion book of business that we built for digital marketing, that's really helping the content and the creative economy. And so that was the idea behind giving you a window into that, and the metrics associated with that are subscription and different kinds of offerings. On the other side of the equation as well, to your point what we wanted to do is reflect the fact that the investments that we made in both Acrobat and Express continuing to ensure distribution when we think about the monthly average users. If you take it in aggregate, I mean, Adobe has hundreds of millions of people who are using monthly -- are using our products. And that will be really the early metrics and the indicators of how Express and Acrobat continue to grow. So I'm glad that you found the additional disclosure beneficial. And that was the idea. And to Brent's earlier question as well, I just wanted to clarify. I mean, we are not taking all of the revenue that we see in Digital Media and Digital Experience and calling that AI revenue. But relative to what I've seen from any other company in our particular space, we've actually been pleased by how much of it, whether it is additional tiers of AI in the Digital Experience, so what we are seeing across Acrobat, as well as the creative professional space, there's been good adoption of AI in that. And so that was the other intent, to start to show that so that we can talk about it more at the FA meeting.
Keith Weiss: Outstanding. Can I sneak one -- last one in for Mr. Durn? It's great to see you guys take advantage of the pullback in the stock price by accelerating the share repurchase which picked up this quarter. Could these -- could this pace of share repurchases, can you guys sustain this throughout the year or is that more of a onetime pickup?
Dan Durn : Yes. So if I take a step back, Keith, and you think about the last four quarters, we've repurchased almost $11 billion. And we've always talked about if there's opportunities to be opportunistic along the way, we would take advantage of it. And I think that's what you saw play out in Q1. We've got a strong point of view about the financial profile throughout the course of the year. Happy to reaffirm guidance, but we're going to drive that with strong operating margins, strong cash flow delivery and be strong capital allocators throughout the year. So we feel good about where we sit. And if there's opportunities to be opportunistic, we will.
Shantanu Narayen : And Keith, it's definitely a vote of confidence that we feel in what we are seeing as the opportunities ahead of us.
Keith Weiss: Yes. It’s great to see you guys putting your money where your mouth is by accelerating that share repurchase. It definitely helps.
Operator: And the next question will come from Kash Rangan with Goldman Sachs.
Kash Rangan: Hi, thank you very much. Much appreciate the disclosure and the color and everything that goes with it. Shantanu, question for you. When you pivoted the company to a new business model through cloud, initially there was a lot of skepticism. Then you proved to us that the TAM was actually larger in the new creative meets the cloud cycle. And the company was able to accelerate through the transition and put up even better margins and by expanding the TAM necessarily. So as you look at AI right now, right now, one bearish argument that one could make which I don't subscribe to, is that you're playing defense and that AI is a cost of staying in business and keeping us relevant to your creative base. But how do you look, since you've been through this 1 big shift before, you've got a lot of experience, where is your conviction on how truly incremental AI can be for your growth? Could you be at a similar junction where you're poised to get into the next cycle is actually bigger TAM, not to put words in your mouth, but even maybe dare I say the potential to accelerate off of the good growth that we've seen so far? Thank you so much.
Shantanu Narayen : Well, Kash what I appreciate about the question is, this is what we wanted to really tee up in front of the FA meeting. But without a doubt, as David described, the opportunity for the business professional and consumers, I think you will start to see and we'll share more at the FA meeting that there are billions of people that we can bring into the fold for creativity and productivity and talk more about how we are, with the distribution that we have and with the monthly average users that we have, monetize that much like we've monetized Acrobat. And we definitely believe that it's a massive, massive opportunity. I think it is the same thing across creators. There are more creators that are entering. And again, I'll preview a little bit of what David will share, which is when you think about the web and mobile offerings that we are providing to attract more people to our platform, as creative professionals and next-generation creators, the number of people who want to enter that profession is significantly larger than it's ever been. And so with products like Photoshop on web and mobile, as well as Firefly app, that's clearly the intent to show how that as a subscription service and attracting the next generation creators will be a tailwind. And then when you put this together in the enterprise, I mean, hopefully, what you also see as part of the additional disclosures is that the enterprise has continued to be a material part of our business and material part of our growth because they are, in order to do personalization at scale, as Anil is talking about, there is going to be more content that's produced. There's going to be more content that's actually inserted into ad systems and social media. And so again, I think setting the stage for how that's a larger opportunity. But if you look at it from not just the length of we were marketing but look at the lens of, hey, that's a content business for us in the enterprise. We will again outline how that is only going to be a growing opportunity. So no question in my mind, all three of these are actually going to accelerate in terms of the TAM and then we have to innovate and execute against that. So I am more excited about the larger opportunity without a doubt as a result of AI. And we've talked about this, Kash. If you don't take advantage of AI, it is a disruption. In our particular case, the intent is clearly to show how it's a tailwind.
Kash Rangan: Excellent. And one follow-up and very quick, promise if I can. With the turbulence in the markets with trade wars, et cetera tariffs, et cetera, how do you feel your customer base is going to behave? Is everything going to be on track from what you can tell by talking to your customers? Or are they kind of perplexed by what's going on and pausing? Thank you so much and that’s it for me.
Shantanu Narayen : Well, I mean I think we just sort of said, assuming current macroeconomic conditions, I mean, we have a diverse business. We are off to a good start in the conversations that we are having. And all of us have conversations with all of our other peers. And I think we have a seasoned management team that will navigate it. But customers, I think we are all jointly trying to understand what happens in the economy. But I'm -- the tariffs, et cetera, don't really impact Adobe, the way they impact other businesses. And so we are optimistic.
Kash Rangan: Thank you so much.
Operator: Thank you. And the next question will come from Mark Moerdler with Bernstein Research.
Mark Moerdler: Thank you very much. Dan, can you give us more color on why you're changing the categorization of revenue, removing the historical Document Cloud and Creative Cloud? Is this driven by the One Adobe sales motion? Is Express now sold predominantly with Document Cloud? How should we think about the drivers? Thank you.
Dan Durn : Yes, so thanks for the question, Mark. As we laid it out, we talked about increasingly driving cross-cloud offerings. We're already doing it today. We're going to be doing more of it going forward. And as you look at individuals increasingly buying offerings, as you look at enterprises increasingly buying solutions and bringing different parts of our portfolio together to meet their highest value needs around these two groupings of the customers, it really is meant to just draw a highlight to our strategy and how we are executing against that strategy. On a go-forward basis, our success is going to be driven by the way we innovate into the intersection of productivity and creativity, into the intersection of creativity and marketing. And those intersections are highlighted by these two groupings of customers. And so the intent around this is to really bring to life how we are driving our strategy, how we're executing against it, provides the best insight in how the company is performing on a go-forward basis.
Shantanu Narayen : And Mark, at least 2 specific things that we've heard as feedback from all of you folks are, you understand that there's an Acrobat within the Creative Cloud and Document Cloud. This pulls out the business in order to show the momentum and the opportunity in that business. And to your question about One Adobe, yes, I mean, the GenStudio solution is, without a doubt taking seats of products like Photoshop or the Creative Cloud, is adding Express in it for every marketer in there. We have Firefly Services and custom models. And so the more we sell that as one enterprise offering and we want to accelerate the sale of that as a strategic partnership, that's now also all reflected in one of those revenue slices. So we believe that the additional disclosure will also give us -- give you more visibility into routes to market.
Mark Moerdler: That makes a lot of sense. And one quick other one. Should we expect the disclosure on the AI ARR something that we'll be getting quarterly or periodically updated?
Shantanu Narayen : Periodically.
Mark Moerdler: Okay. Good luck in quarterly. Thank you.
Operator: And the next question will come from Alex Zukin with Wolfe Research.
Alex Zukin: Hi, thanks guys for taking the question. And I will join the chorus of those commenting positively on some of the new numbers, particularly the AI book of business. And that's where I wanted to ask the question. Basically, look, you are going to give us a number, we're going to ask for more. So in that spirit, if you look at the $125 million and you think about the segmentation between Assistant, Firefly, GenStudio, is there any triangulation around maybe how much -- what the percentages of -- for the breakout of those and maybe stack rank the growth rates that are going to get you to double that by the end of the year? And then kind of similarly, if you think about if that $125 million is impacting or where the tailwinds are more towards the creative and marketing professional or the business professionals?
David Wadhwani : Yes. Great question, Alex. So first of all, if you look at the mix of these things, AI Assistant has been around for about three quarters or four quarters now. Firefly Service has been around for about four quarters as well. GenStudio was introduced late in Q4 of last year. So that gives you a little bit of a sense that the composition is going to sort of like be based on the tenure of these products in the market. But if we take a step back and you look at the growth trajectory, again, we're talking $195 million -- sorry, $125 million doubling in the next nine months. It gives you a sense of the scale of these businesses and really the momentum that's in the business. And when you look at it, the core innovation that Shantanu talked about led to a lot of utilization. And now we are starting to get to a point where we can monetize it. For Firefly, we have imaging, vector, design, video, voice, video and voice coming out just a couple of weeks ago, off to a good start. I know there have been some questions about how important is commercially safety of the models. They're very important. A lot of enterprises are turning to them for the quality, the breadth but also the commercial safety, the creative control that we give them around being able to really match structure, style, set key frames for precise video generation, 3D to image, image to video. The inclusion also, on a road map, and we'll share more about this next week of third-party models really establishes us as the one-stop shop for anything you need to do with creativity. And then when you ladder that into a Firefly stand-alone offer with multiple tiers with Standard, Premium, and Pro, when you look at that integrated into Creative Cloud, you could imagine further tiering there. When you look at the work that we are doing in conjunction with Anil's team around GenStudio and making sure all of these models and this entire platform, including third-party models are exposed within our GenStudio offer. What it's really doing is, it's evolving away from the conversation being about the model to the conversation being about the workflows and the integration and the application tier and the agent-based things that we'll be talking to you more about. And that really plays to our differentiation, our strength and our audiences that we serve. And that's why you see the bullishness of that $125 million doubling in the next nine months.
Shantanu Narayen : Yes. I'm glad that you find the sort of information useful. I will give you a little bit more color as well on that. Remember, with Acrobat, we have AI Assistant that's separate, so this is only the separate Acrobat AI Assistant. So the majority of that revenue is actually Creative because as we can continue to put the AI Assistant, as part of an Acrobat SKU. We would not count that if that came as part of an Acrobat Premium SKU. So color-wise so far, creative actually represents the majority of that. But as you know, Acrobat is doing great.
Alex Zukin: That's very, very helpful. I guess maybe just to follow along there. You've seen -- or we've seen a lot of consolidation start to happen within the AI realm where the model companies or the agent even emerging the agentic companies. Maybe just remind us on how you are thinking about your approach towards organic versus inorganic innovation here, given just the plethora of functionality that you're releasing across the board.
Shantanu Narayen : As it relates to the core creative models, we will have our commercially safe, as David said, Alex, and so within Firefly as an application and within each of our product integrations and Photoshop, et cetera, expect Firefly. We've also signaled and we've shown how we would support third-party models associated with that. And so whether it is a custom model that we create for one of our enterprise customers, I think if you look at it, there have been a couple of articles this week about how whether it's Estee Lauder, who is going to be building their models built on ours and leveraging it or a company like Publicis that's going to be taking these models. So our core imaging video franchise, we will have our models as it relates to text, we have support for other third-party models. And so I think it's a very practical and it's the right one, and we'll support all of the creative third-party models that people want to support, whether it is a custom model we create for them or whether it is any other third-party model within Firefly as an App and within Photoshop, you're going to see support for that as well. And so think of it as we are the way in which those models actually deliver value to a user. And so it is actually just like we did with Photoshop plug-ins in the past, you’re going to see those models supported within our flagship applications. Hopefully, that gives you a sense.
Operator: And the next question will come from Mark Murphy with JPMorgan.
Mark Murphy: Thank you very much. I was wondering if you can just comment on what you are sensing fundamentally in terms of advertising activity and consumer spending trends in the wake of some very choppy results from multiple airlines the last several days and multiple retailers. What is giving you the resilience to reaffirm the FY '25 guidance when some of those are really huge sectors of the economy and they seem to be encountering some turbulence? I'm just wondering if there -- you basically see them continuing to create and market and advertise despite this environment.
Shantanu Narayen : I think at the end of the day, Mark, we just believe that digital is going to continue to be a fundamental part of the economy and the importance is going to continue. I mean, there isn't a single company that I've talked to that doesn't say digital. To your point, as other companies view macroeconomic conditions that may be particular to them, onuses on every company that's serving them with technology to demonstrate how the technology helps, whether it's the top line or the efficiency. But whether it's top-line growth or efficiency or both, they're not going to go out of style, as it relates to any enterprise saying, how can I use technology to accomplish my objectives?
Mark Murphy: Okay. And then -- I appreciate that, Shantanu. As a very quick follow-up on Alex's question, with the ARR the $125 million ARR doubling in the next nine months, do you think it's going to be the same composition or is something going to be coming in from the video models that might change the mix there in the next nine months?
Shantanu Narayen : The video model is part of the creative Firefly app that will be part of this. I think a lot of these great questions, Mark, I mean, at the FA meeting, we'll try and give more color as well as to what we are seeing. But we wanted to at least start to outline what products were in there, the growth rates that we expect and how we are executing on, as I said, the innovation, usage, understanding and offering these as monetization. So we'll also, I know keep a track of the ongoing questions and address them at the FA meeting as well, Mark.
Operator: And our last question will come from Saket Kalia with Barclays.
Saket Kalia: Okay, great. Hi, guys. Thanks for taking my question here and squeezing me here. I'll keep it to one. David, maybe for you. It's great to see the Firefly app tiers that customers can add to their existing subscriptions. And maybe to Shantanu's point, this is a better topic for FA day, but I'm wondering if we could just talk about, how do you envision sort of the potential attach rate there? I mean, Firefly is clearly an unprecedented offering, so maybe that's really tough to answer. But are there any products that maybe Adobe has seen in the past like Adobe Stock or any others that you look at as sort of a framework for what that adoption curve could look like?
David Wadhwani : Yes. I think, so if we take a look -- if you take a step back, the reason we are so excited about the Firefly app is really twofold. One is exactly where you are going, Saket, and what you're asking about, which is the -- with every conversation we've had with creative professionals, we know that wherever they are, they are under an enormous amount of pressure to produce more. And this cohort of creative professionals, we see very strong attach and adoption of the generative AI features we put in the product, partially because they're well integrated and very discoverable and because they just work and people get a lot of value out of that. So what you will see is you'll start to see us integrating these new capabilities, these premium capabilities that are in the Firefly Standard, Pro, and Premium plans more deeply into the creative workflow so more people have the opportunity to discover them. And of course, as part of that, I think you can expect to see what we've done all along is look at where the usage is, look at where the excitement is and make sure we get the pricing and the tiering right in a way that maximizes the opportunity for our customers and maximizes the opportunity and the value that Adobe and our shareholders get as part of that, too. So that will be a big area and a big opportunity, and we see a lot of potential there as we look ahead. The other part that I want to make sure doesn't get lost in this is how relevant this Firefly experience is for non-creative professionals as well, this next generation of creators that we keep talking about. And if we look at the early adoption rates of the Firefly paid-plan, it really tells us both of these stories. We have a high degree of conviction that it is adding value and being used by creative professionals, but it's also proving to be a good onboarding opportunity for next-generation pros -- sorry, next generation pros and creators in general. And that's where Shantanu mentioned earlier, there is an increasing opportunity to merge our web and mobile offerings around not just the generative capabilities but what you do with the content you generate with Photoshop web and mobile, Express web and mobile. And you can imagine other capabilities coming around video as well. So we are excited about Firefly Services and the monetization capabilities there in both directions, new users and also value and ARPU for our existing base.
Shantanu Narayen : And Saket, since that was the last question, thank you. And maybe just in a quick summary, I mean, the four things that I would leave you all with is Q1 was a strong start. We were pleased with our performance. When you think about the addressable markets that we have, as we think about how we serve the business professional and the consumer and the creative professional and the marketing professional, we believe that, that's an immense opportunity that's only going to grow as a result of AI. We are pleased with how AI is now infused across all of our products and how we are further tailoring the breadth of our products to serve these customer groups in a way in which we delight them. And we're starting to outline how the monetization will be different for each one of these and applicable for the customer group that we are serving. We really continue to believe that this will drive growth and profitability for us, as a company in '25 and beyond. And so we look forward to joining you all at the FA meeting, and thank you for joining us today.
Operator: Thank you. That does conclude today's conference. We do thank you for your participation, and have an excellent day. | [
{
"speaker": "Operator",
"text": "Good day, and welcome to the Q1 FY 2025 Adobe Earnings Conference Call. Today's conference is being recorded. At this time, I'd like to turn the conference over to Steve Day, SVP, DX CFO in Corporate Finance, Interim Head of IR. Please go ahead."
},
{
"speaker": "Steve Day",
"text": "Good afternoon and thank you for joining us. With me on the call today are Shantanu Narayen, Adobe’s Chair and CEO; David Wadhwani, President of Digital Media; Anil Chakravarthy, President of Digital Experience, and Dan Durn, Executive Vice President and CFO. On this call, which is being recorded, we will discuss Adobe’s first quarter fiscal year 2025 financial results. You can find our press release, as well as PDFs of our prepared remarks and financial results, on Adobe’s investor relations website. The information discussed on this call, including our financial targets and product plans, is as of today, March 12, and contains forward-looking statements that involve risk, uncertainty and assumptions. Actual results may differ materially from those set forth in these statements. For more information on those risks, please review today's earnings release and Adobe's SEC filings. On this call we will discuss GAAP and non-GAAP financial measures. Our reported results include GAAP growth rates, as well as constant currency rates. During this presentation, Adobe’s executives will refer to constant currency growth rates unless otherwise stated. Non-GAAP reconciliations are available in our earnings release and on Adobe’s Investor Relations website. I will now turn the call over to Shantanu."
},
{
"speaker": "Shantanu Narayen",
"text": "Thanks Steve. Good afternoon and thank you for joining us. Adobe had a record first quarter. We achieved $5.71 billion in revenue in Q1, representing 11% year-over-year growth. GAAP earnings per share for the quarter was $4.14, and non-GAAP earnings per share was $5.08, representing 13% year-over-year growth. Our performance reflects the ongoing critical role that Adobe products play in powering the global digital economy. In addition, given Q1 performance, we are pleased to reaffirm our fiscal ‘25 targets. Next week is Adobe Summit, our flagship digital experience conference, where we will unveil the latest innovations across our portfolio. In addition, we will host our Annual Investor Meeting on March 18th and we wanted to preview what we will share about our growth strategy. Adobe’s success over the past decade has been driven by the exponential growth of the creative economy and the customer-focused innovations we’ve delivered across Creative Cloud, Document Cloud and Experience Cloud. Our groundbreaking solutions are empowering an ever-expanding universe of users to imagine, create and deliver standout content that drives exceptional experiences. Adobe's mission to change the world through personalized digital experiences is more critical than ever as digital continues to rapidly transform work, life, education and entertainment. AI represents a generational opportunity to reimagine our technology platforms to serve an increasingly large and diverse customer universe. With creativity at the core, we have been evolving our offerings and routes to market to anticipate the distinct needs of creative professionals and next generation creators, marketing professionals, agencies and enterprises and the broader set of consumers and business professionals. We believe this will drive continued growth and profitability. Creative professionals and creators need power and precision to bring their ideas to life across any media type. The next generation of creators want the flexibility of web and mobile tools, in addition to the power of the desktop. They will benefit from the variety of AI models to ideate and explore creative possibilities. Adobe will serve this growing community with the most comprehensive set of web, mobile and desktop applications, delivered through various subscription tiers. In addition to Creative Cloud, we will offer new Firefly web app subscriptions that integrate and are an onramp for our web and mobile products. While Adobe’s commercially safe Firefly models will be integral to this offering, we will support additional third-party models to be part of this creative process. The Firefly app will be the umbrella destination for new creative categories like ideation. We recently introduced and incorporated our new Firefly video model into this offering, adding to the already supported image, vector and design models. In addition to monetizing standalone subscriptions for Firefly, we will introduce multiple Creative Cloud offerings that include Firefly tiering. Marketing professionals need to create an unprecedented volume of compelling content and optimize it to deliver personalized digital experiences, across channels including mobile applications, email, social media and advertising platforms. They are looking for agility and self-service, as well as integrated workflows with their creative teams and agencies. To achieve this, enterprises require custom, commercially safe models and agents tailored to address the inefficiencies of the content supply chain. With Adobe GenStudio and Firefly Services, Adobe is transforming how brands and their agency partners collaborate on marketing campaigns, unlocking new levels of creativity, personalization and efficiency. The combination of the Adobe Experience Platform and Apps, and Adobe GenStudio is the most comprehensive marketing platform to deliver on this vision. In addition to our direct sales force, we will leverage an ecosystem of partners and agencies to sell, implement, operate and deliver business outcomes to companies of all sizes. We have accelerated One Adobe, deals by increasingly integrating our creative and marketing products into a single enterprise solution. We will continue to invest in sales capacity to deliver Adobe-wide offerings across business, education and government. Business professionals and consumers want ease of use across web and mobile through a freemium model. They are looking for quick and easy AI-first, category-defining creative applications to help them stand out. While the need for creative expression continues to grow exponentially, the real value is in integrating creativity and productivity in an all-in-one solution. The combination of Express and Acrobat, is Adobe’s opportunity to make the journey from document creation to consumption smoother than ever. AI Assistant in Acrobat, Reader and Express will accelerate the delivery of new conversational and agentic interfaces to add value to this combined offering. Revenue growth will be driven by distribution across web and mobile app stores, partnerships with major software providers and focus on SMB and enterprise sales. Our generative AI innovation is infused across the breadth of our products and its impact is influencing billions of ARR across acquisition, retention and value expansion as customers benefit from these new capabilities. This strength is also reflected in our AI-first standalone and add-on products such as Acrobat AI Assistant, Firefly App and Services and GenStudio for Performance Marketing, which have already contributed greater than $125 million, book of business exiting Q1 fiscal 2025 and we expect this AI book of business to double by the end of fiscal ‘25. In summary, by leveraging the breadth of our products and technology platforms in the era of AI and delivering new tailored offerings and solutions by customer groups, we will drive the engine of growth for the next decade. We will win by focusing on Business Professionals and Consumers and Creative and Marketing Professionals, with a unified product strategy and go-to-market. We will start to provide financial visibility into these two new groups starting this quarter and expand on this at our Investor Day at Summit next week. I’ll now turn it over to David to discuss the momentum in our Digital Media business."
},
{
"speaker": "David Wadhwani",
"text": "Thanks Shantanu. Hello everyone. In Q1, we achieved revenue of $4.23 billion, which grew 12% year-over-year. We exited the quarter with $17.63 billion of Digital Media ARR, growing our ending ARR book of business 12.6% year-over-year. We continue to see healthy performance in both Creative Cloud and Document Cloud. Creative growth was driven by broad-based adoption across our routes to market and product portfolio with particular strength in new offerings like Firefly Services, an increasing number of One Adobe deals, and a growing base of web and mobile users. Document Cloud continued to see strong organic demand, continued optimizations in free-to-paid conversion journeys and AI Assistant being released in additional languages. We drove strong performance across Digital Media in emerging markets. The results represent a good start to the fiscal year. Creativity is going mainstream, and I want to provide more color on the audiences we serve. We live in a visual-first world where creative expression has become pervasive in every facet of life. Business Professionals and Consumers alike aim to produce visually rich, engaging content, whether it is a presentation, birthday invitation or social post. At the same time, creative professionals, creators and marketers are competing on the quality of their online presence and the personalized experiences they deliver to customers. They turn to Document Cloud, Creative Cloud and Experience Cloud to achieve their content goals. Going forward as a result of AI advancements, we see incredible opportunity to serve customers with audience-specific offerings. Business Professionals and Consumers are increasingly benefitting from deep integration between Acrobat, Express and Firefly while Creative Professionals, Creators and Marketers are investing in powerful workflows across Creative Cloud, our new web and mobile creative application, Firefly and GenStudio. PDF continues to be the global standard for digital documents for Business Professionals and Adobe Acrobat is revolutionizing the way people engage with them across mobile, web and desktop. Features like AI Assistant in Acrobat and Reader have been a game-changer for everyone from sales teams to students, looking for faster insights and smarter document editing. And the ability to share links and collect comments has increased document productivity and helped drive additional adoption. These new capabilities and our cross-surface investments have paid off, with Acrobat and Reader monthly active usage growing 23% year-over-year. Our success with Acrobat has also shown us that, whether for a sales presentation, a school project, or a social media post, Business Professionals and Consumers are looking for an easy-to-use solution that helps them create visually compelling content that stands out from the crowd of generic templates. In fact, a significant number of all documents created in Acrobat are visual documents; things like marketing content, sales pitches, presentations, infographics and cover pages. We are making good progress in addressing this need by embedding Express capabilities as a native experience in Acrobat with a goal of boosting productivity and making the journey from document consumption to content creation smoother than ever. The integration of Adobe Express features in Acrobat allows users to create richer PDFs with AI-generated cover pages, embedded infographics and customized images and empowers users to create fully formed animated videos and other rich digital outputs. We see numerous early indicators of user demand as Express usage through Acrobat has grown 10 times year-over-year. Other highlights for Business Professionals and Consumers include; Acrobat AI Assistant support for languages now includes English, French, German, Italian, Portuguese, Spanish and Japanese. Acrobat AI Assistant support for legal workflows with contract-specific features. New AI capabilities in Express, like Clip Maker for auto generation of video highlights, and Text Rewrite, to help produce more effective copy. Expanded Acrobat integrations with Microsoft Edge, Google Chrome, Gmail and Google Drive and strong adoption of link sharing for richer collaborative experiences have led to approximately 50% year-over-year growth in Acrobat web monthly active usage. Expanded Express integrations now include Miro, Box, Slack, Webflow and Hubspot. The Express ecosystem also expanded to 225 plugins, more than doubling in the last year. Strong business and student adoption. Express onboarded nearly 6,000 new businesses in Q1, representing approximately 50% quarter-over-quarter growth. Students with access to Express premium grew 85% year-over-year. Key global customer wins include AT&T, Delta Airlines, Disney, Ernst & Young, IBM, JPMorgan Chase, Microsoft, Paramount and Qatar Airlines. Creative Professionals and the next generation of creators, who make their living by designing and producing content, are focused on standing out and bringing their unique creative visions to life with pixel-perfect precision. As we mark the 35th anniversary of Photoshop, Adobe creative applications remain the solutions of choice for the world's creative professionals across imaging, design, photography, video, illustration and 3D. We also see increasing demand from the next generation of creators, who are looking for freemium, web and mobile applications as they begin their creative journeys. To better serve these users, we launched a new Photoshop mobile app and an expanded web experience, delivering Photoshop’s iconic image editing and design capabilities on the iPhone. The mobile app and all-new web experience are also included in current Photoshop plans, offering established Photoshop customers a flexible ecosystem to create and edit across surfaces. The launch garnered over 30 million social engagements in just two weeks. The release of the Adobe Firefly Video Model in February, a commercially safe generative AI video model, has been very positively received by brands and creative professionals who have already started using it to create production-ready content. Users can generate video clips from a text prompt or image, use camera angles to control shots, create distinct scenes with 3D sketches, craft atmospheric elements and develop custom motion design elements. We’re thrilled to see creative professionals in enterprises and agencies; including dentsu, PepsiCo and Stagwell, finding success with the video model. Additionally, we recently launched an all-new Firefly application, the most comprehensive destination to generate images, vectors and now videos with unmatched creative control and direct integration with our industry-leading creative apps to seamlessly move from ideation to production. In addition to generating images, videos and designs from text, the app lets users generate videos from keyframes, use 3D designs to precisely direct generations, and translate audio and video into multiple languages. We also launched two new plans as part of this release; Firefly Standard and Firefly Pro, and began the rollout of our third plan, Firefly Premium, yesterday. User engagement has been strong, with over 90% of paid users generating videos. The launch of Photoshop on web and mobile and the release of the new Firefly application, expands our growing family of web and mobile products, which now includes, Photoshop for creative imaging, Lightroom for photography, Express for design and Firefly for ideation and early production. These apps serve, as value added capabilities to our existing paid subscribers and as a frictionless, freemium onboarding experience to attract and monetize next generation creators. We’re delighted with the early interest in these new offerings. Other Creative Professional and Creator highlights include; continued strong adoption of GenAI in our products with Photoshop GenAI monthly active users at approximately 35% and Lightroom GenAI MAU at 30%. Users have generated over 20 billion assets with Firefly. The introduction of new features in Premiere Pro beta and After Effects beta are helping editors and motion designers stay ahead of deadlines with AI features like Media Intelligence, which helps users find footage faster using natural language and captions translation for 17 languages, which effortlessly expand video to global audiences. We’re honored to see visionary filmmakers around the world telling this season’s most acclaimed stories using Adobe creative applications including Academy Award winners Anora and Dune: Part Two. The launch of Adaptive Profiles and Distraction Removal in Adobe Lightroom and Adobe Camera Raw, which reduce tedious and repetitive tasks. MAX Japan brought our community together and served as an opportunity for us to launch a number of new innovations including performance improvements in Adobe Illustrator, which accelerate features like pan and zoom and loading large files up to 10 times faster. We had another great quarter in the enterprise with more customers turning to Firefly Services and Custom Models to scale on-brand content production for marketing use cases, including leading brands such as Deloitte Digital, IBM, IPG Health, Mattel and Tapestry. Tapestry, for example, has implemented a new and highly productive digital twin workflow using Custom Models and Firefly. You’ll hear more on how the combination of creativity and marketing is powering personalization at scale in enterprises. Adobe is incredibly well set up to take advantage of AI across creativity. We're rapidly delivering tailored innovations to serve the full continuum of content creation for Business Professionals and Consumers, Creative Professionals and Creators, and Marketing Professionals. Our expanding breadth of offerings is reaching a broader universe of customers, and our incredible go-to-market strength and proven data-driven operating model are propelling the growth of both flagship and new offerings. We will be unveiling more exciting product capabilities at Adobe Summit and MAX London in April. I’ll now pass it to Anil."
},
{
"speaker": "Anil Chakravarthy",
"text": "Thanks, David. Hello everyone. Experience Cloud had a strong Q1, achieving revenue of $1.41 billion for the quarter. Subscription revenue in the quarter was $1.3 billion, representing 11% year-over-year growth. Our leading solutions spanning content, data and customer journeys enable enterprises around the world to deliver personalized experiences at scale, helping customers drive both top-line growth and productivity gains. In Q1, we delivered typical seasonal bookings and advanced our pipeline as enterprise customers initiated the execution of their critical 2025 priorities. Adobe Experience Platform and Apps play a pivotal role in enabling unified customer experiences. With the addition of AEP AI Assistant, we extended the value and impact of Experience Platform by empowering more functions across the business with conversational interfaces for data ingestion, insight generation, audience segmentation and experience delivery. We are now building on these advances and expanding AEP to enable intelligent orchestration of customer experiences with AI agents natively built in. We are empowering customers to make better use of their first-party data and to drive more relevant ad experiences based on direct customer relationships. Our portfolio spans the entire content supply chain from creation and production, workflow and planning, asset management, delivery and activation through to reporting and insights. Now we are bringing together creativity and marketing with AI to help our customers realize the full potential of personalization at scale. Up to now, marketing professionals have been constrained by the number of content variations they can create and the number of journeys they can deploy. With Adobe GenStudio, brands around the globe have been working with Adobe to bring creative and marketing teams closer together, simplify their creation-to-activation process, and unlock new levels of creativity, insights and efficiency in marketing campaigns. Other highlights include; strong demand for Adobe Experience platform and native applications, with Q1 subscription revenue growing nearly 50% year-on-year. Release of Real-Time CDP Collaboration, delivering a secure environment for advertisers and publishers to jointly discover, activate and measure high-value audiences for more relevant campaigns. Built on AEP, Real-Time CDP Collaboration is purpose-built for brands to connect and collaborate on first-party data. Users can now measure ad effectiveness directly with publishers including NBC Universal and Warner Bros. Discovery. Advertisers and agencies including Alterra Mountain Company, GroupM Wavemaker, Major League Baseball and The Coca-Cola Company piloted the solution to deliver personalized and performant ads. Launch of the AEM Cloud Service accelerator with Publicis Sapient which can reduce the labor cost of migration up to 35%. Industry analyst recognition in major analyst reports including the Gartner Magic Quadrant for Digital Experience Platforms and Gartner Magic Quadrant for Personalization Engines. Strong demand for Firefly Services and Custom Models as part of the GenStudio solution with over 1,400 custom models since launch. GenStudio for Performance Marketing wins at leading brands including AT&T, Lennar, Lenovo, Lumen, Nebraska Furniture Mart, Red Hat, Thai Airways, and University of Phoenix. Strong partnership momentum with GenStudio for Performance Marketing supporting ad creation and activation for Google, Meta, Microsoft Ads, Snap, and TikTok and several partners including Accenture, EY, IPG, Merkle and PWC offering vertical extension apps. Partnership with dentsu to bring GenAI from playground to production for our joint customers with Adobe GenStudio dentsu+. Key global customer wins including Delta Airlines, Ford, IBM, M.H. Alshaya, Microsoft, PNC Financial Services and Tyson Foods. These customer wins address the ongoing evolution of the requirements of global brands for an integrated workflow spanning creativity and marketing. This success is driven by product integration and innovation across Creative Cloud and Experience Cloud increasingly delivered through Adobe GenStudio. Our One Adobe enterprise go-to-market engine enables customers to deliver personalized and on-brand content at scale. The combination of our integrated enterprise solutions across creativity and marketing is a unique strength for Adobe. Next week, we are excited to host Adobe Summit, our flagship digital experience conference in Las Vegas, where we will be joined by thousands of customers, partners, and developers from around the world. We will share our vision for how brands can apply the power of generative AI and agentic technology to achieve personalization at scale and look forward to highlighting a number of product innovations. I will now pass it to Dan."
},
{
"speaker": "Dan Durn",
"text": "Thanks, Anil. Adobe’s business has grown over the last decade by delivering world-class products grouped within three clouds; Creative Cloud, Document Cloud and Experience Cloud. In parallel, we have continued to expand cross-cloud offerings to better serve different Customer Groups. Examples include Acrobat which is reflected in Creative Cloud and Document Cloud; GenStudio which includes Creative Cloud, Express, Firefly Services and Experience Cloud; Enterprises who want to engage with One Adobe and combine Creative seats with marketing automation; and increasingly Acrobat and Express. We believe Adobe’s success will be driven by innovation in service of both Business Professionals and Consumers and Creative and Marketing Professionals. Reporting insights and the financial performance across these customer groups will provide a clear view of Adobe’s execution against our strategy. We will therefore provide overall Adobe revenue, Digital Media and Digital Experience segment revenue, Digital Experience Subscription revenue and Digital Media ending ARR in aggregate rather than by cloud, as well as subscription revenue for Business Professionals and Consumers and Creative and Marketing Professionals. Subscription revenue provided will primarily include revenue from SaaS, managed services and term offerings. Business Professionals and Consumers Group will consist of all subscription revenue from Document Cloud, Acrobat subscription revenue in Creative Cloud, and Adobe Express subscription revenue in Creative Cloud, all of which are part of Digital Media. Creative and Marketing Professionals Group will consist of all subscription revenue from Digital Experience, as well as all of the remaining subscription revenue from Creative Cloud in Digital Media. In today's call, I'll cover three main areas: our Q1 FY25 results focusing on key growth drivers, financial targets, and our supplemental disclosures. Now turning to the quarter. In the first quarter of FY’25, Adobe achieved revenue of $5.71 billion, which represents 10% year-over-year growth, or 11% in constant currency. GAAP diluted earnings per share in Q1 was $4.14 and non-GAAP diluted earnings per share was $5.08. Q1 business and financial highlights included: Digital media revenue of $4.23 billion; Digital Media ending ARR of $17.63 billion, growing 12.6% year-over-year. Digital Experience revenue of $1.41 billion. Cash flows from operations of $2.48 billion; and exiting the quarter, remaining performance obligations were $19.69 billion, growing 12% year-over-year and cRPO growing 11%. In our Digital Media segment, we achieved Q1 revenue of $4.23 billion, which represents 11% year-over-year growth, or 12% in constant currency. We exited the quarter with $17.63 billion of Digital Media ARR, growing our ending ARR book of business 12.6% year-over-year in constant currency. First quarter Digital Media growth drivers included, strong growth for Acrobat across all routes to market and geographies; Acrobat Web and Mobile growth driven by freemium funnel and app store optimizations. Growth in Adobe Express, fueled by top of funnel improvements, PLG journeys across Acrobat and Express, and B2B customer onboarding. Strength in user adoption and engagement of Acrobat AI Assistant driven by expansion of features including support for additional languages and contract intelligence capabilities; Growth of Creative flagship offerings driven by All Apps, Stock, Imaging and Photography; Continued momentum in Creative Web and Mobile offerings with 35% year-over-year, ending paid subscription growth; and Strong momentum in the Enterprise, driven by Firefly Services and the continued benefit from the upsell motion of generative AI-enabled offerings. Turning to our Digital Experience segment, in Q1 we achieved revenue of $1.41 billion, which represents 10% year-over-year growth as reported and in constant currency. Digital Experience subscription revenue was $1.30 billion, growing 11% year-over-year, as reported and in constant currency. First quarter Digital Experience growth drivers included; momentum for product offerings across content, data and journeys; AEP and Apps subscription revenue growing nearly 50% year-on-year. GenStudio solution surpassing $1B in ending ARR book of business. Early momentum in GenStudio for Performance Marketing in adoption and pipeline; and improvements in overall enterprise retention. Turning now to our customer group performance. Creative and Marketing Professionals Group subscription revenue was $3.92 billion, which represents 10% year-over-year growth as reported. Business Professionals and Consumers Group subscription revenue was $1.53 billion, which represents 15% year-over-year growth as reported. Adobe’s effective tax rate in Q1 was 17.0% on a GAAP basis and 18.5% on a non-GAAP basis. RPO exiting the quarter was $19.69 billion, growing 12% year-over-year, or 13% in constant currency and cRPO growing 11% year-over-year, or 12% in constant currency. Our cash flows from operations in the quarter were a Q1 record $2.48 billion, and ending cash and short-term investment position exiting Q1 was $7.44 billion. In Q1, we entered into share repurchase agreements totaling $3.25 billion, and we currently have $14.4 billion remaining of our $25 billion authorization granted in March 2024. Let me now turn to our Q2 FY 2025 financial targets. For Q2 FY’25 we are targeting. Total Adobe revenue of $5.77 billion to $5.82 billion. Digital Media segment revenue of $4.27 billion to $4.30 billion. Digital Experience segment revenue of $1.43 billion to $1.45 billion. Digital Experience subscription revenue of $1.315 billion to $1.325 billion. GAAP earnings per share of $3.80 to $3.85; and non-GAAP earnings per share of $4.95 to $5. For Q2, we expect non-GAAP operating margin of approximately 45% and a non-GAAP tax rate of approximately 18.5%. The year is off to a good start and assuming current macroeconomic conditions, I am pleased to reaffirm our full year guidance for fiscal year 2025. This quarter’s strong performance reflects Adobe’s long-standing focus on innovation and meeting the growing needs of our broad customer base. As businesses increasingly prioritize digital transformation, we are uniquely positioned to deliver value through our highly differentiated solutions and proven go-to-market execution to unleash the power of creativity. Looking ahead, we are excited about the opportunities to drive growth for our customers as we continue to shape the future in the era of AI. We look forward to seeing you next week at our Investor Meeting at Summit 2025. Thank you and we will now take questions. Operator."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] The first question will come from Brent Thill with Jefferies."
},
{
"speaker": "Brent Thill",
"text": "Good afternoon Shantanu, if you took the AI book of business, it would be low single-digit percent of your total revenue for the year. I guess many are asking, when does this become more material? How long does it take? What is required? Maybe just help us walk through the AI journey and how that translates to revenue."
},
{
"speaker": "Shantanu Narayen",
"text": "Happy to, Brent. If you take a step back and think about it, we've always talked about the AI journey as three parts. The first is ensuring that we innovate. The second is all about tracking usage and ensuring value and monetization. And I’d say, we are really pleased across all three of those journeys as we've had conversations with you folks as well in the past. A significant amount of the AI monetization is also happening in terms of attracting people to our subscription, making sure they are retained and having them drive higher-value price SKUs. So when somebody buys Creative Cloud or when somebody buys Document Cloud, in effect, they are actually monetizing AI. But in addition to that, Brent what we wanted to do was give you a flavor for the new stand-alone products that we have when we've talked about introducing Acrobat AI Assistant and rolling that out in different languages, Firefly, and making sure that we have a new subscription model associated with that on the web, Firefly Services for the enterprise and GenStudio. So the $125 million book of business that we talked about exiting Q1 only relates to that new book of business. And that's, again stuff that we said we would double. But I think in terms of the impact also on the overall business, that has had a material part. But if you play this out a little bit more and you talk about what investors can expect, I think with the new Firefly app that's come out, this is a web product with a new subscription, ability to have the video model, ability to have ideation as part of it. Think of it as then integrating Photoshop web, Express web and all of the other products, all of that is also upside. And we really -- you'll see a lot more innovation in that area and you'll see a lot more monetization in that area. And again, the last thing I'll probably say, Brent, is that the whole idea was to start to tee it up, and then again at the FA meeting, to continue to expand on how that is. But net-net, I would say, whether it is innovation, having our own models, integrating it across all of our products, brand new revenue streams like GenStudio in the enterprise and then usage and monetization, I feel really good about it."
},
{
"speaker": "Brent Thill",
"text": "Great. Thanks Shantanu."
},
{
"speaker": "Operator",
"text": "And the next question will come from Brent Bracelin with Piper Sandler."
},
{
"speaker": "Brent Bracelin",
"text": "Thanks for taking my question. Good afternoon. I wanted to double-click into the demand linearity you saw in the quarter. I appreciate the commentary reaffirming 11% Digital Media ARR growth guide for the full year. But could you provide more color on trends you saw in the quarter across Creative and Document Cloud here? Thanks."
},
{
"speaker": "David Wadhwani",
"text": "Yes, happy to do that. So again, just Digital Media ARR was a 12.6% growth, which is in-line with our expectation and also the mix was in-line with our expectations. If you take a step back and you look at the demand and sort of the way the business played out this quarter, it's consistent with what we've seen historically, and it's also -- we've seen sort of a broad-based demand for the products with a few highlights that I think are worth calling-out. First of all, as it comes to business professionals and consumers, this is obviously a huge market with billions of users that we are going after. And our strategy here is to really make sure that productivity that we deliver a solution that -- for productivity from consumption all the way to creation and that's really what we're doing with Acrobat and Express. We saw a lot of momentum in these businesses. We talked about how Acrobat is up 23% year-over-year in terms of monthly active users. We're seeing stronger conversion on those users, and that's been helping drive the business. AI Assistant, obviously, we introduced that last year continues to do very well and it is certainly helping with that strategy of faster consumption and conversational experiences. We saw 2 times quarter-over-quarter usage growth in AI Assistant. And of course, in that context, Express has been a great product. The product right now is just -- it's an amazing product to use. And so that also, we've been investing in very significantly. From a marketing standpoint but also from a partnership standpoint, we've doubled the partner ecosystem in the last year. It now includes new names like Mero and Box and Webflow and HubSpot. We have 85% more access -- 85% year-over-year growth in students with access to it. We've been ramping up our student and campus ambassador programs. We added 6,000 new small, medium businesses to the Express product as well. And even within Acrobat where we've been doing more -- we're seeing much more demand. We saw a 10 times year-over-year engagement of Express capabilities from Acrobat users. So feeling really good about that audience group. On the Creative pro and creator side, Shantanu mentioned this already, but the introduction of the Firefly video model being used by Dentsu and PepsiCo and Stagwell, Firefly new offerings from Standard to Pro. And just yesterday, we introduced Premium which is a much larger set of generative credits and all of those represent new monetization models. We introduced Photoshop mobile and web. We saw hundreds of articles, 30 million social engagements. We were just listed as the focused app on the App Store over the weekend. We saw some great new advances for AI coming into Lightroom web and mobile. Premier also saw some great advances in terms of AI. So lots of momentum in that business. And what's really exciting is that as we've done all of this innovation, as Shantanu was talking about, we also have three big milestones coming up with Summit next week then NAB shortly after that, then Max London, shortly after that. And this is starting to show up. Obviously, we've talked about generation as we crossed 20 billion generations. We are doing more than 1 billion generations now a month and 90% of people using Firefly the app also saw -- are generating video as well as part of that. But we also saw a strong growth in the enterprise. I don't know, Anil, if you want to add something?"
},
{
"speaker": "Anil Chakravarthy",
"text": "Yes, exactly. To just echo what you were saying, I think in the enterprise, we see a lot of demand for creativity and marketing and AI coming together. Every CMO that we talk to, every agency that we work with, they are all very interested in how generative AI can be used to transform how the content supply chain works. And with the GenStudio offering, which combines the creativity and the marketing and the AI, we've seen tremendous traction and we saw a number of both customer wins, as well as a number of agency partners, and we look forward to unveiling a lot more of this at Summit."
},
{
"speaker": "David Wadhwani",
"text": "So off to a great start, I think with innovation, new offerings and you can expect to see new offerings and peers in the months ahead."
},
{
"speaker": "Brent Bracelin",
"text": "Helpful. Look forward to talking to you next week. Thanks."
},
{
"speaker": "Operator",
"text": "And the next question will come from Keith Weiss with Morgan Stanley."
},
{
"speaker": "Keith Weiss",
"text": "Excellent. Thank you guys for taking the question. And thank you for the additional disclosure. I think it's a really interesting view kind of breaking down the creative and marketing professionals versus the business professionals and consumer group. And kind of following on that last question, correct me if I'm wrong, but it feels kind of bullish to me that the business professionals and consumer group has a stronger growth rate, creative at 15% creative and marketing professionals, a little bit behind because it feels like business professionals and consumer group, those products would be faster sales cycle, particularly on the consumer side of the equation, faster adoption. The creative and marketing professionals, this broader solution that you are trying to sell would have a longer sales cycle. So the question is, am I thinking about that right? And are you seeing any indications that, that creative and marketing professional group, whether it's in your pipeline or sort of the activity you're seeing, could that catch up with what we're seeing from the business professionals and consumer group?"
},
{
"speaker": "Shantanu Narayen",
"text": "Well, Keith, I mean part of our goal was really to start to provide insight into by the customer groups, how we're starting to see it. And to some degree, when people are wondering how we are actually driving creative, and the reality is that when you think about the GenStudio set of products, which we now said is a $1 billion book of business, AEP and Apps is also a $1 billion book of business and the creative professional, that's actually addressing the entire content supply chain. And so in terms of that growth rate, as we add new subscriptions like the Firefly app subscription, add more video, add more functionality in what we are doing with GenStudio, that growth rate as well, it is a very large untapped opportunity and people have been asking us questions about the strength of the creative market, as well as the strength of that market within the enterprise. And we think that's a large TAM, we'll share more. So I think you are thinking of it right, which is to say the $5 billion book of business that we built for digital marketing, that's really helping the content and the creative economy. And so that was the idea behind giving you a window into that, and the metrics associated with that are subscription and different kinds of offerings. On the other side of the equation as well, to your point what we wanted to do is reflect the fact that the investments that we made in both Acrobat and Express continuing to ensure distribution when we think about the monthly average users. If you take it in aggregate, I mean, Adobe has hundreds of millions of people who are using monthly -- are using our products. And that will be really the early metrics and the indicators of how Express and Acrobat continue to grow. So I'm glad that you found the additional disclosure beneficial. And that was the idea. And to Brent's earlier question as well, I just wanted to clarify. I mean, we are not taking all of the revenue that we see in Digital Media and Digital Experience and calling that AI revenue. But relative to what I've seen from any other company in our particular space, we've actually been pleased by how much of it, whether it is additional tiers of AI in the Digital Experience, so what we are seeing across Acrobat, as well as the creative professional space, there's been good adoption of AI in that. And so that was the other intent, to start to show that so that we can talk about it more at the FA meeting."
},
{
"speaker": "Keith Weiss",
"text": "Outstanding. Can I sneak one -- last one in for Mr. Durn? It's great to see you guys take advantage of the pullback in the stock price by accelerating the share repurchase which picked up this quarter. Could these -- could this pace of share repurchases, can you guys sustain this throughout the year or is that more of a onetime pickup?"
},
{
"speaker": "Dan Durn",
"text": "Yes. So if I take a step back, Keith, and you think about the last four quarters, we've repurchased almost $11 billion. And we've always talked about if there's opportunities to be opportunistic along the way, we would take advantage of it. And I think that's what you saw play out in Q1. We've got a strong point of view about the financial profile throughout the course of the year. Happy to reaffirm guidance, but we're going to drive that with strong operating margins, strong cash flow delivery and be strong capital allocators throughout the year. So we feel good about where we sit. And if there's opportunities to be opportunistic, we will."
},
{
"speaker": "Shantanu Narayen",
"text": "And Keith, it's definitely a vote of confidence that we feel in what we are seeing as the opportunities ahead of us."
},
{
"speaker": "Keith Weiss",
"text": "Yes. It’s great to see you guys putting your money where your mouth is by accelerating that share repurchase. It definitely helps."
},
{
"speaker": "Operator",
"text": "And the next question will come from Kash Rangan with Goldman Sachs."
},
{
"speaker": "Kash Rangan",
"text": "Hi, thank you very much. Much appreciate the disclosure and the color and everything that goes with it. Shantanu, question for you. When you pivoted the company to a new business model through cloud, initially there was a lot of skepticism. Then you proved to us that the TAM was actually larger in the new creative meets the cloud cycle. And the company was able to accelerate through the transition and put up even better margins and by expanding the TAM necessarily. So as you look at AI right now, right now, one bearish argument that one could make which I don't subscribe to, is that you're playing defense and that AI is a cost of staying in business and keeping us relevant to your creative base. But how do you look, since you've been through this 1 big shift before, you've got a lot of experience, where is your conviction on how truly incremental AI can be for your growth? Could you be at a similar junction where you're poised to get into the next cycle is actually bigger TAM, not to put words in your mouth, but even maybe dare I say the potential to accelerate off of the good growth that we've seen so far? Thank you so much."
},
{
"speaker": "Shantanu Narayen",
"text": "Well, Kash what I appreciate about the question is, this is what we wanted to really tee up in front of the FA meeting. But without a doubt, as David described, the opportunity for the business professional and consumers, I think you will start to see and we'll share more at the FA meeting that there are billions of people that we can bring into the fold for creativity and productivity and talk more about how we are, with the distribution that we have and with the monthly average users that we have, monetize that much like we've monetized Acrobat. And we definitely believe that it's a massive, massive opportunity. I think it is the same thing across creators. There are more creators that are entering. And again, I'll preview a little bit of what David will share, which is when you think about the web and mobile offerings that we are providing to attract more people to our platform, as creative professionals and next-generation creators, the number of people who want to enter that profession is significantly larger than it's ever been. And so with products like Photoshop on web and mobile, as well as Firefly app, that's clearly the intent to show how that as a subscription service and attracting the next generation creators will be a tailwind. And then when you put this together in the enterprise, I mean, hopefully, what you also see as part of the additional disclosures is that the enterprise has continued to be a material part of our business and material part of our growth because they are, in order to do personalization at scale, as Anil is talking about, there is going to be more content that's produced. There's going to be more content that's actually inserted into ad systems and social media. And so again, I think setting the stage for how that's a larger opportunity. But if you look at it from not just the length of we were marketing but look at the lens of, hey, that's a content business for us in the enterprise. We will again outline how that is only going to be a growing opportunity. So no question in my mind, all three of these are actually going to accelerate in terms of the TAM and then we have to innovate and execute against that. So I am more excited about the larger opportunity without a doubt as a result of AI. And we've talked about this, Kash. If you don't take advantage of AI, it is a disruption. In our particular case, the intent is clearly to show how it's a tailwind."
},
{
"speaker": "Kash Rangan",
"text": "Excellent. And one follow-up and very quick, promise if I can. With the turbulence in the markets with trade wars, et cetera tariffs, et cetera, how do you feel your customer base is going to behave? Is everything going to be on track from what you can tell by talking to your customers? Or are they kind of perplexed by what's going on and pausing? Thank you so much and that’s it for me."
},
{
"speaker": "Shantanu Narayen",
"text": "Well, I mean I think we just sort of said, assuming current macroeconomic conditions, I mean, we have a diverse business. We are off to a good start in the conversations that we are having. And all of us have conversations with all of our other peers. And I think we have a seasoned management team that will navigate it. But customers, I think we are all jointly trying to understand what happens in the economy. But I'm -- the tariffs, et cetera, don't really impact Adobe, the way they impact other businesses. And so we are optimistic."
},
{
"speaker": "Kash Rangan",
"text": "Thank you so much."
},
{
"speaker": "Operator",
"text": "Thank you. And the next question will come from Mark Moerdler with Bernstein Research."
},
{
"speaker": "Mark Moerdler",
"text": "Thank you very much. Dan, can you give us more color on why you're changing the categorization of revenue, removing the historical Document Cloud and Creative Cloud? Is this driven by the One Adobe sales motion? Is Express now sold predominantly with Document Cloud? How should we think about the drivers? Thank you."
},
{
"speaker": "Dan Durn",
"text": "Yes, so thanks for the question, Mark. As we laid it out, we talked about increasingly driving cross-cloud offerings. We're already doing it today. We're going to be doing more of it going forward. And as you look at individuals increasingly buying offerings, as you look at enterprises increasingly buying solutions and bringing different parts of our portfolio together to meet their highest value needs around these two groupings of the customers, it really is meant to just draw a highlight to our strategy and how we are executing against that strategy. On a go-forward basis, our success is going to be driven by the way we innovate into the intersection of productivity and creativity, into the intersection of creativity and marketing. And those intersections are highlighted by these two groupings of customers. And so the intent around this is to really bring to life how we are driving our strategy, how we're executing against it, provides the best insight in how the company is performing on a go-forward basis."
},
{
"speaker": "Shantanu Narayen",
"text": "And Mark, at least 2 specific things that we've heard as feedback from all of you folks are, you understand that there's an Acrobat within the Creative Cloud and Document Cloud. This pulls out the business in order to show the momentum and the opportunity in that business. And to your question about One Adobe, yes, I mean, the GenStudio solution is, without a doubt taking seats of products like Photoshop or the Creative Cloud, is adding Express in it for every marketer in there. We have Firefly Services and custom models. And so the more we sell that as one enterprise offering and we want to accelerate the sale of that as a strategic partnership, that's now also all reflected in one of those revenue slices. So we believe that the additional disclosure will also give us -- give you more visibility into routes to market."
},
{
"speaker": "Mark Moerdler",
"text": "That makes a lot of sense. And one quick other one. Should we expect the disclosure on the AI ARR something that we'll be getting quarterly or periodically updated?"
},
{
"speaker": "Shantanu Narayen",
"text": "Periodically."
},
{
"speaker": "Mark Moerdler",
"text": "Okay. Good luck in quarterly. Thank you."
},
{
"speaker": "Operator",
"text": "And the next question will come from Alex Zukin with Wolfe Research."
},
{
"speaker": "Alex Zukin",
"text": "Hi, thanks guys for taking the question. And I will join the chorus of those commenting positively on some of the new numbers, particularly the AI book of business. And that's where I wanted to ask the question. Basically, look, you are going to give us a number, we're going to ask for more. So in that spirit, if you look at the $125 million and you think about the segmentation between Assistant, Firefly, GenStudio, is there any triangulation around maybe how much -- what the percentages of -- for the breakout of those and maybe stack rank the growth rates that are going to get you to double that by the end of the year? And then kind of similarly, if you think about if that $125 million is impacting or where the tailwinds are more towards the creative and marketing professional or the business professionals?"
},
{
"speaker": "David Wadhwani",
"text": "Yes. Great question, Alex. So first of all, if you look at the mix of these things, AI Assistant has been around for about three quarters or four quarters now. Firefly Service has been around for about four quarters as well. GenStudio was introduced late in Q4 of last year. So that gives you a little bit of a sense that the composition is going to sort of like be based on the tenure of these products in the market. But if we take a step back and you look at the growth trajectory, again, we're talking $195 million -- sorry, $125 million doubling in the next nine months. It gives you a sense of the scale of these businesses and really the momentum that's in the business. And when you look at it, the core innovation that Shantanu talked about led to a lot of utilization. And now we are starting to get to a point where we can monetize it. For Firefly, we have imaging, vector, design, video, voice, video and voice coming out just a couple of weeks ago, off to a good start. I know there have been some questions about how important is commercially safety of the models. They're very important. A lot of enterprises are turning to them for the quality, the breadth but also the commercial safety, the creative control that we give them around being able to really match structure, style, set key frames for precise video generation, 3D to image, image to video. The inclusion also, on a road map, and we'll share more about this next week of third-party models really establishes us as the one-stop shop for anything you need to do with creativity. And then when you ladder that into a Firefly stand-alone offer with multiple tiers with Standard, Premium, and Pro, when you look at that integrated into Creative Cloud, you could imagine further tiering there. When you look at the work that we are doing in conjunction with Anil's team around GenStudio and making sure all of these models and this entire platform, including third-party models are exposed within our GenStudio offer. What it's really doing is, it's evolving away from the conversation being about the model to the conversation being about the workflows and the integration and the application tier and the agent-based things that we'll be talking to you more about. And that really plays to our differentiation, our strength and our audiences that we serve. And that's why you see the bullishness of that $125 million doubling in the next nine months."
},
{
"speaker": "Shantanu Narayen",
"text": "Yes. I'm glad that you find the sort of information useful. I will give you a little bit more color as well on that. Remember, with Acrobat, we have AI Assistant that's separate, so this is only the separate Acrobat AI Assistant. So the majority of that revenue is actually Creative because as we can continue to put the AI Assistant, as part of an Acrobat SKU. We would not count that if that came as part of an Acrobat Premium SKU. So color-wise so far, creative actually represents the majority of that. But as you know, Acrobat is doing great."
},
{
"speaker": "Alex Zukin",
"text": "That's very, very helpful. I guess maybe just to follow along there. You've seen -- or we've seen a lot of consolidation start to happen within the AI realm where the model companies or the agent even emerging the agentic companies. Maybe just remind us on how you are thinking about your approach towards organic versus inorganic innovation here, given just the plethora of functionality that you're releasing across the board."
},
{
"speaker": "Shantanu Narayen",
"text": "As it relates to the core creative models, we will have our commercially safe, as David said, Alex, and so within Firefly as an application and within each of our product integrations and Photoshop, et cetera, expect Firefly. We've also signaled and we've shown how we would support third-party models associated with that. And so whether it is a custom model that we create for one of our enterprise customers, I think if you look at it, there have been a couple of articles this week about how whether it's Estee Lauder, who is going to be building their models built on ours and leveraging it or a company like Publicis that's going to be taking these models. So our core imaging video franchise, we will have our models as it relates to text, we have support for other third-party models. And so I think it's a very practical and it's the right one, and we'll support all of the creative third-party models that people want to support, whether it is a custom model we create for them or whether it is any other third-party model within Firefly as an App and within Photoshop, you're going to see support for that as well. And so think of it as we are the way in which those models actually deliver value to a user. And so it is actually just like we did with Photoshop plug-ins in the past, you’re going to see those models supported within our flagship applications. Hopefully, that gives you a sense."
},
{
"speaker": "Operator",
"text": "And the next question will come from Mark Murphy with JPMorgan."
},
{
"speaker": "Mark Murphy",
"text": "Thank you very much. I was wondering if you can just comment on what you are sensing fundamentally in terms of advertising activity and consumer spending trends in the wake of some very choppy results from multiple airlines the last several days and multiple retailers. What is giving you the resilience to reaffirm the FY '25 guidance when some of those are really huge sectors of the economy and they seem to be encountering some turbulence? I'm just wondering if there -- you basically see them continuing to create and market and advertise despite this environment."
},
{
"speaker": "Shantanu Narayen",
"text": "I think at the end of the day, Mark, we just believe that digital is going to continue to be a fundamental part of the economy and the importance is going to continue. I mean, there isn't a single company that I've talked to that doesn't say digital. To your point, as other companies view macroeconomic conditions that may be particular to them, onuses on every company that's serving them with technology to demonstrate how the technology helps, whether it's the top line or the efficiency. But whether it's top-line growth or efficiency or both, they're not going to go out of style, as it relates to any enterprise saying, how can I use technology to accomplish my objectives?"
},
{
"speaker": "Mark Murphy",
"text": "Okay. And then -- I appreciate that, Shantanu. As a very quick follow-up on Alex's question, with the ARR the $125 million ARR doubling in the next nine months, do you think it's going to be the same composition or is something going to be coming in from the video models that might change the mix there in the next nine months?"
},
{
"speaker": "Shantanu Narayen",
"text": "The video model is part of the creative Firefly app that will be part of this. I think a lot of these great questions, Mark, I mean, at the FA meeting, we'll try and give more color as well as to what we are seeing. But we wanted to at least start to outline what products were in there, the growth rates that we expect and how we are executing on, as I said, the innovation, usage, understanding and offering these as monetization. So we'll also, I know keep a track of the ongoing questions and address them at the FA meeting as well, Mark."
},
{
"speaker": "Operator",
"text": "And our last question will come from Saket Kalia with Barclays."
},
{
"speaker": "Saket Kalia",
"text": "Okay, great. Hi, guys. Thanks for taking my question here and squeezing me here. I'll keep it to one. David, maybe for you. It's great to see the Firefly app tiers that customers can add to their existing subscriptions. And maybe to Shantanu's point, this is a better topic for FA day, but I'm wondering if we could just talk about, how do you envision sort of the potential attach rate there? I mean, Firefly is clearly an unprecedented offering, so maybe that's really tough to answer. But are there any products that maybe Adobe has seen in the past like Adobe Stock or any others that you look at as sort of a framework for what that adoption curve could look like?"
},
{
"speaker": "David Wadhwani",
"text": "Yes. I think, so if we take a look -- if you take a step back, the reason we are so excited about the Firefly app is really twofold. One is exactly where you are going, Saket, and what you're asking about, which is the -- with every conversation we've had with creative professionals, we know that wherever they are, they are under an enormous amount of pressure to produce more. And this cohort of creative professionals, we see very strong attach and adoption of the generative AI features we put in the product, partially because they're well integrated and very discoverable and because they just work and people get a lot of value out of that. So what you will see is you'll start to see us integrating these new capabilities, these premium capabilities that are in the Firefly Standard, Pro, and Premium plans more deeply into the creative workflow so more people have the opportunity to discover them. And of course, as part of that, I think you can expect to see what we've done all along is look at where the usage is, look at where the excitement is and make sure we get the pricing and the tiering right in a way that maximizes the opportunity for our customers and maximizes the opportunity and the value that Adobe and our shareholders get as part of that, too. So that will be a big area and a big opportunity, and we see a lot of potential there as we look ahead. The other part that I want to make sure doesn't get lost in this is how relevant this Firefly experience is for non-creative professionals as well, this next generation of creators that we keep talking about. And if we look at the early adoption rates of the Firefly paid-plan, it really tells us both of these stories. We have a high degree of conviction that it is adding value and being used by creative professionals, but it's also proving to be a good onboarding opportunity for next-generation pros -- sorry, next generation pros and creators in general. And that's where Shantanu mentioned earlier, there is an increasing opportunity to merge our web and mobile offerings around not just the generative capabilities but what you do with the content you generate with Photoshop web and mobile, Express web and mobile. And you can imagine other capabilities coming around video as well. So we are excited about Firefly Services and the monetization capabilities there in both directions, new users and also value and ARPU for our existing base."
},
{
"speaker": "Shantanu Narayen",
"text": "And Saket, since that was the last question, thank you. And maybe just in a quick summary, I mean, the four things that I would leave you all with is Q1 was a strong start. We were pleased with our performance. When you think about the addressable markets that we have, as we think about how we serve the business professional and the consumer and the creative professional and the marketing professional, we believe that, that's an immense opportunity that's only going to grow as a result of AI. We are pleased with how AI is now infused across all of our products and how we are further tailoring the breadth of our products to serve these customer groups in a way in which we delight them. And we're starting to outline how the monetization will be different for each one of these and applicable for the customer group that we are serving. We really continue to believe that this will drive growth and profitability for us, as a company in '25 and beyond. And so we look forward to joining you all at the FA meeting, and thank you for joining us today."
},
{
"speaker": "Operator",
"text": "Thank you. That does conclude today's conference. We do thank you for your participation, and have an excellent day."
}
] | Adobe Inc. | 24,321 |
ADI | 4 | 2,020 | 2020-11-24 10:00:00 | Operator: Good morning, and welcome to the Analog Devices Third [sic] [Fourth] Quarter Fiscal Year 2020 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Michael Lucarelli, Senior Director of Investor Relations. Sir, the floor is yours.
Michael Lucarelli: Thank you, Cheryl, and good morning, everybody. Thanks for joining our fourth quarter and fiscal 2020 conference call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now on to disclosures. The information we're about to discuss includes forward-looking statements, including statements relating to our objectives, outlook and the proposed Maxim transaction. These forward-looking statements are subject to certain risks and uncertainties, as further described in our earnings release, our most recent 10-K and other periodic reports and materials filed with the SEC. Actual results could differ materially from these forward-looking - this forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. Okay. With that, I'll turn it over to ADI's CEO, Vincent Roche. Vince?
Vincent Roche: Thank you, Mike, and good morning to you all. I hope that you and your families are healthy and safe at this time. So 2020 represents a year of strategic progress for ADI in a very highly uncertain macroeconomic environment. Fortunately, ADI was already operating from a position of strength. Over the last decade, we've created a structurally more profitable business. We realigned our portfolio to target more durable end markets and become more diverse across customers, products and applications. During this past year and at the height of the pandemic, this business model proved quite resilient with gross and operating margins troughing at 68% and 37%, respectively, levels we previously considered peak. It's this resiliency that enables us to sustain a healthy of – level of investment against any economic backdrop. We’ve also been not afraid to make strategic pivots towards the most attractive investment opportunities that enhance our customer engagement and better align us to secular growth trends, such as digital healthcare. Clearly, the biggest investment decision of 2020 was our strategic combination with Maxim, which will further extend the scale and scope of our semiconductor portfolio. And I'll expand on this in a while. As I reflect on the immediate challenges of our current environment, we believe there is more ADI can do to leverage our expertise to engineer a more sustainable future and make an even more positive impact on the world. To that end, earlier this year, we published our first Corporate Responsibility Report and launched the semiconductor industry's first green bond. We also took action in the global fight against COVID-19. We prioritized production of our healthcare solutions to support customers and we're partnering with hospitals and biotech startups to develop solutions that leverage our technology. And our impact has extended beyond our own facilities and capabilities, as we've made multimillion dollar donations through the ADI Foundation to support both global and local pandemic response efforts. Overall, I'm very proud of how we've come together. We embraced and learned from this challenging time and continue to execute at a high level to generate and capture value in the market. Now turning to our results. In the fourth quarter, revenue was $1.53 billion and adjusted EPS was $1.44, above the high end of our outlook. For the year, revenue was $5.6 billion, down mid-single digits year-over-year. This was partly driven by the economic volatility and supply chain disruptions related to the pandemic. Despite this, our cumulative B2B revenue outperformed peers for a third consecutive year. We actively managed operating expenses, delivering operating margins of 40% and adjusted EPS of $4.91. We generated approximately $1.8 billion in free cash flow in 2020. While this year's 33% free cash flow margin is just below our long-term financial model, we continue to be in the top 10% of companies in the S&P 500. So now, I'd like to provide an update on how we are shaping ADI to be even more impactful in the future. During the year, we invested more than $1 billion in R&D, with over 95% targeted at the most attractive B2B opportunities. This includes funding new product development to fortify our franchises and drive new vectors of growth. As you know, we selectively use M&A to complement these organic investments. And we've taken a very significant step forward with the pending acquisition of Maxim. The numerous customers I've spoken with about our combination are delighted that we will join forces. Maxim will strengthen our leadership in the semiconductor industry, creating a more comprehensive analog mixed-signal and power portfolio and further diversifying our business across markets and applications. And at 10,000 engineers strong, the acquisition will solidify ADI as the destination for the world's best analog talent. We've also been disciplined in our approach to managing our balance sheet. Since we closed the Linear acquisition, we've cut our leverage ratio in half, increased our dividend by 40% and repurchased more than $1 billion of shares. And Prashanth will provide further details on our capital allocation outlook for 2021. Shifting now to customer engagement. Our focus has been unwavering, as we continued to solve our customers' toughest challenges. A key strength of ADI is our standard products portfolio. With its unparalleled breadth and depth from DC to 100 gigahertz, from nanowatts to kilowatts and from sensor to cloud, we define the edge of performance. Our portfolio is sold across customers of all sizes and provides recurring revenue for decades. But what's just as important, these standard products are the foundation upon which we build more targeted integrated solutions for higher growth vertical applications, such as 5G radio systems and automotive battery management. To that end, industries are prioritizing digitalization and connectivity more than ever and new industries are emerging, focused on the physical and cyber. In many ways, it's semiconductors that are enabling the current virtual economy and ADI, where data is born, is at the center of this evolution and well aligned with key secular growth trends. Now looking across our segments, I'd like to share some highlights with you. Starting first with industrial, this is an incredibly fragmented market with expanding needs as it transitions Industry 4.0 and beyond. We're in a unique position to not only solve traditional challenges like precision signal processing, control and power, but also new emerging challenges like connectivity and safety. For example, our time-of-flight solution enables safer factory floors by preventing accidents between humans, robots, and cobots. And our connectivity portfolio of Deterministic Ethernet, secure microwave, RF and 5G, is helping our customers to create ubiquitous connectivity, merging their operational and informational technologies to unlock the true value of Industry 4.0. In healthcare, the pandemic is accelerating the market towards telemedicine and transitioning care into the home. To support this, systems are being upgraded and clinical-grade patient monitoring is extending outside of the hospital. We doubled our investment ahead of this trend, bring it to market hundreds of new products and tilting our offerings towards complete system solutions. The result, over the last five years, we've grown our customer base by over 20% and our revenues at a double-digit rate even when excluding pandemic-related demand. And we're now increasing our investment in sensing, computing and cloud, to help enable the secular shift to healthcare from anywhere. In communications, we're the market leader in 5G, a position that will deliver significant growth as 5G broadens globally in 2021 and beyond. At the same time, we view open radio access networks, or O-RAN, as a disruptive technology that enables carriers to scale and upgrade their networks more quickly and economically, an important step to help proliferate 5G into new markets. And for ADI's wireless franchise, O-RAN opens up new avenues for growth. To get ahead of the market, we're further innovating our transceiver and power portfolios to shape the radio of the future. We're also forming strategic partnerships with ecosystem participants such as Intel and Marvell. And this strategy is working. Last quarter, we announced the collaboration with NEC to enable the first O-RAN installation for Rakuten Mobile. The automotive market is undergoing a revolution, with electric vehicles becoming mainstream. ADI is at the heart of this movement, with over half of the top 10 EV brands using our BMS solution. And our new wireless BMS offers the same reliability and performance of our wired solution while enhancing robustness and configurability. General Motors recently announced that they will deploy our wireless BMS across their entire Ultium battery line. Since the launch, just a few months ago, interest in this groundbreaking technology is gaining momentum across the ecosystem. Looking at automotive more broadly, demand for our audio system solutions with signal processing, A2B connectivity and road noise cancellation is intensifying. Our innovative solutions are not only the highest fidelity performance technology in the market, but they also reduce weight, removing nearly 100 pounds from an average vehicle. We've also identified opportunities to attach our LTC portfolio with our A2B platform to deliver both data and power up to 50 watts. By combining all these capabilities, we are creating deeper customer relationships while increasing our SAM for audio system. Turning to consumer now. This is a market that have had its fair share of challenges over the last few years for ADI. However, we believe that the business has bottomed in 2020. Recent design wins across a diverse customer base for new and emerging applications like hearables, wearables, high-end audio and video solutions put consumer on a multi-year growth trajectory. So in closing, this was clearly an unprecedented year for us all. We are optimistic that a broad-based recovery is underway, but acknowledge that the recovery remains dependent on the economic impacts of the pandemic. With that said, I'm encouraged by our momentum and we expect 2021 to be a growth year for the company. We've seen an improvement across nearly all of our end markets and our portfolio is strategically aligned with favorable secular growth trends, a position that gets only stronger with Maxim. In my 30-years plus at ADI, I've never been more confident about our prospects than I'm today. And so with that, I'm going to turn it over to Prashanth, who will take us through the financial details.
Prashanth Mahendra-Rajah: Thank you, Vince. Good morning, everyone. Let me add my welcome to our year-end earnings call. As usual, except for revenue and non-op expenses, my comments on the P&L and our outlook will be on a non-GAAP or adjusted basis, which exclude special items outlined in today's press release. Let me start with a brief recap of 2020. The heightened uncertainty and significant disruption due to the pandemic certainly created a very volatile year. Revenue of $5.6 billion was down 6% year-over-year. However, we saw sequential improvement throughout the year and our revenue was up 14% in the second-half compared to the first. Gross margins finished at 69%, down slightly year-over-year, but we enter 2021 within our long-term financial model. Op margins landed at 40%, as we prudently managed our discretionary spend. All told, full-year adjusted EPS was $4.91. Now turning to the fourth quarter. Revenue of $1.53 billion was up 5% sequentially, marking the third consecutive quarter of growth. This exceeded the high-end of our outlook, driven mainly by stronger-than-anticipated growth in automotive. And if we look at the individual segments, in the fourth quarter, industrial, which represented 53% of revenue, was up 5% sequentially and up 9% year-over-year. We saw growth across nearly all our major applications, notably automation, which makes up approximately 20% of industrial, grew for the first time in two years. For the year, industrial revenue was about flat, underscoring the diversification across customers and applications in this business. In the fourth quarter, communications, which represented 20% of revenue, was down 14% sequentially. However, the segment was up 19% year-over-year, driven by double-digit growth in both wireless and wireline. Importantly, our growth was not aided by customer pull-in activity related to geopolitical tensions. And for the year, communications revenue was down 8% year-over-year. However, excluding Huawei sales that were impacted in '19 and '20 by Entity List restrictions, our revenue grew modestly, a testament to our strong positions in 5G and optical control for carrier networks and data center. In the fourth quarter, automotive which represented 15% of revenue, was up over 40% sequentially and up modestly year-over-year. While we exit the year with revenue above pre-pandemic levels, it was still down mid-teens for the year due to lower vehicle production. And finally, in the fourth quarter, consumer, which represented 11% of revenue, finished up 12% sequentially, down 17% year-over-year. As Vince mentioned, we believe we're positioned to grow in '21 and beyond after three years of declines. Moving on to the rest of the P&L for the fourth quarter. Gross margin was 70%, up 160 bps year-over-year. OpEx was $431 million, up 7% sequentially, as we reinstated merit and experienced higher variable compensation. Op margins finished at 41.7%, up nearly 300 bps year-over-year. Non-op expense was $44 million, down both sequentially and year-over-year, driven by lower interest expense. And our tax rate was lower than usual at approximately 10% and adjusted EPS was $1.44. If we shift to the balance sheet and cash flow, inventory dollars on our balance sheet declined modestly sequentially and inventory days finished at 121 days, down from 125 days in the third quarter. Channel inventory fell slightly and remains below our seven-week to eight-week target as we saw strong sell-through trends across all geographies. We plan to return to our target inventory model as we progress through '21. In the quarter, cash flow from operations was $673 million, up 2% year-over-year. Given the pandemic, we continue to be judicious with our CapEx, spending only $30 million this quarter or 2% of revenue. We do anticipate CapEx to normalize to around 4% of revenue for 2021. And for the full year, we generated over $1.8 billion of free cash flow. We returned $1.1 billion to shareholders through dividends and share buybacks, or about 80% of free cash flow after debt repayments. This was below our target, as we paused our share buyback program at the height of the pandemic and then were restricted following the Maxim announcement. As a result, our cash position increased to over $1 billion. During the quarter, we used $450 million of our cash flow to retire our 2021 notes. Total debt ended the year at approximately $5.1 billion, resulting in a leverage ratio of 1.6 on a trailing 12-month basis. Recently, we reinstated our share buyback program, which has $1.9 billion left in authorization, or approximately 4% of shares outstanding. Given our low leverage, we do not plan to reduce debt further in '21. For context, over the last three years, we've decreased our debt by approximately $3 billion. This stronger balance sheet provides us with the flexibility to improve on our 100% free cash flow return and increase shareholder value over the long term through a combination of reinvestment in the business, continued dividend increases, greater and more consistent share buybacks and targeted acquisitions. So now let's look at our first quarter outlook. Revenue is expected to be $1.5 billion, plus or minus $70 million. At the midpoint of guide, we expect B2B revenue in the aggregate to increase high-teens year-over-year. Op margins are expected to be approximately 40% at the midpoint, down sequentially due to higher variable comp and annual merit. Interest expense is also expected to be down slightly sequentially. For 2021, we anticipate a tax rate between 12% and 14%. And based on these inputs, first quarter adjusted EPS is expected to be $1.30, plus or minus $0.10. I'll wrap with a brief update on our pending acquisition of Maxim. In September, we received clearance from the Federal Trade Commission in the US regarding our merger. Followed by the overwhelming shareholder support of the combination from both ADI and Maxim shareholders, we also submitted initial applications for regulatory clearance in China and the EU. I'm very encouraged by our progress and we remain on track to close the acquisition in the summer of 2021. We are excited about this complementary combination and together, we expect that we will capture additional growth in the years ahead. So with that, let me turn it back over to Mike to lead the Q&A.
Michael Lucarelli: Thanks, Prashanth. Let's get to our Q&A session. We ask that you limit yourself to one question in order to allow time for additional participants on the call this morning. If you have a follow-up question, please re-queue and we will take your question if time allows. With that, can we have our first question, please?
Operator: [Operator Instructions] And our first question comes from Vivek Arya from Bank of America. Please go ahead. Your line is open.
Vivek Arya: Thanks for taking my question, and congratulations on the strong execution, especially the free cash flow generation. Vince, my question is on the demand environment, both near-term and what do you sense for the next calendar year? So in the near-term, which end markets do you feel are back to normal levels, which are below trend line? Because when I look at your January outlook, up 15% or so year-on-year, obviously, against some easier comps. You're certainly starting the year on a very strong note. But just how should we think about the overall year in terms of the puts and takes for the different end markets in industrial, auto, comms and consumer? Any broad color just near-term and then for calendar 2021, I think, it would be really helpful to help kind of frame our models for your forecast? Thank you.
Vincent Roche: Sure. Thanks for your question, Vivek. I would say, clearly, as you said, overall demand is better. And I think as well, there is a very good balance between supply and demand. Inventories are, I'd say, very, very well balanced with our customers as best we can tell. Right now, we are seeing very strong trends in automotive and industrial, while we expected comms a little softer after a big first-half of 2020. But overall, I believe 2021, I think I said in the last call is going to be a solid growth year for ADI and for the industry. And my conviction has become even stronger since the last earnings call here. Let me try and unpack things little for you. If I go through a couple of the market segments, industrial, we've clearly seen a broadening of demand. And if you look at 2020, the first-half was clearly about healthcare, aerospace and defense and automatic test equipment, strength in those areas and that strength has persisted, I think, persisted in the second-half of the year. And I think the second-half actually saw good strength emerge in factory automation, process automation, they are more horizontal businesses for ADI. So, we believe that, that strength will continue into the first quarter and beyond. Automotive, as you will have seen, we had a strong upsurge there as well and the business, in fact, is now back to pre-COVID levels. And bookings continue to remain strong in that area. And if I look at just the sub-segments within to give you a little bit of color, electrification is strong, so are BMS solutions, where we're on the fifth generation of BMS product solutions, are doing particularly well. And our infotainment business, which is - which has emerged beyond high fidelity rendering of audio and video. Our A2B solutions are emerging with great strength, given the pipeline that we've been building over the last several years really. And you will have seen no doubt as well, the active road noise cancellation solutions are riding again on top of the platform. So if I look at maybe comms a little bit here, so 2020 was strong actually across both wireless and wired. Actually, both were up in the fourth quarter of high-teens year-over-year. So if we extract Huawei, where we had the restrictions, 2020 was strong across all the rest of the customers. In fact, they grew during 2020. So, I think 2021 will be about the performance of 5G, which is a pretty good part of the communication story. I expect it will move more global beyond China, particularly with deployments in North America. And I'm glad to have report as well, consumer has been on the downward for ADI for several years. But we believe now that we've reached the bottom as we had expected in 2020. And given the diversity of applications that we're now addressing, broader-based customers, we feel good about that business in both the portable as well as the more professional solutions that we serve also. So hopefully, that answers your question completely, Vivek.
Michael Lucarelli: Thanks, Vivek.
Vivek Arya: Thank you.
Michael Lucarelli: We'll go to next question.
Operator: Thank you. And our next question comes from Tore Svanberg from Stifel. Please go ahead. Your line is open.
Tore Svanberg: Yes. Thank you, and congratulations on the results. Vince, I was hoping you could zoom in a little bit more on comms and on 5G. You talked about O-RAN. Obviously, ADI has a very flexible approach with the software-defined radio. I was just hoping you could talk a little bit about how that architecture plays into the role of O-RAN and just maybe some more comments on 5G generally? Thank you.
Vincent Roche: Yes. So if I look at what's happening in the business, maybe I'll take a shorter-term view than the slightly longer-term view and address your question on O-RAN as well, Tore. So, what we're seeing is that in the business in general, as I said in the answer to the last question there, comms in general for us has seen strength in both wireless and wired technologies, optical wired, particularly in the wired area. And what we're seeing is obviously more aggressive deployments of these massive MIMO-based systems, where our channel count continues to increase, which gives ADI a lot more content for radio. And I would also say that our portfolio has never been stronger given the investments we've been making up for several years. And our customer share has never been higher with the key OEMs far more balanced in terms of the span of technologies and products that we're supplying. So, I think it's important to remember 5G is at the early stages of multi-year, probably a decade of ramp here. And I think 2021 will be characterized by the deployments of 5G more globally beyond China. I expect America to be the primary driver probably towards the second-half of 2021 for 5G. And we've also - we've seen a lot of interest in our technologies for O-RAN. We're working with ecosystem partners in that area. You will have seen. Also the first announcement we've had publicly about the use of our technologies - our radio technologies with Rakuten Mobile in Japan through our partnership with NEC. So, I think it's classical 5G being deployed for consumer applications will continue rapidly over the next three years. But I'm also beginning to see now the early stages of adoption of 5G into more deterministically critical applications like healthcare, factory automation and so on and so forth. So, I think if you look over the long-term, Tore, this is going to continue to be a growth market for ADI with more content. We've got a stronger position with our customers and we continue to push the boundaries of technology here to enable our customers to simply now to deal with the complexity, that's increasing exponentially and the more rapid innovation cycles with our software-defined radio systems.
Tore Svanberg: Thank you.
Michael Lucarelli: Thanks, Tore. We'll go to next question, please.
Operator: Our next question comes from John Pitzer from Credit Suisse. Your line is open.
John Pitzer: Congratulations on solid results. Thanks for letting me ask the question. A modeling question for Prashanth. Prashanth, if you look at the quarter just reported, the October quarter, incremental op margins were perhaps lower than I would have expected. I'm assuming that's variable comp coming back into the model as you guys continue to do better on the top line. But I'd be curious as you look into the January quarter, how we should be thinking about OpEx just given how funky a year, calendar year '20 was because COVID had both some puts and some takes on the OpEx and expense line?
Prashanth Mahendra-Rajah: Yes. Thank you for the question, John. So let me handle that in two pieces. Let's talk gross margins and then OpEx. So for the quarter just passed, 70% gross margins, we had pretty considerable upside from automotive. And so we have some mix headwind with that kind of explosive growth in automotive. It's below the corporate average in terms of margins. As we think about gross margins for the coming quarter - for the first quarter, we are passing through the holiday period. So, we're going to have a little bit of continued pressure on utilization, as we have some of our - some of our fabs will be shut down for the holiday period. But we expect that to improve as the year progresses and we bring in the remaining $50 million of cost reductions from the shutdown of the two LTC facilities in the balance of 2021. On the OpEx side, you're exactly right. We've designed our variable comp system to really act as a shock absorber, as a flywheel. So in 2020 when we had the great deal of uncertainty, that operated the way it should and it unwound. In addition, we made a decision as a leadership team to delay implementing merit in 2020. And we brought that back into place just this past quarter. So, you will see headwind from those - from both of those decisions into the first quarter and I've mentioned that in my guide. So it's both - in my prepared remarks, it's both, a full quarter of merit and better variable compensation.
Michael Lucarelli: Thanks, John. Cheryl, we'll go to our next question.
Operator: Our next question comes from Ambrish Srivastava from BMO. Your line is open.
Ambrish Srivastava: Vince, I wanted to zoom in on the industrial business. This business has been a really resilient compared to the past cycles for yourself, as well as your larger peers. So the question really is, can you just help us understand - and you gave us a number, 20%, for automation. But if you help us understand the various segments that are contributing to how you're able to kind of cloud through what we have seen a pretty disastrous 1Q, 2Q? And then with Maxim, we all understand the complementary parts or the additive parts on the automotive. Can you just help us understand how does the industrial business benefit from the Maxim business that you'll be bolting on? Thank you.
Vincent Roche: Yes. So, thanks Ambrish. First and foremost, it's still a fairly tricky time in terms of trying to predict GDP. But we've come out of the year with tremendous strength. First-half of the year for ADI was about aerospace and defense, healthcare and the automatic test equipment sector as well. So - and that's continued, by the way, through the second-half. And then, we're building upon that in the - with the upsurge, the second-half is the expansion of growth in factory automation, which is, particularly in the fourth quarter, we began to see a very, very good surge, which we expect to continue by the way, albeit of, I'll say, somewhat depressed base as economic expansion really takes roof, I believe, in 2021. So - and also, this business for ADI, industrial is more than half of the company's revenue. The crop of products out there is stronger than it has ever been in the history of the company. Our focus - a decade ago, we decided this was really the roof of the company and we're beginning to really see, demonstrated in our results versus our competition and we're gaining market share, I think that's important to note. So, we cover more customers with more market share, with better product portfolio. So with Industry 4.0 coming on board, healthcare moving towards digitalization, telemedicine, these all bode really well for ADI for the long term. And where does Maxim add value to it as well? Industrial actually is - is really about - is primarily about precision signal processing and power management. And Maxim brings a long heritage in those two areas, which we will deploy to even greater effect across the spectrum of sensor to cloud, the raw signal that are sensing the signal, capture signal processing, connectivity. And that bodes very well for ADI. So, I'm excited about getting more capabilities to bring to more customers. As they require ADI to sell bigger swaths of problems, the complexity is growing in terms of their needs. The analog scale is becoming scarcer and scarcer. So, we will bring more of that skill to bear to solve more problems in a more complete way for our customers. So, I think that's the way to think about it, Ambrish.
Michael Lucarelli: Thanks, Ambrish. Go to our next question, please, Cheryl.
Operator: Your next question comes from C.J. Muse from Evercore. Your line is open.
C.J. Muse: Thank you for taking the question. Another question on the industrial side, Vince. The business is growing 9% year-on-year in October, yet over the last few years is essentially flat. And so curious, it sounds like automation growing for the first time in two years is a real positive signal. So would kind of love to hear your thoughts on, as we come out of this pandemic, what that business segment growth could look like considering some of the growth factors that you're investing in like healthcare, as well as perhaps some of the more tried-and-true machinery, typical industrial business is beginning to recover? Thank you.
Vincent Roche: Yes. So if I look - thanks, C.J. If you look out over the longer term, so industrial automation has been really on its way down for the last two years, two and a half years. And some of that was driven by the trade tensions. Obviously, with the automotive sector way off in, I mean, SAAR was dropping anyway in 2019, the pandemic crush demand there even more so in 2020. So, automotive is a big, big consumer of sophisticated factory automation systems. So that's all improving. If I think about the long-term prospects for the business given the vectors, the market vectors, the technology vectors that we've got, my sense is if you think over the longer-term here and integrate the demand over three-year, five-year period, my sense is this business can grow in the mid-to-high single digit level for ADI.
Michael Lucarelli: Thanks, C.J. Go to next question, please.
Operator: Our next question comes from Toshiya Hari from Goldman Sachs. Your line is open.
Toshiya Hari: Vince, I wanted to follow up on the automotive business, both in terms of your Q4 performance as well as the outlook into fiscal year '21. Just as sort of a clarification on Q4, you guys grew 40%, 40% plus sequentially. I think you were guiding that business to be up in the low teens. So obviously, a very big beat in the quarter. Was that essentially a function of higher volume across your customers and therefore, a beat across most of your customers and most of your applications? Or were there any specific standouts in the quarter? I guess more importantly, into fiscal year '21, when you think about your automotive business and the potential for growth there versus the rate of recovery in the overall global automotive industry, what kind of outperformance would you expect on top of automotive production? It appears as though you guys talk about BMS and active noise cancellation, in particular, but are there any specific drivers that you're most excited about? Thank you.
Vincent Roche: So let me try and unpack that for you. So yes, in fourth quarter, we were up 2% year-over-year. And actually, we had strength across all the applications. But even though our battery management solutions were down year-on-year, we did better than the overall market at large. And our position has gained strength with the new offerings that we have and the sheer performance that we bring that nobody else can match in terms of the sensing and the single processing. So, I think that, just looking at the prognostications of what electrification will do in the electric vehicle area, I think that's a growth trend for decade, decade and a half, two decades. So, we feel good about that given our position. I think also if you just look at the fourth quarter, I talked previously about our signal processing platform, high performance signal processing platform based on our DSP, our A2B technology road noise cancellation. A2B alone was up 70% in the year. So, we've been talking about it a long time. But now the revenues are really coming home to roost in that area. If I look at 1Q, typically, the automotive business for ADI is down seasonally, but we believe that it will be up. So the strength that we've been seeing coming through the fourth quarter here will continue into the first and beyond. And if I look at just the areas that I feel really enthusiastic about that we've been steering investment increasingly towards over the last three years or so, I talked already about the electric vehicle market. And we think about that as an opportunity from battery formation to battery deployment and battery discharge. So, we're growing share in those key markets and we continue to innovate in the space and create more blue sky between ourselves and our competition, as the problems that our customers are solving become more and more challenging. So, we've brought wireless BMS quite recently, which we've announced a partnership with GM. But that is only the start. That is a new growth dimension for ADI in the automotive sector. I've talked about infotainment already, A2B, road noise cancellation. And we've managed to grow that business in 2020 despite the really, really compressor. The other thing I should point out is that we're still in the early innings of attaching our power franchise in the automotive of critical applications in which we play and that's all still ahead of us. Again, we feel good about that in areas like safety, the radar, as well as vision-based safety systems. And just in the car in general, power is an area where we've made excellent progress, I think, getting design ends. Now, we're turning them to revenue.
Michael Lucarelli: Good. Next question, please?
Operator: Our next question comes from Blayne Curtis from Barclays. Please go ahead. Your line is open.
Blayne Curtis: I just want to revisit answer. On the comm, you talked about longer term drivers like O-RAN. I'm just kind of curious. In the January, I think there is going to be a pause between Phase 1 Phase 2 in China. I'm just kind of curious on your perspective. Seems like it might be down a little bit in January. Just curious, when do you think comm could see a recovery in any perspective and timing of China coming back?
Michael Lucarelli: Yes. I think comms is down sequentially. I mean, a big reason why comms was down sequentially in 1Q is the Huawei ban. Huawei was a low single-digit customer, call it, 2%, 3% of sales. They're going to be zero. So, that'll be a headwind into our first quarter. And you're right, I think the timing of next run of China 5G deployment are TBD. I think when they do happen, it will be a great business for us and we'll continue to grow in that market. But it's very hard to call when that market will turn back on. Sometime likely in the first-half of '21, but really unsure to pinpoint it today when that's going to be, given all the geopolitical tensions out there. I think, Vince, did a good job talking about how it's not just about China. The good thing, as you moved to '21, it's more global 5G. North America should start ticking off. Europe, Japan, Korea, has really started to broaden out and less about China. China still will be the biggest market, but really global 5G deployment should do better year-on-year in '21.
Michael Lucarelli: Can we go to our last question, please?
Operator: And our last question comes from Ross Seymore from Deutsche Bank. Please go ahead. Your line is open.
Ross Seymore: Thanks for sneaking me in. I just wanted to wrap up with a little bit of the linearity of demand. Can you just talk about the bookings that you've seen? Have any of the concerns that your customers have had in the past about supply disruptions and all those sorts of things? It seems like those have gone away, given your commentary on channel inventory. But just wanted to get kind of what your book-to-bill was and how linearity played out through the October quarter, please?
Prashanth Mahendra-Rajah: So let me give you a couple of data points here. We started the quarter out strong in August, which was up from July and then we had a pretty normal September. Bookings remain solid so far. I think where - book to bill is at parity, where we're going into the first quarter with very normal backlog coverage for our outlook. All of that is reflected in the guide that we have. I did make a comment about inventory in the channel. So maybe that's also worth making sure people understand that we are below our seven-week to eight-week model and then we're going to kind of build ourselves back into that model over the course of 2021. So, that should also provide a little bit of a - a little bit tailwind as we go through 2021.
Michael Lucarelli: All right. Thanks, Ross. And thanks, everyone, for joining us today this morning. A copy of the transcript will be available on our website. And all available reconciliations, any additional information can also be found in the Quarterly Results section of our IR website. Thanks for joining us and your continued interest in Analog Devices. Hope everyone has a good holiday.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices Third [sic] [Fourth] Quarter Fiscal Year 2020 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Michael Lucarelli, Senior Director of Investor Relations. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Cheryl, and good morning, everybody. Thanks for joining our fourth quarter and fiscal 2020 conference call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now on to disclosures. The information we're about to discuss includes forward-looking statements, including statements relating to our objectives, outlook and the proposed Maxim transaction. These forward-looking statements are subject to certain risks and uncertainties, as further described in our earnings release, our most recent 10-K and other periodic reports and materials filed with the SEC. Actual results could differ materially from these forward-looking - this forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. Okay. With that, I'll turn it over to ADI's CEO, Vincent Roche. Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thank you, Mike, and good morning to you all. I hope that you and your families are healthy and safe at this time. So 2020 represents a year of strategic progress for ADI in a very highly uncertain macroeconomic environment. Fortunately, ADI was already operating from a position of strength. Over the last decade, we've created a structurally more profitable business. We realigned our portfolio to target more durable end markets and become more diverse across customers, products and applications. During this past year and at the height of the pandemic, this business model proved quite resilient with gross and operating margins troughing at 68% and 37%, respectively, levels we previously considered peak. It's this resiliency that enables us to sustain a healthy of – level of investment against any economic backdrop. We’ve also been not afraid to make strategic pivots towards the most attractive investment opportunities that enhance our customer engagement and better align us to secular growth trends, such as digital healthcare. Clearly, the biggest investment decision of 2020 was our strategic combination with Maxim, which will further extend the scale and scope of our semiconductor portfolio. And I'll expand on this in a while. As I reflect on the immediate challenges of our current environment, we believe there is more ADI can do to leverage our expertise to engineer a more sustainable future and make an even more positive impact on the world. To that end, earlier this year, we published our first Corporate Responsibility Report and launched the semiconductor industry's first green bond. We also took action in the global fight against COVID-19. We prioritized production of our healthcare solutions to support customers and we're partnering with hospitals and biotech startups to develop solutions that leverage our technology. And our impact has extended beyond our own facilities and capabilities, as we've made multimillion dollar donations through the ADI Foundation to support both global and local pandemic response efforts. Overall, I'm very proud of how we've come together. We embraced and learned from this challenging time and continue to execute at a high level to generate and capture value in the market. Now turning to our results. In the fourth quarter, revenue was $1.53 billion and adjusted EPS was $1.44, above the high end of our outlook. For the year, revenue was $5.6 billion, down mid-single digits year-over-year. This was partly driven by the economic volatility and supply chain disruptions related to the pandemic. Despite this, our cumulative B2B revenue outperformed peers for a third consecutive year. We actively managed operating expenses, delivering operating margins of 40% and adjusted EPS of $4.91. We generated approximately $1.8 billion in free cash flow in 2020. While this year's 33% free cash flow margin is just below our long-term financial model, we continue to be in the top 10% of companies in the S&P 500. So now, I'd like to provide an update on how we are shaping ADI to be even more impactful in the future. During the year, we invested more than $1 billion in R&D, with over 95% targeted at the most attractive B2B opportunities. This includes funding new product development to fortify our franchises and drive new vectors of growth. As you know, we selectively use M&A to complement these organic investments. And we've taken a very significant step forward with the pending acquisition of Maxim. The numerous customers I've spoken with about our combination are delighted that we will join forces. Maxim will strengthen our leadership in the semiconductor industry, creating a more comprehensive analog mixed-signal and power portfolio and further diversifying our business across markets and applications. And at 10,000 engineers strong, the acquisition will solidify ADI as the destination for the world's best analog talent. We've also been disciplined in our approach to managing our balance sheet. Since we closed the Linear acquisition, we've cut our leverage ratio in half, increased our dividend by 40% and repurchased more than $1 billion of shares. And Prashanth will provide further details on our capital allocation outlook for 2021. Shifting now to customer engagement. Our focus has been unwavering, as we continued to solve our customers' toughest challenges. A key strength of ADI is our standard products portfolio. With its unparalleled breadth and depth from DC to 100 gigahertz, from nanowatts to kilowatts and from sensor to cloud, we define the edge of performance. Our portfolio is sold across customers of all sizes and provides recurring revenue for decades. But what's just as important, these standard products are the foundation upon which we build more targeted integrated solutions for higher growth vertical applications, such as 5G radio systems and automotive battery management. To that end, industries are prioritizing digitalization and connectivity more than ever and new industries are emerging, focused on the physical and cyber. In many ways, it's semiconductors that are enabling the current virtual economy and ADI, where data is born, is at the center of this evolution and well aligned with key secular growth trends. Now looking across our segments, I'd like to share some highlights with you. Starting first with industrial, this is an incredibly fragmented market with expanding needs as it transitions Industry 4.0 and beyond. We're in a unique position to not only solve traditional challenges like precision signal processing, control and power, but also new emerging challenges like connectivity and safety. For example, our time-of-flight solution enables safer factory floors by preventing accidents between humans, robots, and cobots. And our connectivity portfolio of Deterministic Ethernet, secure microwave, RF and 5G, is helping our customers to create ubiquitous connectivity, merging their operational and informational technologies to unlock the true value of Industry 4.0. In healthcare, the pandemic is accelerating the market towards telemedicine and transitioning care into the home. To support this, systems are being upgraded and clinical-grade patient monitoring is extending outside of the hospital. We doubled our investment ahead of this trend, bring it to market hundreds of new products and tilting our offerings towards complete system solutions. The result, over the last five years, we've grown our customer base by over 20% and our revenues at a double-digit rate even when excluding pandemic-related demand. And we're now increasing our investment in sensing, computing and cloud, to help enable the secular shift to healthcare from anywhere. In communications, we're the market leader in 5G, a position that will deliver significant growth as 5G broadens globally in 2021 and beyond. At the same time, we view open radio access networks, or O-RAN, as a disruptive technology that enables carriers to scale and upgrade their networks more quickly and economically, an important step to help proliferate 5G into new markets. And for ADI's wireless franchise, O-RAN opens up new avenues for growth. To get ahead of the market, we're further innovating our transceiver and power portfolios to shape the radio of the future. We're also forming strategic partnerships with ecosystem participants such as Intel and Marvell. And this strategy is working. Last quarter, we announced the collaboration with NEC to enable the first O-RAN installation for Rakuten Mobile. The automotive market is undergoing a revolution, with electric vehicles becoming mainstream. ADI is at the heart of this movement, with over half of the top 10 EV brands using our BMS solution. And our new wireless BMS offers the same reliability and performance of our wired solution while enhancing robustness and configurability. General Motors recently announced that they will deploy our wireless BMS across their entire Ultium battery line. Since the launch, just a few months ago, interest in this groundbreaking technology is gaining momentum across the ecosystem. Looking at automotive more broadly, demand for our audio system solutions with signal processing, A2B connectivity and road noise cancellation is intensifying. Our innovative solutions are not only the highest fidelity performance technology in the market, but they also reduce weight, removing nearly 100 pounds from an average vehicle. We've also identified opportunities to attach our LTC portfolio with our A2B platform to deliver both data and power up to 50 watts. By combining all these capabilities, we are creating deeper customer relationships while increasing our SAM for audio system. Turning to consumer now. This is a market that have had its fair share of challenges over the last few years for ADI. However, we believe that the business has bottomed in 2020. Recent design wins across a diverse customer base for new and emerging applications like hearables, wearables, high-end audio and video solutions put consumer on a multi-year growth trajectory. So in closing, this was clearly an unprecedented year for us all. We are optimistic that a broad-based recovery is underway, but acknowledge that the recovery remains dependent on the economic impacts of the pandemic. With that said, I'm encouraged by our momentum and we expect 2021 to be a growth year for the company. We've seen an improvement across nearly all of our end markets and our portfolio is strategically aligned with favorable secular growth trends, a position that gets only stronger with Maxim. In my 30-years plus at ADI, I've never been more confident about our prospects than I'm today. And so with that, I'm going to turn it over to Prashanth, who will take us through the financial details."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Good morning, everyone. Let me add my welcome to our year-end earnings call. As usual, except for revenue and non-op expenses, my comments on the P&L and our outlook will be on a non-GAAP or adjusted basis, which exclude special items outlined in today's press release. Let me start with a brief recap of 2020. The heightened uncertainty and significant disruption due to the pandemic certainly created a very volatile year. Revenue of $5.6 billion was down 6% year-over-year. However, we saw sequential improvement throughout the year and our revenue was up 14% in the second-half compared to the first. Gross margins finished at 69%, down slightly year-over-year, but we enter 2021 within our long-term financial model. Op margins landed at 40%, as we prudently managed our discretionary spend. All told, full-year adjusted EPS was $4.91. Now turning to the fourth quarter. Revenue of $1.53 billion was up 5% sequentially, marking the third consecutive quarter of growth. This exceeded the high-end of our outlook, driven mainly by stronger-than-anticipated growth in automotive. And if we look at the individual segments, in the fourth quarter, industrial, which represented 53% of revenue, was up 5% sequentially and up 9% year-over-year. We saw growth across nearly all our major applications, notably automation, which makes up approximately 20% of industrial, grew for the first time in two years. For the year, industrial revenue was about flat, underscoring the diversification across customers and applications in this business. In the fourth quarter, communications, which represented 20% of revenue, was down 14% sequentially. However, the segment was up 19% year-over-year, driven by double-digit growth in both wireless and wireline. Importantly, our growth was not aided by customer pull-in activity related to geopolitical tensions. And for the year, communications revenue was down 8% year-over-year. However, excluding Huawei sales that were impacted in '19 and '20 by Entity List restrictions, our revenue grew modestly, a testament to our strong positions in 5G and optical control for carrier networks and data center. In the fourth quarter, automotive which represented 15% of revenue, was up over 40% sequentially and up modestly year-over-year. While we exit the year with revenue above pre-pandemic levels, it was still down mid-teens for the year due to lower vehicle production. And finally, in the fourth quarter, consumer, which represented 11% of revenue, finished up 12% sequentially, down 17% year-over-year. As Vince mentioned, we believe we're positioned to grow in '21 and beyond after three years of declines. Moving on to the rest of the P&L for the fourth quarter. Gross margin was 70%, up 160 bps year-over-year. OpEx was $431 million, up 7% sequentially, as we reinstated merit and experienced higher variable compensation. Op margins finished at 41.7%, up nearly 300 bps year-over-year. Non-op expense was $44 million, down both sequentially and year-over-year, driven by lower interest expense. And our tax rate was lower than usual at approximately 10% and adjusted EPS was $1.44. If we shift to the balance sheet and cash flow, inventory dollars on our balance sheet declined modestly sequentially and inventory days finished at 121 days, down from 125 days in the third quarter. Channel inventory fell slightly and remains below our seven-week to eight-week target as we saw strong sell-through trends across all geographies. We plan to return to our target inventory model as we progress through '21. In the quarter, cash flow from operations was $673 million, up 2% year-over-year. Given the pandemic, we continue to be judicious with our CapEx, spending only $30 million this quarter or 2% of revenue. We do anticipate CapEx to normalize to around 4% of revenue for 2021. And for the full year, we generated over $1.8 billion of free cash flow. We returned $1.1 billion to shareholders through dividends and share buybacks, or about 80% of free cash flow after debt repayments. This was below our target, as we paused our share buyback program at the height of the pandemic and then were restricted following the Maxim announcement. As a result, our cash position increased to over $1 billion. During the quarter, we used $450 million of our cash flow to retire our 2021 notes. Total debt ended the year at approximately $5.1 billion, resulting in a leverage ratio of 1.6 on a trailing 12-month basis. Recently, we reinstated our share buyback program, which has $1.9 billion left in authorization, or approximately 4% of shares outstanding. Given our low leverage, we do not plan to reduce debt further in '21. For context, over the last three years, we've decreased our debt by approximately $3 billion. This stronger balance sheet provides us with the flexibility to improve on our 100% free cash flow return and increase shareholder value over the long term through a combination of reinvestment in the business, continued dividend increases, greater and more consistent share buybacks and targeted acquisitions. So now let's look at our first quarter outlook. Revenue is expected to be $1.5 billion, plus or minus $70 million. At the midpoint of guide, we expect B2B revenue in the aggregate to increase high-teens year-over-year. Op margins are expected to be approximately 40% at the midpoint, down sequentially due to higher variable comp and annual merit. Interest expense is also expected to be down slightly sequentially. For 2021, we anticipate a tax rate between 12% and 14%. And based on these inputs, first quarter adjusted EPS is expected to be $1.30, plus or minus $0.10. I'll wrap with a brief update on our pending acquisition of Maxim. In September, we received clearance from the Federal Trade Commission in the US regarding our merger. Followed by the overwhelming shareholder support of the combination from both ADI and Maxim shareholders, we also submitted initial applications for regulatory clearance in China and the EU. I'm very encouraged by our progress and we remain on track to close the acquisition in the summer of 2021. We are excited about this complementary combination and together, we expect that we will capture additional growth in the years ahead. So with that, let me turn it back over to Mike to lead the Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. Let's get to our Q&A session. We ask that you limit yourself to one question in order to allow time for additional participants on the call this morning. If you have a follow-up question, please re-queue and we will take your question if time allows. With that, can we have our first question, please?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question comes from Vivek Arya from Bank of America. Please go ahead. Your line is open."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question, and congratulations on the strong execution, especially the free cash flow generation. Vince, my question is on the demand environment, both near-term and what do you sense for the next calendar year? So in the near-term, which end markets do you feel are back to normal levels, which are below trend line? Because when I look at your January outlook, up 15% or so year-on-year, obviously, against some easier comps. You're certainly starting the year on a very strong note. But just how should we think about the overall year in terms of the puts and takes for the different end markets in industrial, auto, comms and consumer? Any broad color just near-term and then for calendar 2021, I think, it would be really helpful to help kind of frame our models for your forecast? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Sure. Thanks for your question, Vivek. I would say, clearly, as you said, overall demand is better. And I think as well, there is a very good balance between supply and demand. Inventories are, I'd say, very, very well balanced with our customers as best we can tell. Right now, we are seeing very strong trends in automotive and industrial, while we expected comms a little softer after a big first-half of 2020. But overall, I believe 2021, I think I said in the last call is going to be a solid growth year for ADI and for the industry. And my conviction has become even stronger since the last earnings call here. Let me try and unpack things little for you. If I go through a couple of the market segments, industrial, we've clearly seen a broadening of demand. And if you look at 2020, the first-half was clearly about healthcare, aerospace and defense and automatic test equipment, strength in those areas and that strength has persisted, I think, persisted in the second-half of the year. And I think the second-half actually saw good strength emerge in factory automation, process automation, they are more horizontal businesses for ADI. So, we believe that, that strength will continue into the first quarter and beyond. Automotive, as you will have seen, we had a strong upsurge there as well and the business, in fact, is now back to pre-COVID levels. And bookings continue to remain strong in that area. And if I look at just the sub-segments within to give you a little bit of color, electrification is strong, so are BMS solutions, where we're on the fifth generation of BMS product solutions, are doing particularly well. And our infotainment business, which is - which has emerged beyond high fidelity rendering of audio and video. Our A2B solutions are emerging with great strength, given the pipeline that we've been building over the last several years really. And you will have seen no doubt as well, the active road noise cancellation solutions are riding again on top of the platform. So if I look at maybe comms a little bit here, so 2020 was strong actually across both wireless and wired. Actually, both were up in the fourth quarter of high-teens year-over-year. So if we extract Huawei, where we had the restrictions, 2020 was strong across all the rest of the customers. In fact, they grew during 2020. So, I think 2021 will be about the performance of 5G, which is a pretty good part of the communication story. I expect it will move more global beyond China, particularly with deployments in North America. And I'm glad to have report as well, consumer has been on the downward for ADI for several years. But we believe now that we've reached the bottom as we had expected in 2020. And given the diversity of applications that we're now addressing, broader-based customers, we feel good about that business in both the portable as well as the more professional solutions that we serve also. So hopefully, that answers your question completely, Vivek."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Vivek."
},
{
"speaker": "Vivek Arya",
"text": "Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "We'll go to next question."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from Tore Svanberg from Stifel. Please go ahead. Your line is open."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you, and congratulations on the results. Vince, I was hoping you could zoom in a little bit more on comms and on 5G. You talked about O-RAN. Obviously, ADI has a very flexible approach with the software-defined radio. I was just hoping you could talk a little bit about how that architecture plays into the role of O-RAN and just maybe some more comments on 5G generally? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes. So if I look at what's happening in the business, maybe I'll take a shorter-term view than the slightly longer-term view and address your question on O-RAN as well, Tore. So, what we're seeing is that in the business in general, as I said in the answer to the last question there, comms in general for us has seen strength in both wireless and wired technologies, optical wired, particularly in the wired area. And what we're seeing is obviously more aggressive deployments of these massive MIMO-based systems, where our channel count continues to increase, which gives ADI a lot more content for radio. And I would also say that our portfolio has never been stronger given the investments we've been making up for several years. And our customer share has never been higher with the key OEMs far more balanced in terms of the span of technologies and products that we're supplying. So, I think it's important to remember 5G is at the early stages of multi-year, probably a decade of ramp here. And I think 2021 will be characterized by the deployments of 5G more globally beyond China. I expect America to be the primary driver probably towards the second-half of 2021 for 5G. And we've also - we've seen a lot of interest in our technologies for O-RAN. We're working with ecosystem partners in that area. You will have seen. Also the first announcement we've had publicly about the use of our technologies - our radio technologies with Rakuten Mobile in Japan through our partnership with NEC. So, I think it's classical 5G being deployed for consumer applications will continue rapidly over the next three years. But I'm also beginning to see now the early stages of adoption of 5G into more deterministically critical applications like healthcare, factory automation and so on and so forth. So, I think if you look over the long-term, Tore, this is going to continue to be a growth market for ADI with more content. We've got a stronger position with our customers and we continue to push the boundaries of technology here to enable our customers to simply now to deal with the complexity, that's increasing exponentially and the more rapid innovation cycles with our software-defined radio systems."
},
{
"speaker": "Tore Svanberg",
"text": "Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Tore. We'll go to next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from John Pitzer from Credit Suisse. Your line is open."
},
{
"speaker": "John Pitzer",
"text": "Congratulations on solid results. Thanks for letting me ask the question. A modeling question for Prashanth. Prashanth, if you look at the quarter just reported, the October quarter, incremental op margins were perhaps lower than I would have expected. I'm assuming that's variable comp coming back into the model as you guys continue to do better on the top line. But I'd be curious as you look into the January quarter, how we should be thinking about OpEx just given how funky a year, calendar year '20 was because COVID had both some puts and some takes on the OpEx and expense line?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thank you for the question, John. So let me handle that in two pieces. Let's talk gross margins and then OpEx. So for the quarter just passed, 70% gross margins, we had pretty considerable upside from automotive. And so we have some mix headwind with that kind of explosive growth in automotive. It's below the corporate average in terms of margins. As we think about gross margins for the coming quarter - for the first quarter, we are passing through the holiday period. So, we're going to have a little bit of continued pressure on utilization, as we have some of our - some of our fabs will be shut down for the holiday period. But we expect that to improve as the year progresses and we bring in the remaining $50 million of cost reductions from the shutdown of the two LTC facilities in the balance of 2021. On the OpEx side, you're exactly right. We've designed our variable comp system to really act as a shock absorber, as a flywheel. So in 2020 when we had the great deal of uncertainty, that operated the way it should and it unwound. In addition, we made a decision as a leadership team to delay implementing merit in 2020. And we brought that back into place just this past quarter. So, you will see headwind from those - from both of those decisions into the first quarter and I've mentioned that in my guide. So it's both - in my prepared remarks, it's both, a full quarter of merit and better variable compensation."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, John. Cheryl, we'll go to our next question."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ambrish Srivastava from BMO. Your line is open."
},
{
"speaker": "Ambrish Srivastava",
"text": "Vince, I wanted to zoom in on the industrial business. This business has been a really resilient compared to the past cycles for yourself, as well as your larger peers. So the question really is, can you just help us understand - and you gave us a number, 20%, for automation. But if you help us understand the various segments that are contributing to how you're able to kind of cloud through what we have seen a pretty disastrous 1Q, 2Q? And then with Maxim, we all understand the complementary parts or the additive parts on the automotive. Can you just help us understand how does the industrial business benefit from the Maxim business that you'll be bolting on? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes. So, thanks Ambrish. First and foremost, it's still a fairly tricky time in terms of trying to predict GDP. But we've come out of the year with tremendous strength. First-half of the year for ADI was about aerospace and defense, healthcare and the automatic test equipment sector as well. So - and that's continued, by the way, through the second-half. And then, we're building upon that in the - with the upsurge, the second-half is the expansion of growth in factory automation, which is, particularly in the fourth quarter, we began to see a very, very good surge, which we expect to continue by the way, albeit of, I'll say, somewhat depressed base as economic expansion really takes roof, I believe, in 2021. So - and also, this business for ADI, industrial is more than half of the company's revenue. The crop of products out there is stronger than it has ever been in the history of the company. Our focus - a decade ago, we decided this was really the roof of the company and we're beginning to really see, demonstrated in our results versus our competition and we're gaining market share, I think that's important to note. So, we cover more customers with more market share, with better product portfolio. So with Industry 4.0 coming on board, healthcare moving towards digitalization, telemedicine, these all bode really well for ADI for the long term. And where does Maxim add value to it as well? Industrial actually is - is really about - is primarily about precision signal processing and power management. And Maxim brings a long heritage in those two areas, which we will deploy to even greater effect across the spectrum of sensor to cloud, the raw signal that are sensing the signal, capture signal processing, connectivity. And that bodes very well for ADI. So, I'm excited about getting more capabilities to bring to more customers. As they require ADI to sell bigger swaths of problems, the complexity is growing in terms of their needs. The analog scale is becoming scarcer and scarcer. So, we will bring more of that skill to bear to solve more problems in a more complete way for our customers. So, I think that's the way to think about it, Ambrish."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Ambrish. Go to our next question, please, Cheryl."
},
{
"speaker": "Operator",
"text": "Your next question comes from C.J. Muse from Evercore. Your line is open."
},
{
"speaker": "C.J. Muse",
"text": "Thank you for taking the question. Another question on the industrial side, Vince. The business is growing 9% year-on-year in October, yet over the last few years is essentially flat. And so curious, it sounds like automation growing for the first time in two years is a real positive signal. So would kind of love to hear your thoughts on, as we come out of this pandemic, what that business segment growth could look like considering some of the growth factors that you're investing in like healthcare, as well as perhaps some of the more tried-and-true machinery, typical industrial business is beginning to recover? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes. So if I look - thanks, C.J. If you look out over the longer term, so industrial automation has been really on its way down for the last two years, two and a half years. And some of that was driven by the trade tensions. Obviously, with the automotive sector way off in, I mean, SAAR was dropping anyway in 2019, the pandemic crush demand there even more so in 2020. So, automotive is a big, big consumer of sophisticated factory automation systems. So that's all improving. If I think about the long-term prospects for the business given the vectors, the market vectors, the technology vectors that we've got, my sense is if you think over the longer-term here and integrate the demand over three-year, five-year period, my sense is this business can grow in the mid-to-high single digit level for ADI."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, C.J. Go to next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Toshiya Hari from Goldman Sachs. Your line is open."
},
{
"speaker": "Toshiya Hari",
"text": "Vince, I wanted to follow up on the automotive business, both in terms of your Q4 performance as well as the outlook into fiscal year '21. Just as sort of a clarification on Q4, you guys grew 40%, 40% plus sequentially. I think you were guiding that business to be up in the low teens. So obviously, a very big beat in the quarter. Was that essentially a function of higher volume across your customers and therefore, a beat across most of your customers and most of your applications? Or were there any specific standouts in the quarter? I guess more importantly, into fiscal year '21, when you think about your automotive business and the potential for growth there versus the rate of recovery in the overall global automotive industry, what kind of outperformance would you expect on top of automotive production? It appears as though you guys talk about BMS and active noise cancellation, in particular, but are there any specific drivers that you're most excited about? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "So let me try and unpack that for you. So yes, in fourth quarter, we were up 2% year-over-year. And actually, we had strength across all the applications. But even though our battery management solutions were down year-on-year, we did better than the overall market at large. And our position has gained strength with the new offerings that we have and the sheer performance that we bring that nobody else can match in terms of the sensing and the single processing. So, I think that, just looking at the prognostications of what electrification will do in the electric vehicle area, I think that's a growth trend for decade, decade and a half, two decades. So, we feel good about that given our position. I think also if you just look at the fourth quarter, I talked previously about our signal processing platform, high performance signal processing platform based on our DSP, our A2B technology road noise cancellation. A2B alone was up 70% in the year. So, we've been talking about it a long time. But now the revenues are really coming home to roost in that area. If I look at 1Q, typically, the automotive business for ADI is down seasonally, but we believe that it will be up. So the strength that we've been seeing coming through the fourth quarter here will continue into the first and beyond. And if I look at just the areas that I feel really enthusiastic about that we've been steering investment increasingly towards over the last three years or so, I talked already about the electric vehicle market. And we think about that as an opportunity from battery formation to battery deployment and battery discharge. So, we're growing share in those key markets and we continue to innovate in the space and create more blue sky between ourselves and our competition, as the problems that our customers are solving become more and more challenging. So, we've brought wireless BMS quite recently, which we've announced a partnership with GM. But that is only the start. That is a new growth dimension for ADI in the automotive sector. I've talked about infotainment already, A2B, road noise cancellation. And we've managed to grow that business in 2020 despite the really, really compressor. The other thing I should point out is that we're still in the early innings of attaching our power franchise in the automotive of critical applications in which we play and that's all still ahead of us. Again, we feel good about that in areas like safety, the radar, as well as vision-based safety systems. And just in the car in general, power is an area where we've made excellent progress, I think, getting design ends. Now, we're turning them to revenue."
},
{
"speaker": "Michael Lucarelli",
"text": "Good. Next question, please?"
},
{
"speaker": "Operator",
"text": "Our next question comes from Blayne Curtis from Barclays. Please go ahead. Your line is open."
},
{
"speaker": "Blayne Curtis",
"text": "I just want to revisit answer. On the comm, you talked about longer term drivers like O-RAN. I'm just kind of curious. In the January, I think there is going to be a pause between Phase 1 Phase 2 in China. I'm just kind of curious on your perspective. Seems like it might be down a little bit in January. Just curious, when do you think comm could see a recovery in any perspective and timing of China coming back?"
},
{
"speaker": "Michael Lucarelli",
"text": "Yes. I think comms is down sequentially. I mean, a big reason why comms was down sequentially in 1Q is the Huawei ban. Huawei was a low single-digit customer, call it, 2%, 3% of sales. They're going to be zero. So, that'll be a headwind into our first quarter. And you're right, I think the timing of next run of China 5G deployment are TBD. I think when they do happen, it will be a great business for us and we'll continue to grow in that market. But it's very hard to call when that market will turn back on. Sometime likely in the first-half of '21, but really unsure to pinpoint it today when that's going to be, given all the geopolitical tensions out there. I think, Vince, did a good job talking about how it's not just about China. The good thing, as you moved to '21, it's more global 5G. North America should start ticking off. Europe, Japan, Korea, has really started to broaden out and less about China. China still will be the biggest market, but really global 5G deployment should do better year-on-year in '21."
},
{
"speaker": "Michael Lucarelli",
"text": "Can we go to our last question, please?"
},
{
"speaker": "Operator",
"text": "And our last question comes from Ross Seymore from Deutsche Bank. Please go ahead. Your line is open."
},
{
"speaker": "Ross Seymore",
"text": "Thanks for sneaking me in. I just wanted to wrap up with a little bit of the linearity of demand. Can you just talk about the bookings that you've seen? Have any of the concerns that your customers have had in the past about supply disruptions and all those sorts of things? It seems like those have gone away, given your commentary on channel inventory. But just wanted to get kind of what your book-to-bill was and how linearity played out through the October quarter, please?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "So let me give you a couple of data points here. We started the quarter out strong in August, which was up from July and then we had a pretty normal September. Bookings remain solid so far. I think where - book to bill is at parity, where we're going into the first quarter with very normal backlog coverage for our outlook. All of that is reflected in the guide that we have. I did make a comment about inventory in the channel. So maybe that's also worth making sure people understand that we are below our seven-week to eight-week model and then we're going to kind of build ourselves back into that model over the course of 2021. So, that should also provide a little bit of a - a little bit tailwind as we go through 2021."
},
{
"speaker": "Michael Lucarelli",
"text": "All right. Thanks, Ross. And thanks, everyone, for joining us today this morning. A copy of the transcript will be available on our website. And all available reconciliations, any additional information can also be found in the Quarterly Results section of our IR website. Thanks for joining us and your continued interest in Analog Devices. Hope everyone has a good holiday."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 3 | 2,020 | 2020-08-19 17:00:00 | Operator: Good morning and welcome to the Analog Devices Third Quarter Fiscal Year 2020 Earnings Conference Call which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call Mr. Michael Lucarelli, Senior Director of Investor Relations. Sir the floor is yours.
Michael Lucarelli: Thank you, Cheryl and good morning everybody. Thanks for joining our third quarter fiscal 2020 conference call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release you can find relating financial schedules at investor.analog.com. Now on to the disclosures. The information we're about to discuss includes forward-looking statements including statements relating to our objectives, outlook, and the proposed Maxim transaction. These forward-looking statements are subject to certain risks and uncertainties as further described in our earnings release our most recent 10-Q and other periodic reports and materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of the date of this call and we undertake no obligation to update these statements except as required by law. Our comments today will also include non-GAAP financial measures which exclude special items. Comparing our results to historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO, Vincent Roche. Vince?
Vincent Roche: Thanks very much Mike and good morning to you all. I hope that you and your families are healthy and safe at this time. So, I'll start my remarks today on our quarterly results and the current operating environment before providing you with an update on our priorities. This includes additional insight of course into our recently announced acquisition of Maxim Integrated. ADI executed exceptionally well in the third quarter despite the highly uncertain environment. Demand was resilient surpassing our expectations leading to stronger than expected results. We saw continued strength in communications across both wireless and wireline applications, healthcare saw record demand, and other parts of our industrial portfolio such as instrumentation tests also performed well. Unsurprisingly, the main area of weakness was automotive driven by global factory shutdowns and lower vehicle sales. Turning to supply, we're operating at normal capacity which helped us clear backlog and bring supply and demand into a better balance. Our team delivered third quarter results above the midpoint of our revised guide with revenue at $1.46 billion and EPS at $1.36. B2B revenue was flat year-over-year and increased 11% sequentially and both gross and operating margins returned within the range of our financial model at 70% and 42% respectively. We also generated $1.8 billion of free cash flow or 33% of revenue over the trailing 12 months. This continues to place ADI in the top 10% of the S&P 500. These results further underscore the strength and flexibility of our business model against any economic backdrop and I'm proud of how the ADI team continues to deliver for our customers. Now, I'll turn to an update on our strategic priorities. We're focused on spending our capital efficiently and the first call is funding new product development. During the quarter, we invested approximately $260 million in R&D with more than 95% targeted at the most attractive B2B opportunities. This continued reinvestment in our business is leading to excellent customer engagements and let me provide you now with a couple of examples. In our communications business, we announced the collaboration with Intel to create a flexible radio platform that will enable customers to scale their 5G networks more quickly and more economically. The high-performance ORAN compliance solution leverages our market-leading software-defined transceiver technologies. This positions ADI to expand our market leadership. In automotive, our new road noise canceling solution is gaining traction. Since announcing our initial win with Hyundai in February, we've added five more customers including the North American leader in electric vehicles. This innovative solution reduces the car weights by almost 100 pounds and energy requirements by about 3%, while potentially doubling our content opportunity per vehicle. We're seeing great design momentum across our diversified industrial market also. For example, in factory automation, customers are rethinking supply chains to make them more flexible with faster response times. And to quicken the pace of adoption, we have formed an alliance of partners to develop an open source architecture. I'm excited to announce a Fortune 500 health care customer is teaming with ADI to help upgrade its manufacturing capabilities, using more connected robotics, thereby doubling our addressable market. And in space, we have design wins going to production this year with traditional aerospace companies and new emerging disruptors that enable the proliferation of next-generation communication satellites. These satellites continuously change their position to earth and require space grade phased array and beam forming technology to create an uninterrupted connection. And we're using this strong position in RF to attach power technologies thereby increasing our addressable market by one-third. ADI also remains committed to strong shareholder returns. This quarter, we returned approximately $230 million through dividends. Recall, that we paused share buybacks due to the pandemic. This has helped us further solidify our balance sheet with a cash balance of more than $1 billion. At this point, I'd be remiss to not discuss our M&A strategy in the light of the Maxim acquisition. ADI selectively uses M&A to expand both our scale and our scope in order to better address the future needs of our customers and deliver sustainable profitable growth. And while cost synergies are an important element in evaluating any acquisition from our perspective, the most compelling benefits come from combining technology portfolios to capture new addressable markets and drive on term revenue synergies. This revenue takes time to realize given the nature of the Analog business, but our products deliver recurring revenue streams and cash flow for decades. Therefore, we strive to achieve our return objective within approximately five years. This time frame, allows us to not only achieve the stated cost savings, but also begin to capture the early revenue synergies. And I think the acquisition of LTC illustrates the benefits of our strategy. Our top priorities there were harmonizing the two organizations to create an entity that is better than the sum of its parts. To that end, I'm proud to say that we've retained and invested in LTC's exceptional engineering talent. Together, we've created an exciting road map of high-performance analog and power solutions combined. We're exceeding our original $150 million cost synergy target and we're on track to realize the next $100 million exiting fiscal '21. And from a revenue perspective, we've more than doubled our pipeline value and we have over $500 million of lifetime revenue coming to market this year, increasing our confidence in doubling LTC's historical growth rate. With LTC complete, we pursued the acquisition of Maxim to strengthen our leadership in the analog industry, better positioning ADI to capitalize on secular growth trends. Over the last five years, Maxim has shifted its business strategy to focus on B2B markets, while enhancing profitability. As a result, Maxim has increased its B2B revenue mix to approximately 80% of total from 55%, expanded its gross margins by more than 500 basis points and increased its free cash flow margin by over 600 basis points during this period. Combined, we're confident we will continue to improve Maxim's performance. This will be driven by our cadre of engineering talent, complementary technologies and breadth of market applications that I'd like to expand on a little here. The cultures of ADI and Maxim are very aligned. Both companies share a commitment to innovation and engineering excellence. With a combined team of more than 10,000 engineers and $1.5 billion of annual R&D investment, we will continue to be the destination for the world's best analog talent. And with three times the field technical resources, we'll be better positioned to uncover cross-selling opportunities and serve existing and new customers, who have an increased need for application and design support. In the area of power management, Maxim's application-focused offerings are highly complementary with ADI's more general purpose or catalog power portfolio. Together we will have a more comprehensive power portfolio with approximately $2 billion of revenue. This is particularly important, as power is the largest and fastest-growing Analog subsegment and with increasing design complexity and the need for better efficiency, the system power challenges that our customers must overcome continue to rise and rise. In automotive, Maxim has one of the premier franchisees increasing revenue at a mid-teens rate over the last five years. They're a leader in high-speed data connectivity for cameras, radars and processors with serial link technology, while ADI is a leader in audio solutions with our A2B platform and both companies are well positioned in vehicle electrification, enabling us to better address automakers' EV requirements, which continuously evolve. Together, we will capture more of the increasing system content per vehicle and enable a better experience for the consumer. Taking a step back, the combined company will have unique positioning with 85% exposure to highly profitable long life B2B markets. Maxim's strengths in the automotive and data center markets will complement ADI's strengths across the industrial, communications and digital health care markets. Additionally, the combined company will have increased financial strength. We expect the combination to be accretive to adjusted EPS within 18 months post-close with targeted cost synergies of $275 million by the end of the second year. We also expect to maintain an industry-leading financial profile. As always, we are committed to generating robust free cash flow and our goal is to reach the high end of our margin range of 40%. With our lower leverage ratio at close, we'll also have the opportunity to deliver enhanced cash returns to our shareholders. And I believe that together we can grow revenue at mid-single-digits, due to our alignment with important secular growth trends, such as Industry 4.0, digital health care, next-generation communication systems and vehicle electrification as examples. So in closing, we're seeing promising evidence that a broad-based recovery is underway. However, we recognize that the recovery is highly dependent on the future impacts of the pandemic. We've used this unprecedented time to better align our organization and investments into the most important areas. We believe we'll emerge stronger and are better positioned to drive profitable growth. And as I've shared today, we're very excited about the combination with Maxim, which will drive the next wave of disruptive innovation and deliver significant benefits for all stakeholders. And with that I'll turn it over to Prashanth to go through the financial details and outlook.
Prashanth Mahendra-Rajah: Thank you, Vince. Let me add my welcome to our third quarter earnings call. As a reminder, my comments with the exception of revenue and non-op expenses will be on an adjusted basis, which excludes special items outlined in today's press release. When we provided quarterly guidance in May, we were facing tremendous uncertainty just returning to normal capacity levels and experiencing volatile demand patterns across end markets. As we progressed through the quarter, we saw stronger-than-anticipated demand that resulted in less cancellations and higher-than-anticipated backlog conversion. With that as context, our results came in above the midpoint of our revised outlook with revenue of $1.46 billion, operating margins over 42% and EPS of $1.36. Let me start now with the end market color. Our B2B revenue was up 11% sequentially and flat year-over-year, as strength across industrial and communications offset a sharp decline in automotive. Industrial, which represented 53% of revenue during the quarter, finished up 3% year-over-year. We experienced robust growth in health care, instrumentation test and energy applications. This strength was moderated by weaker trends across our broad market and automation businesses. Communications, which accounted for 25% of revenue, achieved a record quarter. Revenue finished up 14% year-over-year, driven by double-digit increases across both wireless and wireline. This strength came from our leadership position in 5G wireless systems and our solid position in optical connectivity used in carrier networks and data centers. Automotive, which represented 11% of revenue decreased 29% year-over-year with all applications declining due to global factory shutdowns and lower vehicle sales. And while no business is immune to the current environment, our BMS and A2B solutions fared quite well. BMS revenue increased sequentially and was down just modestly year-over-year due to our strong penetration across the ecosystem and increasing consumer preference for electric vehicles. And given the continued adoption of our A2B audio platform, A2B revenue has increased over 70% year-to-date despite lower vehicle sales. Consumer which also represented 11% of revenue was down 13% year-over-year. Relatively flat portable revenue was more than offset by double-digit declines in prosumer due to the pandemic-related softness. We continue to expect 2020 to be the bottom for our consumer business. In addition to the end market commentary, we wanted to provide some insight by geography as we believe it is helpful to investors in this current climate. Most geographies declined year-over-year. We saw double-digit declines in Europe and Japan, while the decline in North America was less pronounced. The rest of Asia increased and China increased double digits year-over-year largely driven by the robust growth in communications given our solid position as well as strength in industrial. Now moving on to the P&L. Gross margins returned to our model at approximately 70% down modestly year-over-year from lower fab utilization. We've accelerated the planned LTC factory closings and have started to realize these benefits in the third quarter. We expect additional savings in the fourth quarter and we'll exit fiscal 2020 with nearly half of the $100 million savings in our run rate. OpEx was $402 million up 3% sequentially yet down 8% year-over-year. We maintained a focus on controlling expenses, which included a one-week global shutdown during the quarter. OP margins finished at 42.3%, the highest level since the third quarter of 2018. Non-op expenses were $46 million down $3 million sequentially and more than $10 million year-over-year driven by lower levels of debt and lower interest rates. Our tax rate for the quarter was approximately 11.5% and all told, third quarter EPS came in at $1.36. Now moving on to the balance sheet. We finished the quarter with over $1 billion of cash and about $5.6 billion in total debt. This resulted in a leverage ratio of 1.8 times on a trailing 12-month basis. Inventory dollars increased $22 million sequentially, but declined year-over-year. Days of inventory remained basically unchanged at 125. Channel inventory remains lean and is below the low end of our seven- to eight-week target range. Cash from operations was $557 million and CapEx was only $21 million as we proactively reduced CapEx spend in the current environment. This resulted in free cash flow of $536 million up 8% year-over-year. Our long-term CapEx target remains the same at approximately 4% of sales. And as Vince mentioned, on a trailing 12, we generated $1.8 billion of free cash flow. Over the same period, we've returned around $860 million to shareholders via dividends and additional $410 million via buybacks. This equates to a free cash flow return after debt reduction of nearly 80%, which is below our 100% return target as we paused our buyback program. Now I'd like to expand on Vince's commentary and discuss how our combination with Maxim will further enhance our financial profile. At deal announcement, ADI and Maxim had a combined pro forma leverage ratio of 1.2 times, which will decrease between today and deal close. The main driver being Maxim which is in cash accumulation phase. They will pay one more quarterly dividend before suspending it for four quarters and their buyback is on pause. Said another way, all the cash generation for the 12 months beginning in the second quarter of their fiscal 2021 will be added to the balance sheet. And for reference, over a trailing 12-month period, Maxim generated $730 million of free cash flow. ADI plans to continue to pay and grow our dividend. And as I mentioned earlier, our buyback program was paused during the height of COVID-19 and will remain on hold for now. When circumstances permit, our intention is to reinstate the program, which has nearly $2 billion remaining under authorization. Also, as we previously outlined, we plan on repaying $300 million to $500 million of debt in 2020. This quarter, we intend to honor that commitment by retiring our $450 million January 2021 note. This will save $13 million of annual interest expense. We believe the stronger balance sheet provides us with flexibility to improve on our 100% free cash flow return and increase shareholder value over the long term through a combination of reinvestment in the business, continued dividend increases, greater and more consistent buybacks and targeted acquisitions. And now on to the fourth quarter outlook. Fourth quarter revenue is expected to be $1.44 billion plus or minus $70 million. This outlook considers our current understanding of the impact related to the recent legislation enacted on Monday. It's important to remember that this customer's revenue has been significantly reduced over the last year to a low single-digit percent of total sales. We anticipate B2B revenue to decrease modestly for the third quarter. Strong growth in automotive as well as growth in industrial is more than offset by a decline in communications. This decline in communications is related to a slowdown of deployment as we forecasted in the last call and the limited impact from the recent legislation. On a year-over-year basis, B2B revenue is forecasted to increase low to mid-single digits. We anticipate our operating margin to be approximately 42% plus or minus 100 bps. We're planning for the tax rate to be between 12% and 13%. And based on these inputs, adjusted EPS is expected to be $1.32 plus or minus $0.10. So now I'll close my remarks by stating that third quarter proved better than our expectations, largely driven by our conservative planning and aggressive execution. As we move through the integration planning process with Maxim, we remain fully committed to driving sustainable growth through cutting-edge innovation and a focus on our customer success. I'm going to pass it back to Mike now to start our Q&A.
Michael Lucarelli: Thanks, Prashanth. Okay. Let's get to our Q&A session. I'll listen to all your feedback about the – around questions and the number of questions on the call. So we're going to run this a little differently than normal. I ask that limit yourself to one question to allow time for additional participants on this call this morning. And with that Cheryl, can we have our first question please.
Operator: [Operator Instructions] And our first question comes from John Pitzer from Credit Suisse. Please go ahead. Your line is open.
John Pitzer: Hi, guys. Good morning and congratulations on the solid results. I just want to follow up on the recent Department of Commerce ruling. Am I to read into that that you've embedded sort of zero revenue coming from that one customer? And just given how strong China has been as a region Vince, are you at all worried that there's been pull forward, or is that just a natural offshoot of that's the geo where a lot of 5G deployment is happening?
Vincent Roche: Yes. Good question. Thanks, John. So we have pretty much discounted our top – what used to be our number one customer in China to pretty much zero in our long-term planning thinking. It has been a low single-digit customer over the past few quarters. So we have factored also by the way the latest regulatory upheaval into our numbers. So at this point in time, the largest 5G customer there in China that used to be is no longer part of the planning or the -- either in the short term or the long term. I'd say as well, what we've seen in terms of the strength in China that Prashanth referred to is really -- is the fact that China was the first to go into the pandemic. First to come out. It's an economy that's growing very, very rapidly and has been up for several years now. So, I think, there's been a very good balance I believe between supply and demand across all the sectors. I mean, we've seen growth in all markets with the exception of automotive. So I think what we're seeing in terms of the strength in China is more about the match between the strength in our business and the economy than anything else.
John Pitzer: Perfect. Thanks guys.
Vincent Roche: Our next question please?
Operator: Thank you. Our next question comes from Vivek Arya from Bank of America Securities. Please go ahead. Your line is open.
Vivek Arya: Thanks for taking my question and congratulations on the strong execution. I wanted to follow up on John's question about your communications business. And I was hoping Vince, if you could help us quantify how much communications could perhaps decline sequentially? And what are you baking in from this Department of Commerce regulation? And then, I think that the bigger question there is that as we look forward to next year, do you think global 5G deployments can stay on track if Huawei doesn't get access to U.S. technology? Like are we really contemplating a world where Huawei is not going to be a player at all in 5G deployment? And if there is such a world, does it still mean that 5G deployments globally can actually happen at the pace people were thinking about before? Any perspective would be very useful. Thank you.
Prashanth Mahendra-Rajah: Yes. Vivek, we're going to split that. And let me take the first part of it. So to clarify, third quarter we believe did not see any pull-ins from Huawei. Fourth quarter outlook reflects the guidance we gave you reflects the full impact for us of the Department of Commerce implications from earlier this week. So, all of that is now baked in. In terms of the amount of decline that we are expecting in the communications business, this is a lumpy business. We've said that consistently. It's growth measured in years and lumpy by quarter. We don't give forward guidance on an end market basis by quarter anymore. We haven't done that for a little bit of time. So, we don't want to start that now. But take it to understand that the movement in the communications business from third to fourth quarter was very much in normal operating lumpiness of the communications business is not exacerbated in any way by what happened on Monday or Tuesday's announcement. And now I'll pass back to Vince for your more challenging strategic question.
Vincent Roche: Yes. So Vivek, I've been in this business a long, long time actually since two -- the inception of 2G all those years ago back in the late 80s, early 90s and what I can tell you is that the patterns we're seeing in 5G are no different to what we've seen in 2G, 3G or 4G. And if you look at 4G specifically, just to give you a bit of perspective here, we grew albeit a very, very lumpy business as we always say, but we grew over the entire era of its build out by mid-single digits. We had more content than we had in the prior generations. We took more share. And we're actually even better positioned in 5G because, it's a more complex radio problem fundamentally. We have a lot more technology to put into the space from microwave and RF right down to the mixed signal. And now, we're attaching power also, so, another factor that we're beginning to see the emergence of. So today, 5G has really been about giving more bandwidth to the consumer, more throughput to the consumer. The future is about I think B2B more so than the consumer. And we're beginning to see I believe the early adoption of 5G in the factory automation area. In fact, I have verified that with some of our industrial automation customers as well. So, 3Q is definitely likely the highest revenue quarter this year, but there are lots of drivers at the secular level and the company level to keep us in good stead for growth over the long term.
Prashanth Mahendra-Rajah: Vivek, I'll add one thing to try to avoid the plethora of Huawei questions that I can tell are winding up. So we've given you a lot of context around that customer. We said they're a mid-single-digit customer. The legislation put in place was, you we can ship for about half this quarter. So they'll be lower this quarter than normal. And going forward after that our expectation should be, it goes to zero. So our outlook for 1Q would be down for communications because of that.
Vincent Roche: The last couple of quarters have actually been low single digits. And as we've said now a couple of times, we are no longer factoring Huawei into our numbers.
Vivek Arya: Thanks for that.
Michael Lucarelli: Thank you. Sheryl, next question, please? Sheryl, are we still on the call? I guess not.
Operator: Your next question comes from Tore Svanberg from Stifel. Your line is open.
Tore Svanberg: Yes. Thank you and congratulations, especially during these tough times. I had a question on sort of bookings linearity and backlog. I know last quarter you obviously entered the quarter with pretty high backlog and you were sort of discounting that. Are we sort of back to a more normal backlog level now for either you Vince or Prashanth?
Vincent Roche: Yes. So let's -- maybe let me answer that by talking about the order patterns. So we saw strong May, some slowdown in June, which was expected. July was sort of a stable month-over-month and that was better than we expected. Through August, relatively stable and August is typically a lower seasonal month. So we have lower backlog in third quarter, as we enter the quarter and a good balance between supply and demand. This quarter, as we look forward to our guide, we’ve got stronger coverage from backlog than we typically do. And if we converted -- if you recall in the third quarter we said that, we had about $50 million of products that we couldn't ship in the second quarter that we caught up with in the third quarter. That actually came in a little bit higher, because we had fewer cancellations. So we probably had maybe $100 million all-in of revenue in third quarter that really related to backlog from second quarter. So, I think, that through fourth quarter we're going to get supply and demand back in balance. Backlog has come down and will be more back to normal levels. As we have guided for the fourth quarter, we've taken into consideration the stronger backlog, but we've also taken into consideration that at an ADI level our book-to-bill for the fourth quarter is now below parity.
Tore Svanberg: Thank you.
Michael Lucarelli: Thanks, Tore.
Operator: Thank you. And our next question comes from Ambrish Srivastava from BMO. Please go ahead. Your line is open.
Vincent Roche: Ambrish, go ahead.
Ambrish Srivastava: Hi. Can you guys hear me?
Vincent Roche: We can Ambrish. Yes.
Ambrish Srivastava: Okay. Vince, I wanted to pivot back to the strategic priorities and thanks for articulating everything in context of the latest acquisition. This is a question I get a lot and I scratch my head on this too, because of you bought Linear and then Maxim also on the power side. So the question -- and you did provide us with some details on Linear. A couple of questions tied to that. With respect to Hittite you have given us the growth in Hittite versus what it used to grow and how you have been able to grow that versus prior to acquisition. So the question is, how has Linear done with respect to the core business? And I don't expect you to answer it every quarter, but I think it's a pertinent question in light of the Maxim acquisition. So kind of two-part question. One how has Linear done since you bought it? And then, this was the year that we were supposed to get revenue synergy. Now this is a very topsy-turvy year, so we all understand that. But should we expect revenue synergies to start showing up from Linear with all the efforts that have been going on? Thank you.
Vincent Roche: Yes. Thanks, Ambrish. So we have already seen the benefit of LTC in our growth numbers. I would say at this point in time we've put more than 100 basis points of growth on the base Linear growth rate to-date. We have -- I think the greatest indicator for what things are likely to be in the future I've said before that I believe that we can double the growth rate of LT over the longer term and just given the markets in which we play and the design cycles the product cycles it takes three years minimum and then you begin to see the real benefits I think after five years. So we're over 100 basis points of additive growth right now. And if you look at our pipeline I referred to it in the prepared remarks we have got a design win pipeline of over $0.5 billion thus far. We have seen wins in communications both on the wireless side as well as the data center side. Infotainment in automotive infotainment radar and of course BMS. We're seeing tremendous uptake for some of our more integrated products in areas like instrumentation tests using our micromodule technologies. And I'm quite pleased given the turmoil in the global markets right now that we continue to see good traction on the design win rates and I'm confident that we can get from 3% to 4% growth rates in the past to more a higher -- mid to high single-digit level in the future and do it sustainably. So I think we have emerging evidence that we're on good track to do that.
Ambrish Srivastava: Okay. Thank you.
Vincent Roche: Thanks, Ambrish.
Operator: Thank you. And our next question comes from Toshiya Hari from Goldman Sachs. Your line is open.
Toshiya Hari: Good morning, guys and congrats on the strong results. Vince, I had a question on your automotive business. Curious how are you thinking about the shape of the recovery in automotive over the next couple of quarters? Obviously, you've been impacted by your customer factory shutdowns and the demand situation post-COVID. But curious are you thinking it could be more of a V-shaped recovery, could it be more U-shaped? Any thoughts there would be super helpful? And if you can speak to your key applications within automotive, you gave great color on the July quarter but if you can talk about BMS A2B some of the key growth drivers for October and beyond that would be helpful? Thank you.
Vincent Roche: Okay. Thanks, Toshi. So yes, we're seeing a recovery in the market. Actually our book-to-bill was greater than unity across all regions over the last month or so. And we believe that our third quarter represents the bottom of the cycle for us. So I think the near-term recovery and the demand that we're seeing relates to factories coming back online and also a slow improvement in SAAR. So I think the shape of the recovery really depends on the demand -- the end demand for cars and how SAAR actually grows. And we'll -- that will need -- we'll need to see continued vehicle demand to get back to the pre-COVID level. So it's not there yet. So factories are coming back online. Demand is slowly increasing. So hard to call the exact shape but somewhere between a V and a U I guess or maybe already a U and we're seeing the upsurge. I would say electric vehicles in general have held up better in this market. As we said in the prepared remarks there's a strong consumer preference for electric vehicles. It's the fastest-growing sector at this point in time. And we're continuing to gain share in the market. We've seen growth quarter-on-quarter in that space. And we're also very pleased with our performance. A2B actually grew about, I think, it was 70% year-to-date. So the adoption the design wins that we had gotten last year across most of the OEMs beginning to turn into serious revenue now. And on top of that, we're also overlaying this road noise cancellation technology that uses our digital signal processors, algorithmic technology and different analog, support technologies on the input and output there. So those are the major areas. And I think, as I said, I believe, we're in a slow recovery phase in automotive. And I think in general very hard to call the next quarter, the next two quarters, but my sense is 2021 will be a growth year for the industry and a growth year for ADI. And – I mean, that's how I viewed at this point in time. So we're seeing a gentle recovery in general across all our market spaces.
Toshiya Hari: Thank you.
Michael Lucarelli: Thank you. Next question please.
Operator: Thank you. Our next question comes from Stacy Rasgon from Bernstein Research. Please go ahead.
Stacy Rasgon: Hi, guys. Thanks for taking my question. I'm a little bit confused. I know you've been saying, we're entering into recovery, but how do I square that with a book-to-bill going forward that is less than one? I mean, is it just comm? Like, how should I be thinking about book-to-bill by segment? And what does that imply for like the longer-term trajectory?
Prashanth Mahendra-Rajah: Yeah. Great question, Stacy. The – so I would say that, certainly, the communications business is a piece of that. And I would also say that, we – when we look back at the demand activity over the last quarter or two, we feel very good that that was driven by very kind of real demand based on conversations with customers. But there was probably some level of inventory building that was going on in there given that the inventory levels at our end customers were so low. Coming into this pandemic, they had taken – end customers really at the industrial level had taken their inventory levels down pretty significantly in 2019. And then the pandemic hit. And so I think some of the strength that the industry is seeing now has a little bit of that renormalizing that. So as we kind of look forward into fourth quarter, there is a lot of opportunity for us. And I think that, the new order activity remains good over dues are declining. So it's – I think, we'll have to let another quarter or two roll out. We don't have enough visibility I think to tell you what the future portends. But we're not seeing a sharp decline in order activity, but it is below one.
Stacy Rasgon: Got it. But just to clarify – I'm sorry?
Michael Lucarelli: Stacy, we are guiding down sequentially. Our book-to-bill is slightly below one. So it does go in tandem to what we're saying. And you're right to think about the tele market. Comm is much below one, auto is a bit above one, industrials around one. So it all lines up to what the guidance we gave and the range we have given.
Stacy Rasgon: Okay. Thank you, guys.
Michael Lucarelli: Thanks, Stacy.
Prashanth Mahendra-Rajah: Thanks, Stacy.
Operator: Thank you. And our next question comes from C.J. Muse, Evercore. Please go ahead. Your line is open.
C.J. Muse: Yeah. Good morning. Thank you for taking the question. I guess a cycle question. And if I look at your S-4, and you projected revenues in there for fiscal 2020, that roughly $170 million below what you're actually looking to accomplish here. And so curious, versus what you put there in the S-4, what led to the upside there? And is that something that we should think can continue beyond the October quarter?
Prashanth Mahendra-Rajah: C.J., that was really around the timing of when we're having those conversations. If you look back at the timing of when we were in those, the world looked very different to us. I think it looked differently to everyone back at that period, when the pandemic looked like it was ranging at a pretty sharp pace across the globe. So, our S-4 probably reflected more of the uncertainty that we had out there that has since been -- more clarity has been brought.
C.J. Muse: Okay. Thank you.
Michael Lucarelli: We'll go to our last question please.
Operator: Thank you. Our last question comes from Craig Hettenbach from Morgan Stanley. Please go ahead. Your line is open.
Craig Hettenbach: Yes. Thanks. Just a question for Vince, on the industrial market and really about the composition maybe in the next couple of quarters, so certainly medical has been strong instrumentation. The more cyclically oriented factory automation has been weak. Do you expect any reversal in some of that kind of by sub-segment performance as we move forward from here and the macro recovers?
Vincent Roche: Yes. Well, we've seen -- I mean energy is a couple of hundred million dollar business a year for ADI. That's been doing well, and we're getting a lot of new design wins. In renewables area, we've seen strong demand in our test business, supporting 5G build out and data centers in particular. And we're seeing a little more weakness in instrumentation in areas that relate more to CapEx. If you look at aerospace and defense, which is an important part of our industrial story, obviously there's weakness in avionics that won't be a huge surprise. But that's a relatively small portion. The biggest portion of our aerospace and defense business is defense, and that business is holding up well as well as the space business, which continues to grow nicely. I would say as well automation is holding better than we had thought. But what really excites us there is the future, as our customers rethink supply chains onshoring, reshoring, and we're going to see more and more automation used in general across the globe. So, I think that unpacks the story for you. So, I think we're seeing strength pretty much across all the sectors or recovery across all the sectors in industrial right now.
Craig Hettenbach: Okay. Got it. Thanks.
Michael Lucarelli: Thanks so much, Craig. And thanks everyone for joining us this morning. A copy of the transcript will be available on our website and all reconciliations and additional information can also be found there. Thanks for joining us and your continued interest in Analog Devices.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
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"speaker": "Operator",
"text": "Good morning and welcome to the Analog Devices Third Quarter Fiscal Year 2020 Earnings Conference Call which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call Mr. Michael Lucarelli, Senior Director of Investor Relations. Sir the floor is yours."
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"speaker": "Michael Lucarelli",
"text": "Thank you, Cheryl and good morning everybody. Thanks for joining our third quarter fiscal 2020 conference call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release you can find relating financial schedules at investor.analog.com. Now on to the disclosures. The information we're about to discuss includes forward-looking statements including statements relating to our objectives, outlook, and the proposed Maxim transaction. These forward-looking statements are subject to certain risks and uncertainties as further described in our earnings release our most recent 10-Q and other periodic reports and materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of the date of this call and we undertake no obligation to update these statements except as required by law. Our comments today will also include non-GAAP financial measures which exclude special items. Comparing our results to historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO, Vincent Roche. Vince?"
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"speaker": "Vincent Roche",
"text": "Thanks very much Mike and good morning to you all. I hope that you and your families are healthy and safe at this time. So, I'll start my remarks today on our quarterly results and the current operating environment before providing you with an update on our priorities. This includes additional insight of course into our recently announced acquisition of Maxim Integrated. ADI executed exceptionally well in the third quarter despite the highly uncertain environment. Demand was resilient surpassing our expectations leading to stronger than expected results. We saw continued strength in communications across both wireless and wireline applications, healthcare saw record demand, and other parts of our industrial portfolio such as instrumentation tests also performed well. Unsurprisingly, the main area of weakness was automotive driven by global factory shutdowns and lower vehicle sales. Turning to supply, we're operating at normal capacity which helped us clear backlog and bring supply and demand into a better balance. Our team delivered third quarter results above the midpoint of our revised guide with revenue at $1.46 billion and EPS at $1.36. B2B revenue was flat year-over-year and increased 11% sequentially and both gross and operating margins returned within the range of our financial model at 70% and 42% respectively. We also generated $1.8 billion of free cash flow or 33% of revenue over the trailing 12 months. This continues to place ADI in the top 10% of the S&P 500. These results further underscore the strength and flexibility of our business model against any economic backdrop and I'm proud of how the ADI team continues to deliver for our customers. Now, I'll turn to an update on our strategic priorities. We're focused on spending our capital efficiently and the first call is funding new product development. During the quarter, we invested approximately $260 million in R&D with more than 95% targeted at the most attractive B2B opportunities. This continued reinvestment in our business is leading to excellent customer engagements and let me provide you now with a couple of examples. In our communications business, we announced the collaboration with Intel to create a flexible radio platform that will enable customers to scale their 5G networks more quickly and more economically. The high-performance ORAN compliance solution leverages our market-leading software-defined transceiver technologies. This positions ADI to expand our market leadership. In automotive, our new road noise canceling solution is gaining traction. Since announcing our initial win with Hyundai in February, we've added five more customers including the North American leader in electric vehicles. This innovative solution reduces the car weights by almost 100 pounds and energy requirements by about 3%, while potentially doubling our content opportunity per vehicle. We're seeing great design momentum across our diversified industrial market also. For example, in factory automation, customers are rethinking supply chains to make them more flexible with faster response times. And to quicken the pace of adoption, we have formed an alliance of partners to develop an open source architecture. I'm excited to announce a Fortune 500 health care customer is teaming with ADI to help upgrade its manufacturing capabilities, using more connected robotics, thereby doubling our addressable market. And in space, we have design wins going to production this year with traditional aerospace companies and new emerging disruptors that enable the proliferation of next-generation communication satellites. These satellites continuously change their position to earth and require space grade phased array and beam forming technology to create an uninterrupted connection. And we're using this strong position in RF to attach power technologies thereby increasing our addressable market by one-third. ADI also remains committed to strong shareholder returns. This quarter, we returned approximately $230 million through dividends. Recall, that we paused share buybacks due to the pandemic. This has helped us further solidify our balance sheet with a cash balance of more than $1 billion. At this point, I'd be remiss to not discuss our M&A strategy in the light of the Maxim acquisition. ADI selectively uses M&A to expand both our scale and our scope in order to better address the future needs of our customers and deliver sustainable profitable growth. And while cost synergies are an important element in evaluating any acquisition from our perspective, the most compelling benefits come from combining technology portfolios to capture new addressable markets and drive on term revenue synergies. This revenue takes time to realize given the nature of the Analog business, but our products deliver recurring revenue streams and cash flow for decades. Therefore, we strive to achieve our return objective within approximately five years. This time frame, allows us to not only achieve the stated cost savings, but also begin to capture the early revenue synergies. And I think the acquisition of LTC illustrates the benefits of our strategy. Our top priorities there were harmonizing the two organizations to create an entity that is better than the sum of its parts. To that end, I'm proud to say that we've retained and invested in LTC's exceptional engineering talent. Together, we've created an exciting road map of high-performance analog and power solutions combined. We're exceeding our original $150 million cost synergy target and we're on track to realize the next $100 million exiting fiscal '21. And from a revenue perspective, we've more than doubled our pipeline value and we have over $500 million of lifetime revenue coming to market this year, increasing our confidence in doubling LTC's historical growth rate. With LTC complete, we pursued the acquisition of Maxim to strengthen our leadership in the analog industry, better positioning ADI to capitalize on secular growth trends. Over the last five years, Maxim has shifted its business strategy to focus on B2B markets, while enhancing profitability. As a result, Maxim has increased its B2B revenue mix to approximately 80% of total from 55%, expanded its gross margins by more than 500 basis points and increased its free cash flow margin by over 600 basis points during this period. Combined, we're confident we will continue to improve Maxim's performance. This will be driven by our cadre of engineering talent, complementary technologies and breadth of market applications that I'd like to expand on a little here. The cultures of ADI and Maxim are very aligned. Both companies share a commitment to innovation and engineering excellence. With a combined team of more than 10,000 engineers and $1.5 billion of annual R&D investment, we will continue to be the destination for the world's best analog talent. And with three times the field technical resources, we'll be better positioned to uncover cross-selling opportunities and serve existing and new customers, who have an increased need for application and design support. In the area of power management, Maxim's application-focused offerings are highly complementary with ADI's more general purpose or catalog power portfolio. Together we will have a more comprehensive power portfolio with approximately $2 billion of revenue. This is particularly important, as power is the largest and fastest-growing Analog subsegment and with increasing design complexity and the need for better efficiency, the system power challenges that our customers must overcome continue to rise and rise. In automotive, Maxim has one of the premier franchisees increasing revenue at a mid-teens rate over the last five years. They're a leader in high-speed data connectivity for cameras, radars and processors with serial link technology, while ADI is a leader in audio solutions with our A2B platform and both companies are well positioned in vehicle electrification, enabling us to better address automakers' EV requirements, which continuously evolve. Together, we will capture more of the increasing system content per vehicle and enable a better experience for the consumer. Taking a step back, the combined company will have unique positioning with 85% exposure to highly profitable long life B2B markets. Maxim's strengths in the automotive and data center markets will complement ADI's strengths across the industrial, communications and digital health care markets. Additionally, the combined company will have increased financial strength. We expect the combination to be accretive to adjusted EPS within 18 months post-close with targeted cost synergies of $275 million by the end of the second year. We also expect to maintain an industry-leading financial profile. As always, we are committed to generating robust free cash flow and our goal is to reach the high end of our margin range of 40%. With our lower leverage ratio at close, we'll also have the opportunity to deliver enhanced cash returns to our shareholders. And I believe that together we can grow revenue at mid-single-digits, due to our alignment with important secular growth trends, such as Industry 4.0, digital health care, next-generation communication systems and vehicle electrification as examples. So in closing, we're seeing promising evidence that a broad-based recovery is underway. However, we recognize that the recovery is highly dependent on the future impacts of the pandemic. We've used this unprecedented time to better align our organization and investments into the most important areas. We believe we'll emerge stronger and are better positioned to drive profitable growth. And as I've shared today, we're very excited about the combination with Maxim, which will drive the next wave of disruptive innovation and deliver significant benefits for all stakeholders. And with that I'll turn it over to Prashanth to go through the financial details and outlook."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Let me add my welcome to our third quarter earnings call. As a reminder, my comments with the exception of revenue and non-op expenses will be on an adjusted basis, which excludes special items outlined in today's press release. When we provided quarterly guidance in May, we were facing tremendous uncertainty just returning to normal capacity levels and experiencing volatile demand patterns across end markets. As we progressed through the quarter, we saw stronger-than-anticipated demand that resulted in less cancellations and higher-than-anticipated backlog conversion. With that as context, our results came in above the midpoint of our revised outlook with revenue of $1.46 billion, operating margins over 42% and EPS of $1.36. Let me start now with the end market color. Our B2B revenue was up 11% sequentially and flat year-over-year, as strength across industrial and communications offset a sharp decline in automotive. Industrial, which represented 53% of revenue during the quarter, finished up 3% year-over-year. We experienced robust growth in health care, instrumentation test and energy applications. This strength was moderated by weaker trends across our broad market and automation businesses. Communications, which accounted for 25% of revenue, achieved a record quarter. Revenue finished up 14% year-over-year, driven by double-digit increases across both wireless and wireline. This strength came from our leadership position in 5G wireless systems and our solid position in optical connectivity used in carrier networks and data centers. Automotive, which represented 11% of revenue decreased 29% year-over-year with all applications declining due to global factory shutdowns and lower vehicle sales. And while no business is immune to the current environment, our BMS and A2B solutions fared quite well. BMS revenue increased sequentially and was down just modestly year-over-year due to our strong penetration across the ecosystem and increasing consumer preference for electric vehicles. And given the continued adoption of our A2B audio platform, A2B revenue has increased over 70% year-to-date despite lower vehicle sales. Consumer which also represented 11% of revenue was down 13% year-over-year. Relatively flat portable revenue was more than offset by double-digit declines in prosumer due to the pandemic-related softness. We continue to expect 2020 to be the bottom for our consumer business. In addition to the end market commentary, we wanted to provide some insight by geography as we believe it is helpful to investors in this current climate. Most geographies declined year-over-year. We saw double-digit declines in Europe and Japan, while the decline in North America was less pronounced. The rest of Asia increased and China increased double digits year-over-year largely driven by the robust growth in communications given our solid position as well as strength in industrial. Now moving on to the P&L. Gross margins returned to our model at approximately 70% down modestly year-over-year from lower fab utilization. We've accelerated the planned LTC factory closings and have started to realize these benefits in the third quarter. We expect additional savings in the fourth quarter and we'll exit fiscal 2020 with nearly half of the $100 million savings in our run rate. OpEx was $402 million up 3% sequentially yet down 8% year-over-year. We maintained a focus on controlling expenses, which included a one-week global shutdown during the quarter. OP margins finished at 42.3%, the highest level since the third quarter of 2018. Non-op expenses were $46 million down $3 million sequentially and more than $10 million year-over-year driven by lower levels of debt and lower interest rates. Our tax rate for the quarter was approximately 11.5% and all told, third quarter EPS came in at $1.36. Now moving on to the balance sheet. We finished the quarter with over $1 billion of cash and about $5.6 billion in total debt. This resulted in a leverage ratio of 1.8 times on a trailing 12-month basis. Inventory dollars increased $22 million sequentially, but declined year-over-year. Days of inventory remained basically unchanged at 125. Channel inventory remains lean and is below the low end of our seven- to eight-week target range. Cash from operations was $557 million and CapEx was only $21 million as we proactively reduced CapEx spend in the current environment. This resulted in free cash flow of $536 million up 8% year-over-year. Our long-term CapEx target remains the same at approximately 4% of sales. And as Vince mentioned, on a trailing 12, we generated $1.8 billion of free cash flow. Over the same period, we've returned around $860 million to shareholders via dividends and additional $410 million via buybacks. This equates to a free cash flow return after debt reduction of nearly 80%, which is below our 100% return target as we paused our buyback program. Now I'd like to expand on Vince's commentary and discuss how our combination with Maxim will further enhance our financial profile. At deal announcement, ADI and Maxim had a combined pro forma leverage ratio of 1.2 times, which will decrease between today and deal close. The main driver being Maxim which is in cash accumulation phase. They will pay one more quarterly dividend before suspending it for four quarters and their buyback is on pause. Said another way, all the cash generation for the 12 months beginning in the second quarter of their fiscal 2021 will be added to the balance sheet. And for reference, over a trailing 12-month period, Maxim generated $730 million of free cash flow. ADI plans to continue to pay and grow our dividend. And as I mentioned earlier, our buyback program was paused during the height of COVID-19 and will remain on hold for now. When circumstances permit, our intention is to reinstate the program, which has nearly $2 billion remaining under authorization. Also, as we previously outlined, we plan on repaying $300 million to $500 million of debt in 2020. This quarter, we intend to honor that commitment by retiring our $450 million January 2021 note. This will save $13 million of annual interest expense. We believe the stronger balance sheet provides us with flexibility to improve on our 100% free cash flow return and increase shareholder value over the long term through a combination of reinvestment in the business, continued dividend increases, greater and more consistent buybacks and targeted acquisitions. And now on to the fourth quarter outlook. Fourth quarter revenue is expected to be $1.44 billion plus or minus $70 million. This outlook considers our current understanding of the impact related to the recent legislation enacted on Monday. It's important to remember that this customer's revenue has been significantly reduced over the last year to a low single-digit percent of total sales. We anticipate B2B revenue to decrease modestly for the third quarter. Strong growth in automotive as well as growth in industrial is more than offset by a decline in communications. This decline in communications is related to a slowdown of deployment as we forecasted in the last call and the limited impact from the recent legislation. On a year-over-year basis, B2B revenue is forecasted to increase low to mid-single digits. We anticipate our operating margin to be approximately 42% plus or minus 100 bps. We're planning for the tax rate to be between 12% and 13%. And based on these inputs, adjusted EPS is expected to be $1.32 plus or minus $0.10. So now I'll close my remarks by stating that third quarter proved better than our expectations, largely driven by our conservative planning and aggressive execution. As we move through the integration planning process with Maxim, we remain fully committed to driving sustainable growth through cutting-edge innovation and a focus on our customer success. I'm going to pass it back to Mike now to start our Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. Okay. Let's get to our Q&A session. I'll listen to all your feedback about the – around questions and the number of questions on the call. So we're going to run this a little differently than normal. I ask that limit yourself to one question to allow time for additional participants on this call this morning. And with that Cheryl, can we have our first question please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question comes from John Pitzer from Credit Suisse. Please go ahead. Your line is open."
},
{
"speaker": "John Pitzer",
"text": "Hi, guys. Good morning and congratulations on the solid results. I just want to follow up on the recent Department of Commerce ruling. Am I to read into that that you've embedded sort of zero revenue coming from that one customer? And just given how strong China has been as a region Vince, are you at all worried that there's been pull forward, or is that just a natural offshoot of that's the geo where a lot of 5G deployment is happening?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Good question. Thanks, John. So we have pretty much discounted our top – what used to be our number one customer in China to pretty much zero in our long-term planning thinking. It has been a low single-digit customer over the past few quarters. So we have factored also by the way the latest regulatory upheaval into our numbers. So at this point in time, the largest 5G customer there in China that used to be is no longer part of the planning or the -- either in the short term or the long term. I'd say as well, what we've seen in terms of the strength in China that Prashanth referred to is really -- is the fact that China was the first to go into the pandemic. First to come out. It's an economy that's growing very, very rapidly and has been up for several years now. So, I think, there's been a very good balance I believe between supply and demand across all the sectors. I mean, we've seen growth in all markets with the exception of automotive. So I think what we're seeing in terms of the strength in China is more about the match between the strength in our business and the economy than anything else."
},
{
"speaker": "John Pitzer",
"text": "Perfect. Thanks guys."
},
{
"speaker": "Vincent Roche",
"text": "Our next question please?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Vivek Arya from Bank of America Securities. Please go ahead. Your line is open."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question and congratulations on the strong execution. I wanted to follow up on John's question about your communications business. And I was hoping Vince, if you could help us quantify how much communications could perhaps decline sequentially? And what are you baking in from this Department of Commerce regulation? And then, I think that the bigger question there is that as we look forward to next year, do you think global 5G deployments can stay on track if Huawei doesn't get access to U.S. technology? Like are we really contemplating a world where Huawei is not going to be a player at all in 5G deployment? And if there is such a world, does it still mean that 5G deployments globally can actually happen at the pace people were thinking about before? Any perspective would be very useful. Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Vivek, we're going to split that. And let me take the first part of it. So to clarify, third quarter we believe did not see any pull-ins from Huawei. Fourth quarter outlook reflects the guidance we gave you reflects the full impact for us of the Department of Commerce implications from earlier this week. So, all of that is now baked in. In terms of the amount of decline that we are expecting in the communications business, this is a lumpy business. We've said that consistently. It's growth measured in years and lumpy by quarter. We don't give forward guidance on an end market basis by quarter anymore. We haven't done that for a little bit of time. So, we don't want to start that now. But take it to understand that the movement in the communications business from third to fourth quarter was very much in normal operating lumpiness of the communications business is not exacerbated in any way by what happened on Monday or Tuesday's announcement. And now I'll pass back to Vince for your more challenging strategic question."
},
{
"speaker": "Vincent Roche",
"text": "Yes. So Vivek, I've been in this business a long, long time actually since two -- the inception of 2G all those years ago back in the late 80s, early 90s and what I can tell you is that the patterns we're seeing in 5G are no different to what we've seen in 2G, 3G or 4G. And if you look at 4G specifically, just to give you a bit of perspective here, we grew albeit a very, very lumpy business as we always say, but we grew over the entire era of its build out by mid-single digits. We had more content than we had in the prior generations. We took more share. And we're actually even better positioned in 5G because, it's a more complex radio problem fundamentally. We have a lot more technology to put into the space from microwave and RF right down to the mixed signal. And now, we're attaching power also, so, another factor that we're beginning to see the emergence of. So today, 5G has really been about giving more bandwidth to the consumer, more throughput to the consumer. The future is about I think B2B more so than the consumer. And we're beginning to see I believe the early adoption of 5G in the factory automation area. In fact, I have verified that with some of our industrial automation customers as well. So, 3Q is definitely likely the highest revenue quarter this year, but there are lots of drivers at the secular level and the company level to keep us in good stead for growth over the long term."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Vivek, I'll add one thing to try to avoid the plethora of Huawei questions that I can tell are winding up. So we've given you a lot of context around that customer. We said they're a mid-single-digit customer. The legislation put in place was, you we can ship for about half this quarter. So they'll be lower this quarter than normal. And going forward after that our expectation should be, it goes to zero. So our outlook for 1Q would be down for communications because of that."
},
{
"speaker": "Vincent Roche",
"text": "The last couple of quarters have actually been low single digits. And as we've said now a couple of times, we are no longer factoring Huawei into our numbers."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for that."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you. Sheryl, next question, please? Sheryl, are we still on the call? I guess not."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tore Svanberg from Stifel. Your line is open."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you and congratulations, especially during these tough times. I had a question on sort of bookings linearity and backlog. I know last quarter you obviously entered the quarter with pretty high backlog and you were sort of discounting that. Are we sort of back to a more normal backlog level now for either you Vince or Prashanth?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. So let's -- maybe let me answer that by talking about the order patterns. So we saw strong May, some slowdown in June, which was expected. July was sort of a stable month-over-month and that was better than we expected. Through August, relatively stable and August is typically a lower seasonal month. So we have lower backlog in third quarter, as we enter the quarter and a good balance between supply and demand. This quarter, as we look forward to our guide, we’ve got stronger coverage from backlog than we typically do. And if we converted -- if you recall in the third quarter we said that, we had about $50 million of products that we couldn't ship in the second quarter that we caught up with in the third quarter. That actually came in a little bit higher, because we had fewer cancellations. So we probably had maybe $100 million all-in of revenue in third quarter that really related to backlog from second quarter. So, I think, that through fourth quarter we're going to get supply and demand back in balance. Backlog has come down and will be more back to normal levels. As we have guided for the fourth quarter, we've taken into consideration the stronger backlog, but we've also taken into consideration that at an ADI level our book-to-bill for the fourth quarter is now below parity."
},
{
"speaker": "Tore Svanberg",
"text": "Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Tore."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from Ambrish Srivastava from BMO. Please go ahead. Your line is open."
},
{
"speaker": "Vincent Roche",
"text": "Ambrish, go ahead."
},
{
"speaker": "Ambrish Srivastava",
"text": "Hi. Can you guys hear me?"
},
{
"speaker": "Vincent Roche",
"text": "We can Ambrish. Yes."
},
{
"speaker": "Ambrish Srivastava",
"text": "Okay. Vince, I wanted to pivot back to the strategic priorities and thanks for articulating everything in context of the latest acquisition. This is a question I get a lot and I scratch my head on this too, because of you bought Linear and then Maxim also on the power side. So the question -- and you did provide us with some details on Linear. A couple of questions tied to that. With respect to Hittite you have given us the growth in Hittite versus what it used to grow and how you have been able to grow that versus prior to acquisition. So the question is, how has Linear done with respect to the core business? And I don't expect you to answer it every quarter, but I think it's a pertinent question in light of the Maxim acquisition. So kind of two-part question. One how has Linear done since you bought it? And then, this was the year that we were supposed to get revenue synergy. Now this is a very topsy-turvy year, so we all understand that. But should we expect revenue synergies to start showing up from Linear with all the efforts that have been going on? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks, Ambrish. So we have already seen the benefit of LTC in our growth numbers. I would say at this point in time we've put more than 100 basis points of growth on the base Linear growth rate to-date. We have -- I think the greatest indicator for what things are likely to be in the future I've said before that I believe that we can double the growth rate of LT over the longer term and just given the markets in which we play and the design cycles the product cycles it takes three years minimum and then you begin to see the real benefits I think after five years. So we're over 100 basis points of additive growth right now. And if you look at our pipeline I referred to it in the prepared remarks we have got a design win pipeline of over $0.5 billion thus far. We have seen wins in communications both on the wireless side as well as the data center side. Infotainment in automotive infotainment radar and of course BMS. We're seeing tremendous uptake for some of our more integrated products in areas like instrumentation tests using our micromodule technologies. And I'm quite pleased given the turmoil in the global markets right now that we continue to see good traction on the design win rates and I'm confident that we can get from 3% to 4% growth rates in the past to more a higher -- mid to high single-digit level in the future and do it sustainably. So I think we have emerging evidence that we're on good track to do that."
},
{
"speaker": "Ambrish Srivastava",
"text": "Okay. Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Thanks, Ambrish."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from Toshiya Hari from Goldman Sachs. Your line is open."
},
{
"speaker": "Toshiya Hari",
"text": "Good morning, guys and congrats on the strong results. Vince, I had a question on your automotive business. Curious how are you thinking about the shape of the recovery in automotive over the next couple of quarters? Obviously, you've been impacted by your customer factory shutdowns and the demand situation post-COVID. But curious are you thinking it could be more of a V-shaped recovery, could it be more U-shaped? Any thoughts there would be super helpful? And if you can speak to your key applications within automotive, you gave great color on the July quarter but if you can talk about BMS A2B some of the key growth drivers for October and beyond that would be helpful? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Okay. Thanks, Toshi. So yes, we're seeing a recovery in the market. Actually our book-to-bill was greater than unity across all regions over the last month or so. And we believe that our third quarter represents the bottom of the cycle for us. So I think the near-term recovery and the demand that we're seeing relates to factories coming back online and also a slow improvement in SAAR. So I think the shape of the recovery really depends on the demand -- the end demand for cars and how SAAR actually grows. And we'll -- that will need -- we'll need to see continued vehicle demand to get back to the pre-COVID level. So it's not there yet. So factories are coming back online. Demand is slowly increasing. So hard to call the exact shape but somewhere between a V and a U I guess or maybe already a U and we're seeing the upsurge. I would say electric vehicles in general have held up better in this market. As we said in the prepared remarks there's a strong consumer preference for electric vehicles. It's the fastest-growing sector at this point in time. And we're continuing to gain share in the market. We've seen growth quarter-on-quarter in that space. And we're also very pleased with our performance. A2B actually grew about, I think, it was 70% year-to-date. So the adoption the design wins that we had gotten last year across most of the OEMs beginning to turn into serious revenue now. And on top of that, we're also overlaying this road noise cancellation technology that uses our digital signal processors, algorithmic technology and different analog, support technologies on the input and output there. So those are the major areas. And I think, as I said, I believe, we're in a slow recovery phase in automotive. And I think in general very hard to call the next quarter, the next two quarters, but my sense is 2021 will be a growth year for the industry and a growth year for ADI. And – I mean, that's how I viewed at this point in time. So we're seeing a gentle recovery in general across all our market spaces."
},
{
"speaker": "Toshiya Hari",
"text": "Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Stacy Rasgon from Bernstein Research. Please go ahead."
},
{
"speaker": "Stacy Rasgon",
"text": "Hi, guys. Thanks for taking my question. I'm a little bit confused. I know you've been saying, we're entering into recovery, but how do I square that with a book-to-bill going forward that is less than one? I mean, is it just comm? Like, how should I be thinking about book-to-bill by segment? And what does that imply for like the longer-term trajectory?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yeah. Great question, Stacy. The – so I would say that, certainly, the communications business is a piece of that. And I would also say that, we – when we look back at the demand activity over the last quarter or two, we feel very good that that was driven by very kind of real demand based on conversations with customers. But there was probably some level of inventory building that was going on in there given that the inventory levels at our end customers were so low. Coming into this pandemic, they had taken – end customers really at the industrial level had taken their inventory levels down pretty significantly in 2019. And then the pandemic hit. And so I think some of the strength that the industry is seeing now has a little bit of that renormalizing that. So as we kind of look forward into fourth quarter, there is a lot of opportunity for us. And I think that, the new order activity remains good over dues are declining. So it's – I think, we'll have to let another quarter or two roll out. We don't have enough visibility I think to tell you what the future portends. But we're not seeing a sharp decline in order activity, but it is below one."
},
{
"speaker": "Stacy Rasgon",
"text": "Got it. But just to clarify – I'm sorry?"
},
{
"speaker": "Michael Lucarelli",
"text": "Stacy, we are guiding down sequentially. Our book-to-bill is slightly below one. So it does go in tandem to what we're saying. And you're right to think about the tele market. Comm is much below one, auto is a bit above one, industrials around one. So it all lines up to what the guidance we gave and the range we have given."
},
{
"speaker": "Stacy Rasgon",
"text": "Okay. Thank you, guys."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Stacy."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thanks, Stacy."
},
{
"speaker": "Operator",
"text": "Thank you. And our next question comes from C.J. Muse, Evercore. Please go ahead. Your line is open."
},
{
"speaker": "C.J. Muse",
"text": "Yeah. Good morning. Thank you for taking the question. I guess a cycle question. And if I look at your S-4, and you projected revenues in there for fiscal 2020, that roughly $170 million below what you're actually looking to accomplish here. And so curious, versus what you put there in the S-4, what led to the upside there? And is that something that we should think can continue beyond the October quarter?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "C.J., that was really around the timing of when we're having those conversations. If you look back at the timing of when we were in those, the world looked very different to us. I think it looked differently to everyone back at that period, when the pandemic looked like it was ranging at a pretty sharp pace across the globe. So, our S-4 probably reflected more of the uncertainty that we had out there that has since been -- more clarity has been brought."
},
{
"speaker": "C.J. Muse",
"text": "Okay. Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "We'll go to our last question please."
},
{
"speaker": "Operator",
"text": "Thank you. Our last question comes from Craig Hettenbach from Morgan Stanley. Please go ahead. Your line is open."
},
{
"speaker": "Craig Hettenbach",
"text": "Yes. Thanks. Just a question for Vince, on the industrial market and really about the composition maybe in the next couple of quarters, so certainly medical has been strong instrumentation. The more cyclically oriented factory automation has been weak. Do you expect any reversal in some of that kind of by sub-segment performance as we move forward from here and the macro recovers?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Well, we've seen -- I mean energy is a couple of hundred million dollar business a year for ADI. That's been doing well, and we're getting a lot of new design wins. In renewables area, we've seen strong demand in our test business, supporting 5G build out and data centers in particular. And we're seeing a little more weakness in instrumentation in areas that relate more to CapEx. If you look at aerospace and defense, which is an important part of our industrial story, obviously there's weakness in avionics that won't be a huge surprise. But that's a relatively small portion. The biggest portion of our aerospace and defense business is defense, and that business is holding up well as well as the space business, which continues to grow nicely. I would say as well automation is holding better than we had thought. But what really excites us there is the future, as our customers rethink supply chains onshoring, reshoring, and we're going to see more and more automation used in general across the globe. So, I think that unpacks the story for you. So, I think we're seeing strength pretty much across all the sectors or recovery across all the sectors in industrial right now."
},
{
"speaker": "Craig Hettenbach",
"text": "Okay. Got it. Thanks."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks so much, Craig. And thanks everyone for joining us this morning. A copy of the transcript will be available on our website and all reconciliations and additional information can also be found there. Thanks for joining us and your continued interest in Analog Devices."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 2 | 2,020 | 2020-05-20 18:00:00 | Operator: Good morning, and welcome to the Analog Devices [Fourth Quarter and Fiscal Year 2019] (sic) Second Quarter 2020 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Michael Lucarelli, Director of Investor Relations. Sir, the floor is yours.
Michael Lucarelli: Thank you, Cheryl, and good morning, everybody. Thanks for joining our second quarter fiscal 2020 conference call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com Now onto the disclosures. The information we're about to discuss, includes forward-looking statements that involve risks and uncertainties. Actual results may differ materially from these forward-looking statements as a result of various factors including the uncertainty regarding the duration of COVID-19 pandemic and its impact on our business, our customers and suppliers and the global economy and also those discussed in our earnings release and our most recent 10-Q. These forward-looking statements reflect our opinion as of the date of this call. We undertake no obligation to update these forward-looking statements in light of new information or future events. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing results to our historical performance, special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that I'll turn it over to ADI's CEO, Vincent Roche. Vince?
Vincent Roche: Thank you, Mike, and good morning to you all from Boston. I hope that you and your families are all staying safe and healthy during this period. First, we want to express our gratitude to the health-care workers and the many other heroes on the frontlines who are protecting the health and the well-being of our communities. Thank you also very, very much. When we had our last earnings call in mid-February, we were just beginning to understand the depths of the COVID-19 impact in China and since then the pandemic has had a profound impact on the world putting tremendous stress on society and of course the global economy. To counterbalance this, we've seen an unprecedented response from governments with the deployment of fiscal and monetary policies to soften the downturn and restart economic activity whenever that may be. While our sector is not immune to the turbulent operating environment it's my belief that technology will be what mollifies the current weakness and drives new demand and business models post pandemic. That's not to say that we're standing still. We've taken actions to curtail spending and reinforce our cash position. And we are learning from this challenging period and adapting quickly while still investing to ensure that we are well-positioned in the recovery and for the long term. Our team has embraced the challenges with many of our employees working from home, but obviously not everyone can work remotely and I want to acknowledge and thank our manufacturing employees. We've continued to perform at exceptional levels and deliver for our customers. For these employees supporting our clinical operations, we've implemented safeguards to protect them, including more PPE, increasing social distancing and enhanced sanitization. And we provided them with additional incentives and benefits to allow for continuity during this very difficult time. Our team has also done an excellent job staying close to our customers. We moved quickly to pivot manufacturing lines and prioritize our healthcare solutions that are needed in the fight against COVID-19. This has allowed us to expedite supply used in products such as ventilators, respirators, imaging systems and patient monitors to our healthcare customers, and I'm incredibly proud of the resourcefulness and commitment that we have shown in rising to this critical challenge. Additionally, through the ADI Foundation, we've made multi-million dollar donations to support both global and local pandemic response efforts, but our work goes beyond financial contributions. We are also partnering with hospitals and biotech start-ups to develop solutions such as rapid point-of-care diagnostic tests and clinical grade patient monitoring that leverage our technologies. So now I'd like to discuss the current operating environment a bit. Given the reach and depth of the current crisis, global business activity has been disrupted, and today we have seen a deterioration in demand within our automotive, broad-based industrial, and consumer businesses. However, our business is proving more resilient than during the global financial crisis. To that end, healthcare demand is at record levels and communications demand is robust across wireless and indeed wireline sectors. We're also seeing strength in portions of our industrial instrumentation business and steadiness in our defense business. Now this success is no accident. Through our organic investments and acquisitions of Hittite and LTC, ADI is a very different company than we were a decade ago with more diversity, a broader portfolio across High-Performance Analog, Power and RF and higher exposure to more profitable and durable end markets. So now let me move to the other side of the equation and talk a little bit about supply. Across the world, supply chains were disrupted when many governments ordered shelter-in-place mandates and closed their borders. For ADI, capacity was reduced at our back-end test and assembly sites in mid-March across the Philippines, Malaysia, and Singapore. Once granted essential status, we acted quickly yet responsibly to ensure employee safety and improve our capacity. And today, I'm glad to say we're operating at normal capacity levels. This demonstrates the agility of our global operations and the dedication of ADI's employees around the world. Despite the fluid and uncertain demand and supply environment, we delivered revenue of 1.32 billion and EPS of $1.08. This was in line with the original range we provided on our first quarter earnings call underscoring the resiliency and flexibility of our business model in any economic backdrop. Now as we've mobilized to preserve ADI strength in the near-term we're capitalizing on the many opportunities we see to fortify and expand our market position for the long-term. Our team remains focused on our three strategic priorities. So let me provide you with a brief update on each. First is the efficient use of capital. Importantly, ADI has ample financial liquidity to meet the needs of our business across critical investments, dividend payments and servicing our debt. Despite the current macro environment, we've generated $1.8 billion of free cash flow or 32% of sales over the trailing 12 months. This continues to place ADI in the top 10% of the S&P 500. Throughout our 55-year history, we've encountered and navigated several Black Swan events successfully by taking a disciplined and balanced approach to financial management. Specifically, the first call on our capital is funding new product development. This means investing smartly in both our people and technologies to ensure we continue to deliver disruptive innovation. In the quarter just passed, we invested 19% of revenue in R&D, spending 95% on the most attractive opportunities across our B2B markets. We also remain committed to strong shareholder returns with our dividend as the cornerstone. In the quarter, we returned over $340 million to shareholders through dividends and share repurchases. So let me turn to our second priority, which is about maximizing customer impact. We are continuously innovating to stay ahead of customer needs and while COVID-19 has brought new challenges it has also revealed new opportunities in a reordered world. During the quarter, our customer engagement didn't slow down. We hosted hundreds of virtual seminars with thousands of customers in attendance, training them on new solutions and new technologies. These interactions were very productive. We saw increased design activity on new product development across markets and customers. For example, we partnered with a key electric vehicle customer to re-imagine how audio is rendered across their fleet. As a result of this increased and focused collaboration, we added our high performance audio digital signal processors to our A2B platform, more than doubling our content per vehicle. And in our instrumentation test business for data center compute, we continue to work with customers on reducing their system complexity and getting to market faster. Our innovative solutions combine our analog mixed-signal and power micro-module portfolios. These solutions deliver four times the channel density, while simultaneously increasing throughput. While these are just two examples, there are many more across all of our markets. It's this current flurry of design activity that positions ADI to accelerate post pandemic. Our third priority is capitalizing on secular trends to expand our addressable markets and drive diversified growth. While every downturn has its own unique characteristics, they all seem to have one thing in common that is they drive tremendous change. Industries are prioritizing digitalization and connectivity more than ever and new industries are emerging focused on the physical and cyber. ADI where the data is born is at the center of these exciting secular growth opportunities. And I wanted to share some thoughts with you today. As I noted earlier, our healthcare business is providing several of the technologies that are critical to the diagnosis and treatment of COVID-19. Taking a step back, ADI has been committed to this market for many years, as we anticipated the opportunity for innovation to deliver better patient outcomes. Now this crisis will challenge us to rethink and hopefully fast track the accessibility, affordability and wellness focus of global healthcare. To achieve this, healthcare systems are going to need to be upgraded and clinical grade patient monitoring will need to be extended from the hospital right down to the patient's home. Massive adoption of sensing, computing, and cloud capabilities is going to be required. And we believe that ADI Technologies will be at the forefront of this transformation. The communications market is moving at a rapid pace to keep up with the strains put on bandwidth and latency, as more people work remotely, transact business more digitally, and consume media from everywhere. Here ADI is playing a critical role in building out the infrastructure required from an always connected world. Our integrated transceiver, power, and optical control portfolios are enabling customers to economically scale their investments to build the next-generation networks. We continue to innovate to meet future performance, size, and power needs positioning us to gain share to capture additional value. Another secular trend we're benefiting from is the rise of Industry 4.0. While this trend isn't so new, the pandemic is moving it to the forefront of our customers' needs. It's clear that post-pandemic supply chains will be re-imagined and new ones will be built, ones that are more flexible, automated, and perhaps sovereign. To solve the economic burden that comes with this, customers will further automate their businesses with intelligent and connected factory floors and the increased use of robots, cobots and analytics. This creates additional demand for our precision signal chain and power franchises and extends ADI into new areas like software IO, depth sensing, condition-based monitoring, and robust connectivity. Outside of these secular growth trends, I'm also personally inspired by the tremendous sustainability benefits that we've seen in a short amount of time. For example, we've seen sizable decreases in carbon-dioxide, nitrous oxide, and carbon monoxide. I believe that ADI and the industry at large can and should be leveraging its creative brainpower to be better stewards of the planet. We recently published our comprehensive corporate responsibility report entitled Engineering Good. And I can assure you, there will be more to come as I'm deeply committed to ADI's leadership here. So, in closing, the shape of the economic recovery is still very, very uncertain and dependent on many variables. While we're confident in our outlook provided today. This unprecedented macro backdrop will continue to influence supply and demand dynamics for some time to come. We are embracing the short-term challenges and by leveraging the collective power of our talents, our technology and customer engagements, I'm very confident we will emerge stronger. So, with that, I'd like to turn it over to Prashanth.
Prashanth Mahendra-Rajah: Thank you, Vince. Let me add my welcome to our second quarter earnings call. As a reminder, my comments today with the exception of revenue and non-op expenses will be on an adjusted basis, which exclude special items outlined in today's press release. Back in March, we would do our guidance for the second quarter as the spread of COVID created an enormous amount of uncertainty and impacted our supply chain. However, we acted quickly and decisively and I'm pleased to say that our second quarter results were within our original guidance with revenue of 1.32 billion, operating margin of 38%, and EPS of $1.08. Without those capacity limitations, we believe revenue would have been above our original midpoint provided at our first quarter earnings or approximately $50 million higher. So let's get into the market results. Our B2B markets while very volatile intra-quarter due to COVID-19 performed relatively in line with our expectations. B2B revenue increased 3% sequentially. And if not for supply constraints we would have delivered on our outlook of growing mid to high single-digits sequentially. Notably, we achieved these results, while reducing channel inventory by 60 million in the quarter. Industrial, which represented 54% of revenue during the quarter, finished up 4% sequentially, and declined 8% year-over-year. While we experienced broad-based weakness across most applications, our healthcare memory test and energy verticals all grew from the year ago period. Communications, which accounted for 21% of revenue, finished up 15% sequentially and given the tough compare decreased 24% year-over-year with weakness across both wireless and wired. This market is and will remain lumpy, but over the long-term will be a high growth market for ADI, given our positioning in 5G and optical control systems. Automotive, which represented 14% of revenue, down 12% sequentially and 23% year-over-year with declines across all major applications. Not surprisingly our auto business was impacted by lower vehicle sales and a global slowdown in production. As many customers were required to suspend their operations in response to COVID-19. Lastly consumer, which represented 11% of revenue was down 14% sequentially, and 5% year-over-year, as lower consumer spending impacted both portables and prosumer. Notably, we continue to expect 2020 to be the bottom for our consumer sector. Let's go to the P&L for the second quarter. Gross margin came in at 67.7% down both sequentially and year-over-year related to low utilizations from reduced production levels and the factory closures I mentioned earlier. As a reminder, we expect to realize 100 million of cost of goods savings exiting fiscal 2021 through the optimization of our manufacturing footprint. OpEx was 390 million, down 5% sequentially marking the sixth consecutive quarter of declines. This was driven by a combination of the quick aggressive measures we took in response to pandemic as well as our continued focus on cost management. Operating margin finished at 38% up over 100 basis points sequentially and down year-over-year. Non-GAAP expenses were 49 million, up sequentially, but down over 10 million compared to last year. Our tax rate for the quarter was approximately 11% and all told second quarter adjusted EPS came in at $1.08. So now let's go to the balance sheet and cash flow. During the quarter, we proactively bolstered our strong liquidity position. We retired a $300 million bond and subsequently raised $400 million from the semiconductor industry's first ever green bond. And as a cautionary measure, we also temporarily suspended our share repurchase program midway through the quarter. As a result, we finished the quarter with approximately 800 million of cash and about 5.6 in total debt. Our net debt to EBITDA ratio is 1.9 times on a trailing 12 month basis. Between cash on our balance sheet and the commitments under our revolving credit facility, ADI has more than 2 billion of liquidity easily eclipsing our annual dividend payment and the debt due in January of 2021. Inventory was essentially flat from the first quarter. However, days of inventory fell to 126 from 133. Our sell-in revenue was well below our sell-through revenue at distributors. As I mentioned, we reduced channel inventory by about 60 million in the second quarter. This brings our total channel reduction to around 100 million in the first half of fiscal 2020. Channel inventory currently sits comfortably at the low end of our seven to eight week range. So finishing on cash flow for the quarter, cash flow from ops was 429 million and CapEx was 60 million. We expect CapEx to decline meaningfully in the second half and finished the year below our normal target range of 4% of revenue. In the quarter, ADI paid approximately 230 million in dividends and repurchased 114 million of our stock. On a trailing 12-month basis, free cash flow finished at 1.8 billion or 32% of revenue. Over this period, we reduced debt by roughly 400 million and returned around 830 million to shareholders via dividends and an additional 500 million via repurchases. As a reminder, our capital return policy is to return all free cash flow after debt reduction to shareholders. In fiscal 2020, we expect to reduce debt by 300 million to 500 million and return 100% of the remaining free cash flow. Before moving to our outlook, I want to highlight what we are seeing in terms of demand and supply. As Vince mentioned earlier, our business is performing quite well under the current macro backdrop. Healthcare is very strong and we expect this strength to persist into the back half of the year. We are seeing robust demand in communications across both wireless from 5G deployments and wireline from data center and networking upgrades. This strength is benefiting our industrial instrumentation business where we sell high performance solutions used in both memory and 5G testing. And lastly defense is typically a steady business against all economic backdrop. All told, these markets represent almost half of ADI's revenue over the last year. From a supply standpoint, we enter our fiscal third quarter at normal capacity levels. This is quite remarkable and I want to echo Vince's appreciation for the dedicated manufacturing teams across the world. And that brings us to our third quarter outlook. Revenue is expected to be flat sequentially at 1.32 billion plus or minus 70 million, which is a wider range than usual to account for the uncertain environment. This outlook includes approximately 50 million of revenue that was pushed from second quarter due to capacity constraints. We are assuming no change in channel inventory in this plan. We anticipate robust sequential growth in comms, modest sequential declines in industrial and consumer, and a sharp sequential decline in automotive. All told, B2B should increase slightly sequentially and decline just under 10% year-over-year. We anticipate op margins to be approximately 38.3 plus or minus 150 bps. We're planning for the tax rate in the quarter to be between 12% and 13% and based on these inputs adjusted EPS is expected to be a $1.08 plus or minus $0.11. As Vince said, we are confident in our third quarter outlook, but we are mindful of the tremendous uncertainty around us. Our operating model is to plan conservatively and execute aggressively to preserve free cash flow in the near-term. At the same time, we remain focused on the long-term, continuing to invest to capture and create value across several exciting secular growth areas. Let me pass it back to Mike now to start our Q&A.
Michael Lucarelli: Okay. Thank you, Prashanth. Now let's get to our Q&A session. Please limit yourself to one question. After our initial response, we'll give you an opportunity for a follow-up questions. Cheryl, can we have our first question please.
Operator: Our first question comes from John Pitzer from Credit Suisse. Your line is open.
John Pitzer: Yes, good morning, guys. Thanks for letting me ask the question and congratulations on the solid results, given the backdrop. Vince, I guess, the question I'm getting this morning from investors is just relative to your July quarter guidance. Most of your peers have been guiding anywhere from 10 to 15 percentage points below seasonal. You guys are guiding about five percentage points below seasonal. And I guess the question that's being asked is, to what extent are you just not being as conservative as your peers. To what extent are there some idiosyncratic drivers. Could you help us parse that out?
Vincent Roche: Yes. Thanks, John. So I think first and foremost. We've seen tremendous strength in our healthcare business over the last quarter and we expect that will also continue. And also generally speaking with virtualized commerce, work from home, we're seeing again very, very strong demand for the communications products. The optical cable portfolios of ADI are doing particularly well and of course 5G especially in China and Asia, the 5G build-out is moving at pace. So what we're seeing, what we are predicting looking ahead is based on the order streams that we've seen and whatever - what others are predicting. We feel comfortable based on the strength in the areas I've just mentioned. Our defense business continues - continues quite strong. Also businesses attached to let's say the build-out of data centers and cloud like advanced instrumentation test systems for memory, storage and so on and so forth are also doing particularly well. So the overall industrial business holds in there. As Prashanth said, we probably see a modest decline, a seasonal decline in the third quarter. So overall they are the drivers. And as Prashanth said we expect a steep decline in the automotive business, but when you look at the puts and takes that's how we see the quarter shaping up.
John Pitzer: That's helpful, Vince. And then just maybe - go ahead Prashanth.
Prashanth Mahendra-Rajah: I was going to give a little bit more background on kind of the orders and outlook, which may help investors as to why our guide came in where it is. So very quickly kind of as expected Feb was weak, March came back very strong largely driven by China, but also some pretty strong demand outside from customer concerns and then it began to correct. So April was soft, continued into May. We finished with kind of book-to-bill above 1.0 in all of our markets except auto. So as we thought about the outlook - we've built our outlook on the expectation that orders are going to continue to slow through the quarter or best case stabilize. The guide that we have out there is built on a 100% backlog coverage, which is much higher than we would normally use when we were at this point in the quarter. We're working terms with our customers and we are enforcing them pretty stringently, so any customers or disty orders are non-cancellable within a 35-day window unless we agree to grant an exception. So that's helping to kind of clean through the backlog and limit order cancellations. So all-in, I think, the assumptions are reasonable given the amount of uncertainty and we did put a little bit wider range on there plus or minus 70 to reflect the uncertainty.
John Pitzer: That's great color, guys. And then Vince just as my follow-up. As you mentioned in your prepared comments, the concept of Industry 4.0 has been around for a while, but it does seem like COVID has the potential of actually shining a spotlight on that in a way that we have. And I guess in my mind that probably also helps the 5G build-out because it's hard to have an intelligent factory floor without that 5G backbone, but I was hoping maybe you could help us define that market opportunity for you. When you look at sort of the intelligent factory floor, what percent of your industrial business is it today, and how should we think about potential growth rate three to five years out, if this really starts to accelerate?
Vincent Roche: Yes, it's a good question, John. I would say today what we would consider to be Industry 4.0 with a highly cloud connected industrial sector is quite small. I think today it's probably less than 10% of the total installations of factory automation and process control systems, but the intelligence we're getting from many of our customers now is that there are two things driving the need for the redeployment of industry. So it's probably three things. One, the need for them to understand how to gather and utilize data analytics to improve the outcomes for their customers. So that assumes automatically that you deploy 5G, you deploy optical connectivity, many forms of shorter robust connectivity. I think also the - we are seeing the fragility of the supply chain globally. And customers are telling us they're expecting to bring more machine capability into managing the supply chain. And I think thirdly is the regionalization or the [suburbanization] [ph] of supply chains and we can see the pressures there globally. And not to mention the demographics, many of the societies that are producing lots of capital goods and consumer good outputs like Germany, China and as America begins to regionalize supply chain, we're likely to see the adoption of cobotics and more robotics technologies in general. So I think there's a long way to go, John. We're in the early innings of the Industrial 4.0, the adoption of that.
Operator: Our next question comes from Tore Svanberg from Stifel. Your line is open.
Tore Svanberg: Thank you and congratulations on the results. First question is for Vince. Vince, you talked quite a bit about sort of investing in this time frame and you highlighted, again, medical and industrial. What about the automotive market, are you seeing sort of a secular change there, are you still investing or will you still be investing as heavily in automotive going forward.
Vincent Roche: Well, we've actually been ramping, Tore, our investments in automotive, particularly, in the infotainment, the power side of things and also the electrification of the vehicle, the electric powertrain. So right now it's a very, very hard market to read both in terms of demand and of course supply. I think automotive has been extremely hard hit by the closures globally. So we see, I would say, the two areas of most interest to us Tore are the infotainment, the car experience, leveraging for example, our A2B technology, our heritage and digital signal processing and audio signal processing in general adding for example active noise cancellation to the portfolio and we're deploying that, starting to deploy that now. So I think the whole Infotainment side of things is an important part of the go-ahead and that's a place where we've a lot of heritage and we're actually increasing investment. We just acquired a company actually during the quarter to enable us to bring more signal processing to the audio space. In the electric vehicle area, I think, it's got a long, long road ahead of it. As the electrification today the powertrain the - as a portion of overall car sales only about one certainly less than 2% of total car sales. So a long, long way to go. And that's an area where we have strong position. We're on our fourth or fifth generation of technology node product delivery to that sector. So I'd say in those areas we are actually increasing investments. Power is another area, the cross-connective power into our business particularly in Europe and the US. That's an important initiative and we're seeing some very good green shoots there in terms of early stage production of designs - of power designs that we've attached to the signal processing portfolio. I think it's also true to say, Tore, that probably on the safety side of things, we've been decreasing our investments over the last several years, partly in MEMS. You'll recall three, four years ago. We withdrew most of our investments in that area. So I would say safety is more opportunistic, infotainment and electric powertrain more strategic.
Michael Lucarelli: And, Tore, do you have follow-up?
Tore Svanberg: Yes, that was very helpful. A follow-up for Prashanth. Prashanth, I do realize obviously right now the orders are kind of all over the place. But if we start to see deterioration, what would be the company's playbook especially on things like manufacturing utilization inventory because it seems like some of your peers have different playbooks. Just wondering what ADI's playbook will be in response to potentially weaker or continuous weaker orders? Thank you.
Prashanth Mahendra-Rajah: Sure, yes. So, Tore, let's do that in two pieces. First, think about how we manage our cost. So, right, in the near-term how we think about cost and you've seen it in the OpEx results already. We have a variable comp structure that is intended to act as a shock absorber and that unwinds as revenue falls. On the discretionary side, we've already proven hiring. We've essentially got travel at zero. We've exited consultants and any discretionary contractors and perhaps most impactful is we've deferred our merit increase, which is usually 2%, 3% year-over-year. We are on track to realize about 35 million of synergies that we announced last year in November. And we still have $100 million of cost synergies that will come through by the end of 2021. So there are some more permanent actions that we can take. And we have taken in the past such as furloughing employees until demand returns. We did this back in 2008, 2009. We would certainly put activities like temporary actions on the table. So there are all items that we'll think about. On the manufacturing side I would emphasize that our utilizations are fairly low right now. So we're kind of at the trough levels. Inventories are we feel at a good position. So I don't think we have kind of the same inventory exposure that we would have had at the same time last year. We've reduced on the balance sheet as well as in the channel. So, overall, I think we're well positioned if this breaks up or should it break down. Maybe Vincent you want to talk a bit more about kind of longer term.
Vincent Roche: Yes. So I think, Tore, we feel good about the stability, the diversity and stability of our business and what the profit margins we generate as a company. We're investing to make sure we come out of this trough, a stronger company both in terms of product development as well as customer engagement. So we also believe very strongly in the persistence and the pervasiveness of our technologies. So I believe that the story for ADI get stronger with the tailwinds that we have and the portfolio that we have for the future. So look, overall, our goal is to take advantage of the disarray. And while - I think Prashanth said in his prepared remarks we're preparing for the worst, but we're executing aggressively for the future.
Operator: And our next question comes from Vivek Arya from Bank of America Securities. Please go ahead. Your line is open.
Vivek Arya: Thanks for taking my question and congratulations on the good execution. I'm curious, Vince, what in the communications segment just near term. Did you see any level of pull-in from China or Huawei in either April our July and then as we get beyond the current environment, do you see any further impact from all the restrictions on Huawei or do you think that share will be shifted over to Huawei's competitors. So longer term you can start to regrow your communication segment?
Vincent Roche: Well, Vivek, let me answer the second part of your question first. So we have tremendous coverage. We've got very strong market share across all the providers all the OEMs of - for 5G across the globe. So irrespective, I mean, the networks are going to get built. And whoever builds and will be using our stuff, our transceiver technologies, our microwave portfolios, many, many other ancillary analog technologies. And so I feel good about the position that we're in. If share shifts from one to the other we will pick it up. And so the - yes in terms of demand, I would say, we have reconciled. So it's pretty clear what the carriers are saying about the deployment of 5G globally right now. Our reconciliation in terms of how we balance the demand of the carriers is with - it is very tightly tied to our supply. So we have a good sense for what the carriers are looking for and that's how we're planning essentially the factory loadings to support this particular area. So I don't think I mean you asked about are we seeing double ordering and so on and so forth. What is characteristic in the base station infrastructure market over many, many years is that get gyrations when a set of contracts are coming due. You see some level of, I would say, core need and a certain amount of redundancy built in, but it's pretty typical. What we're seeing right now in terms of 5G is no different. What we've seen in terms of the dynamics how 4G operated in terms of demand.
Prashanth Mahendra-Rajah: I'll remember on the call, what we said publicly about that large customer in China. A year ago we talked about them being a mid single-digit customer. They've been reduced meaningfully since that time. They're more around the low single-digit percent of sales today. And as we look forward to our third quarter and beyond, we don't see that changing from there. Do you have a follow-up?
Vivek Arya: Yes. Very helpful. Thank you. On gross margins, how should we think about the trajectory from here given all the puts and takes of mix and I think Prashant you mentioned fab under-utilization, but then you also mentioned some of the cost synergies. So let's assume sales stay at similar levels even going into your Q4 what can gross margins do then? Thank you.
Prashanth Mahendra-Rajah: Sure. Yes, good question, Vivek. So our model is 70% long-term and you saw that in good times we can get upto 72% plus and in more challenging times like now we're sort of in the high '60s. So through and through a cycle, we can average 70%. Getting to 70% is very macro dependent as demand gets better, we are going to get utilization tailwind. We have, as I mentioned, utilizations are near trough levels now. We have - what we have in our favor is an additional 100 million of costs of good synergies. So that should begin to give some tailwind as well to our gross margins. And then as 2021 returned to kind of growth numbers then I feel that - it's reasonable for us to kind of get back to that 70% level.
Michael Lucarelli: Cheryl on the call - on the interest of time, we're going to go to one question per caller to get through a bit more.
Operator: And our next question comes from Ambrish Srivastava from BMO. Please go ahead. Your line is open.
Ambrish Srivastava: Prashant, I had a question for you on a couple of quick ones, OpEx trajectory. How should we be thinking about it? And then on capital allocation, is it fair to assume that given all the volatility that share buybacks stays paused for now?
Prashanth Mahendra-Rajah: So for OpEx we are in our sixth quarter of consecutive improvement in OpEx. Some of that was - is clearly actively managing the spend levels down. But some of it is also the result of this COVID situation where travel is at a freeze. I think it's reasonable to expect that as businesses reopen and customer expectations start to change and we need to get back in front of folks that some of that is going to climb and as well as some other discretionary spend will come back in. So I wouldn't run this level of OpEx out too long, but I think you've seen that we have been incredibly diligent with managing our OpEx over the last year and a half and that's a muscle that ADI has built and we're not going to let that go. In terms of how to think about the capital allocation. Our framework really hasn't changed. The first call is to invest in the business and you know whether that is organic or inorganic. And then after that it's really 100% return of free cash flow after debt repayments. So the plan for 2020, we increased the dividend by 15%. We're still intending to reduce debt by 300 million to 500 million in this fiscal year and then everything after that goes back to shareholders either through dividend or share repo. So I would expect that we would be - if the business holds out that we would be reactivating the share repo in the coming quarters.
Michael Lucarelli: We'll go to our next caller please.
Operator: Our next question comes from Ross Seymore from Deutsche Bank. Your line is open.
Ross Seymore: Congrats on the strong results in challenging times. I just wanted to go back to the automotive side. You said it would be down sharply. So just a couple of questions on that. Do you mean sequentially year-over-year or both and given the timing of when the auto factories have been shut down and then are turning back on. How are you viewing the shape of that recovery and how much of that turning back on dynamic influences your thoughts for both your July guide and your October outlook conceptually?
Vincent Roche: Yes, thanks for the question, Ross. So I think first and foremost we expect sequential and annual declines. It is extremely hard to read the automotive sector right now. I think it's easier to predict how factories will reopen and how supply will happen. I think the bigger question is what is going to happen with demand. And I think the way we view it is that we don't understand the pace of reopenings right now and at what level of utilization or capacity will they operate. So I would say we think it will be tough going for the remainder of this year in automotive. And perhaps we'll start to see a recovery in the first half of the coming year. So that's how we're viewing it. So the area that we feel kind of most conviction around in terms of demand will be for electric vehicles where our portfolio is making very strong headway, which was originally centered really in China into Europe and of course America as well. So very, very hard to read, I would say, but my sense is that remainder of this year will be tough and we start to see off a pretty poultry bottom I think some recovery in the first half of '21.
Prashanth Mahendra-Rajah: And Ross, I would say, that is reflected in our guide. We're relatively bearish on automotive in our guidance.
Michael Lucarelli: Cheryl, we'll have our next question.
Operator: Our next question comes from Toshiya Hari from Goldman Sachs. Your line is open.
Toshiya Hari: Good morning and congrats on the strong results. Vince, I wanted to ask about your BMS business specifically. How did that business trend in the quarter? What's the outlook into July? And if you can give us an update on customer traction with your wireless BMS solution into the back half of the year and potentially into fiscal year 2021, that would be helpful? Thank you.
Vincent Roche: Yes, so overall in the quarter just gone, we saw a modest decline, I would say, in our BMS revenues, but our design and hit rates are very, very strong. We're set to - at the present time we have somewhere in the region of 40% to 45% market share in BMS. And we believe that share will grow above 50% given the design pipeline that we have and the commitments that we have from customers across the globe. As I mentioned in the previous - the previous answer there. We managed to take what was a very channel-centric BMS business. We've been taking it across the globe and that's for essentially the non-wireless set of things. The wireless battery. We are expecting to see our first production of that particular product happen in the kind of I think the second half of 2021. So that's how we see it. We are in a great position I think right now in North America, China and we're also beginning to penetrate Japan and Europe, I think, is in the early stages of adoption at any kind of meaningful level and I feel good about where we are there. So and our portfolio is highly differentiated. There are many pretenders out there, but when it comes to optimizing the miles per charge we got more than 20% gain in that - along that metric. So overall it's a 1% to 2% penetration of the car sector. It will probably go to 25% over the next five, 10 years and we're in a very, very good position to see the tailwinds from that as time plays out here.
Michael Lucarelli: Thank you, Toshiya. We'll go to our last question, please.
Operator: And our last question comes from Chris Danely from Citigroup. Please go ahead. Your line is open.
Chris Danely: I guess more of a clarification and a question. So you mentioned that you've seen a little bit of weakness in the April May bookings. Does the guide take into account further weakening in the bookings i.e. did you build any cushion or are you assuming stability from here on out?
Prashanth Mahendra-Rajah: Yes, so I think we feel good about our guide, Chris. We don't put a guide out there that we don't think we can based on what we know today we can get to orders were down in April. May was at a slower pace. Our expectation in the guide is that orders continue to slow through the quarter or best case might stabilize. We've got good coverage from the backlog more than we normally do. So we're prepared for some cancellations or push outs because we would have. We always have some turns business in there. We're trying to control those cancellations or push outs, as I mentioned, by being be pretty tough on the terms that we have for direct or disty customers and we've also assumed that the channel is relatively flat inventory levels sequentially. So we think we've calibrated the guide as best as we can knowing what we know today.
Operator: Thank you. And I'll turn the call back for closing comments.
Michael Lucarelli: Thanks, everyone for joining us this morning. A copy of the transcript will be available on our website investor.analog.com and you also find our recently published ESG report, engineering good there as well. Thanks again for joining us and your continued interest in Analog Devices. Stay healthy.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices [Fourth Quarter and Fiscal Year 2019] (sic) Second Quarter 2020 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Michael Lucarelli, Director of Investor Relations. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Cheryl, and good morning, everybody. Thanks for joining our second quarter fiscal 2020 conference call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com Now onto the disclosures. The information we're about to discuss, includes forward-looking statements that involve risks and uncertainties. Actual results may differ materially from these forward-looking statements as a result of various factors including the uncertainty regarding the duration of COVID-19 pandemic and its impact on our business, our customers and suppliers and the global economy and also those discussed in our earnings release and our most recent 10-Q. These forward-looking statements reflect our opinion as of the date of this call. We undertake no obligation to update these forward-looking statements in light of new information or future events. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing results to our historical performance, special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that I'll turn it over to ADI's CEO, Vincent Roche. Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thank you, Mike, and good morning to you all from Boston. I hope that you and your families are all staying safe and healthy during this period. First, we want to express our gratitude to the health-care workers and the many other heroes on the frontlines who are protecting the health and the well-being of our communities. Thank you also very, very much. When we had our last earnings call in mid-February, we were just beginning to understand the depths of the COVID-19 impact in China and since then the pandemic has had a profound impact on the world putting tremendous stress on society and of course the global economy. To counterbalance this, we've seen an unprecedented response from governments with the deployment of fiscal and monetary policies to soften the downturn and restart economic activity whenever that may be. While our sector is not immune to the turbulent operating environment it's my belief that technology will be what mollifies the current weakness and drives new demand and business models post pandemic. That's not to say that we're standing still. We've taken actions to curtail spending and reinforce our cash position. And we are learning from this challenging period and adapting quickly while still investing to ensure that we are well-positioned in the recovery and for the long term. Our team has embraced the challenges with many of our employees working from home, but obviously not everyone can work remotely and I want to acknowledge and thank our manufacturing employees. We've continued to perform at exceptional levels and deliver for our customers. For these employees supporting our clinical operations, we've implemented safeguards to protect them, including more PPE, increasing social distancing and enhanced sanitization. And we provided them with additional incentives and benefits to allow for continuity during this very difficult time. Our team has also done an excellent job staying close to our customers. We moved quickly to pivot manufacturing lines and prioritize our healthcare solutions that are needed in the fight against COVID-19. This has allowed us to expedite supply used in products such as ventilators, respirators, imaging systems and patient monitors to our healthcare customers, and I'm incredibly proud of the resourcefulness and commitment that we have shown in rising to this critical challenge. Additionally, through the ADI Foundation, we've made multi-million dollar donations to support both global and local pandemic response efforts, but our work goes beyond financial contributions. We are also partnering with hospitals and biotech start-ups to develop solutions such as rapid point-of-care diagnostic tests and clinical grade patient monitoring that leverage our technologies. So now I'd like to discuss the current operating environment a bit. Given the reach and depth of the current crisis, global business activity has been disrupted, and today we have seen a deterioration in demand within our automotive, broad-based industrial, and consumer businesses. However, our business is proving more resilient than during the global financial crisis. To that end, healthcare demand is at record levels and communications demand is robust across wireless and indeed wireline sectors. We're also seeing strength in portions of our industrial instrumentation business and steadiness in our defense business. Now this success is no accident. Through our organic investments and acquisitions of Hittite and LTC, ADI is a very different company than we were a decade ago with more diversity, a broader portfolio across High-Performance Analog, Power and RF and higher exposure to more profitable and durable end markets. So now let me move to the other side of the equation and talk a little bit about supply. Across the world, supply chains were disrupted when many governments ordered shelter-in-place mandates and closed their borders. For ADI, capacity was reduced at our back-end test and assembly sites in mid-March across the Philippines, Malaysia, and Singapore. Once granted essential status, we acted quickly yet responsibly to ensure employee safety and improve our capacity. And today, I'm glad to say we're operating at normal capacity levels. This demonstrates the agility of our global operations and the dedication of ADI's employees around the world. Despite the fluid and uncertain demand and supply environment, we delivered revenue of 1.32 billion and EPS of $1.08. This was in line with the original range we provided on our first quarter earnings call underscoring the resiliency and flexibility of our business model in any economic backdrop. Now as we've mobilized to preserve ADI strength in the near-term we're capitalizing on the many opportunities we see to fortify and expand our market position for the long-term. Our team remains focused on our three strategic priorities. So let me provide you with a brief update on each. First is the efficient use of capital. Importantly, ADI has ample financial liquidity to meet the needs of our business across critical investments, dividend payments and servicing our debt. Despite the current macro environment, we've generated $1.8 billion of free cash flow or 32% of sales over the trailing 12 months. This continues to place ADI in the top 10% of the S&P 500. Throughout our 55-year history, we've encountered and navigated several Black Swan events successfully by taking a disciplined and balanced approach to financial management. Specifically, the first call on our capital is funding new product development. This means investing smartly in both our people and technologies to ensure we continue to deliver disruptive innovation. In the quarter just passed, we invested 19% of revenue in R&D, spending 95% on the most attractive opportunities across our B2B markets. We also remain committed to strong shareholder returns with our dividend as the cornerstone. In the quarter, we returned over $340 million to shareholders through dividends and share repurchases. So let me turn to our second priority, which is about maximizing customer impact. We are continuously innovating to stay ahead of customer needs and while COVID-19 has brought new challenges it has also revealed new opportunities in a reordered world. During the quarter, our customer engagement didn't slow down. We hosted hundreds of virtual seminars with thousands of customers in attendance, training them on new solutions and new technologies. These interactions were very productive. We saw increased design activity on new product development across markets and customers. For example, we partnered with a key electric vehicle customer to re-imagine how audio is rendered across their fleet. As a result of this increased and focused collaboration, we added our high performance audio digital signal processors to our A2B platform, more than doubling our content per vehicle. And in our instrumentation test business for data center compute, we continue to work with customers on reducing their system complexity and getting to market faster. Our innovative solutions combine our analog mixed-signal and power micro-module portfolios. These solutions deliver four times the channel density, while simultaneously increasing throughput. While these are just two examples, there are many more across all of our markets. It's this current flurry of design activity that positions ADI to accelerate post pandemic. Our third priority is capitalizing on secular trends to expand our addressable markets and drive diversified growth. While every downturn has its own unique characteristics, they all seem to have one thing in common that is they drive tremendous change. Industries are prioritizing digitalization and connectivity more than ever and new industries are emerging focused on the physical and cyber. ADI where the data is born is at the center of these exciting secular growth opportunities. And I wanted to share some thoughts with you today. As I noted earlier, our healthcare business is providing several of the technologies that are critical to the diagnosis and treatment of COVID-19. Taking a step back, ADI has been committed to this market for many years, as we anticipated the opportunity for innovation to deliver better patient outcomes. Now this crisis will challenge us to rethink and hopefully fast track the accessibility, affordability and wellness focus of global healthcare. To achieve this, healthcare systems are going to need to be upgraded and clinical grade patient monitoring will need to be extended from the hospital right down to the patient's home. Massive adoption of sensing, computing, and cloud capabilities is going to be required. And we believe that ADI Technologies will be at the forefront of this transformation. The communications market is moving at a rapid pace to keep up with the strains put on bandwidth and latency, as more people work remotely, transact business more digitally, and consume media from everywhere. Here ADI is playing a critical role in building out the infrastructure required from an always connected world. Our integrated transceiver, power, and optical control portfolios are enabling customers to economically scale their investments to build the next-generation networks. We continue to innovate to meet future performance, size, and power needs positioning us to gain share to capture additional value. Another secular trend we're benefiting from is the rise of Industry 4.0. While this trend isn't so new, the pandemic is moving it to the forefront of our customers' needs. It's clear that post-pandemic supply chains will be re-imagined and new ones will be built, ones that are more flexible, automated, and perhaps sovereign. To solve the economic burden that comes with this, customers will further automate their businesses with intelligent and connected factory floors and the increased use of robots, cobots and analytics. This creates additional demand for our precision signal chain and power franchises and extends ADI into new areas like software IO, depth sensing, condition-based monitoring, and robust connectivity. Outside of these secular growth trends, I'm also personally inspired by the tremendous sustainability benefits that we've seen in a short amount of time. For example, we've seen sizable decreases in carbon-dioxide, nitrous oxide, and carbon monoxide. I believe that ADI and the industry at large can and should be leveraging its creative brainpower to be better stewards of the planet. We recently published our comprehensive corporate responsibility report entitled Engineering Good. And I can assure you, there will be more to come as I'm deeply committed to ADI's leadership here. So, in closing, the shape of the economic recovery is still very, very uncertain and dependent on many variables. While we're confident in our outlook provided today. This unprecedented macro backdrop will continue to influence supply and demand dynamics for some time to come. We are embracing the short-term challenges and by leveraging the collective power of our talents, our technology and customer engagements, I'm very confident we will emerge stronger. So, with that, I'd like to turn it over to Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Let me add my welcome to our second quarter earnings call. As a reminder, my comments today with the exception of revenue and non-op expenses will be on an adjusted basis, which exclude special items outlined in today's press release. Back in March, we would do our guidance for the second quarter as the spread of COVID created an enormous amount of uncertainty and impacted our supply chain. However, we acted quickly and decisively and I'm pleased to say that our second quarter results were within our original guidance with revenue of 1.32 billion, operating margin of 38%, and EPS of $1.08. Without those capacity limitations, we believe revenue would have been above our original midpoint provided at our first quarter earnings or approximately $50 million higher. So let's get into the market results. Our B2B markets while very volatile intra-quarter due to COVID-19 performed relatively in line with our expectations. B2B revenue increased 3% sequentially. And if not for supply constraints we would have delivered on our outlook of growing mid to high single-digits sequentially. Notably, we achieved these results, while reducing channel inventory by 60 million in the quarter. Industrial, which represented 54% of revenue during the quarter, finished up 4% sequentially, and declined 8% year-over-year. While we experienced broad-based weakness across most applications, our healthcare memory test and energy verticals all grew from the year ago period. Communications, which accounted for 21% of revenue, finished up 15% sequentially and given the tough compare decreased 24% year-over-year with weakness across both wireless and wired. This market is and will remain lumpy, but over the long-term will be a high growth market for ADI, given our positioning in 5G and optical control systems. Automotive, which represented 14% of revenue, down 12% sequentially and 23% year-over-year with declines across all major applications. Not surprisingly our auto business was impacted by lower vehicle sales and a global slowdown in production. As many customers were required to suspend their operations in response to COVID-19. Lastly consumer, which represented 11% of revenue was down 14% sequentially, and 5% year-over-year, as lower consumer spending impacted both portables and prosumer. Notably, we continue to expect 2020 to be the bottom for our consumer sector. Let's go to the P&L for the second quarter. Gross margin came in at 67.7% down both sequentially and year-over-year related to low utilizations from reduced production levels and the factory closures I mentioned earlier. As a reminder, we expect to realize 100 million of cost of goods savings exiting fiscal 2021 through the optimization of our manufacturing footprint. OpEx was 390 million, down 5% sequentially marking the sixth consecutive quarter of declines. This was driven by a combination of the quick aggressive measures we took in response to pandemic as well as our continued focus on cost management. Operating margin finished at 38% up over 100 basis points sequentially and down year-over-year. Non-GAAP expenses were 49 million, up sequentially, but down over 10 million compared to last year. Our tax rate for the quarter was approximately 11% and all told second quarter adjusted EPS came in at $1.08. So now let's go to the balance sheet and cash flow. During the quarter, we proactively bolstered our strong liquidity position. We retired a $300 million bond and subsequently raised $400 million from the semiconductor industry's first ever green bond. And as a cautionary measure, we also temporarily suspended our share repurchase program midway through the quarter. As a result, we finished the quarter with approximately 800 million of cash and about 5.6 in total debt. Our net debt to EBITDA ratio is 1.9 times on a trailing 12 month basis. Between cash on our balance sheet and the commitments under our revolving credit facility, ADI has more than 2 billion of liquidity easily eclipsing our annual dividend payment and the debt due in January of 2021. Inventory was essentially flat from the first quarter. However, days of inventory fell to 126 from 133. Our sell-in revenue was well below our sell-through revenue at distributors. As I mentioned, we reduced channel inventory by about 60 million in the second quarter. This brings our total channel reduction to around 100 million in the first half of fiscal 2020. Channel inventory currently sits comfortably at the low end of our seven to eight week range. So finishing on cash flow for the quarter, cash flow from ops was 429 million and CapEx was 60 million. We expect CapEx to decline meaningfully in the second half and finished the year below our normal target range of 4% of revenue. In the quarter, ADI paid approximately 230 million in dividends and repurchased 114 million of our stock. On a trailing 12-month basis, free cash flow finished at 1.8 billion or 32% of revenue. Over this period, we reduced debt by roughly 400 million and returned around 830 million to shareholders via dividends and an additional 500 million via repurchases. As a reminder, our capital return policy is to return all free cash flow after debt reduction to shareholders. In fiscal 2020, we expect to reduce debt by 300 million to 500 million and return 100% of the remaining free cash flow. Before moving to our outlook, I want to highlight what we are seeing in terms of demand and supply. As Vince mentioned earlier, our business is performing quite well under the current macro backdrop. Healthcare is very strong and we expect this strength to persist into the back half of the year. We are seeing robust demand in communications across both wireless from 5G deployments and wireline from data center and networking upgrades. This strength is benefiting our industrial instrumentation business where we sell high performance solutions used in both memory and 5G testing. And lastly defense is typically a steady business against all economic backdrop. All told, these markets represent almost half of ADI's revenue over the last year. From a supply standpoint, we enter our fiscal third quarter at normal capacity levels. This is quite remarkable and I want to echo Vince's appreciation for the dedicated manufacturing teams across the world. And that brings us to our third quarter outlook. Revenue is expected to be flat sequentially at 1.32 billion plus or minus 70 million, which is a wider range than usual to account for the uncertain environment. This outlook includes approximately 50 million of revenue that was pushed from second quarter due to capacity constraints. We are assuming no change in channel inventory in this plan. We anticipate robust sequential growth in comms, modest sequential declines in industrial and consumer, and a sharp sequential decline in automotive. All told, B2B should increase slightly sequentially and decline just under 10% year-over-year. We anticipate op margins to be approximately 38.3 plus or minus 150 bps. We're planning for the tax rate in the quarter to be between 12% and 13% and based on these inputs adjusted EPS is expected to be a $1.08 plus or minus $0.11. As Vince said, we are confident in our third quarter outlook, but we are mindful of the tremendous uncertainty around us. Our operating model is to plan conservatively and execute aggressively to preserve free cash flow in the near-term. At the same time, we remain focused on the long-term, continuing to invest to capture and create value across several exciting secular growth areas. Let me pass it back to Mike now to start our Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Okay. Thank you, Prashanth. Now let's get to our Q&A session. Please limit yourself to one question. After our initial response, we'll give you an opportunity for a follow-up questions. Cheryl, can we have our first question please."
},
{
"speaker": "Operator",
"text": "Our first question comes from John Pitzer from Credit Suisse. Your line is open."
},
{
"speaker": "John Pitzer",
"text": "Yes, good morning, guys. Thanks for letting me ask the question and congratulations on the solid results, given the backdrop. Vince, I guess, the question I'm getting this morning from investors is just relative to your July quarter guidance. Most of your peers have been guiding anywhere from 10 to 15 percentage points below seasonal. You guys are guiding about five percentage points below seasonal. And I guess the question that's being asked is, to what extent are you just not being as conservative as your peers. To what extent are there some idiosyncratic drivers. Could you help us parse that out?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks, John. So I think first and foremost. We've seen tremendous strength in our healthcare business over the last quarter and we expect that will also continue. And also generally speaking with virtualized commerce, work from home, we're seeing again very, very strong demand for the communications products. The optical cable portfolios of ADI are doing particularly well and of course 5G especially in China and Asia, the 5G build-out is moving at pace. So what we're seeing, what we are predicting looking ahead is based on the order streams that we've seen and whatever - what others are predicting. We feel comfortable based on the strength in the areas I've just mentioned. Our defense business continues - continues quite strong. Also businesses attached to let's say the build-out of data centers and cloud like advanced instrumentation test systems for memory, storage and so on and so forth are also doing particularly well. So the overall industrial business holds in there. As Prashanth said, we probably see a modest decline, a seasonal decline in the third quarter. So overall they are the drivers. And as Prashanth said we expect a steep decline in the automotive business, but when you look at the puts and takes that's how we see the quarter shaping up."
},
{
"speaker": "John Pitzer",
"text": "That's helpful, Vince. And then just maybe - go ahead Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "I was going to give a little bit more background on kind of the orders and outlook, which may help investors as to why our guide came in where it is. So very quickly kind of as expected Feb was weak, March came back very strong largely driven by China, but also some pretty strong demand outside from customer concerns and then it began to correct. So April was soft, continued into May. We finished with kind of book-to-bill above 1.0 in all of our markets except auto. So as we thought about the outlook - we've built our outlook on the expectation that orders are going to continue to slow through the quarter or best case stabilize. The guide that we have out there is built on a 100% backlog coverage, which is much higher than we would normally use when we were at this point in the quarter. We're working terms with our customers and we are enforcing them pretty stringently, so any customers or disty orders are non-cancellable within a 35-day window unless we agree to grant an exception. So that's helping to kind of clean through the backlog and limit order cancellations. So all-in, I think, the assumptions are reasonable given the amount of uncertainty and we did put a little bit wider range on there plus or minus 70 to reflect the uncertainty."
},
{
"speaker": "John Pitzer",
"text": "That's great color, guys. And then Vince just as my follow-up. As you mentioned in your prepared comments, the concept of Industry 4.0 has been around for a while, but it does seem like COVID has the potential of actually shining a spotlight on that in a way that we have. And I guess in my mind that probably also helps the 5G build-out because it's hard to have an intelligent factory floor without that 5G backbone, but I was hoping maybe you could help us define that market opportunity for you. When you look at sort of the intelligent factory floor, what percent of your industrial business is it today, and how should we think about potential growth rate three to five years out, if this really starts to accelerate?"
},
{
"speaker": "Vincent Roche",
"text": "Yes, it's a good question, John. I would say today what we would consider to be Industry 4.0 with a highly cloud connected industrial sector is quite small. I think today it's probably less than 10% of the total installations of factory automation and process control systems, but the intelligence we're getting from many of our customers now is that there are two things driving the need for the redeployment of industry. So it's probably three things. One, the need for them to understand how to gather and utilize data analytics to improve the outcomes for their customers. So that assumes automatically that you deploy 5G, you deploy optical connectivity, many forms of shorter robust connectivity. I think also the - we are seeing the fragility of the supply chain globally. And customers are telling us they're expecting to bring more machine capability into managing the supply chain. And I think thirdly is the regionalization or the [suburbanization] [ph] of supply chains and we can see the pressures there globally. And not to mention the demographics, many of the societies that are producing lots of capital goods and consumer good outputs like Germany, China and as America begins to regionalize supply chain, we're likely to see the adoption of cobotics and more robotics technologies in general. So I think there's a long way to go, John. We're in the early innings of the Industrial 4.0, the adoption of that."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tore Svanberg from Stifel. Your line is open."
},
{
"speaker": "Tore Svanberg",
"text": "Thank you and congratulations on the results. First question is for Vince. Vince, you talked quite a bit about sort of investing in this time frame and you highlighted, again, medical and industrial. What about the automotive market, are you seeing sort of a secular change there, are you still investing or will you still be investing as heavily in automotive going forward."
},
{
"speaker": "Vincent Roche",
"text": "Well, we've actually been ramping, Tore, our investments in automotive, particularly, in the infotainment, the power side of things and also the electrification of the vehicle, the electric powertrain. So right now it's a very, very hard market to read both in terms of demand and of course supply. I think automotive has been extremely hard hit by the closures globally. So we see, I would say, the two areas of most interest to us Tore are the infotainment, the car experience, leveraging for example, our A2B technology, our heritage and digital signal processing and audio signal processing in general adding for example active noise cancellation to the portfolio and we're deploying that, starting to deploy that now. So I think the whole Infotainment side of things is an important part of the go-ahead and that's a place where we've a lot of heritage and we're actually increasing investment. We just acquired a company actually during the quarter to enable us to bring more signal processing to the audio space. In the electric vehicle area, I think, it's got a long, long road ahead of it. As the electrification today the powertrain the - as a portion of overall car sales only about one certainly less than 2% of total car sales. So a long, long way to go. And that's an area where we have strong position. We're on our fourth or fifth generation of technology node product delivery to that sector. So I'd say in those areas we are actually increasing investments. Power is another area, the cross-connective power into our business particularly in Europe and the US. That's an important initiative and we're seeing some very good green shoots there in terms of early stage production of designs - of power designs that we've attached to the signal processing portfolio. I think it's also true to say, Tore, that probably on the safety side of things, we've been decreasing our investments over the last several years, partly in MEMS. You'll recall three, four years ago. We withdrew most of our investments in that area. So I would say safety is more opportunistic, infotainment and electric powertrain more strategic."
},
{
"speaker": "Michael Lucarelli",
"text": "And, Tore, do you have follow-up?"
},
{
"speaker": "Tore Svanberg",
"text": "Yes, that was very helpful. A follow-up for Prashanth. Prashanth, I do realize obviously right now the orders are kind of all over the place. But if we start to see deterioration, what would be the company's playbook especially on things like manufacturing utilization inventory because it seems like some of your peers have different playbooks. Just wondering what ADI's playbook will be in response to potentially weaker or continuous weaker orders? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Sure, yes. So, Tore, let's do that in two pieces. First, think about how we manage our cost. So, right, in the near-term how we think about cost and you've seen it in the OpEx results already. We have a variable comp structure that is intended to act as a shock absorber and that unwinds as revenue falls. On the discretionary side, we've already proven hiring. We've essentially got travel at zero. We've exited consultants and any discretionary contractors and perhaps most impactful is we've deferred our merit increase, which is usually 2%, 3% year-over-year. We are on track to realize about 35 million of synergies that we announced last year in November. And we still have $100 million of cost synergies that will come through by the end of 2021. So there are some more permanent actions that we can take. And we have taken in the past such as furloughing employees until demand returns. We did this back in 2008, 2009. We would certainly put activities like temporary actions on the table. So there are all items that we'll think about. On the manufacturing side I would emphasize that our utilizations are fairly low right now. So we're kind of at the trough levels. Inventories are we feel at a good position. So I don't think we have kind of the same inventory exposure that we would have had at the same time last year. We've reduced on the balance sheet as well as in the channel. So, overall, I think we're well positioned if this breaks up or should it break down. Maybe Vincent you want to talk a bit more about kind of longer term."
},
{
"speaker": "Vincent Roche",
"text": "Yes. So I think, Tore, we feel good about the stability, the diversity and stability of our business and what the profit margins we generate as a company. We're investing to make sure we come out of this trough, a stronger company both in terms of product development as well as customer engagement. So we also believe very strongly in the persistence and the pervasiveness of our technologies. So I believe that the story for ADI get stronger with the tailwinds that we have and the portfolio that we have for the future. So look, overall, our goal is to take advantage of the disarray. And while - I think Prashanth said in his prepared remarks we're preparing for the worst, but we're executing aggressively for the future."
},
{
"speaker": "Operator",
"text": "And our next question comes from Vivek Arya from Bank of America Securities. Please go ahead. Your line is open."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question and congratulations on the good execution. I'm curious, Vince, what in the communications segment just near term. Did you see any level of pull-in from China or Huawei in either April our July and then as we get beyond the current environment, do you see any further impact from all the restrictions on Huawei or do you think that share will be shifted over to Huawei's competitors. So longer term you can start to regrow your communication segment?"
},
{
"speaker": "Vincent Roche",
"text": "Well, Vivek, let me answer the second part of your question first. So we have tremendous coverage. We've got very strong market share across all the providers all the OEMs of - for 5G across the globe. So irrespective, I mean, the networks are going to get built. And whoever builds and will be using our stuff, our transceiver technologies, our microwave portfolios, many, many other ancillary analog technologies. And so I feel good about the position that we're in. If share shifts from one to the other we will pick it up. And so the - yes in terms of demand, I would say, we have reconciled. So it's pretty clear what the carriers are saying about the deployment of 5G globally right now. Our reconciliation in terms of how we balance the demand of the carriers is with - it is very tightly tied to our supply. So we have a good sense for what the carriers are looking for and that's how we're planning essentially the factory loadings to support this particular area. So I don't think I mean you asked about are we seeing double ordering and so on and so forth. What is characteristic in the base station infrastructure market over many, many years is that get gyrations when a set of contracts are coming due. You see some level of, I would say, core need and a certain amount of redundancy built in, but it's pretty typical. What we're seeing right now in terms of 5G is no different. What we've seen in terms of the dynamics how 4G operated in terms of demand."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "I'll remember on the call, what we said publicly about that large customer in China. A year ago we talked about them being a mid single-digit customer. They've been reduced meaningfully since that time. They're more around the low single-digit percent of sales today. And as we look forward to our third quarter and beyond, we don't see that changing from there. Do you have a follow-up?"
},
{
"speaker": "Vivek Arya",
"text": "Yes. Very helpful. Thank you. On gross margins, how should we think about the trajectory from here given all the puts and takes of mix and I think Prashant you mentioned fab under-utilization, but then you also mentioned some of the cost synergies. So let's assume sales stay at similar levels even going into your Q4 what can gross margins do then? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Sure. Yes, good question, Vivek. So our model is 70% long-term and you saw that in good times we can get upto 72% plus and in more challenging times like now we're sort of in the high '60s. So through and through a cycle, we can average 70%. Getting to 70% is very macro dependent as demand gets better, we are going to get utilization tailwind. We have, as I mentioned, utilizations are near trough levels now. We have - what we have in our favor is an additional 100 million of costs of good synergies. So that should begin to give some tailwind as well to our gross margins. And then as 2021 returned to kind of growth numbers then I feel that - it's reasonable for us to kind of get back to that 70% level."
},
{
"speaker": "Michael Lucarelli",
"text": "Cheryl on the call - on the interest of time, we're going to go to one question per caller to get through a bit more."
},
{
"speaker": "Operator",
"text": "And our next question comes from Ambrish Srivastava from BMO. Please go ahead. Your line is open."
},
{
"speaker": "Ambrish Srivastava",
"text": "Prashant, I had a question for you on a couple of quick ones, OpEx trajectory. How should we be thinking about it? And then on capital allocation, is it fair to assume that given all the volatility that share buybacks stays paused for now?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "So for OpEx we are in our sixth quarter of consecutive improvement in OpEx. Some of that was - is clearly actively managing the spend levels down. But some of it is also the result of this COVID situation where travel is at a freeze. I think it's reasonable to expect that as businesses reopen and customer expectations start to change and we need to get back in front of folks that some of that is going to climb and as well as some other discretionary spend will come back in. So I wouldn't run this level of OpEx out too long, but I think you've seen that we have been incredibly diligent with managing our OpEx over the last year and a half and that's a muscle that ADI has built and we're not going to let that go. In terms of how to think about the capital allocation. Our framework really hasn't changed. The first call is to invest in the business and you know whether that is organic or inorganic. And then after that it's really 100% return of free cash flow after debt repayments. So the plan for 2020, we increased the dividend by 15%. We're still intending to reduce debt by 300 million to 500 million in this fiscal year and then everything after that goes back to shareholders either through dividend or share repo. So I would expect that we would be - if the business holds out that we would be reactivating the share repo in the coming quarters."
},
{
"speaker": "Michael Lucarelli",
"text": "We'll go to our next caller please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ross Seymore from Deutsche Bank. Your line is open."
},
{
"speaker": "Ross Seymore",
"text": "Congrats on the strong results in challenging times. I just wanted to go back to the automotive side. You said it would be down sharply. So just a couple of questions on that. Do you mean sequentially year-over-year or both and given the timing of when the auto factories have been shut down and then are turning back on. How are you viewing the shape of that recovery and how much of that turning back on dynamic influences your thoughts for both your July guide and your October outlook conceptually?"
},
{
"speaker": "Vincent Roche",
"text": "Yes, thanks for the question, Ross. So I think first and foremost we expect sequential and annual declines. It is extremely hard to read the automotive sector right now. I think it's easier to predict how factories will reopen and how supply will happen. I think the bigger question is what is going to happen with demand. And I think the way we view it is that we don't understand the pace of reopenings right now and at what level of utilization or capacity will they operate. So I would say we think it will be tough going for the remainder of this year in automotive. And perhaps we'll start to see a recovery in the first half of the coming year. So that's how we're viewing it. So the area that we feel kind of most conviction around in terms of demand will be for electric vehicles where our portfolio is making very strong headway, which was originally centered really in China into Europe and of course America as well. So very, very hard to read, I would say, but my sense is that remainder of this year will be tough and we start to see off a pretty poultry bottom I think some recovery in the first half of '21."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "And Ross, I would say, that is reflected in our guide. We're relatively bearish on automotive in our guidance."
},
{
"speaker": "Michael Lucarelli",
"text": "Cheryl, we'll have our next question."
},
{
"speaker": "Operator",
"text": "Our next question comes from Toshiya Hari from Goldman Sachs. Your line is open."
},
{
"speaker": "Toshiya Hari",
"text": "Good morning and congrats on the strong results. Vince, I wanted to ask about your BMS business specifically. How did that business trend in the quarter? What's the outlook into July? And if you can give us an update on customer traction with your wireless BMS solution into the back half of the year and potentially into fiscal year 2021, that would be helpful? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes, so overall in the quarter just gone, we saw a modest decline, I would say, in our BMS revenues, but our design and hit rates are very, very strong. We're set to - at the present time we have somewhere in the region of 40% to 45% market share in BMS. And we believe that share will grow above 50% given the design pipeline that we have and the commitments that we have from customers across the globe. As I mentioned in the previous - the previous answer there. We managed to take what was a very channel-centric BMS business. We've been taking it across the globe and that's for essentially the non-wireless set of things. The wireless battery. We are expecting to see our first production of that particular product happen in the kind of I think the second half of 2021. So that's how we see it. We are in a great position I think right now in North America, China and we're also beginning to penetrate Japan and Europe, I think, is in the early stages of adoption at any kind of meaningful level and I feel good about where we are there. So and our portfolio is highly differentiated. There are many pretenders out there, but when it comes to optimizing the miles per charge we got more than 20% gain in that - along that metric. So overall it's a 1% to 2% penetration of the car sector. It will probably go to 25% over the next five, 10 years and we're in a very, very good position to see the tailwinds from that as time plays out here."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Toshiya. We'll go to our last question, please."
},
{
"speaker": "Operator",
"text": "And our last question comes from Chris Danely from Citigroup. Please go ahead. Your line is open."
},
{
"speaker": "Chris Danely",
"text": "I guess more of a clarification and a question. So you mentioned that you've seen a little bit of weakness in the April May bookings. Does the guide take into account further weakening in the bookings i.e. did you build any cushion or are you assuming stability from here on out?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes, so I think we feel good about our guide, Chris. We don't put a guide out there that we don't think we can based on what we know today we can get to orders were down in April. May was at a slower pace. Our expectation in the guide is that orders continue to slow through the quarter or best case might stabilize. We've got good coverage from the backlog more than we normally do. So we're prepared for some cancellations or push outs because we would have. We always have some turns business in there. We're trying to control those cancellations or push outs, as I mentioned, by being be pretty tough on the terms that we have for direct or disty customers and we've also assumed that the channel is relatively flat inventory levels sequentially. So we think we've calibrated the guide as best as we can knowing what we know today."
},
{
"speaker": "Operator",
"text": "Thank you. And I'll turn the call back for closing comments."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, everyone for joining us this morning. A copy of the transcript will be available on our website investor.analog.com and you also find our recently published ESG report, engineering good there as well. Thanks again for joining us and your continued interest in Analog Devices. Stay healthy."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 1 | 2,020 | 2020-02-18 23:15:00 | Operator: Good morning. And welcome to the Analog Devices First Quarter Fiscal Year 2020 Earnings Conference Call, which is being audio webcast via telephone and over the web.
I'd like to now introduce your host for today's call, Mr. Michael Lucarelli, Senior Director of Investor Relations. Sir, the floor is yours.
Michael Lucarelli: Thank you, Cheryl. And good morning, everybody. Thanks for joining our first quarter fiscal 2020 conference call.
With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com.
Now on to the disclosures. The information we're about to discuss, including our objectives and outlook, include forward-looking statements. Actual results may differ materially from these forward-looking statements as a result of various factors, including those discussed in our earnings release and in our most recent 10-Q. These forward-looking statements reflect our opinion as of the date of this call. We undertake no obligation to update these forward-looking statements in light of new information or future events.
Our comments today about ADI's first quarter fiscal 2020 financial results and short-term outlook will also include non-GAAP financial measures, which exclude special items. When comparing results to historical performance, special items are also excluded from their prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release.
And with that, I'll turn it over to ADI's CEO, Vincent Roche. Vince?
Vincent Roche: Thanks, Mike, and good morning to everybody. While our first quarter results were in line with our expectations, as you'll have seen, importantly, we managed our operating costs and working capital effectively to position ourselves to deliver margin expansion in the quarters ahead.
Before I discuss the quarterly highlights, I'd like to address the coronavirus outbreak. First and foremost, our top priority is the health and safety of those affected and, of course, our employees. We're doing everything we can to provide our customers with the support they need to minimize disruption to their businesses. While the situation remains fluid, we are monitoring it closely. Prashanth will expand on the financial implications in just a while.
So now on to the first quarter. Revenue was $1.3 billion, down versus the prior year, but in line with our expectations. Operating margin was approximately 37%, a decline versus last year due to lower revenue and our decision to lower utilization. Adjusted earnings per share was $1.03, above the midpoint of guidance. Over the trailing 12 months, we generated approximately $2 billion of free cash flow, equating to a 35% free cash flow margin, and this continues to place us in the top 10% of the S&P 500.
On our call last quarter, we shared our priorities for 2020, and I'd like to give you an update on our progress so far. Priority 1 is the efficient use of our capital. The first call on our capital is funding new product development activities. In the first quarter, we invested over $250 million in R&D, with more than 90% of this spend targeting the most attractive opportunities across our B2B markets. For example, an area of increased focus for ADI is our power franchise. Here, we've been increasing R&D to enhance our strong position in the broad market and to extend into new opportunities across areas like data center, automotive and 5G infrastructure. Our power design win momentum remains strong, and we expect to double the LTC historical revenue growth rates in the years ahead of us. At the same time, we remain committed to delivering strong shareholder returns. In the first quarter, we returned over $300 million to shareholders and we just announced a 15% increase to our quarterly dividend.
Priority 2 is deepening customer centricity. As I've shared before, the combination of our broad product portfolio, domain expertise and manufacturing capabilities sets ADI apart. We're always anticipating the technology needs of our customers and engaging with them early in order to solve their toughest challenges.
And I'd like to share just a few examples specific to our automotive segment with you now. Our A2B platform continues to gain traction in the cabin electronics ecosystem. By leveraging our platform portfolio, we're opening up new applications for our customers such as active noise cancellation. In the quarter, Hyundai became the 14th auto manufacturer to incorporate our A2B technology. And together, we announced the industry's first all-digital road noise cancellation system. With the rise of active noise cancellation, we're creating stickier customer relationships due to the integration of our hardware and software capabilities while increasing our SAM per vehicle.
There's also a lot of intensity and urgency in OEMs moving towards electric powertrains. We were an early player in the market, partnering with industry leaders to improve the efficiency of the battery in electric vehicles. As a result, our BMS solutions are delivering greater miles per charge and monitoring battery health more accurately. In the U.S. electric vehicle market, we're benefiting from near-term strength as customers ramp production, and new design wins across future models will help us to deliver on our long-term objective of growing BMS revenue at a double-digit rate.
Priority 3 is capitalizing on secular trends to expand our addressable markets and drive diversified growth. We've previously discussed with you key secular trends across our company such as 5G, electric vehicles, factory automation and data center. Now today I'd like to spend some time on the space market, perhaps a more obscure subsegment of our industrial sector. Our space customers' challenges are not just around RF, signal processing and power management. Space solutions must also perform under extreme cosmic radiation and conditions of high temperatures. We solve these challenges through the combination of our comprehensive product portfolio and the passive knowledge base built over many decades of serving this market. While space represents a couple of percent of ADI's total revenue today, it commands stellar margins, and we see potential to double the business over the next 5 years.
Now let me share a little more with you about why this sector is exciting to us. The space market is rapidly evolving. Over the last decade, unprecedented levels of capital have gravitated towards this vertical, thereby increasing the number of privately funded space companies by 20x. Therefore, new technologies and capabilities are emerging that are leading to new opportunities for ADI. This includes the advent of low Earth orbit or LEO communication satellites. These satellites are becoming the new frontier in space with forecasts suggesting that by 2020, over 20,000 will be in orbit, up from just hundreds today.
To provide some context, LEO satellites differ from today's geostationary or geo satellites. Technologically, they provide lower latency and higher bandwidth, which enable real-time communication. Operationally, they continuously change their position relative to the earth and only stay connected with a given terminal for approximately 10 minutes. As a result, the number of terrestrial terminals that communicate with these satellites, whether they're on the ground or in the air, will grow into the millions with the proliferation of LEO satellites. To succeed in creating this network, both satellites and terminals must be capable of being steered. But so this requires an exponential increase in channel count enabled through phased array antennas, an architecture that is used in 5G networks already today. And as you can imagine, more channels packed into smaller form factors is increasing thermal and power hurdles. To help solve the engineering challenges of creating this ubiquitous and always-connected LEO network, our customers are increasingly turning to ADI, looking to us to not only be a supplier, but indeed, a key system architect.
So we're engaging with customers early in their design process to develop end-to-end solutions from antenna to bits, combined with power capabilities, to deliver the required performance and, of course, robustness. Our ability to provide a comprehensive portfolio of space-grade solutions across the entire analog spectrum from RF and signal chain to power is unique. And this cannot be completely replicated by any of our competitors, making ADI the go-to supplier for our traditional OEMs as well as the next wave of disruptors. All told, we see the LEO communications satellite plan becoming at least 4x the size of geo over the next 5 years. And with LEO's shorter refresh cycle compared to today's satellites, we expect our space business to deliver a steadier stream of revenue in the years ahead.
In summary, space has the potential to be a meaningful growth driver and unlock value across other verticals as well. Once fully operational, these LEO networks will provide real-time, reliable high-speed connections globally, ushering in opportunities from autonomous driving to telesurgery.
So in closing, and speaking broadly about ADI, I believe demand for our solutions will be unprecedented as technological innovation underpinned by ubiquitous sensing, hyperscale and edge computing and pervasive connectivity continues to grow rapidly. And as I look ahead, I believe we're very well positioned to deliver sustainable, profitable growth and, indeed, strong shareholder returns.
So with that, I'll hand it over to Prashanth.
Prashanth Mahendra-Rajah: Thank you, Vince. Let me add my welcome to our first quarter earnings call. My comments today, with the exception of revenue and non-op expenses, will be on an adjusted basis which excludes special items outlined in today's press release.
ADI delivered a solid first quarter. Revenue came in line with our outlook as we meaningfully reduced channel inventory. And through our disciplined spending, operating margin and EPS were above the midpoint of guidance. We also raised our quarterly dividend to $0.62, an increase of 15%, the high end of our target range of 7% to 15%.
The dividend is the cornerstone of our capital allocation policy, and this represents the 17th increase over the last 16 years. These consistent increases reflect our commitment to strong shareholder returns as well as our optimism about the long-term prospects for our business.
Before getting into the income statement, let me first cover the end markets. In line with our expectations, our first quarter B2B revenue declined 15% year-over-year as better-than-expected industrial demand was balanced by softer communications activity. Industrial, which represented 53% of revenue during the quarter, declined 7% year-over-year. As we forecasted, most applications within this highly diversified business declined, while aerospace and defense once again grew double digits year-over-year.
Communications, which represents 18% of revenue during the quarter, decreased 31% year-over-year as wireless and wired both declined. While communications is an inherently lumpy market, our position has never been stronger or more balanced across the ecosystem. We are at the early stages of the global 5G rollout, which we continue to expect will be a multiyear tailwind.
Our auto business, which represented 16% of revenues during the quarter, declined 16% year-over-year due to weakness across all applications. As Vince highlighted, we remain confident in auto due to our strong pipeline of customer wins, especially in our infotainment platform and our market-leading BMS position.
And lastly, consumer, which represents 13% of revenue during the first quarter, declined 20% due to portable applications. As we said in our last earnings call, we expect 2020 to be the bottom for our consumer segment.
Now on to the P&L. Gross margin came in at 68.5%, up slightly sequentially and down 180 basis points year-over-year as favorable mix was offset by lower utilization. As a reminder, fab utilization was near trough levels this quarter in order to reduce our balance sheet and our channel inventories. OpEx in the quarter was $412 million, down 4% sequentially and down 8% year-over-year. In light of the softer revenue environment, we've curtailed spending and have delivered sequential OpEx declines in each of the past 5 quarters. As a reminder, we plan to exit fiscal 2020 with $50 million of annualized savings across cost of goods sold and OpEx.
Operating margin finished at approximately 37%, above the guided midpoint. Non-op expenses were $47 million, down $3 million sequentially and $9 million year-over-year, driven by lower interest expense. Our tax rate for the quarter was approximately 12%. All told, first quarter adjusted EPS came in above the midpoint of guide at $1.03.
Now moving on to the balance sheet. As we planned, inventory was reduced by about $20 million or 4% sequentially. Despite this reduction, our inventory days increased to 133 due to the lower level of revenue. Recall that our target for inventory days is 115 to 125. But during the process of closing 2 legacy LTC facilities, we do expect to carry an additional 5 to 10 days of bridge inventory to support our customers.
We also reduced channel inventory by approximately $40 million in the first quarter and plan to reduce channel inventory in the second quarter again but to a lesser degree. CapEx in the quarter was $55 million or about 4% of revenue, and we expect to end fiscal 2020 slightly below our 4% long-term target. On a trailing 12-month basis, free cash flow finished at $2 billion or a free cash flow margin of about 35%. Over this period, we have returned more than 100% of our free cash flow to shareholders through dividends and buybacks after debt repayments. We paid approximately $200 million in dividends and repurchased $106 million of our stock in the first quarter. We still plan to pay down between $300 million to $500 million of debt in fiscal 2020.
Now we'll provide some context on our recent business trends and our current view on the coronavirus. In the first quarter, we saw signs of stabilization as we expected. Orders trended better throughout the quarter and have overall remained relatively resilient into the second quarter. However, unsurprisingly, we have begun to see weaker demand in China related to the extended Chinese New Year and ongoing business disruption. As such, our outlook assumes that China demand for industrial, automotive and consumer is minimal for all of February before returning to a more normal level in the last 2 months of our second quarter. And we are assuming an impact on our communications business due to the high likelihood of a delay in the 5G rollout. So while forecasting business dynamics in China is very difficult today, our guidance reflects our best estimates.
So looking ahead to Q2, revenue is expected to be $1.35 billion, plus or minus $50 million. This includes an approximately $70 million revenue reduction due to the near-term risks with -- associated with the coronavirus. And as I said earlier, we expect to reduce channel inventory again but to a much lesser degree than in the first quarter. At the midpoint of $1.35 billion, we expect B2B revenue in the aggregate to increase mid- to high single digits sequentially with growth across all of our B2B markets of industrial, automotive and communications.
Based on the midpoint of guidance, op margin is expected to be up sequentially to approximately 37.5%. We are planning for our tax rate to be between 10% and 12% for the quarter, and we are improving our fiscal 2020 outlook to between 11% and 13%. Based on these inputs, adjusted EPS is expected to be $1.10, plus or minus $0.08.
While we are mindful of the uncertainty around this, I echo Vince's optimism. We are encouraged by near-term trends that point to a stabilization and improvement across end markets, and we are extremely confident in the long-term growth opportunities for ADI.
Let me give it back to Mike now to start our Q&A.
Michael Lucarelli: Thanks, Prashanth. Okay. Let's get to our Q&A session.
Michael Lucarelli: [Operator Instructions] Operator, can we have our first question, please?
Operator: [Operator Instructions] And our first question comes from Vivek Arya from Bank of America.
Jamie Zakalik: This is Jamie Zakalik on for Vivek. So similar to peers, you guys noted some stabilizing and improving trends in end markets in the January quarter, but it seems that growth has actually decelerated across all the end markets. So I guess are the improving trends more in the -- in February, even with a lot of these virus headwinds? And is it specific to any end market or geography? Or is it more broad-based?
Prashanth Mahendra-Rajah: Yes. So Jamie, I think the first quarter was in line with what we expected. So there was deceleration going into the first quarter. Now remember that in this quarter, we undershipped the channel. And as I said in my prepared comments, we undershipped by $40 million. So on a revenue rec basis, PO ship-in was $40 million below sell-through. As we go into the second quarter, orders were improving over the course of the first quarter, and we expect that to continue into the second quarter with this note that we made on disruption in China where we believe some of this demand is going to get pushed out to future quarters. So I do think that our view here is that we've sort of bottomed out and it gets better from here through subsequent quarters.
Vincent Roche: Yes. Maybe I can add a little bit of color as well from a market perspective on that. So what we're seeing is -- in spite of what looks like a delayed 5G employment -- deployment in China, in the second quarter, we're expecting growth, actually quite good growth, in our communications 5G sector as well as wireline. And that growth is becoming a little more broad-based. We're seeing, I would say, green shoots in the factory automation and process control side of things as well, which is a significant part of ADI's industrial business, and also gathering strength in the ATE sector. And from an automotive standpoint, we're seeing particular strength in our business in America as well as Europe at this point in time.
Operator: And our next question comes from Tore Svanberg from Stifel.
Tore Svanberg: Yes. Vince, I was hoping you could elaborate a little bit more there on 5G. You said it's becoming a more broad-based business. Just trying to understand geographically where the growth is coming from, because, obviously, it's not coming from China near term. So if you could elaborate on that, that'd be great.
Vincent Roche: Well, I think, Tore, China has taken a pause. Asia is still, at this point in time, in terms of deployments today, Asia is by far the strongest in 5G. I think what we're seeing is the -- probably a faster roll off in 4G than we had anticipated. 5G has taken a bit of a pause in China but is set -- based on what we see in terms of demand, is set for a ramp during the second quarter. And also, I pointed out that wireline for ADI in general, whether it's data center, whether it's metro or long-haul networks, is doing quite well. So as we've come into the second quarter, our book-to-bill has been -- is well above 1, and that gives us the confidence in the growing strength of that business through the second quarter here.
Michael Lucarelli: Tore, do you have a follow-up?
Tore Svanberg: Yes. Just a quick one. Prashanth, you did a good job lowering channel inventory. It sounds like you're going to lower a bit more again this quarter. Could you maybe give us some targets either by weeks or what dollar amount are you trying to lower than buy?
Prashanth Mahendra-Rajah: Well, I think, Tore, we had mentioned in the -- in our first quarter -- or fourth quarter call that our goal was to get back to our target range by the end of the second quarter. It may take us a little bit longer now given we didn't include the impact of the coronavirus in the top line. So we're still heading towards the same channel inventory target that we'd had before but with a bit of a softer top line. I think it might actually be end of third quarter before we're back in range.
Operator: Our next question comes from Toshiya Hari from Goldman Sachs.
Toshiya Hari: Your automotive business was down 16% in the quarter, which was in line with your guidance. But relative to peers, a little worse on a year-over-year basis. Vince and Prashanth, you guys talked about your optimism around some of the design win activities in BMS and infotainment. But in the near term, what's driving kind of the double-digit decline in your automotive business? Is that mostly channel inventory reduction? Or are you losing share? I guess, more importantly, how are you guys thinking about kind of the through-cycle growth rate for your automotive business over the next couple of years?
Vincent Roche: Yes. Well, look, we have been very, very clear. The 2 growth drivers for ADI in the automotive sector are the infotainment area, A2B, active noise cancellation, audio signal processing in general. And of course, BMS has been, over the last couple of years, a double-digit growth driver for ADI. I think in the quarter just passed, BMS, which has a route -- a strong route in China, suffered as a result of the virus. And -- but when we look into the second quarter, we expect our -- as I said, our second quarter has better trends in North America and Europe. So we're expecting modest growth in the second quarter.
The headwind for ADI has really been the safety sector where our 24-gigahertz radar technology is declining, probably at a rate a little faster than I had expected. And also in the area of MEMS, more of the kind of the passive safety MEMS where we withdrew investment 3 or 4 years ago. So I think we'll begin to bottom out, I think, on those headwinds, specific to safety. We have a new safety modality in 77 gigahertz, which is, by all accounts, very, very exciting for our customers. We will see bottoming, I think, of the MEMS and the 24-gigahertz radar decline.
So my sense is in the areas we've picked of powertrain, infotainment, we're very, very well positioned to grow those sectors over the next 2, 3, 4 years.
Operator: And our next question comes from Ambrish Srivastava from BMO.
Ambrish Srivastava: Prashanth, I had a question on the actual weeks of channel inventory, and I might have missed it, but did you give an actual number? I think you were 8.5 weeks in the prior quarter.
Prashanth Mahendra-Rajah: We did not give a number, Ambrish. The -- what I mentioned is we took the channel inventory down $40 million. But if you do the math, we're still going to be above our target range because the revenue -- the numerator has moved, but the denominator has also shrunk.
So on a ratio standpoint, the weeks are still high, but we did take a big chunk out, and we're going to take more out in Q2, as we mentioned.
Michael Lucarelli: Do you have a follow-up, Ambrish?
Ambrish Srivastava: I did. Vince, maybe for you. In 2 areas, real quick on industrials. What's the right way to think about, given what's going on in China and broader, how to think about return to growth in the industrials business? You guys outperformed last year, but what -- how should we think about year-over-year growth returning?
And then in comms, we always ask you about wireless. I had a slightly different question. How is -- how are you guys positioned in wireline versus if you look back at 2, 3 years ago? And then what gets you excited about the design wins in -- that should be ramping out in wireline?
Vincent Roche: Thanks, Ambrish. Let me try and address the industrial question first. So we are seeing our aerospace and defense business continue to grow at double-digit rates annually. We are seeing, as I said a little earlier on, the factory automation side of things outside of Asia is on, I'd say, a solid improvement in its demand pattern. I think inventory hangover has largely been taken out of the equation in the industrial sector.
So I think when you look -- when we look at the impact of the virus in China, we're not expecting really anything in the industrial sector in terms of shipments there for the month of February. But all that said, we're -- we have a very solid book-to-bill in the industrial sector, and we will get, I think, a decent increase in our top line in industrial during the second quarter.
On the wireline side of things, our game there is really 2 pieces. We have a very strong -- we have a strong leadership position in optical control systems for data centers. So all of the FANGs, for example, would use our technology in their data centers for control of the optical signal chain and also the cable market, we have a good position there in infrastructure systems. So wireline business has been growing high single digits now for several years, and I don't see any decline in that. I think that will be a decent growth driver for ADI. It runs into the region of $400 million annually in terms of sales at the present time. So I view that very much, Ambrish, as a tailwind for the company.
Michael Lucarelli: Yes. Let me also add on the industrial side, we did take down general inventory meaningfully. A lot of that relates to industrial. And if you look at industrial, you kind of zoom out and you look at it on a trailing 12-month basis, we're only down low single digits, which is a pretty good performance in a tough macro backdrop, and that goes to the diversity of that business.
Operator: Our next question comes from Mitch Steves from RBC Capital Markets.
Mitch Steves: Great quarter. But I just wanted to clarify a couple of things. I think you guys have done a very good job now kind of talking about your capital allocation, but what I'm having a hard time understanding is kind of the margin mix here. I realize that space and satellite is probably higher margin. I'm guessing like 80%, 90% gross margin. You guys are actually coming down a bit on the gross margin line. Can you maybe talk us through what the gross margin profile should look like in the first half and the second half? And then how that would flow through the operating margin line as well?
Prashanth Mahendra-Rajah: Sure. Yes. Thanks for the question, Mitch. So I guess, a little bit of background, right? Our model is 70% gross margins sort of long-term model. And in good times, we were operating at 72%. In more challenging times, like now, we're down in the high 60s. So through the cycle, 70%. As we move forward from here, we see 2 things that are going to be impacting margins, both utilization and mix.
So Q1 represented the trough level of our utilization expectations for the year. So a fair amount of under absorption in our internal manufacturing facilities, that gets better from here on, and that will be tailwind to margins. And also as some of the questions that were asked, Vince mentioned the strength in industrial. We expect industrial to continue to be growing as we move forward. And industrial, in general, is one of our highest margin businesses, so that will also provide tailwind.
So we -- I would expect that you could see sequential improvement in gross margins through the balance of this year likely getting back to our model margins in the second half, maybe towards the end of the year.
Mitch Steves: Okay. That's very helpful. And then I just have one follow-up. Just in terms of the seasonality for the business. I think maybe you should probably be taking a little bit of a more conservative view in April just because it sounds like China is going to open up March 1. But when I look at the July quarter going from April to July, should that be, I guess, above seasonal, given that April is depressed from all the macro items that are going on?
Prashanth Mahendra-Rajah: All right. So the guide for our second quarter included a $70 million adjustment that we made at the top for the impact of the coronavirus. And the math that we use to arrive at that is we essentially zeroed out February in China for industrial and auto and consumer, and then we also made an adjustment for communications being pushed -- or the deployment of 5G being pushed out a bit just because of the labor challenges that are going on there. We expect that to begin unwinding in the subsequent months and certainly be back to normal in the third quarter.
Could it be above normal? That's certainly a possibility. It depends on the timing of how that $70 million comes back. It's our current view that, that is purely a timing shift that, that is not lock demand. But as to when that falls back in, it's hard to say, but the order activity certainly suggests that it's not going away.
Operator: Our next question comes from Stacy Rasgon from Bernstein Research.
Stacy Rasgon: I wanted to zero in first on comm. So it sounds like you're pushing it out. Your prior guidance for comm last year was for it to grow year-over-year, and it feels like you're backing away from that. But the trajectory in the second half on the old guidance was for very strong sequential growth kind of every quarter going forward. How should we be thinking about the trajectory of comm in the second half, I guess, given, I guess, the bump in Q2 versus the profile that was -- that you had in mind 3 months ago when you gave guidance? Do you still expect to see a similar ramp maybe just off a lower base?
Prashanth Mahendra-Rajah: Yes. So I guess a few things, Stacy. For the first quarter, a little bit lower than we expected, mainly due to the 5G pause that started in the second half of '19. Moving into the second quarter, orders have begun to come back in very much as we expected, and our book-to-bill is above 1. So that's supporting a strong sequential increase in second quarter for both 5G, but also as Vince mentioned, we're seeing some good strength in wireline as has been reported by a number of peers as well.
The sequential increase is below our initial expectations because of the -- a lot of that was related to 5G timing in China. So I think everything is moving a little bit to the right here. So it's hard for us to say at this point whether the timing of that recovery is still going to put us up year-on-year, but I think we'll have to see how quickly this demand recovers and whether the installations happen as -- is it caught up in the year or not? But we feel very good that this is really a dislocation of demand versus actual loss or destruction.
Vincent Roche: Yes. I'd say one other comment on that, Stacy. Our optimism about what's happening in America relating to 5G has strengthened over the past quarter as well. So yes, we have the disruption in China. It's really a delay of demand rather than destruction. But my own sense is that we probably see more activity at the back end of the year in the U.S. relating to 5G.
Michael Lucarelli: Do you have a follow-up Stacy?
Stacy Rasgon: I do. So it sounds like also, even though we have the delay because of coronavirus in China, that the order patterns still seem to be very strong. How do we think about the strength of those Chinese orders in relation to potential increases in sanctions that we've been hearing about? Do you feel like there's any sort of scramble on the part of Chinese customers to get out in front of those sanctions? I guess what are you seeing in terms of customer behavior in relation to the regulatory?
Vincent Roche: Yes. I think, first off, when you look at the geopolitical machinations, it's actually very hard to figure out what's going on. So -- but I think with our business in general, we have many thousands of customers in China, many thousands of product SKUs, and we see ongoing demand. There are obviously areas where we are restricted, particularly in 5G, but I think the rest of our business right now is in a kind of a normalized market and regulatory situation.
So the demand we're seeing is -- despite the disruption here because of the virus, the demand in China is actually quite strong across the board otherwise.
Stacy Rasgon: Let me rephrase the question. If, all of a sudden, like the de minimis threshold gets dropped from 25% to 10% and the foreign direct products will get strengthened, and they put more stuff on the controllers, does that impact how you guys view the trajectory in China as we go through the year? Would you have to reevaluate what you can ship and what you can't?
Prashanth Mahendra-Rajah: Well, yes, we would have to reevaluate. But remember that we have adjusted one large communications customer down from traditional mid-single to low single-digit as a percentage of revenue. So that is kind of -- that's the limit of our exposure depending on what happens to that particular customer.
Vincent Roche: Yes. I think it very much depends on the scope of what happens. And so far, everything we've seen is relating to one specific area of communication. So unknown, Stacy, but we'll see. Time will tell.
Operator: And our next question comes from Craig Hettenbach from Morgan Stanley.
Craig Hettenbach: Just wanted to follow on the comments about the opportunity to double Linear's growth in the coming years. And Prashanth, if you could talk about -- I know there's some gross margin levers as you consolidate manufacturing and just kind of how you're viewing on that in terms of the growth profile versus kind of margins for Linear in the next couple of years.
Prashanth Mahendra-Rajah: Sure, sure. So I'll take the margin side of it. And then in terms of doubling the growth, I'll let Vince comment. On the margin side of it, we have talked about the focus we've got on shutting down 2 facilities. We've taken -- we've made announcements on those. We've actually been able to accelerate some of the savings for the -- for one of the factory closures, so we're going to start seeing some of that benefit in cost of goods sale at the end of this year. But the balance of that $100 million, we see feathering in over 2021. And as we've stated in the Q4 earnings call, our intention is to let -- to kind of let all of that come through the bottom line. So we are not -- we're not looking to redeploy that cost of goods savings. So you should see some lift in our gross margins on an ongoing basis as we exit 2020 and through 2021.
In terms of kind of the progress we're making to double that Linear growth rate, let me hand that off to Vince.
Vincent Roche: Yes. So I think we're making good progress, Craig, in trying to equalize the value of the kind of legacy ADI mixed-signal technology value in a given application with power. So we're looking for equivalents. For every dollar of mixed signal, we expect to get $1 of power. And that's what the market opportunity available is.
I can tell you that our pipeline for the LTC portfolio, specifically power, is up about 40% actually year-over-year. And we're moving into production down the automotive sector, the communication wireless sector. Wired, we're in early volume production as well. So we expect to see those areas ramp in terms of meaningful impact on the top line during 2021. And there are many, many, many new sockets in the industrial area that we're working on. So that will just take a little longer given the slower uptake in terms of turning design-ins to revenue.
But I think a lot like Hittite. We feel -- we went through this process with Hittite. We've doubled the size of that company, that franchise over the last 5 years. And I think we're on a very good track right now with LTE to achieving 200, 300 basis points of top line growth based on the strength of the portfolio and the activity at the customer level that we're seeing.
Operator: Our next question comes from Harlan Sur from JPMorgan.
Harlan Sur: Good to see the fundamentals starting to improve here. A&D grew greater than 20% last year. Defense budget was approved beginning of this year. It's strong, up 4% versus last year. It's -- and you guys expect double-digit -- continued double-digit year-over-year growth here this year in A&D. Is most of the strength coming from the defense segment? Or are there also programs in the commercial aerospace SATCOM sector that are starting to fire as well?
Vincent Roche: Yes. As I said in the prepared remarks, obviously, defense budgets are in our favor in terms of buying technology and deploying it. So we're in good shape there. And yes, we're seeing strong double-digit growth in the space area as well. And that's relatively -- we've had a good position there. But the -- if you like, the explosion in the launch of LEO satellites and geo satellites is really increasing demand for the company. And we're looking at, in these applications, many thousands of dollars of content per satellite kind of thing. So we're very optimistic about that, but it's a combination of both. Both parts of that business are really growing well.
Prashanth Mahendra-Rajah: Harlan, I would say, remember, think about defense as when DoD gives the money to the primes and the primes start deploying it, this is going into design decisions that were made many years ago. So we're enjoying the flow of that larger budget into the primes. And then to us, for decisions that were made some time ago, we still have quite a bit of great design activity that has yet to be funded. So that's on to come.
On the aerospace side, it's holding as well as can be expected given the environment that's going on there. And then in space, as Vince mentioned, space is really in front of us, that growth is in front of us. So while ADEF has been growing at a nice clip and continues to, we feel even more optimistic about what's in front of us coming both from space and future design win activity that's happened for the defense business.
Operator: And our last question comes from William Stein from SunTrust.
William Stein: 2 of them, really. First, I'm hoping you can provide some update or commentary as to the competitive situation and maybe the legal competitive situation with an FPGA supplier in high-performance converters, maybe competitive trends as to design win traction relative to that vendor.
Vincent Roche: Well, broadly speaking, in terms of competition, we are -- we've outgrown our closest competitors for the last 3 years. And so we're clearly gaining share across the board in communications and industrial, in particular. So I think competitively, we're in good shape. I think pricing is very, very stable as well. So I think, overall, legacy is strong. Our design pipeline is strong. And we're excited about the new R&D programs as well that are coming to fruition for the company.
In relation to the litigation with, as you said, a large FPGA company, we will give you -- as new information emerges, we'll be transparent with you, and we'll communicate with you. But at this point, all I can say is that we're confident that this matter is going through the court and will be successfully resolved. And we are defending our IP very aggressively, and we believe we have a very, very strong case. So that's where it is. It's within the courts, but we're very optimistic with how things are going.
Michael Lucarelli: You said you had a follow-up, Will?
William Stein: Yes. I appreciate that. Just on the COVID impact. It sounds like what you're saying is that you're assuming certain orders are 0 for February. Given we're February 19th, I assume that's actually what you're seeing in the order book. Is there any anticipation for weakness later in the quarter? And also, any supply disruption that you're noticing at all?
Prashanth Mahendra-Rajah: Sure. So on the orders, as I mentioned in the prepared remarks, it is very hard to kind of size the activity of what's going on in China. So when we arrived at our $70 million, we wanted to give the investor and analyst community what assumptions are we using, knowing that these are very dynamic. So for our assumptions, we've taken our China activity to 0 in February and pushed out a little bit of 5G. The -- on the supply chain side, we are not seeing much disruption at this standpoint. We had some of our back-end suppliers early on. We're struggling just with getting some labor in to run their activity, but that's also been resolved as time has settled out here. So from our standpoint, our supply chain -- and we just revalidated this with the guys this morning. Our supply chain, we feel good about.
Michael Lucarelli: Thanks, Will. I'll also add, I think it might be helpful, given your question, kind of given our outlook of B2B, what we think each market is going to do because there seems a little bit of confusion out there of how we think the market is going to do. We think each market grows sequentially. We said, in total, B2B will be up mid- to high single digits. I will rank order those on priority, I'd say comms is a little better than that, industrial does in line with the overall outlook, and auto does a little bit worse. So that kind of helps you think of how the -- sorry, how the corona is impacting our business.
And with that, thank you, everyone, for joining us. A copy of the transcript will be available on our website, and all available reconciliations and information can also be found on the quarterly results section of our website. Thanks again for joining us and the continued interest in Analog Devices.
Operator: And this concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning. And welcome to the Analog Devices First Quarter Fiscal Year 2020 Earnings Conference Call, which is being audio webcast via telephone and over the web."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Cheryl. And good morning, everybody. Thanks for joining our first quarter fiscal 2020 conference call."
},
{
"speaker": "Vincent Roche",
"text": "Thanks, Mike, and good morning to everybody. While our first quarter results were in line with our expectations, as you'll have seen, importantly, we managed our operating costs and working capital effectively to position ourselves to deliver margin expansion in the quarters ahead."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Let me add my welcome to our first quarter earnings call. My comments today, with the exception of revenue and non-op expenses, will be on an adjusted basis which excludes special items outlined in today's press release."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. Okay. Let's get to our Q&A session."
},
{
"speaker": "Michael Lucarelli",
"text": "[Operator Instructions] Operator, can we have our first question, please?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question comes from Vivek Arya from Bank of America."
},
{
"speaker": "Jamie Zakalik",
"text": "This is Jamie Zakalik on for Vivek. So similar to peers, you guys noted some stabilizing and improving trends in end markets in the January quarter, but it seems that growth has actually decelerated across all the end markets. So I guess are the improving trends more in the -- in February, even with a lot of these virus headwinds? And is it specific to any end market or geography? Or is it more broad-based?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. So Jamie, I think the first quarter was in line with what we expected. So there was deceleration going into the first quarter. Now remember that in this quarter, we undershipped the channel. And as I said in my prepared comments, we undershipped by $40 million. So on a revenue rec basis, PO ship-in was $40 million below sell-through. As we go into the second quarter, orders were improving over the course of the first quarter, and we expect that to continue into the second quarter with this note that we made on disruption in China where we believe some of this demand is going to get pushed out to future quarters. So I do think that our view here is that we've sort of bottomed out and it gets better from here through subsequent quarters."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Maybe I can add a little bit of color as well from a market perspective on that. So what we're seeing is -- in spite of what looks like a delayed 5G employment -- deployment in China, in the second quarter, we're expecting growth, actually quite good growth, in our communications 5G sector as well as wireline. And that growth is becoming a little more broad-based. We're seeing, I would say, green shoots in the factory automation and process control side of things as well, which is a significant part of ADI's industrial business, and also gathering strength in the ATE sector. And from an automotive standpoint, we're seeing particular strength in our business in America as well as Europe at this point in time."
},
{
"speaker": "Operator",
"text": "And our next question comes from Tore Svanberg from Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Vince, I was hoping you could elaborate a little bit more there on 5G. You said it's becoming a more broad-based business. Just trying to understand geographically where the growth is coming from, because, obviously, it's not coming from China near term. So if you could elaborate on that, that'd be great."
},
{
"speaker": "Vincent Roche",
"text": "Well, I think, Tore, China has taken a pause. Asia is still, at this point in time, in terms of deployments today, Asia is by far the strongest in 5G. I think what we're seeing is the -- probably a faster roll off in 4G than we had anticipated. 5G has taken a bit of a pause in China but is set -- based on what we see in terms of demand, is set for a ramp during the second quarter. And also, I pointed out that wireline for ADI in general, whether it's data center, whether it's metro or long-haul networks, is doing quite well. So as we've come into the second quarter, our book-to-bill has been -- is well above 1, and that gives us the confidence in the growing strength of that business through the second quarter here."
},
{
"speaker": "Michael Lucarelli",
"text": "Tore, do you have a follow-up?"
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Just a quick one. Prashanth, you did a good job lowering channel inventory. It sounds like you're going to lower a bit more again this quarter. Could you maybe give us some targets either by weeks or what dollar amount are you trying to lower than buy?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Well, I think, Tore, we had mentioned in the -- in our first quarter -- or fourth quarter call that our goal was to get back to our target range by the end of the second quarter. It may take us a little bit longer now given we didn't include the impact of the coronavirus in the top line. So we're still heading towards the same channel inventory target that we'd had before but with a bit of a softer top line. I think it might actually be end of third quarter before we're back in range."
},
{
"speaker": "Operator",
"text": "Our next question comes from Toshiya Hari from Goldman Sachs."
},
{
"speaker": "Toshiya Hari",
"text": "Your automotive business was down 16% in the quarter, which was in line with your guidance. But relative to peers, a little worse on a year-over-year basis. Vince and Prashanth, you guys talked about your optimism around some of the design win activities in BMS and infotainment. But in the near term, what's driving kind of the double-digit decline in your automotive business? Is that mostly channel inventory reduction? Or are you losing share? I guess, more importantly, how are you guys thinking about kind of the through-cycle growth rate for your automotive business over the next couple of years?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Well, look, we have been very, very clear. The 2 growth drivers for ADI in the automotive sector are the infotainment area, A2B, active noise cancellation, audio signal processing in general. And of course, BMS has been, over the last couple of years, a double-digit growth driver for ADI. I think in the quarter just passed, BMS, which has a route -- a strong route in China, suffered as a result of the virus. And -- but when we look into the second quarter, we expect our -- as I said, our second quarter has better trends in North America and Europe. So we're expecting modest growth in the second quarter."
},
{
"speaker": "Operator",
"text": "And our next question comes from Ambrish Srivastava from BMO."
},
{
"speaker": "Ambrish Srivastava",
"text": "Prashanth, I had a question on the actual weeks of channel inventory, and I might have missed it, but did you give an actual number? I think you were 8.5 weeks in the prior quarter."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "We did not give a number, Ambrish. The -- what I mentioned is we took the channel inventory down $40 million. But if you do the math, we're still going to be above our target range because the revenue -- the numerator has moved, but the denominator has also shrunk."
},
{
"speaker": "Michael Lucarelli",
"text": "Do you have a follow-up, Ambrish?"
},
{
"speaker": "Ambrish Srivastava",
"text": "I did. Vince, maybe for you. In 2 areas, real quick on industrials. What's the right way to think about, given what's going on in China and broader, how to think about return to growth in the industrials business? You guys outperformed last year, but what -- how should we think about year-over-year growth returning?"
},
{
"speaker": "Vincent Roche",
"text": "Thanks, Ambrish. Let me try and address the industrial question first. So we are seeing our aerospace and defense business continue to grow at double-digit rates annually. We are seeing, as I said a little earlier on, the factory automation side of things outside of Asia is on, I'd say, a solid improvement in its demand pattern. I think inventory hangover has largely been taken out of the equation in the industrial sector."
},
{
"speaker": "Michael Lucarelli",
"text": "Yes. Let me also add on the industrial side, we did take down general inventory meaningfully. A lot of that relates to industrial. And if you look at industrial, you kind of zoom out and you look at it on a trailing 12-month basis, we're only down low single digits, which is a pretty good performance in a tough macro backdrop, and that goes to the diversity of that business."
},
{
"speaker": "Operator",
"text": "Our next question comes from Mitch Steves from RBC Capital Markets."
},
{
"speaker": "Mitch Steves",
"text": "Great quarter. But I just wanted to clarify a couple of things. I think you guys have done a very good job now kind of talking about your capital allocation, but what I'm having a hard time understanding is kind of the margin mix here. I realize that space and satellite is probably higher margin. I'm guessing like 80%, 90% gross margin. You guys are actually coming down a bit on the gross margin line. Can you maybe talk us through what the gross margin profile should look like in the first half and the second half? And then how that would flow through the operating margin line as well?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Sure. Yes. Thanks for the question, Mitch. So I guess, a little bit of background, right? Our model is 70% gross margins sort of long-term model. And in good times, we were operating at 72%. In more challenging times, like now, we're down in the high 60s. So through the cycle, 70%. As we move forward from here, we see 2 things that are going to be impacting margins, both utilization and mix."
},
{
"speaker": "Mitch Steves",
"text": "Okay. That's very helpful. And then I just have one follow-up. Just in terms of the seasonality for the business. I think maybe you should probably be taking a little bit of a more conservative view in April just because it sounds like China is going to open up March 1. But when I look at the July quarter going from April to July, should that be, I guess, above seasonal, given that April is depressed from all the macro items that are going on?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "All right. So the guide for our second quarter included a $70 million adjustment that we made at the top for the impact of the coronavirus. And the math that we use to arrive at that is we essentially zeroed out February in China for industrial and auto and consumer, and then we also made an adjustment for communications being pushed -- or the deployment of 5G being pushed out a bit just because of the labor challenges that are going on there. We expect that to begin unwinding in the subsequent months and certainly be back to normal in the third quarter."
},
{
"speaker": "Operator",
"text": "Our next question comes from Stacy Rasgon from Bernstein Research."
},
{
"speaker": "Stacy Rasgon",
"text": "I wanted to zero in first on comm. So it sounds like you're pushing it out. Your prior guidance for comm last year was for it to grow year-over-year, and it feels like you're backing away from that. But the trajectory in the second half on the old guidance was for very strong sequential growth kind of every quarter going forward. How should we be thinking about the trajectory of comm in the second half, I guess, given, I guess, the bump in Q2 versus the profile that was -- that you had in mind 3 months ago when you gave guidance? Do you still expect to see a similar ramp maybe just off a lower base?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. So I guess a few things, Stacy. For the first quarter, a little bit lower than we expected, mainly due to the 5G pause that started in the second half of '19. Moving into the second quarter, orders have begun to come back in very much as we expected, and our book-to-bill is above 1. So that's supporting a strong sequential increase in second quarter for both 5G, but also as Vince mentioned, we're seeing some good strength in wireline as has been reported by a number of peers as well."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I'd say one other comment on that, Stacy. Our optimism about what's happening in America relating to 5G has strengthened over the past quarter as well. So yes, we have the disruption in China. It's really a delay of demand rather than destruction. But my own sense is that we probably see more activity at the back end of the year in the U.S. relating to 5G."
},
{
"speaker": "Michael Lucarelli",
"text": "Do you have a follow-up Stacy?"
},
{
"speaker": "Stacy Rasgon",
"text": "I do. So it sounds like also, even though we have the delay because of coronavirus in China, that the order patterns still seem to be very strong. How do we think about the strength of those Chinese orders in relation to potential increases in sanctions that we've been hearing about? Do you feel like there's any sort of scramble on the part of Chinese customers to get out in front of those sanctions? I guess what are you seeing in terms of customer behavior in relation to the regulatory?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think, first off, when you look at the geopolitical machinations, it's actually very hard to figure out what's going on. So -- but I think with our business in general, we have many thousands of customers in China, many thousands of product SKUs, and we see ongoing demand. There are obviously areas where we are restricted, particularly in 5G, but I think the rest of our business right now is in a kind of a normalized market and regulatory situation."
},
{
"speaker": "Stacy Rasgon",
"text": "Let me rephrase the question. If, all of a sudden, like the de minimis threshold gets dropped from 25% to 10% and the foreign direct products will get strengthened, and they put more stuff on the controllers, does that impact how you guys view the trajectory in China as we go through the year? Would you have to reevaluate what you can ship and what you can't?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Well, yes, we would have to reevaluate. But remember that we have adjusted one large communications customer down from traditional mid-single to low single-digit as a percentage of revenue. So that is kind of -- that's the limit of our exposure depending on what happens to that particular customer."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think it very much depends on the scope of what happens. And so far, everything we've seen is relating to one specific area of communication. So unknown, Stacy, but we'll see. Time will tell."
},
{
"speaker": "Operator",
"text": "And our next question comes from Craig Hettenbach from Morgan Stanley."
},
{
"speaker": "Craig Hettenbach",
"text": "Just wanted to follow on the comments about the opportunity to double Linear's growth in the coming years. And Prashanth, if you could talk about -- I know there's some gross margin levers as you consolidate manufacturing and just kind of how you're viewing on that in terms of the growth profile versus kind of margins for Linear in the next couple of years."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Sure, sure. So I'll take the margin side of it. And then in terms of doubling the growth, I'll let Vince comment. On the margin side of it, we have talked about the focus we've got on shutting down 2 facilities. We've taken -- we've made announcements on those. We've actually been able to accelerate some of the savings for the -- for one of the factory closures, so we're going to start seeing some of that benefit in cost of goods sale at the end of this year. But the balance of that $100 million, we see feathering in over 2021. And as we've stated in the Q4 earnings call, our intention is to let -- to kind of let all of that come through the bottom line. So we are not -- we're not looking to redeploy that cost of goods savings. So you should see some lift in our gross margins on an ongoing basis as we exit 2020 and through 2021."
},
{
"speaker": "Vincent Roche",
"text": "Yes. So I think we're making good progress, Craig, in trying to equalize the value of the kind of legacy ADI mixed-signal technology value in a given application with power. So we're looking for equivalents. For every dollar of mixed signal, we expect to get $1 of power. And that's what the market opportunity available is."
},
{
"speaker": "Operator",
"text": "Our next question comes from Harlan Sur from JPMorgan."
},
{
"speaker": "Harlan Sur",
"text": "Good to see the fundamentals starting to improve here. A&D grew greater than 20% last year. Defense budget was approved beginning of this year. It's strong, up 4% versus last year. It's -- and you guys expect double-digit -- continued double-digit year-over-year growth here this year in A&D. Is most of the strength coming from the defense segment? Or are there also programs in the commercial aerospace SATCOM sector that are starting to fire as well?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. As I said in the prepared remarks, obviously, defense budgets are in our favor in terms of buying technology and deploying it. So we're in good shape there. And yes, we're seeing strong double-digit growth in the space area as well. And that's relatively -- we've had a good position there. But the -- if you like, the explosion in the launch of LEO satellites and geo satellites is really increasing demand for the company. And we're looking at, in these applications, many thousands of dollars of content per satellite kind of thing. So we're very optimistic about that, but it's a combination of both. Both parts of that business are really growing well."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Harlan, I would say, remember, think about defense as when DoD gives the money to the primes and the primes start deploying it, this is going into design decisions that were made many years ago. So we're enjoying the flow of that larger budget into the primes. And then to us, for decisions that were made some time ago, we still have quite a bit of great design activity that has yet to be funded. So that's on to come."
},
{
"speaker": "Operator",
"text": "And our last question comes from William Stein from SunTrust."
},
{
"speaker": "William Stein",
"text": "2 of them, really. First, I'm hoping you can provide some update or commentary as to the competitive situation and maybe the legal competitive situation with an FPGA supplier in high-performance converters, maybe competitive trends as to design win traction relative to that vendor."
},
{
"speaker": "Vincent Roche",
"text": "Well, broadly speaking, in terms of competition, we are -- we've outgrown our closest competitors for the last 3 years. And so we're clearly gaining share across the board in communications and industrial, in particular. So I think competitively, we're in good shape. I think pricing is very, very stable as well. So I think, overall, legacy is strong. Our design pipeline is strong. And we're excited about the new R&D programs as well that are coming to fruition for the company."
},
{
"speaker": "Michael Lucarelli",
"text": "You said you had a follow-up, Will?"
},
{
"speaker": "William Stein",
"text": "Yes. I appreciate that. Just on the COVID impact. It sounds like what you're saying is that you're assuming certain orders are 0 for February. Given we're February 19th, I assume that's actually what you're seeing in the order book. Is there any anticipation for weakness later in the quarter? And also, any supply disruption that you're noticing at all?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Sure. So on the orders, as I mentioned in the prepared remarks, it is very hard to kind of size the activity of what's going on in China. So when we arrived at our $70 million, we wanted to give the investor and analyst community what assumptions are we using, knowing that these are very dynamic. So for our assumptions, we've taken our China activity to 0 in February and pushed out a little bit of 5G. The -- on the supply chain side, we are not seeing much disruption at this standpoint. We had some of our back-end suppliers early on. We're struggling just with getting some labor in to run their activity, but that's also been resolved as time has settled out here. So from our standpoint, our supply chain -- and we just revalidated this with the guys this morning. Our supply chain, we feel good about."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Will. I'll also add, I think it might be helpful, given your question, kind of given our outlook of B2B, what we think each market is going to do because there seems a little bit of confusion out there of how we think the market is going to do. We think each market grows sequentially. We said, in total, B2B will be up mid- to high single digits. I will rank order those on priority, I'd say comms is a little better than that, industrial does in line with the overall outlook, and auto does a little bit worse. So that kind of helps you think of how the -- sorry, how the corona is impacting our business."
},
{
"speaker": "Operator",
"text": "And this concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 4 | 2,021 | 2021-11-23 10:00:00 | Operator: Good morning, and welcome to the Analog Devices Fourth Quarter and Fiscal Year 2021 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations. Sir, the floor is yours.
Michael Lucarelli: Thank you, Stephanie, and good morning, everybody. Thanks for joining our fourth quarter and fiscal 2021 conference call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now on to the disclosures. The information are about to discuss in forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release, ADI and Maxim's periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. Please note we published a table on our Investor web page of historical pro forma combined end market revenue aligned to ADI fiscal quarters. As part of this exercise, we also mapped subsegments to match ADI's groupings. As a result of this reclassification, about $150 million of annual revenue moved from industrial and communications to consumer for the Maxim business. And with that, I'll turn it over to ADI CEO, Vincent Roche. Vince?
Vincent Roche: Thank you very much, Mike, and a very good morning to you all. Well, once again, we delivered record revenue and profits in our fourth quarter, closing out what was a milestone year for ADI. Our success was driven by our industry leading high performance portfolio and our team's strong operational execution, enabling us to better meet the insatiable demand for our products. Now stepping back a little. 2021 truly demonstrated the vital importance of semiconductors to the modern digital age. We invested ahead of this inflection, building a comprehensive portfolio to better solve our customers' most complex problems in this ubiquitously sensed and connected world. As we enter 2022, our backlog and bookings remain robust and we continue to invest in manufacturing capacity, positioning us well for another successful year ahead. Now moving on to our results. Our fourth quarter revenue was $2.34 billion and EPS was $1.73, both exceeding the midpoint of guidance. And for 2021, our revenue was $7.32 billion and EPS was $6.46. Looking at our organic ADI. We delivered new high watermarks on revenue and profits. Industrial and automotive achieved record revenue this year, while consumer returns to annual growth for the first time since 2017. And communications revenue declined its continued strength and wired was offset by weakness in wireless related to the China market. In 2021, we generated a record $2.4 billion of free cash flow, equating to a free cash flow margin of approximately 33%. This maintains our position in the top 10% of the S&P 500. In line with our revised capital allocation strategy to return 100% of free cash flow, we returned $3.7 billion to shareholders in 2021 through dividends and share buybacks. It was not only a record year for performance and shareholder returns but also for investments that position us to better capture market opportunities presented by secular growth drivers in our business. First, we took decisive action to add capacity throughout the year with more than $340 million in capital expenditures. This is enabling us to better navigate the near-term supply/demand imbalance while achieving our long-term growth objectives. And in 2022, we're planning to expand our internal manufacturing capacity at our factories in the US and Europe. These additional investments will create more profitable, flexible and resilient manufacturing capabilities at ADI. Now at our core, we're an innovation driven enterprise. And together with Maxim, we will invest more than $1.6 billion in R&D annually to ensure we continue developing solutions that define the edge of possible. As you know, to complement our organic efforts, we selectively use M&A to expand both our scale and our scope. In 2017, the acquisition of LTC reflected this strategy. Since acquiring the franchise, we delivered on our goal to double its historical growth rate. Equally impressive was our ability to improve on Linear's industry leading gross margins. More recently, we completed the acquisition of Maxim Integrated. Similar to previous acquisitions, we're combining the best from ADI and Maxim to develop a new operating system that enhances customer engagement and drives long term profitable growth. And I'm very pleased with the progress that we've made already. On the customer engagement side, the integration of our field teams has brought a tremendous degree of excitement. The team is already beginning to identify cross selling opportunities and building out our opportunity pipeline. From an engineering and operations perspective, our teams are coming together at a remarkable speed and we're aligning product and technology road maps to help accelerate growth in the years ahead. This combination also strengthens the diversity of our portfolio and enriches our resilient business model. To that end, we now have approximately 75,000 product SKUs and 80% of these products individually account for less than 0.1% of our total revenue. And the addition of Maxim provides us with a more comprehensive power portfolio, Maxim's primarily application focused power offerings are highly complementary with ADI's more general purpose or catalog power portfolio. This adds new SAM in all our markets and enhances cross selling opportunities, accelerating revenue growth in our $2 billion-plus power portfolio. Given these investments, we entered 2022 with an unparalleled portfolio of technology and talent aimed at capitalizing on the secular growth trends across all our markets. And now I'd like to share a few examples of how our business is at the heart of these emerging trends, starting with industrial. 2021 was a better year for our highly diversified and profitable industrial business with all applications achieving all time highs. Our unrivaled high performance portfolio continues to benefit from the mass digitalization movement across industries. Our largest industrial segment, instrumentation and test, is comprised of automated test equipment, electronic test and measurement and scientific instruments. These applications must combat increasing test times as system complexity and metrology requirements rise exponentially. For example, processors in memory and data centers are leveraging finer node geometries with higher levels of integration, which can double the test time. This challenge is our opportunity. Our innovative, purpose built solutions are bringing test time back to parity while increasing our content by more than 50%. Factory automation is one of our largest industrial segments. I believe we're at a tipping point in the Industry 4.0 as customers are looking to add sensing, edge processing and connectivity to make their supply chains more robust, efficient and, of course, flexible. ADI's precision signal chain and power franchises, sensing technologies and robust wired and wireless connectivity are critical to enabling these efforts. Looking ahead, we have an enormous opportunity to connect Maxim's rich power portfolio, which is underrepresented in the industrial sector today with ADI's strong position. Shifting now to automotive. In a year dominated by chip shortage headlines, we achieved record revenue as consumers and manufacturers are embracing electric vehicles and an enhanced in-vehicle experience. These two areas need additional semiconductor content and align very well with the strengths of both ADI and Maxim. In electric vehicles, our market leading wired and wireless battery management systems, or BMS, offer customers the highest levels of accuracy, reliability and safety as well as flexibility to scale across all battery chemistries, including the more environmentally friendly zero cobalt LFP. Our BMS position is further strengthened with Maxim. We now sell to seven of the top 10 EV manufacturers and our increased technology and product scale enables us to address new SAM. Our efficiency is also critical in electric vehicles to better optimize performance and range. Here, Maxim's strong and growing power management capabilities complement our portfolio. Now inside the vehicle, automakers are enhancing the in-cabin experience. ADI's market leading audio systems with signal processing, A2B connectivity and active road noise cancellation continues to gain traction. In 2021, our A2B franchise was designed in at five major OEMs. And since its launch in 2016, we've shipped over 50 million A2B nodes, and we expect this to double within the next three years. With Maxim, our in-cabin connectivity offerings expand to include their industry leading GMSL franchise, which is critical in architecting advanced driver assistance systems. Turning to communications. 2021 was an uneven year as strength in wired was offset by weakness in the China wireless market. Encouragingly, as we look to 2022, the proliferation of 5G is gaining momentum globally, especially in North America. In the wireless market, ADI is the leader with more than double the market share of our closest competitor. This year, we introduced the industry's first software defined radio transceiver that includes a fully integrated digital front end. This next generation transceiver platform enables us to defend and extend our position in traditional 5G and emerging O-RAN networks. Additionally, Maxim's power portfolio will support our goal to increase our power attach rate in the wireless market. In our wired business, we grew again this year as data centers and networking became increasingly vital to accelerating digitalization. Maxim more than doubles our exposure to data centers and adds new growth vectors with its power management solutions for cloud processors and accelerators, and momentum is building with a strong pipeline across traditional customers as well as hyperscalers. Finally, moving on to consumer. Our business delivered double digit growth this year as we executed on our strategy to diversify our customers' products and applications. Maxim further builds in these efforts, bringing additional power, audio and sensing capabilities and adding new applications like fast charging and gaming. Given the strong pipeline and design wins for our signal processing solutions across hearables, wearables and professional audio video, combined with our power management capabilities, I'm confident that we're on the path for continued growth. Now I'd like to focus on ESG just a little, which is now an integral part of our business strategy. Broadly speaking, I believe semiconductors can play a major role in improving our standard of living while also protecting our planetary health. For example, ADI's technology is critical to optimizing global energy efficiency from EVs and charging stations to sustainable energy and smart grids. We're not only investing in these applications, but they represent a meaningful and growing portion of ADI's revenue today. So we've made substantial progress on our ESG initiatives in 2021, including a commitment to increase the use of sustainable energy for 100% of our organic ADI manufacturing activities by 2025, up from 50% today. Actions like these will help us achieve our goal of carbon neutrality by 2030 and net zero emissions by 2050. We launched the Ocean and Climate Innovation Accelerator Consortium focused on the critical role of oceans in combating climate change. And we've enhanced our disclosure and transparency in ESG topics, especially around diversity, equity and inclusion. In the year ahead, we look to extend our ESG initiatives across the combined company and, of course, make further progress toward our goals. So in closing, I'd like to thank our employees and partners who worked tirelessly throughout this past year, helping ADI achieve these historic results. We're off to a strong start in 2022 with continued robust demand and line of sight to capacity additions. And I've never been more optimistic about ADI's future. Our industry leading position is stronger with Maxim as we expand our capabilities to capitalize on emerging secular drivers positioning us for faster growth in the years ahead. And with that, I'll hand you over to Prashanth.
Prashanth Mahendra-Rajah: Thank you, Vince. Let me add my welcome to our year end earnings call. Except for revenue, my comments on the P&L and our outlook will be on a non-GAAP or adjusted basis, which excludes special items outlined in today's press release. Also, the acquisition of Maxim closed on August 26th. As such, I will discuss results inclusive of Maxim's contributions for approximately 9.5 weeks. I'll begin with a brief review of 2021. We delivered sequential revenue growth every quarter, leading to a new all time high of $7.32 billion. Gross margins of 70.9% increased 180 basis points due to favorable product mix, stronger utilization and the savings from a legacy LTC plant optimization. Operating margins of 42.4% increased 250 basis points, reflecting gross margin fall through and disciplined discretionary spending. All told, adjusted EPS increased more than 30% to a record $6.46. Turning to the fourth quarter. Revenue of $2.34 billion exceeded the midpoint of our updated guidance. Maxim's contribution to revenue was $559 million. Looking at the end market results and to give a better view into the underlying trends, I'll focus my remarks on organic ADI results. But this will be the last earnings call where we provide ADI organic commentary. Industrial represented 57% of revenue and increased slightly sequentially and 25% year-over-year with growth across every subsegment. For the full year, industrial increased 28%. This strong performance once again, is a testament to our sustained relative outperformance in the industrial market. Communications represented 16% of revenue and was flat sequentially while decreasing year-over-year. For the year, we delivered record wired sales while total comps declined due to the weakness in China wireless, largely related to geopolitical tensions. Excluding this region, total comps grew more than 20% in 2021. And overall, our [comms] geographic mix shifted with North America, Europe and Korea, now representing our largest sources of revenue. Automotive represented 15% of revenue and was down 9% sequentially as the third quarter included revenue from an IP licensing agreement. Excluding this, auto was flat sequentially. On a year-over-year basis, auto increased 15% with BMS more than doubling, reflecting our leadership position in the electrification ecosystem. For the year, auto exhibited robust broad-based growth, finishing up 36%. Consumer represented 12% of revenue and increased more than 20% sequentially and year-over-year, marking the fourth consecutive quarter of annual growth. Over a year ago, we said consumer would grow in 2021 and the team delivered on this commitment with consumer increasing 12% for the year. Moving on to the rest of the fourth quarter P&L. I'm going to speak to the results inclusive of the partial quarter of Maxim. Gross margins were 70.9%, up 90 bps year-over-year. Operating margins finished at 43.1%, up 140 basis points year-over-year. Non-op expense was $44 million and the tax rate was 12.7%. All in, adjusted EPS was $1.73 above the midpoint of guide and up more than 20% year-over-year. If we look at the balance sheet, we ended the quarter with approximately $2 billion of cash and equivalents and on a trailing 12 month pro forma basis, our net leverage ratio was 1.1 turns. Building on our ESG efforts, we continue to strategically leverage sustainable financing. We're proud to be the first US tech company to deploy three sustainable finance instruments with our inaugural green bond issuance, a sustainability linked revolving credit facility and a sustainability linked to bond offering. Specifically, this bond offering was part of our $4 billion refinancing efforts during the quarter. And as a result, we lowered our weighted average coupon to 2.7% while extending the average duration of our total debt by nearly 10 years. Inventory dollars increased slightly sequentially after adjusting for the partial quarter of Maxim activity and the fair value step-up of inventory related to the acquisition, while inventory days were down slightly. Channel inventory declined and remains below the low end of our seven to eight week target. Moving to the cash flow statement. For the year, cash flow from operations increased 36% to more than $2.7 billion. We generated a record free cash flow of $2.4 billion or approximately 33% of revenue despite CapEx more than doubling to $344 million or 4.7% of revenue. We also returned a record $3.7 billion or more than 150% of free cash flow to shareholders this year by dividends and buybacks, including 80% of our $2.5 billion ASR program. As a reminder, we plan to return 100% of free cash flow to shareholders. This is accomplished by growing our dividend annually with 40% to 60% dividend payout target and by using residual cash flow or buybacks. We entered 2022 as a much larger enterprise with an attractive long term outlook. As Vince mentioned, we plan to increase our capacity investments to support revenue growth and reinforce the resiliency and efficiency of our hybrid manufacturing model. As such, we anticipate CapEx being 6% to 8% of revenue for 2022 above our long term model of 4%. This step-up in CapEx will not impact the commitment we made in September to buy back 5 billion of shares by the end of calendar '22. So now on to the first quarter outlook. Revenue is expected to be $2.6 billion plus or minus $100 million. Based on the midpoint, we expect operating margin to be 43.3 plus or minus 70 bps. We expect non-op expenses of approximately $50 million, a 12.5% tax rate and a share count of approximately 530 million. Based on these inputs, adjusted EPS is expected to be $1.78 plus or minus $0.10. For additional context, using the fourth quarter pro forma combined revenue as a base, our guide at the midpoint implies low single digit growth quarter-on-quarter in Q1 to what is normally a seasonally weaker quarter. This growth is driven by an increase in B2B quarter-over-quarter, while consumer is down sequentially. So before closing, I want to give a brief update on our Maxim integration progress. Phase 1 of shareholder value creation is well underway, building conviction in our cost synergy timeline. We anticipate realizing over 40% of the initial $275 million OpEx and COGS synergy target in fiscal '22 with the remaining coming in fiscal '23. I'm proud of the team's effort and confident this pace of execution will continue. At our Analyst Day next spring, we'll update investors on our progress as well as provide more details on Phases 2 and 3, which relate to additional savings from infrastructure optimization and revenue synergies, respectively. Before turning to Q&A, I'd like to congratulate Mike Lucarelli on his promotion to Vice President of Investor Relations and Financial Planning and Analysis. Look forward to working with you Mike in this continued partnership. Let me hand it over to you to take Q&A.
Michael Lucarelli: Thanks, Prashanth. All right. With that, let's get to our Q&A session. [Operator Instructions] With that, we have our first question, please.
Operator: [Operator Instructions] Your first question comes from the line of John Pitzer with Credit Suisse.
John Pitzer: Congratulations on the solid quarter. Vince, Prashanth, if I exclude kind of the Maxim revenue in the October quarter, the core ADI business just came in line with the midpoint of your original range, which is clearly not horrible. But just given strength of business and kind of your pension to tend to give upside and the view that maybe Maxim was more supply constrained than ADI. I'm just wondering if you can help us understand that dynamic and maybe it's getting rectified in the January quarter being guided above seasonal. But were there supply constraints in the quarter that impacted either revenue and/or margins? And any kind of conversation around that would be helpful.
Vincent Roche: In the past quarter, our organic supply had some impact from some COVID shutdowns in Southeast Asia that affected much of the industry. We still did grow sequentially in the fourth quarter. But as we've been talking about for the last couple of quarters, our supply has been limited and revenue really is a function of supply. So that hiccup did put a little bit of pressure on the revenue line, and you'll see that correct itself as we go forward.
Operator: Your next question comes from Toshiya Hari with Goldman Sachs.
Toshiya Hari: Mike, congrats on the promotion. I guess I had a question on pricing and also long term supply agreements. Quite a few of your competitors or peers in the industry have talked about approaching customers, or customers approaching them about long term agreements. I think you gave a couple of comments on past calls, but if you can update us on how you're thinking about initiatives of that sort, that would be super helpful and how you're balancing that with your long-term purchases of wafer capacity. Any comments on how to think about pricing broadly going forward would be super helpful.
Prashanth Mahendra-Rajah: Why don't I take pricing, and I'll let Vince kind of speak how we think about it longer term. So the short answer is, for 2021, we've been talking about rising cost inflations over the course of the year, and we've been raising our prices with the goal of neutralizing the impact to margin. I would say that in the fiscal year that just finished, cost increases and price increases were not completely synchronized. So it's very likely that cost inflation outpaced our pricing actions for the year and we're likely a modest headwind to the year. As we go into 2022, we're looking for the inverse of that. We're looking for pricing net of inflation to be a modest tailwind to the year as the price increases that have begun -- begin to get more traction. And we believe that while we still will have some cost increases over the course of the year, most of those are now baked into the run rate.
Vincent Roche: Toshi, I can take a slightly longer-term view of things. I think it's true to say, certainly from our standpoint, that price increases aren't new. We've been systematically raising prices as a company for many, many years, I think we've talked about before. We continue to deliver increasing value in our new product streams. And we also maintain products for our customers that are often more than 20 years in -- 20 years old in vintage terms. We've taken a very measured approach to pricing over the last year. And we've been very transparent with our customers as well that price increases are really more about passing on costs rather than looking to enhancing our margins. Last comment on pricing. I think the industry, as we approach this kind of post-Moore's Law era, we're in an era now, I believe, of structural price increases rather than cyclical. In other words, I think you'll start to see inflation sustained for the industry in the years ahead. It's been proven over the last couple of years for certain that semis are the roots of the modern digital economy. And I think customers understand as well that importance and the value that is increasingly created by semi. So I believe that, as I said, inflation will persist. It will moderate, but I think it's a facet now of the business structure of the semi industry and indeed ADI's business.
Operator: Your next question is from Tore Svanberg with Stifel.
Tore Svanberg: Congratulations on the record results. Vince, you're probably not going to share revenue synergy numbers with us probably until the Analyst Day. But could you perhaps just give us some examples of potential revenue synergies between Maxim and ADI, please?
Vincent Roche: I mean, there are many, many. I think I mentioned in the prepared remarks, for example, that Maxim is very underrepresented in the industrial space where ADI is very, very strong. Half our business, total business is industrial, and it's a very, very small part of Maxim's business. And where I see the opportunity there is really on the power side of things, power management, in particular. It's the fastest growing segment in the analog space. And I think generally, across the board, we're still underrepresented as a company in power. We today have approximately $2.3 billion, $2.4 billion of combined power revenues. My sense is we can double that in a reasonable period of time. And we'll give a lot more detail on that when we get to the Investor Day over the next couple of months. And from an application and market standpoint, I'd just like to point to data center. You know the power management solutions that Maxim has for companionship with cloud processors, AI machines, accelerators and so on, I think will combine very nicely with ADI's data center micromodules. And then in automotive, connectivity, Maxim's GMSL high speed link technology used in our in-cabin connectivity portfolio, will enable us to optimize solutions and address a lot more applications in the car. And that's a nice companion as well to ADI's A2B connectivity solution for audio. And last but not least, Maxim has added a lot of heft to our BMS portfolio and our portfolio now is double the size it was pre-Maxim. And as I mentioned, again, in the prepared remarks, we now sell to seven out of the top 10 OEMs in the electric car area. And there's a lot more examples but they are the primary ones I'd like to point out at this stage.
Operator: Your next question is from Vivek Arya with Bank of America Securities.
Vivek Arya: Vince, I just wanted to get your perspective on the shape of kind of fiscal '22 sales growth. Your Q1 outlook implies, I believe, about 19% pro forma sales growth, that's well above your closest Analog peers with an acceleration from Q4. And if I were to assume that Q1 is kind of the low point of the year and you grow supply sequentially, that points to a double digit sales growth. So I know you're not giving full year guidance, but are we thinking about it the right way? And what could be the puts and takes from a supply and then also a mix perspective as we go through the year?
Vincent Roche: So I'm going to at least give you some shape on that. So when we look into 2022, we can see growth across all the various market sectors for the year. And I think it's possible that we'll see another double digit top line year for ADI. And the primary reasons, well, we've got a very strong backlog as we enter the year. We're seeing broad based demand continue. I think also, we're seeing some improvement, generally speaking. With each passing month, we're seeing improvements in supply. So I think that line of sight gives us increased confidence, that's both internally as well as externally. We are in catch up more than pricing. So I think you'll see some significant contribution in 2022 from pricing activities. And also, inventories continue to remain low in the distribution channel and, of course, on the customer side pretty much on a broad basis. So I think overall, '22 should shape up to be a good year and we've got many, many drivers there on our side.
Prashanth Mahendra-Rajah: Vivek, maybe just double clicking on the supply item to provide clarity. We put in a fair amount of equipment orders for the legacy ADI operations. So we expect ADI capacity to continue to increase quarter-on-quarter over the coming fiscal year. On the Maxim side, we've done the same, but those orders only went in when the deal closed. So given the long lead times from the semi-cap guys, we're probably unlikely to see a meaningful increase in Maxim's ability to supply until the tail end of the year. So unfortunately, I think Maxim, from a fiscal year basis, will probably be a little bit of a drag on growth just because we can't get the tools fast enough.
Operator: Your next question is from Ambrish Srivastava with BMO.
Ambrish Srivastava: I just wanted to say thanks to Mike for providing all the web schedule that really goes a long way in transparency. So I really appreciate that. My question is on lead times and the expedites. I just wanted to see what you're seeing versus what TI highlighted, which was very different than what we've heard from other companies. So specifically, are you seeing expedites narrow down and then where are your lead times? So I think in the last earnings call, you had mentioned or in my call back, you had mentioned that you had 25% hotspots. So color on those would be helpful.
Prashanth Mahendra-Rajah: Ambrish, we're really not seeing much of a change. The customer -- on customer buying behavior, book-to-bill is well above one in the fourth quarter. So our outlook to grow quarter-on-quarter for the first quarter in what is normally a seasonally weaker quarter as a reference to that. Our backlog increased and we're starting 2022 with a very high level, and we have not seen much change in cancellations or pushouts. So we're continuing to do what we have been doing and that is we're reviewing with sales and ops for red flags that would indicate there's some level of turning in the market. We haven't seen anything notable, really it's pretty strong across all end markets and all geographies. And as we've said before, we manage our business on sell-through. So we really look through distribution to get insight from where our products are going on a sell-through basis to understand what's happening in terms of who's buying and where it's being shipped to. So we're prepared for things to change but I would say right now, it continues to feel as it did a quarter ago.
Vincent Roche: I think briefly from my perspective. The number of conversations that I've been having with customers certainly hasn't slowed down. And in these conversations, it's pretty clear to me that what we're being requested to support as real demand. So our customers are trying to get products out the door, and they're not building inventories at this point in time.
Ambrish Srivastava: And have the lead times changed versus where they were last quarter?
Prashanth Mahendra-Rajah: It depends on the product, and it depends on the market. So we have some areas where they continue to extend and others that have stabilized. So overall, lead times are above normal and it's not where we want them to be. But it's very product and market specific given the diversity of what we make and where we make it.
Vincent Roche: I think it's true to say lead times have stabilized.
Operator: Your next question comes from Stacy Rasgon with Bernstein Research.
Stacy Rasgon: I wanted to ask a little more about the shape of the synergies. I think you had said the cost synergies would be in 40% this year and the remainder of next year. Can you give us some idea how do those split out between OpEx and gross margin and COGS, and what is the proper sort of all-in baseline for OpEx that we should be building those synergies off of? And I guess, finally, with gross margins along with same lines, given you've got pricing and other stuff as a tailwind and you see revenue growth. Do you still think that Q1 gross margins wherever they want coming out, is that the trough for the year, given how everything else flows through?
Vincent Roche: So Stacy, the way to think about the cost synergies is we said roughly 40% in the coming fiscal and then the balance in 2023. The majority of the coming fiscal will actually be in cost of goods. And then in 2023, you'll see that flip to be the majority of that coming in OpEx. What else can I tell you there -- anything else [Mike] that's relevant…
Michael Lucarelli: I'll call that -- that would be -- that's Phase 1. We will talk more about Phase 2 at the Analyst Day and we'll look to increase that synergy target at that time. And I think you had second question on gross margin, I'll pass it back to Prashanth…
Stacy Rasgon: Also what’s the proper sort of like current like folding run rate for OpEx right now?
Vincent Roche: If you look at our our first quarter guide, and that's probably a good level of run rate OpEx, I would say. In that guide, there is about $20 million of annual OpEx we took out in our fourth quarter. So maybe add $20 million to that for the run rate…
Prashanth Mahendra-Rajah: On gross margins, the -- so first quarter seasonally tends to be a little bit lower because we have the holiday shutdowns and this first quarter here will have a full quarter of Maxim, which as many of you know, had lower gross margins than stand-alone ADI. So we've got some headwind coming from that. The tailwind is we've got the revenue that's coming in strong and pricing, as I mentioned earlier, is going to be -- start to be mildly accretive. So all in, I would think gross margins kind of sequentially, I think, flattish is a safe model.
Vincent Roche: And you're right, on the gross margin for the year, the plan is for it to continue to rise throughout the year, assuming demand remains strong and mix doesn't change given synergies and also our pricing actions.
Operator: Your next question is from Harlan Sur with JPMorgan.
Harlan Sur: Congratulations on the strong results and execution. On inventories, I think you mentioned that they continue to be below your target range of seven to eight weeks. And I know that on a finished goods perspective, at least through Q3, that was down year-over-year, it was down year-to-date versus an increase in total inventories, which implies to me that consignment or direct customer inventories are also quite lean and demand is strong. And so I guess what's your view on when the team and your customers will be in a position to build back inventories or is it just hand them out for the next several quarters?
Prashanth Mahendra-Rajah: I think it probably looks to be continued hand to mouth for the next couple of quarters. Our inventory numbers are a little bit confusing because of some of the map that's in there. So I'll just go back to what I said in the prepared remarks. Days of inventory was down slightly. The internal inventory balance was up as we built raw materials and WIP. You have some noise in there from Maxim's inventory being added into our middle of the quarter as well as the purchase accounting math, which requires us to do a step up of that. So adjusting for all of that, we were up slightly in terms of ADI balance sheet inventory and most of that was in WIP. On the channel side, it remains very lean and well below where we want it to be, and that causes some challenges on customer service as it does for everyone in the industry. We don't see that abating at least for the first or second quarter, and it's hard for us to see further out than that.
Operator: Your last question is from C.J. Muse with Evercore.
C.J. Muse: I guess a question on supply and gross margins. As you look at fiscal '22, can you speak to the growth you anticipate from internal versus external supply? And then based on that, how should we think about the implications to your gross margins?
Prashanth Mahendra-Rajah: So C.J., well, let's break down the dynamics. On the internal supply, I mentioned that ADI's internal capacity will continue to improve as we go through every quarter as we bring more equipment online. On the Maxim side, I mentioned that is pretty much flat for most of the year. We're optimistic that we might be able to see some improvement towards the tail end of the year as we get more equipment in. On the external side, I will say that Vince himself is personally involved in conversations with our foundry partners and looking to get additional wafer capacity when we can, but it's very much driven by what nodes are available. And maybe I'll pass to Vince here to add a bit more comment since you've been having a lot of those conversations…
Vincent Roche: I think the best answer we can give you, C.J., is that we've indicated we expect gross margins to increase throughout the year. And we've got a hybrid model. So we expect to -- against that, we're not expecting any kind of external, internal prohibitions that will impact gross margin but we expect it to increase throughout the year.
Michael Lucarelli: Thanks, everyone, for joining the call this morning. A content transcript will be available on our Web site and all available reconciliations and this information can also be found there. Thanks again for joining us and your continued [Technical Difficulty] Analog Devices. Have a great Thanksgiving.
Prashanth Mahendra-Rajah: Happy Thanksgiving, everyone.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. Speakers, please hold the line. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices Fourth Quarter and Fiscal Year 2021 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Stephanie, and good morning, everybody. Thanks for joining our fourth quarter and fiscal 2021 conference call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now on to the disclosures. The information are about to discuss in forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release, ADI and Maxim's periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. Please note we published a table on our Investor web page of historical pro forma combined end market revenue aligned to ADI fiscal quarters. As part of this exercise, we also mapped subsegments to match ADI's groupings. As a result of this reclassification, about $150 million of annual revenue moved from industrial and communications to consumer for the Maxim business. And with that, I'll turn it over to ADI CEO, Vincent Roche. Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thank you very much, Mike, and a very good morning to you all. Well, once again, we delivered record revenue and profits in our fourth quarter, closing out what was a milestone year for ADI. Our success was driven by our industry leading high performance portfolio and our team's strong operational execution, enabling us to better meet the insatiable demand for our products. Now stepping back a little. 2021 truly demonstrated the vital importance of semiconductors to the modern digital age. We invested ahead of this inflection, building a comprehensive portfolio to better solve our customers' most complex problems in this ubiquitously sensed and connected world. As we enter 2022, our backlog and bookings remain robust and we continue to invest in manufacturing capacity, positioning us well for another successful year ahead. Now moving on to our results. Our fourth quarter revenue was $2.34 billion and EPS was $1.73, both exceeding the midpoint of guidance. And for 2021, our revenue was $7.32 billion and EPS was $6.46. Looking at our organic ADI. We delivered new high watermarks on revenue and profits. Industrial and automotive achieved record revenue this year, while consumer returns to annual growth for the first time since 2017. And communications revenue declined its continued strength and wired was offset by weakness in wireless related to the China market. In 2021, we generated a record $2.4 billion of free cash flow, equating to a free cash flow margin of approximately 33%. This maintains our position in the top 10% of the S&P 500. In line with our revised capital allocation strategy to return 100% of free cash flow, we returned $3.7 billion to shareholders in 2021 through dividends and share buybacks. It was not only a record year for performance and shareholder returns but also for investments that position us to better capture market opportunities presented by secular growth drivers in our business. First, we took decisive action to add capacity throughout the year with more than $340 million in capital expenditures. This is enabling us to better navigate the near-term supply/demand imbalance while achieving our long-term growth objectives. And in 2022, we're planning to expand our internal manufacturing capacity at our factories in the US and Europe. These additional investments will create more profitable, flexible and resilient manufacturing capabilities at ADI. Now at our core, we're an innovation driven enterprise. And together with Maxim, we will invest more than $1.6 billion in R&D annually to ensure we continue developing solutions that define the edge of possible. As you know, to complement our organic efforts, we selectively use M&A to expand both our scale and our scope. In 2017, the acquisition of LTC reflected this strategy. Since acquiring the franchise, we delivered on our goal to double its historical growth rate. Equally impressive was our ability to improve on Linear's industry leading gross margins. More recently, we completed the acquisition of Maxim Integrated. Similar to previous acquisitions, we're combining the best from ADI and Maxim to develop a new operating system that enhances customer engagement and drives long term profitable growth. And I'm very pleased with the progress that we've made already. On the customer engagement side, the integration of our field teams has brought a tremendous degree of excitement. The team is already beginning to identify cross selling opportunities and building out our opportunity pipeline. From an engineering and operations perspective, our teams are coming together at a remarkable speed and we're aligning product and technology road maps to help accelerate growth in the years ahead. This combination also strengthens the diversity of our portfolio and enriches our resilient business model. To that end, we now have approximately 75,000 product SKUs and 80% of these products individually account for less than 0.1% of our total revenue. And the addition of Maxim provides us with a more comprehensive power portfolio, Maxim's primarily application focused power offerings are highly complementary with ADI's more general purpose or catalog power portfolio. This adds new SAM in all our markets and enhances cross selling opportunities, accelerating revenue growth in our $2 billion-plus power portfolio. Given these investments, we entered 2022 with an unparalleled portfolio of technology and talent aimed at capitalizing on the secular growth trends across all our markets. And now I'd like to share a few examples of how our business is at the heart of these emerging trends, starting with industrial. 2021 was a better year for our highly diversified and profitable industrial business with all applications achieving all time highs. Our unrivaled high performance portfolio continues to benefit from the mass digitalization movement across industries. Our largest industrial segment, instrumentation and test, is comprised of automated test equipment, electronic test and measurement and scientific instruments. These applications must combat increasing test times as system complexity and metrology requirements rise exponentially. For example, processors in memory and data centers are leveraging finer node geometries with higher levels of integration, which can double the test time. This challenge is our opportunity. Our innovative, purpose built solutions are bringing test time back to parity while increasing our content by more than 50%. Factory automation is one of our largest industrial segments. I believe we're at a tipping point in the Industry 4.0 as customers are looking to add sensing, edge processing and connectivity to make their supply chains more robust, efficient and, of course, flexible. ADI's precision signal chain and power franchises, sensing technologies and robust wired and wireless connectivity are critical to enabling these efforts. Looking ahead, we have an enormous opportunity to connect Maxim's rich power portfolio, which is underrepresented in the industrial sector today with ADI's strong position. Shifting now to automotive. In a year dominated by chip shortage headlines, we achieved record revenue as consumers and manufacturers are embracing electric vehicles and an enhanced in-vehicle experience. These two areas need additional semiconductor content and align very well with the strengths of both ADI and Maxim. In electric vehicles, our market leading wired and wireless battery management systems, or BMS, offer customers the highest levels of accuracy, reliability and safety as well as flexibility to scale across all battery chemistries, including the more environmentally friendly zero cobalt LFP. Our BMS position is further strengthened with Maxim. We now sell to seven of the top 10 EV manufacturers and our increased technology and product scale enables us to address new SAM. Our efficiency is also critical in electric vehicles to better optimize performance and range. Here, Maxim's strong and growing power management capabilities complement our portfolio. Now inside the vehicle, automakers are enhancing the in-cabin experience. ADI's market leading audio systems with signal processing, A2B connectivity and active road noise cancellation continues to gain traction. In 2021, our A2B franchise was designed in at five major OEMs. And since its launch in 2016, we've shipped over 50 million A2B nodes, and we expect this to double within the next three years. With Maxim, our in-cabin connectivity offerings expand to include their industry leading GMSL franchise, which is critical in architecting advanced driver assistance systems. Turning to communications. 2021 was an uneven year as strength in wired was offset by weakness in the China wireless market. Encouragingly, as we look to 2022, the proliferation of 5G is gaining momentum globally, especially in North America. In the wireless market, ADI is the leader with more than double the market share of our closest competitor. This year, we introduced the industry's first software defined radio transceiver that includes a fully integrated digital front end. This next generation transceiver platform enables us to defend and extend our position in traditional 5G and emerging O-RAN networks. Additionally, Maxim's power portfolio will support our goal to increase our power attach rate in the wireless market. In our wired business, we grew again this year as data centers and networking became increasingly vital to accelerating digitalization. Maxim more than doubles our exposure to data centers and adds new growth vectors with its power management solutions for cloud processors and accelerators, and momentum is building with a strong pipeline across traditional customers as well as hyperscalers. Finally, moving on to consumer. Our business delivered double digit growth this year as we executed on our strategy to diversify our customers' products and applications. Maxim further builds in these efforts, bringing additional power, audio and sensing capabilities and adding new applications like fast charging and gaming. Given the strong pipeline and design wins for our signal processing solutions across hearables, wearables and professional audio video, combined with our power management capabilities, I'm confident that we're on the path for continued growth. Now I'd like to focus on ESG just a little, which is now an integral part of our business strategy. Broadly speaking, I believe semiconductors can play a major role in improving our standard of living while also protecting our planetary health. For example, ADI's technology is critical to optimizing global energy efficiency from EVs and charging stations to sustainable energy and smart grids. We're not only investing in these applications, but they represent a meaningful and growing portion of ADI's revenue today. So we've made substantial progress on our ESG initiatives in 2021, including a commitment to increase the use of sustainable energy for 100% of our organic ADI manufacturing activities by 2025, up from 50% today. Actions like these will help us achieve our goal of carbon neutrality by 2030 and net zero emissions by 2050. We launched the Ocean and Climate Innovation Accelerator Consortium focused on the critical role of oceans in combating climate change. And we've enhanced our disclosure and transparency in ESG topics, especially around diversity, equity and inclusion. In the year ahead, we look to extend our ESG initiatives across the combined company and, of course, make further progress toward our goals. So in closing, I'd like to thank our employees and partners who worked tirelessly throughout this past year, helping ADI achieve these historic results. We're off to a strong start in 2022 with continued robust demand and line of sight to capacity additions. And I've never been more optimistic about ADI's future. Our industry leading position is stronger with Maxim as we expand our capabilities to capitalize on emerging secular drivers positioning us for faster growth in the years ahead. And with that, I'll hand you over to Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Let me add my welcome to our year end earnings call. Except for revenue, my comments on the P&L and our outlook will be on a non-GAAP or adjusted basis, which excludes special items outlined in today's press release. Also, the acquisition of Maxim closed on August 26th. As such, I will discuss results inclusive of Maxim's contributions for approximately 9.5 weeks. I'll begin with a brief review of 2021. We delivered sequential revenue growth every quarter, leading to a new all time high of $7.32 billion. Gross margins of 70.9% increased 180 basis points due to favorable product mix, stronger utilization and the savings from a legacy LTC plant optimization. Operating margins of 42.4% increased 250 basis points, reflecting gross margin fall through and disciplined discretionary spending. All told, adjusted EPS increased more than 30% to a record $6.46. Turning to the fourth quarter. Revenue of $2.34 billion exceeded the midpoint of our updated guidance. Maxim's contribution to revenue was $559 million. Looking at the end market results and to give a better view into the underlying trends, I'll focus my remarks on organic ADI results. But this will be the last earnings call where we provide ADI organic commentary. Industrial represented 57% of revenue and increased slightly sequentially and 25% year-over-year with growth across every subsegment. For the full year, industrial increased 28%. This strong performance once again, is a testament to our sustained relative outperformance in the industrial market. Communications represented 16% of revenue and was flat sequentially while decreasing year-over-year. For the year, we delivered record wired sales while total comps declined due to the weakness in China wireless, largely related to geopolitical tensions. Excluding this region, total comps grew more than 20% in 2021. And overall, our [comms] geographic mix shifted with North America, Europe and Korea, now representing our largest sources of revenue. Automotive represented 15% of revenue and was down 9% sequentially as the third quarter included revenue from an IP licensing agreement. Excluding this, auto was flat sequentially. On a year-over-year basis, auto increased 15% with BMS more than doubling, reflecting our leadership position in the electrification ecosystem. For the year, auto exhibited robust broad-based growth, finishing up 36%. Consumer represented 12% of revenue and increased more than 20% sequentially and year-over-year, marking the fourth consecutive quarter of annual growth. Over a year ago, we said consumer would grow in 2021 and the team delivered on this commitment with consumer increasing 12% for the year. Moving on to the rest of the fourth quarter P&L. I'm going to speak to the results inclusive of the partial quarter of Maxim. Gross margins were 70.9%, up 90 bps year-over-year. Operating margins finished at 43.1%, up 140 basis points year-over-year. Non-op expense was $44 million and the tax rate was 12.7%. All in, adjusted EPS was $1.73 above the midpoint of guide and up more than 20% year-over-year. If we look at the balance sheet, we ended the quarter with approximately $2 billion of cash and equivalents and on a trailing 12 month pro forma basis, our net leverage ratio was 1.1 turns. Building on our ESG efforts, we continue to strategically leverage sustainable financing. We're proud to be the first US tech company to deploy three sustainable finance instruments with our inaugural green bond issuance, a sustainability linked revolving credit facility and a sustainability linked to bond offering. Specifically, this bond offering was part of our $4 billion refinancing efforts during the quarter. And as a result, we lowered our weighted average coupon to 2.7% while extending the average duration of our total debt by nearly 10 years. Inventory dollars increased slightly sequentially after adjusting for the partial quarter of Maxim activity and the fair value step-up of inventory related to the acquisition, while inventory days were down slightly. Channel inventory declined and remains below the low end of our seven to eight week target. Moving to the cash flow statement. For the year, cash flow from operations increased 36% to more than $2.7 billion. We generated a record free cash flow of $2.4 billion or approximately 33% of revenue despite CapEx more than doubling to $344 million or 4.7% of revenue. We also returned a record $3.7 billion or more than 150% of free cash flow to shareholders this year by dividends and buybacks, including 80% of our $2.5 billion ASR program. As a reminder, we plan to return 100% of free cash flow to shareholders. This is accomplished by growing our dividend annually with 40% to 60% dividend payout target and by using residual cash flow or buybacks. We entered 2022 as a much larger enterprise with an attractive long term outlook. As Vince mentioned, we plan to increase our capacity investments to support revenue growth and reinforce the resiliency and efficiency of our hybrid manufacturing model. As such, we anticipate CapEx being 6% to 8% of revenue for 2022 above our long term model of 4%. This step-up in CapEx will not impact the commitment we made in September to buy back 5 billion of shares by the end of calendar '22. So now on to the first quarter outlook. Revenue is expected to be $2.6 billion plus or minus $100 million. Based on the midpoint, we expect operating margin to be 43.3 plus or minus 70 bps. We expect non-op expenses of approximately $50 million, a 12.5% tax rate and a share count of approximately 530 million. Based on these inputs, adjusted EPS is expected to be $1.78 plus or minus $0.10. For additional context, using the fourth quarter pro forma combined revenue as a base, our guide at the midpoint implies low single digit growth quarter-on-quarter in Q1 to what is normally a seasonally weaker quarter. This growth is driven by an increase in B2B quarter-over-quarter, while consumer is down sequentially. So before closing, I want to give a brief update on our Maxim integration progress. Phase 1 of shareholder value creation is well underway, building conviction in our cost synergy timeline. We anticipate realizing over 40% of the initial $275 million OpEx and COGS synergy target in fiscal '22 with the remaining coming in fiscal '23. I'm proud of the team's effort and confident this pace of execution will continue. At our Analyst Day next spring, we'll update investors on our progress as well as provide more details on Phases 2 and 3, which relate to additional savings from infrastructure optimization and revenue synergies, respectively. Before turning to Q&A, I'd like to congratulate Mike Lucarelli on his promotion to Vice President of Investor Relations and Financial Planning and Analysis. Look forward to working with you Mike in this continued partnership. Let me hand it over to you to take Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. All right. With that, let's get to our Q&A session. [Operator Instructions] With that, we have our first question, please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Your first question comes from the line of John Pitzer with Credit Suisse."
},
{
"speaker": "John Pitzer",
"text": "Congratulations on the solid quarter. Vince, Prashanth, if I exclude kind of the Maxim revenue in the October quarter, the core ADI business just came in line with the midpoint of your original range, which is clearly not horrible. But just given strength of business and kind of your pension to tend to give upside and the view that maybe Maxim was more supply constrained than ADI. I'm just wondering if you can help us understand that dynamic and maybe it's getting rectified in the January quarter being guided above seasonal. But were there supply constraints in the quarter that impacted either revenue and/or margins? And any kind of conversation around that would be helpful."
},
{
"speaker": "Vincent Roche",
"text": "In the past quarter, our organic supply had some impact from some COVID shutdowns in Southeast Asia that affected much of the industry. We still did grow sequentially in the fourth quarter. But as we've been talking about for the last couple of quarters, our supply has been limited and revenue really is a function of supply. So that hiccup did put a little bit of pressure on the revenue line, and you'll see that correct itself as we go forward."
},
{
"speaker": "Operator",
"text": "Your next question comes from Toshiya Hari with Goldman Sachs."
},
{
"speaker": "Toshiya Hari",
"text": "Mike, congrats on the promotion. I guess I had a question on pricing and also long term supply agreements. Quite a few of your competitors or peers in the industry have talked about approaching customers, or customers approaching them about long term agreements. I think you gave a couple of comments on past calls, but if you can update us on how you're thinking about initiatives of that sort, that would be super helpful and how you're balancing that with your long-term purchases of wafer capacity. Any comments on how to think about pricing broadly going forward would be super helpful."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Why don't I take pricing, and I'll let Vince kind of speak how we think about it longer term. So the short answer is, for 2021, we've been talking about rising cost inflations over the course of the year, and we've been raising our prices with the goal of neutralizing the impact to margin. I would say that in the fiscal year that just finished, cost increases and price increases were not completely synchronized. So it's very likely that cost inflation outpaced our pricing actions for the year and we're likely a modest headwind to the year. As we go into 2022, we're looking for the inverse of that. We're looking for pricing net of inflation to be a modest tailwind to the year as the price increases that have begun -- begin to get more traction. And we believe that while we still will have some cost increases over the course of the year, most of those are now baked into the run rate."
},
{
"speaker": "Vincent Roche",
"text": "Toshi, I can take a slightly longer-term view of things. I think it's true to say, certainly from our standpoint, that price increases aren't new. We've been systematically raising prices as a company for many, many years, I think we've talked about before. We continue to deliver increasing value in our new product streams. And we also maintain products for our customers that are often more than 20 years in -- 20 years old in vintage terms. We've taken a very measured approach to pricing over the last year. And we've been very transparent with our customers as well that price increases are really more about passing on costs rather than looking to enhancing our margins. Last comment on pricing. I think the industry, as we approach this kind of post-Moore's Law era, we're in an era now, I believe, of structural price increases rather than cyclical. In other words, I think you'll start to see inflation sustained for the industry in the years ahead. It's been proven over the last couple of years for certain that semis are the roots of the modern digital economy. And I think customers understand as well that importance and the value that is increasingly created by semi. So I believe that, as I said, inflation will persist. It will moderate, but I think it's a facet now of the business structure of the semi industry and indeed ADI's business."
},
{
"speaker": "Operator",
"text": "Your next question is from Tore Svanberg with Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Congratulations on the record results. Vince, you're probably not going to share revenue synergy numbers with us probably until the Analyst Day. But could you perhaps just give us some examples of potential revenue synergies between Maxim and ADI, please?"
},
{
"speaker": "Vincent Roche",
"text": "I mean, there are many, many. I think I mentioned in the prepared remarks, for example, that Maxim is very underrepresented in the industrial space where ADI is very, very strong. Half our business, total business is industrial, and it's a very, very small part of Maxim's business. And where I see the opportunity there is really on the power side of things, power management, in particular. It's the fastest growing segment in the analog space. And I think generally, across the board, we're still underrepresented as a company in power. We today have approximately $2.3 billion, $2.4 billion of combined power revenues. My sense is we can double that in a reasonable period of time. And we'll give a lot more detail on that when we get to the Investor Day over the next couple of months. And from an application and market standpoint, I'd just like to point to data center. You know the power management solutions that Maxim has for companionship with cloud processors, AI machines, accelerators and so on, I think will combine very nicely with ADI's data center micromodules. And then in automotive, connectivity, Maxim's GMSL high speed link technology used in our in-cabin connectivity portfolio, will enable us to optimize solutions and address a lot more applications in the car. And that's a nice companion as well to ADI's A2B connectivity solution for audio. And last but not least, Maxim has added a lot of heft to our BMS portfolio and our portfolio now is double the size it was pre-Maxim. And as I mentioned, again, in the prepared remarks, we now sell to seven out of the top 10 OEMs in the electric car area. And there's a lot more examples but they are the primary ones I'd like to point out at this stage."
},
{
"speaker": "Operator",
"text": "Your next question is from Vivek Arya with Bank of America Securities."
},
{
"speaker": "Vivek Arya",
"text": "Vince, I just wanted to get your perspective on the shape of kind of fiscal '22 sales growth. Your Q1 outlook implies, I believe, about 19% pro forma sales growth, that's well above your closest Analog peers with an acceleration from Q4. And if I were to assume that Q1 is kind of the low point of the year and you grow supply sequentially, that points to a double digit sales growth. So I know you're not giving full year guidance, but are we thinking about it the right way? And what could be the puts and takes from a supply and then also a mix perspective as we go through the year?"
},
{
"speaker": "Vincent Roche",
"text": "So I'm going to at least give you some shape on that. So when we look into 2022, we can see growth across all the various market sectors for the year. And I think it's possible that we'll see another double digit top line year for ADI. And the primary reasons, well, we've got a very strong backlog as we enter the year. We're seeing broad based demand continue. I think also, we're seeing some improvement, generally speaking. With each passing month, we're seeing improvements in supply. So I think that line of sight gives us increased confidence, that's both internally as well as externally. We are in catch up more than pricing. So I think you'll see some significant contribution in 2022 from pricing activities. And also, inventories continue to remain low in the distribution channel and, of course, on the customer side pretty much on a broad basis. So I think overall, '22 should shape up to be a good year and we've got many, many drivers there on our side."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Vivek, maybe just double clicking on the supply item to provide clarity. We put in a fair amount of equipment orders for the legacy ADI operations. So we expect ADI capacity to continue to increase quarter-on-quarter over the coming fiscal year. On the Maxim side, we've done the same, but those orders only went in when the deal closed. So given the long lead times from the semi-cap guys, we're probably unlikely to see a meaningful increase in Maxim's ability to supply until the tail end of the year. So unfortunately, I think Maxim, from a fiscal year basis, will probably be a little bit of a drag on growth just because we can't get the tools fast enough."
},
{
"speaker": "Operator",
"text": "Your next question is from Ambrish Srivastava with BMO."
},
{
"speaker": "Ambrish Srivastava",
"text": "I just wanted to say thanks to Mike for providing all the web schedule that really goes a long way in transparency. So I really appreciate that. My question is on lead times and the expedites. I just wanted to see what you're seeing versus what TI highlighted, which was very different than what we've heard from other companies. So specifically, are you seeing expedites narrow down and then where are your lead times? So I think in the last earnings call, you had mentioned or in my call back, you had mentioned that you had 25% hotspots. So color on those would be helpful."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Ambrish, we're really not seeing much of a change. The customer -- on customer buying behavior, book-to-bill is well above one in the fourth quarter. So our outlook to grow quarter-on-quarter for the first quarter in what is normally a seasonally weaker quarter as a reference to that. Our backlog increased and we're starting 2022 with a very high level, and we have not seen much change in cancellations or pushouts. So we're continuing to do what we have been doing and that is we're reviewing with sales and ops for red flags that would indicate there's some level of turning in the market. We haven't seen anything notable, really it's pretty strong across all end markets and all geographies. And as we've said before, we manage our business on sell-through. So we really look through distribution to get insight from where our products are going on a sell-through basis to understand what's happening in terms of who's buying and where it's being shipped to. So we're prepared for things to change but I would say right now, it continues to feel as it did a quarter ago."
},
{
"speaker": "Vincent Roche",
"text": "I think briefly from my perspective. The number of conversations that I've been having with customers certainly hasn't slowed down. And in these conversations, it's pretty clear to me that what we're being requested to support as real demand. So our customers are trying to get products out the door, and they're not building inventories at this point in time."
},
{
"speaker": "Ambrish Srivastava",
"text": "And have the lead times changed versus where they were last quarter?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "It depends on the product, and it depends on the market. So we have some areas where they continue to extend and others that have stabilized. So overall, lead times are above normal and it's not where we want them to be. But it's very product and market specific given the diversity of what we make and where we make it."
},
{
"speaker": "Vincent Roche",
"text": "I think it's true to say lead times have stabilized."
},
{
"speaker": "Operator",
"text": "Your next question comes from Stacy Rasgon with Bernstein Research."
},
{
"speaker": "Stacy Rasgon",
"text": "I wanted to ask a little more about the shape of the synergies. I think you had said the cost synergies would be in 40% this year and the remainder of next year. Can you give us some idea how do those split out between OpEx and gross margin and COGS, and what is the proper sort of all-in baseline for OpEx that we should be building those synergies off of? And I guess, finally, with gross margins along with same lines, given you've got pricing and other stuff as a tailwind and you see revenue growth. Do you still think that Q1 gross margins wherever they want coming out, is that the trough for the year, given how everything else flows through?"
},
{
"speaker": "Vincent Roche",
"text": "So Stacy, the way to think about the cost synergies is we said roughly 40% in the coming fiscal and then the balance in 2023. The majority of the coming fiscal will actually be in cost of goods. And then in 2023, you'll see that flip to be the majority of that coming in OpEx. What else can I tell you there -- anything else [Mike] that's relevant…"
},
{
"speaker": "Michael Lucarelli",
"text": "I'll call that -- that would be -- that's Phase 1. We will talk more about Phase 2 at the Analyst Day and we'll look to increase that synergy target at that time. And I think you had second question on gross margin, I'll pass it back to Prashanth…"
},
{
"speaker": "Stacy Rasgon",
"text": "Also what’s the proper sort of like current like folding run rate for OpEx right now?"
},
{
"speaker": "Vincent Roche",
"text": "If you look at our our first quarter guide, and that's probably a good level of run rate OpEx, I would say. In that guide, there is about $20 million of annual OpEx we took out in our fourth quarter. So maybe add $20 million to that for the run rate…"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "On gross margins, the -- so first quarter seasonally tends to be a little bit lower because we have the holiday shutdowns and this first quarter here will have a full quarter of Maxim, which as many of you know, had lower gross margins than stand-alone ADI. So we've got some headwind coming from that. The tailwind is we've got the revenue that's coming in strong and pricing, as I mentioned earlier, is going to be -- start to be mildly accretive. So all in, I would think gross margins kind of sequentially, I think, flattish is a safe model."
},
{
"speaker": "Vincent Roche",
"text": "And you're right, on the gross margin for the year, the plan is for it to continue to rise throughout the year, assuming demand remains strong and mix doesn't change given synergies and also our pricing actions."
},
{
"speaker": "Operator",
"text": "Your next question is from Harlan Sur with JPMorgan."
},
{
"speaker": "Harlan Sur",
"text": "Congratulations on the strong results and execution. On inventories, I think you mentioned that they continue to be below your target range of seven to eight weeks. And I know that on a finished goods perspective, at least through Q3, that was down year-over-year, it was down year-to-date versus an increase in total inventories, which implies to me that consignment or direct customer inventories are also quite lean and demand is strong. And so I guess what's your view on when the team and your customers will be in a position to build back inventories or is it just hand them out for the next several quarters?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "I think it probably looks to be continued hand to mouth for the next couple of quarters. Our inventory numbers are a little bit confusing because of some of the map that's in there. So I'll just go back to what I said in the prepared remarks. Days of inventory was down slightly. The internal inventory balance was up as we built raw materials and WIP. You have some noise in there from Maxim's inventory being added into our middle of the quarter as well as the purchase accounting math, which requires us to do a step up of that. So adjusting for all of that, we were up slightly in terms of ADI balance sheet inventory and most of that was in WIP. On the channel side, it remains very lean and well below where we want it to be, and that causes some challenges on customer service as it does for everyone in the industry. We don't see that abating at least for the first or second quarter, and it's hard for us to see further out than that."
},
{
"speaker": "Operator",
"text": "Your last question is from C.J. Muse with Evercore."
},
{
"speaker": "C.J. Muse",
"text": "I guess a question on supply and gross margins. As you look at fiscal '22, can you speak to the growth you anticipate from internal versus external supply? And then based on that, how should we think about the implications to your gross margins?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "So C.J., well, let's break down the dynamics. On the internal supply, I mentioned that ADI's internal capacity will continue to improve as we go through every quarter as we bring more equipment online. On the Maxim side, I mentioned that is pretty much flat for most of the year. We're optimistic that we might be able to see some improvement towards the tail end of the year as we get more equipment in. On the external side, I will say that Vince himself is personally involved in conversations with our foundry partners and looking to get additional wafer capacity when we can, but it's very much driven by what nodes are available. And maybe I'll pass to Vince here to add a bit more comment since you've been having a lot of those conversations…"
},
{
"speaker": "Vincent Roche",
"text": "I think the best answer we can give you, C.J., is that we've indicated we expect gross margins to increase throughout the year. And we've got a hybrid model. So we expect to -- against that, we're not expecting any kind of external, internal prohibitions that will impact gross margin but we expect it to increase throughout the year."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, everyone, for joining the call this morning. A content transcript will be available on our Web site and all available reconciliations and this information can also be found there. Thanks again for joining us and your continued [Technical Difficulty] Analog Devices. Have a great Thanksgiving."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Happy Thanksgiving, everyone."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect. Speakers, please hold the line."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 3 | 2,021 | 2021-08-18 10:00:00 | Operator: Good morning. And welcome to the Analog Devices Third Quarter Fiscal Year 2021 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Michael Lucarelli, Senior Director of Investor Relations. Sir, the floor is yours.
Mike Lucarelli: Thank you, Shelby. And good morning, everybody. Thanks for joining our third quarter fiscal 2021 conference call. With me on the call, today are ADI's CEO, Vincent Roche, and ADI's CFO, Prashanth Mahendra-Rajah. Anyone who missed the release, can find it and relatIng financial schedules at investor.analog.com. And onto the disclosures. The information we're about to discuss includes forward-looking statements which are subject to certain risks and uncertainties as described in our earnings release, and our most recent 10-Q and other periodic reports and materials follow the SEC. Actual results could differ materially from this forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements except as required by law. Our comment today will also include non-GAAP financial measures, which exclude special items. When comparing results to our historical performance, special items are also excluded from prior to last period's. Reconciliations of these non-GAAP measures to the most drastic comparable GAAP measures, and additional information about our non-GAAP are included in today's earnings release. And with that, I'll turn it over to ADI's CEO, Vince Roche. Vince?
Vince Roche: Thank you, Mike. And a very good morning to everybody. So, ADI delivered a second consecutive Quarter of record revenue and earnings, despite the challenging supply environments. Our strong performance was driven by continued operational excellence and insatiable demand as semiconductors power the modern digital age. Broadly speaking, the economic recovery continues to take shape with demand still far exceeding supply. We, like many others in our industry, will face a constrained supply environment into 2022. Despite this backdrop, our business continues to achieve record results as our investments and design win over the last few years are matched with strong demand across our end markets. So looking ahead, the combination of robust bookings, lean inventories, and ongoing capacity additions position ADI to close Fiscal '21 on a high note and continue to grow in the next year. So moving to our third-quarter results, revenue was $1.76 billion up 21% year-over-year. All markets increased sequentially with industrial and automotive once again, achieving the record. The gross margin expanded to over 71% and the Operating margin over 43%. Adjusted EPS of $1.72 increased 27% year-over-year. Despite elevated capital spending to increase our capacity, free cash flow over the trailing 12 months was $2.2 billion. This equates to a 34% free cash flow margin, maintaining our position in the top 10% of the S&P 500. Overall, I'm very pleased with our performance and our team's outstanding execution. As you know, at ADI, our ethos of innovation and deep customer engagements ensure that we stay ahead of what's possible. We invest more than a billion dollars annually in R&D focused on strengthening our core franchises and capturing market opportunities presented by sector growth records, which have accelerated the economic recovery. Now, let me share some recent highlights with you. Our industrial business is our most diverse segment across customers, products, and applications and features sticky long product lifecycles. Our largest industrial segment, instrumentation, and test, is comprised of automated test equipment, electronic test and measurement, and scientific instruments. This is truly a performance-driven market that aligns perfectly with our high-performance precision Signal Chain, Power management, and RF portfolios. Importantly, instrumentation and text are aligned with all secular growth trends from connectivity to EVs to sustainability. The growing technical complexity of these applications required more testers with more advanced performance capabilities. Today, ADI is the leader in communications tests. And we're collaborating with Keysight, for example, to advance the development of O-RAN solutions. This partnership will enable the fastest path for the design and cost-effective and power-efficient radio units. Looking ahead, we're already beginning to partner with our customers to test emerging 6G technologies. Our innovations in the instrumentation market also have a positive impact on human and planetary health. One particular area is our environmental monitoring business, where there's an increased need for highly reliable and accurate instruments to improve the standard of living globally. Our market-leading portfolio of precision converters enables 10 times greater measurement resolution of fine particulate matter, better identifying trace pollution. The next largest industrial segment is factory automation. Over the last year, many of our customers are rethinking their factory flows and supply chains to make them more resilient, cost-effective, and flexible through automation and connectivity. To achieve this, our customers will further automate their businesses with intelligent and connected factories, and increase their use of robots and cobots. Specifically, cobots require ADI's precision signal chain and power franchises sensing technologies, and robust wired and wireless connectivity. This new vector of growth increases our sum opportunity by three times that of a traditional robot. To that end, our precision motion control business is on track for a record year of design wins, including a recent win at a leading Japanese robotics Company for its next-generation robots. In addition, we are leveraging our domain knowledge and system-level expertise in a collaboration with Universal Robots to design smaller, smarter, and easier-to-use robots that help scale tasks safely and transform workforces. We're turning now to our Communications business. 5G is beginning to broaden globally, especially in North America, as carriers look to deploy newly acquired C-band spectrum and all-round continues to gain momentum also, with several of the largest European carriers setting ambitious 2025 all-round deployment targets. This includes Vodafone where our technologies are very well represented. This quarter we extended our market-leading position in 5G radio solutions with the introduction of the industry's first software-defined transceiver that includes a fully integrated digital front end. Our innovative radio architecture greatly improves power efficiency, thereby reducing radio weight, size, and carrier expenses. This high level of integration eliminates FPGAs to simplify implementation and facilitate the proliferation of these emerging O-RAN networks. Our next-generation receiver platform is already designed at a major Tier-1 global supplier that is gaining share in this 5 G and O-RAN deployments across North America as well as Europe. Stepping back, we expect our communications business to return to growth in 2022. We have strong design momentum and our geographic mix has shifted with North America, Europe, and Korea representing our largest sources of revenue. Moving now on to automotive. Over the last 2 years, we've realigned our business to focus on electrification and the in-cabin human experience. We're seeing the benefits of this strategy as we continue to scale our market leadership in battery management, power management, audio systems, and connectivity. Starting firstly with our battery management systems or BMS, our wired and wireless portfolios provide unmatched accuracy to deliver market-leading vehicle range and can measure all key battery chemistries, including zero-Cobalt LFP. Additionally, our solutions incorporate ASLD functional safety and an ultra-low power continuous monitoring feature that ensures the battery remains stable even while parked, which is a first in the market. In addition, this quarter marked the first time we recognized revenue for our wireless BMS solution as General Motors prepares to ship its first of 30 EV models powered by the OTM battery platform. And this is just the beginning of this groundbreaking BMS technology as OEMs realized the power of wireless data in scaling their fleets. Turning to audio systems and connectivity. As complexity continues to increase, there's a very strong demand for our market-leading audio systems with signal processing. A2B connectivity, and active road noise cancellation. Our solutions offer the highest fidelity performance in the market while reducing vehicle weight, removing nearly 100 pounds per vehicle. During quarter 2 leading OEMs adopted A2B and a Top 3 European vehicle manufacturer implemented A2B as its audio connectivity standard across its entire fleet. In total, A2B is now designed in over 30 OEMs, including 18 of the top 20 global automotive Companies. Furthermore, interest in our active road noise cancellation feature continues to intensify. We're designed in at 9 OEMs, up from 5 just a year ago, including Hyundai and a leading EV manufacturer. The gadget capability can more than doubled the value of our A2B solution. These are just a few of the countless examples of the tremendous work underway at ADI. We remain focused on delivering breakthrough innovations to stay ahead of our customer's needs. So in closing, I have never been more confident about ADI's future. Over the last decade, we've built an industry-leading portfolio with unparalleled breadth and depth of capabilities that are aligned with more profitable end markets. And our portfolio and leadership position will only get stronger with the acquisition of Maxim, enabling us to deliver strong returns in the years to come. And so with that, I'll hand you over to Prashanth.
Prashanth Mahendra-Rajah: Thank you, Vince. Good morning and welcome to our third-quarter earnings call. My comment today with the exception of revenue and non-op expenses will be on an adjusted basis, which excludes special items outlined in today's press release. ADI delivered exceptional third-quarter results, underpinned by our ability to increase production. Revenue and EPS reached all-time highs for the second straight quarter, with continued gross and Operating margin expansion. If we look at performance by end-market, industrial represented 57% of revenue and increased 3% sequentially and 29% year-over-year. Notably, this business surpassed $1 billion of quarterly revenue for the first time. We experienced broad-based strength across applications and geographies. All subsegments increased double-digits year-over-year, except healthcare, given the elevated pandemic demand a year ago. Communications represented 16% of revenue and decreased 21% year-over-year, while up 4% sequentially with growth in both wireless and wirelines. As we outlined last quarter, we believe our communications revenue has bottomed and we'll continue to grow as 5G deployments broaden globally, especially in North America. Automotive represented 16% of revenue and increased 13% sequentially, and 80% year-over-year. Strength was broad-based with double-digit growth across every major application. BMS and A2B remain our fastest-growing applications and both are on track to nearly double in size this year. As Vince shared earlier, ADI has been strategically pivoting resources to focus more aggressively on electrification and the in-cabin human experience. As part of this strategy, we are licensing select radar IP to a large European Tier-1 auto supplier. This resulted in immediate revenue recognition of 24 million in the quarter. Consumer represented 10% of revenue and increased 16% both sequentially and year-over-year. Our strategy to diversify and grow this business in Fiscal '21 is working, as strength across home entertainment wearables, and wearables more than offset a decline in portables. And now moving to the P&L, gross margin expanded sequentially and year-over-year, finishing at 71.6% mainly due to the cost savings from the LPC manufacturing optimization and the IP license agreement. OpEx in the quarter was 493 million up modestly sequentially, due to a full quarter of mere increases and continued strong variable comp. This netted an Op margin of 43.6%, which marks the 5th straight quarter of year-over-year Op margin expansion, underscoring the strong leverage in our business. Non-op expenses were 37 million below our typical quarterly run rate of approximately 43 due to an investment gain. And our tax rate was approximately 12%, which gives us an adjusted EPS at $1.72, including $0.05 of upside attributable to the IP licensing agreement. Moving onto the balance sheet, we finished the quarter with an ending cash balance of 1.5 billion and a net leverage ratio of 1.2 times. Relative to the second quarter, inventory dollars increased by 16 million, driven entirely by raw materials and the working process. Days of inventory were unchanged at 118 and weeks of channel inventory remain well below the low-end of our seven to eight-week target, as sell-through remains stronger than sell-in. Capex for the quarter was $86 million up meaningfully sequentially, as we continue to add capacity to support our robust and growing order book, which now stretches into Fiscal '22. We will continue to increase capacity in the fourth quarter resulting in full-year capital intensity above our long-term model of 4%. In turning to free cash flow, we generated more than $2.2 billion over the trailing 12 months, up 23% from a year ago. And this represented a 34% free cash flow margin. Over this same period, we have returned nearly 85% of free cash flow after debt repayments via $970 million in dividends and over $500 million in share repurchases. And now onto the Fourth Quarter outlook: Revenue is expected to be $1.78 billion, plus or minus $70 million, up sequentially as additional capacity comes online. At the midpoint, excluding the automotive IP licensing revenue, we expect each of our B2B markets to increase sequentially, led by communications and consumers to be up to 5 single digits. Based on the midpoint of the guide, we expect to deliver a record gross margin. And for operating margins to be 43.7% plus or minus 100 bps. Our tax rate is expected to fall toward the upper end of our range. And based on these inputs, adjusted EPS is expected to be $1.72 plus or minus $0.11. So before moving to the Q&A, I'd like to give a brief update on Maxim. Our discussions with the Chinese Regulatory Authorities have been productive, and we're working towards closing within the initial timeframe. We plan on closing no later than the 3rd business day after China approval has been granted. As we shared before, shortly after the close, we will hold a conference call to provide an update on our capital return plans. Once combined, we anticipate having nearly 4 billion of cash on our balance sheet, a leverage ratio well below one, and more than 3 billion of annual free cash flow. I'll now turn it over to Mike to start the Q&A.
Mike Lucarelli: Thanks, Prashanth. Let's get to our Q&A session. We ask that you limit yourself to 1 question in order to allow for additional participants on the call this morning. If you have a follow-up question, please re-queue and we will take your questions if time allows. With that, to our first question, please.
Operator: If you are listening on a speakerphone, please pick up the handset when asking your question. We'll pause for just a moment to compile the Q&A roster. Your first question is from Vivek Arya of Bank of America Securities.
Vivek Arya: Thanks for taking my question. Once you mentioned demand far exceeds supply, I was hoping if you could help us quantify that. Are you under-shipping by 5%, 10%? How much of a demand cushion does ADI have right now? And kind of Part B of that is how much incremental capacity are you planning to bring online in the next year and is that kind of a proxy for what kind of sales growth we should be looking at? Thank you.
Prashanth Mahendra-Rajah: Thanks, Vivek. So demand continues to grow across our markets. All end markets are up and our book-to-bill was above 1.2. Supply is also expanding. We grew 4% sequentially in the third quarter, and we're at the midpoint, we're going to be up another 3% for the fourth quarter. So you look at that math and it says the supply-demand gap is growing or said another way, the backlog is increasing quarter-over-quarter and it now extends well into 2022. Our view is this gap is likely to persist into calendar year '22 given the long lead time it takes to add supply in the industry plus just the broad strength of the demand.
Vince Roche: Yeah, I think the second part of that question, Vivek, just a little bit of color. So, we're leering an investment in CapEx to support our growth objectives, particularly on the backend of our operation, assembly, and test. And we need this capital now to meet the demand, but also in the longer term, we're very, very optimistic about the tailwinds right across our business, from automation to electrification, connectivity, and so on and so forth. The outlook we've just given you supplies feasible and it is certainly the governor, I would say, right now on revenue for the Company.
Vivek Arya: Thank you.
Mike Lucarelli: Thanks, Vivek. We go to the next question, please.
Operator: Your next question is from Tore Svanberg of Stifel.
Tore Svanberg: Yes. Thank you. I was hoping you could just elaborate a little bit more on the Maxim merger. You said that you'd still expect it to happen within the timeframe you had announced. I believe you had said the summer of 2021, correct me if that was wrong. And related to that is, again, China the only remaining obstacle before you can close the deal?
Vince Roche: Thanks, Tore. So look our confidence in the closing remains unchanged. And as we said in the prepared comments, our discussions with the Chinese Regulatory Authorities have been positive and productive. And we are working towards closing within the initial timeframe. So China is the only outstanding regulatory approval need at this point in time. And I will remind you as well that all of the other regulatory bodies across the globe have approved our deal without condition, without remedies.
Tore Svanberg: Great. Thank you for that, Vince.
Mike Lucarelli: Thanks, Tore. Go to the next questions.
Operator: Your next question is from John Pitzer of Credit Suisse.
John Pitzer: Good morning, guys. Thanks for letting me ask the question, Vince, I wanted to pick up on your prepared comments about your industrial business. You're now going in the third consecutive quarter of sort of record revenue s in that business. You have to go back to April of '18 before -- which was the last peak. But -- but the other date -- but fiscal year to date, that business is up about 30% year-over-year, and for a lot of investors, they're concerned that perhaps that represents more cyclical excess than structural sustainability. And so I'm kind of curious as you break apart your industrial business. What do you think is being driven by the " cycle versus stuff that's a little bit more sustainable? "
Vince Roche: Yes. Thanks, John (ph). First and foremost, I'd like to remind everybody that ADI's industrial business is built on a foundation of many individual market segments like automation, instrumentation that I talked about, healthcare, our space business, and energy, as it moves to renewables and charging infrastructure, for example, the whole need for grid efficiency and stabilization. So that's the foundation. It's a highly diverse business. We've got many tens of thousands of customers. And, you know, the lifecycles in the business are 15 years plus. And it's a very, very, very sticky socket that we've got. So, those of you who followed ADI for a long time, remember about a decade ago, we fairly dramatically increased our focus in terms of R&D, go-to-market activities, in ensuring that we could really grow that business. And the last years have shown that we've been getting market share across the board there. So I think there were a lot of programs that were stalled last year, so there's a certain amount of catch-up there. But I do think that the breadth of the portfolio that we know has the investments we've been making in terms of customer engagement, R&D activities, and the secular trends that we've got all these concurrent secular drivers are propelling that business beyond the market.
Mike Lucarelli: I'll add one thing, John. You're right. As you've seen in our prepared comments, all the markets did increase double-digits year-over-year. Of our 6 applications that Vince outlined, 2 are still below pre-peak levels. We do think Fiscal '21 marks a record for all of them and we don't see why they won't hit another record in '22 given the strong trends that Vince outlined. And with that, we'll go to our next question.
Operator: Your next question is from Stacy Rasgon of Bernstein Research.
Stacy Rasgon: Hi guys. Thanks for taking my questions. I had a question about the pricing environment. Given just the tight supply and the shortage situation, we're starting to see some hints of some of your peers starting to take prices up. And I was curious what you guys are seeing in the pricing environment. Are you seeing that? Are you able to actually do that? Are you trading your own pricing environment down more conservatively?
Prashanth Mahendra-Rajah: Yes. Thanks for the question, Stacy. So I would say that for the results that we printed, pricing is net-neutral. We're passing on cost increase so that we're not impacting margins, but we've made a decision not to take advantage of our customers by structurally increasing pricing in this environment. Our long-term model is unchanged and that is 70% plus. So the goal really is to drive the revenue growth and make the trade-offs that are necessary to drive that revenue growth. Focusing on delivering on the top margin and the free cash flow. So you'll see, if you back out the IP license impact, we had a 71.2% gross margin in the third quarter. And while we don't guide to gross margins, if you impute it from the guide that we gave you, the fourth quarter is going to probably be a record for ADI in terms of gross margins.
Stacy Rasgon: Got it. That's helpful. Thank you.
Mike Lucarelli: Thank Stacy. Next question.
Operator: Your next question is from Toshiya Hari of Goldman Sachs.
Toshiya Hari: Hi guys. Good morning. Thanks for taking the question. I wanted to ask about the comms business. Vince, you talked about 2022 being a growth year, and you talked about North America, Europe, and Korea being the key drivers for you guys going forward. How should we think about the shape of the recovery going forward? Is it going to be a fairly gradual recovery? Could it be sort of a V-shaped recovery over the next couple of quarters? And when you talk about the return to growth in '22, what's sort of implicit assumption are you making for China? Thank you.
Prashanth Mahendra-Rajah: Okay. Thanks. We're going to split that into 2. Let me just quickly talk about what happened and then I'll let Vince speak too more broadly. In the second quarter, as a reminder, we did call the bottom on comms and said that we would grow on a sequential basis. We delivered that in the third quarter and we are on track to deliver that for the fourth quarter. So we believe we're really well-positioned for strong growth into Fiscal '22. And between the two sub-segments there, wire demand remains strong and we expect that to continue as both carriers and data centers continue to do the upgrades to their networks. And wireless, it's always lumpy, growth in the past quarter was really driven by the rest of the world. North America. We do think China bottomed in the third quarter. So that should also represent some growth momentum for us as we go forward. And then I'll hand off to Vince to kind of speak more broadly about what we're seeing.
Vince Roche: Yes, Toshiya, why do I have the confidence I have about 2022 being a strong growth year? So maybe I can unpack that a bit for you. So I think our comms' revenue mix is seeing a benefit from the rest of the world beginning to emerge in 5G. So today, the rest of the world outside of China is 3x in terms of the term. So that's number 1. If you look at then the geographies of North America, the auction to C-band auction's complete. Revenue's really just beginning here. And all the indications are that 5G revenue here will accelerate in 2022 and indeed beyond. Europe, it's -- I would say, a step behind, but we're beginning to see good signs of life in that region but I think it'll be a more elite 2022 driver. We've talked several times in various calls here about O-RAN, what's happening, but we're beginning to see revenue. We've talked before about Rakuten in Japan, that business continues to accelerate. And European carriers are looking right in to make it also an important part of their 5G offering. I mentioned during the prepared remarks as well that Vodafone is a major player there and we happen to be very well represented in their systems. And I'm also having conversations with customers about the use of 5G and O-RAN beyond the classical consumer market. So it's early days, but the characteristics of flexibility, scalability, quicker time-to-market, cost savings, and so on, are enabling private Networks to be configured in factory environments, for example. So that's all still on the comm, but that gives you a sense of our confidence in 2022 and beyond.
Mike Lucarelli: Thanks, Toshiya.
Toshiya Hari: Thank you. We'll go to the next question.
Operator: Your next question is from Ambrish Srivastava of BMO.
Ambrish Srivastava: Hey, thank you. Good morning, folks. I have a question about Maxim. And so my investment case for ADI has not been Maxim and you have a very sticky shareholder base who have been with you before Maxim, but I get this question a lot, so I think it's a fair question to ask. If Maxim was not to go through, what do you think about capital allocation? Do you then go back to the playbook and say you would be changing how you think about capital allocation or you would continue on the M&A path and look at other opportunities? Thank you.
Prashanth Mahendra-Rajah: So, in response to this, let me just remind everyone what the capital allocation policy is today because I think that we have a very shareholder-friendly capital allocation policy. This is, that first call is really to invest in the business and that, although not a traditional definition, we do consider that organically kind of how we spend our R&D, and that is heavily pointed towards the B2B markets. And then we think about inorganic really more as it helps the technology portfolio or finds other ways to help us become more important to customers. But our commitment is to return 100% of free cash flow to customers. So, we are at 1.2 level leverage today. We do not need to reduce debt. So on a -- in an environment, despite the confidence that we have in the Maxim deal closing in an environment where that was not to have happened, would not look for us to really be changing that view of having all our incremental free cash flow go return to shareholders either through buybacks or through dividend. And as a reminder, I think over the past 3 years, we've averaged about a 10% increase in our dividend. So a very healthy commitment for our fixed income-focused investors as well as the repo. I think we're on track this year for an all-time high in terms of our repo activity. Back to the M&A, I'm going to hand that one to Vince to talk more about the alternatives there.
Vince Roche: Yes. So as you know, you've seen over the years, we've always acquired very, very high-quality assets, and that will remain to be our view on things in the years ahead as well.
Ambrish Srivastava: Okay. Thank you.
Mike Lucarelli: Thanks. Ambrish. Next caller.
Operator: Your next question is from Blayne Curtis of Barclays.
Blayne Curtis: Hey, good morning. Thanks for taking the question. Just curious if you looked at the B2B guidance, it's fairly flat, as I think industrial probably is flat given the slug segment guidance you gave. I'm just kind of curious as you look at this. Obviously, you had strong comments on the bookings. Is that gap really supply or are you starting to see demand tends to start to settle out at this level?
Prashanth Mahendra-Rajah: That is purely clearly supplied. I think I mentioned in maybe the first or second question that book-to-bill for the quarter was over 1.2 and that's across all markets. So we are seeing very strong interest in products across all markets. Mike indicated in one of the other Q&A that they were likely to have the industrial markets hit an all-time high collectively for a calendar for Fiscal year '21 and expect that to continue to be on track to another record in FY '22. So very much a supply-constrained environment.
Blayne Curtis: Thanks and I just want to follow up on the gross margin, Prashanth. So you indicated the gross margin would be up and I think that's with the license impact as well. So you saw a benefit from the linear. I was curious how much more there is of that as a benefit. And then maybe just talk about utilizations and another pulling gross margin as you look over the next couple of quarters.
Prashanth Mahendra-Rajah: Yes. So I presume you're asking with respect to the guidance. So in the fourth quarter, and we're not guiding gross margins, but we're pretty confident we are going to hit a new record for gross margins that are coming from the LTC synergies, I think we hit the final phase of closing down the manufacturing operation in California. We still have an opportunity as soon as the supply environment allows us to get some additional savings out of Asia because we haven't closed that facility up because we have no time to shift the tools to their new location. Utilization is also going to provide some level of increase. I would say the mix is a bit of a headwind into the Fourth Quarter. And Fourth Quarters typically have some level of challenges in terms of a holiday shutdown. So, we need to manage through that, which can provide a little bit of headwind for us as well that we got to work ourselves around.
Vince Roche: You know, the foundation for our gross margins being where they are, It's the number 1 innovation. We produced the best performing solutions between the physical and digital worlds and we got a premium. We got very, very well paid for doing that. Also, the diversity of our products and customer portfolios, 125,000 customers with I think I've said this before, 85% of our sales come from products that individually contributed less than 0.1%. And the pricing environment, as we said earlier on the call, has been very, very stable, very steady.
Mike Lucarelli: Thanks, Blayne, for that two-part, one-part question. We'll go to the next caller, please.
Operator: Your next question is from Harlan Sur of JPMorgan.
Harlan Sur: Good morning and congratulations on the strong results in quarterly execution. Channel inventories continue to remain below your target 7 to the 8-week range. You guys can also monitor direct customer inventories at least for those that are on consignment programs. Any signs that customers have been able to build inventories? I mean, it seems unlikely because the entire value chain appears to be sort of hand-to-mouth from a chip supply perspective, but I wanted to get your views. And when do you believe customers will be in a position to start to build that inventory? I'm assuming the soonest is sometime in calendar '22, but I wanted to get your views as well.
Prashanth Mahendra-Rajah: Yes. Thank you, Harlan Sur. I'll take that. So first, a couple of comments on inventory. Inventory on our balance sheet is up year-over-year and sequentially, but that is exclusively due to raw materials and width. We can't keep a finished good in stock. So when it's produced, it either goes to the customer or it goes into the channel, and then it goes out of the channel immediately. So we are struggling to build finished goods inventory both in ADI warehouses as well as in our channel partners. Roughly, let's say a significant amount of our auto business is on consignment which gives us good visibility for that direct business as to what's happening there. And that is also we are seeing that demand pull through pretty quickly and no opportunity for those auto customers to build the inventory within their warehouses, but that's on our books. So it's still very much hand-to-mouth and the focus that we have as we've talked throughout this call and in the prepared remarks is on increasing our capacity or ability to supply by making some significant investments in capacity. I don't see this balance coming into some sense of normalcy until sometime in calendar year '22.
Harlan Sur: Okay, thank you.
Mike Lucarelli: All right. We'll have our last question, please.
Operator: Your next question is from William Stein of Trust Securities
William Stein: Great, thanks for taking my question. You just talked about inventory not coming to some level of ability to rebuild anything until sometime in '22, you talked about the supply debate about lasting. We're well into '22, which put you up to the bill, etc. When we look out to the next quarter, the January quarter, typically, that's a sequentially down quarter in automotive, industrial, consumer, and for the whole business as well. But given these supply constraints of this very significant backlog, should we think about that seasonality as different in the coming year? Should we expect maybe some visibility to sequential growth for the next several quarters? Thank you.
Prashanth Mahendra-Rajah: Yeah, I think the way to answer that would be to say that seasonality in today's environment is a bit of a meaningless concept because revenue growth is really dictated completely by supply. So the print for Q1 is likely to be driven by what more capacity we can get online over the fourth quarter to allow us. Again now we've got a couple of things we need to work through in the first quarter that would be a little bit of an offset. And first, there's the holiday season. So we do need to adjust factory capacity for that. And fourth quarter is the key quarter for the consumer; that's when they build for the holiday season. So there's always going to be a little bit of seasonality impact for the consumer just because they don't need it in our fiscal first quarter as that is the holiday period. So maybe that's where I will finish. Mike, anything you want to add to that?
Mike Lucarelli: Yeah, sure. I guess if you look back, you're right. We talk about seasonality not being as meaningful now, but just give you a bit of a history lesson. If you look past over the past 10 years, you're right, our B2B markets, I would say in good times, which I would call now good times, it's usually flatted down slightly in 1Q and consumer, I will say in good and even normal times it down 5% or maybe more in 1Q. And with that, I want to thank everyone for joining the call this morning. A copy of the transcript will be available on our website. And all reconciliations and additional information can also be found in the Quarterly Results section. Thanks again for joining and your continued interest in ADI.
Operator: This concludes today's Analog Devices Conference Call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning. And welcome to the Analog Devices Third Quarter Fiscal Year 2021 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Michael Lucarelli, Senior Director of Investor Relations. Sir, the floor is yours."
},
{
"speaker": "Mike Lucarelli",
"text": "Thank you, Shelby. And good morning, everybody. Thanks for joining our third quarter fiscal 2021 conference call. With me on the call, today are ADI's CEO, Vincent Roche, and ADI's CFO, Prashanth Mahendra-Rajah. Anyone who missed the release, can find it and relatIng financial schedules at investor.analog.com. And onto the disclosures. The information we're about to discuss includes forward-looking statements which are subject to certain risks and uncertainties as described in our earnings release, and our most recent 10-Q and other periodic reports and materials follow the SEC. Actual results could differ materially from this forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements except as required by law. Our comment today will also include non-GAAP financial measures, which exclude special items. When comparing results to our historical performance, special items are also excluded from prior to last period's. Reconciliations of these non-GAAP measures to the most drastic comparable GAAP measures, and additional information about our non-GAAP are included in today's earnings release. And with that, I'll turn it over to ADI's CEO, Vince Roche. Vince?"
},
{
"speaker": "Vince Roche",
"text": "Thank you, Mike. And a very good morning to everybody. So, ADI delivered a second consecutive Quarter of record revenue and earnings, despite the challenging supply environments. Our strong performance was driven by continued operational excellence and insatiable demand as semiconductors power the modern digital age. Broadly speaking, the economic recovery continues to take shape with demand still far exceeding supply. We, like many others in our industry, will face a constrained supply environment into 2022. Despite this backdrop, our business continues to achieve record results as our investments and design win over the last few years are matched with strong demand across our end markets. So looking ahead, the combination of robust bookings, lean inventories, and ongoing capacity additions position ADI to close Fiscal '21 on a high note and continue to grow in the next year. So moving to our third-quarter results, revenue was $1.76 billion up 21% year-over-year. All markets increased sequentially with industrial and automotive once again, achieving the record. The gross margin expanded to over 71% and the Operating margin over 43%. Adjusted EPS of $1.72 increased 27% year-over-year. Despite elevated capital spending to increase our capacity, free cash flow over the trailing 12 months was $2.2 billion. This equates to a 34% free cash flow margin, maintaining our position in the top 10% of the S&P 500. Overall, I'm very pleased with our performance and our team's outstanding execution. As you know, at ADI, our ethos of innovation and deep customer engagements ensure that we stay ahead of what's possible. We invest more than a billion dollars annually in R&D focused on strengthening our core franchises and capturing market opportunities presented by sector growth records, which have accelerated the economic recovery. Now, let me share some recent highlights with you. Our industrial business is our most diverse segment across customers, products, and applications and features sticky long product lifecycles. Our largest industrial segment, instrumentation, and test, is comprised of automated test equipment, electronic test and measurement, and scientific instruments. This is truly a performance-driven market that aligns perfectly with our high-performance precision Signal Chain, Power management, and RF portfolios. Importantly, instrumentation and text are aligned with all secular growth trends from connectivity to EVs to sustainability. The growing technical complexity of these applications required more testers with more advanced performance capabilities. Today, ADI is the leader in communications tests. And we're collaborating with Keysight, for example, to advance the development of O-RAN solutions. This partnership will enable the fastest path for the design and cost-effective and power-efficient radio units. Looking ahead, we're already beginning to partner with our customers to test emerging 6G technologies. Our innovations in the instrumentation market also have a positive impact on human and planetary health. One particular area is our environmental monitoring business, where there's an increased need for highly reliable and accurate instruments to improve the standard of living globally. Our market-leading portfolio of precision converters enables 10 times greater measurement resolution of fine particulate matter, better identifying trace pollution. The next largest industrial segment is factory automation. Over the last year, many of our customers are rethinking their factory flows and supply chains to make them more resilient, cost-effective, and flexible through automation and connectivity. To achieve this, our customers will further automate their businesses with intelligent and connected factories, and increase their use of robots and cobots. Specifically, cobots require ADI's precision signal chain and power franchises sensing technologies, and robust wired and wireless connectivity. This new vector of growth increases our sum opportunity by three times that of a traditional robot. To that end, our precision motion control business is on track for a record year of design wins, including a recent win at a leading Japanese robotics Company for its next-generation robots. In addition, we are leveraging our domain knowledge and system-level expertise in a collaboration with Universal Robots to design smaller, smarter, and easier-to-use robots that help scale tasks safely and transform workforces. We're turning now to our Communications business. 5G is beginning to broaden globally, especially in North America, as carriers look to deploy newly acquired C-band spectrum and all-round continues to gain momentum also, with several of the largest European carriers setting ambitious 2025 all-round deployment targets. This includes Vodafone where our technologies are very well represented. This quarter we extended our market-leading position in 5G radio solutions with the introduction of the industry's first software-defined transceiver that includes a fully integrated digital front end. Our innovative radio architecture greatly improves power efficiency, thereby reducing radio weight, size, and carrier expenses. This high level of integration eliminates FPGAs to simplify implementation and facilitate the proliferation of these emerging O-RAN networks. Our next-generation receiver platform is already designed at a major Tier-1 global supplier that is gaining share in this 5 G and O-RAN deployments across North America as well as Europe. Stepping back, we expect our communications business to return to growth in 2022. We have strong design momentum and our geographic mix has shifted with North America, Europe, and Korea representing our largest sources of revenue. Moving now on to automotive. Over the last 2 years, we've realigned our business to focus on electrification and the in-cabin human experience. We're seeing the benefits of this strategy as we continue to scale our market leadership in battery management, power management, audio systems, and connectivity. Starting firstly with our battery management systems or BMS, our wired and wireless portfolios provide unmatched accuracy to deliver market-leading vehicle range and can measure all key battery chemistries, including zero-Cobalt LFP. Additionally, our solutions incorporate ASLD functional safety and an ultra-low power continuous monitoring feature that ensures the battery remains stable even while parked, which is a first in the market. In addition, this quarter marked the first time we recognized revenue for our wireless BMS solution as General Motors prepares to ship its first of 30 EV models powered by the OTM battery platform. And this is just the beginning of this groundbreaking BMS technology as OEMs realized the power of wireless data in scaling their fleets. Turning to audio systems and connectivity. As complexity continues to increase, there's a very strong demand for our market-leading audio systems with signal processing. A2B connectivity, and active road noise cancellation. Our solutions offer the highest fidelity performance in the market while reducing vehicle weight, removing nearly 100 pounds per vehicle. During quarter 2 leading OEMs adopted A2B and a Top 3 European vehicle manufacturer implemented A2B as its audio connectivity standard across its entire fleet. In total, A2B is now designed in over 30 OEMs, including 18 of the top 20 global automotive Companies. Furthermore, interest in our active road noise cancellation feature continues to intensify. We're designed in at 9 OEMs, up from 5 just a year ago, including Hyundai and a leading EV manufacturer. The gadget capability can more than doubled the value of our A2B solution. These are just a few of the countless examples of the tremendous work underway at ADI. We remain focused on delivering breakthrough innovations to stay ahead of our customer's needs. So in closing, I have never been more confident about ADI's future. Over the last decade, we've built an industry-leading portfolio with unparalleled breadth and depth of capabilities that are aligned with more profitable end markets. And our portfolio and leadership position will only get stronger with the acquisition of Maxim, enabling us to deliver strong returns in the years to come. And so with that, I'll hand you over to Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Good morning and welcome to our third-quarter earnings call. My comment today with the exception of revenue and non-op expenses will be on an adjusted basis, which excludes special items outlined in today's press release. ADI delivered exceptional third-quarter results, underpinned by our ability to increase production. Revenue and EPS reached all-time highs for the second straight quarter, with continued gross and Operating margin expansion. If we look at performance by end-market, industrial represented 57% of revenue and increased 3% sequentially and 29% year-over-year. Notably, this business surpassed $1 billion of quarterly revenue for the first time. We experienced broad-based strength across applications and geographies. All subsegments increased double-digits year-over-year, except healthcare, given the elevated pandemic demand a year ago. Communications represented 16% of revenue and decreased 21% year-over-year, while up 4% sequentially with growth in both wireless and wirelines. As we outlined last quarter, we believe our communications revenue has bottomed and we'll continue to grow as 5G deployments broaden globally, especially in North America. Automotive represented 16% of revenue and increased 13% sequentially, and 80% year-over-year. Strength was broad-based with double-digit growth across every major application. BMS and A2B remain our fastest-growing applications and both are on track to nearly double in size this year. As Vince shared earlier, ADI has been strategically pivoting resources to focus more aggressively on electrification and the in-cabin human experience. As part of this strategy, we are licensing select radar IP to a large European Tier-1 auto supplier. This resulted in immediate revenue recognition of 24 million in the quarter. Consumer represented 10% of revenue and increased 16% both sequentially and year-over-year. Our strategy to diversify and grow this business in Fiscal '21 is working, as strength across home entertainment wearables, and wearables more than offset a decline in portables. And now moving to the P&L, gross margin expanded sequentially and year-over-year, finishing at 71.6% mainly due to the cost savings from the LPC manufacturing optimization and the IP license agreement. OpEx in the quarter was 493 million up modestly sequentially, due to a full quarter of mere increases and continued strong variable comp. This netted an Op margin of 43.6%, which marks the 5th straight quarter of year-over-year Op margin expansion, underscoring the strong leverage in our business. Non-op expenses were 37 million below our typical quarterly run rate of approximately 43 due to an investment gain. And our tax rate was approximately 12%, which gives us an adjusted EPS at $1.72, including $0.05 of upside attributable to the IP licensing agreement. Moving onto the balance sheet, we finished the quarter with an ending cash balance of 1.5 billion and a net leverage ratio of 1.2 times. Relative to the second quarter, inventory dollars increased by 16 million, driven entirely by raw materials and the working process. Days of inventory were unchanged at 118 and weeks of channel inventory remain well below the low-end of our seven to eight-week target, as sell-through remains stronger than sell-in. Capex for the quarter was $86 million up meaningfully sequentially, as we continue to add capacity to support our robust and growing order book, which now stretches into Fiscal '22. We will continue to increase capacity in the fourth quarter resulting in full-year capital intensity above our long-term model of 4%. In turning to free cash flow, we generated more than $2.2 billion over the trailing 12 months, up 23% from a year ago. And this represented a 34% free cash flow margin. Over this same period, we have returned nearly 85% of free cash flow after debt repayments via $970 million in dividends and over $500 million in share repurchases. And now onto the Fourth Quarter outlook: Revenue is expected to be $1.78 billion, plus or minus $70 million, up sequentially as additional capacity comes online. At the midpoint, excluding the automotive IP licensing revenue, we expect each of our B2B markets to increase sequentially, led by communications and consumers to be up to 5 single digits. Based on the midpoint of the guide, we expect to deliver a record gross margin. And for operating margins to be 43.7% plus or minus 100 bps. Our tax rate is expected to fall toward the upper end of our range. And based on these inputs, adjusted EPS is expected to be $1.72 plus or minus $0.11. So before moving to the Q&A, I'd like to give a brief update on Maxim. Our discussions with the Chinese Regulatory Authorities have been productive, and we're working towards closing within the initial timeframe. We plan on closing no later than the 3rd business day after China approval has been granted. As we shared before, shortly after the close, we will hold a conference call to provide an update on our capital return plans. Once combined, we anticipate having nearly 4 billion of cash on our balance sheet, a leverage ratio well below one, and more than 3 billion of annual free cash flow. I'll now turn it over to Mike to start the Q&A."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Prashanth. Let's get to our Q&A session. We ask that you limit yourself to 1 question in order to allow for additional participants on the call this morning. If you have a follow-up question, please re-queue and we will take your questions if time allows. With that, to our first question, please."
},
{
"speaker": "Operator",
"text": "If you are listening on a speakerphone, please pick up the handset when asking your question. We'll pause for just a moment to compile the Q&A roster. Your first question is from Vivek Arya of Bank of America Securities."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question. Once you mentioned demand far exceeds supply, I was hoping if you could help us quantify that. Are you under-shipping by 5%, 10%? How much of a demand cushion does ADI have right now? And kind of Part B of that is how much incremental capacity are you planning to bring online in the next year and is that kind of a proxy for what kind of sales growth we should be looking at? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thanks, Vivek. So demand continues to grow across our markets. All end markets are up and our book-to-bill was above 1.2. Supply is also expanding. We grew 4% sequentially in the third quarter, and we're at the midpoint, we're going to be up another 3% for the fourth quarter. So you look at that math and it says the supply-demand gap is growing or said another way, the backlog is increasing quarter-over-quarter and it now extends well into 2022. Our view is this gap is likely to persist into calendar year '22 given the long lead time it takes to add supply in the industry plus just the broad strength of the demand."
},
{
"speaker": "Vince Roche",
"text": "Yeah, I think the second part of that question, Vivek, just a little bit of color. So, we're leering an investment in CapEx to support our growth objectives, particularly on the backend of our operation, assembly, and test. And we need this capital now to meet the demand, but also in the longer term, we're very, very optimistic about the tailwinds right across our business, from automation to electrification, connectivity, and so on and so forth. The outlook we've just given you supplies feasible and it is certainly the governor, I would say, right now on revenue for the Company."
},
{
"speaker": "Vivek Arya",
"text": "Thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Vivek. We go to the next question, please."
},
{
"speaker": "Operator",
"text": "Your next question is from Tore Svanberg of Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you. I was hoping you could just elaborate a little bit more on the Maxim merger. You said that you'd still expect it to happen within the timeframe you had announced. I believe you had said the summer of 2021, correct me if that was wrong. And related to that is, again, China the only remaining obstacle before you can close the deal?"
},
{
"speaker": "Vince Roche",
"text": "Thanks, Tore. So look our confidence in the closing remains unchanged. And as we said in the prepared comments, our discussions with the Chinese Regulatory Authorities have been positive and productive. And we are working towards closing within the initial timeframe. So China is the only outstanding regulatory approval need at this point in time. And I will remind you as well that all of the other regulatory bodies across the globe have approved our deal without condition, without remedies."
},
{
"speaker": "Tore Svanberg",
"text": "Great. Thank you for that, Vince."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Tore. Go to the next questions."
},
{
"speaker": "Operator",
"text": "Your next question is from John Pitzer of Credit Suisse."
},
{
"speaker": "John Pitzer",
"text": "Good morning, guys. Thanks for letting me ask the question, Vince, I wanted to pick up on your prepared comments about your industrial business. You're now going in the third consecutive quarter of sort of record revenue s in that business. You have to go back to April of '18 before -- which was the last peak. But -- but the other date -- but fiscal year to date, that business is up about 30% year-over-year, and for a lot of investors, they're concerned that perhaps that represents more cyclical excess than structural sustainability. And so I'm kind of curious as you break apart your industrial business. What do you think is being driven by the \" cycle versus stuff that's a little bit more sustainable? \""
},
{
"speaker": "Vince Roche",
"text": "Yes. Thanks, John (ph). First and foremost, I'd like to remind everybody that ADI's industrial business is built on a foundation of many individual market segments like automation, instrumentation that I talked about, healthcare, our space business, and energy, as it moves to renewables and charging infrastructure, for example, the whole need for grid efficiency and stabilization. So that's the foundation. It's a highly diverse business. We've got many tens of thousands of customers. And, you know, the lifecycles in the business are 15 years plus. And it's a very, very, very sticky socket that we've got. So, those of you who followed ADI for a long time, remember about a decade ago, we fairly dramatically increased our focus in terms of R&D, go-to-market activities, in ensuring that we could really grow that business. And the last years have shown that we've been getting market share across the board there. So I think there were a lot of programs that were stalled last year, so there's a certain amount of catch-up there. But I do think that the breadth of the portfolio that we know has the investments we've been making in terms of customer engagement, R&D activities, and the secular trends that we've got all these concurrent secular drivers are propelling that business beyond the market."
},
{
"speaker": "Mike Lucarelli",
"text": "I'll add one thing, John. You're right. As you've seen in our prepared comments, all the markets did increase double-digits year-over-year. Of our 6 applications that Vince outlined, 2 are still below pre-peak levels. We do think Fiscal '21 marks a record for all of them and we don't see why they won't hit another record in '22 given the strong trends that Vince outlined. And with that, we'll go to our next question."
},
{
"speaker": "Operator",
"text": "Your next question is from Stacy Rasgon of Bernstein Research."
},
{
"speaker": "Stacy Rasgon",
"text": "Hi guys. Thanks for taking my questions. I had a question about the pricing environment. Given just the tight supply and the shortage situation, we're starting to see some hints of some of your peers starting to take prices up. And I was curious what you guys are seeing in the pricing environment. Are you seeing that? Are you able to actually do that? Are you trading your own pricing environment down more conservatively?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thanks for the question, Stacy. So I would say that for the results that we printed, pricing is net-neutral. We're passing on cost increase so that we're not impacting margins, but we've made a decision not to take advantage of our customers by structurally increasing pricing in this environment. Our long-term model is unchanged and that is 70% plus. So the goal really is to drive the revenue growth and make the trade-offs that are necessary to drive that revenue growth. Focusing on delivering on the top margin and the free cash flow. So you'll see, if you back out the IP license impact, we had a 71.2% gross margin in the third quarter. And while we don't guide to gross margins, if you impute it from the guide that we gave you, the fourth quarter is going to probably be a record for ADI in terms of gross margins."
},
{
"speaker": "Stacy Rasgon",
"text": "Got it. That's helpful. Thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "Thank Stacy. Next question."
},
{
"speaker": "Operator",
"text": "Your next question is from Toshiya Hari of Goldman Sachs."
},
{
"speaker": "Toshiya Hari",
"text": "Hi guys. Good morning. Thanks for taking the question. I wanted to ask about the comms business. Vince, you talked about 2022 being a growth year, and you talked about North America, Europe, and Korea being the key drivers for you guys going forward. How should we think about the shape of the recovery going forward? Is it going to be a fairly gradual recovery? Could it be sort of a V-shaped recovery over the next couple of quarters? And when you talk about the return to growth in '22, what's sort of implicit assumption are you making for China? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Okay. Thanks. We're going to split that into 2. Let me just quickly talk about what happened and then I'll let Vince speak too more broadly. In the second quarter, as a reminder, we did call the bottom on comms and said that we would grow on a sequential basis. We delivered that in the third quarter and we are on track to deliver that for the fourth quarter. So we believe we're really well-positioned for strong growth into Fiscal '22. And between the two sub-segments there, wire demand remains strong and we expect that to continue as both carriers and data centers continue to do the upgrades to their networks. And wireless, it's always lumpy, growth in the past quarter was really driven by the rest of the world. North America. We do think China bottomed in the third quarter. So that should also represent some growth momentum for us as we go forward. And then I'll hand off to Vince to kind of speak more broadly about what we're seeing."
},
{
"speaker": "Vince Roche",
"text": "Yes, Toshiya, why do I have the confidence I have about 2022 being a strong growth year? So maybe I can unpack that a bit for you. So I think our comms' revenue mix is seeing a benefit from the rest of the world beginning to emerge in 5G. So today, the rest of the world outside of China is 3x in terms of the term. So that's number 1. If you look at then the geographies of North America, the auction to C-band auction's complete. Revenue's really just beginning here. And all the indications are that 5G revenue here will accelerate in 2022 and indeed beyond. Europe, it's -- I would say, a step behind, but we're beginning to see good signs of life in that region but I think it'll be a more elite 2022 driver. We've talked several times in various calls here about O-RAN, what's happening, but we're beginning to see revenue. We've talked before about Rakuten in Japan, that business continues to accelerate. And European carriers are looking right in to make it also an important part of their 5G offering. I mentioned during the prepared remarks as well that Vodafone is a major player there and we happen to be very well represented in their systems. And I'm also having conversations with customers about the use of 5G and O-RAN beyond the classical consumer market. So it's early days, but the characteristics of flexibility, scalability, quicker time-to-market, cost savings, and so on, are enabling private Networks to be configured in factory environments, for example. So that's all still on the comm, but that gives you a sense of our confidence in 2022 and beyond."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Toshiya."
},
{
"speaker": "Toshiya Hari",
"text": "Thank you. We'll go to the next question."
},
{
"speaker": "Operator",
"text": "Your next question is from Ambrish Srivastava of BMO."
},
{
"speaker": "Ambrish Srivastava",
"text": "Hey, thank you. Good morning, folks. I have a question about Maxim. And so my investment case for ADI has not been Maxim and you have a very sticky shareholder base who have been with you before Maxim, but I get this question a lot, so I think it's a fair question to ask. If Maxim was not to go through, what do you think about capital allocation? Do you then go back to the playbook and say you would be changing how you think about capital allocation or you would continue on the M&A path and look at other opportunities? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "So, in response to this, let me just remind everyone what the capital allocation policy is today because I think that we have a very shareholder-friendly capital allocation policy. This is, that first call is really to invest in the business and that, although not a traditional definition, we do consider that organically kind of how we spend our R&D, and that is heavily pointed towards the B2B markets. And then we think about inorganic really more as it helps the technology portfolio or finds other ways to help us become more important to customers. But our commitment is to return 100% of free cash flow to customers. So, we are at 1.2 level leverage today. We do not need to reduce debt. So on a -- in an environment, despite the confidence that we have in the Maxim deal closing in an environment where that was not to have happened, would not look for us to really be changing that view of having all our incremental free cash flow go return to shareholders either through buybacks or through dividend. And as a reminder, I think over the past 3 years, we've averaged about a 10% increase in our dividend. So a very healthy commitment for our fixed income-focused investors as well as the repo. I think we're on track this year for an all-time high in terms of our repo activity. Back to the M&A, I'm going to hand that one to Vince to talk more about the alternatives there."
},
{
"speaker": "Vince Roche",
"text": "Yes. So as you know, you've seen over the years, we've always acquired very, very high-quality assets, and that will remain to be our view on things in the years ahead as well."
},
{
"speaker": "Ambrish Srivastava",
"text": "Okay. Thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks. Ambrish. Next caller."
},
{
"speaker": "Operator",
"text": "Your next question is from Blayne Curtis of Barclays."
},
{
"speaker": "Blayne Curtis",
"text": "Hey, good morning. Thanks for taking the question. Just curious if you looked at the B2B guidance, it's fairly flat, as I think industrial probably is flat given the slug segment guidance you gave. I'm just kind of curious as you look at this. Obviously, you had strong comments on the bookings. Is that gap really supply or are you starting to see demand tends to start to settle out at this level?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "That is purely clearly supplied. I think I mentioned in maybe the first or second question that book-to-bill for the quarter was over 1.2 and that's across all markets. So we are seeing very strong interest in products across all markets. Mike indicated in one of the other Q&A that they were likely to have the industrial markets hit an all-time high collectively for a calendar for Fiscal year '21 and expect that to continue to be on track to another record in FY '22. So very much a supply-constrained environment."
},
{
"speaker": "Blayne Curtis",
"text": "Thanks and I just want to follow up on the gross margin, Prashanth. So you indicated the gross margin would be up and I think that's with the license impact as well. So you saw a benefit from the linear. I was curious how much more there is of that as a benefit. And then maybe just talk about utilizations and another pulling gross margin as you look over the next couple of quarters."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. So I presume you're asking with respect to the guidance. So in the fourth quarter, and we're not guiding gross margins, but we're pretty confident we are going to hit a new record for gross margins that are coming from the LTC synergies, I think we hit the final phase of closing down the manufacturing operation in California. We still have an opportunity as soon as the supply environment allows us to get some additional savings out of Asia because we haven't closed that facility up because we have no time to shift the tools to their new location. Utilization is also going to provide some level of increase. I would say the mix is a bit of a headwind into the Fourth Quarter. And Fourth Quarters typically have some level of challenges in terms of a holiday shutdown. So, we need to manage through that, which can provide a little bit of headwind for us as well that we got to work ourselves around."
},
{
"speaker": "Vince Roche",
"text": "You know, the foundation for our gross margins being where they are, It's the number 1 innovation. We produced the best performing solutions between the physical and digital worlds and we got a premium. We got very, very well paid for doing that. Also, the diversity of our products and customer portfolios, 125,000 customers with I think I've said this before, 85% of our sales come from products that individually contributed less than 0.1%. And the pricing environment, as we said earlier on the call, has been very, very stable, very steady."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Blayne, for that two-part, one-part question. We'll go to the next caller, please."
},
{
"speaker": "Operator",
"text": "Your next question is from Harlan Sur of JPMorgan."
},
{
"speaker": "Harlan Sur",
"text": "Good morning and congratulations on the strong results in quarterly execution. Channel inventories continue to remain below your target 7 to the 8-week range. You guys can also monitor direct customer inventories at least for those that are on consignment programs. Any signs that customers have been able to build inventories? I mean, it seems unlikely because the entire value chain appears to be sort of hand-to-mouth from a chip supply perspective, but I wanted to get your views. And when do you believe customers will be in a position to start to build that inventory? I'm assuming the soonest is sometime in calendar '22, but I wanted to get your views as well."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thank you, Harlan Sur. I'll take that. So first, a couple of comments on inventory. Inventory on our balance sheet is up year-over-year and sequentially, but that is exclusively due to raw materials and width. We can't keep a finished good in stock. So when it's produced, it either goes to the customer or it goes into the channel, and then it goes out of the channel immediately. So we are struggling to build finished goods inventory both in ADI warehouses as well as in our channel partners. Roughly, let's say a significant amount of our auto business is on consignment which gives us good visibility for that direct business as to what's happening there. And that is also we are seeing that demand pull through pretty quickly and no opportunity for those auto customers to build the inventory within their warehouses, but that's on our books. So it's still very much hand-to-mouth and the focus that we have as we've talked throughout this call and in the prepared remarks is on increasing our capacity or ability to supply by making some significant investments in capacity. I don't see this balance coming into some sense of normalcy until sometime in calendar year '22."
},
{
"speaker": "Harlan Sur",
"text": "Okay, thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "All right. We'll have our last question, please."
},
{
"speaker": "Operator",
"text": "Your next question is from William Stein of Trust Securities"
},
{
"speaker": "William Stein",
"text": "Great, thanks for taking my question. You just talked about inventory not coming to some level of ability to rebuild anything until sometime in '22, you talked about the supply debate about lasting. We're well into '22, which put you up to the bill, etc. When we look out to the next quarter, the January quarter, typically, that's a sequentially down quarter in automotive, industrial, consumer, and for the whole business as well. But given these supply constraints of this very significant backlog, should we think about that seasonality as different in the coming year? Should we expect maybe some visibility to sequential growth for the next several quarters? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yeah, I think the way to answer that would be to say that seasonality in today's environment is a bit of a meaningless concept because revenue growth is really dictated completely by supply. So the print for Q1 is likely to be driven by what more capacity we can get online over the fourth quarter to allow us. Again now we've got a couple of things we need to work through in the first quarter that would be a little bit of an offset. And first, there's the holiday season. So we do need to adjust factory capacity for that. And fourth quarter is the key quarter for the consumer; that's when they build for the holiday season. So there's always going to be a little bit of seasonality impact for the consumer just because they don't need it in our fiscal first quarter as that is the holiday period. So maybe that's where I will finish. Mike, anything you want to add to that?"
},
{
"speaker": "Mike Lucarelli",
"text": "Yeah, sure. I guess if you look back, you're right. We talk about seasonality not being as meaningful now, but just give you a bit of a history lesson. If you look past over the past 10 years, you're right, our B2B markets, I would say in good times, which I would call now good times, it's usually flatted down slightly in 1Q and consumer, I will say in good and even normal times it down 5% or maybe more in 1Q. And with that, I want to thank everyone for joining the call this morning. A copy of the transcript will be available on our website. And all reconciliations and additional information can also be found in the Quarterly Results section. Thanks again for joining and your continued interest in ADI."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices Conference Call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 2 | 2,021 | 2021-05-19 11:40:00 | Operator: Good morning, and welcome to the Analog Devices Second Quarter Fiscal Year 2021 Earnings Conference Call, which is being audio webcast via telephone and over the Web. I'd now like to introduce your host for today's call, Mr. Mike Lucarelli, Senior Director of Investor Relations. Sir, the floor is yours.
Mike Lucarelli: Thank you, Cheryl, and good morning, everybody. Thanks for joining our second quarter fiscal 2021 call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now onto the disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release and our most recent 10-Q and other periodic reports and materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO, Vincent Roche. Vince?
Vince Roche: Thank you, Mike, and good morning to you all. So I'm very pleased to share with you that we delivered record revenue and earnings in the second quarter, exceeding the high end of our outlook. This strength was driven by our disciplined operational execution and our ability to capture the value presented as our solutions become more vital in the modern digital economy. The supply and demand dynamics in our industry have been well publicized. Broadly speaking, the economic recovery has materialized faster and stronger than initially anticipated, placing unprecedented stress on supply chains globally. Late last year, ADI moved with speed and agility, proactively making capital investments to add capacity, positioning us to navigate this disruption and better serve our customers. That said, we, like many others in the industry, will face a supply constrained environment through the balance of 2021. Despite this backdrop, we're positioned for a strong second half as our continued capital investments are aligned with robust demand. Moving to a summary of our results. Revenue was $1.66 billion, increasing 26% year-over-year. The strength was broad based, highlighted by record quarters for our industrial and automotive markets. Gross margin expanded to nearly 71% and operating margin to approximately 42%. Adjusted EPS of $1.54 increased 43% year-over-year. Over the trailing 12 months, we generated $2.2 billion of free cash flow. This equates to a record 36% free cash flow margin, maintaining our position in the top 10% of the S&P 500. So overall, I'm very proud how the ADI team executed this quarter to deliver these impressive results. At ADI, innovation is the root of how we generate value. And to maintain our virtuous cycle of innovation driven success, we invest more than $1 billion in R&D annually. This commitment coupled with the diversity of our business across customers, products and applications, positions us to deliver long-term profitable growth. Now let me share a few customer highlights with you. ADI solutions are embedded across the electrification ecosystem from developing and managing the vehicle battery to the distribution and storage across the digital grid. With the rapid shift to EVs, we're seeing new and increasing investments in battery manufacturing capacity. This quarter, we secured a design win with the supplier of one of the world's top battery producers. Our innovative solution reduces system cost by half by integrating all measurement, control and diagnostics functions. And our portfolio of wired and wireless BMS provides unmatched accuracy to deliver market leading vehicle range as we grow and diversify our BMS business. This quarter, we added Volvo as well as three additional large auto manufacturers, including a prominent luxury brand in Europe and two leading brands in Asia. Moving on to energy infrastructure. Here, energy storage systems are required to make renewable energy a reality and to build the charging infrastructure to support EV proliferation. Our precision Signal Chain Power management and BMS portfolios delivered the level of accuracy necessary to ensure a consistent supply across the digital grid. We have design wins of more than 80% of the top customers, from traditional energy and industrial companies to new entrants. Another area of increasing importance for ADI’s connectivity, which of course is becoming more pervasive across demographics and industries, presenting new opportunities for us. For example, in our communications business, we announced the complete radio platform for the 5G O-RAN ecosystem. This radio platform builds on our market leading integrated transceiver position by expanding into the digital frontend. Our full system solution enables significant size and performance improvements, while reducing customers’ design cycles. O-RAN represents a new vector of growth in the communications market by enabling new entrance and applications, such as private networks that support connected factories. In addition to the partnerships with Intel and Marvell, we are working with key carriers and system integrators to enable this ecosystem. In our space business, our beamforming solution will be used in Telesat Lightspeed LEO satellite constellation scheduled to launch in late 2023. This win speaks to the breadth and depth of our RF portfolio and domain expertise at ADI, which is supporting the adoption broadly of LEO communication satellites. Additionally, we continue to have strong design momentum across our diversified industrial market, the largest, stickiest and most profitable business at ADI. Over the years, we've established a heritage of providing the most precise and efficient solutions required by our factory automation customers. I believe we're at a tipping point in Industrial 4.0 as customers are looking to add sensing, edge processing, and connectivity to make supply chains more robust, more efficient and flexible. We recently won an ultra-high frequency wireless solution at a key automation company. Our solution is being used in advanced robotic systems to reduce downtime and costs. On the wired side, customers are beginning to upgrade to deterministic Ethernet to ensure machines are constantly connected and monitored. This quarter, we secured numerous design wins for a robust Ethernet solution, including two of the largest European industrial machine manufacturers. We recently hosted a deep dive on our instrumentation and test business. This is truly a performance-driven market that requires ADI’s most advanced technology and solutions, making it a great fit for our high-performance precision Signal Chain Power and RF portfolios. Our broad diverse instrumentation business comprised of automated test equipment, electronic test and measurement and scientific instruments is aligned with all secular growth trends across our industry. The increasing complexity of these applications is driving the need for solutions with more advanced technology capabilities. As a result, we expect our SEM to increase by over 20% in the next five years. Now these examples represent only a fraction of the incredible work across ADI. Our team is partnering with our customers everyday to develop increasingly innovative technologies that not only create successful business outcomes, but also enrich people's lives and leave a greater impact on our world. To that end, I wanted to share an exciting update on how we're leveraging innovation to advance our mission of Engineering Good. In April, we launched an innovation accelerator with the Woods Hole Oceanographic Institution. As part of this program, we'll be combining ADI’s engineers and technologies with WHOI’s science and technology platforms to continuously monitor critical oceanographic conditions. This effort supports our overall climate agenda, which includes our commitments to achieving carbon neutrality by 2030 and net zero emissions by 2050. We also published our 2020 Corporate Responsibility Report last week, which provides additional information on how our technologies will continue to play a major role in improving our standard of living, while protecting our planetary health. So in closing, the last year has underscored how semiconductors as the bedrock of the modern digital economy and information age are increasingly important to accelerating digitalization across all industries. We're encouraged by our results this quarter, and the momentum in our pipeline sets the stage for continued profitable growth in the years ahead. So with that, I'll hand you over to Prashanth who will take you through the financial details.
Prashanth Mahendra-Rajah: Thank you, Vince. Good morning, and let me add my welcome to our second quarter earnings call. My comments today with the exception of revenue and non-op expenses will be on an adjusted basis, which excludes special items outlined in today's press release. ADI delivered a record second quarter as revenue, operating margin and EPS finished above the high end of our outlook. As I mentioned last quarter, upside to our second quarter outlook would be predicated on our ability to increase production. And thanks to early strategic investments in capacity, as well as strong execution by our manufacturing operations team, we did just that. Now let's look at performance by end market. Industrial represented 59% of revenue and increased 14% sequentially, and 36% year-over-year. This quarter marks the second consecutive all-time high for industrial. We saw strength across all applications and geographies, with all sub-segments growing double digits sequentially and year-over-year. Communications represented 17% of revenue, fell slightly sequentially and was flat year-over-year. Wireline increased double digits year-over-year, which balanced softness in wireless. As we outlined in the last call, 5G builds have been muted year-to-date. However, we anticipate momentum to pick up as 5G deployments broadened globally in the second half of this year, especially in North America, now that the C-band auction is complete. Automotive represented 16% of revenue and increased 5% sequentially, and 42% year-over-year. Again, we saw double digit growth across every major application as industry production has picked up notably from a year ago. BMS grew the fastest, more than doubling year-over-year. And lastly, consumer decreased 12% sequentially in the seasonally weaker second quarter and represented 9% of revenue. Importantly, consumer grew 8% year-over-year, positioning us to deliver growth in fiscal '21. Now covering the rest of the P&L, gross margin finished just under 71%, up 90 basis points sequentially and 320 basis points year-over-year on higher utilization and better product mix. We expect additional gross margin expansion in the second half as we realize savings from the consolidation of our manufacturing operations. OpEx in the quarter was 484 million, up sequentially and year-over-year. Merit increases went into effect during the second quarter and we also recorded higher variable comp due to the strong results. This netted operating margin of 41.7%, non-op expenses were 44 million, down nearly 10% from the prior year driven by lower interest expense. Our tax rate was approximately 12%. And all-in, adjusted EPS of $1.54 exceeded the high end of our outlook and marks an all-time high. Now moving on to the balance sheet. Relative to the first quarter, inventory dollars increased 23 million to a record 641 million. This increase was driven entirely by raw material and work-in process, as we wrap utilization to better meet the strong customer demand. Days of inventory were relatively unchanged at 118. Weeks of channel inventory finished lower sequentially once again. And due to the strong sell-through at our distys, we anticipate remaining below our seven to eight-week target through the end of the year. CapEx for the quarter was 59 million, bringing our year-to-date total to 127 million or more than double compared to the second half of 2020. We expect to continue to increase capital investment and for CapEx to trend above our long-term model of 4% this year. Turning to cash flow, we generated 2.2 billion over the trailing 12 months, which equates to a record 36% free cash flow margin. And over the same period, we returned approximately 75% of free cash flow after debt repayments via dividends and repos. This is below our long-term target as we paused our buyback program, given the pandemic uncertainty and the pending Maxim deal. We ended the second quarter with 1.3 billion of cash and equivalents on our balance sheet and our net leverage is now 1.3 on a trailing 12. We’re comfortable with the leverage and do not plan to reduce debt. As such, we remain committed to return 100% of free cash flow to shareholders. So let me finish up with our third quarter outlook. Revenue is expected to be 1.7 billion plus or minus 70 million, up sequentially as additional capacity comes online. This is in line with seasonality after a very strong Q2. At the midpoint, we expect each of our B2B markets to increase slightly sequentially, and consumer to be up low double digits. Based on the midpoint of guide, op margin is expected to be 42.5 plus or minus 100 bps. And our tax rate is expected to fall between 11% and 13%. Based on these inputs, adjusted EPS is expected to be $1.61 plus or minus $0.11. So in summary, ADI delivered a very strong quarter highlighted by record revenue, earnings and free cash flow conversion. Importantly, bookings and backlog remain very strong and we're continuing to invest to increase production for the balance of the year, giving us great confidence that our second half will be stronger than our first. We've also made meaningful progress towards closing the Maxim acquisition. Shortly after the deal closes, we are going to hold a conference call to provide an update regarding our capital return plans. As a reminder, once combined, we anticipate having more than $3 billion of cash and a leverage ratio well below 1. Let me now pass it back to Mike for the Q&A.
Mike Lucarelli: Thanks, Prashanth. Let's go to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow-up question, please requeue and we'll take questions if time allows. With that, Cheryl, can we have our first question please?
Operator: Thank you. [Operator Instructions]. Our first question comes from John Pitzer from Credit Suisse. Please go ahead. Your line is open.
John Pitzer: Yes. Good morning, guys. Congratulations on the solid results. Vince, Prashanth, 90 days ago when you sort of guided for the April quarter, the key gating factor was your ability to grow supply. I'm curious, as you look at the July quarter, are you still in a supply constrained environment? And I guess more importantly, given the internal CapEx you’re spending and your work with your foundry partners, how do we think about your ability to grow supply beyond sort of the July quarter guidance?
Vince Roche: Yes. So, John, thanks for the question. Yes, we are constrained. We've got a very, very positive book to build. But what we have forecast for the July quarter factors in all the elements of supply across silicon supply, both internally, externally as well as all the backend operations, assembly and test. So we feel very confident in that number. But beyond that, there is opportunity to ship more. There is more demand out there. But at least in the July quarter, we feel very comfortable with what we have forecast.
John Pitzer: And how do we think about supply growth beyond July? Is July a good proxy to what you should be able to do sequentially for the next couple of quarters, or are you getting a particularly strong uplift in July and things moderate going forward?
Vince Roche: Well, I think -- ultimately, everything will depend on demand. We're increasing our capacity. We're getting more wafer supply in general. And we are, as Prashanth said in his remarks, we've been investing in capital equipment inside the company to expand our backend operations. So you'll see sequential improvements in ADI’s output over the coming months. So as Prashanth said, the second half of the year, given our confidence in supply, we will have a better second half than first half.
John Pitzer: That’s helpful. Thanks.
Mike Lucarelli: Thanks, John. Next question?
Operator: Thank you. Our next question comes from Tore Svanberg from Stifel. Please go ahead. Your line is open.
Tore Svanberg: Yes. Thank you and congratulations on the record results. Prashanth, you talked about just the inventory being sort of way below the seven to eight-week target. Could you tell us where exactly the numbers are right now? And also, do you expect to get back to seven to eight at some point or is this kind of like a new norm now where disty in the channel is going to be sort of running below at what it has historically?
Prashanth Mahendra-Rajah: Yes. Thanks, Tore. Inventory is very lean. We entered the quarter below seven weeks and it decreased again in the quarter. So we would like to build inventory backup. It's unlikely that that's going to happen. Whatever they get their hands on sells through immediately. So until the supply gets improved over the coming quarters, I don't think you'll see us return to normal inventory levels in the channel. But I would say that we do maintain the view that sort of that seven to eight weeks is the right balance for us to have in the channel.
Tore Svanberg: Great. Thank you.
Prashanth Mahendra-Rajah: Thanks, Tore.
Operator: Thank you. Our next question comes from Vivek Arya from Bank of America Securities. Please go ahead. Your line is open.
Vivek Arya: Thanks for taking my question. Vince or Prashanth, I was hoping you could quantify lead times and book to build in various end markets to the extent possible, where are lead times stretched the most? And importantly, what are you doing to prevent double ordering? Are you implementing any firm price, non-cancelable programs like some of your peers are? Any perspective on how do we quantify the state of supply/demand imbalance and how do we get some assurance that this will be resolved I guess peacefully is one word that comes to mind, I think that will be very helpful? Thank you.
Prashanth Mahendra-Rajah: Thank you, Vivek. Maybe just to start with some comments on where demand is coming from. So we're experiencing significant growth in demand and it's very broad based in all of our markets. And when you rewind and think how we got here, our customers entered the pandemic with pretty lean inventories. Then we had this synchronized government stimulus, both fiscal and monetary. We had very strong growth during the pandemic of consumer electronics with the high use of cloud compute connectivity. We're coming out of the pandemic now with GDP driving industrial, and that's driving companies to rethink both where they manufacture and upgrading the style by which they manufacture. So on the supply side, we've been planning for additional capacity, as Vince mentioned, since late summer of 2020. And as we add capacity, our revenue forecast is increasing. And that's really what helped us deliver a better Q2 guide up for Q3 and feel good about Q4. So I think supply will eventually match demand, but I don't see demand really going away. So this feels -- given the secular drivers behind it, it feels that this is going to be with us for a while. Book to build for the past quarter was above 1, and it was the same for all end markets. So it's, again, very broad based. And I think it's really just a reflection of the incredible role that ADI’s products play across the manufacturing ecosystem.
Vivek Arya: And any pricing programs that you might have put in place like your peers?
Prashanth Mahendra-Rajah: I guess a few comments to make there. We are efficiently managing our orders. We're working with our customers, both large and small, across all markets to understand the demand timing and to allocate the supply based on demand. Remember that while we report on a POA basis, we actually run the business on POS. So we look through distribution to understand what's happening at customer. We've also put in a non-cancelable, non-returnable for up to 90 days to help give us better visibility into the backlog and that helps customers sort of manage what they can expect to get from us. So at this point, I would say the focus really has been on communication. And that's the feedback I think Vince has heard from customers as well is that what's important to them is communicating what they're going to get and when they're going to get it, so they can plan their respective downstream production requirements.
Vivek Arya: Thank you.
Mike Lucarelli: Thanks, Vivek. We’ll go to the next question please.
Operator: Our next question comes from Ambrish Srivastava from BMO. Please go ahead. Your line is open.
Ambrish Srivastava: Hi. Thank you very much, Prashanth and Vince. I wanted to just unpack the gross margin comments that you made, Prashanth. You are at the model 70% plus and when you talk about gross margin incrementally getting better, what's the right way to think about it? You had referred to the cost savings that you'll be getting from factory consolidation. Is there an impact from pricing? And then kind of -- and related to that, how are you managing the input cost, which seem to be going up across the board versus pricing? And is that also playing a factor in the gross margin? And sorry, related to that is would you be building inventory as you go through the second half? Thank you.
Prashanth Mahendra-Rajah: Thanks, Ambrish. Do you have a few more add-ons to that? So let's start with -- let's do a quick one on, on pricing. So net impact of pricing changes are immaterial to gross margin. So we're managing our cost increases to net those out from a price standpoint. The gross margin lift that you're seeing really is the productivity that we're driving. So I did say in the first quarter earnings call that that would be the bottom of gross margins for the year and we would expect sequential improvement. You're seeing that in the Q2 results printed. You see that in the guide that we've given for Q3. That is coming from the manufacturing consolidation of the linear factory closure, which we have talked about, and also some step-up in utilization. So that's kind of a tactical way to think about how gross margins with evolved over the balance of this year. Our model remains 70%. And I don't know, Vince, if you want to give some guide on how we think about gross margins long term?
Vince Roche: Yes. Look, the root of our value creation really is innovation. We're spending over $1 billion a year. And we like to have the highest performing products out there that we got well paid for. And I think also the diversity of our product application and customer domains helps us protect margins, as we've seen through the pandemic here. So 85% -- we've got 125,000 customers and 85% of our sales comes from products that individually contribute less than 0.1% of our revenue, or even less. So that's the model of the company. So there's a lot of resilience -- a lot of optionality and resilience built into it.
Mike Lucarelli: Thanks, Ambrish.
Ambrish Srivastava: Thank you.
Operator: Thank you. Our next question comes from Blayne Curtis from Barclays. Please go ahead. Your line is open.
Blayne Curtis: Hi. Good afternoon. Thanks for taking my question. Good morning. Just kind of curious on the industrial segment. I think last quarter you talked about two of six segments being at peak. You talked about all being up in the April quarter. So just any color by segment there and if any more of them are at record revenue, that would be helpful? Thanks.
Vince Roche: Yes. Well, we've seen -- this is a very, very highly diversified business. We saw broad growth across all the individual sectors. In fact, all applications grew double digits year- over-year and sequentially. And I believe there's a lot more upside to come, because we're in a multiyear growth cycle driven by secular trends, Industry 4.0, et cetera. I would say the -- we've seen really strong acceleration in the automation sector. And I think that's driven by such things as the need for onshoring, more flexibility and more robust and connected supply chains. If I just pick healthcare, it has already been a multiyear growth market for ADI. And the pandemic kind of underscored the importance of information technology in managing our healthcare systems. So we've seen an acceleration in our digital healthcare business, as we begin to migrate the hospital environment to the clinic and the home with point of care solutions or healthcare anywhere mentality. And as I mentioned in the prepared remarks as well, the energy sector with the move through renewables and this charging infrastructure that's being laid in to support these electric vehicles, those are some of the areas that we're seeing strongest growth within the industrial area. But I think automation underpins it. Also, I would say, I've been very pleased with the results that we're getting in the very broad bench, scientific and test equipment, analytics equipment, and so on. So it's been very, very broad.
Prashanth Mahendra-Rajah: And Blayne, just to touch on your last point about the record applications. You're right. I think last quarter, two or three had records. We increased that. Four of our six applications are at record. So I think I echo what Vince said is that we're early stages of this cycle. And yes, at some point, we expect all of our applications to be at record probably next year or so. And with that, can we go to our next question please?
Operator: Thank you. Our next question comes from Toshiya Hari from Goldman Sachs. Please go ahead. Your line is open.
Toshiya Hari: Thank you for taking the question and congrats on the strong results. Vince, I had a multipart question on your BMS business. You guys talked about revenue more than doubling in the quarter. I was hoping you could speak to kind of the breadth of your customer profile there on the quarter on a year-over-year basis. And I guess more importantly, based on some of the comments that you've made on past calls and also this call as it relates to your design win pipeline, should we expect some of these wireless BMS projects to ramp in fiscal '22 or is it more fiscal '23 and beyond? And lastly, as it pertains to the combination with Maxim, how should we think about how your position in BMS evolves over time post the combination? Thank you.
Vince Roche: Yes. Thanks, Toshi. Well, first off, we're the market share leader in the electric vehicle battery management systems. And as you know, we have really two portfolios. We have the existing, we like to call it the wired portfolio, the more traditional way of moving data from the battery system and we've introduced a wireless version, a robust cognitive radio-based wireless system. So I think the next 12 months will be driven by the traditional wired battery technology. And after that in late '22 into 2023, we’ll begin to see the upsurge of the wireless battery technology that will complement the wired. So what I believe will happen is, today, what have we got? 2 million, 3 million cars per year being produced -- electric vehicles being produced. That's going to move to we believe somewhere 10x at least over the next seven, eight years. So this is a multiyear cycle. Where our BMS chips today are being used in over half of the top 10 selling EV cars globally, and we're getting share in each of those areas. Today, our best position is in North America and China. And as I mentioned in the prepared remarks, we're beginning to make real tracks in Europe as well as Japan and Korea. So, ultimately, if a manufacturer wants the most miles per charge, they're going to turn to ADI. So that's what we're working on.
Mike Lucarelli: Thanks, Toshiya. We’ll go to our next question please. Cheryl, we'll take our next question. Cheryl?
Vince Roche: Cheryl, can you hear us?
Operator: Please go ahead Ross Seymore from Deutsche Bank, your line is open.
Ross Seymore: Hi, guys. Can you hear me?
Vince Roche: Yes, we can, Ross.
Ross Seymore: Okay, great. Glad Cheryl came back. Just had a couple of questions on your communications business. I guess in the tactical sense, it looked like it was better than you expected in the quarter, the April quarter. Was that specific to the wired or wireless side, or was it just the supply coming on? And then more importantly, looking forward, can you give a little bit more color on what your expectations are for the wireless side? Obviously, we had some difficult comps with what happened with Huawei year-over-year, but how do we think about that returning to year-over-year growth, given the second half commentary that you talked about with some ramps in North America and beyond?
Prashanth Mahendra-Rajah: Yes. Thanks. So I said in the prepared remarks that the communications business for the second quarter was really driven by very strong growth in the wired. I think it was up double digits. Wireless remains lumpy. But we feel pretty good that comms has bottomed in the second quarter and we're going to see growth in the second half, and I'll let Vince jump in with some of the customer conversations he's been having. But with the completion of the C-band auction, we feel very good that you're now going to see the build out of 5G for which we are the largest participant certainly with the transceiver product for both the U.S. and starting to see that in Europe as well.
Vince Roche: Yes. So Ross, what I want to mention is that at this point in time the rest of world is 3x larger than China for ADI. I think that's very, very important to remember. And we're certainly seeing 5G momentum pick up on a global basis. North America, we've recently -- obviously, the C-band auction is complete. And we're beginning to see orders today that we expect will accelerate during 2022 and beyond. Even Europe, where there's been real lethargy in upgrading their communication systems in general over the last several years, we're beginning to see signs of life in the deployment of 5G. India is also -- India has a significant government funded program to make 5G a reality there. We’re beginning to participate in trials. And last but not least is O-RAN. We already have revenue as a company with Rakuten, the online shopping company in Japan and we're very well positioned given our ecosystem position there to unlock potential in what is a brand new stream of revenue, particularly I think as it gets deployed into private networks for machines.
Ross Seymore: Great. Prashanth, just one quick clarification. Double digits in the wired, was that a year-over-year or a sequential comment? Thank you.
Prashanth Mahendra-Rajah: That was a year-over-year.
Ross Seymore: Thank you.
Mike Lucarelli: Thanks, Ross.
Operator: Thank you. Our next question comes from Stacy Rasgon from Bernstein Research. Please go ahead. Your line is open.
Stacy Rasgon: Hi, guys. Thanks for taking my question. I actually wanted to follow up on that comm question. So if I go back to last quarter, you'd kind of talked the comm trajectory down a bit and it was a China statement. So I just want to clarify. Is that -- it doesn't sound like that's changed. It does sound like the uptick you're seeing right now is outside of China, U.S., Europe, India. I guess is that correct? I guess why didn't you see that uptick 90 days ago -- expectations for that uptick 90 days ago versus today? And then what are your broad thoughts on 5G rollout in China going forward from here? How does the rest of that play out given all the dynamics that are happening there?
Vince Roche: Yes. So I think first and foremost, China's opportunistic for ADI at this point. We will sell I think lots of components, and therefore it is more opportunistic. Prashanth, you can talk about the specifics.
Prashanth Mahendra-Rajah: Yes. I think, Stacy, we have always said that we expected 5G deployments in North America to come next and be followed by Europe. When we gave you the commentary for the -- leaning into the second quarter, we were focused on the pause in China. But we have seen now that the auctions are complete, and particularly Verizon being much more public about what they intend to do in the 5G space, as Vince mentioned, orders are starting to come in for that. So the trajectory for communications or for wireless specifically is going to be up in the second half.
Mike Lucarelli: Thanks, Stacy.
Stacy Rasgon: Thank you.
Mike Lucarelli: Can we go to our last question please?
Operator: Thank you. And our last question comes from William Stein from Truist Securities. Please go ahead. Your line is open.
William Stein: Great. Thanks so much for squeezing me in. Guys, I'd like to ask about the cost function. We have two potential looming problems. I think one is inflation broadly, not just materials, potentially labor as well. And then on the OpEx side, the return to work face-to-face sort of operations suggest maybe we start spending on travel and things like that. And I wonder if you can comment as to how we might sensitize our models to these factors? Thank you.
Prashanth Mahendra-Rajah: So let me take the inflation piece first. So I think it was Ambrish who asked a question and we are seeing cost increases from our supply base, but we feel that we're guiding margins on a net basis are going to be neutral for that, because we are where we can pushing that price through. So I'm not as concerned about the inflation side. We have been very mindful of the labor side. And I would say that the data we're seeing is that it's taking us about a week longer than normal to fill jobs at the factory level. So our U.S. factories are facing a little bit longer time to fill jobs, but it's not anywhere as dramatic as what we're hearing in the media in terms of filling these high paying manufacturing jobs. And then for return to office, that is something we spend a lot of time on. There is no doubt that there will be some return to travel. I think that's going to be universal across all companies. But more specifically to how ADI is thinking about return to office, maybe I'll let Vince talk about how we're thinking about that.
Vince Roche: Yes. So we've instituted a three-day per week policy to start with here at ADI for those who have been working remotely, and we will see where things go from there. But my sense is on the OpEx side of things, we will probably not get back to per capita travel spend, entertainment spend and so on and so forth. The other thing I'll remind you, Will, is that we work relentlessly at the company on taking costs out of the business. So we work hard on cost of goods, we work hard on making the business efficient below the cost of goods line as well. So inflation is nothing new. We'll see how it moves over the next -- if we see an acceleration in inflation, then we'll figure out what actions to take.
William Stein: So we shouldn't be modeling some step-up cost function in OpEx related to travel and such activities? I know there's some increase you've already guided to for I think bonuses and such, but for travel no?
Vince Roche: Well, I think that's true. And when you look at the expenses today, our OpEx is laden with some very rich bonus payouts, because the business in terms of growth and profitability is doing very, very well. But we will -- over time, I expect that the growth will moderate and the bonuses will also moderate.
Prashanth Mahendra-Rajah: Will, maybe I can wrap up by saying we're expecting second half revenue to be strong. We indicated that second half gross margins are going to continue to increase, which is going to give you incredible leverage and therefore there is no reason you won't see a meaningful lift in op margins as each quarter rolls out. And all of that is going to translate into more cash flow, which we'll have available to deploy since we're not doing any further debt reduction, that's coming back to shareholders.
William Stein: Great. Thanks so much.
Mike Lucarelli: Thanks, Will, and thanks everyone for joining us this morning. A copy of the transcript will be available on our Web site. Our reconciliations will also be there. You can also find our new CSR report that Vince outlined in his script on our Analog Investor Relations homepage. And with that, thanks for joining us and your continued support of ADI.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices Second Quarter Fiscal Year 2021 Earnings Conference Call, which is being audio webcast via telephone and over the Web. I'd now like to introduce your host for today's call, Mr. Mike Lucarelli, Senior Director of Investor Relations. Sir, the floor is yours."
},
{
"speaker": "Mike Lucarelli",
"text": "Thank you, Cheryl, and good morning, everybody. Thanks for joining our second quarter fiscal 2021 call. With me on the call today are ADI's CEO, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now onto the disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release and our most recent 10-Q and other periodic reports and materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO, Vincent Roche. Vince?"
},
{
"speaker": "Vince Roche",
"text": "Thank you, Mike, and good morning to you all. So I'm very pleased to share with you that we delivered record revenue and earnings in the second quarter, exceeding the high end of our outlook. This strength was driven by our disciplined operational execution and our ability to capture the value presented as our solutions become more vital in the modern digital economy. The supply and demand dynamics in our industry have been well publicized. Broadly speaking, the economic recovery has materialized faster and stronger than initially anticipated, placing unprecedented stress on supply chains globally. Late last year, ADI moved with speed and agility, proactively making capital investments to add capacity, positioning us to navigate this disruption and better serve our customers. That said, we, like many others in the industry, will face a supply constrained environment through the balance of 2021. Despite this backdrop, we're positioned for a strong second half as our continued capital investments are aligned with robust demand. Moving to a summary of our results. Revenue was $1.66 billion, increasing 26% year-over-year. The strength was broad based, highlighted by record quarters for our industrial and automotive markets. Gross margin expanded to nearly 71% and operating margin to approximately 42%. Adjusted EPS of $1.54 increased 43% year-over-year. Over the trailing 12 months, we generated $2.2 billion of free cash flow. This equates to a record 36% free cash flow margin, maintaining our position in the top 10% of the S&P 500. So overall, I'm very proud how the ADI team executed this quarter to deliver these impressive results. At ADI, innovation is the root of how we generate value. And to maintain our virtuous cycle of innovation driven success, we invest more than $1 billion in R&D annually. This commitment coupled with the diversity of our business across customers, products and applications, positions us to deliver long-term profitable growth. Now let me share a few customer highlights with you. ADI solutions are embedded across the electrification ecosystem from developing and managing the vehicle battery to the distribution and storage across the digital grid. With the rapid shift to EVs, we're seeing new and increasing investments in battery manufacturing capacity. This quarter, we secured a design win with the supplier of one of the world's top battery producers. Our innovative solution reduces system cost by half by integrating all measurement, control and diagnostics functions. And our portfolio of wired and wireless BMS provides unmatched accuracy to deliver market leading vehicle range as we grow and diversify our BMS business. This quarter, we added Volvo as well as three additional large auto manufacturers, including a prominent luxury brand in Europe and two leading brands in Asia. Moving on to energy infrastructure. Here, energy storage systems are required to make renewable energy a reality and to build the charging infrastructure to support EV proliferation. Our precision Signal Chain Power management and BMS portfolios delivered the level of accuracy necessary to ensure a consistent supply across the digital grid. We have design wins of more than 80% of the top customers, from traditional energy and industrial companies to new entrants. Another area of increasing importance for ADI’s connectivity, which of course is becoming more pervasive across demographics and industries, presenting new opportunities for us. For example, in our communications business, we announced the complete radio platform for the 5G O-RAN ecosystem. This radio platform builds on our market leading integrated transceiver position by expanding into the digital frontend. Our full system solution enables significant size and performance improvements, while reducing customers’ design cycles. O-RAN represents a new vector of growth in the communications market by enabling new entrance and applications, such as private networks that support connected factories. In addition to the partnerships with Intel and Marvell, we are working with key carriers and system integrators to enable this ecosystem. In our space business, our beamforming solution will be used in Telesat Lightspeed LEO satellite constellation scheduled to launch in late 2023. This win speaks to the breadth and depth of our RF portfolio and domain expertise at ADI, which is supporting the adoption broadly of LEO communication satellites. Additionally, we continue to have strong design momentum across our diversified industrial market, the largest, stickiest and most profitable business at ADI. Over the years, we've established a heritage of providing the most precise and efficient solutions required by our factory automation customers. I believe we're at a tipping point in Industrial 4.0 as customers are looking to add sensing, edge processing, and connectivity to make supply chains more robust, more efficient and flexible. We recently won an ultra-high frequency wireless solution at a key automation company. Our solution is being used in advanced robotic systems to reduce downtime and costs. On the wired side, customers are beginning to upgrade to deterministic Ethernet to ensure machines are constantly connected and monitored. This quarter, we secured numerous design wins for a robust Ethernet solution, including two of the largest European industrial machine manufacturers. We recently hosted a deep dive on our instrumentation and test business. This is truly a performance-driven market that requires ADI’s most advanced technology and solutions, making it a great fit for our high-performance precision Signal Chain Power and RF portfolios. Our broad diverse instrumentation business comprised of automated test equipment, electronic test and measurement and scientific instruments is aligned with all secular growth trends across our industry. The increasing complexity of these applications is driving the need for solutions with more advanced technology capabilities. As a result, we expect our SEM to increase by over 20% in the next five years. Now these examples represent only a fraction of the incredible work across ADI. Our team is partnering with our customers everyday to develop increasingly innovative technologies that not only create successful business outcomes, but also enrich people's lives and leave a greater impact on our world. To that end, I wanted to share an exciting update on how we're leveraging innovation to advance our mission of Engineering Good. In April, we launched an innovation accelerator with the Woods Hole Oceanographic Institution. As part of this program, we'll be combining ADI’s engineers and technologies with WHOI’s science and technology platforms to continuously monitor critical oceanographic conditions. This effort supports our overall climate agenda, which includes our commitments to achieving carbon neutrality by 2030 and net zero emissions by 2050. We also published our 2020 Corporate Responsibility Report last week, which provides additional information on how our technologies will continue to play a major role in improving our standard of living, while protecting our planetary health. So in closing, the last year has underscored how semiconductors as the bedrock of the modern digital economy and information age are increasingly important to accelerating digitalization across all industries. We're encouraged by our results this quarter, and the momentum in our pipeline sets the stage for continued profitable growth in the years ahead. So with that, I'll hand you over to Prashanth who will take you through the financial details."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Good morning, and let me add my welcome to our second quarter earnings call. My comments today with the exception of revenue and non-op expenses will be on an adjusted basis, which excludes special items outlined in today's press release. ADI delivered a record second quarter as revenue, operating margin and EPS finished above the high end of our outlook. As I mentioned last quarter, upside to our second quarter outlook would be predicated on our ability to increase production. And thanks to early strategic investments in capacity, as well as strong execution by our manufacturing operations team, we did just that. Now let's look at performance by end market. Industrial represented 59% of revenue and increased 14% sequentially, and 36% year-over-year. This quarter marks the second consecutive all-time high for industrial. We saw strength across all applications and geographies, with all sub-segments growing double digits sequentially and year-over-year. Communications represented 17% of revenue, fell slightly sequentially and was flat year-over-year. Wireline increased double digits year-over-year, which balanced softness in wireless. As we outlined in the last call, 5G builds have been muted year-to-date. However, we anticipate momentum to pick up as 5G deployments broadened globally in the second half of this year, especially in North America, now that the C-band auction is complete. Automotive represented 16% of revenue and increased 5% sequentially, and 42% year-over-year. Again, we saw double digit growth across every major application as industry production has picked up notably from a year ago. BMS grew the fastest, more than doubling year-over-year. And lastly, consumer decreased 12% sequentially in the seasonally weaker second quarter and represented 9% of revenue. Importantly, consumer grew 8% year-over-year, positioning us to deliver growth in fiscal '21. Now covering the rest of the P&L, gross margin finished just under 71%, up 90 basis points sequentially and 320 basis points year-over-year on higher utilization and better product mix. We expect additional gross margin expansion in the second half as we realize savings from the consolidation of our manufacturing operations. OpEx in the quarter was 484 million, up sequentially and year-over-year. Merit increases went into effect during the second quarter and we also recorded higher variable comp due to the strong results. This netted operating margin of 41.7%, non-op expenses were 44 million, down nearly 10% from the prior year driven by lower interest expense. Our tax rate was approximately 12%. And all-in, adjusted EPS of $1.54 exceeded the high end of our outlook and marks an all-time high. Now moving on to the balance sheet. Relative to the first quarter, inventory dollars increased 23 million to a record 641 million. This increase was driven entirely by raw material and work-in process, as we wrap utilization to better meet the strong customer demand. Days of inventory were relatively unchanged at 118. Weeks of channel inventory finished lower sequentially once again. And due to the strong sell-through at our distys, we anticipate remaining below our seven to eight-week target through the end of the year. CapEx for the quarter was 59 million, bringing our year-to-date total to 127 million or more than double compared to the second half of 2020. We expect to continue to increase capital investment and for CapEx to trend above our long-term model of 4% this year. Turning to cash flow, we generated 2.2 billion over the trailing 12 months, which equates to a record 36% free cash flow margin. And over the same period, we returned approximately 75% of free cash flow after debt repayments via dividends and repos. This is below our long-term target as we paused our buyback program, given the pandemic uncertainty and the pending Maxim deal. We ended the second quarter with 1.3 billion of cash and equivalents on our balance sheet and our net leverage is now 1.3 on a trailing 12. We’re comfortable with the leverage and do not plan to reduce debt. As such, we remain committed to return 100% of free cash flow to shareholders. So let me finish up with our third quarter outlook. Revenue is expected to be 1.7 billion plus or minus 70 million, up sequentially as additional capacity comes online. This is in line with seasonality after a very strong Q2. At the midpoint, we expect each of our B2B markets to increase slightly sequentially, and consumer to be up low double digits. Based on the midpoint of guide, op margin is expected to be 42.5 plus or minus 100 bps. And our tax rate is expected to fall between 11% and 13%. Based on these inputs, adjusted EPS is expected to be $1.61 plus or minus $0.11. So in summary, ADI delivered a very strong quarter highlighted by record revenue, earnings and free cash flow conversion. Importantly, bookings and backlog remain very strong and we're continuing to invest to increase production for the balance of the year, giving us great confidence that our second half will be stronger than our first. We've also made meaningful progress towards closing the Maxim acquisition. Shortly after the deal closes, we are going to hold a conference call to provide an update regarding our capital return plans. As a reminder, once combined, we anticipate having more than $3 billion of cash and a leverage ratio well below 1. Let me now pass it back to Mike for the Q&A."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Prashanth. Let's go to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow-up question, please requeue and we'll take questions if time allows. With that, Cheryl, can we have our first question please?"
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions]. Our first question comes from John Pitzer from Credit Suisse. Please go ahead. Your line is open."
},
{
"speaker": "John Pitzer",
"text": "Yes. Good morning, guys. Congratulations on the solid results. Vince, Prashanth, 90 days ago when you sort of guided for the April quarter, the key gating factor was your ability to grow supply. I'm curious, as you look at the July quarter, are you still in a supply constrained environment? And I guess more importantly, given the internal CapEx you’re spending and your work with your foundry partners, how do we think about your ability to grow supply beyond sort of the July quarter guidance?"
},
{
"speaker": "Vince Roche",
"text": "Yes. So, John, thanks for the question. Yes, we are constrained. We've got a very, very positive book to build. But what we have forecast for the July quarter factors in all the elements of supply across silicon supply, both internally, externally as well as all the backend operations, assembly and test. So we feel very confident in that number. But beyond that, there is opportunity to ship more. There is more demand out there. But at least in the July quarter, we feel very comfortable with what we have forecast."
},
{
"speaker": "John Pitzer",
"text": "And how do we think about supply growth beyond July? Is July a good proxy to what you should be able to do sequentially for the next couple of quarters, or are you getting a particularly strong uplift in July and things moderate going forward?"
},
{
"speaker": "Vince Roche",
"text": "Well, I think -- ultimately, everything will depend on demand. We're increasing our capacity. We're getting more wafer supply in general. And we are, as Prashanth said in his remarks, we've been investing in capital equipment inside the company to expand our backend operations. So you'll see sequential improvements in ADI’s output over the coming months. So as Prashanth said, the second half of the year, given our confidence in supply, we will have a better second half than first half."
},
{
"speaker": "John Pitzer",
"text": "That’s helpful. Thanks."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, John. Next question?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Tore Svanberg from Stifel. Please go ahead. Your line is open."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you and congratulations on the record results. Prashanth, you talked about just the inventory being sort of way below the seven to eight-week target. Could you tell us where exactly the numbers are right now? And also, do you expect to get back to seven to eight at some point or is this kind of like a new norm now where disty in the channel is going to be sort of running below at what it has historically?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thanks, Tore. Inventory is very lean. We entered the quarter below seven weeks and it decreased again in the quarter. So we would like to build inventory backup. It's unlikely that that's going to happen. Whatever they get their hands on sells through immediately. So until the supply gets improved over the coming quarters, I don't think you'll see us return to normal inventory levels in the channel. But I would say that we do maintain the view that sort of that seven to eight weeks is the right balance for us to have in the channel."
},
{
"speaker": "Tore Svanberg",
"text": "Great. Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thanks, Tore."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Vivek Arya from Bank of America Securities. Please go ahead. Your line is open."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question. Vince or Prashanth, I was hoping you could quantify lead times and book to build in various end markets to the extent possible, where are lead times stretched the most? And importantly, what are you doing to prevent double ordering? Are you implementing any firm price, non-cancelable programs like some of your peers are? Any perspective on how do we quantify the state of supply/demand imbalance and how do we get some assurance that this will be resolved I guess peacefully is one word that comes to mind, I think that will be very helpful? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vivek. Maybe just to start with some comments on where demand is coming from. So we're experiencing significant growth in demand and it's very broad based in all of our markets. And when you rewind and think how we got here, our customers entered the pandemic with pretty lean inventories. Then we had this synchronized government stimulus, both fiscal and monetary. We had very strong growth during the pandemic of consumer electronics with the high use of cloud compute connectivity. We're coming out of the pandemic now with GDP driving industrial, and that's driving companies to rethink both where they manufacture and upgrading the style by which they manufacture. So on the supply side, we've been planning for additional capacity, as Vince mentioned, since late summer of 2020. And as we add capacity, our revenue forecast is increasing. And that's really what helped us deliver a better Q2 guide up for Q3 and feel good about Q4. So I think supply will eventually match demand, but I don't see demand really going away. So this feels -- given the secular drivers behind it, it feels that this is going to be with us for a while. Book to build for the past quarter was above 1, and it was the same for all end markets. So it's, again, very broad based. And I think it's really just a reflection of the incredible role that ADI’s products play across the manufacturing ecosystem."
},
{
"speaker": "Vivek Arya",
"text": "And any pricing programs that you might have put in place like your peers?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "I guess a few comments to make there. We are efficiently managing our orders. We're working with our customers, both large and small, across all markets to understand the demand timing and to allocate the supply based on demand. Remember that while we report on a POA basis, we actually run the business on POS. So we look through distribution to understand what's happening at customer. We've also put in a non-cancelable, non-returnable for up to 90 days to help give us better visibility into the backlog and that helps customers sort of manage what they can expect to get from us. So at this point, I would say the focus really has been on communication. And that's the feedback I think Vince has heard from customers as well is that what's important to them is communicating what they're going to get and when they're going to get it, so they can plan their respective downstream production requirements."
},
{
"speaker": "Vivek Arya",
"text": "Thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Vivek. We’ll go to the next question please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ambrish Srivastava from BMO. Please go ahead. Your line is open."
},
{
"speaker": "Ambrish Srivastava",
"text": "Hi. Thank you very much, Prashanth and Vince. I wanted to just unpack the gross margin comments that you made, Prashanth. You are at the model 70% plus and when you talk about gross margin incrementally getting better, what's the right way to think about it? You had referred to the cost savings that you'll be getting from factory consolidation. Is there an impact from pricing? And then kind of -- and related to that, how are you managing the input cost, which seem to be going up across the board versus pricing? And is that also playing a factor in the gross margin? And sorry, related to that is would you be building inventory as you go through the second half? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thanks, Ambrish. Do you have a few more add-ons to that? So let's start with -- let's do a quick one on, on pricing. So net impact of pricing changes are immaterial to gross margin. So we're managing our cost increases to net those out from a price standpoint. The gross margin lift that you're seeing really is the productivity that we're driving. So I did say in the first quarter earnings call that that would be the bottom of gross margins for the year and we would expect sequential improvement. You're seeing that in the Q2 results printed. You see that in the guide that we've given for Q3. That is coming from the manufacturing consolidation of the linear factory closure, which we have talked about, and also some step-up in utilization. So that's kind of a tactical way to think about how gross margins with evolved over the balance of this year. Our model remains 70%. And I don't know, Vince, if you want to give some guide on how we think about gross margins long term?"
},
{
"speaker": "Vince Roche",
"text": "Yes. Look, the root of our value creation really is innovation. We're spending over $1 billion a year. And we like to have the highest performing products out there that we got well paid for. And I think also the diversity of our product application and customer domains helps us protect margins, as we've seen through the pandemic here. So 85% -- we've got 125,000 customers and 85% of our sales comes from products that individually contribute less than 0.1% of our revenue, or even less. So that's the model of the company. So there's a lot of resilience -- a lot of optionality and resilience built into it."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Ambrish."
},
{
"speaker": "Ambrish Srivastava",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Blayne Curtis from Barclays. Please go ahead. Your line is open."
},
{
"speaker": "Blayne Curtis",
"text": "Hi. Good afternoon. Thanks for taking my question. Good morning. Just kind of curious on the industrial segment. I think last quarter you talked about two of six segments being at peak. You talked about all being up in the April quarter. So just any color by segment there and if any more of them are at record revenue, that would be helpful? Thanks."
},
{
"speaker": "Vince Roche",
"text": "Yes. Well, we've seen -- this is a very, very highly diversified business. We saw broad growth across all the individual sectors. In fact, all applications grew double digits year- over-year and sequentially. And I believe there's a lot more upside to come, because we're in a multiyear growth cycle driven by secular trends, Industry 4.0, et cetera. I would say the -- we've seen really strong acceleration in the automation sector. And I think that's driven by such things as the need for onshoring, more flexibility and more robust and connected supply chains. If I just pick healthcare, it has already been a multiyear growth market for ADI. And the pandemic kind of underscored the importance of information technology in managing our healthcare systems. So we've seen an acceleration in our digital healthcare business, as we begin to migrate the hospital environment to the clinic and the home with point of care solutions or healthcare anywhere mentality. And as I mentioned in the prepared remarks as well, the energy sector with the move through renewables and this charging infrastructure that's being laid in to support these electric vehicles, those are some of the areas that we're seeing strongest growth within the industrial area. But I think automation underpins it. Also, I would say, I've been very pleased with the results that we're getting in the very broad bench, scientific and test equipment, analytics equipment, and so on. So it's been very, very broad."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "And Blayne, just to touch on your last point about the record applications. You're right. I think last quarter, two or three had records. We increased that. Four of our six applications are at record. So I think I echo what Vince said is that we're early stages of this cycle. And yes, at some point, we expect all of our applications to be at record probably next year or so. And with that, can we go to our next question please?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Toshiya Hari from Goldman Sachs. Please go ahead. Your line is open."
},
{
"speaker": "Toshiya Hari",
"text": "Thank you for taking the question and congrats on the strong results. Vince, I had a multipart question on your BMS business. You guys talked about revenue more than doubling in the quarter. I was hoping you could speak to kind of the breadth of your customer profile there on the quarter on a year-over-year basis. And I guess more importantly, based on some of the comments that you've made on past calls and also this call as it relates to your design win pipeline, should we expect some of these wireless BMS projects to ramp in fiscal '22 or is it more fiscal '23 and beyond? And lastly, as it pertains to the combination with Maxim, how should we think about how your position in BMS evolves over time post the combination? Thank you."
},
{
"speaker": "Vince Roche",
"text": "Yes. Thanks, Toshi. Well, first off, we're the market share leader in the electric vehicle battery management systems. And as you know, we have really two portfolios. We have the existing, we like to call it the wired portfolio, the more traditional way of moving data from the battery system and we've introduced a wireless version, a robust cognitive radio-based wireless system. So I think the next 12 months will be driven by the traditional wired battery technology. And after that in late '22 into 2023, we’ll begin to see the upsurge of the wireless battery technology that will complement the wired. So what I believe will happen is, today, what have we got? 2 million, 3 million cars per year being produced -- electric vehicles being produced. That's going to move to we believe somewhere 10x at least over the next seven, eight years. So this is a multiyear cycle. Where our BMS chips today are being used in over half of the top 10 selling EV cars globally, and we're getting share in each of those areas. Today, our best position is in North America and China. And as I mentioned in the prepared remarks, we're beginning to make real tracks in Europe as well as Japan and Korea. So, ultimately, if a manufacturer wants the most miles per charge, they're going to turn to ADI. So that's what we're working on."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Toshiya. We’ll go to our next question please. Cheryl, we'll take our next question. Cheryl?"
},
{
"speaker": "Vince Roche",
"text": "Cheryl, can you hear us?"
},
{
"speaker": "Operator",
"text": "Please go ahead Ross Seymore from Deutsche Bank, your line is open."
},
{
"speaker": "Ross Seymore",
"text": "Hi, guys. Can you hear me?"
},
{
"speaker": "Vince Roche",
"text": "Yes, we can, Ross."
},
{
"speaker": "Ross Seymore",
"text": "Okay, great. Glad Cheryl came back. Just had a couple of questions on your communications business. I guess in the tactical sense, it looked like it was better than you expected in the quarter, the April quarter. Was that specific to the wired or wireless side, or was it just the supply coming on? And then more importantly, looking forward, can you give a little bit more color on what your expectations are for the wireless side? Obviously, we had some difficult comps with what happened with Huawei year-over-year, but how do we think about that returning to year-over-year growth, given the second half commentary that you talked about with some ramps in North America and beyond?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thanks. So I said in the prepared remarks that the communications business for the second quarter was really driven by very strong growth in the wired. I think it was up double digits. Wireless remains lumpy. But we feel pretty good that comms has bottomed in the second quarter and we're going to see growth in the second half, and I'll let Vince jump in with some of the customer conversations he's been having. But with the completion of the C-band auction, we feel very good that you're now going to see the build out of 5G for which we are the largest participant certainly with the transceiver product for both the U.S. and starting to see that in Europe as well."
},
{
"speaker": "Vince Roche",
"text": "Yes. So Ross, what I want to mention is that at this point in time the rest of world is 3x larger than China for ADI. I think that's very, very important to remember. And we're certainly seeing 5G momentum pick up on a global basis. North America, we've recently -- obviously, the C-band auction is complete. And we're beginning to see orders today that we expect will accelerate during 2022 and beyond. Even Europe, where there's been real lethargy in upgrading their communication systems in general over the last several years, we're beginning to see signs of life in the deployment of 5G. India is also -- India has a significant government funded program to make 5G a reality there. We’re beginning to participate in trials. And last but not least is O-RAN. We already have revenue as a company with Rakuten, the online shopping company in Japan and we're very well positioned given our ecosystem position there to unlock potential in what is a brand new stream of revenue, particularly I think as it gets deployed into private networks for machines."
},
{
"speaker": "Ross Seymore",
"text": "Great. Prashanth, just one quick clarification. Double digits in the wired, was that a year-over-year or a sequential comment? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "That was a year-over-year."
},
{
"speaker": "Ross Seymore",
"text": "Thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Ross."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Stacy Rasgon from Bernstein Research. Please go ahead. Your line is open."
},
{
"speaker": "Stacy Rasgon",
"text": "Hi, guys. Thanks for taking my question. I actually wanted to follow up on that comm question. So if I go back to last quarter, you'd kind of talked the comm trajectory down a bit and it was a China statement. So I just want to clarify. Is that -- it doesn't sound like that's changed. It does sound like the uptick you're seeing right now is outside of China, U.S., Europe, India. I guess is that correct? I guess why didn't you see that uptick 90 days ago -- expectations for that uptick 90 days ago versus today? And then what are your broad thoughts on 5G rollout in China going forward from here? How does the rest of that play out given all the dynamics that are happening there?"
},
{
"speaker": "Vince Roche",
"text": "Yes. So I think first and foremost, China's opportunistic for ADI at this point. We will sell I think lots of components, and therefore it is more opportunistic. Prashanth, you can talk about the specifics."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. I think, Stacy, we have always said that we expected 5G deployments in North America to come next and be followed by Europe. When we gave you the commentary for the -- leaning into the second quarter, we were focused on the pause in China. But we have seen now that the auctions are complete, and particularly Verizon being much more public about what they intend to do in the 5G space, as Vince mentioned, orders are starting to come in for that. So the trajectory for communications or for wireless specifically is going to be up in the second half."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Stacy."
},
{
"speaker": "Stacy Rasgon",
"text": "Thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "Can we go to our last question please?"
},
{
"speaker": "Operator",
"text": "Thank you. And our last question comes from William Stein from Truist Securities. Please go ahead. Your line is open."
},
{
"speaker": "William Stein",
"text": "Great. Thanks so much for squeezing me in. Guys, I'd like to ask about the cost function. We have two potential looming problems. I think one is inflation broadly, not just materials, potentially labor as well. And then on the OpEx side, the return to work face-to-face sort of operations suggest maybe we start spending on travel and things like that. And I wonder if you can comment as to how we might sensitize our models to these factors? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "So let me take the inflation piece first. So I think it was Ambrish who asked a question and we are seeing cost increases from our supply base, but we feel that we're guiding margins on a net basis are going to be neutral for that, because we are where we can pushing that price through. So I'm not as concerned about the inflation side. We have been very mindful of the labor side. And I would say that the data we're seeing is that it's taking us about a week longer than normal to fill jobs at the factory level. So our U.S. factories are facing a little bit longer time to fill jobs, but it's not anywhere as dramatic as what we're hearing in the media in terms of filling these high paying manufacturing jobs. And then for return to office, that is something we spend a lot of time on. There is no doubt that there will be some return to travel. I think that's going to be universal across all companies. But more specifically to how ADI is thinking about return to office, maybe I'll let Vince talk about how we're thinking about that."
},
{
"speaker": "Vince Roche",
"text": "Yes. So we've instituted a three-day per week policy to start with here at ADI for those who have been working remotely, and we will see where things go from there. But my sense is on the OpEx side of things, we will probably not get back to per capita travel spend, entertainment spend and so on and so forth. The other thing I'll remind you, Will, is that we work relentlessly at the company on taking costs out of the business. So we work hard on cost of goods, we work hard on making the business efficient below the cost of goods line as well. So inflation is nothing new. We'll see how it moves over the next -- if we see an acceleration in inflation, then we'll figure out what actions to take."
},
{
"speaker": "William Stein",
"text": "So we shouldn't be modeling some step-up cost function in OpEx related to travel and such activities? I know there's some increase you've already guided to for I think bonuses and such, but for travel no?"
},
{
"speaker": "Vince Roche",
"text": "Well, I think that's true. And when you look at the expenses today, our OpEx is laden with some very rich bonus payouts, because the business in terms of growth and profitability is doing very, very well. But we will -- over time, I expect that the growth will moderate and the bonuses will also moderate."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Will, maybe I can wrap up by saying we're expecting second half revenue to be strong. We indicated that second half gross margins are going to continue to increase, which is going to give you incredible leverage and therefore there is no reason you won't see a meaningful lift in op margins as each quarter rolls out. And all of that is going to translate into more cash flow, which we'll have available to deploy since we're not doing any further debt reduction, that's coming back to shareholders."
},
{
"speaker": "William Stein",
"text": "Great. Thanks so much."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Will, and thanks everyone for joining us this morning. A copy of the transcript will be available on our Web site. Our reconciliations will also be there. You can also find our new CSR report that Vince outlined in his script on our Analog Investor Relations homepage. And with that, thanks for joining us and your continued support of ADI."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 1 | 2,021 | 2021-02-17 10:00:00 | Operator: Good morning, and welcome to the Analog Devices First Quarter Fiscal Year 2021 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Mike Lucarelli, Senior Director of Investor Relations. Sir, the floor is yours.
Mike Lucarelli: Thank you, Cheryl, and good morning, everybody. Thanks for joining our first quarter fiscal 2021 conference call. With me on the call today are ADI's CEO, Vincent Roche and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now onto the disclosures. The information we're about to discuss includes forward-looking statements, including statements relating to our objectives, outlook and the proposed Maxim transaction. These forward-looking statements are subject to certain risks and uncertainties, as further described in our earnings release and our most recent 10-Q and other periodic reports and materials filed with the SEC. Actual results could differ materially from these forward-looking statements as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO, Vincent Roche. Vince?
Vince Roche: Thanks very much Mike, and good morning to you all. So I'll start my remarks with a review of our results before providing insights into how we're shaping a more connected, safer and sustainable future. The first quarter we delivered strong results that came in at high end of our outlook. Revenue was $1.56 billion and increased 20% year-over-year. The strength was broad based, the growth across all end markets highlighted by a record quarter for our industrial business. We delivered gross margin of 70% and op margin of nearly 41%. All told, we produced adjusted earnings per share of $1.44. Over the trailing 12 months, we generated $1.9 billion free cash flow equating to 33% free cash flow margin placing us in the top 10% of S&P 500. So overall I'm very pleased with our team's performance this quarter. Now I'd like to discuss how we're advancing our mission of engineering good for the planet, social health and economic prosperity which in turn will create long-term sustainable value for our shareholders. Awareness of the world's environmental degradation and climate change specifically is growing tremendously with a global called action building momentum. Semiconductors, as the bedrock of the modern digital economy have a major role to play in improving our standard of living while protecting our planetary health. At ADI, our technology sit at the intersection of our customers and societies most pressing challenges and we're uniquely positioned to drive positive impact. Our industry leading portfolio with its breadth of capabilities defines the edge of performance and inherently delivers sustainable benefit. With each generation of chip designed, we increase efficiency while enhancing the performance of our customers systems. This portfolio supports customers of all sizes and spans industries that are aligned with key secular trends. So today, I'll focus on where ADI is entering goods across the automation, electrification and connectivity sectors. Firstly, the automation of human routines, factory floors and supply chains is critical to our future and the pandemic has further accelerated this paradigm. The World Economic Forum is predicting that by 2025 over half of all tasks will be performed by machines at first in human history. To support this trend, our industrial customer base is boosting deployments of robots and cobots. Over the next five years the global robot installed base is expected to increase by about 60%. With industrial motors currently consuming 25% of all the world's electricity. We urgently need to deploy technologies that not only deliver speed and accuracy, safety and flexibility. But also energy savings. Now let me share a few examples of how our technologies are meeting these challenges in automation. So firstly, variable speed drives can reduce motor energy consumption by up to 40% in a robot. Our precision signal chain isolation and power management technologies together increase response time and improve power conversion. Secondly, our time of flight sensing technology allows robots to sense and interpret the world around them. So our customers can deploy more robots per square foot and improve workers safety. Thirdly, our OtoSense condition-based monitoring solution presciently identifies motor inefficiencies enabling customers to proactively optimize and repair machinery. This avoids costly downtime and lowers energy consumption by 10%. Importantly, these technologies that improve motor efficiency and robotic control can save almost one gigaton of annual CO2 emissions, the equivalent of 330 million residential homes. In total, automation is a key component of our industrial business supporting tens of thousands of customers. We expect this accelerated digitalization to drive continued growth in 2021 and beyond. Now I'll turn to electrification and discuss the important role ADI is playing as consumer demand for greener transportation accelerates. The World Economic Forum predicts that by 2030 there will be approximately 215 million electric vehicles on the road up exponentially from about 7 million today. ADI's solutions are embedded across all phases of the electric vehicle journey from supporting EV infrastructure to forming and managing the vehicle battery. So I'll share now how our technologies are impacting this ecosystem. First, the shift to renewable energy sources drives great environmental benefits. But also creates new obstacles in distribution, transmission and stability. This requires a smart grid which can vividly monitor and adjust performance. Our control and sensing technologies are critical to ensuring the grid parameters remain stable and prevent shutdowns. This shift also requires energy storage systems to mitigate intermittency issues, related to variable user demand. Here our high accuracy monitoring and efficient power conversion technologies help extend systems battery life by more than 30%. Turning to the battery which is the most expensive vehicle part. Our Battery Management System or BMS enables up to 20% more miles per charge than our competition. As the market leader, over half of the top 10 electric vehicle brands use ADI's BMS technology today. In addition, last fall we introduced the industry's first wireless BMS platform. This is all the benefits of our wired solution by lowering vehicle weights and enabling the scalable battery architecture, paving the way for reuse and storage systems. GM's Ultium platform uses our wireless BMS technology which is expected to be deployed across 30 different models by 2025. Interest in our wireless BMS technology is rising and last quarter, we recorded our second OEM design win. Importantly, the environmental impact from our BMS capabilities is notable. In 2020 alone, vehicles equipped with ADI's BMS technologies prevented approximately 70 million tons of carbon dioxide when entering the atmosphere. Our solutions utilized at the battery formation stage enabled more current density thereby shrinking our customer's equipment footprint by up to four times and reducing per channel costs by nearly half. Our technology makes it possible for factories to recycle more than 80% of the energy used during the formation back into the power grid. Based on today's production levels, energy recycling during formation reduces CO2 output by about 1 million tons annually. So all told, electrification not only represents highly valuable market with long-term revenue growth opportunities. But one that will be critical to the preservation of our precious natural ecosystem. So finally, let me turn to connectivity. In the face of the pandemic, connectivity has been the foundation that is sustaining and powering our society and the economy and while the communications market is not known historically for its sustainability benefits. This ability to stay connected and productive from anywhere has also had a positive impact on the environment, a clear proof point is the reduction of global carbon emissions by a record 7% in 2020. By 2030, forecast suggest mobile traffic will increase by about 17-fold. This exponential increase in wireless data combined with pervasive cloud computing puts IP traffic on pace to double every two and a half years. And ADI is playing a critical role in building out the next generation infrastructure to support this exponential increase in data. From capturing the signal at the base station air interface to transferring the information to the data center while substantially decreasing power. So ADI has invested ahead and reshaped the 5G radio architecture, our software defined transceivers with complementary precision signal chain and power technologies are vital to enabling the 5G massive manual architecture. When comparing 5G to 4G, our solutions help deliver a 90% decrease in energy per bit at the air interface by decreasing the channel count by 10x while maintaining the radio size and terminal performance. With the exponential upswing in data generation. Our customers are upgrading their optical infrastructure from 100 to 400 gigabits per second. Our precision signal chain technologies help enable these optical modules maintain constant power while operating at four times the data rate. And with the customers looking to increase to 1 terabit and beyond ADI's opportunity will continue to expand. Capturing and transporting data efficiently is important. But computing in data centers is the primary source of energy consumption in the connectivity ecosystem. Currently, data centers generate more than 130 million tons of CO2 per year globally. So this is where the transition from 12 to 48 volt power distribution can reduce power loss and increase compute density. Our 48 volt to core micromodules power and power system monitoring solutions are enabling this transition and according to Alphabet, this approach and approved data center energy efficiency by 30%. All told, ADI is part of the ecosystem enabling greater efficiency and wireless and wired data capture transmission and of course computing and our solutions of customers to scale their investments and build next generation networks economically and resourcefully. So stepping back, I'm incredibly proud of the progress we've made on our mission to engineer good but a lot remains yet to be done. We're focused on partnering with our customers to develop increasingly innovative technologies that create successful business outcomes in rich people's lives and leave a greater impact on our world. And so with that, I'll hand it over to Prashanth.
Prashanth Mahendra-Rajah: Thank you, Vince. Let me add my welcome to our first quarter earnings call. My comments today with the exception of revenue and non-op expenses will be on an adjusted basis which exclude special items outlined in today's press release. ADI delivered strong first quarter with results at the high end of our outlook. Revenue increased 20% nearing an all-time high, operating margin expanded to 40.7% in line with our long-term model and adjusted EPS grew 40%. We saw tremendous breadth this quarter with all market segments growing year-over-year. The first time in over three years. And B2B revenue increased 2% sequentially and 22% year-over-year with double-digit growth across each end market. Industrial represented 55% of revenue during the quarter increased 5% sequentially and 24% year-over-year. This represented a record quarter for industrial with broad based strength across applications, customers and geographies. Specifically demand across our automation instrumentation and energy businesses accelerated this quarter. Communications which represented 18% of revenue during the quarter decreased 10% sequentially but increased 16% year-over-year. Both wireless and wireline revenue grew double-digit despite zero revenue from Huawei this quarter. Automotive which represented 16% of revenue increased 7% sequentially and 19% year-over-year. With the industry aggressively ramping up production we saw double-digit year-over-year across all applications. BMS exhibited the highest growth, a trend we expect to continue given our growing design pipeline. And lastly, consumer which represented 11% of revenue increased 2% sequentially and 5% year-over-year. We saw strong growth in hearables, wearables and home entertainment. This quarter's inflection puts us on track to return to full year growth in 2021. And now for the rest of the P&L, gross margin which is seasonally weaker in the first quarter finished flat sequentially at 78%. We anticipate our first quarter's gross margin will be the trough for the year as we benefit from a strong top line, improving utilization and capturing the majority of the LTC cost savings. OpEx in the quarter was $456 million up sequentially and year-over-year due mainly to variable compensation. Op margins finished at 40.7% above the guided midpoint. Non-op expenses were $27 million and better than our outlook due to an investment gain. Our tax rate for the quarter was approximately 12%. So all told, adjusted EPS came in above the high end of guidance at $1.44. This included a $0.04 benefit from an investment gain that was not in our prior outlook. Moving onto balance sheet and cash flow, inventory dollars increased modestly while inventory days finished at 119, down from 121 in the fourth quarter. Channel inventory as measured in weeks was flat sequentially and remained well below our seven-to-eight-week target. CapEx in the quarter increased to $67 million or roughly 4% of sales. We're working judiciously to add CapEx to meet this record demand anticipate that CapEx will run slightly above our long-term target of 4% for fiscal 2021. Turning to cash flow, over the trailing 12 months we generated $1.9 billion or 33% of revenue. You'll recall that during the last year, we paused our share repurchase program for few quarters due to the pandemic and our proposed Maxim acquisition. Therefore in 2020, we returned 80% of free cash flow to shareholders after debt repayments. This quarter, we've reinstated our share repurchase program and given our current 1.5 leverage ratio we're committed to returning 100% of free cash flow for the year. Looking at the first quarter, we executed nearly $160 million of repo and we also announced an 11% increase to our quarterly dividend at $0.69 per share. Which marks our 18th increase over the last 17 years? Before moving onto guidance, I want to provide some context on the current state of supply. A sharper than expected recovery in the economy coupled with a lean inventory backdrop is fueling unprecedented demand for semiconductors and putting stress on the global supply chain. While the industry at large is aggressively working to meet this historic demand. It's more than likely we'll be operating in a constrained supply environment for the balance of the year. At ADI, we're confident in our ability to outperform in times like this. Our flexible hybrid manufacturing model, healthy balance sheet inventory and diversified product and customer base position us well. In addition, we're working to secure additional capacity from our external partners and ramping our internal operations to increase output. Now let me provide our second quarter outlook. Revenue is expected to be $1.6 billion plus or minus $50 million. At the midpoint, this guidance reflects would be record revenue. We expect double-digit year-over-year growth for automotive, industrial and consumer market but we do see a decline in our comms. Based on the midpoint of guidance, op margin is expected to be 41% plus or minus 70 bps and our tax rate is expected to be between 11% and 13%. Based on these inputs, adjusted EPS will be $1.44 plus or minus $0.08. So in summary I'm encouraged by the near-term trend we're seeing across our end markets and while we're mindful of the ongoing macroeconomic uncertainty. We're optimistic that a broad-based recovery is underway and with Maxim expected to close this summer. 2021 will be a transformative year for ADI. Let me now pass it back to Mike to start our Q&A.
Mike Lucarelli: Thanks Prashanth. Let's go to the Q&A session. We ask that limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow-up question please requeue and we'll take your question, if time allows. With that, Cheryl can we have our first question please.
Operator: [Operator Instructions] our first question comes from John Pitzer from Credit Suisse. Please go ahead. Your line is open.
John Pitzer: Good morning, guys. Appreciate the question and congratulations on the strong results. Prashanth, I just want to talk a little bit about how the model unfolds from here. I mean clearly you talked about already hitting the gross margin trough for the year. But you're guiding EPS sort of flattish on op revenue. I'm just kind of curious how should we be thinking about OpEx from current run rate levels and specifically, is there incremental OpEx needed because of the tight supply situation? What are the puts and takes as we go throughout the balance of the year?
Prashanth Mahendra-Rajah: Thank you for the question, John. Way to think about OpEx is that, if you recall in the Proxy, we identified that last year in the first half we had a particularly low bonus payout as reflection of the macroeconomic environment. In the first half of this year you're going to see the opposite effect of that. So on average it's a normal bonus payout. But you do see a significant upswing in a variable comp for which is impacting both the first and the second quarter compares. In addition, we have the merit increase if you remember we put that merit increase in several months later than normal as a result of the pandemic last year. So you're beginning to see that on a full year run rate basis in first quarter and then it will carry in second quarter. So beyond these comp related items OpEx is really at a steady level. We're not requiring any additional investment at the OpEx level to support the demand that we're generating.
John Pitzer: Perfect. Thank you, guys.
Mike Lucarelli: Thanks. We'll have our next question.
Operator: Thank you. Our next question comes from Ambrish Srivastava from BMO Capital Markets. Please go ahead. Your line is open.
Ambrish Srivastava: Prashanth and Vince, I just wanted to get back to the current constrained supply condition that the industry is facing. So could you please comment on your lead times and then what are you seeing in the cost increases as you're experiencing and are you able to pass along pricing through the customers and more importantly, does it change your approach? Is there a structural change that you see happening? Prashanth, you talked about CapEx running a little bit higher. Where does that additional CapEx going? Is back end, front end? And I just wanted to get a better sense of how things change from here on the supply chain front for ADI? Thank you.
Prashanth Mahendra-Rajah: Okay, so there's a lot packed into that question, Ambrish. Let me take a couple pieces of it. So we're producing and shipping at record levels and second quarter outlook is going to be a record. We have enough capacity to meet to the guide. But significant additional upside versus that guide will depend on what we're able to procure both from an external wafer standpoint as well as the capital that we're in the process of deploying into our internal facilities to support that. What we're doing to help alleviate that situation is we have been consistently building inventory since last summer to deplete what was pulled down during the pandemic shutdowns. We're adding additional supply both internally and I mentioned the capital that we're deploying which is mostly going to the back end and then externally we've gone out and acquired additional wafers from our partners. I think the answer to your question on CapEx is that is mostly for test and then, on the capacity side. Where we can get additional capacity from our partners, we're doing that. But even with this additional capacity it's very likely that the strength of demand is going to outpace supply for some period of time. So I think we will be chasing demand at least for the balance of this year. From a capital deployment standpoint, some of that as we guide as percentage of revenue some of that is dependent on how strong the year continues to rollout. So when I say slightly above 4%. It could come down to 4% or maybe just a hair below if revenue continues to cripple on here.
Vince Roche: Yes, just on the lead time question, Ambrish. So we entered our first quarter with what we've recalled normal lead times. But during the quarter and into the early part of this quarter we've seen lead times extend which I think is pretty consistent with the industry at large. So while we see some hot spots. We're really talking about is few weeks of extension in different places. Let me remind you too that, we run this company. We run our manufacturing plants; the operating plants are run to POS rather than POA. So what we're seeing right now is a good balance between POS and POA. But as Prashanth said, we're preparing for quite a bit of upside during this year and we've pretty substantially increased the CapEx in our backend.
Mike Lucarelli: Thanks Ambrish. Go to next question, please.
Operator: Our next question comes from Stacy Rasgon from Bernstein Research. Please go ahead. Your line is open.
Stacy Rasgon: I wanted to ask about comm. So it's down sequentially and year-over-year I guess into Q2. Is that the trough for the year for comm.? And do you think the comms segment overall can grow year-over-year for the full year 2021?
Prashanth Mahendra-Rajah: You want to take that, Vince? Okay, I'll take the first part of that, Stacy. So let's break comms into wired and wireless. On the wired, we're looking for continued growth as carriers and data centers are upgrading networks. On the wireless, we said that, that the US deployment of 5G was always going to be a second half event and our view on that has not changed. What we have seen is a bit more of a slowdown in China as they're digesting kind of the 5G that they deployed and the channel counts are a bit lower. So we do think comms troughs in second quarter and then begins to pick up in the second half with the global 5G. In terms of our view on whether we can grow comms on a year-over-year basis. Given the significant headwind we have from Huawei going to zero, that's a tough ask.
Vince Roche: Yes, I think as well, I'll remind everybody that the three-year CAGR for comms has been 7% and that's with that's very, very significant headwind in China. I think when you look at ADI in the comms business it's tremendously diverse. Many, many hundreds of customers. 5G is a critical part. Wireline is an increasingly critical part. So very, very hard to predict in a lumpy business. But our expectation is that, when you have CAGR [indiscernible] we produce better than mid single-digit growth for that business.
Stacy Rasgon: I'm sorry, was that a long-term statement? That didn't sound like that was this year.
Vince Roche: Over the next few years I think Stacy. We will produce something better than mid single-digit growth in that business.
Mike Lucarelli: Yes, Stacy what Prashanth says we don't think it will grow this year in fiscal 2021 due to, I will say the Huawei headwinds, as they go to zero and lower channel count in China. But then pivoting to Vince, over the long-term we should grow - we've been growing 7%. There's no reason to go - going forward we can't grow at least in line to that.
Stacy Rasgon: Didn't you used to talk about double-digit growth in this business?
Mike Lucarelli: We did Stacy. I think the world has changed over the past two years quite a bit. Could it grow double-digit? Sure it could. There's no reason it can't. But I think as we look today with the pressures, you're seeing geopolitically those are things we didn't know two years ago.
Vince Roche: I think high single digits is a reasonable expectation. The early stages of 5G, I think being able to grow at double digits pretty plausible but we're working off a bigger numerator at this point in time. So I think if we can produce something in the high single digits. We'll be in very, very good shape.
Stacy Rasgon: Got it. Thank you, guys.
Mike Lucarelli: Thanks Stacy. Cheryl, next question.
Operator: Our next question comes from Tore Svanberg from Stifel. Please go ahead. Your line is open.
Tore Svanberg: Vince, you talked about second design win for your wireless BMS solution or second OEM using that technology. Could you elaborate a little bit on how quickly this technology is going to penetrate the auto market? Could you potentially get to six, seven OEMs embracing this technology this year and or next?
Vince Roche: Well that's certainly our expectation. I think in terms of getting to market. The latter part of this year we'll see the start of production. And I think between now and the end of 2023 say, we should expect four to five OEMs to adopt that technology. With a strong pipeline, but also remember we have a very strong wired portfolio in BMS. So we've got those two tailwinds working for us. But I think overtime it will be kind of hybrid between wired and wireless. But clearly wireless is the bright star at this point in time and our expectation is, that we'll have at least a handful of OEMs using this technology by start of 2024.
Tore Svanberg: Very helpful. Thank you.
Mike Lucarelli: Thanks Tore.
Operator: And our next question comes from Vivek Arya from Bank of America. Please go ahead. Your line is open.
Vivek Arya: Vince, I wanted to talk about just fiscal 2021 and the sustainability of growth. So you're starting the year of very strong, right? 20% growth rates in Q1 and the Q2 outlook. How should we think about the second half of other - do you want to talk about the fiscal year or the calendar year? Which markets do you think right now are over heated because of whatever reasons which are kind of only - which are in line with demand and which ones can actually accelerate going into the second half? Just how should we think about how the segment mix changes as you go towards the second half of the year? Thank you.
Vince Roche: Thanks for your question. Typically 1Q is the low point for ADI. We had a reasonably strong first Q compared to kind of normal pattern. But I want to stress there's still a tremendous amount of uncertainty out there. And I don't want to get into the business of making strong speculative predictions here. But we can only kind of guide one quarter at a time particularly in this varying market. But if I look at the markets and just kind of peel the story back a little bit for you. So our industrial business which represents about half of the company's revenue was down we had two consecutive down years in 2019 and 2020. But we produced the record quarter in the first. We expect ongoing strength in that business and one thing I'm very, very pleased about is that the most diverse part of our industrial business is automation and I think given the strength of our opportunity pipeline, the new products we've got coming to market. I expect to see a multi-year tailwind in the automation part. I think right now in automotive there's a big push to electric vehicles and I see that as I said in the prepared remarks that is expected to grow by 2030 from kind of 7 million deployed electric vehicles today to over 200 million by 2030. And we talked a lot last quarter about the strength of our cabin electronics business, active noise cancelation, premium audio, our A2B bus deployments and all that through provides good tailwinds for the company going ahead. Comms as we've just narrated weak in the first half of 2021. But really, I think that's about the timing of deployments and my expectation is that, that business would snuck back in the second half of 2021 and continue into 2022. Last but not least, our consumer business has shown our couple of sequential growth quarters and we no longer have the overhang of one big socket and one big customer. So with the diversity of our business. We were addressing more applications, we've a stronger product portfolio than we've had say three years ago. I think we're on a growth track of that business and we're certainly off to a very, very good start. So we believe that 2020 was bottom of that business and certainly the signals are that is the case.
Vivek Arya: Thank you.
Mike Lucarelli: Thanks Vivek.
Operator: Thank you. Our next question comes from Toshiya Hari from Goldman Sachs. Please go ahead. Your line is open.
Toshiya Hari: Vince, you guys talked about growing capacity both internally as well as externally with your foundry partners. How should we think about the step up in your capacity, again both internal and external, over the next couple of quarters? The magnitude at which you can grow capacity for the overall business? And secondly, a couple of your peers have talked about signing long-term contracts with customers. Is that something that ADI is thinking about or considering? Thank you.
Vince Roche: Well, I think what you've got to remember is that first and foremost we're producing and shipping products at record levels. 2Q will be an all-time record for the company, so we're certainly keeping ahead. Our investments are keeping ahead of these revenue levels, obviously. Like most of our peers in the industry, there are supply constraints in parts of the business, so we're not able to meet all of the demand, particularly in auto, which has been very, very well-publicized. And the constraints continue across the front end in wafer procurement and also the backend. But I want to remind you, too, we produce about half our silicon inside ADI, and the other half we procure with external partners. So I think something else worth noting is that we've been building inventory since last summer in terms of die stock and finished goods, which was heavily depleted during the pandemic shutdown. So, as I said, internally we're ramping up our own manufacturing operations and we've been successful in acquiring additional wafers from our external partners. So I think that's the best I can give you in terms of the atmosphere that we're working within. We're certainly keeping CapEx deployments ahead of where we think the revenue could be this year based on the demand patterns we now see.
Prashanth Mahendra-Rajah: Toshi, I would expect that our guide for each of the subsequent quarters is going to be partly influenced by what we're able to supply. So as I said earlier, I think we're going to be chasing demand for the rest of this fiscal year, and we will use our guidance range to inform how we think - what we can build to base on our ability to get capacity third parties as well as increase capacity internally.
Toshiya Hari: And then the long-term contracts, is that something that comes up in conversations or not really?
Vince Roche: I think it depends. We do have long-term contracts, but we're doing that on a more strategic basis than tactical, let's say.
Toshiya Hari: Got it. Thank you so much.
Mike Lucarelli: Thanks, Toshiya.
Operator: Our next question comes from Craig Hettenbach from Morgan Stanley. Please go ahead. Your line is open.
Craig Hettenbach: Any update on just the linear cross selling synergies and efforts? I know a little while back you talked about the pipeline, but just how you're seeing that kind of unfold? And any particular markets for product segments that you're seeing the most traction along those lines?
Vince Roche: Yes, so, Craig, there's a couple of ways to look at this. Obviously, the battery side of things is very, very strong. We've more than doubled the size of that since we acquired LT. And overall, when I look at, for example, power, the mixed signal portfolio, as well as the battery management side of things, we have more than $500 million worth of new revenue going into production this year, and that's just the beginning. So in terms of areas where we're winning, we've got notable wins in communications, in wireless as well as and data center and cloud. In Automotive, we're strongly attaching to our infotainment business, the autonomous radar systems. And the strongest surge in terms of growth in industrial for the LT portfolio, the additional cross selling is instrumentation tests and micromodules generally speaking across the board. We're seeing very, very strong demand for those products. So I think all that said, we had expected that we would double the LTC growth from 3% to 4% historically to high single digits in a five-year period. And that's quite similar to how we viewed our opportunity with Hittite at the beginning and what also has materialized. So that's the story in terms of the markets and the expected growth.
Craig Hettenbach: Got it. Appreciate the color. Thanks, Vince.
Mike Lucarelli: Cheryl, can we have our last question, please?
Operator: Thank you. Our next question comes from C. J. Muse from Evercore. Please go ahead. Your line is open.
C. J. Muse: I guess, Vince, to follow-up on that last question and to kind of go back to what you talked about a quarter ago. I think you said factory automation turned positive for the first time in quite a while year-on-year yet was still significantly below the Q3, 2018 levels. So I was hoping we could level set where we are today in your industrial bucket. And as you think about where you are relative to prior peak, what kind of acceleration in growth should we be able to see in 2021 and 2022 particularly around factory automation, A&D and instrumentation?
Vince Roche: I'd say I mean, just Mike can give you some numerical color. I'll just give you a couple headline here. So what we're seeing, as I said in the prepared remarks, is an acceleration of the market in general, but we're still well below the previous peak. And given the pipeline of opportunities that we've got, the technologies and the products that we've got, I think the long-term trends are going to be very, very strong, accelerated of course by the obvious need for resilience and driven by automation as a result of the pandemic. But, Mike, you might want to add?
Mike Lucarelli: Yes, sure. C. J., you're right. If you look at our Industrial business, we did just achieve a record quarter and we're guiding to another record quarter. So I'll clarify that. But what's interesting is if you peel back a bit, we have six application areas within industrial. Only two of them are above previous peaks. So there's a lot more room for upside across all the verticals. But even if you look back at previous peaks, there's still four application areas we still have more room to run before we hit those peaks. Automation being one of those as well. So I think, as Vince said, it's a long-term growth market, automation and industrial, and you're starting to see that business turn late last year into this year. And I think that continues hopefully into 2022.
Prashanth Mahendra-Rajah: Maybe just to close on that, C. J., we've been gaining share in industrial, and we've been gaining share over the last couple of years while the market hasn't been as strong. Now you're going to see the compounding effect of a growing market with the benefits of the share that we've picked up. So I think you will see significant outperformance for ADI's industrial business versus our peers over the balance of this year.
Vince Roche: I think healthcare as well, C.J., is worth noting that it still remains considerably above pre-COVID levels. We obviously got a boost during the upsurge in COVID-19. And again, I think this has been growing at 10% for the past five or seven years. I think, a multi-year growth market, and we're beginning to see also the acceleration of demand as a result of the pandemic getting healthcare capabilities to anywhere so to speak. So I think - we look across industrial as an area where we've been, I'd say, steering a lot of our R&D over the last decade or so. It's kind of a long burn business, but we're seeing the benefits now in terms of strength of our technology pipe and our customer engagements.
C. J. Muse: Thank you.
Mike Lucarelli: All right. Thanks, C.J., and thanks, everyone, for joining us this morning. A copy of the transcript will be available on the website. Thanks for joining the call and your continued interest in Analog Devices. Have a good day.
Operator: This concludes today's Analog Devices' conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices First Quarter Fiscal Year 2021 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Mike Lucarelli, Senior Director of Investor Relations. Sir, the floor is yours."
},
{
"speaker": "Mike Lucarelli",
"text": "Thank you, Cheryl, and good morning, everybody. Thanks for joining our first quarter fiscal 2021 conference call. With me on the call today are ADI's CEO, Vincent Roche and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now onto the disclosures. The information we're about to discuss includes forward-looking statements, including statements relating to our objectives, outlook and the proposed Maxim transaction. These forward-looking statements are subject to certain risks and uncertainties, as further described in our earnings release and our most recent 10-Q and other periodic reports and materials filed with the SEC. Actual results could differ materially from these forward-looking statements as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO, Vincent Roche. Vince?"
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"speaker": "Vince Roche",
"text": "Thanks very much Mike, and good morning to you all. So I'll start my remarks with a review of our results before providing insights into how we're shaping a more connected, safer and sustainable future. The first quarter we delivered strong results that came in at high end of our outlook. Revenue was $1.56 billion and increased 20% year-over-year. The strength was broad based, the growth across all end markets highlighted by a record quarter for our industrial business. We delivered gross margin of 70% and op margin of nearly 41%. All told, we produced adjusted earnings per share of $1.44. Over the trailing 12 months, we generated $1.9 billion free cash flow equating to 33% free cash flow margin placing us in the top 10% of S&P 500. So overall I'm very pleased with our team's performance this quarter. Now I'd like to discuss how we're advancing our mission of engineering good for the planet, social health and economic prosperity which in turn will create long-term sustainable value for our shareholders. Awareness of the world's environmental degradation and climate change specifically is growing tremendously with a global called action building momentum. Semiconductors, as the bedrock of the modern digital economy have a major role to play in improving our standard of living while protecting our planetary health. At ADI, our technology sit at the intersection of our customers and societies most pressing challenges and we're uniquely positioned to drive positive impact. Our industry leading portfolio with its breadth of capabilities defines the edge of performance and inherently delivers sustainable benefit. With each generation of chip designed, we increase efficiency while enhancing the performance of our customers systems. This portfolio supports customers of all sizes and spans industries that are aligned with key secular trends. So today, I'll focus on where ADI is entering goods across the automation, electrification and connectivity sectors. Firstly, the automation of human routines, factory floors and supply chains is critical to our future and the pandemic has further accelerated this paradigm. The World Economic Forum is predicting that by 2025 over half of all tasks will be performed by machines at first in human history. To support this trend, our industrial customer base is boosting deployments of robots and cobots. Over the next five years the global robot installed base is expected to increase by about 60%. With industrial motors currently consuming 25% of all the world's electricity. We urgently need to deploy technologies that not only deliver speed and accuracy, safety and flexibility. But also energy savings. Now let me share a few examples of how our technologies are meeting these challenges in automation. So firstly, variable speed drives can reduce motor energy consumption by up to 40% in a robot. Our precision signal chain isolation and power management technologies together increase response time and improve power conversion. Secondly, our time of flight sensing technology allows robots to sense and interpret the world around them. So our customers can deploy more robots per square foot and improve workers safety. Thirdly, our OtoSense condition-based monitoring solution presciently identifies motor inefficiencies enabling customers to proactively optimize and repair machinery. This avoids costly downtime and lowers energy consumption by 10%. Importantly, these technologies that improve motor efficiency and robotic control can save almost one gigaton of annual CO2 emissions, the equivalent of 330 million residential homes. In total, automation is a key component of our industrial business supporting tens of thousands of customers. We expect this accelerated digitalization to drive continued growth in 2021 and beyond. Now I'll turn to electrification and discuss the important role ADI is playing as consumer demand for greener transportation accelerates. The World Economic Forum predicts that by 2030 there will be approximately 215 million electric vehicles on the road up exponentially from about 7 million today. ADI's solutions are embedded across all phases of the electric vehicle journey from supporting EV infrastructure to forming and managing the vehicle battery. So I'll share now how our technologies are impacting this ecosystem. First, the shift to renewable energy sources drives great environmental benefits. But also creates new obstacles in distribution, transmission and stability. This requires a smart grid which can vividly monitor and adjust performance. Our control and sensing technologies are critical to ensuring the grid parameters remain stable and prevent shutdowns. This shift also requires energy storage systems to mitigate intermittency issues, related to variable user demand. Here our high accuracy monitoring and efficient power conversion technologies help extend systems battery life by more than 30%. Turning to the battery which is the most expensive vehicle part. Our Battery Management System or BMS enables up to 20% more miles per charge than our competition. As the market leader, over half of the top 10 electric vehicle brands use ADI's BMS technology today. In addition, last fall we introduced the industry's first wireless BMS platform. This is all the benefits of our wired solution by lowering vehicle weights and enabling the scalable battery architecture, paving the way for reuse and storage systems. GM's Ultium platform uses our wireless BMS technology which is expected to be deployed across 30 different models by 2025. Interest in our wireless BMS technology is rising and last quarter, we recorded our second OEM design win. Importantly, the environmental impact from our BMS capabilities is notable. In 2020 alone, vehicles equipped with ADI's BMS technologies prevented approximately 70 million tons of carbon dioxide when entering the atmosphere. Our solutions utilized at the battery formation stage enabled more current density thereby shrinking our customer's equipment footprint by up to four times and reducing per channel costs by nearly half. Our technology makes it possible for factories to recycle more than 80% of the energy used during the formation back into the power grid. Based on today's production levels, energy recycling during formation reduces CO2 output by about 1 million tons annually. So all told, electrification not only represents highly valuable market with long-term revenue growth opportunities. But one that will be critical to the preservation of our precious natural ecosystem. So finally, let me turn to connectivity. In the face of the pandemic, connectivity has been the foundation that is sustaining and powering our society and the economy and while the communications market is not known historically for its sustainability benefits. This ability to stay connected and productive from anywhere has also had a positive impact on the environment, a clear proof point is the reduction of global carbon emissions by a record 7% in 2020. By 2030, forecast suggest mobile traffic will increase by about 17-fold. This exponential increase in wireless data combined with pervasive cloud computing puts IP traffic on pace to double every two and a half years. And ADI is playing a critical role in building out the next generation infrastructure to support this exponential increase in data. From capturing the signal at the base station air interface to transferring the information to the data center while substantially decreasing power. So ADI has invested ahead and reshaped the 5G radio architecture, our software defined transceivers with complementary precision signal chain and power technologies are vital to enabling the 5G massive manual architecture. When comparing 5G to 4G, our solutions help deliver a 90% decrease in energy per bit at the air interface by decreasing the channel count by 10x while maintaining the radio size and terminal performance. With the exponential upswing in data generation. Our customers are upgrading their optical infrastructure from 100 to 400 gigabits per second. Our precision signal chain technologies help enable these optical modules maintain constant power while operating at four times the data rate. And with the customers looking to increase to 1 terabit and beyond ADI's opportunity will continue to expand. Capturing and transporting data efficiently is important. But computing in data centers is the primary source of energy consumption in the connectivity ecosystem. Currently, data centers generate more than 130 million tons of CO2 per year globally. So this is where the transition from 12 to 48 volt power distribution can reduce power loss and increase compute density. Our 48 volt to core micromodules power and power system monitoring solutions are enabling this transition and according to Alphabet, this approach and approved data center energy efficiency by 30%. All told, ADI is part of the ecosystem enabling greater efficiency and wireless and wired data capture transmission and of course computing and our solutions of customers to scale their investments and build next generation networks economically and resourcefully. So stepping back, I'm incredibly proud of the progress we've made on our mission to engineer good but a lot remains yet to be done. We're focused on partnering with our customers to develop increasingly innovative technologies that create successful business outcomes in rich people's lives and leave a greater impact on our world. And so with that, I'll hand it over to Prashanth."
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{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Let me add my welcome to our first quarter earnings call. My comments today with the exception of revenue and non-op expenses will be on an adjusted basis which exclude special items outlined in today's press release. ADI delivered strong first quarter with results at the high end of our outlook. Revenue increased 20% nearing an all-time high, operating margin expanded to 40.7% in line with our long-term model and adjusted EPS grew 40%. We saw tremendous breadth this quarter with all market segments growing year-over-year. The first time in over three years. And B2B revenue increased 2% sequentially and 22% year-over-year with double-digit growth across each end market. Industrial represented 55% of revenue during the quarter increased 5% sequentially and 24% year-over-year. This represented a record quarter for industrial with broad based strength across applications, customers and geographies. Specifically demand across our automation instrumentation and energy businesses accelerated this quarter. Communications which represented 18% of revenue during the quarter decreased 10% sequentially but increased 16% year-over-year. Both wireless and wireline revenue grew double-digit despite zero revenue from Huawei this quarter. Automotive which represented 16% of revenue increased 7% sequentially and 19% year-over-year. With the industry aggressively ramping up production we saw double-digit year-over-year across all applications. BMS exhibited the highest growth, a trend we expect to continue given our growing design pipeline. And lastly, consumer which represented 11% of revenue increased 2% sequentially and 5% year-over-year. We saw strong growth in hearables, wearables and home entertainment. This quarter's inflection puts us on track to return to full year growth in 2021. And now for the rest of the P&L, gross margin which is seasonally weaker in the first quarter finished flat sequentially at 78%. We anticipate our first quarter's gross margin will be the trough for the year as we benefit from a strong top line, improving utilization and capturing the majority of the LTC cost savings. OpEx in the quarter was $456 million up sequentially and year-over-year due mainly to variable compensation. Op margins finished at 40.7% above the guided midpoint. Non-op expenses were $27 million and better than our outlook due to an investment gain. Our tax rate for the quarter was approximately 12%. So all told, adjusted EPS came in above the high end of guidance at $1.44. This included a $0.04 benefit from an investment gain that was not in our prior outlook. Moving onto balance sheet and cash flow, inventory dollars increased modestly while inventory days finished at 119, down from 121 in the fourth quarter. Channel inventory as measured in weeks was flat sequentially and remained well below our seven-to-eight-week target. CapEx in the quarter increased to $67 million or roughly 4% of sales. We're working judiciously to add CapEx to meet this record demand anticipate that CapEx will run slightly above our long-term target of 4% for fiscal 2021. Turning to cash flow, over the trailing 12 months we generated $1.9 billion or 33% of revenue. You'll recall that during the last year, we paused our share repurchase program for few quarters due to the pandemic and our proposed Maxim acquisition. Therefore in 2020, we returned 80% of free cash flow to shareholders after debt repayments. This quarter, we've reinstated our share repurchase program and given our current 1.5 leverage ratio we're committed to returning 100% of free cash flow for the year. Looking at the first quarter, we executed nearly $160 million of repo and we also announced an 11% increase to our quarterly dividend at $0.69 per share. Which marks our 18th increase over the last 17 years? Before moving onto guidance, I want to provide some context on the current state of supply. A sharper than expected recovery in the economy coupled with a lean inventory backdrop is fueling unprecedented demand for semiconductors and putting stress on the global supply chain. While the industry at large is aggressively working to meet this historic demand. It's more than likely we'll be operating in a constrained supply environment for the balance of the year. At ADI, we're confident in our ability to outperform in times like this. Our flexible hybrid manufacturing model, healthy balance sheet inventory and diversified product and customer base position us well. In addition, we're working to secure additional capacity from our external partners and ramping our internal operations to increase output. Now let me provide our second quarter outlook. Revenue is expected to be $1.6 billion plus or minus $50 million. At the midpoint, this guidance reflects would be record revenue. We expect double-digit year-over-year growth for automotive, industrial and consumer market but we do see a decline in our comms. Based on the midpoint of guidance, op margin is expected to be 41% plus or minus 70 bps and our tax rate is expected to be between 11% and 13%. Based on these inputs, adjusted EPS will be $1.44 plus or minus $0.08. So in summary I'm encouraged by the near-term trend we're seeing across our end markets and while we're mindful of the ongoing macroeconomic uncertainty. We're optimistic that a broad-based recovery is underway and with Maxim expected to close this summer. 2021 will be a transformative year for ADI. Let me now pass it back to Mike to start our Q&A."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks Prashanth. Let's go to the Q&A session. We ask that limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow-up question please requeue and we'll take your question, if time allows. With that, Cheryl can we have our first question please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] our first question comes from John Pitzer from Credit Suisse. Please go ahead. Your line is open."
},
{
"speaker": "John Pitzer",
"text": "Good morning, guys. Appreciate the question and congratulations on the strong results. Prashanth, I just want to talk a little bit about how the model unfolds from here. I mean clearly you talked about already hitting the gross margin trough for the year. But you're guiding EPS sort of flattish on op revenue. I'm just kind of curious how should we be thinking about OpEx from current run rate levels and specifically, is there incremental OpEx needed because of the tight supply situation? What are the puts and takes as we go throughout the balance of the year?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you for the question, John. Way to think about OpEx is that, if you recall in the Proxy, we identified that last year in the first half we had a particularly low bonus payout as reflection of the macroeconomic environment. In the first half of this year you're going to see the opposite effect of that. So on average it's a normal bonus payout. But you do see a significant upswing in a variable comp for which is impacting both the first and the second quarter compares. In addition, we have the merit increase if you remember we put that merit increase in several months later than normal as a result of the pandemic last year. So you're beginning to see that on a full year run rate basis in first quarter and then it will carry in second quarter. So beyond these comp related items OpEx is really at a steady level. We're not requiring any additional investment at the OpEx level to support the demand that we're generating."
},
{
"speaker": "John Pitzer",
"text": "Perfect. Thank you, guys."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks. We'll have our next question."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Ambrish Srivastava from BMO Capital Markets. Please go ahead. Your line is open."
},
{
"speaker": "Ambrish Srivastava",
"text": "Prashanth and Vince, I just wanted to get back to the current constrained supply condition that the industry is facing. So could you please comment on your lead times and then what are you seeing in the cost increases as you're experiencing and are you able to pass along pricing through the customers and more importantly, does it change your approach? Is there a structural change that you see happening? Prashanth, you talked about CapEx running a little bit higher. Where does that additional CapEx going? Is back end, front end? And I just wanted to get a better sense of how things change from here on the supply chain front for ADI? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Okay, so there's a lot packed into that question, Ambrish. Let me take a couple pieces of it. So we're producing and shipping at record levels and second quarter outlook is going to be a record. We have enough capacity to meet to the guide. But significant additional upside versus that guide will depend on what we're able to procure both from an external wafer standpoint as well as the capital that we're in the process of deploying into our internal facilities to support that. What we're doing to help alleviate that situation is we have been consistently building inventory since last summer to deplete what was pulled down during the pandemic shutdowns. We're adding additional supply both internally and I mentioned the capital that we're deploying which is mostly going to the back end and then externally we've gone out and acquired additional wafers from our partners. I think the answer to your question on CapEx is that is mostly for test and then, on the capacity side. Where we can get additional capacity from our partners, we're doing that. But even with this additional capacity it's very likely that the strength of demand is going to outpace supply for some period of time. So I think we will be chasing demand at least for the balance of this year. From a capital deployment standpoint, some of that as we guide as percentage of revenue some of that is dependent on how strong the year continues to rollout. So when I say slightly above 4%. It could come down to 4% or maybe just a hair below if revenue continues to cripple on here."
},
{
"speaker": "Vince Roche",
"text": "Yes, just on the lead time question, Ambrish. So we entered our first quarter with what we've recalled normal lead times. But during the quarter and into the early part of this quarter we've seen lead times extend which I think is pretty consistent with the industry at large. So while we see some hot spots. We're really talking about is few weeks of extension in different places. Let me remind you too that, we run this company. We run our manufacturing plants; the operating plants are run to POS rather than POA. So what we're seeing right now is a good balance between POS and POA. But as Prashanth said, we're preparing for quite a bit of upside during this year and we've pretty substantially increased the CapEx in our backend."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks Ambrish. Go to next question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from Stacy Rasgon from Bernstein Research. Please go ahead. Your line is open."
},
{
"speaker": "Stacy Rasgon",
"text": "I wanted to ask about comm. So it's down sequentially and year-over-year I guess into Q2. Is that the trough for the year for comm.? And do you think the comms segment overall can grow year-over-year for the full year 2021?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "You want to take that, Vince? Okay, I'll take the first part of that, Stacy. So let's break comms into wired and wireless. On the wired, we're looking for continued growth as carriers and data centers are upgrading networks. On the wireless, we said that, that the US deployment of 5G was always going to be a second half event and our view on that has not changed. What we have seen is a bit more of a slowdown in China as they're digesting kind of the 5G that they deployed and the channel counts are a bit lower. So we do think comms troughs in second quarter and then begins to pick up in the second half with the global 5G. In terms of our view on whether we can grow comms on a year-over-year basis. Given the significant headwind we have from Huawei going to zero, that's a tough ask."
},
{
"speaker": "Vince Roche",
"text": "Yes, I think as well, I'll remind everybody that the three-year CAGR for comms has been 7% and that's with that's very, very significant headwind in China. I think when you look at ADI in the comms business it's tremendously diverse. Many, many hundreds of customers. 5G is a critical part. Wireline is an increasingly critical part. So very, very hard to predict in a lumpy business. But our expectation is that, when you have CAGR [indiscernible] we produce better than mid single-digit growth for that business."
},
{
"speaker": "Stacy Rasgon",
"text": "I'm sorry, was that a long-term statement? That didn't sound like that was this year."
},
{
"speaker": "Vince Roche",
"text": "Over the next few years I think Stacy. We will produce something better than mid single-digit growth in that business."
},
{
"speaker": "Mike Lucarelli",
"text": "Yes, Stacy what Prashanth says we don't think it will grow this year in fiscal 2021 due to, I will say the Huawei headwinds, as they go to zero and lower channel count in China. But then pivoting to Vince, over the long-term we should grow - we've been growing 7%. There's no reason to go - going forward we can't grow at least in line to that."
},
{
"speaker": "Stacy Rasgon",
"text": "Didn't you used to talk about double-digit growth in this business?"
},
{
"speaker": "Mike Lucarelli",
"text": "We did Stacy. I think the world has changed over the past two years quite a bit. Could it grow double-digit? Sure it could. There's no reason it can't. But I think as we look today with the pressures, you're seeing geopolitically those are things we didn't know two years ago."
},
{
"speaker": "Vince Roche",
"text": "I think high single digits is a reasonable expectation. The early stages of 5G, I think being able to grow at double digits pretty plausible but we're working off a bigger numerator at this point in time. So I think if we can produce something in the high single digits. We'll be in very, very good shape."
},
{
"speaker": "Stacy Rasgon",
"text": "Got it. Thank you, guys."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks Stacy. Cheryl, next question."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tore Svanberg from Stifel. Please go ahead. Your line is open."
},
{
"speaker": "Tore Svanberg",
"text": "Vince, you talked about second design win for your wireless BMS solution or second OEM using that technology. Could you elaborate a little bit on how quickly this technology is going to penetrate the auto market? Could you potentially get to six, seven OEMs embracing this technology this year and or next?"
},
{
"speaker": "Vince Roche",
"text": "Well that's certainly our expectation. I think in terms of getting to market. The latter part of this year we'll see the start of production. And I think between now and the end of 2023 say, we should expect four to five OEMs to adopt that technology. With a strong pipeline, but also remember we have a very strong wired portfolio in BMS. So we've got those two tailwinds working for us. But I think overtime it will be kind of hybrid between wired and wireless. But clearly wireless is the bright star at this point in time and our expectation is, that we'll have at least a handful of OEMs using this technology by start of 2024."
},
{
"speaker": "Tore Svanberg",
"text": "Very helpful. Thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks Tore."
},
{
"speaker": "Operator",
"text": "And our next question comes from Vivek Arya from Bank of America. Please go ahead. Your line is open."
},
{
"speaker": "Vivek Arya",
"text": "Vince, I wanted to talk about just fiscal 2021 and the sustainability of growth. So you're starting the year of very strong, right? 20% growth rates in Q1 and the Q2 outlook. How should we think about the second half of other - do you want to talk about the fiscal year or the calendar year? Which markets do you think right now are over heated because of whatever reasons which are kind of only - which are in line with demand and which ones can actually accelerate going into the second half? Just how should we think about how the segment mix changes as you go towards the second half of the year? Thank you."
},
{
"speaker": "Vince Roche",
"text": "Thanks for your question. Typically 1Q is the low point for ADI. We had a reasonably strong first Q compared to kind of normal pattern. But I want to stress there's still a tremendous amount of uncertainty out there. And I don't want to get into the business of making strong speculative predictions here. But we can only kind of guide one quarter at a time particularly in this varying market. But if I look at the markets and just kind of peel the story back a little bit for you. So our industrial business which represents about half of the company's revenue was down we had two consecutive down years in 2019 and 2020. But we produced the record quarter in the first. We expect ongoing strength in that business and one thing I'm very, very pleased about is that the most diverse part of our industrial business is automation and I think given the strength of our opportunity pipeline, the new products we've got coming to market. I expect to see a multi-year tailwind in the automation part. I think right now in automotive there's a big push to electric vehicles and I see that as I said in the prepared remarks that is expected to grow by 2030 from kind of 7 million deployed electric vehicles today to over 200 million by 2030. And we talked a lot last quarter about the strength of our cabin electronics business, active noise cancelation, premium audio, our A2B bus deployments and all that through provides good tailwinds for the company going ahead. Comms as we've just narrated weak in the first half of 2021. But really, I think that's about the timing of deployments and my expectation is that, that business would snuck back in the second half of 2021 and continue into 2022. Last but not least, our consumer business has shown our couple of sequential growth quarters and we no longer have the overhang of one big socket and one big customer. So with the diversity of our business. We were addressing more applications, we've a stronger product portfolio than we've had say three years ago. I think we're on a growth track of that business and we're certainly off to a very, very good start. So we believe that 2020 was bottom of that business and certainly the signals are that is the case."
},
{
"speaker": "Vivek Arya",
"text": "Thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks Vivek."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Toshiya Hari from Goldman Sachs. Please go ahead. Your line is open."
},
{
"speaker": "Toshiya Hari",
"text": "Vince, you guys talked about growing capacity both internally as well as externally with your foundry partners. How should we think about the step up in your capacity, again both internal and external, over the next couple of quarters? The magnitude at which you can grow capacity for the overall business? And secondly, a couple of your peers have talked about signing long-term contracts with customers. Is that something that ADI is thinking about or considering? Thank you."
},
{
"speaker": "Vince Roche",
"text": "Well, I think what you've got to remember is that first and foremost we're producing and shipping products at record levels. 2Q will be an all-time record for the company, so we're certainly keeping ahead. Our investments are keeping ahead of these revenue levels, obviously. Like most of our peers in the industry, there are supply constraints in parts of the business, so we're not able to meet all of the demand, particularly in auto, which has been very, very well-publicized. And the constraints continue across the front end in wafer procurement and also the backend. But I want to remind you, too, we produce about half our silicon inside ADI, and the other half we procure with external partners. So I think something else worth noting is that we've been building inventory since last summer in terms of die stock and finished goods, which was heavily depleted during the pandemic shutdown. So, as I said, internally we're ramping up our own manufacturing operations and we've been successful in acquiring additional wafers from our external partners. So I think that's the best I can give you in terms of the atmosphere that we're working within. We're certainly keeping CapEx deployments ahead of where we think the revenue could be this year based on the demand patterns we now see."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Toshi, I would expect that our guide for each of the subsequent quarters is going to be partly influenced by what we're able to supply. So as I said earlier, I think we're going to be chasing demand for the rest of this fiscal year, and we will use our guidance range to inform how we think - what we can build to base on our ability to get capacity third parties as well as increase capacity internally."
},
{
"speaker": "Toshiya Hari",
"text": "And then the long-term contracts, is that something that comes up in conversations or not really?"
},
{
"speaker": "Vince Roche",
"text": "I think it depends. We do have long-term contracts, but we're doing that on a more strategic basis than tactical, let's say."
},
{
"speaker": "Toshiya Hari",
"text": "Got it. Thank you so much."
},
{
"speaker": "Mike Lucarelli",
"text": "Thanks, Toshiya."
},
{
"speaker": "Operator",
"text": "Our next question comes from Craig Hettenbach from Morgan Stanley. Please go ahead. Your line is open."
},
{
"speaker": "Craig Hettenbach",
"text": "Any update on just the linear cross selling synergies and efforts? I know a little while back you talked about the pipeline, but just how you're seeing that kind of unfold? And any particular markets for product segments that you're seeing the most traction along those lines?"
},
{
"speaker": "Vince Roche",
"text": "Yes, so, Craig, there's a couple of ways to look at this. Obviously, the battery side of things is very, very strong. We've more than doubled the size of that since we acquired LT. And overall, when I look at, for example, power, the mixed signal portfolio, as well as the battery management side of things, we have more than $500 million worth of new revenue going into production this year, and that's just the beginning. So in terms of areas where we're winning, we've got notable wins in communications, in wireless as well as and data center and cloud. In Automotive, we're strongly attaching to our infotainment business, the autonomous radar systems. And the strongest surge in terms of growth in industrial for the LT portfolio, the additional cross selling is instrumentation tests and micromodules generally speaking across the board. We're seeing very, very strong demand for those products. So I think all that said, we had expected that we would double the LTC growth from 3% to 4% historically to high single digits in a five-year period. And that's quite similar to how we viewed our opportunity with Hittite at the beginning and what also has materialized. So that's the story in terms of the markets and the expected growth."
},
{
"speaker": "Craig Hettenbach",
"text": "Got it. Appreciate the color. Thanks, Vince."
},
{
"speaker": "Mike Lucarelli",
"text": "Cheryl, can we have our last question, please?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from C. J. Muse from Evercore. Please go ahead. Your line is open."
},
{
"speaker": "C. J. Muse",
"text": "I guess, Vince, to follow-up on that last question and to kind of go back to what you talked about a quarter ago. I think you said factory automation turned positive for the first time in quite a while year-on-year yet was still significantly below the Q3, 2018 levels. So I was hoping we could level set where we are today in your industrial bucket. And as you think about where you are relative to prior peak, what kind of acceleration in growth should we be able to see in 2021 and 2022 particularly around factory automation, A&D and instrumentation?"
},
{
"speaker": "Vince Roche",
"text": "I'd say I mean, just Mike can give you some numerical color. I'll just give you a couple headline here. So what we're seeing, as I said in the prepared remarks, is an acceleration of the market in general, but we're still well below the previous peak. And given the pipeline of opportunities that we've got, the technologies and the products that we've got, I think the long-term trends are going to be very, very strong, accelerated of course by the obvious need for resilience and driven by automation as a result of the pandemic. But, Mike, you might want to add?"
},
{
"speaker": "Mike Lucarelli",
"text": "Yes, sure. C. J., you're right. If you look at our Industrial business, we did just achieve a record quarter and we're guiding to another record quarter. So I'll clarify that. But what's interesting is if you peel back a bit, we have six application areas within industrial. Only two of them are above previous peaks. So there's a lot more room for upside across all the verticals. But even if you look back at previous peaks, there's still four application areas we still have more room to run before we hit those peaks. Automation being one of those as well. So I think, as Vince said, it's a long-term growth market, automation and industrial, and you're starting to see that business turn late last year into this year. And I think that continues hopefully into 2022."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Maybe just to close on that, C. J., we've been gaining share in industrial, and we've been gaining share over the last couple of years while the market hasn't been as strong. Now you're going to see the compounding effect of a growing market with the benefits of the share that we've picked up. So I think you will see significant outperformance for ADI's industrial business versus our peers over the balance of this year."
},
{
"speaker": "Vince Roche",
"text": "I think healthcare as well, C.J., is worth noting that it still remains considerably above pre-COVID levels. We obviously got a boost during the upsurge in COVID-19. And again, I think this has been growing at 10% for the past five or seven years. I think, a multi-year growth market, and we're beginning to see also the acceleration of demand as a result of the pandemic getting healthcare capabilities to anywhere so to speak. So I think - we look across industrial as an area where we've been, I'd say, steering a lot of our R&D over the last decade or so. It's kind of a long burn business, but we're seeing the benefits now in terms of strength of our technology pipe and our customer engagements."
},
{
"speaker": "C. J. Muse",
"text": "Thank you."
},
{
"speaker": "Mike Lucarelli",
"text": "All right. Thanks, C.J., and thanks, everyone, for joining us this morning. A copy of the transcript will be available on the website. Thanks for joining the call and your continued interest in Analog Devices. Have a good day."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices' conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 4 | 2,022 | 2022-11-22 10:00:00 | Operator: Good morning, and welcome to the Analog Devices Fourth Quarter and Fiscal Year 2022 Earnings Conference Call, which is being audio webcast via telephone and over the web. As a reminder, this event is being recorded. I'd now like to introduce your host for today's call. Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli: Thank you, Betsy, and good morning, everybody. Thanks for joining our fourth quarter and fiscal 2022 conference call. With me on the call today are ADI's CEO and Chair Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. On to disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release and in our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO and Chair, Vince. Vince?
Vincent Roche: Thank you, Mike, and good morning to you all. Well, I'm really extremely pleased to share that we delivered another record quarter, capping off what was a better year for ADI. Our fourth quarter revenue was $3.25 billion, and adjusted EPS was $2.73, and both at the high end of our outlook. For the fiscal year, revenue was $12 billion, up an impressive 26% year-over-year on a combined basis. Our Industrial, Automotive and Communications markets delivered all-time high revenues, and our Consumer business continued to grow despite industry-wide weakness. Adjusted EPS increased by nearly 50% to $9.57. We also delivered on our commitment to return 100% of free cash flow to shareholders in '22, returning $4.6 billion through share repurchases and dividends. These results not only exemplify the strength of our portfolio, but also our deep customer focus and the hard work of our employees to fortify ADI's brand. To that end, in my recent conversations with customers, the message has been very clear. While we're not immune to supply disruptions, ADI’s service, quality and support throughout this challenging time continues to be outstanding. Importantly, this sentiment is shared by customers of all sizes and across all markets. As a result, our customers are calling upon ADI to engage in longer term, more strategic collaborations to develop solutions that further empower the intelligent edge. So to ensure we remain at the forefront of technological advancements and customer service. We invested $1.7 billion in R&D and $700 million in CapEx in FY'22. Now let me start with R&D. Our investments are targeted at strengthening our foundational high-performance Analog franchises as well as moving up the stack to create more complete solutions for our customers. A prime example is our Apollo platform, which we previewed at our Investor Day in April. Apollo is a flexible high-speed signal processing platform with unmatched levels of functionality, integration and performance, making it ubiquitous for all customers, but especially appealing to those in the broad market. During the quarter, we began sampling this innovative platform with our aerospace, communications and instrumentation customers and their feedback has been extremely positive. Turning now to the operations side. Over the last year, we invested a record amount of CapEx to increase our manufacturing output. And in 2023, we are, once again, investing aggressively in our U.S. and European factories to significantly expand our capacity. These investments will create a more flexible and cost-effective hybrid manufacturing model by increasing our swing capacity to around 70% of revenue in the coming years. Our R&D and supply chain investments are essential to support our design win pipeline, which expanded by more than 10% in '22. This growth was led by our automotive energy systems and digital healthcare businesses. Notably, our growth in Automotive was underpinned by battery management systems, or BMS, which now has an opportunity pipeline nearing $4 billion. This year, eight new manufacturers designed in our BMS solutions, including two that plan to utilize our wireless platform. Our strong leadership position combined with increasing EV penetration globally, gives me great confidence in our future growth prospects. Looking now at some selected design activity in the quarter. In industrial automation, we were designed into an advanced diagnostic system that monitors machine health at a global supplier for energy exploration. Our system solution approach enables an approximate 50% reduction in size and lowers wiring costs meaningfully. In aerospace and defense, we won RF module programs at multiple defense prime contractors. Our modules integrate hundreds of components to simplify the design process for our customers, while increasing our content from hundreds to thousands of dollars per system. In industrial instrumentation, we secured wins at two market leaders of next-generation high-voltage testers for electric vehicles and renewable energy systems. The combination of our high voltage processes and precision technology enables us to deliver accurate, reliable, and efficient testing required to scale the manufacturing of these systems. And lastly, in Communications, we expanded our leadership in 5G radio systems with our transceiver portfolio winning additional share at key suppliers. These new wins position us even better as 5G networks roll out globally, especially in India, and ORAN begins to proliferate. Importantly, our design pipeline is beginning to benefit from cross-selling our ADI and Maxim portfolios. This puts us on a path to achieve our target $1 billion in revenue synergies. For example, at a European auto manufacturer, we built upon our strong audio connectivity position to cross-sell our high-speed GMSL technology, connecting their advanced driver systems. We're also capturing new opportunities with GMSL in the Industrial market. Last quarter, for example, our technology was designed into autonomous order fulfillment systems at one of the largest e-commerce companies. We're also making great inroads with our broader power portfolio, where our opportunity pipeline increased by double digits last year. Our increased breadth is helping us to better match customers' performance and power trade-offs across more applications, expanding our power SAM to nearly $10 billion. For example, at a leading European industrial customer, our position in mid-voltage power for distributed I/O control systems enabled us to pull through additional power content and precision signal chain sockets, thereby doubling our content per system. Our expanding pipeline and significant revenue synergy opportunities instils greater diversity and resilience into our business, while adding new growth vectors. And taken together, I'm confident in our ability to bend the growth curve and move from our historical mid-single digit growth rate to our long-term model of 7% to 10%. So in summary, while the macro crosscurrents are creating an abundance of uncertainty, ADI has successfully navigated many slowdowns over the course of our 57 year history. The strength of our franchise allows us to invest through business cycles, ensuring we continue to deliver breakthrough innovation, deepen our relevance to our customers and capture the emerging secular opportunities at the intelligent edge. And so with that, I'll pass you over to Prashanth.
Prashanth Mahendra-Rajah: Thank you, Vince. Let me add my welcome to our fourth quarter earnings call. My comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today's press release. We closed fiscal 2022 as our second consecutive year of record revenue and profits. We delivered sequential growth each quarter, achieving a new all-time high of $12 billion in revenue; gross margins of 73.6% increased 270 basis points due to favorable product mix, stronger utilization and cost synergies; operating margin of 49.4% increased 700 basis points, reflecting strong execution on OpEx synergies’ and adjusted EPS increased nearly 50% to $9.57. For the fourth quarter, revenue was $3.25 billion, finishing at the high end of our outlook. As I cover the performance by end market, both for the quarter and full year, my growth comments are on an adjusted combined basis where applicable. Industrial, our most diverse and profitable end market hit another all-time high and represented 51% of quarterly revenue. Growth was broad-based with each major application increasing sequentially and year-over-year. For the year, Industrial expanded 29% with growth in each business. Notably, digital healthcare was up over 30% and has now achieved seven straight record years. This consistent success in healthcare underscores the breadth of our ICs and subsystem solutions in a key secular growth market where such performance is critical. Automotive, which represented 21% of quarterly revenue, achieved another record year, growing both sequentially and year-over-year. For the year, Auto was up 31%, a favorable mix of premium vehicles, our growing BMS, GMSL, A2B and functional safe power franchises, combined with enhanced value capture drove significant growth compared to SAAR. Together, these franchises of BMS, GMSL, A2B and functional safe power represent over $1 billion of Automotive revenue. Communications, which represented 15% of quarterly revenue, achieved another record quarter with strong sequential growth in wireline, while our wireless business was about flat. For the year, Comms grew 27%. In wireless, our strong position in radio signal chains is enabling the 5G rollout globally. And in wireline, our optical and power portfolios benefited from the continued demand for bandwidth. Lastly, Consumer represented 13% of quarterly revenue and was up modestly sequentially and flat year-over-year. Despite a challenging year for the broader industry, Consumer finished up 8%. This growth is a testament to how we have diversified our Consumer business and the innovation premium our products command. Today, approximately 30% of revenue is derived from long life cycle prosumer applications, including next-gen conferencing systems, professional AV and home theater, while the remaining revenue in Consumer relates to the faster-growing wearables and hearables as well as premium smartphones. Now I'll move down the P&L for the fourth quarter. Gross margin was 74%, up 310 basis points year-over-year driven by favorable product mix and synergy capture. OpEx was $744 million, down slightly sequentially due to the realization of additional synergies. And operating margin increased 800 basis points year-over-year, finishing at a record 51.1% as we exited the year with roughly $350 million of synergies realized across OpEx and cost of goods in our run rate. This incredible pace of synergy capture would not have been possible without the dedication of our integration office and the cross-functional teams that supported them. Non-op expenses were $57 million, and the tax rate was 12.2%. All told, adjusted EPS came in at $2.73, up 58% year-over-year. Moving on to the balance sheet. We ended the quarter with approximately $1.5 billion of cash and equivalents and our net leverage ratio continues to remain below 1. Days of inventory increased to 140 while channel inventory was once again below our target range of 7 to 8 weeks. Let me provide some additional details on our inventory. But first, during these uncertain times, we believe it is prudent to temporarily hold more finished goods on our balance sheet instead of shipping into the channel. This provides us with enhanced flexibility to better align supply with end customer demand across regions and markets. Second, raw material and WIP are increasing as we begin to rebuild our die bank. Over the last couple of years, our die bank was drastically reduced. And in some cases, sits 50% below optimal levels. Die bank inventory is highly cost efficient and it's critical for customer service as it can be used for different markets and customers. We believe higher inventory is crucial to reducing lead times as we look to return to our 4- to 8-week target service level over time. Given these actions, we expect inventory to increase in the near term before trending back down as we balance die bank rebuild with finished goods depletion. Moving to cash flow items. CapEx was $305 million for the quarter and $699 million for the year or 6% of revenue. As we outlined at our Investor Day, we expect elevated CapEx through 2023 at around high single digits as a percentage of revenue. For fiscal 2022, we generated $3.8 billion of free cash flow or 31% of revenue. This is lower than normal given our higher capital intensity and onetime transaction and restructuring costs. These near-term headwinds were not unexpected when we outlined our long-term free cash flow target at our Investor Day and we remain committed to growing free cash flow to 40% of revenue. As a reminder, we target 100% free cash flow return. We aim to grow our dividend at a 10% CAGR through the cycle with the remaining cash used for share count reduction. And during the year, we returned more than 100% of free cash flow to shareholders. We repurchased $3.1 billion in shares, reducing share count by nearly 4%, while paying $1.5 billion of dividends. So let me close with a brief update on the current operating backdrop. As we noted last quarter, the uncertain and slowing macroeconomic environment has had some impact on demand. However, after a couple of months of slowing orders, we saw bookings stabilize during the quarter at what we'd consider relatively normal levels for entering our first quarter. Not surprisingly, bookings remain the strongest in the Industrial and Auto, while Communications and Consumer are weaker. We're guiding first quarter revenue to $3.15 billion, plus or minus $100 million. Given this environment, we thought it might be helpful to be a little more prescriptive in our outlook by market. So in the first quarter, we expect Auto to be up slightly sequentially; Industrial about flat; Comms to decline by mid-single digits; and Consumer to be down double digits sequentially. At the midpoint of our outlook, revenue will be up high teens year-over-year and our B2B markets increasing over 20%. Op margins are expected to be 50% plus or minus 70 bps. Tax rate is expected to be between 12% to 14%. And based on these inputs, adjusted EPS should be $2.60 plus or minus $0.10. So stepping back, we are well positioned in the near term, but the environment remains highly variable and dynamic. ADI like the rest of the industry is not immune to a softer macro environment; and thus, we remain cautious, yet optimistic. Longer term, we have over a year of backlog and continued momentum in our pipeline. We also have high flexibility with our hybrid manufacturing model and several OpEx levers in our toolkit to support our industry-leading margins and maintain robust cash returns to shareholders. So let me now pass it back to Mike for the Q&A.
Michael Lucarelli: Thanks, Prashanth. Now let's get to my fair part of the call, the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have any follow-up question, please queue and we'll take your question if time allows. With that, can we have our first question, please?
Operator: [Operator Instructions] Our first question today comes from Tore Svanberg with Stifel.
Tore Svanberg: Yes, thank you, and congratulations on another record quarter. Vince, a question for you. When you talked about the design wins, some of the design win activity, we continue to hear more and more of the system solutions. And I was just wondering if you could add a little bit more color on how your growth is being driven by higher ASPs? So I'm not suggesting higher pricing, right? I'm talking about higher ASPs because all of your products, obviously, moving up the value chain to more of a system solution type perspective.
Vincent Roche : Yes. So thanks, Tore. Firstly, if you look at our ASPs compared to the Analog sector, we have a 3x multiple. And versus our closest competitor, we have a 5x multiple, and that diversion has been growing over the last several years. So, we decided quite a while ago that across the markets and the applications that we really cared about that what was really important for us to do was boil down the increasing complexity that our customers are dealing with in their product development systems and activities. And so essentially, what we've done is we've taken that complexity into ADI. We get to the other side of that complexity with the quality of our innovations and our ability to be able to couple many, many different facets of our portfolio together in areas like power management. We're building these 3D stacked module systems, sometimes with ASPs of hundreds of dollars. If you look at our 5G radio systems, same thing. We combine microwave. We combine data conversion, power, digital algorithms and so on and so forth. So we have -- within the company, we believe in diversity of technologies, solutions customers and that choice of business model, Tore, at the end of the day and how we execute it gives us the richer ASPs when compared with our competitors.
Michael Lucarelli: Go to next question please.
Operator: The next question comes from C.J. Muse with Evercore.
C.J. Muse: Thank you for taking the question and happy early Thanksgiving. I guess I was hoping to probe a bit more around the cautious but optimistic view. You talked about orders stabilizing and a backlog that extends out 12 months. So I guess, first question, can you talk about what kind of scrubbing you've done on that backlog? And then secondly, based on that, how does that inform your outlook heading into fiscal '23?
Prashanth Mahendra-Rajah : Let me take that and help give some color on the demand, order booking. So if you step back and think about last year, the first half of the year, we had orders at historical highs. And then last quarter in the earnings call, we called out that orders are beginning to slow, and that's a decline actually continued into the fourth quarter. However, we saw orders start to stabilize about midway through the fourth quarter and into the first couple of weeks here of the first quarter. So there was bookings our strongest in Industrial and Auto, not surprising and weaker in Comms and Consumer, which I reflected in the guide. From a geo standpoint, we'd say that not surprising. We're seeing weakness in Asia, especially China, but North America and Europe are holding up well. So given the combination of orders stabilizing and the backlog coverage that we have out, we feel pretty good about the near term. There is uncertainty out there, and things could change fast, but that’s sort of what's driving our sort of cautious optimism.
Vincent Roche : Yes. One other thing, C.J., to note. We've said before, the signal we watch most carefully in terms of really trying to understand demand is sell-through rather than sell-in. So that, I think, gives us a deeper degree of reality and the match between true demand and supply.
Operator: The next question comes from Vivek Arya with Bank of America.
Vivek Arya : I actually wanted to follow up on that question. Vince or Prashanth, are you surprised why your orders and bookings are holding up better, even though all the headlines we see from a macro perspective seem to be getting tougher? So what is helping you? And then specifically within your Industrial business, is it fair to think that factory automation is perhaps the most macro exposed part? And if yes, how should we think about that specific part of your most macro exposed segment within the Industrial business going into next year?
Vincent Roche : Yes. So, well, let me start with the automation question. I've talked about a lot of the automation customers over the last while. And there continues to be, I would say, bullish expectation. I mean they're not immune from the macro. I think some of our customers are experiencing some soft cancellations in their business. But if you look at what's happening, we're going to see the life sciences transform. We're in the early stages of small batch processing in life sciences for manufacturing, for example. The energy sector is another area where, particularly the American, the U.S.-based automation customers, a lot of their businesses are -- they have a very large portion in the energy sector, oil and gas, for example, and that is likely to remain strong. So if that's a bedrock. I think that will remain strong for for several years to come. We are seeing onshoring, reshoring. We're seeing movement of manufacturing, first time in India for the first time in a serious way. So my sense is, the industry won't outrun the macroeconomic conditions. But overall, I think the landing in terms of where demand will be softer than probably normal.
Prashanth Mahendra-Rajah : Yes. Maybe, Vivek, just -- first, just to emphasize something that we said in the prepared remarks, all subsegments in Industrial grew in the fourth quarter, and we feel pretty good about where we are. From a strength in Industrial versus the other markets, I'd look at it two ways. First, from a supply standpoint as we were seeing demand softening in other markets, we have the ability to use our hybrid model to get more wafers from our external partners, and we are biasing this additional supply into the industrial market, which has remained resilient and strong. At the same time, recall, we made a decision early in the supply disruption to make sure that we were taking care of our broad market and our smaller customers who tend to be more on the Industrial side. From a demand standpoint, the strength and resilience in the Industrial kind of speaks to where we play. We have extremely high share in those markets. And maybe to note versus our peers, some of our peers have cited weakness in -- I think they're calling it consumer industrial. We, on the other hand, put that business into our consumer. We call it the prosumer business, professional audio, video, et cetera. So when comparing us to peers, you'll see that our Industrial may be more pure Industrial.
Vincent Roche : Yes. I think as well, for the last decade, 12, 13 years, we've been treating Industrial as the bedrock of the company. So it gets first call on R&D investments, customer engagements. And never have we been more diverse in terms of geographies, customer coverage, depth of coverage, depth of engagement. So -- and also, we have product life cycles that stretch into the decades with very, very stable pricing. So I think all those factors combine to make this an extremely strong business currently, and we're very, very bullish about the future here as well.
Operator: The next question comes from Joshua Buchalter with Cowen.
Joshua Buchalter : Thanks for taking my question and let me echo Happy Thanksgiving. I wanted to ask about inventory levels and thank you in the prepared remarks for all the color there. I really understand the finished goods and die bank dynamics, along with the lean channel levels, but I was wondering at what range would we be at the point where you'd have to start taking proactive measures to lower inventories? I fully realize you haven't given an inventory target. But can you help us just directionally understand how you're thinking about that?
Prashanth Mahendra-Rajah : So let me start with fourth quarter. Balance sheet days are up to about 140 and the channel is flattish, and it's still below our desired 7 to 8 target. So the growth in inventory that you're seeing in our balance sheet is coming from a couple of different drivers. Certainly, inflation for our cost of goods, sales growth, which requires us to have more coverage of inventory and then the strategic decisions we made in the prepared remarks. So I do just want to go through that one more time here. So we are temporarily going to hold more finished goods versus putting it into the channel. Because we believe that gives us the flexibility to align the supply with end customer demand across regions and markets. A bad outcome for us would be to give product to a particular distributor who doesn't have an end customer demand for that product, where someone else in a different market or geography is in need. Second, the die bank has really been dried out over the last couple of years. And I think I said, at some levels it's below 50% of where we want it. So die bank for us and for folks who may be less familiar with it, this is a product that has finished the front end, but before it goes to assembly and test. This allows us to get it through the back end in roughly four weeks. So it's quick turn, and it gives us maximum flexibility to put it across different markets. So investing in the die bank will help us get our service levels, which are critical for us given the focus we have on customer service, critical for us to get those levels back up. So the result is, expect higher days in the first half, and then it will trend back down as finished goods burn out and the die bank comes to where we would like it to be. So our goal for the inventory is to get our lead times down to our old target, which was roughly 90% of our goods can be shipped within 4 to 8 weeks. And given the long life of our products, we always carry a pretty minimal risk of obsolescence.
Michael Lucarelli : Thanks, Prashanth. And Josh, one thing to add, you asked about utilization when we think about taking them down. One thing I wanted to point out is about our swing capacity and cross-qualification. So before we pulled down our internal utilization, we'll bring what we can back in from external, internal to support utilizations and our gross margins.
Operator: The next question today comes from Ambrish Srivastava with BMO Capital.
Ambrish Srivastava : I'm going to ask the same question. I think we're all struggling with it. You guys won a lot of accolades for being super transparent last earnings call talking about the order trends. I think Vivek asked the right question, were you surprised? Is there a seasonality to it? I mean nobody doubts your positioning and how strong you are in your chosen markets. And Prashanth, thanks for clarifying the prosumer versus other companies calling it legacy industrial. But is there a seasonal aspect to it as well that orders stabilize because it's very contrary to what we’re seeing, hearing from other companies report, including many industrial companies? Because last time, you had said that you expected -- although order cancellations were very small, you expected them to climb in the current quarter. So I would love to get a little bit more color on that. And then a real quick tactical one on lead times. Where are the lead times now?
Prashanth Mahendra-Rajah : Sure. Yes. Let me just make a comment on cancellation. So we provided cancellations as a metric that we watch in the third quarter because we wanted to give everyone some context that we saw an inflection happening with orders. So it was in the spirit of transparency. However, I don't want to get into a pattern of reporting cancellation data every quarter. So if it was something meaningful, we would have called it out, which we didn't. So you can read that for what it is. I would say that unlike others in the industry, we are proactively analyzing our backlog and working with customers to remove orders that they no longer want given the rapidly changing environment. So this strategy for us is to seek out cancellation. It helps us align our backlog with current demand, and it really gives us better visibility into where the supply needs and what we need to build. So that has increased our confidence in the quality of the backlog we have. It is still -- the coverage is out still over a year, but it is down sequentially. And so while we're always mindful that there can be some continued noise in that backlog, we feel pretty good about both the guide and as we mentioned, the near term.
Vincent Roche : Yes. I think the diversities, well, Ambrish, of the business in general is stronger than it's ever been. We're getting benefit. We're winning share in the power management market, that sector of our portfolio. And I think if you look at where we are in the Automotive sector, where we're getting a very strong tailwind from the electrification of the vehicle. In fact, we're gaining a lot of share in general, I think, within in-cabin and the electric vehicle. So I think we've got some tailwinds that are transcending the macro cycle here as well. The only part of the business I would say that has a cyclical timber to it now is the Consumer area, where we have seen kind of the normal pattern there at the -- which happens at the tail end of the year.
Michael Lucarelli : And the question on lead times Ambrish. The lead times actually in the quarter, they have come down. I would say they're still extremely high and much higher than we want them to get. And Prashanth talked about how he wants to -- how he -- or we want to increase our inventory to bring down those lead times, but we have some products that are on time and some products that are lead time to 52 weeks. So lead times have come down overall sequentially from 3Q to 4Q, and that's reflected in kind of our outlook, our backlog, cancellations, everything that we gave you.
Operator: The next question comes from Stacy Rasgon with Bernstein.
Stacy Rasgon : I had a quick housekeeping question and then a broader one. The housekeeping question, you had an extra week in Q1 '18. So Q1 '23 would be five years later. Is there an extra week in the guide at all? And on the broader question, you talked about some of the OpEx levers that you have. I think last quarter, you talked about like in a 15% revenue down year, you could keep gross margins above 70. I guess the question is do you still believe that? And what would OpEx do in a scenario like that? What are some of the levers you would pull?
Michael Lucarelli : Stacy, I'll do the housekeeping. No, I guess our outlook is very, very strong, given you thought it would be a 14-week quarter, it's not. Our first quarter in '23 is a 13-week quarter. Our next 14-week quarter will be in 2024. So to repeat the outlook for 1Q is a 13-week quarter.
Prashanth Mahendra-Rajah : Okay. And I think your question really is on the downturn scenario analysis. I'll just -- I'll restate that, Stacy. We've covered that a few times, but we put our gross margin floor out there at 70%, and we did that because we have confidence that we have the levers, given the flexibility of our hybrid manufacturing model and the resiliency of our business that it's unlikely that we're going to pass through that. So we’ve tested that at a down 15%. And what we've shared with folks in the past is that a down 15% is quite comfortable that we can stay north of that 70% and the OpEx levers for us would be the -- about 80% of our OpEx is fixed or less variable in nature, which leaves us about 20% on the levers that we can work with to ensure that we keep operating margins north of 40%. I will say that for 2023, our commitment is -- and as Vince often says, we run this company for the long term. So we are committed to continuing to invest throughout the course of '23. We'll, obviously, be mindful of the environment. And if we see a change that warrants us to take action, you can count on us to take action but we -- at least for the next quarter, to expect us to continue to make the right decisions for the long-term health of the business.
Stacy Rasgon : It sounds like OpEx ticks up a little bit into Q1 as well, just based on what you just said?
Michael Lucarelli : You read it well, Stacy.
Operator: The next question comes from William Stein with Truist Securities.
William Stein : I'm hoping to hit on the inventory question yet again. You've done a very straightforward, good job of explaining to us what's going on in your own inventory. And it sounds like distribution is still below your target even though on their balance sheets across all their suppliers, it looks like they're elevated. But we've seen other parts of the supply chain, in particular, the manufacturing services companies, which I imagine are a big percentage of sort of your counterparty sales on transactions. And I'm wondering to what degree you've scrubbed that half channel, half customer, however you want to look at it, for inventory that could hurt demand going forward?
Prashanth Mahendra-Rajah : Thanks, Will. Great question. Let me -- I'll -- let me do the easy part of that, and that is, sell-in is essentially equal to sell-through. So from a channel standpoint, we're well aligned and our channel partners are not building inventory. I made the comment that we're holding some finished goods on our own balance sheet. From a customer standpoint, I think Vince has had a lot of conversations with customers. So I'm going to pass to him to talk about what he's hearing from them.
Vincent Roche : Yes. I don't think our customers are in the mode of building safety stocks. There are mismatches, I think. There's the well-described golden screw problem. It's probably a base in compared to where it was six months ago, but I don't think customers -- there's no major inventory building going on right now. And I think our customers are doing their best to match their orders and the product supply to be able to create finished goods. So they're not there yet. I think there is still some unserved demand that customers are trying to fulfill. So -- but we're working very closely with our customers. As we've said, we take our signals from sell-through, and we're working with our customers diligently across all 125,000 of them, big and small, to make sure that we get the best match between what they need and what we're able to deliver. And what I'm hearing in general is that, yes, we haven't serviced all the demands that all the customers have needed. But in general, we've been very transparent. Our customers are very pleased with our customer service. And I think it positions us very, very well coming out of the supply crunch to be able to deepen our engagements with our customers and -- both on the R&D side as well as the supply chain side. And customers are increasingly interested to partner with companies like ADI on both of those dimensions, and we're ready.
Prashanth Mahendra-Rajah : And we're seeing in the pipeline -- we're seeing it in the pipeline growth.
Michael Lucarelli : And we go to our last question, please?
Operator: The last question today comes from Toshiya Hari with Goldman Sachs.
Toshiya Hari : I had one quick housekeeping question and then another broader question. In terms of the housekeeping question, I was curious what did pricing do in fiscal year '22 on a pro forma basis? I think the business grew, what is it, around 25% pro forma. How much of that was pricing? And as you think about fiscal '23 or calendar '23, is the expectation for foundry costs to increase in the out-year as well? And then my broader question is probably for Vince. As you think about the full year '23, based on your backlog, based on your design wins and customer conversations, which end markets or applications are you most excited about in terms of contribution to growth? I realize you run a diverse business, and that's the beauty of ADI. But if you were to single out a couple, where your expectations are the highest, which ones would they be? And which end markets or applications would you be most worried about?
Prashanth Mahendra-Rajah : Sure. Thanks, Toshiya. Let me take the first one quickly. So for '22, growth was fairly balanced and about half of that is coming from ASPs. But I do want to emphasize something that we've said over the course of all of '22, we passed cost through to customers. We did not use that environment to raise our gross margins. That was how we did the calculation of how much price to pass on to a customer was based on the input costs that were relevant to those customers. So with that, I'll let Vince take the more interesting part.
Vincent Roche : Yes. Thanks, Prashant. So yes, I think in terms of '23, the markets that have been performing very, very well for the company over the last couple of years, particularly Automotive, which we've already talked about; the electrification of the vehicle, we're very, very well positioned there. And we're winning a lot of share in the in-cabin electronics as well, the new display systems, which are very, very complex. The dashboard displays need a lot of very, very clever power electronics. So we're well positioned. From an Industrial perspective as well, digital healthcare has been growing at the company in double digits for over the last 7 years or thereabouts. We expect to see that continue. Also, aerospace and defense, that's likely to be a very brisk business. It's performing well for ADI now, and I believe, at least for the next 5 years, we will see stellar growth in that area. And energy, our energy and sustainability businesses are also beginning to really go on the uptick. So where am I concerned? I'm not really concerned about the business in general, given the diversity that we have, diversity of customers, products, applications. 5G, perhaps, we'll see what is likely to be weakness in Europe, offset by growth in India, growth in ORAN, steadiness in the U.S., and that kind of summarizes how we think about things.
Michael Lucarelli : Thanks, everyone, for joining us on the call this morning. Prashanth and I will be at CES this year hosting meetings. We also have a booth on the showroom floor where we have technology demos across auto, healthcare and consumer. We hope to see you there. And with that, have a great Thanksgiving, and thanks for joining the call.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
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"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices Fourth Quarter and Fiscal Year 2022 Earnings Conference Call, which is being audio webcast via telephone and over the web. As a reminder, this event is being recorded. I'd now like to introduce your host for today's call. Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
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"speaker": "Michael Lucarelli",
"text": "Thank you, Betsy, and good morning, everybody. Thanks for joining our fourth quarter and fiscal 2022 conference call. With me on the call today are ADI's CEO and Chair Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. On to disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release and in our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of the date of this call. We undertake no obligation to update these statements except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO and Chair, Vince. Vince?"
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"speaker": "Vincent Roche",
"text": "Thank you, Mike, and good morning to you all. Well, I'm really extremely pleased to share that we delivered another record quarter, capping off what was a better year for ADI. Our fourth quarter revenue was $3.25 billion, and adjusted EPS was $2.73, and both at the high end of our outlook. For the fiscal year, revenue was $12 billion, up an impressive 26% year-over-year on a combined basis. Our Industrial, Automotive and Communications markets delivered all-time high revenues, and our Consumer business continued to grow despite industry-wide weakness. Adjusted EPS increased by nearly 50% to $9.57. We also delivered on our commitment to return 100% of free cash flow to shareholders in '22, returning $4.6 billion through share repurchases and dividends. These results not only exemplify the strength of our portfolio, but also our deep customer focus and the hard work of our employees to fortify ADI's brand. To that end, in my recent conversations with customers, the message has been very clear. While we're not immune to supply disruptions, ADI’s service, quality and support throughout this challenging time continues to be outstanding. Importantly, this sentiment is shared by customers of all sizes and across all markets. As a result, our customers are calling upon ADI to engage in longer term, more strategic collaborations to develop solutions that further empower the intelligent edge. So to ensure we remain at the forefront of technological advancements and customer service. We invested $1.7 billion in R&D and $700 million in CapEx in FY'22. Now let me start with R&D. Our investments are targeted at strengthening our foundational high-performance Analog franchises as well as moving up the stack to create more complete solutions for our customers. A prime example is our Apollo platform, which we previewed at our Investor Day in April. Apollo is a flexible high-speed signal processing platform with unmatched levels of functionality, integration and performance, making it ubiquitous for all customers, but especially appealing to those in the broad market. During the quarter, we began sampling this innovative platform with our aerospace, communications and instrumentation customers and their feedback has been extremely positive. Turning now to the operations side. Over the last year, we invested a record amount of CapEx to increase our manufacturing output. And in 2023, we are, once again, investing aggressively in our U.S. and European factories to significantly expand our capacity. These investments will create a more flexible and cost-effective hybrid manufacturing model by increasing our swing capacity to around 70% of revenue in the coming years. Our R&D and supply chain investments are essential to support our design win pipeline, which expanded by more than 10% in '22. This growth was led by our automotive energy systems and digital healthcare businesses. Notably, our growth in Automotive was underpinned by battery management systems, or BMS, which now has an opportunity pipeline nearing $4 billion. This year, eight new manufacturers designed in our BMS solutions, including two that plan to utilize our wireless platform. Our strong leadership position combined with increasing EV penetration globally, gives me great confidence in our future growth prospects. Looking now at some selected design activity in the quarter. In industrial automation, we were designed into an advanced diagnostic system that monitors machine health at a global supplier for energy exploration. Our system solution approach enables an approximate 50% reduction in size and lowers wiring costs meaningfully. In aerospace and defense, we won RF module programs at multiple defense prime contractors. Our modules integrate hundreds of components to simplify the design process for our customers, while increasing our content from hundreds to thousands of dollars per system. In industrial instrumentation, we secured wins at two market leaders of next-generation high-voltage testers for electric vehicles and renewable energy systems. The combination of our high voltage processes and precision technology enables us to deliver accurate, reliable, and efficient testing required to scale the manufacturing of these systems. And lastly, in Communications, we expanded our leadership in 5G radio systems with our transceiver portfolio winning additional share at key suppliers. These new wins position us even better as 5G networks roll out globally, especially in India, and ORAN begins to proliferate. Importantly, our design pipeline is beginning to benefit from cross-selling our ADI and Maxim portfolios. This puts us on a path to achieve our target $1 billion in revenue synergies. For example, at a European auto manufacturer, we built upon our strong audio connectivity position to cross-sell our high-speed GMSL technology, connecting their advanced driver systems. We're also capturing new opportunities with GMSL in the Industrial market. Last quarter, for example, our technology was designed into autonomous order fulfillment systems at one of the largest e-commerce companies. We're also making great inroads with our broader power portfolio, where our opportunity pipeline increased by double digits last year. Our increased breadth is helping us to better match customers' performance and power trade-offs across more applications, expanding our power SAM to nearly $10 billion. For example, at a leading European industrial customer, our position in mid-voltage power for distributed I/O control systems enabled us to pull through additional power content and precision signal chain sockets, thereby doubling our content per system. Our expanding pipeline and significant revenue synergy opportunities instils greater diversity and resilience into our business, while adding new growth vectors. And taken together, I'm confident in our ability to bend the growth curve and move from our historical mid-single digit growth rate to our long-term model of 7% to 10%. So in summary, while the macro crosscurrents are creating an abundance of uncertainty, ADI has successfully navigated many slowdowns over the course of our 57 year history. The strength of our franchise allows us to invest through business cycles, ensuring we continue to deliver breakthrough innovation, deepen our relevance to our customers and capture the emerging secular opportunities at the intelligent edge. And so with that, I'll pass you over to Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Let me add my welcome to our fourth quarter earnings call. My comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today's press release. We closed fiscal 2022 as our second consecutive year of record revenue and profits. We delivered sequential growth each quarter, achieving a new all-time high of $12 billion in revenue; gross margins of 73.6% increased 270 basis points due to favorable product mix, stronger utilization and cost synergies; operating margin of 49.4% increased 700 basis points, reflecting strong execution on OpEx synergies’ and adjusted EPS increased nearly 50% to $9.57. For the fourth quarter, revenue was $3.25 billion, finishing at the high end of our outlook. As I cover the performance by end market, both for the quarter and full year, my growth comments are on an adjusted combined basis where applicable. Industrial, our most diverse and profitable end market hit another all-time high and represented 51% of quarterly revenue. Growth was broad-based with each major application increasing sequentially and year-over-year. For the year, Industrial expanded 29% with growth in each business. Notably, digital healthcare was up over 30% and has now achieved seven straight record years. This consistent success in healthcare underscores the breadth of our ICs and subsystem solutions in a key secular growth market where such performance is critical. Automotive, which represented 21% of quarterly revenue, achieved another record year, growing both sequentially and year-over-year. For the year, Auto was up 31%, a favorable mix of premium vehicles, our growing BMS, GMSL, A2B and functional safe power franchises, combined with enhanced value capture drove significant growth compared to SAAR. Together, these franchises of BMS, GMSL, A2B and functional safe power represent over $1 billion of Automotive revenue. Communications, which represented 15% of quarterly revenue, achieved another record quarter with strong sequential growth in wireline, while our wireless business was about flat. For the year, Comms grew 27%. In wireless, our strong position in radio signal chains is enabling the 5G rollout globally. And in wireline, our optical and power portfolios benefited from the continued demand for bandwidth. Lastly, Consumer represented 13% of quarterly revenue and was up modestly sequentially and flat year-over-year. Despite a challenging year for the broader industry, Consumer finished up 8%. This growth is a testament to how we have diversified our Consumer business and the innovation premium our products command. Today, approximately 30% of revenue is derived from long life cycle prosumer applications, including next-gen conferencing systems, professional AV and home theater, while the remaining revenue in Consumer relates to the faster-growing wearables and hearables as well as premium smartphones. Now I'll move down the P&L for the fourth quarter. Gross margin was 74%, up 310 basis points year-over-year driven by favorable product mix and synergy capture. OpEx was $744 million, down slightly sequentially due to the realization of additional synergies. And operating margin increased 800 basis points year-over-year, finishing at a record 51.1% as we exited the year with roughly $350 million of synergies realized across OpEx and cost of goods in our run rate. This incredible pace of synergy capture would not have been possible without the dedication of our integration office and the cross-functional teams that supported them. Non-op expenses were $57 million, and the tax rate was 12.2%. All told, adjusted EPS came in at $2.73, up 58% year-over-year. Moving on to the balance sheet. We ended the quarter with approximately $1.5 billion of cash and equivalents and our net leverage ratio continues to remain below 1. Days of inventory increased to 140 while channel inventory was once again below our target range of 7 to 8 weeks. Let me provide some additional details on our inventory. But first, during these uncertain times, we believe it is prudent to temporarily hold more finished goods on our balance sheet instead of shipping into the channel. This provides us with enhanced flexibility to better align supply with end customer demand across regions and markets. Second, raw material and WIP are increasing as we begin to rebuild our die bank. Over the last couple of years, our die bank was drastically reduced. And in some cases, sits 50% below optimal levels. Die bank inventory is highly cost efficient and it's critical for customer service as it can be used for different markets and customers. We believe higher inventory is crucial to reducing lead times as we look to return to our 4- to 8-week target service level over time. Given these actions, we expect inventory to increase in the near term before trending back down as we balance die bank rebuild with finished goods depletion. Moving to cash flow items. CapEx was $305 million for the quarter and $699 million for the year or 6% of revenue. As we outlined at our Investor Day, we expect elevated CapEx through 2023 at around high single digits as a percentage of revenue. For fiscal 2022, we generated $3.8 billion of free cash flow or 31% of revenue. This is lower than normal given our higher capital intensity and onetime transaction and restructuring costs. These near-term headwinds were not unexpected when we outlined our long-term free cash flow target at our Investor Day and we remain committed to growing free cash flow to 40% of revenue. As a reminder, we target 100% free cash flow return. We aim to grow our dividend at a 10% CAGR through the cycle with the remaining cash used for share count reduction. And during the year, we returned more than 100% of free cash flow to shareholders. We repurchased $3.1 billion in shares, reducing share count by nearly 4%, while paying $1.5 billion of dividends. So let me close with a brief update on the current operating backdrop. As we noted last quarter, the uncertain and slowing macroeconomic environment has had some impact on demand. However, after a couple of months of slowing orders, we saw bookings stabilize during the quarter at what we'd consider relatively normal levels for entering our first quarter. Not surprisingly, bookings remain the strongest in the Industrial and Auto, while Communications and Consumer are weaker. We're guiding first quarter revenue to $3.15 billion, plus or minus $100 million. Given this environment, we thought it might be helpful to be a little more prescriptive in our outlook by market. So in the first quarter, we expect Auto to be up slightly sequentially; Industrial about flat; Comms to decline by mid-single digits; and Consumer to be down double digits sequentially. At the midpoint of our outlook, revenue will be up high teens year-over-year and our B2B markets increasing over 20%. Op margins are expected to be 50% plus or minus 70 bps. Tax rate is expected to be between 12% to 14%. And based on these inputs, adjusted EPS should be $2.60 plus or minus $0.10. So stepping back, we are well positioned in the near term, but the environment remains highly variable and dynamic. ADI like the rest of the industry is not immune to a softer macro environment; and thus, we remain cautious, yet optimistic. Longer term, we have over a year of backlog and continued momentum in our pipeline. We also have high flexibility with our hybrid manufacturing model and several OpEx levers in our toolkit to support our industry-leading margins and maintain robust cash returns to shareholders. So let me now pass it back to Mike for the Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. Now let's get to my fair part of the call, the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have any follow-up question, please queue and we'll take your question if time allows. With that, can we have our first question, please?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question today comes from Tore Svanberg with Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Yes, thank you, and congratulations on another record quarter. Vince, a question for you. When you talked about the design wins, some of the design win activity, we continue to hear more and more of the system solutions. And I was just wondering if you could add a little bit more color on how your growth is being driven by higher ASPs? So I'm not suggesting higher pricing, right? I'm talking about higher ASPs because all of your products, obviously, moving up the value chain to more of a system solution type perspective."
},
{
"speaker": "Vincent Roche",
"text": "Yes. So thanks, Tore. Firstly, if you look at our ASPs compared to the Analog sector, we have a 3x multiple. And versus our closest competitor, we have a 5x multiple, and that diversion has been growing over the last several years. So, we decided quite a while ago that across the markets and the applications that we really cared about that what was really important for us to do was boil down the increasing complexity that our customers are dealing with in their product development systems and activities. And so essentially, what we've done is we've taken that complexity into ADI. We get to the other side of that complexity with the quality of our innovations and our ability to be able to couple many, many different facets of our portfolio together in areas like power management. We're building these 3D stacked module systems, sometimes with ASPs of hundreds of dollars. If you look at our 5G radio systems, same thing. We combine microwave. We combine data conversion, power, digital algorithms and so on and so forth. So we have -- within the company, we believe in diversity of technologies, solutions customers and that choice of business model, Tore, at the end of the day and how we execute it gives us the richer ASPs when compared with our competitors."
},
{
"speaker": "Michael Lucarelli",
"text": "Go to next question please."
},
{
"speaker": "Operator",
"text": "The next question comes from C.J. Muse with Evercore."
},
{
"speaker": "C.J. Muse",
"text": "Thank you for taking the question and happy early Thanksgiving. I guess I was hoping to probe a bit more around the cautious but optimistic view. You talked about orders stabilizing and a backlog that extends out 12 months. So I guess, first question, can you talk about what kind of scrubbing you've done on that backlog? And then secondly, based on that, how does that inform your outlook heading into fiscal '23?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Let me take that and help give some color on the demand, order booking. So if you step back and think about last year, the first half of the year, we had orders at historical highs. And then last quarter in the earnings call, we called out that orders are beginning to slow, and that's a decline actually continued into the fourth quarter. However, we saw orders start to stabilize about midway through the fourth quarter and into the first couple of weeks here of the first quarter. So there was bookings our strongest in Industrial and Auto, not surprising and weaker in Comms and Consumer, which I reflected in the guide. From a geo standpoint, we'd say that not surprising. We're seeing weakness in Asia, especially China, but North America and Europe are holding up well. So given the combination of orders stabilizing and the backlog coverage that we have out, we feel pretty good about the near term. There is uncertainty out there, and things could change fast, but that’s sort of what's driving our sort of cautious optimism."
},
{
"speaker": "Vincent Roche",
"text": "Yes. One other thing, C.J., to note. We've said before, the signal we watch most carefully in terms of really trying to understand demand is sell-through rather than sell-in. So that, I think, gives us a deeper degree of reality and the match between true demand and supply."
},
{
"speaker": "Operator",
"text": "The next question comes from Vivek Arya with Bank of America."
},
{
"speaker": "Vivek Arya",
"text": "I actually wanted to follow up on that question. Vince or Prashanth, are you surprised why your orders and bookings are holding up better, even though all the headlines we see from a macro perspective seem to be getting tougher? So what is helping you? And then specifically within your Industrial business, is it fair to think that factory automation is perhaps the most macro exposed part? And if yes, how should we think about that specific part of your most macro exposed segment within the Industrial business going into next year?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. So, well, let me start with the automation question. I've talked about a lot of the automation customers over the last while. And there continues to be, I would say, bullish expectation. I mean they're not immune from the macro. I think some of our customers are experiencing some soft cancellations in their business. But if you look at what's happening, we're going to see the life sciences transform. We're in the early stages of small batch processing in life sciences for manufacturing, for example. The energy sector is another area where, particularly the American, the U.S.-based automation customers, a lot of their businesses are -- they have a very large portion in the energy sector, oil and gas, for example, and that is likely to remain strong. So if that's a bedrock. I think that will remain strong for for several years to come. We are seeing onshoring, reshoring. We're seeing movement of manufacturing, first time in India for the first time in a serious way. So my sense is, the industry won't outrun the macroeconomic conditions. But overall, I think the landing in terms of where demand will be softer than probably normal."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Maybe, Vivek, just -- first, just to emphasize something that we said in the prepared remarks, all subsegments in Industrial grew in the fourth quarter, and we feel pretty good about where we are. From a strength in Industrial versus the other markets, I'd look at it two ways. First, from a supply standpoint as we were seeing demand softening in other markets, we have the ability to use our hybrid model to get more wafers from our external partners, and we are biasing this additional supply into the industrial market, which has remained resilient and strong. At the same time, recall, we made a decision early in the supply disruption to make sure that we were taking care of our broad market and our smaller customers who tend to be more on the Industrial side. From a demand standpoint, the strength and resilience in the Industrial kind of speaks to where we play. We have extremely high share in those markets. And maybe to note versus our peers, some of our peers have cited weakness in -- I think they're calling it consumer industrial. We, on the other hand, put that business into our consumer. We call it the prosumer business, professional audio, video, et cetera. So when comparing us to peers, you'll see that our Industrial may be more pure Industrial."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think as well, for the last decade, 12, 13 years, we've been treating Industrial as the bedrock of the company. So it gets first call on R&D investments, customer engagements. And never have we been more diverse in terms of geographies, customer coverage, depth of coverage, depth of engagement. So -- and also, we have product life cycles that stretch into the decades with very, very stable pricing. So I think all those factors combine to make this an extremely strong business currently, and we're very, very bullish about the future here as well."
},
{
"speaker": "Operator",
"text": "The next question comes from Joshua Buchalter with Cowen."
},
{
"speaker": "Joshua Buchalter",
"text": "Thanks for taking my question and let me echo Happy Thanksgiving. I wanted to ask about inventory levels and thank you in the prepared remarks for all the color there. I really understand the finished goods and die bank dynamics, along with the lean channel levels, but I was wondering at what range would we be at the point where you'd have to start taking proactive measures to lower inventories? I fully realize you haven't given an inventory target. But can you help us just directionally understand how you're thinking about that?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "So let me start with fourth quarter. Balance sheet days are up to about 140 and the channel is flattish, and it's still below our desired 7 to 8 target. So the growth in inventory that you're seeing in our balance sheet is coming from a couple of different drivers. Certainly, inflation for our cost of goods, sales growth, which requires us to have more coverage of inventory and then the strategic decisions we made in the prepared remarks. So I do just want to go through that one more time here. So we are temporarily going to hold more finished goods versus putting it into the channel. Because we believe that gives us the flexibility to align the supply with end customer demand across regions and markets. A bad outcome for us would be to give product to a particular distributor who doesn't have an end customer demand for that product, where someone else in a different market or geography is in need. Second, the die bank has really been dried out over the last couple of years. And I think I said, at some levels it's below 50% of where we want it. So die bank for us and for folks who may be less familiar with it, this is a product that has finished the front end, but before it goes to assembly and test. This allows us to get it through the back end in roughly four weeks. So it's quick turn, and it gives us maximum flexibility to put it across different markets. So investing in the die bank will help us get our service levels, which are critical for us given the focus we have on customer service, critical for us to get those levels back up. So the result is, expect higher days in the first half, and then it will trend back down as finished goods burn out and the die bank comes to where we would like it to be. So our goal for the inventory is to get our lead times down to our old target, which was roughly 90% of our goods can be shipped within 4 to 8 weeks. And given the long life of our products, we always carry a pretty minimal risk of obsolescence."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. And Josh, one thing to add, you asked about utilization when we think about taking them down. One thing I wanted to point out is about our swing capacity and cross-qualification. So before we pulled down our internal utilization, we'll bring what we can back in from external, internal to support utilizations and our gross margins."
},
{
"speaker": "Operator",
"text": "The next question today comes from Ambrish Srivastava with BMO Capital."
},
{
"speaker": "Ambrish Srivastava",
"text": "I'm going to ask the same question. I think we're all struggling with it. You guys won a lot of accolades for being super transparent last earnings call talking about the order trends. I think Vivek asked the right question, were you surprised? Is there a seasonality to it? I mean nobody doubts your positioning and how strong you are in your chosen markets. And Prashanth, thanks for clarifying the prosumer versus other companies calling it legacy industrial. But is there a seasonal aspect to it as well that orders stabilize because it's very contrary to what we’re seeing, hearing from other companies report, including many industrial companies? Because last time, you had said that you expected -- although order cancellations were very small, you expected them to climb in the current quarter. So I would love to get a little bit more color on that. And then a real quick tactical one on lead times. Where are the lead times now?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Sure. Yes. Let me just make a comment on cancellation. So we provided cancellations as a metric that we watch in the third quarter because we wanted to give everyone some context that we saw an inflection happening with orders. So it was in the spirit of transparency. However, I don't want to get into a pattern of reporting cancellation data every quarter. So if it was something meaningful, we would have called it out, which we didn't. So you can read that for what it is. I would say that unlike others in the industry, we are proactively analyzing our backlog and working with customers to remove orders that they no longer want given the rapidly changing environment. So this strategy for us is to seek out cancellation. It helps us align our backlog with current demand, and it really gives us better visibility into where the supply needs and what we need to build. So that has increased our confidence in the quality of the backlog we have. It is still -- the coverage is out still over a year, but it is down sequentially. And so while we're always mindful that there can be some continued noise in that backlog, we feel pretty good about both the guide and as we mentioned, the near term."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think the diversities, well, Ambrish, of the business in general is stronger than it's ever been. We're getting benefit. We're winning share in the power management market, that sector of our portfolio. And I think if you look at where we are in the Automotive sector, where we're getting a very strong tailwind from the electrification of the vehicle. In fact, we're gaining a lot of share in general, I think, within in-cabin and the electric vehicle. So I think we've got some tailwinds that are transcending the macro cycle here as well. The only part of the business I would say that has a cyclical timber to it now is the Consumer area, where we have seen kind of the normal pattern there at the -- which happens at the tail end of the year."
},
{
"speaker": "Michael Lucarelli",
"text": "And the question on lead times Ambrish. The lead times actually in the quarter, they have come down. I would say they're still extremely high and much higher than we want them to get. And Prashanth talked about how he wants to -- how he -- or we want to increase our inventory to bring down those lead times, but we have some products that are on time and some products that are lead time to 52 weeks. So lead times have come down overall sequentially from 3Q to 4Q, and that's reflected in kind of our outlook, our backlog, cancellations, everything that we gave you."
},
{
"speaker": "Operator",
"text": "The next question comes from Stacy Rasgon with Bernstein."
},
{
"speaker": "Stacy Rasgon",
"text": "I had a quick housekeeping question and then a broader one. The housekeeping question, you had an extra week in Q1 '18. So Q1 '23 would be five years later. Is there an extra week in the guide at all? And on the broader question, you talked about some of the OpEx levers that you have. I think last quarter, you talked about like in a 15% revenue down year, you could keep gross margins above 70. I guess the question is do you still believe that? And what would OpEx do in a scenario like that? What are some of the levers you would pull?"
},
{
"speaker": "Michael Lucarelli",
"text": "Stacy, I'll do the housekeeping. No, I guess our outlook is very, very strong, given you thought it would be a 14-week quarter, it's not. Our first quarter in '23 is a 13-week quarter. Our next 14-week quarter will be in 2024. So to repeat the outlook for 1Q is a 13-week quarter."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Okay. And I think your question really is on the downturn scenario analysis. I'll just -- I'll restate that, Stacy. We've covered that a few times, but we put our gross margin floor out there at 70%, and we did that because we have confidence that we have the levers, given the flexibility of our hybrid manufacturing model and the resiliency of our business that it's unlikely that we're going to pass through that. So we’ve tested that at a down 15%. And what we've shared with folks in the past is that a down 15% is quite comfortable that we can stay north of that 70% and the OpEx levers for us would be the -- about 80% of our OpEx is fixed or less variable in nature, which leaves us about 20% on the levers that we can work with to ensure that we keep operating margins north of 40%. I will say that for 2023, our commitment is -- and as Vince often says, we run this company for the long term. So we are committed to continuing to invest throughout the course of '23. We'll, obviously, be mindful of the environment. And if we see a change that warrants us to take action, you can count on us to take action but we -- at least for the next quarter, to expect us to continue to make the right decisions for the long-term health of the business."
},
{
"speaker": "Stacy Rasgon",
"text": "It sounds like OpEx ticks up a little bit into Q1 as well, just based on what you just said?"
},
{
"speaker": "Michael Lucarelli",
"text": "You read it well, Stacy."
},
{
"speaker": "Operator",
"text": "The next question comes from William Stein with Truist Securities."
},
{
"speaker": "William Stein",
"text": "I'm hoping to hit on the inventory question yet again. You've done a very straightforward, good job of explaining to us what's going on in your own inventory. And it sounds like distribution is still below your target even though on their balance sheets across all their suppliers, it looks like they're elevated. But we've seen other parts of the supply chain, in particular, the manufacturing services companies, which I imagine are a big percentage of sort of your counterparty sales on transactions. And I'm wondering to what degree you've scrubbed that half channel, half customer, however you want to look at it, for inventory that could hurt demand going forward?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thanks, Will. Great question. Let me -- I'll -- let me do the easy part of that, and that is, sell-in is essentially equal to sell-through. So from a channel standpoint, we're well aligned and our channel partners are not building inventory. I made the comment that we're holding some finished goods on our own balance sheet. From a customer standpoint, I think Vince has had a lot of conversations with customers. So I'm going to pass to him to talk about what he's hearing from them."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I don't think our customers are in the mode of building safety stocks. There are mismatches, I think. There's the well-described golden screw problem. It's probably a base in compared to where it was six months ago, but I don't think customers -- there's no major inventory building going on right now. And I think our customers are doing their best to match their orders and the product supply to be able to create finished goods. So they're not there yet. I think there is still some unserved demand that customers are trying to fulfill. So -- but we're working very closely with our customers. As we've said, we take our signals from sell-through, and we're working with our customers diligently across all 125,000 of them, big and small, to make sure that we get the best match between what they need and what we're able to deliver. And what I'm hearing in general is that, yes, we haven't serviced all the demands that all the customers have needed. But in general, we've been very transparent. Our customers are very pleased with our customer service. And I think it positions us very, very well coming out of the supply crunch to be able to deepen our engagements with our customers and -- both on the R&D side as well as the supply chain side. And customers are increasingly interested to partner with companies like ADI on both of those dimensions, and we're ready."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "And we're seeing in the pipeline -- we're seeing it in the pipeline growth."
},
{
"speaker": "Michael Lucarelli",
"text": "And we go to our last question, please?"
},
{
"speaker": "Operator",
"text": "The last question today comes from Toshiya Hari with Goldman Sachs."
},
{
"speaker": "Toshiya Hari",
"text": "I had one quick housekeeping question and then another broader question. In terms of the housekeeping question, I was curious what did pricing do in fiscal year '22 on a pro forma basis? I think the business grew, what is it, around 25% pro forma. How much of that was pricing? And as you think about fiscal '23 or calendar '23, is the expectation for foundry costs to increase in the out-year as well? And then my broader question is probably for Vince. As you think about the full year '23, based on your backlog, based on your design wins and customer conversations, which end markets or applications are you most excited about in terms of contribution to growth? I realize you run a diverse business, and that's the beauty of ADI. But if you were to single out a couple, where your expectations are the highest, which ones would they be? And which end markets or applications would you be most worried about?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Sure. Thanks, Toshiya. Let me take the first one quickly. So for '22, growth was fairly balanced and about half of that is coming from ASPs. But I do want to emphasize something that we've said over the course of all of '22, we passed cost through to customers. We did not use that environment to raise our gross margins. That was how we did the calculation of how much price to pass on to a customer was based on the input costs that were relevant to those customers. So with that, I'll let Vince take the more interesting part."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks, Prashant. So yes, I think in terms of '23, the markets that have been performing very, very well for the company over the last couple of years, particularly Automotive, which we've already talked about; the electrification of the vehicle, we're very, very well positioned there. And we're winning a lot of share in the in-cabin electronics as well, the new display systems, which are very, very complex. The dashboard displays need a lot of very, very clever power electronics. So we're well positioned. From an Industrial perspective as well, digital healthcare has been growing at the company in double digits for over the last 7 years or thereabouts. We expect to see that continue. Also, aerospace and defense, that's likely to be a very brisk business. It's performing well for ADI now, and I believe, at least for the next 5 years, we will see stellar growth in that area. And energy, our energy and sustainability businesses are also beginning to really go on the uptick. So where am I concerned? I'm not really concerned about the business in general, given the diversity that we have, diversity of customers, products, applications. 5G, perhaps, we'll see what is likely to be weakness in Europe, offset by growth in India, growth in ORAN, steadiness in the U.S., and that kind of summarizes how we think about things."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, everyone, for joining us on the call this morning. Prashanth and I will be at CES this year hosting meetings. We also have a booth on the showroom floor where we have technology demos across auto, healthcare and consumer. We hope to see you there. And with that, have a great Thanksgiving, and thanks for joining the call."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 3 | 2,022 | 2022-08-17 10:00:00 | Operator: Good morning, and welcome to the Analog Devices Third Quarter Fiscal Year 2022 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like now to introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli: Thank you, Matt, and good morning, everybody. Thanks for joining our third quarter fiscal 2022 call. With me on the call today are ADI's CEO and Chair, CEO Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor. analog.com. Now on to the disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain Vincent Roche; and ADI's CFO, Prashanth and our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. Please note, we've also published our annual ESG report last quarter titled Future Forward. You can find it on the IR web page. And with that, I'll turn the call over to ADI's CEO and Chair, Vince. Vince?
Vincent Roche: Thank you, Mike, and good morning to you, all. Well, I'm pleased to share that we executed very well amidst a dynamic macro backdrop. We delivered another quarter of record results, driven by continued operational excellence, strong financial discipline and resilient demand for our diverse portfolio of innovation-rich products. Revenue was $3.1 billion, up 24% year-over-year on a combined basis and above the midpoint of our outlook. Strength was broad-based with double-digit growth in every end market. Our third quarter profitability reflects ADI's innovation premium and strong operating leverage with gross and operating margins of 74% and 50%, respectively. Adjusted earnings per share of $2.52 finished at the high end of our outlook, marking another new high. I'm exceptionally pleased with our results, and I want to thank our employees for their continued hard work and dedication to our success, and importantly, to the success of our customers. At ADI, innovation is ingrained in our culture, fueled by an unwavering commitment to robust R&D investments. Over the last 12 months, we've invested over $1. 7 billion in R&D. A key facet to our innovation-driven success is our dedication to extensive and deep customer engagements, which enables us to collaborate with them in solving their toughest problems. Now I'd like to share some recent customer highlights. In automotive, we reinforced our market-leading position in BMS with wins at two premium European auto manufacturers. One of these wins was with our wireless BMS solution. This marks the fourth OEM to adopt wireless BMS as customer interest continues to build for this unique technology. In sustainable energy, we announced a design win with Enel Group on the Quantum Edge device used to digitally monitor electric grids. ADI's unmatched precision measurement capabilities are critical to creating a more resilient and flexible grid to help advance efficient electrification globally. In health care, the recently released wireless hospital monitoring system by GE Healthcare in Europe uses ADI solutions across signal chain, power, RF MCUs and sensors. This wearable system enables wireless continuous monitoring to detect patient deterioration earlier, helping to improve outcomes. Today, I'd like to profile our $1.5 billion-plus consumer franchise, a business that plays an important role in our long-term profitable growth strategy. Given the recent negative data points surrounding the consumer end market, one may wonder why highlight this market now. But that's just the reason our consumer business is built differently. In the third quarter, we posted our seventh consecutive growth quarter. And while we are not immune to macro slowdown, we have aligned this business to the high end of the market where performance really matters and into applications where our differentiation is truly valued. The composition of our consumer franchise is indeed unique. Approximately 30% of our revenue comes from long life cycle prosumer applications, including next-generation conferencing systems, professional audio/video and home theater. The remaining revenue in consumer relates to portables, including fast-growing wearables and hearables as well as premium smartphones. Taking a step back, over the last five years-plus, we have reconfigured our consumer business to increase diversity across customers, products and applications to better drive growth and limit volatility while enhancing profitability. The addition of Maxim further enhances our diversity and expanded our portfolio. Over this time, we've increased our product SKUs to just over 10,000 and expanded our customer count to more than 3,000. Importantly, the composition of this business is quite similar to our B2B markets, with no single product contributing more than a couple of percentage points to total ADI sales. The velocity of innovation in the consumer market is appealing. It allows us to accelerate technology development and commercialize solutions quickly at scale. Over time, we take these breakthrough solutions into other markets to create new waves of growth and drive strong profitability and cash flow. For example, we have leveraged our consumer audio expertise into the automotive market. This capability was demonstrated at our Investor Day where we showcased an electric vehicle with Dolby Atmos that uses our Shark DSP and software that was first proven in the consumer business. Additionally, we've also leveraged R&D investments from our core franchises into the consumer market. To that end, our high-precision converters and industrial instrumentation, for example, have been repurposed to solve similar challenges for stabilization in smartphone compass and pressure sensing in wearables. Not only have we created a highly diverse and profitable business but also one that is aimed at key growth drivers that position us to grow at a high single-digit rate over the long term. For example, our prosumer growth has been revitalized as companies implement future of work plans that encompass more immersive enterprise video conferencing. Here, the breadth of our portfolio across DSP, analog, mixed signal and power management enables us to solve the entire customer challenge from high-bandwidth connectivity to video resolution and sound quality. And turning now a moment to the portables market. In hearables, we shift into the majority of premium wireless stereo earbuds. Our newest offerings include software-augmented hearing algorithms and optimized power that reduces size and improves audio fidelity while increasing our value per system by over 3 times. In wearables, we're a leader in personal wellness products with our sensing solutions designed into over 50% of products today. There is a convergence of these personal wellness products and clinical-grade vital signs monitoring solutions that could unlock new opportunities for ADI. And in premium smartphones, we're expanding our share and content at key customers, which is providing us additional diversification and stimulating new growth vectors. An emerging opportunity is the metaverse. ADI's breadth of hardware, software algorithms and domain expertise gives us an ability to provide complete subsystem solutions. While we're still in the early days, of course, momentum is building, and we have design wins in multiple next-generation AR/VR headsets. Across all these consumer applications, power management is becoming ever more critical. Customers are adding more features into smaller spaces, while consumers are demanding longer battery life. Maxim doubled the size of our low-power portfolio and increased our consumer power SAM by over $1 billion. We're already beginning to see the cross-sell benefits of our complementary customer bases and synergistic portfolios with wins in both wearables and conferencing systems. So in summary, I'm very encouraged with the strides we've taken to reignite growth in our consumer business and with a record opportunity pipeline and significant synergy potential, I believe we're in a position to deliver consistent growth over the long term. Now before passing over to Prashanth, I'd like to make some comments on the current business environment. Obviously, the macro backdrop is dynamic and it's clear that we're at an inflection point. Economic conditions are beginning to impact demand with orders showing -- orders slowing later in the quarter and cancellations increasing slightly. Prashanth will provide additional details on these dynamics in his remarks. ADI successfully navigated macro challenges many, many times before in our 57-year history. We've created a premier analog franchise with an unmatched diversity of products, customers and applications. And we've invested in a hybrid manufacturing model that better adapts to demand fluctuations. These characteristics instil a resiliency into our business to mitigate market weaknesses, sustain profitability and enable investment in our business through economic cycles to focus on playing our long game. And with that, I'll hand it over to Prashanth.
Prashanth Mahendra-Rajah: Let me add my welcome to our third quarter earnings call. My comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today's press release. Third quarter revenue of $3.1 billion finished above the midpoint of our outlook and marked our sixth consecutive quarterly record. If we look at third quarter end market performance, industrial, our most diverse and profitable end market, hit another all-time high and represented 50% of growth -- excuse me, 50% of revenue. Growth was broad-based with each of our major applications increasing sequentially. Industrial revenue has now grown more than 20% year-over-year for 7 straight quarters, underscoring ADI's strong position and secular content growth across applications. Automotive, which represented 21% of revenue, achieved another record, increasing 28% year-over-year. The better mix of higher-content premium vehicles, combined with our growth engines of BMS, GMSL, A2B and better value capture is driving our outsized growth versus SAAR. Communications, which represented 16% of revenue, achieved a quarterly record with strong year-over-year growth in both wireless and wireline. Sequentially, wireline outpaced wireless with growing demand for our optical and power portfolios as carriers and hyperscalers invest to meet the ever-growing demand for data. And lastly, consumer represented 13% of revenue and has now grown year-over-year for 7 consecutive quarters. As Vince highlighted, the diversity and growing design momentum across portables and prosumer is enabling us to grow despite the consumer market slowdown. Now on to the rest of the P&L. Gross margin was 74. 1%, up 250 basis points year-over-year, driven by higher utilization, favorable mix and synergy capture. OpEx in the quarter was $747 million, which reflects a full quarter of higher-than-normal merit increases. Operating margin increased 650 basis points year-over-year, finishing at 50.1% toward the high end of our outlook. Non-op was $48 million and the tax rate for the quarter was 13.2%. All told, EPS came in at a record $2. 52, up 47% versus the third quarter of 2021. On balance sheet, we ended the quarter with over $1.5 billion of cash and equivalents. Days of inventory increased to 129, while channel inventory remains below the low end of our target range of 7 to 8 weeks. For cash flow, CapEx for the quarter was $165 million and $526 million over the trailing 12 months, just under 5% of revenue. We continue to expect elevated CapEx investments through 2023 to support the strategic expansion of our hybrid manufacturing model. And these investments will strengthen our resiliency and support our long-term growth outlook of 7% to 10% CAGR. Over the trailing 12 months, we generated over $3.7 billion of free cash flow or 34% of revenue. Included in our free cash flow are onetime deal-related costs which amount to about 3% of revenue. With the intra-quarter volatility, we opportunistically increased repo activity to $906 million. And after approximately one year post the close of Maxim, we've repurchased $4.4 billion worth of shares, putting us on track to exceed our $5 billion commitment by the end of fiscal '22. Including dividend payments, we've returned approximately $6 billion to shareholders over the last 12 months or more than 6% of our market cap. As a reminder, we target 100% free cash flow return. We target to allocate 40% to 60% of our free cash flow to support a 10% dividend CAGR through the cycle, with the remaining cash used for share count reduction. Now before we move to the outlook, I want to provide some additional details around demand. In third quarter, our order book remained strong and backlog increased to a new record, stretching well into mid-2023. However, orders moderated later in the quarter, and as a result, book-to-bill was down from a quarter ago but still well above one. By market, we are seeing strength persist in both industrial and automotive, which together represent over two-thirds of our sales, while consumer and comms were a bit softer. We also saw a modest increase in cancellations and was not specific to any end market or geography. Given these dynamics, coupled with the macro backdrop, we believe it's prudent to take a more cautious stance. As such, we are only forecasting slight sequential revenue growth to $3.15 billion, plus or minus $100 million, despite bookings, backlog and higher supply that would all suggest stronger growth. At the midpoint, we expect all end markets to grow quarter-over-quarter. Op margin is expected to be 50.3%, plus or minus 70 bps. Our tax rate is expected to be 13% to 14%. And based on these inputs, adjusted EPS is expected to be $2. 57, plus or minus $0.10. More broadly, while the macro backdrop is dynamic, our business has several aspects that position us quite well to manage further headwinds. These include our diverse end market exposure, coupled with strong secular drivers that will help buffer our top line. The flexibility of our hybrid manufacturing model gives us confidence in maintaining our 70% gross margin floor. And we also have several OpEx layers to support our industry-leading margins and maintain a solid return of cash to our investors. So in closing, my confidence to our path of $15 of EPS in the next five years remains high. Let me now give it back to Mike for the Q&A.
Michael Lucarelli: Thanks, Prashanth. Let's get to the Q&A session. (Operator Instructions) With that, can we have our first question, please, Matt?
Operator: [Operator Instructions] Our first question will come from Vivek Arya with Bank of America Securities. Please go ahead.
Vivek Arya: I just wanted to clarify how much conservatism is in the Q4 outlook. And then a little bit longer term than that. What happens to the pricing lever as you start to see these bookings start to decelerate? Is pricing holding firm? Is it flat or down as customers start to think about next year?
Prashanth Mahendra-Rajah: Yes. Thank you for the question, Vivek. Let me take the first part of that, and then maybe I'll let Vince speak to the pricing. So we've been talking for a couple of quarters now that we were expecting a meaning full increase and our ability supply in the fourth quarter and we’ve been building that with the installations of equipment to that we’ve been having over the course of the year. So our supply -- our ability supply even access of the guide that we put out there. In addition, our backlog actually increased sequentially from -- into the third quarter to a new all-time record. And given kind of the strength in the backlog, the book-to-bill was still above one and increased supply, it's very logical we could print a bigger number. Having said that, we are very aware of the macro environment and a bit more softening in order activity that we saw towards the tail end of the quarter. So that's why we kind of held back a little bit on the guide to ensure that if this order softness does continue, we're not disappointing. Vince, do you want to address the pricing question?
Vincent Roche: Yes. Thanks, Vivek. Yes, so I think first and foremost, we are seeing tremendous stability. I don't expect to see any downward pressure on prices even in a recessionary environment. I think first and foremost, our products reflects an innovation premium for the kind of value that we deliver to our customers. Now we're never the long pull in the pricing tent either in the customer's bill of material. The other thing I would say, particularly in the high-performance analog space, the substitution costs are very, very high. So the disruption to a customer system design way, way outweighs considerations for price reduction. So where we obviously compete most intensively on a price basis is to get the original socket, but we have long life cycle products with tremendous stability, very, very high substitution costs. So my sense is that pricing will remain very, very steady through the cycle.
Operator: Our next question will come from C.J. Muse with Evercore.
Christopher Muse: I guess I'd like to focus on the slowdown in orders that you saw at the tail end of the quarter as well as the cancellations that you highlighted. Any more kind of detail you can provide there as it relates to subsegment of end markets, geography? Any color would be greatly appreciated.
Prashanth Mahendra-Rajah: Yes. Thank you. Thanks, C.J. Let me maybe talk about kind of the bookings momentum in a couple of different pieces. So first, third quarter results, where we're clearly broad-based strength, all end markets were up quarter-over-quarter and double digits year-over-year, so our sixth consecutive record. The only geography/market that was down year-over-year was China consumer. But that's a very small exposure for ADI, low -- very low exposure for ADI, low -- very low the third quarter, orders were up. Again, as I mentioned, strongest trends were industrial and auto, which represent about 70% of the business. Comms and consumer weaker, but again, we increased our backlog to another record, another new all-time high, and that covers us well into '23. Where we saw that change in demand was really cancellations ticked modestly higher. And I do say modestly. It is -- we want to be fully transparent on this call, so we're calling out but I wouldn't really put too much focus on the cancellation number. But again, in the spirit of transparency, we want to share that we did see that change in the demand profile. And we also saw that the channel sell-through began to moderate towards later in the quarter. So that is the sell-through from the channel or POS began to soften a bit versus what we were originally expecting. Overall, the book-to-bill was still above parity but it was definitely lower than it was a quarter ago. So as we set that guide for fourth quarter, given the uncertainty, changing trends in our business, we thought it's prudent to take a more cautious stance and therefore, we're guiding up only slightly on a quarter-over-quarter basis despite, as I mentioned in answering Vivek's question, despite having very strong backlog coverage, good bookings and better supply, which would all suggest higher growth.
Operator: Our next question will come from Ambrish Srivastava with BMO Capital. Please go ahead.
Ambrish Srivastava: I just had a question, Prashanth, on the floor that you have laid out for the gross margin, which is way above where margins bottomed out at in the prior real cycle and connection prices. And I'm asking this because I get this question a lot. Hey, what's the downside EPS projection for ADI? And so if you could please help us understand kind of what are the underlying assumptions behind that as it relates to utilization inventory. And then more importantly, what are you assuming for revenues to go down to hit that level?
Prashanth Mahendra-Rajah: Sure, sure. Thank you, Ambrish. So maybe let's start with a reminder that this company is structurally more profitable than we ever have been. The addition of Maxim gives us the benefit of scale, and we have the benefit of that hybrid manufacturing model, which really gives us that flexibility to manage our production utilizations by being able to notify our supply chain partners in the event we need to, with essentially a quarter's notice, to bring the outside supply number down and focus on keeping internal utilizations higher. As a result of that, we feel very confident that kind of through the downturn of a cycle, we can maintain that 70% gross margin floor, which from an investor model standpoint, is a unique metric that we put out there to give a floor. In thinking about a downturn scenario, and again, I want to emphasize, this is a projection to help investors model what it could be, not in any way a forecast of what we think is coming at us. But from a revenue standpoint, we have this great diversification, 75,000 products, 125,000 customers and thousands and thousands of applications, which are aligned to numerous secular growth markets. We have exposure to much stronger markets in a down cycle like aerospace and defense and health care, which are not going to be as cyclical. On the gross margin side, I mentioned this flexible manufacturing model that allows us to really help manage utilizations. And then we have a very accordion-driven variable compensation program, which allows us to moderate OpEx. So if we were to think about a downside scenario that was in a 15% down revenue market, we believe op margins would still have a 4 handle on them, probably be in the low 40s and gross margins would probably be, again, above 70, but probably in the low 70s.
Operator: Our next question will come from Stacy Rasgon with Bernstein Research. Please go ahead.
Stacy Rasgon: I wanted to delve a little bit more into the bookings and the order. So was it like bookings before were 150% and now they're 130%? Like where is that book-to-bill actually coming in? How far above one is it? And I guess what are you assuming happens to the backlog as we go into next quarter? Are you assuming that, that backlog gets drawn down at all or are you assuming it goes up? Or just what are the assumptions around that embedded in the guidance?
Prashanth Mahendra-Rajah: Yes. So let's see what can we say here, Stacy. So for the last couple of quarters, excluding the third quarter, book-to-bill was -- actually, you can do the math because you can see how the backlog has increased so substantially. It between a one and a two, right? We're now still above one but we're at the lower end of that. Now industrial and automotive, strong, and that helped to compensate for -- I think I'm going from memory here, my consumer was just about flattish and comms was just a hair below.
Stacy Rasgon: What are you assuming in the next quarter for the backlog?
Michael Lucarelli: Yes, sure. I mean, the backlog is not that indicative of what happens for next quarter because it goes out into '23. So as you see these cancellations, this is a very small percent of the backlog and that's really into '23. So our assumption is backlog probably increases again because book-to-bill at an enterprise level is still above one. It's really not going to affect the demand for the fourth quarter or probably even the first quarter at this point. And as Prashanth said, I say investments bookings used to be way above one. Now they're nicely above one. So we're still booking above what we're shipping. So what would cause us not to come in kind of in line with supply, right? Why would we -- why would -- for the last couple of quarters, our revenue number has been purely a function of supply, and why could that not be the case for the fourth quarter? Why that could not be the case is if customers say, "We'd like to reschedule the timing and we choose, in the spirit of customer satisfaction, not to push it to them although they've ordered it and give them that flexibility to move out." And it could be, as I mentioned, from the channel standpoint, if the channel looks like inventory in the channel is building at a level that we don't think is healthy for the business. And we choose to keep that inventory on our books to give us more flexibility to make sure that we can match customer demand better.
Michael Lucarelli: I have one thing to that, that's important point Prashanth brought up on the channel is that 31:50 assumes really no channel inventory build. That's a sell-through number that we're guiding to.
Prashanth Mahendra-Rajah: Yes. Thank you, Mike.
Michael Lucarelli: That's four different parts to that answer, Stacy, so we'll go to the next question.
Operator: Our next question will come from Blayne Curtis with Barclays. Please go ahead.
Blayne Curtis: I just want to follow up on a part question in terms of just where you're seeing these cancellations. You said consumer and comms are weaker. I think you just said comms book-to-bill is below one. But I'm just trying to understand in the comments of I think channel sell-through was weaker as well. Can you dial us in, is it isolated to certain segments? Or is all of these comments kind of broad-based in terms of where you're seeing the cancellations and the weaker sell-through?
Prashanth Mahendra-Rajah: Everything is broad-based, and we -- I think that if we have overemphasized cancellations on this call, that's probably a true statement right now, is I don't want to mislead folks to think that cancellations are a meaningful concern. But again, in the spirit of transparency, we're saying that they were up modestly.
Michael Lucarelli - Head of IR: But everything we've talked about has been pretty broad-based.
Prashanth Mahendra-Rajah: And on comms, I just -- maybe just one follow-up is this has always been a lumpy business. We know that the wireless guys have spent a big chunk of money buying spectrum. That spectrum has to be deployed, which will require the 5G hardware that we have the market share leading position on. So we're highly confident. This is a pretty of timing issue.
Operator: Our next question will come from Tore Svanberg with Stifel. Please go ahead.
Tore Svanberg: And congrats on another record. As we sort of move through this software environment, how are you thinking about the three big cost levers, utilization, OpEx and CapEx going forward?
Prashanth Mahendra-Rajah: Okay. So I think we've talked through some of that, Tore, but from at least certainly utilization levels, we're going to continue to see relatively good utilization levels across our internal factories for a few reasons: one is the benefit of the hybrid model is that we can bring more production in-house; second is that die bank levels are at very low levels, and we do need to get those die bank levels back to a healthy point. Die bank is an extremely cost-efficient place for us to hold inventory, particularly when you have 75,000 SKUs. You can hold it sort of think of it as $0.10 on the dollar. So it is very economically efficient and allows us to improve customer satisfaction later on. From an OpEx standpoint, as you've seen in the past, we have a very accordion-driven variable compensation program, which automatically unwinds if the financial performance of the company drives it to. And I think what's unique to ADI versus perhaps some of our peers is we have the cost synergies from Maxim, which are independent of the economic environment. From a CapEx standpoint, expect us to be -- it is business as usual. We had committed at the Investor Day to a higher level of CapEx in '22 and '23, which is necessary to add the supply needed to hit our long-term model of 7% to 10% growth, which we are very much committed to, and that is on track. Capital spend for the current quarter -- sorry, for the current year, maybe a bit below what we expected. That's a consequence of revenue coming in stronger, so bigger denominator and also just a little bit of delay in the receiving some of that equipment, but all of that will drive through in 2023.
Vincent Roche: Yes. Sorry, Tore. On the OpEx side, we intend to -- we've been spending R&D at record levels. We intend to continue to ensure that we have properly funded all our critical programs. Innovation at a very, very important part of the value creation story of ADI. We are -- also we've been upping actually the spend in our go-to-market activities as well. So both of those, we will continue to keep our pedal to the metal on.
Operator: Our next question will come from Toshiya Hari with Goldman Sachs. Please go ahead.
Toshiya Hari: I wanted to ask a question on the supply side sort of the equation. Three months ago, you had talked about significant tightness, whether it be your internal supply or external foundry supply. I'm just curious if you're starting to see signs of supply easing. I guess test was a big bottleneck for internal supply 3, 6 months ago. Any changes there? And in terms of foundry wafer supply, again, any signs of easing? And kind of related to that, there have been some headlines about foundry wafer pricing increasing again in late '22 going into '23. Is that sort of the indication you're getting from your suppliers? And if so, are you comfortable that you'd be able to pass those through to your customers?
Vincent Roche: Well, I think the last part of your question, first, on pricing increases, I believe that we are in the post-Moore's Law era and in a period of sustained structural inflation in this business for many, many years ahead. I think it's true to say that supply -- we've been increasing, of course. We've invested strongly in our own manufacturing capabilities to be able to secure supply and increase supply actually across the four wafer fabs inside ADI. So yes, supply is improving there. And thematically as well as supply has been improving actually right through the pandemic, right over the last couple of years from our subcontractors as well. So I think there is a lightening of supply across the board.
Prashanth Mahendra-Rajah: On pricing, maybe I'll just restate what we said in the past. We are not using this environment to take advantage of our customers, and we are really looking to maintain our gross margin model. And the rationale on that gross margin model, which is important to us, is we know, as Vince mentioned, we spend at a healthy clip on R&D to develop highly innovative products, and we need to capture that innovation premium from our customers. So as our costs may increase, it's important that we continue to capture those cost increases back with stable margins because it's a reflection of the value we're bringing to our customers.
Operator: Our next question will come from Harlan Sur with JPMorgan. Please go ahead.
Harlan Sur: Just one clarification. So I just wanted to verify, so you guys said that currently, quarter-to-date, your book-to-bill is still greater than one. That's my clarification question. Then my main question is distribution represents about 60% of the team's revenues, right? And it looks like just the inventories are still below your target levels of 7 to 8 weeks. Obviously, the eventual catch-up should provide you guys with some cushion if the environment continues to weaken further. But that being said, it still feels like auto and industrial demand is still quite strong. So given your outlook, like what's your view on getting to target levels on channel inventories over the next few quarters?
Prashanth Mahendra-Rajah: Yes. Thanks, Harlan. Your -- first of all, say that you recapped it correctly, and there is some opportunity for us to continue to grow our revenue by bringing distis levels back to our healthy target level. But I want to emphasize that the guide, as Mike mentioned, the guide for the fourth quarter is on the basis of POS equals POA. One thing that ADI has been very consistent about for many years is we run our business on POS. So we need to look at end demand, and end demand drives how we end up manufacturing, and we want distis to be able to help us with access for those products, but we are not looking for distribution to be an excess buffer of inventory.
Michael Lucarelli: And the one other part of the question that you had, Harlan, was book-to-bill. Yes, for the quarter, book-to-bill was still well above one at enterprise level. That was driven by industrial and auto with the two strongest markets, while comms and consumer, we'll call about flat, around one. And with that, may we have our last question, please?
Operator: Our last question will come from Ross Seymore with Deutsche Bank. Please go ahead.
Ross Seymore: Vince, a lot of questions about near-term cancellations, bookings, backlog, all those sorts of things. I wanted to ask a slightly longer one. You mentioned in answer to an earlier question about we're in a post-Moore's Law world. We're going to have an inflationary environment rather than deflationary. Can you just talk a little bit about how the customer conversations have changed? Over the last few months, we've heard a lot from last year, a lot from companies saying it's more of a partnership, longer lead times, et cetera, long-term supply agreements, those sorts of things. Do you still see that behavior continuing? Or do you believe that's a little bit more of a reflection of cyclical tightness and you expect some of that to unwind as well?
Vincent Roche: Yes, it's a very good question. I've had a lot of conversations, Ross, over the last couple of years with CEOs of the biggest enterprises in the world of information. And what I can tell you for sure is that everybody wants to get closer to their key suppliers when it comes to aligning product roadmaps for the long term. Particularly companies that are perceived as being critical for their innovation processes. So I can tell you that continues. And the other side of the equation is everybody wants to understand at the customer side of things, what do they need to do to secure supply for the long term? And what kind of arrangements that they need to put in place? What kind of information flows? What kind of models that we develop between each other? So that continues. And I think it has been firmly established now that semiconductors are the bedrock of the modern -- of modern socioeconomic life. So the conversations continue intensively, I would say, and I expect that to continue well into the future.
Michael Lucarelli: And with that, thanks, everyone, for joining our call this morning. I did want to flag that during these more uncertain times and consistent with our commitment to transparency for our owners, we'll be even more available. Vince and Prashanth will be in New York, L.A., the Bay Area, Chicago and across Europe in the next quarter, so it's a busy quarter coming up for us. Please reach out to myself or the IR team if you'd like to be notified when we're in your neighborhood. And with that, thanks for joining us and your continued interest in ADI.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices Third Quarter Fiscal Year 2022 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like now to introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Matt, and good morning, everybody. Thanks for joining our third quarter fiscal 2022 call. With me on the call today are ADI's CEO and Chair, CEO Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor. analog.com. Now on to the disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain Vincent Roche; and ADI's CFO, Prashanth and our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. Please note, we've also published our annual ESG report last quarter titled Future Forward. You can find it on the IR web page. And with that, I'll turn the call over to ADI's CEO and Chair, Vince. Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thank you, Mike, and good morning to you, all. Well, I'm pleased to share that we executed very well amidst a dynamic macro backdrop. We delivered another quarter of record results, driven by continued operational excellence, strong financial discipline and resilient demand for our diverse portfolio of innovation-rich products. Revenue was $3.1 billion, up 24% year-over-year on a combined basis and above the midpoint of our outlook. Strength was broad-based with double-digit growth in every end market. Our third quarter profitability reflects ADI's innovation premium and strong operating leverage with gross and operating margins of 74% and 50%, respectively. Adjusted earnings per share of $2.52 finished at the high end of our outlook, marking another new high. I'm exceptionally pleased with our results, and I want to thank our employees for their continued hard work and dedication to our success, and importantly, to the success of our customers. At ADI, innovation is ingrained in our culture, fueled by an unwavering commitment to robust R&D investments. Over the last 12 months, we've invested over $1. 7 billion in R&D. A key facet to our innovation-driven success is our dedication to extensive and deep customer engagements, which enables us to collaborate with them in solving their toughest problems. Now I'd like to share some recent customer highlights. In automotive, we reinforced our market-leading position in BMS with wins at two premium European auto manufacturers. One of these wins was with our wireless BMS solution. This marks the fourth OEM to adopt wireless BMS as customer interest continues to build for this unique technology. In sustainable energy, we announced a design win with Enel Group on the Quantum Edge device used to digitally monitor electric grids. ADI's unmatched precision measurement capabilities are critical to creating a more resilient and flexible grid to help advance efficient electrification globally. In health care, the recently released wireless hospital monitoring system by GE Healthcare in Europe uses ADI solutions across signal chain, power, RF MCUs and sensors. This wearable system enables wireless continuous monitoring to detect patient deterioration earlier, helping to improve outcomes. Today, I'd like to profile our $1.5 billion-plus consumer franchise, a business that plays an important role in our long-term profitable growth strategy. Given the recent negative data points surrounding the consumer end market, one may wonder why highlight this market now. But that's just the reason our consumer business is built differently. In the third quarter, we posted our seventh consecutive growth quarter. And while we are not immune to macro slowdown, we have aligned this business to the high end of the market where performance really matters and into applications where our differentiation is truly valued. The composition of our consumer franchise is indeed unique. Approximately 30% of our revenue comes from long life cycle prosumer applications, including next-generation conferencing systems, professional audio/video and home theater. The remaining revenue in consumer relates to portables, including fast-growing wearables and hearables as well as premium smartphones. Taking a step back, over the last five years-plus, we have reconfigured our consumer business to increase diversity across customers, products and applications to better drive growth and limit volatility while enhancing profitability. The addition of Maxim further enhances our diversity and expanded our portfolio. Over this time, we've increased our product SKUs to just over 10,000 and expanded our customer count to more than 3,000. Importantly, the composition of this business is quite similar to our B2B markets, with no single product contributing more than a couple of percentage points to total ADI sales. The velocity of innovation in the consumer market is appealing. It allows us to accelerate technology development and commercialize solutions quickly at scale. Over time, we take these breakthrough solutions into other markets to create new waves of growth and drive strong profitability and cash flow. For example, we have leveraged our consumer audio expertise into the automotive market. This capability was demonstrated at our Investor Day where we showcased an electric vehicle with Dolby Atmos that uses our Shark DSP and software that was first proven in the consumer business. Additionally, we've also leveraged R&D investments from our core franchises into the consumer market. To that end, our high-precision converters and industrial instrumentation, for example, have been repurposed to solve similar challenges for stabilization in smartphone compass and pressure sensing in wearables. Not only have we created a highly diverse and profitable business but also one that is aimed at key growth drivers that position us to grow at a high single-digit rate over the long term. For example, our prosumer growth has been revitalized as companies implement future of work plans that encompass more immersive enterprise video conferencing. Here, the breadth of our portfolio across DSP, analog, mixed signal and power management enables us to solve the entire customer challenge from high-bandwidth connectivity to video resolution and sound quality. And turning now a moment to the portables market. In hearables, we shift into the majority of premium wireless stereo earbuds. Our newest offerings include software-augmented hearing algorithms and optimized power that reduces size and improves audio fidelity while increasing our value per system by over 3 times. In wearables, we're a leader in personal wellness products with our sensing solutions designed into over 50% of products today. There is a convergence of these personal wellness products and clinical-grade vital signs monitoring solutions that could unlock new opportunities for ADI. And in premium smartphones, we're expanding our share and content at key customers, which is providing us additional diversification and stimulating new growth vectors. An emerging opportunity is the metaverse. ADI's breadth of hardware, software algorithms and domain expertise gives us an ability to provide complete subsystem solutions. While we're still in the early days, of course, momentum is building, and we have design wins in multiple next-generation AR/VR headsets. Across all these consumer applications, power management is becoming ever more critical. Customers are adding more features into smaller spaces, while consumers are demanding longer battery life. Maxim doubled the size of our low-power portfolio and increased our consumer power SAM by over $1 billion. We're already beginning to see the cross-sell benefits of our complementary customer bases and synergistic portfolios with wins in both wearables and conferencing systems. So in summary, I'm very encouraged with the strides we've taken to reignite growth in our consumer business and with a record opportunity pipeline and significant synergy potential, I believe we're in a position to deliver consistent growth over the long term. Now before passing over to Prashanth, I'd like to make some comments on the current business environment. Obviously, the macro backdrop is dynamic and it's clear that we're at an inflection point. Economic conditions are beginning to impact demand with orders showing -- orders slowing later in the quarter and cancellations increasing slightly. Prashanth will provide additional details on these dynamics in his remarks. ADI successfully navigated macro challenges many, many times before in our 57-year history. We've created a premier analog franchise with an unmatched diversity of products, customers and applications. And we've invested in a hybrid manufacturing model that better adapts to demand fluctuations. These characteristics instil a resiliency into our business to mitigate market weaknesses, sustain profitability and enable investment in our business through economic cycles to focus on playing our long game. And with that, I'll hand it over to Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Let me add my welcome to our third quarter earnings call. My comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today's press release. Third quarter revenue of $3.1 billion finished above the midpoint of our outlook and marked our sixth consecutive quarterly record. If we look at third quarter end market performance, industrial, our most diverse and profitable end market, hit another all-time high and represented 50% of growth -- excuse me, 50% of revenue. Growth was broad-based with each of our major applications increasing sequentially. Industrial revenue has now grown more than 20% year-over-year for 7 straight quarters, underscoring ADI's strong position and secular content growth across applications. Automotive, which represented 21% of revenue, achieved another record, increasing 28% year-over-year. The better mix of higher-content premium vehicles, combined with our growth engines of BMS, GMSL, A2B and better value capture is driving our outsized growth versus SAAR. Communications, which represented 16% of revenue, achieved a quarterly record with strong year-over-year growth in both wireless and wireline. Sequentially, wireline outpaced wireless with growing demand for our optical and power portfolios as carriers and hyperscalers invest to meet the ever-growing demand for data. And lastly, consumer represented 13% of revenue and has now grown year-over-year for 7 consecutive quarters. As Vince highlighted, the diversity and growing design momentum across portables and prosumer is enabling us to grow despite the consumer market slowdown. Now on to the rest of the P&L. Gross margin was 74. 1%, up 250 basis points year-over-year, driven by higher utilization, favorable mix and synergy capture. OpEx in the quarter was $747 million, which reflects a full quarter of higher-than-normal merit increases. Operating margin increased 650 basis points year-over-year, finishing at 50.1% toward the high end of our outlook. Non-op was $48 million and the tax rate for the quarter was 13.2%. All told, EPS came in at a record $2. 52, up 47% versus the third quarter of 2021. On balance sheet, we ended the quarter with over $1.5 billion of cash and equivalents. Days of inventory increased to 129, while channel inventory remains below the low end of our target range of 7 to 8 weeks. For cash flow, CapEx for the quarter was $165 million and $526 million over the trailing 12 months, just under 5% of revenue. We continue to expect elevated CapEx investments through 2023 to support the strategic expansion of our hybrid manufacturing model. And these investments will strengthen our resiliency and support our long-term growth outlook of 7% to 10% CAGR. Over the trailing 12 months, we generated over $3.7 billion of free cash flow or 34% of revenue. Included in our free cash flow are onetime deal-related costs which amount to about 3% of revenue. With the intra-quarter volatility, we opportunistically increased repo activity to $906 million. And after approximately one year post the close of Maxim, we've repurchased $4.4 billion worth of shares, putting us on track to exceed our $5 billion commitment by the end of fiscal '22. Including dividend payments, we've returned approximately $6 billion to shareholders over the last 12 months or more than 6% of our market cap. As a reminder, we target 100% free cash flow return. We target to allocate 40% to 60% of our free cash flow to support a 10% dividend CAGR through the cycle, with the remaining cash used for share count reduction. Now before we move to the outlook, I want to provide some additional details around demand. In third quarter, our order book remained strong and backlog increased to a new record, stretching well into mid-2023. However, orders moderated later in the quarter, and as a result, book-to-bill was down from a quarter ago but still well above one. By market, we are seeing strength persist in both industrial and automotive, which together represent over two-thirds of our sales, while consumer and comms were a bit softer. We also saw a modest increase in cancellations and was not specific to any end market or geography. Given these dynamics, coupled with the macro backdrop, we believe it's prudent to take a more cautious stance. As such, we are only forecasting slight sequential revenue growth to $3.15 billion, plus or minus $100 million, despite bookings, backlog and higher supply that would all suggest stronger growth. At the midpoint, we expect all end markets to grow quarter-over-quarter. Op margin is expected to be 50.3%, plus or minus 70 bps. Our tax rate is expected to be 13% to 14%. And based on these inputs, adjusted EPS is expected to be $2. 57, plus or minus $0.10. More broadly, while the macro backdrop is dynamic, our business has several aspects that position us quite well to manage further headwinds. These include our diverse end market exposure, coupled with strong secular drivers that will help buffer our top line. The flexibility of our hybrid manufacturing model gives us confidence in maintaining our 70% gross margin floor. And we also have several OpEx layers to support our industry-leading margins and maintain a solid return of cash to our investors. So in closing, my confidence to our path of $15 of EPS in the next five years remains high. Let me now give it back to Mike for the Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. Let's get to the Q&A session. (Operator Instructions) With that, can we have our first question, please, Matt?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question will come from Vivek Arya with Bank of America Securities. Please go ahead."
},
{
"speaker": "Vivek Arya",
"text": "I just wanted to clarify how much conservatism is in the Q4 outlook. And then a little bit longer term than that. What happens to the pricing lever as you start to see these bookings start to decelerate? Is pricing holding firm? Is it flat or down as customers start to think about next year?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thank you for the question, Vivek. Let me take the first part of that, and then maybe I'll let Vince speak to the pricing. So we've been talking for a couple of quarters now that we were expecting a meaning full increase and our ability supply in the fourth quarter and we’ve been building that with the installations of equipment to that we’ve been having over the course of the year. So our supply -- our ability supply even access of the guide that we put out there. In addition, our backlog actually increased sequentially from -- into the third quarter to a new all-time record. And given kind of the strength in the backlog, the book-to-bill was still above one and increased supply, it's very logical we could print a bigger number. Having said that, we are very aware of the macro environment and a bit more softening in order activity that we saw towards the tail end of the quarter. So that's why we kind of held back a little bit on the guide to ensure that if this order softness does continue, we're not disappointing. Vince, do you want to address the pricing question?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks, Vivek. Yes, so I think first and foremost, we are seeing tremendous stability. I don't expect to see any downward pressure on prices even in a recessionary environment. I think first and foremost, our products reflects an innovation premium for the kind of value that we deliver to our customers. Now we're never the long pull in the pricing tent either in the customer's bill of material. The other thing I would say, particularly in the high-performance analog space, the substitution costs are very, very high. So the disruption to a customer system design way, way outweighs considerations for price reduction. So where we obviously compete most intensively on a price basis is to get the original socket, but we have long life cycle products with tremendous stability, very, very high substitution costs. So my sense is that pricing will remain very, very steady through the cycle."
},
{
"speaker": "Operator",
"text": "Our next question will come from C.J. Muse with Evercore."
},
{
"speaker": "Christopher Muse",
"text": "I guess I'd like to focus on the slowdown in orders that you saw at the tail end of the quarter as well as the cancellations that you highlighted. Any more kind of detail you can provide there as it relates to subsegment of end markets, geography? Any color would be greatly appreciated."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thank you. Thanks, C.J. Let me maybe talk about kind of the bookings momentum in a couple of different pieces. So first, third quarter results, where we're clearly broad-based strength, all end markets were up quarter-over-quarter and double digits year-over-year, so our sixth consecutive record. The only geography/market that was down year-over-year was China consumer. But that's a very small exposure for ADI, low -- very low exposure for ADI, low -- very low the third quarter, orders were up. Again, as I mentioned, strongest trends were industrial and auto, which represent about 70% of the business. Comms and consumer weaker, but again, we increased our backlog to another record, another new all-time high, and that covers us well into '23. Where we saw that change in demand was really cancellations ticked modestly higher. And I do say modestly. It is -- we want to be fully transparent on this call, so we're calling out but I wouldn't really put too much focus on the cancellation number. But again, in the spirit of transparency, we want to share that we did see that change in the demand profile. And we also saw that the channel sell-through began to moderate towards later in the quarter. So that is the sell-through from the channel or POS began to soften a bit versus what we were originally expecting. Overall, the book-to-bill was still above parity but it was definitely lower than it was a quarter ago. So as we set that guide for fourth quarter, given the uncertainty, changing trends in our business, we thought it's prudent to take a more cautious stance and therefore, we're guiding up only slightly on a quarter-over-quarter basis despite, as I mentioned in answering Vivek's question, despite having very strong backlog coverage, good bookings and better supply, which would all suggest higher growth."
},
{
"speaker": "Operator",
"text": "Our next question will come from Ambrish Srivastava with BMO Capital. Please go ahead."
},
{
"speaker": "Ambrish Srivastava",
"text": "I just had a question, Prashanth, on the floor that you have laid out for the gross margin, which is way above where margins bottomed out at in the prior real cycle and connection prices. And I'm asking this because I get this question a lot. Hey, what's the downside EPS projection for ADI? And so if you could please help us understand kind of what are the underlying assumptions behind that as it relates to utilization inventory. And then more importantly, what are you assuming for revenues to go down to hit that level?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Sure, sure. Thank you, Ambrish. So maybe let's start with a reminder that this company is structurally more profitable than we ever have been. The addition of Maxim gives us the benefit of scale, and we have the benefit of that hybrid manufacturing model, which really gives us that flexibility to manage our production utilizations by being able to notify our supply chain partners in the event we need to, with essentially a quarter's notice, to bring the outside supply number down and focus on keeping internal utilizations higher. As a result of that, we feel very confident that kind of through the downturn of a cycle, we can maintain that 70% gross margin floor, which from an investor model standpoint, is a unique metric that we put out there to give a floor. In thinking about a downturn scenario, and again, I want to emphasize, this is a projection to help investors model what it could be, not in any way a forecast of what we think is coming at us. But from a revenue standpoint, we have this great diversification, 75,000 products, 125,000 customers and thousands and thousands of applications, which are aligned to numerous secular growth markets. We have exposure to much stronger markets in a down cycle like aerospace and defense and health care, which are not going to be as cyclical. On the gross margin side, I mentioned this flexible manufacturing model that allows us to really help manage utilizations. And then we have a very accordion-driven variable compensation program, which allows us to moderate OpEx. So if we were to think about a downside scenario that was in a 15% down revenue market, we believe op margins would still have a 4 handle on them, probably be in the low 40s and gross margins would probably be, again, above 70, but probably in the low 70s."
},
{
"speaker": "Operator",
"text": "Our next question will come from Stacy Rasgon with Bernstein Research. Please go ahead."
},
{
"speaker": "Stacy Rasgon",
"text": "I wanted to delve a little bit more into the bookings and the order. So was it like bookings before were 150% and now they're 130%? Like where is that book-to-bill actually coming in? How far above one is it? And I guess what are you assuming happens to the backlog as we go into next quarter? Are you assuming that, that backlog gets drawn down at all or are you assuming it goes up? Or just what are the assumptions around that embedded in the guidance?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. So let's see what can we say here, Stacy. So for the last couple of quarters, excluding the third quarter, book-to-bill was -- actually, you can do the math because you can see how the backlog has increased so substantially. It between a one and a two, right? We're now still above one but we're at the lower end of that. Now industrial and automotive, strong, and that helped to compensate for -- I think I'm going from memory here, my consumer was just about flattish and comms was just a hair below."
},
{
"speaker": "Stacy Rasgon",
"text": "What are you assuming in the next quarter for the backlog?"
},
{
"speaker": "Michael Lucarelli",
"text": "Yes, sure. I mean, the backlog is not that indicative of what happens for next quarter because it goes out into '23. So as you see these cancellations, this is a very small percent of the backlog and that's really into '23. So our assumption is backlog probably increases again because book-to-bill at an enterprise level is still above one. It's really not going to affect the demand for the fourth quarter or probably even the first quarter at this point. And as Prashanth said, I say investments bookings used to be way above one. Now they're nicely above one. So we're still booking above what we're shipping. So what would cause us not to come in kind of in line with supply, right? Why would we -- why would -- for the last couple of quarters, our revenue number has been purely a function of supply, and why could that not be the case for the fourth quarter? Why that could not be the case is if customers say, \"We'd like to reschedule the timing and we choose, in the spirit of customer satisfaction, not to push it to them although they've ordered it and give them that flexibility to move out.\" And it could be, as I mentioned, from the channel standpoint, if the channel looks like inventory in the channel is building at a level that we don't think is healthy for the business. And we choose to keep that inventory on our books to give us more flexibility to make sure that we can match customer demand better."
},
{
"speaker": "Michael Lucarelli",
"text": "I have one thing to that, that's important point Prashanth brought up on the channel is that 31:50 assumes really no channel inventory build. That's a sell-through number that we're guiding to."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thank you, Mike."
},
{
"speaker": "Michael Lucarelli",
"text": "That's four different parts to that answer, Stacy, so we'll go to the next question."
},
{
"speaker": "Operator",
"text": "Our next question will come from Blayne Curtis with Barclays. Please go ahead."
},
{
"speaker": "Blayne Curtis",
"text": "I just want to follow up on a part question in terms of just where you're seeing these cancellations. You said consumer and comms are weaker. I think you just said comms book-to-bill is below one. But I'm just trying to understand in the comments of I think channel sell-through was weaker as well. Can you dial us in, is it isolated to certain segments? Or is all of these comments kind of broad-based in terms of where you're seeing the cancellations and the weaker sell-through?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Everything is broad-based, and we -- I think that if we have overemphasized cancellations on this call, that's probably a true statement right now, is I don't want to mislead folks to think that cancellations are a meaningful concern. But again, in the spirit of transparency, we're saying that they were up modestly."
},
{
"speaker": "Michael Lucarelli - Head of IR",
"text": "But everything we've talked about has been pretty broad-based."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "And on comms, I just -- maybe just one follow-up is this has always been a lumpy business. We know that the wireless guys have spent a big chunk of money buying spectrum. That spectrum has to be deployed, which will require the 5G hardware that we have the market share leading position on. So we're highly confident. This is a pretty of timing issue."
},
{
"speaker": "Operator",
"text": "Our next question will come from Tore Svanberg with Stifel. Please go ahead."
},
{
"speaker": "Tore Svanberg",
"text": "And congrats on another record. As we sort of move through this software environment, how are you thinking about the three big cost levers, utilization, OpEx and CapEx going forward?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Okay. So I think we've talked through some of that, Tore, but from at least certainly utilization levels, we're going to continue to see relatively good utilization levels across our internal factories for a few reasons: one is the benefit of the hybrid model is that we can bring more production in-house; second is that die bank levels are at very low levels, and we do need to get those die bank levels back to a healthy point. Die bank is an extremely cost-efficient place for us to hold inventory, particularly when you have 75,000 SKUs. You can hold it sort of think of it as $0.10 on the dollar. So it is very economically efficient and allows us to improve customer satisfaction later on. From an OpEx standpoint, as you've seen in the past, we have a very accordion-driven variable compensation program, which automatically unwinds if the financial performance of the company drives it to. And I think what's unique to ADI versus perhaps some of our peers is we have the cost synergies from Maxim, which are independent of the economic environment. From a CapEx standpoint, expect us to be -- it is business as usual. We had committed at the Investor Day to a higher level of CapEx in '22 and '23, which is necessary to add the supply needed to hit our long-term model of 7% to 10% growth, which we are very much committed to, and that is on track. Capital spend for the current quarter -- sorry, for the current year, maybe a bit below what we expected. That's a consequence of revenue coming in stronger, so bigger denominator and also just a little bit of delay in the receiving some of that equipment, but all of that will drive through in 2023."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Sorry, Tore. On the OpEx side, we intend to -- we've been spending R&D at record levels. We intend to continue to ensure that we have properly funded all our critical programs. Innovation at a very, very important part of the value creation story of ADI. We are -- also we've been upping actually the spend in our go-to-market activities as well. So both of those, we will continue to keep our pedal to the metal on."
},
{
"speaker": "Operator",
"text": "Our next question will come from Toshiya Hari with Goldman Sachs. Please go ahead."
},
{
"speaker": "Toshiya Hari",
"text": "I wanted to ask a question on the supply side sort of the equation. Three months ago, you had talked about significant tightness, whether it be your internal supply or external foundry supply. I'm just curious if you're starting to see signs of supply easing. I guess test was a big bottleneck for internal supply 3, 6 months ago. Any changes there? And in terms of foundry wafer supply, again, any signs of easing? And kind of related to that, there have been some headlines about foundry wafer pricing increasing again in late '22 going into '23. Is that sort of the indication you're getting from your suppliers? And if so, are you comfortable that you'd be able to pass those through to your customers?"
},
{
"speaker": "Vincent Roche",
"text": "Well, I think the last part of your question, first, on pricing increases, I believe that we are in the post-Moore's Law era and in a period of sustained structural inflation in this business for many, many years ahead. I think it's true to say that supply -- we've been increasing, of course. We've invested strongly in our own manufacturing capabilities to be able to secure supply and increase supply actually across the four wafer fabs inside ADI. So yes, supply is improving there. And thematically as well as supply has been improving actually right through the pandemic, right over the last couple of years from our subcontractors as well. So I think there is a lightening of supply across the board."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "On pricing, maybe I'll just restate what we said in the past. We are not using this environment to take advantage of our customers, and we are really looking to maintain our gross margin model. And the rationale on that gross margin model, which is important to us, is we know, as Vince mentioned, we spend at a healthy clip on R&D to develop highly innovative products, and we need to capture that innovation premium from our customers. So as our costs may increase, it's important that we continue to capture those cost increases back with stable margins because it's a reflection of the value we're bringing to our customers."
},
{
"speaker": "Operator",
"text": "Our next question will come from Harlan Sur with JPMorgan. Please go ahead."
},
{
"speaker": "Harlan Sur",
"text": "Just one clarification. So I just wanted to verify, so you guys said that currently, quarter-to-date, your book-to-bill is still greater than one. That's my clarification question. Then my main question is distribution represents about 60% of the team's revenues, right? And it looks like just the inventories are still below your target levels of 7 to 8 weeks. Obviously, the eventual catch-up should provide you guys with some cushion if the environment continues to weaken further. But that being said, it still feels like auto and industrial demand is still quite strong. So given your outlook, like what's your view on getting to target levels on channel inventories over the next few quarters?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thanks, Harlan. Your -- first of all, say that you recapped it correctly, and there is some opportunity for us to continue to grow our revenue by bringing distis levels back to our healthy target level. But I want to emphasize that the guide, as Mike mentioned, the guide for the fourth quarter is on the basis of POS equals POA. One thing that ADI has been very consistent about for many years is we run our business on POS. So we need to look at end demand, and end demand drives how we end up manufacturing, and we want distis to be able to help us with access for those products, but we are not looking for distribution to be an excess buffer of inventory."
},
{
"speaker": "Michael Lucarelli",
"text": "And the one other part of the question that you had, Harlan, was book-to-bill. Yes, for the quarter, book-to-bill was still well above one at enterprise level. That was driven by industrial and auto with the two strongest markets, while comms and consumer, we'll call about flat, around one. And with that, may we have our last question, please?"
},
{
"speaker": "Operator",
"text": "Our last question will come from Ross Seymore with Deutsche Bank. Please go ahead."
},
{
"speaker": "Ross Seymore",
"text": "Vince, a lot of questions about near-term cancellations, bookings, backlog, all those sorts of things. I wanted to ask a slightly longer one. You mentioned in answer to an earlier question about we're in a post-Moore's Law world. We're going to have an inflationary environment rather than deflationary. Can you just talk a little bit about how the customer conversations have changed? Over the last few months, we've heard a lot from last year, a lot from companies saying it's more of a partnership, longer lead times, et cetera, long-term supply agreements, those sorts of things. Do you still see that behavior continuing? Or do you believe that's a little bit more of a reflection of cyclical tightness and you expect some of that to unwind as well?"
},
{
"speaker": "Vincent Roche",
"text": "Yes, it's a very good question. I've had a lot of conversations, Ross, over the last couple of years with CEOs of the biggest enterprises in the world of information. And what I can tell you for sure is that everybody wants to get closer to their key suppliers when it comes to aligning product roadmaps for the long term. Particularly companies that are perceived as being critical for their innovation processes. So I can tell you that continues. And the other side of the equation is everybody wants to understand at the customer side of things, what do they need to do to secure supply for the long term? And what kind of arrangements that they need to put in place? What kind of information flows? What kind of models that we develop between each other? So that continues. And I think it has been firmly established now that semiconductors are the bedrock of the modern -- of modern socioeconomic life. So the conversations continue intensively, I would say, and I expect that to continue well into the future."
},
{
"speaker": "Michael Lucarelli",
"text": "And with that, thanks, everyone, for joining our call this morning. I did want to flag that during these more uncertain times and consistent with our commitment to transparency for our owners, we'll be even more available. Vince and Prashanth will be in New York, L.A., the Bay Area, Chicago and across Europe in the next quarter, so it's a busy quarter coming up for us. Please reach out to myself or the IR team if you'd like to be notified when we're in your neighborhood. And with that, thanks for joining us and your continued interest in ADI."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 2 | 2,022 | 2022-05-18 10:00:00 | Operator: Good morning, and welcome to the Analog Devices Second Quarter Fiscal Year 2022 Earnings Conference Call, which is being audio webcast via telephone and over the web. I would like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations. Sir, the floor is yours.
Michael Lucarelli: Thank you, Katrina, and good morning, everybody. Thanks for joining our second quarter fiscal 2022 call. With me on the call today are ADI's CEO and Chair, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. On to the disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our earnings release and our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are also included in today's earnings release. And with that, I'll turn it over to ADI's CEO and Chair, Vincent Roche. Vince?
Vincent Roche : Thank you, Mike, and a very good morning to you all. Well, I'm very pleased to report that ADI delivered another quarter of record revenue, profitability and earnings, driven by continued insatiable demand for our products, strong operational execution and accelerated synergy capture. Moreover, amidst a dynamic macro environment, we're operating from a position of remarkable strength, supported by our record backlog, robust bookings and ongoing capacity expansions, which position us favorably as we enter the second half. Now moving to a summary of our results. Revenue was $2.97 billion, above the high end of our outlook and up 28% year-over-year on a pro forma basis. Strength was broad-based with all segments up double digits year-over-year. Impressively, adjusted gross margin expanded to 74% and operating margin to 50%. Adjusted EPS was $2.40, exceeding the high end of outlook and increasing over 50% from the year ago period. Overall, I'm very excited with our performance and our team's outstanding execution. Today, I'd like to reinforce what we shared at our Investor Day around how our markets are evolving and how we're investing to solve more of our customers' problems while also improving on our business model that's both rich with growth opportunities and, indeed, resiliency. The next wave in the evolution of the ICT sector is the nascent Intelligent Edge revolution. It will be characterized by ubiquitous sensing, hyperscale computing and pervasive connectivity, pushing processing and intelligence closer to the edge. Semiconductors are the bedrock enabling this next wave. And ADI, where data is born, is at the center of this revolution. At our core, we're an innovation-driven enterprise over the last decade through both robust organic investments and strategic M&A. We've built the industry's broadest and highest performance analog, mixed signal and power portfolio. Our offerings span from microwave to bits, nanowatts to kilowatts, sensor to cloud and increasingly from components to subsystems. Our vast arsenal of technologies, along with the deep level of engagement and support we provide our customers, has earned us the number 1 positions in analog, mixed signal, RF and high-performance power. This, coupled with our focus on customer success, awards ADI with an innovation premium that is reflected in our ASPs that are more than 3x the industry average and also industry-leading gross margins. The growing scope of our customers' products is dramatically expanding in complexity and pressuring their product development teams and innovation cycles. To meet these challenges and deliver the next wave of disruptive innovations, we're investing over $1.6 billion in R&D annually. These investments strengthen our broad market franchise and enable us to expand our SAM and vertical applications where more complete solutions are necessary. We achieved this by integrating our core analog technologies with increasing levels of digital algorithms and software. Now let's look at how our technology is intersecting with our markets. Industries like transportation, energy, telecoms, manufacturing and health care are prioritizing digitalization. This is driving new generations of applications and fueling a host of concurrent secular growth trends, and I'd like to touch on just a few now. Starting with automotive. Here, ADI is the market leader in battery management systems, for example, for EVs. Our battery management systems, or BMS, solutions offer customers the highest levels of accuracy, reliability, safety and security. Our wireless BMS solution offers all the benefits of wired but also enables rapid battery pack configurability and cost-effective scaling of our customers' EV fleets. This innovative solution continues to gain traction in the market and adds to our content per system by up to 2x. Moving to communications, where ADI is the market leader in radio signal chains for 5G with a majority share across the ecosystem. Our latest generation transceiver includes a fully integrated digital front end and grows our SAM by 2x. This innovative radio architecture reduces system cost and waste and improves power efficiency. Further, the flexibility of these software-defined solutions allows them to be used across traditional 5G networks as well as an emerging Open RAN and LEO satellite networks. Lastly, health care. We have a number 1 position with dominant share in medical imaging, for example. Subsystems like our photons to bits module are used by the top CT players in the world. Our solution delivers the highest-fidelity images while decreasing radiation dosage. And in the process, it allows us to capture 4x the SAM compared to offering just components alone. In addition to expanding our innovation edge across these secular trends to amplify growth, the Maxim combination creates a $1 billion revenue synergy opportunity for us over the next 5 years. The first opportunity arises from customer cross-selling, leveraging our complementary relationships to pull through our extended portfolio. Second is fusing together the new product road maps of these 2 premier Analog portfolios to push the boundaries of what's possible. And third is power management. Here, the combination with Maxim increases our breadth of power capabilities, creates a more cost competitive portfolio and adds to our engineering talent pool. As a result, we unlocked $4 billion of additional power SAM and look to double our power revenue in the years ahead. The proliferation of the Intelligent Edge and our revenue synergy opportunity gives me great confidence that we can bend the growth curve upwards, moving from our historical mid-single-digit growth rate to our new model of 7% to 10%. Now I'd like to speak a little to the unique resiliency of our business. The diversity of our portfolio is a source of great strength. We shipped 75,000 product SKUs, which support thousands of applications to over 125,000 customers. Notably, 80% of our revenue is derived from products that individually contribute no more than 0.1% of total revenue. And the longevity of our products is unmatched. On average, our products have life spans of a decade or more, effectively delivering recurring revenue streams for decades. It's these characteristics that create a high barrier to entry and an enduring business model. Finally, we utilize a geographically diverse hybrid manufacturing strategy to attain the complexity and fragmentation of the Analog market. This strategy provides us with a broad array of technology and packaging necessary to create innovative solutions from 7 nanometers to 7 micrometers. At the same time this model creates a diverse network of internal and external partners to best manage our operations through economic cycles. As we mentioned at our Investor Day, we're investing in our internal manufacturing operations to build a more robust and cost-effective model. To that end, we're doubling the capacity of our internal factories and adding significant capital to our product test operations. These investments will grow our output this year and into 2023 and increase our swing capacity across our network to over 70% of revenue. So in closing, ADI is a leader in innovating at the edge, and I believe that our best days are still ahead of us as we drive increased value for our customers, shareholders and society. And with that, I'm going to pass it over to Prashanth, who will take you through the financial detail.
Prashanth Mahendra-Rajah : Thank you, Vince. Let me add my welcome to our second quarter earnings call. It was great to see and hear from so many of you at our Investor Day last month, and it was also exciting to welcome so many of our customers to demonstrate our technologies in action. As usual, my comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today's press release. We printed another very impressive quarter with record revenue, profitability and earnings. These strong results reflect increasing demand for our highly differentiated products aligned to multiple secular trends as well as our ability to leverage our hybrid manufacturing model, offset inflation and accelerate synergy capture. Second quarter revenue of $2.97 billion finished above the high end of our outlook, with every B2B end market exceeding initial expectations. This marks our fifth consecutive quarter of record revenue and our ninth straight sequential growth period. So let's look at the performance by end market. Industrial, our most diverse and profitable end market, represented 51% of revenue and hit another all-time high. We experienced broad-based growth with digital health care, automation, instrumentation and test leading the way, underscoring increasing content and our strong position in these secular markets. Industrial has now grown more than 20% year-over-year for 6 straight quarters. Automotive, which represented 21% of revenue, also achieved another record with all applications growing double digits year-over-year. In BMS, where we hold the number 1 position, our quarterly revenue eclipsed $100 million for the first time. We expect strong growth to persist, given the momentum in the market and our continued design wins. Additionally, our A2B and GMSL solutions, which together make up roughly 20% of automotive, continued on their secular growth path fueled by the digitalization of the automobile. Communications represented 16% of revenue with robust broad-based growth. In wireless, we experienced growing demand across our RF portfolio as 5G deployments, particularly in North America, gained momentum. ADI's latest generation transceiver, which Vince spoke to, is ideally positioned to capitalize on the virtualization trend. In wireline, demand for our optical and power products remained strong as carriers and hyperscalers invest to meet the ever-growing demand for bandwidth. And lastly, the consumer represented 12% of revenue and has now grown year-over-year for 6 straight quarters. This consistent growth is a function of our product and customer breadth, which better insulates us from the typical fluctuations associated with PCs and portable devices. Now on to the P&L. Gross margin was a record 74.2%, increasing 230 basis points sequentially and 330 basis points year-over-year. Favorable product mix, high utilization and revenue growth and synergy fall-through were key drivers of the increase. OpEx in the quarter was $710 million, better than anticipated, owing to faster synergy execution. Record operating margins of 50.3% grew 450 basis points sequentially and 860 basis points year-over-year. At the end of the second quarter, we've realized over $250 million of cost synergies. We look to quickly achieve the remaining synergies and hit our recently increased target of $400 million in savings exiting fiscal '23. Non-op expenses were $41 million and the tax rate for the quarter was 13.2%. All told, adjusted EPS came in at a record $2.40, up more than 50% versus the second quarter 2021. And now on to the balance sheet. We ended the quarter with approximately $1.7 billion of cash and equivalents. Days of inventory increased sequentially to 122 and channel inventory remains below the low end of our 7- to 8-week target. If we look at cash flow, CapEx for the quarter was $119 million and $447 million over the trailing 12 months or 5% of revenue. To support our accelerated 7% to 10% long-term revenue growth outlook, we are strategically investing to expand internal capacity while enhancing the resiliency of our hybrid model. To that end, as we stated at Investor Day, we expect CapEx as a percentage of revenue to be in the high single digits during fiscal '22 and '23 before reverting back to 4% to 6% over the long term. And over the trailing 12 months, we generated $3.2 billion of free cash flow or 33% of revenue. Included in our free cash flow are onetime transaction-related costs amounting to about 3% of revenue. Given the recent market weakness, we accelerated our repo activity to $776 million during the second quarter. This brings our total share repurchase to approximately $3.5 billion since the close of Maxim. And we look to maintain this accelerated buyback pace this quarter and achieve our $5 billion commitment by the end of our fiscal year. As a reminder, we target 100% free cash flow return. We will allocate 40% to 60% of our free cash flow to support a 10% dividend CAGR throughout the cycle, with the remaining cash used for buybacks to reduce share count annually. And now on to the outlook for third quarter. Revenue is expected to be $3.05 billion, plus or minus $100 million. We expect all end markets to grow sequentially. Given our higher-than-normal annual merit increase, operating margin is expected to be 49.5%, plus or minus 70 bps. And our tax rate is expected to be between 13% and 14%. Based on these inputs, adjusted EPS is expected to be $2.42, plus or minus $0.10. While we are very mindful of the current economic trends, our demand indicators remain very strong and our customer conversations remain upbeat, giving us confidence for continued growth for the remainder of 2022 and likely into 2023. Importantly, as a result of our vast diversification, leadership in numerous secular growth markets, additional synergies and our resilient hybrid manufacturing model, we believe ADI has never been better positioned to transcend cyclical downturns and accelerate long-term growth. Let me now give it back to Mike to start the Q&A.
Michael Lucarelli: Thanks, Prashanth. Let's get to our Q&A session. [Operator Instructions] With that, Katrina, can we have our first question, please?
Operator: [Operator Instructions] Our first question comes from Tore Svanberg with Stifel.
Tore Svanberg: Congratulations on all the record results, especially on that 50% operating margin. My question is for Vince. Vince, towards the end of your remarks, you talked about growing output to increase swing capacity to 70% of revenues. Could you perhaps elaborate a little bit on that? And what is sort of the time line exactly for when you would hit that number?
Vincent Roche: Yes. So as you know, Tore, we've been investing in our internal semiconductor manufacturing operations from 0.18 micron upwards, and we're doubling the output there over the next year or thereabouts, a year or 15 months. And of course, we cross-license technologies with some of our foundry partners. So when we talk about a 70% swing, it means that because we will have cross-qualified so many process technologies between ADI internal fabs and the external fabs that are controlled by our foundry partners, we got the ability to move utilization, if you like, from 1 place to another, depending on what part of the cycle we're in, in terms of managing utilization inside ADI and being able to meet the demand as it surges or declines.
Operator: And your next question is from Stacy Rasgon with Bernstein Research.
Stacy Rasgon : I wanted to ask about the gross margins. You mentioned a bunch of drivers, but you actually didn't mention pricing at all in your outlook there for the driver side. I mean, what impact has pricing had either to offset inflation or to potentially reprice the Maxim portfolio after the closure? And I guess, how do we think about the forward gross margin trajectory at these current, like, revenue levels? I mean, is there room for it to even go up from here, assuming the revenue levels kind of stay on the current trajectory?
Prashanth Mahendra-Rajah: Thank you for the question. So as you know, we, along with the rest of the industry, has been passing along the higher costs. We have been very focused on not using this environment to take advantage of our customers but to really maintain our gross margins. So in '21, we had some headwind from the timing of inflation versus when we were able to enact the pricing. This has really abated in '22. So really, the gross margin percentage and the growth in gross margin percentage that you see is really being driven, as I mentioned, by the synergies, great utilization at the internal fabs and some mix benefits. I think in my prepared remarks, I talked about industrial hitting 51% of the overall revenue mix. So for the forward look, we updated our model just a couple of weeks back, and we feel very comfortable that in a typical cycle trough, we are going to be able to maintain a 70% floor. Beyond that, we will continue to make the right trade-offs with opportunities to expand the top line and -- at some trade-off on gross margin. So really the focus for the team is deliver the revenue growth and let that leverage drive all the way down through cash flow. So I wouldn't encourage folks to look for significant margin expansion. These are already pretty incredible numbers.
Stacy Rasgon : But if the revenues kind of stay at this trajectory, can at least the gross margins stay where they are or will they just fluctuate around? Will like mix be the biggest driver from here?
Prashanth Mahendra-Rajah: Yes, that's the right way to think about it, yes.
Michael Lucarelli: You're right. If you look at our build margins at this point going forward, it's mix, utilization and then we also have the $125 million of synergies, some of that will be on the cost of goods sold side. As Prashanth laid out, we'll balance both gross margins really to drive operating margins and free cash flow.
Operator: And your next question is from Vivek Arya with Bank of America Securities.
Vivek Arya: Vince, I think or Prashanth mentioned that industrial sales have grown over, I believe, it's over 25% for the last 6 quarters and seem like they could be strong for another 2 or 3 quarters. I'm curious, how do you think about the normalized growth rate? And what macro indicators do you look at to say this is what ADI's industrial growth should be? Like what are the early signals that you get to give you a sense whether you're over- or under-shipping end demand? Because from the outside, we look at all the turmoil in China, we look at all the turmoil in Europe, but then we look at this very strong industrial growth number and it gets harder to kind of reconcile, right, these 2 narratives. So give us a sense for how do you feel about specifically your industrial business right now?
Vincent Roche: Yes. Thanks, Vivek. So first and foremost, it's a highly diversified industrial business that we've been diligently investing in from an R&D perspective, from a customer engagement perspective over the last decade or 12 years with a renewed focus. We've been gaining share very, very clearly. I think our portfolio, particularly combined with the power activity as well from the LTC and Maxim acquisitions puts us in even better stead to capture more SAM essentially. And to your question on growth, I would say that we -- during the Investor Day, we said that the new model is 7% to 10%. So I think industrial is going to be right in there somewhere over time. And we feel more confident now, I think, about our industrial growth than we've ever done, just given the strength of the portfolio, the customer engagements and so on. And in terms of the signals we watch, obviously, we have a lot of conversations with our customers. I personally have had a stream of conversations with many of our largest industrial customers over the last quarter. And I think what they're all trying to convey to us is that things are different. We're moving into a new industrial cycle, Industry 4.0, 5.0, IoT, or I beg your pardon, IT and OT, if you like, colliding in a new partnership for the future, driving a lot of new technologies. So that's one, obviously 1 stream of input we get. The other signals we look at, obviously, are the PMIs, the machine to builders indexes and so on and so forth. Well, I think the greatest source of insight for us is our own knowledge of the end applications coupled with our customers' insights.
Prashanth Mahendra-Rajah: Vivek, maybe I'll just add. I think I said it in the remarks, but to be clear to everyone, our growth in industrial was broad. All applications hit record results in '21 and are on track to hit another record in '22.
Operator: Your next question is from C.J. Muse with Evercore.
C.J. Muse: I guess a comment on my side. With these results, I'm surprised you didn't have Big Papi and Tom Brady at your Analyst Day. So next time. So to my question, your results are much better than your peers. Your B2B business, I think, up 11% versus your peers [at] mid-single digits. How do you think about the outperformance there? Is a part of that your ability to source incremental supply, market share gains, right mix? Would love to hear your thoughts there. And then as you think about the future going into the second half of this year and next, how does that inform your vision for continued outperformance?
Prashanth Mahendra-Rajah: Yes. Maybe I'll start and then hand to -- hand over to Vince. So on the tactical side, we are working on getting additional capacity both from our external partners as well as the investments we're making internally. So you'll see that continue to play out over the course of the year, which is why I mentioned in the prepared remarks, look for us to continue to grow sequentially through this year and likely at least into the early part of next year. We talked about pricing that has been a little bit incremental to the revenue growth. So that's certainly a piece of it. And the demand has just been very broad-based. And again, I said it in my remarks but to be clear, we are seeing demand across all end markets and all geographies. It's very evenly spread and strength across all end applications. So we do feel, to Vince's remarks here, we do feel very well positioned and our technology is really starting to hit the sweet spot across all of our customers. And then maybe I'll pass here to Vince to add some more.
Vincent Roche: Maybe just a little bit of color on the markets, C.J., to try and answer your question. So we have so many vectors of growth now, for example, in industrial, where we're basically playing on all the high-end applications. And as I said, we've been tuning the R&D continuously, the customer engagement. And if I just pick out health care as an example, that's beginning to get on to a $1 billion run rate now. It's been growing consistently for the last 7, 8 years in the -- at the double-digit level. Aerospace and defense, we see that actually, no matter what the cycle will be over the next few years, this is going to be an area of great strength for us. And in the communications area, great position in 5G. But interestingly, our wireline and data center business now is on a par with the wireless sector in terms of revenue contribution. So it's kind of half-and-half. So we see that again as a source of strength, buttressed also by a lot of the technologies that Maxim are bringing to that wireline area. Automotive, we have a great story on the in-cabin experience with A2B, cancellation, premium sign systems being more and more deployed, electrification. We're on a [100] a quarter run rate now, revenue run rate. And we have design-ins at virtually all the electric car companies at this point in time. So we see that on a trajectory to $1 billion-plus in the foreseeable future. So that's just some of the examples to complement what Prashanth has narrated as well in terms of the vectors of growth and prosperity for the company.
Operator: Your next question is from Ambrish Srivastava from BMO.
Ambrish Srivastava: I had a question on the cost synergies, Prashanth. How should we be modeling these on a go-forward basis? You said exiting fiscal '23, but what's the breakout? And then kind of related to that is when we're talking about gross margin, I was a little bit surprised that you said the inflationary pressure would be abating as we go into -- as we continue through this year. Did I catch that right? Because inflation, the headline numbers seem to be -- they haven't -- maybe they have peaked but definitely higher than where they were last year. So would love some color on that comment as well.
Prashanth Mahendra-Rajah: Yes. Thanks, Ambrish. Two good questions, and thanks for giving me the opportunity to clarify. So first, on synergies. We had talked, when we did the Maxim closed that we had some great learnings from LTC on how to get to synergies and that was to move fast and hard, and you're seeing us execute against that strategy. So we captured basically the entire $275 million that we originally committed to as we exited our second quarter. And that at Investor Day, we said we're raising that target to $400 million, and we'll hit that number coming out of -- or as we exit 2023. That first $275 million was a little more tilted towards cost of goods, and the following piece will sort of be balanced between cost of goods and OpEx. So as you look forward, that's how to think about the balance of that. To your question on the comments I made, thank you for giving me a chance to clarify. We have used our pricing opportunities to maintain gross margin. So to be clear, we're not looking at pricing as an opportunity to expand gross margin but really as a way to offset. So when I said abate inflation, I meant versus the historical inflation that we had experienced in 2021. It took us a little bit longer to get those pricing actions in place. So now we have neutralized them and you see that benefit in the current year. And of course, if we do continue to see price increases -- sorry, cost increases in the coming quarters, expect us, like the rest of the industry, to respond by pushing those through.
Ambrish Srivastava: So there's no artifact in the 74% that you reported this quarter for pricing? We should expect kind of that level on a go-forward basis, maybe bounce around based on mix and also the utilization rate?
Michael Lucarelli: Ambrish, this is Mike. Yes, as we had talked about earlier, going forward, that 74% will bounce around, like you said, mixed utilization of the 2 drivers. And then as Prashanth outlined, that [1 25] does have a COGS element in it that will also help gross margins. But if you go forward 74%, plus/minus, I feel pretty good about that.
Prashanth Mahendra-Rajah: With the caveat, again, I want to make it clear for everyone, with the caveat that we are focused on growth. So where it makes sense for us to be a little more flexible to drive top line, we will do that. So I wouldn't want folks getting too laser-focused on modeling in mid-70s on the gross margin. We've given you a floor and we will give the management team the flexibility they need to drive the top line.
Ambrish Srivastava: Right. You've been very consistent about that.
Operator: Your next question is from Chris Danely with Citigroup.
Chris Danely: So with all this talk on revenue growth, your forecasted sequential revenue growth for July is the slowest in a couple of years. Can you talk about why that's happening? And is that because of COVID shutdowns or something else? And then as part of that, with all this focus on increasing capacity, I would assume your capacity is growing faster than the 2% or 3% sequential revenue growth. So can we assume that the lead times are coming in this quarter as well?
Prashanth Mahendra-Rajah: Yes. So Chris, the sequential growth is constrained by capacity. But we've indicated that we will see sequential growth through the year. So look for a more meaningful change as we get past the third quarter, which we've been saying for a while. So if you look back at prior comments, we've been very clear that we've ordered the tools and the equipment. We know our position in the queue. We know when those are coming in, and they go to revenue generation fairly quickly. So we are maintaining our outlook that we will exit the year at a much higher run rate than where we are now. And that is all driven by our ability to produce. And what was the second question?
Chris Danely: Perfect.
Michael Lucarelli: Yes. Chris, I'll also add 1 thing. You're right, the sequential growth is, I'll call it, decelerating now. What happened in the first half of the year, we talked about, we added pricing and that added to the growth. We had volume and pricing in the first half of the year that's driving sequential. Pricing is really in the model now, now that the growth in the back half on a sequential basis is really driven by capacity and volume. And if you zoom out and don't look at sequentials and look at year-over-year, we're growing our B2B business in our fiscal third quarter by over 20% year-over-year again. So it's a fantastic result, I think, and it shows the strength of this franchise.
Prashanth Mahendra-Rajah: Yes. I think we can give everyone the data point that on a sequential basis, think of it as 50-50. The growth is coming from pricing versus units. So that falls into the baseline sequentially as we go forward, pricing falls into the baseline.
Operator: Your next question is from William Stein with Truist Securities.
William Stein: I’ll add my congratulations to the very strong revenue and profitability and the outlook as well. That was great. But despite all that good stuff, there’s a few factors that investors are certainly concerned about potentially disrupting bookings and potentially revenue performance, of course, the war in Ukraine, the COVID shutdowns in China and raising rates. But there’s also a concern maybe not as prominent, but – that we’ve picked up on, which is customers adjusting orders, potentially ancelling or pushing out because they’re very challenged from a kitting perspective. You highlighted yourself that you’re capacity constrained. Can you help us understand how those factors are affecting your business today and how you anticipate them playing out in your business over the next few quarters?
Vincent Roche: Yes. So I think first and foremost, cancellations on ADI are very, very low. They’re very muted. Customers – we’ve been very equitable in terms of how we have moved our supply across the markets, across the geographies, across the customer sizes. And I think that still is in very, very good stead. So my sense is we have – because of the equitable distribution of our goods, so to speak, we’ve got a better, more true read on demand. And I think what we’re shipping reflects what is true demand, I think better than most, I believe, based on feedback I’m getting from customers. So I think those are the facts, cancellations low, equitable distribution of goods. And we don’t see any – our backlog is still, actually during the last quarter, increased so demand continues to remain strong.
A –Prashanth Mahendra-Rajah: Yes. Just the numbers. Well, the book-to-bill is above 1 in the second quarter, and that was, again, by all end markets and geographies. Because of that, the backlog continued to grow. You asked specifically about China. So real quickly, that’s about 20% of our revenue. And the lockdowns had some impact on customer production, but it was really more severe around logistics and the supply chain related to the greater Shanghai area. Our China revenue was up quarter-over-quarter and year-over-year and no notable impacts to demand. Again, cancellations normal, and as I mentioned, book-to-bill above 1 for China. So when our guide reflects that most customers are operating at relatively normal levels and we consider this dynamic, so we think that at least for the third quarter, it’s going to be a negligible impact.
Vincent Roche: Yes. Just add a little bit of color. Also, we have no internal manufacturing operations in China. And from a logistics standpoint as well, we have very, very modest operations also in China.
A –Michael Lucarelli: We’ll go to our last question, please.
Operator: Our last question is from Toshiya Hari with Goldman Sachs.
Prashanth Mahendra-Rajah: Toshi, are you on? Toshi may be on mute. Do we have 1 more in the queue?
Michael Lucarelli: Do we have 1 more in the queue?
Operator: Our next question is from Gary Mobley with Wells Fargo Securities.
Gary Mobley: I wanted to ask a follow-up question on backlog. I think you mentioned that based on the backlog and adding incremental supply, your expectation is for sequential revenue growth for at least maybe the next few quarters, maybe 3, maybe 4 quarters. Wondering to what extent have you stress tested your backlog to see, I guess, under the most bearish of circumstances, how that may trend if perhaps we see further deterioration in the economic backdrop and whatnot?
Prashanth Mahendra-Rajah: Yes. Gary, a fair question. The -- as Vince mentioned, we look at a number of external indicators. So we are mindful of what's happening in the macro environment. But as you mentioned, the conversations that he has with our customers continue to support their need for our products and that we are attached to the right secular driver. So I do want to clarify, you had said sequential growth for the next 3 to 4 quarters. I can't see out that far, Gary. I feel good about the next 2 to 3 quarters sequential growth, but I'm not sure I want to go out further than that at this point.
Michael Lucarelli: Thanks, everyone, for joining us this morning. A copy of the transcript will be available on our website. Thanks again for joining the call and your continued interest in Analog Devices.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices Second Quarter Fiscal Year 2022 Earnings Conference Call, which is being audio webcast via telephone and over the web. I would like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Katrina, and good morning, everybody. Thanks for joining our second quarter fiscal 2022 call. With me on the call today are ADI's CEO and Chair, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. On to the disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our earnings release and our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations as of the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are also included in today's earnings release. And with that, I'll turn it over to ADI's CEO and Chair, Vincent Roche. Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thank you, Mike, and a very good morning to you all. Well, I'm very pleased to report that ADI delivered another quarter of record revenue, profitability and earnings, driven by continued insatiable demand for our products, strong operational execution and accelerated synergy capture. Moreover, amidst a dynamic macro environment, we're operating from a position of remarkable strength, supported by our record backlog, robust bookings and ongoing capacity expansions, which position us favorably as we enter the second half. Now moving to a summary of our results. Revenue was $2.97 billion, above the high end of our outlook and up 28% year-over-year on a pro forma basis. Strength was broad-based with all segments up double digits year-over-year. Impressively, adjusted gross margin expanded to 74% and operating margin to 50%. Adjusted EPS was $2.40, exceeding the high end of outlook and increasing over 50% from the year ago period. Overall, I'm very excited with our performance and our team's outstanding execution. Today, I'd like to reinforce what we shared at our Investor Day around how our markets are evolving and how we're investing to solve more of our customers' problems while also improving on our business model that's both rich with growth opportunities and, indeed, resiliency. The next wave in the evolution of the ICT sector is the nascent Intelligent Edge revolution. It will be characterized by ubiquitous sensing, hyperscale computing and pervasive connectivity, pushing processing and intelligence closer to the edge. Semiconductors are the bedrock enabling this next wave. And ADI, where data is born, is at the center of this revolution. At our core, we're an innovation-driven enterprise over the last decade through both robust organic investments and strategic M&A. We've built the industry's broadest and highest performance analog, mixed signal and power portfolio. Our offerings span from microwave to bits, nanowatts to kilowatts, sensor to cloud and increasingly from components to subsystems. Our vast arsenal of technologies, along with the deep level of engagement and support we provide our customers, has earned us the number 1 positions in analog, mixed signal, RF and high-performance power. This, coupled with our focus on customer success, awards ADI with an innovation premium that is reflected in our ASPs that are more than 3x the industry average and also industry-leading gross margins. The growing scope of our customers' products is dramatically expanding in complexity and pressuring their product development teams and innovation cycles. To meet these challenges and deliver the next wave of disruptive innovations, we're investing over $1.6 billion in R&D annually. These investments strengthen our broad market franchise and enable us to expand our SAM and vertical applications where more complete solutions are necessary. We achieved this by integrating our core analog technologies with increasing levels of digital algorithms and software. Now let's look at how our technology is intersecting with our markets. Industries like transportation, energy, telecoms, manufacturing and health care are prioritizing digitalization. This is driving new generations of applications and fueling a host of concurrent secular growth trends, and I'd like to touch on just a few now. Starting with automotive. Here, ADI is the market leader in battery management systems, for example, for EVs. Our battery management systems, or BMS, solutions offer customers the highest levels of accuracy, reliability, safety and security. Our wireless BMS solution offers all the benefits of wired but also enables rapid battery pack configurability and cost-effective scaling of our customers' EV fleets. This innovative solution continues to gain traction in the market and adds to our content per system by up to 2x. Moving to communications, where ADI is the market leader in radio signal chains for 5G with a majority share across the ecosystem. Our latest generation transceiver includes a fully integrated digital front end and grows our SAM by 2x. This innovative radio architecture reduces system cost and waste and improves power efficiency. Further, the flexibility of these software-defined solutions allows them to be used across traditional 5G networks as well as an emerging Open RAN and LEO satellite networks. Lastly, health care. We have a number 1 position with dominant share in medical imaging, for example. Subsystems like our photons to bits module are used by the top CT players in the world. Our solution delivers the highest-fidelity images while decreasing radiation dosage. And in the process, it allows us to capture 4x the SAM compared to offering just components alone. In addition to expanding our innovation edge across these secular trends to amplify growth, the Maxim combination creates a $1 billion revenue synergy opportunity for us over the next 5 years. The first opportunity arises from customer cross-selling, leveraging our complementary relationships to pull through our extended portfolio. Second is fusing together the new product road maps of these 2 premier Analog portfolios to push the boundaries of what's possible. And third is power management. Here, the combination with Maxim increases our breadth of power capabilities, creates a more cost competitive portfolio and adds to our engineering talent pool. As a result, we unlocked $4 billion of additional power SAM and look to double our power revenue in the years ahead. The proliferation of the Intelligent Edge and our revenue synergy opportunity gives me great confidence that we can bend the growth curve upwards, moving from our historical mid-single-digit growth rate to our new model of 7% to 10%. Now I'd like to speak a little to the unique resiliency of our business. The diversity of our portfolio is a source of great strength. We shipped 75,000 product SKUs, which support thousands of applications to over 125,000 customers. Notably, 80% of our revenue is derived from products that individually contribute no more than 0.1% of total revenue. And the longevity of our products is unmatched. On average, our products have life spans of a decade or more, effectively delivering recurring revenue streams for decades. It's these characteristics that create a high barrier to entry and an enduring business model. Finally, we utilize a geographically diverse hybrid manufacturing strategy to attain the complexity and fragmentation of the Analog market. This strategy provides us with a broad array of technology and packaging necessary to create innovative solutions from 7 nanometers to 7 micrometers. At the same time this model creates a diverse network of internal and external partners to best manage our operations through economic cycles. As we mentioned at our Investor Day, we're investing in our internal manufacturing operations to build a more robust and cost-effective model. To that end, we're doubling the capacity of our internal factories and adding significant capital to our product test operations. These investments will grow our output this year and into 2023 and increase our swing capacity across our network to over 70% of revenue. So in closing, ADI is a leader in innovating at the edge, and I believe that our best days are still ahead of us as we drive increased value for our customers, shareholders and society. And with that, I'm going to pass it over to Prashanth, who will take you through the financial detail."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Let me add my welcome to our second quarter earnings call. It was great to see and hear from so many of you at our Investor Day last month, and it was also exciting to welcome so many of our customers to demonstrate our technologies in action. As usual, my comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today's press release. We printed another very impressive quarter with record revenue, profitability and earnings. These strong results reflect increasing demand for our highly differentiated products aligned to multiple secular trends as well as our ability to leverage our hybrid manufacturing model, offset inflation and accelerate synergy capture. Second quarter revenue of $2.97 billion finished above the high end of our outlook, with every B2B end market exceeding initial expectations. This marks our fifth consecutive quarter of record revenue and our ninth straight sequential growth period. So let's look at the performance by end market. Industrial, our most diverse and profitable end market, represented 51% of revenue and hit another all-time high. We experienced broad-based growth with digital health care, automation, instrumentation and test leading the way, underscoring increasing content and our strong position in these secular markets. Industrial has now grown more than 20% year-over-year for 6 straight quarters. Automotive, which represented 21% of revenue, also achieved another record with all applications growing double digits year-over-year. In BMS, where we hold the number 1 position, our quarterly revenue eclipsed $100 million for the first time. We expect strong growth to persist, given the momentum in the market and our continued design wins. Additionally, our A2B and GMSL solutions, which together make up roughly 20% of automotive, continued on their secular growth path fueled by the digitalization of the automobile. Communications represented 16% of revenue with robust broad-based growth. In wireless, we experienced growing demand across our RF portfolio as 5G deployments, particularly in North America, gained momentum. ADI's latest generation transceiver, which Vince spoke to, is ideally positioned to capitalize on the virtualization trend. In wireline, demand for our optical and power products remained strong as carriers and hyperscalers invest to meet the ever-growing demand for bandwidth. And lastly, the consumer represented 12% of revenue and has now grown year-over-year for 6 straight quarters. This consistent growth is a function of our product and customer breadth, which better insulates us from the typical fluctuations associated with PCs and portable devices. Now on to the P&L. Gross margin was a record 74.2%, increasing 230 basis points sequentially and 330 basis points year-over-year. Favorable product mix, high utilization and revenue growth and synergy fall-through were key drivers of the increase. OpEx in the quarter was $710 million, better than anticipated, owing to faster synergy execution. Record operating margins of 50.3% grew 450 basis points sequentially and 860 basis points year-over-year. At the end of the second quarter, we've realized over $250 million of cost synergies. We look to quickly achieve the remaining synergies and hit our recently increased target of $400 million in savings exiting fiscal '23. Non-op expenses were $41 million and the tax rate for the quarter was 13.2%. All told, adjusted EPS came in at a record $2.40, up more than 50% versus the second quarter 2021. And now on to the balance sheet. We ended the quarter with approximately $1.7 billion of cash and equivalents. Days of inventory increased sequentially to 122 and channel inventory remains below the low end of our 7- to 8-week target. If we look at cash flow, CapEx for the quarter was $119 million and $447 million over the trailing 12 months or 5% of revenue. To support our accelerated 7% to 10% long-term revenue growth outlook, we are strategically investing to expand internal capacity while enhancing the resiliency of our hybrid model. To that end, as we stated at Investor Day, we expect CapEx as a percentage of revenue to be in the high single digits during fiscal '22 and '23 before reverting back to 4% to 6% over the long term. And over the trailing 12 months, we generated $3.2 billion of free cash flow or 33% of revenue. Included in our free cash flow are onetime transaction-related costs amounting to about 3% of revenue. Given the recent market weakness, we accelerated our repo activity to $776 million during the second quarter. This brings our total share repurchase to approximately $3.5 billion since the close of Maxim. And we look to maintain this accelerated buyback pace this quarter and achieve our $5 billion commitment by the end of our fiscal year. As a reminder, we target 100% free cash flow return. We will allocate 40% to 60% of our free cash flow to support a 10% dividend CAGR throughout the cycle, with the remaining cash used for buybacks to reduce share count annually. And now on to the outlook for third quarter. Revenue is expected to be $3.05 billion, plus or minus $100 million. We expect all end markets to grow sequentially. Given our higher-than-normal annual merit increase, operating margin is expected to be 49.5%, plus or minus 70 bps. And our tax rate is expected to be between 13% and 14%. Based on these inputs, adjusted EPS is expected to be $2.42, plus or minus $0.10. While we are very mindful of the current economic trends, our demand indicators remain very strong and our customer conversations remain upbeat, giving us confidence for continued growth for the remainder of 2022 and likely into 2023. Importantly, as a result of our vast diversification, leadership in numerous secular growth markets, additional synergies and our resilient hybrid manufacturing model, we believe ADI has never been better positioned to transcend cyclical downturns and accelerate long-term growth. Let me now give it back to Mike to start the Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. Let's get to our Q&A session. [Operator Instructions] With that, Katrina, can we have our first question, please?"
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Tore Svanberg with Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Congratulations on all the record results, especially on that 50% operating margin. My question is for Vince. Vince, towards the end of your remarks, you talked about growing output to increase swing capacity to 70% of revenues. Could you perhaps elaborate a little bit on that? And what is sort of the time line exactly for when you would hit that number?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. So as you know, Tore, we've been investing in our internal semiconductor manufacturing operations from 0.18 micron upwards, and we're doubling the output there over the next year or thereabouts, a year or 15 months. And of course, we cross-license technologies with some of our foundry partners. So when we talk about a 70% swing, it means that because we will have cross-qualified so many process technologies between ADI internal fabs and the external fabs that are controlled by our foundry partners, we got the ability to move utilization, if you like, from 1 place to another, depending on what part of the cycle we're in, in terms of managing utilization inside ADI and being able to meet the demand as it surges or declines."
},
{
"speaker": "Operator",
"text": "And your next question is from Stacy Rasgon with Bernstein Research."
},
{
"speaker": "Stacy Rasgon",
"text": "I wanted to ask about the gross margins. You mentioned a bunch of drivers, but you actually didn't mention pricing at all in your outlook there for the driver side. I mean, what impact has pricing had either to offset inflation or to potentially reprice the Maxim portfolio after the closure? And I guess, how do we think about the forward gross margin trajectory at these current, like, revenue levels? I mean, is there room for it to even go up from here, assuming the revenue levels kind of stay on the current trajectory?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you for the question. So as you know, we, along with the rest of the industry, has been passing along the higher costs. We have been very focused on not using this environment to take advantage of our customers but to really maintain our gross margins. So in '21, we had some headwind from the timing of inflation versus when we were able to enact the pricing. This has really abated in '22. So really, the gross margin percentage and the growth in gross margin percentage that you see is really being driven, as I mentioned, by the synergies, great utilization at the internal fabs and some mix benefits. I think in my prepared remarks, I talked about industrial hitting 51% of the overall revenue mix. So for the forward look, we updated our model just a couple of weeks back, and we feel very comfortable that in a typical cycle trough, we are going to be able to maintain a 70% floor. Beyond that, we will continue to make the right trade-offs with opportunities to expand the top line and -- at some trade-off on gross margin. So really the focus for the team is deliver the revenue growth and let that leverage drive all the way down through cash flow. So I wouldn't encourage folks to look for significant margin expansion. These are already pretty incredible numbers."
},
{
"speaker": "Stacy Rasgon",
"text": "But if the revenues kind of stay at this trajectory, can at least the gross margins stay where they are or will they just fluctuate around? Will like mix be the biggest driver from here?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes, that's the right way to think about it, yes."
},
{
"speaker": "Michael Lucarelli",
"text": "You're right. If you look at our build margins at this point going forward, it's mix, utilization and then we also have the $125 million of synergies, some of that will be on the cost of goods sold side. As Prashanth laid out, we'll balance both gross margins really to drive operating margins and free cash flow."
},
{
"speaker": "Operator",
"text": "And your next question is from Vivek Arya with Bank of America Securities."
},
{
"speaker": "Vivek Arya",
"text": "Vince, I think or Prashanth mentioned that industrial sales have grown over, I believe, it's over 25% for the last 6 quarters and seem like they could be strong for another 2 or 3 quarters. I'm curious, how do you think about the normalized growth rate? And what macro indicators do you look at to say this is what ADI's industrial growth should be? Like what are the early signals that you get to give you a sense whether you're over- or under-shipping end demand? Because from the outside, we look at all the turmoil in China, we look at all the turmoil in Europe, but then we look at this very strong industrial growth number and it gets harder to kind of reconcile, right, these 2 narratives. So give us a sense for how do you feel about specifically your industrial business right now?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks, Vivek. So first and foremost, it's a highly diversified industrial business that we've been diligently investing in from an R&D perspective, from a customer engagement perspective over the last decade or 12 years with a renewed focus. We've been gaining share very, very clearly. I think our portfolio, particularly combined with the power activity as well from the LTC and Maxim acquisitions puts us in even better stead to capture more SAM essentially. And to your question on growth, I would say that we -- during the Investor Day, we said that the new model is 7% to 10%. So I think industrial is going to be right in there somewhere over time. And we feel more confident now, I think, about our industrial growth than we've ever done, just given the strength of the portfolio, the customer engagements and so on. And in terms of the signals we watch, obviously, we have a lot of conversations with our customers. I personally have had a stream of conversations with many of our largest industrial customers over the last quarter. And I think what they're all trying to convey to us is that things are different. We're moving into a new industrial cycle, Industry 4.0, 5.0, IoT, or I beg your pardon, IT and OT, if you like, colliding in a new partnership for the future, driving a lot of new technologies. So that's one, obviously 1 stream of input we get. The other signals we look at, obviously, are the PMIs, the machine to builders indexes and so on and so forth. Well, I think the greatest source of insight for us is our own knowledge of the end applications coupled with our customers' insights."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Vivek, maybe I'll just add. I think I said it in the remarks, but to be clear to everyone, our growth in industrial was broad. All applications hit record results in '21 and are on track to hit another record in '22."
},
{
"speaker": "Operator",
"text": "Your next question is from C.J. Muse with Evercore."
},
{
"speaker": "C.J. Muse",
"text": "I guess a comment on my side. With these results, I'm surprised you didn't have Big Papi and Tom Brady at your Analyst Day. So next time. So to my question, your results are much better than your peers. Your B2B business, I think, up 11% versus your peers [at] mid-single digits. How do you think about the outperformance there? Is a part of that your ability to source incremental supply, market share gains, right mix? Would love to hear your thoughts there. And then as you think about the future going into the second half of this year and next, how does that inform your vision for continued outperformance?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Maybe I'll start and then hand to -- hand over to Vince. So on the tactical side, we are working on getting additional capacity both from our external partners as well as the investments we're making internally. So you'll see that continue to play out over the course of the year, which is why I mentioned in the prepared remarks, look for us to continue to grow sequentially through this year and likely at least into the early part of next year. We talked about pricing that has been a little bit incremental to the revenue growth. So that's certainly a piece of it. And the demand has just been very broad-based. And again, I said it in my remarks but to be clear, we are seeing demand across all end markets and all geographies. It's very evenly spread and strength across all end applications. So we do feel, to Vince's remarks here, we do feel very well positioned and our technology is really starting to hit the sweet spot across all of our customers. And then maybe I'll pass here to Vince to add some more."
},
{
"speaker": "Vincent Roche",
"text": "Maybe just a little bit of color on the markets, C.J., to try and answer your question. So we have so many vectors of growth now, for example, in industrial, where we're basically playing on all the high-end applications. And as I said, we've been tuning the R&D continuously, the customer engagement. And if I just pick out health care as an example, that's beginning to get on to a $1 billion run rate now. It's been growing consistently for the last 7, 8 years in the -- at the double-digit level. Aerospace and defense, we see that actually, no matter what the cycle will be over the next few years, this is going to be an area of great strength for us. And in the communications area, great position in 5G. But interestingly, our wireline and data center business now is on a par with the wireless sector in terms of revenue contribution. So it's kind of half-and-half. So we see that again as a source of strength, buttressed also by a lot of the technologies that Maxim are bringing to that wireline area. Automotive, we have a great story on the in-cabin experience with A2B, cancellation, premium sign systems being more and more deployed, electrification. We're on a [100] a quarter run rate now, revenue run rate. And we have design-ins at virtually all the electric car companies at this point in time. So we see that on a trajectory to $1 billion-plus in the foreseeable future. So that's just some of the examples to complement what Prashanth has narrated as well in terms of the vectors of growth and prosperity for the company."
},
{
"speaker": "Operator",
"text": "Your next question is from Ambrish Srivastava from BMO."
},
{
"speaker": "Ambrish Srivastava",
"text": "I had a question on the cost synergies, Prashanth. How should we be modeling these on a go-forward basis? You said exiting fiscal '23, but what's the breakout? And then kind of related to that is when we're talking about gross margin, I was a little bit surprised that you said the inflationary pressure would be abating as we go into -- as we continue through this year. Did I catch that right? Because inflation, the headline numbers seem to be -- they haven't -- maybe they have peaked but definitely higher than where they were last year. So would love some color on that comment as well."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thanks, Ambrish. Two good questions, and thanks for giving me the opportunity to clarify. So first, on synergies. We had talked, when we did the Maxim closed that we had some great learnings from LTC on how to get to synergies and that was to move fast and hard, and you're seeing us execute against that strategy. So we captured basically the entire $275 million that we originally committed to as we exited our second quarter. And that at Investor Day, we said we're raising that target to $400 million, and we'll hit that number coming out of -- or as we exit 2023. That first $275 million was a little more tilted towards cost of goods, and the following piece will sort of be balanced between cost of goods and OpEx. So as you look forward, that's how to think about the balance of that. To your question on the comments I made, thank you for giving me a chance to clarify. We have used our pricing opportunities to maintain gross margin. So to be clear, we're not looking at pricing as an opportunity to expand gross margin but really as a way to offset. So when I said abate inflation, I meant versus the historical inflation that we had experienced in 2021. It took us a little bit longer to get those pricing actions in place. So now we have neutralized them and you see that benefit in the current year. And of course, if we do continue to see price increases -- sorry, cost increases in the coming quarters, expect us, like the rest of the industry, to respond by pushing those through."
},
{
"speaker": "Ambrish Srivastava",
"text": "So there's no artifact in the 74% that you reported this quarter for pricing? We should expect kind of that level on a go-forward basis, maybe bounce around based on mix and also the utilization rate?"
},
{
"speaker": "Michael Lucarelli",
"text": "Ambrish, this is Mike. Yes, as we had talked about earlier, going forward, that 74% will bounce around, like you said, mixed utilization of the 2 drivers. And then as Prashanth outlined, that [1 25] does have a COGS element in it that will also help gross margins. But if you go forward 74%, plus/minus, I feel pretty good about that."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "With the caveat, again, I want to make it clear for everyone, with the caveat that we are focused on growth. So where it makes sense for us to be a little more flexible to drive top line, we will do that. So I wouldn't want folks getting too laser-focused on modeling in mid-70s on the gross margin. We've given you a floor and we will give the management team the flexibility they need to drive the top line."
},
{
"speaker": "Ambrish Srivastava",
"text": "Right. You've been very consistent about that."
},
{
"speaker": "Operator",
"text": "Your next question is from Chris Danely with Citigroup."
},
{
"speaker": "Chris Danely",
"text": "So with all this talk on revenue growth, your forecasted sequential revenue growth for July is the slowest in a couple of years. Can you talk about why that's happening? And is that because of COVID shutdowns or something else? And then as part of that, with all this focus on increasing capacity, I would assume your capacity is growing faster than the 2% or 3% sequential revenue growth. So can we assume that the lead times are coming in this quarter as well?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. So Chris, the sequential growth is constrained by capacity. But we've indicated that we will see sequential growth through the year. So look for a more meaningful change as we get past the third quarter, which we've been saying for a while. So if you look back at prior comments, we've been very clear that we've ordered the tools and the equipment. We know our position in the queue. We know when those are coming in, and they go to revenue generation fairly quickly. So we are maintaining our outlook that we will exit the year at a much higher run rate than where we are now. And that is all driven by our ability to produce. And what was the second question?"
},
{
"speaker": "Chris Danely",
"text": "Perfect."
},
{
"speaker": "Michael Lucarelli",
"text": "Yes. Chris, I'll also add 1 thing. You're right, the sequential growth is, I'll call it, decelerating now. What happened in the first half of the year, we talked about, we added pricing and that added to the growth. We had volume and pricing in the first half of the year that's driving sequential. Pricing is really in the model now, now that the growth in the back half on a sequential basis is really driven by capacity and volume. And if you zoom out and don't look at sequentials and look at year-over-year, we're growing our B2B business in our fiscal third quarter by over 20% year-over-year again. So it's a fantastic result, I think, and it shows the strength of this franchise."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. I think we can give everyone the data point that on a sequential basis, think of it as 50-50. The growth is coming from pricing versus units. So that falls into the baseline sequentially as we go forward, pricing falls into the baseline."
},
{
"speaker": "Operator",
"text": "Your next question is from William Stein with Truist Securities."
},
{
"speaker": "William Stein",
"text": "I’ll add my congratulations to the very strong revenue and profitability and the outlook as well. That was great. But despite all that good stuff, there’s a few factors that investors are certainly concerned about potentially disrupting bookings and potentially revenue performance, of course, the war in Ukraine, the COVID shutdowns in China and raising rates. But there’s also a concern maybe not as prominent, but – that we’ve picked up on, which is customers adjusting orders, potentially ancelling or pushing out because they’re very challenged from a kitting perspective. You highlighted yourself that you’re capacity constrained. Can you help us understand how those factors are affecting your business today and how you anticipate them playing out in your business over the next few quarters?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. So I think first and foremost, cancellations on ADI are very, very low. They’re very muted. Customers – we’ve been very equitable in terms of how we have moved our supply across the markets, across the geographies, across the customer sizes. And I think that still is in very, very good stead. So my sense is we have – because of the equitable distribution of our goods, so to speak, we’ve got a better, more true read on demand. And I think what we’re shipping reflects what is true demand, I think better than most, I believe, based on feedback I’m getting from customers. So I think those are the facts, cancellations low, equitable distribution of goods. And we don’t see any – our backlog is still, actually during the last quarter, increased so demand continues to remain strong."
},
{
"speaker": "A –Prashanth Mahendra-Rajah",
"text": "Yes. Just the numbers. Well, the book-to-bill is above 1 in the second quarter, and that was, again, by all end markets and geographies. Because of that, the backlog continued to grow. You asked specifically about China. So real quickly, that’s about 20% of our revenue. And the lockdowns had some impact on customer production, but it was really more severe around logistics and the supply chain related to the greater Shanghai area. Our China revenue was up quarter-over-quarter and year-over-year and no notable impacts to demand. Again, cancellations normal, and as I mentioned, book-to-bill above 1 for China. So when our guide reflects that most customers are operating at relatively normal levels and we consider this dynamic, so we think that at least for the third quarter, it’s going to be a negligible impact."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Just add a little bit of color. Also, we have no internal manufacturing operations in China. And from a logistics standpoint as well, we have very, very modest operations also in China."
},
{
"speaker": "A –Michael Lucarelli",
"text": "We’ll go to our last question, please."
},
{
"speaker": "Operator",
"text": "Our last question is from Toshiya Hari with Goldman Sachs."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Toshi, are you on? Toshi may be on mute. Do we have 1 more in the queue?"
},
{
"speaker": "Michael Lucarelli",
"text": "Do we have 1 more in the queue?"
},
{
"speaker": "Operator",
"text": "Our next question is from Gary Mobley with Wells Fargo Securities."
},
{
"speaker": "Gary Mobley",
"text": "I wanted to ask a follow-up question on backlog. I think you mentioned that based on the backlog and adding incremental supply, your expectation is for sequential revenue growth for at least maybe the next few quarters, maybe 3, maybe 4 quarters. Wondering to what extent have you stress tested your backlog to see, I guess, under the most bearish of circumstances, how that may trend if perhaps we see further deterioration in the economic backdrop and whatnot?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Gary, a fair question. The -- as Vince mentioned, we look at a number of external indicators. So we are mindful of what's happening in the macro environment. But as you mentioned, the conversations that he has with our customers continue to support their need for our products and that we are attached to the right secular driver. So I do want to clarify, you had said sequential growth for the next 3 to 4 quarters. I can't see out that far, Gary. I feel good about the next 2 to 3 quarters sequential growth, but I'm not sure I want to go out further than that at this point."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, everyone, for joining us this morning. A copy of the transcript will be available on our website. Thanks again for joining the call and your continued interest in Analog Devices."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 1 | 2,022 | 2022-02-16 10:00:00 | Operator: Good morning and welcome to the Analog Devices First Quarter Fiscal 2022 Earnings Conference Call, which is being audio webcast via telephone and/or the web. I’d now like to introduce your host for today’s call, Mr. Michael Lucarelli, Vice President of Investor Relations. Sir, the floor is yours.
Michael Lucarelli: Thank you, Holly and good morning everybody. Thanks for joining our first quarter fiscal ‘22 conference call. With me on the call today are ADI’s CEO, Vincent Roche and ADI’s CFO, Prashanth Mahendra-Rajah. Anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now, on to the disclosures. The information we are about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release and our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today’s earnings release. Okay. With that, I will turn it over to ADI’s CEO, Vincent Roche. Vince?
Vincent Roche: Well, thanks, Mike, and good morning to everybody. So once again, ADI delivered another record quarter, marking a strong start to the year. Our continued success was driven by our unparalleled high-performance portfolio and our team’s strong operational execution and intense customer focus, enabling us to better meet the growing demand for our products. Now, looking at our first quarter results, revenue was $2.68 billion, up more than 20% year-over-year on a combined basis. Growth was broad-based, with all segments up double-digits year-over-year, led by industrial and automotive. Gross margin expanded to 72% and operating margin increased to over 45%. Adjusted EPS was $1.94, up 35% year-over-year. Now, it’s been nearly 6 months since we closed the Maxim transaction, overall, we have made great progress on the integration to-date. The feedback we have received from customers and our teams has been overwhelmingly positive and we have taken important steps to strengthen our operations. In the many exchanges I have had with our customers, they have expressed their enthusiasm for the combination recognizing the increased value that ADI and Maxim together bring to the market. Broadly speaking, ADI is viewed as a trusted, long-term focused partner that takes a customer-first approach to our engagements. We offer a unique combination of best-in-class engineering and unmatched domain expertise, with a high-performance portfolio that spans from microwave to bits, from nanowatts to kilowatts and from sensor to cloud. This is enabling us to develop more complete solutions that define the edge of possible. The acquisition of Maxim increases the breadth and depth of our high-performance portfolio, especially in power management. Here, our more comprehensive power portfolio allows us to better address opportunities across industrial, automotive, datacenter, connectivity and consumers. Similar to the cross-selling activity we implemented with the LTC portfolio, we are aggressively identifying areas to attach this power portfolio with ADI’s leadership positions in analog, mixed signal and RF. And with our extended sales and field organizations, we are better positioned to uncover cross-selling opportunities and serve existing and new customers who have an increased need for application and design support at a solutions level. I have also been highly engaged with our teams across ADI. The combination has unleashed excitement throughout the organization. There is a burning desire to capitalize on the numerous opportunities to accelerate revenue growth. And I am already seeing firsthand the benefits of our collaboration, from operations, to engineering, to sales, making me excited for what’s ahead. Turning firstly to our manufacturing operations, the analog sector is characterized by fragmentation, with diversity across products, customers, applications and markets. To tackle this complexity, we utilize a hybrid manufacturing strategy, providing us with vast capabilities across technology, processes and packaging necessary to create innovative solutions from 7 nanometers to 7 microns for our 125,000 customers. The combination with Maxim enhances our hybrid manufacturing model by enabling a more diverse network of internal facilities and external partners. This increases our access to technologies and capabilities, which in turn expands the scale and the scope of our offerings. We are investing in our internal manufacturing operations to build a more robust and cost effective model. To that end, we are expanding the footprints of our Oregon and Limerick fabs and adding significant capital to our test operations at our facilities in the Philippines, Thailand and Malaysia. These investments will grow our capacity this year and into 2023, provides seamless product qualifications for our customers, and give us greater optionality between our internal facilities and foundry partners. Now ahead of our Investor Day in April, I’d like to preview some of the secular growth trends that make us most excited about the future of our industry and for our company. In the industrial market, we are seeing the compounding effect of many concurrent secular trends. For example, our instrumentation business, which is comprised of automated test equipment, electronic test and measurement and scientific instruments, is aligned with growth trends from connectivity, to EVs, to sustainability. The growing technology complexity of these applications requires ADI’s more advanced metrology solutions, enabling us to continue increasing our SAM. Our factory automation business is empowering another critical trend of more intelligent and connected factories. Here, we support tens of thousands of customers of all sizes with our precision signal chain, power management, sensing technologies, and robust wired and wireless connectivity solutions. In automotive electrification, we are the global leader in battery management systems for EVs, with double the market share of our nearest competitor. We are continuing to build momentum globally. And in the last quarter, we have recorded several new design wins from premium European auto manufacturers. Electrification is not exclusive to the automotive sector. There is a necessary shift to sustainable energy sources to deliver the environmental benefits of electrification. This vision requires green energy generation with a smart grid, which digitally monitors and adjusts performance and also energy storage systems, which mitigate intermittency issues related to variable user demand. ADI supports this infrastructure with control and sensing technologies as well as accurate monitoring and efficient power conversion to ensure the grid parameters remain stable. Within automotive, we are also seeing manufacturers create a more immersive human experience by digitalizing the cabin. This requires increased bandwidth, lower latency and more efficient power management, creating new opportunities for ADI’s connectivity and power portfolios. For example, our audio system solutions with signal processing, A2B connectivity and road noise cancellation provide customers with the highest fidelity solution while also reducing the vehicle’s weight. In addition, our GMSL franchise and functional safety certified power management solutions are critical in architecting and efficiently powering advanced driver assistance systems. Overall, our market-leading positions in BMS, audio systems and GMSL, combined with our complementary customer bases, position our automotive franchise to deliver strong growth in the years ahead. Turning now to advanced communications networks, in wireless, ADI’s market leading software-defined transceiver portfolio is enabling next-generation communication systems from traditional 5G, to O-RAN, to low earth orbit satellites. And we are expanding our SAM with the industry’s first transceiver that includes a fully integrated digital front-end. In wireline, our optical control and power portfolios are critical to tackling the exponential growth in bandwidth and compute power of carrier networks and hyperscale datacenters. Here we see a large and underserved opportunity for ADI. So with that backdrop, we look forward to expanding on these areas and more at our Investor Day with our senior leadership team. So in closing, ADI is the leader in innovating at the edge. We have an industry leading high-performance portfolio that continues to benefit from the acceleration of mass digitalization across industries. And with Maxim, our portfolio has increased in breadth and depth and we see even more opportunity than ever to capture additional market share. And I am very optimistic about what our future holds. And so with that, I will hand you over to Prashanth who will take us through the financial details.
Prashanth Mahendra-Rajah: Thank you, Vince. Good morning, everyone. Let me add my welcome to our first quarter earnings call. My comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today’s press release. The revenue commentary is on a pro forma basis and includes pre-acquisition Maxim revenue in the comparable period. ADI delivered a very strong first quarter, with record revenue, profitability and earnings. These results reflect the secular demand for ADI’s products, capturing synergies and effectively passing on inflationary costs. Our manufacturing team is diligently securing additional internal and external capacity as orders remain robust across all our markets and our backlog continues to grow. This sets the stage for continued sequential growth through the balance of fiscal 2022. So for the first quarter, revenue of $2.68 billion finished near the high-end of our outlook, with double-digit growth across all end markets and geographies. This marks our fourth consecutive quarter of record revenue and eighth straight of sequential growth. Looking at our end market performance for the quarter, industrial, our most diverse and profitable market, represented 50% of revenue and achieved a new all-time high. Industrial has grown more than 20% year-over-year for five straight quarters, underscoring our strong market positioning, supported by numerous secular tailwinds, including automation, digital healthcare, sustainable energy, aerospace and instrumentation. Automotive, which represented 21% of revenue, achieved another record, with every major application posting double-digit year-over-year growth. Our battery management system offering continues to outperform and represents over 15% of automotive revenue, underscoring ADI’s leadership in electric powertrains. Additionally, secular content growth inside the cabin continues to drive both the A2B and GMSL connectivity franchises to new heights. Communications represented 15% of revenue and exhibited strength in wireless and wireline. We are in the early days of 5G deployments and expect global rollouts, led by North America, to accelerate in 2022 and beyond. And in wireline, demand remains strong as carriers and hyperscalers continue to upgrade their cloud infrastructure from long-haul to datacenter. And lastly, consumer represented 14% of revenue and was in line with seasonality. Importantly, we continue to grow year-over-year, supported by strategic investments aimed at diversifying our customer and application mix. The first quarter demonstrated our increased portfolio breadth as all segments achieved growth, including professional audio video, gaming, wearables, hearables and personal electronics. Now, looking at the P&L, gross margin increased 100 basis points sequentially and 190 basis points year-over-year, resulting in a record 71.9%. Favorable product mix, higher utilizations and synergies were key drivers of the increase. OpEx in the quarter was $702 million, better than anticipated due to faster synergy progress. Operating margin of 45.8% increased 510 basis points year-over-year. Non-op expenses were $44 million in line with last quarter. And our tax rate for the quarter was approximately 13%. All told, adjusted EPS of $1.94 increased 35%. Our record profitability this quarter was driven by the stronger revenue growth as well as the synergy capture. And now moving on to the balance sheet, we ended the quarter with approximately $1.8 billion of cash and equivalents. And on a trailing 12-month pro forma basis, our net leverage ratio was just under one turn. Days of inventory increased modestly sequentially to 115 and channel inventory remains below the low end of our 7 to 8-week target. Looking at cash flow items, CapEx was $111 million for the quarter and $387 million over the trailing 12 months. As a reminder, during fiscal 2022, we plan to invest 6% to 8% of revenue to significantly grow our front and back-end capacity and build a more resilient hybrid manufacturing model for the long-term. Importantly, this higher level of CapEx will not hinder our capital return commitments. Over the trailing 12 months, we generated $2.78 billion of free cash flow or 33% of revenue. Our free cash flow margin was lower by about 3% due to costs related to the Maxim acquisition. Over the same time period, we returned approximately $4.2 billion or more than 150% of free cash flow via purchases and dividends. And as a reminder, we target 100% free cash flow return. We aim to use 40% to 60% of our free cash flow to consistently grow our dividend, with the remaining free cash flow used for share repo. And just yesterday, we announced a 10% increase to our quarterly dividend, marking the fourth consecutive year of double-digit increases. We have now raised our dividend 19x in the past 18 years. Our ASR program concluded in the first quarter, and as a result, we retired approximately 14.4 million shares. We are now more than halfway towards executing our $5 billion repo commitment by the end of calendar 2022. So let me finish with the second quarter outlook. Revenue is expected to be $2.8 billion, plus or minus $100 million. At the midpoint, we expect all B2B markets to grow sequentially and for consumer to be flattish. At the midpoint, operating margin is expected to be 46.5%, plus or minus 70 bps. And this outlook includes approximately $100 million of annual run rate synergies, split roughly evenly between cost of goods and OpEx as we exit second quarter. Our tax rate is expected to be approximately 13%. So based on these inputs, adjusted EPS should be around $2.07, plus or minus $0.10. And finally, let me end with an invitation. We are holding our Investor Day on April 5, where we look forward to sharing ADI’s long-term strategy, our new financial model and a detailed update on all phases of our synergy road map. We hope to see many of you in person at our headquarters right outside of Boston, where we will offer unique customer-led interactive technology demonstrations and displays throughout the day. This includes showcasing our wireless battery management system for EVs and much more. I’ll hand it off to Mike for the Q&A.
Michael Lucarelli: Thanks, Prashanth. Let’s get to the Q&A session. [Operator Instructions] With that, we have our first question, please.
Operator: [Operator Instructions] And our first question is going to come from the line of Vivek Arya with Bank of America Securities.
Vivek Arya: Thank you for taking my question. And good to see the strong execution. Vince, I was hoping you could maybe give us a readout of what you see as kind of the supply-demand balance in your different end markets. And if – as part of that, if you could help us understand what role is pricing playing in the industry today. And can it be sticky over time? Or will it need to revert back as there is more trailing-edge capacity that comes online, including from your other large U.S. competitor?
Prashanth Mahendra-Rajah: Good morning, Vivek, I’m going to just do the setup for that on the supply and demand environment. So what we’re seeing in 2022 looks a lot like 2021. So we expect that we will be chasing demand throughout the year. We’ve got continued order strength across the business. As I said in the prepared remarks, all end markets, all geographies are looking strong. And our backlog is continuing to expand. We’ve delivered eight sequential quarters of growth, and that’s supported by the manufacturing team continued to increase their ability to supply. And as I mentioned in the remarks, we expect that increase to be progressive over the balance of the year while they continue to debottleneck the process. So that will help us drive sequential growth. From a supply standpoint, we’re going to continue to look at the balance here and keep an eye on how things are going. But our view is that this will run through the balance of this year. And we expect that we will probably still have a little bit of catching up to do in early ‘23. On pricing, that’s a longer question, so let me split that into two pieces. Why don’t I talk margins and then I’ll let Vince talk kind of pricing strategy. So from margins, we along with the rest of the industry have been passing on the higher costs that we’ve been seeing. So we’re not using this environment to take advantage of customers, but really targeting to maintain gross margins. So we have been pushing those costs out. But built into those margins is a number of items, including the synergy execution, which is coming in faster than we thought, some benefit of mix, higher revenue because we are actually shipping more units. So I think on a quarterly basis, unit shipment is up double-digits year-over-year. And then, of course, with all this unit increase in unit shipment, utilizations are also quite strong. So there is a number of benefits that are underlying the margin piece. But to finish off on pricing, I’m going to pass to Vince to maybe talk about how we’re – how he’s talking to customers.
Vincent Roche: Yes. Vivek, just to add a couple of other color comments here. So we have historically managed our pricing to reflect the value that we deliver to our customers. We get an innovation premium for our products. And also, we have very, very long life products in our portfolio. And customers pay us to keep security of supply for the long-term. And that’s an approach that we intend to keep in perpetuity. I think also, pricing for us is more structural than cyclical. I think the last couple of years have really brought semiconductors from the background into the foreground and shown the importance of semiconductors to the modern digital economy. And I think customers understand the value in a more meaningful way. So I think, as Prashanth said, cost inflation, we’re in the post-Moore’s Law era, cost inflation, I think, is going to be a long-term facet of the economic dynamic of the semiconductor business. So I expect that cost increases will moderate, but there will be inflation, I think, for the medium to long-term here. So I think when you put it all together, the industry is in a better place to capture more of the value that it’s been generating over these many, many decades. And then I think we will benefit from that as a company based on the quality of our innovation, but also the new dynamics in the industry.
Michael Lucarelli: Thanks for that, Vivek. Nest question please.
Operator: Thank you. Our next question will come from the line of John Pitzer with Credit Suisse.
John Pitzer: Yes. Good afternoon. And good morning, guys. Thanks for let me ask the question. Just to follow-up on the pricing side of things, Vince. I’m just kind of curious, will this year’s revenue growth be more influenced by pricing than last year? And to the extent that the price environment seems to be structurally changing, are there any parameters you can give us? Historically, pricing did x, and now we think it’s going to do sort of x plus. And because – and the reason why I asked the question is we look at your relative growth rates to some of the end markets that you participate in, and you’re clearly growing significantly faster. And there is a content side of things. But that relative growth does kind of make people concerned about inventory levels. And so we look at inventory and revenue, we probably should be looking at it on units. I’m just kind of curious how we should try to factor in that pricing dynamic.
Prashanth Mahendra-Rajah: John, let me just set the numbers on that. So this year, pricing or – actually, I should say, for the current quarter, pricing counts for less than half the growth. So that kind of helps you size it. And we had said on the prior quarter’s call that in 2021, we had cost increases that were coming at us faster than we were able to push price out because we were in the process of closing the deal on Maxim and beginning the integration. So we did expect more pricing tailwind this year because we actually had inflationary cost headwind last year.
Vincent Roche: Yes. I’d say, John, one other comment. I’ve said many, many times before that for several years up to this step function increase due to inflation in prices and cost of goods and then prices, our pricing was – for many, many years, we had been – we had to fill a gap. We had to ship more units to keep up with the annual price reductions. I would say we were accentuating towards zero price reduction on the average, adding more ASPs to our products for the innovation that we’re creating. And then I think that for the long-term is going to be a better way to gauge ADI’s pricing methodology. So we’re pricing for value. And we’re injecting significant amounts of R&D into the company to make sure that we keep ahead of our customers’ needs. So that will be, I think, the primary dynamic for value capture for ADI for the years ahead.
Michael Lucarelli: Thanks, John. Next question please.
Operator: Our next question will come from the line of Pradeep Ramani with UBS.
Pradeep Ramani: Hi, thanks for taking my question. I just wanted to ask about your automotive business just given how automotive production is sort of sharply rebounding in 2022. How do you feel about how much your automotive business can outgrow SAAR or even production in 2022? How should we think about that? Thank you.
Vincent Roche: Yes. I think right now, the supply chain is very, very lean. That is pretty well established. I’ve talked with a lot of automotive companies over the last 6 months or so. And my sense is that everything that we’re shipping has been used and I don’t see any stockpiling. So content in vehicles is increasing every year. The value generation activity in the auto sector now is – it’s driven by semiconductors and software. So we’re seeing content growth of 5% to 10% per year. And I think that will continue for the foreseeable future. We are seeing, I think, the shift towards EVs. I’ve been surprised by the speed of the shift myself in the 2021 period. And that our customers are tilting the content, the semiconductor content towards premium models. So that accelerates the content growth story versus history. And then long-term, we expect to be able to grow our business in the automotive sector as a multiple of SAAR. We see tremendous opportunity to continue to drive our share and growth story of EVs. In cabin connectivity where we’ve got a very, very strong signal processing franchise, to which we’ve connected our A2B connectivity, road noise cancellations, a new value creator in the cabin. And we’re very excited by the GMSL, the connectivity portfolio, the high-speed connectivity portfolio that we have inherited from legacy Maxim. And we have aggressive plans to continue to build that out, both in terms of product development as well as our manufacturing footprint. And last but not least, power. We are underrepresented in general in power management, I’d say, across the industry, and particularly in automotive and industrial. So, I think the combined portfolio of ADI and Maxim gives us a tremendous opportunity to tap in to what is actually the largest sector. Power is the largest sector of the analog market, and it’s growing at a compounded rate there. So, that gives you a sense for our automotive thinking.
Michael Lucarelli: Thank you.
Operator: Our next question will come from the line of Toshiya Hari with Goldman Sachs.
Toshiya Hari: Hi, good morning. Thanks so much for taking the question and congrats on the strong execution. Prashanth, I wanted to ask about your synergy capture in the quarter and how to think about synergies going forward. In your prepared remarks, I think you talked about earlier than expected synergy capture. Should we consider this as kind of a pull-in of synergies, or would it be fair to assume that the Phase 1 target of $275 million is a little bit more on the conservative side? And then, I guess additionally, on Phase 2, I realize it’s kind of early. But you had talked about potentially looking at your manufacturing footprint similar to how you did with the linear. Is that still the plan, or could things change given the stronger demand backdrop? Thank you.
Prashanth Mahendra-Rajah: Yes. Good question, Toshi. And a great setup to invite folks to join us in April when we are going to answer all those questions. The – in the last call, we talked about $20 million of synergies was realized in fourth quarter. And we said that there would be minimal impact in the first half before ramping more aggressively into the second half. We have moved faster than originally planned and we have captured more earlier. So, we are going to exit second quarter at about $100 million of that $275 million. And as I have said in the remarks, it’s roughly split between both cost of goods and OpEx. The – we will give you an update on that $275 million in terms of how much we believe we can actually achieve in that first Phase 1 time period. We will do that at the April earning – Investor Day. Vivek will also specifically talk about his plans and what he is – has high confidence on for Phase 2 of the cost synergies. And then our Head of – our Chief Customer Officer is going to talk about the revenue synergies that we are expecting from the combination. So, we will lay all that out for you when we see you here in Boston in a couple of weeks.
Toshiya Hari: Got it. Thank you.
Operator: Thank you. Our next question will come from Stacy Rasgon with Bernstein Research.
Stacy Rasgon: Hi guys. Thanks for taking my questions. I wanted to ask about gross margin. So, I hear what you are saying on pricing. It sounds like it’s a revenue boost, but not so much a margin boost yet. But I just look at the company, ADI standalone was kind of 70 to maybe low-70s, Maxim was kind of mid to high-60s. And you are doing 72% out of the gate. Is this mostly just utilization and mix and the synergies? And it sounds like you have got more synergies coming. You have got revenue going through the year. Should we be thinking about the current gross margin level you just put in Q1 as sort of being the bottom for the year as you continue to progress?
Prashanth Mahendra-Rajah: Yes. Stacy, let me just clarify, that I would be incorrect to assume that there was no benefit from pricing in the gross margins. What I wanted to clarify earlier in the response was, embedded in that margin improvement is the synergy, the faster synergy execution, which I just answered in Toshiya’s question. The mix, which we talked about in the prepared remarks, again, very strong industrial at 50%, is great for us. And then higher unit volume, because we are up on a unit basis double-digits, and utilization, and then pricing also fits into that. So, they are all elements of that. In terms of how to think about the gross margin on a go-forward basis, we will share the new operating model or the financial model for the company in April. But I will preview to say that our focus continues to be on how do we drive the best revenue growth balancing that gross margin. So, as we have met with investors, there is pretty uniform agreement that what they would like to see is higher revenue growth and make the trades that are necessary on margin to be able to deliver higher revenue growth. So, we will talk more about the model in Investor Day. But I would not be encouraging folks to be modeling very high gross margin numbers over the long-term.
Michael Lucarelli: Gross margins, Stacy, and how it trends, we don’t guide gross margins, but I will give you some context around. If you look at 2Q, it’s usually up a bit. That’s embedded in our outlook. In the back half, usually about flat from there. That kind of helps you from a kind of near-term 2022 outlook. And then at the Investor Day, we will talk more about the long-term outlook for the business.
Stacy Rasgon: That’s helpful. Thank you so much.
Operator: Our next question will come from the line of Tore Svanberg with Stifel.
Tore Svanberg: Yes. Thank you and congratulations on the record results. Could you just talk a little bit more about your capacity plans? You talked about increasing CapEx 6% to 8% this year. I don’t know if that’s sort of the first year or more to come. And is there any way for you to quantify what that does as far as capacity expansion? I know you have a hybrid model and this is a moving target. But any color you can share with us on how much capacity you are going to have? That would be great. Thank you.
Vincent Roche: Yes. So thanks, Tore. The – well, first off, if we just take it from a high level, first, we have always utilized a hybrid manufacturing model at ADI. And it gives us the reach of process technology and capabilities that we need to support the sheer breadth of our portfolio, which is more than 75,000 unique product sets. And we are supplying 125,000 customers. So, I think when we think about the long-term, we will continue to use the benefits of this hybrid model for optionality, resilience and the availability of technology. So overall, the business that we are in, it is – and given that we are approaching the world with a hybrid mentality, our business is less capital intensive. And it also gives us, as I said, resiliency in terms of gross margin and long-term access to more options for process technology, etcetera, etcetera. So, I will hand it over to Prashant. He will make a few comments on the investments that we are making and how we are going to strengthen that model.
Prashanth Mahendra-Rajah: Yes. Tore, I think your question was specifically related to CapEx. So, let me just – let me kind of size that at a high level. So, we said that our CapEx is going to be doubling in 2022. And we are targeting somewhere between 6% to 8%, which is above our historical long-term rate of 4%. And that CapEx is being used for internal capacity. Specifically, that can swing in and out, so it helps us with optionality. And that’s an important element of the hybrid manufacturing model that Vince talked about is being able to use that same capacity for volume when we need it or utilization if the market should not have the same level of demand as they do today. So, the shelves of the building are complete. And Vince mentioned in his prepared remarks that we were adding in – expanding our footprints in Oregon and Limerick. And also, we are adding a significant amount of testers to our back end in the Phils, Thailand and the LTC site that we acquired in Malaysia.
Tore Svanberg: Great. Helpful. Thank you.
Vincent Roche: Thanks Tore.
Operator: Thank you. Our next question will come from the line of Ambrish Srivastava with BMO Markets.
Ambrish Srivastava: Hi. Thank you very much. Prashanth, I wanted to come back to the inventory. On a GAAP basis, which is consistently how we measure for all companies, it’s pretty low versus the average and versus the long-term target that you have laid out. And on an absolute dollar basis, it was down quite a bit as well. So, I was just wondering, part of it is probably from the accounting and the step-up you had from the Maxim acquisition. Could you just help us understand, was there a drawdown internally? And I don’t think I heard you talk about where channel inventory was. So, what should we expect inventory to do on an absolute dollar basis as we go through the year? Thank you.
Prashanth Mahendra-Rajah: Yes, great question, Ambrish. So first, let me say that you are absolutely right. There is a bunch of purchase accounting that is flowing through the balance sheet. So, the inventory numbers probably have a bit more noise, and we can handle that with your team offline. But let me high level kind of help folks to think about the inventory. So, the channel remains very, very lean. That is not the – not our balance sheet, but the inventory in the channel, that remains very lean, well below our seven-week to eight-week target. We are having difficulty building inventory in the channel. We get it into the channel, and it moves out very quickly. Within ADI’s books, our days of inventory are up slightly, primarily, as I mentioned that we are planning to see revenue increase sequentially for the balance of the year. So, you have the raw material and the WIP is in – is sort of in the middle of the process now before that comes out, and that is – that’s up. We also had a little bit of finished goods up, but that was purely timing on when the quarter ended versus where the goods were in the transit process. So, I wouldn’t read anything into our increase in finished goods, except to say it’s just – it happened to be when the Drawbridge closed for the quarter.
Michael Lucarelli: Thank you, Ambrish. We will go to our last question, please.
Operator: Alright. Our last question will come from the line of Harlan Sur with JPMorgan.
Harlan Sur: Good morning. Congratulations on the strong results and execution. If I look at cloud and hyperscale data center CapEx spending for this year, that’s expected to grow like 30%. And I know that in the data center end market, Maxim, for example, they provide the critical processor power management for NVIDIA’s data center GPUs. They provide power management for Google’s flagship AI processors. On the ADI side, you guys provide server power supply solutions and optical networking solutions. So, I guess my question is, given the strong backdrop, was data center a big driver for your comps business in Q1? How do you see data center growth for the full year? And how big is data center as a percent of your overall comm business?
Michael Lucarelli: I will answer backwards. I will start with kind of the sizing of data center for you. If you look at our comms business, it’s about 15% of total revenue. That’s split about evenly between wireless and wireline, about 50%, 50% in each of those. And if you look at the wireline piece, that’s where data center is embedded, it’s probably about 30% to 35% of that relates to the data center. What do we ship into this, I know you outlined it pretty well. I am not going to go through it again. But I will pass it to Vincent and Prashant, probably Vince to talk a little bit more about what the opportunity is in data center and why we are excited.
Vincent Roche: Yes. Thanks Mike. Well, we have I consider, combined with Maxim, a strong position in optical connectivity as well as carrier networks, but also power management, whether it’s the power system monitoring, energy monitoring and actually power delivery itself. We see that as a phenomenal opportunity. So, my sense is, and we will talk more about this at the Investor Day, but we will unpack the story for you. But my sense is that we can double our data center and cloud business over the next 4 years to 5 years.
Harlan Sur: Great. Thank you.
Michael Lucarelli: Alright. Thank you, Harlan. And thanks, everyone, for joining us this morning. A copy of the transcript and all of our reconciliations will be available on our website. We hope you can join us at our in-person at Investor Day, April 5. Thanks for joining the call and interest in Analog Devices. Have a good day.
Operator: This concludes today’s Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning and welcome to the Analog Devices First Quarter Fiscal 2022 Earnings Conference Call, which is being audio webcast via telephone and/or the web. I’d now like to introduce your host for today’s call, Mr. Michael Lucarelli, Vice President of Investor Relations. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Holly and good morning everybody. Thanks for joining our first quarter fiscal ‘22 conference call. With me on the call today are ADI’s CEO, Vincent Roche and ADI’s CFO, Prashanth Mahendra-Rajah. Anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. Now, on to the disclosures. The information we are about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release and our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as the date of this call. We undertake no obligation to update these statements, except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today’s earnings release. Okay. With that, I will turn it over to ADI’s CEO, Vincent Roche. Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Well, thanks, Mike, and good morning to everybody. So once again, ADI delivered another record quarter, marking a strong start to the year. Our continued success was driven by our unparalleled high-performance portfolio and our team’s strong operational execution and intense customer focus, enabling us to better meet the growing demand for our products. Now, looking at our first quarter results, revenue was $2.68 billion, up more than 20% year-over-year on a combined basis. Growth was broad-based, with all segments up double-digits year-over-year, led by industrial and automotive. Gross margin expanded to 72% and operating margin increased to over 45%. Adjusted EPS was $1.94, up 35% year-over-year. Now, it’s been nearly 6 months since we closed the Maxim transaction, overall, we have made great progress on the integration to-date. The feedback we have received from customers and our teams has been overwhelmingly positive and we have taken important steps to strengthen our operations. In the many exchanges I have had with our customers, they have expressed their enthusiasm for the combination recognizing the increased value that ADI and Maxim together bring to the market. Broadly speaking, ADI is viewed as a trusted, long-term focused partner that takes a customer-first approach to our engagements. We offer a unique combination of best-in-class engineering and unmatched domain expertise, with a high-performance portfolio that spans from microwave to bits, from nanowatts to kilowatts and from sensor to cloud. This is enabling us to develop more complete solutions that define the edge of possible. The acquisition of Maxim increases the breadth and depth of our high-performance portfolio, especially in power management. Here, our more comprehensive power portfolio allows us to better address opportunities across industrial, automotive, datacenter, connectivity and consumers. Similar to the cross-selling activity we implemented with the LTC portfolio, we are aggressively identifying areas to attach this power portfolio with ADI’s leadership positions in analog, mixed signal and RF. And with our extended sales and field organizations, we are better positioned to uncover cross-selling opportunities and serve existing and new customers who have an increased need for application and design support at a solutions level. I have also been highly engaged with our teams across ADI. The combination has unleashed excitement throughout the organization. There is a burning desire to capitalize on the numerous opportunities to accelerate revenue growth. And I am already seeing firsthand the benefits of our collaboration, from operations, to engineering, to sales, making me excited for what’s ahead. Turning firstly to our manufacturing operations, the analog sector is characterized by fragmentation, with diversity across products, customers, applications and markets. To tackle this complexity, we utilize a hybrid manufacturing strategy, providing us with vast capabilities across technology, processes and packaging necessary to create innovative solutions from 7 nanometers to 7 microns for our 125,000 customers. The combination with Maxim enhances our hybrid manufacturing model by enabling a more diverse network of internal facilities and external partners. This increases our access to technologies and capabilities, which in turn expands the scale and the scope of our offerings. We are investing in our internal manufacturing operations to build a more robust and cost effective model. To that end, we are expanding the footprints of our Oregon and Limerick fabs and adding significant capital to our test operations at our facilities in the Philippines, Thailand and Malaysia. These investments will grow our capacity this year and into 2023, provides seamless product qualifications for our customers, and give us greater optionality between our internal facilities and foundry partners. Now ahead of our Investor Day in April, I’d like to preview some of the secular growth trends that make us most excited about the future of our industry and for our company. In the industrial market, we are seeing the compounding effect of many concurrent secular trends. For example, our instrumentation business, which is comprised of automated test equipment, electronic test and measurement and scientific instruments, is aligned with growth trends from connectivity, to EVs, to sustainability. The growing technology complexity of these applications requires ADI’s more advanced metrology solutions, enabling us to continue increasing our SAM. Our factory automation business is empowering another critical trend of more intelligent and connected factories. Here, we support tens of thousands of customers of all sizes with our precision signal chain, power management, sensing technologies, and robust wired and wireless connectivity solutions. In automotive electrification, we are the global leader in battery management systems for EVs, with double the market share of our nearest competitor. We are continuing to build momentum globally. And in the last quarter, we have recorded several new design wins from premium European auto manufacturers. Electrification is not exclusive to the automotive sector. There is a necessary shift to sustainable energy sources to deliver the environmental benefits of electrification. This vision requires green energy generation with a smart grid, which digitally monitors and adjusts performance and also energy storage systems, which mitigate intermittency issues related to variable user demand. ADI supports this infrastructure with control and sensing technologies as well as accurate monitoring and efficient power conversion to ensure the grid parameters remain stable. Within automotive, we are also seeing manufacturers create a more immersive human experience by digitalizing the cabin. This requires increased bandwidth, lower latency and more efficient power management, creating new opportunities for ADI’s connectivity and power portfolios. For example, our audio system solutions with signal processing, A2B connectivity and road noise cancellation provide customers with the highest fidelity solution while also reducing the vehicle’s weight. In addition, our GMSL franchise and functional safety certified power management solutions are critical in architecting and efficiently powering advanced driver assistance systems. Overall, our market-leading positions in BMS, audio systems and GMSL, combined with our complementary customer bases, position our automotive franchise to deliver strong growth in the years ahead. Turning now to advanced communications networks, in wireless, ADI’s market leading software-defined transceiver portfolio is enabling next-generation communication systems from traditional 5G, to O-RAN, to low earth orbit satellites. And we are expanding our SAM with the industry’s first transceiver that includes a fully integrated digital front-end. In wireline, our optical control and power portfolios are critical to tackling the exponential growth in bandwidth and compute power of carrier networks and hyperscale datacenters. Here we see a large and underserved opportunity for ADI. So with that backdrop, we look forward to expanding on these areas and more at our Investor Day with our senior leadership team. So in closing, ADI is the leader in innovating at the edge. We have an industry leading high-performance portfolio that continues to benefit from the acceleration of mass digitalization across industries. And with Maxim, our portfolio has increased in breadth and depth and we see even more opportunity than ever to capture additional market share. And I am very optimistic about what our future holds. And so with that, I will hand you over to Prashanth who will take us through the financial details."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Good morning, everyone. Let me add my welcome to our first quarter earnings call. My comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today’s press release. The revenue commentary is on a pro forma basis and includes pre-acquisition Maxim revenue in the comparable period. ADI delivered a very strong first quarter, with record revenue, profitability and earnings. These results reflect the secular demand for ADI’s products, capturing synergies and effectively passing on inflationary costs. Our manufacturing team is diligently securing additional internal and external capacity as orders remain robust across all our markets and our backlog continues to grow. This sets the stage for continued sequential growth through the balance of fiscal 2022. So for the first quarter, revenue of $2.68 billion finished near the high-end of our outlook, with double-digit growth across all end markets and geographies. This marks our fourth consecutive quarter of record revenue and eighth straight of sequential growth. Looking at our end market performance for the quarter, industrial, our most diverse and profitable market, represented 50% of revenue and achieved a new all-time high. Industrial has grown more than 20% year-over-year for five straight quarters, underscoring our strong market positioning, supported by numerous secular tailwinds, including automation, digital healthcare, sustainable energy, aerospace and instrumentation. Automotive, which represented 21% of revenue, achieved another record, with every major application posting double-digit year-over-year growth. Our battery management system offering continues to outperform and represents over 15% of automotive revenue, underscoring ADI’s leadership in electric powertrains. Additionally, secular content growth inside the cabin continues to drive both the A2B and GMSL connectivity franchises to new heights. Communications represented 15% of revenue and exhibited strength in wireless and wireline. We are in the early days of 5G deployments and expect global rollouts, led by North America, to accelerate in 2022 and beyond. And in wireline, demand remains strong as carriers and hyperscalers continue to upgrade their cloud infrastructure from long-haul to datacenter. And lastly, consumer represented 14% of revenue and was in line with seasonality. Importantly, we continue to grow year-over-year, supported by strategic investments aimed at diversifying our customer and application mix. The first quarter demonstrated our increased portfolio breadth as all segments achieved growth, including professional audio video, gaming, wearables, hearables and personal electronics. Now, looking at the P&L, gross margin increased 100 basis points sequentially and 190 basis points year-over-year, resulting in a record 71.9%. Favorable product mix, higher utilizations and synergies were key drivers of the increase. OpEx in the quarter was $702 million, better than anticipated due to faster synergy progress. Operating margin of 45.8% increased 510 basis points year-over-year. Non-op expenses were $44 million in line with last quarter. And our tax rate for the quarter was approximately 13%. All told, adjusted EPS of $1.94 increased 35%. Our record profitability this quarter was driven by the stronger revenue growth as well as the synergy capture. And now moving on to the balance sheet, we ended the quarter with approximately $1.8 billion of cash and equivalents. And on a trailing 12-month pro forma basis, our net leverage ratio was just under one turn. Days of inventory increased modestly sequentially to 115 and channel inventory remains below the low end of our 7 to 8-week target. Looking at cash flow items, CapEx was $111 million for the quarter and $387 million over the trailing 12 months. As a reminder, during fiscal 2022, we plan to invest 6% to 8% of revenue to significantly grow our front and back-end capacity and build a more resilient hybrid manufacturing model for the long-term. Importantly, this higher level of CapEx will not hinder our capital return commitments. Over the trailing 12 months, we generated $2.78 billion of free cash flow or 33% of revenue. Our free cash flow margin was lower by about 3% due to costs related to the Maxim acquisition. Over the same time period, we returned approximately $4.2 billion or more than 150% of free cash flow via purchases and dividends. And as a reminder, we target 100% free cash flow return. We aim to use 40% to 60% of our free cash flow to consistently grow our dividend, with the remaining free cash flow used for share repo. And just yesterday, we announced a 10% increase to our quarterly dividend, marking the fourth consecutive year of double-digit increases. We have now raised our dividend 19x in the past 18 years. Our ASR program concluded in the first quarter, and as a result, we retired approximately 14.4 million shares. We are now more than halfway towards executing our $5 billion repo commitment by the end of calendar 2022. So let me finish with the second quarter outlook. Revenue is expected to be $2.8 billion, plus or minus $100 million. At the midpoint, we expect all B2B markets to grow sequentially and for consumer to be flattish. At the midpoint, operating margin is expected to be 46.5%, plus or minus 70 bps. And this outlook includes approximately $100 million of annual run rate synergies, split roughly evenly between cost of goods and OpEx as we exit second quarter. Our tax rate is expected to be approximately 13%. So based on these inputs, adjusted EPS should be around $2.07, plus or minus $0.10. And finally, let me end with an invitation. We are holding our Investor Day on April 5, where we look forward to sharing ADI’s long-term strategy, our new financial model and a detailed update on all phases of our synergy road map. We hope to see many of you in person at our headquarters right outside of Boston, where we will offer unique customer-led interactive technology demonstrations and displays throughout the day. This includes showcasing our wireless battery management system for EVs and much more. I’ll hand it off to Mike for the Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. Let’s get to the Q&A session. [Operator Instructions] With that, we have our first question, please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] And our first question is going to come from the line of Vivek Arya with Bank of America Securities."
},
{
"speaker": "Vivek Arya",
"text": "Thank you for taking my question. And good to see the strong execution. Vince, I was hoping you could maybe give us a readout of what you see as kind of the supply-demand balance in your different end markets. And if – as part of that, if you could help us understand what role is pricing playing in the industry today. And can it be sticky over time? Or will it need to revert back as there is more trailing-edge capacity that comes online, including from your other large U.S. competitor?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Good morning, Vivek, I’m going to just do the setup for that on the supply and demand environment. So what we’re seeing in 2022 looks a lot like 2021. So we expect that we will be chasing demand throughout the year. We’ve got continued order strength across the business. As I said in the prepared remarks, all end markets, all geographies are looking strong. And our backlog is continuing to expand. We’ve delivered eight sequential quarters of growth, and that’s supported by the manufacturing team continued to increase their ability to supply. And as I mentioned in the remarks, we expect that increase to be progressive over the balance of the year while they continue to debottleneck the process. So that will help us drive sequential growth. From a supply standpoint, we’re going to continue to look at the balance here and keep an eye on how things are going. But our view is that this will run through the balance of this year. And we expect that we will probably still have a little bit of catching up to do in early ‘23. On pricing, that’s a longer question, so let me split that into two pieces. Why don’t I talk margins and then I’ll let Vince talk kind of pricing strategy. So from margins, we along with the rest of the industry have been passing on the higher costs that we’ve been seeing. So we’re not using this environment to take advantage of customers, but really targeting to maintain gross margins. So we have been pushing those costs out. But built into those margins is a number of items, including the synergy execution, which is coming in faster than we thought, some benefit of mix, higher revenue because we are actually shipping more units. So I think on a quarterly basis, unit shipment is up double-digits year-over-year. And then, of course, with all this unit increase in unit shipment, utilizations are also quite strong. So there is a number of benefits that are underlying the margin piece. But to finish off on pricing, I’m going to pass to Vince to maybe talk about how we’re – how he’s talking to customers."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Vivek, just to add a couple of other color comments here. So we have historically managed our pricing to reflect the value that we deliver to our customers. We get an innovation premium for our products. And also, we have very, very long life products in our portfolio. And customers pay us to keep security of supply for the long-term. And that’s an approach that we intend to keep in perpetuity. I think also, pricing for us is more structural than cyclical. I think the last couple of years have really brought semiconductors from the background into the foreground and shown the importance of semiconductors to the modern digital economy. And I think customers understand the value in a more meaningful way. So I think, as Prashanth said, cost inflation, we’re in the post-Moore’s Law era, cost inflation, I think, is going to be a long-term facet of the economic dynamic of the semiconductor business. So I expect that cost increases will moderate, but there will be inflation, I think, for the medium to long-term here. So I think when you put it all together, the industry is in a better place to capture more of the value that it’s been generating over these many, many decades. And then I think we will benefit from that as a company based on the quality of our innovation, but also the new dynamics in the industry."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks for that, Vivek. Nest question please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from the line of John Pitzer with Credit Suisse."
},
{
"speaker": "John Pitzer",
"text": "Yes. Good afternoon. And good morning, guys. Thanks for let me ask the question. Just to follow-up on the pricing side of things, Vince. I’m just kind of curious, will this year’s revenue growth be more influenced by pricing than last year? And to the extent that the price environment seems to be structurally changing, are there any parameters you can give us? Historically, pricing did x, and now we think it’s going to do sort of x plus. And because – and the reason why I asked the question is we look at your relative growth rates to some of the end markets that you participate in, and you’re clearly growing significantly faster. And there is a content side of things. But that relative growth does kind of make people concerned about inventory levels. And so we look at inventory and revenue, we probably should be looking at it on units. I’m just kind of curious how we should try to factor in that pricing dynamic."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "John, let me just set the numbers on that. So this year, pricing or – actually, I should say, for the current quarter, pricing counts for less than half the growth. So that kind of helps you size it. And we had said on the prior quarter’s call that in 2021, we had cost increases that were coming at us faster than we were able to push price out because we were in the process of closing the deal on Maxim and beginning the integration. So we did expect more pricing tailwind this year because we actually had inflationary cost headwind last year."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I’d say, John, one other comment. I’ve said many, many times before that for several years up to this step function increase due to inflation in prices and cost of goods and then prices, our pricing was – for many, many years, we had been – we had to fill a gap. We had to ship more units to keep up with the annual price reductions. I would say we were accentuating towards zero price reduction on the average, adding more ASPs to our products for the innovation that we’re creating. And then I think that for the long-term is going to be a better way to gauge ADI’s pricing methodology. So we’re pricing for value. And we’re injecting significant amounts of R&D into the company to make sure that we keep ahead of our customers’ needs. So that will be, I think, the primary dynamic for value capture for ADI for the years ahead."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, John. Next question please."
},
{
"speaker": "Operator",
"text": "Our next question will come from the line of Pradeep Ramani with UBS."
},
{
"speaker": "Pradeep Ramani",
"text": "Hi, thanks for taking my question. I just wanted to ask about your automotive business just given how automotive production is sort of sharply rebounding in 2022. How do you feel about how much your automotive business can outgrow SAAR or even production in 2022? How should we think about that? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think right now, the supply chain is very, very lean. That is pretty well established. I’ve talked with a lot of automotive companies over the last 6 months or so. And my sense is that everything that we’re shipping has been used and I don’t see any stockpiling. So content in vehicles is increasing every year. The value generation activity in the auto sector now is – it’s driven by semiconductors and software. So we’re seeing content growth of 5% to 10% per year. And I think that will continue for the foreseeable future. We are seeing, I think, the shift towards EVs. I’ve been surprised by the speed of the shift myself in the 2021 period. And that our customers are tilting the content, the semiconductor content towards premium models. So that accelerates the content growth story versus history. And then long-term, we expect to be able to grow our business in the automotive sector as a multiple of SAAR. We see tremendous opportunity to continue to drive our share and growth story of EVs. In cabin connectivity where we’ve got a very, very strong signal processing franchise, to which we’ve connected our A2B connectivity, road noise cancellations, a new value creator in the cabin. And we’re very excited by the GMSL, the connectivity portfolio, the high-speed connectivity portfolio that we have inherited from legacy Maxim. And we have aggressive plans to continue to build that out, both in terms of product development as well as our manufacturing footprint. And last but not least, power. We are underrepresented in general in power management, I’d say, across the industry, and particularly in automotive and industrial. So, I think the combined portfolio of ADI and Maxim gives us a tremendous opportunity to tap in to what is actually the largest sector. Power is the largest sector of the analog market, and it’s growing at a compounded rate there. So, that gives you a sense for our automotive thinking."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question will come from the line of Toshiya Hari with Goldman Sachs."
},
{
"speaker": "Toshiya Hari",
"text": "Hi, good morning. Thanks so much for taking the question and congrats on the strong execution. Prashanth, I wanted to ask about your synergy capture in the quarter and how to think about synergies going forward. In your prepared remarks, I think you talked about earlier than expected synergy capture. Should we consider this as kind of a pull-in of synergies, or would it be fair to assume that the Phase 1 target of $275 million is a little bit more on the conservative side? And then, I guess additionally, on Phase 2, I realize it’s kind of early. But you had talked about potentially looking at your manufacturing footprint similar to how you did with the linear. Is that still the plan, or could things change given the stronger demand backdrop? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Good question, Toshi. And a great setup to invite folks to join us in April when we are going to answer all those questions. The – in the last call, we talked about $20 million of synergies was realized in fourth quarter. And we said that there would be minimal impact in the first half before ramping more aggressively into the second half. We have moved faster than originally planned and we have captured more earlier. So, we are going to exit second quarter at about $100 million of that $275 million. And as I have said in the remarks, it’s roughly split between both cost of goods and OpEx. The – we will give you an update on that $275 million in terms of how much we believe we can actually achieve in that first Phase 1 time period. We will do that at the April earning – Investor Day. Vivek will also specifically talk about his plans and what he is – has high confidence on for Phase 2 of the cost synergies. And then our Head of – our Chief Customer Officer is going to talk about the revenue synergies that we are expecting from the combination. So, we will lay all that out for you when we see you here in Boston in a couple of weeks."
},
{
"speaker": "Toshiya Hari",
"text": "Got it. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from Stacy Rasgon with Bernstein Research."
},
{
"speaker": "Stacy Rasgon",
"text": "Hi guys. Thanks for taking my questions. I wanted to ask about gross margin. So, I hear what you are saying on pricing. It sounds like it’s a revenue boost, but not so much a margin boost yet. But I just look at the company, ADI standalone was kind of 70 to maybe low-70s, Maxim was kind of mid to high-60s. And you are doing 72% out of the gate. Is this mostly just utilization and mix and the synergies? And it sounds like you have got more synergies coming. You have got revenue going through the year. Should we be thinking about the current gross margin level you just put in Q1 as sort of being the bottom for the year as you continue to progress?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Stacy, let me just clarify, that I would be incorrect to assume that there was no benefit from pricing in the gross margins. What I wanted to clarify earlier in the response was, embedded in that margin improvement is the synergy, the faster synergy execution, which I just answered in Toshiya’s question. The mix, which we talked about in the prepared remarks, again, very strong industrial at 50%, is great for us. And then higher unit volume, because we are up on a unit basis double-digits, and utilization, and then pricing also fits into that. So, they are all elements of that. In terms of how to think about the gross margin on a go-forward basis, we will share the new operating model or the financial model for the company in April. But I will preview to say that our focus continues to be on how do we drive the best revenue growth balancing that gross margin. So, as we have met with investors, there is pretty uniform agreement that what they would like to see is higher revenue growth and make the trades that are necessary on margin to be able to deliver higher revenue growth. So, we will talk more about the model in Investor Day. But I would not be encouraging folks to be modeling very high gross margin numbers over the long-term."
},
{
"speaker": "Michael Lucarelli",
"text": "Gross margins, Stacy, and how it trends, we don’t guide gross margins, but I will give you some context around. If you look at 2Q, it’s usually up a bit. That’s embedded in our outlook. In the back half, usually about flat from there. That kind of helps you from a kind of near-term 2022 outlook. And then at the Investor Day, we will talk more about the long-term outlook for the business."
},
{
"speaker": "Stacy Rasgon",
"text": "That’s helpful. Thank you so much."
},
{
"speaker": "Operator",
"text": "Our next question will come from the line of Tore Svanberg with Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you and congratulations on the record results. Could you just talk a little bit more about your capacity plans? You talked about increasing CapEx 6% to 8% this year. I don’t know if that’s sort of the first year or more to come. And is there any way for you to quantify what that does as far as capacity expansion? I know you have a hybrid model and this is a moving target. But any color you can share with us on how much capacity you are going to have? That would be great. Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes. So thanks, Tore. The – well, first off, if we just take it from a high level, first, we have always utilized a hybrid manufacturing model at ADI. And it gives us the reach of process technology and capabilities that we need to support the sheer breadth of our portfolio, which is more than 75,000 unique product sets. And we are supplying 125,000 customers. So, I think when we think about the long-term, we will continue to use the benefits of this hybrid model for optionality, resilience and the availability of technology. So overall, the business that we are in, it is – and given that we are approaching the world with a hybrid mentality, our business is less capital intensive. And it also gives us, as I said, resiliency in terms of gross margin and long-term access to more options for process technology, etcetera, etcetera. So, I will hand it over to Prashant. He will make a few comments on the investments that we are making and how we are going to strengthen that model."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Tore, I think your question was specifically related to CapEx. So, let me just – let me kind of size that at a high level. So, we said that our CapEx is going to be doubling in 2022. And we are targeting somewhere between 6% to 8%, which is above our historical long-term rate of 4%. And that CapEx is being used for internal capacity. Specifically, that can swing in and out, so it helps us with optionality. And that’s an important element of the hybrid manufacturing model that Vince talked about is being able to use that same capacity for volume when we need it or utilization if the market should not have the same level of demand as they do today. So, the shelves of the building are complete. And Vince mentioned in his prepared remarks that we were adding in – expanding our footprints in Oregon and Limerick. And also, we are adding a significant amount of testers to our back end in the Phils, Thailand and the LTC site that we acquired in Malaysia."
},
{
"speaker": "Tore Svanberg",
"text": "Great. Helpful. Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Thanks Tore."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question will come from the line of Ambrish Srivastava with BMO Markets."
},
{
"speaker": "Ambrish Srivastava",
"text": "Hi. Thank you very much. Prashanth, I wanted to come back to the inventory. On a GAAP basis, which is consistently how we measure for all companies, it’s pretty low versus the average and versus the long-term target that you have laid out. And on an absolute dollar basis, it was down quite a bit as well. So, I was just wondering, part of it is probably from the accounting and the step-up you had from the Maxim acquisition. Could you just help us understand, was there a drawdown internally? And I don’t think I heard you talk about where channel inventory was. So, what should we expect inventory to do on an absolute dollar basis as we go through the year? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes, great question, Ambrish. So first, let me say that you are absolutely right. There is a bunch of purchase accounting that is flowing through the balance sheet. So, the inventory numbers probably have a bit more noise, and we can handle that with your team offline. But let me high level kind of help folks to think about the inventory. So, the channel remains very, very lean. That is not the – not our balance sheet, but the inventory in the channel, that remains very lean, well below our seven-week to eight-week target. We are having difficulty building inventory in the channel. We get it into the channel, and it moves out very quickly. Within ADI’s books, our days of inventory are up slightly, primarily, as I mentioned that we are planning to see revenue increase sequentially for the balance of the year. So, you have the raw material and the WIP is in – is sort of in the middle of the process now before that comes out, and that is – that’s up. We also had a little bit of finished goods up, but that was purely timing on when the quarter ended versus where the goods were in the transit process. So, I wouldn’t read anything into our increase in finished goods, except to say it’s just – it happened to be when the Drawbridge closed for the quarter."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Ambrish. We will go to our last question, please."
},
{
"speaker": "Operator",
"text": "Alright. Our last question will come from the line of Harlan Sur with JPMorgan."
},
{
"speaker": "Harlan Sur",
"text": "Good morning. Congratulations on the strong results and execution. If I look at cloud and hyperscale data center CapEx spending for this year, that’s expected to grow like 30%. And I know that in the data center end market, Maxim, for example, they provide the critical processor power management for NVIDIA’s data center GPUs. They provide power management for Google’s flagship AI processors. On the ADI side, you guys provide server power supply solutions and optical networking solutions. So, I guess my question is, given the strong backdrop, was data center a big driver for your comps business in Q1? How do you see data center growth for the full year? And how big is data center as a percent of your overall comm business?"
},
{
"speaker": "Michael Lucarelli",
"text": "I will answer backwards. I will start with kind of the sizing of data center for you. If you look at our comms business, it’s about 15% of total revenue. That’s split about evenly between wireless and wireline, about 50%, 50% in each of those. And if you look at the wireline piece, that’s where data center is embedded, it’s probably about 30% to 35% of that relates to the data center. What do we ship into this, I know you outlined it pretty well. I am not going to go through it again. But I will pass it to Vincent and Prashant, probably Vince to talk a little bit more about what the opportunity is in data center and why we are excited."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks Mike. Well, we have I consider, combined with Maxim, a strong position in optical connectivity as well as carrier networks, but also power management, whether it’s the power system monitoring, energy monitoring and actually power delivery itself. We see that as a phenomenal opportunity. So, my sense is, and we will talk more about this at the Investor Day, but we will unpack the story for you. But my sense is that we can double our data center and cloud business over the next 4 years to 5 years."
},
{
"speaker": "Harlan Sur",
"text": "Great. Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Alright. Thank you, Harlan. And thanks, everyone, for joining us this morning. A copy of the transcript and all of our reconciliations will be available on our website. We hope you can join us at our in-person at Investor Day, April 5. Thanks for joining the call and interest in Analog Devices. Have a good day."
},
{
"speaker": "Operator",
"text": "This concludes today’s Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 4 | 2,023 | 2023-11-21 10:00:00 | Operator: Good morning and welcome to the Analog Devices Fourth Quarter Fiscal Year 2023 Earnings Conference Call, which is being audio webcast via telephone and over the web. I’d now like to introduce your host for today’s call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli: Thank you, Abigail and good morning everybody. Thanks for joining our fourth quarter fiscal 2023 conference call. With me on the call today are ADI’s CEO and Chair, Vincent Roche; and ADI’s Interim CFO, Jim Mollica. For anyone who missed the release, you can find it in relating financial schedules at investor.analog.com. On our disclosures, the information we are about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our earnings release and our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information. These statements reflect our expectations only as the call today. We undertake no obligation to update these statements, except as required by law. Our references to gross and operating margin, operating and non-op expenses, tax rate, EPS and free cash flow will be on a non-GAAP basis, which excludes special items. When comparing our results to historical performance, special items are also excluded from our prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today’s earnings release. Two comments before we go prepared remarks. We adjusted our mapping to better align revenue to customer end markets. This resulted in slight changes to our end market mix with industrial increasing at each of the other markets slightly lower. These changes are reflected on our web schedule in the quarterly results section for the last 3 years. And second, one more quick reminder, the first quarter of 2024 is a 14-week quarter. And with that, I’ll turn it over to ADI’s CEO and Chair, Vincent.
Vincent Roche: Thank you very much, Mike and a very good morning to you all. Though the industry is obviously moving through a more challenging period of the business cycle, I am very pleased to share that we are preserving the strength of our financial performance while preparing for the market’s recovery. Fourth quarter revenue was $2.7 billion, led by double-digit year-over-year growth in our automotive sector. The combination of careful expense management and our employees’ commitment to high standards of execution enabled us to deliver operating margins of 44.7% and EPS of $2.01 for the quarter. For the fiscal year, ‘23 again set new high watermarks with revenue reaching $12.3 billion, supported by all-time highs in the industrial and automotive sectors. This resulted in EPS of $10.09 up 5% from a year ago. Notably, we returned a record $4.6 billion to shareholders in 2023, exceeding our 100% free cash flow return target. Since the closing of Maxim just over 2 years ago, ADI has returned roughly $12 billion to shareholders or nearly 15% of our market cap. Over the same time, we have reduced our share count by more than 6% and increased our dividend per share by 25%. Now looking to fiscal ‘24, the near-term dynamics remain uncertain. As you will recall, last quarter, we outlined a broad-based inventory correction across all markets and geographies, reflecting the deteriorating macro conditions and our improving lead times. Consistent with our view 90 days ago, we expect the customer inventory overhang to persist through the first half of the year. Challenging times like these confirm the wisdom and the strength of our business model. The diversification of our business across customers, applications and products helps to limit volatility while preserving profitability. Building upon that foundation, we took actions to better ensure we can deliver operating margins in the low 40s and solid free cash flow despite the revenue decline. Importantly, however, we are not simply battening down the hatches. Our resilient financial model enables us to continue making the strategic investments necessary to allow us to capitalize on the upside when the business inflects higher. That longer term focus and commitment is why our customers have the confidence to increasingly depend on us as a key strategic partner. I have been very heartened by my conversations with customers across many markets and geographies over this past quarter. Despite the near-term challenges, they share our optimism that the intelligent edge is enabling a future replete with opportunity, and they are clear about the expanding role that they expect ADI to play in their success. Our customers’ optimism is reflected in the continued expansion of our design win pipeline, which increased by double-digits again in 2023. That growth was enhanced by sustained momentum in our Maxim revenue synergies pipeline, which is tracking ahead of our initial expectations. We expect synergy-driven revenue acceleration in 2025 putting us on a path to achieve our goal of more than $1 billion in revenue synergy by 2027. The combination of our strong design win growth with recurring revenue streams from our 75,000 product SKUs, which have average life spans of a decade or more creates a business with high barriers to entry that’s both resilient and rich with growth opportunities. Now, let me share some examples of recent wins with you. In Industrial Automation, we are increasingly delivering more complete solutions. At a top digital factory automation supplier, for example, we have recently leveraged our anchor position in software configurable I/O to attach additional solutions value across power, isolation and connectivity. As a result, we captured 3x the bill of materials and secured design wins across their entire platform. In Industrial Instrumentation, we have increased our design wins at SOC and memory test market leaders. Our next-generation solutions increased channel density and throughput while reducing energy consumption by up to an incredible 30% per system. These are critical parameters for testing complex, high-performance compute GPUs and high-bandwidth memory for artificial intelligence systems. Looking now to automotive. In electrification, momentum continues for our wireless battery management system. This novel solution enables lower weight, greater scalability and improved manufacturing productivity, driving down the total cost of ownership for our customers while increasing ADI’s content. Last quarter, we secured our fifth customer, a top 10 EV OEM. We’ll begin to deploy our wireless solution in their next-gen EVs in 2026. Now furthermore, during the year, ADI reinforced our industry-leading position in automotive, high-performance functionally save power. To that end, we won next-generation power for ADAS systems at four top suppliers this past year. These wins add another growth vector to our automotive franchise, which has benefited from strong momentum across electrification and in-cabin connectivity. This proliferation of ADAS is benefiting our high-speed GMSL connectivity portfolio. GMSL has been one of our fastest growing areas and a major revenue synergy generator for us. In the last year, we were awarded 4 new wins across leading North American, Asian and European OEMs. We are also expanding our opportunity and increasing our ROI, winning multiple design wins in industrial areas – in adjacent areas such as autonomous robotic systems. Our cloud infrastructure business is beginning to benefit from the power challenges and connectivity requirements necessary in AI ML systems. Notably, a large hyperscaler designed our high-performance power and protection solutions into their next-generation AI platform. And in connectivity, systems are upgrading now to 1 terabit per second and require our highest level of precision control solutions to efficiently support the growth in data generation. In consumer, we won multiple power management sockets in a portable application and a key customer. These wins truly show the combinatorial power of our acquisition strategy. We leveraged our industry leading cell and switcher, Maxim’s cost optimized process technology, and our customer relationships to secure these wins. And lastly, in healthcare, Maxim strengthened our comprehensive suite of technology for personal monitoring solutions, adding sensor AFEs, microcontrollers and ultra-low power technologies. We secured a design win at a leading continuous glucose monitoring customer this year. Our solution increases the robustness, accuracy and power efficiency of their glucose center, thereby helping to extend its life from days to weeks. So in summary, we’re proud of another year of record revenue and earnings. We continue to demonstrate the power of our business model, which delivers results through all phases of the business cycle. Our continued strong investments in technology and business innovation, customer engagement, and our hybrid manufacturing model positions ADI and our customers to take maximum advantage of the opportunities at the intelligent edge when the business recovery arrives. Now I’d like to pass the call over to Jim. Over the past 35 years, Jim has taken on a number of critical financial leadership roles across ADI, enabling him to develop a breadth and depth of understanding of our business that very, very few possess. So I’m pleased now to have him on my leadership team and to be joined by Jim on today’s call. Over to you, Jim.
Jim Mollica: Thank you for that introduction, Vince, I’m excited to be here today, and let me add my welcome to our fourth quarter earnings call. Starting with a brief recap of fiscal 2023 results. Revenue increased 2% to $12.3 billion, marking ADI’s third consecutive record year. Gross margin of 72.5% moderated from last year’s record results of 73.6%. Operating margin of 48.9% decreased 50 basis points, roughly half the decline of gross margin, reflecting strong operating expense control. All told, EPS increased 5% to a record $10.09. Now moving to fourth quarter results. Revenue of $2.72 billion declined 12% sequentially and 16% year-over-year, finishing above the midpoint of our outlook despite the challenging operating environment. Industrial represented 50% of quarterly revenue, declining 19% sequentially and 20% year-over-year. As expected, we experienced broad-based weakness as inventory adjustments continued across our diverse customer base. For the full year, Industrial increased 6%, achieving its third straight record result with strength across instrumentation, test, energy and aerospace and defense. Automotive, which represented 27% of quarterly revenue was down slightly sequentially and up 14% year-over-year, marking 12 straight quarters of double-digit growth. For the year, Automotive also achieved its third straight record result, increasing 19%, with strong growth across our functionally safe power, battery management and in cabin connectivity solutions. Collectively, these were up more than 30%. Communications, which represented 13% of quarterly revenue, declined 6% sequentially and 32% versus a record fourth quarter 2022. For the year, Communications decreased 13%, with steeper declines in wireless versus wireline. And lastly, Consumer represented 11% of quarterly revenue, down 6% sequentially and 28% year-over-year. Consumer decreased 20% in fiscal 2023, driven by industry-wide weaker demand and ongoing inventory corrections. Now on to the rest of the P&L. Fourth quarter gross margin was 70.2%, down sequentially and year-over-year driven by unfavorable product mix, lower factory utilizations and lower revenue. OpEx in the quarter was $692 million, down $60 million sequentially. These significant savings were driven by disciplined expense management and lower variable compensation. As a result, operating margin came in at the higher end of our outlook of 44.7%. Non-op expense finished at $65 million and the tax rate for the quarter was 12.5%. All told, EPS was $2.01, slightly above our outlook. Now on to the balance sheet. We ended the quarter with approximately $1 billion of cash and cash equivalents and a net leverage ratio of 0.9x. Inventory decreased nearly $70 million sequentially, driven by finished goods. Channel inventory also declined as we actively manage sell-in to be less than sell-through. Given lower revenue, inventory days increased to 188 and channel weeks ticked up slightly, ending within our target range of 7 to 8 weeks. Now moving on to our cash flow items. Operating cash for the quarter and the year was $1.2 billion and $4.8 billion, respectively. CapEx for the quarter was $476 million and for fiscal 2023 was $1.3 billion. These CapEx numbers are gross figures, which do not include the benefits of the investment tax credits or grants related to both the U.S. and European Chips Act. Full year free cash flow was $3.6 billion or 29% of revenue. During the year, we returned 130% of free cash flow via roughly $3 billion in share repurchases and $1.7 billion in dividends. Now moving on to the guidance for the first quarter, which will be on a 14-week basis. First quarter revenue is expected to be $2.5 billion, plus or minus $100 million. Once again, we expect sell-through to be higher than sell-in. At the midpoint, we expect all end markets to be down sequentially. Industrial is expected to be down the most, followed by Consumer and Comms with Automotive faring the best. Operating margin is expected to be 41.5%, plus or minus 70 basis points. Our tax rate is expected to be 11% to 13%, and based on these inputs, adjusted EPS is expected to be $1.70 plus or minus $0.10. I will conclude my remarks with a brief update on the current operating backdrop. As Vince mentioned, we continue to see broad-based weakness across markets and geographies as customers work to reduce inventory and a stressed macro backdrop. Importantly, our lead times are now back to normal levels with 95% of our products shipping within 13 weeks, given our customers high confidence and timely supply. Encouragingly, during the fourth quarter, we’ve seen cancellations fall and bookings stabilize. This gives us greater confidence that the ongoing inventory correction will taper through the first half of the fiscal year. As we discussed last time, we’ve taken actions to preserve the integrity of our income statement, our balance sheet and our cash flow statements. Let me provide an update in these areas. We are once again lowering internal utilizations with a goal of significantly reducing inventory in the first half of the year. Our hybrid manufacturing model and ability to swing in external wafers will help us moderate the decline in factory starts. The unique ability positions us to deliver healthy gross margins despite the significant revenue decline from a year ago. Given the enhancements made to our hybrid manufacturing model over the last 2 years, we now plan to slow the expansion of our internal fabs and back-end facilities. As a result, we expect 2024 CapEx to be between $600 million and $800 million or down about 45% versus 2023. Importantly, this CapEx reduction does not compromise our long-term growth or resiliency efforts that gives customers multiple locations to source ADI supply. And lastly, we took additional steps to structurally reduce our OpEx. These actions, combined with lower variable comp and seasonally lower spend in the first quarter will result in a slight decline in OpEx sequentially even with the extra week. So in closing, our ability to generate operating margins in the low 40s, which were our previous highs in the last cycle demonstrates the durability of this franchise and how we’ve enhanced our operating model over time. And with that, I’ll give it back to Mike for Q&A.
Michael Lucarelli: Thanks, Jim. Welcome to the call. It’s great to have you. Now let’s get to the Q&A session. [Operator Instructions] With that, we will have our first question please.
Operator: Thank you. [Operator Instructions] Our first question comes from Ambrish Srivastava with BMO. Your line is open.
Ambrish Srivastava: Hi, thank you. Thank you very much for taking my question. Vince, it looks like order has been restored in the diversified Analog world with – it looks like a very normal cyclical downturn and with you, what you’ve built is a structurally more profitable company holding to 40% – low 40% operating margin line. My question is on a bottoming process. And I know we’re not there yet, but can you just remind us or help us understand metrics you’re following regarding cancellations, pushouts, backlog, you did talk about cancellations, Jim. And then kind of related to that, is if you look at past cycles, does automotive needs to go down double-digit year-over-year decline as industrial has been there? And how should we think about that? Thank you.
Vincent Roche: Yes. God morning, Ambrish, and thank you for the question. So yes, we noted last quarter that we believe the inventory digestion issue would last two to three quarters. And I’d say, given the new information that we have, our conviction of that has actually grown. We have, through careful analysis and observation, we’ve seen inventory digestion accelerate at our largest direct customers across the board and across all the various segments that we support. And we’re continuing to reduce our channel inventories as well. So I think very encouragingly, even with normalized lead times, as we’ve said, we’re shipping that kind of 95% of customer requests within a quarter, which is very, very normal. We saw against that backdrop, a sharp drop in cancellations, and though the book-to-bill was below unity in the fourth quarter. We did see our bookings improve sequentially. So that gives us a lot of confidence as to what’s going on. Regarding Automotive, I’m not sure, by the way. The automotive – the assumption you’re making is that there could be a double-digit drop in Automotive. I’m not sure about that because we know that cars are consuming about 10% more silicon per year. And in fact, we continue to grow in share and ASP in the car. So my own sense is that against what could be a very challenging macro backdrop during 2024, that of all the elements of our portfolio, automotive, we expect will fare best of them all. And we still have pretty strong confidence that we’ll grow in 2024.
Ambrish Srivastava: Thank you, Vince.
Michael Lucarelli: Thanks, Ambrish. Next question please.
Operator: [Operator Instructions] Our next question comes from Vivek Arya with Bank of America Securities. Your line is open.
Vivek Arya: Thank you for taking my question. Vince, I’m trying to reconcile the comments that were made about some stabilization in bookings. That sounds like a positive. But I think in the prepared remarks, you also said some headwinds that could persist through the first half of the fiscal year, suggesting that April could be a sub-seasonal quarter. So I know you’re not guiding specifically out to April, but what is the right way to look at the puts and takes as we think about April? Can it be seasonal, whether it not be seasonal? And also this extra week from January, did that really give you that 7.5% push, so we should be taking that out of April. So any way to help us give us a sense for how the April could shape up would be very helpful. Thank you.
Vincent Roche: Yes. Well, I think it’s – Vivek, thank you for the question. It’s one quarter at a time here. What I will say contextually is that we expect the inventory overhang to have been depleted by the start of our third quarter, which is in May of next year. So, we still remain pretty confident about that, given the dynamics that I just outlined. But the other parts of the cycle that we’re really – I think everybody is seeing pressure from is the macroeconomic climate and particularly the decline of semi business in China. So that’s the piece. I mean that is the piece that isn’t well understood. But all that said, the macro will be the governor on what happens in the second half of the year. And I think another quarter or so will give us a lot more confidence in terms of what is possible in the second half. But I will let Jim answer as well give you some particular statistics to underpin our assumptions here.
Jim Mollica: Thanks, Vince. Yes, let me just speak to – let me unpack lead times a bit first. As we said, lead times are now kind of back to where they were, 95% of our products are shipping within 13 weeks. And we’ve seen steady improvement in lead times in both 3Q and 4Q. And I guess from the refreshing side of that is from a customer viewpoint, customers have now adjusted to those shorter lead times. And our order rates basically in the fourth quarter basically stabilized in fact, picked up in 4Q versus 3Q. So that’s good news for us as the customers have shopped and their signal into us. As Vince said, our book-to-bill will still be low on there, but it is kind of the first lines there. Additionally, cancellations in the fourth quarter were down meaningfully for the first time and probably close to a year. And cancellations on a shorter time fence were also very, very low. So that’s good for us. From a channel perspective, we’re being cautious. We continue to basically ship into the channel less than our sell-through, which basically will position us well for when the upswing occurs. And from an end market viewpoint, let me just close on that point. All markets in 1Q will be down on a quarter-to-quarter basis. Yes, that’s it. Mike, anything else?
Michael Lucarelli: Yes. And it’s very confusing with a 13 to 14-week card, you’re right, Vivek. I’ll kind of add some commentary around that, how to think about that. Normally, 2Q from 1Q and a 13-week to 13-week basis up about 5%. And given what have been said, inventory overhang and bookings getting better. It still feels like we should probably grow some, but I don’t think 5% is likely. Why? There’s still an inventory overhang going on. So if you think 13-week to 13-week were about flattish, plus or minus, in 1Q to 2Q, that’s probably the way to think about it. That means if you include the extra week, it’s probably down about 5% plus or minus sequentially. So I hope that helps back a little bit because it is confusing. And with that we go to our next question, please.
Operator: [Operator Instructions] Our next question comes from Joseph Moore with Morgan Stanley. Your line is open.
Joseph Moore: Great. Thank you. I wonder, I mean now that you’re in a revenue downturn that looks more severe than we saw the last cycle, what are you seeing in terms of pricing? And are people – you obviously raised prices during the upturn. Are people asking you to give that back? And is that a different conversation on kind of a like-for-like basis versus approaching kind of new design win activity?
Vincent Roche: Yes. Thanks, Joe. So look, I think overall, the pricing of our existing portfolio is very, very resilient, very stable. And I think something to note as well is that every new generation of product that we build is capturing more value. And – so if you look at the legacy, it’s very stable. You look at the legacy franchise. We’ve got tremendous stability. We’re capturing more new value per new socket. And I don’t see any particular change. And we, as a company, play at the high end of the performance curve, which enables us to get this innovation premium that is a very, very critical part of our gross margin structure and our revenue growth. And our job is to continue to invest to make sure that we stay on the cutting edge and get well rewarded for that. We fight very, very intensely at the inception of new designs. But as I said in the prepared remarks, Joe, we’re seeing generally speaking, our pipeline of new product design wins as well as the more established products continue to grow quarter-by-quarter, year-over-year. So I feel confident that the pricing that we have managed to increase over the last couple of years, 2.5 years that they’re about to reflect the increased cost of goods. We’ll hold those prices. So overall, we’re bullish about where we are and what the pricing environment holds in the future.
Joseph Moore: Thank you.
Michael Lucarelli: Thanks, Joe.
Operator: [Operator Instructions] Our next question comes from Stacy Rasgon with Bernstein Research. Your line is open.
Stacy Rasgon: Hi, guys. Thanks for taking my questions. I had a question on OpEx and gross margins into Q1. So you said OpEx was down slightly even with the extra week. So, if I sort of understand a little bit, it would imply the normalized like 13-week OpEx would be running around, I don’t know, 640 maybe, maybe a little lower. Once we get through into Q2 when the ex-week rolls off, is that the right sort of like steady-state OpEx run rate to think about as we go through the year and some – are there some other drivers? And I guess if those numbers are right, it sort of implies gross margins implied in Q1 maybe a little below 70, maybe 69, is that the right kind of level that you are thinking about as the revenue is going to drop here?
Jim Mollica: Yes, Stacy, it’s Jim. Let me take that. Let me the margin one first, and then I will talk about the OpEx for the quarter. There is many inputs. There is many levers to the gross margin. There is revenue that’s priced, there is mix as factory loading utilization levels. And let me just try to unpack that a bit. Vince mentioned on the pricing side, basically, that’s stable. So, that’s not a drag to gross margins as we move forward. On the revenue side, basically, we are down – the midpoint of our first quarter guide on a 13-week basis is down, approaching 30% from our previous peak. So, basically revenue is a headwind for us there. Mix basically is unfavorable as well. As you heard in my prepared remarks, industrial was down 19% and 20% last quarter on a year-over-year and sequential basis, and that will be down again in first quarter. So, mix is a headwind for us. When you put all those puts and takes together, we would expect basically gross margin will fall below 70% in the first half of the year at these trough levels. I think if you think about something in the 68% to 69% range, is probably a good range for this trough revenue range. So, that’s kind of the gross margin. On the OpEx side, as I mentioned, our 4Q OpEx basically was down about $60 million on a sequential basis. This was the combination of reducing discretionary spend and of course, a much lower variable comp. Looking into 1Q, we expect that to be down again even with the extra week. And it’s fair to say that probably you can think about 1% to 2% there. This reduction relates to the actions that we structurally took to reduce OpEx as well as a lower typical seasonal spend in 1Q as well. We don’t guide 2Q, but just to give you a sense there, when you look at 2Q, it’s probably best to compare that to the 4Q, which was a like 13 to 13-week comparison. And when you are looking at 4Q ‘23 versus 2Q ‘24, given some of the structural modest reductions we had made, we would expect OpEx in 2Q to be down a few percent from the 4Q operating levels, so I hope that helps.
Stacy Rasgon: That’s helpful. Thank you so much guys.
Michael Lucarelli: Thanks Stacy. I always appreciate your two-part and one-part question. With that, next question, please.
Operator: [Operator Instructions] Our next question comes from Chris Danely with Citi. Your line is open.
Chris Danely: Hey. Thanks. Just a question on industrial, historically this has been a pretty strong sector for you guys, but it seems like it’s – the revenue decline in industrial is worse than the overall company. Can you just talk about why that is and maybe broader speaking, are the bookings or the revenue falling more because the macro is worse than expected, or the inventory situation out there is just worse than you guys thought? And do you think you will be able to hold that 70% gross margin floor for the fiscal ‘24? Thanks.
Vincent Roche: Yes. Thanks Chris. So, yes look, we have come off a record year for ADI and for the industrial sector. But I would say in the second half of ‘23, we began to see momentum slow on the order side of things. And in the fourth quarter, it’s true to say that weakness in the industrial sector broadened and hit all the various market segments with one exception, the aerospace and defense area. And I think when we look into 2024, given the weaker macro backdrop, and we expect the inventory digestion to continue through the first half particularly at the broad market customers who are suffering most here. So, I think, as Jim said, when we talk about gross margins, the weaker industrial over the first half of the year, that weaker mix, if you like, will impact the gross margins. And for the trough periods here, we are thinking kind of 68%, 69% as reasonable assumptions for gross margin in that period of time. So, it really is, at this point, it’s an adjustment of inventories at our customers and how fast we experience the recovery will determine on the macro. But again, I think it’s true to say, during the first half of this year, we do expect to get this overhang of inventory behind us and get back to a more normalized growth pattern in the second half of the year. Jim, do you want to take a comment?
Jim Mollica: Yes. Chris, I think just a couple of points there. Vince talked about at the trough revenue, gross margins in the 68% to 69% range, gross margins at 70% for the year, I think that was the first part of your question as well. A lot of that will depend upon when the demand comes back in terms of – so we don’t really guide for the year, but that’s probably dependent upon revenue coming back to a more normal level. Let me just add a few points, though. We are – utilization levels basically brought them down in 4Q, we are going to bring them down again in 1Q. You see the inventory reduction of $70 million in 4Q, which was a little bit better than I think we guided last quarter, you are going to expect that inventory to be reduced at a similar level in 1Q and again in 2Q. And what we are also doing now is we are activating our hybrid manufacturing strategy. So, we are actually swinging wafers from external back in-house, which moderates the factory load, which gives a little bit of a cushion on that gross margin side as well. So, just a little bit more color as what you can expect for us in the second quarter here.
Chris Danely: Thanks a lot guys.
Michael Lucarelli: Thanks Jim. With that, next question.
Operator: [Operator Instructions] Our next question comes from Tore Svanberg with Stifel. Your line is open.
Tore Svanberg: Yes. Thank you and congratulations on the results in this tough environment. I had a question about CapEx. So, one of your competitors talk about this geopolitical dependable capacity that they are investing in. You are going showed the complete other the way, you are reducing CapEx a lot for this year. Help us understand a little bit what your partners are doing – your founder partners are doing for you to sort of feel comfortable that you don’t have to spend as much in CapEx going forward? Thank you.
Jim Mollica: Thanks Tore. Why don’t we take that in, so I will start.
Vincent Roche: I will sort of add some color.
Jim Mollica: Yes. So let me just – let me pause and take a step back on CapEx for a second. So, at our Investor Day, we outlined basically elevated CapEx in the high-single digit range for 2022 and 2023. And then long-term, that would actually trend back down to mid-single digits. As I have said, this past year, CapEx was about $1.2 billion on a gross basis, which is about 10% of sales, which was a bit higher basically due to the revenue fall off that we saw in the second half of the year. This year, as I have said, we are basically slowing our capacity expansion and our CapEx, given kind of the short-term demand that we are actually seeing there. So, from a CapEx viewpoint, we are going to expect that to drop by about $500 million in our FY ‘24. And as I have noted, this figure doesn’t reflect any of the benefit from either the U.S. or European Chips Act. From a capacity viewpoint, what does that mean, that basically means that we will be able to still double our internal capacity footprint by 2025. Originally, we were thinking that was going to take place more in the 2024 time period. But given the macro and the demand outlook, we are comfortable with that. So, we don’t need basically all of that capacity in the short-term. From a customer viewpoint, from a swing capacity viewpoint, our goal is to be able to basically swing 70% of our product portfolio from internal to external fabs. That’s good for our customers because it gives our customers the ability to dual source, and that really creates a rich and resilient supply chain with multiple options for our customers. And from a gross margin viewpoint, internally, that allows us to moderate the factories a bit with this additional swing coming in-house as well. So, we are comfortable with that strategy. I don’t know if Vince has…?
Vincent Roche: Yes. So, let me – good morning, Tore, let me add a couple of piece of color to what Jim has just said. So, most of ADI’s revenue today is built on process technologies that are 180 nanometers [ph] and above. Now in digital technology terms, that’s a very, very old process technology. That’s more than 25-years-old in terms of its currency. But in the analog space, that is still a very contemporary process node, so more than 70 – a little more than 70% of our revenue today is produced on process technologies at 180 nanometers and above. And as Jim said, we have gone through a major internal expansion to give us more flexibility and agility in terms of where and how we manufacture those process technologies. And we are making all these investments that we have made on the internal fabs of 200-millimeter wafers. So, the tool chains are less expensive, and we are able to get tremendous return on investment over many, many decades on the investments that we are making. So – and I think below that, for the, let’s say, at the final line geometry nodes, we have very, very good alternatives with our external partners who are in a very, very really important piece of how we make the hybrid manufacturing model work. So, anything that is kind of 90 nanometers and below, it’s 300-millimeter wafers, and we secure that production with multiple sources across the globe.
Tore Svanberg: Very helpful. Thank you.
Michael Lucarelli: Thanks so much Tore. And we will go to our last question, please.
Operator: [Operator Instructions] Our last question comes from Timothy Arcuri with UBS. Your line is open.
Timothy Arcuri: Thanks a lot. I had a question on inventory. It sounds like you are planning to bring it down quite a bit from here. And you mentioned that the target is 120 days, but of course, it depends on what the base of revenue is. So, can you quantify how much more you plan to take out of your inventory? It seems like it could come down maybe a couple of hundred million dollars more from here? And then also maybe if you can also quantify – and this is kind of a hard question to answer, but how much is selling below sell-through? I know you get some metrics, particularly inside of distribution? Thanks.
Jim Mollica: Hey Timothy, let me take that. Just to be clear, let me kind of we step that back what I have said. So basically, inventory in fourth quarter was down $70 million, and that was on a quarter-on-quarter compare. That was almost all at the finished goods level. In 1Q, we plan to take inventory down by a similar amount. And then we will do that again in 2Q. That’s on a dollar basis, not on a days basis, just to be clear there. So, over the course of three quarters, fourth quarter and the first half of ‘24, we expect inventory to be down in the $200 million plus range for that. In terms of the channel, as I mentioned, we are – our sell-in to the channel is lower than our sell-through. And in the fourth quarter, that was – it was in the $50 million range. And I would probably expect probably a similar number there in first quarter, yes. And with that…
Vincent Roche: Tim and your question on the days of inventory, I would say our pre-COVID target was 120, we are close to 190 today. I think both of them are going to be wrong when all the dust settles, but we will re-up you on kind of the long-term inventory days model at a future call. And with that…
Timothy Arcuri: Okay. Thanks.
Vincent Roche: Good Tim. Thanks everyone for joining us this morning. A copy of the transcript will be available on our website. Thanks for joining the call. I appreciate your interest in ADI and have a great Thanksgiving.
Operator: This concludes today’s Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning and welcome to the Analog Devices Fourth Quarter Fiscal Year 2023 Earnings Conference Call, which is being audio webcast via telephone and over the web. I’d now like to introduce your host for today’s call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Abigail and good morning everybody. Thanks for joining our fourth quarter fiscal 2023 conference call. With me on the call today are ADI’s CEO and Chair, Vincent Roche; and ADI’s Interim CFO, Jim Mollica. For anyone who missed the release, you can find it in relating financial schedules at investor.analog.com. On our disclosures, the information we are about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our earnings release and our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information. These statements reflect our expectations only as the call today. We undertake no obligation to update these statements, except as required by law. Our references to gross and operating margin, operating and non-op expenses, tax rate, EPS and free cash flow will be on a non-GAAP basis, which excludes special items. When comparing our results to historical performance, special items are also excluded from our prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today’s earnings release. Two comments before we go prepared remarks. We adjusted our mapping to better align revenue to customer end markets. This resulted in slight changes to our end market mix with industrial increasing at each of the other markets slightly lower. These changes are reflected on our web schedule in the quarterly results section for the last 3 years. And second, one more quick reminder, the first quarter of 2024 is a 14-week quarter. And with that, I’ll turn it over to ADI’s CEO and Chair, Vincent."
},
{
"speaker": "Vincent Roche",
"text": "Thank you very much, Mike and a very good morning to you all. Though the industry is obviously moving through a more challenging period of the business cycle, I am very pleased to share that we are preserving the strength of our financial performance while preparing for the market’s recovery. Fourth quarter revenue was $2.7 billion, led by double-digit year-over-year growth in our automotive sector. The combination of careful expense management and our employees’ commitment to high standards of execution enabled us to deliver operating margins of 44.7% and EPS of $2.01 for the quarter. For the fiscal year, ‘23 again set new high watermarks with revenue reaching $12.3 billion, supported by all-time highs in the industrial and automotive sectors. This resulted in EPS of $10.09 up 5% from a year ago. Notably, we returned a record $4.6 billion to shareholders in 2023, exceeding our 100% free cash flow return target. Since the closing of Maxim just over 2 years ago, ADI has returned roughly $12 billion to shareholders or nearly 15% of our market cap. Over the same time, we have reduced our share count by more than 6% and increased our dividend per share by 25%. Now looking to fiscal ‘24, the near-term dynamics remain uncertain. As you will recall, last quarter, we outlined a broad-based inventory correction across all markets and geographies, reflecting the deteriorating macro conditions and our improving lead times. Consistent with our view 90 days ago, we expect the customer inventory overhang to persist through the first half of the year. Challenging times like these confirm the wisdom and the strength of our business model. The diversification of our business across customers, applications and products helps to limit volatility while preserving profitability. Building upon that foundation, we took actions to better ensure we can deliver operating margins in the low 40s and solid free cash flow despite the revenue decline. Importantly, however, we are not simply battening down the hatches. Our resilient financial model enables us to continue making the strategic investments necessary to allow us to capitalize on the upside when the business inflects higher. That longer term focus and commitment is why our customers have the confidence to increasingly depend on us as a key strategic partner. I have been very heartened by my conversations with customers across many markets and geographies over this past quarter. Despite the near-term challenges, they share our optimism that the intelligent edge is enabling a future replete with opportunity, and they are clear about the expanding role that they expect ADI to play in their success. Our customers’ optimism is reflected in the continued expansion of our design win pipeline, which increased by double-digits again in 2023. That growth was enhanced by sustained momentum in our Maxim revenue synergies pipeline, which is tracking ahead of our initial expectations. We expect synergy-driven revenue acceleration in 2025 putting us on a path to achieve our goal of more than $1 billion in revenue synergy by 2027. The combination of our strong design win growth with recurring revenue streams from our 75,000 product SKUs, which have average life spans of a decade or more creates a business with high barriers to entry that’s both resilient and rich with growth opportunities. Now, let me share some examples of recent wins with you. In Industrial Automation, we are increasingly delivering more complete solutions. At a top digital factory automation supplier, for example, we have recently leveraged our anchor position in software configurable I/O to attach additional solutions value across power, isolation and connectivity. As a result, we captured 3x the bill of materials and secured design wins across their entire platform. In Industrial Instrumentation, we have increased our design wins at SOC and memory test market leaders. Our next-generation solutions increased channel density and throughput while reducing energy consumption by up to an incredible 30% per system. These are critical parameters for testing complex, high-performance compute GPUs and high-bandwidth memory for artificial intelligence systems. Looking now to automotive. In electrification, momentum continues for our wireless battery management system. This novel solution enables lower weight, greater scalability and improved manufacturing productivity, driving down the total cost of ownership for our customers while increasing ADI’s content. Last quarter, we secured our fifth customer, a top 10 EV OEM. We’ll begin to deploy our wireless solution in their next-gen EVs in 2026. Now furthermore, during the year, ADI reinforced our industry-leading position in automotive, high-performance functionally save power. To that end, we won next-generation power for ADAS systems at four top suppliers this past year. These wins add another growth vector to our automotive franchise, which has benefited from strong momentum across electrification and in-cabin connectivity. This proliferation of ADAS is benefiting our high-speed GMSL connectivity portfolio. GMSL has been one of our fastest growing areas and a major revenue synergy generator for us. In the last year, we were awarded 4 new wins across leading North American, Asian and European OEMs. We are also expanding our opportunity and increasing our ROI, winning multiple design wins in industrial areas – in adjacent areas such as autonomous robotic systems. Our cloud infrastructure business is beginning to benefit from the power challenges and connectivity requirements necessary in AI ML systems. Notably, a large hyperscaler designed our high-performance power and protection solutions into their next-generation AI platform. And in connectivity, systems are upgrading now to 1 terabit per second and require our highest level of precision control solutions to efficiently support the growth in data generation. In consumer, we won multiple power management sockets in a portable application and a key customer. These wins truly show the combinatorial power of our acquisition strategy. We leveraged our industry leading cell and switcher, Maxim’s cost optimized process technology, and our customer relationships to secure these wins. And lastly, in healthcare, Maxim strengthened our comprehensive suite of technology for personal monitoring solutions, adding sensor AFEs, microcontrollers and ultra-low power technologies. We secured a design win at a leading continuous glucose monitoring customer this year. Our solution increases the robustness, accuracy and power efficiency of their glucose center, thereby helping to extend its life from days to weeks. So in summary, we’re proud of another year of record revenue and earnings. We continue to demonstrate the power of our business model, which delivers results through all phases of the business cycle. Our continued strong investments in technology and business innovation, customer engagement, and our hybrid manufacturing model positions ADI and our customers to take maximum advantage of the opportunities at the intelligent edge when the business recovery arrives. Now I’d like to pass the call over to Jim. Over the past 35 years, Jim has taken on a number of critical financial leadership roles across ADI, enabling him to develop a breadth and depth of understanding of our business that very, very few possess. So I’m pleased now to have him on my leadership team and to be joined by Jim on today’s call. Over to you, Jim."
},
{
"speaker": "Jim Mollica",
"text": "Thank you for that introduction, Vince, I’m excited to be here today, and let me add my welcome to our fourth quarter earnings call. Starting with a brief recap of fiscal 2023 results. Revenue increased 2% to $12.3 billion, marking ADI’s third consecutive record year. Gross margin of 72.5% moderated from last year’s record results of 73.6%. Operating margin of 48.9% decreased 50 basis points, roughly half the decline of gross margin, reflecting strong operating expense control. All told, EPS increased 5% to a record $10.09. Now moving to fourth quarter results. Revenue of $2.72 billion declined 12% sequentially and 16% year-over-year, finishing above the midpoint of our outlook despite the challenging operating environment. Industrial represented 50% of quarterly revenue, declining 19% sequentially and 20% year-over-year. As expected, we experienced broad-based weakness as inventory adjustments continued across our diverse customer base. For the full year, Industrial increased 6%, achieving its third straight record result with strength across instrumentation, test, energy and aerospace and defense. Automotive, which represented 27% of quarterly revenue was down slightly sequentially and up 14% year-over-year, marking 12 straight quarters of double-digit growth. For the year, Automotive also achieved its third straight record result, increasing 19%, with strong growth across our functionally safe power, battery management and in cabin connectivity solutions. Collectively, these were up more than 30%. Communications, which represented 13% of quarterly revenue, declined 6% sequentially and 32% versus a record fourth quarter 2022. For the year, Communications decreased 13%, with steeper declines in wireless versus wireline. And lastly, Consumer represented 11% of quarterly revenue, down 6% sequentially and 28% year-over-year. Consumer decreased 20% in fiscal 2023, driven by industry-wide weaker demand and ongoing inventory corrections. Now on to the rest of the P&L. Fourth quarter gross margin was 70.2%, down sequentially and year-over-year driven by unfavorable product mix, lower factory utilizations and lower revenue. OpEx in the quarter was $692 million, down $60 million sequentially. These significant savings were driven by disciplined expense management and lower variable compensation. As a result, operating margin came in at the higher end of our outlook of 44.7%. Non-op expense finished at $65 million and the tax rate for the quarter was 12.5%. All told, EPS was $2.01, slightly above our outlook. Now on to the balance sheet. We ended the quarter with approximately $1 billion of cash and cash equivalents and a net leverage ratio of 0.9x. Inventory decreased nearly $70 million sequentially, driven by finished goods. Channel inventory also declined as we actively manage sell-in to be less than sell-through. Given lower revenue, inventory days increased to 188 and channel weeks ticked up slightly, ending within our target range of 7 to 8 weeks. Now moving on to our cash flow items. Operating cash for the quarter and the year was $1.2 billion and $4.8 billion, respectively. CapEx for the quarter was $476 million and for fiscal 2023 was $1.3 billion. These CapEx numbers are gross figures, which do not include the benefits of the investment tax credits or grants related to both the U.S. and European Chips Act. Full year free cash flow was $3.6 billion or 29% of revenue. During the year, we returned 130% of free cash flow via roughly $3 billion in share repurchases and $1.7 billion in dividends. Now moving on to the guidance for the first quarter, which will be on a 14-week basis. First quarter revenue is expected to be $2.5 billion, plus or minus $100 million. Once again, we expect sell-through to be higher than sell-in. At the midpoint, we expect all end markets to be down sequentially. Industrial is expected to be down the most, followed by Consumer and Comms with Automotive faring the best. Operating margin is expected to be 41.5%, plus or minus 70 basis points. Our tax rate is expected to be 11% to 13%, and based on these inputs, adjusted EPS is expected to be $1.70 plus or minus $0.10. I will conclude my remarks with a brief update on the current operating backdrop. As Vince mentioned, we continue to see broad-based weakness across markets and geographies as customers work to reduce inventory and a stressed macro backdrop. Importantly, our lead times are now back to normal levels with 95% of our products shipping within 13 weeks, given our customers high confidence and timely supply. Encouragingly, during the fourth quarter, we’ve seen cancellations fall and bookings stabilize. This gives us greater confidence that the ongoing inventory correction will taper through the first half of the fiscal year. As we discussed last time, we’ve taken actions to preserve the integrity of our income statement, our balance sheet and our cash flow statements. Let me provide an update in these areas. We are once again lowering internal utilizations with a goal of significantly reducing inventory in the first half of the year. Our hybrid manufacturing model and ability to swing in external wafers will help us moderate the decline in factory starts. The unique ability positions us to deliver healthy gross margins despite the significant revenue decline from a year ago. Given the enhancements made to our hybrid manufacturing model over the last 2 years, we now plan to slow the expansion of our internal fabs and back-end facilities. As a result, we expect 2024 CapEx to be between $600 million and $800 million or down about 45% versus 2023. Importantly, this CapEx reduction does not compromise our long-term growth or resiliency efforts that gives customers multiple locations to source ADI supply. And lastly, we took additional steps to structurally reduce our OpEx. These actions, combined with lower variable comp and seasonally lower spend in the first quarter will result in a slight decline in OpEx sequentially even with the extra week. So in closing, our ability to generate operating margins in the low 40s, which were our previous highs in the last cycle demonstrates the durability of this franchise and how we’ve enhanced our operating model over time. And with that, I’ll give it back to Mike for Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Jim. Welcome to the call. It’s great to have you. Now let’s get to the Q&A session. [Operator Instructions] With that, we will have our first question please."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from Ambrish Srivastava with BMO. Your line is open."
},
{
"speaker": "Ambrish Srivastava",
"text": "Hi, thank you. Thank you very much for taking my question. Vince, it looks like order has been restored in the diversified Analog world with – it looks like a very normal cyclical downturn and with you, what you’ve built is a structurally more profitable company holding to 40% – low 40% operating margin line. My question is on a bottoming process. And I know we’re not there yet, but can you just remind us or help us understand metrics you’re following regarding cancellations, pushouts, backlog, you did talk about cancellations, Jim. And then kind of related to that, is if you look at past cycles, does automotive needs to go down double-digit year-over-year decline as industrial has been there? And how should we think about that? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes. God morning, Ambrish, and thank you for the question. So yes, we noted last quarter that we believe the inventory digestion issue would last two to three quarters. And I’d say, given the new information that we have, our conviction of that has actually grown. We have, through careful analysis and observation, we’ve seen inventory digestion accelerate at our largest direct customers across the board and across all the various segments that we support. And we’re continuing to reduce our channel inventories as well. So I think very encouragingly, even with normalized lead times, as we’ve said, we’re shipping that kind of 95% of customer requests within a quarter, which is very, very normal. We saw against that backdrop, a sharp drop in cancellations, and though the book-to-bill was below unity in the fourth quarter. We did see our bookings improve sequentially. So that gives us a lot of confidence as to what’s going on. Regarding Automotive, I’m not sure, by the way. The automotive – the assumption you’re making is that there could be a double-digit drop in Automotive. I’m not sure about that because we know that cars are consuming about 10% more silicon per year. And in fact, we continue to grow in share and ASP in the car. So my own sense is that against what could be a very challenging macro backdrop during 2024, that of all the elements of our portfolio, automotive, we expect will fare best of them all. And we still have pretty strong confidence that we’ll grow in 2024."
},
{
"speaker": "Ambrish Srivastava",
"text": "Thank you, Vince."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Ambrish. Next question please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question comes from Vivek Arya with Bank of America Securities. Your line is open."
},
{
"speaker": "Vivek Arya",
"text": "Thank you for taking my question. Vince, I’m trying to reconcile the comments that were made about some stabilization in bookings. That sounds like a positive. But I think in the prepared remarks, you also said some headwinds that could persist through the first half of the fiscal year, suggesting that April could be a sub-seasonal quarter. So I know you’re not guiding specifically out to April, but what is the right way to look at the puts and takes as we think about April? Can it be seasonal, whether it not be seasonal? And also this extra week from January, did that really give you that 7.5% push, so we should be taking that out of April. So any way to help us give us a sense for how the April could shape up would be very helpful. Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Well, I think it’s – Vivek, thank you for the question. It’s one quarter at a time here. What I will say contextually is that we expect the inventory overhang to have been depleted by the start of our third quarter, which is in May of next year. So, we still remain pretty confident about that, given the dynamics that I just outlined. But the other parts of the cycle that we’re really – I think everybody is seeing pressure from is the macroeconomic climate and particularly the decline of semi business in China. So that’s the piece. I mean that is the piece that isn’t well understood. But all that said, the macro will be the governor on what happens in the second half of the year. And I think another quarter or so will give us a lot more confidence in terms of what is possible in the second half. But I will let Jim answer as well give you some particular statistics to underpin our assumptions here."
},
{
"speaker": "Jim Mollica",
"text": "Thanks, Vince. Yes, let me just speak to – let me unpack lead times a bit first. As we said, lead times are now kind of back to where they were, 95% of our products are shipping within 13 weeks. And we’ve seen steady improvement in lead times in both 3Q and 4Q. And I guess from the refreshing side of that is from a customer viewpoint, customers have now adjusted to those shorter lead times. And our order rates basically in the fourth quarter basically stabilized in fact, picked up in 4Q versus 3Q. So that’s good news for us as the customers have shopped and their signal into us. As Vince said, our book-to-bill will still be low on there, but it is kind of the first lines there. Additionally, cancellations in the fourth quarter were down meaningfully for the first time and probably close to a year. And cancellations on a shorter time fence were also very, very low. So that’s good for us. From a channel perspective, we’re being cautious. We continue to basically ship into the channel less than our sell-through, which basically will position us well for when the upswing occurs. And from an end market viewpoint, let me just close on that point. All markets in 1Q will be down on a quarter-to-quarter basis. Yes, that’s it. Mike, anything else?"
},
{
"speaker": "Michael Lucarelli",
"text": "Yes. And it’s very confusing with a 13 to 14-week card, you’re right, Vivek. I’ll kind of add some commentary around that, how to think about that. Normally, 2Q from 1Q and a 13-week to 13-week basis up about 5%. And given what have been said, inventory overhang and bookings getting better. It still feels like we should probably grow some, but I don’t think 5% is likely. Why? There’s still an inventory overhang going on. So if you think 13-week to 13-week were about flattish, plus or minus, in 1Q to 2Q, that’s probably the way to think about it. That means if you include the extra week, it’s probably down about 5% plus or minus sequentially. So I hope that helps back a little bit because it is confusing. And with that we go to our next question, please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question comes from Joseph Moore with Morgan Stanley. Your line is open."
},
{
"speaker": "Joseph Moore",
"text": "Great. Thank you. I wonder, I mean now that you’re in a revenue downturn that looks more severe than we saw the last cycle, what are you seeing in terms of pricing? And are people – you obviously raised prices during the upturn. Are people asking you to give that back? And is that a different conversation on kind of a like-for-like basis versus approaching kind of new design win activity?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks, Joe. So look, I think overall, the pricing of our existing portfolio is very, very resilient, very stable. And I think something to note as well is that every new generation of product that we build is capturing more value. And – so if you look at the legacy, it’s very stable. You look at the legacy franchise. We’ve got tremendous stability. We’re capturing more new value per new socket. And I don’t see any particular change. And we, as a company, play at the high end of the performance curve, which enables us to get this innovation premium that is a very, very critical part of our gross margin structure and our revenue growth. And our job is to continue to invest to make sure that we stay on the cutting edge and get well rewarded for that. We fight very, very intensely at the inception of new designs. But as I said in the prepared remarks, Joe, we’re seeing generally speaking, our pipeline of new product design wins as well as the more established products continue to grow quarter-by-quarter, year-over-year. So I feel confident that the pricing that we have managed to increase over the last couple of years, 2.5 years that they’re about to reflect the increased cost of goods. We’ll hold those prices. So overall, we’re bullish about where we are and what the pricing environment holds in the future."
},
{
"speaker": "Joseph Moore",
"text": "Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Joe."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question comes from Stacy Rasgon with Bernstein Research. Your line is open."
},
{
"speaker": "Stacy Rasgon",
"text": "Hi, guys. Thanks for taking my questions. I had a question on OpEx and gross margins into Q1. So you said OpEx was down slightly even with the extra week. So, if I sort of understand a little bit, it would imply the normalized like 13-week OpEx would be running around, I don’t know, 640 maybe, maybe a little lower. Once we get through into Q2 when the ex-week rolls off, is that the right sort of like steady-state OpEx run rate to think about as we go through the year and some – are there some other drivers? And I guess if those numbers are right, it sort of implies gross margins implied in Q1 maybe a little below 70, maybe 69, is that the right kind of level that you are thinking about as the revenue is going to drop here?"
},
{
"speaker": "Jim Mollica",
"text": "Yes, Stacy, it’s Jim. Let me take that. Let me the margin one first, and then I will talk about the OpEx for the quarter. There is many inputs. There is many levers to the gross margin. There is revenue that’s priced, there is mix as factory loading utilization levels. And let me just try to unpack that a bit. Vince mentioned on the pricing side, basically, that’s stable. So, that’s not a drag to gross margins as we move forward. On the revenue side, basically, we are down – the midpoint of our first quarter guide on a 13-week basis is down, approaching 30% from our previous peak. So, basically revenue is a headwind for us there. Mix basically is unfavorable as well. As you heard in my prepared remarks, industrial was down 19% and 20% last quarter on a year-over-year and sequential basis, and that will be down again in first quarter. So, mix is a headwind for us. When you put all those puts and takes together, we would expect basically gross margin will fall below 70% in the first half of the year at these trough levels. I think if you think about something in the 68% to 69% range, is probably a good range for this trough revenue range. So, that’s kind of the gross margin. On the OpEx side, as I mentioned, our 4Q OpEx basically was down about $60 million on a sequential basis. This was the combination of reducing discretionary spend and of course, a much lower variable comp. Looking into 1Q, we expect that to be down again even with the extra week. And it’s fair to say that probably you can think about 1% to 2% there. This reduction relates to the actions that we structurally took to reduce OpEx as well as a lower typical seasonal spend in 1Q as well. We don’t guide 2Q, but just to give you a sense there, when you look at 2Q, it’s probably best to compare that to the 4Q, which was a like 13 to 13-week comparison. And when you are looking at 4Q ‘23 versus 2Q ‘24, given some of the structural modest reductions we had made, we would expect OpEx in 2Q to be down a few percent from the 4Q operating levels, so I hope that helps."
},
{
"speaker": "Stacy Rasgon",
"text": "That’s helpful. Thank you so much guys."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks Stacy. I always appreciate your two-part and one-part question. With that, next question, please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question comes from Chris Danely with Citi. Your line is open."
},
{
"speaker": "Chris Danely",
"text": "Hey. Thanks. Just a question on industrial, historically this has been a pretty strong sector for you guys, but it seems like it’s – the revenue decline in industrial is worse than the overall company. Can you just talk about why that is and maybe broader speaking, are the bookings or the revenue falling more because the macro is worse than expected, or the inventory situation out there is just worse than you guys thought? And do you think you will be able to hold that 70% gross margin floor for the fiscal ‘24? Thanks."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks Chris. So, yes look, we have come off a record year for ADI and for the industrial sector. But I would say in the second half of ‘23, we began to see momentum slow on the order side of things. And in the fourth quarter, it’s true to say that weakness in the industrial sector broadened and hit all the various market segments with one exception, the aerospace and defense area. And I think when we look into 2024, given the weaker macro backdrop, and we expect the inventory digestion to continue through the first half particularly at the broad market customers who are suffering most here. So, I think, as Jim said, when we talk about gross margins, the weaker industrial over the first half of the year, that weaker mix, if you like, will impact the gross margins. And for the trough periods here, we are thinking kind of 68%, 69% as reasonable assumptions for gross margin in that period of time. So, it really is, at this point, it’s an adjustment of inventories at our customers and how fast we experience the recovery will determine on the macro. But again, I think it’s true to say, during the first half of this year, we do expect to get this overhang of inventory behind us and get back to a more normalized growth pattern in the second half of the year. Jim, do you want to take a comment?"
},
{
"speaker": "Jim Mollica",
"text": "Yes. Chris, I think just a couple of points there. Vince talked about at the trough revenue, gross margins in the 68% to 69% range, gross margins at 70% for the year, I think that was the first part of your question as well. A lot of that will depend upon when the demand comes back in terms of – so we don’t really guide for the year, but that’s probably dependent upon revenue coming back to a more normal level. Let me just add a few points, though. We are – utilization levels basically brought them down in 4Q, we are going to bring them down again in 1Q. You see the inventory reduction of $70 million in 4Q, which was a little bit better than I think we guided last quarter, you are going to expect that inventory to be reduced at a similar level in 1Q and again in 2Q. And what we are also doing now is we are activating our hybrid manufacturing strategy. So, we are actually swinging wafers from external back in-house, which moderates the factory load, which gives a little bit of a cushion on that gross margin side as well. So, just a little bit more color as what you can expect for us in the second quarter here."
},
{
"speaker": "Chris Danely",
"text": "Thanks a lot guys."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks Jim. With that, next question."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our next question comes from Tore Svanberg with Stifel. Your line is open."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you and congratulations on the results in this tough environment. I had a question about CapEx. So, one of your competitors talk about this geopolitical dependable capacity that they are investing in. You are going showed the complete other the way, you are reducing CapEx a lot for this year. Help us understand a little bit what your partners are doing – your founder partners are doing for you to sort of feel comfortable that you don’t have to spend as much in CapEx going forward? Thank you."
},
{
"speaker": "Jim Mollica",
"text": "Thanks Tore. Why don’t we take that in, so I will start."
},
{
"speaker": "Vincent Roche",
"text": "I will sort of add some color."
},
{
"speaker": "Jim Mollica",
"text": "Yes. So let me just – let me pause and take a step back on CapEx for a second. So, at our Investor Day, we outlined basically elevated CapEx in the high-single digit range for 2022 and 2023. And then long-term, that would actually trend back down to mid-single digits. As I have said, this past year, CapEx was about $1.2 billion on a gross basis, which is about 10% of sales, which was a bit higher basically due to the revenue fall off that we saw in the second half of the year. This year, as I have said, we are basically slowing our capacity expansion and our CapEx, given kind of the short-term demand that we are actually seeing there. So, from a CapEx viewpoint, we are going to expect that to drop by about $500 million in our FY ‘24. And as I have noted, this figure doesn’t reflect any of the benefit from either the U.S. or European Chips Act. From a capacity viewpoint, what does that mean, that basically means that we will be able to still double our internal capacity footprint by 2025. Originally, we were thinking that was going to take place more in the 2024 time period. But given the macro and the demand outlook, we are comfortable with that. So, we don’t need basically all of that capacity in the short-term. From a customer viewpoint, from a swing capacity viewpoint, our goal is to be able to basically swing 70% of our product portfolio from internal to external fabs. That’s good for our customers because it gives our customers the ability to dual source, and that really creates a rich and resilient supply chain with multiple options for our customers. And from a gross margin viewpoint, internally, that allows us to moderate the factories a bit with this additional swing coming in-house as well. So, we are comfortable with that strategy. I don’t know if Vince has…?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. So, let me – good morning, Tore, let me add a couple of piece of color to what Jim has just said. So, most of ADI’s revenue today is built on process technologies that are 180 nanometers [ph] and above. Now in digital technology terms, that’s a very, very old process technology. That’s more than 25-years-old in terms of its currency. But in the analog space, that is still a very contemporary process node, so more than 70 – a little more than 70% of our revenue today is produced on process technologies at 180 nanometers and above. And as Jim said, we have gone through a major internal expansion to give us more flexibility and agility in terms of where and how we manufacture those process technologies. And we are making all these investments that we have made on the internal fabs of 200-millimeter wafers. So, the tool chains are less expensive, and we are able to get tremendous return on investment over many, many decades on the investments that we are making. So – and I think below that, for the, let’s say, at the final line geometry nodes, we have very, very good alternatives with our external partners who are in a very, very really important piece of how we make the hybrid manufacturing model work. So, anything that is kind of 90 nanometers and below, it’s 300-millimeter wafers, and we secure that production with multiple sources across the globe."
},
{
"speaker": "Tore Svanberg",
"text": "Very helpful. Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks so much Tore. And we will go to our last question, please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our last question comes from Timothy Arcuri with UBS. Your line is open."
},
{
"speaker": "Timothy Arcuri",
"text": "Thanks a lot. I had a question on inventory. It sounds like you are planning to bring it down quite a bit from here. And you mentioned that the target is 120 days, but of course, it depends on what the base of revenue is. So, can you quantify how much more you plan to take out of your inventory? It seems like it could come down maybe a couple of hundred million dollars more from here? And then also maybe if you can also quantify – and this is kind of a hard question to answer, but how much is selling below sell-through? I know you get some metrics, particularly inside of distribution? Thanks."
},
{
"speaker": "Jim Mollica",
"text": "Hey Timothy, let me take that. Just to be clear, let me kind of we step that back what I have said. So basically, inventory in fourth quarter was down $70 million, and that was on a quarter-on-quarter compare. That was almost all at the finished goods level. In 1Q, we plan to take inventory down by a similar amount. And then we will do that again in 2Q. That’s on a dollar basis, not on a days basis, just to be clear there. So, over the course of three quarters, fourth quarter and the first half of ‘24, we expect inventory to be down in the $200 million plus range for that. In terms of the channel, as I mentioned, we are – our sell-in to the channel is lower than our sell-through. And in the fourth quarter, that was – it was in the $50 million range. And I would probably expect probably a similar number there in first quarter, yes. And with that…"
},
{
"speaker": "Vincent Roche",
"text": "Tim and your question on the days of inventory, I would say our pre-COVID target was 120, we are close to 190 today. I think both of them are going to be wrong when all the dust settles, but we will re-up you on kind of the long-term inventory days model at a future call. And with that…"
},
{
"speaker": "Timothy Arcuri",
"text": "Okay. Thanks."
},
{
"speaker": "Vincent Roche",
"text": "Good Tim. Thanks everyone for joining us this morning. A copy of the transcript will be available on our website. Thanks for joining the call. I appreciate your interest in ADI and have a great Thanksgiving."
},
{
"speaker": "Operator",
"text": "This concludes today’s Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 3 | 2,023 | 2023-08-23 10:00:00 | Operator: Good morning, and welcome to the Analog Devices Third Quarter Fiscal Year 2023 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli: Thank you, Michelle, and good morning, everybody. Thanks for joining our third quarter fiscal '23 conference call. With me on the call today are ADI's CEO and Chair, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. on to the disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our earnings release, and other periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information, as these statements reflect our expectations only at the date of this call. We undertake no obligation to update these statements except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. We are comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO and Chair, Vincent Roche. Vince?
Vincent Roche: Thank you, Mike, and a very good morning to you all. ADI executed well in the third quarter and delivered results within our expectations despite the challenging operating environment. Revenue was nearly $3.1 billion, led by growth in our Industrial and Automotive markets once again. Gross margin remained strong, above 72%, operating margin was nearly 48% and EPS was $249 million. This continued profitability reflects our portfolio's resilience as well as the innovation premium that it commands. I want to turn to the current business environment now just for a moment. As we shared last quarter, we believe we're in a period of customer inventory reconciliation following three consecutive years of steady growth. Through our customer conversations, it's evident these accelerating inventory adjustments relate to the weakening macro backdrop and ADI's rapidly improving lead times. Importantly, we believe we shipped below end market consumption in the third quarter and expect to do so again in the fourth. This will help normalize our customers' inventory more quickly and position us to return to growth more quickly in the coming quarters. Stepping back, while near-term dynamics or turbulence, our long-term confidence remains undiminished. Over the last several decades, we have enhanced the resiliency of our global business, defined by our diversified customer and product portfolio and flexible hybrid manufacturing model. This enables us to ensure softer demand periods while sustaining strategic investments to ensure that we capitalize on the upside when the business inflects. It's these characteristics and our alignment to numerous concurrent secular growth trends that give us confidence that ADI will deliver on our long-term model of 7% to 10% revenue CAGR. Now one area underpinning this growth outlook are the applications tied to sustainable use cases, which currently represents about 1/3 of our total revenue. And today, I want to unpack a vital part of this, the evolving electrification ecosystem that is driving growth in our industrial and automotive markets. As the world marches to net 0, we need to eliminate 51 gigatons of global greenhouse gases emitted every year. Fossil fuels are by far the largest contributor accounting for more than 75% of all emissions. And at the same time, global energy consumption is forecasted to increase by 50% by 2050. A major unnecessary energy transition is underway and an upgraded and expanded energy grid is foundational to support a decarbonization pathway. Making the shift through renewable energy sources in both commercial and residential infrastructure as well as electric vehicles and global transportation will reduce greenhouse gas emissions. These moves also create new challenges in the generation distribution, consumption and smoothing of energy supply. ADI solutions are embedded across all phases of this electrification journey from upgrading the grid infrastructure to forming and managing the vehicle battery. The common thread woven through all these applications is the high-performance precision signal processing, control and power management capabilities they require, capabilities in which ADI excels. Now today, I'll bring the story to life at the application level, starting with grid infrastructure. Overall, today's electrical grid is undergoing modernization to meet current and future demands. Historically, traditional energy sources like coal, oil and gas were centralized and distributed in one direction from the grid to the consumer. Today, renewable energy sources like wind and solar are more distributed necessitating a dynamic bidirectional flow of energy. To achieve this, the grid must be able to adjust performance across the network in real time, which requires an exponential increase in monitoring and storage capabilities. And for example, our collaboration with the Enel Group provides smart meters and grid digitalization solutions for distribution system operators. Here, ADI's control and sensing technologies are enabling high-performance, precision monitoring and data creation at the heart of the digital substation. And we're leveraging our mixed-signal digital and algorithm technologies to enable greater intelligence at the grid's edge. Now moving to energy storage systems, which are critical to mitigate intermittency issues across the network. ADI is a leader with our technologies used in 60% of energy storage systems across residential, commercial and grid scale networks. Leveraging our battery management system technology or BMS. We're increasing capacity and improving energy utilization in energy storage systems, which maximizes the battery's lifetime value. These monitoring and storage challenges extend to the grid's edge as well, including EV charging stations, ADI's energy metrology, isolation and sensing technologies, help enable a broader range of applications in AC and DC charging equipment. In addition to these important applications in our highly diverse industrial segment, our high-performance signal processing platforms and domain expertise are helping to electrify the automotive market. Here, our technology is a key enabler in the transition from combustion engines to cleaner electric vehicles by increasing range and lowering cost. And I'll start with BMS. As we've shared before, we are the leader in this area with our BMS solution designed into 16 of the top 20 EV manufacturers. We're currently sampling our eighth generation solution, which utilizes software and algorithms to enable physical measurement capabilities all the way into the battery cell. These advances in edge processing change the game in how the internal battery health is managed, supporting faster charging and better range prediction. An extension of this is our wireless BMS solution, a first in the industry. It has all the benefits of our wired solution and enables a scalable battery architecture, with quicker and more cost-effective production cycles. Currently, our wireless BMS is designed in at four OEMs, and we expect another large OEM to adopt it in the coming quarters. Given this momentum and the cutting-edge value proposition, we believe the wireless platform will represent a large portion of our BMS revenue by the end of the decade. And looking ahead, we're broadening our EV capabilities beyond battery management and storage to power conversion solutions. Specifically, we're developing a silicon carbide-based smart switch for bidirectional onboard charging that significantly reduces charger size and weight by over 50%, thus driving down cost. Notably, this intelligent integrated switch enables the EV to transfer energy back into the network, creating a more reliable grid. And this innovation solution more than doubles our content opportunity per EV powertrain. So in summary, ADI is driven by a deep sense of purpose and a desire for our innovations to positively impact all stakeholders. We're immensely proud of the role our technologies play to improve the well-being of humanity and indeed the planet, and I remain very confident in our future. Our portfolio of cutting-edge technologies, world-class talent base are aligned with an unprecedented number of attractive secular trends, where the semiconductor content per dollar of CapEx is increasing tremendously. This presents ADI with continued profitable growth opportunities as well as the ability to shape the future of industries. And so with that, I'll hand it over to Prashanth.
Prashanth Mahendra-Rajah: Thank you, Vince. Let me add my welcome to our third quarter earnings call. My comments today, with the exception of revenue will be on an adjusted basis, which excludes special items outlined in today's press release. While demand continued to soften throughout the quarter, ADI delivered nearly $3.1 billion revenue, in line with our guidance. This was driven by continued year-over-year growth for both Industrial and Automotive. Looking at our performance by end market. Industrial, which represented 53% of revenue, finished down 7% sequentially after a tremendous stretch of 13 straight quarters of sequential growth. On a year-over-year basis, revenue increased 4% with most applications up, led by sustainable energy as well as aerospace and defense, which each grew double digits. Automotive, which represented 24% of revenue, was down modestly sequentially in line with our expectations. Year-over-year growth of 15% was broad-based. We saw continued outsized growth for ADI's leading battery management and in-cabin connectivity solutions, which collectively increased nearly 30% year-over-year. Communications, which represented 12% of revenue, decreased double digits, both sequentially and year-over-year due to the broad-based inventory correction we flagged previously. And lastly, consumer, which represented 10% of revenue came in stronger than expected, finishing up 15% sequentially, but down 21% year-over-year. We remain optimistic that our second quarter marked the bottom for this business despite the ongoing inventory correction. And now on to the rest of the P&L. Gross margin of 72.2% remains industry-leading, but declined sequentially due to lower utilization and product mix. Operating expenses of $752 million were roughly flat year-over-year and up sequentially. This quarter's OpEx reflects the full impact of annual merit increases. Operating margin of 47.8% contracted 230 basis points year-over-year, roughly in line with the gross margin decline. Non-op expenses were $57 million, and our tax rate was 11.2%. All told, EPS came in at $2.49 within our guidance range. Moving to the balance sheet. We ended the quarter with over $1.1 billion of cash and a net leverage ratio of 0.8. Given the revenue pressures and our decision to hold more finished goods versus restocking the channel, inventory dollars increased and the days of inventory moved higher to 179. As a result, channel inventory remains below our target level and slightly declined. Specifically, we strategically undershipped Asia, especially China, due to weaker demand trends. CapEx was $325 million for the quarter as we invest to enhance ADI's global resiliency and offer our customers options on where their products are sourced. 2023 should represent the high watermark for CapEx, and we expect it to decline in 2024. Importantly, our investments do not include the benefits of tax credit and grant funds that we anticipate from both the U.S. and the European Chips Act. Over the trailing 12 months, we've generated $3.7 billion of free cash flow or 29% of revenue. And over the same period, we've returned nearly $5 billion to shareholders or over 130% of free cash flow via more than $3.3 billion in buybacks and more than $1.6 billion in dividends. Now turning to the Q4 guidance. We expect the fourth quarter revenue to be $2.7 billion, plus or minus $100 million. This outlook assumes sell-in to be below sell-through. At the midpoint of our outlook, we expect all markets to be down sequentially given the broad-based inventory correction. On a relative basis, Auto and Consumer should perform a bit better than Industrial and Comms. Operating margin is expected to be 44% plus or minus 70 basis points. This margin outlook embeds planned utilization reductions and a decline in OpEx. Our tax rate is expected to be between 11% and 13%. And based on these inputs, adjusted EPS is expected to be $2 plus or minus $0.10. As our outlook is lower than expected, let me provide some context on what we're experiencing and how we will navigate. Our revenue outlook reflects the broad-based macro softness across all end markets, all geographies and customers both large and small. We are also strategically improving lead times to get a better view into demand and enhance customer satisfaction. Today, we're shipping over 85% of our products within 13 weeks, and this is up from 35% a year ago. As Vince mentioned, we are seeing customers accelerate inventory adjustments due to both the softer environment and our lead time improvements. And as such, we're taking measures to preserve the integrity of our balance sheet, cash flow and income statement. This includes further reducing utilization and lowering external wafer purchases with a goal to decrease inventory meaningfully in the coming quarters. And importantly, as we've outlined before, we expect gross margins will maintain a 70% level on a trailing 12-month basis. This gross margin resiliency is a testament to the flexibility of our hybrid manufacturing model and our unique swing capacity capability. In addition to the naturally lower variable comp, we're also taking steps to reduce total OpEx by roughly $50 million sequentially. So stepping back, we're not ready to call the bottom yet but our history shows that we cycle up quickly. And when we do, we will achieve higher highs. ADI has built a very resilient business, rich with opportunities. Our diversification and exposure to numerous secular trends drives our durable earnings stream and solid free cash flow, enabling us to consistently return capital to shareholders. And to that end, over the trailing 12 months, we've returned $5 billion to shareholders or more than 5% of our market cap. As this is my last ADI earnings call, I'd like to give a quick thank you to Vince for his mentorship and counsel over the past six years to the ADI Board, including our audit chair, Karen Golz, for their unwavering support and most importantly, to the world-class finance staff, including young Mike here for always reminding us of our commitments to you, the company's owners. I look forward to seeing many of you in the coming weeks as we get on the road. Mike, let's go to Q&A.
Michael Lucarelli: Thanks, Prashanth. I don't think I've been called young in some time, but I appreciate that. Now let's get to our Q&A session. [Operator Instructions] With that, can be our first question, please.
Operator: Thank you. [Operator Instructions] Our first question comes from Tore Svanberg with Stifel. Your line is open.
Tore Svanberg: Yes. Thank you. I have a question for Vince. So I know you're not ready to call a bottom. But some industry observers would say that this sort of inventory build started maybe late 2021, early 2022 based on your guidance for the October quarter, you're sort of back to that level. So then you've seen these cycles, you've seen many of them. They're all different. But just wanted to get a sense for you what you think we're getting close, especially given what I just said about that inventory adjustment now sort of being complete?
Vincent Roche: Yes. Thanks, Tore. When I look at this current cycle, the symptoms are always the same in these cycles, but the causes tend to have different components. And I think right now, there are two kind of inputs to this particular correction. I think one is the inventory in digestion that exists out there that has been building for 18, 24 months now. And the second, of course, is the macroeconomic situation, which is a major governor as well. But I think if you look at what we understand from the direct side of our business, for example, when we look at our largest customers revenue growth and their forecast compared to our growth at these very same customers, we believe that we've been shipping the low-end consumption in the third and will in the fourth quarter. So I think one way to look at this is how long will the inventory correction take? My sense is it will be two to three quarters before we get through the inventory digestion cycle, and I think we're positioned as a company to get beyond it quite fast because we've been managing our factories very carefully, managing our inventories, both on our own balance sheet as well as our distribution channel. So we've also, I think, taken a long-term view to the demand patterns of our customers. We haven't, in any way, forced them into, for example, long-term supply agreements, essentially, at this point in the cycle, that will be forcing them to take products that they don't really need. We've been managing our channel aggressively. So as I said, we're keeping more inventory on our own balance sheet. So again, we will get to distribute the supply ultimately where we think it's needed when the recovery gets underway here. So that's my sense, sorry. I mean, in the industry, if you look back to the dot com cycle, you look at the 2008 financial crisis cycle, most of the downturns tended to last three to four quarters. So my sense is over the next two, three quarters, we begin to see a recovery here, at least on the inventory side. And then it's really a question of how does the macro-economy perform?
Tore Svanberg: Great perspective. Thank you.
Michael Lucarelli: Thanks Tori. Next question, please.
Operator: Thank you. Our next question comes from Vivek Arya with Bank of America Securities. Your line is open.
Vivek Arya: Thanks Dan. Best wishes again to Prashanth on his next adventure. You said that you're not ready to call the bottom yet and Vince, you mentioned that the inventory digestion period could last for some more time. How should we think about Q1 seasonality? It tends to be down kind of mid-single digit. Do you think we should be prepared for something different than that? Right? And if it is worse than kind of mid-single digit, do you still think that ADI can maintain gross margins above 70%. So just kind of puts and takes to help us align our models would be very useful.
Prashanth Mahendra-Rajah: Why don't I take that, Vivek. So first, quick comments just to make sure everyone has the Q4 guide, correct. So on the channel, as I said in the prepared remarks, we are shipping in below the forecast we have from our channel partners. So we are intentionally bringing channel inventories down to help set us up for some better strength. The -- included in the guide is the backlog coverage has some turns, but less than normal given the higher level of uncertainty. So we would need some more turns and positive book-to-bill, which Vince mentioned is likely to be a quarter or two out. And then just from an end market standpoint, we've got all end markets down quarter-over-quarter. So as you know, we don't guide out further than the current quarter, but some color is I think you essentially have it right. There's no reason to think that first quarter would not be down seasonal on a, which would call it, mid-single digit quarter-over-quarter. But that we -- our view is going to be driven by the holidays and the customer decisions to reduce inventory as they go into the year-end. So we're not, at this point, seeing a more meaningful step down in Q1 based on what we can know today. And I will just remember to plant and everyone as you start to model out Q1 that every once in a couple of years, we have a 14-week quarter, and that will be Q1 of '24. And then on gross margins, I think we're actually quite proud of our gross margin story here that we've been -- we've messaged a number of times that we would have the ability to maintain a 70% gross margin in a -- on a trailing 12-month basis with a peak to trough decline of 15%. Q4 is down about 17% from the Q2 peak. And while we didn't give you a gross margin number, if you impute it from the OpEx math that I gave you, you'll see that we are able to hold that north of 70%, and we'll continue to work that. For Q1, gross margins, my best sense now would be that we are likely to face a little more challenge on the utilization level as we bring inventory levels down, but we have been very successful in activating our swing capacity. We're actually doing about 10% better on utilizations because we have swing than if we hadn't activated it. So it's been a very powerful lever for us. And we need to see how the math on all of that works out for Q1, but I wouldn't expect Q1 to be notably different from kind of where we are for Q4.
Vincent Roche: Yes. I'd like to add one other comment, Vivek, to what Prashanth has said. So the other side of margin is pricing, and pricing is very stable. It's very, very stable, resilient. I don't expect that to change. And our products are very, very sticky. We've got tremendous life cycles and that part of our business, this is really a unit correction in the business rather than price or share.
Vivek Arya: Thanks for that. Helpful.
Operator: Thank you. Our next question comes from Ambrish Srivastava with BMO. Your line is open.
Ambrish Srivastava: Hi. Thank you very much. This is old Ambrish, Young Mike, can feel free to chime in. I was looking at the year-over-year comms, and I look at TI as your closest peer rival competitor. Vince, they started going into a year-over-year decline in 4Q '22 and you are just starting, and you said two to three quarters. So in the past history does suggest that usually on a year-over-year basis, we see roughly around four to five quarters of year decline. Is that the right way to think about your business? You said two to three quarters of digestion and I'm assuming that means year-over-year decline in reps, right?
Vincent Roche: Yes. Good question, Ambrish. So yes, look, I mean, Comms is just a piece of ADI's overall story. We've actually seen -- I mean, we have two components as well. We've got wire line, we have wireless. I would say on the wire line side of things, we've seen the malaise going back into the late part of '22, early part of '23. So that's really things like optical control for data center and carrier networks, and power. We've got a power business there as well. So we think we'll see that, we expect to see CapEx somewhat recover in that space to be able to catch up with the needs, for example, driven by the explosion in computing power that's required to handle the AI inflection here, for example. So -- my sense is the wire line part will probably start its recovery in the first -- second quarter of the year. Wireless is a little harder to call. It's very, very dynamic. We all know that. The developed countries, particularly North America, 5G deployments, which have really been focused on coverage rather than capacity. They're going to be weaker than we thought. So that's probably going to give us headwinds for how long, we don't know, but I think it could be several quarters during our FY '24. India has been very strong this year, of course. And I think we're expecting to see more commitments to lay in both coverage and capacity in India during our FY '24. So look, we've got leadership in many of these areas, like optical control systems, 5G, software-defined solutions. It's really a question of timing in my mind. But -- there's a lot of uncertainty in the communications market in totality and particularly in wireless at this point. So hopefully, that gives you the answer to your question.
Ambrish Srivastava: Well, I was asking about the overall business, Vince, not just about the Comms, sorry.
Vincent Roche: Okay. yes. Look, I think, Ambrish, the overall business. We see some trends, for example, that will transcend the inventory digestion problem. And even the macro-economy areas like digital healthcare, like aerospace and defense, the sustainable energy theme that we spoke to a little while ago. So again, I will just reiterate my sense is the inventory digestion problem will last probably two, three quarters, and then we'll get back into a unit volume increase from there on.
Ambrish Srivastava: Thank you.
Vincent Roche: Thanks Ambrish.
Operator: Thank you. Our next question comes from Stacy Rasgon with Bernstein. Your line is open.
Stacy Rasgon: Hi, guys, thanks so much for taking my question. Prashanth, I don't want to be pedantic on Q1, but I know you said right now, down seasonal, but also as an extra week. That extra week, if I just linearize it is like a plus 7. So do those cancel out? Or is it like it's the week between Christmas and New Year, so it's not a lot of revenue? Or just how do I think about the balance of those two things into Q1, assuming a Q1 that was...
Prashanth Mahendra-Rajah: So when I gave you my comments of down seasonal that was on a 13-week basis, the 14-week was just a reminder as you model it. So Mike, do you want to do the math, but I think you're essentially thinking about it right.
Michael Lucarelli: Yes. So as Prashanth said, let's take a first 13-week quarter. What happens normally in 1Q and a 13-week quarter our business is down, call it, 5%, plus or minus, total business. Now with an extra week, that adds about 7.5%, both on the revenue side and the OpEx side. So there's two pieces, normal, down 5% total company, in the 14-week quarter, you can add 7.5% of revenue and OpEx. That's the best way to think about it.
Prashanth Mahendra-Rajah: And thank you for clarifying that, Stacy, I wasn't clear in my answer.
Stacy Rasgon: Okay. And then that would drop off into Q2, though, you go the other way in Q2. So Q2 under like normal circumstances would be worse than seasonal because you have that extra week drop off?
Michael Lucarelli: Yes. So again, you can parse it in normal times, 2Q is up, call it, 2% to 5% and a 13-week to 13-week quarter, if you take away an extra week, yes, you have a 7.5% headwind. They have got 1Q.
Stacy Rasgon: Got it. Okay. That's helpful. I have another one, but I guess I don't want to get that band next time, so I....
Michael Lucarelli: I'll allow another question because that's a good clarifying question, Stacy.
Stacy Rasgon: Okay. I just wanted to ask about OpEx into next year. So it sounds like you're guiding it to about $700 million in the Q4. How do I think about it next year into a revenue year that's likely to be down potentially reasonably materially. Like how should we think about OpEx just year-over-year for fiscal '24 versus '23?
Prashanth Mahendra-Rajah: Yes. I think, Stacy, as we've always said, we run this business for the long term. So we're going to make the adjustments that are prudent to make on the discretionary side, adjusting the variable comp and where we can, but the value of this company comes from its innovation. So I wouldn't expect meaningfully more attack on the spending into 2024. But remember that our variable comp is designed to be highly accordion. So if '24 plays out as a down year, you will see that meaningfully unwind for us. Anything else...
Stacy Rasgon: Is that $700 million runway Mike, is that like the right run rate to think about?
Michael Lucarelli: That's not a crazy level to think about for the year. I think if you take a step back and look at kind of what we're trying to manage within our control. We talked about gross margin maintaining at 70% a trailing 12-month basis. So for the full year, I think we can do 70% gross margins, and our goal is to maintain our operating margins within our long-term target and the low end of that account 42% to 45%. So that's kind of some guardrails we think about as you're modeling out next year and what would be a down year for revenue.
Stacy Rasgon: Got it. Thank you, guys.
Michael Lucarelli: Thanks Stacy.
Prashanth Mahendra-Rajah: Thank you.
Operator: Thank you. Our next question comes from Chris Danely with Citi. Your line is open.
Chris Danely: Hi. Thanks guys. Congrats Prashanth on retirement. I wish I was joining you. I just had a question on the Auto end market. So you're saying that you expect it to do, I guess, better relatively than Industrial. Given how much inventory has been built there, and the upcoming UAW strike, do you think it's possible that Auto could get materially worse? Are you baking that into any kind of forecast? And then are you I guess, Auto supply chain customers talking about a potential strike and the impact on their inventory.
Prashanth Mahendra-Rajah: Yes. All right. So thank you for the question. Chris, I think we're going to see you in a couple of weeks in New York. So on Auto, I guess some context first, we've grown for 12 consecutive quarters year-over-year. And including the fourth quarter, we're going to be up again. We said in the prepared comments that the lead times and the confidence supply is driving some of that acceleration in inventory adjustments and that's happening across all our markets. When we look specifically at Auto in the quarter and our growth rates there, the same strong growers, BMS, GMSL, A2B. They grew in the third quarter and both on a sequential basis and year-over-year. We expect kind of the similar strength from them into the fourth quarter. So I think that our outlook is, as Vince said, is really end market units driven and we have not yet put in a number nor have we received indicators from our supply chain partners that we should be making adjustments based on any disruption that could come from the negotiations that are going on right now.
Vincent Roche: Yes. I think one other thing, Chris, to note is that, in general, there's more and more silicon value in cars every year, and that's true of ADI. We've got the switch to the electrification, which is, again, in pretty much the early stages of adoption. So there are some great growth drivers that will somewhat transcend the malaise, the economic malaise. But we still expect, overall, as Prashanth said, we've got many growth drivers that Automotive will continue to be the one of the better growth areas for ADI for the foreseeable future.
Chris Danely: Great. Thanks, guys.
Vincent Roche: Thanks, Chris.
Operator: Thank you. Our next question comes from Harlan Sur with JPMorgan. Your line is open.
Harlan Sur: Hi. Good morning. Sorry about that. So in Q3, disti was down, was about 62% of sales. It was down about 4.5% sequentially. So that's less than the total business. Shipments to our direct customers came down around 8%. So maybe you guys can just discuss the shipments and excess inventory dynamics around both for Q3 and here in Q4. Is the excess inventory situation a little bit more pronounced than direct customers? And maybe similar to your disti customers where you have systems in place to monitor sell-through? Like how do you monitor the levels of sell-through and inventories at your direct customers?
Prashanth Mahendra-Rajah: Yes. Great. Okay. So let's do a couple of pieces on that. First, as a reminder, for a distribution company to do business with ADI, you have to give us your sell-through data on a weekly basis in arrears via electronic data feed. So we know exactly where our distribution guys are doing business, and we use that to run the company, as Vince always said, we run it on a POS basis. We said in the third sorry, in the second quarter earnings call, we said that we had gotten a little ahead of ourselves in China and that we intended to undership China. In the third quarter, we have done that. We are now intending to undership all markets generally in the fourth quarter to continue to bring the channel level inventories down. We have limited direct data visibility into our end customers inventory levels, except for those customers where we have consignment. But what we do have is the which you don't have access to is we can see the sales data of our products into our broad set of publicly external customers and their corresponding revenue growth. And our team builds correlation data based on that to tell us how we're doing versus how their growth is. And that's what Vince was referring to that we have seen that their growth is accelerating versus our growth to them, which is why we have confidence that we are undershipping their end market demand, allowing them to pull inventory levels down, which, of course, it is safe to do so because now we can get our products to them within 13 weeks.
Michael Lucarelli: Yes. Prashanth that's a great point you made the less lead times is the best indicator of what our customers' inventory levels need to be. if a customer can get product quick, they need to hold a little less inventory. So our lead time is improving is helping us give us better visibility into what the customers need to hold and what they're holding.
Vincent Roche: Yes. I think Prashanth said earlier, 85% of our total portfolio now is available in less than 13 weeks. Big, big change since this time last year.
Michael Lucarelli: Thank you, Harlan.
Harlan Sur: Thank you.
Operator: Thank you. Our next question comes from Toshiya Hari with Goldman Sachs. Your line is open.
Toshiya Hari: Hi, good morning. Thank you for taking the question. I had two quick ones, if I may. One on pricing. Vince, you mentioned that in the near term, it's more of a unit correction as opposed to a correction in pricing, which makes sense. To the extent foundry pricing improves into 2024, would you be in a position to share that sort of cost down, if you will, with customers the same way you've sort of passed on higher costs over the past couple of years? And then a second quick one for Prashanth. DOI 179, I think that's up, call it, 50, 60 days vis-a-vis pre-pandemic. How should we think about the new normal going forward? And how quickly can you get there?
Vincent Roche: Sure. Let me answer the pricing piece first, Toshiya. There are really two parts to it. One is we have 75,000 product SKUs that are established and are the bedrock of the franchise of the ADI. They're very sticky. The product life cycles tend to be very, very strong. And they tend to be once they're designed and fairly price insensitive. And we're actually -- we're also, by the way, increasing the value of our products each year. We're managing the portfolio in terms of pricing. We're looking for elasticity, which is just a normal part of portfolio management. But -- we're also adding more value to the products that we're introducing to customers, the new products. I think the benefit of lower costs will come at the design-in phase if we do get lower cost, which from our third-party which, by the way, I think, is very, very unlikely. So I think the message is pricing is stable and very, very franchise is very durable.
Prashanth Mahendra-Rajah: And I'll do the DOI one very quickly here, Toshi. So 179 days, balance sheet inventory grew call it, low single digits sequentially on a dollar basis. We have high confidence that we will exit Q1, taking out at least $100 million of inventory value. and the production plans are being oriented to allow us to do that. The days target, we have a model, but we've agreed that it is appropriate for the next CFO really to bless that model because they're going to own that and they need to kind of go through that map. So I can tell you that it's not going to be at 180 days, but I don't think we get back to 120 days. So we'll come back to you at some point on what that looks like.
Toshiya Hari: That's very helpful. Thank you, both.
Prashanth Mahendra-Rajah: Thanks Toshi. Take last question, please.
Operator: Thank you. Our last question comes from Josh Buchalter with TD Cowen. Your line is open.
Josh Buchalter: Hi, guys, thanks for squeezing me in. And Prashanth, congratulations on the great run. You mentioned a few times under shipping in the print and the guidance. I was hoping you could maybe quantify the extent or maybe provide any sort of guidance to the amount that you're under shipping? And then given it sounds like seasonal fiscal first quarter isn't off the table. Does that mean we kind of expect you could be shipping to end demand exiting the October quarter? Thank you.
Prashanth Mahendra-Rajah: I'll let Mike take the second part of that question because I'm not sure I fully comprehended it. But on the first one, so we have our business that goes through the channel and the business that goes direct. Business through the channel, we have the demand forecast from our distribution guys, and we are under shipping into the channel to help them pull inventory levels in the channel down. We said that in the second quarter earnings call that we were going to do that for China. This quarter, we're going to do it across the globe for all distis. Your second question on how to think about the under shipment into end demand that Vince referenced to. All I can really do is refer back to sort of the data analysis that we do. There's not a real way to aggregate that, except to say that we have a relatively good correlation between our end customers revenue growth and our growth to those end customers on an individual basis and when we look at how they grew in third quarter versus our shipments to them and how they're forecasting or you guys or consensus forecasting their fourth quarter growth versus our shipments to them, we know that we're going to be helping them to pull inventory levels down, which again makes tremendous sense because lead times have improved. And Mike, I didn't...
Michael Lucarelli: Sure. On the first -- it's good question. If you look at the first quarter, we always typically undership consumption in the first quarter, why? You see a lot of our customers reduce their working capital going into end of the year-end. So the down 5% in our -- seeing the seasonal first quarter is below consumption. I think after that, you get back to kind of what Vince was saying you get coming back to demand and consumption, all kind of imbalance. And then it comes to a question of macro, what's happening in macro in our second quarter. Thank you, Josh.
Josh Buchalter: Okay. Definitely helpful. Thank you.
Michael Lucarelli: Any time. Thanks, everyone, for joining us this morning. We once again will be on the road a lot this quarter. You'll find us in New York, Chicago, Florida, London and San Fran. Reach out to IR team to be notified when we are in your ZIP code. And with that, thanks for joining us and the interest in ADI.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices Third Quarter Fiscal Year 2023 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Michelle, and good morning, everybody. Thanks for joining our third quarter fiscal '23 conference call. With me on the call today are ADI's CEO and Chair, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. on to the disclosures. The information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our earnings release, and other periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information, as these statements reflect our expectations only at the date of this call. We undertake no obligation to update these statements except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. We are comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO and Chair, Vincent Roche. Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thank you, Mike, and a very good morning to you all. ADI executed well in the third quarter and delivered results within our expectations despite the challenging operating environment. Revenue was nearly $3.1 billion, led by growth in our Industrial and Automotive markets once again. Gross margin remained strong, above 72%, operating margin was nearly 48% and EPS was $249 million. This continued profitability reflects our portfolio's resilience as well as the innovation premium that it commands. I want to turn to the current business environment now just for a moment. As we shared last quarter, we believe we're in a period of customer inventory reconciliation following three consecutive years of steady growth. Through our customer conversations, it's evident these accelerating inventory adjustments relate to the weakening macro backdrop and ADI's rapidly improving lead times. Importantly, we believe we shipped below end market consumption in the third quarter and expect to do so again in the fourth. This will help normalize our customers' inventory more quickly and position us to return to growth more quickly in the coming quarters. Stepping back, while near-term dynamics or turbulence, our long-term confidence remains undiminished. Over the last several decades, we have enhanced the resiliency of our global business, defined by our diversified customer and product portfolio and flexible hybrid manufacturing model. This enables us to ensure softer demand periods while sustaining strategic investments to ensure that we capitalize on the upside when the business inflects. It's these characteristics and our alignment to numerous concurrent secular growth trends that give us confidence that ADI will deliver on our long-term model of 7% to 10% revenue CAGR. Now one area underpinning this growth outlook are the applications tied to sustainable use cases, which currently represents about 1/3 of our total revenue. And today, I want to unpack a vital part of this, the evolving electrification ecosystem that is driving growth in our industrial and automotive markets. As the world marches to net 0, we need to eliminate 51 gigatons of global greenhouse gases emitted every year. Fossil fuels are by far the largest contributor accounting for more than 75% of all emissions. And at the same time, global energy consumption is forecasted to increase by 50% by 2050. A major unnecessary energy transition is underway and an upgraded and expanded energy grid is foundational to support a decarbonization pathway. Making the shift through renewable energy sources in both commercial and residential infrastructure as well as electric vehicles and global transportation will reduce greenhouse gas emissions. These moves also create new challenges in the generation distribution, consumption and smoothing of energy supply. ADI solutions are embedded across all phases of this electrification journey from upgrading the grid infrastructure to forming and managing the vehicle battery. The common thread woven through all these applications is the high-performance precision signal processing, control and power management capabilities they require, capabilities in which ADI excels. Now today, I'll bring the story to life at the application level, starting with grid infrastructure. Overall, today's electrical grid is undergoing modernization to meet current and future demands. Historically, traditional energy sources like coal, oil and gas were centralized and distributed in one direction from the grid to the consumer. Today, renewable energy sources like wind and solar are more distributed necessitating a dynamic bidirectional flow of energy. To achieve this, the grid must be able to adjust performance across the network in real time, which requires an exponential increase in monitoring and storage capabilities. And for example, our collaboration with the Enel Group provides smart meters and grid digitalization solutions for distribution system operators. Here, ADI's control and sensing technologies are enabling high-performance, precision monitoring and data creation at the heart of the digital substation. And we're leveraging our mixed-signal digital and algorithm technologies to enable greater intelligence at the grid's edge. Now moving to energy storage systems, which are critical to mitigate intermittency issues across the network. ADI is a leader with our technologies used in 60% of energy storage systems across residential, commercial and grid scale networks. Leveraging our battery management system technology or BMS. We're increasing capacity and improving energy utilization in energy storage systems, which maximizes the battery's lifetime value. These monitoring and storage challenges extend to the grid's edge as well, including EV charging stations, ADI's energy metrology, isolation and sensing technologies, help enable a broader range of applications in AC and DC charging equipment. In addition to these important applications in our highly diverse industrial segment, our high-performance signal processing platforms and domain expertise are helping to electrify the automotive market. Here, our technology is a key enabler in the transition from combustion engines to cleaner electric vehicles by increasing range and lowering cost. And I'll start with BMS. As we've shared before, we are the leader in this area with our BMS solution designed into 16 of the top 20 EV manufacturers. We're currently sampling our eighth generation solution, which utilizes software and algorithms to enable physical measurement capabilities all the way into the battery cell. These advances in edge processing change the game in how the internal battery health is managed, supporting faster charging and better range prediction. An extension of this is our wireless BMS solution, a first in the industry. It has all the benefits of our wired solution and enables a scalable battery architecture, with quicker and more cost-effective production cycles. Currently, our wireless BMS is designed in at four OEMs, and we expect another large OEM to adopt it in the coming quarters. Given this momentum and the cutting-edge value proposition, we believe the wireless platform will represent a large portion of our BMS revenue by the end of the decade. And looking ahead, we're broadening our EV capabilities beyond battery management and storage to power conversion solutions. Specifically, we're developing a silicon carbide-based smart switch for bidirectional onboard charging that significantly reduces charger size and weight by over 50%, thus driving down cost. Notably, this intelligent integrated switch enables the EV to transfer energy back into the network, creating a more reliable grid. And this innovation solution more than doubles our content opportunity per EV powertrain. So in summary, ADI is driven by a deep sense of purpose and a desire for our innovations to positively impact all stakeholders. We're immensely proud of the role our technologies play to improve the well-being of humanity and indeed the planet, and I remain very confident in our future. Our portfolio of cutting-edge technologies, world-class talent base are aligned with an unprecedented number of attractive secular trends, where the semiconductor content per dollar of CapEx is increasing tremendously. This presents ADI with continued profitable growth opportunities as well as the ability to shape the future of industries. And so with that, I'll hand it over to Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Let me add my welcome to our third quarter earnings call. My comments today, with the exception of revenue will be on an adjusted basis, which excludes special items outlined in today's press release. While demand continued to soften throughout the quarter, ADI delivered nearly $3.1 billion revenue, in line with our guidance. This was driven by continued year-over-year growth for both Industrial and Automotive. Looking at our performance by end market. Industrial, which represented 53% of revenue, finished down 7% sequentially after a tremendous stretch of 13 straight quarters of sequential growth. On a year-over-year basis, revenue increased 4% with most applications up, led by sustainable energy as well as aerospace and defense, which each grew double digits. Automotive, which represented 24% of revenue, was down modestly sequentially in line with our expectations. Year-over-year growth of 15% was broad-based. We saw continued outsized growth for ADI's leading battery management and in-cabin connectivity solutions, which collectively increased nearly 30% year-over-year. Communications, which represented 12% of revenue, decreased double digits, both sequentially and year-over-year due to the broad-based inventory correction we flagged previously. And lastly, consumer, which represented 10% of revenue came in stronger than expected, finishing up 15% sequentially, but down 21% year-over-year. We remain optimistic that our second quarter marked the bottom for this business despite the ongoing inventory correction. And now on to the rest of the P&L. Gross margin of 72.2% remains industry-leading, but declined sequentially due to lower utilization and product mix. Operating expenses of $752 million were roughly flat year-over-year and up sequentially. This quarter's OpEx reflects the full impact of annual merit increases. Operating margin of 47.8% contracted 230 basis points year-over-year, roughly in line with the gross margin decline. Non-op expenses were $57 million, and our tax rate was 11.2%. All told, EPS came in at $2.49 within our guidance range. Moving to the balance sheet. We ended the quarter with over $1.1 billion of cash and a net leverage ratio of 0.8. Given the revenue pressures and our decision to hold more finished goods versus restocking the channel, inventory dollars increased and the days of inventory moved higher to 179. As a result, channel inventory remains below our target level and slightly declined. Specifically, we strategically undershipped Asia, especially China, due to weaker demand trends. CapEx was $325 million for the quarter as we invest to enhance ADI's global resiliency and offer our customers options on where their products are sourced. 2023 should represent the high watermark for CapEx, and we expect it to decline in 2024. Importantly, our investments do not include the benefits of tax credit and grant funds that we anticipate from both the U.S. and the European Chips Act. Over the trailing 12 months, we've generated $3.7 billion of free cash flow or 29% of revenue. And over the same period, we've returned nearly $5 billion to shareholders or over 130% of free cash flow via more than $3.3 billion in buybacks and more than $1.6 billion in dividends. Now turning to the Q4 guidance. We expect the fourth quarter revenue to be $2.7 billion, plus or minus $100 million. This outlook assumes sell-in to be below sell-through. At the midpoint of our outlook, we expect all markets to be down sequentially given the broad-based inventory correction. On a relative basis, Auto and Consumer should perform a bit better than Industrial and Comms. Operating margin is expected to be 44% plus or minus 70 basis points. This margin outlook embeds planned utilization reductions and a decline in OpEx. Our tax rate is expected to be between 11% and 13%. And based on these inputs, adjusted EPS is expected to be $2 plus or minus $0.10. As our outlook is lower than expected, let me provide some context on what we're experiencing and how we will navigate. Our revenue outlook reflects the broad-based macro softness across all end markets, all geographies and customers both large and small. We are also strategically improving lead times to get a better view into demand and enhance customer satisfaction. Today, we're shipping over 85% of our products within 13 weeks, and this is up from 35% a year ago. As Vince mentioned, we are seeing customers accelerate inventory adjustments due to both the softer environment and our lead time improvements. And as such, we're taking measures to preserve the integrity of our balance sheet, cash flow and income statement. This includes further reducing utilization and lowering external wafer purchases with a goal to decrease inventory meaningfully in the coming quarters. And importantly, as we've outlined before, we expect gross margins will maintain a 70% level on a trailing 12-month basis. This gross margin resiliency is a testament to the flexibility of our hybrid manufacturing model and our unique swing capacity capability. In addition to the naturally lower variable comp, we're also taking steps to reduce total OpEx by roughly $50 million sequentially. So stepping back, we're not ready to call the bottom yet but our history shows that we cycle up quickly. And when we do, we will achieve higher highs. ADI has built a very resilient business, rich with opportunities. Our diversification and exposure to numerous secular trends drives our durable earnings stream and solid free cash flow, enabling us to consistently return capital to shareholders. And to that end, over the trailing 12 months, we've returned $5 billion to shareholders or more than 5% of our market cap. As this is my last ADI earnings call, I'd like to give a quick thank you to Vince for his mentorship and counsel over the past six years to the ADI Board, including our audit chair, Karen Golz, for their unwavering support and most importantly, to the world-class finance staff, including young Mike here for always reminding us of our commitments to you, the company's owners. I look forward to seeing many of you in the coming weeks as we get on the road. Mike, let's go to Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. I don't think I've been called young in some time, but I appreciate that. Now let's get to our Q&A session. [Operator Instructions] With that, can be our first question, please."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from Tore Svanberg with Stifel. Your line is open."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you. I have a question for Vince. So I know you're not ready to call a bottom. But some industry observers would say that this sort of inventory build started maybe late 2021, early 2022 based on your guidance for the October quarter, you're sort of back to that level. So then you've seen these cycles, you've seen many of them. They're all different. But just wanted to get a sense for you what you think we're getting close, especially given what I just said about that inventory adjustment now sort of being complete?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks, Tore. When I look at this current cycle, the symptoms are always the same in these cycles, but the causes tend to have different components. And I think right now, there are two kind of inputs to this particular correction. I think one is the inventory in digestion that exists out there that has been building for 18, 24 months now. And the second, of course, is the macroeconomic situation, which is a major governor as well. But I think if you look at what we understand from the direct side of our business, for example, when we look at our largest customers revenue growth and their forecast compared to our growth at these very same customers, we believe that we've been shipping the low-end consumption in the third and will in the fourth quarter. So I think one way to look at this is how long will the inventory correction take? My sense is it will be two to three quarters before we get through the inventory digestion cycle, and I think we're positioned as a company to get beyond it quite fast because we've been managing our factories very carefully, managing our inventories, both on our own balance sheet as well as our distribution channel. So we've also, I think, taken a long-term view to the demand patterns of our customers. We haven't, in any way, forced them into, for example, long-term supply agreements, essentially, at this point in the cycle, that will be forcing them to take products that they don't really need. We've been managing our channel aggressively. So as I said, we're keeping more inventory on our own balance sheet. So again, we will get to distribute the supply ultimately where we think it's needed when the recovery gets underway here. So that's my sense, sorry. I mean, in the industry, if you look back to the dot com cycle, you look at the 2008 financial crisis cycle, most of the downturns tended to last three to four quarters. So my sense is over the next two, three quarters, we begin to see a recovery here, at least on the inventory side. And then it's really a question of how does the macro-economy perform?"
},
{
"speaker": "Tore Svanberg",
"text": "Great perspective. Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks Tori. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Vivek Arya with Bank of America Securities. Your line is open."
},
{
"speaker": "Vivek Arya",
"text": "Thanks Dan. Best wishes again to Prashanth on his next adventure. You said that you're not ready to call the bottom yet and Vince, you mentioned that the inventory digestion period could last for some more time. How should we think about Q1 seasonality? It tends to be down kind of mid-single digit. Do you think we should be prepared for something different than that? Right? And if it is worse than kind of mid-single digit, do you still think that ADI can maintain gross margins above 70%. So just kind of puts and takes to help us align our models would be very useful."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Why don't I take that, Vivek. So first, quick comments just to make sure everyone has the Q4 guide, correct. So on the channel, as I said in the prepared remarks, we are shipping in below the forecast we have from our channel partners. So we are intentionally bringing channel inventories down to help set us up for some better strength. The -- included in the guide is the backlog coverage has some turns, but less than normal given the higher level of uncertainty. So we would need some more turns and positive book-to-bill, which Vince mentioned is likely to be a quarter or two out. And then just from an end market standpoint, we've got all end markets down quarter-over-quarter. So as you know, we don't guide out further than the current quarter, but some color is I think you essentially have it right. There's no reason to think that first quarter would not be down seasonal on a, which would call it, mid-single digit quarter-over-quarter. But that we -- our view is going to be driven by the holidays and the customer decisions to reduce inventory as they go into the year-end. So we're not, at this point, seeing a more meaningful step down in Q1 based on what we can know today. And I will just remember to plant and everyone as you start to model out Q1 that every once in a couple of years, we have a 14-week quarter, and that will be Q1 of '24. And then on gross margins, I think we're actually quite proud of our gross margin story here that we've been -- we've messaged a number of times that we would have the ability to maintain a 70% gross margin in a -- on a trailing 12-month basis with a peak to trough decline of 15%. Q4 is down about 17% from the Q2 peak. And while we didn't give you a gross margin number, if you impute it from the OpEx math that I gave you, you'll see that we are able to hold that north of 70%, and we'll continue to work that. For Q1, gross margins, my best sense now would be that we are likely to face a little more challenge on the utilization level as we bring inventory levels down, but we have been very successful in activating our swing capacity. We're actually doing about 10% better on utilizations because we have swing than if we hadn't activated it. So it's been a very powerful lever for us. And we need to see how the math on all of that works out for Q1, but I wouldn't expect Q1 to be notably different from kind of where we are for Q4."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I'd like to add one other comment, Vivek, to what Prashanth has said. So the other side of margin is pricing, and pricing is very stable. It's very, very stable, resilient. I don't expect that to change. And our products are very, very sticky. We've got tremendous life cycles and that part of our business, this is really a unit correction in the business rather than price or share."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for that. Helpful."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Ambrish Srivastava with BMO. Your line is open."
},
{
"speaker": "Ambrish Srivastava",
"text": "Hi. Thank you very much. This is old Ambrish, Young Mike, can feel free to chime in. I was looking at the year-over-year comms, and I look at TI as your closest peer rival competitor. Vince, they started going into a year-over-year decline in 4Q '22 and you are just starting, and you said two to three quarters. So in the past history does suggest that usually on a year-over-year basis, we see roughly around four to five quarters of year decline. Is that the right way to think about your business? You said two to three quarters of digestion and I'm assuming that means year-over-year decline in reps, right?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Good question, Ambrish. So yes, look, I mean, Comms is just a piece of ADI's overall story. We've actually seen -- I mean, we have two components as well. We've got wire line, we have wireless. I would say on the wire line side of things, we've seen the malaise going back into the late part of '22, early part of '23. So that's really things like optical control for data center and carrier networks, and power. We've got a power business there as well. So we think we'll see that, we expect to see CapEx somewhat recover in that space to be able to catch up with the needs, for example, driven by the explosion in computing power that's required to handle the AI inflection here, for example. So -- my sense is the wire line part will probably start its recovery in the first -- second quarter of the year. Wireless is a little harder to call. It's very, very dynamic. We all know that. The developed countries, particularly North America, 5G deployments, which have really been focused on coverage rather than capacity. They're going to be weaker than we thought. So that's probably going to give us headwinds for how long, we don't know, but I think it could be several quarters during our FY '24. India has been very strong this year, of course. And I think we're expecting to see more commitments to lay in both coverage and capacity in India during our FY '24. So look, we've got leadership in many of these areas, like optical control systems, 5G, software-defined solutions. It's really a question of timing in my mind. But -- there's a lot of uncertainty in the communications market in totality and particularly in wireless at this point. So hopefully, that gives you the answer to your question."
},
{
"speaker": "Ambrish Srivastava",
"text": "Well, I was asking about the overall business, Vince, not just about the Comms, sorry."
},
{
"speaker": "Vincent Roche",
"text": "Okay. yes. Look, I think, Ambrish, the overall business. We see some trends, for example, that will transcend the inventory digestion problem. And even the macro-economy areas like digital healthcare, like aerospace and defense, the sustainable energy theme that we spoke to a little while ago. So again, I will just reiterate my sense is the inventory digestion problem will last probably two, three quarters, and then we'll get back into a unit volume increase from there on."
},
{
"speaker": "Ambrish Srivastava",
"text": "Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Thanks Ambrish."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Stacy Rasgon with Bernstein. Your line is open."
},
{
"speaker": "Stacy Rasgon",
"text": "Hi, guys, thanks so much for taking my question. Prashanth, I don't want to be pedantic on Q1, but I know you said right now, down seasonal, but also as an extra week. That extra week, if I just linearize it is like a plus 7. So do those cancel out? Or is it like it's the week between Christmas and New Year, so it's not a lot of revenue? Or just how do I think about the balance of those two things into Q1, assuming a Q1 that was..."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "So when I gave you my comments of down seasonal that was on a 13-week basis, the 14-week was just a reminder as you model it. So Mike, do you want to do the math, but I think you're essentially thinking about it right."
},
{
"speaker": "Michael Lucarelli",
"text": "Yes. So as Prashanth said, let's take a first 13-week quarter. What happens normally in 1Q and a 13-week quarter our business is down, call it, 5%, plus or minus, total business. Now with an extra week, that adds about 7.5%, both on the revenue side and the OpEx side. So there's two pieces, normal, down 5% total company, in the 14-week quarter, you can add 7.5% of revenue and OpEx. That's the best way to think about it."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "And thank you for clarifying that, Stacy, I wasn't clear in my answer."
},
{
"speaker": "Stacy Rasgon",
"text": "Okay. And then that would drop off into Q2, though, you go the other way in Q2. So Q2 under like normal circumstances would be worse than seasonal because you have that extra week drop off?"
},
{
"speaker": "Michael Lucarelli",
"text": "Yes. So again, you can parse it in normal times, 2Q is up, call it, 2% to 5% and a 13-week to 13-week quarter, if you take away an extra week, yes, you have a 7.5% headwind. They have got 1Q."
},
{
"speaker": "Stacy Rasgon",
"text": "Got it. Okay. That's helpful. I have another one, but I guess I don't want to get that band next time, so I...."
},
{
"speaker": "Michael Lucarelli",
"text": "I'll allow another question because that's a good clarifying question, Stacy."
},
{
"speaker": "Stacy Rasgon",
"text": "Okay. I just wanted to ask about OpEx into next year. So it sounds like you're guiding it to about $700 million in the Q4. How do I think about it next year into a revenue year that's likely to be down potentially reasonably materially. Like how should we think about OpEx just year-over-year for fiscal '24 versus '23?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. I think, Stacy, as we've always said, we run this business for the long term. So we're going to make the adjustments that are prudent to make on the discretionary side, adjusting the variable comp and where we can, but the value of this company comes from its innovation. So I wouldn't expect meaningfully more attack on the spending into 2024. But remember that our variable comp is designed to be highly accordion. So if '24 plays out as a down year, you will see that meaningfully unwind for us. Anything else..."
},
{
"speaker": "Stacy Rasgon",
"text": "Is that $700 million runway Mike, is that like the right run rate to think about?"
},
{
"speaker": "Michael Lucarelli",
"text": "That's not a crazy level to think about for the year. I think if you take a step back and look at kind of what we're trying to manage within our control. We talked about gross margin maintaining at 70% a trailing 12-month basis. So for the full year, I think we can do 70% gross margins, and our goal is to maintain our operating margins within our long-term target and the low end of that account 42% to 45%. So that's kind of some guardrails we think about as you're modeling out next year and what would be a down year for revenue."
},
{
"speaker": "Stacy Rasgon",
"text": "Got it. Thank you, guys."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks Stacy."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Chris Danely with Citi. Your line is open."
},
{
"speaker": "Chris Danely",
"text": "Hi. Thanks guys. Congrats Prashanth on retirement. I wish I was joining you. I just had a question on the Auto end market. So you're saying that you expect it to do, I guess, better relatively than Industrial. Given how much inventory has been built there, and the upcoming UAW strike, do you think it's possible that Auto could get materially worse? Are you baking that into any kind of forecast? And then are you I guess, Auto supply chain customers talking about a potential strike and the impact on their inventory."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. All right. So thank you for the question. Chris, I think we're going to see you in a couple of weeks in New York. So on Auto, I guess some context first, we've grown for 12 consecutive quarters year-over-year. And including the fourth quarter, we're going to be up again. We said in the prepared comments that the lead times and the confidence supply is driving some of that acceleration in inventory adjustments and that's happening across all our markets. When we look specifically at Auto in the quarter and our growth rates there, the same strong growers, BMS, GMSL, A2B. They grew in the third quarter and both on a sequential basis and year-over-year. We expect kind of the similar strength from them into the fourth quarter. So I think that our outlook is, as Vince said, is really end market units driven and we have not yet put in a number nor have we received indicators from our supply chain partners that we should be making adjustments based on any disruption that could come from the negotiations that are going on right now."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think one other thing, Chris, to note is that, in general, there's more and more silicon value in cars every year, and that's true of ADI. We've got the switch to the electrification, which is, again, in pretty much the early stages of adoption. So there are some great growth drivers that will somewhat transcend the malaise, the economic malaise. But we still expect, overall, as Prashanth said, we've got many growth drivers that Automotive will continue to be the one of the better growth areas for ADI for the foreseeable future."
},
{
"speaker": "Chris Danely",
"text": "Great. Thanks, guys."
},
{
"speaker": "Vincent Roche",
"text": "Thanks, Chris."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Harlan Sur with JPMorgan. Your line is open."
},
{
"speaker": "Harlan Sur",
"text": "Hi. Good morning. Sorry about that. So in Q3, disti was down, was about 62% of sales. It was down about 4.5% sequentially. So that's less than the total business. Shipments to our direct customers came down around 8%. So maybe you guys can just discuss the shipments and excess inventory dynamics around both for Q3 and here in Q4. Is the excess inventory situation a little bit more pronounced than direct customers? And maybe similar to your disti customers where you have systems in place to monitor sell-through? Like how do you monitor the levels of sell-through and inventories at your direct customers?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Great. Okay. So let's do a couple of pieces on that. First, as a reminder, for a distribution company to do business with ADI, you have to give us your sell-through data on a weekly basis in arrears via electronic data feed. So we know exactly where our distribution guys are doing business, and we use that to run the company, as Vince always said, we run it on a POS basis. We said in the third sorry, in the second quarter earnings call, we said that we had gotten a little ahead of ourselves in China and that we intended to undership China. In the third quarter, we have done that. We are now intending to undership all markets generally in the fourth quarter to continue to bring the channel level inventories down. We have limited direct data visibility into our end customers inventory levels, except for those customers where we have consignment. But what we do have is the which you don't have access to is we can see the sales data of our products into our broad set of publicly external customers and their corresponding revenue growth. And our team builds correlation data based on that to tell us how we're doing versus how their growth is. And that's what Vince was referring to that we have seen that their growth is accelerating versus our growth to them, which is why we have confidence that we are undershipping their end market demand, allowing them to pull inventory levels down, which, of course, it is safe to do so because now we can get our products to them within 13 weeks."
},
{
"speaker": "Michael Lucarelli",
"text": "Yes. Prashanth that's a great point you made the less lead times is the best indicator of what our customers' inventory levels need to be. if a customer can get product quick, they need to hold a little less inventory. So our lead time is improving is helping us give us better visibility into what the customers need to hold and what they're holding."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think Prashanth said earlier, 85% of our total portfolio now is available in less than 13 weeks. Big, big change since this time last year."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Harlan."
},
{
"speaker": "Harlan Sur",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Toshiya Hari with Goldman Sachs. Your line is open."
},
{
"speaker": "Toshiya Hari",
"text": "Hi, good morning. Thank you for taking the question. I had two quick ones, if I may. One on pricing. Vince, you mentioned that in the near term, it's more of a unit correction as opposed to a correction in pricing, which makes sense. To the extent foundry pricing improves into 2024, would you be in a position to share that sort of cost down, if you will, with customers the same way you've sort of passed on higher costs over the past couple of years? And then a second quick one for Prashanth. DOI 179, I think that's up, call it, 50, 60 days vis-a-vis pre-pandemic. How should we think about the new normal going forward? And how quickly can you get there?"
},
{
"speaker": "Vincent Roche",
"text": "Sure. Let me answer the pricing piece first, Toshiya. There are really two parts to it. One is we have 75,000 product SKUs that are established and are the bedrock of the franchise of the ADI. They're very sticky. The product life cycles tend to be very, very strong. And they tend to be once they're designed and fairly price insensitive. And we're actually -- we're also, by the way, increasing the value of our products each year. We're managing the portfolio in terms of pricing. We're looking for elasticity, which is just a normal part of portfolio management. But -- we're also adding more value to the products that we're introducing to customers, the new products. I think the benefit of lower costs will come at the design-in phase if we do get lower cost, which from our third-party which, by the way, I think, is very, very unlikely. So I think the message is pricing is stable and very, very franchise is very durable."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "And I'll do the DOI one very quickly here, Toshi. So 179 days, balance sheet inventory grew call it, low single digits sequentially on a dollar basis. We have high confidence that we will exit Q1, taking out at least $100 million of inventory value. and the production plans are being oriented to allow us to do that. The days target, we have a model, but we've agreed that it is appropriate for the next CFO really to bless that model because they're going to own that and they need to kind of go through that map. So I can tell you that it's not going to be at 180 days, but I don't think we get back to 120 days. So we'll come back to you at some point on what that looks like."
},
{
"speaker": "Toshiya Hari",
"text": "That's very helpful. Thank you, both."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thanks Toshi. Take last question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our last question comes from Josh Buchalter with TD Cowen. Your line is open."
},
{
"speaker": "Josh Buchalter",
"text": "Hi, guys, thanks for squeezing me in. And Prashanth, congratulations on the great run. You mentioned a few times under shipping in the print and the guidance. I was hoping you could maybe quantify the extent or maybe provide any sort of guidance to the amount that you're under shipping? And then given it sounds like seasonal fiscal first quarter isn't off the table. Does that mean we kind of expect you could be shipping to end demand exiting the October quarter? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "I'll let Mike take the second part of that question because I'm not sure I fully comprehended it. But on the first one, so we have our business that goes through the channel and the business that goes direct. Business through the channel, we have the demand forecast from our distribution guys, and we are under shipping into the channel to help them pull inventory levels in the channel down. We said that in the second quarter earnings call that we were going to do that for China. This quarter, we're going to do it across the globe for all distis. Your second question on how to think about the under shipment into end demand that Vince referenced to. All I can really do is refer back to sort of the data analysis that we do. There's not a real way to aggregate that, except to say that we have a relatively good correlation between our end customers revenue growth and our growth to those end customers on an individual basis and when we look at how they grew in third quarter versus our shipments to them and how they're forecasting or you guys or consensus forecasting their fourth quarter growth versus our shipments to them, we know that we're going to be helping them to pull inventory levels down, which again makes tremendous sense because lead times have improved. And Mike, I didn't..."
},
{
"speaker": "Michael Lucarelli",
"text": "Sure. On the first -- it's good question. If you look at the first quarter, we always typically undership consumption in the first quarter, why? You see a lot of our customers reduce their working capital going into end of the year-end. So the down 5% in our -- seeing the seasonal first quarter is below consumption. I think after that, you get back to kind of what Vince was saying you get coming back to demand and consumption, all kind of imbalance. And then it comes to a question of macro, what's happening in macro in our second quarter. Thank you, Josh."
},
{
"speaker": "Josh Buchalter",
"text": "Okay. Definitely helpful. Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Any time. Thanks, everyone, for joining us this morning. We once again will be on the road a lot this quarter. You'll find us in New York, Chicago, Florida, London and San Fran. Reach out to IR team to be notified when we are in your ZIP code. And with that, thanks for joining us and the interest in ADI."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 2 | 2,023 | 2023-05-24 18:00:00 | Operator: Good morning, and welcome to the Analog Devices Second Quarter Fiscal Year 2023 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli: Thank you, Liz, and good morning, everybody. Thanks for joining our second quarter fiscal '23 conference call. With me on the call today are ADI's CEO and Chair, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial statements and schedules at investor.analog.com. On to the disclosures, the information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our earnings release and other periodic reports and other materials filed with the SEC. Actual results could differ materially from these forward-looking statements, and these statements reflect our expectations only as the date of this call. We undertake no obligation to update these statements except as required by law. Our commentary will also include non-GAAP financial measures, which exclude special items. We're comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO and Chair, Vince.
Vincent Roche: Thanks, Mike, and good morning to you all. Well, I'm very pleased to share that ADI continued to execute well in the second quarter. We delivered our 13th consecutive quarter of revenue growth and record earnings per share. Notably, revenue was $3.26 billion, growing 10% year-over-year. And once again, this was driven by record results in our industrial and automotive sectors. Gross margin was nearly 74% and operating margin surpassed 51%, reflecting the innovation premium our portfolio commands and our strong financial discipline and EPS increased an impressive 18% year-over-year. Now I'd like to spend a moment on the current business conditions. We previously shared that our business was at an inflection point due to uncertain economic and the geopolitical backdrop. After three years of steady growth, customers are beginning to adjust their forecasts and rebalance their inventories. This is most pronounced in Asia, while North-America and Europe demand is moderating, but at a more measured pace. We expect this normalization of revenue will persist through the second half of 2023. Importantly, given our customer conversations and proactive decisions to improve lead times and right-size our backlog, we're in a position to deliver on our goal of delivering a soft lending. Stepping back, we've successfully navigated macro challenges many, many times before. Today, ADI has an even more durable franchise, defined by an unmatched diversity of products, customers and applications. A hybrid manufacturing model that better adapts to demand fluctuations, and of course, a fortified balance sheet. These characteristics instill a resiliency, that helps ADIs mitigate market weakness, and invest through economic cycles in critical areas that will define our future. Notably, unlike previous economic cycles, we have numerous concurrent secular growth drivers across all of our markets that drive more semi-content per dollar of CapEx. And we have exposure to sectors that will transcend the macro uncertainty, including areas like digital healthcare, aerospace, defense and the electrification ecosystem. So to that end, I want to highlight our digital healthcare business, which resides in our industrial end market. Healthcare is a market that is ripe for renovation and it's one that requires the highest levels of performance. Now currently, the United States leads the world in healthcare spending with more than $4 trillion spent in 2022 alone, approaching 20% of GDP. This amount has steadily increased over several decades, and unfortunately does not correlates to world’s leading health outcomes. Both the U.S. along with most international healthcare systems are still reliant on serving the majority of patients with critical or chronic conditions in large, centralized, acute-care hospitals, where specialized expertise and equipment resides. The pandemic highlighted the fragility of the system, underscoring the urgent need for remote physician consultation and distributed clinical grade patient care. This vision of a decentralized system to improve the accessibility, affordability and efficacy of global healthcare can only be realized through the proliferation of edge-based diagnostic and therapeutic technologies. ADI saw this promising opportunity early and made digital healthcare a strategic focus area over a decade ago. Over that time our R&D investments have expanded our portfolio from core signal processing, sensing and power technologies to more highly integrated application specific products to now full system level solutions. The result, our healthcare franchise has delivered seven straight record revenue years, generating $900 million annually and we're on track to achieve a new high watermark in '23 despite the macro backdrop. Importantly ADI has become an industry leader in three primary areas. The first is medical imaging, where our highly integrated products performed critical functions. This includes enhancing image quality, minimizing radiation dosage, improving system assembly, and simplifying field maintenance. Today, we've strong share positions in areas like CT scanners, digital X-ray and ultrasound. Next is automation and instrumentation. For example, our broad portfolio enables us to create the optimized signal chains required in applications such as infusion pumps, ventilators and defibrillators. Third is personal health monitoring. Here, our highest performance products are used throughout the operating room and the ICU, while more compact versions with lower power are designed into wearable devices performing both clinical and consumer wellness monitoring functions. Now let me share some of the examples of how we're seeing ADI's solutions shape the future of healthcare. The ultrasound industry is migrating from large cart based equipment to more compact mobile systems. Recently, ADI won the design as a market leader for their compact ultrasound system. Our solution leverages our complete portfolio including high speed signal chain and high voltage power technologies, to deliver the highest quality images at the lowest power in a smaller footprint. We're also developing an echo to bits technology to untether the ultrasound modality from the hospital and enable hospital grade care in even the most remote locations. Our solution uses proprietary ultra-low power analog technology that performs both the data acquisition and beamforming functions at extremely low power levels with embedded software algorithms. This allows the user to get cart based performance in a handheld form, without compromising image quality, resolution, or functionality. Now turning for a moment to robotic surgery. Currently, only about 15% of the world's surgical procedures use robotic technology despite the many benefits. These include greater precision, flexibility, and control during surgery and shorter hospital stays, fewer complications, and lower levels of pain for patients. We already designed in, at the largest robotic surgical suppliers with our suite of precision motor control, signal processing, power management and sensing solutions. And with content per system in the thousands of dollars and performance demands increasing exponentially, this application is poised to deliver significant growth in the years ahead. In the area of personal health monitoring, clinical grade vital signs monitors are converging with consumer wellness wearables. Now this is an emerging market for our comprehensive suite of technologies, including our sensor AFEs, microcontrollers and ultra-low power technologies, which has been strengthened by the integration of Maxim. For example, in diabetes management, ADI has long been a leading supplier of blood glucose monitoring technology. Now we're working with key customers in the next-generation of continuous glucose monitoring. Our solution increases the level of robustness, accuracy and power efficiency of the glucose sensor, thereby extending its life from days to weeks. And there is much, much more to come. We are extending our reach into innovative medical products that connect our hardware with cloud-based connectivity analytics and service. I'm delighted to share with you that our first non-invasive chronic disease management device is undergoing marketing clearance with the FDA and I look-forward to sharing more as this new market has the potential to significantly expand our healthcare segment (ph). So big picture, we're shaping the digital revolution in healthcare. ADI's ability to go from component to system supplier underscores our deep domain expertise and unrelenting focus on innovation. Setting us apart from the pack, not only in healthcare, but in all of our markets. So while there is near-term uncertainty, we are excited about the long-term opportunities that lie ahead. The center of gravity for data processing is shifting from the cloud to the edge. And ADI where data is born is at the center of this evolution, enabling the next waves of innovation for our customers. Now before I hand over to Prashanth, I want to address our announcement that he will be leaving ADI at the end of the fiscal year. I want to recognize, Prashanth for his many contributions and for his partnership over these past six years. He has played an important role during a period of extraordinary growth and value creation for ADI, including help build a robust finance function and fostering strong investor community engagement. Please know that Prashanth will be remaining in his full capacity and continuing to engage with all of you while we identify our next CFO through a search process that is now underway. And with that, I'll hand it over to Prashanth.
Prashanth Mahendra-Rajah: Thank you, Vince. It has been an honor to serve as the CFO of this phenomenal company and lead this world-class finance organization. As Vince mentioned, I'm fully committed to ensuring a smooth transition and I look forward to engaging with all of you during the coming quarters. I do want to express my deep appreciation to Vince, both as a coach and a mentor, but also for introducing me to this magical world of semiconductors. As my boss often says, we truly are the bedrock upon which the global technology industry is built. Now turning to our second quarter results. As usual, my comments today with the exception of revenue will be on an adjusted basis, which exclude special items outlined in today's press release. We delivered another very strong quarter, record revenue of $3.26 billion exceeded the midpoint of guidance and represented ADI's 13th consecutive quarter of sequential growth. On a year-over-year basis, we grew 10%, led once again by all-time highs in industrial and automotive. Breaking it down by market, industrial, our most diverse and profitable business represented 53% of revenue and finished up 3% sequentially. Year-over-year growth of 16% was broad-based, notable gains in sustainable energy, aerospace and defense. These markets in addition to healthcare, which Vince just highlighted are much better positioned to withstand cyclical slowdown and together they represent roughly 40% of industrial revenue. Automotive, which represented 24% of revenue, once again exhibited broad based strength, growing 10% sequentially and 24% year-over-year. Secular tailwinds fueling content growth continue to drive ADI's leading battery management and in-cabin connectivity solutions, which combined increased nearly 40% year-over-year. Communications, which represented 14% of revenue, decreased both sequentially and year-over-year, due to the ongoing inventory corrections across this end market. And lastly, consumer at 9% of revenue was down more than 20% sequentially and year-over-year, after several quarters of softness, consumer revenue is close to its COVID low, suggesting that the correction is nearly complete. Moving on to the P&L. Gross margin of 73.7% was up slightly sequentially due to favorable product mix. OpEx at $733 million was in line with last quarter and op margins of 51.2%, up roughly 100 basis points year-over-year set a new record. Non-OP expenses were $48 million and our tax rate was 11.4%. Remember that Q2 is typically our lowest rate. All told, EPS came in at $2.83, up an impressive 18% year-over-year. Moving to the balance sheet, we ended the quarter with approximately $1.2 billion of cash and a net leverage ratio of 0.8. We've discussed many times our decision to hold more finished goods inventory versus restocking the channel. Thus, our days of inventory increased to 168, and channel inventory weeks were basically unchanged. As we outlined a quarter ago, we expect inventory dollars will decline in the second half as we balance the replenishment of die bank and moderate external purchases. Moving to cash flow. CapEx was $284 million in the quarter and $930 million over the trailing 12 months, representing 7% of revenue. As a reminder, we outlined at our Investor Day that we expect CapEx to be high-single digits as a percentage of sales in 2023 and then declined in subsequent years to our longer-term target of mid-single digits. These investments will support our long-term growth plans and enable strategic swing capacity between our fabs and our foundry partners. The flexibility of our hybrid model across different geographies, enhances our resiliency. It offers our customers additional optionality and it provides an important financial shock absorber during times of volatility. Of note, our CapEx spend to-date does not include the benefits of both the U.S. and the European tax credits and grant funds that we anticipate from both the U.S. and European CHIPS Acts. Over the trailing 12 months, we generated $4 billion of free cash flow or 31% of revenue. We've returned $5.1 billion to shareholders, $3.5 billion in buybacks and $1.6 billion via dividends. We remain committed to our shareholder friendly policy of returning 100% free cash flow over the long term. Now before moving to the outlook, I do want to provide some additional details on the evolving business conditions. As Vince shared in his remarks, customers are adjusting forecasts and rebalancing inventory. At the same time, our lead times continue to improve with over 70% of our portfolio now shipping in under 13 weeks. This gives customers high confidence into the timeliness of our supply. The result book-to-bill as we outlined last quarter remains below parity in all markets and our backlog due in the current quarter has returned to its typical coverage range. As a result, total backlog continues to decline, but just under a year of revenue, it's still 2x regular levels. And lastly, after a strong start to the second quarter, demand quickly deteriorated in Asia, impacting channel sell-through. As a result, we plan to reduce channel inventory in this region. And in the third quarter, we are planning for sell-in to be below sell-through for the total company. Given these dynamics, we are guiding third quarter revenue to be $3.1 billion, plus or minus $100 million. At the midpoint of our outlook, we expect industrial and auto to be down low to mid-single digit sequentially, communications down around 10% sequentially, while consumer will increase sequentially. Op margin is expected to be 48.5% plus or minus 70 bps. The decline in op margin relates to our annual merit increases, changing product mix and a reduction of manufacturing utilizations given the softer environment. Our tax rate again between 11% and 13%. And based on these inputs, adjusted EPS is expected to be $2.52 plus or minus $0.10. While the near-term operating environment is a difficult one, our diversification and exposure to key secular trends is expected to help mitigate the revenue impact. In addition, we have key levers to help us minimize margin volatility. This include our flexible hybrid manufacturing model, which allows us to quickly reduce spend on external wafers and moderate the impact on internal utilizations. Our variable compensation program, which has a true accordion like function, allowing us to reduce spend, while still investing in key long-term areas. As a result, we expect a durable earnings stream, and solid free cash flow generation, enabling us to take advantage of any share price dislocations. Before handing off to Mike, I want to remind folks that in June, we will be doing a deep dive on the burgeoning opportunity for ADI in the construction of gigafactories. And with that, let me pass it to Mike for Q&A.
Michael Lucarelli: Thanks, Prashanth. I want to echo Vince's comments and thank you for the partnership over the past six years, but I will warn you, it's not done yet, we’ve couple of more earnings calls together. So with that, let's get to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow-up question please requeue and we'll take your question if time allows. With that, can we have our first question please.
Operator: [Operator Instructions] Our first question comes from Vivek Arya with Bank of America Securities.
Vivek Arya: Thanks for the question and thanks and best wishes to Prashanth. So my question really is, I'm trying to understand where is the incremental weakness, is that limited to Asia and within Asia is that industrial or automotive or both? And what about non-Asia demand, how has that changed versus what you had thought three months ago?
Prashanth Mahendra-Rajah: Yes. Thank you. Thank you, Vivek. It's been a pleasure to work with you, Vin, (ph) we still have a few quarters together. Everyone is focused on quarter-over-quarter, but I -- before I get to your answer, I do want to take a step back and look at the year-over-year because I do think that tells the story of share gains and the increasing content per dollar of CapEx, which is what we believe delivers that long-term shareholder value. If you look at our industrial and auto business, they are up year-over-year at the midpoint of guidance. Industrial call it roughly mid-single digit and auto mid-teens year-over-year. And this comes at a time when PMIs are below 50 and auto SAR is relatively modest. So while the economics and the cycle dictate the number of units our customer sell, which will impact our business, our share gains and our increasing content per dollar of CapEx is what we expect to help us outperform, which means we're going to decline less in bad times and accelerate good -- accelerate in good times. To your specific question, China definitely was, sort of the piece of new information that has developed over the year, over the more recent period. We are -- we have had three quarters of decline in China and we're expecting a fourth. We did see an uptick following kind of the resumption or the return to office after Chinese New Year, but that did fade quickly, and the result was we've got inventory a little higher in the channel there than we expected. Very confident that this is not a share issue. This is a reflection of what's going on in those markets. And it's broad-based across both the industrial and auto. Outside of China, I'd say that industrial and auto is holding up relatively well, especially North America, Europe and Japan. Not as strong as it was prior quarter, but it's not falling rapidly. And I would characterize it more as a measured slowdown. Comms and consumer, we've been talking about those in all those geographies, those remain weak.
Vivek Arya: Thank you.
Vincent Roche: Thanks, Vivek.
Operator: Our next question comes from the line of Tore Svanberg with Stifel.
Tore Svanberg: Yes. Thank you. Prashanth, it's been great working with you. Wish you all the best. I know we're together for a few more months, but anyway wish you all the best. My question is on utilization and inventory levels. So could you give us a sense for where utilization is today, what's your plan for the second half, you did talk about inventory in dollar terms coming down in the second half, but if you could give us any color on the extent of that would really appreciate it. Thank you.
Prashanth Mahendra-Rajah: Yeah. Thank you. Thank you, Tore. It's been great working with you. So, as we think about inventory, inventory is going to remain higher than normal because we're keeping the channel lean. This is something we started two or three quarters ago. From a dollar basis, inventory has peaked in second quarter as I mentioned in my prepared remarks, and you should see dollar start to trend down from here, given the actions that we're taking, which is both reducing our external wafer builds, which is an opportunity that we have because of our swing capacity in our hybrid manufacturing model, and that also allows us to balance out the die bank building in our internal factories with softer demand and tap the brakes on internal (ph) utilizations. Utilizations, I would say, still are at elevated levels, so we expect them to start getting closer to what we would consider normal levels in the -- in our fiscal fourth quarter.
Vincent Roche: Tore, to give you a little context, in the outlook we gave, it’s about (ph) 48.5% operating margins that assumes gross margins come down from where they are today. That's mix and also it is utilizations, Prashanth mentioned. And then, OpEx was up a little bit in the third quarter based on merit increase offset some by the variable compensation. So that's kind of the math around that. And then as you said, as you look out, utilizations probably don't go higher in 4Q after 3Q. Just kind of give you a feel for the back half of the year.
Tore Svanberg: Great. Thank you.
Vincent Roche: Thanks for the question. We'll go to next one.
Operator: Our next question comes from the line of Ambrish Srivastava with BMO Capital Markets.
Ambrish Srivastava: Hi.
Vincent Roche: Hi, Ambrish. We hear you.
Ambrish Srivastava: Hi, sorry. Sorry, I lost you for a sec. Thanks. Thank you, Prashanth, pleasure working with you as well. I just wanted to come back to the backlog. And you just went through this comment a little bit too quick for me. So the backlog as you said, 2x regular levels, but book-to-bill below and it is where the typical coverage ranges at this point. So I was really unsure what that means. More importantly book-to-bill should then be trending lower, as we go over the next couple of quarters, is that the right conclusion I should take away from those comments?
Vincent Roche: What I would -- I guess, let me, let's do this in two pieces. First, let's talk about our view on this correction. Obviously no correction is the same. But if you look over at history, Ambrish, most of these sort of downturns last for somewhere between two to four quarters, and it's our view that, that we're going to have weakness for the second half. But a couple of points around that. First, we are really seeing this as a rolling correction across the market, because obviously no market is fully immune, but I do think that we're better-positioned. Comms and consumer, I think we -- you would agree with us, the worst is largely behind us with. We've seen those correct over the last couple of quarters and we're actually being a little bit more optimistic about consumer as we go forward. Industrial and auto, we're starting to see some softness, but that's probably not going to just last a quarter. It's important to point out that we do have some areas of strength in industrial. We mentioned that in the prepared remarks. And auto really is going to continue to be a function of the of the SAR activity. From a bookings and backlog standpoint, the takeaways you want is, bookings overall continue to decrease, but they're basically sitting at about a year of revenue, the total backlog. What that means is that the backlog for the current quarter is now to normal levels, which means that we're back to a point where we will be relying on some book and ship to hit the guide and that's back to normal pre-COVID levels, and on a book-to-bill were below parity, which we had said for a couple quarters now that this was coming and that's pretty broad-based to sort of all markets, industrial and auto are a little bit better, but all markets, all geographies, I did call out on -- in I think Tore's question that China is certainly the weakest of that.
Ambrish Srivastava: Got it. Thank you. I'll queue back for another follow-up.
Michael Lucarelli: Thank you, Ambrish. We'll go to next question.
Operator: Our next question comes from the line of Joseph Moore with Morgan Stanley.
Joseph Moore: Great. Hi. Let me add my congratulations to Prashanth. Can you talk about the backlog being out over a year, when 70% of lead times are below 13 weeks. How much -- I know you've been pretty aggressive scrubbing that backlog. How confident are you that, that reflects real demand? And then, can you sort of describe, it seems like you're still getting a pretty decent amount of bookings, considering that people have booked out 52 weeks and can get product within 13. Can you just -- are people still placing orders beyond lead time to try to assure continuity? Thank you.
Prashanth Mahendra-Rajah: Yeah. Great question, Joe. Thank you. So first, yes, you're exactly right. When we talk about backlog being kind of roughly a year in value, that's phased over several quarters. So we have delivery dates from customers that are in future quarters, which sort of gives us confidence to what the future looks like. And now, we're sort of back to that stage that we've always operated in pre-COVID levels where there is a percentage of the current quarter's revenues that comes from turns business. So we're back to that state of normalcy, with the lead times down as they've improved with our manufacturing capacity additions. Now, there's no incentive for customers to keep giving us orders out with a significant advanced notice, they can get most of what they need pretty quickly. And that's the transition that you're seeing being reflected in the book-to-bill rate. But again, as I mentioned, we are expecting. And Vince has talked for a couple quarters now that, that we were expecting the macro impact to hit us, but we remain very confident that the content story we have is going to help mute the impact relative to others and given our end market exposure, as I mentioned, it's sort of going to be rolling through us. Consumer and comms are largely behind us, we will see auto pressure on units for a couple of quarters -- sorry, industrial pressure on units for a couple of quarters. And auto, we can't give you a good sense of, except to say we know we have a phenomenal content story growth there and it really will depend on consumer purchases.
Vincent Roche: Yeah. I think, Joe, at the margins, I think our customers have changed their behavior. It used to be that the world expect to be able to operate on a very rapid turns cycle. Now I think that, that will persist, but what will also persist is the change in behavior around aligning long -- customers allowing their long-term or longer-term demands with supply. And those are conversations that we're having continuously. So I think the behavior has changed somewhat, and perhaps we've got a new normal.
Michael Lucarelli: Thanks, Joe. We'll go to next question.
Operator: Our next question comes from the line of Chris Danely with Citi.
Chris Danely: Thanks, guys. I'll add my congrats to Prashanth. I wish I was retiring too. I just had a, I guess a question or some more color on the correction. What do you think triggered it? Do you think it was just a function of the shortages going away and people always had a little bit inventory out there. And now they can -- they can start to cancel orders and then how bad do you think it could get. I mean your auto businesses tripled and your industrial business has doubled in the last two years unchanged. So what should we think it for like the October quarter and beyond?
Prashanth Mahendra-Rajah: Yeah. Chris, I don't know that I would call it a trigger per se. I think that -- as I mentioned, we've been sort of rolling through this. It is just that there has been enough growth in some parts of our market that have overshadowed the pressure we've seen on comms and consumer. Now industrial, which is really the flagship is starting to feel a little bit of the impact from the higher interest rate environment. So that's coming through. But again I would call out that we've got a pretty sizable portion of that industrial market that is very recession resistant, that's the healthcare business, which Vince talked about the aerospace and defense, as well as our energy business. I think what I mentioned I think to Ambrish's question is, the piece that perhaps with most surprising to us is, we were expecting a stronger bounce in China, as they reopened from COVID and they got on the other side of Chinese New Year, and that recovery has not happened. And again, as I mentioned, we know that it's not a share issue. It is macro issue to that market. And what was the -- what was the second part of your question?
Chris Danely: Just how bad do you think it could get? Any color on October and beyond?
Prashanth Mahendra-Rajah: I'm going to -- I'm going to turn to the 40-year veteran of this business, who has seen multiple cycles and let Vince take that.
Vincent Roche: Yeah, Chris. I think first and foremost, what we're seeing now in our business is that the troughs are not as deep and the peaks are steeper than they used to be. There is more and more content in every one of the market segments that we participate in. So I think that's the way to look at the troughs are probably going to be -- they're probably going to be shallower. And also we've been very careful at managing our factories and making sure that we don't unnecessarily build inventory and ship product that perhaps isn't needed. So my sense is, we set ourselves for a softer landing just given how we've managed through the cycle and try to match demand of our customers as tightly as we can with the supply system. So, I think perhaps just given where PMIs are at, we would see at least a couple of quarters here of muted demand. And my sense is, when the central (ph) begins to turn, it will turn quickly.
Prashanth Mahendra-Rajah: Yeah, Chris. I’ll add a little bit about -- unit demand for the couple of quarters here. It's good to think like, we've grown 13 quarters of relatively. I think investors and sell-side people forget that you do have down quarter sometimes. And we're kind of going back to, what I'll call a bit more normal and a more normal 4Q, you kind of -- you see industrial kind of flat to down from 3Q, orders about flat. Comms not much activity happening right now in that market and consumer usually up a little bit. And if you look at our 1Q, a normal 1Q for us, the B2B markets, which is industrial, auto, and comms are down, kind of low mid-single digits and consumer is down a bit more due to holiday builds. And then you get a 2Q pickup. Now that's not an outlook. That's kind of what the normal shape was pre-COVID.
Vincent Roche: Yeah. I can tell you as well, Chris, from conversations with our industrial and automotive customers, their sentiment is quite strong. I met the CEO of one of the largest industrial automation companies, very, very recently. And they see tremendous secular growth drivers. There is a rebound in demand from the pandemic stage, where a lot of factory, the CapEx to improve factories, efficiencies and so on was not spent, so that continues. The whole sustainability challenge is on everybody's mind. So there are many reasons to believe that we're going through a short-term period here of reconciliation, normalization of demand and supply, but my sense is, things will recover in the industrial market pretty rapidly. And in automotive, it's a case of, we're getting more and more share in the areas that count with our connectivity products, the electric vehicle portfolio that we've got. And there still reasonable demand, I would say, for mid to high end automobiles. So, we see this as a relatively short-term reset.
Chris Danely: Thanks, guys. Thanks for the color.
Operator: Our next question comes from the line of Ross Seymore with Deutsche Bank.
Ross Seymore: Hi, guys. Just want to echo the congrats for Prashanth. A quick clarification then a question. The clarification is when you talk about the second half being a little bit weaker is that fiscal year or calendar year? And then the two question is on the automotive side of things. You've mentioned a couple of times that it's kind of SAR dependent, but the bigger trend in automotive over the last few years has been mainly content. And you guys have benefited from that as well. I think you're one of the first companies in the semi side to guide that down, albeit minimally on a sequential basis. Has something changed there, that you're seeing that others aren't, is it inventory, is it demand, just anymore color on that would be helpful?
Vincent Roche: Yeah, Mike. You want to take that?
Michael Lucarelli: Yeah. I'll go the first part, Ross, I gave a little bit of comments around kind of what I thought would be for our fiscal 4Q and fiscal 1Q outlook based on kind of normalization. So you can kind of take from that and parse that with your question about is it fiscal second half or calendar second half and put it along that, it's both. With that, I'll pass it to on the auto side.
Prashanth Mahendra-Rajah: I'll take it. All right. Yeah. So look, we've grown 10 quarters in a row and the growth was -- for the last quarter was very broad-based, again across all applications. As we think about the outlook, we are beginning to see some softening though the underlying content growth continue and our top line should still prove to be a strong multiple of SAR. There is some decline that relates to our strong position in China EV. So when you asked about what's different for ADI, Ross, I think that the share position we have in China EV is probably one of those differentiating factors. And that is going through an adjustment as well. While China EVs are still expected to grow, it's not going to be growing as fast as we had originally thought. And so, as this market comes back, it's going to provide the tailwinds we need for our automotive businesses because we have very high share. Again take a step back, we remain very confident that this is a business with the strong product portfolio we have, battery management, in-cabin connectivity with GMSL, A2B, and functional safe power. These represent about half of our business and in a flat SAR environment, we are still going to be able to do double-digit growth.
Ross Seymore: Thank you.
Michael Lucarelli: Thanks, Ross. And Liz, we go to our last question, please.
Operator: This question comes from the line of William Stein with Truist Securities.
William Stein: Thank you for taking my questions. Two quick ones, if I can squeeze them in. First, I wonder you've been very optimistic or relatively optimistic about pricing in the past few discussions we've had, essentially highlighting that foundries are either still raising or certainly not lowering and you're having no problems passing that on. I'd like you to comment if there is any update in that regard. And then the other is just to try to get maybe linger a moment and get a better understanding for what happened in China, because earlier in the quarter, I think you've met with us and some other investors and discussed how business there was recovering. What -- how can you explain how quickly this seems to have changed from improving in China to suddenly getting even worse? Thank you very much.
Prashanth Mahendra-Rajah: Yeah. Thanks, Will. I'm going to do the China one first, so Vince can address the pricing one. The China one is pretty straightforward. We -- as most of the industry, we were watching the recovery coming out of the multi-quarter shutdown in China as well as the Chinese New Year activity looking to see business begin to return to normal levels, given that we had couple of down quarters. We saw a pop-in activity and order activity in the -- as we came out of Chinese New Year. Based on that, we made supply available to the channel that supply did not move as things kind of quickly got softer or didn't move as much I can say, didn't move as much. And therefore, that's why we've now said, for the current quarter, we are going to ship in less than we sell-through to help readjust that level in primarily in Asia. And with that, I'll hand-off to Vince to take the pricing question.
Vincent Roche: Yeah. Thanks, Prashanth. Yeah. Well, I think that the headline of pricing, is that it is very, very resilient. And I expect that to persist. In general, we're getting -- we're putting more value to our customers, we're giving more value to our customers. And in fact the core ASP of our product portfolio has been increasing, not including incidentally inflationary cost that we pass to our customers. So, I think one thing we can say for sure about our franchise is. Our products are very, very sticky, our products persist for many, many decades for example in the industrial sector. And we're in the post Moore's Law era, where the economic conditions have changed fundamentally. So I expect the pricing arena to be very steady across the industry. And in general in the years ahead and we will look for opportunities to pass on inflation, which is going to be persistent in the industry, I believe, in the coming quarters.
William Stein: Thank you.
Michael Lucarelli: Thanks, Will. I thank everyone for joining us this morning. A couple of items before I'll let you go on your way. First, we are playing combined, our general ledger (ph) ERP systems this quarter. This represents one of our final steps for the Maxim integration. Given our typically fast reporting cycle, we've given ourselves an extra week to ensure everything runs smoothly. As such, we plan for our earnings call to be held in the third-week of August versus the second. Also, I wanted to flag that during these more uncertain times and consistent with our commitment for transparency for our owners, we plan being even more available for investors. Vince and Prashanth will be in New York, Boston, The Bay Area and London in the next quarter. Please reach out to the IR team if you be notified when we are in your neighborhood. And with that, a cognitive transcript will be available on the website. Thanks again for joining us and your continued interest in Analog Devices. Have a good day.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
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"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices Second Quarter Fiscal Year 2023 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
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"speaker": "Michael Lucarelli",
"text": "Thank you, Liz, and good morning, everybody. Thanks for joining our second quarter fiscal '23 conference call. With me on the call today are ADI's CEO and Chair, Vincent Roche; and ADI's CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial statements and schedules at investor.analog.com. On to the disclosures, the information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our earnings release and other periodic reports and other materials filed with the SEC. Actual results could differ materially from these forward-looking statements, and these statements reflect our expectations only as the date of this call. We undertake no obligation to update these statements except as required by law. Our commentary will also include non-GAAP financial measures, which exclude special items. We're comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. And with that, I'll turn it over to ADI's CEO and Chair, Vince."
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"speaker": "Vincent Roche",
"text": "Thanks, Mike, and good morning to you all. Well, I'm very pleased to share that ADI continued to execute well in the second quarter. We delivered our 13th consecutive quarter of revenue growth and record earnings per share. Notably, revenue was $3.26 billion, growing 10% year-over-year. And once again, this was driven by record results in our industrial and automotive sectors. Gross margin was nearly 74% and operating margin surpassed 51%, reflecting the innovation premium our portfolio commands and our strong financial discipline and EPS increased an impressive 18% year-over-year. Now I'd like to spend a moment on the current business conditions. We previously shared that our business was at an inflection point due to uncertain economic and the geopolitical backdrop. After three years of steady growth, customers are beginning to adjust their forecasts and rebalance their inventories. This is most pronounced in Asia, while North-America and Europe demand is moderating, but at a more measured pace. We expect this normalization of revenue will persist through the second half of 2023. Importantly, given our customer conversations and proactive decisions to improve lead times and right-size our backlog, we're in a position to deliver on our goal of delivering a soft lending. Stepping back, we've successfully navigated macro challenges many, many times before. Today, ADI has an even more durable franchise, defined by an unmatched diversity of products, customers and applications. A hybrid manufacturing model that better adapts to demand fluctuations, and of course, a fortified balance sheet. These characteristics instill a resiliency, that helps ADIs mitigate market weakness, and invest through economic cycles in critical areas that will define our future. Notably, unlike previous economic cycles, we have numerous concurrent secular growth drivers across all of our markets that drive more semi-content per dollar of CapEx. And we have exposure to sectors that will transcend the macro uncertainty, including areas like digital healthcare, aerospace, defense and the electrification ecosystem. So to that end, I want to highlight our digital healthcare business, which resides in our industrial end market. Healthcare is a market that is ripe for renovation and it's one that requires the highest levels of performance. Now currently, the United States leads the world in healthcare spending with more than $4 trillion spent in 2022 alone, approaching 20% of GDP. This amount has steadily increased over several decades, and unfortunately does not correlates to world’s leading health outcomes. Both the U.S. along with most international healthcare systems are still reliant on serving the majority of patients with critical or chronic conditions in large, centralized, acute-care hospitals, where specialized expertise and equipment resides. The pandemic highlighted the fragility of the system, underscoring the urgent need for remote physician consultation and distributed clinical grade patient care. This vision of a decentralized system to improve the accessibility, affordability and efficacy of global healthcare can only be realized through the proliferation of edge-based diagnostic and therapeutic technologies. ADI saw this promising opportunity early and made digital healthcare a strategic focus area over a decade ago. Over that time our R&D investments have expanded our portfolio from core signal processing, sensing and power technologies to more highly integrated application specific products to now full system level solutions. The result, our healthcare franchise has delivered seven straight record revenue years, generating $900 million annually and we're on track to achieve a new high watermark in '23 despite the macro backdrop. Importantly ADI has become an industry leader in three primary areas. The first is medical imaging, where our highly integrated products performed critical functions. This includes enhancing image quality, minimizing radiation dosage, improving system assembly, and simplifying field maintenance. Today, we've strong share positions in areas like CT scanners, digital X-ray and ultrasound. Next is automation and instrumentation. For example, our broad portfolio enables us to create the optimized signal chains required in applications such as infusion pumps, ventilators and defibrillators. Third is personal health monitoring. Here, our highest performance products are used throughout the operating room and the ICU, while more compact versions with lower power are designed into wearable devices performing both clinical and consumer wellness monitoring functions. Now let me share some of the examples of how we're seeing ADI's solutions shape the future of healthcare. The ultrasound industry is migrating from large cart based equipment to more compact mobile systems. Recently, ADI won the design as a market leader for their compact ultrasound system. Our solution leverages our complete portfolio including high speed signal chain and high voltage power technologies, to deliver the highest quality images at the lowest power in a smaller footprint. We're also developing an echo to bits technology to untether the ultrasound modality from the hospital and enable hospital grade care in even the most remote locations. Our solution uses proprietary ultra-low power analog technology that performs both the data acquisition and beamforming functions at extremely low power levels with embedded software algorithms. This allows the user to get cart based performance in a handheld form, without compromising image quality, resolution, or functionality. Now turning for a moment to robotic surgery. Currently, only about 15% of the world's surgical procedures use robotic technology despite the many benefits. These include greater precision, flexibility, and control during surgery and shorter hospital stays, fewer complications, and lower levels of pain for patients. We already designed in, at the largest robotic surgical suppliers with our suite of precision motor control, signal processing, power management and sensing solutions. And with content per system in the thousands of dollars and performance demands increasing exponentially, this application is poised to deliver significant growth in the years ahead. In the area of personal health monitoring, clinical grade vital signs monitors are converging with consumer wellness wearables. Now this is an emerging market for our comprehensive suite of technologies, including our sensor AFEs, microcontrollers and ultra-low power technologies, which has been strengthened by the integration of Maxim. For example, in diabetes management, ADI has long been a leading supplier of blood glucose monitoring technology. Now we're working with key customers in the next-generation of continuous glucose monitoring. Our solution increases the level of robustness, accuracy and power efficiency of the glucose sensor, thereby extending its life from days to weeks. And there is much, much more to come. We are extending our reach into innovative medical products that connect our hardware with cloud-based connectivity analytics and service. I'm delighted to share with you that our first non-invasive chronic disease management device is undergoing marketing clearance with the FDA and I look-forward to sharing more as this new market has the potential to significantly expand our healthcare segment (ph). So big picture, we're shaping the digital revolution in healthcare. ADI's ability to go from component to system supplier underscores our deep domain expertise and unrelenting focus on innovation. Setting us apart from the pack, not only in healthcare, but in all of our markets. So while there is near-term uncertainty, we are excited about the long-term opportunities that lie ahead. The center of gravity for data processing is shifting from the cloud to the edge. And ADI where data is born is at the center of this evolution, enabling the next waves of innovation for our customers. Now before I hand over to Prashanth, I want to address our announcement that he will be leaving ADI at the end of the fiscal year. I want to recognize, Prashanth for his many contributions and for his partnership over these past six years. He has played an important role during a period of extraordinary growth and value creation for ADI, including help build a robust finance function and fostering strong investor community engagement. Please know that Prashanth will be remaining in his full capacity and continuing to engage with all of you while we identify our next CFO through a search process that is now underway. And with that, I'll hand it over to Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. It has been an honor to serve as the CFO of this phenomenal company and lead this world-class finance organization. As Vince mentioned, I'm fully committed to ensuring a smooth transition and I look forward to engaging with all of you during the coming quarters. I do want to express my deep appreciation to Vince, both as a coach and a mentor, but also for introducing me to this magical world of semiconductors. As my boss often says, we truly are the bedrock upon which the global technology industry is built. Now turning to our second quarter results. As usual, my comments today with the exception of revenue will be on an adjusted basis, which exclude special items outlined in today's press release. We delivered another very strong quarter, record revenue of $3.26 billion exceeded the midpoint of guidance and represented ADI's 13th consecutive quarter of sequential growth. On a year-over-year basis, we grew 10%, led once again by all-time highs in industrial and automotive. Breaking it down by market, industrial, our most diverse and profitable business represented 53% of revenue and finished up 3% sequentially. Year-over-year growth of 16% was broad-based, notable gains in sustainable energy, aerospace and defense. These markets in addition to healthcare, which Vince just highlighted are much better positioned to withstand cyclical slowdown and together they represent roughly 40% of industrial revenue. Automotive, which represented 24% of revenue, once again exhibited broad based strength, growing 10% sequentially and 24% year-over-year. Secular tailwinds fueling content growth continue to drive ADI's leading battery management and in-cabin connectivity solutions, which combined increased nearly 40% year-over-year. Communications, which represented 14% of revenue, decreased both sequentially and year-over-year, due to the ongoing inventory corrections across this end market. And lastly, consumer at 9% of revenue was down more than 20% sequentially and year-over-year, after several quarters of softness, consumer revenue is close to its COVID low, suggesting that the correction is nearly complete. Moving on to the P&L. Gross margin of 73.7% was up slightly sequentially due to favorable product mix. OpEx at $733 million was in line with last quarter and op margins of 51.2%, up roughly 100 basis points year-over-year set a new record. Non-OP expenses were $48 million and our tax rate was 11.4%. Remember that Q2 is typically our lowest rate. All told, EPS came in at $2.83, up an impressive 18% year-over-year. Moving to the balance sheet, we ended the quarter with approximately $1.2 billion of cash and a net leverage ratio of 0.8. We've discussed many times our decision to hold more finished goods inventory versus restocking the channel. Thus, our days of inventory increased to 168, and channel inventory weeks were basically unchanged. As we outlined a quarter ago, we expect inventory dollars will decline in the second half as we balance the replenishment of die bank and moderate external purchases. Moving to cash flow. CapEx was $284 million in the quarter and $930 million over the trailing 12 months, representing 7% of revenue. As a reminder, we outlined at our Investor Day that we expect CapEx to be high-single digits as a percentage of sales in 2023 and then declined in subsequent years to our longer-term target of mid-single digits. These investments will support our long-term growth plans and enable strategic swing capacity between our fabs and our foundry partners. The flexibility of our hybrid model across different geographies, enhances our resiliency. It offers our customers additional optionality and it provides an important financial shock absorber during times of volatility. Of note, our CapEx spend to-date does not include the benefits of both the U.S. and the European tax credits and grant funds that we anticipate from both the U.S. and European CHIPS Acts. Over the trailing 12 months, we generated $4 billion of free cash flow or 31% of revenue. We've returned $5.1 billion to shareholders, $3.5 billion in buybacks and $1.6 billion via dividends. We remain committed to our shareholder friendly policy of returning 100% free cash flow over the long term. Now before moving to the outlook, I do want to provide some additional details on the evolving business conditions. As Vince shared in his remarks, customers are adjusting forecasts and rebalancing inventory. At the same time, our lead times continue to improve with over 70% of our portfolio now shipping in under 13 weeks. This gives customers high confidence into the timeliness of our supply. The result book-to-bill as we outlined last quarter remains below parity in all markets and our backlog due in the current quarter has returned to its typical coverage range. As a result, total backlog continues to decline, but just under a year of revenue, it's still 2x regular levels. And lastly, after a strong start to the second quarter, demand quickly deteriorated in Asia, impacting channel sell-through. As a result, we plan to reduce channel inventory in this region. And in the third quarter, we are planning for sell-in to be below sell-through for the total company. Given these dynamics, we are guiding third quarter revenue to be $3.1 billion, plus or minus $100 million. At the midpoint of our outlook, we expect industrial and auto to be down low to mid-single digit sequentially, communications down around 10% sequentially, while consumer will increase sequentially. Op margin is expected to be 48.5% plus or minus 70 bps. The decline in op margin relates to our annual merit increases, changing product mix and a reduction of manufacturing utilizations given the softer environment. Our tax rate again between 11% and 13%. And based on these inputs, adjusted EPS is expected to be $2.52 plus or minus $0.10. While the near-term operating environment is a difficult one, our diversification and exposure to key secular trends is expected to help mitigate the revenue impact. In addition, we have key levers to help us minimize margin volatility. This include our flexible hybrid manufacturing model, which allows us to quickly reduce spend on external wafers and moderate the impact on internal utilizations. Our variable compensation program, which has a true accordion like function, allowing us to reduce spend, while still investing in key long-term areas. As a result, we expect a durable earnings stream, and solid free cash flow generation, enabling us to take advantage of any share price dislocations. Before handing off to Mike, I want to remind folks that in June, we will be doing a deep dive on the burgeoning opportunity for ADI in the construction of gigafactories. And with that, let me pass it to Mike for Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. I want to echo Vince's comments and thank you for the partnership over the past six years, but I will warn you, it's not done yet, we’ve couple of more earnings calls together. So with that, let's get to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow-up question please requeue and we'll take your question if time allows. With that, can we have our first question please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Vivek Arya with Bank of America Securities."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for the question and thanks and best wishes to Prashanth. So my question really is, I'm trying to understand where is the incremental weakness, is that limited to Asia and within Asia is that industrial or automotive or both? And what about non-Asia demand, how has that changed versus what you had thought three months ago?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes. Thank you. Thank you, Vivek. It's been a pleasure to work with you, Vin, (ph) we still have a few quarters together. Everyone is focused on quarter-over-quarter, but I -- before I get to your answer, I do want to take a step back and look at the year-over-year because I do think that tells the story of share gains and the increasing content per dollar of CapEx, which is what we believe delivers that long-term shareholder value. If you look at our industrial and auto business, they are up year-over-year at the midpoint of guidance. Industrial call it roughly mid-single digit and auto mid-teens year-over-year. And this comes at a time when PMIs are below 50 and auto SAR is relatively modest. So while the economics and the cycle dictate the number of units our customer sell, which will impact our business, our share gains and our increasing content per dollar of CapEx is what we expect to help us outperform, which means we're going to decline less in bad times and accelerate good -- accelerate in good times. To your specific question, China definitely was, sort of the piece of new information that has developed over the year, over the more recent period. We are -- we have had three quarters of decline in China and we're expecting a fourth. We did see an uptick following kind of the resumption or the return to office after Chinese New Year, but that did fade quickly, and the result was we've got inventory a little higher in the channel there than we expected. Very confident that this is not a share issue. This is a reflection of what's going on in those markets. And it's broad-based across both the industrial and auto. Outside of China, I'd say that industrial and auto is holding up relatively well, especially North America, Europe and Japan. Not as strong as it was prior quarter, but it's not falling rapidly. And I would characterize it more as a measured slowdown. Comms and consumer, we've been talking about those in all those geographies, those remain weak."
},
{
"speaker": "Vivek Arya",
"text": "Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Thanks, Vivek."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Tore Svanberg with Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you. Prashanth, it's been great working with you. Wish you all the best. I know we're together for a few more months, but anyway wish you all the best. My question is on utilization and inventory levels. So could you give us a sense for where utilization is today, what's your plan for the second half, you did talk about inventory in dollar terms coming down in the second half, but if you could give us any color on the extent of that would really appreciate it. Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yeah. Thank you. Thank you, Tore. It's been great working with you. So, as we think about inventory, inventory is going to remain higher than normal because we're keeping the channel lean. This is something we started two or three quarters ago. From a dollar basis, inventory has peaked in second quarter as I mentioned in my prepared remarks, and you should see dollar start to trend down from here, given the actions that we're taking, which is both reducing our external wafer builds, which is an opportunity that we have because of our swing capacity in our hybrid manufacturing model, and that also allows us to balance out the die bank building in our internal factories with softer demand and tap the brakes on internal (ph) utilizations. Utilizations, I would say, still are at elevated levels, so we expect them to start getting closer to what we would consider normal levels in the -- in our fiscal fourth quarter."
},
{
"speaker": "Vincent Roche",
"text": "Tore, to give you a little context, in the outlook we gave, it’s about (ph) 48.5% operating margins that assumes gross margins come down from where they are today. That's mix and also it is utilizations, Prashanth mentioned. And then, OpEx was up a little bit in the third quarter based on merit increase offset some by the variable compensation. So that's kind of the math around that. And then as you said, as you look out, utilizations probably don't go higher in 4Q after 3Q. Just kind of give you a feel for the back half of the year."
},
{
"speaker": "Tore Svanberg",
"text": "Great. Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Thanks for the question. We'll go to next one."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Ambrish Srivastava with BMO Capital Markets."
},
{
"speaker": "Ambrish Srivastava",
"text": "Hi."
},
{
"speaker": "Vincent Roche",
"text": "Hi, Ambrish. We hear you."
},
{
"speaker": "Ambrish Srivastava",
"text": "Hi, sorry. Sorry, I lost you for a sec. Thanks. Thank you, Prashanth, pleasure working with you as well. I just wanted to come back to the backlog. And you just went through this comment a little bit too quick for me. So the backlog as you said, 2x regular levels, but book-to-bill below and it is where the typical coverage ranges at this point. So I was really unsure what that means. More importantly book-to-bill should then be trending lower, as we go over the next couple of quarters, is that the right conclusion I should take away from those comments?"
},
{
"speaker": "Vincent Roche",
"text": "What I would -- I guess, let me, let's do this in two pieces. First, let's talk about our view on this correction. Obviously no correction is the same. But if you look over at history, Ambrish, most of these sort of downturns last for somewhere between two to four quarters, and it's our view that, that we're going to have weakness for the second half. But a couple of points around that. First, we are really seeing this as a rolling correction across the market, because obviously no market is fully immune, but I do think that we're better-positioned. Comms and consumer, I think we -- you would agree with us, the worst is largely behind us with. We've seen those correct over the last couple of quarters and we're actually being a little bit more optimistic about consumer as we go forward. Industrial and auto, we're starting to see some softness, but that's probably not going to just last a quarter. It's important to point out that we do have some areas of strength in industrial. We mentioned that in the prepared remarks. And auto really is going to continue to be a function of the of the SAR activity. From a bookings and backlog standpoint, the takeaways you want is, bookings overall continue to decrease, but they're basically sitting at about a year of revenue, the total backlog. What that means is that the backlog for the current quarter is now to normal levels, which means that we're back to a point where we will be relying on some book and ship to hit the guide and that's back to normal pre-COVID levels, and on a book-to-bill were below parity, which we had said for a couple quarters now that this was coming and that's pretty broad-based to sort of all markets, industrial and auto are a little bit better, but all markets, all geographies, I did call out on -- in I think Tore's question that China is certainly the weakest of that."
},
{
"speaker": "Ambrish Srivastava",
"text": "Got it. Thank you. I'll queue back for another follow-up."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Ambrish. We'll go to next question."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Joseph Moore with Morgan Stanley."
},
{
"speaker": "Joseph Moore",
"text": "Great. Hi. Let me add my congratulations to Prashanth. Can you talk about the backlog being out over a year, when 70% of lead times are below 13 weeks. How much -- I know you've been pretty aggressive scrubbing that backlog. How confident are you that, that reflects real demand? And then, can you sort of describe, it seems like you're still getting a pretty decent amount of bookings, considering that people have booked out 52 weeks and can get product within 13. Can you just -- are people still placing orders beyond lead time to try to assure continuity? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yeah. Great question, Joe. Thank you. So first, yes, you're exactly right. When we talk about backlog being kind of roughly a year in value, that's phased over several quarters. So we have delivery dates from customers that are in future quarters, which sort of gives us confidence to what the future looks like. And now, we're sort of back to that stage that we've always operated in pre-COVID levels where there is a percentage of the current quarter's revenues that comes from turns business. So we're back to that state of normalcy, with the lead times down as they've improved with our manufacturing capacity additions. Now, there's no incentive for customers to keep giving us orders out with a significant advanced notice, they can get most of what they need pretty quickly. And that's the transition that you're seeing being reflected in the book-to-bill rate. But again, as I mentioned, we are expecting. And Vince has talked for a couple quarters now that, that we were expecting the macro impact to hit us, but we remain very confident that the content story we have is going to help mute the impact relative to others and given our end market exposure, as I mentioned, it's sort of going to be rolling through us. Consumer and comms are largely behind us, we will see auto pressure on units for a couple of quarters -- sorry, industrial pressure on units for a couple of quarters. And auto, we can't give you a good sense of, except to say we know we have a phenomenal content story growth there and it really will depend on consumer purchases."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. I think, Joe, at the margins, I think our customers have changed their behavior. It used to be that the world expect to be able to operate on a very rapid turns cycle. Now I think that, that will persist, but what will also persist is the change in behavior around aligning long -- customers allowing their long-term or longer-term demands with supply. And those are conversations that we're having continuously. So I think the behavior has changed somewhat, and perhaps we've got a new normal."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Joe. We'll go to next question."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Chris Danely with Citi."
},
{
"speaker": "Chris Danely",
"text": "Thanks, guys. I'll add my congrats to Prashanth. I wish I was retiring too. I just had a, I guess a question or some more color on the correction. What do you think triggered it? Do you think it was just a function of the shortages going away and people always had a little bit inventory out there. And now they can -- they can start to cancel orders and then how bad do you think it could get. I mean your auto businesses tripled and your industrial business has doubled in the last two years unchanged. So what should we think it for like the October quarter and beyond?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yeah. Chris, I don't know that I would call it a trigger per se. I think that -- as I mentioned, we've been sort of rolling through this. It is just that there has been enough growth in some parts of our market that have overshadowed the pressure we've seen on comms and consumer. Now industrial, which is really the flagship is starting to feel a little bit of the impact from the higher interest rate environment. So that's coming through. But again I would call out that we've got a pretty sizable portion of that industrial market that is very recession resistant, that's the healthcare business, which Vince talked about the aerospace and defense, as well as our energy business. I think what I mentioned I think to Ambrish's question is, the piece that perhaps with most surprising to us is, we were expecting a stronger bounce in China, as they reopened from COVID and they got on the other side of Chinese New Year, and that recovery has not happened. And again, as I mentioned, we know that it's not a share issue. It is macro issue to that market. And what was the -- what was the second part of your question?"
},
{
"speaker": "Chris Danely",
"text": "Just how bad do you think it could get? Any color on October and beyond?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "I'm going to -- I'm going to turn to the 40-year veteran of this business, who has seen multiple cycles and let Vince take that."
},
{
"speaker": "Vincent Roche",
"text": "Yeah, Chris. I think first and foremost, what we're seeing now in our business is that the troughs are not as deep and the peaks are steeper than they used to be. There is more and more content in every one of the market segments that we participate in. So I think that's the way to look at the troughs are probably going to be -- they're probably going to be shallower. And also we've been very careful at managing our factories and making sure that we don't unnecessarily build inventory and ship product that perhaps isn't needed. So my sense is, we set ourselves for a softer landing just given how we've managed through the cycle and try to match demand of our customers as tightly as we can with the supply system. So, I think perhaps just given where PMIs are at, we would see at least a couple of quarters here of muted demand. And my sense is, when the central (ph) begins to turn, it will turn quickly."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yeah, Chris. I’ll add a little bit about -- unit demand for the couple of quarters here. It's good to think like, we've grown 13 quarters of relatively. I think investors and sell-side people forget that you do have down quarter sometimes. And we're kind of going back to, what I'll call a bit more normal and a more normal 4Q, you kind of -- you see industrial kind of flat to down from 3Q, orders about flat. Comms not much activity happening right now in that market and consumer usually up a little bit. And if you look at our 1Q, a normal 1Q for us, the B2B markets, which is industrial, auto, and comms are down, kind of low mid-single digits and consumer is down a bit more due to holiday builds. And then you get a 2Q pickup. Now that's not an outlook. That's kind of what the normal shape was pre-COVID."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. I can tell you as well, Chris, from conversations with our industrial and automotive customers, their sentiment is quite strong. I met the CEO of one of the largest industrial automation companies, very, very recently. And they see tremendous secular growth drivers. There is a rebound in demand from the pandemic stage, where a lot of factory, the CapEx to improve factories, efficiencies and so on was not spent, so that continues. The whole sustainability challenge is on everybody's mind. So there are many reasons to believe that we're going through a short-term period here of reconciliation, normalization of demand and supply, but my sense is, things will recover in the industrial market pretty rapidly. And in automotive, it's a case of, we're getting more and more share in the areas that count with our connectivity products, the electric vehicle portfolio that we've got. And there still reasonable demand, I would say, for mid to high end automobiles. So, we see this as a relatively short-term reset."
},
{
"speaker": "Chris Danely",
"text": "Thanks, guys. Thanks for the color."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Ross Seymore with Deutsche Bank."
},
{
"speaker": "Ross Seymore",
"text": "Hi, guys. Just want to echo the congrats for Prashanth. A quick clarification then a question. The clarification is when you talk about the second half being a little bit weaker is that fiscal year or calendar year? And then the two question is on the automotive side of things. You've mentioned a couple of times that it's kind of SAR dependent, but the bigger trend in automotive over the last few years has been mainly content. And you guys have benefited from that as well. I think you're one of the first companies in the semi side to guide that down, albeit minimally on a sequential basis. Has something changed there, that you're seeing that others aren't, is it inventory, is it demand, just anymore color on that would be helpful?"
},
{
"speaker": "Vincent Roche",
"text": "Yeah, Mike. You want to take that?"
},
{
"speaker": "Michael Lucarelli",
"text": "Yeah. I'll go the first part, Ross, I gave a little bit of comments around kind of what I thought would be for our fiscal 4Q and fiscal 1Q outlook based on kind of normalization. So you can kind of take from that and parse that with your question about is it fiscal second half or calendar second half and put it along that, it's both. With that, I'll pass it to on the auto side."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "I'll take it. All right. Yeah. So look, we've grown 10 quarters in a row and the growth was -- for the last quarter was very broad-based, again across all applications. As we think about the outlook, we are beginning to see some softening though the underlying content growth continue and our top line should still prove to be a strong multiple of SAR. There is some decline that relates to our strong position in China EV. So when you asked about what's different for ADI, Ross, I think that the share position we have in China EV is probably one of those differentiating factors. And that is going through an adjustment as well. While China EVs are still expected to grow, it's not going to be growing as fast as we had originally thought. And so, as this market comes back, it's going to provide the tailwinds we need for our automotive businesses because we have very high share. Again take a step back, we remain very confident that this is a business with the strong product portfolio we have, battery management, in-cabin connectivity with GMSL, A2B, and functional safe power. These represent about half of our business and in a flat SAR environment, we are still going to be able to do double-digit growth."
},
{
"speaker": "Ross Seymore",
"text": "Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Ross. And Liz, we go to our last question, please."
},
{
"speaker": "Operator",
"text": "This question comes from the line of William Stein with Truist Securities."
},
{
"speaker": "William Stein",
"text": "Thank you for taking my questions. Two quick ones, if I can squeeze them in. First, I wonder you've been very optimistic or relatively optimistic about pricing in the past few discussions we've had, essentially highlighting that foundries are either still raising or certainly not lowering and you're having no problems passing that on. I'd like you to comment if there is any update in that regard. And then the other is just to try to get maybe linger a moment and get a better understanding for what happened in China, because earlier in the quarter, I think you've met with us and some other investors and discussed how business there was recovering. What -- how can you explain how quickly this seems to have changed from improving in China to suddenly getting even worse? Thank you very much."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yeah. Thanks, Will. I'm going to do the China one first, so Vince can address the pricing one. The China one is pretty straightforward. We -- as most of the industry, we were watching the recovery coming out of the multi-quarter shutdown in China as well as the Chinese New Year activity looking to see business begin to return to normal levels, given that we had couple of down quarters. We saw a pop-in activity and order activity in the -- as we came out of Chinese New Year. Based on that, we made supply available to the channel that supply did not move as things kind of quickly got softer or didn't move as much I can say, didn't move as much. And therefore, that's why we've now said, for the current quarter, we are going to ship in less than we sell-through to help readjust that level in primarily in Asia. And with that, I'll hand-off to Vince to take the pricing question."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Thanks, Prashanth. Yeah. Well, I think that the headline of pricing, is that it is very, very resilient. And I expect that to persist. In general, we're getting -- we're putting more value to our customers, we're giving more value to our customers. And in fact the core ASP of our product portfolio has been increasing, not including incidentally inflationary cost that we pass to our customers. So, I think one thing we can say for sure about our franchise is. Our products are very, very sticky, our products persist for many, many decades for example in the industrial sector. And we're in the post Moore's Law era, where the economic conditions have changed fundamentally. So I expect the pricing arena to be very steady across the industry. And in general in the years ahead and we will look for opportunities to pass on inflation, which is going to be persistent in the industry, I believe, in the coming quarters."
},
{
"speaker": "William Stein",
"text": "Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Will. I thank everyone for joining us this morning. A couple of items before I'll let you go on your way. First, we are playing combined, our general ledger (ph) ERP systems this quarter. This represents one of our final steps for the Maxim integration. Given our typically fast reporting cycle, we've given ourselves an extra week to ensure everything runs smoothly. As such, we plan for our earnings call to be held in the third-week of August versus the second. Also, I wanted to flag that during these more uncertain times and consistent with our commitment for transparency for our owners, we plan being even more available for investors. Vince and Prashanth will be in New York, Boston, The Bay Area and London in the next quarter. Please reach out to the IR team if you be notified when we are in your neighborhood. And with that, a cognitive transcript will be available on the website. Thanks again for joining us and your continued interest in Analog Devices. Have a good day."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 1 | 2,023 | 2023-02-15 16:20:00 | Operator: Good morning, and welcome to the Analog Devices First Quarter Fiscal Year 2023 Earnings Conference Call, which is being audio webcast via telephone and over the web. I’d like to now introduce your host for today’s call. Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli: Thank you, Gigi, and good morning, everybody. Thanks for joining our first quarter fiscal 2023 conference call. With me on the call today are ADI’s CEO and Chair, Vincent Roche; and ADI’s CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. On to disclosures. Information we’re about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release and in our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as date of this call. We undertake no obligation to update these statements except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today’s release. And with that, I’ll turn it over to ADI’s CEO and Chair, Vincent Roche. Vince?
Vincent Roche: Thanks very much, Mike, and good morning to everyone. Well, I’m very pleased to share that ADI continued to execute exceptionally well in the first quarter of fiscal 2023, despite continued macroeconomic uncertainty. Revenue was $3.25 billion, up 21% year-over-year, strength was broad based with all B2B markets, up single-digits. Gross and operating margins were 74% and 51% respectively and adjusted EPS achieved another record at $2.75. Our continued success is driven by a relentless focus on customer collaboration, a growing demand for our innovative technologies and strong operational execution. We play a long game and are excited about what the future holds for us to ensure that we capture the opportunity ahead. We’ve been steadily increasing investments in R&D, manufacturing capabilities and in partnerships that deepen our value to our customers now and over the long-term. For example, in R&D, we’ve invested $1.7 billion over the trailing 12 months to strengthen our core franchises and capture market opportunities presented by secular growth drivers. Over the same period, we’ve invested $760 million in CapEx to enhance the resiliency of our internal semiconductor manufacturing operations. These investments not only increase our operational resiliency, but also modernize our fabs to better address our sustainability ambitions. As mentioned in our press release, our industrial and automotive businesses remain strong as we gain market share. So this morning, I want to focus specifically on our industrial business, which continues to grow significantly despite the macroeconomic backdrop. Now, from a big picture perspective, the industrial market is the bedrock of ADI, representing more than half of our total revenue. It’s also our most diverse and profitable business segment with tens of thousands of customers and products that sustain revenue streams for decades. Additionally, ADI’s industrial revenue is derived from high performance technology in mission-critical CapEx-intensive equipment across the myriad applications. Our leadership position has been strengthened over the last decade as we intensified our focus in this market and invested over $5 billion in R&D activities to capture the opportunity across the hundreds of applications that characterize the industrial sector. This space is inherently fragmented and the unmatched breadth and depth of ADI’s portfolio uniquely allows us to address our customer’s needs across the full spectrum of applications. With core component building blocks to application-specific solutions that encompass analog, digital and algorithms. Today, we’re seeing the rise of new industrial applications that require more sophisticated and more complex architectures as machines become more intelligent and more sustainable. This is driving more semiconductor content per dollar of CapEx, unlocking new opportunities for our portfolio. While this transformation is benefiting all of our industrial applications, including healthcare and aerospace, let me share how we’re winning an industrial automation and instrumentation more specifically and discuss the burgeoning opportunity across the electrification ecosystem. So, starting first with industrial automation. Here, our customers are upgrading their factories with more automation and connectivity to increase output with greater energy efficiency. ADI’s broad portfolio helps customers create these more resilient and flexible footprints while lowering their carbon emissions on the journey to net-zero. As an example, at a leading U.S. robotics manufacturer, we’ve won additional content across power sensing and GMSL connectivity. Our systems approach reduced our customers’ design time and increased our content per cobot by 4x. Also in the last quarter, our IO-Link solution was designed in at multiple leading industrial automation customers. These solutions are critical for delivering robust connectivity to the edge of the factory floor. Turning our attention now to our instrumentation and test business. This subsector is highly aligned to secular growth trends from connectivity to AI-assisted compute to electrification to drug discovery and gene therapies. The consistent thread across this diverse set of applications is the growing complexity that requires more advanced metrology and test. The results, our average content per system is now 2x to 3x higher. Further, the localization of semiconductor supply is providing additional tailwinds for our test business. We’ve secured multiple design wins in North America as well as Asia for memory and high-performance compute. And finally, on to one of our fastest-growing areas, the electrification ecosystem. The collective need for a more sustainable future is driving massive growth in electrical grid infrastructure. Now let me share two examples with you. First, industrial and automotive companies have announced more than $300 billion of investments in greenfield gigafactories, essential to the production of batteries to proliferate the electrification ecosystem. These gigafactories will drive additional demand for our formation and test solutions critical to producing higher density batteries. Further, given the inherent safety hazards of using higher cell voltages, these factories will also provide new growth vectors for ADI. In our sustainable energy franchise, we’re leveraging our industry-leading automotive BMS solutions into energy storage systems for electrical grids and fast-charging infrastructure. We’ve won designs at leading EV infrastructure manufacturers in North America, Europe and Asia, putting us on a path to more than tripling this business in the coming years. Of course, while no market is fully immune to adverse economic cycles, our industrial business is highly diversified and aligned with secular trends. This has translated to more durable revenue streams with sales in this sector increasing more than 25% over the trailing 12 months despite a weakening economic backdrop. But looking ahead, we see continued strength in this franchise as the breadth and depth of our portfolio, our deep customer collaborations and design win pipeline momentum underpin our new phase of profitable growth. So in closing, ADI’s business model is diverse, resilient and rich with opportunity. I’m very optimistic about what our future holds as we drive enhanced value for our customers employees and shareholders as well as society at large. And so with that, I’ll hand you over to Prashanth.
Prashanth Mahendra-Rajah: Thank you, Vince. Let me add my welcome to our first quarter earnings call. My comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today’s press release. First quarter revenue of $3.25 billion finished at the high end of our outlook, driven by continued share gains in industrial and automotive. Our B2B markets represented 89% of revenue, up 25% year-over-year and increased 2% sequentially despite our first quarter typically being down. Now let’s look at performance by end markets. Industrial, our most diverse and profitable end market represented 52% of revenue and hit another all-time high. This business has grown sequentially for 12 consecutive quarters. All markets increased year-over-year, led by automation, sustainable energy, instrumentation and test. Automotive, which represented 22% of revenue, also achieved another record, increasing 29% year-over-year and 6% sequentially. All applications grew double digits year-over-year as our market leading positions across battery management and in-cabin connectivity continue to deliver significant growth. Communications, which represented 15% of revenue, grew 18% year-over-year. As expected, comms declined slightly sequentially as strength in wired was offset by softness in wireless due to the timing of 5G deployments. And lastly, consumer, which represented 11% of revenue, was down 5% year-over-year and declined 14% sequentially given weaker market trends and seasonality. Now onto the rest of the P&L. Gross margin of 73.6% expanded 170 basis points year-over-year, unfavorable mix and cost synergies. OpEx was $733 million down slightly sequentially as we balance strategic hiring with the tight discretionary spend and synergy capture. Given our strong operating leverage combined with the synergy savings, our operating margin was 51.1%. Importantly, we have already captured nearly all of the $400 million cost synergy goals. As such, our communication will now turn to the revenue synergy opportunities from our combined portfolio and our complimentary customer base with Maxim. Recall that Anelise, our Chief Customer Officer, unveiled how we are strategically approaching these synergies during our Investor Day, and Vince has routinely highlighted some of these compelling opportunities over the past few quarters. To that end, we are closely monitoring and measuring progress from opportunity to design win to new revenue. And while it is still early, design win momentum to date has exceeded our expectations. This gives us increased confidence in achieving our $1 billion plus revenue synergy opportunity that we outlined at our Investor Day. Non-op expenses were $60 million, and the tax rate was just over 12%. All told, EPS came in at $2.75, up 42% year-over-year and hitting a new record. Moving to the balance sheet. We ended the quarter with approximately $1.7 billion of cash and a net leverage ratio below 1. Days of inventory increase to 155, while channel inventory remains below our target level. Recall that last quarter, we outlined our strategy to rebuild strategic die bank and hold more finished goods inventory on our balance sheet as we moderate shipment into the channel during this time of inflection. Moving on to cash flow. CapEx for the quarter was $176 million and $764 million over the trailing 12 months, representing 6% of revenue. We continue to expect CapEx to be high-single-digits as a percentage of sales in 2023 and then decline in subsequent years to our long-term target of mid-single-digit. These investments will double our internal revenue output exiting next year and support strategic swing capacity between our fabs and our foundry partners. The flexibility of our hybrid model across different geographies enhances our resiliency and offers our customers additional optionality. Over the trailing 12 months, we generated $4.3 billion of free cash flow or 34% of revenue. Over this period, we have returned $4.7 billion to shareholders or over 100% of free cash flow via $3.1 billion of buybacks and dividends of $1.6 billion. We just raised our quarterly dividend by 13%, marking our fifth consecutive double digit increase, and 19 consecutive years of increases. This is a testament to our durable operating model that has generated positive free cash flow for 26 consecutive years. As a reminder, we target 100% free cash flow return. The dividend is the cornerstone of this policy, and we look to increase our dividend at a 10% CAGR through the cycle with remaining cash used for share count reduction. Now, similar to prior quarters, I’d like to give a brief update on the operating backdrop. First, on markets. Industrial orders, as Vince highlighted, remain the strongest followed by automotive, while comms and consumer remain weak. Given the rapidly changing environment, we are diligently working with our customers to remove orders that they may no longer require. At the same time, we have increased our supply by growing our internal output and working with our foundry partners. These actions have reduced our lead times with half of our portfolio now shipping in under 13 weeks. Despite this, backlog coverage remains around one year of revenue. As such, we expect our book-to-bill will remain below parody over the next couple quarters as our backlog returns to more normal levels. Given these dynamics, we are guiding second quarter revenue to be $3.2 billion plus or minus $100 million. We expect continued sequential growth in our industrial and automotive markets and another sequential decline in our communications and consumer markets. At the midpoint of our outlook, revenue will be up high-single-digits year-over-year with our B2B markets up over 10% once again. Operating margin is expected to be 51% plus or minus 70 basis points. Our tax rate is now expected to be between 11% to 13% for the year. This guide reflects the new U.S. tax requirement to capitalize R&D expenses for tax purposes, resulting in higher upfront cash tax payments, but lowers our effective tax rate temporarily due to the deferred tax accounting requirements. Based on these inputs, adjusted EPS is expected to be $2.75, plus or minus $0.10. In all, the macro backdrop remains uncertain. However, we remain cautiously optimistic on the near-term, given the resilient strength across our industrial and auto businesses, which represent over 75% of our revenue. Longer-term, we remain well positioned to drive growth enabled by our diverse high performance portfolio aligned with the key secular trends at the Intelligent Edge. Let me now pass it back to Mike for our Q&A.
Michael Lucarelli: Thanks, Prashanth. Let’s go to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants in the call this morning. If you have follow-up question, please requeue. I’ll take your question if time allows. With that our first question, please.
Operator: [Operator Instructions] Our first question comes from the line of C.J. Muse from Evercore ISI.
C.J. Muse: Yes, good morning. Thank you for taking the question. I guess the – my question really would center around the industrial strength that you’re seeing. You talked in great detail around kind of emerging new markets as well as increasing content yet, I think a lot of investors are focused on kind of declining PMIs around the globe. And so we’d love to hear your thoughts on why your business is, acting so very different from, maybe some of the larger macro trends. And perhaps more color on how much of it is content? How much of it is maybe emerging growth areas that are not reflected in some of these PMIs would be very helpful? Thanks so much.
Vincent Roche: Yes. Thanks, C.J. So, I think first and foremost, our success isn’t by dent of chance. We’ve been investing heavily in this market for more than a decade, and it’s really our focus. It’s our core, it’s the core of ADI and from both an R&D and customer engagement perspective, we’ve been really doubling down here over this decade plus kind of time span. And we’ve been gaining market share for sure. We have – compared to even kind of three years, four years ago, we have – we’ve always had a very strong position in the signal chain, the kind of data path processing electronics, but we’ve been able to, with the acquisitions of LTC and Maxim, we’ve been able to bring very strong competitive power portfolio to bear as well. So, I think from a portfolio perspective, we’re in much better shape. I pointed out in the script as well that when we talk about industrial, it’s truly the industrial sector. I know many competitors talk about other kind of indescribable sectors or businesses that are not well understood, like consumer, for example, other consumers. So, I want to point that out as well. We have, as I said, many secular growth drivers in play. We see the average content per dollar of CapEx spend increased at a pretty meaningful level across all the applications, including instrumentation, factory automation is changing also. It’s bringing more sensing, more compute to the edge and all of that is driving content gain for ADI. So, I think they are the primary drivers of the business. And yes, PMIs are, I would say, in the kind of retraction zone right now, but we see stabilization. And I think when China comes back as well, which is likely to happen, we believe, over the coming months, that will drive things even further into a positive zone.
Prashanth Mahendra-Rajah: C.J., this is Prashanth. I’ll just put one more thing just to help folks understand kind of the breadth of that growth. All of our submarkets were up double digits year-over-year, and most of them increased quarter-over-quarter. And if you look at it by geography, we had strength in America, Europe and Japan, again, all up double digits year-over-year, offsetting a weaker China. So this industrial strength was very broad-based.
Michael Lucarelli: Thanks, C.J.
Operator: Thank you. [Operator Instructions] Our next question comes from the line of Vivek Arya from Bank of America Securities.
Vivek Arya: Thanks for taking my question. I actually had a pair of kind of related question, which is how long can book-to-bill remain on before it starts to become, [indiscernible]? And usually, if I look historically for ADI, generally, the second half tends to be better than the first half. What would support that view or prevent that from happening this year?
Prashanth Mahendra-Rajah: Okay. Yes. So Vivek, let me maybe take a walk through cancellations, backlog lead times to help answer that. But I do want to clarify, you said on book-to-bill. Our book-to-bill is sub one. I thought I heard you say it was one. Our book-to-bill is sub one. We told you that was happening a couple of months ago, and I’d expect to carry for another quarter or two as we get through this backlog. So on the backlog, we’ve been saying for a while now that we’ve got record backlog, and we are working with our customers and our disti partners to get this rationalized with what customers need today versus perhaps the orders they had placed on us six months or nine months ago when we had very long lead time. This progress is what is being reflected in that book-to-bill ratio below one. I think that it will probably be below parity for another quarter or two as we get back to normal backlog. Lead times, the supply-demand imbalance is definitely getting better, slowly, but it’s getting better. We’re getting more wafers externally, thanks to the hybrid model. We have the flexibility to do that as well as the investments we’re making internally as we’ve talked about with our CapEx deployment to increase production. So, we have about 50% of the portfolio under 13 weeks today, meaning it can ship within the quarter, and that’s going to continue to improve over the – through the second half. So takeaway sort of given lead times falling, bookings getting higher quality compared to year ago as customers aren’t ordering for stuff way into the future. And at the place backlog, and we feel this is positive for visibility, and we’re really getting to true demand.
Vivek Arya: And anything on second half, Prashanth, because it looks more like a soft take of then a soft landing from the trends?
Prashanth Mahendra-Rajah: So, I don’t want to go out too far, but I’ll just give you a couple of comments here. And if Vince wants to make any long-term comment. We feel good about the outlook for the second quarter given the resiliency in auto and industrial. As I said, 75% of our sales come from those two segments, and we still have a year for the backlog. Beyond the second quarter, it’s hard on the one hand to make a call, given that we have strong backlog coverage, but we also understand there’s a lot of macro uncertainty out there and things are changing fast. So, I’m not going to make any predictions one area to pay attention to, and Vince made a comment on this, is China. I think we and many companies are watching China. If demand accelerates in the second half given sort of the optimism on consumers and government that would be – that would be good for a number of organizations. Vince, anything more longer term, you want to add on that?
Vincent Roche: Well, I think, Prashant, we’ve clearly built a lot of resiliency into the way we run the company into the business model as well as the manufacturing operations. So, who knows what the second half is going to bring. But what I can tell you is that – we’ve been through many, many cycles before and never have we been better positioned in our history than we are now from a portfolio, from a customer engagement standpoint. So – this industry is likely – it’s taken us kind of 20 years to double from kind of 2000 to 2020, we’ve probably doubled the content that the industry builds over the next 10 years. And I believe ADI is very, very well positioned given the strength, as I said, of our portfolio, our customer engagements, and this hybrid manufacturing model that we’ve got in place to enable us to capture the upside and manage the downside.
Michael Lucarelli: Thanks, Vivek. Next question please.
Operator: Thank you. [Operator Instructions] Our next question comes from the line of Tore Svanberg from Stifel.
Tore Svanberg: Yes, thank you and congratulations on the results. So on Maxim now that we’re sort of moving from the cost synergies to the revenue synergies, are there any particular areas that we should keep an eye on there, whether end markets or product categories where you expect to see that $1 billion in synergies?
Prashanth Mahendra-Rajah: Yes, let me – let’s do that in two parts. I’ll give you a little bit of context so that everyone remembers what we talked about and then hand over to Vince. So we’ve closed on the cost synergies. We feel great about that. So we’re focusing now on revenue synergies, and we’re tracking ahead of schedule. We think about that synergy in stages. So first we need to identify the socket, we need to win the socket, we begin shipping to the customer, and then we hit volume. So we are tracking all of those stages through our internal material. As I said, Anelise gave you a target in April to come – to deliver $1 billion of incremental. Vince is holding her to a higher bar than that. So she’s on track to hit that $1 billion. And we’ve got – we’ve seen early success. I think you’ve heard Vince share a couple examples over the last couple quarters. For example, in the – our ability to cross sell A to B as well as put GMSL into non-auto customers which is new. So let me pass off to Vince here for what are some of the other areas that we’re thinking about?
Vincent Roche: Yes. When we announced the combination, Tore, with Maxim, we pointed out two particular market areas where we thought ADI was underweight, where power in particular, power management was really important, power in data center, for example. And as the compute density skyrocket, and in fact in the compute area, performance and power are pretty much one and the same thing. So we have now a very competitive power portfolio that we can bring to more application specific areas such as data center as well as automotive. The – I think a very positive surprise is that the connectivity portfolio based on GMSL, the multi gig serial link is that not only are we gaining more and more traction in automotive, but also we’re bringing it to other areas such as industrial, as Prashanth mentioned. BMS, we’ve got 16 of the top 20 wired BMS OEMs sockets in the top 20 OEMs. And Maxim strengthens that portfolio as well. So in industrial, I mentioned in the prepared remarks that the I/O link technology is very, very, that Maxim brings to bear is very, very complementary with ADI’s data path solutions. So I think there are multiple areas and I think the message I want to convey here is that I was always optimistic about what we could do with a greater channel, more cross connectivity to the ADI portfolio. But I’m more enthusiastic than ever based on what I’m actually observing now with the various markets and customers in which we’re playing.
Tore Svanberg: That’s very helpful. Thank you.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Chris Danely from Citi.
Chris Danely: Hey, thanks guys. Just a little more clarification on the lead times and the shortages. So you mentioned that half of the portfolio has lead times of less than 13 weeks right now. Can you talk about what that was three months ago? And then when would you expect the lead times to, I guess, “largely normalized” and with a couple flat quarters? And it seems like you got plenty of inventory. Why aren’t these lead times normalizing a little bit faster? Thanks.
Prashanth Mahendra-Rajah: Sure. Chris let me – Michael have to remind me where we were three months ago. But the – so the supply demand balance is getting better. And we’re getting that – we’re getting more wafers, so – in addition to our internal production. The way to think about the lead times is we’ve got half the portfolio shipping within the quarter. And certainly in the next quarter or two, we will have the overwhelming majority of that down to within one quarter. The inventory build as I mentioned, is in part due to our desire to kind of keep more inventory on ADI’s books because we are clearly in a period of great uncertainty and we’re being very mindful of putting too much to our channel partners when there’s this much uncertainty out there. So that will – as lead times improve, our channel partners can count on us to get what they need in quick terms, and then we’ll be able to more reliably think about what’s the right stocking level for the channel.
Michael Lucarelli: Okay. And Chris to your question, where was it beginning the quarter. If you look at that metrics under 13 weeks, beginning of the quarter was probably about 25% of the portfolio. So we doubled that number and Prashanth laid out, we want to get it close to a 100% exiting this year. And I know Vince is pushing hard to get even sooner than that. I think the biggest takeaway at lead times is the short lead times, the more high quality the bookings are. I think that’s what we want to see is the true underlying of what demand is as those lead times continue to come in and why does it take so long while demand is strong, right? Demand is strong, it’s harder to reduce lead times in a strong demand environment.
Chris Danely: Great. Thanks guys.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Stacy Rasgon from Bernstein Research.
Stacy Rasgon: Hi, guys. Thanks for taking my question. Maybe it’s a dumb question. But I’m having a little bit of trouble squaring the majority of the portfolio getting to be within 13 weekly times together with a year’s worth of backlog. How do I square those two things? It feels like the backlog should be shorter if the lead times are actually like getting back to normal. Maybe the other way to ask it is when the majority of the portfolio has 13-week lead times, where do you expect that backlog to be?
Prashanth Mahendra-Rajah: Yes, so Stacy, I think perhaps the missing elements of your – of how you’re thinking about it is the assumption that that backlog is delinquent. It is not. The – when the lead times get extended, customers put the orders on us, but they also tell us when they want that product delivered. So there’s a visibility curve to that backlog. It is not that it is all past due and needs to be shipped against.
Stacy Rasgon: Oh, I see. Okay. So you’re – okay, so you’ve got orders out. We know that we’re going to be shipping this to you in six months and they placed it [ph]. So I guess where do you expect that backlog to be standing given what you see for demand once, say we’re in a quarter to pass this and the majority of the portfolio is shipping within a quarter. Where do you expect the backlogs to be?
Prashanth Mahendra-Rajah: Well, let’s go back to the – if we get to – if we return to what was normal for us pre COVID, let’s say that’s the best perspective we can give you. If we return to what does normal look like then at the start of a 13-week quarter, we would have about 10 weeks of that quarter in backlog. And then there would still be some incremental backlog out there for future quarters, but it would be meaningfully smaller because customers know that they can put that order on us in essentially less than a quarter’s notice. So that’s what normal looks like. Now, given the supply, demand challenges and the increasing importance of Analog’s products to our customers, we may benefit from some greater visibility in the future, but I don’t want to call that today.
Stacy Rasgon: Got it. So I guess, does this mean, are you effectively over shipping demand right now because the backlog is pulling it? Or is that not the right way to think about it?
Prashanth Mahendra-Rajah: No, I would – I’m not sure how you would conclude that. We are – we have the – we have demand from our customers in that backlog that tells us. I want this product in Q1, I want this product in Q2, this product in Q3, and that is what we are matching up for. But it gives us a visibility that we have historically not had at this level. That is why they are not as incentive to put new orders on us, is because they’ve given us those orders, hence book to bill below one.
Vincent Roche: Yes. One other thing we’re pointing out, Stacy, is that we run – our demand signals are sell through. We run our factories on the basis of POS demand rather than sell in or POA demand. So it gives us more integrity around the demand signal.
Stacy Rasgon: Got it. Okay. That’s helpful. I won’t monopolize anymore. Thank you so much, guys.
Michael Lucarelli: Thanks Stacy, for that three part question. You use your question for next quarter, so we’re not going to – have the call next quarter. Next question, please.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Ambrish Srivastava from BMO Capital Markets.
Ambrish Srivastava: Hi, thank you. I’m going to keep it to one. Mike, I don’t want to get any of bad site. Vince, I actually wanted to focus on a bit on the long-term here. I was called out a much higher growth rate for analog and for themselves as a result. And I was wondering if you share the same view, I know you guys have had a 7% to 10%, and Vince you have always all the conversations over the years, you always felt that the analog industry going forward should grow faster than the 5.6 odd that we’ve seen over the long-term. So I was just wondering how you think about analog growth and you called out a bunch of secular drivers that, four or five years ago didn’t even exist for the analog industry and broadly for semis. Thank you, Vince.
Vincent Roche: Yes, thanks, Ambrish. Well, I think, as I pointed out in the prepared remarks, we are seeing more, for example, in the industrial space, more content per dollar of CapEx invested by our customers. And that trend has been in play for several years now. That coupled with ADI’s portfolio strength, the breadth we have the, as I mentioned, the data path, which has been ADI core, ADI traditional strength, adding LTC and Maxim Power portfolios. That gives us the opportunity to tap into more of the TAM, so to speak. Half of the analog market, TAM is kind of data path. The other half is power. So we’ve now got the, the highest performance portfolio in the industry, the greatest breadth and depth. And, when you see what’s happening there with healthcare, our digital healthcare business, which is getting on for, kind of a $1 billion over the next year, year and a half aerospace and defense, coupled with automation and instrumentation that we’ve talked about in the prepared remarks. We’re very, very bullish about our ability to drive growth in the market. The other thing I want to point out is that we focus on driving our revenue growth through high quality innovation for which we get paid. We get three times the ASPs of the analog market at large, and we get more than that, compared to our biggest competitor. So I want to make the point that we focus on shipping value versus volume. So I think with the sector growth drivers, the way we’ve structured our business model, our focus on high performance and being able to capture more value with all the things we talked about over the course of the call here, I’m focused on what we can do as a company and I believe we’re better positioned than ever.
Prashanth Mahendra-Rajah: Ambrish, Prashanth, maybe just a just two things to add. First our long-term growth model is built on all of our segments. So industrial certainly is an important, very, very important part of it. But we look for all of our operating segments to be able to contribute to that. We’ve had two consecutive record years with greater than 20% growth. And with the numbers that we’ve shared today, we’re off to a strong start for 2023. Our 7% to 10% CAGR outlook, which we revealed, unveiled last April, already reflected a faster growth versus sort of the historical mid-single digit rate. And as we said in the prepared remarks, as well as in addressing, I think it was Tore’s question we have a, we have meaningful delta with the revenue synergies from Maxim, which is really idiosyncratic to the ADI story.
Vincent Roche: Yes, I just want to add one final comment to this, just want to add one final comment Ambrish, to this part of the conversation, I’ve had innumerable conversations with CEOs across the globe over the last three years in particular, it’s certainly intensified with the crunch on supply. But I got two consistent questions from them. Irrespective of what sector they’re in, how can we get closer to ADI’s longer term technology roadmap, and also how do we bond together more tightly when it comes to understanding supply chain and collaborating more together across those two dimensions. So that’s the sentiment and I think given the way we’ve conducted ourselves over the last the last three years we’ve, we’re better positioned. Our brand is has been augmented and strengthened over the last several years. So yes, I think we’ve got a lot of strong logic as to why the market will strengthen and why ADI will be better positioned than ever to capture the opportunity.
Prashanth Mahendra-Rajah: Thanks, Ambrish.
Ambrish Srivastava: Thank you. I’ll jump back in queue. I don’t want to get on mics.
Michael Lucarelli: Not a bad side.
Vincent Roche: Last question?
Michael Lucarelli: Last question please.
Operator: Thank you. One moment for our next question. Our next question comes from the line of Harlan Sur from JPMorgan.
Harlan Sur: Hi, good morning. Thanks for taking my question. There’s second half uncertainty as you mentioned, probably more so in your comms and consumer businesses, maybe a little bit in industrial due to the soft PMIs as was mentioned earlier. But global auto demand trends, especially EVs remains pretty resilient, right? And you guys have a strong design wind portfolio and automotive that is starting to unfold. I know last earnings call, last month at CES, the team remained pretty confident on growing your automotive business this year by double-digit percentage on a flattish, sort of SARs. So, if you look at some of the third party research, I mean, SARs is forecasted to grow 2% to 3% this year. So is the team still confident on driving strong double-digit percentage growth profile this fiscal year on auto?
Prashanth Mahendra-Rajah: Thanks, Harlan. Yes. So if we look at our outperformance versus SAR, it comes down to a couple items. First, as you mentioned, there’s a mix of premium cars, so higher content per vehicle and EV growth is accelerating. And our content is 3x as high on an EV versus a traditional ICE car. We’ve spoken at length that we’ve got real key content adders, our BMS product, our GMSL and our A2B are adopted and they’re really taking meaningful market share across all of our customer base there. And I think because of the performance that we bring to our customers, we’re able to capture value better than perhaps some others. So with those three working, we’re, we still feel pretty good that that we’re going to continue to have a, 2x to 3x multiplier on SAR. So I don’t want to make a prediction as to what SAR is. So you’ve got a, I think IHS has a mid-single digit number, a lower mid-single digit number out there. But we’re for the year, I expect us to kind of be 2x to 3x wherever that lands.
Harlan Sur: Perfect. Insightful. Thank you, Prashanth.
Michael Lucarelli: Thank you Harlan, and thanks everyone for joining us on the call this morning. Two quick ones before I let you guys go. Our next earnings call will be held a week later than normal, as Vince was asked to give a keynote at IMAX Technology World Forum. So do not panic when we see your announcement. The earning is not two and a half weeks after closed, but three and a half weeks. Second, we’re planning to restart our ADI on coverage series where we do a deep dive into a market in the coming months. The first one will be on some of the topics we hit on today, automation, energy efficiency, sustainability, electrification. So stay tuned for those. And with that, thanks again for joining us and interest in Analog Devices.
Operator: This concludes today’s Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices First Quarter Fiscal Year 2023 Earnings Conference Call, which is being audio webcast via telephone and over the web. I’d like to now introduce your host for today’s call. Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Gigi, and good morning, everybody. Thanks for joining our first quarter fiscal 2023 conference call. With me on the call today are ADI’s CEO and Chair, Vincent Roche; and ADI’s CFO, Prashanth Mahendra-Rajah. For anyone who missed the release, you can find it and relating financial schedules at investor.analog.com. On to disclosures. Information we’re about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties, as further described in our earnings release and in our periodic reports and other materials filed with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as date of this call. We undertake no obligation to update these statements except as required by law. Our comments today will also include non-GAAP financial measures, which exclude special items. When comparing our results to our historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to their most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today’s release. And with that, I’ll turn it over to ADI’s CEO and Chair, Vincent Roche. Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thanks very much, Mike, and good morning to everyone. Well, I’m very pleased to share that ADI continued to execute exceptionally well in the first quarter of fiscal 2023, despite continued macroeconomic uncertainty. Revenue was $3.25 billion, up 21% year-over-year, strength was broad based with all B2B markets, up single-digits. Gross and operating margins were 74% and 51% respectively and adjusted EPS achieved another record at $2.75. Our continued success is driven by a relentless focus on customer collaboration, a growing demand for our innovative technologies and strong operational execution. We play a long game and are excited about what the future holds for us to ensure that we capture the opportunity ahead. We’ve been steadily increasing investments in R&D, manufacturing capabilities and in partnerships that deepen our value to our customers now and over the long-term. For example, in R&D, we’ve invested $1.7 billion over the trailing 12 months to strengthen our core franchises and capture market opportunities presented by secular growth drivers. Over the same period, we’ve invested $760 million in CapEx to enhance the resiliency of our internal semiconductor manufacturing operations. These investments not only increase our operational resiliency, but also modernize our fabs to better address our sustainability ambitions. As mentioned in our press release, our industrial and automotive businesses remain strong as we gain market share. So this morning, I want to focus specifically on our industrial business, which continues to grow significantly despite the macroeconomic backdrop. Now, from a big picture perspective, the industrial market is the bedrock of ADI, representing more than half of our total revenue. It’s also our most diverse and profitable business segment with tens of thousands of customers and products that sustain revenue streams for decades. Additionally, ADI’s industrial revenue is derived from high performance technology in mission-critical CapEx-intensive equipment across the myriad applications. Our leadership position has been strengthened over the last decade as we intensified our focus in this market and invested over $5 billion in R&D activities to capture the opportunity across the hundreds of applications that characterize the industrial sector. This space is inherently fragmented and the unmatched breadth and depth of ADI’s portfolio uniquely allows us to address our customer’s needs across the full spectrum of applications. With core component building blocks to application-specific solutions that encompass analog, digital and algorithms. Today, we’re seeing the rise of new industrial applications that require more sophisticated and more complex architectures as machines become more intelligent and more sustainable. This is driving more semiconductor content per dollar of CapEx, unlocking new opportunities for our portfolio. While this transformation is benefiting all of our industrial applications, including healthcare and aerospace, let me share how we’re winning an industrial automation and instrumentation more specifically and discuss the burgeoning opportunity across the electrification ecosystem. So, starting first with industrial automation. Here, our customers are upgrading their factories with more automation and connectivity to increase output with greater energy efficiency. ADI’s broad portfolio helps customers create these more resilient and flexible footprints while lowering their carbon emissions on the journey to net-zero. As an example, at a leading U.S. robotics manufacturer, we’ve won additional content across power sensing and GMSL connectivity. Our systems approach reduced our customers’ design time and increased our content per cobot by 4x. Also in the last quarter, our IO-Link solution was designed in at multiple leading industrial automation customers. These solutions are critical for delivering robust connectivity to the edge of the factory floor. Turning our attention now to our instrumentation and test business. This subsector is highly aligned to secular growth trends from connectivity to AI-assisted compute to electrification to drug discovery and gene therapies. The consistent thread across this diverse set of applications is the growing complexity that requires more advanced metrology and test. The results, our average content per system is now 2x to 3x higher. Further, the localization of semiconductor supply is providing additional tailwinds for our test business. We’ve secured multiple design wins in North America as well as Asia for memory and high-performance compute. And finally, on to one of our fastest-growing areas, the electrification ecosystem. The collective need for a more sustainable future is driving massive growth in electrical grid infrastructure. Now let me share two examples with you. First, industrial and automotive companies have announced more than $300 billion of investments in greenfield gigafactories, essential to the production of batteries to proliferate the electrification ecosystem. These gigafactories will drive additional demand for our formation and test solutions critical to producing higher density batteries. Further, given the inherent safety hazards of using higher cell voltages, these factories will also provide new growth vectors for ADI. In our sustainable energy franchise, we’re leveraging our industry-leading automotive BMS solutions into energy storage systems for electrical grids and fast-charging infrastructure. We’ve won designs at leading EV infrastructure manufacturers in North America, Europe and Asia, putting us on a path to more than tripling this business in the coming years. Of course, while no market is fully immune to adverse economic cycles, our industrial business is highly diversified and aligned with secular trends. This has translated to more durable revenue streams with sales in this sector increasing more than 25% over the trailing 12 months despite a weakening economic backdrop. But looking ahead, we see continued strength in this franchise as the breadth and depth of our portfolio, our deep customer collaborations and design win pipeline momentum underpin our new phase of profitable growth. So in closing, ADI’s business model is diverse, resilient and rich with opportunity. I’m very optimistic about what our future holds as we drive enhanced value for our customers employees and shareholders as well as society at large. And so with that, I’ll hand you over to Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thank you, Vince. Let me add my welcome to our first quarter earnings call. My comments today, with the exception of revenue, will be on an adjusted basis, which excludes special items outlined in today’s press release. First quarter revenue of $3.25 billion finished at the high end of our outlook, driven by continued share gains in industrial and automotive. Our B2B markets represented 89% of revenue, up 25% year-over-year and increased 2% sequentially despite our first quarter typically being down. Now let’s look at performance by end markets. Industrial, our most diverse and profitable end market represented 52% of revenue and hit another all-time high. This business has grown sequentially for 12 consecutive quarters. All markets increased year-over-year, led by automation, sustainable energy, instrumentation and test. Automotive, which represented 22% of revenue, also achieved another record, increasing 29% year-over-year and 6% sequentially. All applications grew double digits year-over-year as our market leading positions across battery management and in-cabin connectivity continue to deliver significant growth. Communications, which represented 15% of revenue, grew 18% year-over-year. As expected, comms declined slightly sequentially as strength in wired was offset by softness in wireless due to the timing of 5G deployments. And lastly, consumer, which represented 11% of revenue, was down 5% year-over-year and declined 14% sequentially given weaker market trends and seasonality. Now onto the rest of the P&L. Gross margin of 73.6% expanded 170 basis points year-over-year, unfavorable mix and cost synergies. OpEx was $733 million down slightly sequentially as we balance strategic hiring with the tight discretionary spend and synergy capture. Given our strong operating leverage combined with the synergy savings, our operating margin was 51.1%. Importantly, we have already captured nearly all of the $400 million cost synergy goals. As such, our communication will now turn to the revenue synergy opportunities from our combined portfolio and our complimentary customer base with Maxim. Recall that Anelise, our Chief Customer Officer, unveiled how we are strategically approaching these synergies during our Investor Day, and Vince has routinely highlighted some of these compelling opportunities over the past few quarters. To that end, we are closely monitoring and measuring progress from opportunity to design win to new revenue. And while it is still early, design win momentum to date has exceeded our expectations. This gives us increased confidence in achieving our $1 billion plus revenue synergy opportunity that we outlined at our Investor Day. Non-op expenses were $60 million, and the tax rate was just over 12%. All told, EPS came in at $2.75, up 42% year-over-year and hitting a new record. Moving to the balance sheet. We ended the quarter with approximately $1.7 billion of cash and a net leverage ratio below 1. Days of inventory increase to 155, while channel inventory remains below our target level. Recall that last quarter, we outlined our strategy to rebuild strategic die bank and hold more finished goods inventory on our balance sheet as we moderate shipment into the channel during this time of inflection. Moving on to cash flow. CapEx for the quarter was $176 million and $764 million over the trailing 12 months, representing 6% of revenue. We continue to expect CapEx to be high-single-digits as a percentage of sales in 2023 and then decline in subsequent years to our long-term target of mid-single-digit. These investments will double our internal revenue output exiting next year and support strategic swing capacity between our fabs and our foundry partners. The flexibility of our hybrid model across different geographies enhances our resiliency and offers our customers additional optionality. Over the trailing 12 months, we generated $4.3 billion of free cash flow or 34% of revenue. Over this period, we have returned $4.7 billion to shareholders or over 100% of free cash flow via $3.1 billion of buybacks and dividends of $1.6 billion. We just raised our quarterly dividend by 13%, marking our fifth consecutive double digit increase, and 19 consecutive years of increases. This is a testament to our durable operating model that has generated positive free cash flow for 26 consecutive years. As a reminder, we target 100% free cash flow return. The dividend is the cornerstone of this policy, and we look to increase our dividend at a 10% CAGR through the cycle with remaining cash used for share count reduction. Now, similar to prior quarters, I’d like to give a brief update on the operating backdrop. First, on markets. Industrial orders, as Vince highlighted, remain the strongest followed by automotive, while comms and consumer remain weak. Given the rapidly changing environment, we are diligently working with our customers to remove orders that they may no longer require. At the same time, we have increased our supply by growing our internal output and working with our foundry partners. These actions have reduced our lead times with half of our portfolio now shipping in under 13 weeks. Despite this, backlog coverage remains around one year of revenue. As such, we expect our book-to-bill will remain below parody over the next couple quarters as our backlog returns to more normal levels. Given these dynamics, we are guiding second quarter revenue to be $3.2 billion plus or minus $100 million. We expect continued sequential growth in our industrial and automotive markets and another sequential decline in our communications and consumer markets. At the midpoint of our outlook, revenue will be up high-single-digits year-over-year with our B2B markets up over 10% once again. Operating margin is expected to be 51% plus or minus 70 basis points. Our tax rate is now expected to be between 11% to 13% for the year. This guide reflects the new U.S. tax requirement to capitalize R&D expenses for tax purposes, resulting in higher upfront cash tax payments, but lowers our effective tax rate temporarily due to the deferred tax accounting requirements. Based on these inputs, adjusted EPS is expected to be $2.75, plus or minus $0.10. In all, the macro backdrop remains uncertain. However, we remain cautiously optimistic on the near-term, given the resilient strength across our industrial and auto businesses, which represent over 75% of our revenue. Longer-term, we remain well positioned to drive growth enabled by our diverse high performance portfolio aligned with the key secular trends at the Intelligent Edge. Let me now pass it back to Mike for our Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Prashanth. Let’s go to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants in the call this morning. If you have follow-up question, please requeue. I’ll take your question if time allows. With that our first question, please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of C.J. Muse from Evercore ISI."
},
{
"speaker": "C.J. Muse",
"text": "Yes, good morning. Thank you for taking the question. I guess the – my question really would center around the industrial strength that you’re seeing. You talked in great detail around kind of emerging new markets as well as increasing content yet, I think a lot of investors are focused on kind of declining PMIs around the globe. And so we’d love to hear your thoughts on why your business is, acting so very different from, maybe some of the larger macro trends. And perhaps more color on how much of it is content? How much of it is maybe emerging growth areas that are not reflected in some of these PMIs would be very helpful? Thanks so much."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Thanks, C.J. So, I think first and foremost, our success isn’t by dent of chance. We’ve been investing heavily in this market for more than a decade, and it’s really our focus. It’s our core, it’s the core of ADI and from both an R&D and customer engagement perspective, we’ve been really doubling down here over this decade plus kind of time span. And we’ve been gaining market share for sure. We have – compared to even kind of three years, four years ago, we have – we’ve always had a very strong position in the signal chain, the kind of data path processing electronics, but we’ve been able to, with the acquisitions of LTC and Maxim, we’ve been able to bring very strong competitive power portfolio to bear as well. So, I think from a portfolio perspective, we’re in much better shape. I pointed out in the script as well that when we talk about industrial, it’s truly the industrial sector. I know many competitors talk about other kind of indescribable sectors or businesses that are not well understood, like consumer, for example, other consumers. So, I want to point that out as well. We have, as I said, many secular growth drivers in play. We see the average content per dollar of CapEx spend increased at a pretty meaningful level across all the applications, including instrumentation, factory automation is changing also. It’s bringing more sensing, more compute to the edge and all of that is driving content gain for ADI. So, I think they are the primary drivers of the business. And yes, PMIs are, I would say, in the kind of retraction zone right now, but we see stabilization. And I think when China comes back as well, which is likely to happen, we believe, over the coming months, that will drive things even further into a positive zone."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "C.J., this is Prashanth. I’ll just put one more thing just to help folks understand kind of the breadth of that growth. All of our submarkets were up double digits year-over-year, and most of them increased quarter-over-quarter. And if you look at it by geography, we had strength in America, Europe and Japan, again, all up double digits year-over-year, offsetting a weaker China. So this industrial strength was very broad-based."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, C.J."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our next question comes from the line of Vivek Arya from Bank of America Securities."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question. I actually had a pair of kind of related question, which is how long can book-to-bill remain on before it starts to become, [indiscernible]? And usually, if I look historically for ADI, generally, the second half tends to be better than the first half. What would support that view or prevent that from happening this year?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Okay. Yes. So Vivek, let me maybe take a walk through cancellations, backlog lead times to help answer that. But I do want to clarify, you said on book-to-bill. Our book-to-bill is sub one. I thought I heard you say it was one. Our book-to-bill is sub one. We told you that was happening a couple of months ago, and I’d expect to carry for another quarter or two as we get through this backlog. So on the backlog, we’ve been saying for a while now that we’ve got record backlog, and we are working with our customers and our disti partners to get this rationalized with what customers need today versus perhaps the orders they had placed on us six months or nine months ago when we had very long lead time. This progress is what is being reflected in that book-to-bill ratio below one. I think that it will probably be below parity for another quarter or two as we get back to normal backlog. Lead times, the supply-demand imbalance is definitely getting better, slowly, but it’s getting better. We’re getting more wafers externally, thanks to the hybrid model. We have the flexibility to do that as well as the investments we’re making internally as we’ve talked about with our CapEx deployment to increase production. So, we have about 50% of the portfolio under 13 weeks today, meaning it can ship within the quarter, and that’s going to continue to improve over the – through the second half. So takeaway sort of given lead times falling, bookings getting higher quality compared to year ago as customers aren’t ordering for stuff way into the future. And at the place backlog, and we feel this is positive for visibility, and we’re really getting to true demand."
},
{
"speaker": "Vivek Arya",
"text": "And anything on second half, Prashanth, because it looks more like a soft take of then a soft landing from the trends?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "So, I don’t want to go out too far, but I’ll just give you a couple of comments here. And if Vince wants to make any long-term comment. We feel good about the outlook for the second quarter given the resiliency in auto and industrial. As I said, 75% of our sales come from those two segments, and we still have a year for the backlog. Beyond the second quarter, it’s hard on the one hand to make a call, given that we have strong backlog coverage, but we also understand there’s a lot of macro uncertainty out there and things are changing fast. So, I’m not going to make any predictions one area to pay attention to, and Vince made a comment on this, is China. I think we and many companies are watching China. If demand accelerates in the second half given sort of the optimism on consumers and government that would be – that would be good for a number of organizations. Vince, anything more longer term, you want to add on that?"
},
{
"speaker": "Vincent Roche",
"text": "Well, I think, Prashant, we’ve clearly built a lot of resiliency into the way we run the company into the business model as well as the manufacturing operations. So, who knows what the second half is going to bring. But what I can tell you is that – we’ve been through many, many cycles before and never have we been better positioned in our history than we are now from a portfolio, from a customer engagement standpoint. So – this industry is likely – it’s taken us kind of 20 years to double from kind of 2000 to 2020, we’ve probably doubled the content that the industry builds over the next 10 years. And I believe ADI is very, very well positioned given the strength, as I said, of our portfolio, our customer engagements, and this hybrid manufacturing model that we’ve got in place to enable us to capture the upside and manage the downside."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Vivek. Next question please."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our next question comes from the line of Tore Svanberg from Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Yes, thank you and congratulations on the results. So on Maxim now that we’re sort of moving from the cost synergies to the revenue synergies, are there any particular areas that we should keep an eye on there, whether end markets or product categories where you expect to see that $1 billion in synergies?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes, let me – let’s do that in two parts. I’ll give you a little bit of context so that everyone remembers what we talked about and then hand over to Vince. So we’ve closed on the cost synergies. We feel great about that. So we’re focusing now on revenue synergies, and we’re tracking ahead of schedule. We think about that synergy in stages. So first we need to identify the socket, we need to win the socket, we begin shipping to the customer, and then we hit volume. So we are tracking all of those stages through our internal material. As I said, Anelise gave you a target in April to come – to deliver $1 billion of incremental. Vince is holding her to a higher bar than that. So she’s on track to hit that $1 billion. And we’ve got – we’ve seen early success. I think you’ve heard Vince share a couple examples over the last couple quarters. For example, in the – our ability to cross sell A to B as well as put GMSL into non-auto customers which is new. So let me pass off to Vince here for what are some of the other areas that we’re thinking about?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. When we announced the combination, Tore, with Maxim, we pointed out two particular market areas where we thought ADI was underweight, where power in particular, power management was really important, power in data center, for example. And as the compute density skyrocket, and in fact in the compute area, performance and power are pretty much one and the same thing. So we have now a very competitive power portfolio that we can bring to more application specific areas such as data center as well as automotive. The – I think a very positive surprise is that the connectivity portfolio based on GMSL, the multi gig serial link is that not only are we gaining more and more traction in automotive, but also we’re bringing it to other areas such as industrial, as Prashanth mentioned. BMS, we’ve got 16 of the top 20 wired BMS OEMs sockets in the top 20 OEMs. And Maxim strengthens that portfolio as well. So in industrial, I mentioned in the prepared remarks that the I/O link technology is very, very, that Maxim brings to bear is very, very complementary with ADI’s data path solutions. So I think there are multiple areas and I think the message I want to convey here is that I was always optimistic about what we could do with a greater channel, more cross connectivity to the ADI portfolio. But I’m more enthusiastic than ever based on what I’m actually observing now with the various markets and customers in which we’re playing."
},
{
"speaker": "Tore Svanberg",
"text": "That’s very helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Chris Danely from Citi."
},
{
"speaker": "Chris Danely",
"text": "Hey, thanks guys. Just a little more clarification on the lead times and the shortages. So you mentioned that half of the portfolio has lead times of less than 13 weeks right now. Can you talk about what that was three months ago? And then when would you expect the lead times to, I guess, “largely normalized” and with a couple flat quarters? And it seems like you got plenty of inventory. Why aren’t these lead times normalizing a little bit faster? Thanks."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Sure. Chris let me – Michael have to remind me where we were three months ago. But the – so the supply demand balance is getting better. And we’re getting that – we’re getting more wafers, so – in addition to our internal production. The way to think about the lead times is we’ve got half the portfolio shipping within the quarter. And certainly in the next quarter or two, we will have the overwhelming majority of that down to within one quarter. The inventory build as I mentioned, is in part due to our desire to kind of keep more inventory on ADI’s books because we are clearly in a period of great uncertainty and we’re being very mindful of putting too much to our channel partners when there’s this much uncertainty out there. So that will – as lead times improve, our channel partners can count on us to get what they need in quick terms, and then we’ll be able to more reliably think about what’s the right stocking level for the channel."
},
{
"speaker": "Michael Lucarelli",
"text": "Okay. And Chris to your question, where was it beginning the quarter. If you look at that metrics under 13 weeks, beginning of the quarter was probably about 25% of the portfolio. So we doubled that number and Prashanth laid out, we want to get it close to a 100% exiting this year. And I know Vince is pushing hard to get even sooner than that. I think the biggest takeaway at lead times is the short lead times, the more high quality the bookings are. I think that’s what we want to see is the true underlying of what demand is as those lead times continue to come in and why does it take so long while demand is strong, right? Demand is strong, it’s harder to reduce lead times in a strong demand environment."
},
{
"speaker": "Chris Danely",
"text": "Great. Thanks guys."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Stacy Rasgon from Bernstein Research."
},
{
"speaker": "Stacy Rasgon",
"text": "Hi, guys. Thanks for taking my question. Maybe it’s a dumb question. But I’m having a little bit of trouble squaring the majority of the portfolio getting to be within 13 weekly times together with a year’s worth of backlog. How do I square those two things? It feels like the backlog should be shorter if the lead times are actually like getting back to normal. Maybe the other way to ask it is when the majority of the portfolio has 13-week lead times, where do you expect that backlog to be?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Yes, so Stacy, I think perhaps the missing elements of your – of how you’re thinking about it is the assumption that that backlog is delinquent. It is not. The – when the lead times get extended, customers put the orders on us, but they also tell us when they want that product delivered. So there’s a visibility curve to that backlog. It is not that it is all past due and needs to be shipped against."
},
{
"speaker": "Stacy Rasgon",
"text": "Oh, I see. Okay. So you’re – okay, so you’ve got orders out. We know that we’re going to be shipping this to you in six months and they placed it [ph]. So I guess where do you expect that backlog to be standing given what you see for demand once, say we’re in a quarter to pass this and the majority of the portfolio is shipping within a quarter. Where do you expect the backlogs to be?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Well, let’s go back to the – if we get to – if we return to what was normal for us pre COVID, let’s say that’s the best perspective we can give you. If we return to what does normal look like then at the start of a 13-week quarter, we would have about 10 weeks of that quarter in backlog. And then there would still be some incremental backlog out there for future quarters, but it would be meaningfully smaller because customers know that they can put that order on us in essentially less than a quarter’s notice. So that’s what normal looks like. Now, given the supply, demand challenges and the increasing importance of Analog’s products to our customers, we may benefit from some greater visibility in the future, but I don’t want to call that today."
},
{
"speaker": "Stacy Rasgon",
"text": "Got it. So I guess, does this mean, are you effectively over shipping demand right now because the backlog is pulling it? Or is that not the right way to think about it?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "No, I would – I’m not sure how you would conclude that. We are – we have the – we have demand from our customers in that backlog that tells us. I want this product in Q1, I want this product in Q2, this product in Q3, and that is what we are matching up for. But it gives us a visibility that we have historically not had at this level. That is why they are not as incentive to put new orders on us, is because they’ve given us those orders, hence book to bill below one."
},
{
"speaker": "Vincent Roche",
"text": "Yes. One other thing we’re pointing out, Stacy, is that we run – our demand signals are sell through. We run our factories on the basis of POS demand rather than sell in or POA demand. So it gives us more integrity around the demand signal."
},
{
"speaker": "Stacy Rasgon",
"text": "Got it. Okay. That’s helpful. I won’t monopolize anymore. Thank you so much, guys."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks Stacy, for that three part question. You use your question for next quarter, so we’re not going to – have the call next quarter. Next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Ambrish Srivastava from BMO Capital Markets."
},
{
"speaker": "Ambrish Srivastava",
"text": "Hi, thank you. I’m going to keep it to one. Mike, I don’t want to get any of bad site. Vince, I actually wanted to focus on a bit on the long-term here. I was called out a much higher growth rate for analog and for themselves as a result. And I was wondering if you share the same view, I know you guys have had a 7% to 10%, and Vince you have always all the conversations over the years, you always felt that the analog industry going forward should grow faster than the 5.6 odd that we’ve seen over the long-term. So I was just wondering how you think about analog growth and you called out a bunch of secular drivers that, four or five years ago didn’t even exist for the analog industry and broadly for semis. Thank you, Vince."
},
{
"speaker": "Vincent Roche",
"text": "Yes, thanks, Ambrish. Well, I think, as I pointed out in the prepared remarks, we are seeing more, for example, in the industrial space, more content per dollar of CapEx invested by our customers. And that trend has been in play for several years now. That coupled with ADI’s portfolio strength, the breadth we have the, as I mentioned, the data path, which has been ADI core, ADI traditional strength, adding LTC and Maxim Power portfolios. That gives us the opportunity to tap into more of the TAM, so to speak. Half of the analog market, TAM is kind of data path. The other half is power. So we’ve now got the, the highest performance portfolio in the industry, the greatest breadth and depth. And, when you see what’s happening there with healthcare, our digital healthcare business, which is getting on for, kind of a $1 billion over the next year, year and a half aerospace and defense, coupled with automation and instrumentation that we’ve talked about in the prepared remarks. We’re very, very bullish about our ability to drive growth in the market. The other thing I want to point out is that we focus on driving our revenue growth through high quality innovation for which we get paid. We get three times the ASPs of the analog market at large, and we get more than that, compared to our biggest competitor. So I want to make the point that we focus on shipping value versus volume. So I think with the sector growth drivers, the way we’ve structured our business model, our focus on high performance and being able to capture more value with all the things we talked about over the course of the call here, I’m focused on what we can do as a company and I believe we’re better positioned than ever."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Ambrish, Prashanth, maybe just a just two things to add. First our long-term growth model is built on all of our segments. So industrial certainly is an important, very, very important part of it. But we look for all of our operating segments to be able to contribute to that. We’ve had two consecutive record years with greater than 20% growth. And with the numbers that we’ve shared today, we’re off to a strong start for 2023. Our 7% to 10% CAGR outlook, which we revealed, unveiled last April, already reflected a faster growth versus sort of the historical mid-single digit rate. And as we said in the prepared remarks, as well as in addressing, I think it was Tore’s question we have a, we have meaningful delta with the revenue synergies from Maxim, which is really idiosyncratic to the ADI story."
},
{
"speaker": "Vincent Roche",
"text": "Yes, I just want to add one final comment to this, just want to add one final comment Ambrish, to this part of the conversation, I’ve had innumerable conversations with CEOs across the globe over the last three years in particular, it’s certainly intensified with the crunch on supply. But I got two consistent questions from them. Irrespective of what sector they’re in, how can we get closer to ADI’s longer term technology roadmap, and also how do we bond together more tightly when it comes to understanding supply chain and collaborating more together across those two dimensions. So that’s the sentiment and I think given the way we’ve conducted ourselves over the last the last three years we’ve, we’re better positioned. Our brand is has been augmented and strengthened over the last several years. So yes, I think we’ve got a lot of strong logic as to why the market will strengthen and why ADI will be better positioned than ever to capture the opportunity."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thanks, Ambrish."
},
{
"speaker": "Ambrish Srivastava",
"text": "Thank you. I’ll jump back in queue. I don’t want to get on mics."
},
{
"speaker": "Michael Lucarelli",
"text": "Not a bad side."
},
{
"speaker": "Vincent Roche",
"text": "Last question?"
},
{
"speaker": "Michael Lucarelli",
"text": "Last question please."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for our next question. Our next question comes from the line of Harlan Sur from JPMorgan."
},
{
"speaker": "Harlan Sur",
"text": "Hi, good morning. Thanks for taking my question. There’s second half uncertainty as you mentioned, probably more so in your comms and consumer businesses, maybe a little bit in industrial due to the soft PMIs as was mentioned earlier. But global auto demand trends, especially EVs remains pretty resilient, right? And you guys have a strong design wind portfolio and automotive that is starting to unfold. I know last earnings call, last month at CES, the team remained pretty confident on growing your automotive business this year by double-digit percentage on a flattish, sort of SARs. So, if you look at some of the third party research, I mean, SARs is forecasted to grow 2% to 3% this year. So is the team still confident on driving strong double-digit percentage growth profile this fiscal year on auto?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"text": "Thanks, Harlan. Yes. So if we look at our outperformance versus SAR, it comes down to a couple items. First, as you mentioned, there’s a mix of premium cars, so higher content per vehicle and EV growth is accelerating. And our content is 3x as high on an EV versus a traditional ICE car. We’ve spoken at length that we’ve got real key content adders, our BMS product, our GMSL and our A2B are adopted and they’re really taking meaningful market share across all of our customer base there. And I think because of the performance that we bring to our customers, we’re able to capture value better than perhaps some others. So with those three working, we’re, we still feel pretty good that that we’re going to continue to have a, 2x to 3x multiplier on SAR. So I don’t want to make a prediction as to what SAR is. So you’ve got a, I think IHS has a mid-single digit number, a lower mid-single digit number out there. But we’re for the year, I expect us to kind of be 2x to 3x wherever that lands."
},
{
"speaker": "Harlan Sur",
"text": "Perfect. Insightful. Thank you, Prashanth."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you Harlan, and thanks everyone for joining us on the call this morning. Two quick ones before I let you guys go. Our next earnings call will be held a week later than normal, as Vince was asked to give a keynote at IMAX Technology World Forum. So do not panic when we see your announcement. The earning is not two and a half weeks after closed, but three and a half weeks. Second, we’re planning to restart our ADI on coverage series where we do a deep dive into a market in the coming months. The first one will be on some of the topics we hit on today, automation, energy efficiency, sustainability, electrification. So stay tuned for those. And with that, thanks again for joining us and interest in Analog Devices."
},
{
"speaker": "Operator",
"text": "This concludes today’s Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 4 | 2,024 | 2024-11-26 10:00:00 | Operator: Good morning, and welcome to the Analog Devices Fourth Quarter Fiscal Year 2024 Earnings Conference Call, which is being audio webcast via telephone and over the web. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star one one on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star one one again. Please be advised that today's conference is being recorded. I would like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli: Excellent. Good morning, everybody. Thank you for joining our Fourth Quarter Fiscal 2024 Conference Call. Joining me on the call today are ADI's CEO, Vincent Roche, and ADI's CFO, Rich Blue Shield. All of our materials can be found at investor.analog.com. Onto disclosures: Information about this discussion includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our filings with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of this call. We undertake no obligation to update these statements except as required by law. In terms of gross margin, operating and non-operating expenses, operating margin, tax rate, EPS, and free cash flow, comments today will be on a non-GAAP basis, which excludes special items. When comparing our results and historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. Please note, references to EPS are on a fully diluted basis. And with that, I will turn it over to ADI's CEO and Chair, Vincent Roche.
Vincent Roche: Thanks very much, Mike, and a very good morning to you all. Our first quarter results reflected the continued steady recovery from our second quarter cyclical bottom with revenue, operating margin, and earnings per share all finishing above the midpoint of our outlook. For the full fiscal year 2024, revenue finished at $9.4 billion with earnings per share of $6.38. The headwinds we faced in fiscal 2024 were most notably pronounced post-pandemic inventory digestion and the challenging macro backdrop muting demand recovery. Despite the external challenges, however, our business model and disciplined execution delivered an impressive 41% operating margin for the year and a free cash flow margin of 33%, up from 29% in fiscal 2023. Importantly, we continued investing in key value generation and capture initiatives to better position ADI to solve our customers' most difficult challenges at the Intelligent Edge. In R&D, which is our first call on capital, we continue to strengthen our world-class analog foundation while extending the scope of our innovation capabilities with investments in digital software and AI. Those investments resulted in, for example, last month's launch of ADI's new CodeFusion Studio software development platform, creating a resource-rich hub and ensuring a programming environment for embedded co-development in support of our analog mixed signal power and digital franchises. To better secure the increasingly connected intelligent edge, we also launched the ADI Assure Trusted Edge Security Architecture, which will enable cybersecurity capabilities on ADI products. The addition of new tech stack capabilities to our tremendous analog foundation enables us to deliver ever more sophisticated innovations for our customers. Our intense focus on R&D is reflected in the double-digit growth of our design win pipeline during fiscal 2024. That growth was enhanced by momentum in our Maxim revenue synergies pipeline across such areas as GMSL, healthcare, and data center power, putting us firmly on a path to achieving our goal of $1 billion in revenue synergies by 2027. Now, to accelerate pipeline growth and conversion, we continue to evolve our digital customer engagement platforms to support a greater range of technical expertise and customer needs. We also expanded our cadre of field engineering experts to provide world-class support and service to our global customer base. Our customers value our thought leadership, the breadth and depth of our cutting-edge technology stack, the strength and resilience of our supply chain, and our service and support integrity. Let me share a few examples with you now. In Industry 4.0, semiconductor content as a percentage of CapEx investments continues to expand rapidly as factories integrate IT and OT to connect and software-define the factory floor. This is creating tremendous growth for ADI's sensor-to-cloud automation solutions, with a large number of customers leveraging our sensing, power control, and deterministic Ethernet technologies. On the factory floor, our intelligent motion and positioning solutions are being designed into robotic systems by several large customers, expanding our content per robot by three times. In our Instrumentation and Test business, ADI's cutting-edge analog signal and power capabilities are the foundation for the leadership position we've established in the AI-related SoC and high-bandwidth memory test market, where our content per tester stretches into the hundreds of thousands of dollars. Now looking ahead, we're developing additional mixed signal and digital capabilities to further reduce test time and power requirements, which we believe will result in more than 20% additional ADI content per test. Within the healthcare sector, our precision signal processing and real-time connectivity solutions are critical to the rapidly expanding surgical robotics market. And in the fast-growing continuous glucose monitoring space, we have won multiple opportunities across several customers. Our unique digitally enabled analog front-end solutions increase the accuracy and power efficiency of sensors and enable a better patient experience by extending battery life from days to weeks. Aerospace and defense has remained our most resilient industrial segment during this downturn, with stellar design win pipeline growth. We expect revenue growth to accelerate to a double-digit level next year due to increasing global defense budgets and the proliferation of space communication systems that rely on our higher value integrated RF modules and subsystems. Within automotive, the performance advantages of our battery management systems are driving substantial pipeline growth among OEMs. In addition, we're also seeing momentum for these solutions in electrical grid storage systems. These trends, combined with recent wins, give us confidence that our BMS revenues should return to growth in fiscal 2025 with meaningful contributions from our higher value wired solution. The proliferation of higher content vehicles that use more power management connectivity and an increasing number of sensor platforms is expanding our content across all vehicle types, combustion engines, hybrids, and indeed full EVs. This trend drove our GMSL and A2B connectivity and functionally safe power franchises to new high watermarks in fiscal 2024, and with a record design win pipeline, we expect this growth to persist.
Michael Lucarelli: Notably, we added to our portfolio of connectivity solutions by launching our Ethernet to the Edge bus solution, or U2B, which is an enabler of the software-defined vehicle vision. And out of the gate, we have design wins with several major OEMs, including BMW. In communications, we've seen a positive inflection in the wireline market and expect that growth to continue in FY 2025 and beyond. Our confidence is based on significant new wins, including a high precision controller for the optical module and the high-performance compute leaders' AI systems, and our next-gen power solutions, which will begin shipping later in 2025. We're also experiencing tremendous demand from leading data center customers for our new innovative hot swap solution, which significantly extends power and control capabilities for AI-based servers. In consumer, new wins coming to market are driving strong growth. We expect this momentum to continue in the years ahead, given new wins across power, audio, optical, and touch in portable applications at multiple key customers. We've also seen growth in wearables. For example, our VSM platform's superior accuracy at lower power is becoming ever more critical for customers seeking to differentiate by capturing and processing more biomarkers. We've seen design momentum accelerate and content opportunities expand at wearable market leaders as well as in disruptors bringing miniaturized form factors to market. In wearable acoustic systems, our combination of ultra-low power and neural processing with application-specific audio processing algorithms is enabling next-generation noise cancellation and hearing augmentation. We're leveraging these technology innovations in several B2B markets. In addition, turning now to manufacturing, we've invested $2.7 billion in CapEx since acquiring Maxim to increase our capacity and enhance resiliency. We also expanded our foundry partnership with TSMC earlier this year to secure additional 300-millimeter fine-pitched technology capacity at their Japan fab. These investments enable a more flexible hybrid manufacturing model, further insulating our supply from regional shocks and increasing our swing capacity to around 70% of revenue in the coming years. This unique ability helps us to capture the upside in strong demand backdrops and better protect our gross margins during more challenging times. So in closing, I'm very proud of how ADI has managed through one of the worst inventory digestion cycles our industry has ever seen. While the macro backdrop presents challenges, I'm confident in our continued recovery in fiscal 2025. And with that, now I'll pass it over to Rich.
Richard Puccio: Thank you, Vince. And let me add my welcome to our fourth quarter earnings call. I'll start with a brief recap of fiscal 2024 results. Revenue of more than $9.4 billion, down from the record fiscal 2023, driven by broad-based inventory digestion and sluggish end demand. Gross margin of 67.9% reflects lower revenue factory utilization and mix headwinds. Decline in revenue and gross margins were partially offset by lower operating expenses, which resulted in an operating margin of 40.9% and EPS of $6.38. Moving to fourth quarter results, revenue of $2.44 billion came in above the midpoint of our outlook for a 6% sequential increase, a 10% decline year over year. Industrial represented 44% of our fourth quarter revenue, finishing up 2% sequentially and down 21% year over year. Continued strength in AI-related test, aerospace and defense, and a return to sequential growth in automation more than offset slower end demand driven by a weaker macro backdrop. For the full year, industrial decreased 35% from a record 2023, with every major application declining double digits except aerospace and defense, which significantly outperformed the rest of industrial. Automotive represented 29% of quarterly revenue, finishing up 4% sequentially and down 2% year over year. This was notably better than our original expectation due to steadily improving demand from China throughout the quarter. For the year, automotive declined 2% from a record fiscal 2023 as double-digit growth across our functionally safe power and leading A2B and GMSL connectivity franchises were offset by broad-based inventory digestion and production headwinds. Communications represented 11% of our quarterly revenue, finishing up 4% sequentially and down 18% year over year. Stronger demand from data center customers for our solutions drove low double-digit sequential growth in our wireline business, which more than offset the decline in wireless. For the year, communications decreased 33%, and similar to the fourth quarter, we saw a relative outperformance in our wireline business over wireless. Lastly, consumer represented 16% of quarterly revenue, finishing up 22% sequentially and 31% year over year, driven by higher share in wearables, premium handsets, and gaming applications. For the year, consumer decreased just 1% with double-digit growth in portable applications, balancing double-digit declines in our prosumer business, which is more industrial-like in nature. Now on to the rest of the P&L. Fourth quarter gross margin was 67.9%, flat sequentially as product mix headwinds offset modestly higher utilization rates. OpEx in the quarter was $655 million, up approximately $35 million sequentially, driven primarily by merit increases, which resulted in an operating margin of 41.1%. Non-operating expenses finished at $55 million, and the tax rate for the quarter was 12.1%. All told, EPS was $1.67, which finished above the midpoint of our outlook. Despite a tough year, we took decisive action to strengthen our financial position, and I'd like to call out a few results from our balance sheet and cash flow statement. We ended the quarter with approximately $2.4 billion in cash, short-term investments, and a net leverage ratio of 1.2. Inventory finished approximately $20 million higher than the third quarter, while days of inventory decreased to 167. Channel inventory finished slightly below the low end of our seven to eight-week target as we continue to prudently manage our supply. Operating cash flow for the quarter was more than $1 billion and more than $3.8 billion for fiscal 2024. CapEx was $165 million for the quarter and $730 million for the year, resulting in fiscal 2024 free cash flow of more than $3.1 billion or 33% of revenue. During the year, we returned $2.4 billion to shareholders via $1.8 billion in dividends and $600 million in repurchases. Now moving on to guidance for the first quarter. Revenue is expected to be $2.35 billion, plus or minus $100 million. Notably, this implies year-over-year growth when compared to a normalized 13-week first quarter of fiscal 2024, a good indication that we're past the trough and in gradual recovery. We expect sell-in to be roughly equal to sell-through in this quarter. At the midpoint, we are expecting a seasonal decline on a sequential basis as noted last quarter. Industrial, automotive, and communications are each expected to decline by low single digits, with consumer down around 15%. Operating margin is expected to be approximately 40%, plus or minus 100 basis points. Our tax rate is expected to be 12 to 14%. And based on these inputs, EPS is expected to be $1.53, plus or minus 10 cents. I'll conclude by noting a few items as we begin the new fiscal year. As Vince mentioned, we made great progress building a more agile and resilient hybrid manufacturing model. As such, we expect our CapEx spend will moderate back to our long-term model of 4 to 6% of revenue in fiscal 2025. We expect this normalized CapEx level and planned receipt of investment tax credits tied to both the US and European CHIPS Acts will provide tailwinds to fiscal 2025's free cash flow. Importantly, while we have delivered on our commitment to return 100% of free cash flow since our Maxim acquisition, fiscal 2024's return was lower due to our decision to increase balance sheet cash during this period of macroeconomic uncertainty and to help us extinguish $400 million of debt coming due in fiscal 2025. That said, investors can expect us to revert to our targeted return of 100% of free cash flow in fiscal 2025. I'm now going to turn it back to Mike for Q&A.
Michael Lucarelli: Thanks, Rich. Let's get to the Q&A session. I ask that you limit yourself to one question to allow for additional participants on the call this morning. If you have follow-up questions, please re-queue. The waiting question time allows. With that, we have our first question, please.
Operator: Thank you. For those participating by telephone, dial in. If you have a question, if your question has been answered and you wish to be removed from the queue, please press star one one again. If you're listening on a speakerphone, please pick up the handset when asking your question. We'll pause just for a moment to compile the Q&A roster. And I show our first question comes from the line of Chris Danley from Citi. Go ahead.
Chris Danley: Hey. Thanks, guys. Just a little color on the auto strength. Can you talk about how big China is as a percent of your auto business? And then within that, how much of the strength was from, say, EV versus ICE or all these EV startups that we're hearing about from China? Thanks.
Richard Puccio: So I'll give you a little bit of the perspective, Chris, on the auto near term. So on the last call, we expected the sequential decline in Q4 given the drop we talked about in bookings during Q3. An adjustment to production for multiple of our OEMs. However, toward the end of Q3, bookings started to improve and that continued throughout our Q4, with stronger demand in China reflecting EV volume growth, share gains, and content growth. As for the other geos, we saw broad weakness, but upside in the U.S., which returned to sequential growth driven mainly by our BMS and wireless BMS portfolio. Secular demand for ADAS and next-gen infotainment continues to drive strength globally for our functionally safe power, audio, and video solutions. Content and share growth in these areas have helped offset broad inventory headwinds resulting in a shallower correction in other end markets. I'd also note that while BMS is still facing inventory headwinds broadly, we saw a strong uptick in China reflecting the expanded share we talked about on our Q2 call compounded by volume growth in the region. BMS also improved in the U.S., including growth for our higher content wireless solution, which is now 10% of total BMS. And as Vince mentioned, design win activity was strong in 2024, giving us confidence that BMS will return to growth in fiscal year 2025.
Vincent Roche: A little more color, Chris, than what Rich has just said. So you know, we've got a really high-performance portfolio. We've got many, many different SKUs, if you like, in that portfolio. And, you know, we're playing the high-performance game with the big players in China for merit. So that's the same business there.
Michael Lucarelli: And they've got some comments on the US-China kind of relative what's the mix of China. Our China business looks a lot like ADI enterprise where industrial are more of the two biggest percent of our revenue in China. I think about 80% of the China business. Comms is in the teens, consumers below 5%.
Chris Danley: Thank you.
Operator: And I show our next question comes from the line of CJ Muse from Cantor Fitzgerald. Please go ahead.
CJ Muse: Yeah. Good morning. Thank you for taking the question. Vince, you talked about a number of company-specific drivers that should allow you to outperform in calendar 2025. So I was hoping you could kind of use that as a backdrop and then maybe layer in kind of your thoughts on how the cycle will kind of emerge from today's trough. And you know, what your kind of thoughts are in terms of pushing, you know, business through 2025 and 2026. Thank you.
Vincent Roche: Yeah. Thanks, CJ. So yeah, obviously, we've already stated our first quarter will be down, so we expect to start getting back to a positive growth trajectory in the second quarter. I think during 2025, if I were to kind of rank the market recoveries, you know, I think it'll be led by industrial. We have very healthy customer inventories. The channel is below seven weeks, and that's a big part of the supply chain into the industrial sector. You know, you couple that with the green shoots that we've mentioned already in areas like AI, tests, and aerospace and defense, which I called out in the script. So I think the compare is easier overall. And, you know, as a result, I think industrial, given the signs we see, will recover briskly in 2025. I've been in consumer, we have a much more diversified business than we've ever had. We've better portfolio than we've ever had. Inventory is normalized and we're already seeing the benefits. We saw it in our in our 4Q results, three and 4Q results, the strength of our consumer business. I think next is the comms business. You know, it declined by over 30% in 2024. And I think that was really an inventory digestion too. So we feel at this point that we're through the worst of the supply normalization. And as we talked about in the scripts, we're beginning to see steady demand improvement, particularly in wireline. Driven by the build-out of these new externalized intelligence systems. And you know, the AI infrastructure. So we're not seeing much on the wireless side. We've I think at a low point in wireless during 2024. So I think it'll all depend on the carrier CapEx investments in 5G moving ahead. Last but not least, the automotive sector. We expect to see continued momentum in areas of function, we say power, the connectivity things that I spoke about, and, essentially, it's globally to be driving share and penetration across all the different types of platforms. So you know, we've had a tough year in 2024 in BMS. 2025, we had expect to see that get back to a better shape, get back to a growth pattern. And you know, given that all of us down just 2% in 2024, it's a tough compare moving ahead. But overall, we feel that we'll be on a solid growth path as well. So that's the ranking, CJ, it's a long answer to a simple question. Thanks, CJ.
CJ Muse: Thank you.
Operator: And I show our next question comes from the line of Vivek Arya from Bank of America Securities. Please go ahead.
Vivek Arya: Thanks for taking my question. My question is on Q4 Industrial and then how it sort of shaped fiscal 2025. I think for Q4 industrial, if I'm not mistaken, you had expected sales to grow high single digit. I think they went up only modestly. And then you're guiding Q1 Industrial down again sequentially. So Vince, my question is Industrial really out of the woods, what helps it grow above seasonal? Because just assuming seasonal growth for the rest of fiscal 2025 may not be sufficient, right, to really grow fiscal 2025 at a strong pace. So just maybe help us you know, understanding what's happening in the industrial market and when do you expect it to start growing above seasonal trends next year?
Richard Puccio: So, Vivek, I'll take that and so Q4, as you mentioned, was a bit lower than we expected. Driven largely by weakness in the broad market and our decision to reduce channel inventory during the quarter. Now as you know, reducing channel inventory has an outsized impact on our industrial business. At the same time, we did see continued strength in ADAS instrumentation and test and a return to sequential growth in automation. If you remember, in the prior two quarters, we've seen significant declines in automation. So to see that return to sequential growth was a very positive sign. You know, taking a step back, we've grown industrial sequentially now for two quarters. Of what we said was our trough in Q2 of 2024. So we feel pretty good that the recovery is still unfolding for us. And now we're gonna wait and give a bit to see what the macros do. But if I look to 2025, you know, one of the important signals for us continues to be we have been under shipping demand for the better part of 18 months. You know, and if you just normalize that for even our historical patterns, or the market patterns, you know, it would indicate we've under shipped something like 20%. Which is how we get confidence in coming out of Q1's seasonal down, we will start to see growth again in industrial in the remainder of 2025. Obviously, the slope of that will be covered a bit by the macro backdrop.
Vivek Arya: Thank you.
Operator: And I show our next question comes from the line of Joe Moore from Morgan Stanley. Please go ahead.
Shane: Hi. Thank you for letting me ask a question. This is Shane from Morgan Stanley on behalf of Joe Moore. Just on your automotive business, how have customer orders and pricing discussions tracked for the growth areas of your portfolio, such as A2B, GMSL, and functional safe power? And then how have they progressed for the sort of other half of the automotive business?
Richard Puccio: So I don't break that into two pieces, I guess. I'll talk about pricing first. So from a pricing perspective so far with customers, it's been largely as expected and continuing to exhibit the stability that we've talked about previously. Right? We continue to focus on the high end where our customers value performance versus price. You know, we can commend ASPs for X the industry average. And that has continued to grow over the cycle. You know, as particularly as we, you know, look across our broad large customers, you know, we're becoming more and more important moving from a essentially, a tier two contracting with tier ones to actually partnering with the OEMs at the early stages of design. You know, and we've talked about before prices set at the design in. Tend to stay pretty fixed throughout a long period of time. So sometimes over a decade on average. Although, there is some volume discounts that come through, so we trade off incremental volume for small decreases in price. And then we do look to mitigate those discounts with our vintage increases on our older products. The other thing that's helping on the pricing stability is we are clearly broadly across costs in our business experiencing inflationary environments, which supports continued stability on the pricing side.
Michael Lucarelli: And your company, guys, well, love the pieces of the automotive business. You're right we break it down. We got two One, we call it, like, the growth areas. Vince outlined a bunch of those, GMSL, A2B, functionally safe power, and BMS. They make up about half our revenue in auto. Those grew in 2024 over 10%. The other part of the business, the other 50%, is really more standard product portfolio that goes across all the OEMs all customers, and really goes up and down in production. That piece was down about 10% in 2024. And you fast forward to 2025, I think it was be more or the same? Or we see a lot of growth come from those GMSL, A2B, functionally safe portfolio. And we said a couple of times, I called BMS and returned to growth as well.
Vincent Roche: Go next question, please.
Operator: Thank you. And I show our next question comes from the line of Tore Svanberg from Stifel. Please go ahead.
Tore Svanberg: Yes. Thank you. Vince, I had a sort of bigger picture question, especially as we embark on this new cycle. So as I navigate your website, I just see some more software products. And I'm just wondering as AI continues to move to the edge, what do you see as a differentiation here for Analog Devices? Especially in relation to some of your other analog signal peers?
Vincent Roche: Yeah. Thanks, Tore. Well, software is not particularly new to ADI in the sense that, you know, for many decades, now, we've had a vibrant DSP franchise. With a lot of, you know, tool chain capability, a lot of algorithmic capability, but we've begun really, I think, over the last decade, taking a more application view to the world across all our core markets, industrial, automotive, communications, etcetera, etcetera. And, you know, we've begun moving up the stack from the core base of analog signal power technologies. So we use, I would say, more algorithmic technology to kind of, at the copilot, so to speak, with the core franchise. So everything we do in software is essentially supports the cutting-edge strength that we have in the analog mix signal and power solutions. And you know, it's increasingly important for our ADI to present our solutions to our customers in a way that makes us easier and more enjoyable for them to use our solution that could complexity and sophistication of what we bring to them. So, you know, over the last couple of months, we announced two new parts to our software story. One is what we call CodeFusion Studio. And, essentially, what that is is an open-source software development environment that includes software development kits, tools, debuggers, and so on and so forth. And that enables our customers to get access. Know, to be able to embed ADI's analog and digital technology into their end system solutions. And the second piece is, it goes without saying, cybersecurity is top of mind for everybody. So we've released what we call the ADI Assure platform. And, essentially, what it is, it's a new security architecture that enables us to provide a root of trust from the hardware rights into the cloud, so to speak, and to understand the movement the creation and movement of data across that spectrum. So you know, we are spending more on software than we've done. But we're taking a very holistic view and I'd say using software to drive the innovation system of the company, the innovation within our products around our products, and making it easier for our customers to access our solutions. That's it in a nutshell, I think.
Operator: Thank you. And I show our next question comes from the line of Stacy Rasgon from Bernstein. Please go ahead.
Stacy Rasgon: Guys. Thanks for taking my question. I wanted to ask about gross margins. What are your thoughts on gross margins into Q1 as revenue declines? And do you think the Q1 is the bottom as it does seem like you do think revenue grows off of there? Like, how do we think about the trajectory off of that gross margins in the next year, what does it take to get them back into the 70% plus range?
Richard Puccio: Stacy, I'll take that one. So Q4 gross margin was lower than we'd expected due to mix. So with consumer and auto being so much stronger while industrial was weaker, you know, that created some downward pressure because then we had talked about a slight sequential increase, which we didn't see. For Q1, we expected slower slightly lower gross margin given sort of normal factory shutdowns around the holidays. As well as the seasonally lower revenue. You know, if we think about the when will we see sort of the 70% this is gonna continue to be driven by mix and utilization as we grow revenue. Right now, industrial is pretty low mix. And utilization, while no longer decreasing and coming off of our low points back in Q2, remain sort of well below optimal levels. Know, if you wanna think about it from a longer-term perspective, from a revenue view, we'd likely, you know, need revenue in the $2.7 billion plus to start seeing 70%. From a 2025 sort of sequential perspective, as we do, as we mentioned, expect revenue to recover to growth coming out of the Q1 seasonality. We would expect to see gross margin improvement as we work through the back half of the year. And then, obviously, as we've talked about the back half macros will determine how much revenue growth we get and how much incremental margin we see.
Michael Lucarelli: Thank you.
Operator: And I show our next question comes from the line of Timothy Arcuri from UBS. Please go ahead.
Timothy Arcuri: Thanks a lot. Rich, you just mentioned that fiscal Q2 is gonna be up. I'm wondering what you consider normal seasonal to be in fiscal Q2. It seems like it's up about three to four. So that's the first part of my question. And then the second part is, you sort of strip out autos, I wonder, like, how is book to bill if you could sort of, you know, strip out autos versus normal? Is it trending pretty much as you would? Thanks.
Michael Lucarelli: Yes, sir. So I'll grab the first question and then go to the book and build question. I was like, I lost the bet to myself. I thought the two key question me with the top three questions were number seven. So yep. That's what that'll go sometimes. But you're right. We keep on seasonality strength. What does seasonal mean into you? It's been a while since seasonality. Usually, you see industrial and auto up. About mid-single digits in Q2. Communication's up some, not as much. Maybe flat up slightly. Well, consumers down a little bit. So overall, you're up about to mid-single digits in a portal company level. Again, that's seasonal trends. There's a wide band. On that, typically how we think about Q2 for a seasonal perspective.
Richard Puccio: Yeah. On the booking side, so as we talked about after the decline in Q3 in auto, total bookings returned to growth driven by continued growth in industrial and a rebound in auto. Overall book to bill was below one, which we would say is pretty normal at this point. Reflecting our seasonally lower Q1 outlook. You know, regionally, bookings were up everywhere, excluding the Americas. And that largely reflects the seasonal decline in consumer.
Timothy Arcuri: Thanks, Tim. Thank you.
Operator: And I show our next question comes from the line of Ross Seymore from Deutsche Bank. Please go ahead.
Ross Seymore: Hi, guys. Thanks for letting me ask a question. Vince, a bit of a longer-term question for you. Cycle to cycle, you know, the good news is it sounds like you found the bottom especially on the industrial side. And you mentioned that it was kind of the worst downturn from an inventory perspective in a long, long time. I guess my question is the prior peak, I guess, in your fiscal 2023 is that attainable? And what are the puts and takes to get to that? Because I guess from a big picture question, was that overinflated or was that a realistic target that we should look forward to? And if so, at what time?
Vincent Roche: Yeah. Thanks, Ross. Well, I think, you know, first and foremost, our portfolio is in better position than it's ever been. I would say ADI's connection with our customers, big and small, is better than it's ever been. You know, we're investing in believe, in the right areas in the R&D sector. Our pipeline coming out of 2024, it grew double digits year over year. Opportunity pipeline. So I think the company is well positioned. We've also been very, very I would say, taking a very almost purest view to how we flush inventory. So my sense is you know, we've got a supply chain that is well capable of meeting what we believe will be good demand during 2024. To get back to the kind of the 2023 levels, you know, we believe that our business is capable of growing double digits. So, you know, through the rest of the decade here, given the position we've got, the demand that we see, the opportunity pipeline. So and I think know, we will see a good down payment on that future prospect. During 2025.
Operator: Thank you. And I show our next question comes from the line of William Stein from Truist Securities. Please go ahead.
William Stein: Oh, great. Thanks for taking my question. Vince, I think you mentioned data center power management in the prepared remarks, but I'm hoping you can dig into this a little bit. There's been quite a bit of all very know, what some people call charismatic design win up opportunities in that end market. I know that at least one of the companies you acquired, Maxim, had a significant effort in 48-volt PMEC, and I suspect Linear had something there as well. I wonder if you can comment as to the medium-term opportunity as you all see it and maybe any comment on design win traction there. Thank you.
Vincent Roche: Yeah. Thanks, Will. So you know, first off, if you just put the entire data center business in ADI perspective, you know, we have really two elements to our power story. I think one is the power solutions that go around the computing chips, and the rest of the, you know, the server infrastructure. The second piece is the control units, things like hot swapping, supervisory, so on and so forth. We've had good traction of that business a long, long time. We've got some new products coming to market. That will continue to boost us in terms of ASP, share, and so on and so forth. We're also getting good traction with our optical control solutions right up to 1.6 terabits. So that's kind of the landscape of products and technologies that we have. You know, if you're going to win anything in this in these this data center business you've gotta play an ecosystem game. So we play with the processor companies. We're playing with the data center companies themselves. And, you know, again, we're picking our places very, very carefully. We're going for the highest end solutions where we can make a big difference in the energy space. By the way, we're even attaching energy solutions at, you know, kind of the more between the grid and the data sector. So we view this power is just merely part of the an energy solution, and we're looking at that from the intersection with grid right down to the chip.
Richard Puccio: Thanks, Will. Can we get to our last question, please?
Operator: Thank you. And I show our last question comes from the line of Joshua Buchalter from TD Cowen. Please go ahead.
Joshua Buchalter: Hey, guys. Thanks for squeezing me in. Wanted to ask about utilization rates. I think you might be the only company in broad-based semis that called out higher utilization rates this quarter. How should we think about how you're thinking about that trending into fiscal 2025? Are you you know, it sounds like sell-in is matching sell-through. Should we just think about that ramping basically directionally and linearly with your revenue or any other puts and takes we should keep in mind as we think about the impact of margins? Thank you.
Richard Puccio: Yeah. So I guess I would start with, you know, from a utilization perspective. We've talked about our agile. You know, one of the reasons we've been able to bring utilization levels up is our ability to swing capacity back into our internal fabs. So I think as I've mentioned, we're still not at anywhere near a normalized utilization rate. Our ability to swing during the downturn has allowed us to continue to grow off the drop that we talked about in Q2. So we have seen two quarters of sequential modest I would say modest sequential increases in utilization and as the revenue picks up as we work our way through best fiscal year 2025, I expect that utilization to continue increase to continue.
Michael Lucarelli: Alright. Thank you, Josh, and thanks everyone for joining us this morning. A cockpit transcript will be available on our website. Thanks again for joining the call. Have a great Thanksgiving.
Operator: Thank you. This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices Fourth Quarter Fiscal Year 2024 Earnings Conference Call, which is being audio webcast via telephone and over the web. After the speaker's presentation, there will be a question and answer session. To ask a question during the session, you will need to press star one one on your telephone. You will then hear an automated message advising your hand is raised. To withdraw your question, please press star one one again. Please be advised that today's conference is being recorded. I would like to now introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Excellent. Good morning, everybody. Thank you for joining our Fourth Quarter Fiscal 2024 Conference Call. Joining me on the call today are ADI's CEO, Vincent Roche, and ADI's CFO, Rich Blue Shield. All of our materials can be found at investor.analog.com. Onto disclosures: Information about this discussion includes forward-looking statements, which are subject to certain risks and uncertainties as further described in our filings with the SEC. Actual results could differ materially from the forward-looking information as these statements reflect our expectations only as of this call. We undertake no obligation to update these statements except as required by law. In terms of gross margin, operating and non-operating expenses, operating margin, tax rate, EPS, and free cash flow, comments today will be on a non-GAAP basis, which excludes special items. When comparing our results and historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. Please note, references to EPS are on a fully diluted basis. And with that, I will turn it over to ADI's CEO and Chair, Vincent Roche."
},
{
"speaker": "Vincent Roche",
"text": "Thanks very much, Mike, and a very good morning to you all. Our first quarter results reflected the continued steady recovery from our second quarter cyclical bottom with revenue, operating margin, and earnings per share all finishing above the midpoint of our outlook. For the full fiscal year 2024, revenue finished at $9.4 billion with earnings per share of $6.38. The headwinds we faced in fiscal 2024 were most notably pronounced post-pandemic inventory digestion and the challenging macro backdrop muting demand recovery. Despite the external challenges, however, our business model and disciplined execution delivered an impressive 41% operating margin for the year and a free cash flow margin of 33%, up from 29% in fiscal 2023. Importantly, we continued investing in key value generation and capture initiatives to better position ADI to solve our customers' most difficult challenges at the Intelligent Edge. In R&D, which is our first call on capital, we continue to strengthen our world-class analog foundation while extending the scope of our innovation capabilities with investments in digital software and AI. Those investments resulted in, for example, last month's launch of ADI's new CodeFusion Studio software development platform, creating a resource-rich hub and ensuring a programming environment for embedded co-development in support of our analog mixed signal power and digital franchises. To better secure the increasingly connected intelligent edge, we also launched the ADI Assure Trusted Edge Security Architecture, which will enable cybersecurity capabilities on ADI products. The addition of new tech stack capabilities to our tremendous analog foundation enables us to deliver ever more sophisticated innovations for our customers. Our intense focus on R&D is reflected in the double-digit growth of our design win pipeline during fiscal 2024. That growth was enhanced by momentum in our Maxim revenue synergies pipeline across such areas as GMSL, healthcare, and data center power, putting us firmly on a path to achieving our goal of $1 billion in revenue synergies by 2027. Now, to accelerate pipeline growth and conversion, we continue to evolve our digital customer engagement platforms to support a greater range of technical expertise and customer needs. We also expanded our cadre of field engineering experts to provide world-class support and service to our global customer base. Our customers value our thought leadership, the breadth and depth of our cutting-edge technology stack, the strength and resilience of our supply chain, and our service and support integrity. Let me share a few examples with you now. In Industry 4.0, semiconductor content as a percentage of CapEx investments continues to expand rapidly as factories integrate IT and OT to connect and software-define the factory floor. This is creating tremendous growth for ADI's sensor-to-cloud automation solutions, with a large number of customers leveraging our sensing, power control, and deterministic Ethernet technologies. On the factory floor, our intelligent motion and positioning solutions are being designed into robotic systems by several large customers, expanding our content per robot by three times. In our Instrumentation and Test business, ADI's cutting-edge analog signal and power capabilities are the foundation for the leadership position we've established in the AI-related SoC and high-bandwidth memory test market, where our content per tester stretches into the hundreds of thousands of dollars. Now looking ahead, we're developing additional mixed signal and digital capabilities to further reduce test time and power requirements, which we believe will result in more than 20% additional ADI content per test. Within the healthcare sector, our precision signal processing and real-time connectivity solutions are critical to the rapidly expanding surgical robotics market. And in the fast-growing continuous glucose monitoring space, we have won multiple opportunities across several customers. Our unique digitally enabled analog front-end solutions increase the accuracy and power efficiency of sensors and enable a better patient experience by extending battery life from days to weeks. Aerospace and defense has remained our most resilient industrial segment during this downturn, with stellar design win pipeline growth. We expect revenue growth to accelerate to a double-digit level next year due to increasing global defense budgets and the proliferation of space communication systems that rely on our higher value integrated RF modules and subsystems. Within automotive, the performance advantages of our battery management systems are driving substantial pipeline growth among OEMs. In addition, we're also seeing momentum for these solutions in electrical grid storage systems. These trends, combined with recent wins, give us confidence that our BMS revenues should return to growth in fiscal 2025 with meaningful contributions from our higher value wired solution. The proliferation of higher content vehicles that use more power management connectivity and an increasing number of sensor platforms is expanding our content across all vehicle types, combustion engines, hybrids, and indeed full EVs. This trend drove our GMSL and A2B connectivity and functionally safe power franchises to new high watermarks in fiscal 2024, and with a record design win pipeline, we expect this growth to persist."
},
{
"speaker": "Michael Lucarelli",
"text": "Notably, we added to our portfolio of connectivity solutions by launching our Ethernet to the Edge bus solution, or U2B, which is an enabler of the software-defined vehicle vision. And out of the gate, we have design wins with several major OEMs, including BMW. In communications, we've seen a positive inflection in the wireline market and expect that growth to continue in FY 2025 and beyond. Our confidence is based on significant new wins, including a high precision controller for the optical module and the high-performance compute leaders' AI systems, and our next-gen power solutions, which will begin shipping later in 2025. We're also experiencing tremendous demand from leading data center customers for our new innovative hot swap solution, which significantly extends power and control capabilities for AI-based servers. In consumer, new wins coming to market are driving strong growth. We expect this momentum to continue in the years ahead, given new wins across power, audio, optical, and touch in portable applications at multiple key customers. We've also seen growth in wearables. For example, our VSM platform's superior accuracy at lower power is becoming ever more critical for customers seeking to differentiate by capturing and processing more biomarkers. We've seen design momentum accelerate and content opportunities expand at wearable market leaders as well as in disruptors bringing miniaturized form factors to market. In wearable acoustic systems, our combination of ultra-low power and neural processing with application-specific audio processing algorithms is enabling next-generation noise cancellation and hearing augmentation. We're leveraging these technology innovations in several B2B markets. In addition, turning now to manufacturing, we've invested $2.7 billion in CapEx since acquiring Maxim to increase our capacity and enhance resiliency. We also expanded our foundry partnership with TSMC earlier this year to secure additional 300-millimeter fine-pitched technology capacity at their Japan fab. These investments enable a more flexible hybrid manufacturing model, further insulating our supply from regional shocks and increasing our swing capacity to around 70% of revenue in the coming years. This unique ability helps us to capture the upside in strong demand backdrops and better protect our gross margins during more challenging times. So in closing, I'm very proud of how ADI has managed through one of the worst inventory digestion cycles our industry has ever seen. While the macro backdrop presents challenges, I'm confident in our continued recovery in fiscal 2025. And with that, now I'll pass it over to Rich."
},
{
"speaker": "Richard Puccio",
"text": "Thank you, Vince. And let me add my welcome to our fourth quarter earnings call. I'll start with a brief recap of fiscal 2024 results. Revenue of more than $9.4 billion, down from the record fiscal 2023, driven by broad-based inventory digestion and sluggish end demand. Gross margin of 67.9% reflects lower revenue factory utilization and mix headwinds. Decline in revenue and gross margins were partially offset by lower operating expenses, which resulted in an operating margin of 40.9% and EPS of $6.38. Moving to fourth quarter results, revenue of $2.44 billion came in above the midpoint of our outlook for a 6% sequential increase, a 10% decline year over year. Industrial represented 44% of our fourth quarter revenue, finishing up 2% sequentially and down 21% year over year. Continued strength in AI-related test, aerospace and defense, and a return to sequential growth in automation more than offset slower end demand driven by a weaker macro backdrop. For the full year, industrial decreased 35% from a record 2023, with every major application declining double digits except aerospace and defense, which significantly outperformed the rest of industrial. Automotive represented 29% of quarterly revenue, finishing up 4% sequentially and down 2% year over year. This was notably better than our original expectation due to steadily improving demand from China throughout the quarter. For the year, automotive declined 2% from a record fiscal 2023 as double-digit growth across our functionally safe power and leading A2B and GMSL connectivity franchises were offset by broad-based inventory digestion and production headwinds. Communications represented 11% of our quarterly revenue, finishing up 4% sequentially and down 18% year over year. Stronger demand from data center customers for our solutions drove low double-digit sequential growth in our wireline business, which more than offset the decline in wireless. For the year, communications decreased 33%, and similar to the fourth quarter, we saw a relative outperformance in our wireline business over wireless. Lastly, consumer represented 16% of quarterly revenue, finishing up 22% sequentially and 31% year over year, driven by higher share in wearables, premium handsets, and gaming applications. For the year, consumer decreased just 1% with double-digit growth in portable applications, balancing double-digit declines in our prosumer business, which is more industrial-like in nature. Now on to the rest of the P&L. Fourth quarter gross margin was 67.9%, flat sequentially as product mix headwinds offset modestly higher utilization rates. OpEx in the quarter was $655 million, up approximately $35 million sequentially, driven primarily by merit increases, which resulted in an operating margin of 41.1%. Non-operating expenses finished at $55 million, and the tax rate for the quarter was 12.1%. All told, EPS was $1.67, which finished above the midpoint of our outlook. Despite a tough year, we took decisive action to strengthen our financial position, and I'd like to call out a few results from our balance sheet and cash flow statement. We ended the quarter with approximately $2.4 billion in cash, short-term investments, and a net leverage ratio of 1.2. Inventory finished approximately $20 million higher than the third quarter, while days of inventory decreased to 167. Channel inventory finished slightly below the low end of our seven to eight-week target as we continue to prudently manage our supply. Operating cash flow for the quarter was more than $1 billion and more than $3.8 billion for fiscal 2024. CapEx was $165 million for the quarter and $730 million for the year, resulting in fiscal 2024 free cash flow of more than $3.1 billion or 33% of revenue. During the year, we returned $2.4 billion to shareholders via $1.8 billion in dividends and $600 million in repurchases. Now moving on to guidance for the first quarter. Revenue is expected to be $2.35 billion, plus or minus $100 million. Notably, this implies year-over-year growth when compared to a normalized 13-week first quarter of fiscal 2024, a good indication that we're past the trough and in gradual recovery. We expect sell-in to be roughly equal to sell-through in this quarter. At the midpoint, we are expecting a seasonal decline on a sequential basis as noted last quarter. Industrial, automotive, and communications are each expected to decline by low single digits, with consumer down around 15%. Operating margin is expected to be approximately 40%, plus or minus 100 basis points. Our tax rate is expected to be 12 to 14%. And based on these inputs, EPS is expected to be $1.53, plus or minus 10 cents. I'll conclude by noting a few items as we begin the new fiscal year. As Vince mentioned, we made great progress building a more agile and resilient hybrid manufacturing model. As such, we expect our CapEx spend will moderate back to our long-term model of 4 to 6% of revenue in fiscal 2025. We expect this normalized CapEx level and planned receipt of investment tax credits tied to both the US and European CHIPS Acts will provide tailwinds to fiscal 2025's free cash flow. Importantly, while we have delivered on our commitment to return 100% of free cash flow since our Maxim acquisition, fiscal 2024's return was lower due to our decision to increase balance sheet cash during this period of macroeconomic uncertainty and to help us extinguish $400 million of debt coming due in fiscal 2025. That said, investors can expect us to revert to our targeted return of 100% of free cash flow in fiscal 2025. I'm now going to turn it back to Mike for Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Rich. Let's get to the Q&A session. I ask that you limit yourself to one question to allow for additional participants on the call this morning. If you have follow-up questions, please re-queue. The waiting question time allows. With that, we have our first question, please."
},
{
"speaker": "Operator",
"text": "Thank you. For those participating by telephone, dial in. If you have a question, if your question has been answered and you wish to be removed from the queue, please press star one one again. If you're listening on a speakerphone, please pick up the handset when asking your question. We'll pause just for a moment to compile the Q&A roster. And I show our first question comes from the line of Chris Danley from Citi. Go ahead."
},
{
"speaker": "Chris Danley",
"text": "Hey. Thanks, guys. Just a little color on the auto strength. Can you talk about how big China is as a percent of your auto business? And then within that, how much of the strength was from, say, EV versus ICE or all these EV startups that we're hearing about from China? Thanks."
},
{
"speaker": "Richard Puccio",
"text": "So I'll give you a little bit of the perspective, Chris, on the auto near term. So on the last call, we expected the sequential decline in Q4 given the drop we talked about in bookings during Q3. An adjustment to production for multiple of our OEMs. However, toward the end of Q3, bookings started to improve and that continued throughout our Q4, with stronger demand in China reflecting EV volume growth, share gains, and content growth. As for the other geos, we saw broad weakness, but upside in the U.S., which returned to sequential growth driven mainly by our BMS and wireless BMS portfolio. Secular demand for ADAS and next-gen infotainment continues to drive strength globally for our functionally safe power, audio, and video solutions. Content and share growth in these areas have helped offset broad inventory headwinds resulting in a shallower correction in other end markets. I'd also note that while BMS is still facing inventory headwinds broadly, we saw a strong uptick in China reflecting the expanded share we talked about on our Q2 call compounded by volume growth in the region. BMS also improved in the U.S., including growth for our higher content wireless solution, which is now 10% of total BMS. And as Vince mentioned, design win activity was strong in 2024, giving us confidence that BMS will return to growth in fiscal year 2025."
},
{
"speaker": "Vincent Roche",
"text": "A little more color, Chris, than what Rich has just said. So you know, we've got a really high-performance portfolio. We've got many, many different SKUs, if you like, in that portfolio. And, you know, we're playing the high-performance game with the big players in China for merit. So that's the same business there."
},
{
"speaker": "Michael Lucarelli",
"text": "And they've got some comments on the US-China kind of relative what's the mix of China. Our China business looks a lot like ADI enterprise where industrial are more of the two biggest percent of our revenue in China. I think about 80% of the China business. Comms is in the teens, consumers below 5%."
},
{
"speaker": "Chris Danley",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And I show our next question comes from the line of CJ Muse from Cantor Fitzgerald. Please go ahead."
},
{
"speaker": "CJ Muse",
"text": "Yeah. Good morning. Thank you for taking the question. Vince, you talked about a number of company-specific drivers that should allow you to outperform in calendar 2025. So I was hoping you could kind of use that as a backdrop and then maybe layer in kind of your thoughts on how the cycle will kind of emerge from today's trough. And you know, what your kind of thoughts are in terms of pushing, you know, business through 2025 and 2026. Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Thanks, CJ. So yeah, obviously, we've already stated our first quarter will be down, so we expect to start getting back to a positive growth trajectory in the second quarter. I think during 2025, if I were to kind of rank the market recoveries, you know, I think it'll be led by industrial. We have very healthy customer inventories. The channel is below seven weeks, and that's a big part of the supply chain into the industrial sector. You know, you couple that with the green shoots that we've mentioned already in areas like AI, tests, and aerospace and defense, which I called out in the script. So I think the compare is easier overall. And, you know, as a result, I think industrial, given the signs we see, will recover briskly in 2025. I've been in consumer, we have a much more diversified business than we've ever had. We've better portfolio than we've ever had. Inventory is normalized and we're already seeing the benefits. We saw it in our in our 4Q results, three and 4Q results, the strength of our consumer business. I think next is the comms business. You know, it declined by over 30% in 2024. And I think that was really an inventory digestion too. So we feel at this point that we're through the worst of the supply normalization. And as we talked about in the scripts, we're beginning to see steady demand improvement, particularly in wireline. Driven by the build-out of these new externalized intelligence systems. And you know, the AI infrastructure. So we're not seeing much on the wireless side. We've I think at a low point in wireless during 2024. So I think it'll all depend on the carrier CapEx investments in 5G moving ahead. Last but not least, the automotive sector. We expect to see continued momentum in areas of function, we say power, the connectivity things that I spoke about, and, essentially, it's globally to be driving share and penetration across all the different types of platforms. So you know, we've had a tough year in 2024 in BMS. 2025, we had expect to see that get back to a better shape, get back to a growth pattern. And you know, given that all of us down just 2% in 2024, it's a tough compare moving ahead. But overall, we feel that we'll be on a solid growth path as well. So that's the ranking, CJ, it's a long answer to a simple question. Thanks, CJ."
},
{
"speaker": "CJ Muse",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And I show our next question comes from the line of Vivek Arya from Bank of America Securities. Please go ahead."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question. My question is on Q4 Industrial and then how it sort of shaped fiscal 2025. I think for Q4 industrial, if I'm not mistaken, you had expected sales to grow high single digit. I think they went up only modestly. And then you're guiding Q1 Industrial down again sequentially. So Vince, my question is Industrial really out of the woods, what helps it grow above seasonal? Because just assuming seasonal growth for the rest of fiscal 2025 may not be sufficient, right, to really grow fiscal 2025 at a strong pace. So just maybe help us you know, understanding what's happening in the industrial market and when do you expect it to start growing above seasonal trends next year?"
},
{
"speaker": "Richard Puccio",
"text": "So, Vivek, I'll take that and so Q4, as you mentioned, was a bit lower than we expected. Driven largely by weakness in the broad market and our decision to reduce channel inventory during the quarter. Now as you know, reducing channel inventory has an outsized impact on our industrial business. At the same time, we did see continued strength in ADAS instrumentation and test and a return to sequential growth in automation. If you remember, in the prior two quarters, we've seen significant declines in automation. So to see that return to sequential growth was a very positive sign. You know, taking a step back, we've grown industrial sequentially now for two quarters. Of what we said was our trough in Q2 of 2024. So we feel pretty good that the recovery is still unfolding for us. And now we're gonna wait and give a bit to see what the macros do. But if I look to 2025, you know, one of the important signals for us continues to be we have been under shipping demand for the better part of 18 months. You know, and if you just normalize that for even our historical patterns, or the market patterns, you know, it would indicate we've under shipped something like 20%. Which is how we get confidence in coming out of Q1's seasonal down, we will start to see growth again in industrial in the remainder of 2025. Obviously, the slope of that will be covered a bit by the macro backdrop."
},
{
"speaker": "Vivek Arya",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And I show our next question comes from the line of Joe Moore from Morgan Stanley. Please go ahead."
},
{
"speaker": "Shane",
"text": "Hi. Thank you for letting me ask a question. This is Shane from Morgan Stanley on behalf of Joe Moore. Just on your automotive business, how have customer orders and pricing discussions tracked for the growth areas of your portfolio, such as A2B, GMSL, and functional safe power? And then how have they progressed for the sort of other half of the automotive business?"
},
{
"speaker": "Richard Puccio",
"text": "So I don't break that into two pieces, I guess. I'll talk about pricing first. So from a pricing perspective so far with customers, it's been largely as expected and continuing to exhibit the stability that we've talked about previously. Right? We continue to focus on the high end where our customers value performance versus price. You know, we can commend ASPs for X the industry average. And that has continued to grow over the cycle. You know, as particularly as we, you know, look across our broad large customers, you know, we're becoming more and more important moving from a essentially, a tier two contracting with tier ones to actually partnering with the OEMs at the early stages of design. You know, and we've talked about before prices set at the design in. Tend to stay pretty fixed throughout a long period of time. So sometimes over a decade on average. Although, there is some volume discounts that come through, so we trade off incremental volume for small decreases in price. And then we do look to mitigate those discounts with our vintage increases on our older products. The other thing that's helping on the pricing stability is we are clearly broadly across costs in our business experiencing inflationary environments, which supports continued stability on the pricing side."
},
{
"speaker": "Michael Lucarelli",
"text": "And your company, guys, well, love the pieces of the automotive business. You're right we break it down. We got two One, we call it, like, the growth areas. Vince outlined a bunch of those, GMSL, A2B, functionally safe power, and BMS. They make up about half our revenue in auto. Those grew in 2024 over 10%. The other part of the business, the other 50%, is really more standard product portfolio that goes across all the OEMs all customers, and really goes up and down in production. That piece was down about 10% in 2024. And you fast forward to 2025, I think it was be more or the same? Or we see a lot of growth come from those GMSL, A2B, functionally safe portfolio. And we said a couple of times, I called BMS and returned to growth as well."
},
{
"speaker": "Vincent Roche",
"text": "Go next question, please."
},
{
"speaker": "Operator",
"text": "Thank you. And I show our next question comes from the line of Tore Svanberg from Stifel. Please go ahead."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you. Vince, I had a sort of bigger picture question, especially as we embark on this new cycle. So as I navigate your website, I just see some more software products. And I'm just wondering as AI continues to move to the edge, what do you see as a differentiation here for Analog Devices? Especially in relation to some of your other analog signal peers?"
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Thanks, Tore. Well, software is not particularly new to ADI in the sense that, you know, for many decades, now, we've had a vibrant DSP franchise. With a lot of, you know, tool chain capability, a lot of algorithmic capability, but we've begun really, I think, over the last decade, taking a more application view to the world across all our core markets, industrial, automotive, communications, etcetera, etcetera. And, you know, we've begun moving up the stack from the core base of analog signal power technologies. So we use, I would say, more algorithmic technology to kind of, at the copilot, so to speak, with the core franchise. So everything we do in software is essentially supports the cutting-edge strength that we have in the analog mix signal and power solutions. And you know, it's increasingly important for our ADI to present our solutions to our customers in a way that makes us easier and more enjoyable for them to use our solution that could complexity and sophistication of what we bring to them. So, you know, over the last couple of months, we announced two new parts to our software story. One is what we call CodeFusion Studio. And, essentially, what that is is an open-source software development environment that includes software development kits, tools, debuggers, and so on and so forth. And that enables our customers to get access. Know, to be able to embed ADI's analog and digital technology into their end system solutions. And the second piece is, it goes without saying, cybersecurity is top of mind for everybody. So we've released what we call the ADI Assure platform. And, essentially, what it is, it's a new security architecture that enables us to provide a root of trust from the hardware rights into the cloud, so to speak, and to understand the movement the creation and movement of data across that spectrum. So you know, we are spending more on software than we've done. But we're taking a very holistic view and I'd say using software to drive the innovation system of the company, the innovation within our products around our products, and making it easier for our customers to access our solutions. That's it in a nutshell, I think."
},
{
"speaker": "Operator",
"text": "Thank you. And I show our next question comes from the line of Stacy Rasgon from Bernstein. Please go ahead."
},
{
"speaker": "Stacy Rasgon",
"text": "Guys. Thanks for taking my question. I wanted to ask about gross margins. What are your thoughts on gross margins into Q1 as revenue declines? And do you think the Q1 is the bottom as it does seem like you do think revenue grows off of there? Like, how do we think about the trajectory off of that gross margins in the next year, what does it take to get them back into the 70% plus range?"
},
{
"speaker": "Richard Puccio",
"text": "Stacy, I'll take that one. So Q4 gross margin was lower than we'd expected due to mix. So with consumer and auto being so much stronger while industrial was weaker, you know, that created some downward pressure because then we had talked about a slight sequential increase, which we didn't see. For Q1, we expected slower slightly lower gross margin given sort of normal factory shutdowns around the holidays. As well as the seasonally lower revenue. You know, if we think about the when will we see sort of the 70% this is gonna continue to be driven by mix and utilization as we grow revenue. Right now, industrial is pretty low mix. And utilization, while no longer decreasing and coming off of our low points back in Q2, remain sort of well below optimal levels. Know, if you wanna think about it from a longer-term perspective, from a revenue view, we'd likely, you know, need revenue in the $2.7 billion plus to start seeing 70%. From a 2025 sort of sequential perspective, as we do, as we mentioned, expect revenue to recover to growth coming out of the Q1 seasonality. We would expect to see gross margin improvement as we work through the back half of the year. And then, obviously, as we've talked about the back half macros will determine how much revenue growth we get and how much incremental margin we see."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "And I show our next question comes from the line of Timothy Arcuri from UBS. Please go ahead."
},
{
"speaker": "Timothy Arcuri",
"text": "Thanks a lot. Rich, you just mentioned that fiscal Q2 is gonna be up. I'm wondering what you consider normal seasonal to be in fiscal Q2. It seems like it's up about three to four. So that's the first part of my question. And then the second part is, you sort of strip out autos, I wonder, like, how is book to bill if you could sort of, you know, strip out autos versus normal? Is it trending pretty much as you would? Thanks."
},
{
"speaker": "Michael Lucarelli",
"text": "Yes, sir. So I'll grab the first question and then go to the book and build question. I was like, I lost the bet to myself. I thought the two key question me with the top three questions were number seven. So yep. That's what that'll go sometimes. But you're right. We keep on seasonality strength. What does seasonal mean into you? It's been a while since seasonality. Usually, you see industrial and auto up. About mid-single digits in Q2. Communication's up some, not as much. Maybe flat up slightly. Well, consumers down a little bit. So overall, you're up about to mid-single digits in a portal company level. Again, that's seasonal trends. There's a wide band. On that, typically how we think about Q2 for a seasonal perspective."
},
{
"speaker": "Richard Puccio",
"text": "Yeah. On the booking side, so as we talked about after the decline in Q3 in auto, total bookings returned to growth driven by continued growth in industrial and a rebound in auto. Overall book to bill was below one, which we would say is pretty normal at this point. Reflecting our seasonally lower Q1 outlook. You know, regionally, bookings were up everywhere, excluding the Americas. And that largely reflects the seasonal decline in consumer."
},
{
"speaker": "Timothy Arcuri",
"text": "Thanks, Tim. Thank you."
},
{
"speaker": "Operator",
"text": "And I show our next question comes from the line of Ross Seymore from Deutsche Bank. Please go ahead."
},
{
"speaker": "Ross Seymore",
"text": "Hi, guys. Thanks for letting me ask a question. Vince, a bit of a longer-term question for you. Cycle to cycle, you know, the good news is it sounds like you found the bottom especially on the industrial side. And you mentioned that it was kind of the worst downturn from an inventory perspective in a long, long time. I guess my question is the prior peak, I guess, in your fiscal 2023 is that attainable? And what are the puts and takes to get to that? Because I guess from a big picture question, was that overinflated or was that a realistic target that we should look forward to? And if so, at what time?"
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Thanks, Ross. Well, I think, you know, first and foremost, our portfolio is in better position than it's ever been. I would say ADI's connection with our customers, big and small, is better than it's ever been. You know, we're investing in believe, in the right areas in the R&D sector. Our pipeline coming out of 2024, it grew double digits year over year. Opportunity pipeline. So I think the company is well positioned. We've also been very, very I would say, taking a very almost purest view to how we flush inventory. So my sense is you know, we've got a supply chain that is well capable of meeting what we believe will be good demand during 2024. To get back to the kind of the 2023 levels, you know, we believe that our business is capable of growing double digits. So, you know, through the rest of the decade here, given the position we've got, the demand that we see, the opportunity pipeline. So and I think know, we will see a good down payment on that future prospect. During 2025."
},
{
"speaker": "Operator",
"text": "Thank you. And I show our next question comes from the line of William Stein from Truist Securities. Please go ahead."
},
{
"speaker": "William Stein",
"text": "Oh, great. Thanks for taking my question. Vince, I think you mentioned data center power management in the prepared remarks, but I'm hoping you can dig into this a little bit. There's been quite a bit of all very know, what some people call charismatic design win up opportunities in that end market. I know that at least one of the companies you acquired, Maxim, had a significant effort in 48-volt PMEC, and I suspect Linear had something there as well. I wonder if you can comment as to the medium-term opportunity as you all see it and maybe any comment on design win traction there. Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Thanks, Will. So you know, first off, if you just put the entire data center business in ADI perspective, you know, we have really two elements to our power story. I think one is the power solutions that go around the computing chips, and the rest of the, you know, the server infrastructure. The second piece is the control units, things like hot swapping, supervisory, so on and so forth. We've had good traction of that business a long, long time. We've got some new products coming to market. That will continue to boost us in terms of ASP, share, and so on and so forth. We're also getting good traction with our optical control solutions right up to 1.6 terabits. So that's kind of the landscape of products and technologies that we have. You know, if you're going to win anything in this in these this data center business you've gotta play an ecosystem game. So we play with the processor companies. We're playing with the data center companies themselves. And, you know, again, we're picking our places very, very carefully. We're going for the highest end solutions where we can make a big difference in the energy space. By the way, we're even attaching energy solutions at, you know, kind of the more between the grid and the data sector. So we view this power is just merely part of the an energy solution, and we're looking at that from the intersection with grid right down to the chip."
},
{
"speaker": "Richard Puccio",
"text": "Thanks, Will. Can we get to our last question, please?"
},
{
"speaker": "Operator",
"text": "Thank you. And I show our last question comes from the line of Joshua Buchalter from TD Cowen. Please go ahead."
},
{
"speaker": "Joshua Buchalter",
"text": "Hey, guys. Thanks for squeezing me in. Wanted to ask about utilization rates. I think you might be the only company in broad-based semis that called out higher utilization rates this quarter. How should we think about how you're thinking about that trending into fiscal 2025? Are you you know, it sounds like sell-in is matching sell-through. Should we just think about that ramping basically directionally and linearly with your revenue or any other puts and takes we should keep in mind as we think about the impact of margins? Thank you."
},
{
"speaker": "Richard Puccio",
"text": "Yeah. So I guess I would start with, you know, from a utilization perspective. We've talked about our agile. You know, one of the reasons we've been able to bring utilization levels up is our ability to swing capacity back into our internal fabs. So I think as I've mentioned, we're still not at anywhere near a normalized utilization rate. Our ability to swing during the downturn has allowed us to continue to grow off the drop that we talked about in Q2. So we have seen two quarters of sequential modest I would say modest sequential increases in utilization and as the revenue picks up as we work our way through best fiscal year 2025, I expect that utilization to continue increase to continue."
},
{
"speaker": "Michael Lucarelli",
"text": "Alright. Thank you, Josh, and thanks everyone for joining us this morning. A cockpit transcript will be available on our website. Thanks again for joining the call. Have a great Thanksgiving."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 3 | 2,024 | 2024-08-21 10:00:00 | Operator: Good morning, and welcome to the Analog Devices ' Third Quarter Fiscal Year 2024 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli: Thank you, Kevin. And good morning, everybody. Thanks for joining our third quarter fiscal 2024 conference call. With me on the call today, ADI's CEO and Chair, Vincent Roche; ADI’s CFO, Richard Puccio. For anyone who missed the release, you can find it in relating financial schedules and investor.analog.com. Onto the disclosures, information we're about to discuss includes forward-looking statements which are subject to certain risks and uncertainties as further described in our earnings release and our periodic reports and other materials follow the SEC. Actual results could differ materially from the forward-looking information, as these statements reflect our expectations only as a date of this call. We undertake no obligation to update the statements except as required by law. Revenue, adjusted gross margin, operating and non-operating expenses, operating margin, tax rate, EPS and free cash flow in our comment today will be on non-GAAP basis, which excludes special items. When comparing our results to historic performance. Special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's release. And with that, I'll turn it over to ADI's CEO and Chair, Vince?
Vincent Roche: Thanks very much, Mike, and a very good morning to you all. The stronger demand for a high-performance product portfolio and skillful execution resulted in third quarter revenue of more than $2.3 billion, operating margin north of 41%, and EPS of $1.58, all above the midpoint of our outlook. These favorable results, combined with improved customer inventory levels and order momentum across most of our markets, increase my confidence that our second quarter marked the cyclical bottom for ADI. My optimism remains guarded, however, as challenging economic and geopolitical conditions are limiting a sharper recovery. We continue to balance near-term fiscal discipline with strategic investment in our long-term growth initiatives, positioning ADI to capitalize on the extraordinary opportunities that we see ahead. Now I'd like to draw attention to our industrial end market, which is our largest, most diverse, and most profitable business, generating durable revenue streams that last close to two decades, on average. As our business begins to recover from the pandemic's volatility, we're excited about the tremendous long-term growth opportunities of the industrial market. We offer our customers an unparalleled suite of high-performance solutions stretching from antenna to bits, sensor to cloud and nanowatts to kilowatts. Our extensive technology portfolio, combined with our deep domain expertise and engineering muscle, has enabled us to secure leading positions across the most attractive industrial sectors. Now, with growing digital software and algorithmic capabilities augmenting our cutting-edge analog portfolio, ADI is strongly positioned to solve our customers most difficult challenges in factory and process automation, energy efficiency, secure connectivity and many, many more. To illustrate the power and potential of our industrial franchise, let me share with you a few examples of how our recent innovations are unlocking new revenue streams and positioning us for strong growth in the years ahead. For example, our Instrumentation and Test business, which includes scientific instruments, electronic test and measurement, and automated test equipment is essential to the important scientific and technological advancements of the digital era. Within automated test equipment, for example, our next generation solutions increase channel density and throughput, while reducing energy consumption by up to 30% per system. These are crucial parameters for testing complex, high performance compute GPUs and high bandwidth memory systems for AI. As the AI infrastructure build up remains a priority for global hyperscalers, we expect growth to continue into 2025 and indeed well beyond. Turning now to Aerospace and Defense, which has been our most resilient business during this downturn, ADI's domain expertise and high performance portfolio across orphan microwaves, high speed and precision converters, power and MEMS uniquely positions us to deliver complete edge solutions offering our customers scale, velocity and lower total cost of ownership. As an example, we're building upon our programmable Apollo signal chain platform today to create full software defined RF communications and sensor systems, which has the potential to increase our sound by five times in commercial, defense and aerospace communication systems. Indeed, we see a path to double-digit revenue growth in this sector in 2025, fueled by several high value design wins that are going to production. In Automation, though we've seen a slow recovery to date, we remain strongly confident in its future growth potential as the benefits of increased productivity are ever more clear. Customers are prioritizing enhanced digitalization and IT/OT integration on their factory floors. Their deployments of in-line instrumentation and advanced robotics are driving the need for more sensing, edge processing, secure connectivity, and car management. Within robotics, we're seeing a progression from fixed-arm machines to autonomous and mobile robots to eventually humanoid robots. This evolution creates additional opportunities for a precision signal chain franchise. And sensing, connectivity, and motion-controlled subsystems with fully isolated and efficient power solutions can drive content from hundreds of dollars in robots today to thousands in autonomous and humanoid robots. What is additionally exciting about these advances is their broad applicability beyond factories, such as surgical robots and imaging systems in healthcare. ADI's products have the potential to dramatically improve a surgeon's effectiveness through a more precise surgical experience with lower latency connectivity. Additionally, patients gain the potential benefits of shorter hospital stays and fewer complications. The evolution in robotics is expected to unlock billions of dollars of potential opportunity for a high-performance analog, mixed signal, power connectivity, and sensing solutions. We see the potential for a doubling of our robotics revenue in the years ahead. Turning now to Energy Transmission and Distribution, our customers are modernizing and digitalizing the electrical grid to respond to exponentially accelerating energy demand driven in part by the proliferation of electric transportation and rapid AI adoption. This process is resulting in a grid that is distributed dynamic and bidirectional, a paradigm shift from the past model of linear stable supply. We're working with traditional suppliers and disruptors to enable the necessary intelligence for the new grid from decentralized power plants to the distribution edge. We're leveraging our analog and algorithm capabilities in cutting-edge energy monitoring and management solutions. Additionally, our battery management technology increases capacity and improves energy utilization in the grid's renewable energy storage systems. This reimagined intelligent grid of the future has the potential to expand our return by over $10 billion and creates tailwinds for our energy franchise for many years to come. Given the synergies across our industrial portfolio, our pace of innovation and the emergent signs of market recovery, we're optimistic for our industrial business that has turned the corner and ‘25 will be a robust growth year. So in closing, our investments in high-performance analog solutions are enabling us to intersect with and leverage the numerous concurrent secular trends that transcend the business cycle and will propel us into the future. Our commitment to our customers' success and to impactful innovation will be the path that carries us there, ultimately increasing long-term shareholder value. And so with that, I'm going to turn it over to Rich, who'll take you through the numbers.
Richard Puccio : Thank you, Vince. And let me add my welcome to our third quarter earnings call. Third quarter revenue of $2.31 billion came in above the midpoint of our outlook, finishing up 7% sequentially and down 25% year-over-year. Industrial represented 46% of revenue in the third quarter, finishing up 6% sequentially and down 37% year-over-year. Every major application increased sequentially except for automation, which declined at a much slower pace than it had in previous quarters. Automotive represented 29% of revenue, finishing flat sequentially and down 8% year-over-year. We saw continued double-digit growth year-over-year for our industry-leading connectivity and functionally safe power platforms. Conversely, automotive production cuts are extending inventory digestion across customers, particularly impacting our legacy automotive and electrification businesses. Communications represented 12% of revenue, finishing up 10% sequentially and down 26% year-over-year. Slowing customer inventory digestion enabled both wireless and wireline growth sequentially. And lastly, Consumer represented 14% of revenue, finishing up 29% sequentially and increased year-over-year for the first time since 2022. We saw diversified growth across applications with notable strength in portables and gaming. Now let's move from the top line to the rest of the P&L. Third quarter gross margin was 67.9%, up 120 basis points sequentially, driven by higher revenue, higher utilization and favorable mix. Operating expenses in the quarter were $619 million, up modestly sequentially, driven primarily by higher variable compensation. Operating margin of 41.2% exceeded the high end of our outlook. Nonoperating expenses finished at $70 million and the tax rate for the quarter was 10.8%. The net result was EPS of $1.58, which finished near the high end of our outlook. Our financial position is solid and I'd like to call out a few items from our balance sheet and cash flow statement. We ended Q3 with more than $2.5 billion of cash and short-term investments and a net leverage ratio of 1.2. Inventory decreased $51 million sequentially and days declined to 178 from 192. As planned, we reduced channel inventory further this quarter with weeks ending near the low end of our 7 to 8 week target. Operating cash flow for the quarter and trailing 12-month was $0.9 billion and $4 billion respectively. CapEx for the quarter and trailing 12-month was $154 million and $1 billion respectively. For fiscal ‘24, CapEx is tracking to our $700 million plan, which is down roughly 45% versus 2023 as our hybrid manufacturing investment cycle tapers. Not included in these figures are the anticipated benefits from both the European and U.S. CHIPS Act. During the last 12 months, we generated $2.9 billion of free cash flow or 30% of revenue. Over this same time period, we have returned $2.8 billion via dividends and share repurchases. As a reminder, our strategy is to return 100% of our free cash flow to our shareholders over the long term. Now I'll turn to the fourth quarter outlook. Revenue is expected to be $2.4 billion plus or minus $100 million, up 4% sequentially at the midpoint. We expect sell through to be roughly equal to sell in this quarter. At the midpoint on a sequential basis, we expect industrial and consumer to increase, communications to be flattish and automotive to decrease. Operating margin is expected to be 41% plus or minus 100 basis points. Our tax rate is expected to be between 11% and 13% and based on these inputs, EPS is expected to be $1.63 plus or minus $0.10. In closing, our third quarter results and fourth quarter outlook support our view that we have passed this cycle's trough. However, challenging economic and geopolitical conditions are limiting a faster demand recovery. I will now give it back to Mike for Q&A.
Michael Lucarelli : Thanks, Rich. Let's get to our Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow -up question, please requeue and we'll take your question if time allows. With that, we have our first question, please.
Operator: [Operator Instructions] Our first question comes from Tore Svanberg with Stifel.
Tore Svanberg: Yes, thank you so much. Great to see the turn here. Vince, could you maybe elaborate a little bit more on this sort of mixed environment, right? Because inventories have bottomed, access to inventories have bottom, at the same time end demand seems to be kind of mixed. So, as you navigate through this period, could you elaborate a little bit on your visibility, how's backlog trending? Are you finally starting to see new products ramping more into production? Because these are typical signals that you want to see at the beginning of a new cycle.
Vincent Roche: Yes, thanks, Tore. Well, I'd say first and foremost, we run this company on POS signals. That's how we plan our production, how we run the company operationally. So, we pay very, very close attention to what's happening in terms of the end market demand. And my confidence has increased since last quarter that indeed 2Q was the cyclical bottom. We've exited 3Q with very, very lean channel inventory. We've taken inventory of our own balance sheet though. We're positioned with a very, very healthy backlog of inventory on our own balance sheet so that the anticipated demand upsurge as we expect in 2025 were very, very well equipped and ready to meet that. So foray in the fourth quarter, as we've said, we expect to see continued sequential growth. And indeed, we'll also see, I think, particularly in the industrial area, continued improvement on customer inventory levels. So, look, it's all the whole recovery, the ramp of the recovery will depend on the macro situation. But nonetheless, given the design wins, we've a record design win pipeline in the company. So we're facing many, many secular tailwinds with a very strong pipeline, a very, very good supply line, and with a very, very lean inventory on the customer's balance sheet. So that gives me the optimism, Tore, that we're very, very well positioned coming into the new year.
Operator: Our next question comes from Joseph Moore with Morgan Stanley.
Joseph Moore: Yes, thank you. My question is on the trajectory of automotive versus industrial. It seems like automotive entered into an inventory correction a little bit later, and so far, has been much less severe. I guess you sort of talked about some ongoing headwinds in that space. Can you just talk about what overall drawdown might you expect in automotive and where are we in customers kind of growing down safety stock inventory
Richard Puccio : So, Joe, this is Rich, and I'll take a crack at that one. So, I'll just level set a little bit from our perspective. And what we're seeing in the market cars continue to become more electric and software-defined, which is also driving our semi-content growth, largely trying to address increased battery densities, more sensors displays. And we do expect that is going to be a long-term tailwind to our business. However, and this is where we're starting to see some of the pullback. The vehicle market has softened in the near-term. We're seeing our customers pull back on their production. And at this point, we're seeing them start to choose to burn off some inventory. So we are seeing that, right? The softness is evidence in our results. Auto has been down year-over-year for two straight quarters and we expect it will be down again in 4Q. And from a bookings perspective, we did see a decline in bookings in auto. In particular, we've seen inventory digestion in our legacy auto and in our BMS portfolios. And we expect that's going to continue into at least the fourth quarter, particularly when you consider the challenging purchasing environment that currently exists for customers. However, to your question around the peak to trough unless our returns to pandemic levels, we don't see the peak to trough being nearly as dramatic as we saw in our other end markets. The underlying secular growth trends that I described driving higher semi content. Also, we've continued to see more penetration and value capture across all vehicle types, whether it's ICE, plug-in hybrid of electric or full electric in the fastest growing applications. If you think about that, ADAS, digital cockpit and electrification. So we will be down, but we don't expect that the cycle depth to be as severe as we saw, for example, in industrial.
Joseph Moore: Great, thank you very much. And I guess as a follow-up, are you seeing that behavior any different regionally? Is the China automotive market different than the western markets in terms of where they are?
Vincent Roche: No, I'll say overall, it's pretty unanimous across all markets. I'd say China, all of us did okay. We talked about some design and branding there, so that's helping offset some of the softness. But it's an overall comment, auto is a bit weaker today than it was 90 days ago, whether it's North America, Europe or Asia.
Operator: Our next question comes from Vivek Arya with Bank of America Securities.
Vivek Arya: Thanks for taking my question. Vince, glad to hear about your optimism about turning the cyclical corner. Do you think the environment allows for sequential growth to continue into Q1? Seems like industrial could grow, autos, I'm not sure, given some of the bookings commentary. And consumer tends to be down seasonally. So just conceptually, how should we model the shape of this recovery into Q1? Thank you.
Vincent Roche: Yes, well, at this point it's hard to call, given that the environment is still a little, let's say, a bit of disequilibrium, but I think generally speaking, we would probably expect to see a bit of a seasonal decline in the first quarter, and then a bounce back in the second, and I think that's the sentiment, but overall I maintain my outlook that we will see a brisk growth year in ‘25.
Richard Puccio : And then I'll help you out a little bit on the seasonality question. It's been a few years now since we've seen seasonal trends in our business. You're right. If you look back over the past 10, 15 years for ADI, consumers down 10%-plus sequentially in 1Q, and the BV markets of industrial, auto, and comms are down low single digits, as Vince said, there's probably no belief today that we'd be any better than seasonal given where we are today, but we'll update you in 90 days of how we feel about 1Q.
Vincent Roche: Yes. I think the big modulator for us will be what happens in industry in particular, and what I can tell you is that the various C-suite conversations I've had with our industrial customers would suggest that their optimism is also strong for ‘25.
Operator: Our next question comes from Timothy Arcuri with UBS.
Timothy Arcuri: Thanks a lot. I just wanted to ask on that answer. So you were above seasonal in fiscal Q3 or above seasonal in fiscal Q4. Sounds like you're not willing to commit that you're going to be above seasonal in fiscal Q1. The street's modeling like 5% or 6% above seasonal for fiscal Q1. Was there something that happened in bookings? Did bookings like slow in the last couple of weeks or the last month or something to make you not want to commit to the fact that fiscal Q1 would be above seasonal or just that it's 90 days away and you just don't want to comment on it? Thanks.
Vincent Roche: I'll start out on the street expectations and then Rich talk a little about bookings. We never guided 1Q. I think the street makes up -- the street expectation for 1Q. I think the street is of everyone better than seasonal for a calendar 4Q or a fiscal 1Q. I would hope of a snapback. I would say, yes, there are things that have changed in 90 days, but we're optimistic about ‘25 and full year. We just don't know if it's above seasonal in that outlook for a good year in ‘25. I'll pass it to Rich to go through some of the bookings dynamics.
Richard Puccio : Yes, so from a bookings perspective up until Q2, as we talked about, we'd seen three straight quarters of broad-based bookings improvement. However, Q3 was different. We saw continued bookings growth for industrial, consumer, and communications, but we did see automotive orders decline, which resulted in a modest drop in our total bookings during the quarter. We did still end with a book to bill around parity. If I look at it from a geographic perspective, regionally bookings were the weakest in Europe. Americas was modestly weaker, which offset bookings growth in Asia.
Operator: Our next question comes from Toshiya Hari from Goldman Sachs.
Toshiya Hari: Hey, good morning. Thanks for taking the question. It was good to see inventory on your balance sheet come down again, and you guys spoke to channel inventory coming down as well. As you look forward, what are your thoughts on utilization rates internally? How are you engaging with your foundry partners, and what's embedded in your October quarter outlook as it pertains to the channel? Thank you.
Richard Puccio : So, as I noted in the last call, we said both utilization and, in fact, gross margins had bottomed in Q2, and that is proving to be true. From an inventory in the channel perspective, the expectation is we will ship to end demand. We are currently at the very low end of our range in the channel at seven to eight weeks. And I think we've mentioned previously if we saw continued improvements, we would start shipping to end demand. So we will do that in the fourth quarter.
Toshiya Hari: Thank you.
Vincent Roche: Obviously, when it comes to the balance, we have a hybrid manufacturing system which enables us to keep utilization rates as high as possible internally, and when our factories run out of capacity, then we have lots of choices externally for silicon capacity. So obviously, we've got a lot of inventory on the balance sheet, and our factories are well capable of improving utilization rates as the demand continues to improve over the coming quarters.
Toshiya Hari: As a quick follow-up, I think your internal utilization rates last quarter were in the mid-50s, if I'm not mistaken. Are you at or above 60% at this point, or if you can comment on that.
Richard Puccio : We have to be -- given our look at the utilization towards as we give the rate, I would say there were lower last score to move in higher here in 3Q and 4Q, and there were well off the normal level, they're all called 85% to 90% utilization.
Toshiya Hari: Got it, thank you.
Richard Puccio : And then I'll give you some context -- I'll give you some little context. What does this mean as utilization ramp? What does that mean for gross margins? If you look at the decline of gross margins over the past year or so, about half the decline relates to utilization, the other half relates to mix. So you can see as you listen, pick up what that means for gross margin expansion.
Operator: Our next question comes from Stacy Rasgon with Bernstein Research
Stacy Rasgon: Hi, guys. Thanks for taking my question. I was hoping you could give us a little more granularity on the segment guide for next quarter. And then you said industrial, and I think consumer up and auto down. Any more for the color, like is consumer usually up, is it up double digits, is industrial up mid-single, auto down by low single, like any further color you could give us on the segments would be helpful.
Vincent Roche: Sure, Stacy, I'll grab that one. Yes, so let's start with consumer. You're right, consumer's up about double digits, about 10% or so embedded in our outlook. Industrial's had another also solid growth quarter, probably high single digits sequentially. We had cases about flattish plus minus, depending on kind of how things go here, and although the weak market as we discussed and hit a little bit earlier on the call, probably down low single digits sequentially.
Stacy Rasgon: Got it. That's helpful. If I could have a quick follow up, just how are you thinking about OpEx growth in the next quarter? It was pretty well under control this quarter. Is there anything that drives that up? Like what do you think about the OpEx trends as we're going to the end of the year?
Richard Puccio : So Stacy, I'll take that one. So obviously we exceeded the high end of our outlook in the third quarter, given the beat on gross margin and revenue as well as our continued cost management. Our Q4 guide obviously does imply a modest margin contraction sequentially despite our expectation for higher revenue and gross margin. The main driver of that is our increase for merit increases that will go into effect during the fourth quarter. So that will be a downward pressure as we head into the fourth quarter.
Vincent Roche: I mean, the big margin on our OpEx, Stacey, is obviously the bonus. And that obviously with declining profit and revenue over the past several quarters, that dropped accordingly. Now, with increase, with growth in revenue and improvement in profitability that will obviously increase. But that's self-funding, so to speak.
Stacy Rasgon: Got it. How much do the OpEx go up then?
Vincent Roche: For our fourth quarter outlook, I’d say sequentially increase in our OpEx around 5%.
Operator: Our next question comes from Christ Danley with Citigroup.
Christopher Danley: Thanks guys. First, just a little clarification on inventory in the auto market. Vince, I said it, I think at the beginning you talked about inventory is very lean out there, but then you're also saying that there's inventory digestion going on in the automotive market. Can you just expand on that a little bit?
Richard Puccio : Dan, I'll grab that, and then Vince, talk about the overall customer inventory. Yes, I think every market spawned in different cases of inventory digestion. We feel good about industrial consumer comms have really normalized inventory levels. There are pockets on the auto side that's still, I'll call it digesting. I mean, production levels have been cut over the past quarter, whether it's an ICE car or an EV car. That impact inventory levels and desire to hold inventory on their balance sheets. From that standpoint, Chris, I don't know, Vince, if you have anything to add.
Vincent Roche: I think, Chris, overall, we've seen the worst is behind us, I think, in the industrial consumer and comms market. But automotive, I think, is a sector where we will see some inventory digestion issues into at least the early part of 2025.
Christopher Danley: Great. Thanks. That's helpful. And then just a quick clarification on industrial. How would you characterize your, I guess, booking/ visibility on the industrial market now versus three months ago? Is it roughly the same, or has it improved a little bit?
Richard Puccio : Hey, Chris, it's Rich. I would say visibility is pretty consistent. And as we talked about, we're seeing continuing growth sequentially across all of the sub-elements of industrial with the exception of automation, which we are seeing improvements, but not yet seeing growth.
Operator: Our next question comes from Harlan Sur with JPMorgan.
Harlan Sur : Good morning. Thanks for taking my question. So for fiscal ‘23, China domestic consumption, I think was about 18% of their total revenues, it was the worst performing geography. Last couple of quarters where bookings in China have been growing sequentially. Did that translate into sequential revenue growth out of the region in the July quarter? And then it looks like orders from the China region grew sequentially in July. How are they trending so far quarter-to-date? Are you still seeing sort of positive signs out of this region?
Vincent Roche: Yes, we continue to see strong performance from a bookings perspective in China. We did see double digit growth across industrial, auto and comms being slightly offset by a decrease in consumer. So China does continue to perform well. And our design win and our pipeline there are very strong.
Operator: Our next question comes from Joshua Butler with TD Cowen.
Joshua Butler: Hey, guys, thanks for taking my question. Maybe you can walk through some of the puts and takes into gross margin into the October quarter. Back the envelope, I'm getting to roughly stable sequentially despite the revenue increase and I imagine utilization is improving as well. How much of that is mixed? And in particular, is there any changes in the pricing environment as we get sort of through this digestion into what I would imagine is a more competitive environment. Thank you.
Richard Puccio : Yes. I'd say it's, as we previously mentioned, it is significantly impacted by the favorable mix. Obviously, we get a benefit out of the revenue upside. From a pricing perspective, and I've talked about this before, we continue to see pretty stable pricing, and I do expect that to continue. Obviously, it's different by geography and for big and small customers, but on balance, we are continuing to see stable pricing, and I expect we will see that going forward.
Vincent Roche: Once our products are installed in a particular customer's design, they tend to, in the industrial business, they will stay for decades, and pricing is very, very stable there. Where the pricing, or the competitiveness, is for new sockets, new wins, but nothing is new there. Now, we as a company -- we play in the high end of the game in terms of innovation, service, support, and so on and so forth. So that's the game we play. In the game we will continue to play. We significantly higher ASPs than most. And those ASPs increase with each new generation of product. So I think overall, as Rich said, the pricing environment is stable. And so I don't see that as a headwind on margin.
Michael Lucarelli: Thanks, Josh. I think that's all the time we have for questions today. I thought we had a little more time, but it's August. You guys can go out there and enjoy the weather a bit. So thanks for joining us, all. We look forward to future calls with you guys, and have a great rest of summer.
Vincent Roche: Thank you.
Operator: This concludes today's Analog Devices Conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices ' Third Quarter Fiscal Year 2024 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Kevin. And good morning, everybody. Thanks for joining our third quarter fiscal 2024 conference call. With me on the call today, ADI's CEO and Chair, Vincent Roche; ADI’s CFO, Richard Puccio. For anyone who missed the release, you can find it in relating financial schedules and investor.analog.com. Onto the disclosures, information we're about to discuss includes forward-looking statements which are subject to certain risks and uncertainties as further described in our earnings release and our periodic reports and other materials follow the SEC. Actual results could differ materially from the forward-looking information, as these statements reflect our expectations only as a date of this call. We undertake no obligation to update the statements except as required by law. Revenue, adjusted gross margin, operating and non-operating expenses, operating margin, tax rate, EPS and free cash flow in our comment today will be on non-GAAP basis, which excludes special items. When comparing our results to historic performance. Special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's release. And with that, I'll turn it over to ADI's CEO and Chair, Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thanks very much, Mike, and a very good morning to you all. The stronger demand for a high-performance product portfolio and skillful execution resulted in third quarter revenue of more than $2.3 billion, operating margin north of 41%, and EPS of $1.58, all above the midpoint of our outlook. These favorable results, combined with improved customer inventory levels and order momentum across most of our markets, increase my confidence that our second quarter marked the cyclical bottom for ADI. My optimism remains guarded, however, as challenging economic and geopolitical conditions are limiting a sharper recovery. We continue to balance near-term fiscal discipline with strategic investment in our long-term growth initiatives, positioning ADI to capitalize on the extraordinary opportunities that we see ahead. Now I'd like to draw attention to our industrial end market, which is our largest, most diverse, and most profitable business, generating durable revenue streams that last close to two decades, on average. As our business begins to recover from the pandemic's volatility, we're excited about the tremendous long-term growth opportunities of the industrial market. We offer our customers an unparalleled suite of high-performance solutions stretching from antenna to bits, sensor to cloud and nanowatts to kilowatts. Our extensive technology portfolio, combined with our deep domain expertise and engineering muscle, has enabled us to secure leading positions across the most attractive industrial sectors. Now, with growing digital software and algorithmic capabilities augmenting our cutting-edge analog portfolio, ADI is strongly positioned to solve our customers most difficult challenges in factory and process automation, energy efficiency, secure connectivity and many, many more. To illustrate the power and potential of our industrial franchise, let me share with you a few examples of how our recent innovations are unlocking new revenue streams and positioning us for strong growth in the years ahead. For example, our Instrumentation and Test business, which includes scientific instruments, electronic test and measurement, and automated test equipment is essential to the important scientific and technological advancements of the digital era. Within automated test equipment, for example, our next generation solutions increase channel density and throughput, while reducing energy consumption by up to 30% per system. These are crucial parameters for testing complex, high performance compute GPUs and high bandwidth memory systems for AI. As the AI infrastructure build up remains a priority for global hyperscalers, we expect growth to continue into 2025 and indeed well beyond. Turning now to Aerospace and Defense, which has been our most resilient business during this downturn, ADI's domain expertise and high performance portfolio across orphan microwaves, high speed and precision converters, power and MEMS uniquely positions us to deliver complete edge solutions offering our customers scale, velocity and lower total cost of ownership. As an example, we're building upon our programmable Apollo signal chain platform today to create full software defined RF communications and sensor systems, which has the potential to increase our sound by five times in commercial, defense and aerospace communication systems. Indeed, we see a path to double-digit revenue growth in this sector in 2025, fueled by several high value design wins that are going to production. In Automation, though we've seen a slow recovery to date, we remain strongly confident in its future growth potential as the benefits of increased productivity are ever more clear. Customers are prioritizing enhanced digitalization and IT/OT integration on their factory floors. Their deployments of in-line instrumentation and advanced robotics are driving the need for more sensing, edge processing, secure connectivity, and car management. Within robotics, we're seeing a progression from fixed-arm machines to autonomous and mobile robots to eventually humanoid robots. This evolution creates additional opportunities for a precision signal chain franchise. And sensing, connectivity, and motion-controlled subsystems with fully isolated and efficient power solutions can drive content from hundreds of dollars in robots today to thousands in autonomous and humanoid robots. What is additionally exciting about these advances is their broad applicability beyond factories, such as surgical robots and imaging systems in healthcare. ADI's products have the potential to dramatically improve a surgeon's effectiveness through a more precise surgical experience with lower latency connectivity. Additionally, patients gain the potential benefits of shorter hospital stays and fewer complications. The evolution in robotics is expected to unlock billions of dollars of potential opportunity for a high-performance analog, mixed signal, power connectivity, and sensing solutions. We see the potential for a doubling of our robotics revenue in the years ahead. Turning now to Energy Transmission and Distribution, our customers are modernizing and digitalizing the electrical grid to respond to exponentially accelerating energy demand driven in part by the proliferation of electric transportation and rapid AI adoption. This process is resulting in a grid that is distributed dynamic and bidirectional, a paradigm shift from the past model of linear stable supply. We're working with traditional suppliers and disruptors to enable the necessary intelligence for the new grid from decentralized power plants to the distribution edge. We're leveraging our analog and algorithm capabilities in cutting-edge energy monitoring and management solutions. Additionally, our battery management technology increases capacity and improves energy utilization in the grid's renewable energy storage systems. This reimagined intelligent grid of the future has the potential to expand our return by over $10 billion and creates tailwinds for our energy franchise for many years to come. Given the synergies across our industrial portfolio, our pace of innovation and the emergent signs of market recovery, we're optimistic for our industrial business that has turned the corner and ‘25 will be a robust growth year. So in closing, our investments in high-performance analog solutions are enabling us to intersect with and leverage the numerous concurrent secular trends that transcend the business cycle and will propel us into the future. Our commitment to our customers' success and to impactful innovation will be the path that carries us there, ultimately increasing long-term shareholder value. And so with that, I'm going to turn it over to Rich, who'll take you through the numbers."
},
{
"speaker": "Richard Puccio",
"text": "Thank you, Vince. And let me add my welcome to our third quarter earnings call. Third quarter revenue of $2.31 billion came in above the midpoint of our outlook, finishing up 7% sequentially and down 25% year-over-year. Industrial represented 46% of revenue in the third quarter, finishing up 6% sequentially and down 37% year-over-year. Every major application increased sequentially except for automation, which declined at a much slower pace than it had in previous quarters. Automotive represented 29% of revenue, finishing flat sequentially and down 8% year-over-year. We saw continued double-digit growth year-over-year for our industry-leading connectivity and functionally safe power platforms. Conversely, automotive production cuts are extending inventory digestion across customers, particularly impacting our legacy automotive and electrification businesses. Communications represented 12% of revenue, finishing up 10% sequentially and down 26% year-over-year. Slowing customer inventory digestion enabled both wireless and wireline growth sequentially. And lastly, Consumer represented 14% of revenue, finishing up 29% sequentially and increased year-over-year for the first time since 2022. We saw diversified growth across applications with notable strength in portables and gaming. Now let's move from the top line to the rest of the P&L. Third quarter gross margin was 67.9%, up 120 basis points sequentially, driven by higher revenue, higher utilization and favorable mix. Operating expenses in the quarter were $619 million, up modestly sequentially, driven primarily by higher variable compensation. Operating margin of 41.2% exceeded the high end of our outlook. Nonoperating expenses finished at $70 million and the tax rate for the quarter was 10.8%. The net result was EPS of $1.58, which finished near the high end of our outlook. Our financial position is solid and I'd like to call out a few items from our balance sheet and cash flow statement. We ended Q3 with more than $2.5 billion of cash and short-term investments and a net leverage ratio of 1.2. Inventory decreased $51 million sequentially and days declined to 178 from 192. As planned, we reduced channel inventory further this quarter with weeks ending near the low end of our 7 to 8 week target. Operating cash flow for the quarter and trailing 12-month was $0.9 billion and $4 billion respectively. CapEx for the quarter and trailing 12-month was $154 million and $1 billion respectively. For fiscal ‘24, CapEx is tracking to our $700 million plan, which is down roughly 45% versus 2023 as our hybrid manufacturing investment cycle tapers. Not included in these figures are the anticipated benefits from both the European and U.S. CHIPS Act. During the last 12 months, we generated $2.9 billion of free cash flow or 30% of revenue. Over this same time period, we have returned $2.8 billion via dividends and share repurchases. As a reminder, our strategy is to return 100% of our free cash flow to our shareholders over the long term. Now I'll turn to the fourth quarter outlook. Revenue is expected to be $2.4 billion plus or minus $100 million, up 4% sequentially at the midpoint. We expect sell through to be roughly equal to sell in this quarter. At the midpoint on a sequential basis, we expect industrial and consumer to increase, communications to be flattish and automotive to decrease. Operating margin is expected to be 41% plus or minus 100 basis points. Our tax rate is expected to be between 11% and 13% and based on these inputs, EPS is expected to be $1.63 plus or minus $0.10. In closing, our third quarter results and fourth quarter outlook support our view that we have passed this cycle's trough. However, challenging economic and geopolitical conditions are limiting a faster demand recovery. I will now give it back to Mike for Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Rich. Let's get to our Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have a follow -up question, please requeue and we'll take your question if time allows. With that, we have our first question, please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from Tore Svanberg with Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Yes, thank you so much. Great to see the turn here. Vince, could you maybe elaborate a little bit more on this sort of mixed environment, right? Because inventories have bottomed, access to inventories have bottom, at the same time end demand seems to be kind of mixed. So, as you navigate through this period, could you elaborate a little bit on your visibility, how's backlog trending? Are you finally starting to see new products ramping more into production? Because these are typical signals that you want to see at the beginning of a new cycle."
},
{
"speaker": "Vincent Roche",
"text": "Yes, thanks, Tore. Well, I'd say first and foremost, we run this company on POS signals. That's how we plan our production, how we run the company operationally. So, we pay very, very close attention to what's happening in terms of the end market demand. And my confidence has increased since last quarter that indeed 2Q was the cyclical bottom. We've exited 3Q with very, very lean channel inventory. We've taken inventory of our own balance sheet though. We're positioned with a very, very healthy backlog of inventory on our own balance sheet so that the anticipated demand upsurge as we expect in 2025 were very, very well equipped and ready to meet that. So foray in the fourth quarter, as we've said, we expect to see continued sequential growth. And indeed, we'll also see, I think, particularly in the industrial area, continued improvement on customer inventory levels. So, look, it's all the whole recovery, the ramp of the recovery will depend on the macro situation. But nonetheless, given the design wins, we've a record design win pipeline in the company. So we're facing many, many secular tailwinds with a very strong pipeline, a very, very good supply line, and with a very, very lean inventory on the customer's balance sheet. So that gives me the optimism, Tore, that we're very, very well positioned coming into the new year."
},
{
"speaker": "Operator",
"text": "Our next question comes from Joseph Moore with Morgan Stanley."
},
{
"speaker": "Joseph Moore",
"text": "Yes, thank you. My question is on the trajectory of automotive versus industrial. It seems like automotive entered into an inventory correction a little bit later, and so far, has been much less severe. I guess you sort of talked about some ongoing headwinds in that space. Can you just talk about what overall drawdown might you expect in automotive and where are we in customers kind of growing down safety stock inventory"
},
{
"speaker": "Richard Puccio",
"text": "So, Joe, this is Rich, and I'll take a crack at that one. So, I'll just level set a little bit from our perspective. And what we're seeing in the market cars continue to become more electric and software-defined, which is also driving our semi-content growth, largely trying to address increased battery densities, more sensors displays. And we do expect that is going to be a long-term tailwind to our business. However, and this is where we're starting to see some of the pullback. The vehicle market has softened in the near-term. We're seeing our customers pull back on their production. And at this point, we're seeing them start to choose to burn off some inventory. So we are seeing that, right? The softness is evidence in our results. Auto has been down year-over-year for two straight quarters and we expect it will be down again in 4Q. And from a bookings perspective, we did see a decline in bookings in auto. In particular, we've seen inventory digestion in our legacy auto and in our BMS portfolios. And we expect that's going to continue into at least the fourth quarter, particularly when you consider the challenging purchasing environment that currently exists for customers. However, to your question around the peak to trough unless our returns to pandemic levels, we don't see the peak to trough being nearly as dramatic as we saw in our other end markets. The underlying secular growth trends that I described driving higher semi content. Also, we've continued to see more penetration and value capture across all vehicle types, whether it's ICE, plug-in hybrid of electric or full electric in the fastest growing applications. If you think about that, ADAS, digital cockpit and electrification. So we will be down, but we don't expect that the cycle depth to be as severe as we saw, for example, in industrial."
},
{
"speaker": "Joseph Moore",
"text": "Great, thank you very much. And I guess as a follow-up, are you seeing that behavior any different regionally? Is the China automotive market different than the western markets in terms of where they are?"
},
{
"speaker": "Vincent Roche",
"text": "No, I'll say overall, it's pretty unanimous across all markets. I'd say China, all of us did okay. We talked about some design and branding there, so that's helping offset some of the softness. But it's an overall comment, auto is a bit weaker today than it was 90 days ago, whether it's North America, Europe or Asia."
},
{
"speaker": "Operator",
"text": "Our next question comes from Vivek Arya with Bank of America Securities."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question. Vince, glad to hear about your optimism about turning the cyclical corner. Do you think the environment allows for sequential growth to continue into Q1? Seems like industrial could grow, autos, I'm not sure, given some of the bookings commentary. And consumer tends to be down seasonally. So just conceptually, how should we model the shape of this recovery into Q1? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yes, well, at this point it's hard to call, given that the environment is still a little, let's say, a bit of disequilibrium, but I think generally speaking, we would probably expect to see a bit of a seasonal decline in the first quarter, and then a bounce back in the second, and I think that's the sentiment, but overall I maintain my outlook that we will see a brisk growth year in ‘25."
},
{
"speaker": "Richard Puccio",
"text": "And then I'll help you out a little bit on the seasonality question. It's been a few years now since we've seen seasonal trends in our business. You're right. If you look back over the past 10, 15 years for ADI, consumers down 10%-plus sequentially in 1Q, and the BV markets of industrial, auto, and comms are down low single digits, as Vince said, there's probably no belief today that we'd be any better than seasonal given where we are today, but we'll update you in 90 days of how we feel about 1Q."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think the big modulator for us will be what happens in industry in particular, and what I can tell you is that the various C-suite conversations I've had with our industrial customers would suggest that their optimism is also strong for ‘25."
},
{
"speaker": "Operator",
"text": "Our next question comes from Timothy Arcuri with UBS."
},
{
"speaker": "Timothy Arcuri",
"text": "Thanks a lot. I just wanted to ask on that answer. So you were above seasonal in fiscal Q3 or above seasonal in fiscal Q4. Sounds like you're not willing to commit that you're going to be above seasonal in fiscal Q1. The street's modeling like 5% or 6% above seasonal for fiscal Q1. Was there something that happened in bookings? Did bookings like slow in the last couple of weeks or the last month or something to make you not want to commit to the fact that fiscal Q1 would be above seasonal or just that it's 90 days away and you just don't want to comment on it? Thanks."
},
{
"speaker": "Vincent Roche",
"text": "I'll start out on the street expectations and then Rich talk a little about bookings. We never guided 1Q. I think the street makes up -- the street expectation for 1Q. I think the street is of everyone better than seasonal for a calendar 4Q or a fiscal 1Q. I would hope of a snapback. I would say, yes, there are things that have changed in 90 days, but we're optimistic about ‘25 and full year. We just don't know if it's above seasonal in that outlook for a good year in ‘25. I'll pass it to Rich to go through some of the bookings dynamics."
},
{
"speaker": "Richard Puccio",
"text": "Yes, so from a bookings perspective up until Q2, as we talked about, we'd seen three straight quarters of broad-based bookings improvement. However, Q3 was different. We saw continued bookings growth for industrial, consumer, and communications, but we did see automotive orders decline, which resulted in a modest drop in our total bookings during the quarter. We did still end with a book to bill around parity. If I look at it from a geographic perspective, regionally bookings were the weakest in Europe. Americas was modestly weaker, which offset bookings growth in Asia."
},
{
"speaker": "Operator",
"text": "Our next question comes from Toshiya Hari from Goldman Sachs."
},
{
"speaker": "Toshiya Hari",
"text": "Hey, good morning. Thanks for taking the question. It was good to see inventory on your balance sheet come down again, and you guys spoke to channel inventory coming down as well. As you look forward, what are your thoughts on utilization rates internally? How are you engaging with your foundry partners, and what's embedded in your October quarter outlook as it pertains to the channel? Thank you."
},
{
"speaker": "Richard Puccio",
"text": "So, as I noted in the last call, we said both utilization and, in fact, gross margins had bottomed in Q2, and that is proving to be true. From an inventory in the channel perspective, the expectation is we will ship to end demand. We are currently at the very low end of our range in the channel at seven to eight weeks. And I think we've mentioned previously if we saw continued improvements, we would start shipping to end demand. So we will do that in the fourth quarter."
},
{
"speaker": "Toshiya Hari",
"text": "Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Obviously, when it comes to the balance, we have a hybrid manufacturing system which enables us to keep utilization rates as high as possible internally, and when our factories run out of capacity, then we have lots of choices externally for silicon capacity. So obviously, we've got a lot of inventory on the balance sheet, and our factories are well capable of improving utilization rates as the demand continues to improve over the coming quarters."
},
{
"speaker": "Toshiya Hari",
"text": "As a quick follow-up, I think your internal utilization rates last quarter were in the mid-50s, if I'm not mistaken. Are you at or above 60% at this point, or if you can comment on that."
},
{
"speaker": "Richard Puccio",
"text": "We have to be -- given our look at the utilization towards as we give the rate, I would say there were lower last score to move in higher here in 3Q and 4Q, and there were well off the normal level, they're all called 85% to 90% utilization."
},
{
"speaker": "Toshiya Hari",
"text": "Got it, thank you."
},
{
"speaker": "Richard Puccio",
"text": "And then I'll give you some context -- I'll give you some little context. What does this mean as utilization ramp? What does that mean for gross margins? If you look at the decline of gross margins over the past year or so, about half the decline relates to utilization, the other half relates to mix. So you can see as you listen, pick up what that means for gross margin expansion."
},
{
"speaker": "Operator",
"text": "Our next question comes from Stacy Rasgon with Bernstein Research"
},
{
"speaker": "Stacy Rasgon",
"text": "Hi, guys. Thanks for taking my question. I was hoping you could give us a little more granularity on the segment guide for next quarter. And then you said industrial, and I think consumer up and auto down. Any more for the color, like is consumer usually up, is it up double digits, is industrial up mid-single, auto down by low single, like any further color you could give us on the segments would be helpful."
},
{
"speaker": "Vincent Roche",
"text": "Sure, Stacy, I'll grab that one. Yes, so let's start with consumer. You're right, consumer's up about double digits, about 10% or so embedded in our outlook. Industrial's had another also solid growth quarter, probably high single digits sequentially. We had cases about flattish plus minus, depending on kind of how things go here, and although the weak market as we discussed and hit a little bit earlier on the call, probably down low single digits sequentially."
},
{
"speaker": "Stacy Rasgon",
"text": "Got it. That's helpful. If I could have a quick follow up, just how are you thinking about OpEx growth in the next quarter? It was pretty well under control this quarter. Is there anything that drives that up? Like what do you think about the OpEx trends as we're going to the end of the year?"
},
{
"speaker": "Richard Puccio",
"text": "So Stacy, I'll take that one. So obviously we exceeded the high end of our outlook in the third quarter, given the beat on gross margin and revenue as well as our continued cost management. Our Q4 guide obviously does imply a modest margin contraction sequentially despite our expectation for higher revenue and gross margin. The main driver of that is our increase for merit increases that will go into effect during the fourth quarter. So that will be a downward pressure as we head into the fourth quarter."
},
{
"speaker": "Vincent Roche",
"text": "I mean, the big margin on our OpEx, Stacey, is obviously the bonus. And that obviously with declining profit and revenue over the past several quarters, that dropped accordingly. Now, with increase, with growth in revenue and improvement in profitability that will obviously increase. But that's self-funding, so to speak."
},
{
"speaker": "Stacy Rasgon",
"text": "Got it. How much do the OpEx go up then?"
},
{
"speaker": "Vincent Roche",
"text": "For our fourth quarter outlook, I’d say sequentially increase in our OpEx around 5%."
},
{
"speaker": "Operator",
"text": "Our next question comes from Christ Danley with Citigroup."
},
{
"speaker": "Christopher Danley",
"text": "Thanks guys. First, just a little clarification on inventory in the auto market. Vince, I said it, I think at the beginning you talked about inventory is very lean out there, but then you're also saying that there's inventory digestion going on in the automotive market. Can you just expand on that a little bit?"
},
{
"speaker": "Richard Puccio",
"text": "Dan, I'll grab that, and then Vince, talk about the overall customer inventory. Yes, I think every market spawned in different cases of inventory digestion. We feel good about industrial consumer comms have really normalized inventory levels. There are pockets on the auto side that's still, I'll call it digesting. I mean, production levels have been cut over the past quarter, whether it's an ICE car or an EV car. That impact inventory levels and desire to hold inventory on their balance sheets. From that standpoint, Chris, I don't know, Vince, if you have anything to add."
},
{
"speaker": "Vincent Roche",
"text": "I think, Chris, overall, we've seen the worst is behind us, I think, in the industrial consumer and comms market. But automotive, I think, is a sector where we will see some inventory digestion issues into at least the early part of 2025."
},
{
"speaker": "Christopher Danley",
"text": "Great. Thanks. That's helpful. And then just a quick clarification on industrial. How would you characterize your, I guess, booking/ visibility on the industrial market now versus three months ago? Is it roughly the same, or has it improved a little bit?"
},
{
"speaker": "Richard Puccio",
"text": "Hey, Chris, it's Rich. I would say visibility is pretty consistent. And as we talked about, we're seeing continuing growth sequentially across all of the sub-elements of industrial with the exception of automation, which we are seeing improvements, but not yet seeing growth."
},
{
"speaker": "Operator",
"text": "Our next question comes from Harlan Sur with JPMorgan."
},
{
"speaker": "Harlan Sur",
"text": "Good morning. Thanks for taking my question. So for fiscal ‘23, China domestic consumption, I think was about 18% of their total revenues, it was the worst performing geography. Last couple of quarters where bookings in China have been growing sequentially. Did that translate into sequential revenue growth out of the region in the July quarter? And then it looks like orders from the China region grew sequentially in July. How are they trending so far quarter-to-date? Are you still seeing sort of positive signs out of this region?"
},
{
"speaker": "Vincent Roche",
"text": "Yes, we continue to see strong performance from a bookings perspective in China. We did see double digit growth across industrial, auto and comms being slightly offset by a decrease in consumer. So China does continue to perform well. And our design win and our pipeline there are very strong."
},
{
"speaker": "Operator",
"text": "Our next question comes from Joshua Butler with TD Cowen."
},
{
"speaker": "Joshua Butler",
"text": "Hey, guys, thanks for taking my question. Maybe you can walk through some of the puts and takes into gross margin into the October quarter. Back the envelope, I'm getting to roughly stable sequentially despite the revenue increase and I imagine utilization is improving as well. How much of that is mixed? And in particular, is there any changes in the pricing environment as we get sort of through this digestion into what I would imagine is a more competitive environment. Thank you."
},
{
"speaker": "Richard Puccio",
"text": "Yes. I'd say it's, as we previously mentioned, it is significantly impacted by the favorable mix. Obviously, we get a benefit out of the revenue upside. From a pricing perspective, and I've talked about this before, we continue to see pretty stable pricing, and I do expect that to continue. Obviously, it's different by geography and for big and small customers, but on balance, we are continuing to see stable pricing, and I expect we will see that going forward."
},
{
"speaker": "Vincent Roche",
"text": "Once our products are installed in a particular customer's design, they tend to, in the industrial business, they will stay for decades, and pricing is very, very stable there. Where the pricing, or the competitiveness, is for new sockets, new wins, but nothing is new there. Now, we as a company -- we play in the high end of the game in terms of innovation, service, support, and so on and so forth. So that's the game we play. In the game we will continue to play. We significantly higher ASPs than most. And those ASPs increase with each new generation of product. So I think overall, as Rich said, the pricing environment is stable. And so I don't see that as a headwind on margin."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Josh. I think that's all the time we have for questions today. I thought we had a little more time, but it's August. You guys can go out there and enjoy the weather a bit. So thanks for joining us, all. We look forward to future calls with you guys, and have a great rest of summer."
},
{
"speaker": "Vincent Roche",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices Conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 2 | 2,024 | 2024-05-22 10:00:00 | Operator: Good morning, and welcome to the Analog Devices' Second Quarter Fiscal Year 2024 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli: Thank you, Judy. And good morning, everybody. Thanks for joining our second quarter fiscal 2024 conference call. With me on the call today, ADI's CEO and Chair, Vincent Roche; and ADI’s CFO, Richard Puccio. For anyone who missed the release, you can find it in relating financial schedules and investor.analog.com. Onto the disclosures, information we're about to discuss includes forward-looking statements which are subject to certain risks and uncertainties as further described in our earnings release and our periodic reports and other materials follow the SEC. Actual results could differ materially from the forward-looking information, as these statements reflect our expectations only as a date of this call. We undertake no obligation to update the statements except as required by law. Revenue, adjusted gross margin, operating and non-operating expenses, operating margin, tax rate, EPS and free cash flow in our comment today will be on non-GAAP basis, which excludes special items. When comparing our results to historic performance. Special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's release. And with that, I'll turn it over to ADI's CEO and Chair, Vince?
Vincent Roche: Thank you very much, Mike. Good morning, and a big welcome to you all. In the second quarter, a strong focus execution resulted in revenue of $2.16 billion, with profitability and earnings per share finishing above the high-end of our outlook. With 2Q now behind us, we believe, we've passed the low point of this cycle. Notably, global manufacturing PMIs, which are highly correlated with our core business are improving, customer inventories are stabilizing and our bookings have improved for a third consecutive quarter. Our growing optimism remains guarded, however, as short-term economic and geopolitical uncertainty persists. As such, we will continue to manage the near-term with great discipline, as we fund and execute against our longer-term strategic priorities to drive increasing levels of value for all of our stakeholders. With that framing, I'd like to share some examples with you of how we are continuing to strengthen ADI's high performance franchise across all markets and creating unique growth drivers that will be additive to what we hope will be a strong cyclical recovery. For example, in healthcare, we have exciting wins in areas such as the rapidly expanding surgical robotics market, where the performance of our precision signal processing and connectivity solutions is critical. In the fast growing, continuous glucose monitoring space, we've won multiple opportunities across several customers. Our unique digitally enabled analog front end solutions increase the accuracy and power efficiency of sensors and extend battery life from days to weeks. In industrial automation, the growth of the digital factory is accelerating upgrades to higher bandwidth, deterministic industrial Ethernet that can support up to 10x the number of edge devices across the factory floor. We believe our leadership position with key customers will create a durable revenue stream, beginning next year that can grow to several hundreds of millions of dollars as deployments ramp over time. Turning to automotive. Our solid performance is being driven by the proliferation of higher content vehicles that use more power management, more connectivity and an increasing number of sensor platforms that open new signal processing opportunities for ADI. The increasing content per vehicle is a pervasive trend across all vehicle types’ combustion engines, hybrids and full EVs. For example, in advanced safety, we've increased our GMSL design wins from 12 to 15 of the top 20 OEMs, and expanded our engagements at two European and one Korean OEM, who intend to deploy our high performance, high bandwidth connectivity solution across a larger share of their fleets. We've also seen strong attach for functionally safe power, which is used with sensors and displays in ADAS systems and recently increased share at the leading global car manufacturer. In electrification, we've expanded our battery management system share at leading Chinese OEMs and more than doubled our BMS share in upcoming European OEM model launches, and two manufacturers intend to deploy our higher content wireless solutions starting next year. Now I'd like to use the rest of my prepared comments today to share our perspective on the role that artificial intelligence is playing and will play at ADI in the future. This technology has clearly reached a tipping point and our AI opportunity spans from sensor to cloud. While we've been adding algorithmic and software intelligence to our products now for decades, we've expanded the scope and pace of our investments in recent years. Today, we are increasingly leveraging AI in and around our products, as well as in our operations to more fully meet our customers' needs and extend our industry leadership. We're deploying AI internally to help to accelerate engineering development, enhance manufacturing efficiency and create a better customer experience. But the majority of our activities are centered around product portfolio innovations that position us to take advantage of AI's enormous potential. We see this business opportunity coming in two distinct waves. The first wave focused on infrastructure is now underway and as we all know is growing very rapidly. In order to tackle the intensified energy and processing demands of AI compute systems, data center customers are investing in new vertical power architectures. As we highlighted previously, our vertical power technology, which can reduce power losses by up to 35% compared to existing architectures is gaining traction with hyperscalers. We continue to leverage our heterogeneous integration expertise to create more efficient, smaller vertical power solutions that deliver more value and enable us to capture more share in this nascent space. Power efficient computing though is just one challenge the AI ecosystem faces. Data must also be transported efficiently, securely and at much, much greater speeds. This is driving wireline customers to upgrade connectivity infrastructure, sparking a transition to 800 gigabit and 1.6 terabit optical modules. At the electro optical interface, our ability to provide high performance solutions that integrate analog, digital and memory in a reduced form factor is indeed a key differentiator. Our high precision controller was recently designed into a 1.6 terabit optical module used in the next gen AI systems of the high performance compute leader. In industrial, AI is fueling extraordinary demand for high bandwidth memory and high performance compute. This in turn is driving a new growth vector for our instrumentation and test business, particularly in SoC and memory test. We are working with key players globally to enable faster digital scan speeds, higher channel density and the improved energy efficiency necessary to scale production of AI systems. The significantly greater amount of ADI content in these systems is positioning our high performance compute and memory test sectors for record revenues in the near to mid-term. The opportunity ahead for ADI is to compound the impact of this first wave by bringing application-specific AI models and high performance compute right down to the physical edge, creating greater system value with added improvements in latency, power efficiency, security and cost. Let me share some examples of how we are working to amplify the second wave. For example, in acoustic systems, we are combining our application specific algorithms with ultra-low energy processing hardware to enrich our audio platform offerings. We are also developing a mixed signal processor with embedded neural networks that enable a system to learn and adapt to the highly variable nature of sound in real time. Excitingly, we have strong traction with multiple customers in this area. Now in the same vein, we're leveraging our rich domain expertise with our growing processing capabilities to enhance our advanced connectivity platform in next generation 5G radios. For example, we've implemented the first AI enabled technology, combining an energy efficient real time neural network with an AI assisted development tool to give customers the ability to solve their linearization challenges in a fraction of the time. In our power management platform, we're using AI to address the arduous challenge of tuning power trees for volatile consumption patterns in data centers. Our solutions reduce complexity for power engineers and compress the time required from weeks to hours, helping to lower costs, and of course, accelerate time to market. The ADI is always operated at the physical edge, where the world's most important real data is born. As multimodal AI becomes more pervasive at the edge and a diversity of sensor types is used to unearth deeper insights, we expect to see an explosion of demand that will accelerate growth for our broad signal chain, as well as power portfolios. In short, ADI's AI future looks bright across the continuum of sensor to cloud. In closing, I'm very proud of how our team has executed in one of the largest downturns the semiconductor industry has seen. More importantly, I've never been more excited about how we are positioned for the future and what it holds for ADI. With that, I'm going to hand it over to Rich.
Richard Puccio: Thank you, Vince. Let me add my welcome to our second quarter earnings call. As a reminder, our first quarter 2024 was a 14 week quarter, so we are going to limit our comparisons this quarter to year-over-year only. Second quarter revenue of $2.16 billion finished above the midpoint of our outlook. This result was down 34% year-over-year. Industrial represented 47% of revenue in the quarter and was down 44% year-over-year. As expected, all applications were impacted by inventory digestion. However, aerospace and defense revenues outperformed broader industrial. Automotive represented 30% of revenue and was down 10% year-over-year. Continued growth in our leading connectivity and functionally safe power franchises balanced broad-based declines elsewhere. Communications represented 11% of revenue and was down 45% year-over-year. Inventory digestion and weaker demand impacted both our wireline and wireless businesses. Lastly, consumer represented 11% of revenue and was down 9% year-over-year with growth in portables, partially offsetting declines across other applications. Now let's move from the top-line to the rest of the P&L. Second quarter gross margin was 66.7%, down sequentially and year-over-year, driven by unfavorable mix, lower revenue and lower utilization as we continue to reduce inventory. Operating expenses in the quarter were $598 million, down significantly year-over-year, driven by lower variable compensation and strong organization wide execution on cost control. Operating margin of 39% exceeded the high end of our outlook. Non-operating expenses finished at $64 million and the tax rate for the quarter was 10.6%. The net result was EPS of $1.40 above the high end of our outlook. Our financial position is solid, and I'd like to call out a few items from our balance sheet and cash flow statement. We ended Q2 with more than $2.3 billion of cash and short-term investments and a net leverage ratio of 1.1. During the quarter, we raised $1.1 billion of debt for general corporate purposes, including upcoming debt maturities. Inventory decreased $74 million sequentially, and days declined to 192 from 201. As planned, we have reduced channel inventory this quarter with weeks ending at approximately eight. Operating cash flow for the quarter and trailing 12 months was $0.8 billion and $4.3 billion respectively. CapEx for the quarter and trailing 12 months was $188 million and $1.2 billion respectively. We continue to expect fiscal '24 CapEx to be roughly $700 million, which is a reduction of approximately 45% versus 2023, as our hybrid manufacturing investment cycle tapers. Not included in these figures are the benefits from both the European and U.S. CHIPS acts. During the last 12 months, we generated $3.1 billion of free cash flow or 29% of revenue. Over the same time period, we have returned roughly 110% of our free cash flow via dividends and share repurchases. As a reminder, our policy is to return 100% of free cash flow to our shareholders over the long-term. Now I'll turn to the third quarter outlook. Revenue is expected to be $2.27 billion plus or minus $100 million, up 5% sequentially at the midpoint. Once again, we expect sell through to be higher than sell in. At the midpoint, we expect all B2B markets to increase sequentially with the fastest growth in industrial, and for consumer to exhibit seasonal strength. Operating margin is expected to be 40% plus or minus 100 basis points. Our tax rate is expected to be between 11% 13%, and based on these inputs, adjusted EPS is expected to be $1.50 plus or minus $0.10. Before passing it back to Mike to begin Q&A, I'll share some final thoughts on our near-term. As Vince indicated, we believe we are at the beginning of a cyclical recovery as our bookings increased throughout the quarter and we exited 2Q with a book-to-bill above parity for the first time in well over a year. No doubt cyclical transitions can be challenging, but they also provide opportunity for outsized business acceleration when approached with a balance of fiscal discipline, smart risk taking and strong execution. ADI has always excelled in these areas and we look forward to driving outstanding value for our stakeholders in the quarters to come. With that, I'll pass it back to Mike for Q&A.
Michael Lucarelli: Thanks, Rich. Let's get to the Q&A session. We ask that you limit yourself to 1 question in order to allow for additional participants on the call this morning. If you have a follow-up question, please re-queue and we'll take your question if time allows. With that, we will have our first question please.
Operator: [Operator Instructions] Our first question comes from the line of Tore Svanberg from Stifel.
Tore Svanberg: Yes. Thank you and congratulations on finding the recovery here. I had a question about the outlook for Q3, specifically in Industrial. I think you indicated that, you expect Industrial to be the strongest performer this quarter. I was hoping you could talk a little bit about what's behind that strength between end market demands, inventory replenishment and if there's any sub-segments within industrial that's driving that outperforming growth?
Richard Puccio: Sure, Tore. This is Rich, and I'll take that one. Industrial obviously is our most diversified and profitable end market, and it's weathered an unprecedented broad-based inventory correction over the past year. Importantly, we expect Q2 was the bottom for industrial and it will grow in the second half starting here in 3Q. Stronger PMIs are supporting the broad-based bookings we've seen for the three consecutive quarters now. As mentioned in the prepared remarks, we are planning to reduce channel inventory further in Q3, which impacts industrial more than any other market. This will be more than a year of under shipping consumptions, one reason we believe inventory headwinds have stabilized for industrial. Given these dynamics and the exciting design wins and AI related tailwinds in our instrumentation and test business, which Vince alluded to, we feel strongly we are at the beginning of the industrial recovery.
Vincent Roche: Yes. I think one other piece of color, Tore, is that, the obviously, the aerospace and defense business is doing well. We've a lot of high prospects for that over the coming years. But I think, in general, geographically, it's been on the upward in terms of demand and across most of the segments, and particularly the ones that Rich pointed out.
Michael Lucarelli: Tore, on the outlook comment, you're right. Just to clarify what we said, of the B2B markets, industrial grow the fastest, consumer will grow faster than industrial in 3Q. If you want to just kind of back it down a little bit, consumer is probably growing about 10% sequentially and industrial is probably closer to mid-single-digits and the other two markets are probably a little bit below that industrial level, but all markets should grow in 3Q.
Operator: Our next question comes from the line of Stacy Rasgon from Bernstein Research.
Stacy Rasgon: Hi, guys. Thanks for taking my question. I wanted to ask about the book-to-bill. It's above one. Is it above one in all the segments, or is it just above one in industrial?
Michael Lucarelli: Yes, sure. It's actually good question. It's above one in all end markets. Not all applications within end markets are above one though. And if you think about the shape of that bookings throughout the quarter, we talked about last earnings call, bookings improved. It started below parity and exit the quarter above parity and that's across all markets and geographies. But again, I reiterate, it's not all applications and we talked a little bit about on the last question about what applications are above one. You can think of some instrumentation, some automation, some aerospace and defense within industrial. Broad-based improvement in bookings across all market geographies is really the main takeaway.
Operator: Our next question comes from the line of Toshiya Hari from Goldman Sachs.
Toshiya Hari: Hi. Good morning. Thank you so much for taking the question. I wanted to ask about the back half of the calendar year and how you're thinking about the shape of the recovery. Vince, you've lived through many cycles. I think typically the same way we underestimate the magnitude of the pace of the downturn, we collectively underestimate the pace of the upturn. I'm curious if you expect this upturn to be similar to past cycles and we kind of follow those patterns or do you see anything in the marketplace today or anything from customers that would indicate something materially different in terms of the shape of the upturn? Thank you.
Vincent Roche: Thanks, Toshiya. Look, first off, we believe we've seen the bottom of the cycle. As Mike indicated, the stronger PMIs that we've seen, particularly in the industrial sector, give us a lot of confidence, and there's a strong correlation between our industrial business, which is about half of the company's total revenue. As we've said now a few times, bookings and backlog coverage for the next several months beyond this quarter would give us strong indications that we expect continued growth during the second half of the year. I'll also point out, I think for 2025, we will have a brisk growth year, that's my sense. We are asked all the time, what's the shape going to be? I don't really know what the exact shape is going to be, but I think we're on the upward trajectory. We have confidence in that across the board.
Operator: Our next question comes from the line of Vivek Arya from Bank of America Securities.
Vivek Arya: Thanks for taking my question. Vince, what is the right way to understand the true change in end demand, if we set aside all the inventory fluctuations? For example, is it worthwhile seeing what the distribution sell through do year-on-year in Q2? What is the assumption for Q3? Does that inform us in any way about can Q4 be seasonal, whatever is the version of seasonality? I'm just trying to see, the right apples-to-apples way of looking at what is end demand doing, setting aside all this inventory noise.
Vincent Roche: Yes. Look, I think it's very hard to answer that question, simply because when history is written, we're going to get the average of what's happened pre-pandemic and post-pandemic. There's been so much ringing in the system, demand overshoot and then demand undershoot. But my sense is, certainly from our perspective, I think we are very well-positioned to be able to capture the upside if things grow faster than we expect. We have got a lot of inventory on the balance sheet. We've kept inventory closer to ADI less downstream. We've got as well a tailwind here from AI, which I think is going to be a multi-year tailwind. We have got that pushing us along. But at the same time, still we've got high interest rates, we've got still relatively high inflation in many places. I think ultimately the size of the recovery and the pace of the recovery will have a strong economic and geopolitical tone to it. But, overall, my sense is, we'll see good growth for the remainder of this year and strong growth in 2025. Beyond that, I think we've got many, many growth drivers that we feel very confident about. We're selling more value into each of our customers and each of our segments. I feel good about the place that semis are in as an industry right now as well in terms of overall demand, as the edge becomes more intelligent and the cloud builds out. But very, very hard to give you an answer on the puts and takes. I mean, the dynamics of the relatively near-term are hard to decode. But what we can tell you is, given where PMIs are at, given where our demand is at, we are in a recovery phase.
Richard Puccio: Vince, I would add to that. While it's impossible to get perfect visibility into our end customer inventory, certainly the signals that we monitor tell us that, customer inventories are much healthier than they were previously as we enter the second half. This is also aided by our belief that, we have been under shipping under consumption for over a year now both in the channel and direct.
Vivek Arya: But that's Quantification, right, of what the sell through has been in the reported quarters year-on-year?
Vincent Roche: Yes. I can help you out there, Vivek. I think your question is kind of what sell in versus sell through. We talked about last year. We talked about reducing the channel inventory by about $100 million. We achieved that in our 2Q. We actually did a little better than that. As you look to 3Q, we'll reduce channel dollars again, but not by that much, not nearly $100 million, much less than $100 million. So, we're getting more normal in the channel as our weeks are coming down into our target range. That normalization is helping some of the growth, but sell through is also increasing in 3Q from 2Q, which is really how we drive the business and look at for indication. As you fast forward to 4Q, if these bookings continue, we don't know. There's no reason to think we won't be more in balance in 4Q from a ship in versus ship out perspective as well, and then we'll see how 1Q goes from there. I think that's kind of the question you're asking is, there's piece Rich talked about and Vince talked about the customer's inventory that's leading out. If you look at us and what we're shipping in the channel that's also normalizing setting us up for a good second half in 2025.
Operator: Our next question comes from the line of Christopher Danley from Citigroup.
Christopher Danley: Can you talk about the gross margin drivers from here? Maybe touch on utilization rates and inventory trends and some of your competitors have talked about pricing returning to historical norms. If that happens, can you still get the gross margins back to the previous peak?
Richard Puccio: Sure. I'll take that one. From a gross margin and utilization perspective, we talked a little bit about this in the first quarter call. We expect both utilization and gross margin bottomed in our Q2. However, we do expect the pace of gross margin expansion in the second half to be modest. Specifically for Q3, we anticipate gross margin a bit above 67%. Looking from here, gross margins expansion is going to be dictated by continued revenue growth, mix of business and utilization. From a balance sheet perspective, since our peak in Q3, we've reduced balance sheet inventory significantly, including over $70 million in Q2. For the third quarter, we expect to reduce inventory again by a lesser amount than in Q2. Overall, we executed pretty strongly against our inventory reduction goals, while mitigating the impact on gross margin, leveraging our dynamic hybrid manufacturing model. One of the things that's been super helpful in protecting us in this trough is the flexibility to swing capacity back into our fabs to help to maintain utilization. We've done that effectively, which is why we called the floor on utilization. I expect that utilizations as the demand continues to increase will start to increase and aid in our margin expansion. From a channel, as Mike mentioned, from a channel perspective, our goal was to reduce by $100 million we achieved. We will reduce an additional amount in Q3 to a lesser degree. Ultimately, we expect that this will get us firmly back into our target range of seven to eight weeks of inventory in the channel.
Vincent Roche: Let me make a comment on the pricing side of things. Across the portfolio, our pricing has been very, very stable and I expect that to continue. Our products are very sticky. The franchise is very, very diversified. It's got lots of long life products in it. We tend to hang on to our sockets for, I think, on an average more than a decade. Clearly, where the competition is for the new sockets. But ADI has the premier innovation system in the analog mixed signal space and we have been pushing that innovation. While others are focused on volume, we're focused on value. I think it's a very, very different approach to things. We are not a commodity supplier at all. So we are not immune to price pressure, but we are more protected I think and we have better meat because of the innovation that we generate. I'll note as well, our ASPs are more than 4x the average. It's our innovation premium that enables us as well to capture more value and to produce the kind of gross margins that that we do.
Operator: Our next question comes from the line of Ross Seymore from Deutsche Bank.
Ross Seymore: Hi, guys. Congrats on marking the trough and turning the corner. Vince, I wanted to ask a bigger picture question. I think it's been four years since you guys bought Maxim and I believe it was four years prior to that with Linear. How are you looking at the M&A environment? Are there any kind of pieces to the puzzle that you wish you had?
Vincent Roche: Thanks, Ross. We've always acquired assets that get ADI ahead of customers' needs. We tend to take a long-term view, get ahead of our customers' needs. Obviously, we've been very, very selective. I will say, Ross, it's fair to say that, in terms of scale and scope of analog high performance franchise, we are where we need to be. Analog mixed signal power, we've got a wonderful power franchise now. But we've been adding, I alluded in my remarks or stated in my prepared remarks that, we have been putting more software content, more digital content and we've also been for about seven or eight years now developing machine learning, neural networking capability. Those are areas where as the world becomes more and more software defined, that is clearly an area where ADI has been organically investing. We've done some more tuck-in type acquisitions as well that help us in that area. But I think right now, we are really focused on making sure that, we fully capture all the synergies, from the revenue synergies from Maxim. But we're always looking, by the way. We're always looking for assets. But clearly I think analog is complete and it's other areas we're now looking.
Operator: Our next question comes from the line of Mark Lipacis from Evercore ISI.
Mark Lipacis: Hi, thanks for taking my question. Vince, it's for you, I think. If you look at your -- if you adjust your revenues for the step function increase that you had for pricing, it looks like on a unit basis, you're shipping 25% below the trend line. I don't think you shipped that far below your long-term trend line since the world financial crisis. At the same time that's happening, you talked about your customers lowering, the supply chain lowering inventories, you are lowering inventories. It seems like there's a real risk that the industry is setting up for you and the industry is setting up for like a really tight supply environment, maybe even as they're early as the end of this year or early next year. I'm wondering, how do you think is there a risk that we enter that kind of a scenario? It seems like your customers never learn about trying to get their inventories right and the order see you on time. Is there something that's changed in your operations that will enable you to adjust to that, what has historically happened, which is your customers overshoot on the downside on their inventories and then come in at the last second when things are really tight?
Vincent Roche: Yes. Well, yes, I think surging demand is a problem of a high quality. And as -- we have virtually 200 days of inventory in our balance sheet, stage primarily at the die socket level. So that gives us a tremendous amount of output that we could bring within weeks to the market. It's a question of packaging and test to a first approximation. Obviously, we're carrying finished goods as well. We have also spent $2.5 billion plus on making sure that we have internal capacity in our 4 internal fabs to be able to meet the demands across the nodes that produce most of the revenue for ADI. We've got great partners, partners like TSMC, for example, who are a critical part of our hybrid manufacturing model. So I think in terms of the ability to be able to address a really short order snapback is good, just given the coverage that we've got with internal inventories. Our distributors are carrying virtually 8 weeks as well as inventory. And then we've got all this new capacity. We've more than doubled the internal capacity on the critical nodes that address every single market that we that we participate in. So I think in terms of manufacturing agility, inventories, we're in good shape.
Operator: Our next question comes from the line of Harlan Sur from JPMorgan.
Harlan Sur: Great job on the quarterly execution. Within your distribution business, it's about 60% of your overall revenues. You can monitor sell-through in near real-time which allows the team to tightly control the inventories into this channel. On the direct business, less visibility on consumption levels of inventory here. I think direct customer orders to you are probably the best indicator of where they are in terms of their inventory targets. So is the return to quarter-on-quarter growth in July and second half optimism on growth being driven by order growth at direct customers as well? And then just any qualitative differences on the residual excess inventory distri versus direct?
Michael Lucarelli: Yes, Harlan, it's Mike. Yes, the direct order we talked about our -- direct orders as well as channel orders, but what's driving the growth is direct sales, out of the channel on a sell-through basis as well imaged directly to our end customers. So yes, it's not about -- we're not growing because the channel is refilling. We're growing because there's real demand out there on the end market level across all of our markets.
Richard Puccio: We expect to reduce both balance sheet and channel inventory further in Q3 while growing.
Michael Lucarelli: Did that [indiscernible] to your question, Harlan?
Harlan Sur: Yes, it does.
Michael Lucarelli: We'll go to our last question, please.
Operator: Our next question comes from the line of Joseph Moore from Morgan Stanley.
Joseph Moore: Great. I wanted to also touch on your margin profile. You used to peak with operating margins in kind of the low 40s. And now you're -- as you said you would, in a very difficult trough, you're troughing for the full year, probably above 40%. So that's pretty good structural improvement. Can you talk about that, what's going on if you sort of look over a decade, why is your through-cycle margin profile going up so much?
Richard Puccio: Yes. So I think a couple of things, right? As we talked about -- the resiliency of our manufacturing process allows us to swing capacity in and out which allows us to offset some of the down cycle pressure on margins because we're able to keep utilization at a higher level given that swing capacity. Obviously, we continue to look for productivity and are executing on productivity improvements across all of our internal fabs. So I think that helps. And then if you think at an overall operating margin perspective, we've been demonstrating and we'll continue to demonstrate pretty strong operational control over expenses. Look, we expect we'll continue to see expansion in the margin as we grow and as revenue returns to a growth phase, we will get comfortably back into our long-term margin model.
Vincent Roche: Yes. I think, Joe, as well, in addition to what Rich has said, it's important to point out that, first and foremost, we're innovation-centered, and if you look at the vintage bands of our products in each of the segments, the big segments that we address, industrial, automotive, consumer and communications, we're seeing ASP increases year-on-year. We're putting more value into our products. We're capturing more value. So I think that is kind of the root of things when I look forward. That's -- I mean that's what's happening to -- that's the origin, if you like, of the margin story for ADI. Our diversity helps us a lot. Our franchise isn't as price-sensitive as many. And as I said earlier, the life cycles matter. When we get our products designed in the pricing is tremendously stable. The other thing that's been happening from a price dynamic over the last several years is that whereas Moore's Law kind of taught everybody that we could give back a lot of the value that was generated in prior years, in the New Year. That has stopped. We asymptote roughly to zero now. We don't give price away. We compete for sockets, computed innovation, but that is really the origin of ADI's margin story.
Michael Lucarelli: All right. Thank you, Joe, and thanks, everyone, for joining us this morning. A copy of the transcript will be available on our website, and all reconciliations are there as well. Have a great Memorial Day weekend, and thank you for listening on ADI's call.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the Analog Devices' Second Quarter Fiscal Year 2024 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Judy. And good morning, everybody. Thanks for joining our second quarter fiscal 2024 conference call. With me on the call today, ADI's CEO and Chair, Vincent Roche; and ADI’s CFO, Richard Puccio. For anyone who missed the release, you can find it in relating financial schedules and investor.analog.com. Onto the disclosures, information we're about to discuss includes forward-looking statements which are subject to certain risks and uncertainties as further described in our earnings release and our periodic reports and other materials follow the SEC. Actual results could differ materially from the forward-looking information, as these statements reflect our expectations only as a date of this call. We undertake no obligation to update the statements except as required by law. Revenue, adjusted gross margin, operating and non-operating expenses, operating margin, tax rate, EPS and free cash flow in our comment today will be on non-GAAP basis, which excludes special items. When comparing our results to historic performance. Special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's release. And with that, I'll turn it over to ADI's CEO and Chair, Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thank you very much, Mike. Good morning, and a big welcome to you all. In the second quarter, a strong focus execution resulted in revenue of $2.16 billion, with profitability and earnings per share finishing above the high-end of our outlook. With 2Q now behind us, we believe, we've passed the low point of this cycle. Notably, global manufacturing PMIs, which are highly correlated with our core business are improving, customer inventories are stabilizing and our bookings have improved for a third consecutive quarter. Our growing optimism remains guarded, however, as short-term economic and geopolitical uncertainty persists. As such, we will continue to manage the near-term with great discipline, as we fund and execute against our longer-term strategic priorities to drive increasing levels of value for all of our stakeholders. With that framing, I'd like to share some examples with you of how we are continuing to strengthen ADI's high performance franchise across all markets and creating unique growth drivers that will be additive to what we hope will be a strong cyclical recovery. For example, in healthcare, we have exciting wins in areas such as the rapidly expanding surgical robotics market, where the performance of our precision signal processing and connectivity solutions is critical. In the fast growing, continuous glucose monitoring space, we've won multiple opportunities across several customers. Our unique digitally enabled analog front end solutions increase the accuracy and power efficiency of sensors and extend battery life from days to weeks. In industrial automation, the growth of the digital factory is accelerating upgrades to higher bandwidth, deterministic industrial Ethernet that can support up to 10x the number of edge devices across the factory floor. We believe our leadership position with key customers will create a durable revenue stream, beginning next year that can grow to several hundreds of millions of dollars as deployments ramp over time. Turning to automotive. Our solid performance is being driven by the proliferation of higher content vehicles that use more power management, more connectivity and an increasing number of sensor platforms that open new signal processing opportunities for ADI. The increasing content per vehicle is a pervasive trend across all vehicle types’ combustion engines, hybrids and full EVs. For example, in advanced safety, we've increased our GMSL design wins from 12 to 15 of the top 20 OEMs, and expanded our engagements at two European and one Korean OEM, who intend to deploy our high performance, high bandwidth connectivity solution across a larger share of their fleets. We've also seen strong attach for functionally safe power, which is used with sensors and displays in ADAS systems and recently increased share at the leading global car manufacturer. In electrification, we've expanded our battery management system share at leading Chinese OEMs and more than doubled our BMS share in upcoming European OEM model launches, and two manufacturers intend to deploy our higher content wireless solutions starting next year. Now I'd like to use the rest of my prepared comments today to share our perspective on the role that artificial intelligence is playing and will play at ADI in the future. This technology has clearly reached a tipping point and our AI opportunity spans from sensor to cloud. While we've been adding algorithmic and software intelligence to our products now for decades, we've expanded the scope and pace of our investments in recent years. Today, we are increasingly leveraging AI in and around our products, as well as in our operations to more fully meet our customers' needs and extend our industry leadership. We're deploying AI internally to help to accelerate engineering development, enhance manufacturing efficiency and create a better customer experience. But the majority of our activities are centered around product portfolio innovations that position us to take advantage of AI's enormous potential. We see this business opportunity coming in two distinct waves. The first wave focused on infrastructure is now underway and as we all know is growing very rapidly. In order to tackle the intensified energy and processing demands of AI compute systems, data center customers are investing in new vertical power architectures. As we highlighted previously, our vertical power technology, which can reduce power losses by up to 35% compared to existing architectures is gaining traction with hyperscalers. We continue to leverage our heterogeneous integration expertise to create more efficient, smaller vertical power solutions that deliver more value and enable us to capture more share in this nascent space. Power efficient computing though is just one challenge the AI ecosystem faces. Data must also be transported efficiently, securely and at much, much greater speeds. This is driving wireline customers to upgrade connectivity infrastructure, sparking a transition to 800 gigabit and 1.6 terabit optical modules. At the electro optical interface, our ability to provide high performance solutions that integrate analog, digital and memory in a reduced form factor is indeed a key differentiator. Our high precision controller was recently designed into a 1.6 terabit optical module used in the next gen AI systems of the high performance compute leader. In industrial, AI is fueling extraordinary demand for high bandwidth memory and high performance compute. This in turn is driving a new growth vector for our instrumentation and test business, particularly in SoC and memory test. We are working with key players globally to enable faster digital scan speeds, higher channel density and the improved energy efficiency necessary to scale production of AI systems. The significantly greater amount of ADI content in these systems is positioning our high performance compute and memory test sectors for record revenues in the near to mid-term. The opportunity ahead for ADI is to compound the impact of this first wave by bringing application-specific AI models and high performance compute right down to the physical edge, creating greater system value with added improvements in latency, power efficiency, security and cost. Let me share some examples of how we are working to amplify the second wave. For example, in acoustic systems, we are combining our application specific algorithms with ultra-low energy processing hardware to enrich our audio platform offerings. We are also developing a mixed signal processor with embedded neural networks that enable a system to learn and adapt to the highly variable nature of sound in real time. Excitingly, we have strong traction with multiple customers in this area. Now in the same vein, we're leveraging our rich domain expertise with our growing processing capabilities to enhance our advanced connectivity platform in next generation 5G radios. For example, we've implemented the first AI enabled technology, combining an energy efficient real time neural network with an AI assisted development tool to give customers the ability to solve their linearization challenges in a fraction of the time. In our power management platform, we're using AI to address the arduous challenge of tuning power trees for volatile consumption patterns in data centers. Our solutions reduce complexity for power engineers and compress the time required from weeks to hours, helping to lower costs, and of course, accelerate time to market. The ADI is always operated at the physical edge, where the world's most important real data is born. As multimodal AI becomes more pervasive at the edge and a diversity of sensor types is used to unearth deeper insights, we expect to see an explosion of demand that will accelerate growth for our broad signal chain, as well as power portfolios. In short, ADI's AI future looks bright across the continuum of sensor to cloud. In closing, I'm very proud of how our team has executed in one of the largest downturns the semiconductor industry has seen. More importantly, I've never been more excited about how we are positioned for the future and what it holds for ADI. With that, I'm going to hand it over to Rich."
},
{
"speaker": "Richard Puccio",
"text": "Thank you, Vince. Let me add my welcome to our second quarter earnings call. As a reminder, our first quarter 2024 was a 14 week quarter, so we are going to limit our comparisons this quarter to year-over-year only. Second quarter revenue of $2.16 billion finished above the midpoint of our outlook. This result was down 34% year-over-year. Industrial represented 47% of revenue in the quarter and was down 44% year-over-year. As expected, all applications were impacted by inventory digestion. However, aerospace and defense revenues outperformed broader industrial. Automotive represented 30% of revenue and was down 10% year-over-year. Continued growth in our leading connectivity and functionally safe power franchises balanced broad-based declines elsewhere. Communications represented 11% of revenue and was down 45% year-over-year. Inventory digestion and weaker demand impacted both our wireline and wireless businesses. Lastly, consumer represented 11% of revenue and was down 9% year-over-year with growth in portables, partially offsetting declines across other applications. Now let's move from the top-line to the rest of the P&L. Second quarter gross margin was 66.7%, down sequentially and year-over-year, driven by unfavorable mix, lower revenue and lower utilization as we continue to reduce inventory. Operating expenses in the quarter were $598 million, down significantly year-over-year, driven by lower variable compensation and strong organization wide execution on cost control. Operating margin of 39% exceeded the high end of our outlook. Non-operating expenses finished at $64 million and the tax rate for the quarter was 10.6%. The net result was EPS of $1.40 above the high end of our outlook. Our financial position is solid, and I'd like to call out a few items from our balance sheet and cash flow statement. We ended Q2 with more than $2.3 billion of cash and short-term investments and a net leverage ratio of 1.1. During the quarter, we raised $1.1 billion of debt for general corporate purposes, including upcoming debt maturities. Inventory decreased $74 million sequentially, and days declined to 192 from 201. As planned, we have reduced channel inventory this quarter with weeks ending at approximately eight. Operating cash flow for the quarter and trailing 12 months was $0.8 billion and $4.3 billion respectively. CapEx for the quarter and trailing 12 months was $188 million and $1.2 billion respectively. We continue to expect fiscal '24 CapEx to be roughly $700 million, which is a reduction of approximately 45% versus 2023, as our hybrid manufacturing investment cycle tapers. Not included in these figures are the benefits from both the European and U.S. CHIPS acts. During the last 12 months, we generated $3.1 billion of free cash flow or 29% of revenue. Over the same time period, we have returned roughly 110% of our free cash flow via dividends and share repurchases. As a reminder, our policy is to return 100% of free cash flow to our shareholders over the long-term. Now I'll turn to the third quarter outlook. Revenue is expected to be $2.27 billion plus or minus $100 million, up 5% sequentially at the midpoint. Once again, we expect sell through to be higher than sell in. At the midpoint, we expect all B2B markets to increase sequentially with the fastest growth in industrial, and for consumer to exhibit seasonal strength. Operating margin is expected to be 40% plus or minus 100 basis points. Our tax rate is expected to be between 11% 13%, and based on these inputs, adjusted EPS is expected to be $1.50 plus or minus $0.10. Before passing it back to Mike to begin Q&A, I'll share some final thoughts on our near-term. As Vince indicated, we believe we are at the beginning of a cyclical recovery as our bookings increased throughout the quarter and we exited 2Q with a book-to-bill above parity for the first time in well over a year. No doubt cyclical transitions can be challenging, but they also provide opportunity for outsized business acceleration when approached with a balance of fiscal discipline, smart risk taking and strong execution. ADI has always excelled in these areas and we look forward to driving outstanding value for our stakeholders in the quarters to come. With that, I'll pass it back to Mike for Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Rich. Let's get to the Q&A session. We ask that you limit yourself to 1 question in order to allow for additional participants on the call this morning. If you have a follow-up question, please re-queue and we'll take your question if time allows. With that, we will have our first question please."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Our first question comes from the line of Tore Svanberg from Stifel."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you and congratulations on finding the recovery here. I had a question about the outlook for Q3, specifically in Industrial. I think you indicated that, you expect Industrial to be the strongest performer this quarter. I was hoping you could talk a little bit about what's behind that strength between end market demands, inventory replenishment and if there's any sub-segments within industrial that's driving that outperforming growth?"
},
{
"speaker": "Richard Puccio",
"text": "Sure, Tore. This is Rich, and I'll take that one. Industrial obviously is our most diversified and profitable end market, and it's weathered an unprecedented broad-based inventory correction over the past year. Importantly, we expect Q2 was the bottom for industrial and it will grow in the second half starting here in 3Q. Stronger PMIs are supporting the broad-based bookings we've seen for the three consecutive quarters now. As mentioned in the prepared remarks, we are planning to reduce channel inventory further in Q3, which impacts industrial more than any other market. This will be more than a year of under shipping consumptions, one reason we believe inventory headwinds have stabilized for industrial. Given these dynamics and the exciting design wins and AI related tailwinds in our instrumentation and test business, which Vince alluded to, we feel strongly we are at the beginning of the industrial recovery."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think one other piece of color, Tore, is that, the obviously, the aerospace and defense business is doing well. We've a lot of high prospects for that over the coming years. But I think, in general, geographically, it's been on the upward in terms of demand and across most of the segments, and particularly the ones that Rich pointed out."
},
{
"speaker": "Michael Lucarelli",
"text": "Tore, on the outlook comment, you're right. Just to clarify what we said, of the B2B markets, industrial grow the fastest, consumer will grow faster than industrial in 3Q. If you want to just kind of back it down a little bit, consumer is probably growing about 10% sequentially and industrial is probably closer to mid-single-digits and the other two markets are probably a little bit below that industrial level, but all markets should grow in 3Q."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Stacy Rasgon from Bernstein Research."
},
{
"speaker": "Stacy Rasgon",
"text": "Hi, guys. Thanks for taking my question. I wanted to ask about the book-to-bill. It's above one. Is it above one in all the segments, or is it just above one in industrial?"
},
{
"speaker": "Michael Lucarelli",
"text": "Yes, sure. It's actually good question. It's above one in all end markets. Not all applications within end markets are above one though. And if you think about the shape of that bookings throughout the quarter, we talked about last earnings call, bookings improved. It started below parity and exit the quarter above parity and that's across all markets and geographies. But again, I reiterate, it's not all applications and we talked a little bit about on the last question about what applications are above one. You can think of some instrumentation, some automation, some aerospace and defense within industrial. Broad-based improvement in bookings across all market geographies is really the main takeaway."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Toshiya Hari from Goldman Sachs."
},
{
"speaker": "Toshiya Hari",
"text": "Hi. Good morning. Thank you so much for taking the question. I wanted to ask about the back half of the calendar year and how you're thinking about the shape of the recovery. Vince, you've lived through many cycles. I think typically the same way we underestimate the magnitude of the pace of the downturn, we collectively underestimate the pace of the upturn. I'm curious if you expect this upturn to be similar to past cycles and we kind of follow those patterns or do you see anything in the marketplace today or anything from customers that would indicate something materially different in terms of the shape of the upturn? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Thanks, Toshiya. Look, first off, we believe we've seen the bottom of the cycle. As Mike indicated, the stronger PMIs that we've seen, particularly in the industrial sector, give us a lot of confidence, and there's a strong correlation between our industrial business, which is about half of the company's total revenue. As we've said now a few times, bookings and backlog coverage for the next several months beyond this quarter would give us strong indications that we expect continued growth during the second half of the year. I'll also point out, I think for 2025, we will have a brisk growth year, that's my sense. We are asked all the time, what's the shape going to be? I don't really know what the exact shape is going to be, but I think we're on the upward trajectory. We have confidence in that across the board."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Vivek Arya from Bank of America Securities."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question. Vince, what is the right way to understand the true change in end demand, if we set aside all the inventory fluctuations? For example, is it worthwhile seeing what the distribution sell through do year-on-year in Q2? What is the assumption for Q3? Does that inform us in any way about can Q4 be seasonal, whatever is the version of seasonality? I'm just trying to see, the right apples-to-apples way of looking at what is end demand doing, setting aside all this inventory noise."
},
{
"speaker": "Vincent Roche",
"text": "Yes. Look, I think it's very hard to answer that question, simply because when history is written, we're going to get the average of what's happened pre-pandemic and post-pandemic. There's been so much ringing in the system, demand overshoot and then demand undershoot. But my sense is, certainly from our perspective, I think we are very well-positioned to be able to capture the upside if things grow faster than we expect. We have got a lot of inventory on the balance sheet. We've kept inventory closer to ADI less downstream. We've got as well a tailwind here from AI, which I think is going to be a multi-year tailwind. We have got that pushing us along. But at the same time, still we've got high interest rates, we've got still relatively high inflation in many places. I think ultimately the size of the recovery and the pace of the recovery will have a strong economic and geopolitical tone to it. But, overall, my sense is, we'll see good growth for the remainder of this year and strong growth in 2025. Beyond that, I think we've got many, many growth drivers that we feel very confident about. We're selling more value into each of our customers and each of our segments. I feel good about the place that semis are in as an industry right now as well in terms of overall demand, as the edge becomes more intelligent and the cloud builds out. But very, very hard to give you an answer on the puts and takes. I mean, the dynamics of the relatively near-term are hard to decode. But what we can tell you is, given where PMIs are at, given where our demand is at, we are in a recovery phase."
},
{
"speaker": "Richard Puccio",
"text": "Vince, I would add to that. While it's impossible to get perfect visibility into our end customer inventory, certainly the signals that we monitor tell us that, customer inventories are much healthier than they were previously as we enter the second half. This is also aided by our belief that, we have been under shipping under consumption for over a year now both in the channel and direct."
},
{
"speaker": "Vivek Arya",
"text": "But that's Quantification, right, of what the sell through has been in the reported quarters year-on-year?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. I can help you out there, Vivek. I think your question is kind of what sell in versus sell through. We talked about last year. We talked about reducing the channel inventory by about $100 million. We achieved that in our 2Q. We actually did a little better than that. As you look to 3Q, we'll reduce channel dollars again, but not by that much, not nearly $100 million, much less than $100 million. So, we're getting more normal in the channel as our weeks are coming down into our target range. That normalization is helping some of the growth, but sell through is also increasing in 3Q from 2Q, which is really how we drive the business and look at for indication. As you fast forward to 4Q, if these bookings continue, we don't know. There's no reason to think we won't be more in balance in 4Q from a ship in versus ship out perspective as well, and then we'll see how 1Q goes from there. I think that's kind of the question you're asking is, there's piece Rich talked about and Vince talked about the customer's inventory that's leading out. If you look at us and what we're shipping in the channel that's also normalizing setting us up for a good second half in 2025."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Christopher Danley from Citigroup."
},
{
"speaker": "Christopher Danley",
"text": "Can you talk about the gross margin drivers from here? Maybe touch on utilization rates and inventory trends and some of your competitors have talked about pricing returning to historical norms. If that happens, can you still get the gross margins back to the previous peak?"
},
{
"speaker": "Richard Puccio",
"text": "Sure. I'll take that one. From a gross margin and utilization perspective, we talked a little bit about this in the first quarter call. We expect both utilization and gross margin bottomed in our Q2. However, we do expect the pace of gross margin expansion in the second half to be modest. Specifically for Q3, we anticipate gross margin a bit above 67%. Looking from here, gross margins expansion is going to be dictated by continued revenue growth, mix of business and utilization. From a balance sheet perspective, since our peak in Q3, we've reduced balance sheet inventory significantly, including over $70 million in Q2. For the third quarter, we expect to reduce inventory again by a lesser amount than in Q2. Overall, we executed pretty strongly against our inventory reduction goals, while mitigating the impact on gross margin, leveraging our dynamic hybrid manufacturing model. One of the things that's been super helpful in protecting us in this trough is the flexibility to swing capacity back into our fabs to help to maintain utilization. We've done that effectively, which is why we called the floor on utilization. I expect that utilizations as the demand continues to increase will start to increase and aid in our margin expansion. From a channel, as Mike mentioned, from a channel perspective, our goal was to reduce by $100 million we achieved. We will reduce an additional amount in Q3 to a lesser degree. Ultimately, we expect that this will get us firmly back into our target range of seven to eight weeks of inventory in the channel."
},
{
"speaker": "Vincent Roche",
"text": "Let me make a comment on the pricing side of things. Across the portfolio, our pricing has been very, very stable and I expect that to continue. Our products are very sticky. The franchise is very, very diversified. It's got lots of long life products in it. We tend to hang on to our sockets for, I think, on an average more than a decade. Clearly, where the competition is for the new sockets. But ADI has the premier innovation system in the analog mixed signal space and we have been pushing that innovation. While others are focused on volume, we're focused on value. I think it's a very, very different approach to things. We are not a commodity supplier at all. So we are not immune to price pressure, but we are more protected I think and we have better meat because of the innovation that we generate. I'll note as well, our ASPs are more than 4x the average. It's our innovation premium that enables us as well to capture more value and to produce the kind of gross margins that that we do."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Ross Seymore from Deutsche Bank."
},
{
"speaker": "Ross Seymore",
"text": "Hi, guys. Congrats on marking the trough and turning the corner. Vince, I wanted to ask a bigger picture question. I think it's been four years since you guys bought Maxim and I believe it was four years prior to that with Linear. How are you looking at the M&A environment? Are there any kind of pieces to the puzzle that you wish you had?"
},
{
"speaker": "Vincent Roche",
"text": "Thanks, Ross. We've always acquired assets that get ADI ahead of customers' needs. We tend to take a long-term view, get ahead of our customers' needs. Obviously, we've been very, very selective. I will say, Ross, it's fair to say that, in terms of scale and scope of analog high performance franchise, we are where we need to be. Analog mixed signal power, we've got a wonderful power franchise now. But we've been adding, I alluded in my remarks or stated in my prepared remarks that, we have been putting more software content, more digital content and we've also been for about seven or eight years now developing machine learning, neural networking capability. Those are areas where as the world becomes more and more software defined, that is clearly an area where ADI has been organically investing. We've done some more tuck-in type acquisitions as well that help us in that area. But I think right now, we are really focused on making sure that, we fully capture all the synergies, from the revenue synergies from Maxim. But we're always looking, by the way. We're always looking for assets. But clearly I think analog is complete and it's other areas we're now looking."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Mark Lipacis from Evercore ISI."
},
{
"speaker": "Mark Lipacis",
"text": "Hi, thanks for taking my question. Vince, it's for you, I think. If you look at your -- if you adjust your revenues for the step function increase that you had for pricing, it looks like on a unit basis, you're shipping 25% below the trend line. I don't think you shipped that far below your long-term trend line since the world financial crisis. At the same time that's happening, you talked about your customers lowering, the supply chain lowering inventories, you are lowering inventories. It seems like there's a real risk that the industry is setting up for you and the industry is setting up for like a really tight supply environment, maybe even as they're early as the end of this year or early next year. I'm wondering, how do you think is there a risk that we enter that kind of a scenario? It seems like your customers never learn about trying to get their inventories right and the order see you on time. Is there something that's changed in your operations that will enable you to adjust to that, what has historically happened, which is your customers overshoot on the downside on their inventories and then come in at the last second when things are really tight?"
},
{
"speaker": "Vincent Roche",
"text": "Yes. Well, yes, I think surging demand is a problem of a high quality. And as -- we have virtually 200 days of inventory in our balance sheet, stage primarily at the die socket level. So that gives us a tremendous amount of output that we could bring within weeks to the market. It's a question of packaging and test to a first approximation. Obviously, we're carrying finished goods as well. We have also spent $2.5 billion plus on making sure that we have internal capacity in our 4 internal fabs to be able to meet the demands across the nodes that produce most of the revenue for ADI. We've got great partners, partners like TSMC, for example, who are a critical part of our hybrid manufacturing model. So I think in terms of the ability to be able to address a really short order snapback is good, just given the coverage that we've got with internal inventories. Our distributors are carrying virtually 8 weeks as well as inventory. And then we've got all this new capacity. We've more than doubled the internal capacity on the critical nodes that address every single market that we that we participate in. So I think in terms of manufacturing agility, inventories, we're in good shape."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Harlan Sur from JPMorgan."
},
{
"speaker": "Harlan Sur",
"text": "Great job on the quarterly execution. Within your distribution business, it's about 60% of your overall revenues. You can monitor sell-through in near real-time which allows the team to tightly control the inventories into this channel. On the direct business, less visibility on consumption levels of inventory here. I think direct customer orders to you are probably the best indicator of where they are in terms of their inventory targets. So is the return to quarter-on-quarter growth in July and second half optimism on growth being driven by order growth at direct customers as well? And then just any qualitative differences on the residual excess inventory distri versus direct?"
},
{
"speaker": "Michael Lucarelli",
"text": "Yes, Harlan, it's Mike. Yes, the direct order we talked about our -- direct orders as well as channel orders, but what's driving the growth is direct sales, out of the channel on a sell-through basis as well imaged directly to our end customers. So yes, it's not about -- we're not growing because the channel is refilling. We're growing because there's real demand out there on the end market level across all of our markets."
},
{
"speaker": "Richard Puccio",
"text": "We expect to reduce both balance sheet and channel inventory further in Q3 while growing."
},
{
"speaker": "Michael Lucarelli",
"text": "Did that [indiscernible] to your question, Harlan?"
},
{
"speaker": "Harlan Sur",
"text": "Yes, it does."
},
{
"speaker": "Michael Lucarelli",
"text": "We'll go to our last question, please."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Joseph Moore from Morgan Stanley."
},
{
"speaker": "Joseph Moore",
"text": "Great. I wanted to also touch on your margin profile. You used to peak with operating margins in kind of the low 40s. And now you're -- as you said you would, in a very difficult trough, you're troughing for the full year, probably above 40%. So that's pretty good structural improvement. Can you talk about that, what's going on if you sort of look over a decade, why is your through-cycle margin profile going up so much?"
},
{
"speaker": "Richard Puccio",
"text": "Yes. So I think a couple of things, right? As we talked about -- the resiliency of our manufacturing process allows us to swing capacity in and out which allows us to offset some of the down cycle pressure on margins because we're able to keep utilization at a higher level given that swing capacity. Obviously, we continue to look for productivity and are executing on productivity improvements across all of our internal fabs. So I think that helps. And then if you think at an overall operating margin perspective, we've been demonstrating and we'll continue to demonstrate pretty strong operational control over expenses. Look, we expect we'll continue to see expansion in the margin as we grow and as revenue returns to a growth phase, we will get comfortably back into our long-term margin model."
},
{
"speaker": "Vincent Roche",
"text": "Yes. I think, Joe, as well, in addition to what Rich has said, it's important to point out that, first and foremost, we're innovation-centered, and if you look at the vintage bands of our products in each of the segments, the big segments that we address, industrial, automotive, consumer and communications, we're seeing ASP increases year-on-year. We're putting more value into our products. We're capturing more value. So I think that is kind of the root of things when I look forward. That's -- I mean that's what's happening to -- that's the origin, if you like, of the margin story for ADI. Our diversity helps us a lot. Our franchise isn't as price-sensitive as many. And as I said earlier, the life cycles matter. When we get our products designed in the pricing is tremendously stable. The other thing that's been happening from a price dynamic over the last several years is that whereas Moore's Law kind of taught everybody that we could give back a lot of the value that was generated in prior years, in the New Year. That has stopped. We asymptote roughly to zero now. We don't give price away. We compete for sockets, computed innovation, but that is really the origin of ADI's margin story."
},
{
"speaker": "Michael Lucarelli",
"text": "All right. Thank you, Joe, and thanks, everyone, for joining us this morning. A copy of the transcript will be available on our website, and all reconciliations are there as well. Have a great Memorial Day weekend, and thank you for listening on ADI's call."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 1 | 2,024 | 2024-02-21 10:00:00 | Operator: Good morning and welcome to the Analog Devices’ First Quarter Fiscal Year 2024 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours.
Michael Lucarelli : Thank you, Josh. And good morning, everybody. Thanks for joining our first quarter fiscal 2024 conference call. With me on the call today, are ADI’s CEO and Chair, Vincent Roche and ADI’s CFO, Richard Puccio. For anyone who missed the release, you can find it in relating financial schedules and investor.analog.com. Onto the disclosures, information we're about to discuss includes forward-looking statements which are subject to certain risks and uncertainties as further described in our earnings release, our periodic reports and other materials follow the SEC. Actual results could differ materially from the forward-looking information, as these statements reflect our expectations only as a date of this call. We undertake no obligation to update the statements except as required by law. Revenue, adjusted gross margin, operating and non-operating expenses, operating margin, tax rate, EPS and free cash flow in our comment today will be on non-GAAP basis, which excludes special items. When comparing our results to historic performance. Special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. As a reminder, the first quarter of 2024 was a 14-week quarter. And with that, I'll turn it over to ADI's CEO and Chair, Vincent Roche, Vince?
Vincent Roche : Thank you very much, Mike, and good morning to you all. But before I begin, I'd like to welcome ADI’s new CFO Richard Puccio to the call, which is only a few weeks in, but we're very excited to have him on board. He brings tremendous financial experience and capability from complex technology sectors, which I think will be very valuable, as we continue to extend our leadership in the Intelligent Edge era. I'd also like to recognize Jim Mollica for serving as Interim CFO and thank Jim for his continued partnership and contributions to our success. Now on to the results for the first quarter. ADI delivered revenue of more than $2.5 billion, operating margins of 42% and earnings per share of $1.73, all above the midpoint of our outlook. As we previously discussed, the inventory rationalization that our customers that began during the middle of 2023 is expected to continue through our second quarter. Encouragingly, first quarter bookings improved sequentially, growing our confidence that inventory related headwinds will largely subside this quarter. That said, the macro situation remains challenging, and the shape and timing of a second half recovery will be governed by underlying demand. Importantly, the strength of our balance sheet, operational agility, and prudent capital management are serving as well during this downturn. We've invested heavily in R&D, customer engagement, activity and manufacturing resiliency, fueling our future growth, even as we maintain the industry leading profitability that supports our practice of robust capital returns. To that end, I'm pleased to highlight that we announced the 7% dividend increase yesterday, making 2024 the 20th consecutive year of higher dividends for shareholders. Now, digging a little deeper into our investment philosophy, we continue to focus on anticipating our customers’ future needs. And what's becoming a software-defined AI-driven world leveraging pervasive sensing, Edge computing and ubiquitous connectivity. The technological complexity facing our customers is compounded by their need to deliver solutions that are both secure and extremely power efficient. So let me share a little more now about how we are strategically allocating our capital to deliver more solutions value to our customers, and further support their confidence in the long-term supply assurance? Since our acquisition of Maxim, we've increased our engineering population by around 10% complementing our world class Analog talent, with increasing levels of digital software, AI, and systems expertise. This breadth of engineering gives ADI the capabilities to tackle more of our customers' challenges, and grow our sell-in across markets. In addition, as our engineers increasingly work shoulder to shoulder with our customers to co-architect their solutions, we further deepen our understanding of their technological and market complexities. This strengthens our ability to deliver increasingly stronger innovation from components to physical Edge systems. And I'd like to share now a few examples of what I mean. For example, in the industrial sector, digital transformation is driving investment in Edge-based connectivity and control platforms that enable secure power efficient monitoring and control of automation systems. Last month, Honeywell announced it will use ADI's Deterministic Ethernet and software-configurable IO solutions across their factory automation and building management offerings. Our portfolio enables customers to securely deliver end-to-end signal integrity between the Edge and the cloud in a power efficient and highly flexible platform configuration. This system approach enables us to capture three times more value, and we expect additional design wins due to high customer interest globally. In the automotive sector, we've aligned our business to the second are trends of electrification, advanced safety systems, and immersive digital in-cabin experience. For example, our Gigabit Multimedia Serial Link or GMSL Solution continues to gain broader adoption, as customers seek to extend high performance data and video capabilities across their fleets. We’ve recently increased our share at a top three global auto manufacturer extending our position across all their brands and quintupling our GMSL opportunity at that customer. In datacenters, AI and machine learning computing systems require orders of magnitude more processing and thus energy, compared to traditional workloads. Our portfolio of high-performance power and protection solutions, specifically designed for vertical power delivery is helping customers re-architect their datacenter systems to improve power delivery and system performance. Last quarter, we secured a significant design win from a large hyperscale customer for our multiphase vertical power solution that reduces power losses by 35% when compared to conventional ones. In Healthcare, this market continues to digitalize to enable more predictive and preventative treatment regimens. ADI has been on the forefront of this transition, and I'm pleased to let you know that we've recently received FDA clearance for a non-invasive remote monitoring platform, that enables home-based management of chronic diseases such as congestive heart failure. This solution leverages our deep domain expertise, leading-edge capabilities across signal processing and sensor modalities, and unique algorithms that enable medical providers to act early, precisely and effectively. As a platform, this also allows us in the future to use our data-driven AI algorithms to make this even more personalized. This advance unlocks a new growth vector for ADI, adding more than $5 billion of new sell-in. Switching now to the evolution of our supply chain, I'd like to share some of our progress in manufacturing resilience, which is a growing priority for our customers. Over the last two years, we've invested record levels of CapEx to expand our capacity and to enhance resiliency. Now with line of sight to achieving our goal of doubling front and back-end internal capacity in 2025 and will begin to significantly reduce our capital spend. Notably, approximately 10% of our investments have been focused on implementing more efficient systems that will deliver sustainability benefits, including greatly reducing input resources and emissions, which, overtime, will also lower our operating costs. These investments enable a more flexible hybrid manufacturing model and will increase our swing capacity to around 70% of revenue in the coming years. This unique ability helps to capture the upside in strong demand backdrops and better protect our gross margins during more challenging times. Complementing these organic investments, we also extended our foundry partnership with TSMC to secure additional 300-millimeter fine-pitch technology capacity at their Japan subsidiary. Our investments, combined with the support of our foundry partners will enable us to manufacture our products in multiple geographic locations, enhancing our resiliency and giving our customers greater optionality and assurance over their supply chains. So in closing, as always, we're keeping one eye on the present and one eye on the future. I have confidence in the steps that we're taking to preserve our capital and navigate the near term challenges while ensuring that we make the necessary investments to increase our competitiveness and accelerate our business in the future. And so with that, I'd like to pass the microphone over to Rich.
Richard Puccio : Thank you, Vince. And let me add my welcome to our first quarter earnings call. I'm excited to have joined ADI and look forward to helping the company navigate the near term while ensuring we are well positioned to capitalize on the tremendous opportunities ahead of us. Despite continued challenging business conditions, we achieved first quarter revenue, which was slightly above the midpoint of our outlook or down 8% sequentially and 23% year-over-year. Industrial represented 48% of revenue in the quarter, down 12% sequentially and 31% year-over-year. As expected, we experienced broad-based weakness as customers continue to work down their inventory levels. Automotive, which represented 29% of revenue, was up 2% sequentially and 9% versus the year ago period, representing 14 consecutive quarters of growth. Notably our leading connectivity and functionally safe power solutions collectively increased double digits year-over-year. Communications, which represented 12% of revenue, declined 10% sequentially and 37% year-over-year. On a sequential basis, wireline fared relatively well driven by AI-related demand, while wireless decreased as global investments in 5G remain depressed. And lastly, consumer represented 11% of revenue, down 7% sequentially and 22% year-over-year driven by continued sluggish end demand across applications. Now on to the rest of the P&L. First quarter gross margin was 69%, down sequentially and year-over-year, driven by unfavorable mix lower revenue and lower utilization. OpEx in the quarter was $679 million, down 2% sequentially despite the extra week, driven by lower variable comp, disciplined discretionary spend and structural cost improvement. As a result, operating margin of 42% finished near the high end of our outlook. Non-operating expenses finished at $75 million, and the tax rate for the quarter was 11.8%. All told, EPS was $1.73, slightly above the guided midpoint. Now on to the balance sheet. Cash and equivalents increased more than $340 million sequentially and ended the quarter at $1.3 billion. Our net leverage ratio remained below 1. Inventory decreased nearly $90 million sequentially, driven primarily by finished goods, while days increased to 201 due to lower revenue. Channel inventory dollars declined again in 1Q with weeks of inventory finishing slightly above our target range of seven to eight weeks. Moving on to cash flow items. Over the trailing 12 months, operating cash flow and CapEx were $4.6 billion and $1.3 billion, respectively. We continue to expect fiscal 2024 CapEx to be approximately $700 million. As a reminder, these are gross CapEx figures, not including any of the anticipated benefits from both the U.S. and European Chips Act. Over the last 12 months, we generated $3.2 billion of free cash flow or 28% of revenue. During the same time period, we have returned more than $4.2 billion through dividends and share repurchases. And since our Maxim acquisition, we have returned nearly $12 billion or more than 130% of free cash flow to shareholders, reducing share count by 8% while also increasing our dividend per share by 33%, including our most recently announced 7% increase. As a reminder, we target 100% free cash flow return over the long term. We aim to use 40% to 60% to grow our dividend annually with the remaining free cash flow used for share count reduction. Now moving on to guidance. Second quarter revenue is expected to be $2.1 billion, plus or minus $100 million, once again, we expect sell through to be higher than sell-in. At the midpoint, we expect all end markets to decline sequentially with the largest decline in industrial as we continue to meaningfully reduce channel inventory. Operating margin is expected to be 37%, plus or minus 100 basis points. This includes the impact of unfavorable mix and lower utilization as we further reduce balance sheet inventory. Our tax rate is expected to be 11% to 13%. And based on these inputs, EPS is expected to be $1.26 plus or minus $0.10. In closing, the actions we've taken to protect profitability in the near term as well as the natural shock absorbers embedded in ADI have enabled us to maintain strong profitability even as our quarterly revenue has fallen significantly from its peak. Importantly, with the strength of our financial profile and the growing importance of our technology, we will continue to invest confidently in our future, regardless of where we are in the cycle. I will now give it back to Mike for Q&A.
Michael Lucarelli : Thanks, Rich, and welcome to the call. Let’s get into our Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have follow up question, please requeue, and we’ll take your question if time allows. With that, we have our first question, please.
Operator: Thank you. [Operator Instructions] Our first question comes from Joseph Moore with Morgan Stanley. You may proceed.
Joseph Moore : Great, thank you. You guys are guiding down now mid-30% year-on-year. If I go back to historic drawdowns, you haven't seen revenue fall that far other than 2001, 2009, where we had kind of significant demand destruction. So it kind of looks like the worst inventory correction maybe we've ever seen. Can you just talk to that? Does that reflect how much inventory excess there might have been? Or just any kind of sense check as we approach the bottom as to why the downturn looks kind of severe?
Vincent Roche : Yeah. Thanks, Joe. I think first and foremost, the -- if you like, the events that caused the supply chain fracture was unique. And every single segment was impacted every single customer, every single business. So this is truly the broadest base demand inflection I've ever seen in my 30-something years with ADI. And I've been through all those different perturbations. So I think that's the uniqueness of the event itself, I think is what caused the level of impact. And we see everything compounded. We saw the supply chain fracture. Then we saw the shortage, and then we got the behavior that we typically see in a shortage situation. You get double ordering, you get holding. And we're seeing that everywhere. The area that we've probably seen, I would say, the biggest correction is in the industrial market. And I think our sense is that it began in the second -- kind of the second half of the past year. And that will take four to five quarters to correct, I believe, from the beginning of the decline to when we start to see growth again. So I think that's pretty much it. But now we're in a situation where the lead times are very uniform. And actually, we got ahead of the supply chain issues, I think, faster than most. We've got our lead times back into better shape than most quite quickly. And so we saw the downturn, I think, more quickly than others. So all that said, Joe, I think the underlying demand for our products and technologies in the years ahead. We remain very, very bullish about that. And I expect, as we've indicated that we'll see a return back to growth in the second half of our fiscal year.
Michael Lucarelli : Thanks, Joe. Operator, next question please?
Operator: Thank you. One moment for questions. Our next question comes from Stacy Rasgon with Bernstein Research. You may proceed.
Stacy Rasgon : Hi, guys. Thanks for taking my questions. Rich, I was wondering if you could give us a little more color on the segment guidance next quarter. I know you said everything down in industrial worse. But I mean like industrial has got to be down probably more than 20% sequentially, and that would probably still assume everything else is down double digit sequentially. Is that what you have in mind? And any further color you could give us would be great.
Michael Lucarelli : Yeah. I'll grab that one. It's Mike. So you're right to think industrial is the weakest. I would say, 20% sequentially, sure, you can put that number in your model if you want to, 20% plus or minus sequentially. I would say comms is also probably worse in the midpoint of your guidance, so down more than the 16% we guided to. While auto and consumer probably do a bit better, but are both down pretty significantly sequentially as well. And really, the big driver on the industrial piece, as we laid out is the channel reduction in the -- for the inventory in the channel, which is impacting industrial more so in other markets. I hope that helps, Stacy.
Stacy Rasgon : Yeah.
Michael Lucarelli : We’ll go to the next question.
Operator: Thank you. One moment for questions. Our next question comes from Chris Danely with Citi. You may proceed.
Chris Danely : Hey, thanks, guys. Just to follow up on that question. How much of this downturn do you think is just pure inventory correction versus demand? And then any comments you could you could have on just demand trends as far as what you're hearing from the distribution channel and your customers?
Michael Lucarelli : Sure. I'll start and then I think Vince will add some clarity also on it, but this really is a supply-driven demand correction, what you're seeing here. And Vince outlined that in the answer to the first question where the supply chain fracture lead times extended for an extended period of time. Those have normalized. We're still seeing what are happening as our customers is, they build a lot of inventory over that time. Why our lead times are extremely long. Now our lead time is back to normal, so they're seeing them reduce their balance sheet inventory to match our short lead times, so the cycle times match up. So really also a majority supply chain some demand. There's some areas of pockets of weakness in demand. But really overall, I'll call it more of a supply than demand correction in our business. And we talked about in the script and as well the press release that supplied normalizing here in our second quarter.
Vincent Roche : Yeah. I think, Chris, if we look at the two halves of FY24, I believe the first half is all about inventory in digestion and digestion. And as Mike said, we largely get through that part of the headwind by the end of our second quarter. And then in the second half, all the indications our bookings are getting stronger, cancellations are abating. Our conversations with customers suggest that we'll begin to return to a growth pattern in the second half. The big question is the macroeconomic dial where that's positioned. And I think at the margins, if I look at where we are this quarter versus last quarter, at least from a macro standpoint, maybe with the exception of China, we're more bullish than we were.
Chris Danely : All right. Thanks, guys.
Michael Lucarelli : Thanks, Chris.
Operator: Thank you. One moment for questions. Our next question comes from Vivek Arya with Bank of America Securities. You may proceed.
Vivek Arya : Thanks for taking my question. Vince, on the last earnings call, you mentioned bookings were stabilizing. I think this quarter, you're saying bookings are improving. And I'm curious which end markets are showing the best recovery in bookings? And then importantly, how should this inform us about what ADI will see as we get into the July quarter? Should we be assuming some kind of seasonal recovery, should we assume things flatten out first? And if I could attach kind of part B of that, which is what happens to gross margins as you start to see that flattening out and potential recovery? So just the shape of what recovery looks like in sales and margins if bookings flatten and now they seem to be improving?
Vincent Roche: Yeah. Well, I think, look, as soon as demand in flex, and we get back into a more normalized growth pattern, Vivek, everything will improve. Our utilizations will improve. We have under-shipped the channel, we've under-shipped our customers. So we've been working very, very hard in the company to make sure that when demand and flex that we will get a -- we've got the supply in place. We've got lots of finished goods and deadstock inventory. So we're in a great position to address the recovery. On the first part of your question about where are we seeing the bookings improvement, pretty much everywhere, pretty much everywhere, across all the segments. And if you look at industrial, I'd say the two healthiest parts of industrial right now is, as we message to the external world, aerospace and defense and healthcare, they've got fundamentally quite different drivers to, say, the factory automation or instrumentation business. But those two sectors are holding up better than the rest. But even in a more traditional industrial sector like instrumentation, all of these new high-performance computing systems need you test equipment, so that benefits ADI. So I think, in general, it's true to say, maybe with the exception of our wireless business, most sectors are seeing a return to a more normalized bookings pattern.
Richard Puccio : And Vivek, I'll give you a little more color on the gross margin outlook. So in the last call, we talked about gross margin will be 68% to 69%. We came in at the high end, a good result given the large drop in industrial that we've been talking about and with an inventory takedown of almost $90 million quarter-over-quarter. The 2Q outlook implies 67% plus or minus, a bit lower than what we thought would be given the weaker revenue, especially in industrial and the fact that we're taking down factory starts further in 2Q to reduce inventory by another $50 million to $100 million. And if I think a little bit further out to the half two outlook, tough to predict right now is the revenue and the shape of the revenue recovery will be the governor on gross margin trajectory. But our best sense is gross margin trends higher in the second half, as we don't see utilization going much lower as inventory continues to decline meaningfully at these start levels and we'll continue to leverage our swing capacity.
Michael Lucarelli : And Vivek, as you asked a three-part question, I'll chime in as well for third quarter outlook. I know you gave me the outlook question. So it's hard to say, right? Our lead times are 13 weeks are lower. So we don't really have visibility into the third quarter today. But if you look back over history over the past decade, our B2B markets are about flattish sequentially in 3Q from 2Q, sometimes they're up a little bit, sometimes they're down a little bit depending where you are in the cycle, while consumers start seeing some holiday builds kind of up mid- to high single digit sequentially. So that's kind of historical context. We're not guiding in the third quarter, but that's how we should frame it. And then to add on to what Vince said about bookings. Bookings actually increased last quarter, and the quarter before that. So 4Q and 1Q bookings both improved. And what's interesting now is you look at our bookings, they're approaching parity, which is a good sign that we just see a pickup in the back half of the year.
Vivek Arya : Very helpful. Thank you.
Operator: Thank you. One moment for questions. Our next question comes from Harlan Sur with JPMorgan. You may proceed.
Harlan Sur : Hi, good morning. Thanks for taking my questions. So if I look at fiscal '23, China was about 18% of your total revenues. It was the worst performing geography down about 13% for the full year. Because Lunar New Year was so late this year, it feels like this did add a little bit of uncertainty at the beginning of this year, but obviously, now we're post-Lunar New Year. What are the demand signs out of this region? Are orders also growing sequentially in the China regions? Are cancellations also showing signs of stabilization patterns as well? Maybe even signs of a potential pickup in the China region? Just want to get your views.
Michael Lucarelli : So if you take a step back from a geo perspective, whole regions are weak, North America, Europe, China. China has been weakest the longest, I would say. The rest of Asia is doing better than the big three, but still weak as well. And like I said, China is the weakest source of demand. Around Chinese New Year, honestly, if there's something unique about it, we called out. But I think what Vince said in the last question basically was bookings are improving globally as well as in China before and after this year. So really no impact from Chinese New Year and kind of the commentary we've made.
Harlan Sur : Perfect. Thank you.
Operator: Thank you. One moment for questions. Our next question comes from Toshiya Hari with Goldman Sachs. You may proceed.
Toshiya Hari : Hi, good morning. Thanks so much for taking the question. Vince, I'm curious how you would characterize sell-through today versus sell-in. I think at a conference a couple of months ago, you had mentioned that sell-in was tracking 15% to 20% below sell-through. Is that still the right ballpark number? And is that what you're seeing in the current quarter? And I guess, if so, if the end demand environment doesn't deteriorate over the next six, nine months? Could there be a quarter later in the year where your revenue run rate is tracking above $2.5 billion, $2.6 billion? Thank you.
Michael Lucarelli : I'll grab the first part of that on the sell-in and sell-through part of it, Toshi. So selling and sell-through really relates to the channel. We reduced our channel inventory dollars the past two quarters, I would call it around a $50 million reduction, plus or minus per quarter over the last two quarters. Looking at embedded in our guidance is a much bigger reduction of channel inventory. If you want to put a number around $100 million or so in our outlook, that's probably what we're seeing on the channel side. So we're reducing a lot in the channel. Now as you look at the back half of the year, from a channel perspective, we think the sell-in and sell-through should be better matched given the actions we've taken over the last three quarters. And I'll pass it to Vince to talk a little about the customer inventory situation on the end customer side.
Vincent Roche : Yeah. On the customer side of things, we've been monitoring very, very carefully across the various segments. Our customer shipment rates, their inventories and their ADI goods on hand. And we're clearly under-shipping our customers' current demands. So we feel that we've got a situation now in terms of our -- we're in a good inventory position on hand. Our customers are beginning, as Mike indicated, to replenish their order books, ADI's goods. And that gives us the confidence as the book-to-bill approaches unity that we're seeing the worst of the inventory correction. And in the second half, we will get back to a more normalized growth pattern. So as Mike said, there's a very good balance between the direct channel, the distribution channel in terms of the inventory situation, but we're ready for the upsurge.
Toshiya Hari : Great. Thank you.
Operator: Thank you. One moment for questions. Our next question comes from William Stein with Truist Securities. You may proceed.
William Stein : Great. Thanks for taking my questions. I want to welcome, Rich, but direct a couple of questions to Vince, please. Vince, the more vertical capabilities that you talked about, it sort of suggests that you're needing to either partner more closely with a smaller number of customers or maybe you wind up pushing somewhat into their capabilities and are potentially competing with some of them. And I wonder how you contemplate managing that dynamic?
Vincent Roche : Yeah. Will, thanks very much. You're -- unfortunately, the line shopped. I think I got your question about verticalization, competing with our customers potentially. Hopefully, you can hear me, okay, that it's not a two-way line problem here. Will, look, the -- we've been on a journey over many, many years now to continue to build out our core component franchise, but also add more value to our solutions. Our business has become more solutions-oriented particularly over the last decade in every single segment that we play. And that kind of domain application-driven engineering that ADI has been distinguishing it so at the edge over the last decade, that will continue, and we're continuing to build that. I talked on the -- in the prepared remarks about this point of care, acute health care solution that we've just brought to market where we've got an FDA approval. I think what's happening, Will, in the world is that there are certain places like that where we have a white space to attack. We're building a complete solution that has both hardware and software makes a lot of sense. But the truth is, even in the traditional markets and with the larger customers that we deal with, more and more footprint capture, if you like, has been taking place. Why? Because we tame our customers' complexity. And I've talked before about the asymmetry and capabilities in the Analog space between the capabilities ADI has got and our customers have got. They expect us actually to add more solution value and build more complete solutions and clearly define where the line is between where their core value is versus where ADI's core values. So I think we're not competing with our customers, but we have very vibrant discussions about where we draw the line of the labor divide, so to speak.
William Stein : That helps. If I can ask a follow-up. You talked a bit about AI. It's sort of a familiar topic to us lately. Maybe too much so.
Vincent Roche : Not much.
William Stein : There's a narrative here where there are some creative capabilities, in fact, I would say, engineering-focused capabilities that maybe made more efficient or productive with Generative AI. In a world where the story about Analog design engineer capability being so limited and that driving a significant advantage for ADI. I wonder if that story changes at all because of this capability. Have you started using this for circuit design? Or do you anticipate that it could be used by others, either competitors or customers? Thank you.
Vincent Roche : Yeah, it's a good question. Well, look, everybody is trying to figure out the meaning of the AI in their businesses. We're using AI today in our tool chains. We're using machine learning and AI in our products, around our products. We're starting to use it in our business. And I think -- I believe that anything that can be -- anything that is routine -- and that can be automated, that's the way of technology. Technology automation will take over the things that are more routine. We play very much at the high end of the performance spectrum. So unless there's generative intelligence that can outperform our imaginations, which I don't see any time in the foreseeable future. We're truly in a realm where the intellectual property value and the learning system that we've got in this company will matter more and more. But yeah, I think we view AI as a tremendous opportunity. As clearly in the product development process from how the products are designed, what we put as ingredients in our products, and we're also, by the way, putting AI into the customer support tool chain. So it is a part. We're embracing it, and we believe that it will be an accelerator and the copilot, if you like, with our engineering population.
William Stein : Thank you.
Michael Lucarelli : Thanks, Will, it sounds like from your cell phone line, we do need some more 5G coverage. So next question, please?
Operator: Thank you. One moment for questions. Our next question comes from Timothy Arcuri with UBS. You may proceed.
Timothy Arcuri : Hi, thanks a lot. Can you talk to any period costs versus underutilization charges that you're taking? And any of those -- how much of a headwind are those now? And how much will those help you as they might reverse themselves coming out of the downturn? Thanks.
Michael Lucarelli : So I think your question is on how much of the impact on our gross margins underutilization versus mix. I think if you look here, our peak gross margins were about 74%. Our outlook, as Rich pointed out, embeds about 67%. That decline is really mix and utilization, about equal parts, I'll call it. As you look to the back half of this year, it depends what mix is going to do. I think industrial is bottoming here, so that should help a little bit. From a utilization standpoint, Rich also pointed out, our starts are low enough to reduce inventory meaningfully. We've been doing that. We'll do it again in 2Q. So I don't see it starts going down, they're probably start going up, which should provide a tailwind to gross margins. How fast the gross margins pick up really depends on those 2 factors, how fast the revenue picks up and how much of it relates to the industrial sector.
Timothy Arcuri : Okay, Mike. But I guess, are there any inventory charges? That's the question.
Michael Lucarelli : So from inventories, yeah, I would say, a good question. You're right. We have a lot of inventory. As you can see on our balance sheet. The -- there's no acceleration of inventory charges in our gross margins. The inventory charge from a reserve standpoint have been elevated for the past few quarters, and they probably stay that way as you go into the back half of this year into next year. But that's not a headwind anymore. It's already kind of built in the run rate.
Timothy Arcuri : Okay, awesome. Thanks, Mike.
Michael Lucarelli : We will go to our last question, please.
Operator: One moment for our last question. And our last question comes from C.J. Muse with Cantor Fitzgerald. You may proceed.
CJ Muse: Yeah. Thank you for taking the question. You talked about auto being down sequentially, but seeing, I guess, the best performance out of all the different segments. Curious if you can kind of walk through what you're seeing from Tier 1 auto correction and whether you think that will be completed exiting April as well? Thanks so much.
Michael Lucarelli : Yeah. Sure. From the auto standpoint, C.J., I would say, yes, there is definitely an inventory correction going on in auto like or market as Vince pointed that out, the supply fracture at everyone is, to a lesser degree, than auto than other markets, but it's not really because of the inventory. It's because of the growth drivers in that business, whether it's BMS, GMSL AB functional safe power, the growth in those areas are offsetting the overall call it inventory digestion in automotive area. You're right to say that on the Tier 1 side or the OEM side, there's some froth inventory. But we're seeing that being digested. Will it be all complete? By the second quarter, we'll see, but I do feel good about those growth areas continue to grow this year. And for the full year, will auto grow, I don't know. We'll see. But it really depends on how strong the growth is in the growth areas and how much of the overhang on the inventory side is. But net-net, we do feel good about auto being our best performing end market here in 2Q and for the full year '24.
Vincent Roche : All right. Thank you, CJ. Thanks, everyone, for joining our call this morning. A copy of the transcript will be available on the website. Thanks for joining us, and have a great rest of the day.
Operator: Thank you. This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning and welcome to the Analog Devices’ First Quarter Fiscal Year 2024 Earnings Conference Call, which is being audio webcast via telephone and over the web. I'd like to now introduce your host for today's call Mr. Michael Lucarelli, Vice President of Investor Relations and FP&A. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Josh. And good morning, everybody. Thanks for joining our first quarter fiscal 2024 conference call. With me on the call today, are ADI’s CEO and Chair, Vincent Roche and ADI’s CFO, Richard Puccio. For anyone who missed the release, you can find it in relating financial schedules and investor.analog.com. Onto the disclosures, information we're about to discuss includes forward-looking statements which are subject to certain risks and uncertainties as further described in our earnings release, our periodic reports and other materials follow the SEC. Actual results could differ materially from the forward-looking information, as these statements reflect our expectations only as a date of this call. We undertake no obligation to update the statements except as required by law. Revenue, adjusted gross margin, operating and non-operating expenses, operating margin, tax rate, EPS and free cash flow in our comment today will be on non-GAAP basis, which excludes special items. When comparing our results to historic performance. Special items are also excluded from prior periods. Reconciliation of these non-GAAP measures to most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. As a reminder, the first quarter of 2024 was a 14-week quarter. And with that, I'll turn it over to ADI's CEO and Chair, Vincent Roche, Vince?"
},
{
"speaker": "Vincent Roche",
"text": "Thank you very much, Mike, and good morning to you all. But before I begin, I'd like to welcome ADI’s new CFO Richard Puccio to the call, which is only a few weeks in, but we're very excited to have him on board. He brings tremendous financial experience and capability from complex technology sectors, which I think will be very valuable, as we continue to extend our leadership in the Intelligent Edge era. I'd also like to recognize Jim Mollica for serving as Interim CFO and thank Jim for his continued partnership and contributions to our success. Now on to the results for the first quarter. ADI delivered revenue of more than $2.5 billion, operating margins of 42% and earnings per share of $1.73, all above the midpoint of our outlook. As we previously discussed, the inventory rationalization that our customers that began during the middle of 2023 is expected to continue through our second quarter. Encouragingly, first quarter bookings improved sequentially, growing our confidence that inventory related headwinds will largely subside this quarter. That said, the macro situation remains challenging, and the shape and timing of a second half recovery will be governed by underlying demand. Importantly, the strength of our balance sheet, operational agility, and prudent capital management are serving as well during this downturn. We've invested heavily in R&D, customer engagement, activity and manufacturing resiliency, fueling our future growth, even as we maintain the industry leading profitability that supports our practice of robust capital returns. To that end, I'm pleased to highlight that we announced the 7% dividend increase yesterday, making 2024 the 20th consecutive year of higher dividends for shareholders. Now, digging a little deeper into our investment philosophy, we continue to focus on anticipating our customers’ future needs. And what's becoming a software-defined AI-driven world leveraging pervasive sensing, Edge computing and ubiquitous connectivity. The technological complexity facing our customers is compounded by their need to deliver solutions that are both secure and extremely power efficient. So let me share a little more now about how we are strategically allocating our capital to deliver more solutions value to our customers, and further support their confidence in the long-term supply assurance? Since our acquisition of Maxim, we've increased our engineering population by around 10% complementing our world class Analog talent, with increasing levels of digital software, AI, and systems expertise. This breadth of engineering gives ADI the capabilities to tackle more of our customers' challenges, and grow our sell-in across markets. In addition, as our engineers increasingly work shoulder to shoulder with our customers to co-architect their solutions, we further deepen our understanding of their technological and market complexities. This strengthens our ability to deliver increasingly stronger innovation from components to physical Edge systems. And I'd like to share now a few examples of what I mean. For example, in the industrial sector, digital transformation is driving investment in Edge-based connectivity and control platforms that enable secure power efficient monitoring and control of automation systems. Last month, Honeywell announced it will use ADI's Deterministic Ethernet and software-configurable IO solutions across their factory automation and building management offerings. Our portfolio enables customers to securely deliver end-to-end signal integrity between the Edge and the cloud in a power efficient and highly flexible platform configuration. This system approach enables us to capture three times more value, and we expect additional design wins due to high customer interest globally. In the automotive sector, we've aligned our business to the second are trends of electrification, advanced safety systems, and immersive digital in-cabin experience. For example, our Gigabit Multimedia Serial Link or GMSL Solution continues to gain broader adoption, as customers seek to extend high performance data and video capabilities across their fleets. We’ve recently increased our share at a top three global auto manufacturer extending our position across all their brands and quintupling our GMSL opportunity at that customer. In datacenters, AI and machine learning computing systems require orders of magnitude more processing and thus energy, compared to traditional workloads. Our portfolio of high-performance power and protection solutions, specifically designed for vertical power delivery is helping customers re-architect their datacenter systems to improve power delivery and system performance. Last quarter, we secured a significant design win from a large hyperscale customer for our multiphase vertical power solution that reduces power losses by 35% when compared to conventional ones. In Healthcare, this market continues to digitalize to enable more predictive and preventative treatment regimens. ADI has been on the forefront of this transition, and I'm pleased to let you know that we've recently received FDA clearance for a non-invasive remote monitoring platform, that enables home-based management of chronic diseases such as congestive heart failure. This solution leverages our deep domain expertise, leading-edge capabilities across signal processing and sensor modalities, and unique algorithms that enable medical providers to act early, precisely and effectively. As a platform, this also allows us in the future to use our data-driven AI algorithms to make this even more personalized. This advance unlocks a new growth vector for ADI, adding more than $5 billion of new sell-in. Switching now to the evolution of our supply chain, I'd like to share some of our progress in manufacturing resilience, which is a growing priority for our customers. Over the last two years, we've invested record levels of CapEx to expand our capacity and to enhance resiliency. Now with line of sight to achieving our goal of doubling front and back-end internal capacity in 2025 and will begin to significantly reduce our capital spend. Notably, approximately 10% of our investments have been focused on implementing more efficient systems that will deliver sustainability benefits, including greatly reducing input resources and emissions, which, overtime, will also lower our operating costs. These investments enable a more flexible hybrid manufacturing model and will increase our swing capacity to around 70% of revenue in the coming years. This unique ability helps to capture the upside in strong demand backdrops and better protect our gross margins during more challenging times. Complementing these organic investments, we also extended our foundry partnership with TSMC to secure additional 300-millimeter fine-pitch technology capacity at their Japan subsidiary. Our investments, combined with the support of our foundry partners will enable us to manufacture our products in multiple geographic locations, enhancing our resiliency and giving our customers greater optionality and assurance over their supply chains. So in closing, as always, we're keeping one eye on the present and one eye on the future. I have confidence in the steps that we're taking to preserve our capital and navigate the near term challenges while ensuring that we make the necessary investments to increase our competitiveness and accelerate our business in the future. And so with that, I'd like to pass the microphone over to Rich."
},
{
"speaker": "Richard Puccio",
"text": "Thank you, Vince. And let me add my welcome to our first quarter earnings call. I'm excited to have joined ADI and look forward to helping the company navigate the near term while ensuring we are well positioned to capitalize on the tremendous opportunities ahead of us. Despite continued challenging business conditions, we achieved first quarter revenue, which was slightly above the midpoint of our outlook or down 8% sequentially and 23% year-over-year. Industrial represented 48% of revenue in the quarter, down 12% sequentially and 31% year-over-year. As expected, we experienced broad-based weakness as customers continue to work down their inventory levels. Automotive, which represented 29% of revenue, was up 2% sequentially and 9% versus the year ago period, representing 14 consecutive quarters of growth. Notably our leading connectivity and functionally safe power solutions collectively increased double digits year-over-year. Communications, which represented 12% of revenue, declined 10% sequentially and 37% year-over-year. On a sequential basis, wireline fared relatively well driven by AI-related demand, while wireless decreased as global investments in 5G remain depressed. And lastly, consumer represented 11% of revenue, down 7% sequentially and 22% year-over-year driven by continued sluggish end demand across applications. Now on to the rest of the P&L. First quarter gross margin was 69%, down sequentially and year-over-year, driven by unfavorable mix lower revenue and lower utilization. OpEx in the quarter was $679 million, down 2% sequentially despite the extra week, driven by lower variable comp, disciplined discretionary spend and structural cost improvement. As a result, operating margin of 42% finished near the high end of our outlook. Non-operating expenses finished at $75 million, and the tax rate for the quarter was 11.8%. All told, EPS was $1.73, slightly above the guided midpoint. Now on to the balance sheet. Cash and equivalents increased more than $340 million sequentially and ended the quarter at $1.3 billion. Our net leverage ratio remained below 1. Inventory decreased nearly $90 million sequentially, driven primarily by finished goods, while days increased to 201 due to lower revenue. Channel inventory dollars declined again in 1Q with weeks of inventory finishing slightly above our target range of seven to eight weeks. Moving on to cash flow items. Over the trailing 12 months, operating cash flow and CapEx were $4.6 billion and $1.3 billion, respectively. We continue to expect fiscal 2024 CapEx to be approximately $700 million. As a reminder, these are gross CapEx figures, not including any of the anticipated benefits from both the U.S. and European Chips Act. Over the last 12 months, we generated $3.2 billion of free cash flow or 28% of revenue. During the same time period, we have returned more than $4.2 billion through dividends and share repurchases. And since our Maxim acquisition, we have returned nearly $12 billion or more than 130% of free cash flow to shareholders, reducing share count by 8% while also increasing our dividend per share by 33%, including our most recently announced 7% increase. As a reminder, we target 100% free cash flow return over the long term. We aim to use 40% to 60% to grow our dividend annually with the remaining free cash flow used for share count reduction. Now moving on to guidance. Second quarter revenue is expected to be $2.1 billion, plus or minus $100 million, once again, we expect sell through to be higher than sell-in. At the midpoint, we expect all end markets to decline sequentially with the largest decline in industrial as we continue to meaningfully reduce channel inventory. Operating margin is expected to be 37%, plus or minus 100 basis points. This includes the impact of unfavorable mix and lower utilization as we further reduce balance sheet inventory. Our tax rate is expected to be 11% to 13%. And based on these inputs, EPS is expected to be $1.26 plus or minus $0.10. In closing, the actions we've taken to protect profitability in the near term as well as the natural shock absorbers embedded in ADI have enabled us to maintain strong profitability even as our quarterly revenue has fallen significantly from its peak. Importantly, with the strength of our financial profile and the growing importance of our technology, we will continue to invest confidently in our future, regardless of where we are in the cycle. I will now give it back to Mike for Q&A."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Rich, and welcome to the call. Let’s get into our Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have follow up question, please requeue, and we’ll take your question if time allows. With that, we have our first question, please."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question comes from Joseph Moore with Morgan Stanley. You may proceed."
},
{
"speaker": "Joseph Moore",
"text": "Great, thank you. You guys are guiding down now mid-30% year-on-year. If I go back to historic drawdowns, you haven't seen revenue fall that far other than 2001, 2009, where we had kind of significant demand destruction. So it kind of looks like the worst inventory correction maybe we've ever seen. Can you just talk to that? Does that reflect how much inventory excess there might have been? Or just any kind of sense check as we approach the bottom as to why the downturn looks kind of severe?"
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Thanks, Joe. I think first and foremost, the -- if you like, the events that caused the supply chain fracture was unique. And every single segment was impacted every single customer, every single business. So this is truly the broadest base demand inflection I've ever seen in my 30-something years with ADI. And I've been through all those different perturbations. So I think that's the uniqueness of the event itself, I think is what caused the level of impact. And we see everything compounded. We saw the supply chain fracture. Then we saw the shortage, and then we got the behavior that we typically see in a shortage situation. You get double ordering, you get holding. And we're seeing that everywhere. The area that we've probably seen, I would say, the biggest correction is in the industrial market. And I think our sense is that it began in the second -- kind of the second half of the past year. And that will take four to five quarters to correct, I believe, from the beginning of the decline to when we start to see growth again. So I think that's pretty much it. But now we're in a situation where the lead times are very uniform. And actually, we got ahead of the supply chain issues, I think, faster than most. We've got our lead times back into better shape than most quite quickly. And so we saw the downturn, I think, more quickly than others. So all that said, Joe, I think the underlying demand for our products and technologies in the years ahead. We remain very, very bullish about that. And I expect, as we've indicated that we'll see a return back to growth in the second half of our fiscal year."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Joe. Operator, next question please?"
},
{
"speaker": "Operator",
"text": "Thank you. One moment for questions. Our next question comes from Stacy Rasgon with Bernstein Research. You may proceed."
},
{
"speaker": "Stacy Rasgon",
"text": "Hi, guys. Thanks for taking my questions. Rich, I was wondering if you could give us a little more color on the segment guidance next quarter. I know you said everything down in industrial worse. But I mean like industrial has got to be down probably more than 20% sequentially, and that would probably still assume everything else is down double digit sequentially. Is that what you have in mind? And any further color you could give us would be great."
},
{
"speaker": "Michael Lucarelli",
"text": "Yeah. I'll grab that one. It's Mike. So you're right to think industrial is the weakest. I would say, 20% sequentially, sure, you can put that number in your model if you want to, 20% plus or minus sequentially. I would say comms is also probably worse in the midpoint of your guidance, so down more than the 16% we guided to. While auto and consumer probably do a bit better, but are both down pretty significantly sequentially as well. And really, the big driver on the industrial piece, as we laid out is the channel reduction in the -- for the inventory in the channel, which is impacting industrial more so in other markets. I hope that helps, Stacy."
},
{
"speaker": "Stacy Rasgon",
"text": "Yeah."
},
{
"speaker": "Michael Lucarelli",
"text": "We’ll go to the next question."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for questions. Our next question comes from Chris Danely with Citi. You may proceed."
},
{
"speaker": "Chris Danely",
"text": "Hey, thanks, guys. Just to follow up on that question. How much of this downturn do you think is just pure inventory correction versus demand? And then any comments you could you could have on just demand trends as far as what you're hearing from the distribution channel and your customers?"
},
{
"speaker": "Michael Lucarelli",
"text": "Sure. I'll start and then I think Vince will add some clarity also on it, but this really is a supply-driven demand correction, what you're seeing here. And Vince outlined that in the answer to the first question where the supply chain fracture lead times extended for an extended period of time. Those have normalized. We're still seeing what are happening as our customers is, they build a lot of inventory over that time. Why our lead times are extremely long. Now our lead time is back to normal, so they're seeing them reduce their balance sheet inventory to match our short lead times, so the cycle times match up. So really also a majority supply chain some demand. There's some areas of pockets of weakness in demand. But really overall, I'll call it more of a supply than demand correction in our business. And we talked about in the script and as well the press release that supplied normalizing here in our second quarter."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. I think, Chris, if we look at the two halves of FY24, I believe the first half is all about inventory in digestion and digestion. And as Mike said, we largely get through that part of the headwind by the end of our second quarter. And then in the second half, all the indications our bookings are getting stronger, cancellations are abating. Our conversations with customers suggest that we'll begin to return to a growth pattern in the second half. The big question is the macroeconomic dial where that's positioned. And I think at the margins, if I look at where we are this quarter versus last quarter, at least from a macro standpoint, maybe with the exception of China, we're more bullish than we were."
},
{
"speaker": "Chris Danely",
"text": "All right. Thanks, guys."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Chris."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for questions. Our next question comes from Vivek Arya with Bank of America Securities. You may proceed."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question. Vince, on the last earnings call, you mentioned bookings were stabilizing. I think this quarter, you're saying bookings are improving. And I'm curious which end markets are showing the best recovery in bookings? And then importantly, how should this inform us about what ADI will see as we get into the July quarter? Should we be assuming some kind of seasonal recovery, should we assume things flatten out first? And if I could attach kind of part B of that, which is what happens to gross margins as you start to see that flattening out and potential recovery? So just the shape of what recovery looks like in sales and margins if bookings flatten and now they seem to be improving?"
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Well, I think, look, as soon as demand in flex, and we get back into a more normalized growth pattern, Vivek, everything will improve. Our utilizations will improve. We have under-shipped the channel, we've under-shipped our customers. So we've been working very, very hard in the company to make sure that when demand and flex that we will get a -- we've got the supply in place. We've got lots of finished goods and deadstock inventory. So we're in a great position to address the recovery. On the first part of your question about where are we seeing the bookings improvement, pretty much everywhere, pretty much everywhere, across all the segments. And if you look at industrial, I'd say the two healthiest parts of industrial right now is, as we message to the external world, aerospace and defense and healthcare, they've got fundamentally quite different drivers to, say, the factory automation or instrumentation business. But those two sectors are holding up better than the rest. But even in a more traditional industrial sector like instrumentation, all of these new high-performance computing systems need you test equipment, so that benefits ADI. So I think, in general, it's true to say, maybe with the exception of our wireless business, most sectors are seeing a return to a more normalized bookings pattern."
},
{
"speaker": "Richard Puccio",
"text": "And Vivek, I'll give you a little more color on the gross margin outlook. So in the last call, we talked about gross margin will be 68% to 69%. We came in at the high end, a good result given the large drop in industrial that we've been talking about and with an inventory takedown of almost $90 million quarter-over-quarter. The 2Q outlook implies 67% plus or minus, a bit lower than what we thought would be given the weaker revenue, especially in industrial and the fact that we're taking down factory starts further in 2Q to reduce inventory by another $50 million to $100 million. And if I think a little bit further out to the half two outlook, tough to predict right now is the revenue and the shape of the revenue recovery will be the governor on gross margin trajectory. But our best sense is gross margin trends higher in the second half, as we don't see utilization going much lower as inventory continues to decline meaningfully at these start levels and we'll continue to leverage our swing capacity."
},
{
"speaker": "Michael Lucarelli",
"text": "And Vivek, as you asked a three-part question, I'll chime in as well for third quarter outlook. I know you gave me the outlook question. So it's hard to say, right? Our lead times are 13 weeks are lower. So we don't really have visibility into the third quarter today. But if you look back over history over the past decade, our B2B markets are about flattish sequentially in 3Q from 2Q, sometimes they're up a little bit, sometimes they're down a little bit depending where you are in the cycle, while consumers start seeing some holiday builds kind of up mid- to high single digit sequentially. So that's kind of historical context. We're not guiding in the third quarter, but that's how we should frame it. And then to add on to what Vince said about bookings. Bookings actually increased last quarter, and the quarter before that. So 4Q and 1Q bookings both improved. And what's interesting now is you look at our bookings, they're approaching parity, which is a good sign that we just see a pickup in the back half of the year."
},
{
"speaker": "Vivek Arya",
"text": "Very helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for questions. Our next question comes from Harlan Sur with JPMorgan. You may proceed."
},
{
"speaker": "Harlan Sur",
"text": "Hi, good morning. Thanks for taking my questions. So if I look at fiscal '23, China was about 18% of your total revenues. It was the worst performing geography down about 13% for the full year. Because Lunar New Year was so late this year, it feels like this did add a little bit of uncertainty at the beginning of this year, but obviously, now we're post-Lunar New Year. What are the demand signs out of this region? Are orders also growing sequentially in the China regions? Are cancellations also showing signs of stabilization patterns as well? Maybe even signs of a potential pickup in the China region? Just want to get your views."
},
{
"speaker": "Michael Lucarelli",
"text": "So if you take a step back from a geo perspective, whole regions are weak, North America, Europe, China. China has been weakest the longest, I would say. The rest of Asia is doing better than the big three, but still weak as well. And like I said, China is the weakest source of demand. Around Chinese New Year, honestly, if there's something unique about it, we called out. But I think what Vince said in the last question basically was bookings are improving globally as well as in China before and after this year. So really no impact from Chinese New Year and kind of the commentary we've made."
},
{
"speaker": "Harlan Sur",
"text": "Perfect. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for questions. Our next question comes from Toshiya Hari with Goldman Sachs. You may proceed."
},
{
"speaker": "Toshiya Hari",
"text": "Hi, good morning. Thanks so much for taking the question. Vince, I'm curious how you would characterize sell-through today versus sell-in. I think at a conference a couple of months ago, you had mentioned that sell-in was tracking 15% to 20% below sell-through. Is that still the right ballpark number? And is that what you're seeing in the current quarter? And I guess, if so, if the end demand environment doesn't deteriorate over the next six, nine months? Could there be a quarter later in the year where your revenue run rate is tracking above $2.5 billion, $2.6 billion? Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "I'll grab the first part of that on the sell-in and sell-through part of it, Toshi. So selling and sell-through really relates to the channel. We reduced our channel inventory dollars the past two quarters, I would call it around a $50 million reduction, plus or minus per quarter over the last two quarters. Looking at embedded in our guidance is a much bigger reduction of channel inventory. If you want to put a number around $100 million or so in our outlook, that's probably what we're seeing on the channel side. So we're reducing a lot in the channel. Now as you look at the back half of the year, from a channel perspective, we think the sell-in and sell-through should be better matched given the actions we've taken over the last three quarters. And I'll pass it to Vince to talk a little about the customer inventory situation on the end customer side."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. On the customer side of things, we've been monitoring very, very carefully across the various segments. Our customer shipment rates, their inventories and their ADI goods on hand. And we're clearly under-shipping our customers' current demands. So we feel that we've got a situation now in terms of our -- we're in a good inventory position on hand. Our customers are beginning, as Mike indicated, to replenish their order books, ADI's goods. And that gives us the confidence as the book-to-bill approaches unity that we're seeing the worst of the inventory correction. And in the second half, we will get back to a more normalized growth pattern. So as Mike said, there's a very good balance between the direct channel, the distribution channel in terms of the inventory situation, but we're ready for the upsurge."
},
{
"speaker": "Toshiya Hari",
"text": "Great. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. One moment for questions. Our next question comes from William Stein with Truist Securities. You may proceed."
},
{
"speaker": "William Stein",
"text": "Great. Thanks for taking my questions. I want to welcome, Rich, but direct a couple of questions to Vince, please. Vince, the more vertical capabilities that you talked about, it sort of suggests that you're needing to either partner more closely with a smaller number of customers or maybe you wind up pushing somewhat into their capabilities and are potentially competing with some of them. And I wonder how you contemplate managing that dynamic?"
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Will, thanks very much. You're -- unfortunately, the line shopped. I think I got your question about verticalization, competing with our customers potentially. Hopefully, you can hear me, okay, that it's not a two-way line problem here. Will, look, the -- we've been on a journey over many, many years now to continue to build out our core component franchise, but also add more value to our solutions. Our business has become more solutions-oriented particularly over the last decade in every single segment that we play. And that kind of domain application-driven engineering that ADI has been distinguishing it so at the edge over the last decade, that will continue, and we're continuing to build that. I talked on the -- in the prepared remarks about this point of care, acute health care solution that we've just brought to market where we've got an FDA approval. I think what's happening, Will, in the world is that there are certain places like that where we have a white space to attack. We're building a complete solution that has both hardware and software makes a lot of sense. But the truth is, even in the traditional markets and with the larger customers that we deal with, more and more footprint capture, if you like, has been taking place. Why? Because we tame our customers' complexity. And I've talked before about the asymmetry and capabilities in the Analog space between the capabilities ADI has got and our customers have got. They expect us actually to add more solution value and build more complete solutions and clearly define where the line is between where their core value is versus where ADI's core values. So I think we're not competing with our customers, but we have very vibrant discussions about where we draw the line of the labor divide, so to speak."
},
{
"speaker": "William Stein",
"text": "That helps. If I can ask a follow-up. You talked a bit about AI. It's sort of a familiar topic to us lately. Maybe too much so."
},
{
"speaker": "Vincent Roche",
"text": "Not much."
},
{
"speaker": "William Stein",
"text": "There's a narrative here where there are some creative capabilities, in fact, I would say, engineering-focused capabilities that maybe made more efficient or productive with Generative AI. In a world where the story about Analog design engineer capability being so limited and that driving a significant advantage for ADI. I wonder if that story changes at all because of this capability. Have you started using this for circuit design? Or do you anticipate that it could be used by others, either competitors or customers? Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yeah, it's a good question. Well, look, everybody is trying to figure out the meaning of the AI in their businesses. We're using AI today in our tool chains. We're using machine learning and AI in our products, around our products. We're starting to use it in our business. And I think -- I believe that anything that can be -- anything that is routine -- and that can be automated, that's the way of technology. Technology automation will take over the things that are more routine. We play very much at the high end of the performance spectrum. So unless there's generative intelligence that can outperform our imaginations, which I don't see any time in the foreseeable future. We're truly in a realm where the intellectual property value and the learning system that we've got in this company will matter more and more. But yeah, I think we view AI as a tremendous opportunity. As clearly in the product development process from how the products are designed, what we put as ingredients in our products, and we're also, by the way, putting AI into the customer support tool chain. So it is a part. We're embracing it, and we believe that it will be an accelerator and the copilot, if you like, with our engineering population."
},
{
"speaker": "William Stein",
"text": "Thank you."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Will, it sounds like from your cell phone line, we do need some more 5G coverage. So next question, please?"
},
{
"speaker": "Operator",
"text": "Thank you. One moment for questions. Our next question comes from Timothy Arcuri with UBS. You may proceed."
},
{
"speaker": "Timothy Arcuri",
"text": "Hi, thanks a lot. Can you talk to any period costs versus underutilization charges that you're taking? And any of those -- how much of a headwind are those now? And how much will those help you as they might reverse themselves coming out of the downturn? Thanks."
},
{
"speaker": "Michael Lucarelli",
"text": "So I think your question is on how much of the impact on our gross margins underutilization versus mix. I think if you look here, our peak gross margins were about 74%. Our outlook, as Rich pointed out, embeds about 67%. That decline is really mix and utilization, about equal parts, I'll call it. As you look to the back half of this year, it depends what mix is going to do. I think industrial is bottoming here, so that should help a little bit. From a utilization standpoint, Rich also pointed out, our starts are low enough to reduce inventory meaningfully. We've been doing that. We'll do it again in 2Q. So I don't see it starts going down, they're probably start going up, which should provide a tailwind to gross margins. How fast the gross margins pick up really depends on those 2 factors, how fast the revenue picks up and how much of it relates to the industrial sector."
},
{
"speaker": "Timothy Arcuri",
"text": "Okay, Mike. But I guess, are there any inventory charges? That's the question."
},
{
"speaker": "Michael Lucarelli",
"text": "So from inventories, yeah, I would say, a good question. You're right. We have a lot of inventory. As you can see on our balance sheet. The -- there's no acceleration of inventory charges in our gross margins. The inventory charge from a reserve standpoint have been elevated for the past few quarters, and they probably stay that way as you go into the back half of this year into next year. But that's not a headwind anymore. It's already kind of built in the run rate."
},
{
"speaker": "Timothy Arcuri",
"text": "Okay, awesome. Thanks, Mike."
},
{
"speaker": "Michael Lucarelli",
"text": "We will go to our last question, please."
},
{
"speaker": "Operator",
"text": "One moment for our last question. And our last question comes from C.J. Muse with Cantor Fitzgerald. You may proceed."
},
{
"speaker": "CJ Muse",
"text": "Yeah. Thank you for taking the question. You talked about auto being down sequentially, but seeing, I guess, the best performance out of all the different segments. Curious if you can kind of walk through what you're seeing from Tier 1 auto correction and whether you think that will be completed exiting April as well? Thanks so much."
},
{
"speaker": "Michael Lucarelli",
"text": "Yeah. Sure. From the auto standpoint, C.J., I would say, yes, there is definitely an inventory correction going on in auto like or market as Vince pointed that out, the supply fracture at everyone is, to a lesser degree, than auto than other markets, but it's not really because of the inventory. It's because of the growth drivers in that business, whether it's BMS, GMSL AB functional safe power, the growth in those areas are offsetting the overall call it inventory digestion in automotive area. You're right to say that on the Tier 1 side or the OEM side, there's some froth inventory. But we're seeing that being digested. Will it be all complete? By the second quarter, we'll see, but I do feel good about those growth areas continue to grow this year. And for the full year, will auto grow, I don't know. We'll see. But it really depends on how strong the growth is in the growth areas and how much of the overhang on the inventory side is. But net-net, we do feel good about auto being our best performing end market here in 2Q and for the full year '24."
},
{
"speaker": "Vincent Roche",
"text": "All right. Thank you, CJ. Thanks, everyone, for joining our call this morning. A copy of the transcript will be available on the website. Thanks for joining us, and have a great rest of the day."
},
{
"speaker": "Operator",
"text": "Thank you. This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADI | 1 | 2,025 | 2025-02-19 10:00:00 | Operator: Good morning and welcome to the Analog Devices first quarter fiscal year 2025 earnings conference call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and Division Controller of Data Center, Energy, Power. Sir, the floor is yours.
Michael Lucarelli: Thank you, Daniel, and good morning, everybody. Thanks for joining our first quarter fiscal 2025 conference call. With me on the call today are ADI's CEO, Vincent Roche, and ADI's CFO, Richard Puccio. When you missed the release, you can find it and the link financial schedules at investor.analog.com. Onto disclosures. Information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in earnings release and other periodic reports and other materials filed with the SEC. Actual results could differ materially from this forward-looking information as these statements reflect our expectations only at the date of this call. We undertake no obligation to update these statements except as required by law. Governance to gross margin, operating non-operating expenses, operating margin, tax rate, EPS, and free cash flow in our comments today will be on a non-GAAP basis. These exclude special items. When comparing our results to historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. All references to earnings per share are on a fully diluted basis. And with that, I'll turn it over to ADI's CEO, Vincent Roche.
Vincent Roche: Thanks very much, Mike, and a very good morning to you all. First quarter revenue, profitability, and earnings per share all finished above the midpoint of our outlook. And while we continue to operate in a challenging macro and geopolitical environment, our first quarter results and outlook for double-digit year-over-year growth in our second quarter build my confidence that 2025 will be a year of growth. Our track record of resilience and profitability through cycles combined with our strong balance sheet supports our long-standing robust capital return program. I'm delighted to share that we've increased our dividend for the twenty-first consecutive year and that over just the past five years, we have returned more than $16 billion or roughly 15% of our current market cap to shareholders through dividends and share repurchases. Turning now to our operating environment, the magnitude and duration of this most recent semiconductor cycle has surprised many of us. But we believe ADI has entered and is well-positioned for sustained recovery. Throughout the cycle, we invested diligently to enhance and leverage our hybrid manufacturing model to support the dynamic needs of our customers both big and small. We work closely with our customers to be responsive to their evolving business needs back. Factory starts to true end demand. As a result, inventory levels have largely normalized and our partnership approach with our customers throughout the volatility of the past several years has enabled us to balance supply and real demand. While the macro backdrop will continue to influence the pace of our recovery, the signals we monitor from lean channel inventories to gradual bookings improvements over the past eighteen months support our view that we've passed the cyclical trough and the tide has turned in our favor. Throughout the cycle, we've been busily deepening our customer engagements and accelerating our pipeline growth and conversion. Many of the design wins I've shared on recent calls are now contributing to growth. And let me give you some examples. For example, in industrial automation, the shift towards decentralized intelligence enabling modular manufacturing is driving significant growth in software-defined connectivity solutions. Our software-configurable IO products at double channel density and reduced power consumption by 40% have been installed across all major automation suppliers. Revenue from these wins has begun ramping as the automation market begins to recover and will provide a durable revenue stream over the next decade. Within the growing surgical robotics segment, increasing levels of content from across our portfolio and in particular, our high precision solutions are being deployed in next-generation surgical systems. Additionally, in healthcare, the growing interest in a data-driven approach to health and wellness is creating a convergence of the clinical and consumer markets and driving demand for higher performance vital signs monitoring in consumer wearables. Our suite of high-performance sensors, signal chains, and efficient power solutions and wins at leaders in these markets position us for double-digit growth this year. Within the automatic testing equipment market, the growth of AI has significantly increased our signal chain and power content, in some cases, up to 300% across memory test systems. Customers are leveraging our solutions to increase channel density and throughput while reducing power demands by up to 30%. In light of increased hyperscaler CapEx, we expect our 2025 memory and high-performance compute test revenue to achieve strong growth. In our broad aerospace and defense portfolio, our modules which support ASPs often into the hundreds of thousands of dollars, are expected to lead double-digit growth in this industrial subsector in 2025. In addition, we're anticipating growth this year from newer design wins in RF and power, in the military and commercial satellite sectors. In automotive, the convergence of trends ranging from autonomy to electrification and immersive in-cabin experiences continue to drive robust demand for many of our solutions. For example, our GMSL portfolio is outpacing the growth of advanced driver assistance systems and is positioned to reach yet another record-breaking year in 2025. Since acquiring this video connectivity technology in 2021, our revenue has nearly tripled. We're also anticipating growth in our connectivity and functionally safe power franchises, which share similar growth trajectories. Lastly, in electric vehicles, BMS is poised to return to growth in 2025 after a challenging prior year. Part of this growth is coming from our higher content wireless solution with key OEMs ramping in America and Europe. In communications, our growth is predominantly being driven by robust CapEx investments to support AI infrastructure build-outs. Our high precision electro-optical controller is now shipping in a 1.6 terabit optical module for AI systems based on industry-leading GPUs. On the power side of the data center, we're delivering high voltage power path protection systems which are on a strong growth trajectory, and we'll begin shipping our vertical power solutions later in this year. Finally, in consumer, design wins secured in recent years have multiple customers across numerous including premium handsets, hearables, wearables, and gaming systems, begun to drive robust diversified growth in the second half of fiscal 2024. With even more content in upcoming launches, we expect a strong year ahead and beyond in consumer. Collectively, we anticipate these combined cyclical and idiosyncratic trends to return us to a solid growth path this year. So in closing, the relatively favorable position in which we find ourselves coming out of one of the worst downturns the industry has ever experienced is not by chance but rather a reflection of our fiscal and operational discipline, commitment to the success of our customers, and our investments for the long term. And while I'm excited about our prospects for 2025, I'm even more excited about the longer-term opportunities across numerous concurrent secular growth areas including automation, digital healthcare, electrification, automotive data center, and many, many more. A common request from our customers across our many diversified applications is that we help them tame the increasing complexity by bringing more complete solutions to them. A reflection of our robust technology stack and stellar customer reputation. In stepping up to our customer's challenge, we continue to push the edges by investing vigorously in our world-class analog mixed signal and power portfolios, and integrate higher levels of supporting digital and software into our solutions to meet our customers at the application layer. And so with that, I'd like to pass the call over to Rich.
Richard Puccio: Thank you, Vince, and let me add my welcome to our first quarter earnings call. First quarter revenue of $2.42 billion came in above the midpoint of our outlook for a 1% sequential decrease and a 4% decline year over year. Adjusting for the extra week in our fiscal Q1 2024, however, our Q1 2025 performance represents a 4% increase in our first year-over-year growth since Q2 of 2023. Industrial represented 44% of our first quarter revenue, finishing up 1% sequentially. The improved customer inventory backdrop is benefiting each of our industry segments. In addition, we are seeing stronger demand in our automatic test and aerospace and defense businesses, each of which were up year over year. Automotive represented 30% of quarterly revenue, finishing up 2% sequentially. Our leading connectivity and functionally safe power solutions were each up double digits year over year once again, reflecting secular content growth and greater share position. Communications represented 12% of quarterly revenue, finishing up 6% sequentially. Wireline, which makes up roughly two-thirds of our total communications business, was up double-digit sequentially and year over year, driven by data center infrastructure build-outs fueled by AI demand. Conversely, our wireless revenue continues to see demand challenges. And lastly, consumer represented 13% of quarterly revenue, finishing down 15% sequentially reflecting seasonal late. Our second consecutive quarter of robust year-over-year growth reflects our greater share and stronger content position across a diversified list of applications. Now on to the rest of the P&L. First quarter gross margin was 68.8%, up 90 basis points sequentially driven by favorable product mix. OpEx in the quarter was $687 million, up $32 million sequentially resulting in an operating margin of 40.5%. All told, non-operating expenses finished at $58 million and the tax rate for the quarter was 11.8%. All told, adjusted EPS was $1.63, at the high end of our guided range. Now, I'd like to highlight a few items from our balance sheet and cash flow statements. Cash and short-term investments finished the quarter at $2.7 billion and our net leverage ratio decreased to 1.1. Inventory increased $27 million sequentially as we replenish the die bank of our fastest turning products. Days of inventory increased to 176 while channel weeks moved lower and remained below our target of seven to eight weeks. The trailing twelve months, operating cash flow and CapEx were $3.8 billion and $656 million respectively. We continue to expect CapEx for fiscal 2025 to decrease from 2024 and fall within our long-term model of 4% to 6% of revenue. Free cash flow over the trailing twelve months was $3.2 billion or 34% of revenue. And during the same time period, we have returned more than $2.4 billion to shareholders through dividends and share repurchases. As a reminder, we target 100% free cash flow return over the long term using 40% to 60% for our dividend, with the remainder used for share count reduction. As Vince mentioned, we announced an 8% increase to our quarterly dividend to $0.99 from $0.92. In addition, our board is authorizing an incremental $10 billion for share repurchases resulting in roughly $11.5 billion of remaining buyback potential under our current program. Moving on to guidance. Second quarter revenue is expected to be $2.5 billion plus or minus $100 million. On a sequential basis, at the midpoint, we expect industrial to lead our growth and automotive to grow, while communications and consumer decline. Operating margin is expected to be 40.5% plus or minus 100 basis points flat sequentially due to a notable uptick in variable compensation. Our tax rate is expected to be 11% to 13% and based on these inputs adjusted EPS is expected to be $1.68 plus or minus $0.10. Before passing it back to Mike to begin our Q&A session, I'd like to address the near-term backdrop. Overall, our business continues to improve off our Q2 2024 trough in what continues to be an uncertain macro environment. We saw further order improvement and a positive book to bill during Q1. Importantly, booking strength was driven by industrial and automotive, our two largest end markets. Given this trend and the exciting product cycles Vince described, I'm confident we will return to long-term model growth in 2025 and believe we are well-positioned to capture additional upside should macro conditions improve. To you, Mike.
Michael Lucarelli: Thanks, Rich. Get to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have follow-up questions, please re-queue and locate your question if time allows. With that, we are ready for the first question, please.
Operator: If you have a question, for those participating by telephone dialing, please press star one one on your phone to enter the queue. If your question has been answered and you wish to be removed from the queue, please press star one one again. If you're listening on a speakerphone, please pick up the handset when asking your question. We'll pause for just a moment to compile the Q&A roster. Our first question comes from Joseph Moore with Morgan Stanley. Your line is open.
Joseph Moore: Great. Thank you. Wanted you to talk about the puts and takes in the auto market. You know, China seems to be the strongest region. Can you talk about how that affects you guys if there is an ongoing shift in the center of gravity towards China? Does that have any impact on pricing, margin, or potential for you guys?
Richard Puccio: Sure. Joe, I'll take that one. This is Rich. Let me give you a little color on what we're seeing in auto. Starting with Q1, you know, revenue came in better than expected driven by Asia, which we've talked about, you know, continued strength in China. As we've talked about in our recent calls, we have flagged that we have stronger share and content position at major Chinese EV OEMs with multiple products, again, including our audio and video connectivity solutions, functionally safe power, and BMS. This is coming through in results and we expect it to continue into Q2. As for the impact of a change in center, you know, we continue to see strong results right from a, you know, three straight quarters of double-digit growth in China being led by auto. In addition, and what we can talk about this, we've seen growth in the other parts of the China business, but the auto is continuing to lead.
Vincent Roche: I've been saying for a long time, Joe, that as long as there is a market for high-performance technologies, that ADI's technologies would continue to be relevant and that is the case. We see it in automotive. We see it in the industrial sector. And, you know, we're getting well paid for the quality of the technologies that we're bringing. So you know, it's clearly a competitive market particularly at the kind of middle low ends. With indigenous suppliers coming on stream. But given the high-performance trust in our portfolio, we were getting rewarded for the capabilities that we bring at the system level for our customers.
Joseph Moore: Thanks, John. Thank you.
Operator: Thank you. Our next question comes from Vivek Arya with Bank of America Securities. Your line is open.
Vivek Arya: Thanks for taking my question. Rich, just to clarify, what is long-term model growth that you expect to return to this year? And then, Vince, my question is for you. You mentioned that the inventory levels have largely normalized. Is that at distributors? Is that at OEMs? Also, does it apply to all end markets or mostly to industrial? Basically, how does that inform us about how ADI can, you know, feel about demand visibility and growth over the next handful of quarters?
Vincent Roche: Thank you. Yeah. Maybe I can take the second part of the question first, Vivek. So we are seeing the normalization across the direct as well as distribution channels. And in pretty much every part of our business, including we were very, very encouraged by the recovery in industrial bookings. And that's a very, very important part of ADI's businesses. At its peak, it was a little over 50% of the total ADI revenue stream. So we're seeing monitor also, by the way, customer inventories. Our top customers. So we see normalization across segments, across customers, both big and small. We've also, by the way, kind of a bellwether for the general base of customers, you know, outside the top few hundreds, would be our mass market or a broad market. We've also started to see recovery there.
Richard Puccio: Yeah. And it's an Vivek, when I talk about the long-term model, I'm talking about the published range at 7% to 10%. Although, I think as we've talked about as the macros turn, I think there's opportunity for us to capture even more growth than that. I think your one part, three-part question, Vivek, talked about what we think from here, a kind of growth back half of this year. I think we knew that is how do you think about seasonality as you get to Q3 and Q4. Again, this is not guidance for Q3, but I'll give you kind of what we see as trends. Typically, our last ten years for our third quarter, you know, our third quarter industrial auto and comp are usually flat plus or minus a little depending on where you're on the cycle. Given what Vince was saying about industry normalizing, new wins coming on, I think those markets should be flat up. So I think the higher end of what normal seasonality is, for those businesses. On the consumer side, we typically start your holiday build which means you start growing 5% to 10% in Q3. Now, obviously a lot of macro crosscurrents. It's really like the cocktail out there on the macro side, which could be a second half. We'll update you in ninety days what we really think about Q3. Your next question, please?
Operator: Thank you. Our next question comes from Tore Svanberg with Stifel. Your line is open.
Tore Svanberg: Yes. Thank you. I had a question for you then. You know, ADI is in a pretty unique position because of your hybrid manufacturing model. And I was just wondering, you know, given all the political turmoil, the geopolitical turmoil that's going on right now, how are you thinking strategically about that hybrid model because obviously, you know, you're working with a very important partner in Asia, but then obviously also do some of your own internal manufacturing. So yeah, how are you thinking about how this is gonna play out in the next few years?
Vincent Roche: Thanks, Tore. Well, I think in times of great turbulence, diversity is a great benefit. Diversity of markets, diversity of products, diversity of customers and geographies. So I think, you know, I feel good in terms of our ability with that diversity to solve two problems essentially. One is diversity gives us optionality. But it also gives us resiliency. And, you know, by the kind of end of 2026 and the early 2027, we will have secured at least dual sourcing for the entire product chain of ADI. So about 95% of the products, you know, we'll have at least dual sources. And, you know, we've obviously desensitized geographic centricity over the last few years. We've invested in our fabs internally in America, in Europe, and we've worked with our partners as well to get at least two geographical sources for the products that we procure from our partners externally. So I think, you know, we're in a good position as a company to make sure that, you know, overall, we've internally got twice the capacity we had at the start of the pandemic. And as I said, we've secured also additional supply in new sources, new fabs, with existing partners. So I think we're in a very, very good position to weather whatever turbulence might come our direction.
Tore Svanberg: That's great color. Thank you, Vince.
Richard Puccio: Thanks, Tore.
Operator: Thank you. Our next question comes from Chris Danley with Citi. Your line is open.
Chris Danley: Hey, thanks guys. I guess just to dig into the industrial strength. Can you just talk about where that's coming from? Is this mostly inventory replenishment? Is it mostly improved demand? Is it both? And then, you know, how did bookings trend during the quarter? Was the linearity pretty steady, or was there a spike? Or just a little more color there would be great. Thanks.
Richard Puccio: Sure, Chris. I'll jump in on that. So on the industrial, if we take a step back, you know, we've grown this business now sequentially for three straight quarters. Off of what we said was our trough in Q2. And then as for Q2, we actually expect industrial to be the fastest growing market. So we feel pretty good that our recovery is taking shape. And really could accelerate if the macro improves. For Q1 specifically, and we've talked about this in a couple of quarters, we saw continued strength in ADA and in the automatic test equipment, and then what we started to see from a positive perspective is stabilization across automation, healthcare, and energy, which I think has been important. And then in Q1, one of the things that we've talked a bunch about on prior calls is watching for the pickup in the broad market. We started to see some of that. In fact, the pickup in the broad market drove much of the upside relative to our initial expectations, which gives us confidence to begin shipping in line with end demand. So if you think about, you know, we've talked about in prior calls that, you know, we took a significant amount of inventory out of the channel during 2024, about $300 million. Most of that impacted the industrial market. So as we look at our growth trajectory, shipping more to sell through into the channel, will be a tailwind for industrial as well.
Vincent Roche: Yeah. As you know, the industrial sector is largely served through the distribution channels. So you know, with leanness there, demand recovering, I think both of those two concurrent streams are tailwinds for the business.
Richard Puccio: Yeah. On the booking side, bookings have improved in industrial in Q1 versus Q4. Pretty much across all the areas with the biggest strength obviously in ATE and ADA as we talked about. And we think it'd also be our fastest growth market in Q2, and that's supported by the bookings. Thanks, Chris.
Operator: Thank you. Our next question comes from Joshua Buchalter with TD Cowen. Your line is open.
Joshua Buchalter: Hey, guys. Thank you for taking my question. I wanted to follow-up on the previous one. I think you mentioned in the prepared remarks inventory levels in the channel moved down and I think they entered the quarter already below your seven to eight weeks target. Does either the April quarter guidance or the fiscal 2025 initial outlook of being in your target range include any sort of channel refill and I guess what signals do you guys need to see before you would wanna more clearly get back into that seven to eight week range? Thank you.
Richard Puccio: Yeah. So go ahead. So the current guide for Q2 has us shipping to sell through, so not adding into the channel. And I'll tell you for me for the benchmark and we talk to our distribution partners pretty regularly is if we're fulfilling customer requirements and we're not getting any escalations, we're feeling pretty comfortable right now operating below the seven weeks seven to eight weeks we've had historically. You know, balance that out, we're carrying a bit more inventory on our own books, which gives us some flexibility particularly given the amount of the inventory we're carrying in DieBank. Which allows us to be quicker to respond. So near to medium term, I don't expect that we would be adding back to the channel but we certainly do not wanna go any lower.
Vincent Roche: Yeah. I think just to add a bit of color to what Richard said as well, the centralization of inventory management I think, has served our customers very well. Customers of all sizes over the past what is essentially now five years of this of the old cycle. So we'll continue doing that, and that will be a critical guide as we think about how we modulate, you know, channel inventories over time.
Joshua Buchalter: Very helpful, caller. Thank you. And congrats on the results in the cocktail of uncertainty.
Vincent Roche: Thank you.
Operator: Our next question comes from Christopher Rollin with Susquehanna. Your line is open.
Christopher Rollin: Hey, guys. Thank you for the question. Mine is around two very specific opportunities that you've talked about in the past. One is optical connectivity, and then the other is AI power. If you have any developments in those products or markets, would love to know those, or maybe it's just playing out like you thought it would. But we'd love to know how interest orders, etcetera, are going for those products.
Vincent Roche: Yeah. Thank you. Well, I'd say first and foremost, our opportunity pipeline has been growing steadily in this AI-driven infrastructure world. And, you know, we've been a long-term player in this electro-optical interface category, you know, where we provide these very precise high compute throughput control systems for stabilizing the electro-optical modems. And, you know, we've just introduced our 1.6 terabit which is very much the benchmark for throughput in these systems today, of course, those speeds will continue to increase. The sophistication of what we build will continue to grow as well. So that's been a very good business, a high growth business for ADI for many, many years, and it predates the AI build-out of the IT build-out AI infrastructure. Our power technologies really straddle two different areas. One is, if you like, the power control systems that are important for the overall operation of a data center at kind of the board level, the server level. And the other is, and a good example, by the way, of that power control will be these hot swapping reset generators and so on. These very, very tough analog problems need to be solved. The second part of the power story is the delivery of energy to the GPUs, the chip systems themselves. And, we're going to production in the second half of this year, with the vertical power technique with one of the big hyperscalers. And we have other designs in train that will come on stream as well, I believe, in the 2026 period.
Christopher Rollin: Fantastic color there. Thank you so much. And maybe just kind of playing into these kind of new products that are emerging here. Are there any new other new products to call out? New customers? New end markets, any of these kind of free options, as I like to call them, that are emerging for your company. And anything you can point to, anything new that maybe you haven't had before any new opportunities?
Vincent Roche: It depends on, you know, how far into the future you want to go, but, you know, let me give you a couple of real-time examples here. I mentioned in the prepared remarks the convergence of wellness-based healthcare solutions with the consumer sector. We see that the interest in building those systems out is becoming, I would say, very, very active. We're well-positioned as a company because we've been building the sensory and signal processing technologies for a long, long time. So I would call that out as an area with a good spectrum of customers across many geographies. And many, many different types of healthcare modalities that need to be measured at the clinical grade level in incidentally, areas like continuous glucose monitoring. Being able to do that in a closed-loop system, both the input and the output. So I think that is an area that we're excited about, but we've a lot of good technologies that are being deployed at faster rates into that area. And if you want to go really into the future, you know, there is light beginning to appear in the whole quantum computing world, and we're at the early stages of building control systems, if you like. Precision control systems for these very, very complex computing elements.
Christopher Rollin: Very cool. Thank you so much.
Michael Lucarelli: Hey, Chris. As a reminder, if there's any additional questions from people who've asked questions, please re-queue your some extra time. Otherwise, we'll go to our next question.
Operator: Thank you. Our next question comes from Harsh Kumar with Piper Sandler. Your line is open.
Harsh Kumar: Yeah. Hey, guys. I just wanted to hit up on the quote-unquote call for the bottom. I guess you're calling that. Guess what is the confidence level that this is not a head fake? I know you're talking about increased orders and normalization of inventory, but there's a lot of geopolitical movement. There's a lot of tariffs. Help us understand why the confidence level is so high that we've reached the bottom and this isn't just some kind of headache. Thank you.
Vincent Roche: Well, I think, you know, first and foremost, we have a lot of conversations with a lot of customers. You know, we've tens of thousands of customers in our portfolio. We pay attention to the signal that matters to us most is sell-through. So POS is how we, that's where we focus and that POS signal is how we plan our supply at ADI, how we run our business and run our supply system. So that's first and foremost. I think, you know, we are seeing the stabilization in the business and growth in certain areas right across the spectrum. And then there is geographically, there is a diversity of progress as well. I'd say Japan is most muted. America and China are strongest. I would say Asia Pacific is strong, and Europe is somewhere between, you know, between where Japan is and where the rest are. So but that's essentially how we view the work. As we said in the prepared remarks, what's incalculable here in our thinking is the effect of any potential geopolitical turmoil, trade war, and so on and so forth. So that I think, will be the governor ultimately. During this year as to the rate of recovery. But I have a strong conviction that in a new cycle in the semi sector uncertainty in aviation business.
Harsh Kumar: Thank you for the color. Thanks.
Michael Lucarelli: Thanks, Harshal. I'm going to our last question, please.
Operator: Thank you. Our next question comes from Tore Svanberg with Stifel. Your line is open.
Tore Svanberg: Yeah. I just had a follow-up on the, you know, conviction in growth there. You know, typically, when we go through these cycles, I think customers, they sort of hold off buying new products on sort of the older products have cleared out. And I'm just wondering if there's some of that going on. I mean, I guess that really relates to your win conversion rate. So, you know, any comments you can make on that conversion rate really starting to play out would be really helpful. Thank you.
Vincent Roche: Yeah. Well, for example, Tore, the strength we're seeing in ATE markets, in the automotive market, for example, in areas like new data center modalities. Those areas are largely driven by a lot of new products. So I would say, there's three examples of where new products are making a huge difference. In fact, they're also with each new generation, we're capturing more ASPs. So, you know, we've often shared with you our famous vintage chart which shows the age of the portfolio. We measure very, very carefully within that vintage chart the contribution of newer products within a three and ten-year period as to what's going on. But I can tell you the conversion rate, the introduction of new parts, and the capturing of opportunity with new parts is strong. New products and new solutions. And, you know, obviously, we've got also a very strong franchise. Our legacy products tend to get pulled by these new anchor products that we're building. I'd say overall, I'm pleased with the effectiveness of our R&D spends and how we're capturing and creating new markets and new applications.
Tore Svanberg: Very helpful. Thank you.
Operator: Thank you. I'm showing no further questions at this time.
Michael Lucarelli: Alright. No problem. I think we answered all the questions then. Thanks, everyone, for joining us this morning. A copy of the transcript will be available on our website. Thanks for joining and your continued interest in Analog Devices.
Operator: This concludes today's Analog Devices conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning and welcome to the Analog Devices first quarter fiscal year 2025 earnings conference call, which is being audio webcast via telephone and over the web. I'd now like to introduce your host for today's call, Mr. Michael Lucarelli, Vice President of Investor Relations and Division Controller of Data Center, Energy, Power. Sir, the floor is yours."
},
{
"speaker": "Michael Lucarelli",
"text": "Thank you, Daniel, and good morning, everybody. Thanks for joining our first quarter fiscal 2025 conference call. With me on the call today are ADI's CEO, Vincent Roche, and ADI's CFO, Richard Puccio. When you missed the release, you can find it and the link financial schedules at investor.analog.com. Onto disclosures. Information we're about to discuss includes forward-looking statements, which are subject to certain risks and uncertainties as further described in earnings release and other periodic reports and other materials filed with the SEC. Actual results could differ materially from this forward-looking information as these statements reflect our expectations only at the date of this call. We undertake no obligation to update these statements except as required by law. Governance to gross margin, operating non-operating expenses, operating margin, tax rate, EPS, and free cash flow in our comments today will be on a non-GAAP basis. These exclude special items. When comparing our results to historical performance, special items are also excluded from prior periods. Reconciliations of these non-GAAP measures to the most directly comparable GAAP measures and additional information about our non-GAAP measures are included in today's earnings release. All references to earnings per share are on a fully diluted basis. And with that, I'll turn it over to ADI's CEO, Vincent Roche."
},
{
"speaker": "Vincent Roche",
"text": "Thanks very much, Mike, and a very good morning to you all. First quarter revenue, profitability, and earnings per share all finished above the midpoint of our outlook. And while we continue to operate in a challenging macro and geopolitical environment, our first quarter results and outlook for double-digit year-over-year growth in our second quarter build my confidence that 2025 will be a year of growth. Our track record of resilience and profitability through cycles combined with our strong balance sheet supports our long-standing robust capital return program. I'm delighted to share that we've increased our dividend for the twenty-first consecutive year and that over just the past five years, we have returned more than $16 billion or roughly 15% of our current market cap to shareholders through dividends and share repurchases. Turning now to our operating environment, the magnitude and duration of this most recent semiconductor cycle has surprised many of us. But we believe ADI has entered and is well-positioned for sustained recovery. Throughout the cycle, we invested diligently to enhance and leverage our hybrid manufacturing model to support the dynamic needs of our customers both big and small. We work closely with our customers to be responsive to their evolving business needs back. Factory starts to true end demand. As a result, inventory levels have largely normalized and our partnership approach with our customers throughout the volatility of the past several years has enabled us to balance supply and real demand. While the macro backdrop will continue to influence the pace of our recovery, the signals we monitor from lean channel inventories to gradual bookings improvements over the past eighteen months support our view that we've passed the cyclical trough and the tide has turned in our favor. Throughout the cycle, we've been busily deepening our customer engagements and accelerating our pipeline growth and conversion. Many of the design wins I've shared on recent calls are now contributing to growth. And let me give you some examples. For example, in industrial automation, the shift towards decentralized intelligence enabling modular manufacturing is driving significant growth in software-defined connectivity solutions. Our software-configurable IO products at double channel density and reduced power consumption by 40% have been installed across all major automation suppliers. Revenue from these wins has begun ramping as the automation market begins to recover and will provide a durable revenue stream over the next decade. Within the growing surgical robotics segment, increasing levels of content from across our portfolio and in particular, our high precision solutions are being deployed in next-generation surgical systems. Additionally, in healthcare, the growing interest in a data-driven approach to health and wellness is creating a convergence of the clinical and consumer markets and driving demand for higher performance vital signs monitoring in consumer wearables. Our suite of high-performance sensors, signal chains, and efficient power solutions and wins at leaders in these markets position us for double-digit growth this year. Within the automatic testing equipment market, the growth of AI has significantly increased our signal chain and power content, in some cases, up to 300% across memory test systems. Customers are leveraging our solutions to increase channel density and throughput while reducing power demands by up to 30%. In light of increased hyperscaler CapEx, we expect our 2025 memory and high-performance compute test revenue to achieve strong growth. In our broad aerospace and defense portfolio, our modules which support ASPs often into the hundreds of thousands of dollars, are expected to lead double-digit growth in this industrial subsector in 2025. In addition, we're anticipating growth this year from newer design wins in RF and power, in the military and commercial satellite sectors. In automotive, the convergence of trends ranging from autonomy to electrification and immersive in-cabin experiences continue to drive robust demand for many of our solutions. For example, our GMSL portfolio is outpacing the growth of advanced driver assistance systems and is positioned to reach yet another record-breaking year in 2025. Since acquiring this video connectivity technology in 2021, our revenue has nearly tripled. We're also anticipating growth in our connectivity and functionally safe power franchises, which share similar growth trajectories. Lastly, in electric vehicles, BMS is poised to return to growth in 2025 after a challenging prior year. Part of this growth is coming from our higher content wireless solution with key OEMs ramping in America and Europe. In communications, our growth is predominantly being driven by robust CapEx investments to support AI infrastructure build-outs. Our high precision electro-optical controller is now shipping in a 1.6 terabit optical module for AI systems based on industry-leading GPUs. On the power side of the data center, we're delivering high voltage power path protection systems which are on a strong growth trajectory, and we'll begin shipping our vertical power solutions later in this year. Finally, in consumer, design wins secured in recent years have multiple customers across numerous including premium handsets, hearables, wearables, and gaming systems, begun to drive robust diversified growth in the second half of fiscal 2024. With even more content in upcoming launches, we expect a strong year ahead and beyond in consumer. Collectively, we anticipate these combined cyclical and idiosyncratic trends to return us to a solid growth path this year. So in closing, the relatively favorable position in which we find ourselves coming out of one of the worst downturns the industry has ever experienced is not by chance but rather a reflection of our fiscal and operational discipline, commitment to the success of our customers, and our investments for the long term. And while I'm excited about our prospects for 2025, I'm even more excited about the longer-term opportunities across numerous concurrent secular growth areas including automation, digital healthcare, electrification, automotive data center, and many, many more. A common request from our customers across our many diversified applications is that we help them tame the increasing complexity by bringing more complete solutions to them. A reflection of our robust technology stack and stellar customer reputation. In stepping up to our customer's challenge, we continue to push the edges by investing vigorously in our world-class analog mixed signal and power portfolios, and integrate higher levels of supporting digital and software into our solutions to meet our customers at the application layer. And so with that, I'd like to pass the call over to Rich."
},
{
"speaker": "Richard Puccio",
"text": "Thank you, Vince, and let me add my welcome to our first quarter earnings call. First quarter revenue of $2.42 billion came in above the midpoint of our outlook for a 1% sequential decrease and a 4% decline year over year. Adjusting for the extra week in our fiscal Q1 2024, however, our Q1 2025 performance represents a 4% increase in our first year-over-year growth since Q2 of 2023. Industrial represented 44% of our first quarter revenue, finishing up 1% sequentially. The improved customer inventory backdrop is benefiting each of our industry segments. In addition, we are seeing stronger demand in our automatic test and aerospace and defense businesses, each of which were up year over year. Automotive represented 30% of quarterly revenue, finishing up 2% sequentially. Our leading connectivity and functionally safe power solutions were each up double digits year over year once again, reflecting secular content growth and greater share position. Communications represented 12% of quarterly revenue, finishing up 6% sequentially. Wireline, which makes up roughly two-thirds of our total communications business, was up double-digit sequentially and year over year, driven by data center infrastructure build-outs fueled by AI demand. Conversely, our wireless revenue continues to see demand challenges. And lastly, consumer represented 13% of quarterly revenue, finishing down 15% sequentially reflecting seasonal late. Our second consecutive quarter of robust year-over-year growth reflects our greater share and stronger content position across a diversified list of applications. Now on to the rest of the P&L. First quarter gross margin was 68.8%, up 90 basis points sequentially driven by favorable product mix. OpEx in the quarter was $687 million, up $32 million sequentially resulting in an operating margin of 40.5%. All told, non-operating expenses finished at $58 million and the tax rate for the quarter was 11.8%. All told, adjusted EPS was $1.63, at the high end of our guided range. Now, I'd like to highlight a few items from our balance sheet and cash flow statements. Cash and short-term investments finished the quarter at $2.7 billion and our net leverage ratio decreased to 1.1. Inventory increased $27 million sequentially as we replenish the die bank of our fastest turning products. Days of inventory increased to 176 while channel weeks moved lower and remained below our target of seven to eight weeks. The trailing twelve months, operating cash flow and CapEx were $3.8 billion and $656 million respectively. We continue to expect CapEx for fiscal 2025 to decrease from 2024 and fall within our long-term model of 4% to 6% of revenue. Free cash flow over the trailing twelve months was $3.2 billion or 34% of revenue. And during the same time period, we have returned more than $2.4 billion to shareholders through dividends and share repurchases. As a reminder, we target 100% free cash flow return over the long term using 40% to 60% for our dividend, with the remainder used for share count reduction. As Vince mentioned, we announced an 8% increase to our quarterly dividend to $0.99 from $0.92. In addition, our board is authorizing an incremental $10 billion for share repurchases resulting in roughly $11.5 billion of remaining buyback potential under our current program. Moving on to guidance. Second quarter revenue is expected to be $2.5 billion plus or minus $100 million. On a sequential basis, at the midpoint, we expect industrial to lead our growth and automotive to grow, while communications and consumer decline. Operating margin is expected to be 40.5% plus or minus 100 basis points flat sequentially due to a notable uptick in variable compensation. Our tax rate is expected to be 11% to 13% and based on these inputs adjusted EPS is expected to be $1.68 plus or minus $0.10. Before passing it back to Mike to begin our Q&A session, I'd like to address the near-term backdrop. Overall, our business continues to improve off our Q2 2024 trough in what continues to be an uncertain macro environment. We saw further order improvement and a positive book to bill during Q1. Importantly, booking strength was driven by industrial and automotive, our two largest end markets. Given this trend and the exciting product cycles Vince described, I'm confident we will return to long-term model growth in 2025 and believe we are well-positioned to capture additional upside should macro conditions improve. To you, Mike."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Rich. Get to the Q&A session. We ask that you limit yourself to one question in order to allow for additional participants on the call this morning. If you have follow-up questions, please re-queue and locate your question if time allows. With that, we are ready for the first question, please."
},
{
"speaker": "Operator",
"text": "If you have a question, for those participating by telephone dialing, please press star one one on your phone to enter the queue. If your question has been answered and you wish to be removed from the queue, please press star one one again. If you're listening on a speakerphone, please pick up the handset when asking your question. We'll pause for just a moment to compile the Q&A roster. Our first question comes from Joseph Moore with Morgan Stanley. Your line is open."
},
{
"speaker": "Joseph Moore",
"text": "Great. Thank you. Wanted you to talk about the puts and takes in the auto market. You know, China seems to be the strongest region. Can you talk about how that affects you guys if there is an ongoing shift in the center of gravity towards China? Does that have any impact on pricing, margin, or potential for you guys?"
},
{
"speaker": "Richard Puccio",
"text": "Sure. Joe, I'll take that one. This is Rich. Let me give you a little color on what we're seeing in auto. Starting with Q1, you know, revenue came in better than expected driven by Asia, which we've talked about, you know, continued strength in China. As we've talked about in our recent calls, we have flagged that we have stronger share and content position at major Chinese EV OEMs with multiple products, again, including our audio and video connectivity solutions, functionally safe power, and BMS. This is coming through in results and we expect it to continue into Q2. As for the impact of a change in center, you know, we continue to see strong results right from a, you know, three straight quarters of double-digit growth in China being led by auto. In addition, and what we can talk about this, we've seen growth in the other parts of the China business, but the auto is continuing to lead."
},
{
"speaker": "Vincent Roche",
"text": "I've been saying for a long time, Joe, that as long as there is a market for high-performance technologies, that ADI's technologies would continue to be relevant and that is the case. We see it in automotive. We see it in the industrial sector. And, you know, we're getting well paid for the quality of the technologies that we're bringing. So you know, it's clearly a competitive market particularly at the kind of middle low ends. With indigenous suppliers coming on stream. But given the high-performance trust in our portfolio, we were getting rewarded for the capabilities that we bring at the system level for our customers."
},
{
"speaker": "Joseph Moore",
"text": "Thanks, John. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Vivek Arya with Bank of America Securities. Your line is open."
},
{
"speaker": "Vivek Arya",
"text": "Thanks for taking my question. Rich, just to clarify, what is long-term model growth that you expect to return to this year? And then, Vince, my question is for you. You mentioned that the inventory levels have largely normalized. Is that at distributors? Is that at OEMs? Also, does it apply to all end markets or mostly to industrial? Basically, how does that inform us about how ADI can, you know, feel about demand visibility and growth over the next handful of quarters?"
},
{
"speaker": "Vincent Roche",
"text": "Thank you. Yeah. Maybe I can take the second part of the question first, Vivek. So we are seeing the normalization across the direct as well as distribution channels. And in pretty much every part of our business, including we were very, very encouraged by the recovery in industrial bookings. And that's a very, very important part of ADI's businesses. At its peak, it was a little over 50% of the total ADI revenue stream. So we're seeing monitor also, by the way, customer inventories. Our top customers. So we see normalization across segments, across customers, both big and small. We've also, by the way, kind of a bellwether for the general base of customers, you know, outside the top few hundreds, would be our mass market or a broad market. We've also started to see recovery there."
},
{
"speaker": "Richard Puccio",
"text": "Yeah. And it's an Vivek, when I talk about the long-term model, I'm talking about the published range at 7% to 10%. Although, I think as we've talked about as the macros turn, I think there's opportunity for us to capture even more growth than that. I think your one part, three-part question, Vivek, talked about what we think from here, a kind of growth back half of this year. I think we knew that is how do you think about seasonality as you get to Q3 and Q4. Again, this is not guidance for Q3, but I'll give you kind of what we see as trends. Typically, our last ten years for our third quarter, you know, our third quarter industrial auto and comp are usually flat plus or minus a little depending on where you're on the cycle. Given what Vince was saying about industry normalizing, new wins coming on, I think those markets should be flat up. So I think the higher end of what normal seasonality is, for those businesses. On the consumer side, we typically start your holiday build which means you start growing 5% to 10% in Q3. Now, obviously a lot of macro crosscurrents. It's really like the cocktail out there on the macro side, which could be a second half. We'll update you in ninety days what we really think about Q3. Your next question, please?"
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Tore Svanberg with Stifel. Your line is open."
},
{
"speaker": "Tore Svanberg",
"text": "Yes. Thank you. I had a question for you then. You know, ADI is in a pretty unique position because of your hybrid manufacturing model. And I was just wondering, you know, given all the political turmoil, the geopolitical turmoil that's going on right now, how are you thinking strategically about that hybrid model because obviously, you know, you're working with a very important partner in Asia, but then obviously also do some of your own internal manufacturing. So yeah, how are you thinking about how this is gonna play out in the next few years?"
},
{
"speaker": "Vincent Roche",
"text": "Thanks, Tore. Well, I think in times of great turbulence, diversity is a great benefit. Diversity of markets, diversity of products, diversity of customers and geographies. So I think, you know, I feel good in terms of our ability with that diversity to solve two problems essentially. One is diversity gives us optionality. But it also gives us resiliency. And, you know, by the kind of end of 2026 and the early 2027, we will have secured at least dual sourcing for the entire product chain of ADI. So about 95% of the products, you know, we'll have at least dual sources. And, you know, we've obviously desensitized geographic centricity over the last few years. We've invested in our fabs internally in America, in Europe, and we've worked with our partners as well to get at least two geographical sources for the products that we procure from our partners externally. So I think, you know, we're in a good position as a company to make sure that, you know, overall, we've internally got twice the capacity we had at the start of the pandemic. And as I said, we've secured also additional supply in new sources, new fabs, with existing partners. So I think we're in a very, very good position to weather whatever turbulence might come our direction."
},
{
"speaker": "Tore Svanberg",
"text": "That's great color. Thank you, Vince."
},
{
"speaker": "Richard Puccio",
"text": "Thanks, Tore."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Chris Danley with Citi. Your line is open."
},
{
"speaker": "Chris Danley",
"text": "Hey, thanks guys. I guess just to dig into the industrial strength. Can you just talk about where that's coming from? Is this mostly inventory replenishment? Is it mostly improved demand? Is it both? And then, you know, how did bookings trend during the quarter? Was the linearity pretty steady, or was there a spike? Or just a little more color there would be great. Thanks."
},
{
"speaker": "Richard Puccio",
"text": "Sure, Chris. I'll jump in on that. So on the industrial, if we take a step back, you know, we've grown this business now sequentially for three straight quarters. Off of what we said was our trough in Q2. And then as for Q2, we actually expect industrial to be the fastest growing market. So we feel pretty good that our recovery is taking shape. And really could accelerate if the macro improves. For Q1 specifically, and we've talked about this in a couple of quarters, we saw continued strength in ADA and in the automatic test equipment, and then what we started to see from a positive perspective is stabilization across automation, healthcare, and energy, which I think has been important. And then in Q1, one of the things that we've talked a bunch about on prior calls is watching for the pickup in the broad market. We started to see some of that. In fact, the pickup in the broad market drove much of the upside relative to our initial expectations, which gives us confidence to begin shipping in line with end demand. So if you think about, you know, we've talked about in prior calls that, you know, we took a significant amount of inventory out of the channel during 2024, about $300 million. Most of that impacted the industrial market. So as we look at our growth trajectory, shipping more to sell through into the channel, will be a tailwind for industrial as well."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. As you know, the industrial sector is largely served through the distribution channels. So you know, with leanness there, demand recovering, I think both of those two concurrent streams are tailwinds for the business."
},
{
"speaker": "Richard Puccio",
"text": "Yeah. On the booking side, bookings have improved in industrial in Q1 versus Q4. Pretty much across all the areas with the biggest strength obviously in ATE and ADA as we talked about. And we think it'd also be our fastest growth market in Q2, and that's supported by the bookings. Thanks, Chris."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Joshua Buchalter with TD Cowen. Your line is open."
},
{
"speaker": "Joshua Buchalter",
"text": "Hey, guys. Thank you for taking my question. I wanted to follow-up on the previous one. I think you mentioned in the prepared remarks inventory levels in the channel moved down and I think they entered the quarter already below your seven to eight weeks target. Does either the April quarter guidance or the fiscal 2025 initial outlook of being in your target range include any sort of channel refill and I guess what signals do you guys need to see before you would wanna more clearly get back into that seven to eight week range? Thank you."
},
{
"speaker": "Richard Puccio",
"text": "Yeah. So go ahead. So the current guide for Q2 has us shipping to sell through, so not adding into the channel. And I'll tell you for me for the benchmark and we talk to our distribution partners pretty regularly is if we're fulfilling customer requirements and we're not getting any escalations, we're feeling pretty comfortable right now operating below the seven weeks seven to eight weeks we've had historically. You know, balance that out, we're carrying a bit more inventory on our own books, which gives us some flexibility particularly given the amount of the inventory we're carrying in DieBank. Which allows us to be quicker to respond. So near to medium term, I don't expect that we would be adding back to the channel but we certainly do not wanna go any lower."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. I think just to add a bit of color to what Richard said as well, the centralization of inventory management I think, has served our customers very well. Customers of all sizes over the past what is essentially now five years of this of the old cycle. So we'll continue doing that, and that will be a critical guide as we think about how we modulate, you know, channel inventories over time."
},
{
"speaker": "Joshua Buchalter",
"text": "Very helpful, caller. Thank you. And congrats on the results in the cocktail of uncertainty."
},
{
"speaker": "Vincent Roche",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Christopher Rollin with Susquehanna. Your line is open."
},
{
"speaker": "Christopher Rollin",
"text": "Hey, guys. Thank you for the question. Mine is around two very specific opportunities that you've talked about in the past. One is optical connectivity, and then the other is AI power. If you have any developments in those products or markets, would love to know those, or maybe it's just playing out like you thought it would. But we'd love to know how interest orders, etcetera, are going for those products."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Thank you. Well, I'd say first and foremost, our opportunity pipeline has been growing steadily in this AI-driven infrastructure world. And, you know, we've been a long-term player in this electro-optical interface category, you know, where we provide these very precise high compute throughput control systems for stabilizing the electro-optical modems. And, you know, we've just introduced our 1.6 terabit which is very much the benchmark for throughput in these systems today, of course, those speeds will continue to increase. The sophistication of what we build will continue to grow as well. So that's been a very good business, a high growth business for ADI for many, many years, and it predates the AI build-out of the IT build-out AI infrastructure. Our power technologies really straddle two different areas. One is, if you like, the power control systems that are important for the overall operation of a data center at kind of the board level, the server level. And the other is, and a good example, by the way, of that power control will be these hot swapping reset generators and so on. These very, very tough analog problems need to be solved. The second part of the power story is the delivery of energy to the GPUs, the chip systems themselves. And, we're going to production in the second half of this year, with the vertical power technique with one of the big hyperscalers. And we have other designs in train that will come on stream as well, I believe, in the 2026 period."
},
{
"speaker": "Christopher Rollin",
"text": "Fantastic color there. Thank you so much. And maybe just kind of playing into these kind of new products that are emerging here. Are there any new other new products to call out? New customers? New end markets, any of these kind of free options, as I like to call them, that are emerging for your company. And anything you can point to, anything new that maybe you haven't had before any new opportunities?"
},
{
"speaker": "Vincent Roche",
"text": "It depends on, you know, how far into the future you want to go, but, you know, let me give you a couple of real-time examples here. I mentioned in the prepared remarks the convergence of wellness-based healthcare solutions with the consumer sector. We see that the interest in building those systems out is becoming, I would say, very, very active. We're well-positioned as a company because we've been building the sensory and signal processing technologies for a long, long time. So I would call that out as an area with a good spectrum of customers across many geographies. And many, many different types of healthcare modalities that need to be measured at the clinical grade level in incidentally, areas like continuous glucose monitoring. Being able to do that in a closed-loop system, both the input and the output. So I think that is an area that we're excited about, but we've a lot of good technologies that are being deployed at faster rates into that area. And if you want to go really into the future, you know, there is light beginning to appear in the whole quantum computing world, and we're at the early stages of building control systems, if you like. Precision control systems for these very, very complex computing elements."
},
{
"speaker": "Christopher Rollin",
"text": "Very cool. Thank you so much."
},
{
"speaker": "Michael Lucarelli",
"text": "Hey, Chris. As a reminder, if there's any additional questions from people who've asked questions, please re-queue your some extra time. Otherwise, we'll go to our next question."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Harsh Kumar with Piper Sandler. Your line is open."
},
{
"speaker": "Harsh Kumar",
"text": "Yeah. Hey, guys. I just wanted to hit up on the quote-unquote call for the bottom. I guess you're calling that. Guess what is the confidence level that this is not a head fake? I know you're talking about increased orders and normalization of inventory, but there's a lot of geopolitical movement. There's a lot of tariffs. Help us understand why the confidence level is so high that we've reached the bottom and this isn't just some kind of headache. Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Well, I think, you know, first and foremost, we have a lot of conversations with a lot of customers. You know, we've tens of thousands of customers in our portfolio. We pay attention to the signal that matters to us most is sell-through. So POS is how we, that's where we focus and that POS signal is how we plan our supply at ADI, how we run our business and run our supply system. So that's first and foremost. I think, you know, we are seeing the stabilization in the business and growth in certain areas right across the spectrum. And then there is geographically, there is a diversity of progress as well. I'd say Japan is most muted. America and China are strongest. I would say Asia Pacific is strong, and Europe is somewhere between, you know, between where Japan is and where the rest are. So but that's essentially how we view the work. As we said in the prepared remarks, what's incalculable here in our thinking is the effect of any potential geopolitical turmoil, trade war, and so on and so forth. So that I think, will be the governor ultimately. During this year as to the rate of recovery. But I have a strong conviction that in a new cycle in the semi sector uncertainty in aviation business."
},
{
"speaker": "Harsh Kumar",
"text": "Thank you for the color. Thanks."
},
{
"speaker": "Michael Lucarelli",
"text": "Thanks, Harshal. I'm going to our last question, please."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Tore Svanberg with Stifel. Your line is open."
},
{
"speaker": "Tore Svanberg",
"text": "Yeah. I just had a follow-up on the, you know, conviction in growth there. You know, typically, when we go through these cycles, I think customers, they sort of hold off buying new products on sort of the older products have cleared out. And I'm just wondering if there's some of that going on. I mean, I guess that really relates to your win conversion rate. So, you know, any comments you can make on that conversion rate really starting to play out would be really helpful. Thank you."
},
{
"speaker": "Vincent Roche",
"text": "Yeah. Well, for example, Tore, the strength we're seeing in ATE markets, in the automotive market, for example, in areas like new data center modalities. Those areas are largely driven by a lot of new products. So I would say, there's three examples of where new products are making a huge difference. In fact, they're also with each new generation, we're capturing more ASPs. So, you know, we've often shared with you our famous vintage chart which shows the age of the portfolio. We measure very, very carefully within that vintage chart the contribution of newer products within a three and ten-year period as to what's going on. But I can tell you the conversion rate, the introduction of new parts, and the capturing of opportunity with new parts is strong. New products and new solutions. And, you know, obviously, we've got also a very strong franchise. Our legacy products tend to get pulled by these new anchor products that we're building. I'd say overall, I'm pleased with the effectiveness of our R&D spends and how we're capturing and creating new markets and new applications."
},
{
"speaker": "Tore Svanberg",
"text": "Very helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Thank you. I'm showing no further questions at this time."
},
{
"speaker": "Michael Lucarelli",
"text": "Alright. No problem. I think we answered all the questions then. Thanks, everyone, for joining us this morning. A copy of the transcript will be available on our website. Thanks for joining and your continued interest in Analog Devices."
},
{
"speaker": "Operator",
"text": "This concludes today's Analog Devices conference call. You may now disconnect."
}
] | Analog Devices, Inc. | 251,411 |
ADM | 4 | 2,020 | 2021-01-26 09:00:00 | Operator: Good morning and welcome to the ADM fourth quarter 2020 earnings conference call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s call, Victoria De La Huerga, Vice President, Investor Relations for ADM. Ms. De La Huerga, you may begin.
Victoria De La Huerga: Thank you Shelby. Good morning and welcome to ADM’s fourth quarter earnings webcast. Starting tomorrow, a replay of today’s webcast will be available at adm.com. For those following the presentation, please turn to Slide 2, the company’s Safe Harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management’s current views and estimates of future economic circumstances, industry conditions, company performance, and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statement as a result of new information or future events. On today’s webcast, our Chairman and Chief Executive Officer, Juan Luciano will provide an overview of the quarter and the year and highlight some of our accomplishments from 2020. Our Chief Financial Officer, Ray Young will review financial highlights and corporate results, as well as the drivers of our performance, then Juan will make some final comments, after which they will take your questions. Please turn to Slide 3. I will now turn the call over to Juan.
Juan Luciano: Thank you Victoria. This morning we reported fourth quarter adjusted earnings per share of $1.21, up 49% year-over-year if we exclude the prior year impact of the retroactive biodiesel tax credit. Adjusted segment operating profit was $1.15 billion, 12% higher than the fourth quarter of 2019. For the full year, we delivered record adjusted EPS of $3.59; $3.4 billion in adjusted segment operating profit, 12% higher than 2019; four straight quarters of year-over-year segment operating profit growth, and trailing four-quarter adjusted ROIC of 7.7%, almost 200 basis points above our weighted cost of capital. We are maintaining our strong balance sheet and generating strong cash flows. The team managed a wide variety of risks superbly and we achieved our strategic initiatives, exceeding our $500 million to $600 million guidance and driving our ability to deliver a steady, sustainable earnings growth. I’d like to thank our team for this tremendous performance and highlight for you some of our many achievements in 2020. In our optimized pillar, around the globe amid lockdowns, rapidly shifting demand patterns and extreme weather events, our colleagues fulfilled our purpose by adapting and innovating to keep our work environment safe from COVID-19, maintaining our operations to support the global food value chain, and delivering for our customers to provide nutrition around the world. Beyond that, for the year, our ag services and oilseeds team delivered more than $300 million in capital reduction initiatives, and we are focusing on new ways to enhance the return structure of that business from digital technologies like our Grainbridge joint venture to differentiated products and services that add share value for growers, customers, and ADM. In our drive pillar, our new organizational structures and business processes, like our centers of excellence and our 1ADM business transformation project are helping drive better decision making and operational excellence. We continued our work to support our planet and its natural resources. We achieved our 15x20 environmental goals ahead of schedule and launched Strive 35, an even more ambitious plan to reduce greenhouse gas emissions, energy, water, and waste by 2035, and we’re partnering with farmers in their efforts toward better outcomes, supported by the 6.5 million acres we have in sustainable farming programs over recent years. In our growth pillar, our nutrition team exceeded our Neovia synergy targets and delivered them ahead of schedule. We expanded our plant-based protein capabilities, including the launch of our PlantPlus Foods joint venture, and amid an incredibly dynamic demand environment, we utilized new, innovative technologies and continued launching new products to ensure we’re meeting our customers’ needs. Our carbohydrate solutions colleagues moved quickly to meet changing customer needs for retail flour, industrial starches for cardboards, and USP-grade alcohol for hand sanitizers, and the ADM team showed its innovative spirit by partnering and supporting companies that are making food out of air, spider silk out of corn, and animal feed out of insects. Finally, I’m proud to say we surpassed by about 10% our stretch goal of $1.3 billion in readiness run rate benefits by the end of the year. Readiness is driving our strategic initiatives, enabling us to be more efficient and powering our growth. Perhaps most importantly, today we can say that readiness is truly embedded in our culture. It’s how we work. Thanks to these impressive achievements, I’m pleased to announce a quarterly dividend increase of 2.8% to $0.37 per quarter. This dividend will be our 357th consecutive quarterly payment, an uninterrupted record of 89 years. It’s been a remarkable year with achievements and results that truly demonstrate the strategic work we’ve been doing over the years to optimize, drive, and grow. Even more important is how we’re building for the future. We’ve created and are now strengthening the strategic foundation to deliver steady, sustained earnings growth for years to come. I’ll be talking about that shortly, but first let me turn the call over to Ray to take us through our business performance. Ray?
Ray Young: Yes, thanks Juan, and good morning everyone. Please turn to Slide No. 4. As Juan mentioned, adjusted EPS for the quarter was $1.21, down from the $1.42 in the prior year quarter. As a reminder, the fourth quarter of last year was positively impacted by the recognition of about $0.61 per share for the retroactive biodiesel tax credits. Absent this, earnings would have grown by about 49%. Our trailing four-quarter average adjusted ROIC was 7.7%, almost 200 basis points higher than our 2020 annual WACC, and our trailing four-quarter adjusted EBITDA was about $3.7 billion. The effective tax rate for the fourth quarter of 2020 was approximately 8% compared to a benefit of 1% in the prior year. The calendar year 2020 effective tax rate was approximately 5%, down from the approximately 13% in 2019. The decrease in the effective tax rate for the calendar year was due primarily to changes in the geographic mix of earnings and the impact of U.S. tax credits, mainly the railroad tax credits, which have an offsetting expense in the cost of products sold. Absent the effect of EPS-adjusting items, the effective tax rate for the fourth quarter was approximately 11%, and for the calendar year 2020, it was approximately 9%. Looking ahead, we’re expecting full year 2021 effective tax rate to be in the range of 14% to 16%. We generated about $3.1 billion of cash from operations before working capital for the year, significantly higher than 2019. Return of capital for the year was $942 million, including more than $800 million from dividends. We finished the quarter with a net debt to total capital ratio of about 32%, up from the 29% a year ago due to higher working capital needs due to rising commodity prices. Capital spending for the year was about $820 million, in line with our guidance and well below our depreciation and amortization rate of about $1 billion dollars. For 2021, we expect capital spending to be in a range of $900 million to $1 billion. Slide 5, please. Other business results were substantially lower than the prior year quarter. ADM investor services earnings were impacted by drastically lower short-term interest rates. Captive insurance results were negatively impacted by $15 million more in net intra-company settlements compared to the prior year quarter. For 2021, we expect other business results to be in line with 2020. In the corporate lines, unallocated corporate costs of $278 million were higher year-over-year due primarily to increased variable performance-related compensation expense accruals, increased IT and project-related expenses, and centralization of certain costs, including from Neovia. Other charges decreased due to lower railroad maintenance expenses partially offset by the absence of prior year investment gains. For 2021, corporate unallocated should be overall similar to 2020. Net interest expense for the quarter was lower than last year due to lower short term interest rates and liability management actions taken in 2020. For 2021, we expect net interest expense for the calendar year to be similar to or slightly lower than 2020. Slide 6, please. The ag services and oilseeds team capped off an outstanding year with record adjusting operating profit in the fourth quarter. Ag services results were significantly higher year over year. In North America, the team executed extremely well, capitalizing on strong global demand particularly from China to deliver higher export volumes and margins. South American origination was lower year over year after significantly accelerated farmer selling in the first half of 2020. Global trade continued to do a great job, contributing to higher results by utilizing its global reach and managing risk well to meet customer demand. Approximately $80 million of prior timing effects reversed in the quarter, as expected. Crushing also delivered substantially higher results versus the prior year period. The business did a great job to capture higher margins in a continued environment of tight soybean supply and strong global demand for both meal and vegetable oils. There was approximately $125 million in net negative timing in the quarter driven by basis impacts and improved soft seed margins. Refined products and other results were higher year over year absent the recognition of the retroactive biodiesel tax credit in the fourth quarter of last year, with good results driven primarily by solid South American margins. Wilmar’s strong performance drove our equity earnings higher versus the prior year despite our slightly lower ownership stake. For the full year, ag service and oilseeds delivered exceptional results of $2.1 billion, 9% higher than 2019. The team achieved multiple records, including all-time high global crush volumes. In addition, we’re proud of the team that brought our reserve export facility back online safely and ahead of schedule despite dealing with multiple severe weather events this year. Looking ahead, we expect the first quarter of 2021 results for ag service and oilseeds to be significantly higher than the prior year first quarter, driven by extremely strong North America export demand and continued healthy crush margins. Slide 7, please. The carbohydrate solutions team again delivered substantially a higher year-over-year result despite the impacts of lockdowns in key market segments. The starches and sweeteners sub-segment achieved significantly higher results driven by lower net corn costs and intra-company insurance settlements. Earnings were partially offset by low results from corn oil and wet mill ethanol margins. Damaged corn processor results were also better versus the prior year, though they continue to reflect the challenging ethanol industry environment. The team delivered higher year-over-year margins as they met increased demand for USP-grade alcohol, partially offset by fixed costs from the two temporarily idled dry mills. Considering the impact of lockdowns in both driving miles and the food service sectors, we’re extremely proud of our carbohydrate solutions team for delivering full year results of $717 million, 11% higher than 2019. The team achieved record high operating profits from starches in the year. They acted decisively by temporarily idling production at our two VCP dry mill plants, helping address industry supply and demand balances, and the wheat milling business’ modernization and optimization plan, including a new state of the art mill in Mendota, Illinois, helped power a significant improvement over full year 2019 for that business. Looking ahead, we expect carbohydrate solutions results in the first quarter to be significantly higher than last year’s first quarter, which was negatively impacted by corn oil mark to market impacts, but below the fourth quarter 2020 levels due to the challenged industry ethanol margins. Slide 8, please. The nutrition team delivered 24% year-over-year growth in the quarter. In human nutrition, flavors delivered a strong quarter driven by good sales and product mix in North America and EMEAI. Continued strength in plant proteins drove higher results in specialty ingredients. Health and wellness delivered higher sales in probiotics and natural health and nutrition. Prior year results included revenue and income related to the launch of the strategic Spiber relationship. Human nutrition results for the quarter also included an intra-company insurance settlement. Animal nutrition results were significantly higher year over year, driven by strong performances in Asia and EMEAI and improvements in amino acid results, partially offset by currency effects in Latin America. We’re continuing to make improvements in our amino acid business, including our announcement last month that we’re discontinuing dry lysine production and transitioning to our liquid and encapsulated products in the first half of this year. For the full year, nutrition results were $574 million, 37% higher than 2019. The nutrition team grew revenue 5% on a constant currency basis and continued to expand EBITDA margins. We exceeded our Neovia synergy targets and delivered them ahead of schedule. We are truly seeing the benefits of our investments in nutrition. Looking ahead, we expect nutrition to solidly grow operating profits in 2021 calendar year, but the first quarter should be similar to the prior year period due to timing of certain expenses over the year, including investments in projects to drive organic growth. With that, let me turn it over to Juan to conclude. Juan?
Juan Luciano: Thank you Ray. Slide 9, please. I’d like to congratulate the team once more on delivering great results in 2020. I’m proud of what we achieved and I’m excited to see our work empowering us to reach even greater heights. In 2020, ag services and oilseeds capitalized on its unparalleled and flexible global footprint to meet strong demand. In 2021, we expect ag services and oilseeds’ strong execution, diverse and flexible crush capabilities, including an extensive soft seed footprint and important strategic work to continue to drive results. In addition, we expect the global demand environment for ag services and oilseeds to remain strong. China should continue to be a significant buyer. We see continued strong global growth in meal demand and we expect increased demand for vegetable oil due to recovering cooking oils for food service and growth in demand for biofuels, including renewable green diesel. That is why we are confident in another outstanding performance from ag services and oilseeds in 2021. Carbohydrate solutions is showing how we have embedded great execution into our operational structure and culture. The team is doing a great job strengthening their business by optimizing their plans and product mix, and their ability to adjust production in 2020 to quickly meet changes in demand showed how those strategic efforts are paying off. Now they are well positioned to use those same tools as the effect of lockdowns on the food service and transportation fuel sectors dissipates throughout 2021. We expect solid profit growth for the year for carbohydrate solutions. Nutrition continued to harvest investments, leading consumer growth trend areas and partnering with customers to bring innovative new products and solutions to market in 2020. Based on our current organic growth plans, we expect the nutrition team to deliver solid revenue expansion and enter the period of an average of 15% per annum operating profit growth consistent with our strategic plan. Across ADM, we are fulfilling our purpose and building on a foundation for steady, sustainable earnings growth. We are growing and leading in key trend areas, including food security, health and wellness, and sustainability. Our continued advancements of readiness is benefiting the entire enterprise and we’re making investments in exciting growth innovation platforms, which we’ll be talking more about in the future. In 2021, we will remain focused on the drivers under our control, having incremental returns as we focus on organic growth, advancing operational excellence initiatives to maximize returns from every business and every asset, and continuing to generate benefits from readiness. With the strong execution of these strategic initiatives and improving market conditions as the year progresses, we expect to build on a record 2020 with strong growth in segment operating profit and another record year of EPS in 2021. With that, Shelby, please open the line for questions.
Operator: [Operator instructions] Your first question is from Michael Piken of Cleveland Research.
Michael Piken: Yes, good morning. Congratulations on the good quarter. Just wanted to dig a little bit more into your thoughts on how U.S. crushing is going to play out throughout the year. I understand 1Q is going to be really strong, but are you worried about tightness and availability of soybeans as we move into the spring and summer, and how are you sort of positioning your crushing business in case the market gets a little bit tighter?
Juan Luciano: Yes Michael, thank you for the question. Good morning. Listen, we expect 2021 to be a very, very strong year for oilseeds and ag services, maybe with a different mix of earnings that we have in this year. If you think about 2021, we’re starting with tailwinds from 2020, so we’re starting from a different position, and we’re starting the year with improved global crush margins in Q1 versus Q1 last year. We see a year in which we flex a little bit more our capabilities. We see a strong, still soybean crush but an exceptional crop and recovery after many years of softness in the soft seed crush, and I’d remind you that we have about 25% of our capacity in soft seed, and we have about 15% of our capacity that is shifting, so that’s a competitive advantage for ADM. We see a strong demand for meal, and we see also the vegetable story playing out with good global demand and prices that are today about 20% higher than at the same time last year, and not only coming from food demand but also from fuels, a new renewable green diesel capacity is having an impact in green oil demand and margins, and think that that could be something about half a billion pounds per year this year of extra demand, so all in all we see tight balances and we see a strong margin environment for the rest of the year.
Michael Piken: Great. Then just as a follow-up, in your slide deck you talked about on Slide 13 having $295 million of cumulative crush deferred timing gains, is that all showing up in oilseed crush or is that across the whole portfolio, and if you could give us any sort of help in terms of the cadence of when we might see that realized - is it going to be primarily in 1Q or more evenly spread throughout the first half? Thanks.
Ray Young : Yes Michael, it’s Ray here. This is in the crush part of the ag services and oilseeds. As you pointed out, we increased by $125 million in the quarter, so now we have a balance of about $295 million in timing effects. We expect that roughly half will get reversed in the first quarter based upon the book that we have right now, and then the other half will be reversed over the second and third quarters and actually we’ll see how prices move, but this is our current expectations in terms of how we expect this to play out over the course of ’21.
Michael Piken: Thank you.
Operator: Your next question is from Adam Samuelson of Goldman Sachs.
Adam Samuelson: Yes, thank you. Good morning everyone.
Ray Young: Morning Adam.
Adam Samuelson: I guess my first question was going to be around the carbohydrate solutions business. I know you talked about seeing a pathway for growth there, and understanding especially in the first half of the year there’s some pretty easy comps in terms of capacity utilization and weak volumes on the HFCS side, but help us think through some of the different pieces there. Ethanol in the first half of this year looks to be in a bit of a tougher spot, obviously corn prices have moved up pretty notably. Just trying to think about some of the different moving pieces and help us how we get to growth in that business in 2021.
Ray Young: Yes, sure Adam. Let me start here. It’s useful to refer to also how they manage 2020, right, because 2020, when you think about businesses that have been most negatively impacted by COVID-19, the carb sol segment was the one most negatively impacted, yet in 2020 they grew earnings. What they did was they really managed product mix extremely well - you know, driving starches, driving industrial alcohol. They managed the ethanol production well and frankly had a positive impact on industry margins through the idling actions it took. But what a lot of people forget is we have an international business that’s growing, right so we’re expanding capacity over in Europe, and the European operations almost doubled in profitability in 2020 compared to 2019, a big contributor there. In the North America milling operations, their footprint optimization is really paying off with 20% growth in profitability in ’20 versus ’19, so when you think about 2021, this playbook continues. Number one, we do expect stabilizations in the North American starches and sweetener business as the beginnings of recovery in demand for certain products occur with the dissipation of lockdowns. Secondly, they’re continuing to drive great product portfolio mix, so particularly in the area of liquid dextrose and maltodextrin and citric acid. Those are actually, from a product mix perspective, very beneficial. Thirdly, continued international growth, so when you think about where sugar prices are around the world right now, our European operations, whereby we’ve added capacity, continues to drive growth, they’re going to be another contributor. Then lastly, we expect continued growth in terms of our milling operations, and very pleased in terms of how their optimization plan is really playing out. Now getting back to some of the comments on the year-over-year comparison, we start off the year with weaker margins in ethanol, but if you recall in last year, margins actually hit a low of negative $0.45 in March. We don’t see that, so when you think about year-over-year comparisons, we’re going to start off on a challenged basis but we do expect the industry supply-demand balances in the ethanol industry get better balance as we move through the year, for several reasons. Number one, China actually has been buying U.S. ethanol. That’s something that they have not been doing over the past couple of years, and we believe that they’ve already made commitments already in the first half of the year for U.S. ethanol equal to the previous all-time high for the calendar year, roughly 200 million gallons. We’ll have to see where China ends up in the calendar year in terms of imports of U.S. ethanol. Secondly, there has been announced reconfiguration of ethanol capacity by various competitors in the industry as they kind of focus their production away from transportation fuel ethanol towards other products, so that’s going to have an impact in industry supply and demand. Thirdly, the industry itself, there is about 10% to 15% of capacity that remains idled, and from our perspective we’re going to remain very disciplined in terms of when we actually re-start the dry mills because we’ll want to see sustainable margins before we re-start, and hopefully sometime in the first half we’re going to see that. Then lastly, how the small refinery exemptions will play out over the first part of the year as the Supreme Court rules on it will have an impact, frankly, in terms of domestic demand for ethanol. If you take a look at RINs pricing right now, there is an expectation in the U.S. that domestic ethanol demand is going to be strong over the course of this calendar year, given just a recovery in terms of driving miles as we go through the year and then, secondly, how the expectations in terms of how the SREs will play out. Overall, Adam, we feel good about how we start the year in terms of the carb solutions businesses, but we do see particularly in the area of ethanol, we see green shoots of recovery in 2021 for this business here.
Adam Samuelson: That’s a lot of really helpful color, Ray. If I could just squeeze in a second one, just on the balance sheet, just given the move up in commodity prices, the increased cost of inventory, how do we think about the tolerance for more offensive capital deployment in terms of buybacks or M&A over the course of ’21? How much dry powder do you think you have as we sit here today?
Ray Young: Well, we finished the year actually from a leverage perspective on a debt to EBITDA ratio in reasonable position because, as you know, inventory financing from a rating agency perspective, you get RMI credit, so with the movement in higher commodity prices which moved working capital higher, clearly we’re financing it. One of the things very different than the last crisis back in 2008 is that we’ve really diversified our working capital lines, and so I feel good about our ability to finance a higher working capital level. But from a leverage perspective with the RMI credits, our leverage--our balance sheet remains strong, and so we believe we’ve got fire power in order to continue to look at opportunistic M&A and opportunistic share buybacks over the course of the year.
Adam Samuelson: All right, I really appreciate all that color. I’ll pass it on. Thank you.
Operator: Your next question is from Vincent Andrews of Morgan Stanley.
Vincent Andrews: Thanks, and good morning everyone. Ray, Juan, just wanted to ask you both about the inverse that we see in the corn and soy markets and how you’re going to manage that in the ag services business this year, and what challenges or opportunities does that present for you?
Juan Luciano: Yes, thank you Vince. Listen, the inverse certainly is indicating to farmers and everybody that to bring the product to the market, so we see a little bit of this talking - of course, nobody wants to run that inverse through--cold inventory through the inverse. What we are seeing is that that inverse is bringing is that--is bringing clear assistance for exports for North America and South America, and we think that that’s an advantage for the ag services business in which it brings better margins normally for export season. You’re going to see a little bit what happened last year, you know, that Brazil sold everything, run out of material, then the tide shifted immediately for the U.S. The U.S. is starting from an extended window of exports because of Brazil started a little bit late the planting, so we are starting with good margins, we are starting with good exports for the first quarter. For the first quarter, Vince, we expect U.S. record volumes for Q1 and then we expect a very strong season at the end of the year with another strong Q4. We’re very, very optimistic about it.
Vincent Andrews: Okay, that’s very helpful. If I could just follow up on freight rates, they really have run up. Is that something that you benefit from, because presumably you have long term contracts that those freight rates have to get pushed into the market pricing, and you just maybe get the benefit on the revenue line but don’t experience the cost, or is there a different dynamic there?
Juan Luciano: No, I think you are correct in your assessment. You also have to understand the value of the full value chain that we run in ADM. When I describe, for example, record exports, that means also record loads for ARTCO, so we get a secondary stream of profits from there for the full value chain. We have stevedoring, we have the barges, and we have the export terminals, so the whole--when you have that kind of volume, the whole value chain gets enhanced margins all through the chain.
Vincent Andrews: Okay, very good. I appreciate the comments. I’ll pass it along.
Juan Luciano: Thank you.
Operator: Your next question is from Ben Bienvenu of Stephens.
Ben Bienvenu: Hey, thanks. Good morning everybody.
Ray Young: Morning Ben.
Ben Bienvenu: I wanted to ask your outlook for the year for 2021, you made a note in your press release and in your comments that you expect improved market conditions. I suspect in light of the detailed comments that you gave, you’re referring to the carbohydrate solutions group particularly, but I’d be curious what you’re expecting on the ag services and oilseeds. Is 2020 a number that you think is probable to be eclipsed for EBIT based on the market view that you have right now, or how should we be thinking about that setup?
Juan Luciano: Yes Ben, when I think about the three businesses for 2021 and when we think about a strong 2021, the ag services and oilseeds business will be a very, very strong year, as I said before, maybe with a different mix of earnings with maybe we’re not going to get to the same levels in RPO business or maybe South American oils, but we’re going to have a better canola and soft seed margins in general for the business. We still expect exports from ag services to be very strong. We had an exceptionally strong year for global trade in 2020, which I think we’re going to have a strong year, we don’t know exactly we’re going to get to the same level. We plan another outstanding year for ag services and oilseeds in 2021. Carb solutions, I think that that’s the business, as Ray explained it before, that has been the biggest impact by COVID-19, and we think that last year, it was a very tough year in which the team did an outstanding job of growing earnings 11% in that environment. We think that conditions for this year, especially when you think about the pent-up demand, the improvements in conditions with more prevalent vaccination in the second half and all that, and with some exports to China in ethanol, we expect there are many elements there to build a more constructive scenario in 2021 than in 2020. The nutrition business will continue to grow. We are investing in that business and it’s a business that has a strong organic growth program, and we see in that range, as I mentioned before, that when we look at the strategic plan for nutrition as we grow nutrition to the billion-dollar OP during our plan, we’ll look for 15% CAGR to get there, and that’s what we’re expecting for this year. That’s how I think about 2021.
Ben Bienvenu: Okay, that’s great. If I could, as it relates to 1Q in particular for carbohydrate solutions, you noted you expect results to be significantly higher than 1Q20 but lower than 4Q20. That’s a pretty big range. Is there any more granularity you could provide there? Should we be thinking about something north of $100 million based on the current market view, or is that too high? Maybe just any more specificity, if you’re willing to give it, on that segment in particular in 1Q, and then I’ll leave it there. Thank you.
Ray Young: Yes, a lot of it is going to be a function of where ethanol moves over the course of the year. We expect it to be over $100 million. We expect it to be over $100 million, but where we land, a lot of it will be where ethanol moves over the next couple months here. But again, if you recall last year, we had about $65 million of negative corn oil market to market that won’t get repeated, so that’s going to be a benefit in our first quarter results this year.
Ben Bienvenu: Okay, thank you both, and best of luck in this year.
Ray Young: Thank you.
Operator: Your next question is from Robert Moskow of Credit Suisse.
Robert Moskow: Hi. Congratulations on a great year. I wanted to know if you have any color for us on the impact of rising corn costs. There’s some comparison, I guess benefits compared to last year where corn oil was out of sync, but is rising corn costs going to be a problem for carbohydrate solutions at any point, and maybe you could talk more specifically about high fructose corn syrup negotiations and were you able to increase your prices to offset the higher corn costs. Thanks.
Ray Young: Yes Rob, it’s Ray here. A couple things to note. First of all, the team did an outstanding job on risk management, so without disclosing everything that they do, it’s fair to say that we had a lot of our requirements for 2021 hedged before the significant run-up in terms of corn costs. I think that the team did some great work in terms of anticipating how S&Ds would actually work over the course of 2021. With respect to contracts, just a reminder not every contract gets negotiated in the contract cycle. We have multi-year contracts, and so a certain amount of contracts got negotiated and the outcome of the negotiations is the fact that we expect to be able to maintain our margins as we go through 2021 relative to 2020, through a combination of contract negotiations as well as the efforts that we’re doing in terms of managing the mix and also managing our costs there. The other comment in terms of rising corn costs, and also given really a strong demand environment for feed, is you’ve seen cold product values go up. That’s a benefit for our businesses as well, so I think in the fourth quarter we made the comment that part of the strong results is that we had very favorable net corn costs. We expect that the team is also going to be able to manage through ’21 with good net corn cost as well, so I think the team--and the carb sol team, they’ve done an outstanding job on the risk management side in managing through the higher corn cost environment here.
Juan Luciano: Rob, if I may add, I think something that gives us confidence, because of course the team is pretty good at doing this, is that in very tight markets, the fundamentals become more important because markets move more based on fundamentals, and there the information we have, the visibility we have in the network becomes much more important to make decisions than in other times, when maybe materials are a little bit longer and softer. Then, there are more variables that come into play.
Robert Moskow: Maybe you can’t this much detail, but in the contracts that you were negotiating, were you able to negotiate prices higher in reaction to higher corn, or was it not like that?
Ray Young: I think, Rob, let’s keep it to the fact that we’ve been able to manage in total the portfolio, the contracts and being able to maintain the margins year over year. That’s the level of disclosure I think we want to make at this point. Thank you.
Robert Moskow: Got it, okay. Thanks.
Operator: Your next question is from Ken Zaslow of BMO.
Ken Zaslow: Hey, good morning everyone. I have two questions. First, the capex spending is going up. What are you incrementally spending on and what do you think the returns are, and when will you actually get the returns associated with that and how do we think about the incremental products there? That’s my first question.
Ray Young: Ken, a couple things on the increased capex. One, I mentioned that we are in the midst of a business transformation program, so 2021 will be one of our peak years into a project, the One ADM project, so we do have some capitalized--some incremental capitalized costs associated with the program that’s part of our capex budget. Secondly, with the pandemic in 2020, some projects got moved over, got pushed from 2020 into 2021. Some of them are growth projects, some of them are cost reduction projects, some of them are non-discretionary expenditure projects, so there’s a series of projects that we did push from 2020 to ’21 just due to the pandemic and our ability to execute. Then thirdly, we do have growth projects. We mentioned organic growth, our focus in that area, so we do have organic growth projects going on in the course of 2021. Those are the three buckets as to why the number is increasing from the number that we finished up in ’20 from ’21. Again, the range, $900 million to $1 billion is a large range. We haven’t approved some of these projects, we’re just putting it in terms of a placeholder, but part of our discipline is we will be evaluating the timing, the returns, and determining do we actually spend it in the course of ’21 or not. As you know, in terms of growth projects, our hurdle rates are double-digit percentages, right? Our hurdle rates are double-digit percentages in order to approve these projects.
Juan Luciano: And I’d remind you, Ken, that first of all, we are also becoming a larger company, so there are projects now that our organic growth is coming from the new Neovia acquisition, the animal nutrition. We are expanding our bioactives production in Valencia, Spain, so we are becoming a larger company. I’d also remind you that we have a program to divest to reduce capital investment, and we achieved $300 million in that side of the ledger, so we’ll continue with the same capital discipline done before. You can be assured of that.
Ken Zaslow: Great. Then my second question, really more of a clarification, you said in 2021 EPS and operating profit would be higher year over year, or could be significantly higher - I forgot the exact word, but does that include or exclude the $295 million? I’ll leave it there.
Ray Young: You’re referring to the $295 million of timing effects, Ken?
Ken Zaslow: Yes, are you going to be able to grow numbers outside that $295 million, or is that $295 million included in what you think is going to be a year-over-year--
Ray Young: It’s all included there. It’s all included in the number there, Ken - all included.
Ken Zaslow: Would you be able to grow even without that, or is that part of the--I guess I’m just trying to figure out, when you say significant growth, is that beyond the $295 million or is that including? If you didn’t have the $295 million, would you still be able to grow? I’ll leave it there.
Ray Young: There’s a lot of puts and takes there, Ken, right, so I think it’s fair to say that our pre-tax numbers are going to grow significantly and there is going to be a little--you take a little bit off with the higher tax rate. I think that’s probably the more important factor, is our higher tax rate will skim off a little bit of the pre-tax improvement that we’re going to drive in ’21 versus ’20.
Ken Zaslow: Okay, great. Thank you guys very much.
Operator: Your next question is from Tom Simonitsch of JP Morgan.
Tom Simonitsch: Hi, good morning everyone.
Juan Luciano: Morning Tom.
Tom Simonitsch: Just following up on U.S. export strength, how much U.S. corn do you expect China to import beyond this marketing year?
Juan Luciano: Yes Tom - sorry, I was trying to get my mask off. We’re expecting China to take about 25 million tons of corn, so you know the situation there in China - we think that inventories are much--reserves are much lower than what the market is reporting there. You can see that in the prices that we’ve seen. China didn’t have a great crop, so we expect significant imports for both oilseeds and corn.
Tom Simonitsch: Do you think that 25 million tons is sustainable beyond this marketing year?
Juan Luciano: Yes, we think so, we think so. Of course, not all comes from the U.S., it comes from different sources, but it is. China is trying other things as well - you know, they are reducing a little bit their wheat stocks, they have imported a lot of wheat from Australia as well. Remember that all this is driven by the recovery from ASF - they are trying to rebuild the curve, but also by the professionalization of the feeding that has included much more of all these grains into Russia. We think that we will continue to see multi-year increases in China’s appetite for all these commodities.
Tom Simonitsch: Okay, thank you. Maybe you could break down your nutrition outlook for 2021 - you mentioned the 15% segment profit growth. How does that compare for human versus animal nutrition?
Juan Luciano: Yes, they have different dynamics. Human nutrition is much more related to specific innovation projects that are driven by customers in our pipeline, and we feel very strongly about that. Our pipeline continues to grow and our win rates continue to grow. Animal nutrition has been a little bit more affected by COVID in the sense that there are some parts of it, like aquaculture, where fish and shrimp are much more consumed in restaurants than at home, while on the other hand pet, with people spending more time at home, companion animals have become a little bit better. I would say there are puts and takes there, and it’s difficult to judge ahead of time. I think the important thing about the nutrition business is when you take a look at what’s happening, is that that’s a business that is investing in growth but also has been able to grow returns and to grow margins within the year in both divisions, both in animal and in human nutrition. I think we’re going to continue to see that with, as I said, the different paths to growth with animal nutrition more in building organic growth for some of the projects, especially in Asia and in parts of Latin America, and then in human nutrition with more specific customer innovation projects in North America and Europe.
Tom Simonitsch: That’s very helpful, thank you. I’ll pass it on.
Juan Luciano: Thank you Tom.
Operator: Your next question is from Eric Larson of Global Securities.
Eric Larson: Yes, thank you. Good morning everyone, and congratulations on a really good year.
Ray Young: Thank you Eric.
Eric Larson: Juan, I just want to dive a little--I just want to add a little bit--my first question is on nutrition, just add a little bit more clarity to that. Last year, you had talked about harvesting more of your investments. You built a lot of plants in South America, in Asia for your nutrition business. I still expect that harvesting that investment is still a big part of your earnings story and your margin story. Can you talk a little bit about where you are in your harvesting of margins for nutrition, and I’m sure it differs between human and animal, but can you help us with that a little bit?
Juan Luciano: Yes, I would say the harvesting continues. These plants that we built are relatively new plants, whether it’s pea protein or specialty proteins in Campo Grande, so we’re going to have harvesting for many years down the road, hopefully. I would say that 2021 is a year of heavier investment, if you will, again another round of investment. Some of those things are capabilities, whether it’s customer insights and marketing, whether it’s new digital connections to customers, new models to innovate virtually, and even a lot of organic growth. We have--we kind of went light in organic growth projects in animal nutrition during 2020 because we were working on the synergies and, to be honest, because the COVID environment didn’t allow for a lot of project work. Now, we are going into more of that, so you’re going to see 2021 being a little bit heavier investment in that, in capabilities and plant. Some of these, you don’t see because this is building the foundations. We are a science based nutrition company, but you see for example in the quarter, we got two awards. We got the FIE Award for Innovation in Pea Protein, and we got the BIG Innovation Award for BPL1, one of our probiotics. We continue to invest in science, in customer insights and in organic growth in this business as we harvest, and the harvesting you see in how our ROIC continues to grow in that business and you see the success of our value proposition in how the EBITDA margins continue to grow in our business. We are very happy, but Eric, we are at the early stages of building the best nutrition company out there. We are probably halfway through that build.
Eric Larson: Okay, great. Thanks for the color there. Juan, the question that I have, and you’ve talked a lot about demand around the world, which is even surprisingly strong despite the grain pricing environment that we have, which is pretty high, and we’re still seeing good exports. But when you look at the U.S. crop upcoming planting season this year, you look at what’s going on in South America, which is clearly the world needed 140 million metric tons of soybeans out of Brazil and they’re not going to get that, and we’re seeing wheat in Russia, can you--it seems to me when you just put all the numbers together on a global basis, we are not going to rebuild these global supplies in a single year. It might take a couple years of good weather and all of that to sustain demand. Can you kind of encapsulate how ADM is looking at the next two years regarding demand and supply of global grains?
Juan Luciano: Yes, we see an environment of real demand, real effective demand happening out there, and to be honest, our customers don’t have a lot of inventory because everybody has been talking of going hand to mouth with this inverse, so we see truly strong demand and tight balance sheets. As you said, corn and oilseeds, I think they’re going to touch [indiscernible] balance sheet. Wheat is a little bit stronger, but the Black Sea has not had a great wheat season, although Australia has a wheat growing season, so we see this is going to take 18 to 24 months for these supply-demand balances to be rebuilt. We see these conditions persisting for the next couple of years, even with farmers, imagine like you, trying to plant more, because I think that these prices will bring more acres into production. But we need those extra acres right now.
Eric Larson: Yes, so not only plant more acres but we’ll also try to maximize our yields, so it’s the combination of both, so.
Juan Luciano: Right.
Eric Larson: Thank you, gentlemen, I’ll pass it on.
Juan Luciano: Thank you Eric.
Operator: Your final question is from Ben Theurer of Barclays.
Ben Theurer: Good morning Juan, Ray, and congrats on the results. Just wanted to follow up on the capex related to the different businesses. Clearly you’ve been putting a lot of emphasis on the growth and the prospects within nutrition, and you’ve just said this will be another year in the need of investments in order to get to that 15% CAGR you’ve been talking about. If we think about the capex in general, that $900 million to maybe a billion dollars, which is clearly up from what we saw in the last two years, could you give us a little bit of an understanding how you allocate or how you plan to allocate within that capex to the different segments, and in particular to the nutrition business, just to understand how much capital you’re adding to that business?
Juan Luciano: Yes, something that you have to understand, and I’m going to speak at a high level here, but the nutrition has a different OP to capital sensitivity than the other businesses. These projects are--sometimes you have big projects like Campo Grande for specialty proteins, but the rest of the projects, if you think that the commodity business has maybe a multiplier of you need five units of capex to get one unit of OP, sometimes in nutrition you get a one-on-one. I think the issue is that because it’s a smaller business, sometimes this investment, this effort has a higher impact in the P&L because they need to carry as they grow and as they build the smaller business. But I would say the nutrition is not a heavy capital intensive business, so when you hear me speaking about animal nutrition organic growth projects, those are small projects. They are not in the hundreds of millions of dollars type of projects, so I would say we continue to emphasize them but it’s not a heavy burden on the capital. That’s why we’re growing so fast and we still are not forecasting north of a billion dollars, even when we’re doing One ADM and all that. I think it’s very affordable growth from a capital perspective.
Ray Young: There’s a couple, Ben. There’s a couple large projects in the carb solutions business that we’re finishing up in 2021, so the Bulgaria expansion, we’re finishing up, we’re finishing up the building of the feed health in Clinton, so there’s a couple of chunky investments that we’re just finishing up over the course of ’21.
Ben Theurer: Okay, perfect Juan and Ray, thanks. Then one final one - just netting it out, you’ve been talking about the ethanol imports over to China, but how is that netting out versus Brazil and what you’re seeing there? Is that--is this just a tit for take, south to north, or how is the balance currently on that export business to China?
Juan Luciano: I think--listen, exports to China, we’ve been talking a lot about that. We expect this year will be a record high, so they are taking because, you know, corn is expensive in China. You also need to remember in this equation, sugar prices are at an all-time high, so in Brazil you make a choice, so it’s different than the U.S., in Brazil you make a choice how much you make of sugar and ethanol, and of course sugar prices are a big temptation this year. We expect higher exports and maybe we expect a little bit of less pressure from Brazil in that sense.
Ben Theurer: Okay, perfect. Thank you very much. I’ll leave it here. Thanks.
Operator: There are no other questions in queue at this time. Ms. De La Huerga, do you have any closing remarks?
Victoria De La Huerga: Yes, thank you for joining us today. Slide 10 notes upcoming investor events in which we will be participating. As always, please feel free to follow up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM.
Operator: Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning and welcome to the ADM fourth quarter 2020 earnings conference call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s call, Victoria De La Huerga, Vice President, Investor Relations for ADM. Ms. De La Huerga, you may begin."
},
{
"speaker": "Victoria De La Huerga",
"text": "Thank you Shelby. Good morning and welcome to ADM’s fourth quarter earnings webcast. Starting tomorrow, a replay of today’s webcast will be available at adm.com. For those following the presentation, please turn to Slide 2, the company’s Safe Harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management’s current views and estimates of future economic circumstances, industry conditions, company performance, and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statement as a result of new information or future events. On today’s webcast, our Chairman and Chief Executive Officer, Juan Luciano will provide an overview of the quarter and the year and highlight some of our accomplishments from 2020. Our Chief Financial Officer, Ray Young will review financial highlights and corporate results, as well as the drivers of our performance, then Juan will make some final comments, after which they will take your questions. Please turn to Slide 3. I will now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Victoria. This morning we reported fourth quarter adjusted earnings per share of $1.21, up 49% year-over-year if we exclude the prior year impact of the retroactive biodiesel tax credit. Adjusted segment operating profit was $1.15 billion, 12% higher than the fourth quarter of 2019. For the full year, we delivered record adjusted EPS of $3.59; $3.4 billion in adjusted segment operating profit, 12% higher than 2019; four straight quarters of year-over-year segment operating profit growth, and trailing four-quarter adjusted ROIC of 7.7%, almost 200 basis points above our weighted cost of capital. We are maintaining our strong balance sheet and generating strong cash flows. The team managed a wide variety of risks superbly and we achieved our strategic initiatives, exceeding our $500 million to $600 million guidance and driving our ability to deliver a steady, sustainable earnings growth. I’d like to thank our team for this tremendous performance and highlight for you some of our many achievements in 2020. In our optimized pillar, around the globe amid lockdowns, rapidly shifting demand patterns and extreme weather events, our colleagues fulfilled our purpose by adapting and innovating to keep our work environment safe from COVID-19, maintaining our operations to support the global food value chain, and delivering for our customers to provide nutrition around the world. Beyond that, for the year, our ag services and oilseeds team delivered more than $300 million in capital reduction initiatives, and we are focusing on new ways to enhance the return structure of that business from digital technologies like our Grainbridge joint venture to differentiated products and services that add share value for growers, customers, and ADM. In our drive pillar, our new organizational structures and business processes, like our centers of excellence and our 1ADM business transformation project are helping drive better decision making and operational excellence. We continued our work to support our planet and its natural resources. We achieved our 15x20 environmental goals ahead of schedule and launched Strive 35, an even more ambitious plan to reduce greenhouse gas emissions, energy, water, and waste by 2035, and we’re partnering with farmers in their efforts toward better outcomes, supported by the 6.5 million acres we have in sustainable farming programs over recent years. In our growth pillar, our nutrition team exceeded our Neovia synergy targets and delivered them ahead of schedule. We expanded our plant-based protein capabilities, including the launch of our PlantPlus Foods joint venture, and amid an incredibly dynamic demand environment, we utilized new, innovative technologies and continued launching new products to ensure we’re meeting our customers’ needs. Our carbohydrate solutions colleagues moved quickly to meet changing customer needs for retail flour, industrial starches for cardboards, and USP-grade alcohol for hand sanitizers, and the ADM team showed its innovative spirit by partnering and supporting companies that are making food out of air, spider silk out of corn, and animal feed out of insects. Finally, I’m proud to say we surpassed by about 10% our stretch goal of $1.3 billion in readiness run rate benefits by the end of the year. Readiness is driving our strategic initiatives, enabling us to be more efficient and powering our growth. Perhaps most importantly, today we can say that readiness is truly embedded in our culture. It’s how we work. Thanks to these impressive achievements, I’m pleased to announce a quarterly dividend increase of 2.8% to $0.37 per quarter. This dividend will be our 357th consecutive quarterly payment, an uninterrupted record of 89 years. It’s been a remarkable year with achievements and results that truly demonstrate the strategic work we’ve been doing over the years to optimize, drive, and grow. Even more important is how we’re building for the future. We’ve created and are now strengthening the strategic foundation to deliver steady, sustained earnings growth for years to come. I’ll be talking about that shortly, but first let me turn the call over to Ray to take us through our business performance. Ray?"
},
{
"speaker": "Ray Young",
"text": "Yes, thanks Juan, and good morning everyone. Please turn to Slide No. 4. As Juan mentioned, adjusted EPS for the quarter was $1.21, down from the $1.42 in the prior year quarter. As a reminder, the fourth quarter of last year was positively impacted by the recognition of about $0.61 per share for the retroactive biodiesel tax credits. Absent this, earnings would have grown by about 49%. Our trailing four-quarter average adjusted ROIC was 7.7%, almost 200 basis points higher than our 2020 annual WACC, and our trailing four-quarter adjusted EBITDA was about $3.7 billion. The effective tax rate for the fourth quarter of 2020 was approximately 8% compared to a benefit of 1% in the prior year. The calendar year 2020 effective tax rate was approximately 5%, down from the approximately 13% in 2019. The decrease in the effective tax rate for the calendar year was due primarily to changes in the geographic mix of earnings and the impact of U.S. tax credits, mainly the railroad tax credits, which have an offsetting expense in the cost of products sold. Absent the effect of EPS-adjusting items, the effective tax rate for the fourth quarter was approximately 11%, and for the calendar year 2020, it was approximately 9%. Looking ahead, we’re expecting full year 2021 effective tax rate to be in the range of 14% to 16%. We generated about $3.1 billion of cash from operations before working capital for the year, significantly higher than 2019. Return of capital for the year was $942 million, including more than $800 million from dividends. We finished the quarter with a net debt to total capital ratio of about 32%, up from the 29% a year ago due to higher working capital needs due to rising commodity prices. Capital spending for the year was about $820 million, in line with our guidance and well below our depreciation and amortization rate of about $1 billion dollars. For 2021, we expect capital spending to be in a range of $900 million to $1 billion. Slide 5, please. Other business results were substantially lower than the prior year quarter. ADM investor services earnings were impacted by drastically lower short-term interest rates. Captive insurance results were negatively impacted by $15 million more in net intra-company settlements compared to the prior year quarter. For 2021, we expect other business results to be in line with 2020. In the corporate lines, unallocated corporate costs of $278 million were higher year-over-year due primarily to increased variable performance-related compensation expense accruals, increased IT and project-related expenses, and centralization of certain costs, including from Neovia. Other charges decreased due to lower railroad maintenance expenses partially offset by the absence of prior year investment gains. For 2021, corporate unallocated should be overall similar to 2020. Net interest expense for the quarter was lower than last year due to lower short term interest rates and liability management actions taken in 2020. For 2021, we expect net interest expense for the calendar year to be similar to or slightly lower than 2020. Slide 6, please. The ag services and oilseeds team capped off an outstanding year with record adjusting operating profit in the fourth quarter. Ag services results were significantly higher year over year. In North America, the team executed extremely well, capitalizing on strong global demand particularly from China to deliver higher export volumes and margins. South American origination was lower year over year after significantly accelerated farmer selling in the first half of 2020. Global trade continued to do a great job, contributing to higher results by utilizing its global reach and managing risk well to meet customer demand. Approximately $80 million of prior timing effects reversed in the quarter, as expected. Crushing also delivered substantially higher results versus the prior year period. The business did a great job to capture higher margins in a continued environment of tight soybean supply and strong global demand for both meal and vegetable oils. There was approximately $125 million in net negative timing in the quarter driven by basis impacts and improved soft seed margins. Refined products and other results were higher year over year absent the recognition of the retroactive biodiesel tax credit in the fourth quarter of last year, with good results driven primarily by solid South American margins. Wilmar’s strong performance drove our equity earnings higher versus the prior year despite our slightly lower ownership stake. For the full year, ag service and oilseeds delivered exceptional results of $2.1 billion, 9% higher than 2019. The team achieved multiple records, including all-time high global crush volumes. In addition, we’re proud of the team that brought our reserve export facility back online safely and ahead of schedule despite dealing with multiple severe weather events this year. Looking ahead, we expect the first quarter of 2021 results for ag service and oilseeds to be significantly higher than the prior year first quarter, driven by extremely strong North America export demand and continued healthy crush margins. Slide 7, please. The carbohydrate solutions team again delivered substantially a higher year-over-year result despite the impacts of lockdowns in key market segments. The starches and sweeteners sub-segment achieved significantly higher results driven by lower net corn costs and intra-company insurance settlements. Earnings were partially offset by low results from corn oil and wet mill ethanol margins. Damaged corn processor results were also better versus the prior year, though they continue to reflect the challenging ethanol industry environment. The team delivered higher year-over-year margins as they met increased demand for USP-grade alcohol, partially offset by fixed costs from the two temporarily idled dry mills. Considering the impact of lockdowns in both driving miles and the food service sectors, we’re extremely proud of our carbohydrate solutions team for delivering full year results of $717 million, 11% higher than 2019. The team achieved record high operating profits from starches in the year. They acted decisively by temporarily idling production at our two VCP dry mill plants, helping address industry supply and demand balances, and the wheat milling business’ modernization and optimization plan, including a new state of the art mill in Mendota, Illinois, helped power a significant improvement over full year 2019 for that business. Looking ahead, we expect carbohydrate solutions results in the first quarter to be significantly higher than last year’s first quarter, which was negatively impacted by corn oil mark to market impacts, but below the fourth quarter 2020 levels due to the challenged industry ethanol margins. Slide 8, please. The nutrition team delivered 24% year-over-year growth in the quarter. In human nutrition, flavors delivered a strong quarter driven by good sales and product mix in North America and EMEAI. Continued strength in plant proteins drove higher results in specialty ingredients. Health and wellness delivered higher sales in probiotics and natural health and nutrition. Prior year results included revenue and income related to the launch of the strategic Spiber relationship. Human nutrition results for the quarter also included an intra-company insurance settlement. Animal nutrition results were significantly higher year over year, driven by strong performances in Asia and EMEAI and improvements in amino acid results, partially offset by currency effects in Latin America. We’re continuing to make improvements in our amino acid business, including our announcement last month that we’re discontinuing dry lysine production and transitioning to our liquid and encapsulated products in the first half of this year. For the full year, nutrition results were $574 million, 37% higher than 2019. The nutrition team grew revenue 5% on a constant currency basis and continued to expand EBITDA margins. We exceeded our Neovia synergy targets and delivered them ahead of schedule. We are truly seeing the benefits of our investments in nutrition. Looking ahead, we expect nutrition to solidly grow operating profits in 2021 calendar year, but the first quarter should be similar to the prior year period due to timing of certain expenses over the year, including investments in projects to drive organic growth. With that, let me turn it over to Juan to conclude. Juan?"
},
{
"speaker": "Juan Luciano",
"text": "Thank you Ray. Slide 9, please. I’d like to congratulate the team once more on delivering great results in 2020. I’m proud of what we achieved and I’m excited to see our work empowering us to reach even greater heights. In 2020, ag services and oilseeds capitalized on its unparalleled and flexible global footprint to meet strong demand. In 2021, we expect ag services and oilseeds’ strong execution, diverse and flexible crush capabilities, including an extensive soft seed footprint and important strategic work to continue to drive results. In addition, we expect the global demand environment for ag services and oilseeds to remain strong. China should continue to be a significant buyer. We see continued strong global growth in meal demand and we expect increased demand for vegetable oil due to recovering cooking oils for food service and growth in demand for biofuels, including renewable green diesel. That is why we are confident in another outstanding performance from ag services and oilseeds in 2021. Carbohydrate solutions is showing how we have embedded great execution into our operational structure and culture. The team is doing a great job strengthening their business by optimizing their plans and product mix, and their ability to adjust production in 2020 to quickly meet changes in demand showed how those strategic efforts are paying off. Now they are well positioned to use those same tools as the effect of lockdowns on the food service and transportation fuel sectors dissipates throughout 2021. We expect solid profit growth for the year for carbohydrate solutions. Nutrition continued to harvest investments, leading consumer growth trend areas and partnering with customers to bring innovative new products and solutions to market in 2020. Based on our current organic growth plans, we expect the nutrition team to deliver solid revenue expansion and enter the period of an average of 15% per annum operating profit growth consistent with our strategic plan. Across ADM, we are fulfilling our purpose and building on a foundation for steady, sustainable earnings growth. We are growing and leading in key trend areas, including food security, health and wellness, and sustainability. Our continued advancements of readiness is benefiting the entire enterprise and we’re making investments in exciting growth innovation platforms, which we’ll be talking more about in the future. In 2021, we will remain focused on the drivers under our control, having incremental returns as we focus on organic growth, advancing operational excellence initiatives to maximize returns from every business and every asset, and continuing to generate benefits from readiness. With the strong execution of these strategic initiatives and improving market conditions as the year progresses, we expect to build on a record 2020 with strong growth in segment operating profit and another record year of EPS in 2021. With that, Shelby, please open the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator instructions] Your first question is from Michael Piken of Cleveland Research."
},
{
"speaker": "Michael Piken",
"text": "Yes, good morning. Congratulations on the good quarter. Just wanted to dig a little bit more into your thoughts on how U.S. crushing is going to play out throughout the year. I understand 1Q is going to be really strong, but are you worried about tightness and availability of soybeans as we move into the spring and summer, and how are you sort of positioning your crushing business in case the market gets a little bit tighter?"
},
{
"speaker": "Juan Luciano",
"text": "Yes Michael, thank you for the question. Good morning. Listen, we expect 2021 to be a very, very strong year for oilseeds and ag services, maybe with a different mix of earnings that we have in this year. If you think about 2021, we’re starting with tailwinds from 2020, so we’re starting from a different position, and we’re starting the year with improved global crush margins in Q1 versus Q1 last year. We see a year in which we flex a little bit more our capabilities. We see a strong, still soybean crush but an exceptional crop and recovery after many years of softness in the soft seed crush, and I’d remind you that we have about 25% of our capacity in soft seed, and we have about 15% of our capacity that is shifting, so that’s a competitive advantage for ADM. We see a strong demand for meal, and we see also the vegetable story playing out with good global demand and prices that are today about 20% higher than at the same time last year, and not only coming from food demand but also from fuels, a new renewable green diesel capacity is having an impact in green oil demand and margins, and think that that could be something about half a billion pounds per year this year of extra demand, so all in all we see tight balances and we see a strong margin environment for the rest of the year."
},
{
"speaker": "Michael Piken",
"text": "Great. Then just as a follow-up, in your slide deck you talked about on Slide 13 having $295 million of cumulative crush deferred timing gains, is that all showing up in oilseed crush or is that across the whole portfolio, and if you could give us any sort of help in terms of the cadence of when we might see that realized - is it going to be primarily in 1Q or more evenly spread throughout the first half? Thanks."
},
{
"speaker": "Ray Young",
"text": "Yes Michael, it’s Ray here. This is in the crush part of the ag services and oilseeds. As you pointed out, we increased by $125 million in the quarter, so now we have a balance of about $295 million in timing effects. We expect that roughly half will get reversed in the first quarter based upon the book that we have right now, and then the other half will be reversed over the second and third quarters and actually we’ll see how prices move, but this is our current expectations in terms of how we expect this to play out over the course of ’21."
},
{
"speaker": "Michael Piken",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question is from Adam Samuelson of Goldman Sachs."
},
{
"speaker": "Adam Samuelson",
"text": "Yes, thank you. Good morning everyone."
},
{
"speaker": "Ray Young",
"text": "Morning Adam."
},
{
"speaker": "Adam Samuelson",
"text": "I guess my first question was going to be around the carbohydrate solutions business. I know you talked about seeing a pathway for growth there, and understanding especially in the first half of the year there’s some pretty easy comps in terms of capacity utilization and weak volumes on the HFCS side, but help us think through some of the different pieces there. Ethanol in the first half of this year looks to be in a bit of a tougher spot, obviously corn prices have moved up pretty notably. Just trying to think about some of the different moving pieces and help us how we get to growth in that business in 2021."
},
{
"speaker": "Ray Young",
"text": "Yes, sure Adam. Let me start here. It’s useful to refer to also how they manage 2020, right, because 2020, when you think about businesses that have been most negatively impacted by COVID-19, the carb sol segment was the one most negatively impacted, yet in 2020 they grew earnings. What they did was they really managed product mix extremely well - you know, driving starches, driving industrial alcohol. They managed the ethanol production well and frankly had a positive impact on industry margins through the idling actions it took. But what a lot of people forget is we have an international business that’s growing, right so we’re expanding capacity over in Europe, and the European operations almost doubled in profitability in 2020 compared to 2019, a big contributor there. In the North America milling operations, their footprint optimization is really paying off with 20% growth in profitability in ’20 versus ’19, so when you think about 2021, this playbook continues. Number one, we do expect stabilizations in the North American starches and sweetener business as the beginnings of recovery in demand for certain products occur with the dissipation of lockdowns. Secondly, they’re continuing to drive great product portfolio mix, so particularly in the area of liquid dextrose and maltodextrin and citric acid. Those are actually, from a product mix perspective, very beneficial. Thirdly, continued international growth, so when you think about where sugar prices are around the world right now, our European operations, whereby we’ve added capacity, continues to drive growth, they’re going to be another contributor. Then lastly, we expect continued growth in terms of our milling operations, and very pleased in terms of how their optimization plan is really playing out. Now getting back to some of the comments on the year-over-year comparison, we start off the year with weaker margins in ethanol, but if you recall in last year, margins actually hit a low of negative $0.45 in March. We don’t see that, so when you think about year-over-year comparisons, we’re going to start off on a challenged basis but we do expect the industry supply-demand balances in the ethanol industry get better balance as we move through the year, for several reasons. Number one, China actually has been buying U.S. ethanol. That’s something that they have not been doing over the past couple of years, and we believe that they’ve already made commitments already in the first half of the year for U.S. ethanol equal to the previous all-time high for the calendar year, roughly 200 million gallons. We’ll have to see where China ends up in the calendar year in terms of imports of U.S. ethanol. Secondly, there has been announced reconfiguration of ethanol capacity by various competitors in the industry as they kind of focus their production away from transportation fuel ethanol towards other products, so that’s going to have an impact in industry supply and demand. Thirdly, the industry itself, there is about 10% to 15% of capacity that remains idled, and from our perspective we’re going to remain very disciplined in terms of when we actually re-start the dry mills because we’ll want to see sustainable margins before we re-start, and hopefully sometime in the first half we’re going to see that. Then lastly, how the small refinery exemptions will play out over the first part of the year as the Supreme Court rules on it will have an impact, frankly, in terms of domestic demand for ethanol. If you take a look at RINs pricing right now, there is an expectation in the U.S. that domestic ethanol demand is going to be strong over the course of this calendar year, given just a recovery in terms of driving miles as we go through the year and then, secondly, how the expectations in terms of how the SREs will play out. Overall, Adam, we feel good about how we start the year in terms of the carb solutions businesses, but we do see particularly in the area of ethanol, we see green shoots of recovery in 2021 for this business here."
},
{
"speaker": "Adam Samuelson",
"text": "That’s a lot of really helpful color, Ray. If I could just squeeze in a second one, just on the balance sheet, just given the move up in commodity prices, the increased cost of inventory, how do we think about the tolerance for more offensive capital deployment in terms of buybacks or M&A over the course of ’21? How much dry powder do you think you have as we sit here today?"
},
{
"speaker": "Ray Young",
"text": "Well, we finished the year actually from a leverage perspective on a debt to EBITDA ratio in reasonable position because, as you know, inventory financing from a rating agency perspective, you get RMI credit, so with the movement in higher commodity prices which moved working capital higher, clearly we’re financing it. One of the things very different than the last crisis back in 2008 is that we’ve really diversified our working capital lines, and so I feel good about our ability to finance a higher working capital level. But from a leverage perspective with the RMI credits, our leverage--our balance sheet remains strong, and so we believe we’ve got fire power in order to continue to look at opportunistic M&A and opportunistic share buybacks over the course of the year."
},
{
"speaker": "Adam Samuelson",
"text": "All right, I really appreciate all that color. I’ll pass it on. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question is from Vincent Andrews of Morgan Stanley."
},
{
"speaker": "Vincent Andrews",
"text": "Thanks, and good morning everyone. Ray, Juan, just wanted to ask you both about the inverse that we see in the corn and soy markets and how you’re going to manage that in the ag services business this year, and what challenges or opportunities does that present for you?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, thank you Vince. Listen, the inverse certainly is indicating to farmers and everybody that to bring the product to the market, so we see a little bit of this talking - of course, nobody wants to run that inverse through--cold inventory through the inverse. What we are seeing is that that inverse is bringing is that--is bringing clear assistance for exports for North America and South America, and we think that that’s an advantage for the ag services business in which it brings better margins normally for export season. You’re going to see a little bit what happened last year, you know, that Brazil sold everything, run out of material, then the tide shifted immediately for the U.S. The U.S. is starting from an extended window of exports because of Brazil started a little bit late the planting, so we are starting with good margins, we are starting with good exports for the first quarter. For the first quarter, Vince, we expect U.S. record volumes for Q1 and then we expect a very strong season at the end of the year with another strong Q4. We’re very, very optimistic about it."
},
{
"speaker": "Vincent Andrews",
"text": "Okay, that’s very helpful. If I could just follow up on freight rates, they really have run up. Is that something that you benefit from, because presumably you have long term contracts that those freight rates have to get pushed into the market pricing, and you just maybe get the benefit on the revenue line but don’t experience the cost, or is there a different dynamic there?"
},
{
"speaker": "Juan Luciano",
"text": "No, I think you are correct in your assessment. You also have to understand the value of the full value chain that we run in ADM. When I describe, for example, record exports, that means also record loads for ARTCO, so we get a secondary stream of profits from there for the full value chain. We have stevedoring, we have the barges, and we have the export terminals, so the whole--when you have that kind of volume, the whole value chain gets enhanced margins all through the chain."
},
{
"speaker": "Vincent Andrews",
"text": "Okay, very good. I appreciate the comments. I’ll pass it along."
},
{
"speaker": "Juan Luciano",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question is from Ben Bienvenu of Stephens."
},
{
"speaker": "Ben Bienvenu",
"text": "Hey, thanks. Good morning everybody."
},
{
"speaker": "Ray Young",
"text": "Morning Ben."
},
{
"speaker": "Ben Bienvenu",
"text": "I wanted to ask your outlook for the year for 2021, you made a note in your press release and in your comments that you expect improved market conditions. I suspect in light of the detailed comments that you gave, you’re referring to the carbohydrate solutions group particularly, but I’d be curious what you’re expecting on the ag services and oilseeds. Is 2020 a number that you think is probable to be eclipsed for EBIT based on the market view that you have right now, or how should we be thinking about that setup?"
},
{
"speaker": "Juan Luciano",
"text": "Yes Ben, when I think about the three businesses for 2021 and when we think about a strong 2021, the ag services and oilseeds business will be a very, very strong year, as I said before, maybe with a different mix of earnings with maybe we’re not going to get to the same levels in RPO business or maybe South American oils, but we’re going to have a better canola and soft seed margins in general for the business. We still expect exports from ag services to be very strong. We had an exceptionally strong year for global trade in 2020, which I think we’re going to have a strong year, we don’t know exactly we’re going to get to the same level. We plan another outstanding year for ag services and oilseeds in 2021. Carb solutions, I think that that’s the business, as Ray explained it before, that has been the biggest impact by COVID-19, and we think that last year, it was a very tough year in which the team did an outstanding job of growing earnings 11% in that environment. We think that conditions for this year, especially when you think about the pent-up demand, the improvements in conditions with more prevalent vaccination in the second half and all that, and with some exports to China in ethanol, we expect there are many elements there to build a more constructive scenario in 2021 than in 2020. The nutrition business will continue to grow. We are investing in that business and it’s a business that has a strong organic growth program, and we see in that range, as I mentioned before, that when we look at the strategic plan for nutrition as we grow nutrition to the billion-dollar OP during our plan, we’ll look for 15% CAGR to get there, and that’s what we’re expecting for this year. That’s how I think about 2021."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay, that’s great. If I could, as it relates to 1Q in particular for carbohydrate solutions, you noted you expect results to be significantly higher than 1Q20 but lower than 4Q20. That’s a pretty big range. Is there any more granularity you could provide there? Should we be thinking about something north of $100 million based on the current market view, or is that too high? Maybe just any more specificity, if you’re willing to give it, on that segment in particular in 1Q, and then I’ll leave it there. Thank you."
},
{
"speaker": "Ray Young",
"text": "Yes, a lot of it is going to be a function of where ethanol moves over the course of the year. We expect it to be over $100 million. We expect it to be over $100 million, but where we land, a lot of it will be where ethanol moves over the next couple months here. But again, if you recall last year, we had about $65 million of negative corn oil market to market that won’t get repeated, so that’s going to be a benefit in our first quarter results this year."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay, thank you both, and best of luck in this year."
},
{
"speaker": "Ray Young",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question is from Robert Moskow of Credit Suisse."
},
{
"speaker": "Robert Moskow",
"text": "Hi. Congratulations on a great year. I wanted to know if you have any color for us on the impact of rising corn costs. There’s some comparison, I guess benefits compared to last year where corn oil was out of sync, but is rising corn costs going to be a problem for carbohydrate solutions at any point, and maybe you could talk more specifically about high fructose corn syrup negotiations and were you able to increase your prices to offset the higher corn costs. Thanks."
},
{
"speaker": "Ray Young",
"text": "Yes Rob, it’s Ray here. A couple things to note. First of all, the team did an outstanding job on risk management, so without disclosing everything that they do, it’s fair to say that we had a lot of our requirements for 2021 hedged before the significant run-up in terms of corn costs. I think that the team did some great work in terms of anticipating how S&Ds would actually work over the course of 2021. With respect to contracts, just a reminder not every contract gets negotiated in the contract cycle. We have multi-year contracts, and so a certain amount of contracts got negotiated and the outcome of the negotiations is the fact that we expect to be able to maintain our margins as we go through 2021 relative to 2020, through a combination of contract negotiations as well as the efforts that we’re doing in terms of managing the mix and also managing our costs there. The other comment in terms of rising corn costs, and also given really a strong demand environment for feed, is you’ve seen cold product values go up. That’s a benefit for our businesses as well, so I think in the fourth quarter we made the comment that part of the strong results is that we had very favorable net corn costs. We expect that the team is also going to be able to manage through ’21 with good net corn cost as well, so I think the team--and the carb sol team, they’ve done an outstanding job on the risk management side in managing through the higher corn cost environment here."
},
{
"speaker": "Juan Luciano",
"text": "Rob, if I may add, I think something that gives us confidence, because of course the team is pretty good at doing this, is that in very tight markets, the fundamentals become more important because markets move more based on fundamentals, and there the information we have, the visibility we have in the network becomes much more important to make decisions than in other times, when maybe materials are a little bit longer and softer. Then, there are more variables that come into play."
},
{
"speaker": "Robert Moskow",
"text": "Maybe you can’t this much detail, but in the contracts that you were negotiating, were you able to negotiate prices higher in reaction to higher corn, or was it not like that?"
},
{
"speaker": "Ray Young",
"text": "I think, Rob, let’s keep it to the fact that we’ve been able to manage in total the portfolio, the contracts and being able to maintain the margins year over year. That’s the level of disclosure I think we want to make at this point. Thank you."
},
{
"speaker": "Robert Moskow",
"text": "Got it, okay. Thanks."
},
{
"speaker": "Operator",
"text": "Your next question is from Ken Zaslow of BMO."
},
{
"speaker": "Ken Zaslow",
"text": "Hey, good morning everyone. I have two questions. First, the capex spending is going up. What are you incrementally spending on and what do you think the returns are, and when will you actually get the returns associated with that and how do we think about the incremental products there? That’s my first question."
},
{
"speaker": "Ray Young",
"text": "Ken, a couple things on the increased capex. One, I mentioned that we are in the midst of a business transformation program, so 2021 will be one of our peak years into a project, the One ADM project, so we do have some capitalized--some incremental capitalized costs associated with the program that’s part of our capex budget. Secondly, with the pandemic in 2020, some projects got moved over, got pushed from 2020 into 2021. Some of them are growth projects, some of them are cost reduction projects, some of them are non-discretionary expenditure projects, so there’s a series of projects that we did push from 2020 to ’21 just due to the pandemic and our ability to execute. Then thirdly, we do have growth projects. We mentioned organic growth, our focus in that area, so we do have organic growth projects going on in the course of 2021. Those are the three buckets as to why the number is increasing from the number that we finished up in ’20 from ’21. Again, the range, $900 million to $1 billion is a large range. We haven’t approved some of these projects, we’re just putting it in terms of a placeholder, but part of our discipline is we will be evaluating the timing, the returns, and determining do we actually spend it in the course of ’21 or not. As you know, in terms of growth projects, our hurdle rates are double-digit percentages, right? Our hurdle rates are double-digit percentages in order to approve these projects."
},
{
"speaker": "Juan Luciano",
"text": "And I’d remind you, Ken, that first of all, we are also becoming a larger company, so there are projects now that our organic growth is coming from the new Neovia acquisition, the animal nutrition. We are expanding our bioactives production in Valencia, Spain, so we are becoming a larger company. I’d also remind you that we have a program to divest to reduce capital investment, and we achieved $300 million in that side of the ledger, so we’ll continue with the same capital discipline done before. You can be assured of that."
},
{
"speaker": "Ken Zaslow",
"text": "Great. Then my second question, really more of a clarification, you said in 2021 EPS and operating profit would be higher year over year, or could be significantly higher - I forgot the exact word, but does that include or exclude the $295 million? I’ll leave it there."
},
{
"speaker": "Ray Young",
"text": "You’re referring to the $295 million of timing effects, Ken?"
},
{
"speaker": "Ken Zaslow",
"text": "Yes, are you going to be able to grow numbers outside that $295 million, or is that $295 million included in what you think is going to be a year-over-year--"
},
{
"speaker": "Ray Young",
"text": "It’s all included there. It’s all included in the number there, Ken - all included."
},
{
"speaker": "Ken Zaslow",
"text": "Would you be able to grow even without that, or is that part of the--I guess I’m just trying to figure out, when you say significant growth, is that beyond the $295 million or is that including? If you didn’t have the $295 million, would you still be able to grow? I’ll leave it there."
},
{
"speaker": "Ray Young",
"text": "There’s a lot of puts and takes there, Ken, right, so I think it’s fair to say that our pre-tax numbers are going to grow significantly and there is going to be a little--you take a little bit off with the higher tax rate. I think that’s probably the more important factor, is our higher tax rate will skim off a little bit of the pre-tax improvement that we’re going to drive in ’21 versus ’20."
},
{
"speaker": "Ken Zaslow",
"text": "Okay, great. Thank you guys very much."
},
{
"speaker": "Operator",
"text": "Your next question is from Tom Simonitsch of JP Morgan."
},
{
"speaker": "Tom Simonitsch",
"text": "Hi, good morning everyone."
},
{
"speaker": "Juan Luciano",
"text": "Morning Tom."
},
{
"speaker": "Tom Simonitsch",
"text": "Just following up on U.S. export strength, how much U.S. corn do you expect China to import beyond this marketing year?"
},
{
"speaker": "Juan Luciano",
"text": "Yes Tom - sorry, I was trying to get my mask off. We’re expecting China to take about 25 million tons of corn, so you know the situation there in China - we think that inventories are much--reserves are much lower than what the market is reporting there. You can see that in the prices that we’ve seen. China didn’t have a great crop, so we expect significant imports for both oilseeds and corn."
},
{
"speaker": "Tom Simonitsch",
"text": "Do you think that 25 million tons is sustainable beyond this marketing year?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, we think so, we think so. Of course, not all comes from the U.S., it comes from different sources, but it is. China is trying other things as well - you know, they are reducing a little bit their wheat stocks, they have imported a lot of wheat from Australia as well. Remember that all this is driven by the recovery from ASF - they are trying to rebuild the curve, but also by the professionalization of the feeding that has included much more of all these grains into Russia. We think that we will continue to see multi-year increases in China’s appetite for all these commodities."
},
{
"speaker": "Tom Simonitsch",
"text": "Okay, thank you. Maybe you could break down your nutrition outlook for 2021 - you mentioned the 15% segment profit growth. How does that compare for human versus animal nutrition?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, they have different dynamics. Human nutrition is much more related to specific innovation projects that are driven by customers in our pipeline, and we feel very strongly about that. Our pipeline continues to grow and our win rates continue to grow. Animal nutrition has been a little bit more affected by COVID in the sense that there are some parts of it, like aquaculture, where fish and shrimp are much more consumed in restaurants than at home, while on the other hand pet, with people spending more time at home, companion animals have become a little bit better. I would say there are puts and takes there, and it’s difficult to judge ahead of time. I think the important thing about the nutrition business is when you take a look at what’s happening, is that that’s a business that is investing in growth but also has been able to grow returns and to grow margins within the year in both divisions, both in animal and in human nutrition. I think we’re going to continue to see that with, as I said, the different paths to growth with animal nutrition more in building organic growth for some of the projects, especially in Asia and in parts of Latin America, and then in human nutrition with more specific customer innovation projects in North America and Europe."
},
{
"speaker": "Tom Simonitsch",
"text": "That’s very helpful, thank you. I’ll pass it on."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Tom."
},
{
"speaker": "Operator",
"text": "Your next question is from Eric Larson of Global Securities."
},
{
"speaker": "Eric Larson",
"text": "Yes, thank you. Good morning everyone, and congratulations on a really good year."
},
{
"speaker": "Ray Young",
"text": "Thank you Eric."
},
{
"speaker": "Eric Larson",
"text": "Juan, I just want to dive a little--I just want to add a little bit--my first question is on nutrition, just add a little bit more clarity to that. Last year, you had talked about harvesting more of your investments. You built a lot of plants in South America, in Asia for your nutrition business. I still expect that harvesting that investment is still a big part of your earnings story and your margin story. Can you talk a little bit about where you are in your harvesting of margins for nutrition, and I’m sure it differs between human and animal, but can you help us with that a little bit?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, I would say the harvesting continues. These plants that we built are relatively new plants, whether it’s pea protein or specialty proteins in Campo Grande, so we’re going to have harvesting for many years down the road, hopefully. I would say that 2021 is a year of heavier investment, if you will, again another round of investment. Some of those things are capabilities, whether it’s customer insights and marketing, whether it’s new digital connections to customers, new models to innovate virtually, and even a lot of organic growth. We have--we kind of went light in organic growth projects in animal nutrition during 2020 because we were working on the synergies and, to be honest, because the COVID environment didn’t allow for a lot of project work. Now, we are going into more of that, so you’re going to see 2021 being a little bit heavier investment in that, in capabilities and plant. Some of these, you don’t see because this is building the foundations. We are a science based nutrition company, but you see for example in the quarter, we got two awards. We got the FIE Award for Innovation in Pea Protein, and we got the BIG Innovation Award for BPL1, one of our probiotics. We continue to invest in science, in customer insights and in organic growth in this business as we harvest, and the harvesting you see in how our ROIC continues to grow in that business and you see the success of our value proposition in how the EBITDA margins continue to grow in our business. We are very happy, but Eric, we are at the early stages of building the best nutrition company out there. We are probably halfway through that build."
},
{
"speaker": "Eric Larson",
"text": "Okay, great. Thanks for the color there. Juan, the question that I have, and you’ve talked a lot about demand around the world, which is even surprisingly strong despite the grain pricing environment that we have, which is pretty high, and we’re still seeing good exports. But when you look at the U.S. crop upcoming planting season this year, you look at what’s going on in South America, which is clearly the world needed 140 million metric tons of soybeans out of Brazil and they’re not going to get that, and we’re seeing wheat in Russia, can you--it seems to me when you just put all the numbers together on a global basis, we are not going to rebuild these global supplies in a single year. It might take a couple years of good weather and all of that to sustain demand. Can you kind of encapsulate how ADM is looking at the next two years regarding demand and supply of global grains?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, we see an environment of real demand, real effective demand happening out there, and to be honest, our customers don’t have a lot of inventory because everybody has been talking of going hand to mouth with this inverse, so we see truly strong demand and tight balance sheets. As you said, corn and oilseeds, I think they’re going to touch [indiscernible] balance sheet. Wheat is a little bit stronger, but the Black Sea has not had a great wheat season, although Australia has a wheat growing season, so we see this is going to take 18 to 24 months for these supply-demand balances to be rebuilt. We see these conditions persisting for the next couple of years, even with farmers, imagine like you, trying to plant more, because I think that these prices will bring more acres into production. But we need those extra acres right now."
},
{
"speaker": "Eric Larson",
"text": "Yes, so not only plant more acres but we’ll also try to maximize our yields, so it’s the combination of both, so."
},
{
"speaker": "Juan Luciano",
"text": "Right."
},
{
"speaker": "Eric Larson",
"text": "Thank you, gentlemen, I’ll pass it on."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Eric."
},
{
"speaker": "Operator",
"text": "Your final question is from Ben Theurer of Barclays."
},
{
"speaker": "Ben Theurer",
"text": "Good morning Juan, Ray, and congrats on the results. Just wanted to follow up on the capex related to the different businesses. Clearly you’ve been putting a lot of emphasis on the growth and the prospects within nutrition, and you’ve just said this will be another year in the need of investments in order to get to that 15% CAGR you’ve been talking about. If we think about the capex in general, that $900 million to maybe a billion dollars, which is clearly up from what we saw in the last two years, could you give us a little bit of an understanding how you allocate or how you plan to allocate within that capex to the different segments, and in particular to the nutrition business, just to understand how much capital you’re adding to that business?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, something that you have to understand, and I’m going to speak at a high level here, but the nutrition has a different OP to capital sensitivity than the other businesses. These projects are--sometimes you have big projects like Campo Grande for specialty proteins, but the rest of the projects, if you think that the commodity business has maybe a multiplier of you need five units of capex to get one unit of OP, sometimes in nutrition you get a one-on-one. I think the issue is that because it’s a smaller business, sometimes this investment, this effort has a higher impact in the P&L because they need to carry as they grow and as they build the smaller business. But I would say the nutrition is not a heavy capital intensive business, so when you hear me speaking about animal nutrition organic growth projects, those are small projects. They are not in the hundreds of millions of dollars type of projects, so I would say we continue to emphasize them but it’s not a heavy burden on the capital. That’s why we’re growing so fast and we still are not forecasting north of a billion dollars, even when we’re doing One ADM and all that. I think it’s very affordable growth from a capital perspective."
},
{
"speaker": "Ray Young",
"text": "There’s a couple, Ben. There’s a couple large projects in the carb solutions business that we’re finishing up in 2021, so the Bulgaria expansion, we’re finishing up, we’re finishing up the building of the feed health in Clinton, so there’s a couple of chunky investments that we’re just finishing up over the course of ’21."
},
{
"speaker": "Ben Theurer",
"text": "Okay, perfect Juan and Ray, thanks. Then one final one - just netting it out, you’ve been talking about the ethanol imports over to China, but how is that netting out versus Brazil and what you’re seeing there? Is that--is this just a tit for take, south to north, or how is the balance currently on that export business to China?"
},
{
"speaker": "Juan Luciano",
"text": "I think--listen, exports to China, we’ve been talking a lot about that. We expect this year will be a record high, so they are taking because, you know, corn is expensive in China. You also need to remember in this equation, sugar prices are at an all-time high, so in Brazil you make a choice, so it’s different than the U.S., in Brazil you make a choice how much you make of sugar and ethanol, and of course sugar prices are a big temptation this year. We expect higher exports and maybe we expect a little bit of less pressure from Brazil in that sense."
},
{
"speaker": "Ben Theurer",
"text": "Okay, perfect. Thank you very much. I’ll leave it here. Thanks."
},
{
"speaker": "Operator",
"text": "There are no other questions in queue at this time. Ms. De La Huerga, do you have any closing remarks?"
},
{
"speaker": "Victoria De La Huerga",
"text": "Yes, thank you for joining us today. Slide 10 notes upcoming investor events in which we will be participating. As always, please feel free to follow up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today’s conference call. Thank you for your participation. You may now disconnect."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 3 | 2,020 | 2020-10-30 08:00:00 | Operator: Good morning, and welcome to the ADM Third Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded.
I would now like to introduce your host for today's call, Victoria de la Huerga, Vice President Investor Relations for ADM. Ms. de la Huerga, you may begin.
Victoria Huerga: Thank you, Amy. Good morning, and welcome to ADM's third quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com.
For those following the presentation, please turn to Slide 2, the company's safe harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC report. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events.
On today's webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and important actions we are taking to meet our strategic goals. Our Chief Financial Officer, Ray Young, will review financial highlights and corporate results as well as the drivers of our performance and our outlook. Vince Macciocchi, Senior Vice President and President of our Nutrition segment, will give an update on our nutrition business and its future growth. Then Juan will make some final comments, after which they will take your questions.
Please turn to Slide 3. I will now turn the call over to Juan.
Juan Luciano: Thank you, Victoria. Last night, we reported third quarter adjusted earnings per share of $0.89, up from $0.77 in the prior year quarter. Adjusted segment operating profit was $849 million, up 11% year-over-year, and our trailing fourth quarter adjusted ROIC was 8.3%.
Our strategic initiatives have continued to enable our teams around the world to demonstrate their expertise and skills. And I'm proud of how our colleagues are supporting customers and driving strong results. The team has done a great job handling the daily and sometimes hourly challenges that have come our way in 2020. That resiliency allows us to deliver outstanding results today while we simultaneously continue our strategic work to make our company better and advance our growth and transformation.
Let me share with you some of our accomplishments. In our optimize pillar, our Ag Services and Oilseeds team continued its work to enhance returns, delivering another $100 million in invested capital reductions in the third quarter. Since 2017, Ag Services and Oilseeds has improved its capital position by exiting from no longer strategic assets, including 71 grain origination locations, 6 oilseed facilities, 14 Golden Peanut and Tree Nuts locations and 7 ocean-going vessels.
We've also seen first-hand how our improvement initiatives have helped drive business continuity. In addition to the pandemic, in recent months, we've seen multiple hurricanes in the U.S. Gulf under the rage of storm that swept across the Midwest. Despite those events, thanks to our teams and our operational excellence, we have continued to serve our customers and fulfill our purpose without significant interruption.
In our drive pillar, we are continuing to accelerate our 1ADM business transformation, expanding the deployment of our procurement, contract labor and sales and marketing modules, which are helping us drive efficiencies and growth and will provide us with a trove of data to support enhanced analytics and decision-making.
Our Decatur corn complex ongoing strong performance from grind to gluten and germ meal to workplace safety continues to demonstrate the benefits of our centralized operations organization. Our supply chain center of excellence is delivering as well. Using our enhanced processes and tools as well as integrated planning between commercial, supply chain and operations, we've recently piloted changes at the nutrition facility that are on track to unlock a 20-plus percent increase in production capacity at that location and have already resulted in enhancements in customer service without additional capital spending. We'll be rolling these kinds of improvements out to other locations.
In our expand pillar, we are continuing to harvest our investments. For example, year-to-date, our Algar Agro acquisition has tripled its year-over-year operating profit. In a very short time, Algar has grown to be an important component of the South American business. We've successfully expanded production of high-quality USP grade alcohol in Peoria and Clinton to meet high demand for hand sanitizer. We announced the construction of a new state-of-the-art production facility in Spain that will dramatically expand our ability to meet growing demand for probiotics and other consumer products to support health and wellness.
We also signed a long-term agreement with Japanese startup Spiber Inc. This project taps into our innovative spirit and capabilities creating value from across our supply chain from the corn we buy to the dextrose we make, to the science and manufacturing technology we have invested in. And it meets a critical need in the marketplace for both consumer and industrial products that come from sustainable sources.
Our transformation and growth and our confidence in the future will not be possible without readiness. By the end of the third quarter, our team identified and executed on readiness initiatives that unlocked almost $1.2 billion in run rate benefits. And now I'm pleased to announce that we are on track to achieve $1.3 billion by the end of the year.
Readiness encompasses and supports our entire company. It drives the strategic imperatives that help us fulfill our purpose, such as sustainability. We are advancing our sustainability efforts on many fronts, such as our Strive 35 goals to improve our performance on greenhouse gases, energy, water and waste.
Readiness creates growth enablers. For example, we're continuing to elevate our commercial excellence with innovative tools like our consumer insight programs and virtual customer technologies. And of course, readiness is one of the key elements powering the growth algorithm we laid out at the beginning of the year. Because of its success, along with tremendous progress in our harvest and improved initiatives, we now expect to meet or exceed the high end of our $500 million to $600 million goal for targeted improvement in 2020.
So before I turn to Ray, I'd like to say that it's our pleasure to welcome Vince today on this call. In 2014, we started a new journey with the acquisition of WILD Flavors and the launch of a full-service nutrition business, offering customers a broad array of products and services. I could not be more proud of the growth we have seen since then.
Nutrition has delivered its fifth consecutive quarter of 20-plus percent year-over-year OP growth. Revenue is up 5.7% on a currency-adjusted basis for the first 9 months of the year. And in the years since we acquired WILD, we are nearly tripled OP in the flavors business. As we've been getting more and more questions about that business and its growth potential, we decided that it was the perfect time to update and explain the business further.
But before we get to Vince though, I'll turn it over to Ray to take us through our business performance. Ray?
Ray Young: Thanks, Juan. And please turn to Slide #4. As Juan mentioned, adjusted EPS for the quarter was $0.89, up from the $0.77 in the prior year quarter. Excluding specified items, adjusted segment operating profit was $849 million, up 11%. And our trailing 4-quarter average adjusted ROIC was 8.3%, 255 basis points higher than our 2020 annual WACC. Our trailing 4-quarter adjusted EBITDA was about $3.7 billion.
Our cash flows are strong as we generate about $2.3 billion of cash from operations before working capital for the first 9 months of the year. The effective tax rate for the third quarter was a benefit of approximately 13% compared to an expense of 19% in the prior year. Our Q3 tax rate was impacted by our debt retirement actions as well as the sale of our Wilmar shares and higher year-over-year Wilmar earnings and U.S. tax credits. Absent the effect of EPS adjusting items, our effective tax rate was approximately 11%. We expect our adjusted tax rate for Q4 to be similar to this adjusted Q3 effective tax rate.
As we announced at various points during Q3, we've taken several actions over the last few months to both utilize and enhance our strong balance sheet. These actions were not about cash flow or liquidity as we had cash and available credit capacity at the end of the quarter of almost $10 billion. They were about creating balance sheet optionality for future transactions while maintaining a strong credit rating profile.
We monetized a portion of our Wilmar investment through a block sale of Wilmar stock and issuance of bonds exchangeable for Wilmar shares at a future date. As we have indicated, we view our significant remaining Wilmar stake as strategic, and we do not have any intentions to sell additional shares.
Leveraging our strong cash position, we also rebalanced our mix between long and short-term debt, economically retiring higher coupon debt through positive NPV transactions and reducing interest payments in the future.
Combined, these actions allow us the flexibility to make strategic investments, further bolt-on acquisitions or buy back shares when it makes sense to do so, all while continuing to make progress in deleveraging our balance sheet and maintaining our single A credit ratings. These actions were also a significant driver of our tax rate.
Return of capital for the first 9 months was $724 million, including around $115 million in opportunistic share repurchases, the vast majority of which were executed earlier this year. We finished the quarter with a net debt to total capital ratio of about 27%, down from the 30% a year ago.
Capital spending for the first 9 months was about $560 million. We expect capital spending for the year to be around $800 million that we previously indicated and well below our depreciation and amortization rate of about $1 billion.
Slide 5, please. Other business results were lower than the prior year quarter, driven by lower ADM investor services earnings and captive insurance underwriting losses, including a $17 million settlement impact for the high water claim with Ag Services and Oilseeds.
In the corporate lines, unallocated corporate costs of $196 million were higher year-over-year, due primarily to variable performance-related incentive compensation accruals, which were low in the prior year. Corporate results this quarter also included $396 million related to the early debt retirement charges that I referred to earlier, which is an EPS adjustment item. Net interest expense for the quarter was similar to the prior year period.
Looking forward, we expect unallocated corporate expenses to be in line with our initial $800 million guidance for calendar year and Q4 net interest expense to be slightly lower than Q3. We also expect a loss of about $50 million in other business in Q4 due to anticipated intercompany insurance claim settlements.
Please turn to Slide 6. Ag Services and Oilseeds results were higher than the third quarter of 2019. In Ag Services, we saw extremely good execution around the globe. The North American team did well to capitalize on strong industry export margins and volumes, and the global trade team had another strong quarter as they continued their focus on serving customers. Ag Services also benefit from a $54 million settlement related to the 2019 U.S. high water insurance claims, which is partially offset by an expense in captive insurance.
The crushing team also did a great job executing in a solid demand environment. Both Ag Services and Crushing saw expanding margins during the quarter resulting in around $155 million in total negative timing effects, which led to lower results. Those timing impacts are expected to reverse in the coming quarters. Refined Products and Other was significantly higher year-over-year, driven by improved biodiesel margins around the globe. Equity earnings from Wilmar were substantially higher versus the prior year period.
Looking ahead, we expect to see strong North American exports in global crush margins in the fourth quarter, combined to contribute to a very strong Ag Services and Oilseeds performance, with results significantly higher than the third quarter of this year, though lower than Q4 of 2019, which included a $270 million benefit for 2 years of the retroactive biodiesel tax credit.
Slide 7, please. Carbohydrate Solutions results were significantly higher year-over-year. The Starches and Sweeteners subsegment was substantially higher driven by strong risk management and improved net corn costs as well as a balanced ethanol industry supply and demand environment. Reduced food service demand affected sweetener and flower volumes but we're seeing good demand recovery for starches in North America. The Vantage corn processors team did a good job executing on the wet mill fuel ethanol distribution and capitalizing on higher year-over-year industry margins while managing the fixed costs from the 2 temporarily idle dry mills. Increased volumes and margins on USP grade industrial alcohol to support the hand sanitizer market also contributed to higher year-over-year profits.
Looking ahead, we expect the fourth quarter for Carbohydrate Solutions to be close to Q3 of this year and substantially higher than the fourth quarter of 2019, driven by improved year-over-year fuel ethanol margins and higher industrial-grade sales. While Sweetener and Flower volumes will still be impacted by weaker food service demand, we expect the year-over-year percentage decline to be smaller than it was in Q3.
On Slide 8, Nutrition delivered its fifth consecutive quarter of 20-plus percent year-over-year profit growth. Human nutrition results were substantially higher versus the prior year quarter, with strength across the entire pantry, including flavors, plant-based proteins and probiotics. Animal Nutrition was also higher year-over-year, driven by continued delivery of Neovia synergies, strengthened livestock and year-over-year improvement in amino acids, partially offset by softer aquaculture feed demand as well as negative foreign currency impacts. Looking ahead to the fourth quarter, we expect nutrition to deliver another quarter of 20-plus percent year-over-year OP growth with a typically seasonally weaker Q4 in Human Nutrition, offset by seasonally stronger Animal Nutrition.
I'd now like to transition to Vince Macciocchi, President of our Nutrition business, for an update and overview of the business. Vince, congratulations to you and your team for not just a great quarter but for consistent delivery of strong growth.
Vincent Macciocchi: Thank you, Ray. Slide 9, please. I'm proud of the team who have delivered in so many ways. When I reflect upon the growth we've made and the journey we are still taking, I keep coming back to our purpose, to unlock the power of nature, to enrich the quality of life. I think it's remarkable how these few words sum up not just what we do but why our work is so important.
The global population is growing, and consumer behavior is shifting in ways we couldn't have predicted only 10 or 15 years ago. The scale of the change and the opportunity for ADM is enormous. Global sales of specialty ingredients across both human and animal nutrition are as much as $85 billion and growing at a rate of 5% to 7% per year. These specialty ingredients, which represent the majority of the nutrition portfolio aside from fee, go into the full array of consumer nutrition products for humans and animals, many of which are projected to grow significantly in the coming years.
For example, the global market for functional beverages could be as large as $190 billion in 2024. The global dietary supplement market could be worth more than $77 billion in that same time frame. Global retail sales of alternative proteins are already a $25 billion market today, with a projected growth rate of 14% per year. Global retail sales of pet food are projected to grow at 4% per year, reaching $120 billion by 2024.
These aren't just numbers. They're indicators of significant long-term trends in how people choose food, drink and other products, driven by a global population that cares deeply about health and sustainability. And based upon the portfolio, footprint, capabilities and talent we've built, no other company is positioned to meet these needs and lead in these industries like ADM.
Please turn to Slide 10. It's been 6 years since we started on this journey. In that time, we built or expanded more than 16 facilities, from our pea protein complex in the U.S. through our network of premix plants in China. We've enhanced our science and technology capabilities, invested in market research and consumer insights and built new interactive ways to engage with customers from our more than 50 global customer innovation centers to daily virtual innovation and tasting sessions. We've made platform acquisitions, and we've added bolt-ons. All in all, we have invested just over $6 billion to build our global leadership position in nutrition.
These investments are delivering results. Since 2014, we've increased our annual revenue by $3 billion. And by the end of this year, we'll have grown operating profits by more than $300 million over those 6 years, more than double.
Slide 11, please. Our Human Nutrition business can offer customers ingredients, flavor systems or turnkey product development solutions, supporting them every step of the way to take their ideas from concept to prototype to market in record time. In Animal Nutrition, only 1.5 years after we completed our Neovia acquisition, we can look back on a successful integration in which we exceeded our synergy goals and built a global business that offers a full portfolio of on-trend items, from pet treats to enzymes to ingredients for aquaculture to meet evolving customer needs.
In our Health and Wellness business, which is part of our Human Nutrition subsegment, our scientists are expanding the universe of pro-, pre- and postbiotics and other functional products to meet growing demand, from stand-alone supplements to ingredients that help enhance our array of human and animal solutions.
Taken together, our extremely broad portfolio of ingredients and solutions can add value for customers across both human and animal nutrition. For instance, taste and color are just as important for animal nutrition customers today, as they are for food and beverage customers. Functional ingredients matter in both human and animal nutrition and so on across our entire pantry.
Then we add the rest of ADM's capabilities. In plant-based protein, for example, we have the unique advantage of ADM's broad and integrated value chain, from sourcing and transporting the soybeans and peas to transforming them into high-protein ingredients at our own facilities, to adding the colors, flavors, oils and other key elements to create just the right taste, appearance, juiciness and sizzle for delicious finished plant-based products.
Please turn to Slide 12. We're proud to have come this far in 6 short years, but our eye is on the future. We are confident in continuing our growth story. It starts with the global category trends I outlined earlier. It continues with our extensive and ongoing research into consumer behavior and needs.
Earlier this week, we released our latest view of the top consumer trends of 2021 based upon research that includes our proprietary outside voice consumer insights program. Our findings show that the events of the past year are accelerating and deepening fundamental market shifts, including consumers taking a more proactive approach to nourishing body and mind, the microbiome as the gateway to wellness, continued growing demand for plant-based foods, sustainability as a key driver of purchasing decisions and transparency as a building block of consumer trust.
The last piece of the equation is how our team brings it all together for our customers, combining unmatched customer support and service with our vast value chain to deliver ingredients, systems and solution that align perfectly with market trends and needs. These are the reasons we expect to continue to lead the industry outpacing the market and operating profit growth, and we remain confident in reaching $1 billion in OP in the medium-term future.
With that, I'll turn it back to Juan.
Juan Luciano: Thank you, Vince. And congratulations to you and the entire ADM team for another outstanding quarter.
Slide 13, please. Across the enterprise, we are continuing to advance our work to enrich the quality of life and meet key needs for consumers around the globe. At the time of heightened concerns around food security, ADM's vast global value chain is helping ensure that countries and families can continue to put nutritious, delicious foods on the table. As consumers focus more and more on proactive approaches to health, we're expanding the frontier in groundbreaking functional ingredients and supplements for people with conditions like migraine and atopic dermatitis, and we're paving the way to a new world of precision nutrition personalized for every individual. And as sustainability becomes a key driver of consumer decisions and business success, we're playing a leading role in the transition to a low-carbon economy for our industry.
We are committed to our purpose, and our team is continuing to deliver for our customers, our shareholders and all could depend on us. And that is why we are confident in a strong finish to 2020 and a positive momentum continuing through 2021.
With that, Amy, please open the line for questions.
Operator: [Operator Instructions] Your first question comes from the line of Eric Larson with Seaport Global.
Eric Larson: Congratulations on a really good quarter. My first question is really for Vince. Vince, thank you for that review of your operation. And I'm going back to Slide 11 and going to your complete pantry of ingredients and solutions from nature. So we've seen some pretty massive consolidation in this industry now the last several years with IFF making some very large acquisitions at extraordinary multiples.
Can you give us just a little flavor for, if you look at the various categories where you've got your pantry, what your shares are in those areas, roughly? I know it's highly fragmented. Where additional opportunity might be available for you -- outside of your normal organic growth, I mean would there be some opportunities to strengthen your portfolio across those various sectors? And where do you think your biggest strengths are? And maybe where you could use some strengthening in those areas?
Vincent Macciocchi: Thank you, Eric. I think if you think about our business -- and maybe I'll start kind of where you finished in terms of some of our greatest strengths. I think our greater strengths are obviously the breadth and depth of the pantry coupled with our technical capabilities and providing solutions backed by science. I think you also marry that with the global consumer trends when you think about the focus on the microbiome, focus on plant-based foods, sustainability and good for you, and you think about clean label moving to clear label.
Our portfolio is really well positioned when you think about our flavors business and the focus on natural and our continued growth in the mature market and as we expand our footprint into the emerging markets.
Specialty ingredients, obviously, we have a dominant share as a key protein -- plant-based protein provider. And we're providing soy, pea and wheat from a plant-based protein perspective and really capitalizing on that global consumer trend.
If you look at our Health and Wellness business, we have a fantastic portfolio, really focused on probiotics and postbiotics as well as fiber as well as vitamins as well as specialty oil, so a really complete portfolio across Health and Wellness.
And then obviously in Animal Nutrition, we completed the acquisition of Neovia in 2019. Obviously, we've over-delivered against the synergy targets, but it's a global, robust business. It's really focused on, obviously, complete feed additives and ingredients, aquaculture, pet. So really moving that portfolio to realize synergies, grow organically and capitalize on our global footprint.
So where is our opportunity? There's certainly opportunity to further expand in the flavors business into emerging markets. We're always looking at technology in our portfolio and geography, in the plant-based business and specialty ingredients. It's really making sure we're providing outside of the Americas and looking to enhance our footprint there.
In Health and Wellness, it's really capitalizing on the microbiome and expanding our capability. Juan mentioned in his remarks that we're expanding our facility in Valencia, Spain. That will give us significant capacity increase to capitalize on our growing demand.
And then on animal, I think our story is really one where we finish the integration, we grow organically, we margin up that portfolio, and we continue to combine all pieces of our portfolio and provide solutions backed by science.
Eric Larson: Okay. Great. And my follow-up question is really kind of -- is for Juan, and this is more of a general question. Juan, I think most of the people on this call are aware of the nice recovery in the global ag markets, et cetera. I think the question that we all have, and we've seen various fits and starts and stops and stall from the last several years. Can you address how you look at the sustainability of the recovery in these -- basically in the ag markets globally, aside from just the current strength that we're seeing? Clearly, it's sustainable in the early part of next year. But beyond that, do you -- can you give us your perspective on sustainability for the next let's say, 1 or 2 years or even more?
Juan Luciano: Yes, Eric, thank you. I think -- listen, I think I'm very proud, first of all, of course, of the way the team has been executed. And I think we have a track record of consistent execution on that so that -- from that perspective. Second, I think the important thing to reflect upon is that we have built the business over these few years, aligned to secular trends on food security, on health and wellness and on sustainability. And we see those trends being with us for the duration that I can see going forward.
So when we look at our planning horizon, we feel very good about that, about achieving our 10% ROIC, and we're achieving our goals in earnings and reduction on invested capital. When we look at the -- even the issues that we're seeing today with the pandemic, the pandemic has basically increased or emphasized some of the trends that we have been already developing over time with the consumers. And you see governments more concerned about food security now and the ability to keep supplying food for the world. And I think that we are a key element in that. And our footprint and our ability to connect the areas of surplus with areas of deficit in the world is valued and is recognized and I think that, that will continue going forward.
I think that everything that we're doing in terms of positioning our portfolio for healthier trends. We see the reaction on that. We see the reaction in plant-based proteins. We see the reaction in probiotics, but we see the reaction also on the snacking in functional foods. And all that is very strong in the ADM portfolio. And we continue to see the pool from biomaterials, from materials based on plant that actually replaces other fossil fuel type of build materials that have more push. So we see it in the scale and the reach that we have for food security. We see it in the specialization that we see in nutrition, and we see it in the demand for sustainability.
So as far as we can tell, again, we are finishing the year very strong with the Q4 that we are very excited about, and we are entering Q1 with a strong momentum. So we certainly see 2021 with a lot of optimism. I think conditions are there for us to have good times, and we don't see at this point in time what is the thing that will change that. Demand is strong. I think if anything, China has come rolling back from the pandemic. Their recovery has surprised everybody. At the same time that the economy recovers, they are recovering from ASF, which they are rebuilding their herds. At the time when, candidly, Brazil has sold -- because we were part of that, has sold all the pipeline of beans in which Argentina doesn't have an incentive to sell. And for the very first time in a long time, the world needs the U.S. supply for both soybeans and corn.
So we are looking at it from several angles, to be honest, and we see it fine. We see also, even in the crush margins that is a crush supported by both legs now. Traditionally, it has been more on the mill side, but we have a very big oil story developing around the world and it has all these conditions. Whether it's biodiesel or renewable green diesel or just the recovery of food service, we have been pulling oil demand.
So again, at this point in time, we see the future with a lot of optimism and a lot of confidence in our team's ability to execute on that.
Operator: Your next question comes from the line of Ben Kallo with Baird.
Ben Kallo: So just you touched on ASF, but could you talk a little bit more about that and when we expect that to be a tailwind? Then my second question is just on the Wilmar and the liquidity from that. Where should we expect, I think, the investment to go and maybe a rank order there? And then third, we get -- we're hearing more and more all over the place about renewable diesel. Can you talk to us about your exposure to that trend as a tailwind?
Juan Luciano: Yes. Thank you, Ben. So the first one, ASF. As we said, I think ASF, we've been following this story for several quarters. And I think that overall, it has developed as we predicted. So initially, with the big gap in protein in China that was supplemented by imports of proteins, and we saw that in the strength of crush margins. Now China has been able to control that. Now China is rebuilding their herd. Remember that herd was -- about half of the herd was decimated. So there is a big effort to rebuild that. As they rebuild the herd, they are going into more professional animal production. That has increased the rations. So -- that has increased soy meal, but that has increased corn. That's why you see so much pull from China from imported corn. At the same time, we have seen the poultry industry coming up in China to supplement a little bit the lack of pork protein that they have in China.
So we've seen all that. We think that there's still probably a couple of years ahead of us for China to recover the herd plenty. And of course, you heard their statement about trying to go for self-sufficiency. So I think they're going to build that. So we're going to see continued strength in crush margins. And we feel that, that's driving demand.
Again, as I said before, the professionalization of the animal husbandry has brought more soybean meal and corn into the ration, and we will continue to see better feeding and better nutrition in that sense. So again, nothing surprising maybe to what we expected.
And remember that in the previous quarter, we talked about our positive view of crush margins over the second half of the year. And that's the way we predicted, that's the way we played, and that's the way it is working out. So -- and China is behind a lot of that.
Your second question was on Wilmar and our allocation of capital. Listen, Wilmar, we are very proud of the Wilmar ownership and relationship that we have had for many years. It's a very strategic partner for us, which gave us last night, another gift with great results. The team continues to execute. And again, it's a little bit related to what I'm saying. China has come in rolling back from the pandemic and the recovery and Wilmar is a big part of that.
We made a reallocation of capital decision. Again, we're going to hold to our 20% share there. We are very comfortable and committed to that for the long term. This was just a matter of we wanted to strengthen our balance sheet after the acquisitions, you heard Vince, between WILD Flavors and Neovia. We need to get back to that. I mean we are comfortable into that. And we want to get back to support Vince with the bolt-ons that he needs and some organic investments. We are increasing the capacity as we announced in Biopolis by fivefold, where things are growing there. And I'm sure Vince has a long list of bolt-ons that he wants to execute, another organic growth as we grow geographically some of the successes that we have in North America and Europe.
So that basically is nothing behind that other than that. And we continue to support R&D. You talked about a lot -- you heard Vince talking a lot about science-based functional products and science-based nutrition. And that's important, and that takes money. So it's money that we gladly invest in that because we are seeing the returns on that. Not everybody has business in their segment that grow 5 consecutive quarters or more than 20% per quarter in terms of operating profit. So we are very proud with that.
And your third question was about renewable green diesel?
Ben Kallo: Yes.
Juan Luciano: Yes. And listen, we participate that as a supplier of feedstock. You see the tightening that this has generated because, of course, there has been stable volumes and very healthy margins of biodiesel that we've been supplying. And also, we've seen the tightness that, that generated as food service has recovered in the oil part of the consumption.
So I think that we follow that with interest. It's another leg that adds to the strength of crush margins. So in the short term, it's a very positive tailwind. We have to see how that industry evolves. There are many factors in this industry. There are many announcements that they are all positive. That will put some pressure in feedstocks, of course. And we're going to see how that announced, how many states or countries adopt these, how many of these investments are actually come through into real plans and then how many other feedstocks are allowed here to come.
Today, the environment of feedstock is a little bit of a rarefied environment because we have less of restaurants creating cooked oil and then we have a little bit of less production of -- in the ethanol side. So -- but we have potential to bring canola into these that we are -- it's a good carbon index also.
So there are a lot of dynamics. But I think short term, we are participating just as a supplier of soybean oil and that we are profiting from that in the crush margins that we are seeing.
Operator: Your next question comes from the line of Ben Theurer with Barclays Bank.
Benjamin Theurer: Yes. Congrats on the results. I tried to get you back on schedule, ask only one question, and that one is for Vince. So when you nicely showed how you've basically increased the nutrition business since the bigger acquisition some 6 years ago, and if we look at it on a trailing basis, we're basically at about $550 million in operating profit, call it, somewhere halfway through of where you want to get. But we've clearly seen a significant acceleration in the last 2, 3 years.
So how should we think about your path to the $1 billion going forward? Is this going to be a 6-year time to get there? Is it going to be accelerated just because of the flexibility? And as Juan just said, he's going to give you a little bit more capital and opportunities as you have a long list for bolt-on M&A. So how should we think about the growth performance M&A versus organic? And when do you think that medium-term target can be achieved?
Juan Luciano: Yes. Maybe if I start, and I'll let Vince complete that with some more granularity. But when we look at our strategic plan, and we plan in 5-year increments, so the last one we did in 2019, so 2019 to 2024, we see our $1 billion OP that Vince described being achieved in that planning cycle. So let's say, by 2024, if you want to say it that way.
In order to get there from here, you can see the nutrition approximately needs to grow around 15% per year compounded to get to that number. So that number is excluded any major M&A. That number is in the current strategy, which is organic growth and bolt on. So about the ratio that you're seeing right now going.
So maybe then I pass it to Vince to provide more granularity on where that growth comes from.
Vincent Macciocchi: Thank you, Juan, and thank you, Ben. I think it's important if you just take a pause and see where we're at. If you look on a year-to-date basis through 3 quarters, we're at $448 million, whereas we did $419 million all of last year. So to Juan's point, it's a good growth story and a good growth trajectory from an organic basis. And what we've done is we've really taken the approach of let's grow organically. Let's expand our customer base. We've made significant investments in our key account management program and our approach to the customers and really expanding that base on a worldwide basis.
As I mentioned in my remarks that we've invested over $6 billion in this business. So yes, we've done platform deals that we've integrated and then grown organically, and we've done a series of bolt-ons. But additionally, we've invested in our own facilities. We built a greenfield pea production facility in Enderlin. We built a soy protein complex in Campo Grande in Brazil. We've done acquisitions in the citrus space, the vanilla space, the food-based space, the bioactive space. And so obviously, we're harvesting those investments right now and continuing to take those businesses and grow those businesses and add them to our portfolio of capabilities. So I think that's what gives us some optimism. And we look at our win rate in the marketplace as well. And we look at our pipeline of opportunities.
Again, when you take these capabilities and the size of the pantry which we depicted earlier, and you marry those with the technical capabilities we have on a worldwide basis from a science and technology perspective and a creation, design and development perspective, that translates to a very high win rate against customer opportunities that actually launched in the marketplace.
Therefore, we have an organic growth road map as Juan identified within the time horizon of the strategic plan that will get us to that $1 billion aspiration. And again, we'll continue to search, as Juan indicated earlier, for smart bolt-ons and perhaps platform deals if and when they make sense.
Juan Luciano: And then we're going to keep pushing Vince to get there faster.
Operator: Our next question comes from the line of Robert Moskow with Crédit Suisse.
Robert Moskow: Juan, the environment looks great. I totally agree. I'm trying to think of things that might derail that situation. One investor asked me about Argentina and the possibility of devaluation. And would that be a catalyst for farmers selling, crushers crushing and leading to a glut in the market that might cause crush margins to fall? Can you comment on that possibility?
Juan Luciano: Yes. Well, so I'm not going to be on record predicting a devaluation in Argentina, Rob, since I would like to go back one day, but let's put it this way. The world is tight today. There is a big demand, as I said, from China. And even if -- let's run your scenario in which Argentina devalue and there is an incentive for the farmer to sell. Then may be only like 5 million tons that they're going to throw into the market. To be honest, the market needs that, and the market will absorb that very quickly and move on.
So I don't see that as a big source of derailment. I don't know what the source of derailment could be. But I don't worry that much about that. I think, again, the market is tight enough today. Brazil's crop is a couple of weeks late. So there is a La Niña effect that we still need to see what's going to do to yields. And although I think that Brazil, we have a big crop, I don't think we're going to have 140 million tons crop given the start and the conditions that there are.
So I think that at this point in time, I worry more about where the beans and where the mill is going to come from later on than actually if Argentina will flood the market. We don't see that as an opportunity. If you hear -- I mean if you -- unfortunately, I don't have the opportunity to be back in Brazil or Argentina at this stage. But as I talked to Brazil, Brazil is an environment of -- in an environment of food inflation and imports right now, where they're bringing imports from Paraguay, from Uruguay for beans.
So I think you see the need, and we see it with a customer base that is very uncovered, to be honest. So these are people that are buying hand to mouth for strong demand. And it's our role to supply that and to cover that. But as I said, we worry a little bit more about making sure that the flow from the farmers continue so we have the material to continue to execute and to feed the world.
Operator: Your next question comes from the line of Ben Bienvenu with Stephens.
Pooran Sharma: This is Pooran filling in for Ben. I just wanted to ask you how you're thinking about your dry mills. Does it seem like it makes more sense to just keep them offline until post-COVID? What do you think is best for that business? And can you talk about any growth you have or could see in USP grade alcohol?
Ray Young: Yes, it's Ray here. Well, first of all, we've done a very good job managing the stranded costs of our 2 temporarily idle dry mills. And I think also with some additional idlings that have occurred in the industry. I think the industry has done a very good job in terms of balancing supply and demand in the ethanol industry. And that's part of the reason why when you look at inventories right now, EIA count on stocks are below 20 million barrels. And that's contributed towards, frankly, a reasonable ethanol margin environment that we've seen. And that's contributed, frankly speaking towards good results that we've seen both in our Starches and Sweeteners segment, which has the wet mills, and then also for VCP, which has the industrial-grade alcohol of our Peoria facility.
So we believe that as we kind of enter the winter season, which you know seasonally driving miles come down during the winter, and so therefore, from an ADM perspective, we believe we're probably going to keep these dry mills temporarily idled as we go through the low season of gasoline demand and hence ethanol demand. That's the responsible thing to do.
Then -- but when we look forward into the new year, as I indicated in the last call, we're going to look at the data, right? And so we're going to look at the data with respect to how the U.S. economy is recovering. We're going to look at the data in terms of how driving miles are going to seasonally recover as well. We're going to look at the data in terms of the industry utilization rates for ethanol because some of these ethanol mills that we've seen idled, they're going to be permanently idled. Some of them -- a lot of them have indicated that they're going to remain permanently idled as opposed to temporarily idled. And then importantly, we're going to be looking on very -- the Tenth Circuit Court ruling on special refinery exemptions and whether the Supreme Court is going to hear the case or not.
So there's a lot of variables that you're going to be looking at. In addition, you may have heard that China is also starting to look at potential imports of ethanol from United States into the country. I think there's been 1 boat that has gone to China. But they are making a lot of inquiries about U.S. ethanol. And so all of these variables are going to be very important factors in terms of our assessment in terms of when we actually restart these dry mills. Based upon any or all these variables becoming favorable, we could see that with the -- let's say, the spring season when normally the industry starts building up inventories of ethanol for the summer driving season, we could see that as we get into spring, that we may restart the dry mills again.
But again, this will be a data-driven decision. We recognize the importance that we play in order to make sure we have good supply/demand balances in our industry. But again, looking at the variables, as we see it right now, we could -- we clearly see the path towards some sort of restart in the first half of next year.
Pooran Sharma: Got it. And then also, could you just maybe provide a little bit more color on the prospects for USP grade alcohol?
Ray Young: It's been a good news story, right? I mean we started the year with 1 plant, our Peoria plant, 85 million gallons a year. Demand shot through the roof for industrial-grade alcohol. And so we actually combination ran the plant hard plus we've expanded the capacity of that plant. So we'll be up to 100 million gallons very shortly. And then secondly, we also made some investments into another facility, Clinton, and we're going to actually expand production of industrial-grade alcohol in that facility as well. So by the end of this year, our run rate in terms of industrial ethanol production would have increased by over 50%.
In addition, the quality of the ethanol that we produce is very, very high. I mean you've probably read many stories about hand sanitizers in whereby the quality of the alcohol within the hand sanitizers is poor. And frankly, a lot of them have been pulled out of the market. The customers are looking for a high-quality industrial alcohol. And that's what ADM is able to deliver. That's the reason why we've expanded capacity in order to meet the demands of these customers.
Operator: Your next question comes from the line of Ken Zaslow with Bank of Montreal.
Kenneth Zaslow: As you see the oil seed markets developing, is there any thoughts that there may be some additional capacity being built anywhere that would be alarming? Or any thought that you would think that would come about? And what are your plans? Is it more of a debottlenecking procedures? Or would you think that there would be some thought that you might find some capacity expansion opportunities?
Juan Luciano: Yes, Ken. At this point in time, again, it's a very positive environment from a margin and demand perspective. So I think that we're all looking through readiness and everything, how to expand capacity with as little capital as possible, of course, to debottleneck every facility. We are very prudent in thinking about new staff that cannot be integrated. I think we're very proud of the integration of our facilities that help a lot the integration with grain, the integration with refineries.
So at this point in time, going to the earlier part of your question, we don't see any major announcement that worries us. I think that in reality, the industry needs some of that extra capacity that we heard about it. And I think that we continue to have our plan. As I said, we put together our 5-year plan from '19 to '24. That includes some expansions to maintain our position there. But this is a very disciplined market in which we follow demand and we follow what our customers and the final consumers are doing. So we are looking at that, and we have flexibility.
I don't think this is an industry that goes like other industries that maybe build a lot of capacity, and then it takes many years for them to build, to grow into that capacity. This is an industry that tend to grow in manageable chunks. And I think that we've been a player into that, and we know how to do it. So I don't worry that much about that, not at this point in time, Ken.
Kenneth Zaslow: I know the question was asked, but I'm going to ask you a little differently because not that I didn't like the answer, I'm just trying to figure out a little bit more quantification. How can you frame the opportunity that's associated with renewable diesel to your margin structure or to your earnings potential? How incremental is this? Is this a noticeable difference? Is this a -- hey, it's kind of like a cherry on an ice cream Sunday? Or is it kind of the ice cream? How do you think about it?
Juan Luciano: So I think -- listen, I think the numbers if -- let's say that even if you take 70% of the announced capacity happened to be through, it's a significant number. It's not -- so we're going to be a player there. Of course, we're going to be a player in -- for a while there. We have very good facilities in biodiesel that are integrated with our refineries, with our crushing plants. So in that sense, they are more secure than others in the fight for soybean oil, if you will.
But I think as we said it -- as I said it at the onset, I think that we need to see how this develop because this is the fight for decarbonization of the economy, if you will. And there are many things coming into play for the long-term perspective, whether it's electric vehicles and other solutions. Remember, we were not discussing renewable green diesel a year ago. And there may be another solution coming back, another thing coming back later. So I think that we are all being prudent, not because we see any long-term bad, but also because we realize there are many people and many technologies looking at how to decarbonize the economy and transportation and all that.
So I think it's a positive. I think we're going to participate in that. I think that if everything that is announced or, as I said, 70% comes, I think it's going to be significant and meaningful. But I think at least for the next few years down the road, this is going to bring tightness to the oil market, which is going to increase associate margins, and we have seen that happening and will increase -- and will keep crush margins robust as they are today.
So -- but reading much further than that, forecasting in this energy area is prone to mislead people because technology is coming very rapidly into the area. And technology tends to have this breakthrough impact, if you will, as renewable green diesel is having it right now, but we need to see the duration of all that.
Operator: Your next question comes from the line of Vincent Andrews with Morgan Stanley.
Steven Haynes: This is actually Steve Haynes on for Vincent. The operating environment clearly firmed up nicely for you guys. I wanted to just come back to kind of some of the self-help things you have going on. And if you got kind of $500 million to $600 million of controllable benefit this year, do you have any kind of target as we look into 2021, so what a like-for-like number could look like?
Juan Luciano: Yes. I would say we probably will provide more granularity on -- we are going through our own planning season. So we're going to provide more granularity at the Q4 call on 2021 targets. But I think that if you've been following us, you see that there is a certain cadence to what we bring to the table. And these programs are not a one-off, when we are engaging things like readiness, which is a key component of that or harvesting or improve. We're working on our portfolio. Hopefully, we're going to have less improved going forward and more harvesting.
But -- so the mix of that is going to change somehow. Some things don't repeat themselves. For example, thankfully, like the storms that we have in 2019 didn't reproduce in the same damage in 2020. So some of those things may come up and down. But there are some solid trends. You can see in readiness, those programs are very robust. So we're going to build the algorithm on the things that we can control. And we're probably going to come again with more granularity in the next earnings call.
But as I said, I think you -- I think investors have gotten used to our cadence on that. And we tend to have a very robust portfolio of things that we can control. And so it's not going to be a shocking array of possibilities. You're going to see possibilities around harvesting, around some improvements and around readiness. And the numbers may fluctuate here and there, but that's the gist of it.
Operator: Your next question comes from the line of Adam Samuelson with Goldman Sachs.
Adam Samuelson: So maybe the first question is just coming back to the balance sheet and capital deployment. And Ray, I think you were -- we have the Wilmar proceeds. You did the kind of debt, kind of optimization actions or -- last quarter. Can you help us think about kind of the -- your very heavy moving into that commentary on balance sheet optionality. Can you talk about kind of what you think the dry powder is from an M&A perspective right now and how that pipeline would look? And what we should be thinking about if there's any immaterial M&A that would kind of just help us frame kind of how -- what -- how big are we thinking about?
Ray Young: Yes. Just to again remind people, when we did the Wilmar equity block transaction, secondary offering, we were creating effectively balance sheet flexibility by improving the capital base of our company. So it was not a liquidity move. We had ample liquidity. It's basically helping to further deleverage the balance sheet. And so -- I mean, as we indicated, our intent -- after funding the Neovia acquisition earlier this year, our intent was to basically get our balance sheet back into the low 2s, when you think about metrics, get down to the low 2s by the end of the year. And so these actions are designed to help us get to the low 2s. And I feel good that with the actions that we've done, we're going to get there towards the low 2s.
And so that creates balance sheet flexibility on our part. And as we indicated, that gives us the flexibility to pursue bolt-on acquisitions. And as you know, Vince always has a list of opportunities that he's looking at. And our responsibility is to make sure that we have the balance sheet in order to kind of support it when these opportunities materialize. And then also share repurchases, I mean, to the extent that the equity markets make a correction in the future, due to whatever reasons, macroeconomic issues. And we have the balance sheet also to pursue opportunistic share repurchases when we think that there is a significant value gap relative to our intrinsic value.
So we're doing this. We've done that. We pursued some debt repurchases as well, debt tenders. And just to remind you, earlier this year, we issued some long bonds when the credit markets were extremely volatile. I mean, at that juncture, we did not know what was going to happen in the short-term credit markets. We didn't know how the central banks were going to behave. Well, what's turned out is that central banks have come in to support the markets. And so with the balance sheet that we had, the liquidity position that we had, we decided to opportunistically go on tender bonds and actually execute some that make-whole on some of the bonds outstanding. And so we actually -- we purchased about $1.2 billion worth of debt in the quarter with positive NPV transactions. And so with the credit profile that we have, our debt cost that we had, this was a tremendous transaction from an NPV perspective, delivering good value for our shareholders here, right?
So I think we've got the balance sheet into the shape that we would like. We got $10 billion in liquidity. So we can weather any type of additional global slowdown that maybe a second wave of COVID-19 could bring to this company. We have no issues in terms of being able to weather any of the risks associated with the second wave and the impacts there. And we have the dry powder right now for Vince to go pursue the bolt-ons that we've talked about in the past.
Operator: Your final question comes from the line of Tom Simonitsch with JPMorgan.
Thomas Simonitsch: So maybe one last question on the $1 billion nutrition operating profit, and apologies if I missed this, but what range of revenues do you need to meet that target? And in the near term, when do you expect the top line in nutrition to return to growth?
Vincent Macciocchi: Thanks, Tom. Well, the top line in nutrition is growing. When you look across the broader nutrition business on a year-to-date basis, where we've grown at approximately 6% FX adjusted. So we have a very aggressive growth plan from a revenue perspective. And obviously, there are some puts and takes. There's been some headwinds related to COVID affecting some of our sectors as well as some FX issues. But at the same token, we've realized significant revenue growth in certain areas of our portfolio. When you look at the Flavors business, primarily in North America and Asia Pacific, we look at our Specialty Ingredients business, primarily in North America, South America, in the growth of plant-based meat alternatives. We look in Health & Wellness. Obviously, very important growth across that space, really in terms of the bioactives, our specialty oils, our fiber portfolio. So with our fixation on customers, we're growing top line revenues. It's one of the key tenets of our organic growth opportunities in our plan. And then look at animal nutrition. So obviously, there's some things that have affected aquaculture and some other FX things there related to the Brazilian real and the Mexican peso. But at the same token on a year-to-date basis, we're up 7.5% FX adjusted. So we do have a very aggressive plan to drive the revenue. We're focused on revenue.
I mentioned pipeline earlier. That's a key barometer to how we measure our opportunity for future success and to drive revenue growth. So it's a heavy emphasis. And obviously, at the same time, while we're growing revenue and we're growing our businesses across the portfolio, if you look at our margin performance, it's increased as well. So we're focused on price, we're focused on profitability, and we're focusing on margining up all of our businesses across the portfolio.
Thomas Simonitsch: And do you have a revenue level in mind getting to that $1 billion operating profit?
Vincent Macciocchi: Yes. I think there's a couple of things. I mean when I spoke at the outset, when you talk about growth in the overall market of 5% to 7% per year, we certainly need to be in that range or outpacing that range. And obviously, we continue to marry with our operating profit performance. As Juan outlined, we're approximately -- to continue on our current trajectory, 15% per year gets us to that within the time horizon of this plan.
Operator: This concludes our question-and-answer session. I will now turn the call back over to Victoria de la Huerga for closing remarks.
Victoria Huerga: Thank you for joining us today. Slide 14 notes upcoming investor events in which we will be participating. As always, please feel free to follow up with me if you have any other questions.
Have a good day, and thanks for your time and interest in ADM.
Operator: Ladies and gentlemen, this concludes today's conference call. On behalf of ADM, thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the ADM Third Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded."
},
{
"speaker": "Victoria Huerga",
"text": "Thank you, Amy. Good morning, and welcome to ADM's third quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Victoria. Last night, we reported third quarter adjusted earnings per share of $0.89, up from $0.77 in the prior year quarter. Adjusted segment operating profit was $849 million, up 11% year-over-year, and our trailing fourth quarter adjusted ROIC was 8.3%."
},
{
"speaker": "Ray Young",
"text": "Thanks, Juan. And please turn to Slide #4. As Juan mentioned, adjusted EPS for the quarter was $0.89, up from the $0.77 in the prior year quarter. Excluding specified items, adjusted segment operating profit was $849 million, up 11%. And our trailing 4-quarter average adjusted ROIC was 8.3%, 255 basis points higher than our 2020 annual WACC. Our trailing 4-quarter adjusted EBITDA was about $3.7 billion."
},
{
"speaker": "Vincent Macciocchi",
"text": "Thank you, Ray. Slide 9, please. I'm proud of the team who have delivered in so many ways. When I reflect upon the growth we've made and the journey we are still taking, I keep coming back to our purpose, to unlock the power of nature, to enrich the quality of life. I think it's remarkable how these few words sum up not just what we do but why our work is so important."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Vince. And congratulations to you and the entire ADM team for another outstanding quarter."
},
{
"speaker": "Operator",
"text": "[Operator Instructions] Your first question comes from the line of Eric Larson with Seaport Global."
},
{
"speaker": "Eric Larson",
"text": "Congratulations on a really good quarter. My first question is really for Vince. Vince, thank you for that review of your operation. And I'm going back to Slide 11 and going to your complete pantry of ingredients and solutions from nature. So we've seen some pretty massive consolidation in this industry now the last several years with IFF making some very large acquisitions at extraordinary multiples."
},
{
"speaker": "Vincent Macciocchi",
"text": "Thank you, Eric. I think if you think about our business -- and maybe I'll start kind of where you finished in terms of some of our greatest strengths. I think our greater strengths are obviously the breadth and depth of the pantry coupled with our technical capabilities and providing solutions backed by science. I think you also marry that with the global consumer trends when you think about the focus on the microbiome, focus on plant-based foods, sustainability and good for you, and you think about clean label moving to clear label."
},
{
"speaker": "Eric Larson",
"text": "Okay. Great. And my follow-up question is really kind of -- is for Juan, and this is more of a general question. Juan, I think most of the people on this call are aware of the nice recovery in the global ag markets, et cetera. I think the question that we all have, and we've seen various fits and starts and stops and stall from the last several years. Can you address how you look at the sustainability of the recovery in these -- basically in the ag markets globally, aside from just the current strength that we're seeing? Clearly, it's sustainable in the early part of next year. But beyond that, do you -- can you give us your perspective on sustainability for the next let's say, 1 or 2 years or even more?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, Eric, thank you. I think -- listen, I think I'm very proud, first of all, of course, of the way the team has been executed. And I think we have a track record of consistent execution on that so that -- from that perspective. Second, I think the important thing to reflect upon is that we have built the business over these few years, aligned to secular trends on food security, on health and wellness and on sustainability. And we see those trends being with us for the duration that I can see going forward."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ben Kallo with Baird."
},
{
"speaker": "Ben Kallo",
"text": "So just you touched on ASF, but could you talk a little bit more about that and when we expect that to be a tailwind? Then my second question is just on the Wilmar and the liquidity from that. Where should we expect, I think, the investment to go and maybe a rank order there? And then third, we get -- we're hearing more and more all over the place about renewable diesel. Can you talk to us about your exposure to that trend as a tailwind?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Ben. So the first one, ASF. As we said, I think ASF, we've been following this story for several quarters. And I think that overall, it has developed as we predicted. So initially, with the big gap in protein in China that was supplemented by imports of proteins, and we saw that in the strength of crush margins. Now China has been able to control that. Now China is rebuilding their herd. Remember that herd was -- about half of the herd was decimated. So there is a big effort to rebuild that. As they rebuild the herd, they are going into more professional animal production. That has increased the rations. So -- that has increased soy meal, but that has increased corn. That's why you see so much pull from China from imported corn. At the same time, we have seen the poultry industry coming up in China to supplement a little bit the lack of pork protein that they have in China."
},
{
"speaker": "Ben Kallo",
"text": "Yes."
},
{
"speaker": "Juan Luciano",
"text": "Yes. And listen, we participate that as a supplier of feedstock. You see the tightening that this has generated because, of course, there has been stable volumes and very healthy margins of biodiesel that we've been supplying. And also, we've seen the tightness that, that generated as food service has recovered in the oil part of the consumption."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ben Theurer with Barclays Bank."
},
{
"speaker": "Benjamin Theurer",
"text": "Yes. Congrats on the results. I tried to get you back on schedule, ask only one question, and that one is for Vince. So when you nicely showed how you've basically increased the nutrition business since the bigger acquisition some 6 years ago, and if we look at it on a trailing basis, we're basically at about $550 million in operating profit, call it, somewhere halfway through of where you want to get. But we've clearly seen a significant acceleration in the last 2, 3 years."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Maybe if I start, and I'll let Vince complete that with some more granularity. But when we look at our strategic plan, and we plan in 5-year increments, so the last one we did in 2019, so 2019 to 2024, we see our $1 billion OP that Vince described being achieved in that planning cycle. So let's say, by 2024, if you want to say it that way."
},
{
"speaker": "Vincent Macciocchi",
"text": "Thank you, Juan, and thank you, Ben. I think it's important if you just take a pause and see where we're at. If you look on a year-to-date basis through 3 quarters, we're at $448 million, whereas we did $419 million all of last year. So to Juan's point, it's a good growth story and a good growth trajectory from an organic basis. And what we've done is we've really taken the approach of let's grow organically. Let's expand our customer base. We've made significant investments in our key account management program and our approach to the customers and really expanding that base on a worldwide basis."
},
{
"speaker": "Juan Luciano",
"text": "And then we're going to keep pushing Vince to get there faster."
},
{
"speaker": "Operator",
"text": "Our next question comes from the line of Robert Moskow with Crédit Suisse."
},
{
"speaker": "Robert Moskow",
"text": "Juan, the environment looks great. I totally agree. I'm trying to think of things that might derail that situation. One investor asked me about Argentina and the possibility of devaluation. And would that be a catalyst for farmers selling, crushers crushing and leading to a glut in the market that might cause crush margins to fall? Can you comment on that possibility?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Well, so I'm not going to be on record predicting a devaluation in Argentina, Rob, since I would like to go back one day, but let's put it this way. The world is tight today. There is a big demand, as I said, from China. And even if -- let's run your scenario in which Argentina devalue and there is an incentive for the farmer to sell. Then may be only like 5 million tons that they're going to throw into the market. To be honest, the market needs that, and the market will absorb that very quickly and move on."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ben Bienvenu with Stephens."
},
{
"speaker": "Pooran Sharma",
"text": "This is Pooran filling in for Ben. I just wanted to ask you how you're thinking about your dry mills. Does it seem like it makes more sense to just keep them offline until post-COVID? What do you think is best for that business? And can you talk about any growth you have or could see in USP grade alcohol?"
},
{
"speaker": "Ray Young",
"text": "Yes, it's Ray here. Well, first of all, we've done a very good job managing the stranded costs of our 2 temporarily idle dry mills. And I think also with some additional idlings that have occurred in the industry. I think the industry has done a very good job in terms of balancing supply and demand in the ethanol industry. And that's part of the reason why when you look at inventories right now, EIA count on stocks are below 20 million barrels. And that's contributed towards, frankly, a reasonable ethanol margin environment that we've seen. And that's contributed, frankly speaking towards good results that we've seen both in our Starches and Sweeteners segment, which has the wet mills, and then also for VCP, which has the industrial-grade alcohol of our Peoria facility."
},
{
"speaker": "Pooran Sharma",
"text": "Got it. And then also, could you just maybe provide a little bit more color on the prospects for USP grade alcohol?"
},
{
"speaker": "Ray Young",
"text": "It's been a good news story, right? I mean we started the year with 1 plant, our Peoria plant, 85 million gallons a year. Demand shot through the roof for industrial-grade alcohol. And so we actually combination ran the plant hard plus we've expanded the capacity of that plant. So we'll be up to 100 million gallons very shortly. And then secondly, we also made some investments into another facility, Clinton, and we're going to actually expand production of industrial-grade alcohol in that facility as well. So by the end of this year, our run rate in terms of industrial ethanol production would have increased by over 50%."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ken Zaslow with Bank of Montreal."
},
{
"speaker": "Kenneth Zaslow",
"text": "As you see the oil seed markets developing, is there any thoughts that there may be some additional capacity being built anywhere that would be alarming? Or any thought that you would think that would come about? And what are your plans? Is it more of a debottlenecking procedures? Or would you think that there would be some thought that you might find some capacity expansion opportunities?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, Ken. At this point in time, again, it's a very positive environment from a margin and demand perspective. So I think that we're all looking through readiness and everything, how to expand capacity with as little capital as possible, of course, to debottleneck every facility. We are very prudent in thinking about new staff that cannot be integrated. I think we're very proud of the integration of our facilities that help a lot the integration with grain, the integration with refineries."
},
{
"speaker": "Kenneth Zaslow",
"text": "I know the question was asked, but I'm going to ask you a little differently because not that I didn't like the answer, I'm just trying to figure out a little bit more quantification. How can you frame the opportunity that's associated with renewable diesel to your margin structure or to your earnings potential? How incremental is this? Is this a noticeable difference? Is this a -- hey, it's kind of like a cherry on an ice cream Sunday? Or is it kind of the ice cream? How do you think about it?"
},
{
"speaker": "Juan Luciano",
"text": "So I think -- listen, I think the numbers if -- let's say that even if you take 70% of the announced capacity happened to be through, it's a significant number. It's not -- so we're going to be a player there. Of course, we're going to be a player in -- for a while there. We have very good facilities in biodiesel that are integrated with our refineries, with our crushing plants. So in that sense, they are more secure than others in the fight for soybean oil, if you will."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Vincent Andrews with Morgan Stanley."
},
{
"speaker": "Steven Haynes",
"text": "This is actually Steve Haynes on for Vincent. The operating environment clearly firmed up nicely for you guys. I wanted to just come back to kind of some of the self-help things you have going on. And if you got kind of $500 million to $600 million of controllable benefit this year, do you have any kind of target as we look into 2021, so what a like-for-like number could look like?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I would say we probably will provide more granularity on -- we are going through our own planning season. So we're going to provide more granularity at the Q4 call on 2021 targets. But I think that if you've been following us, you see that there is a certain cadence to what we bring to the table. And these programs are not a one-off, when we are engaging things like readiness, which is a key component of that or harvesting or improve. We're working on our portfolio. Hopefully, we're going to have less improved going forward and more harvesting."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Adam Samuelson with Goldman Sachs."
},
{
"speaker": "Adam Samuelson",
"text": "So maybe the first question is just coming back to the balance sheet and capital deployment. And Ray, I think you were -- we have the Wilmar proceeds. You did the kind of debt, kind of optimization actions or -- last quarter. Can you help us think about kind of the -- your very heavy moving into that commentary on balance sheet optionality. Can you talk about kind of what you think the dry powder is from an M&A perspective right now and how that pipeline would look? And what we should be thinking about if there's any immaterial M&A that would kind of just help us frame kind of how -- what -- how big are we thinking about?"
},
{
"speaker": "Ray Young",
"text": "Yes. Just to again remind people, when we did the Wilmar equity block transaction, secondary offering, we were creating effectively balance sheet flexibility by improving the capital base of our company. So it was not a liquidity move. We had ample liquidity. It's basically helping to further deleverage the balance sheet. And so -- I mean, as we indicated, our intent -- after funding the Neovia acquisition earlier this year, our intent was to basically get our balance sheet back into the low 2s, when you think about metrics, get down to the low 2s by the end of the year. And so these actions are designed to help us get to the low 2s. And I feel good that with the actions that we've done, we're going to get there towards the low 2s."
},
{
"speaker": "Operator",
"text": "Your final question comes from the line of Tom Simonitsch with JPMorgan."
},
{
"speaker": "Thomas Simonitsch",
"text": "So maybe one last question on the $1 billion nutrition operating profit, and apologies if I missed this, but what range of revenues do you need to meet that target? And in the near term, when do you expect the top line in nutrition to return to growth?"
},
{
"speaker": "Vincent Macciocchi",
"text": "Thanks, Tom. Well, the top line in nutrition is growing. When you look across the broader nutrition business on a year-to-date basis, where we've grown at approximately 6% FX adjusted. So we have a very aggressive growth plan from a revenue perspective. And obviously, there are some puts and takes. There's been some headwinds related to COVID affecting some of our sectors as well as some FX issues. But at the same token, we've realized significant revenue growth in certain areas of our portfolio. When you look at the Flavors business, primarily in North America and Asia Pacific, we look at our Specialty Ingredients business, primarily in North America, South America, in the growth of plant-based meat alternatives. We look in Health & Wellness. Obviously, very important growth across that space, really in terms of the bioactives, our specialty oils, our fiber portfolio. So with our fixation on customers, we're growing top line revenues. It's one of the key tenets of our organic growth opportunities in our plan. And then look at animal nutrition. So obviously, there's some things that have affected aquaculture and some other FX things there related to the Brazilian real and the Mexican peso. But at the same token on a year-to-date basis, we're up 7.5% FX adjusted. So we do have a very aggressive plan to drive the revenue. We're focused on revenue."
},
{
"speaker": "Thomas Simonitsch",
"text": "And do you have a revenue level in mind getting to that $1 billion operating profit?"
},
{
"speaker": "Vincent Macciocchi",
"text": "Yes. I think there's a couple of things. I mean when I spoke at the outset, when you talk about growth in the overall market of 5% to 7% per year, we certainly need to be in that range or outpacing that range. And obviously, we continue to marry with our operating profit performance. As Juan outlined, we're approximately -- to continue on our current trajectory, 15% per year gets us to that within the time horizon of this plan."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session. I will now turn the call back over to Victoria de la Huerga for closing remarks."
},
{
"speaker": "Victoria Huerga",
"text": "Thank you for joining us today. Slide 14 notes upcoming investor events in which we will be participating. As always, please feel free to follow up with me if you have any other questions."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. On behalf of ADM, thank you for your participation. You may now disconnect."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 2 | 2,020 | 2020-07-31 08:00:00 | Operator: Good morning. And welcome to the ADM Second Quarter 2020 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Victoria de la Huerga, Vice President, Investor Relations for ADM. Ms. de la Huerga, you may begin.
Victoria de la Huerga: Thank you, Amy. Good morning and welcome to ADM's second quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. For those following the presentation, please turn to slide 2, the company's Safe Harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risk and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and important actions we're taking to meet our strategic goal. Our Chief Financial Officer, Ray Young, will review financial highlights and corporate results, as well as the drivers of our performance and our outlook. Then Juan will make some final comments after which they will take your question. Please turn to slide 3. I will now turn the call over to Juan.
Juan Luciano: Thank you, Victoria. Last night, we reported second quarter adjusted earnings per share of $0.85 cents, up from $0.60 in the prior year quarter. Adjusted segment operating profit was $804 million and our trailing four-quarter adjusted ROIC was 8.1%. I continue to be proud of how our team is performing under challenging and dynamic circumstances. We are fulfilling our purpose by providing high quality nutrition around the globe, and we are doing it while remaining true to our values, protecting the health and safety of our colleagues, fostering a positive, inclusive culture, both within and outside of ADM and safeguarding our environment. Around the globe, ADM colleagues have continued serving our customers and supporting the global food supply chain with no notable disruptions to our operations. Our results are a testament to their dedication, as well as the resilience of our business model and the transformation we have made in our company. Through good times and challenging times, we have kept a strong and steady focus on our strategy. We are not done, but we can be proud of where we are today. Let me share with you some of our accomplishments from the quarter. In our optimize pillar, our Ag Services & Oilseeds team continued their work to enhance the return structure of the business, identifying and executing on almost $50 million in capital reduction initiatives, including the ongoing optimization of our global origination footprint and the decision to exit two Golden Peanut and Tree Nuts businesses. We took further steps to optimize our North American milling operations with announced closure and sale of our Los Angeles flour mill and the sale of office space in Kansas City. And finally, as we previously announced, we made the difficult but important decision to temporarily idle our VCP dry mills in Cedar Rapids and Columbus, which have helped to right size industry ethanol stocks. In our drive pillar, we continued to advance our 1ADM business transformation with the launch of several new technologies, including applications to more efficiently manage spend and cash flow for our non-commodity purchases and contract labor services. We'll be continuing to deploy new 1ADM technologies in the second half of this year. And we expanded our ambitious efforts to make our operations more efficient and environmentally friendly, adding to our previously announced greenhouse gas and energy reduction goals with new commitments to reduce water intensity by a further 10% and achieve a 90% landfill diversion rate by 2035. In our expand pillar, our global destination marketing model continues to grow in export volumes and new markets as ADM extended its product offerings in Asia, Latin America and Europe. We announced that we're introducing high quality USP grade ethanol production in Clinton to complement production at our Peoria facility as we continue to meet customer demand for hand sanitizer. And we announced another expansion of our leadership position in the fast growing plant-based protein market with the creation of PlantPlus Foods, a joint venture with Marfrig that will offer a variety of plant-based food products for customers and consumers across North and South America. Readiness continues to deliver excellence in execution, and its value has never been more clear than over the past few months. Readiness initiative like consolidation of businesses, centralization of activities, and simplification and improvements of processes have significantly enhanced our resilience and agility, helping us continue to serve customers and keep our operations running through fast-changing environments. We are never done improving, and our team has continued to identify and deliver on readiness initiatives. At the end of the second quarter, readiness has allowed us to unlock a total of just over $1 billion in run rate benefits on annual basis since the program began. And based on our strong progress, we're on track to exceed our $1.2 billion goal by the end of 2020. Now, Ray will take us through our business performance before I come back to offer some final comments – before we answer questions. Ray, please.
Ray Young: Thanks, Juan. Please turn to slide number 4. As Juan mentioned, adjusted EPS for the quarter was $0.85, up from the $0.60 in the prior-year quarter. Excluding specified items, adjusted segment operating profit was $804 million, up 18%. Our trailing four-quarter average adjusted ROIC was 8.1%, 235 basis points higher than our 2020 annual WACC of 5.75%. And our trailing four-quarter adjusted EBITDA was about $3.6 billion. The effective tax rate for the second quarter of 2020 was approximately 14%, very similar to 13% in the prior year and in line with guidance we provided last quarter. For the third and fourth quarters, we continue to expect an effective tax rate in the range of 13% to 15%. We generated $1.6 billion of cash from operations before working capital for the first half of the year, higher than 2019. Return of capital in the first half was $517 million, including a little over $100 million in opportunistic share repurchases in the first quarter to help offset dilution. We finished the quarter with net debt to total capital of about 29%. This is down from 31% a year ago. We had cash and available credit capacity at the end of the quarter of almost $11 billion, a very solid amount of liquidity. Capital spending for the first six months was about $360 million. We continue to expect capital spending for the year to be around $800 million, below our depreciation and amortization rate of about $1 billion. Slide 5 please. Other businesses were also higher versus the second quarter of 2019, driven by improvements in underwriting results from our captive insurance operations. In the corporate lines, unallocated corporate costs of $194 million were higher year-over-year due to a larger delta in variable performance-related compensation expense accruals and transfer of costs from business segments into corporate as we centralize certain activities into our centers of excellences. Other charges declined due to improved foreign currency hedging results on intercompany funding and improved investment performance. Corporate results also included debt extinguishment expenses of $14 million related to an early retirement of a bond. Net interest expense for the quarter decreased due to lower average foreign costs related primarily to liability management actions taken in late 2019. Looking forward, we expect unallocated corporate expenses to be in line with our initial $800 million guidance for the calendar year and net interest expense to end similar to or slightly lower than the 2019 amount of about $350 million. Other business results in the second half of the year are expected to be significantly lower than the first half and likely negative based on expected insurance claims settlements and lower interest income in ADM investor services. Please turn to slide 6. Ag Services & Oilseeds delivered higher results versus the second quarter of 2019. Ag Services results were substantially better year-over-year. Strong execution by the team in South America helped deliver record quarterly origination and export volumes in a significantly improved margin environment, driven by a weaker Brazilian real and strong farmer selling. Global trade delivered best second quarter ever, continuing to demonstrate the importance of our strategic efforts to create value throughout the global supply chain. Destination marketing was a significant contributor as countries look to secure stable supplies of food amid the pandemic. Lower inferior grain margins impacted results in North America. Crushing results were lower year-over-year. The team delivered strong global crush volumes overall, and did a great job capitalizing on solid South American meal demand and weaker Brazilian real, along with a lack of Argentinian imports into EMEAI. In North America, margins were impacted by the pandemic's effects on our customers. Net timing impacts to the quarter were not significant as board crush gains were offset by basis losses and our cash flow hedge program deferred additional positive timing impacts. Refined products and other results were higher year-over-year, driven by improved biodiesel volumes and margins in North and South America, as well as strong volumes in margins in refined and packaged oils in South America. Demand was lower for biodiesel in EMEAI and for edible oils – for food service in both EMEAI and North America. Wilmar results were lower year-over-year. Wilmar's core earnings were strong, but reported earnings were impacted by mark-to-market losses on their investment portfolio in their first quarter. Fundamental global demand trends continue to emphasize the underlying strength and resilience of this industry and our business model. Looking ahead, we expect the pace of Brazilian farmer selling to slow significantly following the aggressive selling in the first half of the year. North American origination should strengthen throughout the second half as we move into the US harvest, and export demand is supported by China's import needs. Global crush margins are likely to remain pressured in the near term, but we expect tight soybean supplies in South America to lead to an improving margin environment as we move through the second half of the year. RPO should continue with solid performance. All told, we currently believe the third quarter will be sequentially lower than the second quarter of this year, followed by a much stronger fourth quarter. Slide 7 please. Carbohydrate Solutions results were similar to the year-ago quarter. Starches and sweetener results were lower year-over-year. COVID-19 related impacts on foodservice demand in North America pressured sweetener volumes. Mark-to-market losses on corn oil contracts indexed to soybean oil also impacted results, similar to what we saw in the first quarter. These impacts were partially offset by lower net raw material costs and positive risk management results. We also continue to benefit from the improvements we made in our Decatur corn complex and the continued turnaround in EMEAI. Wheat milling had another strong quarter as increased levels of home baking in store sales helped drive solid retail demand and footprint optimization initiatives, which reduced costs, continued to drive results. Vantage corn processor results were higher than the second quarter of 2019, driven by favorable risk management results on inventory positions and strong demand for high quality USP grade ethanol used for the hand sanitizer market. While average industry ethanol margins were down versus the prior year, prices and margins improved throughout the quarter as lower production including the two dry mills that we idled and some recovery in driving miles led to falling industry ethanol stocks. Looking ahead, we expect the third quarter results for Carbohydrate Solutions to be similar to the second quarter assuming sweetener demand continues to recover, demand in wheat milling remains solid and average industry ethanol margins over the quarter remain in positive territory. On slide 8, our Nutrition business continued to deliver significant growth, with 35% year-over-year profit improvement for the quarter. Over the first half of the year, adjusted profit for Nutrition is up more than 50%. And despite some COVID-19 impacts, revenue is up about 8% on a constant currency basis, with growth spread across the entire broad portfolio. Human nutrition results were substantially higher in the second quarter of 2020 versus the second quarter of 2019. Flavors continued to deliver solid results as favorable sales mix and margin expansion in North America was offset by some softness in EMEAI. In specialty ingredients, our team's strong execution and operational excellence, including at our soy protein facility in Campo Grande and our pea protein plant in Enderlin enable us to continue to meet rising consumer demand for plant-based proteins and edible beans, driving substantial year-over-year growth. Health and wellness delivered higher performance on strong sales for probiotics, improved volumes and margins in fiber, and additional fermentation income. Animal nutrition results were again higher year-over-year. Despite impacts from COVID-19 on demand in some regions, continued execution on Neovia synergies, robust demand for pet food and treats, and improvement in amino acids drove our ongoing profit growth. The investments we've made in Nutrition and our unique value proposition have positioned us well to support our customers as they continue to innovate and adapt in the current environment. We are winning new business and our pipeline today is strong and growing. We've also equipped our teams with new digital tools and technologies to continue product development work in a virtual environment, ensuring that products advance even in the current dynamic climate. Looking ahead, Nutrition should be around 20% higher in the back half of the year, compared to the second half of 2019, with similar rates of growth in profits in third and fourth quarters. We expect strength in flavors, plant-based proteins, and probiotics continue to drive human nutrition and Neovia synergies and improvements in amino acids to support animal nutrition results. Now, please turn to slide 9. And I'll turn it over back to Juan. Juan?
Juan Luciano: Thank you, Ray. From our work to optimize our footprint and improve our capital position to our new technologies and improved processes to our growth efforts to become a world leader in nutrition and expand margin opportunities across the value chain, the team has done excellent work executing the strategy. And as we continue on this journey, we are increasingly seeing growing benefits flow to our bottom line. That does not mean that we are immune to external conditions. This has been an unpredictable year and we're only at the halfway point. Our team has done a great job moving quickly and adapting to the challenges of COVID-19, and we are continuing to monitor and analyze purchasing and consuming habits to ensure we can continue to anticipate and meet our customers' needs. We're seeing consumers still largely relying on retail and e-commerce to feed their families and demand is spanning a wide spectrum from comfort foods to healthy choices. In-home eating and baking has dramatically increased the demand for both flour and baked goods. Healthy eating has significantly accelerated the purchase and consumption of alternative proteins. And a focus on nourishment and wellness is pushing microbiome solutions to the mainstream. We're meeting this wide variety of customer needs and will continue to do so as many of these trends advance in the future. For the second half of this year, we'll remain focused on optimizing business performance, advancing readiness and harvesting the benefits of strategic growth initiative investments, especially in our Nutrition segment. We are continuing to pull the levers under our control across the enterprise, with our team currently exceeding our mid-year targets by achieving more than two thirds of our $500 million to $600 million in targeted operating profit improvements for 2020. Looking ahead, we remain confident in our positioning, our capabilities and our strategy and we are excited about the second half of the year and delivering strong earnings and returns in 2020 and beyond. With that, operator, please open the line for questions.
Operator: Thank you. [Operator Instructions]. Your first question comes from the line of Adam Samuelson with Goldman Sachs. Adam, your line is open.
Adam Samuelson: Yes, thanks. Good morning, everyone.
Juan Luciano: Good morning, Adam.
Adam Samuelson: So, I guess, first, just thinking about how you kind of frame some of the second half outlook for the different businesses, is it fair to say that the biggest wildcard are pace of US exports and what that does both on the origination and crush side and just underlying kind of food ingredient demand? I'm trying to think about kind of the range of outcomes as we think about for business momentum into the second half of the year.
Juan Luciano: Thank you, Adam. Listen, as we think about the second half of the year, we expect in general businesses to perform better than in the first half. So, that's overall results. When we think about the different businesses, with the aggressive selling in the first half of the year of the Brazilian farmer, we think that the US having a big crop like we're going to have going into harvest will be the most competitive source and China still needs to import a lot in the fourth quarter. So, we feel good about that. We feel good also about destination marketing. Don't forget that. From an Ag Services perspective results, basically, the results of the global trade were equally contributing as the results of origination in South America for the results this quarter. And although South America will shift to North America in terms of grain results, we see destination marketing and the global trade effort to continue to contribute in the second half. We see probably – so far, if we look at all the way to July, we see that the worst of the demand destruction due to COVID was behind us. We saw that in April and then we saw improvement in May, June, July. It will probably be uneven and would start and stop for the rest of the year, but we think that the worst is behind us. So, I would say that that's how we characterize. And then, Nutrition continues to grow strong. There are many opportunities for Nutrition and we had a very strong beginning of the year. The second half of the year is seasonally a little bit softer for Nutrition. But that's the way the demand pattern goes every year. But we feel very strongly about the second half of the year at this point.
Adam Samuelson: All right. That's very helpful color. And then, if I can just ask a second question on capital allocation, just help us think about, with kind of the balance sheet where it is and what seems to be a pretty strong position, what it would take or what you would want to see before you took a more offensive posture on whether it's capital returned to shareholders or maybe there's opportunities in the M&A market that might be emerging?
Juan Luciano: Sure, yes. Listen, as we have said it all along and at the beginning of the year, our priority remains to deliver our balance sheet to the low 2s and protecting our single-A rating is very important to us. And we have aggressive plans in the businesses to – you heard me in the accomplishments of the second quarter – to monetize assets. And to the extent that we continue with that and monetize assets, we will think about increasing our share repurchases. But I think the priority is delevering. But we've been doing very well in this divestiture and we continue to look for our large company and what are the things that we can monetize, so we can apply to that. With regards to M&A, we have a very disciplined process of doing bolt-ons and organic growth. And you see how we pace ourselves. We did WILD in 2014 and we did Neovia in early 2019. And I think that that allows us to recover the ROIC impact. If you think about ROIC at the end of 2018, it was 8.3%. We acquired Neovia and now we're back to that range, 8.1%. So, I think that that allows us to go and buy what we need to buy, continue to grow Nutrition jointly with all the harvesting that we do in Nutrition with the organic growth with Campo Grande and Enderlin and all that. So, I think we have that model and we like it and I think you're going to see that we continue to deliver what we said we were going to do, and it's a very predictable pattern in that trend.
Adam Samuelson: All right, great. I really appreciate the color. I'll pass it on. Thank you.
Juan Luciano: Thank you, Adam.
Operator: Your next question comes from the line of Heather Jones with Heather Jones Research. Heather, your line is open.
Heather Jones: Good morning. Thanks for taking the questions.
Juan Luciano: Good morning, Heather.
Heather Jones: Hi. So, just the details question first. Could you explain to us the results from Vantage Corn was very impressive. Was there a lower cost of market and inventory adjustment or something? Could you help us understand what drove that performance besides the industrial alcohol sales?
Ray Young: Yes, Heather. It's Ray here. Yeah, for Vantage Corn Processor, remember, for VCP, not only are they producing the ethanol from the dry mills, but they're also the distributor of the ethanol that comes out of the wet mills. So, over the course of the quarter, we actually – as we indicate, we had a very, very good risk management on our inventory positions. Now, we knew coming into the quarter that the fact that we're going to cut back on ethanol production, shut down or idle the two dry mills, we had a pretty good sense of margins should improve throughout the quarter. So, the inventories that VCP had, as we went through the quarter, which includes the wet mill ethanol, we basically more or less left that unhedged, whereas we actually did hedge the corn position at a very, very low cost. And so, we benefit from stable risk management in terms of both the input side, meaning the raw corn, and the output side, which is the ethanol within the distribution system. And so, therefore, we had very, very good risk management results based on our inventory decision. So, that was an important driver. But don't underestimate the industrial ethanol business. We actually increased the capacity of our Peoria plant. It was like 85 million gallons entering the year and we were able to debottleneck many aspects of the plant and actually get that thing closer to 100 million gallons on an annual run rate basis. And we ran the plant full well over the quarter. And as you would appreciate, industrial ethanol margins improved also throughout the quarter. So, VCP also benefited from a very stable environment in terms of the aspects of the industrial ethanol business. And then lastly, again, as we indicated, we idled the plant. We did a pretty good job in terms of reducing the amount of stranded costs associated with those dry mills. And that also contributed towards our overall results. So, overall, it was actually, from our perspective, a good quarter for VCP in terms of how we manage the situation.
Heather Jones: Yeah, sounds like it. Thank you. My second question is, I was hoping you could elaborate on your outlook for crush margins. So, in the US, you're clearly pretty soft right now and you noted that, over the near term, they'd be soft, but then you articulated a more constructive outlook further out. I was wondering if you could flesh out for us what you're seeing on the demand and supply side that gives you confidence that we should improve as we move into Q4 and 2021.
Juan Luciano: Yeah. Thank you, Heather. As you said, they are soft at the moment in North America, but improving. And we're going to see that improvement over the end of – through the quarter. Basically, we're going to have – we started to see a little bit better farmer selling. And I think as we get to the harvest, we're going to have less pressure on that side. And we're seeing from the demand side that the customers – our customers for soybean meal are coming back. And then, we're seeing also a little bit more pressure on the oil side. So, the oil story is getting a little bit better. So, in general, from crush margins, we saw good crush margins in Europe with the absence of Argentinian meals – of more aggressive Argentine meal. We saw good crush margins in China. And now, we're seeing improving crush margins in the US for the rest of the year. So, so we feel very good about that business. And we can debate numbers here or there about growth rates, but in general, we see growth going forward. And that's what we're hearing from our customers.
Heather Jones: Okay, thank you so much.
Juan Luciano: You're welcome, Heather.
Operator: Your next question comes from the line of Ken Zaslow with Bank of Montreal. Ken, your line is now open.
Kenneth Zaslow: Hey, good morning, everyone.
Juan Luciano: Good morning, Ken.
Kenneth Zaslow: Can you talk about the elevation margins and what you're seeing there? And how meaningful will that be for ADM and how are you executing on that?
Juan Luciano: Sure. Yes. So, the US export market is setting up for very good times on very solid global demand and competitive prices. And, of course, with a tight supply demand, as I referred before, in South America. So, we do expect large programs for corn, soybeans, as well as wheat and soybean meal for Q4. So, I would say short term in Q2, Q3, it's about $0.10, $0.15. And forward, we're seeing numbers more in the $0.30 range or even slightly better. So, again, we have big volume expectations. And we're looking, Ken, at the full value chain. So, elevation margins and also transportation margin. So, we're seeing the whole thing. So, we care about the full range of margins. So, we feel we feel stronger margins are coming ahead of us for the Q4. And, to be honest, every evidence out there is pointing to that direction as we go around the world and we talk to our teams. So, we feel confident about that.
Kenneth Zaslow: And then, just switching to Nutrition for a second, so two parts to this. One is, obviously, your growth rate has been very strong. How long into the future will that last? Is this a good run rate for a little bit of years? And then, you also mentioned that you're winning new business. Can you quantify or give parameters to how much that is? Is it just typical winning a little business here and there? Or are we talking about larger than a breadbox, but not quite game changing? How do I think about those two things? And I'll leave it there. And I appreciate it.
Juan Luciano: Sure, Ken. Listen, the thing you need to remember is that Nutrition is still in early stages. So, we were building this business and we've been doing it for four or five years versus other businesses that we've been running for 100 years. So, even as good the resources we're getting, we're not even close to fulfill our potential. And we continue to see that in the pipeline. The pipeline continues to be very strong. And again, we measure the value of the pipeline to see the impact of 2021 sales, 2022 sales. And as I said, that continues to grow. But we also look at the win rates to see how we're doing today. And the win rates continue to increase. I can't disclose exactly the win rates because that's confidential information and it's very valuable to us. I think the important thing of Nutrition that sometimes is underestimated is the breadth of our product offer. And when we're talking here, we're talking, Ken, about – we're bringing fibers to a lot of products, whether our beverages or yogurts or cereals. We are bringing probiotics to a lot of products. We have specialty proteins. So, I think – of course, we have flavors going into a myriad of applications. So, I think the versatility that this product gives us – again, even if you go to specialty proteins, we have soy based, we have pea-based. And when you combine all these things into systems, it gives us incredible possibilities and customers are reacting very well to that value proposition. I have to give credit to the team in this difficult circumstance that you could have thought that maybe innovation could have been impacted because of the remoteness of our operations. And our team pivoted very quickly into establishing virtual tasting rooms, virtual innovation and prototyping sessions. And that has been very successful and has been able to keep the growth rate of our pipeline. So, I don't know how long can we predict the 20% rate. But at this point in time, we continue to see it into the immediate future. So, we don't see any slowdown of that. And as I was explaining to Adam before, we're going to continue to do our bolt-ons M&A, and we've been getting better at this. We integrated and we absorbed Neovia and the results and the operations much faster than we did obviously with WILD because this is the second time and we have perfected the system. And I think we're going to be able to keep this pace a little bit more accelerated into the future. So, the possibilities of this business are enormous, Ken.
Kenneth Zaslow: I really appreciate it. Thank you and be safe.
Juan Luciano: Thank you.
Operator: Your next question comes from the line of Vincent Andrews with Morgan Stanley. Vincent, your line is now open.
Steven Haynes: Hey. This is Steve Haynes on for Vincent. Just wanted to come back to the Carb Solutions. The second quarter result was quite a bit better than what you had guided and I appreciate the commentary around risk management. But you also mentioned a number of other buckets. So, can you kind of just bucket out the rest of the beat, so we can get an idea for kind of what drove that delta?
Ray Young: You're referring to Carb Solutions in general for the quarter?
Steven Haynes: Yeah.
Ray Young: Yeah. You look at starches and sweeteners, the other big sub segment here. We had good results. Naturally, for this segment, as Juan talked about earlier, the trough in terms of demand for sweeteners probably was the second quarter. It was probably in April/May timeframe. And so, therefore, we did experience reductions in volumes on the basis of corn sweeteners during that period. But what was interesting is when you look at starch and sweeteners, there were clearly strengths there as well. Number one, for example, wheat milling. Demand for flour continued to be strong in the second quarter. In fact, when we look at our global wheat milling results, our profits in the second quarter were up 50% versus the prior year. So, that was a big contributor towards the starch and sweetener results. Secondly, I did outline in my remarks that we did have mark-to-market losses on our corn oil contracts, just like we had in the first quarter. The fact I didn't highlight a number indicates that the number was actually much smaller than what we had in the first quarter. But we were also able to offset that impact with good risk management from the wet mills there as well. On a net basis, that was really a neutral impact. And then thirdly, it is important to also highlight in starches and sweeteners, the turnaround efforts, the improve efforts that we launched last year in the Decatur corn complex in the European business. They're truly paying off this year and also in the second quarter. So, they're all positive deltas that help neutralize some of the negative effects that we saw in terms of starches and sweetener volumes in the second quarter. And then, I already talked about VCP, which, again, stable risk management on inventory position. So, overall, I would have to say that, yes, it was actually a very strong quarter for starches and sweeteners in the second quarter compared to even what our initial expectations were as we entered into the quarter. But I have to give the team a lot of credit in terms of the efforts that they executed in order to help deliver the results here.
Steven Haynes: Okay. Thanks, Ray.
Operator: Your next question comes from the line of Tom Simonitsch of J.P. Morgan. Tom, your line is open.
Thomas Simonitsch: Thanks. Good morning.
Juan Luciano: Good morning, Tom.
Thomas Simonitsch: So, you noted in your press release some COVID-19 impacts on your animal nutrition business. Can you elaborate on that please?
Juan Luciano: Sure, yes. I think when you see these consumer shifts, of course, Aqua is consumed a lot in the Western Hemisphere in dining out, and so we see a little bit of impact on that – negative impact, I mean. Of course, when some of the large animals feed, we saw a little bit of softness there in North America and Mexico when some of the meatpacking plants have to slow down. But we see positive benefits in pet food and pet treats. Very positive as well. And I think that, in general, there have been countries where we are strong, that their demand has continued strong, like Brazil has continued, Vietnam has continued. And then, we also saw lysine prices and lysine performance actually came back in the quarter. So, those are kind of the puts and takes of COVID impacting us in animal nutrition.
Thomas Simonitsch: Okay, thanks. And you noted immaterial market impacts in Q2, which was a bit of a surprise to me at least, particularly on soy crush. So, can you elaborate on your hedging strategy and clarify any deferred gains you're carrying into the back half?
Ray Young: Yes, Tom. Recall, the objective of our hedging program is really to manage margin risks on our products and to dampen volatility of earnings and cash flow. And we'll call any impact when it's greater than $50 million. That's what we've done in the past. So, we entered the second quarter with about $80 million of favorable timing effects that would be recognized in the future. And then, as you see in the supplementary data, we exit second quarter with about $95 million of favorable timing effect. So, on net, we had actually $15 million of unfavorable timing effects in the second quarter. Now, with board crush falling dramatically in the second quarter, we naturally did have hedge gains on crush. Now, some were deferred due to our cash flow hedge program, which we put in place several years ago, right? And so, although for these gains, they are basically under our cash flow hedge accounting, you don't have to mark-to-market. They're just simply deferred in the future and we'll recognize that. But we did also recognize some timing effects related to basis movements on oil, meal and beans, right? So, therefore, the favorable effect on board crush was offset by some of the unfavorable timing effects on basis movements. And as a result, we had a slight negative impact of $15 million. And again, we didn't call it out in our prepared remarks, but you can actually see that in the data there. The other thing to just note also, we also had some bunker fuel hedges and we call that out in the first quarter, right? Some unfavorable effects on bunker fuel hedges that should reverse out in the second quarter. And we did. We did have some favorable reversals. But, again, nothing significant in terms of size, and that's the reason why we didn't call it out. But in general, I'd have to say, our cash flow hedge program is actually something that helps smooth out some of the fluctuations that we have on our hedging. And then, there's also some other impacts that actually impact the net amount. But again, I think the key is that we saw about $95 million of favorable timing effects that will reverse out over the future quarters.
Thomas Simonitsch: That's very helpful. Thank you. I'll pass it on.
Operator: Your next question comes from the line of Ben Bienvenu with Stephens. Ben, your line is open.
Benjamin Bienvenu: Thanks. Good morning. I wanted to revisit the Vantage segment. I know in April when you guys decided the closure of two dry mills, you talked about kind of a four-month timeline. Recognizing you might not want to telegraph too much the timing of the reopening, what are you looking for from a market perspective as you think about reopening, either sticking to that timeframe or oscillating around the original timeline that you laid out?
Ray Young: Yeah, we did indicate that when we temporarily idled the two facilities. We said that we'll probably keep it down for about four months, which will, frankly, bring us to the end of the third quarter. I think the data that we're going to look at includes things such as industry ethanol levels, and it's actually very encouraging what we've seen recently where EIA data on ethanol and industry stocks, inventory level, they've come down from the peak of 27 million barrels down to about 20 million barrels right now. So, that's actually very, very encouraging. And you have seen ethanol margins respond accordingly with that particular reduction in terms of inventory. The other key variable is just the recovery of driving miles. And you're actually starting to see that. We were down as much as 40% during the trough of the shelter-in-place in terms of gasoline demand. We're starting to see some level of recovery. We're probably down as an industry about 15% right now. And so, I think that some of the key data that we're going to look at is how that recovery continues, how the inventory levels get maintained as we go through the next several months and how the margin environment evolves, and that will guide us also in terms of the appropriate timing to kind of restart both dry mills here. So, it is a dynamic – it's a dynamic situation, but we're going to be very data driven as we look towards the strategy here.
Benjamin Bienvenu: Okay, thanks for that. Following up on just the questions around hedging, how exposed are you to the cash market? How much of 3Q have you hedged? And have you hedged any of your 4Q crush commitments?
Ray Young: Normally, in terms of crush, we normally kind of hedge the fourth quarter significantly, not 100%. But, normally, we're hedged, I think, 50%, 75%. Normally. We're always opportunistic, by the way too. We'll look at the levels and we'll determine when we layer in the levels. And then, as you go out into the future quarters, there's less. But we also do have hedges already in 2021 based upon the stable levels that we saw earlier in the year.
Benjamin Bienvenu: Okay, thanks.
Operator: Your next question comes from the line of Michael Piken with Cleveland Research. Michael, your line is now open.
Michael Piken: Yeah, hi. I just wanted to get an update a little bit in terms of how you sort of see the US-China trade situation playing out. Do you think that China is going to be able to meet all the phase one commitments and then just sort of any update you have on ASF over in China and how quickly they're rebuilding and what that means for meal demand over there?
Juan Luciano: Yeah, Mike. Listen, I think you heard me saying before. I think that China is taking all the actions that reflect their intention to comply with this. Despite their rhetoric, we continue to focus on the facts. The facts are that they have imported more from the US, if you look at corn or if you look at soybeans so far, versus last year. And the reality, there is also a supply/demand reality here. Brazil is out of beans. The Argentine farmer is not going to sell their beans. So, the US is going to be having a big harvest. And I think China, if you think about, they're going to import 95 million tons, 96 million tons and they have imported already 70 million tons, give or take, from South America. So, they need to import about 25 million tons, 26 million tons, of which they have already committed half of that. So, half of this is still to be done, which I think is going to be done from the US in the Q4. So, we feel good about that. And as I answered before to Ken in elevation margins, I think there's going to be corn, it's going to be soybean meal, it's going to be soy, and it's going to be wheat. So, it's going to be a good program for the US in terms of volumes. In terms of ASF, I think that ASF has been evolving as we predicted early on, in which that created a 10 million tons gap of protein in China. China has covered some of that with imports and we've seen those imports up around the world. We enjoy that, especially from Brazil this second quarter. And I think we've seen that growing into the US as well. We also saw the professionalization of animal processing in China. And with that, we've seen the increase of soybean meals in the rations and more efficient rations. So, will it be lineal? Probably like COVID, this will not be lineal. There are going to be ups and downs. There are going to a surge here or there that's going to be squashed. But I think that, overall, we've seen the worst. And I think that we're going to see probably full recovery by some time later 2022 or something like that, but it's going to be an in crescendo from here.
Michael Piken: Great. And then, now last of is just on the destination marketing increases here that you guys talked about. When can we start to see that accrue to the P&L and what does the margin profile look like on destination marketing compared to the North American operations? Thanks.
Juan Luciano: Yeah. Destination marketing has been impacting us already. As I said, when I said global trade had a record second quarter, that's what's driving a lot of that. This is a strategy we put three, four, five years ago. And to be honest, it's been emphasized now with people around the world more concerned about the stability of the supply chains and the ability to move product around, which we've been able to move. But having product locally has been very valuable for a lot of customers around the world. So, we made acquisitions in Egypt, in Israel. We opened some offices and we continue to expand the number of countries in Asia, in Europe and in South America that we are covering with that. So, at the beginning, we saw an expansion in volumes. We doubled the volumes. Now, volumes are growing a little bit more geographically, not in the same place, I would say. It's more by geographic expansion. And margins continue to increase. So, we feel good about it. And it's a big contributor and it was already a big contributor of our services for the first half of the year.
Operator: Your next question comes from the line of David Katter with Baird. David, your line is now open.
David Katter: Hey, guys. Thanks for taking the question.
Juan Luciano: Good morning.
David Katter: Quickly wanted to clarify or get an update on your strategic review for ethanol. Where in the process are we and kind of how has COVID impacted that and what options are being considered?
Ray Young: The review is continuing. We have interested parties in the assets. Naturally, in the COVID-19 environment when the dry mills are shut down, the credit markets are basically shut down, we've taken a little bit of a pause. But, clearly, we expect the process to recommence as we kind of move through the back part of the year, as the markets start recovering back to more of a normality.
David Katter: Got it. And then, one more I just kind of want to hear your thoughts on. The readiness initiative, it's on track to beat its goal, I think you mentioned. But how does the focus shift? Or how does your mentality change once you achieve that $1.2 billion goal? Kind of what's the next step for ADM's readiness?
Juan Luciano: Yes, this is a large company and a growing company. So, as we continue to look for opportunities or buckets of opportunity, we continue to find more. So, everything that we do, David, is run into readiness, which is a way to execute better all our initiative. So, I think that the first stage, if you will, was more on efficiencies. We are shifting a little bit more to growth and innovation and to make sure that our growth and innovation has the same capabilities and power to execute the deficiency it has. But I will say, from a numbers perspective, we feel very good about the $200 million to $300 million of net impact that we get every year. And we don't see any reason for that not to be in the forecast for next year, maybe even a little bit better. So, we feel good about that. I will say if you look at – if I take the opportunity of your question to speak a little bit about the algorithm and how we're thinking for next year, the harvesting part, there's still more in front of us and we continue to see impact of that and probably growing. Maybe hopefully improve will be less so because we are improving those businesses and we don't have that many more businesses to improve maybe. And readiness continue to enlarge the scope. So, the impact of revenues should continue to grow over time.
David Katter: That's excellent. Thank you, guys.
Ray Young: Thank you.
Ray Young: Amy, any more questions? Amy?
Operator: Your next question comes from the line of Ben Theurer of Barclays. Ben, your line is now open.
Benjamin Theurer: Thank you very much. Good morning, Juan, Ray. Hope you're both well.
Juan Luciano: Good morning.
Ray Young: Thank you, Ben.
Benjamin Theurer: Good stuff. Just one quick one and a follow-up. So, within the Carbohydrate Solutions segment, you've also had mentioned that wheat had a very strong performance and I think you said on the call something like it was up 50%. I know it's small, but just out of curiosity, what are you seeing in the month of July and into the rest of 3Q and maybe a little ahead into 4Q on the wheat part within the Carbohydrate Solution business?
Ray Young: The demand for flour continues to be strong. Probably, first quarter, we saw a little bit of a surge because of pantry loading. But the demand effects continue to be solid for wheat, and hence our mills are actually running very, very hard. Now, the other big contributor, don't forget, is just the optimization initiatives that we had in our wheat processing plants. So, we actually shut down some inefficient mills and opened up new mills. The timing cannot be more perfect for that, right? Because the demand is there for our products. And now, we actually produce the flour from very efficient operations. And that has been actually an important contributor towards our overall improvement in terms of results for wheat milling. So, we're actually very, very pleased in terms of how this strategy has unfolded here.
Benjamin Theurer: Okay, perfect. And then, a little more medium, long term. Clearly – and you maybe talked a lot about Brazilian farmer selling was very strong and I think you had in the presentation the status [ph], where they stand. So, what are you seeing on the ground? What's your expectation into the second season in Brazil and then maybe into next year? What are you seeing on the ground in terms of intention to plant just because of what they've been selling so strong right now? Do you see any significant uptick in volume in Brazil that could become a competitor for us in a more relevant way maybe looking into 2021?
Juan Luciano: Yeah. I think, Ben, we will continue to see Brazil adding a little bit of area. And I expect to have a large crop next year in Brazil weather permitting. So, I think that we will continue to see that and we have a strong origination team and crush team in Brazil. And I think we're going to continue to profit from that. I think there is a place for US and for Brazil. So, I think it's just the – I would say the short-term dynamics depends in South America a lot of what happened with currency. And you see the stark contrast between an Argentine farmer that see no benefit in parting ways with the crop, with the Brazilian farmer that due to the weak real was an aggressive seller even of the new crop. So, I think those dynamics will happen, but I think, over time, Brazil will try to continue to increase production.
Benjamin Theurer: Okay, perfect. Thank you very much. And congratulations on the results.
Juan Luciano: Thank you very much.
Juan Luciano: Hello, Amy?
Ray Young: Hello, Amy?
Juan Luciano: Any questions?
Operator: Your next question comes from the line of Vincent Anderson with Stifel. Vincent, your line is open.
Vincent Anderson: Thanks for sliding me in. Good morning and nice quarter. I did just want to clarify a little bit more on the positive mix shift in Nutrition. You called out growth in flavors and probiotics. Are those generally going to be higher margin contributors? And then, also on plant proteins, was that also representative of positive to mix or was it more of that margins in the protein business were improving as you fill the Campo Grande facility?
Juan Luciano: Yeah. A little bit of both. Certainly, Enderlin and Campo Grande are both new facilities. So, they are both getting better every quarter on what did they do. The EBITDA percentage of sales, as you know that I follow that, in the business continued to evolve favorably. If you look at the previous-year quarter was 11.3%. And this quarter was 15.1%. So, of course, our team is very agile, lean, to bring in new products and the new products bring new opportunities for margin up the business. So, we have those benefits. Probiotics are, of course – microbiome was a trend that was incipient, if you will, and COVID has put it right into the mainstream as people think about more health and wellness and immunity concerns. So, I would say probiotics that are science based, like ours, are being added as supplements to many, many products. And those products are highly technical. As I said, they require clinical trials and things like that. So, of course, they command higher margins. So, we feel very good about those products. And flavors, listen, flavors are incredibly important. All these things have to be taken by people and they have to taste good. So, the combination of our scientists creating these flavors and masking maybe different nodes that maybe people don't appreciate is critical to this. And that's one of the reasons we acquired WILD Flavors at that point in time because of those capabilities. When you combine those capabilities with the fact that all our flavors or 95% plus of our flavors are natural, that makes this the preferred solution for most of our customers and certainly for the consumers. So, we feel very good about that.
Vincent Anderson: All right. Thanks. To keep everybody on schedule, I'll just leave it there. Nice job again. Thanks.
Juan Luciano: Thank you, Vince.
Ray Young: Thank you.
Operator: Your final question comes from the line of Eric Larson with Seaport Global. Eric, your line is open.
Eric Larson: Yeah. Thanks for sneaking me in. Congratulations on a great quarter, guys.
Juan Luciano: Thank you, Eric. Welcome back.
Eric Larson: Well, thank you. It's good to be back. It's a pleasure. So, just one really kind of technical question. It comes to the – and then I have a broader question. But the technical question is, we've got elevation margins right now in the Gulf ports that I haven't seen in quite some time. And just put China aside for a minute, there's good demand – there are a lot of other places outside of China. Obviously, the US dollar is helping a little bit. If you think that COVID-19 has maybe put some scare into some other countries, maybe they've loaded some inventory to make sure that they've got enough grain supplies for their people, et cetera, and some of that demand might taper off or are they actually using the products that they're shipping? I'm curious on the demand factor outside of China.
Juan Luciano: Yeah, I would say probably at the beginning of the year, we saw a little bit more of that, Eric. I think now is through demand that is coming through. I think that even through all the peak of the crisis, we've been able to manage every port. We've been able to keep our operations running, the protocols that we have with the crews of the vessels and the different ports have worked well. So, I would say probably early on, maybe March, April, maybe people thought a little bit more about hoarding product. I don't think that's true anymore. I think now we're seeing through demand. What is happening with that demand is looking like strong demand and strong volumes for the US. So, potentially, we could have record profits in Q4 when you look at the volumes plus the attractive prices because we're going to have a big harvest in the US. We're talking about large volumes for North America and we're talking about large crop and maybe even an early corn crop. So, we feel very good about that progress. And that's what you heard me saying before. In general, we look at the second half. And I look at my businesses and I think my businesses are going to perform better in the second half than in the first half. So, overall, the profit coming from the businesses should be stronger in the second half than in the first half.
Eric Larson: Yeah. We're going to have an outstanding harvest this year. And it's going to make us very competitive globally. I would agree with that. So, the other question here that I have – I have two small questions. One, we're starting to see estimates for Brazilian – for next year, for Brazilian soybean production – starting to see estimates north of 130 million metric tons. We're seeing – continue to see global production expansion across all of the major production countries. And my real question is here, obviously, the world is growing as well. Are we going to have enough demand over the next, let's say, three to five years to sell all this product? Or are some countries going to have to cede some share, export share, as this production continues to grow pretty rapidly? It's a longer-term question, but does demand and production match?
Juan Luciano: I do believe so. When we look at the – we've been adding like 2 billion people every 30 years here in the world. And when you see how China is recovering – remember that this virus hit us from the east, coming West. So, we've seen how China is recovering, how Europe is recovering. Of course, still the Americas are in the middle of the pandemic, but we need all that. I think my concerns are not, are we going to find enough demand for that volume. I think we still – on the biggest issue for China and a lot of countries is food security, Eric. And when I go around the world and talk to mandatories and all that, the biggest concern is that, are we going to see – do you have enough investment in infrastructure? Do you have the ports ready to bring all those products? So, we are not hearing a lot of issues with demand.
Eric Larson: Okay. And then – the one last question, and I'm sorry to ask so many – obviously, Nutrition is just doing exceptionally well and you've had a lot of investment in there and it's actually performing the way you have said it's going to. Not to pin you to any kind of a guidance number, Juan, in the past, you have shared what you thought nutrition could be as a contributor to the overall company over the long run. Could you give us an update on your thoughts on that? Because that's truly a new delta for the company.
Juan Luciano: Yeah. Statistically, Eric, I always have – we always have two norths, if you will. One is, we want to get to the 10% ROIC. And the second is, we saw the opportunity to bring growth into the company with extending our value chain into Nutrition. And we always say – you heard me saying, we think that that's a business that could get easily to 25%, 30% of our profits, and it continues to move into that. And to be honest, its moving probably has accelerated into that number, so we might revisit that number. So, we don't have a specific number. But all I wanted to express at that point in time is it will be a meaningful contributor because we saw the opportunity, we saw the potential for that business. And now, I think that everybody else is realizing. At the beginning, we were in an investment phase. So, to a certain degree, some of that performance was masked. But now, we're looking at what we're doing in – look at WFSI. WFSI grew 27%. Of course, animal nutrition grew much more than that. And when we look at all the microbiome potential there, that's an incredible accelerator that is still very small. So, I think I answered before to Ken. You have to remember, this is at the beginnings of what we can uncover in terms of profitability. We are just delivering while we are building the business, but there is much more that will come from Nutrition. And I think that if our track record serves us giving you confidence, trust us, much more is coming from Nutrition.
Eric Larson: Thank you very much. Have a good day.
Juan Luciano: Thank you, Eric.
Operator: This concludes our question-and-answer session I will now turn the call back over to Victoria de la Huerga for closing remarks.
Victoria de la Huerga: Thank you for joining us today. Slide 10 notes upcoming investor events in which we will be participating. As always, please feel free to follow-up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning. And welcome to the ADM Second Quarter 2020 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Victoria de la Huerga, Vice President, Investor Relations for ADM. Ms. de la Huerga, you may begin."
},
{
"speaker": "Victoria de la Huerga",
"text": "Thank you, Amy. Good morning and welcome to ADM's second quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. For those following the presentation, please turn to slide 2, the company's Safe Harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risk and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and important actions we're taking to meet our strategic goal. Our Chief Financial Officer, Ray Young, will review financial highlights and corporate results, as well as the drivers of our performance and our outlook. Then Juan will make some final comments after which they will take your question. Please turn to slide 3. I will now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Victoria. Last night, we reported second quarter adjusted earnings per share of $0.85 cents, up from $0.60 in the prior year quarter. Adjusted segment operating profit was $804 million and our trailing four-quarter adjusted ROIC was 8.1%. I continue to be proud of how our team is performing under challenging and dynamic circumstances. We are fulfilling our purpose by providing high quality nutrition around the globe, and we are doing it while remaining true to our values, protecting the health and safety of our colleagues, fostering a positive, inclusive culture, both within and outside of ADM and safeguarding our environment. Around the globe, ADM colleagues have continued serving our customers and supporting the global food supply chain with no notable disruptions to our operations. Our results are a testament to their dedication, as well as the resilience of our business model and the transformation we have made in our company. Through good times and challenging times, we have kept a strong and steady focus on our strategy. We are not done, but we can be proud of where we are today. Let me share with you some of our accomplishments from the quarter. In our optimize pillar, our Ag Services & Oilseeds team continued their work to enhance the return structure of the business, identifying and executing on almost $50 million in capital reduction initiatives, including the ongoing optimization of our global origination footprint and the decision to exit two Golden Peanut and Tree Nuts businesses. We took further steps to optimize our North American milling operations with announced closure and sale of our Los Angeles flour mill and the sale of office space in Kansas City. And finally, as we previously announced, we made the difficult but important decision to temporarily idle our VCP dry mills in Cedar Rapids and Columbus, which have helped to right size industry ethanol stocks. In our drive pillar, we continued to advance our 1ADM business transformation with the launch of several new technologies, including applications to more efficiently manage spend and cash flow for our non-commodity purchases and contract labor services. We'll be continuing to deploy new 1ADM technologies in the second half of this year. And we expanded our ambitious efforts to make our operations more efficient and environmentally friendly, adding to our previously announced greenhouse gas and energy reduction goals with new commitments to reduce water intensity by a further 10% and achieve a 90% landfill diversion rate by 2035. In our expand pillar, our global destination marketing model continues to grow in export volumes and new markets as ADM extended its product offerings in Asia, Latin America and Europe. We announced that we're introducing high quality USP grade ethanol production in Clinton to complement production at our Peoria facility as we continue to meet customer demand for hand sanitizer. And we announced another expansion of our leadership position in the fast growing plant-based protein market with the creation of PlantPlus Foods, a joint venture with Marfrig that will offer a variety of plant-based food products for customers and consumers across North and South America. Readiness continues to deliver excellence in execution, and its value has never been more clear than over the past few months. Readiness initiative like consolidation of businesses, centralization of activities, and simplification and improvements of processes have significantly enhanced our resilience and agility, helping us continue to serve customers and keep our operations running through fast-changing environments. We are never done improving, and our team has continued to identify and deliver on readiness initiatives. At the end of the second quarter, readiness has allowed us to unlock a total of just over $1 billion in run rate benefits on annual basis since the program began. And based on our strong progress, we're on track to exceed our $1.2 billion goal by the end of 2020. Now, Ray will take us through our business performance before I come back to offer some final comments – before we answer questions. Ray, please."
},
{
"speaker": "Ray Young",
"text": "Thanks, Juan. Please turn to slide number 4. As Juan mentioned, adjusted EPS for the quarter was $0.85, up from the $0.60 in the prior-year quarter. Excluding specified items, adjusted segment operating profit was $804 million, up 18%. Our trailing four-quarter average adjusted ROIC was 8.1%, 235 basis points higher than our 2020 annual WACC of 5.75%. And our trailing four-quarter adjusted EBITDA was about $3.6 billion. The effective tax rate for the second quarter of 2020 was approximately 14%, very similar to 13% in the prior year and in line with guidance we provided last quarter. For the third and fourth quarters, we continue to expect an effective tax rate in the range of 13% to 15%. We generated $1.6 billion of cash from operations before working capital for the first half of the year, higher than 2019. Return of capital in the first half was $517 million, including a little over $100 million in opportunistic share repurchases in the first quarter to help offset dilution. We finished the quarter with net debt to total capital of about 29%. This is down from 31% a year ago. We had cash and available credit capacity at the end of the quarter of almost $11 billion, a very solid amount of liquidity. Capital spending for the first six months was about $360 million. We continue to expect capital spending for the year to be around $800 million, below our depreciation and amortization rate of about $1 billion. Slide 5 please. Other businesses were also higher versus the second quarter of 2019, driven by improvements in underwriting results from our captive insurance operations. In the corporate lines, unallocated corporate costs of $194 million were higher year-over-year due to a larger delta in variable performance-related compensation expense accruals and transfer of costs from business segments into corporate as we centralize certain activities into our centers of excellences. Other charges declined due to improved foreign currency hedging results on intercompany funding and improved investment performance. Corporate results also included debt extinguishment expenses of $14 million related to an early retirement of a bond. Net interest expense for the quarter decreased due to lower average foreign costs related primarily to liability management actions taken in late 2019. Looking forward, we expect unallocated corporate expenses to be in line with our initial $800 million guidance for the calendar year and net interest expense to end similar to or slightly lower than the 2019 amount of about $350 million. Other business results in the second half of the year are expected to be significantly lower than the first half and likely negative based on expected insurance claims settlements and lower interest income in ADM investor services. Please turn to slide 6. Ag Services & Oilseeds delivered higher results versus the second quarter of 2019. Ag Services results were substantially better year-over-year. Strong execution by the team in South America helped deliver record quarterly origination and export volumes in a significantly improved margin environment, driven by a weaker Brazilian real and strong farmer selling. Global trade delivered best second quarter ever, continuing to demonstrate the importance of our strategic efforts to create value throughout the global supply chain. Destination marketing was a significant contributor as countries look to secure stable supplies of food amid the pandemic. Lower inferior grain margins impacted results in North America. Crushing results were lower year-over-year. The team delivered strong global crush volumes overall, and did a great job capitalizing on solid South American meal demand and weaker Brazilian real, along with a lack of Argentinian imports into EMEAI. In North America, margins were impacted by the pandemic's effects on our customers. Net timing impacts to the quarter were not significant as board crush gains were offset by basis losses and our cash flow hedge program deferred additional positive timing impacts. Refined products and other results were higher year-over-year, driven by improved biodiesel volumes and margins in North and South America, as well as strong volumes in margins in refined and packaged oils in South America. Demand was lower for biodiesel in EMEAI and for edible oils – for food service in both EMEAI and North America. Wilmar results were lower year-over-year. Wilmar's core earnings were strong, but reported earnings were impacted by mark-to-market losses on their investment portfolio in their first quarter. Fundamental global demand trends continue to emphasize the underlying strength and resilience of this industry and our business model. Looking ahead, we expect the pace of Brazilian farmer selling to slow significantly following the aggressive selling in the first half of the year. North American origination should strengthen throughout the second half as we move into the US harvest, and export demand is supported by China's import needs. Global crush margins are likely to remain pressured in the near term, but we expect tight soybean supplies in South America to lead to an improving margin environment as we move through the second half of the year. RPO should continue with solid performance. All told, we currently believe the third quarter will be sequentially lower than the second quarter of this year, followed by a much stronger fourth quarter. Slide 7 please. Carbohydrate Solutions results were similar to the year-ago quarter. Starches and sweetener results were lower year-over-year. COVID-19 related impacts on foodservice demand in North America pressured sweetener volumes. Mark-to-market losses on corn oil contracts indexed to soybean oil also impacted results, similar to what we saw in the first quarter. These impacts were partially offset by lower net raw material costs and positive risk management results. We also continue to benefit from the improvements we made in our Decatur corn complex and the continued turnaround in EMEAI. Wheat milling had another strong quarter as increased levels of home baking in store sales helped drive solid retail demand and footprint optimization initiatives, which reduced costs, continued to drive results. Vantage corn processor results were higher than the second quarter of 2019, driven by favorable risk management results on inventory positions and strong demand for high quality USP grade ethanol used for the hand sanitizer market. While average industry ethanol margins were down versus the prior year, prices and margins improved throughout the quarter as lower production including the two dry mills that we idled and some recovery in driving miles led to falling industry ethanol stocks. Looking ahead, we expect the third quarter results for Carbohydrate Solutions to be similar to the second quarter assuming sweetener demand continues to recover, demand in wheat milling remains solid and average industry ethanol margins over the quarter remain in positive territory. On slide 8, our Nutrition business continued to deliver significant growth, with 35% year-over-year profit improvement for the quarter. Over the first half of the year, adjusted profit for Nutrition is up more than 50%. And despite some COVID-19 impacts, revenue is up about 8% on a constant currency basis, with growth spread across the entire broad portfolio. Human nutrition results were substantially higher in the second quarter of 2020 versus the second quarter of 2019. Flavors continued to deliver solid results as favorable sales mix and margin expansion in North America was offset by some softness in EMEAI. In specialty ingredients, our team's strong execution and operational excellence, including at our soy protein facility in Campo Grande and our pea protein plant in Enderlin enable us to continue to meet rising consumer demand for plant-based proteins and edible beans, driving substantial year-over-year growth. Health and wellness delivered higher performance on strong sales for probiotics, improved volumes and margins in fiber, and additional fermentation income. Animal nutrition results were again higher year-over-year. Despite impacts from COVID-19 on demand in some regions, continued execution on Neovia synergies, robust demand for pet food and treats, and improvement in amino acids drove our ongoing profit growth. The investments we've made in Nutrition and our unique value proposition have positioned us well to support our customers as they continue to innovate and adapt in the current environment. We are winning new business and our pipeline today is strong and growing. We've also equipped our teams with new digital tools and technologies to continue product development work in a virtual environment, ensuring that products advance even in the current dynamic climate. Looking ahead, Nutrition should be around 20% higher in the back half of the year, compared to the second half of 2019, with similar rates of growth in profits in third and fourth quarters. We expect strength in flavors, plant-based proteins, and probiotics continue to drive human nutrition and Neovia synergies and improvements in amino acids to support animal nutrition results. Now, please turn to slide 9. And I'll turn it over back to Juan. Juan?"
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ray. From our work to optimize our footprint and improve our capital position to our new technologies and improved processes to our growth efforts to become a world leader in nutrition and expand margin opportunities across the value chain, the team has done excellent work executing the strategy. And as we continue on this journey, we are increasingly seeing growing benefits flow to our bottom line. That does not mean that we are immune to external conditions. This has been an unpredictable year and we're only at the halfway point. Our team has done a great job moving quickly and adapting to the challenges of COVID-19, and we are continuing to monitor and analyze purchasing and consuming habits to ensure we can continue to anticipate and meet our customers' needs. We're seeing consumers still largely relying on retail and e-commerce to feed their families and demand is spanning a wide spectrum from comfort foods to healthy choices. In-home eating and baking has dramatically increased the demand for both flour and baked goods. Healthy eating has significantly accelerated the purchase and consumption of alternative proteins. And a focus on nourishment and wellness is pushing microbiome solutions to the mainstream. We're meeting this wide variety of customer needs and will continue to do so as many of these trends advance in the future. For the second half of this year, we'll remain focused on optimizing business performance, advancing readiness and harvesting the benefits of strategic growth initiative investments, especially in our Nutrition segment. We are continuing to pull the levers under our control across the enterprise, with our team currently exceeding our mid-year targets by achieving more than two thirds of our $500 million to $600 million in targeted operating profit improvements for 2020. Looking ahead, we remain confident in our positioning, our capabilities and our strategy and we are excited about the second half of the year and delivering strong earnings and returns in 2020 and beyond. With that, operator, please open the line for questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions]. Your first question comes from the line of Adam Samuelson with Goldman Sachs. Adam, your line is open."
},
{
"speaker": "Adam Samuelson",
"text": "Yes, thanks. Good morning, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Adam."
},
{
"speaker": "Adam Samuelson",
"text": "So, I guess, first, just thinking about how you kind of frame some of the second half outlook for the different businesses, is it fair to say that the biggest wildcard are pace of US exports and what that does both on the origination and crush side and just underlying kind of food ingredient demand? I'm trying to think about kind of the range of outcomes as we think about for business momentum into the second half of the year."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Adam. Listen, as we think about the second half of the year, we expect in general businesses to perform better than in the first half. So, that's overall results. When we think about the different businesses, with the aggressive selling in the first half of the year of the Brazilian farmer, we think that the US having a big crop like we're going to have going into harvest will be the most competitive source and China still needs to import a lot in the fourth quarter. So, we feel good about that. We feel good also about destination marketing. Don't forget that. From an Ag Services perspective results, basically, the results of the global trade were equally contributing as the results of origination in South America for the results this quarter. And although South America will shift to North America in terms of grain results, we see destination marketing and the global trade effort to continue to contribute in the second half. We see probably – so far, if we look at all the way to July, we see that the worst of the demand destruction due to COVID was behind us. We saw that in April and then we saw improvement in May, June, July. It will probably be uneven and would start and stop for the rest of the year, but we think that the worst is behind us. So, I would say that that's how we characterize. And then, Nutrition continues to grow strong. There are many opportunities for Nutrition and we had a very strong beginning of the year. The second half of the year is seasonally a little bit softer for Nutrition. But that's the way the demand pattern goes every year. But we feel very strongly about the second half of the year at this point."
},
{
"speaker": "Adam Samuelson",
"text": "All right. That's very helpful color. And then, if I can just ask a second question on capital allocation, just help us think about, with kind of the balance sheet where it is and what seems to be a pretty strong position, what it would take or what you would want to see before you took a more offensive posture on whether it's capital returned to shareholders or maybe there's opportunities in the M&A market that might be emerging?"
},
{
"speaker": "Juan Luciano",
"text": "Sure, yes. Listen, as we have said it all along and at the beginning of the year, our priority remains to deliver our balance sheet to the low 2s and protecting our single-A rating is very important to us. And we have aggressive plans in the businesses to – you heard me in the accomplishments of the second quarter – to monetize assets. And to the extent that we continue with that and monetize assets, we will think about increasing our share repurchases. But I think the priority is delevering. But we've been doing very well in this divestiture and we continue to look for our large company and what are the things that we can monetize, so we can apply to that. With regards to M&A, we have a very disciplined process of doing bolt-ons and organic growth. And you see how we pace ourselves. We did WILD in 2014 and we did Neovia in early 2019. And I think that that allows us to recover the ROIC impact. If you think about ROIC at the end of 2018, it was 8.3%. We acquired Neovia and now we're back to that range, 8.1%. So, I think that that allows us to go and buy what we need to buy, continue to grow Nutrition jointly with all the harvesting that we do in Nutrition with the organic growth with Campo Grande and Enderlin and all that. So, I think we have that model and we like it and I think you're going to see that we continue to deliver what we said we were going to do, and it's a very predictable pattern in that trend."
},
{
"speaker": "Adam Samuelson",
"text": "All right, great. I really appreciate the color. I'll pass it on. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Adam."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Heather Jones with Heather Jones Research. Heather, your line is open."
},
{
"speaker": "Heather Jones",
"text": "Good morning. Thanks for taking the questions."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Heather."
},
{
"speaker": "Heather Jones",
"text": "Hi. So, just the details question first. Could you explain to us the results from Vantage Corn was very impressive. Was there a lower cost of market and inventory adjustment or something? Could you help us understand what drove that performance besides the industrial alcohol sales?"
},
{
"speaker": "Ray Young",
"text": "Yes, Heather. It's Ray here. Yeah, for Vantage Corn Processor, remember, for VCP, not only are they producing the ethanol from the dry mills, but they're also the distributor of the ethanol that comes out of the wet mills. So, over the course of the quarter, we actually – as we indicate, we had a very, very good risk management on our inventory positions. Now, we knew coming into the quarter that the fact that we're going to cut back on ethanol production, shut down or idle the two dry mills, we had a pretty good sense of margins should improve throughout the quarter. So, the inventories that VCP had, as we went through the quarter, which includes the wet mill ethanol, we basically more or less left that unhedged, whereas we actually did hedge the corn position at a very, very low cost. And so, we benefit from stable risk management in terms of both the input side, meaning the raw corn, and the output side, which is the ethanol within the distribution system. And so, therefore, we had very, very good risk management results based on our inventory decision. So, that was an important driver. But don't underestimate the industrial ethanol business. We actually increased the capacity of our Peoria plant. It was like 85 million gallons entering the year and we were able to debottleneck many aspects of the plant and actually get that thing closer to 100 million gallons on an annual run rate basis. And we ran the plant full well over the quarter. And as you would appreciate, industrial ethanol margins improved also throughout the quarter. So, VCP also benefited from a very stable environment in terms of the aspects of the industrial ethanol business. And then lastly, again, as we indicated, we idled the plant. We did a pretty good job in terms of reducing the amount of stranded costs associated with those dry mills. And that also contributed towards our overall results. So, overall, it was actually, from our perspective, a good quarter for VCP in terms of how we manage the situation."
},
{
"speaker": "Heather Jones",
"text": "Yeah, sounds like it. Thank you. My second question is, I was hoping you could elaborate on your outlook for crush margins. So, in the US, you're clearly pretty soft right now and you noted that, over the near term, they'd be soft, but then you articulated a more constructive outlook further out. I was wondering if you could flesh out for us what you're seeing on the demand and supply side that gives you confidence that we should improve as we move into Q4 and 2021."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Thank you, Heather. As you said, they are soft at the moment in North America, but improving. And we're going to see that improvement over the end of – through the quarter. Basically, we're going to have – we started to see a little bit better farmer selling. And I think as we get to the harvest, we're going to have less pressure on that side. And we're seeing from the demand side that the customers – our customers for soybean meal are coming back. And then, we're seeing also a little bit more pressure on the oil side. So, the oil story is getting a little bit better. So, in general, from crush margins, we saw good crush margins in Europe with the absence of Argentinian meals – of more aggressive Argentine meal. We saw good crush margins in China. And now, we're seeing improving crush margins in the US for the rest of the year. So, so we feel very good about that business. And we can debate numbers here or there about growth rates, but in general, we see growth going forward. And that's what we're hearing from our customers."
},
{
"speaker": "Heather Jones",
"text": "Okay, thank you so much."
},
{
"speaker": "Juan Luciano",
"text": "You're welcome, Heather."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ken Zaslow with Bank of Montreal. Ken, your line is now open."
},
{
"speaker": "Kenneth Zaslow",
"text": "Hey, good morning, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ken."
},
{
"speaker": "Kenneth Zaslow",
"text": "Can you talk about the elevation margins and what you're seeing there? And how meaningful will that be for ADM and how are you executing on that?"
},
{
"speaker": "Juan Luciano",
"text": "Sure. Yes. So, the US export market is setting up for very good times on very solid global demand and competitive prices. And, of course, with a tight supply demand, as I referred before, in South America. So, we do expect large programs for corn, soybeans, as well as wheat and soybean meal for Q4. So, I would say short term in Q2, Q3, it's about $0.10, $0.15. And forward, we're seeing numbers more in the $0.30 range or even slightly better. So, again, we have big volume expectations. And we're looking, Ken, at the full value chain. So, elevation margins and also transportation margin. So, we're seeing the whole thing. So, we care about the full range of margins. So, we feel we feel stronger margins are coming ahead of us for the Q4. And, to be honest, every evidence out there is pointing to that direction as we go around the world and we talk to our teams. So, we feel confident about that."
},
{
"speaker": "Kenneth Zaslow",
"text": "And then, just switching to Nutrition for a second, so two parts to this. One is, obviously, your growth rate has been very strong. How long into the future will that last? Is this a good run rate for a little bit of years? And then, you also mentioned that you're winning new business. Can you quantify or give parameters to how much that is? Is it just typical winning a little business here and there? Or are we talking about larger than a breadbox, but not quite game changing? How do I think about those two things? And I'll leave it there. And I appreciate it."
},
{
"speaker": "Juan Luciano",
"text": "Sure, Ken. Listen, the thing you need to remember is that Nutrition is still in early stages. So, we were building this business and we've been doing it for four or five years versus other businesses that we've been running for 100 years. So, even as good the resources we're getting, we're not even close to fulfill our potential. And we continue to see that in the pipeline. The pipeline continues to be very strong. And again, we measure the value of the pipeline to see the impact of 2021 sales, 2022 sales. And as I said, that continues to grow. But we also look at the win rates to see how we're doing today. And the win rates continue to increase. I can't disclose exactly the win rates because that's confidential information and it's very valuable to us. I think the important thing of Nutrition that sometimes is underestimated is the breadth of our product offer. And when we're talking here, we're talking, Ken, about – we're bringing fibers to a lot of products, whether our beverages or yogurts or cereals. We are bringing probiotics to a lot of products. We have specialty proteins. So, I think – of course, we have flavors going into a myriad of applications. So, I think the versatility that this product gives us – again, even if you go to specialty proteins, we have soy based, we have pea-based. And when you combine all these things into systems, it gives us incredible possibilities and customers are reacting very well to that value proposition. I have to give credit to the team in this difficult circumstance that you could have thought that maybe innovation could have been impacted because of the remoteness of our operations. And our team pivoted very quickly into establishing virtual tasting rooms, virtual innovation and prototyping sessions. And that has been very successful and has been able to keep the growth rate of our pipeline. So, I don't know how long can we predict the 20% rate. But at this point in time, we continue to see it into the immediate future. So, we don't see any slowdown of that. And as I was explaining to Adam before, we're going to continue to do our bolt-ons M&A, and we've been getting better at this. We integrated and we absorbed Neovia and the results and the operations much faster than we did obviously with WILD because this is the second time and we have perfected the system. And I think we're going to be able to keep this pace a little bit more accelerated into the future. So, the possibilities of this business are enormous, Ken."
},
{
"speaker": "Kenneth Zaslow",
"text": "I really appreciate it. Thank you and be safe."
},
{
"speaker": "Juan Luciano",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Vincent Andrews with Morgan Stanley. Vincent, your line is now open."
},
{
"speaker": "Steven Haynes",
"text": "Hey. This is Steve Haynes on for Vincent. Just wanted to come back to the Carb Solutions. The second quarter result was quite a bit better than what you had guided and I appreciate the commentary around risk management. But you also mentioned a number of other buckets. So, can you kind of just bucket out the rest of the beat, so we can get an idea for kind of what drove that delta?"
},
{
"speaker": "Ray Young",
"text": "You're referring to Carb Solutions in general for the quarter?"
},
{
"speaker": "Steven Haynes",
"text": "Yeah."
},
{
"speaker": "Ray Young",
"text": "Yeah. You look at starches and sweeteners, the other big sub segment here. We had good results. Naturally, for this segment, as Juan talked about earlier, the trough in terms of demand for sweeteners probably was the second quarter. It was probably in April/May timeframe. And so, therefore, we did experience reductions in volumes on the basis of corn sweeteners during that period. But what was interesting is when you look at starch and sweeteners, there were clearly strengths there as well. Number one, for example, wheat milling. Demand for flour continued to be strong in the second quarter. In fact, when we look at our global wheat milling results, our profits in the second quarter were up 50% versus the prior year. So, that was a big contributor towards the starch and sweetener results. Secondly, I did outline in my remarks that we did have mark-to-market losses on our corn oil contracts, just like we had in the first quarter. The fact I didn't highlight a number indicates that the number was actually much smaller than what we had in the first quarter. But we were also able to offset that impact with good risk management from the wet mills there as well. On a net basis, that was really a neutral impact. And then thirdly, it is important to also highlight in starches and sweeteners, the turnaround efforts, the improve efforts that we launched last year in the Decatur corn complex in the European business. They're truly paying off this year and also in the second quarter. So, they're all positive deltas that help neutralize some of the negative effects that we saw in terms of starches and sweetener volumes in the second quarter. And then, I already talked about VCP, which, again, stable risk management on inventory position. So, overall, I would have to say that, yes, it was actually a very strong quarter for starches and sweeteners in the second quarter compared to even what our initial expectations were as we entered into the quarter. But I have to give the team a lot of credit in terms of the efforts that they executed in order to help deliver the results here."
},
{
"speaker": "Steven Haynes",
"text": "Okay. Thanks, Ray."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Tom Simonitsch of J.P. Morgan. Tom, your line is open."
},
{
"speaker": "Thomas Simonitsch",
"text": "Thanks. Good morning."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Tom."
},
{
"speaker": "Thomas Simonitsch",
"text": "So, you noted in your press release some COVID-19 impacts on your animal nutrition business. Can you elaborate on that please?"
},
{
"speaker": "Juan Luciano",
"text": "Sure, yes. I think when you see these consumer shifts, of course, Aqua is consumed a lot in the Western Hemisphere in dining out, and so we see a little bit of impact on that – negative impact, I mean. Of course, when some of the large animals feed, we saw a little bit of softness there in North America and Mexico when some of the meatpacking plants have to slow down. But we see positive benefits in pet food and pet treats. Very positive as well. And I think that, in general, there have been countries where we are strong, that their demand has continued strong, like Brazil has continued, Vietnam has continued. And then, we also saw lysine prices and lysine performance actually came back in the quarter. So, those are kind of the puts and takes of COVID impacting us in animal nutrition."
},
{
"speaker": "Thomas Simonitsch",
"text": "Okay, thanks. And you noted immaterial market impacts in Q2, which was a bit of a surprise to me at least, particularly on soy crush. So, can you elaborate on your hedging strategy and clarify any deferred gains you're carrying into the back half?"
},
{
"speaker": "Ray Young",
"text": "Yes, Tom. Recall, the objective of our hedging program is really to manage margin risks on our products and to dampen volatility of earnings and cash flow. And we'll call any impact when it's greater than $50 million. That's what we've done in the past. So, we entered the second quarter with about $80 million of favorable timing effects that would be recognized in the future. And then, as you see in the supplementary data, we exit second quarter with about $95 million of favorable timing effect. So, on net, we had actually $15 million of unfavorable timing effects in the second quarter. Now, with board crush falling dramatically in the second quarter, we naturally did have hedge gains on crush. Now, some were deferred due to our cash flow hedge program, which we put in place several years ago, right? And so, although for these gains, they are basically under our cash flow hedge accounting, you don't have to mark-to-market. They're just simply deferred in the future and we'll recognize that. But we did also recognize some timing effects related to basis movements on oil, meal and beans, right? So, therefore, the favorable effect on board crush was offset by some of the unfavorable timing effects on basis movements. And as a result, we had a slight negative impact of $15 million. And again, we didn't call it out in our prepared remarks, but you can actually see that in the data there. The other thing to just note also, we also had some bunker fuel hedges and we call that out in the first quarter, right? Some unfavorable effects on bunker fuel hedges that should reverse out in the second quarter. And we did. We did have some favorable reversals. But, again, nothing significant in terms of size, and that's the reason why we didn't call it out. But in general, I'd have to say, our cash flow hedge program is actually something that helps smooth out some of the fluctuations that we have on our hedging. And then, there's also some other impacts that actually impact the net amount. But again, I think the key is that we saw about $95 million of favorable timing effects that will reverse out over the future quarters."
},
{
"speaker": "Thomas Simonitsch",
"text": "That's very helpful. Thank you. I'll pass it on."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ben Bienvenu with Stephens. Ben, your line is open."
},
{
"speaker": "Benjamin Bienvenu",
"text": "Thanks. Good morning. I wanted to revisit the Vantage segment. I know in April when you guys decided the closure of two dry mills, you talked about kind of a four-month timeline. Recognizing you might not want to telegraph too much the timing of the reopening, what are you looking for from a market perspective as you think about reopening, either sticking to that timeframe or oscillating around the original timeline that you laid out?"
},
{
"speaker": "Ray Young",
"text": "Yeah, we did indicate that when we temporarily idled the two facilities. We said that we'll probably keep it down for about four months, which will, frankly, bring us to the end of the third quarter. I think the data that we're going to look at includes things such as industry ethanol levels, and it's actually very encouraging what we've seen recently where EIA data on ethanol and industry stocks, inventory level, they've come down from the peak of 27 million barrels down to about 20 million barrels right now. So, that's actually very, very encouraging. And you have seen ethanol margins respond accordingly with that particular reduction in terms of inventory. The other key variable is just the recovery of driving miles. And you're actually starting to see that. We were down as much as 40% during the trough of the shelter-in-place in terms of gasoline demand. We're starting to see some level of recovery. We're probably down as an industry about 15% right now. And so, I think that some of the key data that we're going to look at is how that recovery continues, how the inventory levels get maintained as we go through the next several months and how the margin environment evolves, and that will guide us also in terms of the appropriate timing to kind of restart both dry mills here. So, it is a dynamic – it's a dynamic situation, but we're going to be very data driven as we look towards the strategy here."
},
{
"speaker": "Benjamin Bienvenu",
"text": "Okay, thanks for that. Following up on just the questions around hedging, how exposed are you to the cash market? How much of 3Q have you hedged? And have you hedged any of your 4Q crush commitments?"
},
{
"speaker": "Ray Young",
"text": "Normally, in terms of crush, we normally kind of hedge the fourth quarter significantly, not 100%. But, normally, we're hedged, I think, 50%, 75%. Normally. We're always opportunistic, by the way too. We'll look at the levels and we'll determine when we layer in the levels. And then, as you go out into the future quarters, there's less. But we also do have hedges already in 2021 based upon the stable levels that we saw earlier in the year."
},
{
"speaker": "Benjamin Bienvenu",
"text": "Okay, thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Michael Piken with Cleveland Research. Michael, your line is now open."
},
{
"speaker": "Michael Piken",
"text": "Yeah, hi. I just wanted to get an update a little bit in terms of how you sort of see the US-China trade situation playing out. Do you think that China is going to be able to meet all the phase one commitments and then just sort of any update you have on ASF over in China and how quickly they're rebuilding and what that means for meal demand over there?"
},
{
"speaker": "Juan Luciano",
"text": "Yeah, Mike. Listen, I think you heard me saying before. I think that China is taking all the actions that reflect their intention to comply with this. Despite their rhetoric, we continue to focus on the facts. The facts are that they have imported more from the US, if you look at corn or if you look at soybeans so far, versus last year. And the reality, there is also a supply/demand reality here. Brazil is out of beans. The Argentine farmer is not going to sell their beans. So, the US is going to be having a big harvest. And I think China, if you think about, they're going to import 95 million tons, 96 million tons and they have imported already 70 million tons, give or take, from South America. So, they need to import about 25 million tons, 26 million tons, of which they have already committed half of that. So, half of this is still to be done, which I think is going to be done from the US in the Q4. So, we feel good about that. And as I answered before to Ken in elevation margins, I think there's going to be corn, it's going to be soybean meal, it's going to be soy, and it's going to be wheat. So, it's going to be a good program for the US in terms of volumes. In terms of ASF, I think that ASF has been evolving as we predicted early on, in which that created a 10 million tons gap of protein in China. China has covered some of that with imports and we've seen those imports up around the world. We enjoy that, especially from Brazil this second quarter. And I think we've seen that growing into the US as well. We also saw the professionalization of animal processing in China. And with that, we've seen the increase of soybean meals in the rations and more efficient rations. So, will it be lineal? Probably like COVID, this will not be lineal. There are going to be ups and downs. There are going to a surge here or there that's going to be squashed. But I think that, overall, we've seen the worst. And I think that we're going to see probably full recovery by some time later 2022 or something like that, but it's going to be an in crescendo from here."
},
{
"speaker": "Michael Piken",
"text": "Great. And then, now last of is just on the destination marketing increases here that you guys talked about. When can we start to see that accrue to the P&L and what does the margin profile look like on destination marketing compared to the North American operations? Thanks."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Destination marketing has been impacting us already. As I said, when I said global trade had a record second quarter, that's what's driving a lot of that. This is a strategy we put three, four, five years ago. And to be honest, it's been emphasized now with people around the world more concerned about the stability of the supply chains and the ability to move product around, which we've been able to move. But having product locally has been very valuable for a lot of customers around the world. So, we made acquisitions in Egypt, in Israel. We opened some offices and we continue to expand the number of countries in Asia, in Europe and in South America that we are covering with that. So, at the beginning, we saw an expansion in volumes. We doubled the volumes. Now, volumes are growing a little bit more geographically, not in the same place, I would say. It's more by geographic expansion. And margins continue to increase. So, we feel good about it. And it's a big contributor and it was already a big contributor of our services for the first half of the year."
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of David Katter with Baird. David, your line is now open."
},
{
"speaker": "David Katter",
"text": "Hey, guys. Thanks for taking the question."
},
{
"speaker": "Juan Luciano",
"text": "Good morning."
},
{
"speaker": "David Katter",
"text": "Quickly wanted to clarify or get an update on your strategic review for ethanol. Where in the process are we and kind of how has COVID impacted that and what options are being considered?"
},
{
"speaker": "Ray Young",
"text": "The review is continuing. We have interested parties in the assets. Naturally, in the COVID-19 environment when the dry mills are shut down, the credit markets are basically shut down, we've taken a little bit of a pause. But, clearly, we expect the process to recommence as we kind of move through the back part of the year, as the markets start recovering back to more of a normality."
},
{
"speaker": "David Katter",
"text": "Got it. And then, one more I just kind of want to hear your thoughts on. The readiness initiative, it's on track to beat its goal, I think you mentioned. But how does the focus shift? Or how does your mentality change once you achieve that $1.2 billion goal? Kind of what's the next step for ADM's readiness?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, this is a large company and a growing company. So, as we continue to look for opportunities or buckets of opportunity, we continue to find more. So, everything that we do, David, is run into readiness, which is a way to execute better all our initiative. So, I think that the first stage, if you will, was more on efficiencies. We are shifting a little bit more to growth and innovation and to make sure that our growth and innovation has the same capabilities and power to execute the deficiency it has. But I will say, from a numbers perspective, we feel very good about the $200 million to $300 million of net impact that we get every year. And we don't see any reason for that not to be in the forecast for next year, maybe even a little bit better. So, we feel good about that. I will say if you look at – if I take the opportunity of your question to speak a little bit about the algorithm and how we're thinking for next year, the harvesting part, there's still more in front of us and we continue to see impact of that and probably growing. Maybe hopefully improve will be less so because we are improving those businesses and we don't have that many more businesses to improve maybe. And readiness continue to enlarge the scope. So, the impact of revenues should continue to grow over time."
},
{
"speaker": "David Katter",
"text": "That's excellent. Thank you, guys."
},
{
"speaker": "Ray Young",
"text": "Thank you."
},
{
"speaker": "Ray Young",
"text": "Amy, any more questions? Amy?"
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Ben Theurer of Barclays. Ben, your line is now open."
},
{
"speaker": "Benjamin Theurer",
"text": "Thank you very much. Good morning, Juan, Ray. Hope you're both well."
},
{
"speaker": "Juan Luciano",
"text": "Good morning."
},
{
"speaker": "Ray Young",
"text": "Thank you, Ben."
},
{
"speaker": "Benjamin Theurer",
"text": "Good stuff. Just one quick one and a follow-up. So, within the Carbohydrate Solutions segment, you've also had mentioned that wheat had a very strong performance and I think you said on the call something like it was up 50%. I know it's small, but just out of curiosity, what are you seeing in the month of July and into the rest of 3Q and maybe a little ahead into 4Q on the wheat part within the Carbohydrate Solution business?"
},
{
"speaker": "Ray Young",
"text": "The demand for flour continues to be strong. Probably, first quarter, we saw a little bit of a surge because of pantry loading. But the demand effects continue to be solid for wheat, and hence our mills are actually running very, very hard. Now, the other big contributor, don't forget, is just the optimization initiatives that we had in our wheat processing plants. So, we actually shut down some inefficient mills and opened up new mills. The timing cannot be more perfect for that, right? Because the demand is there for our products. And now, we actually produce the flour from very efficient operations. And that has been actually an important contributor towards our overall improvement in terms of results for wheat milling. So, we're actually very, very pleased in terms of how this strategy has unfolded here."
},
{
"speaker": "Benjamin Theurer",
"text": "Okay, perfect. And then, a little more medium, long term. Clearly – and you maybe talked a lot about Brazilian farmer selling was very strong and I think you had in the presentation the status [ph], where they stand. So, what are you seeing on the ground? What's your expectation into the second season in Brazil and then maybe into next year? What are you seeing on the ground in terms of intention to plant just because of what they've been selling so strong right now? Do you see any significant uptick in volume in Brazil that could become a competitor for us in a more relevant way maybe looking into 2021?"
},
{
"speaker": "Juan Luciano",
"text": "Yeah. I think, Ben, we will continue to see Brazil adding a little bit of area. And I expect to have a large crop next year in Brazil weather permitting. So, I think that we will continue to see that and we have a strong origination team and crush team in Brazil. And I think we're going to continue to profit from that. I think there is a place for US and for Brazil. So, I think it's just the – I would say the short-term dynamics depends in South America a lot of what happened with currency. And you see the stark contrast between an Argentine farmer that see no benefit in parting ways with the crop, with the Brazilian farmer that due to the weak real was an aggressive seller even of the new crop. So, I think those dynamics will happen, but I think, over time, Brazil will try to continue to increase production."
},
{
"speaker": "Benjamin Theurer",
"text": "Okay, perfect. Thank you very much. And congratulations on the results."
},
{
"speaker": "Juan Luciano",
"text": "Thank you very much."
},
{
"speaker": "Juan Luciano",
"text": "Hello, Amy?"
},
{
"speaker": "Ray Young",
"text": "Hello, Amy?"
},
{
"speaker": "Juan Luciano",
"text": "Any questions?"
},
{
"speaker": "Operator",
"text": "Your next question comes from the line of Vincent Anderson with Stifel. Vincent, your line is open."
},
{
"speaker": "Vincent Anderson",
"text": "Thanks for sliding me in. Good morning and nice quarter. I did just want to clarify a little bit more on the positive mix shift in Nutrition. You called out growth in flavors and probiotics. Are those generally going to be higher margin contributors? And then, also on plant proteins, was that also representative of positive to mix or was it more of that margins in the protein business were improving as you fill the Campo Grande facility?"
},
{
"speaker": "Juan Luciano",
"text": "Yeah. A little bit of both. Certainly, Enderlin and Campo Grande are both new facilities. So, they are both getting better every quarter on what did they do. The EBITDA percentage of sales, as you know that I follow that, in the business continued to evolve favorably. If you look at the previous-year quarter was 11.3%. And this quarter was 15.1%. So, of course, our team is very agile, lean, to bring in new products and the new products bring new opportunities for margin up the business. So, we have those benefits. Probiotics are, of course – microbiome was a trend that was incipient, if you will, and COVID has put it right into the mainstream as people think about more health and wellness and immunity concerns. So, I would say probiotics that are science based, like ours, are being added as supplements to many, many products. And those products are highly technical. As I said, they require clinical trials and things like that. So, of course, they command higher margins. So, we feel very good about those products. And flavors, listen, flavors are incredibly important. All these things have to be taken by people and they have to taste good. So, the combination of our scientists creating these flavors and masking maybe different nodes that maybe people don't appreciate is critical to this. And that's one of the reasons we acquired WILD Flavors at that point in time because of those capabilities. When you combine those capabilities with the fact that all our flavors or 95% plus of our flavors are natural, that makes this the preferred solution for most of our customers and certainly for the consumers. So, we feel very good about that."
},
{
"speaker": "Vincent Anderson",
"text": "All right. Thanks. To keep everybody on schedule, I'll just leave it there. Nice job again. Thanks."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Vince."
},
{
"speaker": "Ray Young",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Your final question comes from the line of Eric Larson with Seaport Global. Eric, your line is open."
},
{
"speaker": "Eric Larson",
"text": "Yeah. Thanks for sneaking me in. Congratulations on a great quarter, guys."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Eric. Welcome back."
},
{
"speaker": "Eric Larson",
"text": "Well, thank you. It's good to be back. It's a pleasure. So, just one really kind of technical question. It comes to the – and then I have a broader question. But the technical question is, we've got elevation margins right now in the Gulf ports that I haven't seen in quite some time. And just put China aside for a minute, there's good demand – there are a lot of other places outside of China. Obviously, the US dollar is helping a little bit. If you think that COVID-19 has maybe put some scare into some other countries, maybe they've loaded some inventory to make sure that they've got enough grain supplies for their people, et cetera, and some of that demand might taper off or are they actually using the products that they're shipping? I'm curious on the demand factor outside of China."
},
{
"speaker": "Juan Luciano",
"text": "Yeah, I would say probably at the beginning of the year, we saw a little bit more of that, Eric. I think now is through demand that is coming through. I think that even through all the peak of the crisis, we've been able to manage every port. We've been able to keep our operations running, the protocols that we have with the crews of the vessels and the different ports have worked well. So, I would say probably early on, maybe March, April, maybe people thought a little bit more about hoarding product. I don't think that's true anymore. I think now we're seeing through demand. What is happening with that demand is looking like strong demand and strong volumes for the US. So, potentially, we could have record profits in Q4 when you look at the volumes plus the attractive prices because we're going to have a big harvest in the US. We're talking about large volumes for North America and we're talking about large crop and maybe even an early corn crop. So, we feel very good about that progress. And that's what you heard me saying before. In general, we look at the second half. And I look at my businesses and I think my businesses are going to perform better in the second half than in the first half. So, overall, the profit coming from the businesses should be stronger in the second half than in the first half."
},
{
"speaker": "Eric Larson",
"text": "Yeah. We're going to have an outstanding harvest this year. And it's going to make us very competitive globally. I would agree with that. So, the other question here that I have – I have two small questions. One, we're starting to see estimates for Brazilian – for next year, for Brazilian soybean production – starting to see estimates north of 130 million metric tons. We're seeing – continue to see global production expansion across all of the major production countries. And my real question is here, obviously, the world is growing as well. Are we going to have enough demand over the next, let's say, three to five years to sell all this product? Or are some countries going to have to cede some share, export share, as this production continues to grow pretty rapidly? It's a longer-term question, but does demand and production match?"
},
{
"speaker": "Juan Luciano",
"text": "I do believe so. When we look at the – we've been adding like 2 billion people every 30 years here in the world. And when you see how China is recovering – remember that this virus hit us from the east, coming West. So, we've seen how China is recovering, how Europe is recovering. Of course, still the Americas are in the middle of the pandemic, but we need all that. I think my concerns are not, are we going to find enough demand for that volume. I think we still – on the biggest issue for China and a lot of countries is food security, Eric. And when I go around the world and talk to mandatories and all that, the biggest concern is that, are we going to see – do you have enough investment in infrastructure? Do you have the ports ready to bring all those products? So, we are not hearing a lot of issues with demand."
},
{
"speaker": "Eric Larson",
"text": "Okay. And then – the one last question, and I'm sorry to ask so many – obviously, Nutrition is just doing exceptionally well and you've had a lot of investment in there and it's actually performing the way you have said it's going to. Not to pin you to any kind of a guidance number, Juan, in the past, you have shared what you thought nutrition could be as a contributor to the overall company over the long run. Could you give us an update on your thoughts on that? Because that's truly a new delta for the company."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Statistically, Eric, I always have – we always have two norths, if you will. One is, we want to get to the 10% ROIC. And the second is, we saw the opportunity to bring growth into the company with extending our value chain into Nutrition. And we always say – you heard me saying, we think that that's a business that could get easily to 25%, 30% of our profits, and it continues to move into that. And to be honest, its moving probably has accelerated into that number, so we might revisit that number. So, we don't have a specific number. But all I wanted to express at that point in time is it will be a meaningful contributor because we saw the opportunity, we saw the potential for that business. And now, I think that everybody else is realizing. At the beginning, we were in an investment phase. So, to a certain degree, some of that performance was masked. But now, we're looking at what we're doing in – look at WFSI. WFSI grew 27%. Of course, animal nutrition grew much more than that. And when we look at all the microbiome potential there, that's an incredible accelerator that is still very small. So, I think I answered before to Ken. You have to remember, this is at the beginnings of what we can uncover in terms of profitability. We are just delivering while we are building the business, but there is much more that will come from Nutrition. And I think that if our track record serves us giving you confidence, trust us, much more is coming from Nutrition."
},
{
"speaker": "Eric Larson",
"text": "Thank you very much. Have a good day."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Eric."
},
{
"speaker": "Operator",
"text": "This concludes our question-and-answer session I will now turn the call back over to Victoria de la Huerga for closing remarks."
},
{
"speaker": "Victoria de la Huerga",
"text": "Thank you for joining us today. Slide 10 notes upcoming investor events in which we will be participating. As always, please feel free to follow-up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for participating. You may now disconnect."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 1 | 2,020 | 2020-04-30 11:00:00 | Operator: Ladies and gentlemen, thank you for standing by, and welcome to the ADM First Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Victoria de la Huerga, Vice President, Investor Relations for Archer Daniels Midland Company. Ms. De la Huerga, you may begin.
Victoria de la Huerga: Thank you, Jack. Good morning and welcome to ADM’s first quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. For those following the presentation, please turn to Slide 2, the company's Safe Harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risk and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and CEO, Juan Luciano, will provide an overview ADM’s actions and operations in the current situation, our plans for the future and our view of market conditions. Our Chief Financial Officer, Ray Young, will review financial highlights and corporate results, as well as the drivers of our performance. Juan will then share some closing comments. Afterwards they'll take your question. Please turn to Slide 3. I will now turn the call over to Juan.
Juan Luciano: Thank you, Victoria. Thank you to everyone who is joining us. I hope everyone listening is staying safe and healthy. These are obviously extraordinary times, so I would like to take a little time today to share with you my thoughts on three important topics. First, how ADM is working to protect our teams and how we’re continuing to provide nutrition to the world. Second, how we are thinking about our strategy and long-term plans in this unique times. And third, some views of the near and medium term demand environment and market conditions. Let me start by offering my thanks to our global team and partners. Across more than 800 facilities and thousands of transportation assets around the globe, ADM colleagues in the first quarter not only maintained our operations, but in some areas set production records. These men and women are supporting the global food supply chain and because of them millions, even billions of people who don't know ADM can eat every day. We are grateful for that commitment. Thousands of other colleagues have been enabled by our IT team to work remotely and are showing their flexibility and ingenuity to keep the rest of our business running smoothly. Just a month ago, we were having discussions about whether we would be able to have this earnings call on our normal quarterly schedule, or whether we should delay a week or more. Thanks to our global business services, IT and financial teams, we closed our Q1 books and we are ready to have this call with you today. Take this across 38,000 colleagues and you can see why, as of today, AVM is continuing to fulfill our purpose by providing nutrition around the globe without any significant operational interruptions due to COVID-19 outbreaks. I am honored and grateful to be part of this great team. And I hope all of our ADM colleagues who are listening on this call are proud of their achievements as well. Our leadership team is doing everything we can to support our colleagues. Circumstances changed fast, so every morning since early February, our cross functional leadership team has met to review the global situation, evaluate new risks, and make timely decisions to protect our teams and our business. We put in place strict guidelines to protect our employees and contractors from enacting travel restrictions early in the year, to a critical focus on enabling social distances in our production facilities, to ongoing remote work. When colleagues do develop symptoms, we have protocols designed to protect them and others who might have come in contact with them, as well as support continuity of operations. This includes paid leave for all colleagues during required quarantine periods where necessary to support them and their families. So far, only a relatively small number of ADM colleagues have tested positive. Tragically, we did suffer our first COVID-related fatality two weeks ago. Our thoughts are with everyone who has been personally impacted by this disease. Our ADM colleague emergency fund is available for team members who are facing economic hardship due to the crisis. And through ADM Cares we have committed funds and other resources to support others in communities around the world who are serving on the front lines in the fight against COVID-19. We also made some early decisions in order to strengthen ADM’s position during what was sure to be a challenging operational and economic environment. For example, our balance sheet has historically been a source of strength for ADM. And in March, we further enhanced our cash position and reduced our exposure to short term credit market risks by issuing $1.5 billion in term debt. We are taking other actions, including reducing capital spending to reflect practical limitations in these environments – in this environment, while still completing projects necessary to maintain our facilities in same hot productive order and advanced critical strategic projects. Our team is delivering. Our first quarter adjusted earnings per share was $0.64. Adjusted segment operating profit was $643 million. And our trailing fourth quarter adjusted ROIC was 7.6%. Our performance is a testament to our team's ability to fulfill our critical role in the global food supply chain and deliver results to our shareholders, despite incredibly challenging circumstances. Please turn to Slide 4. As you can see even amid these global challenges, we're also continuing our work to ensure ADM remains strong and vital in the years to come. We are not slowing down in our commitment to delivering our strategy, nor in our focus on the business drivers under our control and our actions to improve the company. I am proud that even as our team was keeping our operations running under difficult circumstances, they also made great progress advancing the strategic imperatives we've defined this year, with accomplishments like improving capital efficiency in Ag Services & Oilseeds, advancing our center of expertise structure with the new global supply chain organization and delivering on our Neovia synergies more than two years ahead of our target. And we continue to advance readiness, which since the program began, has unlocked $920 million in run-rate benefits on an annual basis. All told, thanks to our team's great work we have achieved about 30% of our $500 million to $600 million in targeted improvements for 2020 and we continue to feel good about reaching our goal by the end of the year. We are also ensuring we live up to our critical role as steel were not just of our company, but of the natural resources that are vital to our business and our future. In 2011, we announced our “15x20” plan in which we committed to per unit improvements in energy use, greenhouse gas emissions, water waste to landfill by 2020. We met each of those goals ahead of schedule and this year we were proud to unveil even more ambitious commitments to reduce our absolute greenhouse gas emissions by 25% and our energy intensity by 15% in the next 15 years. Finally, I would like to talk a little bit about our world view of the markets and our future. With major western economies shut down. We are encouraged by the actions many nations are taking to contain the spread of COVID-19 and enabled an eventual recovery. How that recovery unfolds where and at what pace is something we'll be monitoring very carefully. And while precise predictions of these points are difficult, there are a few ways we can categorize some of the market impacts we're seeing. We saw short term acceleration in demand for certain products, such a flower, or stapled packaged goods that we provide flavors and ingredients for as consumers loaded their pantries in advance to stay-at-home orders. Many of these products have reached or will reach saturation point and we expect demand to normalize. Then there are products that have been impacted as a direct result of the various national and local stay-at-home orders. For ADM, that includes refined oils, or food service, as well as biofuels like ethanol and biodiesel. As you know, we've made the difficult decision last week to idle two of our dry mills amid continued low gasoline demand. We would expect to see some of these demand build back in as economies reopen, though there will be a significant variability depending on when and how those re-openings occur. We’re also seeing volatility in margin environments for certain commodity products, as markets constantly reevaluate global supply and demand balances due to a variety of factors. One key element we’re following closely here is the Phase 1 trade agreement with China. We've seen good buying of U.S. agricultural products by China so far this year, which could bode well for future purchases in the back half of the year. Equally as importantly, our global footprint gives us continued confidence in our ability to support global trade flows of food and agricultural products. Then there are the changing behaviors which might have longer term impacts. For example, in the food market we are seeing a back-to-basics approach, desire for comfort foods, snacks and staple goods, while consumers are staying home. We're seeing consumers increasing their purchases online, which impacts the demand for industrial starches used to make cardboard. And we are seeing an increase in interest in products that support health and wellness. There are many unknowns. What we do know, however, is that the transformation that ADM has undertaken over the last several years is now helping ensure that we're well equipped to pivot to whatever our customers require and whatever the world needs. We built up our product portfolio, our footprint, our innovation and our agility. And we are planning for the future. For example, we thought about the potential for changes in how we all interact with each other, our team launched virtual innovation sessions with customers in order to ensure we can continue to meet their needs. We aren't immune from some of the negative effects of the pandemic and its economic fallout. But we're confident in the ability of our great team to continue to provide nutrition around the globe. Now Ray will take us through our business performance before I come back to offer some final comments, before we go to Q&A. Ray, please.
Ray Young: Thanks, Juan. Good day everyone. Please turn to Slide 5. I like to start by echoing Jyan’s thanks to our ADM colleagues around the globe. We are fortunate to have this team and very grateful for their dedication. As Juan mentioned, adjusted EPS for the quarter was $0.64, up from the $0.46 in the prior year quarter. Excluding specified items, adjusted segment operating profit was $643 million. Our trailing four-quarter average adjusted ROIC was 7.6%, higher than our 2020 WACC of 5.75%. In our trailing four-quarter average adjusted EBITDA was about $3.5 billion. The effective tax rate for the first quarter of 2020 was approximately a positive 4% compared to an expense of 26% in the prior year. The favorable current quarter rate was due primarily to the impact of U.S. tax credits signed into law in December including railway maintenance tax credits. The tax credits primarily benefit our business partners and are substantially passed on to them through the prices of goods and services we negotiate to support their respective businesses. That maintenance expense is reflected in the cost of goods sold line of our GAAP statements and then the other charges line in the management statements. Looking ahead, we’re now expecting effective tax rate to be in the range of 13% to 15% before any discrete tax items. We generated about $800 million of cash from operations before working capital for the year, higher than 2019. Return of capital for the full year was about $315 million including about $110 million in opportunistic share repurchases that will offset dilution for the year. We finished the quarter with a net debt-to-total capital ratio of about 29%, down from the 32% a year ago. Capital spending for the quarter was about $200 million. As Juan said in view of a more challenging environment to execute capital projects, for example, due to social distancing consideration, we're reducing our capital spending plans. We expect spending for the year to be closer to $800 million, down from our initial guidance. We'll continue to advance projects and invest in maintenance necessary to run our operations safely and effectively, of course, but some discretionary projects will be put on hold. Next slide please. Over the past several years, we have been diversifying our sources of funding particularly working capital funding so as not to be relying on any one source. These new sources of funding include Euro CP facilities, U.S. and International receivable securitization facilities, and the structured trade financing facilities. In March, we added to this diversification by putting in place a U.S. inventory financing facility. As it became apparent that the COVID-19 situation could disrupt capital markets, we put in place additional global credit facilities as well as issued $1.5 billion of term debt in order to minimize rollover risk of our commercial paper program. The term debt was rated solid single A. In addition, we have been approved for the Federal Reserve’s commercial paper funding facility, which would serve as an additional backstop to our U.S. commercial paper facility. As a result, at the end of March we had cash and marketable securities of $4.7 billion and available untapped global credit facilities of $5.9 billion. The $4.7 billion of cash is much higher than the normal $1 billion that we would normally carry. As a precaution due to dislocations in the short-term credit markets we saw in the month of March. In future quarter ends, you should expect us to carry significantly lower cash balances as we now have the other liquidity facilities in place. We also had $5.6 billion of readily marketable inventories, which if needed we could sell very quickly and turn into cash. When taken together, we feel confident that we will be able to comfortably weather any prolonged downside economic scenarios and continue funding all of our financial and capital spending obligations including dividends in the foreseeable future. Please turn to Slide 7. Other business results were slightly down year-over-year. Futures commission loss provisions were partially offset by improvements in captive insurance operations. In the corporate lines, unallocated corporate costs of $189 million were slightly higher year-over-year principally due to the continued investments in IT and business transformation. Other charges increased due to the railroad maintenance expenses that I referred to earlier that we funded on behalf of U.S. short line railroads and which had an offsetting credit and tax expense, partially offset by improved foreign hedging results on intercompany funding. Net interest expense for the quarter was lower than last year, benefiting from lower average borrowing costs from liability management actions taken in late 2019. Effective January 1st, we decided to discontinue LIFO inventory valuation method accounting. And the corporate results include a LIFO credit of $91 million or $0.12 per share due to the reversal of the LIFO reserve balance. Please turn to slide 8. The Ag Services and Oilseeds team did a great job to deliver strong results. Ag Services results more than doubled versus the first quarter of 2019, which was negatively impacted by high water conditions in North America. Excellent performances in destination marketing and structured trade finance drove extremely strong results in global trade. Robust farmer selling in Brazil drove higher year-over-year origination volumes and margins, which were partially offset by weaker results in North America. Crushing results were lower than the prior-year-period. The team delivered high overall crushed volumes including a Q1 record for soy crush. Execution margins were solid, though below the high realized margins in the first quarter of 2019, which benefited from the short crop in Argentina. The prior-year quarter also benefited from about $75 million of positive timing impacts. Refined Products and other results were higher than the first quarter of 2019. Higher margins in both biodiesel and refined oils in North America were offset by lower biodiesel margins in EMEA. Peanut shelling results were significantly improved versus the prior-year period; as our improvement actions continued to strengthen that business. Wilmar results were significantly higher year-over-year due to stronger performances in tropicals and oilseeds and grain. Slide 9 please. Carbohydrate Solutions results were lower than the first quarter of 2019. As a reminder starting this quarter, we are reporting different subsegments within this business. The new Starches and Sweeteners subsegment, including wet mill ethanol results, was down year-over-year, largely due to about $50 million in negative mark-to-market impacts on forward sales of corn oil, much of which could reverse over the balance of the year. Absent those impacts, results were higher due to improved manufacturing costs driven impart by improvements made at the Decatur complex last year. Strong results in wheat milling as customers fill pantries and improved performance and conditions in EMEA including stronger demand and lower input costs. Vantage Corn Processors or VCP which includes our dry mill ethanol results was slightly higher versus the prior year. Effective risk management, combined with the lack of severe weather impacts seen in the first quarter of 2019, helped offset weak industry ethanol margins caused by significantly decreased demand. To bring the transition – to bridge the transition this quarter under the prior segmentation of Carbohydrate Solutions, the old Starches and Sweeteners would have reported above $160 million of operating profit. And the bio products segments would have reported about negative $92 million of losses, including the $50 million of negative mark-to-market impacts, which would have been split roughly equally between the two sub-segments. We have also included a pro former 2019 restatement of Carbohydrate Solutions in the appendix to this presentation. Slide 10 please. Nutrition continued its growth trajectory with record results. Our Human Nutrition businesses formerly known as WFSI delivered strong performance and growth across the broad portfolio including flavors, especially ingredients and health and wellness. Increased sales revenue in North America and EMEA flavors, continued sales growth in alternative proteins, and additional bioactives income helped drive improved results. As Juan mentioned earlier, we did see higher demand in some human nutrition areas as a result of new wins as well as some pantry loading effects. Animal Nutrition improved year-over-year results were driven by a strong performance from Neovia, good volumes and margins in feed additives, and solid sales in pet care. The prior year quarter also had been negatively impacted by about $10 million in upfront purchase price adjustments related to Neovia. Amino acids were negatively impacted by a year-over-year decline in the global pricing environment though prices were directly improved over Q4 of 2019 we are also very pleased that we met our Neovia synergy targets more than two years early. Our forward look includes some uncertainty as the impacts from the COVID-19 pandemic continue to reverberate through the global economy. Despite this uncertainty as Juan indicated earlier, we remain focused on the drivers under our control and we're on track to deliver to that target range of controllable benefits this year. Now turning to the second quarter directionally. First, Ag Services and Oilseeds we expect segment results to be lower than Q1 subject to mark-to-market impacts as Ag Services seasonally normalizes, crush margins have come off to highs and the RPO business has some headwinds on near-term demand. In Carbohydrate Solutions, we expect the second quarter to be slightly better than Q1 of this year, but much lower than the year ago quarter, as ethanol industry demand and margins continue to be a negative driver and food service demand negatively impacts negatively impacts Starches and Sweeteners. For nutrition, we feel confident that the business will continue to advance to another calendar year of 20% plus growth. Now please turn to Slide 11, and I'll turn it back over to Juan.
Juan Luciano: Thank you, Ray. I spoke a lot at the beginning of the call, so I'll just close by saying this. The core of our existence is the belief that food is fundamental. It sustains us, fulfills us and fuels our well being. Today, our role in providing for that need is more critical than ever. All of our teams are putting safety first as they support the global food supply chain. We're meeting needs that have changed dramatically in just the last few months and we'll be there to continue to provide nutrition to the world as we emerged from this challenge, I've never been prouder to be part of this team and this company, and I never been more confident about our ability to meet the challenges of today and tomorrow. With that, Jack, please open the line for questions.
Operator: Certainly. [Operator Instructions] Ben Bienvenu with Stephens. Your line is open.
Ben Bienvenu: Yes. Thanks, good morning everybody.
Juan Luciano: Good morning, Ben.
Ray Young: Good morning, Ben.
Ben Bienvenu: I want to ask a question. I'll start with crushing. I appreciate the color that you all gave. Two part question. One, if you could quantify what the mark-to-market impact was for the quarter? And then two, when we look at the data relative to what we can track, the results in the quarter were quite a bit lower than we would have expected. And I'm wondering perhaps there's something we can't track whether its basis or some sort of utilization dynamic and in the facilities that limited your ability to generate a little bit higher crushed margins. Any color that you can provide to elaborate on what's happening there would be helpful?
Juan Luciano: Yes. Let me start, Ben and I then Ray can touch on the mark-to-market. So I think what happened – what you see in the first quarter is that the bean market was supported basically by Chinese buying simply by – while the mill value is impacted by demand issues. So you see a cash margins in beans that they tend to track board crash. But this quarter, the impact of soybean bases, as the ability of the farmer to hold the beans increase, impacted our margins. So margins are down year-to-year by about $15 per ton. So I think that that's quite explains the situation. Of course we have expectations that the overall temporary adjustment of the shift in demand will subside as some of this – some of our customers manage this adjustment. But I think in North America that was the biggest impact, if you will. Soybean, crush soybean base is high and mill values being a little bit soft due to lack of demand in food service. With regards to the mark-to-market, I think Ray can provide some more granularity on that.
Ray Young: Yes. On the mark-to-market impact as I indicated, last year if you recall we had some very stable mark-to-market impacts about $75 million. This quarter we didn't – I didn't highlight anything on the call because it was not material, but if you recall, like we entered the quarter with a fairly large balance in terms of deferred gains. But what happened, as you know, is the board crush actually went up during the course of March, right? And so therefore we actually had mark-to-market losses there. And so when you actually take into account of the deferred gains coming into the quarter, and then the mark-to-market – the new mark-to-market losses that we took as board crush went up, they netted out to be fairly immaterial. I mean, it's just really not meaningful in terms of the overall results there. I do want to remind you, it's actually in your supplemental information that at the end of the first quarter we still have about $80 million of deferred gains that will be recognized as we kind of move through the rest of the year there. So hopefully that will help you in terms of understanding where the mark-to-market currently stands.
Ben Bienvenu: It does. Thank you. My second question is related to the Starches and Sweeteners business. Appreciate the bridge back to apples-to-apples result, and appreciate the 2Q commentary. I'm curious when you think about the COVID operating environment, the stronger demand for container board, stronger demand for the packaged foods consumption netted against weaker demand for food service. Do you think this environment is net positive or negative for Starches and Sweeteners and then the big move down that we've seen in that corn costs, while I realize you all hedged a significant component of your cost there? How impactful is that to the business?
Juan Luciano: Yes. I will say as we look at the demand for Starches and Sweeteners, Ben, we see that that the demand was strong for us at least in January and February. So I think that we saw some decline in demand in March, but not that significant. We see – we saw more significant demand decline in April. Over the last two weeks, I'm talking about mostly Sweeteners and Starches. Over the last two weeks we have seen orders pick-up bunk a little bit again, so maybe there is a little bit more energy in the food service markets around the world right now. So I would say a demand of Sweeteners and Starches we're going to see a bigger impact in second quarter that maybe we saw in the first quarter. Of course the second quarter we have less of a mark-to-market corn oil issues and we will continue to enjoy some of the improvements. The operational improvements were strong. The improvement on European operations were strong and milling had a very good quarter, and we're going to have some as you said, lower net corn cost of all that. So – but when you take all the puts and takes with a slower demand, we probably see a slight improvement versus Q1 into Q2 but not a significant one.
Ben Bienvenu: Okay. Thanks. Good luck.
Ray Young: Thank you, Ben.
Operator: Robert Moskow with Credit Suisse. Your line is open.
Robert Moskow: Hi, thanks. There's increased consumption of food at home. Is it your – your message here is that that only partially offsets the decline from consumption of food away from home. And I guess that flows through vegetable oils, Starches and Sweeteners. Maybe can talk a little bit about the impact on animal care also? Maybe there was a pull forward in the first quarter. But is that the big food consumption message that you have here?
Juan Luciano: Rob, I think that it depends on the business and our exposure to food service versus retail. So if you go to the milling business; the milling business had a very good first quarter and we had a good demand everywhere in the world. If you see the nutrition business, I have less exposure to food service was a very strong quarter and that continues to grow. So I would say, they all said depends on your mix. When we go to things like, for example, the corn oil – corn oil goes more to retail. So we saw better demand for, for things like chips. On the other hand, soybean oil goes to more to foodservice. So we see a little bit of weakness there. When we're talking about food service we think though that probably we saw the trust in late, late April, maybe the orders at the – for the beginning for May and we started to see over the last two weeks, things becoming a little bit better. So I think we are a little bit more optimistic as some of the economies start to reopen. We start to see that. We have the benefit of being a global company. We see that pandemic have all been from East to West. So we’re seeing already food services in Asia getting back to maybe 70% to 80% of where they used to be. Of course much more on food deliveries and takeouts and things like that than actually in-room dining. But we see a little bit of that come back. So again, I think you should think about for ADM the impact has been more in food services North America, in terms oil because even package oils in Europe and South America, since South America and Europe has less impact to food service. We have been a little bit more robust on the last point of your question or regarding animal nutrition. How would animal nutrition with the acquisition of Neovia has become very global and very much diversified into many, many applications and business subsections. So we saw strength on that and we expect a lot of that strength to continue. North America has been more impacted and yes, we’re going to see some of that reduction in feed in North America, probably in the second quarter more immediately than in the West.
Robert Moskow: Okay. And then a follow-up if I could. There's been a lot of news flow about liquidations in U.S. livestock. It sounds like a temporary thing. But at what point does that become a risk to domestic soy meal demand here in the U.S.? Do you have any outlook on that?
Juan Luciano: Yes. Of course, that, I mean, it's unfortunate all this impact that COVID has been having in so many people and so many industries. And when we look at the demand for soybean meal, with everything that's happened, of course, it's going to be lower than we have anticipated before. But I think you need to think about this as a temporary adjustment. Most of our customers are shifting as quickly as possible from foodservice to retail. That's probably is going to be – there is still a strong demand in the retail area. And we started to see much more the increase of China imports from the United States in terms of pork and poultry, and that will help medium-term also to exacerbate the demand for soybean meal. So medium term, we are constructive. I think in the short term, we need to go through this volatility of customers shifting their patterns. And we will have to go through that probably in Q2.
Robert Moskow: Okay. Thank you.
Juan Luciano: You’re welcome Rob.
Operator: Ben Kallo with Baird. Your line is open.
Ben Kallo: Hi, thanks for taking my questions. So I’ve two questions. Just one, kind of going back to the last time you talked after the Q4 results. Could you just talk about maybe just generally how you view the market going forward and your level of visibility, if you're better or worse, then? And then can you just talk about the Nutrition business? Because I think it gets lost kind of in all the other parts of the business, and you made significant improvements there. Just – I know you said that there's – the growth will continue next year. But can you just talk more in-depth about how we should think about margin expansion and then the different trends that are driving that business? Because I know you've put a lot of investment into it. And so I think that maybe just reminding us how we should think about that business, especially in this uncharted territory, about how that holds up? And I know there's a lot there, but thank you.
Juan Luciano: No, that’s all right. Thank you, Ben. So let me start with COVID and how I see the world now versus how I saw it the last time we spoke. First of all, I'm proud and also a little bit surprised how well we managed to keep the operations going through all this. If you have told me that we will be running more than 800 plants around the world with minimum staffing, with people in quarantine and running the rest of the company remotely, I mean, I think it's testament of the resilience of the ADM people and business model. So very proud of that. Second, I think fundamentally, we remain very confident because, first of all, we hit the ground running this year and almost ahead of schedule in most of our improvements. Remember, we call for $500 million to $600 million of self-help here. And as I said in my remarks, we are through 25% of the year, we're probably 30% accomplished there. So I'm happy with that. I'm happy with we are executing in Neovia. We achieved synergies three years ahead of schedule. So the team is clicking on all the boxes that we promised to shareholders and to the Board that we were going to do. In terms of demand, I'm normally a little bit more relaxed because we are in the food industry. We are blessed with that, and there is the same number of mouths out there eating. So our role of it in the world continues to be as important as before. We need to go through this shift and this shift benefits some businesses and creates short-term disruptions in some other business, but the fundamental impact of COVID in the first quarter was to the carbohydrate solution business in terms of death and all. There was some biodiesel, but biodiesel North America navigated it better. South America and Europe was a little bit more impacted in terms of biodiesel. But I will say the big impact was scarf solution in ethanol. And that is something that – it was a very big impact because we were coming already in a situation of high inventories and the industry has negative margins already by the time we get into that. And – but you see us again focusing on why we can control them, so what we did in crush, for example, we have adjusted crush margins in North America, crush rates in – operating rates in North America to offset the little bit – the short term issue on demand that we’re having. And we took the difficult decision of take two of the dry mills down in North America. So, I see fundamentally the demand being solid for us. Margins are still good margins. And I still see all the things that the business has been under management team has been focused on hitting in all cylinders and going a little bit ahead of schedule as of Neovia, or the $500 million to $600 million and the readiness efforts. When talking about nutrition, I said to all of our investors over the last year and a half that they been supporting us through all the investment phase in nutrition and nutrition have not been showing that in the P&L because this was organic growth and we have some – some growing pains into some of these assets as you build them and you have to finance them. But when you see now what's starting to happen is what we predicted before is all those wins, all that innovation, we always said we have our value proposition is resonating with our customers. We had that. That line was a little bit masked by all these organic growth that was coming. Now all that organic growth is hitting the P&Ls because these investments are maturing. And you're going to see that and we grew 23% profits last year. We are growing – we are going to grow another north of 20% this year. You see WFSI during this. So take Neovia and animal nutrition out for a minute since the first quarter is a little bit of a strange comparison because we acquired this last first quarter. So but if you take WFSI, WFSI has grown earnings up 28% in the first quarter. So we continue a little bit rhythm of 23 that we deliver last year and flavors are growing at revenue at 7.8%. So, we feel pretty good about that business. It's a very diversified business. And if anything we experienced in COVID with people that come back from this pandemic like we've seen in Asia, is that people come back with a more – with an enhanced focus on health and then the importance of quality nutrition for their wellbeing. So we've seen the probiotics our health and wellness segment is up like 24% in terms of revenue because the sales of those products are – for humans has been probably reemphasized by all this COVID. So we think that we are in the right segments. We think we have the right product mix. So we feel very bullish about – continue this performance for the nutrition business.
Ben Kallo: And thank you. And I will speak one morning if I can to Ray just range on capital allocation. And – how are you looking at it just because I'm sure there are some distressed businesses out there that could fit into your portfolio. And so has that started to happen yet? Or is that you have bigger fish to fry? Or how do we think about that that fitting in just from an acquisition product? Thank you.
Ray Young: Yes. From a capital allocation perspective as you know this year we are focused on further deleveraging the balance sheet to get towards our low twos target range in terms of debt to EBITDA. At the same time as you pointed out me there could be opportunities out there and we're always looking at opportunities out there. So, nothing, nothing clear right now, but I think we'll just keep an open – keep our ears and eyes open. But again, priority at least in the near term is to get our balance sheet into a little bit lower in terms of the leverage position.
Ben Kallo: Perfect. Thanks guys.
Juan Luciano: Thank you, Ben.
Operator: Tom Simonitsch with JPMorgan. Your line is open.
Tom Simonitsch: Good morning.
Juan Luciano: Good morning, Tom.
Tom Simonitsch: Say just given the fall in fuel demand, can you comment on the outlook for – by diesel demand and production relative to your earlier expectations for this year? And is there a potential for a double negative for ADM as you cut the U.S. production and forgo tax credits or those credits just embedded in the margin structure?
Juan Luciano: I think on biodiesel demand what we're seeing, Tom, is in Europe we're actually seeing more of a hit in terms of our biodiesel demand. A part of it is just simply due to the fact that as in Europe, passenger cars actually use diesel a lot in addition to commercial vehicles. And so when you have to shelter-in-place orders come in for Europe, it really negatively impacted the demand environment over there. What's interesting in the United States, we actually have not seen that that drop-off. In fact in the early part of the quarter, we actually saw strong demand for diesel because as you know, trucks, the trucking industry were actually running very, very hard in order to keep the warehouses supplied. And as airlines kind of shut down, a lot of the goods actually start moving on the truck front. So, we've seen on the biodiesel front, which is tied to the really diesel demand that the United States actually has held up reasonably well. In terms of our block, our biodiesel block, we've got it. A lot of it already sold out into the second and third quarter. So we feel good about – this part of the business is actually holding up right now.
Tom Simonitsch: Okay, that's helpful. And then just a clarification on the railway tax credits, you noted that the cost of acquiring those tax credits reduced your pre-tax profit. Can you just confirm that all those associated costs are recognized in the same quarter as the tax benefit?
Ray Young: Yes, I can confirm that. Again, on a GAAP statement, it’s in the cost of goods sold on the management statements you can look at the other charges line and that full amount – and if you look in the appendix, you can see all the information there, like the $73 million of tax credits is fully reflected in the other chargers line of the management statement there.
Tom Simonitsch: That's great. And just one last one for me. If you could maybe just give us some more color around the negative mark-to-market in corn oil. I don't think I've seen that before. So why are we seeing that this quarter?
Ray Young: Yes, you're right. I've never really talked about mark-to-market on corn oil before in prior earnings calls. And frankly, the last time we actually saw this was about 10 years ago. So, what happened was as ethanol plants slowed down around the country then as you know corn oil is a byproduct of ethanol production. And so, we actually saw a reduction in terms of supply of corn oil. At the same time as Juan indicated earlier, we actually saw a significant demand for fried snacks like chips. So actually demand for corn oil actually went up. And so, we actually start seeing a divergence between soybean oil prices and corn oil prices, which again, historically tracked very closely with one another. And so, as corn oil prices, and this really occurred – started occurring at the end of March, as corn oil prices moved up, we have a forward book of sales contracts in corn oil and some of those sales contracts are actually indexed to bean oil, right. And that's just because of history in terms of how – how these prices have correlated. So when we actually mark the book at the end of March for the forward sales contracts that were indexed to bean oil. We actually had to take a mark-to-market loss on that. Now I do expect, as I indicated in my comments that part of this mark-to-market impact it should reverse, it could reverse as we kind of move through the year, due to two factors. One, with higher corn oil price, that means the corn product credit will actually go up as we kind of move through the year, which means net corn costs compared to where we were at the beginning of the year of the should actually come down. And then secondly, as we move through the year as ethanol production actually starts ramping up due to gasoline demand of returning, and as the shelter-in-place orders come off and maybe chip them in and start to come back off a little bit, then you should actually start seeing the historical correlation start returning back again. So that's the reason why I feel that it's kind of move through the next 12 months. Probably in the back half of the year, I should expect about half of the negative mark-to-market to come back in the form of other lower net corn cost, or mark-to-market reversals. As Juan indicated, I think, for the second quarter I do probably expect that the negative mark-to-market to kind of – it's not going to be the same magnitude of $50 million, but we may have some slightly negative mark-to-market in the second quarter as well in Carb Solutions.
Tom Simonitsch: Thanks, Ray. I'll pass it on.
Operator: Ken Zaslow with Bank of Montreal. Your line is open.
Ken Zaslow: Hey good morning everyone.
Juan Luciano: Good morning Ken.
Ray Young: Hey Ken.
Ken Zaslow: Just a couple of quick ones, on the vegetable oil side, are you still making favorable spreads or have they gone to a negative, is there any thoughts of maybe pulling back capacity or anything like that? How is that playing out?
Juan Luciano: Well, as I said before, we have adjusted crush in North America a little bit. So we ran hard in the first quarter. And then at the end of March we adjusted crush into April a little bit. So we are monitoring all that. And as I said before, I think, that soybean oil mostly has been affected in the oil side in North America. It has been more biodiesel impact in the other places, but package oils has been more robust in the other two geographies in Europe and South America.
Ken Zaslow: And can you also take us around the world are the crush margins in Europe, China, Canada, holding up better than that of the U.S.? And if so, what do you attribute that to?
Juan Luciano: Yes, I think in Europe margins are $25 to $35 per ton, so a little bit better. And I think that a couple of things, Argentine crush is still not a major threat to Europe, maybe in six to eight weeks, when the product of all the harvest start hitting the shores of Europe maybe. And then I think that having the – meat is in very good demand in Europe for all the retail issue and the retail segment. And meat packers in Europe have smaller plants. So I think that they have fewer people in all the plants. So the issue of maybe COVID spreading among workers had been less of an issue there. The issue in Europe has been of course the biodiesel as Ray mentioned before, biodiesel is used more for passenger transportation in Europe, so that was absolutely shut down. And so we adjusted the rate to some of those plans. At the moment we are running as much soya crush as we can in Europe, of course, given our advantage there. Brazil margins are more in the $15 to $25 per ton. They are the big farmer selling. Demand for oil has been – for package oil has been good. And then biodiesel we've been able to move enough biodiesel there in Brazil, this is tied to economic activity. And less of a passenger drive, passenger car there. And we've been able to manage more of that. Demand for meat has I continued to be very strong. Most of our customers, they are exporting a lot of their meat to China. So that demand has been very strong. And other than one announcement of a plant with some issues in poultry a week ago all the plants of our customers have been running in Brazil. So far so good in Brazil. So I would say one of the big things that we noticed this quarter in terms of soybean oil has been the great benefits of having the global trade desk actually working together to facilitate that we continue to crush hard, because basically they took care of the oil, exporting that oil. And you see the one of the benefits of the combination between the Ag Services business and Oilseeds is it business is that the global trade works either to place a little bit more of North America mill into export markets or a lot of the oil into the export market so our plants can continue to run. That has been very beneficial to us.
Ken Zaslow: And then my last question is will we finally get a consolidation or a reduction of number of players in ethanol? Is this an event that could really change the structure of the ethanol industry? Or is it one of those you will see production cuts, everybody goes down and then it just kind of rebounds? How do you think about that? And I'll leave it there. Thank you.
Juan Luciano: Yes Ken, that's a good question. I think it depends on probably the duration of this situation. The industry is working at the lowest production rates ever. And I think that we saw more than 70 plants going down. And for somebody that have run plants before it depends on how long it takes for that plant to be down. After a few months, things start becoming complicated and maybe fewer of those plants will be able to come back. So it depends how quickly margins, rebound. But I would say if there is a prolonged activity or low gasoline prices and margins continue to be down for a while, I think, you will see some players not coming back, whether that's enough to restructure the industry is probably a tall order question there that I would not guess to answer at this point.
Ken Zaslow: Great. Thank you very much.
Operator: Heather Jones with Heather Research. Your line is open.
Heather Jones: Hi, thanks for taking the questions. I know we are running out of time, so I'll just do this quickly. Has your corporate expense outlook changed at all given the deterioration in the economic outlook?
Ray Young: No Heather, I know we were a little lower in the first quarter, but a lot of the initiatives that we announced in our fourth quarter call in terms of our business transformation – we have not slowed that down. In fact one argues that these business transformation initiatives are actually very, very important for the long term of ADM. And so we have not diverted from those particular, strategic initiatives there. So the guidance that we provided to you in the fourth quarter for the calendar years remains in place. I think the only thing that's changed in terms of below line is like interest expense. I think that with the addition of long-term debt that we put onto the balance sheet you should expect probably our net interest expense probably be similar to where we were last year.
Heather Jones: Okay, thank you for that. And then Juan, you had mentioned that you guys moderated your crush rate coming into Q2. Lately I've been hearing multiple reports that bean oil storage in the U.S. has become constrained. And so just wondering if you could walk us through that? And how serious it is? And if so is further moderation going to be required?
Juan Luciano: Yes, I think, that during the first quarter we saw, I mean, as you see March when we saw the decline in economic activity around the world that became the limiting factor for crush, it was like, you know, do you have an outset? Do you have a house for soybean oil? As I said, we have been good at using our integration to make that soybean oil disappear and keep crush margins up. Of course the longer this takes inventories start to pop and not everybody have the same ability to place those things with us. And there is a lot of people fighting for liquid storage these days in North America. But I would say, I think, we are comfortable with the level of adjustment in production that we have at this point. We adjusted about five percentage points. And I think for now that that's good. So we don't foresee more at this point. And as I said before, Heather we started to see…
Heather Jones: Okay, [indiscernible].
Juan Luciano: Yes I'm talking about ADM specifically, I wouldn't venture about what's going to happen for the rest of the industry. But as I said we have that benefit of that integration with the global trade. But I would say over the last week and two weeks as China started to reopen and as Europe prepares to reopen and then in some cases they have done, so we started to see a little bit more activity. And I don't know if people replenishing pipeline in preparation for the summer or what. But orders have popped up a little bit over the last two weeks in general for ADM.
Heather Jones: That's great color. Thank you so much.
Juan Luciano: You are welcome Heather.
Operator: As a reminder, please limit yourself to one question. Vincent Andrews with Morgan Stanley, your line is open.
Vincent Andrews : Hi, thanks for taking my question after the hour and I'll keep it to one. Could you just remind us how the – what we used to call WFSI how that business did during the last recession or in economic slowdowns in general? I'm just thinking once we get past COVID there's really still going to be a recessionary environment for who knows how long but long enough. So any help there would be would be great.
Juan Luciano: Yes. Well, we didn't have WFSI on the last recession, so it's difficult to compare. But I think it's a good question in the sense that the business is relatively less exposed to food service than there may be other segments that we have in the company. And it's very, very diversified because the systems, and the flavors and the pantry is so broad that goes into almost every product, whether it's food or beverage. So I would say a pretty resistance in that point. I think that the thing that we are watching very careful is not that much the absolute demand, which we feel comfortable whether it maybe softer in previous scores than it was in Q1 may be there is some adjustment to pantry filling. But I think what we are seeing is our win rates, our ability to place new orders or bring new products have been strong. Our ability to provide existing sales of existing products to existing customers have been good. And I think that what we may see, because we saw that in Asia, it's a little bit of deceleration in innovations in food services in the first quarter because logically companies as they focus more on delivery or pickups or e-commerce, they tend to emphasize their traditional products. You are not going to go to a food service restaurant and order take out something new, you normally go to something that you know. So we've seen a little bit of decline and that started to come back slowly. But that probably will be the shift. The shift is maybe that we sell more of existing products than the proportion we used to sell off innovative products. So we think that the impact of the recession may be a little bit of a delay in the introduction of our new products.
Vincent Andrews : Thank you very much.
Juan Luciano: Thank you, Vince.
Operator: Michael Piken with Cleveland Research, your line is open.
Michael Piken: Yes, hi. I will also limit it to one question. If you could just talk a little bit about kind of what's happening down in Brazil with the port infrastructure and obviously a lot of talk about how they are managing COVID-19 a little differently. But how are your operations going down there? Are you seeing any port backups? And I know you got a slide on farmer selling being pretty good, but just the overall state of the Ag economy down in Brazil would be great.
Juan Luciano: Yes, I would say listen, the team identify of course very early on potentially ports could be a weak point in terms of the COVID issue. And we took all kinds of precautions to make sure that that was not the case, so it was not impacted. And I would say at this point in time, we have no issues in terms of being able to load. There may be a little bit of an extra cost here and there, but nothing, nothing material that we should worry about. In Argentina there has been a little bit of – even in the phase, to be honest, when I said we were preparing because we were preparing for the big export market because of course China has a lot of appetite and Brazilian farmer was selling. So we saw that flow. We're going to have higher volumes which we saw those higher volumes and we see it event even during Q2. So I would say, given that they work in exceptional volumes, the performance has been a stellar because to be honest, minimal disruptions. Some disruptions in Argentina because the Parana River is very low in water. So we have to move some of the loads to Baia Blanca, a little bit more in the ocean side of the country, but also there, we've been loading well, only we changed the port. So I would say – and then even around the world Romania had record exports and the ports were there as well. So I think they will be happy – we will be happy there. In terms of how I see Brazil in general, this COVID, I think, May is going to be a tough month because we are fighting these two streams. On one side the economy and the social pressure to come back to work and the people basically need for their livelihoods. But the number of cases is still going up. And I think the ability to control that makes me a little bit worried about in general, the health situation in Brazil May. But other than that, I would say so far maybe diary was the segment that had been impacted the most from our customers’ perspective. But for the rest so far the business for us has been strong.
Operator: Vincent Anderson with Stifel, your line is open.
Vincent Anderson: Thanks for sneaking me in. Just quickly on Neovia. I was hoping you can breakout the improvement in the quarter between: one, the synergies, obviously the $10 million adjustment from last year broader revenue improvement and then maybe any seasonal factors just for the purpose of framing what the new baseline of earnings power should be for that business all of equal?
Juan Luciano: Yes I'm not sure I have the breakout that easy, but let me say the following there. The Neovia, the way you need to think about it is because it's very diversified geographically and very diversified in the different sub segments. So I don't want to go into a long explanation, but I think the important thing, if you remember when we acquired Neovia, what I said that the Neovia story was actually a margin up story. So it was very complimentary to ADM from a geographical perspective and business perspective, but it was a margin up story. And although our business in Animal Nutrition was above 9% EBITDA margin on sales or where about, the Neovia business was lower than that. And then our expectation was to start moving up that business in two or three phases. And I am happy to report that margins are improving Neovia as we described. So we went from the margin of about 6.5% to about 9.50% in the Q1. So it's a business that is starting to get closer to our first original goal of about 10%. And then we were planning to go into the lower teens. So it's a business that again, has so many segments and so many geographies and they are all recovering differently and being impacted differently. So I don't think that the Q1 yet is a very good quarter for us to go into a lot of analysis into the future because again we have all these economies, there is a lot of Southeast Asia that is still is impacted by coronavirus. There is China that is coming back. There is Brazil that hasn't been impacted. There is Mexico that is being impacted right now. There is North America that is more impacted. So I think that second quarter will give us maybe a better time to make this analysis. But the business will continue to improve. We are revisiting the synergy numbers, of course, after we achieve €50 million target that we set for ourselves. So, we're still – there's still going to be growth rate, positive growth rate. There is still going to be increasing EBITDA margin on sales. It's just that the market at this point in time is too fluid to develop the algorithm right now.
Vincent Anderson: That’s fair enough. Thank you very much.
Operator: And our final question comes from line of Adam Samuelson with Goldman Sachs.
Adam Samuelson: Thank you everyone. Thank you for squeezing me in. I want to ask a question on Ag Services, something you haven't talked about a lot on this call. Just thinking about the outlook over the balance of the year with what looks to be much bigger U.S. supply of corn than potentially beans. Just given the planted acreage and the loss on demand in ethanol, just wanted to get your sense, the outlook for that business is actually improving probably more second-half weighted, but just the view today relative to where you might have been three months ago.
Ray Young: I think…
Juan Luciano: Yes, go ahead Ray.
Ray Young: I think we are actually encouraged in terms of Ag Services, in terms of how they started out in the first quarter, very strong results. We're also encouraged like the planning estimates in the United States are actually fairly strong, too. So it would be quite an improvement in terms of the acreage this year compared to last year where it was negatively impacted by weather. So we should actually have some – assuming the weather holds up and the planning gets in, we should actually have a very good crop of both corn and soybeans as we kind of go through this year in United States. I think the big variable, Adam, is going to be the China and the Phase 1 deal. As Juan indicated, we're very encouraged in terms of China coming in the first quarter to buy, frankly, a whole portfolio of agricultural products, you got sorghum, you got wheat, you got corn and then some soybeans also right now. So we are very encouraged in terms of what China is doing right now in terms of agricultural purchases and all the signals that we're getting and from both the U.S. side and the China side is that they will be executing their agricultural portion of Phase 1 consistent with what they had talked about. So we think as we kind of move through the year that the China will be increasing the amount of purchases of U.S. agricultural products. So you are already seeing that significantly in terms of animal proteins, pork, meat, chicken. I mean, the year-over-year purchases by China are an area of like 300% higher in terms of pork and big numbers in terms of poultry and beef as well. But in terms of soybeans, we are still thinking that for the year it could be 30 million metric tons to 35 million metric tons of purchases from United States as we move through the year. And that's going to be very supportive in terms of the Ag Services business, particularly in the back half of the year here. So overall, I have to say that we're very constructive. If China buys corn in addition to soybeans, that's going to be extremely constructive. And then the other variable, I just want to mention, is that ethanol as part Phase 1 deal is being viewed as part of the agricultural basket in terms of purchases. So as China moves towards honoring the $36 billion of agricultural purchases, it's very possible that ethanol will enter the picture, particularly in the fourth quarter now.
Adam Samuelson: All right, I think, I will stop it there. Thanks so much.
Operator: I will now turn the call back over to Victoria de la Huerga.
Victoria de la Huerga: Thank you for joining us today. Slide 12 notes some upcoming investor events in which we will be participating. As always, please feel free to follow-up with me if you have any other questions. Have a good day. And thanks for your time and interest in ADM.
Operator: This concludes the ADM first quarter 2020 earnings conference call. We thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Ladies and gentlemen, thank you for standing by, and welcome to the ADM First Quarter 2020 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Victoria de la Huerga, Vice President, Investor Relations for Archer Daniels Midland Company. Ms. De la Huerga, you may begin."
},
{
"speaker": "Victoria de la Huerga",
"text": "Thank you, Jack. Good morning and welcome to ADM’s first quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. For those following the presentation, please turn to Slide 2, the company's Safe Harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risk and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and CEO, Juan Luciano, will provide an overview ADM’s actions and operations in the current situation, our plans for the future and our view of market conditions. Our Chief Financial Officer, Ray Young, will review financial highlights and corporate results, as well as the drivers of our performance. Juan will then share some closing comments. Afterwards they'll take your question. Please turn to Slide 3. I will now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Victoria. Thank you to everyone who is joining us. I hope everyone listening is staying safe and healthy. These are obviously extraordinary times, so I would like to take a little time today to share with you my thoughts on three important topics. First, how ADM is working to protect our teams and how we’re continuing to provide nutrition to the world. Second, how we are thinking about our strategy and long-term plans in this unique times. And third, some views of the near and medium term demand environment and market conditions. Let me start by offering my thanks to our global team and partners. Across more than 800 facilities and thousands of transportation assets around the globe, ADM colleagues in the first quarter not only maintained our operations, but in some areas set production records. These men and women are supporting the global food supply chain and because of them millions, even billions of people who don't know ADM can eat every day. We are grateful for that commitment. Thousands of other colleagues have been enabled by our IT team to work remotely and are showing their flexibility and ingenuity to keep the rest of our business running smoothly. Just a month ago, we were having discussions about whether we would be able to have this earnings call on our normal quarterly schedule, or whether we should delay a week or more. Thanks to our global business services, IT and financial teams, we closed our Q1 books and we are ready to have this call with you today. Take this across 38,000 colleagues and you can see why, as of today, AVM is continuing to fulfill our purpose by providing nutrition around the globe without any significant operational interruptions due to COVID-19 outbreaks. I am honored and grateful to be part of this great team. And I hope all of our ADM colleagues who are listening on this call are proud of their achievements as well. Our leadership team is doing everything we can to support our colleagues. Circumstances changed fast, so every morning since early February, our cross functional leadership team has met to review the global situation, evaluate new risks, and make timely decisions to protect our teams and our business. We put in place strict guidelines to protect our employees and contractors from enacting travel restrictions early in the year, to a critical focus on enabling social distances in our production facilities, to ongoing remote work. When colleagues do develop symptoms, we have protocols designed to protect them and others who might have come in contact with them, as well as support continuity of operations. This includes paid leave for all colleagues during required quarantine periods where necessary to support them and their families. So far, only a relatively small number of ADM colleagues have tested positive. Tragically, we did suffer our first COVID-related fatality two weeks ago. Our thoughts are with everyone who has been personally impacted by this disease. Our ADM colleague emergency fund is available for team members who are facing economic hardship due to the crisis. And through ADM Cares we have committed funds and other resources to support others in communities around the world who are serving on the front lines in the fight against COVID-19. We also made some early decisions in order to strengthen ADM’s position during what was sure to be a challenging operational and economic environment. For example, our balance sheet has historically been a source of strength for ADM. And in March, we further enhanced our cash position and reduced our exposure to short term credit market risks by issuing $1.5 billion in term debt. We are taking other actions, including reducing capital spending to reflect practical limitations in these environments – in this environment, while still completing projects necessary to maintain our facilities in same hot productive order and advanced critical strategic projects. Our team is delivering. Our first quarter adjusted earnings per share was $0.64. Adjusted segment operating profit was $643 million. And our trailing fourth quarter adjusted ROIC was 7.6%. Our performance is a testament to our team's ability to fulfill our critical role in the global food supply chain and deliver results to our shareholders, despite incredibly challenging circumstances. Please turn to Slide 4. As you can see even amid these global challenges, we're also continuing our work to ensure ADM remains strong and vital in the years to come. We are not slowing down in our commitment to delivering our strategy, nor in our focus on the business drivers under our control and our actions to improve the company. I am proud that even as our team was keeping our operations running under difficult circumstances, they also made great progress advancing the strategic imperatives we've defined this year, with accomplishments like improving capital efficiency in Ag Services & Oilseeds, advancing our center of expertise structure with the new global supply chain organization and delivering on our Neovia synergies more than two years ahead of our target. And we continue to advance readiness, which since the program began, has unlocked $920 million in run-rate benefits on an annual basis. All told, thanks to our team's great work we have achieved about 30% of our $500 million to $600 million in targeted improvements for 2020 and we continue to feel good about reaching our goal by the end of the year. We are also ensuring we live up to our critical role as steel were not just of our company, but of the natural resources that are vital to our business and our future. In 2011, we announced our “15x20” plan in which we committed to per unit improvements in energy use, greenhouse gas emissions, water waste to landfill by 2020. We met each of those goals ahead of schedule and this year we were proud to unveil even more ambitious commitments to reduce our absolute greenhouse gas emissions by 25% and our energy intensity by 15% in the next 15 years. Finally, I would like to talk a little bit about our world view of the markets and our future. With major western economies shut down. We are encouraged by the actions many nations are taking to contain the spread of COVID-19 and enabled an eventual recovery. How that recovery unfolds where and at what pace is something we'll be monitoring very carefully. And while precise predictions of these points are difficult, there are a few ways we can categorize some of the market impacts we're seeing. We saw short term acceleration in demand for certain products, such a flower, or stapled packaged goods that we provide flavors and ingredients for as consumers loaded their pantries in advance to stay-at-home orders. Many of these products have reached or will reach saturation point and we expect demand to normalize. Then there are products that have been impacted as a direct result of the various national and local stay-at-home orders. For ADM, that includes refined oils, or food service, as well as biofuels like ethanol and biodiesel. As you know, we've made the difficult decision last week to idle two of our dry mills amid continued low gasoline demand. We would expect to see some of these demand build back in as economies reopen, though there will be a significant variability depending on when and how those re-openings occur. We’re also seeing volatility in margin environments for certain commodity products, as markets constantly reevaluate global supply and demand balances due to a variety of factors. One key element we’re following closely here is the Phase 1 trade agreement with China. We've seen good buying of U.S. agricultural products by China so far this year, which could bode well for future purchases in the back half of the year. Equally as importantly, our global footprint gives us continued confidence in our ability to support global trade flows of food and agricultural products. Then there are the changing behaviors which might have longer term impacts. For example, in the food market we are seeing a back-to-basics approach, desire for comfort foods, snacks and staple goods, while consumers are staying home. We're seeing consumers increasing their purchases online, which impacts the demand for industrial starches used to make cardboard. And we are seeing an increase in interest in products that support health and wellness. There are many unknowns. What we do know, however, is that the transformation that ADM has undertaken over the last several years is now helping ensure that we're well equipped to pivot to whatever our customers require and whatever the world needs. We built up our product portfolio, our footprint, our innovation and our agility. And we are planning for the future. For example, we thought about the potential for changes in how we all interact with each other, our team launched virtual innovation sessions with customers in order to ensure we can continue to meet their needs. We aren't immune from some of the negative effects of the pandemic and its economic fallout. But we're confident in the ability of our great team to continue to provide nutrition around the globe. Now Ray will take us through our business performance before I come back to offer some final comments, before we go to Q&A. Ray, please."
},
{
"speaker": "Ray Young",
"text": "Thanks, Juan. Good day everyone. Please turn to Slide 5. I like to start by echoing Jyan’s thanks to our ADM colleagues around the globe. We are fortunate to have this team and very grateful for their dedication. As Juan mentioned, adjusted EPS for the quarter was $0.64, up from the $0.46 in the prior year quarter. Excluding specified items, adjusted segment operating profit was $643 million. Our trailing four-quarter average adjusted ROIC was 7.6%, higher than our 2020 WACC of 5.75%. In our trailing four-quarter average adjusted EBITDA was about $3.5 billion. The effective tax rate for the first quarter of 2020 was approximately a positive 4% compared to an expense of 26% in the prior year. The favorable current quarter rate was due primarily to the impact of U.S. tax credits signed into law in December including railway maintenance tax credits. The tax credits primarily benefit our business partners and are substantially passed on to them through the prices of goods and services we negotiate to support their respective businesses. That maintenance expense is reflected in the cost of goods sold line of our GAAP statements and then the other charges line in the management statements. Looking ahead, we’re now expecting effective tax rate to be in the range of 13% to 15% before any discrete tax items. We generated about $800 million of cash from operations before working capital for the year, higher than 2019. Return of capital for the full year was about $315 million including about $110 million in opportunistic share repurchases that will offset dilution for the year. We finished the quarter with a net debt-to-total capital ratio of about 29%, down from the 32% a year ago. Capital spending for the quarter was about $200 million. As Juan said in view of a more challenging environment to execute capital projects, for example, due to social distancing consideration, we're reducing our capital spending plans. We expect spending for the year to be closer to $800 million, down from our initial guidance. We'll continue to advance projects and invest in maintenance necessary to run our operations safely and effectively, of course, but some discretionary projects will be put on hold. Next slide please. Over the past several years, we have been diversifying our sources of funding particularly working capital funding so as not to be relying on any one source. These new sources of funding include Euro CP facilities, U.S. and International receivable securitization facilities, and the structured trade financing facilities. In March, we added to this diversification by putting in place a U.S. inventory financing facility. As it became apparent that the COVID-19 situation could disrupt capital markets, we put in place additional global credit facilities as well as issued $1.5 billion of term debt in order to minimize rollover risk of our commercial paper program. The term debt was rated solid single A. In addition, we have been approved for the Federal Reserve’s commercial paper funding facility, which would serve as an additional backstop to our U.S. commercial paper facility. As a result, at the end of March we had cash and marketable securities of $4.7 billion and available untapped global credit facilities of $5.9 billion. The $4.7 billion of cash is much higher than the normal $1 billion that we would normally carry. As a precaution due to dislocations in the short-term credit markets we saw in the month of March. In future quarter ends, you should expect us to carry significantly lower cash balances as we now have the other liquidity facilities in place. We also had $5.6 billion of readily marketable inventories, which if needed we could sell very quickly and turn into cash. When taken together, we feel confident that we will be able to comfortably weather any prolonged downside economic scenarios and continue funding all of our financial and capital spending obligations including dividends in the foreseeable future. Please turn to Slide 7. Other business results were slightly down year-over-year. Futures commission loss provisions were partially offset by improvements in captive insurance operations. In the corporate lines, unallocated corporate costs of $189 million were slightly higher year-over-year principally due to the continued investments in IT and business transformation. Other charges increased due to the railroad maintenance expenses that I referred to earlier that we funded on behalf of U.S. short line railroads and which had an offsetting credit and tax expense, partially offset by improved foreign hedging results on intercompany funding. Net interest expense for the quarter was lower than last year, benefiting from lower average borrowing costs from liability management actions taken in late 2019. Effective January 1st, we decided to discontinue LIFO inventory valuation method accounting. And the corporate results include a LIFO credit of $91 million or $0.12 per share due to the reversal of the LIFO reserve balance. Please turn to slide 8. The Ag Services and Oilseeds team did a great job to deliver strong results. Ag Services results more than doubled versus the first quarter of 2019, which was negatively impacted by high water conditions in North America. Excellent performances in destination marketing and structured trade finance drove extremely strong results in global trade. Robust farmer selling in Brazil drove higher year-over-year origination volumes and margins, which were partially offset by weaker results in North America. Crushing results were lower than the prior-year-period. The team delivered high overall crushed volumes including a Q1 record for soy crush. Execution margins were solid, though below the high realized margins in the first quarter of 2019, which benefited from the short crop in Argentina. The prior-year quarter also benefited from about $75 million of positive timing impacts. Refined Products and other results were higher than the first quarter of 2019. Higher margins in both biodiesel and refined oils in North America were offset by lower biodiesel margins in EMEA. Peanut shelling results were significantly improved versus the prior-year period; as our improvement actions continued to strengthen that business. Wilmar results were significantly higher year-over-year due to stronger performances in tropicals and oilseeds and grain. Slide 9 please. Carbohydrate Solutions results were lower than the first quarter of 2019. As a reminder starting this quarter, we are reporting different subsegments within this business. The new Starches and Sweeteners subsegment, including wet mill ethanol results, was down year-over-year, largely due to about $50 million in negative mark-to-market impacts on forward sales of corn oil, much of which could reverse over the balance of the year. Absent those impacts, results were higher due to improved manufacturing costs driven impart by improvements made at the Decatur complex last year. Strong results in wheat milling as customers fill pantries and improved performance and conditions in EMEA including stronger demand and lower input costs. Vantage Corn Processors or VCP which includes our dry mill ethanol results was slightly higher versus the prior year. Effective risk management, combined with the lack of severe weather impacts seen in the first quarter of 2019, helped offset weak industry ethanol margins caused by significantly decreased demand. To bring the transition – to bridge the transition this quarter under the prior segmentation of Carbohydrate Solutions, the old Starches and Sweeteners would have reported above $160 million of operating profit. And the bio products segments would have reported about negative $92 million of losses, including the $50 million of negative mark-to-market impacts, which would have been split roughly equally between the two sub-segments. We have also included a pro former 2019 restatement of Carbohydrate Solutions in the appendix to this presentation. Slide 10 please. Nutrition continued its growth trajectory with record results. Our Human Nutrition businesses formerly known as WFSI delivered strong performance and growth across the broad portfolio including flavors, especially ingredients and health and wellness. Increased sales revenue in North America and EMEA flavors, continued sales growth in alternative proteins, and additional bioactives income helped drive improved results. As Juan mentioned earlier, we did see higher demand in some human nutrition areas as a result of new wins as well as some pantry loading effects. Animal Nutrition improved year-over-year results were driven by a strong performance from Neovia, good volumes and margins in feed additives, and solid sales in pet care. The prior year quarter also had been negatively impacted by about $10 million in upfront purchase price adjustments related to Neovia. Amino acids were negatively impacted by a year-over-year decline in the global pricing environment though prices were directly improved over Q4 of 2019 we are also very pleased that we met our Neovia synergy targets more than two years early. Our forward look includes some uncertainty as the impacts from the COVID-19 pandemic continue to reverberate through the global economy. Despite this uncertainty as Juan indicated earlier, we remain focused on the drivers under our control and we're on track to deliver to that target range of controllable benefits this year. Now turning to the second quarter directionally. First, Ag Services and Oilseeds we expect segment results to be lower than Q1 subject to mark-to-market impacts as Ag Services seasonally normalizes, crush margins have come off to highs and the RPO business has some headwinds on near-term demand. In Carbohydrate Solutions, we expect the second quarter to be slightly better than Q1 of this year, but much lower than the year ago quarter, as ethanol industry demand and margins continue to be a negative driver and food service demand negatively impacts negatively impacts Starches and Sweeteners. For nutrition, we feel confident that the business will continue to advance to another calendar year of 20% plus growth. Now please turn to Slide 11, and I'll turn it back over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ray. I spoke a lot at the beginning of the call, so I'll just close by saying this. The core of our existence is the belief that food is fundamental. It sustains us, fulfills us and fuels our well being. Today, our role in providing for that need is more critical than ever. All of our teams are putting safety first as they support the global food supply chain. We're meeting needs that have changed dramatically in just the last few months and we'll be there to continue to provide nutrition to the world as we emerged from this challenge, I've never been prouder to be part of this team and this company, and I never been more confident about our ability to meet the challenges of today and tomorrow. With that, Jack, please open the line for questions."
},
{
"speaker": "Operator",
"text": "Certainly. [Operator Instructions] Ben Bienvenu with Stephens. Your line is open."
},
{
"speaker": "Ben Bienvenu",
"text": "Yes. Thanks, good morning everybody."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ben."
},
{
"speaker": "Ray Young",
"text": "Good morning, Ben."
},
{
"speaker": "Ben Bienvenu",
"text": "I want to ask a question. I'll start with crushing. I appreciate the color that you all gave. Two part question. One, if you could quantify what the mark-to-market impact was for the quarter? And then two, when we look at the data relative to what we can track, the results in the quarter were quite a bit lower than we would have expected. And I'm wondering perhaps there's something we can't track whether its basis or some sort of utilization dynamic and in the facilities that limited your ability to generate a little bit higher crushed margins. Any color that you can provide to elaborate on what's happening there would be helpful?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Let me start, Ben and I then Ray can touch on the mark-to-market. So I think what happened – what you see in the first quarter is that the bean market was supported basically by Chinese buying simply by – while the mill value is impacted by demand issues. So you see a cash margins in beans that they tend to track board crash. But this quarter, the impact of soybean bases, as the ability of the farmer to hold the beans increase, impacted our margins. So margins are down year-to-year by about $15 per ton. So I think that that's quite explains the situation. Of course we have expectations that the overall temporary adjustment of the shift in demand will subside as some of this – some of our customers manage this adjustment. But I think in North America that was the biggest impact, if you will. Soybean, crush soybean base is high and mill values being a little bit soft due to lack of demand in food service. With regards to the mark-to-market, I think Ray can provide some more granularity on that."
},
{
"speaker": "Ray Young",
"text": "Yes. On the mark-to-market impact as I indicated, last year if you recall we had some very stable mark-to-market impacts about $75 million. This quarter we didn't – I didn't highlight anything on the call because it was not material, but if you recall, like we entered the quarter with a fairly large balance in terms of deferred gains. But what happened, as you know, is the board crush actually went up during the course of March, right? And so therefore we actually had mark-to-market losses there. And so when you actually take into account of the deferred gains coming into the quarter, and then the mark-to-market – the new mark-to-market losses that we took as board crush went up, they netted out to be fairly immaterial. I mean, it's just really not meaningful in terms of the overall results there. I do want to remind you, it's actually in your supplemental information that at the end of the first quarter we still have about $80 million of deferred gains that will be recognized as we kind of move through the rest of the year there. So hopefully that will help you in terms of understanding where the mark-to-market currently stands."
},
{
"speaker": "Ben Bienvenu",
"text": "It does. Thank you. My second question is related to the Starches and Sweeteners business. Appreciate the bridge back to apples-to-apples result, and appreciate the 2Q commentary. I'm curious when you think about the COVID operating environment, the stronger demand for container board, stronger demand for the packaged foods consumption netted against weaker demand for food service. Do you think this environment is net positive or negative for Starches and Sweeteners and then the big move down that we've seen in that corn costs, while I realize you all hedged a significant component of your cost there? How impactful is that to the business?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I will say as we look at the demand for Starches and Sweeteners, Ben, we see that that the demand was strong for us at least in January and February. So I think that we saw some decline in demand in March, but not that significant. We see – we saw more significant demand decline in April. Over the last two weeks, I'm talking about mostly Sweeteners and Starches. Over the last two weeks we have seen orders pick-up bunk a little bit again, so maybe there is a little bit more energy in the food service markets around the world right now. So I would say a demand of Sweeteners and Starches we're going to see a bigger impact in second quarter that maybe we saw in the first quarter. Of course the second quarter we have less of a mark-to-market corn oil issues and we will continue to enjoy some of the improvements. The operational improvements were strong. The improvement on European operations were strong and milling had a very good quarter, and we're going to have some as you said, lower net corn cost of all that. So – but when you take all the puts and takes with a slower demand, we probably see a slight improvement versus Q1 into Q2 but not a significant one."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay. Thanks. Good luck."
},
{
"speaker": "Ray Young",
"text": "Thank you, Ben."
},
{
"speaker": "Operator",
"text": "Robert Moskow with Credit Suisse. Your line is open."
},
{
"speaker": "Robert Moskow",
"text": "Hi, thanks. There's increased consumption of food at home. Is it your – your message here is that that only partially offsets the decline from consumption of food away from home. And I guess that flows through vegetable oils, Starches and Sweeteners. Maybe can talk a little bit about the impact on animal care also? Maybe there was a pull forward in the first quarter. But is that the big food consumption message that you have here?"
},
{
"speaker": "Juan Luciano",
"text": "Rob, I think that it depends on the business and our exposure to food service versus retail. So if you go to the milling business; the milling business had a very good first quarter and we had a good demand everywhere in the world. If you see the nutrition business, I have less exposure to food service was a very strong quarter and that continues to grow. So I would say, they all said depends on your mix. When we go to things like, for example, the corn oil – corn oil goes more to retail. So we saw better demand for, for things like chips. On the other hand, soybean oil goes to more to foodservice. So we see a little bit of weakness there. When we're talking about food service we think though that probably we saw the trust in late, late April, maybe the orders at the – for the beginning for May and we started to see over the last two weeks, things becoming a little bit better. So I think we are a little bit more optimistic as some of the economies start to reopen. We start to see that. We have the benefit of being a global company. We see that pandemic have all been from East to West. So we’re seeing already food services in Asia getting back to maybe 70% to 80% of where they used to be. Of course much more on food deliveries and takeouts and things like that than actually in-room dining. But we see a little bit of that come back. So again, I think you should think about for ADM the impact has been more in food services North America, in terms oil because even package oils in Europe and South America, since South America and Europe has less impact to food service. We have been a little bit more robust on the last point of your question or regarding animal nutrition. How would animal nutrition with the acquisition of Neovia has become very global and very much diversified into many, many applications and business subsections. So we saw strength on that and we expect a lot of that strength to continue. North America has been more impacted and yes, we’re going to see some of that reduction in feed in North America, probably in the second quarter more immediately than in the West."
},
{
"speaker": "Robert Moskow",
"text": "Okay. And then a follow-up if I could. There's been a lot of news flow about liquidations in U.S. livestock. It sounds like a temporary thing. But at what point does that become a risk to domestic soy meal demand here in the U.S.? Do you have any outlook on that?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Of course, that, I mean, it's unfortunate all this impact that COVID has been having in so many people and so many industries. And when we look at the demand for soybean meal, with everything that's happened, of course, it's going to be lower than we have anticipated before. But I think you need to think about this as a temporary adjustment. Most of our customers are shifting as quickly as possible from foodservice to retail. That's probably is going to be – there is still a strong demand in the retail area. And we started to see much more the increase of China imports from the United States in terms of pork and poultry, and that will help medium-term also to exacerbate the demand for soybean meal. So medium term, we are constructive. I think in the short term, we need to go through this volatility of customers shifting their patterns. And we will have to go through that probably in Q2."
},
{
"speaker": "Robert Moskow",
"text": "Okay. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "You’re welcome Rob."
},
{
"speaker": "Operator",
"text": "Ben Kallo with Baird. Your line is open."
},
{
"speaker": "Ben Kallo",
"text": "Hi, thanks for taking my questions. So I’ve two questions. Just one, kind of going back to the last time you talked after the Q4 results. Could you just talk about maybe just generally how you view the market going forward and your level of visibility, if you're better or worse, then? And then can you just talk about the Nutrition business? Because I think it gets lost kind of in all the other parts of the business, and you made significant improvements there. Just – I know you said that there's – the growth will continue next year. But can you just talk more in-depth about how we should think about margin expansion and then the different trends that are driving that business? Because I know you've put a lot of investment into it. And so I think that maybe just reminding us how we should think about that business, especially in this uncharted territory, about how that holds up? And I know there's a lot there, but thank you."
},
{
"speaker": "Juan Luciano",
"text": "No, that’s all right. Thank you, Ben. So let me start with COVID and how I see the world now versus how I saw it the last time we spoke. First of all, I'm proud and also a little bit surprised how well we managed to keep the operations going through all this. If you have told me that we will be running more than 800 plants around the world with minimum staffing, with people in quarantine and running the rest of the company remotely, I mean, I think it's testament of the resilience of the ADM people and business model. So very proud of that. Second, I think fundamentally, we remain very confident because, first of all, we hit the ground running this year and almost ahead of schedule in most of our improvements. Remember, we call for $500 million to $600 million of self-help here. And as I said in my remarks, we are through 25% of the year, we're probably 30% accomplished there. So I'm happy with that. I'm happy with we are executing in Neovia. We achieved synergies three years ahead of schedule. So the team is clicking on all the boxes that we promised to shareholders and to the Board that we were going to do. In terms of demand, I'm normally a little bit more relaxed because we are in the food industry. We are blessed with that, and there is the same number of mouths out there eating. So our role of it in the world continues to be as important as before. We need to go through this shift and this shift benefits some businesses and creates short-term disruptions in some other business, but the fundamental impact of COVID in the first quarter was to the carbohydrate solution business in terms of death and all. There was some biodiesel, but biodiesel North America navigated it better. South America and Europe was a little bit more impacted in terms of biodiesel. But I will say the big impact was scarf solution in ethanol. And that is something that – it was a very big impact because we were coming already in a situation of high inventories and the industry has negative margins already by the time we get into that. And – but you see us again focusing on why we can control them, so what we did in crush, for example, we have adjusted crush margins in North America, crush rates in – operating rates in North America to offset the little bit – the short term issue on demand that we’re having. And we took the difficult decision of take two of the dry mills down in North America. So, I see fundamentally the demand being solid for us. Margins are still good margins. And I still see all the things that the business has been under management team has been focused on hitting in all cylinders and going a little bit ahead of schedule as of Neovia, or the $500 million to $600 million and the readiness efforts. When talking about nutrition, I said to all of our investors over the last year and a half that they been supporting us through all the investment phase in nutrition and nutrition have not been showing that in the P&L because this was organic growth and we have some – some growing pains into some of these assets as you build them and you have to finance them. But when you see now what's starting to happen is what we predicted before is all those wins, all that innovation, we always said we have our value proposition is resonating with our customers. We had that. That line was a little bit masked by all these organic growth that was coming. Now all that organic growth is hitting the P&Ls because these investments are maturing. And you're going to see that and we grew 23% profits last year. We are growing – we are going to grow another north of 20% this year. You see WFSI during this. So take Neovia and animal nutrition out for a minute since the first quarter is a little bit of a strange comparison because we acquired this last first quarter. So but if you take WFSI, WFSI has grown earnings up 28% in the first quarter. So we continue a little bit rhythm of 23 that we deliver last year and flavors are growing at revenue at 7.8%. So, we feel pretty good about that business. It's a very diversified business. And if anything we experienced in COVID with people that come back from this pandemic like we've seen in Asia, is that people come back with a more – with an enhanced focus on health and then the importance of quality nutrition for their wellbeing. So we've seen the probiotics our health and wellness segment is up like 24% in terms of revenue because the sales of those products are – for humans has been probably reemphasized by all this COVID. So we think that we are in the right segments. We think we have the right product mix. So we feel very bullish about – continue this performance for the nutrition business."
},
{
"speaker": "Ben Kallo",
"text": "And thank you. And I will speak one morning if I can to Ray just range on capital allocation. And – how are you looking at it just because I'm sure there are some distressed businesses out there that could fit into your portfolio. And so has that started to happen yet? Or is that you have bigger fish to fry? Or how do we think about that that fitting in just from an acquisition product? Thank you."
},
{
"speaker": "Ray Young",
"text": "Yes. From a capital allocation perspective as you know this year we are focused on further deleveraging the balance sheet to get towards our low twos target range in terms of debt to EBITDA. At the same time as you pointed out me there could be opportunities out there and we're always looking at opportunities out there. So, nothing, nothing clear right now, but I think we'll just keep an open – keep our ears and eyes open. But again, priority at least in the near term is to get our balance sheet into a little bit lower in terms of the leverage position."
},
{
"speaker": "Ben Kallo",
"text": "Perfect. Thanks guys."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ben."
},
{
"speaker": "Operator",
"text": "Tom Simonitsch with JPMorgan. Your line is open."
},
{
"speaker": "Tom Simonitsch",
"text": "Good morning."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Tom."
},
{
"speaker": "Tom Simonitsch",
"text": "Say just given the fall in fuel demand, can you comment on the outlook for – by diesel demand and production relative to your earlier expectations for this year? And is there a potential for a double negative for ADM as you cut the U.S. production and forgo tax credits or those credits just embedded in the margin structure?"
},
{
"speaker": "Juan Luciano",
"text": "I think on biodiesel demand what we're seeing, Tom, is in Europe we're actually seeing more of a hit in terms of our biodiesel demand. A part of it is just simply due to the fact that as in Europe, passenger cars actually use diesel a lot in addition to commercial vehicles. And so when you have to shelter-in-place orders come in for Europe, it really negatively impacted the demand environment over there. What's interesting in the United States, we actually have not seen that that drop-off. In fact in the early part of the quarter, we actually saw strong demand for diesel because as you know, trucks, the trucking industry were actually running very, very hard in order to keep the warehouses supplied. And as airlines kind of shut down, a lot of the goods actually start moving on the truck front. So, we've seen on the biodiesel front, which is tied to the really diesel demand that the United States actually has held up reasonably well. In terms of our block, our biodiesel block, we've got it. A lot of it already sold out into the second and third quarter. So we feel good about – this part of the business is actually holding up right now."
},
{
"speaker": "Tom Simonitsch",
"text": "Okay, that's helpful. And then just a clarification on the railway tax credits, you noted that the cost of acquiring those tax credits reduced your pre-tax profit. Can you just confirm that all those associated costs are recognized in the same quarter as the tax benefit?"
},
{
"speaker": "Ray Young",
"text": "Yes, I can confirm that. Again, on a GAAP statement, it’s in the cost of goods sold on the management statements you can look at the other charges line and that full amount – and if you look in the appendix, you can see all the information there, like the $73 million of tax credits is fully reflected in the other chargers line of the management statement there."
},
{
"speaker": "Tom Simonitsch",
"text": "That's great. And just one last one for me. If you could maybe just give us some more color around the negative mark-to-market in corn oil. I don't think I've seen that before. So why are we seeing that this quarter?"
},
{
"speaker": "Ray Young",
"text": "Yes, you're right. I've never really talked about mark-to-market on corn oil before in prior earnings calls. And frankly, the last time we actually saw this was about 10 years ago. So, what happened was as ethanol plants slowed down around the country then as you know corn oil is a byproduct of ethanol production. And so, we actually saw a reduction in terms of supply of corn oil. At the same time as Juan indicated earlier, we actually saw a significant demand for fried snacks like chips. So actually demand for corn oil actually went up. And so, we actually start seeing a divergence between soybean oil prices and corn oil prices, which again, historically tracked very closely with one another. And so, as corn oil prices, and this really occurred – started occurring at the end of March, as corn oil prices moved up, we have a forward book of sales contracts in corn oil and some of those sales contracts are actually indexed to bean oil, right. And that's just because of history in terms of how – how these prices have correlated. So when we actually mark the book at the end of March for the forward sales contracts that were indexed to bean oil. We actually had to take a mark-to-market loss on that. Now I do expect, as I indicated in my comments that part of this mark-to-market impact it should reverse, it could reverse as we kind of move through the year, due to two factors. One, with higher corn oil price, that means the corn product credit will actually go up as we kind of move through the year, which means net corn costs compared to where we were at the beginning of the year of the should actually come down. And then secondly, as we move through the year as ethanol production actually starts ramping up due to gasoline demand of returning, and as the shelter-in-place orders come off and maybe chip them in and start to come back off a little bit, then you should actually start seeing the historical correlation start returning back again. So that's the reason why I feel that it's kind of move through the next 12 months. Probably in the back half of the year, I should expect about half of the negative mark-to-market to come back in the form of other lower net corn cost, or mark-to-market reversals. As Juan indicated, I think, for the second quarter I do probably expect that the negative mark-to-market to kind of – it's not going to be the same magnitude of $50 million, but we may have some slightly negative mark-to-market in the second quarter as well in Carb Solutions."
},
{
"speaker": "Tom Simonitsch",
"text": "Thanks, Ray. I'll pass it on."
},
{
"speaker": "Operator",
"text": "Ken Zaslow with Bank of Montreal. Your line is open."
},
{
"speaker": "Ken Zaslow",
"text": "Hey good morning everyone."
},
{
"speaker": "Juan Luciano",
"text": "Good morning Ken."
},
{
"speaker": "Ray Young",
"text": "Hey Ken."
},
{
"speaker": "Ken Zaslow",
"text": "Just a couple of quick ones, on the vegetable oil side, are you still making favorable spreads or have they gone to a negative, is there any thoughts of maybe pulling back capacity or anything like that? How is that playing out?"
},
{
"speaker": "Juan Luciano",
"text": "Well, as I said before, we have adjusted crush in North America a little bit. So we ran hard in the first quarter. And then at the end of March we adjusted crush into April a little bit. So we are monitoring all that. And as I said before, I think, that soybean oil mostly has been affected in the oil side in North America. It has been more biodiesel impact in the other places, but package oils has been more robust in the other two geographies in Europe and South America."
},
{
"speaker": "Ken Zaslow",
"text": "And can you also take us around the world are the crush margins in Europe, China, Canada, holding up better than that of the U.S.? And if so, what do you attribute that to?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, I think in Europe margins are $25 to $35 per ton, so a little bit better. And I think that a couple of things, Argentine crush is still not a major threat to Europe, maybe in six to eight weeks, when the product of all the harvest start hitting the shores of Europe maybe. And then I think that having the – meat is in very good demand in Europe for all the retail issue and the retail segment. And meat packers in Europe have smaller plants. So I think that they have fewer people in all the plants. So the issue of maybe COVID spreading among workers had been less of an issue there. The issue in Europe has been of course the biodiesel as Ray mentioned before, biodiesel is used more for passenger transportation in Europe, so that was absolutely shut down. And so we adjusted the rate to some of those plans. At the moment we are running as much soya crush as we can in Europe, of course, given our advantage there. Brazil margins are more in the $15 to $25 per ton. They are the big farmer selling. Demand for oil has been – for package oil has been good. And then biodiesel we've been able to move enough biodiesel there in Brazil, this is tied to economic activity. And less of a passenger drive, passenger car there. And we've been able to manage more of that. Demand for meat has I continued to be very strong. Most of our customers, they are exporting a lot of their meat to China. So that demand has been very strong. And other than one announcement of a plant with some issues in poultry a week ago all the plants of our customers have been running in Brazil. So far so good in Brazil. So I would say one of the big things that we noticed this quarter in terms of soybean oil has been the great benefits of having the global trade desk actually working together to facilitate that we continue to crush hard, because basically they took care of the oil, exporting that oil. And you see the one of the benefits of the combination between the Ag Services business and Oilseeds is it business is that the global trade works either to place a little bit more of North America mill into export markets or a lot of the oil into the export market so our plants can continue to run. That has been very beneficial to us."
},
{
"speaker": "Ken Zaslow",
"text": "And then my last question is will we finally get a consolidation or a reduction of number of players in ethanol? Is this an event that could really change the structure of the ethanol industry? Or is it one of those you will see production cuts, everybody goes down and then it just kind of rebounds? How do you think about that? And I'll leave it there. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Yes Ken, that's a good question. I think it depends on probably the duration of this situation. The industry is working at the lowest production rates ever. And I think that we saw more than 70 plants going down. And for somebody that have run plants before it depends on how long it takes for that plant to be down. After a few months, things start becoming complicated and maybe fewer of those plants will be able to come back. So it depends how quickly margins, rebound. But I would say if there is a prolonged activity or low gasoline prices and margins continue to be down for a while, I think, you will see some players not coming back, whether that's enough to restructure the industry is probably a tall order question there that I would not guess to answer at this point."
},
{
"speaker": "Ken Zaslow",
"text": "Great. Thank you very much."
},
{
"speaker": "Operator",
"text": "Heather Jones with Heather Research. Your line is open."
},
{
"speaker": "Heather Jones",
"text": "Hi, thanks for taking the questions. I know we are running out of time, so I'll just do this quickly. Has your corporate expense outlook changed at all given the deterioration in the economic outlook?"
},
{
"speaker": "Ray Young",
"text": "No Heather, I know we were a little lower in the first quarter, but a lot of the initiatives that we announced in our fourth quarter call in terms of our business transformation – we have not slowed that down. In fact one argues that these business transformation initiatives are actually very, very important for the long term of ADM. And so we have not diverted from those particular, strategic initiatives there. So the guidance that we provided to you in the fourth quarter for the calendar years remains in place. I think the only thing that's changed in terms of below line is like interest expense. I think that with the addition of long-term debt that we put onto the balance sheet you should expect probably our net interest expense probably be similar to where we were last year."
},
{
"speaker": "Heather Jones",
"text": "Okay, thank you for that. And then Juan, you had mentioned that you guys moderated your crush rate coming into Q2. Lately I've been hearing multiple reports that bean oil storage in the U.S. has become constrained. And so just wondering if you could walk us through that? And how serious it is? And if so is further moderation going to be required?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, I think, that during the first quarter we saw, I mean, as you see March when we saw the decline in economic activity around the world that became the limiting factor for crush, it was like, you know, do you have an outset? Do you have a house for soybean oil? As I said, we have been good at using our integration to make that soybean oil disappear and keep crush margins up. Of course the longer this takes inventories start to pop and not everybody have the same ability to place those things with us. And there is a lot of people fighting for liquid storage these days in North America. But I would say, I think, we are comfortable with the level of adjustment in production that we have at this point. We adjusted about five percentage points. And I think for now that that's good. So we don't foresee more at this point. And as I said before, Heather we started to see…"
},
{
"speaker": "Heather Jones",
"text": "Okay, [indiscernible]."
},
{
"speaker": "Juan Luciano",
"text": "Yes I'm talking about ADM specifically, I wouldn't venture about what's going to happen for the rest of the industry. But as I said we have that benefit of that integration with the global trade. But I would say over the last week and two weeks as China started to reopen and as Europe prepares to reopen and then in some cases they have done, so we started to see a little bit more activity. And I don't know if people replenishing pipeline in preparation for the summer or what. But orders have popped up a little bit over the last two weeks in general for ADM."
},
{
"speaker": "Heather Jones",
"text": "That's great color. Thank you so much."
},
{
"speaker": "Juan Luciano",
"text": "You are welcome Heather."
},
{
"speaker": "Operator",
"text": "As a reminder, please limit yourself to one question. Vincent Andrews with Morgan Stanley, your line is open."
},
{
"speaker": "Vincent Andrews",
"text": "Hi, thanks for taking my question after the hour and I'll keep it to one. Could you just remind us how the – what we used to call WFSI how that business did during the last recession or in economic slowdowns in general? I'm just thinking once we get past COVID there's really still going to be a recessionary environment for who knows how long but long enough. So any help there would be would be great."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Well, we didn't have WFSI on the last recession, so it's difficult to compare. But I think it's a good question in the sense that the business is relatively less exposed to food service than there may be other segments that we have in the company. And it's very, very diversified because the systems, and the flavors and the pantry is so broad that goes into almost every product, whether it's food or beverage. So I would say a pretty resistance in that point. I think that the thing that we are watching very careful is not that much the absolute demand, which we feel comfortable whether it maybe softer in previous scores than it was in Q1 may be there is some adjustment to pantry filling. But I think what we are seeing is our win rates, our ability to place new orders or bring new products have been strong. Our ability to provide existing sales of existing products to existing customers have been good. And I think that what we may see, because we saw that in Asia, it's a little bit of deceleration in innovations in food services in the first quarter because logically companies as they focus more on delivery or pickups or e-commerce, they tend to emphasize their traditional products. You are not going to go to a food service restaurant and order take out something new, you normally go to something that you know. So we've seen a little bit of decline and that started to come back slowly. But that probably will be the shift. The shift is maybe that we sell more of existing products than the proportion we used to sell off innovative products. So we think that the impact of the recession may be a little bit of a delay in the introduction of our new products."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you very much."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Vince."
},
{
"speaker": "Operator",
"text": "Michael Piken with Cleveland Research, your line is open."
},
{
"speaker": "Michael Piken",
"text": "Yes, hi. I will also limit it to one question. If you could just talk a little bit about kind of what's happening down in Brazil with the port infrastructure and obviously a lot of talk about how they are managing COVID-19 a little differently. But how are your operations going down there? Are you seeing any port backups? And I know you got a slide on farmer selling being pretty good, but just the overall state of the Ag economy down in Brazil would be great."
},
{
"speaker": "Juan Luciano",
"text": "Yes, I would say listen, the team identify of course very early on potentially ports could be a weak point in terms of the COVID issue. And we took all kinds of precautions to make sure that that was not the case, so it was not impacted. And I would say at this point in time, we have no issues in terms of being able to load. There may be a little bit of an extra cost here and there, but nothing, nothing material that we should worry about. In Argentina there has been a little bit of – even in the phase, to be honest, when I said we were preparing because we were preparing for the big export market because of course China has a lot of appetite and Brazilian farmer was selling. So we saw that flow. We're going to have higher volumes which we saw those higher volumes and we see it event even during Q2. So I would say, given that they work in exceptional volumes, the performance has been a stellar because to be honest, minimal disruptions. Some disruptions in Argentina because the Parana River is very low in water. So we have to move some of the loads to Baia Blanca, a little bit more in the ocean side of the country, but also there, we've been loading well, only we changed the port. So I would say – and then even around the world Romania had record exports and the ports were there as well. So I think they will be happy – we will be happy there. In terms of how I see Brazil in general, this COVID, I think, May is going to be a tough month because we are fighting these two streams. On one side the economy and the social pressure to come back to work and the people basically need for their livelihoods. But the number of cases is still going up. And I think the ability to control that makes me a little bit worried about in general, the health situation in Brazil May. But other than that, I would say so far maybe diary was the segment that had been impacted the most from our customers’ perspective. But for the rest so far the business for us has been strong."
},
{
"speaker": "Operator",
"text": "Vincent Anderson with Stifel, your line is open."
},
{
"speaker": "Vincent Anderson",
"text": "Thanks for sneaking me in. Just quickly on Neovia. I was hoping you can breakout the improvement in the quarter between: one, the synergies, obviously the $10 million adjustment from last year broader revenue improvement and then maybe any seasonal factors just for the purpose of framing what the new baseline of earnings power should be for that business all of equal?"
},
{
"speaker": "Juan Luciano",
"text": "Yes I'm not sure I have the breakout that easy, but let me say the following there. The Neovia, the way you need to think about it is because it's very diversified geographically and very diversified in the different sub segments. So I don't want to go into a long explanation, but I think the important thing, if you remember when we acquired Neovia, what I said that the Neovia story was actually a margin up story. So it was very complimentary to ADM from a geographical perspective and business perspective, but it was a margin up story. And although our business in Animal Nutrition was above 9% EBITDA margin on sales or where about, the Neovia business was lower than that. And then our expectation was to start moving up that business in two or three phases. And I am happy to report that margins are improving Neovia as we described. So we went from the margin of about 6.5% to about 9.50% in the Q1. So it's a business that is starting to get closer to our first original goal of about 10%. And then we were planning to go into the lower teens. So it's a business that again, has so many segments and so many geographies and they are all recovering differently and being impacted differently. So I don't think that the Q1 yet is a very good quarter for us to go into a lot of analysis into the future because again we have all these economies, there is a lot of Southeast Asia that is still is impacted by coronavirus. There is China that is coming back. There is Brazil that hasn't been impacted. There is Mexico that is being impacted right now. There is North America that is more impacted. So I think that second quarter will give us maybe a better time to make this analysis. But the business will continue to improve. We are revisiting the synergy numbers, of course, after we achieve €50 million target that we set for ourselves. So, we're still – there's still going to be growth rate, positive growth rate. There is still going to be increasing EBITDA margin on sales. It's just that the market at this point in time is too fluid to develop the algorithm right now."
},
{
"speaker": "Vincent Anderson",
"text": "That’s fair enough. Thank you very much."
},
{
"speaker": "Operator",
"text": "And our final question comes from line of Adam Samuelson with Goldman Sachs."
},
{
"speaker": "Adam Samuelson",
"text": "Thank you everyone. Thank you for squeezing me in. I want to ask a question on Ag Services, something you haven't talked about a lot on this call. Just thinking about the outlook over the balance of the year with what looks to be much bigger U.S. supply of corn than potentially beans. Just given the planted acreage and the loss on demand in ethanol, just wanted to get your sense, the outlook for that business is actually improving probably more second-half weighted, but just the view today relative to where you might have been three months ago."
},
{
"speaker": "Ray Young",
"text": "I think…"
},
{
"speaker": "Juan Luciano",
"text": "Yes, go ahead Ray."
},
{
"speaker": "Ray Young",
"text": "I think we are actually encouraged in terms of Ag Services, in terms of how they started out in the first quarter, very strong results. We're also encouraged like the planning estimates in the United States are actually fairly strong, too. So it would be quite an improvement in terms of the acreage this year compared to last year where it was negatively impacted by weather. So we should actually have some – assuming the weather holds up and the planning gets in, we should actually have a very good crop of both corn and soybeans as we kind of go through this year in United States. I think the big variable, Adam, is going to be the China and the Phase 1 deal. As Juan indicated, we're very encouraged in terms of China coming in the first quarter to buy, frankly, a whole portfolio of agricultural products, you got sorghum, you got wheat, you got corn and then some soybeans also right now. So we are very encouraged in terms of what China is doing right now in terms of agricultural purchases and all the signals that we're getting and from both the U.S. side and the China side is that they will be executing their agricultural portion of Phase 1 consistent with what they had talked about. So we think as we kind of move through the year that the China will be increasing the amount of purchases of U.S. agricultural products. So you are already seeing that significantly in terms of animal proteins, pork, meat, chicken. I mean, the year-over-year purchases by China are an area of like 300% higher in terms of pork and big numbers in terms of poultry and beef as well. But in terms of soybeans, we are still thinking that for the year it could be 30 million metric tons to 35 million metric tons of purchases from United States as we move through the year. And that's going to be very supportive in terms of the Ag Services business, particularly in the back half of the year here. So overall, I have to say that we're very constructive. If China buys corn in addition to soybeans, that's going to be extremely constructive. And then the other variable, I just want to mention, is that ethanol as part Phase 1 deal is being viewed as part of the agricultural basket in terms of purchases. So as China moves towards honoring the $36 billion of agricultural purchases, it's very possible that ethanol will enter the picture, particularly in the fourth quarter now."
},
{
"speaker": "Adam Samuelson",
"text": "All right, I think, I will stop it there. Thanks so much."
},
{
"speaker": "Operator",
"text": "I will now turn the call back over to Victoria de la Huerga."
},
{
"speaker": "Victoria de la Huerga",
"text": "Thank you for joining us today. Slide 12 notes some upcoming investor events in which we will be participating. As always, please feel free to follow-up with me if you have any other questions. Have a good day. And thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "This concludes the ADM first quarter 2020 earnings conference call. We thank you for your participation. You may now disconnect."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 4 | 2,021 | 2022-01-25 09:00:00 | Operator: Good morning and welcome to the ADM fourth quarter 2021 earnings conference call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this call is being recorded. I would now like to introduce your host for today’s call, Vikram Luthar, Senior Vice President, Head of Investor Relations, Chief Financial Officer - Nutrition for ADM. Mr. Luthar, you may begin.
Vikram Luthar: Thank you Rika. Good morning and welcome to ADM’s fourth quarter earnings webcast. Starting tomorrow, a replay of today’s webcast will be available at adm.com. For those following the presentation, please turn to Slide 2, the company’s Safe Harbor statement which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today’s webcast, our Chairman and Chief Executive Officer, Juan Luciano will provide an overview of the quarter and the year. Our Chief Financial Officer, Ray Young will review the drivers of our performance as well as corporate results and financial highlights, then Juan will discuss our outlook, after which they will take your questions. Please turn to Slide 3. I will now turn the call over to Juan.
Juan Luciano: Thank you Vikram. Our team delivered a superb fourth quarter. This morning, we reported record fourth quarter adjusted earnings per share of $1.50. Adjusted segment operating profit was $1.4 billion, 23% higher than the fourth quarter of 2020. Our trailing four quarter adjusted EBITDA was $4.9 billion, $1.25 billion more than a year ago, and our trailing fourth quarter average adjusted ROIC was 10%, meeting our objectives. Slide 4 please. That performance represented a strong finish to an astounding 2021. For the full year, our adjusted EPS was $5.19, also a record, and full year adjusted segment operating profit was $4.8 billion. This excellent performance was reflected across the company. [Indiscernible] its team’s actions to improve their business portfolio and strengthen their operating model continues to enable superior performance in a strong market environment. AS&O delivered full year 2021 OP of $2.8 billion with each sub-segment performing at or near historic highs. Carbohydrate solutions executed phenomenally well to deliver full year operating profits of $1.3 billion [indiscernible] from the sale of our Peoria grain dry mill and the announcement of the sustainable aviation fuel MoU through our agreement with [indiscernible] and the continuous growth of our exciting value solutions platform which delivered new revenue [indiscernible] with an annualized run rate of almost $100 billion, to the project we announced earlier this month to further decarbonize our operations by connecting two other major processing facilities to our Decatur carbon capture and storage capabilities. The nutrition team once again delivered industry-leading revenue and OP growth with full year revenues up 16% and full year OP of $691 million, representing a 20% year-over-year increase. We also continued to enhance our nutrition business with strategic investments targeted at growing areas of demand, including soy protein which will expand our participation in alternative proteins; PetDine, which substantially enhanced our presence in pet food and treats; Deerland, which continued the expansion of our functional probiotics and enzymes portfolio within our global health and wellness business; and FISA, which enhanced our flavor footprint by opening up new growth opportunities in Latin America and the Caribbean. Slide 5 please. Last month at our global investor day, we unveiled our strategic plan and reiterated our balanced financial framework for value creation, including using our strong cash flows to deliver both growth investments and distributions to shareholders. We are confident in our plan and committee to continue to deliver value for our shareholders, which is why we are pleased to announce an 8% increase in our quarterly dividend to $0.40 per share. We are proud of our record of 90 uninterrupted years of dividends and more than 40 years of consecutive annual dividend increases, and we are pleased to continue to follow through on our commitment to shareholder value creation. It has been a great year and we are excited about what is to come. Our continuous actions to build a better ADM and dynamically align it with the global trends of food security, health and wellbeing and sustainability, and the steadfast advancement of our productivity and innovation initiatives will help propel our 2022 results. I will talk in more detail about the upcoming calendar year shortly, but first I’d like to turn the call over to Ray to review our business performance. Ray?
Ray Young: Yes, thanks Juan. Good morning and good afternoon everyone. Slide 6 please. The ag services and oilseeds team capped off really a truly impressive year, successfully navigating through supply chain challenges to deliver results largely in line with the extremely strong prior year quarter. The ag services team performed well in an environment of continued strong global demand, including significantly increased export volumes for customers outside of China. Global trade was substantially higher year over year, driven by solid risk management and improved results in global ocean freight. Overall, ag services delivered strong results just slightly off the outstanding fourth quarter of 2020, when we benefited from exceptionally high export margins. Crushing executed well in a continued solid demand environment for both soybean meal and vegetable oil. Lower results in EMEA versus a very strong fourth quarter of 2020 and approximately $250 million in net negative timing impacts versus negative $125 million in the prior year quarter drove overall results lower year over year. The majority of those negative timing effects are expected to reverse in the first half of 2022. The refined products and other team delivered substantially higher results versus the prior year period, driven by strong volumes and margins in North America for refined oils and improved biodiesel margins in North American and EMEA, which more than offset weaker South American results due to the reduced biodiesel mandate. Equity earnings from Wilmar were higher year over year. Looking ahead, we expect a strong first quarter from ag services and oilseeds, higher than the first quarter of 2021 and in line with the just ended fourth quarter. Slide 7 please. Carbohydrate solutions fourth quarter results were more than double the prior year quarter. In starches and sweeteners sub-segment, including ethanol production from our wet mills, results were lower versus the fourth quarter of 2020 driven by higher input costs, including energy costs in EMEA as well as lower wheat milling volumes, partially offset by continued strong ethanol margins. Volumes for North American sweeteners and starches were largely flat year over year. Vantage corn processor results were again substantially higher year over year, driven by historically strong industry ethanol margins as a result of strong demand relative to supply, as well as increased sales volumes due to production at the two dry mills that were idle in the previous year period. As we look ahead, we believe the first quarter for carbohydrate solutions should be similar to or slightly above the strong first quarter of 2021. Slide 8 please. The nutrition business closed out a year of consistent and strong growth with fourth quarter revenues 19% higher year over year, 21% on a constant currency basis with 26% higher profits year over year and sustained strong EBITDA margins. Human nutrition had a great fourth quarter with revenue growth of 21% on a constant currency basis and substantially higher profits. Flavors continued its growth trajectory driven primarily by improved product mix in EMEA and continued strong performance from North America, partially offset by weaker APAC results. In specialty ingredients, overall profits for the fourth quarter were in line with the year ago period as strong demand for plant-based proteins offset the impact of one-time insurance proceeds in the fourth quarter of 2020. Health and wellness was higher versus the prior year quarter as the business continued to deliver growing profits in bioactives and fermentation. Animal nutrition revenue was up 21% on a constant currency basis and operating profit was much higher year over year, driven primarily by continued strength in amino acids. Now looking ahead, we expect nutrition to continue to grow operating profits at a 15%-plus rate for calendar year 2022 with the first quarter similar to the first quarter of 2021, with continued revenue growth offset by some higher costs upfront in the year and the absence of the one-time benefits we saw in the first quarter of the prior year. Slide 9 please. Now let me finish up with a few observations from the other segment, as well as some of the corporate line items. Other business results were substantially higher, driven primarily by higher captive insurance underwriting results as the prior year quarter included larger intra-company insurance settlements. For calendar year 2022, we expect other business results to be similar to 2021, although for the first quarter we expect a loss of about $25 million due to insurance settlements currently planned. Net interest expense increased year over year on higher short term borrowings. In the corporate line, unallocated corporate costs of $276 million were lower year over year due primarily to increased variable performance related compensation expense accruals in the prior year, partially offset by higher IT operating and project-related costs and transfers of costs from business segments into centralized centers of excellence in supply chain and operations. We anticipate calendar year 2022 total corporate costs, including net interest, corporate unallocated, and other corporate to be in line with the $1.2 billion area, consistent with what I discussed at global investor day, with net interest roughly similar, corporate unallocated a bit higher, and corporate other a bit lower. The effective tax rate for the fourth quarter of 2021 was approximately 21% compared to 8% in the prior year. The calendar year 2021 effective tax rate was approximately 17%, up from 5% in 2020. The increase for the calendar year was due primarily to changes in geographic mix of earnings and current year discrete tax items, primarily valuation allowance and return to provision adjustments. Looking ahead, we’re expecting full year 2022 effective tax rate to be in the range of 16% to 19%. Our balance sheet remains solid with a net debt to total capital ratio of about 28% and available liquidity of about $9 billion. With that, let me turn it back to Juan. Juan?
Juan Luciano: Thank you Ray. Slide 10 please. I hope most of you were able to join us on our global investor day last month. There, we showed that we have consistently advanced our strategy, from our work to improve ROIC through capital cost and cash to our strategic growth and margin enhancement accomplishments, including the creation of a global nutrition business, to today’s focus on productivity and innovation. Thanks to this work, we are moving into 2022 with a better ADM, a more returns-focused organization with higher margins and less volatile earnings, and a portfolio that is well positioned to capitalize on the positive structural changes being driven by the enduring global trends of food security, health and wellbeing, and sustainability. Slide 11 please. Let me take a few moments to talk about how we see the 2022 environment. In ag services and oilseeds, we see a continued favorable global demand environment. Due to a short drought in South America with the magnitude of the shortfall still to be determined, we expect global ag commodity buyers will rely relatively more on the U.S. market for their needs, assuming we have a normal U.S. crop later this year. On the oilseeds side, we are starting 2022 with strong soy crush margins, and as we discussed at global investor day, we believe that increasing demand for meal as well as vegetable oil as a feedstock for renewable green diesel should continue to support the positive environment this year with our soy crush margins in the range of $45 to $55 per metric ton. Assuming these dynamics play out, we believe that ag services and oilseeds in 2022 has the potential to deliver an operating profit similar to or better than 2021. For carbohydrate solutions, we are assuming the demand and margin environment for our starch and sweetener products will be steady versus 2021. We expect the industry ethanol environment to continue to be constructive, supported by the recovery of domestic demand to pre-COVID levels, energy costs driving higher exports, and better clarity on the regulatory landscape. With this in mind, we are assuming higher ADM ethanol volumes and EBITDA margins to average $0.15 to $0.25 for the calendar year. In addition, we are expecting our value solutions platform to deliver another year of solid growth as we continue to evolve the carbohydrate solutions business. Putting it all together, we expect carbohydrate solutions to deliver full year operating profits slightly lower than the outstanding 2021. In nutrition, we are expecting continued growth in demand for our unparalleled portfolio of nutrition ingredients and systems, along with the benefits of accretion from our recent acquisitions. With these dynamics, we expect 15%-plus OP growth in 2022, revenue growth above 10%, and EBITDA margins above 20% in human nutrition and high single digits in animal nutrition, consistent with targets we set out at our global investor day. Slide 12 please. As we look forward in 2022, we see a positive demand environment across our portfolio, and then we add to that things we can do better. Our execution was great in 2021, but we’re always identifying opportunities for improvement and we intend to do even more to meet this growing demand in 2022. Put it all together and we’re optimistic for another very strong performance in 2022 as we progress towards our strategic plan next earnings milestones of $6 to $7 per share. With that, Operator, please open the line for questions.
Operator: [Operator instructions] Our first question on the phone lines comes from Ben Theurer of Barclays. Ben, please go ahead.
Ben Theurer: Thank you very much, and good morning, Juan, Ray. Congrats on those very strong results.
Juan Luciano: Thank you Ben.
Ray Young: Thank you Ben.
Ben Theurer: To start off, maybe just to stay a little bit within the outlook, clearly you continue to have a very positive view on the segment side, but could you also share a little bit your assumptions in terms of CapEx needs and where you’re seeing investment needs to be put into in order to deliver on the actual supply of these, so a little bit of your CapEx program and how you feel about that then ultimately the results flowing down to net income and what your expectations are for 2022?
Juan Luciano: Yes, so many questions wrapped in one, Ben - good job. On the CapEx perspective, as you look at our strategic plan, most of our strategic plan is coming from organic growth and productivity, so in order to fund that, we’re going to have a little bit higher CapEx this year of about $1.3 billion. That will be of course in some of the projects we need to do to expand, like Spiritwood that we announced our JV with Marathon, but also again some productivity enhancements to make sure we deliver bigger volumes as we supply that demand. As you know, we are facing 2022 with a very strong perspective for the first quarter. We are entering the year with great momentum as we left 2021 also in a big high, so at this point in time, we continue to see a very strong 2022, and I think I described it in all of my commentary, ag services and oilseeds continue to firing on all cylinders and we expect a year as good as last year, or maybe even better. Carb solutions also going very strong with many--with very stable start and sweeteners, and you know, with always some uncertainty on ethanol but with a favorable environment, and [indiscernible] solutions continued to grow as we grew last year, and again nutrition going up about 15% per year operating profit growth on double-digit revenue growth. All in all, we feel very good about all the things that we can control.
Ben Theurer: Okay, perfect. Thank you very much. Then just one last question, just a quick one. If you think about your medium term targets, and I remember you’ve laid out obviously as well the initiatives for share buybacks, etc., but in light of the higher CapEx plus the increase in dividends, fair to assume that share buybacks, at least in the short term, aren’t going to be a priority yet, correct?
Juan Luciano: Yes, I think the priority for capital allocation is to de-leverage after we had maybe a couple of billion dollars invested in acquisitions, certainly fund the projects that we have in higher CapEx, as I described, and then the dividend, to support the dividend. Of course, cash flow generation is strong in ADM, you know we focus a lot on that, so as cash flow becomes available, we’re going to think again in the five-year plan to have more buybacks in the later period, but if cash flow continues to be as strong, we may anticipate that a little bit. At this point in time, we don’t expect significant M&A as part of our plans, so that would be the capital allocation decision.
Ben Theurer: Perfect Juan, very clear. Thank you very much, and congrats again.
Juan Luciano: Thank you Ben.
Operator: Thank you Ben. We now have the next question from Ben Bienvenu of Stephens. Ben, please go ahead, your line is open.
Ben Bienvenu: Hey, thanks. Good morning and congrats on the strong quarter.
Ray Young: Thank you Ben.
Ben Bienvenu: I wanted to follow up on the outlook commentary, which was really helpful and detailed. Of particular interest to us is the bio product commentary that you offered. I think within the carbohydrate solutions business, the commentary around starches and sweeteners makes sense. The bio products obviously benefited from a very strong fourth quarter, and I suspect perhaps you had an opportunity to secure margins into the first quarter, but the commentary is pretty positive through the balance of the year, and I realize higher production will help in benefiting operating profit for that business. Can you talk a little bit about what informs your view for the strength of the ethanol business sustaining into 2022?
Ray Young: Hey Ben, good morning. It’s Ray here. Yes, we finished up very strong in the bio products business, ethanol specifically. The fourth quarter demand environment was very, very constructive, and I think that’s just reflective of what was happening in terms of the recovery in driving miles in United States, the holiday season. Gasoline demand was strong, that translates to strong demand for ethanol. On the supply side, actually the industry had some supply challenges, and so that translated to a very robust environment; in fact, our EBITDA margins in the fourth quarter for our ethanol business were above a dollar a gallon, which is very, very--you know, on a historical basis is very, very strong. We indicated that as we go into 2022, we feel optimistic about ethanol as well. While inventories have built up a little bit in January, and that’s just the seasonal nature of ethanol--of inventory builds, a couple things give us optimism for 2022. Number one, we do expect domestic demand for ethanol to be strong; in fact, it will be a growth year-over-year from ’21 to ’22, and frankly we’re seeing ethanol demand probably returning back to pre-pandemic levels of demand here in the United States, so we’re talking about domestic demand probably in the 14 billion gallon level. Secondly, I think you’re going to see a recovery around the world on gasoline demand and hence ethanol demand as well, and as you know, with the movement in crude oil prices in general, ethanol is becoming one of the most attractive oxygenates in the world, so we do see the export demand side of the equation in 2022 being also very constructive for ethanol, with ethanol probably recovering to 1.4 billion to 1.5 billion gallons in terms of export demand, so that’s very, very constructive. Thirdly, we do believe that the regulatory landscape has clarified itself in the context of small refinery exemptions. I know there’s some challenges going on here, but what we see right now is going forward, smaller SREs, as they call it, small refinery exemptions will not have an impact in terms of the supply-demand balances, and we talk internally that when they say 15 billion gallons, it means 15 billion gallons in terms of what we need to deliver to the marketplace, so that’s actually a positive also for our industry, and then they’ve also remanded about 250 million gallons in terms of requirements as well going forward. When you add it all together, the fact that we’re starting off the year with a fairly balanced supply-demand perspective in terms of U.S. ethanol inventories; two, a demand environment that’s going to be even more constructive versus 2021; and three, a regulatory environment that seems to be supportive of where we want to go, we actually have a constructive viewpoint. As Juan indicated, directionally we’re assuming $0.15 to $0.25 per gallon as EBITDA margins for 2022 - that’s lower than the ’21 assumption, and maybe we’re just being a little bit conservative at this juncture as we start off the year, but nevertheless we do believe it should be a favorable environment for us as we move forward into 2022.
Ben Bienvenu: Okay, that’s great. Very helpful Ray, thank you. My second question is just related to the global operating environment, and in particular some of the goings on in Ukraine at the moment and tensions there. Is that--how is that manifesting itself today in terms of the impact to your business? I know from an asset footprint perspective, you guys don’t have super-heavy exposure there, but they’re a major producer of rapeseed, corn, wheat, barley, so I’m curious what impact you’re seeing in the market today and how you think about the potential impact as we look into 2022, recognizing a lot of different scenarios could play out there.
Juan Luciano: Yes Ben, of course you realize the supply of many commodities remains at their tightest levels in years, so I think any news around the world of disruption, whether it’s weather or geopolitics is going to prolong the high prices well into, probably, 2023. As you described, at this point in time there are three things. We are all looking at the development of the crops in South America as they need to go through February rains, especially in Argentina and the harvest in Brazil. We are looking of course at geopolitical conflicts like the one you described, and also the expectations of the crop in the U.S., all this in the middle of a very strong demand. As you said, Ukraine is a big exporter, especially if you think about corn and the ability to supply China’s needs. You have the three main suppliers, whether it’s the U.S. and you have Ukraine and you have Brazil, so hopefully Brazil with these rains will have a safrinha crop that is maybe a little bit better than what we expect, but among these three countries need to cover the supply of corn, and corn today is one of the best sources of energy and fat out there, one of the cheapest ones, so it’s a very demanded product, so we’re all paying attention to what happens [indiscernible].
Ben Bienvenu: Okay, thank you Juan. Congrats on the quarter, and best of luck into 2022.
Juan Luciano: Thank you Ben. Thank you very much.
Operator: Thank you. We now have another question on the phone lines from Adam Samuelson of Goldman Sachs. Adam, please go ahead when you’re ready.
Adam Samuelson: Yes, thank you, and good morning everyone.
Ray Young: Morning Adam.
Adam Samuelson: I guess my first question is I want to come back to the outlook in carbohydrate solutions and just make sure I’m understanding the moving pieces to think about a full year 2022 outlook that’s only slightly below 2021, where both your ’22--’21 performance was above what you would have expected and 2025 for the unit, and just trying to think about the moving pieces with ethanol, and maybe there’s a clarification point on the--when you talk about ethanol margin $0.15 to $0.25 a gallon EBITDA, is that purely the dry mill gallons within Vantage corn processors or is that including the wet mill, and I guess in that vein, in the fourth quarter, given the strong ethanol margin environment, I guess I was surprised just to have seen the starches and sweeteners business be down, if that should have also been benefiting from a strong U.S. ethanol environment, so maybe just help us think about some of the bridges of the pieces within the segment to get you to the ’22 outlook.
Ray Young: Yes Adam, it’s Ray here, so $0.15 to $0.25 EBITDA margin represents total ethanol, wet mill and dry mill, so that’s a combined basis on that assumption. In the fourth quarter, we had, as you saw, an outstanding quarter. VCP really benefited from the ethanol margins, and clearly starches and sweeteners also benefited as well on the ethanol side of the business. Our net corn cost was a little bit higher in the fourth quarter for starches and sweeteners, and recall when we hedged 2021 for corn, we put on a very attractive hedge position in 2020 for a lot of our 2021 requirements, but not all the requirements, so when we got to the fourth quarter, I think we were a little bit more exposed on net corn, so therefore the higher net corn cost translates to maybe a little bit lower margin on the sweetener side of the business there. We also had some operating challenges with the start-up of Bulgaria in Europe, which again is an opportunity, frankly speaking, for us in 2022, right, and we also had some higher energy costs over in Europe as well. As you know, natural gas prices ran up significantly in the back part of the year, so that impacted our energy costs over in Europe and that flowed through in terms of our starches and sweeteners segment. There were a bunch of puts and takes that moved through the fourth quarter. Again, we think a lot of that will be behind us because I think we’ve put ourselves--you know, put in a good hedge position for 2022, and then also we believe that we’ve got the Bulgarian project, we’ve addressed a lot of those issues, and that should be a plus delta for us in 2022 as well.
Adam Samuelson: Okay, that color is really helpful. If I could just switch gears over to the nutrition segment, and maybe help us think a little bit about the expectations for the business on an organic basis in 2022. I know there was a--you did some M&A through the second half of 2021, so you talked to 10%-plus revenue growth and 15%-plus profit growth. Can you help us think about the M&A contributions within that, and any specific parts of the business that you might be more optimistic than the segment average, and areas where the growth might be a little bit below that?
Juan Luciano: Yes, so I think most of 2022 will be on an organic growth basis, if you will. The contribution still of the acquisitions is going to happen a little bit later. These acquisitions are not made, to be honest, for the accretion of 2022. As you recall, we are just building the nutrition business, so this is the strategic importance of positioning ourselves in the areas where we’ve been informing you. I think that we always like to have the policy of no surprises, and I think you heard me saying health and wellness is an area where we were going to invest, and that’s why we did Deerland pet food, and that’s why we did PetDine. We continue to think about the incredible potential of plant-based proteins, and that’s why we did soy protein which is making us more international. I talked about how powerful we are in flavors, but we were under-represented, if you will, in the emerging markets, and that’s why we invested in capacity in Pinghu for flavors in China, and we also acquired Fisa that gives us a beachhead into Central America, Caribbean, and maybe the northern part of Latin America. When we look at the business, our confidence in the 15%-plus organic operating profit growth is given by our pipeline and our win rates, to be honest, that’s why we look. Our pipeline continues to increase, our product launches continue to increase and actually accelerate, and our win rates have almost doubled from one year to the other, so the business is operating very well. We guided flat for Q1 just because of the way some of the costs fall, and they are more front-loaded into next year, but this is a business again that’s been growing 34%, 20%, I think we’re going to stabilize in the long term at this rate of 15%, 15%-plus with double digit organic growth, basically, without even touching the M&A for that growth.
Adam Samuelson: Got it. That’s all really helpful. I’ll pass it on, thank you.
Juan Luciano: Thank you Adam.
Operator: Thank you. We now have a question from Robert Moskow of Credit Suisse. Robert, I’ve opened your line.
Robert Moskow: Hi, thanks for the question, and congrats on a great year.
Ray Young: Thanks Robert.
Robert Moskow: Of course. Maybe you’ve kind of implied this already, but your pricing for corn sweeteners in 2022, can you describe how the negotiations went, and it looks like what you’re guiding to was kind of flattish profits in North America for corn sweeteners as a result of that pricing. Is that a fair assessment?
Ray Young: Yes Rob, our objective is really to maintain margins, and so through the course of the negotiations, I think it’s fair to make an assumption that we’ve been able to maintain margins and offset the higher corn costs that has occurred recently. I think we’ve achieved that objective, and that’s a fair assumption to assume as we go into 2022.
Robert Moskow: Okay, and maybe a follow-up, if expansion of refined soybean oil is driven by the growing demand of renewal biodiesel, have you been watching the industry--the planned industry expansion for all those refineries, and what kind of--is it achieving what you’d expect? Is the capacity coming online as expected, and is it having the results on demand for oil that you would expect?
Juan Luciano: Yes, of course we keep a close eye into that. You have to understand that at this point in time, demand continues to outpace even the announced capacity expansions, but there is a reality also in this world of supply shortages and labor issues, that projects are not that easy to execute. I think that when you look at a battery of announcements like the way we’ve seen, I think it’s reasonable to put a percentage that that is going to happen, either the reality or that they’re all going to happen but in a little bit longer timeline. We tend to look at that from a long term basis of maybe something like two-thirds or 75% will happen. At this point in time, we see the volume coming our way, and you have to remember that the original oil story, Rob, it was due to high palm oil around the world, and that drove soybean and other oils up, and now on top of that, now we have the demand for RGD, so that--now, there is a full confluence of raw materials to be able to supply that oil. So yes, we are looking at this very closely, and at this point in time, everything is evolving as planned.
Robert Moskow: Okay, all right. Thank you.
Juan Luciano: You’re welcome.
Operator: Thank you Robert. We now have Tom Palmer of JP Morgan. Tom, your line is open, please go ahead.
Tom Palmer: Good morning. Thank you for the questions, and congratulations on the quarter.
Ray Young: Thank you Tom.
Tom Palmer: Maybe I can follow up on Rob’s question, just on the refined products outlook, and maybe a little more specific on how you’re thinking about the set-up for 2022. We do have maybe the first larger wave of facilities coming online with pre-treatment units, although that is at least back half-weighted, I think, so maybe what’s the assumption for refined products this year, and do you think that that addition in terms of capacity is going to have much impact, or as you were kind of noting with Rob, maybe just with timing and needs of still sourcing from, at least a portion from third parties, it won’t be as impactful?
Juan Luciano: Yes Tom, listen - we continue to believe we will add around a billion gallons per year of incremental RGD capacity and approach that 5 billion gallons total capacity by 2025. As I was telling Rob, we continually reframe the announced capacity and analyze the market conditions, so we have several scenarios in this. We do believe these announced capacities are important to and necessary to keep up with the expected demand growth for both vegetable oil, as I explained before, but also global meal demand needs. At this point, vegetable oil consumption is still growing faster than supply. We’ve gotten a little bit of good news from Sanoil availability from black seed that maybe will help bean oil tightness, and--. So regarding the pre-treat comments, in the end the vegetable oil will be required as a feedstock and pricing will reflect the value of this feedstock, likely based on carbon intensity, so we could see some shift in value between the crude oil and the refining. I think what we need to realize is we are at the early stages of this industry formation, so we’re going to see some of that movement and sometimes we’re going to capture the value in one place, sometimes we’re going to capture the value in another one. But we are well positioned, our biodiesel plants are all integrated in refineries and all that, so we are watching it very closely and we feel good about how it’s developing so far.
Tom Palmer: Great, thank you for that. Maybe I’ll segue with that to the crushing side. It seems like you’re starting off the year with quite strong soy crush margins, perhaps higher than maybe you’re guiding to for the year. Is there a, I guess, catalyst or driver that maybe makes margins weaker? Is there a bit of conservatism embedded? We see headlines around lysine shortage - is that something you’re expecting to resolve itself and maybe see still a very favorable crush environment, but a little more normalized versus to start off the year?
Juan Luciano: Yes, there are many--of course, this is a large industry, so many puts and takes. When we look at the demand side, the forecasted 2022 poultry production is going to be a record and near record for beef and hog, so protein demand continues to grow around the world, and that’s sustaining a lot. There is a tight meat proteins and synthetic amino acids, and that’s supporting soybean meal. Remember, I mentioned fat is very expensive today and energy as well, so corn at this point in time is the cheapest carbohydrate, that’s pulling soybean meal into the Russian, and we expect that one point in time, the lysine market may be back into balance later in 2022. But still, the SMDs are very, very beneficial to soybean meal and to crush, so. I think also, don’t forget RGD is also changing the dynamics for soybean meal, making soybean meal from the U.S. much more competitive and able to gain some export markets, and when you have maybe a less than stellar soybean crop in Argentina, Argentina being such a strong exporter of meal, I think that bodes well for crush margins in North America and also in Europe.
Tom Palmer: Thank you.
Juan Luciano: Thank you Tom.
Operator: We now have the next question from Vincent Andrews from Morgan Stanley. Vincent, please ensure your line is unmuted locally, and you may go ahead.
Steve Haynes: Hi, this is Steve Haynes on for Vincent. Wanted to ask a question on the bio solutions business and the $100 million of annualized revenue wins in 2021, and if you could maybe just provide some more color on specific end markets where you’re getting those wins and then how to think about the size of that going forward.
Juan Luciano: Yes, thank you for the question, Steve. Listen, we are very excited about how that business is developing. I think we recognized in the past that that business happened almost while we were not watching and it was a customer pull more than our push. Now, we have a segment approach to that. We have intentionality in developing that market and as such, the opportunities have flourished. I would say a strong contribution from packaging, a strong contribution from fermentation - you know, we’re helping other people that are creating some of these materials out of a plant base, personal and homecare, a very important segment that is growing, and a growing contribution from pharma, construction and plant treatment. So as you can tell, as we continue to deploy marketing resources into some of these segments, we continue to have success. There are some segments that are more developed and larger for us and some segments that are more incipient, but I think it’s going very well. We are working on the product mix as sometimes the growth is faster than our capacity, so we’re trying to accommodate that and we’re going to be having more capacity coming up soon to be able to sustain this 10% growth rate [indiscernible] that we have.
Steve Haynes: Thank you.
Juan Luciano: You’re welcome.
Operator: Thank you Vincent. We now have Ken Zaslow of BMO Capital Markets. Ken, please go ahead when you’re ready.
Ken Zaslow: Hi, good morning everyone.
Juan Luciano: Morning Ken.
Ray Young: Hey Ken.
Ken Zaslow: Let me just take a different approach. When you think about your--you talk about all the things that are happening on the demand side, but at your analyst day, you kind of did talk about the cost structure increasing and that there were going to be some headwinds. As I look forward, these headwinds don’t seem to be materializing to the extent, or are they, and can you frame how you kind of put it during the analyst day and where you see they are going through to--you know, where you’re seeing them now, where you see them through 2022, and are you really seeing them develop they way you thought they were or are they a little bit lower than you thought?
Juan Luciano: Yes, the dynamics here, Ken, of course is we have forecasted or accounted for some--the potential reversion of margins and some inflation of course that we were going to have, and that is difficult to estimate the timing, and then we have productivity and innovation that is going to be growing in their impact as some of these projects develop. When we look at, if you will, at the negative side of the equation, as the positive side we can control, on the negative side we’ve put together several scenarios, and I would say the biggest manifestation of that at this point in time has been energy inflation, and inflation from some smaller products. We suffer probably more of this, some supply chain disruptions and labor shortages, that you probably hear every company talking about. I would say from an energy perspective, the impact is probably more on Europe, whether it’s on crush or carb solutions, that’s where we see the impact, and we have our team basically working on energy efficiency and shaving some percentages of that increase, and also our hedging mechanisms and all that. On the raw material side and the supply chain disruptions, that’s probably more the territory of nutrition. Nutrition, as you can imagine, has more variety of raw materials and more SKUs, so the complexity of that business makes it more exposed to some of these winds. That’s the way we’re looking at that - it’s more the European energy increase and some of the nutrition one-offs here and there on supply chain.
Ken Zaslow: My second question is--and I appreciate that. On the China side, I think last call and the call before, you kind of outlined how demand is growing. I know 2021 was an extraordinary year for China demand. How do you think that’s going to play out in 2022 and 2023 in terms of will there be a mix change, will there be increased demand? How do you kind of think about it relative to your business model? I appreciate your time, as always.
Juan Luciano: Yes, thank you Ken. Listen, we think that China has recovered from the ASF, they recovered their herd. You saw the dynamics in terms of pork prices coming up and down. We still believe that they will import soybeans in the high 90s - you know, 96, 97 million give or take, and around probably 25 million tons of corn. Again, when we are working the way they are managing through COVID challenges, but we expect demand will continue to grow, it continues to be supported by improved diets and professional feeding practices. Even if we see some moderation of GDP, we think that we’ve seen per capita consumption of the top four meats basically increases, and even if they correct it a little bit, they correct versus 2021, they are still much bigger than pre-ASF and pre-pandemic. We [indiscernible] with a number here or there, but still it’s going to be very strong, and as I said, probably 96, 97 million of soybeans, 25 million of corn, that will provide a good base for the grain industry and the crushing industry.
Ken Zaslow: Great, I appreciate it. Thank you guys.
Juan Luciano: Thank you Ken.
Operator: Thank you Ken. We now have a question from Ben Kallo from Baird. Ben, please go ahead when you’re ready.
Ben Kallo: Hi, good morning everyone, and thanks for taking my questions. Ray, you touched on the regulatory environment just in your ethanol comments, but maybe just on a broader level, maybe around renewable diesel, if you guys could talk about that. Then on the legislative front, I hate to ask because it’s anyone’s best guess, but how you see maybe the blender’s tax credit and anything around aviation fuel evolving. Thank you.
Ray Young: Yes, on the biodiesel, as you know, the current blender’s credit continues until the end of 2022 - December 31, 2022, so naturally we’re looking at what’s happening on the legislative agenda in Washington on the BBB program to see whether it gets renewed. But historically what you’ve seen is, frankly, both parties are supportive of the biodiesel industry - it’s important for the United States, and so even if something doesn’t occur on BBB, we’re optimistic that the blender’s credit will get extended in one way or another through some form of legislation as we move through the year. If you recall, sometimes it happens after you get through the end of the year and then you have a retroactive biodiesel tax credit, which we’ve seen in the past, so we actually feel confident that something will occur there in order to kind of continue with the blender’s credit on the biodiesel tax credit. On the SAF front, as you know, this is something that we’re working on right now with different partners. It is going to be an important part of the fuel industry in the future as we go green in terms of aviation fuel, so [indiscernible] frankly, again, the support we see in terms of the direction of SAF, we’re optimistic that some form of legislative--yes, some form of legislative actions will be taken to support the sustainable aviation fuel, the SAF industry. Again, it’s a nascent industry right now, right - very few gallons are being produced, but projections show that by 2030, there’s going to be a need for about 4 billion gallons of sustainable aviation fuel in combination of United States and Europe, so it’s a significant growth industry and probably there’s going to be some level of support required in order to start up this industry here.
Ben Kallo: And back to the renewable diesel front, could you just talk about any areas that you’re watching? We talked about the supply side and how you discount new production facilities coming online, but could you talk about the demand side and where you’re seeing incremental demand coming from, the regions that we already know out there or new regions? Thank you, and thanks for all of the answers.
Ray Young: The demand side is really driven by the different states implementing low carbon fuel standards, LCFS standards, particularly starting out in the west, but frankly it gets extended across all of the United States and Canada. The demand side is there as all the states move towards LCFS standards, and frankly the industry is just simply trying to respond to that demand by building the supply to meet that particular requirement there.
Ben Kallo: Great, thank you.
Operator: Thank you. We now have a question from Steve Byrne from Bank of America. Steve, please go ahead, I have opened your line.
Steve Byrne: Yes, thank you. Do you think that soybean oil will represent the majority of the feedstock for this 5 billion gallons of renewable diesel?
Ray Young: It’s going to represent an important part of it. As demand grows for renewable green diesel, it’s going to require the pull from many sorts of feedstocks, and in fact it’s very likely that even canola oil will find a pathway eventually to become part of a feedstock for renewable green diesel. But we still believe that maybe about 45% of the production will come from soybean oil, eventually small production out of the canola oil that I referenced there, so it is going to be an important component because there’s just insufficient amount of, let’s say, used cooking oil and other types of feedstocks, fat and rendering. There’s just not enough supply in order to meet this growing demand.
Steve Byrne: Even your 45% is 30 million acres of incremental soybeans, which I don’t think is going to happen. Does that mean soybean exports get squeezed out and instead it gets crushed, the oil goes into RD, and you export the meal?
Ray Young: We’ve indicated we believe that a lot of the U.S. soybean oil exports will actually come down, you’re correct. I think there is going to be a diversion away from exports of soybean oil. There will also be some diversion away from even food applications. There’s going to be a daisy chain effect that goes on which, frankly, is actually supportive for the entire vegetable oil complex around the world. I think there is going to be some daisy chain effects that are going on in order to meet this type of demand.
Steve Byrne: And then what about your Slide 15, where you show forward sales by farmers in South America being below historical averages? Do you attribute that to the uncertainty that they are seeing with their current crop, just from either drought or excessive rain, and if grain and oilseed production is lower there in 2022, or the rest of the world for that matter, is that a net benefit to you in trading?
Juan Luciano: Steve, this is Juan. What you’re seeing from the farmer in South America is reflective of both things. One is the current impact in South America, and the second is, as you see, they are looking at what happened with the size of the crop. In terms of whether it’s beneficial for ADM or not, our role is to try to fulfill our mission of providing nutrition around the world, and that’s where we use our supply chain to make sure that we deliver to our customers and we deliver to the populations around the world. Sometimes it coincides with margin expansion in some parts of the business, sometimes it may not. We like the fact that there is strong demand around the world, and that tends to be good for ADM, yes.
Steve Byrne: Thank you.
Juan Luciano: You’re welcome.
Operator: Thank you. We now have our next question from Michael Piken of Cleveland Research. Michael, please go ahead.
Michael Piken: Yes, good morning. Just wanted to sort of get your take on the current transportation system and the outlook it supports, both in New Orleans, are we fully recovered from the hurricanes, and then kind of the barge system and what’s happening over in the ports in China. What’s sort of the back-up, and is business flowing normally or how backed up is it?
Juan Luciano: Yes Michael, good question. Let’s talk about China. Some slight COVID-related challenges in China are impacting ports, but to be honest, the situation has improved. Initially we got the highlights, but in general the port situation continues to improve, and maybe we have average waiting about two, three days for bulk cargo in agriculture in most main ports, so I would say China is kind of okay. We’ve seen line-ups or demurrage time increasing in Brazil. There are still boats exporting corn and importing fertilizers since the soybean crop is a little bit delayed. We are seeing more--we are seeing waiting times kind of double from maybe 15 days to 30 days in Brazil, and that’s pushing some volume into North America for maybe March-April deliveries. North America export capacity has recovered for the most part. I think there is one plant that was going to have some long term or medium term, if you will, repairments, but for the most part, the export capacity has been recovered to pre-idle levels, at least for us. I would say in terms of the river, the Illinois River, there is a lot of freezing and there is a lot of icy conditions that have slowed down the river movement, and we see that, and that probably will continue.
Michael Piken: Great, that’s helpful. Then just as a follow-up, what’s the elevation margin outlook as you guys see it for the year? Thanks.
Juan Luciano: We’re seeing--as you know, we have the impact of Ida in Q4, we had the demand but we didn’t have the ability to support to supply, so a lot of that volume was moved into Q1. We have seen the elevation margins increasing in Q1, so a little bit as expected, so we feel good about how to satisfy that demand.
Michael Piken: Thank you.
Juan Luciano: You’re welcome.
Operator: Thank you. Our last question comes from Eric of Seaport Research Partners. Eric, please go ahead.
Eric Larson: Yes, thank you. Thanks for squeezing me in everybody. Congrats on a great quarter. Great year everyone.
Juan Luciano: Thank you.
Eric Larson: I know this has kind of been beaten to death and obviously it’s very important, so if you--it’s again on the renewables. If you just take the renewable green diesel market, if you just look at the amount of feedstock that’s required to kind of get to that 2025 goal, your goal of 5 billion gallons, it’s--and I think it was alluded to earlier with that 45% comment, it’s 30 million acres of increased--it’s the equivalent of 30 million acres of soybean production, which it just isn’t going to happen. I know that Greg and Chris are all over this. Doesn’t this--it’s got to be--it is a global market, it will be. Doesn’t this just feed right into your--into a very positive long term outlook for ag services that you’re going to have to be able to pull globally a lot of resources in to meet these demand functions, but that’s what makes it possible. Is that the way to look at this?
Juan Luciano: Yes, I think Eric, when you have one explosion in demand in one place of the world, resources from around the world will come, and as Ray was saying, maybe we’re going to export less, certainly we may import more, and there are going to be shifts between the different products. I would say we continue to be in a world that requires more food and also that requires to help the environment. It has been a structural change in demand for us, and for a company that has assets around the world, that probably means better utilization of those assets and better value of those assets as we try to solve these issues.
Eric Larson: Good, well thanks. The final question I have, and a lot of those have been answered already, so when we look at the current year in terms of U.S. crop production, what are you hearing from your farmer clients? Obviously it looks like we’re putting a bid in the corn markets today to get more corn production. There’s a lot of uncertainty with input costs and all the other stuff. What is your feel for how in this early--well, it’s not so early anymore, it’s getting close to the time, what is your feel on how the crop production outlook looks for this year, kind of by crop?
Juan Luciano: We expect a strong U.S. planting. Of course, some of those decisions, as you said, it’s getting the time to make those decisions, and a lot of people are looking at the South American weather. South American weather is very strange at the moment - there is very dry conditions in Parana or the south of Brazil, and maybe Argentina, and it was a little bit too wet in the north. Numbers in the north are coming strong in terms of yield for Brazil. I think that the recent rains have stopped the deterioration of the crop in Argentina and the south of Brazil, and probably with Paraguay having already felt the damage. We believe in the U.S. We still believe that probably corn will outpace soybeans in terms of acres, so we’d probably think about, I don’t know, something like 93 million acres of corn, 87 million acres of soybeans give or take. I understand the dynamics about fertilizers and all that, but I think even the prices of last year, I think that the prime land will probably maintain the same mix.
Eric Larson: Yes, I would agree with you. Thank you Juan, and again congratulations on a great year.
Juan Luciano: Thank you. Thank you Eric.
Operator: Thank you. I would like to hand it back to Vikram Luthar for some closing remarks.
Vikram Luthar: Thank you Rika. Thank you for joining us today. Slide 13 notes upcoming investor events in which we will be participating. As always, please feel free to follow up with me if you have any other questions. Have a great day and thanks for your time and interest in ADM.
Operator: Thank you everyone for joining. That does conclude today’s call. You may disconnect your lines and have a lovely day. | [
{
"speaker": "Operator",
"text": "Good morning and welcome to the ADM fourth quarter 2021 earnings conference call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this call is being recorded. I would now like to introduce your host for today’s call, Vikram Luthar, Senior Vice President, Head of Investor Relations, Chief Financial Officer - Nutrition for ADM. Mr. Luthar, you may begin."
},
{
"speaker": "Vikram Luthar",
"text": "Thank you Rika. Good morning and welcome to ADM’s fourth quarter earnings webcast. Starting tomorrow, a replay of today’s webcast will be available at adm.com. For those following the presentation, please turn to Slide 2, the company’s Safe Harbor statement which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today’s webcast, our Chairman and Chief Executive Officer, Juan Luciano will provide an overview of the quarter and the year. Our Chief Financial Officer, Ray Young will review the drivers of our performance as well as corporate results and financial highlights, then Juan will discuss our outlook, after which they will take your questions. Please turn to Slide 3. I will now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Vikram. Our team delivered a superb fourth quarter. This morning, we reported record fourth quarter adjusted earnings per share of $1.50. Adjusted segment operating profit was $1.4 billion, 23% higher than the fourth quarter of 2020. Our trailing four quarter adjusted EBITDA was $4.9 billion, $1.25 billion more than a year ago, and our trailing fourth quarter average adjusted ROIC was 10%, meeting our objectives. Slide 4 please. That performance represented a strong finish to an astounding 2021. For the full year, our adjusted EPS was $5.19, also a record, and full year adjusted segment operating profit was $4.8 billion. This excellent performance was reflected across the company. [Indiscernible] its team’s actions to improve their business portfolio and strengthen their operating model continues to enable superior performance in a strong market environment. AS&O delivered full year 2021 OP of $2.8 billion with each sub-segment performing at or near historic highs. Carbohydrate solutions executed phenomenally well to deliver full year operating profits of $1.3 billion [indiscernible] from the sale of our Peoria grain dry mill and the announcement of the sustainable aviation fuel MoU through our agreement with [indiscernible] and the continuous growth of our exciting value solutions platform which delivered new revenue [indiscernible] with an annualized run rate of almost $100 billion, to the project we announced earlier this month to further decarbonize our operations by connecting two other major processing facilities to our Decatur carbon capture and storage capabilities. The nutrition team once again delivered industry-leading revenue and OP growth with full year revenues up 16% and full year OP of $691 million, representing a 20% year-over-year increase. We also continued to enhance our nutrition business with strategic investments targeted at growing areas of demand, including soy protein which will expand our participation in alternative proteins; PetDine, which substantially enhanced our presence in pet food and treats; Deerland, which continued the expansion of our functional probiotics and enzymes portfolio within our global health and wellness business; and FISA, which enhanced our flavor footprint by opening up new growth opportunities in Latin America and the Caribbean. Slide 5 please. Last month at our global investor day, we unveiled our strategic plan and reiterated our balanced financial framework for value creation, including using our strong cash flows to deliver both growth investments and distributions to shareholders. We are confident in our plan and committee to continue to deliver value for our shareholders, which is why we are pleased to announce an 8% increase in our quarterly dividend to $0.40 per share. We are proud of our record of 90 uninterrupted years of dividends and more than 40 years of consecutive annual dividend increases, and we are pleased to continue to follow through on our commitment to shareholder value creation. It has been a great year and we are excited about what is to come. Our continuous actions to build a better ADM and dynamically align it with the global trends of food security, health and wellbeing and sustainability, and the steadfast advancement of our productivity and innovation initiatives will help propel our 2022 results. I will talk in more detail about the upcoming calendar year shortly, but first I’d like to turn the call over to Ray to review our business performance. Ray?"
},
{
"speaker": "Ray Young",
"text": "Yes, thanks Juan. Good morning and good afternoon everyone. Slide 6 please. The ag services and oilseeds team capped off really a truly impressive year, successfully navigating through supply chain challenges to deliver results largely in line with the extremely strong prior year quarter. The ag services team performed well in an environment of continued strong global demand, including significantly increased export volumes for customers outside of China. Global trade was substantially higher year over year, driven by solid risk management and improved results in global ocean freight. Overall, ag services delivered strong results just slightly off the outstanding fourth quarter of 2020, when we benefited from exceptionally high export margins. Crushing executed well in a continued solid demand environment for both soybean meal and vegetable oil. Lower results in EMEA versus a very strong fourth quarter of 2020 and approximately $250 million in net negative timing impacts versus negative $125 million in the prior year quarter drove overall results lower year over year. The majority of those negative timing effects are expected to reverse in the first half of 2022. The refined products and other team delivered substantially higher results versus the prior year period, driven by strong volumes and margins in North America for refined oils and improved biodiesel margins in North American and EMEA, which more than offset weaker South American results due to the reduced biodiesel mandate. Equity earnings from Wilmar were higher year over year. Looking ahead, we expect a strong first quarter from ag services and oilseeds, higher than the first quarter of 2021 and in line with the just ended fourth quarter. Slide 7 please. Carbohydrate solutions fourth quarter results were more than double the prior year quarter. In starches and sweeteners sub-segment, including ethanol production from our wet mills, results were lower versus the fourth quarter of 2020 driven by higher input costs, including energy costs in EMEA as well as lower wheat milling volumes, partially offset by continued strong ethanol margins. Volumes for North American sweeteners and starches were largely flat year over year. Vantage corn processor results were again substantially higher year over year, driven by historically strong industry ethanol margins as a result of strong demand relative to supply, as well as increased sales volumes due to production at the two dry mills that were idle in the previous year period. As we look ahead, we believe the first quarter for carbohydrate solutions should be similar to or slightly above the strong first quarter of 2021. Slide 8 please. The nutrition business closed out a year of consistent and strong growth with fourth quarter revenues 19% higher year over year, 21% on a constant currency basis with 26% higher profits year over year and sustained strong EBITDA margins. Human nutrition had a great fourth quarter with revenue growth of 21% on a constant currency basis and substantially higher profits. Flavors continued its growth trajectory driven primarily by improved product mix in EMEA and continued strong performance from North America, partially offset by weaker APAC results. In specialty ingredients, overall profits for the fourth quarter were in line with the year ago period as strong demand for plant-based proteins offset the impact of one-time insurance proceeds in the fourth quarter of 2020. Health and wellness was higher versus the prior year quarter as the business continued to deliver growing profits in bioactives and fermentation. Animal nutrition revenue was up 21% on a constant currency basis and operating profit was much higher year over year, driven primarily by continued strength in amino acids. Now looking ahead, we expect nutrition to continue to grow operating profits at a 15%-plus rate for calendar year 2022 with the first quarter similar to the first quarter of 2021, with continued revenue growth offset by some higher costs upfront in the year and the absence of the one-time benefits we saw in the first quarter of the prior year. Slide 9 please. Now let me finish up with a few observations from the other segment, as well as some of the corporate line items. Other business results were substantially higher, driven primarily by higher captive insurance underwriting results as the prior year quarter included larger intra-company insurance settlements. For calendar year 2022, we expect other business results to be similar to 2021, although for the first quarter we expect a loss of about $25 million due to insurance settlements currently planned. Net interest expense increased year over year on higher short term borrowings. In the corporate line, unallocated corporate costs of $276 million were lower year over year due primarily to increased variable performance related compensation expense accruals in the prior year, partially offset by higher IT operating and project-related costs and transfers of costs from business segments into centralized centers of excellence in supply chain and operations. We anticipate calendar year 2022 total corporate costs, including net interest, corporate unallocated, and other corporate to be in line with the $1.2 billion area, consistent with what I discussed at global investor day, with net interest roughly similar, corporate unallocated a bit higher, and corporate other a bit lower. The effective tax rate for the fourth quarter of 2021 was approximately 21% compared to 8% in the prior year. The calendar year 2021 effective tax rate was approximately 17%, up from 5% in 2020. The increase for the calendar year was due primarily to changes in geographic mix of earnings and current year discrete tax items, primarily valuation allowance and return to provision adjustments. Looking ahead, we’re expecting full year 2022 effective tax rate to be in the range of 16% to 19%. Our balance sheet remains solid with a net debt to total capital ratio of about 28% and available liquidity of about $9 billion. With that, let me turn it back to Juan. Juan?"
},
{
"speaker": "Juan Luciano",
"text": "Thank you Ray. Slide 10 please. I hope most of you were able to join us on our global investor day last month. There, we showed that we have consistently advanced our strategy, from our work to improve ROIC through capital cost and cash to our strategic growth and margin enhancement accomplishments, including the creation of a global nutrition business, to today’s focus on productivity and innovation. Thanks to this work, we are moving into 2022 with a better ADM, a more returns-focused organization with higher margins and less volatile earnings, and a portfolio that is well positioned to capitalize on the positive structural changes being driven by the enduring global trends of food security, health and wellbeing, and sustainability. Slide 11 please. Let me take a few moments to talk about how we see the 2022 environment. In ag services and oilseeds, we see a continued favorable global demand environment. Due to a short drought in South America with the magnitude of the shortfall still to be determined, we expect global ag commodity buyers will rely relatively more on the U.S. market for their needs, assuming we have a normal U.S. crop later this year. On the oilseeds side, we are starting 2022 with strong soy crush margins, and as we discussed at global investor day, we believe that increasing demand for meal as well as vegetable oil as a feedstock for renewable green diesel should continue to support the positive environment this year with our soy crush margins in the range of $45 to $55 per metric ton. Assuming these dynamics play out, we believe that ag services and oilseeds in 2022 has the potential to deliver an operating profit similar to or better than 2021. For carbohydrate solutions, we are assuming the demand and margin environment for our starch and sweetener products will be steady versus 2021. We expect the industry ethanol environment to continue to be constructive, supported by the recovery of domestic demand to pre-COVID levels, energy costs driving higher exports, and better clarity on the regulatory landscape. With this in mind, we are assuming higher ADM ethanol volumes and EBITDA margins to average $0.15 to $0.25 for the calendar year. In addition, we are expecting our value solutions platform to deliver another year of solid growth as we continue to evolve the carbohydrate solutions business. Putting it all together, we expect carbohydrate solutions to deliver full year operating profits slightly lower than the outstanding 2021. In nutrition, we are expecting continued growth in demand for our unparalleled portfolio of nutrition ingredients and systems, along with the benefits of accretion from our recent acquisitions. With these dynamics, we expect 15%-plus OP growth in 2022, revenue growth above 10%, and EBITDA margins above 20% in human nutrition and high single digits in animal nutrition, consistent with targets we set out at our global investor day. Slide 12 please. As we look forward in 2022, we see a positive demand environment across our portfolio, and then we add to that things we can do better. Our execution was great in 2021, but we’re always identifying opportunities for improvement and we intend to do even more to meet this growing demand in 2022. Put it all together and we’re optimistic for another very strong performance in 2022 as we progress towards our strategic plan next earnings milestones of $6 to $7 per share. With that, Operator, please open the line for questions."
},
{
"speaker": "Operator",
"text": "[Operator instructions] Our first question on the phone lines comes from Ben Theurer of Barclays. Ben, please go ahead."
},
{
"speaker": "Ben Theurer",
"text": "Thank you very much, and good morning, Juan, Ray. Congrats on those very strong results."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Ben."
},
{
"speaker": "Ray Young",
"text": "Thank you Ben."
},
{
"speaker": "Ben Theurer",
"text": "To start off, maybe just to stay a little bit within the outlook, clearly you continue to have a very positive view on the segment side, but could you also share a little bit your assumptions in terms of CapEx needs and where you’re seeing investment needs to be put into in order to deliver on the actual supply of these, so a little bit of your CapEx program and how you feel about that then ultimately the results flowing down to net income and what your expectations are for 2022?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, so many questions wrapped in one, Ben - good job. On the CapEx perspective, as you look at our strategic plan, most of our strategic plan is coming from organic growth and productivity, so in order to fund that, we’re going to have a little bit higher CapEx this year of about $1.3 billion. That will be of course in some of the projects we need to do to expand, like Spiritwood that we announced our JV with Marathon, but also again some productivity enhancements to make sure we deliver bigger volumes as we supply that demand. As you know, we are facing 2022 with a very strong perspective for the first quarter. We are entering the year with great momentum as we left 2021 also in a big high, so at this point in time, we continue to see a very strong 2022, and I think I described it in all of my commentary, ag services and oilseeds continue to firing on all cylinders and we expect a year as good as last year, or maybe even better. Carb solutions also going very strong with many--with very stable start and sweeteners, and you know, with always some uncertainty on ethanol but with a favorable environment, and [indiscernible] solutions continued to grow as we grew last year, and again nutrition going up about 15% per year operating profit growth on double-digit revenue growth. All in all, we feel very good about all the things that we can control."
},
{
"speaker": "Ben Theurer",
"text": "Okay, perfect. Thank you very much. Then just one last question, just a quick one. If you think about your medium term targets, and I remember you’ve laid out obviously as well the initiatives for share buybacks, etc., but in light of the higher CapEx plus the increase in dividends, fair to assume that share buybacks, at least in the short term, aren’t going to be a priority yet, correct?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, I think the priority for capital allocation is to de-leverage after we had maybe a couple of billion dollars invested in acquisitions, certainly fund the projects that we have in higher CapEx, as I described, and then the dividend, to support the dividend. Of course, cash flow generation is strong in ADM, you know we focus a lot on that, so as cash flow becomes available, we’re going to think again in the five-year plan to have more buybacks in the later period, but if cash flow continues to be as strong, we may anticipate that a little bit. At this point in time, we don’t expect significant M&A as part of our plans, so that would be the capital allocation decision."
},
{
"speaker": "Ben Theurer",
"text": "Perfect Juan, very clear. Thank you very much, and congrats again."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Ben."
},
{
"speaker": "Operator",
"text": "Thank you Ben. We now have the next question from Ben Bienvenu of Stephens. Ben, please go ahead, your line is open."
},
{
"speaker": "Ben Bienvenu",
"text": "Hey, thanks. Good morning and congrats on the strong quarter."
},
{
"speaker": "Ray Young",
"text": "Thank you Ben."
},
{
"speaker": "Ben Bienvenu",
"text": "I wanted to follow up on the outlook commentary, which was really helpful and detailed. Of particular interest to us is the bio product commentary that you offered. I think within the carbohydrate solutions business, the commentary around starches and sweeteners makes sense. The bio products obviously benefited from a very strong fourth quarter, and I suspect perhaps you had an opportunity to secure margins into the first quarter, but the commentary is pretty positive through the balance of the year, and I realize higher production will help in benefiting operating profit for that business. Can you talk a little bit about what informs your view for the strength of the ethanol business sustaining into 2022?"
},
{
"speaker": "Ray Young",
"text": "Hey Ben, good morning. It’s Ray here. Yes, we finished up very strong in the bio products business, ethanol specifically. The fourth quarter demand environment was very, very constructive, and I think that’s just reflective of what was happening in terms of the recovery in driving miles in United States, the holiday season. Gasoline demand was strong, that translates to strong demand for ethanol. On the supply side, actually the industry had some supply challenges, and so that translated to a very robust environment; in fact, our EBITDA margins in the fourth quarter for our ethanol business were above a dollar a gallon, which is very, very--you know, on a historical basis is very, very strong. We indicated that as we go into 2022, we feel optimistic about ethanol as well. While inventories have built up a little bit in January, and that’s just the seasonal nature of ethanol--of inventory builds, a couple things give us optimism for 2022. Number one, we do expect domestic demand for ethanol to be strong; in fact, it will be a growth year-over-year from ’21 to ’22, and frankly we’re seeing ethanol demand probably returning back to pre-pandemic levels of demand here in the United States, so we’re talking about domestic demand probably in the 14 billion gallon level. Secondly, I think you’re going to see a recovery around the world on gasoline demand and hence ethanol demand as well, and as you know, with the movement in crude oil prices in general, ethanol is becoming one of the most attractive oxygenates in the world, so we do see the export demand side of the equation in 2022 being also very constructive for ethanol, with ethanol probably recovering to 1.4 billion to 1.5 billion gallons in terms of export demand, so that’s very, very constructive. Thirdly, we do believe that the regulatory landscape has clarified itself in the context of small refinery exemptions. I know there’s some challenges going on here, but what we see right now is going forward, smaller SREs, as they call it, small refinery exemptions will not have an impact in terms of the supply-demand balances, and we talk internally that when they say 15 billion gallons, it means 15 billion gallons in terms of what we need to deliver to the marketplace, so that’s actually a positive also for our industry, and then they’ve also remanded about 250 million gallons in terms of requirements as well going forward. When you add it all together, the fact that we’re starting off the year with a fairly balanced supply-demand perspective in terms of U.S. ethanol inventories; two, a demand environment that’s going to be even more constructive versus 2021; and three, a regulatory environment that seems to be supportive of where we want to go, we actually have a constructive viewpoint. As Juan indicated, directionally we’re assuming $0.15 to $0.25 per gallon as EBITDA margins for 2022 - that’s lower than the ’21 assumption, and maybe we’re just being a little bit conservative at this juncture as we start off the year, but nevertheless we do believe it should be a favorable environment for us as we move forward into 2022."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay, that’s great. Very helpful Ray, thank you. My second question is just related to the global operating environment, and in particular some of the goings on in Ukraine at the moment and tensions there. Is that--how is that manifesting itself today in terms of the impact to your business? I know from an asset footprint perspective, you guys don’t have super-heavy exposure there, but they’re a major producer of rapeseed, corn, wheat, barley, so I’m curious what impact you’re seeing in the market today and how you think about the potential impact as we look into 2022, recognizing a lot of different scenarios could play out there."
},
{
"speaker": "Juan Luciano",
"text": "Yes Ben, of course you realize the supply of many commodities remains at their tightest levels in years, so I think any news around the world of disruption, whether it’s weather or geopolitics is going to prolong the high prices well into, probably, 2023. As you described, at this point in time there are three things. We are all looking at the development of the crops in South America as they need to go through February rains, especially in Argentina and the harvest in Brazil. We are looking of course at geopolitical conflicts like the one you described, and also the expectations of the crop in the U.S., all this in the middle of a very strong demand. As you said, Ukraine is a big exporter, especially if you think about corn and the ability to supply China’s needs. You have the three main suppliers, whether it’s the U.S. and you have Ukraine and you have Brazil, so hopefully Brazil with these rains will have a safrinha crop that is maybe a little bit better than what we expect, but among these three countries need to cover the supply of corn, and corn today is one of the best sources of energy and fat out there, one of the cheapest ones, so it’s a very demanded product, so we’re all paying attention to what happens [indiscernible]."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay, thank you Juan. Congrats on the quarter, and best of luck into 2022."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Ben. Thank you very much."
},
{
"speaker": "Operator",
"text": "Thank you. We now have another question on the phone lines from Adam Samuelson of Goldman Sachs. Adam, please go ahead when you’re ready."
},
{
"speaker": "Adam Samuelson",
"text": "Yes, thank you, and good morning everyone."
},
{
"speaker": "Ray Young",
"text": "Morning Adam."
},
{
"speaker": "Adam Samuelson",
"text": "I guess my first question is I want to come back to the outlook in carbohydrate solutions and just make sure I’m understanding the moving pieces to think about a full year 2022 outlook that’s only slightly below 2021, where both your ’22--’21 performance was above what you would have expected and 2025 for the unit, and just trying to think about the moving pieces with ethanol, and maybe there’s a clarification point on the--when you talk about ethanol margin $0.15 to $0.25 a gallon EBITDA, is that purely the dry mill gallons within Vantage corn processors or is that including the wet mill, and I guess in that vein, in the fourth quarter, given the strong ethanol margin environment, I guess I was surprised just to have seen the starches and sweeteners business be down, if that should have also been benefiting from a strong U.S. ethanol environment, so maybe just help us think about some of the bridges of the pieces within the segment to get you to the ’22 outlook."
},
{
"speaker": "Ray Young",
"text": "Yes Adam, it’s Ray here, so $0.15 to $0.25 EBITDA margin represents total ethanol, wet mill and dry mill, so that’s a combined basis on that assumption. In the fourth quarter, we had, as you saw, an outstanding quarter. VCP really benefited from the ethanol margins, and clearly starches and sweeteners also benefited as well on the ethanol side of the business. Our net corn cost was a little bit higher in the fourth quarter for starches and sweeteners, and recall when we hedged 2021 for corn, we put on a very attractive hedge position in 2020 for a lot of our 2021 requirements, but not all the requirements, so when we got to the fourth quarter, I think we were a little bit more exposed on net corn, so therefore the higher net corn cost translates to maybe a little bit lower margin on the sweetener side of the business there. We also had some operating challenges with the start-up of Bulgaria in Europe, which again is an opportunity, frankly speaking, for us in 2022, right, and we also had some higher energy costs over in Europe as well. As you know, natural gas prices ran up significantly in the back part of the year, so that impacted our energy costs over in Europe and that flowed through in terms of our starches and sweeteners segment. There were a bunch of puts and takes that moved through the fourth quarter. Again, we think a lot of that will be behind us because I think we’ve put ourselves--you know, put in a good hedge position for 2022, and then also we believe that we’ve got the Bulgarian project, we’ve addressed a lot of those issues, and that should be a plus delta for us in 2022 as well."
},
{
"speaker": "Adam Samuelson",
"text": "Okay, that color is really helpful. If I could just switch gears over to the nutrition segment, and maybe help us think a little bit about the expectations for the business on an organic basis in 2022. I know there was a--you did some M&A through the second half of 2021, so you talked to 10%-plus revenue growth and 15%-plus profit growth. Can you help us think about the M&A contributions within that, and any specific parts of the business that you might be more optimistic than the segment average, and areas where the growth might be a little bit below that?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, so I think most of 2022 will be on an organic growth basis, if you will. The contribution still of the acquisitions is going to happen a little bit later. These acquisitions are not made, to be honest, for the accretion of 2022. As you recall, we are just building the nutrition business, so this is the strategic importance of positioning ourselves in the areas where we’ve been informing you. I think that we always like to have the policy of no surprises, and I think you heard me saying health and wellness is an area where we were going to invest, and that’s why we did Deerland pet food, and that’s why we did PetDine. We continue to think about the incredible potential of plant-based proteins, and that’s why we did soy protein which is making us more international. I talked about how powerful we are in flavors, but we were under-represented, if you will, in the emerging markets, and that’s why we invested in capacity in Pinghu for flavors in China, and we also acquired Fisa that gives us a beachhead into Central America, Caribbean, and maybe the northern part of Latin America. When we look at the business, our confidence in the 15%-plus organic operating profit growth is given by our pipeline and our win rates, to be honest, that’s why we look. Our pipeline continues to increase, our product launches continue to increase and actually accelerate, and our win rates have almost doubled from one year to the other, so the business is operating very well. We guided flat for Q1 just because of the way some of the costs fall, and they are more front-loaded into next year, but this is a business again that’s been growing 34%, 20%, I think we’re going to stabilize in the long term at this rate of 15%, 15%-plus with double digit organic growth, basically, without even touching the M&A for that growth."
},
{
"speaker": "Adam Samuelson",
"text": "Got it. That’s all really helpful. I’ll pass it on, thank you."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Adam."
},
{
"speaker": "Operator",
"text": "Thank you. We now have a question from Robert Moskow of Credit Suisse. Robert, I’ve opened your line."
},
{
"speaker": "Robert Moskow",
"text": "Hi, thanks for the question, and congrats on a great year."
},
{
"speaker": "Ray Young",
"text": "Thanks Robert."
},
{
"speaker": "Robert Moskow",
"text": "Of course. Maybe you’ve kind of implied this already, but your pricing for corn sweeteners in 2022, can you describe how the negotiations went, and it looks like what you’re guiding to was kind of flattish profits in North America for corn sweeteners as a result of that pricing. Is that a fair assessment?"
},
{
"speaker": "Ray Young",
"text": "Yes Rob, our objective is really to maintain margins, and so through the course of the negotiations, I think it’s fair to make an assumption that we’ve been able to maintain margins and offset the higher corn costs that has occurred recently. I think we’ve achieved that objective, and that’s a fair assumption to assume as we go into 2022."
},
{
"speaker": "Robert Moskow",
"text": "Okay, and maybe a follow-up, if expansion of refined soybean oil is driven by the growing demand of renewal biodiesel, have you been watching the industry--the planned industry expansion for all those refineries, and what kind of--is it achieving what you’d expect? Is the capacity coming online as expected, and is it having the results on demand for oil that you would expect?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, of course we keep a close eye into that. You have to understand that at this point in time, demand continues to outpace even the announced capacity expansions, but there is a reality also in this world of supply shortages and labor issues, that projects are not that easy to execute. I think that when you look at a battery of announcements like the way we’ve seen, I think it’s reasonable to put a percentage that that is going to happen, either the reality or that they’re all going to happen but in a little bit longer timeline. We tend to look at that from a long term basis of maybe something like two-thirds or 75% will happen. At this point in time, we see the volume coming our way, and you have to remember that the original oil story, Rob, it was due to high palm oil around the world, and that drove soybean and other oils up, and now on top of that, now we have the demand for RGD, so that--now, there is a full confluence of raw materials to be able to supply that oil. So yes, we are looking at this very closely, and at this point in time, everything is evolving as planned."
},
{
"speaker": "Robert Moskow",
"text": "Okay, all right. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Thank you Robert. We now have Tom Palmer of JP Morgan. Tom, your line is open, please go ahead."
},
{
"speaker": "Tom Palmer",
"text": "Good morning. Thank you for the questions, and congratulations on the quarter."
},
{
"speaker": "Ray Young",
"text": "Thank you Tom."
},
{
"speaker": "Tom Palmer",
"text": "Maybe I can follow up on Rob’s question, just on the refined products outlook, and maybe a little more specific on how you’re thinking about the set-up for 2022. We do have maybe the first larger wave of facilities coming online with pre-treatment units, although that is at least back half-weighted, I think, so maybe what’s the assumption for refined products this year, and do you think that that addition in terms of capacity is going to have much impact, or as you were kind of noting with Rob, maybe just with timing and needs of still sourcing from, at least a portion from third parties, it won’t be as impactful?"
},
{
"speaker": "Juan Luciano",
"text": "Yes Tom, listen - we continue to believe we will add around a billion gallons per year of incremental RGD capacity and approach that 5 billion gallons total capacity by 2025. As I was telling Rob, we continually reframe the announced capacity and analyze the market conditions, so we have several scenarios in this. We do believe these announced capacities are important to and necessary to keep up with the expected demand growth for both vegetable oil, as I explained before, but also global meal demand needs. At this point, vegetable oil consumption is still growing faster than supply. We’ve gotten a little bit of good news from Sanoil availability from black seed that maybe will help bean oil tightness, and--. So regarding the pre-treat comments, in the end the vegetable oil will be required as a feedstock and pricing will reflect the value of this feedstock, likely based on carbon intensity, so we could see some shift in value between the crude oil and the refining. I think what we need to realize is we are at the early stages of this industry formation, so we’re going to see some of that movement and sometimes we’re going to capture the value in one place, sometimes we’re going to capture the value in another one. But we are well positioned, our biodiesel plants are all integrated in refineries and all that, so we are watching it very closely and we feel good about how it’s developing so far."
},
{
"speaker": "Tom Palmer",
"text": "Great, thank you for that. Maybe I’ll segue with that to the crushing side. It seems like you’re starting off the year with quite strong soy crush margins, perhaps higher than maybe you’re guiding to for the year. Is there a, I guess, catalyst or driver that maybe makes margins weaker? Is there a bit of conservatism embedded? We see headlines around lysine shortage - is that something you’re expecting to resolve itself and maybe see still a very favorable crush environment, but a little more normalized versus to start off the year?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, there are many--of course, this is a large industry, so many puts and takes. When we look at the demand side, the forecasted 2022 poultry production is going to be a record and near record for beef and hog, so protein demand continues to grow around the world, and that’s sustaining a lot. There is a tight meat proteins and synthetic amino acids, and that’s supporting soybean meal. Remember, I mentioned fat is very expensive today and energy as well, so corn at this point in time is the cheapest carbohydrate, that’s pulling soybean meal into the Russian, and we expect that one point in time, the lysine market may be back into balance later in 2022. But still, the SMDs are very, very beneficial to soybean meal and to crush, so. I think also, don’t forget RGD is also changing the dynamics for soybean meal, making soybean meal from the U.S. much more competitive and able to gain some export markets, and when you have maybe a less than stellar soybean crop in Argentina, Argentina being such a strong exporter of meal, I think that bodes well for crush margins in North America and also in Europe."
},
{
"speaker": "Tom Palmer",
"text": "Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Tom."
},
{
"speaker": "Operator",
"text": "We now have the next question from Vincent Andrews from Morgan Stanley. Vincent, please ensure your line is unmuted locally, and you may go ahead."
},
{
"speaker": "Steve Haynes",
"text": "Hi, this is Steve Haynes on for Vincent. Wanted to ask a question on the bio solutions business and the $100 million of annualized revenue wins in 2021, and if you could maybe just provide some more color on specific end markets where you’re getting those wins and then how to think about the size of that going forward."
},
{
"speaker": "Juan Luciano",
"text": "Yes, thank you for the question, Steve. Listen, we are very excited about how that business is developing. I think we recognized in the past that that business happened almost while we were not watching and it was a customer pull more than our push. Now, we have a segment approach to that. We have intentionality in developing that market and as such, the opportunities have flourished. I would say a strong contribution from packaging, a strong contribution from fermentation - you know, we’re helping other people that are creating some of these materials out of a plant base, personal and homecare, a very important segment that is growing, and a growing contribution from pharma, construction and plant treatment. So as you can tell, as we continue to deploy marketing resources into some of these segments, we continue to have success. There are some segments that are more developed and larger for us and some segments that are more incipient, but I think it’s going very well. We are working on the product mix as sometimes the growth is faster than our capacity, so we’re trying to accommodate that and we’re going to be having more capacity coming up soon to be able to sustain this 10% growth rate [indiscernible] that we have."
},
{
"speaker": "Steve Haynes",
"text": "Thank you."
},
{
"speaker": "Juan Luciano",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Thank you Vincent. We now have Ken Zaslow of BMO Capital Markets. Ken, please go ahead when you’re ready."
},
{
"speaker": "Ken Zaslow",
"text": "Hi, good morning everyone."
},
{
"speaker": "Juan Luciano",
"text": "Morning Ken."
},
{
"speaker": "Ray Young",
"text": "Hey Ken."
},
{
"speaker": "Ken Zaslow",
"text": "Let me just take a different approach. When you think about your--you talk about all the things that are happening on the demand side, but at your analyst day, you kind of did talk about the cost structure increasing and that there were going to be some headwinds. As I look forward, these headwinds don’t seem to be materializing to the extent, or are they, and can you frame how you kind of put it during the analyst day and where you see they are going through to--you know, where you’re seeing them now, where you see them through 2022, and are you really seeing them develop they way you thought they were or are they a little bit lower than you thought?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, the dynamics here, Ken, of course is we have forecasted or accounted for some--the potential reversion of margins and some inflation of course that we were going to have, and that is difficult to estimate the timing, and then we have productivity and innovation that is going to be growing in their impact as some of these projects develop. When we look at, if you will, at the negative side of the equation, as the positive side we can control, on the negative side we’ve put together several scenarios, and I would say the biggest manifestation of that at this point in time has been energy inflation, and inflation from some smaller products. We suffer probably more of this, some supply chain disruptions and labor shortages, that you probably hear every company talking about. I would say from an energy perspective, the impact is probably more on Europe, whether it’s on crush or carb solutions, that’s where we see the impact, and we have our team basically working on energy efficiency and shaving some percentages of that increase, and also our hedging mechanisms and all that. On the raw material side and the supply chain disruptions, that’s probably more the territory of nutrition. Nutrition, as you can imagine, has more variety of raw materials and more SKUs, so the complexity of that business makes it more exposed to some of these winds. That’s the way we’re looking at that - it’s more the European energy increase and some of the nutrition one-offs here and there on supply chain."
},
{
"speaker": "Ken Zaslow",
"text": "My second question is--and I appreciate that. On the China side, I think last call and the call before, you kind of outlined how demand is growing. I know 2021 was an extraordinary year for China demand. How do you think that’s going to play out in 2022 and 2023 in terms of will there be a mix change, will there be increased demand? How do you kind of think about it relative to your business model? I appreciate your time, as always."
},
{
"speaker": "Juan Luciano",
"text": "Yes, thank you Ken. Listen, we think that China has recovered from the ASF, they recovered their herd. You saw the dynamics in terms of pork prices coming up and down. We still believe that they will import soybeans in the high 90s - you know, 96, 97 million give or take, and around probably 25 million tons of corn. Again, when we are working the way they are managing through COVID challenges, but we expect demand will continue to grow, it continues to be supported by improved diets and professional feeding practices. Even if we see some moderation of GDP, we think that we’ve seen per capita consumption of the top four meats basically increases, and even if they correct it a little bit, they correct versus 2021, they are still much bigger than pre-ASF and pre-pandemic. We [indiscernible] with a number here or there, but still it’s going to be very strong, and as I said, probably 96, 97 million of soybeans, 25 million of corn, that will provide a good base for the grain industry and the crushing industry."
},
{
"speaker": "Ken Zaslow",
"text": "Great, I appreciate it. Thank you guys."
},
{
"speaker": "Juan Luciano",
"text": "Thank you Ken."
},
{
"speaker": "Operator",
"text": "Thank you Ken. We now have a question from Ben Kallo from Baird. Ben, please go ahead when you’re ready."
},
{
"speaker": "Ben Kallo",
"text": "Hi, good morning everyone, and thanks for taking my questions. Ray, you touched on the regulatory environment just in your ethanol comments, but maybe just on a broader level, maybe around renewable diesel, if you guys could talk about that. Then on the legislative front, I hate to ask because it’s anyone’s best guess, but how you see maybe the blender’s tax credit and anything around aviation fuel evolving. Thank you."
},
{
"speaker": "Ray Young",
"text": "Yes, on the biodiesel, as you know, the current blender’s credit continues until the end of 2022 - December 31, 2022, so naturally we’re looking at what’s happening on the legislative agenda in Washington on the BBB program to see whether it gets renewed. But historically what you’ve seen is, frankly, both parties are supportive of the biodiesel industry - it’s important for the United States, and so even if something doesn’t occur on BBB, we’re optimistic that the blender’s credit will get extended in one way or another through some form of legislation as we move through the year. If you recall, sometimes it happens after you get through the end of the year and then you have a retroactive biodiesel tax credit, which we’ve seen in the past, so we actually feel confident that something will occur there in order to kind of continue with the blender’s credit on the biodiesel tax credit. On the SAF front, as you know, this is something that we’re working on right now with different partners. It is going to be an important part of the fuel industry in the future as we go green in terms of aviation fuel, so [indiscernible] frankly, again, the support we see in terms of the direction of SAF, we’re optimistic that some form of legislative--yes, some form of legislative actions will be taken to support the sustainable aviation fuel, the SAF industry. Again, it’s a nascent industry right now, right - very few gallons are being produced, but projections show that by 2030, there’s going to be a need for about 4 billion gallons of sustainable aviation fuel in combination of United States and Europe, so it’s a significant growth industry and probably there’s going to be some level of support required in order to start up this industry here."
},
{
"speaker": "Ben Kallo",
"text": "And back to the renewable diesel front, could you just talk about any areas that you’re watching? We talked about the supply side and how you discount new production facilities coming online, but could you talk about the demand side and where you’re seeing incremental demand coming from, the regions that we already know out there or new regions? Thank you, and thanks for all of the answers."
},
{
"speaker": "Ray Young",
"text": "The demand side is really driven by the different states implementing low carbon fuel standards, LCFS standards, particularly starting out in the west, but frankly it gets extended across all of the United States and Canada. The demand side is there as all the states move towards LCFS standards, and frankly the industry is just simply trying to respond to that demand by building the supply to meet that particular requirement there."
},
{
"speaker": "Ben Kallo",
"text": "Great, thank you."
},
{
"speaker": "Operator",
"text": "Thank you. We now have a question from Steve Byrne from Bank of America. Steve, please go ahead, I have opened your line."
},
{
"speaker": "Steve Byrne",
"text": "Yes, thank you. Do you think that soybean oil will represent the majority of the feedstock for this 5 billion gallons of renewable diesel?"
},
{
"speaker": "Ray Young",
"text": "It’s going to represent an important part of it. As demand grows for renewable green diesel, it’s going to require the pull from many sorts of feedstocks, and in fact it’s very likely that even canola oil will find a pathway eventually to become part of a feedstock for renewable green diesel. But we still believe that maybe about 45% of the production will come from soybean oil, eventually small production out of the canola oil that I referenced there, so it is going to be an important component because there’s just insufficient amount of, let’s say, used cooking oil and other types of feedstocks, fat and rendering. There’s just not enough supply in order to meet this growing demand."
},
{
"speaker": "Steve Byrne",
"text": "Even your 45% is 30 million acres of incremental soybeans, which I don’t think is going to happen. Does that mean soybean exports get squeezed out and instead it gets crushed, the oil goes into RD, and you export the meal?"
},
{
"speaker": "Ray Young",
"text": "We’ve indicated we believe that a lot of the U.S. soybean oil exports will actually come down, you’re correct. I think there is going to be a diversion away from exports of soybean oil. There will also be some diversion away from even food applications. There’s going to be a daisy chain effect that goes on which, frankly, is actually supportive for the entire vegetable oil complex around the world. I think there is going to be some daisy chain effects that are going on in order to meet this type of demand."
},
{
"speaker": "Steve Byrne",
"text": "And then what about your Slide 15, where you show forward sales by farmers in South America being below historical averages? Do you attribute that to the uncertainty that they are seeing with their current crop, just from either drought or excessive rain, and if grain and oilseed production is lower there in 2022, or the rest of the world for that matter, is that a net benefit to you in trading?"
},
{
"speaker": "Juan Luciano",
"text": "Steve, this is Juan. What you’re seeing from the farmer in South America is reflective of both things. One is the current impact in South America, and the second is, as you see, they are looking at what happened with the size of the crop. In terms of whether it’s beneficial for ADM or not, our role is to try to fulfill our mission of providing nutrition around the world, and that’s where we use our supply chain to make sure that we deliver to our customers and we deliver to the populations around the world. Sometimes it coincides with margin expansion in some parts of the business, sometimes it may not. We like the fact that there is strong demand around the world, and that tends to be good for ADM, yes."
},
{
"speaker": "Steve Byrne",
"text": "Thank you."
},
{
"speaker": "Juan Luciano",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Thank you. We now have our next question from Michael Piken of Cleveland Research. Michael, please go ahead."
},
{
"speaker": "Michael Piken",
"text": "Yes, good morning. Just wanted to sort of get your take on the current transportation system and the outlook it supports, both in New Orleans, are we fully recovered from the hurricanes, and then kind of the barge system and what’s happening over in the ports in China. What’s sort of the back-up, and is business flowing normally or how backed up is it?"
},
{
"speaker": "Juan Luciano",
"text": "Yes Michael, good question. Let’s talk about China. Some slight COVID-related challenges in China are impacting ports, but to be honest, the situation has improved. Initially we got the highlights, but in general the port situation continues to improve, and maybe we have average waiting about two, three days for bulk cargo in agriculture in most main ports, so I would say China is kind of okay. We’ve seen line-ups or demurrage time increasing in Brazil. There are still boats exporting corn and importing fertilizers since the soybean crop is a little bit delayed. We are seeing more--we are seeing waiting times kind of double from maybe 15 days to 30 days in Brazil, and that’s pushing some volume into North America for maybe March-April deliveries. North America export capacity has recovered for the most part. I think there is one plant that was going to have some long term or medium term, if you will, repairments, but for the most part, the export capacity has been recovered to pre-idle levels, at least for us. I would say in terms of the river, the Illinois River, there is a lot of freezing and there is a lot of icy conditions that have slowed down the river movement, and we see that, and that probably will continue."
},
{
"speaker": "Michael Piken",
"text": "Great, that’s helpful. Then just as a follow-up, what’s the elevation margin outlook as you guys see it for the year? Thanks."
},
{
"speaker": "Juan Luciano",
"text": "We’re seeing--as you know, we have the impact of Ida in Q4, we had the demand but we didn’t have the ability to support to supply, so a lot of that volume was moved into Q1. We have seen the elevation margins increasing in Q1, so a little bit as expected, so we feel good about how to satisfy that demand."
},
{
"speaker": "Michael Piken",
"text": "Thank you."
},
{
"speaker": "Juan Luciano",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Thank you. Our last question comes from Eric of Seaport Research Partners. Eric, please go ahead."
},
{
"speaker": "Eric Larson",
"text": "Yes, thank you. Thanks for squeezing me in everybody. Congrats on a great quarter. Great year everyone."
},
{
"speaker": "Juan Luciano",
"text": "Thank you."
},
{
"speaker": "Eric Larson",
"text": "I know this has kind of been beaten to death and obviously it’s very important, so if you--it’s again on the renewables. If you just take the renewable green diesel market, if you just look at the amount of feedstock that’s required to kind of get to that 2025 goal, your goal of 5 billion gallons, it’s--and I think it was alluded to earlier with that 45% comment, it’s 30 million acres of increased--it’s the equivalent of 30 million acres of soybean production, which it just isn’t going to happen. I know that Greg and Chris are all over this. Doesn’t this--it’s got to be--it is a global market, it will be. Doesn’t this just feed right into your--into a very positive long term outlook for ag services that you’re going to have to be able to pull globally a lot of resources in to meet these demand functions, but that’s what makes it possible. Is that the way to look at this?"
},
{
"speaker": "Juan Luciano",
"text": "Yes, I think Eric, when you have one explosion in demand in one place of the world, resources from around the world will come, and as Ray was saying, maybe we’re going to export less, certainly we may import more, and there are going to be shifts between the different products. I would say we continue to be in a world that requires more food and also that requires to help the environment. It has been a structural change in demand for us, and for a company that has assets around the world, that probably means better utilization of those assets and better value of those assets as we try to solve these issues."
},
{
"speaker": "Eric Larson",
"text": "Good, well thanks. The final question I have, and a lot of those have been answered already, so when we look at the current year in terms of U.S. crop production, what are you hearing from your farmer clients? Obviously it looks like we’re putting a bid in the corn markets today to get more corn production. There’s a lot of uncertainty with input costs and all the other stuff. What is your feel for how in this early--well, it’s not so early anymore, it’s getting close to the time, what is your feel on how the crop production outlook looks for this year, kind of by crop?"
},
{
"speaker": "Juan Luciano",
"text": "We expect a strong U.S. planting. Of course, some of those decisions, as you said, it’s getting the time to make those decisions, and a lot of people are looking at the South American weather. South American weather is very strange at the moment - there is very dry conditions in Parana or the south of Brazil, and maybe Argentina, and it was a little bit too wet in the north. Numbers in the north are coming strong in terms of yield for Brazil. I think that the recent rains have stopped the deterioration of the crop in Argentina and the south of Brazil, and probably with Paraguay having already felt the damage. We believe in the U.S. We still believe that probably corn will outpace soybeans in terms of acres, so we’d probably think about, I don’t know, something like 93 million acres of corn, 87 million acres of soybeans give or take. I understand the dynamics about fertilizers and all that, but I think even the prices of last year, I think that the prime land will probably maintain the same mix."
},
{
"speaker": "Eric Larson",
"text": "Yes, I would agree with you. Thank you Juan, and again congratulations on a great year."
},
{
"speaker": "Juan Luciano",
"text": "Thank you. Thank you Eric."
},
{
"speaker": "Operator",
"text": "Thank you. I would like to hand it back to Vikram Luthar for some closing remarks."
},
{
"speaker": "Vikram Luthar",
"text": "Thank you Rika. Thank you for joining us today. Slide 13 notes upcoming investor events in which we will be participating. As always, please feel free to follow up with me if you have any other questions. Have a great day and thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "Thank you everyone for joining. That does conclude today’s call. You may disconnect your lines and have a lovely day."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 3 | 2,021 | 2021-10-26 09:00:00 | Operator: Hello and good morning and welcome to the ADM's Third Quarter 2021 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Vikram Luthar CEO, Vice President, Head of Investor Relations, Chief Financial Officer, Nutrition for ADM. Mr. Luthar, you may begin.
Vikram Luthar: Thank you, Emily. Good morning and welcome to ADM's third quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at www.ADM.com. For those following the presentation, please turn to Slide 2. The Company's Safe Harbor statement, which says that some of our comments and materials constitute Forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, Company performance, and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer Juan Luciano will provide an overview of the quarter and highlight some of our accomplishments. Our Chief Financial Officer, Ray Young will review the drivers of our performance, as well as corporate results and financial highlights. Then Juan will make some final comments after which, they will take your questions. Please turn to Slide 3, I will now turn the call over to Juan.
Juan Luciano: Thank you, Vikram. This morning, we reported third quarter adjusted earnings per share of $0.97, but it's a 9% year-over-year improvement despite a higher tax rate. And our year-to-date adjusted EPS of $3.69 is already above our full-year 2020 adjusted EPS. Adjusted segment operating profit was $1 billion, up 18% versus the third quarter of 2020. And our 8th consecutive quarter of year-over-year OP growth. Our trailing 4-quarter adjusted EBITDA was about $4.6 billion, almost a billion more than a year ago. And our trailing 4-quarter average adjusted ROIC was 9.6%, significantly higher versus the year-ago period. I remain proud to lead a global team that is delivering robust returns and sustained growth in profits. Our strong quarter and our ongoing upward trajectory are a testament to our team's execution and agility, and the consistent implementation of our strategic plan. I'd like to take a moment now to highlight some of our accomplishments from the quarter. Slide 4, please. I'd like to start by talking about our approach to portfolio management. Our starting point if they believe that in order to thrive and create value, a Company needs to have a dynamic view of its business portfolio. So when we talked about the dramatic transformation of our portfolio over the last 10 years, it's not a discrete event, it's a representation of our continuous work to identify opportunities for growth and improvement. Of course, those opportunities may be the -- must be the right ones. The enduring trends of food security, health, and well-being, and sustainability, provide unique and stable opportunities for ADM to expand our existing capabilities. And we're focusing our efforts on identifying high-growth on-trend areas with attractive margins and which are adjacent to our existing capabilities. That focusing formed the building of our Global Nutrition business. The acquisition of Wild gave us entry into flavors and a global taste platform. With end-used bolt-on acquisitions to add adjacent capabilities and build a one-stop shop with an industry-leading pantry of ingredients and solutions for human nutrition. We do the same for animal nutrition with the acquisition of Neovia. And we continue to do the same today as grows our business. In order to meet growing demand for sustainable solutions, we have announced a joint venture and offtake agreement with Marathon Oil Company to support the production of renewable diesel. We're continuing to invest in key nutrition categories. As demand for alternative protein grows from $10 billion to $30 billion over the next decade, we're further enhancing our work capabilities with the acquisition of Sojaprotein. And with global demand for pet foods growing $240 billion in the coming years, we are continuing our growth with a 75% ownership stake in PetDine. In the area of microbiome, we've signed an agreement with Vland Biotech to launch a joint venture that will perfectly position to help meet $1 billion in retail demand for probiotics in China. These are just some examples of how we are dynamically positioning our portfolio to continue driving growth for years to come. There will be more to come, and you can expect an increased level of investments to support our sustainable earnings growth and further expand our capacity and capabilities. Please turn to Slide 5. As part of our portfolio management approach, we're working to evolve our carbohydrate solutions business. Expanding our arrays of solutions to meet growing customer demand driven by the enduring trend of sustainability. We've made significant progress recently focused on two areas, new opportunities for our alcohol production and our growing value solutions platform. Then we start with alcohol. Last Thursday, we announced that we reached an agreement which we expect to close at the end of the month to sell our ethanol facility in Peoria. And yesterday, we announced a Memorandum of Understanding with Gevo to explore potential joint ventures, one of which would include our Columbus and see that rapid design mills, and our would've ethanol assets indicator. Transitioning 900 million gallons of ethanol production to support growing demand for low-carbon, sustainable aviation fuel. These actions represent our commitment to a process that we began when we first announced the third issue review of our dry mills review of our dry mills. Taken together, they will allow us to significantly reduce our exposure to vehicle fuel ethanol while using our expertise and assets to capitalize on new opportunities. SAS is one of those opportunities. The U.S. and EU have set goals that together, will support almost 4 billion gallons of annual sustainable aviation of fuel production by 2030 and more than 45 billion by 2050. The other focus area for are carbohydrate solutions evolution is our bio solutions growth platform. Biosolutions, which we launched about a year ago, is an effort focused on using our product streams to expand our participation in sustainable, higher-margin solutions for attractive end markets like pharmaceuticals and personal care. This is an area of significant potential, and our team is doing a great job identifying new and exciting opportunities. Earlier this fall, for example, we signed an MOU with LG Chem for the production of lactic and polylactic acid for bioplastics and other plant-based products. These efforts are enabling value solutions to deliver 10% annualized revenue growth, Including more than $80 million in new revenue wins in the first 9 months of this year. And we believe there are many new opportunities to come. So from the transformation of our dry mills to our growing biosolutions platform, our work to evolve our would carbohydrate solutions capabilities is a perfect example of how we're managing our portfolio and delivering the smart strategic growth. And one of the many reasons we remain convinced in our ability to deliver sustainable earnings growth in the years to come. Lets talk a little bit more about our business outlook at the end of our call. And of course, we'll be going into much more detail at our Global Investor Day on December 10th. But in the meantime, I will turn the call over to Ray to talk about our business performance. Ray.
Ray Young: Yeah, thanks, Juan. Slide 6, please. The Ag Services in Oilseeds team continued their outstanding year with another quarter of substantial profit growth. In Ag Services, we're proud of how the team executed in a challenging environment, including a swift return to operation after Hurricane Ida. Overall results were significantly lower versus the prior year quarter, driven by approximately $50 million in net timing effects that should reverse in coming quarters, as well as $54 million in insurance settlement recorded in the prior year period and lower export volumes caused by Hurricane Ida. Global trade continues its strong performance. The crushing team delivered substantially higher year-over-year results executed well, delivering stronger margins in a dynamic environment that includes strong demand for vegetable oils to support our existing food customers, as well as the increasing production of renewable diesel. Results were also driven by about $70 million in net positive timing effects in the quarter. Refined products and other results were significantly higher than prior-year period driven by positive timing effects of approximately $80 million that are expected reverse in future quarters. Strong execution EMEA North America biodiesel, and strong refining premiums due to demand for renewable diesel, and food service recovery in North America also contributed to the results. Equity and earnings from Walmart were lower year-over-year. Now, looking ahead, we expect to see continued fundamental demand strength for egg service and oil seeds products, including from China, as well as solid global soybean crush margin environment in the Fourth Quarter. Partially offset by some higher manufacturing costs. In addition, RPO will be negatively impacted by timing reversals. All told, we expect results in the fourth quarter to be significantly higher than the third quarter of this year. Slide 7, please. Carbohydrate solution results were lower year-over-year. The starches and sweeteners sub-segment, including ethanol production from our wet mills, showed their agility by managing through dynamic market conditions and optimizing mix between sweeteners and ethanol production through the quarter. Year-over-year results were significantly lower primarily due higher input cost. Vantage corn processor results were much higher versus the third quarter of 2020, supported by their resumption of production of -- at our 2 dry mills and improved fuel ethanol margins, particularly late in the quarter. Looking ahead to the fourth quarter, we expect the solid fundamentals from the end of the third quarter to continue for Carbohydrate Solutions with good ethanol margins extending through the quarter due to industry supply demand balance in solid demand for corn oil and starches, offset by higher manufacturing costs, particularly in Europe. As well as the absence of the Peoria dry mill. All told, fourth quarter results for the segment should be similar to the previous year fourth quarter. On Slide 8, the nutrition business remains on its solid growth trajectory with 17% higher revenues and 15% on a constant currency basis and 20% higher profits year-over-year in continued strong EBITDA margins. The Human Nutrition team delivered revenue growth of 12% year-over-year on a constant-currency basis, helping to drive 9% higher profits. Higher volume, improved product mix for particular strength in beverage show strong flavor results in the in North America, partially offset by lower results in APAC. Especially ingredients continued to benefit from strong demand for alternative proteins offset by some higher costs. Health and wellness results were higher on robust sales growth in bioactives and fiber. And nutrition profits were nearly driven primarily by the strength in the mineral assets, as well as feed additives. Looking ahead. We expect nutrition to continue on its impressive growth path with strength across the human and animal nutrition, linked to strong year-over-year earnings expansion and a 20% full-year growth versus 2020. Slide 9, please. Let me finish up with a few observations from the other segment, as well as some of the corporate line items. Other business results were substantially lower in the prior year period, driven primarily by captive insurance underwriting losses, most of which were offset by corresponding recoveries in the other business segments. We expect fourth quarter to have some additional insurance underwriting losses resulting in a break even other business for the Fourth Quarter. As expected, net interest expense for the quarter decreased year-over-year on lower interest rates, and a favorable liability management actions taken in the prior year. In the corporate lines, an allocate corporate costs of $230 million were driven primarily by higher IT offering and project-related costs into the centralized centers of in supply chain and operations. Looking at total corporate costs, in other corporate, we are still on track for the calendar year to be overall similar to 2020. The effective tax rate for the third quarter of 2021 was approximately 18%. We anticipate our calendar-year adjusted effective tax rate to be the upper end of our previously communicated range of 14% to 16%, and potentially a bit higher depending upon the geographic mix in the fourth quarter. Our balance sheet remains solid with a net debt-to-total capital ratio of about 26% and available liquidity of about $11.5 billion. With that, I will turn it back to Juan.
Juan Luciano: Thank you, Ray. Slide 10 please. From consistent sustained profit growth to the ongoing management of our business and product portfolio, our team has a lot to be proud of. And there's one other thing we achieved last quarter that I want to mention. We have many team members impacted when Hurricane Ida hit in late August, so we provide the temporary housing arrangements, portable generators, food and water, and more. In fact, many ADM colleagues traveled to the region and spent time helping repair their co-worker's damaged homes. Out of that, I'm very thankful to our team. as we plan to grow into our outlook in far more of depth on our December 10th Global Investor Day. As I look back at the Third Quarter, and all of the last 9 months, I continue to see a team and a Company that are delivering on our goals and our purpose. We are closing out 2021 with great momentum. We're on track for a strong Fourth Quarter, and the second consecutive year of record earnings per share. And as we look ahead to 2022, we see another strong year for ADM. A robust global demand environment will continue to look for opportunities for us to leverage our indispensable globally origination, processing and logistics capabilities. And nutrition will continue on its strong growth trajectory in line with our 15% and on its way to a billion dollars in operating profit in the coming years. Of course, there are widely. Thanks to our unique value chain and global footprint, our unmatched and well-being and sustainability, and a truly unparalleled team of nearly 40,000 colleagues around the world, we remain very optimistic in the strong year to come. With that, Emily,
Operator: To register your questions, please, Our first question today comes from Ben Bienvenu from Stephens. Ben, your line is open.
Ben Bienvenu: Hey thanks. Good morning, everyone.
Vikram Luthar: Morning Ben.
Ray Young: Hey, Ben.
Ben Bienvenu: I've got one long-term question with regards to your announcement yesterday around SAS. And then I want to ask a clarifier on the guidance. Yesterday, congratulations. A couple of questions. One is, when you think about the total opportunity for SAS, obviously the embedded demand is significant, given SAS seems like one of the most pertinent ways to reduce greenhouse gas emissions, though are unclear at this time. So I'm curious has you think about engaging with Gevo on this partnership? One, well, to commit these facilities. to this end market ultimately. And then to help us think about kind of the the Memorandum of Understanding, why did you go with that initially versus a more legally binding agreement? And then, if you would just talk just bigger picture the ethanol markets that would be helpful. I know a lot in there, but I'd love to hear you talk about it.
Juan Luciano: Thank you, Ben. We've been looking at the options for the dry mills for a very, very long time. So we've been studying the opportunities for the ADM shareholders to o as we try to divert these assets. Certainly, when we look at the sustainability trends and the opportunities, remember one of the issues with these assets are, they are very large. Would become -- would became a little bit of an issue at the time by testing them. So we were looking for opportunities that are sizable. We are that size turns into a competitive advantage. So certainly, when you look at all the industries to CO2, and we have identified, and we have checked with strategic partners, people in the industry that they say yes, is the solution. And I think we see also concurrently that both the U.S. and the European governments are looking at this a year final, trying to incentive the demand for that. So you heard President Biden or Secretary Franco for making statements about that. So we see a very positive environment developing for this, a very sizable adjustable markets for us. And when you combine our size with our raw material procurement and our costs and the ability to decarbonize based on our carbon capture and sequestration. As you recall, we've been running since 2017. Allows that complex to provide very competitive, low CI fuels for the industry. So we decided to . There are many opportunities and options potentially could happen, which is the creation of these two joint ventures. In one of those joint ventures, ADMs contribution will be the 2 dry mills as I would objective it as to deconsolidate these two. So again, but still too many discussions to happen and many foreigners to join us into this. We are thinking over time to have a minority position in diesel, having probably strategics of financial foreigners to join us. So -- but overall, as you can be assured, this is a better outcome for our shareholders in terms of the realization of value from these two drivers. So we're very excited about the opportunities.
Ben Bienvenu: Okay. Great. My next question is a clarifier in the discussion to the extent you can on 2022. First, Ray, did I hear you say on the Ag Services and Oilseeds for the fourth quarter, you expect it to be higher than the third quarter, but you didn't say higher than the fourth quarter last year? Is that -- are those the goalpost we should be thinking about? That's part 1, and then question 2 within that is, export demand looks strong for next year, obviously renewable diesel is continuing to gain steam. How do you feel about Ag Services and crushing in that broader Ag Services and Oilseeds segments as we go into 2022?
Juan Luciano: So Ben, listen. As we think about Q4 for ADM, and when we say we expect a strong Q4, we look at strong crush margins, demand this is strong for proteins, but also the demand for Oilseeds very strong and tight and then you add RGD on top of that. We are facing an improved ethanol environment as we enter the Q4. We are estimating exports from the U.S. in volume similar to last year. competitors plant is down because of our same situation. And then we continue to see nutrition growing at 15 to 20%. Inflation, we have energy issues that the team is dealing with it and trying to mitigate. But we're coming into Q4 and into Q1 with a strong momentum. We feel very strong about crush margins. Our export window given that in September we didn't export that much, is probably going to be extended into January or February. A little bit maybe even longer than last year. So we feel very good at the moment, but again, with an environment that there are supply chain issues, there are energy inflation rising, so we will have to manage all that, but from a demand perspective, we feel very good about it.
Operator: From Bank of America. Luke, your line is now open.
Luke Washer: Thank you. Good morning, team.
Juan Luciano: Good morning.
Ray Young: Good morning, Luke.
Luke Washer: I just wanted to ask a quick question and follow-up on Ben. You mentioned that the Peoria facility and this new MOU, Gevo, you've done a lot with your ethanol assets. So just a clarifying point, are your strategic review of the ethanol assets completed? Are you still thinking about Now how you're looking at your fuel ethanol capacity, even wet mills, or is you're thinking now evolve?
Juan Luciano: Yeah, no, I would say that the conclusion of its review ended being the best option for Peoria was to divest it, which was basically shed about 135 million gallons of our ethanol capacity. And then we are taking about 2/3 of all our ethanol capacity in these MoU with Gevo exploring options solidating because we're going to be reviewed in these to joined . The assets to the joint venture. But of course we're going to have some exposure to ethanol on the long-term basis because that's changed for ethanol. First of all, remember we always said we didn't like the undifferentiating nature of dry mills. In wet mills, we have more options to protect margins and to protect returns. But secondly, is by taking all these capacity out of out of the market, basically got 900 million gallons in about two years are going to move from vehicle ethanol to SAS feedstock. Then we think that supply demand fundamentals and the margin environment that concludes our to now execute on the transaction but still have a lot to be discussed.
Luke Washer: That makes sense. And then just staying on Carbohydrate Solutions quickly. Ray, I believe you said that operating profit last year and ethanol margin turned it looks like you were able to continue seem to be pretty good in 4Q. So when I think about the starches and sweeteners side, it would seem that you are seeing quite a bit of maybe margin compression or at least lower operating profit. Is this just a the function of you have higher input costs? And then how are you thinking about what you're selling, some of your sweeteners at or starches that will offset some of that margin pressure potentially?
Ray Young: No, you're right. We're vertically over in Europe. So that's a little bit of a headwind. At the same time, you are right and the ethanol margins that we're seeing right now in the market are extremely healthy. And that's just reflective above to fallen down to 20 million variables right now. And when you take a look at driving miles in gasoline demand, were sickly back to pre -pandemic levels of demand again. And so on the positive side, I would have to say the ethanol margins. On the issue of sweeteners and starches, what's interesting is while a lot of people focus on the HFCS guide the business, the other parts of our business are doing extremely well than the non - HFCS business. For example, citric acid demand is extremely strong, starches demand, extremely strong. So when we put it all together, that's why we provided the guidance that there are some puts and takes, but we expect our fourth quarter for Carbohydrate Solutions to be similar to where we were last year.
Luke Washer: Got it. Very good. Thank you.
Operator: Our next question comes from Ken Zaslow from Bank of Montreal. Ken, please go ahead.
Ken Zaslow: Hey, good morning, guys.
Juan Luciano: Good morning, Ken.
Ken Zaslow: The investments that you have made, there's several of them, and the 75% in the tech business, the LG Chem, the ACS So how much capital have you deployed to this? What is the return expected on the -- I'll start there and then I'll ask the follow-up to that.
Ray Young: Yeah, I mean, I think we haven't disclosed the amount of capital in terms of the LG Chem, I mean, that's still up -- being discussed right now in terms of how the partnership will form on lactic acid and polylactic acid. The access vial is not that significant. The big, big investment that you mentioned here is really the P4, the investment, the Company. And again, we decided to invest 75% into it, right? So therefore, I think we've managed that capital there. So the total invested capital on these recent announcement, actually, is far less than the billion dollars . This is consistent with the kind of the bolt-on type of investment numbers that we've talked about in the past, Ken.
Ken Zaslow: And then also those Sojaprotein. But if I take that and then, one, you said that in 2022, from nutrition, you still expecting that 15 and then you blood is up a little bit to 15% to 20%, which is always nice to hear. But if you're adding less than a billion, but it sounds like more than a breadbasket, is that number going to start to capitals work? Would we start to see that number accelerate at what year and what type of returns that we expected or is it just not enough to make a difference? I'm just trying to cement that in my head.
Juan Luciano: Yeah. Certainly, Ken, we will see acceleration based on these investments. When we talked about our plan of 15%, that plan was not contemplating any significant acquisitions. And we were thinking and getting to about a billion-dollar OPE in a couple of years, so that trajectory continues and will be accelerated with some of these deals. Some of these deals you have to understand are just bolt - ons where we plant some capacity where we don't have like in Sojaprotein and things like that, and some other ones become more platforms that actually give us people to accelerate even more our growth rate. But we will continue in an investment phase on Nutrition because the opportunities are there. Our customers are reacting positively to our value proposition and we see our pipeline and our quarterly wins continue to grow. As long as we can post numbers of revenue growth in the 15% range and OP growth in the
Ken Zaslow: Are you outlining, every year you do it. consumer trend better, you believe is going to be the future of where we're going. This one you laid out a -- when you think of your portfolio, what percentage of your portfolio you think targets those 8 today and then when I think back in 3 to 5 years, what percentage of your portfolio will target those 8 items. And then I'll leave it there and I appreciate your time.
Juan Luciano: Yeah. That's a very good question to which we'll provide more granularity at the December Investor Day, but I will say in general terms, and that's where you see us working on the evolution of the Carbohydrate Solutions portfolio. Probably, the Carbohydrate Solutions portfolio because of the big assets, it's a one more difficult to adjust to some of these. We think that our services in all and nutrition, are margin that's more aligned to that. And now that we are evolving the portfolio of Car solutions, we feel that the significant percentage of ADMs in couple of years will be aligned towards these trends. Which make us very optimistic about the future. We are very well-positioned for all these long-term trends.
Ken Zaslow: But in the you, percentages are something to give some context to it like, hey, by 5 years will be at 25% or 30% or something part of how you're thinking. So I just hope that you do that. We appreciate it. Thank you.
Juan Luciano: Yes. We will provide that granulating. Thank you.
Operator: Our next question comes from Michael Piken from Cleveland Research. Michael, your line is open.
Michael Piken: To understand a little bit better your outlook for exports, you mentioned that you think the outlook for China and their grain demand can be strong. Could you quantify what you think for their corn and soybean exports for the next year and then also the U.S. share of what's going to go to China?
Juan Luciano: Yeah, Mike listen, we still believe that protein demand is very strong. And when we look and we check with our team in China, we still believe that China will need to import about a 100 million tons give or take of soybeans and about 25 million tons of corn. So of that corn, the majority will come from the U.S. a little bit from Ukraine. So we think that the volumes, although maybe a slightly in a different way than last year, right now, consumers are a little bit more short term. More hand-to-mouth, if you will, because they were expecting from a little bit of a correction in prices as we were hitting the harvest in the last few weeks. And we feel very good about this exports season. You have to remember that we were in a tight situation from a supply-demand perspective given these import numbers. And then when you add that, some of that capacity has been taken out, this will make it for a tight exports season that will probably have rolled forward maybe a month since in October -- at the beginning of October all these facilities were still trying to recover power.
Michael Piken: Right. And then my follow-up is just -- it seems like right now there's shortages of fertilizer and maybe say. What is your expectations for in Brazil or even in the U.S.? Do you think we're going to be able to have enough fertilizer to plant crops around the world? And what does that mean for your fertilizer business that more broadly speaking? Are you worried about being able to get enough crop plant around the world or how -- what's the work around from that? Thanks.
Juan Luciano: Yeah. Listen, at this point in time, it's a matter of price, of course, so natural gas have driven this up. Different situation when you 're in Europe than you 're in North America. So North America is paying like 5 bucks to 6 bucks for natural gas; Europe is paying maybe 30. But I will say, at this point in time, it continues to be available for farmers only at higher prices. And we haven't detected a big shift in acreage from one to the other. It's still a little bit early from planting intentions, and you could think that potentially could be a shift from corn to soybeans, that is not clear yet. And probably, the numbers today are a little bit of a tossup for the farmer on what to go. So, acreage for next year.
Michael Piken: Okay great. Thank you.
Juan Luciano: Thank you.
Operator: Our next question comes from Tom Simonitsch from JP Morgan. Tom, your line is open.
Tom Simonitsch: Thanks. Good morning, everyone. Hey Tom. So you just in China to serve as a supply hub in the region. What is your outlook for Nutrition in Asia-Pacific compared to other regions? You've called out APAC is an area of weakness in both Human and Animal Nutrition in the last couple of quarters. So how much of that relative weakness is down to ADM's current capabilities in the region, as opposed to .
Juan Luciano: Right. I think that we've been very proud of being nutrition is have been happening on the developed parts of the world, if you will, in which developing market's exposure is still hold for ADM, whether we're talking about South America or Asia Pacific. So in Asia Pacific, we've been a player flavors for a while and this is just an expansion. This is at about an hour a way from consumption. So we feel very good from a raw material perspective. We feel very good from an access to a big consumption base. And this will be very important for our customers. Our participation in Asia was limited to one plant for Flavors and about a handful of plants for animal nutrition. And we continue to build that position in animal nutrition. We feel very good about it. And then given this opportunity in flavors, we will enhance our capabilities, not just production, but also market development and probability for customer innovation centers. So you will see us going and putting more flags from the -- on the world in the developing areas. Whether it is Asia-Pacific or South-America, as we need to go and support our global customers. These are our customers that we do business every day here. And some of them are represented there, but also we have a lot of new local customers that are requiring these capabilities. So it's just a natural evolution of the business if you will.
Tom Simonitsch: Thanks for that, Juan. And just following up on SAS. What is your operating plan for the two dry mills between now and 2025, when that SCF production is expected to come online?
Ray Young: We expect construction around that area. There probably is some transition. But as we look out over the next couple of years, we do expect that driving models are going to -- are coming back, we're seeing tight S&D right now in terms of our industry. We are seeing frankly the rest of the world is starting to recover from the pandemic. So we expect rest-of-world driving miles to start recovering. And so therefore, there is a lag in terms of recovery of exports of ethanol from U.S. to the rest of the world. So I think over the next couple of years, I think you're going to continue to see some level of demand recovery from outside the U.S. for ethanol, and then even China, as we talked about, I mean, they're focused on the environment, on energy. You could actually see China and returning back to the markets. And we've seen a little bit of that already.
Juan Luciano: So let me clarify from an operating's perspective. We now going to be doing anything two these dry mills. So dry mills will produce ethanol. And then there is downstream technology and capabilities that Gevo brings to the table to transform them into SAS. But those two plants will continue to produce ethanol as they are. We are not planning to invest capital into that. Our contribution is those two plants, and then Gevo takes it from there, from a downstream perspective.
Tom Simonitsch: That's very helpful. Thank you. I will leave it there and pass it on.
Operator: Our next question comes from Ben Theurer from Barclays. Ben, please proceed.
Ben Theurer: Good morning. Ray congrats on the results. Just two quick follow-up questions. One on and I understand your commentary around the expectation into the Fourth Quarter, but just trying to maybe get a little bit of a sense differently. So clearly, you have some implications in the third quarter because of Hurricane Ida, and you expect some of those effects to reverse in coming quarters. Are you comfortable enough that those almost immediately reversing and benefiting your fourth quarter, so to speak, you have a chance to get some workflows to where it was last year. So that will be my first question.
Juan Luciano: Yeah. I would say, we expect a strong quarter for our services in this year. And you have to understand when sometimes at the end the year it becomes complicated because they could be margin expansion, margin contraction here, and the accounting rules according to Q1 and we need to respect that. What we're talking, what we can be determine from middle of October, which is today, is the fundamentals from the market, and demand is strong, and the export capacity it was tight starting into these. And we started to see our so we feel good about it. But again, it's difficult to call it sometimes Q4 versus Q1 because of the accounting rules and we can determine that now, we have to determine that at the end of the
Ben Theurer: Perfect. And then if we take a look at the Nutrition business and you've highlighted it in your prepared remarks. Obviously, the very strong performance on the Animal Nutrition side, almost doubling operating profit but then Human Nutrition on the other side grow for just in the high single-digits. Could you explore a little more on the details of what were the issues for the maybe lower than what you would want to see grow in Human Nutrition? Was it more of an impact because of input cost pressure where you just didn't pass that on significantly in the way you would have wanted to, or are there certain demand issues there's still in certain areas? Just to understand a little better what's been driving the growth in human nutritional some of the growth that way better.
Juan Luciano: If you look at the Human Nutrition for the quarter, we grew revenue about 12%. I mean, it's actually a pretty good number, and I think, if you look at our EBITDA margin on sales, we were able to maintain that EBITDA margin on sales. So when you grow twice the industry clip, if you will, and you maintain margins, so I was pretty satisfied. Of course, it's not the spectacular maybe improvement year-over-year than Animal Nutrition have, but this is because Human Nutrition has been more stable and doing -- in animals, we're still going through the Neovia integration and all those things, but no, I don't think it was a weak quarter at all actually. Actually, I think as I said, we continue to grow maybe twice the industry rates and maintaining very robust EBITDA margins on sales. So EBITDA margins on sales for flavors are north of 20%. And we've been able to maintain despite
Ben Theurer: Congrats again,. Thank you very much.
Operator: Our next question is from Robert Moskow from Credit Suisse. Robert, please proceed.
Robert Moskow: Just a couple of cleanup questions. Can you talk about your pricing outlook for corn sweeteners? It would appear that corn prices have been on kind of a roller coaster, they're down off their highs. And how is that impacting negotiations for next year? And then I had a follow-up on the pea protein market.
Ray Young: Hey, Robert. It's Ray here. So the contracting season's underway, and we expect HFCS volumes and margins for EM to remain strong in 2022. Clearly, we did see some volatility in terms of corn prices. And that's -- Frankly, the input costs will get reflected in terms of our contract pricing. And we do expect contract pricing to be higher next year compared to this year. Volume-wise, we do expect volumes for '22 to be similar to what we've seen this year.
Juan Luciano: You're seeing recovery in terms of the Food Service Sector. What -- when I look at Carbohydrate Solutions in total, non-HFCS is actually a very important component as well. And we've seen non-HFCS pretty attractive with a good margin side. And that's just reflective of really a strong demand environment for citric acid, for starches, for dextrose, and other products. So that's another important factor when you take a look And look at Carbohydrate Solutions business in total for 2022. As I indicated earlier, we do think that the bio-fuel part of the business should be actually quite positive when you compare year compared to this year. So when you put it all together, we do expect solution to have another strong
Robert Moskow: And then the follow-up on pea proteins. You mentioned -- I think alternative protein. I thought I had heard that the pea crop in Canada was weak. But my perception is that that doesn't matter that much to processors like yourself. But maybe you can help me understand whether it does or it doesn't, and how much volume are you doing in that market for the alternatively end markets.
Juan Luciano: Yeah, Rob. facility, and we feel very good about that business, actually. Specialty Ingredient Systems that we see in some of these new verticals. And both businesses are relatively new. They have almost no revenue solutions for customers. We have a strong customer interest in these areas and everybody wants to foundation. So at this point in time, soy is the main driver for us. or a supplement or is different perspective. It's not a big impact, so we haven't felt any impact in our plant at all.
Robert Moskow: Got it. Okay. Thank you.
Juan Luciano: Thank you, Rob.
Operator: Our next question comes from Vincent Andrews, from Morgan Stanley. Vincent your line is open.
Vincent Andrews: Thank you. And good morning, everyone. One, just want to ask you on the LGM -- LG Chem, excuse me. The LG Chem JV. Why is it set up in two JVs rather than just one integrated production of lack of asset and then into THA? What's the thought process behind having an upstream and the downstream set up?
Juan Luciano: This is a matter of where the expertise of each Company lies and, to be honest also, we want to be as asset life as possible. So in areas where LG is dominant and they're going to build that downstream capacity. When we think about value solutions, our objective , is to make , an ownership position and we start making chemicals application technology and all that, we cannot become a chemical Company. So in that, we let the partner, take position. So we make corn grind plus one if you will, and then we let our partners take it from there. Which is a matter of optimized capital for us and not getting best scenario as where we are -- that are not coal for us. Coal areas for us will continue to be within feed and beverages. When we go into these materials, if we're going to produce that make sense, and then we have the partner doing the rest. Once we get the full details of the agreement, we'll see where the economics are setup and that would make sense to your investments will be in your target is trying to
Vincent Andrews: focus in net-to-net. As a follow-up, on the fertilizer issue, obviously the availability concerns, but seems like it's happening, it's at the high prices, they're deferring fertilizer purchases, particularly in South America. How percentage of the big soy groups to buy less fertilizer, etc., and to you slide showing that farmer sales are I guess at a 5-year average, which is probably okay, but they're well below last year and probably the year before. So what impact does that have on your origination business if the farmer is slow to sell the beans or if they buy less fertilizers, then he may hold onto more beans if they want to keep the FX -- keep the dollars. So how do you think about that playing out for you moving into next year?
Juan Luciano: I'll say South America is always an issue with a little bit more factors in terms of farmer selling just because, although currency and under distortion that sometimes the government bring s into the we continue to see maybe relatively slow farmer selling in Argentina and that will probably continue. It's been a little bit better in in Brazil recently, but it's still relatively slow versus the accelerated pace at which they sold last year.
Vincent Andrews: Thank you.
Operator: Our next question comes from Vincent Anderson from Stifel. Please go ahead.
Vincent Anderson: Yes. Thanks. And I would like to continue as Vincent. Vincent of questioning on PLA.Maybe just approaching it from trying to prioritize getting incremental return out of your core competency and fermentation technology, but maybe limiting direct participation in the PLA Market. And I ask just because that is a bit more of a commodity business than it feels like you've pushed more of your investments to recently?
Juan Luciano: I think that as we said, we are trying to and I think that you said we're trying to optimize our facilities and as such those facilities to demand that has more growth opportunity. In this issue, again, we don't want to go into making chemicals. That's a heavy capital intensive industry, and we want to make one derivative and then, reserve all that capital to continue to grow in food, feed, and beverages, and in health and wellness, that's what we're trying to do so LG Chem is a great partner. We're very honored to have them. They have very good technology and it's a little bit like the discussions. We're going to continue to make ethanol, they will take it from there to make SAF. And with the -- with these partnerships, we're going to make lactic. They're going to take it from there to make PLA. So it's kind of a similar mindset.
Vincent Anderson: That's perfect. Thank you. Then just a quick point of clarification, if I understand the phrasing of that MOU announcement, it sounded like you're considering investing in lactic acid capacity that would maybe exceed LG's needs and then you would market the remaining product yourself. Is that correct? Then could you just talk briefly about the opportunity there as a stand-alone investment?
Juan Luciano: Listen, partial of that is correct. I mean, lactic it can go to many opportunities. But this is relatively early on on the teams are looking at these. There is a lot -- there are a lot of numbers, there are a lot of things that could still change, there are a lot of discussions. So I wouldn't like to venture that much since the teams are still discussing with LG Chem and by 2050, 2060, 2040, whatever it is that these are they are looking back at their portfolio. They need to clean their portfolios, if you will. And one of the ways to do that is through recycling, the other way to do it is to go in plant-based. So we are receiving a lot of inbound request on that, and we're looking at our profits, our ability to produce plant-based products on our carbon capture and sequestration that provides an opportunity to make lower CI products. And we're trying to maximize the opportunity for ADM on all these. So some of these things may not be that well-defined because that volume for the ADM shareholders. But it's a great opportunity for us and we will be mindful of returns and we not going to veer into areas that we shouldn't be putting capitals. The capital will be reserved for our main thrust of the strategy, which is to continue to grow in food, and feed, and beverage.
Vincent Anderson: Understood. I appreciate the added detail on that. Look forward to hearing more about it.
Juan Luciano: Thank you.
Operator: Our next question comes from Eric Larson from Seaport Research Partners. Eric, your line is open.
Eric Larson: and the whole transaction. And I know that one of your -- maybe your dislike that you had with ethanol over the years is the extreme volatility of factors and when we talk about the in the past, one of the things was trying to reduce your earnings volatility. So in your -- in the economic of how you nego -- We don't know much they are, but have you been able to -- do you think you've able to ink an agreement that actually gives you more sustainability or I guess plus volatility of current things on the economics of SAF going forward relative to ethanol.
Juan Luciano: Yeah. You're correct that Returns are important to us, but also dumping the volatility is in the mind of everything we do. So, of course, the team is considering that. I can't disclose that much at this early on. But I think what you need to also think is that over time, we will try to become a minority partner in all these. And the objective all these is to deconsolidate and take all those assets out of our participation. So to a certain degree, we're acting owners long-term of this. That's why I talked before about partners or financial partners. I think we're going to be able to deconsolidate. We're going to be able to monetize some amounts and if there is some upside to that, hopefully participate in all that. But you are correct. The objective is not to participate in
Eric Larson: Okay, no that is a lot. So when you look at the size of your investments, they're -- those are relatively new assets, but I guess they're probably 8 to 10 years older obviously you so you've probably depreciated them pretty significantly already. Is your contribution to the putting those assets in there, or would you expect to see maybe a modest capital return as part of that JV Agreement as well?
Juan Luciano: One of the reasons, Eric, that we landed in this option is that the valuation of our assets, I mean, it's better than the alternatives that we have. So we are pleased with the value at which we are contributing these 2 assets. We don't need or we don't plan to add as such, then the joint venture or Gevo may put money for finishing of the -- and to convert it into through their technology. But our participation stops with the contribution of these 2 dry mills as they are.
Eric Larson: Okay, perfect. Thank you. Juan, my questions at that. Thanks, everybody.
Juan Luciano: Thank you, Eric.
Operator: Our last question comes from Adam Samuelson from Goldman Sachs. Adam, your line is open.
Adam Samuelson: Yes. Thank you. Good morning, everyone. Good morning, Adam. Hi. Well, a lot of ground bidding covered. so I'll try and make this quick. On the DSAS MoU, can you just maybe clarify just in the beginning factors of what you'd be looking for on the regulatory side to really move ahead here. Obviously, SAS doesn't participate today in the RFS or California programs. So what would you want to see in terms of the federal or state action on SAS before you really fully commit to going ahead?
Juan Luciano: Yeah. Listen, we have experienced in both the U.S. and the European Union a strong desire to make this a reality. There is no another efficient way to decarbonize the airlines industry -- the aviation industry. Of course, on the short hauls, you can put the , long hauls is something like this. So we expect the governments to be a partner, to a certain degree, in creating some of these markets. Some of those things are too early for me to disclose. But there are commitments both the U.S. government and the European Union to create a market for that in the 50 billion gallons type of size. So there's going to be some helping in to that. But that's probably to the extent that I can talk about it right now.
Adam Samuelson: Okay. And then, just quickly on the Balance Sheet, maybe this is for Ray. At the end of the quarter, net debt to EBITDA was sub two times. You haven't bought back any stock this year. Just help us think about how we should think about stock buyback as part of the capital allocation mix going forward.
Ray Young: I think that as we -- we've been monitoring commodity prices very carefully. And when you look in our offering working capital, right now it's still $2 billion higher than we were last year. So as we think about commodity prices next year, assuming you have a strong South America crop, you have a normal crop in U.S.. You see commodity prices coming off again. And after we've funded some of the bolt-on acquisitions that we've talked about, I expect our Balance Sheet to be pretty strong. And so there we can probably start looking back at return of capital that we've looked like in the pa st. So I think a lot of it is a function of funding the investments that we've talked about, but importantly, making sure that the working capital environment reverts back to normalized levels, which I think -- I sense, assuming a normal South America crop, a normal U.S. crop next year. I see opportunities to look at return of capital.
Adam Samuelson: Okay. All right. I'll leave it there Thanks so much.
Ray Young: Thank you, Adam.
Juan Luciano: We'll be headlining on December 10th, Global Investor Day. We look forward to talking in more detail projectory and why we are so optimistic about the opportunities ahead. In the meantime, as always, feel free to follow up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM.
Operator: Thank you, everyone for joining us today. This now concludes today's conference call, please now disconnect your lines. | [
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"text": "Hello and good morning and welcome to the ADM's Third Quarter 2021 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Vikram Luthar CEO, Vice President, Head of Investor Relations, Chief Financial Officer, Nutrition for ADM. Mr. Luthar, you may begin."
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{
"speaker": "Vikram Luthar",
"text": "Thank you, Emily. Good morning and welcome to ADM's third quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at www.ADM.com. For those following the presentation, please turn to Slide 2. The Company's Safe Harbor statement, which says that some of our comments and materials constitute Forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, Company performance, and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer Juan Luciano will provide an overview of the quarter and highlight some of our accomplishments. Our Chief Financial Officer, Ray Young will review the drivers of our performance, as well as corporate results and financial highlights. Then Juan will make some final comments after which, they will take your questions. Please turn to Slide 3, I will now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Vikram. This morning, we reported third quarter adjusted earnings per share of $0.97, but it's a 9% year-over-year improvement despite a higher tax rate. And our year-to-date adjusted EPS of $3.69 is already above our full-year 2020 adjusted EPS. Adjusted segment operating profit was $1 billion, up 18% versus the third quarter of 2020. And our 8th consecutive quarter of year-over-year OP growth. Our trailing 4-quarter adjusted EBITDA was about $4.6 billion, almost a billion more than a year ago. And our trailing 4-quarter average adjusted ROIC was 9.6%, significantly higher versus the year-ago period. I remain proud to lead a global team that is delivering robust returns and sustained growth in profits. Our strong quarter and our ongoing upward trajectory are a testament to our team's execution and agility, and the consistent implementation of our strategic plan. I'd like to take a moment now to highlight some of our accomplishments from the quarter. Slide 4, please. I'd like to start by talking about our approach to portfolio management. Our starting point if they believe that in order to thrive and create value, a Company needs to have a dynamic view of its business portfolio. So when we talked about the dramatic transformation of our portfolio over the last 10 years, it's not a discrete event, it's a representation of our continuous work to identify opportunities for growth and improvement. Of course, those opportunities may be the -- must be the right ones. The enduring trends of food security, health, and well-being, and sustainability, provide unique and stable opportunities for ADM to expand our existing capabilities. And we're focusing our efforts on identifying high-growth on-trend areas with attractive margins and which are adjacent to our existing capabilities. That focusing formed the building of our Global Nutrition business. The acquisition of Wild gave us entry into flavors and a global taste platform. With end-used bolt-on acquisitions to add adjacent capabilities and build a one-stop shop with an industry-leading pantry of ingredients and solutions for human nutrition. We do the same for animal nutrition with the acquisition of Neovia. And we continue to do the same today as grows our business. In order to meet growing demand for sustainable solutions, we have announced a joint venture and offtake agreement with Marathon Oil Company to support the production of renewable diesel. We're continuing to invest in key nutrition categories. As demand for alternative protein grows from $10 billion to $30 billion over the next decade, we're further enhancing our work capabilities with the acquisition of Sojaprotein. And with global demand for pet foods growing $240 billion in the coming years, we are continuing our growth with a 75% ownership stake in PetDine. In the area of microbiome, we've signed an agreement with Vland Biotech to launch a joint venture that will perfectly position to help meet $1 billion in retail demand for probiotics in China. These are just some examples of how we are dynamically positioning our portfolio to continue driving growth for years to come. There will be more to come, and you can expect an increased level of investments to support our sustainable earnings growth and further expand our capacity and capabilities. Please turn to Slide 5. As part of our portfolio management approach, we're working to evolve our carbohydrate solutions business. Expanding our arrays of solutions to meet growing customer demand driven by the enduring trend of sustainability. We've made significant progress recently focused on two areas, new opportunities for our alcohol production and our growing value solutions platform. Then we start with alcohol. Last Thursday, we announced that we reached an agreement which we expect to close at the end of the month to sell our ethanol facility in Peoria. And yesterday, we announced a Memorandum of Understanding with Gevo to explore potential joint ventures, one of which would include our Columbus and see that rapid design mills, and our would've ethanol assets indicator. Transitioning 900 million gallons of ethanol production to support growing demand for low-carbon, sustainable aviation fuel. These actions represent our commitment to a process that we began when we first announced the third issue review of our dry mills review of our dry mills. Taken together, they will allow us to significantly reduce our exposure to vehicle fuel ethanol while using our expertise and assets to capitalize on new opportunities. SAS is one of those opportunities. The U.S. and EU have set goals that together, will support almost 4 billion gallons of annual sustainable aviation of fuel production by 2030 and more than 45 billion by 2050. The other focus area for are carbohydrate solutions evolution is our bio solutions growth platform. Biosolutions, which we launched about a year ago, is an effort focused on using our product streams to expand our participation in sustainable, higher-margin solutions for attractive end markets like pharmaceuticals and personal care. This is an area of significant potential, and our team is doing a great job identifying new and exciting opportunities. Earlier this fall, for example, we signed an MOU with LG Chem for the production of lactic and polylactic acid for bioplastics and other plant-based products. These efforts are enabling value solutions to deliver 10% annualized revenue growth, Including more than $80 million in new revenue wins in the first 9 months of this year. And we believe there are many new opportunities to come. So from the transformation of our dry mills to our growing biosolutions platform, our work to evolve our would carbohydrate solutions capabilities is a perfect example of how we're managing our portfolio and delivering the smart strategic growth. And one of the many reasons we remain convinced in our ability to deliver sustainable earnings growth in the years to come. Lets talk a little bit more about our business outlook at the end of our call. And of course, we'll be going into much more detail at our Global Investor Day on December 10th. But in the meantime, I will turn the call over to Ray to talk about our business performance. Ray."
},
{
"speaker": "Ray Young",
"text": "Yeah, thanks, Juan. Slide 6, please. The Ag Services in Oilseeds team continued their outstanding year with another quarter of substantial profit growth. In Ag Services, we're proud of how the team executed in a challenging environment, including a swift return to operation after Hurricane Ida. Overall results were significantly lower versus the prior year quarter, driven by approximately $50 million in net timing effects that should reverse in coming quarters, as well as $54 million in insurance settlement recorded in the prior year period and lower export volumes caused by Hurricane Ida. Global trade continues its strong performance. The crushing team delivered substantially higher year-over-year results executed well, delivering stronger margins in a dynamic environment that includes strong demand for vegetable oils to support our existing food customers, as well as the increasing production of renewable diesel. Results were also driven by about $70 million in net positive timing effects in the quarter. Refined products and other results were significantly higher than prior-year period driven by positive timing effects of approximately $80 million that are expected reverse in future quarters. Strong execution EMEA North America biodiesel, and strong refining premiums due to demand for renewable diesel, and food service recovery in North America also contributed to the results. Equity and earnings from Walmart were lower year-over-year. Now, looking ahead, we expect to see continued fundamental demand strength for egg service and oil seeds products, including from China, as well as solid global soybean crush margin environment in the Fourth Quarter. Partially offset by some higher manufacturing costs. In addition, RPO will be negatively impacted by timing reversals. All told, we expect results in the fourth quarter to be significantly higher than the third quarter of this year. Slide 7, please. Carbohydrate solution results were lower year-over-year. The starches and sweeteners sub-segment, including ethanol production from our wet mills, showed their agility by managing through dynamic market conditions and optimizing mix between sweeteners and ethanol production through the quarter. Year-over-year results were significantly lower primarily due higher input cost. Vantage corn processor results were much higher versus the third quarter of 2020, supported by their resumption of production of -- at our 2 dry mills and improved fuel ethanol margins, particularly late in the quarter. Looking ahead to the fourth quarter, we expect the solid fundamentals from the end of the third quarter to continue for Carbohydrate Solutions with good ethanol margins extending through the quarter due to industry supply demand balance in solid demand for corn oil and starches, offset by higher manufacturing costs, particularly in Europe. As well as the absence of the Peoria dry mill. All told, fourth quarter results for the segment should be similar to the previous year fourth quarter. On Slide 8, the nutrition business remains on its solid growth trajectory with 17% higher revenues and 15% on a constant currency basis and 20% higher profits year-over-year in continued strong EBITDA margins. The Human Nutrition team delivered revenue growth of 12% year-over-year on a constant-currency basis, helping to drive 9% higher profits. Higher volume, improved product mix for particular strength in beverage show strong flavor results in the in North America, partially offset by lower results in APAC. Especially ingredients continued to benefit from strong demand for alternative proteins offset by some higher costs. Health and wellness results were higher on robust sales growth in bioactives and fiber. And nutrition profits were nearly driven primarily by the strength in the mineral assets, as well as feed additives. Looking ahead. We expect nutrition to continue on its impressive growth path with strength across the human and animal nutrition, linked to strong year-over-year earnings expansion and a 20% full-year growth versus 2020. Slide 9, please. Let me finish up with a few observations from the other segment, as well as some of the corporate line items. Other business results were substantially lower in the prior year period, driven primarily by captive insurance underwriting losses, most of which were offset by corresponding recoveries in the other business segments. We expect fourth quarter to have some additional insurance underwriting losses resulting in a break even other business for the Fourth Quarter. As expected, net interest expense for the quarter decreased year-over-year on lower interest rates, and a favorable liability management actions taken in the prior year. In the corporate lines, an allocate corporate costs of $230 million were driven primarily by higher IT offering and project-related costs into the centralized centers of in supply chain and operations. Looking at total corporate costs, in other corporate, we are still on track for the calendar year to be overall similar to 2020. The effective tax rate for the third quarter of 2021 was approximately 18%. We anticipate our calendar-year adjusted effective tax rate to be the upper end of our previously communicated range of 14% to 16%, and potentially a bit higher depending upon the geographic mix in the fourth quarter. Our balance sheet remains solid with a net debt-to-total capital ratio of about 26% and available liquidity of about $11.5 billion. With that, I will turn it back to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ray. Slide 10 please. From consistent sustained profit growth to the ongoing management of our business and product portfolio, our team has a lot to be proud of. And there's one other thing we achieved last quarter that I want to mention. We have many team members impacted when Hurricane Ida hit in late August, so we provide the temporary housing arrangements, portable generators, food and water, and more. In fact, many ADM colleagues traveled to the region and spent time helping repair their co-worker's damaged homes. Out of that, I'm very thankful to our team. as we plan to grow into our outlook in far more of depth on our December 10th Global Investor Day. As I look back at the Third Quarter, and all of the last 9 months, I continue to see a team and a Company that are delivering on our goals and our purpose. We are closing out 2021 with great momentum. We're on track for a strong Fourth Quarter, and the second consecutive year of record earnings per share. And as we look ahead to 2022, we see another strong year for ADM. A robust global demand environment will continue to look for opportunities for us to leverage our indispensable globally origination, processing and logistics capabilities. And nutrition will continue on its strong growth trajectory in line with our 15% and on its way to a billion dollars in operating profit in the coming years. Of course, there are widely. Thanks to our unique value chain and global footprint, our unmatched and well-being and sustainability, and a truly unparalleled team of nearly 40,000 colleagues around the world, we remain very optimistic in the strong year to come. With that, Emily,"
},
{
"speaker": "Operator",
"text": "To register your questions, please, Our first question today comes from Ben Bienvenu from Stephens. Ben, your line is open."
},
{
"speaker": "Ben Bienvenu",
"text": "Hey thanks. Good morning, everyone."
},
{
"speaker": "Vikram Luthar",
"text": "Morning Ben."
},
{
"speaker": "Ray Young",
"text": "Hey, Ben."
},
{
"speaker": "Ben Bienvenu",
"text": "I've got one long-term question with regards to your announcement yesterday around SAS. And then I want to ask a clarifier on the guidance. Yesterday, congratulations. A couple of questions. One is, when you think about the total opportunity for SAS, obviously the embedded demand is significant, given SAS seems like one of the most pertinent ways to reduce greenhouse gas emissions, though are unclear at this time. So I'm curious has you think about engaging with Gevo on this partnership? One, well, to commit these facilities. to this end market ultimately. And then to help us think about kind of the the Memorandum of Understanding, why did you go with that initially versus a more legally binding agreement? And then, if you would just talk just bigger picture the ethanol markets that would be helpful. I know a lot in there, but I'd love to hear you talk about it."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ben. We've been looking at the options for the dry mills for a very, very long time. So we've been studying the opportunities for the ADM shareholders to o as we try to divert these assets. Certainly, when we look at the sustainability trends and the opportunities, remember one of the issues with these assets are, they are very large. Would become -- would became a little bit of an issue at the time by testing them. So we were looking for opportunities that are sizable. We are that size turns into a competitive advantage. So certainly, when you look at all the industries to CO2, and we have identified, and we have checked with strategic partners, people in the industry that they say yes, is the solution. And I think we see also concurrently that both the U.S. and the European governments are looking at this a year final, trying to incentive the demand for that. So you heard President Biden or Secretary Franco for making statements about that. So we see a very positive environment developing for this, a very sizable adjustable markets for us. And when you combine our size with our raw material procurement and our costs and the ability to decarbonize based on our carbon capture and sequestration. As you recall, we've been running since 2017. Allows that complex to provide very competitive, low CI fuels for the industry. So we decided to . There are many opportunities and options potentially could happen, which is the creation of these two joint ventures. In one of those joint ventures, ADMs contribution will be the 2 dry mills as I would objective it as to deconsolidate these two. So again, but still too many discussions to happen and many foreigners to join us into this. We are thinking over time to have a minority position in diesel, having probably strategics of financial foreigners to join us. So -- but overall, as you can be assured, this is a better outcome for our shareholders in terms of the realization of value from these two drivers. So we're very excited about the opportunities."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay. Great. My next question is a clarifier in the discussion to the extent you can on 2022. First, Ray, did I hear you say on the Ag Services and Oilseeds for the fourth quarter, you expect it to be higher than the third quarter, but you didn't say higher than the fourth quarter last year? Is that -- are those the goalpost we should be thinking about? That's part 1, and then question 2 within that is, export demand looks strong for next year, obviously renewable diesel is continuing to gain steam. How do you feel about Ag Services and crushing in that broader Ag Services and Oilseeds segments as we go into 2022?"
},
{
"speaker": "Juan Luciano",
"text": "So Ben, listen. As we think about Q4 for ADM, and when we say we expect a strong Q4, we look at strong crush margins, demand this is strong for proteins, but also the demand for Oilseeds very strong and tight and then you add RGD on top of that. We are facing an improved ethanol environment as we enter the Q4. We are estimating exports from the U.S. in volume similar to last year. competitors plant is down because of our same situation. And then we continue to see nutrition growing at 15 to 20%. Inflation, we have energy issues that the team is dealing with it and trying to mitigate. But we're coming into Q4 and into Q1 with a strong momentum. We feel very strong about crush margins. Our export window given that in September we didn't export that much, is probably going to be extended into January or February. A little bit maybe even longer than last year. So we feel very good at the moment, but again, with an environment that there are supply chain issues, there are energy inflation rising, so we will have to manage all that, but from a demand perspective, we feel very good about it."
},
{
"speaker": "Operator",
"text": "From Bank of America. Luke, your line is now open."
},
{
"speaker": "Luke Washer",
"text": "Thank you. Good morning, team."
},
{
"speaker": "Juan Luciano",
"text": "Good morning."
},
{
"speaker": "Ray Young",
"text": "Good morning, Luke."
},
{
"speaker": "Luke Washer",
"text": "I just wanted to ask a quick question and follow-up on Ben. You mentioned that the Peoria facility and this new MOU, Gevo, you've done a lot with your ethanol assets. So just a clarifying point, are your strategic review of the ethanol assets completed? Are you still thinking about Now how you're looking at your fuel ethanol capacity, even wet mills, or is you're thinking now evolve?"
},
{
"speaker": "Juan Luciano",
"text": "Yeah, no, I would say that the conclusion of its review ended being the best option for Peoria was to divest it, which was basically shed about 135 million gallons of our ethanol capacity. And then we are taking about 2/3 of all our ethanol capacity in these MoU with Gevo exploring options solidating because we're going to be reviewed in these to joined . The assets to the joint venture. But of course we're going to have some exposure to ethanol on the long-term basis because that's changed for ethanol. First of all, remember we always said we didn't like the undifferentiating nature of dry mills. In wet mills, we have more options to protect margins and to protect returns. But secondly, is by taking all these capacity out of out of the market, basically got 900 million gallons in about two years are going to move from vehicle ethanol to SAS feedstock. Then we think that supply demand fundamentals and the margin environment that concludes our to now execute on the transaction but still have a lot to be discussed."
},
{
"speaker": "Luke Washer",
"text": "That makes sense. And then just staying on Carbohydrate Solutions quickly. Ray, I believe you said that operating profit last year and ethanol margin turned it looks like you were able to continue seem to be pretty good in 4Q. So when I think about the starches and sweeteners side, it would seem that you are seeing quite a bit of maybe margin compression or at least lower operating profit. Is this just a the function of you have higher input costs? And then how are you thinking about what you're selling, some of your sweeteners at or starches that will offset some of that margin pressure potentially?"
},
{
"speaker": "Ray Young",
"text": "No, you're right. We're vertically over in Europe. So that's a little bit of a headwind. At the same time, you are right and the ethanol margins that we're seeing right now in the market are extremely healthy. And that's just reflective above to fallen down to 20 million variables right now. And when you take a look at driving miles in gasoline demand, were sickly back to pre -pandemic levels of demand again. And so on the positive side, I would have to say the ethanol margins. On the issue of sweeteners and starches, what's interesting is while a lot of people focus on the HFCS guide the business, the other parts of our business are doing extremely well than the non - HFCS business. For example, citric acid demand is extremely strong, starches demand, extremely strong. So when we put it all together, that's why we provided the guidance that there are some puts and takes, but we expect our fourth quarter for Carbohydrate Solutions to be similar to where we were last year."
},
{
"speaker": "Luke Washer",
"text": "Got it. Very good. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ken Zaslow from Bank of Montreal. Ken, please go ahead."
},
{
"speaker": "Ken Zaslow",
"text": "Hey, good morning, guys."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ken."
},
{
"speaker": "Ken Zaslow",
"text": "The investments that you have made, there's several of them, and the 75% in the tech business, the LG Chem, the ACS So how much capital have you deployed to this? What is the return expected on the -- I'll start there and then I'll ask the follow-up to that."
},
{
"speaker": "Ray Young",
"text": "Yeah, I mean, I think we haven't disclosed the amount of capital in terms of the LG Chem, I mean, that's still up -- being discussed right now in terms of how the partnership will form on lactic acid and polylactic acid. The access vial is not that significant. The big, big investment that you mentioned here is really the P4, the investment, the Company. And again, we decided to invest 75% into it, right? So therefore, I think we've managed that capital there. So the total invested capital on these recent announcement, actually, is far less than the billion dollars . This is consistent with the kind of the bolt-on type of investment numbers that we've talked about in the past, Ken."
},
{
"speaker": "Ken Zaslow",
"text": "And then also those Sojaprotein. But if I take that and then, one, you said that in 2022, from nutrition, you still expecting that 15 and then you blood is up a little bit to 15% to 20%, which is always nice to hear. But if you're adding less than a billion, but it sounds like more than a breadbasket, is that number going to start to capitals work? Would we start to see that number accelerate at what year and what type of returns that we expected or is it just not enough to make a difference? I'm just trying to cement that in my head."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Certainly, Ken, we will see acceleration based on these investments. When we talked about our plan of 15%, that plan was not contemplating any significant acquisitions. And we were thinking and getting to about a billion-dollar OPE in a couple of years, so that trajectory continues and will be accelerated with some of these deals. Some of these deals you have to understand are just bolt - ons where we plant some capacity where we don't have like in Sojaprotein and things like that, and some other ones become more platforms that actually give us people to accelerate even more our growth rate. But we will continue in an investment phase on Nutrition because the opportunities are there. Our customers are reacting positively to our value proposition and we see our pipeline and our quarterly wins continue to grow. As long as we can post numbers of revenue growth in the 15% range and OP growth in the"
},
{
"speaker": "Ken Zaslow",
"text": "Are you outlining, every year you do it. consumer trend better, you believe is going to be the future of where we're going. This one you laid out a -- when you think of your portfolio, what percentage of your portfolio you think targets those 8 today and then when I think back in 3 to 5 years, what percentage of your portfolio will target those 8 items. And then I'll leave it there and I appreciate your time."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. That's a very good question to which we'll provide more granularity at the December Investor Day, but I will say in general terms, and that's where you see us working on the evolution of the Carbohydrate Solutions portfolio. Probably, the Carbohydrate Solutions portfolio because of the big assets, it's a one more difficult to adjust to some of these. We think that our services in all and nutrition, are margin that's more aligned to that. And now that we are evolving the portfolio of Car solutions, we feel that the significant percentage of ADMs in couple of years will be aligned towards these trends. Which make us very optimistic about the future. We are very well-positioned for all these long-term trends."
},
{
"speaker": "Ken Zaslow",
"text": "But in the you, percentages are something to give some context to it like, hey, by 5 years will be at 25% or 30% or something part of how you're thinking. So I just hope that you do that. We appreciate it. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Yes. We will provide that granulating. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Piken from Cleveland Research. Michael, your line is open."
},
{
"speaker": "Michael Piken",
"text": "To understand a little bit better your outlook for exports, you mentioned that you think the outlook for China and their grain demand can be strong. Could you quantify what you think for their corn and soybean exports for the next year and then also the U.S. share of what's going to go to China?"
},
{
"speaker": "Juan Luciano",
"text": "Yeah, Mike listen, we still believe that protein demand is very strong. And when we look and we check with our team in China, we still believe that China will need to import about a 100 million tons give or take of soybeans and about 25 million tons of corn. So of that corn, the majority will come from the U.S. a little bit from Ukraine. So we think that the volumes, although maybe a slightly in a different way than last year, right now, consumers are a little bit more short term. More hand-to-mouth, if you will, because they were expecting from a little bit of a correction in prices as we were hitting the harvest in the last few weeks. And we feel very good about this exports season. You have to remember that we were in a tight situation from a supply-demand perspective given these import numbers. And then when you add that, some of that capacity has been taken out, this will make it for a tight exports season that will probably have rolled forward maybe a month since in October -- at the beginning of October all these facilities were still trying to recover power."
},
{
"speaker": "Michael Piken",
"text": "Right. And then my follow-up is just -- it seems like right now there's shortages of fertilizer and maybe say. What is your expectations for in Brazil or even in the U.S.? Do you think we're going to be able to have enough fertilizer to plant crops around the world? And what does that mean for your fertilizer business that more broadly speaking? Are you worried about being able to get enough crop plant around the world or how -- what's the work around from that? Thanks."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Listen, at this point in time, it's a matter of price, of course, so natural gas have driven this up. Different situation when you 're in Europe than you 're in North America. So North America is paying like 5 bucks to 6 bucks for natural gas; Europe is paying maybe 30. But I will say, at this point in time, it continues to be available for farmers only at higher prices. And we haven't detected a big shift in acreage from one to the other. It's still a little bit early from planting intentions, and you could think that potentially could be a shift from corn to soybeans, that is not clear yet. And probably, the numbers today are a little bit of a tossup for the farmer on what to go. So, acreage for next year."
},
{
"speaker": "Michael Piken",
"text": "Okay great. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tom Simonitsch from JP Morgan. Tom, your line is open."
},
{
"speaker": "Tom Simonitsch",
"text": "Thanks. Good morning, everyone. Hey Tom. So you just in China to serve as a supply hub in the region. What is your outlook for Nutrition in Asia-Pacific compared to other regions? You've called out APAC is an area of weakness in both Human and Animal Nutrition in the last couple of quarters. So how much of that relative weakness is down to ADM's current capabilities in the region, as opposed to ."
},
{
"speaker": "Juan Luciano",
"text": "Right. I think that we've been very proud of being nutrition is have been happening on the developed parts of the world, if you will, in which developing market's exposure is still hold for ADM, whether we're talking about South America or Asia Pacific. So in Asia Pacific, we've been a player flavors for a while and this is just an expansion. This is at about an hour a way from consumption. So we feel very good from a raw material perspective. We feel very good from an access to a big consumption base. And this will be very important for our customers. Our participation in Asia was limited to one plant for Flavors and about a handful of plants for animal nutrition. And we continue to build that position in animal nutrition. We feel very good about it. And then given this opportunity in flavors, we will enhance our capabilities, not just production, but also market development and probability for customer innovation centers. So you will see us going and putting more flags from the -- on the world in the developing areas. Whether it is Asia-Pacific or South-America, as we need to go and support our global customers. These are our customers that we do business every day here. And some of them are represented there, but also we have a lot of new local customers that are requiring these capabilities. So it's just a natural evolution of the business if you will."
},
{
"speaker": "Tom Simonitsch",
"text": "Thanks for that, Juan. And just following up on SAS. What is your operating plan for the two dry mills between now and 2025, when that SCF production is expected to come online?"
},
{
"speaker": "Ray Young",
"text": "We expect construction around that area. There probably is some transition. But as we look out over the next couple of years, we do expect that driving models are going to -- are coming back, we're seeing tight S&D right now in terms of our industry. We are seeing frankly the rest of the world is starting to recover from the pandemic. So we expect rest-of-world driving miles to start recovering. And so therefore, there is a lag in terms of recovery of exports of ethanol from U.S. to the rest of the world. So I think over the next couple of years, I think you're going to continue to see some level of demand recovery from outside the U.S. for ethanol, and then even China, as we talked about, I mean, they're focused on the environment, on energy. You could actually see China and returning back to the markets. And we've seen a little bit of that already."
},
{
"speaker": "Juan Luciano",
"text": "So let me clarify from an operating's perspective. We now going to be doing anything two these dry mills. So dry mills will produce ethanol. And then there is downstream technology and capabilities that Gevo brings to the table to transform them into SAS. But those two plants will continue to produce ethanol as they are. We are not planning to invest capital into that. Our contribution is those two plants, and then Gevo takes it from there, from a downstream perspective."
},
{
"speaker": "Tom Simonitsch",
"text": "That's very helpful. Thank you. I will leave it there and pass it on."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ben Theurer from Barclays. Ben, please proceed."
},
{
"speaker": "Ben Theurer",
"text": "Good morning. Ray congrats on the results. Just two quick follow-up questions. One on and I understand your commentary around the expectation into the Fourth Quarter, but just trying to maybe get a little bit of a sense differently. So clearly, you have some implications in the third quarter because of Hurricane Ida, and you expect some of those effects to reverse in coming quarters. Are you comfortable enough that those almost immediately reversing and benefiting your fourth quarter, so to speak, you have a chance to get some workflows to where it was last year. So that will be my first question."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. I would say, we expect a strong quarter for our services in this year. And you have to understand when sometimes at the end the year it becomes complicated because they could be margin expansion, margin contraction here, and the accounting rules according to Q1 and we need to respect that. What we're talking, what we can be determine from middle of October, which is today, is the fundamentals from the market, and demand is strong, and the export capacity it was tight starting into these. And we started to see our so we feel good about it. But again, it's difficult to call it sometimes Q4 versus Q1 because of the accounting rules and we can determine that now, we have to determine that at the end of the"
},
{
"speaker": "Ben Theurer",
"text": "Perfect. And then if we take a look at the Nutrition business and you've highlighted it in your prepared remarks. Obviously, the very strong performance on the Animal Nutrition side, almost doubling operating profit but then Human Nutrition on the other side grow for just in the high single-digits. Could you explore a little more on the details of what were the issues for the maybe lower than what you would want to see grow in Human Nutrition? Was it more of an impact because of input cost pressure where you just didn't pass that on significantly in the way you would have wanted to, or are there certain demand issues there's still in certain areas? Just to understand a little better what's been driving the growth in human nutritional some of the growth that way better."
},
{
"speaker": "Juan Luciano",
"text": "If you look at the Human Nutrition for the quarter, we grew revenue about 12%. I mean, it's actually a pretty good number, and I think, if you look at our EBITDA margin on sales, we were able to maintain that EBITDA margin on sales. So when you grow twice the industry clip, if you will, and you maintain margins, so I was pretty satisfied. Of course, it's not the spectacular maybe improvement year-over-year than Animal Nutrition have, but this is because Human Nutrition has been more stable and doing -- in animals, we're still going through the Neovia integration and all those things, but no, I don't think it was a weak quarter at all actually. Actually, I think as I said, we continue to grow maybe twice the industry rates and maintaining very robust EBITDA margins on sales. So EBITDA margins on sales for flavors are north of 20%. And we've been able to maintain despite"
},
{
"speaker": "Ben Theurer",
"text": "Congrats again,. Thank you very much."
},
{
"speaker": "Operator",
"text": "Our next question is from Robert Moskow from Credit Suisse. Robert, please proceed."
},
{
"speaker": "Robert Moskow",
"text": "Just a couple of cleanup questions. Can you talk about your pricing outlook for corn sweeteners? It would appear that corn prices have been on kind of a roller coaster, they're down off their highs. And how is that impacting negotiations for next year? And then I had a follow-up on the pea protein market."
},
{
"speaker": "Ray Young",
"text": "Hey, Robert. It's Ray here. So the contracting season's underway, and we expect HFCS volumes and margins for EM to remain strong in 2022. Clearly, we did see some volatility in terms of corn prices. And that's -- Frankly, the input costs will get reflected in terms of our contract pricing. And we do expect contract pricing to be higher next year compared to this year. Volume-wise, we do expect volumes for '22 to be similar to what we've seen this year."
},
{
"speaker": "Juan Luciano",
"text": "You're seeing recovery in terms of the Food Service Sector. What -- when I look at Carbohydrate Solutions in total, non-HFCS is actually a very important component as well. And we've seen non-HFCS pretty attractive with a good margin side. And that's just reflective of really a strong demand environment for citric acid, for starches, for dextrose, and other products. So that's another important factor when you take a look And look at Carbohydrate Solutions business in total for 2022. As I indicated earlier, we do think that the bio-fuel part of the business should be actually quite positive when you compare year compared to this year. So when you put it all together, we do expect solution to have another strong"
},
{
"speaker": "Robert Moskow",
"text": "And then the follow-up on pea proteins. You mentioned -- I think alternative protein. I thought I had heard that the pea crop in Canada was weak. But my perception is that that doesn't matter that much to processors like yourself. But maybe you can help me understand whether it does or it doesn't, and how much volume are you doing in that market for the alternatively end markets."
},
{
"speaker": "Juan Luciano",
"text": "Yeah, Rob. facility, and we feel very good about that business, actually. Specialty Ingredient Systems that we see in some of these new verticals. And both businesses are relatively new. They have almost no revenue solutions for customers. We have a strong customer interest in these areas and everybody wants to foundation. So at this point in time, soy is the main driver for us. or a supplement or is different perspective. It's not a big impact, so we haven't felt any impact in our plant at all."
},
{
"speaker": "Robert Moskow",
"text": "Got it. Okay. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Rob."
},
{
"speaker": "Operator",
"text": "Our next question comes from Vincent Andrews, from Morgan Stanley. Vincent your line is open."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you. And good morning, everyone. One, just want to ask you on the LGM -- LG Chem, excuse me. The LG Chem JV. Why is it set up in two JVs rather than just one integrated production of lack of asset and then into THA? What's the thought process behind having an upstream and the downstream set up?"
},
{
"speaker": "Juan Luciano",
"text": "This is a matter of where the expertise of each Company lies and, to be honest also, we want to be as asset life as possible. So in areas where LG is dominant and they're going to build that downstream capacity. When we think about value solutions, our objective , is to make , an ownership position and we start making chemicals application technology and all that, we cannot become a chemical Company. So in that, we let the partner, take position. So we make corn grind plus one if you will, and then we let our partners take it from there. Which is a matter of optimized capital for us and not getting best scenario as where we are -- that are not coal for us. Coal areas for us will continue to be within feed and beverages. When we go into these materials, if we're going to produce that make sense, and then we have the partner doing the rest. Once we get the full details of the agreement, we'll see where the economics are setup and that would make sense to your investments will be in your target is trying to"
},
{
"speaker": "Vincent Andrews",
"text": "focus in net-to-net. As a follow-up, on the fertilizer issue, obviously the availability concerns, but seems like it's happening, it's at the high prices, they're deferring fertilizer purchases, particularly in South America. How percentage of the big soy groups to buy less fertilizer, etc., and to you slide showing that farmer sales are I guess at a 5-year average, which is probably okay, but they're well below last year and probably the year before. So what impact does that have on your origination business if the farmer is slow to sell the beans or if they buy less fertilizers, then he may hold onto more beans if they want to keep the FX -- keep the dollars. So how do you think about that playing out for you moving into next year?"
},
{
"speaker": "Juan Luciano",
"text": "I'll say South America is always an issue with a little bit more factors in terms of farmer selling just because, although currency and under distortion that sometimes the government bring s into the we continue to see maybe relatively slow farmer selling in Argentina and that will probably continue. It's been a little bit better in in Brazil recently, but it's still relatively slow versus the accelerated pace at which they sold last year."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Vincent Anderson from Stifel. Please go ahead."
},
{
"speaker": "Vincent Anderson",
"text": "Yes. Thanks. And I would like to continue as Vincent. Vincent of questioning on PLA.Maybe just approaching it from trying to prioritize getting incremental return out of your core competency and fermentation technology, but maybe limiting direct participation in the PLA Market. And I ask just because that is a bit more of a commodity business than it feels like you've pushed more of your investments to recently?"
},
{
"speaker": "Juan Luciano",
"text": "I think that as we said, we are trying to and I think that you said we're trying to optimize our facilities and as such those facilities to demand that has more growth opportunity. In this issue, again, we don't want to go into making chemicals. That's a heavy capital intensive industry, and we want to make one derivative and then, reserve all that capital to continue to grow in food, feed, and beverages, and in health and wellness, that's what we're trying to do so LG Chem is a great partner. We're very honored to have them. They have very good technology and it's a little bit like the discussions. We're going to continue to make ethanol, they will take it from there to make SAF. And with the -- with these partnerships, we're going to make lactic. They're going to take it from there to make PLA. So it's kind of a similar mindset."
},
{
"speaker": "Vincent Anderson",
"text": "That's perfect. Thank you. Then just a quick point of clarification, if I understand the phrasing of that MOU announcement, it sounded like you're considering investing in lactic acid capacity that would maybe exceed LG's needs and then you would market the remaining product yourself. Is that correct? Then could you just talk briefly about the opportunity there as a stand-alone investment?"
},
{
"speaker": "Juan Luciano",
"text": "Listen, partial of that is correct. I mean, lactic it can go to many opportunities. But this is relatively early on on the teams are looking at these. There is a lot -- there are a lot of numbers, there are a lot of things that could still change, there are a lot of discussions. So I wouldn't like to venture that much since the teams are still discussing with LG Chem and by 2050, 2060, 2040, whatever it is that these are they are looking back at their portfolio. They need to clean their portfolios, if you will. And one of the ways to do that is through recycling, the other way to do it is to go in plant-based. So we are receiving a lot of inbound request on that, and we're looking at our profits, our ability to produce plant-based products on our carbon capture and sequestration that provides an opportunity to make lower CI products. And we're trying to maximize the opportunity for ADM on all these. So some of these things may not be that well-defined because that volume for the ADM shareholders. But it's a great opportunity for us and we will be mindful of returns and we not going to veer into areas that we shouldn't be putting capitals. The capital will be reserved for our main thrust of the strategy, which is to continue to grow in food, and feed, and beverage."
},
{
"speaker": "Vincent Anderson",
"text": "Understood. I appreciate the added detail on that. Look forward to hearing more about it."
},
{
"speaker": "Juan Luciano",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Eric Larson from Seaport Research Partners. Eric, your line is open."
},
{
"speaker": "Eric Larson",
"text": "and the whole transaction. And I know that one of your -- maybe your dislike that you had with ethanol over the years is the extreme volatility of factors and when we talk about the in the past, one of the things was trying to reduce your earnings volatility. So in your -- in the economic of how you nego -- We don't know much they are, but have you been able to -- do you think you've able to ink an agreement that actually gives you more sustainability or I guess plus volatility of current things on the economics of SAF going forward relative to ethanol."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. You're correct that Returns are important to us, but also dumping the volatility is in the mind of everything we do. So, of course, the team is considering that. I can't disclose that much at this early on. But I think what you need to also think is that over time, we will try to become a minority partner in all these. And the objective all these is to deconsolidate and take all those assets out of our participation. So to a certain degree, we're acting owners long-term of this. That's why I talked before about partners or financial partners. I think we're going to be able to deconsolidate. We're going to be able to monetize some amounts and if there is some upside to that, hopefully participate in all that. But you are correct. The objective is not to participate in"
},
{
"speaker": "Eric Larson",
"text": "Okay, no that is a lot. So when you look at the size of your investments, they're -- those are relatively new assets, but I guess they're probably 8 to 10 years older obviously you so you've probably depreciated them pretty significantly already. Is your contribution to the putting those assets in there, or would you expect to see maybe a modest capital return as part of that JV Agreement as well?"
},
{
"speaker": "Juan Luciano",
"text": "One of the reasons, Eric, that we landed in this option is that the valuation of our assets, I mean, it's better than the alternatives that we have. So we are pleased with the value at which we are contributing these 2 assets. We don't need or we don't plan to add as such, then the joint venture or Gevo may put money for finishing of the -- and to convert it into through their technology. But our participation stops with the contribution of these 2 dry mills as they are."
},
{
"speaker": "Eric Larson",
"text": "Okay, perfect. Thank you. Juan, my questions at that. Thanks, everybody."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Eric."
},
{
"speaker": "Operator",
"text": "Our last question comes from Adam Samuelson from Goldman Sachs. Adam, your line is open."
},
{
"speaker": "Adam Samuelson",
"text": "Yes. Thank you. Good morning, everyone. Good morning, Adam. Hi. Well, a lot of ground bidding covered. so I'll try and make this quick. On the DSAS MoU, can you just maybe clarify just in the beginning factors of what you'd be looking for on the regulatory side to really move ahead here. Obviously, SAS doesn't participate today in the RFS or California programs. So what would you want to see in terms of the federal or state action on SAS before you really fully commit to going ahead?"
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Listen, we have experienced in both the U.S. and the European Union a strong desire to make this a reality. There is no another efficient way to decarbonize the airlines industry -- the aviation industry. Of course, on the short hauls, you can put the , long hauls is something like this. So we expect the governments to be a partner, to a certain degree, in creating some of these markets. Some of those things are too early for me to disclose. But there are commitments both the U.S. government and the European Union to create a market for that in the 50 billion gallons type of size. So there's going to be some helping in to that. But that's probably to the extent that I can talk about it right now."
},
{
"speaker": "Adam Samuelson",
"text": "Okay. And then, just quickly on the Balance Sheet, maybe this is for Ray. At the end of the quarter, net debt to EBITDA was sub two times. You haven't bought back any stock this year. Just help us think about how we should think about stock buyback as part of the capital allocation mix going forward."
},
{
"speaker": "Ray Young",
"text": "I think that as we -- we've been monitoring commodity prices very carefully. And when you look in our offering working capital, right now it's still $2 billion higher than we were last year. So as we think about commodity prices next year, assuming you have a strong South America crop, you have a normal crop in U.S.. You see commodity prices coming off again. And after we've funded some of the bolt-on acquisitions that we've talked about, I expect our Balance Sheet to be pretty strong. And so there we can probably start looking back at return of capital that we've looked like in the pa st. So I think a lot of it is a function of funding the investments that we've talked about, but importantly, making sure that the working capital environment reverts back to normalized levels, which I think -- I sense, assuming a normal South America crop, a normal U.S. crop next year. I see opportunities to look at return of capital."
},
{
"speaker": "Adam Samuelson",
"text": "Okay. All right. I'll leave it there Thanks so much."
},
{
"speaker": "Ray Young",
"text": "Thank you, Adam."
},
{
"speaker": "Juan Luciano",
"text": "We'll be headlining on December 10th, Global Investor Day. We look forward to talking in more detail projectory and why we are so optimistic about the opportunities ahead. In the meantime, as always, feel free to follow up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "Thank you, everyone for joining us today. This now concludes today's conference call, please now disconnect your lines."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 2 | 2,021 | 2021-07-27 09:00:00 | Operator: Good morning and welcome to the ADM Second Quarter 2021 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call Vikram Luthar, Senior Vice President, Head of Investor Relations, Chief Financial Officer, Nutrition for ADM. Mr. Luthar, you may begin.
Vikram Luthar: Thank you, Shelby. Good morning and welcome to ADM's second quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. For those following the presentation, please turn to slide two, the company's Safe Harbor Statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and highlight some of our accomplishments. Our Chief Financial Officer, Ray Young, will review the drivers of our performance, as well as corporate results and financial highlights. Then Juan will make some final comments, after which they will take your questions. Please turn to slide three. I will now turn the call over to Juan.
Juan Luciano: Thank you, Vikram. I'm pleased to share with you results that continue to demonstrate our success in delivering strong and sustained earnings growth. This morning, we reported record second quarter adjusted earnings per share of $1.33. Adjusted segment operating profit was $1.2 billion, up 44% versus the second quarter of 2020. Our trailing fourth quarter adjusted EBITDA was about $4.5 billion, almost $900 million more than a year ago. And I'm proud to report that our trailing fourth quarter average adjusted ROIC was 9.7%, which is both significantly higher than the 8.1% of the prior year period and also represents the achievement of our 10% objective. I'm proud of the entire ADM team for their great results this quarter. We're living up to our promises and our purpose. And the continuing execution of our strategy is delivering impressive ongoing growth for our company, our customers and our shareholders. I'd like to take a moment to highlight some of our accomplishments from the quarter. Slide four, please. Over the last decade, we made cultural, technology and process changes that help us revolutionize how we do our work every day.
Ray Young: Yes. Thanks Juan and good morning everyone. Move to slide nine please. The Ag Services and Oilseeds team followed up on their exceptional first quarter with another outstanding quarter. Ag Services results were higher year-over-year. The North American origination business delivered an outstanding second quarter, managing its positions effectively in a dynamic pricing environment and also achieved significantly higher export volumes, driven by corn sales to China. South American origination was significantly lower than the previous year's quarter driven by slower farmer selling and high commodity prices, which impacted contract fulfillment. Global trade performance was lower than the second -- strong second quarter of 2020 when customers were building inventories in mid-COVID-19. Results were also impacted by timing impacts that should reverse. Crushing had substantially higher year-over-year results. The business executed well in an environment of strong vegetable oil demand to deliver higher execution margins in North America soy and EU softseeds. Results were partially offset by weaker soybean crush margins in South America, driven by lower demand for biodiesel. In addition there were about $70 million in net incremental negative timing effects which should reverse in the coming quarters. Refined products and other results were significantly higher than the prior year period, driven by continued recovery in foodservice as well as positive timing effects in North America, partially offset by the effects of the reduction in the Brazilian biodiesel mandates. Equity earnings from Wilmar were higher year-over-year. Now, looking ahead, we expect Q3 performance for Ag Services and Oilseeds to be higher than the third quarter of 2020, driven by stronger results in crushing. We continue to anticipate full year results that will be significantly higher than 2020's very strong performance. Slide 10 please. The Carbohydrate Solutions team did a great job delivering results that were almost double those of the prior year period. Starches and Sweeteners, including ethanol production from our wet mills, delivered substantially higher year-over-year results in a highly dynamic pricing environment, driven by about $90 million in positioning gains across the ethanol complex, as well as more normalized results from corn oil. Sweetener volumes were higher reflecting the beginnings of a recovery in demand from the foodservice channel. Ethanol margins improved versus the prior year period driven by a resurgence in driving miles in the United States.
Juan Luciano: Thank you, Ray. Slide 13 please. When I look back on our outstanding first half results following a record 2020, I see a team that is executing at a high level and a strategy that is delivering according to our plan. We have been constantly refreshing our portfolio, divesting from non-strategic businesses and redeploying capital consistent with our strategy. In doing so, we've built industry-leading capabilities to meet customer and consumer needs in high-growth categories such as meat alternatives, a category we expect to reach more than $100 billion in sales worldwide by 2030 and in which our PlantPlus Foods joint venture, now is participating, selling consumer products across Brazil and ready in its North American launch. Another example is dietary supplements, a segment on track to have $80 billion in sales globally by 2025; and in which we're constantly expanding our product portfolio including our recently introduced Bio-Kult Brighten, which includes ingredients to reduce tiredness and fatigue. And then there is pet food, which is forecast to grow to more than $130 billion globally by 2025 and an area in which we launched our new premium cat food in Mexico, earlier this year. The list goes on. Renewable green diesel, pharmaceuticals and personal care, beverages all large high-growth opportunities powered by macro consumer trends like sustainability and health and wellbeing. And in each of those segments and more, our unparalleled global footprint, fully integrated value chain, customer insight, broad portfolio and speed to market are setting us ahead of the competition and fueling our growth. That's why, we are so optimistic about our path forward. Of course, there are always going to be short-term factors for us to navigate. But those are not things that will impact our long-term success. Our confidence is rooted in the transformation we began a decade ago and which continues with our work in productivity and innovation, as well as our expanding participation in large and fast-growing market opportunities. So to conclude, we have a great start of the year and we expect to continue our momentum, in the second half to deliver very strong 2021 earnings. As we've discussed, we are moving to a new phase of our strategic growth plan. With what we have accomplished over the years on capital discipline targeted cost reductions and cash generation and moving through our portfolio transformation and our efforts to optimize business performance, drive efficiencies and expand strategically. I believe, we have successfully increased our base earnings power from $3 a share back in 2015 to a range of $4 to $4.50 this year. And now, as we enter the next stage of our growth leveraging the key macro trends of food security health and well-being and sustainability with our continued focus on productivity and innovation and with future targeted investments, we believe our medium-term ,annual earnings trend growth rate will be in the high single-digit percentages from these $4 to $4.50 per share baseline. With that operator please open the line for questions.
Operator: Your first question is from Adam Samuelson of Goldman Sachs.
Adam Samuelson : Yes. Thank you, and good morning, everyone.
Juan Luciano: Good morning, Adam.
Ray Young: Good morning.
Adam Samuelson : I want -- maybe just something you just mentioned in the prepared remarks the $4 to $4.50 baseline of EPS this year and the high single-digit growth thereafter just to be clear is that -- should we take that as a reasonably formal EPS range for 2021 just given the performance year-to-date? I just want to clarify just, how we're framing that.
Juan Luciano: Yes, Adam. Listen, when we were -- when we put together the previous phase of the strategy, we were looking at growing as I said before from $3 to land in the $4 to $4.50 area and achieve 10% ROIC. As we started to see those goals in sight, we started on the development of the new phase of the strategy. So we took that base of $4 to $4.50 and we created a five-year plan. When we put together that plan, with all these opportunities that I highlighted and focused on productivity and innovation, that plan shows that from that base of $4 to $4.50 will grow over the next five years at the rate of high single-digit growth per year. So that's what we said in the -- at the outlook. Hello? Are we still on the line?
Adam Samuelson: I'm sorry. And then, just a market macro question, if I may. Just, we've seen some volatility in oilseed crush margins around the world of late. It seems like, especially, in China, the soy meal demand has waned a little bit, with the wheat substitution and it seems like the global industry is really crushing for veg oil, given all the RD demand around the world. Can you just help us think about kind of how that rolls forward, as we think, especially with -- for you more heavily weighted towards soybeans and some pressure in terms of softseed crop availability on the oil side, as we go through the balance of the year and into 2022?
Juan Luciano: Yes. Thank you, Adam. So, listen, we are very optimistic about the prospects for crush for the rest of the year and into next year. And if I go by geography, as I always do, from a North American perspective, margin remains exceptionally strong in North America in the $45 to $50 range. As you said, with a strong vegetable oil demand, in part driven by RGD, but we had already a very good oil demand and we see more recovery of our foodservices and more reopening of the economy. And that continues to enhance, of course, the oil share of the crush contribution. And also, the tightening supplies and logistical issues in South America are allowing also U.S. soybean meal to be a little bit more competitive in global markets. We see some compression in European soy margins, maybe to $10 to $20, as prices basically from South America oil imports are pressuring crush margins, especially this is the time of the year in which Argentina and Brazil are the most competitive. They are in the middle of the harvest. And of course they have reduced their biodiesel mandate, so there is more oil exportable, if you will. Although, the beauty of our long supply chain is that, as crush margins have softened in Europe, we got the benefit in biodiesel and the RPV given that. Brazil margins continue to remain solid for domestic plants, with maybe $25 to $35, despite the B10 biodiesel situation. And they are expected to remain solid as they move to higher B12 blend rates in the future starting I think in September. China margins are low due to high bean prices and lower soybean in demand. The herd is going through a rebalance there. And at the moment, there is a lot of wheat feed being fed. And -- but we're going to go through the harvest of wheat. And I think that's something that we see with optimism going forward is that, if you look at all the substitutes that we were facing last year whether it was sorghum or canola or sun or wheat, they have increased their inclusion in the Russians. And now all those things are having either weather issues or which is going to go through the harvest. So we see now the ability of soybean meal and corn inclusions to go up and that's positive as we go forward. As you mentioned on our watch list is canola margins. They have weakened. They were very strong in the first -- during the first half and -- but they have weakened on concern of a short drop, driven by the dryness in Canada. And canola margins are probably going to remain volatile until there is more certainty around the Canadian crop side. So two factors that we feel good about here is how valuable our switch capacity is, in this dynamic environment margins have shifted. And also how important it is our integration our long value chain. If you think North America today is capturing it in crush and maybe less so in biodiesel in Europe, we don't capture that much in crush, but we capture it in biodiesel. So, all this ability of our footprint to allow us to follow the margin, as it moves through the value chain has been very, very beneficial in these very volatile times.
Adam Samuelson: That's incredibly helpful color. Thanks so much. I'll pass it on.
Juan Luciano: Adam, maybe on the first question that you mentioned, again, the $4 to $4.50, as I said before, just to clarify, is our baseline in which we ran the exercise, because that was the landing spot of our previous strategy. And it's not a forecast or guidance for this year.
Adam Samuelson: Got it, that's helpful. Thank you.
Operator: Your next question is from Ben Theurer of Barclays.
Juan Luciano: Good morning, Ben.
Ray Young: Hi Ben. Ben, are you on the line?
Operator: We'll go to the next questioner. Your next question is from Luke Washer of Bank of America.
Luke Washer: Hi. Good morning.
Juan Luciano: Good morning, Luke.
Ray Young: Good morning, Luke.
Luke Washer: So, I wanted to ask you a few quick questions on your carbon capture projects. I think they're really interesting. Are you getting any 45Q tax credits, for the implementation of that technology? And now that it appears that it's commercially viable, do you intend to start the permitting process or working with other partners to build out and start capturing carbon at some of the other plants?
Juan Luciano: Yes. So the answer is, yes, to both. So we have a big permit for Decatur that we plan to of course leverage. And then, yes, we are exploring our ability to do so for other plants. We've been doing this relatively quietly, Luke since 2017. And as I said before, we have stored more than 3.5 million tons, safely underground. And this gives us the ability to start differentiating our products that we can assign some of the credits to some of these products and have those products be deemed low-carbon intensity product. So we have again, a big experience. We've been doing this for four years, in two different facilities. And we feel very good about the future. And this is going to be a growing part of our operations, for sure.
Luke Washer: And maybe just a quick follow-up on that, it -- this does lower the carbon score -- the carbon -- the CI scores of your plants, right?
Juan Luciano: That's correct.
Luke Washer: Okay.
Juan Luciano: Yeah.
Luke Washer: Okay, great. And then, maybe just a more short-term question on Carb Solutions, it looks like you really did well this quarter, particularly relative to expectations earlier this year. So can you talk through the -- I guess, the delta in your expectations and how things progress through the quarter? And maybe talk through the $90 million in positioning gains that you had? And then, you also talked about normalized results for corn oil. Corn oil prices are really high right now. So are you saying that that is a bit of a new normal, because of renewable diesel? Any other color there would be great.
Juan Luciano: Yeah. Let me tell you why -- what -- one better if you will, as per your question. I think that this was the quarter that we needed to restart the ethanol dry mills that we have taken down, due to lack of demand. And we have from a technical perspective the perfect start-up. And certainly, they hit the ground with better margins than maybe we anticipated before bringing them up. Second, as we explained before, we have very good risk management that the team positioned very well on corn and on the ethanol complex. And certainly sweeteners volumes came back versus last year, as customers were preparing for the summer. And to a certain degree you might have to take both Q2 and Q3 together from a sweetener perspective, because I think that a lot of customers bought in anticipation of refilling their pipeline given the summer and the openness with COVID that we will go into experience in the U.S. So it was a strong volume month as well.
Ray Young: It's going to -- on your question on corn oil, we've seen convergence of corn oil with soybean oil again. Recall last year, we saw a divergence because of the snack foods people staying at home high demand for corn oil, which is used for frying that caused corn oil prices to move up dramatically and it diverged from soybean oil and that's what's caused a lot of the mark-to-market issues that we had last year. We've worked through all those issues over the course of the period. We're actually seeing right now corn oil and soybean oil really converging. And so we're turning back to, let's say, the normal relationship that we've seen in the past.
Luke Washer: Great. Thank you both.
Operator: Your next question is from Ken Zaslow of Bank of Montreal.
Ken Zaslow: Hi. Good morning, guys.
Ray Young: Hi, Ken.
Juan Luciano: Hi, Ken. Good morning.
Ken Zaslow: You keep on tempting us with this productivity and innovation. Can you put some color in terms of quantification on how much this is going to create in not just 2021, but beyond that and how do you frame those two opportunities?
Juan Luciano: Yes. Ken, I would say, if you look at our past what we have been doing over the last five years probably -- and if you think about translating everything we've done in productivity and innovation we were probably two-third in productivity and one-third in innovation if you will of all the savings we were getting. As we look at as I said before at our plan going forward, the contribution between productivity and innovation is equal. It's about 50-50. And it's mainly driven by all these opportunities that I mentioned not only nutrition, but all the other things that we're seeing whether it's biomaterials or renewable green diesel and all the other things that we've done. Again, when we look at our plan, when we start from this again theoretical $4 to $4.50 range and we apply all these projects that are included in productivity and innovation we see our program over the next five years growing in the high single-digit percentage every year in operating profit. So we feel very good about that. We will be having Ken in Q4 an Investor Day where we will be disclosing much more details and much more granularity about all these. But you can see some of the things that we're doing already whether we are invested in Spiritwood or the acquisition of Sojaprotein or the expansions of our plant in Valencia with Biopolis and microbiome. So all these areas are receiving organic growth dollars. This will be -- as we go forward Ken and you look at this plan this is more an investment plan than maybe the previous period was. So you will see a little bit more CapEx and a little bit more investment given the size of the opportunities. When I was mentioning some of the sizes of these addressable markets we have if you added some of the things I was saying these are markets north of $300 billion in which we have positioned ourselves very, very well and we think that we're going to capture a nice share of those. So the opportunity ahead of us is significant.
Ken Zaslow: Let me just follow on. When you're thinking about the high single-digit growth rate to what extent do you think that is associated with the improvement in -- or the structural improvement in RD over the next couple of years? And how much of that is internally creative?
Juan Luciano: Yes. Let me say, when I look at the three businesses and we move them forward through the five years we see Ag Services and Oilseeds growth moderately, but it grows. We see Carb Solutions being flat to slightly declining in our forecasting. And then we see a strong growth in Nutrition. That's kind of the -- if you will the algorithm of how the business has moved. The Ag Services and Oilseeds part -- part of that has been our own improvement, part of that has been the industry. There has been some consolidations and the industry margins are strong. And there has been a strong demand and we trust that there's going to continue to be a strong demand. There are 400 million people in the middle class in China that are consuming very much like US type of consumer. And that's driving health and wellness, that's driving improving diets. And then there is sustainability that is driving a lot of the things that we're doing, not only RGD, because remember that before RGD, we were already having a very tight oil market based on food, on food oil. So, I think part is our structural issues and part is our own improvements that we have done over these years.
Ken Zaslow: Thank you very much.
Juan Luciano: You’re welcome.
Operator: Your next question is from Michael Piken of Cleveland Research.
Michael Piken: Yes. Good morning. Maybe we can dive a little bit deeper into Nutrition, and it seems like that's a good chunk of where the increase came from. But maybe this 20% growth rate, should we expect for 2022 to expect 15% year-on-year growth from -- on top of this 20% level? And then also, what categories are you seeing the most growth in besides plant protein? Thanks.
Juan Luciano: Yes. Michael, listen, when we look forward on Nutrition. Nutrition is going to grow somewhere in that range, between 15% and 20%. So, we said, 15% this year and half into the year we have moved into 20%. So, something in that range. The business is going very strong. We've been able to grow that revenue during this quarter and we've been able to maintain margins, which it has been a very good job of controlling gross margins and EBITDA margin on sales. Our enthusiasm is not only for the categories in which we are positioned, but also on the win rates and the customer engagement. Our customer engagement as of -- in 2021 have doubled our customer engagement last year. And as the economy is reopening and foodservice become more active, customers are more willing to launch new promotions and new products, something that they were not doing before. So, we see that acceleration, whether it's in beverages or in health and wellness or alternative proteins. So again, I think you should think conservatively 15% per year; more aggressively 20% per year. But in that range, we will be growing over the next few years.
Michael Piken: Great. And then, a follow-up question just shifting gears. Could you talk about the impact of the recent kind of Supreme Court ruling? And there's been some talks about possible changes to the renewable fuel standard. Maybe your thoughts on the growth potential or lack thereof for the US ethanol market moving forward in light of some of these policy uncertainties? Thanks.
Ray Young: Yes, Mike. Yes, there's been a lot of news regarding the recent Supreme Court ruling and some of the comments from the EPA. When you kind of cut through all the headlines, and try to understand like what's fundamentally happening, we still believe the Biden administration and the EPA is committed to fighting climate change and also decarbonizing the economy. And biofuels, frankly, is in a very important part of that agenda. So, the Biden administration has made it very clear that they don't intend to grant SREs or these small refinery exemptions like in the prior administrations. And as President Biden himself has said, he said that we should be insisting not exempting. So, we do expect the Biden EPA to take a very balanced approach towards granting future SREs. So, when you look at supply-demand balances going forward and you take a look at the RINs balances and you think about the recovery of driving miles as we move through the pandemic, our expectation is looking at supply/demand for ethanol -- for gasoline and then which translates to ethanol, we believe that it is going to result in a reasonably constructive ethanol environment for the industry over the medium-term. Now, at the same time, Mike it is important to note that in the case of our -- we've made a strategic decision to monetize our dry mills. And so, we kind of halted that process during the pandemic frankly, because ethanol demand was very weak. But during that period, we did look at alternatives. We took advantage to, frankly, explore other options. And there's -- frankly, as Juan talked about on the issue of sustainability, there's growing interest in sustainable materials and sustainable solutions. And it appears that there may be some opportunities for us to explore non-vehicle uses of ethanol and leveraging ethanol as a sustainable feedstock for other products. And so one of the promising areas is the Sustainable Aviation Fuel, SAF. With the airline industry moving towards effectively a low-carbon or a net-zero future, SAF appears to be an important component of how they will get there. And just for perspective, the US airline industry before the pandemic consumed 30 billion gallons of aviation fuel a year. So we are looking at the possibility of leveraging our Decatur carbon sequestration site, which Juan talked about, with our corn processing output as a feedstock for SAF to get towards a low-carbon SAF product. So in addition to looking at potential monetization of dry mills, we are looking at the SAF concept, which frankly may give us another option for finding another use of the dry mills and then taking those ethanol gallons off the vehicle market.
Operator: Our next question is from Tom Simonitsch of JPMorgan.
Juan Luciano: Good morning, Tom.
Tom Simonitsch: Good morning, everyone. Hi. So following up on the Sojaprotein acquisition yesterday, can you provide some more color around how your strategy for alternative proteins varies by region?
Juan Luciano: Yes. I think that the strategy in specialty proteins is stay close to our customers and match up with capabilities and supply this market that is growing very fast. The market is growing north of 10% per year. So – and it's moving fast in terms of the products. The products are continued to be improved every quarter. So we have a strong position in North America, our heritage position in soy derivatives. Then we build our position in South America, which is very strong. I remind you that that was $0.25 billion investment so significant. Then we build pea protein capacity in North Dakota. And now we're expanding that capacity to Europe. We have a small capacity in Europe. Now with this, we have bought – we have acquired the largest producer in Europe, which again has a great footprint of – in the middle of the non-GMO soybean harvest area but also it has a very nice set of products and they sell to 65 different countries in many, many applications. So we continue to build the capabilities. This will not be the last one that you're going to hear in terms of announcements for specialty protein. Again, this is – these are early days but it's a fast-growing market in which we have a leadership position and we pretend to – we intend to expand.
Tom Simonitsch: That's helpful. And a question on China. The USDA cut its China soybean import forecast this month. What are you assuming for that trade in the near to medium term? And how would it impact your crushing footprint?
Juan Luciano: Yes. Listen, I think that we are maybe more optimistic about China medium-term than maybe with the news are giving right now. China has done an exceptional job of controlling COVID. And as such, they have recovered from that very successfully. So there is a lot of economic activity and hence demand. They have done a terrific job in coming back from the ASF pandemic. They have recovered. So they have the consumer and they have the animals to actually consume. Of course, they are very strategic in their purchases. And right now, it's not the time to be buying a lot of beans because beans are expensive and there is a crop in the US coming. And we think that that's where – when they're going to come. You also have to remember a couple of things, Tom. Over the last two or three weeks, we lost 15 million tons of production around the world due to weather issues. Whether it was the drought in Canada with – that impacted canola and wheat, whether it was Russia, whether it was the impact was on sand and in wheat and whether it was the corn crop in Brazil because of drought, all these products are competitive products in the Russian to soybean meal. So those products will not be available to compete with soybean meal which will give soybean meal a higher inclusion in the ration. And in our estimate given the small canola crop in Canada, we think that China will have to probably import 2 million tons of extra soybean -- soybeans to offset that canola gap that they have right now. So all in all we feel that we're still going to have strong exports -- export volumes in the Q4 of this year from North America.
Tom Simonitsch: Thanks very much. I will pass it on.
Operator: Your next question is from Robert Moskow of Credit Suisse.
Robert Moskow: Good morning. I had a question about the new earnings base that you're putting out there. Historically external factors can change quickly and can have a big impact on your earnings. And I want to know, what do we have to believe about the external environment to feel comfort that the earnings base is credible that it can -- that you can achieve -- that the earnings base is achievable under a variety of different external environments.
Juan Luciano: Yes. Rob, the way we thought about it when we put together the plan is and I think I expressed some of that before is of course we look at the things that we can see into the future. You can argue the magnitude but we give our forecast forward and we add inflation to that. And we say some of these things may come back to the middle if you will or reverse to the means or whatever you want to call it. So, let's put the negative side there. So, we consider some of that. And then we look at our productivity and innovation and we said, can we build a robust enough agenda in productivity and innovation that actually can offset some of those headwinds whether they are headwinds on ethanol or whether they are whatever your favorite crush margin into the future or whether it's inflation? And we look at that and the result of that exercise is that productivity and innovation earnings stream coming forward offset all that potential decline that we have estimated and offset it and giving us a result that high single-digit growth rate in profits over the next five years. So that's the way we think about it. So this is not a scenario in which everything goes perfect and margins are at peak level for five years. In our scenario margins normalize we have inflation and then we are able to offset a lot of that through growth and through productivity. That's what we are saying in terms of our new base.
Robert Moskow: Right. And in terms of things that are going to normalize carbohydrates would be the first -- the most -- the biggest degree of normalization because it looks like it's going to earn $1 billion this year?
Juan Luciano: Yes. I would say, maybe when I was answering Ken I think when we look at the three businesses, Nutrition provides a lot of the growth in that scenario of course. You have to remember, when we started reporting Nutrition yearly they were reporting about $300-and-something million. This quarter they crossed the barrier of $200 million. So now -- so it's significant. And you will see that in crescendo of course over the next few years as we reach $1 billion and beyond. Carb Solutions as you said is -- it basically declines over the period. And then we have a healthy, but not exuberant growth rate for Ag Services and Oilseeds. So all in all, when you look at our numbers it doesn't look a far-fetched scenario. On the contrary it's a scenario that we're very confident that's why we are making it public today. And a lot of things under our control to be honest.
Robert Moskow: And last question. You said that there's been consolidation in the soy crush industry and that is part of the reason for your confidence. But you are opening up a new crush plant now. Can you give a little more color about how much consolidation there's been? What do you think crush capacity looks like today compared to a few years ago? And where do you think it's going in the next few years from an industry perspective?
Juan Luciano: Yeah. Listen I think that there has been consolidation in the small regional players, which has been important. We have the example of Algar in Brazil. We also did the soybean joint venture with Cargill in Egypt. So -- and there have been others around the industry. I think it's important to notice that we've been working in this expansion, the Spiritwood for the last two years. We just announced it now. But this is capacity that, of course, this one is helped by RGD. But when you think about soybean meal in North America, we need about two to three -- to offset -- 2% to 3% growth in demand every year. So we need a full-time full-fledged plant every couple of years just to keep up with demand and to be able to supply the growth. So we don't think that any of these build is excessive. On the contrary, we think that it's needed to allow demand to be fulfilled.
Robert Moskow: Okay. Thank you.
Operator: In the interest of time, please limit yourself to one question. Again, please limit yourself to one question Your next question is from Ben Theurer of Barclays.
Ben Theurer: Great. Good morning, Juan, Ray, now we try it again. Thank you very much, and congrats on the results.
Juan Luciano: Good morning Ben.
Ray Young: Morning Ben.
Ben Theurer: Just one question. If you could elaborate a little bit on those $90 million on positioning gains across ethanol and what's been driving that throughout the quarter. And is that something you think is something recurring, is this a one-off? How should we think about it because it was obviously sizable within the segment? Thank you.
Ray Young: Yeah, Ben. I mean our team’s do an excellent job managing risk, right? And when you just talk about managing risk is both managing the risks of the inputs and the outputs. And so the positioning gains that we had in the quarter, in the second quarter, the $90 million it's a combination of what I call the ethanol complex, right? So it's a combination of how they're managing the corn, how they're managing ethanol, how they're managing RINs, all these positions. And as you know it was a very volatile quarter when you looked at the prices of corn and ethanol and RINs but they managed exceptionally well. And so $90 million normally they would generate risk management gains. We highlighted it this quarter because this was an exceptional quarter. And by the way it wasn't just an exceptional quarter. It was an exceptional first half of the year, because when you take a look at the first half of the year, they probably had positioning gains roughly with a similar amount in the first quarter as well. So, therefore, the Carb Solutions team really hit all of the ballpark in terms of risk management in the first half of this year.
Ben Theurer: So for the future we should expect some of it, but maybe not at the same magnitude. That's a fair assumption?
Ray Young: Yeah. I mean, again I mean I would never ask the Carb Solutions team to hold back. But again they will always manage their positions exceedingly well. And I would say this was probably an exceptional performance for the first half of the year.
Ben Theurer: Okay, perfect. I’ll leave it here. Thank you very much for squeezing me in again.
Ray Young: Thank you Ben.
Operator: Your next question is from Vincent Andrews of Morgan Stanley.
Steve Haynes: Hi. This is Steve Haynes on for Vincent. Maybe I could just squeeze a quick one in on the biosolutions business portfolio. You talked about some of the other growth things. And you've announced -- you've made some announcements already in terms of some partnerships and agreements. But can you I guess maybe just help us think about going forward where your any specific target growth areas would be within that business?
Juan Luciano: Yeah. Listen that is a business that to a certain degree started from a customer pool. We discovered one day that a lot of the products that we were selling in Carb Solutions were finding their way into non-food applications, non-beverage application. So now we have started with a new team on a more proactive approach to that. So we have a market based approach where we're targeting things like construction and pharmaceuticals and cosmetics and other products. And we've been very successful. This team has been growing – they have been growing sales about 10 – at the 10% click. These are very profitable opportunities and opportunities that at this point in time require no capital, because these are existing products going into new applications. So we have hired experts, marketing experts, and technical experts to be able to sell these into new applications. And we fill in an incredible customer pool. Every CEO or company out there that is announcing this de-carbonization goal's for 2040 or whatever needs to shift to plant-based materials from oil based in order to de-carbonize. And we are the largest company in that space with the ability to provide the broadest footprint of products. So you will continue to see growth there, and we are just getting started. That will be my comment. We cannot talk a lot about – as you can understand about our customer engagement, because these are confidential agreements that we have and a lot of these the customers don't want to disclose what they are doing.
Steve Haynes: All right. Thank you.
Juan Luciano: You’re welcome.
Operator: Your next question is from Ben Kallo of Baird.
Ben Kallo: Hi. Thank you very much for taking my question. The first one is just on South America gross margin. Could you just talk about, if there's a structural change or is it just a temporary change as it relates to biodiesel headwinds? And then the second question is on M&A. I know you just did a deal so congratulations on that. But on larger acquisition front from your experience one as – are there targets out there? And then two, is it easier for the heavy lifting of integration to do a large acquisition than the smaller tuck-in ones like you announced yesterday? Thank you.
Juan Luciano: Yeah. Thank you, Ben. So let me address South America first. So, of course, our bigger participation is Brazil. It has been a tough year for Brazil this first half of the year in general. We expect second half of the year to have the possibility to be a little better. Biodiesel is B12 now and that has been confirmed. We'll have to see the first auctions there. So crush margins are better. Domestic margins are $25 to $30 per ton export is about $10. Bottle oil and volumes and prices are better in the last two months. We started the year tough there. Remember that, this is a society that is going through the tougher parts of COVID. So demand is difficult there. But we have seen an improvement. Domestic meal the market is also paying for the higher soybeans. So that's good. We have – Brazil has reduced exports of corn of course, because of the drought. But the domestic market is paying the premium. So Brazil is not going to run out of corn, and it's importing a little bit from Brazil. So I would say in general with oil – domestic oil being supported and the volumes being there and with biodiesel going back to B12, we expect the second half of the year to be a little bit better than maybe what the first half was.
Ben Kallo: And then the second question on M&A, just on targets and appetite for a larger deal and then the integration of smaller deals versus many smaller deals versus the large ones?
Juan Luciano: Yeah. You know that, we've been relatively quiet. We continue to be very selective about this because valuations are in general for some properties are a little bit too high. So it – this needs to be a perfect fit into our portfolio. And the perfect combination of things with Sojaprotein is in terms of the footprint, the complementarily of the geographic nature of it and the quality of management, and the assets and the products. In terms of what is easier to integrate, I think that sometimes bolt-ons are a little bit easier. We find they fit better in a business that is already structured. When you bring a large company you need more adjustments on both sides if you will, if you think about some of these companies that have continued to operate in ADM almost like with the same agility they were operating before, whether you say Protexin or Biopolis and some of these companies. So I think that the smaller companies are probably an easy tuck-in than maybe large companies. Large companies take us a little bit longer.
Ben Kallo: Okay. Great. Thank you very much.
Juan Luciano : You’re welcome.
Operator: Your next question is from Ben Bienvenu of Stephens.
Ben Bienvenu: Hi. Thanks. Good morning everyone. I appreciate you squeezing me in.
Juan Luciano : Hi, Ben.
Ben Bienvenu: One quick one from me. You talked about the operational flexibility to shift and flex between softseed crushing and oilseed crushing. When you think about the backdrop for oilseed crushing margins across all your geographies, but in North America in particular where things are quite strong, those strong driven by soybean oil this go around, do you think the market is able to digest appropriately switching from a higher oil yield to a higher meal yield given the kind of relative softness in the meal market? And just how do you think about toggling between those two crush capacities in a market like this?
Juan Luciano: Listen at this point in time, we are seeing good demand for both products. So, of course, as you know, there is a big pull from oil. There has been a big pull for oil. And then RGD is increasing a little bit of that, but our ability to place the mill given our footprint and our commercial operations is very strong. So that gives us a lot of confidence for North America for the second half. Listen let me be clear. The Oilseeds and Ag Services business will have a very strong year much better than last year and we expect a strong second half as well that will drive the company to earnings that we never had before certainly. And certainly, we'll be probably on the higher side or maybe outside the range of 4 to 4.50 that I mentioned before that was the previous landing spot of our strategy. That's what we're seeing at the moment. So the year started strong and we think that the second half will be very strong. Okay. Very good. Thank you Juan and best of luck in the back half.
Operator: Your final question is from Eric Larson of Seaport Research Partners.
Eric Larson: Yes. Good morning everyone. I hope everybody is doing well.
Juan Luciano: Good morning, Eric.
Ray Young: Thank you, Eric.
Eric Larson: So, on the -- I know we're short on time, I'll make this question pretty quick and pretty direct. It's really going back I think a little to maybe Adam's first question, maybe drilling down on some demand functions here in the near term. Obviously, you've addressed the global biodiesel markets, what's going on there the US ethanol all the job owning of RFS and all that stuff. But people are talking about some chinks in the armor in some of the Chinese demand at least in the near term. They've walked away from a little bit of corn imports in July, which has bought a thimbleful, and I think it spooked the market. But I think the real issue here is ASF in China -- have they had a major setback in that? And we just don't know what to kind of believe what's coming out of there. And now you've had the floods in China that's impacted about 10% of their growing area has killed a lot of hogs. Is that -- is some of the near-term demand function a piece of the Chinese AFS problems that they're having?
Juan Luciano: I think that, of course, as you described, there are many issues going on and there is a little bit of a transition here. But the reality is that pork prices have come down, that will incentivate demand. But you also need to understand that, in the -- during the ASF, people get to eat more poultry as well. And we have seen that demand growth. We think that when we have a better supply and cheaper supply of soybeans, things will come back a little bit more to normal. When we check with our customers over there, fundamentally, nothing has changed. And if you look at the -- as I said the middle class in China and you look at the indicators of that, which is the consumption of the big four protein, they are all higher than prepandemic levels. So the consumer is there, the animals are there to be fed. And I think that the rest is just a matter of tactical approaches, whether we had the big run-up in hog prices in China, then the government intervened to try to control that. Now they are lower. They said more wheat. I think that's going to shift to include more soybean in the portfolio -- in the inclusion. So, we think that at the end of the day, there may be many monthly gyrations, but over time, protein consumption continues to go up and they will import more soybeans to actually satisfy that demand. So, we feel very confident about the future of the demand in China.
Vikram Luthar: Thanks. We do seriously have reached the queues. We have small issues throughout the areas and they have to supplement it with meals at some point. So, thank you, everybody for sharing.
Operator: There are no other questions in queue. I'd like to turn the call back to Mr. Luthar for any closing remarks.
End of Q&A:
Vikram Luthar: Thank you. Slide 14 notes upcoming investor events in which we will be participating. As Juan has already mentioned in the Q&A, we'd also like to announce that we will be hosting a Global Investor Day in the fourth quarter of this year, during which we will be talking more about the next phase of our growth. More particulars, including the specific date and format will be forthcoming. As always please feel free to follow up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM.
Operator: Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning and welcome to the ADM Second Quarter 2021 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call Vikram Luthar, Senior Vice President, Head of Investor Relations, Chief Financial Officer, Nutrition for ADM. Mr. Luthar, you may begin."
},
{
"speaker": "Vikram Luthar",
"text": "Thank you, Shelby. Good morning and welcome to ADM's second quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. For those following the presentation, please turn to slide two, the company's Safe Harbor Statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation, and you should carefully review the assumptions and factors in our SEC reports. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and highlight some of our accomplishments. Our Chief Financial Officer, Ray Young, will review the drivers of our performance, as well as corporate results and financial highlights. Then Juan will make some final comments, after which they will take your questions. Please turn to slide three. I will now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Vikram. I'm pleased to share with you results that continue to demonstrate our success in delivering strong and sustained earnings growth. This morning, we reported record second quarter adjusted earnings per share of $1.33. Adjusted segment operating profit was $1.2 billion, up 44% versus the second quarter of 2020. Our trailing fourth quarter adjusted EBITDA was about $4.5 billion, almost $900 million more than a year ago. And I'm proud to report that our trailing fourth quarter average adjusted ROIC was 9.7%, which is both significantly higher than the 8.1% of the prior year period and also represents the achievement of our 10% objective. I'm proud of the entire ADM team for their great results this quarter. We're living up to our promises and our purpose. And the continuing execution of our strategy is delivering impressive ongoing growth for our company, our customers and our shareholders. I'd like to take a moment to highlight some of our accomplishments from the quarter. Slide four, please. Over the last decade, we made cultural, technology and process changes that help us revolutionize how we do our work every day."
},
{
"speaker": "Ray Young",
"text": "Yes. Thanks Juan and good morning everyone. Move to slide nine please. The Ag Services and Oilseeds team followed up on their exceptional first quarter with another outstanding quarter. Ag Services results were higher year-over-year. The North American origination business delivered an outstanding second quarter, managing its positions effectively in a dynamic pricing environment and also achieved significantly higher export volumes, driven by corn sales to China. South American origination was significantly lower than the previous year's quarter driven by slower farmer selling and high commodity prices, which impacted contract fulfillment. Global trade performance was lower than the second -- strong second quarter of 2020 when customers were building inventories in mid-COVID-19. Results were also impacted by timing impacts that should reverse. Crushing had substantially higher year-over-year results. The business executed well in an environment of strong vegetable oil demand to deliver higher execution margins in North America soy and EU softseeds. Results were partially offset by weaker soybean crush margins in South America, driven by lower demand for biodiesel. In addition there were about $70 million in net incremental negative timing effects which should reverse in the coming quarters. Refined products and other results were significantly higher than the prior year period, driven by continued recovery in foodservice as well as positive timing effects in North America, partially offset by the effects of the reduction in the Brazilian biodiesel mandates. Equity earnings from Wilmar were higher year-over-year. Now, looking ahead, we expect Q3 performance for Ag Services and Oilseeds to be higher than the third quarter of 2020, driven by stronger results in crushing. We continue to anticipate full year results that will be significantly higher than 2020's very strong performance. Slide 10 please. The Carbohydrate Solutions team did a great job delivering results that were almost double those of the prior year period. Starches and Sweeteners, including ethanol production from our wet mills, delivered substantially higher year-over-year results in a highly dynamic pricing environment, driven by about $90 million in positioning gains across the ethanol complex, as well as more normalized results from corn oil. Sweetener volumes were higher reflecting the beginnings of a recovery in demand from the foodservice channel. Ethanol margins improved versus the prior year period driven by a resurgence in driving miles in the United States."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ray. Slide 13 please. When I look back on our outstanding first half results following a record 2020, I see a team that is executing at a high level and a strategy that is delivering according to our plan. We have been constantly refreshing our portfolio, divesting from non-strategic businesses and redeploying capital consistent with our strategy. In doing so, we've built industry-leading capabilities to meet customer and consumer needs in high-growth categories such as meat alternatives, a category we expect to reach more than $100 billion in sales worldwide by 2030 and in which our PlantPlus Foods joint venture, now is participating, selling consumer products across Brazil and ready in its North American launch. Another example is dietary supplements, a segment on track to have $80 billion in sales globally by 2025; and in which we're constantly expanding our product portfolio including our recently introduced Bio-Kult Brighten, which includes ingredients to reduce tiredness and fatigue. And then there is pet food, which is forecast to grow to more than $130 billion globally by 2025 and an area in which we launched our new premium cat food in Mexico, earlier this year. The list goes on. Renewable green diesel, pharmaceuticals and personal care, beverages all large high-growth opportunities powered by macro consumer trends like sustainability and health and wellbeing. And in each of those segments and more, our unparalleled global footprint, fully integrated value chain, customer insight, broad portfolio and speed to market are setting us ahead of the competition and fueling our growth. That's why, we are so optimistic about our path forward. Of course, there are always going to be short-term factors for us to navigate. But those are not things that will impact our long-term success. Our confidence is rooted in the transformation we began a decade ago and which continues with our work in productivity and innovation, as well as our expanding participation in large and fast-growing market opportunities. So to conclude, we have a great start of the year and we expect to continue our momentum, in the second half to deliver very strong 2021 earnings. As we've discussed, we are moving to a new phase of our strategic growth plan. With what we have accomplished over the years on capital discipline targeted cost reductions and cash generation and moving through our portfolio transformation and our efforts to optimize business performance, drive efficiencies and expand strategically. I believe, we have successfully increased our base earnings power from $3 a share back in 2015 to a range of $4 to $4.50 this year. And now, as we enter the next stage of our growth leveraging the key macro trends of food security health and well-being and sustainability with our continued focus on productivity and innovation and with future targeted investments, we believe our medium-term ,annual earnings trend growth rate will be in the high single-digit percentages from these $4 to $4.50 per share baseline. With that operator please open the line for questions."
},
{
"speaker": "Operator",
"text": "Your first question is from Adam Samuelson of Goldman Sachs."
},
{
"speaker": "Adam Samuelson",
"text": "Yes. Thank you, and good morning, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Adam."
},
{
"speaker": "Ray Young",
"text": "Good morning."
},
{
"speaker": "Adam Samuelson",
"text": "I want -- maybe just something you just mentioned in the prepared remarks the $4 to $4.50 baseline of EPS this year and the high single-digit growth thereafter just to be clear is that -- should we take that as a reasonably formal EPS range for 2021 just given the performance year-to-date? I just want to clarify just, how we're framing that."
},
{
"speaker": "Juan Luciano",
"text": "Yes, Adam. Listen, when we were -- when we put together the previous phase of the strategy, we were looking at growing as I said before from $3 to land in the $4 to $4.50 area and achieve 10% ROIC. As we started to see those goals in sight, we started on the development of the new phase of the strategy. So we took that base of $4 to $4.50 and we created a five-year plan. When we put together that plan, with all these opportunities that I highlighted and focused on productivity and innovation, that plan shows that from that base of $4 to $4.50 will grow over the next five years at the rate of high single-digit growth per year. So that's what we said in the -- at the outlook. Hello? Are we still on the line?"
},
{
"speaker": "Adam Samuelson",
"text": "I'm sorry. And then, just a market macro question, if I may. Just, we've seen some volatility in oilseed crush margins around the world of late. It seems like, especially, in China, the soy meal demand has waned a little bit, with the wheat substitution and it seems like the global industry is really crushing for veg oil, given all the RD demand around the world. Can you just help us think about kind of how that rolls forward, as we think, especially with -- for you more heavily weighted towards soybeans and some pressure in terms of softseed crop availability on the oil side, as we go through the balance of the year and into 2022?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Adam. So, listen, we are very optimistic about the prospects for crush for the rest of the year and into next year. And if I go by geography, as I always do, from a North American perspective, margin remains exceptionally strong in North America in the $45 to $50 range. As you said, with a strong vegetable oil demand, in part driven by RGD, but we had already a very good oil demand and we see more recovery of our foodservices and more reopening of the economy. And that continues to enhance, of course, the oil share of the crush contribution. And also, the tightening supplies and logistical issues in South America are allowing also U.S. soybean meal to be a little bit more competitive in global markets. We see some compression in European soy margins, maybe to $10 to $20, as prices basically from South America oil imports are pressuring crush margins, especially this is the time of the year in which Argentina and Brazil are the most competitive. They are in the middle of the harvest. And of course they have reduced their biodiesel mandate, so there is more oil exportable, if you will. Although, the beauty of our long supply chain is that, as crush margins have softened in Europe, we got the benefit in biodiesel and the RPV given that. Brazil margins continue to remain solid for domestic plants, with maybe $25 to $35, despite the B10 biodiesel situation. And they are expected to remain solid as they move to higher B12 blend rates in the future starting I think in September. China margins are low due to high bean prices and lower soybean in demand. The herd is going through a rebalance there. And at the moment, there is a lot of wheat feed being fed. And -- but we're going to go through the harvest of wheat. And I think that's something that we see with optimism going forward is that, if you look at all the substitutes that we were facing last year whether it was sorghum or canola or sun or wheat, they have increased their inclusion in the Russians. And now all those things are having either weather issues or which is going to go through the harvest. So we see now the ability of soybean meal and corn inclusions to go up and that's positive as we go forward. As you mentioned on our watch list is canola margins. They have weakened. They were very strong in the first -- during the first half and -- but they have weakened on concern of a short drop, driven by the dryness in Canada. And canola margins are probably going to remain volatile until there is more certainty around the Canadian crop side. So two factors that we feel good about here is how valuable our switch capacity is, in this dynamic environment margins have shifted. And also how important it is our integration our long value chain. If you think North America today is capturing it in crush and maybe less so in biodiesel in Europe, we don't capture that much in crush, but we capture it in biodiesel. So, all this ability of our footprint to allow us to follow the margin, as it moves through the value chain has been very, very beneficial in these very volatile times."
},
{
"speaker": "Adam Samuelson",
"text": "That's incredibly helpful color. Thanks so much. I'll pass it on."
},
{
"speaker": "Juan Luciano",
"text": "Adam, maybe on the first question that you mentioned, again, the $4 to $4.50, as I said before, just to clarify, is our baseline in which we ran the exercise, because that was the landing spot of our previous strategy. And it's not a forecast or guidance for this year."
},
{
"speaker": "Adam Samuelson",
"text": "Got it, that's helpful. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question is from Ben Theurer of Barclays."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ben."
},
{
"speaker": "Ray Young",
"text": "Hi Ben. Ben, are you on the line?"
},
{
"speaker": "Operator",
"text": "We'll go to the next questioner. Your next question is from Luke Washer of Bank of America."
},
{
"speaker": "Luke Washer",
"text": "Hi. Good morning."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Luke."
},
{
"speaker": "Ray Young",
"text": "Good morning, Luke."
},
{
"speaker": "Luke Washer",
"text": "So, I wanted to ask you a few quick questions on your carbon capture projects. I think they're really interesting. Are you getting any 45Q tax credits, for the implementation of that technology? And now that it appears that it's commercially viable, do you intend to start the permitting process or working with other partners to build out and start capturing carbon at some of the other plants?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. So the answer is, yes, to both. So we have a big permit for Decatur that we plan to of course leverage. And then, yes, we are exploring our ability to do so for other plants. We've been doing this relatively quietly, Luke since 2017. And as I said before, we have stored more than 3.5 million tons, safely underground. And this gives us the ability to start differentiating our products that we can assign some of the credits to some of these products and have those products be deemed low-carbon intensity product. So we have again, a big experience. We've been doing this for four years, in two different facilities. And we feel very good about the future. And this is going to be a growing part of our operations, for sure."
},
{
"speaker": "Luke Washer",
"text": "And maybe just a quick follow-up on that, it -- this does lower the carbon score -- the carbon -- the CI scores of your plants, right?"
},
{
"speaker": "Juan Luciano",
"text": "That's correct."
},
{
"speaker": "Luke Washer",
"text": "Okay."
},
{
"speaker": "Juan Luciano",
"text": "Yeah."
},
{
"speaker": "Luke Washer",
"text": "Okay, great. And then, maybe just a more short-term question on Carb Solutions, it looks like you really did well this quarter, particularly relative to expectations earlier this year. So can you talk through the -- I guess, the delta in your expectations and how things progress through the quarter? And maybe talk through the $90 million in positioning gains that you had? And then, you also talked about normalized results for corn oil. Corn oil prices are really high right now. So are you saying that that is a bit of a new normal, because of renewable diesel? Any other color there would be great."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Let me tell you why -- what -- one better if you will, as per your question. I think that this was the quarter that we needed to restart the ethanol dry mills that we have taken down, due to lack of demand. And we have from a technical perspective the perfect start-up. And certainly, they hit the ground with better margins than maybe we anticipated before bringing them up. Second, as we explained before, we have very good risk management that the team positioned very well on corn and on the ethanol complex. And certainly sweeteners volumes came back versus last year, as customers were preparing for the summer. And to a certain degree you might have to take both Q2 and Q3 together from a sweetener perspective, because I think that a lot of customers bought in anticipation of refilling their pipeline given the summer and the openness with COVID that we will go into experience in the U.S. So it was a strong volume month as well."
},
{
"speaker": "Ray Young",
"text": "It's going to -- on your question on corn oil, we've seen convergence of corn oil with soybean oil again. Recall last year, we saw a divergence because of the snack foods people staying at home high demand for corn oil, which is used for frying that caused corn oil prices to move up dramatically and it diverged from soybean oil and that's what's caused a lot of the mark-to-market issues that we had last year. We've worked through all those issues over the course of the period. We're actually seeing right now corn oil and soybean oil really converging. And so we're turning back to, let's say, the normal relationship that we've seen in the past."
},
{
"speaker": "Luke Washer",
"text": "Great. Thank you both."
},
{
"speaker": "Operator",
"text": "Your next question is from Ken Zaslow of Bank of Montreal."
},
{
"speaker": "Ken Zaslow",
"text": "Hi. Good morning, guys."
},
{
"speaker": "Ray Young",
"text": "Hi, Ken."
},
{
"speaker": "Juan Luciano",
"text": "Hi, Ken. Good morning."
},
{
"speaker": "Ken Zaslow",
"text": "You keep on tempting us with this productivity and innovation. Can you put some color in terms of quantification on how much this is going to create in not just 2021, but beyond that and how do you frame those two opportunities?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Ken, I would say, if you look at our past what we have been doing over the last five years probably -- and if you think about translating everything we've done in productivity and innovation we were probably two-third in productivity and one-third in innovation if you will of all the savings we were getting. As we look at as I said before at our plan going forward, the contribution between productivity and innovation is equal. It's about 50-50. And it's mainly driven by all these opportunities that I mentioned not only nutrition, but all the other things that we're seeing whether it's biomaterials or renewable green diesel and all the other things that we've done. Again, when we look at our plan, when we start from this again theoretical $4 to $4.50 range and we apply all these projects that are included in productivity and innovation we see our program over the next five years growing in the high single-digit percentage every year in operating profit. So we feel very good about that. We will be having Ken in Q4 an Investor Day where we will be disclosing much more details and much more granularity about all these. But you can see some of the things that we're doing already whether we are invested in Spiritwood or the acquisition of Sojaprotein or the expansions of our plant in Valencia with Biopolis and microbiome. So all these areas are receiving organic growth dollars. This will be -- as we go forward Ken and you look at this plan this is more an investment plan than maybe the previous period was. So you will see a little bit more CapEx and a little bit more investment given the size of the opportunities. When I was mentioning some of the sizes of these addressable markets we have if you added some of the things I was saying these are markets north of $300 billion in which we have positioned ourselves very, very well and we think that we're going to capture a nice share of those. So the opportunity ahead of us is significant."
},
{
"speaker": "Ken Zaslow",
"text": "Let me just follow on. When you're thinking about the high single-digit growth rate to what extent do you think that is associated with the improvement in -- or the structural improvement in RD over the next couple of years? And how much of that is internally creative?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Let me say, when I look at the three businesses and we move them forward through the five years we see Ag Services and Oilseeds growth moderately, but it grows. We see Carb Solutions being flat to slightly declining in our forecasting. And then we see a strong growth in Nutrition. That's kind of the -- if you will the algorithm of how the business has moved. The Ag Services and Oilseeds part -- part of that has been our own improvement, part of that has been the industry. There has been some consolidations and the industry margins are strong. And there has been a strong demand and we trust that there's going to continue to be a strong demand. There are 400 million people in the middle class in China that are consuming very much like US type of consumer. And that's driving health and wellness, that's driving improving diets. And then there is sustainability that is driving a lot of the things that we're doing, not only RGD, because remember that before RGD, we were already having a very tight oil market based on food, on food oil. So, I think part is our structural issues and part is our own improvements that we have done over these years."
},
{
"speaker": "Ken Zaslow",
"text": "Thank you very much."
},
{
"speaker": "Juan Luciano",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Your next question is from Michael Piken of Cleveland Research."
},
{
"speaker": "Michael Piken",
"text": "Yes. Good morning. Maybe we can dive a little bit deeper into Nutrition, and it seems like that's a good chunk of where the increase came from. But maybe this 20% growth rate, should we expect for 2022 to expect 15% year-on-year growth from -- on top of this 20% level? And then also, what categories are you seeing the most growth in besides plant protein? Thanks."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Michael, listen, when we look forward on Nutrition. Nutrition is going to grow somewhere in that range, between 15% and 20%. So, we said, 15% this year and half into the year we have moved into 20%. So, something in that range. The business is going very strong. We've been able to grow that revenue during this quarter and we've been able to maintain margins, which it has been a very good job of controlling gross margins and EBITDA margin on sales. Our enthusiasm is not only for the categories in which we are positioned, but also on the win rates and the customer engagement. Our customer engagement as of -- in 2021 have doubled our customer engagement last year. And as the economy is reopening and foodservice become more active, customers are more willing to launch new promotions and new products, something that they were not doing before. So, we see that acceleration, whether it's in beverages or in health and wellness or alternative proteins. So again, I think you should think conservatively 15% per year; more aggressively 20% per year. But in that range, we will be growing over the next few years."
},
{
"speaker": "Michael Piken",
"text": "Great. And then, a follow-up question just shifting gears. Could you talk about the impact of the recent kind of Supreme Court ruling? And there's been some talks about possible changes to the renewable fuel standard. Maybe your thoughts on the growth potential or lack thereof for the US ethanol market moving forward in light of some of these policy uncertainties? Thanks."
},
{
"speaker": "Ray Young",
"text": "Yes, Mike. Yes, there's been a lot of news regarding the recent Supreme Court ruling and some of the comments from the EPA. When you kind of cut through all the headlines, and try to understand like what's fundamentally happening, we still believe the Biden administration and the EPA is committed to fighting climate change and also decarbonizing the economy. And biofuels, frankly, is in a very important part of that agenda. So, the Biden administration has made it very clear that they don't intend to grant SREs or these small refinery exemptions like in the prior administrations. And as President Biden himself has said, he said that we should be insisting not exempting. So, we do expect the Biden EPA to take a very balanced approach towards granting future SREs. So, when you look at supply-demand balances going forward and you take a look at the RINs balances and you think about the recovery of driving miles as we move through the pandemic, our expectation is looking at supply/demand for ethanol -- for gasoline and then which translates to ethanol, we believe that it is going to result in a reasonably constructive ethanol environment for the industry over the medium-term. Now, at the same time, Mike it is important to note that in the case of our -- we've made a strategic decision to monetize our dry mills. And so, we kind of halted that process during the pandemic frankly, because ethanol demand was very weak. But during that period, we did look at alternatives. We took advantage to, frankly, explore other options. And there's -- frankly, as Juan talked about on the issue of sustainability, there's growing interest in sustainable materials and sustainable solutions. And it appears that there may be some opportunities for us to explore non-vehicle uses of ethanol and leveraging ethanol as a sustainable feedstock for other products. And so one of the promising areas is the Sustainable Aviation Fuel, SAF. With the airline industry moving towards effectively a low-carbon or a net-zero future, SAF appears to be an important component of how they will get there. And just for perspective, the US airline industry before the pandemic consumed 30 billion gallons of aviation fuel a year. So we are looking at the possibility of leveraging our Decatur carbon sequestration site, which Juan talked about, with our corn processing output as a feedstock for SAF to get towards a low-carbon SAF product. So in addition to looking at potential monetization of dry mills, we are looking at the SAF concept, which frankly may give us another option for finding another use of the dry mills and then taking those ethanol gallons off the vehicle market."
},
{
"speaker": "Operator",
"text": "Our next question is from Tom Simonitsch of JPMorgan."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Tom."
},
{
"speaker": "Tom Simonitsch",
"text": "Good morning, everyone. Hi. So following up on the Sojaprotein acquisition yesterday, can you provide some more color around how your strategy for alternative proteins varies by region?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I think that the strategy in specialty proteins is stay close to our customers and match up with capabilities and supply this market that is growing very fast. The market is growing north of 10% per year. So – and it's moving fast in terms of the products. The products are continued to be improved every quarter. So we have a strong position in North America, our heritage position in soy derivatives. Then we build our position in South America, which is very strong. I remind you that that was $0.25 billion investment so significant. Then we build pea protein capacity in North Dakota. And now we're expanding that capacity to Europe. We have a small capacity in Europe. Now with this, we have bought – we have acquired the largest producer in Europe, which again has a great footprint of – in the middle of the non-GMO soybean harvest area but also it has a very nice set of products and they sell to 65 different countries in many, many applications. So we continue to build the capabilities. This will not be the last one that you're going to hear in terms of announcements for specialty protein. Again, this is – these are early days but it's a fast-growing market in which we have a leadership position and we pretend to – we intend to expand."
},
{
"speaker": "Tom Simonitsch",
"text": "That's helpful. And a question on China. The USDA cut its China soybean import forecast this month. What are you assuming for that trade in the near to medium term? And how would it impact your crushing footprint?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Listen, I think that we are maybe more optimistic about China medium-term than maybe with the news are giving right now. China has done an exceptional job of controlling COVID. And as such, they have recovered from that very successfully. So there is a lot of economic activity and hence demand. They have done a terrific job in coming back from the ASF pandemic. They have recovered. So they have the consumer and they have the animals to actually consume. Of course, they are very strategic in their purchases. And right now, it's not the time to be buying a lot of beans because beans are expensive and there is a crop in the US coming. And we think that that's where – when they're going to come. You also have to remember a couple of things, Tom. Over the last two or three weeks, we lost 15 million tons of production around the world due to weather issues. Whether it was the drought in Canada with – that impacted canola and wheat, whether it was Russia, whether it was the impact was on sand and in wheat and whether it was the corn crop in Brazil because of drought, all these products are competitive products in the Russian to soybean meal. So those products will not be available to compete with soybean meal which will give soybean meal a higher inclusion in the ration. And in our estimate given the small canola crop in Canada, we think that China will have to probably import 2 million tons of extra soybean -- soybeans to offset that canola gap that they have right now. So all in all we feel that we're still going to have strong exports -- export volumes in the Q4 of this year from North America."
},
{
"speaker": "Tom Simonitsch",
"text": "Thanks very much. I will pass it on."
},
{
"speaker": "Operator",
"text": "Your next question is from Robert Moskow of Credit Suisse."
},
{
"speaker": "Robert Moskow",
"text": "Good morning. I had a question about the new earnings base that you're putting out there. Historically external factors can change quickly and can have a big impact on your earnings. And I want to know, what do we have to believe about the external environment to feel comfort that the earnings base is credible that it can -- that you can achieve -- that the earnings base is achievable under a variety of different external environments."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Rob, the way we thought about it when we put together the plan is and I think I expressed some of that before is of course we look at the things that we can see into the future. You can argue the magnitude but we give our forecast forward and we add inflation to that. And we say some of these things may come back to the middle if you will or reverse to the means or whatever you want to call it. So, let's put the negative side there. So, we consider some of that. And then we look at our productivity and innovation and we said, can we build a robust enough agenda in productivity and innovation that actually can offset some of those headwinds whether they are headwinds on ethanol or whether they are whatever your favorite crush margin into the future or whether it's inflation? And we look at that and the result of that exercise is that productivity and innovation earnings stream coming forward offset all that potential decline that we have estimated and offset it and giving us a result that high single-digit growth rate in profits over the next five years. So that's the way we think about it. So this is not a scenario in which everything goes perfect and margins are at peak level for five years. In our scenario margins normalize we have inflation and then we are able to offset a lot of that through growth and through productivity. That's what we are saying in terms of our new base."
},
{
"speaker": "Robert Moskow",
"text": "Right. And in terms of things that are going to normalize carbohydrates would be the first -- the most -- the biggest degree of normalization because it looks like it's going to earn $1 billion this year?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I would say, maybe when I was answering Ken I think when we look at the three businesses, Nutrition provides a lot of the growth in that scenario of course. You have to remember, when we started reporting Nutrition yearly they were reporting about $300-and-something million. This quarter they crossed the barrier of $200 million. So now -- so it's significant. And you will see that in crescendo of course over the next few years as we reach $1 billion and beyond. Carb Solutions as you said is -- it basically declines over the period. And then we have a healthy, but not exuberant growth rate for Ag Services and Oilseeds. So all in all, when you look at our numbers it doesn't look a far-fetched scenario. On the contrary it's a scenario that we're very confident that's why we are making it public today. And a lot of things under our control to be honest."
},
{
"speaker": "Robert Moskow",
"text": "And last question. You said that there's been consolidation in the soy crush industry and that is part of the reason for your confidence. But you are opening up a new crush plant now. Can you give a little more color about how much consolidation there's been? What do you think crush capacity looks like today compared to a few years ago? And where do you think it's going in the next few years from an industry perspective?"
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Listen I think that there has been consolidation in the small regional players, which has been important. We have the example of Algar in Brazil. We also did the soybean joint venture with Cargill in Egypt. So -- and there have been others around the industry. I think it's important to notice that we've been working in this expansion, the Spiritwood for the last two years. We just announced it now. But this is capacity that, of course, this one is helped by RGD. But when you think about soybean meal in North America, we need about two to three -- to offset -- 2% to 3% growth in demand every year. So we need a full-time full-fledged plant every couple of years just to keep up with demand and to be able to supply the growth. So we don't think that any of these build is excessive. On the contrary, we think that it's needed to allow demand to be fulfilled."
},
{
"speaker": "Robert Moskow",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "In the interest of time, please limit yourself to one question. Again, please limit yourself to one question Your next question is from Ben Theurer of Barclays."
},
{
"speaker": "Ben Theurer",
"text": "Great. Good morning, Juan, Ray, now we try it again. Thank you very much, and congrats on the results."
},
{
"speaker": "Juan Luciano",
"text": "Good morning Ben."
},
{
"speaker": "Ray Young",
"text": "Morning Ben."
},
{
"speaker": "Ben Theurer",
"text": "Just one question. If you could elaborate a little bit on those $90 million on positioning gains across ethanol and what's been driving that throughout the quarter. And is that something you think is something recurring, is this a one-off? How should we think about it because it was obviously sizable within the segment? Thank you."
},
{
"speaker": "Ray Young",
"text": "Yeah, Ben. I mean our team’s do an excellent job managing risk, right? And when you just talk about managing risk is both managing the risks of the inputs and the outputs. And so the positioning gains that we had in the quarter, in the second quarter, the $90 million it's a combination of what I call the ethanol complex, right? So it's a combination of how they're managing the corn, how they're managing ethanol, how they're managing RINs, all these positions. And as you know it was a very volatile quarter when you looked at the prices of corn and ethanol and RINs but they managed exceptionally well. And so $90 million normally they would generate risk management gains. We highlighted it this quarter because this was an exceptional quarter. And by the way it wasn't just an exceptional quarter. It was an exceptional first half of the year, because when you take a look at the first half of the year, they probably had positioning gains roughly with a similar amount in the first quarter as well. So, therefore, the Carb Solutions team really hit all of the ballpark in terms of risk management in the first half of this year."
},
{
"speaker": "Ben Theurer",
"text": "So for the future we should expect some of it, but maybe not at the same magnitude. That's a fair assumption?"
},
{
"speaker": "Ray Young",
"text": "Yeah. I mean, again I mean I would never ask the Carb Solutions team to hold back. But again they will always manage their positions exceedingly well. And I would say this was probably an exceptional performance for the first half of the year."
},
{
"speaker": "Ben Theurer",
"text": "Okay, perfect. I’ll leave it here. Thank you very much for squeezing me in again."
},
{
"speaker": "Ray Young",
"text": "Thank you Ben."
},
{
"speaker": "Operator",
"text": "Your next question is from Vincent Andrews of Morgan Stanley."
},
{
"speaker": "Steve Haynes",
"text": "Hi. This is Steve Haynes on for Vincent. Maybe I could just squeeze a quick one in on the biosolutions business portfolio. You talked about some of the other growth things. And you've announced -- you've made some announcements already in terms of some partnerships and agreements. But can you I guess maybe just help us think about going forward where your any specific target growth areas would be within that business?"
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Listen that is a business that to a certain degree started from a customer pool. We discovered one day that a lot of the products that we were selling in Carb Solutions were finding their way into non-food applications, non-beverage application. So now we have started with a new team on a more proactive approach to that. So we have a market based approach where we're targeting things like construction and pharmaceuticals and cosmetics and other products. And we've been very successful. This team has been growing – they have been growing sales about 10 – at the 10% click. These are very profitable opportunities and opportunities that at this point in time require no capital, because these are existing products going into new applications. So we have hired experts, marketing experts, and technical experts to be able to sell these into new applications. And we fill in an incredible customer pool. Every CEO or company out there that is announcing this de-carbonization goal's for 2040 or whatever needs to shift to plant-based materials from oil based in order to de-carbonize. And we are the largest company in that space with the ability to provide the broadest footprint of products. So you will continue to see growth there, and we are just getting started. That will be my comment. We cannot talk a lot about – as you can understand about our customer engagement, because these are confidential agreements that we have and a lot of these the customers don't want to disclose what they are doing."
},
{
"speaker": "Steve Haynes",
"text": "All right. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Your next question is from Ben Kallo of Baird."
},
{
"speaker": "Ben Kallo",
"text": "Hi. Thank you very much for taking my question. The first one is just on South America gross margin. Could you just talk about, if there's a structural change or is it just a temporary change as it relates to biodiesel headwinds? And then the second question is on M&A. I know you just did a deal so congratulations on that. But on larger acquisition front from your experience one as – are there targets out there? And then two, is it easier for the heavy lifting of integration to do a large acquisition than the smaller tuck-in ones like you announced yesterday? Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Yeah. Thank you, Ben. So let me address South America first. So, of course, our bigger participation is Brazil. It has been a tough year for Brazil this first half of the year in general. We expect second half of the year to have the possibility to be a little better. Biodiesel is B12 now and that has been confirmed. We'll have to see the first auctions there. So crush margins are better. Domestic margins are $25 to $30 per ton export is about $10. Bottle oil and volumes and prices are better in the last two months. We started the year tough there. Remember that, this is a society that is going through the tougher parts of COVID. So demand is difficult there. But we have seen an improvement. Domestic meal the market is also paying for the higher soybeans. So that's good. We have – Brazil has reduced exports of corn of course, because of the drought. But the domestic market is paying the premium. So Brazil is not going to run out of corn, and it's importing a little bit from Brazil. So I would say in general with oil – domestic oil being supported and the volumes being there and with biodiesel going back to B12, we expect the second half of the year to be a little bit better than maybe what the first half was."
},
{
"speaker": "Ben Kallo",
"text": "And then the second question on M&A, just on targets and appetite for a larger deal and then the integration of smaller deals versus many smaller deals versus the large ones?"
},
{
"speaker": "Juan Luciano",
"text": "Yeah. You know that, we've been relatively quiet. We continue to be very selective about this because valuations are in general for some properties are a little bit too high. So it – this needs to be a perfect fit into our portfolio. And the perfect combination of things with Sojaprotein is in terms of the footprint, the complementarily of the geographic nature of it and the quality of management, and the assets and the products. In terms of what is easier to integrate, I think that sometimes bolt-ons are a little bit easier. We find they fit better in a business that is already structured. When you bring a large company you need more adjustments on both sides if you will, if you think about some of these companies that have continued to operate in ADM almost like with the same agility they were operating before, whether you say Protexin or Biopolis and some of these companies. So I think that the smaller companies are probably an easy tuck-in than maybe large companies. Large companies take us a little bit longer."
},
{
"speaker": "Ben Kallo",
"text": "Okay. Great. Thank you very much."
},
{
"speaker": "Juan Luciano",
"text": "You’re welcome."
},
{
"speaker": "Operator",
"text": "Your next question is from Ben Bienvenu of Stephens."
},
{
"speaker": "Ben Bienvenu",
"text": "Hi. Thanks. Good morning everyone. I appreciate you squeezing me in."
},
{
"speaker": "Juan Luciano",
"text": "Hi, Ben."
},
{
"speaker": "Ben Bienvenu",
"text": "One quick one from me. You talked about the operational flexibility to shift and flex between softseed crushing and oilseed crushing. When you think about the backdrop for oilseed crushing margins across all your geographies, but in North America in particular where things are quite strong, those strong driven by soybean oil this go around, do you think the market is able to digest appropriately switching from a higher oil yield to a higher meal yield given the kind of relative softness in the meal market? And just how do you think about toggling between those two crush capacities in a market like this?"
},
{
"speaker": "Juan Luciano",
"text": "Listen at this point in time, we are seeing good demand for both products. So, of course, as you know, there is a big pull from oil. There has been a big pull for oil. And then RGD is increasing a little bit of that, but our ability to place the mill given our footprint and our commercial operations is very strong. So that gives us a lot of confidence for North America for the second half. Listen let me be clear. The Oilseeds and Ag Services business will have a very strong year much better than last year and we expect a strong second half as well that will drive the company to earnings that we never had before certainly. And certainly, we'll be probably on the higher side or maybe outside the range of 4 to 4.50 that I mentioned before that was the previous landing spot of our strategy. That's what we're seeing at the moment. So the year started strong and we think that the second half will be very strong. Okay. Very good. Thank you Juan and best of luck in the back half."
},
{
"speaker": "Operator",
"text": "Your final question is from Eric Larson of Seaport Research Partners."
},
{
"speaker": "Eric Larson",
"text": "Yes. Good morning everyone. I hope everybody is doing well."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Eric."
},
{
"speaker": "Ray Young",
"text": "Thank you, Eric."
},
{
"speaker": "Eric Larson",
"text": "So, on the -- I know we're short on time, I'll make this question pretty quick and pretty direct. It's really going back I think a little to maybe Adam's first question, maybe drilling down on some demand functions here in the near term. Obviously, you've addressed the global biodiesel markets, what's going on there the US ethanol all the job owning of RFS and all that stuff. But people are talking about some chinks in the armor in some of the Chinese demand at least in the near term. They've walked away from a little bit of corn imports in July, which has bought a thimbleful, and I think it spooked the market. But I think the real issue here is ASF in China -- have they had a major setback in that? And we just don't know what to kind of believe what's coming out of there. And now you've had the floods in China that's impacted about 10% of their growing area has killed a lot of hogs. Is that -- is some of the near-term demand function a piece of the Chinese AFS problems that they're having?"
},
{
"speaker": "Juan Luciano",
"text": "I think that, of course, as you described, there are many issues going on and there is a little bit of a transition here. But the reality is that pork prices have come down, that will incentivate demand. But you also need to understand that, in the -- during the ASF, people get to eat more poultry as well. And we have seen that demand growth. We think that when we have a better supply and cheaper supply of soybeans, things will come back a little bit more to normal. When we check with our customers over there, fundamentally, nothing has changed. And if you look at the -- as I said the middle class in China and you look at the indicators of that, which is the consumption of the big four protein, they are all higher than prepandemic levels. So the consumer is there, the animals are there to be fed. And I think that the rest is just a matter of tactical approaches, whether we had the big run-up in hog prices in China, then the government intervened to try to control that. Now they are lower. They said more wheat. I think that's going to shift to include more soybean in the portfolio -- in the inclusion. So, we think that at the end of the day, there may be many monthly gyrations, but over time, protein consumption continues to go up and they will import more soybeans to actually satisfy that demand. So, we feel very confident about the future of the demand in China."
},
{
"speaker": "Vikram Luthar",
"text": "Thanks. We do seriously have reached the queues. We have small issues throughout the areas and they have to supplement it with meals at some point. So, thank you, everybody for sharing."
},
{
"speaker": "Operator",
"text": "There are no other questions in queue. I'd like to turn the call back to Mr. Luthar for any closing remarks."
},
{
"speaker": "End of Q&A",
"text": ""
},
{
"speaker": "Vikram Luthar",
"text": "Thank you. Slide 14 notes upcoming investor events in which we will be participating. As Juan has already mentioned in the Q&A, we'd also like to announce that we will be hosting a Global Investor Day in the fourth quarter of this year, during which we will be talking more about the next phase of our growth. More particulars, including the specific date and format will be forthcoming. As always please feel free to follow up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "Ladies and gentlemen, this concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 1 | 2,021 | 2021-04-27 15:00:00 | Operator: Good morning. And welcome to the ADM First Quarter 2021 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Victoria de la Huerga, Vice President, Investor Relations for ADM. Ms. De la Huerga, you may begin.
Victoria de la Huerga: Thank you, Chris. Good morning, and welcome to ADM's first quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com.
Juan Luciano: Thank you, Victoria. This morning, I am pleased to share with you results that demonstrate an outstanding start to 2021, building on our momentum from a record 2020. We reported first quarter adjusted earnings per share of $1.39, more than double the year ago period. Adjusted segment operating profit was $1.2 billion, 86% higher than the first quarter of 2020 and our sixth consecutive quarter of year-over-year adjusted OP growth. Our trailing fourth quarter average adjusted ROIC was 9%, 375 basis points higher than our 2021 annual WACC and significantly higher than the 7.6% in the year ago period. And our trailing fourth quarter adjusted EBITDA was about $4.2 billion, 19% higher than the prior year period. I am proud of our team, and they continue to deliver sustained strong growth, powered by their continued advancement of the strategic transformation of our business, outstanding execution and excellent risk management and commitment to serving the evolving needs of our customers in new and innovative ways. I'd like to take a moment now to highlight some of the trends, developments and accomplishments from the first quarter. Turn to slide four, please. First, we are encouraged by many of the demand indicators we are seeing. From a geographic perspective, China was one of the first countries to emerge from COVID-related restrictions, and we are continuing to see significant export demand driven by its economic recovery.
Ray Young: Yes. Thanks, Juan. Good morning, everyone. Slide eight, please. The Ag Services and Oilseeds team delivered an outstanding quarter with operating profit of $777 million, representing a record for a first quarter. Ag Services results were substantially higher year-over-year. Results were driven by a record Q1 for our North American origination team, which executed extremely well to capitalize on strong Chinese demand. As expected, results in South America were significantly lower versus the prior year period. Farmer selling was lower versus the extremely aggressive pace in the year ago quarter. Lower margins, including the impacts from the slightly delayed harvest and higher freight costs also affected South American results. Results for the quarter were affected by about $75 million in negative timing related to ocean freight position. Those impacts will reverse as contracts execute in the coming quarters. Crushing delivered its best quarter ever, as the business leverage its global footprint and diversified capabilities to capture strong execution margins in both soybean and softseed crushing, driven by robust vegetable oil demand and tight soybean stocks. Net timing impacts for the quarter in crush were minimal.
Juan Luciano: Thank you, Ray. Slide 12, please. I'm proud of the team for our great start to 2021. And I'm even more proud of the strategic work we have done to transform our company and enable our growing success. We began in 2011 by committing to specific strategic goals and financial metrics focused on what we call the three Cs, capital discipline, cost reduction and cash generation. We launched new initiatives like our $1 billion challenge with prioritized operational excellence, and we focused on returns our primary financial metric. We call that getting fit for the journey. Once we were fit, we launched the next part of our strategy, focusing on three core pillars to enhance returns, deliver more predictable growth and strengthen our ability to control our results. During this time, our team has done a great job, optimizing business performance, realigning our portfolio and building a global leader in nutrition, driving efficiencies through our operational excellence initiatives and expanding through organic growth investments, M&A and the broadening of our customer base and product offerings. Now we're moving into the next phase of our strategic transformation by sharpening our focus on two strategic pillars, productivity and innovation. Our productivity efforts will take many actions that were part of our optimized and drive focuses and boost them to the next level. The productivity pillar will include; advancing the roles of our Centers of Excellence or COEs in procurement, supply chain and operations to deliver additional efficiencies across the enterprise, the continued rollout of our One ADM business transformation program and implementation of improved standardized business processes, and increasing our use of technology, analytics and automation at our production facilities in our offices and with our customers. Our innovation activities will help us accelerate growth and profitability, not just for the near term, but importantly, for the long-term. We will expand and invest in improving the customer experience, including leveraging our producer relationships and enhancing our use of state-of-the-art digital technology to help our customers grow. Sustainability-driven innovation, which encompasses the full range of our products, solutions, capabilities and commitments to serve our customers' needs, and growth initiatives, including organic growth to support additional capacity and meet growing demand, opportunistic M&A and increased leveraging of our very successful venture capital portfolio. We'll support both pillars with investments in technology, which include expanding our digital capabilities and investing further in product research and development. And of course, all of our efforts will continue to be strengthened by our ongoing commitment to revenues. As I look at our long-term plans and this evolution of our strategy, I'm very excited about the value creation opportunities ahead of us. Our teams are continuing to perform at the high level and doing a great job serving our customers. The demand outlook for our products is strong, driven by the pre and during global trends of food security, health and well-being and sustainability. And we are delivering on our potential and our promise. That is why we are even more optimistic in our 2021 outlook today than we were three months ago, with expectations for significantly higher full year operating profit and EPS versus our record 2020. And as we look beyond 2021, we expect that our sharpened focus on productivity and innovation, combined with continuing demand expansion driven by the fundamental needs and evolving demands of our global customers and the multi-year COVID recovery will deliver sustained growth in earnings in the years to come. With that, Chris, please open the line for questions.
Operator: Thank you. The first question comes from Ken Zaslow of Bank of Montreal. Your line is open.
Ken Zaslow: Hey. Good morning, everyone.
Juan Luciano: Good morning, Ken.
Ken Zaslow: Just want to touch base. You kind of - your comment was - which was actually really interesting, that you expect growth, sustainable growth for years to come. So with that, just a couple of points. One is, do you look at 2021 or 2020 as the base year from which you can grow? And then second, what are the key demand drivers that you see beyond 2021 that will continue to propel you? Or is it more internal actions that would create the growth?
Juan Luciano: Yes. Thank you, Ken. Listen, as I was referring in my remarks, we see the future with a lot of optimism. I mean, we think that fundamentally, we have, as you know, a strong agenda of both now productivity and innovation where there are things that we can control, that we drive under our control. And we've been executing a similar plan. So now you're going to see it strengthen. And it has a more longer horizon reach, if you will, that's where we like about this sharpening. But all this is in the - as supported by these three strong trends that we see in food security, health and well-being and sustainability. So let me give you a little bit of flavor there. We continue to see strong demand. You see food security, of course, as the global population grows. Protein demand continues to grow around the world as people increase their standards of living. And as countries come back from the pandemic on this demand that was, to a certain degree suppressed, we see that in China, we see that in the US. And we believe that given the uneven vaccine recovery of vaccine rollout, this will take several years. So that's in an environment, Ken, as you know, a very tight supply, demand balances. So we expect an environment of good profits for the following years. Then when we look at health and well-being, that's propelling our Nutrition division and many of our other offerings in which we continue to see strong growth even exacerbated, if you will with pandemics or other events. And we continue to see more demand for products made based on plans that what we call biosolutions or products that actually replace industrial products made from resources that are not renewable. We have a long list of interested parties in doing more of that and we continue to develop solutions for that. So again, when we see the trends, when we see the strong demand environment in a tight supply, demand environment, plus the agenda of productivity and innovation, we feel very strong about our ability to deliver earnings growth from where we are today.
Ken Zaslow: So in 2020 or 2021, would you say, is your year from which we could start thinking about growth?
Juan Luciano: Yes. I think that we - 2021, we're going to grow significantly versus 2020. So in 2021, we are establishing this sharpening again. So if you will, maybe we can reset to that level to 2021 and we start it from here. We have a rolling five year plan, as you know, Ken that we constantly update. And we constantly make it more robust, so we can deliver earnings growth year-over-year.
Ken Zaslow: Great. I appreciate. Thank you.
Juan Luciano: Thank you, Ken.
Operator: Your next question comes from Adam Samuelson of Goldman Sachs. Your line is open.
Adam Samuelson: Yes. Thanks. Good morning, everyone.
Juan Luciano: Good morning, Adam.
Adam Samuelson: Hi. So, I guess, my first question, really just trying to think about the market environment a little bit, and obviously, a lot of crop currents happening at the moment. Specifically, I want to think about on the oilseed franchise and the expansion of renewable diesel. And as we think about, one, you can sort of see it already in the soybean oil market and what that's doing to crush margins. But as we think about the second half of the year into next year as some of the bigger capacities start to come on, how do we think about the earnings leverage, both in your crushing franchise, but also in the edible oils business with the refining that we - a business that never really got that much attention and grown much for a number of years given the move away from Transfast , but would seem to be kind of very strategic for a bunch of refiners who don't have pre-treatment over the next couple of years? And then I got a capital allocation question afterwards.
Juan Luciano: Adam, listen, we said it before, we feel very strongly about the future of our Oilseeds business. It's a business that was built traditionally in one leg, if you will, from the mill supporting all these, and we were always waiting for the oil story. The oil story, I mean, you can see that right now playing up, oil values that reach record levels, softseed margins that been the best in the last eight years, if you will. So they are supporting very good soy crush margins and great softseed margins. We invested in this many years ago, remember, with all the switch capacity, we have about give or take, 15% of our total crush capacity that can be switched from soybeans to softseed. So that's an advantage for us. And now all of a sudden, we are having this new demand that is coming because of all the sustainability trends that we discussed before with this in the form of renewable green diesel. So it just comes to strengthen our belief into this business that is very strategic for us. And to be honest, very proud of the way the business is executing. These are not easy markets to navigate with a lot of volatility, with very big values, and they are having touch wood and impeccable run. And they've done very well, given their sophistication and knowledge of - and to be honest, also the visibility that being a full value chain supplier and a global supplier gives us. So continue to work very close with our food and fuel customers and staying close to them to make sure we can read what's coming down the pipe. But again, Adam, very, very encouraged by all these developments and very happy for our strategic Oilseed business.
Adam Samuelson: Okay. That's really helpful, Juan. And my second question is really on the balance sheet. Maybe this is more for Ray. And I'm just trying to think about kind of cash capital deployment from here. Obviously, you have to be very sensitive to the increase in commodity prices and the impact that has on readily marketable inventories. But I mean impressively, your credit capacity has actually gone up on a year-on-year basis, despite the rising in RMI. And so I'm just trying to think about what would it take to see cash return to shareholders or more aggressive or offensive M&A moving forward? It seems like there's a lot of underlying cash generation in the business, and it doesn't seem like we've got a clear kind of target of where it's going at the moment.
Ray Young: Well, first of all, the balance sheet is what I consider one of the greatest assets of ADM. And while inventories have actually increased 50% compared to March of last year, we still have significant available credit capacity to undertake actions, right? And so I think the first priority is continue to fund the working capital needs. It's not a surprise. Commodity prices continue to go up right now. And so therefore, we will use our balance sheet to kind of fund additional working capital requirements. And - but secondly, we have flexibility to do whatever we need to do from a strategic perspective. As you know, in prior periods, during higher commodity prices, there are distressed assets in the marketplace. And so to the extent that there are distressed assets that make sense for us to acquire in order to consolidate, we'll look at those. That's one of the big advantages of our ADM balance sheet. So - but we all know that eventually commodity prices will come down, and that will free up additional capital on the balance sheet. And then we can look at additional incremental returns on capital to our shareholders at that point in time. But again, the dividend, we've increased the dividend. That's an important element of return on capital to our shareholders. But I'm convinced that our balance sheet because we all know prices go through cycles, there will be a release of working capital at some juncture that will again free up significant capacity for us to take additional return of capital actions.
Adam Samuelson: Okay. That’s a really helpful color. I’ll pass it on. Thank you.
Juan Luciano: Thank you, Adam.
Operator: Your next question comes from Tom Simonitsch of JPMorgan. Your line is open.
Tom Simonitsch: Hi. Good morning, everyone.
Juan Luciano: Good morning, Tom.
Ray Young: Hey, Tom.
Tom Simonitsch: Could you give us some more color around your - how you're managing your crush assets this year compared to any other? To what extent are you locking in crush capacity for the next few quarters? And on the oil side, how are you approaching negotiations with potential renewable diesel customers versus your more traditional food customers?
Juan Luciano: Yes. So I can say we have a reasonable visibility on the Q2 for Oilseeds as we have a book build. And we stay a little bit more open for the Q3 and Q4. That's probably to the extent that I will disclose. In terms of food versus oil customers, listen, we're staying close to both. Of course, we provide - we have long-term relationships with our food customers that - we've been working with them through all these and educating them on this new demand that is coming. And we are forging new relationships with customers from renewable diesel that of course, the big issue for that industry is feedstock availability. So we're having a lot of discussions that range from the tactical to the strategic discussions with some of them as they decide on their future investments. So that's what I will describe the relationship.
Tom Simonitsch: Thank you. And then just a question on Nutrition, I think you mentioned a shift in demand for texturants. Can you provide some more color there?
Juan Luciano: Yes. We've seen some softness in some of those segments. But I would say this is a little bit of a transition time in - Nutrition goes to so many applications, and depending on the geography, foodservices in some parts are coming back and in some other parts, that's still delayed. So, I would say, in general, I'm very pleased actually. Nutrition surpassed my own expectations this quarter by growing profitability by around 9% and revenue 5%. It was - the demand recovery from COVID and the impact of that in different markets is very uneven around the world, as the world is getting access to vaccination at different rates. So we are seeing that. So, as I said, this was a quarter of, remember, investment in Nutrition. So we were expecting results similar to last year. We end up delivering results that are 9% better than last year, so very happy with this. We had some specific pockets of softness, maybe some chewing gum kind of softness, some softness in some places in Animal Nutrition. But overall, very strong flavors, beverages, supplements, fibers, probiotics, specialty proteins. So, the main trends remain there.
Tom Simonitsch: Thank you for that. And maybe just one more question for me. If you wouldn't mind, could you share your house view of US planted acres of corn versus beans?
Juan Luciano: Yes. I would say, in our view, given the early planting the start that we have in the US, I think we have corn about 17%, on soybeans and about 8% at the moment. We believe that there is probably upside to the USDA numbers. So we believe that by the next time USDA will report acres, we're probably going to find maybe five more million acres, combined between soy and corn, kind of evenly split, if you will, give or take between the two.
Tom Simonitsch: Excellent. Thank you very much. I'll pass it on.
Juan Luciano: Thank you, Tom.
Operator: Your next question comes from Luke Washer of Bank of America. Your line is open.
Luke Washer: Hi. Good morning, everybody.
Juan Luciano: Hi, Luke.
Ray Young: Hey, Luke.
Luke Washer: So I wanted to touch on, soybean oil a little bit. I know you've talked a little bit about renewable diesel trend. But have you seen soybean oil demand ramp this quarter relative to your expectations perhaps at the beginning of this quarter? And is this largely driven by renewable diesel demand? Or are you also seeing increased demand for edible oils? And is there any distraction is happening with the prices where they are?
Juan Luciano: Yes. Listen, we continue to see strong demand. I think that as some restaurants and in some places are reopening, we started to see food services coming back a little bit. To be honest, we saw that across the company, not only in soybean oil, I would say March orders were significantly better than January and February. And I think we see that continuing in April. So again, a - recovery, but we can see that. I would say, of course, green diesel customers are starting to show in demand. So we see that increase demand. So in general, we see a strong demand. In terms of disruption of demand, we haven't seen that to any degree. Probably the only example I can pinpoint is Brazil with biodiesel that reduced from B13 to B10. That's probably the only thing you can say. Things have become expensive, at least. And Brazil, as I may -- as I've mentioned, in my onset remarks, Brazil is having a very difficult time with COVID. So I think that the overall economy is suffering. And I think the government is trying to alleviate some - to alleviate a little bit the pressure on inflation there. So - but that's probably the only example I can pinpoint to at this point of demand disruption.
Luke Washer: Great. Thanks, Juan. And then maybe one more on Nutrition, can you talk about what's driving your confidence in the 15% CAGR that you expect this year? What are the ways that you're driving operating profit margins higher? Is this simply growing in higher-margin businesses? Or are you doing cross-selling or any other actions you're taking? Maybe just some of the puts and takes for this year.
Juan Luciano: Yes, absolutely. Listen, remember the 15% came from - we put together the five year plan. And when we see us achieving our target of $1 billion OP, basically by 2024, give or take, in order to get there, we need to grow 15%. So we were planning to start this year. And this year, it's not an exception to that. We plan 15%. When we started the year, we were planning to start the year, as I said, kind of flattish versus - and the business continue to show strength. How that strength comes part is revenue growth. Part of my confidence is given by the pipeline. We have a strong pipeline. We are very - the team is very disciplined and religious in looking at the pipeline and looking at customer-by-customer and the projects. And that pipeline continues to grow, and our win rate continues to grow. So those are very positive indicators that your value proposition is very appreciated by our customers. Certainly, another thing that we do is that the team manage the product mix very well. And that allows us to increase profitability even in excess of the revenue growth that we see. And you know, there are different parts, while, for example, for flavors and for plant based proteins and certainly for probiotics is much more a revenue growth story. For parts like Animal Nutrition, it's more like a margin recovery story. And so we have different ways to manage this portfolio that we call nutrition, but it's a very complex portfolio. But that complexity also brings a lot of growth opportunities. And that's why it give us a confidence that it's a very balanced business from an opportunity perspective, supported by a very strong pipeline.
Luke Washer: Sounds good. Thank you.
Operator: Your next question comes from Robert Moskow of Credit Suisse. Your line is open.
Robert Moskow: Hi. Thank you and congratulations. I have a question about the crush margins in the quarter. I mean, such an outstanding result. And I think you've mentioned that risk management or just execution played a role. If you look at spot margins during the quarter, just looking at board prices, they weren't nearly this good. But I've heard that you and others have been delivering results much better than that. So I guess, my question is, can you explain why it's so different from what we see in the spot markets? And is this sustainable into 2Q? Or are there some unusual aspects of first quarter that we should know about?
Juan Luciano: Yes. No, listen, it was a very clean quarter. There's nothing that you should know about other than cash crush margins remain very healthy. We have a strong product demand from both meal and specialty oil. And these margins remain considerably stronger than what board crush indicates, particularly in North America and Europe. If you look at board crush in North America or Europe per month is about $25 per ton, and then we see margins on a cash basis of around $40 per ton. So there is a significant difference there. I would say, we see - as I said before, we have reasonable visibility into Q2 given the book of business we have. So we shouldn't see any surprises there, and we are expecting another good quarter of crush over there. So I mentioned before, we have our switch capacity. Softseed margins have been good. They moderated a little bit since Q1, but they continue to be very good. So oil values continue to be strong. And demand for our customers in mill in North America, our customers are enjoying good margins at this point in time. So they are trying to produce as much as they can. So we see strong demand from both lakes of the crush. So we feel good about it at the moment.
Robert Moskow: Okay. Thank you.
Juan Luciano: Welcome.
Operator: Your next question comes from Ben Bienvenu of Stephens. Your line is open.
Ben Bienvenu: Hi. Good morning, everybody.
Juan Luciano: Good morning, Ben.
Ben Bienvenu: I want to focus on – with two questions on the Carbohydrate Solutions business, which was really, really solid in the quarter, and focusing first on those Starches and Sweeteners business. To the extent you can, can you disaggregate the contribution from your ethanol production out of your wet mills versus the kind of core Starches and Sweeteners business. And on that Starches and Sweeteners business, were net corn cost a tailwind for you guys? I know you favorably hedged your gross corn costs in 4Q. So I'm wondering kind of what the relationship between that hedged corn versus the strong co-product values delivered as it relates to your realized net corn costs?
Ray Young: Yes, Ben. So let me improve reverse order. So net corn cost was a tailwind for us. I mean, clearly, as we pointed out in the last earnings call, we actually procured a lot of our requirements at a very attractive price last year. And hence, we benefit from basically a very good procurement. And hence, net corn was a tailwind for us, despite the fact that when you look at the board, corn costs are higher right now. With respect to the question on disaggregating Starches and Sweeteners from ethanol, my only comment is one of the big improvements in Starches and Sweeteners in the quarter compared to last quarter, last year's first quarter was the fact that we didn't have the corn oil mark-to-market impact. If you recall last year, we had about a $50 million negative impact due to the corn oil divergence from soybean oil. We didn't have it this year. So that was clearly a tailwind in terms of our results. From a volume perspective, when you look at the Starches and Sweetener business right now, we're still - we're certainly looking, I'm looking at corn - high fructose corn syrup. And corn syrup, we're still down versus last year. So we are suffering from the impact of the pandemic and because the foodservice sector is not fully recovered, we indicated that we're starting to see elements of recovery in the month of March. But from a volume perspective, in the first quarter, total Sweetener volumes are still down versus last year, right? So therefore, that's kind of like a headwind. But we expect that to progressively recover as we move through the year. So I guess, overall, I mean, we've been actually pretty pleased in terms of the performance. Given this particular headwind we had in the first quarter, we were very pleased in terms of how we manage the business, favorable net corn procurement, favorable risk management. And frankly, even with the cold weather impacts that we had in the first quarter, we were able to keep on delivering to our customers, which is very, very important.
Ben Bienvenu: Very good. Okay. Great. My second question is on DCP and your decision to restart your dry mills. We're seeing improving driving demand, gasoline demand off of kind of low this year and last year. I'm curious, though, we've seen production in the weekly EIA numbers come out that have been a little bit lagging, I think, what might be expected when thinking about your facilities coming back online. Can you help us think about your outlook for as much visibility as you have as it relates to ethanol S&D And when you think about the velocity of restarting your mills, what is your focus there? Are you worried about that disrupting the S&D and ethanol? To the extent you can give us any color on?
Juan Luciano: And they have grown in the first three months of the year. They import proteins, that’s up like 20% and they continue to have very strong forecast for the importation of grains to feed animals. So that's what we're seeing. Of course, corn prices have been expensive in China. And so, China has been taking as much as wheat as they can from Europe to try to make a little bit of substitution. But they also don't have infinite wheat reserves. And during this year, we think that both coal reserves and wheat reserve needs to be replenished at one point in time. We don't think that that's happening now. Nobody is replenishing inventories in the face of an inverse. But we think that, that may happen later in the year.
Ben Bienvenu: Okay. And one, if I could just ask you a follow-up about your comments on sort of bio-based products that you made during your prepared remarks, were you just referring to sort of the initiative – the existing initiatives around FDME and cardboard and fiber and acrylic acid? Or are there new things that you're looking at? Or going back to some of the old stuff like PHA? Or just - what did you want to tell us about that, anything incremental?
Juan Luciano: Yes. I think that there is a portfolio of things. Some of the ones you mentioned, we are not going back to PHA. But there are some more in areas like, construction or pharma or personal care. We continue to find customers that have application development capabilities, but they want to change their input. And instead of being natural gas on oil, they want it plant-based. And for that, listen, we have - we stand on a great source of sugar that is the car solution business. We have fermentation technologies. And we have a good cost position here in the US, and as we have the capability, the critical mass. So I think that we are an attractive partner that everybody that is brainstorming or looking for a solution to match their sustainability targets is having discussions with our team. So there are some things that we cannot unveil right now, but we may unveil it over the course of the year.
Ben Bienvenu: Thanks very much.
Juan Luciano: You're welcome.
Operator: Your next question comes from Michael Piken of Cleveland Research. Your line is open.
Michael Piken: Yes. Good morning. I just wanted to talk a little bit about South America. Maybe we could start with Brazil and just you know, things like there is been some weather issues with the safrinha crop. And just trying to understand, how you see kind of your volumes and business shaping out in South America over the next couple of quarters? And if net-net, at this point, do we - are we cheering for a bigger South American crop or a smaller South American crop with respect to your overall global footprint?
Juan Luciano: Yes. Thank you, Michael. Yes. South America, the weather in South America, of course, delayed a little bit the growth. And certainly, it's hurting a little bit the safrinha. We still expect - traditionally, April and May are dry weather months in Brazil. So that's not great for this. And that's what putting a little bit of the premium in - the weather premium on corn. So we expect that crop to be a little bit smaller. And Brazil exports about 35% of their corn production. So that is an impact in the market. What are we rooting for? We are rooting for larger crops. We like to move crops. So the soy crop is expected to be a good one, maybe 135 million, 136 million tons, so that's in check. And I think what Brazil is doing at the moment is maybe getting a little bit of corn from Argentina. Certainly, it's getting wheat to try to replace some of the corn in feeding. Because adjusted, as I said before, the B13 bio-diesel to B10. So it's a year in which Brazil needs to navigate with - on very tight stocks. And so it's going to be a difficult year and a year of heavy management for the Brazilian, the crush and the grain side of this.
Michael Piken: Great. And then as a follow-up, just thinking ahead to 2022, with the projected growth in renewable biodiesel combined with a very - or a tightening corn market. I mean, how do you sort of see the acreage playing out in the US for 2022 between corn and soybeans to meet this demand? And I guess from your perspective, I know you guys have some swing capacity, but just, it seems like there's other crushing capacity up in Canada. Softseed, three of their competitors have announced expansions. How do you see kind of the margin environment working out if we need to plant more corn next year? Thanks.
Juan Luciano: Yes. I think that, of course, the farmer react to pricing. And although - this may be too late to shift a lot of acres to corn, given how late we are already. I think, first of all, they will try to plant as much as possible next year as well, given prices will continue to be elevated. I think, listen, as it gets tied the market, that's an advantage of our value chain. Our procurement, our long value chain, the fact that we have such a good coverage of everywhere, in a tight market, that's where our footprint shines and we get the competitive advantage, if you will. So we like to have more crops. But in periods in which crops are going to be tied, we have a good system to make sure we get our hands into the crops. And because of sometimes basis go up. But to be honest, given the strong demand and the good profitability of our customers, I think we will be able to price those in. So I think that we are looking constructively about in terms of margins for the future.
Michael Piken: And your thoughts on the acreage shift?
Juan Luciano: It's too early to tell. And there are too many factors. I mean, we are still trying to plant, we haven't planted like 10% of our crop, it's difficult to speculate about the 2022 crop here.
Michael Piken: Okay. Thank you.
Operator: Your next question comes from Ben Theurer of Barclays. Your line is open.
Ben Theurer: Hi. Good morning, Juan, Ray and thanks for taking my question.
Juan Luciano: Good morning, Ben.
Ben Theurer: Congrats on the results.
Juan Luciano: Thank you.
Ben Theurer: Two quick ones. So first of all, you gave a little bit of guidance into the different segments, but could you elaborate first on the Ag Service piece within ASO, how you think about that turning into 2Q and particularly in light what we're seeing in your appendix on the cumulative crush deferred timing gains? Because I remember last call, you said the vast majority of the close to $300 million to likely reverse within the first half. And we haven't seen much in 1Q. So how do we think - shall we think about those timing gains? And how shall we think about the underlying business within Ag Service in particular over the second quarter?
Ray Young: Yes. For Ag Services, seasonally, Q2 will be lower than Q1, right? I mean that's what happens. I mean North America, we had a very strong Q1 in terms of North American exports. Again, partly as Juan indicated, a delayed South American harvest. It allowed the export window in North America to really benefit. And then we just had significant demand pull, which resulted in very strong elevation margins in the first quarter. So second quarter for Ag Services, it will revert back to more of a normal level here. The demand environment is still good, but it's not going to be as stellar as what we saw in the first quarter. On your question on timing differences, remember, this is a question, right? I mentioned in my prepared remarks that there's about $75 million related to global trade and ocean freight that will reverse over the course of the year. In the appendix, the timing effects referred to in the appendix are related to crush. And just a reminder, in the first quarter, we didn't see much of a reversal in the first quarter, despite the fact that we had at the end of 2020, about $295 million in timing effects. And the reason being is that while we're seeing some reversals occurring, we're also building up new timing effects, because as you know, cash crush remains extremely strong. So some of the new contracts we're putting on, we're actually creating new timing effects. And so I just want to just kind of caution people that in this type of environment, even though there's about like $265 million of timing effects yet to unwind because of new timing effects that will likely occur over the course of the year, we may not see the full unwind occur this year. So that's just my only caution I want to provide listeners to the call on these timing effects. Thank you.
Ben Theurer: Okay. And then just, Ray, not pushing much here, but how do you think about the actual on a year-over-year basis, not on a sequential basis just compared to second quarter of last year because there was obviously a lot of things going on and some structure and some of the plans, just try to understand how we should put the second quarter of ‘21 into context with the second quarter of ‘20?
Ray Young: Yes. So in my prepared remarks, I did say that we're likely going to have lower Ag Services results this year, second quarter compared to last year, right. So - don't forget, remember, last year, we were benefiting a lot from South America, a farmer selling, right, and that was extremely strong last year first quarter, but particularly second quarter. So we're not going to see that impact this year, so that's going to be the primary driver as to why Ag Services. This year Q2 will be lower than last year's Q2.
Ben Theurer: Okay. Perfect. Thank you very much. I'll leave it here. Thanks. Congrats again.
Ray Young: Thanks.
Operator: Your next question comes from Eric Larson of Seaport Global Securities. Your line is open.
Eric Larson: Yes. Thank you and congratulations, everyone.
Juan Luciano: Hi, Eric.
Ray Young: Hi, Eric.
Eric Larson: I'll make it really quick I have a couple questions that - one's a real near term question of kind of exports over the next couple quarters, the USDA is way behind I think in what they're going - what they're giving China credit for corn exports through the year, something like 6 million or 7 million metric tons, and yet we're seeing the cash markets, futures are strong, but the cash markets are nothing short of astonishing. So are we trying to fill some of those on-price, maybe, China contracts from US farmers, are they just holding back. I guess how tight really is the US corn market? We know the oil markets are really tight. Canada's importing rapeseed from the Ukraine, so we know that the North American oilseed markets are tight, but how tight is the US corn market right now given cash prices?
Juan Luciano: Yes. Eric listen, we think as I said before that the US continues to be competitive in the second quarter for corn exports, so we're going to see some of those exports. As Ray was saying before, Ag Services probably innovation margin will not be the same because we won't have the same program of soybean on top of that. China continues to be buying everything they can, they are buying corn, but they are buying wheat as I said before, from several places and we have certain weather sports in the world. Canada and France are too cold and too dry, that has put some pressure on wheat with all this demand. Australia's infrastructure is trying to recover from a cyclone, so the exploitability of wheat there is also a little bit limited for loading that has created some pressure. So, for the moment corn continues to be competitive, the US exporting corn, but pretty soon it will become landed in China a little bit more expensive than wheat and then - but then we're getting tighter because of the bad weather. So we are looking at all those dynamics. So it's very difficult to answer this tough question specifically, but that's what I will think that all day is looking at all those dynamics and making sure we alter our product flows to fit the best origin.
Eric Larson: Okay, yes. Okay, thank you. Yes, well, Chad is playing every bushel of barley and sorghum and I think they're around the world everywhere, but. So the final question is a longer term question that I'm really - somewhat concerned about, we've seen the Biden administration now talk about a 30% Conservation Plan, meaning they want to put 30% of USA, of all US land, all 30% of all water into conservation programs. At the same time increase the CRP program. Does that mean that we're in a land grab, I know we're in early stages, just as I said buy land, do we encourage people to put it aside. Does it take more farmland out of production now at a time when we really actually need the production. How do you - what are initial reads of the Biden's recently announced conservation plans?
Juan Luciano: Yes. Listen, I think the administration has shown from the beginning that of course, fighting climate change was going to be one of their priorities, which we support. And we have a strong sustainability program. I think that we need to start working on - and it's important to work very closely with the farmers to try to listen to - the farmer understands the responsibility. We have at the moment maybe 25% of acres doing precision agriculture, which I think will increase yield without needing more land. And I think that there will be a discussion with the administration and it will be a pressure between environmental long-term goals and short term feeding needs of the world. The world needs the US capacity as they need the Brazilian capacity, so these prices show that we need those acres. So I think that this cannot be automatic, is something that we will have to work out balancing all the stakeholders, people that need the food or with the long term needs for conserving the planet.
Eric Larson: All right. Thank you, everyone.
Juan Luciano: Thank you, Eric.
Operator: And that was our final question for today. I will now return the call to Ms. de la Huerga for final remarks.
Victoria de la Huerga: Thank you, Chris. Slide 13 notes upcoming investor events in which we will be participating. Before we close, I wanted to note that, I will be transitioning to a new position as President of our Sweet Foods and Dairy products group in ADM Human Nutrition business. I will be transitioning my investor relations role to Vikram Luthar, who will also continue to be the CFO for our Nutrition Business. I'd like to thank our analysts and shareholders for all their insight and support over the past three years. And as always, please feel free to follow-up with me, if you have any questions. Have a good day. And thanks for your time and interest in ADM.
Operator: Thank you for your participation. This concludes today's conference call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning. And welcome to the ADM First Quarter 2021 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Victoria de la Huerga, Vice President, Investor Relations for ADM. Ms. De la Huerga, you may begin."
},
{
"speaker": "Victoria de la Huerga",
"text": "Thank you, Chris. Good morning, and welcome to ADM's first quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Victoria. This morning, I am pleased to share with you results that demonstrate an outstanding start to 2021, building on our momentum from a record 2020. We reported first quarter adjusted earnings per share of $1.39, more than double the year ago period. Adjusted segment operating profit was $1.2 billion, 86% higher than the first quarter of 2020 and our sixth consecutive quarter of year-over-year adjusted OP growth. Our trailing fourth quarter average adjusted ROIC was 9%, 375 basis points higher than our 2021 annual WACC and significantly higher than the 7.6% in the year ago period. And our trailing fourth quarter adjusted EBITDA was about $4.2 billion, 19% higher than the prior year period. I am proud of our team, and they continue to deliver sustained strong growth, powered by their continued advancement of the strategic transformation of our business, outstanding execution and excellent risk management and commitment to serving the evolving needs of our customers in new and innovative ways. I'd like to take a moment now to highlight some of the trends, developments and accomplishments from the first quarter. Turn to slide four, please. First, we are encouraged by many of the demand indicators we are seeing. From a geographic perspective, China was one of the first countries to emerge from COVID-related restrictions, and we are continuing to see significant export demand driven by its economic recovery."
},
{
"speaker": "Ray Young",
"text": "Yes. Thanks, Juan. Good morning, everyone. Slide eight, please. The Ag Services and Oilseeds team delivered an outstanding quarter with operating profit of $777 million, representing a record for a first quarter. Ag Services results were substantially higher year-over-year. Results were driven by a record Q1 for our North American origination team, which executed extremely well to capitalize on strong Chinese demand. As expected, results in South America were significantly lower versus the prior year period. Farmer selling was lower versus the extremely aggressive pace in the year ago quarter. Lower margins, including the impacts from the slightly delayed harvest and higher freight costs also affected South American results. Results for the quarter were affected by about $75 million in negative timing related to ocean freight position. Those impacts will reverse as contracts execute in the coming quarters. Crushing delivered its best quarter ever, as the business leverage its global footprint and diversified capabilities to capture strong execution margins in both soybean and softseed crushing, driven by robust vegetable oil demand and tight soybean stocks. Net timing impacts for the quarter in crush were minimal."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ray. Slide 12, please. I'm proud of the team for our great start to 2021. And I'm even more proud of the strategic work we have done to transform our company and enable our growing success. We began in 2011 by committing to specific strategic goals and financial metrics focused on what we call the three Cs, capital discipline, cost reduction and cash generation. We launched new initiatives like our $1 billion challenge with prioritized operational excellence, and we focused on returns our primary financial metric. We call that getting fit for the journey. Once we were fit, we launched the next part of our strategy, focusing on three core pillars to enhance returns, deliver more predictable growth and strengthen our ability to control our results. During this time, our team has done a great job, optimizing business performance, realigning our portfolio and building a global leader in nutrition, driving efficiencies through our operational excellence initiatives and expanding through organic growth investments, M&A and the broadening of our customer base and product offerings. Now we're moving into the next phase of our strategic transformation by sharpening our focus on two strategic pillars, productivity and innovation. Our productivity efforts will take many actions that were part of our optimized and drive focuses and boost them to the next level. The productivity pillar will include; advancing the roles of our Centers of Excellence or COEs in procurement, supply chain and operations to deliver additional efficiencies across the enterprise, the continued rollout of our One ADM business transformation program and implementation of improved standardized business processes, and increasing our use of technology, analytics and automation at our production facilities in our offices and with our customers. Our innovation activities will help us accelerate growth and profitability, not just for the near term, but importantly, for the long-term. We will expand and invest in improving the customer experience, including leveraging our producer relationships and enhancing our use of state-of-the-art digital technology to help our customers grow. Sustainability-driven innovation, which encompasses the full range of our products, solutions, capabilities and commitments to serve our customers' needs, and growth initiatives, including organic growth to support additional capacity and meet growing demand, opportunistic M&A and increased leveraging of our very successful venture capital portfolio. We'll support both pillars with investments in technology, which include expanding our digital capabilities and investing further in product research and development. And of course, all of our efforts will continue to be strengthened by our ongoing commitment to revenues. As I look at our long-term plans and this evolution of our strategy, I'm very excited about the value creation opportunities ahead of us. Our teams are continuing to perform at the high level and doing a great job serving our customers. The demand outlook for our products is strong, driven by the pre and during global trends of food security, health and well-being and sustainability. And we are delivering on our potential and our promise. That is why we are even more optimistic in our 2021 outlook today than we were three months ago, with expectations for significantly higher full year operating profit and EPS versus our record 2020. And as we look beyond 2021, we expect that our sharpened focus on productivity and innovation, combined with continuing demand expansion driven by the fundamental needs and evolving demands of our global customers and the multi-year COVID recovery will deliver sustained growth in earnings in the years to come. With that, Chris, please open the line for questions."
},
{
"speaker": "Operator",
"text": "Thank you. The first question comes from Ken Zaslow of Bank of Montreal. Your line is open."
},
{
"speaker": "Ken Zaslow",
"text": "Hey. Good morning, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ken."
},
{
"speaker": "Ken Zaslow",
"text": "Just want to touch base. You kind of - your comment was - which was actually really interesting, that you expect growth, sustainable growth for years to come. So with that, just a couple of points. One is, do you look at 2021 or 2020 as the base year from which you can grow? And then second, what are the key demand drivers that you see beyond 2021 that will continue to propel you? Or is it more internal actions that would create the growth?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Ken. Listen, as I was referring in my remarks, we see the future with a lot of optimism. I mean, we think that fundamentally, we have, as you know, a strong agenda of both now productivity and innovation where there are things that we can control, that we drive under our control. And we've been executing a similar plan. So now you're going to see it strengthen. And it has a more longer horizon reach, if you will, that's where we like about this sharpening. But all this is in the - as supported by these three strong trends that we see in food security, health and well-being and sustainability. So let me give you a little bit of flavor there. We continue to see strong demand. You see food security, of course, as the global population grows. Protein demand continues to grow around the world as people increase their standards of living. And as countries come back from the pandemic on this demand that was, to a certain degree suppressed, we see that in China, we see that in the US. And we believe that given the uneven vaccine recovery of vaccine rollout, this will take several years. So that's in an environment, Ken, as you know, a very tight supply, demand balances. So we expect an environment of good profits for the following years. Then when we look at health and well-being, that's propelling our Nutrition division and many of our other offerings in which we continue to see strong growth even exacerbated, if you will with pandemics or other events. And we continue to see more demand for products made based on plans that what we call biosolutions or products that actually replace industrial products made from resources that are not renewable. We have a long list of interested parties in doing more of that and we continue to develop solutions for that. So again, when we see the trends, when we see the strong demand environment in a tight supply, demand environment, plus the agenda of productivity and innovation, we feel very strong about our ability to deliver earnings growth from where we are today."
},
{
"speaker": "Ken Zaslow",
"text": "So in 2020 or 2021, would you say, is your year from which we could start thinking about growth?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I think that we - 2021, we're going to grow significantly versus 2020. So in 2021, we are establishing this sharpening again. So if you will, maybe we can reset to that level to 2021 and we start it from here. We have a rolling five year plan, as you know, Ken that we constantly update. And we constantly make it more robust, so we can deliver earnings growth year-over-year."
},
{
"speaker": "Ken Zaslow",
"text": "Great. I appreciate. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ken."
},
{
"speaker": "Operator",
"text": "Your next question comes from Adam Samuelson of Goldman Sachs. Your line is open."
},
{
"speaker": "Adam Samuelson",
"text": "Yes. Thanks. Good morning, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Adam."
},
{
"speaker": "Adam Samuelson",
"text": "Hi. So, I guess, my first question, really just trying to think about the market environment a little bit, and obviously, a lot of crop currents happening at the moment. Specifically, I want to think about on the oilseed franchise and the expansion of renewable diesel. And as we think about, one, you can sort of see it already in the soybean oil market and what that's doing to crush margins. But as we think about the second half of the year into next year as some of the bigger capacities start to come on, how do we think about the earnings leverage, both in your crushing franchise, but also in the edible oils business with the refining that we - a business that never really got that much attention and grown much for a number of years given the move away from Transfast , but would seem to be kind of very strategic for a bunch of refiners who don't have pre-treatment over the next couple of years? And then I got a capital allocation question afterwards."
},
{
"speaker": "Juan Luciano",
"text": "Adam, listen, we said it before, we feel very strongly about the future of our Oilseeds business. It's a business that was built traditionally in one leg, if you will, from the mill supporting all these, and we were always waiting for the oil story. The oil story, I mean, you can see that right now playing up, oil values that reach record levels, softseed margins that been the best in the last eight years, if you will. So they are supporting very good soy crush margins and great softseed margins. We invested in this many years ago, remember, with all the switch capacity, we have about give or take, 15% of our total crush capacity that can be switched from soybeans to softseed. So that's an advantage for us. And now all of a sudden, we are having this new demand that is coming because of all the sustainability trends that we discussed before with this in the form of renewable green diesel. So it just comes to strengthen our belief into this business that is very strategic for us. And to be honest, very proud of the way the business is executing. These are not easy markets to navigate with a lot of volatility, with very big values, and they are having touch wood and impeccable run. And they've done very well, given their sophistication and knowledge of - and to be honest, also the visibility that being a full value chain supplier and a global supplier gives us. So continue to work very close with our food and fuel customers and staying close to them to make sure we can read what's coming down the pipe. But again, Adam, very, very encouraged by all these developments and very happy for our strategic Oilseed business."
},
{
"speaker": "Adam Samuelson",
"text": "Okay. That's really helpful, Juan. And my second question is really on the balance sheet. Maybe this is more for Ray. And I'm just trying to think about kind of cash capital deployment from here. Obviously, you have to be very sensitive to the increase in commodity prices and the impact that has on readily marketable inventories. But I mean impressively, your credit capacity has actually gone up on a year-on-year basis, despite the rising in RMI. And so I'm just trying to think about what would it take to see cash return to shareholders or more aggressive or offensive M&A moving forward? It seems like there's a lot of underlying cash generation in the business, and it doesn't seem like we've got a clear kind of target of where it's going at the moment."
},
{
"speaker": "Ray Young",
"text": "Well, first of all, the balance sheet is what I consider one of the greatest assets of ADM. And while inventories have actually increased 50% compared to March of last year, we still have significant available credit capacity to undertake actions, right? And so I think the first priority is continue to fund the working capital needs. It's not a surprise. Commodity prices continue to go up right now. And so therefore, we will use our balance sheet to kind of fund additional working capital requirements. And - but secondly, we have flexibility to do whatever we need to do from a strategic perspective. As you know, in prior periods, during higher commodity prices, there are distressed assets in the marketplace. And so to the extent that there are distressed assets that make sense for us to acquire in order to consolidate, we'll look at those. That's one of the big advantages of our ADM balance sheet. So - but we all know that eventually commodity prices will come down, and that will free up additional capital on the balance sheet. And then we can look at additional incremental returns on capital to our shareholders at that point in time. But again, the dividend, we've increased the dividend. That's an important element of return on capital to our shareholders. But I'm convinced that our balance sheet because we all know prices go through cycles, there will be a release of working capital at some juncture that will again free up significant capacity for us to take additional return of capital actions."
},
{
"speaker": "Adam Samuelson",
"text": "Okay. That’s a really helpful color. I’ll pass it on. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Adam."
},
{
"speaker": "Operator",
"text": "Your next question comes from Tom Simonitsch of JPMorgan. Your line is open."
},
{
"speaker": "Tom Simonitsch",
"text": "Hi. Good morning, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Tom."
},
{
"speaker": "Ray Young",
"text": "Hey, Tom."
},
{
"speaker": "Tom Simonitsch",
"text": "Could you give us some more color around your - how you're managing your crush assets this year compared to any other? To what extent are you locking in crush capacity for the next few quarters? And on the oil side, how are you approaching negotiations with potential renewable diesel customers versus your more traditional food customers?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. So I can say we have a reasonable visibility on the Q2 for Oilseeds as we have a book build. And we stay a little bit more open for the Q3 and Q4. That's probably to the extent that I will disclose. In terms of food versus oil customers, listen, we're staying close to both. Of course, we provide - we have long-term relationships with our food customers that - we've been working with them through all these and educating them on this new demand that is coming. And we are forging new relationships with customers from renewable diesel that of course, the big issue for that industry is feedstock availability. So we're having a lot of discussions that range from the tactical to the strategic discussions with some of them as they decide on their future investments. So that's what I will describe the relationship."
},
{
"speaker": "Tom Simonitsch",
"text": "Thank you. And then just a question on Nutrition, I think you mentioned a shift in demand for texturants. Can you provide some more color there?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. We've seen some softness in some of those segments. But I would say this is a little bit of a transition time in - Nutrition goes to so many applications, and depending on the geography, foodservices in some parts are coming back and in some other parts, that's still delayed. So, I would say, in general, I'm very pleased actually. Nutrition surpassed my own expectations this quarter by growing profitability by around 9% and revenue 5%. It was - the demand recovery from COVID and the impact of that in different markets is very uneven around the world, as the world is getting access to vaccination at different rates. So we are seeing that. So, as I said, this was a quarter of, remember, investment in Nutrition. So we were expecting results similar to last year. We end up delivering results that are 9% better than last year, so very happy with this. We had some specific pockets of softness, maybe some chewing gum kind of softness, some softness in some places in Animal Nutrition. But overall, very strong flavors, beverages, supplements, fibers, probiotics, specialty proteins. So, the main trends remain there."
},
{
"speaker": "Tom Simonitsch",
"text": "Thank you for that. And maybe just one more question for me. If you wouldn't mind, could you share your house view of US planted acres of corn versus beans?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I would say, in our view, given the early planting the start that we have in the US, I think we have corn about 17%, on soybeans and about 8% at the moment. We believe that there is probably upside to the USDA numbers. So we believe that by the next time USDA will report acres, we're probably going to find maybe five more million acres, combined between soy and corn, kind of evenly split, if you will, give or take between the two."
},
{
"speaker": "Tom Simonitsch",
"text": "Excellent. Thank you very much. I'll pass it on."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Tom."
},
{
"speaker": "Operator",
"text": "Your next question comes from Luke Washer of Bank of America. Your line is open."
},
{
"speaker": "Luke Washer",
"text": "Hi. Good morning, everybody."
},
{
"speaker": "Juan Luciano",
"text": "Hi, Luke."
},
{
"speaker": "Ray Young",
"text": "Hey, Luke."
},
{
"speaker": "Luke Washer",
"text": "So I wanted to touch on, soybean oil a little bit. I know you've talked a little bit about renewable diesel trend. But have you seen soybean oil demand ramp this quarter relative to your expectations perhaps at the beginning of this quarter? And is this largely driven by renewable diesel demand? Or are you also seeing increased demand for edible oils? And is there any distraction is happening with the prices where they are?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Listen, we continue to see strong demand. I think that as some restaurants and in some places are reopening, we started to see food services coming back a little bit. To be honest, we saw that across the company, not only in soybean oil, I would say March orders were significantly better than January and February. And I think we see that continuing in April. So again, a - recovery, but we can see that. I would say, of course, green diesel customers are starting to show in demand. So we see that increase demand. So in general, we see a strong demand. In terms of disruption of demand, we haven't seen that to any degree. Probably the only example I can pinpoint is Brazil with biodiesel that reduced from B13 to B10. That's probably the only thing you can say. Things have become expensive, at least. And Brazil, as I may -- as I've mentioned, in my onset remarks, Brazil is having a very difficult time with COVID. So I think that the overall economy is suffering. And I think the government is trying to alleviate some - to alleviate a little bit the pressure on inflation there. So - but that's probably the only example I can pinpoint to at this point of demand disruption."
},
{
"speaker": "Luke Washer",
"text": "Great. Thanks, Juan. And then maybe one more on Nutrition, can you talk about what's driving your confidence in the 15% CAGR that you expect this year? What are the ways that you're driving operating profit margins higher? Is this simply growing in higher-margin businesses? Or are you doing cross-selling or any other actions you're taking? Maybe just some of the puts and takes for this year."
},
{
"speaker": "Juan Luciano",
"text": "Yes, absolutely. Listen, remember the 15% came from - we put together the five year plan. And when we see us achieving our target of $1 billion OP, basically by 2024, give or take, in order to get there, we need to grow 15%. So we were planning to start this year. And this year, it's not an exception to that. We plan 15%. When we started the year, we were planning to start the year, as I said, kind of flattish versus - and the business continue to show strength. How that strength comes part is revenue growth. Part of my confidence is given by the pipeline. We have a strong pipeline. We are very - the team is very disciplined and religious in looking at the pipeline and looking at customer-by-customer and the projects. And that pipeline continues to grow, and our win rate continues to grow. So those are very positive indicators that your value proposition is very appreciated by our customers. Certainly, another thing that we do is that the team manage the product mix very well. And that allows us to increase profitability even in excess of the revenue growth that we see. And you know, there are different parts, while, for example, for flavors and for plant based proteins and certainly for probiotics is much more a revenue growth story. For parts like Animal Nutrition, it's more like a margin recovery story. And so we have different ways to manage this portfolio that we call nutrition, but it's a very complex portfolio. But that complexity also brings a lot of growth opportunities. And that's why it give us a confidence that it's a very balanced business from an opportunity perspective, supported by a very strong pipeline."
},
{
"speaker": "Luke Washer",
"text": "Sounds good. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Robert Moskow of Credit Suisse. Your line is open."
},
{
"speaker": "Robert Moskow",
"text": "Hi. Thank you and congratulations. I have a question about the crush margins in the quarter. I mean, such an outstanding result. And I think you've mentioned that risk management or just execution played a role. If you look at spot margins during the quarter, just looking at board prices, they weren't nearly this good. But I've heard that you and others have been delivering results much better than that. So I guess, my question is, can you explain why it's so different from what we see in the spot markets? And is this sustainable into 2Q? Or are there some unusual aspects of first quarter that we should know about?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. No, listen, it was a very clean quarter. There's nothing that you should know about other than cash crush margins remain very healthy. We have a strong product demand from both meal and specialty oil. And these margins remain considerably stronger than what board crush indicates, particularly in North America and Europe. If you look at board crush in North America or Europe per month is about $25 per ton, and then we see margins on a cash basis of around $40 per ton. So there is a significant difference there. I would say, we see - as I said before, we have reasonable visibility into Q2 given the book of business we have. So we shouldn't see any surprises there, and we are expecting another good quarter of crush over there. So I mentioned before, we have our switch capacity. Softseed margins have been good. They moderated a little bit since Q1, but they continue to be very good. So oil values continue to be strong. And demand for our customers in mill in North America, our customers are enjoying good margins at this point in time. So they are trying to produce as much as they can. So we see strong demand from both lakes of the crush. So we feel good about it at the moment."
},
{
"speaker": "Robert Moskow",
"text": "Okay. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Welcome."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ben Bienvenu of Stephens. Your line is open."
},
{
"speaker": "Ben Bienvenu",
"text": "Hi. Good morning, everybody."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ben."
},
{
"speaker": "Ben Bienvenu",
"text": "I want to focus on – with two questions on the Carbohydrate Solutions business, which was really, really solid in the quarter, and focusing first on those Starches and Sweeteners business. To the extent you can, can you disaggregate the contribution from your ethanol production out of your wet mills versus the kind of core Starches and Sweeteners business. And on that Starches and Sweeteners business, were net corn cost a tailwind for you guys? I know you favorably hedged your gross corn costs in 4Q. So I'm wondering kind of what the relationship between that hedged corn versus the strong co-product values delivered as it relates to your realized net corn costs?"
},
{
"speaker": "Ray Young",
"text": "Yes, Ben. So let me improve reverse order. So net corn cost was a tailwind for us. I mean, clearly, as we pointed out in the last earnings call, we actually procured a lot of our requirements at a very attractive price last year. And hence, we benefit from basically a very good procurement. And hence, net corn was a tailwind for us, despite the fact that when you look at the board, corn costs are higher right now. With respect to the question on disaggregating Starches and Sweeteners from ethanol, my only comment is one of the big improvements in Starches and Sweeteners in the quarter compared to last quarter, last year's first quarter was the fact that we didn't have the corn oil mark-to-market impact. If you recall last year, we had about a $50 million negative impact due to the corn oil divergence from soybean oil. We didn't have it this year. So that was clearly a tailwind in terms of our results. From a volume perspective, when you look at the Starches and Sweetener business right now, we're still - we're certainly looking, I'm looking at corn - high fructose corn syrup. And corn syrup, we're still down versus last year. So we are suffering from the impact of the pandemic and because the foodservice sector is not fully recovered, we indicated that we're starting to see elements of recovery in the month of March. But from a volume perspective, in the first quarter, total Sweetener volumes are still down versus last year, right? So therefore, that's kind of like a headwind. But we expect that to progressively recover as we move through the year. So I guess, overall, I mean, we've been actually pretty pleased in terms of the performance. Given this particular headwind we had in the first quarter, we were very pleased in terms of how we manage the business, favorable net corn procurement, favorable risk management. And frankly, even with the cold weather impacts that we had in the first quarter, we were able to keep on delivering to our customers, which is very, very important."
},
{
"speaker": "Ben Bienvenu",
"text": "Very good. Okay. Great. My second question is on DCP and your decision to restart your dry mills. We're seeing improving driving demand, gasoline demand off of kind of low this year and last year. I'm curious, though, we've seen production in the weekly EIA numbers come out that have been a little bit lagging, I think, what might be expected when thinking about your facilities coming back online. Can you help us think about your outlook for as much visibility as you have as it relates to ethanol S&D And when you think about the velocity of restarting your mills, what is your focus there? Are you worried about that disrupting the S&D and ethanol? To the extent you can give us any color on?"
},
{
"speaker": "Juan Luciano",
"text": "And they have grown in the first three months of the year. They import proteins, that’s up like 20% and they continue to have very strong forecast for the importation of grains to feed animals. So that's what we're seeing. Of course, corn prices have been expensive in China. And so, China has been taking as much as wheat as they can from Europe to try to make a little bit of substitution. But they also don't have infinite wheat reserves. And during this year, we think that both coal reserves and wheat reserve needs to be replenished at one point in time. We don't think that that's happening now. Nobody is replenishing inventories in the face of an inverse. But we think that, that may happen later in the year."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay. And one, if I could just ask you a follow-up about your comments on sort of bio-based products that you made during your prepared remarks, were you just referring to sort of the initiative – the existing initiatives around FDME and cardboard and fiber and acrylic acid? Or are there new things that you're looking at? Or going back to some of the old stuff like PHA? Or just - what did you want to tell us about that, anything incremental?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I think that there is a portfolio of things. Some of the ones you mentioned, we are not going back to PHA. But there are some more in areas like, construction or pharma or personal care. We continue to find customers that have application development capabilities, but they want to change their input. And instead of being natural gas on oil, they want it plant-based. And for that, listen, we have - we stand on a great source of sugar that is the car solution business. We have fermentation technologies. And we have a good cost position here in the US, and as we have the capability, the critical mass. So I think that we are an attractive partner that everybody that is brainstorming or looking for a solution to match their sustainability targets is having discussions with our team. So there are some things that we cannot unveil right now, but we may unveil it over the course of the year."
},
{
"speaker": "Ben Bienvenu",
"text": "Thanks very much."
},
{
"speaker": "Juan Luciano",
"text": "You're welcome."
},
{
"speaker": "Operator",
"text": "Your next question comes from Michael Piken of Cleveland Research. Your line is open."
},
{
"speaker": "Michael Piken",
"text": "Yes. Good morning. I just wanted to talk a little bit about South America. Maybe we could start with Brazil and just you know, things like there is been some weather issues with the safrinha crop. And just trying to understand, how you see kind of your volumes and business shaping out in South America over the next couple of quarters? And if net-net, at this point, do we - are we cheering for a bigger South American crop or a smaller South American crop with respect to your overall global footprint?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Michael. Yes. South America, the weather in South America, of course, delayed a little bit the growth. And certainly, it's hurting a little bit the safrinha. We still expect - traditionally, April and May are dry weather months in Brazil. So that's not great for this. And that's what putting a little bit of the premium in - the weather premium on corn. So we expect that crop to be a little bit smaller. And Brazil exports about 35% of their corn production. So that is an impact in the market. What are we rooting for? We are rooting for larger crops. We like to move crops. So the soy crop is expected to be a good one, maybe 135 million, 136 million tons, so that's in check. And I think what Brazil is doing at the moment is maybe getting a little bit of corn from Argentina. Certainly, it's getting wheat to try to replace some of the corn in feeding. Because adjusted, as I said before, the B13 bio-diesel to B10. So it's a year in which Brazil needs to navigate with - on very tight stocks. And so it's going to be a difficult year and a year of heavy management for the Brazilian, the crush and the grain side of this."
},
{
"speaker": "Michael Piken",
"text": "Great. And then as a follow-up, just thinking ahead to 2022, with the projected growth in renewable biodiesel combined with a very - or a tightening corn market. I mean, how do you sort of see the acreage playing out in the US for 2022 between corn and soybeans to meet this demand? And I guess from your perspective, I know you guys have some swing capacity, but just, it seems like there's other crushing capacity up in Canada. Softseed, three of their competitors have announced expansions. How do you see kind of the margin environment working out if we need to plant more corn next year? Thanks."
},
{
"speaker": "Juan Luciano",
"text": "Yes. I think that, of course, the farmer react to pricing. And although - this may be too late to shift a lot of acres to corn, given how late we are already. I think, first of all, they will try to plant as much as possible next year as well, given prices will continue to be elevated. I think, listen, as it gets tied the market, that's an advantage of our value chain. Our procurement, our long value chain, the fact that we have such a good coverage of everywhere, in a tight market, that's where our footprint shines and we get the competitive advantage, if you will. So we like to have more crops. But in periods in which crops are going to be tied, we have a good system to make sure we get our hands into the crops. And because of sometimes basis go up. But to be honest, given the strong demand and the good profitability of our customers, I think we will be able to price those in. So I think that we are looking constructively about in terms of margins for the future."
},
{
"speaker": "Michael Piken",
"text": "And your thoughts on the acreage shift?"
},
{
"speaker": "Juan Luciano",
"text": "It's too early to tell. And there are too many factors. I mean, we are still trying to plant, we haven't planted like 10% of our crop, it's difficult to speculate about the 2022 crop here."
},
{
"speaker": "Michael Piken",
"text": "Okay. Thank you."
},
{
"speaker": "Operator",
"text": "Your next question comes from Ben Theurer of Barclays. Your line is open."
},
{
"speaker": "Ben Theurer",
"text": "Hi. Good morning, Juan, Ray and thanks for taking my question."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ben."
},
{
"speaker": "Ben Theurer",
"text": "Congrats on the results."
},
{
"speaker": "Juan Luciano",
"text": "Thank you."
},
{
"speaker": "Ben Theurer",
"text": "Two quick ones. So first of all, you gave a little bit of guidance into the different segments, but could you elaborate first on the Ag Service piece within ASO, how you think about that turning into 2Q and particularly in light what we're seeing in your appendix on the cumulative crush deferred timing gains? Because I remember last call, you said the vast majority of the close to $300 million to likely reverse within the first half. And we haven't seen much in 1Q. So how do we think - shall we think about those timing gains? And how shall we think about the underlying business within Ag Service in particular over the second quarter?"
},
{
"speaker": "Ray Young",
"text": "Yes. For Ag Services, seasonally, Q2 will be lower than Q1, right? I mean that's what happens. I mean North America, we had a very strong Q1 in terms of North American exports. Again, partly as Juan indicated, a delayed South American harvest. It allowed the export window in North America to really benefit. And then we just had significant demand pull, which resulted in very strong elevation margins in the first quarter. So second quarter for Ag Services, it will revert back to more of a normal level here. The demand environment is still good, but it's not going to be as stellar as what we saw in the first quarter. On your question on timing differences, remember, this is a question, right? I mentioned in my prepared remarks that there's about $75 million related to global trade and ocean freight that will reverse over the course of the year. In the appendix, the timing effects referred to in the appendix are related to crush. And just a reminder, in the first quarter, we didn't see much of a reversal in the first quarter, despite the fact that we had at the end of 2020, about $295 million in timing effects. And the reason being is that while we're seeing some reversals occurring, we're also building up new timing effects, because as you know, cash crush remains extremely strong. So some of the new contracts we're putting on, we're actually creating new timing effects. And so I just want to just kind of caution people that in this type of environment, even though there's about like $265 million of timing effects yet to unwind because of new timing effects that will likely occur over the course of the year, we may not see the full unwind occur this year. So that's just my only caution I want to provide listeners to the call on these timing effects. Thank you."
},
{
"speaker": "Ben Theurer",
"text": "Okay. And then just, Ray, not pushing much here, but how do you think about the actual on a year-over-year basis, not on a sequential basis just compared to second quarter of last year because there was obviously a lot of things going on and some structure and some of the plans, just try to understand how we should put the second quarter of ‘21 into context with the second quarter of ‘20?"
},
{
"speaker": "Ray Young",
"text": "Yes. So in my prepared remarks, I did say that we're likely going to have lower Ag Services results this year, second quarter compared to last year, right. So - don't forget, remember, last year, we were benefiting a lot from South America, a farmer selling, right, and that was extremely strong last year first quarter, but particularly second quarter. So we're not going to see that impact this year, so that's going to be the primary driver as to why Ag Services. This year Q2 will be lower than last year's Q2."
},
{
"speaker": "Ben Theurer",
"text": "Okay. Perfect. Thank you very much. I'll leave it here. Thanks. Congrats again."
},
{
"speaker": "Ray Young",
"text": "Thanks."
},
{
"speaker": "Operator",
"text": "Your next question comes from Eric Larson of Seaport Global Securities. Your line is open."
},
{
"speaker": "Eric Larson",
"text": "Yes. Thank you and congratulations, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Hi, Eric."
},
{
"speaker": "Ray Young",
"text": "Hi, Eric."
},
{
"speaker": "Eric Larson",
"text": "I'll make it really quick I have a couple questions that - one's a real near term question of kind of exports over the next couple quarters, the USDA is way behind I think in what they're going - what they're giving China credit for corn exports through the year, something like 6 million or 7 million metric tons, and yet we're seeing the cash markets, futures are strong, but the cash markets are nothing short of astonishing. So are we trying to fill some of those on-price, maybe, China contracts from US farmers, are they just holding back. I guess how tight really is the US corn market? We know the oil markets are really tight. Canada's importing rapeseed from the Ukraine, so we know that the North American oilseed markets are tight, but how tight is the US corn market right now given cash prices?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Eric listen, we think as I said before that the US continues to be competitive in the second quarter for corn exports, so we're going to see some of those exports. As Ray was saying before, Ag Services probably innovation margin will not be the same because we won't have the same program of soybean on top of that. China continues to be buying everything they can, they are buying corn, but they are buying wheat as I said before, from several places and we have certain weather sports in the world. Canada and France are too cold and too dry, that has put some pressure on wheat with all this demand. Australia's infrastructure is trying to recover from a cyclone, so the exploitability of wheat there is also a little bit limited for loading that has created some pressure. So, for the moment corn continues to be competitive, the US exporting corn, but pretty soon it will become landed in China a little bit more expensive than wheat and then - but then we're getting tighter because of the bad weather. So we are looking at all those dynamics. So it's very difficult to answer this tough question specifically, but that's what I will think that all day is looking at all those dynamics and making sure we alter our product flows to fit the best origin."
},
{
"speaker": "Eric Larson",
"text": "Okay, yes. Okay, thank you. Yes, well, Chad is playing every bushel of barley and sorghum and I think they're around the world everywhere, but. So the final question is a longer term question that I'm really - somewhat concerned about, we've seen the Biden administration now talk about a 30% Conservation Plan, meaning they want to put 30% of USA, of all US land, all 30% of all water into conservation programs. At the same time increase the CRP program. Does that mean that we're in a land grab, I know we're in early stages, just as I said buy land, do we encourage people to put it aside. Does it take more farmland out of production now at a time when we really actually need the production. How do you - what are initial reads of the Biden's recently announced conservation plans?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Listen, I think the administration has shown from the beginning that of course, fighting climate change was going to be one of their priorities, which we support. And we have a strong sustainability program. I think that we need to start working on - and it's important to work very closely with the farmers to try to listen to - the farmer understands the responsibility. We have at the moment maybe 25% of acres doing precision agriculture, which I think will increase yield without needing more land. And I think that there will be a discussion with the administration and it will be a pressure between environmental long-term goals and short term feeding needs of the world. The world needs the US capacity as they need the Brazilian capacity, so these prices show that we need those acres. So I think that this cannot be automatic, is something that we will have to work out balancing all the stakeholders, people that need the food or with the long term needs for conserving the planet."
},
{
"speaker": "Eric Larson",
"text": "All right. Thank you, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Eric."
},
{
"speaker": "Operator",
"text": "And that was our final question for today. I will now return the call to Ms. de la Huerga for final remarks."
},
{
"speaker": "Victoria de la Huerga",
"text": "Thank you, Chris. Slide 13 notes upcoming investor events in which we will be participating. Before we close, I wanted to note that, I will be transitioning to a new position as President of our Sweet Foods and Dairy products group in ADM Human Nutrition business. I will be transitioning my investor relations role to Vikram Luthar, who will also continue to be the CFO for our Nutrition Business. I'd like to thank our analysts and shareholders for all their insight and support over the past three years. And as always, please feel free to follow-up with me, if you have any questions. Have a good day. And thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "Thank you for your participation. This concludes today's conference call. You may now disconnect."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 4 | 2,022 | 2023-01-26 09:00:00 | Operator: Good morning and welcome to the ADM Fourth Quarter 2022 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s call, Megan Britt, Vice President, Investor Relations for ADM. Ms. Britt, you may begin.
Megan Britt: Thank you. Hello and welcome to the fourth quarter earnings webcast for ADM. Starting tomorrow, a replay of this webcast will be available on our Investor Relations website. Please turn to Slide 2, which says that some of our comments and materials constitute forward-looking statements that reflect management’s current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in the presentation. To the extent permitted, under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today’s webcast, our Chairman and Chief Executive Officer, Juan Luciano, will discuss our full year accomplishments and share detail on our priorities for 2023. Our Chief Financial Officer, Vikram Luthar, will review the drivers of our financial performance at the segment level and review our cash generation and capital allocation results. Juan will have closing remarks regarding our planning framework for 2023 and then he and Vikram will take your questions. Please turn to Slide 3. I will now turn the call over to Juan.
Juan Luciano: Thank you, Megan. This morning, we reported very strong fourth quarter adjusted earnings per share of $1.93. Adjusted segment operating profit was $1.7 billion. Our full year adjusted EPS of $7.85, adjusted segment operating profit of $6.6 billion, and trailing fourth quarter average adjusted ROIC of 13.6% demonstrate once again the great work of our global team of dedicated colleagues who manage unprecedented market disruptions to deliver an outstanding year. Our full year operating cash flow before working capital was $5.3 billion. This strong cash flow and the disciplined management of our balance sheet allow us to continue to reinvest in our business, with $1.3 billion in capital expenditures and return cash to shareholders. In total, we returned $2.3 billion to our shareholders in the forms of dividends and share repurchases in 2022. Next slide, please. With the expectation of continued strong cash flow, today, we are announcing a 12.5% increase in our quarterly dividend to $0.45 per share. We are proud of our record of 91 years of uninterrupted dividends and 50 consecutive years of annual dividend increases. And I’d like to thank our shareholders for their continued support of ADM. Next slide, please. When I examine 2022, our ability to drive structural growth in earnings and improvement in ROIC was supported by key strategic accomplishments across the enterprise, particularly the progress we made on our productivity and innovation objectives. Our productivity work in 2022 included enhancing our operational resilience, including through stabilizing our plant operations and streamlining our operating systems. In order to meet growing customer demand and drive efficiencies, we delivered multiple projects to enhance our operational footprint, from modernization to improving and scheduled downtime to capacity expansions. We completed our Marshall, Minnesota modernization, opened a new mill house in Clinton, completed our Quincy refinery expansion and improved output and yields at our Rondonopolis diesel plant in Brazil. We also continued to optimize our North American milling footprint. As you know, we also introduced a new $1 billion challenge in 2022. There is no clearer demonstration of how our colleagues and culture are driving returns than the fact that thousands of ADM team members from around the globe took the initiative, step up and identified opportunities that unlocked more than $1.6 billion in cash in 2022. On innovation, our accomplishments include a focus on capturing the benefits of organic growth investments and M&A as we continue to get closer to our customers and extend our capabilities to meet growing global demand for our products. Our Nutrition business continued to outpace the industry, with 18% constant currency revenue growth for the full year. We delivered an impressive 26% in year-over-year revenue growth in BioSolutions. The portfolio of acquisitions we made in the prior year continued to deliver OP above our financial projections and we advanced targeted production capacity expansions to meet growing customer demand. We announced expansions of our alternative protein capabilities in Decatur, Illinois, and starch production in Marshall, Minnesota. We completed our alternative protein expansion in Serbia and are able to launch our expanded probiotic capacity in Valencia, Spain. And we continue to expect our joint venture crush and refining facility in North Dakota to be operational by this year’s harvest. Slide 6 please. Now let’s look ahead. We have a robust plan for driving enduring value creation in 2023 and beyond. In productivity, our work has a common theme, changing the way we work by standardizing, digitizing and automating our manufacturing plants and our offices alike. I previously mentioned our successful Marshall modernization. That was the blueprint for our wider work to unlock value across our production footprint through enhanced automation, more sophisticated control systems and the increased use of analytics. We have now approved the scope for the first 2 years of the program, encompassing 18 manufacturing facilities. We continue to expect double-digit returns from this important initiative. And we are continuing to advance 1ADM, which is enabling us to improve our processes and expand capabilities across the value chain. 2022 was an important year for our 1ADM business transformation. We completed several rollouts and we are seeing benefits in areas ranging from indirect procurement to go-to-market strategies to grain merchandising. In 2023, we will continue to expand the breadth and scope of this work, which is empowering our businesses to deliver profitable revenue growth and higher margins. Next, we are focused on maintaining our structural growth momentum via our innovation work. As you might recall, we have spoken in the past about our strategic growth platforms: sustainability, differentiated grain, alternative proteins, BioSolutions, microbial solutions and microbiome modification. These growth opportunities go through a natural evolution. When new, we launch them at the corporate level. As they mature, they become more embedded in our businesses. Differentiated grain is now firm part of our Ag Services and Oilseeds segments everyday work. BioSolutions is growing within carbohydrate solutions. Alternative proteins and microbiome are pillars of nutrition. With these efforts maturing in the businesses, we are able to focus on other opportunities. One of the most important is decarbonization, which is a critical component of our sustainability growth platform and is driving the evolution of our carbohydrate solutions business. Our goal is to reduce the carbon intensity of our assets and value chain in order to be the preferred partner in low-carbon intensity feedstocks for a growing demand base. We have made several announcements to mark milestones towards this goal in recent years, including our regenerative agriculture efforts, which enrolled 1 million unique acres over the past year; our Strive 35 goals; our initiatives to connect and expand our carbon capture and storage capabilities; and our heat and energy project indicator. We are looking at multiple other pathways to reducing our carbon intensity, like more sustainable energy sources for our facilities. And our efforts aren’t just in the U.S. We have plans for other regions as well, including some EMEA projects we hope to speak about in the future. All of these projects contribute to our ability to offer low carbon intensity feedstocks and that is allowing us to continue to advance our work to transition our dry mills to produce sustainable aviation fuel; help scale up the scaled food products with new sustainable attributes, like the ingredients we will sell to Pepsi from the regenerative agriculture agreement we announced last year, and propelled the expansion of BioSolutions with joint ventures like with LG Chem. And even as we advance our decarbonization plan, we are always looking at new ways to help solve our world’s challenges for food security, health and well-being and sustainability. For example, we are continuing to explore opportunities around precision fermentation, which we used to call microbial solutions, in which microbes rapidly grown in fermenters fed by dextrose, transform the sugars into a wide variety of products for food, feed and fiber. That’s a longer term horizon for ADM, but it gives us a hint of the kind of opportunities we see in the years ahead. Now, I would like to turn the call over to Vikram to talk about our business performance. Vikram?
Vikram Luthar: Thank you, Juan. Please turn to Slide 7. The Ag Services and Oilseeds team capped off an outstanding year with substantially higher year-over-year results in Q4. Ag Services results were higher than the fourth quarter of 2021. Low water conditions reduced North American export volumes, partially offset by the South American team, which executed well to deliver higher margins and volumes. Global trade results were lower than the strong fourth quarter of 2021 with lower ocean freight results partially offset by higher results in EMEA origination and destination marketing. The business benefited from a $110 million legal recovery related to the 2019 and 2020 closure of the Reserve Louisiana Export facility. Crushing results were more than double those of the prior year period. In North America, strong export volumes for soybean meal and growing domestic demand for renewable diesel contributed to strong margins. In EMEA, oil demand powered strong rapeseed margins more than offsetting higher energy costs compared to the prior year. Expanding margins drove negative timing impacts in the quarter of approximately $40 million. RPO results were significantly higher year-over-year as the business continued to execute well to meet demand for food oil, renewable diesel in the U.S. and biodiesel globally. Equity earnings from Wilmar were much higher versus the fourth quarter of 2021. Looking ahead, we expect AS&O results for Q1 to remain strong, similar to last year’s very strong quarter led by continued strength in crush margins and RPO. Ag Services is likely to be lower year-over-year, particularly in light of very strong global trade results in the prior year quarter. Slide 8, please. Carbohydrate Solutions had a strong 2022, with full year results higher than 2021. For the quarter, results were substantially lower than the fourth quarter of 2021 due to pressured industry ethanol margins. The starches and sweeteners sub-segment, which includes ethanol production from our wet mills, delivered much higher year-over-year results. The North America business delivered solid volumes and strong margins in both starches and sweeteners, partially offsetting lower ethanol margins. The EMEA team effectively managed risk and delivered improved results on better margins in a continued dynamic environment. The global wheat milling business delivered higher margins driven by solid customer demand. Vantage Corn Processors results were substantially lower as higher ethanol inventory levels pressured margins especially compared to the very strong margin environment in the fourth quarter of 2021. Looking at the first quarter for Carbohydrate Solutions, we expect continued solid demand and strong margins for starches, sweeteners and wheat flour. Ethanol margins are currently pressured due to high industry inventory levels. If industry stocks come back down, results for the quarter could be similar to Q1 of 2022. If margins remain pressured, results would likely be lower. On Slide 9, the Nutrition business continued its strong growth trajectory in 2022. ADM demonstrated that it remains the provider of choice in Nutrition for systems as our growing pipeline and continued strong win rates delivered full year revenue growth of 18% on a constant currency basis. The business continued to outperform industry growth levels and delivered 11% higher profits for the full year on a constant currency basis. For the fourth quarter, revenues grew 11% on a constant currency basis. Q4 operating profits were significantly lower than the prior year quarters. Human Nutrition results were lower than those of the fourth quarter of 2021. Flavors results were similar to the prior year as strong revenue growth helped offset demand fulfillment challenges. Specialty Ingredients continued to see strong demand for its product portfolio, including plant-based proteins, offset by inventory adjustments. Health & Wellness was higher year-over-year, driven primarily by the bioactives portfolio, including the results from the Deerland acquisition. Animal results were substantially lower than the prior year quarter, primarily due to the lower margins in amino acids, driven by recovery in the global supply of lysine. Pet Nutrition volumes were lower in Latin America, partially driven by demand fulfillment challenges. Feed results were stronger driven by APAC and Latin America partially offset by the impact of softer demand in EMEA. As we look ahead, we expect overall Nutrition results in Q1 to be lower than the prior year’s record first quarter, with Human Nutrition delivering similar year-over-year results on strong flavors and SI growth and lower Animal Nutrition results primarily due to weaker margins in amino acids. I want to take a moment to expand on our view of Nutrition in 2023. Nutrition is expected to continue on a positive growth trajectory for full year 2023, including 10% plus profit growth and a similar level of revenue growth. The growth is likely to be led by Human Nutrition and to be weighted in the back half of the year as the first half will see headwinds in Animal Nutrition due to the continued impacts of weaker margins in amino acids and because we will see increasing recovery in demand fulfillment as we move through the year. Slide 10, please. Other business results for Q4 was significantly higher than the prior year’s fourth quarter. Higher short-term interest rates drove improved earnings in ADM investor services, and captive insurance experienced favorable underwriting results and lower claim settlements versus the prior year. In the corporate lines, unallocated corporate costs of $299 million were higher year-over-year due primarily to higher IT operating and project-related costs and higher costs in the company’s centers of excellence related to growth initiatives. Other corporate was favorable versus the prior year primarily due to higher contributions from foreign currency-related hedge activity and lower railroad maintenance expense. Corporate results also included losses related to the mark-to-market adjustment on the Wilmar exchangeable bond and severance totaling $6 million. Net interest expense for the quarter increased year-over-year on higher interest rates. We expect corporate cost for 2023 to be around $1.5 billion, driven primarily by inflation and higher interest expense. Other business performance should be higher than 2022, offsetting a significant portion of the increased corporate costs as higher interest rates positively impact our ADM IS business. The effective tax rate for the fourth quarter of 2022 was approximately 16% compared to 21% in the prior year. The decreased rate was driven primarily by changes in the geographic mix of pretax earnings in addition to lower discrete tax expense versus the prior year. Our full year adjusted tax rate was 17%. For 2023, we expect our adjusted tax rate to be between 16% and 19%. Next slide, please. Year-to-date operating cash flows before working capital of $5.3 billion are up significantly versus $3.9 billion over the same period last year. Our net debt to total capital ratio is about 25%, and we continue to have ample available liquidity. Our strong cash flows and balance sheet have enabled continued investment in the business, with $1.3 billion in capital expenditures for the full year. We currently plan to maintain capital expenditures at about $1.3 billion in 2023 and continue to have significant financial capacity to pursue strategic growth objectives. We have been continuing to return capital to shareholders. We distributed $900 million in dividends and repurchased almost $1.5 billion of shares in 2022. We are planning $1 billion in opportunistic buybacks for 2023, subject to other strategic uses of capital. Juan?
Juan Luciano: Thank you, Vikram. Next slide, please. 2022 was a truly outstanding year for ADM. As we look forward to 2023, we expect another very strong year. There are a number of market factors that we see as relevant for shipping our performance. We still see tightness in supply and demand balances in key products and regions. We see strong demand for vegetable oil, driven largely but robust demand for biodiesel and renewable diesel. Resilient food demand should drive higher volumes and margins in starches, sweeteners and wheat milling. We see continued strong demand for ethanol, including positive discretionary blending economics. And as Vikram mentioned, we expect 10% plus constant currency OP growth from Nutrition. We have a strong playbook powered by our deep expertise and our unparalleled footprint and capabilities to manage a dynamic market environment. Our healthy balance sheet provides ongoing optionality as we continue to pull the levers under our control to deliver results. And we expect positive contributions from productivity and innovation initiatives across the company that will help us drive value in 2023. Taken together, we expect to deliver another very strong year in 2023. With that, Bailey, please open the line for questions.
Operator: Thank you. [Operator Instructions] Our first question today comes from the line of Ben Bienvenu from Stephens. Please go ahead. Your line is now open.
Ben Bienvenu: Hey, thanks. Good morning, everybody.
Juan Luciano: Good morning, Ben.
Ben Bienvenu: So I want to ask in the Nutrition segment. Your guidance, I think, Juan, you said 10% growth in constant currency. Two questions I have. One is at the current exchange rate levels, what would that imply in just a reported growth rate? And then secondarily, just thinking strategically, you’re talking about some of the expansions that you’re making in organic growth investment. What does your appetite for M&A look like in that segment? And how fertile is the landscape for potential M&A?
Juan Luciano: Yes. Thank you, Ben. Listen, that business has been a very successful story at the customer level for many, many years. We continue to drive higher growth rates than the industry we participate in. So that has not changed, the robust pipeline growth there, and we have achieved all that then through a very disciplined strategy of bolt-on acquisitions and organic growth. So we did 4 bolt-ons in 2021. We took the time in 2022 to integrate them and digest them. At the same time, in 2022, we started many projects that I highlighted in my initial comments on organic growth. So I would say that will be the pattern that you should expect to us. I mean we have stated many years in our balanced capital allocation, and in this nutrition pace, if you will, of bolt-on and M&A and taking some time to digest some of those things. Very pleased to report that the four acquisitions we made in 2021 are executing or delivering ahead of their business model. So we’re not planning to change the pace or the strategy that we have had so far. The projects that we are making selective expansions on or bringing to life soon are all going well even despite the long time – long lead time equipment and sometimes you face in the industry. We’ve done that in anticipation of all that. So we feel very good about being able to support, with capacity, the growth in demand that we see in the marketplace from our participations.
Ben Bienvenu: Okay. And the question on the constant currency versus reported any color you can offer there at current exchange rates?
Vikram Luthar: Yes. So effectively, Ben, we don’t assume a lot of change in currency for 2023. Yes, you’ve seen some weakness in the U.S. dollar, but you can assume that, even on a reported basis right now, we assume similar growth rates in OP.
Ben Bienvenu: Okay, great. Can I ask one follow-up or is that too greedy?
Juan Luciano: Go ahead, Ben.
Ben Bienvenu: Okay. I actually want to shift gears a little bit and pivots to Starches and Sweeteners, that business was fantastic in the quarter. Your forward commentary sounded quite constructive as well. Could you give us a little bit more color on how you see that evolving into 2023? And do you think you can achieve margin expansion there?
Vikram Luthar: So based on the customer contracting we’ve seen in the Sweeteners and Starches portfolio, Ben, we do see strong volumes and margins. And with the improved mix, we talked about BioSolutions expansion, we actually have 26% year-on-year growth, and BioSolution margin remained very robust. And with the improved mix we actually see a potential, in the Sweeteners and Starches business, to have higher volumes and margins in 2023. Clearly, ethanol remains uncertain and we’ve seen recently inventory levels remain high, and that’s actually pretty similar to January of last year as well. But we’re still constructive in terms of outlook for ethanol, given what’s happening with the RVO framework, the fact that gasoline demand is expected to be roughly flat versus 2022, blending economics remain very favorable. And frankly, export volume should be similar to last year, around 1.4 billion gallons. So that’s a quick snapshot of our outlook for 2023.
Operator: The next question today comes from the line of Adam Samuelson from Goldman Sachs. Please go ahead. Your line is open.
Adam Samuelson: Hi, yes, thank you. Good morning, everyone.
Juan Luciano: Good morning, Adam.
Adam Samuelson: So I wanted to hopefully tie together some of the forward comments that you made and see just to help calibrate kind of us on the net impact of that at the earnings level. So Nutrition is going to have kind of 10% constant currency profit growth, not much FX right now. Other – and other and corporate and interest kind of basically seemingly netting out to roughly flat year-over-year. Tax rate, flat to maybe up slightly year-over-year. So I guess the two pieces of the puzzle that are missing from their Ag Services and Oilseeds profit in Carbohydrate Solutions. I think ethanol remains somewhat of a wildcard on carbohydrates, although the rest of Starches and Sweeteners, you sound generally constructive. So can you help us, Juan, Vikram, just thinking about kind of a range of outcomes on Ag Services and Oilseeds based on where crush margins are today kind of assuming, let’s say, an average U.S. crop, no enormous supply dislocation coming out of the U.S. in the second half of the year? Just how kind of the profit outlook would be tracking in Ag Services and Oilseeds, and if there is anything else on a year-on-year basis, you want us to be considering, that would be really helpful.
Juan Luciano: Yes. Thank you, Adam. I think you captured the situation well. I think we continue to see a very strong margin environment in Ag Services and Oilseeds. 2022, we hit in all cylinders. I think that every piece of our business hit records. When we look at the 2023, we continue to see very strong demand. If you look at North America, North America had a strong meal demand and certainly very strong domestic demand for oil, driven by all the factors, driven by sustainability that you know. We see a strong potential for crush margins in Europe, given the bad crop in Argentina and the fact that Europe will continue to export biodiesel to the U.S. given the need that we have here. So all in all, we continue to see strength. Certainly, RPO, we’re going to see the strong demand. Biodiesel and all that is going – we’re seeing strong margins and very good volumes for next year. We do have visibility into this – into the next year, given our book, so we feel good about that business. As Vikram mentioned in the commentary may be Ag Services that we’re planning it a little bit slower than last year, given the exceptional results that we had last year. And – but as difficult as it is to pinpoint a number, Adam, given that we have China uncertainty, war that has been going on for a year and, certainly, weather events, that we still need to build the U.S. crop, and we still need to finish the Latin American crops. I would say we favor more range scenarios. And in the range of scenarios, 2023, falls into a very strong range for us. So I don’t know – I will not venture to pinpoint a specific number, but certainly strong range. When you go to Carb Solutions, when we talk to our customers, demand for the products is stable. We’ve been able to have strong margins in all that, whether it’s sweeteners and starches or whether it’s wheat milling. When we look at BioSolutions, it continues to grow, like 26% of revenue. And then we see EBITDA margins in the 20% for that business, which is a very profitable business that is growing their contribution into Carb Solutions as part of the total UP. So that is a business that Vikram called the question mark of – the more volatile part of it probably is ethanol. And that’s – right now, like a little bit like in the last year, we start with this time of the year with low margins. And – but we think that we’re going to have very good incentive for people to blend ethanol, the numbers are there. RINs balances are tight, will encourage people to blend. So I think that given the prices that they have, I think that expecting export in the range of 1.4 billion to 1.5 billion gallons per year is reasonable. And you saw these days, Petrobras in Brazil, increasing the gasoline prices by 7%, so they are going to be less flow from there to here in all these. So we’re still planning for a little bit softer, maybe Carb Solutions in light of our ethanol forecast. But conditions are – could change in ethanol and it could make it a close year. So all in all, we continue to see a very strong year for 2023.
Operator: The next question today comes from the line of Ben Theurer from Barclays. Please go ahead. Your line is now open.
Ben Theurer: Thank you very much. Good morning, Juan. Good morning, Vikram.
Juan Luciano: Hi, Ben.
Vikram Luthar: Good morning.
Ben Theurer: Just wanted to quickly follow-up on the Nutrition dynamics you seen in the fourth quarter and how that translated into 1Q and somehow if you could frame it for that medium-term growth algorithm you’ve laid out a little over a year ago during your Capital Markets update. So fair to assume that there was obviously a lot of specific issues around fulfillment, some very specific demand items that kind of impacted in the fourth quarter, and you expect this, obviously, to continue into the first half and then recover into the second half. Now clearly, the 10% you’ve laid out and what you’ve talked about of growth in 2023 is kind of below the algorithm. So can you help us frame how ‘23 kind of fits within your ‘25 strategy and where you want to go? Is that just a small dip can then be recovered? Or would you need some M&A to get back on track to the target of 1.2 at least by 2025, so that we understand how to think about the specific headwinds that can potentially be offset versus what might be more of a structural challenge within Nutrition?
Vikram Luthar: Yes, Ben, in terms of Q4, the issues that affected Q4, I’d say, are kind of a little more temporary, right, that we think we will be able to work through over the course of 2023, as I talked about. Specifically, what’s important for you to know that the demand is very, very strong, right? So that is – we talked about the strongest-ever pipeline in the Human Nutrition business and very strong win rates. So across every category that we play in, almost we’ve got strong demand. Yes, there is some softening in certain parts of the business, right? We are aware of dietary supplements that being a little softer. Plant-based protein growth may moderate a bit from the pace we’ve seen historically. But nevertheless, our growth has been very strong in Human Nutrition. The challenge we’ve had is the demand fulfillment. That’s going to take us a while to address and overcome. Animal Nutrition, on the other hand, we benefited from strong margins in lysine, but in Q4, the compression in margins were sharper and faster than we expected, and that’s going to continue over the course of 2023. So we’ve got to offset that plus drive growth, and that’s what gives us a slightly below trend line growth for 2023 around 10% plus. Having said that, the outlook remains robust. And maybe, Juan, do you want to talk about the 2025 perspective?
Juan Luciano: Yes. Thank you, Vikram. Ben, listen, I think we have been – you have been witnessing how we built this nutrition business over the years. This is a business that, if I take over the last 3 years, it has been growing OP by 20%, CAGR if you will. So, it’s a business that we continue to add layers of capabilities so we can continue to win at the customer front, whether it is we go from individual ingredients to systems, where we bring functionality to those systems through bioactives, whether we bring sustainability benefits to that through our decarbonization or regen Ag. So, we continue to add layers to continue to help customers excel at the consumer level. And we see that in our win rates, and we see that in our pipeline. So, we have visibility into that. As Vikram said, maybe some of the categories soften a little bit, but our ability to gain share, to win faster than those categories, has been demonstrated. I think this year, we grew revenue significantly higher than the market. So, when we look forward, as I said in my – I think one of the earlier answers, we continue to expect bolt-on and M&A – bolt-on M&A and organic growth. We had four companies in 2021. We are building capabilities and new capacity in 2022 that we are going to see on the stream in ‘23, and we are going to continue to grow that. So, we haven’t deviated from our 2025 plan. And I don’t think it will require massive M&A to achieve there. It will – you will see this steady state. But this is a business that we are building in the middle of a lot of volatility in the market. This is of course, versus the legacy ADM business, it’s more complex in the number of SKUs that we have, in the number of customers that we have, in the number of plants and categories that we manage. So, when supply chain issues happen or market volatility happen, it’s a little bit more complex to fix in this business. And that’s why we expect a first half that’s going to be a little bit subdued when you add the demand fulfillment issues and some of the capability building, with the fact that also lysine is coming down, if you will, in prices, at least for the moment. So, I would say nothing that deviated. Certainly, if you ask me personally, and I think the management team, are we happy with Q4, I mean of course, Q4 underperformed our own expectations. I mean that’s nothing new for a business that, again, has been growing 20% per year CAGR. And – but we think that this is just a trajectory in the business that continued to win faster than what the market gives us at this point in time. We don’t expect a deviation to our long-term plan at this point.
Operator: Thank you. Our next question today comes from the line of Manav Gupta from UBS. Please go ahead. Your line is now open.
Manav Gupta: Congrats on the beat and the dividend hike, shareholder returns matter and you have continuously rewarded your shareholders. My quick question here is, and you have kind of alluded to it also is we are seeing a lot of new capacity start up on the renewable diesel side. I think major projects starting up even last quarter. And then your outlook for both soybean oil and soybean meal, it seems pretty strong right now, any risks to that? And how do you see the year progressing from the perspective of both soybean oil and soybean meal?
Juan Luciano: Thank you, Manav. Thank you for the question. We continued to see very strong demand across the world, not only for all the oils. I think that if you take the four oils, demand is running harder than production, if you will, globally. So, even I would say before renewable green diesel happened, we had already a tight balance sheet from an oils perspective, and that has continued. When you think about the capacity that renewable green diesel is installing, it’s going to have a huge pull in soybean oil. And we have found that there is – we have found relatively easy to place the mill in the export markets. And if you look at the market overall, the meal market is a market of like 175 million metric tons and growing. So, if you calculate by 2026, we need to have 20 million tons more soybean meal, just to catch up with the demand. And if you look at everything that we are building through the RGD and the capacity expansions, we are estimating about 15 million tons of supply on soybean meal. So, it’s still we have – we are still covered in only 75% of the expected soybean meal demand out there. So, we are looking at this as you can understand very carefully. Remember, as I always mentioned, it took us 2 years to assess Spiritwood and start building it. I am happy to report that is going to come online for the harvest. So, I would say we look at this, but the demand on both sides on the soybean meal and soybean oil clearly can support all this capacity. So, we continued to see an environment in which crush margins will be strong and highly supportive for many, many years.
Operator: Thank you. The next question comes from the line of Steve Byrne from Bank of America. Please go ahead. Your line is now open.
Salvator Tiano: Yes. Thank you very much. This is Salvator Tiano filling in for Steve. So, firstly, I wanted to ask a little bit about China and specifically, you mentioned mill demand. So, a little bit short and long-term view. In the short-term, I guess the re-openings there, etcetera, do you see actually a positive momentum for demand for soybean meal or soybeans versus what you saw in the past couple of years with COVID zero? And then long-term actually is we have been reading how Chinese population dropped last year, essentially, it seems to have peaked much than it’s expected. And there are articles talking about what could be the long-term trajectory of food demand there, including protein demand and therefore, what would be the demand for feed. So, how are you seeing the long-term outlook in China for soybean meal and other products that you make?
Juan Luciano: Yes. Thank you. Good questions. So, on the short-term part of the question, we see China will continue to increase imports. If you look at domestic grain prices are at historically high levels, especially now that we are – that they are reopening. Of course, a reopening of China could be a game changer for a variety of commodities, not just grains. We look at domestic vegetable oil stocks have been at relatively low levels. And we have seen, during the second half of 2022, an increase in domestic pork prices since, I would say, last spring. So, that prompted farmers to increase their herd. So, we see that demand in the short-term. But again, I think the variability here may be on the upside on how much of the reopening is bringing people to consumption. Of course, people have been in lockdown almost for 2 years in China. And there is a – you are going to find the same pent-up demand that we saw ourselves maybe since last year when everybody came out of COVID. So, I think at this point in time, short-term, China will be probably a positive upside, if anything, to our forecast. When you look at the long-term and the demographics of China that you described, probably about 50% of the Chinese population is middle class or what you will consider middle class, and they are in this process of increasing their protein consumption. But still historically, if you look at what the U.S., we consume about 270 pounds per year of proteins. China is at the 170 pounds per year level. So, they are still far from our level of consumption. And again, if you look at our lifestyles are converging slowly. So, you will expect their protein per capita consumption to grow significantly during this period. The other thing you need to remember is that we are still going to be 10 billion people in the planet by 2050, which is one of the issues that serves our – or drives our purpose, which is trying to increase the carrying capacity of the planet, trying to feed all that. And whether it’s in China or whether it’s in Africa or whether it’s in Southeast Asia, we are a global company, we have a global footprint, and you have seen us continue to expand our destination marketing footprint to serve customers around the world. So, we will serve – we will serve the feeding of growing population of the world, whether it’s in China or somewhere else. But as I said, I don’t expect China to have a decline in the next probably two decades in terms of their demand for protein consumption.
Operator: The next question today comes from the line of Robert Moskow from Credit Suisse. Please go ahead. Your line is now open.
Robert Moskow: Hi. Thank you. I was hoping to get a little more detail on your forward outlook for ASO. In the slides in the pack, you indicated that the front month board crush is at $75 a ton, and that’s lower than where it was on your third quarter growth [ph]. Does that influence your outlook for forward crush and the fact that it’s come down a bit? And how can I relate that to what happened in calendar ‘22?
Juan Luciano: Yes. Rob, I couldn’t hear you very well, but I get the gist of the question. So, listen, I think at this point in time – and as I said before, we have visibility for probably the first quarter and big part of the first half, 2023 will be another strong year for crush, certainly above the long-term guidance that we provided at our global Investor Day. We also are planning to have an improvement in our process volumes that given some of the operational resilience initiatives. And we are going to have Spiritwood online in Q4. And hopefully, by in a couple of – maybe in a couple of weeks and a month, we will resume crush in Paraguay. We continue to have good crush margins in Europe. Certainly, Europe will be helped by the small crop in Argentina. Also, I think energy prices have moderated a little bit in Europe given the warm summer. So, we are also shifting in Europe as much to soybean crush as we can as there is margin there. We are also going to have this year that we didn’t have last year, better canola margins. Canola crush margins certainly and now that we have a Canadian crop, are more in the $120 to $140 per ton in North America, maybe $70 to $75 in Europe. So, I would say, we are having good crush rates. We are having good mill export demand in the U.S. We are having very strong soybean oil demand here in the U.S. So, I will say, in general, we don’t see any clouds in the horizon for crush. The crush business will have a very strong year in 2023. As I have said before, Rob, I wouldn’t pinpoint a specific number given the China reopening, given the issues in Ukraine that whether it’s not driving crush margins that may drive energy prices. And certainly, the crops, we are expecting that Brazil needs to have a big crop that will offset the decline in Argentina. And we hope that the U.S. will have a big crop as well, but we still need to go through the weather in both instances. So, again, I will just reiterate a very strong environment for crush as far as we can see.
Operator: The next question today comes from the line of Eric Larson from Seaport Global Securities. Please go ahead. Your line is now open.
Eric Larson: Yes. Thanks. Thank you and congratulations on a great year, everyone.
Juan Luciano: Thank you.
Eric Larson: So, yes, my question comes down to, we have talked a lot about the bean markets globally and domestically here. But one of the big kind of hangovers right now in the grain market is corn demand. And obviously, I think Brazil is going to be running out of corn here pretty quickly. We may have seen some new Chinese demand coming in here for corn. But how do you look at – and we have been on competitive, I think just from a currency basis – from everything else. But could you talk a little bit, Juan, about the corn market and how you see the export situation with that particular commodity?
Juan Luciano: Yes. I think you called it well. I think that when we had the low water levels in the Q4 that hurt us, of course, we lost some bean business. But the corn business basically is going to be with us until the crop in Brazil – the harvest in Brazil comes, so it’s like middle of the year. So, we see that as a very strong business in Ag services for North America. We also have, unfortunately, I think Ukraine Grain Association has come up with a statement that they don’t believe corn for ‘23 will exceed 18 million tons, which is a far cry from the 29 million tons or 30 million tons that they used to produce or we expected. So, demand continues to be solid out there. And we still – as a world, we need Brazil to have a good crop. Of course, if there are rains and delay a little bit the harvest of soybeans, that may delay a little bit the planting of the next crop. But we hope that in your farm and everybody’s farm, corn is growing strongly because we need it. And again, the U.S. will be exporting a lot of that from here until probably July.
Operator: The final question today comes from the line of Steve Byrne from Bank of America. Please go ahead. Your line is now open.
Steve Byrne: Yes. Thanks. Just wanted to ask about the press release that was out a couple of days ago about the new biostimulant of ADM released, the data for rating sold. And I know that you do have a business where you work with farmers to provide them fertilizers, etcetera. But I think this seems to be the first time that you are actually rolling out one of your own proprietary products. So, I am just trying to understand a little bit about your strategy here. Will you invest more in products for nutrition and crop protection, especially biologicals? And what do you think is the potential market and actually the earnings potential for ADM?
Juan Luciano: Yes. Thank you for the question. Listen, I think that we continued to enlarge our relationships with customers, but also with farmers. And as we continue to increase our digital engagement with them, we also increased the bartering and exchange of many, many products. And we have a good relationship with farmers. We have the trust of the farmers, and so every now and then, they bring challenges to us. And I think the challenges of biologicals, if you will, given that we have some work in precision fermentation and things like that is, we are always interested in doing that. So, there is always division out there in ADM exploring and extending a little bit our franchises and our engagement. So, I wouldn’t be surprised to see experiments or tests here and there. And we do that a lot. We do that in products at our B2C. We do that in products that are biologicals. We do that in products related to the farmer. And we continue to expand. These are things that, over the years, they turn out into big businesses. At one point in time, we started with destination market and now it’s a big part of our franchise. At one point in time, we started with BioSolutions and now we are making more $0.25 billion of EBITDA on that. At one point in time, we started with the differentiated grain that now we call regen Ag, and now we are in the million acres of that. So, I think it’s just the innovation part of ADM, and you are going to see green shoots at that. I am glad you are paying attention to that. And we are going to see expansion of those things into the future. So, thank you.
Megan Britt: So, with that, I think that was the last question for the call today. I would like to thank you for joining us. Please feel free to following up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM.
Operator: This concludes today’s conference call. Thank you all for your participation. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Good morning and welcome to the ADM Fourth Quarter 2022 Earnings Conference Call. [Operator Instructions] As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s call, Megan Britt, Vice President, Investor Relations for ADM. Ms. Britt, you may begin."
},
{
"speaker": "Megan Britt",
"text": "Thank you. Hello and welcome to the fourth quarter earnings webcast for ADM. Starting tomorrow, a replay of this webcast will be available on our Investor Relations website. Please turn to Slide 2, which says that some of our comments and materials constitute forward-looking statements that reflect management’s current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in the presentation. To the extent permitted, under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today’s webcast, our Chairman and Chief Executive Officer, Juan Luciano, will discuss our full year accomplishments and share detail on our priorities for 2023. Our Chief Financial Officer, Vikram Luthar, will review the drivers of our financial performance at the segment level and review our cash generation and capital allocation results. Juan will have closing remarks regarding our planning framework for 2023 and then he and Vikram will take your questions. Please turn to Slide 3. I will now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Megan. This morning, we reported very strong fourth quarter adjusted earnings per share of $1.93. Adjusted segment operating profit was $1.7 billion. Our full year adjusted EPS of $7.85, adjusted segment operating profit of $6.6 billion, and trailing fourth quarter average adjusted ROIC of 13.6% demonstrate once again the great work of our global team of dedicated colleagues who manage unprecedented market disruptions to deliver an outstanding year. Our full year operating cash flow before working capital was $5.3 billion. This strong cash flow and the disciplined management of our balance sheet allow us to continue to reinvest in our business, with $1.3 billion in capital expenditures and return cash to shareholders. In total, we returned $2.3 billion to our shareholders in the forms of dividends and share repurchases in 2022. Next slide, please. With the expectation of continued strong cash flow, today, we are announcing a 12.5% increase in our quarterly dividend to $0.45 per share. We are proud of our record of 91 years of uninterrupted dividends and 50 consecutive years of annual dividend increases. And I’d like to thank our shareholders for their continued support of ADM. Next slide, please. When I examine 2022, our ability to drive structural growth in earnings and improvement in ROIC was supported by key strategic accomplishments across the enterprise, particularly the progress we made on our productivity and innovation objectives. Our productivity work in 2022 included enhancing our operational resilience, including through stabilizing our plant operations and streamlining our operating systems. In order to meet growing customer demand and drive efficiencies, we delivered multiple projects to enhance our operational footprint, from modernization to improving and scheduled downtime to capacity expansions. We completed our Marshall, Minnesota modernization, opened a new mill house in Clinton, completed our Quincy refinery expansion and improved output and yields at our Rondonopolis diesel plant in Brazil. We also continued to optimize our North American milling footprint. As you know, we also introduced a new $1 billion challenge in 2022. There is no clearer demonstration of how our colleagues and culture are driving returns than the fact that thousands of ADM team members from around the globe took the initiative, step up and identified opportunities that unlocked more than $1.6 billion in cash in 2022. On innovation, our accomplishments include a focus on capturing the benefits of organic growth investments and M&A as we continue to get closer to our customers and extend our capabilities to meet growing global demand for our products. Our Nutrition business continued to outpace the industry, with 18% constant currency revenue growth for the full year. We delivered an impressive 26% in year-over-year revenue growth in BioSolutions. The portfolio of acquisitions we made in the prior year continued to deliver OP above our financial projections and we advanced targeted production capacity expansions to meet growing customer demand. We announced expansions of our alternative protein capabilities in Decatur, Illinois, and starch production in Marshall, Minnesota. We completed our alternative protein expansion in Serbia and are able to launch our expanded probiotic capacity in Valencia, Spain. And we continue to expect our joint venture crush and refining facility in North Dakota to be operational by this year’s harvest. Slide 6 please. Now let’s look ahead. We have a robust plan for driving enduring value creation in 2023 and beyond. In productivity, our work has a common theme, changing the way we work by standardizing, digitizing and automating our manufacturing plants and our offices alike. I previously mentioned our successful Marshall modernization. That was the blueprint for our wider work to unlock value across our production footprint through enhanced automation, more sophisticated control systems and the increased use of analytics. We have now approved the scope for the first 2 years of the program, encompassing 18 manufacturing facilities. We continue to expect double-digit returns from this important initiative. And we are continuing to advance 1ADM, which is enabling us to improve our processes and expand capabilities across the value chain. 2022 was an important year for our 1ADM business transformation. We completed several rollouts and we are seeing benefits in areas ranging from indirect procurement to go-to-market strategies to grain merchandising. In 2023, we will continue to expand the breadth and scope of this work, which is empowering our businesses to deliver profitable revenue growth and higher margins. Next, we are focused on maintaining our structural growth momentum via our innovation work. As you might recall, we have spoken in the past about our strategic growth platforms: sustainability, differentiated grain, alternative proteins, BioSolutions, microbial solutions and microbiome modification. These growth opportunities go through a natural evolution. When new, we launch them at the corporate level. As they mature, they become more embedded in our businesses. Differentiated grain is now firm part of our Ag Services and Oilseeds segments everyday work. BioSolutions is growing within carbohydrate solutions. Alternative proteins and microbiome are pillars of nutrition. With these efforts maturing in the businesses, we are able to focus on other opportunities. One of the most important is decarbonization, which is a critical component of our sustainability growth platform and is driving the evolution of our carbohydrate solutions business. Our goal is to reduce the carbon intensity of our assets and value chain in order to be the preferred partner in low-carbon intensity feedstocks for a growing demand base. We have made several announcements to mark milestones towards this goal in recent years, including our regenerative agriculture efforts, which enrolled 1 million unique acres over the past year; our Strive 35 goals; our initiatives to connect and expand our carbon capture and storage capabilities; and our heat and energy project indicator. We are looking at multiple other pathways to reducing our carbon intensity, like more sustainable energy sources for our facilities. And our efforts aren’t just in the U.S. We have plans for other regions as well, including some EMEA projects we hope to speak about in the future. All of these projects contribute to our ability to offer low carbon intensity feedstocks and that is allowing us to continue to advance our work to transition our dry mills to produce sustainable aviation fuel; help scale up the scaled food products with new sustainable attributes, like the ingredients we will sell to Pepsi from the regenerative agriculture agreement we announced last year, and propelled the expansion of BioSolutions with joint ventures like with LG Chem. And even as we advance our decarbonization plan, we are always looking at new ways to help solve our world’s challenges for food security, health and well-being and sustainability. For example, we are continuing to explore opportunities around precision fermentation, which we used to call microbial solutions, in which microbes rapidly grown in fermenters fed by dextrose, transform the sugars into a wide variety of products for food, feed and fiber. That’s a longer term horizon for ADM, but it gives us a hint of the kind of opportunities we see in the years ahead. Now, I would like to turn the call over to Vikram to talk about our business performance. Vikram?"
},
{
"speaker": "Vikram Luthar",
"text": "Thank you, Juan. Please turn to Slide 7. The Ag Services and Oilseeds team capped off an outstanding year with substantially higher year-over-year results in Q4. Ag Services results were higher than the fourth quarter of 2021. Low water conditions reduced North American export volumes, partially offset by the South American team, which executed well to deliver higher margins and volumes. Global trade results were lower than the strong fourth quarter of 2021 with lower ocean freight results partially offset by higher results in EMEA origination and destination marketing. The business benefited from a $110 million legal recovery related to the 2019 and 2020 closure of the Reserve Louisiana Export facility. Crushing results were more than double those of the prior year period. In North America, strong export volumes for soybean meal and growing domestic demand for renewable diesel contributed to strong margins. In EMEA, oil demand powered strong rapeseed margins more than offsetting higher energy costs compared to the prior year. Expanding margins drove negative timing impacts in the quarter of approximately $40 million. RPO results were significantly higher year-over-year as the business continued to execute well to meet demand for food oil, renewable diesel in the U.S. and biodiesel globally. Equity earnings from Wilmar were much higher versus the fourth quarter of 2021. Looking ahead, we expect AS&O results for Q1 to remain strong, similar to last year’s very strong quarter led by continued strength in crush margins and RPO. Ag Services is likely to be lower year-over-year, particularly in light of very strong global trade results in the prior year quarter. Slide 8, please. Carbohydrate Solutions had a strong 2022, with full year results higher than 2021. For the quarter, results were substantially lower than the fourth quarter of 2021 due to pressured industry ethanol margins. The starches and sweeteners sub-segment, which includes ethanol production from our wet mills, delivered much higher year-over-year results. The North America business delivered solid volumes and strong margins in both starches and sweeteners, partially offsetting lower ethanol margins. The EMEA team effectively managed risk and delivered improved results on better margins in a continued dynamic environment. The global wheat milling business delivered higher margins driven by solid customer demand. Vantage Corn Processors results were substantially lower as higher ethanol inventory levels pressured margins especially compared to the very strong margin environment in the fourth quarter of 2021. Looking at the first quarter for Carbohydrate Solutions, we expect continued solid demand and strong margins for starches, sweeteners and wheat flour. Ethanol margins are currently pressured due to high industry inventory levels. If industry stocks come back down, results for the quarter could be similar to Q1 of 2022. If margins remain pressured, results would likely be lower. On Slide 9, the Nutrition business continued its strong growth trajectory in 2022. ADM demonstrated that it remains the provider of choice in Nutrition for systems as our growing pipeline and continued strong win rates delivered full year revenue growth of 18% on a constant currency basis. The business continued to outperform industry growth levels and delivered 11% higher profits for the full year on a constant currency basis. For the fourth quarter, revenues grew 11% on a constant currency basis. Q4 operating profits were significantly lower than the prior year quarters. Human Nutrition results were lower than those of the fourth quarter of 2021. Flavors results were similar to the prior year as strong revenue growth helped offset demand fulfillment challenges. Specialty Ingredients continued to see strong demand for its product portfolio, including plant-based proteins, offset by inventory adjustments. Health & Wellness was higher year-over-year, driven primarily by the bioactives portfolio, including the results from the Deerland acquisition. Animal results were substantially lower than the prior year quarter, primarily due to the lower margins in amino acids, driven by recovery in the global supply of lysine. Pet Nutrition volumes were lower in Latin America, partially driven by demand fulfillment challenges. Feed results were stronger driven by APAC and Latin America partially offset by the impact of softer demand in EMEA. As we look ahead, we expect overall Nutrition results in Q1 to be lower than the prior year’s record first quarter, with Human Nutrition delivering similar year-over-year results on strong flavors and SI growth and lower Animal Nutrition results primarily due to weaker margins in amino acids. I want to take a moment to expand on our view of Nutrition in 2023. Nutrition is expected to continue on a positive growth trajectory for full year 2023, including 10% plus profit growth and a similar level of revenue growth. The growth is likely to be led by Human Nutrition and to be weighted in the back half of the year as the first half will see headwinds in Animal Nutrition due to the continued impacts of weaker margins in amino acids and because we will see increasing recovery in demand fulfillment as we move through the year. Slide 10, please. Other business results for Q4 was significantly higher than the prior year’s fourth quarter. Higher short-term interest rates drove improved earnings in ADM investor services, and captive insurance experienced favorable underwriting results and lower claim settlements versus the prior year. In the corporate lines, unallocated corporate costs of $299 million were higher year-over-year due primarily to higher IT operating and project-related costs and higher costs in the company’s centers of excellence related to growth initiatives. Other corporate was favorable versus the prior year primarily due to higher contributions from foreign currency-related hedge activity and lower railroad maintenance expense. Corporate results also included losses related to the mark-to-market adjustment on the Wilmar exchangeable bond and severance totaling $6 million. Net interest expense for the quarter increased year-over-year on higher interest rates. We expect corporate cost for 2023 to be around $1.5 billion, driven primarily by inflation and higher interest expense. Other business performance should be higher than 2022, offsetting a significant portion of the increased corporate costs as higher interest rates positively impact our ADM IS business. The effective tax rate for the fourth quarter of 2022 was approximately 16% compared to 21% in the prior year. The decreased rate was driven primarily by changes in the geographic mix of pretax earnings in addition to lower discrete tax expense versus the prior year. Our full year adjusted tax rate was 17%. For 2023, we expect our adjusted tax rate to be between 16% and 19%. Next slide, please. Year-to-date operating cash flows before working capital of $5.3 billion are up significantly versus $3.9 billion over the same period last year. Our net debt to total capital ratio is about 25%, and we continue to have ample available liquidity. Our strong cash flows and balance sheet have enabled continued investment in the business, with $1.3 billion in capital expenditures for the full year. We currently plan to maintain capital expenditures at about $1.3 billion in 2023 and continue to have significant financial capacity to pursue strategic growth objectives. We have been continuing to return capital to shareholders. We distributed $900 million in dividends and repurchased almost $1.5 billion of shares in 2022. We are planning $1 billion in opportunistic buybacks for 2023, subject to other strategic uses of capital. Juan?"
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Vikram. Next slide, please. 2022 was a truly outstanding year for ADM. As we look forward to 2023, we expect another very strong year. There are a number of market factors that we see as relevant for shipping our performance. We still see tightness in supply and demand balances in key products and regions. We see strong demand for vegetable oil, driven largely but robust demand for biodiesel and renewable diesel. Resilient food demand should drive higher volumes and margins in starches, sweeteners and wheat milling. We see continued strong demand for ethanol, including positive discretionary blending economics. And as Vikram mentioned, we expect 10% plus constant currency OP growth from Nutrition. We have a strong playbook powered by our deep expertise and our unparalleled footprint and capabilities to manage a dynamic market environment. Our healthy balance sheet provides ongoing optionality as we continue to pull the levers under our control to deliver results. And we expect positive contributions from productivity and innovation initiatives across the company that will help us drive value in 2023. Taken together, we expect to deliver another very strong year in 2023. With that, Bailey, please open the line for questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question today comes from the line of Ben Bienvenu from Stephens. Please go ahead. Your line is now open."
},
{
"speaker": "Ben Bienvenu",
"text": "Hey, thanks. Good morning, everybody."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ben."
},
{
"speaker": "Ben Bienvenu",
"text": "So I want to ask in the Nutrition segment. Your guidance, I think, Juan, you said 10% growth in constant currency. Two questions I have. One is at the current exchange rate levels, what would that imply in just a reported growth rate? And then secondarily, just thinking strategically, you’re talking about some of the expansions that you’re making in organic growth investment. What does your appetite for M&A look like in that segment? And how fertile is the landscape for potential M&A?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Ben. Listen, that business has been a very successful story at the customer level for many, many years. We continue to drive higher growth rates than the industry we participate in. So that has not changed, the robust pipeline growth there, and we have achieved all that then through a very disciplined strategy of bolt-on acquisitions and organic growth. So we did 4 bolt-ons in 2021. We took the time in 2022 to integrate them and digest them. At the same time, in 2022, we started many projects that I highlighted in my initial comments on organic growth. So I would say that will be the pattern that you should expect to us. I mean we have stated many years in our balanced capital allocation, and in this nutrition pace, if you will, of bolt-on and M&A and taking some time to digest some of those things. Very pleased to report that the four acquisitions we made in 2021 are executing or delivering ahead of their business model. So we’re not planning to change the pace or the strategy that we have had so far. The projects that we are making selective expansions on or bringing to life soon are all going well even despite the long time – long lead time equipment and sometimes you face in the industry. We’ve done that in anticipation of all that. So we feel very good about being able to support, with capacity, the growth in demand that we see in the marketplace from our participations."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay. And the question on the constant currency versus reported any color you can offer there at current exchange rates?"
},
{
"speaker": "Vikram Luthar",
"text": "Yes. So effectively, Ben, we don’t assume a lot of change in currency for 2023. Yes, you’ve seen some weakness in the U.S. dollar, but you can assume that, even on a reported basis right now, we assume similar growth rates in OP."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay, great. Can I ask one follow-up or is that too greedy?"
},
{
"speaker": "Juan Luciano",
"text": "Go ahead, Ben."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay. I actually want to shift gears a little bit and pivots to Starches and Sweeteners, that business was fantastic in the quarter. Your forward commentary sounded quite constructive as well. Could you give us a little bit more color on how you see that evolving into 2023? And do you think you can achieve margin expansion there?"
},
{
"speaker": "Vikram Luthar",
"text": "So based on the customer contracting we’ve seen in the Sweeteners and Starches portfolio, Ben, we do see strong volumes and margins. And with the improved mix, we talked about BioSolutions expansion, we actually have 26% year-on-year growth, and BioSolution margin remained very robust. And with the improved mix we actually see a potential, in the Sweeteners and Starches business, to have higher volumes and margins in 2023. Clearly, ethanol remains uncertain and we’ve seen recently inventory levels remain high, and that’s actually pretty similar to January of last year as well. But we’re still constructive in terms of outlook for ethanol, given what’s happening with the RVO framework, the fact that gasoline demand is expected to be roughly flat versus 2022, blending economics remain very favorable. And frankly, export volume should be similar to last year, around 1.4 billion gallons. So that’s a quick snapshot of our outlook for 2023."
},
{
"speaker": "Operator",
"text": "The next question today comes from the line of Adam Samuelson from Goldman Sachs. Please go ahead. Your line is open."
},
{
"speaker": "Adam Samuelson",
"text": "Hi, yes, thank you. Good morning, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Adam."
},
{
"speaker": "Adam Samuelson",
"text": "So I wanted to hopefully tie together some of the forward comments that you made and see just to help calibrate kind of us on the net impact of that at the earnings level. So Nutrition is going to have kind of 10% constant currency profit growth, not much FX right now. Other – and other and corporate and interest kind of basically seemingly netting out to roughly flat year-over-year. Tax rate, flat to maybe up slightly year-over-year. So I guess the two pieces of the puzzle that are missing from their Ag Services and Oilseeds profit in Carbohydrate Solutions. I think ethanol remains somewhat of a wildcard on carbohydrates, although the rest of Starches and Sweeteners, you sound generally constructive. So can you help us, Juan, Vikram, just thinking about kind of a range of outcomes on Ag Services and Oilseeds based on where crush margins are today kind of assuming, let’s say, an average U.S. crop, no enormous supply dislocation coming out of the U.S. in the second half of the year? Just how kind of the profit outlook would be tracking in Ag Services and Oilseeds, and if there is anything else on a year-on-year basis, you want us to be considering, that would be really helpful."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Adam. I think you captured the situation well. I think we continue to see a very strong margin environment in Ag Services and Oilseeds. 2022, we hit in all cylinders. I think that every piece of our business hit records. When we look at the 2023, we continue to see very strong demand. If you look at North America, North America had a strong meal demand and certainly very strong domestic demand for oil, driven by all the factors, driven by sustainability that you know. We see a strong potential for crush margins in Europe, given the bad crop in Argentina and the fact that Europe will continue to export biodiesel to the U.S. given the need that we have here. So all in all, we continue to see strength. Certainly, RPO, we’re going to see the strong demand. Biodiesel and all that is going – we’re seeing strong margins and very good volumes for next year. We do have visibility into this – into the next year, given our book, so we feel good about that business. As Vikram mentioned in the commentary may be Ag Services that we’re planning it a little bit slower than last year, given the exceptional results that we had last year. And – but as difficult as it is to pinpoint a number, Adam, given that we have China uncertainty, war that has been going on for a year and, certainly, weather events, that we still need to build the U.S. crop, and we still need to finish the Latin American crops. I would say we favor more range scenarios. And in the range of scenarios, 2023, falls into a very strong range for us. So I don’t know – I will not venture to pinpoint a specific number, but certainly strong range. When you go to Carb Solutions, when we talk to our customers, demand for the products is stable. We’ve been able to have strong margins in all that, whether it’s sweeteners and starches or whether it’s wheat milling. When we look at BioSolutions, it continues to grow, like 26% of revenue. And then we see EBITDA margins in the 20% for that business, which is a very profitable business that is growing their contribution into Carb Solutions as part of the total UP. So that is a business that Vikram called the question mark of – the more volatile part of it probably is ethanol. And that’s – right now, like a little bit like in the last year, we start with this time of the year with low margins. And – but we think that we’re going to have very good incentive for people to blend ethanol, the numbers are there. RINs balances are tight, will encourage people to blend. So I think that given the prices that they have, I think that expecting export in the range of 1.4 billion to 1.5 billion gallons per year is reasonable. And you saw these days, Petrobras in Brazil, increasing the gasoline prices by 7%, so they are going to be less flow from there to here in all these. So we’re still planning for a little bit softer, maybe Carb Solutions in light of our ethanol forecast. But conditions are – could change in ethanol and it could make it a close year. So all in all, we continue to see a very strong year for 2023."
},
{
"speaker": "Operator",
"text": "The next question today comes from the line of Ben Theurer from Barclays. Please go ahead. Your line is now open."
},
{
"speaker": "Ben Theurer",
"text": "Thank you very much. Good morning, Juan. Good morning, Vikram."
},
{
"speaker": "Juan Luciano",
"text": "Hi, Ben."
},
{
"speaker": "Vikram Luthar",
"text": "Good morning."
},
{
"speaker": "Ben Theurer",
"text": "Just wanted to quickly follow-up on the Nutrition dynamics you seen in the fourth quarter and how that translated into 1Q and somehow if you could frame it for that medium-term growth algorithm you’ve laid out a little over a year ago during your Capital Markets update. So fair to assume that there was obviously a lot of specific issues around fulfillment, some very specific demand items that kind of impacted in the fourth quarter, and you expect this, obviously, to continue into the first half and then recover into the second half. Now clearly, the 10% you’ve laid out and what you’ve talked about of growth in 2023 is kind of below the algorithm. So can you help us frame how ‘23 kind of fits within your ‘25 strategy and where you want to go? Is that just a small dip can then be recovered? Or would you need some M&A to get back on track to the target of 1.2 at least by 2025, so that we understand how to think about the specific headwinds that can potentially be offset versus what might be more of a structural challenge within Nutrition?"
},
{
"speaker": "Vikram Luthar",
"text": "Yes, Ben, in terms of Q4, the issues that affected Q4, I’d say, are kind of a little more temporary, right, that we think we will be able to work through over the course of 2023, as I talked about. Specifically, what’s important for you to know that the demand is very, very strong, right? So that is – we talked about the strongest-ever pipeline in the Human Nutrition business and very strong win rates. So across every category that we play in, almost we’ve got strong demand. Yes, there is some softening in certain parts of the business, right? We are aware of dietary supplements that being a little softer. Plant-based protein growth may moderate a bit from the pace we’ve seen historically. But nevertheless, our growth has been very strong in Human Nutrition. The challenge we’ve had is the demand fulfillment. That’s going to take us a while to address and overcome. Animal Nutrition, on the other hand, we benefited from strong margins in lysine, but in Q4, the compression in margins were sharper and faster than we expected, and that’s going to continue over the course of 2023. So we’ve got to offset that plus drive growth, and that’s what gives us a slightly below trend line growth for 2023 around 10% plus. Having said that, the outlook remains robust. And maybe, Juan, do you want to talk about the 2025 perspective?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Vikram. Ben, listen, I think we have been – you have been witnessing how we built this nutrition business over the years. This is a business that, if I take over the last 3 years, it has been growing OP by 20%, CAGR if you will. So, it’s a business that we continue to add layers of capabilities so we can continue to win at the customer front, whether it is we go from individual ingredients to systems, where we bring functionality to those systems through bioactives, whether we bring sustainability benefits to that through our decarbonization or regen Ag. So, we continue to add layers to continue to help customers excel at the consumer level. And we see that in our win rates, and we see that in our pipeline. So, we have visibility into that. As Vikram said, maybe some of the categories soften a little bit, but our ability to gain share, to win faster than those categories, has been demonstrated. I think this year, we grew revenue significantly higher than the market. So, when we look forward, as I said in my – I think one of the earlier answers, we continue to expect bolt-on and M&A – bolt-on M&A and organic growth. We had four companies in 2021. We are building capabilities and new capacity in 2022 that we are going to see on the stream in ‘23, and we are going to continue to grow that. So, we haven’t deviated from our 2025 plan. And I don’t think it will require massive M&A to achieve there. It will – you will see this steady state. But this is a business that we are building in the middle of a lot of volatility in the market. This is of course, versus the legacy ADM business, it’s more complex in the number of SKUs that we have, in the number of customers that we have, in the number of plants and categories that we manage. So, when supply chain issues happen or market volatility happen, it’s a little bit more complex to fix in this business. And that’s why we expect a first half that’s going to be a little bit subdued when you add the demand fulfillment issues and some of the capability building, with the fact that also lysine is coming down, if you will, in prices, at least for the moment. So, I would say nothing that deviated. Certainly, if you ask me personally, and I think the management team, are we happy with Q4, I mean of course, Q4 underperformed our own expectations. I mean that’s nothing new for a business that, again, has been growing 20% per year CAGR. And – but we think that this is just a trajectory in the business that continued to win faster than what the market gives us at this point in time. We don’t expect a deviation to our long-term plan at this point."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question today comes from the line of Manav Gupta from UBS. Please go ahead. Your line is now open."
},
{
"speaker": "Manav Gupta",
"text": "Congrats on the beat and the dividend hike, shareholder returns matter and you have continuously rewarded your shareholders. My quick question here is, and you have kind of alluded to it also is we are seeing a lot of new capacity start up on the renewable diesel side. I think major projects starting up even last quarter. And then your outlook for both soybean oil and soybean meal, it seems pretty strong right now, any risks to that? And how do you see the year progressing from the perspective of both soybean oil and soybean meal?"
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Manav. Thank you for the question. We continued to see very strong demand across the world, not only for all the oils. I think that if you take the four oils, demand is running harder than production, if you will, globally. So, even I would say before renewable green diesel happened, we had already a tight balance sheet from an oils perspective, and that has continued. When you think about the capacity that renewable green diesel is installing, it’s going to have a huge pull in soybean oil. And we have found that there is – we have found relatively easy to place the mill in the export markets. And if you look at the market overall, the meal market is a market of like 175 million metric tons and growing. So, if you calculate by 2026, we need to have 20 million tons more soybean meal, just to catch up with the demand. And if you look at everything that we are building through the RGD and the capacity expansions, we are estimating about 15 million tons of supply on soybean meal. So, it’s still we have – we are still covered in only 75% of the expected soybean meal demand out there. So, we are looking at this as you can understand very carefully. Remember, as I always mentioned, it took us 2 years to assess Spiritwood and start building it. I am happy to report that is going to come online for the harvest. So, I would say we look at this, but the demand on both sides on the soybean meal and soybean oil clearly can support all this capacity. So, we continued to see an environment in which crush margins will be strong and highly supportive for many, many years."
},
{
"speaker": "Operator",
"text": "Thank you. The next question comes from the line of Steve Byrne from Bank of America. Please go ahead. Your line is now open."
},
{
"speaker": "Salvator Tiano",
"text": "Yes. Thank you very much. This is Salvator Tiano filling in for Steve. So, firstly, I wanted to ask a little bit about China and specifically, you mentioned mill demand. So, a little bit short and long-term view. In the short-term, I guess the re-openings there, etcetera, do you see actually a positive momentum for demand for soybean meal or soybeans versus what you saw in the past couple of years with COVID zero? And then long-term actually is we have been reading how Chinese population dropped last year, essentially, it seems to have peaked much than it’s expected. And there are articles talking about what could be the long-term trajectory of food demand there, including protein demand and therefore, what would be the demand for feed. So, how are you seeing the long-term outlook in China for soybean meal and other products that you make?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you. Good questions. So, on the short-term part of the question, we see China will continue to increase imports. If you look at domestic grain prices are at historically high levels, especially now that we are – that they are reopening. Of course, a reopening of China could be a game changer for a variety of commodities, not just grains. We look at domestic vegetable oil stocks have been at relatively low levels. And we have seen, during the second half of 2022, an increase in domestic pork prices since, I would say, last spring. So, that prompted farmers to increase their herd. So, we see that demand in the short-term. But again, I think the variability here may be on the upside on how much of the reopening is bringing people to consumption. Of course, people have been in lockdown almost for 2 years in China. And there is a – you are going to find the same pent-up demand that we saw ourselves maybe since last year when everybody came out of COVID. So, I think at this point in time, short-term, China will be probably a positive upside, if anything, to our forecast. When you look at the long-term and the demographics of China that you described, probably about 50% of the Chinese population is middle class or what you will consider middle class, and they are in this process of increasing their protein consumption. But still historically, if you look at what the U.S., we consume about 270 pounds per year of proteins. China is at the 170 pounds per year level. So, they are still far from our level of consumption. And again, if you look at our lifestyles are converging slowly. So, you will expect their protein per capita consumption to grow significantly during this period. The other thing you need to remember is that we are still going to be 10 billion people in the planet by 2050, which is one of the issues that serves our – or drives our purpose, which is trying to increase the carrying capacity of the planet, trying to feed all that. And whether it’s in China or whether it’s in Africa or whether it’s in Southeast Asia, we are a global company, we have a global footprint, and you have seen us continue to expand our destination marketing footprint to serve customers around the world. So, we will serve – we will serve the feeding of growing population of the world, whether it’s in China or somewhere else. But as I said, I don’t expect China to have a decline in the next probably two decades in terms of their demand for protein consumption."
},
{
"speaker": "Operator",
"text": "The next question today comes from the line of Robert Moskow from Credit Suisse. Please go ahead. Your line is now open."
},
{
"speaker": "Robert Moskow",
"text": "Hi. Thank you. I was hoping to get a little more detail on your forward outlook for ASO. In the slides in the pack, you indicated that the front month board crush is at $75 a ton, and that’s lower than where it was on your third quarter growth [ph]. Does that influence your outlook for forward crush and the fact that it’s come down a bit? And how can I relate that to what happened in calendar ‘22?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Rob, I couldn’t hear you very well, but I get the gist of the question. So, listen, I think at this point in time – and as I said before, we have visibility for probably the first quarter and big part of the first half, 2023 will be another strong year for crush, certainly above the long-term guidance that we provided at our global Investor Day. We also are planning to have an improvement in our process volumes that given some of the operational resilience initiatives. And we are going to have Spiritwood online in Q4. And hopefully, by in a couple of – maybe in a couple of weeks and a month, we will resume crush in Paraguay. We continue to have good crush margins in Europe. Certainly, Europe will be helped by the small crop in Argentina. Also, I think energy prices have moderated a little bit in Europe given the warm summer. So, we are also shifting in Europe as much to soybean crush as we can as there is margin there. We are also going to have this year that we didn’t have last year, better canola margins. Canola crush margins certainly and now that we have a Canadian crop, are more in the $120 to $140 per ton in North America, maybe $70 to $75 in Europe. So, I would say, we are having good crush rates. We are having good mill export demand in the U.S. We are having very strong soybean oil demand here in the U.S. So, I will say, in general, we don’t see any clouds in the horizon for crush. The crush business will have a very strong year in 2023. As I have said before, Rob, I wouldn’t pinpoint a specific number given the China reopening, given the issues in Ukraine that whether it’s not driving crush margins that may drive energy prices. And certainly, the crops, we are expecting that Brazil needs to have a big crop that will offset the decline in Argentina. And we hope that the U.S. will have a big crop as well, but we still need to go through the weather in both instances. So, again, I will just reiterate a very strong environment for crush as far as we can see."
},
{
"speaker": "Operator",
"text": "The next question today comes from the line of Eric Larson from Seaport Global Securities. Please go ahead. Your line is now open."
},
{
"speaker": "Eric Larson",
"text": "Yes. Thanks. Thank you and congratulations on a great year, everyone."
},
{
"speaker": "Juan Luciano",
"text": "Thank you."
},
{
"speaker": "Eric Larson",
"text": "So, yes, my question comes down to, we have talked a lot about the bean markets globally and domestically here. But one of the big kind of hangovers right now in the grain market is corn demand. And obviously, I think Brazil is going to be running out of corn here pretty quickly. We may have seen some new Chinese demand coming in here for corn. But how do you look at – and we have been on competitive, I think just from a currency basis – from everything else. But could you talk a little bit, Juan, about the corn market and how you see the export situation with that particular commodity?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I think you called it well. I think that when we had the low water levels in the Q4 that hurt us, of course, we lost some bean business. But the corn business basically is going to be with us until the crop in Brazil – the harvest in Brazil comes, so it’s like middle of the year. So, we see that as a very strong business in Ag services for North America. We also have, unfortunately, I think Ukraine Grain Association has come up with a statement that they don’t believe corn for ‘23 will exceed 18 million tons, which is a far cry from the 29 million tons or 30 million tons that they used to produce or we expected. So, demand continues to be solid out there. And we still – as a world, we need Brazil to have a good crop. Of course, if there are rains and delay a little bit the harvest of soybeans, that may delay a little bit the planting of the next crop. But we hope that in your farm and everybody’s farm, corn is growing strongly because we need it. And again, the U.S. will be exporting a lot of that from here until probably July."
},
{
"speaker": "Operator",
"text": "The final question today comes from the line of Steve Byrne from Bank of America. Please go ahead. Your line is now open."
},
{
"speaker": "Steve Byrne",
"text": "Yes. Thanks. Just wanted to ask about the press release that was out a couple of days ago about the new biostimulant of ADM released, the data for rating sold. And I know that you do have a business where you work with farmers to provide them fertilizers, etcetera. But I think this seems to be the first time that you are actually rolling out one of your own proprietary products. So, I am just trying to understand a little bit about your strategy here. Will you invest more in products for nutrition and crop protection, especially biologicals? And what do you think is the potential market and actually the earnings potential for ADM?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you for the question. Listen, I think that we continued to enlarge our relationships with customers, but also with farmers. And as we continue to increase our digital engagement with them, we also increased the bartering and exchange of many, many products. And we have a good relationship with farmers. We have the trust of the farmers, and so every now and then, they bring challenges to us. And I think the challenges of biologicals, if you will, given that we have some work in precision fermentation and things like that is, we are always interested in doing that. So, there is always division out there in ADM exploring and extending a little bit our franchises and our engagement. So, I wouldn’t be surprised to see experiments or tests here and there. And we do that a lot. We do that in products at our B2C. We do that in products that are biologicals. We do that in products related to the farmer. And we continue to expand. These are things that, over the years, they turn out into big businesses. At one point in time, we started with destination market and now it’s a big part of our franchise. At one point in time, we started with BioSolutions and now we are making more $0.25 billion of EBITDA on that. At one point in time, we started with the differentiated grain that now we call regen Ag, and now we are in the million acres of that. So, I think it’s just the innovation part of ADM, and you are going to see green shoots at that. I am glad you are paying attention to that. And we are going to see expansion of those things into the future. So, thank you."
},
{
"speaker": "Megan Britt",
"text": "So, with that, I think that was the last question for the call today. I would like to thank you for joining us. Please feel free to following up with me if you have any other questions. Have a good day and thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "This concludes today’s conference call. Thank you all for your participation. You may now disconnect your lines."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 3 | 2,022 | 2022-10-25 09:00:00 | Operator: Good morning, and welcome to the ADM Third Quarter 2022 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s call, Megan Britt, Vice President, Investor Relations for ADM. Ms. Britt, you may begin.
Megan Britt: Thank you, Alex. Good morning, and welcome to ADM’s third quarter earnings webcast. Starting tomorrow, a replay of today’s webcast will be available at adm.com. Please turn to slide 2, the Company’s safe harbor statement, which says that some of our comments and materials constitute forward-looking statement that reflects management’s current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation. To the extent permitted under applicable law, ADM assumes no to update any forward-looking statements as a result of new information or future events. On today’s webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and how we’re continuing to advance our strategy. Our Chief Financial Officer, Vikram Luthar, will review the drivers of our performance as well as corporate results and financial highlights. Then Juan will make some final comments, and he and Vikram will take your questions. Please turn to slide 3. I’ll now turn the call over to Juan.
Juan Luciano: Thank you, Megan. This morning, we reported a strong third quarter adjusted earnings per share of $1.86. Adjusted segment operating profit was $1.6 billion. Our trailing four-quarter adjusted EBITDA approached $6.6 billion, and our trailing four-quarter average adjusted ROIC was 13%. Throughout the quarter, our 40,000 colleagues around the globe continued to deliver on our purpose by supporting the global food system and providing needed nutrition to billions. Global demand for our products remained robust, and our ability to meet customer needs demonstrated our team’s expertise in managing dynamic market conditions as well as the unique benefits of our integrated global value chain and product portfolio. We continue to generate strong cash flows, which support the continued advancement of our strategy, including investments in new capabilities and growth engines across our three businesses and the return of capital to our shareholders. Next slide, please. Even as the team demonstrated superb day-to-day execution in the third quarter, we continued to make great progress on driving our strategic growth priorities. In each of our business segments, we’ve created and are continuing to build new growth engines that are aligned with enduring global trends. As demand for more sustainable produced low carbon intensity products continues to drive growth across our portfolio, our AS&O team signed a groundbreaking long-term strategic agreement with PepsiCo to enroll up to 2 million regenerative agricultural acres over the next 7.5 years. I’ll be talking more about our regen ag efforts in a moment. Sustainability from demand for sustainable package into the ongoing energy transformation supported by policies like the inflation Reduction Act in the U.S. is also driving the evolution of our Carbohydrate Solutions business. In the third quarter, for example, we formally signed two joint ventures with LG Chem for U.S. production of lactic acid and polylactic acid for a variety of applications, including bioplastics. Both sustainability and food security are powering our growth in nutrition, including our continued investment in alternative proteins. In Q3, we advanced several alternative protein enhancements and expansions, including an agreement with Benson Hill for the exclusive rights to process and commercialize a portfolio of proprietary ingredients derived from their ultra-high protein soybeans. Each of these investments is aligned with global trends and each demonstrates how we are advancing new avenues of growth across all three of our business segments. Slide 5, please. Our strategic work remains focused on two pillars: productivity and innovation. As we discussed at our Global Investor Day last December, we are targeting $1.1 billion in benefits from our productivity efforts, which improve our long-term returns profile while helping us mitigate the impact of market forces, including inflation. Strong returns means focusing on both, the numerator and the denominator. That is why around the globe, our team is continuing to identify opportunities to monetize assets and optimize working capital as part of our $1 billion challenge. As of last week, we had realized cash generation in excess of $1 billion from this initiative. On the numerator side, we’re investing in new technologies to enhance our efficiencies. Last quarter, I highlighted the operational transformation of our core facility in Marshall, Minnesota, and discussed how we hope to emulate that success more widely across our production footprint. We are now advancing an ambitious plan to install enhanced automation, more sophisticated control systems and the increased use of analytics and more than 50 production facilities globally with further expansion possible as we evaluate and size the opportunities. These investments will enable us to unlock capacity, improve reliability and enhance safety. We are currently evaluating partners to support us in this important work, which we intend to execute in a phased approach, focusing on 8 to 10 facilities per year. We anticipate investing more than $1 billion over this period, and we expect double-digit returns on this investment as we are seeing in Marshall. We’ll be updating you on our progress towards these goals and other productivity efforts on upcoming calls. Next slide, please. Turning to innovation. Sustainability is driving force both of our purpose and our growth strategy. And one great example is the scaling up of our regenerative agricultural efforts. regen ag practices include cover cropping, improved nutrient management and conservation tillage. The environmental and climate benefits associated with regen ag can include greenhouse gas emissions reductions, increased soil carbon sequestration, water quality improvements and biodiversity promotion. With global scale and a value chain that reaches from 220,000 farmers to customers ranging from multinational CPGs to start-ups, ADM has a unique opportunity to lead in this area. I already mentioned our strategic partnership with PepsiCo, which we believe is truly groundbreaking in its scope and long-term vision. We’re working with other partners as well. For example, in the spring, we announced an agreement with the National Fish and Wildlife Foundation that includes a commitment of $20 million to sign up more regen ag acres. And we’re partnering with Farmers Business Network to make their gradable farm management platform available as a regen ag technology enabler for our North American farmer base. We’ve signed about 750,000 unique regen ag acres in the U.S. so far this year. We expect this number to grow with every passing year. These programs are getting us closer to farmers and closer to our customers. And we anticipate that within the next five years, our annual operating profit impact from this work will reach more than $100 million, while continuing to help lead our industry to a more responsible, sustainable future. While we are on the subject of sustainability, I’m very proud that some of the good work we’ve done in this arena is being recognized. Just yesterday, ADM was included on the Investor’s Business Daily annual list of 100 Best ESG Companies. And in July, Environment and Energy Leader magazine recognized our Illinois-based indicator carbon capture and storage partnership as a top project for energy and environmental management. We posted a new update on our website that details our progress in advancing our Strive 35 goals, including our commitment to reduce our Scope 3 greenhouse gas emissions 25% by 2035. And because Strive 35 isn’t the end of our sustainability journey, that update includes our aspiration to work towards net zero emissions by 2050. We’ll have more to say about this as we continue to evaluate and develop our path forward. Now, I would like to turn the call over to Vikram to talk about our business performance. Vikram?
Vikram Luthar: Thanks, Juan. Slide 7, please. The Ag Services and Oilseeds team delivered substantially higher year-over-year results. Ag Services results were significantly higher than the third quarter of 2021. The short crops in South America supported U.S. exports, driving improved volumes and margins in North American origination, which had significant negative impacts from Hurricane Ida in the prior year. Better margins in global ocean freight, driven by good execution amid dynamic global trade flows, powered better results in global trade. South American origination saw improved volumes and margins driven by increased farmer selling in addition to higher volumes through our export facilities. Crushing results were significantly higher with margins driven by resilient global demand for both meal and oil. Strong rapeseed margins in EMEA, driven by robust oil demand and continued market dislocations along with positive impacts from an insurance settlement helped drive improved results. North American soy crush margins continued to benefit from renewable diesel demand. Also, net positive timing effects in the quarter were about $175 million as compared to the approximately $70 million in the prior year quarter. Positive results were partially offset by lower crush volumes, including impacts from idle facilities in Ukraine and Paraguay. Refined products and other results were higher year-over-year in a strong margin environment for both refined oil and biodiesel. Robust performance in global refined oils was driven by healthy demand and elevated refined oil margins amid supply chain disruptions. Equity earnings from Wilmar were much higher versus the third quarter of 2021. Looking ahead to Q4, we expect AS&O to deliver much better results in the fourth quarter of 2021. We expect continued strength in crush margins to more than offset the adverse impact of low water conditions on U.S. export volumes. Slide 8, please. The Carbohydrate Solutions team delivered significantly higher results versus the prior year quarter. The Starches and Sweeteners subsegment, which includes ethanol production from our wet mills, delivered much improved year-over-year results amid steady global demand for sweeteners and starches. Corn co-products, including continued robust demand for corn oil as well as effective risk management drove higher execution margins in North America. Wheat milling had a strong performance, delivering improved volumes and margins to meet healthy demand for flower. In EMEA, the business delivered solid volumes and margins and managed through a dynamic energy environment to drive stronger results. Our BioSolutions platform continued its upward trajectory with 29% year-over-year revenue growth year-to-date. Vantage Corn Processors results were substantially lower. Ethanol margins were pressured by higher industry inventories, lower domestic demand and elevated corn costs. In addition, the prior year’s results included contributions from the now sold Peoria facility. Looking ahead, we expect the fourth quarter of this year for Carbohydrate Solutions to be significantly lower than the fourth quarter of last year. Demand and margins for sweeteners, starches and flower should remain healthy, but ethanol margins are expected to be substantially lower than last year’s historic highs. On slide 9, the Nutrition business continued to outpace the industry with Q3 revenue growth of 10% on a reported basis and 16% on a constant currency basis. Third quarter adjusted operating profit was similar to last year and 7% higher on a constant currency basis. Profit was impacted in the quarter by the significant strengthening of the U.S. dollar and demand fulfillment challenges as the rapid growth in customer demand exceeded our operational capacity. We are prioritizing unlocking capacity in the face of some persistent supply chain bottlenecks. Our year-to-date performance remains very strong, including 20% revenue and 19% OP growth on a constant currency basis. And our portfolio of acquisitions from 2021 continues to deliver OP above our acquisition models. In this quarter, Human Nutrition results were higher than the third quarter of 2021. We strong demand for plant-based proteins as well as solid performance in texturants drove continued growth in specialty ingredients. Flavors results were impacted by adverse currency translation effects in EMEA, partially offset by continued strong demand growth in the region. Demand fulfillment challenges in North America and lower demand in APAC, driven partly by the lockdowns in China also negatively impacted results. Health and Wellness was lower versus the prior year, which included higher income from the fiber fermentation agreement. Animal Nutrition results were down versus the prior year quarter. Pet results were lower in Latin America on lower volumes, partially offset by strong volumes and margins in North America. Softer animal protein demand affected feed volumes. Looking ahead, we expect the fourth quarter for Nutrition this year to be higher than the fourth quarter of 2021 with continued strong demand in human nutrition more than offsetting adverse currency effects. We expect Nutrition’s full year OP growth to be between 15% and 20% on a constant currency basis. Slide 10, please. Other business results increased from the prior year quarter. Higher short-term interest rates drove improved earnings in ADM Investor Services, partially offset by increased claim settlements in captive insurance. In the corporate lines, unallocated corporate costs of $251 million were higher year-over-year due primarily to performance-related compensation accruals, higher IT operating and project-related costs and higher costs in the Company’s centers of excellence. Other Corporate was favorable versus the prior year, primarily due to higher results from foreign currency-related hedge activity. Net interest expense for the quarter increased year-over-year on higher interest rates. The effective tax rate for the third quarter of 2022 was approximately 16%. We still project full year corporate costs to be about $1.3 billion, and we still expect our adjusted tax rate to remain in the range of 16% to 19%. Next slide, please. Year-to-date, operating cash flows, before working capital of $4.7 billion, are up significantly versus $3.1 billion over the same period last year. Our net debt to total capital ratio is about 24%, and we have available liquidity of about $11.2 billion. We are continuing to invest in the business with $841 million in capital expenditures and have returned capital to shareholders with $677 million in dividends and $1.2 billion in share repurchases through the third quarter, which reflects the completion of the $1 billion stock buyback announced last quarter. And with enhanced financial flexibility and in line with our balanced capital allocation framework, we plan to repurchase an additional $1 billion of shares by the end of 2023, subject to other strategic uses of capital. Juan?
Juan Luciano: Thank you, Vikram. Slide 12, please. So to recap, our team delivered another outstanding quarter. And thanks to our execution and the advancement of our strategy, we are well positioned to end 2022 strong. Last quarter, we said we were expecting full year earnings higher than $6.50 per share. Based on where we are today, we now clearly expect to exceed $7 per share. Looking ahead, there are several externalities that we are monitoring going into 2023. We anticipate ongoing resilient demand for our products, a strong crush margin environment, a positive outlook for starches and sweeteners, and a continuation of our growth trajectory in Nutrition. There is also significant uncertainty in the global economy and geopolitical environment. We expect to carry our strong momentum into the first quarter of 2022. And beyond that, we are confident that our scenario planning and execution will give us the ability to effectively manage through a dynamic environment. We’re also going to continue to benefit from our strategic work, and we’ll continue to deliver on those priorities throughout 2023. We’ll advance productivity initiatives to improve operations and processes, optimize costs and enhance efficiencies. We’ll drive innovation, expanding and creating new growth engines across our entire business portfolio, Ag Services and Oilseeds, Carbohydrate Solutions and Nutrition. And we’ll advance those strategic objectives as we always have, alongside our team’s exceptional day-to-day execution, delivering for our colleagues, consumers, customers and stakeholders. With that, operator, please open the line for questions.
Operator: Thank you. [Operator Instructions] Our first question for today comes from Ben Bienvenu from Stephens Inc.
Ben Bienvenu: I want to ask about your process volumes in the quarter. You cited lower crush volume utilization in Ukraine as well as Paraguay. Could you talk a little bit about what you expect your go-forward process volumes to look like? And is the lion’s share of the decline in oilseeds processed year-over-year, that 10% decline, is that from those two regions? Were there any other contributing factors?
Juan Luciano: Yes. Thank you, Ben. Yes, as you noted, we had lower volumes, and part of that were coming from Europe in soil and rape. We had some adverse weather and some logistical constraints in Europe in terms of navigation, some of the rivers. We also have a reduction in South America, in soy crush because of Paraguay shutdown, mostly because of lack of beans. We had also some reductions in North America due to canola seed availability. And certainly, we have our Ukraine sun crush facility down, as you know, since last March. So, we have 850 facilities around the world, as you know. And we deal with logistics, with adverse weather with manpower issues like every company out there. So, that what was the decline in volumes at this point in time. As some of those one-off issues subside, I mean, we will see those volumes coming back to normal rates.
Operator: Thank you. Our next question comes from Ben Theurer of Barclays.
Ben Theurer: Juan, Vikram, congrats on the results. I wanted to follow up on Nutrition. As you’ve talked about some of the logistics bottlenecks that you plan to overcome, could you elaborate a little more in detail those issues are and what you may have to do in terms of investments to get this right. And then also aligned with that, what is actually your kind of FX assumption because you stretched the constant currency terms commentary on the outlook for the fourth quarter. So, just to understand a little bit the regional breakdown as well and what FX headwinds we should expect into the short-term period, just given the euro weakness. Thank you.
Juan Luciano: Yes. Thank you, Ben. Listen, as Vikram mentioned in his commentary, we are exceptionally proud of how the team is generating demand, how our value proposition in Nutrition continues to resonate and attract customers. Our pipeline has never been bigger and our growth rates continue to be -- our winning rates continue to be off the chart. So, the problem with that is that it catches up with your production pretty quickly. And although we have plans to expand those, some of the supply chain issues in delivery equipment and all that, sometimes don’t play exactly in our favor. When you look at where specifically those issues have impacted us the most, it has been in flavors, I would say, and mostly in North America, but some of that in Europe. On the other hand, the facility that we inaugurated last year, Pinghu in China has suffered from lack of volumes because of the lockdowns due to COVID restrictions in China. So, I would say, we had a little bit upset in the sense that we couldn’t bring all that demand that we have generated into the P&L. And certainly, those things are, to a certain degree, now under control. And as you can imagine, everybody in the Company is driving very hard to bring extra capacity. As you know, on the last quarter or a couple of quarters ago, we bought FISA precisely to alleviate a little bit that. Of course, we’re using contract manufacturing. So, we are pulling everything. But in a very tight environment with also some shifting of demand based on consumer demand, customers are shifting some of that demand, our ability to react promptly to that given the high growth rates caught up with us in the quarter. There is a lot of capacity coming for next year. So first of all, all this is an upside for next year. Hopefully, we’re going to be able to fulfill all that demand next year. But there is also expansions. If you think about -- we have a new line in soya protein, we also have the Biopolis expansion in Valencia. We have PetDine expansion coming up. So, the business is -- has a long list of organic growth capacity that will come to help next year. But again, it’s all the problem of maybe a strong successful sales and marketing organization, driving double-digit growth rates.
Vikram Luthar: Yes. And Ben, on the FX side, just a reminder for everyone, right. In 2020, we grew operating profit 37%, in 2021 nutrition profit was 20%. If you look at the FX over that two-year period, it was almost flat, went up one year, went down the other year. But the European part of our business, EMEA, and we referenced this in our Global Investor Day, the revenue contribution from Europe is about 40% of the Human Nutrition side and about 20% on the Animal Nutrition side, and that’s getting bigger because of the event. So consequently, given the profitability there and the significant move in the dollar this year, we thought it was appropriate to highlight the growth on a like-for-like basis, which basically means on a constant currency basis. So, it’s a significant strengthening of the dollar. That basically called this out and the underlying growth in the European region.
Operator: Our next question comes from Adam Samuelson from Goldman Sachs.
Juan Luciano: Alex, maybe we skip to the next question. Maybe, Alan, come back later.
Operator: We will move on. Our next question comes from Tom Palmer of JP Morgan.
Tom Palmer: I wanted to ask on the barge delays on the Mississippi River. Does this have much effect on your business as we look towards the fourth quarter? Is it -- if there is impact, should we mainly think about it being in Ag Services, or just given the diversity of your business, are there offsets to consider?
Juan Luciano: Yes. Of course, we have an unprecedented situation and especially in the Lower Mississippi River that will reduce the volume of exports for Ag Services North America. As it’s going to be a negative impact in Ag Services North America, of course, that -- part of that is because of soy and we’re going to lose that volume. In the corn side, we’re probably going to extend the window of exports from North America into the first quarter. So part of the offset is you’re going to see that in the first quarter. I think also part of the offset is South America will be able to export more. We are a large exporter in South America, of course, and you’re going to see that. And then normally, what we noticed or we expect to happen because we’ve seen it before, is when you export less from North America, where destination marketing sometimes get a little bit of a pop in margins, the products and destination become naturally more valuable, if you will. That was part of the original strategy of going into destination marketing. And then, the other impact is that as beans are not exported that matters not that much demand, local values come down, local bases come down and that may be a boost for crush that you may be able to crush lower-priced beans or maybe eventually lower-priced corn for Carbohydrate Solutions. So, we see some puts and takes. So probably negative for North America Ag Services and Oilseeds, maybe neutral for Ag Services and positive overall maybe for the whole.
Operator: Our next question comes from Ken Zaslow from Bank of Montreal.
Ken Zaslow: Just a couple of questions. One is, can you give a little bit more color on Ag Services and Oilseeds outlook as well as carb guidance? I know you said significantly up and significantly lower, some parameters to that? And then, can you also talk about your nutrition outlook, if your supply chain gets repaired, demand is there, do you think that your long-term growth algorithm is intact? And I’ll leave it there, and I appreciate your time, as always.
Juan Luciano: Thank you, Ken. Yes, let me address maybe the outlook of Ag Services and Oilseeds, Q4. So, first of all, very dynamic environment, but very positive environment. The teams continue to manage exceptionally well. And demand continues to be very robust. So, as we go forward, Q4 again in Ag Services, I was mentioning, maybe a little bit lower for North American exports, but that will be offset for other things that I explained in the question before. So, we still expect significantly better results in the Q4, barring any big mark-to-market, that’s our expectation at this point in time. Crush margins continue to strengthen. That’s on the strength of feeding animals around the world, but also on the extra demand for oil from all the renewable green diesel or biodiesel around the world. We expect continued strength in global trade and destination market. And as I explained before, I would say the business at this point in time is hitting in all cylinders. So, I would say, the 3 parts of the business will be very robust into bigger than last year, certainly. Maybe Vikram can give a little bit of an update on the other two.
Vikram Luthar: Yes. So on Carbohydrate Solutions, you’re right, we did say significantly lower. But if you look at the two independent parts, S&S, sweeteners and starches, we continue to expect that to be strong. We’re seeing robust volumes and margins with obviously, the corn oil benefits we are seeing. So net corn costs are attractive as well as margins continue to be attractive. The issue is on ethanol. Lastly, if you remember, we actually had $1-plus ethanol margins. This year, we clearly do not anticipate margins to be that high. We still expect to be healthy given continued strong gasoline demand, the discount that ethanol has versus RBOB as well as the reasonable inventory levels. So, it’s really the ethanol side that is going to drive the significantly lower performance in Carbohydrate Solutions Q4 to Q4. On the nutrition side, yes, as Juan said, we are working and prioritizing unlocking capacity. We anticipate much of that to get unlocked over the course of 2023. And on a constant currency basis, we continue to expect growth going forward to be in that 15-plus-percent range. It’s important to highlight constant currency because that part of the business in Europe, as I mentioned, is becoming bigger and bigger. And that’s clearly -- and currency is not something we can control and important therefore for us to call that out.
Operator: Our next question comes from Steven Haynes of Morgan Stanley.
Steven Haynes: I just wanted to ask on the Brazil-China corn export agreement and see if you could get a little bit of color on any impact you think you’ll see in your businesses? And if you can just kind of remind us of how big your export origination footprint is in Brazil versus North America? Thank you.
Juan Luciano: Yes. Good morning. So first thing you need to understand is we are living in a very tight global corn environment. So, if you put yourself in the foot of China, China finds itself with lower production, lower domestic production of corn with certainly higher feed demand lower barley and sorghum imports. So naturally, it will have to import more corn. So in my mind, they are just building origin optionality. Again, you have still the La Niña effect in Argentina. So they are planting less corn there. Certainly, our last check up here, yields for corn in North America were going to be lower. And of course, there’s always the uncertainty of Ukraine ability to export. So I think that from a Chinese perspective, this is nothing more than just risk management and expanding open up another optionality. Of course, we are a large exporter from South America as well. We have a very robust Ag Services business in Brazil. And I remind you, we are the largest exporter of corn from Argentina. So, as always, we will offer Black Sea, we will offer North America, we will offer Brazil, and we will offer Argentine origins to China. So, as long as demand remains tight, we will see a lot of activity within the trade flow because naturally people want optionality, so.
Operator: Thank you. Our next question comes from Rob Dickerson of Jefferies.
Rob Dickerson: I guess, just first question, kind of a broad question. There are a number of times you said in the commentary upfront that should be ongoing momentum kind of going into 2023, and it sounds like more specifically kind of in Q1. If we think about just kind of the general macro backdrop, right, all the tailwinds that are benefiting the business, and maybe this is a little dumb down for some, but not for me. Maybe you could just kind of touch on what could be some drivers that could loosen the overall tightness in the supply chain as we get through next year? Then I have a follow-up.
Juan Luciano: Okay. So, let me talk a little bit. As I said, we are finishing a very strong 2022, and that will get us into a strong -- with good momentum into 2023. What are the things that we are seeing because of course, I mean, it’s difficult place to prognosticate these days. But we anticipate ongoing resilient demand for our products. We have not seen, maybe with the exceptions of some tiny businesses in Animal Nutrition. We have not seen a deceleration of demand across ADM at this point in time. We foresee also a strong crush margin environment based on the two legs. We have a strong pork and poultry feeding demand across the world. And we see tight soybean oil stocks and RGD and biodiesel demand that continues to be strong and growing. We see, as Vikram expressed before, a positive outlook for starches and sweeteners. We have finished some of our contracting, and we see the volume, and we see the margins holding or slightly expanding there. And we see a continuation of our growth trajectory in Nutrition. When I talk about the pipeline, that’s the business in which we have the biggest visibility into the future because these are projects that, barring any supply issues, we will bring to the P&L. So, I would say that is what gives us some positive momentum or positive expectations for ‘23. You have to remember also that we dealt with a lot of weather issues, logistical issues, whether it is the river, whether there is hurricanes -- many issues. And we had, as I explained before, some manufacturing volumes impact here and there. We expect that all to be corrected and to be potentially a plus into next year. And as I explained in the Nutrition question, we have new capacity coming on stream. We have -- we are expanding Biopolis probiotics capacity by a factor of 5. We are bringing a new line for plant-based proteins in soya protein. We are expanding our PetDine capacity. So, we are bringing a lot of new capacity to bear because we have the pipeline to actually transfer them into profit. So, from what we can see here, and again, in a very uncertain world, is we have good -- very good momentum going into 2023.
Operator: Thank you. Our next question comes from Steve Byrne of Bank of America.
Steve Byrne: Yes. Thank you. I’d like to better understand this regenerative ag outlook you have for $100 million of operating profit in five years. Would it be reasonable to assume that that’s roughly 10 million acres of $10 an acre operating profit? Is that kind of where you’re thinking? And maybe more broadly, do you see the value here more on generating grain that has been produced in some kind of sustainable way i.e., that a CPG customer of yours would be willing to pay a premium for that grain? Or do you see this as really the generation of carbon credits that could be sold on various exchanges? I welcome your thoughts on that.
Juan Luciano: Yes. Thank you. Very good question and something that is very close to our heart and tied to our strategy. The Regen Ag programs and acres are certainly in high demand. We have made public one announcement, but we have been working on what we call the differentiated bushel, if you will, for like three or four years already. And ADM naturally sits in a unique place in the value chain, and we have the global scale to drive improvements in agriculture, and we have the ability to tie both the farmer with the CPG companies, and so this is a privileged position. We are working very hard to simplify the process for the farmer. And as you described, there are many ways to potentially create value here. When we thought about the differentiated bushel, one is as you described, eventually, and we’re seeing more evidence of that, there’s going to be a premium price for bushels that are grown or metric tons that are grown in a certain way. And I think that the whole society is looking for that. It’s looking for agriculture to actually do their part in creating a more sustainable world. One is that. The second, and that’s where we’re working with FBN, with Gradable and all that, is to simplify the collection of data and all that in the preparation, we’re working with the government on that, on the protocols to be able to have carbon offsets or carbon credits based on that. So, it’s a little bit of both. The economics that you described are not as simple as $10 per ton or whatever. But to a certain degree, that they are also not that much more complicated than that. We just have a portfolio of different accounts and different contracts, and they’re all slightly different, but it is conceptually aligned to what you described is converting more acres, it’s signing more acres. That’s where we leverage the relationship we have with farmers globally. ADM has 220,000 farmers portfolio in the world that we are engaged in discussing this. Of course, the customer -- the farmers will embrace these as they see more demand for this. That’s why it’s important to have the CPG companies aligned to this. And that’s why we make these agreements because, of course, the farmer will generate the production in order to satisfy the demand. So, both lines need to grow together. So again, I think we are just leveraging our incredible farmer network and the desire of CPG companies and consumer in general, to see bushels or metric tons grown in a differentiated way. So, we’re very excited about the future of this.
Operator: Thank you. Our next question comes from Eric Larson of Seaport Research Partners.
Eric Larson: Congratulations on a good quarter, everyone. So, the question I have is -- and thank you for all your regen comments, Juan, it’s pretty dear to our heart to result. I’m looking forward to even having more discussions on that. The question I would have this morning is, could you give us a little more detail on the situation in Ukraine? What you folks are seeing? We’re hearing that there are only plant -- only able to plant enough winter wheat this year to even meet kind of their own domestic needs for next year? It seems that maybe Ukraine is going to be an even smaller contributor to global exports, both on the oil season and grains next year. I guess, it’s just hard to get all the information put together. Could you just share some thoughts on what you see developing in that region of the world?
Juan Luciano: Yes. Thank you, Eric. And also, it gives me an opportunity to emphasize the message we sent to our employees in Ukraine to -- for strength and ADM is doing everything possible to make their lives as bearable as possible through all these. And hopefully, one day, we will be talking about the rebuilding of Ukraine and all of them coming back to their land. So listen, we’ve been involved. As you know, we have more than 650 employees. So, we’ve been deeply involved in that. A vast majority of them are in their jobs, in their positions right now. So we’ve been able to export from Ukraine and the industry has worked together with governments and through this corridor agreement, we’ve been able to, in September, to reach the same level of exports almost that Ukraine used to have last year, so about 7 million tons. October, starting with a little bit more of wrinkles, if you will. We are having an issue, which is this joint group that is supposed to inspect the vessels have been a little bit overwhelmed by the number of vessels that we have. So they are adding more people to that group in order to continue to move material. We need to move material. There are like 100 vessels, give or take, in a queue right now. We need to take that material out because storage in Ukraine is becoming full. And then, there’s going to be a harvest and we need to be able to use that storage to harvest the material and to store the material there. So, my point to all this is dynamic. This continues to be a very dynamic environment. Certainly, there are still shelling in the area sometimes, hitting some of the soybean oil, sunseed oil tanks, if you will. So, this is not an easy area. In the middle of that, of course, Ukraine is trying to plant, as you described, difficult to judge a number. I mean, our estimate is that maybe 30% less, but it’s difficult to make the calculation because some territory are now claimed to be in Russian control. So, it’s difficult for us to know even when data are put together, if you will, if that counts with the planting in that Russian controlled territory or not. So, I would say, it’s a little bit difficult to make prognostications. So wheat, thankfully, Australia has a good crop. It has rained a lot in Australia. So, that’s a positive of the La Niña. Hopefully we stop now with the rain because they need to harvest and we don’t want damage into the harvest. India also has declared there are some inventories and can come to the world to help. Corn situation, certainly more difficult maybe. There is a strong demand. We are in coarse grains in the tightest inventories in the world that we have in seven years. So I think that will be complicated. As I said, Argentina has planted like 10% of the first corn because of incredible drought there. So, I think that at this point in time, the U.S. will be a big supplier of corn for the world. On sun oil, I think the world adjusts a little bit more to present in different blends of different oils. But of course, the oil environment is tight because of all the renewable green diesel and biodiesel. So I would say maybe wheat is a little bit better, but corn and sun oil will be difficult if we stop with the corridor. So hopefully, now November 19, the corridor gets extended. And everything we hear at this point in time, there may be an objection here or there, but nothing significant that could derail this. So we are still counting that the corridor will continue to function, hopefully, with a little bit more efficiency as we appoint more inspectors on with the joint committee.
Operator: Next question comes from Robert Moskow of Credit Suisse.
Robert Moskow: I was hoping you could give a little more color on the outsized performance in Ag Services in the quarter. I mean, this is the strongest third quarter I think I’ve seen from ADM in many years. And it’s not what I would have expected given the challenges on the Mississippi River. So, of these factors that you mentioned, the short crop in South America, the better margins in ocean freight, can you give us kind of some sizing as to what were the biggest factors for the outperformance? And also, was there any kind of positioning benefit from your -- from how you hedged your grain in the quarter?
Juan Luciano: Yes. So, it was a great performance, as you described, very proud of the team. Traditionally, our Q3s have lower volumes because we are getting out of the end of the season and waiting for the next harvest. What happened this time is I think given the short South American crop, we’ve been able to move more volumes, especially exports in North America. Exports were down Q3 to Q2, but not down as much as maybe you see in other years. The same has been a little bit for origination volumes. And when exports go, we have benefits in our transportation businesses, our barges and all that. Also, do not forget, it’s not just North America, but it’s also the global nature. The global trades have done a spectacular performance. And I think we have benefits in ocean freight. It was a very good quarter from that perspective, and also destination market. In destination market that we started four or five years ago, I don’t remember exactly, has continued to grow volumes and expanding margins. So that, I would say, is what created this great Ag Services in Q3. So, great performance by the team.
Operator: Thank you. Our final question is from Adam Samuelson from Goldman Sachs.
Adam Samuelson: So, a lot of ground has been covered today. I wanted to maybe come to capital allocation on the balance sheet. And first, just to clarify on repurchase because you did a very sizable amount of buybacks in the third quarter. The incremental $1 billion was over the next five quarters. Did I understand that right from the earlier comments? And then just more broadly, Juan, Vikram, any way to frame CapEx over the -- into 2023 kind of -- you got a lot of capacity actions underway. Just help frame kind of the internal investments. And relatedly, help us think about maybe the M&A optionality in the current marketplace, especially with rising interest rates that might put some more working capital strain on smaller players in the market? Thank you.
Vikram Luthar: Yes. Adam, thanks for the question. So, in terms of the share buybacks, yes, we -- as you rightly noted, we did execute the entire $1 since we announced it in -- the buyback in Q2. Looking forward, you’re right, in terms of the additional buyback, that is anticipated to be completed over the next five quarters through the end of 2023. But I also want to emphasize, partially getting to one of your questions that we see a rich pipeline of opportunities even on the M&A side. And it is, as always, our responsibility to continue evaluating that. And if we find the right acquisition with the right set of capabilities at the right price, absolutely, we would divert potential capital to that in lieu of buybacks. But absent that, we anticipate to complete this by the end of 2023. In terms of CapEx, we had signaled about $1.3 billion for this year. We remain on track to be around that, maybe slightly under. And we anticipate that similar level of spend to continue over the next couple of years as well, given the significant need for adding capacity as Juan mentioned, but also some of the additional high-return projects we see on the horizon, such as the analytics and digital automation of our facilities. So, we see rich opportunities to reinvest in the business as well as potentially explore more M&A. One other point that’s very important to highlight, and this really underscores our emphasis on driving returns, which is not just focusing on the profitability but also on the asset, on the denominator is a $1 billion challenge. Even in the face of this outstanding performance this year, the teams are rigorously focused on reducing the assets deployed to produce that profit. And the $1 billion challenge, we actually anticipated to -- we’ve actually got -- we’ve got cash in hand as of last week of $1 billion, as Juan noted. So, I think it’s important to note that we are very focused on driving returns and hence that 13% that we are very proud of we achieved in 3Q. So, I’ll pause there.
Operator: Thank you. We have no further questions for today. So, I’ll hand back to Megan Britt for any further remarks.
Megan Britt: Thank you for joining us today. Please feel free to follow up with me if you have any other questions. Have a good day, and thanks for your time and interest in ADM.
Operator: Thank you for joining today’s call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the ADM Third Quarter 2022 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today’s call, Megan Britt, Vice President, Investor Relations for ADM. Ms. Britt, you may begin."
},
{
"speaker": "Megan Britt",
"text": "Thank you, Alex. Good morning, and welcome to ADM’s third quarter earnings webcast. Starting tomorrow, a replay of today’s webcast will be available at adm.com. Please turn to slide 2, the Company’s safe harbor statement, which says that some of our comments and materials constitute forward-looking statement that reflects management’s current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation. To the extent permitted under applicable law, ADM assumes no to update any forward-looking statements as a result of new information or future events. On today’s webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and how we’re continuing to advance our strategy. Our Chief Financial Officer, Vikram Luthar, will review the drivers of our performance as well as corporate results and financial highlights. Then Juan will make some final comments, and he and Vikram will take your questions. Please turn to slide 3. I’ll now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Megan. This morning, we reported a strong third quarter adjusted earnings per share of $1.86. Adjusted segment operating profit was $1.6 billion. Our trailing four-quarter adjusted EBITDA approached $6.6 billion, and our trailing four-quarter average adjusted ROIC was 13%. Throughout the quarter, our 40,000 colleagues around the globe continued to deliver on our purpose by supporting the global food system and providing needed nutrition to billions. Global demand for our products remained robust, and our ability to meet customer needs demonstrated our team’s expertise in managing dynamic market conditions as well as the unique benefits of our integrated global value chain and product portfolio. We continue to generate strong cash flows, which support the continued advancement of our strategy, including investments in new capabilities and growth engines across our three businesses and the return of capital to our shareholders. Next slide, please. Even as the team demonstrated superb day-to-day execution in the third quarter, we continued to make great progress on driving our strategic growth priorities. In each of our business segments, we’ve created and are continuing to build new growth engines that are aligned with enduring global trends. As demand for more sustainable produced low carbon intensity products continues to drive growth across our portfolio, our AS&O team signed a groundbreaking long-term strategic agreement with PepsiCo to enroll up to 2 million regenerative agricultural acres over the next 7.5 years. I’ll be talking more about our regen ag efforts in a moment. Sustainability from demand for sustainable package into the ongoing energy transformation supported by policies like the inflation Reduction Act in the U.S. is also driving the evolution of our Carbohydrate Solutions business. In the third quarter, for example, we formally signed two joint ventures with LG Chem for U.S. production of lactic acid and polylactic acid for a variety of applications, including bioplastics. Both sustainability and food security are powering our growth in nutrition, including our continued investment in alternative proteins. In Q3, we advanced several alternative protein enhancements and expansions, including an agreement with Benson Hill for the exclusive rights to process and commercialize a portfolio of proprietary ingredients derived from their ultra-high protein soybeans. Each of these investments is aligned with global trends and each demonstrates how we are advancing new avenues of growth across all three of our business segments. Slide 5, please. Our strategic work remains focused on two pillars: productivity and innovation. As we discussed at our Global Investor Day last December, we are targeting $1.1 billion in benefits from our productivity efforts, which improve our long-term returns profile while helping us mitigate the impact of market forces, including inflation. Strong returns means focusing on both, the numerator and the denominator. That is why around the globe, our team is continuing to identify opportunities to monetize assets and optimize working capital as part of our $1 billion challenge. As of last week, we had realized cash generation in excess of $1 billion from this initiative. On the numerator side, we’re investing in new technologies to enhance our efficiencies. Last quarter, I highlighted the operational transformation of our core facility in Marshall, Minnesota, and discussed how we hope to emulate that success more widely across our production footprint. We are now advancing an ambitious plan to install enhanced automation, more sophisticated control systems and the increased use of analytics and more than 50 production facilities globally with further expansion possible as we evaluate and size the opportunities. These investments will enable us to unlock capacity, improve reliability and enhance safety. We are currently evaluating partners to support us in this important work, which we intend to execute in a phased approach, focusing on 8 to 10 facilities per year. We anticipate investing more than $1 billion over this period, and we expect double-digit returns on this investment as we are seeing in Marshall. We’ll be updating you on our progress towards these goals and other productivity efforts on upcoming calls. Next slide, please. Turning to innovation. Sustainability is driving force both of our purpose and our growth strategy. And one great example is the scaling up of our regenerative agricultural efforts. regen ag practices include cover cropping, improved nutrient management and conservation tillage. The environmental and climate benefits associated with regen ag can include greenhouse gas emissions reductions, increased soil carbon sequestration, water quality improvements and biodiversity promotion. With global scale and a value chain that reaches from 220,000 farmers to customers ranging from multinational CPGs to start-ups, ADM has a unique opportunity to lead in this area. I already mentioned our strategic partnership with PepsiCo, which we believe is truly groundbreaking in its scope and long-term vision. We’re working with other partners as well. For example, in the spring, we announced an agreement with the National Fish and Wildlife Foundation that includes a commitment of $20 million to sign up more regen ag acres. And we’re partnering with Farmers Business Network to make their gradable farm management platform available as a regen ag technology enabler for our North American farmer base. We’ve signed about 750,000 unique regen ag acres in the U.S. so far this year. We expect this number to grow with every passing year. These programs are getting us closer to farmers and closer to our customers. And we anticipate that within the next five years, our annual operating profit impact from this work will reach more than $100 million, while continuing to help lead our industry to a more responsible, sustainable future. While we are on the subject of sustainability, I’m very proud that some of the good work we’ve done in this arena is being recognized. Just yesterday, ADM was included on the Investor’s Business Daily annual list of 100 Best ESG Companies. And in July, Environment and Energy Leader magazine recognized our Illinois-based indicator carbon capture and storage partnership as a top project for energy and environmental management. We posted a new update on our website that details our progress in advancing our Strive 35 goals, including our commitment to reduce our Scope 3 greenhouse gas emissions 25% by 2035. And because Strive 35 isn’t the end of our sustainability journey, that update includes our aspiration to work towards net zero emissions by 2050. We’ll have more to say about this as we continue to evaluate and develop our path forward. Now, I would like to turn the call over to Vikram to talk about our business performance. Vikram?"
},
{
"speaker": "Vikram Luthar",
"text": "Thanks, Juan. Slide 7, please. The Ag Services and Oilseeds team delivered substantially higher year-over-year results. Ag Services results were significantly higher than the third quarter of 2021. The short crops in South America supported U.S. exports, driving improved volumes and margins in North American origination, which had significant negative impacts from Hurricane Ida in the prior year. Better margins in global ocean freight, driven by good execution amid dynamic global trade flows, powered better results in global trade. South American origination saw improved volumes and margins driven by increased farmer selling in addition to higher volumes through our export facilities. Crushing results were significantly higher with margins driven by resilient global demand for both meal and oil. Strong rapeseed margins in EMEA, driven by robust oil demand and continued market dislocations along with positive impacts from an insurance settlement helped drive improved results. North American soy crush margins continued to benefit from renewable diesel demand. Also, net positive timing effects in the quarter were about $175 million as compared to the approximately $70 million in the prior year quarter. Positive results were partially offset by lower crush volumes, including impacts from idle facilities in Ukraine and Paraguay. Refined products and other results were higher year-over-year in a strong margin environment for both refined oil and biodiesel. Robust performance in global refined oils was driven by healthy demand and elevated refined oil margins amid supply chain disruptions. Equity earnings from Wilmar were much higher versus the third quarter of 2021. Looking ahead to Q4, we expect AS&O to deliver much better results in the fourth quarter of 2021. We expect continued strength in crush margins to more than offset the adverse impact of low water conditions on U.S. export volumes. Slide 8, please. The Carbohydrate Solutions team delivered significantly higher results versus the prior year quarter. The Starches and Sweeteners subsegment, which includes ethanol production from our wet mills, delivered much improved year-over-year results amid steady global demand for sweeteners and starches. Corn co-products, including continued robust demand for corn oil as well as effective risk management drove higher execution margins in North America. Wheat milling had a strong performance, delivering improved volumes and margins to meet healthy demand for flower. In EMEA, the business delivered solid volumes and margins and managed through a dynamic energy environment to drive stronger results. Our BioSolutions platform continued its upward trajectory with 29% year-over-year revenue growth year-to-date. Vantage Corn Processors results were substantially lower. Ethanol margins were pressured by higher industry inventories, lower domestic demand and elevated corn costs. In addition, the prior year’s results included contributions from the now sold Peoria facility. Looking ahead, we expect the fourth quarter of this year for Carbohydrate Solutions to be significantly lower than the fourth quarter of last year. Demand and margins for sweeteners, starches and flower should remain healthy, but ethanol margins are expected to be substantially lower than last year’s historic highs. On slide 9, the Nutrition business continued to outpace the industry with Q3 revenue growth of 10% on a reported basis and 16% on a constant currency basis. Third quarter adjusted operating profit was similar to last year and 7% higher on a constant currency basis. Profit was impacted in the quarter by the significant strengthening of the U.S. dollar and demand fulfillment challenges as the rapid growth in customer demand exceeded our operational capacity. We are prioritizing unlocking capacity in the face of some persistent supply chain bottlenecks. Our year-to-date performance remains very strong, including 20% revenue and 19% OP growth on a constant currency basis. And our portfolio of acquisitions from 2021 continues to deliver OP above our acquisition models. In this quarter, Human Nutrition results were higher than the third quarter of 2021. We strong demand for plant-based proteins as well as solid performance in texturants drove continued growth in specialty ingredients. Flavors results were impacted by adverse currency translation effects in EMEA, partially offset by continued strong demand growth in the region. Demand fulfillment challenges in North America and lower demand in APAC, driven partly by the lockdowns in China also negatively impacted results. Health and Wellness was lower versus the prior year, which included higher income from the fiber fermentation agreement. Animal Nutrition results were down versus the prior year quarter. Pet results were lower in Latin America on lower volumes, partially offset by strong volumes and margins in North America. Softer animal protein demand affected feed volumes. Looking ahead, we expect the fourth quarter for Nutrition this year to be higher than the fourth quarter of 2021 with continued strong demand in human nutrition more than offsetting adverse currency effects. We expect Nutrition’s full year OP growth to be between 15% and 20% on a constant currency basis. Slide 10, please. Other business results increased from the prior year quarter. Higher short-term interest rates drove improved earnings in ADM Investor Services, partially offset by increased claim settlements in captive insurance. In the corporate lines, unallocated corporate costs of $251 million were higher year-over-year due primarily to performance-related compensation accruals, higher IT operating and project-related costs and higher costs in the Company’s centers of excellence. Other Corporate was favorable versus the prior year, primarily due to higher results from foreign currency-related hedge activity. Net interest expense for the quarter increased year-over-year on higher interest rates. The effective tax rate for the third quarter of 2022 was approximately 16%. We still project full year corporate costs to be about $1.3 billion, and we still expect our adjusted tax rate to remain in the range of 16% to 19%. Next slide, please. Year-to-date, operating cash flows, before working capital of $4.7 billion, are up significantly versus $3.1 billion over the same period last year. Our net debt to total capital ratio is about 24%, and we have available liquidity of about $11.2 billion. We are continuing to invest in the business with $841 million in capital expenditures and have returned capital to shareholders with $677 million in dividends and $1.2 billion in share repurchases through the third quarter, which reflects the completion of the $1 billion stock buyback announced last quarter. And with enhanced financial flexibility and in line with our balanced capital allocation framework, we plan to repurchase an additional $1 billion of shares by the end of 2023, subject to other strategic uses of capital. Juan?"
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Vikram. Slide 12, please. So to recap, our team delivered another outstanding quarter. And thanks to our execution and the advancement of our strategy, we are well positioned to end 2022 strong. Last quarter, we said we were expecting full year earnings higher than $6.50 per share. Based on where we are today, we now clearly expect to exceed $7 per share. Looking ahead, there are several externalities that we are monitoring going into 2023. We anticipate ongoing resilient demand for our products, a strong crush margin environment, a positive outlook for starches and sweeteners, and a continuation of our growth trajectory in Nutrition. There is also significant uncertainty in the global economy and geopolitical environment. We expect to carry our strong momentum into the first quarter of 2022. And beyond that, we are confident that our scenario planning and execution will give us the ability to effectively manage through a dynamic environment. We’re also going to continue to benefit from our strategic work, and we’ll continue to deliver on those priorities throughout 2023. We’ll advance productivity initiatives to improve operations and processes, optimize costs and enhance efficiencies. We’ll drive innovation, expanding and creating new growth engines across our entire business portfolio, Ag Services and Oilseeds, Carbohydrate Solutions and Nutrition. And we’ll advance those strategic objectives as we always have, alongside our team’s exceptional day-to-day execution, delivering for our colleagues, consumers, customers and stakeholders. With that, operator, please open the line for questions."
},
{
"speaker": "Operator",
"text": "Thank you. [Operator Instructions] Our first question for today comes from Ben Bienvenu from Stephens Inc."
},
{
"speaker": "Ben Bienvenu",
"text": "I want to ask about your process volumes in the quarter. You cited lower crush volume utilization in Ukraine as well as Paraguay. Could you talk a little bit about what you expect your go-forward process volumes to look like? And is the lion’s share of the decline in oilseeds processed year-over-year, that 10% decline, is that from those two regions? Were there any other contributing factors?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Ben. Yes, as you noted, we had lower volumes, and part of that were coming from Europe in soil and rape. We had some adverse weather and some logistical constraints in Europe in terms of navigation, some of the rivers. We also have a reduction in South America, in soy crush because of Paraguay shutdown, mostly because of lack of beans. We had also some reductions in North America due to canola seed availability. And certainly, we have our Ukraine sun crush facility down, as you know, since last March. So, we have 850 facilities around the world, as you know. And we deal with logistics, with adverse weather with manpower issues like every company out there. So, that what was the decline in volumes at this point in time. As some of those one-off issues subside, I mean, we will see those volumes coming back to normal rates."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Ben Theurer of Barclays."
},
{
"speaker": "Ben Theurer",
"text": "Juan, Vikram, congrats on the results. I wanted to follow up on Nutrition. As you’ve talked about some of the logistics bottlenecks that you plan to overcome, could you elaborate a little more in detail those issues are and what you may have to do in terms of investments to get this right. And then also aligned with that, what is actually your kind of FX assumption because you stretched the constant currency terms commentary on the outlook for the fourth quarter. So, just to understand a little bit the regional breakdown as well and what FX headwinds we should expect into the short-term period, just given the euro weakness. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Ben. Listen, as Vikram mentioned in his commentary, we are exceptionally proud of how the team is generating demand, how our value proposition in Nutrition continues to resonate and attract customers. Our pipeline has never been bigger and our growth rates continue to be -- our winning rates continue to be off the chart. So, the problem with that is that it catches up with your production pretty quickly. And although we have plans to expand those, some of the supply chain issues in delivery equipment and all that, sometimes don’t play exactly in our favor. When you look at where specifically those issues have impacted us the most, it has been in flavors, I would say, and mostly in North America, but some of that in Europe. On the other hand, the facility that we inaugurated last year, Pinghu in China has suffered from lack of volumes because of the lockdowns due to COVID restrictions in China. So, I would say, we had a little bit upset in the sense that we couldn’t bring all that demand that we have generated into the P&L. And certainly, those things are, to a certain degree, now under control. And as you can imagine, everybody in the Company is driving very hard to bring extra capacity. As you know, on the last quarter or a couple of quarters ago, we bought FISA precisely to alleviate a little bit that. Of course, we’re using contract manufacturing. So, we are pulling everything. But in a very tight environment with also some shifting of demand based on consumer demand, customers are shifting some of that demand, our ability to react promptly to that given the high growth rates caught up with us in the quarter. There is a lot of capacity coming for next year. So first of all, all this is an upside for next year. Hopefully, we’re going to be able to fulfill all that demand next year. But there is also expansions. If you think about -- we have a new line in soya protein, we also have the Biopolis expansion in Valencia. We have PetDine expansion coming up. So, the business is -- has a long list of organic growth capacity that will come to help next year. But again, it’s all the problem of maybe a strong successful sales and marketing organization, driving double-digit growth rates."
},
{
"speaker": "Vikram Luthar",
"text": "Yes. And Ben, on the FX side, just a reminder for everyone, right. In 2020, we grew operating profit 37%, in 2021 nutrition profit was 20%. If you look at the FX over that two-year period, it was almost flat, went up one year, went down the other year. But the European part of our business, EMEA, and we referenced this in our Global Investor Day, the revenue contribution from Europe is about 40% of the Human Nutrition side and about 20% on the Animal Nutrition side, and that’s getting bigger because of the event. So consequently, given the profitability there and the significant move in the dollar this year, we thought it was appropriate to highlight the growth on a like-for-like basis, which basically means on a constant currency basis. So, it’s a significant strengthening of the dollar. That basically called this out and the underlying growth in the European region."
},
{
"speaker": "Operator",
"text": "Our next question comes from Adam Samuelson from Goldman Sachs."
},
{
"speaker": "Juan Luciano",
"text": "Alex, maybe we skip to the next question. Maybe, Alan, come back later."
},
{
"speaker": "Operator",
"text": "We will move on. Our next question comes from Tom Palmer of JP Morgan."
},
{
"speaker": "Tom Palmer",
"text": "I wanted to ask on the barge delays on the Mississippi River. Does this have much effect on your business as we look towards the fourth quarter? Is it -- if there is impact, should we mainly think about it being in Ag Services, or just given the diversity of your business, are there offsets to consider?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Of course, we have an unprecedented situation and especially in the Lower Mississippi River that will reduce the volume of exports for Ag Services North America. As it’s going to be a negative impact in Ag Services North America, of course, that -- part of that is because of soy and we’re going to lose that volume. In the corn side, we’re probably going to extend the window of exports from North America into the first quarter. So part of the offset is you’re going to see that in the first quarter. I think also part of the offset is South America will be able to export more. We are a large exporter in South America, of course, and you’re going to see that. And then normally, what we noticed or we expect to happen because we’ve seen it before, is when you export less from North America, where destination marketing sometimes get a little bit of a pop in margins, the products and destination become naturally more valuable, if you will. That was part of the original strategy of going into destination marketing. And then, the other impact is that as beans are not exported that matters not that much demand, local values come down, local bases come down and that may be a boost for crush that you may be able to crush lower-priced beans or maybe eventually lower-priced corn for Carbohydrate Solutions. So, we see some puts and takes. So probably negative for North America Ag Services and Oilseeds, maybe neutral for Ag Services and positive overall maybe for the whole."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ken Zaslow from Bank of Montreal."
},
{
"speaker": "Ken Zaslow",
"text": "Just a couple of questions. One is, can you give a little bit more color on Ag Services and Oilseeds outlook as well as carb guidance? I know you said significantly up and significantly lower, some parameters to that? And then, can you also talk about your nutrition outlook, if your supply chain gets repaired, demand is there, do you think that your long-term growth algorithm is intact? And I’ll leave it there, and I appreciate your time, as always."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ken. Yes, let me address maybe the outlook of Ag Services and Oilseeds, Q4. So, first of all, very dynamic environment, but very positive environment. The teams continue to manage exceptionally well. And demand continues to be very robust. So, as we go forward, Q4 again in Ag Services, I was mentioning, maybe a little bit lower for North American exports, but that will be offset for other things that I explained in the question before. So, we still expect significantly better results in the Q4, barring any big mark-to-market, that’s our expectation at this point in time. Crush margins continue to strengthen. That’s on the strength of feeding animals around the world, but also on the extra demand for oil from all the renewable green diesel or biodiesel around the world. We expect continued strength in global trade and destination market. And as I explained before, I would say the business at this point in time is hitting in all cylinders. So, I would say, the 3 parts of the business will be very robust into bigger than last year, certainly. Maybe Vikram can give a little bit of an update on the other two."
},
{
"speaker": "Vikram Luthar",
"text": "Yes. So on Carbohydrate Solutions, you’re right, we did say significantly lower. But if you look at the two independent parts, S&S, sweeteners and starches, we continue to expect that to be strong. We’re seeing robust volumes and margins with obviously, the corn oil benefits we are seeing. So net corn costs are attractive as well as margins continue to be attractive. The issue is on ethanol. Lastly, if you remember, we actually had $1-plus ethanol margins. This year, we clearly do not anticipate margins to be that high. We still expect to be healthy given continued strong gasoline demand, the discount that ethanol has versus RBOB as well as the reasonable inventory levels. So, it’s really the ethanol side that is going to drive the significantly lower performance in Carbohydrate Solutions Q4 to Q4. On the nutrition side, yes, as Juan said, we are working and prioritizing unlocking capacity. We anticipate much of that to get unlocked over the course of 2023. And on a constant currency basis, we continue to expect growth going forward to be in that 15-plus-percent range. It’s important to highlight constant currency because that part of the business in Europe, as I mentioned, is becoming bigger and bigger. And that’s clearly -- and currency is not something we can control and important therefore for us to call that out."
},
{
"speaker": "Operator",
"text": "Our next question comes from Steven Haynes of Morgan Stanley."
},
{
"speaker": "Steven Haynes",
"text": "I just wanted to ask on the Brazil-China corn export agreement and see if you could get a little bit of color on any impact you think you’ll see in your businesses? And if you can just kind of remind us of how big your export origination footprint is in Brazil versus North America? Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Good morning. So first thing you need to understand is we are living in a very tight global corn environment. So, if you put yourself in the foot of China, China finds itself with lower production, lower domestic production of corn with certainly higher feed demand lower barley and sorghum imports. So naturally, it will have to import more corn. So in my mind, they are just building origin optionality. Again, you have still the La Niña effect in Argentina. So they are planting less corn there. Certainly, our last check up here, yields for corn in North America were going to be lower. And of course, there’s always the uncertainty of Ukraine ability to export. So I think that from a Chinese perspective, this is nothing more than just risk management and expanding open up another optionality. Of course, we are a large exporter from South America as well. We have a very robust Ag Services business in Brazil. And I remind you, we are the largest exporter of corn from Argentina. So, as always, we will offer Black Sea, we will offer North America, we will offer Brazil, and we will offer Argentine origins to China. So, as long as demand remains tight, we will see a lot of activity within the trade flow because naturally people want optionality, so."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Rob Dickerson of Jefferies."
},
{
"speaker": "Rob Dickerson",
"text": "I guess, just first question, kind of a broad question. There are a number of times you said in the commentary upfront that should be ongoing momentum kind of going into 2023, and it sounds like more specifically kind of in Q1. If we think about just kind of the general macro backdrop, right, all the tailwinds that are benefiting the business, and maybe this is a little dumb down for some, but not for me. Maybe you could just kind of touch on what could be some drivers that could loosen the overall tightness in the supply chain as we get through next year? Then I have a follow-up."
},
{
"speaker": "Juan Luciano",
"text": "Okay. So, let me talk a little bit. As I said, we are finishing a very strong 2022, and that will get us into a strong -- with good momentum into 2023. What are the things that we are seeing because of course, I mean, it’s difficult place to prognosticate these days. But we anticipate ongoing resilient demand for our products. We have not seen, maybe with the exceptions of some tiny businesses in Animal Nutrition. We have not seen a deceleration of demand across ADM at this point in time. We foresee also a strong crush margin environment based on the two legs. We have a strong pork and poultry feeding demand across the world. And we see tight soybean oil stocks and RGD and biodiesel demand that continues to be strong and growing. We see, as Vikram expressed before, a positive outlook for starches and sweeteners. We have finished some of our contracting, and we see the volume, and we see the margins holding or slightly expanding there. And we see a continuation of our growth trajectory in Nutrition. When I talk about the pipeline, that’s the business in which we have the biggest visibility into the future because these are projects that, barring any supply issues, we will bring to the P&L. So, I would say that is what gives us some positive momentum or positive expectations for ‘23. You have to remember also that we dealt with a lot of weather issues, logistical issues, whether it is the river, whether there is hurricanes -- many issues. And we had, as I explained before, some manufacturing volumes impact here and there. We expect that all to be corrected and to be potentially a plus into next year. And as I explained in the Nutrition question, we have new capacity coming on stream. We have -- we are expanding Biopolis probiotics capacity by a factor of 5. We are bringing a new line for plant-based proteins in soya protein. We are expanding our PetDine capacity. So, we are bringing a lot of new capacity to bear because we have the pipeline to actually transfer them into profit. So, from what we can see here, and again, in a very uncertain world, is we have good -- very good momentum going into 2023."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Steve Byrne of Bank of America."
},
{
"speaker": "Steve Byrne",
"text": "Yes. Thank you. I’d like to better understand this regenerative ag outlook you have for $100 million of operating profit in five years. Would it be reasonable to assume that that’s roughly 10 million acres of $10 an acre operating profit? Is that kind of where you’re thinking? And maybe more broadly, do you see the value here more on generating grain that has been produced in some kind of sustainable way i.e., that a CPG customer of yours would be willing to pay a premium for that grain? Or do you see this as really the generation of carbon credits that could be sold on various exchanges? I welcome your thoughts on that."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you. Very good question and something that is very close to our heart and tied to our strategy. The Regen Ag programs and acres are certainly in high demand. We have made public one announcement, but we have been working on what we call the differentiated bushel, if you will, for like three or four years already. And ADM naturally sits in a unique place in the value chain, and we have the global scale to drive improvements in agriculture, and we have the ability to tie both the farmer with the CPG companies, and so this is a privileged position. We are working very hard to simplify the process for the farmer. And as you described, there are many ways to potentially create value here. When we thought about the differentiated bushel, one is as you described, eventually, and we’re seeing more evidence of that, there’s going to be a premium price for bushels that are grown or metric tons that are grown in a certain way. And I think that the whole society is looking for that. It’s looking for agriculture to actually do their part in creating a more sustainable world. One is that. The second, and that’s where we’re working with FBN, with Gradable and all that, is to simplify the collection of data and all that in the preparation, we’re working with the government on that, on the protocols to be able to have carbon offsets or carbon credits based on that. So, it’s a little bit of both. The economics that you described are not as simple as $10 per ton or whatever. But to a certain degree, that they are also not that much more complicated than that. We just have a portfolio of different accounts and different contracts, and they’re all slightly different, but it is conceptually aligned to what you described is converting more acres, it’s signing more acres. That’s where we leverage the relationship we have with farmers globally. ADM has 220,000 farmers portfolio in the world that we are engaged in discussing this. Of course, the customer -- the farmers will embrace these as they see more demand for this. That’s why it’s important to have the CPG companies aligned to this. And that’s why we make these agreements because, of course, the farmer will generate the production in order to satisfy the demand. So, both lines need to grow together. So again, I think we are just leveraging our incredible farmer network and the desire of CPG companies and consumer in general, to see bushels or metric tons grown in a differentiated way. So, we’re very excited about the future of this."
},
{
"speaker": "Operator",
"text": "Thank you. Our next question comes from Eric Larson of Seaport Research Partners."
},
{
"speaker": "Eric Larson",
"text": "Congratulations on a good quarter, everyone. So, the question I have is -- and thank you for all your regen comments, Juan, it’s pretty dear to our heart to result. I’m looking forward to even having more discussions on that. The question I would have this morning is, could you give us a little more detail on the situation in Ukraine? What you folks are seeing? We’re hearing that there are only plant -- only able to plant enough winter wheat this year to even meet kind of their own domestic needs for next year? It seems that maybe Ukraine is going to be an even smaller contributor to global exports, both on the oil season and grains next year. I guess, it’s just hard to get all the information put together. Could you just share some thoughts on what you see developing in that region of the world?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Eric. And also, it gives me an opportunity to emphasize the message we sent to our employees in Ukraine to -- for strength and ADM is doing everything possible to make their lives as bearable as possible through all these. And hopefully, one day, we will be talking about the rebuilding of Ukraine and all of them coming back to their land. So listen, we’ve been involved. As you know, we have more than 650 employees. So, we’ve been deeply involved in that. A vast majority of them are in their jobs, in their positions right now. So we’ve been able to export from Ukraine and the industry has worked together with governments and through this corridor agreement, we’ve been able to, in September, to reach the same level of exports almost that Ukraine used to have last year, so about 7 million tons. October, starting with a little bit more of wrinkles, if you will. We are having an issue, which is this joint group that is supposed to inspect the vessels have been a little bit overwhelmed by the number of vessels that we have. So they are adding more people to that group in order to continue to move material. We need to move material. There are like 100 vessels, give or take, in a queue right now. We need to take that material out because storage in Ukraine is becoming full. And then, there’s going to be a harvest and we need to be able to use that storage to harvest the material and to store the material there. So, my point to all this is dynamic. This continues to be a very dynamic environment. Certainly, there are still shelling in the area sometimes, hitting some of the soybean oil, sunseed oil tanks, if you will. So, this is not an easy area. In the middle of that, of course, Ukraine is trying to plant, as you described, difficult to judge a number. I mean, our estimate is that maybe 30% less, but it’s difficult to make the calculation because some territory are now claimed to be in Russian control. So, it’s difficult for us to know even when data are put together, if you will, if that counts with the planting in that Russian controlled territory or not. So, I would say, it’s a little bit difficult to make prognostications. So wheat, thankfully, Australia has a good crop. It has rained a lot in Australia. So, that’s a positive of the La Niña. Hopefully we stop now with the rain because they need to harvest and we don’t want damage into the harvest. India also has declared there are some inventories and can come to the world to help. Corn situation, certainly more difficult maybe. There is a strong demand. We are in coarse grains in the tightest inventories in the world that we have in seven years. So I think that will be complicated. As I said, Argentina has planted like 10% of the first corn because of incredible drought there. So, I think that at this point in time, the U.S. will be a big supplier of corn for the world. On sun oil, I think the world adjusts a little bit more to present in different blends of different oils. But of course, the oil environment is tight because of all the renewable green diesel and biodiesel. So I would say maybe wheat is a little bit better, but corn and sun oil will be difficult if we stop with the corridor. So hopefully, now November 19, the corridor gets extended. And everything we hear at this point in time, there may be an objection here or there, but nothing significant that could derail this. So we are still counting that the corridor will continue to function, hopefully, with a little bit more efficiency as we appoint more inspectors on with the joint committee."
},
{
"speaker": "Operator",
"text": "Next question comes from Robert Moskow of Credit Suisse."
},
{
"speaker": "Robert Moskow",
"text": "I was hoping you could give a little more color on the outsized performance in Ag Services in the quarter. I mean, this is the strongest third quarter I think I’ve seen from ADM in many years. And it’s not what I would have expected given the challenges on the Mississippi River. So, of these factors that you mentioned, the short crop in South America, the better margins in ocean freight, can you give us kind of some sizing as to what were the biggest factors for the outperformance? And also, was there any kind of positioning benefit from your -- from how you hedged your grain in the quarter?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. So, it was a great performance, as you described, very proud of the team. Traditionally, our Q3s have lower volumes because we are getting out of the end of the season and waiting for the next harvest. What happened this time is I think given the short South American crop, we’ve been able to move more volumes, especially exports in North America. Exports were down Q3 to Q2, but not down as much as maybe you see in other years. The same has been a little bit for origination volumes. And when exports go, we have benefits in our transportation businesses, our barges and all that. Also, do not forget, it’s not just North America, but it’s also the global nature. The global trades have done a spectacular performance. And I think we have benefits in ocean freight. It was a very good quarter from that perspective, and also destination market. In destination market that we started four or five years ago, I don’t remember exactly, has continued to grow volumes and expanding margins. So that, I would say, is what created this great Ag Services in Q3. So, great performance by the team."
},
{
"speaker": "Operator",
"text": "Thank you. Our final question is from Adam Samuelson from Goldman Sachs."
},
{
"speaker": "Adam Samuelson",
"text": "So, a lot of ground has been covered today. I wanted to maybe come to capital allocation on the balance sheet. And first, just to clarify on repurchase because you did a very sizable amount of buybacks in the third quarter. The incremental $1 billion was over the next five quarters. Did I understand that right from the earlier comments? And then just more broadly, Juan, Vikram, any way to frame CapEx over the -- into 2023 kind of -- you got a lot of capacity actions underway. Just help frame kind of the internal investments. And relatedly, help us think about maybe the M&A optionality in the current marketplace, especially with rising interest rates that might put some more working capital strain on smaller players in the market? Thank you."
},
{
"speaker": "Vikram Luthar",
"text": "Yes. Adam, thanks for the question. So, in terms of the share buybacks, yes, we -- as you rightly noted, we did execute the entire $1 since we announced it in -- the buyback in Q2. Looking forward, you’re right, in terms of the additional buyback, that is anticipated to be completed over the next five quarters through the end of 2023. But I also want to emphasize, partially getting to one of your questions that we see a rich pipeline of opportunities even on the M&A side. And it is, as always, our responsibility to continue evaluating that. And if we find the right acquisition with the right set of capabilities at the right price, absolutely, we would divert potential capital to that in lieu of buybacks. But absent that, we anticipate to complete this by the end of 2023. In terms of CapEx, we had signaled about $1.3 billion for this year. We remain on track to be around that, maybe slightly under. And we anticipate that similar level of spend to continue over the next couple of years as well, given the significant need for adding capacity as Juan mentioned, but also some of the additional high-return projects we see on the horizon, such as the analytics and digital automation of our facilities. So, we see rich opportunities to reinvest in the business as well as potentially explore more M&A. One other point that’s very important to highlight, and this really underscores our emphasis on driving returns, which is not just focusing on the profitability but also on the asset, on the denominator is a $1 billion challenge. Even in the face of this outstanding performance this year, the teams are rigorously focused on reducing the assets deployed to produce that profit. And the $1 billion challenge, we actually anticipated to -- we’ve actually got -- we’ve got cash in hand as of last week of $1 billion, as Juan noted. So, I think it’s important to note that we are very focused on driving returns and hence that 13% that we are very proud of we achieved in 3Q. So, I’ll pause there."
},
{
"speaker": "Operator",
"text": "Thank you. We have no further questions for today. So, I’ll hand back to Megan Britt for any further remarks."
},
{
"speaker": "Megan Britt",
"text": "Thank you for joining us today. Please feel free to follow up with me if you have any other questions. Have a good day, and thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "Thank you for joining today’s call. You may now disconnect."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 2 | 2,022 | 2022-07-26 09:00:00 | Operator: Good morning and welcome to the ADM Second Quarter 2022 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Michael Cross, Director of Investor Relations. You may begin.
Michael Cross: Thank you, Alex. Good morning and welcome to ADM's second quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. Please turn to Slide 2, the company's safe harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in the presentation. To the extent permitted under applicable law, ADM assumes no obligations to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and highlight some of our accomplishments. Our Chief Financial Officer, Vikram Luthar, will review the drivers of our performance as well as corporate results and financial highlights. Then Juan will make some final comments, and he and Vikram will take your questions. Please turn to Slide 3. I will now turn the call over to Juan.
Juan Luciano: Thank you, Michael. This morning, we reported outstanding second quarter adjusted earnings per share of $2.15. Adjusted segment operating profit was $1.8 billion, and our trailing fourth quarter adjusted EBITDA approached $6 billion. And our trailing fourth quarter average adjusted ROIC was 11.6%. Our team executed extremely well in the second quarter, navigating dynamic conditions to deliver nutritions to billions. And even as we work tirelessly to serve our customers and consumers around the globe, we are continuing to advance our strategy with productivity initiatives that are improving our efficiency and cost structure and innovation work that is powering profitable growth. Slide 4, please. Productivity is how we are improving our execution and optimizing costs, is key to our long term success but equally and importantly our productivity work is helping us mitigate the impact of inflation. We have a very strong pipeline of productivity initiatives and I will be updating you on them regularly. There are 2 initiatives I'd like to highlight today. First is a set of operational transformation efforts we are driving across production facilities around the globe and spanning all 3 businesses. Earlier this year, we completed a modernization project in our Marshall, Minnesota corn facility that is unlocking significant new value through enhanced automation, more sophisticated control systems and the increased use of analytics. We're already seeing double-digit returns on the investment we made in that project. This is an example of the kinds of projects we're undertaking across our operational footprint, designed to unlock incremental volumes and deliver safer, more reliable, more cost-efficient operations. Second, as we look to continue to grow returns, we want to focus not only on the numerator but also the denominator. Our original $1 billion challenge and its follow-up, the next billion, help us drive to 10% ROIC. Earlier this year, we launched a new challenge aimed at monetizing assets and optimizing working capital to unlock another $1 billion in cash, helping us to continue to drive returns. In fact, we already realized more than $400 million. Next slide, please. We're also advancing our innovation pillar, fueling profitable growth as we continue to expand our capabilities to meet demand across the 3 global trends of food security, health and well-being and sustainability. For example, last November, we added significant new capabilities in our Health and Wellness business with the acquisition of Deerland Probiotics. Demand in the human microbiome space is expected to reach $9.1 billion by 2026. While in animal feed, probiotic demand is expected to grow to $6.2 billion. Deerland with a broad portfolio of probiotics, prebiotics and enzymes provides a wide array of commercial, R&D and operations-related synergy opportunities to help us meet that demand. And we're taking advantage of those opportunities from connecting our deal and capabilities with our Biopolis team in Spain to utilize sport probiotics in a functional chocolate bar; to bringing together our expertise to expand our capabilities in pet, a key growth category; to looking across teams to offer new types of dietary supplements. Thanks to the strong collaboration across the enterprise, Deerland today is increasing our share of wallet for customers in both human and pet solutions. And we're seeing similar outcomes from other recent investments as well. In the first half of the year, our combined portfolio of 2021 nutrition acquisitions has delivered significantly more OP than we had in our acquisition models. Now I'd like to turn the call over to Vikram to talk about our business performance. Vikram?
Vikram Luthar: Thanks, Juan. Slide 6, please. The Ag Services and Oilseeds team delivered exceptional results in a dynamic market. Ag Services results more than doubled versus the year ago quarter. Global trade had an outstanding quarter. The destination marketing team's ability to meet customer demand around the globe helped drive strong volumes and margins. And good execution in global freight as well as net timing gains of about $65 million for the quarter contributed to significantly higher year-over-year profits. North America had a solid performance as export volumes remained strong in a good global demand environment, though year-over-year results were lower due to the prior year's insurance settlement and strong positioning gains. South America results were higher based on stronger origination volumes and better margins driven by strong global grain demand. Crushing delivered substantially higher results. Strong soy crush margins drove improved performance in all 3 regions as meal and oil demand remained robust. Positive net timing effects of approximately $90 million for the quarter versus the $70 million of negative timing in the year ago period helped drive year-over-year results. Refined products and other results were similar to the prior year period as strong demand for biofuels and food oils drove refining premiums and biodiesel margins, offset by approximately $150 million of negative timing effects versus negative $30 million in the prior year quarter. Equity earnings from Wilmar were significantly higher versus the second quarter of 2021. Looking ahead for AS&O. We expect Q3, the seasonal transition quarter from the South American to the North American harvest, to deliver results significantly higher than the prior year period driven by continued strong global demand for grains and strong cash -- crush margins. Slide 7, please. The Carbohydrate Solutions team delivered a second quarter of extremely strong results. The Starches and Sweeteners subsegment, including ethanol production from our wet mills, delivered much better results due to solid demand as food service volumes reached close to pre-pandemic levels. Corn coproducts, including strong demand for corn oil and effective risk management, drove higher ethanol and sweetener margins. BioSolutions continued its strong growth with $81 million in year-over-year revenue growth in Q2 and $136 million year-to-date. Vantage Corn Processors results was slightly higher in an environment of good gasoline demand and strong ethanol blending economics. A $50 million recovery from the USDA Biofuel Producer Recovery Program helped offset the prior year's strong industrial alcohol results from the now sold Peoria facility as well as valuation losses on ethanol inventory as prices fell late in the quarter. Looking ahead to the third quarter. We expect results significantly higher versus the third quarter of 2021 driven by steady demand for our products and favorable ethanol blending economics. On Slide 8, the Nutrition business continued on its strong growth trajectory with 19% year-over-year profit growth. Revenues increased by 20% on a constant currency basis and 13% like-for-like, and the team did a good job protecting margins. Human Nutrition delivered higher year-over-year results. Flavors grew revenue in North America, EMEA and South America, though profits were lower due to negative currency effects in EMEA as well as weaker results in APAC. Healthy demand for alternative proteins resulted in strong soy protein volumes and margins as contributions from the Sojaprotein acquisition as well as good demand for texturants drove higher results in Specialty Ingredients. Strength across probiotics, including in the recently acquired Deerland business as well as robust demand for fibers, contributed to a stronger quarter in Health & Wellness. Across the Human Nutrition business, we continue to see low price elasticity and good demand for our diverse portfolio of ingredients and systems as we continue to support our customers with new product and cost-out innovation and drive industry-leading win rates. Animal Nutrition profits were up substantially year-over-year driven by continued strong volumes and margins in amino acids. Looking ahead, we expect third quarter results for Nutrition to be higher year-over-year as the business remains on a trajectory to deliver 20% OP growth for the full year. Slide 9, please. Other business results increased from the prior year quarter driven primarily by higher ADM investor services earnings due to higher short-term interest rates. In the corporate lines, unallocated corporate costs of $267 million was slightly higher year-over-year due primarily to higher IT operating and project-related costs and higher costs in the company's centers of excellence. Net interest expense for the quarter increased year-over-year on higher rates and higher short-term borrowings to support working capital needs as well as higher expense for long-term debt. The effective tax rate for the second quarter of 2022 was approximately 18%. Based upon our current outlook, we expect full year corporate costs to trend towards $1.3 billion versus our previous outlook of about $1.2 billion, largely due to higher year-over-year interest rates. We still expect our adjusted tax rate to be in the range of 16% to 19%. Next slide, please. Year-to-date operating cash flows before working capital of $3.2 billion are up significantly versus $2.2 billion at the same time last year. Our balance sheet remains solid with a net debt-to-total capital ratio of about 30% and available liquidity of about $11.5 billion. Driven by our strong cash flows and robust earnings, we expect to accelerate our share repurchase program adding to the $200 million we repurchased in the second quarter of the year with an additional $1 billion in the back half. And of course, the strong cash flows and balance sheet also preserve our flexibility to continue reinvesting in the business and advancing upside growth opportunities. Our CapEx outlook is unchanged at approximately $1.3 billion for the year. Juan?
Juan Luciano: Thank you, Vikram. Slide 11, please. For context as we discuss our outlook, I would like to go back to the goals and drivers we laid out at our Global Investor Day in December. We talked about the plan in which our strategic productivity and innovation actions will continue to build a better ADM and align our portfolio to meet accelerating structural demand changes driven by the enduring global trends of food security, health and well-being and sustainability and how that would drive a strong earnings trajectory over the plan horizon. What has transpired since then is that some of the market factors have reinforced and further enhanced the value proposition of our diverse product portfolio and our integrated global network of assets. This helps drive stronger-than-expected margins. So while we may see some reversion in the medium term, we now believe that margin structures are generally higher than when we have laid out in December. We are on a trajectory to deliver a very strong second half, resulting in expected full year earnings above $6.50 per share. And as Vikram said, the strong cash flows we are generating will enable us to accelerate the timing of our share repurchase program with $1 billion in repurchases in the back half of the year. As we look beyond that, we have not changed our strategy, nor our expectations of strong earnings growth and returns over our plan horizon. And as we laid out at our Global Investor Day, there are upside opportunities to our medium-term plan. But as we have already covered today, we are advancing those now and realizing higher value from them. Higher BioSolutions revenue growth, higher Health & Wellness OP contributions, the operational transformation across the enterprise, we expect these and more to add further upside in the medium term. The opportunities before us are significant. I'm proud of what our team has achieved, but I'm even more excited about what we're going to deliver tomorrow, next year and in the years to come. With that, operator, please open the line for questions.
Operator: Our first question for today comes from Ben Bienvenu from Stephens.
Benjamin Bienvenu : I want to ask one kind of bigger-picture conceptual question, and then my second question is more near term in nature. The first is on the accelerated share repurchase. I'd be curious to hear a little bit more about all of the decision points that flow into that bigger-picture decision. I would imagine -- you highlighted strong underlying fundamentals in the business. I imagine there's a component associated with working capital as well as some of that frees up with commodity markets cooling a bit. I'm curious also to get an update on your longer-term capacity expansion pipeline and how on schedule those build-outs are. And should we think of share repurchase as a lever to throttle up and pull back depending on M&A and CapEx timing of kind of long-lived capital investments? That's my first question.
Juan Luciano : Yes. Thank you, Ben. Good question. We are maintaining our balanced capital allocation that we put together some years back. We always said that we're going to take about 30% to 40% of our free cash flow to reinvest in the business, and that's what our strategy of bolt-on and organic growth normally takes. And that will be the priority. We have exciting opportunities ahead of us. So we're going to prioritize our investment plan. But of course, we've been paying dividends for 90 years. We've been growing dividends for more than 40 years, and we will continue that. We increased dividends 8% this year. And when we're looking at our distribution, again, this 60% to 70%, whether there are strategic opportunities to do M&A or giving back to shareholders, as we said before, at this point in time, when valuations may be correcting and all that, we don't have any significant targets in front of us. Our team continue to look for bolt-ons. And given the significant strength of our cash flows, we have decided to honor that return of shareholder -- of funds to shareholders. So I would say we will maintain that balanced allocation. We are not -- in the plan when we presented in December, we were looking at the later part of the plan as we were approaching $6 to $7 per share that we will have ability to repurchase about $5 billion of that. Certainly, we will be, as I said in my initial remarks, north of $6.50 today. So some of those buybacks are accelerated to the scenario. So I would say it continues to be consistent in that regard. Is there a later part of the question I'm missing or forgetting? Oh, the capacity to increase, yes, organic capacity. Listen, we are -- as you can -- Vikram mentioned it, we are increasing our CapEx into $1.3 billion. And we've been accelerating some long lead equipment this year to make sure that our capacity expansions remain on schedule. So if we look at the big ones that we have right now, whether it's Spiritwood, it's still expected to be online by the harvest of 2023. We are expanding capacity in bioactives in Valencia. That's expected to come in the first quarter of 2023. That's also on schedule. So I would say, in general, across the globe, since we have the ability and the funds, we've been making sure that we eliminated that risk or we minimized that risk. Of course, there is always a risk of labor and labor is tight, especially in North America. But I think at this point in time, we don't have any major deviation to our plans.
Benjamin Bienvenu: Okay. Great. My second question is related to the grappling of supply-demand that we're seeing right now. Obviously, there, you highlighted your expectation of structurally higher margins across your business. That makes sense given the kind of bigger-picture structural changes in demand that support the profitability of your business over the next several years. But we are starting to see demand destruction cyclically as the consumer deteriorates. I think your business is really well positioned. But I'm curious about kind of what you guys are keeping your eyes on relative to deteriorating underlying consumer and that -- the consequence of that rippling back up the supply chain -- the value chain potentially.
Juan Luciano : Yes. Ben, listen, we're watching the demand, of course. We go -- we work very closely with our customers and our farmers on this. I would say we have seen demand substitution, demand shifting here or there. And you see it in retail, maybe to private label. We've seen a little bit to people looking into smaller packaging to make things more affordable. So I would say, if I think of the big categories for ADM, food tends to be, despite all these comments, much more reliable, much more stable in that -- just the essential nature of that. I think our fuels business, our biofuels business in general, are more tied to programs that are long term and to initiatives to reduce emissions and improve climate over the long term. So they also tend to be relatively firm, if you will. And we see that with RGD bringing new demand for oil. So if we have any issue in edible oils, it's certainly been more than offset by the new demand on renewables. And I will say the area where maybe we keep a closer look to all that is animal feed. Animal feed has been impacted by this. We estimate something in the range of maybe 10 million to 15 million tons on a global basis that maybe we took out of our SMBs from the globe perspective, not just from our own revenue, from the globe SMBs. I think we have seen less of an impact on an OP perspective because as people like to trade down, if you will, or if they were to trade down from beef, chicken is a cheaper protein. It's a more affordable protein. And chicken is where we get all the soybean meal mostly sourced. If you think about what's happening with soybean meal, is -- it has a cost advantage to corn. So it continues to have a high proportion in the Russians on things that are, if you will, more demanded right now like poultry. When we go to Nutrition, I think you said it in your -- in the question is we are well positioned in some of the applications that are growing the fastest, and of course, not completely insulated. To a certain degree, we haven't seen significant drops at this point in time. So our expansions and -- continue forward. And you saw in our remarks, our -- the acquisitions we made last year are actually performing from an OP perspective better than in the economic model we put together.
Operator: Our next question comes from Ben Theurer from Barclays.
Benjamin Theurer : Good morning, Juan, Vikram. So my first question is also related a little bit to, the picture you draw and you laid out just about 7, 8 months ago during the Capital Markets Day back in December and you talked about the path to get to the $6 to $7. Now you're just at $6.50 for this year. But the one thing that kind of pops out is the significant strength and the up we've been seeing on the return on invested capital. And you still say your long-term objective is 10%, but now we've been consistently gone higher. So if we put it like into the context and your comments of the margin structure to remain higher, how should we think conceptually over the medium to long term? Where is your real ROIC objective given that you've been consistently above that 10% level? And what does that mean for your potential to return cash to shareholders via dividends, buybacks versus then ultimately the CapEx needs?
Vikram Luthar : Thanks, Ben, for the question. So just to give you some context, when we decided on the 10% ROIC target, it was based on an expectation of about 300 basis points above our long-term cost of capital. The long-term cost of capital has been around 7% for some time now. But as we look forward and we see interest rates on the rise, there is likelihood that over the medium term, the long-term WACC is going to increase. We still want to maintain our buffer or our spread versus that long-term WACC. So in short, yes, we are actually looking at growing our ROIC beyond the 10%. We haven't firmly established a new target. But clearly, as you've seen, we are well ahead of 10% on the back of a strong demand outlook for the medium term as well a strong discipline on the denominator from a balance sheet perspective. So in terms of the capital allocation and the forward outlook, Ben, I think it's consistent with what Juan said. We expect we are going to be very disciplined and balanced in terms of how we deploy that capital both in terms of reinvesting in the business. And by the way, the opportunities to reinvest in the business are significant. Juan mentioned some, including the operational transformation. And much of that is not even baked into the medium-term plan that we highlighted. So we anticipate there likely will be some additional reinvestment in the business, but that should still leave us enough flexibility to do share buyback, potentially even in excess of $5 billion as well as continue our pace of dividend growth as we've done historically over the last 40-plus years.
Benjamin Theurer : Got it. That sounds very promising, Vikram. And then just coming back on the growth and what's being delivered within the Nutrition segment, just to kind of frame it and understand it well what you're seeing into the back half here because clearly, you kind of reconfirmed the 20-ish percent growth in op income. We've had a very strong first half. You expect next quarter to be better. Is there anything where you think there could be a little bit of a headwind in the more short term just because of people maybe down-trading on the consumption side? You mentioned a little bit maybe the packaging side going to smaller sizes, et cetera, but to understand a little bit the risks versus the opportunities within Nutrition.
Juan Luciano : Yes. Ben, first of all, Nutrition is the business where we're probably exposed the most to the supply chain issues that everybody is talking about because we have a more variety of raw materials that we consume in all these formulations. So that is always something that the team works very well to overcome. But that's an issue we watch very closely. The second is, as you know, that business is also very strong in Europe. So there is a ForEx exposure that we keep on looking. And I mentioned at the beginning that Animal Nutrition volumes are a little bit more difficult, I think that given the price point where we are. So I would say those are the 3 levers that we keep on looking to make sure that we balance that. I would have to say the business has done a terrific job of offsetting all that. And again, we still believe in our enhanced guidance from 15% to 20% for this year. We're still going to do that. And the business, again, as I've said many, many times before, it's clearly in its path to achieve our $1 billion operating profit objective probably next year. So we feel good about the business, but it's not without a lot of active management, if you will. So...
Operator: Our next question comes from Adam Samuelson from Goldman Sachs.
Adam Samuelson : So I wanted to maybe dig into the outlook on oilseeds a little bit. In your prepared remarks, you alluded to a mid-cycle or normalized medium-term kind of margin structure that moves higher, and I'd love to get a little bit more color on how your view over the medium term has evolved there and especially in the context of a North American kind of industry that's in the midst of some pretty healthy capacity expansions by you and many others.
Juan Luciano : Yes. Adam, listen, we continue to see a strong demand for meal and oil. North America has many advantages. North America has the beans, and North America has a robust domestic consumption. North America has the new demand for oil. So that makes, of course, soybean meal more competitive in the world. We continue to see good margins and good volumes in poultry as -- again, as the consumer favors that meat. We continue to see soybean meal advantage to corn. As I said before, in the Russian, that continues to have high inclusion rates. We see China recovering from COVID, so activity coming back. And we see Argentina pretty much given the current financial issues outside of the markets in terms of their aggressiveness. So I would say the scenario that we've been seeing, it continues with strength going forward. I think that's kind of what we see at the moment. So Q3 is strong. I would say maybe if I go to canola, canola has been -- margins have popped. So maybe we had -- we didn't have that in the past. Now we have, very strong. So we see a strong demand for biodiesel. I'm just trying to go mentally through all the businesses. And as we said before, Wilmar has been doing very good. So we don't see any significant clouds in the horizon right now. We have good expectations. We think that for the second half, the U.S. will become the place to export for corn and soybeans. So I think that exports should come to the U.S. from the period of September to maybe February or maybe even March. So we will have to watch logistics and whether logistics can allow us to execute a strong export season. But that's probably the only thing out there that I will be thinking, Adam, in terms of puts and takes.
Adam Samuelson : Okay. That's all really helpful. And if I could maybe just switch gears over to Carbohydrate Solutions and specifically Starches and Sweeteners. I mean very strong kind of first half results. And I guess I'm trying to think about the contributions of between kind of volume growth, better ethanol profitability, coproducts and kind of -- and risk management and just that thing could be your most mature business and seeing some very, very healthy absolute and year-over-year performance and trying to just maybe disaggregate some of the drivers there a little bit.
Vikram Luthar : Yes. Sure. So Adam, just breaking it down into volume margin and mix. In Sweeteners and Starches, from a volume perspective, actually, we saw volumes in North America higher year-over-year in the first half. And that is different from what you may have heard generally in the marketplace. We clearly benefit from an integrated network that enables us to deliver to our customers effectively and efficiently. And in some cases, we've actually also imported tapioca starch, for example, from Europe to meet that demand. So volume has been strong. In terms of margin, clearly, we benefited from higher coproduct values, including corn oil in particular. So that's also helped in terms of the net corn and effective margins for Sweeteners and Starches. And from a mix perspective, we talked about BioSolutions driving more and more growth, higher than what we had anticipated. So on all 3 fronts, in terms of volume, margin and mix, S&S looks brighter than what we had anticipated at the beginning of the year. In terms of ethanol also, if you think about similar way of thinking about volumes, volumes have been strong in terms of gasoline demand locally. Strong exports expected. We've had strong exports outlook for exports about 1.6 billion gallons for the year. In terms of margins, we've also again benefited from the fact that we've had good coproduct values particularly, again, in DCO. And that has helped us maintain margins. The other aspect is the RVOs have been finalized. So that puts -- removes the cloud from the regulatory landscape, at least for 2022. And gasoline -- and ethanol blending economics remain fantastic. If you include RIN values, that's above $2 relative to our BOB today. So I think based on all those facts, we think Q3 is going to be stronger quarter-over-quarter. And our outlook for the year is also very constructive.
Adam Samuelson : Just to clarify, Vikram, because I don't think that was a nuance you said in the remarks. You said -- in the prepared remarks you said significantly higher year-over-year. And you're saying all of Carbohydrate Solutions will be higher quarter-over-quarter as well. I just want to be clear on that point.
Vikram Luthar : No. My comments were specifically quarter-over-quarter, significantly higher quarter-over-quarter for Q3. And what I just emphasized as well, we are constructive for the outlook for the full year.
Operator: Our next question comes from Ken Zaslow from Bank of Montreal.
Kenneth Zaslow : Just a couple of questions. One is, how much dollar amount do you expect to increase in 2023 from your cost your harvesting of your growth investments? How do we kind of think about that for 2023 in terms of the dollar amount that's going to be coming out from both your cost savings and your investments in growth?
Vikram Luthar : So I think, Ken, just providing context, going back to the Global Investor Day in terms of the framework, right, we talked about productivity and innovation driving about $1.1 billion in aggregate each. And then we expected market forces should be about $1 billion. In terms of 2023, we haven't gone through the specific plan yet, right? We are still working through that. But you could assume kind of a flat line, roughly speaking, over that 4-year time frame. What I would submit to you, Ken, is over the last 3 or 4 months, as Juan mentioned, we see additional opportunities on the horizon as it relates to operational transformation with digitization and automation. We talked about the Marshall example. If we multiply that Marshall example, the upside could be even more. But that's something that we are still fleshing out, and we will be prepared in the foreseen quarters to provide you a little more granularity on that. Juan?
Juan Luciano : Yes. Ken, what I would like to add to what Vikram said is that if I think back to December, there are 2 things that are different. A lot of the productivity efforts this year have been used to offset inflation, and I think the team has done a terrific job of protecting margins in that sense. Those productivity efforts continue. And as inflation may be received next year, we might see that -- more of that coming to actually improve our productivity versus just offsetting inflation. The second thing that I noticed and I tried to make a point in my prepared remarks is that we probably see innovation -- a little bit more activity in innovation. I think that as customers are trying to fight inflation, I think that bringing newness, bringing new categories, new innovation, we've seen that in Nutrition and other pieces of the portfolio. So I think there is an opportunity there. And some of the things that were not included in our 5-year estimate, whether it was some of the growth on Health and Wellness or some of the BioSolutions opportunities and all that, are coming stronger and faster than maybe we anticipated. So Vikram said it, we normally start the planning season maybe late September or October. So we're going to be looking at '23 there. But I think we're going to have a lot of puts and takes on a scenario that is very dynamic. But we feel good about the initiatives we can control, let's say.
Kenneth Zaslow : Great. Just a clarification question. You talked about the $6.50 number. That includes share repurchases. Is that -- does that -- but yes, underlying fundamentals seem stronger than maybe you expected. Can you reconcile that? Because if it includes the share repurchase, I would argue that maybe better than that. I don't know if you're being conservative, but I'm not trying to pinpoint you. Just there was some incongruence in terms of the accelerated share repurchase and just kind of sticking to that $6.50 number. Just wanted to touch base with that -- touch base on that, if you could help us out on that.
Vikram Luthar : Yes. So Ken, just to be clear, we did not say an ASR. We did not say accelerated share repurchase, right? I want to make sure that we clarify that comment. We did say that we are going to do $1 billion in the back half of the year. And as you well know is EPS impact of that given the averaging is pretty minimized for this calendar year. So the impact, whether you consider a share repurchase in the $6.50 number or not is frankly insignificant for 2022.
Kenneth Zaslow : Okay. So just putting this all together, even as fundamentals kind of stabilize at this higher level, your share repurchases, your productivity and your growth initiatives can propel earnings higher in 2023 even if fundamentals kind of stabilize and not -- not to say we're peaking, I don't want to use that word, but if we stabilize at a higher level. Is that fair way to think about it that your interim actions of those 3 components can drive earnings growth in 2023? And I'll leave it there and I appreciate your time as always.
Juan Luciano : Ken, the way I think about it, let me share that, is we need to have in ADM certain ambidexterity. On one side, we have a team that executed on opportunities presented by the market. And the team is executing on great opportunities this year. We don't control that all the time. We control our execution, but we don't control the opportunities that pop based on the macro environment. On the other hand, we are committed to keep improving the company. So -- and that's what we committed in December over the 5-year plan. So to the extent that those forces, whether favorable or negative, offset our productivity and innovation, at times, we're going to see more of that effect and at times, we're going to see less. So we know we're going to grow earnings over the next 5 years based on all that. We have not gotten to 2023 at this point in time. So I want to make sure that people don't hear that what we're going to do is a promise to grow earnings every year. We cannot control all the environment in the world, but we can control that we get better and we can control that we can maximize our execution on the opportunities provided. Will 2023 provide the same opportunities of 2022? Unclear at this point in time, and we need to go through our scenarios. But I think we're going to feel -- we feel very good, as I said, on the team's ability to execute. Some of the macro that we're seeing in terms of demand, demand for food has been growing over the last 15 years at 1.8% per year. You can argue that at times, we are getting to the peak of arable land being brought into production; that at times, we are hitting the peak of maybe even yield in the area. So we think that although margins may not stay at this level, if they're going to stabilize, they're going to stabilize at higher level than in the past. And that's where we based our forecast in December, and we are maintaining that. So we feel good about continue to grow earnings. We haven't gotten to the specific 2023 number yet.
Operator: Our next question comes from Steve Byrne of Bank of America.
Steve Byrne : Vikram, you had some constructive comments about third quarter for Ag Solutions and Oilseeds. And I wanted to specifically ask you about which of those 2 big businesses is primarily driving that favorable outlook. And in Ag Services, what is it? What regions of the world? Where do you see that strength coming from? And then one more for you on that. And if there is less crop production in the world in 2022 just from significantly less fertilizer applications, is that positive or net negative for you? You could have tighter supplies but less volume.
Vikram Luthar : Yes. So thanks for the question, Steve. In terms of AS&O, I'll break it up. In terms of AS, we talked about destination marketing being very strong, right? So that's part of global trading. We anticipate that to remain strong given our ability to deliver to customers around the globe. And actually, we have the globally integrated network we have enables us to do that very effectively and efficiently. So we believe that's going to be a continued contributor of the growth. You think about also where we are positioned as a company in North America and South America. Where is the world likely going to come for grain in the back half of this year? It's probably going to be in North America. And with a reasonable crop that we expect right now, we should be well positioned to be able to benefit from that given our footprint. So I think the strength in destination marketing within global trade as well as our asset footprint and the dearth of grain around the globe in light of what's happened gives us good flexibility and constructive margin outlook for the back half. On the Oilseeds side, the fundamentals remain strong. I mean you've seen that the demand for oil both on the food side as well as RGD remains strong. So North American crush margins should be constructive. As soybean meal remains a very efficient and cost-effective protein substitute for even wheat as wheat prices, even though they've come up, they're still relatively expensive. So soybean meal remains an important feed for all types of protein and especially for poultry, and you've seen the number of poultry rising. So we're constructive for crush margins in North America. And even with biodiesel as well, that's also providing another avenue to support crush margins even in Europe. So crush margin outlook for the back half is strong in terms of the fundamentals that I highlighted. So candidly, the strength in AS&O is both on AS, as well as O for the back half of this year.
Steve Byrne : And you made a comment on one of the slides about investing in this sustainable agriculture initiative of FBN. My question for you on that is, how meaningful of an opportunity do you think this is for you? Are your food company customers willing to pay a premium to you, and thus the farmer, for grains and oilseeds that are produced in various sustainable ways? Is this a niche? Or is this a potentially meaningful portion of your origination business?
Juan Luciano : Yes. Steve, this is Juan. We are building this. I think we have a division now within the business to look at these certified grains, if you will, or differentiated grains. There is certainly a consumer push into this that we feel through the CPGs and having the desire to engage in these transactions with us. So it continues to build. I don't think it's going to be meaningful to our earnings over the next 2, 3 years, but it's something that is aligned with sustainability trends. It's aligned with the ability of the whole industry to decarbonize and become better. So it makes us more sustainable. But it is growing. It's still small, but it continues to accelerate. So I don't think you should expect an OP impact over the next 2 years, but we're building a good position here. And with partners like FBN and all that, we continue to improve the economics and simplify the recognition to farmers as they embrace sustainable practices. So there is an economic motive or result later on, maybe in the planning cycle. At this point in time, it's more a sustainability thing that we do to help our customers as they need more of this.
Operator: Our next question comes from Tom Palmer of JPMorgan.
Tom Palmer : Maybe I'll just start off on the crushing side. Margin info in the earnings presentation was encouraging as was your second half commentary. At the same time, we saw Board Crush at least temporarily weaken going back a month or 2. So it looks like it hasn't carried forward in terms of Board Crush or in spot as much but -- and nor have much bearing on third quarter results, but I hope to get at least a little bit of color on what happened and why the impact was so temporary?
Juan Luciano : Yes. I think, Tom, what we saw -- of course, base has become -- became a little bit tighter in the U.S. and so, and we saw a little bit of palm oil correction that maybe impacted some of the oil. So you get board compress a little bit. In reality, the cash markets have never moved, and they remain very constructive and very strong. And now you have seen how Board Crush have bounced back. I think that what we need to remember is like before all this volatility, whether it's the war or this or that, we were coming into very strong markets. Again, demand continues to grow for meal. And now we have another leg of that, that has a new demand. And mature markets like this, when they get new demand in a significant quantity like RGD, you get a significant change in margin. When you think about the structural changes that have happened over time, whether it's the different way in which China feeds porks now or Argentina with an exchange rate delta that makes the farmer really have no desire to sell and the farmer, to a certain degree, curtailing crush in Argentina. And then we see China coming back from the lockdowns and soybean meal being better than corn into the Russian, we continue to see this strong. Now we have also canola helping onto this on the strength in biofuels, in biodiesel per se. So I think from our perspective, we were always looking at cash margins. And so we -- it didn't make a significant shift in our operating profit as we were saying in the last earnings call, to be honest. So it has moved and at times some of these moves, to be honest, in commodities has been driven more by financial flows than fundamentals. I would say the fundamentals were strong before the war. They continue to be strong. Some prices have spiked because of the war, then they came back, but they came back to the high levels that we had before the war because it was just supply-demand fundamentals. And as much as people talk about rising interest rates and all that, rising interest rates do not produce grain. So we have not seen any change in our supply-demand fundamentals that were in place before the war, before the tightening by the Fed. So to a certain degree, we need to keep our eyes on the fundamentals. That's what matters.
Tom Palmer : That's very helpful color. Maybe I'll just follow up on the soybean oil side. There's a lot of renewable diesel capacity scheduled to come online later this year. What are you seeing in terms of that demand environment? Are you starting to see inventories build to essentially new customers? Because the soybean curve at least is downward sloping and it does seem like there's a lot more demand to step up that could at least theoretically change that.
Juan Luciano : Yes. Listen, I think we're building new industries. So there are so many players here and so many things in motion. It's a very dynamic environment that we continue to watch. I think with -- we see the demand coming as expected. I think you may have, like in every capital project these days, some projects that may be a little bit delayed. But we don't see any significant change to our medium-term forecast. So we see the strength. We see the recovery on even potentially edible oils based on China coming back into the markets and coming back from lockdowns. So none of our forecast has changed in the oil side. And if you look at the contribution of meal and oil to crush from the last quarter to this quarter, it has maintained. So it looks like both legs continue to have the same strength at this point than we expected.
Operator: Our next question comes from Eric Larson of Seaport Research Partners.
Eric Larson : Good morning, everyone, and congratulations on a great quarter. So this maybe some kind of like a little bit of a corny question Juan in this very 30,000-foot kind of speaking level. In the past, there's no promise that aren't long enough. When you have global recession, it does change the fundamentals for grain demand. And I get the question all the time. My sense is so that there are enough structural changes, particularly in the U.S. market, where even if we did have a global recession is that the fundamentals have a reasonable chance of remaining fairly strong. Is that an off-base thought? Or how would you look at that?
Juan Luciano : Yes. As I was saying in the previous question, I think that, again, before rising rates that could drive into a slowdown of the economy or the war, we had a tight balance sheet. I mean, Eric, and you want to keep it at 30,000 feet. We're going to run this experiment of trying to feed 2 more billion people from here to 2050, something that we haven't done in the past. And as I said, you could argue that if we're going to move population from 7 billion to like 9.5 billion by 2050, there's not the same proportion of arable land are going to be brought into production nor the same proportion of yield going to be. So I think in recessions, food is more protected than other things. So we don't expect a significant drop in demand, at least not for a sustainable period of time. While the reality is that production may or may not be there when you think about weather, when you think about the limitations of acreage or the limitations of potential yield. So our scenario is for tightness going forward. And we will do our best to make sure we continue to supply the billions of people around the world with their needs. But I think it's more prudent to plan on a tight supply-demand scenario. And at this point in time, when we run the supply-demand going a little bit more shorter term, we think that at least we need to have 2 very good years of good crops in North America and South America to bring a little bit more of relief to the current supply-demand inventories. Even if we have a good growth in North America, I don't think we're going to increase pipeline from -- for soybeans at this point in time. So South America has been with La Niña for like 3 years or something like that. So some of these events are starting to last a little bit longer. Thankfully, in North America, everything looks like we're still going to have another good year. So we welcome the end of the harvest to see a very good crop this year in North America.
Eric Larson : Yes. No, I would agree with that. So I'll ask one more quick question, and it's more technical in nature. So in the quarter, you put over $3 billion on top of your inventories. And I'm just curious when you look at where grain prices were on March 31 versus June 30, June 30 you were down across the board, corn, beans, meal, oil, wheat, all the prices were down. So does that mean that you've just taken on -- you've been able to buy more grain, taken on bigger positions so your volume inventory is larger? Does that explain that $3 billion-plus of inventory increase?
Vikram Luthar : Well, I think the inventory, when you're talking about us, I think our working capital effectively from Q1 to Q2 has come down a bit, Eric. So I think it's a function of both volumes as well as prices. Yes, prices have come off. But I think it's a function of also what's happening around the globe. You've got to think about not just our Ag Services and Oilseeds business. You got to think about also the other parts of our business. So while in general, there is a correlation to prices, there's also not necessarily same flat volume across every quarter.
Operator: Our next question comes from Steven Haynes of Morgan Stanley.
Steven Haynes : I just wanted to ask a question on China. It's come up a few times. Maybe could you just go into a little bit more detail around demand dynamics there? I think soybean imports are still kind of trending down year-over-year. So are we kind of at an inflection point there? And any additional color would be great.
Juan Luciano : Yes. We think -- we are in close contact with our China team, of course. And I think demand there has, of course, suffered an impact. You saw their quarterly growth rate for the whole country. But we get encouraging reports of how activity is coming back. I think that at the beginning, even if they relieved on some of the restrictions, people were still a little bit shy to come out. But I think that now we're seeing people coming back to the office, were a 100% back into the office. That brings traffic and that brings external breakfast and external lunches and things like that. So we see that with a recovery, if you will, coming from our perspective. If you think about the 4 main meats for China, China has produced about 5% more of the combined 4 meats in the first half of the year. So you could see there that, of course, the mouths are still there to be fed. And certainly, food security continues to be a high priority of, of course, the very responsible Chinese government. So nothing significant to report other than the ease of the COVID situation that is happening in multiple cities.
Operator: Our next question comes from Robert Moskow of Credit Suisse.
Robert Moskow: Hi, Juan and Vikram. Juan, forgive me if you've addressed this already, but there's a lot of grain still trapped in Ukraine. And I want to know if you have a view on what's going to happen to it and how it will affect your business.
Juan Luciano : Yes. So thank you for the question on Ukraine. So our priorities in the company, Rob, as we have said it before, continue to be twofold. First is to provide for the support and well-being of our employees now and into the future. But the second very close priority, what you described, is that how do we help the industry in Ukraine, the agricultural industry to come back on their feet? As you know, there are 20 million, 30 million tons trapped there. And we've been working to increase the land exports and I think even some of the river exports. And so we're very proud of what the whole industry has done to increase those. We're still short of that. And of course, that's why you see both countries signing this Black Sea initiative, which is to allow Odessa and other ports there to come back to full capacity to be able to export. At this point in time, as you have read the news, you get encouraging news 1 day and maybe discouraging news the other day. I do believe that both countries are committed to help keep this corridor open. I think that at the beginning, you're going to see a little bit of a trickle down of exports, maybe smaller boats. I think it's going to take a little bit of building confidence that this works before you can put the bigger boats. There are issues in the country about getting fuel for that. There are issues in the country about getting the crews to man this boat. There are also issues about insurance and financial institutions guaranteeing some of these large transactions. So I think I'm optimistic. I think you're going to have a trickle-down. That will be good for all for us and for everybody that we allow that capacity not to be unutilized, if you will. At this point in time, the world need to access to those inventories. So this is an important thing. If we don't have access to those inventories and they are not clear from the storage next year, we may have an availability issue for food because we will lose part of the crop. Ukrainians apparently have done a very good job of planting about 70% of all the capacity -- all the area, and they are harvesting right now the wheat. They're going to be harvesting in September and October, the corn and the sun seed. So we need that space to be able to store those in September and October. So we are optimistic. We are helping as much as possible. There is a lot of people with good intention. So hopefully, we will see the sea exports to grow over the next 2 or 3 months.
Operator: Our final question for today comes from Michael Piken of Cleveland Research.
Michael Piken : A couple of parts on Nutrition. The first part being within Human Nutrition, how much of your revenue growth was with new customers versus expansion of current customers? And then on the Animal Nutrition side, how much of the growth was due to the favorability of the lysine market versus just internal operational improvements? And how sustainable is that?
Vikram Luthar : On the Human Nutrition side, it was a balanced growth across new customers as well as existing customers. And we think about our revenue growth in terms of volume, pricing and mix, right? So I think we had balanced growth across the 3. We drove early action on pricing to ensure that we maintain margins and kept a strong focus on driving mix. Price elasticity for some of the products -- or most of the products, frankly, we participate in Human Nutrition has tended to be pretty low as Juan noted. So I think that's helped benefit protecting margins as well as driving revenue growth. On the Animal Nutrition side, as I highlighted in my prepared comments, most of that growth has come from amino acids, and amino acids has benefited from, a, the relative protein demand as well as supply chain challenges out of China. And the third aspect that's benefited us is our conscious effort to switch from liquid lysine to dry lysine and that's -- sorry, so from dry lysine to liquid lysine, yes. And that's actually helped us drive improved profitability and improved margins as well as increase stickiness with our customers. So most of that volume growth in Animal Nutrition has been driven by amino acids.
Operator: Thank you. We have no further questions for today, so I will hand back to Michael Cross for any further remarks.
Michael Cross: Thank you for joining us today. Slide 12 notes upcoming investor events in which we will be participating. As always, please feel free to follow up with me if you have any other questions. Have a good day, and thanks for your time and interest in ADM.
Operator: Thank you all for joining today's call. You may now disconnect. | [
{
"speaker": "Operator",
"text": "Good morning and welcome to the ADM Second Quarter 2022 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Michael Cross, Director of Investor Relations. You may begin."
},
{
"speaker": "Michael Cross",
"text": "Thank you, Alex. Good morning and welcome to ADM's second quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. Please turn to Slide 2, the company's safe harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in the presentation. To the extent permitted under applicable law, ADM assumes no obligations to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and highlight some of our accomplishments. Our Chief Financial Officer, Vikram Luthar, will review the drivers of our performance as well as corporate results and financial highlights. Then Juan will make some final comments, and he and Vikram will take your questions. Please turn to Slide 3. I will now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Michael. This morning, we reported outstanding second quarter adjusted earnings per share of $2.15. Adjusted segment operating profit was $1.8 billion, and our trailing fourth quarter adjusted EBITDA approached $6 billion. And our trailing fourth quarter average adjusted ROIC was 11.6%. Our team executed extremely well in the second quarter, navigating dynamic conditions to deliver nutritions to billions. And even as we work tirelessly to serve our customers and consumers around the globe, we are continuing to advance our strategy with productivity initiatives that are improving our efficiency and cost structure and innovation work that is powering profitable growth. Slide 4, please. Productivity is how we are improving our execution and optimizing costs, is key to our long term success but equally and importantly our productivity work is helping us mitigate the impact of inflation. We have a very strong pipeline of productivity initiatives and I will be updating you on them regularly. There are 2 initiatives I'd like to highlight today. First is a set of operational transformation efforts we are driving across production facilities around the globe and spanning all 3 businesses. Earlier this year, we completed a modernization project in our Marshall, Minnesota corn facility that is unlocking significant new value through enhanced automation, more sophisticated control systems and the increased use of analytics. We're already seeing double-digit returns on the investment we made in that project. This is an example of the kinds of projects we're undertaking across our operational footprint, designed to unlock incremental volumes and deliver safer, more reliable, more cost-efficient operations. Second, as we look to continue to grow returns, we want to focus not only on the numerator but also the denominator. Our original $1 billion challenge and its follow-up, the next billion, help us drive to 10% ROIC. Earlier this year, we launched a new challenge aimed at monetizing assets and optimizing working capital to unlock another $1 billion in cash, helping us to continue to drive returns. In fact, we already realized more than $400 million. Next slide, please. We're also advancing our innovation pillar, fueling profitable growth as we continue to expand our capabilities to meet demand across the 3 global trends of food security, health and well-being and sustainability. For example, last November, we added significant new capabilities in our Health and Wellness business with the acquisition of Deerland Probiotics. Demand in the human microbiome space is expected to reach $9.1 billion by 2026. While in animal feed, probiotic demand is expected to grow to $6.2 billion. Deerland with a broad portfolio of probiotics, prebiotics and enzymes provides a wide array of commercial, R&D and operations-related synergy opportunities to help us meet that demand. And we're taking advantage of those opportunities from connecting our deal and capabilities with our Biopolis team in Spain to utilize sport probiotics in a functional chocolate bar; to bringing together our expertise to expand our capabilities in pet, a key growth category; to looking across teams to offer new types of dietary supplements. Thanks to the strong collaboration across the enterprise, Deerland today is increasing our share of wallet for customers in both human and pet solutions. And we're seeing similar outcomes from other recent investments as well. In the first half of the year, our combined portfolio of 2021 nutrition acquisitions has delivered significantly more OP than we had in our acquisition models. Now I'd like to turn the call over to Vikram to talk about our business performance. Vikram?"
},
{
"speaker": "Vikram Luthar",
"text": "Thanks, Juan. Slide 6, please. The Ag Services and Oilseeds team delivered exceptional results in a dynamic market. Ag Services results more than doubled versus the year ago quarter. Global trade had an outstanding quarter. The destination marketing team's ability to meet customer demand around the globe helped drive strong volumes and margins. And good execution in global freight as well as net timing gains of about $65 million for the quarter contributed to significantly higher year-over-year profits. North America had a solid performance as export volumes remained strong in a good global demand environment, though year-over-year results were lower due to the prior year's insurance settlement and strong positioning gains. South America results were higher based on stronger origination volumes and better margins driven by strong global grain demand. Crushing delivered substantially higher results. Strong soy crush margins drove improved performance in all 3 regions as meal and oil demand remained robust. Positive net timing effects of approximately $90 million for the quarter versus the $70 million of negative timing in the year ago period helped drive year-over-year results. Refined products and other results were similar to the prior year period as strong demand for biofuels and food oils drove refining premiums and biodiesel margins, offset by approximately $150 million of negative timing effects versus negative $30 million in the prior year quarter. Equity earnings from Wilmar were significantly higher versus the second quarter of 2021. Looking ahead for AS&O. We expect Q3, the seasonal transition quarter from the South American to the North American harvest, to deliver results significantly higher than the prior year period driven by continued strong global demand for grains and strong cash -- crush margins. Slide 7, please. The Carbohydrate Solutions team delivered a second quarter of extremely strong results. The Starches and Sweeteners subsegment, including ethanol production from our wet mills, delivered much better results due to solid demand as food service volumes reached close to pre-pandemic levels. Corn coproducts, including strong demand for corn oil and effective risk management, drove higher ethanol and sweetener margins. BioSolutions continued its strong growth with $81 million in year-over-year revenue growth in Q2 and $136 million year-to-date. Vantage Corn Processors results was slightly higher in an environment of good gasoline demand and strong ethanol blending economics. A $50 million recovery from the USDA Biofuel Producer Recovery Program helped offset the prior year's strong industrial alcohol results from the now sold Peoria facility as well as valuation losses on ethanol inventory as prices fell late in the quarter. Looking ahead to the third quarter. We expect results significantly higher versus the third quarter of 2021 driven by steady demand for our products and favorable ethanol blending economics. On Slide 8, the Nutrition business continued on its strong growth trajectory with 19% year-over-year profit growth. Revenues increased by 20% on a constant currency basis and 13% like-for-like, and the team did a good job protecting margins. Human Nutrition delivered higher year-over-year results. Flavors grew revenue in North America, EMEA and South America, though profits were lower due to negative currency effects in EMEA as well as weaker results in APAC. Healthy demand for alternative proteins resulted in strong soy protein volumes and margins as contributions from the Sojaprotein acquisition as well as good demand for texturants drove higher results in Specialty Ingredients. Strength across probiotics, including in the recently acquired Deerland business as well as robust demand for fibers, contributed to a stronger quarter in Health & Wellness. Across the Human Nutrition business, we continue to see low price elasticity and good demand for our diverse portfolio of ingredients and systems as we continue to support our customers with new product and cost-out innovation and drive industry-leading win rates. Animal Nutrition profits were up substantially year-over-year driven by continued strong volumes and margins in amino acids. Looking ahead, we expect third quarter results for Nutrition to be higher year-over-year as the business remains on a trajectory to deliver 20% OP growth for the full year. Slide 9, please. Other business results increased from the prior year quarter driven primarily by higher ADM investor services earnings due to higher short-term interest rates. In the corporate lines, unallocated corporate costs of $267 million was slightly higher year-over-year due primarily to higher IT operating and project-related costs and higher costs in the company's centers of excellence. Net interest expense for the quarter increased year-over-year on higher rates and higher short-term borrowings to support working capital needs as well as higher expense for long-term debt. The effective tax rate for the second quarter of 2022 was approximately 18%. Based upon our current outlook, we expect full year corporate costs to trend towards $1.3 billion versus our previous outlook of about $1.2 billion, largely due to higher year-over-year interest rates. We still expect our adjusted tax rate to be in the range of 16% to 19%. Next slide, please. Year-to-date operating cash flows before working capital of $3.2 billion are up significantly versus $2.2 billion at the same time last year. Our balance sheet remains solid with a net debt-to-total capital ratio of about 30% and available liquidity of about $11.5 billion. Driven by our strong cash flows and robust earnings, we expect to accelerate our share repurchase program adding to the $200 million we repurchased in the second quarter of the year with an additional $1 billion in the back half. And of course, the strong cash flows and balance sheet also preserve our flexibility to continue reinvesting in the business and advancing upside growth opportunities. Our CapEx outlook is unchanged at approximately $1.3 billion for the year. Juan?"
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Vikram. Slide 11, please. For context as we discuss our outlook, I would like to go back to the goals and drivers we laid out at our Global Investor Day in December. We talked about the plan in which our strategic productivity and innovation actions will continue to build a better ADM and align our portfolio to meet accelerating structural demand changes driven by the enduring global trends of food security, health and well-being and sustainability and how that would drive a strong earnings trajectory over the plan horizon. What has transpired since then is that some of the market factors have reinforced and further enhanced the value proposition of our diverse product portfolio and our integrated global network of assets. This helps drive stronger-than-expected margins. So while we may see some reversion in the medium term, we now believe that margin structures are generally higher than when we have laid out in December. We are on a trajectory to deliver a very strong second half, resulting in expected full year earnings above $6.50 per share. And as Vikram said, the strong cash flows we are generating will enable us to accelerate the timing of our share repurchase program with $1 billion in repurchases in the back half of the year. As we look beyond that, we have not changed our strategy, nor our expectations of strong earnings growth and returns over our plan horizon. And as we laid out at our Global Investor Day, there are upside opportunities to our medium-term plan. But as we have already covered today, we are advancing those now and realizing higher value from them. Higher BioSolutions revenue growth, higher Health & Wellness OP contributions, the operational transformation across the enterprise, we expect these and more to add further upside in the medium term. The opportunities before us are significant. I'm proud of what our team has achieved, but I'm even more excited about what we're going to deliver tomorrow, next year and in the years to come. With that, operator, please open the line for questions."
},
{
"speaker": "Operator",
"text": "Our first question for today comes from Ben Bienvenu from Stephens."
},
{
"speaker": "Benjamin Bienvenu",
"text": "I want to ask one kind of bigger-picture conceptual question, and then my second question is more near term in nature. The first is on the accelerated share repurchase. I'd be curious to hear a little bit more about all of the decision points that flow into that bigger-picture decision. I would imagine -- you highlighted strong underlying fundamentals in the business. I imagine there's a component associated with working capital as well as some of that frees up with commodity markets cooling a bit. I'm curious also to get an update on your longer-term capacity expansion pipeline and how on schedule those build-outs are. And should we think of share repurchase as a lever to throttle up and pull back depending on M&A and CapEx timing of kind of long-lived capital investments? That's my first question."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Ben. Good question. We are maintaining our balanced capital allocation that we put together some years back. We always said that we're going to take about 30% to 40% of our free cash flow to reinvest in the business, and that's what our strategy of bolt-on and organic growth normally takes. And that will be the priority. We have exciting opportunities ahead of us. So we're going to prioritize our investment plan. But of course, we've been paying dividends for 90 years. We've been growing dividends for more than 40 years, and we will continue that. We increased dividends 8% this year. And when we're looking at our distribution, again, this 60% to 70%, whether there are strategic opportunities to do M&A or giving back to shareholders, as we said before, at this point in time, when valuations may be correcting and all that, we don't have any significant targets in front of us. Our team continue to look for bolt-ons. And given the significant strength of our cash flows, we have decided to honor that return of shareholder -- of funds to shareholders. So I would say we will maintain that balanced allocation. We are not -- in the plan when we presented in December, we were looking at the later part of the plan as we were approaching $6 to $7 per share that we will have ability to repurchase about $5 billion of that. Certainly, we will be, as I said in my initial remarks, north of $6.50 today. So some of those buybacks are accelerated to the scenario. So I would say it continues to be consistent in that regard. Is there a later part of the question I'm missing or forgetting? Oh, the capacity to increase, yes, organic capacity. Listen, we are -- as you can -- Vikram mentioned it, we are increasing our CapEx into $1.3 billion. And we've been accelerating some long lead equipment this year to make sure that our capacity expansions remain on schedule. So if we look at the big ones that we have right now, whether it's Spiritwood, it's still expected to be online by the harvest of 2023. We are expanding capacity in bioactives in Valencia. That's expected to come in the first quarter of 2023. That's also on schedule. So I would say, in general, across the globe, since we have the ability and the funds, we've been making sure that we eliminated that risk or we minimized that risk. Of course, there is always a risk of labor and labor is tight, especially in North America. But I think at this point in time, we don't have any major deviation to our plans."
},
{
"speaker": "Benjamin Bienvenu",
"text": "Okay. Great. My second question is related to the grappling of supply-demand that we're seeing right now. Obviously, there, you highlighted your expectation of structurally higher margins across your business. That makes sense given the kind of bigger-picture structural changes in demand that support the profitability of your business over the next several years. But we are starting to see demand destruction cyclically as the consumer deteriorates. I think your business is really well positioned. But I'm curious about kind of what you guys are keeping your eyes on relative to deteriorating underlying consumer and that -- the consequence of that rippling back up the supply chain -- the value chain potentially."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Ben, listen, we're watching the demand, of course. We go -- we work very closely with our customers and our farmers on this. I would say we have seen demand substitution, demand shifting here or there. And you see it in retail, maybe to private label. We've seen a little bit to people looking into smaller packaging to make things more affordable. So I would say, if I think of the big categories for ADM, food tends to be, despite all these comments, much more reliable, much more stable in that -- just the essential nature of that. I think our fuels business, our biofuels business in general, are more tied to programs that are long term and to initiatives to reduce emissions and improve climate over the long term. So they also tend to be relatively firm, if you will. And we see that with RGD bringing new demand for oil. So if we have any issue in edible oils, it's certainly been more than offset by the new demand on renewables. And I will say the area where maybe we keep a closer look to all that is animal feed. Animal feed has been impacted by this. We estimate something in the range of maybe 10 million to 15 million tons on a global basis that maybe we took out of our SMBs from the globe perspective, not just from our own revenue, from the globe SMBs. I think we have seen less of an impact on an OP perspective because as people like to trade down, if you will, or if they were to trade down from beef, chicken is a cheaper protein. It's a more affordable protein. And chicken is where we get all the soybean meal mostly sourced. If you think about what's happening with soybean meal, is -- it has a cost advantage to corn. So it continues to have a high proportion in the Russians on things that are, if you will, more demanded right now like poultry. When we go to Nutrition, I think you said it in your -- in the question is we are well positioned in some of the applications that are growing the fastest, and of course, not completely insulated. To a certain degree, we haven't seen significant drops at this point in time. So our expansions and -- continue forward. And you saw in our remarks, our -- the acquisitions we made last year are actually performing from an OP perspective better than in the economic model we put together."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ben Theurer from Barclays."
},
{
"speaker": "Benjamin Theurer",
"text": "Good morning, Juan, Vikram. So my first question is also related a little bit to, the picture you draw and you laid out just about 7, 8 months ago during the Capital Markets Day back in December and you talked about the path to get to the $6 to $7. Now you're just at $6.50 for this year. But the one thing that kind of pops out is the significant strength and the up we've been seeing on the return on invested capital. And you still say your long-term objective is 10%, but now we've been consistently gone higher. So if we put it like into the context and your comments of the margin structure to remain higher, how should we think conceptually over the medium to long term? Where is your real ROIC objective given that you've been consistently above that 10% level? And what does that mean for your potential to return cash to shareholders via dividends, buybacks versus then ultimately the CapEx needs?"
},
{
"speaker": "Vikram Luthar",
"text": "Thanks, Ben, for the question. So just to give you some context, when we decided on the 10% ROIC target, it was based on an expectation of about 300 basis points above our long-term cost of capital. The long-term cost of capital has been around 7% for some time now. But as we look forward and we see interest rates on the rise, there is likelihood that over the medium term, the long-term WACC is going to increase. We still want to maintain our buffer or our spread versus that long-term WACC. So in short, yes, we are actually looking at growing our ROIC beyond the 10%. We haven't firmly established a new target. But clearly, as you've seen, we are well ahead of 10% on the back of a strong demand outlook for the medium term as well a strong discipline on the denominator from a balance sheet perspective. So in terms of the capital allocation and the forward outlook, Ben, I think it's consistent with what Juan said. We expect we are going to be very disciplined and balanced in terms of how we deploy that capital both in terms of reinvesting in the business. And by the way, the opportunities to reinvest in the business are significant. Juan mentioned some, including the operational transformation. And much of that is not even baked into the medium-term plan that we highlighted. So we anticipate there likely will be some additional reinvestment in the business, but that should still leave us enough flexibility to do share buyback, potentially even in excess of $5 billion as well as continue our pace of dividend growth as we've done historically over the last 40-plus years."
},
{
"speaker": "Benjamin Theurer",
"text": "Got it. That sounds very promising, Vikram. And then just coming back on the growth and what's being delivered within the Nutrition segment, just to kind of frame it and understand it well what you're seeing into the back half here because clearly, you kind of reconfirmed the 20-ish percent growth in op income. We've had a very strong first half. You expect next quarter to be better. Is there anything where you think there could be a little bit of a headwind in the more short term just because of people maybe down-trading on the consumption side? You mentioned a little bit maybe the packaging side going to smaller sizes, et cetera, but to understand a little bit the risks versus the opportunities within Nutrition."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Ben, first of all, Nutrition is the business where we're probably exposed the most to the supply chain issues that everybody is talking about because we have a more variety of raw materials that we consume in all these formulations. So that is always something that the team works very well to overcome. But that's an issue we watch very closely. The second is, as you know, that business is also very strong in Europe. So there is a ForEx exposure that we keep on looking. And I mentioned at the beginning that Animal Nutrition volumes are a little bit more difficult, I think that given the price point where we are. So I would say those are the 3 levers that we keep on looking to make sure that we balance that. I would have to say the business has done a terrific job of offsetting all that. And again, we still believe in our enhanced guidance from 15% to 20% for this year. We're still going to do that. And the business, again, as I've said many, many times before, it's clearly in its path to achieve our $1 billion operating profit objective probably next year. So we feel good about the business, but it's not without a lot of active management, if you will. So..."
},
{
"speaker": "Operator",
"text": "Our next question comes from Adam Samuelson from Goldman Sachs."
},
{
"speaker": "Adam Samuelson",
"text": "So I wanted to maybe dig into the outlook on oilseeds a little bit. In your prepared remarks, you alluded to a mid-cycle or normalized medium-term kind of margin structure that moves higher, and I'd love to get a little bit more color on how your view over the medium term has evolved there and especially in the context of a North American kind of industry that's in the midst of some pretty healthy capacity expansions by you and many others."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Adam, listen, we continue to see a strong demand for meal and oil. North America has many advantages. North America has the beans, and North America has a robust domestic consumption. North America has the new demand for oil. So that makes, of course, soybean meal more competitive in the world. We continue to see good margins and good volumes in poultry as -- again, as the consumer favors that meat. We continue to see soybean meal advantage to corn. As I said before, in the Russian, that continues to have high inclusion rates. We see China recovering from COVID, so activity coming back. And we see Argentina pretty much given the current financial issues outside of the markets in terms of their aggressiveness. So I would say the scenario that we've been seeing, it continues with strength going forward. I think that's kind of what we see at the moment. So Q3 is strong. I would say maybe if I go to canola, canola has been -- margins have popped. So maybe we had -- we didn't have that in the past. Now we have, very strong. So we see a strong demand for biodiesel. I'm just trying to go mentally through all the businesses. And as we said before, Wilmar has been doing very good. So we don't see any significant clouds in the horizon right now. We have good expectations. We think that for the second half, the U.S. will become the place to export for corn and soybeans. So I think that exports should come to the U.S. from the period of September to maybe February or maybe even March. So we will have to watch logistics and whether logistics can allow us to execute a strong export season. But that's probably the only thing out there that I will be thinking, Adam, in terms of puts and takes."
},
{
"speaker": "Adam Samuelson",
"text": "Okay. That's all really helpful. And if I could maybe just switch gears over to Carbohydrate Solutions and specifically Starches and Sweeteners. I mean very strong kind of first half results. And I guess I'm trying to think about the contributions of between kind of volume growth, better ethanol profitability, coproducts and kind of -- and risk management and just that thing could be your most mature business and seeing some very, very healthy absolute and year-over-year performance and trying to just maybe disaggregate some of the drivers there a little bit."
},
{
"speaker": "Vikram Luthar",
"text": "Yes. Sure. So Adam, just breaking it down into volume margin and mix. In Sweeteners and Starches, from a volume perspective, actually, we saw volumes in North America higher year-over-year in the first half. And that is different from what you may have heard generally in the marketplace. We clearly benefit from an integrated network that enables us to deliver to our customers effectively and efficiently. And in some cases, we've actually also imported tapioca starch, for example, from Europe to meet that demand. So volume has been strong. In terms of margin, clearly, we benefited from higher coproduct values, including corn oil in particular. So that's also helped in terms of the net corn and effective margins for Sweeteners and Starches. And from a mix perspective, we talked about BioSolutions driving more and more growth, higher than what we had anticipated. So on all 3 fronts, in terms of volume, margin and mix, S&S looks brighter than what we had anticipated at the beginning of the year. In terms of ethanol also, if you think about similar way of thinking about volumes, volumes have been strong in terms of gasoline demand locally. Strong exports expected. We've had strong exports outlook for exports about 1.6 billion gallons for the year. In terms of margins, we've also again benefited from the fact that we've had good coproduct values particularly, again, in DCO. And that has helped us maintain margins. The other aspect is the RVOs have been finalized. So that puts -- removes the cloud from the regulatory landscape, at least for 2022. And gasoline -- and ethanol blending economics remain fantastic. If you include RIN values, that's above $2 relative to our BOB today. So I think based on all those facts, we think Q3 is going to be stronger quarter-over-quarter. And our outlook for the year is also very constructive."
},
{
"speaker": "Adam Samuelson",
"text": "Just to clarify, Vikram, because I don't think that was a nuance you said in the remarks. You said -- in the prepared remarks you said significantly higher year-over-year. And you're saying all of Carbohydrate Solutions will be higher quarter-over-quarter as well. I just want to be clear on that point."
},
{
"speaker": "Vikram Luthar",
"text": "No. My comments were specifically quarter-over-quarter, significantly higher quarter-over-quarter for Q3. And what I just emphasized as well, we are constructive for the outlook for the full year."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ken Zaslow from Bank of Montreal."
},
{
"speaker": "Kenneth Zaslow",
"text": "Just a couple of questions. One is, how much dollar amount do you expect to increase in 2023 from your cost your harvesting of your growth investments? How do we kind of think about that for 2023 in terms of the dollar amount that's going to be coming out from both your cost savings and your investments in growth?"
},
{
"speaker": "Vikram Luthar",
"text": "So I think, Ken, just providing context, going back to the Global Investor Day in terms of the framework, right, we talked about productivity and innovation driving about $1.1 billion in aggregate each. And then we expected market forces should be about $1 billion. In terms of 2023, we haven't gone through the specific plan yet, right? We are still working through that. But you could assume kind of a flat line, roughly speaking, over that 4-year time frame. What I would submit to you, Ken, is over the last 3 or 4 months, as Juan mentioned, we see additional opportunities on the horizon as it relates to operational transformation with digitization and automation. We talked about the Marshall example. If we multiply that Marshall example, the upside could be even more. But that's something that we are still fleshing out, and we will be prepared in the foreseen quarters to provide you a little more granularity on that. Juan?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Ken, what I would like to add to what Vikram said is that if I think back to December, there are 2 things that are different. A lot of the productivity efforts this year have been used to offset inflation, and I think the team has done a terrific job of protecting margins in that sense. Those productivity efforts continue. And as inflation may be received next year, we might see that -- more of that coming to actually improve our productivity versus just offsetting inflation. The second thing that I noticed and I tried to make a point in my prepared remarks is that we probably see innovation -- a little bit more activity in innovation. I think that as customers are trying to fight inflation, I think that bringing newness, bringing new categories, new innovation, we've seen that in Nutrition and other pieces of the portfolio. So I think there is an opportunity there. And some of the things that were not included in our 5-year estimate, whether it was some of the growth on Health and Wellness or some of the BioSolutions opportunities and all that, are coming stronger and faster than maybe we anticipated. So Vikram said it, we normally start the planning season maybe late September or October. So we're going to be looking at '23 there. But I think we're going to have a lot of puts and takes on a scenario that is very dynamic. But we feel good about the initiatives we can control, let's say."
},
{
"speaker": "Kenneth Zaslow",
"text": "Great. Just a clarification question. You talked about the $6.50 number. That includes share repurchases. Is that -- does that -- but yes, underlying fundamentals seem stronger than maybe you expected. Can you reconcile that? Because if it includes the share repurchase, I would argue that maybe better than that. I don't know if you're being conservative, but I'm not trying to pinpoint you. Just there was some incongruence in terms of the accelerated share repurchase and just kind of sticking to that $6.50 number. Just wanted to touch base with that -- touch base on that, if you could help us out on that."
},
{
"speaker": "Vikram Luthar",
"text": "Yes. So Ken, just to be clear, we did not say an ASR. We did not say accelerated share repurchase, right? I want to make sure that we clarify that comment. We did say that we are going to do $1 billion in the back half of the year. And as you well know is EPS impact of that given the averaging is pretty minimized for this calendar year. So the impact, whether you consider a share repurchase in the $6.50 number or not is frankly insignificant for 2022."
},
{
"speaker": "Kenneth Zaslow",
"text": "Okay. So just putting this all together, even as fundamentals kind of stabilize at this higher level, your share repurchases, your productivity and your growth initiatives can propel earnings higher in 2023 even if fundamentals kind of stabilize and not -- not to say we're peaking, I don't want to use that word, but if we stabilize at a higher level. Is that fair way to think about it that your interim actions of those 3 components can drive earnings growth in 2023? And I'll leave it there and I appreciate your time as always."
},
{
"speaker": "Juan Luciano",
"text": "Ken, the way I think about it, let me share that, is we need to have in ADM certain ambidexterity. On one side, we have a team that executed on opportunities presented by the market. And the team is executing on great opportunities this year. We don't control that all the time. We control our execution, but we don't control the opportunities that pop based on the macro environment. On the other hand, we are committed to keep improving the company. So -- and that's what we committed in December over the 5-year plan. So to the extent that those forces, whether favorable or negative, offset our productivity and innovation, at times, we're going to see more of that effect and at times, we're going to see less. So we know we're going to grow earnings over the next 5 years based on all that. We have not gotten to 2023 at this point in time. So I want to make sure that people don't hear that what we're going to do is a promise to grow earnings every year. We cannot control all the environment in the world, but we can control that we get better and we can control that we can maximize our execution on the opportunities provided. Will 2023 provide the same opportunities of 2022? Unclear at this point in time, and we need to go through our scenarios. But I think we're going to feel -- we feel very good, as I said, on the team's ability to execute. Some of the macro that we're seeing in terms of demand, demand for food has been growing over the last 15 years at 1.8% per year. You can argue that at times, we are getting to the peak of arable land being brought into production; that at times, we are hitting the peak of maybe even yield in the area. So we think that although margins may not stay at this level, if they're going to stabilize, they're going to stabilize at higher level than in the past. And that's where we based our forecast in December, and we are maintaining that. So we feel good about continue to grow earnings. We haven't gotten to the specific 2023 number yet."
},
{
"speaker": "Operator",
"text": "Our next question comes from Steve Byrne of Bank of America."
},
{
"speaker": "Steve Byrne",
"text": "Vikram, you had some constructive comments about third quarter for Ag Solutions and Oilseeds. And I wanted to specifically ask you about which of those 2 big businesses is primarily driving that favorable outlook. And in Ag Services, what is it? What regions of the world? Where do you see that strength coming from? And then one more for you on that. And if there is less crop production in the world in 2022 just from significantly less fertilizer applications, is that positive or net negative for you? You could have tighter supplies but less volume."
},
{
"speaker": "Vikram Luthar",
"text": "Yes. So thanks for the question, Steve. In terms of AS&O, I'll break it up. In terms of AS, we talked about destination marketing being very strong, right? So that's part of global trading. We anticipate that to remain strong given our ability to deliver to customers around the globe. And actually, we have the globally integrated network we have enables us to do that very effectively and efficiently. So we believe that's going to be a continued contributor of the growth. You think about also where we are positioned as a company in North America and South America. Where is the world likely going to come for grain in the back half of this year? It's probably going to be in North America. And with a reasonable crop that we expect right now, we should be well positioned to be able to benefit from that given our footprint. So I think the strength in destination marketing within global trade as well as our asset footprint and the dearth of grain around the globe in light of what's happened gives us good flexibility and constructive margin outlook for the back half. On the Oilseeds side, the fundamentals remain strong. I mean you've seen that the demand for oil both on the food side as well as RGD remains strong. So North American crush margins should be constructive. As soybean meal remains a very efficient and cost-effective protein substitute for even wheat as wheat prices, even though they've come up, they're still relatively expensive. So soybean meal remains an important feed for all types of protein and especially for poultry, and you've seen the number of poultry rising. So we're constructive for crush margins in North America. And even with biodiesel as well, that's also providing another avenue to support crush margins even in Europe. So crush margin outlook for the back half is strong in terms of the fundamentals that I highlighted. So candidly, the strength in AS&O is both on AS, as well as O for the back half of this year."
},
{
"speaker": "Steve Byrne",
"text": "And you made a comment on one of the slides about investing in this sustainable agriculture initiative of FBN. My question for you on that is, how meaningful of an opportunity do you think this is for you? Are your food company customers willing to pay a premium to you, and thus the farmer, for grains and oilseeds that are produced in various sustainable ways? Is this a niche? Or is this a potentially meaningful portion of your origination business?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Steve, this is Juan. We are building this. I think we have a division now within the business to look at these certified grains, if you will, or differentiated grains. There is certainly a consumer push into this that we feel through the CPGs and having the desire to engage in these transactions with us. So it continues to build. I don't think it's going to be meaningful to our earnings over the next 2, 3 years, but it's something that is aligned with sustainability trends. It's aligned with the ability of the whole industry to decarbonize and become better. So it makes us more sustainable. But it is growing. It's still small, but it continues to accelerate. So I don't think you should expect an OP impact over the next 2 years, but we're building a good position here. And with partners like FBN and all that, we continue to improve the economics and simplify the recognition to farmers as they embrace sustainable practices. So there is an economic motive or result later on, maybe in the planning cycle. At this point in time, it's more a sustainability thing that we do to help our customers as they need more of this."
},
{
"speaker": "Operator",
"text": "Our next question comes from Tom Palmer of JPMorgan."
},
{
"speaker": "Tom Palmer",
"text": "Maybe I'll just start off on the crushing side. Margin info in the earnings presentation was encouraging as was your second half commentary. At the same time, we saw Board Crush at least temporarily weaken going back a month or 2. So it looks like it hasn't carried forward in terms of Board Crush or in spot as much but -- and nor have much bearing on third quarter results, but I hope to get at least a little bit of color on what happened and why the impact was so temporary?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I think, Tom, what we saw -- of course, base has become -- became a little bit tighter in the U.S. and so, and we saw a little bit of palm oil correction that maybe impacted some of the oil. So you get board compress a little bit. In reality, the cash markets have never moved, and they remain very constructive and very strong. And now you have seen how Board Crush have bounced back. I think that what we need to remember is like before all this volatility, whether it's the war or this or that, we were coming into very strong markets. Again, demand continues to grow for meal. And now we have another leg of that, that has a new demand. And mature markets like this, when they get new demand in a significant quantity like RGD, you get a significant change in margin. When you think about the structural changes that have happened over time, whether it's the different way in which China feeds porks now or Argentina with an exchange rate delta that makes the farmer really have no desire to sell and the farmer, to a certain degree, curtailing crush in Argentina. And then we see China coming back from the lockdowns and soybean meal being better than corn into the Russian, we continue to see this strong. Now we have also canola helping onto this on the strength in biofuels, in biodiesel per se. So I think from our perspective, we were always looking at cash margins. And so we -- it didn't make a significant shift in our operating profit as we were saying in the last earnings call, to be honest. So it has moved and at times some of these moves, to be honest, in commodities has been driven more by financial flows than fundamentals. I would say the fundamentals were strong before the war. They continue to be strong. Some prices have spiked because of the war, then they came back, but they came back to the high levels that we had before the war because it was just supply-demand fundamentals. And as much as people talk about rising interest rates and all that, rising interest rates do not produce grain. So we have not seen any change in our supply-demand fundamentals that were in place before the war, before the tightening by the Fed. So to a certain degree, we need to keep our eyes on the fundamentals. That's what matters."
},
{
"speaker": "Tom Palmer",
"text": "That's very helpful color. Maybe I'll just follow up on the soybean oil side. There's a lot of renewable diesel capacity scheduled to come online later this year. What are you seeing in terms of that demand environment? Are you starting to see inventories build to essentially new customers? Because the soybean curve at least is downward sloping and it does seem like there's a lot more demand to step up that could at least theoretically change that."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Listen, I think we're building new industries. So there are so many players here and so many things in motion. It's a very dynamic environment that we continue to watch. I think with -- we see the demand coming as expected. I think you may have, like in every capital project these days, some projects that may be a little bit delayed. But we don't see any significant change to our medium-term forecast. So we see the strength. We see the recovery on even potentially edible oils based on China coming back into the markets and coming back from lockdowns. So none of our forecast has changed in the oil side. And if you look at the contribution of meal and oil to crush from the last quarter to this quarter, it has maintained. So it looks like both legs continue to have the same strength at this point than we expected."
},
{
"speaker": "Operator",
"text": "Our next question comes from Eric Larson of Seaport Research Partners."
},
{
"speaker": "Eric Larson",
"text": "Good morning, everyone, and congratulations on a great quarter. So this maybe some kind of like a little bit of a corny question Juan in this very 30,000-foot kind of speaking level. In the past, there's no promise that aren't long enough. When you have global recession, it does change the fundamentals for grain demand. And I get the question all the time. My sense is so that there are enough structural changes, particularly in the U.S. market, where even if we did have a global recession is that the fundamentals have a reasonable chance of remaining fairly strong. Is that an off-base thought? Or how would you look at that?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. As I was saying in the previous question, I think that, again, before rising rates that could drive into a slowdown of the economy or the war, we had a tight balance sheet. I mean, Eric, and you want to keep it at 30,000 feet. We're going to run this experiment of trying to feed 2 more billion people from here to 2050, something that we haven't done in the past. And as I said, you could argue that if we're going to move population from 7 billion to like 9.5 billion by 2050, there's not the same proportion of arable land are going to be brought into production nor the same proportion of yield going to be. So I think in recessions, food is more protected than other things. So we don't expect a significant drop in demand, at least not for a sustainable period of time. While the reality is that production may or may not be there when you think about weather, when you think about the limitations of acreage or the limitations of potential yield. So our scenario is for tightness going forward. And we will do our best to make sure we continue to supply the billions of people around the world with their needs. But I think it's more prudent to plan on a tight supply-demand scenario. And at this point in time, when we run the supply-demand going a little bit more shorter term, we think that at least we need to have 2 very good years of good crops in North America and South America to bring a little bit more of relief to the current supply-demand inventories. Even if we have a good growth in North America, I don't think we're going to increase pipeline from -- for soybeans at this point in time. So South America has been with La Niña for like 3 years or something like that. So some of these events are starting to last a little bit longer. Thankfully, in North America, everything looks like we're still going to have another good year. So we welcome the end of the harvest to see a very good crop this year in North America."
},
{
"speaker": "Eric Larson",
"text": "Yes. No, I would agree with that. So I'll ask one more quick question, and it's more technical in nature. So in the quarter, you put over $3 billion on top of your inventories. And I'm just curious when you look at where grain prices were on March 31 versus June 30, June 30 you were down across the board, corn, beans, meal, oil, wheat, all the prices were down. So does that mean that you've just taken on -- you've been able to buy more grain, taken on bigger positions so your volume inventory is larger? Does that explain that $3 billion-plus of inventory increase?"
},
{
"speaker": "Vikram Luthar",
"text": "Well, I think the inventory, when you're talking about us, I think our working capital effectively from Q1 to Q2 has come down a bit, Eric. So I think it's a function of both volumes as well as prices. Yes, prices have come off. But I think it's a function of also what's happening around the globe. You've got to think about not just our Ag Services and Oilseeds business. You got to think about also the other parts of our business. So while in general, there is a correlation to prices, there's also not necessarily same flat volume across every quarter."
},
{
"speaker": "Operator",
"text": "Our next question comes from Steven Haynes of Morgan Stanley."
},
{
"speaker": "Steven Haynes",
"text": "I just wanted to ask a question on China. It's come up a few times. Maybe could you just go into a little bit more detail around demand dynamics there? I think soybean imports are still kind of trending down year-over-year. So are we kind of at an inflection point there? And any additional color would be great."
},
{
"speaker": "Juan Luciano",
"text": "Yes. We think -- we are in close contact with our China team, of course. And I think demand there has, of course, suffered an impact. You saw their quarterly growth rate for the whole country. But we get encouraging reports of how activity is coming back. I think that at the beginning, even if they relieved on some of the restrictions, people were still a little bit shy to come out. But I think that now we're seeing people coming back to the office, were a 100% back into the office. That brings traffic and that brings external breakfast and external lunches and things like that. So we see that with a recovery, if you will, coming from our perspective. If you think about the 4 main meats for China, China has produced about 5% more of the combined 4 meats in the first half of the year. So you could see there that, of course, the mouths are still there to be fed. And certainly, food security continues to be a high priority of, of course, the very responsible Chinese government. So nothing significant to report other than the ease of the COVID situation that is happening in multiple cities."
},
{
"speaker": "Operator",
"text": "Our next question comes from Robert Moskow of Credit Suisse."
},
{
"speaker": "Robert Moskow",
"text": "Hi, Juan and Vikram. Juan, forgive me if you've addressed this already, but there's a lot of grain still trapped in Ukraine. And I want to know if you have a view on what's going to happen to it and how it will affect your business."
},
{
"speaker": "Juan Luciano",
"text": "Yes. So thank you for the question on Ukraine. So our priorities in the company, Rob, as we have said it before, continue to be twofold. First is to provide for the support and well-being of our employees now and into the future. But the second very close priority, what you described, is that how do we help the industry in Ukraine, the agricultural industry to come back on their feet? As you know, there are 20 million, 30 million tons trapped there. And we've been working to increase the land exports and I think even some of the river exports. And so we're very proud of what the whole industry has done to increase those. We're still short of that. And of course, that's why you see both countries signing this Black Sea initiative, which is to allow Odessa and other ports there to come back to full capacity to be able to export. At this point in time, as you have read the news, you get encouraging news 1 day and maybe discouraging news the other day. I do believe that both countries are committed to help keep this corridor open. I think that at the beginning, you're going to see a little bit of a trickle down of exports, maybe smaller boats. I think it's going to take a little bit of building confidence that this works before you can put the bigger boats. There are issues in the country about getting fuel for that. There are issues in the country about getting the crews to man this boat. There are also issues about insurance and financial institutions guaranteeing some of these large transactions. So I think I'm optimistic. I think you're going to have a trickle-down. That will be good for all for us and for everybody that we allow that capacity not to be unutilized, if you will. At this point in time, the world need to access to those inventories. So this is an important thing. If we don't have access to those inventories and they are not clear from the storage next year, we may have an availability issue for food because we will lose part of the crop. Ukrainians apparently have done a very good job of planting about 70% of all the capacity -- all the area, and they are harvesting right now the wheat. They're going to be harvesting in September and October, the corn and the sun seed. So we need that space to be able to store those in September and October. So we are optimistic. We are helping as much as possible. There is a lot of people with good intention. So hopefully, we will see the sea exports to grow over the next 2 or 3 months."
},
{
"speaker": "Operator",
"text": "Our final question for today comes from Michael Piken of Cleveland Research."
},
{
"speaker": "Michael Piken",
"text": "A couple of parts on Nutrition. The first part being within Human Nutrition, how much of your revenue growth was with new customers versus expansion of current customers? And then on the Animal Nutrition side, how much of the growth was due to the favorability of the lysine market versus just internal operational improvements? And how sustainable is that?"
},
{
"speaker": "Vikram Luthar",
"text": "On the Human Nutrition side, it was a balanced growth across new customers as well as existing customers. And we think about our revenue growth in terms of volume, pricing and mix, right? So I think we had balanced growth across the 3. We drove early action on pricing to ensure that we maintain margins and kept a strong focus on driving mix. Price elasticity for some of the products -- or most of the products, frankly, we participate in Human Nutrition has tended to be pretty low as Juan noted. So I think that's helped benefit protecting margins as well as driving revenue growth. On the Animal Nutrition side, as I highlighted in my prepared comments, most of that growth has come from amino acids, and amino acids has benefited from, a, the relative protein demand as well as supply chain challenges out of China. And the third aspect that's benefited us is our conscious effort to switch from liquid lysine to dry lysine and that's -- sorry, so from dry lysine to liquid lysine, yes. And that's actually helped us drive improved profitability and improved margins as well as increase stickiness with our customers. So most of that volume growth in Animal Nutrition has been driven by amino acids."
},
{
"speaker": "Operator",
"text": "Thank you. We have no further questions for today, so I will hand back to Michael Cross for any further remarks."
},
{
"speaker": "Michael Cross",
"text": "Thank you for joining us today. Slide 12 notes upcoming investor events in which we will be participating. As always, please feel free to follow up with me if you have any other questions. Have a good day, and thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "Thank you all for joining today's call. You may now disconnect."
}
] | Archer-Daniels-Midland Company | 251,704 |
ADM | 1 | 2,022 | 2022-04-26 09:00:00 | Operator: Good morning, and welcome to the ADM First Quarter 2022 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Michael Cross, Director of Investor Relations. You may begin.
Michael Cross: Thank you, Emily. Good morning and welcome to ADM's first quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. Please turn to Slide 2, the company's Safe Harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and highlight some of our accomplishments; our Chief Financial Officer, Vikram Luthar, will review the drivers of our performance as well as corporate results and financial highlights. Then Juan will make some final comments, and our Vice Chairman, Ray Young, will join us for questions. Please turn to Slide 3. I will now turn the call over to Juan.
Juan Luciano: Thank you, Michael. This morning, we reported first quarter adjusted earnings per share of $1.90. Adjusted segment operating profit was $1.6 billion. Our trailing four quarter adjusted EBITDA was about $5.3 billion, and our trailing four quarter average adjusted ROIC was 10.6%. What we saw in the first quarter was an extension and amplification of the factors that supported our growth in 2021. First was our team's great execution. Exceptional growth in nutrition and effective risk management exemplified how we continued to serve our customers and provide nutrition around the globe amid volatile market conditions and an inflationary environment. Second was an environment of tight supply and demand. We operated in the first quarter in a constrained supply environment for crops, mostly driven by the smaller South American crop, and for other products driven by some continued supply chain and labor availability issues. And we continued to see solid global demand across most of our products and in most regions. While the pandemic is not over and we're particularly monitoring the impact of rising cases and lockdowns in China, much of the world continued to emerge. Pent-up demand remained solid, even in the phase of higher prices. The great work our team did was in service to our customers, our company and our purpose. Our company has come together once again in the wake of the unprovoked and unjustified invasion of Ukraine. ADM has about 650 colleagues in Ukraine, and of course, our highest priority continues to be supporting and protecting them and their families as well as helping Ukrainian farmers to get as much of their crop production as possible into world markets. Our thoughts and prayers remain with the people of Ukraine. Slide 4, please. Food security is foundational to ADM's purpose and beliefs and recent events have only magnified its importance. From a global pandemic to the short crop in South America to the conflict in Ukraine, it has become clear that we cannot take an abundant and efficient supply of food for granted. Even beyond the current dislocations, this issue will remain one of critical importance over the next many years. As the global population grows, the need for nutrition will continue to grow with it. At our Global Investor Day last December, we talked about how we expect demand to push global trade flows of corn, wheat, soybeans and soybean meal up 21% or 130 million tons in the next 10 years. Meeting that demand will not happen automatically. It will take dedication, expertise and agility as well as global scale and capabilities. An example of that is ADM's destination marketing network, which gives us a presence in more regions where demand is strong and growing as well as more direct connections to customers and the ability to offer the full end-to-end capabilities of our integrated value chain. We are seeing how important that is today as customers are coming to us knowing that they can rely on ADM to meet their specific needs in a supply-constrained environment. We are not immune to the impacts of global disruptions, including those in the Black Sea region, but our broad portfolio of nutrition products and our ability to efficiently move them around the world will allow us to manage through these dynamic market conditions and continue to help support the food needs of billions of people. Please turn to Slide 5. Sustainability is another one of the global trends, so important to our companies and our planet's future. We remain focused on our strategy, which is aligned with fast growing demand for an array of products that are environmentally friendly, including alternative proteins. That industry continues to show impressive growth. Global sales for alternative meats and dairy products are expected to increase 14% annually, reaching is targeting $125 billion by 2030. When you look at the full range of products that alternative proteins could go into from meat alternatives and meat extensions to emerging categories like ready meals and specialized nutrition, the opportunities are even greater. Our own growth in this area is faster than the industries. The quality of our product, our integrated end-to-end value chain, our innovative product development and application capabilities and our global scale make us the partner of choice for our customers. In fact, we never had a stronger demand for our alternative protein products than we are seeing now and we are confident in continued growth. That is why earlier this month, we announced a significant investment to nearly double extrusion capacity at our Decatur, Illinois specialty protein complex. We also announced the industry's first end-to-end alternative Protein Innovation Center. This, of course, follows up on last year's addition of leading European alternative protein provider, Sojaprotein. Alternative proteins are just one of the many areas in which we are expanding our capabilities to meet growing customer demand for more environmentally responsible products. Our Biosolutions team, for example, continued to expand its pipeline and advance the evolution of our Carbohydrate Solutions business with an impressive $55 million in revenue growth in the quarter. Please turn to Slide 6. We are advancing sustainability commitments in other parts of our business as well. Last year, we unveiled new goals to reduce its Scope 3 emissions and eliminate deforestation from our supply chain. This is critical work. We do not make these kinds of commitments without an achievable plan to meet them. And once we move forward, we constantly challenge ourselves to do it faster. That is why last week, we announced that we've accelerated our deadline for a completely deforestation free supply chain by five years from 2030 to 2025. We also recently committed to work with the science-based targets initiative with the goal of obtaining their approval of ADM's climate targets and our alignment with ambitious global goals to limit rising temperatures to 1.5 degrees Celsius. Across ADM, we are continuing to align our portfolio with the world's growing needs and with our own purpose, positioning us to serve our customers, our communities and our planet and powering our future. I'll discuss our business outlook at the end of our call, but in the meantime, I'd like to turn to Vikram to talk about our business performance. Vikram?
Vikram Luthar: Thanks, Juan. Slide 7 please. The Ag Services and Oilseeds team effectively manage risk and executed exceptionally well in a dynamic environment of robust global demand and tight supply, driven primarily by the short South American crop. Ag Services results were significantly higher versus the first quarter of 2021. Global Trade results were higher, driven by strong performances in destination marketing and global ocean freight. North American origination margins and volumes were lower year-over-year, including approximately $75 million in negative timing effects, which will reverse in the coming quarters. Crushing was higher year-over-year in a strong global margin environment, driven by robust protein and vegetable oil demand. Improving margins in the quarter resulted in approximately $60 million in negative timing effects, which will reverse in the coming quarters versus approximately $50 million in positive timing in the prior year quarter. Refined products and other results were much higher than the prior year period, driven by healthy refining premiums and good refined oils demand in North America, as well as strong biodiesel margins in EMEA. Equity earnings from Wilmar were significantly higher versus the first quarter of 2021. Looking ahead, we expect substantially higher Q2 AS&O results than the second quarter of 2021. Slide 8 please. Carbohydrate Solutions delivered substantially higher year-over-year results. The Starches and Sweeteners subsegment including ethanol production from our wet mills delivered much higher results versus the prior year quarter, driven by higher corn co-product revenues, improved citric acid profits and excellent risk management in North America, higher volumes and margins in EMEA and higher volumes and margins in wheat milling. Sales volumes for starches and sweeteners continued their recovery toward pre-pandemic levels. And as Juan mentioned, our biosolutions platform continue to deliver impressive growth with $55 million in new sales as demand for plant-based products expands into more diverse applications. Vantage corn processes delivered solid execution margins, but position losses on ethanol inventory as prices fell early in the quarter, drove lower results versus the prior year. The prior year quarter’s results also benefited from demand for USP-grade industrial alcohol from the Peoria facility, which was divested in Q4 2021. Looking ahead to the second quarter, we expect the current market dynamics to continue delivering carbohydrate solutions results similar to the very strong second quarter of 2021. On Slide 9, the nutrition business delivered continued strong profit growth. Revenues increased by a very impressive 23%, even when adjusting for currency effects and removing the impacts of recent acquisitions revenue was up by 17%. And while margins have softened somewhat they remain healthy. Human Nutrition delivered higher year-over-year results. Flavors continued to deliver solid revenue growth, offset by some higher costs. Strong sales growth in alternative proteins, including contributions from our Sojaprotein acquisition, and positive currency timing effects in South America, offset some higher operating costs to help deliver better year-over-year results in Specialty Ingredients. Health and wellness results were was also higher year-over-year, powered by continued growth in probiotics, including our late-2021 Deerland Probiotics acquisition, and robust demand for fiber. Animal nutrition profits were nearly double the year-ago period, due primarily to strength in amino acids, driven by a combination of product mix changes, improved North American demand and global supply chain disruptions. Looking ahead, we expect nutrition to deliver as second quarter significantly higher than the prior year period. And with our recent acquisitions delivering ahead of our expectations, we are raising a profit growth outlook for the full year from 15% plus to 20%. Slide 10, please. Let me finish up with a few observations from the Other segment, as well as some of the corporate line items. Other business results were substantially higher driven primarily by better performance in captive insurance, including reduced claims settlements versus the prior year. Some of the claims settlements that we expected to negatively impact Q1 results are now expected in the second quarter. Net interest expense for the quarter was higher year-over-year on higher expense for long-term debt, higher short-term borrowings to support working capital needs and interest-related to a tax item. In the corporate lines, unallocated corporate costs of $209 million were due primarily to higher IT operating and project related costs and higher costs in the company’s centers of excellence, partially offset by incentive compensation, accrual adjustments. The effective tax rate for the first quarter of 2022 was approximately 16%. For the full year, we are now anticipating an effective tax rate at the higher end of our previously guided range of 16% to 19%. Cash flow generation remained strong $1.6 billion before working capital changes versus $1.2 billion in the prior year period. Our balance sheet remained solid with a net debt to total capital ratio of about 34% and available liquidity of about $9.3 billion, even with almost $3 billion in higher working capital needs since December. With that, I’ll turn it back to Juan.
Juan Luciano: Thank you, Vikram. Slide 11, please. After a strong start of the year, we are looking ahead. In the near-term future, we expect lower crop supplies caused by the weak Canadian canola crop, the short South American crops, and now the Black Sea disruptions to drive continued tightness in global grain markets through 2022 well into 2023 and perhaps beyond. As we look further ahead, markets will continue to reflect the importance of the enduring global trends that are fueling performance across our portfolio, including a growing global population, driving expansion in demand for food and healthy nutrition. That is why the work we’ve done to build a better ADM is so important. We have the global integrated network, risk management capabilities and diverse product portfolio to help us navigate through tight market conditions and meet global nutritional needs. This is the challenge we expanded, improved and repositioned our business to meet. And we’ll continue to advance our strategy and grow our capabilities through our productivity and innovation initiatives in order to drive performance under our control and deliver on the evolving needs of our customers, but it doesn't stop with ADM. Our working with other participants across the food and agriculture value chain, from farmers who continue to do more every year to sustainably increase production, to technology providers who offer new ways to make more with less, to governments who in a tight supply and demand environment, should resist the impulse to impose export restrictions. So looking at the balance of the year, when we combine the strategic work we have done to align our portfolio with fundamental global trends with our strong execution and the expectation of a continued tight supply-demand environment, we expect 2022 results to substantially exceed 2021's. And as we look further ahead to a future of increasing needs for more and better foods, we will continue to work to add new adjacent products to address the world's toughest challenges and unlock the power of nature to enrich the quality of life. Once again, I'd like to thank our colleagues around the globe for their commitment and hard work to serve vital global needs in a challenging and dynamic environment. With that, Emily, please open the line for questions.
Operator: Thank you very much. We will now begin the question-and-answer session. In the interest of time please limit yourself to one question and rejoin the queue for additional follow ups. Our first question today comes from the line of Adam Samuelson with Goldman Sachs. Adam, your line is open.
Adam Samuelson: Yes, thank you. Good morning everyone.
Juan Luciano: Good morning, Adam.
Adam Samuelson: Good morning. So I want to – Vikram, I guess, first question just as we think about the current market environment, obviously, a tremendous number of moving pieces. I guess I'm trying to calibrate some of the things that could prove more enduring to the business. And the one that sticks out, I mean, is inflation broadly. And I'm thinking about energy costs and what that – especially in Europe, thinking about construction costs for new plants. And I'm just trying to think, specifically in oilseeds, how higher operating costs in Europe, higher replacement costs if we're thinking about new builds, how that might be impacting oilseed crush margins around the world? And do you think that has a bit longer tail to it? And I would think that benefits you, given your footprint is principally in the Americas.
Vikram Luthar: Yes, Adam, thanks for the question. Yes, in terms of energy costs, clearly, we are not immune to that and we've seen an elevation in energy costs. As you well know, we have a program to actively hedge our program. So I think to a large degree, we've been successful in doing that. Nevertheless, in places like Europe, where energy costs have been significantly elevated, yes, that's had an impact on net margins. But as you look at the broader dynamics, we continue to see very strong outlook in terms of vegetable demand as well as protein demand. And as you see, most of the grain flows, given what's happening around the world particularly in the Black Sea region and the short South American crop moving to North America that should actually support us in terms of our footprint. So the structural changes associated with RGD remain very much in intact. So we think longer term, we feel very confident about the move higher that we cited in the Global Investor Day in terms of crush margins. And for 2022, in particular, we see even farther – even more strength, given some of the near-term dynamics I just referenced.
Adam Samuelson: Okay. That's helpful. And then I guess the second question is more on capital, on the balance sheet, and I think it was impressive to see in the quarter the growth in inventories, yet the committed credit capacity basically being unchanged from year-end. And I'm wondering how you think about that as a strategic asset and the opportunities it presents both in terms of merchandising and risk in the short-term, but also if the M&A pipeline is maybe improving as some others may not have the liquidity that you do in the current high commodity environment?
Vikram Luthar: Yes, Adam, we clearly view our balance sheet as a competitive advantage. And in terms of capital allocation, we've talked about this before. Our capital allocation is inextricably linked to our strategy. In terms of the guidelines, in terms of the framework, we've articulated about 30% to 40% of our cash flow as we'll direct towards capital expenditures and the remaining 60% to 70% for strategic growth investments. And given our balance sheet flexibility, we are clearly in a position to undertake some of those growth investments, including M&A, if that becomes attractive, but also shareholder distributions, including 30% to 40% towards dividends. As we cited in Global Investor Day, we expect dividend payouts to be actually at the higher end of that 30% to 40% range in the near to medium term. But at the end of the day, if you step back, think about the operating cash flow we generated, $1.6 billion in Q1. So we should be in a position to conduct meaningful buybacks as well in the medium term, as we noted in the Global Investor Day. In the near term, we will repurchase shares to at least offset dilution.
Adam Samuelson: Great. And that color is all really helpful. I'll pass it on. Thank you.
Operator: Our next question is from Ben Theurer from Barclays. Ben, please go ahead.
Ben Theurer: Yes, perfect. Thank you very much. Juan, Vikram, congrats on the strong results. I wanted to ask a question around just the global freight and global trade environment, and obviously, with some of the backlog that's been caused on unloading ships over in China because of all the lockdowns. Have you seen or are you seeing any incremental disruptions over the last couple of weeks that you think is going to cost greater opportunities for you guys within the next coming weeks to excel here and to ultimately deliver a strong quarter on the ex-service piece, just similarly what we saw already in 1Q?
Juan Luciano: Yes. Thank you Ben and good morning. Of course, we've been dealing with supply chain issues for a while, and I think that the situation in China has nothing more than just bring back more challenges, if you will. We see the number of ships in congestion, if you will, from Capesize, Panamax, Supramax and Handysize have increased over the last week, increases about 10% give or take depending on the category. So I think that's especially complicated as you see that because of the different conflicts and different shortages in crops that we have, some of these trading flows around the world that are being redirected. So you redirect trading flows with maybe less ship availability and higher freight and longer travel times. So the situation continues to be dire. And that's why it's so important to have a team, a global team, very active with many options to provide supply and then to reach different destinations. So the combination, if you will, of our global trade with the destination marketing and all that becomes more and more important every day for customers around the world.
Ben Theurer: Okay. Perfect. Thank you very much. I'll leave it here so you can stay on track.
Juan Luciano: Thank you, Ben.
Operator: The next question comes from the line of Tom Palmer with JP Morgan. Tom, please go ahead with your question.
Tom Palmer: Good morning and thank you for the question. Maybe just follow up on the outlook for the second quarter in the AS&O segment, maybe just a little commentary on the subsegment expectations. Are you expecting year-over-year profit increases across all three of the subsegments? Are there any to call out of particular strength?
Juan Luciano: Yes. I would say our first quarter was – showed strength across the three businesses, very good performance. And as we look at Q2, probably we see the same. There was some reduction in exports in Ag Services in the first quarter because of weather issues and some of that has been moved into the second quarter, so we have a good book there. China has put some orders also for corn Q2 and Q3. We expect the crush profits to continue to be very strong in the second quarter, certainly, refining margins also very good. So I would say demand has been domestically strong for soybean meal in North America and certainly a lot of demand around the world for that. So, we continue to see crush very well supported by the oil and the meal. We continue to see demand for our exports in the second quarter. So had the window of exports of North America, we will have expanded a little bit. And certainly, the refining materials are – they've maintained very strong margins. If you look at last year, we entered into Q1 with low margins and we ended with strong margins. This year has been strong margins across the quarter and we expect that to continue into the second quarter.
Tom Palmer: Great. Thank you.
Juan Luciano: Thank you, Tom.
Operator: Our next question comes from Ken Zaslow from Bank of Montreal.
Juan Luciano: Good morning, Ken.
Operator: Apologies, we have lost Ken from the queue. So next in the queue we have Ben Bienvenu from Stephens. Ben, your line is open.
Ben Bienvenu: Hi, thanks. Good morning everybody.
Juan Luciano: Good morning, Ben.
Vikram Luthar: Good morning.
Ben Bienvenu: I want to ask about the nutrition business. Strong results in the first quarter, you noted it, versus the prior expectation of 15% plus, now 20% growth for the year. You called out acquisition contribution or the performance of acquisitions. Is that a fair breakdown of organic versus inorganic growth, thinking about maybe 15% organic growth plus 5% inorganic? Or how would you delineate between the two contributing factors?
Vikram Luthar: Well, so as we talked about – I referenced in my comments, Ben, the revenue growth, right, was 23%. And if you exclude M&A and adjusted for FX, it was 17%, so strong revenue growth frankly across Human Nutrition and Animal Nutrition. The reason our profits were stronger than what we had guided in Q4 were threefold. One is, we did expect some upfront costs that we cited and we had anticipated inflationary cost pressures and supply disruptions. However, with the smart pricing and active supply chain collaboration with our AS&O carb solutions teams, we manage these very well across all the nutrition businesses. The other aspect as we talked about industry-leading win rates in our Global Investor Day, actually our win rates are even expanding beyond that. And the second point is, as you referenced, the OP contribution from our M&A were actually higher than expected. The third point is amino acids. Because of the deliberate switch we mad e from dry to liquid lysine last year, combined with the strong North American protein demand and the supply chain disruptions, our contribution from amino acids business was actually higher. So really, it's a reflection of those three factors that resulted in higher than expected nutrition profit for Q1.
Ben Bienvenu: Okay, great. I'll get back in the queue. Thanks.
Juan Luciano: Thank you, Ben.
Operator: We do have a question on the line now from Ken Zaslow with Bank of Montreal. Ken, please go ahead.
Ken Zaslow: Hi, good morning guys.
Juan Luciano: Thank you, Ken.
Vikram Luthar: Good morning.
Ken Zaslow: When I think about longer term, you guys set out two targets: one, high single-digit growth, and then the $6 to $7 outlook by 2025. Given the operating environment, I know you just literally just put this out, so it's hard to change it on a change of environment. But how do you see that? Do you think that the growth rate is higher? Or do you think that the ability to get to the $6 to $7 comes earlier than expected given the favorable operating environment?
Juan Luciano: Yes. Thank you, Ken. Good question. Listen, when we put the plan in front of shareholders in December, we're just mostly to explain how our company and our business model and portfolio continues to evolve, aligning ourselves with markets of higher growth rates and actually higher margins. And so, what we can control, as you can imagine, is a portfolio, capital allocation and our execution, so we focus on that. So directionally, we're going into that, and we just put a milestone there to have a reference for investors. Of course, at this point in time, we're going to hit those numbers earlier. It is obvious. But I think we don't worry that much of the pace. It's more important for us the direction we're going is higher margins, higher growth rates. The pace sometimes is dictated for outside events in which our team and their execution are supposed to capitalize as much as possible into them. So do you ask me, it's going to be $6 to $7 in 2025, certainly, is going to happen sooner than that. But again, I think it's important to keep the team continue to build that better company with Vikram's explain how we have generated $1.6 billion of cash flow in this, that gives us much more optionality on how much to accelerate that shift of the company into higher margin and higher growth rates. And to be honest, after we have created nutrition and nutrition – we continue to upgrade targets, even if they make $700 million last year. We are now focusing on building the next scale business. We're looking at microbial solutions and how that will drive the next generation of food and proteins. We are looking at climate solutions or biosolutions, which will drive the next generation of sustainable products and also microbiome modulators, which with the pre, pro and post biotics will drive personalized health and nutrition. And let me remind you and the shareholders, contributions for all these three elements that we're thinking on building was basically muted during the forecast that we showed in the December Global Investor Day. So we feel pretty good about the existing business is delivering $6 to $7 maybe earlier than expected, but we have in the capabilities to build the next scale business for ADM.
Ken Zaslow: Great. And then my follow-up question is, when I think about the renewable diesel and the way it's going to happen. And with the backdrop of inflation, how does the balance between the renewable diesel kind of going versus the potential for inflation to curtail that, where do you see that renewable diesel already, the horse is already out of the barn that momentum as we continue versus is there a potential that the inflation can kind of either elongate the timing of it or delay anything. And then I'll leave it there and I appreciate your time.
Juan Luciano: Thank you, Ken. Good questions as always. Listen, first of all, let me say on that, I'm very proud that our team, and remember, when we announced speeded with, we said we've been looking at that for two years. So we took into considerations, all of these aspects. And so our product remains to be remains on schedule to deliver on the harvest 2023. So most important, what we can control that project is going well and we managing through inflations and delays. So proud of the team there. Listen, at the end of the day, we still expect the significant new capacity will come online. Of course, when there are so many announcements in any industry, you're going to have the percentage of that being coming on a stream. I think that there may be somebody ability on the timing of all that, it doesn't escape anybody that there are labor availability issues, especially in the U.S., certainly raw materials, whether it is a steel or energy or whatever are more expensive than whenever some of these things were announced. And maybe the builders of these hedge, the raw materials exposure to both things in anticipation but I will say, if there is some delay, it may not be bad to allow crush expansions to actually come on a stream. So they can provide the soybean oil for all these plants to run and we also wait for canola to have a path to that. So I think, listen, the industry will develop, it may have some short-term issues here or there, but at the end of the day, a significant piece of new demand for soybean oil is being built and will be built.
Ken Zaslow: Perfect. Thank you very much.
Juan Luciano: Thank you, ken.
Operator: Our next question is from Steve Byrne from Bank of America. Your line is open.
Steve Byrne: Yes, thank you. Given those comments you just made there Juan about the outlook for renewable diesel and you also had comments in your slide deck about your own views about the demand growth for alternative meat and dairy, which could potentially lead to less demand for soybean meal. I'm curious to hear your own view on, do you see any challenge here meeting what might be a disparate growth in demand for the oil versus the meal side of all of these crush plants that are going to be built.
Juan Luciano: Yes. Listen, it's a very good question. And we look at that, of course, with a lot of attention. I think right now, when we see the capacity coming, it's all capacity needed actually to supply the growth of protein around the world. We see North America with very strong domestic demand for meal, but we see also in North America soybean meal being the most competitive around the world. Especially now, when you have issues in Argentina with some changes in the deal when you have short crops in South America, like we have had and we continue to have a strong demand. We see also that customers are relatively open, so there's not a lot of inventory in the chain that are one point needs to be flushed out. And when you look at, what's happening with feed and competitive feeds, certainly wheat given the conflict in Ukraine, the unfortunate conflict in Ukraine. Wheat prices needs to go up high enough that they get out of the feeding Russians, so they can be preserved to feeding people. When you take that up, you bring corn, the most effective carbohydrate and corn immediately brings soybean meal into the Russian. So we're not only see strong demand, but we see high inclusion rates staying. And again, given the strong leg of soybean oil in North America that will make soybean meal the most competitive in the world. So we actually are very positive about that demand and we think that we need all the expansion to match the market share that soybean meal North America will take from the rest of the world.
Steve Byrne: Thank you, Juan. Maybe just one more on the oil side and that is, what do you see as the global impacts of Indonesia's ban on palm oil exports. How does that affect the global supply of oil and your business in particular?
Juan Luciano: Yes. Oils have been tied for several months already, if not the year and of course, any announcement in the proximity also of the largest producer of palm oil in the world rattles the markets. Of course, it was immediately clarified that this doesn't include crude palm oil, which is the biggest product. So I would say, I think Indonesia is just trying to take a short-term palliative for their domestic inflation. I don't think it will significantly alter the global balances. Although, the global balance is continue to be very tight and any disruption, we have the Ukrainian disruption of course with and the Russian with sunflower oil so this is an area that everybody has to pay a lot of attention and it will require companies like ADM to having the ability to reformulate, so we can take some customers that our existing customers or either palm oil or sunflower oil to have alternatives to continue to supply their customers. So we are seeing that through our Olenex joint venture, we're seeing that through our Stratas joint venture. So as we’ve seen the opportunity to add a lot of value to some of the customers that are looking for replacements at this point in time.
Steve Byrne: Thank you.
Operator: Our next question comes from Robert Moskow from Credit Suisse. Robert, please go ahead with your question.
Robert Moskow: Hi, thank you. I was wondering if you could give us a little insight into your visibility into crush margins in the second half of this year. Are your customers locking in their commitments for demand and supplying you yet? And can you use that to lock-in those margins. And then I had a quick follow-up if I could.
Juan Luciano: Sure. Yes, Rob. As I said, I think that we have very strong visibility of course into Q2. I would say further than that, I think customers – the markets are inverted. So customers see prices relatively high right now, those customers that are not covered, they feel like maybe the course is showing them that they can get covered later at the cheaper rate than today. So I would say, in general, we have coverage for the next quarter, not for Q3 or Q4. But when we look at the demand that we are seeing around the world, we think that when you think about meal and oil, in general, not only North America, but also Brazil. The crush margins need to be there to encourage the crushers to crush. We need the demand for oil and we need the soybean meal. So you will have to have the demand, the crush margins to incentivate people to crush. And we are seeing that with the margins that are happening in Brazil or the U.S. or Europe, all our margins today are higher than what we anticipated. And we think that that's the year rollout and demand continues to be solid out there and strong, crush margins will continue to send that signal to all of our crushers, which is we need the meal, we need the oil keep crushing.
Robert Moskow: Got it. And just a follow-up, you mentioned ocean freight being a big benefit. And I think it had to do with some redirecting of ships in China related to lockdowns. But I'm sure, it also has to do with just overall moving freight from one destination to another and shifting directions. Can I assume that is a big benefit to you and that could continue for the rest of 2022 or is it kind of like more episodic in nature.
Juan Luciano: Rob, we have – as part of our global trade group, we have a strong ocean freight group and they work hand in glove to make sure that we continue to serve the customers with the most effective destinations, the most efficient destinations. So we are a big player. And as a big player with a lot of resources, we tend to have a relative advantage to others. So when things get complicated and right now, they are very complicated. We tend to have a relative higher competitive advantage than others. So I think that shows in the margins that we obtained in this. And logistics right now are complicated. They are complicated in the river. They are complicated in the oceans and there is a lot of redrawing of trade flows and you can only redraw a lot of trade flows, if you have a lot of origin options and a lot of destination options, because you need to connect both. And our ocean freight group counts with that blessing, which is ADM originating all the key parts of the world. I have destination units in all key parts of the world. So it provides them with more ability to play supply routes than maybe other players.
Operator: Our next question comes from Vincent Andrews from Morgan Stanley. Vincent, your line is open.
Vincent Andrews: Thank you, and good morning, everyone, and congratulations to Vikram and Ray on your new roles. And Ray, it was great to work with you all those years. Juan, could I ask you just to talk a little bit about, how you're thinking about the consumer and consumer demand, maybe particularly in Europe, but I guess, also globally. Just given we have a lot of food inflation, we have lot of energy inflation. What do you think gives clearly we need to destroy some demand just given how tight suppliers. But how are you thinking about that equation this year into next year?
Juan Luciano: Yes. Listen, we are paying, of course, close attention to that. At this point in time, we haven't seen any significant impact on demand for us. If you think about so far customers are paying higher prices, but they still, especially in North America, they still haven't changed their behaviors. We think that, of course, if you have disposable income suffering from higher gas prices and higher food prices eventually, they will have to adjust. We have seen more to be honest, Vincent, in the – some of the emerging markets in which may be food is a bigger percentage of their disposable income. So we have seen some adjustments, a small adjustment in that. But I would say, at this point in time, we have not seen any relevant or material adjustment to our demand. And we think that given the pent-up demand that existed from recovery of the coming out of COVID, people, in general, have been – having higher saving rates. And we have seen wage inflation around the world that have gotten more money in the pockets of many. So at this point in time, we think consumer has been and demand has been very resilient. But there’s going to be a point in which disposable income will get tight and we will see some changes into that. We haven’t seen it yet. We don’t see it in the immediate future either.
Vincent Andrews: Okay. Thanks guys.
Operator: Our next question comes from Michael Piken from Cleveland Research. Michael, please go ahead.
Michael Piken: Yes. Hi. I was wondering if you could talk a little bit about the impact of the ADM crew here in the U.S. as well as internationally and what that might look like in terms of the impact for meal demand.
Juan Luciano: Yes. Listen Michael, we haven’t seen at this point in time any significant impact to our poultry demand in North America. The numbers at this point in time seems to be about half the size of the issue that was in 2015. So it’s something we are following very closely. Of course, but we cannot say that we have an impact so far. And hopefully this virus are difficult to control. So of course, there is a lot of sanitary elements being thrown at that, hopefully, that will placate. But we will have to keep a close eye to them.
Michael Piken: Great. And a follow-up question is just shifting gears. Are you concerned about the movement of fertilizer throughout the world? I know you have a fertilizer business. But beyond that just the impact if we do end up in a really tight grain environment, are you – how do you think there is a food versus fuel debate. How do you see that sort of playing out? And is there any risk to the ethanol volumes or the growth in biodiesel or how do you sort of see that playing out. Thanks.
Juan Luciano: Yes. On fertilizers, to be honest, Michael, of course, fertilizer supply chains are tight and it’s been highly publicized. However, our evidence shows that trade lanes are adopting and markets are getting sufficient supplies of fertilizer. Of course, we had much higher prices that will drive prices for grain. I think today, especially Brazil – the U.S. certainly have the fertilizer for this crop. So the question is the Brazilian crop, which is coming in a few months. And I think it is still possible what we get from our people in Brazil to get enough potassium fertilizer in country by the planting season. And of course, any shortages can produce production losses. But at this point in time, when people are thinking between maybe 15% or 20% less application at that level, we don’t think that we’re going to see a significant change in the production forecast. It is probably more depending on the weather at this point in time and rain than fertilizer application. And the second was on food versus fuel. At this point in time, I think that we are committed to try to help the world with food and the environment. So they’re both axis of the same equation. I would say, they both touch disposable income that I was saying before, if you get ethanol to reduce the cost of gasoline that creates more disposable income to take on food inflation. If you take – if you don’t put any biofuels into gasoline and you pay more for gasoline, then you may get cheaper food, but you have less disposable income there. So, to be honest, I think the molecules react to the prices that they are given in the market given the different regulations and the different values. Well, we try to be as efficient as possible bring in as much of those – as many of those molecules to the market as possible to satisfy everybody. So I think at this point in time, we have seen some corrections in certain biofuels mandates across the world. But in other countries, it has been only a reduction and not an elimination. So this – I think they are short-term things, because we still have the climate crisis, which is a long-term objective that mostly the transportation industry, but also every industry will have to address biofuels, sustainable aviation fuels and all that are a big part of that reduction.
Operator: Our next question comes from Eric Larson from Seaport Research Partners. Eric, please go ahead.
Eric Larson: Yes. Thanks. Congratulations, everybody. And Vikram, I congratulate you on your new role and Ray you as well. I look forward to working with both of you on that. So congrats. So listening to the call today, Juan, I hear as all of us, there is a lot of confusion, there’s lot of moving parts. So when I look back 10 weeks ago, I realized that U.S. grain prices had to move higher in order to even – kind of even begin to maybe ration demand or not, and of course, they’ve moved quite a bit higher. So what I’d really like you to do Juan is, kind of take a 30,000 foot view point here. As we all know price does ultimately ration demand. And the only thing I can see that would maybe through that at this point is maybe global recession or U.S. recession. So can you kind of – I don’t see a lot of demand destruction at this point a little bit from bird flu, maybe it’s 25 million bushels, which is a spit in the ocean. But do you see any significant demand destruction today and including what’s happening in Ukraine. And what they have in storage for corn and other things. What – how do you look at the world today from a demand – total demand perspective versus supply and are we seeing demand destruction with high prices?
Juan Luciano: Yes. Thank you, Eric. Let me see – let me tell you how I see this. So last year was a big production year and the world needed to consume more grain than that big production. So the issue is, the world continues to grow and sometimes it’s not a matter of population growth, but it’s a matter of income. And how people like – people in China has been an incredible economic improvement of their standards on living that improve their diet, that doesn’t go down. So we think that’s where we keep on talking about our trend of food security. We will have to provide more for the world. In situations like today, where we are already tight from a supply demand perspective and we will get tighter as demand continues to grow. We see here in ADM that at least we need two very good seasons of crops in North America and South America to actually balance and become more comfortable in those supply-demand balances. When we think about prices today, prices today are going up to mark three things that needs to happen. One is export prices need to go up to being able to draw out all the inventories that are stuck there or they are safe, they are hoarded there to be able to replace the production that we have lost. The production we have lost in South America, but the production we are losing now in the Ukraine and Russia. So first, you need to draw out those inventories and bring them into market. So we can balance ourselves. The second, as I said before, wheat needs to be placed out of the Russians. So you can be preserved for human consumption. And the third one is to give farmers like you, the signal that they need to plant more and I think the world need more acres. Those acres today, they are not going to happen from the Baltic area, they are not going to happen from U.S. that we are basically maxed out. So they may happen in South America. So we need higher prices to bring South American acres, we need higher prices to draw those inventories into the market. And we need two good years of crops, both in North America and South America. That will allow us to balance the supply demand, given the strong demand.
Eric Larson: Yes. And I agree is that – we need this year’s crop in the U.S., next year’s crop in Brazil and we need 2023 in the U.S. to do very well again. And maybe even another – we need four maybe big crops around the world. But sometimes what rebalances some of this is, this high inflation rate we have around the world, there is an economic recession that comes in place. Have you factored anything into that forecast that would change your outlook?
Juan Luciano: Eric, I’m not an economist. But I think there is a narrow path to achieve a soft landing here. And the U.S. economy has been very resilient through all this events. So I think the U.S. economy is driven by the consumer. The consumer has been saving money for two years that they didn’t spend a lot. And as I said before, they were COVID recovery packages. But there is also been salary inflations and wages inflation that has put money in the pockets of customers. So I think that for the foreseeable future, we don’t see a significant impact of demand. If not, we will be flagging that out, but we look at that, we look at our plans, we are preparing our plans for a long period of the strong demand. We want to run them at high capacity. So at this point in time, I don’t see an issue in the west maybe the only flag is how COVID lockdowns evolve in China. But that I don’t have a lot of visibility at this point in time.
Eric Larson: All right. Thank you, Juan. I appreciate your comments.
Juan Luciano: Thank you, Eric.
Operator: Those are all the questions we have time for today. So I will now turn the call back over to Juan Luciano.
Juan Luciano: Thank you, Emily. Before we close our call, I wanted to take a minute to thank Ray for his exceptional contribution all this year to ADM’s as our CFO. So thank you, Ray. And it’s been a pleasure and I’m delighted that you continue with us to continue to help take ADM’s a bigger player.
Ray Young: Thank you, Juan. And also I just want to thank all the investors and all the analysts for really like 11 years in this role, I’ve grown, I’ve learned from you. And hopefully, we’ve been also been able to teach you about ADM and how this is a great company. And the future is incredible for this company and I look forward to continuing support Juan and support the company in my new role. So thank you, Juan.
Juan Luciano: Thank you and congratulations, Ray. And, of course, welcome Vikram and this was your baptism of fire here in the earnings call. So thank you very much and welcome to the role and looking forward to it.
Vikram Luthar: Thank you so much, Juan.
Michael Cross: Thank you everybody for joining us today. Slide 12 notes upcoming investor events in which will be participating. I will also note that our annual sustainability report, which will detail our significant progress and our bold ambitions across the value chain is scheduled to be published in May. As always, please feel free to follow-up with me if you have any other questions. Have a good day. And thanks for your time and interest in ADM.
Operator: Thank you everyone for joining us today. This concludes our conference call. You may now disconnect your lines. | [
{
"speaker": "Operator",
"text": "Good morning, and welcome to the ADM First Quarter 2022 Earnings Conference Call. All lines have been placed on a listen-only mode to prevent background noise. As a reminder, this conference call is being recorded. I would now like to introduce your host for today's call, Michael Cross, Director of Investor Relations. You may begin."
},
{
"speaker": "Michael Cross",
"text": "Thank you, Emily. Good morning and welcome to ADM's first quarter earnings webcast. Starting tomorrow, a replay of today's webcast will be available at adm.com. Please turn to Slide 2, the company's Safe Harbor statement, which says that some of our comments and materials constitute forward-looking statements that reflect management's current views and estimates of future economic circumstances, industry conditions, company performance and financial results. These statements and materials are based on many assumptions and factors that are subject to risks and uncertainties. ADM has provided additional information in its reports on file with the SEC concerning assumptions and factors that could cause actual results to differ materially from those in this presentation. To the extent permitted under applicable law, ADM assumes no obligation to update any forward-looking statements as a result of new information or future events. On today's webcast, our Chairman and Chief Executive Officer, Juan Luciano, will provide an overview of the quarter and highlight some of our accomplishments; our Chief Financial Officer, Vikram Luthar, will review the drivers of our performance as well as corporate results and financial highlights. Then Juan will make some final comments, and our Vice Chairman, Ray Young, will join us for questions. Please turn to Slide 3. I will now turn the call over to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Michael. This morning, we reported first quarter adjusted earnings per share of $1.90. Adjusted segment operating profit was $1.6 billion. Our trailing four quarter adjusted EBITDA was about $5.3 billion, and our trailing four quarter average adjusted ROIC was 10.6%. What we saw in the first quarter was an extension and amplification of the factors that supported our growth in 2021. First was our team's great execution. Exceptional growth in nutrition and effective risk management exemplified how we continued to serve our customers and provide nutrition around the globe amid volatile market conditions and an inflationary environment. Second was an environment of tight supply and demand. We operated in the first quarter in a constrained supply environment for crops, mostly driven by the smaller South American crop, and for other products driven by some continued supply chain and labor availability issues. And we continued to see solid global demand across most of our products and in most regions. While the pandemic is not over and we're particularly monitoring the impact of rising cases and lockdowns in China, much of the world continued to emerge. Pent-up demand remained solid, even in the phase of higher prices. The great work our team did was in service to our customers, our company and our purpose. Our company has come together once again in the wake of the unprovoked and unjustified invasion of Ukraine. ADM has about 650 colleagues in Ukraine, and of course, our highest priority continues to be supporting and protecting them and their families as well as helping Ukrainian farmers to get as much of their crop production as possible into world markets. Our thoughts and prayers remain with the people of Ukraine. Slide 4, please. Food security is foundational to ADM's purpose and beliefs and recent events have only magnified its importance. From a global pandemic to the short crop in South America to the conflict in Ukraine, it has become clear that we cannot take an abundant and efficient supply of food for granted. Even beyond the current dislocations, this issue will remain one of critical importance over the next many years. As the global population grows, the need for nutrition will continue to grow with it. At our Global Investor Day last December, we talked about how we expect demand to push global trade flows of corn, wheat, soybeans and soybean meal up 21% or 130 million tons in the next 10 years. Meeting that demand will not happen automatically. It will take dedication, expertise and agility as well as global scale and capabilities. An example of that is ADM's destination marketing network, which gives us a presence in more regions where demand is strong and growing as well as more direct connections to customers and the ability to offer the full end-to-end capabilities of our integrated value chain. We are seeing how important that is today as customers are coming to us knowing that they can rely on ADM to meet their specific needs in a supply-constrained environment. We are not immune to the impacts of global disruptions, including those in the Black Sea region, but our broad portfolio of nutrition products and our ability to efficiently move them around the world will allow us to manage through these dynamic market conditions and continue to help support the food needs of billions of people. Please turn to Slide 5. Sustainability is another one of the global trends, so important to our companies and our planet's future. We remain focused on our strategy, which is aligned with fast growing demand for an array of products that are environmentally friendly, including alternative proteins. That industry continues to show impressive growth. Global sales for alternative meats and dairy products are expected to increase 14% annually, reaching is targeting $125 billion by 2030. When you look at the full range of products that alternative proteins could go into from meat alternatives and meat extensions to emerging categories like ready meals and specialized nutrition, the opportunities are even greater. Our own growth in this area is faster than the industries. The quality of our product, our integrated end-to-end value chain, our innovative product development and application capabilities and our global scale make us the partner of choice for our customers. In fact, we never had a stronger demand for our alternative protein products than we are seeing now and we are confident in continued growth. That is why earlier this month, we announced a significant investment to nearly double extrusion capacity at our Decatur, Illinois specialty protein complex. We also announced the industry's first end-to-end alternative Protein Innovation Center. This, of course, follows up on last year's addition of leading European alternative protein provider, Sojaprotein. Alternative proteins are just one of the many areas in which we are expanding our capabilities to meet growing customer demand for more environmentally responsible products. Our Biosolutions team, for example, continued to expand its pipeline and advance the evolution of our Carbohydrate Solutions business with an impressive $55 million in revenue growth in the quarter. Please turn to Slide 6. We are advancing sustainability commitments in other parts of our business as well. Last year, we unveiled new goals to reduce its Scope 3 emissions and eliminate deforestation from our supply chain. This is critical work. We do not make these kinds of commitments without an achievable plan to meet them. And once we move forward, we constantly challenge ourselves to do it faster. That is why last week, we announced that we've accelerated our deadline for a completely deforestation free supply chain by five years from 2030 to 2025. We also recently committed to work with the science-based targets initiative with the goal of obtaining their approval of ADM's climate targets and our alignment with ambitious global goals to limit rising temperatures to 1.5 degrees Celsius. Across ADM, we are continuing to align our portfolio with the world's growing needs and with our own purpose, positioning us to serve our customers, our communities and our planet and powering our future. I'll discuss our business outlook at the end of our call, but in the meantime, I'd like to turn to Vikram to talk about our business performance. Vikram?"
},
{
"speaker": "Vikram Luthar",
"text": "Thanks, Juan. Slide 7 please. The Ag Services and Oilseeds team effectively manage risk and executed exceptionally well in a dynamic environment of robust global demand and tight supply, driven primarily by the short South American crop. Ag Services results were significantly higher versus the first quarter of 2021. Global Trade results were higher, driven by strong performances in destination marketing and global ocean freight. North American origination margins and volumes were lower year-over-year, including approximately $75 million in negative timing effects, which will reverse in the coming quarters. Crushing was higher year-over-year in a strong global margin environment, driven by robust protein and vegetable oil demand. Improving margins in the quarter resulted in approximately $60 million in negative timing effects, which will reverse in the coming quarters versus approximately $50 million in positive timing in the prior year quarter. Refined products and other results were much higher than the prior year period, driven by healthy refining premiums and good refined oils demand in North America, as well as strong biodiesel margins in EMEA. Equity earnings from Wilmar were significantly higher versus the first quarter of 2021. Looking ahead, we expect substantially higher Q2 AS&O results than the second quarter of 2021. Slide 8 please. Carbohydrate Solutions delivered substantially higher year-over-year results. The Starches and Sweeteners subsegment including ethanol production from our wet mills delivered much higher results versus the prior year quarter, driven by higher corn co-product revenues, improved citric acid profits and excellent risk management in North America, higher volumes and margins in EMEA and higher volumes and margins in wheat milling. Sales volumes for starches and sweeteners continued their recovery toward pre-pandemic levels. And as Juan mentioned, our biosolutions platform continue to deliver impressive growth with $55 million in new sales as demand for plant-based products expands into more diverse applications. Vantage corn processes delivered solid execution margins, but position losses on ethanol inventory as prices fell early in the quarter, drove lower results versus the prior year. The prior year quarter’s results also benefited from demand for USP-grade industrial alcohol from the Peoria facility, which was divested in Q4 2021. Looking ahead to the second quarter, we expect the current market dynamics to continue delivering carbohydrate solutions results similar to the very strong second quarter of 2021. On Slide 9, the nutrition business delivered continued strong profit growth. Revenues increased by a very impressive 23%, even when adjusting for currency effects and removing the impacts of recent acquisitions revenue was up by 17%. And while margins have softened somewhat they remain healthy. Human Nutrition delivered higher year-over-year results. Flavors continued to deliver solid revenue growth, offset by some higher costs. Strong sales growth in alternative proteins, including contributions from our Sojaprotein acquisition, and positive currency timing effects in South America, offset some higher operating costs to help deliver better year-over-year results in Specialty Ingredients. Health and wellness results were was also higher year-over-year, powered by continued growth in probiotics, including our late-2021 Deerland Probiotics acquisition, and robust demand for fiber. Animal nutrition profits were nearly double the year-ago period, due primarily to strength in amino acids, driven by a combination of product mix changes, improved North American demand and global supply chain disruptions. Looking ahead, we expect nutrition to deliver as second quarter significantly higher than the prior year period. And with our recent acquisitions delivering ahead of our expectations, we are raising a profit growth outlook for the full year from 15% plus to 20%. Slide 10, please. Let me finish up with a few observations from the Other segment, as well as some of the corporate line items. Other business results were substantially higher driven primarily by better performance in captive insurance, including reduced claims settlements versus the prior year. Some of the claims settlements that we expected to negatively impact Q1 results are now expected in the second quarter. Net interest expense for the quarter was higher year-over-year on higher expense for long-term debt, higher short-term borrowings to support working capital needs and interest-related to a tax item. In the corporate lines, unallocated corporate costs of $209 million were due primarily to higher IT operating and project related costs and higher costs in the company’s centers of excellence, partially offset by incentive compensation, accrual adjustments. The effective tax rate for the first quarter of 2022 was approximately 16%. For the full year, we are now anticipating an effective tax rate at the higher end of our previously guided range of 16% to 19%. Cash flow generation remained strong $1.6 billion before working capital changes versus $1.2 billion in the prior year period. Our balance sheet remained solid with a net debt to total capital ratio of about 34% and available liquidity of about $9.3 billion, even with almost $3 billion in higher working capital needs since December. With that, I’ll turn it back to Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Vikram. Slide 11, please. After a strong start of the year, we are looking ahead. In the near-term future, we expect lower crop supplies caused by the weak Canadian canola crop, the short South American crops, and now the Black Sea disruptions to drive continued tightness in global grain markets through 2022 well into 2023 and perhaps beyond. As we look further ahead, markets will continue to reflect the importance of the enduring global trends that are fueling performance across our portfolio, including a growing global population, driving expansion in demand for food and healthy nutrition. That is why the work we’ve done to build a better ADM is so important. We have the global integrated network, risk management capabilities and diverse product portfolio to help us navigate through tight market conditions and meet global nutritional needs. This is the challenge we expanded, improved and repositioned our business to meet. And we’ll continue to advance our strategy and grow our capabilities through our productivity and innovation initiatives in order to drive performance under our control and deliver on the evolving needs of our customers, but it doesn't stop with ADM. Our working with other participants across the food and agriculture value chain, from farmers who continue to do more every year to sustainably increase production, to technology providers who offer new ways to make more with less, to governments who in a tight supply and demand environment, should resist the impulse to impose export restrictions. So looking at the balance of the year, when we combine the strategic work we have done to align our portfolio with fundamental global trends with our strong execution and the expectation of a continued tight supply-demand environment, we expect 2022 results to substantially exceed 2021's. And as we look further ahead to a future of increasing needs for more and better foods, we will continue to work to add new adjacent products to address the world's toughest challenges and unlock the power of nature to enrich the quality of life. Once again, I'd like to thank our colleagues around the globe for their commitment and hard work to serve vital global needs in a challenging and dynamic environment. With that, Emily, please open the line for questions."
},
{
"speaker": "Operator",
"text": "Thank you very much. We will now begin the question-and-answer session. In the interest of time please limit yourself to one question and rejoin the queue for additional follow ups. Our first question today comes from the line of Adam Samuelson with Goldman Sachs. Adam, your line is open."
},
{
"speaker": "Adam Samuelson",
"text": "Yes, thank you. Good morning everyone."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Adam."
},
{
"speaker": "Adam Samuelson",
"text": "Good morning. So I want to – Vikram, I guess, first question just as we think about the current market environment, obviously, a tremendous number of moving pieces. I guess I'm trying to calibrate some of the things that could prove more enduring to the business. And the one that sticks out, I mean, is inflation broadly. And I'm thinking about energy costs and what that – especially in Europe, thinking about construction costs for new plants. And I'm just trying to think, specifically in oilseeds, how higher operating costs in Europe, higher replacement costs if we're thinking about new builds, how that might be impacting oilseed crush margins around the world? And do you think that has a bit longer tail to it? And I would think that benefits you, given your footprint is principally in the Americas."
},
{
"speaker": "Vikram Luthar",
"text": "Yes, Adam, thanks for the question. Yes, in terms of energy costs, clearly, we are not immune to that and we've seen an elevation in energy costs. As you well know, we have a program to actively hedge our program. So I think to a large degree, we've been successful in doing that. Nevertheless, in places like Europe, where energy costs have been significantly elevated, yes, that's had an impact on net margins. But as you look at the broader dynamics, we continue to see very strong outlook in terms of vegetable demand as well as protein demand. And as you see, most of the grain flows, given what's happening around the world particularly in the Black Sea region and the short South American crop moving to North America that should actually support us in terms of our footprint. So the structural changes associated with RGD remain very much in intact. So we think longer term, we feel very confident about the move higher that we cited in the Global Investor Day in terms of crush margins. And for 2022, in particular, we see even farther – even more strength, given some of the near-term dynamics I just referenced."
},
{
"speaker": "Adam Samuelson",
"text": "Okay. That's helpful. And then I guess the second question is more on capital, on the balance sheet, and I think it was impressive to see in the quarter the growth in inventories, yet the committed credit capacity basically being unchanged from year-end. And I'm wondering how you think about that as a strategic asset and the opportunities it presents both in terms of merchandising and risk in the short-term, but also if the M&A pipeline is maybe improving as some others may not have the liquidity that you do in the current high commodity environment?"
},
{
"speaker": "Vikram Luthar",
"text": "Yes, Adam, we clearly view our balance sheet as a competitive advantage. And in terms of capital allocation, we've talked about this before. Our capital allocation is inextricably linked to our strategy. In terms of the guidelines, in terms of the framework, we've articulated about 30% to 40% of our cash flow as we'll direct towards capital expenditures and the remaining 60% to 70% for strategic growth investments. And given our balance sheet flexibility, we are clearly in a position to undertake some of those growth investments, including M&A, if that becomes attractive, but also shareholder distributions, including 30% to 40% towards dividends. As we cited in Global Investor Day, we expect dividend payouts to be actually at the higher end of that 30% to 40% range in the near to medium term. But at the end of the day, if you step back, think about the operating cash flow we generated, $1.6 billion in Q1. So we should be in a position to conduct meaningful buybacks as well in the medium term, as we noted in the Global Investor Day. In the near term, we will repurchase shares to at least offset dilution."
},
{
"speaker": "Adam Samuelson",
"text": "Great. And that color is all really helpful. I'll pass it on. Thank you."
},
{
"speaker": "Operator",
"text": "Our next question is from Ben Theurer from Barclays. Ben, please go ahead."
},
{
"speaker": "Ben Theurer",
"text": "Yes, perfect. Thank you very much. Juan, Vikram, congrats on the strong results. I wanted to ask a question around just the global freight and global trade environment, and obviously, with some of the backlog that's been caused on unloading ships over in China because of all the lockdowns. Have you seen or are you seeing any incremental disruptions over the last couple of weeks that you think is going to cost greater opportunities for you guys within the next coming weeks to excel here and to ultimately deliver a strong quarter on the ex-service piece, just similarly what we saw already in 1Q?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you Ben and good morning. Of course, we've been dealing with supply chain issues for a while, and I think that the situation in China has nothing more than just bring back more challenges, if you will. We see the number of ships in congestion, if you will, from Capesize, Panamax, Supramax and Handysize have increased over the last week, increases about 10% give or take depending on the category. So I think that's especially complicated as you see that because of the different conflicts and different shortages in crops that we have, some of these trading flows around the world that are being redirected. So you redirect trading flows with maybe less ship availability and higher freight and longer travel times. So the situation continues to be dire. And that's why it's so important to have a team, a global team, very active with many options to provide supply and then to reach different destinations. So the combination, if you will, of our global trade with the destination marketing and all that becomes more and more important every day for customers around the world."
},
{
"speaker": "Ben Theurer",
"text": "Okay. Perfect. Thank you very much. I'll leave it here so you can stay on track."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ben."
},
{
"speaker": "Operator",
"text": "The next question comes from the line of Tom Palmer with JP Morgan. Tom, please go ahead with your question."
},
{
"speaker": "Tom Palmer",
"text": "Good morning and thank you for the question. Maybe just follow up on the outlook for the second quarter in the AS&O segment, maybe just a little commentary on the subsegment expectations. Are you expecting year-over-year profit increases across all three of the subsegments? Are there any to call out of particular strength?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. I would say our first quarter was – showed strength across the three businesses, very good performance. And as we look at Q2, probably we see the same. There was some reduction in exports in Ag Services in the first quarter because of weather issues and some of that has been moved into the second quarter, so we have a good book there. China has put some orders also for corn Q2 and Q3. We expect the crush profits to continue to be very strong in the second quarter, certainly, refining margins also very good. So I would say demand has been domestically strong for soybean meal in North America and certainly a lot of demand around the world for that. So, we continue to see crush very well supported by the oil and the meal. We continue to see demand for our exports in the second quarter. So had the window of exports of North America, we will have expanded a little bit. And certainly, the refining materials are – they've maintained very strong margins. If you look at last year, we entered into Q1 with low margins and we ended with strong margins. This year has been strong margins across the quarter and we expect that to continue into the second quarter."
},
{
"speaker": "Tom Palmer",
"text": "Great. Thank you."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Tom."
},
{
"speaker": "Operator",
"text": "Our next question comes from Ken Zaslow from Bank of Montreal."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ken."
},
{
"speaker": "Operator",
"text": "Apologies, we have lost Ken from the queue. So next in the queue we have Ben Bienvenu from Stephens. Ben, your line is open."
},
{
"speaker": "Ben Bienvenu",
"text": "Hi, thanks. Good morning everybody."
},
{
"speaker": "Juan Luciano",
"text": "Good morning, Ben."
},
{
"speaker": "Vikram Luthar",
"text": "Good morning."
},
{
"speaker": "Ben Bienvenu",
"text": "I want to ask about the nutrition business. Strong results in the first quarter, you noted it, versus the prior expectation of 15% plus, now 20% growth for the year. You called out acquisition contribution or the performance of acquisitions. Is that a fair breakdown of organic versus inorganic growth, thinking about maybe 15% organic growth plus 5% inorganic? Or how would you delineate between the two contributing factors?"
},
{
"speaker": "Vikram Luthar",
"text": "Well, so as we talked about – I referenced in my comments, Ben, the revenue growth, right, was 23%. And if you exclude M&A and adjusted for FX, it was 17%, so strong revenue growth frankly across Human Nutrition and Animal Nutrition. The reason our profits were stronger than what we had guided in Q4 were threefold. One is, we did expect some upfront costs that we cited and we had anticipated inflationary cost pressures and supply disruptions. However, with the smart pricing and active supply chain collaboration with our AS&O carb solutions teams, we manage these very well across all the nutrition businesses. The other aspect as we talked about industry-leading win rates in our Global Investor Day, actually our win rates are even expanding beyond that. And the second point is, as you referenced, the OP contribution from our M&A were actually higher than expected. The third point is amino acids. Because of the deliberate switch we mad e from dry to liquid lysine last year, combined with the strong North American protein demand and the supply chain disruptions, our contribution from amino acids business was actually higher. So really, it's a reflection of those three factors that resulted in higher than expected nutrition profit for Q1."
},
{
"speaker": "Ben Bienvenu",
"text": "Okay, great. I'll get back in the queue. Thanks."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ben."
},
{
"speaker": "Operator",
"text": "We do have a question on the line now from Ken Zaslow with Bank of Montreal. Ken, please go ahead."
},
{
"speaker": "Ken Zaslow",
"text": "Hi, good morning guys."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ken."
},
{
"speaker": "Vikram Luthar",
"text": "Good morning."
},
{
"speaker": "Ken Zaslow",
"text": "When I think about longer term, you guys set out two targets: one, high single-digit growth, and then the $6 to $7 outlook by 2025. Given the operating environment, I know you just literally just put this out, so it's hard to change it on a change of environment. But how do you see that? Do you think that the growth rate is higher? Or do you think that the ability to get to the $6 to $7 comes earlier than expected given the favorable operating environment?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Ken. Good question. Listen, when we put the plan in front of shareholders in December, we're just mostly to explain how our company and our business model and portfolio continues to evolve, aligning ourselves with markets of higher growth rates and actually higher margins. And so, what we can control, as you can imagine, is a portfolio, capital allocation and our execution, so we focus on that. So directionally, we're going into that, and we just put a milestone there to have a reference for investors. Of course, at this point in time, we're going to hit those numbers earlier. It is obvious. But I think we don't worry that much of the pace. It's more important for us the direction we're going is higher margins, higher growth rates. The pace sometimes is dictated for outside events in which our team and their execution are supposed to capitalize as much as possible into them. So do you ask me, it's going to be $6 to $7 in 2025, certainly, is going to happen sooner than that. But again, I think it's important to keep the team continue to build that better company with Vikram's explain how we have generated $1.6 billion of cash flow in this, that gives us much more optionality on how much to accelerate that shift of the company into higher margin and higher growth rates. And to be honest, after we have created nutrition and nutrition – we continue to upgrade targets, even if they make $700 million last year. We are now focusing on building the next scale business. We're looking at microbial solutions and how that will drive the next generation of food and proteins. We are looking at climate solutions or biosolutions, which will drive the next generation of sustainable products and also microbiome modulators, which with the pre, pro and post biotics will drive personalized health and nutrition. And let me remind you and the shareholders, contributions for all these three elements that we're thinking on building was basically muted during the forecast that we showed in the December Global Investor Day. So we feel pretty good about the existing business is delivering $6 to $7 maybe earlier than expected, but we have in the capabilities to build the next scale business for ADM."
},
{
"speaker": "Ken Zaslow",
"text": "Great. And then my follow-up question is, when I think about the renewable diesel and the way it's going to happen. And with the backdrop of inflation, how does the balance between the renewable diesel kind of going versus the potential for inflation to curtail that, where do you see that renewable diesel already, the horse is already out of the barn that momentum as we continue versus is there a potential that the inflation can kind of either elongate the timing of it or delay anything. And then I'll leave it there and I appreciate your time."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Ken. Good questions as always. Listen, first of all, let me say on that, I'm very proud that our team, and remember, when we announced speeded with, we said we've been looking at that for two years. So we took into considerations, all of these aspects. And so our product remains to be remains on schedule to deliver on the harvest 2023. So most important, what we can control that project is going well and we managing through inflations and delays. So proud of the team there. Listen, at the end of the day, we still expect the significant new capacity will come online. Of course, when there are so many announcements in any industry, you're going to have the percentage of that being coming on a stream. I think that there may be somebody ability on the timing of all that, it doesn't escape anybody that there are labor availability issues, especially in the U.S., certainly raw materials, whether it is a steel or energy or whatever are more expensive than whenever some of these things were announced. And maybe the builders of these hedge, the raw materials exposure to both things in anticipation but I will say, if there is some delay, it may not be bad to allow crush expansions to actually come on a stream. So they can provide the soybean oil for all these plants to run and we also wait for canola to have a path to that. So I think, listen, the industry will develop, it may have some short-term issues here or there, but at the end of the day, a significant piece of new demand for soybean oil is being built and will be built."
},
{
"speaker": "Ken Zaslow",
"text": "Perfect. Thank you very much."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, ken."
},
{
"speaker": "Operator",
"text": "Our next question is from Steve Byrne from Bank of America. Your line is open."
},
{
"speaker": "Steve Byrne",
"text": "Yes, thank you. Given those comments you just made there Juan about the outlook for renewable diesel and you also had comments in your slide deck about your own views about the demand growth for alternative meat and dairy, which could potentially lead to less demand for soybean meal. I'm curious to hear your own view on, do you see any challenge here meeting what might be a disparate growth in demand for the oil versus the meal side of all of these crush plants that are going to be built."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Listen, it's a very good question. And we look at that, of course, with a lot of attention. I think right now, when we see the capacity coming, it's all capacity needed actually to supply the growth of protein around the world. We see North America with very strong domestic demand for meal, but we see also in North America soybean meal being the most competitive around the world. Especially now, when you have issues in Argentina with some changes in the deal when you have short crops in South America, like we have had and we continue to have a strong demand. We see also that customers are relatively open, so there's not a lot of inventory in the chain that are one point needs to be flushed out. And when you look at, what's happening with feed and competitive feeds, certainly wheat given the conflict in Ukraine, the unfortunate conflict in Ukraine. Wheat prices needs to go up high enough that they get out of the feeding Russians, so they can be preserved to feeding people. When you take that up, you bring corn, the most effective carbohydrate and corn immediately brings soybean meal into the Russian. So we're not only see strong demand, but we see high inclusion rates staying. And again, given the strong leg of soybean oil in North America that will make soybean meal the most competitive in the world. So we actually are very positive about that demand and we think that we need all the expansion to match the market share that soybean meal North America will take from the rest of the world."
},
{
"speaker": "Steve Byrne",
"text": "Thank you, Juan. Maybe just one more on the oil side and that is, what do you see as the global impacts of Indonesia's ban on palm oil exports. How does that affect the global supply of oil and your business in particular?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Oils have been tied for several months already, if not the year and of course, any announcement in the proximity also of the largest producer of palm oil in the world rattles the markets. Of course, it was immediately clarified that this doesn't include crude palm oil, which is the biggest product. So I would say, I think Indonesia is just trying to take a short-term palliative for their domestic inflation. I don't think it will significantly alter the global balances. Although, the global balance is continue to be very tight and any disruption, we have the Ukrainian disruption of course with and the Russian with sunflower oil so this is an area that everybody has to pay a lot of attention and it will require companies like ADM to having the ability to reformulate, so we can take some customers that our existing customers or either palm oil or sunflower oil to have alternatives to continue to supply their customers. So we are seeing that through our Olenex joint venture, we're seeing that through our Stratas joint venture. So as we’ve seen the opportunity to add a lot of value to some of the customers that are looking for replacements at this point in time."
},
{
"speaker": "Steve Byrne",
"text": "Thank you."
},
{
"speaker": "Operator",
"text": "Our next question comes from Robert Moskow from Credit Suisse. Robert, please go ahead with your question."
},
{
"speaker": "Robert Moskow",
"text": "Hi, thank you. I was wondering if you could give us a little insight into your visibility into crush margins in the second half of this year. Are your customers locking in their commitments for demand and supplying you yet? And can you use that to lock-in those margins. And then I had a quick follow-up if I could."
},
{
"speaker": "Juan Luciano",
"text": "Sure. Yes, Rob. As I said, I think that we have very strong visibility of course into Q2. I would say further than that, I think customers – the markets are inverted. So customers see prices relatively high right now, those customers that are not covered, they feel like maybe the course is showing them that they can get covered later at the cheaper rate than today. So I would say, in general, we have coverage for the next quarter, not for Q3 or Q4. But when we look at the demand that we are seeing around the world, we think that when you think about meal and oil, in general, not only North America, but also Brazil. The crush margins need to be there to encourage the crushers to crush. We need the demand for oil and we need the soybean meal. So you will have to have the demand, the crush margins to incentivate people to crush. And we are seeing that with the margins that are happening in Brazil or the U.S. or Europe, all our margins today are higher than what we anticipated. And we think that that's the year rollout and demand continues to be solid out there and strong, crush margins will continue to send that signal to all of our crushers, which is we need the meal, we need the oil keep crushing."
},
{
"speaker": "Robert Moskow",
"text": "Got it. And just a follow-up, you mentioned ocean freight being a big benefit. And I think it had to do with some redirecting of ships in China related to lockdowns. But I'm sure, it also has to do with just overall moving freight from one destination to another and shifting directions. Can I assume that is a big benefit to you and that could continue for the rest of 2022 or is it kind of like more episodic in nature."
},
{
"speaker": "Juan Luciano",
"text": "Rob, we have – as part of our global trade group, we have a strong ocean freight group and they work hand in glove to make sure that we continue to serve the customers with the most effective destinations, the most efficient destinations. So we are a big player. And as a big player with a lot of resources, we tend to have a relative advantage to others. So when things get complicated and right now, they are very complicated. We tend to have a relative higher competitive advantage than others. So I think that shows in the margins that we obtained in this. And logistics right now are complicated. They are complicated in the river. They are complicated in the oceans and there is a lot of redrawing of trade flows and you can only redraw a lot of trade flows, if you have a lot of origin options and a lot of destination options, because you need to connect both. And our ocean freight group counts with that blessing, which is ADM originating all the key parts of the world. I have destination units in all key parts of the world. So it provides them with more ability to play supply routes than maybe other players."
},
{
"speaker": "Operator",
"text": "Our next question comes from Vincent Andrews from Morgan Stanley. Vincent, your line is open."
},
{
"speaker": "Vincent Andrews",
"text": "Thank you, and good morning, everyone, and congratulations to Vikram and Ray on your new roles. And Ray, it was great to work with you all those years. Juan, could I ask you just to talk a little bit about, how you're thinking about the consumer and consumer demand, maybe particularly in Europe, but I guess, also globally. Just given we have a lot of food inflation, we have lot of energy inflation. What do you think gives clearly we need to destroy some demand just given how tight suppliers. But how are you thinking about that equation this year into next year?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Listen, we are paying, of course, close attention to that. At this point in time, we haven't seen any significant impact on demand for us. If you think about so far customers are paying higher prices, but they still, especially in North America, they still haven't changed their behaviors. We think that, of course, if you have disposable income suffering from higher gas prices and higher food prices eventually, they will have to adjust. We have seen more to be honest, Vincent, in the – some of the emerging markets in which may be food is a bigger percentage of their disposable income. So we have seen some adjustments, a small adjustment in that. But I would say, at this point in time, we have not seen any relevant or material adjustment to our demand. And we think that given the pent-up demand that existed from recovery of the coming out of COVID, people, in general, have been – having higher saving rates. And we have seen wage inflation around the world that have gotten more money in the pockets of many. So at this point in time, we think consumer has been and demand has been very resilient. But there’s going to be a point in which disposable income will get tight and we will see some changes into that. We haven’t seen it yet. We don’t see it in the immediate future either."
},
{
"speaker": "Vincent Andrews",
"text": "Okay. Thanks guys."
},
{
"speaker": "Operator",
"text": "Our next question comes from Michael Piken from Cleveland Research. Michael, please go ahead."
},
{
"speaker": "Michael Piken",
"text": "Yes. Hi. I was wondering if you could talk a little bit about the impact of the ADM crew here in the U.S. as well as internationally and what that might look like in terms of the impact for meal demand."
},
{
"speaker": "Juan Luciano",
"text": "Yes. Listen Michael, we haven’t seen at this point in time any significant impact to our poultry demand in North America. The numbers at this point in time seems to be about half the size of the issue that was in 2015. So it’s something we are following very closely. Of course, but we cannot say that we have an impact so far. And hopefully this virus are difficult to control. So of course, there is a lot of sanitary elements being thrown at that, hopefully, that will placate. But we will have to keep a close eye to them."
},
{
"speaker": "Michael Piken",
"text": "Great. And a follow-up question is just shifting gears. Are you concerned about the movement of fertilizer throughout the world? I know you have a fertilizer business. But beyond that just the impact if we do end up in a really tight grain environment, are you – how do you think there is a food versus fuel debate. How do you see that sort of playing out? And is there any risk to the ethanol volumes or the growth in biodiesel or how do you sort of see that playing out. Thanks."
},
{
"speaker": "Juan Luciano",
"text": "Yes. On fertilizers, to be honest, Michael, of course, fertilizer supply chains are tight and it’s been highly publicized. However, our evidence shows that trade lanes are adopting and markets are getting sufficient supplies of fertilizer. Of course, we had much higher prices that will drive prices for grain. I think today, especially Brazil – the U.S. certainly have the fertilizer for this crop. So the question is the Brazilian crop, which is coming in a few months. And I think it is still possible what we get from our people in Brazil to get enough potassium fertilizer in country by the planting season. And of course, any shortages can produce production losses. But at this point in time, when people are thinking between maybe 15% or 20% less application at that level, we don’t think that we’re going to see a significant change in the production forecast. It is probably more depending on the weather at this point in time and rain than fertilizer application. And the second was on food versus fuel. At this point in time, I think that we are committed to try to help the world with food and the environment. So they’re both axis of the same equation. I would say, they both touch disposable income that I was saying before, if you get ethanol to reduce the cost of gasoline that creates more disposable income to take on food inflation. If you take – if you don’t put any biofuels into gasoline and you pay more for gasoline, then you may get cheaper food, but you have less disposable income there. So, to be honest, I think the molecules react to the prices that they are given in the market given the different regulations and the different values. Well, we try to be as efficient as possible bring in as much of those – as many of those molecules to the market as possible to satisfy everybody. So I think at this point in time, we have seen some corrections in certain biofuels mandates across the world. But in other countries, it has been only a reduction and not an elimination. So this – I think they are short-term things, because we still have the climate crisis, which is a long-term objective that mostly the transportation industry, but also every industry will have to address biofuels, sustainable aviation fuels and all that are a big part of that reduction."
},
{
"speaker": "Operator",
"text": "Our next question comes from Eric Larson from Seaport Research Partners. Eric, please go ahead."
},
{
"speaker": "Eric Larson",
"text": "Yes. Thanks. Congratulations, everybody. And Vikram, I congratulate you on your new role and Ray you as well. I look forward to working with both of you on that. So congrats. So listening to the call today, Juan, I hear as all of us, there is a lot of confusion, there’s lot of moving parts. So when I look back 10 weeks ago, I realized that U.S. grain prices had to move higher in order to even – kind of even begin to maybe ration demand or not, and of course, they’ve moved quite a bit higher. So what I’d really like you to do Juan is, kind of take a 30,000 foot view point here. As we all know price does ultimately ration demand. And the only thing I can see that would maybe through that at this point is maybe global recession or U.S. recession. So can you kind of – I don’t see a lot of demand destruction at this point a little bit from bird flu, maybe it’s 25 million bushels, which is a spit in the ocean. But do you see any significant demand destruction today and including what’s happening in Ukraine. And what they have in storage for corn and other things. What – how do you look at the world today from a demand – total demand perspective versus supply and are we seeing demand destruction with high prices?"
},
{
"speaker": "Juan Luciano",
"text": "Yes. Thank you, Eric. Let me see – let me tell you how I see this. So last year was a big production year and the world needed to consume more grain than that big production. So the issue is, the world continues to grow and sometimes it’s not a matter of population growth, but it’s a matter of income. And how people like – people in China has been an incredible economic improvement of their standards on living that improve their diet, that doesn’t go down. So we think that’s where we keep on talking about our trend of food security. We will have to provide more for the world. In situations like today, where we are already tight from a supply demand perspective and we will get tighter as demand continues to grow. We see here in ADM that at least we need two very good seasons of crops in North America and South America to actually balance and become more comfortable in those supply-demand balances. When we think about prices today, prices today are going up to mark three things that needs to happen. One is export prices need to go up to being able to draw out all the inventories that are stuck there or they are safe, they are hoarded there to be able to replace the production that we have lost. The production we have lost in South America, but the production we are losing now in the Ukraine and Russia. So first, you need to draw out those inventories and bring them into market. So we can balance ourselves. The second, as I said before, wheat needs to be placed out of the Russians. So you can be preserved for human consumption. And the third one is to give farmers like you, the signal that they need to plant more and I think the world need more acres. Those acres today, they are not going to happen from the Baltic area, they are not going to happen from U.S. that we are basically maxed out. So they may happen in South America. So we need higher prices to bring South American acres, we need higher prices to draw those inventories into the market. And we need two good years of crops, both in North America and South America. That will allow us to balance the supply demand, given the strong demand."
},
{
"speaker": "Eric Larson",
"text": "Yes. And I agree is that – we need this year’s crop in the U.S., next year’s crop in Brazil and we need 2023 in the U.S. to do very well again. And maybe even another – we need four maybe big crops around the world. But sometimes what rebalances some of this is, this high inflation rate we have around the world, there is an economic recession that comes in place. Have you factored anything into that forecast that would change your outlook?"
},
{
"speaker": "Juan Luciano",
"text": "Eric, I’m not an economist. But I think there is a narrow path to achieve a soft landing here. And the U.S. economy has been very resilient through all this events. So I think the U.S. economy is driven by the consumer. The consumer has been saving money for two years that they didn’t spend a lot. And as I said before, they were COVID recovery packages. But there is also been salary inflations and wages inflation that has put money in the pockets of customers. So I think that for the foreseeable future, we don’t see a significant impact of demand. If not, we will be flagging that out, but we look at that, we look at our plans, we are preparing our plans for a long period of the strong demand. We want to run them at high capacity. So at this point in time, I don’t see an issue in the west maybe the only flag is how COVID lockdowns evolve in China. But that I don’t have a lot of visibility at this point in time."
},
{
"speaker": "Eric Larson",
"text": "All right. Thank you, Juan. I appreciate your comments."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Eric."
},
{
"speaker": "Operator",
"text": "Those are all the questions we have time for today. So I will now turn the call back over to Juan Luciano."
},
{
"speaker": "Juan Luciano",
"text": "Thank you, Emily. Before we close our call, I wanted to take a minute to thank Ray for his exceptional contribution all this year to ADM’s as our CFO. So thank you, Ray. And it’s been a pleasure and I’m delighted that you continue with us to continue to help take ADM’s a bigger player."
},
{
"speaker": "Ray Young",
"text": "Thank you, Juan. And also I just want to thank all the investors and all the analysts for really like 11 years in this role, I’ve grown, I’ve learned from you. And hopefully, we’ve been also been able to teach you about ADM and how this is a great company. And the future is incredible for this company and I look forward to continuing support Juan and support the company in my new role. So thank you, Juan."
},
{
"speaker": "Juan Luciano",
"text": "Thank you and congratulations, Ray. And, of course, welcome Vikram and this was your baptism of fire here in the earnings call. So thank you very much and welcome to the role and looking forward to it."
},
{
"speaker": "Vikram Luthar",
"text": "Thank you so much, Juan."
},
{
"speaker": "Michael Cross",
"text": "Thank you everybody for joining us today. Slide 12 notes upcoming investor events in which will be participating. I will also note that our annual sustainability report, which will detail our significant progress and our bold ambitions across the value chain is scheduled to be published in May. As always, please feel free to follow-up with me if you have any other questions. Have a good day. And thanks for your time and interest in ADM."
},
{
"speaker": "Operator",
"text": "Thank you everyone for joining us today. This concludes our conference call. You may now disconnect your lines."
}
] | Archer-Daniels-Midland Company | 251,704 |
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